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311100_1993.txt	311100	1993	Item 1. Business Incorporated herein by reference is the information appearing under the heading "Business of Jefferson Bankshares" on page 4 of the 1993 Annual Report to Shareholders ("1993 Annual Report"). Also incorporated herein by reference is the information on pages 7 through 10 of the 1993 Annual Report as to the distribution of the Corporation's assets, liabilities and shareholders' equity; pages 15 and 16 of the 1993 Annual Report as to the Corporation's investment portfolio; pages 12 through 15 of the 1993 Annual Report as to the Corporation's loan loss experience; pages 11 through 15 of the 1993 Annual Report as to the Corporation's loan portfolio; pages 16 and 17 of the 1993 Annual Report as to the Corporation's deposits; page 19 of the 1993 Annual Report as to the Corporation's return on equity and assets; and page 17 of the 1993 Annual Report as to the Corporation's short-term borrowings. Item 2.		Item 2. Properties Incorporated herein by reference is the information appearing under the heading "Business of Jefferson Bankshares" on page 4 of the 1993 Annual Report and the discussion of premises and equipment in Note 7 (entitled "Premises and Equipment") to the financial statements in the 1993 Annual Report. Item 3.	Item 3. Legal Proceedings There are no legal proceedings against the Corporation that would have a material adverse effect on the Corporation or its financial condition. Item 4.	Item 4. Submission of Matters to a Vote of Security Holders None Executive Officers of Jefferson Bankshares The executive officers of the Corporation are set forth below. All officers are elected annually and, except for Hovey S. Dabney who had an employment contract extending until January 1, 1994, serve at the discretion of the Board of Directors. Except as otherwise noted below, each of the executive officers has worked with the Corporation or its affiliates for at least five years. Hovey S. Dabney, 70, is Chairman of the Board of Directors and, until January 1, 1994, was also Chief Executive Officer. O. Kenton McCartney, 50, is President and Chief Executive Officer. Prior to January 1, 1994, Mr. McCartney was President and Chief Operating Officer. Robert H. Campbell, Jr., 59, is Senior Vice President and Treasurer. Allen T. Nelson, Jr., 44, is Senior Vice President and Chief Financial Officer. Mr. Nelson joined the Corporation on December 6, 1993. Prior to that date, Mr. Nelson was Senior Vice President and Controller of Dominion Bankshares, Inc. from February, 1992 until joining the Corporation. Prior to February, 1992 he served as Finance Executive Officer with C&S/Sovran Corporation. Walter A. Pace, Jr., 61, is Senior Vice President. Donald W. Fulton, Jr., 47, is Vice President-Investor Relations. William M. Watson, Jr., 39, is Vice President and Secretary. Mr. Watson joined the Corporation on May 13, 1991. Prior to that date, he was an attorney with McGuire, Woods, Battle & Boothe. Part II Item 5.	Item 5. Market for the Registrant's Common Stock and Related Shareholder Matters Incorporated herein by reference is the information on page 18 under the heading "Capital Resources" and in the table captioned "Common Stock Performance and Dividends" on page 19 of the 1993 Annual Report. Incorporated herein by reference is the discussion of restrictions on the payment of cash dividends in Note 8 (entitled "Long Term Debt") to the financial statements in the 1993 Annual Report. Item 6.	Item 6. Selected Financial Data Incorporation herein by reference in the information in the table captioned "Selected Financial Data" on page 5 of the 1993 Annual report. Item 7.	Item 7. Management's Discussion and Analysis and Results of Operations and Financial Condition Incorporated herein by reference is the information appearing under the heading "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 5 through 20 of the 1993 Annual Report, except for the information in the tables captioned "Selected Financial Data," "Summary of Financial Results by Quarter," and "Common Stock Performance and Dividends" on pages 5, 6 and 19, respectively, of the 1993 Annual Report. Item 8.	Item 8. Financial Statements and Supplementary Data Incorporated herein by reference is the information appearing under the heading "Independent Auditors' Report," Consolidated Balance Sheets," "Consolidated Statements of Income," "Consolidated Statements of Changes in Shareholders' Equity," "Consolidated Statements of Cash Flows" and "Notes to Consolidated Financial Statements," on pages 21 through 34 of the 1993 Annual Report. Incorporated by reference is the information in the table captioned "Summary of Financial Results by Quarter" on page 6 of the 1993 Annual Report. 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 Registrant The information concerning the Corporation's directors is incorporated by reference to the section entitled "Nominations for Directors" on pages 4 through 6 of the Corporation's definitive Proxy Statement for the 1994 Annual Meeting of Shareholders. The information concerning the Corporation's executive officers is incorporated by reference to Part I hereof entitled "Executive Officers of Jefferson Bankshares." Item 11.	Item 11. Executive Compensation The information required by this item is incorporated by reference to the sections entitled "Compensation of Executive Officers and Directors" on pages 6 through 15 of the Corporation's definitive Proxy Statement for the 1994 Annual Meeting of Shareholders. Item 12.	Item 12. Security Ownership of Certain Beneficial Owners and Management The information required by this item is incorporated by reference to the sections entitled "Principal Beneficial Owners" and "Shares Beneficially Owned by Directors and Executive Officers" on pages 2 and 3 of the Corporation's definitive Proxy Statement for the 1994 Annual Meeting of Shareholders. Item 13.	Item 13. Certain Relationships The information required by this item is incorporated by reference to the section entitled "Loans to Officers and Directors" on page 15 of the corporation's definitive Proxy Statement for the 1994 Annual Meeting of Shareholders. Part IV Item 14.	Item 14. Exhibits, Financial Statements and Reports on Form 8-K (a) The following documents are filed as part of this report: 1. Financial Statements. The following Consolidated Financial Statements of Jefferson Bankshares, Inc. and subsidiaries and the Independent Auditors' Report are incorporated by reference to pages 21 through 34 of the 1993 Annual Report: Independent Auditors' Report. Consolidated Balance Sheets at December 31, 1993 and December 31, 1992. Consolidated Statements of Income for the years ended December 31, 1993, December 31, 1992 and December 31, 1991. Consolidated Statements of Changes in Shareholders' Equity for the years ended December 31, 1993, December 31, 1992, and December 31, 1991. Consolidated Statements of Cash Flows for the years ended December 31, 1993, December 31, 1992 and December 31, 1991. Notes to Consolidated Financial Statements. 2. Exhibits. The exhibits listed on the accompanying Index to Exhibits immediately following the signature page are filed as part of, or incorporated by reference into, this report. (b) Reports on Form 8-K The Corporation did not file any reports on Form 8-K for the last fiscal quarter covered by this report. Except for the information referred to in Items 1, 2, 5, 6, 7, 8 and 14(a)(1) hereof, the 1993 Annual Report will not be deemed to be filed pursuant to the Securities Exchange Act of 1934. 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. DATE: March 10, 1994 JEFFERSON BANKSHARES, INC. By: O. Kenton McCartney 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. DATE SIGNATURE CAPACITY ---- --------- -------- March 10, 1994 O. Kenton McCartney President, Chief Executive Officer and Director March 10, 1994 Allen T. Nelson, Jr. Senior Vice President and Chief Financial Officer March 10, 1994 Hovey S. Dabney Chairman of the Board March 10, 1994 John T. Casteen, III* Director March 10, 1994 Hunter Faulconer* Director March 10, 1994 Lawrence S. Eagleburger* Director March 10, 1994 Fred L. Glaize, III* Director March 10, 1994 Henry H. Harrell* Director March 10, 1994 Alex J. Kay, Jr.* Director March 10, 1994 J. A. Kessler, Jr.* Director March 10, 1994 W. A. Rinehart, III* Director March 10, 1994 Gilbert M Rosenthal* Director March 10, 1994 Alson H. Smith, Jr.* Director March 10, 1994 Lee C. Tait* Director March 10, 1994 H. A. Williamson, Jr.* Director By: William M. Watson, Jr. Attorney-in-Fact EXHIBIT INDEX Exhibit No. Exhibit 3. Articles of Incorporation and Bylaws: (a) Articles of Incorporation incorporated by reference to Jefferson Bankshares' Annual Report on Form 10-K for 1984. (b) Articles of Amendment to Articles of Incorporation dated May 7, 1987, incorporated by reference to Jefferson Bankshares' report on Form 10-Q for the quarter ended June 30, 1987. (c) Articles of Amendment to Articles of Incorporation dated March 23, 1993, incorporated by reference to Jefferson Bankshares' report on Form 10-Q for the quarter ended June 30, 1993. (d) Amended and Restated Bylaws incorporated by reference to Jefferson Bankshares' Annual Report on Form 10-K for 1991. 4. Instruments defining the rights of security holders including indentures: (a) Articles of Incorporation of Jefferson Bankshares', incorporated by reference to Jefferson Bankshares' 1984 Annual Report on Form 10-K. (b) Articles of Amendment to Articles of Incorporation dated May 7, 1987, incorporated by reference to Jefferson Bankshares' report on Form 10-Q for the quarter ended June 30, 1987. (c) Articles of Amendment to Articles of Incorporation dated March 23, 1993, incorporated by reference to Jefferson Bankshares' report on Form 10-Q for the quarter ended June 30, 1993. (d) Term Loan Agreement dated as of February 1, 1984, between Jefferson Bankshares and Wachovia Bank and Trust Company, N.A., incorporated by reference to Jefferson Bankshares' quarterly report on Form 10-Q for the quarter ended March 31, 1984. (e) Amendments dated September 8, 1988 and September 21, 1989, to the Term Loan Agreement between Jefferson Bankshares and Wachovia Bank and Trust Company, N.A., incorporated by reference to Jefferson Bankshares' quarterly report on Form 10-Q for the quarter ended March 31, 1991. (f) Amendment dated December 20, 1990, to the Term Loan Agreement between Jefferson Bankshares and Wachovia Bank and Trust Company, N.A., incorporated by reference to Jefferson Bankshares' Annual Report on Form 10-K for 1990. 10. Material Contracts: (a) Senior Officers Supplemental Pension Plan, incorporated by reference to Jefferson Bankshares' 1982 Annual Report on Form 10-K. (b) Amended and Restated Employment Agreement dated August 26, 1987, with Hovey S. Dabney, incorporated by reference to Jefferson Bankshares' report on Form 10-Q for the quarter ended September 30, 1987. (c) Amendment dated September 26, 1989 to the Amendment and Restated Employment Agreement with Hovey S. Dabney, incorporated by reference to Jefferson Bankshares' report on Form 10-Q for the quarter ended September 30, 1989. (d) Amendment dated September 26, 1990 to the Amended and Restated Employment Agreement with Hovey S. Dabney, incorporated by reference to Jefferson Bankshares' report on Form 10-Q for the quarter ended September 30, 1990. (e) Deferred Compensation Agreement dated December 18, 1979 with Hovey S. Dabney, incorporated by reference to Jefferson Bankshares' 1984 Annual Report on Form 10-K. (f) Amendment dated September 26, 1989 to the Deferred Compensation Agreement with Hovey S. Dabney, incorporated by reference to Jefferson Bankshares' report on Form 10-Q for the quarter ended September 30, 1989. (g) Incentive Stock Plan, incorporated by reference to Jefferson Bankshares' report on Form 10-Q for the quarter ended June 30, 1985. (h) Amendment dated April 28, 1992 to the Incentive Stock Plan, incorporated by reference to Exhibit 10(f) to Form S-4 of Jefferson Bankshares, Inc., File No. 33-47929. (i) Amended and Restated Deferred Compensation Plan for Directors, incorporated by reference to Jefferson Bankshares' Annual Report on Form 10-K for 1985. (j) Split Dollar Life Insurance Plan, incorporated by reference to Jefferson Bankshares' Annual Report on Form 10-K for 1984. (k) Executive Severance Agreement dated October 25, A 1993 between Jefferson Bankshares and O. Kenton McCartney is filed herewith. (l) Executive Severance Agreement dated October 25, B 1993 between Jefferson Bankshares and Robert H. Campbell, Jr. is filed herewith. (m) Amended and Restated Split Dollar Life Insurance C Agreement dated October 29, 1993 between Jefferson Bankshares and Hovey S. Dabney is filed herewith. (n) Amended and Restated Split Dollar Life Insurance D Agreement dated October 29, 1993 between Jefferson Bankshares and Robert H. Campbell, Jr. is filed herewith. (o) Amended and Restated Split Dollar Life Insurance E Agreement dated October 29, 1993 between Jefferson Bankshares and O. Kenton McCartney filed herewith. 13. Annual Report to Security Holders, Form 10-Q or F Quarterly Report to Security Holders 21. Subsidiaries of the Registrant G 23. Consents of Experts and Counsel H Consent of KPMG Peat Marwick to incorporation by reference of auditors' reports into Jefferson Bankshare's Registration Statement Form S-3 is filed herewith. 24. Powers of Attorney I * Management contract or compensatory plan or arrangement of the Corporation required to be filed as an exhibit.
805019_1993.txt	805019	1993	ITEM 1. BUSINESS. Tenneco Credit Corporation (the "Company") was incorporated in 1981 under the laws of the State of Delaware and commenced operations on October 1, 1984. All of the issued and outstanding capital stock of the Company is owned by Tenneco Inc. The business of the Company relates primarily to financing, on a nonrecourse basis, receivables of Tenneco Inc. and its subsidiaries. The Company's headquarters are located at 1010 Milam, Houston, Texas 77002. The Company has no employees, and employees of Tenneco Management Company, a subsidiary of Tenneco Inc., render all services to the Company which are necessary for the conduct of its operations. PURCHASE OF RECEIVABLES The Company has entered into an agreement (the "Operating Agreement") with several subsidiaries of Tenneco Inc. ("Tenneco Subsidiaries") pursuant to which the Company buys trade receivables generated by the Tenneco Subsidiaries from the sale of goods or services. Each Tenneco Subsidiary, as the Company's agent, makes all collections and services the receivables sold by it to the Company. The Company also may purchase receivables and other assets from subsidiaries of Tenneco Inc. on terms different from those set forth in the Operating Agreement. Under the Operating Agreement, the Company purchases trade receivables from the Tenneco Subsidiaries at a purchase price equal to the trade account balances being acquired less a discount agreed by the Company and the Tenneco Subsidiaries at the time of sale. The average yield for 1993 on retail receivables purchased from Case Corporation ("Case") was 11.4% down from 11.8% in both 1992 and 1991. The discount rate charged on pipeline and other short- term receivables ranged from 5.75% to 6.5% during 1993 and from 6.5% to 8.5% during 1992. Sales of receivables to the Company under the Operating Agreement are without recourse to the selling Tenneco Subsidiaries. Case sells all of its domestic retail receivables to the Company. These receivables arise from sales by stores owned by Case and sales through independent dealers. As an incentive to dealers to assist in assuring the collectibility of their receivables, the purchase price discount includes an amount for possible losses that may arise from their receivables. This portion of the discount becomes payable to the dealers as their receivables are collected and is recorded by the Company as a dealers' reserve. Any loss arising from the uncollectibility of a dealer's receivables is charged against this dealer's reserve; any excess losses would be recorded as a loss by the Company. Generally, trade accounts receivable purchased from Case pursuant to the Operating Agreement have original maturities ranging from 24 months to 60 months. As of December 31, 1993, the weighted average remaining life to maturity of trade accounts receivable purchased from Case was approximately 22 months. Substantially all of the trade accounts receivable purchased from other Tenneco Subsidiaries pursuant to the Operating Agreement have an original maturity of approximately one month. The Operating Agreement does not restrict the maturities of receivables which may be purchased by the Company. As of December 31, 1993, and December 31, 1992, the Company held trade notes and accounts receivable which it had purchased from Tenneco Subsidiaries as follows: See Note 3 to the Financial Statements of Tenneco Credit Corporation and Consolidated Subsidiaries for an analysis of the maturities of the trade notes and accounts receivable held by the Company on December 31, 1993. In addition to purchasing receivables under the Operating Agreement, the Company has acquired, and may acquire in the future, long-term receivables of subsidiaries of Tenneco Inc. As of December 31, 1993, the Company held $121 million of such receivables. Purchases of long-term receivables are not made pursuant to the Operating Agreement, and the terms of such purchases are negotiated on an arm's length basis by the Company and the seller at the time of purchase. TENNECO SUBSIDIARIES As of December 31, 1993, the Company held trade notes and accounts receivable purchased under the Operating Agreement from 12 Tenneco Subsidiaries. The information below is provided with respect to those Tenneco Subsidiaries from which the Company expects to purchase a substantial amount of trade receivables. Case and other subsidiaries of Tenneco Inc. manufacture a full line of farm equipment and light- and medium-sized construction equipment. The business of Case is affected by the general level of activity in the agricultural and construction industries, including the rate of worldwide agricultural production and demand, levels of total industry capacity, weather conditions, exchange rates, commodity prices, levels of equipment inventory and prevailing levels of construction. The markets for farm and construction equipment are highly competitive. Both United States and international manufacturers of farm and construction equipment compete on a worldwide basis in such markets. This could affect the level of trade receivables generated by Case. Tenneco Inc. announced on March 22, 1993, that its Board of Directors adopted a major restructuring program to be implemented at Case. The restructuring program includes rationalizing the production of selected components, consolidating and resizing production capacity and privatization of Case-owned retail stores and restructuring the parts distribution network. Adoption of the restructuring program resulted in a pre-tax charge of $920 million ($843 million after taxes), which was reflected in the 1992 loss from continuing operations. Implementation of the restructuring was commenced in 1993, and various restructuring actions in the program were completed in 1993 and others are in process. The restructuring program is expected to be substantially completed by the end of 1996. Case has advised the Company that the restructuring program will not have a material adverse effect on the volume of trade receivables generated by Case in the future. Tennessee Gas Pipeline Company ("Tennessee") and other subsidiaries of Tenneco Inc. transport gas for, or sell gas to, primarily transmission and distribution companies. Its multiple-line interstate natural gas transmission system begins in the gas-producing areas of Texas and Louisiana, including the continental shelf of the Gulf of Mexico, and extends into the northeastern section of the United States, including the New York City and Boston metropolitan areas. Packaging Corporation of America ("Packaging") and other subsidiaries of Tenneco Inc. manufacture and sell paperboard, corrugated shipping containers, folding cartons, molded fibre products, disposable plastic and aluminum containers and other related products. Its shipping container products are used in the packaging of food, paper products, rubber and plastics, automotive products and point of purchase displays. Its folding cartons are used in the packaging of soap and detergent, food products and a wide range of other consumer goods. Uses for its molded fibre products include produce and egg packaging, food service items and institutional and consumer disposable dinnerware. Its disposable plastic and aluminum containers are sold to the food service, food processing and related industries. OTHER INVESTMENTS The Company owns a 95% interest in a limited partnership which owns a multifuel boiler which is leased to Packaging for use in its paper mill at Counce, Tennessee, pursuant to an agreement designed to return to the Company its investment and a return on investment during the term of the lease. RELATIONSHIP WITH TENNECO INC. The Company's business is substantially dependent upon the level of operations conducted by the Tenneco Subsidiaries. Accordingly, lower levels of sales from such operations could result in a reduction in the level of finance operations of the Company. The agreements described below have been entered into by or among Tenneco Inc., the Company and the Tenneco Subsidiaries and relate to the operations of the Company. These agreements, which are governed by New York law, are enforceable by holders of the Unaffiliated Debt (as defined in the Investment Agreement described below). The following statements are summaries of certain provisions contained in such agreements, copies of which are filed as exhibits to this annual report. They do not purport to be complete statements of all the terms and provisions of such agreements, and reference is made to such agreements for full and complete statements of such terms and provisions. Operating Agreement The Operating Agreement, as amended and restated as of June 15, 1988, provides that purchases from the Tenneco Subsidiaries of notes and accounts receivable owed to the Tenneco Subsidiaries by third parties will be made by the Company at a purchase price equal to the amount of such receivables less a discount determined by the parties at the time of the sale. Under the Operating Agreement, the selling Tenneco Subsidiaries are required to collect the receivables on behalf of the Company and remit the proceeds to it promptly after collection. From time to time, additional subsidiaries of Tenneco Inc. may become parties to the Operating Agreement and begin selling receivables to the Company. The Operating Agreement contains representations and warranties of the Tenneco Subsidiaries to the effect that (i) the amount of receivables purchased will be true and correct at the time of purchase; (ii) at the time of assignment, each receivable will be recorded on the books of the selling Tenneco Subsidiary as an account receivable and will represent a valid and legally enforceable obligation of a person incurred in connection with the sale or lease of a product or service; (iii) each assignment of receivables to the Company will vest in the Company the right, title and interest in and to such receivables and the proceeds of collection therefrom free and clear from claims of third persons; (iv) at the time of assignment, beneficial ownership of such assigned receivable will not have been conveyed to any other person; (v) the receivables assigned to the Company will be free and clear of all liens and encumbrances and will not be subject to any setoff or counterclaim, except as provided by law; (vi) each receivable assigned to the Company will conform with any and all applicable laws and governmental rules and regulations; and (vii) all obligations to be performed by or on behalf of the selling Tenneco Subsidiary in connection with such receivables will have been or will be promptly fulfilled. Each Tenneco Subsidiary has agreed to indemnify the Company for any loss which it sustains as a result of any breach of a representation or warranty. Although each Tenneco Subsidiary has made the foregoing representations, it has not warranted the ultimate collectibility of receivables which it sells to the Company. These representations and warranties do not apply to sales of receivables by Tenneco Subsidiaries which are sold outside of the Operating Agreement. Performance Agreement Tenneco Inc. has agreed, pursuant to a Performance Agreement dated as of June 15, 1988 (the "Performance Agreement"), to guarantee to the Company the due and punctual performance of the obligations of each of the Tenneco Subsidiaries under the Operating Agreement when and as the same shall become due and payable or performable. The obligations of Tenneco Inc. under the Performance Agreement are continuing, absolute and unconditional and are not subject to any defense which might otherwise be available to the selling Tenneco Subsidiary. Tennessee entered into a Performance Agreement dated as of June 14, 1988, which is substantially identical to the Performance Agreement of Tenneco Inc. except that Tennessee guarantees only the obligations of Sellers which are subsidiaries of Tennessee. Investment Agreement Tenneco Inc. and the Company have entered into an Investment Agreement dated as of June 15, 1988 (the "Investment Agreement"). The principal provisions of the Investment Agreement are set forth below. The Investment Agreement contains definitions of certain terms used in the Investment Agreement, including the following: "Affiliated Debt" means Debt owed to Tenneco Inc. or any affiliate of Tenneco Inc. "Debt" means any obligation of the Company or a subsidiary of the Company which in accordance with generally accepted accounting principles would be recorded as a liability on a consolidated balance sheet of the Company and its subsidiaries as of the date that Debt is to be determined. "Fixed Charges" means for any period the aggregate interest expense (whether or not capitalized) of the Company and its subsidiaries for such period including, without limitation, the following: (i) the portion of any obligation under capital leases allocable to interest expense in accordance with generally accepted accounting principles, (ii) the portion of any debt discount that shall be amortized in such period in accordance with generally accepted accounting principles, and (iii) all amounts (other than amounts described in clauses (i) or (ii) above) accrued in accordance with generally accepted accounting principles (whether or not capitalized) by the Company or its subsidiaries for such period in respect of Debt. Notwithstanding the foregoing, no amounts which are applicable to the payment of the principal amount of Debt shall be included in the determination of Fixed Charges. "Senior Debt" means Unaffiliated Debt for money borrowed which is not Subordinated Debt. "Subordinated Debt" means any of the following: (i) Unaffiliated Debt which is subordinate in right of payment to Senior Debt and inferior to Senior Debt with respect to the general assets of the Company, (ii) Affiliated Debt. "Unaffiliated Debt" means all Debt for money borrowed other than Affiliated Debt (Unaffiliated Debt may be either Senior Debt or Subordinated Debt). The principal covenants in the Investment Agreement are as follows: (i) Tenneco Inc. will at all times directly or indirectly own and hold legal and beneficial interest in and to all of the outstanding shares of capital stock of the Company having the right to vote for the election of members of the Company's Board of Directors. (ii) Tenneco Inc. will not, directly or indirectly, sell, exchange, transfer, pledge or in any way encumber or otherwise dispose of any such shares of stock so long as the Company has outstanding any Unaffiliated Debt. (iii) All of the Company's Affiliated Debt will be subordinate and inferior to the following in the manner and to the extent provided below: (a) all Senior Debt, and (b) all Unaffiliated Debt which is Subordinated Debt. In the event of any distribution, division or application, partial or complete, voluntary or involuntary, by operation of law or otherwise, of all or any part of the assets of the Company, or the proceeds thereof, to creditors of the Company, or by reason of any execution, sale, receivership, insolvency or bankruptcy proceedings or other proceedings for the reorganization or readjustment of the Company or its debts or properties, then in any such event Senior Debt is preferred in payment over any Subordinated Debt, and when Senior Debt has been paid and satisfied in full, then all other Unaffiliated Debt which is Subordinated Debt is preferred in payment over all Affiliated Debt, and such Unaffiliated Debt which is Subordinated Debt will first be paid and satisfied in full (pari passu unless a different order or priority of payment is established by any applicable provisions thereof or by any instruments whereunder any Unaffiliated Debt which is Subordinated Debt is issued) before any payments or distribution of any kind or character, whether in cash, property or securities (other than in securities the payment of which is subordinated to said Unaffiliated Debt which is Subordinated Debt to the same extent as herein provided), will be made on or in respect of any such Affiliated Debt. During the continuance of any payment default on Unaffiliated Debt, no payment may be made on or with respect to any Affiliated Debt. No payment may be made on any Affiliated Debt if such payment would constitute a default under the terms of any Unaffiliated Debt. (iv) At all times when the Company incurs Unaffiliated Debt it will own assets in an amount at least equivalent to 125% of the aggregate amount to Senior Debt outstanding after giving effect to the issuance of such Unaffiliated Debt. (v) At no time while any Unaffiliated Debt is outstanding will the Company sell, lease, transfer or otherwise dispose of any of its assets, other than in the ordinary course of its business, if immediately after such disposition its assets would be less than 125% of the aggregate amount of Senior Debt outstanding. (vi) While the Company has outstanding any Unaffiliated Debt, Tenneco Inc. or affiliates of Tenneco Inc. will maintain an investment in the Company (i.e., the aggregate of Affiliated Debt and stockholder's equity) so that the sum of such investment and Unaffiliated Debt which is Subordinated Debt is at least equal to 20% of the sum of the Company's total obligations for debt and stockholder's equity. (vii) The Company will not declare or pay any dividends or make any distributions upon any of its capital stock (other than stock dividends), and neither the Company nor any subsidiaries of the Company will directly or indirectly apply any of their assets toward the redemption, retirement, purchase or other acquisition of capital stock of the Company or any such subsidiary if, immediately after giving effect to any such action, the Company would be unable to meet any of its requirements for the payment of principal of, or interest or premium, if any, on, Unaffiliated Debt. (viii) Tenneco Inc. will pay to the Company a service charge for each month during the term of the Investment Agreement equal to the amount, if any, by which the cumulative earnings of the Company and its consolidated subsidiaries for the period from the beginning of the calendar year to the end of such month, before deduction of Fixed Charges and income taxes (but including in earnings all such service charges previously paid by Tenneco Inc. for such year) are less than 125% of the Fixed Charges. The Company and Tennessee also are parties to an investment agreement which enures to the benefit of holders of Unaffiliated Debt (as defined in that agreement) outstanding on January 14, 1987, and the Company, Tennessee and Tenneco Inc. are parties to another agreement which enures to the holders of Unaffiliated Debt issued after January 14, 1987, and prior to June 14, 1988, and certain holders of Unaffiliated Debt outstanding on January 14, 1987. The principal differences between the two agreements are that (i) under the former agreement the definition of "Debt" does not include obligations of subsidiaries of the Company and (ii) the definition of "Fixed Charges" in the former agreement is limited to that which is charged as an expense on the Company's income statement. Amendments The Operating Agreement, Performance Agreement and Investment Agreement may each be amended or modified at any time by the parties thereto; provided, that (i) no amendment or modification which adversely affects the rights of holders of Senior Debt or Subordinated Debt, other than Affiliated Debt, outstanding at the time of execution thereof shall be binding on or in any manner become effective with respect to such Senior Debt or Subordinated Debt at the time outstanding except with the prior written consent of (a) the holders of not less than 66 2/3% in principal amount of the Senior Debt at the time outstanding if such holders would be adversely affected thereby and (b) the holders of not less than 66 2/3% in principal amount of the Subordinated Debt, other than Affiliated Debt, at the time outstanding if such holders would be adversely affected thereby. ITEM 2.		ITEM 2. PROPERTIES. The Company believes that the multifuel boiler leased to Packaging is well maintained and in good operating condition. This boiler is subject to a mortgage and other security interests which secure indebtedness assumed by a subsidiary of the Company in connection with the acquisition of the boiler. ITEM 3.	ITEM 3. LEGAL PROCEEDINGS. The Company is not a party to any material legal proceedings. ITEM 4.	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Item 4, "Submission of Matters to a Vote of Security Holders", has been omitted from this report pursuant to the reduced disclosure format permitted by General Instruction J to Form 10-K. PART II ITEM 5.	ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. All of the capital stock of the Company is owned by Tenneco Inc. and, therefore, there is no trading market for such securities. See Note 1 to the Financial Statements of Tenneco Credit Corporation and Consolidated Subsidiaries. The Company paid no dividends in 1993. During 1992, the Company declared and paid $45,000,000 in dividends. During 1991, the Company declared and paid $10,000,000 in dividends. The Company may pay additional dividends to Tenneco Inc. from time to time depending upon the profitability, liquidity and capital requirements of the Company. See "Relationship with Tenneco Inc.-- Investment Agreement" under Item 1 for information concerning restrictions on the Company's ability to pay dividends. ITEM 6.	ITEM 6. SELECTED FINANCIAL DATA. Item 6, "Selected Financial Data", has been omitted from this report pursuant to the reduced disclosure format permitted by General Instruction J to Form 10- K. ITEM 7.	ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Pursuant to paragraph (2)(a) of General Instruction J to Form 10-K, the following analysis explains the reasons for material changes in the amount of revenue and expense items between 1993, 1992 and 1991. Revenues The Company and its consolidated subsidiaries reported total revenues of $232 million in 1993, down 30% or $98 million from 1992 and down 29% or $96 million from 1991. This decrease is attributable to a decrease in Case retail receivables due to the sale of $395 million and $439 million net book value of certain retail farm and construction equipment receivables to limited purpose business trusts, which utilized the receivables as collateral for the issuance of asset backed securities to the public in May 1993 and November 1993, respectively. Additional sales of retail receivables are expected to be made in the future. See "Other Income" for additional information. Presented below are the percentages of revenues from the various sources for the years ended December 31: Revenues generated by the purchase of Case receivables include finance charges earned on trade and other receivables and earned on third party trade receivables. The average yield on Case retail receivables for 1993 was 11.4% down from 11.8% in both 1992 and 1991. The decrease in pipeline revenues is a result of the collection of take-or-pay receivables. Discount rates charged on pipeline and other short-term receivables purchased ranged from 5.75% to 6.5% during 1993 as compared to ranges of 6.5% to 8.5% and 8.5% to 10.3% for 1992 and 1991, respectively. The Company's only leasing activity is the multifuel boiler facility leased to Packaging. Leasing activities provided $6 million of revenues in each of the years 1993, 1992, and 1991. Under an Investment Agreement between the Company and Tenneco Inc., the Company is to receive a service charge from Tenneco Inc. for each month equal to the amount, if any, by which the cumulative earnings of the Company for the period from the beginning of the calendar year to the end of such month, before deduction of fixed charges and federal income taxes, are less than 125% of the Company's fixed charges. Expenses During 1993, interest expense totaled $160 million representing a decrease of $47 million or 23% and a decrease of $61 million or 27% over 1992 and 1991, respectively. The decrease resulted from lower average total debt outstanding in 1993. The average interest rate for 1993 was 9.0% compared to 8.9% in 1992 and 8.8% in 1991. The higher average interest rate in 1993 was due to the maturity of lower interest long-term debt. Other Income In May 1993 and November 1993, the Company received proceeds of $420 million and $461 million, respectively, from the sale of certain retail farm and construction equipment receivables to limited purpose business trusts, which utilized the receivables as collateral for the issuance of asset backed securities to the public. The net book value of the receivables sold was $395 million and $439 million and accordingly, the Company recognized a pre-tax gain of $23 million and $20 million in May 1993 and November 1993, respectively, due to the sale. In addition, the Company recognized a gain of $6 million from the sale of trade receivables to Asset Securitization Cooperative Corporation. These receivables originated with Tenneco Inc.'s packaging, automotive parts and natural gas subsidiaries. Net Income Net income for 1993 of $70 million represented a decrease of 22% from 1992 net income of $90 million and a 9% increase over 1991 net income of $64 million. The decrease in net income from 1992 to 1993 was primarily attributable to decreased revenues due to the lower levels of Case retail receivables. This revenue decline was partially offset by lower interest expense and higher gains on the receivables sales. Assets The Company had total assets of $2,238 million at December 31, 1993, compared to $2,539 million at December 31, 1992. The 12% decrease from year-end 1992 is due primarily to the sale of $834 million net book value of Case retail receivables. As of December 31, 1993, the Company held net trade notes and accounts receivable totaling $1,860 million, which made up 83% of the Company's total assets. This compares to $2,205 million or 87% of assets as of December 31, 1992. Details of these receivables are shown as follows: Case net trade notes and accounts receivable are $399 million lower at December 31, 1993, compared to December 31, 1992, due to the sale of certain retail farm and construction equipment receivables to limited purpose business trusts. The Company held $106 million of notes receivable from non-affiliated companies at December 31, 1993, down from $154 million held at December 31, 1992. Long-term receivables from non-affiliated companies represented 5% of the Company's total assets at December 31, 1993. At December 31, 1993, the Company had $53 million invested in a multifuel boiler leased to Packaging. The leased facility represented 2% of the Company's total assets at December 31, 1993. CAPITALIZATION AND CAPITAL RESOURCES Pursuant to the Investment Agreement, Tenneco Inc. is required to maintain an investment in the Company as necessary to assure that at all times the sum of the Company's subordinated debt plus stockholder's equity will be at least equal to 20% of the Company's total debt plus stockholder's equity. The Company's capital requirements have been financed through the issuance of commercial paper, publicly and privately placed medium-term notes, senior public debt and bank loans, subordinated debt, and advances and equity capital from Tenneco Inc. plus earnings retained in the business. The Company's total capitalization was $2,170 million at December 31, 1993, and was $2,444 million at December 31, 1992. The components of capitalization at such dates are set forth in the following table: ITEM 8.	ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. INDEX TO FINANCIAL STATEMENTS OF TENNECO CREDIT CORPORATION AND CONSOLIDATED SUBSIDIARIES REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Tenneco Credit Corporation: We have audited the accompanying balance sheets of Tenneco Credit Corporation (a Delaware corporation and a wholly-owned subsidiary of Tenneco Inc.) and consolidated subsidiaries as of December 31, 1993 and 1992, and the related statements of income, cash flows and changes in stockholder's equity for each of the three years in the period ended December 31, 1993. These financial statements and the schedule referred to below are the responsibility of Tenneco Credit Corporation's management. Our responsibility is to express an opinion on these 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 financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Tenneco Credit Corporation and consolidated subsidiaries as of December 31, 1993 and 1992, and the results of their operations, cash flows and changes in stockholder's equity for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in Note 2 to the financial statements, effective January 1, 1992, Tenneco Credit Corporation changed its method of accounting for income taxes. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The supplemental schedule listed in the index to Item 14 relating to Tenneco Credit Corporation and consolidated subsidiaries is presented for purposes of complying with the Securities and Exchange Commission's rules and is not part of the basic financial statements. The supplemental 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 of Tenneco Credit Corporation and consolidated subsidiaries taken as a whole. Arthur Andersen & Co. Houston, Texas February 14, 1994 TENNECO CREDIT CORPORATION AND CONSOLIDATED SUBSIDIARIES BALANCE SHEET (THOUSANDS EXCEPT SHARE AMOUNTS) (The accompanying notes to financial statements are an integral part of this balance sheet.) TENNECO CREDIT CORPORATION AND CONSOLIDATED SUBSIDIARIES STATEMENT OF INCOME (THOUSANDS) (The accompanying notes to financial statements are an integral part of this statement of income.) TENNECO CREDIT CORPORATION AND CONSOLIDATED SUBSIDIARIES STATEMENT OF CASH FLOWS (THOUSANDS) (The accompanying notes to financial statements are an integral part of this statement of cash flows.) TENNECO CREDIT CORPORATION AND CONSOLIDATED SUBSIDIARIES STATEMENT OF CHANGES IN STOCKHOLDER'S EQUITY (THOUSANDS) (The accompanying notes to financial statements are an integral part of this statement of changes in stockholder's equity.) TENNECO CREDIT CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS (1) CONTROL AND SUMMARY OF ACCOUNTING POLICIES Control All of the outstanding common stock of Tenneco Credit Corporation is owned by Tenneco Inc. Tenneco Credit Corporation and consolidated subsidiaries ("TCC" or the "Company") are thus members of an operating group under the control of Tenneco Inc. As such, TCC engages in transactions characteristic of group administration and operation with other members of the group. The primary purpose of TCC is to finance, on a nonrecourse basis, receivables of Tenneco Inc. and its subsidiaries. Consolidation The consolidated financial statements include the accounts of Tenneco Credit Corporation, its majority-owned subsidiaries, Counce Limited Partnership and subsidiary, and its wholly-owned subsidiary, TenFac Corporation. Counce Limited Partnership was organized to construct a multifuel steam boiler and turbine generator facility for lease to Packaging Corporation of America ("Packaging"), an indirect wholly-owned subsidiary of Tenneco Inc. TenFac Corporation was organized to purchase inventory acquired by Packaging in a 1991 acquisition. All significant intercompany items have been eliminated in consolidation. Revenue Recognition Finance charges earned from affiliates on trade and other receivables purchased in 1993, 1992 and 1991 were approximately $107 million, $136 million and $117 million, respectively. Finance charges on these receivables are charged by TCC to these affiliates at mutually agreed amounts based on current rates of interest. In addition, finance charges and interest earned from third parties on trade receivables purchased from affiliates totaled approximately $120 million, $188 million and $204 million in 1993, 1992 and 1991, respectively. Rates charged on pipeline and other short-term receivables purchased ranged from 5.75% to 6.5% during 1993 as compared to ranges of 6.5% to 8.5% and 8.5% to 10.3% for 1992 and 1991, respectively. The average yield on Case retail receivables for 1993 was 11.4%, down from 11.8% in both 1992 and 1991. Revenue from the operating lease is recognized monthly on a pro rata basis over the terms of the related contract. Related Party Transactions The Company has entered into an agreement (the "Operating Agreement") with several subsidiaries of Tenneco Inc. ("Tenneco Subsidiaries") pursuant to which the Company buys trade receivables generated by the Tenneco Subsidiaries from the sale of goods and services. Each Tenneco Subsidiary, as the Company's agent, makes all collections and services the receivables sold by it to the Company. The Company also may purchase receivables and other assets from Tenneco Subsidiaries on terms different from those set forth in the Operating Agreement. Receivables purchased from affiliates at December 31, 1993 and 1992, totaled $2.1 billion and $2.6 billion, respectively. Reclassification Certain reclassifications have been made to prior year amounts to conform with the current year's presentation. TENNECO CREDIT CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) (2) INCOME TAXES TCC and its parent Tenneco Inc., together with certain of their respective subsidiaries which are owned 80% or more, have entered into an agreement to file a consolidated federal income tax return. Such agreement provides, among other things, that (1) each company in a taxable income position will be currently charged with an amount equivalent to its federal income tax computed on a separate return basis and (2) each company in a tax loss position will be currently reimbursed to the extent its deductions and tax credits are utilized in the consolidated return. Effective January 1, 1992, TCC changed its method of accounting for income taxes from the deferred method to the liability method required by Statement of Financial Accounting Standards (FAS) No. 109, "Accounting for Income Taxes" using the cumulative catch-up method. This new standard requires that a deferred tax be recorded to reflect the tax expense (benefit) resulting from the recognition of temporary differences. Temporary differences are differences between the tax basis of assets and liabilities and their reported amounts in the financial statements that will result in differences between income for tax purposes and income for financial statement purposes in future years. The components of income tax expense (benefit) are as follows: The difference between income tax expense and the amount computed by applying the statutory federal income tax rate to income before income taxes is primarily due to state income taxes of $6 million and $7 million in 1993 and 1992, respectively, net of federal income tax benefit. The components of net deferred tax liability at December 31, 1993 and 1992, were as follows: TENNECO CREDIT CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) Prior to adoption of FAS No. 109, TCC recorded deferred federal income tax expense (benefit) based on timing differences in the recognition of revenues and expenses for tax and financial reporting purposes. A description of the differences and the related tax effect on operations for the year ended December 31, 1991 are, as follows (in thousands): (3) NOTES AND ACCOUNTS RECEIVABLE PURCHASED FROM AFFILIATES Contractual maturities of notes and accounts receivable purchased from affiliates as of December 31, 1993, are as follows: During 1993 and 1992, TCC received proceeds of $881 million and $552 million, respectively, from the sale of certain retail farm and construction equipment receivables to a limited purpose business trust, which utilized the notes as collateral for the issuance of asset backed securities to the public. The net book value of the receivables sold was $834 million and $519 million for 1993 and 1992, respectively, and accordingly, TCC recognized pre-tax gains on the transactions of $43 million and $31 million for 1993 and 1992, respectively. Additional sales of retail receivables are expected to be made in the future. In addition, the Company recognized a gain of $6 million from the sale of trade receivables to Asset Securitization Cooperative Corporation. These receivables originated with Tenneco Inc.'s packaging, automotive and natural gas subsidiaries. (4) COMMERCIAL PAPER AND LINES OF CREDIT TCC sells commercial paper on a short-term unsecured basis. Information regarding commercial paper follows: TENNECO CREDIT CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) At December 31, 1993, TCC had available total lines of credit of $480 million with various non-U.S. banks which are available for periods up to twenty-four months. Borrowings are available as either domestic loans or as Eurodollar loans. The agreements provide for commitment fee rates (from 1/20 of 1% to 1/8 of 1%) on the unused portion of the total commitment. At December 31, 1993, TCC had no amounts outstanding under the lines of credit. (5) SENIOR AND SUBORDINATED DEBT A summary of Senior and Subordinated Debt outstanding is set forth in the following tabulation (in thousands): At December 31, 1993, approximately $70 million of gross equipment under lease was pledged as collateral to secure $32 million of senior notes. The aggregate maturities applicable to the notes outstanding at December 31, 1993, are $503 million, $239 million, $158 million, $176 million and $73 million for 1994, 1995, 1996, 1997 and 1998, respectively. On February 28, 1994, Tenneco Credit Corporation redeemed all of its issued and outstanding 8 3/8% notes due February 1, 1997. TENNECO CREDIT CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) (6) EQUIPMENT UNDER OPERATING LEASES TO AFFILIATES At December 31, 1993, Counce Limited Partnership had a long-term operating lease with Packaging, covering equipment with a net book value of $53 million. The lease requires Packaging to pay all operating, maintenance and insurance costs. The aggregate minimum future annual rentals under the operating lease at December 31, 1993, are as follows: Depreciation of the equipment under lease is provided on a straight-line basis in amounts which, in the opinion of management, are adequate to allocate the cost of the property over its estimated useful life. (7) FINANCIAL INSTRUMENTS In accordance with the requirements of FAS No. 107, the estimated fair values of TCC's financial instruments at December 31, 1993, were estimated as follows: The following methods and assumptions were used to estimate the fair value of financial instruments: Receivables--TCC believes that in the aggregate, the carrying amount of its receivables, both current and non-current, was not materially different from the fair value of those receivables. Customer notes and accounts receivable purchased from affiliates are concentrated in the farm and construction business. At December 31, 1993, the receivables related to the farm and construction business represented 81% of the total customer notes and accounts receivable purchased from affiliates. Commercial Paper--Fair value was considered to be the same as the carrying amount. Senior and Subordinated Notes--The fair value of fixed-rate long-term debt was based on the market value of debt with similar maturities and interest rates; the carrying amount of floating rate long-term debt was assumed to approximate its fair value. (8) COVENANTS UNDER INVESTMENT AGREEMENT Under the terms of the Investment Agreement between TCC and Tenneco Inc., the companies have agreed, among other terms, that: (a) Tenneco Inc. will own, directly or indirectly, all the outstanding shares of TCC stock. TENNECO CREDIT CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) (b) TCC's consolidated assets must equal at least 125% of all consolidated "senior debt" (commercial paper and senior notes) outstanding. (c) TCC will not declare or pay any dividends or make any capital distributions if such action would render TCC unable to meet any of its requirements for the payment of principal of, or interest or premium, if any, on unaffiliated debt. (d) Tenneco Inc.'s investment in TCC (either directly or through its subsidiary companies) and subordinated debt must equal at least 20% of TCC's total consolidated debt plus stockholder's equity. (e) Tenneco Inc. will pay to TCC a service charge for each month during the term of the Investment Agreement equal to the amount, if any, by which the cumulative consolidated earnings of TCC and its consolidated subsidiaries for the period from the beginning of the calendar year to the end of such month, before deduction of fixed charges (interest expense) and income taxes (but including in earnings all such service charges previously paid by Tenneco Inc. for such year) are less than 125% of the fixed charges. TCC was in compliance with these covenants as of December 31, 1993, 1992 and 1991. (9) QUARTERLY FINANCIAL DATA (UNAUDITED) (The above notes are an integral part of the foregoing financial statements.) ITEM 9.	ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE There has been no change in accountants during 1993 or 1992, nor has there been any disagreement on any matter of accounting principles or practices or financial disclosure which in either case is required to be reported pursuant to this Item 9. PART III. Item 10, "Directors and Executive Officers of the Registrant", Item 11, "Executive Compensation", Item 12, "Security Ownership of Certain Beneficial Owners and Management", and Item 13, "Certain Relationships and Related Transactions", have been omitted from this report pursuant to the reduced disclosure format permitted by General Instruction J to Form 10-K. PART IV. ITEM 14.					ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. FINANCIAL STATEMENTS INCLUDED IN ITEM 8 See "Index to Financial Statements of Tenneco Credit Corporation and Consolidated Subsidiaries" set forth in Item 8, "Financial Statements and Supplementary Data." INDEX TO FINANCIAL STATEMENTS AND SCHEDULES INCLUDED IN ITEM 14 SCHEDULE IX TENNECO CREDIT CORPORATION AND CONSOLIDATED SUBSIDIARIES SCHEDULE IX--SHORT-TERM BORROWINGS (NOTE) (THOUSANDS) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- NOTE: See Note 4 to the financial statements for additional information. REPORTS ON FORM 8-K No Reports on Form 8-K have been filed with the Securities and Exchange Commission during the last quarter of the period covered by this Report. EXHIBITS All exhibits not incorporated by reference to a prior filing are designated by an asterisk; all exhibits not so designated are incorporated herein by reference to a prior filing as indicated. SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED. Tenneco Credit Corporation Robert T. Blakely By___________________________________ Robert T. Blakely President Date: March 31, 1994 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. EXHIBIT 12 TENNECO CREDIT CORPORATION AND CONSOLIDATED SUBSIDIARIES COMPUTATION OF RATIO OF EARNINGS TO FIXED CHARGES TOTAL ENTERPRISE BASIS (THOUSANDS) INDEX TO EXHIBITS - -------- * Exhibit incorporated by reference. - -------- * Exhibit incorporated by reference.
894651_1993.txt	894651	1993	ITEM 1 Business ________ Introduction ____________ American Annuity Group, Inc. ("American Annuity", "AAG", or "the Company") is a holding company whose only significant asset is the capital stock of Great American Life Insurance Company ("GALIC"). American Annuity is the successor to STI Group, Inc., formerly known as Sprague Technologies, Inc. ("STI"). STI was formed in May 1987 by The Penn Central Corporation ("Penn Central") for the purpose of divesting its electronics components businesses. STI subsequently sold substantially all of its assets and retired its debt, netting approximately $100 million in cash and cash equivalents. In September 1992, STI reached an agreement with Great American Insurance Company ("GAI") to purchase 100% of the capital stock of GALIC for $468 million. The acquisition was consummated on December 31, 1992. The purchase of GALIC was financed with (a) $230 million of borrowings, (b) $156 million of new equity raised from the sale of common and preferred stock to GAI, and (c) cash available at the Company. American Financial Corporation ("AFC"), the parent of GAI, beneficially owned approximately 80% of American Annuity's Common Stock at March 1, 1994. GALIC _____ For definitions of many of the insurance terms used throughout this section, please see the glossary beginning on page 11. GALIC is an insurance company which was incorporated in New Jersey in 1959 and redomiciled as an Ohio corporation in 1982. GALIC was acquired by AFC in 1973 through AFC's acquisition of GAI. GALIC entered the tax-deferred annuity business in 1976; prior to that time it wrote primarily whole-life, term-life, and accident and health insurance policies. GALIC is currently rated "A" (Excellent) by A.M. Best. Annuities are long-term retirement savings plans that benefit from interest accruing on a tax-deferred basis. The issuer of the annuity collects contributions, credits interest or investment income and pays out a benefit upon surrender or annuitization. Annuity contracts can be either variable rate or fixed rate. With a variable rate annuity, the rate at which interest is credited to the contract is tied to an underlying securities portfolio or other performance index. With a fixed rate annuity, an interest crediting rate is set by the issuer, periodically reviewed by the issuer, and changed from time to time as determined to be appropriate. GALIC is engaged in the sale of fixed rate annuities primarily to employees of qualified not-for-profit organizations under Section 403(b) of the Internal Revenue Code. These employees are eligible to save for retirement through contributions made on a before-tax basis to purchase 403(b) annuities. Contributions are made at the discretion of the participants through payroll deductions. Federal income taxes are not payable on contributions or earnings until amounts are withdrawn. GALIC markets its annuities principally to employees of educational institutions in the kindergarten through high school ("K-12") segment. Management believes that the K-12 segment is attractive because of the growth potential and persistency rate it has demonstrated. In 1993, written premiums from the K-12 segment represented approximately 90% of GALIC's total tax-qualified premiums, with sales of annuities to other not-for- profit groups accounting for the balance. The following table (in millions) presents information concerning GALIC in accordance with generally accepted accounting principles ("GAAP"), unless otherwise noted. Sales of annuities are affected by many factors, including: (i) competitive rates and products; (ii) the general level of interest rates; (iii) the favorable tax treatment of annuities; (iv) commissions paid to agents; (v) services offered; (vi) ratings from independent insurance rating agencies; and (vii) general economic conditions. Annuity receipts in 1993 increased primarily due to the introduction of new single premium products in the second half of 1992. Receipts in 1992 were lower than anticipated due to (i) a reduction in receipts relating to a new product introduced in 1990 which encouraged rollovers of other retirement funds and (ii) unfavorable economic and market conditions, including the impact of the negative publicity associated with a number of highly publicized insolvencies in the life insurance industry. GALIC's Corporate Strategy GALIC's primary business objective is to maximize its long-term profitability through the sale of 403(b) annuities. GALIC seeks to achieve this objective through a strategy of: (i) offering annuity products that are tailored to meet its policyholders' financial needs and designed to encourage a high level of persistency; (ii) providing competitive commission structures and high-quality service in order to foster long-term relationships with its independent agents; (iii) maintaining a conservative investment portfolio in order to demonstrate financial stability to its policyholders; (iv) maintaining competitive crediting rates on annuity policies to encourage new, as well as renewal, business while achieving the desired spread between investment earnings and interest credited; (v) developing complementary distribution channels; and (vi) maintaining high ratings from independent insurance rating agencies. Annuity Products GALIC's principal products are Flexible Premium Deferred Annuities ("FPDAs") and Single Premium Deferred Annuities ("SPDAs"). In 1993, FPDAs accounted for approximately two-thirds of GALIC's total annuity receipts, with SPDAs accounting for the remainder. GALIC's annuity products are designed to discourage early terminations and withdrawals through the use of various surrender charges. Over the past five years, the annual persistency rate of GALIC's annuity products has averaged approximately 92%. The following table summarizes GALIC's written premiums and policyholder benefit reserves on a statutory basis by product line (dollars in millions). Policyholder 1993 Premiums Written Benefit Reserves at _____________________ First % of December 31, 1993 ___________________ YearRenewal Total Amount % ____________ _____ ______ ___ Flexible Premium: 403(b) Single-tier $ 14 $ 14 7.0% $ 70 1.6% 403(b) Two-tier 31 202 58.0 2,739 63.5 Other Single-tier 2 1 0.7 39 0.9 Other Two-tier 2 6 2.0 187 4.4 ____ ____ _____ ______ _____ Total 49 223 67.7 3,035 70.4 ____ ____ _____ ______ _____ Single Premium: Single-tier 13 - 3.2 27 0.6 Two-tier 115 - 28.6 1,012 23.5 ____ ____ _____ ______ _____ Total 128 - 31.8 1,039 24.1 ____ ____ _____ ______ _____ Annuities in Pay Out - - - 217 5.0 Life, Accident & Health - 2 0.5 23 0.5 ____ ____ _____ ______ _____ Total $177 $225 100.0% $4,314 100.0% ____ ____ _____ ______ _____ GALIC's FPDAs are characterized by premium payments that are flexible in amount and timing as determined by the policyholder. GALIC's SPDAs require a one-time lump-sum premium payment. Since January 1, 1988, approximately three-fourths of GALIC's SPDA receipts have resulted from rollovers of tax- deferred funds previously maintained by policyholders with other insurers. All of GALIC's annuity products are fixed rate annuities which provide minimum interest rate guarantees of 3% to 4% per annum. At December 31, 1993, approximately 95% of GALIC's policyholder liabilities consisted of annuities which offered a minimum interest rate guarantee of 4%. All of GALIC's annuity policies permit GALIC to change the crediting rate at any time (subject to the minimum guaranteed interest rate). In determining the frequency and extent of changes in the crediting rate, GALIC takes into account the profitability of its annuity business and the relative competitive position of its products. The average rate being credited on funds held by GALIC was approximately 5.3%, 6.2%, and 7.2% at December 31, 1993, 1992, and 1991, respectively. GALIC seeks to maintain a desired spread between the yield on its investment portfolio and the rate it credits to its policies. GALIC accomplishes this by (i) offering flexible crediting rates, (ii) designing annuity products that encourage persistency and (iii) maintaining an appropriate matching of assets and liabilities. Tax qualified annuity policyholders maintain access to their funds without incurring penalties through a provision in the contract which allows policy loans in accordance with the Internal Revenue Code. The persistency rates of GALIC's products are helped by the two-tier design contained in most of GALIC's products. Two-tier annuities have a permanent surrender charge for funds withdrawn in a lump sum in excess of the amount permitted to be withdrawn pursuant to the contract. Two account values are maintained for two-tier annuities -- the annuitization (or upper-tier) value and the surrender (or lower-tier) value. The annuitization value is paid only if the policyholder chooses to annuitize (withdraw funds in a series of periodic payments for at least the minimum number of years specified in the contract). If a lump sum payment is desired, the surrender value is paid. After the initial surrender charges have been reduced to zero, single-tier annuities have only one value which is available whether the policy is surrendered or annuitized. With some two-tier annuities, the annuitization value and the surrender value are the same at inception of the policy, but since each value accumulates interest at a different rate, over time, the annuitization value will grow to an amount which is greater than the surrender value. Other two-tier annuities credit the same interest rate to both the surrender and the annuitization value but withhold a portion of the first-year premiums when calculating the surrender value; no such amounts are withheld in calculating the annuitization value. GALIC's two-tier annuities are particularly attractive to policyholders who intend to utilize funds accumulated to provide retirement income since the annuitization value is accumulated at a competitive long-term interest rate. Management believes that over time, as the policyholder population ages, the percentage of policyholders annuitizing will increase. In addition to its use of two-tier structures, GALIC imposes certain surrender charges and front-end fees during the first five to ten years of a new policy to discourage customers from withdrawing funds in the early years of a policy. As a result of these features, GALIC's annuity products have achieved high persistency. As the following table illustrates, GALIC's annual persistency rates for its major products have averaged approximately 92% over the past five years. Persistency Rates ___________________________________________ Product Group 1993 1992 1991 1990 1989 _____________ ____ ____ ____ ____ ____ Flexible Premium 92.0% 90.6% 89.3% 91.2% 94.4% Single Premium 93.3 93.8 92.8 92.6 92.0 Annuity surrender payments represented 6.9%, 7.8% and 9.4% of average statutory reserves in 1993, 1992 and 1991, respectively. At December 31, 1993, GALIC had approximately 230,000 annuity policies in force, nearly all of which were individual contracts. GALIC's policyholders are employees of over 8,300 institutions nationwide. Of the $4.3 billion in total statutory reserves held by GALIC as of December 31, 1993, approximately 95% were attributable to policies in the accumulation phase. Marketing and Distribution GALIC markets its annuity products through approximately 55 managing general agents ("MGAs") who, in turn, direct more than 1,000 actively producing independent agents. GALIC has developed its business since 1980 on the basis of its relationships with MGAs and independent agents primarily through a consistent marketing approach and responsive service. GALIC seeks to attract and retain MGAs who are experienced and highly motivated and who consistently place a high volume of the types of annuities offered by GALIC. Toward this end, GALIC has established a "President's Advisory Council" consisting of 10 of the top producers each year, all of whom must market primarily GALIC products. The President's Advisory Council serves as a major influence on new product design and marketing strategy. To extend the distribution of GALIC annuities to a broader customer base, the Company began to develop a Personal Producing General Agent ("PPGA") distribution system. Over 85 PPGAs are contracted to sell GALIC annuities to both qualified and non-qualified customers. These new appointments will give the Company the opportunity to expand the premium writings in those territories not served by an MGA. GALIC's strategy is to offer its agents competitive commission rates and to provide prompt processing of agent requests, with the objective of attracting and retaining agents on the basis of service, as well as compensation. Commissions paid on first year premiums are significantly higher than those paid on renewal premiums. Commissions are generally lower for sales of annuities to older policyholders, reflecting the lower profit potential available from policyholders who maintain their funds with GALIC for a shorter period. GALIC is licensed to sell its products in all states (except Kansas and New York) and in the District of Columbia. The geographical distribution of GALIC's annuity premiums written in 1993 compared to 1989 was as follows (dollars in millions): Investments GALIC's annuity products are structured to generate a stable flow of investable funds. GALIC earns a spread by investing these funds at an investment earnings rate in excess of the crediting rate payable to its policyholders. The Ohio Insurance Code contains rules governing the types and amounts of investments which are permissible for an Ohio life insurer, including GALIC. These rules are designed to ensure the safety and liquidity of the insurer's investment portfolio by placing restrictions on the quality, quantity and diversification of permitted investments. Investments comprise approximately 96% of American Annuity's assets and are the principal source of its income. Fixed income securities (including policy loans, mortgage loans and short-term investments) comprise over 98% of AAG's investment portfolio. Risks inherent in connection with fixed income securities include loss upon default and market price volatility. Factors which can affect the market price of these securities include: (i) creditworthiness of issuers; (ii) changes in market interest rates; (iii) the number of market makers and investors; and (iv) defaults by major issuers of securities. In recent years, GALIC has reduced its holdings in non-investment grade fixed maturity securities and equity securities of affiliates. This shift in investment strategy has placed an emphasis on high quality fixed income securities which management believes should produce a more consistent and predictable level of investment income. The National Association of Insurance Commissioners ("NAIC") assigns quality ratings to publicly traded as well as privately placed securities. These ratings range from Class 1 (highest quality) to Class 6 (lowest quality). The following table shows GALIC's fixed maturity portfolio by NAIC designation (and comparable Standard & Poor's Corporation rating) at December 31: GALIC's primary investment objective in selecting securities for its fixed maturity portfolio is to optimize interest yields while maintaining an appropriate relationship of maturities between GALIC's assets and expected liabilities. GALIC invests in bonds that have primarily intermediate-term maturities. This practice provides GALIC with additional flexibility to respond to fluctuations in the marketplace. The table below sets forth the maturities of GALIC's fixed maturity investments based on their carrying value. At December 31, 1993, the average maturity of GALIC's fixed maturity investments was approximately 6 years (including CMOs, which had an estimated average life of approximately 4 years). The following table shows the performance of GALIC's investment portfolio, excluding equity investments in affiliates (dollars in millions): GALIC's investment portfolio is managed by American Money Management ("AMM"), a subsidiary of AFC. As part of the acquisition by STI, GALIC and AMM executed an investment services agreement which established the investment management fee paid to AMM at a maximum of one-tenth of one percent of GALIC's invested assets. Independent Ratings GALIC is currently rated "A" (Excellent) by A.M. Best and "A+" (High claims paying ability) by Duff & Phelps. Publications of A.M. Best indicate that an "A" rating is assigned to those companies which in A.M. Best's opinion have achieved excellent overall performance when compared to the standards established by A.M. Best as norms of the life insurance industry and which generally have demonstrated a strong ability to meet their obligations to policyholders over a long period of time. In evaluating a company's financial and operating performance, independent rating agencies review the company's profitability, leverage and liquidity, as well as the company's book of business, the quality and estimated market value of its assets, the adequacy of its policy reserves and the experience and competency of its management. Their ratings are based upon factors of concern to policyholders and agents and are not directed toward the protection of investors. Management believes that the ratings assigned to GALIC by independent insurance rating agencies are important because potential policyholders often use a company's rating as an initial screening device in considering annuity products. Management also believes that the majority of purchasers of 403(b) annuities would not be willing to purchase annuities from an issuer that had an A.M. Best rating below certain levels. In addition, certain school districts, hospitals and banks do not allow insurers with an A.M. Best rating below certain levels to sell annuity products through their institutions. Policy Liabilities and Reserves GALIC establishes and carries reserves to meet future obligations under its annuity policies. GALIC's $4.3 billion liability for accumulated policyholders' funds at December 31, 1993, is calculated based upon assumptions of future interest rate spreads expected to be realized and expected mortality, maturity and surrender rates to be experienced on the annuity policies in force. Annuity premiums are generally recorded under GAAP as increases to the liability for accumulated policyholders' funds rather than as revenues. Accumulated interest also increases this liability. Benefit payments are recorded as decreases to this liability instead of as expenses. Competition GALIC operates in a highly competitive environment. More than 100 insurance companies offer tax-deferred annuities. GALIC competes with other insurers and financial institutions based on many factors, including ratings, financial strength, reputation, service to policyholders, product design (including interest rates credited), commissions and service to agents. Since GALIC markets and distributes policies through independent agents, it must also compete for agents. Management believes that consistently targeting the same market and emphasizing service to agents and policyholders give GALIC a competitive advantage. No single insurer dominates the marketplace. Competitors include (i) individual insurers and insurance groups, (ii) mutual funds and (iii) other financial institutions of varying sizes, some of which are mutual insurance companies possessing competitive advantages in that all of their profits inure to their policyholders, and many of which possess financial resources substantially in excess of those available to GALIC. In a broader sense, GALIC competes for retirement savings with a variety of financial institutions offering a full range of financial services. Regulation GALIC is subject to comprehensive regulation under the insurance laws of the States of Ohio and California and the other states in which it operates. These laws, in general, require approval of the particular insurance regulators prior to certain actions such as the payment of dividends in excess of statutory limitations, continuing service arrangements with affiliates and certain other transactions. Regulation and supervision are administered by a state insurance commissioner who has broad statutory powers with respect to granting and revoking licenses, approving forms of insurance contracts and determining types and amounts of business which may be conducted in light of the financial strength and size of the particular company. State insurance departments conduct periodic financial examinations of insurance companies. GALIC's state of domicile, Ohio, requires that examinations be conducted at least every three years and its most recent examination was for the three-year period ended December 31, 1990. State insurance laws also regulate the character of each insurance company's investments, reinsurance and security deposits. GALIC may be required, under the solvency or guaranty laws of most states in which it does business, to pay assessments (up to certain prescribed limits) to fund policyholder losses or liabilities of insurance companies that become insolvent. These assessments may be deferred or forgiven under most guaranty laws if they would threaten an insurer's financial strength and, in certain instances, may be offset against future premium taxes. The incurrence and amount of such assessments have increased in recent years. In connection with the GALIC purchase, GALIC's costs for state guarantee funds are set at $1 million per year for a five-year period with respect to insurance companies in receivership, rehabilitation, liquidation or similar situations at December 31, 1992. For any year in which GALIC pays more than $1 million to the various states, GAI will reimburse GALIC for the excess assessments. For any year in which GALIC pays less than $1 million, AAG will pay GAI the difference between $1 million and the assessed amounts. GALIC paid $2.2 million in assessments in 1993 and, accordingly, has recorded a receivable from GAI at December 31, 1993 of $1.2 million. The Ohio Department of Insurance is GALIC's principal regulatory agency. GALIC is deemed to be "commercially domiciled" in California based on past premium volume written in the state and, as a result, is subject to certain provisions of the California Insurance Holding Company laws, particularly those governing the payment of stockholder dividends, changes in control and intercompany transactions. An insurer's status as "commercially domiciled" is determined annually under a statutory formula. GALIC's status may change in California in the future if its premium volume there decreases to below 20% of its overall premium volume over the most recent three years. The NAIC is an organization comprised of the chief insurance regulator for each of the 50 states and the District of Columbia. One of its major roles is to develop model laws and regulations affecting insurance company operations and encourage uniform regulation through the adoption of such models in all states. As part of the overall insurance regulatory process, the NAIC forms numerous task forces to review, analyze and recommend changes to a variety of areas affecting both the operating and financial aspects of insurance companies. Recently, increased scrutiny has been placed upon the insurance regulatory framework, and a number of state legislatures have considered or enacted legislative proposals that alter, and in many cases increase, state authority to regulate insurance companies and their holding company systems. In light of recent legislative developments, the NAIC and state insurance regulators have also become involved in a process of re- examining existing laws and regulations and their application to insurance companies. Legislation has also been introduced in Congress which could result in the federal government's assuming some role in the insurance industry, although none has been enacted to date. In 1990, the NAIC began an accreditation program to ensure that states have adequate procedures in place for effective insurance regulation, especially with respect to financial solvency. The accreditation program requires that a state meet specific minimum standards in over 15 regulatory areas to be considered for accreditation. The accreditation program is an ongoing process and once accredited, a state must enact any new or modified standards approved by the NAIC within two years following adoption. As of December 31, 1993, 32 states, including Ohio and California, were accredited. In December 1992, the NAIC adopted a model law enacting risk-based capital formulas which became effective in 1993. The model law sets thresholds for regulatory action, and currently GALIC's capital significantly exceeds risk- based capital requirements. If the NAIC elects to impose more stringent risk-based capital rules in the future, GALIC's ability to pay dividends could be adversely affected. The current NAIC model for extraordinary dividends requires prior regulatory approval of any dividend that exceeds the "lesser of" 10% of statutory surplus or 100% of the prior year's net gain from operations. Prior to 1986, the model standard was the "greater of" such amounts. The NAIC has approved eight alternative provisions which may be considered "substantially similar" to the model. The NAIC model or one of the alternatives must be adopted by a state in order to be accredited by the NAIC. In October 1993, Ohio revised its dividend law to adopt one of the eight alternatives. The standard in Ohio requires 30 days prior notice of any dividend which, together with all such amounts paid in the preceding twelve months, exceeds the "greater of" 10% of statutory surplus or 100% of the prior year's net income, but not exceeding earned surplus as of the prior year-end. The maximum dividend permitted by law is not indicative of an insurer's actual ability to pay dividends, which may be constrained by business and regulatory considerations. These considerations include the impact of dividends on surplus, which could affect (i) an insurer's ratings, (ii) its competitive position and (iii) the amount of premiums that can be written. Furthermore, the Ohio Insurance Department has broad discretion to limit the payment of dividends by insurance companies domiciled in Ohio. California amended its dividend law effective January 1, 1994, adopting one of the alternative provisions approved by the NAIC. Under the new California law, approval is required for dividends which exceed the "greater of" 10% of statutory surplus or 100% of "net gain from operations", but not exceeding earned surplus, in any twelve month period. The NAIC has been considering the adoption of a model investment law for several years. The current projection for adoption of a model law is the end of 1994, at the earliest. A draft is not scheduled to be released until the second quarter of 1994. In addition, it is not yet determined whether the model law would be added to the NAIC accreditation standards so that consideration of the model for adoption in states would be required for the achievement or continuation of any state's accreditation. It is not possible to predict the impact of these activities on GALIC. In 1991, the NAIC adopted additional disclosure requirements relating to the marketing and sale of two-tier annuities. Certain states have adopted regulations or interpreted existing regulations to restrict the sale of two- tier annuity products or impose limitations on the terms of such products that make their sale less attractive to GALIC. To date, these additional disclosure requirements and restrictions have not had a material impact on GALIC's business. The NAIC is also considering the adoption of actuarial guidelines with respect to two-tier annuity products. In connection with the sale of GALIC, GAI is obligated to neutralize the financial effects of implementing any such guidelines on GALIC's statutory earnings and capital, except for the initial, one-time impact on GALIC's statutory earnings. GAI's obligations will apply only to GALIC's annuity business at the date of adoption and only if the guidelines are (i) adopted prior to January 1, 1996, or (ii) on the NAIC agenda for adoption as of December 31, 1995, and actually adopted on or prior to December 31, 1996. Management cannot predict whether or when the guidelines will be adopted nor can it predict the form of the guidelines and, therefore, cannot predict the final impact on GALIC. There can be no assurance that existing insurance-related laws and regulations will not become more restrictive in the future and thereby have a material adverse effect on the operations of GALIC and on the ability of GALIC to pay dividends. Discontinued Manufacturing Operations _____________________________________ Prior to 1993, the Company sold most of its manufacturing operations. These actions were taken in light of an ongoing strategic review process that led management and the Board of Directors to conclude that such operations either lacked a strong competitive position in the relevant product markets or did not have strong growth prospects or provide sufficiently high returns on investment. In 1991, the Company sold its interest in a manufacturing operation for $18 million in cash. In 1992, the Company sold substantially all of its remaining operations for $130 million in cash, notes and property. In 1993, AAG recorded a $14.8 million pretax provision related to discontinued operations. Approximately $9.7 million of the provision represented employee related obligations resulting primarily from a decrease in the discount rate used to calculate pension obligations; approximately $3.3 million related to adjustments for certain property and inventory associated with the Company's former manufacturing properties. At December 31, 1993, the Company owned an electronic components manufacturer with assets of approximately $8.6 million and 1993 revenues of approximately $11.9 million. Employees _________ As of December 31, 1993, AAG employed approximately 15 persons and GALIC employed approximately 425 persons. None of the employees are represented by a labor union. AAG believes that its employee relations are excellent. In 1993, AAG and GALIC moved their offices to Cincinnati from Stamford, Connecticut and Los Angeles, California, respectively. Most of the manufacturing facilities are currently being leased to companies using them for manufacturing operations. The Company is attempting to sell or extend leases on these facilities. In addition, the Company has agreed to contribute a facility in North Adams, Massachusetts which has been vacant for several years to a not-for-profit entity which intends to develop the property into a multi-discipline art center. Environmental Matters Federal and state laws and regulations, including the federal Comprehensive Environmental Response, Compensation, and Liability Act and similar state laws, impose liability on the Company (as the successor to Sprague) for the investigation and cleanup of hazardous substances disposed of or spilled by its discontinued manufacturing operations, at facilities still owned by the Company and facilities transferred in connection with the sales of certain operations, as well as at disposal sites operated by third parties. In addition, the Company has indemnified the purchasers of its former operations for the cost of such activities. At several sites, the Company is conducting cleanup activities of soil and ground water contamination in accordance with consent agreements between the Company and state environmental agencies. The Company has also conducted or is aware of investigations at a number of other locations of its former operations that have disclosed environmental contamination that could cause the Company to incur additional costs of investigation and remediation. The Company has also been identified by state and federal regulators as a potentially responsible party at a number of other disposal sites. Based on the costs incurred by the Company over the past several years and discussions with its independent environmental consultants, management believes that reserves recorded for such clean-up activities are sufficient in all material respects to satisfy the known liabilities. However, the regulatory standards for clean-up are continually evolving toward more stringent requirements. In addition, many of the environmental investigations at the Company's former operating locations and third-party sites are still preliminary, and where clean-up plans have been proposed, they have not yet received full approval from the relevant regulatory agencies. Further, the presence of the Company generated wastes at third-party disposal sites exposes the Company to joint and several liability for the potential additional costs of cleaning up wastes generated by others. Accordingly, there can be no assurance that the costs of environmental clean-up for the Company may not be significantly higher in future years, possibly necessitating additional charges. Except as set forth below, the Company considers any administrative or judicial proceedings involving the Company which are related to environmental matters to be ordinary routine litigation incidental to its business. The Maine Department of Environmental Protection has issued a proposed Administrative Consent Agreement and Enforcement Order calling for a $328,000 fine based on alleged 1991 violations of certain reporting regulations. The Company is working with the Department of Environmental Protection to resolve this matter and is negotiating the amount of the fine. ITEM 3			ITEM 3 Legal Proceedings _________________ American Annuity (as the successor to STI), its directors and AFC are defendants in seven class and derivative actions which were filed in the Court of Chancery of the State of Delaware. These actions were filed following the public announcement on June 26, 1992 that STI was considering a proposal from GAI relating to the purchase of GALIC. The actions are captioned: (a) William Steiner v. STI Group, Inc., et al., Civil Action No. ___________________________________________ 12614 filed June 29, 1992; (b) Frank Seinfeld v. STI Group, Inc., et al., __________________________________________ Civil Action No. 12616 filed June 29, 1992; (c) Frederick Rand v. STI Group, ____________________________ Inc., et al., Civil Action No. 12622 filed June 30, 1992; (d) Eli Ballan, et _____________ ______________ al., v. Carl H. Lindner, et al., Civil Action No. 12619 filed June 30, 1992; ________________________________ (e) Seymour Arkin v. Carl H. Lindner, et al., Civil Action No. 12620 filed _________________________________________ June 20, 1992; (f) Jeffrey Rubenstein v. Carl H. Lindner, et al., Civil ______________________________________________ Action No. 12532 filed July 7, 1992; and (g) Harry Lewis v. Carl H. Lindner, _______________________________ et al., Civil Action No. 12633 filed July 7, 1992. On September 24, 1992, _______ all of the foregoing actions were consolidated under the caption In re STI _________ Group, Inc. Shareholders Litigation, Consolidated Civil Action No. 12619. ___________________________________ The consolidated action asserts both class and derivative claims against American Annuity, its directors and AFC. The consolidated action alleges that the acquisition of GALIC by the Company was a self-dealing transaction designed to benefit AFC, was a waste of the Company's assets and constituted a breach of fiduciary duties by AFC and the Company's directors. Following the filing of the suits, the Company and AFC engaged in active settlement discussions with the plaintiffs. These discussions resulted in an agreement to settle the consolidated action on the basis of the earlier increase in the per share consideration paid by AFC for shares of the Company's common stock in connection with the acquisition and the decrease in the price paid by the Company for GALIC. The plaintiffs' counsel have applied to the Court of Chancery for an award of fees and expenses in the amount of $550,000. The Company has not opposed this application. The Court is scheduled to consider approval of the settlement and an award of attorneys' fees in April 1994. AAG and GALIC are subject to litigation and arbitration in the normal course of its business. GALIC is not a party to any material pending litigation or arbitration. PART II ITEM 5		ITEM 5 Market for Registrant's Common Equity and Related Stockholder Matters _______________________________ AAG's Common Stock is listed and traded principally on the New York Stock Exchange ("NYSE") under the symbol AAG. On March 1, 1994, there were approximately 10,000 holders of record of Common Stock. The following table sets forth the range of high and low sales prices for the Common Stock on the NYSE Composite Tape. _________________ _________________ High Low High Low ____ ___ ____ ___ First Quarter $11.38 $5.63 $8.00 $6.13 Second Quarter 11.38 8.75 6.75 5.63 Third Quarter 11.00 7.88 6.75 5.63 Fourth Quarter 10.38 8.25 6.75 5.88 The Company paid annual dividends of $.05 per share in 1993, 1992 and 1991. AAG has not determined a dividend paying policy for the future; the amount of dividends available to be paid at December 31, 1993 is limited to $2.5 million by certain indenture covenants. In December 1993, AAG announced an offer to purchase stock from holders of ten or fewer shares of its Common Stock. In February 1994, AAG repurchased 4,107 shares at $11 per share from approximately 1,100 shareholders. ITEM 6	ITEM 6 Selected Financial Data _______________________ The following financial data have been summarized from, and should be read in conjunction with, the Company's consolidated financial statements and "Management's Discussion and Analysis of Financial Condition and Results of Operations". The data reflects the purchase of GALIC as of December 31, 1992 (in millions, except per share amounts). Operations Statement Data: 1993 1992 1991 1990 1989 __________________________ ____ ____ ____ ____ ____ Net investment income $353.3 $ 3.6 $ 1.9 $ 0.4 $ 1.2 Total revenues 387.2 3.6 1.9 0.4 1.2 Earnings (loss) from continuing operations 53.0 (9.0) (4.7) (6.0) (6.9) Loss from discontinued operations (9.6) (16.8) (47.8) (43.3) (89.9) Extraordinary item (3.4) - - - - Change in accounting principle - (3.1) - - - ______ _____ _____ _____ _____ Net earnings (loss) $ 40.0 ($28.9) ($52.5) ($49.3) ($96.8) ______ _____ _____ _____ _____ Earnings (loss) per common share: Continuing operations $1.41 ($0.50)($0.26) ($0.33) ($0.37) Discontinued operations (.27) (.94) (2.66) (2.37) (4.94) Extraordinary item (.10) - - - - Change in accounting principle - (.17) - - - _____ _____ _____ _____ _____ Net earnings (loss) $1.04 ($1.61) ($2.92) ($2.70) ($5.31) _____ _____ _____ _____ _____ Balance Sheet Data: ___________________ Total assets $4,913.8 $4,480.4 $170.1 $294.8 $382.6 Long-term debt 225.9 230.9 27.9 30.6 65.7 Total stockholders' equity 250.3 186.6 108.5 171.8 216.7 ITEM 7	ITEM 7 Management's Discussion and Analysis of Financial Condition and Results of Operations ________________________________________________ General Following is a discussion and analysis of the financial statements and other statistical data that management believes will enhance the understanding of AAG's financial condition and results of operations. This discussion should be read in conjunction with the financial statements beginning on page. AAG is organized as a holding company with nearly all of its operations being conducted by Great American Life Insurance Company ("GALIC"), which was acquired by AAG on December 31, 1992. The parent corporation, however, has continuing expenditures for administrative expenses, corporate services, liabilities in connection with discontinued operations and, most importantly, for the payment of interest on borrowings and dividends on preferred stock. Since its business is financial in nature, AAG does not prepare its consolidated financial statements using a current-noncurrent format. Consequently, certain traditional ratios and financial analysis tests are not meaningful. Liquidity and Capital Resources Ratios The ratio of AAG's long-term debt to equity was .90 at December 31, ______ 1993, compared to 1.24 at December 31, 1992. AAG's ratio of earnings to fixed charges was 4.7 in 1993; the ratio of earnings to fixed charges and preferred dividends was 3.8 for the same period. Sources and Uses of Funds In connection with the GALIC acquisition, AAG _________________________ sold common and preferred stock to GALIC's parent, Great American Insurance Company, for $156 million in cash. The proceeds of those stock sales together with $230 million in new borrowings and most of the accumulated cash funds of the Company were used to purchase GALIC. The total cost to acquire GALIC was approximately $486 million, including transaction costs and fees of $17.4 million. The borrowings used to fund the GALIC acquisition were repaid during 1993 from the sales of $125 million of 11-1/8% Senior Subordinated Notes due 2003 and $100 million of 9-1/2% Senior Notes due 2001. As a result of the refinancings, AAG has no scheduled principal maturities until the year 2001. Annual interest and dividend payments on AAG's debt and preferred stock are approximately $26.6 million. AAG's ability to make interest and principal payments on its debt, and pay dividends on its preferred stock and other holding company costs is dependent on cash payments from GALIC. In 1993, AAG received $53.6 million in tax allocation payments (including $19 million for 1992) and $18.2 million in capital distributions from GALIC. In the second quarter of 1993, AAG made a capital contribution of $13.0 million to GALIC. Capital distributions by GALIC are subject to various laws and regulations which limit the amount of dividends that can be paid without regulatory approval. (See Note L to the financial statements.) The maximum amount of dividends payable by GALIC in 1994 without approval is approximately $44.0 million. In January 1994, AAG entered into a four-year $20 million revolving line of credit agreement with a bank. AAG has not made any cash draws under this agreement. Based upon the current level of GALIC's operations and anticipated growth, AAG believes that it will have sufficient resources from GALIC's dividends and tax allocation payments to meet its liquidity requirements. Investments The National Association of Insurance Commissioners ("NAIC") ___________ assigns quality ratings to publicly traded as well as privately placed securities. At December 31, 1993, 95% of GALIC's fixed maturity portfolio was comprised of investment grade bonds (NAIC rating of "1" or "2") compared to 91% at December 31, 1992. Management believes that the high credit quality of GALIC's investment portfolio should generate a stable and predictable investment return. GALIC invests primarily in fixed income investments which approximated 98% of its investment portfolio at December 31, 1993. GALIC generally invests in securities with intermediate term maturities with an objective of optimizing interest yields while maintaining an appropriate relationship of maturities between GALIC's assets and expected liabilities. GALIC's fixed maturity portfolio is classified into two categories: "held to maturity" and "available for sale". (See Note A to the financial statements.) At December 31, 1993, GALIC had approximately $206 million in net unrealized gains on its fixed maturity portfolio compared to $117 million at December 31, 1992. At December 31, 1993, none of the Company's fixed maturity investments were non-performing. In addition, GALIC has little exposure to mortgage loans and real estate. As of December 31, 1993, these investments represented only 1.6% of total assets. The majority of mortgage loans and real estate was purchased in the latter half of 1993. At December 31, 1993, collateralized mortgage obligations ("CMOs") represented approximately 35% of fixed maturity investments compared to 42% at December 31, 1992. As of December 31, 1993, interest only (I/O), principal only (P/O) and other "high risk" CMOs represented approximately 0.2% of total CMOs. GALIC invests primarily in CMOs which are structured to minimize prepayment risk. In addition, the majority of CMOs held by GALIC were purchased at a discount to par value. Management believes that the structure and discounted nature of the CMOs will minimize the effect of prepayments on earnings over the anticipated life of the CMO portfolio. Substantially all of GALIC's CMOs are AAA-rated by Standard & Poor's Corporation and are collateralized by GNMA, FNMA and FHLMC single-family residential pass-through certificates. The market in which these securities trade is highly liquid. Aside from interest rate risk, AAG does not believe a material risk (relative to earnings or liquidity) is inherent in holding such investments. The Ohio Insurance Code contains rules restricting the types and amounts of investments which are permissible for an Ohio life insurer, including GALIC. These rules are designed to ensure the safety and liquidity of the insurer's investment portfolio. The NAIC is considering the formulation of a model investment law which, if adopted, would have to be considered by Ohio for adoption. The formulation is in the preliminary stages and management believes its impact on GALIC's operations will not be material. Results of Operations Net Earnings and General Net earnings were $40.0 million or $1.04 per ________________________ common share in 1993. GALIC was acquired by AAG on December 31, 1992; accordingly, its results are not included in the Company's statement of operations prior to 1993. All of GALIC's products are fixed rate annuities which permit GALIC to change the crediting rate at any time (subject to minimum interest rate guarantees of 3% to 4% per annum). As a result, management has been able to react to changes in interest rates and maintain a desired interest rate "spread" with little or no effect on persistency. The following table provides a comparison of certain amounts for GALIC (in millions): Total annuity receipts increased primarily due to the introduction of new single premium products in the second half of 1992. Net Investment Income GALIC's net investment income increased 7% over the _____________________ comparable 1992 period. An increase in average fixed maturity investments more than offset a decrease in interest rates available in the marketplace. Investment income is reflected in the Statement of Operations net of investment expenses of $4.9 million in 1993. Realized Gains Individual securities are sold from time to time as market ______________ opportunities appear to present optimal situations under AAG's investment strategies. Equity in Net Loss of Affiliate Equity in net loss of affiliate represents _______________________________ AAG's proportionate share of Chiquita's losses in 1993. Chiquita reported a net loss for 1993 of $51 million compared to a net loss of $284 million for 1992. The improvement in 1993 was attributed primarily to a multi-year investment spending program and the ongoing impact of its restructuring and cost reduction efforts. Interest on Annuity Policyholders' Funds GALIC's interest on annuity ________________________________________ policyholders' funds decreased 5% from its comparable 1992 period. The average crediting rate on funds held by GALIC has decreased from 7.2% at December 31, 1991, to 6.2% at December 31, 1992 and to 5.3% at December 31, 1993. The rate at which GALIC credits interest on annuity policyholders' funds is subject to change based on management's judgment of market conditions. Provision for Relocation Expenses In 1993, GALIC relocated its corporate _________________________________ offices from Los Angeles to Cincinnati; the estimated cost of this move ($8.0 million) was included in 1993 continuing operations. Also in 1993, AAG relocated its corporate offices from Stamford to Cincinnati; the estimated cost of this relocation and related shutdown and severance costs ($5.0 million) was provided for in discontinued operations in 1992. Discontinued Operations The Company has sold virtually all of its former _______________________ manufacturing businesses. A small Belgium based subsidiary continues to be held for sale along with certain properties, most of which are currently leased to companies using them for manufacturing operations. The Company has certain obligations related to its former business activities. Among these obligations is the funding of pension plans, environmental remediation costs, lease payments for two former plant sites, certain retiree medical benefits, and certain obligations associated with the sales of the Company's manufacturing operations. In 1992, the Company recorded pretax charges related to discontinued operations totalling $24.5 million. In the fourth quarter of 1993, AAG recorded pretax charges for discontinued operations totalling $14.8 million. These charges included employee related obligations of approximately $9.7 million resulting primarily from a decrease (from 9.5% to 7.125%) in the discount rate used to calculate pension obligations. The remaining charges reflected write-downs and other estimated expenses associated with the Company's former manufacturing properties. (See Note H to the financial statements.) While it is difficult to estimate future environmental remediation costs accurately, management believes the aggregate cost of remediation at all sites for which it has responsibility will range from $10 million to $15 million. The reserve for environmental remediation work was $10.6 million at December 31, 1993. Changes in regulatory standards and further investigation of these sites could affect estimated costs in the future. Management believes, based on the costs incurred by the Company over the past several years and discussions with its independent environmental consultants, that reserves recorded for such clean-up activities are sufficient to satisfy the known liabilities and that the outcome of the contingencies will not, individually or in the aggregate, have a material adverse effect on the financial condition or results of operations of AAG. Extraordinary Item In August 1993, AAG prepaid its Bank Term Loan and wrote __________________ off $5.2 million ($3.4 million net of tax) of related unamortized debt issuance costs. Accounting Change Effective January 1, 1992, AAG implemented Statement of _________________ Financial Accounting Standards ("SFAS") No. 106, "Accounting for Postretirement Benefits Other Than Pensions", and recorded a provision of $3.1 million for the projected future costs of providing postretirement benefits to retirees in its discontinued manufacturing operations. New Accounting Standard to be Implemented The FASB has issued SFAS No. 112, _________________________________________ "Employers' Accounting for Postemployment Benefits", which became effective in 1994. The FASB has also issued SFAS No. 114, "Accounting by Creditors for Impairment of a Loan", which is scheduled to become effective in 1995. Implementation of these standards is not expected to have a material effect on AAG. ITEM 8	ITEM 8 Financial Statements and Supplementary Data ___________________________________________ PAGE ____ Reports of Independent Auditors Consolidated Balance Sheet: December 31, 1993 and 1992 Consolidated Statement of Operations: Years Ended December 31, 1993, 1992 and 1991 Consolidated Statement of Changes in Stockholders' Equity: Years Ended December 31, 1993, 1992 and 1991 Consolidated Statement of Cash Flows: Years Ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements "Selected Quarterly Financial Data" has been included in Note M to the Consolidated Financial Statements. PART III The information required by the following Items will be included in American Annuity's definitive Proxy Statement for the 1994 Annual Meeting of Stockholders which will be filed with the Securities and Exchange Commission within 120 days of the Company's fiscal year end and is herein incorporated by reference: ITEM 10		ITEM 10 Directors and Executive Officers of the Registrant __________________________________________________ ITEM 11	ITEM 11 Executive Compensation ______________________ ITEM 12	ITEM 12 Security Ownership of Certain Beneficial Owners and ___________________________________________________ Management __________ ITEM 13	ITEM 13 Certain Relationships and Related Transactions ______________________________________________ REPORTS OF INDEPENDENT AUDITORS American Annuity Group, Inc.: We have audited the accompanying consolidated balance sheets of American Annuity Group, Inc. and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, changes in stockholders' equity and cash flows for the years then ended. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. The consolidated financial statements of American Annuity Group, Inc. for the year ended December 31, 1991, were audited by other auditors whose report thereon dated March 24, 1992, expressed an unqualified opinion on those statements prior to adjustment for reclassification of discontinued operations. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of American Annuity Group, Inc. and subsidiaries at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for the years then ended, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. In 1992, the Company discontinued its manufacturing operations. As a result, these operations were reclassified and reported as discontinued operations. We also audited the adjustments that were applied to reclassify the discontinued operations in the 1991 consolidated financial statements. In our opinion such reclassifications were appropriate and properly applied. As discussed in Note A to the consolidated financial statements, the Company changed its method of accounting in 1993 for certain investments in debt and equity securities and in 1992 for income taxes and postretirement benefits other than pensions. Ernst & Young Cincinnati, Ohio March 11, 1994 American Annuity Group, Inc.: We have audited the consolidated balance sheet of American Annuity Group, Inc., formerly Sprague Technologies, Inc., and subsidiaries (not presented separately herein) as of December 31, 1991, and the related consolidated statements of operations, common stockholders' equity and cash flows for the year then ended (before adjustments and reclassifications to conform with the presentation for 1992). Our audit also included the 1991 financial statement schedule listed in the Index at Item 14(a) for the year ended December 31, 1993. These financial statements and the financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements and the financial statement schedule based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, such consolidated financial statements (before adjustments and reclassifications to conform with the presentation for 1992) present fairly, in all material respects, the financial position of American Annuity Group, Inc. and subsidiaries as of December 31, 1991, and the results of their operations and their cash flows for the year then ended in conformity with generally accepted accounting principles. Also, in our opinion, the financial statement schedule for 1991, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein. Deloitte & Touche Stamford, Connecticut March 24, 1992 AMERICAN ANNUITY GROUP, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET (Dollars in millions) AMERICAN ANNUITY GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF OPERATIONS (In millions, except per share amounts) AMERICAN ANNUITY GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY (In millions) AMERICAN ANNUITY GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS (In millions) AMERICAN ANNUITY GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS A. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation The accompanying consolidated financial statements include the accounts of American Annuity Group, Inc. and its subsidiaries ("American Annuity", "AAG" or "the Company"). Intercompany transactions and balances are eliminated in consolidation. Certain reclassifications have been made to prior periods to conform to the current year's presentation. American Financial Corporation and subsidiaries ("AFC") owned 28,081,467 shares (80%) of AAG's Common Stock at December 31, 1993. The acquisition of Great American Life Insurance Company ("GALIC"), a subsidiary of AFC, on December 31, 1992, was recorded as a transfer of net assets between companies under common control. As a result, the net assets of GALIC were recorded by AAG at AFC's historical basis and the excess consideration paid over AFC's historical basis was treated as a reduction of common stockholders' equity. The results of GALIC's operations have been included in AAG's consolidated financial statements since its acquisition. Investments When available, fair values for investments are based on prices quoted in the most active market for each security. If quoted prices are not available, fair value is estimated based on present values, fair values of comparable securities, or similar methods. AAG implemented Statement of Financial Accounting Standards ("SFAS") No. 115, "Accounting for Certain Investments in Debt and Equity Securities", beginning December 31, 1993. This standard requires that (i) debt securities be classified as "held to maturity" and reported at amortized cost if AAG has the positive intent and ability to hold them to maturity, (ii) debt and equity securities be classified as "trading" and reported at fair value, with unrealized gains and losses included in earnings, if they are bought and held principally for selling in the near term and (iii) debt and equity securities not classified as held to maturity or trading be classified as "available for sale" and reported at fair value, with unrealized gains and losses reported as a separate component of stockholders' equity. Only in certain limited circumstances, such as significant issuer credit deterioration or if required by insurance or other regulators, may a company change its intent to hold a certain security to maturity without calling into question its intent to hold other debt securities to maturity in the future. Prior to the implementation of SFAS No. 115, AAG carried a portion of its fixed maturity securities at fair value with unrealized gains and losses carried as a separate component of stockholders' equity with the remainder of such securities carried at amortized cost. In connection with implementing SFAS No. 115, AAG reviewed its investment portfolio resulting in a reclassification at December 31, 1993 of approximately $704 million of its fixed maturity portfolio (including approximately $485 million in CMOs) from "held to maturity" to "available for sale" which, in turn, resulted in (i) an increase of $36 million in the carrying value of fixed maturity investments and (ii) an increase of $23 million in stockholders' equity. The reclassification reflects management's intention to reduce the proportion of CMOs owned and more actively manage the duration of its fixed maturity portfolio. The implementation of SFAS No. 115 had no effect on net income. AMERICAN ANNUITY GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued Short-term investments are carried at cost; mortgage loans on real estate are generally carried at amortized cost; policy loans are stated at the aggregate unpaid balance. Carrying amounts of these investments approximate their fair value. Gains or losses on sales of securities are recognized at the time of disposition with the amount of gain or loss determined on the specific identification basis. When a decline in the value of a specific investment is considered to be other than temporary, a provision for impairment is charged to earnings and the carrying value of that investment is reduced. Premiums and discounts on CMOs are amortized over their expected average lives using the interest method. Investment in Affiliates AAG's investments in equity securities of companies that are 20% to 50% owned by AFC and its subsidiaries are carried at cost, adjusted for a proportionate share of their undistributed earnings or losses. Deferred Policy Acquisition Costs ("DPAC") DPAC (principally new commissions, advertising, underwriting, policy issuance and sales expenses that vary with and are primarily related to the production of new business) is deferred and amortized, with interest, in relation to the present value of expected gross profits on the policies. These gross profits consist principally of net investment income and future surrender charges, less interest on policyholders' funds and future policy administration expenses. DPAC is reported net of unearned revenue relating to certain policy charges that represent compensation for future services. These unearned revenues are recognized as income using the same assumptions and factors used to amortize DPAC. Beginning with the implementation of SFAS No. 115 in 1993, to the extent that unrealized gains from securities classified as "available for sale" would result in adjustments to DPAC, unearned revenues and policyholder liabilities had those gains actually been realized, such balance sheet amounts are adjusted, net of deferred taxes. Annuity Policyholders' Funds Accumulated Annuity premium deposits and benefit payments are generally recorded as increases or decreases in "annuity policyholders' funds accumulated" rather than as revenue and expense. Increases in this liability for interest credited are charged to expense and decreases for surrender charges are credited to other income. The fair value of the liability for annuities in the payout phase is assumed to be the present value of the anticipated cash flows, discounted at current interest rates. Fair value of annuities in the accumulation phase is assumed to be the policyholders' cash surrender amount. The aggregate fair value of all annuity liabilities, net of DPAC, at December 31, 1993, approximates the amounts recorded in the financial statements. Income Taxes As of December 31, 1992, AAG and its 80%-owned U.S. subsidiaries were consolidated with AFC for federal income tax purposes. For periods prior to December 31, 1992, AAG filed consolidated tax returns which included all of its 80%-owned U.S. subsidiaries. AMERICAN ANNUITY GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued AAG and GALIC have separate tax allocation agreements with AFC which designate how tax payments are shared by members of the tax group. In general, both companies compute taxes on a separate return basis. GALIC is obligated to make payments to (or receive benefits from) AFC based on taxable income without regard to temporary differences. In accordance with terms of AAG's indentures, AAG receives GALIC's tax allocation payments for the benefit of AAG's deductions arising from current operations. If GALIC's taxable income (computed on a statutory accounting basis) exceeds a current period net operating loss of AAG, the taxes payable by GALIC associated with the excess are payable to AFC. If the AFC tax group utilizes any of AAG's net operating losses or deductions that originated prior to 1993, AFC will pay to AAG an amount equal to the benefit received. Effective January 1, 1992, the Company implemented SFAS No. 109, "Accounting for Income Taxes". As permitted under the Statement, AAG's prior year financial statements have not been restated and no adjustment was necessary for the cumulative effect of the change. Under SFAS No. 109, the liability method used in accounting for income taxes is less restrictive than the liability method under SFAS No. 96, previously used by the Company. The provisions of SFAS No. 109 allow AAG to recognize deferred tax assets if it is more likely than not that a benefit will be realized. Under SFAS No. 109, deferred income tax assets and liabilities are determined based on differences between financial reporting and tax bases and are measured using enacted tax rates. Current and deferred tax assets and liabilities are aggregated with other amounts receivable from or payable to affiliates. Debt Issuance Costs Debt expenses are amortized over the terms of the respective borrowings on the interest method. Statement of Cash Flows For cash flow purposes, "investing activities" are defined as making and collecting loans and acquiring and disposing of debt or equity instruments and property and equipment. "Financing activities" include annuity receipts, surrenders and withdrawals and obtaining resources from owners and providing them with a return on their investments. All other activities are considered "operating". Short-term investments having original maturities of three months or less when purchased are considered to be cash equivalents for purposes of the financial statements. Benefit Plans AAG participates in AFC's Employee Stock Ownership Retirement Plan ("ESORP") covering all employees who are qualified as to age and length of service. The ESORP is a trusteed, noncontributory plan which invests in securities of AFC for the benefit of the employees of AFC and its subsidiaries. Contributions are discretionary by the directors of AAG and are charged against earnings in the year for which they are declared. Qualified employees having vested rights in the plan are entitled to benefit payments at age 60. AAG and certain of its subsidiaries provide health care and life insurance benefits to eligible retirees. Effective January 1, 1992, AAG implemented SFAS No. 106, "Accounting for Postretirement Benefits Other Than Pensions". Prior to 1992, the cost of these benefits had generally been recognized as claims were incurred. AMERICAN ANNUITY GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued B. ACQUISITION OF GALIC On December 31, 1992, AAG acquired GALIC from Great American Insurance Company ("GAI"), a wholly owned subsidiary of AFC, for $468 million. In connection with the acquisition, GAI purchased from AAG 17,076,923 shares of AAG's Common Stock at $6.50 per share, and 450,000 shares of its Series A Preferred Stock at $100 per share. Concurrent with the acquisition, GAI purchased 5,140,973 shares of AAG's Common Stock pursuant to a cash tender offer. C. INVESTMENTS Fixed maturity investments at December 31, consisted of the following (in millions): Distribution based on market value is generally the same. Collateralized mortgage obligations had an expected average life of approximately 4 years at December 31, 1993. The carrying values of investments were determined after deducting cumulative provisions for impairment aggregating $14.4 million and $20.0 million at December 31, 1993 and 1992, respectively. AMERICAN ANNUITY GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued Gross gains of $45.3 million and gross losses of $11.0 million were realized on sales of fixed maturity investments during 1993. The carrying value of investments in any entity in excess of 10% of stockholders' equity at December 31, 1993, other than investments in affiliates and investments issued or guaranteed by the U.S. Government or government agencies, were as follows (in millions): At December 31, 1993, gross unrealized gains on marketable equity securities were $13.1 million and gross unrealized losses were zero. Realized gains and changes in unrealized appreciation on fixed maturity and equity security investments are summarized as follows (in millions): GALIC's investment portfolio is managed by a subsidiary of AFC. Investment expenses included investment management charges of $4.4 million, which represented approximately one-tenth of one percent of GALIC's invested assets during 1993. AMERICAN ANNUITY GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued D. INVESTMENT IN AFFILIATES Investment in affiliates at December 31, 1993, reflects AAG's 5% ownership (2.7 million shares) of the common stock of Chiquita Brands International ("Chiquita") which is accounted for under the equity method. At that same date, AFC and its other subsidiaries owned an additional 41% interest in the common stock of Chiquita. Chiquita is a leading international marketer, processor and producer of quality food products. The carrying value of AAG's investment in Chiquita at December 31, 1993 was $25.2 million. The market value of AAG's investment in Chiquita was approximately $30.7 million at December 31, 1993 and $46.1 million at March 1, 1994. In addition to AAG's investment in Chiquita, investment in affiliates at December 31, 1992, included a $9.0 million investment in the preferred stock of Spelling Entertainment Group Inc. The Spelling preferred stock was redeemed in November 1993. Included in AAG's retained earnings (deficit) at December 31, 1993, was approximately $2.6 million applicable to equity in undistributed net losses of Chiquita. E. DEFERRED POLICY ACQUISITION COSTS The DPAC balances at December 31, 1993 and 1992 are shown net of unearned revenues of $146.2 million and $152.8 million, respectively. F. LONG-TERM DEBT Long-term debt consisted of the following at December 31, (in millions): In connection with the GALIC acquisition, AAG borrowed $180 million under a Bank Term Loan Agreement and $50 million under a Bridge Loan. In 1993, AAG sold $225 million principal amount of Notes to the public and used the proceeds to repay the Bank and Bridge Loans. As a result, AAG has no scheduled principal maturities until the year 2001. AAG recorded an extraordinary loss of $5.2 million ($3.4 million net of tax) representing unamortized bank debt issue costs which were written off upon retirement of the bank debt. The fair value of AAG's outstanding debt exceeds the carrying value (net of unamortized debt issuance costs) by approximately $19 million at December 31, 1993. Interest payments were $11.7 million in 1993, $2.0 million in 1992 and $4.9 million in 1991. AMERICAN ANNUITY GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued G. STOCKHOLDERS' EQUITY The Company is authorized to issue 25,000,000 shares of Preferred Stock, par value $1.00 per share. On December 31, 1992, AAG issued 17,076,923 shares of Common Stock and 450,000 shares of Series A Cumulative Preferred Stock, $100 redemption value, in connection with the acquisition of GALIC. Holders of the Series A Preferred Stock are entitled to receive dividends at the rate of $7.00 per share per annum. The preferred shares issued were recorded at $29.4 million (imputed dividend rate of 12% through 2007) with the excess paid of $15.6 million credited to capital surplus and accreting over 15 years. If the preferred shares are outstanding after January 1, 2008, substantial limitations on the ability of AAG and its subsidiaries to borrow funds, issue stock or pay common stock dividends will become effective. In 1993, 1992 and 1991, AAG paid annual dividends of $.05 per common share. At December 31, 1993, AAG's cash dividends were limited to $2.5 million under indenture covenants. Under the Company's 1987 Stock Option Plan ("Option Plan"), stock options were granted to officers and other key employees of the Company to purchase shares of Common Stock. The Company also had a Spin-Off Stock Option Plan ("Spin-Off Plan") under which a one-time grant of options was made to directors, officers and employees of the Company who had held options or shares of STI's former parent on the STI distribution date. As a result of the sales of subsidiaries and pursuant to the terms of the plans, all options became fully vested and exercisable in January 1992. In February 1992, 1.5 million options were exercised; a total of 93,550 shares under the Option Plan and 377,804 shares under the Spin-Off Plan expired. Also in February 1992, under the Company's Redemption Program, AAG purchased from employees (i) 499,025 shares of Common Stock at a price of $6.725 per share and (ii) 867,000 shares of Common Stock at a price of $6.8125 per share. A charge to income of $2.8 million was recorded in 1991 to reflect the exercise of stock options and the repurchase of Common Stock pursuant to the Redemption Program. H. DISCONTINUED OPERATIONS The results of discontinued operations included in the Statement of Operations were as follows (in millions): Year ended December 31, _______________________ 1993 1992 1991 ____ ____ ____ Net sales $ - $ 80.7 $294.1 Cost of sales - (80.7)(258.8) Interest and debt expense - (1.2) (3.7) Selling, general and administrative costs - - (37.3) Loss on sales of businesses and restructuring provisions (14.8) (24.5) (55.1) Gain on sale of investment in affiliate - - 8.5 _____ _____ _____ Loss from discontinued operations before tax (14.8) (25.7) (52.3) Income tax benefit (5.2) (8.9) (4.5) _____ ______ _____ Loss from discontinued operations ($ 9.6) ($16.8)($47.8) _____ _____ _____ AMERICAN ANNUITY GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued All of the Company's former manufacturing businesses are reported as discontinued operations. At December 31, 1993, the Company's last manufacturing unit, Electromag NV, was being held for sale and was carried at estimated net realizable value. The loss from discontinued operations in 1993 included charges for employee related obligations of approximately $9.7 million resulting primarily from a decrease (from 9.5% to 7.125%) in the discount rate used to calculate pension obligations. The remaining charges reflected additional write-downs and other estimated expenses associated with the Company's former manufacturing properties. During 1992, the Company recorded charges related to discontinued operations as follows: employee related obligations -- $6.8 million; environmental liabilities -- $5.0 million; corporate office shutdown and severance costs - - $5.0 million; property valuation adjustments -- $3.6 million; potential merchandise returns -- $2.0 million and other -- $2.1 million. In 1992, AAG sold its capacitor and thick film network businesses for approximately $130 million in cash, notes and property. The Company recorded provisions of $42.6 million related to the anticipated sales of these operations during 1991. In 1991, the Company sold its 45.3% interest in a manufacturing operation for a cash payment of $18.0 million, recognizing a pretax gain of $8.5 million on the sale. The Company has a noncontributory defined benefit pension plan covering former U.S. employees of its discontinued manufacturing operations. The former employees in this plan generally receive pension benefits that are based upon formulas that reflect all past service with the Company and the employee's compensation during employment. Contributions are made on an actuarial basis in amounts necessary to satisfy requirements of ERISA. At December 31, 1993, the actuarial value of the benefit obligations, which are being discounted at 7.125%, exceeded the plan assets by $15.1 million, which has been included in accrued expenses in the financial statements. Effective January 1, 1992, AAG implemented SFAS No. 106 and recorded a provision of $3.1 million for the projected future costs of providing postretirement medical benefits to retirees in its discontinued manufacturing operations. I. INCOME TAXES Provision (benefit) for income taxes consisted of (in millions): 1993 1992 1991 ____ ____ ____ Federal: Current $27.4 $ - $2.6 Deferred (7.4) (8.9) (5.0) Foreign: Current - - 0.3 Deferred - - (2.6) State - 0.5 0.4 _____ ____ ____ Total $20.0 ($8.4) ($4.3) _____ ____ ____ AMERICAN ANNUITY GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued At December 31, 1993, AAG had net operating loss carryforwards for federal income tax purposes of approximately $161 million which are scheduled to expire as follows: $18.6 million in 1994, $24.1 million in 1995 through 2001 and $118.3 in 2002 through 2005. An income tax refund of $1.1 million was received in 1991. Cash disbursements for income taxes were not material. AMERICAN ANNUITY GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued J. LEASES Leases relate principally to certain administrative facilities and discontinued operations. Future minimum lease payments, net of sublease revenues, under operating leases having initial or remaining noncancellable lease terms in excess of one year at December 31, 1993 are payable as follows: 1994 -- $700,000; 1995 -- $1.0 million; 1996 -- $1.1 million; 1997 -- $1.1 million; 1998 -- $800,000; 1999 and beyond -- $2.8 million. Rental expense for operating leases was $900,000 in 1993, $1.5 million in 1992 and $6.7 million in 1991. K. CONTINGENCIES The Company is presently conducting investigations or clean-up activities in accordance with consent agreements with state environmental agencies. Based on the costs incurred over the past several years and discussions with independent environmental consultants, the Company believes the aggregate cost of environmental remediation work at all sites for which it has responsibility will range from $10 million to $15 million. The reserve for environmental remediation work was $10.6 million at December 31, 1993. Management does not believe that these clean-up activities will have a material effect upon the Company's financial position, results of operations or cash flows. "Marketable securities, restricted in use" consists primarily of amounts held in escrow with respect to certain clean-up activities due to sales of various discontinued operations. In 1991, the Company identified possible deficiencies in procedures for reporting quality assurance information to the Defense Electronics Supply Center ("DESC") with respect to the manufacturing of capacitors utilized by, among others, the United States Government. The Company has certain indemnification obligations for losses, if any, which result from these matters. Management believes an adequate accrual has been recorded at December 31, 1993, and that any future impact on AAG's operations will not be material. L. STATUTORY INFORMATION; RESTRICTIONS ON TRANSFERS OF FUNDS AND ASSETS OF SUBSIDIARIES GALIC is required to file financial statements with state insurance regulatory authorities prepared on an accounting basis prescribed or permitted by such authorities (statutory basis). For the year ended December 31, 1993, GALIC's statutory net earnings were $44.0 million. Certain statutory balance sheet amounts at December 31, were as follows (in millions): 1993 1992 ____ ____ Policyholders' surplus $251.3 $216.2 Asset valuation reserve 70.3 70.9 Interest maintenance reserve 35.7 17.2 The amount of dividends which can be paid by GALIC without prior approval of regulatory authorities is subject to restrictions relating to capital and surplus and statutory net income. GALIC may pay approximately $44.0 million in dividends in 1994, based on statutory net income, without prior approval. AMERICAN ANNUITY GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued PART IV ITEM 14.	ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) Documents filed as part of this Report: 1. Financial Statements are Included in Part II, Item 8. 2. Financial Statement Schedules: Selected Quarterly Financial Data is included in Note M to the Consolidated Financial Statements. Schedules filed herewith: For 1993, 1992 and 1991 Page _______________________ ____ II - Amounts Receivable from Related Parties and Underwriters, Promoters, and Employees other than Related Parties S-2 III - Condensed Financial Information of Registrant S-3 All other schedules for which provisions are made in the applicable regulation of the Securities and Exchange Commission have been omitted as they are not applicable, not required, or the information required thereby is set forth in the Financial Statements or the notes thereto. 3. Exhibits - See Exhibit Index on Page E-1. (b) Reports on Form 8-K's: None AMERICAN ANNUITY GROUP, INC. AND SUBSIDIARIES SCHEDULE II - AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES THREE YEARS ENDED DECEMBER 31, 1993 (In Thousands) AMERICAN ANNUITY GROUP, INC. AND SUBSIDIARIES SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT (In millions) AMERICAN ANNUITY GROUP, INC. AND SUBSIDIARIES SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT (In millions) Condensed Statement of Cash Flows _________________________________ Year ended December 31 _____ Operating Activities: Net earnings $40.0 Adjustments: Discontinued operations 9.6 Extraordinary item 3.4 Equity in net earnings of affiliates (77.6) Increase in receivables from affiliates (2.8) Amortization of debt expense 1.2 Decrease in other assets 0.4 Increase in payables to affiliates 42.8 Decrease in other liabilities (10.7) Dividends from GALIC 18.2 Other, net (0.1) _____ 24.4 _____ Investing Activities: Additional investment in GALIC (13.0) _____ Financing Activities: Additional long-term borrowings 225.0 Reductions of long-term debt (230.0) Cash dividends paid (4.1) _____ (9.1) _____ Net Increase in Cash and Short-term Investments 2.3 Cash and short-term investments at beginning of period 8.1 _____ Cash and short-term investments at end of period $10.4 _____ AMERICAN ANNUITY GROUP, INC. INDEX TO EXHIBITS Number Exhibit Description ______ ___________________ 3.1 Certificate of Incorporation of Registrant 3.2 By-laws of Registrant 4.1 Indenture dated as of February 2, 1993, between the Registrant and Star Bank, National Association, as Trustee, relating to the Registrant's 11-1/8% Senior Subordinated Notes due 2003, incorporated herein by reference to Exhibit 4.2 to the Registrant's Current Report on Form 8-K, dated February 5, 1993. 4.2 Indenture dated as of August 18, 1993, between the Registrant and NationsBank, National Association, as Trustee, relating to the Registrant's 9-1/2% Senior Notes due 2001, incorporated herein by reference to Exhibit 4.1 to the Registrant's Registration Statement on Form S-2 dated August 11, 1993. 10.1 Agreement of Allocation of Payment of Federal Income Taxes ("American Annuity Tax Allocation Agreement"), dated December 31, 1992, between American Financial Corporation and the Registrant incorporated herein by reference to Exhibit 10.12 to the Registrant's Registration Statement on Form S-2 dated January 7, 1993. 10.2 Assignment of Tax Allocation Payments dated December 31, 1992, between American Financial Corporation and the Registrant incorporated herein by reference to Exhibit 10.15 to the Registrant's Registration Statement on Form S-2 dated January 7, 1993. 10.3 Agreement for the Allocation of Federal Income Taxes dated May 13, 1974, between American Financial Corporation and Great American Life Insurance Company, as supplemented on January 1, 1987 incorporated herein by reference to Exhibit 10.16 to the Registrant's Registration Statement on Form S-2 dated January 7, 1993. 10.4 Investment Services Agreement, dated December 31, 1992, between Great American Life Insurance Company and American Money Management Corporation incorporated herein by reference to Exhibit 10.17 to the Registrant's Registration Statement on Form S-2 dated January 7, 1993. 10.5 Common Stock Registration Agreement, dated December 31, 1992, between the Registrant and American Financial Corporation and its wholly owned subsidiary Great American Insurance Company incorporated herein by reference to Exhibit 10.22 to the Registrant's Registration Statement on Form S-2 dated January 7, 1993. 10.6 Preferred Stock Registration Agreement, dated December 31, 1992, between the Registrant and American Financial Corporation and its wholly owned subsidiary Great American Insurance Company incorporated herein by reference to Exhibit 10.23 to the Registrant's Registration Statement on Form S-2 dated January 7, 1993. AMERICAN ANNUITY GROUP, INC. INDEX TO EXHIBITS - Continued Number Exhibit Description ______ ___________________ 10.7 Common Stock Registration Agreement, dated December 31, 1992 between Chiquita Brands International, Inc. and Great American Life Insurance Company incorporated herein by reference to Exhibit 10.24 to the Registrant's Registration Statement on Form S-2 dated January 7, 1993. 10.8 American Annuity Group's 1993 Stock Appreciation Rights Plan. Signatures __________ Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, American Annuity Group, Inc. has duly caused this Report to be signed on its behalf by the undersigned, duly authorized. American Annuity Group, Inc. Signed: March 25, 1994 BY:s/CARL H. LINDNER _______________________________ Carl H. Lindner Chairman of the Board 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 Capacity Date _________ ________ ____ s/CARL H. LINDNER Chairman of the Board March 25, 1994 _______________________ Carl H. Lindner of Directors s/S. CRAIG LINDNER Director March 25, 1994 ________________________ S. Craig Lindner s/ROBERT A. ADAMS Director March 25, 1994 _______________________ Robert A. Adams s/A. LEON FERGENSON Director March 25, 1994 _______________________ A. Leon Fergenson s/RONALD F. WALKER Director March 25, 1994 _______________________ Ronald F. Walker s/WILLIAM J. MANEY Senior Vice President, March 25, 1994 _______________________ William J. Maney Treasurer and Chief Financial Officer
101063_1993.txt	101063	1993	ITEM 1 - BUSINESS GENERAL Chiquita Brands International, Inc. ("Chiquita" or the "Company") is a leading international marketer, processor and producer of quality fresh and processed food products. In recent years, the Company has capitalized on its "Chiquita" and other premium brand names by building on its worldwide leadership position in the marketing, distribution and sourcing of bananas; by expanding its quality fresh fruit and vegetable operations; and by further developing its business in value-added processed foods. Chiquita's products include: - Bananas, citrus, grapes, kiwi, mangos, pears and pineapples sold under the "Chiquita" brand name; - Bananas, citrus and other quality fresh fruit including apples, grapes, papaya, peaches, pears, plums, strawberries and tomatoes sold under the "Consul," "Chico," "Amigo," "Frupac" and other brand names; - A wide variety of fresh vegetables including asparagus, beans, broccoli, carrots, celery, lettuce, onions and potatoes sold under the "Premium" and various other brand names; - Fruit and vegetable juices and other processed fruits and vegetables, including banana puree, marketed under the "Chiquita," "Friday" and other brands; - Wet and dry salads sold under the "Club Chef," "Chef Classic" and "Naked Foods" brands; and - Margarine, shortening and other consumer packaged foods sold under the "Numar," "Clover" and various regional brand names. No individual customer accounted for more than 10% of the Company's consolidated net sales during any of the last three years. See "Management's Analysis of Operations and Financial Condition," which is incorporated by reference in Item 7 herein from the Company's 1993 Annual Report to Shareholders, for a discussion of factors affecting results of the Company's operations for 1993, 1992 and 1991. Factors which may cause fluctuations in the results of operations are also discussed in the description of the Company's operations below. Fresh food products The Company markets an extensive line of fresh fruits and vegetables sold under the "Chiquita" and other brand names. The core of Chiquita's fresh foods operations is the marketing, distribution and sourcing of bananas. Sales of bananas, as a percent of consolidated net sales, were 67% in 1991, 62% in 1992 and 58% in 1993. Chiquita believes that it derives competitive benefits in the marketing, distribution and sourcing of fresh foods through its: - Recognized brand names and reputation for quality; - Strong market position in Europe, North America and Japan, the world's principal markets for fresh fruit; - Modern, cost-efficient fresh fruit transportation system; and - Industry leading position in terms of number and geographic diversity of its sources of bananas, which enhances its ability to provide customers with premium quality products on a consistent basis. Chiquita has benefitted from its multi-year investment spending program and the ongoing effects of its restructuring and cost reduction efforts to adjust its fresh foods volume and cost infrastructure to significantly reduce production, distribution and overhead costs. (See "Distribution and Logistics" and "Sourcing" below and ITEM 2		ITEM 2 - PROPERTIES The Company owns approximately 132,000 acres and leases approximately 46,000 acres of improved land, principally in Costa Rica, Panama and Honduras. Substantially all of this land is used for the cultivation of bananas and oil palm and support activities, including the maintenance of floodways. The Company also owns power plants, packing stations, warehouses, irrigation systems and loading and unloading facilities used in connection with its banana and oil palm operations. The Company owns or controls under long-term bareboat leases 23 ocean-going refrigerated vessels, including 1 delivered in early 1994, and has 21 additional such vessels under time charters, primarily for transporting tropical fruit sold by the Company. From time to time, excess capacity may be chartered or subchartered to others. In addition, the Company enters into spot charters as necessary to supplement its transportation resources. The Company also owns or leases other related equipment, including refrigerated container units, used to transport fresh food. The majority of the ships owned and related container units are pledged as collateral for related financings. Properties used by the Company's processed foods operations include processing facilities in Costa Rica and Honduras, and vegetable canning facilities in Wisconsin. Other operating units of the Company own, lease and operate properties, principally in the United States and Central and South America. The Company leases the space for its executive offices in Cincinnati, Ohio. For further information with respect to the Company's physical properties, see the descriptions under ITEM 1 - BUSINESS - GENERAL and DISCONTINUED OPERATIONS, above, and Notes 6 and 7 to the Consolidated Financial Statements included in the Company's 1993 Annual Report to Shareholders. ITEM 3	ITEM 3 - LEGAL PROCEEDINGS A number of legal actions are pending against the Company, including those described below and in ITEM 1 - BUSINESS - DISCONTINUED OPERATIONS affecting the Meat Division, which is reported as a discontinued operation. Based on evaluations of facts which have been ascertained and opinions of counsel, management does not believe such litigation will, individually or in the aggregate, have a material adverse effect on the consolidated financial condition or results of operations of the Company. The Company and other major banana producing companies have been added as defendants in two purported class actions, filed in state courts in Galveston and Brazoria counties, Texas, and in three other Texas state court cases. These cases were originally filed in early 1993 against the manufacturers of an agricultural chemical called DBCP by an aggregate of approximately 20,000 individuals. Most of the plaintiffs are foreign citizens who claim to have been employees of banana companies, including in some cases subsidiaries of the Company. The plaintiffs allege they were injured as a result of exposure to DBCP, which was used primarily in the 1970's. The damage claims have not been quantified. The suits are Franklin Rodriguez Delgado, et al. v. Shell Oil Company, et al., Cause No. 93-CV-0030 (Galveston County, Texas); Armando Ramos Bermudez, et al. v. Shell Oil Company, et al., Cause No. 93-C-2290 (Brazoria County, Texas); Narcisco Borja, et al. v. Dow Chemical Company, et al., Cause No. 93-320 (Dallas County, Texas); Juan Ramon Valdez, et al. v. Shell Oil Company, et al., Cause No. 17814 (Morris County, Texas); and Ramon Rodriguez Rodriguez, et al. v. Shell Oil Company, et al., Cause No. 3813 (Jim Hogg County, Texas). Similar suits have been filed in Costa Rica and Panama by approximately 800 individuals against subsidiaries of the Company, including Compania Palma Tica and Compania Bananera Atlantica Limitada. Similar suits have been filed in other countries against other defendants as well. The Company has answered all suits, believes it has substantial and meritorious defenses and is vigorously defending the actions. ITEM 4	ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. PART II ITEM 5	ITEM 5 - MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Information concerning the number of shareholders at March 1, 1994, and the market for the Company's capital stock is set forth on the inside back cover of the Company's 1993 Annual Report to Shareholders under "Investor Information." Information concerning the price ranges of the Company's capital stock and dividends declared thereon is set forth in Note 15 to the Consolidated Financial Statements included in the 1993 Annual Report to Shareholders. Information concerning restrictions on the Company's ability to declare and pay dividends is set forth in Note 8 to the Consolidated Financial Statements included in the 1993 Annual Report to Shareholders. All such information is incorporated herein by reference. ITEM 6	ITEM 6 - SELECTED FINANCIAL DATA This information is included in the table entitled "Selected Financial Data" on page 6 of the Company's 1993 Annual Report to Shareholders and is incorporated herein by reference. ITEM 7	ITEM 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This information is included under the caption "Management's Analysis of Operations and Financial Condition" included on pages 8 through 10 of the Company's 1993 Annual Report to Shareholders and is incorporated herein by reference. ITEM 8	ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Consolidated Financial Statements of Chiquita Brands International, Inc. and its subsidiaries included on pages 11 through 23 of the Company's 1993 Annual Report to Shareholders, and "Quarterly Financial Data" which is set forth in Note 15 to such Consolidated Financial Statements, are incorporated herein by reference. ITEM 9	ITEM 9 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III Except for information relating to the Company's executive officers set forth in ITEM 10	ITEM 10 - DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The executive officers of the Company are: Carl H. Lindner (age 74) - Mr. Lindner has been Chairman of the Board of Directors and Chief Executive Officer of the Company since August 1984 and Chairman of the Board of Directors and Chief Executive Officer of AFC since AFC was founded over 30 years ago. AFC is a holding company which, through subsidiaries, is engaged in several financial businesses, including property and casualty insurance, annuities, and portfolio investing. In nonfinancial areas, AFC has substantial operations in the food products industry, through its ownership in Chiquita, in television and radio station operations, through its ownership of Great American Communications Company ("GACC"), and in industrial manufacturing. Keith E. Lindner (age 34) - Mr. Lindner has been President and Chief Operating Officer of the Company since June 1989 and President of its Chiquita Brands, Inc. subsidiary since December 1986. He was Senior Executive Vice President of the Company from March 1986 to June 1989. Fred J. Runk (age 51) - Mr. Runk has been a Vice President of the Company since September 1984. From September 1984 to March 1994 he served as the Company's Chief Financial Officer. From February 1985 until June 1988, he was also Treasurer of the Company. Mr. Runk has served as Vice President and Treasurer of AFC for more than five years. Steven G. Warshaw (age 40) - Mr. Warshaw was named Chief Financial Officer of the Company in March 1994. He has also served as the Company's Executive Vice President and Chief Administrative Officer since January 1990. Mr. Warshaw has been employed by the Company in various executive capacities since April 1986. Robert F. Kistinger (age 41) - Mr. Kistinger was named Senior Executive Vice President of the Company's Chiquita Banana Group in February 1994. From March 1989 until February 1994, he was Executive Vice President, Operations of the Company's Chiquita Tropical Products Division. Mr. Kistinger has been employed by the Company in various capacities since 1980. Thomas E. Mischell (age 46) - Mr. Mischell has served as a Vice President of the Company since July 1986 and has served as Vice President of AFC for more than five years. Charles R. Morgan (age 47) - Mr. Morgan has been Vice President, General Counsel and Secretary of the Company since January 1990. Mr. Morgan has also served as Vice President, General Counsel and Secretary of Chiquita Brands, Inc. since June 1988 and as Vice President and Secretary of Morrell since February 1989. From February 1989 to July 1993, he was also General Counsel of Morrell. Jos P. Stalenhoef (age 52) - Mr. Stalenhoef was named President, Chiquita Banana-North American Division in February 1994. From March 1989 until February 1994, he was Senior Vice President, North America, Chiquita Tropical Products Division. Prior to that time, Mr. Stalenhoef was Vice President, Marketing, Chiquita Tropical Products Division. William A. Tsacalis (age 50) - Mr. Tsacalis has served as Vice President and Controller of the Company since November 1987. In December 1993, GACC completed a comprehensive financial restructuring which included a prepackaged plan of reorganization filed in November of that year under Chapter 11 of the Bankruptcy Code. Carl H. Lindner and Fred J. Runk were executive officers of GACC within two years before GACC's bankruptcy reorganization. ITEM 11	ITEM 11 - EXECUTIVE COMPENSATION ITEM 12	ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT ITEM 13	ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS PART IV ITEM 14	ITEM 14 - EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) 1. Financial Statements The following consolidated financial statements of the Company and the Report of Independent Auditors are included in the Company's 1993 Annual Report to Shareholders and are incorporated by reference in Part II, Item 8: Page of Annual Report Report of Independent Auditors 7 Consolidated Statement of Income Years ended December 31, 1993, 1992 and 1991 11 Consolidated Balance Sheet December 31, 1993 and 1992 12 Consolidated Statement of Shareholders' Equity Years ended December 31, 1993, 1992 and 1991 13 Consolidated Statement of Cash Flow Years ended December 31, 1993, 1992 and 1991 14 Notes to Consolidated Financial Statements 15 2. Financial Statement Schedules The following consolidated financial statement schedules of the Company, which exclude amounts relating to its discontinued operations, are included in this Annual Report on Form 10-K: Page of Form 10-K II - Amounts Receivable from Related Parties, and Underwriters, Promoters, and Employees Other Than Related Parties V - Property, Plant and Equipment 18 VI - Accumulated Depreciation of Property, Plant and Equipment VIII - Allowance for Doubtful Accounts Receivable 20 IX - Short-term Borrowings 21 X - Supplementary Income Statement Information 22 All other schedules are not required under the related instructions or are inapplicable and, therefore, have been omitted. 3. Exhibits See Index of Exhibits (page 23) for a listing of all exhibits filed with this Annual Report on Form 10-K. (b) There were no reports on Form 8-K filed by the Company during the quarter ended December 31, 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on March 30, 1994. CHIQUITA BRANDS INTERNATIONAL, INC. By /s/ Carl H. Lindner Carl H. Lindner Chairman of the Board 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 indicated below on March 30, 1994: /s/ Carl H. Lindner Chairman of the Board and Carl H. Lindner Chief Executive Officer /s/ Keith E. Lindner Director; President and Keith E. Lindner Chief Operating Officer /s/ S. Craig Lindner Director S. Craig Lindner Hugh F. Culverhouse* Director Hugh F. Culverhouse /s/ Fred J. Runk Director and Vice President Fred J. Runk Jean H. Sisco* Director Jean H. Sisco /s/ Ronald F. Walker Director Ronald F. Walker /s/ Steven G. Warshaw Executive Vice President, Chief Administrative Steven G. Warshaw Officer and Chief Financial Officer /s/ William A. Tsacalis Vice President and Controller William A. Tsacalis (Chief Accounting Officer) * By /s/ William A. Tsacalis Attorney-in-Fact By authority of powers of attorney filed with this annual report on Form 10-K. (This page left blank intentionally.) CHIQUITA BRANDS INTERNATIONAL, INC. AND SUBSIDIARY COMPANIES SCHEDULE IX - SHORT-TERM BORROWINGS (In thousands) Short-term borrowings include borrowings in currencies other than the U.S. dollar carrying interest rates which generally are higher than interest rates on U.S. dollar debt. Average outstanding borrowings during each year were determined based on the amounts outstanding at the end of each month during the year. The weighted average interest rate during each year was computed by dividing actual interest expense on short-term borrowings in each year by average short-term borrowings in such year. CHIQUITA BRANDS INTERNATIONAL, INC. AND SUBSIDIARY COMPANIES SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION (In thousands) CHIQUITA BRANDS INTERNATIONAL, INC. Index of Exhibits Exhibit Number Description 3-a The Company's Certificate of Incorporation 3-b The Company's By-Laws, filed as Exhibit 3-b to Annual Report on Form 10-K for the year ended December 31, 1992 4 Registrant has no outstanding debt issues exceeding 10% of the assets of Registrant and its consolidated subsidiaries. The Registrant will furnish to the Securities and Exchange Commission, upon request, copies of all agreements and instruments defining the rights of security holders for debt issues not exceeding 10% of the assets of Registrant and its consolidated subsidiaries. 10-a Lease of Lands and Operating Contract between United Brands Company, Chiriqui Land Company, Compania Procesadora de Frutas and the Republic of Panama, dated January 8, 1976, effective January 1, 1976 10-b Agreement dated April 22, 1976 effective January 1, 1976 between Tela Railroad Company and the Government of Honduras Executive Compensation Plans 10-c 1986 Stock Option and Incentive Plan, filed as Exhibit A to the definitive Proxy Statement in connection with the Company's 1992 Annual Meeting of Shareholders 10-d Individual Stock Option Plan and Agreement, filed as Exhibit 4 to Registration Statement on Form S-8 No. 33- 25950 dated December 7, 1988 10-e Deferred Compensation Plan, filed as Exhibit 10-e to Annual Report on Form 10-K for the year ended December 31, 1992 11 Computation of Earnings Per Common Share 12 Computation of Ratios of Earnings to Fixed Charges and Earnings to Combined Fixed Charges and Preferred Stock Dividends 13 Chiquita Brands International, Inc. 1993 Annual Report to Shareholders (pages 6 through 23 and inside back cover) 21 Subsidiaries of Registrant 23 Consent of Independent Auditors 24 Powers of Attorney 99 Annual Reports on Form 11-K for the Chiquita Savings and Investment Plan and the John Morrell & Co. Salaried Employees Incentive Savings Plan for 1993 will be filed by amendment on or before June 29, 1994. * Incorporated by reference.
354964_1993.txt	354964	1993	ITEM 1. BUSINESS. GENERAL Household International, Inc. ("Household International" or the "Company") is a publicly owned corporation which, with its subsidiaries, provides a broad range of diversified financial services for individuals and businesses. The Company employs approximately 16,900 people and serves approximately 17 million customers in the United States, Canada, the United Kingdom and Australia. In 1993 Household International was ranked as the 61st largest publicly owned company, based on total assets by Forbes magazine which annually lists the 500 largest public corporations in the United States. The Company's operations are divided into three business segments: Finance and Banking, Individual Life Insurance, and Liquidating Commercial Lines. Household International was created in 1981 as a result of a shareholder approved restructuring of Household Finance Corporation ("HFC"), a publicly owned corporation since 1925, whereby Household International became a holding company for various subsidiaries, including HFC. At that time Household International had operations in the financial services, manufacturing, transportation and merchandising industries. In 1985 the Company began to restructure its operations away from being a diversified conglomerate. This action resulted in the disposition of its merchandising (1985), transportation (1986) and manufacturing (1989-1990) businesses, including the spin-off to its common stock shareholders of three manufacturing companies in 1989: Eljer Industries, Inc., Schwitzer, Inc. and Scotsman Industries, Inc. The products offered by Household International, a description of the geographic markets in which the Company operates and summary financial information for each of the Company's business segments is set forth in the Company's Annual Report to Shareholders (the "1993 Annual Report"), portions of which are incorporated herein by reference. See pages 12, 13 and 33 through 80 of the 1993 Annual Report. The Company markets its products to its customers through a number of different distribution channels, including consumer finance branch offices, consumer bank branch offices, loan origination offices, retail merchants, independent insurance agents, direct mail and telemarketing, and retail securities brokerage offices. 1993 DEVELOPMENTS. In 1993 the Company's bankcard operations continued to grow, principally through the continuing success of the GM Card(sm). The GM Card is a general-purpose credit card which allows the users thereof to earn credit toward the purchase of new General Motors vehicles. The GM Card was publicly introduced in September 1992 and as of December 31, 1993, there were approximately 5.9 million accounts which had generated approximately $4.9 billion credit card receivables. As of this date, the GM Card accounts are generally active and are of high credit quality. In the fourth quarter, the Company announced expansion of its alliance with General Motors Corporation with the introduction of a GM Card from Vauxhall in the United Kingdom, permitting users to earn rebates toward the purchase of a new Vauxhall vehicle. The card will be issued by HFC Bank plc, the Company's principal operating subsidiary in the United Kingdom. Also in the fourth quarter, the Company announced an alliance to issue a new co-branded credit card with Charles Schwab & Co. In 1993 Household International strengthened its capital base through the issuance of additional equity securities. In March 1993 the Company raised additional capital of approximately $269 million (net of issuance costs) through the sale of 4,025,000 shares of common stock (on a pre-split basis). In addition, during the year the Company issued approximately $44 million of common stock through employee benefit and dividend reinvestment plans. The Company also issued 4,000,000 depositary shares, with each depositary share representing a one-fortieth interest in a share of the Company's 7.35% Cumulative Preferred Stock, Series 1993-A. The underwritten public offering raised approximately $97 million (net of issuance costs) for the Company. The issuance of this common and preferred stock, together with a conservative growth posture, strengthened its capital ratios. In October, the Company's common stock was split 2-for-1 through a 100% stock dividend. The split doubled the number of shares of common stock outstanding and was affected for the primary purpose of making the common stock more affordable to a broader base of investors. The lowest interest rates in the United States in over twenty years contributed to high prepayment rates in the first mortgage portfolio, resulting in write-downs of capitalized servicing rights and lower earnings for the mortgage banking operation. In foreign operations, despite continuing weak economic growth in the United Kingdom, Household International's United Kingdom operation was profitable for the first time in five years. The improvement was primarily attributable to actions taken in prior years such as implementing tightened underwriting standards and improved collections efforts. For the year, the United Kingdom operation earned $10.3 million compared to a 1992 loss of $45.9 million. The Company's operation in Canada was adversely affected by a continuing poor economic environment resulting in low receivables origination volume. The Company's performance in Canada was also impacted by establishment of higher loss reserves during the fourth quarter as a result of the completion of the first phase of a strategic assessment of the Canadian market, economic conditions, products and the Company's Canadian cost structure and policies. The Company's Australian operation was profitable, comparable with its 1992 results. FINANCE AND BANKING Total Finance and Banking receivables at December 31, classified by type, consisted of the following (in millions): CONSUMER OPERATIONS. Household International is primarily a consumer financial services company, with consumer receivables of $18.6 billion, representing approximately 96 percent of Finance and Banking owned receivables and approximately 59 percent of total assets at December 31, 1993, excluding the discontinued commercial product lines. The Company's primary target customer for consumer lending is generally between 25 and 50 years of age with a household income of $15,000 to $50,000. Approximately 82 percent of the Company's Finance and Banking receivables are located in the United States. Through its consumer lending businesses, the Company competes with banks, thrifts, finance companies and other financial institutions through the offering of a variety of products, a strong service orientation and innovative marketing programs. The Company believes that the fragmented nature of the consumer financial services industry provides ample opportunity for the Company to increase market share, and therefore profitability. The Company has focused on being a low-cost producer in its consumer financial services businesses. Highly automated processing facilities have been developed to support underwriting, loan administration and collection functions across business lines. By supporting its multiple-distribution networks with centralized processing centers, the Company has improved efficiency through specialization and economies of scale. In addition, by removing such functions from branch offices, the Company is able to concentrate on sales activities in the branch offices. Underwriting and collection of consumer credit products and internal controls over these functions have been improved over the last few years through the segregation of the sales, underwriting and collection functions. For example, loan approvals are handled by non-sales personnel located in regional servicing centers ("RSC") whose primary concern is credit quality, not volume. Underwriting and collections are supported by automated systems which analyze the likelihood of delinquency or bankruptcy. The Company believes it is an industry leader in implementing automated underwriting and collection management systems which improve its ability to manage credit quality. The Company considers factors such as the applicant's income, expenses, paying habits, value of collateral, if any, and length and stability of employment, in its effort to determine whether the borrower has the ability to support the loan. The objective of the Company's program to automate and centralize the back office processing of U.S. consumer finance accounts has been to transfer the record keeping and collection tasks necessary to service accounts from its branch offices to an RSC. The RSCs were created to provide higher quality customer service and cost savings resulting from greater efficiency through economies of scale. By doing so, the Company's branch offices have been able to focus on sales and marketing efforts. The Company's first RSC began operations in Illinois in 1987. By the first quarter of 1990, all U.S. branch offices of HFC were served by RSCs. As a result of efficiencies achieved since that time, the operations of the servicing centers have been further consolidated, and in 1993 the servicing operation for all HFC originated loans was moved to a single servicing center located in Illinois. The former western region RSC, which began operations in the first quarter of 1989, now supports HFC's portfolio acquisition business and services acquired consumer credit receivables. The former eastern region RSC, which opened in Virginia in the fourth quarter of 1989, now supports the GM Card exclusively. Additional facilities exist to provide the Company's bankcard and merchant participation business with centralized automated support. The Company has also established regional processing centers ("RPC") in California, Illinois, Maryland, Nevada and Ohio to perform payment processing, check processing, statement billings and other administrative tasks for all domestic consumer operations. In the United Kingdom, HFC Bank plc's Birmingham Business Center provides operating and administrative functions in centers modeled after the RSCs and RPCs used in the United States. In 1990, the Canadian operation opened two centers similar to the United Kingdom center and the Australian operation opened one center. Over the last few years, the Company has invested in the development of its bankcard, private-label credit card and consumer and mortgage banking services which have been an important contributor to the Company's growth. Net income on an operating basis from these newer businesses increased from $7 million in 1988 to $201 million in 1993. At December 31, 1993, the Company had acquired intangibles associated with acquisitions of thrift institutions and bankcard portfolios of approximately $473 million. The Company amortizes purchased credit card intangibles on a straight-line basis, not to exceed 10 years and other intangibles over their estimated life not exceeding 15 years. The average amortization period for the acquired intangibles was approximately 7 years in 1993. Since 1988 the Company has increased significantly its portfolio of receivables sold and serviced with limited recourse. This portfolio has grown to $9.8 billion at year-end 1993 from none at the beginning of 1988. The Company was the first public issuer of home equity loan asset-backed securities in 1988 and continues to be one of the largest issuers of asset-backed securities. In 1993, including replenishments of certificateholders interests, the Company securitized and sold $9.4 billion of receivables. In addition, the Company sells first mortgages with no recourse and retains the servicing and also acquires servicing rights for first mortgages. This portfolio of first mortgage receivables serviced with no recourse has grown to $13.9 billion at year-end 1993 from $500 million at year-end 1986. In the third quarter of 1993, the Company began servicing an unsecured consumer portfolio without recourse which totaled $1.3 billion at December 31, 1993. Major consumer business units within the Finance and Banking segment are described below. Household Finance Corporation Household Finance Corporation, the Company's principal business, traces its origins to a loan office established in 1878. HFC offers a variety of secured and unsecured lending products to middle-income customers through a network of 432 branch lending offices throughout the United States. This business is conducted primarily through state-licensed companies. Home equity loans, and to a lesser extent, unsecured credit products have been HFC's primary focuses over the last several years as these products are preferred by consumers due to the flexible nature of the credit relationship, where the timing and amount of borrowing can be tailored to the borrower's particular circumstances. These products also are advantageous to HFC due to lower relative administrative costs and typically have variable rate terms which move with market rates of interest. Home equity loans and unsecured consumer credit products in the HFC domestic network represented approximately 30 percent of total Finance and Banking managed receivables at December 31, 1993. Home equity loans, representing approximately 27 percent of total Finance and Banking managed receivables at December 31, 1993, have lower chargeoff rates than the unsecured credit products. In 1992, HFC launched a new portfolio acquisition business focusing on open-end and closed-end home equity loan products. In 1993, HFC acquired approximately 3,800 new accounts aggregating $430 million in such receivables. In addition, in 1993 HFC acquired the right to service without recourse approximately 1.1 million accounts aggregating approximately $2.0 billion in unsecured loans. The Company believes that the portfolio acquisition business provides an additional source for developing new customer relationships. Household Retail Services Household Retail Services ("HRS") is a revolving credit merchant participation business. HRS purchases and services merchants' revolving charge accounts. These accounts result from consumer purchases of furniture, appliances, home improvement products and other durable merchandise, and generally are without credit recourse to the originating merchant. Loans are underwritten by HRS based on its credit standards. This business is an important source of new customers to HFC's direct lending business. HRS became a separate business unit in 1988 and is currently the second largest provider of private-label credit cards in the United States. This business is conducted through state-licensed companies and through Household Bank (Illinois), National Association. Household Bank, f.s.b. Household Bank, f.s.b. (the "Bank"), a federally chartered savings bank, comprises the majority of the Company's consumer banking and mortgage business. At December 31, 1993, the Bank's assets totaled $9.1 billion, which includes $2.2 billion of receivables attributable to the GM Card. Although there was a slight decline in deposits in 1993 from $6.5 billion at December 31, 1992, deposits have increased to $6.2 billion at December 31, 1993 from $1.6 billion at year-end 1986. Much of the strategic growth of the Company has been through its consumer banking operations, where the Company believes the most efficient use of capital can be achieved. The Company's consumer banking strategy is intended to diversify its funding base, provide a stable and relatively low-cost funding source, create a more competitively leveraged entity and market financial service products to a different customer base. In 1988, the Company formalized its consumer banking strategy and launched its consumer bank development program with a geographic focus on California and the arc of states from Illinois to Maryland. At December 31, 1993 the Bank had 171 branches in 7 states: California (54); Illinois (44); Ohio (26); Maryland (24); Virginia (15); Indiana (5); and Kansas (3). The Bank is a full-service consumer bank, marketing itself as "America's Family Bank"(R). It operates as a single institution in all states where it is active, with common marketing programs and processing systems. The Company believes the Bank is one of the few consumer banks of its size to operate in this manner. The Bank's acquisition strategy involves identification of institutions which complement the existing network in target markets. The ideal acquisition includes only deposits, customer relationships and branches. Acquired institutions are quickly integrated into the existing network. The integration process includes new signage, decor, product offerings, pricing and back office systems. Since the Bank generally does not need acquired administrative and executive personnel and facilities, operating expenses of the acquired entity have been reduced in most acquisitions. First mortgages are originated in branch locations and loan production offices by Household Mortgage Services, a division of the Bank, or may be acquired from correspondents and other wholesale sources. In 1993, Household Mortgage Services originated approximately $4 billion in first mortgages. However, refinancing resulting from the record low interest rates caused the first mortgage portfolio to decline by approximately $1 billion in 1993. At December 31, 1993, $2 billion, or approximately 28 percent, of the Bank's owned receivables represented first mortgages for single-family residences. Adjustable-rate mortgage loans represented approximately 43 percent of this portfolio. This first mortgage portfolio is well-diversified geographically and the Bank has originated no negative amortization loans. The weighted average loan-to-value ratio at the origination of the loan for the entire portfolio was approximately 70 percent. While emphasizing single-family mortgage lending, the Bank also provides mortgage loans for various multi-family and income-producing properties and makes various types of consumer loans, including savings account secured loans and secured and unsecured lines of credit. Household Credit Services Household Credit Services is the tradename used for the marketing of bankcards throughout the United States issued by one of the Company's subsidiary national credit card banks, the Bank, or one of the other financial institutions affiliated with Household International. The Company had $8.8 billion of bankcard receivables owned and serviced with limited recourse at December 31, 1993, up from $207 million at year-end 1986. The Company is one of the top 6 issuers of VISA and MasterCard credit cards in the United States. The Company strives to build its bankcard business by developing strategic alliances with industry leaders to effectively create and market general purpose credit cards to targeted consumers. In accordance with this philosophy, in 1991 the Company established a program with Ameritech Corporation, in 1992 established a program with General Motors Corporation and in 1993 expanded the relationship through an agreement with General Motors to issue the GM Card from Vauxhall in the United Kingdom. Also in 1993 the Company announced an alliance with Charles Schwab & Co. See "1993 Developments." The Company intends to continue to explore other co-branding relationships of this type with various entities. The Company also seeks to build its bankcard business by selectively purchasing portfolios while managing geographic concentrations. The Company evaluates bankcard acquisitions utilizing criteria related to strategic fit and economic value. To assess strategic fit, the Company considers the following: the composition and behavior of the customer franchise; product pricing compatibility with the Company's pricing strategies; geographic distribution of the customer base; and opportunities to add value through improved portfolio management. To assess economic value, the Company evaluates the risk/return characteristics of the portfolio, particularly with respect to revenue generating potential and asset quality, and identifies and quantifies legitimate opportunities to add value through price changes, more efficient servicing, improved collections, and credit line management. The Company also applies traditional financial analysis techniques to evaluate financial returns in relation to the proposed investment. The bankcard business is a highly competitive and fragmented industry currently in the process of consolidation. The Company believes that its relatively large size in the industry provides substantial competitive advantages over smaller credit card issuers through reduced operating expense ratios. The Company's focus is to develop a nationally diverse customer franchise that contains three to four hubs of concentration while employing value-based pricing. These hubs are expected to promote operating and marketing efficiencies without creating overdependence on a single geographic area that would potentially expose the Company to regional credit risk and usage patterns. Currently, the Company's largest account base is in California supplemented by significant hubs in the Midwest and on the East coast. International Operations International operations in Canada, the United Kingdom and Australia accounted for approximately 18 percent of the Finance and Banking owned receivables at December 31, 1993. In Canada, the Company operates consumer finance, private-label credit card and consumer banking operations similar to its businesses in the United States. With 30 offices at December 31, 1993, the Canadian consumer finance business operates under the HFC tradename. The Canadian consumer banking business, with 12 branches, operates as Household Trust Company. At December 31, 1993, the Canadian operations had $1.9 billion of receivables. In the United Kingdom, the Company owns HFC Bank plc, a fully licensed United Kingdom bank. HFC Bank plc had 150 branches at December 31, 1993 and approximately $1.2 billion of receivables. In Australia, the Company operates primarily as a consumer finance company under the HFC tradename. The Company had 22 offices in Australia at December 31, 1993 and approximately $375 million of consumer receivables. Credit Insurance In conjunction with its consumer lending operations and where applicable laws permit, the Company makes credit life, credit accident and health, term and specialty insurance products available to its customers. This insurance generally is directly written by or reinsured with Alexander Hamilton Life Insurance Company of America ("Alexander Hamilton"). Financial results for sales of these types of products through affiliated operations are reported as part of the Finance and Banking segment. Hamilton Investments Hamilton Investments was acquired by Household International during 1989 as part of the Bank's acquisition of a savings institution. Hamilton Investments is a retail-oriented investment banking and brokerage firm. It has 24 branch offices which are located in the following states: Illinois (9); Wisconsin (6); Minnesota (5); Michigan (2); and one each in Indiana and Nebraska. In addition, Hamilton operates through 150 Household Bank locations. In 1992 Hamilton Investments acquired Craig-Hallum, Inc., a Minneapolis-based investment banking and brokerage firm with 100 registered representatives and 26,000 customer accounts. Hamilton Investments is registered as a broker-dealer with the Securities and Exchange Commission and as a futures commission merchant with the Commodities Futures Trading Commission. It is a member of the National Association of Securities Dealers, the New York Stock Exchange, the American Stock Exchange, the Chicago Stock Exchange and the National Futures Association. A subsidiary of Hamilton Investments acts as the investment adviser to the Oberweis Emerging Growth Fund, the Household Personal Portfolios and General Securities, Inc., mutual funds with assets of approximately $101, $26 and $28 million, respectively, at year-end 1993. COMMERCIAL OPERATIONS. Approximately 3 percent of the Finance and Banking managed receivables portfolio at December 31, 1993 consisted of leveraged leases, other equipment financing, and specialized corporate lending. Products in these areas include loan and lease financing for aircraft, other transportation equipment, capital equipment and specialized secured corporate loans. In addition, the Company invests in term preferred stocks. See also "Liquidating Commercial Lines" below. The commercial finance business of the Company has been operated under Household Commercial Financial Services ("Household Commercial") since 1974. The industry in which Household Commercial operates is highly competitive and the Company's position in this market is relatively small. Commercial loans are underwritten based upon specific criteria by product, which include the following items: borrower's financial strength; underlying value of any collateral; ability of the property/business to generate cash flow and pricing considerations. For financing commitments in excess of $1 million, the loan request must be approved by an investment committee consisting of senior management. The financial and operating performance of all borrowers is monitored and reported to management on an ongoing basis. Additionally, the conclusions of this monitoring process are reported to the senior management of the Company on a quarterly basis. A description of Household's operational policy with respect to commercial receivables is set forth on page 41 of the 1993 Annual Report. INDIVIDUAL LIFE INSURANCE The Company's individual life insurance operations are conducted by Alexander Hamilton Life Insurance Company of America. Alexander Hamilton markets universal life, term life and annuity products to a higher income category consumer than that targeted by the consumer lending businesses. Alexander Hamilton also underwrites credit life, credit accident and health, and other specialty products sold through the Company's consumer businesses. The Alexander Hamilton products sold by affiliated entities are included in results of the Finance and Banking segment. Alexander Hamilton offers universal life insurance, term life insurance and annuity products through approximately 16,300 independent agents and 1,790 licensed consumer finance and banking employees. These individual products are sold in all states, with the largest concentration in 10 states (California, Florida, Illinois, Maryland, Michigan, New Jersey, New York, Ohio, Pennsylvania and Wisconsin) accounting for 63 percent of premium income in 1993. The Company also sells credit insurance to customers of banks and retail merchants which are not affiliated with Household International. Alexander Hamilton has been assigned a claims-paying ability rating of "AA" from three nationally recognized statistical rating organizations. LIQUIDATING COMMERCIAL LINES As of December 31, 1991, Household International ceased offering certain commercial product lines. The decision to withdraw from these product lines was made to enable Household International to concentrate its resources on operations it believes offer the opportunity for more consistent financial returns relative to risks assumed. These liquidating commercial lines are: speculative real estate secured lending; highly leveraged acquisition finance transactions; subordinated corporate lending; higher-risk equipment loans and leases and other commercial assets. These discontinued product lines are managed by Household Commercial separately from continuing commercial lines. The Company intends to liquidate this portfolio over time in a manner that will maximize the value of these assets and believes that, depending on the economic environment, it should be able to liquidate these portfolios over the next several years. Liquidating commercial assets at December 31, 1993 consisted of the following (in millions): INVESTMENT SECURITIES Investment securities of the Company are principally held by Alexander Hamilton. At December 31, 1993, Alexander Hamilton had $6.4 billion or approximately 73 percent of the Company's $8.8 billion total investment portfolio. The composition of this portfolio is set forth on pages 59 and 60 of the 1993 Annual Report. Investment securities are also held by the Bank, Household Global Funding, Inc., the United States holding company for Household's operations in Canada and the United Kingdom, and Household Commercial and represent approximately 14, 6 and 4 percent, respectively, of the Company's total investment portfolio. FUNDING RESOURCES As a financial services organization, Household International must have access to funds at competitive rates, terms and conditions to be successful. Household International and its subsidiaries fund their operations in the global capital markets, primarily through the use of commercial paper, medium-term notes and long-term debt, and have used financial instruments to hedge their currency and interest-rate exposure. Four nationally recognized statistical rating organizations currently assign investment grade ratings to the debt and preferred stock issued by the Company and its subsidiaries. In addition, these organizations rated the commercial paper of HFC in their highest rating category. The securitization and sale of consumer receivables is an important source of liquidity for HFC and the Bank. During 1993 the Company's subsidiaries securitized and sold, including replenishments of certificateholder interests, approximately $9.4 billion of home equity, merchant participation and bankcard receivables compared to $4.8 billion in 1992. To diversify its funding base and add more stability to funding costs, the Company developed a retail deposit base in recent years through its consumer banking business. Customer deposits have grown from $3.9 billion at year-end 1988 to $7.5 billion at December 31, 1993. The Company intends to continue to expand this deposit base through selective acquisitions of savings institutions. See "Finance and Banking-- Household Bank, f.s.b.". REGULATION AND COMPETITION REGULATION. The Company's businesses are subject to various regulations covering their conduct. Generally, HFC's consumer branch lending offices are regulated by legislation and licensed in those jurisdictions where they operate. Such licenses have limited terms but are renewable, and are revocable for cause. In addition to licensing provisions, statutes in some jurisdictions may provide that a loan not exceed a certain period of time, or may place limits on the size or interest rate of the loan. HFC's sales finance business is also subject to regulatory legislation in certain jurisdictions which, among other things, may limit the interest rates or fees which may be charged or which may inhibit HFC's ability to collect or foreclose upon delinquent loans. All of Household International's consumer finance operations are subject to federal laws relating to discrimination in credit extensions, use of credit reports, disclosure of credit terms, and correction of billing errors. The Bank is chartered by the Office of Thrift Supervision ("OTS") and is a member of the Federal Home Loan Bank System. The Bank has its customer deposit accounts insured for up to $100,000 per insured depositor by the Federal Deposit Insurance Corporation ("FDIC"), for which the Bank is assessed a fee. The Bank is subject to examination and supervision by the OTS and FDIC and to federal regulations governing such matters as general investment authority, acquisitions of financial institutions, transactions with affiliates, establishment of branch offices, subsidiaries' investments and activities, and restrictions on dividend payments to Household International. The Bank is also subject to regulatory requirements setting forth minimum capital and liquidity levels. In addition, regulations of the Federal Reserve Board require the Bank to maintain non- interest bearing reserves against the Bank's transaction accounts (primarily NOW and money-market checking accounts) and non-personal time deposits. Because of its ownership of the Bank, Household International is a savings and loan holding company subject to reporting and other regulations of the OTS. Household International has agreed with the OTS to maintain the regulatory capital of the Bank at certain specified levels. This agreement between Household International and the OTS was amended in 1989 to reflect regulatory changes in the methodology of calculating the Bank's regulatory capital. Household Bank, National Association, Household Bank (Illinois), National Association, Household Bank (Nevada), National Association and Household Bank (SB), National Association are chartered by the Comptroller of the Currency and are members of the Federal Reserve System. The deposit accounts of these national banks are insured by the FDIC. National banks are generally subject to the same type of regulatory supervision and restrictions as the Bank, although these national banks only engage in credit card operations. The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"), enacted in December 1991, significantly expanded the regulatory and enforcement powers of federal banking regulators, in particular the FDIC. FDICIA also created additional reporting, disclosure and independent auditing requirements, changed FDIC insurance premiums from flat amounts to a new system of risk-based assessments, and placed limits on the ability of depository institutions to acquire brokered deposits. Under FDICIA, there are five tiers of capital measurement for regulatory purposes ranging from "Well-Capitalized" to "Critically Undercapitalized". FDICIA directs banking regulators to take increasingly strong corrective steps, based on the capital tier of any subject insured depository institution, to cause such bank to achieve and maintain capital adequacy. Even if an insured depository institution is adequately capitalized, the banking regulators are authorized to apply corrective measures if the insured depository institution is determined to be in an unsafe or unsound condition or engaging in an unsafe or unsound activity. FDICIA grants the banking regulators broad powers to require undercapitalized institutions to adopt and implement a capital restoration plan and to restrict or prohibit a number of activities, including the payment of cash dividends, which may impair or threaten the capital adequacy of the insured depository institution. FDICIA also expanded the grounds upon which a receiver or conservator may be appointed for an insured depository institution. Pursuant to FDICIA, federal banking regulatory agencies have proposed new safety and soundness standards governing operational and managerial activities of insured depository institutions and their holding companies, regarding internal controls, loan documentation, credit underwriting, interest rate exposure, asset growth and compensation. The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 ("FIRREA"), among other things, provides generally that, upon the default of any insured institution, the FDIC may assess an affiliated insured depository institution for the estimated losses incurred by the FDIC. Specifically, FIRREA provides that a depository institution insured by the FDIC can be held liable for any loss incurred by, or reasonably expected to be incurred by, the FDIC in connection with (i) the default of a commonly controlled FDIC-insured depository institution or (ii) any assistance provided by the FDIC to a commonly controlled FDIC-insured depository institution in danger of default. "In danger of default" is defined generally as the existence of certain conditions indicating that a default is likely to occur in the absence of regulatory assistance. As an insurance company, Alexander Hamilton is subject to regulatory supervision under the laws of the states in which it operates. Regulations vary from state to state but generally cover licensing of insurance companies, premium rates, dividend restrictions, types of insurance that may be sold, permissible investments, policy reserve requirements, and insurance marketing practices. COMPETITION. The consumer credit industry is highly fragmented, with thousands of banks, thrifts and other financial institutions competing in the United States alone. The industry has been consolidating in recent years, and the Company expects this consolidation to continue. The Company believes it has positioned itself to compete effectively and benefit from this consolidation because of its centralized distribution, processing and marketing capabilities, and advanced technology to support these activities. The financial services industry is highly competitive, and the Company's financial services businesses compete with a number of institutions that extend credit to consumers and businesses, some of which are larger than the Company. The Company competes not only with other finance companies, banks, and savings and loan companies, but also with credit unions and retailers. Alexander Hamilton competes with many other life insurance companies offering similar products. ITEM 2.		ITEM 2. PROPERTIES. Household International has operations in 35 states in the United States, 10 provinces in Canada, 6 states and 2 territories in Australia and in the United Kingdom with principal facilities located in Anaheim, California; Chesapeake, Virginia; Chicago, Illinois; Elmhurst, Illinois; Farmington Hills, Michigan; Hanover, Maryland; Las Vegas, Nevada; North York, Ontario, Canada; Pomona, California; Prospect Heights, Illinois; St. Leonards, New South Wales, Australia; Salinas, California; Windsor, Berkshire, United Kingdom; Wood Dale, Illinois; and Worthington, Ohio. Substantially all branch offices, bank branches, divisional offices, corporate offices, RPC and RSC space is operated under lease with the exception of the principal executive offices of Household International in Prospect Heights, Illinois, the headquarters building for HFC Bank plc in the United Kingdom, Alexander Hamilton's headquarters building in Farmington Hills, Michigan, and administration buildings in Northbrook, Illinois and Salinas, California. An additional administrative facility is currently under construction in Las Vegas, Nevada. The Company believes that such properties are in good condition and are adequate to meet Household International's current and reasonably anticipated needs. Household International has, and will continue to, invest in property and technological improvements to achieve greater efficiencies in the marketing, servicing and production of its loan products. During 1993 the Company invested $110 million in capital expenditures, compared to $90 million in 1992. Automobiles, office equipment and real estate properties owned and in use by the Company are not significant in relation to the total assets of the Company. ITEM 3.	ITEM 3. LEGAL PROCEEDINGS. The Company and its subsidiaries are parties to various legal proceedings, including product liability and environmental claims, resulting from ordinary business activities related to its current operations and/or former businesses which were managed as independent subsidiaries of the Company. Certain of these actions are or purport to be class actions seeking damages in very large amounts. Due to the uncertainties in litigation and other factors, no assurance can be given that the Company or its subsidiaries will ultimately prevail in each instance. However, for all litigation involving the Company and/or its subsidiaries, the Company believes that amounts, if any, that may ultimately be paid by the Company as damages in any such proceedings will not have a material adverse effect on the consolidated financial position of the Company. ITEM 4.	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Not applicable. EXECUTIVE OFFICERS OF THE REGISTRANT. The following information on executive officers of Household International is included pursuant to Item 401(b) of Regulation S-K. Information with respect to Mr. Clark is incorporated herein by reference to "Election of Household Directors--Information Regarding Nominees" in Household International's definitive Proxy Statement for its 1994 Annual Meeting of Stockholders scheduled to be held May 11, 1994 (the "1994 Proxy Statement"). References herein to "Household" refer to Household International, Inc. for all periods after June 26, 1981 (the date of the corporate restructuring by which Household International became the holding company of Household Finance Corporation) and to Household Finance Corporation on and before such date. Robert F. Elliott, age 53, was appointed Group Executive-Office of the President in 1993. Prior thereto he was the Group Executive-U.S. Consumer Finance and Australia. Mr. Elliott joined Household in 1964 and has served in various capacities in the Company's consumer finance business during his career with Household. Joseph W. Saunders, age 48, was appointed Group Executive-Office of the President in 1993, having previously served as Group Executive-U.S. BankCard and Canada: He is also President of the Company's subsidiary, Household Bank, National Association. Prior to joining Household in 1985, Mr. Saunders was Vice President-Credit Card Operations of Bank of America. Antonia Shusta, age 44, was appointed to her present position as Group Executive-Office of the President in 1993. Ms. Shusta joined Household in 1988 as Group Executive-Mortgage Banking and Acquisitions and most recently served as Group Executive-U.S. Consumer and Mortgage Banking and the United Kingdom. Prior to joining Household, she was employed with Citicorp for 16 years, most recently as division executive for its Northern Latin American operation. Glen O. Fick, age 47, was appointed Group Executive-Commercial Finance and President of Household Commercial in 1991. Mr. Fick joined Household in 1971 and has served in various capacities in the Company's treasury, corporate finance and investor relations departments, as well as the specialty commercial services division of its commercial finance business. Gary D. Gilmer, age 43, was appointed President and Chief Executive Officer of Alexander Hamilton in 1993. Mr. Gilmer joined Household in 1972 and has served in various capacities within the consumer finance and banking divisions, most recently as President of Household Retail Services. Richard H. Headlee, age 63, has been Chairman of the Board of Alexander Hamilton since 1988. Mr. Headlee joined Alexander Hamilton in 1970 and served as its Chief Executive Officer from 1972 to 1993. Gaylen N. Larson, age 54, is Group Vice President of Household. Mr. Larson has previously served Household as Chief Accounting Officer, Controller and Group Vice President-Finance. Mr. Larson was a partner of the accounting firm of Deloitte & Touche prior to joining Household in 1979. David B. Barany, age 50, was appointed to his present position as Vice President-Chief Information Officer of Household in 1988. Mr. Barany joined Household in 1985 as Vice President/Controller of Household's financial services business. Prior to joining Household, he was employed by Four Phase Systems, Inc., a subsidiary of Motorola, Inc., as Vice President/Finance. John W. Blenke, age 38, is Assistant General Counsel and Secretary of Household. Mr. Blenke joined Household in 1989 as Corporate Finance Counsel, was promoted to Assistant General Counsel-Securities & Corporate Law and Assistant Secretary in 1991 and was appointed Secretary in 1993. Prior to joining Household, Mr. Blenke was employed with a subsidiary of Transamerica Corporation. Michael A. DeLuca, age 45, joined Household in 1985 as Director of Tax Planning and Tax Counsel and was appointed to his present position as Vice President-Taxes in 1988. Colin P. Kelly, age 51, is Vice President-Human Resources of Household. Mr. Kelly joined Household in 1965 and has served in various management positions, most recently as Senior Vice President-Human Resources of Household's financial services business. Mr. Kelly was appointed to his present position in 1988. Michael H. Morgan, age 39, was appointed to his present position as Vice President-Corporate Communications in 1989. Mr. Morgan joined Household in 1984, and has served in various capacities within the planning and analysis and investor relations areas. From 1978 until joining Household, Mr. Morgan was employed with Arthur Andersen & Co. Randall L. Raup, age 40, was appointed Vice President-Planning in 1992, having most recently served as Vice President-Financial Control Treasury. Since joining Household in 1984, Mr. Raup has held positions in the treasury control, corporate reporting and internal audit areas. Prior to joining Household, he served as an auditor with Esmark, Inc. and KPMG Peat Marwick. Kenneth H. Robin, age 47, was appointed Vice President-General Counsel of Household in 1993, having previously served as Assistant General Counsel -- Financial Services. Prior to joining Household in 1989, Mr. Robin was employed with Citicorp from 1977 to 1989, most recently as a vice president responsible for legal policies for its operations in 23 countries in the Caribbean, Central America and South America. David A. Schoenholz, age 42, was appointed Vice President-Chief Accounting Officer of Household in 1993, Vice President in 1989 and Controller in 1987. He joined Household in 1985 as Director-Internal Audit. Prior to joining Household, Mr. Schoenholz was employed with The Commodore Corporation, a manufacturer of mobile homes, as Vice President/Controller from 1983 to 1985. Charles R. Wallace, age 45, was appointed Corporate Controller of Household in 1993, having previously served as Executive Vice President-Chief Operating Officer of Hamilton Investments since 1989. Prior to joining Household, Mr. Wallace was employed with Clayton Brown & Associates, Inc. and Ernst & Young. There are no family relationships among the executive officers of the Company. The term of office of each executive officer is at the discretion of the Board of Directors. PART II. ITEM 5.	ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The number of record holders of Household International's Common Stock, as of March 16, 1994, was 14,679. Additional information required by this Item is incorporated by reference to page 32 of Household International's 1993 Annual Report. ITEM 6.	ITEM 6. SELECTED FINANCIAL DATA. Information required by this Item is incorporated by reference to page 34 of Household International's 1993 Annual Report. ITEM 7.	ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Information required by this Item is incorporated by reference to pages 38 through 51 of Household International's 1993 Annual Report. ITEM 8.	ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. Financial Statements of Household International and subsidiaries meeting the requirements of Regulation S-X, and supplementary financial information specified by Item 302 of Regulation S-K, is incorporated by reference to pages 35 through 37 and pages 52 through 80 of Household International's 1993 Annual Report. ITEM 9.	ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. Not applicable. PART III. ITEM 10.	ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. Information required by this Item is incorporated by reference to "Election of Household Directors-- Information Regarding Nominees" and "Shares of Household Stock Beneficially Owned by Directors and Executive Officers" in Household International's 1994 Proxy Statement. Also, information on certain Executive Officers appears in Part I of this Annual Report on Form 10-K. ITEM 11.	ITEM 11. EXECUTIVE COMPENSATION. Information required by this Item is incorporated by reference to "Remuneration of Executive Officers", "Savings--Stock Ownership and Pension Plans", "Incentive and Stock Option Plans", and "Directors' Compensation" in Household International's 1994 Proxy Statement. ITEM 12.	ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Information required by this Item is incorporated by reference to "Shares of Household Stock Beneficially Owned by Directors and Executive Officers" and "Security Ownership of Certain Beneficial Owners" in Household International's 1994 Proxy Statement. ITEM 13.	ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Information required by this Item is incorporated by reference to "Remuneration of Executive Officers" in Household International's 1994 Proxy Statement. PART IV. ITEM 14.	ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (A) FINANCIAL STATEMENTS. The following financial statements, together with the opinion thereon of Arthur Andersen & Co., dated February 1, 1994, appearing on pages 35 through 37 and pages 52 through 80 of Household International's 1993 Annual Report are incorporated herein by reference. An opinion of Arthur Andersen & Co. is included in this Annual Report on Form 10-K. Household International, Inc. and Subsidiaries: Statements of Income for the Three Years Ended December 31, 1993. Balance Sheets, December 31, 1993 and 1992. Statements of Cash Flows for the Three Years Ended December 31, 1993. Statements of Changes in Preferred Stock and Common Shareholders' Equity for the Three Years Ended December 31, 1993. Business Segment Data. Notes to Financial Statements. Independent Auditors' Report. Selected Quarterly Financial Data (Unaudited). (B) REPORTS ON FORM 8-K. During the three months ended December 31, 1993, the Company did not file with the Securities and Exchange Commission any Current Report on Form 8-K. (C) EXHIBITS. Copies of exhibits referred to above will be furnished to stockholders upon written request at a cost of fifteen cents per page. Requests should be made to Household International, Inc., 2700 Sanders Road, Prospect Heights, Illinois 60070, Attention: Office of the Secretary. (D) SCHEDULES. Report of Independent Public Accountants. III--Condensed Financial Information of Registrant. VIII--Valuation and Qualifying Accounts. X--Supplementary Statement of Income Information. SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934, HOUSEHOLD INTERNATIONAL, INC. HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED. HOUSEHOLD INTERNATIONAL, INC. Dated: March 28, 1994 By /s/ D. C. CLARK ------------------------------------ D. C. Clark, Chairman of the Board 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 HOUSEHOLD INTERNATIONAL, INC. AND IN THE CAPACITIES AND ON THE DATE INDICATED. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS Household International, Inc.: We have audited in accordance with generally accepted auditing standards, the financial statements included in Household International, Inc.'s 1993 annual report to shareholders incorporated by reference in this Form 10-K, and have issued our report thereon dated February 1, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed in Item 14(d) are the responsibility of the Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state 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 & CO. Chicago, Illinois February 1, 1994 SCHEDULE III HOUSEHOLD INTERNATIONAL, INC. CONDENSED FINANCIAL INFORMATION OF REGISTRANT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- CONDENSED STATEMENTS OF INCOME (ALL DOLLAR AMOUNTS EXCEPT PER SHARE DATA ARE STATED IN MILLIONS.) - --------------- * Amounts have been restated to reflect the two-for-one stock split in the form of a 100 percent stock dividend, effective October 15, 1993. See accompanying notes to condensed financial statements. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SCHEDULE III (CONTINUED) HOUSEHOLD INTERNATIONAL, INC. CONDENSED FINANCIAL INFORMATION OF REGISTRANT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- CONDENSED BALANCE SHEETS (IN MILLIONS) See accompanying notes to condensed financial statements. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SCHEDULE III (CONTINUED) HOUSEHOLD INTERNATIONAL, INC. CONDENSED FINANCIAL INFORMATION OF REGISTRANT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- CONDENSED STATEMENTS OF CASH FLOWS (IN MILLIONS) See accompanying notes to condensed financial statements - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SCHEDULE III (CONTINUED) HOUSEHOLD INTERNATIONAL, INC. CONDENSED FINANCIAL INFORMATION OF REGISTRANT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NOTES TO CONDENSED FINANCIAL STATEMENTS OF REGISTRANT 1. FINANCE RECEIVABLES Receivables at December 31 consisted of the following (in millions): 2. SENIOR DEBT (WITH ORIGINAL MATURITIES OVER ONE YEAR) Debt at December 31 consisted of the following (in millions): 3. COMMITMENTS Under an agreement with the Office of Thrift Supervision, the Company will maintain the net worth of Household Bank, f.s.b., at a level consistent with certain minimum net worth requirements. The Company has guaranteed payment of all debt obligations issued subsequent to 1989 (excluding deposits) of Household Financial Corporation Limited ("HFCL"), a Canadian subsidiary. The amount of guaranteed debt outstanding at HFCL on December 31, 1993 was approximately $853 million. The Company has also guaranteed payment of all debt obligations (excluding certain deposits) of Household International (U.K.) Limited ("HIUK"). The amount of guaranteed debt outstanding at HIUK on December 31, 1993 was approximately $936 million. The Company has guaranteed payment of a $62 million deposit held by one of its operating subsidiaries on behalf of another operating subsidiary. 4. CONVERTIBLE PREFERRED STOCK SUBJECT TO MANDATORY REDEMPTION At December 31, 1993 and 1992, the Company had outstanding 385,439 and 720,415 shares, respectively, of the $6.25 cumulative convertible preferred stock subject to mandatory redemption provisions (the "$6.25 stock"). Each share of the $6.25 stock is convertible, at the option of its holder, into 4.654 shares of common stock, is entitled to one vote, as are common shares, and has a liquidation value of $50 per share. Holders of such stock are entitled to payment before any capital distribution is made to common shareholders. The Company is required to call for redemption, on an annual basis through 2010, a minimum of 4 percent to a maximum of 8 percent of the 3.5 million originally issued shares and is required to redeem all of the remaining unconverted and unredeemed shares in 2011. The Company called for redemption 8 percent of the originally issued shares in both 1993 and 1992. The Company redeemed 2,323 and 4,711 shares for $50 per share in 1993 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SCHEDULE III (CONTINUED) HOUSEHOLD INTERNATIONAL, INC. CONDENSED FINANCIAL INFORMATION OF REGISTRANT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NOTES TO CONDENSED FINANCIAL STATEMENTS OF REGISTRANT -- (CONTINUED) and 1992, respectively. The remaining shares called, but not redeemed for cash, were converted into common stock. If certain conditions are met, the Company may redeem the entire $6.25 stock issue at $50 per share plus accrued and unpaid dividends. At December 31, 1993, 1.8 million shares of common stock were reserved for conversion of the $6.25 stock. 5. COMMON STOCK On September 14, 1993 the Board of Directors of the Company declared a two-for-one stock split in the form of a 100 percent stock dividend effective October 15, 1993. The stock split resulted in an increase in common stock and a reduction in additional paid-in capital of $56.6 million. All share and per share data, except as otherwise indicated, have been restated to give retroactive effect to the stock split. On March 8, 1993 the Company sold 4,025,000 shares of common stock at $68.88 per share, on a pre-split basis. Net proceeds of approximately $269 million were used for general corporate purposes, including investments in the Company's subsidiaries and reduction of short-term debt. Assuming the additional shares of common stock had been issued on January 1, 1993 and the proceeds resulted in after-tax interest savings from reduction of short-term debt since that date, earnings per share for 1993 would have been $2.82 per share on a fully diluted basis. Common stock at December 31 consisted of the following (millions of shares): - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SCHEDULE III (CONTINUED) HOUSEHOLD INTERNATIONAL, INC. CONDENSED FINANCIAL INFORMATION OF REGISTRANT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NOTES TO CONDENSED FINANCIAL STATEMENTS OF REGISTRANT -- (CONTINUED) 6. PREFERRED STOCK Preferred stock at December 31 consisted of the following (in millions): - --------------- (1) Depositary share represents 1/4 share of preferred stock. (2) Depositary share represents 1/10 share of preferred stock. (3) Depositary share represents 1/40 share of preferred stock. Dividends on the 9.50 percent preferred stock, Series 1989-A, are cumulative and payable quarterly. The Company may, at its option, redeem in whole or in part the 9.50 percent preferred stock, Series 1989-A, at $26.19 per depositary share beginning on November 9, 1994 and at amounts declining to $25 per depositary share thereafter, plus accrued and unpaid dividends. Dividends on the 9.50 percent preferred stock, Series 1991-A, are cumulative and payable quarterly. The Company may, at its option, redeem in whole or in part the 9.50 percent preferred stock, Series 1991-A, on any date after August 13, 1996 for $10 per depositary share plus accrued and unpaid dividends. Dividends on the 8.25 percent preferred stock, Series 1992-A, are cumulative and payable quarterly. The Company may, at its option, redeem in whole or in part the 8.25 percent preferred stock, Series 1992-A, on any date after October 15, 2002 for $25 per depositary share plus accrued and unpaid dividends. Dividends on the 7.35 percent preferred stock, Series 1993-A, are cumulative and payable quarterly. The Company may, at its option, redeem in whole or in part the 7.35 percent preferred stock, Series 1993-A, on any date after October 15, 1998 for $25 per depositary share plus accrued and unpaid dividends. On October 1, 1993 the Company redeemed 450,000 shares (equivalent to 4,500,000 depositary shares) of the 11.25 percent Enhanced Rate Cumulative Preferred Stock for $102.50 per share plus accrued and unpaid dividends. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SCHEDULE III (CONTINUED) HOUSEHOLD INTERNATIONAL, INC. CONDENSED FINANCIAL INFORMATION OF REGISTRANT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NOTES TO CONDENSED FINANCIAL STATEMENTS OF REGISTRANT -- (CONTINUED) On July 13, 1993 the Company redeemed 350,000 shares of the Flexible Rate Auction Preferred Stock ("Flex APS"), Series A, for $100 per share plus accrued and unpaid dividends. Dividends on the Flex APS are cumulative and payable when and as declared by the Board of Directors of the Company. The initial dividend rate on the Flex APS, Series B, is 9.50 percent. The initial rate on the Flex APS, Series B, extends through July 15, 1995, with subsequent dividend rates determined in accordance with a formula based on orders placed in a dutch auction generally held every 49 days. The Company may, at its option, redeem in whole or in part the Flex APS, Series B, for $100 per share plus accrued and unpaid dividends beginning on July 15, 1995. Each preferred stock issue ranks equally with the $6.25 stock and has a liquidation value of $100 per share except for the 8.25 percent preferred stock, Series 1992-A, and the 7.35 percent preferred stock, Series 1993-A, each of which have a liquidation value of $1,000 per share. Holders of all issues of preferred stock are entitled to payment before any capital distribution is made to common shareholders. The Company is authorized to issue cumulative nonconvertible preferred stock in one or more series in an amount not to exceed $620 million, and currently has $320 million of such preferred stock outstanding. 7. INCOME TAXES Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("FAS No. 109"). As a result of implementing FAS No. 109, retained earnings for all periods between 1986 and 1992 have been reduced by approximately $63 million from amounts previously reported. The statements of income for those periods subsequent to December 31, 1986 have not been restated as the impact of FAS No. 109 on net income is immaterial to any such year and in total. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SCHEDULE VIII HOUSEHOLD INTERNATIONAL, INC. VALUATION AND QUALIFYING ACCOUNTS FOR THE THREE YEARS ENDED DECEMBER 31, 1993 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SCHEDULE X HOUSEHOLD INTERNATIONAL, INC. SUPPLEMENTARY STATEMENT OF INCOME INFORMATION FOR THE THREE YEARS ENDED DECEMBER 31, 1993 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - --------------- * Represents less than 1 percent of total revenues as reported in the related consolidated statements of income. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- EXHIBIT INDEX
355429_1993.txt	355429	1993	ITEM 1. BUSINESS Protective Life Corporation is an insurance holding company, whose subsidiaries provide financial services through the production, distribution, and administration of insurance and investment products. Founded in 1907, Protective Life Insurance Company ("Protective Life") is the Company's principal operating subsidiary. Unless the context otherwise requires, the "Company" refers to the consolidated group of Protective Life Corporation and its subsidiaries. The Company has five marketing divisions: Agency, Group, Guaranteed Investment Contracts, Financial Institutions, and Investment Products. The Company has two additional business segments: Acquisitions and Corporate and Other. The following table sets forth revenues, income before income tax, and identifiable assets for the Company's business segments. The primary components of revenues are premiums and policy fees, net investment income, and realized investment gains or losses. Premiums and policy fees are attributable directly to each business segment. Net investment income is allocated based on directly related assets required for transacting that segment of business. Realized investment gains or losses and expenses are allocated to the business segments in a manner that most appropriately reflects the operations of that segment. Unallocated realized investment gains or losses are deemed not to be associated with any specific business segment. Assets are allocated based on policy liabilities and deferred policy acquisition costs directly attributable to each segment. AGENCY DIVISION Since 1983, the Agency Division has utilized a distribution system based on experienced independent personal producing general agents who are recruited by regional sales managers. At December 31, 1993, there were 26 regional sales managers located in Alabama, Arizona, Arkansas, California, Colorado, Florida, Georgia, Illinois, Indiana, Iowa, Louisiana, Maine, Maryland, Michigan, Minnesota, Missouri, New Jersey, North Carolina, Ohio, Oregon, Texas, and Wisconsin. During 1993, the Division had approximately 12,847 independent personal producing general agents, brokers, and other agents under contract of whom approximately 517 received first year commissions in excess of $10,000 from the Company. In 1993, the Division began distributing insurance products through securities broker-dealers. The Division also distributes insurance products through the payroll deduction market. Current marketing efforts in the Agency Division are directed toward the Company's various universal life products and products designed to compete in the term marketplace. Universal life products combine traditional life insurance protection with the ability to tailor a more flexible payment schedule to the individual's needs, provide an accumulation of cash values on which income taxes are deferred, and permit the Company to change interest rates credited on policy cash values as often as monthly to reflect current market rates. The Company currently emphasizes back-end loaded universal life policies which reward the continuing policyholder and which should maintain the persistency of its universal life business. The products designed to compete in the term marketplace are term-like policies with guaranteed level premiums for the first 15 years which provide a competitive net cost to the insured. The Division's total revenues and income before income tax have increased each year from 1989 through 1993 primarily due to a growing block of business brought about by sales and improved persistency. GROUP DIVISION The Company markets its group insurance products primarily in the southeastern and southwestern United States using the services of brokers who specialize in group products. Sales offices in Alabama, Florida, Georgia, Illinois, Missouri, North Carolina, Ohio, Oklahoma, Tennessee, and Texas are maintained to serve these brokers. The Group Division offers substantially all forms of group insurance customary in the industry, making available complete packages of life and accident and health insurance to employers. The life and accident and health insurance packages include hospital and medical coverages as well as dental and disability coverages. To address rising health care costs, the Division provides cost containment services such as utilization review and catastrophic case management. Group policies are directed primarily at employers and associations with between 25 and 1,000 employees. Two new marketing initiatives will permit direct sales to employers (by full-time Company employees) of cancer, dental, and other supplemental insurance coverages. The Division hopes to have these initiatives fully operational in 1994. Group accident and health insurance is generally considered to be cyclical. Profits rise or fall as competitive forces allow or prevent rate increases to keep pace with changes in group health medical costs. The Company is placing marketing emphasis on other health insurance products which are not as subject to medical cost inflation. These products include dental insurance policies and hospital indemnity policies which are distributed nationally through the Division's existing distribution system, as well as through joint marketing arrangements with independent marketing organizations, and through reinsurance contracts with other insurers. These products also include an individual cancer insurance policy marketed through a nationwide network of agents. It is anticipated that a significant part of the growth in the Company's health insurance premium income in the next several years will be from products like dental and individual cancer insurance which have not been as subject to medical cost inflation as traditional group health products. The Division's total revenues have increased each year from 1989 through 1993 primarily due to increased sales. Income before income tax has increased each year except in 1992 which was lower than the preceding year due to less favorable life and health claims experience. FINANCIAL INSTITUTIONS DIVISION The Financial Institutions Division specializes in marketing insurance products through commercial banks, savings and loan associations, and mortgage bankers. The Division markets an array of life and health products, the majority of which are used to secure consumer and mortgage loans made by financial institutions located primarily in the southeastern United States. The Division also markets life and health products through the consumer finance industry and through automobile dealerships. The Division markets through both employee field representatives and brokers. The Division also offers certain products through direct mail solicitation to customers of financial institutions. In July 1992, in a major expansion of the Division, the Company acquired the credit insurance business of Durham Life Insurance Company ("Durham") which more than doubled the reserves the Company then held for its existing credit insurance activities. The acquisition provided significant market share in the southeastern states not previously covered by the Company. The larger size of the Division has allowed it to lower unit costs through economies of scale. After increases in total revenues in 1989 and 1990, the Division experienced a reduction in 1991 revenues that was largely recession-related, reflecting the fact that the demand for credit life and credit health insurance is related to the level of loan demand. Total revenues significantly increased in 1992 and 1993 due to the Durham acquisition and increased sales. The Division's income before income tax has increased each year since 1989 due to a related increase in loan demand. INVESTMENT PRODUCTS DIVISION The Investment Products Division manufactures, sells, and supports annuity products. These products are sold through the Agency Division, financial institutions, and broker-dealer distribution channels. This Division was formed to respond to an increased consumer demand for savings vehicles. In April 1990, the Company began sales of modified guaranteed annuity products ("MGA products") which guarantee a compounded interest rate for a fixed term. MGA products provide the Company a greater degree of protection from changes in interest rates, because contract values are "market-value adjusted" upon surrender prior to maturity. During 1992, the Company acquired a marketing company that had previously been under contract with the Company to distribute annuities. This acquisition improved the Division's ability to distribute the Company's annuity products. In late 1992, the Division ceased sales of single premium deferred annuities in an effort to focus marketing efforts on products with less disintermediation risk such as the MGA. Also, in 1993, the Division initiated development of variable annuity products, for introduction in early 1994, to broaden the Division's product line. The Division also includes Protective Equity Services, Inc. ("PES"), a securities broker-dealer subsidiary. Through PES, licensed members of the Company's field force can sell stocks, bonds, mutual funds, and other financial instruments that may be manufactured or issued by companies other than the Company. The Company's MGA products are also sold through PES. The Division's total revenues have increased each year since 1989 as annuity account balances have increased. Income before income tax has improved each year since 1989, except for 1993. In 1993, the Division's results reflect an increase of $3.2 million of amortization of deferred policy acquisition costs. GUARANTEED INVESTMENT CONTRACTS DIVISION In November 1989, the Company began selling guaranteed investment contracts ("GICs"). The Company's GICs are contracts, generally issued to a 401(k) or other retirement savings plan, which guarantee a fixed return on deposits from the plan for a specified period and often provide flexibility for withdrawals, in keeping with the benefits provided by the plan. The Company also offers a related product which is purchased primarily as a temporary investment vehicle by the trustees of escrowed municipal bond proceeds. GICs are sold to customers through a network of specialized GIC managers, consultants, and brokers. The Company entered the GIC business in 1989 through a joint venture. The joint venture arrangement was ended in 1991. Life insurer credit concerns and a demand shift to non-traditional GIC alternatives have generally caused the GIC market to contract somewhat. Management believes that, due to its credit position, Protective Life remains well positioned in this market. The Company anticipates broadening its GIC marketing capability by introducing new products in 1994. Management believes that the introduction of these new products should enhance the Company's ability to compete in the marketplace by broadening the Division's product line. The Division's total revenues and income before income tax have significantly increased each year since 1989 as GIC account balances have increased. The rate of growth in GIC account balances will most likely significantly decrease as the number of maturing contracts increases. The assets supporting the Company's GIC and annuity businesses are generally susceptible to interest rate and asset/liability matching risks. See "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - LIQUIDITY AND CAPITAL RESOURCES" in the Company's 1993 Annual Report to Stockholders. ACQUISITIONS DIVISION The Company actively seeks to acquire blocks of insurance policies. These acquisitions may be accomplished through acquisitions of companies or through the assumption or reinsurance of policies. Reinsurance transactions may be made from court-administered insolvent companies or from companies otherwise divesting themselves of blocks of business. Most acquisitions do not include the Company's acquisition of an active sales force, but some do. Blocks of policies acquired through the Acquisitions Division are administered as "closed" blocks; i.e., no new policies are being sold. Therefore, the amount of insurance in force for a particular acquisition is expected to decline with time due to lapses and deaths of the insureds. The experience of the Company has been that acquired or reinsured business can be administered more efficiently by the Company than by previous management or court administrators. In addition, in some instances a supervising court may permit legal modification of the terms of reinsured policies to increase the profitability of the reinsurance (and thus encourage such transactions). More than twenty separate transactions were made between 1970 and 1987. From 1987 through 1989, the Company encountered more competition concerning acquisitions; however, it did not change its strategy concerning the margins it sought from acquisitions. Consequently, no material transactions were entered into from 1987 to 1989. The environment for acquisitions has become more favorable since 1989 and management believes that this favorable environment likely will continue into the immediate future. Insurance companies are facing heightened regulatory and market pressure to increase statutory capital and thus may seek to increase capital by selling blocks of policies. Insurance companies also appear to be selling blocks of policies in conjunction with programs to narrow strategic focus. In addition, smaller companies without strong ratings may face difficulties in marketing and thus may seek to be acquired. Several states have enacted statutes that allow policyholders to "opt out" of an assumption reinsurance transaction; this environment appears to have caused sellers to place more emphasis on the financial condition and acquisition experience of the purchaser which management believes will favorably impact the Company's competitive position. However, it appears that other companies are entering this market and therefore the Company may face increased competition in future acquisitions. Total revenues and income before income tax from the Acquisitions Division are expected to decline with time unless new acquisitions are made. Therefore, the Division's revenues and earnings may fluctuate from year-to-year depending upon the level of acquisition activity. Revenues and earnings declined in 1990 and 1992, but increased in 1991 and 1993 due to new acquisitions. In the fourth quarter of 1990, Protective Life reinsured two separate blocks of insurance. In the first quarter of 1992, Employers National Life Insurance Company, a small Texas insurance company, was purchased and merged into Protective Life. In the third quarter of 1993, Protective Life acquired Wisconsin National Life Insurance Company and coinsured a small block of universal life policies. CORPORATE AND OTHER The Corporate and Other segment consists of several small insurance lines of business, net investment income and expenses not attributable to the business segments described above (including interest on substantially all debt), the earnings of Southeast Health Plan, Inc. ("SEHP"), and the operations of several small noninsurance subsidiaries. The earnings of this segment may fluctuate from year to year. In 1988, the Company acquired convertible preferred stock of SEHP, a Birmingham-based health maintenance organization. In August 1991, the Company converted the preferred stock into 80% of the common stock of SEHP. In August 1993, the Company sold its interest in SEHP. In 1991, this segment's earnings were reduced from 1990 levels as a result of interest on debt relating to a 1990 reinsurance transaction, a write-off of certain computer equipment, and losses at SEHP. In 1992, Corporate and Other earnings were slightly higher due to SEHP having a $0.6 million profit compared to the loss in 1991, the SEHP increase being largely offset by several factors of negative effect. In 1993, the Company changed the method used to apportion net investment income within the Company. This change resulted in increased income attributable to the Agency, Investment Products, and Acquisitions Divisions of $3.0 million, $2.0 million, and $2.6 million, respectively, while decreasing income of the Corporate and Other segment. INSURANCE IN FORCE The Company's total consolidated life insurance in force at December 31, 1993 was $42.5 billion. The following table shows sales by face amount and insurance in force for the Company's business segments. The ratio of voluntary terminations of individual life insurance to mean individual life insurance in force, which is determined by dividing the amount of insurance terminated due to surrenders and lapses during the year by the mean of the insurance in force at the beginning and end of the year, adjusted for the timing of major acquisitions and assumptions was: Net terminations reflect voluntary lapses and cash surrenders, some of which may be due to the replacement of the Company's products with competitors' products. Also, a higher percentage of voluntary lapses typically occurs in the first 15 months of a policy, and accordingly, lapses will tend to increase or decrease in proportion to the change in new insurance written during the immediately preceding periods. The amount of investment products in force is measured by account balances. The following table shows guaranteed investment contract and annuity account balances. UNDERWRITING The underwriting policies of the Company's insurance subsidiaries are established by management. With respect to individual insurance, the subsidiaries use information from the application and, in some cases, inspection reports, attending physician statements, or medical examinations to determine whether a policy should be issued as applied for, rated, or rejected. Medical examinations of applicants are required for individual life insurance in excess of certain prescribed amounts (which vary based on the type of insurance) and for most ordinary insurance applied for by applicants over age 50. In the case of "simplified issue" policies, which are issued primarily through the Financial Institutions Division and the payroll deduction market, coverage is rejected if the responses to certain health questions contained in the application indicate adverse health of the applicant. For other than "simplified issue" policies, medical examinations are requested of any applicant, regardless of age and amount of requested coverage if an examination is deemed necessary to underwrite the risk. Substandard risks may be referred to reinsurers for rating and in some instances, full or partial reinsurance of the substandard risk. The Company's insurance subsidiaries require blood samples to be drawn with ordinary insurance applications for coverage at $100,000 (ages 16-50) or $150,000 (age 51 and above). Blood samples are tested for a wide range of chemical values and are screened for antibodies to the HIV virus. Applications also contain questions permitted by law regarding the HIV virus which must be answered by the proposed insureds. Group insurance underwriting policies, which are administered by experienced group underwriters, are similar to the underwriting policies of other major group insurers. The underwriting policies are designed for single employer groups. Initial premium rates are based on prior claim experience and manual premium rates with relative weights depending on the size of the group and the nature of the benefits. INVESTMENTS The Company's investment philosophy is to maintain a portfolio that is matched with respect to yield, risk, and cash flow characteristics to its liabilities. The types of assets in which the Company may invest are governed by state laws which prescribe qualified investment assets. Within the parameters of these laws, the Company invests its assets giving consideration to such factors as liquidity needs, investment quality, investment return, matching of assets and liabilities, and the composition of the investment portfolio by asset type and credit exposure. Because liquidity is important, the Company continually balances maturity against yield and quality considerations in selecting new investments. The Company's asset/liability matching practices involve monitoring of asset and liability durations for various product lines; cash flow testing under various interest rate scenarios; and rebalancing of assets and liabilities with respect to yield, risk, and cash flow characteristics. In accordance with current generally accepted accounting principles, most of the Company's fixed maturities, equity securities, and short-term investments are valued at market. Mortgage loans, investment real estate, policy loans, and other long-term investments are valued at amortized cost. The following table shows the Company's investments at December 31, 1993, valued on the basis of generally accepted accounting principles. Approximately 51% of the Company's bond portfolio is invested in mortgage- backed securities. Mortgage-backed securities are based upon residential mortgages which have been pooled into securities. Mortgage-backed securities may have greater cash flow volatility as a result of the pass-through of prepayments of principal on the underlying loans. Prepayments of principal on the underlying residential loans can be expected to accelerate with decreases in interest rates and diminish with increases in interest rates. In management's view, the overall quality of the Company's investment portfolio continues to be strong. The following table shows the approximate percentage distribution of the Company's fixed maturities by rating (utilizing Standard & Poor Corporation's rating categories) at December 31, 1993: At December 31, 1993, approximately 97.7% of the Company's bond portfolio was invested in U.S. Government-backed securities or investment grade corporate bonds and only 2.3% of its bond portfolio was rated less than investment grade by Moody's Investors Service, Inc. ("Moody's") and Standard & Poor's Corporation ("S&P"). Risks associated with investments in less than investment-grade debt obligations may be significantly higher than risks associated with investments in debt securities rated investment grade. Risk of loss upon default by the borrower is significantly greater with respect to such debt obligations than with other debt securities because these obligations may be unsecured or subordinated to other creditors. Additionally, there is often a thinly traded market for such securities and current market quotations are frequently not available for some of these securities. Issuers of less than investment-grade debt obligations usually have higher levels of indebtedness and are more sensitive to adverse economic conditions, such as recession or increasing interest rates, than investment-grade issuers. The Company also invests in those bank loan participations that are the most senior debt issued in highly leveraged transactions. They are generally unrated by the credit rating agencies. In selecting bank participations for investment, the Company requires cash flows, without asset sales, to cover all interest and scheduled amortization of the bank debt by 140% and to cover total debt service by 110%. The debt is generally secured by most of the tangible assets of the issuing company. Of the $151.3 million of bank loan participations owned by the Company at December 31, 1993, $121.7 million were classified by the Company as less than investment grade. The Company also invests a significant portion of its portfolio in mortgage loans. Results for these investments have been excellent due to careful management and a focus on a specialized segment of the market. The Company generally does not lend on speculative properties and has specialized in making loans on either credit-oriented commercial properties, or credit-anchored strip shopping centers in smaller towns and cities. The following table shows a breakdown of the Company's mortgage loan portfolio by property type: The Company's mortgage lending criteria generally require that loan-to- value ratios on each mortgage remain at or under 75%. Rental payments from credit anchors (i.e., excluding rental payments from smaller local tenants) generally exceed 70% of the property's operating expenses and debt service. The average size mortgage loan in the Company's portfolio is approximately $1.4 million. The largest single loan amount is $9.3 million. Many of the Company's mortgage loans have call or interest rate reset provisions after five to seven years. However, if interest rates were to significantly increase, the Company may be unable to increase the interest rates on its existing mortgage loans commensurate with the significantly increased market rates, or call the loans. At December 31, 1993, 1.9% of the mortgage loan portfolio was nonperforming. It is the Company's policy to cease to carry accrued interest on loans that are over 90 days delinquent. For loans less than 90 days delinquent, interest is accrued unless it is determined that the accrued interest is not collectible. If a loan becomes over 90 days delinquent, it is the Company's policy to initiate foreclosure proceedings or, much less often, to adopt a workout arrangement to bring the loan current. As a general rule, the Company does not invest directly in real estate. The investment real estate held by the Company consists largely of properties obtained through foreclosures or the acquisition of other insurance companies. At foreclosure, a new appraisal is obtained, and the value of real estate acquired through foreclosure is valued at the lesser of the mortgage loan balance plus costs of foreclosure or appraised value. In the Company's experience, the appraised value of foreclosed properties often equals or exceeds the mortgage loan balance on the property plus costs of foreclosure. Also, foreclosed properties often generate a positive cash flow, enabling the Company to hold and manage the property until the property can be profitably sold. The Company has established an allowance for uncollectible amounts on investments. This allowance was $35.9 million at December 31, 1993. A combination of futures contracts and options on treasury notes are currently being used in connection with a hedging program which is designed to hedge against rising interest rates for asset/liability management of certain investments, primarily mortgage loans on real estate, and liabilities arising from interest sensitive products such as GICs and individual annuities. Realized investment gains and losses on such contracts are deferred and amortized over the life of the hedged asset. The Company also uses interest rate swap contracts to effectively convert certain investments from a variable to a fixed rate of interest. For further discussion regarding the maturity of and the concentration of risk among the Company's invested assets, see Note C to the Consolidated Financial Statements. The following table shows the investment results of the Company for the years 1989 through 1993: See "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - LIQUIDITY AND CAPITAL RESOURCES" in the Company's 1993 Annual Report to Stockholders for certain information relating to the Company's investments and liquidity. The Company is involved in financial guarantees of the debt of others. For further details, see Note G to Consolidated Financial Statements. INDEMNITY REINSURANCE As is customary in the insurance industry, the Company's insurance subsidiaries cede insurance to other insurance companies. The ceding insurance company remains contingently liable with respect to ceded insurance should any reinsurer be unable to meet the obligations assumed by it. The Company sets a limit on the amount of insurance retained on the life of any one person. In the individual lines it will not retain more than $500,000, including accidental death benefits, on any one life. Certain of the term-like plans of the Company have a retention of $50,000 per life. For group insurance, the maximum amount retained on any one life is $100,000. At December 31, 1993, the Company had insurance in force of $42.5 billion of which approximately $7.5 billion was ceded to reinsurers. RESERVES The applicable insurance laws under which the Company's insurance subsidiaries operate require that each insurance company report policy reserves as liabilities to meet future obligations on the outstanding policies. These reserves are the amounts which, with the additional premiums to be received and interest thereon compounded annually at certain assumed rates, are calculated in accordance with applicable law to be sufficient to meet the various policy and contract obligations as they mature. These laws specify that the reserves shall not be less than reserves calculated using certain named mortality tables and interest rates. The reserves carried in the Company's financial reports (presented on the basis of generally accepted accounting principles) differ from those specified by the laws of the various states and carried in the insurance subsidiaries' statutory financial statements (presented on the basis of statutory accounting principles mandated by state insurance regulation). For policy reserves other than those for universal life policies, annuity contracts, and GICs, these differences arise from the use of mortality and morbidity tables and interest rate assumptions which are deemed under generally accepted accounting principles to be more appropriate for financial reporting purposes than those required for statutory accounting purposes; from the introduction of lapse assumptions into the reserve calculation; and from the use of the net level premium reserve method on all business. Policy reserves for universal life policies, annuity contracts, and GICs are carried in the Company's financial reports at the account value of the policy or contract. FEDERAL INCOME TAX CONSEQUENCES The Company's insurance subsidiaries are taxed by the federal government in a manner similar to companies in other industries. However, certain restrictions on consolidating life insurance company income with noninsurance income are applicable to the Company; thus, the Company is not able to fully consolidate the operating results of its subsidiaries for federal income tax purposes. Under pre-1984 tax law, certain income of the Company was not taxed currently, but was accumulated in the "Policyholders' Surplus Account" for each insurance company subsidiary to be taxed only when such income was distributed to the stockholders or when certain limits on accumulated amounts were exceeded. Consistent with current tax law, amounts accumulated in the Policyholders' Surplus Account have been carried forward, although no accumulated income may be added to these accounts. As of December 31, 1993, the combined Policyholders' Surplus Accounts for the life insurance subsidiaries of the Company and the estimated tax which would become payable on these amounts if distributed to stockholders were $50.7 million and $17.7 million, respectively. The Company does not anticipate any of its life insurance subsidiaries exceeding applicable limits on amounts accumulated in these accounts and, therefore, does not expect to involuntarily pay tax on the amounts held therein. COMPETITION The Company operates in a highly competitive industry. In connection with the development and sale of its products, the Company encounters significant competition from other insurance companies, many of which have financial resources greater than those of the Company, as well as from other investment alternatives available to its customers. The operating results of companies in the insurance industry have historically been subject to significant fluctuations due to competition, economic conditions, interest rates, investment performance, maintenance of insurance ratings, and other factors. Management believes that the Company's ability to compete is dependent upon, among other things, its ability to attract and retain agents to market its insurance products, its ability to develop competitive and profitable products, and its maintenance of a high rating from rating agencies. Nontraditional sources of health care coverages, such as health maintenance organizations and preferred provider organizations, are developing rapidly in the Company's operating territory and provide competitive alternatives to the Company's group health products. Banks, by offering bank investment contracts currently guaranteed by the FDIC, provide competitive alternatives to GICs. In addition, banks and other financial institutions may be granted approval to underwrite and sell insurance products and compete directly with the Company. REGULATION Insurance companies are subject to comprehensive and detailed regulation and supervision in the states in which they transact business. The laws of the various jurisdictions establish supervisory agencies with broad administrative powers relative to granting and revoking licenses to transact business, regulating trade practices, licensing agents, approving policy forms, establishing reserve requirements, fixing maximum interest rates on life insurance policy loans and minimum rates for accumulation of surrender values, prescribing the form and content of required statutory financial statements, and regulating the type and amount of investments permitted. Insurance companies are required to file detailed annual reports with the supervisory agencies in each of the jurisdictions in which they do business and their business and accounts are subject to examination by such agencies at any time. Under the rules of the National Association of Insurance Commissioners ("NAIC"), insurance companies are examined periodically (generally every three years) by one or more of the supervisory agencies on behalf of the states in which they do business. To date, no such insurance department examinations have produced any significant adverse findings regarding any insurance company subsidiary of the Company. Recently, the insurance regulatory framework has been placed under increased scrutiny by various states, the federal government, and the NAIC. Various states have considered or enacted legislation which changes, and in many cases increases, the state's authority to regulate insurance companies. Legislation is under consideration in Congress which would result in the federal government assuming some role in the regulation of insurance companies. The NAIC, in conjunction with state regulators, has been reviewing existing insurance laws and regulations. The NAIC recently approved and recommended to the states for adoption and implementation several regulatory initiatives designed to reduce the risk of insurance company insolvencies. These initiatives include a risk-based capital requirement. A life insurance company's statutory capital is computed according to rules prescribed by the NAIC as modified by the insurance company's state of domicile. Statutory accounting rules are different from generally accepted accounting principles and are intended to reflect a more conservative view. The NAIC's risk-based capital requirements require insurance companies to calculate and report information under a risk-based capital formula. These risk-based capital requirements are intended to allow insurance regulators to identify inadequately capitalized insurance companies based upon the types and mixtures of risks inherent in the insurer's operations. The formula includes components for asset risk, liability risk, interest rate exposure, and other factors. Based upon the December 31, 1993 statutory financial reports of the Company's insurance subsidiaries, management believes that the Company's insurance subsidiaries are adequately capitalized under the formula. Under insurance guaranty fund laws, in most states, insurance companies doing business therein can be assessed up to prescribed limits for policyholder losses incurred by insolvent companies. The Company does not believe that any such assessments will be materially different from amounts already provided for in the financial statements. Most of these laws do provide, however, that an assessment may be excused or deferred if it would threaten an insurer's own financial strength. In addition, several states, including the states in which the Company's insurance subsidiaries are domiciled, have enacted legislation or adopted regulations regarding insurance holding company systems. These laws require registration of and periodic reporting by insurance companies domiciled within the jurisdiction which control or are controlled by other corporations or persons so as to constitute an insurance holding company system. These laws also affect the acquisition of control of insurance companies as well as transactions between insurance companies and companies controlling them. Most states, including Tennessee, where Protective Life is domiciled, require administrative approval of the acquisition of control of an insurance company domiciled in the state or the acquisition of control of an insurance holding company whose insurance subsidiary is incorporated in the state. In Tennessee, the acquisition of 10% of the voting securities of a person is generally deemed to be the acquisition of control for the purpose of the insurance holding company statute and requires not only the filing of detailed information concerning the acquiring parties and the plan of acquisition, but also administrative approval prior to the acquisition. Tennessee insurance laws also impose certain restrictions on Protective Life's ability to pay dividends to the Company. Under Tennessee insurance laws, Protective Life may only pay dividends out of that part of its available surplus which is derived from realized statutory net profits. In addition, the Tennessee Commissioner of Insurance must approve (or not disapprove within 30 days of notice) payment of a dividend from Protective Life which exceeds, together with all dividends paid by Protective Life within the previous 12 months, the greater of (i) 10% of Protective Life's surplus as regards policyholders at the preceding December 31 or (ii) the net gain from operations of Protective Life for the 12 months ended on such December 31. Additional issues related to regulation of the Company and its insurance subsidiaries are discussed in "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - LIQUIDITY AND CAPITAL RESOURCES" in the Company's 1993 Annual Report to Stockholders. EMPLOYEES The Company had 990 full-time employees, including 841 in the Home Office in Birmingham, Alabama at December 31, 1993. These employees are covered by contributory major medical insurance, group life, and long-term disability insurance plans. The cost of these benefits in 1993 amounted to approximately $2.0 million for the Company. In addition, substantially all of the employees are covered by a pension plan. The Company also matches employee contributions to its 401(k) Plan. See Note K to Consolidated Financial Statements. RECENT DEVELOPMENTS The Clinton Administration has advocated changes to the current health care delivery system which will address both affordability and availability issues. The ultimate scope and effective date of any proposals are unknown at this time and are likely to be modified as they are considered for enactment by Congress. It is anticipated that these proposals may adversely affect certain products in the Company's group health insurance business. In addition to the federal initiatives, a number of states are considering legislative programs that are intended to affect the accessibility and affordability of health care. Some states have recently enacted health care reform legislation. These various state programs (which could be preempted by any federal program) may also adversely affect the Company's group health insurance business. However, in light of the small relative proportion of the Company's earnings attributable to group health insurance, management does not expect that either the federal or state proposals will have a material adverse effect on the Company's earnings. The Company has entered into a joint venture arrangement with the Lippo Group to enter the Hong Kong insurance market. Subject to regulatory approval, the Company and the Lippo Group will jointly own a recently acquired, inactive Hong Kong insurer. Management anticipates that the Hong Kong insurer will commence business in mid-1994. The Hong Kong insurer's products will be similar to those currently being offered by the Company. ITEM 2.		ITEM 2. PROPERTIES The Company's Home Office building is located at 2801 Highway 280 South, Birmingham, Alabama. This building includes the original 142,000 square-foot building which was completed in 1976 and a second contiguous 220,000 square-foot building which was completed in 1985. In addition, parking is provided for approximately 1,000 vehicles. The Company leases administrative space in Birmingham, Alabama; Brentwood, Tennessee; Greenville, South Carolina; Cary, North Carolina; Indianapolis, Indiana; and Oklahoma City, Oklahoma. Substantially all of these offices are rented under leases that run for periods of three to five years. The aggregate monthly rent is approximately $32 thousand. Marketing offices are leased in 15 cities, substantially all under leases for periods of three to five years with only three leases running longer than five years. The aggregate monthly rent is approximately $31 thousand. ITEM 3.	ITEM 3. LEGAL PROCEEDINGS There are no material pending legal proceedings, other than ordinary routine litigation incidental to the business of the Company, to which the Company or any of its subsidiaries is a party or of which any of the Company's properties is the subject. ITEM 4.	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matter was submitted during the fourth quarter of 1993 to a vote of security holders of the Company. PART II ITEM 5.	ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Through Friday, October 1, 1993, the Company's Common Stock was traded on the over-the-counter market (NASDAQ symbol: PROT) and was quoted on the NASDAQ National Market System. On Monday, October 4, 1993, the Company's Common Stock began trading on the New York Stock Exchange (NYSE symbol: PL). The following table sets forth the highest and lowest closing prices of the Company's Common Stock, $0.50 par value, as reported by NASDAQ and the New York Stock Exchange during the periods indicated, along with the dividends paid per share of Common Stock during the same periods. At February 18, 1994, there were approximately 2,170 holders of record of Company Common Stock. The Company (or its predecessor) has paid cash dividends each year since 1926 and each quarter since 1934. The Company expects to continue to pay cash dividends, subject to the earnings and financial condition of the Company and other relevant factors. The ability of the Company to pay cash dividends is dependent in part on cash dividends received by the Company from its life insurance subsidiaries. See Item 7 - "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - LIQUIDITY AND CAPITAL RESOURCES" in the Company's 1993 Annual Report to Stockholders. Such subsidiary dividends are restricted by the various insurance laws of the states in which the subsidiaries are incorporated. See Item 1 - "BUSINESS - REGULATION". ITEM 6.	ITEM 6. SELECTED FINANCIAL DATA ITEM 7.	ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Information regarding the Company's financial condition and results of operations is included under the caption "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS" in the Company's 1993 Annual Report to Stockholders and is incorporated herein by reference. ITEM 8.	ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial statements and supplementary data for the Company and its subsidiaries, which are included under the caption "CONSOLIDATED FINANCIAL STATEMENTS" in the Company's 1993 Annual Report to Stockholders, are incorporated herein by reference. COOPERS & LYBRAND REPORT OF INDEPENDENT ACCOUNTANTS To the Directors and Stockholders Protective Life Corporation Birmingham, Alabama Our report on the consolidated financial statements of Protective Life Corporation and Subsidiaries has been incorporated by reference in this Form 10-K from page 66 of the 1993 Annual Report to Stockholders of Protective Life Corporation. In connection with our audits of such financial statements, we have also audited the related financial statement schedules listed in the index on page 27 of this Form 10-K. In our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. /s/ Coopers & Lybrand - --------------------- COOPERS & LYBRAND Birmingham, Alabama February 14, 1994 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 Except for the information concerning executive officers of the Company set forth below, the information called for by this Item 10 is incorporated herein by reference to the section entitled "ELECTION OF DIRECTORS AND INFORMATION ABOUT NOMINEES" in the Company's definitive proxy statement for the Annual Meeting of Stockholders, May 2, 1994, to be filed with the Securities and Exchange Commission by the Company pursuant to Regulation 14A within 120 days after the end of its 1993 fiscal year. The executive officers of the Company are as follows: Name Age Position ---- --- -------- Drayton Nabers, Jr. 53 President and Chief Executive Officer and a Director R. Stephen Briggs 44 Executive Vice President John D. Johns 41 Executive Vice President and Chief Financial Officer Ormond L. Bentley 58 Senior Vice President, Group Deborah J. Long 40 Senior Vice President and General Counsel Jim E. Massengale 51 Senior Vice President Steven A. Schultz 40 Senior Vice President, Financial Institutions Wayne E. Stuenkel 40 Senior Vice President and Chief Actuary A. S. Williams III 57 Senior Vice President, Investments and Treasurer Jerry W. DeFoor 41 Vice President and Controller, and Chief Accounting Officer All executive officers are elected annually and serve at the pleasure of the Board of Directors. None is related to any director of the Company or to any other executive officer. Mr. Nabers was President and Chief Operating Officer and a Director from August 1982 until May 1992, when he became President and Chief Executive Officer. From July 1981 to August 1982, he was Senior Vice President of the Company. Since August 1982, he has also been President of Protective Life and had been its Senior Vice President from September 1981 to August 1982. From February 1980 to September 1981, he served as Senior Vice President, Operations of Protective Life. From 1979 to February 1980, he was Senior Vice President, Operations and General Counsel of Protective Life. From February 1980 to March 1983, he served as President of Empire General Life Insurance Company, a subsidiary, and from March 1983 to December 31, 1984, he was Chairman of the Executive Committee of Empire General. He is also a director of Energen Corporation and National Bank of Commerce of Birmingham. Mr. Briggs has been Executive Vice President of the Company and of Protective Life since October 1993. From January 1993 to October 1993, he was Senior Vice President, Life Insurance and Investment Products of the Company and of Protective Life. Mr. Briggs had been Senior Vice President, Ordinary Marketing of the Company since August 1988 and of Protective Life since April 1986. From July 1983 to April 1986, he was President of First Protective Insurance Group, Inc. Mr. Johns has been Executive Vice President and Chief Financial Officer of the Company and of Protective Life since October 1993. From August 1988 to October 1993, he served as Vice President and General Counsel of Sonat, Inc. He is a director of National Bank of Commerce of Birmingham and Parisian Services, Inc. Mr. Bentley has been Senior Vice President, Group of the Company since August 1988 and of Protective Life since December 1978. Mr. Bentley has been employed by Protective Life since October 1965. Ms. Long has been Senior Vice President and General Counsel of the Company and of Protective Life since February 1, 1994. From August 2, 1993 to January 31, 1994, Ms. Long served as General Counsel of the Company and from February 1984 to January 31, 1994 she practiced law with the law firm of Maynard, Cooper & Gale, P.C. Mr. Massengale has been Senior Vice President of the Company and of Protective Life since May 1992. From May 1989 to May 1992, he was Senior Vice President, Operations and Systems of the Company and Protective Life. From January 1983 to May 1989, he served as Senior Vice President, Corporate Systems of the Company and Protective Life. Mr. Schultz has been Senior Vice President, Financial Institutions of the Company and of Protective Life since March 1993. Mr. Schultz served as Vice President, Financial Institutions of the Company from February 1993 to March 1993 and of Protective Life from February 1989 to March 1993. From June 1977 through January 1989, he was employed by and served in a number of capacities with The Minnesota Mutual Life Insurance Company, finally serving as Director, Group Sales. Mr. Stuenkel has been Senior Vice President and Chief Actuary of the Company and of Protective Life since March 1987. Mr. Stuenkel is a Fellow of the Society of Actuaries and has been employed by Protective Life since September 1978. Mr. Williams has been Senior Vice President, Investments and Treasurer of the Company since July 1981. Mr. Williams also serves as Senior Vice President, Investments and Treasurer of Protective Life. Mr. Williams has been employed by Protective Life since November 1964. Mr. DeFoor has been Vice President and Controller, and Chief Accounting Officer of the Company and Protective Life since April 1989. Mr. DeFoor is a certified public accountant and has been employed by Protective Life since August 1982. Certain of these executive officers also serve as executive officers and/or directors of various other Company subsidiaries. ITEM 11.	ITEM 11. EXECUTIVE COMPENSATION ITEM 12.	ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT ITEM 13.	ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information called for by Items 11 through 13 is incorporated herein by reference from the Company's definitive proxy statement for the Annual Meeting of Stockholders, May 2, 1994, to be filed with the Securities and Exchange Commission by the Company pursuant to Regulation 14A within 120 days after the end of its 1993 fiscal year. PART IV ITEM 14.	ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The following documents are filed as part of this report: 1. Financial Statements: The following financial statements set forth in the Company's 1993 Annual Report to Stockholders as indicated on the following table are incorporated by reference (See Exhibit 13). PAGE Report of Independent Accountants. . . . . . . . 66 Consolidated Statements of Income for the years ended December 31, 1993, 1992, and 1991 . . . . 43 Consolidated Balance Sheets as of December 31, 1993 and 1992 . . . . . . . . . . . . . . . . . 44 PAGE Consolidated Statements of Stockholders' Equity for the years ended December 31, 1993, 1992, and 1991. . . . . . . . . . . . . . . . . . . . 46 Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992, and 1991. . . . . . . . . . . . . . . . . . . . 47 Notes to Consolidated Financial Statements. . . . 48 2. Financial Statement Schedules: The Report of Independent Accountants which covers the financial statement schedules appears on page 23 of this report. The following schedules are located in this report on the pages indicated. PAGE Schedule I - Summary of Investments - Other Than Investments in Related Parties. . . . 33 Schedule III - Condensed Financial Information of Registrant . . . . . . . . . . . . . . . . . 34 Schedule V - Supplementary Insurance Information . 38 Schedule VI - Reinsurance . . . . . . . . . . . . 39 Schedule IX - Short-Term Borrowings . . . . . . . 40 All other schedules to the consolidated financial statements required by Article 7 of Regulation S-X are not required under the related instructions or are inapplicable and therefore have been omitted. 3. Exhibits: Included as exhibits are the items listed below. The Company will furnish a copy of any of the exhibits listed upon the payment of $5.00 per exhibit to cover the cost of the Company in furnishing the exhibit. ITEM NUMBER DOCUMENT 3(a) 1985 Restated Certificate of Incorporation of the Company 3(a)(1) Certificate of Amendment of 1985 Restated Certificate of Incorporation of the Company 3(a)(2) Certificate of Designation of Junior Participating Cumulative Preferred Stock of the Company filed with the Secretary of State of Delaware on July 14, 1987 - Filed as Exhibit A to the Company's Form 8-K Report filed July 15, 3(a)(3) Certificate of Correction of Certificate of Designation of Junior Participating Cumulative Preferred Stock of the Company filed with the Secretary of State of Delaware on July 27, 1987 - Filed as Exhibit 3(a)(4) to the Company's Form 10-K Annual Report for the year ended December 31, 1987 3(b) By-laws of the Company filed as Exhibit C to the Company's Form 10 Registration Statement filed September 4, 1981 3(b)(1) Amended By-laws of the Company filed as Exhibit B to the Company's Form 8-K Report filed May 18, 1983 4(a) 1985 Restated Certificate of Incorporation of the Company (filed as Exhibit 3(a)) 4(a)(1) Certificate of Amendment of 1985 Restated Certificate of Incorporation of the Company (filed as Exhibit 3(a)(1)) 10(a) Management Incentive Plan filed as Exhibit 10(a) to the Company's Form 10-K Annual Report for the year ended December 31, 1984 10(a)(1) Amendment to the Company's Management Incentive Plan renamed as the Company's Annual Incentive Plan filed as Exhibit 10(a)(1) to the Company's Form 10-Q Report filed May 14, 10(b) Performance Share Plan filed as Exhibit G to the Company's Form 10 Registration Statement filed September 4, 1981 (expired as to new grants) - -------------------------- incorporated by reference 28 10(b)(1) 1983 Performance Share Plan filed as Exhibit C to the Company's Form 8-K Report filed May 18, 1983 10(b)(2) The Company's 1983 Performance Share Plan (as amended March 19, 1990) filed as Exhibit 10(b)(2) to the Company's Form 10-Q Report filed May 14, 1990 10(b)(3) The Company's 1992 Performance Share Plan filed as Exhibit 10(b)(3) to the Company's Form 10-Q filed May 15, 1992 10(c) Excess Benefit Plan filed as Exhibit 10(c) to the Company's Form 10-K Annual Report for the year ended December 31, 1984 10(c)(1) Excess Benefit Plan amended and restated as of January 1, 1989 filed as Exhibit 10(c)(1) to the Company's Form 10-K Annual Report for the year ended December 31, 1991 10(d) Bond Purchase Agreement filed as Exhibit 10(d) to the Company's Form 10-K Annual Report for the year ended December 31, 1991 10(d)(1) Escrow Agreement filed as Exhibit 10(d)(1) to the Company's Form 10-K Annual Report for the year ended December 31, 1991 10(e) Indemnity Agreements filed as Exhibits to the Company's Form 10-Q Report, filed August 14, 1986 10(f) Preferred Share Purchase Rights Plan filed as Exhibit to the Company's Form 8-A Report filed July 15, 1987, as amended July 23 and July 29, 1987 10(i) Form of Severance Compensation Agreement filed as Exhibit 10(i) to the Company's Form 10-K Annual Report for the year ended December 31, 1991 10(i)(1) Form of First Amendment to Severance Compensation Agreement filed as Exhibit 10(i)(1) to the Company's Form 10-K Annual Report for the year ended December 31, 1991 10(iii)(A)(1) The Company's Deferred Compensation Plan for Directors who are not Employees of the Company filed as Exhibit 4 to the Company's Form S-8 filed August 27, 1993 - -------------------------- incorporated by reference 29 10(iii)(A)(2) The Company's Deferred Compensation Plan for Officers filed as Exhibit 4 to the Company's Form S-8 filed January 13, 13 1993 Annual Report To Stockholders 21 Organization Chart of the Company and Affiliates 23 Consent of Coopers & Lybrand 24 Power of Attorney The following is a list of each management contract or compensatory plan or arrangement required to be filed as an exhibit to this form pursuant to Item 14(c) of this Form 10-K: Exhibit Item Numbers 10(a), 10(a)(1), 10(b), 10(b)(1), 10(b)(2), 10(b)(3), 10(c), 10(c)(1), 10(i), 10(i)(1), 10(iii)(A)(1), and 10(iii)(A)(2). (b) Reports on Form 8-K: (1) Form 8-K, filed February 17, 1993 - Item 5 (2) Form 8-K, filed April 28, 1993 - Item 5 (3) Form 8-K, filed July 28, 1993 - Item 5 (4) Form 8-K, filed August 4, 1993 - Item 2 - Item 7 (5) Form 8-K, filed September 14, 1993 - Item 5 (6) Form 8-K, filed October 1, 1993 - Item 5 (7) Form 8-K, filed October 28, 1993 - Item 5 - -------------------------- incorporated by reference 30 SIGNATURES Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. PROTECTIVE LIFE CORPORATION By:/s/Drayton Nabers, Jr. -------------------------------------- Drayton Nabers, Jr. President and Chief Executive Officer March 25, 1994 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 Company and in the capacities and on the dates indicated. SIGNATURE CAPACITY IN WHICH SIGNED DATE /s/Drayton Nabers, Jr. President and Chief Executive March 25, 1994 - ------------------------- Officer (Principal Executive DRAYTON NABERS, JR. Officer) and Director /s/John D. Johns Executive Vice President and March 25, 1994 - ------------------------- Chief Financial Officer JOHN D. JOHNS (Principal Financial Officer) /s/Jerry W. DeFoor Vice President and Controller, March 25, 1994 - ------------------------- and Chief Accounting Officer JERRY W. DEFOOR (Principal Accounting Officer) Chairman of the Board and March 25, 1994 - ------------------------- Director WILLIAM J. RUSHTON III * Director March 25, 1994 - ------------------------- JOHN W. WOODS * Director March 25, 1994 - ------------------------- CRAWFORD T. JOHNSON III * Director March 25, 1994 - ------------------------- WILLIAM J. CABANISS, JR. * Director March 25, 1994 - ------------------------- H. G. PATTILLO * Director March 25, 1994 - ------------------------- EDWARD L. ADDISON * Director March 25, 1994 - ------------------------- JOHN J. MCMAHON, JR. * Director March 25, 1994 - ------------------------- A. W. DAHLBERG * Director March 25, 1994 - ------------------------- JOHN W. ROUSE, JR. * Director March 25, 1994 - ------------------------- ROBERT T. DAVID * Director March 25, 1994 - ------------------------- RONALD L. KUEHN, JR. * Director March 25, 1994 - ------------------------- HERBERT A. SKLENAR - -------------------- Drayton Nabers, Jr., by signing his name hereto, does sign this document on behalf of each of the persons indicated above pursuant to powers of attorney duly executed by such persons and filed with the Securities and Exchange Commission. By: /s/Drayton Nabers, Jr. -------------------------------------- DRAYTON NABERS, JR. Attorney-in-fact SCHEDULE I - SUMMARY OF INVESTMENTS - OTHER THAN INVESTMENTS IN RELATED PARTIES PROTECTIVE LIFE CORPORATION AND SUBSIDIARIES DECEMBER 31, 1993 (in thousands) SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT STATEMENTS OF INCOME PROTECTIVE LIFE CORPORATION (PARENT COMPANY) YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 (in thousands) See notes to condensed financial statements. SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT BALANCE SHEETS PROTECTIVE LIFE CORPORATION (PARENT COMPANY) (in thousands) See notes to condensed financial statements. SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT STATEMENTS OF CASH FLOWS PROTECTIVE LIFE CORPORATION (PARENT COMPANY) YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 (in thousands) See notes to condensed financial statements. SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT PROTECTIVE LIFE CORPORATION (PARENT COMPANY) NOTES TO CONDENSED FINANCIAL STATEMENTS The Company publishes consolidated financial statements that are its primary financial statements. Therefore, these parent company condensed financial statements are not intended to be the primary financial statements of the Company, and should be read in conjunction with the consolidated financial statements and notes thereto of Protective Life Corporation and subsidiaries. NOTE 1 - DEBT At December 31, 1993, the Company had borrowed $118.0 million of its $138 million revolving line of credit. In addition, the Company has borrowed $29.0 million under an installment note. Future maturities of this note are $9.5 million in 1994, $9.5 million in 1995, and $10.0 million in 1996. NOTE 2 - SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION NOTE 3 - SUBSIDIARY SURPLUS DEBENTURES Protective Life Insurance Company ("Protective Life") has issued surplus debentures to the Company in order to finance acquisitions and growth. At December 31, 1993, the balance of the surplus debentures was $48.9 million. The surplus debentures are included in receivables from subsidiaries. Protective Life must obtain the approval of the Commissioner of Insurance before it may repay any portion of the surplus debenture. NOTE 4 - SALE OF SUBSIDIARY On January 27, 1993, Protective Life contributed (in the form of a dividend) its 80% ownership interest in the common stock of Southeast Health Plan, Inc. ("SEHP"). Because SEHP was in a deficit position, the transaction was recorded as a "negative" dividend by the Company. On August 6, 1993, the Company sold its ownership interest in SEHP. The sale has been accounted for in a manner similar to an installment sale. A gain of $3.5 million is included in the Company's 1993 other income. - ---------------------------- Eliminated in consolidation. SCHEDULE V - SUPPLEMENTARY INSURANCE INFORMATION PROTECTIVE LIFE CORPORATION AND SUBSIDIARIES (in thousands) SCHEDULE VI - REINSURANCE PROTECTIVE LIFE CORPORATION AND SUBSIDIARIES (dollars in thousands) SCHEDULE IX - SHORT-TERM BORROWINGS PROTECTIVE LIFE CORPORATION AND SUBSIDIARIES (dollars in thousands) EXHIBITS TO FORM 10-K OF PROTECTIVE LIFE CORPORATION FOR THE FISCAL YEAR ENDED DECEMBER 31, 1993 INDEX TO EXHIBITS PAGE 3(a).................................................................... 3(a)(1)................................................................. 13 ..................................................................... 21 ..................................................................... 23 ..................................................................... 24 .....................................................................
716783_1993.txt	716783	1993	Item 1. BUSINESS Lafarge Corporation (the "Registrant"), a Maryland corporation, is engaged in the production and sale of cement and ready-mixed concrete, aggregates, asphalt, concrete blocks and pipes and precast and prestressed concrete components in the United States and Canada. The Registrant believes that it is one of the largest producers of cement and construction materials in North America. The Registrant is also engaged in road building and other construction using many of its own products. Its wholly-owned subsidiary, Systech Environmental Corporation ("Systech"), provides waste-derived fuels and alternative raw materials to cement plants for use in kilns across North America. The Registrant's Canadian operations are carried out by Lafarge Canada Inc. ("LCI"), a major operating subsidiary of the Registrant. Lafarge Coppee S.A. ("Lafarge Coppee"), a French corporation, and certain of its affiliates own a majority of the Registrant's outstanding voting securities. The terms "Registrant", "LCI" and "Systech", as used in this Annual Report, include not only Lafarge Corporation, LCI, Inc. and Systech Environmental Corporation, respectively, but also their respective subsidiaries and predecessors, unless the context indicates otherwise. The Registrant manufactures and sells various types of portland cement, which is widely used in most types of residential, institutional, commercial and industrial construction. The Registrant also manufactures and sells a variety of special purpose cements. At December 31, 1993 the Registrant operated 15 full-production cement manufacturing plants with a combined rated annual clinker production capacity of approximately 12.3 million tons and two cement grinding facilities. The Registrant sells cement primarily to manufacturers of ready-mixed concrete and other concrete products and to contractors throughout Canada and in many areas of the United States. During 1993 the Registrant's cement operations accounted for 47 percent of consolidated net sales, after the elimination of intracompany sales, and 76 percent of consolidated income from operations. Management believes that LCI is the largest producer of concrete-related building materials in Canada, where approximately 73 percent of the Registrant's construction materials facilities were located at December 31, 1993. The U.S. construction materials operations are located primarily in Texas, Louisiana, Ohio, Pennsylvania, Illinois, New York, Missouri, Kansas and Washington. The Registrant's significant construction materials activities include the manufacture and sale of ready-mixed concrete, construction aggregates, other concrete products and asphalt and road construction. The Registrant has operations at approximately 420 locations including ready-mixed concrete plants, crushed stone and sand and gravel sites, concrete product and asphalt plants. During 1993 the Registrant's construction materials operations accounted for 53 percent of consolidated net sales, after the elimination of intracompany sales, and 24 percent of consolidated income from operations. I-1 At December 31, 1993 Systech operated eight facilities at cement plants in the U.S. and Canada, including five plants that are owned by the Registrant. Systech processed approximately 66 million gallons of supplemental fuel in 1993. Systech's results of operations are included in the results of the Registrant's construction materials operations. The executive offices of the Registrant are located at 11130 Sunrise Valley Drive, Suite 300, Reston, Virginia 22091, and its telephone number is (703) 264-3600. (A) GENERAL DEVELOPMENT OF BUSINESS In 1970, Lafarge Coppee acquired control of Canada Cement Lafarge Ltd. (now LCI) which was Canada's largest cement producer. In 1974, LCI extended its cement manufacturing operations into the United States through a joint venture which operated three cement plants in the United States. Following the termination of the joint venture in 1977, the Registrant (which was incorporated in Maryland in 1977 under the name Citadel Cement Corporation of Maryland) operated two of these U.S. cement plants. In 1981, a subsidiary of the Registrant acquired the stock of General Portland Inc. ("General Portland"), the second largest cement producer in the U.S. In 1983, a corporate reorganization was effected which established the Registrant as the parent company of LCI and General Portland (General Portland was merged into the Registrant in 1988), and the Registrant's name was changed to Lafarge Corporation. In 1986, the Registrant purchased substantially all the assets of National Gypsum Company's Huron Cement Division, consisting of one cement plant, 13 cement terminals and related distribution facilities around the Great Lakes. Also in 1986, the Registrant acquired Systech. During 1989, 1990 and 1991, the Registrant significantly expanded its U.S. construction materials operations through acquisitions, the largest of which included 32 plant facilities in five states and substantial mineral reserves acquired from Standard Slag Holding Company headquartered in Ohio. The Registrant acquired Missouri Portland Cement Company, Davenport Cement Company and certain related companies and assets in 1991. This acquisition included three cement plants and 15 cement distribution terminals located in the Mississippi River Basin, more than 30 ready-mixed concrete and aggregate operations and the assets of a chemical admixtures business. Restructuring In December 1993 the Registrant announced the restructuring of its North American business units to be more efficient and cost competitive. The Registrant will consolidate 11 regional operating units into six in its two main business lines, cement and construction materials. To increase organizational efficiency, the Registrant is reducing management layers, eliminating duplicative administrative functions, and standardizing procedures and information systems. Manufacturing and distribution facilities will not be materially affected by the reorganization. I-2 As of January 1, 1994, the Registrant's new North American organization included three regions for construction materials: Western, based in Calgary, Alberta; Eastern, based in Toronto, Ontario; and U.S., based in Canfield, Ohio. Similarly, the cement group was divided into Western, Eastern and U.S. regions, with office locations in Calgary; Montreal, Quebec; and Southfield, Michigan, respectively. A technical services group will be maintained at the Registrant's research center in Montreal and Corporate headquarters will remain in Reston, Virginia. See page II-7 of Item 7 and page II-35 of Item 8 of this Annual Report for further discussion regarding the restructuring. Sale of Demopolis Cement Operations Effective February 1, 1993 the Registrant sold its cement plant in Demopolis, Alabama. The sale included the Registrant's 810,000 ton single- kiln plant and related assets, seven cement distribution terminals and two terminal leases in the southeastern United States, a cement grinding plant and several barges. The purchase price was approximately $50 million in cash. The Registrant used the proceeds from the sale to repay debt. The gain from the sale was immaterial. Systech continues to supply the Demopolis plant with waste-derived fuels. (B) FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS The Registrant's operations are closely integrated. For reporting purposes, the Registrant currently has only one industry segment, which includes the manufacture and sale of cement, ready-mixed concrete, precast and prestressed concrete components, concrete blocks and pipes, aggregates, asphalt and reinforcing steel. In addition, the Registrant is engaged in road building and other construction utilizing many of its own products. Its subsidiary, Systech, provides waste-derived fuels and alternative raw materials for use in cement kilns. Financial information with respect to the Registrant's product lines and geographic segments is set forth under Item 7 Management's Discussion of Income on pages II-3 through II-19, Management's Discussion of Cash Flows on pages II-20 and II-21 and Item 8 - Consolidated Financial Statements and Supplementary Data on pages II-45 and II-46 of this Annual Report. The Registrant's business is affected significantly by seasonal variations in weather conditions, primarily in Canada and the northern United States. Information with respect to quarterly financial results is set forth in Item 8 page II-54 of this Annual Report. I-3 (C) NARRATIVE DESCRIPTION OF BUSINESS Cement Product Line The Registrant manufactures and sells in Canada (through its subsidiary LCI) and in the United States various types of portland cement, a basic construction material manufactured principally from limestone and clay or shale. Portland cement is the essential binding ingredient in concrete, which is widely used in most types of residential, institutional, commercial and industrial construction. In addition to normal portland cement, the Registrant manufactures and sells a variety of special purpose cements, such as high early strength, low and moderate heat of hydration, sulphate resistant, silica fume, masonry and oilwell cement. At December 31, 1993 the rated annual clinker production capacity of the Registrant's operating cement manufacturing plants was approximately 12.3 million tons with about 5.2 million tons in Canada and approximately 7.1 million tons in the United States. The Canadian Portland Cement Association's "Plant Information Summary Report" dated December 31, 1992 shows that the Canadian capacity is the largest of the cement companies in Canada and represented approximately 31 percent of the total active industry clinker production capacity in that country. This same report for the U.S. at December 31, 1992 shows that the Registrant's operating cement manufacturing plants in the United States accounted for an estimated nine percent of total U.S. active industry clinker production capacity. Cement Plants The following table indicates the location, types of process and rated annual clinker production capacity (based on management's estimates) of each of the Registrant's operating cement manufacturing plants at December 31, 1993. The total clinker production of a cement plant might be less than its rated capacity due principally to product demand and seasonal factors. Generally, a plant's cement production capacity is greater than its clinker production capacity. I-4 Rated Annual Clinker Production Capacity of Cement Manufacturing Plants (In short tons) * * One short ton equals 2,000 pounds. Preheater, pre-calciner plants. The capacity of Exshaw's preheater, pre-calciner kiln is 53 percent of the plant's clinker production capacity. * Preheater plants. All of the Registrant's cement plants are fully equipped with raw grinding mills, kilns, finish grinding mills, environmental protective dust collection systems and storage facilities. Each plant has facilities for shipping by rail and by truck. The Richmond, Alpena, Bath, Davenport, Sugar Creek and Joppa plants have facilities for transportation by water. The Exshaw and Brookfield plants and the Kamloops limestone and cinerite quarries are located on sites leased on a long-term basis. The Registrant owns all other plant sites. The Registrant believes that each of its producing plants is in satisfactory operating condition. At December 31, 1993, the Registrant owned cement grinding plants for the processing of clinker into cement at Fort Whyte, Manitoba; Edmonton, Alberta; Saskatoon, Saskatchewan; Montreal East, Quebec and Superior, Wisconsin. The Edmonton, Montreal East, Saskatoon and Superior grinding plants have been shutdown for several years as cement grinding has not been cost effective at these locations. These plants were used during 1993 for the storage of cement. The Registrant also owns a cement regrind plant and terminal facilities at Tampa, Florida which include facilities for receiving cement by water. The Registrant owns clinker producing plants which have been shut down in Havelock, New Brunswick, Ft. Whyte, Manitoba and Metaline Falls, Washington. I-5 During 1987 the Registrant re-opened the two million ton clinker capacity Alpena plant with restructured low-cost operations utilizing waste- derived fuels supplied by Systech. The Alpena plant was acquired by the Registrant in December 1986. In January 1989 the Registrant announced a multi-year, two-phase modernization and expansion program for the Alpena plant. The first phase of this project, substantially completed in 1990, included approximately $55 million for equipment and related support systems and between $10 and $15 million in facility upgrades. The second phase of the modernization program totalling approximately $26 million is currently underway and will involve additional improvements to the plant's raw materials handling and storage facilities. The facility upgrade and modernization program is expected to reduce operating costs and increase the plant's rated annual cement production capacity to 2.5 million tons. In January 1991, as part of the Missouri Portland/Davenport acquisition, the Registrant acquired three cement plants located in the Mississippi River Basin: a 1,150,000-ton clinker capacity cement plant located in Joppa, Illinois, a 858,000-ton clinker capacity cement plant located in Davenport, Iowa and a 482,000-ton clinker capacity cement plant located near Kansas City, Missouri (Sugar Creek). Total 1993 clinker production from these three dry-process cement plants was 2,225,000 short tons, or 89 percent of capacity. The three cement plants acquired in the Missouri Portland/Davenport acquisition increased the Registrant's annual clinker production capacity by 25 percent. The Manufacturing Process The Registrant manufactures cement by a closely controlled chemical process which begins with the crushing and mixing of calcium carbonates, argillaceous material (clay, shale or kaolin) and silicates (sand). Once mixed, the crushed raw materials undergo a grinding process, which mixes the various materials more thoroughly and increases fineness in preparation for the kiln. This mixing and grinding process may be done by either the wet or the dry method. In the wet process, the materials are mixed with water to form "slurry", which is heated in kilns, forming a hard substance called "clinker". In the more fuel-efficient dry process, the addition of water and the formation of slurry are eliminated, and clinker is formed by heating the dry raw materials. In the preheater process, which provides further fuel efficiencies, the dry raw materials are preheated by air exiting the kiln, and part of the chemical reaction takes place prior to entry of the materials into the kiln. In the pre-calciner process, an extension of the preheater process, heat is applied to the raw materials, increasing the proportion of the chemical reaction taking place prior to the kiln and, as a result, increasing clinker production capacity. After the addition of gypsum, the clinker is ground into an extremely fine powder called cement. In this form, cement is the binding agent which, when mixed with sand, stone or other aggregates and water, produces either concrete or mortar. I-6 The raw materials required to manufacture cement are obtained principally from operations which are owned by the Registrant or in which it has long-term quarrying rights. These sources are located close to the manufacturing plants except for the Joppa and Richmond quarries which are located approximately 70 and 80 miles, respectively, from the plant site. Each cement manufacturing plant except New Braunfels is equipped with rock crushing equipment. At New Braunfels and Richmond, the Registrant owns the reserves, but does not currently quarry them. The Registrant purchases limestone for Richmond from a local source and for New Braunfels from Parker Lafarge, Inc. an affiliate of the Registrant. At Whitehall, Joppa and Kamloops the Registrant sub-contracts the quarry operations. Fuel represents a significant portion of the cost of manufacturing cement. The Registrant has placed special emphasis on becoming, and has become, more efficient in its sourcing and use of fuel. Dry process plants generally consume significantly less fuel per ton of output than do wet process plants. At year-end approximately 79 percent and 89 percent of the Registrant's clinker production capacity in Canada and the United States, respectively, used the dry process. As an additional means of reducing energy costs, most plants are now equipped to convert from one form of fuel to another with very little interruption in production, thus avoiding dependence on a single fuel and permitting the Registrant to take advantage of price variations between fuels. The use of waste-derived fuels supplied by Systech has also resulted in substantial fuel cost savings to the Registrant. At December 31, 1993, the Registrant used industrial waste materials obtained and processed by Systech as fuel at three of the Registrant's United States cement plants. Waste-derived fuels supplied by Systech constituted approximately 10 percent of the fuel used by the Registrant in all of its cement operations during 1993. In August 1991, the Registrant's U.S. cement plants which utilize hazardous waste-derived fuels became subject to a substantial new federal permit program known as the Resource Conservation and Recovery Act ("RCRA") boiler and industrial furnaces (BIF) regulations. In August 1992, these plants submitted certifications of compliance for the emission limits established under these regulations. In Canada, the St. Constant and Brookfield plants have submitted permit applications to use hazardous waste as supplemental fuel. These applications are in the public review phase. The following table shows the possible alternative fuel sources of the Registrant's cement manufacturing plants in the United States and Canada at December 31, 1993. I-7 Marketing Cement is sold by the Registrant primarily to manufacturers of ready-mixed concrete and other concrete products and to contractors throughout Canada and in many areas of the United States. The states in which the Registrant had the most significant U.S. sales in 1993 were Texas and Wisconsin. Other states in which the Registrant had significant sales include Florida, Illinois, Indiana, Iowa, Kansas, Louisiana, Massachusetts, Michigan, Minnesota, Missouri, New Jersey, New York, North Dakota, Ohio, Pennsylvania, Tennessee and Washington. The provinces in Canada in which the Registrant had the most significant sales of cement products were Ontario and Quebec, which together accounted for approximately 44 percent of the Registrant's total Canadian cement shipments in 1993. Approximately 35 percent of the Registrant's cement shipments in Canada were made to affiliates. The Registrant sells cement to several thousand unaffiliated customers. No single unaffiliated customer accounted for more than 10 percent of the Registrant's cement sales during 1993, 1992 or 1991. Sales are made on the basis of competitive prices in each market area, generally pursuant to telephone orders from customers who purchase quantities sufficient for their immediate requirements. The amount of backlog orders, as measured by written contracts, is normally not significant. At December 31, 1993 sales offices in the United States were located in or near New Orleans, Louisiana; Buffalo, New York; Dallas, Texas; Tampa, Florida; Fort Wayne, Indiana; Whitehall, Pittsburgh and Hamburg, I-8 Pennsylvania; East Cambridge, Massachusetts; Chicago, Illinois; Cleveland, Ohio; Lansing, Michigan; Milwaukee, Wisconsin; Seattle and Spokane, Washington; Minneapolis, Minnesota; Kansas City , Missouri; Davenport, Iowa; Valley City and Grand Forks, North Dakota and Nashville, Tennessee. At December 31, 1993 sales offices in Canada were located in Dartmouth, Nova Scotia; Moncton, New Brunswick; Quebec City and Montreal, Quebec; Toronto, Ontario; Winnipeg, Manitoba; Regina and Saskatoon, Saskatchewan; Calgary and Edmonton, Alberta; and Kamloops and Vancouver, British Columbia. Distribution and storage facilities are maintained at all cement manufacturing and finishing plants and at approximately 100 other locations including five deep water ocean terminals. These facilities are strategically located to extend the marketing areas of each plant. Because of freight costs, most cement is sold within a radius of 250 miles from the producing plant, except for waterborne shipments which can be shipped economically considerably greater distances. Cement is distributed primarily in bulk but also in paper bags. The Registrant utilizes trucks, rail cars and waterborne vessels to transport cement from its plants to distribution points or directly to customers. Transportation equipment is owned, leased or contracted for as required. In addition, some customers in the United States make their own transportation arrangements and take delivery of cement at the manufacturing plant or distribution point. Construction Materials Product Line The Registrant is engaged in the production and sale of ready-mixed concrete, aggregates, asphalt, precast and prestressed concrete, concrete block, concrete pipe and other related products. The Registrant is also engaged in highway and municipal paving and road building work. During 1993, 1992 and 1991 no single customer accounted for more than 10 percent of the Registrant's construction materials sales. LCI is the only producer of ready-mixed concrete and construction aggregates in Canada that has operations extending from coast to coast. Ready-mixed concrete plants mix controlled portions of cement, water and aggregates to form concrete which is sold primarily to building contractors and delivered to construction sites by mixer trucks. In addition, management believes that LCI is one of the largest manufacturers of precast concrete products and concrete pipe in Canada. These products are sold primarily to contractors engaged in all phases of construction activity. The Registrant owns substantially all of its ready-mixed concrete, concrete products and aggregates plants and believes that all such plants are in satisfactory operating condition. I-9 The Registrant owned or had a majority interest in 311 construction materials facilities in Canada at December 31, 1993. Of these, 118 are ready-mixed concrete plants concentrated in the Provinces of Ontario (where approximately one-half of the plants are located), Alberta, Quebec and British Columbia. The Registrant also owns ready-mixed concrete plants in New Brunswick, Nova Scotia, Saskatchewan and Manitoba. The Registrant owns 112 construction aggregates facilities in Canada, more than half of which are located in Ontario. The other aggregates facilities are located in Alberta, Saskatchewan, British Columbia, Quebec, Manitoba, New Brunswick and Nova Scotia. The Registrant's 29 Canadian asphalt facilities are also concentrated primarily in Ontario with the remaining plants in Alberta, Nova Scotia, New Brunswick and Quebec. The Registrant owns a total of 52 precast and prestressed concrete, concrete block and concrete pipe plants and miscellaneous other construction materials operations in Ontario (where approximately one-half of the plants are located), Alberta, British Columbia, Manitoba, Quebec and New Brunswick. In the U.S., the Registrant owned or had a majority interest in 117 construction materials facilities at year end. Of these, 54 are ready- mixed concrete plants concentrated in Texas, Missouri, and to a lesser extent, Louisiana, Ohio and Kansas. Of the Registrant's 44 U.S. construction aggregates facilities, 12 were in Ohio, 14 in Texas, five in Pennsylvania, with the remainder located in West Virginia, New York, Louisiana, Michigan, Missouri, and Washington. Two of the Registrant's six U.S. asphalt plants were located in New York and four in Texas. The Registrant owned a total of 13 concrete paving stone, road paving, soil cement, concrete paving and miscellaneous other construction materials operations located in Ohio, Michigan, Texas, Pennsylvania, Missouri and New York. In addition, the Registrant has minority interests in a number of smaller companies primarily engaged in the manufacture and sale of ready- mixed concrete, other concrete products and aggregates in Canada and the U.S. Systech Environmental Corporation provides waste-derived fuels and alternative raw materials for use in cement kilns. Using a technology called co-processing, Systech is able to use high BTU value waste as a fuel substitute for coal, natural gas and petroleum coke in heating the cement kiln. Co-processing preserves natural resources and serves as a safe and efficient method to manage selected waste. In addition, co- processing makes the product more competitive by reducing fuel cost, which represents about 15 percent of the expense of cement manufacturing. Research, Development and Engineering The Registrant is involved in research and development work through its own technical services and laboratories and through its participation in the Portland Cement Association. In addition, Lafarge Coppee, LCI I-10 and the Registrant are parties to agreements relating to the exchange of technical and management expertise under which the Registrant has access to the research and development resources of Lafarge Coppee. Research is directed toward improvement of existing technology in the manufacturing of cement, concrete and related products as well as the development of new manufacturing techniques and products. Systech is also engaged in research and development in an effort to further develop the technology to handle additional waste materials. Research and development costs, which are charged to expense as incurred, were $7.3 million, $8.1 million and $7.5 million for 1993, 1992 and 1991, respectively. This includes amounts accrued for technical services rendered by Lafarge Coppee to the Registrant, under the terms of the agreements discussed above of $4.8 million during 1993, $5.3 million during 1992 and $5.4 million during 1991. Capital Expenditures and Asset Dispositions The Registrant's business is relatively capital-intensive. During the three-year period ended December 31, 1993 the Registrant invested approximately $209 million in capital expenditures, principally for the modernization or replacement of existing equipment. Of this amount, approximately 42 percent related to cement operations and 58 percent to construction materials operations. During the same period, the Registrant also invested approximately $31 million in various acquisitions that expanded its market and product lines which primarily related to the Registrant's construction materials operations. For a discussion on the sale of the Demopolis cement operations see "General Development of Business - Sale of Demopolis Cement Operations". Cement terminal facilities in St. Louis, Missouri and Houston, Texas were shutdown in February 1993. The Registrant intends to sell the land on which these terminals and related assets are located. In September 1992, the Registrant sold the assets of Conchem, a chemical admixtures business located in the United States and Canada. The divestiture included seven facilities engaged in the production and sale of admixture and specialty products for the concrete and construction industry throughout North America. The U.S. assets had been acquired as part of the Missouri Portland/Davenport acquisition in January 1991 (see "General Development of Business"). During 1993, 1992 and 1991 the Registrant disposed of various surplus properties; however, there were no other material divestments of property, plant and equipment during these three years. In December 1993 the Registrant's Construction Materials operations purchased a plant from Koch Industries, Inc. for grinding iron blast furnace slag into slag cement at Spragge, Ontario. In April 1993 the Registrant entered into a joint venture, Richvale-York Block Inc. with another block producer to carry on its concrete block business in the Greater Metropolitan Toronto area. The Registrant is the majority I-11 shareholder in this joint venture which owns two modern block plants that are strategically located in this market. Environmental Matters The Registrant's operations, like those of other companies engaged in similar businesses, involve the use, release/discharge, disposal and clean-up of substances regulated under increasingly stringent federal, state, provincial and/or local environmental protection laws. The major environmental statutes and regulations affecting the Registrant's business and the status of certain environmental enforcement matters involving the Registrant are discussed in Item 7 of this Annual Report in the "Environmental Matters" section of Management's Discussion and Analysis beginning on page II-15. Additionally, certain enforcement matters are described in Item 3 (Legal Proceedings) of this Annual Report. Employees As of December 31, 1993, the Registrant and its subsidiaries employed approximately 7,400 individuals of which 4,640 were hourly rated wage workers. Approximately 1,530 of these hourly employees were engaged in the production of portland cement products and approximately 3,110 were employed in the Registrant's construction materials operations. Salaried employees totalled approximately 2,750. These employees generally perform work in administrative, managerial, marketing, professional and technical endeavors. Overall, the Registrant considers its relations with employees to be satisfactory. - - - U.S. CEMENT OPERATIONS The majority of the Registrant's approximately 2,200 U.S. hourly employees are represented by labor unions. During 1993, labor agreements were renegotiated at the Buffalo, Iowa and Fredonia, Kansas cement plants (including distribution terminals in Fort Worth, Texas and Westlake, Louisiana). Five other terminal labor agreements expired and new agreements were reached during 1993: Waukegan, Illinois; Duluth, Minnesota; Superior, Wisconsin; Toledo; Ohio and Oswego, New York. Four cement plant labor agreements will expire in 1994: Whitehall, Pennsylvania; Sugar Creek, Kansas; Paulding, Ohio; and Balcones, Texas. The labor agreement for Whitehall was renewed for a period of 46 months in early 1994. Effective February 1, 1993, the Registrant completed the sale of its Demopolis, Alabama cement plant and surrounding sales and distribution operations (see "General Development of Business - Sale of Demopolis Cement Operations" above). In addition, terminal facilities in St. Louis, Missouri and Houston, Texas were shut down in February. The Registrant intends to sell the land on which these terminals and related assets are located. In late 1993, it was announced that in connection with the restructuring of the Registrant's North American business units (see "General Development of Business - Restructuring" above), the administrative operations of the Southern Region office in I-12 Dallas would be consolidated into one U.S. region based in Southfield, Michigan. This transition is expected to be completed by June 1994. - - - U.S. CONSTRUCTION MATERIALS OPERATIONS The Registrant's approximately 1,715 U.S. construction materials employees consist of approximately 1,200 hourly employees and 515 salaried employees. In 1993, divestiture of aggregate and construction operations in southern Ohio, northern Kentucky and central Illinois resulted in a reduction of 119 employees (96 hourly and 23 salaried). In the Registrant's Sullivan Lafarge operations in New York, the closure of six plants resulted in the severance of 110 hourly employees. In the Registrant's Standard Lafarge division, a labor agreement covering six plants was negotiated in 1993, and four single site labor agreements covering a total of approximately 105 employees will expire in 1994. Although a work stoppage is possible at one of these sites, it is expected that operations will continue without interruption. At the Registrant's Kurtz Lafarge division, the labor agreement for ready-mixed concrete truck drivers expired in May 1993 for the plants located west of the Missouri River. Negotiations were unsuccessful and 35 drivers went on strike July 15, 1993 and remain on strike. Replacement drivers have been hired and the affected plants are now operating. The labor agreement for the drivers on the east side of the Missouri River expired on March 15, 1994 and negotiations for a new contract have begun. A work stoppage could occur but is not expected. The Kurtz Lafarge operations which are based in Sedalia, Missouri negotiated a new labor agreement in 1993. Labor agreements relating to operations based in Waynesville and Kansas City, Missouri will expire in 1994. - - - CANADIAN CEMENT OPERATIONS Substantially all of the approximately 540 Canadian cement hourly employees are covered by labor agreements. The Kamloops, British Columbia plant's labor agreement was renewed in 1993 for a period of two years. On January 7, 1994 a lock-out was initiated by the Registrant for its 112 hourly employees at the Exshaw, Alberta plant and it remains in effect as of the date of this Report. The plant has continued to operate without interruption, and this situation will not have a material effect on the Registrant's financial condition or results of operations in 1994. The Bath, Ontario plant's labor agreement expired at the end of 1993 and was renewed for 23 months. Labor agreements for the Woodstock, Ontario plant and the St. Constant, Quebec plant will expire in 1994 and are expected to be renegotiated without any work stoppage. Also, several terminal labor agreements will expire in 1994. I-13 - - - CANADIAN CONSTRUCTION MATERIALS OPERATIONS Employees working in the Canadian construction materials operations totalled approximately 2,825 at the end of 1993 with approximately 1,915 hourly employees and 910 salaried employees. In western Canada, twelve labor agreements were renegotiated in 1993, and it is anticipated that 24 labor agreements will be renegotiated during 1994. In eastern Canada, sixteen labor agreements were renegotiated. Competition The competitive marketing radius of a typical cement plant for common types of cement is approximately 250 miles except for waterborne shipments which can be economically transported considerably greater distances. Cement, concrete products and aggregates and construction services are sold in competitive markets. These products and services are obtainable from alternate suppliers. Vigorous price, service and quality competition is encountered in each of the Registrant's primary marketing areas. The Registrant's operating cement plants located in Canada represented an estimated 31 percent of the rated annual active clinker production capacity of all Canadian cement plants at December 31, 1992. The Registrant is the only cement producer serving all regions of Canada. The Registrant's largest competitor in Canada accounted for approximately 23 percent of rated annual active clinker production capacity. The Registrant's operating cement plants located in the United States at December 31, 1992 represented an estimated nine percent of the rated annual active clinker production capacity of all U.S. cement plants. The Registrant's three largest competitors in the United States accounted for 14, seven and five percent, respectively, of the rated annual active clinker production capacity. The preceding statements regarding the Registrant's ranking and competitive position in the cement industry are based on the U.S. and Canadian Portland Cement Industry: "Plant Information Summary Report" dated December 31, 1992. The Registrant also encounters competition from foreign cement producers, especially in its markets in the southern coastal portion of the United States. (D) FINANCIAL INFORMATION ABOUT FOREIGN AND DOMESTIC OPERATIONS AND EXPORT SALES The information with respect to foreign and domestic operations and export sales is set forth on pages II-45 and II-46 of Item 8 - Financial Statements and Supplementary Data of this annual report and is incorporated herein by reference. I-14 EXECUTIVE OFFICERS OF THE REGISTRANT The following tabulation sets forth as of March 25, 1994 the name and age of each of the executive officers of the Registrant and indicates all positions and offices with the Registrant held by them at said date. I-15 Bertrand P. Collomb was appointed to his current position in January 1989. He has also served as Chairman of the Board and Chief Executive Officer of Lafarge Coppee since August 1, 1989. From January 1, 1989 to August 1, 1989 he was Vice Chairman of the Board and Chief Operating Officer of Lafarge Coppee, and from 1987 until January 1, 1989 he was Senior Executive Vice President of Lafarge Coppee. He served as Vice Chairman of the Board and Chief Executive Officer of the Registrant from February 1987 to January 1989. Michel Rose was appointed to his current position in September 1992. He previously served as President and Chief Executive Officer of Orsan, a Lafarge Coppee subsidiary, from 1987 until September 1992. Since 1989 he has served as Senior Executive Vice President of the Lafarge Coppee Group. John M. Piecuch was appointed to his current position in July 1992. Prior to that, he served as Executive Vice President and President of the Registrant's Cement Group. He served as Senior Vice President and President of the Registrant's Great Lakes Region from January 1987 to January 1989. R. Gary Gentles was appointed to his current position in November 1992. He served as President of Lafarge Coppee's European plaster operations from 1990 to 1992 and was President of the Registrant's Northeast Cement Region from 1987 to 1990. Jean-Pierre Cloiseau was appointed to his current position in January 1994. He previously served as Senior Vice President and Chief Financial Officer of the Registrant from September 1990 to December 1993. Prior to that, he served as Vice President and Controller of the Registrant from January 1989 to September 1990. He had served as Vice President and Treasurer of the Registrant from May 1985 to January 1989. Peter H. Cooke was appointed to his current position in July 1990. Prior to that, he served as Vice President of Operations of the Registrant's Great Lakes Region from April 1987 to June 1990. H. L. Youngblood was appointed to his current position in January 1989. He served as Vice President - Distribution of the Registrant's Great Lakes Region from May 1987 to January 1989. Duncan Gage was appointed to his current position in January 1994. He previously served as Senior Vice President and President of the Registrant's Southern Region from May 1992 to December 1993. He served as President of Parker Lafarge, a construction materials affiliate of the Registrant, from 1990 to 1992 and President of Francon Lafarge, another construction materials affiliate of the Registrant, from 1987 to 1990. I-16 Edward T. Balfe was appointed to his current position in January 1994. Prior to that he served as President of the Registrant's Construction Materials Eastern Group and President and General Manager of Permanent Lafarge, a construction materials affiliate of the Registrant, from 1990 to 1993. He had served as President and General Manager of Permanent Lafarge from 1986 - 1990. Patrick Demars was appointed to his current position effective February 1991. He previously served as Vice President - Products and Process of the Registrant's Corporate Technical Services operations from July 1990 to January 1991. He was a Regional Vice President at CNCP, a Brazilian subsidiary of Lafarge Coppee, from July 1986 to June 1990. Thomas W. Tatum was appointed to his current position in April 1987. John C. Porter was appointed to his current position in September 1990. He served as Vice President and Controller of the Registrant's Great Lakes Region from April 1989 until September 1990 and was Assistant Controller of that Region from August 1987 until March 1989. Philip A. Millington was appointed to his current position in January 1989. He served as Assistant Treasurer of the Registrant from October 1987 to January 1989 and as Controller of the Registrant from 1983 to 1987. David C. Jones was appointed to his current position in February 1990. He served as Corporate Secretary of the Registrant from November 1987 to February 1990. David W. Carroll was appointed to his current position in February 1992. He served as Director Environmental Affairs of the Registrant from February 1990 to February 1992. Prior to that he was Director Environmental Programs for the Chemical Manufacturers Association from 1978 to 1990. There is no family relationship between any of the executive officers of the Registrant or its subsidiaries. None was selected as an officer pursuant to any arrangement or understanding between him and any other person. The term of office for each executive officer of the Registrant expires on the date of the next annual meeting of the Board of Directors, scheduled to be held on May 3, 1994. I-17 Item 2.		Item 2. PROPERTIES Information set forth in Item 1 of this Annual Report, insofar as it relates to the location and general character of the principal plants, mineral reserves and other significant physical properties owned in fee or leased by the Registrant, is incorporated herein by reference in answer to this Item 2. All of the Registrant's cement plant sites (active and closed) and quarries (active and closed), as well as terminals, grinding plants and miscellaneous properties, are owned by the Registrant free of major encumbrances, except the Exshaw and Brookfield plants and the Kamloops limestone and cinerite quarries. Title to the Brookfield plant site is held by Industrial Estates Limited, a Crown corporation of the Province of Nova Scotia, in connection with assistance provided by the Province in financing the cost of construction of the plant. The site is leased by LCI at rentals sufficient to repay principal and interest on the loan. The lease, which expires in 1998, grants LCI an option to acquire title to the plant site during the term of the lease upon payment of the unpaid principal amount. During 1993, LCI exercised its option to acquire title to the Brookfield plant by paying the unpaid principal. Title to the property is in the process of being transferred to the Registrant. The Exshaw plant is built on land leased from the Province of Alberta. The original lease has been renewed for a 42-year term commencing in 1992. Annual payments under the lease are presently based on a fixed fee per acre. The Kamloops plant, as well as the gypsum quarry which serves this plant, is on land owned by the Registrant. The limestone and cinerite quarries are on land leased from the province of British Columbia until March 2022. Limestone quarry sites for the cement manufacturing plants in the United States are owned and are conveniently located near each plant except for the Joppa plant quarry which is located approximately 70 miles from the plant site. At December 31, 1993, the Registrant also owned substantial reserves which previously supplied raw materials to former cement production facilities which are located at Miami, Tampa, Fort Worth and Dallas. The Fort Worth plant facility is now a cement terminal. The Tampa plant is now operated as a cement grinding and distribution facility. LCI's quarrying rights for limestone in the Canadian provinces of Manitoba, New Brunswick, Quebec, Nova Scotia, Ontario, Alberta and British Columbia, are held under quarry leases, some of which require annual royalty payments to the provincial authorities. Management of the Registrant estimates that its limestone reserves for the cement plants currently producing clinker will be adequate to permit production at present capacities for at least 20 years. Other raw materials, such as clay, shale, sandstone and gypsum, are either obtained from reserves I-18 owned by the Registrant or are purchased from suppliers and are readily available. Deposits of raw materials for the Registrant's aggregate producing plants are located on or near the plant sites. These deposits, due to their varying nature, are either owned by the Registrant or leased upon terms which permit orderly mining of reserves. I-19 Item 3.	Item 3. LEGAL PROCEEDINGS During 1989 and 1990, CSX Transportation, Inc., Metro-North Commuter Railroad Company, National Railroad Passenger Corp., Peerless Insurance Company and Massachusetts Bay Transit Authority (the "Railroads") filed actions against Lone Star Industries Inc. and affiliates ("Lone Star") for damages resulting from its fabrication and sale of allegedly defective concrete railroad ties to the Railroads. The Registrant and LCI have been named in third party actions in which Lone Star is claiming indemnity for liability to the Railroads, for damages to its business and for costs and losses suffered as a result of the Registrant and LCI supplying allegedly defective cement used by Lone Star in the fabrication of the railroad ties. The damages claimed total approximately $226.5 million. The Registrant denied the allegations and vigorously defended against the lawsuits (the "Lone Star Case"). During September and October 1992, Lone Star entered into agreements with all five plaintiff Railroads settling their claims regarding the Lone Star Case for an amount totalling approximately $66.7 million. These settlements have been submitted to and approved by the United States Bankruptcy Court for the Southern District of New York which is handling the Lone Star bankruptcy. Lone Star commenced trial in November 1992 in its third party complaint against the Registrant and LCI seeking indemnity for the Railroads' claims in addition to its own claim for business destruction. A jury verdict in this case reached in December 1992 awarded Lone Star $1.2 million as damages. Both Lone Star and the Registrant and LCI have appealed the trial court verdict to the United States Court of Appeals for Fourth Circuit. A decision is expected in the near future. In late 1990 Nationwide Mutual Insurance Company ("Nationwide"), one of the Registrant's primary insurers during the period when allegedly defective cement was supplied to Lone Star by the Registrant, filed a complaint for declaratory judgement against the Registrant, several of its affiliates and eleven other liability insurers of the Registrant (the "Coverage Suit"). The complaint seeks a determination of all insurance coverage issues impacting the Registrant in the Lone Star Case. The Registrant has answered the complaint, counterclaimed against Nationwide, cross-claimed against the co-defendant insurers and filed a third party complaint against 36 additional insurers. In December 1991, the Registrant and Nationwide entered into a settlement agreement pursuant to which Nationwide settled its claim in the Coverage Suit and, among other things, paid the Registrant a portion of past due defense expenses in the Lone Star Case, promised to pay its proportion of continuing defense expenses therein and to post the entire remaining aggregate limits of its policies as reserves to be used in the Lone Star Case, if necessary. Virtually all of LCI's Canadian insurers involved in the Coverage Suit filed motions for summary judgment. In January 1993, the court denied all of the insurers' summary judgment motions. In January 1994 the Registrant filed motions for partial summary judgment regarding the insurers' defense obligations and regarding the reasonableness of fees and expenses included in the defense of the Lone Star Case. In addition, the Registrant filed a motion to strike the designation of several expert witnesses of the insurers. The Registrant I-20 believes that it has substantial insurance coverage that will respond to a large portion of defense expenses and liability, if any, in the Lone Star Case. During 1992, a number of owners of buildings located in Eastern Ontario, Canada most of whom are residential homeowners, filed actions in the Ontario Court (General Division) against Bertrand & Frere Construction Company Limited and a number of other defendants seeking damages as a result of allegedly defective footings, foundations and floors made with ready-mixed concrete supplied by Bertrand. The largest of these cases involves claims by approximately 99 plaintiffs owning 53 homes, a 20-unit condominium building and a municipal building. Together, these plaintiffs are claiming approximately Cdn. $40 million against Bertrand, each plaintiff seeking Cdn. $200,000 for costs of repairs and loss of capital value of their respective home or building, Cdn. $200,000 for punitive and exemplary damages and Cdn. $20,000 for hardship, inconvenience and mental distress, together with interest and costs. Other owners, owning a total of 13 buildings (of which 11 are residential homes), have instituted similar suits against Bertrand and, based on the information available at this time, these claims total approximately Cdn. $9 million. As of the end of December 1993, LCI has been served with third- or fourth-party claims by Bertrand in all but one of the referenced lawsuits. Bertrand is seeking indemnity for its liability to the owners as a result of the supply by LCI of allegedly defective flyash. LCI also supplied cement to Bertrand. It is expected that Bertrand will file a third-party claim against LCI in the other case as well. LCI has delivered its statements of defense. The discoveries are to begin in February 1994. LCI has denied liability and will defend the lawsuits vigorously. The Registrant believes it has substantial insurance coverage that will respond to defense expenses and liability, if any, in the said lawsuits. The Registrant has received a notice of violation and/or a complaint with respect to each of its three cement plants that use hazardous waste derived fuel alleging violations of the Boiler and Industrial Furnaces ("BIF") regulations of the federal Resources Conservation and Recovery Act ("RCRA"). These notices of violation and complaints were issued by the U.S. Environmental Protection Agency ("EPA") with respect to the plants, located in Fredonia, Kansas and Paulding, Ohio and by the State of Michigan, which has been delegated BIF enforcement authority by the EPA, with respect to the plant located in Alpena, Michigan. Although the details of each notice of violation or complaint are specific to the particular plant, the major recurring issue has been the existence or adequacy of the plant's waste analysis plan to ensure compliance with the established allowable emission limits and feed rates. The State of Michigan has proposed a penalty of $979,750 for the Alpena plant and the EPA has proposed penalties of $619,800 for the Paulding plant and $1,200,474 for the Fredonia plant. The Registrant has submitted a response to each notice of violation and complaint setting forth certain defenses and factual information and has had meetings with the EPA and Michigan state officials to discuss the alleged violations and possibilities of settlement. At this time, it is unknown whether the Registrant will be able to settle any or all of these matters or whether I-21 one or more adjudicatory proceedings will result. With respect to a similar EPA complaint regarding the Registrant's Demopolis, Alabama plant (which was sold by the Registrant in early 1993), the Registrant settled the matter in September 1993 by paying a civil penalty of $594,000, approximately one-third of the penalty originally proposed by the EPA. In 1993, the State of Michigan alleged that the Registrant's Alpena plant was managing CKD in violation of applicable state solid waste management requirements. The Registrant has formally responded to the State setting forth defenses and factual information and has had numerous meetings with State officials to discuss the matters raised, the possible technical solutions and the possibilities of settlement. Although significant progress has been made towards potential settlement, it is unknown at this time whether the Registrant will be able to settle this matter by agreeing to make certain operational changes at the plant and/or by paying a penalty amount, or whether an adjudicatory proceeding will result. In another matter relating to the Alpena plant and CKD, the State of Michigan has contacted the Registrant and the former owner of the plant seeking remediation of an old CKD pile from which there is runoff of hazardous substances into Lake Huron. The Registrant has advised the State that it is not responsible for remediating this property because the property was expressly excluded in the purchase agreement pursuant to which the Registrant acquired the plant. The Registrant has advised the former plant owner of the Registrant's position on this matter. In July 1993, the Registrant received a complaint from the EPA alleging certain RCRA violations at its cement plant in Buffalo, Iowa. The alleged violations related to the storage of leaded grease hazardous waste at the plant, and the EPA proposed a penalty of $284,020. The Registrant has reached an agreement in principle with the EPA to settle this matter by paying a penalty of approximately $40,000. On or about March 2, 1994 the Registrant was served with a civil investigative demand by the U.S. Department of Justice, Antitrust Division, requesting the production of documents and responses to interrogatories in connection with an investigation of potential price fixing and market allocation by cement producers. The Registrant is presently engaged in preparing its responses to the inquiry. The Registrant is involved in certain other legal actions and claims. It is the opinion of management that all such legal matters will be resolved without material effect on the Registrant's Consolidated Financial Statements. I-22 Item 4.	Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. None during the fourth quarter ended December 31, 1993. I-23 PART II Item 5.	Item 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. Information required in response to Item 5 is reported in Item 7, pages II-24 and II-25 of this Annual Report and is incorporated herein by reference. On March 9, 1994, 58,406,650 Common Shares were outstanding and held by approximately 2,970 record holders. In addition, on March 9, 1994, 9,104,150 exchangeable preference shares of LCI, which are exchangeable at the option of the holder into Common Shares on a one-for-one basis and have rights and privileges that parallel those of the Common Shares, were outstanding and held by 7,040 record holders. The Registrant may obtain funds required for dividend payments, expenses and interest payments on its debt from its operations in the U.S., dividends from its subsidiaries or from external sources, including bank or other borrowings. LCI's loan and credit agreements do not contain restrictions on the payment of dividends but do contain maximum borrowing restrictions. II - 1 Item 6.	Item 6. SELECTED FINANCIAL DATA The table below summarizes selected financial information for the Registrant. For further information, refer to the Registrant's consolidated financial statements and notes thereto presented under Item 8 of this Annual Report. (a) Before cumulative effect of change in accounting principles. II - 2 Item 7.	Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis should be read in conjunction with the consolidated financial statements and notes thereto: MANAGEMENT'S DISCUSSION OF INCOME The Consolidated Statements of Income (Item 8, page II-28) summarize the Registrant's operating performance for the past three years. To facilitate analysis, sales and operating profit will be discussed by product line and are summarized in the table on page II-4 (in millions). The Registrant's two product lines are: 1. Cement-the production and distribution of portland and specialty cements and cementitious materials. 2. Construction materials-the production and distribution of ready-mixed concrete, construction aggregates, other concrete products, asphalt, road construction and the conversion of industrial waste into fuels for use in cement kilns. II - 3 II - 4 YEAR ENDED DECEMBER 31, 1993 Net Sales The Registrant's net sales were $1,494.5 million, down slightly from $1,511.2 million in 1992. The decrease was due to a drop in the value of the Canadian dollar relative to the U.S. dollar and sales lost from divested operations including the Registrant's cement plant in Demopolis, Alabama. Partially offsetting these declines were a four percent increase in average cement net sales prices and higher sales volumes from both cement and construction materials operations. Canadian net sales were $640.5 million, a decline of four percent from last year while U.S. net sales increased one and one-half percent to $854.0 million. The Registrant's net sales from cement operations increased one percent in 1993. Cement average net sales prices improved four percent over 1992 due to a six percent increase in the U.S. Canadian net sales decreased four percent due to the impact of exchange rates. In the U.S., net sales increased three percent. Prices increased an average of six percent in the Great Lakes U.S. market and seven percent in the southern U.S. The Canadian average net sales price remained stable with lower prices in Ontario offset by higher prices in the west. Cement shipments (after adjusting for sales from the Demopolis, Alabama plant, which was divested in February 1993) increased four percent in 1993 to 12.3 million tons from 11.8 million tons in 1992. Demand was strongest in U.S. markets and in western Canada. U.S. and Canadian shipments increased four percent and two percent, respectively. Spot shortages occurred during 1993 in the southern Great Lakes and Mississippi River markets as the continued improvement in the U.S. construction market increased the demand for cement. Additionally, construction activity in the Midwest increased after the flood waters receded. Shipments in the Pennsylvania and New England markets increased over 1992 and prices improved three percent from 1992's depressed levels. The Florida market performed well in 1993, with sales volumes up 14 percent from the previous year. Oilwell cement sales in the western provinces of Canada nearly doubled in 1993 as an increase in natural gas prices and changes to the royalty system resulted in an increase in drilling activity. Additionally, cement shipments in British Columbia increased nine percent over 1992. In 1993, market conditions in eastern Canada were adversely impacted by excess cement capacity. However, the Registrant used surplus capacity in Ontario to supplement U.S. facilities that were facing inventory shortages. The Registrant's two cement plants in Ontario increased production and lowered unit costs although cement demand dropped two percent in the province. Shipments in the Quebec and Atlantic provinces of Canada were flat in 1993. II - 5 Net sales from the Registrant's construction materials and waste management operations were $802.2 million, down three percent from 1992. The drop in the value of the Canadian dollar, sales lost from divested operations in 1992, the sluggish economy in Canada and flooding in the midwest U.S. were the major causes of this decline. In Canada, net sales dropped five percent primarily due to the decline in the value of the Canadian dollar and the divestment of the Registrant's chemical admixtures operations in 1992. Net sales in the U.S. declined slightly as a result of the weak performance in the Registrant's northern markets, flooding in the midwest and the divestment of several construction materials businesses. These declines were nearly offset by strong performance in the Registrant's southern U.S. markets. Registrant-wide, ready-mixed concrete shipments of 6.1 million cubic yards were one percent higher than a year ago. Aggregate sales of 48.1 million tons were four percent higher than the previous year. In Canada, ready-mixed concrete shipments increased two percent due to an increase in construction activity in British Columbia and Quebec while infrastructure work in eastern Canada boosted aggregate volumes by eight percent. In the U.S., ready-mixed concrete and aggregate volumes declined slightly due to the floods and a drivers strike in St. Louis coupled with the 1992 sale of several construction materials businesses. Gross Profit and Cost of Goods Sold The Registrant's gross profit as a percentage of net sales improved from 15 percent in 1992 to 17 percent in 1993. Cement gross profit was 20 percent compared to 17 percent in 1992 as a result of improved prices. Over the two year period, construction materials gross profit was approximately 11 percent. The Registrant's cement cost per ton is heavily influenced by plant capacity utilization. The following table summarizes the Registrant's cement production (in millions of tons) and the utilization rate of clinker production capacity. The 1993 figures exclude the Demopolis, Alabama plant which was divested in February 1993. Cement production and clinker capacity utilization in 1993 were down somewhat from a year ago. In the U.S., cement production totalled 7.2 million tons, an 11 percent decrease from 1992. Capacity utilization at U.S. plants was 90 percent in 1993 compared to 95 percent in 1992. The decrease in production and utilization was due to operating problems at three of the Registrant's cement plants. Canadian cement production II - 6 was 4.1 million tons in 1993, an increase of 11 percent from 3.7 million tons in 1992. Capacity utilization was 72 percent and 66 percent in 1993 and 1992. The increase in production and utilization was primarily due to higher sales volumes and the use of surplus capacity in the Registrant's Ontario plants to supplement U.S. markets that were experiencing cement shortages. Selling and Administrative Selling and administrative expenses were $161.4 million in 1993, $23.3 million (13 percent) lower than 1992. This reduction resulted primarily from divestments and actions taken to streamline operations and reduce costs in the Registrant's cement and construction materials operations over the last two years. Selling and administrative expenses as a percentage of net sales declined to 10.8 percent in 1993 from 12.2 percent in 1992. Other (Income) Expense, Net Other income and expense consists of items such as net retirement costs, equity income, amortization of intangibles and nonrecurring gains and losses from divestitures. Other income, net was $1.0 million in 1993 compared to expense of $9.1 million in 1992. The change was the result of higher divestment gains from the sale of non-strategic assets and lower amortization coupled with the absence of strike related costs at the Richmond plant. Restructuring In the fourth quarter of 1993, the Registrant recorded a one-time pre-tax restructuring charge of $21.6 million ($16.4 million net of tax benefits) to cover the direct expenses of restructuring the Registrant's North American business units to increase organizational efficiency. The primary components of the restructuring charge are separation benefits for approximately 350 employees ($15.2 million), and employee relocation ($3.3 million). The charge also includes expenses such as office relocation and lease termination. No amounts were paid relative to these items in 1993. The restructuring plan entails the consolidation of 11 regional operating units into six units in the Registrant's two main business lines. This consolidation reduces management layers, eliminates duplicative administrative functions and standardizes procedures and information systems. Manufacturing and distribution facilities will not be materially affected by the restructuring. The Registrant expects the annual expense reductions from the restructuring to be approximately $8 million after-tax in 1994 and increasing to approximately $19 million after-tax once the restructuring is fully implemented. II - 7 Performance by Line of Business In 1993, the Registrant's operating profit from cement operations (before corporate and unallocated expenses) was $96.4 million, $29.8 million better than 1992. All regions reported better results than the prior year. Cement results were much better due to higher prices and stronger shipments, particularly in the second half of 1993. The most notable progress was in the U.S. markets. Prices were up six percent in the U.S. but unchanged in Canada. The Registrant's Canadian operations reported an operating profit of $46.2 million, $5.5 million better than last year. Earnings increased in western Canada due to higher shipments and the absence of costs related to the strike at the Richmond plant that was settled in March 1992. Earnings declined in central Canada due to the continued sluggish market but improved in eastern Canada primarily due to higher intraregional sales to the U.S. New England markets. Earnings from U.S. cement operations were $50.2 million, or $24.3 million better than 1992. Results improved in all U.S. regions, mainly due to the six percent increase in average net selling prices combined with a four percent increase in shipments. The operating profit from the Registrant's construction materials and waste management operations in 1993 (before corporate and unallocated expenses) was $30.6 million, $20.9 million better than 1992. Earnings were boosted by cost reductions and higher ready-mixed concrete and block prices in central Canada, improved ready-mixed concrete and aggregate volumes in eastern Canada, partially offset by lower ready-mixed concrete prices in the western provinces due to competitive pressures in a number of markets. The Canadian operations contributed $20.3 million, $14.7 million higher than the prior year. Most of the increase was attributable to the Registrant's Ontario-based concrete products operations. The U.S. operating profit totalled $10.3 million, $6.2 million better than 1992. This improvement was primarily attributable to the Registrant's construction materials operations in the southern U.S. resulting from higher ready-mixed concrete volumes, lower stone costs and a $3.1 million write-down of a quarry last year. Partially offsetting these gains were an earnings decline in the Registrant's northern U.S. markets due to the continued poor economic climate and high operating costs in the midwest markets as a result of the summer floods and a drivers strike. Total Income From Operations Total income from operations was $70.2 million in 1993, an increase of $42.2 million from 1992. The improved performance was due largely to a six percent increase in the U.S. average cement net sales price. Also contributing to the results were an $18.2 million turnaround in profitability of the Registrant's construction materials operations in central and eastern Canada, higher shipments in the western cement region, higher divestment gains from the sale of non-strategic assets and a 13 percent reduction in selling and administrative expenses. These improvements were partially offset by a one-time restructuring II - 8 charge of $21.6 million. The Registrant's operating profit from its Canadian operations was $36.7 million, $3.2 million better than 1992. Operating profit from U.S. operations was $33.5 million, $39.0 million better than 1992. Interest Expense, Net Net interest expense decreased by $6.7 million in 1993 due to lower average debt levels. Income Taxes Income tax expense increased $5.9 million in 1993. U.S. taxes increased $3.0 million primarily due to a $2.6 million increase in deferred income taxes. The Canadian income taxes increased $2.9 million due to higher earnings in Canada. The Canadian effective income tax rates were 46.1 percent in 1993 and 42.7 percent in 1992. Certain elements of the Canadian income tax provision are fixed in amount. The increase in the Canadian effective tax rate in 1993 was caused by the relatively higher percentage of these fixed amounts to the higher earnings experienced in 1993, partially offset by a tax rate reduction enacted during 1993. Net Income In 1993, the Registrant reported net income of $5.9 million. This was $106.5 million better than 1992's net loss of $100.6 million. The 1992 loss included $12.1 million after-tax of employee severance and other nonrecurring charges, while 1993 results included an after-tax charge of $16.4 million related to corporate restructuring recorded in the fourth quarter. The 1992 loss also included $63.5 million in after-tax charges related to the adoption of new accounting rules for postretirement benefits and income taxes. Excluding this one-time charge, net income in 1993 was $43.0 million better than 1992. Excluding one-time charges resulting from the adoption of these new accounting rules, the Registrant's Canadian operations reported net income of $20.5 million, $0.8 million higher than 1992. The increase was due to better results in the Registrant's ready-mixed concrete and aggregate operations in central and eastern Canada, higher shipments in the western cement region and the absence of strike related costs at the Richmond plant. These increases were offset by a four percent decline in net sales and lower divestment gains. After excluding one-time charges resulting from the adoption of new accounting rules, the Registrant's U.S. operations incurred a net loss of $14.6 million. This was $42.2 million better than 1992. The improved U.S. performance was the result of a $4.9 million gain realized from the expropriation of property at one of the Registrant's construction materials operations and an increase in cement volumes and II - 9 prices. In addition, interest expense in the U.S. was $6.2 million lower than the previous year. U.S. results were negatively impacted by infrequently occurring maintenance projects (those required every three years or more) and an earnings decline in the Registrant's northern and midwest construction materials markets. Recent Acquisitions On January 16, 1991, the Registrant acquired Missouri Portland/ Davenport which was engaged in the production and distribution of cement and construction materials. The three cement plants acquired increased the Registrant's annual clinker production capacity by 25 percent and created significant production and distribution synergies with the Registrant's existing operations, especially along the Mississippi River. The acquisition included 30 ready-mix operations, two aggregate quarries as well as the assets of a chemical admixtures business which was divested in 1992. General Outlook The Registrant's general outlook for 1994 in the Cement Group is favorable, particularly in the United States. According to the Dodge/Sweet's Outlook '94, total new construction in the U.S. is projected to increase six percent in real terms in 1994. This would be the third consecutive year of improvement. Cement consumption generally correlates with trends in construction expenditures. In Canada, cement consumption is expected to be boosted by the housing sector and Ottawa's Cdn. $6 billion public works program. Additionally, in early 1994, the Registrant was chosen to supply 160,000 metric tons of silica fume cement over three years starting in 1994 for the construction of the Prince Edward Island eight-mile bridge in Canada's Atlantic provinces. The Portland Cement Association ("PCA") forecasts higher cement consumption in all provinces. The upward trend in prices during 1993 and the higher cement consumption forecasted by the PCA provides some optimism about the 1994 climate for cement prices. Price increases were phased in at various times during 1993; therefore, their full impact will not be realized until 1994. Also, the Registrant has announced increases for the first part of 1994 in most North American markets. The Registrant's expectations for the construction materials group hold promise for 1994. In Canada, the gradual recovery of construction activity should allow room for a modest increase in construction materials volumes, although performance will once again vary by region. In the Maritimes, the Registrant has a contract to furnish approximately 370,000 cubic meters of concrete over a three year period for the bridge to Prince Edward Island. In the U.S., the group's major business line, II - 10 aggregates, is likely to experience a decline in volumes due to recent divestments; however, average margins are expected to improve. The Registrant's U.S. ready-mixed concrete deliveries should improve as the economic recovery continues to gain momentum. II - 11 YEAR ENDED DECEMBER 31, 1992 Net Sales Net sales in 1992 decreased four percent to $1,511.2 million from $1,568.8 million in 1991 due to sluggish construction activity in central and eastern Canada and a drop in the value of the Canadian dollar relative to the U.S. dollar. The Registrant's net sales from cement operations declined two percent in 1992 due mainly to a five percent decline in the average value of the Canadian dollar. The average net sales price declined slightly from 1991 due to lower prices in the U.S. In the Great Lakes and Northeastern Regions, competitive pressures caused prices to fall, offsetting price gains in the west. Cement shipments were up two percent from 1991 due to improvements in the U.S. Great Lakes. In Canada, higher shipments in the west were offset by decreases in eastern and central Canada due to sluggish construction activity. Net sales from the Registrant's construction materials and waste management operations were 12 percent less than 1991 in Canada but nine percent more in the U.S., resulting in an overall decline of five percent. Compared to 1991, ready-mixed concrete and aggregate volumes in Canada were nine and six percent lower due to the continued weakness in the Toronto and Montreal markets. Ready-mixed concrete and aggregate volumes in the U.S. were six percent and 11 percent higher. The U.S. improvement was primarily the result of a greater market penetration in the northern U.S. and an improving market in Texas. Gross Profit and Cost of Goods Sold The Registrant's gross profit as a percentage of net sales was 14.7 percent in 1992, slightly better than 14.3 percent in 1991. Cement gross profit as a percentage of net sales was 17.4 percent in 1992 and 16.6 percent in 1991. Over the two-year period, construction materials gross profit as a percentage of net sales was approximately 10 percent. The Registrant's cement unit cost is heavily influenced by plant capacity utilization. The following table summarizes the Registrant's cement production (in millions of tons) and the utilization rate of clinker production capacity. II - 12 Cement production increased one and one-half percent in 1992 while clinker capacity utilization was 83 percent, down from 85 percent in 1991. In the U.S., cement production totalled 8.1 million tons, an increase of four percent over 1991. Capacity utilization at U.S. plants was 95 percent in 1992 compared to 94 percent in 1991. The increase in production and utilization was primarily due to higher sales volumes. Canadian cement production fell to 3.7 million tons in 1992, a decline of three percent from 1991. Capacity utilization was 66 percent and 71 percent in 1992 and 1991, respectively. The decline resulted from the temporary shutdown of certain kilns at three of the Registrant's plants in Canada due to a decrease in cement demand. Selling and Administrative Selling and administrative expenses decreased seven percent in 1992 primarily due to the 1991 restructuring of the Registrant's cement operations following the Missouri Portland/Davenport acquisition in January 1991 and other restructuring in the Registrant's construction materials operations, particularly in Ontario. These savings were partially offset by 1992 provisions for additional restructuring. Selling and administrative expenses as a percentage of net sales were 12.2 percent in 1992, down from 12.7 percent in 1991. Other (Income) Expense, Net Other income and expense consists of items such as net retirement costs, equity income, amortization of intangibles and nonrecurring gains and losses from divestitures. Other expense, net was $9.1 million in 1992 compared to $8.1 million in 1991. The change was the result of recurring expenses from adopting the new accounting rule for postretirement benefits as well as nonrecurring provisions for contingencies and restructuring. These charges were partially offset by lower retirement costs, higher equity income and divestment gains from the sale of non- strategic assets and lower costs related to the strike at the Richmond plant. Performance by Line of Business The Registrant's operating profit from cement operations in 1992 was $66.6 million, $14.7 million better than 1991. Earnings improved in three of the Registrant's four cement regions. Depreciation expense increased by $3.4 million as a result of the new accounting rule for income taxes. The Canadian operating profit was $40.8 million, $7.5 million better than 1991. Profits in western Canada improved due to the end of a strike at the Richmond plant plus higher shipments and prices. Profits declined in central and eastern Canada due to sluggish construction activity. In the U.S., operating profit was $25.8 million, up $7.2 million from 1991. Earnings improved in all markets except the Northeast. II - 13 In 1992, operating profit from the Registrant's construction materials and waste management operations was $9.7 million, $4.6 million lower than 1991. Earnings declined because of lower shipments in central and eastern Canada. Canadian operating profit was $5.6 million, $11.6 million less than 1991. Weak construction activity in central and eastern Canada was primarily responsible for the decline. Profit was higher in western Canada as a result of higher shipments. In the U.S., operating profit in 1992 was $4.1 million, or $7.0 million better than the previous year. The improvement resulted from better market conditions and higher prices in the South coupled with a reduction of overhead expenses in the Midwest. Total Income From Operations Total income from operations improved in 1992 to $28.0 million from $17.7 million in 1991, after recording as an additional expense the $9.4 million recurring impact of accounting changes. A majority of the improvement came from restructuring and cost-reduction programs as well as divestment gains. Earnings were boosted by $9.6 million of gains from the sale of non-strategic assets. Operating profit from the Registrant's Canadian operations before the impact of accounting changes was $34.4 million, $7.6 million better than 1991. The U.S. operating profit before accounting changes was $3.0 million, $12.1 million better than 1991. Interest Expense, Net In 1992, net interest expense decreased five percent due to lower interest rates and lower average debt levels in both the U.S. and Canada. Income Taxes Income tax expense decreased $0.4 million in 1992. The Canadian effective income tax rates were 42.7 percent in 1992 and 56.0 percent in 1991. Certain elements of the Canadian income tax provision which are fixed in amount were higher in 1991 but lower in 1992. The decrease in the Canadian effective tax rate in 1992 was caused by a lower percentage of these fixed amounts relative to the higher earnings experienced in 1992. Net Loss The Registrant's net loss in 1992, excluding charges resulting from the adoption of the new accounting rules, was $28.1 million. This was a 44 percent improvement over the 1991 net loss of $50.3 million. The Registrant's Canadian operations reported net income of $20.3 million, an $8.1 million increase over 1991. Canadian earnings benefitted from II - 14 $4.1 million of gains (net of tax), realized primarily from the sale of surplus land and a chemical admixtures business. In addition, expenses were reduced from actions taken in 1991 and during 1992 to streamline operations and reduce cost, and a reallocation of corporate overhead from the U.S. to Canada. Offsetting these gains were a nine percent decline in Canadian net sales due to weak shipments in eastern and central Canada, nonrecurring provisions for contingencies and restructuring, and a decrease in the value of the Canadian dollar. In the U.S., the net loss before accounting changes was $48.4 million, which was $14.1 million better than 1991. The U.S. improvement was primarily due to restructuring and cost reduction programs as well as better market conditions and higher prices in the Registrant's southern construction materials operations offset by reallocation of corporate overhead from Canada. ENVIRONMENTAL MATTERS The Registrant's operations, like those of other companies engaged in similar businesses, involve the use, release/discharge, disposal and clean-up of substances regulated under increasingly stringent federal, state, provincial and/or local environmental protection laws. Many of the regulations are technically and legally complex, posing significant compliance challenges. The Registrant's environmental compliance program includes an environmental policy designed to provide corporate direction for all operations and employees, routine compliance oversight of the Registrant's facilities, routine training and exchange of information by its environmental professionals, and routine and emergency reporting systems. The Registrant has been, or is presently involved in certain environmental enforcement matters, in both the U.S. and Canada. Management's philosophy is to attempt to actively resolve such matters with the appropriate governmental authorities. In certain circumstances, notwithstanding management's belief that a particular alleged violation poses no significant threat to the environment, the Registrant may decide to resolve such matter by entering into a consent agreement and/or paying a penalty. In 1992, the Registrant's four cement plants using hazardous waste derived fuels submitted certifications of compliance for the emission limits established under the federal Resource Conservation and Recovery Act ("RCRA"), Boiler and Industrial Furnaces ("BIF") regulations. The BIF regulations also require extensive record keeping of operational parameters and of fuels and raw materials used. The BIF regulations are extremely complex and certain provisions have been subject to different interpretations. The Registrant has received a notice of violation and/or a complaint alleging violations of the BIF regulations at each of four cement plants. These notices of violation and complaints were issued by the U.S. Environmental Protection Agency ("EPA") with respect to three plants and by the State of Michigan, which has been delegated BIF enforcement authority by the EPA, with respect to a fourth plant. II - 15 Although the details of each notice of violation or complaint are specific to the particular plant, a recurring issue has been the existence or adequacy of the plant's waste analysis plan to ensure compliance with the established allowable emission limits and feed rates. All of the Registrant's plants which are subject to the BIF regulations have revised their waste analysis plans and submitted them for approval. Furthermore, to reduce the potential recurrence of BIF violations, the Registrant has designated an employee who is responsible for managing the Registrant's BIF compliance, including routine auditing of plant operations and plant records which are required to document compliance with the BIF regulations. The current status of these BIF-related matters is as follows: With respect to the Demopolis, Alabama plant (which was sold by the Registrant in early 1993), the Registrant settled the matter by paying a penalty of $594,000, approximately one-third of the penalty originally proposed by the EPA. The State of Michigan has proposed a penalty of $979,750 with respect to the Alpena, Michigan plant and the EPA has proposed penalties of $619,800 with respect to the Paulding, Ohio plant and $1,200,474 with respect to the Fredonia, Kansas plant. The Registrant has submitted a response to each notice of violation and complaint setting forth certain defenses and factual information and has had meetings with the EPA and Michigan State officials to discuss the alleged violations and the possibilities of settlement. At this time, it is unknown whether the Registrant will be able to settle any or all of these matters or whether one or more adjudicatory proceedings will result. In late February 1994, a decision was issued in a lawsuit challenging certain aspects of the BIF regulations. The court's decision, among other things, vacated the tier III standard for hydrocarbon emission levels and instructed the EPA to reconsider the tier III standard. Two of the Registrant's plants have been complying with the tier III standard and are currently not able to meet either the tier I standard or the tier II standard, which are the two remaining standards. The Registrant is evaluating potential raw material alternatives and technological modifications at these two plants to determine whether one or both of the plants could meet the tier I standard or the tier II standard. The Registrant is also working with the EPA to have an interim replacement standard put in place pending the EPA's reconsideration of the tier III standard. In the absence of the tier III standard or a substantially similar replacement standard, the Registrant might have to stop using supplemental fuels at one or both of these plants. A by-product of many of the Registrant's cement manufacturing plants is cement kiln dust ("CKD"). CKD has been excluded from regulation as a hazardous waste under the so-called "Bevill Amendment" to RCRA until the EPA completes a study of CKD, determines if it is hazardous waste, and issues appropriate rules. On December 30, 1993, the EPA issued its Report to Congress and proposed five regulatory options for CKD. The EPA has solicited public comments on the Report to Congress and the regulatory options, following which it will make a final regulatory II - 16 determination of how, if at all, CKD should be regulated in the future. The Registrant is actively participating in this opportunity to submit comments and offer constructive regulatory alternatives. One of the regulatory alternatives being considered by the EPA would classify as a hazardous waste the CKD which is produced by facilities burning hazardous waste as a supplemental fuel. The Registrant's management does not believe that the data included in the Report to Congress support such an approach. If, however, this option is selected by the EPA, the Registrant could incur significant capital costs to meet these new standards, might have to stop using supplemental fuels at its plants, and/or might close one or more plants. In 1993, the State of Michigan alleged that the Registrant's Alpena plant was managing CKD in violation of applicable state solid waste management requirements. The Registrant has formally responded to the State setting forth defenses and factual information and has had numerous meetings with State officials to discuss the matters raised, the possible technical solutions and the possibilities of settlement. Although significant progress has been made towards potential settlement, it is unknown at this time whether the Registrant will be able to settle this matter by agreeing to make certain operational changes at the plant and/or by paying a penalty, or whether an adjudicatory proceeding will result. In another matter relating to the Alpena plant and CKD, the State of Michigan has contacted the Registrant and the former owner of the plant seeking remediation of an old CKD pile from which there is runoff of hazardous substances into Lake Huron. The Registrant has advised the State that it is not responsible for remediating this property because the property was expressly excluded in the purchase agreement pursuant to which the Registrant acquired the plant. The Registrant has advised the former plant owner of the Registrant's position on this matter. In view of the current uncertainty regarding the future regulatory treatment of CKD and with the goal of minimizing long-term liability exposure, the Registrant has been assessing its management practices for CKD in the U.S. and Canada and is voluntarily taking remedial steps and instituting new management practices as well as assessing and modifying process operations, evaluating and using alternative raw materials and implementing new technologies for reducing the generation of CKD. As with most industrial companies in the U.S., the Registrant is involved in certain remedial actions to clean up historical problem waste disposal sites as required by federal and state laws, which provide that responsible parties must fund remedial actions regardless of fault or legality at the time of the original disposal. In this regard, the Registrant is presently involved in approximately 15 federal and state administrative proceedings. At all but four of these sites, the Registrant is either a de minimis party or the Registrant has information to support its position that it did not contribute/dispose, or is not legally responsible for the disposal of materials at the site. With respect to two of the four sites, the Registrant has entered into II - 17 consent agreements with the applicable governmental authorities and received approval in late 1993 to proceed with its proposed remediation plans. In these two cases, the Registrant has recorded provisions for exposure, but has sought to obtain contributions from other non-settling parties and/or believes that its liability insurance covers these costs and is pursuing recovery from its insurers. At a third site, the Registrant has undertaken remediation under a state order of property which the Registrant had leased to an automobile workshop that had a leaking underground storage tank. The lessee vacated the property and did not have the financial resources to clean up the site. The Registrant has completed remediation of the site and is awaiting state approval. The fourth site is the old CKD pile at the Alpena plant discussed above. The 1990 Clean Air Act Amendments have the potential to result in significant capital expenditures and operational expenses for the Registrant. The Clean Air Act Amendments established a new federal operating permit and fee program for virtually all manufacturing operations. By 1995, the Registrant's U.S. operations that are deemed to be "major sources" of air pollution will have to submit detailed permit applications and pay recurring permit fees. To ensure the timely submittal and completeness of permit applications for the Registrant's "major sources", the Registrant has designated an employee to manage the identification of "major sources", prepare permit applications, and negotiate permit terms with the appropriate state agencies. The EPA is also developing air toxics regulations for a broad spectrum of industrial sectors including portland cement manufacturing. The EPA has indicated that the new maximum available control technology ("MACT") standards could force a significant reduction of air pollutants below existing levels. The Registrant is actively participating with other cement manufacturers in working with the EPA to define test protocols, better define the scope of MACT standards and develop realistic emission limitations for the portland cement industry. Until the EPA better defines the applicability and scope, and the proposed emission standards, management cannot determine whether technology in fact exists today to meet such standards and, if it does, the facilities which will be required to install additional controls and the associated costs for such controls. The Registrant's ready-mixed concrete operations generate a cement sludge from concrete recycling. Governmental authorities, especially in Canada, are beginning to focus on regulating management of this residual waste. The Registrant has been voluntarily assessing its cement sludge management practices in the U.S. and Canada. The Registrant hopes to identify new technologies, process modifications and alternative raw materials/additives with the goal of reducing the generation of cement sludge and/or establishing alternative management practices. Because of differences between requirements in the U.S. and Canada, and the complexity and uncertainty of existing and future environmental requirements, permit conditions, costs of new and existing technology, potential remedial costs and insurance coverage, and/or enforcement II - 18 related activities and costs, it is difficult for management to estimate the ultimate level of the Registrant's expenditures related to environmental matters. The Registrant's capital expenditures and operational expenses for environmental matters have increased, and are likely to increase in the future. The Registrant, however, cannot determine at this time if capital expenditures and other remedial actions that the Registrant has taken, or may in the future be required to undertake, in order to comply with the laws governing environmental protection will have a material effect upon its capital expenditures or earnings. II - 19 MANAGEMENT'S DISCUSSION OF CASH FLOWS The Consolidated Statements of Cash Flows summarize the Registrant's main sources and uses of cash. These statements show the relationship between operations which are presented in the Consolidated Statements of Income and liquidity and financial resources which are depicted in the Consolidated Balance Sheets. The Registrant's liquidity requirements arise primarily from the funding of its capital expenditures, working capital needs, debt service obligations and dividends. The Registrant has met its operating liquidity needs primarily through internal generation of cash and expects to continue to do so for both the short-term and long-term. However, because of the seasonality of the Registrant's business, it must borrow to fund operating activities during the spring and summer. The net cash provided by operations for each of the three years presented reflects the Registrant's net income (loss) adjusted primarily for depreciation, depletion and amortization, changes in working capital, restructuring charges in 1993, and the cumulative effect of accounting changes in 1992. Depreciation and depletion increased in 1992 from 1991 because of capital expenditures and acquisitions but declined in 1993 due to lower capital spending and divestments. In addition, net income (loss) was adjusted by the provision for bad debts. This provision has declined over the three year period due to tighter credit policies and a healthier construction market in 1993. During all three years presented, net income (loss) was also adjusted for the turnaround of deferred income taxes, primarily from reversing depreciation differences in Canada, and changes in working capital, which is discussed in Management's Discussion of Financial Position. Finally, net income (loss) from operations was adjusted for gains on sales of assets and other noncash charges and credits. These charges and credits consist principally of equity income net of dividends received, other postretirement benefit accruals, increases in prepaid pension assets and minority interests. Cash flows invested consist primarily of capital expenditures and acquisitions partially offset by proceeds on property, plant and equipment dispositions. Sales of property, plant and equipment during 1993 and 1992 included significant divestments of non-strategic assets. During 1993 the Registrant's proceeds from the sale of non-strategic assets and surplus land totalled approximately $68.9 million. In 1992 the proceeds from divestment of several construction materials businesses and surplus land totalled $25.1 million. Capital investments, including acquisitions, by product line were as follows (in millions): II - 20 Capital investments related to existing operations are not expected to exceed $130 million in 1994. This capital spending is anticipated to be funded by cash flows from operations, after dividends, and proceeds from divestments. During 1993, the Registrant continued its program to regain financial flexibility by reducing its debt position. Debt was reduced by cash flows from operations, divestments and proceeds from the sale of Common Shares. Net cash outflows from financing activities were $124.4 million in 1993 and $14.9 million in 1992. In 1991, cash flows from financing activities were $26.3 million, reflecting borrowings required to finance a portion of the Registrant's capital investments. In February 1993, the Registrant sold its Demopolis, Alabama cement facility and other related assets for approximately $50 million cash. In early 1992, the Registrant sold 1.7 million Exchangeable Shares of LCI, a wholly owned subsidiary, that it had accumulated through exchange transactions for net proceeds of $25.8 million. In October 1993 the Registrant completed an offering of 6.75 million Common Shares priced at $18.25 per share. The net proceeds from the offering, which were used initially to reduce long-term debt, totalled $117.6 million. The Registrant intends to apply the proceeds to internal capital improvement projects and investment or acquisition opportunities to enhance or expand the Registrant's competitive position in the U.S. and Canada. The Registrant has access to a wide variety of short-term and long-term financing alternatives in both the U.S. and Canada. Effective December 15, 1993, the Registrant extended the maturity of its $200 million committed credit facility to December 31, 1996. Although none of the credit facility had been drawn down at December 31, 1993, approximately $11 million was utilized to back outstanding short-term bank loans. Most of the Registrant's cash and cash equivalents are in Canada. If the cash were transferred to the U.S., a 10 percent withholding tax would be levied in Canada which, because of the Registrant's U.S. net operating loss position, would not provide an offsetting tax credit in the U.S. II - 21 MANAGEMENT'S DISCUSSION OF FINANCIAL POSITION The Consolidated Balance Sheets summarize the Registrant's financial position at December 31, 1993 and 1992. The value reported for Canadian dollar denominated net assets decreased from December 31, 1992 as a result of a drop in the value of the Canadian dollar relative to the U.S. dollar. At December 31, 1993 the U.S. dollar equivalent of a Canadian dollar was $ .76 versus $ .79 at December 31, 1992. Working capital, excluding cash and current portion of long-term debt, decreased $6.5 million as a result of the drop in the value of the Canadian dollar relative to the U.S. dollar. The impact of these exchange rate changes was to reduce accounts receivable by $5.8 million, inventories by $4.0 million, and accounts payable by $2.7 million. Working capital, excluding cash, current portion of long-term debt and the impact of exchange rate changes, decreased $49.2 million from December 31, 1992 to December 31, 1993. Accounts receivable increased $14.3 million during the year primarily due to a five percent increase in net sales in the fourth quarter of 1993 compared to 1992. (Net sales are detailed in Management's Discussion of Income). Inventories decreased $36.1 million mainly due to a seven percent increase in cement shipments in the fourth quarter resulting from the continued improvement in the construction market coupled with milder weather conditions in most of the Registrant's major markets. Also contributing to the decline in inventories was the impact of divestments. The increase in other current assets was due to higher deferred income tax assets. Accounts payable and accrued liabilities increased $38.8 million, mainly due to the $21.6 million restructuring accrual and the timing of purchases and payments. Net property, plant and equipment decreased $101.6 million during 1993. The impact of exchange rates resulted in $16.0 million of this decrease. Depreciation and divestments were $108.5 million and $51.9 million. Capital expenditures and acquisitions totalled $67.2 million. The excess of cost over net assets of businesses acquired related primarily to a 1981 U.S. acquisition. During 1993, this balance decreased primarily due to current year amortization. Other long-term liabilities increased $13.9 million during 1992. The increase was due to higher minority interests of $12.4 million primarily resulting from a construction materials joint venture in Canada ($7.2 million) and proceeds from the expropriation of property in a U.S. construction materials joint venture ($4.7 million). The adoption of SFAS No. 106, "Employers Accounting for Postretirement Benefits Other than Pensions", was recorded effective January 1, 1992 and resulted in the establishment of a $111.0 million liability. The related 1993 and 1992 accruals, net of actual payments, were $4.5 million and $6.0 million, respectively. The new accounting standard requires that the expected cost of retiree health care and life insurance benefits be charged to expense during the II - 22 years that the employees render service rather than the Registrant's past practice of recognizing these costs on a cash basis. The Registrant's capitalization is summarized in the following table: The increase in shareholders' equity is discussed in Management's Discussion of Shareholders' Equity. The decline in long-term debt is discussed in Management's Discussion of Cash Flows. II - 23 MANAGEMENT'S DISCUSSION OF SHAREHOLDERS' EQUITY The Consolidated Statements of Shareholders' Equity summarize the activity in each of the components of shareholders' equity for the three years presented. Shareholder's equity increased $91.7 million in 1993. The increase was mainly due to the October 1993 sale of 6.75 million shares of Common Shares for net proceeds of $117.6 million. Also positively impacting 1993 shareholders' equity was net income of $5.9 million. Partially offsetting these increases were dividend payments, net of reinvestments of $14.3 million, and a change in the foreign currency translation adjustments of $24.6 million resulting from a decline in the value of the Canadian dollar relative to the U.S. dollar. Shareholders' equity decreased $142.0 million in 1992 due to the net loss of $100.6 million, a change in the foreign currency translation adjustments of $62.8 million resulting from a significant decline in the value of the Canadian dollar relative to the U.S. dollar and dividend payments, net of reinvestments, totalling $7.7 million. Offsetting these declines were the sale of 1.7 million Exchangeable Shares of LCI in February 1992 for net proceeds of $25.8 million. Common equity interests include Common Shares and the LCI Exchangeable Shares, which have comparable voting, dividend and liquidation rights. Common Shares are traded on the New York Stock Exchange under the ticker symbol "LAF" and on The Toronto Stock Exchange and the Montreal Exchange. The Exchangeable Shares are traded on the Montreal Exchange and The Toronto Stock Exchange. The following table reflects the range of high and low closing prices of Common Shares by quarter for 1993 and 1992 as quoted on the New York Stock Exchange: II - 24 Dividends are summarized in the following table (in thousands, except per share amounts): Net dividend payments during 1993 were higher than 1992 because of an increase in the number of shares outstanding during the year and a decrease in the reinvestment of dividends. II - 25 MANAGEMENT'S DISCUSSION OF SELECTED FINANCIAL DATA The Selected Consolidated Financial Data provides both a handy reference for some data frequently requested about the Registrant and a useful record in reviewing trends. The Selected Consolidated Financial Data for 1990 and 1989 has been restated from January 1, 1989 to reflect the Missouri Portland/Davenport acquisition. The Registrant's net sales increased six percent from 1989 to 1990 because of acquisitions and, to a lesser extent, increased business activity in the Registrant's markets. The 11 percent decline in the Registrant's net sales from 1990 to 1991 reflects the lower sales volumes during the recession, whereas the four percent decline from 1991 to 1992 was caused by sluggish construction activity in central and eastern Canada coupled with a decline in the average value of the Canadian dollar. The one percent decline from 1992 to 1993 was due to the drop in the value of the Canadian dollar and lost sales from divested operations, partially offset by a four percent increase in average cement net sales prices and higher cement and construction materials sales volumes as discussed in Management's Discussion of Income. Inflation has not been a significant factor in the Registrant's sales or earnings growth due to lower inflation rates in recent years, and because the Registrant continually attempts to offset the effect of inflation by improving operating efficiencies, especially in the areas of selling and administrative expenses, productivity and energy costs. The ability to recover increasing costs by obtaining higher prices for the Registrant's products varies with the level of activity in the construction industry and the availability of products to supply a local market. During 1989 and 1990, the Registrant's cement selling price increases in the U.S. and in Canada were generally less than the rate of inflation. In 1991, that pattern continued in the U.S.; however, Canadian selling prices were relatively stable in 1991. In 1992, selling prices in the U.S. decreased 1.4 percent while Canadian selling prices increased one percent. In 1993 selling prices in the U.S. increased six percent while average Canadian prices were unchanged despite depressed volumes and competitive pressures in Ontario. Net cash provided by operations consists primarily of net income (loss), adjusted primarily for depreciation, restructuring charges in 1993 and, in 1992, the cumulative effect of changes in accounting principles. The Registrant is in a capital intensive industry and as a result recognizes large amounts of depreciation. The Registrant has used the cash provided by operations primarily to expand its markets and to improve the performance of its plants and other operating equipment. II - 26 Capital expenditures and acquisitions totalled $771.1 million over the five years and included the acquisition of The Standard Slag Company (Part of the U.S. Region) which has a network of aggregates and construction materials businesses located in the U.S. Great Lakes area. Other significant investments during the period included a variety of cement plant projects to increase production capacity and reduce costs, the installation of waste fuel receiving and handling facilities, the building of additional distribution terminals to extend markets and improve existing supply networks, acquisitions of ready-mixed concrete plants and aggregate operations, and modernization of the construction materials mobile equipment fleet. II - 27 Item 8.	Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA CONSOLIDATED STATEMENTS OF INCOME (in thousands, except per share amounts) See Notes to Consolidated Financial Statements II - 28 CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) See Notes to Consolidated Financial Statements II - 29 CONSOLIDATED BALANCE SHEETS (in thousands) See Notes to Consolidated Financial Statements II - 30 CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (in thousands) See Notes to Consolidated Financial Statements II - 31 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Together with its subsidiaries, Lafarge Corporation (the "Registrant"), a Maryland corporation, is engaged in the production and sale of cement, ready-mix concrete, aggregates and other concrete products. The Registrant operates in the U.S. and its major operating subsidiary, LCI, operates in Canada. The Registrant's wholly-owned subsidiary, Systech Environmental Corporation, and its Canadian affiliate (together "Systech"), are involved in the conversion of waste into fuels for use in cement kilns. Lafarge Coppee S.A., a French corporation, and certain of its affiliates ("Lafarge Coppee") own a majority of the voting securities of the Registrant. ACCOUNTING AND FINANCIAL REPORTING POLICIES Principles of Consolidation The consolidated financial statements include the accounts of the Registrant and all of its majority-owned subsidiaries (the "Registrant"), after the elimination of intercompany transactions and balances. Investments in affiliates in which the Registrant has less than a majority ownership are accounted for by the equity method. Foreign Currency Translation Assets and liabilities of LCI are translated at the exchange rate prevailing at the balance sheet date. Revenue and expense accounts for this subsidiary are translated using the average exchange rate during the period. Foreign currency translation adjustments are disclosed as a separate item in shareholders' equity. Revenue Recognition Revenue from the sale of cement, concrete products and aggregates is recorded at the time the products are shipped. Revenue from waste recovery and disposal is recorded at the time the material is received, tested and accepted. Revenue from road construction contracts is recognized on the basis of units of work completed, while revenue from other indivisible lump sum contracts is recognized using the percentage-of-completion method. Change in Accounting Principles Effective January 1, 1992 the Registrant adopted Statements of Financial Accounting Standards ("SFAS") No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions," and No. 109, "Accounting for Income Taxes." The cumulative effect of these changes in accounting principles of $63.5 million (after-tax) was recorded as a charge to expense in 1992. II - 32 Other Postretirement Benefits SFAS No. 106 requires that the expected cost of retiree health care and life insurance benefits be charged to expense during the years that the employees render service rather than the Registrant's practice, prior to 1992, of recognizing these costs on a cash basis. The January 1, 1992 noncash cumulative charge for the adoption of this standard was $86.1 million, or $1.47 per share, after income taxes of $24.9 million. This charge represents the discounted present value of expected future benefits attributed to employees' service rendered prior to January 1, 1992. The adoption of this accounting principle also reduced 1992 pre-tax income by approximately $6.0 million. The amount of claims paid for these benefits was approximately $7.2 million, $5.5 million and $3.9 million during 1993, 1992 and 1991, respectively. Income Taxes SFAS No. 109 requires a change from the deferred method to the liability method of accounting for income taxes. Under the liability method, deferred income taxes are recognized for the tax consequences of "temporary differences" by applying enacted statutory tax laws and rates applicable to future years to differences between the financial statement carrying amounts and the tax bases of existing assets and liabilities. Under this standard, the effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date. Under the deferred method, deferred taxes were recognized using the tax rate applicable to the year of the calculation and were not adjusted for subsequent changes in tax rates. The January 1, 1992 noncash cumulative credit recognized as income for the adoption of this standard was $22.6 million, or $.39 per share. The adoption of SFAS No. 109 reduced 1992 pre-tax income from continuing operations by $3.4 million. Cash Equivalents For purposes of the Consolidated Statements of Cash Flows, "cash" includes cash and cash equivalents. The Registrant considers liquid investments purchased with a maturity of three months or less to be cash equivalents. Because of the short maturity of those investments, their carrying amount approximates fair value. Inventories Inventories are valued at lower of cost or market. The majority of the Registrant's U.S. inventories, other than maintenance and operating supplies, are stated at last-in, first-out ("LIFO") cost and all other inventories are valued at average cost. Property, Plant and Equipment Depreciation of property, plant and equipment is computed for financial reporting purposes using the straight-line method over the estimated useful lives of the assets. These lives range from three years on light mobile equipment to forty years on certain buildings. Land and mineral II - 33 deposits include depletable raw material reserves on which depletion is recorded using a units-of-production method. Excess of Cost Over Net Assets of Businesses Acquired The excess of cost over fair value of net assets of businesses acquired is amortized on a straight-line basis over periods not exceeding forty years. The amortization recorded for 1993, 1992 and 1991 was $4.3 million, $5.4 million and $6.4 million, respectively. Accumulated amortization at December 31, 1993 and 1992 was $38.2 million and $33.9 million, respectively. Research and Development The Registrant is committed to improving its manufacturing process, maintaining product quality and meeting existing and future customer needs. These objectives are pursued through various programs. Research and development costs, which are charged to expense as incurred, were $7.3 million, $8.1 million and $7.5 million for 1993, 1992 and 1991, respectively. Interest No interest was capitalized during 1993, 1992 or 1991. Interest income of $5.3 million, $4.5 million and $3.3 million, has been applied against interest expense for 1993, 1992 and 1991, respectively. The interest differential to be paid or received as a result of interest rate swaps is accrued as interest rates change and recognized over the life of the agreements as an adjustment to interest expense. Net Income Per Common Equity Share The calculation of net income per common equity share is based on the weighted average number of the Registrant's Common Shares and the Exchangeable Preference Shares of LCI ("Exchangeable Shares") outstanding in each period and the assumed exercise of stock options. The weighted average number of shares and share equivalents outstanding was (in thousands) 61,636, 58,652 and 55,925 in 1993, 1992 and 1991, respectively. The computation of fully diluted earnings per share was antidilutive in 1993, 1992 and 1991. Other Postemployment Benefits In December 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 112, "Accounting for Other Postemployment Benefits." SFAS No. 112 requires the accrual of the estimated cost of benefits provided to former or inactive employees after employment but before retirement. These benefits include long-term disability, temporary disability income, medical coverage continuation and COBRA medical coverage continuation. This new standard, which the Registrant must adopt by 1994, requires that the expected cost of these benefits be charged to expense during the years that the employees render service. The Registrant will adopt this new II - 34 standard on January 1, 1994. The impact of adopting this standard will not be material to the Registrant's financial position and operating results. RESTRUCTURING In the fourth quarter of 1993, the Registrant recorded a one-time pre-tax restructuring charge of $21.6 million ($16.4 million net of tax benefits, or $.27 per share) to cover the direct expenses of restructuring the Registrant's North American business units to increase organizational efficiency. The primary components of the restructuring charge are separation benefits for approximately 350 employees, employee relocation costs and early retirement benefits for eligible employees electing early retirement. The charge also includes expenses such as office relocation and lease termination. The restructuring plan entails the consolidation of eleven regional operating units into six units in the Registrant's two main business lines. This consolidation reduces management layers, eliminates duplicative administrative functions and standardizes procedures and information systems. Manufacturing and distribution facilities will not be materially affected by the restructuring. RECEIVABLES Receivables consist of the following (in thousands): II - 35 INVENTORIES Inventories consist of the following (in thousands): Included in the finished products, work in process and raw materials and fuel categories are inventories valued using the LIFO method of $54.8 million and $74.4 million at December 31, 1993 and 1992, respectively. If these inventories were valued using the average cost method, such inventories would have decreased by $7.5 million and $9.7 million, respectively. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment consist of the following (in thousands): II - 36 OTHER ASSETS Other assets consist of the following (in thousands): Property held for sale represents certain permanently closed cement plants and land which are carried at the lower of cost or estimated net realizable value. ACCOUNTS PAYABLE AND ACCRUED LIABILITIES Accounts payable and accrued liabilities consist of the following (in thousands): II - 37 LONG-TERM DEBT Long-term debt consists of the following (in thousands): The fair value of long-term debt at December 31, 1993 was approximately $428.0 million. This fair value was estimated based upon quoted market prices or current interest rates offered to the Registrant for debt of the same maturity. The Registrant, does not generally anticipate the refinancing of these obligations prior to maturity. II - 38 The Registrant is a party to $98 million net notional amount of interest rate swap agreements which have effectively fixed the interest rates on its floating rate debt. The fixed rates payable under these agreements have a weighted average of 9.3 percent with terms expiring at various dates from 1996 through 2000. The Registrant is exposed to credit loss in the event of nonperformance by the other parties to the interest rate swap agreements, but does not anticipate nonperformance by such parties. Based on current market interest rates, the net termination cost at December 31, 1993 for the Registrant to unwind its various hedging positions was approximately $17.0 million. Annual principal payment requirements on long-term debt for each of the five years in the period ending December 31, 1998, after the exclusion of short-term bank loans for which anticipated refinancing is available, are as follows (in millions): Effective December 15, 1993, the Registrant extended the maturity of its $200 million revolving credit facility to December 1996. At the end of 1993, no amounts were outstanding under the revolving credit facility. The Registrant is required to pay annual commitment fees of up to one-quarter of one percent of the unused portion of the funds available for borrowing under these credit agreements. There was approximately $11.1 million of short-term debt backed by the revolving credit facility outstanding at December 31, 1993. The revolving credit facility and several other off-balance sheet arrangements are generally at market conditions. The Registrant's debt agreements require the maintenance of certain financial ratios relating to cash flow, leverage, working capital and net worth. At December 31, 1993, the Registrant was in compliance with these requirements. II - 39 OTHER LONG-TERM LIABILITIES Other long-term liabilities consist of the following (in thousands): PREFERRED STOCK At December 31, 1990, there were 9.0 million shares of the Registrant's Third Preferred Stock authorized, of which 1 million were outstanding. These shares were issued at a par value of $1.00 per share and were held by Lafarge Coppee. The holders were entitled to one vote per share. The shares were not entitled to any equity participation or dividends and had a cash redemption and liquidation value of $.25 per share. The Third Preferred Stock had certain mandatory redemption provisions and all outstanding shares were redeemed under these provisions on December 31, 1991. The Registrant's charter provides that redeemed shares of Third Preferred Stock automatically become authorized but unissued shares of Common stock. COMMON EQUITY INTERESTS Holders of Exchangeable Shares have voting, dividend and liquidation rights which parallel those of holders of the Registrant's Common Shares. The Exchangeable Shares are exchangeable into the Registrant's Common Shares on a one-for-one basis. Dividends on the Exchangeable Shares are cumulative and payable at the same time as any dividends declared on the Registrant's Common Shares. The Registrant has agreed not to pay dividends on its Common Shares without causing LCI to declare an equivalent dividend in Canadian dollars on the Exchangeable Shares. Dividend payments and the exchange rate on the Exchangeable Shares are subject to adjustment from time to time to take into account certain dilutive events. At December 31, 1993 the Registrant had reserved for issuance approximately 13.4 million Common Shares to allow for the exchange of outstanding Exchangeable Shares. Additional common equity shares are reserved to cover grants under the Registrant's stock option program (3.3 million), employee stock purchase plan (.8 million), conversion of the Convertible Debentures (4.5 million) and issuances pursuant to the Registrant's optional stock dividend plan (.5 million). II - 40 In February 1992, the Registrant sold 1.7 million Exchangeable Shares that it had accumulated through exchange transactions for net proceeds of $25.8 million. On October 13, 1993, the Registrant sold 6.75 million Common Shares for $18.25 per share with net proceeds of $117.6 million. Lafarge Coppee, the Registrant's majority shareholder, purchased 1.0 million of these shares. OPTIONAL STOCK DIVIDEND PLAN The Registrant has an optional stock dividend plan which permits holders of record of common equity shares to elect to receive new common equity shares issued as stock dividends in lieu of cash dividends on such shares. The common equity shares are issued under the plan at 95 percent of the average market price, as defined in the plan. STOCK OPTION AND PURCHASE PLANS Options to purchase the Registrant's Common Shares and Exchangeable Shares have been granted to key employees of the Registrant at option prices based on the market price of the securities at the date of grant. One-fourth of the options granted are exercisable at the end of each year following the date of grant, and all the options granted are exercisable in four years. The options expire ten years from the date of grant. II - 41 The following table summarizes activity for options related to the Registrant's common equity interests: The Registrant has an Employee Stock Purchase Plan which permits substantially all employees to purchase the Registrant's common equity interests through payroll deductions at 90 percent of the lower of the beginning or end of plan year market prices. In 1993, 83,517 shares were issued to employees under the plan at a share price of $15.08 and in 1992, 101,866 shares were issued at a share price of $12.94. At December 31, 1993 and 1992, $.7 million and $.8 million were subscribed for future share purchases, respectively. INCOME TAXES Pre-tax income (loss) is summarized by country in the following table (in thousands): II - 42 The provision for income taxes includes the following components (in thousands): A reconciliation of taxes at the U.S. federal income tax rate to the Registrant's actual income taxes is as follows (in millions): Effective January 1, 1992 the Registrant adopted SFAS No. 109 "Accounting for Income Taxes." The cumulative effect of this accounting change is reported in the Consolidated Statements of Income. Deferred income taxes for 1993 and 1992 reflect the tax consequences of "temporary differences" between the financial statement carrying amounts and the tax bases of existing assets and liabilities. These temporary differences are determined in accordance with SFAS No. 109 and are more II - 43 inclusive in nature than "timing differences" as determined under previously applicable accounting principles. Temporary differences and carryforwards which give rise to deferred tax assets and liabilities are as follows (in thousands): Upon adoption of SFAS No. 109, effective January 1, 1992, the Registrant determined a valuation allowance requirement in the amount of $46.5 million. During 1993 and 1992, the valuation allowance increased to $68.1 million and $66.2 million, respectively, due primarily to the increase in unutilized net operating losses in 1992. In 1991 and prior years, deferred income taxes resulted from timing differences in the recognition of revenues and expenses for tax return and financial reporting purposes. The primary timing difference was caused by tax depreciation less than book depreciation. II - 44 At December 31, 1993 the Registrant had tax net operating loss and investment and other tax credit carryforwards of $110.3 million and $4.4 million, respectively, which expire as follows (in thousands): At December 31, 1993, cumulative undistributed earnings of LCI were $546.9 million. No provision for U.S. income taxes or Canadian withholding taxes has been made since the Registrant considers the undistributed earnings to be permanently invested in Canada. The Registrant believes that such earnings, if repatriated, would not result in significant U.S. income taxes because of tax planning alternatives but would incur a Canadian withholding tax of ten percent of the amount remitted. The Registrant's U.S. federal tax liability has not been finalized by the Internal Revenue Service for any year subsequent to 1983 due to the existence of tax net operating loss and credit carryforwards. The Registrant's Canadian federal tax liability for all taxation years through 1989 has been reviewed and finalized by Revenue Canada Taxation except for certain transactions for the tax years 1984 through 1989 which are currently being reviewed. SEGMENT INFORMATION The Registrant's single business segment includes the manufacture and sale of cement and ready-mixed concrete, precast and prestressed concrete components, concrete block and pipe, aggregates, asphalt and reinforcing steel. In addition, the Registrant is engaged in road building and other construction utilizing many of its own products, and in waste recovery and disposal utilizing industrial waste as supplemental fuels in cement kilns. II - 45 Sales between the United States and Canada are accounted for at fair market value. Income from operations equals net sales plus other income less cost of goods sold, selling and administrative expenses and, in 1993, restructuring charges. It also excludes interest expense and income taxes. Financial information by country is as follows (in millions): SUPPLEMENTAL CASH FLOW INFORMATION Non-cash investing and financing activities included (in thousands) the issuance of 232, 730, and 792 common equity shares upon the reinvestment of dividends totalling $4.1 million, $9.9 million, and $10.2 million in 1993, 1992 and 1991, respectively. II - 46 Cash paid during the year for interest and income taxes is as follows (in thousands): PENSION PLANS The Registrant has several defined benefit and defined contribution retirement plans covering substantially all employees. Benefits paid under the defined benefit plans are based generally either on years of service and the employee's compensation over the last few years of employment or years of service multiplied by a contractual amount. The Registrant's funding policy is to contribute amounts that are deductible for income tax purposes. The following table summarizes the consolidated funded status of the Registrant's defined benefit retirement plans and provides a reconciliation to the consolidated prepaid pension asset recorded on the Registrant's Consolidated Balance Sheets at December 31, 1993 and 1992(in millions). For 1993 the assumed settlement interest rate was 7.5 percent for the Registrant's U.S. plans and 8.0 percent for the Canadian plans. For 1992, the assumed settlement rate was 8.0 percent for the Registrant's U.S. plans and 8.5 percent for the Canadian plans. For 1993, the assumed rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligations was 4.5 percent. The 1992 rate was 5.0 percent. The expected long-term rate of investment return on pension assets, which include listed stocks, fixed income securities and real estate, was 9.0 percent for each year presented. II - 47 The preceding table includes information for certain pension plans with an excess of accumulated benefit obligations over plan assets. These particular plans are generally unfunded in nature and result in net deferred pension liabilities in 1993 and 1992 of $14.0 million and $12.1 million, respectively. Net retirement cost for the years indicated includes the following components (in millions): II - 48 Certain employees are also covered under multi-employer pension plans administered by unions. Amounts included in the preceding table as defined benefit plans retirement cost and contributions to such plans were $3.5 million, $3.5 million and $3.4 million for 1993, 1992 and 1991, respectively. The data available from administrators of the multi-employer plans are not sufficient to determine the accumulated benefit obligation, nor the net assets attributable to the multi-employer plans in which Registrant employees participate. The defined contribution plans costs in the preceding table relate to thrift savings plans for eligible U.S. employees in 1991 and for all eligible U.S. and Canadian employees in 1992 and 1993. Under the provisions of the plans, the Registrant contributes an amount proportionate to each participant's salary and will also match a portion of each participant's contribution. OTHER POSTRETIREMENT BENEFITS Effective January 1, 1992 the Registrant adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions." The cumulative effect of this accounting change is reported in the Consolidated Statements of Income. The Registrant provides certain retiree health and life insurance benefits to eligible employees who retire in the U.S. or Canada. Salaried participants generally become eligible for retiree health care benefits when they retire from active service at age 55 or later, although there are some variances by plan or unit in Canada and the U.S. Benefits, eligibility and cost-sharing provisions for hourly employees vary by location and/or bargaining unit. Generally, the health plans pay a stated percentage of most medical/dental expenses reduced for any deductible, co-payment and payments made by government programs and other group coverage. These plans are unfunded. An eligible retiree's health care benefit coverage is coordinated in Canada with Provincial Health and Insurance Plans and in the U.S., after attaining age 65, with Medicare. Certain retired employees of businesses acquired by the Registrant are covered under other care plans that differ from current plans in coverage, deductibles and retiree contributions. In the U.S., salaried retirees and dependents under age 65 have a $1,000,000 health care lifetime maximum benefit. At age 65 or over, the maximum is $50,000. Lifetime maximums for hourly retirees are governed by the location and/or bargaining agreement in effect at the time of retirement. In Canada, some units have maximums, but in most cases there are no lifetime maximums. In some units in Canada, spouses of retirees have lifetime medical coverage. In Canada, both salaried and nonsalaried employees are generally eligible for life insurance benefits. In the U.S., life insurance is provided for a number of hourly retirees as stipulated in their hourly bargained agreements, but not for salaried retirees except those of certain acquired companies. II - 49 The following table sets forth the plans' combined status reconciled with the accrued postretirement benefit cost included in the Registrant's Consolidated Balance Sheets (in thousands): Net periodic postretirement benefit cost includes the following components (in thousands): The assumed health care cost trend rate used in measuring the accumulated postretirement benefit obligation differs between U.S. and Canadian plans. For plans in both the U.S. and Canada, the pre-65 assumed rate was 13.4 percent decreasing to 5.5 percent over 14 years. For post-65 retirees in the U.S., the assumed rate was 8.8 percent decreasing to 5.5 percent over 14 years with a Medicare assumed rate for the same group of 7.9 percent decreasing to 5.5 percent over 14 years. For post-65 retirees in Canada, the assumed rate was 11.6 percent decreasing to 5.5 percent over 14 years. If the health care cost trend rate assumptions were increased by 1 percent, the accumulated postretirement benefit obligation as of December 31, 1993 would be increased by 11.7 percent. The effect of this change on the net periodic postretirement benefit cost for 1993 would be an increase of 13.3 percent. II - 50 The weighted average discount rate used in determining the accumulated postretirement benefit obligation was 7.5 percent for U.S. plans and 8.0 percent for Canadian plans. COMMITMENTS AND CONTINGENCIES The Registrant leases office space and certain equipment. Total rental expense for 1993, 1992 and 1991 was $16.7 million, $19.3 million and $16.2 million, respectively. Future minimum annual rental commitments for all non-cancelable leases are as follows (in thousands): During 1989 and 1990, CSX Transportation, Inc., Metro-North Commuter Railroad Company, National Railroad Passenger Corp., Peerless Insurance Company and Massachusetts Bay Transit Authority (the "Railroads") filed actions against Lone Star Industries Inc. and affiliates ("Lone Star") for damages resulting from its fabrication and sale of allegedly defective concrete railroad ties to the Railroads. The Registrant and LCI have been named in third party actions in which Lone Star is claiming indemnity for liability to the Railroads, for damages to its business and for costs and losses suffered as a result of the Registrant and LCI supplying allegedly defective cement used by Lone Star in the fabrication of the railroad ties. The damages claimed total approximately $226.5 million. The Registrant denied the allegations and vigorously defended against the lawsuits (the "Lone Star Case"). During September and October 1992, Lone Star entered into agreements with all five plaintiff Railroads settling their claims regarding the Lone Star Case for an amount totalling approximately $66.7 million. These settlements have been submitted to and approved by the United States Bankruptcy Court for the Southern District of New York which is handling the Lone Star bankruptcy. Lone Star commenced trial in November 1992 in its third party complaint against the Registrant and LCI seeking indemnity for the Railroads' claims in addition to its own claim for business destruction. A jury verdict in this case reached in December 1992 awarded Lone Star $1.2 million as damages. Both Lone Star and the Registrant and LCI have appealed the trial court verdict to the United States Court of Appeals for Fourth Circuit. A decision is expected in the near future. In late 1990 Nationwide Mutual Insurance Company ("Nationwide"), one of the Registrant's primary insurers during the period when allegedly defective cement was supplied to Lone Star by the Registrant, filed a II - 51 complaint for declaratory judgement against the Registrant, several of its affiliates and eleven other liability insurers of the Registrant (the "Coverage Suit"). The complaint seeks a determination of all insurance coverage issues impacting the Registrant in the Lone Star Case. The Registrant has answered the complaint, counterclaimed against Nationwide, cross-claimed against the co-defendant insurers and filed a third party complaint against 36 additional insurers. In December 1991, the Registrant and Nationwide entered into a settlement agreement pursuant to which Nationwide settled its claim in the Coverage Suit and, among other things, paid the Registrant a portion of past due defense expenses in the Lone Star Case, promised to pay its proportion of continuing defense expenses therein and to post the entire remaining aggregate limits of its policies as reserves to be used in the Lone Star Case, if necessary. Virtually all of LCI's Canadian insurers involved in the Coverage Suit filed motions for summary judgment. In January 1993, the court denied all of the insurers' summary judgment motions. In January 1994 the Registrant filed motions for partial summary judgment regarding the insurers' defense obligations and regarding the reasonableness of fees and expenses included in the defense of the Lone Star Case. In addition, the Registrant filed a motion to strike the designation of several expert witnesses of the insurers. The Registrant believes that it has substantial insurance coverage that will respond to a large portion of defense expenses and liability, if any, in the Lone Star Case. During 1992, a number of owners of buildings located in Eastern Ontario, Canada most of whom are residential homeowners, filed actions in the Ontario Court (General Division) against Bertrand & Frere Construction Company Limited ("Bertrand") and a number of other defendants seeking damages as a result of allegedly defective footings, foundations and floors made with ready-mixed concrete supplied by Bertrand. The largest of these cases involves claims by approximately 99 plaintiffs owning 53 homes, a 20-unit condominium building and a municipal building. Together, these plaintiffs are claiming approximately Cdn. $40 million against Bertrand, each plaintiff seeking Cdn. $200,000 for costs of repairs and loss of capital value of their respective home or building, Cdn. $200,000 for punitive and exemplary damages and Cdn. $20,000 for hardship, inconvenience and mental distress, together with interest and costs. Other owners, owning a total of 13 buildings (of which 11 are residential homes), have instituted similar suits against Bertrand and, based on the information available at this time, these claims total approximately Cdn. $9 million. As of the end of December 1993, LCI has been served with third- or fourth-party claims by Bertrand in all but one of the referenced lawsuits. Bertrand is seeking indemnity for its liability to the owners as a result of the supply by LCI of allegedly defective flyash. LCI also supplied cement to Bertrand. It is expected that Bertrand will file a third-party claim against LCI in the other case as well. LCI has delivered its statements of defense. The discoveries are to begin in February 1994. LCI has denied liability and will defend the lawsuits vigorously. The Registrant believes it has substantial insurance coverage that will respond to defense expenses and liability, if any, in the said lawsuits. II - 52 The Registrant is involved in certain environmental enforcement matters including being notified by the EPA that it is one of several potentially responsible parties for clean-up costs at waste disposal sites. The Registrant accrues for fines, penalties and/or costs of remedial actions when it believes it has a responsibility for the enforcement matter. The ultimate costs related to all such matters and the Registrant's degree of responsibility, in some of these matters, is not presently determinable. In addition, the Registrant is involved in certain other legal actions and claims. It is the opinion of management that such legal and environmental matters will be resolved without material effect on the Registrant's Consolidated Financial Statements. RELATED PARTY TRANSACTIONS The Registrant is a participant in agreements with Lafarge Coppee for the sharing of certain costs incurred for technical, research and managerial assistance and for the use of certain trademarks. The net expenses accrued for these services were $4.8 million, $5.3 million and $5.4 million during 1993, 1992 and 1991, respectively. In addition, the Registrant purchases various products from Lafarge Coppee. Such purchases totaled $6.3 million, $17.1 million and $27.5 million in 1993, 1992 and 1991, respectively. All transactions with Lafarge Coppee were conducted on an arms-length basis. Lafarge Coppee reinvested a portion of dividends it was entitled to receive on the Registrant's Common Shares during 1993, 1992 and 1991. These reinvestments totaled $3.0 million, $8.9 million and $9.2 million, respectively. At year-end, $15 million of the Registrant's 7% Convertible Debentures were held by Lafarge Coppee. In 1993, Lafarge Coppee purchased 1.0 million Common Shares as part of the Registrant's equity offering of 6.75 million Common Shares. The price paid for these shares was the price to the public. (See Common Equity Interests). II - 53 QUARTERLY DATA (UNAUDITED) The following table summarizes financial data by quarter for 1993 and 1992 (in millions, except per share information): (a) The sum of these amounts does not equal the annual amount because of changes in the average number of common equity shares outstanding during the year. (b) Loss for the fourth quarter of 1992 includes nonrecurring charges of $12.1 million, after tax. Excluding these charges, losses per share for the fourth quarter and year were $(.10) and $(.42), before the cumulative effect of accounting changes. (c) Income for the fourth quarter of 1993 includes nonrecurring restructuring charges of $16.4 million, after tax. Excluding these charges, earnings per share for the fourth quarter and year were $0.28 and $0.36. See Restructuring. II - 54 MANAGEMENT'S REPORT ON FINANCIAL REPORTING RESPONSIBILITY Management is responsible for the preparation, integrity and objectivity of the consolidated financial statements of Lafarge Corporation and subsidiaries and other information contained in this Annual Report. This responsibility includes the selection of accounting procedures and practices, which are in accordance with generally accepted accounting principles. The consolidated financial statements have been prepared in conformity with these procedures and practices applied on a consistent basis. These consolidated financial statements reflect informed judgments and estimates, which management believes to be reasonable, in the determination of certain data used in the accounting and reporting process. The Registrant maintains an effective system of internal accounting controls which is periodically modified and improved to correspond with changes in the Registrant's operations. An important element of the system is an ongoing internal audit function, which has direct access to the Audit Committee of the Board of Directors. The internal audit staff coordinates its audit activities with the Registrant's independent public accountants, Arthur Andersen & Co., to maximize audit effectiveness. The Board of Directors, acting through its Audit Committee, monitors the accounting affairs of the Registrant and has approved the consolidated financial statements. The Audit Committee, consisting of five outside directors, reviews audit plans and results as well as the actions taken by management in discharging its responsibilities for accounting, financial reporting and internal control systems and recommends to the Board of Directors the appointment of the independent public accountants. The Audit Committee meets periodically and privately with management, internal auditors and the independent public accountants to assure that each is carrying out its responsibilities. II - 55 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Lafarge Corporation: We have audited the accompanying consolidated balance sheets of Lafarge Corporation (a Maryland corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, cash flows, and shareholders' equity for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform an audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above (appearing on pages II-28 through II-53) present fairly, in all material respects, the financial position of Lafarge Corporation and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in the notes to the consolidated financial statements, effective January 1, 1992, the Company changed its method of accounting for postretirement benefits other than pensions and for income taxes. Arthur Andersen & Co. Washington, D.C., January 27, 1994 II - 56 Item 9.	Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None II - 57 PART III Item 10.	Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The section entitled "Election of Directors" appearing on pages four through seven of the Registrant's proxy statement for the annual meeting of stockholders to be held on May 3, 1994 sets forth certain information with respect to the directors and nominees for election as directors of the Registrant and is incorporated herein by reference. Certain information with respect to persons who are or may be deemed to be executive officers of the Registrant is set forth under the caption "Executive Officers of the Registrant" in Part I of this Annual Report. Information with respect to directors' and officers' compliance with Section 16(a) of the Securities Exchange Act of 1934 is set forth in the section entitled "Executive Compensation - Compliance with Section 16(a) of the Exchange Act" on page 16 of the Registrant's proxy statement referred to above. III - 1 Item 11.	Item 11. EXECUTIVE COMPENSATION The section entitled "Executive Compensation" appearing on pages seven through 16 of the Registrant's proxy statement for the annual meeting of stockholders to be held on May 3, 1994 sets forth certain information with respect to the compensation of management of the Registrant, and is incorporated herein by reference. III - 2 Item 12.	Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The sections entitled "Voting Securities", "Security Ownership of Certain Beneficial Owners" and "Security Ownership of Management" appearing on pages one through four and "Election of Directors" appearing on pages four through seven of the Registrant's proxy statement for the annual meeting of stockholders to be held on May 3, 1994 set forth certain information with respect to the ownership of the Registrant's voting securities, and are incorporated herein by reference. III - 3 Item 13.	Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The sections entitled "Executive Compensation - Indebtedness of Management" and "Executive Compensation - Transactions with Management and Others" appearing on pages 15 and 16 of the Registrant's proxy statement for the annual meeting of stockholders to be held on May 3, 1994 set forth certain information with respect to relations of and transactions by management of the Registrant, and are incorporated herein by reference. III - 4 PART IV Item 14.	Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) The following documents are filed as part of this Annual Report: 1. Financial Statements Consolidated Financial Statements filed as part of this Form 10-K are listed under Part II, Item 8 of this Form 10-K. 2. Financial Statement Schedules and Report of Independent Public Accountants IV - 1 Schedules I, III, IV, VII, XI, XII and XIII have been omitted because they are not applicable or the information is included in the consolidated financial statements. Column and line items not included in certain schedules have been omitted because the information is not applicable. IV - 2 IV - 3 IV - 4 IV - 5 IV - 6 CONSOLIDATED SUPPORTING SCHEDULES IV - 7 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Lafarge Corporation: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements of Lafarge Corporation included in this Form 10-K and have issued our report thereon dated January 27, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The consolidated schedules (Schedules II, V, VI, VIII and X) are the responsibility of the company's management and are presented for the purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These consolidated schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state 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 & CO. Washington, D.C., January 27, 1994. IV - 8 SCHEDULE II LAFARGE CORPORATION AND SUBSIDIARIES CONSOLIDATED AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES Years Ended December 31, 1993, 1992 and 1991 IV - 9 (1) Represents a non-interest bearing house loan to an officer or employee of the Registrant. Principal is to be repaid monthly at a rate of 5 percent per year. Term of the loan is for twenty years and the loan is secured by a second mortgage on the individual's house. (2) Represents a non-interest bearing house loan to an officer of the Registrant. Principal is to be repaid at a minimum of $3,750 per year, with balance due at maturity. Term of this loan is for twenty years and the loan is secured by a second mortgage on this individual's house. Effective 1-1-93, this employee retired and the house loan was paid in full in 1993. (3) Represents an non-interest bearing long-term house loan of Cdn $152,000 and a non-interest bearing short-term house loan of $38,488 to an officer of the Registrant. The long-term loan, which is secured by a second mortgage on the individual's house, carries a term of twenty years with annual principal repayments of 5 percent per year. The short-term loan was repaid in 1990. (4) Represents an interest-free, short-term house loan to an employee of the Registrant. (5) Represents an interest-free long-term house loan to an employee of the Registrant. Principal is to be repaid at the rate of Canadian $4,000 for the first three years, Canadian $6,349 for the next two years and Canadian $9,013 for the following fifteen years. The loan is secured by a second mortgage on the individual's house. (6) Represents a long-term, non-interest bearing house loan of Canadian $62,300 and an interest bearing long-term loan to an employee of the Registrant. The house loan, which is secured by a second mortgage on the individual's house, carries a term of twenty years, with principal repayments of 5 percent per year. The interest bearing long-term loan carries a term of fifteen years with monthly repayments of Canadian $672. (7) Represents a 1991 non-interest bearing, short-term loan of $319,633, which was repaid in 1991. 1992 includes an interest bearing, short-term loan of $329,842 and a non-interest bearing, long-term house loan of $65,000. The long-term house loan of $65,000 was repaid in 1993. The interest-bearing, short-term loan of $329,842 was replaced in 1993 with another short-term loan of $194,176 and two non-interest bearing, long-term house loans of $60,666 and $75,000. The loan of $194,176 was interest-bearing from November 1992 until July 1993. The $60,666 loan, which is secured by a second mortgage on the individual's house, carries a term of twenty years with annual principal repayments of 5 percent per year. The $75,000 loan, which is secured by a third mortgage on the individual's house, is payable when the individual's house is sold. (8) Canadian to U.S. foreign currency translation. IV - 10 LAFARGE CORPORATION AND SUBSIDIARIES SCHEDULE V CONSOLIDATED PROPERTY, PLANT AND EQUIPMENT Years Ended December 31, 1993, 1992 and 1991 (In Thousands) - -------------------------------- (1) Primarily represents transfers from construction in progress to the other components of fixed assets. (2) Includes adjustment for adoption of SFAS 109. IV - 11 LAFARGE CORPORATION AND SUBSIDIARIES SCHEDULE VI CONSOLIDATED ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT Years Ended December 31, 1993, 1992 and 1991 (In Thousands) - -------------------------------- (1) Includes adjustment for adoption of SFAS 109. IV - 12 SCHEDULE VIII LAFARGE CORPORATION AND SUBSIDIARIES CONSOLIDATED VALUATION AND QUALIFYING ACCOUNTS Years Ended December 31, 1993, 1992 and 1991 (In Thousands) - -------------------------------- (1) Primarily foreign currency translation adjustments. IV - 13 LAFARGE CORPORATION AND SUBSIDIARIES SCHEDULE X CONSOLIDATED SUPPLEMENTARY INCOME STATEMENT INFORMATION Years Ended December 31, 1993, 1992 and 1991 (In Thousands) IV - 14 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Annual Report to be signed on its behalf by the undersigned, thereunto duly authorized. LAFARGE CORPORATION By: /s/ JEAN-PIERRE CLOISEAU ---------------------------- Jean-Pierre Cloiseau, Senior Vice President and Chief Financial Officer Date: March 25, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this Annual Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated: IV - 15 IV - 16 INDEX OF EXHIBITS IV-17 INDEX OF EXHIBITS IV-18 INDEX OF EXHIBITS IV-19 INDEX OF EXHIBITS IV-20 INDEX OF EXHIBITS - ------------------------------------------------ * Filed herewith. IV-21
63276_1993.txt	63276	1993	Item 1. Business - ------- -------- The Company designs, develops, manufactures, markets and distributes a broad variety of toy products on a worldwide basis. Measured by revenues, the Company is the second largest toy company in the world. The Company's three strongest principal product lines are BARBIE fashion dolls and doll clothing and accessories, FISHER-PRICE toys and juvenile products and the Company's Disney- licensed toys, each of which has broad worldwide appeal. Additional current principal product lines consist of die-cast vehicles and accessories, including HOT WHEELS; large dolls; preschool toys, including SEE 'N SAY talking toys; and the UNO and SKIP-BO games. Revenues for 1993 of $2.7 billion were a record level for the Company. In November 1993, Fisher-Price, Inc. ("Fisher-Price") became a wholly- owned subsidiary of Mattel as a result of a merger transaction (the "Fisher- Price Merger"). See Note 2 to the Consolidated Financial Statements in the Annual Report to Shareholders for the year ended December 31, 1993 (the "Annual Report to Shareholders"), incorporated herein by reference and Item 4 "Submission of Matters to a Vote of Security Holders" below. As used herein, unless the context requires otherwise, "Mattel" refers to Mattel, Inc., and its subsidiaries other than Fisher-Price, and the "Company" refers to Mattel together with Fisher-Price. Mattel was incorporated in California in 1948 and reincorporated in Delaware in 1968. Its executive offices are located at 333 Continental Boulevard, El Segundo, California 90245-5012, telephone (310) 524-2000. Competition and Industry Background - ----------------------------------- Competition in the toy industry is based primarily on price, quality and play value. In recent years, the toy industry has experienced rapid consolidation driven, in part, by the desire of industry competitors to offer a range of products across a broader variety of categories. In the United States, the Company competes with several large toy companies, including Hasbro, Inc. and Tyco Toys, Inc. as well as a number of smaller toy companies. The larger toy companies have pursued a strategy of focusing on core product lines. Core product lines are lines which are expected to be marketed for an extended period of time, and which historically have provided relatively consistent growth in sales and profitability. By focusing on core product lines, toy manufacturers have been able to reduce their reliance on new product introductions and the associated risk and volatility. The juvenile products market, in which Fisher-Price is one of the leading companies, is more fragmented. The more significant competitors in this area include Gerry Baby Products Company, Century Products Company, Graco Children's Products, Inc., Cosco, Inc. and Evenflo Juvenile Furniture Company, Inc. The toy industry is also experiencing a shift toward greater consolidation of retail distribution channels, such as large specialty toy stores and discount retailers, including Toys R Us, Wal-Mart, Kmart and Target, which have increased their overall share of the retail market. This consolidation has resulted in an increasing reliance among retailers on the large toy companies because of their financial stability and their ability to support products through advertising and promotion and to distribute products on a national basis. These retailers' growing acceptance of electronic data interchange has provided toy manufacturers with an ability to more closely monitor consumers' acceptance of a particular product or product line. Over the last ten years, toy companies based in the United States have expanded their international marketing and manufacturing operations. The Company believes a strong international distribution system can add significantly to the sales volume of core product lines and extend the life cycles of newly-developed products. Seasonality - ----------- Sales of toy products at retail are seasonal, with a majority of retail sales occurring during the period from September through December. Consequently, shipments of toy products to retailers are greater in the third and fourth quarters than in each of the first and second quarters. As the large toy retailers become more efficient in their control of inventory levels, this seasonality is likely to increase. In anticipation of this seasonal increase in retail sales, the Company significantly increases its production in advance of the peak selling period, resulting in a seasonal build-up of inventory levels. In addition, the Company and others in the industry develop sales programs, including offering extended payment terms, to encourage retailers to purchase merchandise earlier in the year. These sales programs, coupled with seasonal shipping patterns, result in significant peaks in the third and fourth quarters in the respective levels of inventories and accounts receivable, which contribute to a seasonal working capital financing requirement. See "Seasonal Financing." Products - -------- The Company has been able to record consistent sales and earnings growth by focusing on a number of core product lines supplemented by various new product introductions. The Company's three strongest core product lines are BARBIE fashion dolls and doll clothing and accessories, FISHER-PRICE toys and juvenile products, and the Company's Disney-licensed toys, each of which has broad worldwide appeal. Additional current core product lines consist of die-cast vehicles and accessories, including HOT WHEELS; large dolls; preschool toys, including SEE 'N SAY talking toys; and the UNO and SKIP-BO games. Core product lines are expected to be marketed for an extended period of time and historically have provided relatively consistent growth in sales and profitability. For the year ended December 31, 1993, core products accounted for approximately 86% of sales. In order to provide greater flexibility in the manufacture and delivery of products, and as part of a continuing effort to reduce manufacturing costs, the Company has concentrated production of most of its core products in Company-owned facilities and generally uses independent contractors for the production of non-core products. With respect to new product introductions, the Company's strategy is to begin production on a limited basis until a product's initial success has been proven in the marketplace. The production schedule is then modified to meet anticipated demand. The Company further limits its risk by generally having independent contractors manufacture new product lines in order to minimize capital expenditures associated with new product introductions. This strategy has reduced inventory risk and significantly limited the potential loss associated with new product introductions. New product introductions in 1993 included the HOLLYWOOD HAIR BARBIE doll and the MY SIZE BARBIE doll, the addition of a series of dolls based on the animated feature "Snow White and the Seven Dwarfs" to the Company's Disney line, the BABY WALK 'N ROLL and SALLY SECRETS large dolls and the addition of the ATTACK PACK line of monster trucks to the Company's HOT WHEELS line. The Company also introduced a line of activity toys called McDONALD'S HAPPY MEAL MAGIC. New product introductions in 1994 will include the Gymnast BARBIE, Bedtime BARBIE and DR. BARBIE dolls; Fisher-Price's new plush RUMPLE BEARS, TRIPLE ARCADE electronic game, and electronic learning toys; the additions of COLOR FX and HOT WHEELS TOP SPEED PIPEJAMMER vehicles to the HOT WHEELS line; and the addition to the Company's Disney line of a series of plush products, action figures and small dolls based on the animated feature "The Lion King". The Company also will introduce a new line of large dolls called DREAMLAND Babies, and Nickelodeon THINGMAKER, a new activity toy. In conjunction with the release of the feature film "The Flintstones," the Company will introduce a line of small dolls, large dolls, action figures and accessories. International Operations - ------------------------ Revenues from the Company's international operations represented approximately 40% of total consolidated revenues in 1993. Products which are developed and marketed successfully in the United States typically generate incremental sales and profitability when marketed through the Company's international distribution network. Generally, products marketed internationally are the same as those marketed domestically, although some are developed or adapted for particular international markets. The Company sells its products directly through its wholly-owned subsidiaries in Australia, Austria, the Benelux countries, Canada, Chile, France, Germany, Greece, Italy, Japan, Mexico, Scandinavia, Spain, Switzerland, the United Kingdom and in certain areas of Eastern Europe and Asia. In 1994, the Company will begin selling its products directly in Argentina, Portugal and Venezuela through newly established subsidiaries. In addition to direct sales, the Company sells principally through distributors in Central and South America, the Middle East, South Africa and Southeast Asia. It also licenses some of its products to other toy companies for sale in various other countries. Until December 1993, Mattel also distributed the Nintendo Entertainment System and related products in Australia. See "Licenses and Distribution Agreements." The strength of the U.S. dollar relative to other currencies can significantly affect the revenues and profitability of the Company's international operations. The Company hedges intercompany purchases and sales of inventory in order to protect local cash flows and profitability from currency fluctuations. See "Foreign Currency Contracts." For financial information by geographic area, see Note 8 to the Consolidated Financial Statements in the Annual Report to Shareholders, incorporated herein by reference. Product Design and Development - ------------------------------ Through its product design and development group, the Company regularly refreshes, redesigns and extends existing product lines and develops innovative new product lines. The Company's success is dependent on its ability to continue this activity. Product design and development are principally conducted by a group of professional designers and engineers employed by the Company. License agreements with third parties permit the Company to utilize the name, character or product of the licensor in its product line. A principal licensor is The Walt Disney Company, which licenses many of its characters for use on the Company's products. The Company also has entered into license agreements with, among others, McDonald's, Inc., MCA Universal Merchandising, Inc., the Time Warner Entertainment Company, L.P. and DC Comics, Inc. units of Time Warner Inc., LucasArts Entertainment Company, Turner Home Entertainment, Inc., Hanna-Barbera Productions, Inc., American Greeting Cards, Inc., Children's Television Workshop, and Viacom International, Inc. relating to its Nickelodeon properties. A number of these licenses relate to product lines that are significant to the Company. Independent toy designers and developers bring products to the Company and are generally paid a royalty on the net sales price of products licensed by the Company. These independent toy designers may also create different products for other toy companies. The Company devotes substantial resources to product design and development. During the years ended December 31, 1993, December 31, 1992 and December 31, 1991, the Company expended approximately $75 million, $77 million and $56 million, respectively, in connection with the design and development of products, exclusive of royalty payments. Advertising and Promotion - ------------------------- The Company supports its product lines with extensive advertising and consumer promotions. Advertising continues at varying levels throughout the year and peaks during the Christmas season. Advertising includes television and radio commercials and magazine and newspaper ads. Promotions include in-store displays, coupons, merchandising materials and major events focusing on products and tie-ins with various consumer product companies. To further promote the Company and its products, the Company participates in the attractions "It's A Small World" at Disneyland and Disney World and "Autopia" at Euro Disneyland under a ten-year agreement with The Walt Disney Company. The Company also participates in toy stores in Disneyland and in the Disney Village Market Place near Disney World and commenced participation in a new toy store in Euro Disneyland in December 1993. Separately, the Company has established a total of six BARBIE Boutiques in F.A.O. Schwarz toy stores, including the "BARBIE on Madison" boutique at the F.A.O. Schwarz flagship store in New York City. During the years ended December 31, 1993, December 31, 1992 and December 31, 1991, Mattel spent approximately $427 million (16% of net sales), $403 million (16% of net sales) and $308 million (15% of net sales), respectively, on worldwide advertising and promotion. Marketing and Sales - ------------------- The Company's toy products are sold throughout the world. In the United States, the Company's products are distributed directly to large retailers, including discount and free-standing toy stores, chain stores and department stores, and other retail outlets and, to a limited extent, to wholesalers. Discount and free-standing toy stores continue to increase their market share. During the year ended December 31, 1993, Toys R Us and Wal-Mart accounted for approximately 22% and 10%, respectively, of worldwide consolidated net sales and were the only customers accounting for 10% or more of consolidated net sales. In general, the Company's major domestic and international customers review its product lines and product concepts for the upcoming year at showings beginning in late summer. The Company also participates in the domestic and international toy industry trade fairs in the first quarter of the year. A majority of the full-year orders are received by May 1. As is traditional in the toy industry, these orders may be canceled at any time before they are shipped. Historically, the greater proportion of shipments of products to retailers occurs during the third and fourth quarters of the year. See "Seasonality." Through its marketing research department, the Company conducts basic consumer research and product testing and monitors demographic factors and trends. This information assists the Company in evaluating consumer acceptance of products, including an analysis of increasing or decreasing demand for its products. The Company bases its production schedules on customer orders, modified by historical trends, results of market research and current market information. The actual shipments of products ordered and the order cancellation rate are affected by consumer acceptance of the product line, the strength of competing products, marketing strategies of retailers and overall economic conditions. Unexpected changes in these factors can result in a lack of product availability or excess inventory in a particular product line. Manufacturing - ------------- The Company's products are manufactured in Company facilities and by independent contractors. Products are also purchased from unrelated entities that design, develop and manufacture the products. In order to provide greater flexibility in the manufacture and delivery of products, and as part of a continuing effort to reduce manufacturing costs, the Company has concentrated production of most of its core products in the Company's facilities and generally uses independent contractors for the production of non-core products. As a result of the Fisher-Price Merger, Mattel acquired manufacturing facilities in the states of Kentucky and New York, and in England and Mexico, which are in addition to its existing manufacturing facilities in the Far East (China, Indonesia and Malaysia), Mexico and Italy. The Company also utilizes independent contractors to manufacture products in the United States, the Far East and Australia. To protect the stability of its product supply, the Company produces many of its key products in more than one facility. Foreign countries in which the Company's products are manufactured (principally China, Indonesia, Malaysia and Mexico) currently enjoy "most favored nation" ("MFN") status under U.S. tariff laws, which provides the most favorable category of U.S. import duties. As a result of conditions in China, there has been, and may be in the future, opposition to the extension of MFN status for China. In May 1993, President Clinton signed an executive order extending MFN status for China through June 3, 1994. The loss of MFN status for China would result in a substantial increase in the import duty for toys manufactured in China and imported into the United States and would result in increased costs for the Company and others in the toy industry. The impact of such an event on the Company would be significantly mitigated by the Company's ability to source product for the U.S. market from countries other than China and ship product manufactured in China elsewhere. Toward that end, the Company has extended its production capacity in other countries. In addition, all of the manufacturing facilities gained by the Company in the Fisher-Price Merger are outside of China, although some Fisher-Price product is sourced in China. A number of other factors, including the Company's ability to pass along the added costs through price increases and the pricing policies of vendors in China, could further mitigate the impact of a loss of China's MFN status. On February 8, 1994, the European Union ("EU") adopted quotas on the importation of certain classes of toys (as well as other products) manufactured in China, although regulations implementing the quotas have yet to be promulgated. The Company expects that the impact of these quotas on its business will be significantly mitigated by shifts in demand in favor of toy categories not subject to the quotas, and by the ability of the Company to source product for the EU from countries other than China and ship product manufactured in China elsewhere. The Company does not currently expect that these quotas will have a material effect on its business. Commitments - ----------- In the normal course of business, the Company enters into contractual arrangements for future purchases of goods and services to ensure availability and timely delivery, and to obtain and protect the right to create and market certain toys. Such arrangements include commitments for future inventory purchases and royalty payments pursuant to licensing agreements. Certain of these purchase agreements and licenses contain provisions for guaranteed or minimum payments during the terms of the contracts and licenses. See "Management's Discussion and Analysis of Results of Operations and Financial Condition--Commitments" and Note 7 to the Consolidated Financial Statements in the Annual Report to Shareholders, incorporated herein by reference. Licenses and Distribution Agreements - ------------------------------------ The Company's level of licensing activity has expanded in recent years. Royalties paid to licensors during the years ended December 31, 1993, December 31, 1992 and December 31, 1991 were approximately $69 million, $50 million and $39 million, respectively. The Company also distributes products which are independently designed and manufactured. The Company's agreement for the distribution of the Nintendo Entertainment System and related products in Australia was terminated in December 1993. Foreign Currency Contracts - -------------------------- From time to time, the Company enters into foreign currency forward exchange contracts, swaps and options as hedges of inventory purchases and sales and various other intercompany transactions. The contracts are intended to fix a portion of the Company's product cost and intercompany cash flows, and thereby moderate the impact of currency fluctuations. The Company does not speculate in foreign currencies. For additional information regarding foreign currency contracts, see Note 7 to the Consolidated Financial Statements in the Annual Report to Shareholders, incorporated herein by reference. Seasonal Financing - ------------------ The Company's financing of seasonal working capital typically grows throughout the first half of the year and peaks in the third or fourth quarter, when accounts receivable are at their highest due to increased sales volume and Company sales programs, and when inventories are at their highest in anticipation of expected second half sales volume. See "Seasonality." Borrowings for seasonal financing are generally repaid in full by year-end from cash flows generated in the fourth quarter from sales and collection of accounts receivable. To finance its working capital requirements, the Company maintains and periodically revises or replaces a revolving credit agreement with a commercial bank group. The agreement in effect during 1993, which was recently replaced (see below), was amended in the first quarter of 1993 to increase the total facility to $350 million from $250 millon and to release the banks' lien on Mattel's inventory and receivables. Within the total facility, up to $175.0 million was a standard revolving credit line available for either advances or letters of credit in support of commercial paper issuances. Interest was charged at alternative rates selected by Mattel not greater than the prime rate charged by the agent bank, plus a commitment fee of 3/8 of one percent of the unused line available for advances and 1/2 of one percent of the amount utilized for standby letters of credit. The remaining $175.0 million was available for nonrecourse purchases of certain trade accounts receivable of Mattel by the commercial bank group providing the credit line. The agreement required Mattel to comply with certain consolidated financial ratios and to maintain certain levels of income. In 1993, the Company's domestic seasonal borrowings outstanding under the revolving credit agreement and other bank borrowings averaged approximately $45.1 million and reached a peak of approximately $167.0 million during the third quarter. This balance was fully repaid by December 31, 1993. The Company's 1993 seasonal borrowings outstanding under foreign credit lines averaged approximately $55.1 million, reached a peak of approximately $76.1 million in the third quarter, and were also fully repaid by year end. Effective in March 1994, the Company renegotiated its revolving credit agreement. The new agreement consists of unsecured facilities providing a total of $500.0 million in seasonal financing from the same group of commercial banks. The facilities provide for up to $250.0 million in advances and backup for commercial paper issuances ($125.0 million of which is a 364-day facility and the other $125.0 million is a 3-year facility), and up to an additional $250.0 million (a 3-year facility) for nonrecourse purchases of certain trade accounts receivable by the bank group. In connection with the agreement, the Company is to comply with certain consolidated financial covenants for debt-to-capital, interest coverage and tangible net worth levels. Concurrently with the consummation of the Fisher-Price Merger, the Fisher- Price domestic seasonal credit line was terminated with a view to financing Fisher- Price's domestic seasonal working capital needs under Mattel's revolving credit agreement. During 1994, the Company expects to finance Fisher-Price's foreign seasonal working capital needs under Mattel's seasonal credit facilities and to terminate Fisher-Price's foreign seasonal credit lines. Borrowings for seasonal financing were significantly reduced in 1993 primarily as a result of a higher level of cash at the beginning of the year, the issuance by the Company in May 1993 of $100 million aggregate principal amount of 6-3/4% Notes due 2000 and the utilization of the Company's accounts receivable sales facility. The Company believes the amounts available to it under its revolving credit agreement and its foreign credit lines will be adequate to meet its seasonal financing requirements. Raw Materials - ------------- Packaging materials, most plastics and zinc essential to the production and marketing of toy products are currently in adequate supply. These and other raw materials are generally available from a number of suppliers. Trademarks, Copyrights, and Patents - ----------------------------------- Most of the Company's products are sold under trademarks, trade names and copyrights and a number of those products incorporate patented devices or designs. Trade names and trademarks are significant assets to the Company in that they provide product recognition and acceptance worldwide. The Company customarily seeks patent, trademark or copyright protection covering its products, and it owns or has applications pending for United States and foreign patents covering many of its products. A number of these trademarks and copyrights relate to product lines that are significant to the Company and the Company believes its rights to these properties are adequately protected. The Company also licenses various of its trademarks, characters and other property rights to others for use in connection with the sale by others of non-toy products and other products which do not compete with the Company's products. Government Regulations - ---------------------- The Company's toys are subject to the provisions of the Consumer Product Safety Act, the Federal Hazardous Substances Act and the Flammable Fabrics Act, and the regulations promulgated thereunder. The Consumer Product Safety Act and the Federal Hazardous Substances Act enable the Consumer Product Safety Commission (the "CPSC") to exclude from the market consumer products that fail to comply with applicable product safety regulations or otherwise create a substantial risk of injury, and articles that contain excessive amounts of a banned hazardous substance. The Flammable Fabrics Act enables the CPSC to regulate and enforce flammability standards for fabrics used in consumer products. The CPSC may also require the repurchase by the manufacturer of articles which are banned. Similar laws exist in some states and cities and in various international markets. Fisher-Price's car seats are subject to the provisions of the National Highway Transportation Safety Act, which enables the National Highway Traffic Safety Administration ("NHTSA") to promulgate performance standards for child restraint systems. Fisher-Price conducts periodic tests to ensure that its child restraint systems meet applicable standards. A Canadian agency, Transport Canada, also regulates child restraint systems sold for use in Canada. As with the CPSC, NHTSA and Transport Canada can require the recall and repurchase or repair of products which do not meet their respective standards. The Company maintains a quality control program to ensure product safety compliance with the various federal, state and international requirements. Effects of Inflation - -------------------- Inflation rates in the U.S. and major foreign countries in which the Company operates have not had a significant impact on operating results for the three years ended December 31, 1993. The U.S. Consumer Price Index increased 2.7% in 1993, 2.9% in 1992 and 3.1% in 1991. The Company is afforded some protection from the impact of inflation as a result of high turnover of inventories and benefitted from inflation on the repayment of fixed-rate liabilities during these periods. Employees - --------- The total number of persons employed by the Company and its subsidiaries at any one time varies because of the seasonal nature of its manufacturing operations. At December 31, 1993, the Company's total number of employees, including its international operations, was approximately 21,000. Executive Officers of the Registrant - ------------------------------------ The executive officers of the Company, all of whom are appointed annually by the Board of Directors and serve at the pleasure of the Board, are as follows: Mr. Amerman has been Chairman of the Board & Chief Executive Officer since February 1987 and a member of the Board of Directors since November 1985. Prior to that he served as President of Mattel International. Ms. Barad has been President & Chief Operating Officer since August 1992 and a member of the Board of Directors since November 1991. From December 1989 until August 1992, she was President, Mattel USA. Prior to that she served in various executive positions in the Marketing, Product Design and Product Development areas. Mr. Eskridge has been a member of the Board of Directors since February 1993 and President of Fisher-Price, Inc. since November 1993. Prior to that he was Executive Vice President & Chief Financial Officer of Mattel, Inc. Mr. Gandolfo has been President, Mattel Operations, since April 1990. Prior to that he was General Manager of Manufacturing, Thompson Consumer Electronics. Mr. Williams has been a member of the Board of Directors since November 1991 and has been President, Mattel International for more than five years. Mr. McCafferty has been Executive Vice President & Chief Financial Officer since November 1993. From June 1993 to November 1993 and from November 1985 to October 1992 he was Senior Vice President & Treasurer. During the period from October 1992 to June 1993, he was Senior Vice President & Controller. Mr. McKay has been Senior Vice President, Human Resources and Administration since November 1993. From December 1991 until November 1993 he was Vice President, Human Resources. He was Senior Director Human Resources from March 1991 to December 1991. Prior to that he was Vice President Human Resources-Administration of Mileage Plus, Inc. Mr. Mansour has been Senior Vice President, General Counsel & Secretary since February 1993. From May 1992 until February 1993 he was Senior Vice President & General Counsel and from April 1991 until May 1992 he was Vice President & Associate General Counsel. Prior to that he was Vice President & Assistant General Counsel. Mr. Rolfes has been Senior Vice President & Controller since November 1993. From June 1993 to November 1993 he was Vice President & Controller. Prior to that he held various executive positions within the finance department. Mr. Stavro has been Vice President & Treasurer since November 1993. From March 1992 to November 1993 he was Vice President and Assistant Treasurer. Prior to that he was Assistant Treasurer for more than five years. Item 2.		Item 2. Properties - ------- ---------- The Company owns its corporate headquarters consisting of approximately 335,000 square feet in El Segundo, California. The facility is subject to a $45 million mortgage. The Company also leases two buildings in El Segundo which consist of a total of approximately 250,000 square feet for its design and development and audio-visual departments. The Company maintains sales offices in California, Illinois, New York and Texas and warehouse and distribution facilities in California and Texas. The Company owns a computer facility in Phoenix, Arizona. Internationally, the Company has offices and/or warehouse space in Argentina, Australia, Belgium, Canada, Chile, Denmark, France, Germany, Greece, Hong Kong and in certain other areas of Asia, Italy, Japan, The Netherlands, Spain, Switzerland and the United Kingdom. The Company's principal manufacturing facilities, including the Fisher-Price facilities, are located in China, Indonesia, Italy, Malaysia, Mexico, the United Kingdom and the United States. See "Manufacturing." Most of the Company's facilities are occupied under long-term leases and, for the most part, are fully utilized, although excess manufacturing capacity exists from time to time based on product mix and demand. With respect to leases which are scheduled to expire during the next twelve months, the Company may negotiate new lease agreements, renew leases or utilize alternative facilities. As a result of the Fisher-Price Merger, Mattel acquired the approximately 288,000 square foot Fisher-Price headquarters building and a second smaller office building in East Aurora, New York and manufacturing, distribution and warehousing facilities in Kentucky, New York, Tennessee, Belgium, Canada, Mexico and the United Kingdom. In addition, Fisher-Price owns or leases office and showroom space in New York, Texas, Belgium, Canada, Denmark, France, Germany, Hong Kong, Italy, Mexico and the United Kingdom. The Company is currently in the process of evaluating the desirability of maintaining certain of these facilities and expects to sell, sublease or not renew the leases of those facilities which are vacant, underutilized or redundant of Mattel facilities. Item 3.	Item 3. Legal Proceedings - ------- ----------------- The Company's Fisher-Price subsidiary has executed a consent order with the State of New York involving a remedial action/feasibility study for voluntary cleanup of contamination at one of its manufacturing plants. The ultimate liability associated with this cleanup presently is estimated to be less than $850,000. The Company is involved in various litigation and other legal matters which are being defended and handled in the ordinary course of business. None of these matters is expected to result in outcomes having a material adverse effect on the Company's liquidity, operating results or consolidated financial position. Item 4.	Item 4. Submission of Matters to a Vote of Security Holders - ------ --------------------------------------------------- A Special Meeting of Stockholders of Mattel was held on November 30, 1993 to consider the three proposals described below. Proxies for the meeting were solicited pursuant to Regulation 14A of the Securities Exchange Act of 1934, as amended, and there was no solicitation in opposition to that of management. Each of the proposals was approved based upon the respective tallies of votes set forth below. Proposal 1: To approve the issuance of shares of Mattel common stock in connection with the Agreement and Plan of Merger, dated as of August 19, 1993, among Mattel, MAT Acquisition, Inc., a wholly-owned subsidiary of Mattel ("Sub"), and Fisher-Price pursuant to which (i) Sub was merged into Fisher-Price and Fisher-Price became a wholly-owned subsidiary of Mattel, and (ii) each outstanding share of Fisher-Price common stock (other than shares owned by Fisher-Price as treasury stock or by its subsidiaries or by Mattel or its subsidiaries, all of which were canceled), were converted into 1.275 shares of Mattel common stock, including the corresponding percentage of rights to purchase Mattel's Series E Junior Participating Preference Stock. Votes Cast Votes Cast Votes Broker For Against Abstaining Non-votes ---------- ---------- ---------- --------- 76,565,585 761,611 155,626 6,753,524 Proposal 2: To approve an amendment to the Amended & Restated Certificate of Incorporation of Mattel to increase the number of shares of common stock authorized to be issued from 150,000,000 to 300,000,000. Votes Cast Votes Cast Votes Broker For Against Abstaining Non-votes ---------- ---------- ---------- --------- 80,704,897 2,741,169 790,280 0 Proposal 3: To approve an amendment to the Mattel 1990 Stock Option Plan to increase, above the 1% limitation set forth in the plan, the amount of capital stock that may be the subject of awards granted wholly or partly in stock in 1993 by 3,000,000 shares of capital stock (with any such capital stock which is not the subject of awards in 1993 to be carried forward and available for awards in succeeding calendar years). Votes Cast Votes Cast Votes Broker For Against Abstaining Non-votes ---------- ---------- ---------- --------- 64,197,291 12,446,002 839,528 6,753,525 PART II ------- Item 5.	Item 5. Market for the Registrant's Common Equity and Related - ------- Stockholder Matters ----------------------------------------------------- For information regarding the markets in which the Company's common stock is traded, see the cover page hereof, and for information regarding the high and low sales prices of the Company's common stock for the last two calendar years, see Note 9 to the Consolidated Financial Statements in the Annual Report to Shareholders, incorporated herein by reference. As of March 18, 1994, the Company had approximately 40,000 holders of record of its common stock. In April 1992 the Company paid a dividend of $0.026 per share of common stock. The Company paid per share dividends of $0.040 in July and October of 1992 and in January and April of 1993. In each of July and October of 1993 and January of 1994, the Company paid dividends of $0.048 per share. The dividends have been adjusted to reflect a three-for-two stock split and a five-for-four stock split which the Company declared on its common stock to holders of record on May 18, 1992 and December 17, 1993, respectively. Item 6.	Item 6. Selected Financial Data - ------- ----------------------- The information under the caption "Five-Year Financial Summary" on page 27 in the Annual Report to Shareholders is incorporated herein by reference. Item 7.	Item 7. Management's Discussion and Analysis of Results of Operations - ------- and Financial Condition ------------------------------------------------------------- The information under the caption "Management's Discussion and Analysis of Results of Operations and Financial Condition" on pages 28 through 31 in the Annual Report to Shareholders is incorporated herein by reference. Item 8.	Item 8. Financial Statements and Supplementary Data - ------- ------------------------------------------- The consolidated financial statements of Mattel, Inc. and Subsidiaries, together with the report of Price Waterhouse dated February 8, 1994, included on pages 32 through 51 in the Annual Report to Shareholders are incorporated herein by reference. 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 - --------- -------------------------------------------------- Information required under this Item relating to members of the Board of Directors is incorporated by reference herein from the Company's 1994 Notice of Annual Meeting of Stockholders and Proxy Statement. The information with respect to executive officers of the Company appears under the heading "Executive Officers of the Registrant" in Part I herein. Item 11.	Item 11. Executive Compensation - -------- ---------------------- The information required under this Item is incorporated by reference herein from the Company's 1994 Notice of Annual Meeting of Stockholders and Proxy Statement. Item 12.	Item 12. Security Ownership of Certain Beneficial Owners and - -------- Management --------------------------------------------------- The information required under this Item is incorporated by reference herein from the Company's 1994 Notice of Annual Meeting of Stockholders and Proxy Statement. Item 13.	Item 13. Certain Relationships and Related Transactions - -------- ---------------------------------------------- The information required under this Item is incorporated by reference herein from the Company's 1994 Notice of Annual Meeting of Stockholders and Proxy Statement. PART IV ------- Item 14.	Item 14. Exhibits, Financial Statements, and Reports on Form 8-K - -------- ------------------------------------------------------- (a) The following documents are filed as part of this report: Annual Report Page Number(1) ------------- (1) Financial Statements Consolidated Balance Sheets as of 32-33 December 31, 1993 and December 31, 1992 Consolidated Results of Operations for 34 the years ended December 31, 1993, December 31, 1992 and December 31, 1991 Consolidated Statements of Cash Flows for 35 the years ended December 31, 1993, December 31, 1992 and December 31, 1991 Consolidated Statements of Shareholders' 36 Equity for the years ended December 31, 1993, December 31, 1992 and December 31, 1991 Notes to Consolidated Financial Statements 37-50 Report of Price Waterhouse, Independent Accountants 51 to the Company (1) Incorporated by reference from the indicated pages of the Annual Report to Shareholders for the year ended December 31, 1993. With the exception of the information incorporated by reference in Items 1, 5, 6, 7, 8 and 14 of this report, the Annual Report to Shareholders is not deemed filed as part of this report. REPORT OF INDEPENDENT ACCOUNTANTS --------------------------------- To the Board of Directors and Stockholders of Fisher-Price, Inc. We have audited the consolidated balance sheet of Fisher-Price, Inc. and subsidiaries as of January 3, 1993, and the related consolidated statements of income, stockholder's equity and cash flows for the fiscal year then ended. We have also audited the financial statement schedules. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Fisher-Price, Inc. and subsidiaries as of January 3, 1993, and the consolidated results of their operations and their cash flows for the fiscal year then ended in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. /s/ Coopers & Lybrand - --------------------- Boston, Massachusetts February 4, 1993 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ---------------------------------------- To the Board of Directors and Stockholders of Fisher-Price, Inc.: We have audited the consolidated statement of income, stockholders' equity and cash flows of Fisher-Price, Inc. (a Delaware Corporation) and subsidiaries for the six months ended December 29, 1991, prior to the restatement (and, therefore, are not presented herein) for the merger between Mattel, Inc. and Fisher-Price, Inc. as described in Note 2 to the Mattel, Inc. and subsidiaries consolidated financial statements included in Mattel, Inc.'s Form 10-K as of December 31, 1993. Fisher-Price, Inc.'s consolidated financial statements and schedules related thereto referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on Fisher-Price, Inc.'s consolidated financial statements and schedules based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the results of operations and cash flows of Fisher-Price, Inc. and subsidiaries for the six months ended December 29, 1991, in conformity with generally accepted accounting principles. Our audit was made for the purpose of forming an opinion on the basic financial statements prior to the restatement, taken as a whole. The schedules, prior to the restatement (and therefore, not presented herein), listed in Part IV, Item 14(a)2 are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. Fisher-Price, Inc.'s schedules, prior to restatement, have been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements, prior to restatement, taken as a whole. /s/ ARTHUR ANDERSEN & CO. - ------------------------- Rochester, New York February 11, 1992 (2) Financial Statement Schedules for the years ended December 31, 1993, December 31, 1992 and December 31, 1991 (1) Schedule II - Amounts Receivable from Related Parties and Underwriters, Promoters, and Employees Other than Related Parties Schedule VIII - Valuation and Qualifying Accounts and Allowances (3) Exhibits (Listed by numbers corresponding to Item 601 of Regulation S-K) 2.0 Agreement and Plan of Merger, dated as of August 19, 1993, by and among the Company, MAT Acquisition, Inc. and Fisher-Price, Inc. (incorporated by reference from Exhibit 2.1 to the Company's Registration Statement on Form S-4, Registration Statement No. 33-50749) 3.0 Restated Certificate of Incorporation of the Company 3.1 By-laws of the Company, as amended to date (incorporated by reference to Exhibit 3.1 to the Company's Annual Report on Form 10-K for the year ended December 31, 1992) 4.0 Rights Agreement, dated as of February 7, 1992, between the Company and The First National Bank of Boston, as Rights Agent (incorporated by reference to Exhibit 1 to the Company's Registration Statement on Form 8-A, dated February 12, 1992) (The Company has not filed certain long-term debt instruments under which the principal amount of securities authorized to be issued does not exceed 10% of the total assets of the Company. Copies of such agreements will be provided to the Securities and Exchange Commission upon request.) 10.0 Credit Agreement (Multi-Year Facility) dated as of March 18, 1994 among the Company, the Banks named therein and Bank of America National Trust and Savings Association, as Agent (incorporated by reference to Exhibit 99.1 to the Company's Current Report on Form 8-K dated March 23, 1994) 10.1 Credit Agreement (364-Day Facility) dated as of March 18, 1994 among the Company, the Banks named therein and Bank of America National Trust and Savings Association, as Agent (incorporated by reference to Exhibit 99.2 to the Company's Current Report on Form 8-K dated March 23, 1994) (1) All other schedules are omitted because they are not applicable or the required information is shown in the financial statements or notes thereto. 10.2 Amended and Restated Transfer and Administration Agreement dated as of March 18, 1994 among the Company, Mattel Sales Corp., the Banks named therein and Nationsbank of Texas, N.A., as Agent (incorporated by reference to Exhibit 99.3 to the Company's Current Report on Form 8-K dated March 23, 1994) 10.3 Underwriting Agreement dated May 19, 1993 between the Company, Morgan Stanley & Co. Incorporated and Kidder, Peabody & Co. Incorporated 10.4 Stock Subscription Warrant dated as of June 28, 1991 between Fisher-Price and certain investors (incorporated by reference to Exhibit 4(c) to Fisher-Price's Report on Form 10-K for the transition period from July 1, 1991 to December 29, 1991) 10.5 Third Amended and Restated Credit Agreement dated as of March 19, 1993 among the Company, the Banks named therein, Bank of America National Trust and Savings Association, as Agent and Bank of America National Trust and Savings Association, as Collateral Agent ("Third Amended and Restated Credit Agreement") (incorporated by reference to Exhibit 99.1 to the Company's Current Report on Form 8-K dated September 29, 1993) 10.6 First Amendment to Third Amended and Restated Credit Agreement, dated as of July 19, 1993, among the Company, the Banks named therein, Bank of America National Trust and Savings Association, as Agent, and Bank of America National Trust and Savings Association, as Collateral Agent (incorporated by reference to Exhibit 99.2 to the Company's Current Report on Form 8-K dated September 29, 1993) 10.7 Second Amendment to Third Amended and Restated Credit Agreement, dated as of November 8, 1993, among the Company, the Banks named therein, Bank of America National Trust and Savings Association, as Agent and Bank of America National Trust and Savings Association, as Collateral Agent 10.8 Transfer and Administration Agreement, dated as of March 19, 1993, among Mattel Sales Corp., Mattel, Inc., the Banks named therein and Nationsbank of Texas, N.A., as Agent (incorporated by reference to Exhibit 99.3 to the Company's Current Report on Form 8-K dated September 29, 1993) 10.9 Underwriting Agreement dated July 31, 1992 between the Company, Morgan Stanley & Co. Incorporated and Kidder, Peabody & Co. Incorporated (incorporated by reference to Exhibit 10.5 to the Company's Annual Report on Form 10-K for the year ended December 31, 1992) Executive Compensation Plans and Arrangements of the Company - ------------------------------------------------------------ 10.10 Form of Indemnity Agreement between Mattel and its directors and certain of its executive officers (incorporated by reference to Exhibit B to Notice of Annual Meeting of Stockholders of the Company dated March 24, 1987) 10.11 Form of Employment Agreement between the Company and certain executive officers (incorporated by reference to Exhibit 10.6 of Amendment No. 1 of the Company's Annual Report on Form 10-K for the fiscal year ended December 26, 1987) 10.12 Form of Employment Agreement between the Company and certain executive officers (incorporated by reference to Exhibit 10.8 to the Company's Annual Report on Form 10-K for the year ended December 31, 1992) 10.13 Form of Amended & Restated Employment Agreement between the Company and certain executive officers 10.14 Mattel, Inc. 1993 Management Incentive Plan Highlights 10.15 Mattel, Inc. 1993 - 1995 Long-Term Incentive Plan Highlights (incorporated by reference to Exhibit 99.4 to the Company's Current Report on Form 8-K dated September 29, 1993) 10.16 Mattel, Inc. Financial Security Program Agreement for certain officers (incorporated by reference to Exhibit 10.7 of the Company's Registration Statement No. 2-95161 on Form S-1, filed January 7, 1985) 10.17 Form of Deferred Compensation Plan for Directors (incorporated by reference to Exhibit No. 10.11 of Amendment No. 1 of the Company's Annual Report on Form 10-K for the year ended December 26, 1987) 10.18 Mattel, Inc. 1990 Stock Option Plan (incorporated by reference to Exhibit A to the Notice of Annual Meeting of Stockholders and Proxy Statement of the Company dated March 15, 1990) 10.19 Amendment No. 1 to the Mattel, Inc. 1990 Stock Option Plan (incorporated by reference to the information under the heading "Amendment to Mattel 1990 Stock Option Plan" on page of the Joint Proxy Statement/Prospectus of the Company and Fisher-Price included in the Company's Registration Statement on Form S-4, Registration Statement No. 33-50749) 10.20 Form of Award Agreement evidencing award of stock appreciation rights granted pursuant to the Company's 1990 Stock Option Plan to certain executive officers of the Company ("Award Agreement") (incorporated by reference to Exhibit 10.12 to the Company's Annual Report on Form 10-K for the year ended December 31, 1991) 10.21 Form of First Amendment to Award Agreement 10.22 Form of Restricted Stock Award Agreement under the Mattel 1990 Stock Option Plan 10.23 Mattel, Inc. Supplemental Executive Retirement Plan (incorporated by reference to Exhibit 10.10 of the Company's Annual Report on Form 10-K for the fiscal year ended December 29, 1990) 10.24 Description of the Mattel, Inc. Deferred Compensation Plan for Officers (incorporated by reference to Exhibit 10.16 to the Mattel, Inc. Annual Report on Form 10-K for the year ended December 31, 1991) Executive Compensation Plans and Arrangements of Fisher-Price - ------------------------------------------------------------- 10.25 Form of Employment Agreement, dated August 16, 1993, between Fisher-Price and certain executive officers 10.26 Form of Employment Agreement, dated August 16, 1993, between Fisher-Price and an executive officer 10.27 Form of Employment Agreement, dated as of March 12, 1993, between Fisher-Price and Ronald J. Jackson (incorporated by reference to Exhibit 10(f)(1) to Fisher-Price's Annual Report on Form 10-K for the fiscal year ended January 3, 1993) 10.28 Form of Amendment, dated August 16, 1993, to Employment Agreement, dated as of March 12, 1993, between Fisher-Price and Ronald J. Jackson 10.29 Form of Employment Agreement, dated as of February 25, 1992, between Fisher-Price and certain executive officers (incorporated by reference to Exhibit 10(f)(2) to Fisher-Price's Form 10-K for the transition period from July 1, 1991 to December 29, 1991) 10.30 Deferred Compensation Plan for Outside Directors of Fisher-Price (incorporated by reference to Exhibit 10(g) to Fisher-Price's Registration Statement on Form 10 dated June 28, 1991) 10.31 Fisher-Price Long-Term Incentive Plan of 1991 (incorporated by reference to Exhibit 10(h) to Fisher-Price's Registration Statement on Form 10 dated June 28, 1991) 10.32 Fisher-Price Executive Incentive Bonus Plan (incorporated by reference to Exhibit 10(i) to Fisher-Price's Registration Statement on Form 10 dated June 28, 1991) 10.33 First Amendment to Executive Incentive Bonus Plan, dated as of February 12, 1992 (incorporated by reference to Exhibit 10(i)(1) to Fisher-Price's Report on Form 10-K for the transition period from July 1, 1991 to December 29, 1991) 10.34 The Fisher-Price Management Incentive Bonus Plan (incorporated by reference to Exhibit 10(j) to Fisher-Price's Registration Statement on Form 10 dated June 28, 1991) 10.35 Fisher-Price Matching Savings Plan (incorporated by reference to Exhibit 10(k) to Fisher-Price's Registration Statement on Form 10 dated June 28, 1991) 10.36 The Fisher-Price Pension Plan (1989 Restatement) (incorporated by reference to Exhibit 10(l) to Fisher-Price's Registration Statement on Form 10 dated June 28, 1991) 10.37 The Fisher-Price Profit Sharing and Retirement Savings Plan (1989 Restatement) (incorporated by reference to Exhibit 10(m) to Fisher-Price's Registration Statement on Form 10 dated June 28, 1991) 10.38 The Fisher-Price Deferral and Compensation Adjustment Benefit Plan (incorporated by reference to Exhibit 10(o) to Fisher-Price's Registration Statement on Form 10 dated June 28, 1991) 10.39 The Fisher-Price Salaried Employees Compensation and Benefits Protection Plan (incorporated by reference to Exhibit 10(p) to Fisher-Price's Registration Statement on Form 10 dated June 28, 1991) 11.0 Computation of Income per Common and Common Equivalent Share 13.0 Pages 27 through 53 of the Mattel, Inc. Annual Report to Shareholders for the year ended December 31, 1993 21.0 Subsidiaries of the Registrant 23.0 Consent of Price Waterhouse 23.1 Consent of Arthur Andersen & Co. 23.2 Consent of Coopers & Lybrand 24.0 Power of Attorney (on page 28 of Form 10-K) (b) Reports on Form 8-K Mattel, Inc. filed the following Current Reports on Form 8-K during the quarterly period ended December 31, 1993 Financial Date of Report Items Reported Statements Filed ------------------ -------------- ---------------- September 29, 1993 7 None October 18, 1993 5, 7 None November 3, 1993 5, 7 None November 30, 1993 5, 7 None (c) Exhibits Required by Item 601 of Regulation S-K See Item (3) above (d) Financial Statement Schedules Schedule II - Amounts Receivable from Related Parties and Underwriters, Promoters, and Employees Other than Related Parties Schedule VIII - Valuation and Qualifying Accounts and Allowances Copies of Form 10-K (which includes Exhibit 24.0), Exhibits 11.0, 13.0, 21.0, 23.0, 23.1, 23.2, and the Annual Report to Shareholders are available to stockholders of the Company without charge. Copies of other Exhibits can be obtained by stockholders of the Company upon payment of ten cents per page for such Exhibits. Written requests should be sent to Secretary, Mattel, Inc., 333 Continental Boulevard, El Segundo, California 90245-5012. SIGNATURES ---------- Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. MATTEL, INC. Registrant By: /s/ Gary P. Rolfes ----------------------- Gary P. Rolfes Senior Vice President & Date: As of March 24, 1994 Controller -------------------- POWER OF ATTORNEY ----------------- We, the undersigned directors and officers of Mattel, Inc. do hereby severally constitute and appoint John W. Amerman, N. Ned Mansour, Michael G. McCafferty, Robert Normile and John L. Vogelstein, and each of them, our true and lawful attorneys and agents, to do any and all acts and things in our name and behalf in our capacities as directors and officers and to execute any and all instruments for us and in our names in the capacities indicated below, which said attorneys and agents, or any of them, may deem necessary or advisable to enable said Corporation to comply with the Securites Exchange Act of 1934, as amended, and any rules, regulations and requirements of the Securities and Exchange Commission, in connection with this Annual Report on Form 10-K, including specifically, but without limitation, power and authority to sign for us or any of us, in our names in the capacities indicated below, any and all amendments hereto; and we do each hereby ratify and confirm all that said attorneys and agents, or any one of them, shall do or cause to be done by virtue hereof. 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. REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES --------------------------------- To the Board of Directors of Mattel, Inc. Our audits of the consolidated financial statements referred to in our report dated February 8, 1994, appearing on page 51 of the December 31, 1993 Annual Report to Shareholders of Mattel, Inc. (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) and the reports of other auditors also included an audit of the Financial Statement Schedules listed in Item 14(a)(2) of this Form 10-K. In our opinion, based on our audits and the reports of other auditors, these Financial Statement Schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. /s/ PRICE WATERHOUSE - ----------------------- Los Angeles, California February 8, 1994 SCHEDULE VIII MATTEL, INC. AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS AND ALLOWANCES (In thousands)
789388_1993.txt	789388	1993	Item 1. Business Overview SunGard Data Systems Inc. (the "Company") is a computer services company that specializes in proprietary investment support systems and comprehensive computer disaster recovery services. The Company believes that it is the only large specialized provider of investment support systems to the financial services industry, as well as the pioneer and a leading provider of comprehensive computer disaster recovery services. The Company's business approach is to focus on markets in which it has opportunities to develop or acquire leading products and advantageous market positions. The Company seeks to maximize recurring revenues by selling most of its computer services under fixed-term contracts and by emphasizing customer support and product quality in order to establish long-term relationships with customers. The Company's recurring revenues are derived primarily under contracts for remote processing services, disaster recovery services and software maintenance, which together accounted for approximately 83% of the Company's total revenues during the last three years (84% in 1993). Of the total number of the Company's remote processing and disaster recovery services contracts that were scheduled to expire during the last three years, approximately 86% were renewed or replaced with new contracts (85% in 1993). While there can be no assurance that this renewal rate will not decline, the Company believes that it will continue to renew a high percentage of these contracts. None of the Company's customers individually accounted for more than two percent of the Company's revenues in 1993. The Company's operations are decentralized, and its management philosophy is one of "controlled entrepreneurship." The Company's services are provided through separate business units, which are organized into five groups of related businesses, as follows: Each group is directed by its own management team and has its own sales, marketing, product development, operations and customer support personnel. Overall corporate control and coordination are achieved through centralized budgeting, financial and legal reporting, cash management and strategic planning. The Company believes that this approach has facilitated more focused marketing, specialized product development, responsive customer service and highly motivated management. The Company is a Delaware corporation that was organized in 1982 to acquire certain computer services companies from Sun Company, Inc. The Company's principal executive offices are located at 1285 Drummers Lane, Wayne, Pennsylvania, 19087, and its telephone number is (610) 341-8700. Investment Support Systems The Company designs, markets and maintains a comprehensive family of proprietary investment support systems for the financial services industry. The fundamental purpose of these systems is to automate the complex accounting calculations, record keeping and reporting associated with investment operations. The Company markets its investment support systems throughout the United States and internationally. The Company delivers its investment support systems primarily as remote data processing services using the Company's computer equipment and also through software licenses for use on its customers' computers. The Company provides investment support remote processing services primarily from its computer centers in Birmingham, Boston (two centers), Charlotte, Fairfield (New Jersey), London, Los Angeles, Minneapolis, Sydney and Voorhees (New Jersey) (see Properties on page 13). As of December 31, 1993, the Company had approximately 1,550 remote processing contracts in force. These contracts generally have initial terms of one to three years and then continue for successive, one-year renewal terms, although some allow the customer to terminate on relatively short notice. During the past three years, the Company's investment support systems business has increased significantly in both size and scope, due primarily to acquisitions (see Acquisitions and Offerings on page 10). During 1993, the Company continued consolidating its investment support products and marketing activities. This included ongoing product unification and enhancement to provide customers with access to multiple systems and data through common graphical interfaces and shared databases. The Company also continued evolving its mainframe computer systems by converting some systems to client-server technology and by developing sophisticated personal computer and workstation front-end products for others. Also during 1993, the Company continued to add multicurrency functionality to its systems and pursue opportunities to market more of its systems internationally, especially in Europe. Investment Accounting and Portfolio Management Systems. The Company's investment accounting and portfolio management systems maintain the books of record for all types of large investment portfolios such as those managed by banks, mutual funds, employee retirement plans and insurance companies. The primary functions of these systems are to accept investment transactions, value portfolios using transmissions of security prices received from various worldwide sources, perform complex accounting calculations and general ledger postings, and generate a variety of accounting, audit, tax and regulatory reports. In addition, some of these products are used by investment advisers and other portfolio managers to manage large investment portfolios. These systems track investment activities such as purchases and sales, combine these activities with outside market data such as security prices and quality ratings, and provide analytical models to assist with investment strategy and management decisions. The following table lists the Company's principal investment accounting and portfolio management systems, the hardware systems they require, their modes of delivery to customers and their primary markets. Some of these products can process information in multiple foreign currencies. During 1993, the Company completed the UNIX workstation version of INVEST ONE. The Company also developed major enhancements for INVEST ONE to account for complex securities including multicurrency options and futures and mortgage- backed securities. PRISM is a new product added during 1993 as a result of the Company's acquisition of the business of Information Systems of America, Inc. (see Acquisitions and Offerings on page 10). In 1993, ON-SITE, which provides multicurrency functionality in a UNIX workstation version, was formally introduced and sold as a system for client-server environments in two major transactions, one involving a large European company. Securities and Derivatives Trading and Accounting Systems. The Company's securities and derivatives trading and accounting systems are used primarily by the so-called "sell side" of the investment business. The users of these products generally are traders or dealers of securities or derivative instruments (including those trading for their own accounts) and their back- office operations. In addition to performing many investment accounting functions, the Company's securities and derivatives trading and accounting systems maintain inventories of unsold securities, process trade activities, provide risk management capabilities, and assist users in determining hedging strategies and monitoring compliance with audit limits, trading limits and government regulations. The Company's principal software products in this category are: In 1993, the Company licensed GSM--GLOBAL SECURITIES MANAGER/TM/, a multicurrency system for client-server environments designed to be used on any platform, to several banks and continued development work on the system (see Product Development on page 9). In 1993, the Company enhanced the BOLT product line by adding an interface for the clearing of mutual funds. As a result of the acquisition of Digital Solutions, Inc., the Company acquired rights to Fi- Trac(R), consisting of on-line clearing and settlement interfaces to two major New York clearing banks (see Acquisitions and Offerings on page 10). The Company directly markets The Devon Derivatives, Futures and Securities Systems--all referred to as The Devon System(R)--throughout the world, except in Japan where the system is exclusively marketed by a representative that is entitled to certain percentages of the license and maintenance fees generated from sales in Japan. The Devon Derivatives System is comprised of one or more modules depending upon the types of derivative instruments traded. These modules include, among others, Devon Swaps/TM/ for interest rate and currency swaps, Devon Options/TM/ for interest rate caps, floors, collars and debt options, Devon Bonds/TM/ for bonds and floating rate notes, Devon FRAs/TM/ for forward rate agreements, loans and deposits, and Devon FX/TM/ for spot and forward foreign currency trades and over-the-counter foreign currency options. Several modules, including the module with newly developed Sybase SQL client-server functionality, incorporate certain software developed by third parties. The Company holds worldwide licensing rights to this software and in some cases is required to pay royalties. OPTAS provides trading and risk management of exchange-traded derivative instruments. In 1993, several additional products were added to the Devon Futures System product line as a result of the acquisitions of the FORTE(R) system of ICCH Financial Markets Limited and the FIRST FUTURES(R) system of Microtech Financial Systems (Europe) Limited. INTRADER is a new product added during 1993 as a result of the Company's acquisition of the business of Digital Solutions, Inc. (see Acquisitions and Offerings on page 10). Trust and Global Custody Systems. The Company's trust systems automate the investment operations unique to the bank trust business including cash management, management of specialized assets such as real estate and oil wells, preparation of tax returns for taxable trusts, payment of trust expenses, payment of benefits to retirees, and other customer service duties. The Company's global custody systems automate the functions associated with the worldwide custody and safekeeping of investment assets, such as trade settlement, investment income collection, preparation of client fee statements, tax reclamation, foreign exchange, and reconciliation of depository and sub-custodian positions. The Company's principal trust and global custody systems are: In 1993, the Company continued selling OMNITRUST ES as a remote processing service, including a multimillion dollar sale to a major midwest bank. The Company offers specialized trust asset custody services to its AUTOTRUST customers and other banks and trust companies. These services are provided under a master contract with The Bank of New York (the "Bank"). The Bank holds the customers' trust assets, and the Company handles account record keeping and customer communications. The Company is liable to the Bank for any unpaid obligations of the Company's Custody Services customers that exceed the value of their assets held in the Bank's custody. In 1993, the Company introduced a new product, EXPEDITER/TM/, which facilitates the automated entry of mutual fund transactions. The first major implementation of this product was concluded with the Company entering into an arrangement with a major mutual fund company to provide automated entry services for users of AUTOTRUST. Shareholder Accounting Systems. The Company's shareholder accounting systems automate the transfer agent process for stock, bond and mutual fund issues. These systems maintain shareholder and bondholder positions, process dividend and interest distributions, generate proxy materials, tabulate votes, and produce tax reports and periodic shareholder statements. The Company's principal software products in this category are: In 1993, the Company signed three significant contracts with major financial institutions for SUNSTAR and signed a multimillion dollar contract for INVESTAR. Participant Accounting Systems. The Company's participant accounting systems automate the investment operations associated with defined contribution retirement plans such as 401(k) plans. These systems maintain the books of record for each participant's share of the cash and securities in the plan, monitor compliance with government regulations and plan restrictions, process payments of benefits to retirees, and produce tax reports for plan sponsors and participants. The Company's principal participant accounting systems are: During 1993, three major corporations signed multimillion dollar contracts for OMNIPLAN. In addition, the Company formally introduced and sold OMNIPAY, a benefits payment system. Investment Reporting and Analysis Systems. The Company's investment reporting and analysis systems accept accounting data from other investment support systems and perform special analyses for fund managers and customers. These systems analyze the performance of portfolios, perform other types of investment measurement and analysis, and produce regulatory reports for retirement plan sponsors and participants. The Company's principal software products in this category are: During 1993, the Company concluded a license and development contract with a major bank for SUPERF4 and developed a UNIX workstation version of SUPERF4. Also in 1993, a high-volume bridge between customer trust accounting systems and SUPERF4 was developed, making it possible for customers to compute investment performance statistics on thousands of trust accounts. Also in 1993, the Company, as an enhancement to EMBERS, developed a global client statement reporting subsystem. Disaster Recovery Services Many businesses depend upon computers to perform critical tasks. Many companies use communications networks to transmit data between a centralized computer facility and distant offices. If a natural disaster, fire, power failure or other emergency disrupts a company's computer operations or interrupts communications between its data processing center and remote locations, its ability to stay in business may be jeopardized. To address this problem, the Company maintains alternate data processing sites for use by customers whenever they are unable to operate or communicate with their own computer systems. The primary alternate sites provided by the Company are fully equipped and operational computer centers known as "hotsites," where customers may restore their critical applications using the Company's computer equipment. The Company also provides environmentally prepared computer centers known as "coldsites," in which customers may install and operate their own computer equipment, and remote operations centers for using the Company's alternate sites from long distance. In addition, the Company provides mobile recovery resources that are delivered or shipped directly to customer-specified locations. Most of the Company's larger disaster recovery customers purchase a basic package of services that includes use of a hotsite for six weeks to recover from any computer center failure, use of a coldsite for six months if recovery operations must continue for more than six weeks, use of a hotsite to regularly test disaster recovery procedures, use of adjacent office and terminal space during recovery operations and tests, technical assistance when conducting recovery operations and tests, and technical assistance with designing and implementing a backup communications network. The Company also provides WGR--Work Group Recovery/SM/ services through MetroCenter(R) facilities that provide customers with the use of general office space and office equipment, as well as enhanced remote operations capabilities for using the Company's disaster recovery systems for tests or recovery operations without traveling to a Company hotsite. This product line also includes MegaVoice/SM/, a centralized voice communications recovery service that backs up customers' automated telephone call distribution systems. The Company provides disaster recovery services to users of IBM (and compatible) mainframe computers and also to users of DEC, Hewlett Packard, IBM midrange, Prime, Stratus, Tandem, Texas Instruments and Unisys computers. These services are marketed, directly and through representatives, primarily to IBM (and compatible), DEC and Unisys mainframe and midrange computer installations in North America. In 1993, the Company developed a new sales force directed at marketing disaster recovery services, including mobile recovery services, to users of smaller computer installations. This effort was enhanced by several acquisitions that increased the number of customer contracts for smaller, midrange computer facilities (see Acquisitions and Offerings on page 10). Also in 1993, the Company established two major marketing alliances and signed certain agreements with third parties to expand and enhance its recovery services and capabilities. During 1993, for the eighth consecutive year, the Company successfully supported all customers who experienced computer center failures, including five customers with operations disrupted by the World Trade Center bombing. Disaster Recovery Facilities. The Company believes that it conceived and first implemented the concept of the MegaCenter(R), a multiple hotsite and coldsite facility that customers may use directly or remotely. The Company operates four MegaCenters, located in Atlanta, Chicago, Philadelphia and Warminster (see Properties on page 12). The Company believes that its Philadelphia MegaCenter, which houses six IBM mainframe hotsites, three DEC, five mobile IBM midrange, three Stratus, one Tandem hotsite, and three stationary and four mobile Hewlett Packard computer systems, is the largest commercial disaster recovery facility in the world. The Company also operates three combined coldsite and remote operations centers, located in Honolulu, St. Paul and Toronto. The Company has established MetroCenters in strategic locations throughout North America, including Atlanta, Boston, Dallas, Los Angeles, St. Louis and Toronto, and plans to open a new MetroCenter in Washington, D.C. in the second quarter of 1994. As a result of acquisitions in 1993, the Company also operates computer centers in Solon, Ohio and Phoenix, Arizona (see Acquisitions and Offerings on page 10). Each of the Company's hotsite systems includes, in addition to the central processing unit, a complete set of peripheral equipment. The Company markets its multiple recovery centers and comprehensive hotsite services on a component pricing basis, allowing each customer to select the specific items of equipment and other recovery services needed to satisfy its individual disaster recovery requirements. The Company periodically opens new facilities to accommodate both the growth in its customer base and the addition of different types of computer systems. Also, the Company regularly upgrades its systems to offer the most advanced computer equipment generally used by its customers. During 1993, the Company upgraded hotsites at all four MegaCenters. In addition to computer equipment added with acquisitions in 1993, a new IBM midrange system was offered in Philadelphia and in Atlanta. The disk access, tape cartridge and other peripheral equipment at all facilities were upgraded or augmented, including the addition of a state-of-the-art storage and retrieval system for mainframe customers. The Company leases most of its disaster recovery computer equipment under operating leases. The duration of these leases, generally two to four years, is based largely upon the Company's strategy to reduce the risks associated with the potential obsolescence of its disaster recovery computer systems. The Company's disaster recovery equipment is covered by maintenance contracts to assure that it is properly functioning at all times. The Company believes that, by operating a relatively small number of large facilities linked by a comprehensive communications network, it can provide superior disaster recovery services in the most effective manner. All MegaCenters and MetroCenters, as well as coldsites and other remote operations centers, are linked by a communications network that is capable of handling a full range of digital and analog data transmission methods, including satellite and fiber optics applications. The Company regularly upgrades this network to offer the communications technology used by its customers. During 1993, the Company continued expanding its matrix switching capabilities to allow for more efficient and reliable communications during customer tests and recovery operations. Disaster Recovery Contracts. As of December 31, 1993, the Company had approximately 3,300 disaster recovery contracts in force. These contracts generally require the payment of monthly fees and range in duration from one to five years. The amount of the monthly fees depends upon the type of alternate site selected, any additional services provided, contract duration and competitive factors. The Company's disaster recovery contracts limit the number of computer centers that may be serviced by each of the Company's large IBM mainframe hotsites. As of December 31, 1993, the Company had a maximum capacity of 1090 contracts for large IBM mainframe hotsites, with current contracts utilizing approximately 85% of such capacity. The Company manages this capacity and, when necessary, opens new hotsites to accommodate the anticipated continued growth in its customer base (see Product Development on page 9). Planning Services. The Company provides professional consulting services for disaster recovery and business resumption planning, not only for computer operations, but also for company-wide purposes encompassing all important business operations. This includes the development of customized disaster recovery and business resumption plans for customers. The Company also performs risk analyses to determine customers' exposure to the disruption or loss of critical operations and resources, audits customers' disaster recovery and business resumption procedures, and recommends improvements. In addition, the Company conducts regular seminars on disaster recovery, business resumption and related topics. The Company also markets microcomputer software, known as DP/90 PLUS(R), that automates the preparation and maintenance of disaster recovery and business resumption plans, including comprehensive company-wide planning capabilities. This software is marketed throughout the world, directly and through distributors. There also is a customized version for financial institutions. In 1994, the Company plans to introduce a new business recovery planning product entitled CBR--Comprehensive Business Recovery/TM/ that is compatible with Microsoft Windows. Computer Services and Other The Company provides nonproprietary, remote-access computer services primarily to software developers and government agencies and also provides outsourcing services. In addition, the Company provides direct marketing computer services and automated mass mailing and printing services. These activities are supported at the Company's computer centers in Voorhees and Birmingham (see Properties on page 12), which also are used to provide remote processing services for several of the Company's investment support systems business units. In 1993, the Company purchased a state-of-the-art data processing facility in Voorhees, New Jersey and moved its Philadelphia computer services operations to the new facility. Also, in the first quarter of 1993, the Company sold its CARS(R) automotive dealership systems product line, resulting in a one-time, after-tax gain of $3,371,000. Product Development The investment support systems needs of the financial services industry are complex and substantial, and continually evolve as a result of changes in laws, introductions of new types of investment vehicles and increased competition. For these reasons, the Company believes that it is important to continually maintain, enhance and evolve its proprietary investment support systems. The Company funds most of its ongoing software maintenance and support activities through the software maintenance fees paid by its investment support systems license customers and a portion of the monthly fees paid by its investment support systems remote processing customers. As of December 31, 1993, the Company had in force approximately 1,850 software maintenance contracts for its investment support systems. The Company's expenditures for software development during 1993, 1992 and 1991, including amounts that were capitalized, totalled approximately $37,581,000, $24,899,000 and $13,745,000, respectively. These amounts do not include certain software maintenance and support costs that are included in cost of sales, nor do they include costs incurred in performing certain custom development projects for individual customers in the ordinary course of business. During 1994, the Company plans to continue its development work on GSM--GLOBAL SECURITIES MANAGER and to develop UNIX versions of SUNSTAR and OMNIPLAN. Microsoft Windows versions of AUTOTRUST and PMS also are planned in 1994. These developments are examples of the Company's strategy of using the established functionality of its mainframe systems to develop state-of-the-art systems for new technological environments. Also in 1994, the Company plans to enhance the capabilities of INVEST ONE to include corporate action processing, reversal processing and UK unit trust processing. The Company plans to develop software for defined benefit plans that will interface with the Company's OMNIPLAN software for defined contribution plans. In 1994, the Company will continue to expand the application of EXPEDITER, which facilitates the automated entry of mutual fund transactions for users of AUTOTRUST, OMNITRUST, OMNIPLAN, BOLT and eventually other investment support systems. In 1994, the Company plans to continue the development of DEVON CONNECT/TM/ to enhance data distribution and exchange among The Devon Derivatives System, real-time price data and customer systems, and to provide a digital platform for order trading, routing and monitoring. The Company expands its disaster recovery services by adding new hotsites at existing facilities, upgrading its computer equipment, developing new services and opening new facilities. During 1994, the Company plans to upgrade its IBM ES9000-720 to an IBM ES9000-942 mainframe, IBM's newest H5 technology, at its Philadelphia MegaCenter. Also during 1994, the Company plans to add new IBM command centers at its MegaCenters to provide additional testing and recovery capability. The Company also plans to continue upgrading its disk storage, tape cartridge and other peripheral hotsite equipment and to continue opening new MetroCenters where the demand exists. The Company expands its disaster recovery communications network by upgrading its communications equipment, adding new communications capabilities and establishing additional remote operations centers where the demand exists. Acquisitions and Offerings The Company seeks to grow through both internal development and the acquisition of businesses that broaden or complement its existing product lines. Since its initial public offering in 1986, the Company has acquired thirteen investment support systems businesses, ten disaster recovery businesses and two computer services businesses. Also during this period, the Company completed two additional public offerings, a common stock offering in 1987 and a convertible debenture offering in 1990. In May 1993, the Company converted $86,055,000 of its $86,250,000 8 1/4% Convertible Subordinated Debentures due 2015, into 3,309,803 shares of common stock. The $195,000 balance of the debentures was redeemed at face value plus a premium of 5.78%. During 1993, the Company spent approximately $30,808,000 in cash, net of cash acquired, to acquire four investment support systems businesses and four disaster recovery businesses. In January 1993, the Company enhanced its Capital Markets Group by purchasing the London-based capital markets business of ICCH Financial Markets Limited. The primary product line of the acquired business, FORTE, is a back-office trading, clearing and administration system for exchange-traded derivative instruments. Also in January 1993, the Company purchased the FIRST FUTURES product line of London-based Microtech Financial Systems (Europe) Limited. FIRST FUTURES is an analysis system for exchange-traded and equity derivative instruments. As additions to the Financial Systems Group, in May 1993, the Company purchased the business of Information Systems of America, Inc. Based in Atlanta, ISA's major products include PRISM, a portfolio management, investment accounting and reporting system, and ABC/TM/ and CDS/TM/, general accounting and financial management systems, for insurance companies. In October 1993, the Company purchased the business of Digital Solutions, Inc., headquartered in Minneapolis. DSI's major product, INTRADER, is a portfolio management, investment accounting and securities trading system for bank capital market departments and other financial institutions. The Recovery Services Group increased its presence in the midrange computer market with four acquisitions in 1993. In May 1993, the Company purchased the disaster recovery business of LDI Corporation, which consists primarily of recovery services for midrange IBM platforms. In June 1993, the acquisition of the disaster recovery business of Uptime Disaster Recovery, Inc. increased the Hewlett Packard product line and enhanced the Company's mobile recovery offerings. The acquisition of the disaster recovery business of Sun Data, Inc. in October 1993 resulted in the addition of approximately 1,200 contracts in the IBM AS/400 market. In November 1993, the acquisition of the disaster recovery business of Computer Recovery Services, Inc. increased the Company's services in Unisys A and V platforms. In June 1993, the Company's common stock was listed on the London Stock Exchange. Competition Since most of the Company's computer services and software are specialized and technical in nature, the various markets in which the Company competes have a relatively small number of significant competitors. Some of the Company's existing competitors and some potential competitors have substantially greater financial, technological and marketing resources than the Company. The Company believes that, for most of its businesses, service, quality and reliability are more important competitive factors than price. In its investment support systems business, the Company competes with numerous other data processing and financial software vendors, which may be broadly categorized into two groups. One is comprised of specialized investment support systems companies, most of which are much smaller than the Company. The other is comprised of large computer services companies whose principal businesses are not in the investment support systems area. The Company also faces competition from the internal processing and development capabilities of its potential customers. The key competitive factors in marketing investment support systems are the accuracy and timeliness of processed information provided to customers, features and adaptability of the software, level and quality of customer support, level of software development expertise and overall net cost. The Company believes that it competes effectively as to each of these factors and that its reputation and experience in these markets are important competitive advantages. The computer disaster recovery business remains highly competitive. The Company's principal competitors in this business are Comdisco Disaster Recovery Services, Inc., Digital Equipment Corporation and IBM Corporation, all of which have substantially greater financial and other resources than the Company. The Company also faces potential competition from major companies that have computer facilities that could be made available for disaster recovery use. The Company believes that it competes effectively as to the key competitive factors in this market, namely quality of facilities, scope and quality of services, level and quality of customer support, level of technical expertise and price. The Company also believes that its experience and reputation as the innovator in this business are important competitive advantages. Marketing All of the Company's specialized computer services and software are marketed throughout the United States, and many are marketed internationally as well. The Company's export sales during 1993, 1992 and 1991 totalled approximately $29,061,000, $32,501,000 and $28,177,000, respectively. In addition, the Company's foreign subsidiaries had sales that for those years totalled approximately $18,437,000, $3,211,000 and $1,123,000, respectively. The Company develops and maintains proprietary marketing information by identifying prospective customers through a variety of data bases and other sources, and then canvassing the prospects by direct mail, telephone calls and personal visits. The Company also attempts to identify and attract customers by conducting seminars and participating in industry conferences. Customer references have been an important aid in obtaining new business. Employees At December 31, 1993, the Company had approximately 2,276 full-time employees. The Company believes that its success depends, in part, on its continuing ability to attract and retain skilled technical, marketing and management personnel. While data processing professionals and software developers are in high demand, the Company believes that, to date, it has been able to attract and retain highly qualified personnel. None of the Company's employees is covered by a collective bargaining contract. The Company believes that its employee relations are excellent. Proprietary Protection The Company owns registered marks for the SunGard name and owns or has applied for registered marks for many of its service and software names. The Company owns few registered copyrights and no patents. The Company believes that registered copyrights and patents are of less significance in its business than software development skills, technological expertise and marketing capabilities. The Company relies primarily on contractual restrictions and trade secret laws for the protection of its proprietary services and software. The Company also has established policies requiring its personnel to maintain the confidentiality of the Company's proprietary property. Item 2.		Item 2. Properties The following table indicates the location, purpose and size of the Company's principal offices, principal computer facilities, business unit headquarters and disaster recovery MegaCenters. The Company leases all of the offices and facilities listed in the preceding table, with the exception of its Birmingham, Voorhees and Warminster facilities, which are owned, and its Hopkins facility, which consists of two connected buildings, one leased and the other owned. The Company also owns its disaster recovery facility in St. Paul, Minnesota. The Company also leases space, primarily for sales offices, customer support offices, MetroCenters and remote operations centers, in many locations in the United States and internationally. The Company believes that its leased and owned facilities are adequate for the Company's present operations. Item 3.	Item 3. Legal Proceedings The Company is presently a party to certain lawsuits arising in the ordinary course of its business. The Company believes that none of its current legal proceedings will have a material adverse effect on its business or financial condition. Item 4.	Item 4. Submission of Matters to a Vote of Security Holders None. Item 4.1 Certain Executive Officers of the Registrant The executive officers of the Company who are not also directors are listed below. Mr. Adams has been Chairman and Chief Executive Officer of SunGard Recovery Services Inc. since 1988 and was its President from 1990 to 1992. From 1983 to 1988, Mr. Adams was President and a director of SunGard Trust Systems Inc. Mr. Bronstein became Vice President and Controller of the Company in February 1994. Before that, he was Corporate Controller from 1992. From 1985 to 1992, he was a manager with Coopers & Lybrand, Philadelphia, where he served most recently as senior manager on the Company's account and as director of the firm's Philadelphia high technology group. Mr. Bronstein is a director and officer of most of the Company's domestic subsidiaries. Mr. Conde has been Chief Executive Officer and a director of SunGard Capital Markets Inc. since 1991. He was one of the founders of that company in 1983 and was its Executive Vice President from 1983 to 1991. Before it was acquired by the Company in 1987, SunGard Capital Markets Inc., originally named Devon Systems International, Inc., was an independent software company. Mr. Conde is a director and/or officer of most of the Company's foreign subsidiaries. Mr. Dowd has been Chief Executive Officer of SunGard Investment Systems Inc. since 1990 and one of its directors since 1982. He was President of SunGard Investment Systems Inc. from 1982 to 1990. Mr. Dowd has been Chief Executive Officer and a director of SunGard Shareholder Systems Inc. since 1989, President-Software Divisions of SunGard Business Systems Inc. since 1990, Chief Executive Officer and a director of SunGard Trust Systems Inc. since 1991, and a director of Shaw Data Services, Inc. since 1992. Mr. Gathman has been Chief Financial Officer and Treasurer of the Company since 1987 and Vice President-Finance of the Company since 1985. From 1982 to 1985, he was Corporate Controller of the Company. Mr. Gathman is a director and officer of most of the Company's domestic subsidiaries. Mr. Gathman has resigned from his various positions with the Company effective April 1, 1994. Michael J. Ruane, age 40, will succeed Mr. Gathman as Vice President-Finance and Chief Financial Officer. Since 1992, Mr. Ruane has served as Chief Financial Officer and Vice President-Finance of SunGard Capital Markets Inc. Before that, he was Corporate Controller of the Company from 1985 to 1990 and then Vice President- Controller from 1990 through 1992. Mr. Gross has been Vice President and General Counsel of the Company since 1986 and Secretary of the Company since 1987. From 1979 to 1986, he was a lawyer with Blank, Rome, Comisky & McCauley, Philadelphia, and he has represented the Company since 1983. Mr. Gross is a director and officer of most of the Company's domestic subsidiaries and some of its foreign subsidiaries. Mr. Muratore has been Chief Executive Officer and a director of SunGard Computer Services Inc. since 1989 and President-Processing Divisions of SunGard Business Systems Inc. since 1990. From 1985 to 1988, Mr. Muratore was President of the Company's Central Computer Facility, which was consolidated with SunGard Computer Services Inc. at the end of 1988. Mr. Peterson has been Chief Executive Officer and a director of SunGard Financial Systems Inc. since October of 1993. From 1990 to 1993, Mr. Peterson was Chief Executive Officer of EJV Partners, L.P., a financial information firm. Before that, he was an executive at SEI Corporation, a trust system and mutual fund company, for seven years, where his last position was Executive Vice President. Ms. Pedrick has been Vice President-Human Resources of the Company since 1988. From 1983 to 1988, she was Director-Human Resources of the Company. Mr. Tarbox has been Vice President-Corporate Development of the Company since 1987. He is an officer of several of the Company's domestic subsidiaries. Dr. Wismer has been Executive Vice President of SunGard Data Systems Inc. since October 1993. Before that, he was Chief Executive Officer and a director of SunGard Financial Systems Inc. from 1990. Dr. Wismer was the founder of Wismer Associates, Inc. in 1975 and was its President and one of its directors from 1975 until the beginning of 1992, when Wismer Associates, Inc. was merged into SunGard Financial Systems Inc. Before it was acquired by the Company in 1986, Wismer Associates, Inc. was an independent computer services company. PART II Item 5.	Item 5. Market for Registrant's Common Equity and Related Stockholder Matters This information is presented under the caption, Stock Information, on page 23 of this Report on Form 10-K. Item 6.	Item 6. Selected Financial Data This information is presented under the caption, Selected Financial Information, on page 40 of this Report on Form 10-K. Item 7.	Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations This information is presented under the caption, Management's Discussion and Analysis of Financial Condition and Results of Operations, on pages 24 through 27 of this Report on Form 10-K. Item 8.	Item 8. Financial Statements and Supplementary Data The financial statements of the Company, financial statement schedules of the Company, supplementary data and related documents that are included in this Report on Form 10-K are listed in Item 14(a), Part IV, of this Report. Item 9.	Item 9. Changes In and Disagreements With Accountants on Accounting and Financial Disclosure None. PART III This Part incorporates certain information from the Company's definitive proxy statement for its 1994 Annual Meeting of Stockholders ("1994 Proxy Statement") to be filed with the Securities and Exchange Commission not later than 120 days after the end of the Company's fiscal year covered by this Report on Form 10-K. Notwithstanding such incorporation, the sections of the Company's 1994 Proxy Statement entitled Compensation Committee Report and Performance Graph shall not be deemed to be "filed" as part of this Report. Item 10.	Item 10. Directors and Executive Officers of the Registrant Information concerning the directors of the Company is incorporated by reference to the Company's 1994 Proxy Statement including but not necessarily limited to the section of such proxy statement entitled Election of Directors. Information concerning executive officers of the Company who are not also directors is included in Item 4.1, Part I, of this Report on Form 10-K. Item 11.	Item 11. Executive Compensation This information is incorporated by reference to the Company's 1994 Proxy Statement including but not necessarily limited to the section of such proxy statement entitled Executive Compensation. Item 12.	Item 12. Security Ownership of Certain Beneficial Owners and Management This information is incorporated by reference to the Company's 1994 Proxy Statement including but not necessarily limited to the section of such proxy statement entitled Beneficial Ownership of Common Stock. Item 13.	Item 13. Certain Relationships and Related Transactions This information is incorporated by reference to the Company's 1994 Proxy Statement including but not necessarily limited to the sections of such proxy statement entitled Executive Compensation, Beneficial Ownership of Common Stock and Election of Directors. PART IV Item 14.	Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a)(1) Financial Statements The following financial statements of the Company, supplementary data and related documents are included in this Report on Form 10-K: (a)(2) Financial Statement Schedules The following financial statement schedules of the Company and related documents are included in this Report on Form 10-K: (a)(3) Exhibits The Exhibits that are incorporated by reference in this Report on Form 10-K, or are filed with this Report, are listed in the List of Exhibits beginning on page 19 of this Report. Exhibits 1011 through 1019 are the management contracts and compensatory plans and arrangements that are required to be filed as Exhibits to this Report. (b) Reports on Form 8-K None. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. SunGard Data Systems Inc. Date: March 28, 1994 By: s/ James L. Mann ------------------------------------------ James L. Mann, 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 Capacity Date --------- -------- ---- s/ James L. Mann Chief Executive Officer, March 28, 1994 - -------------------------------- President, and Chairman James L. Mann of the Board of Directors (principal executive officer) s/ David D. Gathman Chief Financial Officer and March 28, 1994 - -------------------------------- Vice President-Finance David D. Gathman (principal financial officer) s/ Andrew P. Bronstein Vice President and Controller March 28, 1994 - -------------------------------- (principal accounting officer) Andrew P. Bronstein s/ Gregory S. Bentley Director March 28, 1994 - -------------------------------- Gregory S. Bentley s/ Michael C. Brooks Director March 28, 1994 - -------------------------------- Michael C. Brooks s/ Albert A. Eisenstat Director March 28, 1994 - -------------------------------- Albert A. Eisenstat s/ Michael Roth Director March 28, 1994 - -------------------------------- Michael Roth s/ Malcolm I. Ruddock Director March 28, 1994 - -------------------------------- Malcolm I. Ruddock s/ Lawrence J. Schoenberg Director March 28, 1994 - -------------------------------- Lawrence J. Schoenberg LIST OF EXHIBITS _____________ (1) Incorporated by reference to the Exhibits filed with the Company's Annual Report on Form 10-K for the fiscal year ended December, 1991 (Commission File No. 0-14232). (2) Incorporated by reference to the Exhibits filed with the Company's Registration Statement on Form S-1 and Amendments No. 1, No. 2, and No. 3 thereto (Registration No. 33-3181). (3) Incorporated by reference to the Exhibits filed with the Company's Registration Statement on Form S-1 and Amendment No. 1 thereto (Registration No. 33-12536). (4) Incorporated by reference to the Exhibits filed with the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1987 (Commission File No. 0-14232). (5) Incorporated by reference to the Exhibits filed with the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1988 (Commission File No. 0-14232). (6) Incorporated by reference to the Exhibits filed with the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1989 (Commission File No. 0-14232). (7) Incorporated by reference to the Exhibits filed with the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992 (Commission File No. 0-14232). (8) Incorporated by reference to the Exhibits filed with the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1990 (Commission File No. 0-14232). (9) Management contract or compensatory plan or arrangement. Exhibit 23.1 CONSENT OF INDEPENDENT ACCOUNTANTS We consent to the incorporation by reference into the Company's Registration Statements on Form S-8 (Registration Nos. 33-6425, 33-14984, 33-33602, 33-42345 and 33-69650) of our reports dated February 10, 1994 on our audits of the consolidated financial statements and consolidated financial statement schedules of SunGard Data Systems Inc. and subsidiaries as of December 31, 1993 and 1992, and for each of the years in the three-year period ended December 31, 1993, which reports are included in this Report on Form 10-K. COOPERS & LYBRAND 2400 Eleven Penn Center Philadelphia, Pennsylvania March 25, 1994 - -------------------------------------------------------------------------------- REPORT OF INDEPENDENT ACCOUNTANTS ON SCHEDULES To the Board of Directors and Stockholders SunGard Data Systems Inc. Our report on the consolidated financial statements of SunGard Data Systems Inc. and subsidiaries is included in this Report on Form 10-K. In connection with our audit of such consolidated financial statements, we also have audited the related consolidated financial statement schedules listed in Item 14(a)(2), Part IV, of this Report on Form 10-K. In our opinion, the consolidated financial statement schedules referred to above, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. COOPERS & LYBRAND 2400 Eleven Penn Center Philadelphia, Pennsylvania February 10, 1994 SunGard Data Systems Inc. and Subsidiaries Financial Statement Schedules SCHEDULE II Amounts Receivable from Related Parties and Underwriters, Promoters and Employees (other than related parties) (1) Loan made under the Company's restricted stock incentive plan; bears interest at the prime rate, is due May 2, 1995, and is secured by shares of the Company's common stock but is otherwise non-recourse. (2) Personal loan that was repaid in two weeks together with $200 interest, which was calculated at the prime rate. - -------------------------------------------------------------------------------- SCHEDULE VIII Valuation and Qualifying Accounts Allowance for Doubtful Accounts ------------------------------- (1) Net impact of acquired companies, foreign currency translation, and, in 1993, the sale of a product line. Accumulated Amortization of Software ------------------------------------ (1) Principally represents reclassifications. Accumulated Amortization of Goodwill ------------------------------------ Accumulated Amortization of Other Intangible Assets --------------------------------------------------- SunGard Data Systems Inc. and Subsidiaries Quarterly Financial Information [Unaudited] In thousands, except per share amounts * First quarter includes after-tax gain on sale of product line of $3,371, or $0.18 per share, on a fully diluted basis. See Note 2 of Notes to Consolidated Financial Statements. - -------------------------------------------------------------------------------- Stock Information The common stock of SunGard Data Systems Inc. is traded in the National Over- the-Counter (OTC) Market and is reported on the NASDAQ National Market System and the London Stock Exchange under the symbol SNDT. At March 10, 1994, the Company had approximately 2,040 stockholders of record. No dividends have ever been paid on the Company's common stock. The Company's policy is to retain earnings for use in its business. The following table indicates high and low sales prices per share for the Company's common stock, as reported by NASDAQ. The last sale price for the Company's common stock on March 10, 1994, as reported by NASDAQ, was $39 3/4 per share. SunGard Data Systems Inc. and Subsidiaries Management's Discussion and Analysis of Financial Condition and Results of Operations Results of Operations The following table sets forth, for the periods indicated, certain amounts included in the Consolidated Statements of Income of SunGard Data Systems Inc., the relative percentage that those amounts represent to consolidated revenues (unless otherwise indicated), and the percentage change in those amounts from period to period. (1) All percentages are calculated using actual amounts rounded to the nearest $1,000. (2) Percent of revenues is calculated as a percent of investment support systems, disaster recovery services and computer services and other revenues, respectively. Income from Operations Investment Support Systems (ISS) The ISS operating margin declined in 1993 compared to 1992 due primarily to the initial effect of acquired businesses and, to a lesser extent, to software license revenues comprising a smaller portion of total ISS revenues. The businesses acquired during 1993 and 1992 have historically lower operating margins than the rest of the Company's ISS businesses. The Company expects that the full year 1994 ISS operating margin will increase slightly compared to 1993 as a result of a combination of continued improvement in operating margins of acquired businesses and an expected increase in software license revenues. Disaster Recovery Services (DRS) The improvement in the DRS operating margin in 1993 is attributable primarily to deferral of equipment expenditures, the positive effect of businesses acquired during 1993 and the signing of new contracts and contract renewals. The Company expects that the DRS operating margin will decline during the full year 1994 compared to 1993 due principally to an increase in spending in connection with disaster recovery computer system upgrades. Computer Services and Other (CS) The CS operating margin improved during 1993 due to the addition of new processing customers in the second half of 1993 and the effect of the sale of the Company's automotive dealership systems product line in February 1993. This improvement is net of the impact of lower royalties earned in connection with the 1986 sale of certain product rights and costs associated with data center consolidations. The Company expects that the CS operating margin will increase for the full year 1994 compared to 1993. Revenues Total revenues increased $56.8 million and $41.0 million, or 18% and 14%, in 1993 and 1992, respectively. Acquired businesses, net of the sale of the Company's automotive dealership systems product line in February 1993, account for approximately $36.5 million of the 1993 increase. Acquired businesses account for $14.4 million of the 1992 increase. Recurring revenues derived from remote-processing services, alternate-site services and software maintenance are approximately $321.0 million, $267.0 million and $235.0 million in 1993, 1992 and 1991, respectively, representing 84%, 82% and 83% of consolidated revenues, respectively. Investment Support Systems ISS revenues increased $47.1 million and $30.4 million in 1993 and 1992, respectively. Acquired businesses account for approximately $44.3 million and $14.4 million of the respective 1993 and 1992 increases. The balance of the 1993 revenue increase is attributable to the net impact of a $6.8 million increase in data processing and software maintenance revenues and a $4.0 million decrease in software license and professional services revenues. The balance of the 1992 revenue increase is attributable to increases in data processing and software maintenance revenues of $7.2 million and software license and professional services revenues of $8.8 million. The Company expects that ISS revenues will increase in 1994 compared to 1993. The Company believes that the trend of mergers in the financial services industry will continue, but it is unable to predict what effect, if any, future mergers may have. Disaster Recovery Services DRS revenues increased $18.6 million and $11.2 million in 1993 and 1992, respectively. Acquired businesses account for $5.4 million of the 1993 increase, and alternate-site service revenues resulting primarily from new contract signings and renewals account for the balance of the 1993 revenue increase. The 1992 increase is comprised of the net impact of an $11.8 million increase in alternate-site service revenues and a $0.6 million decrease in software maintenance, license and professional services revenues. The Company expects that DRS revenues will increase in 1994 due primarily to new contracts and businesses acquired in 1993. The Company believes that mainframe computer platforms will continue to play an integral role in data processing solutions for the foreseeable future and, therefore, will continue to provide a market for the Company's principal DRS services. In addition, the Company believes that midrange systems and client- server and local- and wide-area-network technologies increasingly will become components of distributed data processing systems, and that they represent continuing market opportunities for the DRS business. Computer Services and Other CS revenues decreased $8.9 million and $0.6 million in 1993 and 1992, respectively. The February 1993 sale of the Company's automotive dealership systems product line accounts for a decrease of approximately $13.3 million in 1993 revenue. This decrease was partially offset by a $4.4 million increase in revenue due primarily to an increase in remote-access computer services. The 1992 decrease is attributable primarily to the net impact of the September 1991 sale of a small, unprofitable product line, a $0.7 million decrease in royalties, an increase in license fees from the Company's automotive dealership systems and, to a lesser extent, an increase in remote-access computer services. The Company expects that CS revenues will increase slightly during 1994 as a result of the net impact of both new contracts signed and the product line sold in 1993. Costs and Expenses Total costs and expenses increased $47.5 million and $33.2 million, or 17% and 14%, in 1993 and 1992, respectively. Acquired businesses, net of the product line sold, account for $34.0 million of the 1993 increase. Acquired businesses account for $13.9 million of the 1992 increase. Excluding the effect of acquired businesses and, in 1993, the product line sold, total costs and expenses increased 5% in 1993 and 8% in 1992. Cost of sales and direct operating expenses increased $20.3 million and $12.3 million in 1993 and 1992, respectively. Acquired businesses, net of the product line sold, account for approximately $12.5 million of the 1993 increase. Acquired businesses account for $8.2 million of the 1992 increase. The decrease in cost of sales and direct operating expenses as a percentage of 1993 and 1992 revenues is due primarily to a shift of resources to product development efforts and, to a lesser extent, to DRS cost of sales and direct operating costs increasing at a slower rate than DRS revenues. Sales, marketing and administration expenses increased $9.9 million and $7.5 million in 1993 and 1992, respectively. Acquired businesses, net of the product line sold, account for approximately $6.3 million of the 1993 increase. Acquired businesses account for $2.6 million of the 1992 increase. Sales, marketing and administration expenses as a percentage of revenues declined slightly in 1993 and remained unchanged during 1992 compared to 1991. Product development expenses increased $11.7 million and $10.0 million in 1993 and 1992, respectively. Acquired businesses account for approximately $9.8 million of the 1993 increase and $1.7 million of the 1992 increase. The balance of the 1993 and 1992 increases is attributable primarily to increased development spending in connection with the Company's employee benefit systems products and, in 1992, the Company's derivative systems products. In addition, development costs capitalized were $2.5 million and $1.5 million in 1993 and 1992, respectively. Depreciation of property and equipment increased $3.6 million and $1.5 million in 1993 and 1992, respectively. Acquired businesses, net of the product line sold, account for approximately $1.8 million of the 1993 increase. Acquired businesses account for approximately $0.6 million of the 1992 increase. The balance of the 1993 and 1992 increases is attributable primarily to DRS capital expenditures. Amortization of intangible assets increased $2.0 million and $1.9 million in 1993 and 1992, respectively. The 1993 increase is comprised of the net impact of acquired businesses, the product line sold and intangible assets that became fully amortized. The 1992 increase is due to acquired businesses and accelerated amortization of certain intangible assets. Interest income in 1993 was approximately the same as in 1992 because the average amount of cash and short-term investments was comparable in both years. During 1993, the Company continued to invest a portion of excess cash and investments in tax-free instruments. Interest expense declined in 1993 by $4.4 million due to the conversion of the Company's subordinated convertible debentures (Debentures) on May 12, 1993 (see Note 4 of Notes to Consolidated Financial Statements). The Company's effective tax rate was 39.1% and 43.2% in 1993 and 1992, respectively. The 1993 effective tax rate was lower than in 1992 due primarily to a lower effective tax rate associated with the gain on the sale of the product line. The Company believes that its business is not seasonal; nevertheless, the timing and magnitude of software sales, commitments for equipment and facilities, product development efforts and disaster recovery activities may cause profitability to fluctuate from one quarter to another. The Company believes that inflation has not had a material impact on its results of operations to date. Liquidity and Capital Resources At December 31, 1993, cash and short-term investments increased $1.4 million, to $84.8 million from $83.4 million at December 31, 1992. Cash flow from operations decreased approximately $2.1 million in 1993 due primarily to an increase in working capital requirements. During 1993, cash paid for acquired businesses was approximately $30.8 million. Cash received from the sale of assets includes $11.1 million received in connection with the sale of the product line. Capital expenditures in 1993 increased approximately $11.1 million from 1992 due primarily to capital requirements for the Company's DRS and CS businesses, including approximately $7.5 million in connection with the purchase of a data center facility to house the CS business operations. The Company's capital spending for property and equipment during 1994 is expected to be slightly lower than 1993 spending. On May 12, 1993, $86.1 million of the Company's $86.25 million Debentures were converted into 3,309,803 shares of common stock of the Company. On May 24, 1993, the remainder of the Debentures was redeemed at par plus a premium of 5.78%. Also, on April 15, 1993, the Company established $25.0 million of revolving credit facilities. As of December 31, 1993, no borrowings had been made under these facilities. At December 31, 1993, the Company's remaining commitments consisted primarily of operating leases for computer equipment and facilities aggregating $112.6 million, of which $38.0 million will be paid in 1994. The Company believes that its existing cash resources, cash generated from operations and borrowing capacity will be sufficient to meet its operating, capital spending and debt service requirements. - -------------------------------------------------------------------------------- Report of Independent Accountants To The Board of Directors and Stockholders SunGard Data Systems Inc. We have audited the accompanying consolidated balance sheets of SunGard Data Systems Inc. and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of SunGard Data Systems Inc. and subsidiaries as of December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. COOPERS & LYBRAND 2400 Eleven Penn Center Philadelphia, Pennsylvania February 10, 1994 SunGard Data Systems Inc. and Subsidiaries Consolidated Statements of Income In thousands, except per share amounts The accompanying notes are an integral part of these financial statements. SunGard Data Systems Inc. and Subsidiaries Consolidated Balance Sheets In thousands, except per share amounts The accompanying notes are an integral part of these financial statements. SunGard Data Systems Inc. and Subsidiaries Consolidated Statements of Cash Flows In thousands The accompanying notes are an integral part of these financial statements. SunGard Data Systems Inc. and Subsidiaries Consolidated Statement of Stockholders' Equity In thousands, except per share amounts The accompanying notes are an integral part of these financial statements. SunGard Data Systems Inc. and Subsidiaries Notes to Consolidated Financial Statements 1. Summary of Significant Accounting Policies Principles of Consolidation SunGard Data Systems Inc. (the Company), through its wholly owned subsidiaries, operates in a single industry segment providing computer services, principally proprietary processing services and software to the financial services industry and computer disaster recovery services. The consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany transactions and accounts have been eliminated. Revenue Recognition Revenues from disaster recovery, software maintenance and remote processing services are recognized as the related service is provided. License fee revenues from proprietary products are generally recognized upon the signing of a contract and delivery of the product. In those instances where the Company provides training, installation and other post-delivery services, a portion of the contract price is deferred and recognized as the services are provided. Revenues from fixed-fee contracts requiring a significant amount of program modification or customization are recognized based on the estimated percentage of completion. Changes in estimated costs during the course of the contract are reflected in the period in which the facts become known. Cash Equivalents and Short-Term Investments Cash in excess of daily requirements is invested primarily in institutional money market funds, commercial paper, time deposits, certificates of deposit and short-term bonds. Investments purchased with a maturity of three months or less are considered cash equivalents. Investments purchased with a maturity of more than three months are considered short-term investments. All investments are stated at cost, which approximates fair value. Concentration of Credit Risk Financial instruments that potentially subject the Company to concentrations of credit risk consist of temporary cash and short-term investments and trade receivables. The Company places its temporary cash and short-term investments with institutions of high credit quality and, by policy, limits the amount of credit exposure to any one institution and industry. The Company sells a significant portion of its products and services to the U.S. banking industry and, although the Company could be directly affected by the well-being of the U.S. banking industry in general, the Company does not believe significant credit risk existed at December 31, 1993. Trade receivables are stated at estimated net realizable value, which approximates fair value. Property and Equipment Property and equipment are recorded at cost, and depreciation is provided on the straight-line method over the estimated useful lives of the related assets (two to eight years for equipment and ten to forty years for buildings and improvements). Leasehold improvements are amortized ratably over their remaining lease term or useful life, if shorter. Foreign Currency Translation The functional currency of each of the Company's foreign operations is the local currency of the country in which the operation is headquartered. Accordingly, all assets and liabilities are translated into U.S. dollars using exchange rates in effect at the balance sheet date. Revenues and expenses are translated using average exchange rates during the period. Increases and decreases in net assets resulting from foreign currency translation are reported as a separate component of stockholders' equity. Transaction gains and losses are included in the results of operations and are not material. Software Development and Product Costs Product development costs are charged to expense as incurred and consist primarily of design and development costs of new products and significant enhancements incurred prior to the establishment of a product's technological feasibility and of routine maintenance of proprietary software products. Costs associated with purchased software, software acquired through business acquisitions, and new products and enhancements to existing products that meet technological feasibility and recoverability tests are capitalized and amortized over the estimated useful lives of the related products, generally five to ten years, using the straight-line method or the ratio of current revenues to current and anticipated revenues from such software, whichever provides the greater amortization. Amortization of all software products aggregated $8,564,000,$7,227,000 and $6,955,000 during 1993, 1992 and 1991, respectively. Goodwill Goodwill represents the excess of cost over the fair value of net assets acquired and is amortized on the straight-line method over periods ranging from ten to forty years. Other Intangible Assets Other intangible assets consist primarily of certain acquired contract rights, which are amortized on the straight-line method over their estimated remaining lives, not exceeding twenty years. Income Taxes Effective January 1, 1992, the Company implemented Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," which requires recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred tax assets and liabilities are determined based on the difference between the financial and tax bases of assets and liabilities using the currently enacted tax rates in effect during the years in which the differences are expected to reverse. The impact of implementing the provisions of Statement No. 109 did not have a material effect upon the Company's financial position or its results of operations. Prior to 1992, the provision for income taxes was computed based on income and expenses included in the accompanying Consolidated Statements of Income. Differences between taxes computed based on financial statement income and taxes payable under applicable tax regulations were recorded as deferred tax assets and liabilities arising from timing differences. Net Income Per Share Primary net income per share is computed by dividing net income by the weighted- average number of common and common-equivalent shares outstanding. Fully diluted net income per share is computed based on the assumption that all of the Company's convertible subordinated debentures were converted into common shares on the date of issue (see Note 4). For purposes of calculating fully diluted net income per share, net income is increased by the assumed incremental after-tax interest savings, and the weighted-average number of shares outstanding is increased by the additional common shares assumed to be issued upon conversion of the subordinated debentures. 2. Acquisitions and Dispositions Purchase Transactions and Product Line Sale During 1993, the Company completed eight business acquisitions. Four acquisitions were in the Company's investment support systems business and four were in its disaster recovery services business. Total cash paid in connection with the acquisitions was approximately $30,808,000, subject to certain adjustments. Goodwill recorded in connection with these acquisitions was approximately $11,700,000. On February 5, 1993, the Company sold its automotive dealership systems product line, resulting in an after-tax gain of $3,371,000, or $0.18 per share, on a fully diluted basis. Effective October 31, 1992, the Company completed the acquisition of AJL Holding AB (AJL), of Stockholm, Sweden, whose subsidiary Front Capital Systems AB is a developer and marketer of one of the world's leading front-office and analysis systems for exchange-traded and equity derivatives. The purchase price was approximately $7,900,000 in cash, plus a contingent payment of up to 50,000,000 Swedish Kronor (approximately $6,000,000 at December 31, 1993) depending upon AJL achieving certain financial results during the forty-two- month period ending April 30, 1996. The Consolidated Statements of Income include the results of AJL from November 1, 1992. Goodwill recorded in connection with this acquisition was approximately $4,200,000. On July 31, 1992, the Company completed the acquisition of Shaw Data Services, Inc. and its affiliates (Shaw), the largest domestic provider of portfolio management and performance measurement systems and computer services to institutional investment organizations and investment advisors. The initial purchase price was approximately $14,500,000 in cash, subject to certain adjustments, plus a contingent payment of up to $15,000,000 depending upon Shaw achieving certain financial results during the three-year period ending July 31, 1995. The Consolidated Statements of Income include the results of Shaw from August 1, 1992. Goodwill recorded in connection with this acquisition was approximately $5,300,000. During 1991, the Company paid a total of approximately $8,900,000 in connection with three acquisitions, one for each of its product groups. Pro forma combined results of operations are not presented since the results of operations as reported in the accompanying Consolidated Statements of Income would not be materially different. 3. Property and Equipment Property and equipment consist of the following at December 31 (in thousands): 4. Long-Term Debt Long-term debt consists of the following at December 31 (in thousands): On April 22, 1993, the Company issued a Notice of Redemption for all of its $86,250,000 convertible subordinated debentures (Debentures). On May 12, 1993, $86,055,000 of the Debentures were converted into 3,309,803 shares of common stock of the Company at a conversion price of $26.00 per share. On May 24, 1993, the balance of $195,000 was redeemed at par plus a premium of 5.78%. On a pro forma basis, had the Debentures been converted on January 1, 1993, primary earnings per share would have approximated earnings per share on a fully diluted basis. On April 15, 1993, the Company entered into two unsecured revolving credit agreements (Credit Agreements) that provide for up to $25,000,000 of revolving credit for a three-year period (renewable on an annual basis at the lenders' option) at an interest rate based upon LIBOR plus 0.75%, the CD rate plus 0.875%, or the Prime rate, at the Company's option. In order to remain eligible for borrowing under the Credit Agreements, the Company must, among other requirements, maintain a defined minimum tangible net worth and limit its other unsubordinated debt. There has been no borrowing under the Credit Agreements through December 31, 1993. Annual maturities of long-term debt during the next five years are as follows: 1994-$3,162,000; 1995-$374,000; 1996-$358,000; 1997-$365,000 and 1998- $365,000. 5. Stock Option and Award Plans Employee Stock Purchase Plan Under the Company's Employee Stock Purchase Plan, a maximum of 600,000 shares of common stock may be issued to substantially all full-time employees. Eligible employees may purchase a limited number of shares of common stock each quarter through payroll deductions at a purchase price equal to 85% of the closing price of the Company's common stock on the last business day of each calendar quarter. During 1993, 1992 and 1991, employees purchased 64,000, 63,000 and 71,000 shares, respectively, at average purchase prices of $30.06, $22.21 and $13.95 per share, respectively. At December 31, 1993, 269,000 common shares were reserved for issuance under this plan. Restricted Stock Plans On April 30, 1991, the stockholders approved the Company's Restricted Stock Award Plan for Outside Directors (RSAP). The RSAP provides for awards of up to 100,000 shares of the Company's common stock. Each outside director will automatically receive an initial award of 5,000 shares of the Company's common stock upon election to the Company's Board of Directors and, upon reelection as an outside director every fifth year thereafter, will automatically receive another 5,000 shares. Shares awarded under the RSAP are subject to certain transfer and forfeiture restrictions that lapse over a five-year vesting period. During 1993 and 1991, RSAP awards of 5,000 and 29,000 shares, respectively, were granted at weighted-average market values of $29.00 and $17.02 per share, respectively. There were no awards during 1992. On May 1, 1990, the stockholders approved the Company's Restricted Stock Incentive Plan (RSIP). The RSIP provides for awards of up to 400,000 shares of the Company's common stock to key management employees. Shares awarded under the RSIP are subject to certain transfer and forfeiture restrictions that lapse over a five-year vesting period. During 1991, RSIP awards of 4,000 shares were granted at a weighted-average market value of $17.75 per share. There were no awards during 1993 or 1992. Unearned compensation expense related to the restricted stock plans is reported as a reduction of stockholders' equity in the accompanying consolidated financial statements. For accounting purposes, compensation expense is recorded ratably over the five-year period during which the shares are subject to transfer and forfeiture restrictions and is based on the market value on the award date less the par value of the shares awarded. Compensation expense related to these plans aggregated $1,432,000, $1,414,000 and $1,450,000 for the years ended December 31, 1993, 1992 and 1991, respectively. Stock Option Plans Under the Company's 1986 Stock Option Plan, options to purchase up to 1,000,000 shares of the Company's common stock may be issued to officers and key employees. These options may be either incentive stock options or nonqualified stock options, and the option price must be at least equal to the fair value of the Company's common stock on the date of grant. Options are granted for a ten-year term and become fully exercisable one year from the date of grant, subject to five-year vesting schedules. Under the Company's 1982 Incentive Stock Option Plan, employees were granted options to purchase up to 1,047,000 shares of the Company's common stock at 100% of the fair value of the stock on the date of grant. Options were granted for a ten-year term and became exercisable in five cumulative annual installments of 20%, commencing one year from the date of grant. The table below summarizes transactions under the Company's 1986 and 1982 stock option plans. Under the Company's 1988 Non-Qualified Stock Option Plan (the 1988 Plan), options to purchase up to 200,000 shares of the Company's common stock may be issued to officers and key employees of the Company at a price equal to the lower of $8.00 per share or 50% of the fair value of the Company's common stock on the date of grant. Stock appreciation rights may be granted with respect to options granted or outstanding. Upon exercise of stock appreciation rights, the holder will receive cash, common stock or a combination thereof, as determined by the Compensation Committee of the Board of Directors, equal to the difference between the increase in the market value and the underlying option price. Options and stock appreciation rights granted under the 1988 Plan expire ten years and five days from the date of grant. Under a compensation arrangement with an executive officer of the Company, the executive had the right to receive options to purchase common stock of the Company under the 1988 Plan based on performance during the four-year period ended December 31, 1992. Based upon achieving the goals which were established in 1988, the executive received options to purchase a total of approximately 159,000 shares of the Company's common stock at $8.00 per share. Compensation expense related to this agreement was charged to income over the period earned and aggregated $1,264,000 and $467,000 for the years ended December 31, 1992 and 1991, respectively. There were no options granted during 1993. 6. Savings Plans The Company and its subsidiaries maintain savings plans that cover substantially all employees. These plans generally provide that the Company will contribute a certain percentage of employee compensation or contributions up to a specified level. Company contributions charged to income under these plans aggregated $3,092,000, $2,466,000 and $1,972,000 for the years ended December 31, 1993, 1992 and 1991, respectively. 7. Income Taxes Effective January 1, 1992, the Company implemented Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." The implementation of the provisions of Statement No. 109 did not have a material effect upon the Company's financial position or results of operations. Prior- year financial statements have not been restated to apply the provisions of Statement No. 109. Statement No. 109 requires recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements or tax returns. Deferred tax assets and liabilities are determined based on the difference between financial and tax bases of assets and liabilities using currently enacted tax rates in effect during the years in which the differences are expected to reverse. The provisions for income taxes for the years ended December 31, 1993, 1992 and 1991 consist of the following (in thousands): The principal sources of temporary differences for 1993 and 1992 and timing differences for 1991 that gave rise to deferred taxes and their tax effects for the years ended December 31, 1993, 1992 and 1991 follow (in thousands): Differences between income tax expense at the statutory U.S. federal income tax rate and the Company's effective tax rate are as follows (in thousands): Deferred taxes are recorded based upon differences between financial statement and tax bases of assets and liabilities. The following deferred taxes were recorded as of December 31, 1993 and 1992 (in thousands): 8. Royalty Income In 1986, the Company sold a software product to Electronic Data Systems Corporation (EDS). Under the terms of the agreement, EDS made an initial payment of $2,000,000 and agreed to pay additional royalties of $10,000 per system installation licensed by EDS, up to a maximum of $15,000,000. The accompanying Consolidated Statements of Income include revenues of $632,000, $1,189,000 and $1,911,000 derived from EDS for the years ended December 31, 1993, 1992 and 1991, respectively. Cumulative royalties recognized under this agreement were $8,670,000 at December 31, 1993. 9. Export Sales The Company's domestic operations recorded revenues from international software license, maintenance and professional services of approximately $29,061,000, $32,501,000 and $28,177,000 for the years ended December 31, 1993, 1992 and 1991, respectively. 10. Commitments The Company leases a substantial portion of its computer equipment and facilities under operating leases. Future minimum rentals under operating leases with initial or remaining noncancelable lease terms in excess of one year as of December 31, 1993 follow (in thousands): Rent expense aggregated $40,914,000, $38,130,000 and $37,923,000 for the years ended December 31, 1993, 1992 and 1991, respectively. Equipment and software maintenance expense aggregated $15,117,000, $11,763,000 and $9,953,000 for the years ended December 31, 1993, 1992 and 1991, respectively. SunGard Data Systems Inc. and Subsidiaries Selected Financial Information * In thousands, except per share amounts *See Note 2 of Notes to Consolidated Financial Statements. 1993 includes after- tax gain on sale of product line of $3,371, or $0.18 per share, on a fully diluted basis. INDEX OF EXHIBITS FILED WITH THIS REPORT - ----------- (1) Management contract or compensatory plan or arrangement.
63541_1993.txt	63541	1993	Item 1. Business. Maytag Corporation (the "Company") was organized as a Delaware corporation in 1925. In 1989, the Company completed the acquisition of Chicago Pacific Corporation ("CPC"), a furniture and international home appliance company, through a cash tender offer followed by a stock merger. CPC operated in two segments, home appliances and furniture; however, the Company later sold the furniture companies segment. The Company is engaged in two industry segments: home appliances and vending equipment. Financial and other information relating to industry segment and geographic data is included in Part II, Item 7 and Item 8. HOME APPLIANCES The home appliances segment comprises approximately 95% of 1993 consolidated net sales. The Company, through its various business units, manufactures and distributes a broad line of home appliances including laundry equipment, gas and electric ranges, refrigerators, freezers, dishwashers, and floor care products. In 1992, the Company sold its microwave oven and dehumidifier manufacturing operations. The Company continues to distribute microwave ovens and dehumidifiers, as well as compactors. Maytag Customer Service (formerly Maycor Appliance Parts & Service Co.) provides product service and parts distribution in the United States and Canada for all of the Company's appliance brands, except Hoover. Maytag International Inc., the Company's international marketing subsidiary, handles the sales of appliances and licensing of certain home appliance brands in markets outside the United States and Canada. Maytag Financial Services Corporation provides financing programs primarily to certain customers of the Company in North America. The Company markets its home appliances to all major United States and many major international markets, including the replacement market, the commercial laundry market, the new home and apartment builder market, the manufactured housing (mobile home) market, the recreational vehicle market, the private label market and the household/commercial floor care market. Products are primarily sold directly to dealers but are also sold through independent distributors, mass merchandisers and large national department stores. Sales of appliances to manufacturers of mobile homes and recreational vehicles are made directly by specialized marketing personnel. Most home appliance sales are made within North America. A portion of the Company's operations and sales are outside the United States. The risks involved in foreign operations vary from country to country and include tariffs, trade restrictions, changes in currency values, economic conditions and international relations. Geographic information is included in Part II, Item 8, Page 29. The Company uses basic raw materials such as steel, copper, aluminum, rubber and plastic in its manufacturing process in addition to purchased motors, compressors, timers, valves and other components. These materials are supplied by established sources and the Company anticipates that such sources will, in general, be able to meets its future requirements. The Company holds a number of patents which are important in the manufacture of its products. The licenses it holds on other patents are not considered to be critical to its business. The Company holds a number of trademark registrations of which the most important are ADMIRAL, HOOVER, JENN-AIR, MAGIC CHEF, MAYTAG, NORGE and the associated corporate symbols. The Company's home appliance business is not seasonal. The Company is not dependent upon a single home appliance customer or a few customers. Therefore, the loss of any one customer would not have a material adverse effect on its business. The dollar amount of backlog orders of the Company is not considered significant for home appliances in relation to the total annual dollar volume of sales. Because it is the Company's practice to maintain a level of inventory sufficient to cover anticipated shipments and since orders are generally shipped upon receipt, a large backlog would be unusual. The home appliance market is highly competitive with the principal competitors being larger than the Company. Because of continued competitiveness within the industry, price increases continue to be difficult to implement. There were no significant increases in the costs of the Company's raw materials or components in 1993. Information regarding the Company's improvement in gross margin over 1992 is included in Part II, Item 7. The Company uses product quality, customer service, advertising and sales promotion, warranty and pricing as its principal methods of competition. Although the Company has many manufacturing sites with environmental concerns, compliance with laws and regulations regarding the discharge of materials into the environment or relating to the protection of the environment has not had a material effect on capital expenditures, earnings or the Company's competitive position. The scheduled phase-out of chlorofluorocarbons ("CFCs", an aerosol propellant and refrigerant) by the mid-1990s, mandated by government standards, continues to cause concern throughout the refrigeration industry. In addition, alternative washing machine designs to meet anticipated future government regulations dealing with energy and water usage are being evaluated by the Company and the industry. Because compliance with these current and anticipated laws and regulations is essentially prospective, it has not had a significant impact on current operations. It is anticipated that the industry and the Company will meet all final standards. The number of employees of the Company within the home appliances segment as of December 31, 1993 was 19,661. VENDING EQUIPMENT The vending equipment segment comprises approximately 5% of 1993 consolidated net sales. The Company manufactures, through its Dixie-Narco subsidiary, a variety of soft drink vending machines and money changers. The products are sold primarily to companies bottling soft drinks such as Coca-Cola, Dr. Pepper, Pepsi Cola, Royal Crown Cola and Seven-Up. The Company uses steel as a basic raw material in its manufacturing processes in addition to purchased motors, compressors and other components made of copper, aluminum, rubber and plastic. These materials are supplied by established sources and the Company anticipates that such sources will, in general, be able to meet its future requirements. The Company holds a number of patents which are important in the manufacture of its products. The Company holds a DIXIE-NARCO trademark registration and its associated corporate symbol. Vending equipment sales, though stronger in the first six months of the year, are considered by the Company to be essentially nonseasonal. The Company's vending equipment segment is dependent upon a few major soft drink suppliers. Therefore, the loss of one or more of these customers could have a material adverse effect on this segment. The Company manufactures and sells its vending machines in competition with a small number of other manufacturers and is the major manufacturer of such equipment. The principal methods of competition utilized by the vending equipment segment are product quality, customer service, delivery, warranty and price. Positive factors pertaining to the Company's competitive position include product design, manufacturing efficiency and superior service, while new product innovations by competitors and severe price competition negatively impact its position. The dollar amount of backlog orders of the Company is not considered significant for vending equipment in relation to the total annual dollar volume of sales. Because it is the Company's practice to maintain a level of inventory sufficient to cover shipments and since orders are generally shipped upon receipt, a large backlog would be unusual. Although the Company has manufacturing sites with environmental concerns, compliance with laws and regulations regarding the discharge of materials into the environment or relating to the protection of the environment has not had a material effect on capital expenditures, earnings or the Company's competitive position. The scheduled phase-out of chlorofluorocarbons ("CFCs', an aerosol propellant and refrigerant) by the mid-1990s, mandated by government standards, will also not affect the production technology in the vending equipment industry. This has not had a significant impact on current operations, and it is anticipated that the industry and the Company will meet all final standards. The number of employees of the Company within the vending equipment segment as of December 31, 1993 was 1,136. Item 2.		Item 2. Properties. The Company's corporate headquarters is located in Newton, Iowa. Major offices and manufacturing facilities in the United States related to the home appliances segment are located at: Galesburg, Illinois; Jackson, Tennessee; Indianapolis, Indiana; Cleveland, Tennessee; Herrin, Illinois; Newton, Iowa; North Canton, Ohio; and El Paso, Texas. Maytag Customer Service, which is located in Cleveland, Tennessee, operates an automated national parts distribution center in Milan, Tennessee which services all of the Company's appliance brands, except Hoover. In addition to manufacturing facilities in the United States, the Company has three other North American manufacturing facilities located in Canada and Mexico. The Company also has five manufacturing facilities outside North America in Australia, Portugal and the United Kingdom. A sixth manufacturing facility in Dijon, France was closed in 1993. Major facilities related to the vending equipment segment are: Dixie-Narco, Inc., with offices and manufacturing facilities located in Williston, South Carolina and Eastlake, Ohio. The manufacturing facilities are well maintained, suitably equipped and in good operating condition. The facilities used in the production of home appliances and vending equipment had sufficient capacity to meet production needs in 1993, and the Company expects that such capacity will be adequate for planned production in 1994. The Company's 1993 capital expenditures and the planned 1994 capital expenditures include an ongoing program of product improvements and enhanced manufacturing efficiencies. The Company also owns or leases sales offices in many large metropolitan areas throughout the United States, Australia, Canada, the United Kingdom and Western Europe. Lease commitments were not material at December 31, 1993. Item 3.	Item 3. Legal Proceedings. The Company is involved in contractual disputes, environmental, administrative and legal proceedings and investigations of various types. Although any litigation, proceeding or investigation has an element of uncertainty, the Company believes that the outcome of any proceeding, lawsuit or claim which is pending or threatened, or all of them combined, will not have a material adverse effect on its consolidated financial position. Item 4.	Item 4. Submission of Matters to a Vote of Security Holders. The Company did not submit any matters to a vote of security holders during the fourth quarter of 1993 through a solicitation of proxies or otherwise. Executive Officers of the Registrant The following sets forth the names of all executive officers of the Company, the offices held by them, the year they first became an officer of the Company and their ages: First Became Name Office Held an Officer Age - ----------------- ----------------------- ------------ --- Leonard A. Hadley Chairman and Chief Executive Officer 1979 59 John P. Cunningham Executive Vice President and Chief Financial Officer 1994 56 Joseph F. Fogliano Executive Vice President and President North American Appliance Group 1993 54 Jon O. Nicholas Senior Vice President, Human Resources 1993 54 Carleton F. Zacheis Senior Vice President, Planning 1988 60 and Business Development Terry A. Carlson Vice President, Purchasing 1991 51 Janis C. Cooper Vice President, Public 1989 46 Affairs Randall J. Espeseth Vice President, Taxes 1992 47 Mark A. Garth Vice President - Controller and Chief Accounting Officer 1994 34 Edward H. Graham Vice President, General Counsel 1990 58 and Assistant Secretary Douglass C. Horstman Vice President, Government Affairs 1993 54 John H. Jansen Vice President, Technology 1992 54 Thomas C. Vice President and Treasurer 1989 55 Ringgenberg Steven H. Wood Vice President, Information Services 1992 36 E. James Bennett Secretary and Assistant General Counsel 1985 52 The executive officers were elected to serve in the indicated office until the organizational meeting of the Board of Directors following the annual meeting of shareholders on April 26, 1994 or until their successors are elected. Each of the executive officers has served the Company or an acquired company in various executive or administrative positions for at least five years except for: Name Company/Position Period - -------------------- ---------------------------- -------- Terry A. Carlson Estee Lauder, Inc - Vice President, Corporate Purchasing 1987-1991 John P. Cunningham IBM Corporation - Vice President and Assistant General Manager, Main Frame Division 1992-1993 - Vice President, Member Europe Executive Committee, Paris, 1990-1992 France - Vice President, Corporate 1988-1990 Controller Joseph F. Fogliano Thomson Consumer Electronics, Inc. 1988-1993 - President and CEO Douglass C. Horstman D. C. Horstman & Associates (government affairs consulting firm) 1973-1993 - Owner/Operator John H. Jansen Ridge Tool Company (a division of Emerson Electric Company) - Vice President, Engineering 1985-1992 Steven H. Wood Ernst & Young, Chicago, Illinois - Senior Manager 1985-1989 Part II Item 5.	Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. MARKET AND DIVIDEND INFORMATION - ------------------------------------------------------------------------------- Sales Price of Common Shares Dividends In Whole Dollars Per Share ------------------------------------------ ---------------- 1993 1992 1993 1992 ----------------- ----------------- ---- ---- Quarter High Low High Low - ------- ---- --- ---- --- First $16 $13 $20 $15 $.125 $.125 Second 16 13 21 16 .125 .125 Third 18 15 18 13 .125 .125 Fourth 19 15 16 13 .125 .125 The principal U.S. market in which the Company's common stock is traded is the New York Stock Exchange. As of March 1, 1994 the Company had 32,334 shareowners of record. Item 6.	Item 6. Selected Financial Data. Thousands of Dollars Except Per Share Data (1) (2) (3) 1993 1992 1991 1990 1989 ---------- ---------- ---------- ---------- ---------- Net sales $2,987,054 $3,041,223 $2,970,626 $3,056,833 $3,088,753 Cost of sales 2,262,942 2,339,406 2,254,221 2,309,138 2,312,645 Income taxes 38,600 15,900 44,400 60,500 75,500 Income (loss) from continuing operations 51,270 (8,354) 79,017 98,905 131,472 Percent of income (loss) from continuing operations to net sales 1.7% (.3%) 2.7% 3.2% 4.3% Income (loss) from continuing operations per share $ .48 $ (.08) $ .75 $ .94 $ 1.27 Dividends paid per share .50 .50 .50 .95 .95 Average shares outstanding (in thousands) 106,252 106,077 105,761 105,617 103,694 Working capital $ 406,181 $ 452,626 $ 509,025 $ 612,802 $ 650,905 Depreciation of property, plant and equipment 102,459 94,032 83,352 76,836 68,077 Additions to property, plant and equipment 99,300 129,891 143,372 141,410 127,838 Total assets 2,469,498 2,501,490 2,535,068 2,586,541 2,436,319 Long-term debt 724,695 789,232 809,480 857,941 876,836 Total debt to capitalization 60.6% 58.7% 45.9% 47.7% 50.6% Shareowners' equity per share of Common stock $ 5.50 $ 5.62 $ 9.50 $ 9.60 $ 8.89 (1) Includes $60.4 million in pretax charges ($50 million in a special charge and $10.4 million in selling, general and administrative expenses) for additional costs associated with two Hoover Europe "free flights" promotion programs. (2) Includes a $95 million pretax charge relating to the reorganization of the North American and European business units and before cumulative effect of accounting changes. (3) These amounts reflect the acquisition of Hoover on January 26, 1989. Item 7.	Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. _____________________________________________________________________________ COMPARISON OF 1993 WITH 1992 The Company operates in two business segments, home appliances and vending equipment. The operations of the home appliance segment represented 95.0 percent of net sales in 1993 and 1992. Consolidated net sales decreased 1.8 percent in 1993 compared to 1992. Although sales volumes in the United States increased due to improved consumer confidence, the overall decline in sales resulted from a decrease in European sales, less favorable currency conversions of sales outside the United States, and the absence of sales from the microwave oven operation that was sold in June 1992. North American home appliance sales increased 3.1 percent in spite of the absence of sales from the microwave oven operation. European sales decreased 22.1 percent from 1992 due to less favorable currency conversions and lower sales volumes due to some market share declines. Lower sales volumes in Europe are expected in 1994 compared to 1993. Sales in the Company's vending equipment segment declined 5.3 percent from 1992 due to slow economic activity in Europe, cutbacks by domestic bottlers and increased competition. Gross profit as a percent of sales increased to 24.2 percent from 23.1 percent in 1992. The increase in margins resulted principally from improvements in the North American Appliance Group. The improvement in the North American Appliance Group was primarily due to production efficiencies, reductions of certain employee-related costs and some selective price increases. In addition, 1992 results for the North American Appliance Group included plant start-up costs. Gross margins in Hoover Europe declined primarily due to operating inefficiencies associated with previously announced plans to close a factory in Dijon, France and higher pension costs. Vending equipment margins improved in 1993 due to reductions in material, distribution and warranty costs from 1992. In 1994, although consolidated pension and postretirement medical costs are expected to increase due to a reduction in the discount rate assumption and lower pension assets, this is expected to be offset by other cost reductions. Selling, general and administrative (S,G&A) expenses decreased to 17.2 percent in 1993 from 17.4 percent in 1992. The decline was principally due to cost efficiencies resulting from the reorganization of the North American Appliance Group. Special charges consisted of a $50 million pretax charge in the first quarter of 1993 to cover anticipated additional costs associated with two "free flights" promotional programs in Europe and a $95 million pretax charge in the third quarter of 1992 for a reorganization of U.S. and European operations. Total pretax charges relating to the "free flights" promotion programs in 1993 were $60.4 million ($50 million in a special charge and $10.4 million in S,G&A) and in 1992 were $12.2 million. See the notes to the financial statements for a discussion of this matter. Offsetting a portion of the 1993 European "free flights" expenses in S,G&A was a $5 million reversal of excess reorganization reserves in Europe. Operating income for 1993 totaled $158.9 million compared to $78.6 million in 1992. Before special charges, operating income would have been $208.9 million or 7.0 percent of sales in 1993 compared to $173.6 million or 5.7 percent of sales in 1992. The decrease in the effective tax rate for 1993 was primarily due to the 1992 tax rate reflecting the impact of non-recoverable losses outside the MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - continued _____________________________________________________________________________ United States. The notes to the financial statements include a reconciliation between the statutory tax and the actual tax provided. Excluding special charges in 1993 and 1992 and the cumulative effect of accounting changes in 1992, net income would have been $81.3 million or $.76 per share in 1993 compared to net income of $65.4 million or $.62 per share in 1992. In November 1992, the Financial Accounting Standards Board issued Statement No. 112 (FAS 112), "Employers' Accounting for Postemployment Benefits." The new rules require recognition of specified postemployment benefits provided to former or inactive employees, such as severance pay, workers' compensation, supplemental unemployment benefits, disability benefits and continuation of healthcare and life insurance coverages. The Company has estimated that the cumulative effect of adopting FAS 112, which will be recorded in the first quarter of 1994, will be between $.02-$.04 per share. The ongoing expenses associated with the adoption of the new rules are not expected to be material. _____________________________________________________________________________ COMPARISON OF 1992 WITH 1991 The Company operates in two business segments, home appliances and vending equipment. The operations of the home appliance segment represented 95.0 percent of net sales in 1992 and 1991. Effective January 1, 1992, the Company adopted Statement of Financial Accounting Standards No. 106 (FAS106) "Employers' Accounting for Postretirement Benefits Other than Pensions." FAS 106 requires companies to recognize the cost of postretirement benefits over an employee's service period. The Company's previous practice had been to recognize these costs as claims were received. The one-time transitional cost for adopting FAS106 resulted in an aftertax charge of $222 million or $2.09 per share in the first quarter of 1992. FAS106 also resulted in an additional pretax charge of approximately $24 million in 1992. Implementation of FAS106 had no impact on cash flows and the Company continues to pay the cost of postretirement benefits as claims are received. Also effective January 1, 1992, the Company adopted Statement of Financial Accounting Standards No. 109 (FAS109) "Accounting for Income Taxes." The adoption of FAS109 required a one-time aftertax charge of $85 million or $.80 per share. However, there was no cash flow impact of adopting the pronouncement since deferred taxes changed by a like amount. The one-time cumulative impact of adopting both FAS106 and FAS109 totaled $307 million or $2.89 per share. Consolidated net sales increased 2.4 percent in 1992 compared to 1991. The overall sales increase, although partially offset by lower prices, was due to market share gains in most product categories and increased volume as a result of improved consumer confidence in the United States. Sales of the Company's home appliances within North America increased 2.7 percent from 1991. While European sales were 1.3 percent higher in 1992 compared to 1991, the majority of the increase is due to favorable currency translation with volume remaining flat. The Company's vending sales increased 10.4 percent in 1992, primarily due to increased volume within the United States. Gross profit as a percent of sales decreased to 23.1 percent from 24.1 percent in 1991. The deterioration in margins was principally caused by additional expenses arising from the use of FAS106 as well as expenses related to a plant start-up, new product introductions and price reductions. Excluding FAS106 charges, gross profit as a percent of sales would have been 23.8 percent for 1992. Selling, general and administrative expenses as a percent of sales and MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - continued _____________________________________________________________________________ before reorganization remained relatively level at 17.4 percent in 1992 and 17.7 percent in 1991. The slight decrease was caused primarily by increased sales in 1992. During the third quarter of 1992, the Company provided for the costs of reorganizing its North American and European operations. In North America, several manufacturing facilities are being realigned, effectively combining expertise in research, engineering and product development. In addition, sales forces were reorganized and streamlined. The Company was also implementing a centralized distribution and order system for its North American operations designed to enhance customer service and operational efficiency. The effort in Europe was aimed at downsizing production capacity and streamlining sales, marketing, administration and distribution activities. This special charge reduced income before income taxes by $95 million or $.70 per share after tax. Operating income for 1992 amounted to $78.6 million compared to $191.5 million in 1991. Before the special reorganization charge, 1992 operating income would have been $173.6 million or 5.7 percent of sales, down $17.9 million or 9.4 percent from 1991. The net operating loss of the Company's European operations in 1992 increased $66.2 million from 1991 primarily due to a provision of $55 million for reorganization expenses relating to plant closings and other organizational changes and the continuing recession in the United Kingdom. The increase in the effective tax rate was primarily due to the effect of non-recoverable losses outside of the United States. The notes to the financial statements contain a reconciliation between the statutory tax and the actual tax provided. Excluding the cumulative effect of accounting changes and reorganization expenses, for comparative purposes, net income would have been $65.4 million or $.62 per share compared to net income of $79 million or $.75 per share in 1991. _____________________________________________________________________________ LIQUIDITY AND CAPITAL RESOURCES Cash provided by operations in 1993 totaled $71.3 million compared to $183.1 million in 1992. The overall decrease resulted from the funding of expenditures relating to the reorganization of the North American and European operations, the Hoover Europe "free flights" promotions and working capital needs in the North American Appliance Group. Offsetting this decrease was a $42 million withdrawal from an over-funded pension plan in Europe and lower funding of an employee benefit trust. Current assets were 1.6 times current liabilities at December 31, 1993 and 1.8 times at December 31, 1992. Gross capital expenditures in 1993 were $99.3 million compared to $129.9 million in 1992. The expenditures in 1993 were mainly related to improvements in product design and manufacturing processes and increases in manufacturing capacity. Capital spending in 1992 was higher as it included major plant start-up projects. Planned capital expenditures for 1994 approximate $110 million and relate to ongoing production improvements and product enhancements. Depreciation expense increased to $102.5 million in 1993 from $94.0 million in 1992 resulting from major capital projects completed near the end of 1992. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - continued _____________________________________________________________________________ Significant investing and financing transactions related to capital expenditures, debt retirement and dividend payments were funded through operations and the issuance of $5.5 million in medium term notes and a $139.0 million increase in notes payable and commercial paper borrowings. The Company also reduced long term debt by $94.4 million during 1993. The Company has two credit facilities which support the Company's commercial paper program. Subject to certain exceptions, the credit agreements require the Company to maintain certain quarterly levels of consolidated tangible net worth, leverage ratios and interest coverage ratios. The Company was in compliance with all covenants at December 31, 1993 and expects to be in compliance with all covenants. The covenants become more stringent commencing in the first quarter of 1994. Additional funds available at December 31, 1993 under all credit agreements, applying the terms of the most restrictive covenant above, totaled $243 million. Dividend payments in both 1993 and 1992 amounted to $53 million or $.50 per share. Dividends amounted to nine percent of average shareowners' equity in 1993 and seven percent in 1992. Any funding requirements for future capital expenditures and other cash requirements in excess of cash generated from operations will be supplemented with issuance of debt securities and bank borrowings. _____________________________________________________________________________ IMPACT OF INFLATION The Company uses the LIFO method of accounting for approximately 79 percent of its inventories. Under this method, the cost of sales reported in the financial statements approximates current costs. The charges to operations for depreciation represent the allocation of historical costs incurred over past years and are significantly less than if they were based upon current costs of productive capacity being consumed. Assets acquired in prior years will, of course, be replaced at higher costs but this will take place over several years. New higher-cost assets will result in higher depreciation charges, but in many cases due to technological improvements, there will be operating cost savings as well. Item 8.	Item 8. Financial Statements and Supplementary Data. Page ---- Report of Independent Auditors 13 Statements of Consolidated Income--Years ended December 31, 1993, 1992 and 1991 14 Statements of Consolidated Financial Condition-- December 31, 1993 and 1992 15 Statements of Consolidated Cash Flows--Years ended December 31, 1993, 1992 and 1991 17 Notes to Consolidated Financial Statements 18 Quarterly Results of Operations--Years 1993 and 1992 30 Report of Independent Auditors Shareowners and Board of Directors Maytag Corporation We have audited the accompanying statements of consolidated financial condition of Maytag Corporation and subsidiaries as of December 31, 1993 and 1992, and the related statements of consolidated income and consolidated cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and related schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and related schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. These standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Maytag Corporation and subsidiaries at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in notes to consolidated financial statements, in 1992 the Company changed its method of accounting for postretirement benefits other than pensions and income taxes. Ernst & Young February 1, 1994 Chicago, Illinois STATEMENTS OF CONSOLIDATED INCOME (LOSS) Thousands of Dollars Except Per Share Data Year ended December 31 1993 1992 1991 --------- --------- --------- Net sales $2,987,054 $3,041,223 $2,970,626 Cost of Sales 2,262,942 2,339,406 2,254,221 --------- --------- --------- GROSS PROFIT 724,112 701,817 716,405 Selling, general and administrative expenses 515,234 528,250 524,898 Special charges 50,000 95,000 --------- --------- --------- OPERATING INCOME 158,878 78,567 191,507 Interest expense (75,364) (75,004) (75,159) Other--net 6,356 3,983 7,069 --------- --------- --------- INCOME BEFORE INCOME TAXES AND CUMULATIVE EFFECT OF ACCOUNTING CHANGES 89,870 7,546 123,417 Income taxes 38,600 15,900 44,400 --------- --------- --------- INCOME (LOSS) BEFORE CUMULATIVE EFFECT OF ACCOUNTING CHANGES 51,270 (8,354) 79,017 Cumulative effect of accounting changes for postretirement benefits other than pensions and income taxes (307,000) --------- --------- -------- NET INCOME (LOSS) $ 51,270 $ (315,354) $ 79,017 ========= ========= ======== Income (loss) per average share of Common stock: Income (loss) before cumulative effect of accounting changes $ .48 $ (.08) $ .75 Cumulative effect of accounting changes $ (2.89) Net income (loss) per Common share $ .48 $ (2.97) $ .75 See notes to consolidated financial statements. STATEMENTS OF CONSOLIDATED FINANCIAL CONDITION Thousands of Dollars December 31 -------------------- ASSETS 1993 1992 - ------ --------- --------- CURRENT ASSETS Cash and cash equivalents $ 31,730 $ 57,032 Accounts receivable, less allowance-- (1993--$15,629; 1992--$16,380) 532,353 476,850 Inventories 429,154 401,083 Deferred income taxes 46,695 52,261 Other current assets 16,919 28,309 ---------- ---------- Total current assets 1,056,851 1,015,535 NONCURRENT ASSETS Deferred income taxes 68,559 71,442 Pension investments 168,103 215,433 Intangibles, less allowance for amortization-- (1993--$46,936; 1992--$37,614) 319,657 328,980 Other noncurrent assets 35,266 35,989 ----------- ---------- Total noncurrent assets 591,585 651,844 PROPERTY, PLANT AND EQUIPMENT Land 46,149 47,370 Buildings and improvements 288,590 286,368 Machinery and equipment 1,068,199 962,006 Construction in progress 44,753 90,847 ---------- ---------- 1,447,691 1,386,591 Less allowance for depreciation 626,629 552,480 ---------- ---------- Total property, plant and equipment 821,062 834,111 ---------- ---------- TOTAL ASSETS $2,469,498 $2,501,490 ========== ========== December 31 ---------------------- LIABILITIES AND SHAREOWNERS' EQUITY 1993 1992 ---------- ---------- CURRENT LIABILITIES Notes payable $ 157,571 $ 19,886 Accounts payable 195,981 218,142 Compensation to employees 84,405 89,245 Accrued liabilities 178,015 180,894 Income taxes payable 16,193 11,323 Current maturities of long-term debt 18,505 43,419 --------- ---------- Total current liabilities 650,670 562,909 NONCURRENT LIABILITIES Deferred income taxes 44,882 89,011 Long-term debt 724,695 789,232 Postretirement benefits other than pensions 391,635 380,376 Other noncurrent liabilities 70,835 80,737 --------- ---------- Total noncurrent liabilities 1,232,047 1,339,356 SHAREOWNERS' EQUITY Common stock: Authorized--200,000,000 shares (par value $1.25) Issued--117,150,593 shares, including shares in treasury 146,438 146,438 Additional paid-in capital 480,067 478,463 Retained earnings 325,823 328,122 Cost of Common stock in treasury (1993--10,430,833 shares; 1992--10,545,915 shares) (232,510) (234,993) Employee stock plans (62,342) (65,638) Foreign currency translation (70,695) (53,167) --------- ---------- Total shareowners' equity 586,781 599,225 --------- ---------- TOTAL LIABILITIES AND SHAREOWNERS' EQUITY $2,469,498 $2,501,490 ========= ========= See notes to consolidated financial statements. STATEMENTS OF CONSOLIDATED CASH FLOWS Thousands of Dollars Year ended December 31 ------------------------------ 1993 1992 1991 -------- -------- -------- OPERATING ACTIVITIES Net income (loss) $ 51,270 $(315,354) $ 79,017 Adjustments to reconcile net income (loss) to net cash provided by operating activities: Cumulative effect of accounting changes 307,000 Depreciation and amortization 111,781 103,351 92,667 Deferred income taxes (35,833) (30,210) 1,700 Reorganization expenses (5,000) 95,000 "Free flights" promotion expenses 60,379 12,235 Changes in selected working capital items: Inventories (29,323) 80,731 37,075 Receivables and other current assets (48,609) (6,051) 12,867 Reorganization reserve (39,671) (15,530) "Free flights" promotion reserve (42,981) (1,604) Other current liabilities (17,383) (70,422) 46,623 Net change in pension assets and liabilities 43,513 (12,149) (22,385) Postretirement benefits 11,259 21,254 Other--net 11,913 14,814 (12,894) --------- -------- -------- NET CASH PROVIDED BY OPERATIONS 71,315 183,065 234,670 INVESTING ACTIVITIES Capital expenditures--net (95,990) (120,364) (138,100) --------- -------- -------- TOTAL INVESTING ACTIVITIES (95,990) (120,364) (138,100) FINANCING ACTIVITIES Proceeds from credit agreements and long-term borrowings 5,500 73,712 57,900 Increase (decrease) in notes payable 138,951 (2,378) (31,023) Reduction in long-term debt (94,449) (70,158) (92,832) Stock options exercised and other Common stock transactions 5,903 5,558 3,421 Dividends (53,569) (53,269) (53,150) --------- --------- -------- TOTAL FINANCING ACTIVITIES 2,336 (46,535) (115,684) Effect of exchange rates on cash (2,963) (7,886) (1,721) INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS (25,302) 8,280 (20,835) Cash and cash equivalents at beginning of year 57,032 48,752 69,587 --------- --------- -------- CASH AND CASH EQUIVALENTS AT END OF YEAR $ 31,730 $ 57,032 $ 48,752 ========= ======== ========= See notes to consolidated financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ______________________________________________________________________ SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: Principles of Consolidation: The consolidated financial statements include the accounts and transactions of the Company and its wholly owned subsidiaries. Certain subsidiaries located outside the United States are consolidated as of a date one month earlier than subsidiaries in the United States. Intercompany accounts and transactions are eliminated in consolidation. Exchange rate fluctuations from translating the financial statements of subsidiaries located outside the United States into U.S. dollars and exchange gains and losses from designated foreign currency transactions are recorded in a separate component of shareowners' equity. All other foreign exchange gains and losses are included in income. Certain reclassifications have been made to prior years' financial statements to conform with the 1993 presentation. Cash Equivalents: Highly liquid investments with a maturity of 90 days or less when purchased are considered by the Company to be cash equivalents. Inventories: Inventories are stated at the lower of cost or market. Cost is determined by the last-in, first-out (LIFO) method for approximately 79% and 76% of the Company's inventories at December 31, 1993 and 1992. The remaining inventories, which are primarily outside the United States, are stated using the first-in, first-out (FIFO) method. Intangibles: Intangibles principally represent goodwill, which is the cost of business acquisitions in excess of the fair value of identifiable net tangible assets. Goodwill is amortized over 40 years on the straight-line basis and the carrying value is reviewed annually. If this review indicates that goodwill will not be recoverable as determined based on the undiscounted cash flows of the entity acquired over the remaining amortization period, the Company's carrying value of the goodwill will be reduced by the estimated shortfall of cash flows. Income Taxes: Certain expenses (principally related to accelerated tax depreciation, employee benefits and various other accruals) are recognized in different periods for financial reporting and income tax purposes. Property, Plant and Equipment: Property, plant and equipment is stated on the basis of cost. Depreciation expense is calculated principally on the straight-line method for financial reporting purposes. The depreciation methods are designed to amortize the cost of the assets over their estimated useful lives. Short and Long-Term Debt: The carrying amounts of the Company's borrowings under its short-term revolving credit agreements, including multicurrency loans, approximate their fair value. The fair values of the Company's long- term debt are estimated based on quoted market prices of comparable instruments. - ------------------------------------------------------------------------------ INVENTORIES In thousands 1993 1992 -------- -------- Finished products $282,841 $249,289 Work in process, raw materials and supplies 146,313 151,794 -------- -------- $429,154 $401,083 ======== ======== If the first-in, first-out (FIFO) method of inventory accounting, which approximates current cost, had been used for all inventories, they would have been $76.3 million and $78.1 million higher than reported at December 31, 1993 and 1992. ___________________________________________________________________________ PENSION BENEFITS The Company and its subsidiaries have noncontributory defined benefit pension plans covering most employees. Plans covering salaried and management employees generally provide pension benefits that are based on an average of the employee's earnings and credited service. Plans covering hourly employees generally provide benefits of stated amounts for each year of service. The Company's funding policy is to contribute amounts to the plans sufficient to meet minimum funding requirements. A summary of the components of net periodic pension expense (income) for the defined benefit plans is as follows: Year ended December 31 -------------------------------- In thousands 1993 1992 1991 --------- ---------- --------- Service cost--benefits earned during the period $ 24,067 $ 21,469 $ 23,520 Interest cost on projected benefit obligation 90,322 87,654 85,325 Actual return on plan assets (167,539) (87,263) (141,918) Net amortization and deferral 59,315 (25,239) 23,602 --------- --------- --------- Net pension expense (income) $ 6,165 $ (3,379) $ (9,471) ========= ========= ========= The change in pension expense (income) from 1992 to 1993 resulted from pension benefit improvements, a reduction in the discount rate and lower expected return on assets resulting from lower asset values at the beginning of the year. Assumptions used in determining net periodic pension expense (income) for the defined benefit plans in the United States were: 1993 1992 1991 ---- ---- ---- Discount rates 8.5% 9% 9% Rates of compensation increase 6 6 6 Expected long-term rates of return on assets 9.5 9.5 9.5 For the valuation of pension obligations at the end of 1993 and for determining pension expense in 1994, the discount rate and rate of compensation increase have been decreased to 7.5% and 5.0% respectively. Assumptions for defined benefit plans outside the United States are comparable to the above in all periods. As of December 31, 1993, approximately 87% of the plan assets are invested in listed stocks and bonds. The balance is invested in real estate and short term investments. Certain pension plans in the United States provide that in the event of a change of Company control and plan termination, any excess funding may be used only to provide pension benefits or to fund retirees' health care benefits. The use of all pension assets for anything other than providing employee benefits is either limited by legal restrictions or subject to severe taxation. The following table sets forth the funded status and amounts recognized in the statements of consolidated financial condition for the Company's defined benefit pension plans: Pension investments above of approximately $104 million and $142 million at December 31, 1993 and 1992, and pension income of $5.4 million, $10.9 million and $7.1 million in 1993, 1992 and 1991 relate to pension plans covering employees in Europe. In 1993 and 1992, the Company recorded $4.9 million and $4.5 million, respectively, to recognize the minimum pension liability required by the provisions of Statement of Financial Accounting Standards No. 87, "Employers' Accounting for Pensions." The transaction, which had no effect on income, was offset by recording an intangible asset of an equivalent amount. ____________________________________________________________________________ POSTRETIREMENT BENEFITS OTHER THAN PENSIONS In addition to providing pension benefits, the Company provides postretirement health care and life insurance benefits for its employees in the United States. Most of the postretirement plans are contributory, and contain certain other cost sharing features such as deductibles and coinsurance. The plans are unfunded. Employees are not vested and these benefits are subject to change. Death benefits for certain retired employees are funded as part of, and paid out of, pension plans. In 1992, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," which requires employers to accrue the cost of such retirement benefits during the employee's service with the Company. Prior to 1992, the cost of providing these benefits to retired employees was recognized as a charge to income as claims were received. The transition obligation of $355 million as of January 1, 1992 was recorded as a one-time charge in the first quarter of 1992 and reduced net income by $222 million or $2.09 per share. The ongoing effect of adopting the new standard increased 1993 and 1992 periodic postretirement benefit cost by $11.3 and $23.9 million respectively. Postretirement benefit costs in 1991 of approximately $11.7 million were recorded on a cash basis and have not been restated. A summary of the components of net periodic postretirement benefit cost is as follows: In thousands 1993 1992 ------- ------- Service cost $10,225 $ 8,258 Interest cost 26,939 30,421 Net amortization and deferral (8,228) 2,106 ------- ------- Net periodic postretirement benefit cost $28,936 $40,785 ======= ======= Postretirement benefit costs for 1993 decreased primarily due to a plan amendment to eligibility requirements. Assumptions used in determining net periodic postretirement benefit cost were: 1993 1992 Health care cost trend rates (1): ---- ---- Current year 14% 15% Decreasing gradually to 6% 6% Until the year 2009 2009 Each year thereafter 6% 6% Discount rates 8.5% 9.0% (1) Weighted-average annual assumed rate of increase in the per capita cost of covered benefits. For the valuation of the accumulated benefit obligation at December 31, 1993 and for determining postretirement benefit costs in 1994, the health care cost trend rates were decreased. This results in a health care cost trend rate of 12.5 percent in 1994, decreasing gradually to 6 percent until 2001 and remaining at that level thereafter. In addition, the discount rate was reduced to 7.5 percent. The health care cost trend rate assumption has a significant impact on the amounts reported. For example, increasing the assumed health care cost trend rates by one percentage point in each year would increase the accumulated postretirement benefit obligation as of December 31, 1993 by $43.6 million and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for 1993 by $5.9 million. The following table presents the status of the plans reconciled with amounts recognized in the statements of consolidated financial condition for the Company's postretirement benefits. December 31 ---------------- 1993 1992 In thousands ---- ---- Accumulated postretirement benefit obligation: Retirees $284,524 $189,764 Fully eligible active plan participants 58,709 60,236 Other active plan participants 56,465 76,587 -------- -------- 399,698 326,587 Unamortized plan amendment 54,248 62,476 Unrecognized net loss (62,311) (8,687) Postretirement benefit liability recognized in the -------- -------- the statements of consolidated financial condition $391,635 $380,376 ======== ======== __________________________________________________________________________ OTHER EMPLOYEE BENEFITS The Company has a leveraged employee stock ownership plan (ESOP) for eligible United States employees. The ESOP is designed to fund the Company's contribution to an existing salaried savings plan. The Company made contributions to the plan of $5.5 million, $5.2 million and $4.9 million for loan payments in 1993, 1992 and 1991, the majority of which represents interest on the ESOP debt. With each loan and interest payment, a portion of the Common stock in the ESOP becomes available for allocation to participating employees. The Company also sponsors other defined contribution plans. Contributions to these plans are generally based on employees' compensation. Expenses of the Company related to these plans, including the ESOP, amounted to $8.6 million in 1993, $7.9 million in 1992 and $7.8 million in 1991. In November 1992, the Financial Accounting Standards Board issued Statement No. 112 (FAS 112), "Employers' Accounting for Postemployment Benefits." The new rules require recognition of specified postemployment benefits provided to former or inactive employees, such as severance pay, workers' compensation, supplemental employment benefits, disability benefits and continuation of healthcare and life insurance coverages. The Company has estimated the cumulative effect of adopting FAS 112, which will be recorded in the first quarter of 1994, will not have a material impact on the annual results for 1994. The ongoing expenses associated with the new statement are not expected to be material. ______________________________________________________________________________ ACCRUED LIABILITIES In thousands 1993 1992 ------ ------ Warranties $ 46,281 $ 50,877 Advertising/sales promotion 51,946 30,054 Other 79,788 99,963 ------ ------ $178,015 $180,894 ======= ======= ______________________________________________________________________________ INCOME TAXES Effective January 1, 1992, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," which requires recognition of deferred tax liabilities and assets for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred tax liabilities and assets are are determined based on the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. Prior to 1992, the provision for income taxes was based on income and expenses included in the accompanying consolidated statements of income. As permitted under the new rules, prior years' financial statements have not been restated. The cumulative effect of adopting Statement 109 was to decrease net income by $85 million or $.80 per share as of January 1, 1992. At December 31, 1993, the Company has available for tax purposes approximately $177 million of net operating loss carryforwards outside the United States, of which $38 million expire in various years through 1999 and $139 million is available indefinitely. Of this amount, $30 million relates to pre-acquisition net operating losses which will be used to reduce intangibles when utilized. Deferred income taxes reflect the net tax effects of temporary differences between the amount of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Company's deferred tax assets and liabilities as of December 31, 1993 and 1992 are as follows: In thousands 1993 1992 ---------- --------- Deferred tax assets (liabilities): Tax over book depreciation $(118,973) $(116,725) Postretirement benefit obligation 151,424 143,197 Product warranty accruals 20,021 20,221 Pensions and other employee benefits (38,753) (58,704) Reorganization accrual 8,856 23,586 Net operating loss carryforwards 48,817 23,178 Other 14,937 15,812 --------- --------- 86,329 50,565 Less valuation allowance for deferred tax assets (15,957) (15,873) --------- --------- Net deferred tax assets $ 70,372 $ 34,692 Recognized in statements of consolidated ========= ========= financial condition: Deferred tax assets-current $ 46,695 $ 52,261 Deferred tax assets-noncurrent 68,559 71,442 Deferred tax liabilities (44,882) (89,011) --------- --------- Net deferred tax assets $ 70,372 $ 34,692 ========= ========= Income (loss) before income taxes and cumulative effect of accounting changes consists of the following: Year ended December 31 ------------------------------- In thousands 1993 1992 1991 ------- ------ ------ United States $162,554 $ 80,013 $112,988 Non-United States (72,684) (72,467) 10,429 ------- ------- ------- $ 89,870 $ 7,546 $123,417 ======= ======= ======= Significant components of the provision for income taxes are as follows: Year ended December 31 ---------------------------- In thousands 1993 1992 1991 Current provision: ---- ---- ---- Federal $ 51,700 $ 37,000 $ 28,600 State 9,100 7,100 6,000 Non-United States 20,000 2,000 8,100 ------ ------ ------ 80,800 46,100 42,700 Deferred provision: Federal 400 (13,800) 7,600 State 700 (3,100) Non-United States (43,300) (13,300) (5,900) ------ ------ ------ (42,200) (30,200) 1,700 ------ ------ ------ Provision for income taxes $ 38,600 $ 15,900 $ 44,400 ====== ====== ====== Significant items impacting the effective income tax rate follow: Year ended December 31 ------------------------------- In thousands 1993 1992 1991 ------ ------ ------ Income before cumulative effect of accounting changes computed at the statutory United States income tax rate $31,500 $ 2,600 $42,000 Increase (reduction) resulting from: Acquisitions: Intangibles amortization 3,200 3,100 3,100 Depreciation 2,400 The effect of statutory rate differences outside the United States 2,500 2,600 600 Non-United States losses with no tax benefit 10,700 State income taxes, net of federal tax benefit 6,400 2,700 4,000 Tax credits arising outside the United States (800) (5,400) (7,300) Effect of tax rate changes on deferred taxes (2,500) Other-net (1,700) (400) (400) -------- ------- ------- Provision for income taxes $38,600 $15,900 $44,400 ======== ======= ======= Since the Company plans to continue to finance expansion and operating requirements of subsidiaries outside the United States through reinvestment of the undistributed earnings of these subsidiaries (approximately $81 million at December 31, 1993), taxes which would result from distribution have not been provided on such earnings. If such earnings were distributed, additional taxes payable would be significantly reduced by available tax credits arising from taxes paid outside the United States. Income taxes paid, net of refunds received, during 1993, 1992 and 1991 were $68.3 million, $28.5 million, and $34.5 million, respectively. ______________________________________________________________________________ LONG-TERM DEBT AND NOTES PAYABLE In thousands The following sets forth the long-term debt in the statements of consolidated financial condition: 1993 1992 Notes payable with interest payable semiannually: Due May 15, 2002 at 9.75% $200,000 $200,000 Due July 15, 1999 at 8.875% 175,000 175,000 Due July 1, 1997 at 8.875% 100,000 100,000 Medium-term notes, maturing from 1994 to 2010, from 7.69% to 9.03% with interest payable semiannually 177,750 197,250 Employee stock ownership plan notes payable semiannually through July 2, 2004 at 9.35% 59,129 60,307 Multicurrency loans at 5.4% to 9.475% 63,631 Other 31,321 36,463 --------- -------- 743,200 832,651 Less current portion 18,505 43,419 --------- -------- $724,695 $789,232 ========= ======== The 9.75% notes, the 8.875% notes due in 1999 and the medium-term notes grant the holders the right to require the Company to repurchase all or any portion of their notes at 100% of the principal amount thereof, together with accrued interest, following the occurrence of both a change in Company control and a credit rating decline. The Company has established a trust to administer a leveraged employee stock ownership plan (ESOP) within an existing employee savings plan. The Company has guaranteed the debt of the trust and will service the repayment of the notes, including interest, through the Company's employee savings plan contribution and from the quarterly dividends paid on stock held by the ESOP. Dividends paid by the Company on stock held by the ESOP totaled $1.4 million in 1993, 1992 and 1991. The ESOP notes are secured by the Common stock owned by the ESOP trust. The fair value of the Company's long-term debt, based on public quotes if available, exceeded the amount recorded in the statements of consolidated financial condition at December 31, 1993 and 1992 by $83.7 million and $50 million, respectively. Notes payable at December 31, 1993 and 1992 consisted of notes payable to banks, in addition to $112 million in commercial paper borrowings at December 31, 1993. The Company's commercial paper program is supported by two credit agreements totaling $300 million, which were entered into on June 25, 1993. The $100 million agreement expires June 24, 1994 and the $200 million agreement expires June 25, 1996. Subject to certain exceptions, the credit agreements require the Company to maintain certain quarterly levels of consolidated tangible net worth, leverage ratios and interest coverage ratios. At December 31, 1993, the Company was in compliance with all covenants. Additional funds available at December 31, 1993 under all credit agreements, applying the terms of the most restrictive covenant, totaled $243 million. Interest paid during 1993, 1992 and 1991 was $76.2 million, $77.4 million, and $78.4 million. The aggregate maturities of long-term debt in each of the next five fiscal years is as follows (in thousands): 1994- $18,505; 1995-$45,185; 1996-$5,308; 1997-$106,535; 1998-$7,147. ______________________________________________________________________________ STOCK PLANS In 1992, the shareowners approved the 1992 stock option plan for executives and key employees. The plan provides that options could be granted to key employees for not more than 3.6 million shares of the Common stock of the Company. The option price under the plan is the fair market value at the date of the grant. Options may not be exercised until one year after the date granted. Under the Company's 1986 plan which expired in 1991, options to purchase 1.6 million shares of Common stock were granted at the market value at the date of grant. Some options were also granted under this plan with stock appreciation rights (SAR) which entitle the employee to surrender the right to receive up to one-half of the shares covered by the option and to receive a cash payment equal to the difference between the option price and the market value of the shares being surrendered. Under a plan which expired in 1986, options to purchase 800,000 shares of Common stock were granted at the market value at date of grant. In April 1990, the Company's shareowners approved the Maytag Corporation 1989 Stock Option Plan for Non-Employee Directors which authorizes the issuance of up to 250,000 shares of Common stock to the Company's non-employee directors. Options under this plan are immediately exercisable upon grant. The following is a summary of certain information relating to these plans: Average Option Price Shares SAR ------- ------- ------- Outstanding December 31, 1990 $14.81 966,851 459,131 Granted 14.76 885,920 246,240 Exercised 10.49 (7,526) Canceled or expired 17.59 (18,450) (12,988) --------- ------- Outstanding December 31, 1991 14.76 1,826,795 692,383 Granted 14.54 411,910 Exercised 9.86 (179,736) (11,192) Exchanged for SAR 11.16 (11,192) Canceled or expired 12.63 (34,640) (93,242) --------- ------- Outstanding December 31, 1992 15.09 2,013,137 587,949 Granted 15.92 599,060 Exercised 12.89 (101,156) (5,360) Exchanged for SAR 12.53 (5,360) Canceled or expired 16.26 (147,080) (85,728) --------- ------- Outstanding December 31, 1993 15.33 2,358,601 496,861 ========= ======= Options for 1,777,361 shares, 1,623,227 shares and 964,875 shares were exercisable at December 31, 1993, 1992 and 1991. There were 2,784,030 shares available for future grants at December 31, 1993. In the event of a change in Company control, all stock options granted become immediately exercisable. In 1991, the shareowners approved the 1991 Stock Incentive Award Plan For Key Executives. This plan authorizes the issuance of up to 2.5 million shares of Common stock to certain key employees of the Company, of which 1,980,338 shares are available for future grants as of December 31, 1993. Under the terms of the plan, the granted stock vests three years after the award date and is contingent upon pre-established performance objectives. In the event of a change in Company control, all incentive stock awards become fully vested. No incentive stock awards may be granted under this plan on or after May 1, 1996. Incentive stock award shares outstanding at December 31, 1993 under a 1993 grant total 459,957, and $3.6 million has been expensed during 1993 for the the anticipated payout on these awards. Under a 1991 grant which expired in 1993, 53,068 shares are vested and outstanding and $1.1 million has been expensed during 1993. No amounts were expensed in 1992 and 1991 under these awards. ______________________________________________________________________________ SHAREOWNERS' EQUITY The Company has 24 million authorized shares of Preferred stock, par value $1 per share, none of which is issued. Pursuant to a Shareholder Rights Plan approved by the Company in 1988, each share of Common stock carries with it one Right. Until exercisable, the Rights will not be transferable apart from the Company's Common stock. When exercisable, each Right will entitle its holder to purchase one one-hundredth of a share of Preferred stock of the Company at a price of $75. The Rights will only become exercisable if a person or group acquires 20% or more of the Company's Common stock which may be reduced to not less than 10% at the discretion of the Board of Directors. In the event the Company is acquired in a merger or 50% or more of its consolidated assets or earnings power are sold, each Right entitles the holder to purchase Common stock of either the surviving or acquired company at one-half its market price. The Rights may be redeemed in whole by the Company at a purchase price of $.01 per Right. The Preferred shares will be entitled to 100 times the aggregate per share dividend payable on the Company's Common stock and to 100 votes on all matters submitted to a vote of shareowners. The Rights expire May 2, 1998. ______________________________________________________________________________ INDUSTRY SEGMENT AND GEOGRAPHIC INFORMATION Principal financial data by industry segment is as follows: In thousands 1993 1992 1991 Net Sales --------- --------- --------- Home appliances $2,830,457 $2,875,902 $2,820,828 Vending equipment 156,597 165,321 149,798 --------- --------- --------- Total $2,987,054 $3,041,223 $2,970,626 ========= ========= ========= Income (Loss) Before Income Taxes and Cumulative Effect of Accounting Changes Home appliances $ 160,431 $ 62,568 $ 187,018 Vending equipment 17,566 16,311 4,498 Corporate (including interest expense) (88,127) (71,333) (68,099) --------- --------- --------- Total $ 89,870 $ 7,546 $ 123,417 ========= ========= ========= Capital Expenditures-net Home appliances $ 92,194 $ 115,676 $ 133,504 Vending equipment 1,028 771 4,612 Corporate 2,768 3,917 (16) --------- --------- --------- Total $ 95,990 $ 120,364 $ 138,100 ========= ========= ========= Depreciation and Amortization Home appliances $ 105,916 $ 98,116 $ 86,928 Vending equipment 4,377 4,236 4,805 Corporate 1,488 999 934 --------- --------- --------- Total $ 111,781 $ 103,351 $ 92,667 ========= ========= ========= Identifiable Assets Home appliances $2,147,174 $2,135,961 $2,200,227 Vending equipment 103,765 104,119 119,752 Corporate 218,559 261,410 215,089 --------- --------- --------- Total $2,469,498 $2,501,490 $2,535,068 ========= ========= ========= Information about the Company's operations in different geographic locations is as follows: In thousands 1993 1992 1991 Net Sales --------- --------- --------- North America $2,468,374 $2,407,591 $2,332,365 Europe 390,761 501,857 495,517 Other 127,919 131,775 142,744 --------- --------- --------- Total $2,987,054 $3,041,223 $2,970,626 ========= ========= ========= Income (Loss) Before Income Taxes and Cumulative Effect of Accounting Changes North America $ 246,981 $ 145,991 $ 190,820 Europe (72,358) (67,061) (865) Other 3,374 (51) 1,561 Corporate (including interest expense) (88,127) (71,333) (68,099) --------- --------- --------- Total $ 89,870 $ 7,546 $ 123,417 ========= ========= ========= Identifiable Assets North America $1,794,271 $1,677,131 $1,681,304 Europe 359,323 452,995 507,746 Other 97,345 109,954 130,929 Corporate 218,559 261,410 215,089 --------- ---------- --------- Total $2,469,498 $2,501,490 $2,535,068 ========= ========= ========= Sales between affiliates of different geographic regions are not significant. The amount of exchange gain or loss included in operations in any of the years presented was not material. In 1993 the Company incurred $60.4 million in pretax charges for two "free flights" promotion programs in Europe ($50 million in a special charge and $10.4 million in selling, general and administrative expenses). In 1992 the Company incurred $95 million of reorganization expenses for marketing and distribution changes in North America and plant closings and other organizational changes in Europe. Of the $95 million allocated to Home Appliances, $40 million was allocated to North America and $55 million to Europe. _____________________________________________________________________________ CONTINGENT LIABILITIES In 1993 and 1992, the Company made provisions to cover the cost of two Hoover Europe "free flights" promotion programs, including a $50 million special charge in the first quarter of 1993. The promotions began in August, 1992 and included qualified purchases through January, 1993. The terms of the promotions require all flights to be completed by the end of the second quarter of 1994. The Company believes that it has made adequate provisions for any costs to be incurred relating to these promotions. Although the final costs of the promotions cannot be determined at this time, management does not believe that any additional costs that may be incurred will have a material adverse effect on the financial condition of the Company. At December 31, 1993, the Company is contingently liable for guarantees of indebtedness owed by a third party ("the borrower") of $21.3 million relating to the sale of one of its manufacturing facilities in 1992. The borrower is performing under the payment terms of the loan agreement; however, it had been out of compliance with certain financial covenants at December 31, 1993 for which it has requested a waiver from the lender involved. The indebtedness is collateralized by the assets of the borrower. Other contingent liabilities arising in the normal course of business, including guarantees, repurchase agreements, pending litigation, environmental issues, taxes and other claims are not considered to be material in relation to the Company's financial position. QUARTERLY RESULTS OF OPERATIONS (Unaudited) ________________________________________________________________________________ The following is a summary of unaudited quarterly results of operations for the years ended December 31, 1993 and 1992. December 31 September 30 June 30 March 31 ----------- ------------ ---------- --------- In thousands except per share data Net sales $746,723 $770,222 $753,256 $716,853 Gross profit 179,066 188,501 183,812 172,733 Net income (loss) 17,469 23,040 21,307 (10,546) Per average share $ .16 $ .22 $ .20 $ (.10) Net sales $782,446 $735,540 $770,060 $753,177 Gross profit 173,495 161,871 176,803 189,648 Income (loss) before cumulative effect of accounting change 11,238 (63,234) 18,937 24,705 Per average share .11 (.60) .18 .23 Net income (loss) 11,238 (63,234) 18,937 (282,295) Per average share $ .11 $ (.60) $ .18 $ (2.66) The quarter ended March 31, 1993 includes a $50 million pretax special charge for additional costs associated with two Hoover Europe "free flights" promotion programs. The quarter ended September 30, 1992 includes a nonrecurring $95 million pretax charge relating to the reorganization of the Company's North American and European operations. 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. Information concerning directors and officers on pages 1 through 6 of the Proxy Statement of the Company is incorporated herein by reference. Additional information concerning executive officers of the Company is included under "Executive Officers of the Registrant" included in Part I,Item 4. Item 11.	Item 11. Executive Compensation. Information concerning executive compensation on pages 7 through 12 of the Proxy Statement, is incorporated herein by reference; provided that the information contained in the Proxy Statement under the heading "Compensation Committee Report on Executive Compensation" is specifically not incorporated herein by reference. Information concerning director compensation on pages 15 and 16 of the Proxy Statement is incorporated herein by reference, provided that the information contained in the Proxy Statement under the headings "Shareholder Return Performance" and "Shareholder Proposal Concerning Chief Executive Officer Compensation" is specifically not incorporated herein by reference. Item 12.	Item 12. Security Ownership of Certain Beneficial Owners and Management. The security ownership of certain beneficial owners and management is incorporated herein by reference from pages 4 through 6 of the Proxy Statement. Item 13.	Item 13. Certain Relationships and Related Transactions. Information concerning certain relationships and related transactions is incorporated herein by reference from pages 2 through 4 of the Proxy Statement. PART IV Item 14.	Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a)(1) and (2) The response to this portion of Item 14 is submitted as a separate section of this report in the "List of Financial Statements and Financial Statement Schedules" on page 34. (3) The response to this portion of Item 14 is submitted as a separate section of this report in the "List of Exhibits" on pages 35 through 38. (b) No reports on Form 8-K were filed during the fourth quarter of 1993. (c) Exhibits--The response to this portion of Item 14 is submitted as a separate section of this report in the "List of Exhibits" on pages 35 through 38. (d) Financial Statement Schedules--The response to this portion of Item 14 is submitted as a separate section of this report in the "List of Financial Statements and Financial Statement Schedules" on page 34. SIGNATURES Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. MAYTAG CORPORATION (Registrant) Leonard A. Hadley Leonard A. Hadley Chairman and Chief Executive Officer Director Pursuant to the requirement of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. John P. Cunningham John A. Sivright John P. Cunningham John A. Sivright Executive Vice President and Director Chief Financial Officer Mark A. Garth Lester Crown Mark A. Garth Lester Crown Vice President-Controller and Director Chief Accounting Officer Fred G. Steingraber Edward C. Cazier, Jr. Fred G. Steingraber Edward C. Cazier, Jr. Director Director Neele E. Stearns, Jr. Peter S. Willmott Neele E. Stearns, Jr. Peter S. Willmott Director Director Date: March 30, 1994 ANNUAL REPORT ON FORM 10-K Item 14(a)(1), (2) and (3), (c) and (d) LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES LIST OF EXHIBITS FINANCIAL STATEMENT SCHEDULES Year Ended December 31, 1993 MAYTAG CORPORATION NEWTON, IOWA FORM 10-K--ITEM 14(a)(1) AND ITEM 14(d) MAYTAG CORPORATION LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES The following consolidated financial statements and supplementary data of Maytag Corporation and subsidiaries are included in Part II, Item 8: Page ---- Statements of Consolidated Income--Years Ended December 31, 1993, 1992 and 1991 . . . . . . . . . . . . . 14 Statements of Consolidated Financial Condition-- December 31, 1993 and 1992 . . . . . . . . . . . . . . . . 15 Statements of Consolidated Cash Flows--Years Ended December 31, 1993, 1992 and 1991 . . . . . . . . . . . . . 17 Notes to Consolidated Financial Statements . . . . . . . . . 18 Quarterly Results of Operations--Years 1993 and 1992 . . . . 30 The following consolidated financial statement schedules of Maytag Corporation and subsidiaries are included in Item 14(d): Schedule V Property, Plant and Equipment . . . . . . . . . 39 Schedule VI Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment . 40 Schedule VIII Valuation and Qualifying Accounts . . . . . . 41 Schedule IX Short-Term Borrowings . . . . . . . . . . . . . 42 Schedule X Supplementary Income Statement Information . . 43 All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted. FORM 10-K--ITEM 14(a) (3) AND ITEM 14(c) MAYTAG CORPORATION LIST OF EXHIBITS The following exhibits are filed herewith or incorporated by reference. Items indicated by (1) are considered a compensatory plan or arrangement required to be filed pursuant to Item 14 of Form 10-K. Incorporated Filed with Exhibit Herein by Electronic Number Description of Document Reference to Submission - ------- ----------------------- ------------ ---------- 3(a) Restated Certificate of Incorporation of X Registrant. 3(b) Certificate of Designations of Series A 1988 Annual Junior Participating Preferred Stock of Report on Registrant. Form 10-K. 3(c) Certificate of Increase of Authorized 1988 Annual Number of Shares of Series A Junior Report on Participating Preferred Stock of Form 10-K. Registrant. 3(d) By-Laws of Registrant, as amended through X February 7, 1991. 4(a) Rights Agreement dated as of May 2, 1988 Current between Registrant and The First National Report on Bank of Boston. Form 8-K dated May 5, 1988, Exhibit 1. 4(b) Amendment, dated as of September 24, 1990 Current to the Rights Agreement, dated as of May Report on 2, 1988 between the Registrant and The Form 8-K First National Bank of Boston. dated October 3, 1990, Exhibit 1. 4(c) Indenture dated as of June 15, 1987 Quarterly between Registrant and The First National Report on Bank of Chicago. Form 10-Q for the quarter ended June 30, 1987. 4(d) First Supplemental Indenture dated as of Current September 1, 1989 between Registrant and Report on The First National Bank of Chicago. Form 8-K dated September 28, 1989, Exhibit 4.3. Incorporated Filed with Exhibit Herein by Electronic Number Description of Document Reference to Submission - ------ ----------------------- ------------ ---------- 4(e) Second Supplemental Indenture dated as of Current November 15, 1990 between Registrant and Report on The First National Bank of Chicago. Form 8-K dated November 29, 1990. 4(f) U.S. $100,000,000 Credit Agreement Dated X as of June 25, 1993 Among Registrant, the Banks Party Hereto and Bank of Montreal, Chicago Branch as Agent and Royal Bank of Canada. 4(g) U.S. $200,000,000 Credit Agreement Dated X as of June 25, 1993 Among Registrant, the Banks Party Hereto and Bank of Montreal, Chicago Branch as Agent and Royal Bank of Canada. 4(h) First Amendment, Dated as of March 4, X 1994 to the U.S. $100,000,000 Credit Agreement, Dated as of June 25, 1993 among Registrant, the Banks party Hereto and Bank of Montreal, Chicago Branch as Agent and Royal Bank of Canada as Co- Agent. 4(i) First Amendment, Dated as of March 4, X 1994 to the U.S. $200,000,000 Credit Agreement, dated as of June 25, 1993 among Registrant, the banks Party Hereto and Bank of Montreal, Chicago Branch as Agent and Royal Bank of Canada as Co- Agent. 4(j) Copies of instruments defining the rights of holders of long-term debt not required to be filed herewith or incorporated herein by reference will be furnished to the Commission upon request. 10(a) Annual Management Incentive Plan, as 1990 Annual amended through December 21, 1990 (1). Report on Form 10-K 10(b) Executive Severance Agreements (1). X 10(c) Corporate Severance Agreements (1). 1989 Annual Report on Form 10-K. 10(d) Termination Agreement with Harvey 1989 Annual Kapnick, Director and former Chief Report on Executive Officer of Chicago Pacific Form 10-K. Corporation (1). Incorporated Filed with Exhibit Herein by Electronic Number Description of Document Reference to Submission - ------- ----------------------- ------------ ---------- 10(e) 1989 Non-Employee Directors Stock Option Exhibit A to Plan (1). Registrant's Proxy Statement dated March 18, 1990. 10(f) 1981 Stock Option Plan for Executives 1992 Annual and Key Employees (1). Report on Form 10-K. 10(g) 1986 Stock Option Plan for Executives Exhibit A to and Key Employees (1). Registrant's Proxy Statement dated March 14, 1986. 10(h) 1992 Stock Option Plan for Executives Exhibit A to and Key Employees (1). Registrant's Proxy Statement dated March 16, 1992. 10(i) 1987 Stock Incentive Award Plan for Key Exhibit B to Executives (1). Registrant's Proxy Statement dated March 25, 1987. 10(j) 1991 Stock Incentive Award Plan for Key Exhibit A to Executives (1). Registrant's Proxy Statement dated March 15, 1991. 10(k) Directors Deferred Compensation Plan (1). Amendment No. 1 on Form 8 dated April 5, 1990 to 1989 Annual Report on Form 10-K. 10(l) 1988 Capital Accumulation Plan for Key Amendment No. Employees (1). 1 on Form 8 dated April 5, 1990 to 1989 Annual Report on Form 10-K. Incorporated Filed with Exhibit Herein by Electronic Number Description of Document Reference to Submission - ------- ----------------------- ------------ ---------- 10(m) Directors Retirement Plan (1). Amendment No. 1 on Form 8 dated April 5, 1990 to 1989 Annual Report on Form 10-K. 11 Computation of Per Share Earnings. X 12 Ratio of Earnings to Fixed Charges. X 21 List of Subsidiaries of the Registrant. X 23 Consent of Ernst & Young. X 99(a) Annual Report on Form 11-K of the Maytag X Corporation Salary Savings Plan. 99(b) Annual Report on Form 11-K of the Hoover X Company Retirement Savings Plan for Hourly-Rated Employees. SCHEDULE X--SUPPLEMENTARY INCOME STATEMENT INFORMATION Thousands of Dollars COL. A COL. B ITEM Charged to Costs and Expenses - ------------------------ ------------------------------------------------ 1993 1992 1991 ---- ---- ---- Maintenance and repairs $ 53,128 $ 54,982 $ 50,504 Advertising costs 136,452 134,024 119,391 NOTE - All other items are not stated as such amounts are less than 1% of total sales and revenues.
770461_1993.txt	770461	1993	ITEM 1. DESCRIPTION OF BUSINESS General Development of the Business Fast Eddie Racing Stables, Inc. (the Company ), was incorporated under the laws of the State of Florida on April 3, 1981. During the period from inception through the year ended December 31, 1988 the Company was engaged in the business of acquiring, racing and selling standardbred race horses (pacers and trotters. During the year ended December 31, 1989, the Company discontinued operations and through the date hereof, has been inactive. Description of the Business During the years it conducted operations, the Company owned and raced standardbred race horses at facilities in Florida, New York, New Jersey, Maryland and California. The horses were trained and driven by independent professional personnel pursuant to specific agreements. Under these agreements, the bulk of the training, boarding and related costs of maintaining the Company s horses were borne by the driver/trainer. During the year ended December 31, 1989 the Company sold or otherwise disposed of all remaining horses in order to settle outstanding indebtedness. At that point and through the date hereof the Company has been inactive. At present, the Company has only one employee, its President and Chief Financial Officer, Edward T. Shea, Jr. ITEM 2.		ITEM 2. PROPERTIES The Company utilizes it President s home, which is located at 424 N.E. 10th Street, Boca Raton, Florida 33432-2938, as its principal place of business. Such facilities are available to the Company on an informal basis. ITEM 3.	ITEM 3. LEGAL PROCEEDINGS No legal proceeding occurred during the periods covered by this report. ITEM 4.	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the periods covered by this report. PART II ITEM 5.	ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company has been inactive for a period in excess of five years as of the date hereof and has not filed all required reports with the United States Securities and Exchange Commission. Accordingly, there has been no available market for its common stock. During the year ended December 31, 1986 the Company s common stock price, as reported in the Pink Sheets published by the National Quotation Bureau, Inc., had a high and low of $1.25 and $.12, respectively. During most of 1987 and periods subsequent thereto, the shares were either unquoted or quoted at $.01. As of December 31, 1987, there were approximately 47 holders of record of the Company's common stock. This information was obtained from the Company's transfer agent. Subsequent transfers of the Company s common stock , if any, are unknown. The Company has not paid any cash dividends on its common stock to date and does not anticipate or contemplate paying dividends in the foreseeable future. Any decisions as to future payment of dividends will depend on earnings and financial position of the Company and such other factors as the Board of Directors deems relevant. ITEM 6.	ITEM 6. MANAGEMENT S DISCUSSION AND ANALYSIS AND RESULTS OF OPERATIONS Results of operations During the years it conducted operations (1983 - 1989), the Company owned and raced standardbred race horses at facilities in Florida, New York, New Jersey, Maryland and California. Through such period, the Company was not able to generate income from operations or net income. Accordingly, its resources were exhausted and during the year ended December 31, 1989, the Company sold or otherwise disposed of all remaining horses and other assets in order to settle outstanding indebtedness. At that point and through the date hereof the Company has been inactive. Liquidity The Company does not currently have any cash or cash equivalents. Current expenses of the Company including licenses, regulatory filings and related professional fees have been paid by the Company s President. Foreign operations The Company has not had, and does not presently have any foreign operations. ITEM 7.	ITEM 7. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Financial Statements and Supplementary Data are set forth in ITEM 14. ITEM 8.	ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE The Company s independent accountants during the period from inception through the Company s Form 10-K filing for the year ended December 31, 1987 was Imber & Anchel, Certified Public Accountants. Such firm is no longer in existence, and the successor firm does not provide accounting services to companies filing with the United States Securities and Exchange Commission. During 1996, the Company engaged Levi, Rattner, Cahlin & Co., Certified Public Accountants, as independent accountants for financial statements to be included in prospective filings with the United States Securities and Exchange Commission. The Company has never had a disagreement with its accountants relating to accounting or financial disclosures. PART III ITEM 9.	ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS; COMPLIANCE WITH SECTION 16 (a) OF THE EXCHANGE ACT The following table sets forth certain information concerning the Directors and Executive Officers of the Company: Name Age Position Since (see Notes) Edward T. Shea, Jr. 52 President/Chief Financial April, 1981 Officer/Director Notes: (1) During 1989, Michael Jamison resigned his position as the Company's Chief Financial Officer and Director. At that point and through the date hereof, Mr. Shea has assumed his responsibilities. (2) During 1989, Messrs. Eugene Cooke, Vincent Mulhall and Thomas McGinty resigned the positions as Directors of the Company. (3) Directors are elected to serve until the next annual meeting of shareholders. The Company's Executive Officers serve at the discretion of the Board of Directors. Each of the Company s Directors and Officers continues to serve until their successors have been elected and qualified. The following is information regarding the principal occupations of the Director, officer and sole employee of the Company: Edward T. Shea, Jr. - From 1978 to date, except for the an approximate one year period from mid-1985 through 1986 when he worked full time for the Company, Mr. Shea has been a registered representative with several stock brokerage firms. For the past three years he has been employed in such capacity by PCM Securities, Ltd., Boca Raton, Florida. From 1980 through 1983, Mr. Shea was Racing Handicapper and harness racing columnist for the Boca Raton New, Boca Raton, Florida. He is a licensed owner of race horses. ITEM 10.	ITEM 10. EXECUTIVE COMPENSATION The Company has no full time employees at present. The sole employee is Edward T. Shea, Jr., the Company s President and Chief Financial Officer. He serves in these capacities on a part time basis without compensation. Mr. Shea was compensated through December 31, 1987 pursuant to an Employment Agreement which provided for an annual salary of $60,000. In connection with the winding down of operations during 1989, loans advance to Mr. Shea aggregating $79,374 were charged against operations in satisfaction of any past or prospective obligation the Company would have related to such Employment Agreement. ITEM 11.	ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Amount and nature of Name of Beneficial Owner Beneficial Ownership Percent of class At present, there are no outstanding stock options or purchase warrants to acquire shares of the Company s common stock. ITEM 12.	ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS During the period 1985 - 1989, the Company had advanced loans to its President, Edward T. Shea. Jr. Mr. Shea had repaid approximately $33,000 of the loans leaving a balance of $79,374 due to the Company when it discontinued operations in 1989. Such amount was written off as a charge against operations during the fiscal year ended December 31, 1989. During the year ended December 31, 1987, Edward T. Shea, Jr. borrowed $120,000 from the Company in order to purchase investment stock on the behalf of the Company. Subsequent to the original purchase of such stock, it was titled in the name of the Company rather than Mr. Shea, personally. When such transfer occurred, the stock had already decreased in value to approximately $22,000. Mr. Shea agreed to reimburse the Company for any losses realized from this investment. During 1988 and through the date of discontinuing operations in 1989 the Company sustained additional losses on its investments. Aggregate investment losses charged against operations since inception amounted to approximately $139,000. Mr. Shea s informal agreement to reimburse the Company for losses associated with the 1987 investment was excused in conjunction with the discontinuance of operations. PART IV ITEM 14.		ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, AND REPORTS ON FORM 8-K (a) There are filed as part of this Form 10-KSB the following: (1) Financial statements - Pursuant to Section 210.3-11 of Regulation SX, the financial statements presented herein are unaudited as the registrant is deem to be inactive (as that term is defined within the Regulation): (I) Balance sheets as of December 31, 1992 and 1993 (ii) Statements of operations for each of the three years ended December 31, 1991, 1992 and 1993 (iii)Statements of shareholders equity for each of the three years ended December 31, 1991, 1992 and 1993 (iv) Statements of cash flows for each of the three years ended December 31, 1991, 1992 and 1993 (v) Notes to financial statements (2) Schedules are omitted because either they are not applicable or the required information is shown in the financial statements or notes thereto. (3) Form 8-K - The Company did not file any Form 8-K during the periods covered by this filing. (4) The documents listed below were previously filed with the Commission with the Company's Form S-18 Registration No. 2-98138-A filed October 7, 1985 and are incorporated by reference: (i) Articles of Incorporation of the Company (ii) Bylaws of the Company (iii)Specimen common stock certificate of the Company SIGNATURES Pursuant to the requirements of Section 13 or 15 (d) of the Securities Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on the date hereof. FAST EDDIE RACING STABLES, INC. By:/s/ Edward T. Shea, Jr. Edward T. Shea, Jr., President Dated: August 9, 1996 SIGNATURES Pursuant to the requirements of the Securities Act of 1934, this report has been signed below by the following persons on the behalf of the registrant in the capacity indicated as of the date hereof Signatures Titles Date President, Principal Operating Officer, Principal Financial Officer, Principal Accounting /s/ Edward T. Shea, Jr. Oficer August 9, 1996 Edward T. Shea, Jr. FAST EDDIE RACING STABLES, INC. BALANCE SHEETS DECEMBER 31, 1992 AND 1993 1992 1993 Total liabilities and shareholders' equity $ - $ - The accompanying notes to the financial statements are an integral part of these financial statements. FAST EDDIE RACING STABLES, INC. STATEMENTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 1991, 1992 AND 1993 1991 1992 1993 The accompanying notes to the financial statements are an integral part on these financial statements. FAST EDDIE RACING STABLES, INC. STATEMENTS OF SHAREHOLDERS' EQUITY FOR THE YEARS ENDED DECEMBER 31, 1991, 1992 AND 1993 Additional Total Common paid-in shareholders' stock capital Deficit equity The accompanying notes to the financial statements are an integral part on these financial statements. FAST EDDIE RACING STABLES, INC. STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1991, 1992 AND 1993 1991 1992 1993 The accompanying notes to the financial statements are an integral part on these financial statements. FAST EDDIE RACING STABLES, INC. NOTES TO FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 1991, 1992 AND 1993 NOTE 1. Organization Fast Eddie Racing Stables, Inc. (the Company ) was organized under the laws of the State of Florida in 1981 and commenced operations in September, 1983. The Company was involved in the business of racing and trading standardbred race horses until 1989 when it ceased operations. NOTE 2. Summary of significant accounting policies Standardbred race horses are stated at cost. Depreciation is computed utilizing the straight-line method over a five (5) year period, the estimated useful life of such asset. NOTE 3. Loans to officer and related party transactions As of December 31, 1988, the president of Company, Edward T. Shea, Jr., was obligated to the Company in the amount of $78,083. The terms of the loan were unsecured, due on demand, and bearing interest at 10% per annum. In connection with winding down operations in 1989, the Company charged this loan off against operations. Concurrent with their employment with the Company, the president and vice president also acted as account executives with a brokerage firm used by the Company for its investments. In this capacity, they earned commissions for brokerage transactions made by the Company. The amount of such commissions cannot be determined at this time. NOTE 4. Commitments and contingencies In connection with the cessation of operations, the Company abrogated certain lease obligations covering the president s vehicle and the Company s corporate offices. The potential liability, if any, associated with these actions has not been reflected in the accompanying financial statements. The Company may be contingently liable for payroll taxes and related costs associated with the forgiveness of the president s loan and unsubstantiated travel and entertainment expenses. No provision has been made in the accompanying financial statements for such items. NOTE 5. Investment in limited partnership Through December 31, 1988, the Company had expended approximately $9,500 for organizing a limited partnership in which it was contemplated that the Company would act as the general partner. In connection with the cessation of operations in 1989, the related costs associated with the development of the limited partnership were charged to operations. NOTE 6. Income taxes The Company has potential net operating loss carryforwards of approximately $707,000 as of December 31, 1995 expiring in 1998 through 2002.
811532_1993.txt	811532	1993
68330_1993.txt	68330	1993	Item 1. Business - ------ -------- General - ------- MGI Properties (the "Trust" or "MGI") is an unincorporated business trust organized under the laws of the Commonwealth of Massachusetts. MGI commenced operations in 1971 as a real estate investment trust. Since that time, the Trust has elected to be treated as a real estate investment trust (a "REIT") under Sections 856-860 of the Internal Revenue Code of 1986, as amended (the "Internal Revenue Code"), and expects to continue to operate in a manner which will entitle the Trust to be so treated. For each taxable year in which the Trust qualifies as a REIT under the Internal Revenue Code, taxable income distributed to the holders of its shares will not be taxable to the Trust (other than certain items of tax preference which are subject to minimum tax in the hands of the Trust). See "Investment and Operating Policies" and "Portfolio" below and the description of dividend policy included under Item 5 of this Annual Report on Form 10-K for the year ended November 30, 1993 (the "Report"). References herein to the Trust include its wholly-owned subsidiaries. Narrative Description of Business - --------------------------------- The Trust, which is a self-administered and self-managed equity REIT, owns and manages a diversified portfolio of income-producing real estate assets. The Trust's portfolio consists of investments in apartment complexes, multi-use industrial facilities (such as warehouses and research and development buildings), shopping centers and office buildings. The primary investment objective of the Trust is to make diversified equity and equity-oriented investments in existing properties believed to be capable of producing stable and rising income streams and having long-term capital appreciation potential. The Trust also believes that its active managing and leasing practices can enhance rental income, funds from operations and long-term capital appreciation. These investments have typically taken the form in recent years of a direct equity ownership interest. The Trust employs ten persons. Investment and Operating Policies - --------------------------------- The investment policy of the Trust in its broadest aspect is to seek income of the types permitted to a REIT under Section 856 of the Internal Revenue Code, consistent with its Declaration of Trust. Under its Declaration of Trust, the Trust is permitted to invest in a broad range of real estate and mortgage investments, including among other things equity interests, full or participating interests in securities, whether or not secured by mortgages, interests in rents and any other interests related to real property. The Trust's policies are subject to ongoing review by the Board of Trustees and may be modified from time to time to take into consideration changes in business or economic conditions or otherwise as circumstances warrant. The Trust's investment focus with respect to type of property has, during the last several years, been directed to equity and equity-oriented investments in existing income-producing properties, principally apartment complexes, multi-use industrial facilities, shopping centers and office buildings. MGI continues to believe it is beneficial to diversify its assets by location and type of real estate, although it periodically changes its emphasis from one sector to another in accordance with its perception of market opportunities. Over the past several years MGI, has increased its emphasis on acquisitions in the northeastern region of the United States, including industrial and office properties. Although the principal investment emphasis is on the direct ownership of income-producing equity real estate, MGI was historically an equity-oriented or "hybrid" (equity and mortgage) trust. MGI's focus turned from mortgage loans with equity participations toward equity investments in which the Trust becomes the sole owner of the property and realizes all of the property's future benefits and risks. Management believes that this evolution has given the Trust greater control over the direction of its portfolio and the opportunity to increase its capital gains potential. Previously, when operating as a hybrid trust, the investments financed as mortgages (first mortgage loans, junior liens, including wrap- around mortgages, or purchase-money mortgages taken back on the sale of former equity investments) have in many instances included an option to acquire, or a provision for the conversion of such mortgage into, a material equity position at a cost believed by management to be favorable, and in some instances, a participation in the earnings from the property over a base amount or a percentage of the proceeds from the sale of the property. In making new investments, MGI's investment focus has been primarily directed to acquiring quality income-producing properties. Over the last several years, MGI's investment philosophy has been to seek what management believes to be value- creating opportunities by acquiring quality properties that have not met their full potential at a cost believed to be below or near replacement value. Management believes that its investments can be managed to create a total return which includes current income and appreciation. The Trust seeks to implement its investment objectives through selective acquisitions of quality properties, leasing and property management in accordance with its defined long term goals, investment in property improvements and periodic sales of selected properties. The Trust has recently operated with an individual investment parameter of below $20,000,000, but has exceeded and may occasionally exceed this parameter. The decision to sell specific properties or investments involves a number of factors, including the economic climate (giving effect also to the impact of tax laws and other regulatory factors), future potential and reinvestment alternatives. As indicated above, the investment focus may change, based upon the ongoing review of the Trust's policies by the Board of Trustees. As is common with any real estate owner or lender investing in equity real estate, partnerships, mortgage loans and other investments, the Trust from time to time may restructure its financial arrangements with partners, tenants or borrowers who encounter financial or other difficulties. Accordingly, the Trust, as circumstances warrant, has modified and will modify a lease, partnership, loan or other agreement if, after investigation, it is established that such modification would be economically feasible and in the best interests of the Trust. Protection of the Trust's investments may require foreclosure or other action leading to acquisition of title to properties underlying its mortgage loans or investments. The Trust's business is limited to investments in real estate, direct or indirect, including investments in and possible future acquisitions of real estate companies. To the extent that the Trust has assets not otherwise invested in real estate, the Trust may invest such assets in other securities, including United States government obligations and commercial paper, so long as, in the opinion of the Trustees, such securities may be held without jeopardizing the Trust's qualification as a REIT under the Internal Revenue Code. Funds necessary to conduct operations are provided from rental and interest income, mortgaging of equity investments, lines of credit, corporate borrowings, sale of marketable securities and loan repayments and amortization. Such operations include the Trust's continuous incurrence of costs, reimbursed and unreimbursed, for improvements and renovations of its existing properties in order to maintain and enhance their value. From time to time, as conditions warrant, the Trust may operate on a leveraged basis by incurring indebtedness in order to increase its capital available for investment when, in the Trustees' judgment, the Trust will benefit thereby. There is no assurance at any given time that borrowed funds will be available or that the terms and conditions of such borrowings will be acceptable. The Trust may employ short-term borrowings to fund some of its investments. Reference is made to Note 4 of the Notes to Consolidated Financial Statements included in Item 14 below. Portfolio - --------- The Trust's real estate portfolio as of November 30, 1993 consisted of interests in fifty properties, forty-five of which are wholly- owned, three are owned by partnerships in which the Trust has an equity interest, one is a property sold by the Trust in a prior year transaction which did not meet the conditions for a completed sale and is still carried as a real estate investment for financial accounting purposes and one is a mortgage loan that is accounted for as real estate owned. For tax purposes, the property sold and the property accounted for as real estate owned are treated as mortgage loans receivable. The Trust's real estate investments can be classified by type of property and market region. As of November 30, 1993, the Trust's real estate investments were diversified by type of property as follows: Number of Percent of Type Of Property Properties Cost Total ---------------- ---------- ------------- ---------- Apartments 10 $ 78,955,000 30.5% Retail 5 53,198,000 20.6 Office 9 65,230,000 25.2 Industrial 25 61,255,000 23.7 Land 1 25,000 * -- ------------ ------ Total 50 $ 258,663,000 100.0% -- ------------ ------ - ---------- * Less than 1% As of November 30, 1993, the Trust's real estate investments were diversified by geographic region as follows: Percent of Number of Portfolio Based Region Properties Cost on Cost ------ ---------- ----------- --------------- Midwest 22 $ 99,726,000 38.5% Southeast 13 74,408,000 28.8 Mid-Atlantic 4 23,129,000 8.9 Northeast 10 61,175,000 23.7 Other 1 225,000 .1 -- ----------- ------ Total 50 $258,663,000 100.0% -- ----------- ------ Terms under leases to tenants at the Trust's properties range from tenancies-at-will up to eighteen years. The Trust leases commercial space to approximately 260 commercial tenants, including 130 office tenants, 71 retail tenants and 59 industrial tenants. Additional information concerning the Trust's mortgage and real estate investments is set forth under Item 2		Item 2. Properties. - ------ ---------- The following table sets forth certain information concerning the Trust's properties. SUMMARY OF PROPERTIES AT NOVEMBER 30, 1993 Note: (a) See Note 2 of the Notes to Consolidated Financial Statements included under Item 14 of this Report. (continued) Item 2. Properties. (cont'd) - ------ ---------- Reference is made to Notes 1, 2 and 3 in the Notes to the Consolidated Financial Statement and Schedules XI and XII of the Financial Statement Schedules for descriptions of the Trust's investments and properties. Executive Office. - ---------------- The Trust's headquarters, at 30 Rowes Wharf, Boston, Massachusetts, includes approximately 5,400 square feet and is occupied under a lease expiring November 30, 1994. Item 3.	Item 3. Legal Proceedings. - ------ ----------------- The Trust is not a party to any material legal proceedings as to which it does not have adequate insurance coverage. Item 4.	Item 4. Submission of Matters to a - ------ Vote of Security Holders. ------------------------ Not applicable. PART II ------- Item 5.	Item 5. Market for Registrant's Common Equity - ------ and Related Stockholder Matters. ------------------------------- (a) Market Information and Dividends. The principal market on which the Trust's common shares are traded is the New York Stock Exchange, under the symbol MGI. The table below sets forth, for the fiscal quarters indicated, the high and low sales prices on the New York Stock Exchange of the Trust's common shares and dividends paid per common share. Fiscal Sales Price -------------------------- 1993 High Low Dividends ------ ---- --- --------- First Quarter 15 3/4 11 $.20 Second Quarter 16 1/2 13 $.20 Third Quarter 13 3/8 12 $.20 Fourth Quarter 15 1/8 12 3/4 $.21 Fiscal Sales Price -------------------------- 1992 High Low Dividends ------ ---- --- --------- First Quarter 12 1/2 9 5/8 $.20 Second Quarter 12 10 7/8 $.20 Third Quarter 12 1/8 11 1/8 $.20 Fourth Quarter 12 1/8 11 1/8 $.20 Future dividends will be determined by the Trust's Board of Trustees and will be dependent upon the earnings, financial position and cash requirements of the Trust and other relevant factors existing at the time. The Trust must distribute at least 95% of the Trust's taxable income in order to enable it to qualify as a real estate investment trust for tax purposes. So long as the Trust continues to qualify as a REIT, shareholders will, therefore, receive in the form of dividends at least 95% of the taxable income of the Trust. (b) Approximate Number of Holders of Common Shares. Approximate Number of Holders (as of Title of Class February 8, 1994) - ----------------------------------------------------- Common Shares, $1.00 3,219 par value Item 6.	Item 6. Selected Financial Data (a) - ------ ----------------------- (Not covered by Independent Auditors' Report) Item 7.	Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. --------------------------------------------- Liquidity and Capital Resources - ------------------------------- At November 30, 1993 financial liquidity was provided by $12.7 million in cash and investment securities and by an unused $10.0 million line of credit. Shareholders' equity of $171.0 million at November 30, 1993, when compared to $145.7 million at November 30, 1992, reflects net proceeds of $25.6 million received in connection with the May 6, 1993 public offering of 2,000,000 common shares, dividends of $0.5 million paid in excess of net income and, to a lesser extent, treasury stock issued in connection with stock options exercised. Sources of funds in 1993 included the public sale of common shares, operations, interest income and the Trust's portfolio of investment securities. In 1993, these resources were used to: (i) acquire ten industrial properties and two office buildings, totaling 950,300 square feet and 215,000 square feet of space, respectively, for an aggregate of $41.1 million cash and a $6.6 million wrap-around mortgage loan of which MGI had been the lender, (ii) pay dividends of $8.5 million, (iii) repay debt of $7.7 million, and (iv) fund $2.7 million of tenant and capital improvements. Total mortgage and other loans payable aggregated $66.9 million at November 30, 1993, a net increase of $6.3 million compared to $60.6 million at November 30, 1992. The increase resulted from the addition of $14.0 million of debt (which included $0.7 million of debt in connection with the acquisition of four industrial buildings), offset by scheduled amortization payments of $0.9 million, a $5.6 million repayment of a maturing loan and prepayments of $1.1 million (which included $0.7 million in connection with the amendment and assignment of a lease at Yorkshire Plaza located in Aurora, Illinois and $0.4 million related to three first mortgages acquired in connection with three industrial buildings). Mortgage and other loans payable are collateralized by sixteen of MGI's properties having an aggregate carrying value of $115.8 million, $3.2 million of investment securities and MGI's guarantees of $9.2 million. Subsequent to November 30, 1993, mortgage loans payable increased by $2.2 million as MGI received the balance of the proceeds of a loan which closed in November 1993. Loans payable due within twelve months of November 30, 1993 totaled $18.7 million, including a $6.3 million 12.75% loan with an April 1994 maturity and a $11.2 million floating rate loan with a September 1994 maturity. MGI has commenced, on a preliminary basis, several mortgage financing initiatives. If MGI proceeds with all of these borrowing initiatives a net increase in outstanding debt of approximately $30,000,000 may result. Despite the generally reduced availability of real estate financing, MGI believes it will be successful extending or refinancing maturing mortgage loans upon satisfactory terms although there can be no assurance thereof. In December 1993, MGI acquired two industrial/research and development buildings, one totaling 100,000 square feet and the other 56,300 square feet, located in suburban Boston, Massachusetts for an aggregate price of $6.3 million cash. Both buildings are 100% occupied by the same publicly- traded tenant with leases that expire in June 1998 and December 1999. Other cash requirements in 1994 are distributions to shareholders, capital and tenant improvements and other leasing expenditures required to maintain MGI's occupancy levels and other investment undertakings. During the period 1990 through 1993, annual expenditures for capital and tenant improvements averaged approximately 1.2% of real estate investments. In 1994 budgeted capital and tenant improvements which are based on assumed leasing activity, completion of discretionary capital projects and estimated costs, approximates 1.7% of real estate investments. Principal sources of funds in the future are expected to be from operations of properties including those acquired in the future, mortgaging or refinancing existing mortgages on properties and MGI's portfolio of investment securities. Other potential sources of funds may include the proceeds of offerings of additional equity or debt securities or the sale of real estate investments. The cost of new borrowings or issuances of equity capital will be measured against the anticipated yields of investments to be acquired with such funds. Following the December 1993 acquisition of two buildings, the purchase of additional properties in 1994 may require the use of funds from MGI's line of credit, new borrowings, the sale of properties currently owned or the issuance of equity securities. MGI believes the combination, at November 30, 1993, of cash and investment securities, the value of MGI's unencumbered properties, and other resources are sufficient to meet its short and long term liquidity requirements. Results of Operations - --------------------- Net income for 1993 of $8.0 million, or $0.75 per share on the greater number of shares outstanding, exceeded net income of $7.2 million, or $0.77 per share, in 1992. Included in net income in 1992 was a net gain of $1.6 million, or $.17 per share. Funds from operations in 1993 totaled $15.0 million, or $1.42 per share on the greater number of shares outstanding, compared to $11.7 million, or $1.24 per share, in 1992. MGI defines funds from operations as net income (computed in accordance with generally accepted accounting principles), excluding gains (or losses) from debt restructuring, sales of property and similar non-cash items, depreciation and amortization charges, and equity method partnership losses. MGI believes funds from operations is an appropriate supplemental measure of operating performance. The change in funds from operations is attributable to the same factors that affected income before net gains, with the exception of depreciation and amortization expense. The increase in income before net gains when comparing 1993 to 1992 resulted principally from the increase in properties owned and the receipt of a non-recurring fee. As a result, rental and other income, property operating expenses, real estate tax expense, depreciation and amortization expense increased and mortgage interest income decreased in 1993. The $8.2 million increase in rental and other income in 1993 compared to 1992 was principally the result of (i) $3.6 million from the properties acquired in 1993, (ii) $2.4 million related to the reclassification of MGI's investment in a Metairie, Louisiana apartment complex to owned real estate from a mortgage receivable, (iii) $1.0 million of non-recurring income received in connection with the assignment and amendment of a lease at Yorkshire Plaza, Aurora, Illinois, (iv) $0.8 million due to the partial year ownership of properties acquired in 1992 and (v) the $0.4 million increase from the balance of the portfolio. The $2.4 million increase in property operating expenses and the $0.9 million increase in real estate taxes in 1993 as compared to 1992, reflect primarily (i) $1.0 million and $0.1 million, respectively, related to the Metairie, Louisiana apartment complex, (ii) $0.8 million and $0.6 million, respectively, from the properties acquired in 1993, (iii) $0.2 million and $0.1 million, respectively, due to the buildings acquired in 1992 and (iv) $0.4 million and $0.1 million, respectively, from the balance of the portfolio. The $1.0 million increase in depreciation and amortization expense for 1993 when compared to 1992 was mostly due to partial year ownership of the properties acquired in 1993 and 1992 ($0.4 million) and the Louisiana apartment complex ($0.5 million). The $1.6 million decrease in mortgage interest income in 1993 is due to the reclassification of the Metairie, Louisiana investment to real estate owned and the acquisition by MGI of the four properties that secured a $6.6 million MGI wrap-around mortgage loan. Three additional factors also contributed to the increase in income before net gains and funds from operations when 1993 is compared to 1992. Interest income in 1993 reflects a decrease in the average outstanding balance of short-term investments and lower interest rates. General and administrative expenses increased in 1993 primarily reflecting an increase in personnel. Lower average levels of debt outstanding, combined with lower interest rates on variable rate debt, resulted in decreased interest expense of $0.5 million when 1993 is compared to 1992. Average occupancy levels of 94% in 1993 were higher than the level achieved in 1992. Average occupancy of MGI's industrial properties was 96% in 1993 compared to 92% for 1992. Average occupancy of MGI's office buildings was 94% in 1993 and 91% in 1992. Retail average occupancy during 1993 was 92% compared to 90% in 1992. Average residential occupancy at 94% in 1993 was comparable to 1992. At November 30, 1993, scheduled 1994 lease expirations for non- residential space approximates 426,000 square feet, or 11% of the entire commercial portfolio. Of the scheduled 1994 expirations, 275,000 square feet is industrial space, 128,000 square feet is office and 23,000 is retail. During the second half of 1993, MGI was notified that a 40,000 square-foot tenant in a suburban Chicago, Illinois office building was not renewing its lease upon its December 31, 1993 expiration. This tenant contributed annual rental revenues of approximately $0.6 million. Although MGI believes that the rental rates for this tenant's lease is at or below current market rents, rents paid by replacement tenants for this space could be modestly below the existing rent, depending on length of vacancy, tenant size and other market factors. Net income for 1992 of $7.2 million, or $.77 per share, exceeded net income of $6.2 million, or $.66 per share, for 1991. Net income in 1992 included net gains of $1.6 million. Funds from operations totaled $11.7 million, or $1.24 per share, in 1992 compared to $12.2 million, or $1.30 per share, in 1991. The changes in 1992 income before net gains when compared to 1991 were the result of various factors. The principal factors were the sale of an interest in a California apartment complex ("the San Bruno Transaction"), the acquisitions of two industrial properties and lower interest expense. The $2.7 million decline in rental and other income was the result of a $3.3 million decrease in rental income from the San Bruno Transaction offset by the increase of $0.3 million from the partial-year ownership of the 1992 acquisitions and $0.3 million of increased revenues from the other properties. Property operating expenses, including real estate taxes, decreased $1.0 million as a result of a $1.4 million decrease in operating expenses from the San Bruno Transaction, an increase of $0.1 million in such expenses from the properties acquired in 1992 and an increase of $0.3 million from other properties. Depreciation and amortization expense was $6.0 million in both 1992 and 1991. A decrease in depreciation and amortization expense related to the San Bruno Transaction was offset by an increase related to the 1992 acquisitions and increased amortization expense related to tenant improvements. The $0.9 million decrease in interest expense for 1992 when compared to 1991 was the result of the decrease in debt outstanding combined with lower interest rates on variable rate debt. Increased levels of funds available to invest in 1992, due to the San Bruno Transaction, produced an increase in interest income on investment securities for 1992 when compared to 1991, which offset the lower interest rates generally available in 1992 for short- term investments. Net gains in 1992 included a $3.7 million gain related to the repayment of approximately $18.8 million of the outstanding financing provided to the partnership owning a San Bruno, California apartment complex. This repayment effected the partial sale of the Trust's interest for financial accounting purposes. Previously this property was carried as a real estate investment since a 1976 sale had not met the financial accounting conditions for a completed sale. In addition, MGI deferred $3.7 million of gain related to this property. Partially offsetting this gain was a $2.1 million write-down recorded in connection with the reclassification of the Trust's mortgage loan receivable on a Metairie, Louisiana apartment complex to owned real estate at November 30, 1992. Real estate investments and operations are subject to a number of factors including changes in general economic climate, local conditions (such as an oversupply of space, a decline in effective rents or a reduction in the demand for real estate), competition from other available space, the ability of the owner to provide adequate maintenance, to fund capital and tenant improvements required to maintain market position and control of operating costs. In certain markets in which the Trust owns real estate, overbuilding and local or national economic conditions have combined to produce lower effective rents and/or longer absorption periods for vacant space. As the Trust re-leases space, certain effective rents may be less than those earned previously. Management believes its diversification by region and property type reduces the risks associated with these factors and enhances opportunities for cash flow growth and capital gains potential, although there can be no assurance thereof. During the past three fiscal years, the impact of inflation on MGI's operations and investment activity has not been significant. Item 8.	Item 8. Financial Statements and Supplementary Data. - ------ ------------------------------------------- The financial statements and supplementary data are included under Item 14 of this Report. Item 9.	Item 9. Changes in and Disagreements with Accountants on - ------ Accounting and Financial Disclosure. ----------------------------------- None. PART III -------- The information required by Items 10, 11, 12 and 13 of this Part III has been omitted from this Report since the Registrant intends to file with the Securities and Exchange Commission a definitive proxy statement which involves the election of Trustees not later than 120 days after the close of the Registrant's last fiscal year. PART IV ------- Item 14.					Item 14. Exhibits, Financial Statement Schedules - ------- and Reports on Form 8-K. --------------------------------------- (a) 1. CONSOLIDATED FINANCIAL STATEMENTS INDEX - ----- Independent Auditors' Report Financial Statements: Consolidated Balance Sheets, November 30, 1993 and 1992 Consolidated Statements of Earnings, Years ended November 30, 1993, 1992 and 1991 Consolidated Statements of Changes in Shareholders' Equity, Years ended November 30, 1993, 1992 and 1991 Consolidated Statements of Cash Flows, Years ended November 30, 1993, 1992 and 1991 Notes to Consolidated Financial Statements 2. CONSOLIDATED FINANCIAL STATEMENT SCHEDULES Schedules (as of or for the year ended November 30, 1993): Schedule X, Supplementary Income Statement Information Schedule XI, Real Estate and Accumulated Depreciation Schedule XII, Mortgage Loans on Real Estate Exhibit XI - Computation of Net Income Per Share, Assuming Full Dilution Other schedules are omitted for the reasons that they are not required, are not applicable, or the required information is set forth in the financial statements or notes thereto. 3. EXHIBITS* Sequentially Numbered Page ------------- 3(a) Second Amended and Restated Declaration of Trust, incorporated by reference to Exhibit 3 of the Trust's Annual Report on Form 10-K for the fiscal year ended November 30, 1981 (the "1981 10-K"). (b) Certificate of First Amendment of Second Amended and Restated Declaration of Trust, incorporated by reference to Exhibit 3 of the 1981 10-K. (c) Certificate of Second Amendment of Second Amended and Restated Declaration of Trust, incorporated by reference to the Trust's Report on Form 8-K, filed on January 13, 1983. (d) Certificate of Third Amendment of Second Amended and Restated Declaration of Trust, incorporated by reference to Exhibit 3(d) to Amendment No. 1 to the Trust's Registration Statement on Form S-2 filed on June 7, 1985. (e) Certificate of Fourth Amendment of Second Amended and Restated Declaration of Trust, dated October 17, 1986, incorporated by reference to the Trust's Annual Report on Form 10-K for the year ended November 30, 1986. (f) Certificate of Fifth Amendment of Second Amended and Restated Declaration of Trust, dated March 25, 1987, incorporated by reference to Exhibit 3(f) of the Trust's Annual Report on Form 10-K for the fiscal year ended November 30, 1987. (g) Certificate of Sixth Amendment of Second Amended and Restated Declaration of Trust, dated February 10, 1988, incorporated by reference to Exhibit 4(g) of the Trust's Registration Statement on Form S-8 filed on May 3, 1988. (h) Certificate of Seventh Amendment of Second Amended and Restated Declaration of Trust, dated June 30, 1988, incorporated by reference to Exhibit 4.8 of the Trust's Registration Statement on Form S-4 filed on November 10, 1988 (Reg. No. 33-25495). (i) Certificate of Eighth Amendment of Second Amended and Restated Declaration of Trust, dated March 27, 1989, incorporated by reference to Exhibit 3(i) of the Trust's Annual Report on Form 10-K for the fiscal year ended November 30, 1989 (the "1989 10- K"). (j) By-Laws, incorporated by reference to the Trust's Report on Form 8-K, filed on January 12, 1983. (k) Certificate of Amendment of By-Laws, dated March 21, 1989, incorporated by reference to the Trust's Report on Form 8-K dated March 21, 1989. (l) Rights Agreement, dated as of June 21, 1989 between the Trust and The First National Bank of Boston as Rights Agent, incorporated by reference to Exhibit 1 to the Trust's Registration Statement on Form 8-A, filed on June 27, 1989. (m) Certificate of Vote of the Trustees Designating a Series of Preferred Shares, dated June 21, 1989, incorporated by reference to Exhibit 3(m) of the 1989 10-K. 10(a) Mortgage Growth Investors Incentive Stock Option Plan for Key Employees, incorporated by reference to the Trust's Definitive Proxy Statement dated March 15, 1982. (b) Mortgage Growth Investors Stock 1982 Option Plan For Trustees, incorporated by reference to the Trust's Definitive Proxy Statement dated March 15, 1982. (c) MGI Properties 1988 Stock Option and Stock Appreciation Rights Plans for Key Employees and Trustees, incorporated by reference to the Trust's Definitive Proxy Statement, dated February 19, 1988. (d) Amendment to MGI Properties' 1982 Incentive Stock Option Plan for Key Employees, dated as of December 19, 1989, incorporated by reference to Exhibit 10(d) of the 1989 10- K. (e) Amendment to MGI Properties' 1982 Stock Option Plan for Trustees, dated as of December 19, 1989, incorporated by reference to Exhibit 10(e) of the 1989 10- K. (f) Amendment to MGI Properties' 1988 Stock Option and Stock Appreciation Rights Plan for Key Employees, dated as of December 19, 1989, incorporated by reference to Exhibit 10(f) of the 1989 10-K. (g) Amendment to MGI Properties' 1988 Stock Option Plan for Trustees, dated as of December 19, 1989, incorporated by reference to Exhibit 10(g) of the 1989 10- K. (h) Amended and Restated Severance Compensation Plan, dated as of December 19, 1989, incorporated by reference to Exhibit 10(i) of the 1989 10-K. (i) Amended and Restated MGI Properties Long Term Share Bonus Plan, dated December 18, 1991, incorporated by reference to Exhibit 10(i) of the 1991 10-K. (j) Purchase Agreement, dated December 29, 1992, among West Port Park, Inc., a Massachusetts corporation, those persons named on Schedule A thereto, MGI Properties and MGI West Port, Inc., a Delaware corporation, incorporated by reference to the Trust's Report on Form 8-K, filed on February 14, 1994 (the "1994 8-K") (k) Agreement of Sale, dated as of May 7, 1993, among MGI Properties and Continental Bank, National Association, as successor trustee, and Jesse B. Morgan and Thomas E. Meador, as co-trustees, incorporated by reference to the Trust's 1994 8-K. (l) Agreement of Purchase and Sale, dated as of April 6, 1993, between MGI Properties and Hexalon Real Estate, Inc., incorporated by reference to the Trust's 1994 8-K. (m) Contract of Sale, effective June 1, 1993, between Nationwide Life Insurance Company and MGI Properties, incorporated by reference to the Trust's 1994 8-K. (n) Real Estate Sale Agreement, dated as of July 16, 1993, between The Travelers Insurance Company and MGI Properties, incorporated by reference to the Trust's 1994 8-K. (o) Agreement to Purchase Real Property, dated July 23, 1993, between Bedford Property Investors, Inc. and MGI Properties, incorporated by reference to the Trust's 1994 8-K. (p) Agreement for Purchase and Sale of Property, dated as of October 21, 1993, between New York Life Insurance Company, MGI Properties and Sherburne, Powers & Needham, P.C., as escrow agent, incorporated by reference to the Trust's 1994 8-K. (q) Purchase and Sale Agreement, dated as of October 1, 1993, between The Boston Finance Company and MGI Properties, incorporated by reference to the Trust's 1994 8-K. (r) Real Estate Sale Contract, dated as of November 1993, between The Prudential Insurance Company of America and MGI Properties, incorporated by reference to the Trust's 1994 8-K. 11 Computation of Net Income Per Share, Assuming Full Dilution, included under Item 14 of this Report. 24 Auditors' consent to the incorporation by reference in the Trust's Registration Statements on Form S-8 of the independent auditor's report included herein. * On file at Securities and Exchange Commission as indicated. (b) REPORTS ON FORM 8-K: No reports on Form 8-K were filed during the fourth quarter of the fiscal year ended November 30, 1993. ------------------------- MGI Properties (the "Trust") is a Massachusetts business trust and all persons dealing with the Trust must look solely to the property of the Trust for the enforcement of any claims against the Trust. Neither the Trustees, officers, agents nor shareholders of the Trust assume any personal liability in connection with its business or assume any personal liability for obligations entered into in its behalf. POWER OF ATTORNEY ----------------- MGI Properties and each of the undersigned do hereby appoint W. Pearce Coues and Phillip C. Vitali and each of them severally, its or his true and lawful attorneys to execute on behalf of MGI Properties and the undersigned any and all amendments to this Report and to file the same with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission. Each of such attorneys shall have the power to act hereunder with or without the other. SIGNATURES ---------- Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Annual Report on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized. Dated: February 17, 1994 MGI PROPERTIES (Registrant) By: /s/ W. Pearce Coues ---------------------------- W. Pearce Coues, Chairman of the Board of Trustees Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the date indicated. Signature Title Date - --------- ----- ---- /s/ W. Pearce Coues Chairman of the Board February 17, 1994 - ------------------------- of Trustees and Chief W. Pearce Coues Executive Officer /s/ Phillip C. Vitali Principal Financial Officer February 17, 1994 - ------------------------- and Principal Accounting Phillip C. Vitali Officer /s/ Herbert D. Conant Trustee February 17, 1994 - ------------------------- Herbert D. Conant /s/ Francis P. Gunning Trustee February 17, 1994 - ------------------------- Francis P. Gunning /s/ Colin C. Hampton Trustee February 17, 1994 - ------------------------- Colin C. Hampton /s/ George M. Lovejoy, Jr. Trustee February 17, 1994 - -------------------------- George M. Lovejoy, Jr. /s/ Rodger P. Nordblom Trustee February 17, 1994 - ------------------------- Rodger P. Nordblom /s/ John R. White Trustee February 17, 1994 - ------------------------- John R. White UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K ITEM 8 - CONSOLIDATED FINANCIAL STATEMENTS November 30, 1993 MGI PROPERTIES MGI PROPERTIES Index to Consolidated Financial Statements and Schedules Page Independent Auditors' Report 1 Financial Statements: Consolidated Balance Sheets, November 30, 1993 and 1992 2 Consolidated Statements of Earnings, Years ended November 30, 1993, 1992 and 1991 3 Consolidated Statements of Cash Flows, Years ended November 30, 1993, 1992 and 1991 4 Consolidated Statements of Changes in Shareholders' Equity, Years ended November 30, 1993, 1992 and 1991 5 Notes to Consolidated Financial Statements 6-11 Schedules (as of or for the year ended November 30, 1993): Schedule X - Supplementary Income Statement Information Schedule XI - Real Estate and Accumulated Depreciation Schedule XII - Mortgage and Other Loans on Real Estate Exhibit XI - Computation of Net Income Per Share, Assuming Full Dilution Other schedules are omitted as they are not required, are not applicable, or the required information is set forth in the consolidated financial statements or notes thereto. Independent Auditors' Report The Board of Trustees and Shareholders MGI Properties: We have audited the consolidated financial statements of MGI Properties and subsidiaries as listed in the accompanying index. In connection with our audits of the consolidated financial statements, we have also audited the financial statement schedules as listed in the accompanying index. These consolidated financial statements and financial statement schedules are the responsibility of the Trust's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of MGI Properties and subsidiaries as of November 30, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three-year period ended November 30, 1993 in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. KPMG PEAT MARWICK Boston, Massachusetts January 6, 1994 MGI PROPERTIES Consolidated Balance Sheets November 30, 1993 and 1992 See accompanying notes to consolidated financial statements. MGI PROPERTIES Consolidated Statements of Earnings See accompanying notes to consolidated financial statements. MGI PROPERTIES Consolidated Statements of Cash Flows See accompanying notes to consolidated financial statements. MGI PROPERTIES Consolidated Statements of Changes in Shareholders' Equity See accompanying notes to consolidated financial statements. MGI PROPERTIES Notes to Consolidated Financial Statements (1) Summary of Significant Accounting Policies (a) Consolidation The consolidated financial statements of the Trust include the accounts of its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. (b) Income Taxes The Trust intends to continue to qualify to be taxed as a real estate investment trust under Sections 856-860 of the Internal Revenue Code of 1986 and the related regulations. In order to qualify as a real estate investment trust for tax purposes, the Trust, among other things, must distribute to shareholders at least 95% of its taxable income. It has been the Trust's policy to distribute 100% of its taxable income to shareholders; accordingly, no provision has been made for Federal income taxes. (c) Income and Expense Recognition Income and expenses are recorded using the accrual method of accounting for financial reporting and tax purposes. Income or loss from real estate partnerships is accounted for according to generally accepted accounting principles using either the cost method or the equity method. (d) Depreciation and Amortization Real estate investments, excluding land costs, are depreciated using the straight-line method over estimated useful lives of 20 to 40 years. Tenant improvements are amortized over the shorter of their estimated useful lives or lease terms ranging from 2 to 10 years. Equipment is depreciated over 5, 10 or 20 years. Maintenance and repairs are charged to expense as incurred; major improvements are capitalized. (e) Statements of Cash Flows For purposes of the statements of cash flows, all short-term investments with a maturity, at date of purchase, of three months or less are considered to be cash equivalents. During 1993, the Trust purchased four industrial properties for $6.8 million. The purchase price consisted of cash and a $6.6 million mortgage loan receivable. Only the cash portion of the purchase price is reflected in the accompanying consolidated statement of cash flows. Mortgage loans payable assumed with the acquisition of real estate investments amounted to $.7 million for the year ended November 30, 1993. Cash interest payments of $5.3 million, $5.5 million and $6.5 million were made for the years ended November 30, 1993, 1992 and 1991, respectively. (f) Fair Value of Financial Instruments The Trust estimated the fair values of its financial instruments at November 30, 1993 using discounted cash flow analysis and quoted market prices. Such financial instruments include short-term investments, U.S. Government securities, mortgage and other loans payable and mortgage notes receivable which were received in connection with transactions not qualifying as sales for financial accounting purposes and accordingly not reflected in the Trust's consolidated balance sheet. The excess of the aggregate fair value of the Trust's financial instruments over their aggregate carrying amounts is not material. (Continued) MGI PROPERTIES Notes to Consolidated Financial Statements (g) Net Income Per Share Net income per share is computed based on the weighted average number of common shares outstanding. (2) Investments (a) Real Estate A summary of real estate investments follows: A discussion of certain real estate investments follows: In 1982, the Trust sold its investment in a Michigan apartment complex and received a $15.5 million purchase money mortgage in a transaction that did not meet the conditions for a completed sale for financial accounting purposes. The loan, which matures in February 1995, has an interest rate of 7% and provides for the Trust to receive at least 50% but not more than 60% of the shared appreciation value in excess of the outstanding note balance. In addition, the Trust has a 35% ownership interest, direct and indirect, in the partnership owning this complex. The Trust's purchase option expires in February 1995 and allows it to obtain a maximum equity interest of 67.5%. At November 30, 1993, the Trust carried this asset as a real estate investment at a net carrying value of $7.5 million, which excludes the gain from the sale. At November 30, 1992, the Trust began to account for its loan on a Metairie, Louisiana apartment complex as real estate owned. The Trust had been recognizing interest income ($1.1 million in 1992 and 1991) on the related mortgage loan as received. During 1993, the Trust has recognized property income and expenses as if it owned the property. For tax purposes, this investment is reflected as a $14.1 million, 8.5% mortgage loan receivable at November 30, 1993. With respect to a California partnership investment, the Trust is entitled to receive 50% of property cash flow and residuals through a 2% limited partnership interest (carrying value of $225,000) and has an option to increase its equity interest. In addition, the Trust has a loan receivable from the partnership with a $3.1 million tax basis. Such loan is not recorded in the accompanying financial statements. (Continued) MGI PROPERTIES Notes to Consolidated Financial Statements (b) Mortgage Loan At November 30, 1992, the Trust had reached agreement with the borrower to purchase the four industrial properties securing this $5.9 million wrap-around mortgage loan for a price of $225,000 over the mortgage face value (face value $6.6 million). The acquisition of these buildings was completed December 31, 1992. This loan was subordinate to prior liens which aggregated $.7 million. (c) Other Gains In 1992, the Trust recognized a gain of $3.7 million and deferred an additional gain of $3.7 million, which was effectuated by the December 1991 repayment of approximately $18.8 million of financing it had provided to the partnership owning a San Bruno, California apartment complex. Prior to the completion of the December 1991 transaction, a 1976 sale had not met the conditions for a completed sale and the Trust carried this property as a real estate investment for financial accounting purposes. In addition, in 1992, the Trust recognized a $2.1 million write-down of the Metairie, Louisiana investment discussed above. (3) Leases All leases relating to real estate investments are operating leases; accordingly, rental income is reported when earned. Future minimum lease payments on noncancelable operating leases at commercial properties at November 30, 1993 are: $23.0 million in 1994, $19.5 million in 1995, $16.4 million in 1996, $12.4 million in 1997, $9.1 million in 1998, and $22.2 million thereafter. The above amounts do not include contingent rental income which is received under certain leases based upon tenant sales, ad valorem taxes, property operating expenses and/or costs to maintain common areas. Contingent rental income was $3.4 million in 1993 and $2.6 million in 1992 and 1991. Operating leases on apartments generally have a term of one year or less. (4) Mortgage and Other Loans Payable (Continued) MGI PROPERTIES Notes to Consolidated Financial Statements Mortgage loans payable are nonrecourse and are collateralized by certain real estate investments having a net carrying value of $115.8 million and the Trust's guarantee of $6.2 million. Loans require monthly principal amortization and/or a balloon payment at maturity. The mortgage loan maturing in September 1994 and a $10.0 million line of credit are part of a credit agreement which requires the Trust to maintain compensating balances of 4% of the outstanding loan balance in non-interest bearing accounts with the lender or pay a deficiency fee. The credit agreement contains restrictive covenants which, among other things, require the Trust to maintain certain financial ratios and restricts the incurrence of certain additional indebtedness and the making of certain investments. No borrowing under this line of credit was outstanding during the fiscal year. In connection with this line, a fee is charged on the unused amount. The housing revenue bond is tax exempt and is secured by real estate having a net carrying value of $5.1 million. The bond is also secured by a letter of credit which is collateralized by $3.2 million of short-term investments and U.S. Government securities. The Trust has also guaranteed $3.0 million of the debt. The base interest rate floats weekly and was 2.35% at November 30, 1993 (an effective interest rate of 4.28% due to the payment of fees). Principal payments on mortgage and other loans payable due in the next five years and thereafter are as follows: $18.7 million in 1994, $1.3 million in 1995, $13.4 million in 1996, $16.8 million in 1997, $0.8 million in 1998, and $16.0 million thereafter. (5) Shareholders' Equity (a) Stock Option Plans Under the Trust's 1988 stock option plans for key employees and Trustees (the "Plans"), incentive stock options with or without stock appreciation rights or nonqualified options and related stock appreciation rights may be granted to employees, and nonqualified options may be granted to Trustees. Under the Plans, options may be granted at an exercise price not less than fair market value of the Trust's common shares on the date of grant. Changes in options outstanding during the years ended November 30 were as follows: The weighted average exercise price per option at November 30, 1993, 1992 and 1991 was $12.16, $11.88 and $11.81, respectively. The shares reserved expire by April 1998 and all outstanding options expire by March, 2003. Subsequent to November 30, 1993, 61,000 options were granted. All options outstanding are currently exercisable. (Continued) MGI PROPERTIES Notes to Consolidated Financial Statements (b) Shareholder Rights Plan On June 21, 1989, the Board of Trustees adopted a shareholder rights plan. Under this plan, one right was attached to each outstanding common share on July 5, 1989, and one right will be attached to each share issued in the future. Each right entitles the holder to purchase, under certain conditions, one one-hundredth of a share of Series A participating preferred stock for $60. The rights may also, under certain conditions, entitle the holders to receive common shares of the Trust, common shares of an entity acquiring the Trust, or other consideration, each having a value equal to twice the exercise price of each right ($120). One hundred fifty thousand preferred shares have been designated as Series A participating preferred shares and are reserved for issuance under the shareholder rights plan. The rights are redeemable by the Trust at a price of $.01 per right. If not exercised or redeemed, all rights expire on July 5, 1999. (c) Common Stock Offering In May 1993 the Trust sold 2,000,000 shares of common stock in a public offering for a price of $13.785 per share. The Trust received net proceeds of $25.6 million after the underwriting discount and offering costs. (6) Cash Distributions and Federal Income Taxes The difference between taxable income and net income reported in the consolidated financial statements is due principally to reporting certain gains for tax purposes under the installment method, use of net operating loss carryforwards available and differences in depreciation and in the basis of real estate sold as reported for tax and financial statement purposes. The Trust made cash distributions of ordinary income of $.81 per share ($8,460,000) in 1993, and cash distributions of ordinary income and capital gains of $.80 per share is 1992 ($7,523,000) and in 1991 ($7,518,000). On December 15, 1993, the Trust declared a dividend of $.21 per share payable on January 11, 1994 to shareholders of record on January 3, 1994. (7) Commitments In November 1993, the Trust agreed to acquire two industrial research and development buildings totaling 156,000 sq. ft. for an aggregate price of approximately $6.3 million. The purchase transaction closed in December 1993. (8) Quarterly Financial Information (Unaudited) Quarterly results of operations for the years ending November 30, 1993 and 1992 follow: (Continued) MGI PROPERTIES Notes to Consolidated Financial Statements Schedule X MGI PROPERTIES Supplementary Income Statement Information Charged to Costs and Expenses Schedule XI MGI PROPERTIES Real Estate and Accumulated Depreciation November 30, 1993 Schedule XI (Continued) MGI PROPERTIES Real Estate and Accumulated Depreciation A summary of real estate investments and accumulated depreciation and amortization for the three years ended November 30 follows: The aggregate cost for Federal income tax purposes of the above investments is approximately $215.0 million. Refer to Note 1 regarding the Trust's accounting policies on real estate investments and depreciation and amortization. Schedule XII MGI PROPERTIES Mortgage and Other Loans on Real Estate November 30, 1993 A summary of mortgage and other loan activity for the years ended November 30 follows: Exhibit XI MGI PROPERTIES Computation of Net Income Per Share Assuming Full Dilution Consent of Independent Auditors The Board of Trustees MGI Properties: We consent to incorporation by reference in the registration statements (Nos. 33-21584, 2-97270 and 33-65844) on Form S-8 of MGI Properties and subsidiaries of our report dated January 6, 1994, relating to the consolidated balance sheets of MGI Properties and subsidiaries as of November 30, 1993 and 1992, and the related consolidated statements of earnings, changes in shareholders' equity, and cash flows and related schedules for each of the years in the three-year period ended November 30, 1993, which report appears in the November 30, 1993 annual report on Form 10-K of MGI Properties and subsidiaries. KPMG PEAT MARWICK Boston, Massachusetts February 15, 1994
842635_1993.txt	842635	1993				Item 3 -- "Claims Relating To Waste Disposal Sites". Item 3. Legal Proceedings General In connection with the transfer of assets and liabilities from ARCO to Lyondell, Lyondell agreed to assume certain liabilities arising out of the operation of the Company's integrated petrochemical and petroleum processing business prior to July 1, 1988. At that time, the Company and ARCO entered into an agreement (Cross-Indemnity Agreement) whereby the Company agreed to defend and indemnify ARCO against certain uninsured claims and liabilities which ARCO may incur relating to the operation of the business of the Company prior to July 1, 1988, including liabilities which may arise out of certain of the legal proceedings described in this Item 3. See Item 13 -- "Certain Relationships and Related Transactions". Prior to November 20, 1990, ARCO's insurance carriers had assumed the defense of most of the lawsuits described in this Item 3. Since that date, ARCO's insurance carriers have refused to advance defense costs in those lawsuits relating to certain of the waste disposal sites. See "Claims Relating To Waste Disposal Sites - ARCO Insurance Litigation". In addition to the proceedings specifically described in this Item 3, ARCO, the Company and its subsidiaries are defendants in other suits, some of which are not covered by insurance. Many of these additional suits involve smaller amounts than the matters described herein, or make no specific claim for relief. Although final determination of legal liability and the resulting financial impact with respect to the litigation described in this Item 3, as well as the other litigation affecting the Company, cannot be ascertained with any degree of certainty, the Company does not believe that any ultimate uninsured liability resulting from the legal proceedings in which it currently is involved (directly or indirectly) will individually, or in the aggregate, have a material adverse effect on the business or financial condition of the Company. See Note 18 of "NOTES TO CONSOLIDATED FINANCIAL STATEMENTS". Although Lyondell is involved in numerous and varied legal proceedings, a significant portion of its litigation arises in three contexts: (1) claims for personal injury or death allegedly arising out of exposure to the Company's products; (2) claims for personal injury or death, and/or property damage allegedly arising out of the generation and disposal of chemical wastes at Superfund and other waste disposal sites; and (3) claims for personal injury and/or property damage and air and noise pollution allegedly arising out of the operation of the Company's facilities. The following sections of this Item 3 describe these types of pending proceedings. Lyondell (either directly or through ARCO as its indemnitee) is the real party at interest in these proceedings. Claims Related To Company Products ARCO and the Company are involved in numerous suits arising in whole or in part from the operation of the Company's, including LCR, petrochemical and petroleum processing businesses and the assets related thereto in which the plaintiffs allege damages arising from exposure to allegedly toxic chemical products, such as benzene and butadiene. Plaintiffs in these cases usually worked at a manufacturing facility as employees of one of Lyondell's customers, were employees of the Company's contractors, or were employees of companies involved in the transportation of the Company's products to its customers. These suits allege toxic effects of exposure to chemicals sold in the ordinary course of business to third parties by various industrial concerns, including ARCO or the Company, or allege toxic chemical exposures at the Company's manufacturing facilities. Issues common to these cases include: (1) whether the plaintiff can identify a specific product to which he was allegedly exposed; (2) whether the Company supplied the identified product to which plaintiff claims he was exposed; (3) whether the plaintiff has a medical condition which, based upon competent scientific and medical evidence, is causally related to the identified product; (4) whether, and under what conditions, the plaintiff was exposed to the identified product; and (5) if the plaintiff was exposed, whether the Company has any legal defenses to the plaintiff's claims and whether there are other parties or defendants to whom the Company can turn for contribution or indemnification. The Company believes that it has always followed a policy of not only complying with all mandated standards related to product warnings and exposure levels but also of complying with Company specific standards that were more strict than those imposed by the law. As a result, the Company believes that it has a basis to avail itself of legal defenses against claims regarding its products due to exposures by employees and by claims of exposures from third parties to whom the Company sold its products. The vast majority of chemical exposure cases name a large number of industrial concerns, in addition to the Company, as defendants and are at various stages of discovery. Although the Company does not believe that the pending chemical exposure cases will have a material adverse effect on its business or financial condition, it is difficult to determine the potential outcome of this type of case. The majority of the plaintiffs in chemical exposure legal proceedings request relief in the form of unspecified monetary damages. Furthermore, when specific amounts are requested they often bear no objective relation to the merits of the case. Notwithstanding the foregoing, it is possible that if one or more of the presently pending chemical exposure cases were resolved against ARCO or the Company, the resulting damage award could be material to the Company without giving effect to contribution or indemnification obligations of co- defendants or others, or to the effect of any insurance coverage that may be available to offset the effects of any such award. Claims Relating To Waste Disposal Sites Wastes generated from products produced by facilities transferred from ARCO and now owned by the Company or LCR have, from time to time, been disposed of at third-party landfills. Two of these facilities, known as the "French Ltd." and the "Brio" Sites, both of which are located near Houston, Texas, have been classified as "Superfund" sites under the Comprehensive Environmental Response, Compensation and Liability Act of 1980 (CERCLA). The Environmental Protection Agency (EPA) has named many potentially responsible parties (PRPs) at each site from whom wastes were allegedly received. Based on the current law, the Company does not believe that its obligation to ARCO related to ARCO's share of clean-up costs at either of these sites will result in a liability that will have, individually or in the aggregate, a material adverse effect on the business or financial condition of the Company. It is possible, however, that the Company may be involved in future CERCLA and comparable state law investigations and clean-ups. The current presidential administration recently proposed a plan to significantly revise the Superfund law which is scheduled for reauthorization this year. Because the proposal is so recent and because it is expected to generate strong reactions from business, insurance companies, lenders, municipalities and environmentalists, the Company is not able to predict whether the administration's plan will be enacted or to determine with specificity what the impact would be on the Company. French Ltd. Site Remediation -- At the French Ltd. site, ARCO and the other PRPs have entered into a settlement agreement relating to the allocation of clean-up costs. The EPA approved the clean-up plan and a Consent Decree was entered in the Federal District Court for the Southern District of Texas in the first quarter of 1990. An amendment to the Consent Decree relating to natural resource damage has been negotiated and submitted to the court for approval. The total costs associated with the Consent Decree are currently estimated to be approximately $90 million. The Company believes that its share of clean-up costs (as allocated pursuant to the Cross-Indemnity Agreement) will be no more than five percent of total costs recovered without giving effect to any insurance coverage which may be available to offset these costs. French Ltd. Site Litigation -- Approximately 2,500 plaintiffs have made claims related to wastes in the French Ltd. Superfund site. In each of these cases, ARCO is one of many defendants. These suits generally allege that unspecified chemical waste sent to the site by the defendants caused a decrease in property value, a decrease in plaintiffs' ability to enjoy their property, and unspecified adverse effects on plaintiffs' health. Although some of the lawsuits request relief in the form of unspecified monetary damages, the aggregate amount of actual damages sought in those cases where damages are specified exceeds $5 billion. The aggregate amount of punitive damages sought in those cases where damages are specified exceeds $20 billion. In December, 1992, after mediation, ARCO, along with several other defendants, entered into a preliminary agreement to settle claims of approximately 2,200 plaintiffs. The remaining claims are in pretrial discovery. The Company's obligation to reimburse ARCO for defense costs and settlements related to French Ltd. has not been determined. Brio Site Remediation -- At the Brio site, a definitive agreement allocating these remedial costs among ARCO and other PRPs has been reached. The EPA approved the plan and a Consent Decree between the Department of Justice and a group of PRPs (including ARCO on behalf of its former divisions and subsidiaries) was entered in Federal District Court for the Southern District of Texas, in April, 1991 and remediation work is ongoing. In 1991, various parties filed an appeal to the entering of the Consent Decree after the denial of their motions to intervene in the proceedings. This appeal was denied in December, 1991. The total clean-up cost is currently estimated to be approximately $60 million. The Company believes that its share of the clean-up costs (as allocated pursuant to the Cross-Indemnity Agreement) will be no more than one percent of total costs without giving effect to any insurance coverage which may be available to offset these costs. Brio Site Litigation -- There currently are eight separate pending legal proceedings filed against ARCO or its affiliates and numerous others in connection with the Brio Superfund site. In these proceedings, there are approximately 600 plaintiffs, many of whom are suing in their capacity as next friend of minor children. In each of these cases, ARCO is one of many defendants. Plaintiffs allege personal injury as a result of exposure to various substances that were disposed of or stored at the Brio site. These suits generally allege that defendants were negligent in sending chemical substances to the site and also contain allegations of nuisance and strict liability. The suits involve: a school district alleging damages as a result of the closing of Weber Elementary; employees of the various entities who operated the refining and reprocessing facilities at Brio; and other plaintiffs. All of the lawsuits request relief in the form of unspecified compensatory and exemplary damages. These suits are in pretrial discovery. ARCO (or its affiliate) is the named defendant in the above proceedings. Under the provisions of the Cross-Indemnity Agreement, Lyondell is not obligated to indemnify ARCO for costs arising out of this litigation for which ARCO is insured. Although ARCO is currently litigating the nature and extent of its coverage with its insurance carriers (see "ARCO Insurance Litigation"), Lyondell believes that the ultimate resolution of the above described lawsuits, ARCO's insurance litigation and related issues will not result in any material obligation on the part of Lyondell to ARCO with respect to the Brio and the French Ltd. Superfund Sites. Other Waste Disposal Site Litigation -- The Company and ARCO are named defendants in three of four presently pending lawsuits filed on behalf of 73 plaintiffs in the state district court in Galveston County, Texas involving the alleged release of toxic and hazardous substances from the Hall's Bayou Ranch. LCR sends and, prior to July 1, 1993, Lyondell and its predecessor sent surface water runoff and process waste water from the Refinery to Gulf Coast Waste Disposal Authority (GCWDA) and a portion of the solids output from GCWDA is sent for storage to the Hall's Bayou Ranch site. Plaintiffs claim personal injury, diminution of property value and loss of use and enjoyment of the property. They are seeking $7 billion in actual damages and $28 billion in punitive damages. In March 1993, the Company and ARCO entered a preliminary settlement agreement to resolve these proceedings with all plaintiffs. The proposed settlement is not expected to have a material adverse effect on the Company's financial position. ARCO Insurance Litigation -- On November 21, 1990, ARCO filed suit against certain of its insurers with respect to insurance policies in effect at times during past years. This litigation involves claims for reimbursement of defense costs and environmental expenses incurred by ARCO in connection with ARCO's activities at sites and locations throughout the United States. ARCO's insurers had been participating in the defense of the Company and ARCO for the Mont Belvieu proceedings (see "Claims Related To Company Operations -- Mont Belvieu Litigation") as well as the litigation involving the French Ltd. and the Brio Superfund sites; however, subsequent to the filing of ARCO's lawsuit, the insurers have refused to advance defense costs for these proceedings (and certain other proceedings relating to the Company's products) until the coverage dispute has been resolved. ARCO is currently paying the defense costs in these proceedings, as well as other waste disposal site litigation, pending the resolution of the coverage dispute. It has not been determined whether or not the Company has an obligation to reimburse ARCO for defense costs related to the coverage dispute. Claims Related To Company Operations Mont Belvieu Litigation -- Several organizations and groups of citizens who own property in the vicinity of Mont Belvieu, Texas, have instituted suits for monetary damages and injunctive relief against ARCO and others who own underground storage and transportation facilities in the city of Mont Belvieu. In September, 1980, Warren Petroleum Company (Warren) experienced a leak in one of its underground hydrocarbon storage wells in Mont Belvieu. On March 18, 1983, suit was brought by 34 plaintiffs, naming Warren, ARCO and other companies with operations in Mont Belvieu as defendants. These plaintiffs claimed property damage, and, in some instances, personal injuries allegedly resulting from storage operations in Mont Belvieu. Later, 83 additional plaintiffs joined the suit. Because of the number of plaintiffs, the court divided this lawsuit into three separate lawsuits. In February, 1986, ARCO was granted a directed verdict as to all of the claims of the plaintiffs in the first of the three lawsuits to be tried which had the effect of dismissing all the pending claims without the ability to refile. Thereafter, the plaintiffs in the two remaining cases dropped their claims against ARCO. ARCO remains in these two cases as a result of cross claims for contribution filed by other defendants. These suits have not been set for trial. In 1986, a number of companies that operated facilities in Mont Belvieu, including ARCO, instituted a program to make offers to purchase certain properties in Mont Belvieu. The purpose of the purchase program was to give persons within a certain area the opportunity to move, if they so desired. A number of residents and litigants participated in the program. The implementation of the purchase program described above led to the filing of a new set of lawsuits. There are two separate legal proceedings which have resulted from eight lawsuits filed against ARCO, the Company, and a number of other companies that operate facilities in Mont Belvieu. These claims are made by persons outside of the area designated by the purchase program and are pending in state and federal court. The lawsuits name ARCO and the Company as well as every other company that participated in the purchase program as defendants. In six of the cases, which involve a total of 94 plaintiffs, the city of Mont Belvieu also is named as a defendant. These plaintiffs claim that industry operations, together with incidents that occurred at certain facilities, and the publicity surrounding those incidents, destroyed the value of their property. The plaintiffs also assert that they were discriminated against by the purchase program and that their civil rights were violated since they did not receive an offer to buy their property. The plaintiffs further claim that the purchase violated antitrust provisions of state law, and that the defendants were negligent in their operations and trespassed onto plaintiffs' properties. In December, 1991, the trial court in the lawsuit pending in state district court entered a take nothing summary judgment in favor of ARCO, the Company and other companies who were named as defendants in that lawsuit. The plaintiff sought injunctive relief, recovery of more than $9 million in actual damages and more than $28 million in punitive damages in this case. The plaintiff appealed the adverse ruling. In July, 1992, the state court of appeals in Houston reversed and remanded the case for retrial in a different county based on its interpretation of proper venue. In September, 1993, a summary judgment in the state district court in the new county was granted in favor of all defendants in this matter. An appeal is pending. All other Mont Belvieu cases were consolidated in the Federal District Court in the Southern District of Texas. In addition to unspecified damages, the aggregate amount of actual damages sought from all defendants in all of these Mont Belvieu cases exceeds $241 million. The aggregate amount of punitive damages sought exceeds $675 million. These lawsuits went to trial on December 1, 1992. On January 11, 1993, after the plaintiffs concluded their offer of evidence, the trial court granted the defendants' motion for directed verdict which dismissed plaintiffs' claims without the ability to refile. An appeal is pending. ARCO is paying all defense costs in all of the Mont Belvieu litigation and the Company does not expect that a claim will be made under the Cross-Indemnity Agreement. Channelview Nuisance Litigation -- In 1992 and 1993, the Company, together with two other corporate defendants, was named as a defendant in two separate lawsuits that were filed in two state district courts in Harris County, Texas. In the first suit, the 15 plaintiffs allege that one or all of the named defendants' facilities emit loud noises, bright lights and noxious fumes in proximity to the plaintiffs' homes. The 15 plaintiffs in the second lawsuit make these same allegations. Some of these latter plaintiffs also allege a diminished quality of the water in their water wells. The two lawsuits have been consolidated. The plaintiffs are claiming, among other things, diminution in property value, interference with the use and enjoyment of their property and personal injuries. The consolidated lawsuits seek unspecified actual damages in excess of $5 million and punitive damages in excess of $20 million. Arceneaux Litigation -- In November, 1993, multiple lawsuits were filed in state district court on behalf of approximately 70,000 plaintiffs residing or doing business in the vicinity of the lower San Jacinto River against hundreds of named businesses, including the Company, owning or operating facilities situated in the vicinity of the Houston Ship Channel alleging, among other things, pollution to the San Jacinto River watershed below the Ship Channel and requesting damages in the aggregate in excess of $1.5 trillion. In January, 1994, one of the suits against a single defendant was non-suited and the three remaining suits were dismissed on the defendants' motion without the ability to refile. Other Matters In April, 1993 the City of Houston, Texas (joining the Texas Air Control Board as a necessary party) filed suit in the state district court of Harris County, Texas against the Company, alleging violations of the Texas Clean Air Act and the Texas Administrative Code and seeking maximum civil penalties and appropriate injunctive relief. In July, 1993 the City of Houston filed an amended and restated petition which added as causes of action certain allegations made by the Texas Air Control Board, now the TNRCC, following its April, 1993 state inspection plan (SIP) inspection. The Company filed a general denial to all allegations of the lawsuit in July, 1993 and is engaged in settlement negotiations with the City and the State. In the fourth quarter of 1992, the Refinery underwent an EPA multi-media inspection and an Occupational Safety and Health Administration (OSHA) Process Quality Verification Audit. The OSHA inspection of the Refinery was resolved in an informal settlement agreement in April, 1993. At this time, the EPA has not formally notified the Company of the enforcement action to be taken, if any. In addition to the matters reported herein, from time to time the Company receives notices from federal, state or local governmental entities of alleged violations of environmental laws and regulations pertaining to, among other things, the disposal, emission and storage of chemical and petroleum substances, including hazardous wastes. Although the Company has not been the subject of significant penalties to date, such alleged violations may become the subject of enforcement actions or other legal proceedings and may (individually or in the aggregate) involve monetary sanctions of $100,000 or more (exclusive of interest and costs). Item 4.	Item 4. Submission of Matters to a Vote of Security Holders No matters were submitted to a vote of security holders during the fourth quarter of 1993. EXECUTIVE OFFICERS OF THE REGISTRANT Set forth below are the executive officers of Registrant as of March 1, 1994. Name, Age and Present Business Experience During Past Position with Lyondell Five Years and Period Served as Officer(s) - ---------------------- ------------------------------------------ John R. Beard, 41................. Mr. Beard became Vice President Quality, Vice President, Supply and Planning on July 1, 1993. Quality, Supply and Planning Mr. Beard was appointed Vice President, Planning and Evaluations in May, 1992. He served as the Site Manager of Lyondell's Houston Refinery from 1988 until April, 1992. From 1985 until 1988, he served in management assignments in evaluations, marketing and manufacturing. Prior to 1985, he served in various management positions for ARCO Products Company and the ARCO Chemical Division. He originally joined ARCO in 1974. Bob G. Gower, 56.................. Mr. Gower was elected Chief Executive Officer Chief Executive Officer, of the Company on October 24, 1988 and President and Director Director and President of the Company on June 27, 1988. He has been President of Lyondell and its predecessor, the Lyondell Division, since formation of the Lyondell Division in April, 1985. Mr. Gower was a Senior Vice President of ARCO from June, 1984 until his resignation as an officer of ARCO in January, 1989. Prior to 1984, he served in various capacities with the then ARCO Chemical Division. He originally joined ARCO in 1963. Robert H. Ise, 59................. Mr. Ise was appointed Vice President, Vice President, Marketing, Supply and Evaluations of Lyondell Petrochemical Company LYONDELL-CITGO Refining Company Ltd. on Vice President, July 1, 1993. He previously served Lyondell Marketing, Supply and Evaluations as Vice President, Marketing and Sales, LYONDELL-CITGO Refining Polymers and Petroleum Products from April, Company Ltd. 1992 until June, 1993 and continues to serve as a Vice President of Lyondell. He served as Vice President, Marketing and Sales, Petroleum Products, from December, 1988 until April, 1992. He served as Vice President of Industrial Products Marketing of the Lyondell Division from June, 1987 to December, 1988. From May, 1985 to June, 1987 he served as Director, Industrial Products Marketing for the Lyondell Division. Prior thereto, he served in various marketing capacities for the ARCO Products Division. He originally joined ARCO in 1959. Richard W. Park, 54............... Mr. Park was elected Vice President, Human Vice President, Resources on June 27, 1988. He previously Human Resources served as Vice President of Employee Relations of the Lyondell Division since February, 1987. From 1985 to 1987 he served as Manager of Personnel for the then ARCO Chemical Division's Specialty Chemicals and International Units. Prior to 1985 he held other employee relations positions with divisions of ARCO. He originally joined ARCO in 1965. Name, Age and Present Business Experience During Past Position with Lyondell Five Years and Period Served as Officer(s) - ---------------------- ------------------------------------------ Jeffrey R. Pendergraft, 45........ Mr. Pendergraft was named Senior Vice Senior Vice President, President on May 6, 1993. Mr. Pendergraft Secretary and General Counsel was elected Vice President and General Counsel on June 27, 1988 and Secretary on October 24, 1988. From September, 1985 to June, 1988, he served as General Attorney of the Lyondell Division. Prior to September, 1985, he served as an attorney for various operating divisions and corporate units of ARCO at increasing levels of responsibility. He originally joined ARCO in 1972. W. Norman Phillips, Jr., 39....... Mr. Phillips was elected Vice President, Vice President, Channelview Operations on May 6, 1993. From Channelview Operations May 22, 1992 until May 6, 1993, he served as Site Manager of Channelview Operations. He previously served as Manager, Planning from August, 1991 until May, 1992. Prior to August, 1991, he served in various positions in manufacturing and marketing for ARCO and Lyondell, including Sales Manager in the Petroleum Products Marketing Department from September, 1987 until August, 1991. He originally joined ARCO in 1977. Joseph M. Putz, 53................ Mr. Putz was elected Vice President and Vice President Controller on October 24, 1988. Previously and Controller he was Vice President, Control and Administration of Lyondell, and its predecessor, the Lyondell Division, from June, 1987 to October, 1988. From 1986 to 1987 he served as Director, Internal Control of ARCO. From 1985 to 1986 he served as Manager of Special Projects for ARCO. Prior to 1985, he held various financial positions with divisions of ARCO. He originally joined ARCO in 1965. Dan F. Smith, 47.................. Mr. Smith was elected a Director of the Executive Vice President and Company on October 24, 1988. He was elected Chief Operating Officer Executive Vice President and Chief Operating Officer on May 6, 1993. He served as Vice President Corporate Planning of ARCO from October, 1991 until May, 1993. He previously served as Executive Vice President and Chief Financial Officer of the Company from October, 1988 to October, 1991 and as Senior Vice President of Manufacturing of Lyondell, and its predecessor, the Lyondell Division, from June, 1986 to October 1988. From August, 1985 to June, 1986, Mr. Smith served as Vice President of Manufacturing for the Lyondell Division. He joined the Lyondell division in April, 1985 as Vice President, Control and Administration. Prior to 1985, he served in various financial, planning and manufacturing positions with ARCO. He originally joined ARCO in 1968. Name, Age and Present Business Experience During Past Position with Lyondell Five Years and Period Served as Officer(s) ---------------------- ------------------------------------------ Debra L. Starnes, 41.............. Ms. Starnes was appointed Vice President, Vice President, Petrochemicals Business Management and Petrochemicals Business Management Marketing on July 1, 1993. She previously and Marketing served as Vice President, Petrochemicals Business Management from May 22, 1992 to July, 1993. She served as Vice President, Corporate Planning from September, 1991 until May, 1992. From January, 1989 to September, 1991, she served as Director, Planning. Prior to 1989, she held various manufacturing, marketing and planning positions with ARCO and Lyondell. She originally joined ARCO in 1975. Russell S. Young, 45.............. Mr. Young was elected Senior Vice President, Senior Vice President, Chief Financial Officer and Treasurer on Chief Financial Officer May 7, 1992. He previously served as Vice and Treasurer President and Treasurer from November, 1988 until May, 1992. Mr. Young served as Controller of the ARCO Products Division from September, 1986 to January, 1989. From July, 1984 to September, 1986 he served as Assistant Treasurer of ARCO. Prior thereto he served in corporate finance positions for ARCO. He originally joined ARCO in 1980. (a) The By-Laws of the Company provide that each officer shall hold office until the officer's successor is elected or appointed and qualified or until the officer's death, resignation or removal by the Board of Directors. DESCRIPTION OF CAPITAL STOCK The authorized capital stock of the Company currently consists of 250,000,000 shares of common stock, par value $1 per share. The following summary description of the capital stock of the Company is qualified in its entirety by reference to the Certificate of Incorporation and By-Laws of the Company, copies of which are filed as exhibits to the Company's Registration Statement on Form S-1 (No. 33-25407) and incorporated herein by reference. Common Stock The Company is currently authorized to issue 250,000,000 shares of common stock, of which 80,000,000 shares of common stock are outstanding at the date hereof. Holders of common stock (Stockholders) are entitled (i) to receive such dividends as may from time to time be declared by the Board of Directors of the Company; (ii) to one vote per share on all matters on which the Stockholders are entitled to vote; (iii) to act by written consent in lieu of voting at a meeting of stockholders; and (iv) to share ratably in all assets of the Company available for distribution to the Stockholders, in the event of liquidation, dissolution or winding up of the Company. For additional information regarding the Company's dividend policy, see Item 5	Item 5. Market for Registrant's Common Equity and Related Stockholder Matters The common stock is listed on the New York Stock Exchange. ARCO has advised the Company that, as of March 1, 1994, ARCO owned 39,921,400 shares of the common stock, which represented 49.9 percent of the outstanding shares. The reported high and low sale prices of the common stock on the New York Stock Exchange (New York Stock Exchange Composite Tape) for each quarter from January 1, 1992 through December 31, 1993, inclusive, were: On March 1, 1994 the closing price of the common stock was $22-3/4 and there were 2,976 record holders of the common stock. On January 21, 1994 the Board of Directors declared a quarterly dividend in the amount of $0.225 per share payable on March 15, 1994 to stockholders of record on February 18, 1994. During the last two years, Lyondell has declared per share quarterly cash dividends (which were paid in the subsequent quarter) as follows: * On July 23, 1993, the Board of Directors decreased the amount of the regular quarterly dividend from $0.45 to $0.225 per share. The declaration and payment of dividends is at the discretion of the Board of Directors of the Company. The future declaration and payment of dividends and the amount thereof will be dependent upon the Company's results of operations, financial condition, cash position and requirements, investment opportunities, future prospects and other factors deemed relevant by the Board of Directors. Subject to these considerations and to the legal considerations discussed in the following paragraph, the Company currently intends to distribute to its stockholders cash dividends on its common stock at a quarterly rate of $0.225 per share. In order to declare and pay dividends in the future, the Company's Board of Directors will have to make the determination that for purposes of the General Corporation Law of the State of Delaware (Delaware Law) there is a sufficient amount of surplus (the amount by which its assets exceed its liabilities and capital) at that time or sufficient net profits. In determining the amount of surplus of the Company for purposes of Delaware Law, the Company's assets, including the stock of any of its subsidiaries, may be valued by the Board of Directors at their current market value. If prior to or as a result of any future dividend the Company had a negative stockholders' equity, the Company's Board of Directors would have to make the determination that, based upon its familiarity with the Company's business, prospects and financial condition, the Company's recent earnings history and forecast, an appraisal of the Company's assets and discussions with the Company's executive officers, legal department and accountants, the dividend was a permitted dividend under Delaware Law. As detailed on page 12 herein, certain of the Company's debt instruments contain provisions that generally provide that the holders of such debt may, under certain limited circumstances, require the Company to repurchase the debt (Put Rights). In addition to the occurrences described on page 12 herein, the Put Rights may be triggered by the making of certain unearned distributions to stockholders, other than regular dividends, that are followed by a specified decline in public ratings on such debt. Regular dividends are those quarterly cash dividends determined in good faith by the Company's Board of Directors (whose determination is conclusive) to be appropriate in light of the Company's results of operations and capable of being sustained. The determinations described in the paragraphs above were made prior to the declaration of $0.225 per share dividend to be made on March 15, 1994. The Company's $400 million Facility also could limit the Company's ability to pay dividends under certain circumstances. See "Items 1 and 2 -- Finance Matters". During 1993, the Company paid $108 million in dividends. Total dividends paid during the year exceeded cumulative earnings and profits, as computed for federal income tax purposes. Subject to final determination by the Internal Revenue Service, 100 percent of each of the 1993 quarterly dividend payments was considered a return of capital. The operation of certain of the Company's employee benefit plans may result in the issuance of common stock upon the exercise of options granted to employees of the Company, including its officers. Although the terms of these plans provide that additional shares may be issued to satisfy the Company's obligations under the options, the Company from time to time may cause common stock to be repurchased in the market in order to satisfy these obligations. Item 6.	Item 6. Selected Financial Data The following table sets forth selected financial information for the Company: (1) The 1993 increase in net income from the cumulative effect of the accounting change for turnarounds was $22 million, or $0.27 per share. See Note 4 to Notes to Consolidated Financial Statements. The 1992 reduction in net income from the cumulative effect of the accounting change for postretirement benefits other than pensions was $18 million, or $.22 per share. See Notes 4 and 16 of Notes to Consolidated Financial Statements. The 1992 increase in net income from the cumulative effect of the accounting change for income taxes was $8 million, or $.10 per share. See Notes 4 and 17 of Notes to Consolidated Financial Statements. (2) Distributions to ARCO were made prior to the initial public offering of the Company's common stock on January 25, 1989. Item 7.	Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations General As discussed in Note 3 of Notes to Consolidated Financial Statements, on July 1, 1993, the Company and CITGO Petroleum Corporation (CITGO) announced the commencement of operations of LYONDELL-CITGO Refining Company Ltd. (LCR), a new entity owned by subsidiaries of the Company and CITGO. LCR owns and operates the refining business, formerly owned by the Company, including the full- conversion refinery (Refinery). LCR is undertaking a major upgrade project at the Refinery to enable the facility to process substantial additional volumes of very heavy crude oil. CITGO will provide a major portion of the funds for the upgrade project as well as the funding of certain capital projects. On July 1, 1993, LCR entered into a long-term crude oil supply contract (Crude Supply Contract) with LAGOVEN, S.A., an affiliate of CITGO. In addition, under terms of a long-term product sales agreement (Products Agreement), CITGO will purchase a substantial portion of the refined products produced at the Refinery. Both LAGOVEN and CITGO are subsidiaries of Petroleos de Venezuela, S.A., the national oil company of Venezuela. The Company believes that the principal benefit from its participation in LCR will be stabilized earnings and cash flow from the refining business. During 1993, the Refinery increased the volumes of heavy Venezuelan crude oil processed and it is anticipated that the Refinery will continue to achieve increased benefits from processing heavy Venezuelan crude oil as it achieves improved operating efficiency. Prior to July 1, 1993, the petrochemical and refining operations of the Company were considered to be a single segment due to the integrated nature of their operations. However, these operations are now considered to be separate segments due to the formation of LCR and the related separate management and operations of that entity. See Note 19 - Segment Information, of Notes to Consolidated Financial Statements. The Petrochemical segment consists of olefins, including ethylene, propylene, butadiene, butylenes and specialty products; polyolefins, including polypropylene and low density polyethylene; aromatics produced at the Channelview Petrochemical Complex, including benzene and toluene; methanol and refinery blending stocks. The Refining segment consists of refined petroleum products, including gasoline, heating oil and jet fuel; aromatics produced at the Refinery, including benzene, toluene, paraxylene and orthoxylene; lubricants; olefins feedstocks and crude oil resales. The following table sets forth sales volumes for the Company's major products, excluding intersegment sales volumes, for the periods indicated. Sales volumes include production, purchases of products for resale, propylene production from the product flexibility unit and draws from inventory. The following table sets forth the Company's sales and other revenues, excluding intersegment sales, for the periods indicated: (*) Crude oil resales consist of revenues from the resale of previously purchased crude oil and from locational exchanges of crude oil that are settled on a cash basis. Crude oil exchanges and resales facilitate the operation of the Company's petroleum processing business by allowing the Company to optimize the crude oil feedstock mix in response to market conditions and refinery maintenance turnarounds and also to reduce transportation costs. RESULTS OF OPERATIONS Overview Net income for 1993 was $26 million or $.33 per share compared with $16 million or $.20 per share in 1992 and $222 million or $2.78 per share in 1991. Earnings for 1993 included a net $13 million after-tax benefit associated with a change in accounting for major maintenance turnarounds consisting of a $22 million favorable adjustment for the cumulative effect related to prior periods, partially offset by a $9 million charge to current operations. Earnings for 1992 reflect a net after-tax charge of $10 million for the cumulative effect related to prior periods of adopting Financial Accounting Standards Board mandated accounting standards for postretirement benefits and income taxes. Excluding the effect of these accounting changes, the earnings decline was primarily due to lower ethylene sales volumes and lower polyolefins margins, partially offset by higher refined products margins. The decrease in 1992 versus 1991 resulted primarily from lower refining and ethylene margins as well as higher maintenance expenses for scheduled and unscheduled downtime at the Refinery. The 1993 results included after-tax charges of $11 million consisting of the cancellation of a capital project, an increase in the environmental reserve and a workforce reduction and realignment and an additional charge of $3 million for an adjustment to deferred income taxes associated with an increase in the federal income tax rate. These charges were partially offset by a benefit of $7 million due to a contract adjustment and LIFO inventory profits. Net income in 1992 included a benefit of $3 million due to an insurance recovery. This compares to a benefit of $25 million in 1991 primarily associated with insurance and litigation settlements and LIFO inventory profits. Refining Segment Revenues Sales and other operating revenues, including intersegment sales, were $2.8 billion in 1993 compared to $3.7 billion in 1992 and $4.5 billion in 1991. The 1993 decrease of $973 million compared to 1992 was due to lower crude oil resale volumes, lower sales prices for refined products and lower resale volumes of purchased light products. Crude oil resale volumes were lower due to reduced logistical purchases required to meet refinery feedstock requirements which were impacted by higher Venezuelan crude oil volumes purchased under the Crude Supply Contract. Refined products sales prices were lower as additional industry supply exceeded demand growth due to additions of oxygenates, primarily MTBE, to meet stricter environmental standards, as well as new industry conversion capacity. The purchase and resale activity for light refined products conducted for logistic and other reasons was curtailed during the current period because, effective with the beginning of LCR operations on July 1, 1993, a majority of the refined products produced at the Refinery are now sold to CITGO under the Products Agreement. The 1992 decrease in sales and other operating revenues of $790 million versus 1991 was primarily due to lower crude oil resales and to lower sales prices and volumes for refined products. The price premium that existed for refined products during 1991 that was caused by the 1990-1991 Gulf War dissipated in 1992 resulting in lower prices. Refined products sales volumes were lower primarily due to lower production resulting from scheduled and unscheduled downtime of major units. Cost of Sales Cost of sales was $2.6 billion in 1993, compared to $3.6 billion in 1992 and $4.2 billion in 1991. The 1993 decrease compared to 1992 of $1,010 million was principally due to lower quantities of crude oil purchased, lower light refined products purchased and lower crude oil prices. Crude oil purchases were lower due to the reduced logistical purchases. Purchases of light refined products were lower primarily due to lower purchases for resale activity. Lower crude oil prices were due to generally lower industry-wide crude oil prices and to the processing of higher volumes of lower priced, heavy Venezuelan crude oil purchased under the Crude Supply Contract. The 1992 decrease compared to 1991 of $605 million was principally due to lower crude oil purchases that were resold and to lower refining feedstock costs. Refining feedstock costs were lower primarily due to lower production resulting from the scheduled and unscheduled downtime and a reduction in crude oil runs due to unfavorable margins. Partially offsetting this decrease were higher maintenance expenses related to the scheduled and unscheduled downtime. Cost of sales was reduced in 1991 by $8 million relating to LIFO inventory profits. Selling, General and Administrative Expenses Selling, general and administrative expenses were $48 million in 1993, compared to $43 million in 1992 and $42 million in 1991. The increase in 1993 compared to 1992 of $5 million resulted primarily from higher personnel and realignment expenses associated with ongoing operations of LCR starting on July 1, 1993. Operating Income Operating income amounted to $81 million in 1993, compared to $49 million in 1992 and $235 million in 1991. The $32 million increase in 1993 compared to 1992 was primarily due to improved refined products margins, partially offset by higher selling, general and administrative expenses. Refined products margins were higher due to processing higher volumes of heavy, low cost Venezuelan crude oil purchased under the Crude Supply Contract. The decrease in operating income of $186 million in 1992 compared to 1991 resulted primarily from lower refined products margins and to higher maintenance expenses. Refined products margins were lower primarily because decreasing product prices more than offset reductions in crude oil costs. Product prices were lower due to the dissipation during 1992 of the Gulf War related price premium created in 1990 and 1991. Higher maintenance expenses and the reduced ability to process higher margin heavy crude oils which resulted from the scheduled and unscheduled downtime of major units during 1992 contributed to lower operating profits. Also contributing to the decrease in operating income during 1992 compared to 1991 was a net reduction in benefits of $11 million from insurance settlements and lower LIFO inventory profits of $8 million. Petrochemical Segment Revenues Sales and other operating revenues, including intersegment sales, were $1.5 billion in 1993 compared to $1.7 billion in 1992 and $2.0 billion in 1991. The 1993 decrease of $169 million compared to 1992 was primarily due to lower olefins and polyolefins sales volumes and prices caused by continued weak demand associated with poor worldwide industry conditions and higher industry production due to reduced maintenance downtime during 1993. The 1992 decrease in sales and other operating revenues of $284 million versus 1991 was primarily due to lower sales prices for olefins and methanol. Olefins sales prices were negatively affected by the continued weak worldwide economy and by additional industry production capability due to capacity additions. Cost of Sales Cost of sales was $1.4 billion in 1993 compared to $1.5 billion in 1992 and $1.7 billion in 1991. The 1993 decrease of $124 million compared to 1992 and the 1992 decrease of $175 million compared to 1991 were principally due to lower olefins feedstock costs due to the curtailment of production resulting from the poor economic conditions and to a lesser extent to lower feedstock prices. Cost of sales was reduced in 1993 and 1992 by $5 million and $2 million, respectively, and was increased $2 million in 1991 relating to LIFO inventory adjustments. Operating Income Operating income amounted to $57 million in 1993 compared to $102 million in 1992 and $213 million in 1991. The decrease of $45 million in operating income in 1993 compared to 1992 was primarily due to lower ethylene sales volumes and lower polyolefins margins. Ethylene sales volumes and polyolefins margins were lower primarily due to poor industry and economic conditions. The decrease of $111 million in operating income in 1992 compared to 1991 was primarily due to lower ethylene and methanol margins. Ethylene margins were negatively affected by the continued weak worldwide economy and by industry capacity additions. Methanol sales prices were lower due to the dissipation during 1992 of the Gulf War related price premium created during 1990 and 1991. Contributing to the decrease in operating income was the absence of a $12 million one-time gain recorded in 1991 for proceeds received from an out-of- period settlement of litigation. Unallocated and Headquarters Selling, General and Administrative General and administrative expenses were $45 million in 1993, $47 million in 1992 and $49 million in 1991. The reduction of $2 million in general and administrative expenses in 1993 compared to 1992 and in 1992 compared to 1991 primarily resulted from lower personnel related costs. Interest Expense and Interest Income Interest expense was $74 million in 1993 compared to $79 million in 1992 and $74 million in 1991. The $5 million reduction in interest expense in 1993 compared to 1992 was primarily caused by a reduction of outstanding debt due to the prepayment of amounts due under capitalized leases during April, 1992. The $5 million increase in 1992 compared to 1991 resulted from higher average debt outstanding in 1992 which more than offset lower interest rates. Interest income was $2 million in 1993 compared to $10 million in 1992 and $14 million in 1991. The $8 million decrease in 1993 versus 1992 was primarily due to lower amounts of cash available for investment. The $4 million decrease in 1992 versus 1991 was primarily due to lower interest rates and to a lesser extent to lower amounts of cash available for investment. Minority Interest in LYONDELL-CITGO Refining Company Ltd. Minority interest was $5 million in 1993 representing CITGO's allocation of LCR's income. Income Tax The effective income tax rate during 1993 from continuing operations was 73.1 percent compared to 27.3 percent for 1992 and 34.6 percent for 1991. The difference for 1993, between the effective tax rate and the federal statutory rate was primarily due to a charge to state deferred taxes related to Texas franchise taxes and the unfavorable impact on federal deferred taxes of the increase in the federal tax rate. The difference for 1992 was primarily due to a state income tax adjustment, tax exempt income related to company owned life insurance and tax exempt interest. FINANCIAL CONDITION Investing Activities Cash flows associated with investing activities during 1993 included capital expenditures of $60 million, excluding $9 million related to the Refinery upgrade project, of which $38 million was for environmentally related projects at the Refinery and the Channelview Complex. During 1992, capital expenditures were $97 million, of which $57 million was for environmentally related projects. The 1994 capital expenditures budget, excluding the Refinery upgrade project, has been set at $90 million. The budget provides $60 million for refinery projects, $26 million of which are to be funded by Lyondell according to the terms of the agreement with LCR and $34 million to be funded from the restricted cash balance which was created by CITGO's 1993 contributions to LCR. The remaining $30 million is for petrochemical projects at the Channelview Complex. In addition to the capital expenditures budget, $150 million of spending, funded by CITGO, is planned for the Refinery upgrade project designed to increase the Refinery's ability to process larger volumes of very heavy Venezuelan crude oil. As of December 31, 1993, $73 million of cash and $6 million of short-term investments were restricted for use in LCR capital projects, including the Refinery upgrade project and other expenditures as determined by the LCR owners. Financing Activities Cash flows associated with financing activities during 1993 included $108 million of dividend payments, $29 million for scheduled repayments of Medium-Term Notes and $4 million of net proceeds from short-term debt. In December 1993, the Company completed a five-year, $400 million revolving credit facility with a group of banks, representing an increase in amount and term compared to the Company's previous $300 million bank credit facility, which was scheduled to terminate in July, 1994. Borrowings under the new credit facility bear interest based on Euro-Dollar, CD or Prime rates, at the Company's option. The facility is available for working capital and general corporate purposes as needed. This credit facility contains covenants relating to dividend payments, debt incurrence, liens, disposition of assets, mergers and consolidations, fixed charge and leverage ratios and certain payments to LCR. At December 31, 1993, no amounts were outstanding under this credit facility. See Note 11 of Notes to Consolidated Financial Statements. Effective July 1, 1993, LCR entered into a 364 day unsecured $100 million revolving credit facility with a group of banks. Under terms of the credit facility, LCR may borrow with interest based on prime, LIBOR or CD rates at LCR's option or have letters of credit issued on its behalf. The facility is available for working capital and general corporate purposes as needed. At December 31, 1993, no amounts were outstanding under this credit facility. See Note 11 of Notes to Consolidated Financial Statements. On January 21, 1994, the Board of Directors declared a quarterly dividend in the amount of $.225 per share of common stock, payable March 15, 1994 to stockholders of record on February 18, 1994. During 1993, all of the $108 million of dividend payments exceeded cumulative earnings and profits in 1993, as computed for federal income tax purposes subject to final determination by the Internal Revenue Service, and will be considered a return of capital to all stockholders. See Note 13 of Notes to Consolidated Financial Statements. Environmental Matters Various environmental laws and regulations impose substantial requirements upon the operations of the Company. The Company's policy is to be in compliance with such laws and regulations, which include, among others, the Comprehensive Environmental Response, Compensation and Liability Act of 1980 (CERCLA), as amended, the Resource Conservation and Recovery Act (RCRA) and the Clean Air Act and Clean Air Act Amendments of 1990. ARCO, along with many other companies, has been named a potentially responsible party (PRP) under CERCLA in connection with the past disposal of waste at third party waste sites. The Company may have an obligation to reimburse ARCO for a portion of the remediation costs for two of those sites pursuant to the Cross-Indemnity Agreement. The Company reserves for contingencies, including those based upon unasserted claims, that are probable and reasonably estimable. In connection with environmental matters, the Company established reserves based upon known facts and circumstances. Based on current environmental laws and regulations, the Company believes that it has adequately reserved for the matters described above and, based upon such reserves, does not anticipate any material adverse effect upon its earnings, operations or competitive position, although the resolution in any reporting period of one or more of these matters could have a material impact on the Company's results of operations for that period. The environmental reserve on December 31, 1993 was $24 million. The environmental reserve includes $0.5 million of estimated advances to ARCO for remediation costs associated with CERCLA waste disposal sites and $23.5 million of estimated remediation costs related to waste disposal sites located within the Company's facilities associated with RCRA. The Company spent $627,000, $593,000 and $1 million in 1993, 1992 and 1991, respectively, relating to CERCLA matters. The Company also spent $2 million, $158,000 and $224,000 in 1993, 1992 and 1991, respectively, in conjunction with RCRA matters. The Company estimates it will incur approximately $7 million of costs in conjunction with CERCLA and RCRA matters in 1994 which is included in the December 31, 1993 environmental reserve. Current Business Outlook The year 1993 was difficult for the petrochemical and refining industries which are sensitive to economic cycles. Downward pressure on petrochemical sales prices continued during 1993 due to significant increases in manufacturing capacity, which has occurred since early 1991, coupled with weak worldwide demand growth. Profitability and cash flows for the petrochemical and refining businesses are affected by market conditions, feedstock cost volatility, capital expenditures required to meet increasing environmental standards, repair and maintenance costs, and downtime of production units due to turnarounds. Turnarounds on major units can have significant financial impacts due to the repair and maintenance costs incurred as well as loss of production, ultimately resulting in lower profitability. Turnarounds on certain of the Company's major production units are scheduled for 1994; however, the timing of such turnarounds can be accelerated or delayed because of numerous factors, many of which are beyond the Company's control. In view of the above factors, the Company, during 1993, took actions to improve near-term earnings and cash flows and to position the Company for better results as the business environment improves. Those actions included the completion of the refining venture with CITGO, a significant reduction in capital expenditures from the budgeted amount, implementation of a cost reduction program which the Company expects will reduce overhead costs by approximately $30 to $50 million on an annual basis and the reduction of regular quarterly dividends from $.45 per share to $.225 per share beginning with the dividend paid in the third quarter of 1993. The Company's Board of Directors' decision to reduce the dividend reflects the Company's belief that payment of quarterly dividends at the previous level was no longer appropriate in light of current business conditions. The actions taken to conserve cash, including the dividend reduction, were consistent with the Company's objective of maximizing total return to stockholders. The Company believes that its ability to maintain suitable debt ratings, to fund a capital program appropriate to its asset base and to position the Company to benefit from an upturn in the business cycle are critical factors in maintaining and increasing future stockholder value. Progress was made during 1993 in achieving the cost reduction targets, which are reflected primarily within the operating incomes of the Refining and Petrochemical segments. Continued efforts are planned during 1994 to fully achieve these savings. Although future industry conditions cannot be known with certainty, the Company believes that the business climate necessary for improved profitability within its petrochemical segment has begun to stabilize. U.S. ethylene demand grew approximately three percent during 1993 and was particularly strong in the fourth quarter. The rapid increase in world capacity in recent years, which caused a contraction of U.S. exports, has slowed. Domestically, new capacity over the next two years is expected to be relatively in balance with demand growth and there are no additional capacity expansions currently announced for the U. S. after 1995. The Company significantly improved the performance and outlook for its refining business in 1993 with the completion of the refining venture with CITGO. This agreement has stabilized refining margins and improved cash flows. The refining segment began to see the economic benefits from the venture in 1993 and results should further improve through increased utilization of heavy Venezuelan crude oil and recent efficiency improvements. Although the future economic environment cannot be known with certainty, the Company believes that the cash flow management, cost reduction and other steps recently taken have positioned it to capitalize on the anticipated improvement in the business environment. Further, the Company believes that business conditions will be such that cash balances, cash generated from operating activities and existing lines of credit will be adequate to meet future cash requirements for scheduled debt repayments, necessary capital expenditures and to sustain for the reasonably foreseeable future the revised regular quarterly dividend. However, the Company continually evaluates its cash requirements and allocates cash in order to maximize stockholder returns. --------------------- Management cautions against projecting any future results based on present or prior earnings levels because of the cyclical nature of the refining and petrochemical industries and uncertainties associated with the United States and worldwide economies and United States governmental regulatory actions. Item 8.	Item 8. Financial Statements and Supplementary Data Index to Consolidated Financial Statements and Financial Statement Schedules Financial statement schedules other than those listed above have been omitted because they are either not applicable or the required information is shown in the financial statements or related notes. REPORT OF INDEPENDENT ACCOUNTANTS To the Stockholders and Board of Directors of Lyondell Petrochemical Company We have audited the accompanying consolidated balance sheet of Lyondell Petrochemical Company as of December 31, 1993 and 1992, and the related consolidated statements of income and accumulated deficit and cash flows for each of the three years in the period ended December 31, 1993, and the related financial statement schedules. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Lyondell Petrochemical Company as of December 31, 1993 and 1992, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. As discussed in Note 4 to the consolidated financial statements, during 1993 the Company changed its method of accounting for the cost of repairs and maintenance incurred in connection with turnarounds of major units at its manufacturing facilities, and in 1992, the Company changed its method of accounting for income taxes and for postretirement benefits other than pensions. COOPERS & LYBRAND Houston, Texas February 11, 1994 LYONDELL PETROCHEMICAL COMPANY CONSOLIDATED STATEMENT OF INCOME AND ACCUMULATED DEFICIT See notes to consolidated financial statements. LYONDELL PETROCHEMICAL COMPANY CONSOLIDATED BALANCE SHEET See notes to consolidated financial statements. LYONDELL PETROCHEMICAL COMPANY CONSOLIDATED STATEMENT OF CASH FLOWS See notes to consolidated financial statements. LYONDELL PETROCHEMICAL COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Formation of the Company and Operations In 1985, Atlantic Richfield Company (ARCO) established the Lyondell Petrochemical Company as a division of ARCO (Lyondell Division). Lyondell Petrochemical Corporation, a wholly-owned subsidiary of ARCO, was incorporated in the state of Delaware in 1985 and subsequently changed its name to Lyondell Petrochemical Company (Company). Effective July 1, 1988, ARCO transferred substantially all the assets and liabilities relating to the integrated petrochemical and petroleum processing business of the Lyondell Division to the Company. In addition, certain pipeline assets were transferred to the Company. For financial reporting purposes, the transfer of these assets and liabilities was recorded at the historical net book value of $127 million as of July 1, 1988. On January 25, 1989, ARCO completed an initial public offering of 43,000,000 shares of the Company's 80,000,000 shares of common stock owned by ARCO. The Company received none of the proceeds from the sale. As of December 31, 1993, ARCO owned 39,921,400 shares, which represents 49.9 percent of the outstanding common stock. The Company and LYONDELL-CITGO Refining Company Ltd. (LCR) operate in two business segments: petrochemicals and refining. The Company generally sells its petrochemical products to customers for use primarily in the manufacture of other chemicals and products, which in turn are used in the production of a wide variety of consumer and end-use products. LCR sells its principal refined products primarily to CITGO Petroleum Corporation (CITGO) and to a lesser extent, other marketers of petroleum products. See Note 3. 2. Summary of Significant Accounting Policies Basis of Presentation - The consolidated financial statements include the accounts of the Company and its subsidiaries. All significant transactions between the entities of the Company have been eliminated from the consolidated financial statements. Certain amounts from prior years have been reclassified to conform to current year presentation. Cash, Cash Equivalents and Short-Term Investments - Cash equivalents consist of highly liquid debt instruments such as certificates of deposit, commercial paper and money market accounts purchased with an original maturity date of three months or less. Short-term investments consist of similar investments maturing in more than three months from purchase. The Company's policy is to invest cash in conservative, highly rated instruments and limit the amount of credit exposure to any one institution. The Company performs periodic evaluations of the relative credit standing of these financial institutions which are considered in the Company's investment strategy. Cash equivalents and short- term investments are stated at cost which approximates market value because of the short maturity of these instruments. The Company has no requirements for compensating balances in a specific amount at a specific point in time. The Company does maintain compensating balances for some of its banking services and products. Such balances are maintained on an average basis and are solely at the Company's discretion, so that effectively on any given date, none of the Company's cash is restricted with the exception of cash held for use in connection with LCR capital projects and other expenditures as determined by the LCR owners (see Note 3). LYONDELL PETROCHEMICAL COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) 2. Summary of Significant Accounting Policies - (continued) Accounts Receivable - The Company sells its products primarily to companies in the petrochemical and refining industries. The Company performs ongoing credit evaluations of its customers' financial condition and in certain circumstances requires letters of credit from them. The Company's allowance for doubtful accounts receivable, which is reflected in the consolidated balance sheet as a reduction in accounts receivable, totaled $2 million at December 31, 1993 and 1992. Inventories - Inventories are stated at the lower of cost or market. Cost is determined on the last-in, first-out (LIFO) basis except for materials and supplies, which are valued at average cost. Fixed Assets - Fixed assets are recorded at cost. Depreciation of fixed assets is computed using the straight-line method over the estimated useful lives of the related assets as follows: Manufacturing facilities and equipment - 5 to 30 years Leased assets and improvements - 5 to 20 years Upon retirement or sale, the Company removes the cost of the assets and the related accumulated depreciation from the accounts and reflects any resulting gains or losses in income. Environmental Remediation Costs - Expenditures related to investigation and remediation of contaminated sites which include operating facilities and waste disposal sites, are accrued when it is probable that a liability has been incurred and the amount of that liability can reasonably be estimated. These costs are expensed or capitalized in accordance with generally accepted accounting principles. Futures Contracts - The Company executes futures contracts primarily to hedge fluctuations in product prices and feedstock costs. Changes in the market value of hedging contracts are reported as an adjustment to cost of sales upon completion of the hedged transaction. Exchanges - Crude oil and finished product exchange transactions, which are of a homogeneous nature of commodities in the same line of business, that do not involve the payment or receipt of cash, are not accounted for as purchases and sales. Any resulting volumetric exchange balances are accounted for as inventory in accordance with the normal LIFO valuation policy. Exchanges that are settled through payment and receipt of cash are accounted for as purchases and sales. Income Taxes - Deferred taxes result from temporary differences in the recognition of revenues and expenses for tax and financial reporting purposes and are calculated, effective in 1992 with the adoption of Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes", based upon cumulative book/tax differences in the balance sheet. 3. Formation of LYONDELL-CITGO Refining Company Ltd. On July 1, 1993, the Company and CITGO announced the commencement of operations of LCR, a new entity formed and owned by the Company and CITGO in order to own and operate the Company's refining business, including the full-conversion Houston refinery (Refinery). LCR is undertaking a major upgrade project at the Refinery to enable the facility to process substantial additional volumes of very heavy crude oil. LCR is a limited liability company organized under the laws of the state of Texas. The Company owns its interest in LCR through a wholly-owned subsidiary, Lyondell Refining Company. CITGO holds its interest through CITGO Refining Investment Company, a wholly-owned subsidiary of CITGO. CITGO has committed to reinvest its share of operating cash flow during the upgrade project, while the Company has unrestricted access to its share of operating cash flow from LCR. LYONDELL PETROCHEMICAL COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) 3. Formation of LYONDELL-CITGO Refining Company Ltd. - (continued) Under the terms of the transaction, CITGO will provide a major portion of the funds for the upgrade project, as well as certain funds for general refinery capital projects. Project engineering for the upgrade is currently underway and at the present time, LCR management anticipates the cost over the next three to four years to be approximately $800 million. Funding for the upgrade project will occur in three phases. The first phase, the initial $300 million, will be funded by CITGO. The second phase will be funded by an LCR borrowing of $200 million. The third phase, which is expected to occur toward the end of the upgrade project, will be a combination of LCR borrowing and contributions from CITGO and the Company. Prior to completion of the upgrade project, the financing costs for the upgrade project loans will be funded by CITGO. The timing of the third phase and the level of contributions from the Company and CITGO will be dependent upon the total cost of the upgrade project. It is currently anticipated that the Company will contribute, in the form of a subordinated loan, 25 percent of the cost of the upgrade project in excess of $500 million ($75 million if the cost of the upgrade project equals $800 million). On July 1, 1993, the Company contributed its refining assets (including the lube oil blending and packaging plant in Birmingport, Alabama) and refining working capital to LCR and retained an approximate 95 percent interest in LCR. CITGO contributed $50 million for future capital projects of LCR and in exchange received an approximate five percent interest in LCR. CITGO also made an additional $50 million contribution for future capital projects of LCR on December 31, 1993. At December 31, 1993, CITGO had an approximate 10 percent interest in LCR. In addition to the funding related to the upgrade project described in the prior paragraph, CITGO has one additional contribution commitment of $30 million to be made upon completion of the upgrade project and it has an option to make an additional equity contribution sufficient to increase its interest to 50 percent. On July 1, 1993, LCR entered into a long-term crude oil supply agreement with LAGOVEN, S.A., an affiliate of CITGO. In addition, under the terms of a long- term product sales agreement, CITGO will purchase a majority of the refined products produced at the Refinery. Both LAGOVEN and CITGO are subsidiaries of Petroleos de Venezuela, S.A., the national oil company of Venezuela. Also effective July 1, 1993, the parties entered into multiple agreements for feedstock and product sales between LCR and the Company. These agreements generally are aimed at preserving much of the synergy that previously existed between the Company's refining and petrochemical businesses. LCR and the Company also have entered into a tolling agreement, pursuant to which alkylate and MTBE will be produced at the Channelview Complex for LCR, and various administrative services agreements. With respect to liabilities associated with LCR, the Company generally has retained liability for events that occurred prior to July 1, 1993 and certain on-going environmental projects at the Refinery. LCR generally is responsible for liabilities associated with events occurring after June 30, 1993 and on- going environmental compliance inherent to the operation of the Refinery. At December 31, 1993, $73 million of cash and $6 million of short-term investments were restricted for use in connection with LCR capital projects, including the Refinery upgrade project and other expenditures as determined by the LCR owners. LYONDELL PETROCHEMICAL COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) 4. Accounting Changes In the first quarter of 1993, effective January 1, 1993, the Company changed its method of accounting for the cost of repairs and maintenance incurred in connection with turnarounds of major units at its manufacturing facilities. Under the new method, turnaround costs exceeding $5 million are deferred and amortized on a straight-line basis until the next planned turnaround, generally four to six years. In prior years, all turnaround costs were expensed as incurred. The Company believes that the new method of accounting is preferable in that it provides for a better matching of turnaround costs with future product revenues. The cumulative effect of this accounting change for years prior to 1993 resulted in a benefit of $33 million ($22 million or $.27 per share after income taxes), and was included in first quarter income. The change resulted in $9 million after-tax (or $.11 per share) of additional amortization expenses during the year ended December 31, 1993. In the fourth quarter of 1992, the Company adopted, effective January 1, 1992, the provisions of SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", requiring the accrual of postretirement benefits. The applicable postretirement benefits include medical and life benefit plans. In prior years, expenses for these plans were recognized on a pay-as-you-go basis. The change resulted in a decrease of 1992 net income before cumulative effect of accounting changes of approximately $3 million (or $.04 per share). The unfavorable effect of this accounting change through December 31, 1991 amounted to $28 million before taxes or $18 million (or $.22 per share) net of tax and was charged against 1992 income. In the fourth quarter of 1992, the Company adopted, effective January 1, 1992, the provisions of SFAS No. 109, "Accounting for Income Taxes". The Statement requires, among other things, a change from the deferred to the liability method of computing deferred income taxes. The favorable cumulative effect of this accounting change on years prior to 1992 was an $8 million (or $.10 per share) reduction in the Company's deferred tax liability and was included in 1992 income. The favorable effect of the change on 1992 net income, excluding the cumulative effect upon adoption, was $2 million (or $.02 per share). Effective January 1, 1992, the Company adopted SFAS No. 112, "Employers' Accounting for Postemployment Benefits". The standard requires companies to accrue the cost of postemployment (prior to retirement) benefits either during the years that the employee renders the necessary service or at the date of the event giving rise to the benefit, depending upon whether certain conditions are met. The effect of adoption did not have a material impact on 1992 net income. 5. Related Party Transactions Related party transactions with ARCO are summarized as follows: In addition, sales to an affiliate, ARCO Chemical Company, consisting of benzene, ethylene, propylene, butylene, methanol and other products and services, were $263 million, $296 million and $355 million for the years ended December 31, 1993, 1992 and 1991, respectively. LYONDELL PETROCHEMICAL COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) 6. Supplemental Cash Flow Information Supplemental cash flow information is summarized as follows: As of December 31, 1993, fixed assets included $16 million of non-cash additions of which $14 million related to accounts payable accruals. 7. Inventories The categories of inventory and their book values at December 31, 1993 and 1992, were as follows: For the years ended December 31, 1993, 1992 and 1991, the Company reduced cost of sales by approximately $6 million, $1 million and $6 million, respectively, associated with the reduction in LIFO inventories. The excess of the current cost of inventories over book value was approximately $56 million and $135 million at December 31, 1993 and 1992, respectively. 8. Fixed Assets The components of fixed assets at December 31, 1993 and 1992, were as follows: 9. Deferred Charges and Other Assets Deferred charges and other assets at December 31, 1993 and 1992, was comprised of the following: LYONDELL PETROCHEMICAL COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) 10. Other Accrued Liabilities Other accrued liabilities at December 31, 1993 and 1992, were as follows: 11. Long-Term Debt and Financing Arrangements Long-term debt at December 31, 1993 and 1992, was comprised of the following: Aggregate maturities of long-term debt during the five years subsequent to December 31, 1993 are as follows: 1994-$8 million; 1995-$10 million; 1996-$150 million; 1997-$112 million; 1998-$32 million. Effective July 1, 1993, LCR entered into a 364 day unsecured revolving credit facility with a group of banks with Continental Bank, N.A., as agent. Under terms of the credit facility, LCR may borrow a maximum of $100 million in the form of cash or letters of credit with interest based on prime, LIBOR or CD rates at LCR's option. The credit facility may be extended at the request of LCR upon consent of the bank group. The credit facility contains covenants that limit LCR's ability to modify certain significant contracts, dispose of assets or merge or consolidate with other entities. At December 31, 1993, no amounts were outstanding under this credit facility. During December, 1993, the Company finalized a five year, $400 million unsecured revolving credit facility (Credit Facility) which replaced its existing $300 million credit facility which was due to expire in July, 1994. In connection with the Credit Facility, the Company paid administrative, arrangement and commitment fees totaling $3.2 million. At December 31, 1993, no amounts were outstanding under the Credit Facility. Under the terms of the Credit Facility, the interest rate is based on Euro- Dollar or CD rates, at the Company's option, and also is dependent upon the Credit Facility utilization rate and the Company's debt ratings. The Credit Facility contains restrictive covenants regarding the incurrence of additional debt, the maintenance of certain fixed charge coverage and leverage ratios and the making of contributions to LCR, as well as the payment of dividends to the extent that the Company's net income after January 1, 1994 generally does not exceed, over time, dividends declared or paid after that date. The Credit Facility's debt incurrence covenant restricts the incurrence by the Company of additional debt, including debt under the Credit Facility, unless, immediately after giving effect to the additional borrowing, the ratio of earnings before depreciation, amortization, interest and income taxes, to interest expense exceeds the limits set forth in the Credit Facility. However, the debt incurrence covenant does not become applicable until the debt incurred by the Company after December 31, 1993 exceeds $75 million. LYONDELL PETROCHEMICAL COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) 11. Long-Term Debt and Financing Arrangements- (continued) During March, 1992, the Company completed the placement of $200 million of Notes consisting of $100 million of 8.25 percent Notes due 1997 and $100 million of 9.125 percent Notes due 2002. A majority of the proceeds was used in April, 1992 to prepay amounts due under capitalized leases relating to the olefins plants, which allowed the Company to terminate the leases and acquire ownership of the plants. The Company's Medium-Term Notes mature at various dates from 1994 to 2005 and have a weighted average interest rate at December 31, 1993 and 1992 of 9.85 percent. The Notes due 1996 and 1999, and the Medium-Term Notes contain provisions that would allow the holders to require the Company to repurchase the debt upon the occurrence of certain events together with specified declines in public ratings on the Notes due 1996 and 1999. Certain events include acquisitions by persons other than ARCO or the Company of more than 20 percent of the Company's common stock, any merger or transfer of substantially all of the Company's assets, in connection with which the Company's common stock is changed into or exchanged for cash, securities or other property and payment of certain "special" dividends. At December 31, 1993, the Company had letters of credit outstanding totaling $33.8 million. Based on the borrowing rates currently available to the Company for debt with terms and average maturities similar to the Company's debt portfolio, the fair value of long-term debt is $776 million. 12. Earnings Per Share Earnings per share were computed based on the weighted average number of shares outstanding of 80,000,000 for the years ended December 31, 1993, 1992 and 1991. 13. Stockholders' Equity (Deficit) Dividends - During 1993, the Company paid a regular dividend to stockholders in the amount of $.45 per share during the first and second quarters and a regular dividend to stockholders in the amount of $.225 per share during each of the remaining two quarters. During 1992, the Company paid regular quarterly dividends of $.45 per share. During 1991, the Company paid a regular dividend to stockholders in the amount of $.40 per share during the first quarter and $.45 per share during each of the remaining three quarters. Return of Capital - During 1993, the Company paid $108 million in dividends. Total dividends paid during the year exceeded cumulative earnings and profits, as computed for federal income tax purposes. Subject to final determination by the Internal Revenue Service, 100 percent of each of the 1993 quarterly dividend payments was considered a return of capital. Stock Options - The Company's Executive Long-Term Incentive Plan (LTI Plan), became effective November 7, 1988. The LTI Plan provides, among other things, for the granting to officers and other key management employees of non-qualified stock options for the purchase of up to 1,295,000 shares of the Company's common stock. The number of options exercisable each year is equal to 25 percent of the number granted after each year of continuous service starting one year from the date of grant. The LTI Plan provides that the option price per share will not be less than 100 percent of the fair market value of the stock on the effective date of the grant. As of December 31, 1993, options covering 761,732 shares were outstanding under the LTI Plan of which 283,056 were exercisable at a weighted average price of $22.10 per share. LYONDELL PETROCHEMICAL COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued) 13. Stockholders' Equity (Deficit) - (continued) The Company's Incentive Stock Option Plan (ISO Plan) became effective January 12, 1989. The ISO Plan is a qualified plan which provides for the granting of stock options for the purchase of up to 550,000 shares of the Company's common stock. All employees of the Company who are not on the executive payroll are eligible to participate in the ISO Plan, subject to certain restrictions. Various restrictions apply as to when and to the number of stock options that may be exercised during any year. In no event, however, may a stock option be exercised prior to the first anniversary of the date the stock option was granted. As of December 31, 1993, options covering 476,665 shares were outstanding at an average exercise price of $29.35 per share. These options were held by 2,053 eligible employees. At December 31, 1993, no stock options were exercisable. The following summarizes stock option activity for the ISO Plan: LYONDELL PETROCHEMICAL COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued) 14. Leases At December 31, 1993, future minimum rental payments for operating leases with noncancelable lease terms in excess of one year were as follows: LYONDELL PETROCHEMICAL COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued) 14. Leases-(Continued) Operating lease net rental expenses for 1993, 1992 and 1991 were $43 million, $35 million and $33 million, respectively. 15. Retirement Plans All Lyondell and LCR employees are covered by defined benefit pension plans. Retirement benefits are based on years of service and the employee's compensation primarily during the last three years of service. The funding policy for these plans is to make periodic contributions as required by applicable regulations. Lyondell and LCR accrue pension costs based on an actuarial valuation and fund the plans through contributions to separate trust funds that are kept apart from Lyondell or LCR's funds. Lyondell and LCR also have unfunded supplemental nonqualified retirement plans which provide pension benefits for certain employees in excess of the qualified plans' limits. The following table sets forth the funded status of Lyondell and LCR's retirement plans and the amounts recognized in the Company's consolidated balance sheet at December 31, 1993 and 1992: The Company's net pension cost for 1993, 1992 and 1991 included the following components: LYONDELL PETROCHEMICAL COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) 15. RETIREMENT PLANS - (CONTINUED) The assumptions used as of December 31, 1993, 1992 and 1991, in determining the pension costs and pension liability shown above were as follows: Lyondell and LCR also maintain voluntary defined contribution Capital Accumulation and Savings plans for eligible employees. Under provisions of the plans, Lyondell and LCR contribute an amount equal to 150 percent of employee contributions up to a maximum Lyondell or LCR contribution of 6 percent of the employee's base salary for the Capital Accumulation plans and 200 percent of employee contributions up to a maximum Lyondell or LCR contribution of 2 percent of the employee's base salary for the Savings plans. Lyondell and LCR contributions to these plans totaled $8 million in 1993, $7 million in 1992 and $7 million in 1991. 16. Postretirement Benefits Other Than Pensions Lyondell and LCR sponsor unfunded defined benefit postretirement plans other than pensions that cover both salaried and non-salaried employees which provide medical and life insurance benefits. The postretirement health care plans are contributory while the life insurance plans are non-contributory. Currently, Lyondell and LCR pay approximately 80 percent of the cost of the health care plans, but reserve the right to modify the cost-sharing provisions at any time. The following table sets forth the plans' separate postretirement benefit liabilities as of December 31, 1993 and 1992: Net periodic postretirement benefit costs for 1993 and 1992 included the following components: LYONDELL PETROCHEMICAL COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) 16. POSTRETIREMENT BENEFITS OTHER THAN PENSIONS - (continued) For measurement purposes, the assumed annual rate of increase in the per capita cost of covered health care benefits was 13 percent for 1993-1996, 9 percent for 1997-2001, and 6 percent thereafter. The health care cost trend rate assumption has a significant effect on the amounts reported. To illustrate, increasing the assumed health care cost trend rates by one percentage point in each year would increase the accumulated postretirement benefit liability as of December 31, 1993 by $10 million and the net periodic postretirement benefit cost for the year then ended by $1 million. The accumulated postretirement benefit obligation was calculated utilizing a weighted-average discount rate of 7.25 percent and 8.75 percent at December 31, 1993 and 1992, respectively, and an average rate of salary progression of 5 percent in each year. Lyondell and LCR's current policy is to fund the postretirement health care and life insurance plans on a pay-as-you-go basis. 17. INCOME TAXES Effective January 1, 1992, the Company changed its method of accounting for income taxes from the deferred method to the liability method required by SFAS No. 109, "Accounting for Income Taxes" (see Note 4). As permitted under the new standard, prior years' financial statements have not been restated. During 1993, the Company increased its provision for deferred income taxes by $3 million due to an increase in the federal corporate income tax rate from 34 percent to 35 percent effective January 1, 1993. Significant components of the Company's provision for income taxes attributable to continuing operations follows: Prior to the change in accounting methods, the components of the Company's provision for deferred income taxes for the year ended December 31, 1991 were as follows (millions of dollars): LYONDELL PETROCHEMICAL COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) 17. INCOME TAXES - (continued) Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Company's deferred tax liabilities and assets as of December 31, 1993 and 1992 are as follows: Pretax income from continuing operations for the years ended December 31, 1993, 1992 and 1991 was taxed under domestic jurisdictions only. The reconciliation of income tax attributable to continuing operations computed at the U.S. federal statutory tax rates to the Company's effective tax rates follows: 18. COMMITMENTS AND CONTINGENCIES The Company has various purchase commitments for materials, supplies and services incident to the ordinary conduct of business. In the aggregate, such commitments are not at prices in excess of current market. In connection with the transfer of assets and liabilities from ARCO to the Company, the Company agreed to assume certain liabilities arising out of the operation of the Company's integrated petrochemical and petroleum processing business prior to July 1, 1988. In connection with the transfer of such liabilities, the Company and ARCO entered into an agreement (Cross-Indemnity Agreement) whereby the Company has agreed to defend and indemnify ARCO against certain uninsured claims and liabilities which ARCO may incur relating to the operation of the business of the Company prior to July 1, 1988, including certain liabilities which may arise out of pending and future lawsuits. LYONDELL PETROCHEMICAL COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) 18. COMMITMENTS AND CONTINGENCIES - (CONTINUED) ARCO indemnified the Company under the Cross-Indemnity Agreement with respect to other claims or liabilities and other matters of litigation not related to the assets or business included in the consolidated financial statements. ARCO has also indemnified the Company for all federal taxes which might be assessed upon audit of the operations of the Company included in the consolidated financial statements prior to January 12, 1989, and for all state and local taxes for the period prior to July 1, 1988. In addition to lawsuits for which the Company has indemnified ARCO, the Company is also subject to various lawsuits and proceedings. Subject to the uncertainty inherent in all litigation, management believes the resolution of these proceedings will not have a material adverse effect upon the Company's operations. The Company's policy is to be in compliance with all applicable environmental laws. The Company is subject to extensive environmental laws and regulations concerning emissions to the air, discharges to surface and subsurface waters and the generation, handling, storage, transportation, treatment and disposal of waste materials. Some of these laws and regulations are subject to varying and conflicting interpretations. In addition, the Company cannot accurately predict future developments, such as increasingly strict requirements of environmental laws, inspection and enforcement policies and compliance costs therefrom which might affect the handling, manufacture, use, emission or disposal of products, other materials or hazardous and non-hazardous waste. Subject to the terms of the Cross-Indemnity Agreement, the Company is currently contributing funds to the cleanup of two waste sites (French Ltd. and Brio, both of which are located near Houston, Texas) under the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA) as amended and the Superfund Amendments and Reauthorization Act of 1986. The Company is also subject to certain assessment and remedial actions at the Refinery under the Resource Conservation and Recovery Act (RCRA). In addition, the Company has negotiated an order with the Texas Water Commission, now the Texas Natural Resource Conservation Commission (TNRCC), for assessment and remediation of groundwater and soil contamination at the Refinery. The Company has accrued $24 million related to future CERCLA, RCRA and TNRCC assessment and remediation costs, of which $7 million is included in current liabilities while the remaining amounts are expected to be incurred over the next three to seven years. However, it is possible that new information about the sites for which the reserve has been established, or future developments such as involvement in other CERCLA, RCRA, TNRCC or other comparable state law investigations could require the Company to reassess its potential exposure related to environmental matters. In the opinion of management, any liability arising from these matters will not have a material adverse effect on the consolidated financial condition of the Company, although the resolution in any reporting period of one or more of these matters could have a material impact on the Company's results of operations for that period. 19. SEGMENT INFORMATION As discussed in Note 3, the refining operations of the Company were contributed to LCR effective July 1, 1993. Prior to July 1, 1993, the petrochemical and refining operations of the Company were considered to be a single segment due to the integrated nature of their operations. However, these operations are now considered to be separate segments due to the formation of LCR and the related separate management and operations of that entity. The Petrochemical segment consists of olefins, including ethylene, propylene, butadiene, butylenes and specialty products; polyolefins, including polypropylene and low density polyethylene; aromatics produced at the Channelview Complex, including benzene and toluene; methanol and refinery blending stocks. LYONDELL PETROCHEMICAL COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) 19. SEGMENT INFORMATION - (CONTINUED) The refining segment is primarily composed of the LCR venture (see Note 3) and consists of refined petroleum products, including gasoline, heating oil and jet fuel; aromatics produced at the Refinery, including benzene, toluene, paraxylene and orthoxylene; lubricants; olefins feedstocks and crude oil resales. Crude oil resales consist of revenues from the resale of previously purchased crude oil and from locational exchanges of crude oil that are settled on a cash basis. Crude oil exchanges and resales facilitate the operation of the Company's petroleum processing business by allowing the Company to optimize the crude oil feedstock mix in response to market conditions and refinery maintenance turnarounds and also to reduce transportation costs. Crude oil resales amounted to $401 million, $893 million and $1,308 million for years ended December 31, 1993, 1992 and 1991, respectively. Consolidated sales to CITGO totaled $864 million in 1993, $282 million in 1992 and $181 million in 1991. No other customer accounted for 10 percent or more of consolidated sales. Summarized below is the segment data for the Company which includes certain pro forma adjustments necessary to present the petrochemical and refining operations as individual segments for periods prior to the formation of LCR. These adjustments relate principally to allocations of costs and expenses between the two segments and are based on current operating agreements between the Company and LCR. Intersegment sales between petrochemical and refining segments include olefins feedstocks produced at the Refinery and gasoline and fuel oil blending stocks produced at the Channelview Complex and were made at prices based on current market values. LYONDELL PETROCHEMICAL COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) 19. SEGMENT INFORMATION - (CONTINUED) LYONDELL PETROCHEMICAL COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) 20. Unaudited Quarterly Results (*) The 1992 quarterly results have been restated to reflect the adoption during the fourth quarter of 1992, of accounting changes which were effective January 1, 1992. In addition, the first two quarters of 1993 and all four quarters of 1992 include certain pro forma adjustments necessary to present the petrochemical and refining operations as individual segments for periods prior to the formation of LCR effective July 1, 1993. 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 Set forth below are the directors of the Registrant as of March 1, 1994. The executive officers of the Registrant are listed on page 19 herein. Mike R. Bowlin, 51............ Mr. Bowlin was elected a Director of the Chairman of the Board Company on July 23, 1993 and Chairman of the Board on August 13, 1993. He has been President and Chief Operating Officer of ARCO since June 1, 1993 and a director of ARCO since June, 1992. He was an Executive Vice President of ARCO from June, 1992 to May, 1993. He was a Senior Vice President of ARCO from August, 1985 to June, 1992 and President of ARCO International Oil and Gas Company from November, 1987 to June, 1992. He was Senior Vice President of International Oil and Gas Acquisitions from July, 1987 to November, 1987. He was President of ARCO Coal Company from August, 1985 to July, 1987. He was a Vice President of ARCO from October, 1984 to July, 1985. From April, 1981 to December, 1984, he was Vice President of ARCO Oil and Gas Company. He has been an officer of ARCO since October, 1984. He originally joined ARCO in 1969. William T. Butler, 61....... Dr. Butler was elected a Director of the Company on December 21, 1988, effective as of January 25, 1989. He has held his current position as President and Chief Executive Officer of Baylor College of Medicine (education and research) since 1979. He is also a director of First City Bancorporation of Texas, Inc., C. R. Bard, Inc. and Browning-Ferris Industries Inc. Allan L. Comstock, 50........ Mr. Comstock was elected a Director of the Company on July 23, 1993. He has been a Vice President and Controller of ARCO since June, 1993. He was a Vice President of ARCO Chemical from October, 1989 through May, 1993. From November, 1985 to September, 1989 he was General Auditor of ARCO. He originally joined ARCO in 1969. Terry G. Dallas, 43.......... Mr. Dallas was elected a Director of the Company on July 23, 1993. He has been a Vice President of ARCO since June, 1993 and Treasurer of ARCO since January 24, 1994. He was Vice President, Corporate Planning of ARCO from June, 1993 to January, 1994. He served as Assistant Treasurer for ARCO Corporate Finance from 1990 to 1993. He was Vice President of Finance, Control and Planning for ARCO British, Ltd. from 1988 to 1990 and Manager of International Acquisitions for ARCO International Oil and Gas Company from 1986 to 1988. He originally joined ARCO in 1979. Bob G. Gower, 56............. Mr. Gower was elected Chief Executive Officer President and Chief of the Company on October 24, 1988 and a Executive Officer Director and President of the Company on June 27, 1988. He has been President of Lyondell and its predecessor, the Lyondell Division, since the formation of the Lyondell Division in April, 1985. Mr. Gower was a Senior Vice President of ARCO from June, 1984 until his resignation as an officer of ARCO in January, 1989. Prior to 1984 he served in various capacities with the then ARCO Chemical Division. He originally joined ARCO in 1963. Mr. Gower is also a director of Texas Commerce Bank-Houston and Keystone International Inc. Stephen F. Hinchliffe, Jr. 60. Mr. Hinchliffe was elected a Director of the Company on March 1, 1991. Since 1988, he has held his current position of Chairman of the Board and Chief Executive Officer of BHH Management, Inc., the managing partner of Leisure Group, Inc. Previously, he served as Chairman of the Board of Leisure Group, Inc. (a manufacturer of consumer products), which he founded in 1964. Dudley C. Mecum II, 59....... Mr. Mecum was elected a Director of the Company on November 28, 1988, effective as of January 25, 1989. He has held his current position as a partner with G. L. Ohrstrom & Company (merchant banking) since August, 1989. Previously he was Chairman of Mecum Associates, Inc. (management consulting) from December, 1987 to August, 1989. He served as Group Vice President and director of Combustion Engineering Inc. from 1985 to December, 1987, and as a managing partner of the New York region of Peat, Marwick, Mitchell & Co. from 1979 to 1985. He is also a director of The Travelers, Inc., Dyncorp, VICORP Restaurants, Inc., Fingerhut Companies, Inc. and Roper Industries, Inc. William C. Rusnack, 49...... Mr. Rusnack was elected a Director of the Company on October 24, 1988. He has been a Senior Vice President of ARCO since July 1990 and President of ARCO Products Company since June, 1993. He was President of ARCO Transportation Company from July, 1990 to May, 1993. He was Vice President, Corporate Planning, of ARCO from July, 1987 to July, 1990. He was Senior Vice President, Marketing and Employee Relations, of the ARCO Oil and Gas Division from August, 1985 to July, 1987 and Vice President, Manufacturing, of the ARCO Products Division from July, 1984 to August, 1985. From June 1983 to July, 1984 he was Vice President, Planning and Control, of the ARCO Products Division. He originally joined ARCO in 1966. Mr. Rusnack is also a director of BWIP Holding, Inc. Dan F. Smith, 47.............. Mr. Smith was elected a Director of the Executive Vice President Company on October 24, 1988. He was elected and Chief Operating Officer Executive Vice President and Chief Operating Officer on May 6, 1993. He served as Vice President Corporate Planning of ARCO from October, 1991 until May, 1993. He previously served as Executive Vice President and Chief Financial Officer of the Company from October, 1988 to October, 1991 and as Senior Vice President of Manufacturing of Lyondell, and its predecessor, the Lyondell Division, from June, 1986 to October, 1988. From August, 1985 to June, 1986 Mr. Smith served as Vice President of Manufacturing for the Lyondell Division. He joined the Lyondell Division in April, 1985 as Vice President, Control and Administration. Prior to 1985, he served in various financial, planning and manufacturing positions with ARCO. He originally joined ARCO in 1968. Paul R. Staley, 64........... Mr. Staley was elected a Director of the Company on November 28, 1988, effective as of January 25, 1989. He has held his current position as Chairman of the Executive Committee of the Board of Directors of P. Q. Corporation (an industry supplier of silicates) since January, 1991. He held the positions of President and Chief Executive Officer of P.Q. Corporation from 1973 and 1981, respectively, until January, 1991. William E. Wade, Jr., 51..... Mr. Wade was elected a director of the Company on August 13, 1993. He has been Executive Vice President of ARCO since June 1, 1993 and a director of ARCO since June 1, 1993. He was a Senior Vice President of ARCO from May, 1987 to May, 1993 and President of ARCO Oil and Gas Company from October, 1990 to May, 1993. He was President of ARCO Alaska, Inc. from July, 1987 to July, 1990. He was a Vice President of ARCO from 1985 to May, 1987. From 1981 to 1985, he was Vice President of ARCO Exploration Company. He has been an officer of ARCO since 1985. He originally joined ARCO in 1968. ITEM 11.	ITEM 11. Executive Compensation EXECUTIVE COMPENSATION The following table sets forth information as to the Chief Executive Officer and the next four most highly compensated executive officers of the Company. SUMMARY COMPENSATION TABLE - ----------- In accordance with the transition provisions applicable to the revised proxy rules covering disclosure of executive compensation adopted under the Securities Exchange Act of 1934 (the "Proxy Rules"), amounts of other annual compensation and all other compensation are excluded for the Company's 1991 fiscal year. (a) Special bonuses were paid in 1993 in recognition of the executive officers' and other key employees' significant contributions during 1992 and 1993 to the successful completion of the Company's refining venture with CITGO Petroleum Corporation and Lagoven S.A. (b) Includes imputed income in respect of the Long-Term Disability Plan, tax gross-ups in respect of financial counseling reimbursements and in respect of other miscellaneous items, and the amount of incremental interest accrued under the Executive Deferral Plan that exceeds 120 percent of a specified IRS rate. "Tax gross-ups" refers to the additional reimbursement paid to a recipient to cover the federal income tax obligations associated with the underlying benefit, including an additional amount, based on maximum applicable income tax rates. (c) Amounts shown in the LTIP Payouts column represent payment of performance units (including associated dividend share credits) awarded under the Company's Executive Long-Term Incentive Plan (the "LTIP"). The LTIP provides for the granting of stock options and the right to receive performance units under certain circumstances and a cash payment in respect of dividend share credits as described in this footnote. Dividend share credits are allocated to an optionee's account whenever dividends are declared on shares of common stock. The number of dividend share credits to be allocated on each record date to an optionee's account is computed by multiplying the dividend rate per share of Common Stock by the sum of (i) the number of shares subject to outstanding options, (ii) the number of performance units and (iii) the number of dividend share credits then credited to the optionee's account and dividing the resulting figure by the fair market value of a share of Common Stock ("FMV") on such dividend record date. As future dividends are declared, the participant will receive dividend share credits not only on the number of shares covered by unexercised options and the number of performance units but also on the number of dividend share credits in the participant's account. The dividend crediting mechanism will continue to operate in this manner (i) with respect to options, until the participant exercises such options or the options expire, and (ii) with respect to performance units, until payment is made (or not made, as the case may be) in respect of performance units. Dividend share credits do not represent earned compensation and have no definite value, if any, until the date on which the options or performance units, as applicable, in respect of which such credits have been allocated, are exercised or paid. See footnote (b) to the Aggregated Option Exercises and Fiscal Year-End Option Values Table. Dividend share credits are canceled upon an optionee's termination of employment under certain specified circumstances. In addition to the dollar amounts shown in the LTIP Payouts column, the number of dividend share credits accrued to the accounts of the named executives during 1993 and 1992, respectively, is as follows: Mr. Gower: 13,819 and 13,200; Mr. Smith: 2,405 and 4,399; Mr. Pendergraft: 3,414 and 2,885; Mr. Young: 2,625 and 2,311; and Mr. Ise: 3,384 and 2,900. (d) Includes contributions to the Executive Supplementary Savings Plan, incremental executive medical plan premiums, financial counseling reimbursements and certain amounts in respect of the Executive Life Insurance Plan, as follows: (e) In 1993 a revised methodology was adopted to calculate certain amounts in respect of the Executive Life Insurance Plan; accordingly, 1992 amounts have been restated to reflect this methodology. The effect of this restatement is not material to the overall figure previously reported. (f) Mr. Smith was elected Executive Vice President and Chief Operating Officer on May 6, 1993. The salary figure for 1993 is the amount paid to Mr. Smith for his service from that date. Prior to that he served as Vice President Corporate Planning of ARCO from October, 1991. He previously served as Executive Vice President and Chief Financial Officer of the Company from October, 1988 to October, 1991. The salary figure for 1991 is the amount paid to Mr. Smith for that portion of the year he was employed by the Company. (g) Includes relocation expenses in connection with his relocation to Houston of $540,000 for the loss from the sale of a home. Mr. Smith also received $370,000 as a tax gross-up in connection with that loss, which is included in this column. (h) Mr. Ise served as Vice President, Marketing and Sales, Polymers and Petroleum Products through June 30, 1993. Effective as of July 1, 1993, Mr. Ise began providing services as a loaned executive as a Vice President of LYONDELL-CITGO Refining Company Ltd., a limited liability company in which the Company currently owns an approximate 90% interest and CITGO Petroleum Corporation owns an approximate 10% interest. LYONDELL-CITGO Refining Company Ltd. reimburses the Company for the cost of salary and other compensation paid to Mr. Ise. Mr. Ise continues to serve as a Vice President of Lyondell. EXECUTIVE LONG-TERM INCENTIVE PLAN The LTIP provides for the granting of stock options, the right to receive performance units under certain circumstances and a cash payment in respect of dividend share credits. The following table describes the grants to the named executive officers of stock options and certain other information with respect to the exercise of stock options. No performance units were granted in 1993. Additional information with respect to payouts of performance units under the LTIP is contained in the Summary Compensation Table. OPTIONS OPTION GRANTS IN LAST FISCAL YEAR The following table provides information regarding stock options granted to the named executive officers during 1993. The values assigned to each reported option are shown using the Black-Scholes option pricing model. In assessing these values it should be kept in mind that no matter what theoretical value is placed on a stock option on the date of grant, its ultimate value will be dependent on the market value of the company's stock at a future date. - ----------- (a) The ten-year options were granted on March 5, 1993 pursuant to the LTIP at an exercise price equal to the FMV on the date of grant. The options become exercisable in four equal annual installments beginning March, 1994. Options and the dividend share credits associated with such options are canceled upon an optionee's termination of employment under certain specified circumstances. Stock options also carry eligibility for dividend share credits as described in footnote (c) to the Summary Compensation Table. (b) The values shown reflect a variation of the Black-Scholes pricing model. The pricing model used by the Company includes the following assumptions: options are exercised at the end of the 10-year term; no premium for risk is assigned; the dividend yield is assumed to be the current yield on the date of grant; and a long-term (200 days) historical volatility rate is applied. The values relate solely to stock options (and not performance units) and do not take into account risk factors such as nontransferability and limits on exercisability. The values do take into account the fact that dividend share credits are allocated to an optionee's account whenever dividends are declared on shares of common stock. (c) Mr. Smith was not an executive officer when options were granted in 1993. See footnote (f) to the Summary Compensation Table. The following table shows the number of shares of Common Stock represented by outstanding stock options held by each of the named executive officers as of December 31, 1993. Also reported are the values for "in-the-money" options which represent the positive spread between the exercise price of any such existing stock options and the year end price of common stock. AGGREGATED OPTION EXERCISES IN 1993 AND FISCAL YEAR-END OPTION VALUES - ---------- (a) The FMV of Lyondell Common Stock on December 31, 1993 was $21.25 (b) Each option carries with it the right to dividend share credits, as described in footnote (c) to the Summary Compensation Table. Set forth below is a calculation of the value of accrued dividend share credits, assuming exercise at December 31, 1993, of the in-the-money options. These hypothetical values have been calculated for illustration purposes only. ANNUAL PENSION BENEFITS The following table shows estimated annual pension benefits payable to the Company's employees, including executive officers of the Company, upon retirement on January 1, 1994 at age 65 under the provisions of the Lyondell Retirement Plan and the Executive Supplementary Retirement Plan. PENSION PLAN TABLE - --------- (a) The amounts shown in the above table are necessarily based upon certain assumptions, including retirement of the employee on January 1, 1994 and payment of the benefit under the basic form of allowance provided under the Lyondell Retirement Plan (payment for the life of the employee only with a guaranteed minimum payment period of 60 months). The amounts will change if the payment is made under any other form of allowance permitted by the Lyondell Retirement Plan, or if an employee's retirement occurs after January 1, 1994, since the "annual covered compensation level" of such employee (one of the factors used in computing the annual retirement benefits) may change during the employee's subsequent years of membership service. The benefits shown are not subject to deduction for Social Security benefits or other offset amounts. The plans, however, provide a higher level of benefits for the portion of compensation above the compensation levels on which Social Security benefits are based. (b) As of December 31, 1993, the credited years of service (rounded to the nearest whole number) under the Lyondell Retirement Plan for the named executive officers are: Mr. Gower, 30; Mr. Smith, 17; Mr. Pendergraft, 21; Mr. Young, 13; and Mr. Ise, 34. (c) All employees' (including executive officers') years of service with ARCO prior to the creation of Lyondell have been credited under the Company's retirement plans. ITEM 12.	ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT PRINCIPAL STOCKHOLDERS The Company's principal stockholder, ARCO, is one of the nation's leading integrated oil companies and maintains its headquarters at 515 South Flower Street, Los Angeles, California 90071. At March 1, 1994 ARCO owned 39,921,400 shares of Lyondell's Common Stock, which represent 49.9 percent of the outstanding stock. ARCO has consistently maintained an ownership position of just under 50 percent of Lyondell's Common Stock from the date of the Company's public offering of stock; however, there is no assurance that ARCO will maintain such ownership position in the future. ARCO officers and directors do not constitute a majority of the Board of Directors; however, ARCO officers and directors hold five of eleven directorships. Beginning in 1989, the Company was not included as a consolidated subsidiary in ARCO's financial statements; however, for certain securities laws purposes, ARCO could be deemed to be a "control" person or an "affiliate" of Lyondell. The table below sets forth certain information as of December 31, 1993 (the most recent date as of which the Company has information) regarding the beneficial ownership of the Common Stock by persons other than ARCO known by the Company to own beneficially more than five percent of its outstanding shares of Common Stock. - ---------- (a) Wellington Management Company ("WMC") (together with its wholly-owned subsidiary, Wellington Trust Company, National Association) may be deemed a beneficial owner of the 5,356,300 shares by virtue of the direct or indirect investment and/or voting discretion they possess pursuant to the provisions of investment advisory agreements with clients. WMC has shared dispositive power over the 5,356,300 shares of Common Stock, including the 5,083,900 shares beneficially owned by Vanguard/Windsor Fund Inc., an investment advisory client of WMC. SECURITY OWNERSHIP OF MANAGEMENT The following table sets forth the number of shares of Common Stock owned beneficially as of March 1, 1994 by each director, each of the executive officers named on the Summary Compensation Table and by all current directors and officers as a group. As of March 1, 1994, the percentage of shares of Common Stock beneficially owned by any director, named executive officers or by all directors and officers as a group, did not exceed one percent of the issued and outstanding Common Stock. Unless otherwise noted, each individual has sole voting and investment power. (a) Includes shares held by the trustees under the Lyondell Capital Accumulation Plan and the Lyondell Savings Investment Plan for the accounts of participants as of December 31, 1993. (b) The amounts shown include shares that may be acquired within 60 days following March 1, 1994 through the exercise of stock options, as follows: Mr. Gower, 112,137; Mr. Smith, 20,366; Mr. Pendergraft, 23,285; Mr. Young, 20,704; Mr. Ise, 25,879 and all directors and officers as a group, including those just named, 272,984. (c) Does not include 1,000 shares held by a trust of which Mr. Hinchliffe is a trustee, as to which shares he disclaims beneficial ownership. (d) Does not include 1,100 shares owned by Mr. Young's spouse, as to which shares he disclaims beneficial ownership. (e) Does not include 5,059 shares owned by spouses and a trust, as to which shares beneficial ownership is disclaimed. Compliance with Section 16(a) of the Securities Exchange Act of 1934 Section 16(a) of the Securities Exchange Act of 1934 requires the Company's directors and executive officers, and persons who own more than eleven percent of a registered class of the Company's equity securities, to file with the Securities and Exchange Commission ("SEC") and the New York Stock Exchange initial reports of ownership and reports of changes in ownership of Common Stock of the Company. Officers, directors and greater than ten-percent shareholders are required by SEC regulation to furnish the Company with copies of all Section 16(a) forms they file. To the Company's knowledge, based solely on review of the copies of such reports furnished to the Company and written representations that such reports accurately reflect all reportable transactions and holdings, during the fiscal year ended December 31, 1993 all Section 16(a) filing requirements applicable to its officers, directors and greater than ten-percent beneficial owners were complied with. ITEM 13.	ITEM 13. Certain Relationships and Related Transactions TRANSACTIONS BETWEEN THE COMPANY AND ARCO In connection with the transfer of assets and liabilities to Lyondell, the Company and ARCO entered into a number of agreements for the purpose of defining their ongoing relationships. In addition, in July 1987 the Lyondell Division and ARCO Chemical Company ("ARCO Chemical"), then a wholly owned subsidiary of ARCO, entered into a number of agreements in connection with the organization of ARCO Chemical. None of these agreements was the result of arm's-length negotiations between independent parties. It was the intention of the Company, ARCO and ARCO Chemical that such agreements and the transactions provided for therein, taken as a whole, accommodate the parties' interests in a manner that was fair to the parties, while continuing certain mutually beneficial joint arrangements. The Audit Committee of the Board of Directors of the Company, none of the members of which are affiliated with the Company (including LCR), ARCO or ARCO Chemical has determined that such agreements, taken as a whole, were fair to the Company and its stockholders. Because of the complexity of the various relationships between the Company, ARCO and its direct and indirect subsidiaries, including ARCO Chemical (together, "ARCO Affiliates"), however, there can be no assurance that each of such agreements, or the transactions provided for therein, has been effected on terms at least as favorable to the Company as could have been obtained from unaffiliated third parties. The terms and provisions of many of those initial agreements have been modified subsequently or supplemented and additional or modified agreements, arrangements and transactions have been and will continue to be entered into by the Company and ARCO Affiliates. Any such future agreements, arrangements and transactions will be determined through negotiation between the Company and ARCO Affiliates and it is possible that conflicts of interest will be involved. Future contractual relations among the Company and ARCO Affiliates will be subject to certain provisions of the Company's Certificate of Incorporation. See "Certificate of Incorporation Provisions Relating to Corporate Conflicts of Interest." In addition, the Audit Committee of the Board of Directors has adopted a set of guidelines for the review of all agreements entered into between the Company and ARCO Affiliates. These guidelines include a provision that, at least annually, the Audit Committee will review such agreements, or the transactions provided for therein, to assure that such agreements are, in its opinion, fair to the Company and its stockholders. For the year ended December 31, 1993, Lyondell (including LCR) paid ARCO Affiliates an aggregate of approximately $80 million. For the year ended December 31, 1993, Lyondell recorded revenues of approximately $278 million from sales to ARCO Affiliates, of which $263 million represented sales to ARCO Chemical. THE FOLLOWING IS A SUMMARY OF CERTAIN AGREEMENTS, ARRANGEMENTS AND TRANSACTIONS AMONG THE COMPANY AND ARCO AFFILIATES EFFECTIVE DURING THE PAST FISCAL YEAR, AS WELL AS CERTAIN AGREEMENTS, ARRANGEMENTS AND TRANSACTIONS THAT ARE CURRENTLY PROPOSED. TECHNOLOGY TRANSFERS AND LICENSES Effective July 1, 1988, ARCO assigned to the Company numerous domestic and foreign trademarks and certain U.S. and foreign patents and granted the Company a nonexclusive license to use other trademarks which contain the word "ARCO," to use ARCO's spark symbol as a logo and to use ARCO's color striping scheme, which license was royalty-free for a period of four years. The Company paid ARCO approximately $80,000 under the terms of this license in 1993. In connection with the transfer of assets and liabilities relating to the Lyondell Division from ARCO to the Company, the Company and ARCO, effective July 1, 1988, entered into (i) a License Agreement pursuant to which ARCO licensed to the Company on a nonexclusive, royalty-free basis certain rights (including Lyondell's right to sublicense to third parties, in some cases without accounting to ARCO) to ARCO's technology and intellectual property related to certain operations or assets of the Company, (ii) a technology assignment agreement pursuant to which legal title to certain other technology and intellectual property useful in the Company's business (including, without limitation, technology relating to olefins, including product flexibility) was transferred to the Company; provided, however, that except for technology relating to the product flexibility unit, ARCO retained a nonexclusive license to use the technology and property rights in ARCO's other operations, and (iii) an immunity from suit agreement in respect of the Company's right to practice all remaining technology in the possession of the Company prior to July 1, 1988. During 1990, the Company and ARCO entered into a series of amendments to these agreements designed to clarify the parties' rights under the original technology transfer. In addition, Lyondell and ARCO executed a patent maintenance agreement pursuant to which ARCO agreed to maintain certain patents licensed to Lyondell. Lyondell and ARCO also entered into a letter agreement granting Lyondell the right to obtain additional licensing rights. CROSS-INDEMNITY AGREEMENT In connection with the transfer by ARCO of substantially all of the assets and liabilities of its Lyondell Division to the Company, the Company and ARCO executed a Cross-Indemnification Agreement (the "Cross-Indemnity Agreement"). In the Cross-Indemnity Agreement, the Company agreed generally to indemnify ARCO against substantially all fixed and contingent liabilities relating to the integrated petrochemical and petroleum processing business and certain assets of the Lyondell Division. The liabilities assumed by the Company include the following, to the extent not covered by ARCO's insurance: (a) all liabilities and obligations of the Company and its combined subsidiaries, as of July 1, 1988; (b) all liabilities and obligations under contracts and commitments relating to the business of the Lyondell Division and certain assets relating thereto; (c) employment and collective bargaining agreements affecting the Company's employees; (d) specified pending litigation and other proceedings; (e) federal, state, foreign and local income taxes to the extent provided in the Cross-Indemnity Agreement; (f) liabilities for other taxes associated with the Lyondell Division's business and certain assets relating thereto; (g) liabilities for any past, present or future violations of federal, state or other laws (including environmental laws), rules, regulations or other requirements of any governmental authority in connection with the business of the Lyondell Division and certain assets relating thereto; (h) existing or future liabilities for claims based on breach of contract, breach of warranty, personal or other injury or other torts relating to such integrated petrochemical and petroleum processing businesses and certain assets relating thereto; and (i) any other liabilities relating to the assets transferred to the Company or its subsidiaries. ARCO has indemnified the Company with respect to other claims or liabilities and other matters of litigation not related to the assets or business transferred by ARCO to the Company. The Cross-Indemnity Agreement includes procedures for notice and payment of indemnification claims and provides that a party entitled to indemnification for a claim or suit brought by a third party may require the other party to assume the defense of such claim. The Cross-Indemnity Agreement also includes a defense cost-sharing agreement, whereby the Company will bear its allocated defense costs for certain lawsuits. DISPUTE RESOLUTION AGREEMENT In April 1993, the Company, ARCO and ARCO Chemical entered into a Dispute Resolution Agreement that mandates a procedure for negotiation and binding arbitration of significant commercial disputes among any two or more of the parties. SERVICES AGREEMENTS The Company and ARCO entered into an agreement effective January 1, 1991 and amended as of February, 1992 (the "Administrative Services Agreement") under which ARCO agreed to continue to provide various transitional services to the Company that ARCO had been providing pursuant to previous administrative service agreements. The services which ARCO agreed to provide the Company in the Administrative Services Agreement included employee benefits administration services, payroll, telecommunications and certain computer-related services. The Administrative Services Agreement terminates no later than December 31, 1997 although it may be terminated in its entirety earlier than such date upon the terminating party providing the other party with at least one year's prior notice, and a party may elect to terminate some of the services it is receiving upon 30 days prior notice to the other party. The Administrative Services Agreement provides for an annual renegotiation of fees. ARCO earned a fee of approximately $2 million during 1993 for all of the services which it provided under the Administrative Services Agreement. Effective January 1, 1991, the Company and ARCO entered into an agreement (the "Insurance Termination Agreement") which terminated the insurance coverage previously provided by ARCO and established procedures for the resolution of pending and future claims that are or will be covered under ARCO's policies in effect prior to January 1, 1991. OTHER AGREEMENTS BETWEEN THE COMPANY AND ARCO Lyondell has purchased and LCR continues to purchase certain of its crude oil requirements from ARCO Oil and Gas ("AOGC") under short-term arrangements at prices based on market values at the time of delivery. LCR also purchases crude oil from AOGC from time to time on the spot market at then-current spot market prices. The Company and LCR also purchased natural gas and natural gas liquids from AOGC during 1993 on the spot market at then-current spot market prices. The Company (including LCR) also sold products to ARCO Affiliates, including crude oil resales and sales of heating oil and lube oil at market-based prices. The Company has entered into several contracts with ARCO Pipe Line Company (ARCO Pipe Line) pursuant to which the Company (i) leased certain pipelines and pipeline segments from ARCO Pipe Line at annual rental rates which include recovery of operating costs, return on capital investment and inflation escalators (ii) acquired the services of ARCO Pipe Line to operate various groups of pipelines owned by the Company, (iii) entered into a throughput and deficiency commitment for volumes at tariff rates for transportation of crude oil and other products. Certain of these contracts that relate to the refining business were assigned to LCR as of July 1, 1993. The Company and LCR paid ARCO Pipe Line approximately $20 million during 1993 for rental fees and services under these contracts. ARCO Pipe Line and LCR have agreed to use jointly a control room owned by LCR and located at the Houston Refinery. ARCO Pipe Line also owns various easements and licenses for its pipelines and related equipment located on the property of the Company or LCR and has performed services relating to the pipeline systems. The Company (including LCR) also ships products over common carrier pipelines owned and operated by ARCO Pipe Line pursuant to filed tariffs on the same basis as other non-affiliated customers. AGREEMENTS BETWEEN THE COMPANY AND ARCO CHEMICAL COMPANY Lyondell provides to ARCO Chemical a large portion of the feedstocks purchased by ARCO Chemical for its manufacturing facilities located at Channelview, Texas. Pricing arrangements under these contracts are generally representative of prevailing market prices. Lyondell also provides certain nominal plant services at the aforementioned plants. ARCO Chemical in turn provides certain feedstocks and supplies to Lyondell at market-based prices. The Company processes MTBE (using one of the Company's two MTBE units) for ARCO Chemical, and ARCO Chemical markets this product for its own account. The term of this agreement extends through June 30, 1997. ARCO Chemical purchases certain base feedstocks for this processing agreement from Lyondell at market based prices. A processing fee is paid by ARCO Chemical to Lyondell to cover variable and fixed operating costs, as well as capital costs. In addition, the Company has agreed to sell to ARCO Chemical MTBE produced at the Company's second MTBE unit that is in excess of the Company's requirements at market-based prices. CERTIFICATE OF INCORPORATION PROVISIONS RELATING TO CORPORATE CONFLICTS OF INTEREST In order to address certain potential conflicts of interest between the Company and ARCO (for purposes of this section the term "ARCO" also includes ARCO's successors and any corporation, partnership or other entity in which ARCO owns fifty percent or more of the voting securities or other interest), the Company's Certificate of Incorporation contains provisions regulating and defining the conduct of certain affairs of the Company as they may involve ARCO and its officers and directors, and the powers, rights, duties and liabilities of the Company and its officers, directors and stockholders in connection therewith. In general, these provisions recognize that from time to time the Company and ARCO may engage in the same or similar activities or lines of business and have an interest in the same areas of corporate opportunities. The Certificate of Incorporation provides that ARCO has no duty to refrain from (1) engaging in business activities or lines of business that are the same as or similar to those of the Company, (2) doing business with any customer of the Company or (3) employing any officer or employee of the Company. The Certificate of Incorporation provides that ARCO is not under any duty to present any corporate opportunity to the Company which may be a corporate opportunity for both ARCO and the Company, and that ARCO will not be liable to the Company or its stockholders for breach of any fiduciary duty as a stockholder of the Company by reason of the fact that ARCO pursues or acquires such corporate opportunity for itself, directs such corporate opportunity to another person or does not present the corporate opportunity to the Company. ARCO currently owns interests in certain chemical companies and refiners (other than the Company) and has advised the Company that it may continue to acquire additional interests in chemical companies and refiners. The Certificate of Incorporation provides that directors and officers of the Company will not be liable to the Company or its stockholders for breach of any fiduciary duty if they comply with the following provisions of the Certificate of Incorporation. When a corporate opportunity is offered in writing to an officer or an officer and a director of the Company who is also an officer or an officer and a director of ARCO, solely in his or her designated capacity with one of the two companies, such opportunity shall be first presented to whichever company was so designated. No person is currently in this category. Otherwise, (i) a corporate opportunity offered to any person who is an officer or officer and director of the Company and who is also a director of ARCO, shall be first presented to the Company, (ii) a corporate opportunity offered to a person who is a director of the Company and who is also an officer or officer and director of ARCO shall be first presented to ARCO, (iii) in all other cases, a corporate opportunity offered to any person who is an officer and/or a director of both the Company and ARCO shall be first presented to the Company. Mr. Bowlin, Mr. Comstock, Mr. Dallas, Mr. Rusnack and Mr. Wade are in category (ii) and no persons currently are in categories (i) and (iii). Another section of the Certificate of Incorporation provides that no contract, agreement, arrangement or transaction between the Company and ARCO or between the Company and a director or officer of the Company or of ARCO would be void or voidable for the reason that ARCO or any director or officer of the Company or of ARCO are parties thereto or because any such director or officer were present or participated in the meeting of the Board of Directors which authorized the contract if the material facts about the contract, agreement, arrangement or transaction were disclosed or known to the Board of Directors or the stockholders and the Board of Directors in good faith authorizes the contract by a vote of a majority of the disinterested directors or the majority of stockholders approves such contract, agreement, arrangement or transaction. The foregoing Certificate of Incorporation provisions describe the obligations of officers and directors of the Company with respect to presentation of corporate opportunities, but do not limit the ability of the Company or of ARCO to consider and act upon such opportunities whether or not such provisions have been followed. CERTAIN OTHER TRANSACTIONS During the 1993 fiscal year, Dan F. Smith, a director and the Company's Executive Vice President and Chief Operating Officer, was indebted to the Company in the amount of $349,000. This interest-free loan, which was repaid within seven months and was not outstanding at the end of the year, was made in connection with his relocation to Houston. PART IV ITEM 14.	ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) The following documents are filed as a part of this report: 1 and 2 -- Consolidated Financial Statements and Financial Statement Schedules: these documents are listed in the Index to Consolidated Financial Statements and Financial Statement Schedules. Exhibits: 3.1 -- Restated Certificate of Incorporation of the Registrant filed with the State of Delaware on November 2, 1988.* 3.2 -- By-Laws of the Registrant.* 4.1 -- Indenture, dated as of May 31, 1989, as supplemented by a First Supplemental Indenture dated as of May 31, 1989, between the Registrant and Texas Commerce Bank National Association, as Trustee. 4.2 -- Indenture, dated as of March 10, 1992, as supplemented by a First Supplemental Indenture dated as of March 10, 1992, between the Registrant and Continental Bank, National Association, as Trustee.*** 4.3 -- Specimen certificate.* 4.4 -- Form of Medium-Term Note. 10.1 -- Lyondell Petrochemical Company Amended & Restated Annual Incentive Plan. 10.2 -- Lyondell Petrochemical Company Executive Supplementary Savings Plan. 10.3 -- Lyondell Petrochemical Company Executive Long-Term Incentive Plan as amended and restated as of October 19, 1990.* 10.4 -- Lyondell Petrochemical Company Supplementary Executive Retirement Plan, effective October 1, 1990.* 10.5 -- Lyondell Petrochemical Company Executive Medical Insurance Plan - Summary Plan Description.* 10.6 -- Lyondell Petrochemical Company Executive Deferral Plan, effective October 1, 1990. 10.7 -- Lyondell Petrochemical Company Executive Long-Term Disability Plan, effective October 1, 1990.* 10.8 -- Lyondell Petrochemical Company Executive Life Insurance Plan, effective October 1, 1990.* 10.9 -- Lyondell Petrochemical Company Elective Deferral Plan for Outside Directors. 10.10 -- Lyondell Petrochemical Company Retirement Plan for Outside Directors, as amended and restated. 10.11 -- Lyondell Petrochemical Company Supplemental Executive Benefit Plans Trust Agreement.** 10.12 -- Form of Registrant's Indemnity Agreement with Officers and Directors.* 10.13 -- Asset Purchase Agreement (conformed without exhibits), dated as of December 19, 1989, between the Registrant and Rexene Products Company.** 10.14 -- Conveyance (conformed without exhibits), dated as of July 1, 1988 between the Registrant and ARCO.* 10.15(a) -- Cross-Indemnification Agreement, dated as of July 1, 1988, between the Registrant and ARCO and Amendment No. 1 to the Cross- Indemnification Agreement effective as of July 1, 1988.* 10.15(b) -- Dispute Resolution Agreement, dated as of April, 1993, between the Registrant, ARCO and ARCO Chemical Company. 10.16(a) -- Administrative Services Agreement, dated as of January 1, 1991, between the Registrant and ARCO.** 10.16(b) -- Letter Agreement regarding Administrative Services Agreement, between the Registrant and ARCO dated as of February 26, 1992.*** 10.17 -- Agreements Implementing Transfer of Pipeline Rights from ARCO Pipe Line Company to Registrant.* 10.18(a) -- Amended and Restated Limited Liability Company Regulations of LYONDELL-CITGO Refining Company Ltd. dated as of July 1, 1993.**** 10.18(b) -- Contribution Agreement between Lyondell Petrochemical Company and LYONDELL-CITGO Refining Company Ltd. dated as of July 1, 1993.** 10.18(c) -- Crude oil Supply Agreement between LYONDELL-CITGO Refining Company Ltd. and Lagoven, S.A. dated as of May 5, 1993**** 10.19(a) -- Immunity From Suit Agreement, effective July 1, 1988, between ARCO and the Registrant.* 10.19(b) -- Amendment to Immunity From Suit Agreement, effective July 1, 1988, between ARCO and the Registrant.*** 10.20(a) -- License Agreement, effective July 1, 1988, between ARCO and the Registrant.* 10.20(b) -- License Agreement Amendment, effective July 1, 1988, between ARCO and the Registrant.* 10.21(a) -- Technology Agreement, effective as of July 1, 1988, between ARCO and the Registrant, as amended. 10.21(b) -- Technology Agreement Amendment dated September 14, 1990, effective July 1, 1988 between ARCO and the Registrant.*** 10.22 -- Assignment of Common Law Trademark(s), dated October 3, 1988, between ARCO and the Registrant.* 10.23 -- Assignment of U.S. Trademark(s), dated October 3, 1988, between ARCO and the Registrant.* 10.24 -- Crystalline Polymers License and Block Copolymer License dated February 14, 1990 between Phillips Petroleum Co. and the Registrant. 10.25(a) -- Assignment of Foreign Trademarks, dated October 3, 1988, as amended February 14, 1988, between ARCO and the Registrant. 10.25(b) -- Assignment of Foreign Trademarks, dated October 24, 1990, between ARCO and the Registrant.* 10.26 -- Assignment of Patents and Patent Applications, dated December 27, 1988, between ARCO and the Registrant. 10.27 -- Assignment of Technology Agreement, dated July 1, 1988, as amended, between ARCO and the Registrant. 10.28 -- Trademark License Agreement, dated October 7, 1988 between, ARCO and the Registrant. 10.29 -- Trademark License Agreement Amendment, dated October 7, 1991, between ARCO and the Registrant.** 10.30 -- Symbol Agreement dated July 1, 1988 between ARCO and the Registrant. 10.31 -- Joint Pipeline Use Agreement, dated July 1, 1987, between ARCO Chemical Company and the Registrant.* 10.32 -- MTBE Purchase, Transportation & Storage Agreement, dated July 1, 1987, between ARCO Chemical Company and the Registrant.* 10.33(a) -- Isobutylene Purchase and MTBE Tolling Agreement, dated July 1, 1987 and amended May 2, 1988, between the Registrant and ARCO Chemical Company.* 10.33(b) -- Amendment No. 1 to Isobutylene Purchase and MTBE Tolling Agreement.***** 10.34 -- LYONDELL-CITGO Refining Company Ltd. $100,000,000 Credit Agreement dated as of July 1, 1993. 10.35 -- Lyondell Petrochemical Company $400,000,000 Credit Agreement dated as of December 6, 1993 22 -- Subsidiaries of the Registrant. 24 -- Consent of Coopers & Lybrand. 25 -- Powers of Attorney * Filed as an exhibit to Registrant's Registration Statement on Form S-1 (No. 33-25407) and incorporated herein by reference. Filed as an exhibit to Registrant's Annual Report on Form 10-K Report for the year ended December 31, 1989 and incorporated herein by reference. * Filed as an exhibit to Registrant's Annual Report on Form 10-K Report for the year ended December 31, 1990 and incorporated herein by reference. ** Filed as an exhibit to Registrant's Annual Report on Form 10-K Report for the year ended December, 31, 1991 and incorporated herein by reference. * Filed as an exhibit to Registrant's Annual Report on Form 10-K Report for the year ended December 31, 1992 and incorporated herein by reference. **** Filed as an exhibit to Registrant's Form 8-K dated as of July 1, 1993 and incorporated herein by reference. (b) Consolidated Financial Statements and Financial Statement Schedules (1) Consolidated Financial Statements Consolidated Financial Statements and Financial Statement Schedules filed as part of this Annual Report on Form 10-K are listed in the Index to Consolidated Financial Statements and Financial Statement Schedules on page 34. (2) Financial Statement Schedules For years ended 1993, 1992, and 1991. V. -- Property, Plant and Equipment. VI. -- Accumulated Depreciation and Amortization of Property, Plant and Equipment. IX. -- Short-Term Borrowings X. -- Supplementary Income Statement Information All other schedules are omitted because they are not applicable or the required information is contained in the Financial Statements or notes thereto. Copies of exhibits will be furnished upon prepayment of 25 cents per page. Requests should be addressed to the Secretary. (c) Reports on Form 8-K: No Current Reports on Form 8-K were filed during the quarter ended December 31, 1993 or thereafter through March 16, 1994. 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. LYONDELL PETROCHEMICAL COMPANY By: BOB G. GOWER ------------------------------------------- Bob G. Gower 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. SCHEDULE V LYONDELL PETROCHEMICAL COMPANY PROPERTY, PLANT AND EQUIPMENT MILLIONS OF DOLLARS SCHEDULE VI LYONDELL PETROCHEMICAL COMPANY ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT MILLIONS OF DOLLARS SCHEDULE IX LYONDELL PETROCHEMICAL COMPANY SHORT-TERM BORROWINGS MILLIONS OF DOLLARS (a) Total of daily outstanding principal divided by the actual number of days in the period (365 days). (b) Actual interest expense on short-term borrowing divided by the average amount outstanding during the period, based upon a 365-day year. SCHEDULE X LYONDELL PETROCHEMICAL COMPANY SUPPLEMENTARY INCOME STATEMENT INFORMATION MILLIONS OF DOLLARS (a) Includes amortization of deferred turnaround costs. See Note 4 of Notes to Consolidated Financial Statements. (b) Includes property, superfund and other taxes. EXHIBIT INDEX
764542_1993.txt	764542	1993	ITEM 1. BUSINESS GENERAL MAXXAM Group Inc. and its majority and wholly owned subsidiaries are collectively referred to herein as the "Company" or "MGI" unless otherwise indicated or the context indicates otherwise. The Company is a wholly owned subsidiary of MAXXAM Inc. ("MAXXAM"). As a result of the Forest Products Group Formation described in the following paragraph, the Company is engaged almost exclusively in forest products operations through its wholly owned subsidiaries, The Pacific Lumber Company and its wholly owned subsidiaries (collectively referred to herein as "Pacific Lumber," unless the context indicates otherwise), and Britt Lumber Co., Inc. ("Britt"). Pacific Lumber, which has been in continuous operation for 125 years, engages in all principal aspects of the lumber industry--the growing and harvesting of redwood and Douglas-fir timber, the milling of logs into lumber products and the manufacturing of lumber into a variety of value-added finished products. Britt manufactures redwood and cedar fencing and decking products from small diameter logs, a substantial portion of which Britt acquires from Pacific Lumber (which cannot efficiently process them in its own mills). FOREST PRODUCTS GROUP FORMATION On August 4, 1993, the Company issued $100 million aggregate principal amount of 11 1/4% Senior Secured Notes due 2003 (the "MGI Senior Notes") and $126.7 million aggregate principal amount (approximately $70 million net of original issue discount) of 12 1/4% Senior Secured Discount Notes due 2003 (the "MGI Discount Notes" and together with the MGI Senior Notes, the "MGI Notes"). In connection with such offering, the Company reorganized its operations so that it would be engaged in the forest products business (the "Forest Products Group Formation"). Prior to the Forest Products Group Formation, the Company also operated in two other industries: aluminum, through its majority owned subsidiary, Kaiser Aluminum Corporation ("Kaiser"), a fully integrated aluminum producer, and real estate management and development, through the Palmas del Mar development located in Puerto Rico ("Palmas") owned by a subsidiary of the Company. On August 4, 1993, the Company (i) transferred to MAXXAM 50 million shares of Kaiser's common stock held by a subsidiary of the Company, representing the Company's entire interest in Kaiser's common stock, (ii) transferred to MAXXAM 60,075 shares of MAXXAM's common stock held by a subsidiary of the Company, (iii) transferred to MAXXAM certain notes receivable, long-term investments, and other assets, each net of related liabilities, collectively having a carrying value to the Company of approximately $1.1 million, and (iv) exchanged with MAXXAM 2,132,950 Depositary Shares, acquired from Kaiser in June 1993 for $15.0 million, such exchange being in satisfaction of a $15.0 million promissory note evidencing a cash loan made by MAXXAM to the Company in January 1993. On the same day, MAXXAM assumed approximately $17.5 million of certain liabilities of the Company that were unrelated to the Company's forest products operations or were related to operations which have been disposed of by the Company. Additionally, in September 1993, the Company transferred to MAXXAM its interest in Palmas. PACIFIC LUMBER REFINANCING On March 23, 1993 (the "Closing Date"), Pacific Lumber transferred (the "Transfer") approximately 179,000 acres of timberlands (the "Subject Timberlands"), its geographical information system and certain other assets to its newly-formed wholly owned subsidiary, Scotia Pacific Holding Company ("SPHC"), in exchange for (i) the assumption by SPHC of $323.4 million of Pacific Lumber's public indebtedness consisting of all of Pacific Lumber's 12% Series A Senior Notes due July 1, 1996 (the "Series A Notes") and a portion of Pacific Lumber's 12.2% Series B Senior Notes due July 1, 1996 (the "Series B Notes") and (ii) all of SPHC's outstanding common stock. SPHC was organized as a special purpose Delaware corporation to facilitate the Transfer and the offering of the Timber Notes described below. The Subject Timberlands consist substantially of residual old growth and young growth redwood and Douglas-fir timber. On the Closing Date, Pacific Lumber and SPHC entered into a Master Purchase Agreement, a Services Agreement, an Additional Services Agreement and certain other agreements providing for a variety of ongoing relationships. See "Pacific Lumber Operations-- Relationships with SPHC and Britt Lumber." On the Closing Date, Pacific Lumber also transferred to its newly-formed wholly owned subsidiary, Salmon Creek Corporation ("Salmon Creek"), in exchange for all of Salmon Creek's common stock, approximately 3,000 contiguous acres of its virgin old growth redwood timber, together with approximately 3,000 additional acres of adjacent timberlands owned by Pacific Lumber which could not be readily segregated from such virgin old growth redwood timberlands (collectively, the "Salmon Creek Property"). Pacific Lumber retained the exclusive right to harvest (the "Pacific Lumber Harvest Rights") approximately 8,000 non-contiguous acres of the Subject Timberlands consisting substantially of virgin old growth redwood and virgin old growth Douglas-fir timber located on numerous small parcels throughout the Subject Timberlands. In addition, Pacific Lumber retained its lumber milling, manufacturing, cogeneration and related facilities, as well as approximately 11,000 acres of real property located in Humboldt County, California, which do not constitute part of the Subject Timberlands (collectively, the "Pacific Lumber Real Property"). The Pacific Lumber Real Property consists of the town of Scotia, the land on which Pacific Lumber's sawmills, manufacturing facilities and related facilities are located and areas adjacent thereto, certain potential residential and commercial development sites and other areas, including timberlands owned by Pacific Lumber which cannot be readily segregated from the foregoing properties. Pacific Lumber is milling logs and producing and marketing lumber products from timber located on the timberlands of SPHC, Pacific Lumber and Salmon Creek in substantially the same manner as conducted prior to the Transfer. Pacific Lumber is, pursuant to the Master Purchase Agreement, harvesting and purchasing from SPHC all or substantially all of the logs harvested from the Subject Timberlands. See "--Pacific Lumber Operations--Relationships with SPHC and Britt Lumber" below. On the Closing Date, Pacific Lumber consummated its offering of $235 million aggregate principal amount of 10 1/2% Senior Notes due 2003 (the "Pacific Lumber Senior Notes") and SPHC consummated its offering of $385 million aggregate principal amount of 7.95% Timber Collateralized Notes due 2015 (the "Timber Notes"). The net proceeds of such offerings, together with cash and marketable securities, were used to redeem all of Pacific Lumber's outstanding public indebtedness (including the amounts assumed by SPHC), to make required deposits into certain accounts for the benefit of the holders of the Timber Notes, to repay Pacific Lumber's cogeneration loan and to pay a $25.0 million dividend to MAXXAM Properties Inc., a subsidiary of the Company ("MPI"). Substantially all of SPHC's assets, including the Subject Timberlands, were pledged as security for the Timber Notes. PACIFIC LUMBER OPERATIONS TIMBERLANDS Pacific Lumber owns and manages approximately 187,000 acres of commercial timberlands in Humboldt County in northern California. These timberlands contain approximately three-quarters redwood and one-quarter Douglas-fir timber. Pacific Lumber's acreage is virtually contiguous, is located in close proximity to its sawmills and contains an extensive (1,100 mile) network of roads. These factors significantly reduce harvesting costs and facilitate Pacific Lumber's forest management techniques. The extensive roads throughout Pacific Lumber's timberlands facilitate log hauling, serve as fire breaks and allow Pacific Lumber's foresters access to employ forest stewardship techniques which protect the trees from forest fires, erosion, insects and other damage. The forest products industry grades lumber in various classifications according to quality. The two broad categories within which all grades fall, based on the absence or presence of knots, are called "upper" and "common" grades, respectively. "Old growth" trees, often defined as trees which have been growing for approximately 200 years or longer, have a higher percentage of upper grade lumber than "young growth" trees (those which have been growing for less than 200 years). "Virgin" old growth trees are located in timber stands that have not previously been harvested. "Residual" old growth trees are located in timber stands which have been selectively harvested in the past. Pacific Lumber has engaged in extensive efforts, at relatively low cost, to supplement the natural regeneration of timber and increase the amount of timber on its timberlands. Regeneration of redwood timber generally is accomplished through the natural growth of redwood sprouts from the stump remaining after a redwood tree is harvested. Such new redwood sprouts grow quickly, thriving on existing mature root systems. In addition, Pacific Lumber supplements natural redwood generation by planting redwood seedlings. Douglas-fir timber grown on Pacific Lumber's timberlands is regenerated almost entirely by planting seedlings. During the 1992-93 planting season (December through March), Pacific Lumber planted approximately 488,000 redwood and Douglas-fir seedlings at a cost of approximately $215,500. HARVESTING PRACTICES The ability of Pacific Lumber to sell logs or lumber products will depend, in part, upon its ability to obtain regulatory approval of timber harvesting plans ("THPs"). THPs are required to be filed with the California Department of Forestry ("CDF") prior to the harvesting of timber and are designed to comply with existing environmental laws and regulations. The CDF's evaluation of proposed THPs incorporates review and analysis of such THPs provided by several California and federal agencies and public comments received with respect to such THPs. An approved THP is applicable to specific acreage and specifies the harvesting method and other conditions relating to the harvesting of the timber covered by such THP. The method of harvesting as set forth in a THP is chosen from among a number of accepted methods based upon suitability to the particular site conditions. Pacific Lumber maintains a detailed geographical information system covering its timberlands (the "GIS"). The GIS covers numerous aspects of Pacific Lumber's properties, including timber type, tree class, wildlife data, roads, rivers and streams. By carefully monitoring and updating this data base, Pacific Lumber's foresters are able to develop detailed THPs which are required to be filed with and approved by the CDF prior to the harvesting of timber. Pacific Lumber principally harvests trees through selective harvesting, which harvests only a portion of the trees in a given area, as opposed to clearcutting, which harvests an entire area of trees in one logging operation. Selective harvesting generally accounts for over 90% (by volume on a net board foot basis) of Pacific Lumber's timber harvest in any given year. Harvesting by clearcutting is used only when selective harvesting methods are impractical due to unique conditions. Selective harvesting allows the remaining trees to obtain more light, nutrients and water thereby promoting faster growth rates. Due to the size of its timberlands and conservative harvesting practices, Pacific Lumber has historically conducted harvesting operations on approximately 5% of its timberlands in any given year. PRODUCTION FACILITIES Pacific Lumber owns four highly mechanized sawmills and related facilities located in Scotia, Fortuna and Carlotta, California. The sawmills historically have been supplied almost entirely from timber harvested from Pacific Lumber's timberlands. Since 1986, Pacific Lumber has implemented numerous technological advances which have increased the operating efficiency of its production facilities and the recovery of finished products from its timber. Over the past three years, Pacific Lumber's annual lumber production has averaged approximately 249 million board feet, with approximately 228, 264 and 256 million board feet produced in 1993, 1992 and 1991, respectively. Pacific Lumber operates a finishing plant which processes rough lumber into a variety of finished products such as trim, fascia, siding and paneling. These finished products include the industry's largest variety of customized trim and fascia patterns. Pacific Lumber also enhances the value of some grades of common grade lumber by cutting out knot-free pieces and reassembling them into longer or wider pieces in Pacific Lumber's state-of-the-art end and edge glue plant. The result is a standard sized upper grade product which can be sold at a significant premium over common grade products. Pacific Lumber dries the majority of its upper grade lumber before it is sold. Upper grades of redwood lumber are generally air-dried for six to eighteen months and then kiln-dried for seven to twenty-four days to produce a dimensionally stable and high quality product which generally commands higher prices than "green" lumber (which is lumber sold before it has been dried). Upper grade Douglas-fir lumber is generally kiln-dried immediately after it is cut. Pacific Lumber owns and operates 34 kilns, having an annual capacity of approximately 95 million board feet, to dry its upper grades of lumber efficiently in order to produce a quality, premium product. Pacific Lumber also maintains several large enclosed storage sheds which hold approximately 25 million board feet of lumber. In addition, Pacific Lumber owns and operates a modern 25-megawatt cogeneration power plant which is fueled almost entirely by the wood residue from Pacific Lumber's milling and finishing operations. This power plant generates substantially all of the energy requirements of Scotia, California, the town adjacent to Pacific Lumber's timberlands owned by Pacific Lumber where several of its manufacturing facilities are located. Pacific Lumber sells surplus power to Pacific Gas and Electric Company. In 1993, the sale of surplus power to Pacific Gas and Electric Company accounted for approximately 2% of Pacific Lumber's total revenues. In April 1992, an earthquake and a series of aftershocks occurred in northern California which produced a significant amount of damage in and around the area where Pacific Lumber's forest products operations are located. Standing timber on Pacific Lumber's timberlands suffered virtually no damage; however, among other damage, a large number of kilns used to dry upper grade redwood lumber and two sawmills were damaged, including one sawmill which was not operational for a period of approximately six weeks. Pacific Lumber maintains insurance coverage with respect to damage to its property and the disruption of its business from earthquakes. Consistent with its past practices and the owners of most other timber tracts in the United States, Pacific Lumber does not maintain earthquake or fire insurance in respect of standing timber. PRODUCTS Lumber Pacific Lumber primarily produces and markets lumber. In 1993, Pacific Lumber sold approximately 240 million board feet of lumber, which accounted for approximately 82% of Pacific Lumber's total revenues. Lumber products vary greatly by the species and quality of the timber from which it is produced. Lumber is sold not only by grade (such as "upper" grade versus "common" grade), but also by board size and the drying process associated with the lumber. Redwood lumber is Pacific Lumber's largest product category, constituting approximately 81% of Pacific Lumber's total lumber revenues and 67% of Pacific Lumber's total revenues in 1993. Redwood is commercially grown only along the northern coast of California and possesses certain unique characteristics which permit it to be sold at a premium to many other wood products. Such characteristics include its natural beauty, superior ability to retain paint and other finishes, dimensional stability and innate resistance to decay, insects and chemicals. Typical applications include exterior siding, trim and fascia for both residential and commercial construction, outdoor furniture, decks, planters, retaining walls and other specialty applications. Redwood also has a variety of industrial applications because of its chemical resistance and because it does not impart any taste or odor to liquids or solids. Upper grade redwood lumber, which is derived primarily from old growth trees and is characterized by an absence of knots and other defects and a very fine grain, is used primarily in more costly and distinctive interior and exterior applications. During 1993, upper grade redwood lumber products accounted for approximately 25% of Pacific Lumber's total lumber production volume (on a net board foot basis), 49% of its total lumber revenues and 40% of its total revenues. Common grade redwood lumber, Pacific Lumber's largest volume product, has many of the same aesthetic and structural qualities of redwood uppers, but has some knots, sapwood and a coarser grain. Such lumber is commonly used for construction purposes, including outdoor structures such as decks, hot tubs and fencing. In 1993, common grade redwood lumber accounted for approximately 48% of Pacific Lumber's total lumber production volume (on a net board foot basis), 32% of its total lumber revenues and 26% of its total revenues. Douglas-fir lumber is used primarily for new construction and some decorative purposes and is widely recognized for its strength, hard surface and attractive appearance. Douglas-fir is grown commercially along the west coast of North America and in Chile and New Zealand. Upper grade Douglas-fir lumber is derived primarily from old growth Douglas-fir timber and is used principally in finished carpentry applications. In 1993, upper grade Douglas-fir lumber accounted for approximately 5% of Pacific Lumber's total lumber production volume (on a net board foot basis), 8% of its total lumber revenues and 6% of its total revenues. Common grade Douglas-fir lumber is used for a variety of general construction purposes and is largely interchangeable with common grades of other whitewood lumber. In 1993, common grade Douglas-fir lumber accounted for approximately 22% of Pacific Lumber's total lumber production volume, 11% of its total lumber revenues and 9% of its total revenues. Logs Pacific Lumber currently sells certain logs that, due to their size or quality, cannot be efficiently processed by its mills into lumber. The purchasers of these logs are largely Britt, and surrounding mills which do not own sufficient timberlands to support their mill operations. In 1993, log sales accounted for approximately 10% of Pacific Lumber's total revenues. See "--Relationships with SPHC and Britt Lumber" below. Except for the agreement with Britt described below, Pacific Lumber does not have a significant contractual relationships with any third parties relating to the purchase of logs. Pacific Lumber has historically not purchased significant quantities of logs from third parties; however, Pacific Lumber may from time to time purchase logs from third parties for processing in its mills or for resale to third parties if, in the opinion of management, economic factors are advantageous to the Company. See also Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations--Results of Operations--Operating Income" for a description of 1993 log purchases by Pacific Lumber due to inclement weather conditions. Wood Chips In 1990, Pacific Lumber installed a whole-log chipper to produce wood chips from hardwood trees which were previously left as waste. These chips primarily are sold to third parties for the production of facsimile and other specialty papers. In 1993, hardwood chips accounted for approximately 3% of Pacific Lumber's total revenues. Pacific Lumber also produces softwood chips from the wood residue and waste from its milling and finishing operations. These chips are sold to third parties for the production of wood pulp and paper products. In 1993, softwood chips accounted for approximately 3% of Pacific Lumber's total revenues. BACKLOG AND SEASONALITY Pacific Lumber's backlog of sales orders at December 31, 1993 and 1992 was approximately $16.0 million and $15.4 million, respectively, the substantial portion of which was delivered in the first quarter of the succeeding fiscal year. Pacific Lumber has historically experienced lower first and fourth quarter sales due largely to the general decline in construction-related activity during the winter months. As a result, Pacific Lumber's results in any one quarter are not necessarily indicative of results to be expected for the full year. MARKETING The housing, construction and remodeling markets are the primary markets for Pacific Lumber's lumber products. Pacific Lumber's policy is to maintain a wide distribution of its products both geographically and in terms of the number of customers. Pacific Lumber sells its lumber products throughout the country to a variety of accounts, the large majority of which are wholesalers, followed by retailers, industrial users, exporters and manufacturers. Upper grades of redwood and Douglas-fir lumber are sold throughout the entire United States, as well as to export markets. Common grades of redwood lumber are sold principally west of the Mississippi river, with California accounting for approximately 60% of these sales in 1993. Common grades of Douglas-fir lumber are sold primarily in California. In 1993, no single customer accounted for more than 6% of Pacific Lumber's total revenues. Exports of lumber accounted for approximately 4% of Pacific Lumber's total lumber revenues in 1993. Pacific Lumber markets its products through its own sales staff which focuses primarily on domestic sales. Pacific Lumber actively follows trends in the housing, construction and remodeling markets in order to maintain an appropriate level of inventory and assortment of product. Due to its high quality products, large inventory, competitive prices and long history, Pacific Lumber believes that it has a strong degree of customer loyalty. COMPETITION Pacific Lumber's lumber is sold in highly competitive markets. Competition is generally based upon a combination of price, service and product quality. Pacific Lumber's products compete not only with other wood products but with metals, masonry, plastic and other construction materials made from non-renewable resources. The level of demand for Pacific Lumber's products is dependent on such broad factors as overall economic conditions, interest rates and demographic trends. In addition, competitive considerations, such as total industry production and competitors' pricing, as well as the price of other construction products, affect the sales prices for Pacific Lumber's lumber products. Pacific Lumber currently enjoys a competitive advantage in the upper grade redwood lumber market due to the quality of its timber holdings and relatively low cost production operations. Competition in the common grade redwood and Douglas-fir lumber market is more intense, and Pacific Lumber competes with numerous large and small lumber producers. EMPLOYEES As of March 1, 1994, Pacific Lumber had approximately 1,200 employees. RELATIONSHIPS WITH SPHC AND BRITT LUMBER On the Closing Date, Pacific Lumber and SPHC entered into a Services Agreement (the "Services Agreement") and an Additional Services Agreement (the "Additional Services Agreement"). Pursuant to the Services Agreement, Pacific Lumber provides operational, management and related services with respect to the Subject Timberlands containing timber of SPHC ("SPHC Timber") not performed by SPHC's own employees. Such services include the furnishing of all equipment, personnel and expertise not within the SPHC's possession and reasonably necessary for the operation and maintenance of the Subject Timberlands containing the SPHC Timber. In particular, Pacific Lumber is required to regenerate SPHC Timber, prevent and control loss of the SPHC Timber by fires, maintain a system of roads throughout the Subject Timberlands, take measures to control the spread of disease and insect infestation affecting the SPHC Timber and comply with environmental laws and regulations, including measures with respect to waterways, habitat, hatcheries and endangered species. Pacific Lumber also is required (to the extent necessary) to assist SPHC personnel in updating the GIS and to prepare and file, on SPHC's behalf, all pleadings and motions and otherwise diligently pursue appeals of any denial of any THP and related matters. As compensation for these and the other services to be provided by Pacific Lumber, SPHC pays a fee which is adjusted on January 1 of each year based on a specified government index relating to wood products. The fee was $100,000 per month in 1993 and is expected to be approximately $114,000 per month in 1994. Pursuant to the Additional Services Agreement, SPHC provides Pacific Lumber with a variety of services, including (a) assisting Pacific Lumber to operate, maintain and harvest its own timber properties, (b) updating and providing access to the GIS with respect to information concerning Pacific Lumber's own timber properties, and (c) assisting Pacific Lumber with its statutory and regulatory compliance. Pacific Lumber pays SPHC a fee for such services equal to the actual cost of providing such services, as determined in accordance with generally accepted accounting principles. Pacific Lumber and SPHC also entered into the Master Purchase Agreement on the Closing Date. The Master Purchase Agreement governs all purchases of logs by the Company from SPHC. Each purchase of logs by Pacific Lumber from SPHC is made pursuant to a separate log purchase agreement (which incorporates the terms of the Master Purchase Agreement) for the SPHC Timber covered by an approved THP. Each log purchase agreement generally constitutes an exclusive agreement with respect to the timber covered thereby, subject to certain limited exceptions. The purchase price must be at least equal to the SBE Price (as defined below). The Master Purchase Agreement provides that if the purchase price equals or exceeds (i) the price for such species and category thereof set forth on the structuring schedule applicable to the Timber Notes, and (ii) the SBE Price, then such price shall be deemed to be the fair market value of such logs. The Master Purchase Agreement defines the "SBE Price," for any species and category of timber, as the stumpage price for such species and category as set forth in the most recent "Harvest Value Schedule" published by the California State Board of Equalization applicable to the timber sold during the period covered by such Harvest Value Schedule. Such Harvest Value Schedules are published for purposes of computing yield taxes and generally are established every six months. As Pacific Lumber purchases logs from SPHC pursuant to the Master Purchase Agreement, Pacific Lumber is responsible, at its own expense, for harvesting and removing the standing SPHC Timber covered by approved THPs and, thus, the purchase price thereof is based upon "stumpage prices." Title to the harvested logs does not pass to Pacific Lumber until the logs are transported to Pacific Lumber's log decks and measured. Substantially all of SPHC's revenues are derived from the sale of logs to Pacific Lumber under the Master Purchase Agreement. In connection with the Transfer, Pacific Lumber, SPHC and Salmon Creek also entered into a Reciprocal Rights Agreement granting to each other certain reciprocal rights of egress and ingress through their respective properties in connection with the operation and maintenance of such properties and their respective businesses. In addition, on the Closing Date, Pacific Lumber entered into an Environmental Indemnification Agreement with SPHC pursuant to which Pacific Lumber agreed to indemnify SPHC from and against certain present and future liabilities arising with respect to hazardous materials, hazardous materials contamination or disposal sites, or under environmental laws with respect to the Subject Timberlands. On the Closing Date, Pacific Lumber entered into an agreement with Britt which governs the sale of logs by Pacific Lumber and Britt to each other, the sale of hog fuel (wood residue) by Britt to Pacific Lumber for use in Pacific Lumber's cogeneration plant, the sale of lumber by Pacific Lumber and Britt to each other, and the provision by Pacific Lumber of certain administrative services to Britt (including accounting, purchasing, data processing, safety and human resources services). The logs which Pacific Lumber sells to Britt and which are used in Britt's manufacturing operations are sold at approximately 75% of applicable SBE prices (to reflect the lower quality of these logs). Logs which either Pacific Lumber or Britt purchases from third parties and which are then sold to each other are transferred at the actual cost of such logs. Hog fuel is sold at applicable market prices, and administrative services are provided by Pacific Lumber based on Pacific Lumber's actual costs and an allocable share of Pacific Lumber's overhead expenses consistent with past practice. BRITT LUMBER OPERATIONS BUSINESS Britt is located in Arcata, California, approximately 45 miles north of Pacific Lumber's headquarters. Britt's primary business is the processing of small diameter redwood logs into wood fencing products for sale to retail and wholesale customers. Britt was incorporated in 1965 and operated as an independent manufacturer of fence products until July 1990, when it was purchased by a subsidiary of the Company. Britt purchases small diameter (6 to 14 inch) and short length (6 to 12 feet) redwood logs from Pacific Lumber and a variety of different diameter and different length logs from various timberland owners. Britt processes logs at its mill into a variety of different fencing products, including "dog-eared" 1" to 6" fence stock in six and eight foot lengths, 4" x 4" fence posts in 6 through 12 foot lengths, and other fencing products in 6 through 12 foot lengths. Britt's purchases of logs from third parties are generally consummated pursuant to short-term contracts of twelve months or less. See "--Pacific Lumber Operations--Relationships with SPHC and Britt Lumber" for a description of Britt's log purchases from Pacific Lumber. MARKETING In 1993, Britt sold approximately 73 million board feet of lumber products to approximately 90 different customers, compared to 1992 sales of approximately 68 million board feet of lumber products to approximately 100 customers. In both years, over one-half of its sales were in northern California. The remainder of its 1993 and 1992 sales were in southern California, Arizona, Colorado, Hawaii and Nevada. The largest and top five of such customers accounted for approximately 33% and 46%, respectively, of such 1993 sales and 33% and 80%, respectively, of 1992 sales. Britt markets its products through its own sales person to a variety of customers, including distribution centers, industrial remanufacturers, wholesalers and retailers. FACILITIES AND EMPLOYEES Britt's manufacturing operations are conducted on 12 acres of land, 10 acres of which are leased on a long-term fixed-price basis from an unrelated third party. Fence production is conducted in a 46,000 square foot mill. An 18 acre log sorting and storage yard is located 1/4 mile away. The mill was constructed in 1980, and capital expenditures to enhance its output and efficiency are made on a yearly basis. Britt's (single shift) mill capacity, assuming 40 production hours per week, is estimated at 40.3 million board feet of fencing products per year. As of March 1, 1994, Britt employed approximately 100 people. COMPETITION Management estimates that Britt accounted for approximately 24% of the redwood fence market in 1993 in competition with the northern California mills of Louisiana Pacific and Georgia Pacific. REGULATORY AND ENVIRONMENTAL FACTORS Regulatory and environmental issues play a significant role in Pacific Lumber's forest products operations. Pacific Lumber's forest products operations are subject to a variety of California, and in some cases, federal laws and regulations dealing with timber harvesting, endangered species, and air and water quality. These laws include the California Forest Practice Act (the "Forest Practice Act"), which requires that timber harvesting operations be conducted in accordance with detailed requirements set forth in the Forest Practice Act and in the regulations promulgated thereunder by the California Board of Forestry (the "BOF"). The federal Endangered Species Act (the "ESA") and the California Endangered Species Act (the "CESA") provide in general for the protection and conservation of specifically listed fish, wildlife and plants which have been declared to be endangered or threatened. The California Environmental Quality Act ("CEQA") provides, in general, for protection of the environment of the state, including protection of air and water quality and of fish and wildlife. In addition, the California Water Quality Act requires, in part, that Pacific Lumber's operations be conducted so as to reasonably protect the water quality of nearby rivers and streams. Pacific Lumber does not expect that compliance with such existing laws and regulations will have a material adverse effect on its timber harvesting practices or future operating results. There can be no assurance, however, that future legislation, governmental regulations or judicial or administrative decisions would not adversely affect Pacific Lumber. Additional BOF regulations (i.e., late succession forest stand rules and sensitive watershed rules) went into effect March 1, 1994. These new regulations require, among other things, the inclusion of more information in THPs (concerning, among other things, timber generation systems, the presence or absence of fish, wildlife and plant species, and potentially impacted watersheds) and modification of certain timber harvesting practices to comply with the new regulations. In early March 1994, the BOF also approved silviculture with sustained yield rules. The Office of Administrative Law (the "OAL") is expected to (i) approve these proposed regulations, (ii) request additional review, information or action and resubmittal to the OAL, or (iii) reject the proposed regulations. These proposed regulations are scheduled to become effective on May 1, 1994, and if approved, will require additional information to be included in THPs (concerning, among other things, compliance with long-term sustained yield objectives) and modifications of certain timber harvesting practices (including the creation of buffer zones between harvest areas and increases in the amount of timber required to be retained in a harvest area). Various groups and individuals have filed objections with the CDF regarding the CDF's actions and rulings with respect to certain of Pacific Lumber's THPs, and the Company expects that such groups and individuals will continue to file objections to certain of Pacific Lumber's THPs. In addition, lawsuits are pending which seek to prevent Pacific Lumber from implementing certain of its approved THPs. These challenges have severely restricted Pacific Lumber's ability to harvest virgin old growth timber on its property during the past few years. To date, litigation with respect to Pacific Lumber's THPs relating to young growth and residual old growth timber has been limited; however, no assurance can be given as to the extent of such litigation in the future. See Item 3. "Legal Proceedings--Pacific Lumber Environmental Litigation." In June 1990, the U.S. Fish and Wildlife Service (the "USFWS") designated the northern spotted owl as threatened under the ESA. The State of California also has adopted regulations designed to protect the northern spotted owl, although the northern spotted owl has not been listed as threatened or endangered under the CESA. The owl's range includes all of Pacific Lumber's timberlands. The ESA and its implementing regulations generally prohibit harvesting operations in which individual owls might be killed, displaced or injured or which result in significant habitat modification that could impair the survival of individual owls or the species as a whole. Since 1988, biologists have conducted inventory and habitat utilization studies of northern spotted owls on Pacific Lumber's timberlands. The USFWS has given its full concurrence to a northern spotted owl management plan (the "Owl Plan"), a comprehensive wildlife management plan submitted by Pacific Lumber with respect to the northern spotted owl. Pacific Lumber incorporates this plan into each THP filed with the CDF and is no longer required to receive individual approval of its northern spotted owl conservation practices in connection with each THP it submits. The Owl Plan enables Pacific Lumber to expedite the approval process with respect to its THPs. Both federal and state agencies continue to review and consider possible additional regulations regarding the northern spotted owl. It is uncertain if such additional regulations will become effective or their ultimate content. On March 12, 1992, the marbled murrelet was approved for listing as endangered under the CESA. Pacific Lumber has incorporated, and will continue to incorporate, additional mitigation measures into its THPs to protect and maintain habitat for marbled murrelets on its timberlands. The California Department of Fish and Game (the "CDFG") requires Pacific Lumber to conduct pre-harvest marbled murrelet surveys and to provide certain other site specific mitigations in connection with its THPs covering virgin old growth timber and unusually dense stands of residual old growth timber. Such surveys can only be conducted during April to July, the murrelets' nesting and breeding season. Accordingly, such surveys are expected to delay the approval process with respect to certain of the THPs filed by Pacific Lumber. The results of such surveys could prevent Pacific Lumber from conducting certain of its harvesting operations. In October 1992, the USFWS issued its final rule listing the marbled murrelet as a threatened species under the ESA in the tri-state area of Washington, Oregon and California. In January 1994, the USFWS proposed designation of critical habitat for the marbled murrelet under the ESA. This proposal is subject to public comment, hearings and possible future modification. Both federal and state agencies continue to review and consider possible additional regulations regarding the marbled murrelet. It is uncertain if such additional regulations will become effective or their ultimate content. Pacific Lumber's wildlife biologist is conducting research concerning the marbled murrelet on Pacific Lumber's timberlands and is currently developing a comprehensive management plan for the marbled murrelet (the "Murrelet Plan") similar to the Owl Plan. Pacific Lumber is continuing to work with the USFWS and the other government agencies on the Murrelet Plan. It is uncertain when the Murrelet Plan will be completed and approved. In October 1993, the USFWS received a petition proposing listing the coho salmon (which is found on Pacific Lumber's property) as threatened or endangered. Laws and regulations dealing with Pacific Lumber's operations are subject to change and new laws and regulations are frequently introduced concerning the California timber industry. A variety of bills are currently pending in the California legislature and the U.S. Congress which relate to the business of Pacific Lumber, including the protection and acquisition of old growth and other timberlands, endangered species, environmental protection and the restriction, regulation and administration of timber harvesting practices. For example, the U.S. Congressman for the congressional district in which Pacific Lumber is located has introduced a bill which would, among other things, incorporate within the boundaries of an existing national forest approximately 42,000 acres of Pacific Lumber's timberlands and would designate approximately 12,000 acres of Pacific Lumber's timberlands to be studied for possible inclusion within such national forest. Corresponding legislation has been introduced in the California legislature. These 54,000 acres constitute approximately 30% of Pacific Lumber's timberlands. Since this and the other bills are subject to amendment, it is premature to assess the ultimate content of these bills, the likelihood of any of the bills passing, or the impact of any of these bills on the financial position or results of operations of the Company. Furthermore, any bills which are passed are subject to executive veto and court challenge. In addition to existing and possible new or modified statutory enactments, regulatory requirements, administrative and legal actions, the California timber industry remains subject to potential California or local ballot initiatives and evolving federal and California case law which could affect timber harvesting practices. It is, however, impossible to assess the effect of such matters on the future operating results or consolidated financial position of the Company. ITEM 2.		ITEM 2. PROPERTIES A description of the Company's properties is included under Item 1 above ITEM 3.	ITEM 3. LEGAL PROCEEDINGS PACIFIC LUMBER MERGER LITIGATION During the mid-to-late 1980's, Pacific Lumber was named as defendant along with several other entities and individuals, including MAXXAM and MGI, in various class, derivative and other actions brought in the Superior Court of Humboldt County by former stockholders of Pacific Lumber relating to the cash tender offer (the "Tender Offer") for the shares of Pacific Lumber by a subsidiary of MGI and the subsequent merger (the "Merger"), as a result of which Pacific Lumber became a wholly-owned subsidiary of MGI (the "Humboldt County Lawsuits"). The Humboldt County Lawsuits which remain open are captioned: Fries, et al. v. Carpenter, et al. (No. 76328) ("Fries State"); Omicini, et al. v. The Pacific Lumber Company, et al. (No. 76974) ("Omicini"); Thompson, et al. v. Elam, et al. (No. 78467) ("Thompson State"); and Russ, et al. v. Milken, et al. (No. DR-85429) ("Russ"). The Humboldt County Lawsuits generally allege, among other things, that in documents filed with the Securities and Exchange Commission (the "Commission"), the defendants made false statements concerning, among other things, the estimated value of Pacific Lumber's assets, financing for the Tender Offer and the Merger and minority stockholders' appraisal rights, and that the individual directors of Pacific Lumber breached certain fiduciary duties owed stockholders and other constituencies of Pacific Lumber. MGI and MAXXAM are alleged to have aided and abetted these violations and committed other wrongs. The Thompson State, Omicini and Fries State suits seek compensatory damages in excess of $1 billion, exemplary damages in excess of $750 million, rescission and other relief. The Russ suit does not specify the amount of damages sought. There has been no activity in the Fries State case since 1987 nor in the Omicini case since 1986. The Thompson State and Russ actions are stayed pending the outcome of the In re Ivan F. Boesky Multidistrict Securities Litigation described below. In 1988, the plaintiffs in the Fries State action filed another action entitled Fries, et al. v. Hurwitz, et al. (No. 88-3493 RMT), in United States District Court, Central District of California ("Fries Federal") against Pacific Lumber, MGI, MAXXAM and others. Fries Federal repeats many of the allegations and seeks damages and relief similar to that contained in the Humboldt County Lawsuits, and, among other things, asserts that the defendants violated RICO and the Hart-Scott-Rodino Antitrust Improvements Act, and further alleges that, as a result of alleged arrangements between Ivan F. Boesky and others, MGI beneficially owned, for purposes of Pacific Lumber's bylaws, more than 5% of Pacific Lumber's outstanding shares so that the Merger required the approval of 80% of the outstanding shares rather than a majority. In 1988, plaintiffs in the Thompson State action and others filed a complaint in the United States District Court, Central District of California, entitled Thompson, et al. v. MAXXAM Group Inc., et al. (No. 88-06274) ("Thompson Federal"). The defendants in the Thompson Federal action include Pacific Lumber, MGI, MAXXAM and others. This action, as amended, repeats the allegations, asserts claims and seeks damages and relief similar to that contained in the Fries Federal and Fries State actions. In May 1989, the Thompson Federal and Fries Federal actions were consolidated in the In re Ivan F. Boesky Multidistrict Securities Litigation in the United States District Court, Southern District of New York (MDL No. 732 M 21-45-MP) ("Boesky"). An additional action filed in November 1989, entitled American Red Cross, et al. v. Hurwitz, et al. (No. 89 Civ 7722) ("American Red Cross"), has been consolidated with the Boesky action. The American Red Cross action contains allegations and seeks damages and relief similar to that contained in the Russ, Thompson Federal and Fries Federal actions. In September 1990, the Court in the Boesky action certified a class of plaintiffs comprised of persons who sold their shares in Pacific Lumber on or after September 27, 1985. Various plaintiffs in the Boesky action have opted out of the certified class of plaintiffs and are prosecuting their claims individually within the Boesky proceeding. The Boesky action has been set for trial commencing April 11, 1994. In September 1989, seven past and present employees of Pacific Lumber brought an action against Pacific Lumber, MAXXAM, MGI, certain current and former directors and officers of Pacific Lumber, MAXXAM and MGI, and First Executive Life Insurance Company ("First Executive") (subsequently dismissed as a defendant) in the United States District Court, Northern District of California, entitled Kayes, et al. v. Pacific Lumber Company, et al. (No. C89-3500) ("Kayes"). Plaintiffs purport to be participants in or beneficiaries of Pacific Lumber's former Retirement Plan (the "Retirement Plan") for whom a group annuity contract was purchased from Executive Life Insurance Company ("Executive Life") in 1986 after termination of the Retirement Plan. The Kayes action alleges that the Pacific Lumber, MAXXAM and MGI defendants breached their ERISA fiduciary duties to participants and beneficiaries of the Retirement Plan by purchasing the group annuity contract from First Executive and selecting First Executive to administer the annuity payments. Plaintiffs seek, among other things, a new group annuity contract on behalf of the Retirement Plan participants and beneficiaries. This case was dismissed on April 14, 1993 and was refiled as Jack Miller, et al. v. Pacific Lumber Company, et al. (No. C-89- 3500-SBA) ("Miller") on April 26, 1993; the Miller case was dismissed on May 14, 1993. These dismissals have been appealed. On October 28, 1993, a bill amending ERISA, was passed by the U.S. Senate which appears to be intended, in part, to overturn the District Court's dismissal of the Miller action and to make available certain remedies. This bill has not been voted upon by the House of Representatives. It is impossible to say if the bill will be enacted or if enacted its ultimate content. In June 1991, the U.S. Department of Labor filed a civil action entitled Lynn Martin, Secretary of the U.S. Department of Labor v. The Pacific Lumber Company, et al. (No. 91-1812-RHS) ("DOL civil action") in the United States District Court, Northern District of California, against Pacific Lumber, MAXXAM, MGI and certain of their current and former officers and directors. The allegations in the DOL civil action are substantially similar to that in the Kayes action. The DOL civil action has been stayed pending resolution of the Kayes and Miller appeals. Management is of the opinion that the outcome of the foregoing litigation is unlikely to have a material adverse effect on the Company's consolidated financial position. Management is unable to express an opinion as to whether the outcome of such litigation is unlikely to have a material adverse effect on the Company's results of operations in respect of any fiscal year. In April 1991, the California Commissioner of Insurance (the "Commissioner") filed for conservatorship of Executive Life in Los Angeles County Superior Court in proceedings entitled Insurance Commissioner of the State of California v. Executive Life Insurance Co. and Does 1-1000 (Case No. BS006912) ("Executive Life Conservatorship"). In September 1993, the final rehabilitation plan for Executive Life (the "Plan") was closed. The Commissioner expects that for nearly all policyholders who chose to remain with Aurora National Life Assurance Corporation, the new owner and successor of Executive Life ("Aurora"), such persons will receive full payments. Policyholders who chose to "opt-out" of the Plan (i.e., chose to terminate their policy and cash in at a discounted rate), will be paid in accordance with their choice to opt-out. PACIFIC LUMBER ENVIRONMENTAL LITIGATION Various actions, similar to each other, have been filed against Pacific Lumber, MAXXAM, MGI, various state officials and others, alleging, among other things, violations of the Forest Practices Act, the CEQA, ESA, CESA, and/or related regulations. These actions seek to prevent Pacific Lumber from harvesting certain of its THPs. The Sierra Club, et al. v. State Board of Forestry, et al. (No. 82371) action in Superior Court of Humboldt County, filed by the Sierra Club and the Environmental Protection Information Center ("EPIC") in 1988, relates to two THPs for approximately 82 and 237 acres, respectively, of Pacific Lumber's virgin old growth timber. On appeal, the Court of Appeal overturned the Superior Court's decision upholding the BOF's approval of the two THPs. Pacific Lumber appealed the Court of Appeal decision and in June 1992 the California Supreme Court granted Pacific Lumber's petition for review. This matter is still pending before the California Supreme Court. Harvesting has been stayed pending outcome of the appeal. The Sierra Club, et al. v. The California Department of Forestry, et al. (No. 82983) and Sierra Club, et al. v. The California Department of Forestry, et al. (No. 83428) actions in the Superior Court of Humboldt County, each filed by the Sierra Club and EPIC in 1988, relate to two THPs for approximately 230 and 226 acres, respectively, of virgin old growth timber. Initially, the Superior Court ruled in favor of Pacific Lumber and dismissed these cases. After plaintiffs' appeal, the cases were remanded to Superior Court for trial. On remand, the decision of the Superior Court in each action prevented Pacific Lumber from harvesting the contested THP. Both decisions were appealed to the Court of Appeal, which in December 1993, affirmed the trial court's judgments reversing the approval of the THPs. In February 1994, Pacific Lumber sought review of this case by the California Supreme Court. In March 1994, the California Supreme Court affirmed the decision of the Court of Appeal, but ordered the decision of the Court of Appeal depublished, rendering it without precedential value. The Sierra Club, et al. v. The California Department of Forestry, et al. (No. DR84664) action in the Superior Court of Humboldt County, filed by the Sierra Club and EPIC in 1989, seeks substantially the same relief requested in the Sierra Club action No. 83428 cited above. After the Superior Court dismissed this action and imposed sanctions on plaintiffs based on the pending resolution of Sierra Club III, the plaintiffs appealed the sanction decision. The Court of Appeal remanded the action back to the Superior Court for further review. The EPIC v. The California Department of Forestry, et al. (No. 90CP0341) action in Superior Court of Humboldt County, filed by EPIC in May 1990, relates to a THP for approximately 378 acres of virgin old growth timber. A nearly identical action in Superior Court of Humboldt County, entitled Sierra Club v. The California Department of Forestry, et al. (No. 90CP0405), was brought by the Sierra Club in June 1990. These actions were subsequently consolidated and after a trial on the merits, the Superior Court in June 1992 issued its judgment in favor of Pacific Lumber and affirming the BOF's approval of this THP. The trial court's decision was appealed and the matter is still pending before the Court of Appeal. Except for certain previously felled trees, all timber harvesting operations have been stayed pending the outcome of the appeal. The EPIC, et al. v. California State Board of Forestry, et al. (No. 91CP244) action in the Superior Court of Humboldt County, filed by the Sierra Club and EPIC in 1991, relates to a THP for approximately 237 acres of virgin old growth timber ("THP 90-237"). After the Superior Court reversed the BOF's approval of this THP, certain modifications were made to the THP which was then unanimously approved by the BOF. The Superior Court later issued judgment in favor of Pacific Lumber. On appeal, the Court of Appeal in October 1993 affirmed the trial court's judgment approving THP 90-237. In April 1993, EPIC filed another action with respect to THP 90-237 entitled Marbled Murrelet, et al. v. Bruce Babbitt, Secretary, Department of Interior, et al. (No. C93-1400) in the U.S. District Court for the Northern District of California, alleging an unlawful "taking" of the marbled murrelet. The Court has dismissed the federal and state agency defendants and limited plaintiffs' claims against Pacific Lumber. In January 1994, plaintiffs appealed the dismissal of the state and federal defendants. Harvesting has been stayed pending outcome of the trial which is scheduled to commence in July 1994. The Lost Coast League v. The California Department of Forestry, et al. (No. 94DR0046) action in Superior Court of Humboldt County, filed in February 1994, relates to a THP for approximately 121 acres of primarily virgin old growth timber. On March 10, 1994, the Court heard plaintiff's request for a preliminary injunction, took the matter under submission, and issued a stay of timber harvesting while the Court reviews the matter. The Company's management believes that the matters described above are unlikely to have a material adverse effect on the Company's consolidated financial position or results of operations. See Item 1. "Business--Regulatory and Environmental Factors" above for a general description of regulatory and similar matters which could effect Pacific Lumber's timber harvesting practices and future operating results. Pacific Lumber is also involved as a plaintiff, directly and indirectly, in various legal proceedings relating to its timber harvesting operations. For example, Redwood Coast Watersheds Alliance v. California State Board of Forestry, et al. (No. 932123), in the Superior Court of San Francisco, California, challenges certain BOF regulations; Marbled Murrelet, et al. v. Bruce Babbitt, et al. (No. C92-522WDR), in the U.S. District Court for the Western District of Washington, challenges the USFWS's delay in listing as threatened, and designating critical habitat for, the marbled murrelet under the ESA; The Pacific Lumber Company v. California State Board of Forestry (No. 366197), in the Superior Court of Sacramento County, California, challenges the denial of two Pacific Lumber THPs for the harvest of approximately 558 acres of virgin old growth timber; The Pacific Lumber Company v. California Department of Fish & Game, et al. (No. 370562), in the Superior Court of Sacramento County, California, challenges the listing of the marbled murrelet as endangered under the CESA; Northwest Forest Resource Council, et al. v. Bruce Babbitt, et al. (No. 93-1579), in the U.S. District Court, District of Columbia, challenges the listing of the marbled murrelet as a threatened species under the ESA in the tri-state area of Washington, Oregon and California; and Sierra Club, et al. v. California State Board of Forestry, et al. (No. 95104), in the Superior Court of San Francisco County, California, challenges the approval of certain BOF regulations. ZERO COUPON NOTE LITIGATION In April 1989, an action was filed against the Company, MAXXAM, MPI and certain of MAXXAM's directors in the Court of Chancery of the State of Delaware, entitled Progressive United Corporation v. MAXXAM Inc., et al., Civil Action No. 10785. Plaintiff purports to bring this action as a stockholder of MAXXAM derivatively on behalf of MAXXAM and MPI. In May 1989, a second action containing substantially similar allegations was filed in the Court of Chancery of the State of Delaware, entitled Wolf v. Hurwitz, et al. (No. 10846) and the two cases were consolidated (collectively, the "Zero Coupon Note" actions). The Zero Coupon Note actions relate to a Put and Call Agreement between MPI and Mr. Charles Hurwitz (Chairman of the Board of the Company, MAXXAM and MPI), as well as a predecessor agreement (the "Prior Agreement"). Among other things, the Put and Call Agreement provided that Mr. Hurwitz had the option (the "Call") to purchase from MPI certain notes (or the common stock of MAXXAM into which they were converted) for $10.3 million. In July 1989, Mr. Hurwitz exercised the Call and acquired 990,400 shares of MAXXAM's common stock. The Zero Coupon Note actions generally allege that in entering into the Prior Agreement Mr. Hurwitz usurped a corporate opportunity belonging to MAXXAM, that the Put and Call Agreement constituted an alleged waste of corporate assets of MAXXAM and MPI, and that the defendant directors breached their fiduciary duties in connection with these matters. Plaintiffs seek to have the Put and Call Agreement declared null and void, among other remedies. OTHER LITIGATION MATTERS The Company and certain of its subsidiaries are also involved in other claims and litigation, both as plaintiffs and defendants, in the ordinary course of business. Management is of the opinion that the outcome of such other litigation will not have a material adverse effect upon the Company's consolidated financial position or results of operations. ITEM 4.	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. MAXXAM GROUP INC. PART II ITEM 5.	ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's common stock is held entirely by MAXXAM. Accordingly, the Company's common stock is not traded on any stock exchange and has no established public trading market. Provisions in the indenture governing the Notes contain certain restrictions on transactions with affiliates and the payment of dividends. As of December 31, 1993, no dividends may be paid by the Company. The Company declared and paid cash dividends on its common stock of $20.0 million and $110.9 million in 1993 and 1991, respectively. The MGI Notes are secured by the Company's pledge of 100% of the common stock of Pacific Lumber, Britt and MPI, and by a pledge of 28 million common shares of Kaiser that are owned by MAXXAM. See Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the Notes to the Consolidated Financial Statements appearing in Item 8. ITEM 6.	ITEM 6. SELECTED FINANCIAL DATA Not applicable. ITEM 7.	ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS As a result of the Forest Products Group Formation, the Company's financial statements have been restated to present the historical results of operations relating to the net assets transferred to MAXXAM pursuant to the Forest Products Group Formation. Such restatement has been made with respect to all periods presented in this Report in a manner similar to that which would be presented if the Company had discontinued the operations relating to such net assets. RESULTS OF OPERATIONS The following should be read in conjunction with the Company's Consolidated Financial Statements and the Notes thereto appearing in Item 8.	ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Stockholder and Board of Directors of MAXXAM Group Inc.: We have audited the accompanying consolidated balance sheets of MAXXAM Group Inc. (a Delaware corporation and a wholly owned subsidiary of MAXXAM Inc.) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, cash flows and stockholder's equity for each of the three years in the period ended December 31, 1993. 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 these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of MAXXAM Group Inc. and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As explained in Notes 7 and 8 to the financial statements, effective January 1, 1993, the Company changed its method of accounting for income taxes and postretirement benefits other than pensions. Our audits were made for the purpose of forming an opinion on the basic consolidated financial statements taken as a whole. The schedule listed in Item 14(a)(2) of this Form 10-K is presented for purposes of complying with the Securities and Exchange Commission's rules and is not part of the basic consolidated financial statements. This schedule has been subjected to the auditing procedures applied in the audits of the basic consolidated 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 consolidated financial statements taken as a whole. ARTHUR ANDERSEN & CO. Houston, Texas January 27, 1994 CONSOLIDATED BALANCE SHEET CONSOLIDATED STATEMENT OF OPERATIONS CONSOLIDATED STATEMENT OF CASH FLOWS CONSOLIDATED STATEMENT OF STOCKHOLDER'S EQUITY (DEFICIT) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (IN THOUSANDS OF DOLLARS, EXCEPT SHARE AMOUNTS) 1. BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION The consolidated financial statements include the accounts of MAXXAM Group Inc. ("MGI") and its subsidiaries, collectively referred to herein as the "Company." The Company is a wholly owned subsidiary of MAXXAM Inc. ("MAXXAM"). The Company conducts its business primarily through the operations of its subsidiaries. Prior to the Forest Products Group Formation (as defined below), the Company operated in three industries: aluminum, through its majority owned subsidiary, Kaiser Aluminum Corporation ("Kaiser"), a fully integrated aluminum producer; forest products, through The Pacific Lumber Company ("Pacific Lumber") and Britt Lumber Co., Inc. ("Britt"), each a wholly owned subsidiary; and real estate management and development, through the Palmas del Mar development located in Puerto Rico ("Palmas") which was owned by the Company's subsidiary, MAXXAM Properties Inc. ("MPI"). On August 4, 1993, contemporaneously with the consummation of the sale of the Notes (as defined in Note 6), the Company (i) transferred to MAXXAM 50 million common shares of Kaiser held by a subsidiary of the Company, representing the Company's (and MAXXAM's) entire interest in Kaiser's common stock, (ii) transferred to MAXXAM 60,075 shares of MAXXAM common stock held by a subsidiary of the Company, (iii) transferred to MAXXAM certain notes receivable, long-term investments, and other assets, each net of related liabilities, collectively having a carrying value to the Company of approximately $1,100 and (iv) exchanged with MAXXAM 2,132,950 Depositary Shares, acquired from Kaiser on June 30, 1993 for $15,000, such exchange being in satisfaction of a $15,000 promissory note evidencing a cash loan made by MAXXAM to the Company in January 1993. On the same day, MAXXAM assumed approximately $17,500 of certain liabilities of the Company that were unrelated to the Company's forest products operations or were related to operations which have been disposed of by the Company. Additionally, on September 28, 1993, the Company transferred to MAXXAM its interest in Palmas. The foregoing transactions are collectively referred to as the "Forest Products Group Formation." As a result of the Forest Products Group Formation, the Company restated its Consolidated Financial Statements to present the net assets transferred to MAXXAM pursuant to the Forest Products Group Formation (including certain allocated costs from MAXXAM for general and administrative expenses unrelated to the Company's forest products operations). Such restatement has been made with respect to all periods presented in a manner similar to that which would have been presented if the Company had discontinued the operations relating to such net assets. See Note 2. As a result of the Forest Products Group Formation, the Company's business is substantially limited to forest products operations which consists of 100% of the outstanding common stock of Pacific Lumber and 100% of the outstanding common stock of Britt. Pacific Lumber is engaged in all principal aspects of the lumber industry, including the growing and harvesting of redwood and Douglas-fir timber, the milling of logs into lumber and the production of manufactured lumber products. Britt mills logs to produce a variety of fencing and decking products. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Cash Equivalents Cash equivalents consist of highly liquid money market instruments with original maturities of three months or less. The carrying amount of these instruments approximates fair value. Marketable Securities On December 31, 1993, the Company adopted Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities ("SFAS 115"). In accordance with the provisions of SFAS 115, marketable securities are carried at market value on December 31, 1993. Prior to that date, marketable securities portfolios were carried at the lower of cost or market at the balance sheet date. The cost of the securities sold is determined using the first-in, first-out method. Market values are determined based on quoted prices. The cost and market values of securities held at December 31, 1992 were $24,793 and $22,730, respectively. Included in investment, interest and other income for each of the three years ended December 31, 1993 were: 1993 - net realized gains of $3,510, the recovery of $2,063 of net unrealized losses and net unrealized gains of $841; 1992 - net realized losses of $5,003 and net unrealized losses of $371; and 1991 - net realized gains of $73 and the recovery of $367 of net unrealized losses. Net unrealized losses represent the amount required to reduce the short-term marketable securities portfolios from cost to market value prior to December 31, 1993. Inventories Inventories are stated at the lower of cost or market. Cost is primarily determined using the last-in, first-out (LIFO) method. Timber and Timberlands Depletion is computed utilizing the unit-of-production method based upon estimates of timber values and quantities. Property, Plant and Equipment Property, plant and equipment, including capitalized interest, is stated at cost, net of accumulated depreciation. Depreciation is computed utilizing the straight-line method at rates based upon the estimated useful lives of the various classes of assets. Deferred Financing Costs Costs incurred to obtain financing are deferred and amortized over the estimated term of the related borrowing. Restricted Cash and Concentrations of Credit Risk Restricted cash represents the amount initially deposited into an account (the "Liquidity Account") held by the trustee under the indenture governing the 7.95% Timber Collateralized Notes due 2015 (the "Timber Notes") as described in Note 6. The Liquidity Account is not available, except under certain limited circumstances, for working capital purposes; however, it is available to pay the Rated Amortization (as defined below) and interest on the Timber Notes if and to the extent that cash flows are insufficient to make such payments. The required Liquidity Account balance will generally decline as principal payments are made on the Timber Notes. The carrying amount of the Liquidity Account approximates its fair value. Investment, interest and other income includes approximately $2,101 attributable to an investment rate agreement (at 7.95% per annum) with the financial institution which holds the Liquidity Account. At December 31, 1993, the balance of the Liquidity Account is $33,562. At December 31, 1993, cash and cash equivalents includes $20,280 (the "Payment Account") which is reserved for debt service payments on the Timber Notes (see Note 6). The Payment Account and the Liquidity Account are each held by a different financial institution. In the event of nonperformance by such financial institutions, the Company's exposure to credit loss is represented by the amounts deposited plus any unpaid accrued interest thereon. The Company mitigates its concentrations of credit risk with respect to these restricted cash deposits by maintaining them at high credit quality financial institutions and monitoring the credit ratings of these institutions. Stockholder's Equity (Deficit) Adjustments to the Company's additional capital for the years ended December 31, 1993, 1992 and 1991 resulted from transactions relating to Kaiser's common stock prior to the Forest Products Group Formation. The transactions included Kaiser's 1991 initial public offering of 7.25 million shares for net proceeds of $93,216 and Kaiser's subsequent issuance of shares to certain members of its management pursuant to the terms of an amended compensation plan in 1992 and 1993 of 77,279 and 4,228 shares, respectively. As a result of these transactions, the Company's equity in Kaiser's net assets differed from the Company's historical cost. The Company accounted for these differences as adjustments to additional capital. Reclassifications Certain reclassifications have been made to prior years' financial statements to be consistent with the presentation in the current year. 2. NET ASSETS TRANSFERRED TO MAXXAM As a result of the Forest Products Group Formation (as described in Note 1), the Company transferred all of its interest in Kaiser's common stock, the assets and related liabilities of Palmas, and certain other net assets that were unrelated to the Company's forest products operations, to MAXXAM. The Company did not incur any gain or loss relating to the transfer of such assets and liabilities to MAXXAM. The net income (loss) from net assets transferred to MAXXAM are as follows: Net assets transferred to MAXXAM are as follows: 3. INVENTORIES Inventories consist of the following: During 1993, 1992 and 1991, Pacific Lumber's inventory quantities were reduced. These reductions resulted in the liquidation of Pacific Lumber's LIFO inventory quantities carried at prevailing costs from prior years which were higher than the current cost of inventory in 1993 and lower than current costs in 1992 and 1991. The effects of these inventory liquidations increased cost of goods sold by approximately $222 for the year ended December 31, 1993 and decreased cost of goods sold by approximately $372 and $3,286 for the years ended December 31, 1992 and 1991, respectively. 4. TIMBER AND TIMBERLANDS The following table presents the changes in timber and timberlands for the three years ended December 31, 1993. 5. PROPERTY, PLANT AND EQUIPMENT The major classes of property, plant and equipment are as follows: Depreciation expense for the years ended December 31, 1993, 1992 and 1991 was $8,670, $8,491 and $8,106, respectively. 6. LONG-TERM DEBT Long-term debt consists of the following: On March 23, 1993, Pacific Lumber issued $235,000 of 10 1/2% Senior Notes due 2003 (the "Pacific Lumber Senior Notes") and its newly-formed wholly owned subsidiary, Scotia Pacific Holding Company ("SPHC"), issued $385,000 of the Timber Notes. Pacific Lumber and SPHC used the net proceeds from the sale of the Pacific Lumber Senior Notes and the Timber Notes, together with Pacific Lumber's cash and marketable securities, to (i) retire (a) $163,784 aggregate principal amount of Pacific Lumber's 12% Series A Senior Notes due July 1, 1996 (the "Series A Notes"), (b) $299,725 aggregate principal amount of Pacific Lumber's 12.2% Series B Senior Notes due July 1, 1996 (the "Series B Notes") and (c) $41,750 aggregate principal amount of Pacific Lumber's 12 1/2% Senior Subordinated Debentures due July 1, 1998 (the "Debentures;" the Series A Notes, the Series B Notes and the Debentures are referred to collectively as the "Old Pacific Lumber Securities"); (ii) pay accrued interest on the Old Pacific Lumber Securities through the date of redemption thereof; (iii) pay the applicable redemption premiums on the Old Pacific Lumber Securities; (iv) repay Pacific Lumber's $28,867 cogeneration facility loan; (v) fund the initial deposit of $35,000 to the Liquidity Account; and (vi) pay a $25,000 dividend to a subsidiary of the Company. These transactions resulted in a pre-tax extraordinary loss of $16,368, consisting primarily of the payment of premiums and the write-off of unamortized deferred financing costs on the Old Pacific Lumber Securities. The indenture governing the Timber Notes (the "Timber Note Indenture") prohibits SPHC from incurring any additional indebtedness for borrowed money and limits the business activities of SPHC to the ownership and operation of its timber and timberlands. The Timber Notes are senior secured obligations of SPHC and are not obligations of, or guaranteed by, Pacific Lumber or any other person. The Timber Notes are secured by a lien on (i) SPHC's timber and timberlands, (ii) substantially all of SPHC's property and equipment, (iii) SPHC's contract rights and certain other assets and (iv) the funds deposited in the Payment Account and the Liquidity Account. The Timber Notes are structured to link, to the extent of cash available, the deemed depletion of SPHC's timber (through the harvest and sale of logs) to required amortization of the Timber Notes. The actual required amount of such amortization due on any Timber Note payment date is determined by various mathematical formulas set forth in the Timber Note Indenture. The minimum amount of principal which SPHC must pay (on a cumulative basis) through any Timber Note payment date in order to avoid an Event of Default (as defined in the Timber Note Indenture) is referred to as rated amortization ("Rated Amortization"). If all payments of principal are made in accordance with Rated Amortization, the payment date on which SPHC will pay the final installment of principal is July 20, 2015. The amount of principal which SPHC must pay through each Timber Note payment date in order to avoid payment of prepayment or deficiency premiums is referred to as scheduled amortization ("Scheduled Amortization"). If all payments of principal are made in accordance with Scheduled Amortization, the payment date on which SPHC will pay the final installment of principal is July 20, 2009. Substantially all of the Company's consolidated assets are owned by Pacific Lumber and a significant portion of Pacific Lumber's assets are owned by SPHC. The Company expects that Pacific Lumber will provide a major portion of the Company's future operating cash flow. Pacific Lumber is dependent upon SPHC for a significant portion of its operating cash flow. The holders of the Timber Notes have priority over the claims of creditors of Pacific Lumber with respect to the assets and cash flow of SPHC, and the holders of the Pacific Lumber Senior Notes have priority over the claims and creditors of the Company with respect to the assets and cash flows of Pacific Lumber. Under the terms of the Timber Note Indenture, SPHC will not have available cash for distribution to Pacific Lumber unless SPHC's cash flow from operations exceeds the amounts required by the Timber Note Indenture to be reserved for the payment of current debt service (including interest, principal and premiums) on the Timber Notes, capital expenditures and certain other operating expenses. Principal and interest on the Timber Notes is payable semi- annually on January 20 and July 20. The Timber Notes are redeemable at the option of SPHC, in whole but not in part, at any time. The redemption price of the Timber Notes is equal to the sum of the principal amount, accrued interest and a prepayment premium calculated based upon the yield of like term Treasury securities plus 50 basis points. Interest on the Pacific Lumber Senior Notes is payable semi- annually on March 1 and September 1. The Pacific Lumber Senior Notes are redeemable at the option of Pacific Lumber, in whole or in part, on or after March 1, 1998 at a price of 103% of the principal amount plus accrued interest. The redemption price is reduced annually until March 1, 2000, after which time the Pacific Lumber Senior Notes are redeemable at par. Pacific Lumber has a revolving credit agreement with a bank (the "Revolving Credit Agreement") which expires on May 31, 1996. Borrowings under the Revolving Credit Agreement are secured by Pacific Lumber's trade receivables and inventories, with interest computed at the bank's reference rate plus 1 1/2% or the bank's offshore rate plus 2 1/2%. The Revolving Credit Agreement provides for borrowings of up to $30,000, of which $15,000 may be used for standby letters of credit. As of December 31, 1993, $19,742 of borrowings was available under the Revolving Credit Agreement, of which $4,742 was available for letters of credit. No borrowings were outstanding as of December 31, 1993, and letters of credit outstanding amounted to $10,258. The indentures governing the Pacific Lumber Senior Notes and the Timber Notes and Pacific Lumber's Revolving Credit Agreement contain various covenants which, among other things, limit the payment of dividends and restrict transactions between Pacific Lumber and its affiliates. As of December 31, 1993, under the most restrictive of these covenants, approximately $5,731 of dividends could be paid by Pacific Lumber. On August 4, 1993, the Company issued $100,000 aggregate principal amount of 11 1/4% Senior Secured Notes due 2003 (the "MGI Senior Notes") and $126,720 aggregate principal amount (approximately $70,000 net of original issue discount) of 12 1/4% Senior Secured Discount Notes due 2003 (the "MGI Discount Notes", which, together with the MGI Senior Notes, are referred to collectively as the "MGI Notes"). The MGI Notes are secured by the Company's pledge of 100% of the common stock of Pacific Lumber, Britt and MPI, and by MAXXAM's pledge of 28 million shares of Kaiser's common stock it received as a result of the Forest Products Group Formation. The indenture governing the MGI Notes, among other things, restricts the ability of the Company to incur additional indebtedness, engage in transactions with affiliates, pay dividends and make investments. At December 31, 1993, under the most restrictive of these covenants, no dividends may be paid by the Company. The MGI Notes are senior indebtedness of the Company; however, they are effectively subordinate to the liabilities of the Company's subsidiaries, which includes the Timber Notes and the Pacific Lumber Senior Notes. The MGI Discount Notes are net of discount of $53,221 at December 31, 1993. The MGI Senior Notes will pay interest semiannually on February 1 and August 1 of each year beginning on February 1, 1994. The MGI Discount Notes will not pay any interest until February 1, 1999, at which time semiannual interest payments will become due on each February 1 and August 1 thereafter. The Company used a portion of the net proceeds from the sale of the MGI Notes to retire the entire outstanding balance of its 12 3/4% Notes at 101% of their principal amount, plus accrued interest through November 14, 1993. The Company used the remaining portion of the net proceeds from the sale of the MGI Notes, together with a portion of its existing cash resources, to pay a $20,000 dividend to MAXXAM. MAXXAM used such proceeds to redeem, on August 20, 1993, $20,000 aggregate principal amount of its 14% Senior Subordinated Reset Notes due 2000 at 100% of their principal amount plus accrued interest thereon. The Company incurred a pre-tax extraordinary loss associated with the early retirement of the 12 3/4% Notes of $9,677 consisting of net interest cost of $3,763, the write-off of $3,472 of unamortized deferred financing costs, a premium of $1,500 and the write-off of $942 of unamortized original issue discount. Repurchase of Debt During 1991, Pacific Lumber purchased $15,452 principal amount of its Series B Notes for $15,029. Cash flow from operations was used to repurchase the Series B Notes. Maturities The following table of scheduled maturities of long-term debt outstanding at December 31, 1993 reflects Scheduled Amortization with respect to the Timber Notes: Restricted Net Assets of Subsidiaries At December 31, 1993, certain debt instruments restricted the ability of Pacific Lumber to transfer assets, make loans and advances and pay dividends to the Company. The restricted net assets of Pacific Lumber totaled $20,000 at December 31, 1993. Fair Value The estimated fair value of the Company's long-term debt is determined based on the quoted market prices for the Timber Notes, the Pacific Lumber Senior Notes, the MGI Notes, the Old Pacific Lumber Securities and the 12 3/4% Notes, and on the current rates offered for borrowings similar to the other debt. At December 31, 1993 and 1992, the fair value of the Company's long-term debt is estimated to be $817,400 and $704,100, respectively. 7. CREDIT (PROVISION) IN LIEU OF INCOME TAXES The Company and its subsidiaries are members of MAXXAM's consolidated return group for federal income tax purposes. Prior to August 4, 1993, the Company and each of its subsidiaries computed their tax liabilities or tax benefits on a separate company basis (except as discussed in the following paragraph), in accordance with their respective tax allocation agreements with MAXXAM. Effective on March 23, 1993, MAXXAM, Pacific Lumber, SPHC and Salmon Creek Corporation ("Salmon Creek") entered into a tax allocation agreement that, among other things, amended the tax calculations with respect to Pacific Lumber (the "Amended PL Tax Allocation Agreement"). Under the terms of the Amended PL Tax Allocation Agreement, Pacific Lumber is liable to MAXXAM for the federal consolidated income tax liability of Pacific Lumber, SPHC and certain other subsidiaries of Pacific Lumber (but excluding Salmon Creek) (collectively, the "PL Subgroup") computed as if the PL Subgroup was a separate affiliated group of corporations which was never connected with MAXXAM. The Amended PL Tax Allocation Agreement further provides that Salmon Creek is liable to MAXXAM for its federal income tax liability computed on a separate company basis as if it was never connected with MAXXAM. The remaining subsidiaries of MGI are each liable to MAXXAM for their respective income tax liabilities computed on a separate company basis as if they were never connected with MAXXAM, pursuant to their respective tax allocation agreements. Effective on August 4, 1993, MGI amended its tax allocation agreement with MAXXAM (the "Amended Tax Allocation Agreement") to provide that the Company's federal income tax liability is computed as if MGI files a consolidated tax return with all of its subsidiaries except Salmon Creek, and that such corporations were never connected with MAXXAM (the "MGI Consolidated Tax Liability"). The federal income tax liability of MGI is the difference between (i) the MGI Consolidated Tax Liability and (ii) the sum of the separate tax liabilities for the Company's subsidiaries (computed as discussed above), but excluding Salmon Creek. To the extent that the MGI Consolidated Tax Liability is less than the aggregate amounts in (ii), MAXXAM is obligated to pay the amount of such difference to MGI. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes ("SFAS 109"). The adoption of SFAS 109 changes the Company's method of accounting for income taxes to an asset and liability approach from the deferral method prescribed by Accounting Principles Board Opinion No. 11, Accounting for Income Taxes ("APB 11"). The asset and liability approach requires the recognition of deferred income tax assets and liabilities for the expected future tax consequences of events that have been recognized in the Company's financial statements or tax returns. Under this method, deferred income tax assets and liabilities are determined based on the temporary differences between the financial statement and tax bases of assets and liabilities using enacted tax rates. The cumulative effect of the change in accounting principle, as of January 1, 1993, increased the Company's results of operations by $14,916. The implementation of SFAS 109 required the Company to restate certain assets and liabilities to their pre-tax amounts from their net-of-tax amounts originally recorded in connection with the acquisitions of Pacific Lumber in 1986 and Britt in 1990. The restatement of the assigned values with respect to assets and liabilities recorded as a result of the acquisitions and the recomputation of deferred income tax assets and liabilities under SFAS 109 resulted in: (i) a decrease of $8,128 in the net carrying value of timber and timberlands, (ii) an increase of $181 in the net carrying value of property, plant and equipment and (iii) an increase of $22,863 in net deferred income tax assets. As a result of restating these assets and liabilities, the loss from continuing operations before income taxes, extraordinary item and cumulative effect of changes in accounting principles for the year ended December 31, 1993 was decreased by $377. Concurrent with the adoption of SFAS 109, the Company implemented changes in its accounting method for postretirement benefits pursuant to Statement of Financial Accounting Standards No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions ("SFAS 106") (see Note 8). The pre-tax cumulative effect of the change in accounting principle relating to SFAS 106 was a charge of $3,914 and resulted in the recognition of deferred income tax assets of $1,566. The credit (provision) in lieu of income taxes on the loss from continuing operations before income taxes, extraordinary item and cumulative effect of changes in accounting principles consists of the following: The Omnibus Budget Reconciliation Act of 1993 (the "Act"), enacted on August 10, 1993, retroactively increased the maximum federal statutory income tax rate from 34% to 35% for periods beginning on or after January 1, 1993. The 1993 deferred federal credit in lieu of income taxes of $4,825 includes $2,601 for the benefit of operating loss carryforwards generated in 1993 and includes an $850 benefit for increasing net deferred income tax assets (liabilities) as of the date of enactment of the Act due to the increase in the federal statutory income tax rate. The deferred credit (provision) in lieu of income taxes results from the following timing differences for 1992 and 1991: A reconciliation between the credit (provision) in lieu of income taxes and the amount computed by applying the federal statutory income tax rate to the loss from continuing operations before income taxes, extraordinary item and cumulative effect of changes in accounting principles is as follows: The credit in lieu of income taxes as a percentage of the loss from continuing operations before income taxes, extraordinary item and cumulative effect of changes in accounting principles would have approximated the federal statutory rate had the Company computed the credit (provision) in lieu of income taxes for the year ended December 31, 1993 on a consolidated return basis. The Company would not have been able to record a credit in lieu of income taxes with respect to the losses from continuing operations computed on a consolidated return basis, for each of the years ended December 31, 1992 and 1991, due to the uncertainty of realizing any future tax benefit attributable to such losses pursuant to the provisions of APB 11. As shown in the Consolidated Statement of Operations for the year ended December 31, 1993, the Company reported an extraordinary loss related to the early extinguishment of debt. The Company reported the loss net of related deferred income taxes of $8,856 which approximated the federal statutory income tax rate in effect on the dates the transactions occurred. The related deferred income tax benefit recorded by the Company in respect of SFAS 106 was recorded at the federal and state statutory rates in effect on the date the accounting standard was adopted. After giving effect to the adoption of SFAS 109, the components of the Company's net deferred income tax assets (liabilities) are as follows: The valuation allowances listed above relate primarily to loss and credit carryforwards. As of December 31, 1993, approximately $36,443 of the net deferred income tax assets listed above relate to the excess of the tax basis over financial statement basis with respect to timber and timberlands. The Company believes that it is more likely than not that this net deferred income tax asset will be realized, based primarily upon the estimated value of its timber and timberlands which is well in excess of its tax basis. Also included in net deferred income tax assets as of December 31, 1993 is approximately $36,231 which relates to the benefit of loss and credit carryforwards, net of valuation allowances. The Company evaluated all appropriate factors to determine the proper valuation allowances for loss and credit carryforwards. These factors included any limitations concerning use of the carryforwards, the year the carryforwards expire and the levels of taxable income necessary for utilization. The Company has concluded that it will more likely than not generate sufficient taxable income to realize the benefit attributable to the loss and credit carryforwards for which valuation allowances were not provided. Included in the net deferred income tax assets listed above are $42,752 at December 31, 1993 and $23,519 at January 1, 1993 which are recorded pursuant to the tax allocation agreements with MAXXAM. The following table presents the estimated tax attributes for federal income tax purposes for the Company and its subsidiaries as of December 31, 1993, under the terms of the respective tax allocation agreements. The utilization of certain of these attributes are subject to limitations. 8. EMPLOYEE BENEFIT PLANS The Company has a defined benefit plan which covers all employees of Pacific Lumber. Under the plan, employees are eligible for benefits at age 65 or earlier, if certain provisions are met. The benefits are determined under a career average formula based on each year of service with Pacific Lumber and the employee's compensation for that year. Pacific Lumber's funding policy is to contribute annually an amount at least equal to the minimum cash contribution required by The Employee Retirement Income Security Act of 1974, as amended. A summary of the components of net periodic pension cost is as follows: The following table sets forth the funded status and amounts recognized in the Consolidated Balance Sheet: The Company has an unfunded defined benefit plan for certain postretirement and other benefits which covers substantially all employees of Pacific Lumber. Participants of the plan are eligible for certain health care benefits upon termination of employment and retirement and commencement of pension benefits. Participants make contributions for a portion of the cost of their health care benefits. The Company adopted SFAS 106 as of January 1, 1993. The costs of postretirement benefits other than pensions are now accrued over the period the employees provide services to the date of their full eligibility for such benefits. Previously, such costs were expensed as actual claims were incurred. The cumulative effect of the change in accounting principle for the adoption of SFAS 106 was recorded as a charge to results of operations of $2,348, net of related income taxes of $1,566. A summary of the components of net periodic postretirement benefit cost for the year ended December 31, 1993 is as follows: The adoption of SFAS 106 increased the Company's loss from continuing operations before extraordinary item and cumulative effect of changes in accounting principles by $212 ($360 before tax) for the year ended December 31, 1993. The postretirement benefit liability recognized in the Company's Consolidated Balance Sheet was: The annual assumed rate of increase in the per capita cost of covered benefits (i.e., health care cost trend rate) is 13% for 1994 and is assumed to decrease gradually to 5.5% for 2007 and remain at that level thereafter. Each one percentage point increase in the assumed health care cost trend rate would increase the accumulated postretirement benefit obligation as of December 31, 1993 by approximately $582 and the aggregate of the service and interest cost components of net periodic postretirement benefit cost by approximately $76. The discount rate used in determining the accumulated postretirement benefit obligation was 7.5% at December 31, 1993 and 8.25% at January 1, 1993. 9. RELATED PARTY TRANSACTIONS MAXXAM provides the Company and certain of the Company's subsidiaries with accounting and data processing services. In addition, MAXXAM provides the Company with office space and various office personnel, insurance, legal, operating, financial and certain other services. MAXXAM's expenses incurred on behalf of the Company are reimbursed by the Company through payments consisting of (i) an allocation of the lease expense for the office space utilized by or on behalf of the Company and (ii) a reimbursement of actual out-of-pocket expenses incurred by MAXXAM, including, but not limited to, labor costs (including costs associated with phantom share and stock appreciation rights) of MAXXAM personnel rendering services to the Company. Charges by MAXXAM for such services included in continuing operations were $3,347, $3,735 and $3,652 for the years ended December 31, 1993, 1992 and 1991, respectively. The Company believes that the services being rendered are on terms not less favorable to the Company than those which would be obtainable from unaffiliated third parties. In November 1991, MAXXAM purchased $1,222 of MAXXAM's 12 1/2% Subordinated Debentures (the "MAXXAM Debentures") from the Company for $1,304. Interest earned on the MAXXAM Debentures amounted to $164 for the year ended December 31, 1991. Interest income on loans to MAXXAM was approximately $9,810 for the year ended December 31, 1991. 10. CONTINGENCIES The Company's operations are subject to a variety of California and, in some cases, federal laws and regulations dealing with timber harvesting, endangered species, water quality and air and water pollution. The Company does not expect that compliance with such existing laws and regulations will have a material adverse effect on the Company's future operating results. There can be no assurance, however, that future legislation, governmental regulations or judicial or administrative decisions would not adversely affect the Company or its ability to sell lumber, logs or timber. Various groups and individuals have filed objections with the California Department of Forestry ("CDF") regarding the CDF's actions and rulings with respect to certain of the Company's timber harvesting plans ("THPs"), and the Company expects that such groups and individuals will continue to file objections to the Company's THPs. In addition, lawsuits are pending which seek to prevent the Company from implementing certain of its approved THPs. These challenges have severely restricted Pacific Lumber's ability to harvest virgin old growth redwood timber on its property during the past few years, as well as substantial amounts of virgin Douglas-fir timber which are located in virgin old growth redwood stands. No assurance can be given as to the extent of such litigation in the future. The Company believes that environmentally focused challenges to its THPs are likely to occur in the future. Although such challenges have delayed or prevented the Company from conducting a portion of its operations, to date such challenges have not had a material adverse effect on the Company's consolidated financial position or results of operations. It is, however, impossible to predict the future nature or degree of such challenges or their ultimate impact on the operating results or consolidated financial position of the Company. The Company, Pacific Lumber, MAXXAM and certain of their former and current officers and directors are defendants in various actions related to the Company's acquisition of Pacific Lumber. Management is of the opinion that the outcome of such litigation is unlikely to have a material adverse effect on the Company's consolidated financial position. Management is unable to express an opinion as to whether the outcome of such litigation is unlikely to have a material adverse effect on the Company's results of operations in respect of any fiscal year. The Company is also involved in various claims, lawsuits and proceedings relating to a wide variety of other matters. While there are uncertainties inherent in the ultimate outcome of such matters and it is impossible to presently determine the ultimate costs that may be incurred, management believes the resolution of such uncertainties and the incurrence of such costs should not have a material adverse effect upon the Company's consolidated financial position or results of operations. 11. SUPPLEMENTARY INFORMATION The following amounts are included in the Company's Consolidated Statement of Operations: Pacific Lumber is self-insured for workers' compensation benefits. Included in accrued compensation and related benefits and other noncurrent liabilities are accruals for workers' compensation claims amounting to $7,008 and $5,400 at December 31, 1993 and 1992, respectively. In 1993 and 1992, Pacific Lumber recorded reductions in cost of sales of $1,200 and $3,300, respectively, from business interruption insurance claims for reimbursement of higher operating costs and the related loss of revenues resulting from the April 1992 earthquake. In 1992, Pacific Lumber recorded a $1,600 gain in investment, interest and other income on a casualty insurance claim for the loss of certain commercial property due to the earthquake. Other receivables at December 31, 1993 and 1992 included $1,235 and $7,723, respectively, related to these and other earthquake related insurance claims. In June 1991, Pacific Lumber completed the sale of its San Mateo County, California timberlands for $7,492. This sale resulted in a pre-tax gain of $3,482 which is included in investment, interest and other income for the year ended December 31, 1991. 12. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) Summary quarterly financial information for the years ended December 31, 1993 and 1992 is as follows: ITEM 9.	ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III Not applicable. PART IV ITEM 14.					ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (A) INDEX TO FINANCIAL STATEMENTS PAGE 1. FINANCIAL STATEMENTS (INCLUDED UNDER ITEM 8): Report of Independent Public Accountants 27 Consolidated balance sheet at December 31, 1993 and 1992 28 Consolidated statement of operations for the years ended December 31, 1993, 1992 and 1991 29 Consolidated statement of cash flows for the years ended December 31, 1993, 1992 and 1991 30 Consolidated statement of stockholder's equity for the years ended December 31, 1993, 1992 and 1991 31 Notes to consolidated financial statements 32 The consolidated financial statements and notes thereto of Kaiser Aluminum Corporation are incorporated herein by reference and included as Exhibit 99 hereto. 2. FINANCIAL STATEMENT SCHEDULES: Schedule III - Condensed financial information of Registrant at December 31, 1993 and 1992 and for the years ended December 31, 1993, 1992 and 1991 53 All other schedules are inapplicable or the required information is included in the consolidated financial statements or the notes thereto. (B) REPORTS ON FORM 8-K None. (C) EXHIBITS Reference is made to the Index of Exhibits immediately preceding the exhibits hereto (beginning on page 58), which index is incorporated herein by reference. SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT BALANCE SHEET (UNCONSOLIDATED) STATEMENT OF OPERATIONS (UNCONSOLIDATED) STATEMENT OF CASH FLOWS (UNCONSOLIDATED) NOTES TO FINANCIAL STATEMENTS A. BASIS OF PRESENTATION As described in Note 1 to the Company's Consolidated Financial Statements (contained in Item 8), the Forest Products Group Formation required the Company to restate its historical financial statements with respect to the net assets transferred to MAXXAM. Such restatement has been made with respect to all periods presented in a manner similar to that which would have been presented if the Company had discontinued the operations relating to such net assets. B. LONG-TERM DEBT The Forest Products Group Formation was done contemporaneously with the issuance of the MGI Notes and the retirement of the 12 3/4% Notes as described in Note 6 to the Consolidated Financial Statements. The MGI Notes are secured by the Company's pledge of 100% of the common stock of Pacific Lumber, Britt and MPI and by MAXXAM's pledge of 28 million shares of Kaiser's common stock it received as a result of the Forest Products Group Formation. SIGNATURES Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. MAXXAM GROUP INC. INDEX OF EXHIBITS
79636_1993.txt	79636	1993	Item 1. Business Portland General Corporation - Holding Company Portland General Corporation (Portland General), an electric utility holding company, was organized in December 1985. Portland General Electric Company (PGE or the Company), an electric utility company and Portland General's principal operating subsidiary, accounts for substantially all of Portland General's assets, revenues and net income. Portland General is also the parent company of Portland General Holdings, Inc. (Holdings) which is presently involved in leveraged leasing and the liquidation of its real estate investments. Portland General is exempt from regulation under the Public Utility Holding Company Act of 1935, except Section 9(a)(2) thereof relating to the acquisition of securities of other public utility companies. As of December 31, 1993, Portland General and its subsidiaries had 2,618 regular employees compared to 3,253 and 3,256 at December 31, 1992 and 1991, respectively. Portland General Electric Company - Electric Utility General PGE, incorporated in 1930, is an electric utility engaged in the generation, purchase, transmission, distribution, and sale of electricity in the State of Oregon. In addition, PGE sells energy in the wholesale market to other utilities, primarily in the State of California. Its Oregon service area is 3,170 square miles, including 54 incorporated cities of which Portland and Salem are the largest, within a state-approved service area allocation of 4,070 square miles. PGE estimates that the population of its service area at the end of 1993 was approximately 1.3 million, constituting approximately 45% of the state's population. At December 31, 1993 PGE served over 620,000 customers. In early 1993, PGE ceased commercial operation of the Trojan Nuclear Plant (Trojan). PGE determined that the likelihood of increasing costs made continued operation not cost effective. 5 Retail (including other) revenues increased $94 million in 1993 primarily due to a $49 million increase in accrued revenues related to the future recovery of incremental power costs, and the combination of retail load growth of 2.6% and cooler weather during the early months of 1993 which increased sales of electricity 5%. 1992 retail (including other) revenues increased $17 million over 1991 due primarily to revenues related to a temporary price increase to recover a portion of excess power costs incurred during the March 1991 to February 1992 Trojan outage. Due to replacement of Trojan generation, excess low-cost power was not readily available for resale which drove wholesale revenues down $30 million. 1992 wholesale revenues declined $23 million due to poor hydro conditions experienced in the region which reduced surplus power and limited PGE's ability to make nonfirm resales. Regulation PGE is subject to regulation by the Oregon Public Utility Commission (PUC), which consists of a three-member commission appointed by the Governor. The PUC approves PGE's retail rates and establishes conditions of utility service. The PUC ensures that prices are fair and equitable and provides PGE an opportunity to earn a fair return on its investment. In addition, the PUC regulates the issuance of securities and prescribes the system of accounts to be kept by Oregon utilities. PGE is also subject to the jurisdiction of the Federal Energy Regulatory Commission (FERC) with regard to the transmission and sale of electric energy between utilities as well as with respect to licensed hydroelectric projects and certain other matters. Construction of new generating facilities requires a permit from the Energy Facility Siting Council, a council of the Oregon Department of Energy. This council reviews the Company's need for energy and the resulting environmental impact of the generating plant. The Nuclear Regulatory Commission (NRC) regulates the licensing, construction, operation and decommissioning of nuclear power plants. In 1993 the NRC issued PGE a possession only license amendment to its Trojan operating license allowing it to own the reactor and nuclear fuel but not to operate the facility. This license amendment eliminates certain operating requirements that are unnecessary for a permanently shut down and defueled reactor. PGE will continue to be subject to NRC regulation until the Trojan plant is fully decommissioned, all nuclear fuel is removed from the site to a U.S. Department of Energy facility and its license is terminated. The Oregon Department of Energy also monitors Trojan. Oregon Regulatory Matters General Rate Filing On November 8, 1993 PGE filed a request with the PUC to increase electric prices by an average of 5.1% beginning January 1, 1995. Commercial and industrial customers rates would increase, on average, 3.2%. The proposed increase in average annual revenues is $43 million, after the effects of the Regional Power Act exchange credit. PGE requested a return on equity of 11.5%, down from the current authorized return of 12.5%. If approved, this would be PGE's first general price increase since 1991. Power Cost Deferrals PGE has operated without a power cost adjustment provision in its rates since late 1987 which necessitates separate filings with the PUC to recover increases in power costs. In February 1993 the PUC authorized PGE to defer, for later collection, 80% of the incremental costs incurred from December 4, 1992 to March 31, 1993 to replace power no longer generated by Trojan. In January 1994 the PUC authorized PGE to start collecting this power cost deferral beginning in April 1994. In August 1993 the PUC authorized PGE to defer, for later collection, 50% of the incremental replacement power costs incurred from July 1, 1993 to March 31, 1994, subject to a review of PGE earnings. 1993 Residential and Small Farm Customer Price Increase Under provisions of the Regional Power Act (RPA) PGE exchanges higher-cost power for lower-cost federal hydroelectric power with BPA and passes the benefits to residential and small farm customers. In September 1993 the PUC approved PGE's request to raise its electricity prices to residential and small farm customers an average of 7.8%, or $28.6 million in annual revenues, effective October 1, 1993 to pass through the Bonneville Power Administration's (BPA) nearly 16% price increase. BPA's price increase reduces the power exchange credit that is passed through to PGE residential and small farm customers. 1992 Temporary Rate Increase The PUC granted PGE recovery of a portion of its incremental power costs incurred during Trojan's 1991 extended outage. PGE was allowed to recover 90% of the excess power costs incurred from November 1, 1991 until Trojan returned to service in early March 1992. Revenue collections started on January 1, 1992, with commercial and industrial rates increasing 4.8% and residential rates increasing 0.6%. On April 7, 1992, the PUC approved the Company's request to decrease the rate at which it was recovering excess power costs. Residential rates decreased 0.5% while commercial and industrial rates decreased 3.3%. Revenue collections were completed in June 1993. The PUC's temporary rate increase order has been challenged by the Utility Reform Project. See Item 3, Legal Proceedings. Energy Efficiency PGE and the PUC are working together to provide the appropriate financial incentives for PGE's energy efficiency programs. PGE is allowed a return on energy efficiency program expenditures. PGE and the PUC also developed the Share All Value Equitably (SAVE) program to remove a financial disincentive and encourage PGE to aggressively pursue cost-effective energy efficiency measures. SAVE, which began in 1991 consists of a lost revenue component and a shared savings incentive that rewards PGE with additional revenues for a portion of the difference between the equivalent cost a new generation and the cost of the energy efficiency measures. The shared savings component of the SAVE tariff can result in a penalty if the amount of energy savings falls short of the established benchmark levels. During the first three years of the program, PGE exceeded benchmarks set by the PUC, and qualified programs achieved an annualized 35 average megawatts of saved energy. 1991 General Rate Increase The PUC authorized PGE a $27 million, or 3.4%, rate increase which became effective February 5, 1991. The tariff change represented PGE's first general price increase since 1984. The PUC set PGE's allowed return on common shareholders' equity at 12.5%, a decrease from 12.75%. The price increase covered higher operating costs, including programs to improve efficiency and safety at Trojan. Additional revenues were granted to cover higher depreciation and decommissioning provisions for Trojan. The PUC also allowed PGE to recover, over ten years, $29 million of costs associated with terminating a prior coal supply contract for Boardman. Prior Years Prior to the 1991 general rate increase, general prices had not increased since 1984. Between 1985 and 1990, PGE had price reductions totaling $79 million in revenue requirements including refunds of excess tax credits. In October 1989, PGE lowered residential and small farm customer prices by 3.8%, or $11 million in annual revenue requirements. The lower prices resulted from increased benefits under the provisions of the RPA. In January 1989 revenue requirements were reduced $12 million as a result of the completion of PGE's recovery of abandoned nuclear project costs. Litigation Settlement In July 1990, PGE reached an out- of-court settlement with the PUC on two of three rate matters being litigated. PGE had sought judicial review of the three rate matters related to a 1987 general case. In 1989, PGE reserved $89 million for an unfavorable outcome on these three issues. As a result of the settlement, $16 million, or $.35 per share, was restored to income during the 1990 third quarter. The settlement resolved the dispute regarding treatment of accelerated amortization of certain investment tax credits (ITC) and 1986-1987 interim relief. PGE restored ITC in a manner consistent with the way the PUC had ordered that it be treated for ratemaking purposes. As settlement of the interim relief issue, PGE refunded $17 million to its customers over a 12-month period beginning November 1, 1991. The settlement, however, did not resolve the issue regarding the gain on the sale of a portion of the Boardman/Intertie assets, which the parties continue to litigate. PGE's position is that 28% of the gain should be allocated to customers. The 1987 rate order 8 allocated 77% of the gain to customers. PGE has fully reserved this amount which is being amortized over a 27-year period in accordance with the rate order. In PGE's general rate filing filed November 8, 1993 PGE proposes to accelerate the amortization of the Boardman gain to customers from 27 years to three years, starting in January 1995, as part of a comprehensive settlement of the outstanding litigation on this issue. Least Cost Energy Planning The PUC adopted Least Cost Energy Planning for all energy utilities in Oregon with the goal of selecting the mix of options that yields an adequate and reliable supply of energy at the least cost to the utilities and customers. "Demand side" options (ie, conservation and load management) as well as traditional "supply side" options (ie, generation and purchase of power) are evaluated. Although utility management continues to be fully responsible for decision-making, the process allows the PUC and the public to participate in resource planning. Ratemaking decisions are not made in the planning process. However, participation by the PUC and the public may reduce the uncertainty regarding the ratemaking treatment of the acquisition of new resources. PGE filed its first Least Cost Energy Plan (LCP) with the PUC in October 1990, and the PUC subsequently reviewed and acknowledged PGE's plan. The plan is updated every two years. In August 1992, PGE submitted its draft 1992 LCP to the PUC. Included in the LCP was PGE's plan for an orderly phase-out of Trojan by 1996. In January 1993, PGE submitted an update to its LCP reflecting its decision to immediately shut down Trojan. The PUC acknowledged the LCP plan on June 11, 1993. Competition and Marketing Retail Competition PGE competes with a local natural gas utility for residential and commercial customers' space and water heating. PGE captures the majority of the space and water heating market for new multi- family construction, but most new single-family homes are built with natural gas heat and hot water. PGE operates within a state-approved service area and is substantially free from direct competition with other electric utilities. Competition in the industrial market has increased in recent years due to the availability and low price of natural gas. To meet this competition, PGE is working to retain customers by assisting them with energy- related decisions. Neighboring retail electric utilities are becoming another competitive factor. In 1990, two of PGE's industrial customers approached other utilities to investigate obtaining power at a lower price. PGE has signed a settlement agreement with Pacific Power & Light (PP&L) permitting PP&L to serve one of these customers and is continuing to serve the other customer. See Item 3, Legal Proceedings for more information. Cogeneration is another form of competition. However, PGE also views it as an opportunity to invest in joint projects which earn a return and provide additional resources to meet PGE's load growth and to replace Trojan's output. Retail Marketing PGE recognizes that all customers do not have the same energy needs and that they do no all value a product equally. Some customers require more reliable services to reduce outage costs. Other price sensitive customers prefer reduced service levels to achieve a lower electric bill. PGE continues to work with customers to develop and deliver kWh products and services that meet different customers' needs. Meeting customer needs while promoting energy efficiency means employing demand side management strategies. Demand side management includes influencing market growth through high value electrical applications, managing wise use of electricity through energy efficiency and managing capacity demand through load shaping. PGE and the PUC developed the SAVE program (see discussion on page 8) to remove a financial disincentive from energy efficiency measures. The most successful programs under PGE's SAVE incentive tariff include low-flow showerheads, the Super Good Cents program which encourages energy-efficient construction, the Commercial Rationalization program for construction of energy-efficient commercial buildings, commercial and industrial lighting, and a program to encourage industrial customers to install more efficient motors. 9 PGE also has programs for residential energy audits, low- income weatherization, more efficient lighting and appliances, and the repair and replacement of water heaters. Among the other services provided to commercial and industrial customers, PGE and subsidiaries offer power quality services and high voltage maintenance services for customer-owned equipment. PGE's Energy Resource Center provides commercial and other customers with technical assistance and training for energy-related business issues. Commercial customers can receive a design review of energy efficiency systems for their buildings. The U.S. Environmental Protection Agency (EPA) has selected PGE as the first utility in the Pacific Northwest to participate in its Green Lights program. This program encourages the largest businesses and industries to use energy-efficient lighting. PGE is working with its customers to help them qualify for the Green Lights program. In addition, PGE is the first U.S. utility to become a member of Power Smart, an international organization that promotes energy efficiency through marketing and product endorsements. PGE has joined with the Oregon Superintendent of Public Instruction and other utilities to develop a curriculum to encourage teachers, students, and parents to use energy more efficiently in their homes. A related plan is designed to make school facilities more energy- efficient. Wholesale Sales Energy sales to other utilities depend on the availability of surplus power in the Pacific Northwest, access to transmission systems, changing prices of fossil fuels, competition from alternative suppliers, and the demand for power by other utilities. Power supply and transmission assets, including a partial ownership in the AC Intertie, provide valuable linkages to a wide array of wholesale customers. The AC Intertie is a transmission line with a total capacity of 4,800 megawatts that links winter-peaking northwest utilities with summer-peaking wholesale customers in California. Currently, PGE has total scheduling capability for 950 megawatts on the AC Intertie including 150 MW gained from the recent capacity expansion. PGE and BPA completed expansion of the capacity of the AC Intertie in 1993. PGE has traded 100 megawatts of this scheduling capability to BPA for 100 megawatts of scheduling capability on BPA's DC Intertie in order to reach additional wholesale customers in the Southwest. The January 1994 earthquake experienced in the Los Angeles area removed the DC intertie from service. Until repaired, this outage limits PGE's ability to make wholesale sales to the southwest region. FERC can now order wholesale transmission access, wholesale wheeling, of electric power. Wholesale wheeling allows independent power producers and utilities to market excess power to other utilities over wide geographic areas. PGE's ownership of 950 megawatts of transmission rights on the Pacific Northwest Intertie provides access to power and wholesale customers beyond PGE's service territory. Power Supply PGE's decision in January 1993 to immediately cease operation of Trojan (see Note 6, Trojan Nuclear Plant) ended 17 years of operation during which the plant provided about a quarter of PGE's annual energy requirements. PGE is replacing this output and meeting new load growth with a mix of demand-side and supply- side resources, including renewables, cogeneration, combined-cycle combustion turbines, and energy purchases from other utilities. Removing this major generating plant from service increased the importance of PGE's existing hydroelectric and thermal resources. Hydro power is a key economic resource for the Company. In addition to company- owned hydroelectric projects, PGE relies on long term power contracts with four hydro projects on the mid-Columbia River. PGE also purchases surplus energy, primarily hydro- generated, from other Pacific Northwest utilities. Operation of the gas-fired Beaver plant (Beaver) continues to benefit from a larger natural gas pipeline. This pipeline, completed in 1993, gives PGE assured access to natural gas markets, enabling Beaver generation to be competitive with other resources in the Pacific Northwest. The Boardman coal- fired plant (Boardman) has run as a base load plant since lower- cost coal supply contracts were negotiated in 1990. 10 Generating Capability PGE has 1,911 megawatts of generating capability, which consists of hydroelectric, coal-fired and gas-fired plants. PGE's lowest-cost producers are its eight hydroelectric projects on the Clackamas, Sandy, Deschutes, and Willamette rivers in Oregon. With the decision to permanently close Trojan, PGE lost 745 megawatts of generating capability. Purchased Power Long-term firm power contracts with four hydro projects on the mid-Columbia River in central Washington state provide PGE with 669 megawatts. A long-term contract with the BPA for 250 megawatts of capacity expired in 1991 and was replaced with 550 megawatts of new long-term (3 to 23 years) firm contracts from several utilities. In addition, PGE has long- term exchange contracts with summer-peaking California utilities to help meet its winter-peaking requirements. During 1993 PGE negotiated new firm power purchase contracts ranging from two to four years for the purchase of 300 MW to replace capacity and energy previously supplied by Trojan. These agreements, with companies in the Northwest and Southwest, will help meet the Company's needs until new resources are brought on-line in the 1995/96 timeframe. These and other sources provide PGE with a total of 2,095 megawatts of firm capacity to serve PGE's peak loads. PGE also has access to surplus energy in the "spot market", referred to as secondary energy, which is utilized to meet customers' needs when it is economical to do so, and to provide replacement energy during plant maintenance outages. Reserve Margin Reserve margin is the amount of firm resource capacity in excess of customer demand during a period of peak loads. Based on its generating plants and firm purchased power contracts in place as of December 31, 1993, capacity available to PGE compared with historical peak loads is: Source: Megawatts PGE-owned hydro plants 609 Coal-fired plants 652 Gas-fired plants 650 Firm power purchase contracts 2,095 Total 4,006 Peak Load: System record (Dec. 1990) 3,698 1993 peak (Jan.) 3,441 PGE has access to spot-market purchases (referred to as secondary energy) during peak demand. Year in Review PGE generated 42% of its load requirements in 1993 compared with 58% in 1992. Trojan operated at a 48% capacity factor in 1992. Firm and secondary purchases primarily replaced Trojan generation in 1993. Below average precipitation in some parts of the Columbia River basin reduced the availability of inexpensive hydro power on the secondary market in 1993. Regional water conditions were about 83% of normal. Poor water conditions in the region drove secondary prices up, causing Beaver to be a more economical source of energy. Beaver produced 13% more energy than in 1992. 11 1994 Forecast The combination of power purchases and increased internal generation will continue to be utilized to replace Trojan's energy. PGE expects to purchase 57% of its 1994 load requirement. The early predictions of water conditions indicate they will be about 75% of normal. A high run-off in late spring is expected because of water release for fisheries. Early spring and summer run-off will likely be low due to the low water content of the snow pack in the Columbia River Basin. PGE plans to operate Beaver at a 38% capacity factor, the same level experienced in 1993. Boardman will continue to operate as a base-load plant. Outlook PGE's Least Cost Energy Plan (see the discussion on page 9) focuses on meeting customers' current and anticipated future energy needs with cogeneration, additional natural gas-fired combined-cycle combustion turbines, wind power, geothermal, energy efficiency, repowering existing resources and efficiency improvements to generating and transmission facilities. Energy efficiency programs include demand-side measures such as load management and encouraging more efficient use of electricity by customers. PGE plans on meeting 45% of new load growth needs with energy efficiency programs. PGE is beginning construction of the Coyote Springs Generation Project (Coyote Springs). This project will be a 220 megawatt cogeneration facility constructed near Boardman as part of the Trojan replacement resource portfolio. Coyote Springs is expected to be completed in the fall of 1995. The Company is reviewing plans to bring an additional 380 average megawatts (MWa) of new resources on-line by 1997. Average megawatts are calculated by converting the total annual output of a resource into an hourly average. Until new generating resources come on line PGE will utilize a combination of additional internal generation and short and medium-term power 12 purchase contracts. Price and supply of these power purchases will be of particular importance until PGE brings new resources on-line. Adequate supplies of secondary energy are expected to be available to meet customer demand. The completion of the third intertie in 1993 increased PGE's access to surplus energy in California and Arizona. However, potential curtailments of power supply and voltage instability could result if unusual weather- related events or loss of generating resources occur in the region. The January, 1994 earthquake in the Los Angeles area caused damage to the direct current (DC) intertie. PGE expects this transmission loss to affect the supply of power from the southwest to the Pacific northwest. As a result, the price of secondary power may be affected. Restoration of Salmon Runs - The Snake River chinook salmon has been listed as a threatened species and the Snake River sockeye salmon has been listed as endangered under the federal Endangered Species Act (ESA). The National Marine Fisheries Service (NMFS) has appointed a 7- member team to develop a recovery plan to reestablish these fish runs. This plan was completed in November 1993 and is now undergoing public comment. The plan proposes changes to current river operations. Some environmental organizations are calling for major improvements in fish passage around hydro projects on the Snake and lower Columbia rivers during the spring and summer by increasing the amount of water released from the reservoirs. This could mean less water will be available for release from the reservoirs in the fall and winter, resulting in less electricity generated at the hydro projects. NMFS is required to consider the economic impact as well as biological value of the proposed measures. Much of the regional impact from reduced power generation could be mitigated by increasing the region's seasonal power exchanges with California. California has peak energy needs in the summer while the Pacific Northwest has peaks in the winter. BPA estimates that proposed Columbia and Snake river flows would have only a small impact on power generation. BPA estimates the cost of power to replace lost generation would result in a retail rate increase of less than 2%. However, the final recovery plan could alter this estimate. PGE is closely monitoring this process and the potential impact of the proposals on its operations. PGE does not own hydro projects on the lower Columbia or Snake rivers although PGE purchases power from facilities located on these rivers. PGE's biologists are working with state and federal agencies to ensure that its hydro operations are compatible with the survival of both hatchery and wild salmon and steelhead trout. PGE does not expect the ESA process to significantly impact its generation or long-term purchased power contracts. However, the costs of secondary purchased power may increase throughout the region during low- water years. Fuel Supply Nuclear Since the permanent closure of Trojan in January 1993 PGE has terminated all uranium conversion, enrichment and fabrication contracts. Termination costs were approximately $4.5 million. In addition PGE terminated, at no cost, a uranium supply contract from an Australian source and assigned its remaining uranium supply contract from a domestic source to a third party, permanently relieving PGE of any future obligations associated with either contract. PGE sold its remaining inventory of enriched and natural uranium. Coal PGE has an agreement with Cyprus AMAX Coal Sales Company (in 1993 AMAX Coal Company merged with Cyprus Coal Sales Corporation to become Cyprus AMAX Coal Sales Corporation) to supply coal to Boardman through the year 2000. The agreement does not require a minimum amount of coal to be purchased, leaving PGE free to obtain coal from other sources. PGE did not take deliveries from AMAX under this agreement in 1993 because lower priced coal was available on the spot market. The coal purchased contained less than 0.5% of sulfur by weight and emitted less than the EPA allowable limit of 1.2 pounds of sulfur dioxide per MMBtu (million British thermal units) when burned. The coal is from both surface mining operations and underground operations, each subject to federal, state, and local regulations. Railroad transportation to Boardman represents the single largest component of the total cost of the coal. In 1993 PGE negotiated a favorable railroad transportation rate with the Union Pacific Railroad and Western Railroad Properties. PGE believes it will continue to have several coal supply sources and will be able to continue meeting Boardman's needs. Coal for Colstrip 3 and 4, located in southeastern Montana, is provided under contract with Western Energy Company, a wholly owned subsidiary of Montana Power Company. The contract provides that the coal delivered will not exceed a maximum sulfur content of 1.5% by weight. The plant design includes sulfur dioxide removal equipment to allow operation in compliance with EPA's source performance emission standards. Coal for Centralia 1 and 2, located in southwestern Washington, is provided under contract with PacifiCorp doing business as PacifiCorp Electric Operations. The plant will need to implement a blending (adding low-sulphur coal to the current supply), co-firing (adding natural gas to the fuel mix), or other strategies to achieve compliance with EPA's source performance emission standards. The majority of Centralia's coal requirements are expected to be provided under this contract. Natural Gas PGE has short-term agreements with various suppliers to purchase gas during the winter peak demand period. PGE also utilizes spot-market purchases of gas when necessary. PGE owns 90% of a pipeline which directly connects Beaver to Northwest Pipeline, an interstate gas pipeline operating between British Columbia and New Mexico. Beginning in June 1993 PGE has access to 30,000 MMBtu/day of Northwest Natural Gas's capacity on Northwest Pipeline. Increased access to gas supplies improves the cost effectiveness and reliability of gas transportation to the plant. This agreement also allows for an increase to 76,000 MMBtu/day in November 1995. PGE also signed an agreement in 1993 with Pacific Gas Transmission to provide 41,000 MMBtu/day of capacity on its natural gas pipeline. This service is scheduled to start on or after November 1995, when PGE's new gas-fired resources come on line. Environmental Matters PGE operates in a state recognized for environmental leadership. PGE's commitment to environmental stewardship resulted in the adoption of a corporate environmental policy in 1991. The policy asserts PGE's commitment to minimize waste in its operations, minimize environmental risk and take the lead in promoting energy efficiency. Environmental Regulation PGE is subject to regulation by federal, state, and local authorities with regard to air and water quality, noise, waste disposal and other environmental issues. PGE is also subject to the Rivers and Harbors Act of 1899 and similar Oregon laws under which it must obtain permits from the U.S. Army Corps of Engineers or the Oregon Division of State Lands to construct facilities or perform activities in navigable waters or in waters of the State. The EPA regulates the proper use, transportation, clean up and disposal of Polychlorinated biphenyls (PCBs). State agencies or departments which have direct jurisdiction over environmental matters include the Environmental Quality Commission, the Department of Environmental Quality (DEQ), the Oregon Department of Energy, and the Energy Facility Siting Council. Environmental matters regulated by these agencies include the siting and operation of generating facilities and the accumulation, clean-up and disposal of toxic and hazardous wastes. Air/Water Quality Congress passed amendments to the Clean Air Act (Act) in 1990 that will renew and intensify national efforts to reduce air pollution. Significant 14 reductions in emissions of sulfur dioxide, nitrogen oxide and other air toxic contaminants will be required over the next several years. Coal-fired plant operations will be affected by these emission limitations. Federal implementing standards under the Act are being drafted at the present time. State governments are also charged with monitoring and administering certain portions of the Act. Each state is required to set guidelines that at least equal the federal standards. On March 5, 1993, the EPA issued its final allocation of emission allowances. Boardman was assigned sufficient allowances to operate after the year 2000 at a 60 to 67% capacity factor without having to further reduce emissions or to buy additional credits. Centralia will be required to reduce emissions by the year 2000 and the owners are examining several options such as installing scrubbers, converting to lower-sulfur coal or natural gas, or purchasing emission allowances. It is not anticipated that Colstrip will be required to reduce emissions because it utilizes scrubbers. In addition, Congress is currently considering other legislation to reduce emissions of gases that are thought to cause global atmospheric warming. The burning of coal, oil, and natural gas by electric utilities is thought to be a source of these pollutants. Legislation, if adopted, could significantly increase PGE operating costs and reduce coal-fired capacity. Boardman's air contaminant discharge permit, issued by the DEQ, has no restrictions on plant operations. This permit expires in 1994 and will be automatically extended until a new permit is issued under new permit rules being reviewed by the EPA for final approval. The water pollution control facilities permit for Boardman expired in May 1991. The DEQ is processing the permit application and renewal is expected. In the interim, Boardman is permitted to continue operating under the terms of the original permit. The wastewater discharge permit for Beaver expires in 1994. DEQ is currently reviewing the permit renewal application. DEQ air contaminant discharge permits for the combustion turbine generators at Bethel expire in 1995. The existing air permits will automatically be extended until new permits are issued under new air permit rules being reviewed by the EPA for final approval. The current permits allow unrestricted plant operations except for a limitation whereby only one Bethel unit may operate at night due to noise limitations. The combustion turbines are allowed to operate on either natural gas or oil. PGE has developed an emergency oil spill response plan for the fuel oil storage tanks and unloading dock at Beaver. This plan has been submitted to the Coast Guard, EPA and DEQ in compliance with new federal and state oil spill regulations. The plan includes employee training and the probable acquisition of clean up equipment. Environmental Clean Up PGE, as a "potentially responsible party", is involved with others in environmental clean up of PCB contaminants at various sites. The clean up effort is underway and is anticipated to take several years to complete. The total cost of clean up is presently estimated at $27 million. PGE's share is approximately $3 million. Human Resources As of December 31, 1993, PGE had 2,577 regular employees, including 224 employees at Trojan, compared to 3,157 and 3,094 employees at December 31, 1992 and 1991, respectively. Portland General Holdings, Inc. - Nonutility Businesses General Holdings is a wholly owned subsidiary of Portland General and is the parent company of Portland General's subsidiaries presently engaged in leveraged leasing and the liquidation of its real estate investment. Holdings has provided organizational separation from PGE and financial flexibility and support for the operation of non- utility businesses. The assets and businesses of Holdings are its investments in its subsidiaries. Portland General has determined to no longer pursue development in the independent power and real estate businesses, and has recorded write-offs and reserves for related phase-out costs. Leasing Portland General Financial Services, Inc Portland General Financial Services (PGFS) is the parent company of Columbia Willamette Leasing (CWL), which acquired and leases capital equipment on a leveraged basis. CWL accounts for essentially all of the assets and earnings of PGFS. During 1993 and 1992, CWL made no new investments in leveraged leases. CWL's investment portfolio consists of six commercial aircraft, two container ships, 5,500 containers, coal, tank, and hopper railroad cars, a truck assembly plant, an acid treatment facility, and a wood chipping facility, totaling $454 million in original cost. No new investments are expected or planned for the foreseeable future. Independent Power Production PowerLink Corporation PowerLink Corporation (PowerLink) was Portland General's entry into the independent power business. During 1992 Portland General sold PowerLink. Investment in Bonneville Pacific Corporation In October 1990, Holdings purchased 20% of the common stock of Bonneville Pacific, an independent power producer headquartered in Salt Lake City, Utah. Over the next six months, Holdings purchased additional shares of Bonneville Pacific common stock, increasing its investment to 46% of the outstanding stock. Holdings also has outstanding loans of $28 million to Bonneville Pacific and its subsidiaries. In November 1991, Portland General announced that it was halting further investments, and Holdings wrote off its equity investment in and loans to Bonneville Pacific. In addition, Holdings' representatives resigned from Bonneville Pacific's board of directors. These decisions were based in part on Bonneville Pacific underperforming expectations, the impairment of the investment in Bonneville Pacific and the inability of Bonneville Pacific to meet project sell-down commitments under the original purchase agreement. Bonneville Pacific has filed for protection under Chapter 11 of the Federal Bankruptcy Code. Holdings has instituted legal proceedings with regard to its investment in Bonneville Pacific. See Note 3, Loss From Independent Power and Note 14, Legal Matters, in the Notes to the Financial Statements and Item 3. Legal Proceedings for more information. Real Estate Columbia Willamette Development Company Projects in Columbia Willamette Development Company's (CWDC) development portfolio include an upscale retirement community and single family residential developments. The process of liquidating the projects is expected to be substantially completed during 1994. See Note 2, Real Estate - Discontinued Operations, in Notes to the Financial Statements. 16 Item 2.		Item 2. Properties Portland General Corporation Discussion regarding nonutility properties is included in the previous section. Portland General Electric Company Generating facilities owned by PGE are set forth in the following table: (*) Officers are listed as of January 31, 1994. The officers are elected to serve for a term of one year or until their successors are elected and qualified. 23 PART II Item 5.			Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters Portland General Corporation Portland General's common stock is publicly held and traded on the New York and Pacific Stock Exchanges. The table below reflects the dividends on Portland General's common stock and the stock price ranges as reported by The Wall Street Journal for 1993 and 1992. The approximate number of shareholders of record as of December 31, l993 was 48,521. Portland General Electric Company PGE is a wholly owned subsidiary of Portland General. PGE's common stock is not publicly traded. Aggregate cash dividends declared on common stock were as follows (thousands of dollars): PGE is restricted, without prior PUC approval, from making any dividend distributions to Portland General that would reduce PGE's common equity capital below 36% of total capitalization. 24 Item 6.	Item 6. Selected Financial Data Portland General Corporation Portland General Electric Company Item 7.	Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Financial and Operating Outlook Trojan Related Issues Shutdown - In early 1993, Portland General Electric Company (PGE or the Company) ceased commercial operation of the Trojan Nuclear Plant (Trojan). PGE made the decision to shut down Trojan as part of its least cost planning process, a biennial process whereby PGE evaluates a mix of energy options that yield an adequate and reliable supply of electricity at the least cost to the utility and to its customers. On June 3, 1993 the Oregon Public Utility Commission (PUC) acknowledged PGE's Least Cost Plan. Decommissioning Estimate - The 1993 nuclear decommissioning estimate of $409 million represents a site-specific decommissioning cost estimate performed for Trojan by an experienced decommissioning engineering firm. This cost estimate assumes that the majority of decommissioning activities will occur between 1998 and 2002, after construction of a temporary dry spent fuel storage facility. The final decommissioning activities will occur in 2018 after PGE completes shipment of spent fuel to a United States Department of Energy (USDOE) facility. The decommissioning cost estimate includes the cost of decommissioning planning, removal and burial of irradiated equipment and facilities as required by the Nuclear Regulatory Commission (NRC); building demolition and nonradiological site remediation; and fuel management costs including licensing, surveillance and $75 million of transition costs. Transition costs are the costs associated with operating and maintaining the spent fuel pool and securing the plant until dismantlement can begin. The 1992 decommissioning cost estimate of $411 million was based upon a study performed on a nuclear plant similar to Trojan and included the cost of dismantlement activities performed during the years 1996 through 2002, monitoring of stored spent fuel through 2018 and $130 million of miscellaneous closure and transition costs ($43 million was amortized to nuclear operating expenses during 1993). The 1992 estimate and the 1993 site- specific estimate are reflected in the Company's financial statements in nominal dollars (actual dollars expected to be spent in each year). The difference between the 1992 and the 1993 cost estimates, reflected in nominal dollars, is due to the application of a higher inflation factor, the timing of decommissioning activities and certain changes in assumptions, such as decommissioning the temporary dry spent fuel storage facility and shipping highly activated reactor components to the USDOE repository in 2018, which are included in the 1993 estimate. Both the 1992 cost estimate and the 1993 site- specific cost estimate reflected in 1993 (current) dollars are $289 million. Assumptions used to develop the site- specific cost estimate represent the best information PGE has currently. However, the Company is continuing its analysis of various options which could change the timing and scope of dismantling activities. Presently, PGE is planning to accelerate the timing of large component removal which could reduce overall decommissioning costs. PGE plans to submit a detailed decommissioning work plan to the NRC in mid-1994. The Company expects any future changes in estimated decommissioning costs to be incorporated in future revenues to be collected from customers. Investment Recovery - PGE filed a general rate case on November 8, 1993, which addresses recovery of Trojan plant costs, including decommissioning. In late February 1993, the PUC granted PGE accounting authorization to continue using previously approved depreciation and decommissioning rates and lives for its Trojan investment. Least cost analysis assumed that recovery of the Trojan plant investment, including future decommissioning costs, would be granted by the PUC. Regarding the authority of the PUC to grant recovery, the Oregon Department of Justice (Attorney General) issued an opinion that the PUC may allow rate recovery of total plant costs, including operating expenses, taxes, decommissioning costs, return of capital invested in the plant and return on the undepreciated investment. While the Attorney General's opinion does not guarantee recovery of costs associated with the shutdown, it does clarify that under current law the PUC has authority to allow recovery of such costs in rates. 26 PGE asked the PUC to resolve certain legal and policy questions regarding the statutory framework for future ratemaking proceedings related to the recovery of the Trojan investment and decommissioning costs. On August 9, 1993, the PUC issued a declaratory ruling agreeing with the Attorney General's opinion discussed above. The ruling also stated that the PUC will favorably consider allowing PGE to recover in rates some or all of its return on and return of its undepreciated investment in Trojan, including decommissioning costs, if PGE meets certain conditions. PGE believes that its general rate filing provides evidence that satisfies the conditions established by the PUC. In February 1993 the Citizens' Utility Board of Oregon appealed the ruling to the Marion County Circuit Court. Management believes that the PUC will grant future revenues to cover all, or substantially all, of Trojan plant costs with an appropriate return. However, future recovery of the Trojan plant investment and future decommissioning costs requires PUC approval in a public regulatory process. Although the PUC has allowed PGE to continue, on an interim basis, collection of these costs in the same manner as prescribed in the Company's last general rate proceeding, the PUC has yet to address recovery of costs related to a prematurely retired plant when the decision to close the plant was based upon a least cost planning process. Due to uncertainties inherent in a public process, management cannot predict, with certainty, whether all, or substantially all, of the $367 million Trojan plant investment and $356 million of future decommissioning costs will be recovered. Management believes the ultimate outcome of this public regulatory process will not have a material adverse effect on the financial condition, liquidity or capital resources of Portland General. However, it may have a material impact on the results of operations for a future reporting period. The Company's independent accountants are satisfied that management's assessment regarding the ultimate outcome of the regulatory process is reasonable. Due to the inherent uncertainties in the regulatory process discussed above, the magnitude of the amounts involved and the possible impact on the results of operations for a future reporting period, the Company's independent accountants have added a paragraph to their audit report to give emphasis to this matter. General Rate Filing On November 8, 1993, the Company filed a request with the PUC to increase electric prices by an average of 5% beginning January 1, 1995. Commercial and industrial customers' rates would increase, on average, 3.2%. The proposed increase in average annual revenues is $43 million, after the effects of the Regional Power Act exchange credit. PGE requested a return on equity of 11.5%, down from the current authorized return of 12.5%. If approved, this would be the Company's first general price increase since 1991. The increase in the cost of power, driven by higher priced purchased power and increased fuel costs, is the single largest factor behind the need to request an increase in prices. Other operating factors that contributed to the request are federal tax increases and capital improvements to PGE's distribution system. Helping to offset these cost increases are cost savings at Trojan, property tax reductions and customer growth. In addition, the Company is proposing to accelerate the return to customers of profits from the 1985 sale of a portion of the Boardman Coal Plant (Boardman) from 27 years to three years. In the 1987 rate proceeding the PUC ordered PGE to allocate 77% of the gain to customers over a 27 year period. The general rate filing includes PGE's request for continued recovery of Trojan costs including decommissioning, operating expenses, taxes, return of capital invested in the plant and return on the undepreciated investment. PGE's current rates include recovery of these Trojan costs. The Company expects a PUC decision in late 1994. Recovery of power cost deferrals is addressed in separate rate proceedings, not in the general rate filing (see the discussion of Power Cost Recovery below). Customer Growth and Revenues Customer growth in PGE's service territory was evident with the addition of 11,000 retail customers in 1993. This growth accounted for a 2.6% increase in weather-adjusted retail sales. In 1993, 9,300 residential customers were added to the system, compared to 9,400 in 1992. The Company estimates retail load growth in 1994 to be approximately the same as the growth experienced in 1993. Power Cost Recovery The Company is incurring substantial near-term power costs to replace Trojan generation. PGE's Power Cost Adjustment Tariff (PCA) was eliminated in 1987. As a result, adjustments for power costs above or below those used in existing general tariffs are not automatically reflected in 27 customers' rates. In February 1993, the PUC authorized PGE to defer, for later collection, 80% of the incremental power costs incurred from December 4, 1992, to March 31, 1993, to replace Trojan generation. In January 1994, the PUC authorized PGE to start collecting this power cost deferral beginning in April 1994. In August 1993, the PUC authorized PGE to defer, for later collection, 50% of the incremental replacement power costs incurred from July 1, 1993, to March 31, 1994, subject to a review of PGE earnings. This power cost deferral authorization does not immediately affect customer rates. However, PGE expects future rates to allow recovery of these costs. Power Supply The combination of power purchases and internal generation will continue to be utilized to replace Trojan's energy until new generating resources come on line by 1996. PGE expects to purchase approximately 57% of its 1994 load requirement. The early predictions of 1994 water conditions indicate they will be about 75% of normal. However, adequate supplies of secondary energy are expected to be available to meet customer demand. The completion of the third intertie in 1993 increased the Company's access to surplus energy and sales opportunities in California and Arizona. The January 1994 earthquake in the Los Angeles area caused damage to the direct current (DC) intertie. PGE expects this transmission loss to affect the supply of power from the Southwest to the Pacific Northwest. As a result, the price of secondary power, and the Company's wholesale efforts, may be affected. PGE has 100 MW of scheduling capability on the DC line to reach wholesale customers in the Southwest. Restoration of Salmon Runs - The Snake River chinook salmon has been listed as a threatened species and the Snake River sockeye salmon has been listed as endangered under the federal Endangered Species Act. The National Marine Fisheries Service has proposed minor changes to current river operations in a draft recovery plan that is undergoing public comment. Proposals to restore these salmon runs include measures to increase the river flows on the Snake and lower Columbia rivers during the spring to allow salmon to reach the Pacific Ocean faster, resulting in less water available for power generation in the fall and winter months. Although Company-owned hydro projects are not located on these rivers, future costs of secondary purchased power will likely increase throughout the region during low-water years. Fuel Supply PGE has short-term agreements with various suppliers to purchase gas during the winter peak demand period. PGE also utilizes spot-market purchases of gas when necessary. PGE owns 90% of a pipeline which directly connects the Beaver Combustion Turbine Plant (Beaver) to an interstate gas pipeline operating between British Columbia and New Mexico. Beginning in June 1993, PGE had access to 30,000 million British thermal units (MMBtu/day) of capacity on the pipeline, increasing to 76,000 MMBtu/day in November 1995. Also in 1993, PGE signed an agreement with Pacific Gas Transmission to provide 41,000 MMBtu/day of capacity, starting in November 1995, on its natural gas pipeline. National Energy Policy Act of 1992 The Federal Energy Regulatory Commission (FERC) can now order wholesale transmission access (wholesale wheeling) of electric power. Wholesale wheeling allows independent power producers and utilities to market excess power to other utilities over wide geographic areas. PGE's ownership of 950 megawatts of transmission rights on the Pacific Northwest Intertie provides access to power and wholesale customers beyond PGE's service territory. Nonutility Bonneville Pacific Litigation - Portland General Corporation (Portland General), Portland General Holdings, Inc. (Holdings), and certain affiliated individuals have been named in a class action suit by investors in Bonneville Pacific Corporation (Bonneville Pacific) and in a suit filed by the bankruptcy trustee for Bonneville Pacific. The class action suit alleges various violations of securities law, fraud and misrepresentation. The suit by the bankruptcy trustee for Bonneville Pacific alleges federal and Utah securities violations, common law fraud, breach of fiduciary duty, tortious interference, negligence, negligent misrepresentation and other actionable wrongs. Holdings has filed a complaint seeking approximately $228 million in damages against Deloitte & Touche and certain parties associated with Bonneville Pacific alleging that it relied on fraudulent and negligent statements and omissions when it acquired a 46% interest in and made loans to Bonneville Pacific. A detailed report released in June 1992, by a U.S. Bankruptcy examiner outlined a number of questionable transactions that resulted in gross exaggeration of Bonneville Pacific's assets prior to Holdings' investment. This report includes the examiner's opinion that there was significant mismanagement and very likely fraud at Bonneville Pacific. These findings support management's belief that a favorable outcome on these matters can be achieved. For background information and further details, see Note 14, Legal Matters, in Notes to Financial Statements. Results of Operations 1993 Compared to 1992 Portland General reported 1993 earnings of $89 million, $1.88 per share, compared to $90 million, $1.93 per share, in 1992. In 1992, upon approval from the PUC, PGE applied capital treatment to $18 million of Trojan steam generator repair costs which were incurred in 1991. As a result, $11 million, after tax, was restored to 1992 earnings. Excluding this event, 1992 earnings would have been $79 million compared to $89 million in 1993. Regulatory action, continued customer growth and cost reductions contributed to the favorable 1993 results. In August 1993, the PUC authorized PGE to defer, for later collection, 50% of the incremental Trojan replacement power costs incurred from July 1, 1993, through March 31, 1994. This authorization, coupled with the 80% deferral in place from December 4, 1992, to March 31, 1993, (see the Power Cost Recovery discussion in the Outlook section above) allowed the Company to record, in 1993, $67 million of revenues related to the future recovery of replacement power costs. Retail load growth of 2.6% and cooler weather during the early months of 1993 positively affected revenue by increasing sales of kilowatt-hours 5%. Wholesale revenue declined $30 million due to the lack of low-cost power for resale. The recording of replacement power revenues and retail sales growth, partially offset by the decline in wholesale revenues, yielded an operating revenue increase of $64 million. Operating costs (excluding variable power, depreciation, decommissioning and amortization) declined 14% due to a $53 million decline in nuclear expenses. In May 1993, the NRC issued PGE a possession only license amendment for Trojan. This license amendment reduced or eliminated certain operating requirements that were unnecessary for a shut down and defueled reactor which allowed PGE to reduce personnel. Nuclear expenses for 1993 reflect the amortization of Trojan miscellaneous closure and transition costs (which were accrued and capitalized at December 31, 1992). These costs are amortized as payments are made. During 1993 the Company amortized $43 million to nuclear operating expenses. The $53 million nuclear savings partially offset the $90 million increase in variable power costs. The average variable power cost increased from 15 mills per kilowatt-hour in 1992 to 19 mills per kilowatt-hour (10 mills = 1 cent) in 1993. Trojan generated 16% of the Company's 1992 power needs at an average fuel cost of 4 mills per kilowatt-hour. This generation was primarily replaced by power purchases at an average price of 24 mills per kilowatt-hour. Good plant performance helped control variable power costs. PGE's Beaver plant operated well in 1993, generating 13% more power than in 1992. Company- owned hydro production rose 21%. Additional maintenance outage time caused the Colstrip Units 3 and 4 Coal Plant (Colstrip) generation to decline which slightly reduced the Company's 1993 thermal generation from the 1992 level (excluding Trojan), however the total average fuel cost increased from 9 mills per kilowatt-hour to 10 mills per kilowatt-hour driving 1993 fuel expense up $5 million. Depreciation, decommissioning and amortization increased $24 million in 1993. The 1992 amount includes a credit of $18 million associated with the capitalization of 1991 Trojan steam generator repair costs discussed above. The remaining increase reflects depreciation charges for new plant placed in service. Other income increased slightly reflecting accrued interest on deferred charges and declining interest costs, partially offset by an increase in charitable contributions of approximately $4 million. 1992 Compared to 1991 Financial results for 1992 were much improved over 1991. Portland General's earnings of $90 million, or $1.93 per share, reflected improved operations at the utility's generating facilities, continued customer growth and cost control. In 1991, Portland General experienced a loss of $50 million, or $1.06 per share, which included losses from independent power of $74 million and additional real estate reserves of $29 million. Excluding the effects of losses from nonutility interests, 1991 earnings would have been $53 million. Trojan operated for six months in 1992 compared with two months in 1991, generating more than twice the power. This reduced the need for power purchases on the secondary market. Operating and maintenance costs for Trojan declined 30% in 1992. The 1991 operating and maintenance costs included $18 million for repairs that were capitalized in 1992 (see the discussion of 1993 compared to 1992 above). The Company's non-nuclear generating facilities performed well in 1992. Boardman operated at an 85% capacity factor generating 31% more power than in 1991. Other thermal generation increased 30%, while Company-owned hydro power production declined 9% due to poor water conditions. Higher internal generation raised fuel expense 34%, but significantly reduced the need for incremental power purchases. 34% fewer megawatt-hours were purchased; however, the average price per megawatt-hour purchased increased 26% due to poor hydro conditions experienced in the region. The poor hydro conditions also limited PGE's ability to make nonfirm resales. Consequently, 1992 wholesale revenue declined 17%. Even though unseasonably warm weather reduced demand, 1992 retail revenues rose slightly due to the addition of 11,000 retail customers and $18 million of accrued revenues associated with the recovery of Trojan replacement power costs. Accrued revenues of $12 million were recorded in 1991 representing the 1991 portion of 90% of the replacement power costs incurred from November 1, 1991 to March 6, 1992. The PUC authorized a temporary price increase to collect these revenues. The 1992 accrued revenues of $18 million represented $10 million of the 90% deferral and $8 million of the 80% deferral (see the Power Cost Recovery discussion in the Outlook section above). Total 1992 operating revenues declined slightly due to the drop in wholesale revenue. Corporate cost containment also contributed to the earnings growth. Operating expenses (excluding variable power, depreciation, decommissioning and amortization) declined 10% due to cost cutting measures. A manpower reduction program was implemented in 1991 that eliminated 300 positions. The severance costs associated with the program were reflected in 1991 results. Interest expense declined 10% as the Company took advantage of lower interest rates. Financial Condition 1993 Compared to 1992 During 1993 PGE invested approximately $126 million in electric utility plant. Plant investments included $29 million in the Coyote Springs Generation Project (Coyote Springs). This project will be a 220 megawatt cogeneration facility constructed near Boardman as part of the Trojan replacement resource portfolio. Coyote Springs is expected to be completed in the fall of 1995. Also during 1993, PGE completed construction of a third intertie to California which gave the Company an additional 150 megawatts of scheduling capability. The intertie project has increased PGE's capacity for buying and selling wholesale energy. In addition to utility plant, the Company invested $18 million in energy efficiency assets including new construction, lighting and appliances. The PUC has authorized a return on PGE's investment in energy efficiency projects. The Company's non-cash revenues increased in 1993 due to the recording of $67 million of revenues associated with the future recovery of Trojan replacement power costs (see the Power Cost Recovery discussion in the Financial and Operating Outlook section). Deferred charges increased over $200 million primarily due to the recording of $228 million of deferred tax liabilities and related regulatory assets representing future collections from customers. Under the liability method specified by SFAS No. 109, the deferred tax assets and liabilities are determined based on the temporary differences between the financial statement bases and tax bases of assets and liabilities as measured by the enacted tax rates for the years in which the taxes are expected to be paid. Management believes it is probable that the regulatory asset will be fully recovered in customer rates. Changes in liabilities primarily reflect the adoption of SFAS No. 109, the revision of the decommissioning estimate to $409 million, and financing activities. Common stock equity of Portland General increased $46 million reflecting earnings of $89 million, dividends declared of $57 million, and common stock issuances. Portland General's return on average shareholders' equity was 11.6% in 1993. Cash Flow Portland General Corporation Portland General requires cash to pay dividends to its common stockholders, to provide funds to its subsidiaries, to meet debt service obligations and for day to day operations. Sources of cash are dividends from PGE, its principal subsidiary, asset sales and leasing rentals, short- and intermediate-term borrowings, and the sale of its common stock. Portland General received $73 million in dividends from PGE and $10 million in proceeds from the issuance of shares of common stock under its Dividend Reinvestment and Optional Cash Payment Plan. In October 1993, Portland General filed a Registration Statement with the Securities and Exchange Commission (SEC) to issue up to 5,000,000 additional shares of its $3.75 par value common stock. The net proceeds from the sale of common stock will be used to purchase additional shares of PGE common stock. In February 1994, Portland General filed a Prospectus Supplement covering the sale of up to 2,300,000 of these shares. Portland General Electric Company Cash Provided by Operations is the primary source of cash used for day to day operating needs of PGE and funding of construction activities. PGE also obtains cash from external borrowings, as needed. A significant portion of cash from operations comes from depreciation and amortization of utility plant, charges which are recovered in customer revenues but require no current cash outlay. Changes in accounts receivable and accounts payable can also be significant contributors or users of cash. Cash provided by operations increased slightly in 1993 reflecting lower income tax payments. The 1992 cash flow from current operations declined slightly from the 1991 level. Increased replacement power costs have affected current cash flows. A significant portion of such costs have been offset by cost savings driven by personnel reductions at Trojan. Future cash requirements may be affected by the ultimate outcome of the IRS audit of PGE's 1985 WNP-3 abandonment loss deduction. The IRS has completed its audit of Portland General's tax returns for the years 1985 to 1987 and has issued a statutory notice of tax deficiency, which PGE is contesting. See Notes 5 and 5A, Income Taxes, in Notes to Financial Statements for further information. PGE has been named a "potentially responsible party" (PRP) of PCB contaminants at various environmental cleanup sites. The total cost of cleanup is estimated at $27 million, of which the Company's share is approximately $3 million. Should the eventual outcome of these uncertainties result in additional cash requirements, PGE expects internally generated cash flows or external borrowings to be sufficient to fund such obligations. PGE has made an assessment of the other involved PRP's and is satisfied that they can meet their share of the obligation. Investing activities are primarily for investment in facilities for generation, transmission and distribution of electric energy and for energy efficiency improvements. In 1993, PGE's capital expenditures of $144 million were 20% new generating resources, 7% existing generation plants, 43% transmission and distribution, 13% energy efficiency, and 17% general plant and other. 1994 expected capital expenditures of $265 million include $115 million for new generating resources, $20 million for existing generating plants, $75 million for transmission and distribution, $25 million for energy efficiency and $30 million of other expenditures. The PUC has authorized a return on PGE's investment in energy efficiency projects, which will help alleviate the need for additional energy resources in the future. PGE continues to fund an external trust for the future costs of Trojan decommissioning. Funding began in March 1991. Currently PGE funds $11 million each year. As of December 31, 1993, $46 million had been funded and invested primarily in investment grade tax-exempt bonds with a current market value of $49 million. PGE's future capital expenditure program is expected to include investment of $400 million to $450 million to add up to 600 megawatts of gas-fired combustion turbines and cogeneration projects to PGE's resource base over the next five years. In addition, PGE expects to continue investing in energy efficiency programs. PGE's cash provided by operations, after dividends, is expected to meet approximately 50% of PGE's estimated 1994 investing activities compared to 90% in 1993 and 85% in 1992. Financing activities to fund the remaining capital requirements are accomplished through intermediate-term and long-term debt and equity issuances. Access to capital markets is necessary to implement the asset growth strategy discussed above. PGE intends to maintain approximately the same capitalization ratios while funding this asset expansion. The maturities of intermediate and long- term debt are chosen to match expected asset lives and maintain a balanced maturity schedule. Short-term debt, which includes commercial paper and lines of credit, is used for day-to-day operations. Interest rates continued to decline during 1993. As a result, PGE refunded higher coupon debt. PGE issued $150 million of 7 3/4% First Mortgage Bonds in April 1993, and $27 million of 5.65 % Medium Term Notes in May 1993. Proceeds from these issuances redeemed the 9 5/8% Series First Mortgage Bonds and 10% Debentures. Additionally, in August 1993 PGE issued $75 million of Medium Term Notes consisting of $35 million of five year notes at 5.69% and $40 million of ten year notes at 6.47%. Proceeds from this issuance were used to redeem the 8% and both 8 3/4% Series First Mortgage Bonds. The issuance of additional preferred stock and First Mortgage Bonds requires PGE to meet earnings coverage and security provisions set forth in the Articles of Incorporation and the Indenture securing its First Mortgage Bonds. As of December 31, 1993, PGE could issue $475 million of preferred stock and $370 million of additional First Mortgage Bonds. Appendix (Electronic Filing Only) Omitted graphic material: Page 8 Retail Price v. Inflation graph comparing PGE retail price (price per KWh) to Portland CPI Retail Price CPI 1984 4.84 102.8 1985 5.12 106.7 1986 5 108.2 1987 4.93 110.9 1988 4.77 114.7 1989 4.69 120.3 1990 4.57 127.4 1991 4.69 134 1992 4.78 140 1993 4.86 143.6 Page 12 Loads v. Firm Resources graph: (average MW) Loads Firm Resources 1989 1862 2079 1990 1973 2078 1991 2018 2071 1992 2138 2225 1993 2195 2022 1994 2268 2051 1995 2316 2055 1996 2368 2049 1997 2432 2223 1998 2479 2223 Page 12 1993 Actual Power Sources pie chart: PGE Hydro: 12% (2,355,000 MWh) Coal: 21% (4,111,000 MWh) Secondary Purchases: 28% (5,305,000 MWh) Firm Purchases: 30% (5,888,000 MWh) Combustion Turbines: 9% (1,714,000 MWh) Page 12 1994 Forecasted Power Sources pie chart: PGE Hydro: 12% (2,347,000 MWh) Secondary Purchases: 20% (3,980,000 MWh) Coal: 21% (4,272,000 MWh) Firm Purchases: 37% (7,231,000 MWh) Combustion Turbines: 10% (1,874,000 MWh) Page 28 Residential Customers graph: (Thousands) 1983 454950 1984 454732 1985 461076 1986 470136 1987 476481 1988 484293 1989 496165 1990 512913 1991 526699 1992 536111 1993 545410 Page 29 Operating Revenue and Net Income (Loss) graph: ($ Millions) Operating Revenue Net Income 1989 797 -27 1990 852 100 1991 890 -50 1992 884 90 1993 947 89 Page 29 PGE Electricity Sales graph: (Billions of KWh) 1989 Residential 6.1 Commercial 5.2 Industrial 3.5 Wholesale 3.0 1990 Residential 6.4 Commercial 5.5 Industrial 3.6 Wholesale 4.3 1991 Residential 6.5 Commercial 5.6 Industrial 3.6 Wholesale 3.9 1992 Residential 6.3 Commercial 5.8 Industrial 3.6 Wholesale 2.7 1993 Residential 6.8 Commercial 6.0 Industrial 3.8 Wholesale 1.6 Page 30 Operating Expenses graph: ($ Millions) 1989 Operating Expenses 295 Variable Power 179 Depreciation 91 Operating Expenses 302 Variable Power 200 Depreciation 90 Operating Expenses 361 Variable Power 226 Depreciation 112 Operating Expenses 327 Variable Power 222 Depreciation 99 Operating Expenses 283 Variable Power 311 Depreciation 122 Page 30 Net Variable Power Costs graph: Net variable power is defined as variable power less wholesale revenues. (Mills/KWh) Net Variable Power Retail Revenues 1989 5 46 1990 5 46 1991 6 48 1992 7 49 1993 13 52 Page 32 Utility Capital Expenditures graph: ($ Millions) 1989 119 1990 109 1991 148 1992 154 1993 144 Page 33 Capitalization ($ Millions) 1989 Long-term Debt 817 Common Equity 762 Preferred Stock 153 1990 Long-term Debt 763 Common Equity 771 Preferred Stock 152 1991 Long-term Debt 913 Common Equity 679 Preferred Stock 150 1992 Long-term Debt 874 Common Equity 724 Preferred Stock 152 1993 Long-term Debt 803 Common Equity 744 Preferred Stock 140 Management's Statement of Responsibility Portland General Corporation's management is responsible for the preparation and presentation of the consolidated financial statements in this report. Management is also responsible for the integrity and objectivity of the statements. Generally accepted accounting principles have been used to prepare the statements, and in certain cases informed estimates have been used that are based on the best judgment of management. Management has established, and maintains, a system of internal accounting controls. The controls provide reasonable assurance that assets are safeguarded, transactions receive appropriate authorization, and financial records are reliable. Accounting controls are supported by written policies and procedures, an operations planning and budget process designed to achieve corporate objectives, and internal audits of operating activities. Portland General's Board of Directors includes an Audit Committee composed entirely of outside directors. It reviews with management, internal auditors and independent auditors, the adequacy of internal controls, financial reporting, and other audit matters. Arthur Andersen & Co. is Portland General's independent public accountant. As a part of its annual audit, internal accounting controls are selected for review in order to determine the nature, timing and extent of audit tests to be performed. All of the corporation's financial records and related data are made available to Arthur Andersen & Co. Management has also endeavored to ensure that all representations to Arthur Andersen & Co. were valid and appropriate. Joseph M. Hirko Vice President Finance, Chief Financial Officer, Chief Accounting Officer and Treasurer Report of Independent Public Accountants To the Board of Directors and Shareholders of Portland General Corporation: We have audited the accompanying consolidated balance sheets and statements of capitalization of Portland General Corporation and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, retained earnings and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As more fully discussed in Note 6 to the consolidated financial statements, the realization of assets related to the abandoned Trojan Nuclear Plant in the amount of $722 million is dependent upon the ratemaking treatment as determined by the Public Utility Commission of Oregon. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Portland General Corporation and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. As more fully discussed in Note 5 to the consolidated financial statements, effective January 1, 1993, the Company changed its method of accounting for income taxes. Portland, Oregon, January 25, 1994 (except with respect to the matter discussed in Note 16, as to which the date is February 23, 1994) ARTHUR ANDERSEN & CO. Item 8.	Item 8. Financial Statements and Supplementary Data The accompanying notes are an integral part of these consolidated statements. The accompanying notes are an integral part of these consolidated statements. The accompanying notes are an integral part of these consolidated statements. Portland General Corporation and Subsidiaries Notes to Financial Statements Note 1 Summary of Significant Accounting Policies Consolidation Principles The consolidated financial statements include the accounts of Portland General Corporation (Portland General or the Company) and all of its majority-owned subsidiaries. Significant intercompany balances and transactions have been eliminated. Basis of Accounting Portland General and its subsidiaries conform to generally accepted accounting principles. In addition, Portland General Electric Company's (PGE) policies are in accordance with the accounting requirements and the ratemaking practices of regulatory authorities having jurisdiction. Revenues PGE accrues estimated unbilled revenues for services provided to month-end. Purchased Power PGE credits purchased power costs for the net amount of benefits received through a power purchase and sale contract with the Bonneville Power Administration (BPA). Reductions in purchased power costs that result from this exchange are passed directly to PGE's residential and small farm customers in the form of lower prices. Depreciation PGE's depreciation is computed on the straight-line method based on the estimated average service lives of the various classes of plant in service. Excluding the Trojan Nuclear Plant (Trojan), depreciation expense as a percent of the related average depreciable plant in service was approximately 3.9% in 1993, 3.8% in 1992 and 3.9% in 1991. The cost of renewal and replacement of property units is charged to plant, and repairs and maintenance are charged to expense as incurred. The cost of utility property units retired, other than land, is charged to accumulated depreciation. Allowance for Funds Used During Construction (AFDC) AFDC represents the pretax cost of borrowed funds used for construction purposes and a reasonable rate for equity funds. AFDC is capitalized as part of the cost of plant and is credited to income but does not represent current cash earnings. The average rates used by PGE were 3.52%, 4.72% and 8.05% for the years 1993, 1992 and 1991, respectively. Income Taxes Portland General files a consolidated federal income tax return. Portland General's policy is to collect for tax liabilities from subsidiaries that generate taxable income and to reimburse subsidiaries for tax benefits utilized in its tax return. Income tax provisions are adjusted, when appropriate, for potential tax adjustments. Deferred income taxes are provided for temporary differences between financial and income tax reporting. See Notes 5 and 5A, Income Taxes, for more details. Amounts recorded for Investment Tax Credits (ITC) have been deferred and are being amortized to income over the approximate lives of the related properties, not to exceed 25 years. Nuclear Fuel Amortization of the cost of nuclear fuel was based on the quantity of heat produced for the generation of electric energy. Investment in Leases Columbia Willamette Leasing (CWL), a subsidiary of Portland General Holdings, Inc. (Holdings), acquires and leases capital equipment. Leases that qualify as direct financing leases and are substantially financed with nonrecourse debt at lease inception are accounted for as leveraged leases. Recorded investment in leases is the sum of the net contracts receivable and the estimated residual value, less unearned income and deferred ITC. Unearned income and deferred ITC are amortized to income over the life of the leases to provide a level rate of return on net equity invested. The components of CWL's net investment in leases as of December 31, 1993 and 1992, are as follows (thousands of dollars): 1993 1992 Lease contracts receivable $ 600,710 $ 645,746 Nonrecourse debt service (481,988) (524,661) Net contracts receivable 118,722 121,085 Estimated residual value 88,047 88,085 Less - Unearned income (41,395) (43,436) Investment in leveraged leases 165,374 165,734 Less - Deferred ITC (9,756) (10,037) Investment in leases, net $ 155,618 $ 155,697 Cash and Cash Equivalents Highly liquid investments with original maturities of three months or less are classified as cash equivalents. WNP-3 Settlement Exchange Agreement The Washington Public Power Supply System Unit 3 (WNP-3) Settlement Exchange Agreement, which has been excluded from PGE's rate base, is carried at present value and amortized on a constant return basis. Regulatory Assets PGE defers, or accrues revenue for, certain costs which otherwise would be charged to expense, if it is probable that future collections will permit recovery of such costs. These costs are reflected as deferred charges or accrued revenues in the financial statements and are amortized over the period in which revenues are collected. Trojan plant and decommissioning costs are currently covered in customer rates. Of the remaining regulatory assets, approximately 78% have been treated by the Oregon Public Utility Commission (PUC) as allowable cost of service items in PGE's most recent rate processes. The remaining amounts are subject to regulatory confirmation in PGE's future ratemaking proceedings. Reclassifications Certain amounts in prior years have been reclassified for comparative purposes. Note 2 Real Estate - Discontinued Operations Portland General is divesting its real estate operations, which consist primarily of Columbia Willamette Development Company (CWDC). In early 1993, CWDC withdrew from the Cornerstone Columbia Development Company (Cornerstone), a partnership with Weyerhauser Real Estate Company. As a distribution and complete liquidation of CWDC's interest in Cornerstone, CWDC received all of Cornerstone's interest in a joint venture. In 1991, Portland General reviewed the adequacy of its real estate loss reserve and determined that an additional reserve was warranted. A loss of $29 million (net of related income tax benefits of $17 million) was recorded in the fourth quarter of 1991 to recognize lower market values and additional holding costs. At December 31, 1993 and 1992, the net assets of real estate operations were composed of the following (thousands of dollars): 1993 1992 Assets Real estate development $18,900 $22,132 Other assets 21,234 27,248 Total assets 40,134 49,380 Liabilities 1,632 2,181 Reserve for discontinuance - net 7,124 13,221 Net assets $31,378 $33,978 Management believes that it has adequately provided for accounting losses to be incurred during the disposal of real estate assets. Prior estimates will be continually monitored during the liquidation period. Note 3 Loss from Independent Power In late 1991 Holdings, a wholly owned subsidiary of Portland General, recorded losses totaling $74 million, net of tax benefits of $16 million, related to the write-off of Holdings' equity investment in Bonneville Pacific Corporation (Bonneville Pacific) and a provision for uncollectible loans, project development and other costs. Holdings owns 9.8 million shares, or 46%, of Bonneville Pacific's common stock. The write-off followed a review of the Bonneville Pacific investment, which raised various concerns including the carrying values of certain of its assets, the lack of progress by Bonneville Pacific to complete agreed- upon project selldowns and Bonneville Pacific's poor financial performance. In December 1991, Bonneville Pacific voluntarily filed for protection under Chapter 11 of the Bankruptcy Code. Holdings also has $28 million of secured and unsecured loans outstanding to Bonneville Pacific and its subsidiaries. Holdings recorded a reserve in December 1991 against the outstanding loans. Holdings intends to pursue recovery of these loans but cannot predict what amount, if any, may be recovered. See Note 14, Legal Matters, for litigation related to Bonneville Pacific. Note 4 Employee Benefits Pension Plan Portland General has a non-contributory pension plan (the Plan) covering substantially all of its employees. Benefits under the Plan are based on years of service, final average pay and covered compensation.Portland General's policy is to contribute annually to the Plan at least the minimum required under the Employee Retirement Income Security Act of 1974 but not more than the maximum amount deductible for income tax purposes. The Plan's assets are held in a trust and consist primarily of investments in common and preferred stocks, corporate bonds and US government and agency issues. Portland General determines net periodic pension expense according to the principles of SFAS No. 87, Employers' Accounting for Pensions. The following table sets forth the Plan's funded status and amounts recognized in Portland General's financial statements (thousands of dollars): 1993 1992 Actuarial present value of benefit obligations: Accumulated benefit obligation, including vested benefits of $151,334 and $133,870 $166,301 $145,670 Effect of projected future compensation levels 32,608 34,531 Projected benefit obligation (PBO) 198,909 180,201 Plan assets at fair value 262,412 226,413 Plan assets in excess of PBO 63,503 46,212 Unrecognized net experience gain (60,445) (42,324) Unrecognized prior service costs 14,147 16,677 Unrecognized net transition asset being recognized over 18 years (21,533) (23,490) Pension - prepaid cost (liability) $ (4,328) $(2,925) 1992 1991 Assumptions: Discount rate used to calculate PBO 7.25% 8.00% 8.00% Rate of increase in future compensation levels 5.25 6.00 6.25 Long-term rate of return on assets 8.50 8.50 8.50 Net pension expense for 1993, 1992 and 1991 included the following components (thousands of dollars): 1993 1992 Service cost $ 6,151 $ 6,082 $ 5,627 Interest cost on PBO 14,241 13,792 13,641 Actual return on plan assets (48,231) (18,272) (45,693) Net amortization and deferral 29,839 1,496 30,029 Net periodic pension expense $ 2,000 $ 3,098 $ 3,604 Other Post-Retirement Benefit Plans Portland General accrues for health, medical and life insurance costs during the employees' service years, per SFAS No. 106. PGE receives recovery for the annual provision in customer rates. Employees are covered under a Defined Dollar Medical Benefit Plan which limits Portland General's obligation by establishing a maximum contribution per employee. The accumulated benefit obligation for postretirement health and life insurance benefits at December 31, 1993 was $31 million, for which there were $31 million of assets held in trust. The projected benefit obligation for postretirement health and life insurance benefits at December 31, 1992 was $29 million. Portland General also provides senior officers with additional benefits under an unfunded Supplemental Executive Retirement Plan (SERP). Projected benefit obligations for the SERP are $16 million and $12 million at December 31, 1993 and 1992, respectively. Deferred Compensation Portland General provides certain management employees with benefits under an unfunded Management Deferred Compensation Plan (MDCP). Obligations for the MDCP are $18 million and $14 million at December 31, 1993 and 1992, respectively. Trojan Retention Plan In October 1992, Portland General implemented a defined contribution plan to retain Trojan employees during a phaseout of plant operations. Trojan ceased commercial operation in early 1993; participation in the retention plan was terminated on May 31, 1993 and all benefits under the plan were paid. Employee Stock Ownership Plan Portland General has an Employee Stock Ownership Plan (ESOP) which is a part of its 401(k) retirement savings plan. Employee contributions up to 6% of base pay are matched by employer contributions in the form of ESOP common stock. Shares of common stock to be used to match contributions of PGE employees were purchased from a $36 million loan from PGE to the ESOP trust in late 1990. This loan is presented in the common equity section as unearned compensation. Cash contributions from PGE and dividends on shares held in the trust are used to pay the debt service on PGE's loan. As the loan is retired, an equivalent amount of stock is allocated to employee accounts. In 1993, total contributions to the ESOP of $5 million combined with dividends on unallocated shares of $2 million were used to pay debt service and interest on PGE's loan. Shares of common stock used to match contributions by employees of Portland General and its subsidiaries are purchased on the open market. Note 5 Income Taxes The following table shows the detail of taxes on income and the items used in computing the differences between the statutory federal income tax rate and Portland General's effective tax rate. Note: The table does not include income taxes related to 1991 losses from independent power or discontinued real estate operations (thousands of dollars): 1993 1992 Income Tax Expense: Currently payable $ 2,989 $ 44,057 $ 22,520 Deferred income taxes Accelerated depreciation 15,477 20,049 26,258 WNP-3 amortization (1,099) (2,190) (2,570) AMAX coal contract (1,238) (1,227) (1,050) Trojan operating costs 17,332 7,402 4,080 Energy efficiency programs 7,327 3,246 2,859 Replacement power costs 26,543 (246) 5,084 Repurchase debt 4,847 1,019 (850) USDOE nuclear fuel assessment 6,108 - - Excess deferred taxes (3,494) (1,888) (1,557) Interim rate relief - 6,573 1,036 Lease income (18,151) (15,453) (14,892) Nonrecourse debt interest 12,578 11,621 12,156 Other 6,659 (1,258) (3,469) Investment tax credit adjustments (4,356) (6,981) (4,589) $ 71,522 $ 64,724 $ 45,016 Provision Allocated to: Operations $ 67,520 $ 67,235 $ 44,005 Other income and deductions 4,002 (2,511) 1,011 $ 71,522 $ 64,724 $ 45,016 Effective Tax Rate Computation: Computed tax based on statutory $ 56,224 $ 52,478 $ 33,477 federal income tax rates applied to income before income taxes Increases (Decreases) resulting from: Accelerated depreciation 10,748 9,462 7,763 State and local taxes - net 3,288 10,117 5,766 Investment tax credits (4,356) (6,981) (4,589) Adjustments to income tax reserves - (3,284) (393) Excess deferred taxes (3,419) (1,816) (1,483) USDOE nuclear fuel assessment 5,075 - - - Preferred dividend requirement 3,935 4,296 4,390 Other 27 452 85 $ 71,522 $ 64,724 $ 45,016 Effective tax rate 44.5% 41.9% 45.7% Effective January 1, 1993, Portland General adopted SFAS No. 109, "Accounting for Income Taxes". Prior to SFAS No. 109, Portland General accounted for income taxes in accordance with Accounting Principles Board Opinion No. 11. Prior period financial statements have not been restated. As of December 31, 1993 and 1992, the significant components of the Company's deferred income tax assets and liabilities were as follows (thousands of dollars): 1993 1992 Deferred Tax Assets Plant-in-service $ 83,602 $ 18,608 Regulatory reserve 47,718 46,804 Other 75,404 40,796 206,724 106,208 Deferred Tax Liabilities Plant-in-service (497,476) (201,596) WNP-3 exchange contract (70,542) (71,099) Replacement power costs (29,574) (4,838) Leasing (147,101) (140,980) Other (94,924) (53,129) (839,617) (471,642) Less current deferred taxes 842 - Less valuation allowance (28,197) - Total $(660,248) $(365,434) As a result of implementing SFAS No. 109, Portland General has recorded deferred tax assets and liabilities for all temporary differences between the financial statement bases and tax bases of assets and liabilities. Portland General has certain state pollution control tax credit carryforwards and the benefits of capital loss carryforwards that presently cannot be offset with future taxable income or capital gains and accordingly has recorded a valuation allowance totalling $28.2 million at December 31, 1993 to fully reserve against these assets. Federal alternative minimum tax credit carryforwards, which have no expiration date, are $15.7 million at December 31, 1993. The Omnibus Budget Reconciliation Act of 1993 resulted in a federal tax rate increase from 34% to 35% effective January 1, 1993. The tax rate increase resulted in additional income tax expense for the Company of $4.9 million. The IRS completed its examination of Portland General's tax returns for the years 1985 to 1987 and has issued a statutory notice of tax deficiency, which Portland General is contesting. As part of this audit, the IRS has proposed to disallow PGE's 1985 WNP-3 abandonment loss deduction on the premise that it is a taxable exchange. PGE disagrees with this position and will take appropriate action to defend its deduction. Management believes that it has appropriately provided for probable tax adjustments and is of the opinion that the ultimate disposition of this matter will not have a material adverse impact on the financial condition of Portland General. Note 6 Trojan Nuclear Plant Shutdown - PGE is the 67.5% owner of Trojan. In early 1993, PGE ceased commercial operation of Trojan. PGE made the decision to shut down Trojan as part of its least cost planning process, a biennial process whereby PGE evaluates a mix of energy options that yield an adequate and reliable supply of electricity at the least cost to the utility and to its customers. On June 3, 1993 the PUC acknowledged PGE's Least Cost Plan (LCP). Decommissioning Estimate - The 1993 nuclear decommissioning estimate of $409 million represents a site-specific decommissioning cost estimate performed for Trojan by an experienced decommissioning engineering firm. This cost estimate assumes that the majority of decommissioning activities will occur between 1998 and 2002, after construction of a temporary dry spent fuel storage facility. The final decommissioning activities will occur in 2018 after PGE completes shipment of spent fuel to a United States Department of Energy (USDOE) facility. The decommissioning cost estimate includes the cost of decommissioning planning, removal and burial of irradiated equipment and facilities as required by the Nuclear Regulatory Commission (NRC); building demolition and nonradiological site remediation; and fuel management costs including licensing, surveillance and $75 million of transition costs. Transition costs are the operating costs associated with closing Trojan, operating and maintaining the spent fuel pool and securing the plant until dismantlement can begin. Except for transition costs, which will continue to be amortized as incurred PGE will fund the decommissioning costs through contributions to the Trojan decommissioning trust. The 1992 decommissioning cost estimate of $411 million was based upon a study performed on a nuclear plant similar to Trojan and included the cost of dismantlement activities performed during the years 1996 through 2002, monitoring of stored spent fuel through 2018 and $130 million of miscellaneous closure and transition costs ($43 million was amortized to nuclear operating expenses during 1993). The 1992 estimate and the 1993 site- specific estimate are reflected in the financial statements in nominal dollars (actual dollars expected to be spent in each year). The difference between the 1992 and the 1993 cost estimates, reflected in nominal dollars, is due to the application of a higher inflation factor, the timing of decommissioning activities and certain changes in assumptions, such as decommissioning the temporary dry spent fuel storage facility and shipping highly activated reactor components to the USDOE repository in 2018, which are included in the 1993 estimate. Both the 1992 cost estimate and the 1993 site-specific cost estimate reflected in 1993 (current) dollars are $289 million. Assumptions used to develop the site- specific cost estimate represent the best information PGE has currently. However, the Company is continuing its analysis of various options which could change the timing and scope of dismantling activities. Presently, PGE is planning to accelerate the timing of large component removal which could reduce overall decommissioning costs. PGE plans to submit a detailed decommissioning work plan to the NRC in mid-1994. PGE expects any future changes in estimated decommissioning costs to be incorporated in future revenues to be collected from customers. PGE is recording an annual operating provision of $11 million for decommissioning. This provision is being collected from customers and deposited in an external trust fund. Earnings on the trust fund assets reduce the amount of decommissioning costs to be collected from customers. Trojan abandonment - decommissioning of $356 million (reflected in the deferred charges section of the Company's balance sheet) represents remaining decommissioning costs expected to be collected from customers. Trojan decommissioning trust assets are invested primarily in investment grade tax-exempt bonds. At December 31, 1993 the trust reflects the following activity (thousands of dollars): Beginning Balance 1/01/93 $32,945 1993 Activity Contributions 11,220 Earnings 4,696 Ending Balance 12/31/93 $48,861 Investment Recovery - PGE filed a general rate case on November 8, 1993 which addresses recovery of Trojan plant costs, including decommissioning. In late February 1993, the PUC granted PGE accounting authorization to continue using previously approved depreciation and decommissioning rates and lives for its Trojan investment. As stated earlier, PGE made the decision to permanently cease commercial operation of Trojan as part of its least cost planning process. Management determined that continued operation of Trojan was not cost effective. Least cost analysis assumed that recovery of the Trojan plant investment, including future decommissioning costs, would be granted by the PUC. Regarding the authority of the PUC to grant recovery, the Oregon Department of Justice (Attorney General) issued an opinion that the PUC may allow rate recovery of total plant costs, including operating expenses, taxes, decommissioning costs, return of capital invested in the plant and return on the undepreciated investment. While the Attorney General's opinion does not guarantee recovery of costs associated with the shutdown, it does clarify that under current law the PUC has authority to allow recovery of such costs in rates. PGE asked the PUC to resolve certain legal and policy questions regarding the statutory framework for future ratemaking proceedings related to the recovery of the Trojan investment and decommissioning costs. On August 9, 1993, the PUC issued a declaratory ruling agreeing with the Attorney General's opinion discussed above. The ruling also stated that the PUC will favorably consider allowing PGE to recover in rates some or all of its return on and return of its undepreciated investment in Trojan, including decommissioning costs, if PGE meets certain conditions. PGE believes that its general rate filing provides evidence that satisfies the conditions established by the PUC. Management believes that the PUC will grant future revenues to cover all, or substantially all, of Trojan plant costs with an appropriate return. However, future recovery of the Trojan plant investment and future decommissioning costs requires PUC approval in a public regulatory process. Although the PUC has allowed PGE to continue, on an interim basis, collection of these costs in the same manner as prescribed in its last general rate proceeding, the PUC has yet to address recovery of costs related to a prematurely retired plant when the decision to close the plant was based upon a least cost planning process. Due to uncertainties inherent in a public process, management cannot predict, with certainty, whether all, or substantially all, of the Trojan plant investment and future decommissioning costs will be recovered. Management believes the ultimate outcome of this public regulatory process will not have a material adverse effect on the financial condition, liquidity or capital resources of Portland General. However, it may have a material impact on the results of operations for a future reporting period. Portland General's independent accountants are satisfied that management's assessment regarding the ultimate outcome of the regulatory process is reasonable. Due to the inherent uncertainties in the regulatory process discussed above, the magnitude of the amounts involved and the possible impact on the results of operations for a future reporting period, the independent accountants have added a paragraph to their audit report to give emphasis to this matter. Nuclear Fuel Disposal and Clean up of Federal Plants - PGE has a contract with the USDOE for permanent disposal of spent nuclear fuel in USDOE facilities. These disposal services are now estimated to commence no earlier than 2010. PGE paid the USDOE .1 cent per net kilowatt-hour sold at Trojan for these future disposal services. On-site storage capacity is able to accommodate fuel until the federal facilities are available. The Energy Policy Act of 1992 provided for the creation of a Decontamination and Decommissioning Fund (DDF) to provide for the clean up of the USDOE gas diffusion plants. The DDF is to be funded by domestic nuclear utilities and the Federal Government. The legislation provided that each utility pays based on the ratio of the amount of enrichment services the utility purchased and the total amount of enrichment services purchased by all domestic utilities prior to the enactment of the legislation. Trojan's estimated usage was 1.03%. Based on this estimate, PGE's portion of the funding requirement is approximately $15.6 million. Amounts are funded over 15 years beginning with the USDOE's fiscal year 1993. PGE made its first of the 15 annual payments on September 30, 1993 for $1.04 million. Nuclear Insurance - The Price-Anderson Amendment of 1988 limits public liability claims that could arise from a nuclear incident to a maximum of $9.4 billion per incident. PGE has purchased the maximum primary insurance coverage currently available of $200 million. The remaining $9.2 billion is covered by secondary financial protection required by the NRC. This secondary coverage provides for loss sharing among all owners of nuclear reactor licenses. In the event of an incident at any nuclear plant in which the amount of the loss exceeds $200 million, PGE could be assessed retrospective premiums of up to $53.5 million per incident, limited to a maximum of $7 million per incident in any one year under the secondary financial protection coverage. PGE's share of property damage and decontamination coverage is provided for losses at Trojan up to $337 million primary and $378 million excess. The $378 million excess coverage is provided subject to a potential maximum retrospective premium adjustment of $0.8 million per policy year. The NRC requires that, in case of an incident, insurance proceeds must first be dedicated to stabilizing and decontaminating the reactor. This could reduce the amount of proceeds available to repair, replace or restore the property or otherwise available to the trustee for application under PGE's First Mortgage Bond Indenture. Insurance coverage is provided primarily through insurance companies owned by utilities with nuclear facilities. Note 7 *See the discussion of stock compensation plans below and Note 4, Employee Benefits for a discussion of the ESOP. Common Stock As of December 31, 1993, Portland General had reserved 367,000 authorized but unissued common shares for issuance under its dividend reinvestment plan. In addition, new shares of common stock are issued under an employee stock purchase plan. Cumulative Preferred Stock of Subsidiary No dividends may be paid on common stock or any class of stock over which the preferred stock has priority unless all amounts required to be paid for dividends and sinking fund payments have been paid or set aside, respectively. The 7.75% Series preferred stock has an annual sinking fund requirement which requires the redemption of 15,000 shares at $100 per share beginning in 2002. At its option, PGE may redeem, through the sinking fund, an additional 15,000 shares each year. All remaining shares shall be mandatorily redeemed by sinking fund in 2007. This Series is only redeemable by operation of the sinking fund. The 8.10% Series preferred stock has an annual sinking fund requirement which requires the redemption of 100,000 shares at $100 per share beginning in 1994. At its option, PGE may redeem, through the sinking fund, an additional 100,000 shares each year. This Series is redeemable at the option of PGE at $103 per share to April 14, 1994 and at reduced amounts thereafter. Common Dividend Restriction of Subsidiary PGE is restricted from paying dividends or making other distributions to Portland General, without prior PUC approval, to the extent such payment or distribution would reduce PGE's common stock equity capital below 36% of its total capitalization. At December 31, 1993, PGE's common stock equity capital was 44% of its total capitalization. Stock Compensation Plans Portland General has a plan under which 2.3 million shares of Portland General common stock are available for stock- based incentives. Upon termination, expiration or lapse of certain types of awards, any shares remaining subject to the award are again available for grant under the plan. As of December 31, 1993, 856,800 stock options were outstanding. Of the outstanding options, 20,000 are exercisable: 10,000 at a price of $15.75 per share; 2,500 at $17.375 per share; and 7,500 at $14.75 per share. The remaining 836,800 options are exercisable beginning in 1994 through 1998 at prices ranging from $14 to $22.25 per share. In addition, 25,000 options granted under a separate award were exercised in 1993. On December 6, 1993 Portland General issued 64,000 restricted common shares for officers of Portland General and PGE. Note 8 Short-Term Borrowings Portland General meets its liquidity needs through the issuance of commercial paper and borrowings from commercial banks. At December 31, 1993, Portland General had total committed lines of credit of $240 million. Portland General has a $40 million committed facility expiring in July 1994. PGE has committed facilities of $120 million expiring in July 1996 and $80 million expiring in July 1994. These lines of credit have annual fees ranging from 0.15% to 0.25% and do not require compensating cash balances. The facilities are used primarily as backup for both commercial paper and borrowings from commercial banks under uncommitted lines of credit. At December 31, 1993, there were no outstanding borrowings under the committed facilities. Portland General has a commercial paper facility of $40 million in addition to PGE's $200 million facility. The amount of commercial paper outstanding cannot exceed each company's unused committed lines of credit. Commercial paper and lines of credit borrowings are at rates reflecting current market conditions and, generally, are substantially below the prime commercial rate. Short-term borrowings and related interest rates were as follows (thousands of dollars): 1993 1992 1991 As of year end: Aggregate short-term debt outstanding Bank loans - $ 10,002 $ 16,000 Commercial paper $159,414 130,676 76,473 Weighted average interest rate Bank loans - 4.4% 6.8% Commercial paper 3.5% 4.1 5.5 Unused committed lines of credit $240,000 $180,000 $175,000 For the year ended: Average daily amounts of short-term debt outstanding Bank loans $ 10,949 $ 7,671 $ 56,579 Commercial paper 123,032 89,077 30,539 Weighted daily average interest rate Bank loans 3.6% 5.0% 7.2% Commercial paper 3.5 4.2 6.5 Maximum amount outstanding during the year $171,208 $144,056 $108,231 Interest rates exclude the effect of commitment fees, facility fees and other financing fees. Note 9 Long-Term Debt The Indenture securing PGE's First Mortgage Bonds constitutes a direct first mortgage lien on substantially all utility property and franchises, other than expressly excepted property. The following principal amounts of long-term debt become due for redemption through sinking funds and maturities (thousands of dollars): 1994 1995 1996 1997 Sinking Funds $ 1,313 $ 1,138 $ 988 $ 688 $ 688 Maturities 41,289 71,356 57,528 56,085 64,745 The sinking funds include $988,000 a year for 1994 through 1996 and $688,000 for 1997 and 1998, which, in accordance with the terms of the Indenture, PGE may satisfy by pledging available property additions equal to 166-2/3% of the sinking fund requirements. Note 10 Commitments New Generating Resources During 1993 PGE entered into a $133 million agreement with a contractor for construction of the Coyote Springs cogeneration facility. Under the terms of the agreement, PGE is committed to making progress payments of approximately $91 million in 1994, and $16 million in 1995. At December 31, 1993, progress payments of approximately $26 million have been made. Natural Gas Transmission Agreements In January 1993, PGE signed two long- term agreements for transmission of natural gas from domestic and Canadian sources to PGE's existing and proposed natural gas-fired generating facilities. One agreement provides PGE firm pipeline capacity beginning June, 1993 and increased pipeline capacity in November 1995. Beginning in late 1995, the second agreement will give PGE capacity on a second interstate gas pipeline. Under the terms of these two agreements, PGE is committed to paying capacity charges of approximately $3 million during 1994, $4 million in 1995, $11 million annually through 2010 and $3 million annually until 2015. Under these agreements PGE has the right to assign unused capacity to other parties. In addition, PGE will make a capital contribution for pipeline construction of between $3 million and $7 million in 1995. Railroad Service Agreement In October 1993, PGE entered into a railroad service agreement and will make capital contributions toward upgrading a line used to deliver coal from Wyoming to the Boardman Coal Plant (Boardman). PGE is required to contribute $8 million over the 6-year contract life. Purchase Commitments Other purchase commitments outstanding (principally construction at PGE) totaled approximately $14 million at December 31, 1993. Cancellation of these purchase agreements could result in cancellation charges. Purchased Power PGE has long-term power purchase contracts with certain public utility districts in the state of Washington and with the City of Portland, Oregon. PGE is required to pay its proportionate share of the operating and debt service costs of the hydro projects whether or not they are operable. Selected information is summarized as follows (thousands of dollars): Rocky Priest Portland Reach Rapids Wanapum Wells Hydro Revenue bonds outstanding at December 31, 1993 $189,752 $141,245 $189,395 $199,920 $ 40,230 PGE's current share of output, capacity, and cost Percentage of output 12.0% 13.9% 18.7% 21.9% 100% Net capability in megawatts 154 125 170 184 36 Annual cost, including debt service 1993 $4,000 $3,800 $5,400 $5,500 $4,800 1992 3,900 3,100 4,400 4,800 4,400 1991 3,800 3,400 4,000 4,300 3,800 Contract expiration date 2011 2005 2009 2018 2017 PGE's share of debt service costs, excluding interest, will be approximately $6 million for each of the years 1994 through 1996, $7 million for 1997 and $5 million for 1998. The minimum payments through the remainder of the contracts are estimated to total $104 million. PGE has entered into long-term contracts to purchase power from three other utilities in the region. These contracts will require fixed payments of up to $25 million in 1994 and $32 million in 1995 and 1996. After that date, capacity charges will be up to $25 million annually until the second contract terminates in 2001. The third contract will continue until 2016 with capacity charges of $19 million annually. Leases PGE has operating and capital leasing arrangements for its headquarters complex, combustion turbines and the coal-handling facilities and certain railroad cars for Boardman. PGE's aggregate rental payments charged to expense amounted to $22 million in 1993, $20 million in 1992 and $21 million in 1991. PGE has capitalized its combustion turbine leases. However, these leases are considered operating leases for ratemaking purposes. As of December 31, 1993, the future minimum lease payments under non- cancelable leases are as follows (thousands of dollars): Year Ending Operating Leases December 31 Capital Leases (Net of Sublease Rentals) Total 1994 $ 3,016 $ 18,568 $ 21,584 1995 3,016 19,711 22,727 1996 3,016 20,261 23,277 1997 3,016 19,794 22,810 1998 3,016 18,992 22,008 Remainder 1,388 186,575 187,963 Total 16,468 $283,901 $300,369 Imputed (2,775) Interest Present Value of Minimum Future Net Lease Payments $13,693 Included in the future minimum operating lease payments schedule above is approximately $140 million for PGE's headquarters complex. Note 11 WNP-3 Settlement Exchange Agreement PGE is selling energy received under a WNP-3 Settlement Exchange Agreement (WSA) to the Western Area Power Administration (WAPA) for 25 years, which began October 1990. Revenues from the WAPA sales contract are expected to be sufficient to support the carrying value of PGE's investment. The energy received by PGE under WSA is the result of a settlement related to litigation surrounding the abandonment of WNP-3. PGE receives about 65 average annual megawatts for approximately 30 years from BPA under the WSA. In exchange PGE will make available to BPA energy from its combustion turbines or from other available resources at an agreed-to price. Note 12 Jointly-Owned Plant At December 31, 1993, PGE had the following investments in jointly-owned generating plants (thousands of dollars): MW PGE % Plant Accumulated Facility Location Fuel Capacity Interest In Service Depreciation Boardman Boardman, OR Coal 508 65.0 $359,555 $152,981 Colstrip 3&4 Colstrip, MT Coal 1,440 20.0 444,817 157,576 Centralia Centralia, WA Coal 1,310 2.5 9,301 5,143 The dollar amounts in the table above represent PGE's share of each jointly- owned plant. Each participant in the above generating plants has provided its own financing. PGE's share of the direct expenses of these plants is included in the corresponding operating expenses on Portland General's and PGE's consolidated income statements. Note 13 Regulatory Matters Public Utility Commission of Oregon PGE had sought judicial review of three rate matters related to a 1987 general rate case. In 1989, PGE reserved $89 million for an unfavorable outcome of these matters. In July 1990, PGE reached an out-of-court settlement with the PUC on two of the three rate matter issues being litigated. As a result of the settlement, $16 million was restored to income in 1990. The settlement resolved the dispute with the PUC regarding treatment of accelerated amortization of certain ITC and 1986- 1987 interim relief. As a settlement of the interim relief issue, PGE refunded approximately $17 million to customers. In 1991, the Utility Reform Project (URP) petitioned the PUC to reconsider the order approving the settlement. The Oregon legislature subsequently passed a law clarifying the PUC's authority to approve the settlement. As a result, the PUC issued an order implementing the settlement. URP has filed an appeal in Multnomah County Circuit Court to overturn the PUC's order implementing settlement. In addition, CUB filed a complaint in 1991 in Marion County Circuit Court seeking to modify, vacate, set aside or reverse the PUC's order implementing settlement. In September 1992, the Marion County Circuit Court judge issued a decision upholding the PUC orders approving the settlement. CUB appealed the decision. In December 1993 the Oregon Court of Appeals affirmed without opinion the Circuit Court decision upholding the PUC order. The settlement, however, did not resolve the Boardman/Intertie gain issue, which the parties continue to litigate. PGE's position is that 28% of the gain should be allocated to customers. The 1987 rate order allocated 77% of the gain to customers over a 27-year period. PGE has fully reserved this amount, which is being amortized over a 27-year period in accordance with the 1987 rate order. The unamortized gain, $120 million at December 31, 1993, is shown as "Regulatory reserves" on the balance sheet. In PGE's general rate filing, PGE proposes to accelerate the amortization of the Boardman gain to customers from 27 years to three years, starting in January 1995, as part of a comprehensive settlement of the outstanding litigation on this issue. While the ultimate disposition of these matters may have an impact on the results of operations for a future reporting period, management believes, based on discussion of the underlying facts and circumstances with legal counsel, these matters will not have a material adverse effect on the financial condition of Portland General. Note 14 Legal Matters WNP Cost Sharing PGE and three other investor-owned utilities (IOUs) are involved in litigation surrounding the proper allocation of shared costs between Washington Public Power Supply System (Supply System) Units 1 and 3 and Units 4 and 5. A court ruling issued in May 1989 stated that Bond Resolution No. 890, adopted by the Supply System, controlled disbursement of proceeds from bonds issued for the construction of Unit 5, including the method for allocation of shared costs. It is the IOUs' contention that at the time the project commenced there was agreement among the parties as to the allocation of shared costs and that this agreement and the Bond Resolution are consistent such that the allocation under the agreement is not prohibited by the Bond Resolution. In October 1990, the U.S. District Court ruled that the methodology for the allocation of shared costs required the application of principles akin to those espoused by Chemical Bank. In February 1992, the Court of Appeals reversed the U.S. District Court's decision and ruled that shared costs between Units 3 and 5 should be allocated in proportion to benefits under the equitable method supported by PGE and the other IOUs. A trial remains necessary to assure that the allocations are properly performed. Bonneville Pacific Class Action Suit and Lawsuit A consolidated case of all previously filed class actions has been filed in U.S. District Court for the District of Utah purportedly on behalf of purchasers of common shares and convertible subordinated debentures of Bonneville Pacific Corporation in the period from August 18, 1989 until January 22, 1992 alleging violations of federal and Utah state securities laws, common law fraud and negligent misrepresentation. The defendants are specific Bonneville Pacific insiders, Portland General, Portland General Holdings, Inc., certain Portland General individuals, Deloitte & Touche and three underwriters of a Bonneville Pacific offering of subordinated debentures. The amount of damages alleged is not specified. In addition, the bankruptcy trustee for Bonneville Pacific has filed an amended complaint against Portland General, Holdings, and certain affiliated individuals in U.S. District Court for the District of Utah alleging common law fraud, breach of fiduciary duty, tortious interference, negligence, negligent misrepresentation and other actionable wrongs. The original suit was filed by Bonneville Pacific prior to the appointment of the bankruptcy trustee. The amount of damages sought is not specified in the complaint. Other Legal Matters Portland General and certain of its subsidiaries are party to various other claims, legal actions and complaints arising in the ordinary course of business. These claims are not considered material. Summary While the ultimate disposition of these matters may have an impact on the results of operations for a future reporting period, management believes, based on discussion of the underlying facts and circumstances with legal counsel, that these matters will not have a material adverse effect on the financial condition of Portland General. Other Bonneville Pacific Related Litigation Holdings filed complaints seeking approximately $228 million in damages in the Third Judicial District Court for Salt Lake County (in Utah) against Deloitte & Touche and certain other parties associated with Bonneville Pacific alleging that it relied on fraudulent and negligent statements and omissions by Deloitte & Touche and the other defendants when it acquired a 46% interest in and made loans to Bonneville Pacific starting in September 1990. Note 15 Fair Value of Financial Instruments The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value: Cash and cash equivalents The carrying amount of cash and cash equivalents approximates fair value because of the short maturity of those instruments. Other investments Other investments approximate market value. Redeemable preferred stock The fair value of redeemable preferred stock is based on quoted market prices. Long-term debt The fair value of long-term debt is estimated based on the quoted market prices for the same or similar issues or on the current rates offered to Portland General for debt of similar remaining maturities. The estimated fair values of financial instruments are as follows (thousands of dollars): Note 16 Subsequent Event In February 1994, Portland General issued 2.3 million shares of common stock. Proceeds to Portland General were $41 million. These proceeds were used to purchase 2.3 million additional shares of PGE common stock. PGE, in turn, will use the funds to repay all or a portion of its short-term borrowings or for its construction program. QUARTERLY COMPARISON FOR 1993 AND 1992 (Unaudited) Portland General Corporation Item 9.	Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. Part III Item 10	Item 10 - 13. Information Regarding Directors and Executive Officers of the Registrant Portland General Corporation Information for items 10-13 are incorporated by reference to Portland General's definitive proxy statement to be filed on or about March 29, 1994. Executive officers of Portland General are listed on page 23 of this report. Portland General Electric Company Information regarding item 10 (Executive Compensation) is incorporated by reference to Portland General's definitive proxy statement to be filed on or about March 29, 1994 with the exception of Mr. Cross' compensation for the year 1991 when he was an executive officer at Portland General Electric. The information for Mr. Cross is as follows: Annual Compensation Long-Term Compensation Awards/Options Year Salary ($) Bonus ($) (#) 1991 $150,000 $ 5,0251 15,000 1Mr. Cross received a bonus in 1991 due to his mid-year starting date the prior year; this bonus was attributable to both 1990 and 1991. Information for items 11-13 are incorporated by reference to Portland General's definitive proxy statement to be filed on or about March 29, 1994. Executive officers of Portland General Electric are listed on page 23 of this report. Part IV Item 14.				Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K Portland General Corporation and Portland General Electric Company (a)Index to Financial Statements and Financial Statement Schedules Exhibits See Exhibit Index on Page 69 of this report. (b) Report on Form 8-K PGC PGE November 8, 1993 - Item 5. Other Events: X X A request was filed by PGE to increase electric prices. February 15, 1994 - Item 5. Other Events: X X Portland General and PGE 1993 financial information. Schedule V - Property, Plant and Equipment (Thousands of Dollars) Portland General Corporation Substantially the same as PGE's Schedule V below. Portland General Electric Company Schedule X - Supplementary Income Statement Information (Thousands of Dollars) Portland General Corporation Substantially the same as PGE's Schedule X below. PORTLAND GENERAL CORPORATION AND SUBSIDIARIES EXHIBIT INDEX Number Exhibit PGC PGE (3) * Restated Articles of Incorporation of Portland General Corporation [Pre-effective Amendment No. 1 to Form S-4, Registration No. 33-1987, dated December 31, 1985, Exhibit (B)]. X * Certificate of Amendment, dated July 2, 1987, to the Articles of Incorporation limiting the personal liability of directors of Portland General Corporation [Form 10-K for the fiscal year ended December 31, 1987, Exhibit (3)]. X * Copy of Articles of Incorporation of Portland General Electric Company [Registration No. 2-85001, Exhibit (4)]. X * Certificate of Amendment, dated July 2, 1987, to the Articles of Incorporation limiting the personal liability of directors of Portland General Electric Company [Form 10-K for the fiscal year ended December 31, 1987, Exhibit (3)]. X Form of Articles of Amendment of the New Preferred Stock of Portland General Electric Company [Registration No. 33-21257, Exhibit (4)]. X Bylaws of Portland General Corporation as amended on February 5, 1991 [Form 10-K for the fiscal year ended December 31, 1990, Exhibit (10)]. X * Bylaws of Portland General Electric Company as amended on October 1, 1991 [Form 10-K for the fiscal X year ended December 31, 1991, Exhibit (3)]. (4) Portland General Electric Company Indenture of Mortgage and Deed of Trust dated July 1, 1945; Ninth Supplemental Indenture dated June 1, 1960; Tenth Supplemental Indenture dated November 1, 1961; Eleventh Supplemental Indenture dated February 1, 1963; Twelfth Supplemental Indenture dated June 1, 1963; Thirteenth Supplemental Indenture dated April 1, 1964; Fourteenth Supplemental Indenture dated March 1, 1965 (Form 8, Amendment No. 1, dated June 14, 1965). X X Fifteenth Supplemental Indenture, dated June 1, 1966; Sixteenth Supplemental Indenture, dated October 1, 1967; Eighteenth Supplemental Indenture, dated November 1, 1970; Nineteenth Supplemental Indenture, dated November 1, 1971; Twentieth Supplemental Indenture, dated November 1, 1972; Twenty-First Supplemental Indenture, dated April 1, 1973; Twenty-Second Supplemental Indenture, dated October 1, 1973; Twenty-Seventh Supplemental Indenture, dated April 1, 1976; 69PORTLAND GENERAL CORPORATION AND SUBSIDIARIES EXHIBIT INDEX Number Exhibit PGC PGE Twenty-Ninth Supplemental Indenture, dated June 1, 1977 (Registration No. 2-61199, Exhibit 2.d-1). X X * Thirtieth Supplemental Indenture, dated October 1, 1978; Thirty-First Supplemental Indenture, dated November 1, 1978 (Registration No. 2-63516, Exhibit 2.d-3). X X * Thirty-Eighth Supplemental Indenture dated June 1, 1985 [Form 10-Q for the quarter ended June 30, 1985, Exhibit (4)]. X X * Thirty-Ninth Supplemental Indenture, dated March 1, 1986 [Form 10-K for the fiscal year ended December 31, 1985, Exhibit (4)]. X X * Fortieth Supplemental Indenture, dated October 1, 1990 [Form 10-K for the fiscal year ended December 31, 1990, Exhibit (4)]. X X * Forty-First Supplemental Indenture dated December 31, 1991 [Form 10-K for the fiscal year ended December 31, X X 1991, Exhibit (4)]. Forty-Second Supplemental Indenture dated April 1, 1993 [Form 10-Q for the quarter ended March 31,1993, Exhibit (4)]. X X Forty-Third Supplemental Indenture dated July 1, 1993 [Form 10-Q for the quarter ended September 30, 1993, Exhibit (4)]. X X Other instruments which define the rights of holders of long-term debt not required to be filed herein will be furnished upon written request. (10) Residential Purchase and Sale Agreement with the Bonneville Power Administration [Form 10-K for the fiscal year ended December 31, 1981, Exhibit (10)]. X X Power Sales Contract and Amendatory Agreement Nos. 1 and 2 with Bonneville Power Administration [Form 10-K for the fiscal year ended December 31, 1982, Exhibit (10)]. X X The following exhibits were filed in conjunction with the 1985 Boardman/Intertie Sale: Long-term Power Sale Agreement, dated November 5, 1985 [Form 10-K for the fiscal year ended December 31, 1985, Exhibit (10)]. X X Long-term Transmission Service Agreement, dated November 5, 1985 [Form 10-K for the fiscal year ended December 31, 1985, Exhibit (10)]. X X 70PORTLAND GENERAL CORPORATION AND SUBSIDIARIES EXHIBIT INDEX Number Exhibit PGC PGE * Participation Agreement, dated December 30, 1985 [Form 10-K for the fiscal year ended December 31, 1985, Exhibit (10)]. X X * Lease Agreement, dated December 30, 1985 [Form 10-K for the fiscal year ended December 31, 1985, Exhibit (10)]. X X * PGE-Lessee Agreement, dated December 30, 1985 [Form 10-K for the fiscal year ended December 31, 1985, Exhibit (10)]. X X * Asset Sales Agreement, dated December 30, 1985 [Form 10-K for the fiscal year ended December 31, 1985, Exhibit (10)]. X X * Bargain and Sale Deed, Bill of Sale and Grant of Easements and Licenses, dated December 30, 1985 [Form 10-K for the fiscal year ended December 31, 1985, Exhibit (10)]. X X * Supplemental Bill of Sale, dated December 30, 1985 [Form 10-K for the fiscal year ended December 31, 1985, Exhibit (10)]. X X * Trust Agreement, dated December 30, 1985 [Form 10-K for the fiscal year ended December 31, 1985, Exhibit (10)] X X * Tax Indemnification Agreement, dated December 30, 1985 [Form 10-K for the fiscal year ended December 31, 1985, Exhibit (10)]. X X * Trust Indenture, Mortgage and Security Agreement, dated December 30, 1985 [Form 10-K for the fiscal year ended December 31, 1985, Exhibit (10)]. X X * Restated and Amended Trust Indenture, Mortgage and Security Agreement, dated February 27, 1986 [Form 10-K for the fiscal year ended December 31, 1985, Exhibit (10)]. X X 71PORTLAND GENERAL CORPORATION AND SUBSIDIARIES EXHIBIT INDEX Number Exhibit PGC PGE Portland General Corporation Outside Directors' Deferred Compensation Plan, 1990 Restatement dated November 1, 1990 [Form 10-K for the fiscal year ended December 31, 1990, Exhibit (10)]. X X Portland General Corporation Retirement Plan for Outside Directors, 1990 Restatement dated July 10, 1990 [Form 10-K for the fiscal year ended December 31, 1990, Exhibit (10)]. X X * Portland General Electric Company Outside Directors' Life Insurance Benefit Plan 1988 Restatement [Form 10-K for the fiscal year ended December 31, 1988, Exhibit (10)]. X X * Portland General Electric Company Outside Directors Life Insurance Benefit Plan, Amendment No. 1 dated October 3, 1989 [Form 10-K for the fiscal year ended December 31, 1989, Exhibit (10)]. X X * Portland General Corporation Outside Directors Life Insurance Benefit Plan, Amendment No. 2 dated December 3, 1989 [Form 10-K for the fiscal year ended December 31, 1989, Exhibit (10)]. X X * Portland General Corporation Outside Directors' Stock Compensation Plan, Amended and Restated December 6, 1989 [Form 10-K for the fiscal year ended December 31, X 1991, Exhibit (10)]. * Special Board Assignment for Robert W. Roth, dated May 1, 1992. [Form 10-K for the fiscal year ended December 31, 1992, Exhibit (10)] X X (24) Portland General Corporation Consent of Independent Public Accountants (filed herewith). X Portland General Electric Company Consent of Independent Public Accountants (filed herewith). X (25) Portland General Corporation Power of Attorney (filed herewith). X Portland General Electric Company Power of Attorney (filed herewith). X (28) Form 11-K relating to Employee Stock Purchase Plan of Portland General Corporation (filed herewith). X 72PORTLAND GENERAL CORPORATION AND SUBSIDIARIES EXHIBIT INDEX Number Exhibit PGC PGE Executive Compensation Plans and Arrangements (10) * Portland General Corporation Management Deferred Compensation Plan, 1990 Restatement dated November 1, 1990 [Form 10-K for the fiscal year ended December 31, 1990, Exhibit (10)]. X X * Portland General Corporation Management Deferred Compensation Plan, Amendment No. 1 dated December 16, 1991 [Form 10-K for the fiscal year ended December 31, X X 1991, Exhibit (10)]. Portland General Electric Company Senior Officers' Life Insurance Benefit Plan 1988 Restatement [Form 10-K for the fiscal year ended December 31, 1988, Exhibit (10)]. X X Portland General Electric Company Senior Officers' Life Insurance Benefit Plan, Amendment No. 1 dated October 3, 1989 [Form 10-K for the fiscal year ended December 31, 1989, Exhibit (10)]. X X * Portland General Corporation Senior Officers Life Insurance Benefit Plan, Amendment No. 2 dated December 3, 1989 [Form 10-K for the fiscal year ended December 31, 1989, Exhibit (10)]. X X * Portland General Corporation Annual Incentive Master Plan [Form 10-K for the fiscal year ended December 31, 1987, Exhibit (10)]. X * Portland General Corporation Annual Incentive Master Plan, Amendments No. 1 and No. 2 dated March 5, 1990 [Form 10-K for the fiscal year ended December 31, 1989, Exhibit (10)]. X * Portland General Electric Company Annual Incentive Master Plan [Form 10-K for the fiscal year ended December 31, 1987, Exhibit (10)]. X * Portland General Electric Company Annual Incentive Master Plan, Amendments No. 1 and No. 2 dated March 5, 1990 [Form 10-K for the fiscal year ended December 31, 1989, Exhibit (10)]. X * Portland General Corporation 1990 Long-term Incentive Master Plan [Form 10-K for the fiscal year ended December 31, 1990, Exhibit (10)]. X X * Portland General Corporation Supplemental Executive Retirement Plan, 1990 Restatement dated July 10, 1990 [Form 10-K for the fiscal year ended December 31, 1990, Exhibit (10)]. X X 73PORTLAND GENERAL CORPORATION AND SUBSIDIARIES EXHIBIT INDEX Number Exhibit PGC PGE (10) * Portland General Corporation Supplemental Executive Cont.Retirement Plan, Amendment No. 1 dated January 1, 1991, [Form 10-K for the fiscal year ended December 31, 1991, X X Exhibit (10)]. * Change in Control Severance Agreement, dated October 11, 1989 [Form 10-K for the fiscal year ended December 31, 1989, Exhibit (10)]. X X * Employment Contract for James E. Cross, dated April 17, 1990. [Form 10-K for the fiscal year ended December 31, 1992, Exhibit (10)]. X * Salary Continuation Agreement for James E. Cross, dated December 21, 1992. [Form 10-K for the fiscal year ended December 31, 1992, Exhibit (10)]. X * Enhanced Benefit Under Supplemental Executive Retirement Plan for James E. Cross, dated August 4, 1992. [Form 10-K for the fiscal year ended December 31, 1992, Exhibit (10)]. X Portland General Corporation Amended and Restated 1990 Long-Term Incentive Master Plan, amended July 1993 (filed herewith). X Portland General Corporation 1990 Long-Term Incentive Master Plan, Amendment No. 1 dated February 8, 1994 (filed herewith). X * Incorporated by reference as indicated. APPENDIX PORTLAND GENERAL ELECTRIC COMPANY Page PART II Item 8. Financial Statements and Notes ...... 77 Management's Statement of Responsibility PGE's management is responsible for the preparation and presentation of the consolidated financial statements in this report. Management is also responsible for the integrity and objectivity of the statements. Generally accepted accounting principles have been used to prepare the statements, and in certain cases informed estimates have been used that are based on the best judgment of management. Management has established, and maintains, a system of internal accounting controls. The controls provide reasonable assurance that assets are safeguarded, transactions receive appropriate authorization, and financial records are reliable. Accounting controls are supported by written policies and procedures, an operations planning and budget process designed to achieve corporate objectives, and internal audits of operating activities. PGE's Board of Directors includes an Audit Committee composed entirely of outside directors. It reviews with management, internal auditors and independent auditors, the adequacy of internal controls, financial reporting, and other audit matters. Arthur Andersen & Co. is PGE's independent public accountant. As a part of its annual audit, internal accounting controls are selected for review in order to determine the nature, timing and extent of audit tests to be performed. All of the corporation's financial records and related data are made available to Arthur Andersen & Co. Management has also endeavored to ensure that all representations to Arthur Andersen & Co. were valid and appropriate. Joseph M. Hirko Vice President Finance, Chief Financial Officer, Chief Accounting Officer and Treasurer Report of Independent Public Accountants To the Board of Directors and Shareholder of Portland General Electric Company: We have audited the accompanying consolidated balance sheets and statements of capitalization of Portland General Electric Company and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, retained earnings and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As more fully discussed in Note 6 to the consolidated financial statements, the realization of assets related to the abandoned Trojan Nuclear Plant in the amount of $722 million is dependent upon the ratemaking treatment as determined by the Public Utility Commission of Oregon. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Portland General Electric Company and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. As more fully discussed in Note 5A to the consolidated financial statements, effective January 1, 1993, the Company changed its method of accounting for income taxes. Portland, Oregon, January 25, 1994 (except with respect to the matter discussed in Note 16, as to which the date is February 23, 1994) ARTHUR ANDERSEN & CO. Item 8. Financial Statements and Supplementary Data Portland General Electric Company and Subsidiaries Consolidated Statements of Income Portland General Electric Company and Subsidiaries Consolidated Statements of Retained Earnings Portland General Electric Company and Subsidiaries Consolidated Balance Sheets The accompanying notes are an integral part of these consolidated balance sheets. Portland General Electric Company and Subsidiaries Consolidated Statements of Capitalization The accompanying notes are an integral part of these consolidated statements. Portland General Electric Company and Subsidiaries Consolidated Statements of Cash Flow The accompanying notes are an integral part of these consolidated statements. PAGE> 80 Portland General Electric Company and Subsidiaries Notes to Financial Statements Certain information, necessary for a sufficient understanding of PGE's financial condition and results of operations, is substantially the same as that disclosed by Portland General in this report. Therefore, the following PGE information is incorporated by reference to Portland General's financial information on the following page numbers. Note 5A Income Taxes The following table shows the detail of taxes on income and the items used in computing the differences between the statutory federal income tax rate and Portland General Electric Company's (PGE) effective tax rate. (thousands of dollars) Effective January 1, 1993, PGE adopted Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes". Prior to SFAS No. 109, PGE accounted for income taxes in accordance with Accounting Principles Board Opinion No. 11. Prior period financial statements have not been restated. As of December 31, 1993 and 1992, the significant components of PGE's deferred income tax assets and liabilities were as follows: As a result of implementing SFAS No. 109, PGE has recorded deferred tax assets and liabilities for all temporary differences between the financial statement bases and tax bases of assets and liabilities. The Omnibus Budget Reconciliation Act of 1993 resulted in a federal tax rate increase from 34% to 35% effective January 1, 1993. The tax rate increase resulted in additional income tax expense for PGE of $3.6 million. The IRS completed its examination of Portland General Corporation's (Portland General) tax returns for the years 1985 to 1987 and has issued a statutory notice of tax deficiency which Portland General is contesting. As part of this audit, the IRS has proposed to disallow PGE's 1985 Washington Public Power Supply System Unit 3 (WNP-3) abandonment loss deduction on the premise that it is a taxable exchange. PGE disagrees with this position and will take appropriate action to defend its deduction. Management believes that it has appropriately provided for probable tax adjustments and is of the opinion that the ultimate disposition of this matter will not have a material adverse impact on the financial condition of PGE. Note 7A Common Stock Common Stock Portland General is the sole shareholder of PGE common stock. PGE is restricted, without prior Oregon Public Utility Commission (PUC) approval, from paying dividends or making other distributions to Portland General to the extent such payment or distribution would reduce PGE's common stock equity capital below 36% of total capitalization. At December 31, 1993, PGE's common stock equity capital was 44% of its total capitalization. Note 8A Short-Term Borrowings PGE meets liquidity needs through the issuance of commercial paper and borrowings from commercial banks. At December 31, 1993, PGE had a committed facilities of $120 million expiring in July 1996 and an $80 million expiring in July 1994. These lines of credit have commitment fees and/or facility fees ranging from 0.15 to 0.20 of one percent and do not require compensating cash balances. The facilities are used primarily as back-up for both commercial paper and borrowings from commercial banks under uncommitted lines of credit. At December 31, 1993, there were no outstanding borrowings under the committed facilities. PGE has a $200 million commercial paper facility. Unused committed lines of credit must be at least equal to the amount of commercial paper outstanding. Most of PGE's short-term borrowings are through commercial paper. Commercial paper and lines of credit borrowing are at rates reflecting current market conditions and generally are substantially below the prime commercial rate. Short-term borrowings and related interest rates were as follows (thousands of dollars): Interest rates exclude the effect of commitment fees, facility fees, and other financing fees. Note 9A Long-Term Debt The Indenture securing PGE's first mortgage bonds constitutes a direct first mortgage lien on substantially all utility property and franchises, other than expressly excepted property. The following principal amounts of long-term debt become due for redemption through sinking funds and maturities (thousands of dollars): The sinking funds include $988,000 a year for 1994 through 1996 and $688,000 for 1997 and 1998, which, in accordance with the terms of the Indenture, PGE may satisfy by pledging available property additions equal to 166-2/3% of the sinking fund requirements. Note 15A Fair Value of Financial Instruments The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value: Cash and cash equivalents The carrying amount of cash and cash equivalents approximates fair value because of the short maturity of those instruments. Other investments Other investments approximate market value. Redeemable preferred stock The fair value of redeemable preferred stock is based on quoted market prices. Long-term debt The fair value of long-term debt is estimated based on the quoted market prices for the same or similar issues or on the current rates offered to PGE for debt of similar remaining maturities. The estimated fair values of financial instruments are as follows (thousands of dollars):
101778_1993.txt	101778	1993	ITEM 1. BUSINESS USX CORPORATION USX Corporation was incorporated in 1901 and is a Delaware corporation. Executive offices are located at 600 Grant Street, Pittsburgh, PA 15219-4776. The terms "USX" and "Corporation" when used herein refer to USX Corporation or USX Corporation and its subsidiaries, as required by the context. INDUSTRY SEGMENTS For consolidated reporting purposes, USX's reportable industry segments correspond with its three groups. A description of the groups and their products and services is as follows: o The Marathon Group is engaged in worldwide exploration, production, transportation and marketing of crude oil and natural gas; and domestic refining, marketing and transportation of petroleum products. o The U. S. Steel Group includes U. S. Steel, one of the largest integrated steel producers in the United States, which is primarily engaged in the production and sale of a wide range of steel mill products, coke, and taconite pellets. The U. S. Steel Group also includes the management of mineral resources, domestic coal mining, engineering and consulting services and technology licensing. Other businesses that are part of the U. S. Steel Group include real estate development and management, fencing products, leasing and financing activities, and a majority interest in a titanium metal products company. o The Delhi Group is engaged in the purchasing, gathering, processing, transporting and marketing of natural gas. Data with respect to the Delhi Group for periods prior to October 2, 1992, represent the historical financial data of the businesses included in the Delhi Group. Such data for periods prior to that date are included in the Marathon Group. With respect to the number of active employees reported for each of the groups, USX Headquarters employees, whose functions are of a corporate nature not directly attributable to a specific group, are excluded from the total number of employees reported for each group. The total number of such USX Headquarters employees at year-end was 292 in 1993, 364 in 1992 and 507 in 1991. The reduction in total number of such employees between 1991 and 1993 primarily reflected a reorganization in August 1992 which resulted in certain USX Headquarters employees being reclassified as U. S. Steel Group employees. Below is a three-year summary of financial highlights for the groups. - - -------------------- (a) Included the following: a $342 million charge related to the Lower Lake Erie Iron Ore Antitrust Litigation against a former USX subsidiary, the Bessemer & Lake Erie Railroad, for the U. S. Steel Group in 1993; restructuring charges of $42 million, $10 million and $402 million for the U. S. Steel Group in 1993, 1992 and 1991, respectively; restructuring charges of $115 million and $24 million for the Marathon Group in 1992 and 1991, respectively; and inventory market valuation charges (credits) for the Marathon Group of $241 million, $(62) million and $260 million in 1993, 1992 and 1991, respectively. (b) Included sales and operating income for the businesses comprising the Delhi Group for periods prior to October 2, 1992, and assets related to the businesses comprising the Delhi Group at year-end 1991. (c) Data presented for periods prior to October 2, 1992, reflect the combined historical financial information for the businesses comprising the Delhi Group. Data presented for periods beginning on or subsequent to October 2, 1992, reflect the financial information for the businesses of the Delhi Group as well as the effects of the capital structure of the Delhi Group determined by the Board of Directors in accordance with the USX Certificate of Incorporation; and a portion of the corporate assets and liabilities and related transactions which are not separately identified with the ongoing operating units of USX. MARATHON GROUP The Marathon Group includes Marathon Oil Company ("Marathon") and certain other USX subsidiaries. The Marathon Group is engaged in worldwide exploration, production, transportation and marketing of crude oil and natural gas; and domestic refining, marketing and transportation of petroleum products. Marathon Group sales (excluding sales from businesses now included in the Delhi Group) as a percentage of USX consolidated sales were 66% in 1993, 69% in 1992 and 72% in 1991. Prior to October 2, 1992, the Marathon Group also included the businesses of Delhi Gas Pipeline Corporation and certain other USX subsidiaries engaged in the purchasing, gathering, processing, transporting and marketing of natural gas which are now included in the Delhi Group. The Marathon Group financial data for the periods prior to October 2, 1992, include the combined historical financial position, results of operations and cash flows for the businesses of the Delhi Group. Beginning October 2, 1992, the financial statements of the Marathon Group do not include the financial position, results of operations and cash flows for the businesses of the Delhi Group except for the financial effects of the Retained Interest. For a further discussion of the Retained Interest, see "Financial Statements and Supplementary Data - Notes to Financial Statements - 3. Corporate Activities - Common stock transactions" for the Marathon Group. The following table summarizes Marathon Group sales for each of the last three years: - - -------------------- (a) Consists of sales of crude oil and refined products which are offset in cost of sales by costs of matching purchases of corresponding volumes, resulting in no effect on income. Buy/sell transactions are settled in cash. (b) Included in both sales and operating costs, resulting in no effect on income. The oil and gas industry is characterized by a large number of companies, none of which is dominant within the industry but a number of which have greater resources than Marathon. Marathon must compete with these companies for the rights to explore for oil and gas. Acquiring the more attractive exploration opportunities frequently requires competitive bids involving substantial front-end bonus payments or commitments to work programs. Based on 1992 worldwide liquid hydrocarbon and natural gas production, as compiled by Oil & Gas Journal, Marathon ranked 13th among U.S. based petroleum corporations. Marathon believes it has 28 primary U.S. based exploration and production competitors, and a much larger number worldwide. Marathon must also compete with these and many other companies to acquire crude oil for refinery processing and in the distribution and marketing of a full array of petroleum products. Based on the U. S. Department of Energy's PETROLEUM SUPPLY ANNUAL for 1992, which is the most recent year for which such information is available and which was published prior to the 1993 temporary idling of Marathon's 50,000 barrel per day Indianapolis refinery, Marathon ranked seventh among U. S. petroleum corporations on the basis of crude oil refining capacity. In addition, Marathon ranked tenth in refined product sales based on 1992 data published by NATIONAL PETROLEUM NEWS. Marathon competes in three separate markets for the sale of refined products. Marathon believes that it competes with primarily 37 companies in the wholesale distribution of petroleum products to private brand marketers and large commercial and industrial consumers; nine refiner/marketers in the supply of branded petroleum products to dealers and jobbers; and over 1,000 petroleum product retailers in the retail sale of petroleum products. Marathon also competes in the convenience store industry through its retail market outlets. The Marathon Group's operating results are affected by price changes in crude oil, natural gas and petroleum products as well as changes in competitive conditions in the markets it serves. Generally, operating results from production operations benefit from higher crude oil and natural gas prices while refining and marketing margins may be adversely affected by crude oil price increases, depending upon market conditions. The total number of active Marathon Group employees at year-end was 21,914 in 1993, 22,509 in 1992 and 24,352 in 1991. The reduction in the total number of employees between 1991 and 1993 reflected the exclusion in 1992 of employees of the businesses of the Delhi Group, the consolidation of several production and marketing offices, the closing of marginal retail outlets, the temporary idling of Marathon's Indianapolis refinery in 1993 and improved operating efficiencies. In addition, Marathon implemented early retirement and termination programs which resulted in the reduction of nearly 500 employees during 1992. Certain Marathon hourly employees at two of its four operating refineries and various other locations are represented by labor unions. Such employees at the Detroit refinery are represented by the International Brotherhood of Teamsters under a labor agreement which will expire on November 15, 1994. Such employees at the Texas City refinery are represented by the Oil, Chemical and Atomic Workers Union under a labor agreement which expires on March 31, 1996. OIL AND NATURAL GAS EXPLORATION AND DEVELOPMENT Marathon is currently conducting exploration and development activities in 16 countries, including the United States. Principal exploration activities are in the United States, Australia, the United Kingdom, Ireland, Bolivia, Gabon, Tunisia, Egypt and the Netherlands. Principal development activities are in the United States, the United Kingdom, Indonesia, the Netherlands, Ireland, Norway and Egypt. Exploration activities during 1993 resulted in discoveries in the United Kingdom, Egypt and the United States (both onshore and the Gulf of Mexico). The following table sets forth, by geographic area, the number of net productive and dry development and exploratory wells completed in each of the last three years (references to "net" wells or production indicate Marathon's ownership interest or share as the context requires): - - -------------------- (a) Includes the number of wells completed during the year regardless of when drilling was initiated. Completion refers to the installation of permanent equipment for the production of oil or gas or, in the case of a dry well, the reporting of abandonment to the appropriate agency. (b) The fluctuations between years primarily reflected a reduction in domestic drilling activity in 1992 followed by increased activity in 1993. UNITED STATES Exploration wells completed in the United States during 1993 totaled 32 gross wells (23 net wells) consisting of wildcat and delineation wells. Principal domestic exploration and development activities were in the U. S. Gulf of Mexico and the states of Texas, Louisiana, Oklahoma and Wyoming. Exploration expenses during the three years ended December 31, 1993, totaled $240 million in the United States, of which $60 million was incurred in 1993. Development expenditures during the three years ended December 31, 1993, totaled $543 million in the United States, of which $233 million was incurred in 1993. The following is a summary of recent, significant exploration and development activity in the United States including discussion, as deemed appropriate, of completed wells, drilling wells and wells under evaluation. Platform fabrication begun in 1992 to develop the Ewing Bank 873 Block in the Gulf of Mexico was approximately 70% completed by year-end 1993. The Ewing Bank 873 discovery well was drilled in early 1991 and tested at 2,400 gross barrels per day ("bpd"). Three delineation wells were completed in 1992 establishing an oil column of 2,300 feet. First production is planned for late 1994 and is expected to peak at 27,000 gross bpd of oil and 18 gross million cubic feet per day ("mmcfd") of gas. Marathon is the operator and has a 66.7% working interest in this development which is located in 775 feet of water. Development options are being evaluated for an exploratory well drilled in 1993. The well was drilled in 1,900 feet of water at Ewing Bank 1006, located ten miles south of Ewing Bank 873. The well encountered 77 feet of oil sand and tested at a rate of 1,200 gross bpd of oil and 0.7 gross mmcfd of natural gas. Marathon is the operator and has a 33.3% working interest in the well. Initial development drilling was completed on South Pass 86 Platform "C" in 1993. A total of seven wells were producing at December 31, 1993. Production in 1993 averaged 7,100 gross bpd of oil and 34 gross mmcfd of natural gas. Natural gas production is expected to be maintained at about the 1993 level until the year 2000, then rise to a peak of approximately 70 gross mmcfd. Marathon is the operator and has a 25% working interest in this property. At South Pass 87, drilling in 1992 and 1993 confirmed the presence of gas and condensates with an associated oil reservoir discovered in 1991. The total hydrocarbon column is approximately 2,500 feet. The No. 4 well was tested in 1992 at a rate of 2,590 gross bpd of oil and 4.6 gross mmcfd of gas. Two delineation wells drilled in early 1994 from the South Pass 87 template to bottom hole locations on West Delta Block 128 and South Pass Block 88, encountered 222 feet and 60 feet of net gas/condensate pay, respectively. An additional well is planned for 1994. Fabrication of "platform D" is scheduled to commence in 1994 and first production is planned for 1995. Marathon is the operator and has a 33.3% working interest in South Pass 87, which is located in 375 feet of water, and a 50% working interest in West Delta 128 and South Pass 88. In 1992, Marathon announced that a discovery well drilled on South Marsh Island Block 192, offshore Louisiana encountered 65 feet of net gas pay. A subsea completion is tentatively scheduled by the third-party operator for late 1994 with first production in early 1995. Marathon has a 33.3% working interest in this block, which is located in 394 feet of water. In the first quarter of 1993, Marathon drilled two successful gas wells in East Texas. The Lewis #1 well found 57 feet of net gas and condensate pay in multiple zones. The timing of initial sales from the well is contingent upon the construction of a necessary treatment facility and further development of the area. The Poth #1 well found over 300 feet of net gas pay in the Cotton Valley. Initial sales from this well totaled 21 gross mmcfd. Additional three dimensional seismic data is being acquired in preparation for drilling in this area in 1994. Marathon has a 100% working interest in both of these discoveries. In 1993, Marathon drilled 11 gross horizontal wells (11 net wells) in the Austin Chalk formation, of which 9 were commercially productive. During 1993, development activities in northern Louisiana and southern Arkansas continued with the drilling of seven gross wells (five net wells) in the established Shongaloo/Red Rock, Haynesville and Springhill Fields. Gas cycling projects were commenced in the Shongaloo/Red Rock Field in 1991 and the Haynesville Field in mid-1992, to enhance ultimate recovery. Contract Drilling--FWA Drilling Company, Inc. owns 28 onshore rotary drilling rigs operating in the state of Texas. INTERNATIONAL In 1993, Marathon drilled 13 gross wildcat and delineation wells (7 net wells) in seven countries. Of the 13 wells, 3 encountered hydrocarbons: 2 in the United Kingdom and 1 in Egypt. Significant net exploration acreage was obtained by Marathon during 1993 in the United Kingdom (269,687 acres), Ireland (178,055 acres) and Egypt (41,143 acres). Marathon's expenses for international oil and natural gas exploration activities during the three years ended December 31, 1993, totaled $256 million, of which $85 million was incurred in 1993. Marathon's international development expenditures during the three years ended December 31, 1993, totaled $1.1 billion, of which $319 million was incurred in 1993. Development expenditures during this three-year period included $696 million for the development of the East Brae Field and construction of the Scottish Area Gas Evacuation ("SAGE") system. Marathon expects continued expenditures on international projects. U. K. NORTH SEA--Marathon is continuing its development of the Brae area in the United Kingdom sector of the North Sea where it is the operator and owns a 41.6% revenue interest in the South, Central and North Brae Fields and a 39.1% revenue interest in the East Brae Field. Marathon has interests in 28 blocks in the U.K. North Sea. A 1992 appraisal well of the 1987 Middle Jurassic Beinn gas condensate discovery has been the subject of a U.K. Government approved production test since December 1992. A second delineation/development well was drilled in 1993 to the Beinn reservoir, and was initially completed in the shallower, Upper Jurassic formation adjacent to the North Brae field. Following depletion of that reservoir, the well will be completed as a Beinn development well. Marathon began drilling a third Beinn delineation/development well in late 1993 which is scheduled for completion in 1994. Formal U.K. Government approval to develop the field was received in February 1994. Marathon has a 41.6% revenue interest in these discoveries. See "Oil and Natural Gas Production - International - North Sea" for a description of Brae production operations. East Brae is a gas condensate field and the largest field yet discovered by Marathon in the Brae area. Liquid hydrocarbon production commenced in late December 1993 and is expected to reach 115,000 gross bpd by late 1994. Gross estimated reserves exceed 300 million barrels of liquids and 1.5 trillion cubic feet ("tcf") of natural gas. Marathon classified its share of these reserves as proved in 1990. The East Brae design and development program is projected to require a gross investment of $1.5 billion, of which Marathon's share is $620 million, 90% of which was expended as of December 31, 1993. Participation in the SAGE system will provide pipeline transportation for Brae gas. The Brae group owns 50% of SAGE, which will have a wet gas capacity of 1.2 gross billion cubic feet ("bcf") per day. The other 50% is owned by the Beryl group which operates the system. The 30-inch pipeline will connect the Brae and Beryl Fields to a gas processing terminal at St. Fergus in northeast Scotland. Construction of the Brae phase of this project is complete and commissioning of gas processing facilities will be concluded in 1994. Gross project costs approximate $1.2 billion, of which Marathon's share is approximately $280 million. Marathon has entered into agreements for the sale of more than 1.1 gross tcf of Brae area gas (615 net bcf). As a result, approximately 205 gross mmcfd (112 net mmcfd ) will be supplied under separate gas contracts to U.K. utilities over 15 years, commencing in late 1994. EGYPT--Marathon has rejoined a Nile Delta exploration effort by agreeing to a three well drilling program. The first of these wells was a successful exploration well drilled and tested in 1993 on the Abu Madi West Development Lease seven miles northwest of Marathon's joint-interest El Qar'a Gas Field. The well's production potential and opportunities for delineation are being evaluated. Marathon has a 25% working interest in the El Qar'a Northwest discovery. Also in the Nile Delta area, contract negotiations are underway for exploration of the 840,000 acre El Manzala Block. RUSSIA--During 1993, significant progress was made on the Sakhalin project. An international consortium, led by Marathon, neared completion of negotiations on a Production Sharing Contract for the development of the Lunskoye gas field and the Piltun-Astokhskoye oil field. Marathon has a 30% equity interest in the consortium. It is anticipated that the consortium will form a joint venture company which is expected to sign the Production Sharing Contract in 1994. Any commitment of the joint venture company will be conditioned upon the adoption of a set of laws, regulations and permits by the necessary Russian authorities such that the Production Sharing Contract would essentially have the force of law. The proposed Production Sharing Contract initially provides for appraisal periods of 2 to 3 years for the oil field and 3 to 5 years for the gas field. According to Russian experts, these two fields contain reserves of 750 million barrels of oil and condensate and 14 tcf of natural gas. INDONESIA--On December 31, 1992, the Plan of Development ("POD")for the Kakap KRA and KG oil fields in the South China Sea was approved by the Indonesian Government. This project will develop an estimated 50 million gross barrels of oil through existing infrastructure. A contract was awarded in November 1993 for the engineering, construction and installation of the platforms, facilities and pipelines along with connection to existing production facilities in the Kakap Block. First oil is anticipated in April 1995 and production is expected to peak at an estimated 50,000 gross bpd of oil later that year. Marathon is the operator and has a 37.5% working interest in this development. IRELAND--In 1993, Marathon drilled the second and third wells in a seven well exploratory drilling program required by a 1991 agreement between Marathon and the Irish Government. None of the wells drilled to date encountered commercial quantities of hydrocarbons. BOLIVIA--Marathon earned, subject to government approval, a 50% working interest in a six million acre concession in Bolivia by completing a seismic program in 1993. The first exploratory well is tentatively scheduled for late 1994. AUSTRALIA--During 1993, Marathon continued an exploration program in two blocks in Zone-of-Cooperation "A" located between Indonesia and Australia in the Timor Gap. An exploratory drilling program is currently planned for 1994 in both blocks. TUNISIA--Marathon plans to drill three exploratory wells in 1994, two in the Grombalia Block and one in the Cap Bon Block. GABON--Marathon began work on the Kowe permit (offshore block) awarded in 1992. A seismic program was conducted during 1993 in anticipation of a one well drilling program in late 1994. Marathon has a 75% working interest in the block which is located approximately 90 miles southeast of Port Gentil. SYRIA--Marathon is awaiting approval of a POD submitted to the Syria Petroleum Company in May 1993, for the development of Marathon's gas reserves in the Palmyra Block. Negotiation of a gas sales agreement would be required following approval of the POD. NETHERLANDS--Marathon, through its 50% equity interest in CLAM Petroleum Company ("CLAM"), drilled one well during 1993 in Block K11 in the Netherlands North Sea. Two additional wells are planned for 1994, one in Block E18 which was awarded in 1993 and one in Block L13 in the existing joint development area. The following table sets forth, by geographic area, the developed and undeveloped oil and gas acreage held as of December 31, 1993: RESERVES Estimated quantities of net proved oil and gas reserves at the end of each of the last three years are summarized in the table presented below. Reports have been filed with the U.S. Department of Energy ("DOE") for the years 1992 and 1991 disclosing the year-end estimated oil and gas reserves. A similar report will be filed for 1993. The year-end estimates reported to the DOE are the same as the estimates reported herein. For additional information regarding oil and gas reserves see "Financial Statements and Supplementary Data - Supplementary Information on Oil and Gas Producing Activities - Estimated Quantities of Proved Oil and Gas Reserves". - - -------------------- (a) Proved developed reserves located in Libya have been excluded. See "Financial Statements and Supplementary Data - Notes to Financial Statements - 26. Contingencies and Commitments - Libyan operations" for the Marathon Group. (b) For a description of CLAM, see "Oil and Natural Gas Production - International - North Sea" below. At December 31, 1993, the Marathon Group's combined net proved reserves of liquid hydrocarbons and natural gas were approximately 1.5 billion barrels of oil equivalent, of which approximately 85% were proved developed reserves and 15% were proved undeveloped reserves. (Natural gas reserves are converted to barrels of oil equivalent using a conversion factor of six thousand cubic feet ("mcf") of natural gas to one barrel of oil.) Net proved reserves are located principally in the United States, the U.K. North Sea, the Irish Celtic Sea, the Norwegian North Sea and North Africa. Liquid hydrocarbons represented approximately 57% of combined net proved reserves. OIL AND NATURAL GAS PRODUCTION The following tables set forth net production of crude oil, condensate and natural gas liquids, and natural gas by geographic area for each of the last three years: - - ---------------------- (a) Amounts include production from leasehold and plant ownership, after interest of others and after royalties. (b) Amounts represent equity tanker liftings, truck deliveries and direct deliveries of liquid hydrocarbons before royalties. The amounts correspond with the basis for fiscal settlements with governments. Crude oil purchases, if any, from host governments are not included. (c) For a description of CLAM, see "International - North Sea" below. Marathon is currently producing crude oil and/or natural gas in eight countries, including the United States. Marathon's 1993 liquid hydrocarbon production averaged 156,000 net bpd, down 18,000 net bpd from the prior year. The domestic decline of 7,000 net bpd largely reflected natural declines and property sales. The 11,000 net bpd decline in international production was primarily attributable to natural declines at the North, South and Central Brae Fields in the U.K. sector of the North Sea and a required four-week shut-in of Brae operations for maintenance of third-party platforms and pipelines. An increase in domestic production is expected in 1994 and 1995 attributable to offshore U. S. Gulf Coast projects, while previously mentioned declines in international production will be more than offset by new U.K. East Brae production (which commenced in late December 1993), along with planned new production from the Indonesia KRA/KG development. Natural gas production, including Marathon's equity share of CLAM's production, averaged 937 net mmcfd for 1993. Net natural gas production in the U.S. declined by 11% in 1993 as a result of asset sales and natural declines, but is expected to remain stable at least through 1995 as natural declines are offset by increased drilling activity. International natural gas production increased by 10% in 1993 with further increases expected in 1994 and 1995 primarily due to Brae area gas sales which are contracted to commence in the fourth quarter of 1994. UNITED STATES Approximately 71% of Marathon's 1993 worldwide liquid hydrocarbon production and equity liftings and 56% of worldwide natural gas production were from domestic operations. The principal domestic producing areas are located in Texas, Wyoming, the U.S. Gulf of Mexico and Alaska. TEXAS--Marathon owns a 49.48% working interest in, and is the operator of, the Yates Field Unit, one of the largest fields in the United States. Marathon's 22,000 net bpd of 1993 liquid hydrocarbon production from the Yates Field and Gas Plant accounted for 20% of Marathon's total U.S. production. The field's average annual production declined less than 3% during 1993, which was the first year since 1985 that the field's production rate at year-end exceeded the production rate at the beginning of the year. The field's average annual production declined by 9% in 1992, 8% in 1991 and 19% in 1990. Marathon continues to apply new technologies in the Yates Field to further extend production life and maximize oil recovery and profitability. WYOMING--Since operations began in 1912, Marathon has produced over one billion gross barrels of oil in the state and was the leading oil producer in 1993. Production for 1993 averaged 27,200 net bpd representing 25% of Marathon's total U.S. liquid hydrocarbon production. Continuing development of mature fields such as Oregon Basin, the state's largest oil producing field, combined with developments in other fields have offset most recent production declines. Marathon continues to apply enhanced recovery and reservoir management programs and cost containment efforts to maximize oil recovery and profitability. GULF OF MEXICO--During 1993, Marathon produced 10,500 net bpd of liquid hydrocarbons and 99 net mmcfd of natural gas in the U.S. Gulf of Mexico, representing a 9% increase in liquid hydrocarbon production and a 25% decline in natural gas production from the prior year. Approximately 50% of the decline in natural gas production was due to property sales. At year-end 1993, Marathon held working interests in 14 fields producing from 31 platforms, 23 of which Marathon operates. The Gulf of Mexico remains an area of prime importance to Marathon with new production platforms planned for the Ewing Bank 873 Field in 1994 and the South Pass 87 development in 1995. See "Oil and Natural Gas Exploration and Development -- United States" above. ALASKA--Marathon has interests in seven of the 15 drilling and production platforms in the Cook Inlet, and operates four of the platforms . The McArthur River Field, located in the Cook Inlet, continues to be Marathon's largest field in Alaska. In 1993, the Steelhead platform, the largest platform in Cook Inlet, produced an average of 152 gross mmcfd of natural gas, a decline of 11% from the prior year due primarily to reduced demand. Development drilling in the McArthur River Field, in which Marathon has a 51% working interest, is planned to continue in 1994. INTERNATIONAL Interests in liquid hydrocarbon and/or natural gas production are held in the U.K. North Sea, Ireland, the Norwegian North Sea, Indonesia, Tunisia and Egypt. In addition, Marathon has an equity interest in the Netherlands North Sea. NORTH SEA--Marathon's crude oil and natural gas liquids liftings from the North, South and Central Brae Fields for 1993 averaged 23,300 net bpd compared with 34,400 net bpd in 1992. Liftings for 1993 from the maturing South Brae Field averaged 4,200 net bpd compared with 5,200 net bpd in 1992 and 8,400 net bpd in 1991. The South Brae platform also serves as a vital link in generating third-party pipeline tariff revenue. To date, production from seven third-party fields is contracted to the Brae pipeline system. Five of the fields are currently onstream, one is expected to be placed onstream in 1994 and another is scheduled to be brought on in 1996. North Brae is a maturing gas condensate field and continues to be developed using the gas cycling technique. This technique separates natural gas liquids and returns the dry gas to the reservoir for pressure maintenance, increasing the overall liquids recovery. During 1993, liftings, including production from the previously mentioned Beinn discovery processed by North Brae facilities, totaled 14,100 net bpd compared with 21,600 net bpd and 28,400 net bpd in 1992 and 1991, respectively. Central Brae is a multi-well subsea development tied to South Brae facilities. Liftings averaged 5,000 net bpd in 1993 compared with 7,600 net bpd in 1992 and 5,300 net bpd in 1991. East Brae production commenced in late December 1993 and is expected to reach 115,000 gross bpd (45,000 net bpd) late 1994. Marathon holds an interest in the V-Fields gas development in the Southern Basin of the U.K. North Sea. Marathon's sales from the V-Fields averaged 22 net mmcfd in 1993 compared with 18 net mmcfd in 1992 and 33 net mmcfd in 1991. The changes in average equity production during the three-year period primarily reflected fluctuations in customer demand. In the Norwegian North Sea, Marathon has a 24% working interest in the Heimdal Field with sales of 75 net mmcfd of natural gas and 2,000 net bpd of condensate in 1993. Marathon's 50% equity interest in CLAM, a natural gas and gas liquids producer in the Netherlands North Sea, provides a 6% entitlement in the production of 16 gas fields which provided sales of 35 net mmcfd of natural gas in 1993. IRELAND--Marathon owns a 100% working interest in the Kinsale Head and Ballycotton Fields in the Celtic Sea. Combined sales of natural gas averaged 258 net mmcfd, 227 net mmcfd and 230 net mmcfd in 1993, 1992 and 1991, respectively. Four compressors were installed at Kinsale Head, two in each of 1992 and 1993, to increase the deliverability from the fields. TUNISIA--Marathon has a 50% working interest in the Belli Field which is located 30 miles southeast of Tunis. Liftings averaged 5,900 net bpd of oil in 1993 compared with 6,500 net bpd in 1992. Marathon also owns a 31% interest in the Ezzaouia Field, located 220 miles south of Tunis. Liftings from this field averaged 2,300 net bpd in 1993, a decline of 45% from the prior year due to natural declines. INDONESIA--Marathon operates and has a 37.5% working interest in two producing fields (KH and KF) in the Kakap Block in the Natuna Sea. The fields produce into a floating production and storage tanker. Liftings from Marathon's Kakap Block averaged 3,300 net bpd in 1993, a decline of 35% from the prior year primarily reflecting natural declines. EGYPT--Marathon has interests in three fields in Egypt. Liftings from the Ashrafi field, in which Marathon has a 50% working interest, averaged 5,500 net bpd of oil in 1993. Marathon has a 25% working interest in the El Qar'a Gas field which had average production of 17 net mmcfd of natural gas and 500 net bpd of liquid hydrocarbons in 1993. Marathon also has a 50% working interest in, and is the operator of, the Gazwarina field which had average 1993 crude oil liftings of 300 net bpd of oil. ABU DHABI--Effective December 31, 1993, Marathon relinquished its interest in the Arzanah Oil Field in Abu Dhabi. Liftings from this field averaged 1,800 net bpd of crude oil in 1993. The following tables set forth productive wells and drilling wells as of December 31, 1993; and average production costs and sales prices per unit of production for each of the last three years: - - ------------------- (a) Of the gross productive wells, gross wells with multiple completions operated by Marathon totaled 325. Information on wells with multiple completions operated by other companies is not available to Marathon. (b) Consisted of exploration and development wells. (c) Excluded Libya. See, "Financial Statements and Supplementary Data - Notes to Financial Statements - 26. Contingencies and Commitments - Libyan operations" for the Marathon Group. - - ------------------- (a) Production costs are as defined by the Securities and Exchange Commission and include property taxes, severance taxes and other costs, but exclude depreciation, depletion and amortization of capitalized acquisition, exploration and development costs. Natural gas volumes were converted to barrels of oil equivalent using a conversion factor of six mcf of natural gas to one barrel of oil. Certain prior years' data were restated to conform to 1993 reporting practices. (b) Production costs in 1992 and 1991 were favorably impacted by $1.50 per equivalent barrel and $.24 per equivalent barrel, respectively, for the settlement of prior years' production taxes. Production costs in 1992 excluded the effect of a $115 million restructuring charge relating to the disposition of certain domestic exploration and production properties. REFINING, MARKETING AND TRANSPORTATION Marathon's refining, marketing and transportation ("RM&T") operations are geographically concentrated in the Midwest and Southeast. This regional focus allows Marathon to achieve operating efficiencies between its integrated refining and distribution systems and its marketing operations. REFINING Marathon is a leading domestic petroleum refiner with 620,000 bpd of combined stated crude oil refining capacity. Marathon's refining system operated at 90% of its in-use capacity in 1993. The following table sets forth the location and rated throughput capacity of each of Marathon's refineries at December 31, 1993: - - ------------------------ (a) Temporarily idled in October 1993. Marathon's five refineries are integrated via pipelines and barges to maximize operating efficiency. The transportation links that connect the refineries allow the movement of intermediate products to optimize operations and the production of higher margin products. For example, naphtha is moved from Texas City to Robinson where excess reforming capacity is available. Gas oil is moved from Robinson to Detroit, which allows the Detroit refinery to upgrade diesel fuel to gasoline, using excess fluid catalytic cracking unit capacity. Raffinate, a low-octane, low-vapor pressure stream, is moved from Texas City to Robinson, where it is used to maximize production of blend-grade fuels. Light cycle oil is also moved from Texas City to Robinson, for sulfur removal. In October 1993, Marathon temporarily idled its 50,000 bpd Indianapolis refinery due to unfavorable plant economics and increased environmental spending requirements. The idling had no adverse impact on Marathon's supply of transportation fuels to its various classes of trade in Indiana or to its Midwest marketing area. During 1993, Marathon completed installation of desulfurization facilities at its Detroit, Garyville and Robinson refineries, which enable Marathon to meet the United States Environmental Protection Agency's ("EPA") standards limiting the sulfur content of highway transportation fuels. Of the nine cities that will require reformulated gasoline by 1995 under the 1990 Amendments to the Clean Air Act, only two, Chicago and Milwaukee, are in Marathon's marketing area, although other areas may opt into the program. Moreover, an insignificant share of Marathon's sales are in carbon monoxide non-attainment areas where oxygenated fuels were required effective November 1992. Marathon has oxygenate units - methyl tertiary butyl ether ("MTBE") units - at its Detroit and Robinson refineries. See "Environmental Matters" below. MARKETING In 1993, Marathon achieved record refined product sales volumes (excluding matching buy/sell transactions) of 10.4 billion gallons, which reflected an increase of 4% from the previous record in 1992. Excluding sales related to matching buy/sell transactions, wholesale distribution of petroleum products to private brand marketers and to large commercial and industrial consumers, primarily located in the Midwest and Southeast, accounted for about 61% of Marathon's marketing volume in 1993. Approximately 44% of Marathon's gasoline volumes and 74% of its distillate volumes were sold on a wholesale basis to independent unbranded customers in 1993. As of December 31, 1993, Marathon supplied petroleum products to 2,331 Marathon branded retail outlets located primarily in Ohio, Michigan, Indiana, Kentucky and Illinois. Substantially all Marathon branded petroleum products are sold to independent dealers and jobbers. In addition, Marathon branded operations are being expanded into areas in proximity to Marathon's existing terminal and transportation system where new accounts can be supplied at minimal incremental cost. At December 31, 1993, Marathon supplied 195 stations in states outside its traditional branded marketing territory including Tennessee, West Virginia, Virginia, Wisconsin, North Carolina and Pennsylvania. Retail sales of gasoline and diesel fuel are also made through limited and self-service stations and truck stops in 15 states. These facilities are operated by a wholly owned subsidiary, Emro Marketing Company ("Emro"), which sells products primarily under the brand names "Speedway", "United", "Bonded", "Cheker", "Gastown", "Wake Up", "Port", "Starvin' Marvin" and "Ecol". A majority of the retail outlets also sell convenience store items. As of December 31, 1993, this subsidiary had 1,568 retail outlets, including 36 retail outlets marketing under the name "Wake Up". Marathon increased its 50% ownership interest in Wake Up Oil Co. to 100% in December 1993. Also, in December 1993, Emro signed a letter of intent to acquire 36 retail outlets in the Greater Chicago and Northern Indiana areas, from a leading independent retailer. The acquisition is expected to be completed in the second quarter of 1994. Emro has made substantial progress in streamlining its operations and reducing costs during the three-year period ended December 31, 1993. To enhance profitability, Emro closed 139 marginal outlets during this period. Petroleum product sales volumes have increased slightly over this period, despite the reduced number of outlets. In 1993, Emro sold the assets of a subsidiary, Bosart Co., which consisted primarily of a convenience store distribution warehouse facility in Springfield, OH. Emro, through its wholly owned subsidiary, Emro Propane Company, distributes propane to residential heating and industrial consumers through 98 bulk plants (including 42 satellite branches) located in Michigan, Illinois, Ohio and Indiana under the brand names "Fuelgas", "Bonded Propane" and "Emro Propane". SUPPLY AND TRANSPORTATION Marathon obtains nearly 70% of its crude oil feedstocks from North and South America and the balance primarily from the Middle East, the North Sea and West Africa. In 1993, Marathon was a net purchaser of 440,000 bpd of crude oil from both domestic and international sources, including approximately 165,000 bpd obtained from the Middle East. Marathon's strategy in acquiring raw materials for its refineries is to obtain supply from secure, long-term sources. Marathon generally sells its international equity production into local markets, but has the ability to satisfy about 80% of its requirements from a combination of its international equity crude and current supply arrangements in the Western Hemisphere. Marathon operates a system of terminals, trucks and pipelines to provide crude oil to its refineries and refined products to marketing outlets. Fifty-one terminals are strategically located throughout the Midwest and Southeast, providing petroleum products to its marketing areas. During late 1993 and early 1994, Marathon installed automated fuel dye-injection equipment at 30 of these terminals in order to facilitate the sale of low-sulfur fuel oils for tax-exempt uses. The dye injection equipment was installed to comply with a January 1, 1994, requirement that terminal operators collect and remit federal excise taxes on all fuels suitable for use as on-highway diesel fuel, unless the fuel is dyed to indicate its tax-exempt status. In 1993, Marathon sold two tug/barge units totaling approximately 39,000 deadweight tons, which previously served waterborne refined product terminals in the Southeast. Marathon, through a wholly owned subsidiary, Marathon Pipe Line Company ("MPLC"), owns and operates, as a common carrier, approximately 1,100 miles of crude oil gathering lines; 1,500 miles of crude oil trunk lines; and 1,500 miles of products trunk lines. MPLC also owns interests in various pipeline systems, including approximately 11% of the Capline system, a large diameter crude pipeline extending from St. James, LA to Patoka, IL. Additionally, MPLC owns approximately 32% of LOOP INC. which is the owner and operator of the only U.S. deepwater oil port. LOOP is located off the coast of Louisiana. Marathon holds equity interests in a number of pipeline companies, including approximately 17% of the Explorer Pipeline Company, which operates a light products pipeline system extending from the Gulf Coast to the Midwest, and 2.5% of the Colonial Pipeline Company, which operates a light products pipeline system extending from the Gulf Coast to the East Coast. LIQUEFIED NATURAL GAS MARKETING AND TRANSPORTATION Liquefied natural gas ("LNG") is manufactured at the Kenai, AK gas liquefication plant, in which Marathon has a 30% equity interest, from a portion of Marathon's natural gas production in Alaska for delivery to two Japanese utilities under a contract which was renewed in April 1989 for a 15 year period. Marathon has a 30% participation in this contract which calls for sales of more than 900 gross bcf over the contract life. During 1993, LNG deliveries totaled 56.0 gross bcf (17.0 net bcf), up from 52.5 gross bcf in 1992. Two new LNG tankers, each of which had greater capacity than the one it replaced, were chartered and placed in service in 1993. NATURAL GAS UTILITIES Carnegie Natural Gas Company ("Carnegie") is an interstate pipeline company engaged in the transportation and sale-for-resale of natural gas in interstate commerce. In addition, Carnegie functions as a local distribution company serving residential, commercial and industrial customers in West Virginia and western Pennsylvania. Carnegie is a supplier and transporter of natural gas for U. S. Steel's Mon Valley Works near Pittsburgh. Apollo Gas Company ("Apollo") is engaged in the distribution of natural gas to residential, commercial and industrial customers in western Pennsylvania. Both Carnegie and Apollo are regulated as public utilities by state commissions within their service areas. Carnegie is also regulated by the Federal Energy Regulatory Commission as an interstate pipeline. Total natural gas throughput for Carnegie and Apollo was 37 bcf in 1993, 33 bcf in 1992 and 25 bcf in 1991. PROPERTY, PLANT AND EQUIPMENT ADDITIONS The following table sets forth property, plant and equipment additions for the Marathon Group for each of the last three years. - - ---------------------------------- (a) Represents property, plant and equipment additions for the businesses of the Delhi Group for the periods prior to October 2, 1992. Property, plant and equipment additions, including capital leases, have been primarily for the replacement, modernization and expansion of facilities and production capabilities including: development of the Brae Fields and the related SAGE pipeline system in the U. K. North Sea; refinery modifications at Robinson, Garyville and Detroit (including the construction of facilities required to meet federal low-sulfur diesel requirements); and environmental controls. For information concerning capital expenditures for environmental controls in 1993, 1992, and 1991 and estimated capital expenditures for such purposes in 1994 and 1995, see "Environmental Matters" below. Depreciation, depletion and amortization costs for the Marathon Group were $723 million, $787 million and $870 million in 1993, 1992 and 1991, respectively. RESEARCH AND DEVELOPMENT The research and development activities of the Marathon Group are conducted mainly at Marathon's Petroleum Technology Center in Littleton, CO. Expenditures by Marathon for research and development were $19 million in each of 1993 and 1992 and $22 million in 1991. Activities at the Petroleum Technology Center are devoted primarily to assisting Marathon's operating organizations in finding, producing and processing oil and gas efficiently and economically. Current efforts include new concepts in regional geological interpretation, enhanced seismic interpretation, development of computer-based techniques for reservoir description and performance modeling, methods to improve production and injection well performance and enhanced oil recovery techniques. The staff at the Petroleum Technology Center also provides a broad range of technical assistance and consultation to Marathon's RM&T operating organizations, including refinery process optimization. ENVIRONMENTAL MATTERS The Marathon Group maintains a comprehensive environmental policy overseen by the Public Policy Committee of the USX Board of Directors. The Environmental Affairs, Health and Safety organization has the responsibility to ensure that the Marathon Group's operating organizations maintain environmental compliance systems that are in accordance with applicable laws and regulations. The Health, Environmental and Safety Management Committee, which is comprised of officers of the group, is charged with reviewing its overall performance with various environmental compliance programs. Also, the Marathon Group has formed the Emergency Management Team, composed of senior management, which will oversee the response to any major emergency environmental incident throughout the group. The Marathon Group participates in the "Strategies for Today's Environmental Partnership" program, sponsored by the American Petroleum Institute, which is designed to improve the environmental performance of the petroleum industry. Additionally, since 1987, the Marathon Group has reduced the volume of toxic releases reported under the Superfund Amendments and Reauthorization Act of 1986 (Section 313) by 50%, primarily through recycling, process changes and chemical substitutions. The businesses of the Marathon Group are subject to numerous federal, state and local laws and regulations relating to the protection of the environment. These environmental laws and regulations include the Clean Air Act ("CAA") with respect to air emissions, the Clean Water Act ("CWA") with respect to water discharges, the Resource Conservation and Recovery Act ("RCRA") with respect to solid and hazardous waste treatment, storage and disposal, the Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA") with respect to releases and remediation of hazardous substances, and the Oil Pollution Act of 1990 ("OPA-90") with respect to oil pollution and response. In addition, many states where the Marathon Group operates have similar laws dealing with the same matters. These laws are constantly evolving and becoming increasingly stringent. The ultimate impact of complying with existing laws and regulations is not always clearly known or determinable due in part to the fact that certain implementing regulations for laws such as RCRA and the CAA have not yet been promulgated or in certain instances are undergoing revision. These environmental laws and regulations, particularly the 1990 Amendments to the CAA and new water quality standards, could result in substantially increased capital, operating and compliance costs. For a discussion of environmental expenditures, see "Management's Discussion and Analysis of Financial Condition and Results of Operations - Management's Discussion and Analysis of Environmental Matters, Litigation and Contingencies" for the Marathon Group. The Marathon Group has incurred and will continue to incur substantial capital, operating and maintenance, and remediation expenditures as a result of environmental laws and regulations. In recent years, these expenditures have increased primarily due to required product reformulation and process changes in order to meet CAA requirements, although ongoing compliance costs have also been significant. To the extent these expenditures, as with all costs, are not ultimately reflected in the prices of the Marathon Group's products and services, operating results will be adversely affected. The Marathon Group believes that substantially all of its competitors are subject to similar environmental laws and regulations. However, the specific impact on each competitor may vary depending on a number of factors, including the age and location of their operating facilities, their production processes and whether or not they are engaged in the petrochemical business or the marine transportation of crude oil. AIR The 1990 Amendments to the CAA impose more stringent limits on air emissions, establish a federally mandated operating permit program and allow for enhanced civil and criminal enforcement sanctions. The principal impact of the 1990 Amendments to the CAA on the Marathon Group is on RM&T operations. The amendments establish attainment deadlines and control requirements based on the severity of air pollution in a geographical area. Under the 1990 Amendments to the CAA, refiners were required to lower the amount of sulfur in diesel fuel produced for highway transportation use effective October 1993; "reformulated gasoline" is required by 1995 in the nine metropolitan areas classified as severe or extreme for ozone non-attainment and other ozone non-attainment areas may elect to opt into the reformulated gasoline program. Marathon will have the capability to produce about 25% of its gasoline output as reformulated fuels to comply with the CAA. This amount is well above Marathon's requirements within its marketing area. A major cost of reformulation will be the mandated use of oxygenates in gasoline. Marathon has constructed MTBE complexes at its Detroit and Robinson refineries. The decision to construct additional complexes is affected by uncertainties regarding the EPA's final regulations governing reformulated gasoline and whether particular oxygenates will be mandated or supported with economic incentives. In addition to the foregoing, refueling controls are required on fuel dispensers (so called Stage II Recovery) at gasoline stations located in ozone non-attainment areas classified as moderate, serious, severe and extreme. The potential impact of the requirement may be reduced as a result of a recent EPA decision requiring vehicles to be equipped with on-board vapor recovery systems. Nevertheless, individual states could elect to maintain the requirement for refueling controls. Marathon may be required to install equipment at up to 700 gasoline stations. WATER The Marathon Group maintains numerous discharge permits as required under the National Pollutant Discharge Elimination System program of the CWA, and has implemented systems to oversee its compliance efforts. In addition, the Marathon Group is regulated under OPA-90 which amended the CWA. Among other requirements, OPA-90 requires the owner or operator of a tank vessel or a facility to maintain an emergency plan to respond to discharges of oil or hazardous substances. Also, in case of such spills, OPA-90 requires responsible companies to pay removal costs and damages caused by them, provides for substantial civil penalties, and imposes criminal sanctions for violations of this law. Unlike many of its competitors within the oil industry, Marathon does not operate tank vessels, and therefore, has significantly less exposure under OPA-90 than competitors who do operate tank vessels. However, it does operate facilities at which spills of oil and hazardous substances could occur. Furthermore, several coastal states in which Marathon operates have passed or are expected to pass state laws similar to OPA-90, but with expanded liability provisions, including provisions for cargo owners as well as shipowners. Marathon has implemented approximately 50 emergency oil response plans for all its components and facilities covered by OPA-90, and it is an active member, along with other oil companies, in the Marine Preservation Association, which funds the Marine Spill Recovery Corporation, a major oil spill response organization covering a number of U.S. coastal areas. SOLID WASTE The Marathon Group continues to seek methods to minimize the generation of hazardous wastes in its operations. RCRA establishes standards for the management of solid and hazardous wastes. Besides affecting current waste disposal practices, RCRA also addresses the environmental effects of certain past waste disposal operations, the recycling of wastes and the regulation of underground storage tanks ("USTs") containing regulated substances. Since the EPA has not yet promulgated implementing regulations for all provisions of RCRA and has not yet made clear the practical application of all the implementing regulations it has promulgated, the ultimate cost of compliance cannot be accurately estimated. In addition, new laws are being enacted and regulations are being adopted by various regulatory agencies on a continuing basis and the costs of compliance with these new rules can only be broadly appraised until their implementation becomes more accurately defined. Corrective action under RCRA related to past waste disposal activities is discussed under "Remediation" below. REMEDIATION The Marathon Group operates certain gasoline stations where, during the normal course of operations, releases of petroleum products from USTs have occurred. Federal and state laws require that contamination caused by such releases at these sites be assessed and remediated to meet applicable standards. The enforcement of the UST regulations under RCRA has been delegated to the states which administer their own UST programs. The Marathon Group's obligation to remediate such contamination varies, depending upon the extent of the releases and the stringency of the laws and regulations of the states in which it operates. A portion of these remediation costs can be recovered from state UST reimbursement funds once the applicable deductibles have been satisfied. Accruals for remediation expenses are established for sites where contamination has been determined to exist and the amount of associated costs is reasonably determinable. The Marathon Group is involved with a potential corrective action at its Robinson, IL refinery where the remediation costs have been estimated at between $4 million and $18 million over the next 20 to 30 years. There are two other corrective action sites where the estimated remediation costs are not significant. Remediation activities might also be required at other Marathon Group sites under RCRA. USX is also involved in a number of remedial actions under CERCLA and similar state statutes related to the Marathon Group. See "Legal Proceedings - Environmental Proceedings" below. It is possible that additional matters may come to USX's attention which may require remediation. CAPITAL EXPENDITURES The Marathon Group's capital expenditures for environmental controls were $123 million in 1993, $240 million in 1992 and $102 million in 1991. The increase from 1991 to 1992 and the decline in 1993 was primarily the result of the Marathon Group's multi-year capital spending program for diesel fuel desulfurization which was substantially completed in 1993. The Marathon Group currently expects such expenditures to approximate $75 million in 1994. Predictions beyond 1994 can only be broad-based estimates which have varied, and will continue to vary, due to the ongoing evolution of specific regulatory requirements, the possible imposition of more stringent requirements and the availability of new technologies, among other matters. Based upon currently identified projects, the Marathon Group anticipates that environmental capital expenditures will be approximately $60 million in 1995; however, actual expenditures may increase as additional projects are identified or additional requirements are imposed. U. S. STEEL GROUP The U. S. Steel Group includes U. S. Steel, one of the largest integrated steel producers in the United States (referred to hereinafter as "U. S. Steel"), which is primarily engaged in the production and sale of a wide range of steel mill products, coke and taconite pellets. The U. S. Steel Group also includes the management of mineral resources, domestic coal mining, engineering and consulting services and technology licensing (together with U. S. Steel, the "Steel and Related Businesses"). Other businesses that are part of the U. S. Steel Group include real estate development and management, fencing products, leasing and financing activities and a majority interest in a titanium metal products company. U. S. Steel Group sales as a percentage of USX consolidated sales were 31% in 1993, 28% in 1992 and 26% in 1991. The following table sets forth the total sales of the U. S. Steel Group for each of the last three years. Such information does not include sales by joint ventures and other affiliates of USX accounted for by the equity method. - - ------------------------------ (a) U. S. Steel ceased producing structural and piling products when South Works in Chicago closed in April 1992. (b) Includes all other products sold by Steel and Related Businesses, including minerals and coke and all services sold, such as technical services. The total number of active employees for the U. S. Steel Group at year-end was 21,892 in 1993, 21,183 in 1992 and 21,968 in 1991. Most hourly and certain salaried employees are represented by the United Steelworkers of America ("USWA"). U. S. Steel entered into a new five and one-half year contract with the USWA, effective February 1, 1994, covering approximately 15,000 employees. The agreement will result in higher labor and benefit costs for the U. S. Steel Group each year throughout the term of the agreement. The agreement includes a signing bonus of $1,000 per USWA represented employee that will be paid the first quarter of 1994, $500 of which represents the final bonus payable under the previous contract. The agreement also provides for the establishment of a Voluntary Employee Beneficiary Association Trust to prefund health care and life insurance benefits for retirees covered under the agreement. Minimum contributions, in the form of USX stock or cash, are expected to be $25 million in 1994 and $10 million per year thereafter. The funding of the trust will have no direct effect on income of the U. S. Steel Group. Management believes that this agreement is competitive with labor agreements reached by U. S. Steel's major domestic integrated competitors and thus does not believe that U. S. Steel's competitive position with regard to such competitors will be materially affected by its ratification. In January 1994, U. S. Steel Mining Co., Inc. ("U. S. Steel Mining") entered into a five year agreement with the United Mine Workers of America ("UMW") covering approximately 1,700 employees, approximately 400 of which are employed at the Maple Creek coal mine which is expected to be permanently closed on or about March 31, 1994. STEEL INDUSTRY BACKGROUND AND COMPETITION The domestic steel industry is cyclical and highly competitive. Despite significant reductions in raw steel production capability by major domestic producers over the last decade, the domestic industry continues to be adversely affected by excess world capacity. In certain years over the last decade, extensive downsizings have necessitated costly restructuring charges which, when combined with highly competitive market conditions, resulted in substantial losses for most domestic integrated producers. U. S. Steel is one of the largest integrated steel producers in the United States and ranked first in both tons of raw steel production and in tons of steel shipped by domestic producers based on data for 1993. U. S. Steel competes with many other domestic steel companies, a number of which have gone through bankruptcy reorganization. Compared to integrated producers, minimills, which rely on less capital intensive hot metal sources, have certain competitive advantages. Since minimills are typically not unionized, they enjoy lower employment costs and more flexible work rules. In certain product lines like structural shapes, bars and rods, minimills have provided significant competition for integrated producers in the domestic market. One minimill company has constructed two plants utilizing thin slab casting technology to produce flat rolled products which previously were produced domestically only by integrated companies. These two plants are currently being expanded, and this company has announced its intention to construct a third flat-rolled plant with a joint venture partner. At least two other flat-rolled mill projects have been announced and several other companies are currently considering additional projects for construction in the United States. The domestic steel industry has been adversely affected by unfairly traded imports. Steel imports to the United States accounted for an estimated 19% of the domestic steel market during 1993, and for an estimated 22% in the fourth quarter. Steel imports to the United States accounted for an estimated 17% to 18% of the domestic steel market in 1992 and 1991. On March 31, 1992, Voluntary Restraint Agreements restricting the level of steel imports to the United States expired and in June 1992, USX and other domestic steel firms filed a number of antidumping and countervailing duty cases with the U.S. Department of Commerce ("USDC") and the International Trade Commission ("ITC") against unfairly traded imported carbon flat-rolled steel. Beginning in late 1992, as a result of affirmative preliminary determinations by both the ITC and the USDC in the vast majority of cases, provisional duties were imposed on the imported steel products under investigation. On June 22, 1993, the USDC issued the final determinations of subsidization in the countervailing duty cases and final margins for sales at less than fair value in the antidumping cases. On July 27, 1993, the ITC issued affirmative determinations of material injury to the domestic steel industry by reason of imports in cases representing an estimated 51% of the dollar value and 42% of the volume of all flat rolled carbon steel imports under investigation. Affirmative determinations were found in cases relating to 37% of such volume of cold rolled steel, 92% of such volume of the higher-value-added corrosion resistant steel and 97% of such volume of plate steel. Negative determinations were found in the other cases, including all cases related to hot-rolled steel, the largest import market. In those cases where negative determinations were made by the ITC, provisional duties imposed on imports covered by the cases were removed and final remedial duties were not imposed. While USX is unable to predict the effect these negative determinations may have on the business or results of operations of the U. S. Steel Group, they may result in increasing levels of imported steel and may adversely affect some product prices. As discussed above, steel imports to the United States have increased in recent months. Although the affirmative determinations are helpful in offsetting the harm to the U. S. steel industry caused by subsidized and dumped imports, USX believes that the negative determinations were improper and, together with other domestic steel firms, has appealed such determinations to the U. S. Court of International Trade and, in certain cases involving imports from Canada, to a bi-national panel in accordance with the Canadian Free Trade Agreement. Many of the affirmative determinations similarly have been challenged in appeals filed by foreign steel producers. USX may file additional antidumping and countervailing duty petitions if unfairly traded imports adversely impact, or threaten to adversely impact, the results of the U. S. Steel Group. In addition to competition from other domestic and foreign steel producers, U. S. Steel faces competition from producers of materials such as aluminum, cement, composites, glass, plastics and wood in many markets. The U. S. Steel Group's businesses are subject to numerous federal, state and local laws and regulations relating to the storage, handling, emission and discharge of environmentally sensitive materials. U. S. Steel believes that its major domestic integrated steel competitors are confronted by substantially similar conditions and thus does not believe that its relative position with regard to such other competitors is materially affected by the impact of environmental laws and regulations. However, the costs and operating restrictions necessary for compliance with environmental laws and regulations may have an adverse effect on U. S. Steel's competitive position with regard to domestic minimills and some foreign steel producers and producers of materials which compete with steel, which may not be required to undertake equivalent costs in their operations. For further information, see "Environmental Matters" below. BUSINESS STRATEGY U. S. Steel's principal raw steel production facilities are Gary Works in Indiana, Mon Valley Works in Pennsylvania and Fairfield Works in Alabama. Over the last ten years, U. S. Steel has responded to competition resulting from excess steel industry capability by eliminating less efficient facilities, modernizing those that remain and entering into joint ventures, all with the objective of focusing production on higher value-added products for customers in industries such as automotive, appliance, containers and oil country tubular goods where superior quality and special characteristics are of critical importance. U. S. Steel does not intend to sell all steel products but intends to focus on selected markets with developments such as bake-hardenable steels and coated sheets for the automobile industry, lamination sheet for the manufacture of motors and electrical equipment and improved tin mill products for the container industry. In addition, U. S. Steel intends to pursue lower manufacturing cost objectives through continuing cost improvement programs. These initiatives include, but are not limited to, reduced production cycle time, improved yields, continued customer orientation and improved process control. For example, the Pulverized Coal Injection project at Gary Works has resulted in reduced dependence on coke and lower operating expenses. Since 1982, the number of U. S. Steel raw steel production facilities has been reduced from nine to the three mentioned above, and annual raw steel capability has been reduced from 31 million to 12 million tons. Steel employment has been reduced from approximately 89,000 in 1982 to about 18,000 in 1993. As a result of downsizing its operations, the U. S. Steel Group recognized restructuring charges aggregating $2.8 billion since 1982 as its less efficient facilities have been shut down. During that period, U. S. Steel also invested approximately $3.2 billion in capital facilities for its steel operations. U. S. Steel believes that these expenditures have made its remaining steel operations among the most modern, efficient and competitive in the world. With the completion of new continuous casters at Gary Works in 1991 and at Mon Valley Works in 1992, U. S. Steel has achieved the ability to continuously cast 100% of its raw steel production. This method of producing steel results in higher quality steel at a lower cost than the previously used ingot method. Heavy investment has also been made in technology that complements the casters. For example, U. S. Steel's largest blast furnace, located at Gary, was rebuilt in 1991, at a cost of $110 million, to improve environmental controls and install a state-of-the-art process control system and a third high-efficiency hot-blast stove. The plate mill at Gary was also rebuilt in 1991, and hot strip mill modifications and improvements were made over a number of years at Fairfield and Gary to improve the quality of coils provided to customers. For additional information concerning capital expenditures for the U. S. Steel Group see "Property, Plant and Equipment Additions" below. In addition to the modernization of its production facilities, USX has entered into a number of joint ventures with domestic and foreign partners to take advantage of market or manufacturing opportunities in the sheet, tin plate, tubular, bar and plate consuming industries. See "Joint Ventures and Other Investments" below. STEEL AND RELATED BUSINESSES U. S. Steel operates plants which produce steel mill products in a variety of forms and grades. Gary Works, Mon Valley Works and Fairfield Works accounted for 58%, 22% and 20%, respectively, of U. S. Steel's 1993 raw steel production of 11.3 million tons. The annual raw steel production capability at December 31, 1993, of each of the three facilities in millions of net tons was Gary Works - 7.1, Mon Valley Works - 2.6 and Fairfield Works - 2.2. The following tables set forth significant U. S. Steel shipment data by major market and product for each of the last three years. Such data do not include shipments by joint ventures and other affiliates of USX accounted for by the equity method. Total steel shipments in 1990 and 1989 were 11,039 thousand tons and 11,469 thousand tons, respectively. - - -------------------------------- (a) U. S. Steel ceased production of structural products when South Works closed in April 1992. (b) Includes steel export shipments of approximately 0.4 million tons in 1993, 0.6 million tons in 1992 and 1.3 million tons in 1991. USX and its wholly owned subsidiary, U. S. Steel Mining, have domestic coal properties with demonstrated bituminous coal reserves of approximately 945 million net tons at year-end 1993 compared with approximately 981 million net tons at year-end 1992. This decline primarily reflects the 1993 sale of the Cumberland coal mine which had reserves of approximately 36 million net tons. The remaining reserves are of metallurgical and steam quality in approximately equal proportions. They are located in Alabama, Pennsylvania, Virginia, West Virginia, Illinois and Indiana. Approximately 77% of the reserves are owned, and the rest are leased. Of the leased properties, 85% are renewable indefinitely and the balance are covered by a lease which expires in 2005. U. S. Steel Mining's Maple Creek coal mine and a related preparation plant are expected to be permanently closed on or about March 31, 1994, because unforeseen and unpredictable geologic conditions made continued mining economically infeasible. Reserves associated with the Maple Creek coal mine were 31 million net tons at December 31, 1993. In early February 1994, USX announced its willingness to sell the idled mine and preparation plant, including coal reserves, surface facilities and certain equipment. Any prospective buyer would be a successor to U. S. Steel Mining's labor agreement with the UMW. USX controls domestic iron ore properties having demonstrated iron ore reserves in grades subject to beneficiation processes in commercial use by U. S. Steel of approximately 790 million tons at year-end 1993, substantially all of which are iron ore concentrate equivalents available from low-grade iron-bearing materials, and the rest are higher grade ore. All of these demonstrated reserves are located in Minnesota. Approximately 40% of these reserves are owned and the remaining 60% are leased. Most of the leased reserves are covered by a lease expiring in 2058 and a group of leases expiring from 1996 to 2007. U. S. Steel's iron ore operations at Mt. Iron, MN ("Minntac") produced 16.0 million net tons of taconite pellets in 1993 compared with 14.7 million net tons and 14.9 million net tons in 1992 and 1991, respectively. USX's Resource Management administers the remaining mineral lands and timber lands of the U. S. Steel Group, and is responsible for the lease or sale of these lands and their associated resources, which encompass approximately 300,000 acres of surface rights and 1,500,000 acres of mineral rights in 18 states. USX Engineers and Consultants, Inc. sells technical services worldwide to the steel, mining, chemical and related industries. Together with its subsidiary companies, it provides engineering and consulting services for facility expansions and modernizations, operating improvement projects, integrated computer systems, coal and lubrication testing and environmental projects. The following tables set forth significant production data for Steel and Related Businesses for each of the last five years and products and services by facility: - - -------------------------------- (a) In July 1991, U. S. Steel closed all iron and steel producing operations at Fairless Works. In April 1992, U. S. Steel closed South Works. (b) The Maple Creek coal mine, which is expected to be permanently closed on or about March 31, 1994, produced 1.0 million net tons of metallurgical coal and 0.7 million net tons of steam coal in 1993. (c) The Cumberland coal mine, which was sold in June 1993, produced 4.0 million net tons in 1992 and 1.6 million net tons in 1993 prior to the sale. - - -------------------------------- (a) In 1991, U. S. Steel closed all iron and steel producing operations and the pipe mill facilities at Fairless Works. Operations at the Fairless sheet and tin finishing facilities are sourced with hot strip mill coils from other U. S. Steel plants. JOINT VENTURES AND OTHER INVESTMENTS USX participates directly and through subsidiaries in a number of joint ventures included in the U. S. Steel Group. All of the joint ventures are accounted for under the equity method. Certain of the joint ventures are described below, all of which are 50% owned except Transtar, Inc. ("Transtar"). USX and Pohang Iron & Steel Co., Ltd. ("POSCO") of South Korea participate in a joint venture ("USS-POSCO Industries") which owns and operates the former U. S. Steel Pittsburg, CA Plant. The joint venture markets high quality sheet and tin products, principally in the western United States market area. USS-POSCO Industries produces cold-rolled sheets, galvanized sheets, tin plate and tin-free steel. A capital modernization and expansion program of nearly $400 million to upgrade the facilities was completed in 1989. USS-POSCO's annual capacity is 1.4 million tons. USX and Kobe Steel Ltd. ("Kobe") of Japan participate in a joint venture ("USS/Kobe Steel Company") which owns and operates the former U. S. Steel Lorain, OH Works. The joint venture produces raw steel for the manufacture of bar and tubular products. Bar products are sold by USS/Kobe Steel Company while U. S. Steel retains sales and marketing responsibilities for tubular products. Shipments in 1993 were 1.5 million tons. USS/Kobe Steel Company entered into a new five and one-half year labor contract with the USWA, effective February 1, 1994, covering approximately 2,300 employees. USX and Kobe have formed another joint venture ("PRO-TEC Coating Company") to construct, own and operate a hot dip galvanizing line in Leipsic, OH. Capacity is approximately 600,000 tons per year, with substrate coils provided by U. S. Steel. The facility commenced operations in early 1993. USX and Worthington Industries Inc. participate in a joint venture known as Worthington Specialty Processing which operates a steel processing facility in Jackson, MI. The plant is operated by Worthington Industries, Inc. and is dedicated to serving U. S. Steel customers. The facility contains state-of-the-art technology capable of processing master steel coils into both slit coils and sheared first operation blanks including rectangles, trapezoids, parallelograms and chevrons. It is designed to meet specifications for the automotive, appliance, furniture and metal door industries. The joint venture processes material sourced by U. S. Steel, with a production capacity of almost 708,000 net tons annually. USX and Rouge Steel Company participate in Double Eagle Steel Coating Company, a joint venture which operates an electrogalvanizing facility located in Dearborn, MI. This facility enables U. S. Steel to further participate in the expanding automotive demand for steel with corrosion resistant properties. The facility utilizes U. S. Steel's proven CAROSEL technology coupled with many refinements developed through actual operating experience on the No. 1 Electrogalvanizing Line located at Gary Works. The facility can coat both sides of sheet steel with zinc or alloy coatings and has the capability to coat one side with zinc and the other side with alloy. Capacity is 700,000 tons of galvanized steel annually, with availability of the facility shared by the partners on an equal basis. National-Oilwell, a joint venture with National Supply Company, Inc., a subsidiary of Armco Inc., operates in the oil field service industry and has six manufacturing plants in the United States and abroad that produce a broad line of drilling and production equipment. In the United States and abroad, it also operates 121 oilfield supply stores, 18 service centers and 17 sales offices where it sells its own manufactured equipment, tubular goods and other oilfield operating supplies manufactured by others. USX owns a 45% interest in Transtar, which purchased in 1988 the former domestic transportation businesses of USX including railroads, a dock company, USS Great Lakes Fleet, Inc. and Warrior & Gulf Navigation Company. Blackstone Transportation Partners, L.P. and Blackstone Capital Partners L.P., both affiliated with The Blackstone Group, together own 52% of Transtar, and the senior management of Transtar own the remaining 3%. For a discussion of litigation related to Transtar, see "Legal Proceedings - USX Legal Proceedings Attributable to the U.S. Steel Group". OTHER BUSINESSES In addition to the Steel and Related Businesses, the U. S. Steel Group includes various other businesses, the most significant of which are described below. The other businesses that are included in the U. S. Steel Group accounted for 3% of the U. S. Steel Group's sales in both 1993 and 1992 and 5% in 1991. USX Realty Development develops real estate for sale or lease and manages retail and office space, business and industrial parks and residential and recreational properties. USX Credit operates in the leasing and financing industry, managing a portfolio of real estate and equipment loans. Those loans are generally secured by the real property or equipment financed, often with additional security. USX Credit's portfolio is diversified in terms of types and terms of loans, borrowers, loan sizes, sources of business and types and locations of collateral. USX Credit is not actively making new loan commitments. Cyclone Fence distributes and erects fencing products for commercial use. RMI Titanium Company ("RMI") is a leading producer of titanium metal products. USX has a majority interest in RMI which is a publicly traded company listed on the New York Stock Exchange. PROPERTY, PLANT AND EQUIPMENT ADDITIONS During the years 1991-1993, the U. S. Steel Group made property, plant and equipment additions, including capital leases, aggregating $949 million. Additions were $198 million, $318 million and $433 million in 1993, 1992 and 1991, respectively. The additions have been primarily for the replacement, modernization and expansion of facilities and production capabilities, including steel production and finishing, the mining of raw materials, and environmental controls associated with steel production and other facilities. Significant expenditures in 1993 included amounts for upgrades of the hot strip mill and a pickle line at Gary Works and environmental projects at Gary Works and Mon Valley Works. The decline in capital spending over this period primarily reflected the completion of U. S. Steel's continuous cast modernization program in 1992. Capital expenditures for 1994 are currently estimated at $260 million and will include continued expenditures for projects begun in 1993 relative to environmental, hot-strip mill and pickle line improvements at Gary Works and initial expenditures for a blast furnace reline project at Mon Valley Works which is planned for completion in 1995. Capital expenditures in 1995 and 1996 are currently expected to remain at about the same level as in 1994. Depreciation, depletion and amortization costs for the U. S. Steel Group were $314 million, $288 million and $254 million in 1993, 1992 and 1991, respectively. RESEARCH AND DEVELOPMENT The research and development activities of the U. S. Steel Group are conducted mainly at the U. S. Steel Technical Center in Monroeville, PA. Expenditures for steel research and development were $22 million in 1993, $23 million in 1992 and $22 million in 1991. Steel research is devoted to developing new or improved processes for the mining and beneficiation of raw materials such as coal and iron ore and for the production of steel; developing new and improved products in steel and other product lines; developing technology for meeting environmental regulations and for achieving higher productivity in these areas; and serving customers in the selection and use of U. S. Steel's products. Steel research has contributed to current business performance through expanded use of on-site plant improvement teams. In addition, several collaborative research programs with technical projects directed at mid- to long-range research opportunities have been continued at universities and in conjunction with other domestic steel companies through the American Iron and Steel Institute. ENVIRONMENTAL MATTERS The U. S. Steel Group maintains a comprehensive environmental policy overseen by the Public Policy Committee of the USX Board of Directors. The Environmental Affairs organization has the responsibility to ensure that the U. S. Steel Group's operating organizations maintain environmental compliance systems that are in accordance with applicable laws and regulations. The Executive Environmental Committee, which is comprised of officers of the group, is charged with reviewing its overall performance with various environmental compliance programs. Also, the U. S. Steel Group, largely through the American Iron and Steel Institute, continues its deep involvement in the negotiation of various air, water, and waste regulations with federal, state and local governments to assure the implementation of cost effective pollution reduction strategies, such as the innovative regulatory-negotiation activities for coke plants, which are regulated under the Clean Air Act ("CAA"). The U. S. Steel Group has voluntarily participated in the EPA 33-50 program to reduce toxic releases and the EPA Greenlights program to promote energy efficiency. The U. S. Steel Group has also developed an award winning environmental education program (the Continuous Improvement to the Environment, or CITE, program), a corporate program to reduce the volume of wastes the U. S. Steel Group generates, and wildlife management programs certified by the Wildlife Habitat Enhancement Council at U. S. Steel Group operating facilities. Additionally, over the past 5 years, it has reduced the volume of toxic releases reported under the Superfund Amendments and Reauthorization Act of 1986 (Section 313) by 75%, primarily through recycling and process changes. The businesses of the U. S. Steel Group are subject to numerous federal, state and local laws and regulations relating to the protection of the environment. These environmental laws and regulations include the CAA with respect to air emissions, the Clean Water Act ("CWA") with respect to water discharges, the Resource Conservation and Recovery Act ("RCRA") with respect to solid and hazardous waste treatment, storage and disposal, and the Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA") with respect to releases and remediation of hazardous substances. In addition, all states where the U. S. Steel Group operates have similar laws dealing with the same matters. These laws are constantly evolving and becoming increasingly stringent. The ultimate impact of complying with existing laws and regulations is not always clearly known or determinable due in part to the fact that certain implementing regulations for laws such as RCRA and the CAA have not yet been promulgated or in certain instances are undergoing revision. These environmental laws and regulations, particularly the 1990 Amendments to the CAA and new water quality standards, could result in substantially increased capital, operating and compliance costs. For a discussion of environmental expenditures, see "Management's Discusssion and Analysis of Financial Condition and Results of Operations - Management's Discussion and Analysis of Environmental Matters, Litigation and Contingencies" for the U.S. Steel Group. The U. S. Steel Group has incurred and will continue to incur substantial capital, operating and maintenance, and remediation expenditures as a result of environmental laws and regulations. In recent years, these expenditures have been mainly for process changes in order to meet CAA requirements, although ongoing compliance costs have also been significant. To the extent these expenditures, as with all costs, are not ultimately reflected in the prices of the U. S. Steel Group's products and services, operating results will be adversely affected. The U. S. Steel Group believes that all of its domestic competitors are subject to similar environmental laws and regulations. However, the specific impact on each competitor may vary depending on a number of factors, including the age and location of their operating facilities and their production methods. AIR The 1990 Amendments to the CAA impose more stringent limits on air emissions, establish a federally mandated operating permit program and allow for enhanced civil and criminal enforcement sanctions. The principal impact of the 1990 Amendments to the CAA on the U. S. Steel Group is on the coke-making operations of U. S. Steel, as described below. The coal mining operations and sales of U. S. Steel Mining may also be affected. The 1990 Amendments to the CAA specifically address the regulation and control of hazardous air pollutants, including emissions from coke ovens. Generally, emissions for existing coke ovens must comply with technology-based limits by the end of 1995 and comply with a health risk-based standard by the end of 2003. However, a coke oven will not be required to comply with the health risk-based standard until January 1, 2020, if it complied with the technology-based standard at the end of 1993 and also complies with additional technology-based standards, by January 1, 1998, and by January 1, 2010. USX believes that it met the 1993 requirement and will be able to meet the 1998 and 2010 compliance dates. The 1990 Amendments to the CAA also mandate the nationwide reduction of emissions of acid rain precursors (sulfur dioxide and nitrogen oxides) from fossil fuel-fired electrical utility plants. Specified emission reductions are to be achieved by 2000. Phase I begins on January 1, 1995, and applies to 110 utility plants specifically listed in the law. Phase II, which begins on January 1, 2000, will apply to other utility plants which may be regulated under the law. U. S. Steel, like all other electricity consumers, will be impacted by increased electrical energy costs that are expected as electric utilities seek rate increases to comply with the acid rain requirements. In 1993, 77% of the coal production of U. S. Steel Mining was metallurgical coal, which is used in coke production, and the balance was steam coal. Most of U.S. Steel Mining's production of steam coal was from the Cumberland Coal mine, which was sold in 1993. While USX believes that the new requirements for coke ovens will not have an immediate effect on U. S. Steel Mining, the requirements may encourage development of steelmaking processes that do not require the use of coke. WATER The U. S. Steel Group maintains the necessary discharge permits as required under the National Pollutant Discharge Elimination System program of the CWA and it is in compliance with such permits. U. S. Steel is currently negotiating with the Environmental Protection Agency ("EPA") to develop a plan to remediate the section of the Grand Calumet River that runs through Gary Works. Approval of the sedimentation remediation plan is expected in early 1994. The entire remediation process through validation of the environmental recovery of the river is expected to take about 10 years. The program cost will be approximately $29 million over 5 to 6 years, all of which has previously been accrued. SOLID WASTE The U. S. Steel Group continues to seek methods to minimize the generation of hazardous wastes in its operations. RCRA establishes standards for the management of solid and hazardous wastes. Besides affecting current waste disposal practices, RCRA also addresses the environmental effects of certain past waste disposal operations, the recycling of wastes and the regulation of underground storage tanks containing regulated substances. Since the EPA has not yet promulgated implementing regulations for all provisions of RCRA and has not yet made clear the practical application of all the implementing regulations it has promulgated, the ultimate cost of compliance cannot be accurately estimated. In addition, new laws are being enacted and regulations are being adopted by various regulatory agencies on a continuing basis and the costs of compliance with these new rules can only be broadly appraised until their implementation becomes more accurately defined. Corrective action under RCRA related to past waste disposal activities is discussed under "Remediation" below. PROPOSED COMPREHENSIVE ENVIRONMENTAL COMPLIANCE PROGRAM AT GARY WORKS In order to facilitate long-term environmental compliance planning and spending at Gary Works and allow it to remain competitive, USX has entered into discussions with the Indiana Department of Environmental Management ("IDEM") and the EPA concerning the development of a 10-year environmental enhancement program at Gary Works. This program, as proposed, would cover all state and federal environmental laws, including air, water and hazardous waste. Under such a program, USX would agree in advance to expend up to a specified amount (possibly in the range of $20 million to $30 million) each year during the period for environmental enhancement projects at Gary Works. These projects would include those anticipated under future regulations and voluntary projects for which there is no present or anticipated future legal requirement, including the Grand Calumet River sediment remediation plan discussed above. This program would benefit USX by enabling it to better plan for its environmental expenditures over the next ten years. In addition, IDEM, the EPA and the public would benefit from having a major industrial facility committed to environmental expenditures not presently mandated by law. This project is in the early stages of discussion and there is no present commitment that the program will be accepted. REMEDIATION A significant portion of the U. S. Steel Group's currently identified environmental remediation projects relate to the dismantlement and restoration of former and present operating locations. These projects include continuing remediation at an IN SITU uranium mining operation, the dismantling and management of former coke-making facilities and the closure of permitted hazardous waste landfills. The U. S. Steel Group has commenced a RCRA Facility Investigation and a Corrective Measure Study at its Fairless Works. This study is expected to take three years to complete at a cost of $2 million to $3 million. The cost associated with any remediation which may ultimately be required is not presently reasonably estimable. Remediation activities might also be required at other U. S. Steel Group sites under RCRA. USX is also involved in a number of remedial actions under CERCLA and similar state statutes related to the U. S. Steel Group. See "Legal Proceedings - Environmental Proceedings" below. It is possible that additional matters may come to USX's attention which may require remediation. CAPITAL EXPENDITURES The U. S. Steel Group's capital expenditures for environmental controls were $53 million in 1993, $52 million in 1992 and $73 million in 1991. The U. S. Steel Group currently expects such expenditures to approximate $70 million in 1994, including the expected completion of major air quality projects at Gary Works. Predictions beyond 1994 can only be broad-based estimates which have varied, and will continue to vary, due to the ongoing evolution of specific regulatory requirements, the possible imposition of more stringent requirements and the availability of new technologies, among other matters. Based upon currently identified projects, the U. S. Steel Group anticipates that environmental capital expenditures will be approximately $25 million in 1995; however, actual expenditures may increase as additional projects are identified or additional requirements are imposed. DELHI GROUP The Delhi Group ("Delhi") consists of Delhi Gas Pipeline Corporation ("DGP") and certain related companies which are engaged in the purchasing, gathering, processing, transporting and marketing of natural gas. Prior to establishment of the Delhi Group on October 2, 1992, these businesses were included in the Marathon Group. Sales from the businesses included in the Delhi Group as a percentage of USX consolidated sales were 3% in both 1993 and 1992 and 2% in 1991. See "Financial Statements and Supplementary Data - Notes to Financial Statements - 1. Basis of Presentation" for the Delhi Group. Delhi is an established natural gas merchant engaged in the purchasing, gathering, processing, transporting and marketing of natural gas. It uses its extensive pipeline systems to provide gas producers with a ready purchaser for their gas or transportation to other pipelines and markets and to provide customers with an aggregated, reliable gas supply. Delhi has the ability to offer a complete package of services to customers, relieving them of the need to locate, negotiate for, purchase and arrange transportation of gas. As a result, margins realized in its merchant function, particularly when providing premium supply services, are generally higher than those realized when providing separate gathering, processing or transporting services or those realized from short-term, interruptible ("spot") market sales. Delhi provides premium supply services to customers directly connected to its pipeline systems ("on-system"), such as local distribution companies ("LDCs") and utility electric generators ("UEGs"). These services include providing reliable supplies tailored to meet the peak demand requirements of customers. Premium supply services range from standby service, where the customer has no obligation to take any volumes but may immediately receive gas from Delhi upon an increase in the customer's demand, to baseload firm service where delivery of continuous volumes is assured by Delhi and the customer is obligated to take the gas provided. Delhi attempts to structure its gas sales to balance the peak demand requirements of LDCs during the winter heating season and of UEGs during the summer air conditioning season. In addition, Delhi provides premium supply services to customers connected to other pipelines ("off-system") through its interconnections with intrastate and interstate pipelines. Gas supplies not sold under premium service contracts are generally sold in the spot market. Delhi also extracts and markets natural gas liquids ("NGLs") from natural gas gathered on its pipeline systems. Delhi sells NGLs to a variety of purchasers, including petrochemical companies, refiners, retailers, resellers and trading companies. Delhi owns interests in 18 natural gas processing facilities which include 22 gas processing plants, eleven of which are wholly owned and eleven of which are 50% owned. Fifteen of the plants were operating as of December 31, 1993. These facilities straddle Delhi's pipelines and have been located to maximize utilization. Delhi faces competition in all of its businesses, including obtaining additional dedicated gas reserves and providing premium supply services and gas transportation services. Delhi's competitors include major integrated oil and gas companies, more than 100 major intrastate and interstate pipelines, and national and local gas gatherers, brokers, marketers, distributors and end- users of varying size, financial resources and experience. Based on 1992 data published in the September 1993 Pipeline & Gas Journal, Delhi ranked seventeenth among domestic pipeline companies in terms of total miles of gas pipeline operated and second in terms of miles of gathering line operated. With respect to competition in Delhi's gas processing business, Delhi estimates there are approximately 400 gas processing plants in Texas and Oklahoma. Certain competitors, such as major integrated oil companies and intrastate and interstate pipelines, have financial resources and control supplies of gas substantially greater than those of Delhi. Competition for premium supply services varies for individual customers depending on the number of other potential suppliers capable of providing the level of service required by the customers. In addition, certain regulatory actions of the Federal Energy Regulatory Commission ("FERC"), designed to deregulate the gas industry, particularly FERC Order No. 636, have increased competition in providing premium supply services and gas transportation services. See "Regulatory Matters - FERC Regulation" below. The following tables set forth the distribution of the Delhi Group's sales and gross margin for each of the last three years: - - -------------------- (a) See "Natural Gas Sales" below for a discussion of a January 1994 settlement agreement which will affect Gas Sales and Gas Sales Margins in 1994 and 1995. (b) Gas Sales Margin reflects revenues less associated gas purchase costs. Transportation Margin reflects fees charged by Delhi for the transportation of volumes owned by third parties. Gas Processing Margin reflects (i) the sale of NGLs extracted from gas, less the cost of gas purchased for feedstock and (ii) processing fees charged by Delhi to third parties. (c) Included favorable effects of $2.6 million, $1.5 million and $8.0 million in 1993, 1992 and 1991, respectively, for settlements of certain contractual issues. The total number of Delhi employees at year-end was 805 in 1993, 810 in 1992 and 865 in 1991. Delhi employees are not represented by labor unions. NATURAL GAS GATHERING AND SUPPLY Delhi provides a valuable service to producers of natural gas by providing direct markets for the sale of their natural gas. Following discovery of commercial quantities of natural gas, producers generally must either build their own gathering lines or negotiate with another party, such as Delhi, to have gathering lines built to connect their wells to a pipeline for delivery to market. Delhi typically aggregates natural gas production from several wells in a gathering system where it may also provide additional services for the producers by compressing and dehydrating the gas. Depending on the quality of the gas stream, the gas may be treated to make it suitable for market. Delhi's ability to offer producers treating services and its willingness to purchase untreated gas give it an advantage in acquiring gas supplies, particularly in East Texas, where much of the gas produced is not pipeline quality gas. After processing, the residue gas flows through pipelines for ultimate delivery to market. Delhi owns and operates extensive gathering systems which are strategically located in the major gas producing areas of Texas and Oklahoma, including East Texas, South Texas and the Anadarko and Permian basins, and also operates in Arkansas, Kansas and Louisiana. Delhi's principal intrastate natural gas pipeline systems total approximately 7,600 miles and interconnect with other intrastate and interstate pipelines at more than 120 points. Interests in two partnerships, one of which operates a FERC regulated interstate pipeline system, bring total systems miles to approximately 8,100 at December 31, 1993. In January 1993, Delhi sold its 25% interest in Red River Pipeline. Total throughput, including Delhi's share of partnership volumes, was 327 billion cubic feet ("bcf") in 1993, 314 bcf in 1992 and 291 bcf in 1991. Delhi's existing systems are capable of handling substantially increased throughput without major investment. The following table sets forth the pipeline mileage for pipeline systems, including partnerships, owned and operated by Delhi at December 31, 1993, and natural gas throughput volumes for pipeline systems operated during 1993: - - -------------------- (a) Delhi sold its Colorado gas gathering facilities (including pipeline systems) during 1993. (b) Reflects Delhi's interest in partnership throughput. While Delhi obtains gas supplies from various sources, including major oil and gas companies and other pipelines, its primary source has been independent producers. It offers competitive prices for gas, a full range of pipeline services and stable, year-round takes of production. Stable takes are particularly important to small producers who may not have the financial capacity to withstand significant variations in cash flow. The services Delhi provides to producers include gathering, dehydration, treating, compression, blending, processing and transportation. Delhi's ability to provide this wide range of services, together with the location of its gathering systems within major gas-producing basins, has allowed it to build a large, flexible gas supply base. The pricing mechanisms under Delhi's contracts with producers generally result in variable market-based prices or periodically renegotiable fixed prices. The majority of Delhi's contracts with producers are "take-or-release" contracts under which Delhi has the right to purchase the gas or, if it does not purchase minimum volumes of gas over a specified period, the producer has the right to sell the gas to another party and have it transported on Delhi's system for a fee. Take-or-release contracts present less risk to Delhi than the formerly prevalent take-or-pay contracts, while affording producers an opportunity to protect their cash flow by selling to other buyers. Delhi believes that its liability on take-or-pay contracts, if any, is not material. Delhi must add dedicated gas reserves in order to offset the natural declines in production from existing wells on its systems and to meet any increase in demand. In the past, Delhi has successfully connected new sources of supply to its pipeline systems. Management attributes this past success to the strategic location of Delhi's gathering systems in major producing basins, the quality of its service and its ability to adjust to changing market conditions. Delhi's future ability to contract for additional dedicated gas reserves also depends in part on the level and success of drilling by producers in the areas in which Delhi operates. Delhi has added dedicated reserves at increasing levels since 1987. The following table sets forth information concerning Delhi's dedicated gas reserves for each of the last three years: - - -------------------- (a) During 1993, dedicated gas reserve additions related to Marathon were less than 8% of total additions. At December 31, 1993, approximately 12% of Delhi's dedicated gas reserves were owned by Marathon. NATURAL GAS SALES Delhi sells natural gas nationwide to LDCs, UEGs, pipeline companies, various industrial end-users and marketers under both long and short term contracts. As a result of Delhi's ability to offer a complete package of services to customers, relieving them of the need to locate, negotiate for, purchase and arrange transportation and processing of gas, margins realized by Delhi in its merchant function, particularly when providing premium supply services, are generally higher than those realized when providing separate gathering, processing or transportation services or those realized from spot market sales. In 1993, merchant gas sales represented approximately 63% of Delhi's total systems throughput and 77% of Delhi's total gross margin. Delhi sells gas under both firm and interruptible contracts at varying volumes and in 1993 sold gas to over 160 customers. Delhi principally targets sales to on-system LDCs and UEGs. LDCs and UEGs generally are willing to pay higher prices to gas suppliers who can provide reliable gas supplies and adjust to rapid changes in their demand for gas service. Fluctuations in demand for natural gas by LDCs and UEGs are influenced by the seasonal requirements of purchasers using gas for space heating and the generation of electricity for air conditioning. LDCs require maximum deliveries during the winter heating season, while UEGs require maximum deliveries during the summer air-conditioning season. In order to increase flexibility for supplying gas to premium customers, Delhi entered into an arrangement in the fourth quarter of 1993 with a large LDC in Texas to store up to 2.5 bcf of natural gas in an East Texas storage facility. Delhi serves over 30 LDCs and UEGs and total sales to these customers in 1993 exceeded 84 bcf. Delhi also sells gas to industrial end-users. These customers are generally more price-sensitive, but diversify Delhi's customer base and provide a stable market for gas. Delhi uses the spot market to balance its gas supply with the demands for premium services. It attempts to sell all of its available gas each month. Delhi typically estimates sales to its premium market, then places the rest of its supply on the spot market. If the estimated premium load does not materialize, spot market sales are increased. If the actual premium load is greater than expected, spot market sales are interrupted to divert additional gas to the premium market. Spot market sales allow Delhi to balance its gas supply with its sales and to maximize throughput on its systems. Because of prevailing industry conditions, most recent sales contracts are for periods of one year or less, and many are for periods of 30 days or less. Pricing mechanisms under Delhi's contracts result in gas sales at either market sensitive prices or fixed prices with the unit margin fluctuating in both cases based on the sales price and the cost of gas. Various contracts permit the customer or Delhi to interrupt the gas purchased or sold, under certain circumstances. Other contracts provide Delhi or the customer the right to renegotiate the gas sales price at specified intervals, often monthly or annually. Sales under these contracts may be terminated if the parties are unable to agree on a new price. These contract provisions may make the specified term of a contract less meaningful. During 1993, Delhi's four largest customers, which accounted for approximately 30% of total sales, were the Oklahoma Natural Gas Company ("ONG"), the largest LDC in Oklahoma; Southwestern Electric Power Company ("SWEPCO"), a UEG primarily serving locations in Louisiana, Arkansas and Texas; Central Power and Light Company ("CP&L"), a UEG serving South Texas; and Lone Star Gas Company, the largest LDC in Texas, serving the north central part of the state. Natural gas sales to these four largest customers accounted for 18%, 14% and 17% of total systems throughput and 45%, 39% and 37% of total gross margin in 1993, 1992 and 1991, respectively. Sales to two customers, ONG and SWEPCO, accounted for an aggregate of 34%, 30% and 29% of total gross margin in 1993, 1992 and 1991, respectively. Except for ONG, discussed below, no customer accounted for 10% or more of sales in such periods. SWEPCO and CP&L are owned by a common parent, but operate independently in different geographical areas. In the event that one or more of Delhi's large premium supply service customers reduce volumes taken under an existing contract or choose not to renew such contract(s), Delhi would be adversely affected to the extent it is unable to find alternative customers to buy gas at the same level of profitability. Delhi has maintained long-term sales relationships with many of its customers and has done business with ONG since 1971. ONG accounted for 14%, 12% and 14% of total sales in 1993, 1992 and 1991, respectively. Since 1987, sales contracts with ONG have been negotiated annually. During 1992, Delhi executed a contract with ONG relating to sales for the 1993 and 1994 contract years. Delhi is in the second year of this contract and has recently negotiated specific pricing provisions for both the 1994 and 1995 contract years. Sales to SWEPCO accounted for 7% of total sales in each of 1993 and 1992 and 6% in 1991. Sales to SWEPCO pursuant to one contract ("original contract") were at prices substantially above spot market prices and, as a result, this contract has accounted for more than 10% of Delhi's total gross margin in each year subsequent to 1990. On January 26, 1994, a settlement agreement was executed between DGP and SWEPCO, resolving litigation which began in 1991 related to the original contract which was due to expire in April 1995. The settlement agreement provides that SWEPCO will pay Delhi the price under the original contract through January 1994. Concurrent with the execution of the settlement agreement, Delhi executed a new four-year agreement with SWEPCO enabling Delhi to supply increased volumes of gas to two SWEPCO power plants in East Texas at market sensitive prices and premiums commensurate with the level of service provided. The agreement provides for swing service and does not require any minimum gas purchase volumes. Delhi's operating income and cash flow will be adversely affected by the amount of premiums lost under the original contract for the period February 1, 1994, through April 1, 1995. Broad estimates of the potential premium losses are $18 million and $4 million in 1994 and 1995, respectively. Delhi continues to pursue opportunities for long-term gas sales to LDCs and UEGs. During 1992, Delhi executed a new contract with Entex, a Division of Arkla, Inc., to supply for up to ten years the total gas requirements for the city of Tyler, TX. Entex is the second largest LDC in Texas. In early 1993, Delhi entered into additional contracts with Entex to supply gas to Longview, TX and Kilgore, TX. Delhi believes that there are additional opportunities to provide premium supply services to both on-system and off-system LDCs and UEGs at premium prices. Delhi can sell gas to off-system customers because of its numerous interconnections with other pipelines and the availability of transportation service from other pipelines. Delhi's interconnections with other pipelines give it access to virtually every significant interstate pipeline in the United States and permit it to take advantage of regional pricing differentials. Delhi has both firm and interruptible transportation agreements with various pipelines. Delhi attempts to minimize the payment of reservation fees associated with transportation arrangements and had only one contract with an obligation for fixed reservation fees at December 31, 1993. In a typical off-system sale transaction, Delhi sells gas to a customer at an interconnection point with another pipeline and the customer arranges further pipeline transportation of the gas to the point of consumption. Delhi's off-system sales in 1993 included sales to LDCs in Indiana, Illinois, Iowa, Kansas, Missouri, Nebraska, New York, California and Minnesota; UEGs in Pennsylvania, California, Kansas and Louisiana; and industrial end-users in many of the same states. Margins realized from off-system sales to LDCs and UEGs have traditionally been lower than those realized from on-system sales to such customers, reflecting the lower level of service typically received by the off-system customers. However, off-system LDCs and UEGs generally are willing to pay a premium over industrial and spot market sales prices. Delhi believes that with the implementation of FERC Order No. 636, its opportunities to make premium sales to off-system customers will continue to improve because interstate pipelines will increasingly become primarily transporters of natural gas as opposed to marketers of gas to LDCs, UEGs and large industrial end-users. During 1993, Delhi negotiated three FERC Order No. 636 sales of gas moving to off-system markets. For additional information concerning FERC Order No. 636, see "Regulatory Matters - FERC Regulation" below. The following table sets forth the distribution of Delhi's natural gas throughput volumes for each of the last three years: TRANSPORTATION Delhi transports natural gas on its pipeline systems for third parties at negotiated fees. When transporting gas for others, Delhi does not take title but delivers equivalent amounts to designated locations. The core of Delhi's transportation business is moving gas for on-system producers who market their own gas. Delhi's transportation business complements its sales and gas processing businesses by generating incremental revenues and margins. Transportation volumes also may be available for purchase by Delhi during periods of peak demand to increase Delhi's supply base. Delhi's more than 120 points of interconnection with both intrastate and interstate pipeline systems facilitate its transportation business. In 1993, transportation services accounted for approximately 37% of Delhi's total systems throughput and 10% of its total gross margin. GAS PROCESSING AND NGLS MARKETING Natural gas processing involves the extraction of NGLs (ethane, propane, isobutane, normal butane and/or natural gasoline) from the natural gas stream, thereby removing some of the British thermal units ("Btus") from the gas. Delhi processes most of the gas moved on its pipeline systems in its own plants, which straddle its pipelines, and processes a smaller portion at third-party plants. Delhi has the processing rights under a substantial majority of its contracts with producers. By processing gas, Delhi captures the differential between the price obtainable for the Btus if sold as NGLs and the price obtainable for the Btus if left in the gas. Delhi has the ability to take advantage of such price differentials by utilizing additional processing capacity at operating plants or by starting up and shutting down processing plants quickly at relatively minimal cost. Delhi monitors the economics of removing NGLs from the gas stream for processing on an ongoing basis to determine the appropriate level of each plant's operation and the viability of starting up or idling individual plants. At December 31, 1993, 15 of Delhi's 22 plants were operating. Delhi restarted one idled plant in 1993 and two in 1991 because of favorable processing economics. One plant was idled in November 1993, due to insufficient volumes of gas for processing. Delhi expanded its facilities in Custer County, Oklahoma by installing a two-mile pipeline and redesigning and moving the idled Cimarron processing plant to this area. The plant began operations in March 1994. Delhi has a 50% interest in the plant project which has an estimated total project cost of $4.2 million. Delhi also plans a 21-mile system expansion to provide additional system capacity to this plant. This project is scheduled for completion in the third quarter of 1994. In October 1993, Delhi purchased the 30 million cubic feet per day ("mmcfd") Pettus gas plant in South Texas. Construction of a pipeline linking the plant to the Delhi system was completed in November 1993. The following table sets forth, by state, the number of Delhi's processing plants at December 31, 1993, and the volume of NGLs sold during 1993: - - ----------------------------- (a) 100% owned (b) 50% owned; NGLs sales volumes reflect Delhi's interest. Delhi retains the rights to the NGLs on more than 90% of the gas it processes. The remainder is shared with either producers or other pipelines. For certain 50% owned plants, Delhi shares the retained NGLs equally with the joint owner. Delhi pursues incremental processing business from third parties with unprocessed gas accessible to Delhi's pipeline systems to take advantage of excess capacity when processing economics are favorable. Delhi also receives fees for providing treating services for producers whose gas requires the removal of various impurities to make it marketable. The impurities may include water, carbon dioxide or hydrogen sulfide. Delhi owns and operates its own treating facilities, including three sulfur plants, and also has contracts to treat gas at third-party plants. The ability to offer treating services to producers gives Delhi a competitive advantage in acquiring gas supplies in East Texas, where much of the gas produced is not pipeline quality gas. Delhi markets NGLs either at the two major domestic marketing centers for NGLs, Mont Belvieu, TX and Conway, KS, or at the processing plant sites. Delhi also markets NGLs for third parties for a fee. Condensate (free liquids in the gas stream before processing) is very similar to crude oil and is marketed to crude oil purchasers at various separation or collection facilities located throughout Delhi's pipeline systems. Prices for NGLs and condensates are closely related to the price of crude oil. Delhi has transportation, fractionation and exchange agreements for the movement of NGLs to market. Delhi sells NGLs to a variety of purchasers including petrochemical companies, refiners, retailers, resellers and trading companies. In 1993, Delhi marketed 282 million gallons ("mmgal") of NGLs to over 64 different customers at spot market prices. Delhi also has agreements with third parties to store NGLs, which provide the flexibility to delay NGLs sales until demand and prices are higher. Delhi's average NGLs sales volumes have increased in each year since 1991, totaling 282.0 mmgal, 261.4 mmgal and 214.7 mmgal in 1993, 1992 and 1991, respectively. In addition, NGLs volumes which Delhi processed for third parties for a fee were 45.7 mmgal and 40.5 mmgal in 1993 and 1992, respectively. Delhi also processed nominal amounts of gas for third parties during 1991. Gas processing unit margins, which trended downward over the last three years, averaged 6 cents per gallon in 1993 (1 cent per gallon in the fourth quarter) compared with 10 cents per gallon in 1992 and 13 cents per gallon in 1991. The decline primarily reflected increased average natural gas prices (feedstock costs) and lower average NGLs prices, which trended downward with crude oil. PROPERTY, PLANT AND EQUIPMENT ADDITIONS During the three years 1991-1993, Delhi made property, plant and equipment additions aggregating $87.8 million. Additions were $42.6 million, $26.6 million and $18.6 million in 1993, 1992 and 1991, respectively. A portion of these expenditures related to the connection of new dedicated gas reserves. Additions to Delhi's dedicated gas reserves totaled 382 bcf, 273 bcf and 255 bcf in 1993, 1992 and 1991, respectively. In addition, expenditures were made to purchase facilities and to improve and upgrade existing facilities. Expenditures in 1993 included amounts for a multi-pipeline interconnection and compression project in the Carthage area of East Texas, the acquisition and connection of a 65-mile gas gathering system in West Texas and the purchase, connection and upgrade of a 30 mmcfd cryogenic gas processing facility near existing systems in South Texas. For information concerning capital expenditures for environmental controls in 1993, 1992 and 1991 and estimated capital expenditures for such purposes in 1994 and 1995, see "Environmental Matters" below. Capital expenditures in 1994 are expected to exceed 1993 levels as Delhi continues to pursue opportunities at attractive prices to connect dedicated gas reserves by the expansion or acquisition of gas gathering, processing and transmission assets, including those made available as a result of current industry conditions and regulatory initiatives. Depreciation, depletion and amortization costs for Delhi were $36.3 million, $40.2 million and $38.7 million in 1993, 1992 and 1991, respectively. REGULATORY MATTERS Delhi's facilities and operations are subject to regulation by various governmental agencies. STATE REGULATION The Texas Railroad Commission ("RRC") has the authority to regulate natural gas sales and transportation rates charged by intrastate pipelines in Texas. The RRC requires tariff filings for certain of Delhi's transactions and, under limited circumstances, could propose changes in such filed tariffs. Rates charged for pipeline-to-pipeline transactions and to transportation, industrial and other similar large volume contract customers (other than LDCs) are presumed by the RRC to be just and reasonable where (i) neither the supplier nor the customer had an unfair advantage during negotiations, (ii) the rates are substantially the same as rates between the gas utility and two or more of these customers for similar service or (iii) competition does or did exist for the market with another supplier of natural gas or an alternative form of energy. Competition generally exists in the markets Delhi serves and rate cases have been infrequent. Delhi's Texas pipeline systems are subject to the "ratable take rules" of the RRC. Under ratable take rules, each purchaser of gas is generally required first to take ratably certain high-priority gas (i.e., principally casinghead gas from oil wells) produced from wells from which it purchases gas and, if its sales volumes exceed amounts of such high-priority gas available, thereafter to take gas well gas from wells from which it purchases gas on a ratable basis, by categories, to the extent of demand. Under other RRC regulations, large industrial customers are subject to curtailment or service interruption during periods of peak demand. Certain Delhi customers in Texas and Oklahoma may also be subject to state ratable take rules. Such rules have affected purchases of gas from Delhi in the past and may affect such purchases in the future. The RRC has promulgated Statewide Rules which streamline the process for determining gas demand and gas allowables in Texas. By setting allowables to meet market demand, Delhi believes the RRC rules will foster more accurate pricing signals between the wellhead and the burnertip. Although the ultimate impact of these changes to the proration rules is uncertain, Delhi believes it is well positioned to benefit from the new pricing structure. Delhi generally does not engage in the type of sales or transportation transactions which would subject it to cost of service regulation in the states where it does business. Louisiana exercises limited jurisdiction over certain facilities constructed in that state by Delhi. FERC REGULATION As a gas gatherer and an operator primarily of intrastate pipelines, Delhi is generally exempt from regulation under the Natural Gas Act of 1938 ("NGA"). Delhi operates and owns a 25% interest in Ozark Gas Transmission System ("Ozark"), an interstate pipeline providing transportation services in western Arkansas and eastern Oklahoma. Ozark is subject to FERC regulation under the NGA and the Natural Gas Policy Act of 1978 ("NGPA"). FERC also exercises jurisdiction over transportation services provided by Delhi under Section 311 of the NGPA. This jurisdiction is limited to a review of the rates, terms and conditions of such services. In April 1992, FERC issued Order No. 636, which makes significant changes to the regulatory schedule applicable to the services provided by interstate natural gas pipelines. The changes are intended to ensure that pipelines provide transportation service that is equal in quality for all gas supplies, whether the customer purchases the gas from the pipeline or from another supplier. FERC believes these structural changes will benefit the public and all segments of the natural gas industry by improving the access of gas buyers to a variety of gas sellers so as to maximize the benefits of the competitive wellhead gas market. During restructuring proceedings mandated by Order No. 636, current interstate pipeline customers have an opportunity to reduce their purchases of gas from the pipeline or to release their firm transportation capacity if they do not need the capacity. FERC is in the process of implementing Order No. 636, but Delhi cannot predict the final requirements of the FERC initiatives or their effect upon the availability or cost of transportation services to Delhi. Delhi anticipates that the merchant function of interstate pipelines will continue to be reduced as a result of Order No. 636 and Delhi believes that this reduction will provide Delhi with a number of opportunities to expand its merchant function. Under Order No. 636, Delhi will be able to offer its merchant services to existing customers of interstate pipelines who are seeking an alternative gas supply source. During 1993, Delhi negotiated three Order No. 636 sales of gas moving to off-system markets. ENVIRONMENTAL MATTERS The Delhi Group maintains a comprehensive environmental policy overseen by the Public Policy Committee of the USX Board of Directors. The Safety and Environmental Affairs organization has the responsibility to ensure that the Delhi Group's operating organizations maintain environmental compliance systems that are in accordance with applicable laws and regulations. The businesses of the Delhi Group are subject to numerous federal, state and local laws and regulations relating to the protection of the environment. These environmental laws and regulations include the Clean Air Act ("CAA") with respect to air emissions, the Clean Water Act ("CWA") with respect to water discharges, the Resource Conservation and Recovery Act ("RCRA") with respect to solid and hazardous waste treatment, storage and disposal, and the Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA") with respect to releases and remediation of hazardous substances. In addition, many states where the Delhi Group operates have similar laws dealing with the same matters. These laws are constantly evolving and becoming increasingly stringent. The ultimate impact of complying with existing laws and regulations is not always clearly known or determinable due in part to the fact that certain implementing regulations for laws such as RCRA and the CAA have not yet been promulgated or in certain instances are undergoing revision. These environmental laws and regulations, particularly the 1990 Amendments to the CAA, could result in increased capital, operating and compliance costs. For a discussion of environmental expenditures, see "Management's Discussion and Analysis of Financial Condition and Results of Operations - Management's Discussion and Analysis of Environmental Matters, Litigation and Contingencies" for the Delhi Group. The Delhi Group has incurred and will continue to incur capital and operating and maintenance expenditures as a result of environmental laws and regulations. To the extent these expenditures, as with all costs, are not ultimately reflected in the prices of the Delhi Group's products and services, operating results will be adversely affected. The Delhi Group believes that substantially all of its competitors are subject to similar environmental laws and regulations. However, the specific impact on each competitor may vary depending on a number of factors, including the age and location of their operating facilities and their production proceses. AIR The 1990 Amendments to the CAA impose more stringent limits on air emissions, establish a federally mandated operating permit program and allow for enhanced civil and criminal enforcement sanctions. The principal impact of the 1990 Amendments to the CAA on the Delhi Group is on its compressor stations and its processing plants. The amendments establish attainment deadlines and control requirements based on the severity of air pollution in a geographical area. All facilities that are major sources as defined by the CAA will require Title V permits. WATER The Delhi Group maintains the necessary discharge permits as required under the National Pollutant Discharge Elimination System program of the CWA and it is in compliance with such permits. SOLID WASTE The Delhi Group continues to seek methods to minimize the generation of hazardous wastes in its operations. RCRA establishes standards for the management of solid and hazardous wastes. Besides affecting current waste disposal practices, RCRA also addresses the environmental effects of certain past waste disposal operations, the recycling of wastes and the regulation of underground storage tanks containing regulated substances. Since the EPA has not yet promulgated implementing regulations for all provisions of RCRA and has not yet made clear the practical application of all the implementing regulations it has promulgated, the ultimate cost of compliance cannot be accurately estimated. In addition, new laws are being enacted and regulations are being adopted by various regulatory agencies on a continuing basis and the costs of compliance with these new rules can only be broadly appraised until their implementation becomes more accurately defined. REMEDIATION Minor remediation projects are done on a routine basis and related expenditures have not been material. CAPITAL EXPENDITURES The Delhi Group's capital expenditures for environmental controls were $4.5 million in 1993, $3.0 million in 1992 and $2.0 million in 1991. The Delhi Group currently expects such expenditures to approximate $5 million in 1994. Predictions beyond 1994 can only be broad-based estimates which have varied, and will continue to vary, due to the ongoing evolution of specific regulatory requirements, the possible imposition of more stringent requirements and the availability of new technologies, among other matters. Based upon currently identified projects, the Delhi Group anticipates that environmental capital expenditures in 1995 will remain at about the same levels experienced in 1994; however, actual expenditures may increase as additional projects are identified or additional requirements are imposed. Expenditures for environmental controls include amounts for projects which, while benefitting the environment, also enhance operating efficiencies. ITEM 2.		ITEM 2. PROPERTIES The location and general character of the principal oil and gas properties, plants, mines, pipeline systems and other important physical properties of USX are described in Item 1, the BUSINESS section of this document. Except for oil and gas producing properties, which generally are leased, or as otherwise stated, such properties are held in fee. The plants and facilities have been constructed or acquired over a period of years and vary in age and operating efficiency. At the date of acquisition of important properties, titles were examined and opinions of counsel obtained, but no title examination has been made specifically for the purpose of this document. The properties classified as owned in fee generally have been held for many years without any material unfavorably adjudicated claim. Several steel production facilities and interests in two liquefied natural gas tankers are leased. See "Financial Statements and Supplementary Data - Notes to Consolidated Financial Statements - 16. Leases". The basis for estimating oil and gas reserves is set forth in the "Consolidated Financial Statements and Supplementary Data - Supplementary Information on Oil and Gas Producing Activities - Estimated Quantities of Proved Oil and Gas Reserves". USX believes that its surface and mineral rights covering reserves are adequate to assure the basic legal right to extract the minerals, but may not yet have obtained all governmental permits necessary to do so. Unless otherwise indicated, all reserves shown are as of December 31, 1993. ITEM 3.	ITEM 3. LEGAL PROCEEDINGS USX is the subject of, or a party to, a number of pending or threatened legal actions, contingencies and commitments related to the Marathon Group, the U. S. Steel Group and the Delhi Group involving a variety of matters, including laws and regulations relating to the environment. Certain of these matters are discussed below. The ultimate resolution of these contingencies could, individually or in the aggregate, be material to the consolidated financial statements and/or to the financial statements of the applicable group. However, management believes that USX will remain a viable and competitive enterprise even though it is possible that these contingencies could be resolved unfavorably. USX LEGAL PROCEEDINGS ATTRIBUTABLE TO THE MARATHON GROUP TEXAS CITY REFINERY LITIGATION On October 30, 1987, there was a release of hydrofluoric acid ("HF") at Marathon's Texas City refinery when a contractor-operated crane failed and ruptured the HF tank. As a result, a number of lawsuits were filed against Marathon and others for property damage and personal injury. During the third quarter of 1993, Marathon agreed to settle with over 3,000 plaintiffs. Aggregate litigation settlements with respect to these cases (some of which have been agreed to but not finalized) are less than $14 million. Excluding those cases with agreed settlements, there are less than 100 plaintiffs remaining in the cases still pending. USX believes that a liability in excess of the amount which had been provided for in this matter through December 31, 1993, is remote. ENVIRONMENTAL PROCEEDINGS The following is a summary of proceedings attributable to the Marathon Group that were pending or contemplated as of December 31, 1993, under federal and state environmental laws. Except as described herein, it is not possible to accurately predict the ultimate outcome of these matters; however, management's belief set forth in the first paragraph under "Item 3. LEGAL PROCEEDINGS" above takes such matters into account. Claims under the Comprehensive Environmental Response, Compensation, and Liability Act ("CERCLA") and related state acts have been raised with respect to the cleanup of various waste disposal and other sites. CERCLA is intended to expedite the cleanup of hazardous substances without regard to fault. Potentially responsible parties ("PRPs") for each site include present and former owners and operators of, transporters to and generators of the substances at the site. Liability is strict and can be joint and several. Because of the ambiguity of the regulations, the difficulty of identifying the responsible parties for any particular site, the complexity of determining the relative liability among them, the uncertainty as to the most desirable remediation techniques and the amount of damages and cleanup costs and the time period during which such costs may be incurred, USX is unable to reasonably estimate its ultimate cost of compliance with CERCLA. At December 31, 1993, USX had been identified as a PRP at a total of 14 CERCLA sites related to the Marathon Group. Based on currently available information, which is in many cases preliminary and incomplete, USX believes that its liability for cleanup and remediation costs in connection with 13 of these sites will be under $1 million per site and most will be under $100,000. The other site is the MOTCO site near La Marque, TX, where Marathon was named as a PRP in a complaint filed by the United States in 1986 concerning the release of hazardous substances. In 1993, Marathon and other PRPs entered into a comprehensive consent decree with the federal government covering both onsite and offsite remediation, and superseding a 1987 partial consent decree. In anticipation of the comprehensive consent decree, Marathon paid approximately $1.8 million to the major PRP for the site, in exchange for that party's assumption of Marathon's responsibility for onsite and offsite remediation and indemnification of Marathon as to the remediation costs. In addition, there are 22 sites related to the Marathon Group where USX has received information requests or other indications that USX may be a PRP under CERCLA but where sufficient information is not presently available to confirm the existence of liability or make any judgment as to the amount thereof. There are also 49 additional sites, excluding retail marketing outlets and the three RCRA sites mentioned below, related to the Marathon Group where state governmental agencies or private parties are seeking remediation under state environmental laws through discussions or litigation. Based on currently available information, which is in many cases preliminary and incomplete, the Marathon Group believes that its liability for cleanup and remediation costs in connection with 26 of these sites will be under $100,000 per site, another 18 sites have potential costs between $100,000 and $1 million per site and four sites may involve remediation costs between $1 million and $5 million per site. There is one location which involves a remediation program in cooperation with the Michigan Department of Natural Resources at a closed and dismantled refinery site located near Muskegon, MI. The Marathon Group anticipates spending between $8 million and $18 million over the next 10 to 20 years at this site. Additionally, the Marathon Group is involved with a potential corrective action at its Robinson, IL refinery where the remediation costs have been estimated at between $4 million and $18 million over the next 20 to 30 years. There are two other corrective action sites where the Marathon Group believes that its liability for cleanup and remediation costs will be under $100,000 per site. In January 1994, the U.S. Environmental Protection Agency ("EPA") (Region 5, Chicago) served Marathon with a Complaint and Compliance Order for Resource Conservation and Recovery Act ("RCRA") violations at the Robinson refinery seeking a penalty of $298,990. The Complaint alleges that the refinery violated RCRA for failure to properly characterize the waste water from a truck rinse pad and to maintain records of such characterization and failure to file a Class I permit modification and to implement the Contingency Plan. Marathon has filed its Answer denying liability. USX LEGAL PROCEEDINGS ATTRIBUTABLE TO THE U. S. STEEL GROUP B&LE LITIGATION; MDL-587 On January 24, 1994, the U.S. Supreme Court denied a petition for Writ of Certiorari by the Bessemer & Lake Erie Railroad ("B&LE") in the lower Lake Erie Iron Ore Antitrust Litigation ("MDL-587"). As a result, the decision of the U.S. Court of Appeals for the Third Circuit affirming judgments against the B&LE of approximately $498 million, plus interest, relating to antitrust violations by the B&LE was permitted to stand. In addition, the Third Circuit decision remanded the claims of two plaintiffs for retrial of their damage awards. At trial these plaintiffs asserted claims of approximately $8 million, but were awarded only nominal damages by the jury. A new trial date has not been set. Any damages awarded in a new trial may be more or less than $8 million and would be subject to trebling. The B&LE was a wholly owned subsidiary of USX throughout the period the conduct occurred. It is now a subsidiary of Transtar, Inc. ("Transtar") in which USX has a 45% equity interest. These actions were excluded liabilities in the sale of USX's transportation units in 1988, and USX is obligated to reimburse Transtar for judgments paid by the B&LE. Following the Court of Appeals decision, USX, which had previously accrued $90 million on a pre-tax basis for this litigation, charged an additional amount of $619 million on a pre-tax basis against the results of the U. S. Steel Group in the second quarter of 1993. In late 1993, USX and LTV Steel Corp. ("LTV"), one of the Plaintiffs in MDL-587, agreed to settle all LTV's claims in that action for $375 million. USX paid $200 million on December 29, 1993, and the balance on February 28, 1994. Claims of three additional plaintiffs were also settled in December 1993. These settlements resulted in a pre-tax credit of $127 million in the fourth quarter financial results of the U. S. Steel Group. As a result of the denial of the Petition for Writ of Certiorari, judgments for the other MDL-587 plaintiffs (other than the two remanded for retrial), totaling approximately $190 million, including post-judgment interest, were paid in the first quarter of 1994. Claims for legal fees and costs related to these actions, estimated not to exceed $20 million, remain to to paid. B&LE LITIGATION; ARMCO In June 1990, following judgments entered on behalf of steel company plaintiffs in MDL-587, Armco Steel filed federal antitrust claims against the B&LE and other railroads in the Federal District Court for the District of Columbia. B&LE successfully challenged the actions for lack of jurisdiction and venue, and the case was transferred to the Federal District Court for the Northern District of Ohio. Other defendant railroads settled with Armco, leaving B&LE the only remaining defendant. On April 7, 1993, B&LE's motion to dismiss the federal antitrust claims on grounds of statute of limitations was granted. Subsequently, Armco refiled its claims under the Ohio Valentine Act. B&LE's motions for summary judgment on time bar issues and for change of venue to another Ohio county are pending, and not yet fully briefed. No discovery has been taken on the merits of Armco's claims, but if Armco survives the present and possibly further pre-trial motions and the case proceeds to trial on the merits, Armco's claimed damages are likely to be substantial. Unlike MDL-587, it is USX's position that the Armco case was not an excluded liability in the sale of USX's transportation units to Transtar in 1988, and that USX therefore is not obligated to reimburse Transtar for any judgments rendered in the Armco case; however, this position is being disputed by Transtar and The Blackstone Group, the ultimate owner of 52% of Transtar's outstanding shares. FAIRFIELD AGREEMENT LITIGATION On November 15, 1989, USX and two former officials of the USWA were indicted by a federal grand jury in Birmingham, AL which alleged that USX granted leaves of absence and pensions to the union officials with intent to influence their approval, implementation and interpretation of the December 24, 1983, Fairfield agreement, a local labor agreement which resulted in reopening USX's Fairfield Works. On July 10, 1990, USX and the union officials were convicted. On September 27, 1990, the District Court imposed a $4.1 million fine on USX and ordered restitution to the U. S. Steel and Carnegie Pension Fund of approximately $300,000. USX believes the verdicts were erroneous and has appealed the decision to the Court of Appeals for the 11th Circuit. The payment of the fine and the restitution have been stayed pending the appeal. A former executive officer of USX who was also subsequently indicted has pleaded not guilty and has not yet been tried. A related civil action against USX, which was dismissed by the trial court, has been appealed to the U. S. Court of Appeals for the 11th Circuit. PICKERING LITIGATION On November 3, 1992, the United States District Court for the District of Utah Central Division issued a Memorandum Opinion and Order in PICKERING V. USX relating to pension and compensation claims by approximately 1,900 employees of USX's former Geneva (UT) Works. Although the court dismissed a number of the claims by the plaintiffs, it found that USX had violated the Employee Retirement Income Security Act by interfering with the accrual of pension benefits of certain employees and amending a benefit plan to reduce the accrual of future benefits without proper notice to plan participants. Further proceedings were held to determine damages and, pending the court's determinations, USX may appeal. Plaintiffs' counsel has been reported as estimating plaintiffs' recovery to be in excess of $100 million. USX believes any such damages will likely be substantially less than the plaintiff's estimate. ENERGY BUYERS LITIGATION On December 21, 1992, an arbitrator issued an award for approximately $117 million, plus interest under Ohio law, against USX in ENERGY BUYERS SERVICE CORPORATION V. USX CORPORATION, a case originally filed in the District Court of Harris County, TX. Such amount was fully accrued as of December 31, 1992. On December 15, 1993, USX agreed to settle all claims in the case for $95 million and deferred payments of up to $9 million. ALOHA STADIUM LITIGATION A jury trial commenced in late June 1993, in a case filed in the Circuit Court of the First Circuit of Hawaii by the State of Hawaii alleging, among other things, that the weathering steel, including USS COR-TEN Steel, which was incorporated into the Aloha Stadium was unsuitable for the purpose used. The State sought damages of approximately $97 million for past and future repair costs and also sought treble damages and punitive damages for deceptive trade practices and fraud, respectively. On October 1, 1993, the jury returned a verdict finding no liability on the part of U. S. Steel. In January 1994, the State appealed the decision to the Supreme Court of Hawaii. INLAND STEEL PATENT LITIGATION In July 1991, Inland Steel Company ("Inland") filed an action against USX and another domestic steel producer in the U. S. District Court for the Northern District of Illinois, Eastern Division, alleging defendants had infringed two of Inland's steel-related patents. Inland seeks monetary damages of up to approximately $50 million and an injunction against future infringement. USX in its answer and counterclaim alleges the patents are invalid and not infringed and seeks a declaratory judgment to such effect. In May 1993, a jury found USX to have infringed the patents. The District Court has yet to rule on the validity of the patents. In July 1993, the U. S. Patent Office rejected the claims of the two Inland patents upon a reexamination at the request of USX and the other steel producer. A further request was submitted by USX to the Patent Office in October 1993, presenting additional questions as to patentability which was granted and consolidated for consideration with the original request. Inland is entitled to a hearing prior to the time that the decision of the Patent Office becomes final, and any final decision by the Patent Office is subject to judicial appeal. SECURITIES LITIGATION In July 1993, a class action was filed in the U.S. District Court for the Western District of Pennsylvania (FINKEL V. LEHMAN BROTHERS, ET AL.) naming as defendants USX, Messrs. C.A. Corry, R.M. Hernandez and L.B. Jones, officers of the Corporation, and the underwriters in a public offering of 10 million shares of Steel Stock completed on July 29, 1993. The complaint alleges that the Corporation's prospectus and registration statement was false and misleading with respect to the effect of unfairly traded imports on the domestic steel industry and the then pending ITC proceedings and seeks as damages the difference between the public offering price and the value of the shares at the time the action was brought or the price at which shares were disposed of prior to filing the suit. Two additional actions (SNYDER V. USX, ET AL. AND ERENBERG V. USX, ET AL.) involving essentially the same issues were filed in August 1993 in the same court and added Mr. T.J. Usher, also an officer, as a defendant. In January 1994, USX filed a motion to dismiss these cases, which have been consolidated. This motion has not yet been acted upon. ENVIRONMENTAL PROCEEDINGS The following is a summary of the proceedings attributable to the U. S. Steel Group that were pending or contemplated as of December 31, 1993, under federal and state environmental laws. Except as described herein, it is not possible to accurately predict the ultimate outcome of these matters; however, management's belief set forth in the first paragraph under "Item 3. LEGAL PROCEEDINGS" above takes such matters into account. Claims under CERCLA and related state acts have been raised with respect to the cleanup of various waste disposal and other sites. CERCLA is intended to expedite the cleanup of hazardous substances without regard to fault. PRP's for each site include present and former owners and operators of, transporters to and generators of the substances at the site. Liability is strict and can be joint and several. Because of the ambiguity of the regulations, the difficulty of identifying the responsible parties for any particular site, the complexity of determining the relative liability among them, the uncertainty as to the most desirable remediation techniques and the amount of damages and cleanup costs and the time period during which such costs may be incurred, USX is unable to reasonably estimate its ultimate cost of compliance with CERCLA. At December 31, 1993, USX had been identified as a PRP at a total of 41 CERCLA sites related to the U. S. Steel Group. Based on currently available information, which is in many cases preliminary and incomplete, USX believes that its liability for cleanup and remediation costs in connection with 34 of these sites will be under $1 million per site and most will be under $100,000. At one site, U. S. Steel's former Duluth, MN Works, USX had estimated spending approximately $3.3 million over the next three years. However, in September 1993, USX was directed to develop alternative methods of remediation for this site, the cost of which is presently unknown and indeterminable and, as a result, future costs may be more or less than the $3.3 million previously estimated. At the remaining six sites, USX has no reason to believe that its share in the remaining cleanup costs at any single site will exceed $5 million, although it is not possible to accurately predict the amount of USX's share in any final allocation of such costs. Following is a summary of the status of the six sites: In 1988, USX and three other PRPs agreed to the issuance of an administrative order by the EPA to undertake emergency removal work at the Municipal & Industrial Disposal Co. site in Elizabeth, PA. The cost of such removal, which has been completed, was approximately $3 million, of which USX paid $2.5 million. The EPA has indicated that further remediation of this site may be required in the future, but it has not conducted any assessment or investigation to support what remediation would be required. In October 1991, the Pennsylvania Department of Environmental Resources ("PaDER") placed the site on the Pennsylvania State Superfund list and began a Remedial Investigation and Feasibility Study ("RI/FS") which is expected to be completed in late 1994. It is not possible to estimate accurately the cost of any remediation or USX's share in any final allocation formula; however, based on presently available information, USX may have been responsible for approximately 70% of the waste material deposited at the site. In 1989, a consent decree negotiated between the EPA and USX was entered in the U.S. District Court of New Jersey requiring USX to undertake remedial work at the Tabernacle Drum Dump site in Tabernacle, NJ. USX has expended $2.5 million in completing the remedial design and in constructing the treatment system. It is expected that the remaining remedial work will cost approximately $1.0 million. Additionally, the Department of Justice filed a complaint in 1990 against USX and a waste disposal firm seeking recovery of $1.7 million expended by the EPA in conducting a RI/FS for the site. USX has cross claimed against the waste disposal firm, and its successor in ownership, which improperly disposed of the waste material. At the Arrowhead Refinery site in Hermantown, MN, USX is one of 17 defendants named in a complaint filed by the EPA in 1989. The agency is seeking to recover over $4 million in past costs and a declaratory judgment as to all future costs that may be expended by the government at this site. The Record of Decision issued by the EPA in 1986 selected a remediation plan which was projected by the agency in 1990 to cost over $60 million. In response to a unilateral administrative order issued by the EPA in March 1990, USX and 28 other PRPs are implementing the groundwater remedial phase of the site remediation, which is expected to cost a total of $2 million. The EPA issued a further administrative order in May 1991, to USX and 150 other PRPs mandating remediation of the site sludge material. However, in response to treatability studies performed by USX and thirty other PRPs, the EPA amended the Record of Decision on February 9, 1994, to allow a more cost effective remediation of the site's sludge material and contaminated soils to be implemented. The remediation costs under the revised remedy will be under $25 million. Subject to completing the ongoing negotiations for a global settlement involving all PRPs, the EPA has agreed to forgive its past costs and implement a component of the site remediation. The EPA's contribution towards the necessary site expenditures would be over 30%. Additionally, an allocation consultant submitted its final report on January 14, 1994, with the approval of the court in an attempt to determine each PRP's share of the waste disposed of at the site. Based upon this report, USX should be responsible for no more than 3% of the site costs. However, this percentage may increase slightly due to the inability of some PRPs to contribute financially towards the site remediation. USX participated with thirty-five other PRPs in performing removal work at the Ekotek/Petrochem site in Salt Lake City, UT under the terms of a 1991 administrative order negotiated with the EPA. The removal work was completed in 1992 at a cost of over $9 million. In July 1992, the PRP Remediation Committee negotiated an administrative order on consent to perform a RI/FS of the site. It is expected the RI/FS will be completed by the end of 1994. USX has contributed approximately $550,000 through 1993 towards completing the removal work and performing the RI/FS. USX's proportionate share of costs presently being used by the PRP Remediation Committee is approximately 5% of the participating PRPs, but a final determination has not yet been made and it is expected that the percentage may decrease as a result of the participation of additional PRPs. The PRP Remediation Committee is attempting to involve non-participating PRPs in financing all the site response work. USX owns about 51% of the common stock of RMI Titanium Company ("RMI") which has been identified as a PRP (together with 31 other companies) at the Fields Brook Superfund site in Ashtabula, OH. In 1986, the EPA estimated the cost of remediation at $48 million, although the actual costs may be significantly more or less depending on a variety of factors. RMI and twelve other PRPs are conducting a study at an estimated cost of $16.5 million. The thirteen PRPs have agreed to non-binding arbitration to allocate the cost of complying with the order to do the study. It is not possible to determine accurately RMI's share in any final allocation formula with respect to the study or the cleanup; however, on the basis of its current knowledge, RMI believes its share of the ultimate costs will be in the range of 5% to 11%. The Buckeye Reclamation Landfill, near St. Clairsville, OH, has been used at various times as a disposal site for coal mine refuse and municipal and industrial waste. USX is one of fifteen PRPs that have indicated a willingness to enter into an agreed order with the EPA to perform a remediation of the site. Until there is a final determination of each PRP's proportionate share at the site, USX has agreed to accept a share of 9.26% under an interim allocation agreement among all fifteen PRPs. Since 1992, USX has spent approximately $250,000 at the site, primarily on remedial design work estimated to total $2.5 million. Implementation of the remedial design plan, resulting in a long-term cleanup of the site, is expected to cost approximately $21.5 million. In addition, there are 28 sites related to the U. S. Steel Group where USX has received information requests or other indications that USX may be a PRP under CERCLA but where sufficient information is not presently available to confirm the existence of liability or make any judgment as to the amount thereof. There are also nine additional sites, excluding the RCRA site mentioned below, related to the U. S. Steel Group where state governmental agencies or private parties are seeking remediation under state environmental laws through discussions or litigation. Based on currently available information, which is in many cases preliminary and ,incomplete, the U. S. Steel Group believes that its liability for cleanup and remediation costs in connection with two of these sites will be under $100,000 per site, another two sites have potential costs between $100,000 and $1 million per site and one site may involve remediation costs between $1 million and $5 million. The U. S. Steel Group is currently unable to classify the potential costs associated with remediation at four of the sites. Additionally, the U. S. Steel Group has commenced a RCRA Facility Investigation and a Corrective Measure Study at its Fairless Works. This study is expected to take three years to complete at a cost of $2 million to $3 million. The cost associated with any remediation which may ultimately be required is not presently reasonably estimable. The following cases are also pending: In 1987, USX and the PaDER entered into a consent order to resolve an incident in January 1985 involving the alleged unauthorized discharge of benzene and other organic pollutants from U. S. Steel's Clairton Works in Clairton, PA. That consent order required USX to pay a penalty of $50,000 and a monthly payment of $2,500 for five years. In 1990, USX and the PaDER reached agreement to amend the consent order. Under the amended order, USX has agreed to continue paying the prior $2,500 monthly penalty until February 1997; to clean up and close a former coke plant waste disposal site over a period of 15 years; to pay a penalty of $300,000; and to pay a monthly penalty of up to $1,500 each month until the former disposal site is closed. A study is underway to determine clean up and closure requirements. In 1988, the United States filed an action in the United States District Court, Northern District of Indiana, for alleged violations of its National Pollutant Discharge Elimination System ("NPDES") permit effluent limitations and proposed including U. S. Steel's Gary Works on the EPA's List of Violating Facilities under Section 508 of the Clean Water Act based upon the EPA's allegations of continuing or recurring non-compliance with clean water standards at the facility. A consent decree signed by USX and approved by the court in 1990 requires USX to pay a civil penalty of $1.6 million, to study and implement a program to remediate the sediment in a portion of the Grand Calumet River and to comply with specified wastewater control requirements entailing up to $25 million for new control equipment. In addition, the EPA withdrew the proposal to include Gary Works on the List of Violating Facilities. A proposed sediment remediation plan was submitted to the EPA in February 1993, which is estimated to cost approximately $29 million. USX and the EPA are currently negotiating the terms under which the sediment remediation plan will be implemented. In 1990, USX received a Notice of Violation issued by IDEM alleging the violation of regulations concerning hazardous wastes at U. S. Steel's Gary Works. The proposed Agreed Order included with the Notice of Violation provided for a civil penalty of $145,000. After several unsuccessful discussions with the agency in an attempt to resolve the issues raised in the Notice of Violation, including the amount of any penalty, the agency issued an Order assessing a civil penalty of $180,225. USX filed an appeal of the Order. USX and the agency are pursuing settlement discussions. In 1991, the Department of Justice filed an action against USX in the U.S. District Court for the Western District of Pennsylvania alleging that USX used process waste water to quench coke at U. S. Steel's Clairton Works on 381 occasions and had vented unburned coke oven gas into the atmosphere on 13 occasions. The complaint requested that USX be enjoined from operating the coke batteries in violation of the CAA and related state and local laws and to install appropriate pollution control equipment. The action sought civil penalties at the maximum statutory rate of $25,000 per day of violation from December 1, 1985. An agreement on the final consent decree was reached in late 1992 and the proposed consent decree was filed with the court on February 18, 1993. The consent decree was approved and entered by the court on June 24, 1993, and USX paid civil penalties of $1.8 million on July 1, 1993. In January 1992, USX commenced negotiations with the EPA regarding the terms of an administrative order on consent, pursuant to the RCRA, under which USX would perform a RCRA Facility Investigation ("RFI") and a Corrective Measure Study ("CMS") at USX's Fairless Works. USX commenced the RFI/CMS during 1993, which will require over three years to complete at an approximate cost ranging from $2-3 million. The RFI/CMS will determine whether there is a need for, and the scope of, any remedial activities at Fairless Works. In January 1992, the EPA filed an Administrative Complaint against USX's Gary Works alleging violations of the regulations governing releases from underground storage tanks. On July 30, 1993, a Consent Agreement and Final Order was signed by USX and the EPA in resolution of the Administrative Complaint. USX is required to perform additional assessment work and complete any soil and groundwater contamination indicated by the assessments. USX also paid a civil penalty in the amount of $164,550. On October 9, 1992, the EPA filed a complaint against RMI alleging certain RCRA violations at RMI's closed sodium plant in Ashtabula, OH. The EPA's determination is based on information gathered during inspections of the facility in 1991. Under the complaint, the EPA proposed to assess a civil penalty of approximately $1.4 million for alleged failure to comply with RCRA. RMI is contesting the complaint. It is RMI's position that it has complied with the provisions of RCRA and that the EPA's assessment of penalties is inappropriate. A formal hearing has been requested and informal discussions with the EPA to settle this matter are ongoing. Based on the preliminary nature of the proceedings, RMI is currently unable to determine the ultimate liability, if any, that may arise from this matter. On January 17, 1992, USX filed an appeal with the Pennsylvania Environmental Hearing Board contesting the issuance of a NPDES permit for the Taylor Landfill in West Mifflin, PA. On June 23, 1993, the Board approved a Consent Order and Adjudication between USX and the PaDER resolving issues raised by USX in its appeal. The agreement provides USX with a compliance schedule to install water pollution control equipment. In addition, USX agreed to pay a total civil penalty of $300,000 in annual payments of $100,000. USX paid the first payment in June 1993. USX LEGAL PROCEEDINGS ATTRIBUTABLE TO THE DELHI GROUP SWEPCO LITIGATION On January 26, 1994, a settlement agreement was executed between Delhi and Southwestern Electric Power Company ("SWEPCO"), resolving litigation which began in 1991 related to a 15-year natural gas purchase contract ("original contract") which was due to expire in April 1995. The settlement agreement provides that SWEPCO pay Delhi the price under the original contract through January 1994. Concurrent with execution of the settlement agreement, Delhi executed a new four-year agreement with SWEPCO enabling Delhi to supply increased volumes of gas to two SWEPCO power plants in East Texas at market sensitive prices and premiums commensurate with the level of service provided. The agreement provides for swing service and does not require any minimum gas purchase volumes. The Delhi Group's operating income and cash flow will be adversely affected by the amount of premiums lost under the original contract for the period February 1, 1994, through April 1, 1995. Broad estimates of the potential premium losses are $18 million and $4 million in 1994 and 1995, respectively. ENSERCH LITIGATION Delhi is also a defendant in ENSERCH EXPLORATION, INC., AND EP OPERATING COMPANY V. DELHI GAS PIPELINE CORPORATION, which was filed in the 193rd District Court in Dallas County, TX, in July 1990. This lawsuit involves a take-or-pay claim against Delhi under a contract which provided Delhi the right to suspend the contract if it was uneconomic to purchase gas thereunder. The plaintiffs seek unspecified damages for breach of the contract, as well as a declaratory judgment as to the rights and obligations of the parties under the contract. A summary judgment previously granted by the trial court in Delhi's favor was reversed upon appeal. The trial date has been set for August 1, 1994, and the case is currently in the discovery phase. ENVIRONMENTAL REGULATION Delhi is subject to federal, state and local laws and regulations relating to the environment. Based on procedures currently in place, including routine reviews of existing and proposed environmental laws and regulations and unannounced environmental inspections performed periodically at company facilities, and the associated expenditures for environmental controls, Delhi believes that its facilities and operations are in general compliance with environmental laws and regulations. However, because some of these requirements presently are not fixed, Delhi is unable to accurately predict the eventual cost of compliance. ITEM 4.	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. PART II ITEM 5.	ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The principal market on which Marathon Stock, Steel Stock and Delhi Stock are traded is the New York Stock Exchange. Information concerning the high and low sales prices for the common stocks as reported in the consolidated transaction reporting system and the frequency and amount of dividends paid during the last two years is set forth in "Consolidated Financial Statements and Supplementary Data - Selected Quarterly Financial Data (Unaudited)". As of February 28, 1994, there were 116,979 registered holders of Marathon Stock, 83,297 registered holders of Steel Stock and 124 registered holders of Delhi Stock. The Board of Directors intends to declare and pay dividends on Marathon Stock, Steel Stock and Delhi Stock based on the financial condition and results of operations of the Marathon Group, the U. S. Steel Group and the Delhi Group, respectively, although it has no obligation under Delaware law to do so. In determining its dividend policy with respect to Marathon Stock, Steel Stock and Delhi Stock, the Board will rely on the separate financial statements of the Marathon Group, the U. S. Steel Group and the Delhi Group, respectively. The method of calculating earnings per share for Marathon Stock, Steel Stock and Delhi Stock reflects the Board's intent that separately reported earnings and the surplus of the Marathon Group, the U. S. Steel Group and the Delhi Group, as determined consistent with the Certificate of Incorporation, are available for payment of dividends to the respective classes of stock, although legally available funds and liquidation preferences of these classes of stock do not necessarily correspond with these amounts. Dividends on Marathon Stock, Steel Stock and Delhi Stock are limited to legally available funds of USX, which are determined on the basis of the entire Corporation. Distributions on Marathon Stock, Steel Stock and Delhi Stock would be precluded by a failure to pay dividends on preferred stock of USX. In addition, net losses of any group, as well as dividends or distributions on any class of USX common stock or series of preferred stock and repurchases of any class of USX common stock or certain series of preferred stock, will reduce the funds of USX legally available for payment of dividends on the three classes of USX common stock as well as any preferred stock. Dividends on Steel Stock are further limited to the Available Steel Dividend Amount. Net losses of the Marathon Group and the Delhi Group and distributions on Marathon Stock, Delhi Stock and on any preferred stock attributed to the Marathon Group or the Delhi Group will not reduce the funds available for declaration and payment of dividends on Steel Stock unless the legally available funds of USX are less than the Available Steel Dividend Amount. Dividends on Delhi Stock are further limited to the Available Delhi Dividend Amount. Net losses of the Marathon Group and the U. S. Steel Group and distributions on Marathon Stock, Steel Stock and on any preferred stock attributed to the Marathon Group or the U. S. Steel Group will not reduce the funds available for declaration and payment of dividends on Delhi Stock unless the legally available funds of USX are less than the Available Delhi Dividend Amount. See "Financial Statements and Supplementary Data - Notes to Consolidated Financial Statements - 21. Dividends". The Board has adopted certain policies with respect to the Marathon Group, the U. S. Steel Group and the Delhi Group, including, without limitation, the intention to: (i) limit capital expenditures of the U. S. Steel Group over the long term to an amount equal to the internally generated cash flow of the U. S. Steel Group, including funds generated by sales of assets of the U. S. Steel Group, (ii) sell assets and provide services between any of the Marathon Group, the U. S. Steel Group and the Delhi Group only on an arm's-length basis and (iii) treat funds generated by sales of Marathon Stock, Steel Stock or Delhi Stock (except for sales of Delhi Stock deemed to represent the Retained Interest) and securities convertible into such stock as assets of the Marathon Group, the U. S. Steel Group, or the Delhi Group, as the case may be, and apply such funds to acquire assets or reduce liabilities of the Marathon Group, the U. S. Steel Group or the Delhi Group, respectively. These policies may be modified or rescinded by action of the Board, or the Board may adopt additional policies, without the approval of holders of the three classes of USX common stock, although the Board has no present intention to do so. FIDUCIARY DUTIES OF THE BOARD; RESOLUTION OF CONFLICTS Under Delaware law, the Board must act with due care and in the best interest of all the stockholders, including the holders of the shares of each class of USX common stock. The interests of the holders of any class of USX common stock may, under some circumstances, diverge or appear to diverge. Examples include the determination of whether shares of Delhi Stock offered for sale will be deemed to represent either part of the Retained Interest or an additional equity interest in the Delhi Group; the optional exchange of Steel Stock for Marathon Stock at the 10% premium or of Delhi Stock for Marathon Stock or Steel Stock at the 10% premium or 15% premium, as the case may be, the determination of the record date of any such exchange or for the redemption of any Steel Stock or Delhi Stock; the establishing of the date for public announcement of the liquidation of USX and the commitment of capital among the Marathon Group, the U. S. Steel Group and the Delhi Group. Because the Board owes an equal duty to all common stockholders regardless of class, the Board is the appropriate body to deal with these matters. In order to assist the Board in this regard, USX has formulated policies to serve as guidelines for the resolution of matters involving a conflict or a potential conflict, including policies dealing with the payment of dividends, limiting capital investment in the U. S. Steel Group over the long term to its internally generated cash flow and allocation of corporate expenses and other matters. The Board has been advised concerning the applicable law relating to the discharge of its fiduciary duties to the common stockholders in the context of the separate classes of USX common stock and has delegated to the Audit Committee of the Board the responsibility to review matters which relate to this subject and report to the Board. While the classes of USX common stock may give rise to an increased potential for conflicts of interest, established rules of Delaware law would apply to the resolution of any such conflicts. Under Delaware law, a good faith determination by a disinterested and adequately informed Board with respect to any such matter would be a defense to any claim of liability made on behalf of the holders of any class of USX common stock. USX is aware of no precedent concerning the manner in which such rules of Delaware law would be applied in the context of its capital structure. ITEM 6.	ITEM 6. SELECTED FINANCIAL DATA USX -- CONSOLIDATED (Footnotes presented on the following page.) SELECTED FINANCIAL DATA (CONTD.) USX -- CONSOLIDATED (CONTD.) - - ----------------------------------- (a) For purposes of computing Marathon Stock per share data for periods prior to May 7, 1991, the numbers of shares are assumed to be the same as the corresponding numbers of shares of USX common stock. For computing Steel Stock per share data for periods prior to May 7, 1991, the number of shares are assumed to be one-fifth of the corresponding number of shares of USX common stock. (b) The initial dividends on the Marathon Stock and Steel Stock were paid on September 10, 1991; dividends paid prior to that date on the common stock were attributed to the Marathon Group and the U. S. Steel Group based upon the relationship of the initial dividends on the Marathon Stock and the Steel Stock. - - -------------------------------------- (a) Earnings did not cover fixed charges by $281 million in 1993, $197 million in 1992 and $681 million in 1991. (b) Earnings did not cover combined fixed charges and preferred stock dividends by $325 million in 1993, $211 million in 1992 and $696 million in 1991. SELECTED FINANCIAL DATA (CONTD.) USX -- MARATHON GROUP - - ---------------------------- (a) For purposes of computing Marathon Stock per share data for periods prior to May 7, 1991, the numbers of shares are assumed to be the same as the corresponding numbers of shares of USX common stock. (b) The initial dividends on the Marathon Stock were paid on September 10, 1991; dividends paid prior to that date on the common stock were attributed to the Marathon Group based upon the relation of the initial dividends on the Marathon Stock and the Steel Stock. SELECTED FINANCIAL DATA (CONTD.) USX -- U. S. STEEL GROUP - - -------------------- (a) For purposes of computing Steel Stock per share data for periods prior to May 7, 1991, the numbers of shares are assumed to be one-fifth of the corresponding numbers of shares of USX common stock. (b) The initial dividends on the Steel Stock were paid on September 10, 1991; dividends paid prior to that date on the common stock were attributed to the U. S. Steel Group based upon the relationship of the initial dividends on the Steel Stock and the Marathon Stock. SELECTED FINANCIAL DATA (CONTD.) USX -- DELHI GROUP (a) - - --------------------- (a) The Delhi Group was established on October 2, 1992. The financial data for the periods prior to this date include the businesses of the Delhi Group, which were included in the Marathon Group. Pro forma income data reflect results as if the capital structure of the Delhi Group was in effect beginning January 1, 1991. (b) Includes $145.0 million in 1989 for the favorable settlement of three lawsuits related to gas sales contracts. ITEM 7.	ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Indexes to Financial Statements, Supplementary Data and Management's Discussion and Analysis of USX Consolidated, the Marathon Group, the U. S. Steel Group and the Delhi Group, are presented on pages U-1, M-1, S-1 and D-1, respectively. ITEM 8.	ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Indexes to Financial Statements, Supplementary Data and Management's Discussion and Analysis for USX Consolidated, the Marathon Group, the U. S. Steel Group and the Delhi Group, are presented on pages U-1, M-1, S-1 and D-1, respectively. ITEM 9.	ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. THIS PAGE IS INTENTIONALLY LEFT BLANK USX INDEX TO CONSOLIDATED FINANCIAL STATEMENTS, SUPPLEMENTARY DATA AND MANAGEMENT'S DISCUSSION AND ANALYSIS U-1 USX EXPLANATORY NOTE REGARDING FINANCIAL INFORMATION Although the financial statements of the Marathon Group, the U. S. Steel Group and the Delhi Group separately report the assets, liabilities (including contingent liabilities) and stockholders' equity of USX attributed to each such group, such attribution does not affect legal title to such assets and responsibility for such liabilities. Holders of USX-Marathon Group Common Stock, USX-U.S. Steel Group Common Stock and USX-Delhi Group Common Stock are holders of common stock of USX and continue to be subject to all the risks associated with an investment in USX and all of its businesses and liabilities. Financial impacts arising from any of the Marathon Group, the U.S. Steel Group or the Delhi Group which affect the overall cost of USX's capital could affect the results of operations and financial condition of all groups. In addition, net losses of any group, as well as dividends or distributions on any class of USX common stock or series of Preferred Stock and repurchases of any class of USX common stock or certain series of Preferred Stock, will reduce the funds of USX legally available for payment of dividends on all classes of USX common stock. U-2 Management's Report The accompanying consolidated financial statements of USX Corporation and Subsidiary Companies (USX) are the responsibility of and have been prepared by USX in conformity with generally accepted accounting principles. They necessarily include some amounts that are based on best judgments and estimates. The consolidated financial information displayed in other sections of this report is consistent with that in these consolidated financial statements. USX seeks to assure the objectivity and integrity of its financial records by careful selection of its managers, by organizational arrangements that provide an appropriate division of responsibility and by communications programs aimed at assuring that its policies and methods are understood throughout the organization. USX has a comprehensive formalized system of internal accounting controls designed to provide reasonable assurance that assets are safeguarded and that financial records are reliable. Appropriate management monitors the system for compliance, and the internal auditors independently measure its effectiveness and recommend possible improvements thereto. In addition, as part of their audit of the consolidated financial statements, USX's independent accountants, who are elected by the stockholders, review and test the internal accounting controls selectively to establish a basis of reliance thereon in determining the nature, extent and timing of audit tests to be applied. The Board of Directors pursues its oversight role in the area of financial reporting and internal accounting control through its Audit Committee. This Committee, composed solely of nonmanagement directors, regularly meets (jointly and separately) with the independent accountants, management and internal auditors to monitor the proper discharge by each of its responsibilities relative to internal accounting controls and the consolidated financial statements. Report of Independent Accountants To the Stockholders of USX Corporation: In our opinion, the accompanying consolidated financial statements appearing on pages U-4 through U-26 and as listed in Item 14.A.2 on page 61 of this report present fairly, in all material respects, the financial position of USX Corporation and Subsidiary Companies at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of USX's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. As discussed in Note 1, page U-10, in 1993 USX adopted new accounting standards for postemployment benefits and for retrospectively rated insurance contracts. As discussed in Note 8, page U-15, and Note 9, page U-16, in 1992 USX adopted new accounting standards for postretirement benefits other than pensions and for income taxes, respectively. Price Waterhouse 600 Grant Street, Pittsburgh, Pennsylvania 15219-2794 February 8, 1994 U-3 Consolidated Statement of Operations The accompanying notes are an integral part of these consolidated financial statements. U-4 Income Per Common Share See Note 22, page U-23, for a description of net income per common share. The accompanying notes are an integral part of these consolidated financial statements. U-5 Consolidated Balance Sheet The accompanying notes are an integral part of these consolidated financial statements. U-6 Consolidated Statement of Cash Flows See Note 18, page U-21, for supplemental cash flow information. The accompanying notes are an integral part of these consolidated financial statements. U-7 Consolidated Statement of Stockholders' Equity USX has three classes of common stock, being USX -- Marathon Group Common Stock (Marathon Stock), USX -- U. S. Steel Group Common Stock (Steel Stock), and USX -- Delhi Group Common Stock (Delhi Stock), which are intended to reflect the performance of the Marathon Group, the U. S. Steel Group, and the Delhi Group, respectively. (See Note 6, page U-12 for a description of the three groups.) The Marathon Stock and Steel Stock were initially authorized and issued on May 6, 1991, when the USX Certificate of Incorporation was amended and a distribution was made to holders of USX common stock of one-fifth of a share of Steel Stock, for each share of USX common stock held. Concurrent with the Steel Stock distribution, each share of USX common stock was changed into one share of Marathon Stock. Retroactive effect has been given to the Marathon Stock and Steel Stock in these consolidated financial statements. Also on May 6, 1991, all shares of existing USX treasury stock were retired. The USX Certificate of Incorporation was amended on September 30, 1992, to authorize a new class of common stock. On October 2, 1992, USX sold 9,000,000 shares of Delhi Stock to the public. On all matters where the holders of Marathon Stock, Steel Stock and Delhi Stock vote together as a single class, Marathon Stock has one vote per share, and Steel Stock and Delhi Stock each have a fluctuating vote per share based on the relative market value of a share of Steel Stock or Delhi Stock, as the case may be, to the market value of a share of Marathon Stock. In the event of a disposition of all or substantially all the properties and assets of either the U. S. Steel Group or the Delhi Group, USX must either distribute the net proceeds to the holders of the Steel Stock or Delhi Stock, as the case may be, as a special dividend or in redemption of the stock, or exchange the Steel Stock or Delhi Stock, as the case may be, for one or the other remaining two classes of stock. In the event of liquidation of USX, the holders of the Marathon Stock, Steel Stock and Delhi Stock will share in the funds remaining for common stockholders based on the relative market capitalization of the respective Marathon Stock, Steel Stock or Delhi Stock to the aggregate market capitalization of all classes of common stock. (Table continued on next page) U-8 The accompanying notes are an integral part of these consolidated financial statements. U-9 Notes to Consolidated Financial Statements 1. SUMMARY OF PRINCIPAL ACCOUNTING POLICIES PRINCIPLES APPLIED IN CONSOLIDATION -- The consolidated financial statements include the accounts of USX Corporation and its majority-owned subsidiaries (USX). Investments in unincorporated oil and gas joint ventures are accounted for on a pro rata basis. Investments in other entities in which USX has significant influence in management and control are accounted for using the equity method of accounting and are carried in the investment account at USX's share of net assets plus advances. The proportionate share of income from equity investments is included in other income. Investments in marketable equity securities are carried at lower of cost or market and investments in other companies are carried at cost, with income recognized when dividends are received. NEW ACCOUNTING STANDARDS -- The following accounting standards were adopted by USX during 1993: Postemployment benefits -- Effective January 1, 1993, USX adopted Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" (SFAS No. 112). SFAS No. 112 requires employers to recognize the obligation to provide postemployment benefits on an accrual basis if certain conditions are met. USX is affected primarily by disability-related claims covering indemnity and medical payments. The obligation for these claims is measured using actuarial techniques and assumptions including appropriate discount rates. The cumulative effect of the change in accounting principle determined as of January 1, 1993, reduced net income $86 million, net of $50 million income tax effect. The effect of the change in accounting principle reduced 1993 operating income by $23 million. Accounting for multiple-year retrospectively rated insurance contracts -- USX adopted Emerging Issues Task Force (EITF) Consensus No. 93-14, "Accounting for Multiple-Year Retrospectively Rated Insurance Contracts". EITF No. 93-14 requires accrual of retrospective premium adjustments when the insured has an obligation to pay cash to the insurer that would not have been required absent experience under the contract. The cumulative effect of the change in accounting principle determined as of January 1, 1993, reduced net income $6 million, net of $3 million income tax effect. USX has not adopted Statement of Financial Accounting Standards No. 114, "Accounting by Creditors for Impairment of a Loan" (SFAS No. 114). SFAS No. 114 requires impairment of loans based on either the sum of discounted cash flows or the fair value of underlying collateral. USX expects to adopt SFAS No. 114 in the first quarter of 1995. Based on preliminary estimates, USX expects the unfavorable effect of adopting SFAS No. 114 will be less than $2 million. CASH AND CASH EQUIVALENTS -- Cash and cash equivalents includes cash on hand and on deposit and highly liquid debt instruments with maturities generally of three months or less. INVENTORIES -- Inventories are carried at lower of cost or market. Cost of inventories is determined primarily under the last-in, first-out (LIFO) method. HEDGING TRANSACTIONS -- USX enters into futures contracts, commodity swaps and options to hedge exposure to price fluctuations relevant to the purchase or sale of crude oil, refined products and natural gas. Such transactions are accounted for as part of the commodity being hedged. Forward contracts are used to hedge currency risks, and the accounting is based on the requirements of Statement of Financial Accounting Standards No. 52. EXPLORATION AND DEVELOPMENT -- USX follows the successful efforts method of accounting for oil and gas exploration and development. GAS BALANCING -- USX follows the sales method of accounting for gas production imbalances. PROPERTY, PLANT AND EQUIPMENT -- Except for oil and gas producing properties, depreciation is generally computed on the straight-line method based upon estimated lives of assets. USX's method of computing depreciation for steel producing assets modifies straight-line depreciation based on level of U-10 production. In 1992, USX revised the modification factors used in the depreciation of steel assets accounted for by the modified straight-line method to reflect that raw steel production capability is entirely continuous cast. The revised modification factors range from a minimum of 85% at a production level below 81% of capability, to a maximum of 105% for a 100% production level. No modification is made at the 95% production level, considered the normal long-range level. Depreciation and depletion of oil and gas producing properties are computed using predetermined rates based upon estimated proved oil and gas reserves applied on a units-of-production method. Depletion of mineral properties, other than oil and gas, is based on rates which are expected to amortize cost over the estimated tonnage of minerals to be removed. When an entire property, plant, major facility or facilities depreciated on an individual basis are sold or otherwise disposed of, any gain or loss is reflected in income. Proceeds from disposal of other facilities depreciated on a group basis are credited to the depreciation reserve with no immediate effect on income. INSURANCE -- USX is insured for catastrophic casualty and certain property exposures, as well as those risks required to be insured by law or contract. Costs resulting from noninsured losses are charged against income upon occurrence. RECLASSIFICATIONS -- Certain reclassifications of prior years' data have been made to conform to 1993 classifications. 2. SALES The items below were included in both sales and operating costs, resulting in no effect on income: (a) Reflected the gross amount of purchases and sales associated with crude oil and refined product buy/sell transactions which are settled in cash. 3. OTHER ITEMS (a) Gains resulted primarily from the sale of the Cumberland coal mine, an investment in an insurance company and the realization of deferred gain resulting from collection of a subordinated note related to the 1988 sale of Transtar, Inc. (Transtar). The collection also resulted in interest income of $37 million. (b) Included a $29 million favorable minority interest effect related to a loss of RMI Titanium Company (a 51%-owned company), of which $19 million resulted from restructuring charges. (c) Included a $177 million favorable adjustment related to interest income from a refund of prior years' production taxes. (d) Reflected $164 million related to the B&LE litigation (Note 5, page U-12). (e) Included a $26 million favorable adjustment related to interest accrued for prior years' production taxes. (f) Excluded financial income and costs of finance operations, which are included in operating income. U-11 4. RESTRUCTURING CHARGES The 1993 restructuring action involving the planned closure of a Pennsylvania coal mine resulted in a $42 million charge to operating income, primarily related to the writedown of property, plant and equipment, contract termination, and mine closure cost. In 1992, restructuring actions resulted in a $125 million charge to operating income, of which $115 was for the disposition of nonstrategic domestic exploration and production properties, and $10 million for the completion of the 1991 restructuring plan related to steel operations. The 1991 restructuring actions resulted in a $426 million charge to operating income, primarily related to write-downs of property, plant and equipment and employee costs related to the permanent closing of certain steel facilities. 5. B&LE LITIGATION Pretax income (loss) in 1993 included a $506 million charge related to the adverse decision in the Lower Lake Erie Iron Ore Antitrust Litigation against a former USX subsidiary, the Bessemer & Lake Erie Railroad (B&LE) (Note 25, page U-24). Charges of $342 million were included in operating costs and $164 million included in interest and other financial costs. The effect on 1993 net income (loss) was $325 million unfavorable ($5.04 per share of Steel Stock). At December 31, 1993, accounts payable included $376 million for this litigation. 6. SEGMENT INFORMATION USX has three classes of common stock: Marathon Stock, Steel Stock and Delhi Stock, which are intended to reflect the performance of the Marathon Group, the U. S. Steel Group and the Delhi Group, respectively. The segments of USX conform to USX's group structure. A description of each group and its products and services is as follows: MARATHON GROUP -- The Marathon Group is involved in worldwide exploration, production, transportation and marketing of crude oil and natural gas; and domestic refining, marketing and transportation of petroleum products. U. S. STEEL GROUP -- The U. S. Steel Group, which consists primarily of steel operations, includes one of the largest domestic integrated steel producers and is primarily engaged in the production and sale of a wide range of steel mill products, coke and taconite pellets. The U. S. Steel Group also includes the management of mineral resources, domestic coal mining, and engineering and consulting services and technology licensing. Other businesses that are part of the U. S. Steel Group include real estate development and management, fencing products, leasing and financing activities, and a majority interest in a titanium metal products company. DELHI GROUP -- The Delhi Group is engaged in the purchasing, gathering, processing, transporting and marketing of natural gas. The Delhi Group amounts prior to October 2, 1992, represent the historical financial data of the businesses included in the Delhi Group which were also included in the amounts of the Marathon Group. Intergroup sales and transfers were conducted on an arm's-length basis. Assets include certain assets attributed to each group that are not used to generate operating income. INDUSTRY SEGMENT: (a) Operating income (loss) included the following: a $342 million charge related to the B&LE litigation for the U. S. Steel Group in 1993 (Note 5, page U-12); restructuring charges of $42 million, $10 million and $402 million for the U.S. Steel Group in 1993, 1992 and 1991, respectively; restructuring charges of $115 million and $24 million, for the Marathon Group in 1992 and 1991, respectively; (Note 4, page U-12); and inventory market valuation charges (credits) for the Marathon Group of $241 million, $(62) million and $260 million in 1993, 1992 and 1991, respectively (Note 17, page U-21). U-12 EXPORT SALES: The information below summarizes export sales by geographic area for the U. S. Steel Group. Export sales from domestic operations for the Marathon Group and the Delhi Group were not material. The information below summarizes the operations in different geographic areas. Transfers between geographic areas are at prices which approximate market. U-13 7. PENSIONS USX has noncontributory defined benefit plans covering substantially all employees. Benefits under these plans are based upon years of service and final average pensionable earnings, or a minimum benefit based upon years of service, whichever is greater. In addition, contributory pension benefits, which cover certain participating salaried employees, are based upon years of service and career earnings. The funding policy for defined benefit plans provides that payments to the pension trusts shall be equal to the minimum funding requirements of ERISA plus such additional amounts as may be approved from time to time. USX also participates in multi-employer plans, most of which are defined benefit plans associated with coal operations. PENSION COST (CREDIT) -- The defined benefit cost for major plans was determined assuming an expected long-term rate of return on plan assets of 10% for 1993 and 11% for 1992 and 1991. FUNDS' STATUS -- The assumed discount rate used to measure the benefit obligations of major plans was 6.5% and 7% at December 31, 1993, and December 31, 1992, respectively. The assumed rate of future increases in compensation levels was 3% and 4% at December 31, 1993 and December 31, 1992, respectively. Plans with accumulated benefit obligations (ABO) in excess of plan assets were not material in 1992. U-14 8. POSTRETIREMENT BENEFITS OTHER THAN PENSIONS USX has defined benefit retiree health and life insurance plans covering most employees upon their retirement. Health benefits are provided, for the most part, through comprehensive hospital, surgical and major medical benefit provisions subject to various cost sharing features. Life insurance benefits are provided to nonunion and certain union represented retiree beneficiaries primarily based on employees' annual base salary at retirement. For other union retirees, benefits are provided for the most part based on fixed amounts negotiated in labor contracts with the appropriate unions. Except for certain life insurance benefits paid from reserves held by insurance carriers, benefits have not been prefunded. In 1994, USX agreed to establish a Voluntary Employee Beneficiary Association (VEBA) Trust to prefund health care and life insurance benefits for retirees who are covered under the USWA union agreement. Minimum contributions, in the form of USX Corporation stock or cash, are expected to be $25 million in 1994 and $10 million per year thereafter. In 1992, USX adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" (SFAS No. 106), which requires accrual accounting for all postretirement benefits other than pensions. USX elected to recognize immediately the transition obligation determined as of January 1, 1992, which represents the excess accumulated postretirement benefit obligation (APBO) for current and future retirees over the fair value of plan assets and recorded postretirement benefit cost accruals. The cumulative effect of the change in accounting principle reduced net income $1,306 million, consisting of the transition obligation of $2,070 million, net of $764 million income tax effect. POSTRETIREMENT BENEFIT COST -- Postretirement benefit cost for defined benefit plans for 1993 and 1992 was determined assuming a discount rate of 7% and 8%, respectively, and an expected return on plan assets of 10% for each year presented below: (a)In 1993, a new multi-employer benefit plan created by the Coal Industry Retiree Health Benefit Act of 1992 replaced the previous plan provided under the collective bargaining agreement with the United Mine Workers of America. USX is required to make payments to the plan based on assigned beneficiaries receiving benefits and such payments are expected to increase to approximately $15 million to $25 million in 1994 and subsequent years. The present value of this unrecognized obligation is broadly estimated to be $220 million, including the effects of future medical inflation, and this amount could increase if additional beneficiaries are assigned. Prior to 1992, the cost of providing health care benefits to retired employees was recognized as an expense primarily as claims were paid, and the cost of life insurance benefits for retirees was generally accrued during their working years. These costs totaled $155 million for 1991. FUNDS' STATUS -- The following table sets forth the plans' funded status and the amounts reported in USX's consolidated balance sheet: The assumed discount rate used to measure the APBO was 6.5% and 7% at December 31, 1993, and December 31, 1992, respectively. The assumed rate of future increases in compensation levels was 4% at December 31, 1993, and December 31, 1992. The weighted average health care cost trend rate in 1994 is approximately 8%, gradually declining to an ultimate rate in 1997 of approximately 6%. A one percentage point increase in the assumed health care cost trend rates for each future year would have increased the aggregate of the service and interest cost components of the 1993 net periodic postretirement benefit cost by $34 million and would have increased the APBO as of December 31, 1993, by $372 million. SETTLEMENTS -- Other income disclosed in Note 3, page U-11, included a settlement gain of $24 million resulting from the sale of the Cumberland coal mine. U-15 9. INCOME TAXES In 1992, USX adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS No. 109), which requires an asset and liability approach in accounting for income taxes. Under this method, deferred income tax assets and liabilities are established to reflect the future tax consequences of carryforwards and differences between the tax bases and financial bases of assets and liabilities. The cumulative effect of the change in accounting principle determined as of January 1, 1992, reduced net income $360 million. Provisions (credits) for estimated income taxes: (a)Computed in accordance with Accounting Principles Board Opinion No. 11. The deferred tax benefit of $144 million in 1991 was primarily the net result of the generation of federal tax loss carryforwards and timing differences related to restructuring charges and pension accruals. In 1993, the cumulative effect of the change in accounting principles for postemployment benefits and for retrospectively rated insurance contracts included deferred tax benefits of $50 million and $3 million, respectively (Note 1, page U-10). In 1992, the cumulative effect of the change in accounting principle for other postretirement benefits included a deferred tax benefit of $764 million (Note 8, page U-15). Reconciliation of federal statutory tax rate (35% in 1993 and 34% in 1992 and 1991) to total provisions (credits): (b)Includes incremental deferred tax benefit of $64 million in 1993 resulting from USX's ability to credit, rather than deduct, certain foreign income taxes for federal income tax purposes when paid in future periods. Deferred tax assets and liabilities resulted from the following: (c)Includes the benefit of federal tax loss carryforwards associated with a majority owned subsidiary which is not included in USX's consolidated federal tax return of $26 million and $21 million at December 31, 1993 and 1992, respectively, for which a full valuation allowance has been provided at both dates. (d)Valuation allowances have been established for certain federal, state and foreign income tax assets. The valuation allowances increased $70 million primarily for certain tax credits and tax loss carryforwards which USX may not fully utilize. U-16 The consolidated tax returns of USX for the years 1988 through 1991 are under various stages of audit and administrative review by the IRS. USX believes it has made adequate provision for income taxes and interest which may become payable for years not yet settled. Pretax income (loss) included $(53) million, $55 million and $162 million attributable to foreign sources in 1993, 1992 and 1991, respectively. 10. TAXES OTHER THAN INCOME TAXES (a)Included a favorable adjustment of $119 million and $20 million in 1992 and 1991, respectively, for prior years' production taxes. 11. LONG-TERM RECEIVABLES AND OTHER INVESTMENTS The following financial information summarizes USX's share in investments accounted for by the equity method: USX purchases from equity affiliates totaled $375 million, $330 million and $336 million in 1993, 1992 and 1991, respectively. USX sales to equity affiliates totaled $547 million, $283 million and $320 million in 1993, 1992 and 1991, respectively. U-17 12. SALES OF RECEIVABLES ACCOUNTS RECEIVABLE -- USX has entered into agreements to sell certain accounts receivable subject to limited recourse. Payments are collected from the sold accounts receivable; the collections are reinvested in new accounts receivable for the buyers; and a yield based on defined short-term market rates is transferred to the buyers. Collections on sold accounts receivable will be forwarded to the buyers at the end of the agreements in 1994 and 1995, in the event of earlier contract termination or if USX does not have a sufficient quantity of eligible accounts receivable to reinvest in for the buyers. The balance of sold accounts receivable averaged $733 million, $703 million and $704 million for years 1993, 1992 and 1991, respectively. At December 31, 1993, the balance of sold accounts receivable that had not been collected was $740 million. Buyers have collection rights to recover payments from an amount of outstanding receivables equal to 120% of the outstanding receivables purchased on a nonrecourse basis; such overcollateralization cannot exceed $150 million. USX does not generally require collateral for accounts receivable, but significantly reduces credit risk through credit extension and collection policies, which include analyzing the financial condition of potential customers, establishing credit limits, monitoring payments and aggressively pursuing delinquent accounts. In the event of a change in control of USX, as defined in the agreements, USX may be required to forward payments collected on sold accounts receivable to the buyers. LOANS RECEIVABLE -- Prior to 1993, USX Credit, a division of USX, sold certain of its loans receivable subject to limited recourse. USX Credit continues to collect payments from the loans and transfer to the buyers principal collected plus yield based on defined short-term market rates. In 1993, 1992 and 1991, USX Credit net sales (repurchases) of loans receivable totaled $(50) million, $(24) million and $85 million, respectively. At December 31, 1993, the balance of sold loans receivable subject to recourse was $205 million. USX Credit is not actively seeking new loans at this time. USX Credit is subject to market risk through fluctuations in short-term market rates on sold loans which pay fixed interest rates. USX Credit significantly reduces credit risk through a credit policy, which requires that loans be secured by the real property or equipment financed, often with additional security such as letters of credit, personal guarantees and committed long-term financing takeouts. Also, USX Credit diversifies its portfolio as to types and terms of loans, borrowers, loan sizes, sources of business and types and locations of collateral. As of December 31, 1993, and December 31, 1992, USX Credit had outstanding loan commitments of $29 million and $32 million, respectively. In the event of a change in control of USX, as defined in the agreement, USX may be required to provide cash collateral in the amount of the uncollected loans receivable to assure compliance with the limited recourse provisions. Estimated credit losses under the limited recourse provisions for both accounts receivable and loans receivable are recognized when the receivables are sold consistent with bad debt experience. Recognized liabilities for future recourse obligations of sold receivables were $3 million and $1 million at December 31, 1993, and December 31, 1992, respectively. 13. NOTES PAYABLE (a) Commercial paper outstanding at December 31, 1992, and substantially all of the balance outstanding at December 31, 1991, were supported by long-term credit arrangements and were classified as long-term debt (Note 14, page U-19). (b) USX had short-term credit agreements totaling $175 million at December 31, 1993. These agreements are with two banks, with interest based on their prime rate or London Interbank Offered Rate (LIBOR), and carry a commitment fee of 3/8%. Certain other banks provide short-term lines of credit totaling $185 million which require maintenance of compensating balances of 3%. No amounts were outstanding under these agreements at December 31, 1993. (c) Computed by relating interest expense to average daily borrowing. U-18 14. LONG-TERM DEBT (a) An agreement which terminates in October 1995 provides for borrowing under a $1,000 million revolving credit facility and a $500 million term loan. A second agreement provides for a $500 million revolving credit facility with a second revolving credit period terminating on July 1, 1994, unless otherwise extended; any participating bank failing to extend the revolving credit period has an obligation, upon the demand of USX, to fund a term loan which would be payable in October 1995. Interest is based on defined short-term market rates. During the term of these agreements, USX is obligated to pay a commitment fee of 3/8% on the unused portions. At December 31, 1993, the unused and available credit was $1,500 million; accordingly, the 9 1/2% Guaranteed Notes due 1994 have been classified as long-term debt. (b) Foreign currency exchange agreements were executed in connection with these foreign currency obligations, which effectively fixed the amount of interest and debt in U.S. dollars, thereby eliminating currency exchange risks. (c) The Zero Coupon Convertible Senior Debentures have a principal at maturity of $920 million. The original issue discount is being amortized recognizing a yield to maturity of 7 7/8% per annum. The carrying value represents the principal at maturity less the unamortized discount. Each debenture of $1,000 principal at maturity is convertible into a unit consisting of 8.207 shares of Marathon Stock and 1.6414 shares of Steel Stock subject to adjustment or, at the election of USX, cash equal to the market value of the unit. At the option of the holder, USX will purchase debentures at the carrying value of $430 million and $625 million on August 9, 1995, and August 9, 2000, respectively; USX may elect to pay the purchase price in cash, shares of both common stocks or notes. USX may call the debentures for redemption at the issue price plus amortized discount beginning on August 9, 1995, or earlier if the market value of one share of Marathon Stock and one-fifth of a share of Steel Stock equals or exceeds $57.375 for 20 out of 30 consecutive trading days. (d) The debentures are convertible into one share of Marathon Stock and one-fifth of a share of Steel Stock subject to adjustment for $62.75 and are redeemable at USX's option. Sinking fund requirements for all years through 1995 have been satisfied through repurchases. (e) The debentures are convertible into one share of Marathon Stock and one-fifth of a share of Steel Stock subject to adjustment for $38.125 and may be redeemed by USX. The sinking fund begins in 1997. (f) At December 31, 1993, USX had outstanding obligations relating to short-term maturity Environmental Improvement Bonds in the amount of $203 million, which were supported by long-term credit arrangements. (g) The notes may be redeemed at par by USX on or after March 1, 1996. (h) The notes pay interest monthly at 9 3/4% per annum until March 1, 1994, and at 7% per annum thereafter. (i) The guaranteed loan was used to fund a portion of the costs in connection with the development of the East Brae Field and the SAGE pipeline in the North Sea. A portion of proceeds from a long-term gas sales contract is dedicated to loan service under certain circumstances. Prepayment of the loan may be required under certain situations, including events impairing the security interest. (j) Required payments of long-term debt for the years 1995- 1998 are $595 million, $349 million, $233 million and $509 million, respectively. (k) In the event of a change in control of USX, as defined in the related agreements, debt obligations totaling $3,795 million may be declared immediately due and payable. The principal obligations subject to such a provision are Revolving credit/term loan agreements -- $500 million; Senior Notes -- $100 million; Notes payable -- $2,098 million; Zero Coupon Convertible Senior Debentures -- $378 million; Guaranteed Loan -- $300 million; and 9 3/4% Guaranteed Notes -- $161 million. In such event, USX may also be required to either repurchase the leased Fairfield slab caster for $116 million or provide a letter of credit to secure the remaining obligation. (l) At December 31, 1993, $82 million of 4 5/8% Sinking Fund Subordinated Debentures due 1996, which have been extinguished by placing securities into an irrevocable trust, were still outstanding. U-19 15. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment included gross assets acquired under capital leases (including sale-leasebacks accounted for as financings) of $156 million at December 31, 1993, and $164 million at December 31, 1992; related amounts included in accumulated depreciation, depletion and amortization were $73 million and $66 million, respectively. 16. LEASES Future minimum commitments for capital leases (including sale-leasebacks accounted for as financings) and for operating leases having remaining noncancelable lease terms in excess of one year are as follows: USX leases a wide variety of facilities and equipment under operating leases, including land and building space, office equipment, production facilities and transportation equipment. Contingent rental includes payments based on facility production and operating expense escalation on building space. Most long-term leases include renewal options and, in certain leases, purchase options. In the event of a change in control of USX, as defined in the agreements, or certain other circumstances, lease obligations totaling $196 million may be declared immediately due and payable. U-20 17. INVENTORIES At December 31, 1993, and December 31, 1992, the LIFO method accounted for 87% and 91%, respectively, of total inventory value. Current acquisition costs were estimated to exceed the above inventory values at December 31 by approximately $340 million and $390 million in 1993 and 1992, respectively. Cost of sales was reduced and operating income was increased by $11 million, $24 million and $36 million in 1993, 1992 and 1991, respectively, as a result of liquidations of LIFO inventories. The inventory market valuation reserve reflects the extent that the recorded cost of crude oil and refined products inventories exceeds net realizable value. The reserve is decreased to reflect increases in market prices and inventory turnover and increased to reflect decreases in market prices. Changes in the inventory market valuation reserve resulted in charges (credits) to operating income of $241 million, $(62) million and $260 million in 1993, 1992 and 1991, respectively. 18. SUPPLEMENTAL CASH FLOW INFORMATION 19. PREFERRED STOCK USX is authorized to issue 40,000,000 shares of preferred stock, without par value. The following series were outstanding as of December 31, 1993: ADJUSTABLE RATE CUMULATIVE PREFERRED STOCK -- As of December 31, 1993, a total of 2,099,970 shares (stated value $50 per share) were outstanding. Dividend rates vary within a range of 7-1/2% to 15-3/4% per annum in accordance with a formula based on various U.S. Treasury security rates. In 1993, dividend rates on an annualized basis ranged from 7.5% to 8.15%. This stock is redeemable, at USX's sole option, at a price of $50 per share. 6.50% CUMULATIVE CONVERTIBLE PREFERRED STOCK (6.50% CONVERTIBLE PREFERRED STOCK) -- As of December 31, 1993, 6,900,000 shares (stated value of $1.00 per share; liquidation preference of $50.00 per share) were outstanding. The 6.50% Convertible Preferred Stock is convertible at any time, at the option of the holder, into shares of Steel Stock at a conversion price of $46.125 per share of Steel Stock, subject to adjustment in certain circumstances. On and after April 1, 1996, this stock is redeemable at USX's sole option, at a price of $52.275 per share, and thereafter at prices declining annually on each April 1 to an amount equal to $50.00 per share on and after April 1, 2003. U-21 20. STOCK PLANS The 1990 Stock Plan (1990 Plan) and its predecessor plans were amended in 1991 to reflect the distribution of Steel Stock and change of USX common stock into Marathon Stock and in 1992 to reflect the issuance of Delhi Stock. Each option or stock appreciation right outstanding on May 6, 1991, was converted into two awards: one for the same number of shares of Marathon Stock and the other for one-fifth of that number of shares of Steel Stock, separately exercisable at prices based on the former exercise price apportioned on the basis of the fair market value of the two stocks on May 7, 1991. No adjustment of previously granted options or stock appreciation rights was made to reflect the authorization or the issuance of Delhi Stock. The 1990 Plan authorizes the Compensation Committee of the Board of Directors to grant the following awards to key management employees; no further options will be granted under the predecessor plans. OPTIONS -- the right to purchase shares of Marathon Stock, Steel Stock or Delhi Stock at not less than 100 percent of the fair market value of the stock at date of grant. STOCK APPRECIATION RIGHTS -- the right to receive cash and/or common stock equal to the excess of the fair market value of a share of common stock, as determined in accordance with the plan, over the fair market value of a share on the date the right was granted for a specified number of shares. RESTRICTED STOCK -- stock for no cash consideration or for such other consideration as determined by the Compensation Committee, subject to provisions for forfeiture and restricting transfer. Restriction may be removed as conditions such as performance, continuous service and other criteria are met. Such employees are generally granted awards of the class of common stock intended to reflect the performance of the group in which they work. Up to .5 percent of the outstanding Marathon Stock and .8 percent of each of the outstanding Steel Stock and Delhi Stock, as determined on December 31 of the preceding year, are available for grants during each calendar year the 1990 Plan is in effect. In addition, awarded shares that do not result in shares being issued are available for subsequent grant in the same year, and any ungranted shares from prior years' annual allocations are available for subsequent grant during the years the 1990 Plan is in effect. As of December 31, 1993, 3,984,949 Marathon Stock shares, 1,246,329 Steel Stock shares and 74,307 Delhi Stock shares were available for grants in 1994. The following table presents a summary of option and stock appreciation right transactions: (a) Virtually all outstanding options and stock appreciation rights are exercisable. Deferred compensation is charged to stockholders' equity when the restricted stock is granted and is expensed over the balance of the vesting period if conditions of the restricted stock grant are met. The following table presents a summary of restricted stock transactions: (b) Outstanding shares of USX common stock subject to restricted stock grants at May 6, 1991, were treated in an identical manner as other outstanding shares of such common stock. U-22 21. DIVIDENDS In accordance with the USX Certificate of Incorporation, dividends on the Marathon Stock, Steel Stock and Delhi Stock are limited to the legally available funds of USX. Net losses of the Marathon Group, the U. S. Steel Group or the Delhi Group as well as dividends or distributions on any class of USX common stock or series of preferred stock and repurchases of any class of USX common stock or certain series of Preferred Stock, will reduce the funds of USX legally available for payment of dividends on all classes of USX common stock. Subject to this limitation, the Board of Directors intends to declare and pay dividends on the Marathon Stock, Steel Stock and Delhi Stock based on the financial condition and results of operations of the related group, although it has no obligation under Delaware Law to do so. In making its dividend decisions with respect to each of the Marathon Stock, Steel Stock and Delhi Stock, the Board of Directors considers, among other things, the long-term earnings and cash flow capabilities of the related group as well as the dividend policies of similar publicly traded companies. Dividends on the Steel Stock and Delhi Stock are further limited to the Available Steel Dividend Amount and the Available Delhi Dividend Amount, respectively. At December 31, 1993, the Available Steel Dividend Amount was at least $1.849 billion, and the Available Delhi Dividend Amount was at least $125 million. The Available Steel Dividend Amount and Available Delhi Dividend Amount, respectively, will be increased or decreased, as appropriate, to reflect the respective group's separately reported net income, dividends, repurchases or issuances with respect to the related class of common stock and preferred stock attributed to the respective groups and certain other items. The initial dividends on the Marathon Stock and Steel Stock were paid September 10, 1991. Dividends paid by USX prior to that date were attributed to the Marathon Group and the U. S. Steel Group based upon the relationship of the initial dividends on the Marathon Stock and Steel Stock. 22. NET INCOME PER COMMON SHARE Net income (loss) per share amounts are presented for the Marathon Stock and Steel Stock to reflect the distribution of the Steel Stock and change of USX common stock into Marathon Stock effective at the close of business on May 6, 1991. For purposes of computing net income (loss) per share data for periods prior to May 7, 1991, the numbers of Marathon Stock shares are assumed to be the same as the corresponding numbers of shares of USX common stock, while the numbers of Steel Stock shares are assumed to be one-fifth of the corresponding numbers of shares of USX common stock. The method of calculating net income (loss) per share for the Marathon Stock, Steel Stock and Delhi Stock reflects the USX Board of Directors' intent that the separately reported earnings and surplus of the Marathon Group, the U. S. Steel Group and the Delhi Group, as determined consistent with the USX Certificate of Incorporation, are available for payment of dividends to the respective classes of stock, although legally available funds and liquidation preferences of these classes of stock do not necessarily correspond with these amounts. The financial statements of the Marathon Group, the U. S. Steel Group and the Delhi Group, taken together, include all accounts which comprise the corresponding consolidated financial statements of USX. The USX Board of Directors initially deemed 14,000,000 shares of Delhi Stock to represent 100% of the common stockholders' equity value of USX attributable to the Delhi Group. The Delhi Fraction is the percentage interest in the Delhi Group represented by the shares of Delhi Stock that are outstanding at any particular time and, based on 9,282,870 outstanding shares at December 31, 1993, is approximately 66%. The Marathon Group financial statements reflect a percentage interest in the Delhi Group of approximately 34% (Retained Interest) at December 31, 1993. Income per share applicable to outstanding Delhi Stock is presented for the periods subsequent to the October 2, 1992, initial issuance of Delhi Stock. Primary net income (loss) per share is calculated by adjusting net income (loss) for dividend requirements of preferred stock and, in the case of Delhi Stock, for the income applicable to the Retained Interest; and is based on the weighted average number of common shares outstanding plus common stock equivalents, provided they are not antidilutive. Common stock equivalents result from assumed exercise of stock options and surrender of stock appreciation rights associated with stock options where applicable. Fully diluted net income (loss) per share assumes conversion of convertible securities for the applicable periods outstanding and assumes exercise of stock options and surrender of stock appreciation rights, provided, in each case, the effect is not antidilutive. U-23 23. FOREIGN CURRENCY TRANSLATION Exchange adjustments resulting from foreign currency transactions generally are recognized in income, whereas adjustments resulting from translation of financial statements are reflected as a separate component of stockholders' equity. For 1993, 1992 and 1991, respectively, the aggregate foreign currency transaction gains (losses) included in determining net income were $(3) million, $14 million and $(3) million. An analysis of changes in cumulative foreign currency translation adjustments follows: 24. STOCKHOLDER RIGHTS PLAN USX's Board of Directors has adopted a Stockholder Rights Plan and declared a dividend distribution of one right for each outstanding share of Marathon Stock, Steel Stock and Delhi Stock referred to together as "Voting Stock." Each right becomes exercisable, at a price of $120, when any person or group has acquired, obtained the right to acquire or made a tender or exchange offer for 15 percent or more of the total voting power of the Voting Stock, except pursuant to a qualifying all-cash tender offer for all outstanding shares of Voting Stock, which is accepted with respect to shares of Voting Stock representing a majority of the voting power other than Voting Stock beneficially owned by the offeror. Each right entitles the holder, other than the acquiring person or group, to purchase one one-hundredth of a share of Series A Junior Preferred Stock or, upon the acquisition by any person of 15 percent or more of the total voting power of the Voting Stock, Marathon Stock, Steel Stock or Delhi Stock (as the case may be) or other property having a market value of twice the exercise price. After the rights become exercisable, if USX is acquired in a merger or other business combination where it is not the survivor, or if 50 percent or more of USX's assets, earnings power or cash flow are sold or transferred, each right entitles the holder to purchase common stock of the acquiring entity having a market value of twice the exercise price. The rights and exercise price are subject to adjustment, and the rights expire on October 9, 1999, or may be redeemed by USX for one cent per right at any time prior to the point they become exercisable. Under certain circumstances, the Board of Directors has the option to exchange one share of the respective class of Voting Stock for each exercisable right. 25. CONTINGENCIES AND COMMITMENTS USX is the subject of, or party to, a number of pending or threatened legal actions, contingencies and commitments involving a variety of matters, including laws and regulations relating to the environment. Certain of these matters are discussed below. The ultimate resolution of these contingencies could, individually or in the aggregate, be material to the consolidated financial statements. However, management believes that USX will remain a viable and competitive enterprise even though it is possible that these contingencies could be resolved unfavorably. LEGAL PROCEEDINGS -- B&LE litigation; MDL-587 On January 24, 1994, the U.S. Supreme Court denied a petition for Writ of Certiorari by the B&LE in the Lower Lake Erie Iron Ore Antitrust Litigation (MDL-587). As a result, the decision of the U.S. Court of Appeals for the Third Circuit affirming judgments of approximately $498 million, plus interest, relating to antitrust violations by the B&LE was permitted to stand. In addition, the Third Circuit decision remanded the claims of two plaintiffs for retrial of their damage awards. At trial these plaintiffs asserted claims of approximately $8 million, but were awarded only nominal damages by the jury. A new trial date has not been set. Any damages awarded in a new trial may be more or less than $8 million and would be subject to trebling. The B&LE was a wholly owned subsidiary of USX throughout the period the conduct occurred. It is now a subsidiary of Transtar in which USX has a 45% equity interest. These actions were excluded liabilities in the sale of USX's transportation units in 1988, and USX is obligated to reimburse Transtar for judgments paid by the B&LE. Following the Court of Appeals decision, USX, which had previously accrued $90 million on a pretax basis for this litigation, charged an additional amount of $619 million on a pretax basis in the second quarter of 1993. In late 1993, USX and LTV Steel Corp. ("LTV"), one of the plaintiffs in MDL-587, agreed to settle all of LTV's claims in that action for $375 million. USX made a payment of $200 million on December 29, 1993, and is obligated to pay an additional $175 million not later than February 28, 1994. Claims of three additional plaintiffs were also settled in December 1993. These settlements resulted in a pretax credit of $127 million in the fourth quarter financial results of the U.S. Steel Group. As a result of the denial of the Petition for Writ of Certiorari, judgments for the other MDL-587 plaintiffs (other than the two remanded for retrial), totaling approximately $210 million, including postjudgment interest, are due for payment in the first quarter of 1994. U-24 25. CONTINGENCIES AND COMMITMENTS (CONTINUED) B&LE litigation; Armco In June 1990, following judgments entered on behalf of steel company plaintiffs in MDL-587, Armco Steel filed federal antitrust claims against the B&LE and other railroads in the Federal District Court for the District of Columbia. B&LE successfully challenged the actions for lack of jurisdiction and venue, and the case was transferred to the Federal District Court for the Northern District of Ohio. Other defendant railroads settled with Armco, leaving B&LE as the only remaining defendant. On April7, 1993, B&LE's motion to dismiss the federal antitrust claims on grounds of statute of limitations was granted. Subsequently, Armco refiled its claims under the Ohio Valentine Act. B&LE's motions for summary judgment on time bar issues and for change of venue are pending, and not yet fully briefed. No discovery has been taken on the merits of Armco's claims, but if Armco survives the present and possibly further pretrial motions and the case proceeds to trial on the merits, Armco's claimed damages are likely to be substantial. Unlike MDL-587, it is USX's position that the Armco case was not an excluded liability in the sale of USX's transportation units to Transtar in 1988, and that USX therefore is not obligated to reimburse Transtar for any judgments rendered in the Armco case; however, this position is being disputed by Transtar and The Blackstone Group, the ultimate owner of 52% of Transtar's outstanding shares. Energy Buyers litigation On December 21, 1992, an arbitrator issued an award for approximately $117 million, plus interest under Ohio law, against USX in Energy Buyers Service Corporation v. USX, a case originally filed in the District Court of Harris County, Texas. Such amount was fully accrued as of December 31, 1992. On December 15, 1993, USX agreed to settle all claims in the case for $95 million and deferrred payments of up to $9 million. Pickering litigation On November 3, 1992, the United States District Court for the District of Utah Central Division issued a Memorandum Opinion and Order in Pickering v. USX relating to pension and compensation claims by approximately 1,900 employees of USX's former Geneva (Utah) Works. Although the court dismissed a number of the claims by the plaintiffs, it found that USX had violated the Employee Retirement Income Security Act by interfering with the accrual of pension benefits of certain employees and amending a benefit plan to reduce the accrual of future benefits without proper notice to plan participants. Further proceedings were held to determine damages and, pending the court's determinations, USX may appeal. Plaintiffs' counsel has been reported as estimating plaintiffs' anticipated recovery to be in excess of $100 million. USX believes actual damages will be substantially less than plaintiffs' estimates. ENVIRONMENTAL MATTERS -- USX is subject to federal, state, local and foreign laws and regulations relating to the environment. These laws generally provide for control of pollutants released into the environment and require responsible parties to undertake remediation of hazardous waste disposal sites. Penalties may be imposed for noncompliance. USX provides for remediation costs and penalties when the responsibility to remediate is probable and the amount of associated costs is reasonably determinable. Generally, the timing of these accruals coincides with completion of a feasibility study or the commitment to a formal plan of action. At December 31, 1993, and 1992, accrued liabilities for remediation, platform abandonment and mine reclamation totaled $312 million and $280 million, respectively. It is not presently possible to estimate the ultimate amount of all remediation costs that might be incurred or the penalties that may be imposed. For a number of years, USX has made substantial capital expenditures to bring existing facilities into compliance with various laws relating to the environment. In 1993 and 1992, such capital expenditures totaled $181 million and $294 million, respectively. USX anticipates making additional such expenditures in the future; however, the exact amounts and timing of such expenditures are uncertain because of the continuing evolution of specific regulatory requirements. LIBYAN OPERATIONS -- By reason of Executive Orders and related regulations under which the U.S. Government is continuing economic sanctions against Libya, USX was required to discontinue performing its Libyan petroleum contracts on June 30, 1986. In June 1989, the Department of the Treasury authorized USX to resume performing under those contracts. Pursuant to that authorization, USX has engaged the Libyan National Oil Company and the Secretary of Petroleum in continuing negotiations to determine when and on what basis they are willing to allow USX to resume realizing revenue from USX's investment of $108 million in Libya. USX is uncertain when these negotiations can be completed or how the negotiations will be affected by the United Nations sanctions against Libya. GUARANTEES -- Guarantees by USX of the liabilities of affiliated and other entities totaled $227 million at December31, 1993, and $258 million at December 31, 1992. In the event that any defaults of guaranteed liabilities occur, USX has access to its interest in the assets of most of the affiliates to reduce losses resulting from these guarantees. As of December 31, 1993, the largest guarantee for a single affiliate was $96 million. U-25 25. CONTINGENCIES AND COMMITMENTS (CONTINUED) At December 31, 1993, and December 31, 1992, USX's pro rata share of obligations of LOOP INC. and various pipeline affiliates secured by throughput and deficiency agreements totaled $206 million and $216 million, respectively. Under the agreements, USX is required to advance funds if the affiliates are unable to service debt. Any such advances are prepayments of future transportation charges. COMMITMENTS -- At December 31, 1993, and December 31, 1992, contract commitments for capital expenditures for property, plant and equipment totaled $389 million and $423 million, respectively. USX has entered into a 15-year take-or-pay arrangement which requires USX to accept pulverized coal each month or pay a minimum monthly charge. In 1993, charges for deliveries of pulverized coal which began in 1993 totaled $14 million. In the future, USX will be obligated to make minimum payments of approximately $16 million per year. If USX elects to terminate the contract early, a maximum termination payment of $126 million, which declines over the duration of the agreement, may be required. USX is a party to a transportation agreement with Transtar for Great Lakes shipments of raw materials required by steel operations. The agreement cannot be canceled until 1999 and requires USX to pay, at a minimum, Transtar's annual fixed costs related to the agreement, including lease/charter costs, depreciation of owned vessels, dry dock fees and other administrative costs. Total transportation costs under the agreement were $68 million in 1993 and $66 million in 1992, including fixed costs of $21 million in each year. The fixed costs are expected to continue at approximately the same level over the duration of the agreement. 26. FAIR VALUE OF FINANCIAL INSTRUMENTS Fair value of the financial instruments disclosed herein is not necessarily representative of the amount that could be realized or settled, nor does the fair value amount consider the tax consequences of realization or settlement. The following table summarizes financial instruments by individual balance sheet account: (a) The difference between carrying value and fair value principally represented the subordinated note related to the earlier sale of the majority interest in Transtar which was carried at no value due to the highly leveraged nature of the transaction. The note was paid in full in 1993 resulting in other income of $70 million and interest income of $37 million (Note 3, page U-11). Fair value of financial instruments classified as current assets or liabilities approximate carrying value due to the short-term maturity of the instruments. Fair value of long-term receivables and other investments was based on discounted cash flows or other specific instrument analysis. Fair value of long-term debt instruments was based on market prices where available or current borrowing rates available for financings with similar terms and maturities. USX's unrecognized financial instruments consist of receivables sold subject to limited recourse, commitments to extend credit, financial guarantees, and commodity swaps. It is not practicable to estimate the fair value of these forms of financial instrument obligations. For details relating to sales of receivables and commitments to extend credit see Note 12, page U-18. For details relating to financial guarantees see Note 25, page U-25. The contract value of open natural gas commodity swaps, as of December 31, 1993 and December 31, 1992 totaled $92 million and $13 million, respectively. The swap arrangements vary in duration with certain individual contracts extending into early 1996. 27. SUBSEQUENT EVENT On February 2, 1994, USX sold 5,000,000 shares of Steel Stock to the public for net proceeds of $201 million, which will be reflected in their entirety in the U. S. Steel Group financial statements. U-26 Selected Quarterly Financial Data (Unaudited) (a) Restated to reflect fourth quarter implementation of SFAS No. 112 and EITF No. 93-14 (Note 1, page U-10). Operating income was reduced $5 million and total income before cumulative effect of changes in accounting principles (total income) was reduced $3 million in each of the first three quarters of 1993. In addition, the first quarter net income was reduced $95 million including the cumulative effect of the changes in accounting principles as of January 1, 1993. (b) Reflects a decrease of $13 million for reclassifications with no effect on net income. (a) Composite tape. (a) In conjunction with the restatement discussed above, total income was reduced $3 million in each of the first three quarters of 1993. Total income per share was reduced $.05 in the first and second quarters and $.03 in the third quarter of 1993. (b) Composite tape. U-27 Selected Quarterly Financial Data (Unaudited) (continued) (a) Delhi Stock was issued on October 2, 1992. (b) Composite tape. Principal Unconsolidated Affiliates (Unaudited) (a) Ownership interest as of December 31, 1993. Supplementary Information on Mineral Reserves (Unaudited) MINERAL RESERVES (OTHER THAN OIL AND GAS) (a) Commercially recoverable reserves include demonstrated (measured and indicated) quantities which are expressed in recoverable net product tons. Coal reserves of 284 million tons for years 1992 and 1991, were included in the Marathon Group; the remaining coal reserves and all iron reserves, as well as related production, were included in the U. S. Steel Group. (b) In 1993, 320 million tons of reserves were sold, including all the Marathon Group reserves and 36 million tons associated with the Cumberland coal mine. In 1992, 4 million tons of reserves were added, net of lease activity. U-28 Supplementary Information on Oil and Gas Producing Activities (Unaudited) RESULTS OF OPERATIONS FOR OIL AND GAS PRODUCING ACTIVITIES, EXCLUDING CORPORATE OVERHEAD AND INTEREST COSTS(a) (a) Certain restatement of prior years' data has been made to conform to 1993 reporting practices. (b) Other income consisted of gains and losses on sales of oil and gas producing property. (c) U.S. production costs included a $119 million refund of prior years' production taxes and excluded a $115 million restructuring charge relating to planned disposition of certain domestic exploration and production properties. CAPITALIZED COSTS AND ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION U-29 Supplementary Information on Oil and Gas Producing Activities (Unaudited) CONTINUED COSTS INCURRED FOR PROPERTY ACQUISITION, EXPLORATION AND DEVELOPMENT -- INCLUDING CAPITAL EXPENDITURES(A) ESTIMATED QUANTITIES OF PROVED OIL AND GAS RESERVES The following estimates of net reserves have been determined by deducting royalties of various kinds from USX's gross reserves. The reserve estimates are believed to be reasonable and consistent with presently known physical data concerning size and character of the reservoirs and are subject to change as additional knowledge concerning the reservoirs becomes available. The estimates include only such reserves as can reasonably be classified as proved; they do not include reserves which may be found by extension of proved areas or reserves recoverable by secondary or tertiary recovery methods unless these methods are in operation and are showing successful results. Undeveloped reserves consist of reserves to be recovered from future wells on undrilled acreage or from existing wells where relatively major expenditures will be required to realize production. Liquid hydrocarbon production amounts for international operations principally reflect tanker liftings of equity production. USX did not have any quantities of oil and gas reserves subject to long-term supply agreements with foreign governments or authorities in which USX acts as producer. (a) Excluded reserves located in Libya. See Note 25, page U-25, for current status. U-30 Supplementary Information on Oil and Gas Producing Activities (Unaudited) CONTINUED ESTIMATED QUANTITIES OF PROVED OIL AND GAS RESERVES (CONTINUED) (a) Excluded reserves located in Libya. See Note 25, page U-25, for current status. STANDARDIZED MEASURE OF DISCOUNTED FUTURE NET CASH FLOWS AND CHANGES THEREIN RELATING TO PROVED OIL AND GAS RESERVES Estimated discounted future net cash flows and changes therein were determined in accordance with Statement of Financial Accounting Standards No. 69. Certain information concerning the assumptions used in computing the valuation of proved reserves and their inherent limitations are discussed below. USX believes such information is essential for a proper understanding and assessment of the data presented. Future cash inflows are computed by applying year-end prices of oil and gas relating to USX's proved reserves to the year-end quantities of those reserves. Future price changes are considered only to the extent provided by contractual arrangements in existence at year-end. The assumptions used to compute the proved reserve valuation do not necessarily reflect USX's expectations of actual revenues to be derived from those reserves nor their present worth. Assigning monetary values to the estimated quantities of reserves, described on the preceding page, does not reduce the subjective and ever-changing nature of such reserve estimates. Additional subjectivity occurs when determining present values because the rate of producing the reserves must be estimated. In addition to uncertainties inherent in predicting the future, variations from the expected production rate also could result directly or indirectly from factors outside of USX's control, such as unintentional delays in development, environmental concerns, changes in prices or regulatory controls. The reserve valuation assumes that all reserves will be disposed of by production. However, if reserves are sold in place or subjected to participation by foreign governments, additional economic considerations also could affect the amount of cash eventually realized. Future development and production costs are computed by estimating the expenditures to be incurred in developing and producing the proved oil and gas reserves at the end of the year, based on year-end costs and assuming continuation of existing economic conditions. Future income tax expenses are computed by applying the appropriate year-end statutory tax rates, with consideration of future tax rates already legislated, to the future pretax net cash flows relating to USX's proved oil and gas reserves. Permanent differences in oil and gas related tax credits and allowances are recognized. Discount was derived by using a discount rate of 10 percent a year to reflect the timing of the future net cash flows relating to proved oil and gas reserves. U-31 Supplementary Information on Oil and Gas Producing Activities (Unaudited) CONTINUED STANDARDIZED MEASURE OF DISCOUNTED FUTURE NET CASH FLOWS AND CHANGES THEREIN RELATING TO PROVED OIL AND GAS RESERVES (CONTINUED) STANDARDIZED MEASURE OF DISCOUNTED FUTURE NET CASH FLOWS RELATING TO PROVED OIL AND GAS RESERVES SUMMARY OF CHANGES IN STANDARDIZED MEASURE OF DISCOUNTED FUTURE NET CASH FLOWS RELATING TO PROVED OIL AND GAS RESERVES U-32 Five-Year Operating Summary -- Marathon Group (a)The Indianapolis Refinery was temporarily idled in October 1993. U-33 FIVE-YEAR OPERATING SUMMARY -- U. S. STEEL GROUP (a)In July 1991, U. S. Steel closed all iron and steel producing operations at Fairless (PA) Works. In April 1992, U.S. Steel closed South (IL) Works. (b)In June 1993, U. S. Steel sold the Cumberland coal mine. On or about March 31, 1994, U. S. Steel will permanently close the Maple Creek coal mine. (c)U. S. Steel ceased production of structural products when South Works closed in April 1992. U-34 Five-Year Operating Summary -- Delhi Group (a)In January 1993, the Delhi Group sold its 25% interest in Red River Pipeline. (b)Included the effect of a significant favorable settlement of three lawsuits related to gas sales contracts. (c)In 1993, the Delhi Group sold all of its pipeline systems located in Colorado. U-35 USX CORPORATION Management's Discussion and Analysis Management's Discussion and Analysis should be read in conjunction with the Consolidated Financial Statements and Notes to Consolidated Financial Statements. MANAGEMENT'S DISCUSSION AND ANALYSIS OF INCOME SALES were $18.1 billion in 1993, compared with $17.8 billion in 1992 and $18.8 billion in 1991. The increase in 1993 primarily reflected increased sales for the U. S. Steel Group due mainly to higher steel shipment volumes and prices, and increased commercial shipments of taconite pellets and coke. These were partially offset by lower sales for the Marathon Group (excluding the effect of the businesses of the Delhi Group which were included in the Marathon Group for periods prior to October 2, 1992) due mainly to lower worldwide liquid hydrocarbon volumes and prices and lower average refined product prices, partially offset by increased excise taxes (which have no effect on income) and higher refined product sales volumes, excluding matching buy/sell transactions. The decrease from 1991 to 1992 primarily reflected reduced sales for the Marathon Group due mainly to lower average refined product prices, reduced volumes and prices for crude oil matching buy/sell transactions (which have no effect on income) and lower worldwide liquid hydrocarbon volumes. OPERATING INCOME decreased by $14 million in 1993, following a $329 million improvement in 1992. Results in 1993 included a $342 million charge as a result of the adverse decision in the Lower Lake Erie Iron Ore Antitrust Litigation against the Bessemer & Lake Erie Railroad ("B&LE litigation") (which also resulted in $164 million of interest costs) (see Note 5 to the Consolidated Financial Statements), a $241 million unfavorable noncash effect resulting from an increase in the inventory market valuation reserve and restructuring charges of $42 million related to the planned shutdown of the Maple Creek coal mine and preparation plant. Results in 1992 included a favorable impact of $119 million for the settlement of a tax refund claim related to prior years' production taxes and a $62 million favorable noncash effect resulting from a decrease in the inventory market valuation reserve, partially offset by restructuring charges of $125 million primarily related to the disposition of certain domestic exploration and production properties. Excluding the effects of these items, operating income increased $667 million in 1993 predominantly due to improved results for the U. S. Steel Group, as well as the Marathon Group. The adoption of Statement of Financial Accounting Standards No. 112 - Employers' Accounting for Postemployment Benefits ("SFAS No. 112") resulted in a $23 million increase in operating costs in 1993, principally for the U. S. Steel Group. Operating income in 1991 included restructuring charges of $426 million mainly related to the shutdown of certain steel facilities and a $260 million unfavorable noncash effect resulting from an increase in the inventory market valuation reserve, partially offset by a favorable $20 million adjustment of prior years' production tax accruals. Excluding the effects of these items and the 1992 special items previously discussed, operating income declined $393 million from 1991 to 1992 due mainly to lower results for the Marathon Group. Contributing to the decline was a $58 million increase in operating costs resulting from the 1992 adoption of Statement of Financial Accounting Standards No. 106 - Employers' Accounting for Postretirement Benefits Other Than Pensions ("SFAS No. 106"), $42 million for the U. S. Steel Group and $16 million for the Marathon Group. Net pension credits included in operating income totaled $211 million in 1993, compared with $260 million in 1992 and $224 million in 1991. The decrease in 1993 was primarily due to a lower assumed long-term rate of return on plan assets. The increase in 1992 from 1991 primarily reflected recognition of the growth in plan assets. In 1994, net pension credits are expected to decline by approximately $95 million primarily due to a further reduction in the assumed long-term rate of return on plan assets. See Note 7 to the Consolidated Financial Statements. U-36 Management's Discussion and Analysis CONTINUED OTHER INCOME was $257 million in 1993, compared with a loss of $2 million in 1992 and income of $39 million in 1991. The increase in 1993 primarily resulted from higher gains from the disposal of assets, including the sale of the Cumberland coal mine, the realization of a $70 million deferred gain resulting from the collection of a subordinated note related to the 1988 sale of Transtar, Inc. ("Transtar") (which also resulted in $37 million of interest income) and the sale of an investment in an insurance company. The increase in 1993 also reflected the absence of a $19 million impairment of an investment recorded in 1992. The decline in 1992 relative to 1991 primarily resulted from the nonrecurrence of 1991's favorable minority interest effect related to RMI Titanium Company and the $19 million impairment of an investment in 1992. INTEREST AND OTHER FINANCIAL INCOME was $78 million in 1993, compared with $228 million in 1992 and $38 million in 1991. The 1993 amount included $37 million of interest income resulting from collection of the Transtar note. The 1992 amount included $177 million of interest income resulting from the settlement of a tax refund claim related to prior years' production taxes. Excluding these items, interest and other financial income was $41 million in 1993, compared with $51 million in 1992 and $38 million in 1991. INTEREST AND OTHER FINANCIAL COSTS were $630 million in 1993, compared with $485 million in 1992 and $509 million in 1991. The 1993 amount included $164 million of interest expense related to the adverse decision in the B&LE litigation. Excluding this amount, the decrease in 1993 primarily reflected an increase in capitalized interest. The 1991 amount included a $26 million favorable adjustment related to interest accrued for prior years' production taxes. Excluding this item, the decrease from 1991 to 1992 was mainly due to the favorable effect of declining variable interest rates. THE CREDIT FOR ESTIMATED INCOME TAXES in 1993 was $72 million, compared with credits of $29 million in 1992 and $113 million in 1991. The 1993 U.S. income tax credit included an incremental deferred tax benefit of $64 million resulting from USX Corporation's ("USX") ability to elect to credit, rather than deduct, certain foreign income taxes for U.S. federal income tax purposes when paid in future years. The anticipated use of the U.S. foreign tax credit reflects the Marathon Group's improving international production profile including income which will be generated by the East Brae platform in the United Kingdom sector of the North Sea. The 1993 U.S. income tax credit also included a $29 million charge associated with an increase in the federal income tax rate from 34% to 35%, reflecting remeasurement of deferred federal income tax liabilities as of January 1, 1993. THE TOTAL LOSS BEFORE CUMULATIVE EFFECT OF CHANGES IN ACCOUNTING PRINCIPLES was $167 million in 1993, compared with a loss of $160 million in 1992 and a loss of $578 million in 1991. THE UNFAVORABLE CUMULATIVE EFFECT OF CHANGES IN ACCOUNTING PRINCIPLES totaled $92 million in 1993 and $1,666 million in 1992. The cumulative effect of adopting SFAS No. 112, determined as of January 1, 1993, decreased 1993 income by $86 million, net of the income tax effect. The cumulative effect of adopting Emerging Issues Task Force Consensus No. 93-14 - Accounting for Multiple-Year Retrospectively Rated Insurance Contracts, determined as of January 1, 1993, decreased 1993 income by $6 million, net of the income tax effect. The immediate recognition of the transition obligation resulting from the adoption of SFAS No. 106, measured as of January 1, 1992, decreased 1992 income by $1,306 million, net of the income tax effect. The cumulative effect of adopting Statement of Financial Accounting Standards No. 109 - Accounting for Income Taxes, measured as of January 1, 1992, decreased 1992 net income by $360 million. USX RECORDED A NET LOSS of $259 million in 1993, compared with a net loss of $1,826 million in 1992 and a net loss of $578 million in 1991. U-37 Management's Discussion and Analysis CONTINUED MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION CURRENT ASSETS increased $80 million from year-end 1992. The increase primarily reflected higher cash and cash equivalents and deferred income tax benefits, partially offset by a decrease in inventories. Cash and cash equivalents totaled $268 million at year-end 1993, compared to $57 million at year-end 1992. Cash from operations, new debt borrowings, equity issued and asset sales exceeded cash applied to capital spending, debt repayment and dividends. Deferred income tax benefits increased $171 million, resulting primarily from increases in the inventory market valuation reserve and accruals related to the B&LE litigation. The decrease in inventories primarily reflected a reduction in inventory values due to an increase in the inventory market valuation reserve. This reserve reflects the extent to which the recorded cost of crude oil and refined product inventories exceeds net realizable value. Subsequent changes to the inventory market valuation reserve are dependent on changes in future crude oil and refined product price levels and inventory turnover. PREPAID PENSION ASSETS increased $234 million from year-end 1992 mainly as a result of pension credits which primarily reflected the investment performance of defined benefit plan assets. CURRENT LIABILITIES were lower at year-end 1993 mainly due to a reduction in long-term debt due within one year, partially offset by an increase in accounts payable. The increase in accounts payable primarily reflected an increase in litigation accruals, partially offset by a decrease in trade payables. TOTAL LONG-TERM DEBT AND NOTES PAYABLE at December 31, 1993, was $5.9 billion. The $425 million decrease from year-end 1992 mainly reflected cash provided from operating activities, issuance of common and preferred stock and disposal of assets, partially offset by capital expenditures, dividend payments and an increase in cash and cash equivalents. Repayments under USX's revolving credit agreements and of commercial paper and other debt were partially offset by new issuances of debt. At December 31, 1993, USX had outstanding borrowings of $500 million against credit agreements, leaving $1,675 million of available unused committed credit lines. In addition, USX had $185 million of available unused short-term lines of credit, which generally require maintenance of compensating balances. In the event of a change of control of USX, debt and guaranteed obligations totaling $5.1 billion at year-end 1993, may be declared immediately due and payable or required to be collateralized (see Notes 12, 14 and 16 to the Consolidated Financial Statements). EMPLOYEE BENEFITS liabilities increased $355 million compared with year-end 1992 mainly due to increases in workers' compensation liabilities (including the effects of the adoption of SFAS No. 112), retiree medical liabilities and pension liabilities. DEFERRED CREDITS AND OTHER LIABILITIES decreased $130 million in 1993 mainly as a result of transfers of certain litigation accruals to current liabilities and the reclassification of certain amounts to the employee benefits liability account in conjunction with the adoption of SFAS No. 112. STOCKHOLDERS' EQUITY of $3.9 billion at year-end 1993 increased by $155 million from the end of 1992 mainly reflecting the issuance of additional common and preferred equity, partially offset by the 1993 net loss and dividend payments. MANAGEMENT'S DISCUSSION AND ANALYSIS OF CASH FLOWS NET CASH PROVIDED FROM OPERATING ACTIVITIES totaled $944 million in 1993, compared with $920 million in 1992. The 1993 period was negatively affected by payments of $314 million related to partial settlement of the B&LE litigation and settlement of the Energy Buyers litigation. The 1992 period included $296 million associated with the refund of prior years' production taxes. Excluding these items, net cash provided from operating activities improved $634 million from 1992. The increase primarily reflected improved operations for the U. S. Steel Group, improved refined product margins for the Marathon Group and a $103 million favorable effect from the use of available funds from previously established (now depleted) insurance reserves to pay for certain active and retired employee insurance benefits. U-38 Management's Discussion and Analysis CONTINUED Excluding the 1992 refund discussed above, net cash provided from operating activities in 1992 declined $399 million from 1991 primarily due to lower income, partially offset by favorable changes in working capital accounts. CAPITAL EXPENDITURES were $1,151 million in 1993, compared with $1,505 million in 1992 and $1,392 million in 1991. The $354 million decrease in 1993 was due primarily to lower expenditures for the Marathon Group and the U. S. Steel Group. The $283 million decline for the Marathon Group mainly reflected decreased expenditures for environmental projects and for development of the East Brae Field and SAGE system in the United Kingdom and other international projects, partially offset by increased exploration drilling and development projects in the Gulf of Mexico and increased drilling activity for onshore domestic natural gas projects. The $100 million decrease for the U. S. Steel Group primarily reflected completion of U. S. Steel's continuous cast modernization program in 1992. Contract commitments for capital expenditures at year-end 1993 were $389 million, compared with $423 million at year-end 1992. For the year 1994, capital expenditures are expected to total approximately $1.1 billion. The slight anticipated decrease in 1994 is expected to result mainly from lower expenditures for the Marathon Group, partially offset by higher expenditures for the U. S. Steel Group. The Marathon Group's capital expenditures are expected to decrease by approximately $100 million in 1994 mainly reflecting lower expenditures for development of the East Brae Field and SAGE system. The U. S. Steel Group's capital expenditures are expected to increase by approximately $60 million in 1994 and will include continued expenditures for projects begun in 1993 relative to environmental, hot-strip mill and pickle line improvements at Gary (IN) Works and initial expenditures for a blast furnace reline project at Mon Valley (PA) Works which is planned for completion in 1995. CASH FROM THE DISPOSAL OF ASSETS was $469 million in 1993, compared with $117 million in 1992 and $78 million in 1991. The 1993 amount primarily reflected the realization of proceeds from a subordinated note related to the 1988 sale of Transtar, the sale of the Cumberland coal mine, the sale/leaseback of interests in two LNG tankers, and the sales of various domestic oil and gas production properties and of an investment in an insurance company. No individually significant sales transactions occurred in 1992 or 1991. FINANCIAL OBLIGATIONS decreased by $458 million in 1993, compared with a decrease of $240 million in 1992 and an increase of $662 million in 1991. These amounts represent net cash flows on commercial paper and the revolving credit agreements and lines of credit, other debt and production financing and other agreements. During 1993, USX issued an aggregate principal amount of $800 million of fixed rate debt through its medium-term note program and three separate series of unsecured, noncallable debt securities in the public market. Maturities ranged from 5 to 30 years and interest rates ranged from 6-3/8% to 8-1/2% per annum. In addition, an aggregate principal amount of $77 million of Marathon Oil Company's ("Marathon") 9-1/2% Guaranteed Notes Due 1994 was tendered in exchange for its Monthly Interest Guaranteed Notes Due 2002, 9-3/4% to March 1, 1994 and 7% thereafter ("7% Notes"). During 1992, USX issued an aggregate principal amount of $748 million of fixed rate debt through its medium-term note program and three separate series of unsecured, noncallable debt securities in the public market. Maturities ranged from 5 to 30 years and interest rates ranged from 6.65% to 9.375% per annum. During 1991, debt borrowings included the issuance of three separate series of unsecured, noncallable debt securities in the public market in the aggregate principal amount of $550 million and a $300 million loan to Marathon Oil U. K., Ltd. from the European Investment Bank. PREFERRED STOCK ISSUED totaled $336 million in 1993. This amount reflected the sale of 6,900,000 shares of 6.50% Cumulative Convertible Preferred Stock ($50.00 liquidation preference per share) ("6.50% Convertible Preferred") to the public for net proceeds of $336 million. The 6.50% Convertible Preferred is convertible at any time into shares of USX-U. S. Steel Group Common Stock ("Steel Stock") at a conversion price of $46.125 per share of Steel Stock. U-39 Management's Discussion and Analysis CONTINUED COMMON STOCK ISSUED, net of repurchases, totaled $371 million in 1993, compared with $942 million in 1992 and $70 million in 1991. The 1993 amount mainly reflected the sale of 10,000,000 shares of Steel Stock to the public for net proceeds of $350 million. The increase in 1992 primarily reflected sales to the public of all three classes of common stock. In 1992, USX sold 25,000,000 shares of USX-Marathon Group Common Stock ("Marathon Stock") for net proceeds of $541 million, 8,050,000 shares of Steel Stock for net proceeds of $198 million and 9,000,000 shares of USX-Delhi Group Common Stock for net proceeds of $136 million. DIVIDEND PAYMENTS decreased in 1993 primarily due to a decrease in the dividend rate on Marathon Stock in the fourth quarter of 1992, partially offset by increased dividends due primarily to the sale in 1993 of additional shares of Steel Stock and of the 6.50% Convertible Preferred. The increase in 1992 from 1991 primarily resulted from higher dividends due to the sale of additional shares of all three classes of common stock in 1992, partially offset by the fourth quarter decrease in the dividend rate on Marathon Stock. In September 1993, Standard & Poor's Corp. ("S&P") lowered its ratings on USX's and Marathon's senior debt to below investment grade (from BBB- to BB+) and on USX's subordinated debt, preferred stock and commercial paper. S&P cited extremely aggressive financial leverage, burdensome retiree medical liabilities and litigation contingencies. In October 1993, Moody's Investors Services, Inc. ("Moody's") confirmed its Baa3 investment grade ratings on USX's and Marathon's senior debt. Moody's also confirmed its ratings on USX's subordinated debt and commercial paper, but lowered its ratings on USX's preferred stock from ba1 to ba2. Moody's noted that the rating confirmation on USX debt securities reflected confidence in the expected performance of USX during the intermediate term, while the downward revision of the preferred stock ratings incorporated a narrow fixed charge coverage going forward. The downgrades by S&P and the downgrade of ratings on preferred stock by Moody's could increase USX's cost of capital. In December 1993, USX filed a universal shelf registration statement with the Securities and Exchange Commission which became effective on January 6, 1994 and allows USX to offer and issue up to $850 million of debt and equity securities. The equity securities include preferred stock as well as each class of USX's common stock. In February 1994, USX sold 5,000,000 shares of Steel Stock to the public for net proceeds of $201 million and issued $300 million in aggregate principal amount of 7.2% Notes Due 2004 under the shelf registration. In February 1994, USX issued $150 million in aggregate principal amount of LIBOR-based Floating Rate Notes Due 1996 through its medium-term note program under a shelf registration statement which became effective on April 26, 1993. In February 1994, an additional aggregate principal amount of $57 million of Marathon's 9-1/2% Guaranteed Notes Due 1994 was tendered in exchange for its 7% Notes. In March 1994, USX Capital LLC, a wholly owned subsidiary of USX, sold $250 million of 8-3/4% Cumulative Monthly Income Preferred Shares ("MIPS"). As a result of the settlement of LTV Steel Corp.'s ("LTV") portion of the B&LE litigation, USX is obligated to pay an additional $175 million to LTV in the first quarter of 1994. In addition, approximately $210 million in judgments for other plaintiffs in the B&LE litigation are due for payment in the first quarter of 1994. See Note 25 to the Consolidated Financial Statements. USX anticipates that it will begin funding the U. S. Steel Group's pension plan by approximately $100 million per year commencing with the 1994 plan year. The funding for both the 1994 and 1995 plan years will impact cash flows in 1995. USX believes that its short-term and long-term liquidity is adequate to satisfy its obligations (including those related to the B&LE litigation) as of December 31, 1993, and to complete currently authorized capital spending programs. USX actively used its access to capital markets during 1993 to meet its business needs beyond internally generated funds. Future requirements for its business needs, including the funding of capital expenditures, debt maturities for the years 1994 to 1996 and amounts which may ultimately be paid in connection with contingencies are expected to be financed by a combination of internally generated funds, proceeds from the sale of stock (including the Steel Stock sold in February 1994 and the MIPS sold in March 1994), proceeds from debt issued in February 1994, future borrowings and other external financing sources. Long-term debt of $734 million matures within one year, including $699 million classified as long-term debt at December 31, 1993. The $699 million represents the Marathon 9-1/2 % Guaranteed Notes Due March 1, 1994. See Note 14 to the Consolidated Financial Statements. U-40 Management's Discussion and Analysis CONTINUED MANAGEMENT'S DISCUSSION AND ANALYSIS OF ENVIRONMENTAL MATTERS, LITIGATION AND CONTINGENCIES USX has incurred and will continue to incur substantial capital, operating and maintenance, and remediation expenditures as a result of environmental laws and regulations. In recent years, these expenditures have increased primarily due to required product reformulation and process changes in order to meet Clean Air Act obligations, although ongoing compliance costs have also been significant. To the extent these expenditures, as with all costs, are not ultimately reflected in the prices of USX's products and services, operating results will be adversely affected. USX believes that domestic competitors of the U. S. Steel Group and substantially all the competitors of the Marathon Group and the Delhi Group are subject to similar environmental laws and regulations. However, the specific impact on each competitor may vary depending on a number of factors, including the age and location of their operating facilities, their production processes and the specific products and services they provide. USX's environmental expenditures for 1993 and 1992 are discussed below and have been estimated for the Marathon Group and the Delhi Group based on American Petroleum Institute ("API") survey guidelines and for the U. S. Steel Group based on U.S. Department of Commerce ("USDC") survey guidelines. These guidelines are subject to differing interpretations which could affect the comparability of such data. Some environmental related expenditures, while benefitting the environment, also enhance operating efficiencies. The Marathon Group's total environmental expenditures in 1993 were $253 million compared with $370 million in 1992. These amounts consisted of capital expenditures of $123 million in 1993 and $240 million in 1992 and estimated compliance expenditures (including operating and maintenance) of $130 million in both 1993 and 1992. Compliance expenditures were broadly estimated based on API survey guidelines and represented 1% of the Marathon Group's total operating costs in both 1993 and 1992. The decline in environmental capital expenditures from 1992 to 1993 primarily reflected lower expenditures for the Marathon Group's multi-year capital projects for diesel fuel desulfurization. By the end of 1993, these projects were substantially completed. The U. S. Steel Group's total environmental expenditures in 1993 were $240 million compared with $220 million in 1992. These amounts consisted of capital expenditures of $53 million in 1993 and $52 million in 1992 and estimated compliance expenditures (including operating and maintenance) of $187 million in 1993 and $168 million in 1992. Compliance expenditures were broadly estimated based on USDC survey guidelines and represented 3% of the U. S. Steel Group's total operating costs in both 1993 and 1992. The Delhi Group's total environmental expenditures in 1993 were $10 million compared with $8 million in 1992. These amounts consisted of capital expenditures of $5 million in 1993 and $3 million in 1992 and estimated compliance expenditures (including operating and maintenance) of $5 million in both 1993 and 1992. Compliance expenditures were broadly estimated based on API survey guidelines and represented 1% of the Delhi Group's total operating costs in both 1993 and 1992. USX's environmental capital expenditures totaled $181 million in 1993, $294 million in 1992 and $175 million in 1991. Such expenditures accounted for 16%, 20% and 13% of total consolidated capital expenditures in 1993, 1992 and 1991, respectively. The increase from 1991 to 1992 and the decline in 1993 was primarily the result of the Marathon Group's multi-year capital spending program for diesel fuel desulfurization which was substantially completed in 1993. USX expects environmental capital expenditures to approximate $150 million in 1994 or approximately 13% of total estimated consolidated capital expenditures. Predictions beyond 1994 can only be broad-based estimates which have varied, and will continue to vary, due to the ongoing evolution of specific regulatory requirements, the possible imposition of more stringent requirements and the availability of new technologies, among other matters. Based upon currently identified projects, USX anticipates that environmental capital expenditures in 1995 will total approximately $90 million; however, actual expenditures may increase as additional projects are identified or additional requirements are imposed. U-41 Management's Discussion and Analysis CONTINUED USX has been notified that it is a potentially responsible party ("PRP") at 55 waste sites under the Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA") as of December 31, 1993. In addition, there are 50 sites where USX has received information requests or other indications that USX may be a PRP under CERCLA but where sufficient information is not presently available to confirm the existence of liability or make any judgment as to the amount thereof. There are also 62 additional sites, excluding retail gasoline stations, where state governmental agencies or private parties are seeking remediation under state environmental laws through discussions or litigation. At many of these sites, USX is one of a number of parties involved and the total cost of remediation, as well as USX's share thereof, is frequently dependent upon the outcome of investigations and remedial studies. Total environmental expenditures for the Marathon Group included remediation related expenditures estimated at $38 million in 1993 and $35 million in 1992. Remediation spending was primarily related to retail gasoline stations which incur ongoing clean-up costs for soil and groundwater contamination associated with underground storage tanks and piping. Total environmental expenditures for the U. S. Steel Group included remediation related expenditures estimated at $19 million in 1993 and $11 million in 1992. Remediation spending was mainly related to dismantlement and restoration activities at former and present operating locations. Remediation related expenditures for the Delhi Group were not material. USX accrues for environmental remediation activities when the responsibility to remediate is probable and the amount of associated costs is reasonably determinable. As environmental remediation matters proceed toward ultimate resolution or as additional remediation obligations arise, charges in excess of those previously accrued may be required. See Note 25 to the Consolidated Financial Statements. New or expanded requirements for environmental regulations, which could increase USX's environmental costs, may arise in the future. USX intends to comply with all legal requirements regarding the environment, but since many of them are not fixed or presently determinable (even under existing legislation) and may be affected by future legislation, it is not possible to accurately predict the ultimate cost of compliance, including remediation costs which may be incurred and penalties which may be imposed. However, based on presently available information, and existing laws and regulations as currently implemented, USX does not anticipate that environmental compliance expenditures will materially increase in 1994. As discussed above, environmental capital expenditures are currently expected to decrease in 1994 and again in 1995. USX is the subject of, or party to, a number of pending or threatened legal actions, contingencies and commitments involving a variety of matters, including laws and regulations relating to the environment, certain of which are discussed in Note 25 to the Consolidated Financial Statements. The ultimate resolution of these contingencies could, individually or in the aggregate, be material to the consolidated financial statements. However, management believes that USX will remain a viable and competitive enterprise even though it is possible that these contingencies could be resolved unfavorably. See "Management's Discussion and Analysis of Cash Flows." MANAGEMENT'S DISCUSSION AND ANALYSIS OF ACCOUNTING STANDARDS Statement of Financial Accounting Standards No. 114 - Accounting by Creditors for Impairment of a Loan ("SFAS No. 114") requires impairment of loans based on either the sum of discounted cash flows or the fair value of underlying collateral. USX expects to adopt SFAS No. 114 in the first quarter of 1995. Based on preliminary estimates, USX expects that the unfavorable effect of adopting SFAS No. 114 will be less than $2 million. U-42 Management's Discussion and Analysis CONTINUED MANAGEMENT'S DISCUSSION AND ANALYSIS OF OPERATIONS BY INDUSTRY SEGMENT THE MARATHON GROUP The Marathon Group includes Marathon, a wholly owned subsidiary of USX, which is engaged in worldwide exploration, production, transportation and marketing of crude oil and natural gas; and domestic refining, marketing and transportation of petroleum products. The Marathon Group financial data for the periods prior to the creation of the Delhi Group on October 2, 1992, include the combined historical financial position, results of operations and cash flows for the businesses of the Delhi Group. Sales of $12.0 billion in 1993 declined $820 million from 1992 mainly due to lower worldwide liquid hydrocarbon volumes and prices, lower average refined product prices and the absence of sales from the Delhi Group. These decreases were partially offset by increased excise taxes and higher refined product sales volumes, excluding matching buy/sell transactions. Sales of $12.8 billion in 1992 declined $1.2 billion from 1991 primarily due to lower average refined product prices, reduced volumes and prices for crude oil matching buy/sell transactions and lower worldwide liquid hydrocarbon volumes. Matching buy/sell transactions and excise taxes are included in both sales and operating costs, resulting in no effect on operating income. The Marathon Group reported operating income of $169 million in 1993, compared with $304 million in 1992 and $358 million in 1991. Results included a $241 million unfavorable effect in 1993, a $62 million favorable effect in 1992 and a $260 million unfavorable effect in 1991 resulting from noncash adjustments to the inventory market valuation reserve. The 1992 results also included a favorable impact of $119 million for the settlement of a tax refund claim related to prior years' production taxes, compared with a favorable $20 million adjustment of prior years' production tax accruals in 1991. Also, the 1992 results included a restructuring charge of $115 million related to the disposition of certain domestic exploration and production properties, compared with a 1991 restructuring charge of $24 million. Excluding the effects of these items, operating income was $410 million in 1993, $238 million in 1992 and $622 million in 1991. The increase in 1993 primarily reflected increased average refined product margins and increased domestic natural gas prices, partially offset by lower worldwide liquid hydrocarbon prices and volumes. The decrease in 1992 predominantly reflected lower average refined product margins, as well as reduced worldwide liquid hydrocarbon prices and volumes and lower international natural gas prices. The outlook regarding prices and costs for the Marathon Group's principal products is largely dependent upon world market developments for crude oil and refined products. Market conditions in the petroleum industry are cyclical and subject to global economic and political events. THE U. S. STEEL GROUP The U. S. Steel Group includes U. S. Steel, which is primarily engaged in the production and sale of a wide range of steel mill products, coke and taconite pellets. The U. S. Steel Group also includes the management of mineral resources, domestic coal mining, engineering and consulting services and technology licensing (together with U. S. Steel, the "Steel and Related Businesses"). Other businesses that are part of the U. S. Steel Group include real estate development and management, fencing products, leasing and financing activities and a majority interest in a titanium metal products company. U-43 Management's Discussion and Analysis CONTINUED Sales increased from $4.9 billion in 1992 to $5.6 billion in 1993. The increase primarily reflected higher steel shipment volumes and prices, and increased commercial shipments of taconite pellets and coke. The $55 million increase in sales from 1991 to 1992 primarily reflected significantly higher commercial shipments of coke, improvements in steel shipment volumes from ongoing operations and an improved shipment mix, partially offset by the absence of sales of structural products due to the closure of South (IL) Works early in 1992. The U. S. Steel Group reported an operating loss of $149 million in 1993, compared with an operating loss of $241 million in 1992 and an operating loss of $617 million in 1991. The 1993 operating loss included a $342 million charge as a result of the adverse decision in the B&LE litigation and restructuring charges of $42 million related to the planned shutdown of the Maple Creek coal mine and preparation plant. The 1992 operating loss included a charge of $10 million for completion of the portion of the 1991 restructuring plan related to steel facilities. The 1991 loss included $402 million of restructuring charges primarily related to the shutdown of certain steel facilities. Excluding the effects of these items, operating income was $235 million in 1993, compared with operating losses of $231 million in 1992 and $215 million in 1991. The $466 million improvement in 1993 was mainly due to higher steel shipment volumes and prices, improved operating efficiencies and lower accruals for environmental and legal contingencies. In addition, 1993 results benefitted from a $39 million favorable effect from the utilization of funds from previously established insurance reserves to pay for certain employee insurance benefits, lower provisions for loan losses by USX Credit and the absence of a 1992 unfavorable effect of $28 million resulting from market valuation provisions for foreclosed real estate assets. These were partially offset by higher hourly steel labor costs, unfavorable effects associated with pension and other employee benefits, lower results from coal operations and a $21 million increase in operating costs related to the adoption of SFAS No. 112. The slight decrease from 1991 to 1992 was primarily due to higher charges for legal contingencies, increased costs of $42 million related to the adoption of SFAS No. 106, higher depreciation charges, increased provisions for loan losses by USX Credit and a $28 million unfavorable effect resulting from market valuation provisions for foreclosed real estate assets. These factors were partially offset by the favorable effects of savings from cost reduction programs, higher utilization of raw steel and raw material production capability and the absence of costs incurred in 1991 related to the lack of an early labor agreement with the United Steelworkers of America ("USWA"). Based on strong recent order levels and assuming a continuing recovery of the U.S. economy, the U. S. Steel Group anticipates that steel demand will remain strong in 1994. The U. S. Steel Group believes that domestic industry shipments will reach 89 to 90 million tons in 1994 as compared to approximately 88 million tons in 1993. Price increases on sheet products have been announced effective January 2 and July 3, 1994. Price increases on certain other products have also been announced. Although early indications suggest that the January price increase is holding, full realization of the price increases will be dependent upon steel demand and the level of imports. Steel imports to the United States have increased in recent months. Steel imports to the United States accounted for an estimated 19% of the domestic steel market in 1993, and for an estimated 22% in the fourth quarter. U. S. Steel entered into a new five and one-half year contract with the USWA, effective February 1, 1994, covering approximately 15,000 employees. The agreement will result in higher labor and benefit costs for the U. S. Steel Group each year throughout the term of the agreement. The agreement includes a signing bonus of $1,000 per USWA represented employee that will be paid in the first quarter of 1994, $500 of which represents the final bonus payable under the previous agreement. The agreement also provides for the establishment of a Voluntary Employee Beneficiary Association Trust to prefund health care and life insurance benefits for retirees covered under the agreement. Minimum contributions, in the form of USX stock or cash, are expected to be $25 million in 1994 and $10 million per year thereafter. The funding of the trust will have no direct effect on income of the U. S. Steel Group. Management believes that this agreement is competitive with labor agreements reached by U. S. Steel's major domestic integrated competitors and thus does not believe that U. S. Steel's competitive position with regard to such other competitors will be materially affected by its ratification. U-44 Management's Discussion and Analysis CONTINUED Severe cold and extreme winter weather conditions disrupted steel and raw materials operations and caused forced utility curtailments at Gary Works, Mon Valley Works and Fairless (PA) Works in January 1994. These events will have some negative effects on operations in the first quarter of 1994. Net pension credits for the U. S. Steel Group in 1994 are expected to decline by approximately $85 million primarily due to a lower assumed long-term rate of return on plan assets. THE DELHI GROUP The Delhi Group includes Delhi Gas Pipeline Corporation, a wholly owned subsidiary of USX, and certain related companies which are engaged in the purchasing, gathering, processing, transporting and marketing of natural gas. Sales of $535 million in 1993 increased $77 million from 1992, mainly due to increased revenues from premium services and higher average natural gas sales prices. Sales of $458 million in 1992 increased $35 million from 1991 primarily due to higher average natural gas sales prices, increased systems throughput volumes and increased gas processing revenues. Operating income was $36 million in 1993, compared with $33 million in 1992 and $31 million in 1991. Operating income in 1993 included favorable effects of $2 million for the reversal of a prior-period accrual related to a natural gas contract settlement, $1 million related to gas imbalance settlements and a net $1 million for a refund of prior years' taxes other than income taxes. Operating income in 1992 included favorable effects totaling $2 million relating to the settlement of various lawsuits and third-party disputes. Excluding the effects of these items, 1993 operating income improved by $1 million, primarily as a result of higher gas sales margins and lower operating and other expenses, partially offset by a 34% decline in gas processing margins from the sale of natural gas liquids ("NGLs"). Operating income in 1991 included $8 million for favorable settlements of certain contractual issues. Excluding the effects of the settlements in 1992 and 1991, the $8 million improvement in 1992 operating income was primarily due to increased NGLs volumes from gas processing, higher natural gas systems throughput volumes and lower operating and other expenses. These favorable items were partially offset by lower unit margins for NGLs, reflecting lower NGLs prices and higher feedstock costs. U-45 Marathon Group Index to Financial Statements, Supplementary Data and Management's Discussion and Analysis M-1 Marathon Group Explanatory Note Regarding Financial Information Although the financial statements of the Marathon Group, the U.S. Steel Group and the Delhi Group separately report the assets, liabilities (including contingent liabilities) and stockholders' equity of USX attributed to each such group, such attribution does not affect legal title to such assets and responsibility for such liabilities. Holders of USX-Marathon Group Common Stock, USX-U.S. Steel Group Common Stock and USX-Delhi Group Common Stock are holders of common stock of USX and continue to be subject to all the risks associated with an investment in USX and all of its businesses and liabilities. Financial impacts arising from any of the Marathon Group, the U.S. Steel Group or the Delhi Group which affect the overall cost of USX's capital could affect the results of operations and financial condition of all groups. In addition, net losses of any group, as well as dividends or distributions on any class of USX common stock or series of Preferred Stock and repurchases of any class of USX common stock or certain series of Preferred Stock, will reduce the funds of USX legally available for payment of dividends on all classes of USX common stock. Accordingly, the USX consolidated financial information should be read in connection with the Marathon Group financial information. M-2 Management's Report The accompanying financial statements of the Marathon Group are the responsibility of and have been prepared by USX Corporation (USX) in conformity with generally accepted accounting principles. They necessarily include some amounts that are based on best judgments and estimates. The Marathon Group financial information displayed in other sections of this report is consistent with that in these financial statements. USX seeks to assure the objectivity and integrity of its financial records by careful selection of its managers, by organizational arrangements that provide an appropriate division of responsibility and by communications programs aimed at assuring that its policies and methods are understood throughout the organization. USX has a comprehensive formalized system of internal accounting controls designed to provide reasonable assurance that assets are safeguarded and that financial records are reliable. Appropriate management monitors the system for compliance, and the internal auditors independently measure its effectiveness and recommend possible improvements thereto. In addition, as part of their audit of the financial statements, USX's independent accountants, who are elected by the stockholders, review and test the internal accounting controls selectively to establish a basis of reliance thereon in determining the nature, extent and timing of audit tests to be applied. The Board of Directors pursues its oversight role in the area of financial reporting and internal accounting control through its Audit Committee. This Committee, composed solely of nonmanagement directors, regularly meets (jointly and separately) with the independent accountants, management and internal auditors to monitor the proper discharge by each of its responsibilities relative to internal accounting controls and the consolidated and group financial statements. Report of Independent Accountants To the Stockholders of USX Corporation: In our opinion, the accompanying financial statements appearing on pages M-4 through M-20 and as listed in Item 14.A.2 on page 61 of this report present fairly, in all material respects, the financial position of the Marathon Group at December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of USX's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. As discussed in Note 2, page M-7, in 1993 USX adopted new accounting standards for postemployment benefits and for retrospectively rated insurance contracts. As discussed in Note 10, page M-13, and Note 11, page M-14, in 1992 USX adopted new accounting standards for postretirement benefits other than pensions and for income taxes, respectively. The Marathon Group is a business unit of USX Corporation (as described in Note 1, page M-7); accordingly, the financial statements of the Marathon Group should be read in connection with the consolidated financial statements of USX Corporation and Subsidiary Companies. Price Waterhouse 600 Grant Street, Pittsburgh, Pennsylvania 15219-2794 February 8, 1994 M-3 Statement of Operations Income Per Common Share of Marathon Stock See Note 22, page M-18, for a description of net income per common share. The accompanying notes are an integral part of these financial statements. M-4 Balance Sheet The accompanying notes are an integral part of these financial statements. M-5 Statement of Cash Flows See Note 7, page M-11, for supplemental cash flow information. The accompanying notes are an integral part of these financial statements. M-6 Notes to Financial Statements 1. BASIS OF PRESENTATION USX Corporation (USX) has three classes of common stock: USX -- Marathon Group Common Stock (Marathon Stock), USX U. S. Steel Group Common Stock (Steel Stock) and USX -- Delhi Group Common Stock (Delhi Stock), which are intended to reflect the performance of the Marathon Group, the U.S. Steel Group and the Delhi Group, respectively. The financial statements of the Marathon Group include the financial position, results of operations and cash flows for the businesses of Marathon Oil Company and certain other subsidiaries of USX, and a portion of the corporate assets and liabilities and related transactions which are not separately identified with ongoing operating units of USX. The Marathon Group is involved in worldwide exploration, production, transportation and marketing of crude oil and natural gas; and domestic refining, marketing and transportation of petroleum products. The Marathon Group financial statements are prepared using the amounts included in the USX consolidated financial statements. The Delhi Group was established October 2, 1992; the Marathon Group financial data for the periods presented prior to this date included the combined historical financial position, results of operations and cash flows for the businesses of the Delhi Group. Beginning October 2, 1992, the financial statements of the Marathon Group do not include the financial position, results of operations and cash flows for the businesses of the Delhi Group except for the financial effects of the Retained Interest (Note 3, page M-9). Although the financial statements of the Marathon Group, the U. S. Steel Group and the Delhi Group separately report the assets, liabilities (including contingent liabilities) and stockholders' equity of USX attributed to each such group, such attribution does not affect legal title to such assets and responsibility for such liabilities. Holders of Marathon Stock, Steel Stock and Delhi Stock are holders of common stock of USX and continue to be subject to all the risks associated with an investment in USX and all of its businesses and liabilities. Financial impacts arising from any of the Marathon Group, the U. S. Steel Group or the Delhi Group which affect the overall cost of USX's capital could affect the results of operations and financial condition of all groups. In addition, net losses of any group, as well as dividends or distributions on any class of USX common stock or series of Preferred Stock and repurchases of any class of USX common stock or certain series of Preferred Stock, will reduce the funds of USX legally available for payment of dividends on all classes of USX common stock. Accordingly, the USX consolidated financial information should be read in connection with the Marathon Group financial information. 2. SUMMARY OF PRINCIPAL ACCOUNTING POLICIES PRINCIPLES APPLIED IN CONSOLIDATION -- These financial statements include the accounts of the businesses comprising the Marathon Group. The Marathon Group, the U. S. Steel Group and the Delhi Group financial statements, taken together, comprise all of the accounts included in the USX consolidated financial statements. Investments in unincorporated oil and gas joint ventures are accounted for on a pro rata basis. Investments in other entities in which the Marathon Group has significant influence in management and control are accounted for using the equity method of accounting and are carried in the investment account at the Marathon Group's share of net assets plus advances. The proportionate share of income from equity investments is included in other income. The proportionate share of income represented by the Retained Interest in the Delhi Group is included in other income. Investments in marketable equity securities are carried at lower of cost or market and investments in other companies are carried at cost, with income recognized when dividends are received. NEW ACCOUNTING STANDARDS -- The following accounting standards were adopted by USX during 1993: Postemployment benefits -- Effective January 1, 1993, USX adopted Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" (SFAS No. 112). SFAS No. 112 requires employers to recognize the obligation to provide postemployment benefits on an accrual basis if certain conditions are met. The Marathon Group is affected M-7 primarily by disability-related claims covering indemnity and medical payments. The obligation for these claims is measured using actuarial techniques and assumptions including an appropriate discount rate. The cumulative effect of the change in accounting principle determined as of January 1, 1993, reduced net income $17 million, net of $10 million income tax effect. The effect of the change in accounting principle reduced 1993 operating income by $2 million. Accounting for multiple-year retrospectively rated insurance contracts -- USX adopted Emerging Issues Task Force (EITF) Consensus No. 93-14, "Accounting for Multiple-Year Retrospectively Rated Insurance Contracts". EITF No. 93-14 requires accrual of retrospective premium adjustments when the insured has an obligation to pay cash to the insurer that would not have been required absent experience under the contract. The cumulative effect of the change in accounting principle determined as of January 1, 1993, reduced net income $6 million, net of $3 million income tax effect. CASH AND CASH EQUIVALENTS -- Cash and cash equivalents includes cash on hand and on deposit and highly liquid debt instruments with maturities generally of three months or less. INVENTORIES -- Inventories are carried at lower of cost or market. Cost of inventories is determined primarily under the last-in, first-out (LIFO) method. HEDGING TRANSACTIONS -- The Marathon Group enters into commodity swaps, futures contracts and options to hedge exposure to price fluctuations relevant to the purchase or sale of crude oil, refined products and natural gas. Such transactions are accounted for as part of the commodity being hedged. Forward contracts are used to hedge currency risks, and the accounting is based on the requirements of Statement of Financial Accounting Standards No. 52. EXPLORATION AND DEVELOPMENT -- The Marathon Group follows the successful efforts method of accounting for oil and gas exploration and development. GAS BALANCING -- The Marathon Group follows the sales method of accounting for gas production imbalances. PROPERTY, PLANT AND EQUIPMENT -- Depreciation and depletion of oil and gas producing properties are computed using predetermined rates based upon estimated proved oil and gas reserves applied on a units-of-production method. Other items of property, plant and equipment are depreciated principally by the straight-line method. When an entire property, major facility or facilities depreciated on an individual basis are sold or otherwise disposed of, any gain or loss is reflected in income. Proceeds from disposal of other facilities depreciated on a group basis are credited to the depreciation reserve with no immediate effect on income. INSURANCE -- The Marathon Group is insured for catastrophic casualty and certain property exposures, as well as those risks required to be insured by law or contract. Costs resulting from noninsured losses are charged against income upon occurrence. RECLASSIFICATIONS -- Certain reclassifications of prior years' data have been made to conform to 1993 classifications. 3. CORPORATE ACTIVITIES FINANCIAL ACTIVITIES -- As a matter of policy, USX manages most financial activities on a centralized, consolidated basis. Such financial activities include the investment of surplus cash; the issuance, repayment and repurchase of short-term and long-term debt; the issuance, repurchase and redemption of preferred stock; and the issuance and repurchase of common stock. Transactions related primarily to invested cash, short-term and long-term debt (including convertible debt), related net interest and other financial costs, and preferred stock and related dividends are attributed to the Marathon Group, the U.S. Steel Group and the Delhi Group based upon the cash flows of each group for the periods presented and the initial capital structure of each group. Most financing transactions are attributed to and reflected in the financial statements of all three groups. See Note 5, page M-10, for the Marathon Group's portion of USX's financial activities attributed to all three groups. However, certain transactions such as leases, production payment financings, financial activities of consolidated entities which are less than wholly owned by USX and transactions related to securities convertible solely into any one class of common stock are or will be specifically attributed to and reflected in their entirety in the financial statements of the group to which they relate. CORPORATE GENERAL & ADMINISTRATIVE COSTS -- Corporate general and administrative costs are allocated to the Marathon Group, the U. S. Steel Group and the Delhi Group based upon utilization or other methods management believes to be reasonable and which consider certain measures of M-8 business activities, such as employment, investments and sales. The costs allocated to the Marathon Group were $28 million, $30 million and $45 million in 1993, 1992 and 1991, respectively, and primarily consist of employment costs including pension effects, professional services, facilities and other related costs associated with corporate activities. COMMON STOCK TRANSACTIONS -- All financial statement impacts of purchases and issuances of Marathon Stock after the change of USX common stock into Marathon Stock and the distribution of Steel Stock on May 6, 1991, are reflected in their entirety in the Marathon Group financial statements. Financial statement impacts of treasury stock transactions occurring before May 7, 1991, have been attributed to the two groups in relationship to their respective common equity. The initial dividend on the Marathon Stock was paid on September 10, 1991. Dividends paid by USX prior to September 10, 1991, were attributed to the Marathon Group and the U.S. Steel Group based upon the relationship of the initial dividends on the Marathon Stock and Steel Stock. The USX Certificate of Incorporation was amended on September 30, 1992, to authorize a new class of common stock, Delhi Stock, which is intended to reflect the performance of the Delhi Group. On October 2, 1992, USX sold 9,000,000 shares of Delhi Stock to the public. The businesses of the Delhi Group were previously included in the Marathon Group. The USX Board of Directors deemed 14,000,000 shares of Delhi Stock to represent 100% of the common stockholders' equity value of USX attributable to the Delhi Group. The Delhi Fraction is the percentage interest in the Delhi Group represented by the shares of Delhi Stock that are outstanding at any particular time and, based on 9,282,870 outstanding shares at December 31, 1993, is approximately 66%. The Marathon Group financial statements reflect a percentage interest in the Delhi Group of approximately 34% (Retained Interest) at December 31, 1993. Beginning October 2, 1992, the financial position, results of operations and cash flows of the Delhi Group were reflected in the financial statements of the Marathon Group only to the extent of the Retained Interest. The shares deemed to represent the Retained Interest are not outstanding shares of Delhi Stock and cannot be voted by the Marathon Group. As additional shares of Delhi Stock deemed to represent the Retained Interest are sold, the Retained Interest will decrease. When a dividend or other distribution is paid or distributed in respect to the outstanding Delhi Stock, or any amount paid to repurchase shares of Delhi Stock generally, the Marathon Group financial statements are credited, and the Delhi Group financial statements are charged, with the aggregate transaction amount times the quotient of the Retained Interest divided by the Delhi Fraction. INCOME TAXES -- All members of the USX affiliated group are included in the consolidated United States federal income tax return filed by USX. Accordingly, the provision for federal income taxes and the related payments or refunds of tax are determined on a consolidated basis. The consolidated provision and the related tax payments or refunds have been reflected in the Marathon Group, the U.S. Steel Group and the Delhi Group financial statements in accordance with USX's tax allocation policy. In general, such policy provides that the consolidated tax provision and related tax payments or refunds are allocated among the Marathon Group, the U.S. Steel Group and the Delhi Group, for group financial statement purposes, based principally upon the financial income, taxable income, credits, preferences and other amounts directly related to the respective groups. For tax provision and settlement purposes, tax benefits resulting from attributes (principally net operating losses), which cannot be utilized by one of the three groups on a separate return basis but which can be utilized on a consolidated basis in that year or in a carryback year, are allocated to the group that generated the attributes. However, if such tax benefits cannot be utilized on a consolidated basis in that year or in a carryback year, the prior years' allocation of such consolidated tax effects is adjusted in a subsequent year to the extent necessary to allocate the tax benefits to the group that would have realized the tax benefits on a separate return basis. The allocated group amounts of taxes payable or refundable are not necessarily comparable to those that would have resulted if the groups had filed separate tax returns; however, such allocation should not result in any of the three groups paying more income taxes over time than it would if it filed separate tax returns and, in certain situations, could result in any of the three groups paying less. 4. SALES The items below were included in both sales and operating costs, resulting in no effect on income: (a) Reflected the gross amount of purchases and sales associated with crude oil and refined product buy/sell transactions which are settled in cash. M-9 5. FINANCIAL ACTIVITIES ATTRIBUTED TO ALL THREE GROUPS As described in Note 3, page M-8, the Marathon Group's portion of USX's financial activities attributed to all groups based on their respective cash flows (which excludes amounts specifically attributed to any of the groups, Note 6, page M-10) is as follows: (a) For details of USX notes payable, long-term debt and preferred stock, see Notes 13, page U-18; 14, page U-19; and 19 page U-21, respectively, to the USX consolidated financial statements. (b) The Marathon Group's net interest and other financial costs reflect weighted average effects of all financial activities attributed to all three groups. 6. LONG-TERM DEBT The Marathon Group's portion of USX's consolidated long-term debt is as follows: (a) See Note 14, page U-19, to the USX consolidated financial statements for details of interest rates, maturities and other terms of long-term debt. (b) As described in Note 3, page M-8, certain financial activities are specifically attributed only to the Marathon Group, the U.S. Steel Group or the Delhi Group. (c) Most long-term debt activities of USX Corporation and its wholly owned subsidiaries are attributed to all three groups (in total, but not with respect to specific debt issues) based on their respective cash flows (Notes 3, page M-8; 5, page M-10; and 7, page M-11). M-10 7. SUPPLEMENTAL CASH FLOW INFORMATION 8. OTHER ITEMS (a) Gains resulted primarily from the sale of two product tug/barge units and the sale of assets of a convenience store wholesale distributor subsidiary, Bosart Co. (b) See Note 3, page M-8, for discussion of USX net interest and other financial costs attributable to the Marathon Group. (c) Included a $177 million favorable adjustment related to interest income from a refund of prior years' production taxes. (d) Included a $26 million favorable adjustment related to interest accrued for prior years' production taxes. M-11 9. PENSIONS The Marathon Group has noncontributory defined benefit plans covering substantially all employees. Benefits under these plans are based primarily upon years of service and the highest three years earnings during the last ten years before retirement. Certain subsidiaries provide benefits for employees covered by other plans based primarily upon employees' service and career earnings. The funding policy for all plans provides that payments to the pension trusts shall be equal to the minimum funding requirements of ERISA plus such additional amounts as may be approved from time to time. PENSION COST (CREDIT) -- The defined benefit cost for major plans was determined assuming an expected long-term rate of return on plan assets of 10% for 1993 and 11% for 1992 and 1991. FUNDS' STATUS -- The assumed discount rate used to measure the benefit obligations of major plans was 6.5% and 7% at December 31, 1993, and December 31, 1992, respectively. The assumed rate of future increases in compensation levels was 5% and 5.5% at December 31, 1993, and December 31, 1992, respectively. Plans with accumulated benefit obligations (ABO) in excess of plan assets were not material in 1992. M-12 10. POSTRETIREMENT BENEFITS OTHER THAN PENSIONS The Marathon Group has defined benefit retiree health and life insurance plans covering most employees upon their retirement. Health benefits are provided, for the most part, through comprehensive hospital, surgical and major medical benefit provisions subject to various cost sharing features. Life insurance benefits are provided to nonunion and most union represented retiree beneficiaries primarily based on employees' annual base salary at retirement. Benefits have not been prefunded. In 1992, USX adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" (SFAS No. 106), which requires accrual accounting for all postretirement benefits other than pensions. USX elected to recognize immediately the transition obligation determined as of January 1, 1992, which represents the excess accumulated postretirement benefit obligation (APBO) for current and future retirees over the recorded postretirement benefit cost accruals. The cumulative effect of the change in accounting principle for the Marathon Group reduced net income $147 million, consisting of the transition obligation of $233 million, net of $86 million income tax effect. POSTRETIREMENT BENEFIT COST -- Postretirement benefit cost for defined benefit plans for 1993 and 1992 was determined assuming a discount rate of 7% and 8%, respectively. Prior to 1992, the cost of providing health care and life insurance benefits to retired employees was recognized as an expense primarily as claims were paid. These costs totaled $11 million for 1991. OBLIGATIONS -- The following table sets forth the plans' obligations and the amounts reported in the Marathon Group's balance sheet: The assumed discount rate used to measure the APBO was 6.5% and 7% at December 31, 1993, and December 31, 1992, respectively. The assumed rate of future increases in compensation levels was 5.0% and 5.5% at December 31, 1993, and December 31, 1992, respectively. The weighted average health care cost trend rate in 1994 is approximately 7%, gradually declining to an ultimate rate in 1999 of approximately 5.5%. A one percentage point increase in the assumed health care cost trend rates for each future year would have increased the aggregate of the service and interest cost components of the 1993 net periodic postretirement benefit cost by $6 million and would have increased the APBO as of December 31, 1993, by $46 million. M-13 11. INCOME TAXES Income tax provisions and related assets and liabilities attributed to the Marathon Group are determined in accordance with the USX group tax allocation policy (Note 3, page M-9). In 1992, USX adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS No. 109), which requires an asset and liability approach in accounting for income taxes. Under this method, deferred income tax assets and liabilities are established to reflect the future tax consequences of carryforwards and differences between the tax bases and financial bases of assets and liabilities. The cumulative effect of the change in accounting principle determined as of January 1, 1992, reduced net income $184 million. Provisions (credits) for estimated income taxes: (a) Computed in accordance with Accounting Principles Board Opinion No. 11. The deferred tax benefit of $5 million in 1991 was primarily the net result of timing differences related to depreciation, depletion and amortization, intangible development costs, pension accruals and the usage of business credit carryforwards. In 1993, the cumulative effects of the changes in accounting principles for postemployment benefits and for retrospectively rated insurance contracts included deferred tax benefits of $10 million and $3 million, respectively (Note 2, page M-7). In 1992, the cumulative effect of the change in accounting principle for other postretirement benefits included a deferred tax benefit of $86 million (Note 10, page M-13). Reconciliation of federal statutory tax rate (35% in 1993, and 34% in 1992 and 1991) to total provisions (credits): (b) Includes incremental deferred tax benefit of $64 million in 1993 resulting from USX's ability to credit, rather than deduct, certain foreign income taxes for federal income tax purposes when paid in future periods. Deferred tax assets and liabilities resulted from the following: (c) Valuation allowances have been established for certain federal, state and foreign income tax assets. The valuation allowances increased $39 million primarily for certain tax credits and tax loss carryforwards which USX may not fully utilize. M-14 The consolidated tax returns of USX for the years 1988 through 1991 are under various stages of audit and administrative review by the IRS. USX believes it has made adequate provision for income taxes and interest which may become payable for years not yet settled. Pretax income (loss) included $(55) million, $54 million and $155 million attributable to foreign sources in 1993, 1992 and 1991, respectively. 12. TAXES OTHER THAN INCOME TAXES (a) Included a favorable adjustment of $119 million and $20 million in 1992 and 1991, respectively, for prior years' production taxes. 13. RESTRUCTURING CHARGES In 1992, restructuring actions involving the disposition of nonstrategic domestic exploration and production properties, resulted in a $115 million charge to operating income. In 1991, a $24 million restructuring charge resulted from the planned disposition of certain drilling operations and two regulated utility companies. 14. LONG-TERM RECEIVABLES AND OTHER INVESTMENTS The following financial information summarizes the Marathon Group's share in other investments accounted for by the equity method: Marathon Group purchases from equity affiliates totaled $62 million, $57 million and $49 million in 1993, 1992 and 1991, respectively. Marathon Group sales to equity affiliates totaled $21 million, $34 million and $38 million in 1993, 1992 and 1991, respectively. The following financial information summarizes the Marathon Group's Retained Interest in the Delhi Group which is accounted for under the principles of equity accounting (Note 3, page M-9): (a) For period from October 2, 1992 to December 31, 1992. M-15 15. INTERGROUP TRANSACTIONS SALES AND PURCHASES -- Marathon Group sales to the U. S. Steel Group totaled $10 million, $16 million and $14 million in 1993, 1992 and 1991, respectively. Marathon Group purchases from the U.S. Steel Group were not material. Marathon Group sales to the Delhi Group totaled $30 million in 1993 and $8 million from October 2 through December 31, 1992. Marathon Group purchases from the Delhi Group totaled $4 million in 1993 and $2 million from October 2 through December 31, 1992. These transactions were conducted on an arm's-length basis. See Note 19, page M-17 for purchases of Delhi Group accounts receivable. PAYABLE TO THE U. S. STEEL GROUP -- Accounts payable to the U.S. Steel Group totaled $13 million at December 31, 1993 and $41 million at December 31, 1992. These amounts represent payables for income taxes determined in accordance with the tax allocation policy described in Note 3, page M-9. Tax settlements between the groups are generally made in the year succeeding that in which such amounts are accrued. 16. LEASES Future minimum commitments for capital leases and for operating leases having remaining noncancelable lease terms in excess of one year are as follows: Operating lease rental expense: The Marathon Group leases a wide variety of facilities and equipment under operating leases, including land and building space, office equipment, production facilities and transportation equipment. Most long-term leases include renewal options and, in certain leases, purchase options. In the event of a change in control of USX, as defined in the agreements, or certain other circumstances, lease obligations totaling $119 million may be declared immediately due and payable. 17. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment included gross assets acquired under capital leases of $39 million and $38 million at December 31, 1993, and December 31, 1992, respectively; related amounts included in accumulated depreciation, depletion and amortization were $32 million and $29 million, respectively. M-16 18. INVENTORIES Inventories of crude oil and refined products are valued by the LIFO method. The LIFO method accounted for 87% and 91% of total inventory value at December 31, 1993, and December 31, 1992, respectively. The inventory market valuation reserve reflects the extent that the recorded cost of crude oil and refined products inventories exceeds net realizable value. The reserve is decreased to reflect increases in market prices and inventory turnover and increased to reflect decreases in market prices. Changes in the inventory market valuation reserve resulted in charges (credits) to operating income of $241 million, $(62) million and $260 million in 1993, 1992 and 1991, respectively. 19. SALES OF RECEIVABLES The Marathon Group has entered into an agreement, subject to limited recourse, to sell certain accounts receivable including accounts receivable purchased from the Delhi Group. Payments are collected from the sold accounts receivable; the collections are reinvested in new accounts receivable for the buyers; and a yield based on defined short-term market rates is transferred to the buyers. Collections on sold accounts receivable will be forwarded to the buyers at the end of the agreement in 1995, in the event of earlier contract termination or if the Marathon Group does not have a sufficient quantity of eligible accounts receivable to reinvest in for the buyers. The balance of sold accounts receivable averaged $400 million, $393 million and $354 million for the years 1993, 1992 and 1991, respectively. At December 31, 1993, the balance of sold accounts receivable that had not been collected was $400 million. Buyers have collection rights to recover payments from an amount of outstanding receivables equal to 120% of the outstanding receivables purchased on a nonrecourse basis; such overcollateralization cannot exceed $80 million. The Marathon Group does not generally require collateral for accounts receivable, but significantly reduces credit risk through credit extension and collection policies, which include analyzing the financial condition of potential customers, establishing credit limits, monitoring payments and aggressively pursuing delinquent accounts. In the event of a change in control of USX, as defined in the agreement, the Marathon Group may be required to forward payments collected on sold accounts receivable to the buyers. 20. STOCKHOLDERS' EQUITY (a) Reflected the proceeds received from the sale of Delhi Stock to the public of $136 million, net of the Delhi Fraction multiplied by the USX common stockholders' equity of $191 million attributed to the Delhi Group as of October 2, 1992 (Note 3, page M-9). (b) The initial dividend on the Marathon Stock was paid on September 10, 1991. Dividends paid by USX prior to that date were attributed to the Marathon Group and the U. S. Steel Group based upon the relationship of the initial dividends on the Marathon Stock and Steel Stock. M-17 21. DIVIDENDS In accordance with the USX Certificate of Incorporation, dividends on the Marathon Stock, Steel Stock and Delhi Stock are limited to the legally available funds of USX. Net losses of the Marathon Group, the U.S. Steel Group or the Delhi Group, as well as dividends or distributions on any class of USX common stock or series of Preferred Stock and repurchases of any class of USX common stock or certain series of Preferred Stock, will reduce the funds of USX legally available for payment of dividends on all classes of USX common stock. Subject to this limitation, the Board of Directors intends to declare and pay dividends on the Marathon Stock based on the financial condition and results of operation of the Marathon Group, although it has no obligation under Delaware Law to do so. In making its dividend decisions with respect to Marathon Stock, the Board of Directors considers among other things, the long-term earnings and cash flow capabilities of the Marathon Group as well as the dividend policies of similar publicly traded companies. 22. NET INCOME PER COMMON SHARE The method of calculating net income (loss) per share for the Marathon Stock, Steel Stock and Delhi Stock reflects the USX Board of Directors' intent that the separately reported earnings and surplus of the Marathon Group, the U.S. Steel Group and the Delhi Group, as determined consistent with the USX Certificate of Incorporation, are available for payment of dividends to the respective classes of stock, although legally available funds and liquidation preferences of these classes of stock do not necessarily correspond with these amounts. For purposes of computing net income (loss) per share of Marathon Stock for periods prior to May 7, 1991, the numbers of Marathon Stock shares are assumed to be the same as the total corresponding numbers of shares of USX common stock. Primary net income (loss) per share is calculated by adjusting net income (loss) for dividend requirements of preferred stock and is based on the weighted average number of common shares outstanding plus common stock equivalents, provided they are not antidilutive. Common stock equivalents result from assumed exercise of stock options and surrender of stock appreciation rights associated with stock options, where applicable. Fully diluted net income (loss) per share assumes conversion of convertible securities for the applicable periods outstanding and assumes exercise of stock options and surrender of stock appreciation rights, provided, in each case, the effect is not antidilutive. 23. FOREIGN CURRENCY TRANSLATION Exchange adjustments resulting from foreign currency transactions generally are recognized in income, whereas adjustments resulting from translation of financial statements are reflected as a separate component of stockholders' equity. For 1993, 1992 and 1991, respectively, the aggregate foreign currency transaction gains (losses) included in determining net income were $1 million, $16 million and $(1) million. An analysis of changes in cumulative foreign currency translation adjustments follows: 24. STOCK PLANS AND STOCKHOLDER RIGHTS PLAN USX Stock Plans and Stockholder Rights Plan are discussed in Note 20, page U-22, and Note 24, page U-24, respectively, to the USX consolidated financial statements. M-18 25. FAIR VALUE OF FINANCIAL INSTRUMENTS Fair value of the financial instruments disclosed herein is not necessarily representative of the amount that could be realized or settled, nor does the fair value amount consider the tax consequences of realization or settlement. As described in Note 3, page M-8, the Marathon Group's specifically attributed financial instruments and the Marathon Group's portion of USX's financial instruments attributed to all groups are as follows: Fair value of financial instruments classified as current assets or liabilities approximate carrying value due to the short-term maturity of the instruments. Fair value of long-term receivables and other investments was based on discounted cash flows or other specific instrument analysis. Fair value of long-term debt instruments was based on market prices where available or current borrowing rates available for financings with similar terms and maturities. The Marathon Group's unrecognized financial instruments consist of accounts receivables sold subject to limited recourse, financial guarantees and commodity swaps. It is not practicable to estimate the fair value of these forms of financial instrument obligations. For details relating to sales of receivables see Note 19, page M-17. For details relating to financial guarantees see Note 26, page M-20. The contract value of open natural gas commodity swaps totaled $41 million at December 31, 1993. The swap arrangements vary in duration with certain individual contracts extending into early 1996. 26. CONTINGENCIES AND COMMITMENTS USX is the subject of, or party to, a number of pending or threatened legal actions, contingencies and commitments relating to the Marathon Group involving a variety of matters, including laws and regulations relating to the environment. Certain of these matters are discussed below. The ultimate resolution of these contingencies could, individually or in the aggregate, be material to the Marathon Group financial statements. However, management believes that USX will remain a viable and competitive enterprise even though it is possible that these contingencies could be resolved unfavorably to the Marathon Group. ENVIRONMENTAL MATTERS -- The Marathon Group is subject to federal, state, local and foreign laws and regulations relating to the environment. These laws generally provide for control of pollutants released into the environment and require responsible parties to undertake remediation of hazardous waste disposal sites. Penalties may be imposed for noncompliance. The Marathon Group provides for remediation costs and penalties when the responsibility to remediate is probable and the amount of associated costs is reasonably determinable. Generally, the timing of these accruals coincides with completion of a feasibility study or the commitment to a formal plan of action. At December 31, 1993, and December 31, 1992, accrued liabilities for remediation and platform abandonment totaled $161 million and $138 million, respectively. It is not presently possible to estimate the ultimate amount of all remediation costs that might be incurred or the penalties that may be imposed. For a number of years, the Marathon Group has made substantial capital expenditures to bring existing facilities into compliance with various laws relating to the environment. In 1993 and 1992, such capital expenditures totaled $123 million and $240 million, respectively. The Marathon Group anticipates making additional such expenditures in the future; however, the exact amounts and timing of such expenditures are uncertain because of the continuing evolution of specific regulatory requirements. M-19 LIBYAN OPERATIONS -- By reason of Executive Orders and related regulations under which the U.S. Government is continuing economic sanctions against Libya, the Marathon Group was required to discontinue performing its Libyan petroleum contracts on June 30, 1986. In June 1989, the Department of the Treasury authorized the Marathon Group to resume performing under those contracts. Pursuant to that authorization, the Marathon Group has engaged the Libyan National Oil Company and the Secretary of Petroleum in continuing negotiations to determine when and on what basis they are willing to allow the Marathon Group to resume realizing revenue from the Marathon Group's investment of $108 million in Libya. The Marathon Group is uncertain when these negotiations can be completed or how the negotiations will be affected by the United Nations sanctions against Libya. GUARANTEES -- Guarantees by USX of the liabilities of affiliated and other entities of the Marathon Group totaled $18 million and $12 million at December 31, 1993, and December 31, 1992, respectively. At December 31, 1993, and December 31, 1992, the Marathon Group's pro rata share of obligations of LOOP INC. and various pipeline affiliates secured by throughput and deficiency agreements totaled $206 million and $216 million, respectively. Under the agreements, the Marathon Group is required to advance funds if the affiliates are unable to service debt. Any such advances are prepayments of future transportation charges. COMMITMENTS -- At December 31, 1993, and December 31, 1992, contract commitments for the Marathon Group's capital expenditures for property, plant and equipment totaled $284 million and $360 million, respectively. Principal Unconsolidated Affiliates (Unaudited) (a) Ownership interest as of December 31, 1993. Supplementary Information on Oil and Gas Producing Activities (Unaudited) See the USX consolidated financial statements for Supplementary Information on Oil and Gas Producing Activities relating to the Marathon Group, pages U-29 through U-32. M-20 Selected Quarterly Financial Data (Unaudited) (a) Reflects a $15 million decrease in the loss for a reclassification with no effect on net income. (b) Restated to reflect fourth quarter implementation of SFAS No. 112 and EITF No. 93-14 (Note 2, page M-7). Net income declined $23 million reflecting the cumulative effect of the changes in accounting principles determined as of January 1, 1993. (c) Composite tape. M-21 Five-Year Operating Summary (a) The Indianapolis Refinery was temporarily idled in October 1993. M-22 THE MARATHON GROUP Management's Discussion and Analysis The Marathon Group includes Marathon Oil Company ("Marathon"), a wholly owned subsidiary of USX Corporation ("USX"), which is engaged in worldwide exploration, production, transportation and marketing of crude oil and natural gas; and domestic refining, marketing and transportation of petroleum products. Management's Discussion and Analysis should be read in conjunction with the Marathon Group's Financial Statements and Notes to Financial Statements. Prior to October 2, 1992, the Marathon Group also included the businesses of Delhi Gas Pipeline Corporation and certain other USX subsidiaries engaged in the purchasing, gathering, processing, transporting and marketing of natural gas which are now included in the Delhi Group. The Marathon Group financial data for the periods prior to October 2, 1992, include the combined historical financial position, results of operations and cash flows for the businesses of the Delhi Group. Beginning October 2, 1992, the financial statements of the Marathon Group do not include the financial position, results of operations and cash flows for the businesses of the Delhi Group except for the financial effects of the Retained Interest (see Note 3 to the Marathon Group Financial Statements). MANAGEMENT'S DISCUSSION AND ANALYSIS OF INCOME SALES declined $820 million in 1993 from 1992, following a $1.2 billion decrease in 1992 from 1991. The 1993 decline primarily reflected lower worldwide liquid hydrocarbon volumes and prices, lower average refined product prices and the absence of sales from the Delhi Group. These decreases were partially offset by increased excise taxes and higher refined product sales volumes, excluding matching buy/sell transactions. The decrease in 1992 from 1991 was mainly due to lower average refined product prices, reduced volumes and prices for crude oil matching buy/sell transactions and lower worldwide liquid hydrocarbon volumes. Matching buy/sell transactions and excise taxes are included in both sales and operating costs, resulting in no effect on operating income. OPERATING INCOME decreased $135 million in 1993, following a $54 million decline in 1992 from 1991. Results in 1993 and 1991 were adversely affected, while 1992 was favorably affected, by special items (see Management's Discussion and Analysis of Operations). Excluding the effects of these special items, operating income in 1993 increased $172 million from 1992, mainly due to increased average refined product margins and increased domestic natural gas prices, partially offset by lower worldwide liquid hydrocarbon prices and volumes. Operating income declined $384 million in 1992 from 1991, excluding the special items, predominantly due to lower average refined product margins, as well as reduced worldwide liquid hydrocarbon prices and volumes and decreased international natural gas prices. OTHER INCOME was $46 million in 1993, compared with a loss of $7 million in 1992 and income of $30 million in 1991. In addition to the absence of a $19 million impairment of an investment recorded in 1992, other income in 1993 increased primarily due to gains from disposal of assets totaling $34 million, which mainly reflected the sale of assets of a convenience store wholesale distributor, two tug/barge units and various domestic oil and gas production properties. Other income decreased $37 million in 1992 from 1991 primarily reflecting the investment impairment and lower gains from disposal of assets. INTEREST AND OTHER FINANCIAL INCOME was $22 million in 1993, compared with $210 million in 1992 and $18 million in 1991. The 1992 amount included $177 million of interest income resulting from the settlement of a tax refund claim related to prior years' production taxes. INTEREST AND OTHER FINANCIAL COSTS were $292 million in 1993, $306 million in 1992 and $341 million in 1991. The decrease in 1993 from 1992 mainly reflected higher capitalized interest for international projects, predominantly offset by higher interest costs related to increased levels of debt. The 1991 amount included a $26 million favorable adjustment related to interest accrued for prior years' production taxes. Excluding this item, the 1992 decrease from 1991 mainly reflected a decline in variable interest rates, higher capitalized interest and lower average debt levels. M-23 Management's Discussion and Analysis CONTINUED THE CREDIT FOR ESTIMATED INCOME TAXES in 1993 was $49 million, compared to provisions of $92 million in 1992 and $136 million in 1991. The 1993 U.S. income tax credit included an incremental deferred tax benefit of $64 million resulting from USX's ability to elect to credit, rather than deduct, certain foreign income taxes for U. S. federal income tax purposes when paid in future years. The anticipated use of the U. S. foreign tax credit reflects the Marathon Group's improving international production profile including income which will be generated by the East Brae platform in the United Kingdom ("U.K.") sector of the North Sea. The 1993 U. S. income tax credit also included a $40 million charge associated with an increase in the federal income tax rate from 34% to 35%, reflecting remeasurement of deferred federal income tax liabilities as of January 1, 1993. THE TOTAL LOSS BEFORE CUMULATIVE EFFECT OF CHANGES IN ACCOUNTING PRINCIPLES was $6 million in 1993, compared to income of $109 million in 1992 and a loss of $71 million in 1991. THE UNFAVORABLE CUMULATIVE EFFECT OF CHANGES IN ACCOUNTING PRINCIPLES totaled $23 million in 1993 and $331 million in 1992. The cumulative effect of adopting Statement of Financial Accounting Standards No. 112 - Employers' Accounting for Postemployment Benefits, determined as of January 1, 1993, decreased 1993 income by $17 million, net of the income tax effect. The cumulative effect of adopting Emerging Issues Task Force Consensus No. 93-14 - Accounting for Multiple-Year Retrospectively Rated Insurance Contracts, determined as of January 1, 1993, decreased 1993 income by $6 million, net of the income tax effect. The immediate recognition of the transition obligation resulting from the adoption of Statement of Financial Accounting Standards No. 106 - Employers' Accounting for Postretirement Benefits Other Than Pensions, measured as of January 1, 1992, decreased 1992 income by $147 million, net of the income tax effect. The cumulative effect of adopting Statement of Financial Accounting Standards No. 109 - Accounting for Income Taxes, measured as of January 1, 1992, decreased 1992 net income by $184 million. A NET LOSS of $29 million was recorded in 1993, compared to a net loss of $222 million in 1992 and a net loss of $71 million in 1991. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION CURRENT ASSETS declined $336 million from year-end 1992. The decline was mainly due to lower inventories and receivables, partially offset by an increase in cash and cash equivalents. The decrease in inventories was mainly due to a reduction in inventory values, which reflected a $241 million increase in the inventory market valuation reserve. This reserve reflects the extent to which the recorded cost of crude oil and refined product inventories exceeds net realizable value. Subsequent changes to the inventory market valuation reserve are dependent on changes in future crude oil and refined product price levels and inventory turnover. The reduction in accounts receivable primarily resulted from lower selling prices of crude oil and refined products, decreased forward currency hedging activities and reduced receivables from partners in international joint venture activities. The decrease in receivables related to currency hedging and joint venture activities was largely offset by a related decrease in accounts payable. CURRENT LIABILITIES declined $610 million in 1993. The reduction was primarily due to reduced accounts payable and long-term debt due within one year. The reduction in accounts payable was largely due to a decrease in trade payables caused mainly by lower crude oil purchase prices and volumes, decreased forward currency hedging activities and reduced trade payables for international joint venture activities. The decrease in payables related to currency hedging and joint venture activities was largely offset by a related decrease in accounts receivable. M-24 Management's Discussion and Analysis CONTINUED TOTAL LONG-TERM DEBT AND NOTES PAYABLE at December 31, 1993, was $4.3 billion. The $287 million increase from year-end 1992 was primarily due to capital expenditures, dividend payments and an increase in cash and cash equivalents from year-end 1992, partially offset by cash provided from operating activities and disposal of assets. The amount of total long-term debt, as well as the amount shown as notes payable, principally represented the Marathon Group's portion of USX debt attributed to all three groups. Virtually all of the debt is a direct obligation of, or is guaranteed by, USX. STOCKHOLDERS' EQUITY of $3,110 million at year-end 1993 declined $225 million from year-end 1992 mainly reflecting dividends paid on USX-Marathon Group Common Stock ("Marathon Stock"). MANAGEMENT'S DISCUSSION AND ANALYSIS OF CASH FLOWS THE MARATHON GROUP'S NET CASH PROVIDED FROM OPERATING ACTIVITIES totaled $827 million in 1993, down 17% from 1992. Results in 1992 included $296 million associated with the refund of prior years' production taxes. Excluding the impact of this item, net cash provided from operating activities in 1993 improved $128 million mainly due to the impact of improved average refined product margins on operating results. Net cash provided from operating activities in 1992 declined $315 million from 1991, excluding the previously mentioned tax refund, mainly due to the decrease in income. CAPITAL EXPENDITURES of $910 million in 1993 decreased $283 million from 1992, following an increase of $233 million from 1991. The decrease in 1993 mainly reflected decreased expenditures for environmental projects and for development of the East Brae Field and SAGE system in the U.K. and other international projects, partially offset by increased exploration drilling and development projects in the Gulf of Mexico and increased drilling activity for onshore domestic natural gas projects. Contract commitments for capital expenditures at year-end 1993 were $284 million, compared with $360 million at year-end 1992. Capital expenditures are expected to decrease in 1994 by approximately $100 million mainly reflecting decreased expenditures for development of the East Brae Field and SAGE system. CASH FROM DISPOSAL OF ASSETS was $174 million in 1993, a significant increase over $77 million in 1992 and $52 million in 1991. The 1993 proceeds primarily reflected the sale/leaseback of interests in two LNG tankers and the sales of various domestic oil and gas production properties, assets of a convenience store wholesale distributor and two tug/barge units. No individually significant sales transactions occurred in 1992 or 1991. PROCEEDS FROM ISSUANCE OF USX-DELHI GROUP COMMON STOCK by USX were $5 million in 1993 and $122 million in 1992, net of cash attributed to the Delhi Group. FINANCIAL OBLIGATIONS increased $261 million, compared with a decrease of $426 million in 1992, and an increase of $160 million in 1991. The amount by which the obligations changed in 1993 was primarily a reflection of the Marathon Group's net cash flows from operating activities, investment activities and dividends paid during the period. These obligations consist of the Marathon Group's portion of USX debt attributed to all three groups as well as debt and production financing and other agreements that are specifically attributed to the Marathon Group. MARATHON STOCK ISSUED, net of repurchases, totaled $595 million in 1992 and $67 million in 1991. The 1992 amount mainly reflected the sale of 25,000,000 shares of Marathon Stock to the public for net proceeds of $541 million, which were reflected in their entirety in the Marathon Group financial statements. The 1991 amount primarily reflected stock issued to employee savings plans. M-25 Management's Discussion and Analysis CONTINUED DIVIDEND PAYMENTS decreased $139 million in 1993, after a $13 million increase in 1992. The decline in 1993 was primarily due to a decrease in the Marathon Stock dividend rate which was reduced in the fourth quarter of 1992. The slight increase in 1992 reflected the incremental dividends paid on Marathon Stock shares sold in January 1992 which were partially offset by the decrease in the dividend rate. Dividends attributed to the Marathon Stock prior to September 10, 1991, were based on the relationship of the initial dividends of the Marathon Stock and the USX-U. S. Steel Group Common Stock. The annualized rate of dividends per share for the Marathon Stock based on the most recently declared quarterly dividend is $.68. In September 1993, Standard & Poor's Corp. ("S&P") lowered its ratings on USX's and Marathon's senior debt to below investment grade (from BBB- to BB+) and on USX's subordinated debt, preferred stock and commercial paper. S&P cited extremely aggressive financial leverage, burdensome retiree medical liabilities and litigation contingencies. In October 1993, Moody's Investors Services, Inc. ("Moody's") confirmed its Baa3 investment grade ratings on USX's and Marathon's senior debt. Moody's also confirmed its ratings on USX's subordinated debt and commercial paper, but lowered its ratings on USX's preferred stock from ba1 to ba2. Moody's noted that the rating confirmation on USX debt securities reflected confidence in the expected performance of USX during the intermediate term, while the downward revision of the preferred stock ratings incorporated a narrow fixed charge coverage going forward. The downgrades by S&P and the downgrade of ratings on preferred stock by Moody's could increase USX's cost of capital. Any related increase in interest costs would be reflected in the consolidated financial statements and the financial statements of each group. MANAGEMENT'S DISCUSSION AND ANALYSIS OF ENVIRONMENTAL MATTERS, LITIGATION AND CONTINGENCIES The Marathon Group has incurred and will continue to incur substantial capital, operating and maintenance, and remediation expenditures as a result of environmental laws and regulations. In recent years, these expenditures have increased primarily due to required product reformulation and process changes in order to meet Clean Air Act obligations, although ongoing compliance costs have also been significant. To the extent these expenditures, as with all costs, are not ultimately reflected in the prices of the Marathon Group's products and services, operating results will be adversely affected. The Marathon Group believes that substantially all of its competitors are subject to similar environmental laws and regulations. However, the specific impact on each competitor may vary depending on a number of factors, including the age and location of their operating facilities, their production processes and whether or not they are engaged in the petrochemical business or the marine transportation of crude oil. The Marathon Group's environmental expenditures for 1993 and 1992 are discussed below and have been estimated based on American Petroleum Institute ("API") survey guidelines. These guidelines are subject to differing interpretations which could affect the comparability of such data. Some environmental related expenditures, while benefiting the environment, also enhance operating efficiencies. Total environmental expenditures for the Marathon Group in 1993 were $253 million compared with $370 million in 1992. These amounts consisted of capital expenditures of $123 million in 1993 and $240 million in 1992 and estimated compliance expenditures (including operating and maintenance) of $130 million in both 1993 and 1992. Compliance expenditures were broadly estimated based on API survey guidelines and represented 1% of the Marathon Group's total operating costs in both 1993 and 1992. The decline in environmental capital expenditures from 1992 to 1993 primarily reflected lower expenditures for the Marathon Group's multi-year capital projects for diesel fuel desulfurization. By the end of 1993, these projects were substantially completed. M-26 Management's Discussion and Analysis CONTINUED USX has been notified that it is a potentially responsible party ("PRP") at 14 waste sites related to the Marathon Group under the Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA") as of December 31, 1993. In addition, there are 22 sites related to the Marathon Group where USX has received information requests or other indications that USX may be a PRP under CERCLA but where sufficient information is not presently available to confirm the existence of liability or make any judgment as to the amount thereof. There are also 52 additional sites, excluding retail gasoline stations, related to the Marathon Group where state governmental agencies or private parties are seeking remediation under state environmental laws through discussions or litigation. At many of these sites, USX is one of a number of parties involved and the total cost of remediation, as well as USX's share thereof, is frequently dependent upon the outcome of investigations and remedial studies. Total environmental expenditures included remediation related expenditures estimated at $38 million in 1993 and $35 million in 1992. Remediation spending was primarily related to retail gasoline stations which incur ongoing clean-up costs for soil and groundwater contamination associated with underground storage tanks and piping. The Marathon Group accrues for environmental remediation activities when the responsibility to remediate is probable and the amount of associated costs is reasonably determinable. As environmental remediation matters proceed toward ultimate resolution or as additional remediation obligations arise, charges in excess of those previously accrued may be required. See Note 26 to the Marathon Group Financial Statements. New or expanded requirements for environmental regulations, which could increase the Marathon Group's environmental costs, may arise in the future. USX intends to comply with all legal requirements regarding the environment, but since many of them are not fixed or presently determinable (even under existing legislation) and may be affected by future legislation, it is not possible to accurately predict the ultimate cost of compliance, including remediation costs which may be incurred and penalties which may be imposed. However, based on presently available information, and existing laws and regulations as currently implemented, the Marathon Group does not anticipate that environmental compliance expenditures will materially increase in 1994. The Marathon Group's capital expenditures for environmental controls are expected to be approximately $75 million in 1994. Predictions beyond 1994 can only be broad-based estimates which have varied, and will continue to vary, due to the ongoing evolution of specific regulatory requirements, the possible imposition of more stringent requirements and the availability of new technologies, among other matters. Based upon currently identified projects, the Marathon Group anticipates that environmental capital expenditures will be approximately $60 million in 1995; however, actual expenditures may increase as additional projects are identified or additional requirements are imposed. USX is the subject of, or party to, a number of pending or threatened legal actions, contingencies and commitments relating to the Marathon Group involving a variety of matters, including laws and regulations relating to the environment, certain of which are discussed in Note 26 to the Marathon Group Financial Statements. The ultimate resolution of these contingencies could, individually or in the aggregate, be material to the Marathon Group financial statements. However, management believes that USX will remain a viable and competitive enterprise even though it is possible that these contingencies could be resolved unfavorably to the Marathon Group. See USX Consolidated Management's Discussion and Analysis of Cash Flows. M-27 Management's Discussion and Analysis CONTINUED MANAGEMENT'S DISCUSSION AND ANALYSIS OF OPERATIONS The Marathon Group had operating income of $169 million in 1993, compared with $304 million in 1992 and $358 million in 1991. Results for 1993 and 1991 were adversely affected, while 1992 was favorably affected, by special items. Results included a $241 million unfavorable effect in 1993, a $62 million favorable effect in 1992 and a $260 million unfavorable effect in 1991 resulting from noncash adjustments to the inventory market valuation reserve. The 1992 results also included a favorable impact of $119 million for the settlement of a tax refund claim related to prior years' production taxes, partially offset by a $115 million restructuring charge related to the disposition of certain domestic exploration and production properties. The 1991 results also included a $24 million restructuring charge, partially offset by a favorable $20 million adjustment of prior years' production tax accruals. Excluding the effects of these special items, operating income was $410 million in 1993, $238 million in 1992 and $622 million in 1991. The increase in 1993 primarily reflected increased average refined product margins and increased domestic natural gas prices, partially offset by lower worldwide liquid hydrocarbon prices and volumes. The decrease in 1992 predominantly reflected lower average refined product margins, as well as reduced worldwide liquid hydrocarbon prices and volumes and a decrease in international natural gas prices. OPERATING INCOME (LOSS) Certain reclassifications have been made to conform to 1993 classifications. AVERAGE VOLUMES AND SELLING PRICES Includes Crude Oil, Condensate and Natural Gas Liquids. M-28 Management's Discussion and Analysis CONTINUED Upstream operating income decreased $92 million in 1993, following an $88 million decrease in 1992. Operating income in 1992 included a $20 million gain recognized as a result of a settlement of a natural gas contract. Excluding this settlement, the decline in 1993 was mainly due to significant decreases in worldwide liquid hydrocarbon prices and volumes and lower international natural gas prices, partially offset by increased domestic natural gas prices. The decline in 1992, excluding this contract settlement, was also primarily caused by decreases in worldwide liquid hydrocarbon prices and volumes and lower international natural gas prices, partially offset by ongoing cost reduction efforts. Domestic upstream operating income in 1993 declined $6 million from 1992, following a $19 million increase in 1992 from 1991. Excluding the previously mentioned contract settlement, the 14% increase in 1993 was primarily due to increased natural gas prices and reduced dry well expenses, partially offset by reduced liquid hydrocarbon prices and volumes. In addition, operating income in 1993 reflected ongoing cost reduction efforts and reduced depletion expenses. The results in 1992, excluding the previously mentioned contract settlement, remained level with 1991, as ongoing cost reduction efforts and reduced exploration expenses were offset by lower liquid hydrocarbon prices. International upstream operating income declined $86 million in 1993, following a $107 million decline in 1992. Natural gas prices have declined 30% since 1991, primarily reflecting changes in contract sales prices in Norway. The decrease in 1993 was primarily due to lower liquid hyrdocarbon prices, reduced liftings primarily from the U.K. sector of the North Sea as a result of natural production declines, lower natural gas prices, and a $17 million charge for the relinquishment of the Marathon Group's interest in the Arzanah Oil Field, Abu Dhabi. The decrease was partially offset by reduced pipeline and terminal expenses and reduced dry well expenses. The decrease in 1992 was primarily due to lower natural gas prices, lower liquid hydrocarbon liftings and increased dry well expenses. In December 1993, the East Brae Field in the U.K. North Sea was brought onstream. East Brae liquids production is expected to peak at 45,000 net barrels per day in the fourth quarter of 1994. Worldwide liquid volumes are expected to increase approximately 15% in 1994, reflecting a full year of East Brae production, which should continue to contribute to increased volumes in 1995. Worldwide natural gas volumes are expected to increase approximately 5% in 1994, reflecting the start of Brae area gas sales in October 1994. The 1995 volumes are expected to continue to increase reflecting a full year of Brae area production. In 1992, Marathon and its partners finalized and delivered a feasibility study to the Russian Government assessing the technical and economic viability of developing fields offshore Sakhalin Island. After positive review by the State Expertise Commission in 1993, negotiations to sign a production sharing contract are currently being held among the Russian Government and representatives of the consortium. Downstream operating income increased $279 million in 1993, after decreasing $294 million in 1992. The increase in 1993 was primarily due to increased average refined product margins from refining and wholesale marketing which nearly doubled since 1992 as a result of decreased crude oil costs and lower maintenance costs for refinery turnaround activities, partially offset by decreased average refined product prices. Also contributing to the increase in operating income were record margins in both refined products and convenience store merchandise experienced by Emro Marketing Company, a Marathon subsidiary. Downstream operating income in 1993 also included a $17 million charge for future environmental remediation. The decrease in 1992 was chiefly the result of lower average refined product margins which were adversely impacted as declines in average refined product sales prices exceeded decreases in raw material costs. Results in 1992 were also negatively affected by increased maintenance costs as a result of planned refinery turnaround activities. In 1993, the Marathon Group temporarily idled its 50,000 barrels-per-day Indianapolis Refinery to enhance the efficiency of downstream operations. Idling of the Indianapolis facility will have no impact on the Marathon Group's supply of transportation fuels to its various classes of trade in Indiana or the Midwest marketing area. The costs related to the idling did not have a material effect on the Marathon Group's 1993 operating results. M-29 Management's Discussion and Analysis CONTINUED Gas Gathering and Processing results decreased due to the exclusion of the businesses now in the Delhi Group. Other Administrative expenses were $77 million in 1993, compared to $83 million in 1992 and $90 million in 1991. These costs include the portion of the Marathon Group's administrative costs not allocated to the individual business components and the portion of USX corporate general and administrative costs allocated to the Marathon Group. The outlook regarding prices and costs for the Marathon Group's principal products is largely dependent upon world market developments for crude oil and refined products. Market conditions in the petroleum industry are cyclical and subject to global economic and political events. M-30 U.S. Steel Group Index to Financial Statements, Supplementary Data and Management's Discussion and Analysis S-1 U. S. Steel Group Explanatory Note Regarding Financial Information Although the financial statements of the U. S. Steel Group, the Marathon Group and the Delhi Group separately report the assets, liabilities (including contingent liabilities) and stockholders' equity of USX attributed to each such group, such attribution does not affect legal title to such assets and responsibility for such liabilities. Holders of USX-U.S. Steel Group Common Stock, USX-Marathon Group Common Stock and USX-Delhi Group Common Stock are holders of common stock of USX and continue to be subject to all the risks associated with an investment in USX and all of its businesses and liabilities. Financial impacts arising from any of the U.S. Steel Group, the Marathon Group or the Delhi Group which affect the overall cost of USX's capital could affect the results of operations and financial condition of all groups. In addition, net losses of any group, as well as dividends or distributions on any class of USX common stock or series of Preferred Stock and repurchases of any class of USX common stock or certain series of Preferred Stock, will reduce the funds of USX legally available for payment of dividends on all classes of USX common stock. Accordingly, the USX consolidated financial information should be read in connection with the U.S. Steel Group financial information. S-2 Management's Report The accompanying financial statements of the U. S. Steel Group are the responsibility of and have been prepared by USX Corporation (USX) in conformity with generally accepted accounting principles. They necessarily include some amounts that are based on best judgments and estimates. The U. S. Steel Group financial information displayed in other sections of this report is consistent with that in these financial statements. USX seeks to assure the objectivity and integrity of its financial records by careful selection of its managers, by organizational arrangements that provide an appropriate division of responsibility and by communications programs aimed at assuring that its policies and methods are understood throughout the organization. USX has a comprehensive formalized system of internal accounting controls designed to provide reasonable assurance that assets are safeguarded and that financial records are reliable. Appropriate management monitors the system for compliance, and the internal auditors independently measure its effectiveness and recommend possible improvements thereto. In addition, as part of their audit of the financial statements, USX's independent accountants, who are elected by the stockholders, review and test the internal accounting controls selectively to establish a basis of reliance thereon in determining the nature, extent and timing of audit tests to be applied. The Board of Directors pursues its oversight role in the area of financial reporting and internal accounting control through its Audit Committee. This Committee, composed solely of nonmanagement directors, regularly meets (jointly and separately) with the independent accountants, management and internal auditors to monitor the proper discharge by each of its responsibilities relative to internal accounting controls and the consolidated and group financial statements. Report of Independent Accountants To the Stockholders of USX Corporation: In our opinion, the accompanying financial statements appearing on pages S-4 through S-20 and as listed in Item 14.A.2 on page 61 of this report present fairly, in all material respects, the financial position of the U. S. Steel Group at December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of USX's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. As discussed in Note 26, page S-19, the U. S. Steel Group is involved in certain contingencies, the outcome of which cannot presently be determined. As discussed in Note 2, page S-7, in 1993 USX adopted a new accounting standard for postemployment benefits. As discussed in Note 11, page S-13, and Note 12, page S-14, in 1992 USX adopted new accounting standards for postretirement benefits other than pensions and for income taxes, respectively. The U. S. Steel Group is a business unit of USX Corporation (as described in Note 1, page S-7); accordingly, the financial statements of the U. S. Steel Group should be read in connection with the consolidated financial statements of USX Corporation and Subsidiary Companies. Price Waterhouse 600 Grant Street, Pittsburgh, Pennsylvania 15219-2794 February 8, 1994 S-3 Statement of Operations See Note 22, page S-18, for a description of net income per common share. The accompanying notes are an integral part of these financial statements. S-4 Balance Sheet The accompanying notes are an integral part of these financial statements. S-5 Statement of Cash Flows See Note 8, page S-10, for supplemental cash flow information. The accompanying notes are an integral part of these financial statements. S-6 Notes to Financial Statements 1. BASIS OF PRESENTATION USX Corporation (USX) has three classes of common stock: USX -- U. S. Steel Group Common Stock (Steel Stock), USX -- Marathon Group Common Stock (Marathon Stock) and USX -- Delhi Group Common Stock (Delhi Stock), which are intended to reflect the performance of the U. S. Steel Group, the Marathon Group and the Delhi Group, respectively. The financial statements of the U. S. Steel Group include the financial position, results of operations and cash flows for all businesses of USX other than the businesses, assets and liabilities included in the Marathon Group or the Delhi Group, and a portion of the corporate assets and liabilities and related transactions which are not separately identified with ongoing operating units of USX. The U. S. Steel Group, which consists primarily of steel operations, includes one of the largest domestic integrated steel producers and is primarily engaged in the production and sale of a wide range of steel mill products, coke and taconite pellets. The U. S. Steel Group also includes the management of mineral resources, domestic coal mining, and engineering and consulting services and technology licensing. Other businesses that are part of the U. S. Steel Group include real estate development and management, fencing products, leasing and financing activities, and a majority interest in a titanium metal products company. The U. S. Steel Group financial statements are prepared using the amounts included in the USX consolidated financial statements. Although the financial statements of the U. S. Steel Group, the Marathon Group and the Delhi Group separately report the assets, liabilities (including contingent liabilities) and stockholders' equity of USX attributed to each such group, such attribution does not affect legal title to such assets and responsibility for such liabilities. Holders of Steel Stock, Marathon Stock and Delhi Stock are holders of common stock of USX and continue to be subject to all the risks associated with an investment in USX and all of its businesses and liabilities. Financial impacts arising from any of the U. S. Steel Group, the Marathon Group or the Delhi Group which affect the overall cost of USX's capital could affect the results of operations and financial condition of all groups. In addition, net losses of any group, as well as dividends or distributions on any class of USX common stock or series of Preferred Stock and repurchases of any class of USX common stock or certain series of Preferred Stock, will reduce the funds of USX legally available for payment of dividends on all classes of common stock. Accordingly, the USX consolidated financial information should be read in connection with the U. S. Steel Group financial information. 2. SUMMARY OF PRINCIPAL ACCOUNTING POLICIES PRINCIPLES APPLIED IN CONSOLIDATION - These financial statements include the accounts of the U. S. Steel Group. The U. S. Steel Group, the Marathon Group and the Delhi Group financial statements, taken together, comprise all of the accounts included in the USX consolidated financial statements. Investments in other entities in which the U. S. Steel Group has significant influence in management and control are accounted for using the equity method of accounting and are carried in the investment account at the U. S. Steel Group's share of net assets plus advances. The proportionate share of income from equity investments is included in other income. Investments in marketable equity securities are carried at lower of cost or market and investments in other companies are carried at cost, with income recognized when dividends are received. NEW ACCOUNTING STANDARDS - The following accounting standard was adopted by USX during 1993: Postemployment benefits - Effective January 1, 1993, USX adopted Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" (SFAS No. 112). SFAS No. 112 requires employers to recognize the obligation to provide postemployment benefits on an accrual basis if certain conditions are met. The U. S. Steel Group is affected primarily by disability- related claims covering indemnity and medical payments. The obligation for these claims is measured using actuarial techniques and assumptions including appropriate discount rates. The cumulative effect of the change in accounting principle determined as of January 1, 1993, reduced net income $69 million, net of $40 million income tax effect. The effect of the change in accounting principle reduced 1993 operating income by $21 million. S-7 USX has not adopted Statement of Financial Accounting Standards No. 114, "Accounting by Creditors for Impairment of a Loan" (SFAS No. 114). SFAS No. 114 requires impairment of loans based on either the sum of discounted cash flows or the fair value of underlying collateral. USX expects to adopt SFAS No. 114 in the first quarter of 1995. Based on preliminary estimates, USX expects the unfavorable effect of adopting SFAS No. 114 for the U. S. Steel Group will be less than $2 million. CASH AND CASH EQUIVALENTS -- Cash and cash equivalents includes cash on hand and on deposit and highly liquid debt instruments with maturities generally of three months or less. INVENTORIES -- Inventories are carried at lower of cost or market. Cost of inventories is determined primarily under the last-in, first-out (LIFO) method. HEDGING TRANSACTIONS -- Commodity swaps are used to hedge exposure to price fluctuations relevant to the purchase of natural gas. Such transactions are accounted for as part of the commodity being hedged. Forward contracts are used to hedge currency risks, and the accounting is based on the requirements of Statement of Financial Accounting Standards No. 52. PROPERTY, PLANT AND EQUIPMENT -- Depreciation is generally computed using a modified straight-line method based upon estimated lives of assets and production levels. In 1992, the U. S. Steel Group revised the modification factors used in the depreciation of steel producing assets accounted for by the modified straight-line method to reflect that raw steel production capability is entirely continuous cast. The revised modification factors range from a minimum of 85% at a production level below 81% of capability, to a maximum of 105% for a 100% production level. No modification is made at the 95% production level, considered the normal long-range level. Depletion of mineral properties is based on rates which are expected to amortize cost over the estimated tonnage of minerals to be removed. When an entire plant, major facility or facilities depreciated on an individual basis are sold or otherwise disposed of, any gain or loss is reflected in income. Proceeds from disposal of other facilities depreciated on a group basis are credited to the depreciation reserve with no immediate effect on income. INSURANCE -- The U. S. Steel Group is insured for catastrophic casualty and certain property and business interruption exposures, as well as those risks required to be insured by law or contract. Costs resulting from noninsured losses are charged against income upon occurrence. RECLASSIFICATIONS -- Certain reclassifications of prior years' data have been made to conform to 1993 classifications. 3. CORPORATE ACTIVITIES FINANCIAL ACTIVITIES -- As a matter of policy, USX manages most financial activities on a centralized, consolidated basis. Such financial activities include the investment of surplus cash; the issuance, repayment and repurchase of short-term and long-term debt; the issuance, repurchase and redemption of preferred stock; and the issuance and repurchase of common stock. Transactions related primarily to invested cash, short-term and long-term debt (including convertible debt), related net interest and other financial costs, and preferred stock and related dividends are attributed to the U. S. Steel Group, the Marathon Group and the Delhi Group based upon the cash flows of each group for the periods presented and the initial capital structure of each group. Most financing transactions are attributed to and reflected in the financial statements of all three groups. See Note 6, page S-9, for the U. S. Steel Group's portion of USX's financial activities attributed to all three groups. However, certain transactions such as leases, production payment financings, financial activities of consolidated entities which are less than wholly owned by USX and transactions related to securities convertible solely into any one class of common stock are or will be specifically attributed to and reflected in their entirety in the financial statements of the group to which they relate. CORPORATE GENERAL & ADMINISTRATIVE COSTS -- Corporate general and administrative costs are allocated to the U. S. Steel Group, the Marathon Group and the Delhi Group based upon utilization or other methods management believes to be reasonable and which consider certain measures of business activities, such as employment, investments and sales. The costs allocated to the U. S. Steel Group were $33 million in both 1993 and 1992, and $45 million in 1991, and primarily consist of employment costs including pension effects, professional services, facilities and other related costs associated with corporate activities. COMMON STOCK TRANSACTIONS -- All financial statement impacts of purchases and issuances of Steel Stock after the change of USX common stock into Marathon Stock and the distribution of Steel Stock on May 6, 1991, are reflected in their entirety in the U. S. Steel Group financial statements. Financial statement impacts of treasury stock transactions occurring before May 7, 1991, have been attributed to the two groups in relationship to their respective common equity. The initial dividend on the Steel S-8 Stock was paid on September 10, 1991. Dividends paid by USX prior to September 10, 1991, were attributed to the U. S. Steel Group and the Marathon Group based upon the relationship of the initial dividends on the Steel Stock and Marathon Stock. INCOME TAXES -- All members of the USX affiliated group are included in the consolidated United States federal income tax return filed by USX. Accordingly, the provision for federal income taxes and the related payments or refunds of tax are determined on a consolidated basis. The consolidated provision and the related tax payments or refunds have been reflected in the U. S. Steel Group, the Marathon Group and the Delhi Group financial statements in accordance with USX's tax allocation policy. In general, such policy provides that the consolidated tax provision and related tax payments or refunds are allocated among the U. S. Steel Group, the Marathon Group and the Delhi Group, for group financial statement purposes, based principally upon the financial income, taxable income, credits, preferences and other amounts directly related to the respective groups. For tax provision and settlement purposes, tax benefits resulting from attributes (principally net operating losses), which cannot be utilized by one of the three groups on a separate return basis but which can be utilized on a consolidated basis in that year or in a carryback year, are allocated to the group that generated the attributes. However, if such tax benefits cannot be utilized on a consolidated basis in that year or in a carryback year, the prior years' allocation of such consolidated tax effects is adjusted in a subsequent year to the extent necessary to allocate the tax benefits to the group that would have realized the tax benefits on a separate return basis. The allocated group amounts of taxes payable or refundable are not necessarily comparable to those that would have resulted if the groups had filed separate tax returns; however, such allocation should not result in any of the three groups paying more income taxes over time than it would if it filed separate tax returns, and in certain situations, could result in any of the three groups paying less. 4. RESTRUCTURING CHARGES The 1993 restructuring action involving the planned closure of a Pennsylvania coal mine resulted in a $42 million charge to operating income, primarily related to the writedown of property, plant and equipment, contract termination, and mine closure cost. A $10 million restructuring charge for the completion of the 1991 restructuring plan related to steel operations reduced operating income in 1992. The 1991 restructuring actions resulted in a $402 million charge to operating income, primarily related to write-downs of property, plant and equipment and employee costs related to the permanent closing of certain steel facilities. 5. B&LE LITIGATION CHARGES Pretax income (loss) in 1993 included a $506 million charge related to the adverse decision in the Lower Lake Erie Iron Ore Antitrust Litigation against a former USX subsidiary, the Bessemer & Lake Erie Railroad (B&LE) (Note 26, page S-19). Charges of $342 million were included in operating costs and $164 million included in interest and other financial costs. The effect on 1993 net income (loss) was $325 million unfavorable ($5.04 per share of Steel Stock). At December 31, 1993, accounts payable included $376 million for this litigation. 6. FINANCIAL ACTIVITIES ATTRIBUTED TO ALL THREE GROUPS As described in Note 3, page S-8, the U. S. Steel Group's portion of USX's financial activities attributed to all groups based on their respective cash flows (which excludes amounts specifically attributed to any of the groups, Note 7, page S-10) is as follows: (a) For details of USX notes payable, long-term debt and preferred stock, see Notes 13, page U-18; 14, page U-19; and 19, page U-21, respectively, to the USX consolidated financial statements. (b) The U. S. Steel Group's net interest and other financial costs reflect weighted average effects of all financial activities attributed to all three groups. S-9 7. LONG-TERM DEBT The U. S. Steel Group's portion of USX's consolidated long-term debt is as follows: (a) See Note 14, page U-19, to the USX consolidated financial statements for details of interest rates, maturities and other terms of long-term debt. (b) As described in Note 3, page S-8, certain financial activities are specifically attributed only to the U. S. Steel Group, the Marathon Group or the Delhi Group. (c) Most long-term debt activities of USX Corporation and its wholly owned subsidiaries are attributed to all three groups (in total, but not with respect to specific debt issues) based on their respective cash flows (Notes 3, page S-8, 6, page S-9, and 8, page S-10). 8. SUPPLEMENTAL CASH FLOW INFORMATION S-10 9. OTHER ITEMS (a) Gains resulted primarily from the sale of the Cumberland coal mine, an investment in an insurance company and the realization of deferred gain resulting from collection of a subordinated note related to the 1988 sale of Transtar, Inc. (Transtar). The collection also resulted in interest income of $37 million. (b) Reflected the $29 million favorable minority interest effect related to a loss of RMI Titanium Company (a 51%-owned company), of which $19 million resulted from restructuring charges. (c) See Note 3, page S-8, for discussion of USX net interest and other financial costs attributable to the U. S. Steel Group. (d) Excluded financial income and costs of finance operations, which are included in operating income. S-11 10. PENSIONS The U. S. Steel Group has noncontributory defined benefit plans covering substantially all employees. Benefits under these plans are based upon years of service and final average pensionable earnings, or a minimum benefit based upon years of service, whichever is greater. In addition, contributory pension benefits, which cover participating salaried employees, are based upon years of service and career earnings. The funding policy for defined benefit plans provides that payments to the pension trusts shall be equal to the minimum funding requirements of ERISA plus such additional amounts as may be approved from time to time. Certain of these plans provide benefits to USX corporate employees, and the related costs or credits for such employees are allocated to all three groups (Note 3, page S-8). The U. S. Steel Group also participates in multiemployer plans, most of which are defined benefit plans associated with coal operations. PENSION COST (CREDIT) -- The defined benefit cost for major plans was determined assuming an expected long-term rate of return on plan assets of 10% for 1993 and 11% for 1992 and 1991. The total pension credit is primarily included in selling, general and administrative expenses. FUNDS' STATUS -- The assumed discount rate used to measure the benefit obligations of major plans was 6.5% and 7% at December 31, 1993, and December 31, 1992, respectively. The assumed rate of future increases in compensation levels was 3% in both years. Plans with accumulated benefit obligations (ABO) in excess of plan assets were not material in 1992. S-12 11. POSTRETIREMENT BENEFITS OTHER THAN PENSIONS The U. S. Steel Group has defined benefit retiree health and life insurance plans covering most employees upon their retirement. Health benefits are provided, for the most part, through comprehensive hospital, surgical and major medical benefit provisions subject to various cost sharing features. Life insurance benefits are provided to nonunion retiree beneficiaries primarily based on employees' annual base salary at retirement. For union retirees, benefits are provided for the most part based on fixed amounts negotiated in labor contracts with the appropriate unions. Except for certain life insurance benefits paid from reserves held by insurance carriers, benefits have not been prefunded. In 1994, the U. S. Steel Group agreed to establish a Voluntary Employee Beneficiary Association (VEBA) Trust to prefund health care and life insurance benefits for retirees, who are covered under the USWA union agreement. Minimum contributions, in the form of USX Corporation stock or cash, are expected to be $25 million in 1994 and $10 million per year thereafter. In 1992, USX adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" (SFAS No. 106), which requires accrual accounting for all postretirement benefits other than pensions. USX elected to recognize immediately the transition obligation determined as of January 1, 1992, which represents the excess accumulated postretirement benefit obligation (APBO) for current and future retirees over the fair value of plan assets and recorded postretirement benefit cost accruals. The cumulative effect of the change in accounting principle for the U. S. Steel Group reduced net income $1,159 million, consisting of the transition obligation of $1,837 million, net of $678 million income tax effect. POSTRETIREMENT BENEFIT COST -- Postretirement benefit cost for defined benefit plans for 1993 and 1992 was determined assuming a discount rate of 7% and 8%, respectively, and an expected return on plan assets of 10% for each year presented below: (a) In 1993, a new multi-employer benefit plan created by the Coal Industry Retiree Health Benefit Act of 1992 replaced the previous plan provided under the collective bargaining agreement with the United Mine Workers of America. The U. S. Steel Group is required to make payments to the plan based on assigned beneficiaries receiving benefits, and such payments are expected to increase to approximately $15 million to $25 million in 1994 and subsequent years. The present value of this unrecognized obligation is broadly estimated to be $220 million, including the effects of future medical inflation, and this amount could increase if additional beneficiaries are assigned. Prior to 1992, the cost of providing health care benefits to retired employees was recognized as an expense primarily as claims were paid, and the cost of life insurance benefits for retirees was generally accrued during their working years. These costs totaled $144 million for 1991. FUNDS' STATUS -- The following table sets forth the plans' funded status and the amounts reported in the U. S. Steel Group's balance sheet: The assumed discount rate used to measure the APBO was 6.5% and 7% at December 31, 1993, and December 31, 1992, respectively. The assumed rate of future increases in compensation levels was 3% for both years. The weighted average health care cost trend rate in 1994 is approximately 8%, gradually declining to an ultimate rate in 1997 of approximately 6%. A one percentage point increase in the assumed health care cost trend rates for each future year would have increased the aggregate of the service and interest cost components of the 1993 net periodic postretirement benefit cost by $28 million and would have increased the APBO as of December 31, 1993, by $326 million. Settlements -- Other income disclosed in Note 9, page S-11, included a settlement gain of $24 million resulting from the sale of the Cumberland coal mine. S-13 12. INCOME TAXES Income tax provisions and related assets and liabilities attributed to the U.S. Steel Group are determined in accordance with the USX group tax allocation policy (Note 3, page S-9). In 1992, USX adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS No. 109), which requires an asset and liability approach in accounting for income taxes. Under this method, deferred income tax assets and liabilities are established to reflect the future tax consequences of carryforwards and differences between the tax bases and financial bases of assets and liabilities. The cumulative effect of the change in accounting principle determined as of January 1, 1992, reduced net income $176 million. Provisions (credits) for estimated income taxes: (a) Computed in accordance with Accounting Principles Board Opinion No. 11. The deferred tax benefit of $139 million in 1991 was primarily the net result of the generation of federal tax loss carryforwards and timing differences related to restructuring charges and pension accruals. In 1993, the cumulative effect of the change in accounting principle for postemployment benefits included a deferred tax benefit of $40 million (Note 2, page S-7). In 1992, the cumulative effect of the change in accounting principle for other postretirement benefits included a deferred tax benefit of $678 million (Note 11, page S-13). Reconciliation of federal statutory tax rate (35% in 1993, and 34% in 1992 and 1991) to total provisions (credits): Deferred tax assets and liabilities resulted from the following: (b) Includes the benefit of federal tax loss carryforwards associated with a majority owned subsidiary which is not included in USX's consolidated federal tax return of $26 million and $21 million at December 31, 1993 and 1992, respectively, for which a full valuation allowance has been provided at both dates. (c) Valuation allowances have been established for certain federal and state income tax assets. The valuation allowances increased $31 million primarily for certain tax credits and tax loss carryforwards which USX may not fully utilize. The consolidated tax returns of USX for the years 1988 through 1991 are under various stages of audit and administrative review by the IRS. USX believes it has made adequate provision for income taxes and interest which may become payable for years not yet settled. S-14 13. TAXES OTHER THAN INCOME TAXES 14. INTERGROUP TRANSACTIONS PURCHASES AND SALES -- U. S. Steel Group purchases from the Marathon Group totaled $10 million, $16 million and $14 million in 1993, 1992 and 1991, respectively. These transactions were conducted on an arm's length basis. RECEIVABLES FROM THE MARATHON GROUP AND THE DELHI GROUP -- U. S. Steel Group receivables from the Marathon Group totaled $13 million and $41 million at December 31, 1993 and 1992, respectively. U. S. Steel Group receivables from the Delhi Group totaled $6 million at December 31, 1992. These amounts represent receivables for income taxes determined in accordance with the tax allocation policy described in Note 3, page S-9. Tax settlements between the groups are generally made in the year succeeding that in which such amounts are accrued. 15. LONG-TERM RECEIVABLES AND OTHER INVESTMENTS The following financial information summarizes U. S. Steel Group's share in investments accounted for by the equity method: U. S. Steel Group purchases of transportation services and semi-finished steel from equity affiliates totaled $313 million, $273 million and $287 million in 1993, 1992 and 1991, respectively. At December 31, 1993 and 1992, U. S. Steel Group payables to these affiliates totaled $17 million and $18 million, respectively. U. S. Steel Group sales of steel and raw materials to equity affiliates totaled $526 million, $249 million and $282 million in 1993, 1992 and 1991, respectively. At December 31, 1993 and 1992, U. S. Steel Group receivables from these affiliates was $168 million and $86 million, respectively. Generally, these transactions were conducted under long-term, market-based contractual arrangements. 16. INVENTORIES At December 31, 1993, and December 31, 1992, the LIFO method accounted for 89% and 91% of total inventory value. Current acquisition costs were estimated to exceed the above inventory values at December 31 by approximately $340 million in 1993 and $390 million in 1992. Cost of sales was reduced by $11 million in 1993, $24 million in 1992 and $36 million in 1991 as a result of liquidations of LIFO inventories. S-15 17. LEASES Future minimum commitments for capital leases (including sale-leasebacks accounted for as financings) and for operating leases having remaining noncancelable lease terms in excess of one year are as follows: The U. S. Steel Group leases a wide variety of facilities and equipment under operating leases, including land and building space, office equipment, production facilities and transportation equipment. Contingent rental includes payments based on facility production and operating expense escalation on building space. Most long-term leases include renewal options and, in certain leases, purchase options. In the event of a change in control of USX, as defined in the agreements, or certain other circumstances, lease obligations totaling $77 million may be declared immediately due and payable. 18. PROPERTY, PLANT AND EQUIPMENT Amounts included in accumulated depreciation, depletion and amortization for assets acquired under capital leases (including sale-leasebacks accounted for as financings) were $41 million and $37 million at December 31, 1993, and December 31, 1992, respectively. 19. SALES OF RECEIVABLES ACCOUNTS RECEIVABLE - The U. S. Steel Group has entered into an agreement to sell certain accounts receivable subject to limited recourse. Payments are collected from the sold accounts receivable; the collections are reinvested in new accounts receivable for the buyers; and a yield based on defined short-term market rates is transferred to the buyers. Collections on sold accounts receivable will be forwarded to the buyers at the end of the agreement in 1994, in the event of earlier contract termination or if a sufficient quantity of eligible accounts receivable is not available to reinvest in for the buyers. The balance of sold accounts receivable averaged $333 million, $310 million and $350 million for the years 1993, 1992 and 1991, respectively. At December 31, 1993, the balance of sold accounts receivable that had not been collected was $340 million. Buyers have collection rights to recover payments from an amount of outstanding receivables equal to 120% of the outstanding receivables purchased on a nonrecourse basis; such overcollateralization cannot exceed $70 million. The U. S. Steel Group does not generally require collateral for accounts receivable, but significantly reduces credit risk through credit extension and collection policies, which include analyzing the financial condition of potential customers, establishing credit limits, monitoring payments and aggressively pursuing delinquent accounts. In the event of a change in control of USX, as defined in the agreement, the U. S. Steel Group may be required to forward payments collected on sold accounts receivable to the buyers. S-16 LOANS RECEIVABLE -- Prior to 1993, USX Credit, a division of USX, sold certain of its loans receivable subject to limited recourse. USX Credit continues to collect payments from the loans and transfer to the buyers principal collected plus yield based on defined short-term market rates. In 1993, 1992 and 1991, USX Credit net sales (repurchases) of loans receivable totaled $(50) million, $(24) million and $85 million, respectively. At December 31, 1993, the balance of sold loans receivable subject to recourse was $205 million. USX Credit is not actively seeking new loans at this time. USX Credit is subject to market risk through fluctuations in short-term market rates on sold loans which pay fixed interest rates. USX Credit significantly reduces credit risk through a credit policy, which requires that loans be secured by the real property or equipment financed, often with additional security such as letters of credit, personal guarantees and committed long-term financing takeouts. Also, USX Credit diversifies its portfolio as to types and terms of loans, borrowers, loan sizes, sources of business and types and locations of collateral. As of December 31, 1993, and December 31, 1992, USX Credit had outstanding loan commitments of $29 million and $32 million, respectively. In the event of a change in control of USX, as defined in the agreement, the U. S. Steel Group may be required to provide cash collateral in the amount of the uncollected loans receivable to assure compliance with the limited recourse provisions Estimated credit losses under the limited recourse provisions for both accounts receivable and loans receivable are recognized when the receivables are sold consistent with bad debt experience. Recognized liabilities for future recourse obligations of sold receivables were $3 million and $1 million at December 31, 1993, and December 31, 1992, respectively. 20. STOCKHOLDERS' EQUITY (a) For details of 6.50% Cumulative Convertible Preferred Stock, which was sold in 1993 for net proceeds of $336 million and attributed entirely to the U. S. Steel Group, see Note 19, page U-21 to the USX consolidated financial statements. (b) The initial dividend on the Steel Stock was paid on September 10, 1991. Dividends paid by USX prior to that date were attributed to the U. S. Steel Group and the Marathon Group based upon the relationship of the initial dividends on the Steel Stock and Marathon Stock. 21. DIVIDENDS In accordance with the USX Certificate of Incorporation, dividends on the Steel Stock, Marathon Stock and Delhi Stock are limited to the legally available funds of USX. Net losses of the U. S. Steel Group, the Marathon Group or the Delhi Group, as well as dividends or distributions on any class of USX common stock or series of Preferred Stock and repurchases of any class of USX common stock or certain series of Preferred Stock, will reduce the funds of USX legally available for payment of dividends on all classes of USX common stock. Subject to this limitation, the Board of Directors intends to declare and pay dividends on the Steel Stock based on the financial condition and results of operations of the U. S. Steel Group, although it has no obligation under Delaware Law to do so. In making its dividend decisions with respect to Steel Stock, the Board of Directors considers, among other things, the long-term earnings and cash flow capabilities of the U. S. Steel Group as well as the dividend policies of similar publicly traded steel companies. Dividends on the Steel Stock are further limited to the Available Steel Dividend Amount. At December 31, 1993, the Available Steel Dividend Amount was at least $1.849 billion. The Available Steel Dividend Amount will be increased or decreased, as appropriate, to reflect U. S. Steel Group net income, dividends, repurchases or issuances with respect to the Steel Stock and preferred stock attributed to the U. S. Steel Group and certain other items. S-17 22. NET INCOME PER COMMON SHARE The method of calculating net income (loss) per share for the Steel Stock, Marathon Stock and Delhi Stock reflects the USX Board of Directors' intent that the separately reported earnings and surplus of the U. S. Steel Group, the Marathon Group and the Delhi Group, as determined consistent with the USX Certificate of Incorporation, are available for payment of dividends to the respective classes of stock, although legally available funds and liquidation preferences of these classes of stock do not necessarily correspond with these amounts. For purposes of computing net income (loss) per share of Steel Stock for periods prior to May 7, 1991, the numbers of shares of Steel Stock are assumed to be one-fifth of the total corresponding numbers of shares of USX common stock. Primary net income (loss) per share is calculated by adjusting net income (loss) for dividend requirements of preferred stock and is based on the weighted average number of common shares outstanding plus common stock equivalents, provided they are not antidilutive. Common stock equivalents result from assumed exercise of stock options and surrender of stock appreciation rights associated with stock options, where applicable. Fully diluted net income (loss) per share assumes conversion of convertible securities for the applicable periods outstanding and assumes exercise of stock options and surrender of stock appreciation rights, provided, in each case, the effect is not antidilutive. 23. FOREIGN CURRENCY TRANSLATION Exchange adjustments resulting from foreign currency transactions generally are recognized in income, whereas adjustments resulting from translation of financial statements are reflected as a separate component of stockholders' equity. For 1993, 1992 and 1991, respectively, the aggregate foreign currency transaction losses included in determining net income were $4 million, $2 million and $2 million. An analysis of changes in cumulative foreign currency translation adjustments follows: 24. STOCK PLANS AND STOCKHOLDER RIGHTS PLAN USX Stock Plans and Stockholder Rights Plan are discussed in Note 20, page U-22, and Note 24, page U-24, respectively, to the USX consolidated financial statements. 25. FAIR VALUE OF FINANCIAL INSTRUMENTS Fair value of the financial instruments disclosed herein is not necessarily representative of the amount that could be realized or settled, nor does the fair value amount consider the tax consequences of realization or settlement. As described in Note 3, page S-8, the U. S. Steel Group's specifically attributed financial instruments and the U. S. Steel Group's portion of USX's financial instruments attributed to all groups are as follows: (a) The difference between carrying value and fair value principally represented the subordinated note related to the earlier sale of a majority interest in Transtar, Inc. (Transtar) which was carried at no value due to the highly leveraged nature of the transaction. The note was paid in full in 1993 resulting in other income of $70 million and interest income of $37 million (Note 9, page S-11). S-18 25. FAIR VALUE OF FINANCIAL INSTRUMENTS (CONTINUED) Fair value of financial instruments classified as current assets or liabilities approximate carrying value due to the short-term maturity of the instruments. Fair value of long-term receivables and other investments was based on discounted cash flows or other specific instrument analysis. Fair value of long-term debt instruments was based on market prices where available or current borrowing rates available for financings with similar terms and maturities. The U. S. Steel Group's unrecognized financial instruments consist of receivables sold subject to limited recourse, commitments to extend credit, financial guarantees, and commodity swaps. It is not practicable to estimate the fair value of these forms of financial instrument obligations. For details relating to sales of receivables and commitments to extend credit see Note 19, page S-16. For details relating to financial guarantees see Note 26, page S-20. The contract value of open natural gas commodity swaps, as of December 31, 1993 and December 31, 1992 totaled $51 million and $13 million, respectively. The swap arrangements extend for no longer than one year. 26. CONTINGENCIES AND COMMITMENTS USX is the subject of, or party to, a number of pending or threatened legal actions, contingencies and commitments relating to the U. S. Steel Group involving a variety of matters, including laws and regulations relating to the environment. Certain of these matters are discussed below. The ultimate resolution of these contingencies could, individually or in the aggregate, be material to the U. S. Steel Group financial statements. However, management believes that USX will remain a viable and competitive enterprise even though it is possible that these contingencies could be resolved unfavorably to the U. S. Steel Group. LEGAL PROCEEDINGS -- B&LE litigation; MDL-587 On January 24, 1994, the U.S. Supreme Court denied a petition for Writ of Certiorari by the B&LE in the Lower Lake Erie Iron Ore Antitrust Litigation (MDL-587). As a result, the decision of the U.S. Court of Appeals for the Third Circuit affirming judgments of approximately $498 million, plus interest, relating to antitrust violations by the B&LE was permitted to stand. In addition, the Third Circuit decision remanded the claims of two plaintiffs for retrial of their damage awards. At trial these plaintiffs asserted claims of approximately $8 million, but were awarded only nominal damages by the jury. A new trial date has not been set. Any damages awarded in a new trial may be more or less than $8 million and would be subject to trebling. The B&LE was a wholly owned subsidiary of USX throughout the period the conduct occurred. It is now a subsidiary of Transtar in which USX has a 45% equity interest. These actions were excluded liabilities in the sale of USX's transportation units in 1988, and USX is obligated to reimburse Transtar for judgments paid by the B&LE. Following the Court of Appeals decision, USX, which had previously accrued $90 million on a pretax basis for this litigation, charged an additional amount of $619 million on a pretax basis in the second quarter of 1993. In late 1993, USX and LTV Steel Corp. ("LTV"), one of the plaintiffs in MDL-587, agreed to settle all of LTV's claims in that action for $375 million. USX made a payment of $200 million on December 29, 1993, and is obligated to pay an additional $175 million not later than February 28, 1994. Claims of three additional plaintiffs were also settled in December 1993. These settlements resulted in a pretax credit of $127 million in the fourth quarter financial results of the U.S. Steel Group. As a result of the denial of the Petition for Writ of Certiorari, judgments for the other MDL-587 plaintiffs (other than the two remanded for retrial), totaling approximately $210 million, including postjudgment interest, are due for payment in the first quarter of 1994. B&LE litigation; Armco In June 1990, following judgments entered on behalf of steel company plaintiffs in MDL-587, Armco Steel filed federal antitrust claims against the B&LE and other railroads in the Federal District Court for the District of Columbia. B&LE successfully challenged the actions for lack of jurisdiction and venue, and the case was transferred to the Federal District Court for the Northern District of Ohio. Other defendant railroads settled with Armco, leaving B&LE as the only remaining defendant. On April 7, 1993, B&LE's motion to dismiss the federal antitrust claims on grounds of statute of limitations was granted. Subsequently, Armco refiled its claims under the Ohio Valentine Act. B&LE's motions for summary judgment on time bar issues and for change of venue are pending, and not yet fully briefed. No discovery has been taken on the merits of Armco's claims, but if Armco survives the present and possibly further pretrial motions and the case proceeds to trial on the merits, Armco's claimed damages are likely to be substantial. Unlike MDL-587, it is USX's position that the Armco case was not an excluded liability in the sale of USX's transportation units to Transtar in 1988, and that USX therefore is not obligated to reimburse Transtar for any judgments rendered in the Armco case; however, this position is being disputed by Transtar and The Blackstone Group, the ultimate owner of 52% of Transtar's outstanding shares. S-19 26. CONTINGENCIES AND COMMITMENTS (CONTINUED) Energy Buyers litigation On December 21, 1992, an arbitrator issued an award for approximately $117 million, plus interest under Ohio law, against USX in Energy Buyers Service Corporation v. USX, a case originally filed in the District Court of Harris County, Texas. Such amount was fully accrued as of December 31, 1992. On December 15, 1993, USX agreed to settle all claims in the case for $95 million and deferred payments of up to $9 million. Pickering litigation On November 3, 1992, the United States District Court for the District of Utah Central Division issued a Memorandum Opinion and Order in Pickering v. USX relating to pension and compensation claims by approximately 1,900 employees of USX's former Geneva (Utah) Works. Although the court dismissed a number of the claims by the plaintiffs, it found that USX had violated the Employee Retirement Income Security Act by interfering with the accrual of pension benefits of certain employees and amending a benefit plan to reduce the accrual of future benefits without proper notice to plan participants. Further proceedings were held to determine damages and, pending the court's determinations, USX may appeal. Plaintiffs' counsel has been reported as estimating plaintiffs' anticipated recovery to be in excess of $100 million. USX believes actual damages will be substantially less than plaintiffs' estimates. ENVIRONMENTAL MATTERS -- The U. S. Steel Group is subject to federal, state and local laws and regulations relating to the environment. These laws generally provide for control of pollutants released into the environment and require responsible parties to undertake remediation of hazardous waste disposal sites. Penalties may be imposed for noncompliance. The U. S. Steel Group provides for remediation costs and penalties when the responsibility to remediate is probable and the amount of associated costs is reasonably determinable. Generally, the timing of these accruals coincides with completion of a feasibility study or the commitment to a formal plan of action. Accrued liabilities for remediation and mine reclamation totaled $151 million and $142 million at December 31, 1993 and December 31, 1992, respectively. It is not presently possible to estimate the ultimate amount of all remediation costs that might be incurred or the penalties that may be imposed. For a number of years, the U. S. Steel Group has made substantial capital expenditures to bring existing facilities into compliance with various laws relating to the environment. In 1993 and 1992, such capital expenditures totaled $53 million and $52 million, respectively. The U. S. Steel Group anticipates making additional such expenditures in the future; however, the exact amounts and timing of such expenditures are uncertain because of the continuing evolution of specific regulatory requirements. GUARANTEES -- Guarantees by USX of the liabilities of affiliated entities of the U. S. Steel Group totaled $209 million at December 31, 1993, and $242 million at December 31, 1992. In the event that any defaults of guaranteed liabilities occur, USX has access to its interest in the assets of the affiliates to reduce U. S. Steel Group losses resulting from these guarantees. As of December 31, 1993, the largest guarantee for a single affiliate was $96 million. COMMITMENTS -- At December 31, 1993, and December 31, 1992, contract commitments for the U. S. Steel Group's capital expenditures for property, plant and equipment totaled $105 million and $63 million, respectively. USX has entered into a 15-year take-or-pay arrangement which requires the U. S. Steel Group to accept pulverized coal each month or pay a minimum monthly charge. In 1993, charges for deliveries of pulverized coal which began in 1993 totaled $14 million. In the future, the U. S. Steel Group will be obligated to make minimum payments of approximately $16 million per year. If USX elects to terminate the contract early, a maximum termination payment of $126 million, which declines over the duration of the agreement, may be required. The U. S. Steel Group is a party to a transportation agreement with Transtar for Great Lakes shipments of raw materials required by the U. S. Steel Group. The agreement cannot be canceled until 1999 and requires the U. S. Steel Group to pay, at a minimum, Transtar's annual fixed costs related to the agreement, including lease/charter costs, depreciation of owned vessels, dry dock fees and other administrative costs. Total transportation costs under the agreement were $68 million in 1993 and $66 million in 1992, including fixed costs of $21 million in each year. The fixed costs are expected to continue at approximately the same level over the duration of the agreement. 27. SUBSEQUENT EVENT On February 2, 1994, USX sold 5,000,000 shares of Steel Stock to the public for net proceeds of $201 million, which will be reflected in their entirety in the U. S. Steel Group financial statements. S-20 Selected Quarterly Financial Data (Unaudited) (a) Restated to reflect fourth quarter implementation of SFAS No. 112 (Note 2, page S-7). Operating income declined $5 million and total income before cumulative effect of change in accounting principle (total income) declined $3 million in each of the first three quarters of 1993 due to restatement. Total income per share of common stock declined $.05 in the first and second quarter and $.03 in the third quarter of 1993. In addition, the first quarter net income declined $69 million due to the cumulative effect of the change in accounting principle as of January 1, 1993. (b) Reflects a decrease of $28 million for a reclassification with no effect on net income. (c) Composite tape. Principal Unconsolidated Affiliates (Unaudited) (a) Ownership interest as of December 31, 1993. Supplementary Information on Mineral Reserves (Unaudited) See the USX consolidated financial statements for Supplementary Information on Mineral Reserves relating to the U. S. Steel Group, page U-28. S-21 Five-Year Operating Summary (a) In July 1991, U. S. Steel closed all iron and steel producing operations at Fairless (PA) Works. In April 1992, U. S. Steel closed South (IL) Works. (b) In June 1993, U. S. Steel sold the Cumberland coal mine. On or about March 31, 1994, U. S. Steel will permanently close the Maple Creek coal mine. (c) U. S. Steel ceased production of structural products when South Works closed in April 1992. S-22 THE U. S. STEEL GROUP Management's Discussion and Analysis The U. S. Steel Group includes U.S. Steel, which is primarily engaged in the production and sale of a wide range of steel mill products, coke and taconite pellets. The U. S. Steel Group also includes the management of mineral resources, domestic coal mining, engineering and consulting services and technology licensing (together with U. S. Steel, the "Steel and Related Businesses"). Other businesses that are part of the U.S. Steel Group include real estate development and management, fencing products, leasing and financing activities and a majority interest in a titanium metal products company. Management's Discussion and Analysis should be read in conjunction with the U. S. Steel Group's Financial Statements and Notes to Financial Statements. MANAGEMENT'S DISCUSSION AND ANALYSIS OF INCOME THE U. S. STEEL GROUP'S SALES increased by $693 million in 1993 from 1992 following an increase of $55 million in 1992 from 1991. The increase in 1993 primarily reflected an increase in steel shipment volumes of approximately 1.1 million tons, higher average steel prices and increased commercial shipments of taconite pellets and coke. The increase in 1992 relative to 1991 was primarily due to significantly higher commercial shipments of coke, improvements in steel shipment volumes from ongoing operations and an improved shipment mix, partially offset by the absence of sales of structural products due to the closure of South (IL) Works early in 1992. THE U. S. STEEL GROUP REPORTED AN OPERATING LOSS of $149 million in 1993 compared with an operating loss of $241 million in 1992 and an operating loss of $617 million in 1991. The 1993 operating loss included a $342 million charge as a result of the adverse decision in the Lower Lake Erie Iron Ore Antitrust Litigation against the Bessemer & Lake Erie Railroad ("B&LE litigation") (which also resulted in $164 million of interest costs) (see Note 5 to the U. S. Steel Group Financial Statements), and restructuring charges of $42 million related to the planned shutdown of the Maple Creek coal mine and preparation plant. The 1992 operating loss included a charge of $10 million for completion of the portion of the 1991 restructuring plan related to steel facilities. Excluding these charges, operating results in 1993 improved by $466 million over 1992 primarily due to higher steel shipment volumes and prices, improved operating efficiencies and lower accruals for environmental and legal contingencies. In addition, 1993 results benefitted from a $39 million favorable effect from the utilization of funds from previously established insurance reserves to pay for certain employee insurance benefits, lower provisions for loan losses by USX Credit and the absence of a 1992 unfavorable effect of $28 million resulting from market valuation provisions for foreclosed real estate assets. These were partially offset by higher hourly steel labor costs, unfavorable effects associated with pension and other employee benefits, lower results from coal operations and a $21 million increase in operating costs related to the adoption of Statement of Financial Accounting Standards No. 112 - Employers' Accounting for Post Employment Benefits ("SFAS No. 112"). The operating loss in 1991 included $402 million of restructuring charges primarily related to the shutdown of certain steel facilities. Excluding the effect of this item and the 1992 special item previously discussed, operating results decreased by $16 million from 1991 to 1992. The decrease in 1992 was primarily due to higher charges for legal contingencies, increased costs of $42 million related to the adoption of Statement of Financial Accounting Standards No. 106 - Employers' Accounting for Postretirement Benefits Other Than Pensions ("SFAS No. 106"), higher depreciation charges, increased provisions for loan losses by USX Credit and a $28 million unfavorable effect resulting from market valuation provisions for foreclosed real estate assets. These were partially offset by the favorable effects of savings from cost reduction programs, higher utilization of raw steel and raw material production capability and the absence of costs incurred in 1991 related to the lack of an early labor agreement with the United Steelworkers of America ("USWA"). S-23 Management's Discussion and Analysis CONTINUED OTHER INCOME was $210 million in 1993 compared with $5 million in 1992 and $9 million in 1991. The increase in 1993 primarily resulted from higher gains from the disposal of assets, including the sale of the Cumberland coal mine, the realization of a $70 million deferred gain resulting from the collection of a subordinated note related to the 1988 sale of Transtar, Inc. ("Transtar") (which also resulted in $37 million of interest income) and the sale of an investment in an insurance company. The decline in 1992 relative to 1991 primarily resulted from the nonrecurrence of 1991's favorable minority interest effect related to RMI Titanium Company ("RMI"), partially offset by reduced losses from equity affiliates. INTEREST AND OTHER FINANCIAL INCOME was $59 million in 1993. The 1993 amount included $37 million of interest income resulting from collection of the Transtar note. Excluding this item, interest and other financial income was $22 million in 1993, compared with $18 million in 1992 and $20 million in 1991. INTEREST AND OTHER FINANCIAL COSTS were $330 million in 1993. The 1993 amount included $164 million of interest expense related to the adverse decision in the B&LE litigation. Excluding the effect of this item, interest and other financial costs were $166 million in 1993, compared to $176 million in 1992 and $168 million in 1991. The changes over the three-year period primarily reflected differences in average debt levels. THE CREDIT FOR ESTIMATED INCOME TAXES in 1993 was $41 million, compared with credits of $123 million in 1992 and $249 million in 1991. The U. S. income tax provision for 1993 included a $15 million favorable effect associated with an increase in the federal income tax rate from 34% to 35%, reflecting remeasurement of deferred federal income tax assets as of January 1, 1993. This benefit was offset by adjustments for prior years' Internal Revenue Service examinations. THE U. S. STEEL GROUP GENERATED A LOSS BEFORE CUMULATIVE EFFECT OF CHANGES IN ACCOUNTING PRINCIPLES of $169 million in 1993, compared with a loss of $271 million in 1992 and a loss of $507 million in 1991. THE UNFAVORABLE CUMULATIVE EFFECT OF CHANGES IN ACCOUNTING PRINCIPLES totaled $69 million in 1993 and $1,335 million in 1992. The cumulative effect of adopting SFAS No. 112, determined as of January 1, 1993, decreased 1993 income of the U. S. Steel Group by $69 million, net of the income tax effect. The immediate recognition of the transition obligation resulting from the adoption of SFAS No. 106, measured as of January 1, 1992, decreased the U. S. Steel Group's 1992 income by $1,159 million, net of the income tax effect. The cumulative effect of adopting Statement of Financial Accounting Standards No. 109 - Accounting for Income Taxes ("SFAS No. 109"), measured as of January 1, 1992, decreased 1992 net income by $176 million. The adoption of SFAS No. 109 had no material effect on the U. S. Steel Group's 1992 income tax expense. THE U. S. STEEL GROUP RECORDED A NET LOSS of $238 million in 1993, compared with a net loss of $1,606 million in 1992 and a net loss of $507 million in 1991. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION CURRENT ASSETS at year-end 1993 increased $254 million from year-end 1992 primarily due to increases in receivables and deferred income tax benefits. The increase in receivables was primarily due to an increase in trade receivables as a result of higher steel shipment activity. The increase in deferred income tax benefits primarily reflected an increase in accruals related to the B&LE litigation. The U. S. Steel Group financial statements reflect current and deferred tax assets and liabilities that relate to tax attributes utilized and recognized on a consolidated basis and attributed in accordance with the USX Corporation ("USX") group tax allocation policy (see Note 3 to the U. S. Steel Group Financial Statements). S-24 Management's Discussion and Analysis CONTINUED PROPERTY, PLANT AND EQUIPMENT (LESS DEPRECIATION) decreased $156 million from 1992. The decrease was primarily due to depreciation, the sale of the Cumberland coal mine and the writedown of Maple Creek coal mine assets in connection with the planned closure which, in total, exceeded capital expenditures. PREPAID PENSION ASSETS increased $223 million from year-end 1992 mainly as a result of pension credits which primarily reflected the investment performance of defined benefit plan assets. CURRENT LIABILITIES increased $358 million over year-end 1992 primarily due to an increase in accounts payable, partially offset by a reduction in long-term debt due within one year. The increase in accounts payable in 1993 mainly reflected an increase in accruals related to the B&LE litigation and higher trade payables. TOTAL LONG-TERM DEBT AND NOTES PAYABLE at December 31, 1993 was $1,551 million. The $723 million decrease from year-end 1992 primarily reflected cash generated from issuance of 6.50% Cumulative Convertible Preferred Stock ("6.50% Convertible Preferred") and USX-U. S. Steel Group Common Stock ("Steel Stock"), disposal of assets and operating activities, partially offset by capital expenditures, dividend payments and an increase in cash and cash equivalents. The amount of total long-term debt, as well as the amount shown as notes payable, principally represented the U. S. Steel Group's portion of USX debt attributed to all three groups. Virtually all of the debt is a direct obligation of, or is guaranteed by, USX. EMPLOYEE BENEFITS liabilities increased $309 million compared with year-end 1992 mainly due to increases in workers' compensation liabilities (including the effects of the adoption of SFAS No. 112), retiree medical liabilities and pension liabilities, partially offset by a decrease in liabilities due to asset sale transactions. DEFERRED CREDITS AND OTHER LIABILITIES decreased $80 million in 1993 mainly as a result of transfers of certain litigation accruals to current liabilities. STOCKHOLDERS' EQUITY of $617 million at year-end 1993 increased $370 million from the end of 1992 mainly reflecting the issuance of additional preferred and common equity, partially offset by the 1993 net loss and dividend payments. Management's Discussion and Analysis of Cash Flows THE U. S. STEEL GROUP'S NET CASH PROVIDED FROM OPERATING ACTIVITIES in 1993 was $86 million compared with net cash used in operating activities of $89 million in 1992. The 1993 period was negatively affected by payments of $314 million related to partial settlement of the B&LE litigation and settlement of the Energy Buyers litigation. Excluding these payments, net cash provided from operating activities improved by $489 million in 1993. The increase primarily reflected improved operations and a $103 million favorable effect from the use of available funds from previously established (now depleted) insurance reserves to pay for certain active and retired employee insurance benefits. The U. S. Steel Group's net cash used in operating activities in 1992 was $89 million compared to net cash generated of $9 million in 1991. The results primarily reflected unfavorable changes in working capital accounts resulting mainly from a lower settlement from the Marathon Group related to prior years' income taxes in accordance with USX's group tax allocation policy, partially offset by favorable effects due to changes in the amount of sold accounts receivable. CAPITAL EXPENDITURES totaled $198 million in 1993 compared with $298 million in 1992 and $432 million in 1991. The year-to-year reductions over this period primarily reflected the completion of U. S. Steel's continuous cast modernization program, as the Gary (IN) Works caster was completed during 1991 and the Mon Valley (PA) Works caster was completed in 1992. In addition to spending for S-25 Management's Discussion and Analysis CONTINUED the continuous caster at Mon Valley Works, significant projects in 1992 included modernization of the hot strip mill and the electrogalvanizing line at Gary Works. Contract commitments for capital expenditures at year-end 1993 were $105 million, compared with $63 million at year-end 1992. Capital expenditures in 1994 are expected to be approximately $260 million and will include continued expenditures for projects begun in 1993 relative to environmental, hot-strip mill and pickle line improvements at Gary Works and initial expenditures for a blast furnace reline project at Mon Valley Works which is planned for completion in 1995. Capital expenditures in 1995 and 1996 are currently expected to remain at about the same level as in 1994. CASH FROM THE DISPOSAL OF ASSETS totaled $291 million in 1993, compared with $39 million in 1992 and $26 million in 1991. The 1993 amount primarily reflected the realization of proceeds from a subordinated note related to the 1988 sale of Transtar and the sales of the Cumberland coal mine and investments in an insurance company and a foreign manganese mining affiliate. FINANCIAL OBLIGATIONS decreased by $730 million in 1993, compared with an increase of $203 million in 1992 and an increase of $502 million in 1991. The decrease in 1993 primarily reflected the use of proceeds from the issuance of common and preferred stock attributed to the U. S. Steel Group, asset sales and net cash flows from operating activities of the U. S. Steel Group. These obligations consist of the U. S. Steel Group's portion of USX debt attributed to all three groups as well as debt and financing agreements specifically attributed to the U. S. Steel Group. PREFERRED STOCK ISSUED totaled $336 million in 1993. This amount was due to the sale of 6,900,000 shares of 6.50% Convertible Preferred ($50.00 liquidation preference per share) to the public for net proceeds of $336 million which were reflected in their entirety in the U. S. Steel Group financial statements. The 6.50% Convertible Preferred is convertible at any time into shares of Steel Stock at a conversion price of $46.125 per share of Steel Stock. STEEL STOCK ISSUED totaled $366 million in 1993. This amount was mainly due to the sale of 10,000,000 shares of Steel Stock to the public for net proceeds of $350 million, which were reflected in their entirety in the U. S. Steel Group financial statements. The increase in 1992 primarily reflected the sale of 8,050,000 shares of Steel Stock to the public for net proceeds of $198 million, which were reflected in their entirety in the U. S. Steel Group financial statements. In February 1994, USX sold 5,000,000 shares of Steel Stock to the public for net proceeds of $201 million, which will be reflected in their entirety in the U. S. Steel Group financial statements. DIVIDEND PAYMENTS increased in 1993 primarily as a result of higher dividends due to the sale of additional shares of Steel Stock and of the 6.50% Convertible Preferred mentioned above. Dividends attributed to the Steel Stock prior to September 10, 1991 were based upon the relationship of the initial dividends of the Steel Stock and the USX-Marathon Group Common Stock. The annualized rate of dividends per share for the Steel Stock based on the most recently declared quarterly dividend is $1.00. In September 1993, Standard & Poor's Corp. ("S&P") lowered its ratings on USX's and Marathon Oil Company's ("Marathon") senior debt to below investment grade (from BBB- to BB+) and on USX's subordinated debt, preferred stock and commercial paper. S&P cited extremely aggressive financial leverage, burdensome retiree medical liabilities and litigation contingencies. In October 1993, Moody's Investors Services, Inc. ("Moody's") confirmed its Baa3 investment grade ratings on USX's and Marathon's senior debt. Moody's also confirmed its ratings on USX's subordinated debt and commercial paper, but lowered its ratings on USX's preferred stock from ba1 to ba2. Moody's noted that the rating confirmation on USX debt securities reflected confidence in the expected performance of USX during the intermediate term, while the downward revision of the preferred stock ratings incorporated a narrow fixed charge coverage going forward. The downgrades by S&P and the downgrade of ratings on preferred stock by Moody's could increase USX's cost of capital. Any related increase in interest costs would be reflected in the consolidated financial statements and the financial statements of each group. S-26 Management's Discussion and Analysis CONTINUED As a result of the settlement of LTV Steel Corp.'s ("LTV") portion of the B&LE litigation, USX is obligated to pay an additional $175 million to LTV in the first quarter of 1994. In addition, approximately $210 million in judgments for other plaintiffs in the B&LE litigation are due for payment in the first quarter of 1994. See Note 26 to the U. S. Steel Group Financial Statements. USX anticipates that it will begin funding the U. S. Steel Group's pension plan for approximately $100 million per year commencing with the 1994 plan year. The funding for both the 1994 and 1995 plan years will impact cash flows in 1995. MANAGEMENT'S DISCUSSION AND ANALYSIS OF ENVIRONMENTAL MATTERS, LITIGATION AND CONTINGENCIES The U. S. Steel Group has incurred and will continue to incur substantial capital, operating and maintenance, and remediation expenditures as a result of environmental laws and regulations. In recent years, these expenditures have been mainly for process changes in order to meet Clean Air Act obligations, although ongoing compliance costs have also been significant. To the extent these expenditures, as with all costs, are not ultimately reflected in the prices of the U. S. Steel Group's products and services, operating results will be adversely affected. The U. S. Steel Group believes that all of its domestic competitors are subject to similar environmental laws and regulations. However, the specific impact on each competitor may vary depending on a number of factors, including the age and location of their operating facilities and their production methods. The U. S. Steel Group's environmental expenditures for 1993 and 1992 are discussed below and have been estimated based on U. S. Department of Commerce ("USDC") survey guidelines. These guidelines are subject to differing interpretations which could affect the comparability of such data. Some environmental related expenditures, while benefitting the environment, also enhance operating efficiencies. Total environmental expenditures for the U. S. Steel Group in 1993 were $240 million compared with $220 million in 1992. These amounts consisted of capital expenditures of $53 million in 1993 and $52 million in 1992 and estimated compliance expenditures (including operating and maintenance) of $187 million in 1993 and $168 million in 1992. Compliance expenditures were broadly estimated based on USDC survey guidelines and represented 3% of the U. S. Steel Group's total operating costs in both 1993 and 1992. USX has been notified that it is a potentially responsible party ("PRP") at 41 waste sites related to the U. S. Steel Group under the Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA") as of December 31, 1993. In addition, there are 28 sites related to the U. S. Steel Group where USX has received information requests or other indications that USX may be a PRP under CERCLA but where sufficient information is not presently available to confirm the existence of liability or make any judgment as to the amount thereof. There are also 10 additional sites related to the U. S. Steel Group where state governmental agencies or private parties are seeking remediation under state environmental laws through discussions or litigation. At many of these sites, USX is one of a number of parties involved and the total cost of remediation, as well as USX's share thereof, is frequently dependent upon the outcome of investigations and remedial studies. Total environmental expenditures included remediation related expenditures estimated at $19 million in 1993 and $11 million in 1992. Remediation spending was mainly related to dismantlement and restoration activities at former and present operating locations. The U. S. Steel Group accrues for environmental remediation activities when the responsibility to remediate is probable and the amount of associated costs is reasonably determinable. As environmental remediation matters proceed toward ultimate resolution or as additional remediation obligations arise, charges in excess of those previously accrued may be required. See Note 26 to the U. S. Steel Group Financial Statements. S-27 Management's Discussion and Analysis CONTINUED New or expanded requirements for environmental regulations, which could increase the U. S. Steel Group's environmental costs, may arise in the future. USX intends to comply with all legal requirements regarding the environment, but since many of them are not fixed or presently determinable (even under existing legislation) and may be affected by future legislation, it is not possible to accurately predict the ultimate cost of compliance, including remediation costs which may be incurred and penalties which may be imposed. However, based on presently available information, and existing laws and regulations as currently implemented, the U. S. Steel Group does not anticipate that environmental compliance expenditures will materially increase in 1994. The U. S. Steel Group's capital expenditures for environmental controls are expected to be approximately $70 million in 1994, including the expected completion of major air quality projects at Gary Works. Predictions beyond 1994 can only be broad-based estimates which have varied, and will continue to vary, due to the ongoing evolution of specific regulatory requirements, the possible imposition of more stringent requirements and the availability of new technologies, among other matters. Based upon currently identified projects, the U. S. Steel Group anticipates that environmental capital expenditures will be approximately $25 million in 1995; however, actual expenditures may increase as additional projects are identified or additional requirements are imposed. USX is the subject of, or party to, a number of pending or threatened legal actions, contingencies and commitments relating to the U. S. Steel Group involving a variety of matters, including laws and regulations relating to the environment, certain of which are discussed in Note 26 to the U. S. Steel Group Financial Statements. The ultimate resolution of these contingencies could, individually or in the aggregate, be material to the U. S. Steel Group financial statements. However, management believes that USX will remain a viable and competitive enterprise even though it is possible that these contingencies could be resolved unfavorably to the U.S. Steel Group. See USX Consolidated Management's Discussion and Analysis of Cash Flows. MANAGEMENT'S DISCUSSION AND ANALYSIS OF ACCOUNTING STANDARDS Statement of Financial Accounting Standards No. 114 - Accounting by Creditors for Impairment of a Loan ("SFAS No. 114") requires impairment of loans based on either the sum of discounted cash flows or the fair value of underlying collateral. USX expects to adopt SFAS No. 114 in the first quarter of 1995. Based on preliminary estimates, USX believes the unfavorable effect on the U. S. Steel Group of adopting SFAS No. 114 will be less than $2 million. MANAGEMENT'S DISCUSSION AND ANALYSIS OF OPERATIONS The U. S. Steel Group reported an operating loss of $149 million in 1993 compared with operating losses of $241 million in 1992 and $617 million in 1991. The operating loss for 1993 included a $342 million charge as a result of the adverse decision in the B&LE litigation. The 1993, 1992, and 1991 operating losses included restructuring charges of $42 million, $10 million, and $402 million, respectively, which are discussed below. S-28 Management's Discussion and Analysis CONTINUED *Certain reclassifications have been made to conform to 1993 classifications. Steel and Related Businesses recorded operating income of $123 million in 1993 compared with a loss of $140 million in 1992 and a loss of $235 million in 1991. The improvement in 1993 over 1992 was predominantly due to higher steel shipment volumes and prices, improved operating efficiencies and lower accruals for environmental and legal contingencies. In addition, 1993 results benefitted from a $39 million favorable effect from the utilization of funds from previously established insurance reserves to pay for certain employee insurance benefits. These positive factors were partially offset by higher hourly steel labor costs, unfavorable effects associated with pension and other employee benefits, lower results from coal operations and a $21 million increase in operating costs related to the adoption of SFAS No. 112. The improvement in 1992 compared with 1991 was primarily due to savings from cost reduction programs, higher utilization of raw steel and raw material capability and the absence of costs incurred in 1991 due to the lack of an early labor settlement with the USWA. These were partially offset by an increase in post retirement benefit costs in connection with the adoption of SFAS No. 106, higher depreciation charges and start-up costs for the Mon Valley Works continuous caster. Average realized steel prices improved $8 per ton in 1993 after virtually no change in 1992. Steel shipments were just under 10 million tons in 1993, an increase of 1.1 million tons over 1992. Shipments in 1992 were basically flat with the 1991 level. U. S. Steel Group shipments comprised approximately 11% of the domestic steel market in each of the three years. Exports accounted for 4% of U. S. Steel Group shipments in 1993, compared with 7% in 1992 and 15% in 1991. Raw steel production was 11.3 million tons in 1993, compared with 10.4 million tons in 1992 and 10.5 million tons in 1991. Raw steel produced was nearly 100% continuous cast in 1993, versus 83% in 1992 and 67% in 1991. U. S. Steel completed its continuous cast modernization program in 1992 with the start-up of the Mon Valley Works continuous caster in August 1992. Raw steel production averaged 96% of capability in 1993 compared with 86% of capability in 1992 and 70% of capability in 1991. Other Businesses recorded an operating loss of $29 million in 1993, compared with operating losses of $96 million in 1992 and $30 million in 1991. The improvement in 1993 of $67 million and the decrease in 1992 of $66 million primarily reflected a $28 million charge in 1992 resulting from market valuation provisions for foreclosed real estate assets and higher provisions in 1992 for loan losses by USX Credit. Loan loss provisions were $11 million in 1993, $42 million in 1992 and $14 million in 1991. USX Credit is not actively making new loan commitments. Excluding loan loss provisions, the balance of the operating losses for Other Businesses during the three-year period was largely due to the effect of depressed titanium markets on RMI's results. Other Administrative includes the portion of pension credits, postretirement benefit costs and certain other expenses principally attributable to former business units of the U. S. Steel Group as well as USX corporate general and administrative costs allocated to the U. S. Steel Group. Operating income from Other Administrative was $141 million in 1993 compared to $5 million in 1992 and $50 million in 1991. The 1993 increase resulted mainly from the absence of a charge incurred in 1992 to cover the amount of the award in the Energy Buyers litigation, and a credit in 1993 due to settlement S-29 Management's Discussion and Analysis CONTINUED of all claims in the case (see Note 26 to the U. S. Steel Group Financial Statements). The decrease from 1991 to 1992 primarily reflected the 1992 charge related to the Energy Buyers litigation, partially offset by a decrease in postretirement benefit costs charged to Other Administrative in connection with the adoption of SFAS No. 106. The U. S. Steel Group's 1993 operating loss also included restructuring charges of $42 million related to the planned shutdown of the Maple Creek coal mine and preparation plant. The 1992 loss included a charge of $10 million for completion of the portion of the 1991 restructuring plan related to steel facilities. The 1991 loss included $402 million of restructuring charges primarily related to the closing of the iron and steel producing, slab and hot strip mill and pipe mill facilities at Fairless (PA) Works; all facilities at South Works; RMI's sodium and sponge production facilities; a previously idled plate mill in Baytown, Texas; and miscellaneous other facilities. The U. S. Steel Group's 1993 operating income was reduced by a total of $21 million due to the adoption of SFAS No. 112. Operating income in 1992 compared to 1991 was reduced by a total of $42 million due to the adoption of SFAS No. 106. The pension credits referred to in Other Administrative, combined with pension costs for ongoing operating units of the U. S. Steel Group, resulted in net pension credits (which are primarily noncash) of $202 million, $231 million and $196 million in 1993, 1992 and 1991, respectively. The decrease in 1993 from 1992 was primarily due to a lower assumed long-term rate of return on plan assets. The increase in 1992 from 1991 primarily reflected recognition of the 1991 growth in plan assets. In 1994, net pension credits are expected to decline by approximately $85 million primarily due to a further reduction in the assumed long-term rate of return on plan assets. See Note 10 to the U. S. Steel Group Financial Statements. The domestic steel industry has been adversely affected by unfairly traded imports. Steel imports to the United States accounted for an estimated 19% of the domestic steel market in 1993, and for an estimated 22% in the fourth quarter. Steel imports to the United States accounted for an estimated 17% to 18% of the domestic steel market in 1992 and 1991. On March 31, 1992, Voluntary Restraint Agreements restricting the level of steel imports to the United States expired, and in June 1992, in conjunction with other domestic steel firms, USX filed a number of antidumping and countervailing duty cases with the USDC and the International Trade Commission ("ITC") against unfairly traded imported carbon flat rolled steel. Beginning in late 1992, as a result of affirmative preliminary determinations by both the ITC and the USDC in the vast majority of cases, provisional duties were imposed on the imported steel products under investigation. On June 22, 1993, the USDC issued the final determinations of subsidization in the countervailing duty cases and final margins for sales at less than fair value in the antidumping cases. On July 27, 1993, the ITC issued affirmative determinations of material injury to the domestic steel industry by reason of imports in cases representing an estimated 51% of dollar value and 42% of the volume of all flat-rolled carbon steel imports under investigation. Affirmative determinations were found in cases relating to 37% of such volume of cold-rolled steel, 92% of such volume of the higher value-added corrosion resistant steel and 97% of such volume of plate steel. Negative determinations were found in all cases related to hot-rolled steel, the largest import market. In those cases where negative determinations were made by the ITC, provisional duties imposed on imports covered by the cases were removed and final remedial duties were not imposed. While USX is unable to predict the effect these negative determinations may have on the business or results of operations of the U. S. Steel Group, they may result in increasing levels of imported steel and may adversely affect some product prices. As discussed above, steel imports to the United States have increased in recent months. S-30 Management's Discussion and Analysis CONTINUED Although the affirmative determinations are helpful in offsetting the harm to the U.S. steel industry caused by subsidized and dumped imports, USX believes that certain of the negative determinations were improper and, together with other steel firms, has appealed such determinations to the U.S. Court of International Trade and, in certain cases involving imports from Canada, to a bi-national panel in accordance with the Canadian Free Trade Agreement. Several of the affirmative determinations similarly have been challenged in appeals filed by foreign steel producers. USX will file additional antidumping and countervailing duty petitions if unfairly traded imports adversely impact, or threaten to adversely impact, the results of the U. S. Steel Group. The U. S. Steel Group depreciates steel assets by modifying straight-line depreciation based on the level of production. Depreciation charges for 1993 were 100% of straight-line depreciation based on production levels for the year. Depreciation charges for 1992 and 1991 approximated 91% and 89% of the amounts that would have been reported if production levels had not been considered. In 1992, the U. S. Steel Group revised the modification factors used in the depreciation of steel assets to reflect that raw steel production capability is entirely continuous cast (see Note 2 to the U. S. Steel Group Financial Statements). OUTLOOK FOR 1994 Based on strong recent order levels and assuming a continuing recovery of the U. S. economy, the U. S. Steel Group anticipates that steel demand will remain strong in 1994. The U. S. Steel Group believes that domestic industry shipments will reach 89 to 90 million tons in 1994 as compared to approximately 88 million tons in 1993. Price increases on sheet products have been announced effective January 2 and July 3, 1994. Price increases on certain other products have also been announced. Although early indications suggest that the January price increase is holding, full realization of the price increases will be dependent upon steel demand and the level of imports. As previously discussed, steel imports to the United States have increased in recent months. U. S. Steel entered into a new five and one-half year contract with the USWA, effective February 1, 1994, covering approximately 15,000 employees. The agreement will result in higher labor and benefit costs for the U. S. Steel Group each year throughout the term of the agreement. The agreement includes a signing bonus of $1,000 per USWA represented employee that will be paid in the first quarter of 1994, $500 of which represents the final bonus payable under the previous contract. The agreement also provides for the establishment of a Voluntary Employee Beneficiary Association Trust to prefund health care and life insurance benefits for retirees covered under the agreement. Minimum contributions, in the form of USX stock or cash, are expected to be $25 million in 1994 and $10 million per year thereafter. The funding of the trust will have no direct effect on income of the U. S. Steel Group. Management believes that this agreement is competitive with labor agreements reached by U. S. Steel's major domestic integrated competitors and thus does not believe that U. S. Steel's competitive position with regard to such other competitors will be materially affected by its ratification. Severe cold and extreme winter weather conditions disrupted steel and raw materials operations and caused forced utility curtailments at Gary Works, Mon Valley Works and Fairless Works in January 1994. These events will have some negative effects on operations in the first quarter of 1994. Net pension credits for the U. S. Steel Group in 1994 are expected to decline by approximately $85 million primarily due to a lower assumed long-term rate of return on plan assets. S-31 Delhi Group Index to Financial Statements, Supplementary Data and Management's Discussion and Analysis D-1 Delhi Group Explanatory Note Regarding Financial Information Although the financial statements of the Delhi Group, the Marathon Group and the U. S. Steel Group separately report the assets, liabilities (including contingent liabilities) and stockholders' equity of USX attributed to each such group, such attribution does not affect legal title to such assets and responsibility for such liabilities. Holders of USX-Delhi Group Common Stock, USX-Marathon Group Common Stock and USX-U. S. Steel Group Common Stock are holders of common stock of USX and continue to be subject to all the risks associated with an investment in USX and all of its businesses and liabilities. Financial impacts arising from any of the Delhi Group, the Marathonl Group or the U. S. Steel Group which affect the overall cost of USX's capital could affect the results of operations and financial condition of all groups. In addition, net losses of any group, as well as dividends or distributions on any class of USX common stock or series of Preferred Stock and repurchases of any class of USX common stock or certain series of Preferred Stock, will reduce the funds of USX legally available for payment of dividends on all classes of USX common stock. Accordingly, the USX consolidated financial information should be read in connection with the Delhi Group financial information. D-2 Management's Report The accompanying financial statements of the Delhi Group are the responsibility of and have been prepared by USX Corporation (USX) in conformity with generally accepted accounting principles. They necessarily include some amounts that are based on best judgments and estimates. The Delhi Group financial information displayed in other sections of this report is consistent with that in these financial statements. USX seeks to assure the objectivity and integrity of its financial records by careful selection of its managers, by organizational arrangements that provide an appropriate division of responsibility and by communications programs aimed at assuring that its policies and methods are understood throughout the organization. USX has a comprehensive formalized system of internal accounting controls designed to provide reasonable assurance that assets are safeguarded and that financial records are reliable. Appropriate management monitors the system for compliance, and the internal auditors independently measure its effectiveness and recommend possible improvements thereto. In addition, as part of their audit of the financial statements, USX's independent accountants, who are elected by the stockholders, review and test the internal accounting controls selectively to establish a basis of reliance thereon in determining the nature, extent and timing of audit tests to be applied. The Board of Directors pursues its oversight role in the area of financial reporting and internal accounting control through its Audit Committee. This Committee, composed solely of nonmanagement directors, regularly meets (jointly and separately) with the independent accountants, management and internal auditors to monitor the proper discharge by each of its responsibilities relative to internal accounting controls and the consolidated and group financial statements. Report of Independent Accountants To the Stockholders of USX Corporation: In our opinion, the accompanying financial statements appearing on pages D-4 through D-18 and as listed in Item 14.A.2 on page 61 of this report present fairly, in all material respects, the financial position of the Delhi Group at December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of USX's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. As discussed in Note 10, page D-12, in 1992 USX adopted a new accounting standard for income taxes. The Delhi Group is a business unit of USX Corporation (as described in Note 1, page D-7); accordingly, the financial statements of the Delhi Group should be read in connection with the consolidated financial statements of USX Corporation and Subsidiary Companies. Price Waterhouse 600 Grant Street, Pittsburgh, Pennsylvania 15219-2794 February 8, 1994 D-3 Statement of Operations Income Per Common Share of Delhi Stock (a) For period from October 2, 1992, to December 31, 1992. See Note 1, page D-7, for basis of presentation and Note 19, page D-16, for a description of net income per common share. Pro Forma Income Per Common Share of Delhi Stock (Unaudited) See Note 23, page D-18, for a description of pro forma income per common share. The accompanying notes are an integral part of these financial statements. D-4 Balance Sheet The accompanying notes are an integral part of these financial statements. D-5 Statement of Cash Flows See Note 6, page D-10, for supplemental cash flow information. The accompanying notes are an integral part of these financial statements. D-6 Notes to Financial Statements 1. BASIS OF PRESENTATION On October 2, 1992, USX Corporation (USX) publicly sold 9,000,000 shares of a new class of common stock, USX -- Delhi Group Common Stock (Delhi Stock), which is intended to reflect the performance of the Delhi Group. As a result, USX has three classes of common stock, the others being USX -- Marathon Group Common Stock (Marathon Stock) and USX -- U. S. Steel Group Common Stock (Steel Stock), which are intended to reflect the performance of the Marathon Group and the U. S. Steel Group, respectively. The Delhi Group includes the businesses of the Delhi Gas Pipeline Corporation (DGP) and certain other subsidiaries of USX. The Delhi Group is engaged in the purchasing, gathering, processing, transporting and marketing of natural gas. The financial data for the periods presented prior to October 2, 1992, reflected the combined historical financial position, results of operations and cash flows for the businesses of the Delhi Group which were included in the financial statements of the Marathon Group. Beginning October 2, 1992, the financial statements of the Delhi Group include the financial position, results of operations and cash flows for the businesses of the Delhi Group; the effects of the capital structure of the Delhi Group determined by the Board of Directors in accordance with the USX Certificate of Incorporation; and a portion of the corporate assets and liabilities and related transactions which are not separately identified with ongoing operating units of USX. Pro forma data is reported for the years 1992 and 1991 to reflect the results of operations as if the capital structure of the Delhi Group were in effect beginning January 1, 1991 (Note 23, page D-18). The Delhi Group financial statements are prepared using the amounts included in the USX consolidated financial statements. The USX Board of Directors initially designated 14,000,000 shares of Delhi Stock as the total number of shares of Delhi Stock which it deemed to represent 100% of the common stockholders' equity value of USX attributable to the Delhi Group. The Delhi Fraction is the percentage interest in the Delhi Group represented by the shares of Delhi Stock that are outstanding at any particular time and, based on 9,282,870 outstanding shares at December 31, 1993, is approximately 66%. The Marathon Group financial statements reflect a percentage interest in the Delhi Group of approximately 34% (Retained Interest) at December 31, 1993. The Retained Interest is subject to reduction as shares of Delhi stock attributed to the Retained Interest are sold. (See Note 3, page D-9, for a description of common stock transactions.) During 1993, 1992 and 1991 sales to one customer who accounted for 10 percent or more of the Delhi Group's total revenues totaled $76.4 million, $55.4 million and $59.2 million, respectively. In addition, sales to several customers having a common parent aggregated $66.3 million, $63.2 million and $53.7 million during 1993, 1992 and 1991, respectively. Although the financial statements of the Delhi Group, the Marathon Group and the U. S. Steel Group separately report the assets, liabilities (including contingent liabilities) and stockholders' equity of USX attributed to each such group, such attribution does not affect legal title to such assets and responsibility for such liabilities. Holders of Delhi Stock, Marathon Stock and Steel Stock are holders of common stock of USX and continue to be subject to all the risks associated with an investment in USX and all of its businesses and liabilities. Financial impacts arising from any of the Delhi Group, the Marathon Group or the U. S. Steel Group which affect the overall cost of USX's capital could affect the results of operations and financial condition of all groups. In addition, net losses of any group, as well as dividends or distributions on any class of USX common stock or series of Preferred Stock and repurchases of any class of USX common stock or certain series of Preferred Stock, will reduce the funds of USX legally available for payment of dividends on all classes of USX common stock. Accordingly, the USX consolidated financial information should be read in connection with the Delhi Group financial information. 2. SUMMARY OF PRINCIPAL ACCOUNTING POLICIES PRINCIPLES APPLIED IN CONSOLIDATION -- These financial statements include the accounts of the businesses comprising the Delhi Group. Beginning October 2, 1992, the Delhi Group, the Marathon Group and the U. S. Steel Group financial statements, taken together, comprise all of the accounts included in the USX consolidated financial statements. Investments in jointly owned gas processing plants are accounted for on a pro rata basis. D-7 Investments in other entities in which the Delhi Group has significant influence in management and control are accounted for using the equity method of accounting and are carried in the investment account at the Delhi Group's share of net assets plus advances. The proportionate share of income from equity investments is included in other income. Investments in marketable equity securities are carried at lower of cost or market. CASH AND CASH EQUIVALENTS -- Cash and cash equivalents includes cash on hand and on deposit and highly liquid debt instruments with maturities generally of three months or less. INVENTORIES -- Inventories are carried at lower of average cost or market. HEDGING TRANSACTIONS -- The Delhi Group enters into futures contracts to hedge exposure to price fluctuations relevant to the purchase or sale of natural gas. Such transactions are accounted for as part of the commodity being hedged. PROPERTY, PLANT AND EQUIPMENT -- Depreciation is generally computed on a straight-line method based upon estimated lives of assets. When an entire pipeline system, plant, major facility or facilities depreciated on an individual basis are sold or otherwise disposed of, any gain or loss is reflected in income. Proceeds from disposal of other facilities depreciated on a group basis are credited to the depreciation reserve with no immediate effect on income. INSURANCE -- The Delhi Group is insured for catastrophic casualty and certain property exposures, as well as those risks required to be insured by law or contract. Costs resulting from noninsured losses are charged against income upon occurrence. 3. CORPORATE ACTIVITIES Beginning October 2, 1992, the following corporate activities were reflected in the Delhi Group financial statements. FINANCIAL ACTIVITIES -- As a matter of policy, USX manages most financial activities on a centralized, consolidated basis. Such financial activities include the investment of surplus cash; the issuance, repayment and repurchase of short-term and long-term debt; the issuance, repurchase and redemption of preferred stock; and the issuance and repurchase of common stock. The initial capital structure of the Delhi Group determined by the Board of Directors pursuant to the USX Certificate of Incorporation as of June 30, 1992, reflects the Delhi Group's portion of USX's financial activities attributed to each of the three groups. Subsequent to June 30, 1992, transactions related primarily to invested cash, short-term and long-term debt (including convertible debt), related net interest and other financial costs, and preferred stock and related dividends are attributed to the Delhi Group, as well as to the Marathon Group and the U. S. Steel Group, based upon the cash flows of each group for the periods presented. Most financing transactions are attributed to and reflected in the financial statements of all three groups. See Note 4, page D-9, for the Delhi Group's portion of USX's financial activities attributed to all three groups. However, certain transactions such as leases, production payment financings, financial activities of consolidated entities which are less than wholly owned by USX and transactions related to securities convertible solely into any one class of common stock are or will be specifically attributed to and reflected in their entirety in the financial statements of the group to which they relate. CORPORATE GENERAL & ADMINISTRATIVE COSTS -- Corporate general and administrative costs are allocated to the Delhi Group, the Marathon Group and the U. S. Steel Group based upon utilization or other methods management believes to be reasonable and which consider certain measures of business activities, such as employment, investments and sales. Such costs were also reflected in the historical financial data of the businesses of the Delhi Group. The costs allocated to the Delhi Group were $1.4 million, $1.5 million and $2.4 million in 1993, 1992 and 1991, respectively, and primarily consist of employment costs including pension effects, professional services, facilities and other related costs associated with corporate activities. D-8 COMMON STOCK TRANSACTIONS -- The proceeds from issuances of Delhi Stock representing shares attributable to the Retained Interest will be reflected in the financial statements of the Marathon Group (Note 1, page D-7). All proceeds from issuances of additional shares of Delhi Stock not deemed to represent the Retained Interest will be reflected in their entirety in the financial statements of the Delhi Group. When a dividend or other distribution is paid or distributed in respect to the outstanding Delhi Stock, or any amount paid to repurchase shares of Delhi Stock generally, the Marathon Group financial statements are credited, and the Delhi Group financial statements are charged, with the aggregate transaction amount times the quotient of the Retained Interest divided by the Delhi Fraction. INCOME TAXES -- All members of the USX affiliated group are included in the consolidated United States federal income tax return filed by USX. Accordingly, the provision for federal income taxes and the related payments or refunds of tax are determined on a consolidated basis. The consolidated provision and the related tax payments or refunds will be reflected in the Delhi Group, the Marathon Group and the U. S. Steel Group financial statements in accordance with USX's tax allocation policy. In general, such policy provides that the consolidated tax provision and related tax payments or refunds are allocated among the Delhi Group, the Marathon Group and the U. S. Steel Group, for financial statement purposes, based principally upon the financial income, taxable income, credits, preferences and other amounts directly related to the respective groups. For tax provision and settlement purposes, tax benefits resulting from attributes (principally net operating losses), which cannot be utilized by one of the three groups on a separate return basis but which can be utilized on a consolidated basis in that year or in a carryback year, are allocated to the group that generated the attributes. However, if such tax benefits cannot be utilized on a consolidated basis in that year or in a carryback year, the prior years' allocation of such consolidated tax effects is adjusted in a subsequent year to the extent necessary to allocate the tax benefits to the group that would have realized the tax benefits on a separate return basis. The allocated group amounts of taxes payable or refundable are not necessarily comparable to those that would have resulted if the groups had filed separate returns; however, such allocation should not result in any of the three groups paying more taxes over time than it would if it filed separate tax returns and, in certain situations, could result in any of the three groups paying less. 4. FINANCIAL ACTIVITIES ATTRIBUTED TO ALL THREE GROUPS As described in Note 3, page D-8, the Delhi Group's portion of USX's financial activities attributed to all groups based on their respective cash flows is as follows: (a) For details of USX notes payable, long-term debt and preferred stock, see Notes 13, page U-18; 14, page U-19; and 19, page U-21, respectively, to the USX consolidated financial statements. (b) The Delhi Group's net interest and other financial costs reflect weighted average effects of all financial activities attributed to all three groups. The costs reported for 1992 are for the period October 2, 1992, to December 31, 1992. D-9 5. LONG-TERM DEBT The Delhi Group's portion of USX's consolidated long-term debt is as follows: (a) See Note 14, page U-19, to the USX consolidated financial statements for details of interest rates, maturities and other terms of long-term debt. (b) Most long-term debt activities of USX Corporation and its wholly owned subsidiaries are attributed to all three groups (in total, but not with respect to specific debt issues) based on their respective cash flows (Notes 3, page D-8; 4, page D-9; and 6, page D-10). 6. SUPPLEMENTAL CASH FLOW INFORMATION 7. OTHER ITEMS (a) Gain includes the sale of Red River Pipeline partnership, which had been written down in 1991. (b) See Note 3, page D-8, for discussion of USX interest and other financial costs attributable to the Delhi Group. D-10 8. INTERGROUP TRANSACTIONS SALES AND PURCHASES -- Delhi Group sales to the Marathon Group totaled $4.3 million, $4.3 million and $4.9 million in 1993, 1992 and 1991, respectively. Delhi Group purchases from the Marathon Group totaled $30.3 million, $31.2 million and $36.1 million in 1993, 1992 and 1991, respectively. These transactions were conducted on an arm's-length basis. See Note 16, page D-14, for sales of Delhi Group receivables to the Marathon Group. PAYABLE TO THE U. S. STEEL GROUP -- These amounts represent payables to the U. S. Steel Group for income taxes determined in accordance with the tax allocation policy described in Note 3, page D-9. Tax settlements between the groups are generally made in the year succeeding that in which such amounts are accrued. 9. PENSIONS The Delhi Group has a noncontributory defined benefit plans covering all employees over 21 years of age who have one or more years of continuous service. Benefits are based primarily on years of service and compensation during the later years of employment. The funding policy for the plan provides that payments to the pension trust shall be equal to the minimum funding requirements of ERISA plus such additional amounts as may be approved from time to time. The plan also provides benefits to certain employees of the Marathon Group which are not part of the Delhi Group. PENSION COST (CREDIT) -- The defined benefit cost was determined assuming an expected long-term rate of return on plan assets of 10% for 1993 and 11% for 1992 and 1991. FUNDS' STATUS -- The assumed discount rate used to measure the benefit obligations was 6.5% and 7% at December 31, 1993, and December 31, 1992, respectively. The assumed rate of future increases in compensation levels was 4.5% and 5% at December 31, 1993, and December 31, 1992, respectively. PENSION CURTAILMENTS -- In addition to the periodic pension credit, a curtailment gain of $1.2 million resulted in 1991 from the reduction in plan participants due to terminations or transfers to affiliated plans of employees which were not part of the Delhi Group. D-11 10. INCOME TAXES Income tax provisions and related assets and liabilities attributed to the Delhi Group are determined in accordance with the USX group tax allocation policy (Note 3, page D-9). In 1992, USX adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS No. 109), which requires an asset and liability approach in accounting for income taxes. Under this method, deferred income tax assets and liabilities are established to reflect the future tax consequences of carryforwards and differences between the tax bases and financial bases of assets and liabilities. The cumulative effect of the change in accounting principle determined as of January 1, 1992, increased net income $17.9 million. Provisions (credits) for estimated income taxes: (a) Computed in accordance with Accounting Principles Board Opinion No. 11. The deferred tax benefit of $7.2 million in 1991 was primarily the result of timing differences related to the impairment of an investment. Reconciliation of federal statutory tax rate (35% in 1993, and 34% in 1992 and 1991) to total provisions (credits): Deferred tax liabilities primarily relate to property, plant and equipment: The consolidated tax returns of USX for the years 1988 through 1991 are under various stages of audit and administrative review by the IRS. USX believes it has made adequate provision for income taxes and interest which may become payable for years not yet settled. 11. TAXES OTHER THAN INCOME TAXES D-12 12. LEASES Future minimum commitments for operating leases having remaining noncancelable lease terms in excess of one year are as follows: Operating lease rental expense: The Delhi Group leases a wide variety of facilities and equipment under operating leases, including building space, office equipment and production equipment. Contingent rental includes payments for the lease of a pipeline system owned by an affiliate; payments to the lessor are based on the volume of gas transported through the pipeline system less certain operating expenses. Most long-term leases include renewal options and, in certain leases, purchase options. 13. LONG-TERM RECEIVABLES AND OTHER INVESTMENTS The following financial information summarizes the Delhi Group's share in investments accounted for by the equity method: 14. INVENTORIES D-13 15. PROPERTY, PLANT AND EQUIPMENT The Delhi Group leases the Shackelford gas gathering system and an associated processing plant to a third party for $.1 million per year. The leases continue until June 30, 1998, and, if not terminated by either party, continue on a year-to-year basis thereafter. The leased facilities had a net book value of $4.1 million at December 31, 1993, which will be fully depreciated by the end of the lease term. 16. SALES OF RECEIVABLES Certain of the Delhi Group accounts receivables are sold in combination with the Marathon Group receivables under a limited recourse agreement. Payments are collected from the sold accounts receivable; the collections are reinvested in new accounts receivable for the buyers; and a yield, based on short-term market rates, is transferred to the buyers. Collections on sold accounts receivable will be forwarded to the buyers at the end of the agreement in 1995, in the event of earlier contract termination or if the Delhi Group does not have a sufficient quantity of eligible accounts receivable to reinvest in for the buyers. The balance of sold accounts receivable averaged $69.1 million, $56.9 million and $55.4 million for the years 1993, 1992 and 1991, respectively. At December 31, 1993, the balance of the Delhi Group's sold accounts receivable that had not been collected was $73.6 million. A substantial portion of the Delhi Group's sales are to local distribution companies and electric utilities. This could impact the Delhi Group's overall exposure to credit risk inasmuch as these customers could be affected by similar economic or other conditions. The Delhi Group does not generally require collateral for accounts receivable, but significantly reduces credit risk through credit extension and collection policies, which include analyzing the financial condition of potential customers, establishing credit limits, monitoring payments and aggressively pursuing delinquent accounts. In the event of a change in control of USX, as defined in the agreement, the Delhi Group may be required to forward payments collected on sold Delhi Group accounts receivable to the buyers. D-14 17. EQUITY (a) Transactions with USX included cash management, intergroup sales and purchases (Note 8, page D-11), settlement of federal income taxes with USX (Note 3, page D-9) and allocation of corporate general and administrative costs (Note 3, page D-8). Cash management reflected net distributions to USX of $65.5 million and $141.9 million in 1992, and 1991, respectively. (b) Pursuant to the USX Certificate of Incorporation and the capital structure of the Delhi Group determined by the Board of Directors, the USX equity investment in the Delhi Group was eliminated on October 2, 1992, in conjunction with the attribution of the Delhi Group's portion of USX's financial activities attributed to all groups (Note 3, page D-8) and the USX common stockholders' equity value, attributed to the 14,000,000 shares of Delhi Stock deemed to represent 100% of the initial common stockholders' equity in the Delhi Group. 18. DIVIDENDS In accordance with the USX Certificate of Incorporation, dividends on the Delhi Stock, Marathon Stock and Steel Stock are limited to the legally available funds of USX. Net losses of the Delhi Group, the Marathon Group or the U. S. Steel Group, as well as dividends or distributions on any class of USX common stock or series of Preferred Stock and repurchases of any class of USX common stock or certain series of Preferred Stock, will reduce the funds of USX legally available for payment of dividends on all classes of USX common stock. Subject to this limitation, the Board of Directors intends to declare and pay dividends on the Delhi Stock based on the financial condition and results of operations of the Delhi Group, although it has no obligation under Delaware Law to do so. In making its dividend decisions with respect to Delhi Stock, the Board of Directors considers among other things, the long-term earnings and cash flow capabilities of the Delhi Group as well as the dividend policies of similar publicly traded companies. Dividends on the Delhi Stock are further limited to the Available Delhi Dividend Amount. At December 31, 1993, the Available Delhi Dividend Amount was at least $125.2 million. The Available Delhi Dividend Amount will be increased or decreased, as appropriate, to reflect Delhi Net Income, dividends, repurchases or issuances with respect to the Delhi Stock and preferred stock attributed to the Delhi Group and certain other items. D-15 19. NET INCOME PER COMMON SHARE The method of calculating net income (loss) per share for the Delhi Stock, Marathon Stock and Steel Stock reflects the USX Board of Director's intent that the separately reported earnings and surplus of the Delhi Group, the Marathon Group and the U. S. Steel Group, as determined consistent with the USX Certificate of Incorporation, are available for payment of dividends to the respective classes of stock, although legally available funds and liquidation preferences of these classes of stock do not necessarily correspond with these amounts. Net income per share applicable to outstanding Delhi Stock is presented for periods subsequent to the October 2, 1992, initial issuance of Delhi Stock. (See Note 23, page D-18, for pro forma income per common share.) Primary net income per share is calculated by adjusting net income for dividend requirements of preferred stock and income applicable to the Retained Interest and is based on the weighted average number of common shares outstanding plus common stock equivalents, provided they are not antidilutive. Common stock equivalents result from assumed exercise of stock options and surrender of stock appreciation rights associated with stock options, where applicable. Fully diluted net income (loss) per share assumes exercise of stock options and surrender of stock appreciation rights, provided, in each case, the effect is not antidilutive. 20. STOCK PLANS AND STOCKHOLDER RIGHTS PLAN USX Stock Plans and Stockholder Rights Plan are discussed in Note 20, page U-22, and Note 24, page U-24, respectively, to the USX consolidated financial statements. 21. FAIR VALUE OF FINANCIAL INSTRUMENTS Fair value of the financial instruments disclosed herein is not necessarily representative of the amount that could be realized or settled, nor does the fair value amount consider the tax consequences of realization or settlement. As described in Note 3, page D-8, the Delhi Group's specifically attributed financial instruments and the Delhi Group's portion of USX's financial instruments attributed to all groups are as follows: Fair value of financial instruments classified as current assets or liabilities approximate carrying value due to the short-term maturity of the instruments. Fair value of long-term receivables and other investments was based on discounted cash flows or other specific instrument analysis. Fair value of long-term debt instruments was based on market prices where available or current borrowing rates available for financings with similar terms and maturities. The Delhi Group's unrecognized financial instruments consist of accounts receivables sold subject to limited recourse. It is not practicable to estimate the fair value of this form of financial instrument obligation. For details relating to sales of receivables see Note 16, page D-14. D-16 22. CONTINGENCIES USX is the subject of, or a party to, a number of pending or threatened legal actions, contingencies and commitments relating to the Delhi Group involving a variety of matters, including laws and regulations relating to the environment. Certain of these matters are discussed below. The ultimate resolution of these contingencies could, individually or in the aggregate, be material to the Delhi Group financial statements. However, management believes that USX will remain a viable and competitive enterprise even though it is possible that these contingencies could be resolved unfavorably to the Delhi Group. SWEPCO litigation -- On January 26, 1994, a settlement agreement was executed between Delhi and Southwestern Electric Power Company (SWEPCO), resolving litigation which began in 1991 related to a 15-year natural gas purchase contract (original contract) which was due to expire in April 1995. The settlement agreement provides that SWEPCO pay Delhi the price under the original contract through January 1994. This included the release of $2.9 million to Delhi which was previously deposited by SWEPCO to the custody of the court in 1993. Concurrent with execution of the settlement agreement, Delhi executed a new four-year agreement with SWEPCO enabling Delhi to supply increased volumes of gas to two SWEPCO power plants in East Texas at market sensitive prices and premiums commensurate with the level of service provided. The agreement provides for swing service and does not require any minimum gas purchase volumes. ENVIRONMENTAL MATTERS -- The Delhi Group is subject to federal, state and local laws and regulations relating to the environment. These laws generally provide for control of pollutants released into the environment and require responsible parties to undertake remediation of hazardous waste disposal sites. Penalties may be imposed for noncompliance. Expenditures for remediation and penalties have not been material. For a number of years, the Delhi Group has made capital expenditures to bring existing facilities into compliance with various laws relating to the environment. In 1993 and 1992, such capital expenditures totaled approximately $4.5 million and $3.0 million, respectively. The Delhi Group anticipates making additional such expenditures in the future; however, the exact amounts and timing of such expenditures are uncertain because of the continuing evolution of specific regulatory requirements. D-17 23. PRO FORMA INCOME PER COMMON SHARE (UNAUDITED) Income per share data applicable to outstanding Delhi Stock is reported on a pro forma basis for the years 1992 and 1991 to reflect the per share income as if the capital structure of the Delhi Group was in effect beginning January 1, 1991. The capital structure of the Delhi Group as of June 30, 1992, was determined by the Board of Directors pursuant to the USX Certificate of Incorporation. Historical income before the cumulative effect of the change in accounting principle was adjusted for the attribution of certain corporate activities (Note 3, page D-8). The pro forma data are not necessarily indicative of the results that would have occurred if the capital structure of the Delhi Group was in effect for the periods indicated. (a) The adjustment for net interest and other financial costs reflects the weighted average effects of all USX financial activities assumed to be attributed to the Delhi Group for the periods prior to October 2, 1992. The adjustment for the provision for estimated income taxes reflects the change in total income before taxes due to recognition of these adjustments. The adjustment to dividends on preferred stock reflects the assumed effects of attributed preferred stock. (b) Pro forma income applicable to Retained Interest represents the pro forma income before the cumulative effect of the change in accounting principle less dividends on preferred stock, multiplied by the initial Retained Interest of approximately 36% for each year presented. (c) Pro forma income per share before the cumulative effect of the change in accounting principle applicable to outstanding Delhi Stock is calculated by dividing the pro forma income before the cumulative effect of the change in accounting principle applicable to outstanding Delhi Stock by the pro forma average number of shares outstanding, which assumes 9,000,000 shares initially sold were outstanding for all periods. Principal Unconsolidated Affiliates (Unaudited) (a) Ownership interest as of December 31, 1993. D-18 Selected Quarterly Financial Data (Unaudited) (a) Includes a $4.1 million unfavorable effect associated with an increase in the federal income tax rate from 34% to 35%, reflecting remeasurement of deferred income tax liabilities as of January 1, 1993. (b) Total income (loss) before cumulative effect of change in accounting principle applicable to outstanding Delhi Stock and related per share amounts have been provided on a pro forma basis prior to the October 2, 1992, initial issuance of Delhi Stock. See Note 23, page D-18. (c) Composite tape. Delhi Stock was issued on October 2, 1992. D-19 Five-Year Operating Summary (a) In January 1993, the Delhi Group sold its 25% interest in Red River Pipeline. (b) Included the effect of a significant favorable settlement of three lawsuits related to gas sales contracts. (c) In 1993, the Delhi Group sold all of its pipeline systems located in Colorado. D-20 THE DELHI GROUP Management's Discussion and Analysis The Delhi Group includes Delhi Gas Pipeline Corporation ("DGP"), a wholly owned subsidiary of USX Corporation ("USX"), and certain related companies which are engaged in the purchasing, gathering, processing, transporting and marketing of natural gas. Management's Discussion and Analysis should be read in conjunction with the Delhi Group's Financial Statements and Notes to Financial Statements. The financial data presented for the periods prior to October 2, 1992, (with the exception of pro forma data) reflected the combined historical financial position, results of operations and cash flows for the businesses of the Delhi Group. Beginning October 2, 1992, the financial statements of the Delhi Group include the financial position, results of operations and cash flows for the businesses of the Delhi Group and the effects of the capital structure of the Delhi Group which includes a portion of the corporate assets and liabilities and related transactions which are not separately identified with the ongoing operations of USX. MANAGEMENT'S DISCUSSION AND ANALYSIS OF INCOME The following table provides a summary of the Delhi Group's sales for each of the last three years: TOTAL SALES in 1993 increased by 17% from 1992, mainly due to increased revenues from premium services and higher average natural gas sales prices. Total sales revenues in 1992 increased by 8% from 1991 primarily due to higher average natural gas sales prices, increased systems throughput volumes and increased gas processing revenues. OPERATING INCOME for the Delhi Group was $35.6 million in 1993, $32.6 million in 1992 and $31.0 million in 1991. Operating income in 1993 included favorable effects of $1.8 million for the reversal of a prior-period accrual related to a natural gas contract settlement, $0.8 million related to gas imbalance settlements and a net $0.6 million for a refund of prior years' taxes other than income taxes. Operating income in 1992 included favorable effects totaling $1.5 million relating to the settlement of various lawsuits and third-party disputes. Excluding the effects of these items, 1993 operating income improved by $1.3 million, primarily as a result of higher gas sales margins and lower operating and other expenses, partially offset by a 34% decline in gas processing margins from the sale of natural gas liquids ("NGLs"). Depreciation, depletion and amortization of $36.3 million in 1993 declined from 1992 mainly due to certain assets becoming fully depreciated during the prior year. Operating income in 1991 included $8.0 million for favorable settlements of certain contractual issues. Excluding the effects of the settlements in 1992 and 1991, operating income in 1992 improved by $8.1 million, primarily due to increased NGLs volumes from gas processing, higher natural gas systems throughput volumes and lower operating and other expenses. These favorable items were partially offset by lower unit margins for NGLs, reflecting lower NGLs prices and higher feedstock costs. (See "Management's Discussion and Analysis of Operations" below for a further discussion of operating income.) D-21 Management's Discussion and Analysis CONTINUED OTHER INCOME of $5.2 million in 1993 included the favorable pretax effect of a $0.9 million accrual reversal recognizing the expiration of certain obligations related to a prior asset acquisition, and a pretax gain of $2.9 million from disposal of assets. The disposal of assets included pretax gains of $0.8 million on the sale of nonstrategic gas gathering systems in Colorado and $1.6 million on the sale of the Delhi Group's interest in a natural gas transmission partnership. The 1993 U.S. income tax provision included a $2.9 million unfavorable tax effect associated with the sale of the transmission partnership interest, which resulted in a $1.3 million net loss on the transaction. Other loss in 1991 reflected an $18.7 million impairment of the Delhi Group's interest in the previously mentioned transmission partnership. INTEREST AND OTHER FINANCIAL COSTS increased by $5.9 million in 1993 following a $4.0 million increase in 1992. Interest and other financial costs of $10.5 million in 1993 included $7.7 million representing the Delhi Group's portion of USX's financial activities attributable to all three groups and $2.5 million related to the sale of the Delhi Group's accounts receivables. Interest and other financial costs in 1992 included $2.3 million related to the sale of the Delhi Group's accounts receivables, which began in December 1991, and interest expense of $2.1 million representing the Delhi Group's portion of USX's financial activities attributable to all three groups for the period October 2, 1992, through December 31, 1992. THE PROVISION FOR ESTIMATED INCOME TAXES is based on tax rates and amounts which recognize management's best estimate of current and deferred tax assets and liabilities. In addition to the previously mentioned $2.9 million unfavorable tax effect associated with the sale of the Delhi Group's interest in a natural gas transmission partnership, the income tax provision for 1993 included a $4.1 million charge associated with an increase in the federal income tax rate from 34% to 35%, reflecting remeasurement of deferred federal income tax liabilities as of January 1, 1993. CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE in 1992 reflected the $17.9 million favorable cumulative noncash effect, measured as of January 1, 1992, of adopting Statement of Financial Accounting Standards No. 109--Accounting for Income Taxes ("SFAS No. 109"), which requires an asset and liability approach for measuring deferred income taxes. NET INCOME was $12.2 million in 1993, $36.5 million in 1992 and $7.2 million in 1991. Excluding the cumulative effect of the adoption of SFAS No. 109, net income decreased by $6.4 million in 1993 following an increase of $11.4 million in 1992 from 1991. Net income presented for 1991, and for the portion of 1992 relating to the period prior to October 2, 1992, reflected the historical income for the businesses of the Delhi Group. Net income for these periods does not reflect interest costs and related income tax amounts of the Delhi Group as it was capitalized in accordance with the USX Certificate of Incorporation effective October 2, 1992. However, pro forma income before the cumulative effect of the change in accounting principle of $13.8 million in 1992 and $1.0 million in 1991 are presented as if the capital structure of the Delhi Group was in effect beginning January 1, 1991. (See Note 23 to the Delhi Group Financial Statements.) MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION CURRENT ASSETS of $42.2 million at year-end 1993 were $16.7 million higher than the year-end 1992 balance due primarily to increases in receivables and in cash and cash equivalents. The increase in receivables mainly reflected increased natural gas sales in December 1993 as compared with December 1992 and a delay in collection of amounts for gas sold to Southwestern Electric Power Company ("SWEPCO"), related to a natural gas contract dispute which was settled in January 1994 (see Note 22 to the Delhi Group Financial Statements, and Management's Discussion and Analysis of Operations below). These items were partially offset by a decline in NGLs sales in December 1993 as compared with December 1992 and the sale of additional receivables of $3.5 million. D-22 Management's Discussion and Analysis CONTINUED CURRENT LIABILITIES were $102.4 million at year-end 1993, $7.3 million lower than at year-end 1992 due primarily to lower accrued taxes reflecting higher estimated federal income tax payments and a decline in the current portion of USX's long-term debt attributed to the Delhi Group. These items were partially offset by increased accounts payable mainly resulting from higher gas purchase volumes and prices. TOTAL LONG-TERM DEBT AND NOTES PAYABLE at December 31, 1993 was $109.6 million. The $11.3 million increase from year-end 1992 was primarily due to capital expenditures, dividend payments and an increase in cash and cash equivalents from year-end 1992, partially offset by cash provided from operating activities and disposal of assets. The amount of total long-term debt, as well as the amount shown as notes payable, represented the Delhi Group's portion of USX debt attributed to all three groups. Virtually all of the debt is a direct obligation of, or is guaranteed by, USX. DEFERRED CREDITS AND OTHER LIABILITIES declined to $9.5 million at year-end 1993, primarily reflecting the amortization of income from reservation fees related to certain natural gas contracts and the previously mentioned reversal of an accrual related to a prior asset acquisition. STOCKHOLDERS' EQUITY of $205.5 million at year-end 1993 increased $9.4 million from year-end 1992 mainly reflecting the net income recorded during 1993, partially offset by dividends paid. MANAGEMENT'S DISCUSSION AND ANALYSIS OF CASH FLOWS NET CASH PROVIDED FROM OPERATING ACTIVITIES totaled $33.2 million in 1993, down $42.6 million from 1992 primarily reflecting the payment of income taxes (including settlements with other groups) totaling $22.7 million in 1993 (of which $8.5 million related to prior year federal taxes) versus $12.3 million in 1992, an increase in interest paid, a decline in cash realized from the sale of receivables and the previously mentioned delay in collection of receivables relating to a natural gas contract dispute with SWEPCO. Cash provided from operating activities in 1992 declined $40.4 million from 1991 due primarily to changes in cash realized from sold accounts receivables. CAPITAL EXPENDITURES of $42.6 million in 1993 increased by 60% from 1992 following a 43% increase in 1992 from 1991. Expenditures were primarily for the expansion of existing systems and the acquisition of pipeline systems enabling the Delhi Group to connect additional new dedicated natural gas reserves. Additions to the Delhi Group's dedicated gas reserves totaled 382 billion cubic feet ("bcf"), 273 bcf and 255 bcf in 1993, 1992 and 1991, respectively. Expenditures in all three years included amounts for improvements and upgrades to existing facilities. Expenditures in 1993 included amounts for a multi-pipeline interconnection and compression project in the Carthage area of East Texas, the acquisition and connection of a 65-mile gas gathering system in West Texas and the purchase, connection and upgrade of a 30 million cubic feet per day cryogenic gas processing facility near existing systems in South Texas. Capital expenditures in 1994 are expected to exceed 1993 levels as the Delhi Group continues to pursue opportunities to connect dedicated gas reserves by the expansion or acquisition of gas gathering, processing and transmission assets, including those made available as a result of current industry conditions and regulatory initiatives. CASH GENERATED FROM DISPOSAL OF ASSETS in 1993 was $4.2 million, an increase of $3.3 million from 1992 and $3.9 million from 1991. The increases primarily reflected proceeds in 1993 from the sale of the Delhi Group's interest in a natural gas transmission partnership and from the sale of nonstrategic gas gathering systems in Colorado. D-23 Management's Discussion and Analysis CONTINUED FINANCIAL OBLIGATIONS increased $10.6 million in 1993, primarily reflecting the Delhi Group's net cash flows from operating activities, investment activities and dividends paid during the period. These obligations consist of the Delhi Group's portion of USX debt attributed to all three groups. TRANSACTIONS WITH USX THROUGH OCTOBER 2, 1992, which impacted 1992 and 1991, reflected centrally managed cash transactions prior to formation of the Delhi Group. DIVIDEND PAYMENTS of $1.9 million in 1993 included the payment of four quarterly dividends compared with one dividend payment in 1992, reflecting the formation of the Delhi Group on October 2, 1992. The annualized rate of dividends per share for the USX-Delhi Group Common Stock, based on the most recently declared quarterly dividend, is $.20. In September 1993, Standard and Poor's Corporation ("S&P")lowered its ratings on USX's and Marathon's senior debt to below investment grade (from BBB- to BB+) and on USX's subordinated debt, preferred stock and commercial paper. S&P cited extremely aggressive financial leverage, burdensome retiree medical liabilities and litigation contingencies. In October 1993, Moody's Investors Service, Inc. ("Moody's") confirmed its Baa3 investment grade ratings on USX's and Marathon's senior debt. Moody's also confirmed its ratings on USX's subordinated debt and commercial paper, but lowered its ratings on USX's preferred stock from ba1 to ba2. Moody's noted that the rating confirmation on USX debt securities reflected confidence in the expected performance of USX during the intermediate term, while the downward revision of the preferred stock ratings incorporated a narrow fixed charge coverage going forward. The downgrades by S&P and the downgrade of ratings on preferred stock by Moody's could increase USX's cost of capital. Any related increase in interest costs would be reflected in the consolidated financial statements and the financial statements of each group. USX anticipates that the Delhi Group will resume cash funding of its pension plan in amounts approximating $0.1 million for the 1993 plan year and $1 million for the 1994 plan year, with the funding for both plan years impacting cash flows in 1994. MANAGEMENT'S DISCUSSION AND ANALYSIS OF ENVIRONMENTAL MATTERS, LITIGATION AND CONTINGENCIES The Delhi Group has incurred and will continue to incur capital and operating and maintenance expenditures as a result of environmental laws and regulations. To the extent these expenditures, as with all costs, are not ultimately reflected in the prices of the Delhi Group's products and services, operating results will be adversely affected. The Delhi Group believes that substantially all of its competitors are subject to similar environmental laws and regulations. However, the specific impact on each competitor may vary depending on a number of factors, including the age and location of their operating facilities and their production processes. The Delhi Group's environmental expenditures for 1993 and 1992 are discussed below and have been estimated based on American Petroleum Institute ("API") survey guidelines. These guidelines are subject to differing interpretations which could affect the comparability of such data. Some environmental related expenditures, while benefiting the environment, also enhance operating efficiencies. The Delhi Group's total environmental expenditures in 1993 were $9.8 million compared with $7.9 million in 1992. These amounts consisted of capital expenditures of $4.5 million in 1993 and $3.0 million in 1992 and estimated compliance expenditures (including operating and maintenance) of $5.3 million in 1993 and $4.9 million in 1992. Compliance expenditures were broadly estimated based on API survey guidelines and represented 1% of the Delhi Group's total operating costs in both 1993 and 1992. Remediation related expenditures were not material. D-24 Management's Discussion and Analysis CONTINUED New or expanded requirements for environmental regulations, which could increase the Delhi Group's environmental costs, may arise in the future. USX intends to comply with all legal requirements regarding the environment, but since many of them are not fixed or presently determinable (even under existing legislation) and may be affected by future legislation, it is not possible to accurately predict the ultimate cost of compliance, including remediation costs which may be incurred and penalties which may be imposed. However, based on presently available information, and existing laws and regulations as currently implemented, management does not anticipate that environmental compliance expenditures will materially increase in 1994. The Delhi Group's capital expenditures for environmental controls are expected to be approximately $5 million in 1994. Predictions beyond 1994 can only be broad-based estimates which have varied, and will continue to vary, due to the ongoing evolution of specific regulatory requirements, the possible imposition of more stringent requirements and the availability of new technologies, among other matters. Based upon currently identified projects, the Delhi Group anticipates that environmental capital expenditures in 1995 will remain at about the same levels experienced in 1994; however, actual expenditures may increase as additional projects are identified or additional requirements are imposed. USX is the subject of, or a party to, a number of pending or threatened legal actions, contingencies and commitments relating to the Delhi Group involving a variety of matters, including laws and regulations relating to the environment, certain of which are discussed in Note 22 to the Delhi Group Financial Statements. The ultimate resolution of these contingencies could, individually or in the aggregate, be material to the Delhi Group financial statements. However, management believes that USX will remain a viable and competitive enterprise even though it is possible that these contingencies could be resolved unfavorably to the Delhi Group. (See USX Consolidated Management's Discussion and Analysis of Cash Flows.) MANAGEMENT'S DISCUSSION AND ANALYSIS OF OPERATIONS The Delhi Group's operating results are affected by fluctuations in natural gas prices and demand levels in the markets that it serves. Natural gas prices were volatile in 1993 causing disruption of the Delhi Group's short term interruptible ("spot") market program and gas processing business. In addition, NGLs prices, which tend to follow fluctuations in crude oil prices, declined significantly in the last half of 1993. The Delhi Group intends to remain competitive in this market environment by maximizing gas sales to higher margin customers and maximizing its total systems throughput by supplementing higher margin sales with gas sales to industrial end users, spot market sales and transportation revenues. The Delhi Group can also be affected by changes in the regulatory environment governing its businesses and the businesses of its competitors. In April 1992, the Federal Energy Regulatory Commission issued Order No. 636, ("the Order") which makes significant changes to the structure of the services provided by interstate natural gas pipelines. The changes are intended to ensure that interstate pipeline companies provide transportation service that is equal in quality for all gas supplies, whether the customer purchases the gas from the pipeline or from another supplier. The Delhi Group is primarily an intrastate gas gatherer (as opposed to an interstate pipeline company) and does not face significant transition costs as a result of the Order. The Delhi Group believes that the Order will provide opportunities to offer its merchant gas services to existing customers of interstate pipelines who are seeking an alternative gas supply source. However, as the Order is implemented, any additional Delhi Group gas sales resulting from the Order will be subject to negotiation with the individual customers. The Delhi Group cannot accurately determine the financial effect of such opportunities on future operating results. The Delhi Group's four largest customers accounted for 45% and 39% of its total gross margin and 18% and 14% of its total systems throughput in 1993 and 1992, respectively. In the event that one or more of the Delhi Group's largest customers reduce volumes taken under an existing contract or chooses not to renew such contract, the Delhi Group would be adversely affected to the extent it is unable to find alternative customers to buy gas at the same level of profitability. D-25 Management's Discussion and Analysis CONTINUED On January 26, 1994, a settlement agreement was executed between DGP and SWEPCO, (one of the Delhi Group's four largest customers) resolving litigation which began in 1991 related to a 15-year natural gas purchase contract ("original contract") which was due to expire in April 1995. Sales under the original contract were at prices substantially above spot prices and, as a result, this contract accounted for more than 10% of Delhi's total gross margin in each of the last three years. The settlement agreement provides that SWEPCO will pay the Delhi Group the price under the original contract through January 1994. Concurrent with the execution of the settlement agreement, the Delhi Group executed a new four-year agreement with SWEPCO enabling Delhi to supply increased volumes of gas to two SWEPCO power plants in East Texas at market sensitive prices and premiums commensurate with the level of service provided. The agreement provides for swing service and does not require any minimum gas purchase volumes. The Delhi Group's operating income and cash flow will be adversely affected by the amount of premiums lost under the original contract for the period February 1, 1994, through April 1, 1995. Broad estimates of the potential premium losses are $18 million and $4 million in 1994 and 1995, respectively. SWEPCO has purchased gas under the new agreement. Operating income of $35.6 million in 1993 increased by $3.0 million, or 9%, from 1992 following a $1.6 million, or 5%, increase in 1992 from 1991. The following is a discussion of the Delhi Group's gross margin by principal service for each of the last three years and an analysis of the reasons for changes in such margins between years. The gas sales margin and gas sales throughput for each of the last three years were: Excluding the effects of the contractual issues, described under Management's Discussion and Analysis of Income above, gas sales margin increased by 8% in 1993 and 7% in 1992 from the respective prior years. The improvement in 1993 mainly reflected increased sales to higher margin customers. Margins on spot sales were affected by fluctuations in natural gas prices throughout most of 1993 although overall average prices increased in 1993 from the prior year. The successful dedicated natural gas reserve addition programs in 1993 and 1992 contributed to the increases in both sales and transportation volumes for those years by making more natural gas available. Natural gas sales unit margins in 1992 benefitted from a favorable change in premium sales mix. Average natural gas sales prices trended downward over most of 1991 and 1992, but stabilized in mid-1992 and increased during the last several months of 1992 contributing to improved 1992 gas sales unit margins from the prior year. Gas sales margins in 1994 will be affected by factors relating to the natural gas contract settlement with SWEPCO described above. The transportation margin and throughput for each of the last three years were: D-26 Management's Discussion and Analysis CONTINUED Transportation margins declined by 4% to $14.2 million in 1993, following a 6% increase in 1992 from 1991. Average throughput volumes increased in 1993 and 1992 from the respective prior year periods, while average transportation rates trended downward over those periods. The rate decline in 1993 more than offset the favorable effect of the increase in throughput volumes for that year. The changes in transportation volumes and rates during the three-years reflected a strategy of offering producers transportation rate incentives in order to increase the Delhi Group's dedicated natural gas reserve base and the supply of processable gas to its plants. The aggregation of transportation and processing services increased the Delhi Group's overall gross margin, although the transportation rate was lower than the normal rate charged for transportation as a separate service. The gas processing margin, NGLs sales volume and NGLs sales price for each of the last three years were: The 34% decline in gas processing margins in 1993 resulted from higher average feedstock costs stemming from increased average natural gas prices, primarily in the first nine months of 1993, and lower NGLs prices which trended downward with crude oil prices in the last half of 1993. NGLs volumes for 1993 increased by 8% from the prior year as the Delhi Group continued to add dedicated natural gas reserves, with the associated gas processing rights, to its systems. However, fourth quarter 1993 NGLs volumes declined by 17% from the third quarter of 1993 as the Delhi Group chose not to fully process some gas due to the decline in NGLs prices. The Delhi Group will continue to monitor the economics of removing NGLs from the gas stream for processing on an ongoing basis to determine the appropriate level of each gas plant's operation. The Delhi Group anticipates that margins for gas processing will continue to be depressed in the first quarter of 1994. The gas processing margin declined by 4% in 1992 from 1991 reflecting lower average NGLs sales prices and higher feedstock costs. These factors were partially offset by a 22% increase in NGLs sales volumes due in part to the previously mentioned increase in systems throughput, which resulted in increased availability of gas for processing. Operating expenses of $28.0 million in 1993 declined by $1.1 million from 1992 due mainly to cost control procedures. Operating expenses of $29.1 million in 1992 declined by $1.9 million from 1991 primarily due to cost control procedures implemented during the year and reduced maintenance and repair costs. D-27 PART III ITEM 10.	ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information concerning the directors of USX required by this item is incorporated by reference to the material appearing under the headings "Election of Directors" in USX's Proxy Statement for the 1994 Annual Meeting of Stockholders. The executive officers of USX and their ages as of February 1, 1994 are as follows: All of the executive officers have held responsible management or professional positions with USX or its subsidiaries for more than the past five years. ITEM 11.	ITEM 11. MANAGEMENT REMUNERATION Information required by this item is incorporated by reference to the material appearing under the heading "Executive Compensation and Other Information" in USX's Proxy Statement dated March 18, 1994, for the 1994 Annual Meeting of Stockholders. ITEM 12.	ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information required by this item is incorporated by reference to the material appearing under the headings, "Security Ownership of Certain Beneficial Owners" and "Security Ownership of Directors and Executive Officers" in USX's Proxy Statement dated March 18, 1994, for the 1994 Annual Meeting of Stockholders. ITEM 13.	ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information required by this item is incorporated by reference to the material appearing under the heading "Transactions" in USX's Proxy Statement dated March 18, 1994, for the 1994 Annual Meeting of Stockholders. PART IV ITEM 14.	ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K A. DOCUMENTS FILED AS PART OF THE REPORT 1. Financial Statements Financial Statements filed as part of this report are listed on the Index to Financial Statements, Supplementary Data and Management's Discussion and Analysis of USX Consolidated on page U-1, of the Marathon Group on Page M-1, of the U. S. Steel Group on page S-1 and of the Delhi Group on Page D-1. 2. Financial Statement Schedules and Supplementary Data Financial Statement Schedules -- For the Years Ended December 31, 1993, 1992 and 1991. All other schedules are omitted because they are not applicable or the required information is contained in the applicable financial statements or notes thereto. B. REPORTS ON FORM 8-K 1.1 None C. EXHIBITS SIGNATURES 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 capacity indicated on March 14, 1994. USX CORPORATION By /s/ Lewis B. Jones --------------------------------- LEWIS B. JONES VICE PRESIDENT & COMPTROLLER USX CONSOLIDATED SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT SCHEDULE VI--ACCUMULATED DEPRECIATION, DEPLETION, AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT - - ----------------- (a) Reflects expenditures for many varied facilities, none of which is in excess of 2% of total assets. (b) Includes restructuring activities. USX CONSOLIDATED SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT (CONT'D.) SCHEDULE VI--ACCUMULATED DEPRECIATION, DEPLETION, AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (CONT'D.) - - ----------------- (a) Reflects expenditures for many varied facilities, none of which is in excess of 2% of total assets. (b) Comprehends elimination of assets for businesses included in the Delhi Group which were also included in the Marathon Group prior to October 2, 1992. (c) Includes restructuring activities. USX CONSOLIDATED SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT (CONT'D.) SCHEDULE VI--ACCUMULATED DEPRECIATION, DEPLETION, AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (CONT'D.) - - ----------------- (a) Reflects expenditures for many varied facilities, none of which is in excess of 2% of total assets. (b) Includes restructuring activities. MARATHON GROUP SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT SCHEDULE VI--ACCUMULATED DEPRECIATION, DEPLETION, AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT - - ----------------- (a) Reflects expenditures for many varied facilities, none of which is in excess of 2% of total assets. MARATHON GROUP SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT (CONT'D.) SCHEDULE VI--ACCUMULATED DEPRECIATION, DEPLETION, AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (CONT'D.) - - ----------------- (a) Reflects expenditures for many varied facilities, none of which is in excess of 2% of total assets. (b) Comprehends elimination of assets for businesses included in the Delhi Group beginning October 2, 1992. (c) Includes restructuring activities. MARATHON GROUP SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT (CONT'D.) SCHEDULE VI--ACCUMULATED DEPRECIATION, DEPLETION, AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (CONT'D.) - - ----------------- (a) Reflects expenditures for many varied facilities, none of which is in excess of 2% of total assets. U. S. STEEL GROUP SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT SCHEDULE VI--ACCUMULATED DEPRECIATION, DEPLETION, AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT - - ----------------- (a) Reflects expenditures for many varied facilities, none of which is in excess of 2% of total assets. (b) Including restructuring activities. U. S. STEEL GROUP SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT (CONT'D.) SCHEDULE VI--ACCUMULATED DEPRECIATION, DEPLETION, AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (CONT'D) - - ----------------- (a) Reflects expenditures for many varied facilities, none of which is in excess of 2% of total assets. U. S. STEEL GROUP SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT (CONT'D.) SCHEDULE VI--ACCUMULATED DEPRECIATION, DEPLETION, AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (CONT'D.) - - ----------------- (a) Reflects expenditures for many varied facilities, none of which is in excess of 2% of total assets. (b) Includes restructuring activities. DELHI GROUP SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT SCHEDULE VI--ACCUMULATED DEPRECIATION, DEPLETION, AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT - - ----------------- (a) Reflects expenditures for many varied facilities, none of which is in excess of 2% of total assets. DELHI GROUP SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT (CONT'D.) SCHEDULE VI--ACCUMULATED DEPRECIATION, DEPLETION, AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (CONT'D.) - - ----------------- (a) Data for periods prior to October 2, 1992, were included in the Marathon Group. (b) Reflects expenditures for many varied facilities, none of which is in excess of 2% of total assets. DELHI GROUP SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT (CONT'D.) SCHEDULE VI--ACCUMULATED DEPRECIATION, DEPLETION, AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (CONT'D.) - - ----------------- (a) Data were included in the Marathon Group. (b) Reflects expenditures for many varied facilities, none of which is in excess of 2% of total assets. SUPPLEMENTARY DATA SUMMARIZED FINANCIAL INFORMATION OF MARATHON OIL COMPANY - - ----------------------------------------------------------------------------- Summarized financial information of Marathon Oil Company, a wholly owned subsidiary of USX Corporation, is presented below.
798905_1993.txt	798905	1993	Item 1. Business. General Development of Business. Phoenix Leasing Cash Distribution Fund II, a California limited partnership (the "Partnership"), was organized on June 28, 1984. The Partnership was registered with the Securities and Exchange Commission with an effective date of November 20, 1986 and shall continue to operate until its termination date unless dissolved sooner due to the sale of substantially all of the assets of the Partnership or a vote of the Limited Partners. The Partnership will terminate on December 31, 1997. The General Partner is Phoenix Leasing Incorporated, a California corporation. The General Partner or its affiliates also is or has been a general partner in several other limited partnerships formed to invest in capital equipment and other assets. The initial registration was for 300,000 units of limited partnership interest at a price of $250 per unit with an option of increasing the public offering up to a maximum of 400,000 units. The Partnership sold 386,308 units for a total capitalization of $96,577,000. Of the proceeds received through the offering, the Partnership has incurred $11,540,000 in organizational and offering expenses. The Partnership concluded its public offering on February 4, 1988. From the initial formation of the Partnership through December 31, 1993, the total investments in equipment leases and financing transactions (loans), including the Partnership's pro rata interest in investments made by joint ventures, approximate $174,034,000. The average initial firm term of contractual payments from equipment subject to lease was 32.20 months, and the average initial net monthly payment rate as a percentage of the original purchase price was 2.24%. The average initial firm term of contractual payments from loans was 82.01 months. Narrative Description of Business. The Partnership's principal objective is to produce cash flow to the investors on a continuing basis over the life of the Partnership. To achieve this objective, the Partnership has invested in various types of capital equipment and other assets to provide leasing or financing of the same to third parties, including Fortune 1000 companies and their subsidiaries, middle-market companies, emerging growth companies, cable television operators and others, on either a long-term or short-term basis. The types of equipment that the Partnership has invested in includes computer peripherals, terminal systems, small computer systems, communications equipment, IBM mainframes, IBM-software compatible mainframes, office systems, CAE/CAD/CAM equipment, telecommunications equipment, cable television equipment, medical equipment, production and manufacturing equipment and software products. The Partnership has made secured loans to cable television systems, emerging growth companies, security monitoring companies and other businesses. These loans are asset-based and the Partnership receives a security interest in the assets financed. Page 4 of 36 Item 1. Business (continued): Narrative Description of Business (continued). The Partnership's financing activities have been concentrated in the cable television industry. The Partnership has made secured loans (notes receivable) to operators of cable television systems for the acquisition, refinancing, construction, upgrade and extension of such systems located throughout the United States. The loans to cable television system operators are secured by a senior or subordinated interest in the assets of the cable television system, its franchise agreements, subscriber lists, material contracts and other related assets. In some cases the Partnership has also received personal guarantees from the owners of the systems. At December 31, 1993, the Partnership's investments in notes receivable primarily consist of notes receivable from four cable television system operators. The Partnership's net investment in notes receivable (including notes receivable reclassified to in-substance foreclosed cable systems) of $2,740,000 approximate 40% of the total assets of the Partnership at December 31, 1993. Several of the cable television system operators the Partnership provided financing to have experienced financial difficulties. These difficulties are believed to have been caused by several factors such as: a significant reduction in the availability of debt from banks and other financial institutions to finance acquisitions and operations, uncertainties related to future government regulation in the cable television industry and the economic recession in the United States. These factors have resulted in a significant decline in the demand for the acquisition of cable systems and have further caused an overall decrease in the value of many cable television systems. The Partnership has acquired equipment pursuant to either "Operating" leases or "Full Payout" leases. The Partnership has also provided and intends to provide financing secured by assets in the form of notes receivable. Operating leases are generally short-term leases under which the lessor will receive aggregate rental payments in an amount that is less than the purchase price of the equipment. Full Payout leases are generally for a longer term under which the non-cancellable rental payments due during the initial term of the lease are at least sufficient to recover the purchase price of the equipment. The General Partner has concentrated the Partnership's activities in the equipment leasing and financing industry, an area in which the General Partner has developed an expertise. The computer equipment leasing industry is extremely competitive. The Partnership competes with many well established companies having substantially greater financial resources. Competitive factors include pricing, technological innovation and methods of financing (including use of various short-term and long-term financing plans, as well as the outright purchase of equipment). Although IBM is still a dominant factor in the computer equipment marketplace, even IBM has been adversely affected by wide-spread competition in this industry. Given the high degree of competition and rapid pace of technological development in the computer equipment industry, revolutionary changes with respect to pricing, marketing practices, technological innovation and the availability of new and attractive financing plans could occur at almost any time. Significant action in any of these areas might materially and adversely affect the remarketability of equipment owned by the Partnership. Any such adverse effect on remarketability could also be reflected in the overall return realized by the Partnership. The General Partner believes that IBM and its competitors will continue to make significant Page 5 of 36 Item 1. Business (continued): Narrative Description of Business (continued): advances in the computer equipment industry, some of which may result in revolutionary changes with respect to small, medium and large computer systems. The Partnership will maintain working capital reserves in an amount which will fluctuate from time to time depending upon the needs of the Partnership, but which will be at least one percent of the gross offering proceeds. Other. A brief description of the type of assets in which the Partnership has invested as of December 31, 1993, together with information concerning the uses of assets is set forth in Item 2.		Item 2. Properties. The Partnership is engaged in the equipment leasing and financing industry and as such, does not own or operate any principal plants, mines or real property. The primary assets held by the Partnership are its investments in leases and loans. As of December 31, 1993, the Partnership owns equipment and has outstanding loans to borrowers with an aggregate original cost of $44,250,000. The equipment and loans have been made to customers located throughout the United States. The following table summarizes the type of equipment owned or financed by the Partnership, including its pro rata interest in joint ventures, at December 31, 1993. Percentage of Asset Types Purchase Price(1) Total Assets (Amounts in Thousands) Reproduction Equipment $14,636 33% Computer Peripherals 12,701 29 Mainframes 9,126 21 Financing Related to Cable Television Systems 4,157 9 Capital Equipment Leased to Emerging Growth Companies 1,880 4 Telecommunications 1,350 3 Small Computer Systems 344 1 Financing of Security Monitoring System Companies 56 - TOTAL $44,250 100% (1) These amounts include the Partnership's pro rata interest in equipment joint ventures of $945,000, cost of equipment on financing leases of $1,898,000 and original cost of outstanding loans of $4,213,000 at December 31, 1993. Page 6 of 36 Item 3.	Item 3. Legal Proceedings. On July 1, 1991, Phoenix Leasing Incorporated, as General Partner to the Partnership and sixteen other affiliated partnerships, filed suit in the Superior Court for the County of Marin, Case No. 150016, against Xerox Corporation, a corporation in which the General Partner had entered into a contractual agreement for the acquisition and administration of leased equipment. Phoenix Leasing Incorporated alleges on behalf of the Partnership that Xerox Corporation breached certain agreements when it failed to remit and account for certain funds due as adjustments to purchase prices, failed to properly refurbish and remarket certain equipment, and failed to properly administer the Partnership's portfolio of equipment. The suit seeks recovery of damages and attorney costs of a yet to be determined amount. Discovery in the case is currently in process. Item 4.	Item 4. Submission of Matters to a Vote of Security Holders. No matters were submitted to a vote of Limited Partners, through the solicitation of proxies or otherwise, during the year covered by this report. Item 5.	Item 5. Market for the Registrant's Securities and Related Security Holder Matters. (a) The Registrant's limited partnership interests are not publicly traded. There is no market for the Registrant's limited partnership interests and it is unlikely that any will develop. (b) Approximate number of equity security investments: Number of Unit Holders Title of Class as of December 31, 1993 Limited Partners 9,316 General Partner 1 Page 7 of 36 PART II Item 6.	Item 6. Selected Financial Data. Amounts in Thousands Except for Per Unit Amounts 1993 1992 1991 1990 1989 Total Income $5,613 $10,706 $14,290 $27,016 $42,644 Net Income (Loss) 1,570 (1,540) (5,429) (2,969) 4,149 Total Assets 6,922 10,168 24,728 45,925 83,935 Long-term Debt Obligations - - - - 405 Distributions to Partners 3,794 14,269 14,623 14,119 13,896 Net Income (Loss) per Limited Partnership Unit 4 (4) (14) (8) 9 Distributions per Limited Partnership Unit 10 38 37 35 34 The above selected financial data should be read in conjunction with the financial statements and related notes appearing elsewhere in this report. Page 8 of 36 Item 7.	Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Results of Operations =============================================================================== For the years ended December 31, Description 1993 1992 1991 (Amounts in Thousands) - ------------------------------------------------------------------------------ Net income (loss) $1,570 $(1,540) $(5,429) Rental income 3,779 7,072 12,077 Gain from equipment insurance settlement - 1,235 - Depreciation expense 1,888 8,471 13,630 Lease related operating expenses 1,081 2,116 3,853 =============================================================================== Phoenix Leasing Cash Distribution Fund II (the Partnership) reported net income of $1,570,000 during the year ended December 31, 1993, as compared to net losses of $1,540,000 and $5,429,000 during 1992 and 1991, respectively. The improvement in earnings during 1993 is attributable to a substantial decrease of $6,583,000 in depreciation expense. As of December 31, 1992, a majority of the Partnership's reproduction equipment had become fully depreciated, causing a major portion of the decrease in depreciation expense during 1993. The decreased net loss during 1992 was primarily attributable to an equipment insurance settlement received by the Partnership of $1,235,000 and a decrease in lease-related operating expenses of $1,737,000. The equipment insurance settlement received during 1992 was for the full replacement value of certain capital equipment owned by the Partnership and is not a recurring event. The decrease in rental income of $3,293,000 and $5,005,000 during 1993 and 1992, respectively, is attributable to a decrease in the size of the equipment portfolio due to equipment sales. At December 31, 1993, the Partnership owned equipment with an aggregate original cost of $40 million as compared to $58 million and $79 million at December 31, 1992 and 1991, respectively. As the Partnership continues to sell equipment upon expiration of the lease terms, it is anticipated that the equipment portfolio and rental income will continue to decrease. Total expenses decreased by $8,203,000 and $7,473,000 during 1993 and 1992, respectively, as compared to the same period in the preceding year due primarily to the decrease in depreciation of $6,583,000 and $5,159,000 during 1993 and 1992, respectively. The decrease in depreciation expense is attributable to the decrease in the size of the equipment portfolio due to the sale of equipment and a large portion of the equipment having been fully depreciated. The Partnership sold equipment with an aggregate original cost of $18,149,000, $20,744,000 and $26,074,000 during the years ended December 31, 1993, 1992 and 1991, respectively. During 1993 and 1992, the Partnership also experienced a decrease in lease related operating expenses of $1,035,000 and $1,737,000, respectively, due to a decrease in maintenance, remarketing and refurbishing expenses incurred on a portion of the Partnership's reproduction equipment purchased pursuant to a vendor lease and remarketing agreement. In accordance with the agreement, these expenses are deducted from the rents and sales proceeds received from such leases. Page 9 of 36 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) Results of Operations (continued) The Partnership has been impacted by the recession through an increase in the number of lessee and borrower defaults. This has caused an increase in delinquent lease and loan payments from customers, and the Partnership has seen an increase in lessees and borrowers filing for protection under the bankruptcy laws. This has caused the Partnership a loss of revenues from such delinquent or defaulted leases and has also forced the Partnership to renegotiate its leases on far less favorable terms. These defaults and delinquencies have also resulted in an increase in legal and collection related expenses. The recession has also caused manufacturers of newer computer equipment to engage in highly aggressive sales practices by discounting new products by as much as 50-60%. The effects of this practice have been lower re-leasing and resale revenues on the equipment owned by the Partnership, thereby earning lower returns than originally anticipated as reflected by the decrease in rental income. Inflation affects the Partnership in relation to the current cost of equipment placed on lease and the residual values realized when the equipment comes off-lease and is sold. During the last several years inflation has been low, thereby having very little impact upon the Partnership. Liquidity and Capital Resources =============================================================================== For the years ended December 31, Description 1993 1992 1991 (Amounts in Thousands) - ------------------------------------------------------------------------------ MAJOR CASH SOURCES: Net cash from equipment leasing and financing operations (1) $ 3,003 $ 5,270 $10,707 Proceeds from sale of equipment 1,857 3,520 6,328 Proceeds from equipment insurance settlement - 1,273 - Proceeds from payoff of notes receivable - - 543 MAJOR CASH USES: Cost of equipment acquired 192 221 2,704 Investment in notes receivable - - 166 Principal payments, notes payable 291 - 156 Cash distributions to partners 3,794 14,269 14,623 (1) Includes a per copy charge from the Partnership's reproduction equipment of $640,000, $978,000 and $1,370,000 during 1993, 1992 and 1991, respectively. =============================================================================== The Partnership's primary source of liquidity comes from equipment leasing and financing activities. The Partnership has contractual obligations with a diversified group of lessees for fixed lease terms at fixed rental amounts and will also receive payments on its outstanding notes receivable. The Partnership's future liquidity is dependent upon its receiving payment of such contractual obligations. As the initial lease terms expire, the Partnership will continue to renew, remarket or sell the equipment. The future liquidity in excess of the remaining contractual obligations will depend upon the General Partner's success in re-leasing and selling the Partnership's equipment as it comes off lease. Page 10 of 36 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) Liquidity and Capital Resources (continued) During the fourth quarter of 1992, the Partnership borrowed an additional $465,000 from a bank. The Partnership repaid $291,000 of its outstanding debt during 1993. Proceeds from sale of equipment decreased due to a decrease in the amount of equipment sold of $1,663,000 and $2,808,000 during 1993 and 1992, respectively, as well as a decrease in the market value of such equipment. During 1993, the Partnership purchased $192,000 in equipment subject to operating and financing type leases, compared to the $221,000 and $2,704,000 in equipment acquired during 1992 and 1991, respectively. As a result, the aggregate original cost of equipment owned by the Partnership at December 31, 1993 approximates $40 million, as compared to the $58 million and $79 million at December 31, 1992 and 1991, respectively. The $40 million of equipment owned at December 31, 1993 is classified as follows: 36% reproduction equipment, 32% computer peripheral equipment, 23% computer mainframes, 5% capital equipment leased to emerging growth companies, 3% telecommunications equipment and 1% small computer systems. The $58 million of equipment owned at December 31, 1992 was classified as follows: 58% computer peripheral equipment, 31% reproduction equipment, 6% capital equipment leased to emerging growth companies, 2% telecommunications equipment, 1% small computer systems, 1% computer mainframes and 1% miscellaneous, as compared to $79 million of equipment owned at December 31, 1991 which was classified as follows: 58% computer peripheral equipment, 28% reproduction equipment, 9% capital equipment leased to emerging growth companies, 2% small computer systems, 2% telecommunications equipment and 1% computer mainframes. The Partnership is currently in its liquidation stage and accordingly has no obligations or commitments to purchase additional equipment. In addition to acquiring equipment for lease to third parties, the Partnership has provided financing to cable television system operators, emerging growth companies, security monitoring system companies, and other businesses. The Partnership maintains a security interest in the equipment financed. Such security interest will give the Partnership the right, upon default, to obtain possession of the assets. The Partnership provided financing of $0, $0, and $166,000 during 1993, 1992 and 1991, respectively. As a result, the aggregate original amount of outstanding financing provided by the Partnership approximates $4.2 million at December 31, 1993, as compared to $4.2 million and $4.6 million at December 31, 1992 and 1991, respectively. The $4.2 million of financing as of December 31, 1993 is classified as follows: 99% financing to cable television systems and 1% financing to security monitoring companies. The Partnership has equipment held for lease with a purchase price of $13,484,000, $16,645,000 and $22,535,000 with a net book value of $40,000, $549,000 and $4,098,000 at December 31, 1993, 1992 and 1991, respectively. The General Partner is actively engaged, on behalf of the Partnership, in remarketing and selling the Partnership's off-lease equipment portfolio. The cash distributed to partners for the years ended December 31, 1993, 1992 and 1991 are $3,794,000, $14,269,000 and $14,623,000, respectively. In accordance with the Limited Partnership Agreement, the limited partners are entitled to 95% of the cash available for distribution and the General Partner Page 11 of 36 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) Liquidity and Capital Resources (continued) is entitled to 5%. As a result, the limited partners received distributions of $3,794,000, $14,269,000 and $14,071,000 for the years ended December 31, 1993, 1992 and 1991, respectively. The cumulative distributions to Limited Partners are $75,219,000, $71,425,000 and $57,156,000 at December 31, 1993, 1992 and 1991, respectively. The General Partner received $0, $0 and $741,000 in cash distributions for the year ended December 31, 1993, 1992 and 1991, respectively. In accordance with the partnership agreement, upon termination of the Partnership, the General Partner is required to restore any deficit balance in its capital account. During 1992, the General Partner elected to make an early contribution for such deficit capital balance. In addition, the General Partner is no longer receiving payment for its share of the cash available for distribution. The Partnership's asset portfolio continues to decline as a result of the ongoing liquidation of assets, and therefore it is expected that the cash generated from operations will also decline. As the cash generated by Partnership operations continues to decline, the rate of cash distributions made to limited partners will also decline. During 1993, the Partnership reduced the cash distributions to partners due to such decline in the cash available for distribution. It is anticipated that the Partnership will make distributions to partners during 1994 at approximately the same rate as those made during 1993. The Partnership has been adversely impacted by several factors that have caused them to achieve returns and recovery of investment in lower than anticipated amounts. The factors impacting the Partnership have been, the economic recession in the United States, the rate of obsolescence of computer equipment, the market demand and remarketability for equipment owned by the Partnership, aggressive manufacturer sales practices and a general unavailability of debt to companies. All of these factors have resulted in the decline in revenues and the reduced distributions to partners. Cash generated from leasing and financing operations has been and is anticipated to continue to be sufficient to meet the Partnership's ongoing operational expenses and debt service. Page 12 of 36 Item 8.	Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA PHOENIX LEASING CASH DISTRIBUTION FUND II YEAR ENDED DECEMBER 31, 1993 Page 13 of 36 REPORT OF INDEPENDENT AUDITORS The Partners Phoenix Leasing Cash Distribution Fund II We have audited the financial statements of Phoenix Leasing Cash Distribution Fund II (a California limited partnership) listed in the accompanying index to financial statements (Item 14(a)). These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements listed in the accompanying index to financial statements (Item 14(a)) present fairly, in all material respects the financial position of Phoenix Leasing Cash Distribution Fund II at December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. San Francisco, California ERNST & YOUNG January 20, 1994 Page 14 of 36 PHOENIX LEASING CASH DISTRIBUTION FUND II BALANCE SHEETS (Amounts in Thousands Except for Unit Amounts) December 31, 1993 1992 ASSETS Cash and cash equivalents $2,032 $ 1,459 Accounts receivable (net of allowance for losses on accounts receivable of $453 and $468 at December 31, 1993 and 1992, respectively) 262 623 Notes receivable (net of allowance for losses on notes receivable of $368 and $253 at December 31, 1993 and 1992, respectively) 1,960 2,972 Equipment on operating leases and held for lease (net of accumulated depreciation of $34,365 and $47,638 at December 31, 1993 and 1992, respectively) 641 2,890 Net investment in financing leases (net of allowance for early terminations of $0 and $4 at December 31, 1993 and 1992, respectively) 998 1,367 Capitalized acquisition fees (net of accumulated amortization of $6,681 and $6,559 at December 31, 1993 and 1992, respectively) 191 305 In-substance foreclosed cable systems 780 - Other assets 58 552 Total Assets $6,922 $10,168 LIABILITIES AND PARTNERS' CAPITAL Liabilities: Accounts payable and accrued expenses $1,093 $ 1,824 Notes payable 174 465 Total Liabilities 1,267 2,289 Partners' Capital: General Partner 63 47 Limited Partners, 400,000 units authorized, 386,308 units issued and 379,583 units outstanding at December 31, 1993 and 1992 5,592 7,832 Total Partners' Capital 5,655 7,879 Total Liabilities and Partners' Capital $6,922 $10,168 [FN] The accompanying notes are an integral part of these statements. Page 15 of 36 PHOENIX LEASING CASH DISTRIBUTION FUND II STATEMENTS OF OPERATIONS (Amounts in Thousands Except for Per Unit Amounts) For the Years Ended December 31, 1993 1992 1991 INCOME Rental income $3,779 $ 7,072 $12,077 Gain on sale of equipment 1,450 1,804 1,641 Interest income, notes receivable 294 451 163 Equipment insurance settlement - 1,235 - Other income 90 144 409 Total Income 5,613 10,706 14,290 EXPENSES Depreciation 1,888 8,471 13,630 Amortization of acquisition fees 122 445 858 Lease related operating expenses 1,081 2,116 3,853 Management fees to General Partner 230 459 646 Interest expense 18 - 1 Provision for losses on receivables 111 111 71 Reimbursed administrative costs to General partner 133 174 289 Other expenses 460 470 371 Total Expenses 4,043 12,246 19,719 NET INCOME (LOSS) $1,570 $(1,540) $(5,429) NET INCOME (LOSS) PER LIMITED PARTNERSHIP UNIT $ 4 $ (4) $ (14) NET INCOME (LOSS) General Partner $ 16 $ (15) $ (54) Limited Partners 1,554 (1,525) (5,375) $1,570 $(1,540) $(5,429) [FN] The accompanying notes are an integral part of these statements. Page 16 of 36 PHOENIX LEASING CASH DISTRIBUTION FUND II STATEMENTS OF PARTNERS' CAPITAL (Amounts in Thousands Except for Unit Amounts) General Partner's Limited Partners' Total Amount Units Amount Amount Balance, December 31, 1990 $ (736) 382,384 $ 43,272 $ 42,536 Distributions to partners ($37 per limited partnership unit) (741) - (14,071) (14,812) Redemptions of capital - (2,010) (174) (174) Net loss (54) - (5,375) (5,429) Balance, December 31, 1991 (1,531) 380,374 23,652 22,121 Partners' contributions 1,404 - - 1,404 Distributions to partners ($38 per limited partnership unit) - - (14,269) (14,269) Redemptions of capital - (791) (26) (26) Reversal of 1991 General Partner distributions accrued but not paid 189 - - 189 Net loss (15) - (1,525) (1,540) Balance, December 31, 1992 47 379,583 7,832 7,879 Distributions to partners ($10 per limited partnership unit) - - (3,794) (3,794) Net income 16 - 1,554 1,570 Balance, December 31, 1993 $ 63 379,583 $ 5,592 $ 5,655 [FN] The accompanying notes are an integral part of these statements. Page 17 of 36 PHOENIX LEASING CASH DISTRIBUTION FUND II STATEMENTS OF CASH FLOWS (Amounts in Thousands) For the Years Ended December 31, 1993 1992 1991 Operating Activities: Net income (loss) $ 1,570 $ (1,540) $ (5,429) Adjustments to reconcile net income (loss) to net cash provided by operating activities: Depreciation 1,888 8,471 13,630 Amortization of acquisition fees 122 445 858 Gain on sale of equipment (1,450) (1,804) (1,641) Gain on equipment insurance settlement - (1,235) - Provision for early termination, financing leases (4) 1 7 Provision for losses on notes receivable 115 110 64 Gain on sale of marketable securities - (2) (196) Decrease in accounts receivable 361 296 1,543 Decrease in accounts payable and accrued expenses (729) (590) (821) Decrease in other assets 494 314 166 Interest income added to principal on notes receivable - (97) (133) Net cash provided by operating activities 2,367 4,369 8,048 Investing Activities: Principal payments, financing leases 519 875 2,115 Principal payments, notes receivable 117 26 544 Proceeds from sale of equipment 1,857 3,520 6,328 Proceeds from equipment insurance settlement - 1,273 - Proceeds from payoff of notes receivable - - 543 Proceeds from sale of marketable securities - 44 196 Purchase of equipment (7) - (1,681) Investment in financing leases (185) (221) (1,023) Investment in notes receivable - - (166) Investment in marketable securities - (42) - Payment of acquisition fees (10) (12) (109) Net cash provided by investing activities 2,291 5,463 6,747 Financing Activities: Partners' contributions - 1,404 - Payments of principal, notes payable (291) - (156) Proceeds from notes payable - 465 - Redemptions of capital - (26) (174) Distributions to partners (3,794) (14,269) (14,623) Net cash used by financing activities (4,085) (12,426) (14,953) [FN] The accompanying notes are an integral part of these statements. Page 18 of 36 PHOENIX LEASING CASH DISTRIBUTION FUND II STATEMENTS OF CASH FLOWS (continued) (Amounts in Thousands) For the Years Ended December 31, 1993 1992 1991 Increase (decrease) in cash and cash equivalents $ 573 $ (2,594) $ (158) Cash and cash equivalents, beginning of period 1,459 4,053 4,211 Cash and cash equivalents, end of period $ 2,032 $ 1,459 $ 4,053 Supplemental Cash Flow Information: Cash paid for interest expense $ 18 $ - $ 1 [FN] The accompanying notes are an integral part of these statements. Page 19 of 36 PHOENIX LEASING CASH DISTRIBUTION FUND II NOTES TO FINANCIAL STATEMENTS DECEMBER 31, 1993 Note 1. Organization and Partnership Matters. Phoenix Leasing Cash Distribution Fund II, a California limited partnership (the "Partnership"), was formed on June 28, 1984, to invest in capital equipment of various types and to lease such equipment to third parties on either a long- term or short-term basis, and to provide financing to emerging growth companies and cable television system operators. The Partnership's minimum investment requirements were met November 24, 1986. The Partnership's termination date is December 31, 1997. For financial reporting purposes, Partnership income shall be allocated as follows: (a) first, to the General Partner until the cumulative income so allocated is equal to the cumulative distributions to the General Partner, (b) second, before redemption fees, 1% to the General Partner and 99% to the Limited Partners until the cumulative income so allocated is equal to any cumulative Partnership loss and syndication expenses for the current and all prior accounting periods, and (c) the balance, if any, to the Unit Holders. All Partnership losses shall be allocated, before redemption fees, 1% to the General Partner and 99% to the Unit Holders. The General Partner is entitled to receive 5% of all cash distributions until the Limited Partners have recovered their initial capital contributions plus a cumulative return of 12% per annum. Thereafter, the General Partner will receive 15% of all cash distributions. In the event the General Partner has a deficit balance in its capital account at the time of partnership liquidation, it will be required to contribute the amount of such deficit to the Partnership. During the year ended December 31, 1992, the General Partner elected to make an early contribution of $1,404,000, and the $189,000 in accrued distributions to the General Partner at December 31, 1991 was reversed. In addition, the General Partner did not draw its share of the 1993 and 1992 cash available for distribution. As compensation for management services, the General Partner receives a fee payable quarterly, in an amount equal to 3.5%, subject to certain limitations, of the Partnership's gross revenues for the quarter from which such payment is being made, which revenues shall include, but are not limited to, rental receipts, maintenance fees, proceeds from the sale of equipment and interest income. The General Partner will be compensated for services performed in connection with the analysis of assets available to the Partnership, the selection of such assets and the acquisition thereof, including obtaining lessees for the equipment, negotiating and concluding master lease agreements with certain lessees. As compensation for such acquisition services, the General Partner will receive a fee equal to 4%, subject to certain limitations, of (a) the purchase price of equipment acquired by the Partnership, or equipment leased to customers Page 20 of 36 PHOENIX LEASING CASH DISTRIBUTION FUND II NOTES TO FINANCIAL STATEMENTS (Continued) DECEMBER 31, 1993 Note 1. Organization and Partnership Matters (continued). by manufacturers, the financing for which is provided by the Partnership, or (b) financing provided to businesses such as cable operators, emerging growth companies, or security monitoring system companies, payable upon such acquisition or financing, as the case may be. As of December 31, 1993, $6,872,000 had been paid or accrued to the General Partner for its acquisition fee. Acquisition fees are amortized over the life of the assets principally on a straight-line basis. Phoenix Securities, Inc., an affiliate of the General Partner, has contracted with or employs certain persons who have performed wholesaling activities in connection with the offering of the units through broker-dealers. As of December 31, 1993, $1,336,000 has been paid or accrued to Phoenix Securities, Inc. Note 2. Summary of Significant Accounting Policies. Leasing Operations. The Partnership's leasing operations consist of both financing and operating leases. The financing method of accounting for leases records as unearned income at the inception of the lease, the excess of net rentals receivable and estimated residual value at the end of the lease term, over the cost of equipment leased. Unearned income is credited to income monthly over the term of the lease on a declining basis to provide an approximate level rate of return on the unrecovered cost of the investment. Initial direct costs of consummating new leases are capitalized and included in the cost of equipment. Under the operating method of accounting for leases, the leased equipment is recorded as an asset at cost and depreciated primarily on an accelerated depreciation method over the estimated useful life of six years, except for equipment leased under vendor agreements, which is depreciated on a straight-line basis over the estimated useful life, ranging up to six years. The Partnership's policy is to review periodically the expected economic life of its rental equipment in order to determine the probability of recovering its undepreciated cost. Such reviews address, among other things, recent and anticipated technological developments affecting computer equipment and competitive factors within the computer marketplace. Although remarketing rental rates are expected to decline in the future with respect to some of the Partnership's rental equipment, such rentals are expected to exceed projected expenses and depreciation. Where reviews of the equipment portfolio indicate that rentals plus anticipated sales proceeds will not exceed expenses in any future period, the Partnership revises its depreciation policy and accelerates depreciation as appropriate. As a result of such periodic Page 21 of 36 PHOENIX LEASING CASH DISTRIBUTION FUND II NOTES TO FINANCIAL STATEMENTS (Continued) DECEMBER 31, 1993 Note 2. Summary of Significant Accounting Policies (continued). reviews, the Partnership recognized additional depreciation expense of $0, $12,000 and $1,812,000 ($0, $.03 and $4.75 per limited partnership unit) for the years ended December 31, 1993, 1992 and 1991, respectively. Rental income for the year is determined on the basis of rental payments due for the period under the terms of the lease. Maintenance, repairs and minor renewals of the leased equipment are charged to expense. Non Cash Investing Activities. During the year ended December 31, 1993, the Partnership reclassified two foreclosed notes receivable from Notes Receivable to Investment in Foreclosed Cable Systems on the balance sheet. The amount of such reclassification was $780,000. Reclassification. Certain 1992 and 1991 amounts have been reclassified to conform to the 1993 presentation. Cash and Cash Equivalents. This includes deposits at banks, investments in money market funds and other highly liquid short-term investments with original maturities of less than 90 days. Credit and Collateral. The Partnership's activities have been concentrated in the equipment leasing and financing industry. A credit evaluation is performed by the General Partner for all leases and loans made, with the collateral requirements determined on a case-by-case basis. The Partnership's loans are generally secured by the equipment or assets financed and, in some cases, other collateral of the borrower. In the event of default, the Partnership has the right to foreclose upon the collateral used to secure such loans. Note 3. Accounts Receivable. Accounts receivable consist of the following at December 31: 1993 1992 (Amounts in Thousands) Lease payments $ 636 $ 920 Other 79 168 Interest - 3 715 1,091 Less: allowance for doubtful accounts receivable (453) (468) Total $ 262 $ 623 Page 22 of 36 PHOENIX LEASING CASH DISTRIBUTION FUND II NOTES TO FINANCIAL STATEMENTS (Continued) DECEMBER 31, 1993 Note 4. Notes Receivable. Notes receivable consist of the following at December 31: 1993 1992 (Amounts in Thousands) Notes receivable from cable television system operators with stated interest ranging from 17% to 19% per annum, receivable in installments ranging from 60 to 108 months, collateralized by a security interest in the cable system assets. These notes have a graduated repayment schedule followed by a balloon payment. $2,282 $3,176 Notes receivable from security monitoring companies with stated interest at 16% per annum, with payments to be taken out of the monthly payments received from assigned contracts, collateralized by all assets of the borrower. At the end of 48 months, the remaining balance, if any, is due and payable. 46 49 2,328 3,225 Less: allowance for losses on notes receivable (368) (253) Total $1,960 $2,972 The Partnership's notes receivable to cable television system operators provide a payment rate in an amount that is usually less than the contractual interest rate. The difference between the payment rate and the contractual interest rate is added to the principal and therefore deferred until the maturity date of the note. Upon maturity of the note, the original principal and deferred interest is due and payable in full. Although the contractual interest rates may be higher, effective January 1, 1993, the amount of interest being recognized on the Partnership's outstanding notes receivable to cable television system operators is being limited to the amount of the payments received, thereby deferring the recognition of a portion of the deferred interest until the loan is paid off. During 1992 and 1991, the Partnership had been limiting the amount of interest income to 16% on these notes receivable. Page 23 of 36 PHOENIX LEASING CASH DISTRIBUTION FUND II NOTES TO FINANCIAL STATEMENTS (Continued) DECEMBER 31, 1993 Note 5. Equipment on Operating Leases and Investment in Financing Leases. Equipment on lease consists primarily of computer peripheral equipment, computer mainframes and reproduction equipment. The Partnership's operating leases are for initial lease terms of approximately 12 to 48 months. During the remaining terms of existing operating leases, the Partnership will not recover all of the undepreciated cost and related expenses of its rental equipment, and therefore must remarket a portion of its equipment in future years. The Partnership has agreements with some of the manufacturers of its equipment, whereby such manufacturers will undertake to remarket off-lease equipment on a best-efforts basis. This agreement permits the Partnership to assume the remarketing function directly if certain conditions contained in the agreements are not met. For their remarketing services, the manufacturers are paid a percentage of net monthly rentals. The Partnership has entered into direct lease arrangements with lessees consisting of Fortune 1000 companies and other businesses in different industries located throughout the United States. Generally, it is the responsibility of the lessee to provide maintenance on leased equipment. The General Partner administers the equipment portfolio of leases acquired through the direct leasing program. Administration includes the collection of rents from the lessees and remarketing of the equipment. The net investment in financing leases consists of the following at December 31: 1993 1992 (Amounts in Thousands) Minimum lease payments to be received $ 959 $1,380 Estimated residual value of leased equipment (unguaranteed) 140 175 Less: unearned income (101) (184) allowance for early termination - (4) Net investment in financing leases $ 998 $1,367 Minimum rentals to be received on noncancellable operating and financing leases for the years ended December 31 are as follows: Page 24 of 36 PHOENIX LEASING CASH DISTRIBUTION FUND II NOTES TO FINANCIAL STATEMENTS (Continued) DECEMBER 31, 1993 Note 5. Equipment on Operating Leases and Investment in Financing Leases (continued). Operating Financing (Amounts in Thousands) 1994 . . . . . . . . . . . . . . . . . . $ 862 $451 1995 . . . . . . . . . . . . . . . . . . 171 349 1996 . . . . . . . . . . . . . . . . . 136 159 1997 . . . . . . . . . . . . . . . . . . 32 - 1998 and future . . . . . . . . . . . . 16 - Total $1,217 $959 The Partnership receives contingent monthly rental payments on its reproduction equipment that is not included in the minimum rentals to be received. The contingent monthly rentals consist of a monthly rental payment that is based upon actual machine usage. The monthly usage charge included in income for the years ended December 31, 1993, 1992 and 1991 was $640,000, $978,000 and $1,370,000, respectively. The net book value of equipment held for lease at December 31, 1993 and 1992 amounted to $40,000 and $549,000, respectively. The General Partner, on behalf of the Partnership and sixteen other affiliated partnerships, filed suit against one manufacturer of its equipment. The partnerships allege that this manufacturer breached certain agreements with respect to the equipment portfolios. The suit seeks damages and attorney's fees in unspecified amounts. The Partnership will recognize any such amounts in income when received. Note 6. In-Substance Foreclosed Cable Systems. The Partnership has reclassified two nonperforming outstanding notes receivable from cable television system operators to In-Substance Foreclosed Cable Systems where in-substance foreclosure has occurred. Upon reclassification, these notes are recorded at the lower of their carrying value or estimated fair market value of the cable system. The Partnership, along with other affiliated partnerships managed by the General Partner, has a total carrying value in these cable systems of $1,399,000. The net carrying value of the Partnership's investment is $780,000 which represents a 56% pro rata interest in the total investment. In order to maximize the recovery of the Partnership's investment, the General Partner anticipates that upon foreclosure, it will hold and manage the operations of the foreclosed cable systems, on behalf of the partnerships, until such time that the General Partner can sell the cable television systems. Page 25 of 36 PHOENIX LEASING CASH DISTRIBUTION FUND II NOTES TO FINANCIAL STATEMENTS (Continued) DECEMBER 31, 1993 Note 7. Accounts Payable and Accrued Expenses. Accounts payable and accrued expenses consist of the following at December 31: 1993 1992 (Amounts in Thousands) Equipment lease operations $ 732 $1,173 Sales tax 257 268 General Partner and affiliates 38 228 Security deposits 8 82 Other 57 73 Accrued interest 1 - Total $1,093 $1,824 Note 8. Notes Payable. Notes payable consist of the following at December 31: 1993 1992 (Amounts in Thousands) Note payable to a bank, collateralized by leased equipment, non-recourse to the other assets of the Partnership, with interest of 4.75% per annum, payable in 22 monthly installments through August 1, 1994 $174 $465 Principal payments of $174,000 are due in 1994. Note 9. Income Taxes. Federal and state income tax regulations provide that taxes on the income or loss of the Partnership are reportable by the partners in their individual income tax returns. Accordingly, no provision for such taxes has been made in the accompanying financial statements. In 1993, the Partnership adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS 109). One of the requirements of SFAS 109 is for a public enterprise that is not subject to income taxes, because its income is taxed directly to its owners, to disclose the net difference between the tax basis and the reported amounts of the enterprise's assets and liabilities. Page 26 of 36 PHOENIX LEASING CASH DISTRIBUTION FUND II NOTES TO FINANCIAL STATEMENTS (Continued) DECEMBER 31, 1993 Note 9. Income Taxes (continued). The net differences between the tax basis and the reported amounts of the Partnership's assets and liabilities at December 31, 1993 are as follows: Reported Amounts Tax Basis Net Difference Assets $6,922,000 $7,966,000 $(1,044,000) Liabilities 1,267,000 1,267,000 0 Note 10. Related Entities. The General Partner and its affiliates serves in the capacity of general partner in other partnerships, all of which are engaged in the equipment leasing and financing business. Note 11. Reimbursed Costs to the General Partner. The General Partner incurs certain administrative costs, such as data processing, investor and lessee communications, lease administration, accounting, equipment storage and equipment remarketing, for which it is reimbursed by the Partnership. These expenses incurred by the General Partner are to be reimbursed at the lower of the actual costs or an amount equal to 90% of the fair market value for such services. The reimbursed costs to the General Partner for the years ended December 31 are as follows: 1993 1992 1991 (Amounts in Thousands) General administration $139 $179 $289 Equipment remarketing and administrative 81 168 565 Data processing 14 20 43 Totals $234 $367 $897 In addition, the General Partner receives a management fee and an acquisition fee (see Note 1). Page 27 of 36 PHOENIX LEASING CASH DISTRIBUTION FUND II NOTES TO FINANCIAL STATEMENTS (Continued) DECEMBER 31, 1993 Note 12. Net Income (Loss) and Distributions per Limited Partnership Unit. Net income (loss) and distributions per limited partnership unit were based on the Limited Partners' share of net income (loss) and distributions, and the weighted average number of units outstanding of 379,583, 380,133 and 381,453 for the years ended December 31, 1993, 1992 and 1991, respectively. For the purposes of allocating income (loss) and distributions to each individual Limited Partner, the Partnership allocates net income (loss) and distributions based upon each respective Limited Partner's ending capital account balance. Note 13. Subsequent Events. In January 1994, cash distributions of $957,000 were made to the Limited Partners. Page 28 of 36 Item 9.	Item 9. Disagreements on Accounting and Financial Disclosure Matters. None. Page 29 of 36 PART III Item 10.	Item 10. Directors and Executive Officers of the Registrant. The registrant is a limited partnership and, therefore, has no executive officers or directors. The general partner of the registrant is Phoenix Leasing Incorporated, a California corporation. The directors and executive officers of Phoenix Leasing Incorporated (PLI) are as follows: GUS CONSTANTIN, age 56, is President, Chief Executive Officer and a Director of PLI. Mr. Constantin received a B.S. degree in Engineering from the University of Michigan and a Master's Degree in Management Science from Columbia University. From 1969 to 1972, he served as Director, Computer and Technical Equipment of DCL Incorporated (formerly Diebold Computer Leasing Incorporated), a corporation formerly listed on the American Stock Exchange, and as Vice President and General Manager of DCL Capital Corporation, a wholly-owned subsidiary of DCL Incorporated. Mr. Constantin was actively engaged in marketing manufacturer leasing programs to computer and medical equipment manufacturers and in directing DCL Incorporated's IBM System/370 marketing activities. Prior to 1969, Mr. Constantin was employed by IBM as a data processing systems engineer for four years. Mr. Constantin is an individual general partner in four active partnerships and is an NASD registered principal. Mr. Constantin is the founder of PLI and the beneficial owner of all of the common stock of Phoenix American Incorporated. PARITOSH K. CHOKSI, age 40, is Senior Vice President, Chief Financial Officer, Treasurer and a Director of PLI. He has been associated with PLI since 1977. Mr. Choksi oversees the finance, accounting, information services and systems development departments of the General Partner and its Affiliates and oversees the structuring, planning and monitoring of the partnerships sponsored by the General Partner and its Affiliates. Mr. Choksi graduated from the Indian Institute of Technology, Bombay, India with a degree in Engineering. He holds an M.B.A. degree from the University of California, Berkeley. GARY W. MARTINEZ, age 43, is Senior Vice President and a Director of PLI. He has been associated with PLI since 1976. He manages the Asset Management Department, which is responsible for lease and loan portfolio management. This includes credit analysis, contract terms, documentation and funding; remittance application, change processing and maintenance of customer accounts; customer service, invoicing, collection, settlements and litigation; negotiating lease renewals, extensions, sales and buyouts; and management information reporting. From 1973 to 1976, Mr. Martinez was a Loan Officer with Crocker National Bank, San Francisco. Prior to 1973, he was an Area Manager with Pennsylvania Life Insurance Company. Mr. Martinez is a graduate of California State University, Chico. BRYANT J. TONG, age 39, is Senior Vice President, Financial Operations of PLI. He has been with PLI since 1982. Mr. Tong is responsible for investor services and overall company financial operations. He is also responsible for the technical and administrative operations of the cash management, corporate accounting, partnership accounting, accounting systems, internal controls and tax departments, in addition to Securities and Exchange Commission and other regulatory agency reporting. Prior to his association with PLI, Mr. Tong was Controller-Partnership Accounting with the Robert A. McNeil Corporation for two years and was an auditor with Ernst & Whinney (succeeded by Ernst & Young) from 1977 through 1980. Mr. Tong holds a B.S. in Accounting from the University of California, Berkeley, and is a Certified Public Accountant. Page 30 of 36 Item 10. Directors and Executive Officers of the Registrant (continued). Neither the General Partner nor any Executive Officer of the General Partner has any family relationship with the others. Phoenix Leasing Incorporated or its affiliates and the executive officers of the General Partner serve in a similar capacity to the following affiliated limited partnerships: Phoenix Leasing American Business Fund, L.P. Phoenix Leasing Cash Distribution Fund V, L.P. Phoenix Income Fund, L.P. Phoenix High Tech/High Yield Fund Phoenix Leasing Cash Distribution Fund IV Phoenix Leasing Cash Distribution Fund III Phoenix Leasing Cash Distribution Fund Phoenix Leasing Capital Assurance Fund Phoenix Leasing Income Fund VII Phoenix Leasing Income Fund VI Phoenix Leasing Growth Fund 1982 Phoenix Leasing Income Fund 1982-4 Phoenix Leasing Income Fund 1982-3 Phoenix Leasing Income Fund 1982-2 Phoenix Leasing Income Fund 1982-1 Phoenix Leasing Income Fund 1981 Phoenix Leasing Income Fund 1980 Phoenix Leasing Income Fund 1977 and Phoenix Leasing Income Fund 1975 Item 11.	Item 11. Executive Compensation. Set forth is the information relating to all direct remuneration paid or accrued by the Registrant during the last year to the General Partner. (A) (B) (C) (D) Aggregate of Name of Capacities Cash and cash- contingent Individual or in which equivalent forms forms of persons in group served of remuneration remuneration (C1) (C2) Securities or Salaries, fees, property insurance directors' fees, benefits or reim- commissions and bursement, personal bonuses benefits (Amounts in Thousands) Phoenix Leasing Incorporated General Partner $238(1) $0 $0 (1) consists of management and acquisition fees. Page 31 of 36 Item 12.	Item 12. Security Ownership of Certain Beneficial Owners and Management. (a) No person owns of record, or is known by the Registrant to own beneficially, more than five percent of any class of voting securities of the Registrant. (b) The General Partner of the Registrant owns the equity securities of the Registrant set forth in the following table: (1) (2) (3) Title of Class Amount Beneficially Owned Percent of Class General Partner Represents a 5% interest in the 100% Interest Registrant's profits and distributions, until the Limited Partners have recovered their capital contributions plus a cumulative return of 12% per annum, compounded quarterly, on the unrecovered portion thereof. Thereafter, the General Partner will receive 15% interest in the Registrant's profits and distributions. Item 13.	Item 13. Certain Relationships and Related Transactions. None. Page 32 of 36 PART IV Item 14.	Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. Page No. (a) 1. Financial Statements for the year ended December 31, 1993: Balance Sheets as of December 31, 1993 and 1992 14 Statements of Operations for the Years Ended December 31, 1993, 1992 and 1991 15 Statements of Partners' Capital for the Years Ended December 31, 1993, 1992 and 1991 16 Statements of Cash Flows for the Years ended December 31, 1993, 1992 and 1991 17 Notes to Financial Statements 19 - 27 2. Financial Statement Schedules: Schedule V - Property, Plant, and Equipment 34 Schedule VI - Accumulated Depreciation and Amortizable Costs of Equipment 35 Schedule VIII - Valuation and Qualifying Accounts and Reserves 36 All other schedules are omitted because they are not applicable, or not required, or because the required information is included in the financial statements or notes thereto. Page 33 of 36 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. PHOENIX LEASING CASH DISTRIBUTION FUND II (Registrant) BY: PHOENIX LEASING INCORPORATED, A CALIFORNIA CORPORATION GENERAL PARTNER Date: March 29, 1994 BY: /S/ GUS CONSTANTIN, President Gus Constantin, President Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Signature Title Date /S/ GUS CONSTANTIN President, Chief Executive March 29, 1994 (Gus Constantin) Officer and a Director of Phoenix Leasing Incorporated, General Partner /S/ PARITOSH K. CHOKSI Chief Financial Officer March 29, 1994 (Paritosh K. Choksi) Senior Vice President Treasurer and a Director of Phoenix Leasing Incorporated General Partner /S/ BRYANT J. TONG Senior Vice President, March 29, 1994 (Bryant J. Tong) Financial Operations (Principal Accounting Officer) Phoenix Leasing Incorporated General Partner /S/ GARY W. MARTINEZ Senior Vice President and March 29, 1994 (Gary W. Martinez) a Director of Phoenix Leasing Incorporated General Partner /S/ MICHAEL K. ULYATT Partnership Controller March 29, 1994 (Michael K. Ulyatt) Phoenix Leasing Incorporated General Partner
100893_1993.txt	100893	1993	ITEM 1. BUSINESS GENERAL Union Planters Corporation (the Corporation) is a registered bank holding company and savings and loan holding company incorporated under the laws of Tennessee in 1971 and headquartered in Memphis, Tennessee. The Corporation's activities are conducted primarily through its 32 (38 including acquisitions consummated subsequent to December 31, 1993 and through March 1, 1994) bank and savings and loan subsidiaries headquartered in Tennessee, Mississippi, Arkansas, Kentucky, and Alabama. The largest subsidiary of the Corporation is Union Planters National Bank (UPNB), a financial services company which provides commercial banking services and products in Tennessee and other selected markets, primarily in the Mid-South and the Southeastern United States. Reference is made to Table 15 in Part II, Item 7, of Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) for a listing of the Corporation's subsidiaries owned at December 31, 1993, showing their respective total assets, total loans, total deposits, and total shareholders' equity. The Corporation serves its customers through 234 banking offices. Reference is made to page 59 of the 1993 Annual Report to Shareholders for a listing of the cities and communities served and the number of banking offices for each of the Corporation's banking subsidiaries. UNION PLANTERS NATIONAL BANK (UPNB) UPNB offers a full range of traditional commercial banking services and products to individuals, businesses, and public and private entities. In addition to commercial loans, UPNB offers cash management and depository services, correspondent banking services, real estate and construction lending services, secured or asset-based lending, agri-business lending, leasing, and international trade services. Retail banking services include demand, savings and time deposit accounts, money market accounts, small commercial loans, personal loans, real estate and installment loans, credit cards, safe deposit facilities, trust and discount brokerage services, and other ancillary financial services normally furnished by full-service banks. Special private banking centers offer a complete range of personal financial services including credit and special investment services suitable to individuals having complex financial services needs. Trust services offered by UPNB include investment of funds, financial planning, estate and trust administration, and other trust services to individuals, businesses, government, and nonprofit organizations. UPNB acts in various corporate trust and agency capacities in connection with living trusts, retirement plans, and wills. Trust services are offered through UPNB's branch system, an office in Jackson, Tennessee, and its principal trust office in Memphis, Tennessee. Trust revenues for 1993 were $5.0 million compared to $4.5 million in 1992. UPNB is a major residential mortgage and construction lender in Shelby County, Tennessee. UPNB acts as a mortgage loan originator, processor, and servicer and its revenues are derived from brokerage, origination, and servicing fees. For 1993, these business activities had total revenues of approximately $13.2 million compared to $15.3 million in 1992. Commercial banking services also include providing data processing for correspondent banks and a computerized remote data- processing system to both correspondent and non-affiliated small and medium-sized banks. Management has decided to discontinue its data-processing services and the wind-down should be completed by mid-year 1994. Gross revenues from this operation were $482,000 in 1993 compared to $786,000 in 1992. Union Planters Brokerage Services (UPBS), an unincorporated division of UPNB, offers discount securities brokerage services to retail customers, primarily individuals. Revenues from this operation were $1.5 million in 1993 compared to $1.2 million in 1992. Through its Capital Markets Operation, UPNB purchases, pools, and securitizes portfolios of whole mortgage loans, consumer loans, and other financial instruments. The UPNB SBA Loan Trading Operation is similar to the Capital Markets Operations except that it involves the purchasing, pooling, and securitization of the government-guaranteed portions of SBA loans. The Capital Markets and SBA Loan Trading Operations contributed approximately $474,000 and $4.1 million, respectively, to the pretax earnings of UPNB in 1993 and had gross revenues of $4.0 million and $12.7 million, respectively. In 1992, these operations generated pretax earnings of $2.5 million and $3.8 million, respectively, on gross revenues of $8.6 million and $11.2 million, respectively. In 1993, UPNB had net earnings of $35.6 million, which represented a return on average assets (ROA) of 1.07%, compared to net earnings of $27.1 million and an ROA of .89% for 1992. COMMUNITY BANKING SUBSIDIARIES The Corporation's Community Bank Group consists of 28 (34 including acquisitions consummated subsequent to December 31, 1993 and through March 1, 1994) bank and three savings and loan subsidiaries headquartered in Tennessee, Mississippi, Arkansas, Kentucky, and Alabama, and offers full retail banking services in the market areas served. These services include checking and savings accounts, money market accounts, various types of time deposits, safe deposit facilities, 24-hour service for certain banking transactions through automated teller machines, limited trust services, and money transfers. Services also include financing of commercial transactions and making and servicing both secured and unsecured loans to individuals, partnerships, and corporations. The installment loan departments of the Community Banks make direct loans to individuals for personal, automobile, real estate, home improvement, business, and similar needs. In 1993, the Community Bank Group had net earnings of $30.2 million which represented a 1.01% ROA. This compares to net earnings of $24.4 million in 1992 which represented a 1.36% ROA. The decline in ROA between 1992 and 1993 was due primarily to one-time charges related to institutions acquired in 1993 and provisions for conversion to a new data processing system. Reference is made to the MD&A discussion incorporated herein by reference in Part II, Item 7, and to Note 2 to the financial statements for information regarding the Corporation's completed and pending acquisitions. UNION PLANTERS INVESTMENT BANKERS CORPORATION (UPIBC) In the fourth quarter of 1990, the broker/dealer operations conducted by UPIBC and its subsidiaries were discontinued, and on January 2, 1991, the Corporation acquired an interest as a limited partner in Vining-Sparks IBG, Limited Partnership (VSIBG), the general partner of which is Memphis-headquartered broker/dealer, Vining Sparks Securities, Inc. (VSS). VSIBG engages in certain broker/dealer activities of the types formerly carried on separately by VSS and UPIBC. As discussed above, the activities of the Capital Markets and SBA Loan Trading Operations which were formerly part of UPIBC have been transferred to UPNB and are now part of UPNB's banking operations. The revenues of the broker/dealer operations are now limited to the Corporation's proportionate share (29%) of net earnings from its passive investment as a limited partner in VSIBG, which amounted to $3.7 million in 1993 and $3.9 million in 1992. The Corporation's investment in VSIBG at December 31, 1993 was $5.5 million. The only significant accounting transactions related to UPIBC in 1993 and 1992 were expenses related to pending litigation and some expenses related to winding down the former operations. Reference is made to Notes 13 and 19 to the financial statements found on pages 25 and 33, respectively, of the 1993 Annual Report to Shareholders. Reference is also made to Table 1, "Summary of Consolidated Results" on page 49 of the 1993 Annual Report to Shareholders for the impact of the broker/dealer operations on 1993 operating results. The material specifically referred to is incorporated by reference as a part of this response. SUPERVISION AND REGULATION Bank holding companies, banks, savings and loan holding companies, savings and loan associations, and many of their non-bank subsidiaries are extensively regulated under both federal and state law. Compliance with these laws, including the Federal Deposit Insurance Corporation Improvement Act of 1991, continues to increase the regulatory burden on depository institutions, including the banking and thrift subsidiaries of the Corporation. The following description of statutory and regulatory provisions is not intended to be exhaustive and is qualified in its entirety by reference to such provisions. Any significant change in applicable law or regulations may have a material effect on the businesses and prospects of the Corporation. GENERAL As a bank holding company ("BHC"), the Corporation is subject to the regulation and supervision of the Board of Governors of the Federal Reserve System (the "Federal Reserve"). In addition, as a savings and loan holding company, the Corporation is registered with the Office of Thrift Supervision (the "OTS") and is subject to OTS regulations, supervision, and reporting requirements under the Home Owners Loan Act. The Corporation's subsidiaries which are national banking associations, including UPNB, are subject to supervision and examination by the Office of the Comptroller of the Currency (the "Comptroller") and the Federal Deposit Insurance Corporation (the "FDIC"). State bank subsidiaries of the Corporation which are members of the Federal Reserve System are subject to supervision and examination by both the Federal Reserve and the state banking authorities of the states in which their headquarters are located. State bank subsidiaries which are not members of the Federal Reserve System are subject to supervision and examination both by the FDIC and the state banking authorities of the states in which they are located. The Corporation's savings and loan and savings bank subsidiaries are subject to supervision and examination by the OTS. The Corporation's "Banking Subsidiaries" (which term, as used herein, shall be deemed to include its savings and loan and savings bank subsidiaries) are subject to various requirements and restrictions, including requirements to maintain reserves against deposits, restrictions on the types and amounts of loans that may be granted and the rate of interest that may be charged thereon, and limitations on the types and amounts of investments which may be made and the types of services that may be offered. Various consumer-protection laws and regulations also affect the operations of the Corporation's Banking Subsidiaries. In addition to the impact of regulation, the Banking Subsidiaries are affected significantly by the actions of the Federal Reserve as it attempts to control the money supply and credit availability in order to influence the economy. The Bank Holding Company Act of 1956, as amended (the "BHCA") generally requires the prior approval of the Federal Reserve where a BHC proposes to acquire direct or indirect ownership or control of more than 5% of the voting shares of any bank or otherwise to acquire control of a bank or to merge or consolidate with any other BHC. The BHCA generally prohibits the Federal Reserve from approving an application by a BHC to acquire a bank located in another state, unless such an acquisition is specifically authorized by statute of the state in which the bank to be acquired is located. Tennessee and certain other states, including most states contiguous to Tennessee, have adopted reciprocal interstate banking legislation permitting Tennessee-based bank holding companies to acquire banks and bank holding companies in such other states and allowing bank holding companies located in such states other than Tennessee to acquire banks and bank holding companies headquartered in Tennessee. A BHC is generally prohibited under the BHCA from acquiring voting shares of any company which is not a bank and from engaging in any activities other than those of banking or of managing or controlling banks or furnishing services to, or performing services for its subsidiaries. An exception to these prohibitions permits a BHC to engage in, or to acquire an interest in a company, such as a thrift institution, which engages in activities which the Federal Reserve has determined are so closely related to banking or managing or controlling banks as to be a proper incident thereto. CAPITAL ADEQUACY The Federal Reserve has adopted risk-based capital guidelines for bank holding companies. The minimum requirement of the guidelines for the ratio of a BHC's total capital to risk-weighted assets, including certain off-balance-sheet activities such as standby letters of credit (the "Total Capital Ratio") is 8%. At least one-half of a BHC's total capital must be composed of Tier 1 Capital which consists of common shareholders' equity, minority interests in the equity accounts of consolidated subsidiaries, non-cumulative perpetual preferred stock, and a limited amount of cumulative perpetual preferred stock, less goodwill ("Tier 1 Capital"). The remainder of total capital is classified as "Tier 2 Capital," which may consist of subordinated debt (or certain other qualifying debt issued prior to March 12, 1988), other preferred stock, and a limited amount of loan loss reserves. In addition, the Federal Reserve has established minimum leverage ratio guidelines for bank holding companies. These guidelines provide for a minimum ratio of Tier 1 Capital to average total assets, less goodwill (the "Leverage Ratio") of 3% for bank holding companies that meet certain specified criteria, including those having the highest regulatory rating. All other bank holding companies generally are required to maintain a Leverage Ratio of at least 3% plus an additional cushion of 100 to 200 basis points. The guidelines also provide that bank holding companies experiencing internal growth or making acquisitions are expected to maintain strong capital positions substantially above the minimum prescribed supervisory levels without significant reliance on intangible assets. Moreover, the Federal Reserve has indicated that it will consider a tangible Tier 1 Capital leverage ratio (arrived at by deducting all intangibles) and other indicia of capital strength in evaluating proposals for expansion or new activities. The Federal Reserve has not advised the Corporation of any specific minimum Leverage Ratio which would be applied to the Corporation. In addition to those applicable to BHCs, there are capital guidelines which must also be met by each of a BHC's depository-institution subsidiaries. The Federal Reserve, the FDIC, the Comptroller, and the OTS have adopted substantially similar minimum capital guidelines with which each of the Corporation's Banking Subsidiaries regulated by them is expected to comply. State-chartered banks are also required to meet minimum capital requirements prescribed by their respective state bank regulatory authorities. Failure to meet minimum capital requirements could subject a depository institution to a variety of enforcement remedies, including issuance of a capital directive, the termination of deposit insurance by the FDIC, and a prohibition on the taking of brokered deposits. As described below, under the "Prompt Corrective Action" regulations, substantial additional restrictions can be imposed upon FDIC-insured institutions which fail to meet applicable capital requirements. See " -- Prompt Corrective Action." At December 31, 1993, the Corporation's Total (risk-based) Capital Ratio was 18.59%, its Tier 1 Capital ratio was 14.85% and its Leverage Ratio was 7.10%. In addition, each of the Corporation's Banking Subsidiaries satisfied the minimum capital requirements applicable to it and had the requisite capital levels to qualify as a "well-capitalized" institution under the prompt corrective action provisions discussed below. PROMPT CORRECTIVE ACTION The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") enacted in December 1991 requires the appropriate federal bank regulatory authorities to take "prompt corrective action" with respect to depository institutions which do not meet their minimum capital requirements. FDICIA establishes five capital tiers: "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized," and "critically undercapitalized." Under the capital regulations, a bank is defined to be well capitalized if it maintains a Leverage Ratio of at least 5%, a Tier 1 Capital ratio of at least 6% and a Total Capital ratio of at least 10% and has not been determined to be in a "troubled condition" by its appropriate federal regulatory authority. A bank is defined to be adequately capitalized if it meets all of its minimum capital requirements as described above under " -- Capital Adequacy." A bank will be considered to be undercapitalized if it should fail to meet any minimum required measure, significantly undercapitalized if it should fall significantly below such measure, and critically undercapitalized if it should fail to maintain a level of tangible equity equal to not less than 2% of its total assets. A bank may be deemed to be in a capitalization category which is lower than is indicated by its actual capital position if it should receive an unsatisfactory examination rating. All institutions, regardless of their capital levels, are restricted from making any capital distributions or paying any management fees if, as a result thereof, the institution would fail to satisfy the minimum levels required in order to be considered adequately capitalized. An undercapitalized institution is: (i) subject to increased monitoring by the appropriate federal banking regulator; (ii) required to submit to its regulator an acceptable capital restoration plan within 45 days; (iii) subject to asset growth limitations; and (iv) required to obtain prior regulatory approval for acquisitions, branching, and new lines of business. The capital restoration plan must include a guarantee by the institution's holding company that the institution will comply with the plan until it has been adequately capitalized on average for four consecutive quarters. Pursuant to the guarantee, the institution's holding company would be liable up to the lesser of 5% of the institution's total assets or the amount necessary to bring the institution into capital compliance as of the date it failed to comply with its capital restoration plan. If the controlling BHC should fail to fulfill its obligations under the guarantee and should file (or have filed against it) a petition under the federal Bankruptcy Code, the appropriate federal banking regulator could have a claim as a general creditor of the BHC, and, if the guarantee were deemed to be a commitment to maintain capital under the federal Bankruptcy Code, the claim would be entitled to a priority position in such bankruptcy proceeding over third-party creditors of the BHC. The regulatory agencies have discretionary authority to reclassify well-capitalized institutions as adequately capitalized or to impose on adequately capitalized institutions requirements or actions specified for undercapitalized institutions if the agency should determine, after notice and an opportunity for hearing, that the institution is in an unsafe or unsound condition or is engaging in an unsafe or unsound practice, which may consist of its receipt of an unsatisfactory examination rating if the deficiencies cited are not corrected. A significantly undercapitalized institution, as well as any undercapitalized institution which fails to submit an acceptable capital restoration plan, may be subject to regulatory demands for recapitalization, broader application of restrictions on transactions with affiliates, limitations upon interest rates paid on deposits, asset growth and other activities, possible replacement of directors and officers and restrictions on capital distributions by any BHC controlling the institution. Any company controlling the institution could also be required to divest the institution or the institution could be required to divest subsidiaries. The senior executive officers of a significantly undercapitalized institution may not receive bonuses or increases in compensation without prior regulatory approval and the institution would be prohibited from making payments of the principal of, or interest on its subordinated debt. If an institution should become critically undercapitalized, the institution will be subject to conservatorship or receivership within 90 days unless periodic determinations are made that forbearance from such action would better protect the deposit insurance fund. Unless appropriate findings and certifications are made by the appropriate federal bank regulatory agencies, a critically undercapitalized institution must be placed in receivership if it should remain critically undercapitalized on average during the calendar quarter beginning 270 days after the date on which it became critically undercapitalized. DIVIDEND RESTRICTIONS The Corporation is a legal entity which is separate and distinct from its Subsidiary Banks as well as its non-bank subsidiaries. The Corporation's revenues (on a parent company only basis) result, in significant part, from dividends and management fees paid to the Corporation by its subsidiaries. The right of the Corporation, and consequently the right of creditors and shareholders of the Corporation, to participate in any distribution of the assets or earnings of any subsidiary, through the payment of such dividends or otherwise, is necessarily subject to the prior claims of creditors of the subsidiary (including its depositors, in the case of the Banking Subsidiaries) except to the extent that claims of the Corporation in its capacity as a creditor may be recognized. There are statutory and regulatory requirements applicable to the payment of dividends by the Corporation's Banking Subsidiaries to the Corporation. Each subsidiary of the Corporation which is a national banking association, including UPNB, is required by federal law to obtain the prior approval of the Comptroller for the payment of dividends if the total of all dividends declared by the board of directors of such bank in any year would exceed the total of (i) such bank's net profits (as defined and interpreted by regulation) for that year plus (ii) the retained net profits (as defined and interpreted by regulation) for the preceding two years, less any required transfers to surplus. In addition, national banks may only pay dividends to the extent that their retained net profits (including the portion transferred to surplus) exceed statutory bad debts (as defined by regulation). The Corporation's state-chartered Depository Subsidiaries are subject to similar restrictions on the payment of dividends by the respective state laws under which they are organized. Moreover, as noted above under " -- Prompt Corrective Action," all depository institutions are prohibited from paying any dividends, making other distributions or paying any management fees if, after such payment, the depository institution would fail to satisfy its minimum capital requirements. At December 31, 1993, UPNB and the Corporation's other Depository Subsidiaries had, in the aggregate, approximately $74.3 million available for distribution to the Corporation without obtaining prior regulatory approval. The actual amount of dividends paid will be limited to a lesser amount by management of the Corporation in order to maintain compliance with the Corporation's own internal capital guidelines and to maintain strong capital positions in each of the Banking Subsidiaries of the Corporation. Future dividends will essentially depend upon the level of earnings of the Banking Subsidiaries of the Corporation. It is the policy of the Federal Reserve that bank holding companies should pay dividends only out of current earnings. The federal bank regulatory authorities may also prohibit banks and bank holding companies from paying a dividend if they should deem such payment to be an unsafe or unsound practice. Furthermore, it is the position of the Federal Reserve that as a BHC, the Corporation is expected to act as a source of financial strength to each of its subsidiary banks. See " -- Support of Banking Subsidiaries" below. SUPPORT OF BANKING SUBSIDIARIES Under Federal Reserve policy, the Corporation is expected to act as a source of financial strength to its Banking Subsidiaries and, where required, to commit resources to support each of such Subsidiaries. This support may be required at times when, absent such Federal Reserve policy, the Corporation might not be inclined to provide it. Moreover, if one of its subsidiary banks should become undercapitalized, the Corporation would be required by FDICIA to guarantee the subsidiary bank's compliance with its capital plan in order for such plan to be accepted by the appropriate federal regulatory authority. See "-- Prompt Corrective Action." Under the "cross guarantee" provisions of the Federal Deposit Insurance Act, any FDIC-insured subsidiary of the Corporation (which includes all of the Corporation's Banking Subsidiaries) may be held liable for any loss incurred by, or reasonably expected to be incurred by the FDIC in connection with (i) the "default" of any other commonly controlled FDIC-insured subsidiary or (ii) any assistance provided by the FDIC to any commonly controlled FDIC-insured subsidiary "in danger of default." "Default" is defined generally as the appointment of a conservator or receiver and "in danger of default" is defined generally as the existence of certain conditions indicating that a default is likely to occur in the absence of regulatory assistance. Because it is a bank holding company, any capital loans made by the Corporation to any of its Banking Subsidiaries are subordinate in right of payment to the claims of depositors and to certain other indebtedness of such Banking Subsidiary. In the event of a BHC's bankruptcy, any commitment by the BHC to a federal bank regulatory agency to maintain the capital of a subsidiary bank will be assumed by the bankruptcy trustee and entitled to priority of payment over certain other creditors of the BHC. TRANSACTIONS WITH AFFILIATES Provisions of the Federal Reserve Act impose restrictions and limitations upon the type, amount, quantity, and quality of transactions between an "affiliate" (as defined below) of an FDIC-insured bank and the insured bank (including transactions with its bank holding company and its nonbank subsidiaries). The purpose of these restrictions and limitations is to prevent misuse of the resources of an FDIC-insured institution by its uninsured affiliates. An exception to most of these restrictions is provided for transactions between two insured banks which are subsidiaries of the same bank holding company where the holding company owns 80% or more of each of these banks (the "sister bank" exception). The restrictions are also inapplicable to transactions between an insured bank and its wholly-owned subsidiaries. These restrictions include limitations on the purchase and sale of assets and extensions of credit by the insured bank to its BHC or its BHC's nonbank subsidiaries. An insured bank and its subsidiaries are limited in engaging in "covered transactions" with their nonbank or non-savings bank affiliates to the following amounts: (i) in the case of any one such affiliate, the aggregate amount of covered transactions of the insured bank and its subsidiaries may not lawfully exceed 10% of the capital stock and surplus of the insured bank and (ii) in the case of all affiliates of such insured bank, the aggregate amount of covered transactions of the insured bank and its subsidiaries may not lawfully exceed 20% of the capital stock and surplus of the bank. "Covered transactions" are defined by statute to include a loan or extension of credit, as well as a purchase of securities issued by an affiliate, a purchase of assets (unless otherwise exempted by the Federal Reserve), the acceptance of securities issued by the affiliate as collateral for a loan and the issuance of a guarantee, acceptance, or letter of credit for, or on behalf of, an affiliate. An "affiliate" of an insured bank is a person or entity which controls, is controlled by or is under common control with, such insured bank. The BHCA also prohibits a BHC and its subsidiaries from engaging in certain tie-in arrangements in connection with any extension of credit, lease or sale of property or furnishing of services. FDIC INSURANCE ASSESSMENTS The Banking Subsidiaries of the Corporation are subject to FDIC deposit insurance assessments. The FDIC has adopted a risk-based premium schedule which has increased the assessment rates for most FDIC-insured depository institutions. Under the new schedule, the annual premiums initially range from $.23 to $.31 for every $100 of deposits. Each financial institution is assigned to one of three capital classifications -- well capitalized, adequately capitalized or undercapitalized -- and further assigned to one of three subgroups within its capital classification based upon supervisory evaluations by the institution's primary federal and, if applicable, state supervisory authorities and on the basis of other information relevant to the institution's financial condition and the risk posed to the applicable insurance fund. The actual assessment rate applicable to a particular institution will, therefore, depend in part upon the risk assessment classification so assigned to the institution by the FDIC. RECENT BANKING LEGISLATION In addition to the matters noted above, FDICIA made other significant changes to the federal banking laws. FDICIA institutes certain changes to the supervisory process, including provisions that mandate certain regulatory agency actions against undercapitalized institutions within specified time limits. STANDARDS FOR SAFETY AND SOUNDNESS. FDICIA required the federal bank regulatory agencies to prescribe, by regulation to become effective no later than December 1, 1993, standards for all insured depository institutions and depository-institution holding companies relating to: (i) internal controls, information systems and audit systems; (ii) loan documentation; (iii) credit underwriting; (iv) interest-rate risk exposure; (v) asset growth; and (vi) compensation, fees, and benefits. The compensation standards must prohibit employment contracts, compensation or benefit arrangements, stock option plans, fee arrangements or other compensatory arrangements that would provide excessive compensation, fees or benefits or could lead to material financial loss, but (subject to certain exceptions) may not prescribe specific compensation levels or ranges for directors, officers or employees. In addition, the federal bank regulatory agencies are required to prescribe by regulation standards specifying: (i) maximum classified assets to capital ratios; (ii) minimum earnings sufficient to absorb losses without impairing capital; and (iii) to the extent feasible, a minimum ratio of market value to book value for publicly traded shares of depository institutions and depository-institution holding companies. BROKERED DEPOSITS. The FDIC has adopted regulations governing the receipt of brokered deposits. Under the regulations, a bank may not lawfully accept, roll over or renew any brokered deposits unless (i) it is well capitalized or (ii) it is adequately capitalized and receives a waiver from the FDIC. A bank that may not receive brokered deposits also may not offer "pass-through" insurance on certain employee benefit accounts. Whether or not it has obtained such a waiver, an adequately capitalized bank may not pay an interest rate on any deposits in excess of 75 basis points over certain prevailing market rates specified by regulation. There are no such restrictions on a bank that is well capitalized. Because UPNB and all of the Community Banks had at December 31, 1993, the requisite capital levels to qualify as well capitalized institutions, management of the Corporation believes that the brokered deposits regulation will have no material effect on the funding or liquidity of any of its Banking Subsidiaries. Moreover, management does not believe that the Corporation now has, or at that date had brokered deposits in any amount. CONSUMER PROTECTION PROVISIONS. FDICIA seeks to encourage enforcement of existing consumer-protection laws and enacted new consumer-oriented provisions including a requirement of notice to appropriate regulatory authorities and customers of any proposed branch closing and provisions intended to encourage the offering of "lifeline" banking accounts and lending in distressed communities. FDICIA also requires depository institutions to make additional disclosures to depositors with respect to the rate of interest to be paid on, and the terms of their deposit accounts. INSTITUTIONAL EXPOSURE. FDICIA also required the Federal Reserve to prescribe standards which limit the risks posed by an insured institution's "exposure" to any other depository institution in order to limit the risks that the failure of a large depository institution would pose to an insured depository institution. FDICIA broadly defines "exposure" to include extensions of credit to the other institution; purchases of, or investments in, securities issued by the other institution; securities issued by the other institution and accepted as collateral for an extension of credit to any person; and all similar transactions which the Federal Reserve has defined by regulation to constitute exposure. The Federal Reserve has adopted certain procedures and "benchmark" standards to limit an insured depository institution's credit and settlement exposure to each of its correspondent banks. The final rules were effective on December 19, 1992, but provided for a two-year transition period. MISCELLANEOUS. FDICIA also made extensive changes in the applicable rules regarding audit, examinations, and accounting. FDICIA generally requires annual, on-site, full-scope examinations by each bank's primary federal regulatory authority. FDICIA also imposes new responsibilities on management, the independent audit committee and outside accountants to develop, approve or attest to reports regarding the effectiveness of internal controls, legal compliance, and off-balance-sheet liabilities and assets. DEPOSITOR PREFERENCE. Legislation recently enacted by Congress establishes a nationwide depositor preference rule in the event of a bank failure. Under this arrangement, all deposits and certain other claims against a bank, including the claim of the FDIC as subrogee of insured depositors, would receive payment in full before any general creditor of the bank would be entitled to any payment in the event of an insolvency or liquidation of the bank. SECURITIES ACTIVITIES The Securities Exchange Act of 1934 and in some instances state securities statutes impose supervisory and regulatory requirements on the various securities activities conducted by banks and non-banking subsidiaries of bank holding companies. GOVERNMENT POLICIES The earnings of the Corporation may be significantly affected by the policies of various regulatory authorities, including the domestic monetary policies of the Federal Reserve regulating credit, United States fiscal policy, and policies implemented by regulations affecting interest rates payable on deposits. The effect of such changes in policies upon the future earnings of the Corporation cannot be predicted. COMPETITION The Corporation and its subsidiaries are subject to substantial competition in all aspects of their businesses. They compete directly with numerous other financial services firms, a significant number of which have substantially greater capital and other resources, higher lending limits, larger advertising budgets, and which offer a wider range of financial services. In addition to the competition from commercial banks and securities firms, there is increasing competition from other sources such as savings and loans, insurance companies, consumer finance companies, credit unions, mortgage companies, money market funds, and lending agencies of the United States Government. In the five-county Memphis market alone, there were approximately 45 banks and savings and loan associations (excludes credit unions) at June 30, 1993, as well as numerous other competing financial institutions. There is significant competition with respect to interest rates paid on deposits, interest rates charged on loans, and fees charged for services. PERSONNEL As of February 28, 1994, the Corporation, including all subsidiaries, had 3,457 employees (including 517 part-time employees). STATISTICAL DISCLOSURES The statistical information required by Item 1 may be found in the 1993 Annual Report to Shareholders, and, to the extent indicated, is incorporated herein by reference, as follows: The following table presents the maturities and sensitivities of the Corporation's loans to changes in interest rates at December 31, 1993: The following table presents maturities of certificates of deposit of $100,000 and over and other time deposits of $100,000 and over: ITEM 1A.	ITEM 1A. EXECUTIVE OFFICERS OF THE REGISTRANT The following is a list of executive officers of the Corporation. Information regarding the executive officers, their ages, their present positions held with the Corporation and its subsidiaries, and their principal occupations for the last five years are as follows: Mr. Rawlins has been Chairman of the Board of the Corporation and UPNB since April, 1989 and January, 1986, respectively. He has also served as Chief Executive Officer of the Corporation and UPNB since September, 1984. Mr. Rawlins was President of the Corporation from September, 1984 until he was elected Chairman. Mr. Smith has been Vice Chairman of the Corporation since 1989. Effective March, 1994, Mr. Smith became Chairman of the East Tennessee Region of the Corporation. He was President of the Corporation's Community Bank Group from April of 1992 until February, 1994. Mr. Smith was President of UPNB from 1988 to April, 1992. Prior to becoming a Vice Chairman of the Corporation, Mr. Smith was an Executive Vice President of the Corporation from 1987 until elected Vice Chairman. He was a Vice Chairman of UPNB from 1985 until he was elected President. Mr. Moore has been President of the Corporation since April, 1989. Since 1977, he had been a partner in the law firm of Wildman, Harrold, Allen, Dixon & McDonnell (and its predecessor Canada, Russell & Turner), the Corporation's outside legal counsel and had served on its Management Committee and as Chairman of its Administrative Committee for five years. He is also Chairman of PSB Bancshares, Inc. and is a Vice President and Director of its subsidiary, The Peoples Savings Bank, located in Clanton, Alabama. He has served on the Boards of the Corporation and UPNB since 1986. Mr. Parker has been Executive Vice President and Chief Financial Officer of the Corporation since March, 1990. He has been an Executive Vice President and Chief Financial Officer of UPNB since March, 1990. From 1987 until being elected to these positions with the Corporation, he was an Executive Vice President of UPNB and President of the Mortgage Banking Group of UPNB. Mr. Walters was elected Senior Vice President of the Corporation in November, 1990 and has been Chief Accounting Officer since February, 1990. He has been Treasurer of the Corporation since 1985. He was a Vice President of the Corporation from 1975 until he was elected to his current position. Mr. Walters has been an officer of UPNB for more than twenty years and is currently a Senior Vice President. Mr. Springfield has been Secretary and General Counsel of the Corporation and Secretary and General Counsel of UPNB since December, 1985. He has been an officer of UPNB for more than thirty-seven years, and is currently an Executive Vice President. Mr. Gurley was elected Executive Vice President of the Corporation in November, 1990. He was a Vice President of the Corporation from 1980 until he was elected Executive Vice President. He has been an officer of UPNB for more than twenty years and is currently an Executive Vice President. ITEM 2.	ITEM 2. PROPERTIES The Corporation's corporate headquarters are located in the company-owned UPNB Administrative Center at 7130 Goodlett Farms Parkway, Memphis, Tennessee, a two-building complex located near the center of Shelby County. In addition to being the corporate headquarters, it contains approximately 250,000 square feet of space and houses Retail Branch Administration, Bank Cards, Mortgage Servicing and Origination, Funds Management, Data Processing, Operations, Marketing, Human Resources, Financial, Legal, Insurance Services, and Community Bank Group Administration. UPNB's headquarters is located in a 70,000 square foot company-owned building in East Memphis. In addition to being its headquarters, the building also houses UPNB's Commercial Group, Trust Group, Credit and Review, and Brokerage Services. As of December 31, 1993, UPNB and other subsidiaries of the Corporation operated 170 banking offices in Tennessee, 25 in Mississippi, 22 in Arkansas, and 2 in Alabama. Of these, 150 are owned and 69 are leased by the subsidiaries. The subsidiaries also operate 167 twenty-four hour automated teller locations. The acquisitions completed subsequent to December 31, 1993 and through March 1, 1994 increased by 15 the number of banking offices to 234, of which 10 were added in Tennessee and five in Kentucky. There are no material encumbrances on any of the company-owned properties. ITEM 3.	ITEM 3. LEGAL PROCEEDINGS The Corporation and/or various subsidiaries are parties to various pending civil actions, all of which are being defended vigorously. Management is of the opinion that the Corporation has accrued liabilities sufficient to cover the estimated costs associated with the ultimate resolution of all pending matters, including those discussed below. While additional provisions for litigation are possible, management is of the opinion, based on current information, including evaluations of outside counsel, that no additional provisions will be necessary for the foreseeable future. Any such additional provisions would obviously impact earnings in the operating periods in which such provisions were made. Nevertheless, management's view is that such additional provisions, if any, would not materially affect the financial condition of the Corporation. Various other legal proceedings against the Corporation and its subsidiaries have arisen in the ordinary course of business. Management is of the opinion that the Corporation's financial position will not be materially affected by the ultimate resolution of these other legal matters. UPNB and one of its officers are co-defendants in two civil actions seeking $29 million (after trebling) filed on or about July 25, 1985 in the U.S. Bankruptcy Court for the Eastern District of Missouri by the trustee for a failed grocery and its shareholders purportedly predicated upon an August, 1981 $115,000 loan by the First National Bank of Gibson County, Tennessee, later acquired by UPNB, to finance the shareholders' acquisition of the grocery business from other defendants unrelated to UPNB. The actions allege that the defendants subsequently conspired to defraud the plaintiffs of their rights in the grocery. This matter has been dormant since UPNB filed a motion for summary judgment in 1985. In 1988, the Corporation rescinded and terminated a purported agreement for the acquisition of a Louisiana bank holding company, Great American Corporation (GAC). The Corporation and a subsidiary were made parties to several civil actions relating to the failed acquisition alleging damages estimated at $66 million and founded essentially upon theories that the Corporation had breached the acquisition agreement and committed wrongful acts under state law and a separate confidentiality agreement. In November, 1992, the Corporation completed the negotiation and signing of definitive agreements for the settlement of all the pending civil actions. A class consisting of all outside GAC shareholders between January 22 and October 4, 1988 was certified for purposes of consummating the settlement and the number of share owners excluded from that class was immaterial. Early in the second quarter of 1993 consummation of the settlement of all pending civil actions involving the Corporation and a subsidiary arising from the attempted acquisition of GAC was effected. The costs of such settlement did not exceed amounts previously reserved for such purpose. UPNB, a member of the MasterCard and VISA organizations, was a co-defendant or cross-claim defendant in two related civil actions arising out of its previous utilization of a third party, Electronic Transaction Network, Inc.(E-Net), to solicit and assist in the administration of credit card transaction processing arrangements with several thousand consumer merchants located throughout the United States. The plaintiff sought compensatory damages said to exceed $10 million (trebled to exceed $30 million) and other relief based on various alleged wrongdoing by UPNB and two co-defendants. During the third quarter of 1993, a definitive agreement was entered into for the settlement of all pending litigation against UPNB in connection with its former relationship with E-Net, without the payment of any sum by UPNB. The Corporation's broker/dealer subsidiaries (now inactive) are among the more than eighty defendants in various actions brought by purchasers of $400 million in housing revenue bonds issued by the Health, Educational, and Housing Facility Board of the City of Memphis, Tennessee and by purchasers of bonds that were part of seven other taxable municipal issues. These actions have been transferred to the United States District Court for the Eastern District of Louisiana for pretrial proceedings captioned In Re: Taxable Municipal Bond Securities Litigation, Multi-district Litigation ("MDL" 863). Focusing upon the fact that the bond sale proceeds were initially invested and remain in "guaranteed investment contracts" ("GICs") with Executive Life Insurance Company ("ELIC"), whose own investments were allegedly concentrated in so-called "junk bonds" of declining value, the lawsuits in MDL 863 allege that the offering materials failed to make adequate disclosures and that the bonds represented a scheme among the Executive Life organization, Drexel Burnham Lambert, Inc., and the other defendants to raise money for "junk bond" purchases, rather than for public purposes. ELIC is in conservatorship, interest on the bonds is in default, and Drexel is in Chapter 11 reorganization. The complaint for the Memphis issue requests certification of a plaintiff class including substantially all persons who purchased a Memphis bond through April 9, 1990, either in the original $400 million Memphis bond underwriting, in which a broker/dealer subsidiary of the Corporation participated, or in the secondary market, wherein such subsidiary sold a total of approximately $120 million par value in Memphis bonds. The class claims in respect of the Memphis issue seek to impose joint and several liability upon, among others, numerous defendants who participated in the underwriting, including such subsidiary. In addition, a number of individual actions naming the Corporation's broker/dealer subsidiaries have been brought by secondary market purchasers. The class and individual plaintiffs predicate their claims upon Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5 promulgated thereunder, the Investment Company Act, the Investment Advisors Act, common law fraud, negligent misrepresentation, gross and ordinary negligence, breach of fiduciary duty, the Tennessee Securities Act, and other laws. For relief, the various complaints seek a declaratory judgment that the Memphis bonds were void from their inception, rescission of all of plaintiffs' purchases, punitive damages, prejudgment interest, and other relief. While the actions originally included Investment Company Act, Investment Advisers Act, and racketeering (RICO) claims, most of these have been dismissed, and the current complaints do not assert any such claims against the UPC parties. On January 28, 1993, the California Supreme Court declined to review a lower court ruling to the effect that claims to ELIC assets by policyholders, annuitants, and holders of GICs are to be treated as equal in priority in the distribution of such assets. The Corporation's broker/dealer subsidiaries have joined in a common defense with other members of the syndicate which underwrote the bonds which are the subject of the litigation. On May 30, 1991, in an action originally filed by UPNB in the Circuit Court of Cook County, Illinois, Chancery Division, seeking to foreclose on a single parcel of mortgaged residential property, the defendant debtors filed a counterclaim against UPNB and the Corporation individually and on the purported behalf of a requested class which would have consisted essentially of all persons who had a mortgage loan serviced by UPNB at any time during the past 10 years. The counterclaim alleged that UPNB, like other participants in the mortgage loan industry, engaged in a regular practice of charging mortgage debtors greater amounts to escrow for estimated property taxes and insurance than is allowed by law and applicable loan agreements. The counterclaim sought recovery of all excess charges and/or interest thereon, and other relief. The class action aspects of this counterclaim have been dismissed, leaving only a setoff claim by the defendant debtors with respect to the foreclosure. On February 16, 1993, an action was filed in the Circuit Court of Choctaw County, Alabama as an individual action and as a purported class action against UPNB and UPC with theories of recovery and relief requested similar to the Illinois counterclaim. On or about July 10, 1991, UPNB was joined with nine other banks as defendants in a civil action in the Circuit Court of Shelby County, Tennessee. The suit as originally filed alleges that the banks unlawfully conspired to fix the charges for checks drawn on insufficient funds. The suit seeks compensatory and punitive damages of $25 million against each defendant and certification of a class of plaintiffs comprised of all depositors who have been charged the NSF fees. The suit was amended on or about July 12, 1991, August 2, 1991 and again on November 25, 1991 to add plaintiffs and to include claims of unfair and deceptive trade practices, breach of contract, tortious conduct, violation of provisions of the UCC, treble damages under the Tennessee Consumer Protection Act, and usury. The amendments also broadened the class and the claims to seek recovery for fees charged for deposited third-party checks which were returned uncollected. In March, 1992 the state court proceeding was dismissed; plaintiffs subsequently appealed the dismissal, and on February 23, 1993, the Tennessee Court of Appeals affirmed the dismissal of five of the six counts in the state court action but reversed the dismissal of the count alleging violation of the contractual duty of good faith and fair dealing, holding that the plaintiffs met bare minimum pleading requirements to permit that claim to go forward. During the third quarter of 1993, class certification was granted by the state court, with the plaintiff class apparently consisting of all persons in the United States who, in the six years prior to the filing of the complaint were charged the fees described above. However, on December 17, 1993, the defendants' motion for summary judgment was granted on the remaining breach of contract claim. Plaintiffs have appealed that ruling. Further, on May 22, 1992, substantially the same group of plaintiffs filed a civil action in the U.S. District Court for the Western District of Tennessee against UPNB and eight other banks, alleging violations of the Sherman Act, the federal anti-trust statute prohibiting the fixing of prices by competitors, as well as the Tennessee Consumer Protection Act. The suit further requests certification of a similarly broad class, seeks injunctive relief and damages for the class members in amounts, according to the suit, "which are presently undetermined but believed to be more than $100 million." The complaint also seeks treble damages and a jury trial. On March 19, 1993 the federal court granted defendants' motion to dismiss the Tennessee Consumer Protection Act claim, but permitted the Sherman Act claim to remain at that stage of the proceedings. On September 15, 1993 the defendants filed a motion for summary judgment seeking dismissal of the price fixing allegations as well, and on March 11, 1994, the court granted that motion. Plaintiffs have indicated they will appeal. Certain subsidiaries of the Corporation and UPNB were threatened in 1989 with a civil action by the FDIC for the estate of a closed savings association. If filed, the action would reportedly seek compensatory damages of at least $37 million, and other relief including an injunction against transferring or encumbering any assets until any judgments were paid, based upon allegations of wrongdoing in the sale of covered call options to the closed savings association. A tolling and forbearance agreement, entered into by all parties to the threatened action in 1989, continues in effect. The Corporation has furnished the FDIC with information assertedly demonstrating the lack of merit in the threatened action and believes that such action, if nevertheless filed, can be resolved without material loss. During 1993, agreements-in-principle and/or final settlements were reached with plaintiffs to resolve a significant number of previously reported legal claims, utilizing reserves previously established in prior periods or otherwise having no material effect upon the Corporation's financial position. PART II ITEM 5.		ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS The information required by Item 5 is included in the Corporation's 1993 Annual Report to Shareholders on page 57 under the heading Table 14, "Selected Quarterly Data," which is incorporated herein by reference. ITEM 6.	ITEM 6. SELECTED FINANCIAL DATA The information required by Item 6 is included in the Corporation's 1993 Annual Report to Shareholders on page 35 under the heading "Selected Financial Data," and which is incorporated herein by reference. ITEM 7.	ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information required by Item 7 is included in the Corporation's 1993 Annual Report to Shareholders on pages 36-58 under the heading "Management's Discussion and Analysis of Results of Operations and Financial Condition," and which is incorporated herein by reference. ITEM 8.	ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required by Item 8 is included in the Corporation's 1993 Annual Report to Shareholders on pages 4-34 and on page 57 under the heading Table 14, "Selected Quarterly Data," and which is incorporated herein by reference. PART III ITEM 10.		ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by Item 10 as to the directors of the Corporation is included on pages 3-5 and 15 of the definitive proxy statement of the Corporation for the annual meeting of shareholders to be held on April 28, 1994 (Proxy Statement) and which is incorporated herein by reference. The information concerning "Executive Officers of the Registrant" is included in Part I (Item 1a) of this Form 10-K in accordance with Instruction 3 to paragraph (b) of Item 401 of Regulation S-K. ITEM 11.	ITEM 11. EXECUTIVE COMPENSATION The information required by Item 11 as to compensation of directors and executive officers is included on pages 5 and 6 and 7-14 of the Proxy Statement which is incorporated herein by reference. ITEM 12.	ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by Item 12 as to certain beneficial owners and management is included on pages 2-5 of the Proxy Statement which is incorporated herein by reference. ITEM 13.	ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by Item 13 as to transactions and relationships with certain directors and executive officers of the Corporation and their associates is included on page 13 of the Proxy Statement which is incorporated herein by reference. PART IV ITEM 14.	ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) (1) The following audited consolidated financial statements of Union Planters Corporation and Subsidiaries, included in the Corporation's 1993 Annual Report to Shareholders, are incorporated herein by reference in Item 8: (a) (2) All schedules have been omitted since the required information is either not applicable, not deemed material, or is included in the respective consolidated financial statements or in the notes thereto. (a) (3) Exhibits: The exhibits listed on the Exhibit Index on pages i, ii, and iii, following page 30 of this Form 10-K are filed herewith or are incorporated herein by reference. (b) Reports on Form 8-K: SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. UNION PLANTERS CORPORATION (Registrant) By: /s/ Benjamin W. Rawlins, Jr. --------------------------------------------------- Benjamin W. Rawlins, Jr., Chairman of the Board and Chief Executive Officer Date: March 23, 1994 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 indicated on the 23rd of March, 1994 EXHIBIT INDEX 3 (a) Restated Charter of Incorporation, as amended December 17, 1992, of Union Planters Corporation (Filed herewith) 3 (b) Amended and Restated By-Laws, as amended January 20, 1994, of Union Planters Corporation (Filed herewith) 2 Amendment and Plan of Reorganization, along with the Plan of Merger annexed thereto as Exhibit A, dated as of January 27, 1994 between Union Planters Corporation and BFC Acquisition Company, Inc. and BANCFIRST Corporation and BANKFIRST, a federal savings bank (incorporated by reference to Exhibit 2 to Union Planters Corporation Current Report on Form 8-K dated February 8, 1994 filed on February 18, 1994). 4 (a) Rights Agreement, dated January 19, 1989 between Union Planters Corporation and Union Planters National Bank, including Form of Rights Certificate (Exhibit A), and a Form Summary of Rights (Exhibit B) (Incorporated by reference to Exhibit 1 to Union Planters Corporation's Current Report dated as of January 19, 1989 on Form 8-K filed February 1, 1989 Commission File No. 0-6919) 4 (b) Indenture dated April 1, 1989 between Union Planters Corporation and LaSalle National Bank for $34,500,000 of 10 1/8% Subordinated Capital Debentures due 1999 * 4 (c) Indenture dated October 1, 1992 between Union Planters Corporation and The First National Bank of Chicago (Trustee) for $40,250,000 of 8 1/2% Subordinated Notes due 2002 * 4 (d) Subordinated Indenture dated October 15, 1993 between Union Planters Corporation and The First National Bank of Chicago for $75,000,000 of 6.25% Subordinated Notes due 2003 10 (a) Employment Agreement between Union Planters Corporation and Benjamin W. Rawlins, Jr. (incorporated by reference to Exhibit 10(a) to the Annual Report on Form 10-K dated December 31, 1992) 10 (b) Employment Agreement between Union Planters Corporation and J. Armistead Smith (incorporated by reference to Exhibit 10(b) to the Annual Report on Form 10-K dated December 31, 1992) -i- 10 (c) Employment Agreement between Union Planters Corporation and Jackson W. Moore (incorporated by reference to Exhibit 10(c) to the Annual Report on Form 10-K dated December 31, 1992) 10 (d) Deferred Compensation Agreements between Union Planters Corporation and certain highly compensated officers (incorporated by reference to Exhibit 10 (g) to the Annual Report on Form 10-K dated December 31, 1989) 10 (e) Union Planters Corporation 1983 Stock Incentive Plan 10 (f) (1) Amended Union Planters Corporation 1983 Stock Incentive Plan ***** 10 (g) Union Planters Corporation 1992 Stock Incentive Plan (incorporated by reference to Exhibit 10(g) to the Annual Report on Form 10-K dated December 31, 1992) 10 (h) Deferred Compensation Agreements between Union Planters Corporation and Union Planters National Bank and certain outside directors (Incorporated by reference to Exhibit 10(m) to the Annual Report on Form 10-K dated December 31, 1989) 10 (i) Executive Deferred Compensation Agreement between Union Planters Corporation and certain highly compensated officers (Incorporated by reference to Exhibit 10 (n) to the Annual Report on Form 10-K dated December 31, 1989) 10 (j) "Standard Form of Agreement Between Owner and Contractor" between Union Planters National Bank and Martin, Cole, Dando, and Robertson, Inc. (incorporated by reference to Exhibit 10(j) to the Annual Report on Form 10-K dated December 31, 1992) 10 (k) "Standard Form of Agreement Between Owner and Architect" between Union Planters National Bank and Hnedak Bobo Group, P.C. (incorporated by reference to Exhibit 10(k) to the Annual Report on Form 10-K dated December 31, 1992) 11 Computation of Per Share Earnings (Filed herewith) 13 Annual Report to Security Holders (Filed herewith) 21 Subsidiaries of the Registrant (Filed herewith) 23 Consent of Price Waterhouse (Filed herewith) ii * Incorporated by reference to exhibit number 4 filed as part of Registration Statement No. 33-27784 Incorporated by reference to exhibit 10 (1) filed as part of Registration Statement 2-97661 * Incorporated by reference to exhibit number 4 filed as part of Registration Statement No. 33-52434 ** Incorporated by reference to Exhibit Number 4(d) filed as part of Registration Statement No. 33-50655 *** Incorporated by reference to Exhibit Number 4 filed as part of Registration Statement No. 33-23306 -iii-
74931_1993.txt	74931	1993	ITEM 1. BUSINESS Orion Capital Corporation ("Orion") is a property and casualty insurance holding company incorporated under the laws of the State of Delaware in 1960. Although Orion's insurance subsidiaries and affiliates are authorized to underwrite and sell most types of property and casualty insurance, their businesses are concentrated in niche insurance markets, particularly specialty workers compensation, architect and engineer professional liability and nonstandard automobile insurance. (Orion and its wholly-owned subsidiaries are referred to collectively as the "Company.") The Company markets its workers compensation insurance through the EBI Companies and a newly created entity, Nations' Care, Inc. ("Nations' Care"). Nations' Care was created in late 1993 and will primarily focus on alternative workers compensation services and products. The Company sells its professional liability insurance through the DPIC Companies and participates in the nonstandard commercial and personal automobile insurance business through its slightly less than 50% interest in Guaranty National Corporation ("Guaranty National"). (Guaranty National and its wholly-owned subsidiaries are referred to collectively as the "Guaranty National Companies.") The Company writes assumed reinsurance through SecurityRe Companies and other specialty property and casualty insurance, principally through the Connecticut Specialty Insurance Group. The Company currently holds 6,143,414 shares of Guaranty National common stock. Between November 1988 and November 20, 1991, Guaranty National was a wholly-owned subsidiary of the Company. On November 20, 1991, the Company sold slightly more than half of its interest in Guaranty National. Guaranty National and its subsidiaries operate as an independent publicly-held company and, except for certain services contractually provided, are not managed by the Company. Three of the eight members of Guaranty National's board of directors are selected by Orion. See "Summary of Insurance Operations - Guaranty National Companies." In December 1993, the Company completed the acquisition of approximately 20% of the outstanding common stock (1,526,484 shares) of Intercargo Corporation ("Intercargo") for a total cash purchase price of $19,314,000. Intercargo is an insurance holding company whose subsidiaries specialize in international trade and transportation coverages. Intercargo operates as an independent company. One member of Intercargo's seven-member board of directors is selected by Orion. The Company's insurance subsidiaries are licensed to transact business throughout the United States and in several Canadian provinces. They obtain substantially all of their business from approximately 675 independent insurance agents and brokers. The Company has approximately 1,400 employees, substantially all of whom are employed in the Company's insurance operations. During 1992 and the first part of 1993, Orion reconfigured and simplified its debt and capital structure by issuing $110,000,000 of 9 1/8% Notes due September 1, 2002, ("9 1/8% Senior Notes") and calling for the redemption of all three of its outstanding preferred stocks and both issues of its outstanding debentures. Most holders of its two Convertible Exchangeable Preferred Stocks opted to convert their shares of preferred stock into shares of Common Stock at or prior to the redemption date. The conversions resulted in the issuance of 3,982,000 shares of Common Stock. As a result of those actions, the only outstanding securities of Orion are its common stock and its 9 1/8% Senior Notes. The reconfiguration and simplification of its debt and capital structure enabled the Company to take advantage of generally lower interest rates, decrease the cost of its capital, and reduce the amount of debt and preferred stock sinking fund payments that were coming due in the next few years. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources." The Company's principal executive offices are located at 30 Rockefeller Plaza, New York, New York 10112, and its telephone number is (212) 332-8080. The home offices of all the Company's insurance subsidiaries are located at 9 Farm Springs Drive, Farmington, Connecticut 06032. For segment reporting purposes, the operations of the Company are reported as four segments. The insurance operations of the Company are treated as three segments, Regional Operations, Reinsurance/Special Programs and the Company's interest in the Guaranty National Companies. Guaranty National's operations were reported on a consolidated basis from 1988 through November 20, 1991 and on the equity accounting basis since then. The miscellaneous activities of Orion, the parent holding company, and various incidental subsidiaries not involved in insurance-related activities are reported as a fourth segment under the heading "Other." Regional Operations is composed primarily of two divisions, the EBI Companies and Nations' Care. These operations underwrite and sell workers compensation insurance through independent agents and brokers. Nations' Care also offers workers compensation consulting and administrative services. Regional Operations' results include the declining costs associated with the run-off of the Company's commercial multiple peril insurance business, which was discontinued in 1988. Reinsurance/Special Programs includes the DPIC Companies, which markets professional liability insurance; SecurityRe Companies, which writes reinsurance; the Connecticut Specialty Insurance Group, which underwrites and sells specialty insurance programs through independent agents and general agents; and Intercargo, which specializes in international trade and transportation coverages. The Guaranty National Companies specialize in writing nonstandard commercial and personal automobile insurance, general liability insurance, surplus lines commercial property and casualty insurance and collateral protection insurance. The business of Orion's other subsidiaries, all of which are insubstantial, as well as the miscellaneous income and expenses (primarily interest, general and administrative expenses and other consolidating elimination entries) of Orion itself, are reported as a fourth segment. Net earnings for 1993 amounted to $68,813,000 or $4.69 per primary common share (after preferred dividends) on 14,598,000 weighted average common shares outstanding as compared with net earnings of $42,872,000 or $3.35 per primary common share (after preferred dividends) in 1992 on 10,914,000 weighted average common shares outstanding. Earnings per share in 1993 include a benefit of $.81 from the cumulative effect of changes in accounting principles and 1992 earnings per share were reduced $.27 per share by an extraordinary loss from the early extinguishment of debt. Common stock and per common share data have been restated to reflect Orion's 5-for-4 stock splits paid on both December 7, 1992 and November 15, 1993. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." The following tables present condensed financial information showing revenues, pre-tax earnings (loss) and other financial data and ratios of the Company's four segments for each of the three years in the period ended December 31, 1993. Identifiable assets, by segment, are included in Note L to Consolidated Financial Statements, "Industry Segment Information." - 4 - For 1993, approximately 49.0% of the Company's net premiums written was derived from workers compensation insurance written in twelve selected states (including all states listed in the preceding table except Florida and California), approximately 22.9% related to liability insurance other than automobile, primarily professional liability insurance, and approximately 21.1% came from automobile insurance (not including premiums from Guaranty National Companies). No other line of business contributed in excess of 3% to 1993 premiums written. The following table shows premiums written for the Company, net of reinsurance, by major statutory lines of business. See "Insurance Industry Characteristics - Loss Reserves" for a discussion of losses incurred in specific geographical regions and in specific lines of business. REGIONAL OPERATIONS The Regional Operations segment is comprised primarily of two divisions, the EBI Companies and the newly created entity, Nations' Care. The EBI Companies provides traditional workers compensation insurance and Nations' Care will focus on providing alternative workers compensation services and products. From 1989 through 1993, the EBI Companies' net premiums written have accounted for almost all of the premium volume of the Regional Operations segment. The EBI Companies devote substantially all of their resources to underwriting and selling workers compensation insurance through independent agents and brokers. EBI believes it has a competitive edge stemming from its service oriented approach. It is among the 25 largest writers of workers compensation insurance in the United States based on net premiums written. For a variety of reasons, EBI has phased out of the workers compensation business in California, a process it began in 1990. The decrease in premium volume in California has been substantially offset by growth in other markets, such as Connecticut, Illinois, Indiana, Pennsylvania, Texas and Wisconsin. Regional Operations staffs its offices with underwriters, field production representatives, claims and loss control representatives, medical and rehabilitation experts and other technical and administrative personnel. The EBI Companies' specialized approach is founded upon a team concept under which loss control and claims management personnel have significant direct involvement in account selection and in underwriting each policy. Upon acceptance of each new account, an EBI team begins to work with the insured and its employees to identify the factors that influence their insurance costs. During the policy term, the EBI team continues to provide services designed to reduce the frequency and severity of injuries. Because of its desire to influence and impact the workplace environment in order to reduce losses, EBI concentrates its efforts on single-location, fixed-plant insureds, such as small to medium-sized manufacturers and selected service businesses. Regional Operations' new division, Nations' Care, will capitalize on the Company's expertise acquired from its service oriented and team approach to traditional workers compensation. It will apply these skills in writing workers compensation for large accounts, accounts with large deductibles and other insurance products. It will also offer consulting and administrative services to self-insured workers compensation programs. Nations' Care will emphasize its cost effective loss control and claims management consulting services. Nations' Care currently operates in five states but expects ultimately to sell its services more broadly throughout the United States. A workers compensation policy obligates an insurance company to pay all compensation and other benefits for injured workers as may be required by applicable state workers compensation laws. Such benefits include, among other things, payments for medical and hospital expenses, and disability and vocational rehabilitation expenses. The insurance policies currently written by the EBI Companies provide workers compensation coverage with limits of liability set by the provisions of the state workers compensation laws. The benefits provided by these laws vary with the nature and severity of the injury or disease, as well as with the wage level, occupation and age of the employee. Employers liability coverage is also provided to employers who may be subject to claims for damages (not workers compensation benefits) because of an injury to a worker. The amount of workers compensation premiums earned is directly dependent upon wage levels as well as the number of employees on the payroll of each policyholder and the job classification of those employees. Accordingly, premiums may be affected by the level of unemployment in general, and particularly by the level of unemployment experienced in those industries and geographic areas which represent a substantial portion of the Company's workers compensation insurance business. Premium rates are revised annually in most states in which the EBI Companies do business. Rates vary with different job classifications and among different employers. The EBI Companies use the rates and rating plans filed in the states where they do business. See "Industry Characteristics - Rates." Approximately 600 independent agents and brokers produced substantially all of the direct business written in 1993 by the EBI Companies. All of such agents and brokers receive commissions on the sale of insurance. No single independent agent or broker contributed more than 5% of this segment's net written premiums. The agents and brokers provide a broad range of insurance services to the public within their local areas, operate as independent contractors and generally represent other insurers as well. REINSURANCE/SPECIAL PROGRAMS The Company's Reinsurance/Special Programs segment is comprised of four components: DPIC Companies, SecurityRe Companies, Connecticut Specialty Insurance Group ("Connecticut Specialty") and the Company's 20% equity interest in Intercargo Corporation. All of such components concentrate in highly specialized lines of business in the property and casualty insurance field. DPIC Companies writes professional liability insurance for architects, engineers and accountants. DPIC Companies is the second largest underwriter of architect and engineer liability insurance in the United States. DPIC Companies also writes business in Canada. On October 1, 1993, DPIC Companies substantially reorganized its operations into a structure that more directly aligns its various business functions with particular types of customers. DPIC Companies' Architects and Engineers Underwriting unit was divided into three major divisions: Architects, Engineers and Special Risks. Each division is now staffed with underwriters focused on a more specific discipline thus engendering in them a greater familiarity with the issues facing their customers. DPIC Companies markets a program of professional liability insurance, similar to its architects and engineers products, for selected medium-sized certified public accounting firms in a program called A/PLS+. In 1994 DPIC Companies plans to introduce a similar program for preferred law firms in a program called L/PLS+. DPIC Companies' accountants, lawyers and Canadian programs comprise a fourth DPIC Companies division - the Emerging Businesses group. Professional liability insurance covers liability arising out of alleged negligent performance of professional services. Underwriting and claims management require a high level of knowledge and expertise. In an attempt to limit risk exposure, DPIC Companies' specialized underwriters evaluate a great number of factors, including the experience of an applicant firm's professional personnel, the loss history of the firm and the employees to be covered, the type of work performed and the firm's utilization of suggested loss prevention measures. DPIC Companies uses a premium credit incentive program to encourage insureds to participate in its interactive liability education program and to use other loss prevention practices, such as use of "limitation of liability" clauses in their client contracts. The coverage offered by DPIC Companies is on a "claims-made and reported" policy form, a form which generally insures claims reported by the insured only during the policy term. DPIC Companies generally uses a policy form under which defense costs, primarily legal fees, are limited by their inclusion within the insured's stated policy limits. This policy form has had a favorable impact in controlling legal costs. DPIC Companies' specialized claims staff, located in eight offices in the United States and Canada, stress early intervention in disputes to avoid litigation whenever possible. DPIC Companies has been a pioneer in using alternative dispute resolution methods to mediate and promptly resolve disputes. DPIC Companies' "Mediation Works" program has been particularly successful. DPIC Companies offers incentives to insureds who agree to mediate disputes. Currently, nearly 28% of all open claims are in mediation or proceeding under some other form of alternative dispute resolution. Management believes that the use of such methods has had a beneficial impact on DPIC Companies' operating results. DPIC Companies markets its products through 54 specialized agencies, each highly knowledgeable about risk management for the professions served and about the DPIC Companies' loss reduction programs. Management believes that this "value added" approach is the reason why DPIC Companies has experienced a high customer retention rate over a long period of time and why it is less vulnerable to price competition. The agents participate in continuing education programs sponsored by DPIC Companies, and also actively participate in professional societies. Connecticut Specialty administers the operation of approximately 30 specialty programs written through general agencies. The specialized coverages include personal lines automobile insurance, workers compensation insurance, as well as various liability coverages for the trucking industry. Connecticut Specialty utilizes a profit sharing approach in writing its special programs whereby minimal profit is earned by the general agent until the program is profitable. Connecticut Specialty closely monitors its programs throughout their existence to ensure that profit potential is maximized. Pricing volatility for the business that Connecticut Specialty writes is generally low. The specialty nature of such business provides some insulation against the competitive pressures of the overall insurance market. Connecticut Specialty's ability to exit and enter markets rather quickly is an added competitive advantage. The Reinsurance/Special Programs segment also participates in facultative and treaty reinsurance throughout the United States through SecurityRe Companies. SecurityRe Companies underwrites a diverse book of property and casualty business using reinsurance intermediaries. Treaty business is focused on small to medium-sized specialty or regional insurance companies. The Reinsurance/Special Programs segment also includes the Company's 20% interest in Intercargo. Intercargo is an insurance holding company whose subsidiaries specialize in international trade and transportation coverages. Its principal product lines are U.S. Customs bonds and marine cargo insurance sold to importers and exporters through customs brokers and other service firms engaged in the international movement of goods. Intercargo operates as an independent entity and a pro rata share of any profit or loss is reflected in the Company's consolidated financial statements, based on the Company's equity interest in Intercargo. The shares of Intercargo were purchased by the Company in September and December 1993. GUARANTY NATIONAL COMPANIES The Company participates in nonstandard commercial and personal automobile insurance and surplus lines insurance through its slightly less than 50% interest in Guaranty National. Based in Englewood, Colorado, the Guaranty National Companies underwrite and sell specialty property and casualty coverages which are not readily available in traditional insurance markets. Approximately 87% of the Guaranty National Companies' net written premiums during 1993 was derived from writing automobile (both private passenger and commercial) insurance. Other types of insurance products sold by Guaranty National Companies are general liability, commercial multi-peril, umbrella and property. Guaranty National Companies has historically focused its operations on the nonstandard markets. Nonstandard risks require specialized underwriting, claims management and other skills and experience. Guaranty National Companies' expertise and market position has allowed it to generate an underwriting profit in five of the last six years. Guaranty National Companies' personal lines unit principally writes nonstandard automobile insurance, insurance for drivers usually unacceptable to other insurers for, among other reasons, adverse driving or accident histories, ages or vehicle types. This business represents approximately 33% of the Guaranty National Companies' total gross written premiums and is sold through approximately 1,950 independent agents in 21 states, primarily in the Rocky Mountain and Pacific Northwest regions. Guaranty National Companies' largest unit, its commercial lines, wrote approximately 58% of Guaranty National Companies' gross written premiums in 1993. Approximately 73% of the commercial insurance was derived during 1993 from commercial automobile insurance, which covers policyholders such as sand and gravel haulers, used car dealers, automobile repair facilities, and local log hauling and trucking firms. Other commercial lines coverage includes property (for example, motor-truck cargo), general liability (for example, contractors and fuel convenience stores), low hazard professional liability (for example, teachers), standard umbrella insurance, standard commercial packages and other commercial coverages. Guaranty National Companies' commercial lines business is written through three divisions. The general and specialty divisions write business through 68 general agents and various brokers throughout the United States except for New Jersey, Massachusetts and four other Northeastern states. Guaranty National Companies' third commercial lines division is the standard division, whose business is written by Colorado Casualty Insurance Company ("CCIC"). In October 1992, Guaranty National acquired CCIC, an insurance company which writes primarily small standard commercial packages in the Rocky Mountain Region. CCIC has been successful in serving a niche market of approximately 290 rural retail agents. The Guaranty National Companies' third operating unit, Intercon General Agency, Inc., is a wholly-owned managing general agency which obtains business from 28 general agents across the country. Intercon principally markets collateral protection insurance, primarily insuring automobiles pledged as security for bank loans for which the borrower has not maintained physical damage coverage as required by the bank. The collateral protection business represents 9% of Guaranty National Companies' gross written premiums for 1993. Nonstandard risks generally involve a potential for poor claims experience because of increased risk exposure. Premium levels for nonstandard risks are substantially higher than for preferred or standard risks. In personal lines, Guaranty National Companies' loss exposure is limited by the fact that its insureds typically purchase low liability limits, often a state's statutory minimum. The nonstandard insurance industry is also characterized by the insurer's ability to minimize its exposure to unprofitable business by effecting timely changes in premium rates and policy terms in response to changing loss and other experiences. In the states where the Guaranty National Companies writes the majority of its business, prior approval to effectuate rate changes is not required. In those states where prior approval is required, the Guaranty National Companies has generally gained approval in a timely manner. In November 1993, Guaranty National acquired Peak Property and Casualty Insurance Corporation ("PEAK"), a property and casualty insurance company "shell" licensed in 39 states. The PEAK acquisition increases the Guaranty National Companies' marketing and licensing flexibility to take advantage of opportunities to write more special program business and allows the Guaranty National Companies to expand its standard commercial business to states outside the Rocky Mountain region. On November 20, 1991, the Company sold 6,250,000 shares, or slightly more than half, of the common stock of Guaranty National in a public offering ("Guaranty Sale") and received a special one-time dividend in the form of notes. As a result of the Guaranty Sale, Guaranty National became a publicly- held company with its stock listed on the New York Stock Exchange. In February 1994 Guaranty National's Board of Directors approved a stock repurchase program. The Company has agreed to sell, and Guaranty National to buy, a portion of Guaranty National's common stock to the extent necessary for the Company to maintain its ownership interest in Guaranty National at approximately its present level of slightly under 50%. In conjunction with the Guaranty Sale, Guaranty National and its subsidiaries entered into a series of agreements to formalize their continuing business relationships with Orion and the Company's insurance subsidiaries. Among the more significant of these agreements is a shareholders agreement pursuant to which the Company has the right to designate three members of Guaranty National's board, including the Chairman of the Board, for so long as the Company beneficially owns 30% or more of Guaranty National. Under this agreement, the Company also has a right until 1997 to require Guaranty National to register under the Securities Act of 1933 all or part of the 6,143,414 shares of common stock it continues to hold. In addition, the Company's insurance subsidiaries and the Guaranty National Companies also entered into certain reinsurance agreements and a trade name agreement. Orion and Guaranty National have signed an investment management agreement pursuant to which the Guaranty National Companies' investment portfolio (except for a portion of the equity securities portfolio which is managed by an unaffiliated portfolio manager) is managed by Orion's investment managers (under the direction and supervision of Guaranty National) for a fee of $550,000 per year for 1993 and 1994. After September 30, 1994, the investment management agreement continues for annual periods, unless terminated by either party upon 90 days prior written notice. INSURANCE INDUSTRY CHARACTERISTICS Loss Reserves - ------------- The Company establishes reserve liabilities for reported losses, incurred but not reported ("IBNR") losses, and claim settlement and administration expenses. Reserves for reported losses and loss adjustment expenses are estimates of the ultimate costs of claims incurred but not settled. IBNR loss reserves are estimates for both unreported claims and additional development of previously reported claims. Such reserves are primarily based on the circumstances surrounding each claim, the Company's historical experience with losses arising from claims not yet reported, the particular experience associated with the line of business and type of risk involved, and changes in costs. Changes in costs relate to costs for property, repairs to property, medical care, litigation and other legal costs, and vocational rehabilitation. The Company regularly monitors the factors affecting its reserves to better control claim costs, which also provides a base of information to reevaluate reserve estimates with regard to the amount and timing of claim reporting. The reserve estimation process is regularly reviewed and adjusted to consider all pertinent information as it becomes available as to the ultimate net cost of losses and claims incurred. Such reevaluation is a normal, recurring activity that is inherent in the process of loss reserves estimation. Management revises its reserve estimates as appropriate and believes that the loss and loss adjustment expense reserves of the Company's insurance subsidiaries make reasonable and sufficient provision for the ultimate net cost of all losses and claims incurred. However, no assurances can be given that reserve development will not occur in the future. Accident Year Loss and Loss Adjustment Expense Analysis - ------------------------------------------------------- Accident year is a period of exposure that is used to accumulate loss and loss adjustment experience by the year in which an incident giving rise to a claim occurs. Accident year information is used for loss reserving and in establishing premium rates. Accident year loss experience is updated in subsequent calendar years until all losses and loss adjustment expenses related to that given accident year have been settled. Accident year loss ratio relates losses associated with incidents giving rise to claims occurring within a given calendar year to premiums earned during the same calendar year. Presented below is a loss reserve development table for the five years ended December 31, 1993 prepared in accident year format. In this accident year analysis, reserves related to insurance subsidiaries acquired in 1984 and 1988 are included from the dates of acquisition. Redundancies or deficiencies related to the reserves of these subsidiaries are included in years subsequent to their acquisition. For each accident year, the following table presents premiums earned, and the provision for loss and loss adjustment expenses as a percentage of premiums earned (the "loss ratios") as established in the initial accident year and cumulative as of December 31, 1993. The preceding loss reserve development table indicates the aggregate year-end liability for loss and loss adjustment expenses net of reinsurance, the cumulative amounts paid attributable to those reserves through December 31, 1993, the re-estimate of the aggregate liability as of December 31 of each subsequent year and the cumulative development of prior years' reserves. Information is also provided on a gross basis for 1992 and 1993. Consistent with industry practice, certain claims for long-term disability workers compensation benefits are carried at discounted values. At December 31, 1993 and 1992, approximately $73,215,000 and $68,882,000, respectively, of long- term disability workers compensation loss reserves are included in the consolidated financial statements at net present value using a statutory interest rate of 3.5%. The Company's IBNR loss and loss adjustment expense reserves and other reserves for losses and loss adjustment expenses for which claim files have not been established, net of reinsurance and exclusive of Guaranty National Companies, were $336,446,000, $298,653,000 and $271,959,000 as of December 31, 1993, 1992 and 1991, respectively. The following table presents the differences between loss and loss adjustment expense reserves reported in the consolidated financial statements in accordance with generally accepted accounting principles ("GAAP"), and those reported in the consolidated annual statement filed with state insurance departments in accordance with statutory accounting practices ("SAP"): During 1993, the Company strengthened loss reserves and experienced development for prior years' business based upon the Company's ongoing actuarial analysis utilizing the most current information available. The 1993 provision for prior accident year losses by major line of business is as follows: (000s omitted) Reinsurance, pools and associations ....... $ 7,719 Other liability ........................... 5,364 Automobile liability ...................... 5,314 Surety .................................... 3,017 Commercial multiple peril ................. 1,869 Other...................................... 1,009 ------- $24,292 ======= Adverse development relating to reinsurance, pools and associations includes the Company's assumed reinsurance business, in which loss and loss adjustment expense experience is indicative of the ceding companies' experience. The Company's voluntary participation in various pools and associations business is generally recorded as the information is reported to the Company. Adverse development relating to other liability includes the Company's professional liability program for architects and engineers and losses from the Company's discontinued general liability line of business. The development from automobile liability relates to the Company's truck and Florida non-standard automobile programs where reported losses in 1993 developed greater than anticipated. Losses in the surety line of business principally relates to a program that was discontinued in 1993. The majority of the adverse development for the other lines of business relate to strengthening reserves based on historical loss development patterns. In prior years, the commercial multiple peril line was responsible for a greater amount of the adverse development. Starting in 1983, the Company expanded its commercial multiple peril business and then withdrew from that line of business in 1988 due to greater than expected losses. In 1993, the commercial multiple peril line had significantly less development due to stronger reserving. The significantly decreased level of adverse development during 1992 and 1993 is consistent with the Company's expectations. Loss reserve estimates are based on forecasts of the ultimate settlement of claims and are subject to uncertainty with respect to future events. Loss reserve amounts are based on management's informed estimates and judgments, using data currently available. Reserve amounts and the underlying actuarial factors and assumptions are regularly analyzed and adjusted to reflect new information. The Company has experienced substantial development of losses from prior accident years, particularly accident years 1984 and 1985 which were the worst years in recent history for the Company and for the property/casualty insurance industry in general. The Company's adverse development primarily resulted from the terminated lines of business, pools and other programs, higher than anticipated inflationary pressures, unforeseen judicial decisions (including interpretations of policy coverages beyond what was originally anticipated) and other external factors exposing the Company to risks not known when the insurance policies were priced and issued. To reduce loss development, the Company realigned certain management responsibilities in its Regional Operations segment over the past several years, thereby streamlining operations. Key management positions were added in that segment to further strengthen loss control and prevention, and to focus more attention towards back-to-work programs for injured workers. These factors tend to reduce loss costs and adverse development. For the design professionals liability line of business, the Company has increasingly used alternative dispute resolution techniques which includes the extensive use of mediation procedures to settle claims. These procedures often result in reduced litigation and other claim related expenses. The commercial multiple peril business that is being run off has a specifically designated group of claim personnel assigned who have been aggressively settling claims, resulting in an acceleration of payment patterns in more recent years. Estimates for IBNR claim reserves are based on actuarial analysis of historical loss experience and current trends. Although the reserve is deemed adequate to cover all probable claims, there is a reasonable possibility that the adverse development from prior accident years could continue into the future. Variability in claim emergence and settlement patterns, and other trends in loss experience, can result in future development patterns different than expected. The Company believes that the adverse development experienced in recent years relates to the timing of recurring claims activities that are inherent to the estimation of property/casualty reserves. Future variability cannot be accurately factored into the reserve estimations. In recent years, to limit future adverse loss development, the Company has reserved at higher initial levels as can be seen in the table on page 16, where initial accident year reserving percentages for the applicable calendar years have increased from 67.5%, 67.4% and 67.7% in 1989, 1990 and 1991, respectively, to 71.0% in 1992 and 70.4% in 1993. Management believes that the reserve strengthening and the higher level of initial reserving, together with increased stabilization in the Company's business, are expected to limit adverse loss development in the future. The Company analyzes loss reserves for its major lines of business on a regular basis. Several methods are used, including paid and incurred loss development, and incurred claim counts and average claim costs. These methods are subject to variability in reserve estimation for various reasons, including improved claims department operating procedures and accelerated claims settlement due to the use of alternate dispute resolution and expedited resolution of civil suits in litigation. Additionally, other factors that are analyzed and are considered in the determination of loss reserves include (i) claim emergence and settlement patterns and changes in these patterns from year to year,(ii) trends in the frequency and severity of paid and incurred losses, (iii) changes in policy limits and changes in reinsurance coverages, (iv) changes in the mix and classes of business, and (v) changes in claims handling procedures as determined by discussions with claims and operating staff and through claim audits. Current operations are greater focused on underwriting selection where the Company has specialized knowledge and can provide enhanced service to its customers. This concentration, and the specialized knowledge and growing experience in its selected lines of business arising from such concentration, have enabled the Company to implement improvements in its claims administration and underwriting procedures which have enhanced the Company's ability to analyze data and project reserve trends. Investments - ------------ The Company derives a significant part of its income from its investments. Investments of the Company's insurance subsidiaries are made in compliance with applicable insurance laws and regulations of the respective states in which such companies are domiciled and other jurisdictions in which they conduct business. Neither Orion nor any of its non-insurance subsidiaries is constrained by investment restrictions set forth in state insurance laws. The Company maintains a diversified portfolio representing a broad spectrum of industries and types of securities. The Company has no significant investments in real estate, although it does own the DPIC Companies' home office building and has invested in several real estate limited partnerships valued at $11,891,000. Investments are managed to achieve superior total return, while maintaining a proper balance of safety, liquidity, maturity and marketability. Investments are made based on long-term economic value rather than short-term market conditions. Except for investments in Guaranty National and securities of the United States Government and its agencies, the Company did not have any other investments in any one issuer that exceeded $20,000,000. During 1993 and 1992 the Company has continued in the process of changing the composition of its investment portfolio toward more tax- advantaged securities. Historically, as a result of the Company's net operating tax loss carryforwards ("NOLs"), the Company invested primarily in fully taxable securities, since the income of such securities could be offset by the NOLs. Such fully taxable securities, in general, pay a higher pre-tax rate of return than tax advantaged securities. With the change in the Company's tax position, resulting from the full utilization of all of its NOLs for federal income tax purposes, and with the increased liquidity from the sale of Guaranty National shares, management began in 1991 a shift in the composition of the Company's investment portfolio toward the purchase of a greater percentage of tax-advantaged securities. The following table shows the composition of the investment portfolio of the Company as of December 31, 1993 and 1992, and the quality ratings for the Company's fixed maturity investments. The investments shown below are listed at their cost, market value and financial statement values (carrying or book values). Fixed maturity investments that the Company has both the positive intent and the ability to hold to maturity are recorded at amortized cost. Fixed maturity investments which may be sold in response to, among other things, changes in interest rates, prepayment risk, income tax strategies, or liquidity needs are recorded at market value, and changes in unrealized appreciation are reflected in stockholders' equity. Equity securities are stated at market value. Both the fixed maturities and equity investments consist primarily of readily marketable securities. - 21 - Effective December 31, 1993, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 115, "Accounting for Certain Investments in Debt and Equity Securities," which establishes the "available- for-sale" category of investment securities and requires such securities to be recorded at market value, with unrealized gains and losses reported in a separate component of stockholders' equity. As a result of the adoption of this standard, the Company increased its investments recorded at market value on December 31, 1993 by $452,102,000, and its unrealized appreciation on investments, a component of stockholders' equity, by $20,720,000, net of deferred income taxes. The Company strives to enhance the average return of its portfolio by investing a small percentage of it in a diversified group of non-investment grade fixed maturity securities, or securities that are not rated. The risk of loss due to default is generally considered greater for non-investment grade securities than for investment grade securities because the former, among other things, are typically unsecured, often subordinated to other debts of the issuer and are often issued by highly leveraged companies. In the non- investment grade segment of the investment portfolio, the Company maintains a high degree of diversity, with an average investment per issuer of approximately $1,935,000 at December 31, 1993. Only four high yield investments, aggregating $23,422,000, were in excess of $5,000,000 as of December 31, 1993. The Company closely monitors the financial stability of issuers of securities that it owns. When conditions are deemed appropriate, the Company ceases to accrete discount, or accrue interest and dividends. In cases where the value of investments are deemed to be other than temporarily impaired, the Company recognizes losses. During 1993, provisions for such losses were $6,310,000 for equity securities and $2,147,000 for fixed maturity investments. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Net Investment Income and Realized Investment Gains." Reinsurance - ------------ In the ordinary course of business, the Company's insurance subsidiaries enter into reinsurance contracts with other insurers which serve to limit such insurer's maximum loss from catastrophes, large risks or unusually hazardous risks. Ceding reinsurance reduces an insurer's operating leverage ratio. A large portion of the Company's reinsurance protection is provided by reinsurance contracts known as treaties. In other instances, reinsurance is obtained by negotiation for individual risks, or facultative reinsurance. The Company's insurance subsidiaries have certain excess-of-loss and catastrophe treaties with unaffiliated insurers or reinsurers which provide protection against a specified part or all of certain types of losses over stipulated dollar amounts arising from one or more occurrences. The amount of each risk retained by an insurer is subject to maximum limits which vary by line of business and type of coverage. Retention limits are periodically revised as the capacity of the Company's insurance subsidiaries to retain risk varies and as reinsurance prices change. The Company is very selective as to its reinsurers, placing reinsurance with only those reinsurers considered to be in sound financial condition and having satisfactory underwriting ability. Many of the Company's reinsurance agreements are subject to annual renewal as to coverage, limits and price. The Company continually monitors the financial strength of its reinsurers. The Company's insurance subsidiaries, to their knowledge, have no material exposure to potential unrecognized losses due to reinsurers that are in known financial difficulties. The Company's insurance subsidiaries have reinsurance protection for workers compensation losses in excess of $1,500,000 up to $100,000,000. DPIC Companies have reinsurance for a portion of losses from architect and engineer liability in excess of $250,000 up to $5,000,000, the maximum policy limit written by the DPIC Companies. In 1990 certain of the Company's insurance subsidiaries entered into an aggregate excess-of-loss reinsurance contract for workers compensation and architect and engineer professional liability lines of business which provides excess coverage and limits future loss development. That reinsurance protection provides various layers of coverage up to a maximum aggregate limit of liability of $48,000,000. Certain commercial auto and general liability policies are reinsured by a 35% quota share with excess of loss protection from $500,000 to $1,000,000. The Company's reinsurance subsidiary maintains various reinsurance arrangements for its facultative and treaty exposures, including catastrophe protection above the $1,000,000 level. In addition to the foregoing, the Company's insurance subsidiaries also maintain other reinsurance arrangements in support of their specific business needs. In 1993 and 1992, the Company's insurance subsidiaries net premiums written to year-end statutory surplus were at the conservative levels of 1.4:1 and 1.5:1, respectively. Government Regulation - ---------------------- The Company's insurance subsidiaries are subject to regulation primarily by the insurance departments of the states of their incorporation, Connecticut and California. All insurance companies must file annual statements and other reports with state regulatory agencies and are subject to regular and special examinations by those agencies. A regular periodic examination of the Company's California and Connecticut pooled insurance subsidiaries, covering their operations and statutory financial statements through December 31, 1991, was satisfactorily completed in 1993 by the Insurance Departments of California and Connecticut. Each of the Company's insurance subsidiaries is also subject to regulation by other jurisdictions in which it sells insurance, including certain Canadian provinces. States regulate the insurance business through supervisory agencies which have broad administrative powers, including powers relating to, among other things, the standards of solvency which must be met and maintained; the licensing of insurers and their agents; restrictions on the amount of risk which may be insured under a single policy; the approval of premium rates; the form and content of the insurance policy and sales literature; the form and content of financial statements; reserve requirements; and the nature of and limitations on permitted investments. In general, such regulation is for the protection of policyholders rather than shareholders. In some instances, particularly in connection with workers compensation insurance, various states routinely require deposits of assets for the protection of policyholders and their employee claimants in those states. As of December 31, 1993 and 1992, securities representing approximately 21% and 29%, respectively, of the book value of the Company's investment portfolio were on deposit with various state treasurers or custodians. Such deposits consist of securities of types which comply with the standards that each state has established. The Company is also subject to state laws regulating insurance holding company systems. Most states have enacted legislation and adopted administrative regulations affecting insurance holding companies and the acquisition of control of insur-ance companies, as well as transactions between insurance companies and their affiliates. The nature and extent of such legislation and regulations currently in effect vary from state to state. However, most states currently require administrative approval of the acquisition of 10% or more of the outstanding shares of an insurance company incorporated in the state or the acquisition of 10% or more of an insurance holding company whose insurance subsidiary is incorporated in the state. The acquisition of 10% of such shares (which would include securities convertible into voting securities) is deemed to be the acquisition of "control" for the purpose of most holding company statutes and requires not only the filing of detailed information concerning the acquiring parties and the plan of acquisition but also administrative approval prior to the acquisition. Material transactions between insurance companies and affiliated members of the holding company system are generally required to be "fair and reasonable" and in some cases are subject to administrative approval. All state jurisdictions in which the Company is authorized to transact business require participation in guaranty funds. Insurers authorized to transact business in those jurisdictions can be assessed by a state guaranty fund a percentage (usually from 1% to 2%) of direct premiums written in that jurisdiction each year to pay claims on behalf of insolvent insurers. The likelihood and amount of any future assessment cannot be estimated until after an insolvency has occurred. For the years ended December 31, 1993 and 1992 the Company's insurance subsidiaries were assessed approximately $407,000 and $54,000, respectively (net of estimated future recoveries) as a result of known insolvencies. Insurance companies are required by certain states in which they do business to participate in automobile insurance plans and workers compensation plans. These plans provide insurance on risks which are not written in the voluntary market. Participation in these plans has usually been unprofitable for the Company. A number of state legislatures and the United States Congress have for years been considering, or have now enacted, some type of legislative proposals which alter the rules for tort claims and increase the states' authority to regulate insurance companies. These initiatives have expanded, in some instances, the states' regulation over rates (See "Rates" below) and also have increased data reporting requirements. In recent years the state insurance regulatory framework has come under federal scrutiny, and certain state legislatures have considered or enacted laws that alter, and in many cases increase, state authority to regulate insurance companies and insurance holding company systems. Further, the National Association of Insurance Commissioners ("NAIC") and state regulators are re-examining existing laws and regulations and issues relating to the solvency of insurers. The NAIC has decided to adopt risk based capital ("RBC") requirements for property and casualty insurers to test the solvency of an insurer to write specific lines of insurance. Applying the current RBC requirements to the Company's insurance operations at December 31, 1993 reveal that the capital of each of its insurance subsidiaries exceeds the RBC requirements. Although the federal government generally does not directly regulate the business of insurance, federal initiatives often have an impact on the business in a variety of ways. There are various current and proposed federal measures which may significantly affect the Company's insurance business, including, among other proposals, the revocation of the antitrust exemption provided by the McCarran-Ferguson Act. The Clinton administration's proposed reforms of the nation's health care system also might negatively affect the Company's workers compensation and automobile liability businesses. The economic and competitive effects of any proposals upon the Company would depend upon the final form such legislation might take. The Company is unable to predict what regulatory proposals may be adopted in the future, or the effect any such proposals might have on the Company's business if adopted. Limitations on Payments from Insurance Subsidiaries - ---------------------------------------------------- The principal sources of cash available to Orion are dividends and tax payments from its subsidiaries. The payment of dividends to Orion by its insurance subsidiaries is subject to state regulation. No state restricts dividend payments by Orion to its stockholders. The ability of the Company's insurance subsidiaries to declare dividends is governed primarily by the insurance laws of each subsidiary's state of incorporation. Generally, such laws currently provide that, unless prior approval is obtained, dividends of a property and casualty insurance company in any consecutive 12-month period shall not exceed the greater of its net income for the preceding calendar year or 10% of its policyholders' surplus as of the preceding December 31, determined on a statutory accounting basis. Dividends and distributions by the Company's insurance subsidiaries are also subject to a requirement that statutory policyholders' surplus be reasonable in relation to outstanding liabilities and adequate to meet the companies' financial needs following the declaration of any dividends or distributions. State insurance regulators have, however, broad discretionary authority with respect to approving the payment of dividends by insurance companies. As part of the process of accreditation by the NAIC, state insurance regulators have been recommending the adoption of new state statutory standards for the payment of dividends by insurance companies without prior approval. Some states have implemented more restrictive dividend standards. Under current regulations, the maximum dividends permitted at December 31, 1993 for the ensuing twelve months, without prior approval, aggregated $37,373,000. Since it is difficult to predict future levels of statutory policyholders' surplus or earnings, the amount of dividends that could be paid in the future without prior approval cannot be determined at this time. All business written and expenses incurred by most of the Company's insurance subsidiaries are combined, and allocated back to each insurance company in accordance with a reinsurance pooling agreement among them. Effective December 31, 1992, the Company changed the pooling percentages among its insurance subsidiaries to 85% and 15% between the Connecticut and California insurance companies, respectively. Previously, the pooling percentages had been 50% for each group of companies. As a result of the change in pooling, on January 4, 1993 a directly owned California-domiciled subsidiary paid Orion an extraordinary dividend totalling $65,470,000, after receiving approval from the California Department. The proceeds from this dividend were simultaneously contributed by Orion to a directly owned Connecticut-domiciled subsidiary. Rates - ----- All of the Company's insurance subsidiaries are subject to regulation as to rates, availability and cancellation of insurance. Most states have insurance laws requiring that rate schedules and other information be filed with or made available to the state's regulatory authority, either directly or through a rating organization with which the insurer is affiliated. The regulatory authority may, in most states, disapprove a rate filing if it finds that the rates are inadequate, excessive or unfairly discriminatory. Rates, which are not necessarily uniform for all insurers, vary by class of business, hazard assumed and size of risk. Subject to regulatory requirements, the Company's management determines the prices charged for its policies based on a variety of factors including recent historical claims experience, inflation, competition, tax law and rate changes and anticipated changes in the legal environment, both judicial and legislative. Subject to the possible adoption of legislation which would require rate rollbacks in the Company's major lines of business, the Company's management believes that its rate outlook for its principal lines of business will remain stable during 1994. Some states have adopted open rating systems for workers compensation which permit insurers to set premium rates independently without the prior approval of the insurance commissioners. A number of other states permit insurers to deviate from standard rates for workers compensation insurance after receiving prior approval. In insuring professional liability risks the DPIC Companies are generally not limited to the standard rates of a rating organization, but set their own rates because of the unique nature of the risk being underwritten. In November 1988, California voters passed an initiative known as Proposition 103 (the "California Proposition") which amended the California Insurance Code to provide, among other things, that rates for automobile and many other insurance policies issued or renewed on or after November 8, 1988, be rolled back to the levels of November 8, 1987 and then reduced by 20%. Workers compensation insurance and reinsurance are excluded from the California Proposition's rate rollback provisions. On January 8, 1991, the California Insurance Department issued rate regulation proposals regarding the California Proposition. On October 16, 1991, the California Insurance Commissioner issued notices of premium refunds to 14 insurers. In February 1993, the California State Court invalidated the regulations with respect to one insurance company that received notice of a premium refund. The decision is currently on appeal to the California Supreme Court. None of the Company's insurance subsidiaries were among the companies that received the refund notices. Although it is not possible to predict with any degree of certainty the ultimate outcome of such regulations or their impact on the Company's rates charged since November 8, 1988, management currently believes the effect of the regulations will not be material to the Company. Based on the foregoing and management's belief that the rates filed by the Company comply with applicable California law, no provision has been made in the Company's consolidated financial statements for denial or partial denial of the Company's rollback exemption applications or the partial or total disapproval of the Company's rates filed since November 8, 1989. In recent years, certain social, economic and political issues have led to an increased number of legislative and regulatory proposals and judicial decisions aimed at addressing the cost, benefits and availability of certain types of insurance. Initiatives attempting to freeze or roll back premium rates, similar to the California Proposition have been introduced in other states, as well as proposals to redefine or expand risk exposure, such as by increasing the amount and types of workers compensation benefits and by the expansion of the liability for employee illness caused by cumulative trauma, stress or previously unknown causes. While most of the new legislative proposals have failed to date to become law, the Company believes that these initiatives will continue. It is impossible to predict whether any such proposals will be adopted. However, depending on the circumstances, the Company may be able to mitigate the longer term effects on profitability through discontinuance of the affected business and redeployment into more attractive markets. Competition - ------------ The insurance industry is highly competitive. Of the nearly 3,900 property and casualty insurance companies in the United States, about 900 companies write most of the business but no single company or group has more than 10% of the market. The Company's insurance subsidiaries are in competition with numerous stock and mutual property and casualty insurance companies, as well as state run workers compensation insurance funds, many of which are substantially larger and have significantly greater resources than the Company. Competition may take the form of lower premiums, specialized products, more complete and complex product lines, greater pricing flexibility, superior service, different marketing methods or higher policyholder dividend rates. Superior service and marketing methods are of particular importance in workers compensation. Competition might also come from service organizations which administer self-insured programs. The Company's insurance subsidiaries sell their insurance principally through independent agents, brokers and general agencies, who typically also represent one or more competing insurance companies. They are paid commissions based on premiums collected from insureds. Commission rates vary according to the type and amount of insurance sold. Some competitors in certain lines obtain their business at a lower direct cost through the use of salaried personnel rather than independent agents and brokers. Rating - ------ A.M. Best Company raised the Company's rating in September, 1993 to an "A (Excellent)" from a "A- (Excellent)." In general, A.M. Best Company's ratings are based on an analysis of the financial condition and operation of an insurance company as they relate to the industry. These ratings are not primarily designed for investors and do not constitute recommendations to buy, sell or hold any security. A.M. Best Company has upgraded the ratings of the Company three times in the last four years. MISCELLANEOUS OPERATIONS The Company's fourth business segment consists primarily of the miscellaneous income and expense (principally interest and general and administrative expenses) of Orion itself. For financial reporting purposes, the Company applies federal income taxes and benefits, as if fully utilizable, to its segments. Any consolidating elimination entries are accounted for in this fourth segment. In late 1984 the Company purchased 26.3% of the common stock of Sentry Savings and Loan Association ("Sentry"), located in Stamford, Connecticut. Sentry operated as an independent entity and a pro rata share of any profit or loss was reflected in the Company's consolidated financial statements, based on the Company's equity interest in Sentry. On November 22, 1993, after obtaining all necessary state and federal regulatory approvals, Sentry's assets were acquired by the Frank and Joanne Warren Connecticut Stock Revocable Trust (the "Trust"). As a result of consummation of the sale of the assets of Sentry to the Trust, the Company is no longer a unitary savings and loan holding company under federal law and has been released from all obligations and restrictions under those laws. ITEM 2.		ITEM 2. PROPERTIES The Company's executive office is located at 30 Rockefeller Plaza, New York, New York and the home office of the insurance operations of the Company is located in Farmington, Connecticut. These office facilities consist of approximately 150,000 square feet, in the aggregate, and are leased at a total annual rental of $4,650,000. The DPIC Companies owns its office building in Monterey, California. The DPIC Companies occupy 39,900 square feet of the building and lease to others the remaining 12,200 square feet. The DPIC Companies purchased the building on January 26, 1990 for aproximately $11,950,000. In November 1990 the DPIC Companies mortgaged the leasehold interest in its office building to other subsidiaries of the Company and to Guaranty National Insurance Company for an aggregate of $9,000,000. The other insurance operations of the Company are conducted from leased premises in or adjacent to major urban centers throughout the United States and in Canada. These operations, in the aggregate, occupy approximately 303,000 square feet, excluding the home office building in Connecticut, at an annual rental of approximately $4,483,000. The Company believes that its current facilities are suitable and adequate for its present use and its presently anticipated requirements. ITEM 3.	ITEM 3. LEGAL PROCEEDINGS The Company is routinely engaged in litigation incidental to its businesses; however, in the judgment of the Company's management, there are no significant legal proceedings pending against Orion or its wholly-owned subsidiaries which, net of reserves established therefor and giving effect to reinsurance, are likely to result in judgments for amounts that are material to the financial condition of Orion and its consolidated subsidiaries, taken as a whole. ITEM 4.	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. INFORMATION CONCERNING EXECUTIVE OFFICERS OF THE COMPANY The following is a summary of certain information regarding the executive officers of Orion. All officers of Orion and its subsidiaries serve at the pleasure of their respective Boards of Directors. Alan R. Gruber, Chairman of the Board and Chief Executive Officer of Orion since March 1976; Chairman of Orion Capital Companies, Inc. ("OC Companies"), which provides management services to the Orion Capital Companies, since October 1982; age 66. Robert B. Sanborn, Vice Chairman of Orion since March 1, 1994, and a Director since May 1987; President and Chief Operating Officer of Orion from May 1987 to February 28, 1994; Chairman of the American Insurance Association, a property and casualty insurance company trade group, from January 1993 to January 1994; President of OC Companies from May 1987 to February 28, 1994; age 65. Larry D. Hollen, President and Chief Operating Officer of Orion since March 1, 1994; Executive Vice President and Assistant Chief Operating Officer of Orion from December 1, 1992 to February 28, 1994; Senior Vice President of Orion from March 1990 to December 1992; a director of Orion since March 20, 1992; Vice President of Orion from 1988 to March 1990; President of the EBI Companies from January 1990 to May 31, 1993; President of the Eastern Division of the EBI Companies from July 1988 to December 1989; age 48. Peter B. Hawes, Senior Vice President and a Director of Orion since March 1988; President of the DPIC Companies since 1982; Senior Vice President of OC Companies since March 1987; age 58. Daniel L. Barry, Vice President and Controller of Orion since October 1987; Senior Vice President of OC Companies since January 1989; Controller of OC Companies since October 1986; Treasurer of OC Companies from October 1987 to December 1990; age 43. Raymond W. Jacobsen, Vice President of Orion since March 1990; President of the EBI Companies since June 1, 1993; Executive Vice President of the EBI Companies from December 1989 to May 31, 1993; Regional Vice President of the EBI Companies from July 1988 to December 1989; age 41. Michael P. Maloney, Vice President, General Counsel and Secretary of Orion since August 1979; Senior Vice President of OC Companies since March 1987; age 49. William G. McGovern, Vice President and Chief Actuary of Orion since March 1990; Senior Vice President and Chief Actuary of OC Companies since October 1989; Manager in the Management Consulting Department of Peat Marwick Main & Co. from January 1988 to October 1989; age 41. Vincent T. Papa, Vice President and Treasurer of Orion since June 1985; Senior Vice President of OC Companies since March 1987 and Treasurer since December 1990; age 47. Raymond J. Schuyler, Vice President-Investments of Orion since June 1984; Senior Vice President of OC Companies since March 1986; age 58. PART II ITEM 5.	ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS (a) Principal Market. The principal market on which Orion's Common Stock is traded is the New York Stock Exchange. (b) Stock Price and Dividend Information The table below presents the high and low market prices and dividend information for Orion's Common Stock for 1993 and 1992, adjusted to reflect the effect of the 5-for-4 stock splits paid on both December 7, 1992 and November 15, 1993. Cash Stock Prices Dividends High Low Declared ---- --- --------- 1993: Quarter Ended December 31........ $36.30 $28.625 $.18 Quarter Ended September 30....... 37.50 30.30 .18 Quarter Ended June 30............ 37.10 30.10 .16 Quarter Ended March 31........... 36.80 27.20 .16 ---- Total........................ $.68 ===== 1992: Quarter Ended December 31........ $28.70 $23.84 $.16 Quarter Ended September 30....... 25.76 21.92 .147 Quarter Ended June 30............ 22.72 19.68 .147 Quarter Ended March 31........... 21.92 18.56 .147 ----- Total........................ $.601 ===== Cash dividends have been paid on Orion's Common stock in every quarter since the fourth quarter of 1978, when dividends were first commenced. (c) Approximate Number of Holders of Common Stock The number of holders of record of Orion's Common Stock as of March 11, 1994 was 2,000. ITEM 7:		ITEM 7: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS GENERAL Orion Capital Corporation ("Orion") and its wholly-owned subsidiaries (collectively the "Company") operate principally in the property and casualty insurance business which is reported as three segments - Regional Operations, Reinsurance/Special Programs and Guaranty National Companies. Regional Operations markets workers compensation insurance through EBI Companies and Nation's Care, Inc. Reinsurance/Special Programs includes (i) DPIC Companies ("DPIC"), which markets the Company's professional liability insurance, (ii) Connecticut Specialty Insurance Group ("Connecticut Specialty"), which underwrites and sells specialty insurance programs, (iii) SecurityRe Companies ("SecurityRe"), which writes reinsurance and (iv) a 20.0% interest in Intercargo Corporation ("Intercargo") which underwrites insurance coverages for international trade. The third segment, Guaranty National Companies, specializes in writing nonstandard commercial and personal automobile insurance. The miscellaneous income and expenses (primarily interest, general and administrative expenses and other consolidating elimination entries) of the parent company are reported as a fourth segment. During 1993 Orion completed the recapitalization and debt restructuring which it began in 1992. The Company issued $110,000,000 of 9 1/8% Senior Notes due September 1, 2002 (the "9 1/8% Senior Notes"), redeemed both its 13 1/2% Senior Subordinated Debentures and its 12 1/2% Subordinated Debentures with face values of $19,375,000 and $20,000,000, respectively, entered into a new bank loan agreement and called for the redemption of all of its preferred stock. Substantially all of the outstanding shares of the $1.90 Convertible Exchangeable Preferred Stock were converted into 2,554,594 shares of common stock. Shares of the $2.125 Convertible Exchangeable Preferred Stock were converted into 1,427,123 shares of common stock, and the Adjustable Rate Preferred Stock was redeemed for $18,520,000. As a result of the refinancing, the Company recorded a loss on the redemption of its Debentures prior to maturity of $2,920,000, net of a tax benefit of $60,000, as an extraordinary item in 1992. The Company's objectives in this refinancing were to reduce the amount of the Company's debt maturing in the next five years, lower the interest rate on its long-term debt and increase the earnings available to common stockholders by lowering the cost of capital. RESULTS OF OPERATIONS Earnings (loss) by segment before federal income taxes, cumulative effect of the adoption of new accounting principles and extraordinary item are summarized as follows for the three years ended December 31, 1993: REVENUES Premiums Net premiums written increased 12.0% ($68,156,000) in 1993 to $635,586,000. Net premiums written in 1992 were $567,430,000, which was a decrease of 22.7% ($166,635,000) from the 1991 net premiums written of $734,065,000. The decrease in 1992 results from the exclusion of net premiums written by the Guaranty National Companies, which amounted to $181,226,000 from January 1 to November 20, 1991. The results by segment are as follows: - Regional Operations' net premiums written decreased 1.7% ($4,468,000) to $265,082,000 in 1993 from $269,550,000 in 1992 and 1.2% ($3,208,000) in 1992 from $272,758,000 in 1991. The reduction in premium volume for 1993, while operating results continue to improve, reflects this segment's emphasis on underwriting profitability rather than premium growth and the impact of legislative reforms in certain states which has led to lower premium rates. Such reforms have also had the effect of reducing loss expenses, generally leading to more profitable business. Premiums written in 1993 and 1992 were reduced in states where the business or regulatory environment has become less favorable and by the closure of offices during these years in certain areas, offset by growth in geographic areas where the Company has had favorable loss experience stemming from its service-oriented approach. - Reinsurance/Special Programs' net premiums written increased 24.4% ($72,624,000) to $370,504,000 in 1993 from $297,880,000 in 1992 and 6.4% ($17,799,000) in 1992 from $280,081,000 in 1991. Premium volume for Connecticut Specialty increased 21.8% ($34,360,000) to $192,246,000 in 1993 from $157,886,000 in 1992 and increased 44.7% ($48,740,000) in 1992 from $109,146,000 in 1991. The largest increases were in the automobile personal injury protection ($17,372,000) and physical damage ($14,010,000) programs, which programs have been growing steadily throughout 1992 and 1993. Gross premiums written by DPIC for professional liability insurance, the largest special program, were $167,273,000, $161,432,000 and $184,314,000 in 1993, 1992 and 1991, respectively. The increase for 1993 is reflective of both new business and a continuation of a high level of policy renewals. Contributing to the decrease in professional liability insurance premiums written in 1992 as compared to 1991 were the impact of generally weak economic conditions in the construction industry, increased premium credits given for favorable loss experience or an insureds participation in loss prevention programs, and non-recurring premiums in 1991 representing a reimbursement of losses incurred on behalf of an insured. The percentage of treaty and facultative reinsurance assumed to total net premiums written for Reinsurance/Special Programs amounted to 14.7%, 11.7% and 10.2% in 1993, 1992 and 1991, respectively. Premiums earned increased 10.2% ($57,199,000) in 1993 to $617,404,000. Premiums earned in 1992 were $560,205,000, which was a decrease of 20.1% ($141,181,000) versus the 1991 premiums earned of $701,386,000. Premiums earned for 1993 and 1992 reflect the recognition in income of the changing levels of net premium writings. The decrease in 1992 results from the exclusion of net premiums earned by the Guaranty National Companies, which amounted to $181,289,000 from January 1 to November 20, 1991. Gain on Sale of Common Stock of Guaranty National The Company sold 6,250,000 shares of Guaranty National's common stock in a public offering on November 20, 1991, (the "Guaranty Sale") reducing ownership of its common stock to 49.3%. The sale resulted in a gain of $33,931,000, and reduced the operating leverage and strengthened the capital positions of the Company's other insurance subsidiaries. The Guaranty National Companies' operations have been consolidated in the Company's financial statements through November 20, 1991. For periods subsequent to that date, the financial statements of the Company include the portion of Guaranty National's earnings attributable to the Company's ownership on an equity accounting basis. The shares of Guaranty National owned by the Company at December 31, 1993 and 1992 carried on an equity basis had book values of $75,394,000 and $64,436,000, respectively; the market values of these shares, based on the New York Stock Exchange closing price on those dates, were $107,510,000 and $121,332,000, respectively. Net Investment Income Pre-tax net investment income amounted to $91,803,000, $82,483,000 and $100,206,000 in 1993, 1992 and 1991, respectively. Included in net investment income is $23,060,000 for the 1991 period attributable to the consolidation of Guaranty National. The increase in net investment income for 1993 was attributable to an increase in average investable assets of approximately $132,000,000, and an increase in equity earnings from limited partnerships of $5,708,000 compared to 1992 due to both increased investment and a higher rate of return from these partnerships. The pre-tax yields on the average investment portfolio were 7.4% for both 1993 and 1992, and 8.5% for 1991, reflecting the increase in earnings from limited partnership investments in 1993, offset by a change in the Company's mix of investments toward higher amounts of tax-advantaged securities which generally yield less than fully taxable securities, issuers calling their securities in order to refinance at lower rates and generally lower yields on new investments due to current market conditions. The decrease in net investment income for 1992 as compared to 1991 was the result of the deconsolidation of Guaranty National and lower pre-tax investment yields, offset by the investment of the proceeds of the Guaranty Sale. The impact of the lower interest rates for 1992 and 1993 on net income is offset in part by reductions in interest expense on the Company's variable rate bank loans. The carrying value of the Company's investment portfolio increased $165,921,000 in 1993 (including the change attributable to a new in accounting principle discussed in the following paragraph) to $1,322,536,000 at December 31, 1993 from $1,156,615,000 at December 31, 1992. The Company's investment philosophy is to achieve a superior rate of return after taxes and maintain a high degree of safety and liquidity. Effective December 31, 1993, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 115, "Accounting for Certain Investments in Debt and Equity Securities," which establishes the "available-for-sale" category of investment securities and requires such securities to be recorded at market value, with unrealized gains and losses reported in a separate component of stockholders' equity. As a result of the adoption of this standard, the Company increased its investments recorded at market value on December 31, 1993 by $452,102,000, and its unrealized appreciation on investments, a component of stockholders' equity, by $20,720,000, net of deferred income taxes. Fixed maturity investments which the Company has both the positive intent and the ability to hold to maturity are recorded at amortized cost. Investments which may be sold in response to, among other things, changes in interest rates, prepayment risk, income tax strategies or liquidity needs are included in the available-for-sale category at market value. The carrying value of fixed maturity and short-term investments amounted to $1,029,211,000 and $934,496,000 at December 31, 1993 and 1992, respectively, or approximately 77.8% and 80.8% of the investment portfolio. The Company invests primarily in investment grade securities and strives to enhance the average return of its portfolio through limited investment in a diversified group of non-investment grade fixed maturity securities or securities that are not rated. The risk of loss due to default is generally considered greater for non-investment grade securities than for investment grade securities because the former, among other things, are often subordinated to other indebtedness of the issuer and are often issued by highly leveraged companies. At December 31, 1993 and 1992, the Company's investment in non-investment grade and unrated fixed maturity securities were carried at $97,653,000 and $89,156,000 with market values of $97,306,000 and $89,064,000, respectively. These investments represented a total of 7.2% and 7.6% of cash and investments at December 31, 1993 and 1992, respectively, and 4.6% of total assets as of both year end dates. The Company closely monitors the financial condition of the issuers of securities that it owns. When conditions are deemed appropriate, the Company ceases to accrete discount, or accrue interest and dividends, and, in cases where the value of such investments is deemed to be other than temporarily impaired, recognizes losses. The Company's non-investment grade investments are highly diversified, with an average investment per issuer of approximately $1,935,000 at December 31, 1993. Only four non-investment grade investments aggregating $23,422,000 were in excess of $5,000,000 at December 31, 1993. Realized Investment Gains Net realized investment gains (losses) amounted to $9,478,000 in 1993, $3,667,000 in 1992 and ($1,009,000) in 1991 excluding the $33,931,000 gain on the Guaranty Sale. Sales of equity securities resulted in net gains of $11,273,000, $5,864,000 and $4,960,000 and sales of fixed maturities resulted in net gains of $6,662,000, $5,365,000 and $6,925,000 in 1993, 1992 and 1991, respectively. Realized investment gains were reduced by provisions for losses on securities deemed to be other than temporarily impaired. These provisions amounted to $6,310,000 in 1993, $5,429,000 in 1992 and $5,124,000 in 1991 for equity securities and $2,147,000, $2,133,000 and $7,770,000 in 1993, 1992 and 1991, respectively, for fixed maturity investments. Such provisions, based on available information at the time, were made in consideration of the decline in the financial condition of the issuers of these securities. Realized gains (losses) vary from period to period, depending on market conditions relative to the Company's investment holdings, the timing of investment sales generating gains and losses, the occurrence of events which give rise to other than temporary impairment of investments, and other factors. At December 31, 1993 the Company held equity securities with unrealized appreciation of $32,332,000, as compared to $15,864,000 for equity securities held at December 31, 1992. The market value of the fixed maturities portfolio at December 31, 1993 exceeded their amortized cost values by $48,367,000. This compares with an excess of market value over amortized cost of $26,811,000 for fixed maturities at December 31, 1992. Such amounts can vary significantly depending upon fluctuations in the financial markets. The average maturity of the Company's fixed maturity investments has not varied significantly in recent years, and no material change in average maturity is expected in the foreseeable future. The performance of the Company's investments, including net investment income, net realized gains (losses) and unrealized appreciation (depreciation), and excluding the $33,931,000 gain on the sale of Guaranty National stock in 1991, is as follows for the three most recent years: 1993 1992 1991 ---- ---- ---- (000s omitted) Net investment income ..................... $ 91,803 $ 82,483 $100,206 -------- -------- -------- Net realized gains (losses) - Fixed maturities ........................ 4,515 3,232 (845) Equity securities ....................... 4,963 435 (164) -------- -------- -------- 9,478 3,667 (1,009) -------- -------- -------- Net unrealized appreciation - Fixed maturities ........................ 21,556 11,954 71,787 Equity securities ....................... 16,468 22,584 25,515 -------- -------- -------- 38,024 34,538 97,302 -------- -------- -------- $139,305 $120,688 $196,499 ======== ======== ======== EXPENSES AND OTHER Operating Ratios The following table sets forth certain ratios of insurance operating expenses to premiums earned for the Company: Year Ended December 31, -------------------------------- 1993 1992 1991 ---- ---- ---- Loss and loss adjustment expenses ....... 74.4% 75.7% 76.8% Policy acquisition and other insurance expenses .............................. 26.8 27.3 30.2 ----- ----- ----- Total before policyholders' dividends.. 101.2 103.0 107.0 Policyholders' dividends ................ 2.0 2.4 2.4 ----- ----- ----- Total after policyholders' dividends .. 103.2% 105.4% 109.4% ===== ===== ===== The ratio of loss and loss adjustment expenses to premiums earned (the "loss ratio") was 74.4%, 75.7% and 76.8% in 1993, 1992 and 1991, respectively. The improvement in the 1993 loss ratio was attributable to a decrease in the loss ratio for the Regional Operations segment offset by higher levels of initial reserving in the Reinsurance/Special Programs segment. The improvement in the 1992 loss ratio was primarily attributable to a decrease in adverse development of prior years' losses. Lower assignments from the National Council on Compensation Insurance ("NCCI") improved the operating results for 1992 as compared to 1991 by $6,042,000 and had a favorable impact on the loss ratio of .9 percentage points. The decreases in adverse development and NCCI assignments in 1992 were offset by establishing initial loss reserves at higher levels and by an increase of .6 percentage points from losses stemming from Hurricanes Andrew and Iniki. The inclusion of Guaranty National Companies' loss experience for 1991 had the effect of lowering the loss ratio by 3.0 percentage points. The 1991 loss ratio also included a provision (the "cumulative loss provision") of $25,000,000, or 3.6 percentage points, recorded at year end 1991 in response to the Company's internal actuarial analysis, and to an independent actuarial review commissioned by the Connecticut Insurance Department in connection with a regular statutory examination of the Company's insurance subsidiaries. The loss ratio for Regional Operations was 72.0% in 1993, 80.1% in 1992 and 85.5% in 1991 (80.9% excluding the effect of the cumulative loss provision). These loss ratios reflect continued improvement in workers compensation insurance, reduced losses due to the cancellation in 1992 of participation in a workers compensation loss sharing pool and lower losses for runoff, principally from closed offices and discontinued commercial package business. Reinsurance/Special Programs' loss ratio was 76.1% in 1993, 71.7% in 1992 and 73.9% in 1991, (68.9% excluding the effect of the cumulative loss provision). The increase for 1993 is primarily due to higher levels of initial reserving. The segment's loss ratio for 1992 was favorably impacted by lower assignments from assigned risk pools and increased premium volume for programs with lower loss ratios, offset by higher levels of loss reserving for the DPIC program. The ratio of deferred acquisition costs and other insurance expenses to premiums earned (the "expense ratio") was 26.8%, 27.3% and 30.2% in 1993, 1992 and 1991, respectively. The 1993 expense ratio was favorably impacted by the spreading of costs over a higher premium volume. The higher ratio for 1991 results from increased provisions for assessments from statutory assigned risk plans, particularly in Texas. Provisions for losses and loss adjustment expenses include development of loss and loss adjustment expense reserves relating to prior accident years, which increased the calendar year combined ratio by 3.9 percentage points in 1993, 4.7 percentage points in 1992 and 9.1 percentage points in 1991 including the impact of the cumulative loss provision. The loss ratios were adversely affected by such factors as higher than anticipated reported losses for automobile liability business and reserve strengthening for certain other lines of business. Other sources of loss development included pool and association business (including assigned risk pools) where loss reserves are established by the Company based on information provided by the pools and associations and loss patterns which were significantly different than in the past. Management believes that the Company's reserves for loss and loss adjustment expenses make reasonable and sufficient provision for the ultimate net cost of all losses on claims incurred. However, there can be no assurance that changes in loss trends will not result in additional development of prior years' reserves in the future. Variability in claim emergence and settlement patterns and other trends in loss experience can result in future development patterns different than expected. The Company believes that any such development will continue to be substantially lower than that experienced in years prior to 1992, considering the actions taken to increase reserving levels, to improve underwriting standards and to emphasize loss control and prevention. The Company's loss ratios in recent years, including development of prior years' losses, have compared favorably with loss ratios experienced by the industry. The Company limits both current loss expense and future development of losses by ceding business to reinsurers (See Note D to Consolidated Financial Statements). The Company continually monitors the financial strength of its reinsurers and, to the Company's knowledge, has no material exposure with regard to potential unrecognized losses due to reinsurers having known financial difficulties. The Company's environmental claims principally relate to asbestos and hazardous waste, arising from certain liability business written prior to the mid 1980's, which business was never a major element of the Company's operations. Environmental claims are also received from certain reinsurance pools and associations where reserves are established based on information reported to the Company by the managers of those pools and associations. Establishing reserve liabilities for environmental claims is subject to significant uncertainties that make reserve estimation difficult. Legal decisions have tended to expand insurance coverage beyond the intent of the original policies. The disposition of such claims often requires lengthy and costly litigation. Uncertainties as to required clean-up remedies, and difficulties in identifying the responsible parties, add further to the complexity of reserve estimation for these claims. In recent years, the Company has intensified its efforts to settle and close environmental claims. To help minimize the cost of losses and claims, the Company maintains a dedicated environmental claims staff which administers the defense and settlement of each claim and continually evaluates them. In 1993 and 1992, the Company paid $5,557,000 and $4,221,000, respectively, for the costs of defending and settling claims. Payments in 1993 and 1992 related to 216 and 117 claims, respectively, for the Company's direct business. Claim counts have been aggregated by the Company by year of coverage for each alleged occurrence for which policyholders are being defended, and often include numerous claimants. As of December 31, 1993, the Company has environmental claims-related loss and loss adjustment expense reserves, net of reinsurance recoverables, of $17,189,000, which include 512 claims for direct business written by the Company. In estimating liabilities for environmental-related claims, the Company considers all pertinent information as it becomes available. Interest Expense Interest expense was $13,044,000 in 1993, $12,754,000 in 1992 and $16,131,000 in 1991. The 2.3% increase from 1992 to 1993 reflects an increase in the average amount of debt outstanding in 1993 as compared to 1992, including debt incurred to redeem the Company's Adjustable Rate Preferred Stock, offset for the most part by lower average interest rates. The 20.9% decrease from 1991 to 1992 is the result of declining average interest rates and a reduction in the amount of debt outstanding. Interest expense for both 1993 and 1992 was impacted by the issuance of $110,000,000 of 9 1/8% Senior Notes on September 8, 1992, and the reduction of average bank debt outstanding and repayment of debentures (See "Liquidity and Capital Resources"). Equity in Earnings of Affiliates The Company's portion of Guaranty National's net earnings before the cumulative effect of adopting changes in accounting principles was $9,509,000 in 1993, $9,994,000 for 1992 and $1,207,000 for the period from November 20 to December 31, 1991. The Company's portion of Intercargo's net loss for 1993 was $122,000. Guaranty National's full year net earnings were $19,285,000, $20,271,000 and $17,813,000 for 1993, 1992 and 1991, respectively. Gross premiums written for Guaranty National increased to $321,766,000 in 1993 from $273,400,000 in 1992 and $229,139,000 in 1991. Guaranty National's combined ratios were 99.6% in 1993, 97.7% in 1992 and 99.2% in 1991. Earnings From Operations Before Federal Income Taxes Operating earnings before income taxes were $72,505,000, $46,714,000 and $46,069,000 for 1993, 1992 and 1991, respectively. The 55.2% increase in pre- tax earnings from 1992 to 1993 reflects an improvement in insurance operations profitability of $19,980,000 and an increase in realized investment gains of $5,811,000. Pre-tax earnings for 1991 were increased by the gain of $33,931,000 realized on the Guaranty Sale and decreased by the $25,000,000 cumulative loss provision. Excluding these items, the 25.8% increase in pre- tax earnings for 1992 over 1991 is the result of an increase in insurance operations profitability of $4,900,000 and an increase in realized investment gains of $4,676,000. Federal Income Taxes Federal income taxes on pre-tax operating results and the related effective tax rates amounted to $15,517,000 (21.4%), $922,000 (2.0%) and $1,401,000 (3.0%) in 1993, 1992 and 1991, respectively. The Company files consolidated federal income tax returns, which include the taxable income of Guaranty National from November 1, 1988 through November 20, 1991. Effective January 1, 1993, the Company adopted SFAS No. 109, "Accounting for Income Taxes." Upon adoption of SFAS No. 109, the Company recorded a benefit of $16,881,000 which was principally attributable to its deferred tax benefits that had not been recognized due to limitations under prior accounting standards. The Company's effective tax rate for 1993 reflects the absence of such deferred tax benefits, as well as a continuation of the Company's shift in its investment portfolio toward more tax-advantaged securities. The tax rate for 1993 reflects a tax benefit of $450,000 from the effect of the increase in the federal tax rate on the Company's deferred tax asset. The consolidated federal income tax provisions for 1991 through 1993 were computed by the regular tax method, reduced by alternative minimum and other tax credits in 1991 and the recognition of deferred tax benefits in 1991 and 1992 to the extent that the Company was able to utilize its NOL for financial reporting purposes under SFAS No. 96, "Accounting for Income Taxes." Cumulative effect of adoption of new accounting principles Effective January 1, 1993 the Company recorded the cumulative effect of adopting SFAS No. 109 (discussed above) and SFAS No. 106 "Employers' Accounting for Postretirement Benefits Other than Pensions." SFAS No. 106 requires the accrual of the estimated cost of retiree benefit payments during the years the employees provide services. Upon adoption of SFAS No. 106 the cumulative effect of the Company's accumulated obligation for providing medical benefits to retirees was $5,056,000, after a related tax benefit of $2,604,000. Included in the cumulative effects of adopting these accounting principles is the Company's portion of Guaranty National's benefit from changes in accounting principles in 1993 of $360,000, net of $185,000 of federal income taxes provided by the Company. Earnings Per Common Share Common stock and per common share data have been restated to give effect to the 5-for-4 stock splits paid on both November 15, 1993 and December 7, 1992. Primary earnings per share amounted to $4.69 ($3.88 before the effect of adopting new accounting principles) in 1993, $3.35 ($3.62 before extraordinary item) in 1992 and $3.75 in 1991. Reflected in the calculation of 1993, 1992 and 1991 earnings per common share are dividends of $409,000, $6,358,000 and $7,276,000, respectively, on the Company's Adjustable Rate Preferred Stock, (redeemed in 1993), $1.90 Preferred Stock (converted into common stock or redeemed in 1992) and $2.125 Preferred Stock (converted into common stock or redeemed in 1993). All of these conversions and redemptions were effected pursuant to the terms of the preferred stock. The $1.90 Preferred Stock and the $2.125 Preferred Stock were assumed to be converted, if dilutive, for the purpose of computing fully-diluted earnings per common share. Fully-diluted earnings per share amounted to $4.67 ($3.86 before the effect of adopting new accounting principles in 1993, $2.85 ($3.05 before extraordinary item) in 1992 and $3.05 in 1991. Reflected in the calculation of fully-diluted earnings per share in 1993, 1992 and 1991 are Adjustable Rate Preferred Stock dividends of $407,000, $1,581,000 and $1,679,000, respectively. LIQUIDITY AND CAPITAL RESOURCES Cash provided by operating activities increased $42,621,000 to $123,154,000 in 1993 from $80,533,000 in 1992 and decreased $59,371,000 in 1992 from $139,904,000 in 1991. The increase in operating cash flow for 1993 is primarily due to an increase in premiums collected, particularly for Connecticut Specialty, and a receipt of $17,096,000 under a retrospectively rated program written by DPIC, offset in part by an increase in paid losses. Also, cash provided by operations in 1992 was decreased by an $18,410,000 payment for reinsurance applicable to a 1991 contract. The decrease in 1992 is attributable to the exclusion of Guaranty National's cash flow which amounted to $17,048,000 from January 1 through November 20, 1991, as well as a decrease in premiums collected and increases in payments for reinsurance and federal income taxes, offset by a decrease in paid losses and loss adjustment expenses, policy acquisition costs and interest expense. Cash used in investment activities increased $65,162,000 to $124,415,000 in 1993 from $59,253,000 in 1992 and decreased by $46,081,000 in 1992 from $105,334,000 in 1991. The use of investment cash is attributable to purchases of investments which exceeded maturities and sales of investments, reflecting positive operating cash flows. Investable cash of $84,885,000 was provided on November 20, 1991 by the Guaranty Sale which significantly increased short- term investments at the end of that year. Cash used in financing activities decreased $16,250,000 to $5,046,000 in 1993 from $21,296,000 in 1992 and decreased $11,255,000 in 1992 from $32,551,000 in 1991. Cash provided in 1993 from an increase in bank borrowings was more than offset by the redemption of the Company's Adjustable Rate Preferred Stock, purchase of common stock and the payment of dividends. Dividends paid to stockholders were lower in 1993 due to the conversions and redemptions of the $1.90 Preferred Stock and $2.125 Preferred Stock into common stock and the redemption of the Adjustable Rate Preferred Stock. Proceeds from financing activities in 1992 include $107,834,000 from the issuance of 9 1/8% Senior Notes on September 8, 1992, $19,930,000 from the issuance of bank debt in December 1992 and proceeds of $9,497,000 from the issuance of common stock in April 1992. These sources of cash were offset by debt repayments in 1992, including repayment of the Company's bank loan and the retirement of the Company's 13 1/2% Senior Subordinated Debentures and its 12 1/2% Subordinated Debentures. Orion's uses of cash consist of debt service, dividends to stockholders and overhead expenses. These cash uses are funded from existing available cash, financing transactions and receipt of dividends, reimbursement of overhead expenses and amounts in lieu of federal income taxes from Orion's insurance subsidiaries. In 1993 Orion received $25,512,000 in dividends, $5,230,000 for overhead expenses and federal tax payments of $5,600,000 from its insurance subsidiaries. Orion also received an extraordinary dividend of $65,470,000 (principally securities) from a California-domiciled subsidiary which was simultaneously contributed as capital to a Connecticut-domiciled subsidiary to effect a change in pooling percentages among its insurance subsidiaries. Payments of dividends by Orion's insurance subsidiaries must comply with insurance regulatory limitations concerning stockholder dividends and capital adequacy. State insurance regulators have broad discretionary authority with respect to limitations on the payment of dividends by insurance companies. Limitations under current regulations are well in excess of Orion's cash requirements. Orion's insurance subsidiaries maintain liquidity in their investment portfolios substantially in excess of that required to pay claims and expenses. The insurance subsidiaries held cash and short-term investments of $92,421,000 and $115,527,000 at December 31, 1993 and 1992, respectively. Orion's insurance subsidiaries had consolidated policyholders' surplus of $460,986,000 at December 31, 1993 and $385,803,000 at December 31, 1992, and statutory operating leverage ratios of net premiums written to policyholders' surplus of 1.4:1 and 1.5:1 at December 31, 1993 and 1992, respectively. Approximately $21,800,000 of the increase in surplus during 1993 relates to the elimination of a statutory valuation allowance related to the Guaranty National investment. During 1992 and 1993, Orion reconfigured its debt structure to take advantage of generally lower interest rates and the stronger capital position of the Company, and to reduce the amount of debt maturing in the next five years. On September 8, 1992, the Company issued 9 1/8% Senior Notes due 2002 with a face value of $110,000,000 in a public offering. The net proceeds from the offering of $107,834,000 were used to repay the Company's bank debt of $80,100,000, and to retire the Company's 13 1/2% Senior Subordinated Debentures on October 9, 1992 for $20,160,000 plus accrued interest. On November 30, the Company entered into a bridge loan facility (the "Bridge Loan") with two banks aggregating $25,000,000. In December 1992, the Company borrowed $20,000,000 under the Bridge Loan to redeem the Company's 12 1/2% Subordinated Debentures on December 31, 1992 for $20,500,000 plus accrued interest. In March 1993 Orion entered into a bank loan arrangement (the "Loan Agreement") that provided for initial borrowings of up to $60,000,000, consisting of a $50,000,000 term loan (reduced by $4,500,000 in scheduled commitment reductions through December 31, 1993) and a $10,000,000 line of credit. These borrowings are unsecured and bear interest at or below prime. Borrowings under the Loan Agreement amounted to $50,500,000 at December 31, 1993. The proceeds were used to repay the Bridge Loan and to redeem the Company's Adjustable Rate Preferred Stock. At December 31, 1993, the Company has available $5,000,000 in unused commitments under the line of credit. The terms of the Loan Agreement and Orion's Indenture for its 9 1/8% Senior Notes limit the amount of additional borrowings, prepayments on existing indebtedness, liens and guarantees by the Company. Management does not believe that any of these limitations unduly restrict the Company's operations or limits Orion's ability to pay dividends on its stock. At December 31, 1993 the Company was in compliance with the terms of its debt agreements. Management believes that the Company continues to have substantial sources of capital and liquidity from the capital markets and bank borrowings. On October 1, 1992 and December 21, 1992, Orion called for the redemption of all of its $1.90 Preferred Stock and $2.125 Preferred Stock on November 2, 1992 and January 21, 1993, respectively. In both cases, the market price of the shares of common stock that a holder would receive upon conversion of the preferred stock was substantially higher than the redemption price of $21.30 per share and $25.76 per share, respectively. Consequently, most holders converted into common stock prior to the redemption dates, resulting in the issuance of 2,558,173 shares of common stock prior to December 31, 1992 and 1,423,544 shares of common stock in January 1993. Holders of 2,730 shares of $1.90 Preferred Stock and 21,605 shares of $2.125 Preferred Stock, who did not elect to convert, redeemed their shares for an aggregate of $58,000 and $557,000, respectively. On April 15, 1992, Orion sold 515,625 shares of its common stock for $9,497,000, net of expenses. The sale was made in a private transaction, subject to the provisions of Regulation S of the Securities Act of 1933, as amended. The proceeds from the sale were used for general corporate purposes. The Company repurchased 177,658 shares, 22,420 shares and 52,700 shares of its common stock at an aggregate cost of $5,472,000, $554,000 and $655,000 in 1993, 1992 and 1991, respectively. The Company's remaining stock purchase authorization from its Board of Directors amounted to $5,819,000 at December 31, 1993. As of December 31, 1993 there were no significant contingencies or commitments outstanding which, net of reserves established therefor and giving effect to reinsurance, are likely to have a material effect on the liquidity or financial position of Orion and its consolidated subsidiaries, taken as a whole (See Notes G and H to the consolidated financial statements). ITEM 8.	ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA REPORT OF MANAGEMENT The management of Orion Capital Corporation is responsible for the consolidated financial statements and the information included therein. The consolidated financial statements are fairly presented and have been prepared in accordance with generally accepted accounting principles appropriate in the circumstances, and, where necessary, include amounts based on management's informed estimates and judgments. The Company has a system of internal controls which it believes provides reasonable assurance that assets are safeguarded from loss or unauthorized use, transactions are recorded in accordance with management's policies and that the financial records are reliable for preparing financial statements. The system of internal controls includes written policies and procedures which are communicated to all appropriate personnel and updated as necessary. Compliance with the system of internal controls is continuously maintained and monitored by management. The internal audit staff of the Company evaluates and reports on the adequacy of and adherence to these controls, policies and procedures. In addition, as part of its audit of the consolidated financial statements, Deloitte & Touche, the independent auditors for the Company, perform a review and evaluation of the system of internal controls to the extent they consider necessary to express an opinion on the consolidated financial statements. Recommendations concerning the system of internal controls are provided by both the internal auditors and Deloitte & Touche, and management takes actions which are believed to be appropriate responses to these recommendations. The Audit Committee of the Board of Directors is comprised of independent directors, and has general responsibility for oversight of financial controls and audit activities of the Company and its subsidiaries. The Audit Committee, which reports to the Board, annually reviews the qualifications of the independent auditors and meets periodically with them, the internal auditors and management to review the plans and results of the audits. Both internal and independent auditors have free access to the Audit Committee, without members of management present, to discuss the adequacy of the system of internal controls and any other matters which they believe should be brought to the attention of the Committee. Alan R. Gruber Daniel L. Barry Chairman & Chief Executive Officer Vice President & Controller INDEPENDENT AUDITORS' REPORT The Board of Directors and Stockholders ORION CAPITAL CORPORATION New York, New York We have audited the accompanying consolidated balance sheets of Orion Capital Corporation and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of earnings, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a)2. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Orion Capital Corporation and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note A to the consolidated financial statements, in 1993 the Company adopted four new accounting standards required by generally accepted accounting principles. On January 1, 1993 the Company changed its method of accounting for income taxes and postretirement benefits to conform with Statement of Financial Accounting Standards Nos. 109 and 106, respectively. The Company changed its method of accounting for reinsurance to conform with Statement of Financial Accounting Standards No. 113. Also, effective December 31, 1993 the Company changed its method of accounting for investments to conform with Statement of Financial Accounting Standards No. 115. DELOITTE & TOUCHE Hartford, Connecticut February 22, 1994 Proceeds from sales of investments in fixed maturities were $90,720,000 in 1993, $189,282,000 in 1992, and $535,975,000 during 1991. Realized investment gains (losses) on fixed maturities during 1993, 1992 and 1991 include gross gains of $10,817,000, $10,273,000 and $18,287,000, gross losses realized from sales of $4,155,000, $4,908,000 and $11,362,000 and $2,147,000, $2,133,000 and $7,770,000, respectively, of loss provisions recorded for other than temporary impairment in the value of investments. The Company had $226,000 and $1,666,000 of fixed maturity investments for which it was not accruing income for the years ended December 31, 1993 and 1992, respectively. Other long-term investments had aggregate carrying values of $50,682,000 at December 31, 1993 and $36,419,000 at December 31, 1992 including mortgage loans on real estate of $1,690,000 and $434,000, respectively. Estimated market values of mortgage loans and other long-term investments approximate their carrying values. The carrying value of securities on deposit with state regulatory authorities in accordance with statutory requirements totalled $283,537,000 and $340,699,000 at December 31, 1993 and 1992, respectively. Excluding investments in Guaranty National and securities of the United States Government and its agencies, the Company did not have any investments in securities of any one issuer that exceeded $20,000,000. ORION CAPITAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note D - Reinsurance In the normal course of business, the Company's insurance subsidiaries reinsure certain risks, generally on an excess-of-loss or pro rata basis, with other companies in order to limit losses. Reinsurance does not discharge the primary liability of the original insurer. As of December 31, 1993 and 1992, recoverables for reinsurance ceded to the Company's three largest reinsurers were an aggregate of $106,414,000 and $112,553,000, respectively. At December 31, 1993, these reinsurers provided qualified trust accounts for the benefit of the Company of $46,167,000 and letters of credit totalling $4,372,000. At December 31, 1992, the Company held $36,855,000 in funds of one of these reinsurers, and another provided a qualified trust account for the benefit of the Company of $31,129,000 and a letter of credit for $3,131,000. The table below illustrates the effect of reinsurance on premiums written and premiums earned: Included in other liabilities are funds held under various reinsurance treaties of $5,487,000 and $39,072,000 at December 31, 1993 and 1992, respectively. Reinsurance recoverables and prepaid reinsurance includes prepaid reinsurance of $55,043,000 at December 31, 1993 and $46,183,000 at December 31, 1992. ORION CAPITAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note E - Notes Payable Orion issued 9 1/8% Senior Notes due 2002 (the "9 1/8% Senior Notes") in a public offering on September 8, 1992. The proceeds were used to extinguish the Company's debt under its loan agreement with various banks at that date, and to redeem its 13 1/2% Senior Subordinated Debentures on October 9, 1992. The Company entered into a loan agreement (the "Bridge Loan") with two banks on November 30, 1992, and borrowed $20,000,000 under this agreement in December 1992, the proceeds of which were used to redeem the Company's 12 1/2% Subordinated Debentures on December 31, 1992. The costs of the early extinguishment of the Company's bank debt and debentures in 1992 were approximately $2,980,000. These costs are reported as an extraordinary item in the Company's financial statements, net of a $60,000 tax benefit. Debt extinguishment costs include the premiums required to call the debentures, the unamortized discount of the debentures and unamortized deferred financing costs of the debentures and bank debt. Orion entered into a bank loan agreement (the "Loan Agreement") in March 1993 that provided for initial borrowings of up to $60,000,000, consisting of a $50,000,000 term loan (reduced by $4,500,000 in scheduled commitment reductions through December 31, 1993) and a $10,000,000 line of credit. The proceeds were used to repay the Bridge Loan and to redeem the Company's Adjustable Rate Preferred Stock. As of December 31, 1993, the Company had $50,500,000 outstanding under the Loan Agreement, and $5,000,000 in unused commitments available under the line of credit. There is a commitment fee of 1/4% of 1% per annum on the unused portion of the revolving credit facility. The Company can elect to borrow at the prime rate, or at certain other short- term borrowing rates. The rates for notes payable under the Loan Agreement were between 4.59% and 4.90% at December 31, 1993. The terms of the Loan Agreement limit the amount of additional borrowings, prepayments on existing indebtedness, liens and guarantees by the Company, and require the Company to meet minimum net worth and certain financial ratio tests. The 9 1/8% Senior Notes Indenture limits the Company's ability to incur secured indebtedness without equally and ratably securing the 9 1/8% Senior Notes. ORION CAPITAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Notes payable are recorded at face value less unamortized discount. The carrying value and estimated market value of notes payable consists of the following: Note F - Federal Income Taxes Orion and its wholly-owned subsidiaries file consolidated federal income tax returns. The Company adopted SFAS No. 109 effective January 1, 1993. The new standard provides for the recognition of deferred tax assets that were not recognized under the prior standard, SFAS No. 96. The cumulative effect of adopting SFAS No. 109 was a benefit of $16,881,000. Accounting for income taxes using SFAS No. 109 increased income taxes on continuing operations for 1993 by $3,909,000. The consolidated federal income tax current provisions for 1991 through 1993 were computed by the regular tax method, reduced by alternative minimum and other tax credits in 1991. The deferred tax benefit for 1993 results primarily from the increase in the discount on loss reserves for income tax purposes offset by the undistributed earnings of Guaranty National. The 1993 tax provision reflects a tax benefit of $450,000 from the ORION CAPITAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) effect of the increase in the federal tax rate on the Company's deferred tax asset. The consolidated federal income tax deferred benefits for 1992 and 1991 result from the recognition of previously unrecorded deferred tax benefits to the extent that they could be carried back to generate the recovery of income taxes under SFAS No 96. Substantially all federal income taxes incurred by the Company and its subsidiaries relate to domestic operations. The tax effects of the temporary differences comprising the Company's net deferred tax asset as of December 31, 1993 and January 1, 1993 are as follows: ORION CAPITAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note G - Commitments Minimum lease commitments at December 31, 1993, with the majority having initial lease periods from one to twenty-five years, are as follows: (000s omitted) 1994 ....................................... $10,721 1995 ....................................... 9,009 1996 ....................................... 7,446 1997 ....................................... 5,898 1998 ....................................... 4,959 1999 and thereafter ........................ 45,439 ------- Minimum rental commitments ............... $83,472 ======= Rent expense amounted to $11,976,000, $12,224,000 and $13,521,000 net of sublease rentals of $419,000, $765,000 and $791,000 in 1993, 1992 and 1991, respectively. Substantially all leases are for office space and equipment. A number of lease commitments contain renewal options ranging from one to thirty years. Note H - Contingencies In November 1988, California voters passed an initiative known as Proposition 103 (the "California Proposition") which amended the California Insurance Code to provide, among other things, that rates for automobile and many other insurance policies issued or renewed on or after November 8, 1988, be rolled back to the levels of November 8, 1987 and then reduced by 20%. Workers compensation insurance and reinsurance are excluded from the California Proposition's rate rollback provisions. On January 8, 1991, the California Insurance Department issued rate regulation proposals regarding the California proposition. On October 16, 1991, the California Insurance Commissioner issued notices of premium refunds to 14 insurers. In February 1993, the California State Court invalidated the regulations with respect to one insurance company that received notice of a premium refund. The decision is currently on appeal to the California Supreme Court. None of the Company's insurance subsidiaries were among the companies that received the refund notices. Although it is not possible to predict with any degree of certainty the ultimate outcome of such regulations or their impact on the Company's rates charged since November 8, 1988, management currently believes that the effect of the regulations will not be material to the Company. Based on the foregoing, and management's belief that the rates filed by the Company comply with applicable California law, no provision has been made in the accompanying consolidated financial statements for denial or partial denial of the Company's rollback exemption applications or partial or total disapproval of the Company's rates filed since November 8, 1989. ORION CAPITAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Orion and its subsidiaries are routinely engaged in litigation incidental to their businesses; however, in the judgment of the Company's management, there are no significant legal proceedings pending against Orion or its subsidiaries, which, net of reserves established therefor and giving effect to reinsurance, are likely to result in judgments for amounts that are material to the financial condition of Orion and its consolidated subsidiaries, taken as a whole. Note I - Stockholders' Equity and Earnings Per Common Share Orion declared a 5-for-4 split of its common stock which was paid on November 15, 1993 to shareholders of record on October 15, 1993. All common stock and per common share data presented in the financial statements has been restated to give effect to this stock split. The Company had also paid a 5- for-4 common stock split on December 7, 1992 to shareholders of record on November 20, 1992. During 1993, the Company repurchased 177,658 shares of its common stock at an aggregate cost of $5,472,000. The Company repurchased 22,420 shares for $554,000 in 1992 and 52,700 shares for $655,000 in 1991. On April 15, 1992, Orion sold 515,625 shares of its common stock for $9,497,000, net of expenses. The sale was made in a private transaction, subject to the provisions of Regulation S of the Securities Act of 1933, as amended. On December 21, 1992, Orion called for the redemption of its $2.125 Convertible Exchangeable Preferred Stock (the "$2.125 Preferred Stock") on January 21, 1993. The market price of the shares of common stock that a holder would receive upon conversion of the preferred stock was substantially higher than the redemption price of $25.76 per share. Consequently, most holders converted into common stock prior to the redemption date, resulting in the issuance of 3,579 shares of common stock in December 1992 and 1,423,544 shares of common stock in January 1993. Holders of 21,605 shares of $2.125 Preferred Stock, who did not elect to convert, redeemed their shares for an aggregate of $557,000. Orion issued 2,601,050 and 42,428 shares of common stock for conversions elected by holders of 1,581,470 and 25,800 shares of the Company's $1.90 Convertible Exchangeable Preferred Stock (the "$1.90 Preferred Stock"), in 1992 and 1991, respectively. The 1992 conversions were primarily the result of Orion calling this issue on November 2, 1992 at the redemption price of $21.30 per share including accrued dividends. The remaining 2,730 shares of $1.90 Preferred Stock were redeemed for approximately $58,000. ORION CAPITAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) On April 7, 1993, the Company redeemed all of the outstanding shares of its Adjustable Rate Preferred Stock for $18,520,000 in cash. The redemption was funded with borrowings under the Loan Agreement. Dividends declared on Orion's common and preferred stock for 1993, 1992 and 1991 were as follows: The weighted average common shares outstanding for purposes of computing earnings per share amounted to 14,598,000, 10,914,000 and 9,964,000 shares for 1993, 1992 and 1991, respectively. Dividends on preferred stock were deducted from earnings to compute primary earnings per common share. The $2.125 Preferred Stock and, for 1992 and 1991, the $1.90 Preferred Stock are assumed to be converted for the full year, if dilutive, for the purpose of computing fully-diluted earnings per common share. The weighted average common shares, on a fully-diluted basis, amounted to 14,655,000, 14,474,000 and 14,086,000 shares for 1993, 1992 and 1991, respectively. Orion has a Stockholder Rights Plan (the "Rights Plan") under which each outstanding share of common stock includes 64% of one preferred stock purchase right (the "Rights"). The Rights Plan is designed to assure stockholders that they will receive equitable treatment in the event of a proposed takeover. Under the Rights Plan, each holder of a Right is entitled to buy one-hundredth of a share of Series A Participating Junior Preferred Stock. The Rights become exercisable if an acquiror gains a 20% or greater beneficial ownership interest in Orion's common stock, on other than fair and favorable terms to all stockholders. Each Right not owned by such acquiror will enable the holder to purchase, at an initial exercise price of $80, common stock having a value of twice the Right's exercise price. In addition, under certain circumstances if Orion is involved in a merger each Right will entitle its holder to purchase, at the Right's then current exercise price, common shares of such other company having a value of twice the Right's exercise price. ORION CAPITAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note J - Employee Benefit Plans The Company maintains a Stock Savings and Retirement Plan (the "Plan"), qualified under Internal Revenue Code Section 401(k), for eligible employees of the Company. Employee and employer matched contributions to the savings funds are limited to the extent allowable under the Plan and federal income tax law. The Plan also provides for a defined contribution retirement benefit that allows the Company to make annual contributions to the Plan based on a percentage of the participating employees' compensation. Employees vest in the Company's contributions over a six-year period with vesting credit given for prior service with the Company. The Company has adopted a Surplus Benefit Plan which provides deferred benefits for those employees who received less than the full employer contribution to the Company's 401(k) plan as a result of federal tax limitations on participation in the Plan. The Company maintains a number of incentive plans for key employees. These plans include the Company's 1979 stock option plan and the Company's 1982 Long-Term Performance Incentive Plan. Under the latter plan, shares of restricted stock as well as stock options may be granted by Orion. Orion granted 5,688, 66,016 and 4,063 shares of restricted stock to key employees during 1993, 1992 and 1991, respectively. Restricted stock is considered issued and outstanding when awarded, and is recorded as deferred compensation. There are restrictions as to its transferability, which restrictions lapse proportionately from the second to the fifth anniversaries of grant date. As of December 31, 1993, the restrictions have not lapsed on 130,089 shares of restricted stock. All stock options granted by Orion, at fair market value at date of grant, are intended to qualify as incentive stock options becoming exercisable from the first through fourth anniversaries of the date of grant, expiring ten years after the date of grant. As of December 31, 1993, the number of shares of stock reserved under all plans is 641,113 of which 284,337 are for outstanding stock options and 197,696 of these stock options are exercisable. A summary of the option transactions is as follows: ORION CAPITAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Orion also maintains a non-qualified defined benefit retirement plan for members of the Board of Directors who are not employees. Benefits are based on years of service and director fee levels at retirement. The total expense for 1993, 1992 and 1991 for the above pension benefit plans for employees and directors amounted to $3,277,000, $2,694,000 and $1,695,000, respectively. Note K - Postretirement Medical Benefits The Company provides postretirement medical benefits to full-time employees who have worked for 10 years and attained age 55 while in service with the Company. The effect on income from continuing operations after federal income taxes for 1993 of accounting for retirement benefits using SFAS No. 106 was to increase expenses by $211,000, net of federal income taxes. The Company's postretirement health care plan is not funded. The accumulated postretirement benefit obligation of the plan at December 31, 1993 included in other liabilities in the consolidated balance sheet is as follows: (000s omitted) Retirees ................................. $2,260 Fully eligible active plan participants .. 1,425 Other active plan participants ........... 4,104 ------ $7,789 ====== Net postretirement benefit cost for the year ended December 31, 1993 was $598,000 and consisted of service cost benefits earned of $130,000 and interest on the accumulated postretirement benefit obligation of $468,000. The expected health care cost trend rate used as of December 31, 1993 was 16.0% for 1994, and 10% in 1995 decreasing linearly each year until it reaches 6% for 2003 and future years. A one-percentage-point increase in the assumed health care cost trend rate for each year would increase the accumulated postretirement benefit obligation as of December 31, 1993 by $1,325,000 and increase net postretirement health care costs by $145,000 for 1993. The assumed discount rate used in determining the accumulated postretirement benefit obligation was 7.0% at December 31, 1993. ORION CAPITAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note L - Industry Segment Information The Company's insurance operations are organized and reported as three business segments: Regional Operations, Reinsurance/Special Programs and Guaranty National Companies. Regional Operations markets workers compensation insurance through EBI Companies and Nation's Care, Inc. Reinsurance/Special Programs includes DPIC Companies (which markets the Company's professional liability insurance), Connecticut Specialty Insurance Group (which directs the underwriting and sale of specialty insurance programs), SecurityRe Companies (which underwrites reinsurance), and a 20% interest in Intercargo (which underwrites international trade). The third segment, Guaranty National Companies, specializes in writing nonstandard commercial and personal automobile insurance. The operations of the Guaranty National Companies are included in revenues and expenses through November 20, 1991, the date that the Company sold 6,250,000 shares of Guaranty National's common stock in a public offering, reducing the Company's ownership of Guaranty National to approximately 49%. Earnings subsequent to November 20, 1991 include the Company's share of Guaranty National's earnings using the equity method of accounting. The miscellaneous income and expenses (primarily interest, general and administrative expenses and other consolidating elimination entries) of the parent company are reported as a fourth segment. Identifiable assets of the Regional Operations and Reinsurance/Special Programs segments are primarily allocated based on the cash flows of these segments, and for 1992 and 1991 have been restated to conform with SFAS No. 113. ORION CAPITAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note M - Selected Quarterly Financial Data (Unaudited) ITEM 9.	ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III Pursuant to General Instruction G(3) to this form, the information required by Part III (Items 10, 11, 12 and 13) hereof is incorporated by reference from the Company's definitive proxy statement for its Annual Meeting to be held on June 1, 1994. The Company intends to file the proxy material, which involves the election of directors, not later than 120 days after the close of the Company's fiscal year. PART IV ITEM 14.					ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) 1 Financial Statements: The following financial statements are included in Part II, Item 8. Page ---- Report of Management................................. 47 Independent Auditors' Report......................... 48 Orion Capital Corporation and Subsidiaries: December 31, 1993 and 1992 Consolidated Balance Sheet................. 49-50 For the years ended December 31, 1993, 1992 and Consolidated Statement of Earnings......... 51 Consolidated Statement of Stockholders' Equity..................................... 52 Consolidated Statement of Cash Flows....... 53-54 Notes to the Consolidated Financial Statements.. 55-74 (a) 2. Financial Statement Schedules: Selected Quarterly Financial Data - for the years ended December 31, 1993, 1992 and 1991 - Included in Part II, Item 8. Page ---- Schedule I Consolidated Summary of Investments - Other than Investments in Related Parties - December 31, 1993........................ S-1 III Condensed Financial Information of Registrant - S-2, S-3, December 31, 1993, 1992 S-4, S-5, and 1991.................... S-6 V Supplementary Insurance Information - December 31, 1993, 1992 and 1991......... S-7 VIII Valuation and Qualifying Accounts - December 31, 1993, 1992 and 1991............... S-8 IX Short-Term Borrowings - December 31, 1993, 1992 and 1991.................... S-9 X Supplemental Information For Property - Casualty Insurance Underwriters - December 31, 1993, 1992 and 1991........................ S-10 Schedules other than those listed above are omitted for the reason that they are not required or are not applicable, or the required information is shown in the Financial Statements or notes thereto. (a) 3. Exhibits: Exhibit 3(i) Restated Certificate of Incorporation of the Company, as amended on June 3, 1993. Exhibit 3(ii) By-Laws of the Company, as amended on May 7, 1993. Exhibit 4(i) Certificate of Designation, Preferences and Rights of Series A Junior Participating Preferred Stock of the Company, dated March 23, 1989; filed as Exhibit 4(xi) to the Company's Annual Report on Form 10-K for 1988. Exhibit 4(ii) Specimen certificate representing shares of the Company's Common Stock (proof of March 27, 1989); filed as Exhibit 4(xii) to the Company's Annual Report on Form 10-K for 1988. Exhibit 4(iii) Indenture, dated as of September 8, 1992, between the Company and the Connecticut National Bank (now known as Shawmut Bank Connecticut, National Association), as Trustee of the Company's 9 1/8% Senior Notes due September 1, 2002; filed as Exhibit 4(v) to the Company's Annual Report on Form 10-K for 1992. Exhibit 4(iv) Specimen certificate representing the Company's 9 1/8% Senior Notes; filed as Exhibit 4(vi) to the Company's Annual Report on Form 10-K for 1992. Exhibit 10 (i)* The Company's Deferred Compensation Plan, as amended (effective July 1, 1992); filed as Exhibit 10(i) to the Company's Annual Report on Form 10-K for 1991. Exhibit 10(ii)* The Company's 1982 Long-Term Performance Incentive Plan (as amended); filed as Exhibit 10(iii) to the Company's Annual Report on Form 10-K for 1992. Exhibit 10(iii)* The Company's 1979 Stock Option Plan, as amended; filed as Exhibit 10(lx) to the Company's Annual Report on Form 10-K for 1981. Exhibit 10(iv)* Employment Agreement between Alan R. Gruber and the Company, dated as of March 19, 1993; filed as Exhibit 10(v) to the Company's Annual Report on Form 10-K for 1992. Exhibit 10(v)* Employment Agreement, between the Company and Robert B. Sanborn, dated as of March 19, 1993; filed as Exhibit 10(vi) to the Company's Annual Report on Form 10-K for 1992. Exhibit 10(vi)* Employment Agreement, dated as of August 1, 1987, between the Company and Peter B. Hawes; filed as Exhibit 10(x) to the Company's Annual Report on Form 10-K for 1989. Management contract or compensatory plan or arrangement. Exhibit 10(vii) Employent Agreement, dated as of December 1, 1992 between the Company and Larry D. Hollen; filed as Exhibit 10(viii) to the Company's Annual Report on Form 10-K for 1992. Exhibit 10(viii) Lease Agreement between Connecticut UTF, Inc., as lessor, and Security Insurance Company of Hartford ("Security"), as lessee, dated as of December 19, 1984; filed as Exhibit 10(xxxiii) to the Company's Annual Report on Form 10-K for l984. Exhibit 10(ix) Second Assignment of Lease and Agreement from Connecticut UTF, Inc. to Security, dated as of December 19, 1984; filed as Exhibit 10(xxxiv) to the Company's Annual Report on Form 10-K for 1984. Exhibit 10(x) Purchase Money Second Mortgage from Connecticut UTF, Inc., as mortgagor, to Security, as mortgagee, dated as of December 19, 1984; filed as Exhibit 10(xxxvi) to the Company's Annual Report on Form 10-K for 1984. Exhibit 10(xi) Purchase Money Note, in the face amount of $2,800,000, from Connecticut UTF, Inc. to Security, dated December 19, 1984; filed as Exhibit 10(xxxvi) to the Company's Annual Report on Form 10-K for l984. Exhibit 10(xii) Guarantee from the Company to Connecticut UTF, Inc., dated as of December 19, 1984, guaranteeing the performance of Security under its lease with Connecticut UTF, Inc.; filed as Exhibit 10(xxxvii) to the Company's Annual Report on Form 10-K for 1984. Exhibit 10(xiii) Form of Indemnification Agreement, dated as of June 3, 1987, between the Company and each of its Directors and Executive Officers; filed as Exhibit 10(xl) to the Company's Annual Report on Form 10-K for l987. Exhibit 10(xiv) Rights Agreement, dated as of March 15, 1989, between the Company and Manufacturers Hanover Trust Company, Rights Agent; filed as Exhibit 1 to the Company's Form 8-A filed March 28, 1989. Management contract or compensatory plan or arrangement. Exhibit 10(xv) First Aggregate Excess of Loss Reinsurance Contract, effective January 1, 1990, by and among several of the Company's wholly-owned insurance subsidiaries and United States Fidelity and Guaranty Company; filed as Exhibit 10(xxxvi) to the Company's Annual Report on Form 10-K for 1990. Exhibit 10(xvi) Second Aggregate Excess of Loss Reinsurance Contract, effective January 1, 1990, by and among several of the Company's wholly-owned insurance subsidiaries and Helmsman Insurance Company, Ltd.; filed as Exhibit 10(xxvii) to the Company's Annual Report on Form 10-K for 1990. Exhibit 10(xvii) Specific Excess Reinsurance Agreement, effective January 1, 1990, by and among several of the Company's wholly-owned insurance subsidiaries and Cologne Reinsurance Company (Dublin) Ltd.; filed as Exhibit 10(xxiv) to the Company's Annual Report on Form 10-K for 1990. Exhibit 10(xviii) Retirement Plan for Directors of Orion Capital Corporation, as amended (May 9, 1990); filed as Exhibit 10(xxviii) to the Company's Annual Report on Form 10-K for 1990. Exhibit 10(xix)* Orion Capital Companies Supplemental Benefits Plan, adopted in February 1991, filed as Exhibit 10(xxv) to the Company's Annual Report on Form 10-K for 1991. Exhibit 10(xx) Shareholder Agreement, dated as of November 7, 1991 by and among the Company, Guaranty National Corporation and certain wholly owned subsidiaries and affiliates filed as Exhibit 10(xxvi) to the Company's Annual Report on Form 10K for 1991. *Management contract or compensatory plan or arrangement. Exhibit 10(xxi) Loan Agreement, dated March 8, 1993, by and among the Company, the banks signatory thereto and National Westminster Bank USA, as Agent; filed as Exhibit 10(xxvi) to the Company's Annual Report on Form 10-K for 1992. Exhibit 10(xxii) Letter Agreement, dated September 13, 1993, by and between the Company and Intercargo Corporation. Exhibit 10(xxiii) Agreement, dated September 13, 1993, by and between the Company and The Harper Group, Inc. Exhibit 11 Statement re: computation of earnings per common share. Exhibit 21 Subsidiaries of the Company. Exhibit 23 Consents of Deloitte & Touche Exhibit 28 Information from reports furnished to state insurance regulatory authorities. Copies of exhibits may be obtained upon payment of a $.50 per page fee. Such requests should be made in writing to: Corporate Secretary, Orion Capital Corporation, 30 Rockefeller Plaza, New York, New York 10112. (b) Reports on Form 8-K: None. (c) Filed exhibits: See Exhibit Index (d) Financial statements of non-consolidated subsidiaries: The Audited Consolidated Financial Statements of Guaranty National Corporation and subsidiaries, Consolidated Balance Sheets at December 31, 1993 and 1992, Consolidated Statement of Earnings, Statement of Changes to Stockholders Equity and Statement of Cash Flows for the periods ended December 31, 1993, 1992 and 1991, the Related Notes to the Consolidated Financial Statements and Financial Statement Schedules are incorporated herein by reference. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. ORION CAPITAL CORPORATION By: /s/ Alan R. Gruber March 16, 1994 ------------------ Alan R. Gruber Chairman of the Board (Principal Executive) and Financial Officer) By: /s/ Daniel L. Barry March 16, 1994 --------------------- Daniel L. Barry Vice President and Controller (Principal Accounting Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons (including a majority of the members of the Board of Directors of the Registrant) in the capacities and on the dates indicated: Signature and Title Date - ---------------------- -------- /s/ Alan R. Gruber March 16, 1994 - ------------------------- Alan R. Gruber Chairman of the Board /s/ Bertram J. Cohn March 16, 1994 - ------------------------- Bertram J. Cohn Director /s/ John C. Colman March 16, 1994 - ------------------------- John C. Colman Director /s/ Peter B. Hawes March 16, 1994 - ------------------------- Peter B. Hawes Director /s/ Larry D. Hollen March 16, 1994 ------------------------ Larry D. Hollen Director /s/ R. H. Jeffrey March 16, 1994 - ------------------------- Robert H. Jeffrey Director /s/ Warren R. Lyons March 16, 1994 - ------------------------ Warren R. Lyons Director /s/ James K. McWilliams March 16, 1994 - ------------------------- James K. McWilliams Director Signature and Title Date - ---------------------- -------- /s/ R. W. Moore March 16, 1994 - ---------------------- Ronald W. Moore Director /s/ Donald Reich March 16, 1994 - ---------------------- Donald Reich Director /s/ Robert B. Sanborn March 16, 1994 - ------------------------ Robert B. Sanborn Director /s/ William J. Shepherd March 16, 1994 - -------------------------- William J. Shepherd Director /s/ John R. Thorne March 16, 1994 - -------------------------- John R. Thorne Director /s/ Roger Ware March 16, 1994 - ---------------------------- Roger B. Ware Director SCHEDULE III ORION CAPITAL CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED FINANCIAL INFORMATION OF REGISTRANT Years Ended December 31, 1993, 1992 and 1991 Note A - Reclassifications The condensed financial information of Orion Capital Corporation (the "Registrant") has been reclassified for 1992 and 1991 to conform to the classifications used in 1993. Note B - Notes Payable Notes payable consist of the following: Note C - Expense Reimbursement and Management Fees During 1991 through 1993, the Registrant was reimbursed for payroll, office rental and other expenses incurred by it to support the operations of its insurance subsidiaries. This reimbursement of $5,230,000, $4,500,000 and $4,078,000 in 1993, 1992 and 1991, respectively, is accounted for as a reduction of general and administrative expenses. The Company received an investment management fee from Guaranty National of $550,000 in 1993 and $700,000 in 1992. Note D - Sale of Guaranty National Common Stock The equity in net earnings of subsidiaries for 1991 reflects the impact of the sale of the common stock of Guaranty National by the Company's insurance subsidiaries which resulted in a net gain of $33,931,000. S-6 S-9 SCHEDULE X ORION CAPITAL CORPORATION AND SUBSIDIARIES SUPPLEMENTAL INFORMATION FOR PROPERTY-CASUALTY INSURANCE UNDERWRITERS (000s omitted) =================================================================================================================================== Column A Column B Column C Column D Column E Column F Column G Column H Column I Column J Column K -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- Reserve for Losses and Loss Unpaid Adjustment Expenses Amortization Paid Deferred Losses Discount Incurred Related to of Deferred Losses Policy and Loss Deducted Net (1) (2) Policy and Loss Affiliation with Acquisition Adjustment in Column Unearned Premiums Investment Current Prior Acquisition Adjustment Premiums Registrant Costs Expenses (C) Premiums Earned Income Year Year Costs Expenses Written (a) (b) (a) ___________________________________________________________________________________________________________________________________ 1993: Consolidated property and casualty entities $ 57,522 $1,140,403 $ 4,100 $259,359 $617,404 $ 89,260 $434,840 $ 24,292 $148,440 $374,625 $635,586 ======== ========== ======== ======== ======== ======== ======== ======== ======== ======== ======== 1992: Consolidated property and casualty entities $ 56,134 $1,081,396 $ 4,100 $232,316 $560,205 $ 81,598 $397,551 $ 26,481 $135,670 $346,201 $567,430 ======== ========== ======== ======== ======== ======== ======== ======== ======== ======== ======== 1991: Consolidated property and casualty entities $701,386 $ 98,998 $474,925 $ 63,490 $183,773 $461,888 $734,065 ======== ======== ======== ======== ======== ======== ======== (a) Balances for 1992 have been restated to reflect the adoption of SFAS No. 113, which requires reinsurance recoverables to be recorded as assets rather than offsetting liabilities. (b) Discount deducted in Column C is computed using a statutory interest rate of 3.5% at December 31, 1993 and 1992 for certain workers compensation losses. Amounts for Guaranty National are consolidated through November 20, 1991. At that date, Guaranty National became a separate registrant and files its own Form 10-K and related schedules. S-10 /TABLE EXHIBIT INDEX Exhibit 3(i) Restated Certificate of Incorporation of the Company, as amended on June 3, 1993. Exhibit 3(ii) By-Laws of the Company, as amended on May 7, 1993. Exhibit 10(xxii) Letter Agreement, dated September 13, 1993, by and between the Company and Intercargo Corporation. Exhibit 10(xxiii) Agreement, dated September 13, 1993, by and between the Company and The Harper Group, Inc. Exhibit 11 Statement re: computation of earnings per common share. Exhibit 21 Subsidiaries of the Company. Exhibit 23 Consents of Deloitte & Touche. Exhibit 28 Information from reports furnished to state insurance regulatory authorities.
37634_1993.txt	37634	1993	Item 1. Business General. FPL supplies electric service throughout most of the east and lower west coasts of Florida. This service territory contains 27,650 square miles with a population of approximately 6.5 million. During 1993, FPL served approximately 3.4 million customer accounts. Operating revenues amounted to approximately $5.2 billion, of which about 56% was derived from residential customers, 37% from commercial customers, 4% from industrial customers and 3% from other sources. FPL was incorporated in 1925 under the laws of Florida. All of its common stock is owned by FPL Group; all of its preferred stock is held by non-affiliated persons. Holding Company Act. FPL Group is a public utility holding company as defined in the Holding Company Act, but is exempt from substantially all of the provisions thereof on the basis that FPL Group's and FPL's businesses are predominantly intrastate in character and carried on substantially in a single state, in which both are incorporated. Regulation. The retail operations of FPL represent approximately 98% of operating revenues and are regulated by the FPSC, which has jurisdiction over retail rates, service territory, issuances of securities, planning, siting and construction of facilities and other matters. FPL is also subject to regulation by the FERC in various respects, including the acquisition and disposition of certain facilities, interchange and transmission services and wholesale purchases and sales of electric energy. FPL is subject to the jurisdiction of the NRC with respect to its nuclear power plants. NRC regulations govern the granting of licenses for the construction and operation of nuclear power plants and subject such power plants to continuing review and regulation. Federal, state and local environmental laws and regulations cover air and water quality, land use, power plant and transmission line siting, electric and magnetic fields from power lines and substations, noise and aesthetics, solid waste and other environmental matters. Compliance with these laws and regulations increases the cost of electric service by requiring, among other things, changes in the design and operation of existing facilities and changes or delays in the location, design, construction and operation of new facilities. FPL estimates that capital expenditures for improvements needed to comply with environmental laws and regulations will be approximately $10 million to $30 million annually for the years 1994 through 1998. These amounts are included in FPL's projected capital expenditures set forth in Item 1. Capital Expenditures. FPL holds franchises with varying expiration dates to provide electric service in various municipalities and seven counties in Florida. FPL considers its franchises to be adequate for the conduct of its business. Retail Ratemaking. The underlying concept of utility ratemaking is to set rates at a level that allows the utility to collect total revenues (revenue requirements) equal to its cost of providing service, including a reasonable return on invested capital. To accomplish this, the FPSC uses various ratemaking mechanisms. The basic costs of providing electric service, other than fuel and certain other costs, are recovered through base rates, which are designed to recover the costs of constructing, operating and maintaining the utility system. These costs include operations and maintenance expenses, depreciation and taxes, as well as a rate of return on FPL's investment in assets used and useful in providing electric service (rate base). The rate of return on rate base approximates FPL's weighted cost of capital, which includes its costs for debt and preferred stock and an allowed ROE. Base rates are determined in rate proceedings which occur at irregular intervals at the initiative of FPL, the FPSC or a substantially affected party. Fuel costs are recovered through levelized monthly charges established pursuant to the fuel clause. These charges, which are calculated semi-annually, are based on estimated costs of fuel and estimated customer usage for the ensuing six-month period, plus or minus a true-up adjustment to reflect the variance of actual costs and usage from the estimates used in setting the fuel adjustment charges for prior periods. Capacity payments to other utilities and generators for purchased power are recovered primarily through the capacity clause. Costs associated with implementing energy conservation programs are recovered through rates established pursuant to the conservation clause. Certain other non-fuel costs and the accelerated recovery of the costs of certain projects that displace oil-fired generation are recovered through the oil-backout clause. Beginning in April 1994, costs of complying with new federal, state and local environmental regulations will be recovered through the environmental compliance cost recovery clause. In the past such costs would have been recoverable through base rates. The FPSC has the power to disallow recovery of costs which it considers excessive or imprudently incurred. Such costs may include operations and maintenance expenses, the cost of replacing power lost when fossil and nuclear units are unavailable and costs associated with the construction or acquisition of new facilities. Also, the FPSC does not provide any assurance that the allowed ROE will be achieved. System Capability and Load. FPL's resources for serving load as of January 1, 1994 consist of 16,708 mw of firm electric power generated by FPL-owned facilities (see Item 2.		Item 2. Properties General. FPL considers that its properties are well maintained and in good operating condition. The electric generating, transmission, distribution and general facilities represent approximately 48%, 12%, 33% and 7%, respectively, of FPL's gross investment in electric utility plant in service. Generating Facilities. As of December 31, 1993, FPL had the following generating facilities: (1) Represents FPL's 20% ownership of SJRPP Units Nos. 1 and 2, which are jointly owned with the JEA. (2) Excludes Orlando Utilities Commission's and FMPA's combined share of approximately 15% of St. Lucie Unit No. 2. (3) Represents FPL's 49% ownership of Scherer Unit No. 4, which is jointly owned with the JEA and Georgia Power Company. FPL has contracted to purchase an additional 27% undivided ownership interest in Scherer Unit No. 4 in stages through 1995, including 17% (140 mw) in June 1994. Transmission and Distribution. FPL owns and operates 451 substations with a total capacity of 100,054,470 kva. Electric transmission and distribution lines owned and in service as of December 31, 1993 are as follows: (1) Includes approximately 80 miles owned jointly with the JEA. Character of Ownership. Substantially all of FPL's properties are subject to the lien of its mortgage, which secures debt securities issued by FPL. The principal properties of FPL are held by it in fee and are free from other encumbrances, subject to minor exceptions, none of which is of such a nature as to substantially impair the usefulness to FPL of such properties. Some of the electric lines are located on land not owned in fee but are covered by necessary consents of governmental authorities or rights obtained from owners of private property. Item 3.	Item 3. Legal Proceedings In October 1988, Union Carbide Corporation, the corporate predecessor of Praxair, Inc. (Praxair), filed suit against FPL and Florida Power Corporation (Florida Power) in the United States District Court for the Middle District of Florida. Praxair requested that Florida Power sell power to its facility located within FPL's service territory, and that FPL transport the power to the facility. Florida Power and FPL denied the request as being inconsistent with Florida law and public policy. The FPSC has issued a declaratory statement that FPL's denial of Praxair's request was proper and ordered FPL not to wheel power under such circumstances. The suit alleges that through a territorial agreement, FPL and Florida Power have conspired to eliminate competition for the sale of electric power to retail customers, thereby unreasonably restraining trade and commerce in violation of federal antitrust laws as contained in Section 1 of the Sherman Antitrust Act (Sherman Act). The suit seeks an award of three times Praxair's alleged damages in an unspecified amount based on alleged higher prices paid for electricity and product sales lost by Praxair. Cross motions for summary judgment were denied. Both parties are appealing the denials. In November 1988, TEC Cogeneration, Inc., its affiliate Thermo Electron Corporation, RRD Corp. and its affiliate Rolls Royce Inc. filed suit in the United States District Court for the Southern District of Florida against FPL and FPL Group on behalf of South Florida Cogeneration Associates (SFCA), a joint venture which since 1986 has operated a cogeneration facility for Metropolitan Dade County within FPL's service territory in Miami, Florida. The suit alleges that the defendants have engaged in anti-competitive conduct intended to prevent and defeat competition from cogenerators within FPL's service territory, and from SFCA's Metropolitan Dade County facility in particular. It alleges that the defendants' actions constitute monopolization and attempts to monopolize in violation of Section 2 of the Sherman Act; conspiracy in restraint of trade in violation of Section 1 of the Sherman Act; unlawful discrimination in prices, services or facilities in violation of Section 2 of the Clayton Act; and intentional interference with SFCA's contractual relationship with Metropolitan Dade County in violation of Florida law. The suit seeks damages in excess of $100 million, to be trebled under the Sherman and Clayton Acts, as well as compensatory and punitive damages under Florida law, and injunctive relief. FPL's motion for summary judgment has been denied. FPL believes that it has meritorious defenses to all of the litigation described above and is vigorously defending these suits. Accordingly, the liabilities, if any, arising from this litigation are not anticipated to have a material adverse effect on FPL's financial statements. Item 4.	Item 4. Submission of Matters to a Vote of Security Holders None PART II Item 5.	Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters All of FPL's common stock is owned by FPL Group. For information regarding dividends paid to FPL Group, see Management's Discussion and Note 7. Item 6.	Item 6. Selected Financial Data (1) Reduced by after-tax effect of cost reduction program or restructuring charge. See Note 2. (2) Includes unbilled sales. (3) The winter season generally represents November and December of the prior year and January through March of the current year. (4) Includes unbilled and deferred cost recovery clause revenues. Item 7.	Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations RESULTS OF OPERATIONS For the three periods presented, net income benefitted from increased energy sales, primarily from customer growth, and the effects of cost control measures. Charges associated with a cost reduction program in 1993 and a corporate restructuring in 1991 reduced net income in those years. In addition, 1992 net income was adversely affected by Hurricane Andrew. In the following discussion, all comparisons are with the corresponding items in the prior year. Operating Income - FPL's retail operations are regulated by the FPSC. Energy sales to retail customers, which represent over 96% of total energy sales, increased 4.0%, 0.1% and 3.3% in 1993, 1992 and 1991, respectively. Retail customer growth for those years was 2.1%, 1.7% and 2.1%, respectively. Revenues from base rates, which represented 61%, 57% and 56% of operating revenues for 1993, 1992 and 1991, respectively, increased for the three years presented due to higher energy sales. Revenues derived from cost recovery clauses (including fuel) and franchise fees comprise substantially all of the remaining portion of operating revenues. These revenues represent a pass- through of costs and do not significantly affect net income. With increasing competition in the utility industry, FPL is continuing its efforts to reduce its operating and capital costs and avoid filing for rate increases, the traditional response to increased rate base and cost pressures. In connection with these efforts, a major cost reduction program was implemented during 1993, resulting in a $138 million pretax charge. The charge consisted primarily of severance pay and employee retirement benefits related to a workforce reduction of approximately 1,700 positions. Approximately 45% of the charge relates to retirement benefits. Substantially all of the balance represents severance costs, of which about $60 million remains to be paid in 1994. In addition, substantial reductions were reflected in FPL's 1994-98 capital expenditure forecast, including a $210 million reduction from the previous capital expenditure forecast for 1994. The majority of the reductions in the 1994-97 period reflect a decrease in transmission and distribution expenditures through more efficient use of existing plant and more cost effective designs for new facilities. In 1991, FPL implemented a corporate restructuring that eliminated approximately 1,400 FPL positions and about 900 contractor positions. See Note 2. Other operations and maintenance expenses reflect cost savings from the 1991 restructuring, partially offset by the effects of an increasing customer base, changes in prices and operating activities, as well as the implementation of two new accounting standards relating to postretirement and postemployment benefits. See Note 4. As a result of FPL's recent cost reduction measures, other operations and maintenance expense is expected to decline in 1994, despite projected sales growth, additional generating units in service and two additional nuclear refueling outages. Higher utility plant balances, reflecting facilities added to meet customer growth, resulted in increased depreciation expense. FPL filed new depreciation studies with the FPSC in December 1993. Changes in depreciation rates, when adopted, will be retroactive to January 1994 and, together with increases in utility plant, will increase depreciation expense in 1994. In addition, FPL is scheduled to file updated nuclear decommissioning studies with the FPSC in December 1994. Changes, if any, in the accrual for nuclear decommissioning costs will be effective January 1995. See Note 1. Non-Operating Income and Deductions - AFUDC increased in 1993 and 1992 due to higher construction activity in the generation area. In future periods AFUDC is expected to decrease because the repowered Lauderdale units were placed in service in the second quarter of 1993, the Martin units are scheduled to be in service by June 1994 and no new generating capacity is under construction. During the three year period, FPL has been refunding existing debt and preferred stock with lower rate instruments. The reduction in interest due to these refundings has been offset by the interest on new debt issued to fund growth in electric plant. Premiums paid on the redemption of FPL debt are amortized over the remaining life of the respective debt securities, consistent with the ratemaking treatment. See Note 1. LIQUIDITY AND CAPITAL RESOURCES Capital Requirements and Resources - FPL's primary capital requirements consist of expenditures under its construction program. Total capital expenditures for the period 1994-98, including AFUDC, are expected to be $3.7 billion, including $879 million in 1994. Internally generated funds are expected to fund an increasing percentage of capital expenditures. The balance will be provided primarily through the issuance of long-term debt, preferred stock and commercial paper. See Note 7. Debt maturities and minimum sinking fund requirements will require cash outflows of approximately $376 million through 1998, including $2 million in 1994. See Note 8. Bank lines of credit currently available to FPL aggregate $800 million. Financial Covenants - FPL's charter and mortgage contain provisions which, under certain conditions, restrict the payment of dividends and other distributions to FPL Group. Given FPL's current financial condition and level of earnings, these restrictions do not currently limit FPL's ability to pay dividends to FPL Group. FPL's charter limits the amount of unsecured debt and FPL's mortgage limits the amount of secured debt FPL can issue. At December 31, 1993, the charter and mortgage provisions would allow issuance of approximately $1.3 billion of additional unsecured debt and $5.5 billion of additional first mortgage bonds, respectively. The amount of additional first mortgage bonds that are permitted to be issued will increase as the amount of unfunded property additions increases. FPL's charter also prohibits the issuance of preferred stock unless the preferred stock coverage ratio, as prescribed, is at least 1.5; for the twelve months ended December 31, 1993 it was 2.24. Item 8.	Item 8. Financial Statements and Supplementary Data INDEPENDENT AUDITORS' REPORT FLORIDA POWER & LIGHT COMPANY: We have audited the consolidated financial statements of Florida Power & Light Company and its subsidiaries, listed in the accompanying index as Item 14(a)1 of this Annual Report (Form 10-K) to the Securities and Exchange Commission for the year ended December 31, 1993. Our audits also comprehended the financial statement schedules of Florida Power & Light Company and its subsidiaries, listed in the accompanying index as Item 14(a)2. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Florida Power & Light Company and its subsidiaries at December 31, 1993 and 1992 and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information shown therein. As discussed in Notes 3 and 4 to the consolidated financial statements, Florida Power & Light Company and its subsidiaries changed their method of accounting for income taxes and postretirement benefits other than pensions effective January 1, 1993. DELOITTE & TOUCHE Certified Public Accountants Miami, Florida February 11, 1994 FLORIDA POWER & LIGHT COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (Thousands of Dollars) The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. FLORIDA POWER & LIGHT COMPANY AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS ASSETS (Thousands of Dollars) The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. FLORIDA POWER & LIGHT COMPANY AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS CAPITALIZATION AND LIABILITIES (Thousands of Dollars) The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. FLORIDA POWER & LIGHT COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Thousands of Dollars) (1) Represents the effect on cash flows from operating activities of the net amounts deferred or recovered under the fuel and purchased power, oil- backout, energy conservation, capacity and environmental cost recovery clauses. (2) Excludes allowance for other funds used during construction. The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. FLORIDA POWER & LIGHT COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Years Ended December 31, 1993, 1992 and 1991 1. Summary of Significant Accounting and Reporting Policies Basis of Presentation - The consolidated financial statements include the accounts of Florida Power & Light Company (FPL) and its subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation. FPL is a wholly-owned subsidiary of FPL Group, Inc. (FPL Group). Certain amounts included in prior years' consolidated financial statements have been reclassified to conform to the current year's presentation. Regulation - FPL's accounting practices are subject to regulation by the Florida Public Service Commission (FPSC) and the Federal Energy Regulatory Commission (FERC). As a result of such regulation, FPL follows the accounting practices set forth in Statement of Financial Accounting Standard (SFAS) No. 71, "Accounting for the Effects of Certain Types of Regulation." Revenues and Rates - Retail and wholesale utility rate schedules are approved by the FPSC and the FERC, respectively. FPL records the estimated amount of base revenues for energy delivered to customers but not billed. Such unbilled revenues are included in receivables - customers and amounted to approximately $112 million and $120 million at December 31, 1993 and 1992, respectively. Revenues include amounts resulting from cost recovery clauses, which are designed to permit full recovery of certain costs and provide a return on certain assets utilized by these programs, and franchise fees. Such revenues represent a pass-through of costs and include substantially all fuel, purchased power and interchange expenses, conservation-related expenses, revenue taxes and franchise fees. Revenues from cost recovery clauses are recorded when billed; FPL achieves matching of costs and related revenues by deferring the net under or over recovery. Electric Utility Plant, Depreciation and Amortization - The cost of additions to units of utility property is added to electric utility plant. The cost of units of property retired, less net salvage, is charged to accumulated depreciation. Maintenance and repairs of property as well as replacements and renewals of items determined to be less than units of property are charged to other operations and maintenance expense. Depreciation of utility property is provided primarily on a straight-line average remaining life basis. Depreciation studies are performed at least every four years for substantially all utility property. The weighted annual composite depreciation rate was approximately 3.9%, 3.5% and 3.8% for the years 1993, 1992 and 1991, respectively. These rates exclude decommissioning expense and certain accelerated depreciation under cost recovery clauses. All depreciation methods and rates are approved by the FPSC. Nuclear fuel costs, including a charge for spent nuclear fuel disposal, is accrued in fuel expense on a unit of production method. Substantially all electric utility plant is subject to the lien of the Mortgage and Deed of Trust, as supplemented, securing FPL's first mortgage bonds. Allowance for Funds Used During Construction (AFUDC) - FPL recognizes AFUDC as a noncash item which represents the allowed cost of capital used to finance a portion of its construction work in progress. AFUDC is capitalized as an additional cost of utility plant and is recorded as an addition to income. The capitalization rate used in computing AFUDC was 8.67% from January 1993 through June 1993, 8.26% from July 1993 through December 1993, 8.61% in 1992 and 8.46% in 1991. Nuclear Decommissioning - FPL accrues nuclear decommissioning costs over the expected service life of each plant. Nuclear decommissioning studies are performed at least every five years for FPL's four nuclear units. A provision for nuclear decommissioning of $38 million for each of the years 1993, 1992 and 1991 is included in depreciation expense. The accumulated provision for nuclear decommissioning totaled $445 million and $390 million at December 31, 1993 and 1992, respectively, and is included in accumulated depreciation. Amounts equal to decommissioning expense are deposited in either qualified funds on a pretax basis or in a non-qualified fund on a net of tax basis. Fund earnings, net of taxes, are reinvested in the funds. Both fund earnings and the charge resulting from reinvestment of the earnings are included in other income (deductions). The related income tax effects are included in deferred taxes. The decommissioning reserve funds may be used only for the payment of the cost of decommissioning FPL's nuclear units. Securities held in the funds consist primarily of tax-exempt obligations and are carried at cost. See Note 9. The most recent decommissioning studies assume prompt dismantlement for the Turkey Point nuclear units commencing in the year 2005 and for St. Lucie Unit No. 2 commencing in 2021. St. Lucie Unit No. 1 will be mothballed in 2016 until St. Lucie Unit No. 2 is ready for dismantlement. FPL's portion of the cost of decommissioning these units, including dismantlement and reclamation, expressed in 1993 dollars, is currently estimated to aggregate $935 million. Storm and Property Insurance Reserve Fund - The storm and property insurance reserve fund provides coverage toward storm damage costs and possible retrospective premium assessments stemming from a nuclear incident under the various insurance programs covering FPL's nuclear generating plants. The storm and property insurance reserve represents amounts accumulated to date net of expenditures for storm damages. The related income tax effects are included in accumulated deferred income taxes. Securities held in the fund consist primarily of tax-exempt obligations and are carried at cost. In 1992, $21 million of the storm fund was used for storm damage costs associated with Hurricane Andrew. See Note 9. Cash Equivalents - Cash equivalents consist of short-term, highly liquid investments with original maturities of three months or less. The carrying amount of these investments approximates their market value. Retirement of Long-Term Debt - The excess of reacquisition cost over the book value of long-term debt is deferred and amortized to expense ratably over the remaining life of the original issue, which is consistent with its treatment in the ratemaking process. Rate Matters - Deferred litigation items at December 31, 1993 and 1992, represent costs approved by the FPSC for recovery over five years commencing with the effective date of new base rates to be established in the next general rate proceeding. Income Taxes - Deferred income taxes are provided on all significant temporary differences between the financial statement and tax bases of assets and liabilities. Investment tax credits are used to reduce current federal income taxes and are deferred and amortized to income over the approximate lives of the related property. FPL is included in the consolidated federal income tax return filed by FPL Group. FPL determines its income tax provision on the "separate return method." See Note 3. 2. Cost Reduction Program and Restructuring Charge In 1993, FPL implemented a major cost reduction program, which resulted in a $138 million charge and reduced net income by approximately $85 million. The program consisted primarily of a Voluntary Retirement Plan (VRP) and a Special Severance Plan (SSP). The VRP was offered to all employees who were at least 54 years of age and had at least 10 years of service. The plan, among other things, added five years to age and service for the determination of plan benefits to be received by eligible employees. Approximately 700 employees, or 75% of those eligible, elected to retire under this program. The impact on pension cost resulting from the two programs as determined under the provisions of SFAS No. 88, "Employers' Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits," was approximately $34 million. The impact on postretirement benefits as determined under SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" was approximately $29 million. These amounts are included as part of the total charge of $138 million. See Note 4. In 1991, FPL recorded a $90 million restructuring charge in connection with a company-wide restructuring which reduced net income by $56 million. The charge included severance pay for departing employees, as well as relocation and facility modification expenditures. 3. Income Taxes In 1993, FPL adopted SFAS No. 109, "Accounting for Income Taxes," which requires the use of the liability method in accounting for income taxes. Under the liability method, the tax effect of temporary differences between the financial statement and tax bases of assets and liabilities are reported as deferred taxes measured at current tax rates. The principal effect of adopting SFAS No. 109 was the reclassification of the revenue equivalent of deferred taxes in excess of the amount required to be reported as a liability under SFAS No. 109 from accumulated deferred income taxes to a newly- established deferred regulatory credit - income taxes. This amount will be amortized over the estimated lives of the assets or liabilities which resulted in the initial recognition of the deferred tax amount. Adoption of this standard had no effect on results of operations. The net result of amortizing the deferred regulatory credit and the related deferred taxes established under SFAS No. 109 is to yield comparable amounts to those included in the tax provision under accounting rules applicable to prior periods. The components of income taxes are as follows: A reconciliation between income tax expense and the expected income tax expense at the applicable statutory rates is as follows: The income tax effects of temporary differences giving rise to FPL's deferred income tax assets and liabilities after adoption of SFAS No. 109 are as follows: 4. Employee Retirement Benefits Pension Benefits - Substantially all employees of FPL are covered by FPL Group's noncontributory defined benefit pension plan. Plan benefits are generally based on employees' years of service and compensation during the last years of employment. Participants are vested after five years of service. Plan assets consist primarily of bonds, common stocks and short- term investments. Any pension cost recognized by FPL Group is allocated to FPL on a pro rata basis. For 1993, 1992 and 1991 the components of pension cost which were allocated to FPL, a portion of which has been capitalized, are as follows: Prior to 1993, an adjustment was made to reflect in the results of operations the pension cost calculated under the actuarial cost method used for ratemaking purposes. In 1993, FPL adopted consistent pension measurements for ratemaking and financial reporting. The accumulated regulatory adjustment is being amortized to income over five years. At December 31, 1993 and 1992, the cumulative amounts of these regulatory adjustments included in other deferred credits were approximately $16 million and $20 million, respectively. During 1992, the method used for valuing plan assets in the calculation of pension cost was changed from fair value to a calculated market-related value. The new method was adopted to reduce the volatility in annual pension expense that results from short-term fluctuations in the securities markets. The cumulative effect of the change was to reduce prepaid pension cost and the related accumulated regulatory adjustment by approximately $37 million, with no effect on earnings. During 1993, the effect of a prior plan amendment that changed the manner in which benefits accrue was recognized and included as part of prior service cost to be amortized over the remaining service life of the employees. FPL funds the pension cost calculated under the entry age normal level percentage of pay actuarial cost method, provided that this amount satisfies the Employee Retirement Income Security Act minimum funding standards and is not greater than the maximum tax deductible amount for the year. No contributions to the plan were required for 1993, 1992 or 1991. In 1993, the FPL pension plan and the FPL Group pension plan were combined. Accordingly, the 1992 amounts have been restated to present the position of the combined plans. Any pension cost recognized by FPL Group has been allocated to FPL on a pro rata basis. At December 31, 1993, the portion of prepaid pension cost recognized in FPL's statement of position was a liability of approximately $.3 million. A reconciliation of the funded status of the combined FPL Group Plan is presented below: (1) Includes $37 million effect of changing to calculated market-related method of valuing plan assets. As of December 31, 1993 and 1992, the weighted-average discount rate used in determining the actuarial present value of the projected benefit obligation was 7.0% and 6.0%, respectively. The assumed rate of increase in future compensation levels at those respective dates was 5.5% and 6.0%. The expected long-term rate of return on plan assets used in determining pension cost was 7.75% for 1993 and 7.0% for 1992 and 1991. Other Postretirement Benefits - Substantially all employees of FPL are covered by FPL Group's defined benefit postretirement plans for health care and life insurance benefits. Eligibility for health care benefits is based upon age plus years of service at retirement. The plans are contributory, and contain cost-sharing features such as deductibles and coinsurance. FPL Group has capped company contributions for postretirement health care at a defined level which, depending on actual claims experience, may be reached by the year 2000. Generally, life insurance benefits for retirees are capped at $50,000. FPL Group's policy is to fund postretirement benefits in amounts determined at the discretion of management. Benefit payments in 1993 and 1992 totaled $13 million and $12 million, respectively, and were paid out of existing plan assets. In 1993, FPL adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions." For the year ended December 31, 1993, the components of net periodic postretirement benefit cost allocated to FPL, a portion of which has been capitalized, are as follows: A reconciliation of the funded status of the combined FPL Group Plan is presented below. The portion of accrued postretirement benefit cost recognized in the statement of position of FPL is approximately $44 million. The weighted-average annual assumed rate of increase in the per capita cost of covered benefits (i.e., health care cost trend rate) for 1993 is 10.5% for retirees under age 65 and 6.5% for retirees over age 65. These rates are assumed to decrease gradually to 6.0% by the year 2000, which is when it is anticipated that benefit costs will reach the defined level at which FPL Group's contributions will be capped. The cap on FPL Group's contributions mitigates the potential significant increase in costs resulting from an increase in the health care cost trend rate. Increasing the assumed health care cost trend rate by one percentage point would increase the plan's accumulated postretirement benefit obligation as of December 31, 1993 by $8 million, and the aggregate of the service and interest cost components of net periodic postretirement benefit cost of the plan for 1993 by approximately $1 million. The weighted-average discount rate used in determining the accumulated postretirement benefit obligation was 7.0% at December 31, 1993. The expected long-term rate of return on plan assets was 7.75% at December 31, 1993. Postemployment Benefits - In 1993, FPL adopted SFAS No. 112, "Employers' Accounting for Postemployment Benefits," which requires a change from recognizing expenses when paid to recording the benefits as the liability is incurred. Implementation of this pronouncement did not have a material effect on FPL's results of operations. 5. Leases In 1991, FPL expanded its nuclear fuel lease program to include all four of its nuclear units. In connection with this expansion, FPL sold to a non-affiliated lessor and leased back approximately $220 million of nuclear fuel held in reactors of these units, as well as nuclear fuel in various stages of enrichment. The fuel was sold at book value. Nuclear fuel payments, which are based on energy production and are charged to fuel expense, were $122 million, $120 million and $81 million for the years ended December 31, 1993, 1992 and 1991, respectively. Included in these payments was an interest component of $11 million, $13 million and $9 million in 1993, 1992 and 1991, respectively. Under certain circumstances of lease termination, FPL is required to purchase all nuclear fuel in whatever form at a purchase price designed to allow the lessor to recover its net investment cost in the fuel, which totaled $226 million at December 31, 1993. For ratemaking purposes, the leases encompassed within this lease arrangement are classified as operating leases. For financial reporting purposes, the capital lease obligation is recorded at the amount due in the event of lease termination. In 1992, FPL entered into a noncancellable capital lease arrangement for an office building whose net book value at December 31, 1993 and 1992 was approximately $46 million and $48 million, respectively. The present value of future minimum lease payments at December 31, 1993 totaled $49 million. Future minimum annual lease payments under this lease arrangement, which expires in 2016, are estimated to be $4 million. Excluding these leases, the amount of assets and capitalized lease obligations for other capital leases is not material. FPL leases automotive, computer, office and other equipment through rental agreements with various terms and expiration dates. Rental expense totaled $31 million, $53 million and $50 million for 1993, 1992 and 1991, respectively. Minimum annual rental commitments for noncancellable operating leases are $21 million for 1994, $18 million for 1995, $12 million for 1996, $6 million for 1997, $5 million for 1998 and $13 million thereafter. 6. Jointly-Owned Facilities FPL owns approximately 85% of the St. Lucie Nuclear Unit No. 2, 20% of the St. Johns River Power Park (SJRPP) units and coal terminal and a 49% undivided interest in Scherer Unit No. 4. FPL expects to purchase an additional 27% undivided ownership interest in Scherer Unit No. 4 in two stages through 1995. At December 31, 1993, FPL's investment in St. Lucie Unit No. 2 was $768 million, net of accumulated depreciation of $397 million; the investment in the SJRPP units and coal terminal was $221 million, net of accumulated depreciation of $110 million; the investment in Scherer Unit No. 4 was $296 million, net of accumulated depreciation of $54 million. FPL is responsible for its share of the operating costs, as well as providing its own financing. At December 31, 1993, there was no significant balance of construction work in progress on these facilities. 7. Common Shareholder's Equity The changes in common shareholder's equity accounts are as follows: (1) Common stock, no par value, 1,000 shares authorized, issued and outstanding. FPL's charter and mortgage contain provisions that, under certain conditions, restrict the payment of dividends and other distributions to FPL Group. Given FPL's current financial condition and level of earnings, these restrictions do not currently limit FPL's ability to pay dividends to FPL Group. In 1993, 1992 and 1991 FPL paid, as dividends to FPL Group, its net income available to FPL Group on a one-month lag basis. 8. Preferred Stock and Long-Term Debt Preferred Stock (1) (1) FPL's charter authorizes the issuance of 5 million shares of subordinated preferred stock, no par value. No shares of subordinated preferred stock are outstanding. In 1993, FPL issued 1,900,000 shares of $100 par value preferred stock. In 1992, FPL issued 5,000,000 shares of $2.00 No Par Value, Series A, preferred stock. There were no issuances of preferred stock in 1991. (2) Not redeemable prior to 2003. (3) Minimum annual sinking fund requirements on preferred stock are approximately $2 million for each of the years 1994 and 1995 and $4 million for each of the years 1996, 1997 and 1998. In the event that FPL should be in arrears on its sinking fund obligations, FPL may not pay dividends on common stock. (4) Entitled to a sinking fund to retire a minimum of 15,000 shares and a maximum of 30,000 shares annually from 1994 through 2026 at $100 per share plus accrued dividends. FPL redeemed and retired 15,000 shares in 1992, satisfying the 1993 minimum annual sinking fund requirement. (5) Entitled to a sinking fund to retire a minimum of 25,000 shares and a maximum of 50,000 shares annually from 1996 through 2015 at $100 per share plus accrued dividends. Long-Term Debt(1)(2) (1) Minimum annual maturities and sinking fund requirements of long-term debt are approximately $80 million for 1995, $100 million for 1996 and $181 million for 1998. (2) Available lines of credit aggregated approximately $800 million at December 31, 1993, all of which were based on firm commitments. (3) Excludes approximately $46 million principal amount of bonds removed from the balance sheet in December 1993 as a result of an in-substance defeasance. Such bonds were redeemed in January 1994 with funds previously placed in an irrevocable trust. 9. Fair Value of Financial Instruments The following estimates of the fair value of financial instruments have been made using available market information and other valuation methodologies. However, the use of different market assumptions or methods of valuation could result in different estimated fair values. (1) Based on the quoted market prices for these or similar issues. (2) Includes current maturities. 10. Commitments and Contingencies Capital Commitments - FPL has made certain commitments in connection with its projected capital expenditures. These expenditures, for the construction or acquisition of additional facilities and equipment to meet customer demand, are estimated to be $3.7 billion, including AFUDC, for the years 1994 through 1998. Insurance - Liability for accidents at nuclear power plants is governed by the Price-Anderson Act, which limits the liability of nuclear reactor owners to the amount of the insurance available from private sources and under an industry retrospective payment plan. In accordance with this Act, FPL maintains $200 million of private liability insurance, which is the maximum obtainable, and participates in a secondary financial protection system under which it is subject to retrospective assessments of up to $317 million per incident at any nuclear utility reactor in the United States, payable at a rate not to exceed $40 million per incident per year. FPL participates in insurance pools and other arrangements that provide $2.75 billion of limited insurance coverage for property damage, decontamination and premature decommissioning risks at its nuclear plants. The proceeds from such insurance, however, must first be used for reactor stabilization and site decontamination before they can be used for plant repair. FPL also participates in an insurance program that provides limited coverage for replacement power costs if a plant is out of service because of an accident. In the event of an accident at one of FPL's or another participating insured's nuclear plant, FPL could be assessed up to $58 million in retrospective premiums, and in the event of a subsequent accident at such nuclear plants during the policy period, the maximum assessment is $72 million under the programs in effect at December 31, 1993. This contingent liability would be partially offset by a portion of FPL's storm and property insurance reserve (storm fund), which totaled $82 million at that date. In the event of a catastrophic loss at one of FPL's nuclear plants, the amount of insurance available may not be adequate to cover property damage and other expenses incurred. Uninsured losses, to the extent not recovered through rates, would be borne by FPL and could have a material adverse effect on FPL's financial condition. In 1993, FPL replaced its transmission and distribution (T&D) property insurance coverage with a self-insurance program due to the high cost and limited coverage available from third-party insurers. Costs incurred under the self-insurance program will be charged against FPL's storm fund. Recovery of any losses in excess of the storm fund from ratepayers will require the approval of the FPSC. FPL's available lines of credit include $300 million to provide additional liquidity in the event of a T&D property loss. Contracts - FPL has take-or-pay contracts with the Jacksonville Electric Authority (JEA) for 374 megawatts (mw) through 2023 and with the subsidiaries of the Southern Company to purchase 1,406 mw of power through May 1994, and declining amounts thereafter through mid-2010. FPL also has various firm pay-for-performance contracts to purchase 1,031 mw from certain cogenerators and small power producers (qualifying facilities) with expiration dates ranging from 2002 through 2026. These contracts provide for capacity and energy payments. Capacity payments for the pay-for-performance contracts are subject to the qualifying facilities meeting certain contract obligations. Energy payments are based on the actual power taken under these contracts. The required capacity payments through 1998 under these contracts are estimated to be as follows: FPL's capacity and energy charges under these contracts for 1993, 1992 and 1991 were as follows: (1) Recovered through base rates and the capacity cost recovery clause (capacity clause). (2) Recovered through the capacity clause. (3) Recovered through the fuel and purchased power cost recovery clause. (4) Recoverable through base rates. FPL has take-or-pay contracts for the supply and transportation of natural gas under which it is required to make payments estimated to be $280 million for 1994, $380 million for 1995 and $390 million for each of the years 1996, 1997 and 1998. Total payments made under these contracts were $270 million, $269 million and $221 million for 1993, 1992 and 1991, respectively. Litigation - Union Carbide Corporation sued FPL and Florida Power Corporation alleging that, through a territorial agreement approved by the FPSC, they conspired to eliminate competition in violation of federal antitrust laws. Praxair, Inc., an entity that was formerly a unit of Union Carbide, has been substituted as the plaintiff. The suit seeks treble damages of an unspecified amount based on alleged higher prices paid for electricity and product sales lost. Cross motions for summary judgment were denied. Both parties are appealing the denials. A suit brought by the partners in a cogeneration project located in Dade County, Florida, alleges that FPL has engaged in anti-competitive conduct intended to eliminate competition from cogenerators generally, and from their facility in particular, in violation of federal antitrust laws and have wrongfully interfered with the cogeneration project's contractual relationship with Metropolitan Dade County. The suit seeks damages in excess of $100 million before trebling under antitrust law, plus other unspecified compensatory and punitive damages. FPL's motion for summary judgment has been denied. FPL believes that it has meritorious defenses to all of the litigation described above and is vigorously defending these suits. Accordingly, the liabilities, if any, arising from this litigation are not anticipated to have a material adverse effect on FPL's financial statements. 11. Transactions with Related Parties FPL provides certain services to and receives services from FPL Group, or other subsidiaries of FPL Group. The full cost of such services is charged to the entity benefitting from the service. In addition, certain common costs of FPL Group are allocated to all subsidiaries, including FPL, based primarily on each subsidiary's equity. Neither current period amounts charged or allocated, nor balances outstanding, were material for any year. See Note 3 - Income Taxes. 12. Quarterly Data (Unaudited) Condensed consolidated quarterly financial information for 1993 and 1992 is as follows: (1) In the opinion of FPL, all adjustments, which consist of normal recurring accruals necessary to present a fair statement of such amounts for such periods, have been made. Results of operations for an interim period may not give a true indication of results for the calendar year. (2) Charge resulting from cost reduction program reduced amount shown by $85 million. See Note 2. 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 DIRECTORS(1) James L. Broadhead. Mr. Broadhead, 58, is chairman and chief executive officer of FPL. He is also chairman, president and chief executive officer of FPL Group and president and chief executive officer of FPL Group Capital Inc. Mr. Broadhead is a director of FPL Group and its subsidiary FPL Group Capital Inc, Barnett Banks, Inc., Delta Air Lines, Inc. and The Pittston Company. He is also a board fellow of Cornell University. Mr. Broadhead has been a director of FPL since 1989. Dennis P. Coyle. Mr. Coyle, 55, is general counsel and secretary of FPL and FPL Group. He is also secretary of FPL Group Capital Inc. Mr. Coyle was formerly vice president of FPL Group and partner of the law firm Steel Hector & Davis. Mr. Coyle has been a director of FPL since 1990. Paul J. Evanson. Mr. Evanson, 52, is senior vice president, finance and chief financial officer of FPL, vice president, finance and chief financial officer of FPL Group and vice president and chief financial officer of FPL Group Capital Inc. He is a director of FPL Group Capital Inc, Lynch Corporation and Southern Energy Homes, Inc. Mr. Evanson was formerly president and chief operating officer of the Lynch Corporation, a diversified holding company. Mr. Evanson has been a director of FPL since 1992. Stephen E. Frank. Mr. Frank, 52, is president and chief operating officer of FPL. He was formerly executive vice president and chief financial officer of TRW, Inc., a Cleveland-based diversified, high technology, multinational company. He is a director of FPL Group, Arkwright Mutual Insurance Company and Great Western Financial Corporation and a trustee of the University of Miami. Mr. Frank has been a director of FPL since 1990. Jerome H. Goldberg. Mr. Goldberg, 62, is president of FPL's nuclear division. He was formerly executive vice president of FPL and group vice president- nuclear of Houston Lighting & Power Company, an electric utility. Mr. Goldberg has been a director of FPL since 1990. Lawrence J. Kelleher. Mr. Kelleher, 46, is senior vice president, human resources of FPL and vice president, human resources of FPL Group. He was formerly chief human resources officer of FPL, director of corporate development of FPL Group and director of management services of FPL. Mr. Kelleher has been a director of FPL since 1990. J. Thomas Petillo. Mr. Petillo, 49, is senior vice president, external affairs of FPL. He was formerly group vice president of FPL. Mr. Petillo has been a director of FPL since 1991. C. O. Woody. Mr. Woody, 55, is senior vice president, power generation of FPL. He was formerly executive vice president of FPL. Mr. Woody has been a director of FPL since 1990. Michael W. Yackira. Mr. Yackira, 42, is senior vice president, market and regulatory services of FPL. He was formerly chief planning officer of FPL, vice president of FPL Group and vice president of GTE Florida, a telecommunications company, and assistant controller of GTE Service Corp., a telecommunications company. Mr. Yackira has been a director of FPL since 1990. (1) Directors are elected annually and serve until their resignation, removal or until their respective successors are elected. Includes each director's business experience during the past five years. EXECUTIVE OFFICERS(1) (1) Executive officers are elected annually by, and serve at the pleasure of, FPL's Board of Directors. The business experience of the above named executive officers is as follows: Mr. Davis was previously comptroller of FPL. Ms. Samil was previously assistant treasurer of FPL and FPL Group. For the business experience of the remaining executive officers, see Item 10. Directors and Executive Officers of the Registrant - Directors. Item 11.	Item 11. Executive Compensation The following table sets forth compensation paid during the past three years to FPL's chief executive officer and the other four most highly-compensated persons who served as executive officers of FPL at December 31, 1993. SUMMARY COMPENSATION TABLE (1) Dividends at normal rates are paid on restricted common stock. (2) Payouts were made 60% in shares of common stock, valued at $37.875 per share, and 40% in cash. (3) Employer matching contributions to employee thrift plans. (4) At December 31, 1993, Mr. Broadhead held 96,800 shares of restricted common stock with a value of $3,787,300. These shares were awarded in 1991 for the purpose of financing Mr. Broadhead's supplemental retirement plan and will offset lump sum benefits that would otherwise be payable to him in cash upon retirement. See Retirement Plans herein. (5) At December 31, 1993, Mr. Frank held 1,882 shares of restricted common stock with a value of $73,633. A total of 5,644 shares were awarded to Mr. Frank in 1991 pursuant to an undertaking made to him when he was initially employed by FPL and vested in equal installments on February 15, 1992, 1993 and 1994. Stock Options The following table sets forth information with respect to the only executive officer named in the Summary Compensation Table who held any stock options or stock appreciation rights (SARs) during 1993. Long Term Incentive Plan Awards In 1993 and 1994, awards of performance shares under FPL Group's Long Term Incentive Plan were made to the executive officers named in the Summary Compensation Table as set forth in the following table. LONG TERM INCENTIVE PLAN AWARDS The performance share awards shown above are payable at the end of the four-year performance periods. The amount of the payout is determined by multiplying the participant's target number of shares by his average level of attainment, expressed as a percentage, which may not exceed 100%, of his targeted awards under the Annual Incentive Plans for each of the years encompassed by the award period. The incentive performance measures were financial (weighted 50%), operating (weighted 30%) and major projects (weighted 20%). The financial performance indicators were operations and maintenance costs, capital expenditure levels, book and regulatory return on equity and net income. The operating performance indicators were customer satisfaction survey results, service reliability as measured by the frequency and duration of service interruptions, system performance as measured by the equivalent availability factors for the fossil and nuclear power plants, unplanned trips of nuclear power plants, the NRC's systematic assessment of licensee performance for the nuclear plants, employee staffing levels, number of significant environmental violations and employee safety. The major projects performance indicators were load management installed capability, the adherence to schedules and budgets for the Lauderdale repowering project, the Martin plant construction project, and customer information system project, implementation of an integrated resource plan and conservation programs annual installed capacity. If FPL Group shareholders approve the Annual Incentive Plan and Long Term Incentive Plan described in FPL Group's proxy statement for the 1994 Annual Meeting, future annual incentive payouts will be based on achieving specific net income goals. Payouts under the current Long Term Incentive Plan can range from zero to 100% of the target amount. Payouts under the proposed new Long Term Incentive Plan can range from zero to 160%. Retirement Plans FPL Group maintains a non-contributory defined benefit pension plan and supplemental executive retirement plans which cover FPL employees. The following table shows the estimated annual benefits, calculated on a straight-line annuity basis, payable upon retirement in 1993 at age 65 after the indicated years of service. PENSION PLAN TABLE The compensation covered by the plans includes annual salaries and bonuses of officers of FPL Group and annual salaries of officers of FPL, as shown in the Summary Compensation Table, but no other amounts shown in the Table. The estimated credited years of service for the executive officers named in the Summary Compensation Table are: Mr. Broadhead, 5 years; Mr. Frank, 3 years; Mr. Goldberg, 4 years; Mr. Coyle, 4 years; and Mr. Woody, 37 years. A supplemental retirement plan for Mr. Broadhead provides for a lump-sum retirement benefit equal to the then present value of a joint and survivor annuity providing annual payments to him equal to 61% to 65% of his average annual compensation for the three years prior to his retirement between age 62 (1998) and age 65 (2001) and to his surviving beneficiary of 37.5% of such average annual compensation, reduced by the then present value of the annual amount of payments to which he is entitled under all other pension and retirement plans of FPL Group and former employers. This benefit is further reduced by the then value of 96,800 shares of restricted common stock which vest as to 77,000 shares in 1998 and as to 19,800 shares in 2001. Upon a change of control of FPL Group, (as defined below under Employment Agreements), the restrictions on the restricted stock lapse and the full retirement benefit becomes payable. Upon termination of Mr. Broadhead's employment agreement (also described below) without cause, the restrictions on the restricted stock lapse and he becomes fully vested under the supplemental retirement plan. Absent any such change of control or termination of employment, Mr. Broadhead will have no right to such shares of restricted stock, and there will be no payments under the supplemental retirement plan, unless he remains with the Corporation until at least age 62. Mr. Goldberg's employment agreement with FPL provides for a retirement benefit which, together with the amount received by him pursuant to his former employer's deferred compensation program, equals the total postretirement benefits he would have received if he had remained employed by such employer until age 65. The terms of Mr. Frank's employment with FPL provide for a benefit, upon retirement at age 62 or more, equal to the difference between a pension benefit for 30 years of credited service and the normal pension plan benefit. A supplemental retirement plan for Mr. Coyle provides for benefits, upon retirement at age 62 or more, based on two times his credited years of service. FPL Group sponsors a split-dollar life insurance plan for certain of FPL and FPL Group's senior officers. Benefits under the split-dollar plan are provided by universal life insurance policies purchased by FPL Group. If the officer dies prior to retirement, the officer's beneficiaries generally receive two and one-half times the officer's annual salary at the time of death. If the officer dies after retirement, the officer's beneficiaries receive between 50% to 100% of the officer's final annual salary. Each officer is taxable on the insurance carrier's one year term rate for his or her life insurance coverage. Employment Agreements FPL Group has entered into an employment agreement with Mr. Broadhead for an initial term ending December 1997, with automatic one-year extensions thereafter unless either party elects not to extend. The agreement provides for a base salary of $795,800 plus annual and long-term incentive compensation opportunities at least equal to those currently in effect. If FPL Group terminates Mr. Broadhead's employment without cause, he is entitled to receive a lump sum payment of two years' compensation. Compensation is measured by the then current base salary plus the average of the preceding two years' annual incentive awards. He would also be entitled to receive all amounts accrued under all performance share grants in progress, prorated for the year of termination and assuming achievement of the targeted award, and to full vesting of his benefits under his supplemental retirement plan. FPL Group and FPL have entered into employment agreements with certain officers, including the individuals named in the Summary Compensation Table (other than Mr. Goldberg), to become effective in the event of a change of control of FPL Group, which is defined as the acquisition of beneficial ownership of 20% of the voting power of FPL Group, certain changes in FPL Group's Board, or approval by the shareholders of the liquidation of FPL Group or of certain mergers or consolidations or of certain transfers of FPL Group's assets. These agreements are intended to assure FPL of the continued services of key officers. The agreements provide that each officer shall be employed by FPL Group or one of its subsidiaries in his or her then current position, with compensation and benefits at least equal to the then current base and incentive compensation and benefit levels, for an employment period of four, and in certain cases five, years after a change of control occurs. In the event that the officer's employment is terminated (except for death, disability or cause) or if the officer terminates his or her employment for good reason, as defined in the agreement, the officer is entitled to severance benefits in the form of a lump sum payment equal to the compensation due for the remainder of the employment period or for two years, whichever is longer. Such benefits would be based on the officer's then base salary plus an annual bonus at least equal to the average bonus for the two years preceding the change of control. The officer is also entitled to the maximum amount payable under all long-term incentive compensation grants outstanding, continued coverage under all employee benefit plans, supplemental retirement benefits and reimbursement for any tax penalties incurred as a result of the severance payments. An employment agreement between Mr. Goldberg and FPL, which expires in 1994, provides for a base salary of at least $350,000 per year, targeted annual incentive compensation equal to 35% of his base salary, and either the retirement benefit described above under Retirement Plans plus a death benefit to his beneficiary equal to 300% of his base salary, payable over 6 years, or, if he dies before his contract expires, a death benefit to his beneficiary equal to 550% of his base salary, payable over 10 years. Director Compensation All of the directors of FPL are salaried employees of FPL and do not receive any additional compensation for serving as a director. Item 12.	Item 12. Security Ownership of Certain Beneficial Owners and Management FPL Group owns 100% of FPL's common stock. FPL's directors and executive officers beneficially own shares of common stock as follows: (1) Includes 1,907 shares held in the Thrift Plans and 96,800 shares of restricted stock as to which Mr. Broadhead has voting but not investment power. (2) Includes 1,864 shares held in the Thrift Plans. (3) Includes 137 shares held in the Thrift Plans. (4) Includes 884 shares held in the Thrift Plans and 1,882 shares of restricted stock as to which Mr. Frank has voting but not investment power. (5) Includes 2,051 shares held in the Thrift Plans. (6) Includes 5,483 shares held in the Thrift Plans. (7) Includes 5,178 shares held in the Thrift Plans and 38 shares held beneficially by a relative of Mr. Petillo with whom he shares investment power and to which he disclaims any beneficial ownership. (8) Includes 12,868 shares held in the Thrift Plans and 1,787 shares subject to exercisable stock options. (9) Includes 2,856 shares held in the Thrift Plans. (10) Less than 1% of the common stock outstanding. Includes 36,960 shares held in the Thrift Plans and 1,787 shares subject to exercisable stock options. Item 13.	Item 13. Certain Relationships and Related Transactions None PART IV Item 14.	Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) 1. Financial Statements Page(s) Independent Auditors' Report 12 Consolidated Statements of Income for the Years Ended December 31, 1993, 1992 and 1991 13 Consolidated Balance Sheets at December 31, 1993 and 1992 14-15 Consolidated Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 16 Notes to Consolidated Financial Statements for the Years Ended December 31, 1993, 1992 and 1991 17-29 2. Financial Statement Schedules(1) Schedule V Property, Plant and Equipment 39-40 Schedule VI Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment 41-42 Schedule IX Short-Term Borrowings 43 Schedule X Supplementary Income Statement Information 44 (1) All other schedules are omitted as not applicable or not required. 3. Exhibits including those Incorporated by Reference Exhibit Number Description 1(a) Form of Proposal and attached Underwriting Agreement dated December 6, 1993 1(b) Underwriting Agreement between the Dade County Industrial Development Authority and Goldman, Sachs & Co., Artemis Capital Group, Inc., First Equity Corporation of Florida and Howard Gary & Company dated December 20, 1993 3(i)a Restated Articles of Incorporation of FPL dated March 23, 1992 3(i)b Amendment to FPL's Restated Articles of Incorporation dated March 23, 1992 3(i)c Amendment to FPL's Restated Articles of Incorporation dated May 11, 1992 3(i)d Amendment to FPL's Restated Articles of Incorporation dated March 12, 1993 3(i)e Amendment to FPL's Restated Articles of Incorporation dated June 16, 1993 3(i)f Amendment to FPL's Restated Articles of Incorporation dated August 31, 1993 3(i)g Amendment to FPL's Restated Articles of Incorporation dated November 30, 1993 3(ii) Bylaws of FPL dated May 11, 1992 (filed as Exhibit 3 to Form 8-K dated May 1, 1992, File No. 1-3545) 4(a) Mortgage and Deed of Trust dated as of January 1, 1944, and Ninety-three Supplements thereto between FPL and Bankers Trust Company and The Florida National Bank of Jacksonville (now First Union National Bank of Florida), Trustees (as of September 2, 1992, the sole trustee is Bankers Trust Company) (filed as Exhibit B-3, File No. 2-4845; Exhibit 7(a), File No. 2-7126; Exhibit 7(a), File No. 2-7523; Exhibit 7(a), File No. 2-7990; Exhibit 7(a), File No. 2-9217; Exhibit 4(a)-5, File No. 2-10093; Exhibit 4(c), File No. 2-11491; Exhibit 4(b)-1, File No. 2-12900; Exhibit 4(b)-1, File No. 2-13255; Exhibit 4(b)-1, File No. 2-13705; Exhibit 4(b)-1, File No. 2-13925; Exhibit 4(b)-1, File No. 2-15088; Exhibit 4(b)-1, File No. 2-15677; Exhibit 4(b)-1, File No. 2-20501; Exhibit 4(b)-1, File No. 2-22104; Exhibit 2(c), File No. 2-23142; Exhibit 2(c), File No. 2-24195; Exhibit 4(b)-1, File No. 2-25677; Exhibit 2(c), File No. 2-27612; Exhibit 2(c), File No. 2-29001; Exhibit 2(c), File No. 2-30542; Exhibit 2(c), File No. 2-33038; Exhibit 2(c), File No. 2-37679; Exhibit 2(c), File No. 2-39006; Exhibit 2(c), File No. 2-41312; Exhibit 2(c), File No. 2-44234; Exhibit 2(c), File No. 2-6502; Exhibit 2(c), File No. 2-48679; Exhibit 2(c), File No. 2-49726; Exhibit 2(c), File No. 2-50712; Exhibit 2(c), File No. 2-52826; Exhibit 2(c), File No. 2-53272; Exhibit 2(c), File No. 2-54242; Exhibit 2(c), File No. 2-56228; Exhibits 2(c) and 2(d), File No. 2-60413; Exhibits 2(c) and 2(d), File No. 2-65701; Exhibit 2(c), File No. 2-66524; Exhibit 2(c), File No. 2-67239; Exhibit 4(c), File No. 2-69716; Exhibit 4(c), File No. 2-70767; Exhibit 4(b), File No. 2-71542; Exhibit 4(b), File No. 2-73799; Exhibits 4(c), 4(d) and 4(e), File No. 2-75762; Exhibit 4(c), File No. 2-77629; Exhibit 4(c), File No. 2-79557; Exhibit 99(a) to Post-Effective Amendment No. 5 to Form S-8, File No. 33-18669; and Exhibit 99(a) to Post-Effective Amendment No. 1 to Form S-3, File No. 33-46076) 4(b) Ninety-fourth Supplemental Indenture dated as of December 1, 1993 between FPL and Bankers Trust Company, Trustee 12(a) Computation of Ratio of Earnings to Fixed Charges 12(b) Computation of Ratio of Earnings to Combined Fixed Charges and Preferred Stock Dividend Requirements 23 Independent Auditors' Consent * Incorporated herein by reference (b) Reports on Form 8-K A Current report on Form 8-K dated October 22, 1993 was filed on October 22, 1993 reporting one event under Item 5. Other Events. SCHEDULE V FLORIDA POWER & LIGHT COMPANY AND SUBSIDIARIES PROPERTY, PLANT AND EQUIPMENT SCHEDULE V FLORIDA POWER & LIGHT COMPANY AND SUBSIDIARIES PROPERTY, PLANT AND EQUIPMENT (Concluded) (1) Substantially all additions are originally charged to construction work in progress and transferred to electric plant accounts upon completion. Additions at cost give effect to such transfers. (2) The installed cost of individual units of plant retired is not always available. Plant accounts are credited for such retirements on the basis of estimates when the original cost is not available. Nuclear fuel materials sold are reflected as retirements. SCHEDULE VI FLORIDA POWER & LIGHT COMPANY AND SUBSIDIARIES ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT SCHEDULE VI FLORIDA POWER & LIGHT COMPANY AND SUBSIDIARIES ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (Concluded) (1) Depreciation of transportation equipment is charged to various accounts based on the use of such equipment. Amortization of nuclear fuel assemblies is charged to fuel, purchased power and interchange expense. (2) This reserve is maintained for all depreciable property. The amount in the retirement column is net of removal costs and salvage. (3) Includes fossil decommissioning reserves of $102 million, $92 million and $83 million at December 31, 1993, 1992 and 1991, respectively. SCHEDULE IX FLORIDA POWER & LIGHT COMPANY AND SUBSIDIARIES SHORT-TERM BORROWINGS (1) Represents the maximum amount outstanding at any month end. (2) Computed by dividing the sum of the daily ending balances by the number of days in the year. (3) Computation is based upon the principal amounts weighted by the number of days outstanding. SCHEDULE X FLORIDA POWER & LIGHT COMPANY AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION(1) (1) Other information required by Article 5, Schedule X - Supplementary Income Statement Information is shown in the Consolidated Financial Statements or notes thereto, or is not presented as such amounts are less than 1% of total revenues. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Florida Power & Light Company Date: March 21, 1994 By STEPHEN E. FRANK Stephen E. Frank (President and Chief Operating Officer and Director) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. Signature Title Date JAMES L. BROADHEAD Principal Executive James L. Broadhead Officer and Director (Chairman of the Board) PAUL J. EVANSON Principal Financial Officer Paul J. Evanson and Director (Senior Vice President, Finance and Chief Financial Officer) K. MICHAEL DAVIS Principal Accounting Officer K. Michael Davis (Vice President, Accounting, Controller and Chief Accounting Officer) DENNIS P. COYLE March 21,1994 Dennis P. Coyle JEROME H. GOLDBERG Jerome H. Goldberg LAWRENCE J. KELLEHER Directors Lawrence J. Kelleher J. THOMAS PETILLO J. Thomas Petillo C. O. WOODY C. O. Woody MICHAEL W. YACKIRA Michael W. Yackira
26058_1993.txt	26058	1993	Item 1. Business INTRODUCTION AND GENERAL DEVELOPMENT OF BUSINESS The registrant, CTS Corporation (CTS or Company), is an Indiana corporation incorporated in 1929 as a successor to a company started in 1896. CTS' principal executive offices are located at 905 West Boulevard North, Elkhart, Indiana 46514, telephone number (219) 293-7511. CTS designs, manufactures and sells electronic components. The engineering and manufacturing of CTS products is performed at 15 facilities worldwide. CTS products are sold through sales engineers, sales representatives, agents and distributors. In March 1987, a settlement was announced between CTS and Dynamics Corporation of America (DCA), terminating the sale process of the Company and resolving all disputes between CTS and DCA. Subsequently, the United States Supreme Court held that the Control Share Acquisition Chapter was constitutional. As a result of the Court's decision, the issue of voting rights of 1,020,000 shares of CTS common stock acquired by DCA in 1986 was submitted to a vote of CTS stockholders at the 1987 annual meeting. A majority of all shares eligible to vote was necessary to grant voting rights. DCA was not eligible to vote on the issue. The stockholders voted not to grant voting rights to DCA on these shares. The Court's decision did not have an impact with respect to voting rights on additional shares of CTS common stock previously acquired by DCA. In May 1988, the settlement agreement expired pursuant to its terms. At the end of 1993, DCA owned 1,920,900 shares (37.3%) of CTS common stock, including the 1,020,000 shares without voting rights. In January 1990, the Company formally announced the closing of its Switch Division located in Paso Robles, California. The Paso Robles manufacturing operations were relocated to the Company's facilities in Taiwan and Bentonville, Arkansas. During 1992, the Company completed the sale of the Paso Robles manufacturing plant and most of the associated real estate for $1.9 million. A pre- tax gain of $0.9 was realized from the sale. The manufacturing operations for certain variable resistor and selector switch products, which formerly were performed in Elkhart, Indiana, were also transferred to Bentonville in 1990, to take advantage of any efficiencies to be gained in consolidating such operations in Bentonville. The buildings located in Elkhart which housed the plastics molding, and element production, were vacated, with these manufacturing operations being consolidated into the main Elkhart plant. CTS announced in July 1990 that its facility near Glasgow, Scotland, would be expanded in order to manufacture and sell additional electronic products in Europe. The total capital investment has been approximately $10 million as of December 31, 1993. Automotive throttle position sensors and precision and clock oscillators were added to the product lines already manufactured in Scotland. The decision to expand the Scottish facility was based on several factors, including the excellent business climate and skills base in Scotland and the anticipated full participation of the United Kingdom in the European Economic Community. The expansion of the Scotland facility represents a major effort by CTS to serve the large and rapidly growing European market on a direct basis. In November 1991, construction was completed on a 53,000 square foot manufacturing facility in Bangkok, Thailand. During 1992, the Company idled operations at this facility. Also during 1991, the Company significantly reduced the operating activities at its Brownsville, Texas, facility and plans to sell this property. The manufacturing space owned by CTS in Hong Kong, which consisted of two floors in a multi-story building, was sold in March 1991. One floor was leased back by CTS for the continuation of its manufacturing operations in Hong Kong. During 1992, the Company terminated this lease and discontinued its manufacturing operations in Hong Kong. FINANCIAL INFORMATION ON INDUSTRY SEGMENTS All of the Company's products are considered one industry segment. Sales to unaffiliated customers, operating profit and identifiable assets, by geographic area, are contained in "Note I - Business Segment and Non-U.S. Operations," pages 21-22 , of the CTS Corporation 1993 Annual Report, and is incorporated herein by reference. PRINCIPAL BUSINESS AND PRODUCTS OF CTS CTS is primarily in the business of developing, manufacturing and selling a broad line of electronic components principally serving the electronic needs of original equipment manufacturers (OEM). The Company sells classes of similar products consisting of the following: Automotive control devices Loudspeakers Electronic connectors Programmable switches Frequency control devices Resistor networks Hybrid microcircuits Selector switches Industrial electronics Variable resistors Most products within these product classes are manufactured by CTS from purchased raw materials or subassemblies. Some products sold by CTS are purchased and resold under the Company's name. During the past three years, five classes of similar product lines accounted for 10% or more of consolidated revenue during one or more years, as follows: Percent of Consolidated Revenue Class of Similar Products 1993 1992 1991 Automotive Control Devices 26 20 18 Frequency Control Devices 15 17 16 Hybrid Microcircuits 14 11 7 Electronic Connectors 14 17 15 Resistor Networks 14 16 18 MARKETS CTS estimates that its products have been sold in the following segments of the electronics OEM and distribution markets and in the following percentages during the preceding three fiscal years: Percent of Consolidated Revenue Markets 1993 1992 1991 Automotive 32 25 22 Data Processing 22 20 20 Communications Equipment 17 18 19 Defense and Aerospace 12 17 19 Instruments and Controls 9 12 11 Distribution 4 5 5 Consumer Electronics 4 3 4 Total 100% 100% 100% Products for the automotive market include throttle position sensors, switch assemblies for operator interface, exhaust gas recirculation subsystems, variable resistors and switches for automotive entertainment systems and other applications, and loudspeakers. Products for the data processing market include resistor networks, frequency control devices, programmable switches and hybrid microcircuits. Products for this market are principally used in computers and computer peripheral equipment. In the communications equipment market, CTS products include frequency control devices, switches and resistor networks. Products for this market are principally used in telephone equipment and in telephone switching systems. CTS products for the defense and aerospace market, usually procured through government contractors or subcontractors, are electronic connectors, hybrid microcircuits, backpanels, frequency control devices and programmable key storage devices. Products for the instruments and controls market include hybrid microcircuits, variable resistors and switches. Principal end uses are medical electronic devices and electronic testing, measuring and servicing instruments. In the distribution market, CTS' primary products include programmable switches, resistor networks and frequency control devices. In this market, standard CTS products are sold for a wide variety of applications. Products for the consumer electronics market, primarily variable resistors and switches, are principally used in home entertainment equipment and appliances. MARKETING AND DISTRIBUTION Sales of CTS electronic components to original equipment manufacturers are principally by CTS sales engineers and manufacturers representatives. CTS maintains sales offices in Elkhart, Indiana; Detroit, Michigan; and in the United Kingdom, Hong Kong, Taiwan and Japan. Various regions of the United States are serviced by sales engineers working out of their homes. The sale of electronic components is relatively integrated such that most of the product lines of CTS are sold through the same field sales force. Approximately 36% of net sales in 1993 were attributable to coverage by CTS sales engineers. Generally, CTS sales engineers service the Company's largest customers with application specific products. CTS sales engineers work closely with major customers in determining customer requirements and in designing CTS products to be provided to such customers. CTS uses the services of independent sales representatives and distributors in the United States and foreign countries for customers not serviced by CTS sales engineers. Sales represen- tatives receive commissions from CTS. During 1993, about 60% of net sales were attributable to coverage by sales representatives. Independent distributors purchase products from CTS for resale to customers. In 1993, independent distributors accounted for about 4% of net sales. RAW MATERIALS Generally, CTS' major raw materials are steel, copper, brass, certain precious metals, resistive and conductive inks, passive components and semiconductors, used in several CTS products; ceramic materials used particularly in resistor networks and hybrid microcircuits; synthetic quartz used in frequency control devices; and laminate material used in printed circuit boards. These raw materials are purchased from several vendors, and except for certain semiconductors, CTS does not believe that it is dependent on one or on a very few vendors. In 1993 all of these materials were available in adequate quantities to meet CTS' production demands. The Company does not presently anticipate any raw material short- ages which would significantly affect production. However, the lead times between the placement of orders for certain raw mater- ials and actual delivery to CTS are quite variable, and the Company may from time to time be required to order raw materials in quantities and at prices less than optimal to compensate for the variability of lead times for delivery. Precious metals prices have a significant effect on the manufacturing cost and selling prices of many CTS products, particularly some programmable switches, electronic connectors and resistor networks. CTS has continuing programs to reduce the precious metals content of several products, when consistent with customer specifications. WORKING CAPITAL CTS does not usually buy inventories or manufacture products without actual or reasonably anticipated customer orders, except for some standard, off-the-shelf distributor products. The Company is not generally required to carry significant amounts of inventories to meet rapid delivery requirements because most customer orders are for custom products. CTS has entered into "just-in-time" arrangements with certain major customers in order to meet customers' just-in-time delivery needs. CTS carries raw materials, including certain semiconductors, and certain work-in-process and finished goods inventories which are unique to a particular customer or to a small number of customers, and in the event of reductions in or cancellations of orders, some inventories are not useable or cannot be returned to vendors for credit. CTS generally imposes charges for the reduction or cancellation of orders by customers, and these charges are usually sufficient to cover the financial exposure of CTS to inventories which are unique to a customer. CTS does not customarily grant special return privileges or payment privileges to customers, although CTS' distributor program permits certain returns. CTS' working capital requirements are generally cyclical but not seasonal. Working capital requirements are generally dependent on the overall business level. During 1993, working capital decreased slightly to $47.4 million. Cash represents a significant part of the Company's working capital. Most of CTS' cash at December 31, 1993, was held in U.S.-denominated cash equivalents for the credit of the various non-U.S. operations. The cash, other than approximately $5 million, is generally available to the parent Company. PATENTS, TRADEMARKS AND LICENSES CTS maintains a program of obtaining and protecting U.S. and non U.S. patents and trademarks. CTS believes that the success of its business is not materially dependent on the existence or duration of any patent, group of patents or trademarks. CTS licenses the manufacture of several electronic products to companies in the United States and non U.S. countries. In 1993 license and royalty income was 0.03% of net sales. CTS believes that the success of its business is not materially dependent upon any licensing arrangement where CTS is either the licensor or licensee. MAJOR CUSTOMERS CTS' 15 largest customers represented about 62%, 58% and 59% of net sales in 1993, 1992 and 1991, respectively. Of the net sales to unaffiliated customers, approximately $40.1 million, $30.7 million and $29.9 million were derived from sales to General Motors Corporation in 1993, 1992 and 1991, respectively. About $24.0 million, $19.3 million and $23.5 million were derived from sales to International Business Machines Corporation in 1993, 1992 and 1991, respectively. CTS is dependent upon these and other customers for a significant percentage of its sales and profits, and the loss of one or more of these customers or reduction of orders by one or more of these customers would have a materially adverse effect upon the Company. BACKLOG OF ORDERS Backlog of orders does not necessarily provide an accurate indication of present or future business levels for CTS. For many electronic products, the period between receipt of orders and delivery is relatively short. For large orders from major customers that may constitute backlog over an extended period of time, production scheduling and delivery are subject to change or cancellation by the customers on relatively short notice. At the end of 1993, the Company's backlog of orders was $70.5 million, compared with $64.0 million at the end of 1992. This increase was primarily attributable to increased demand from automotive customers. The backlog of orders at the end of 1993 will generally be filled during the 1994 fiscal year. GOVERNMENT CONTRACTS CTS believes that about 12% of its net sales are associated with purchases by the U.S. Government or foreign governments, principally for defense and aerospace applications. Because most CTS products procured through government contractors and subcontractors are for military end uses, the level of defense and aerospace market sales by CTS is dependent upon government budgeting and funding of programs utilizing electronic systems. Almost all CTS sales involving government purchases are to primary government contractors or subcontractors. CTS is usually subject to contract provisions permitting termination of the contract, usually with penalties payable by the government; maintenance of specified accounting procedures; limitations on and renegotiations of profits; priority production scheduling; and possible penalties or fines against CTS for late delivery or substandard quality. Such contract provisions have not previously resulted in material uncertainties or disruptions for CTS. COMPETITION CTS competes with many domestic and non U.S. manufacturers prin- cipally on the basis of product features, price, engineering, quality, reliability, delivery and service. Most product lines of CTS encounter significant competition. The number of significant competitors varies from product line to product line. No single competitor competes with CTS in every product line, but many competitors are larger and more diversified than CTS. Some competitors are divisions or affiliates of customers. CTS is subject to competitive risks typical in the electronics industry such as shorter product life cycles and new products causing existing products to become obsolete. Some customers have reduced or plan to reduce the number of suppliers while increasing the volume of purchases from independent suppliers. Most customers are demanding higher quality, reliability and delivery standards from CTS as well as competitors. These trends may create opportunities for CTS while also increasing the risk of loss of business to competitors. The Company believes that it competes most successfully in custom products manufactured to meet specific applications of major original equipment manufacturers. CTS believes that it has some advantages over certain competitors because of its ability to apply a broad range of technologies and materials capabilities to develop products for the special requirements of customers. CTS also believes that it has an advantage over some competitors in its capability to sell a broad range of products manufactured to relatively consistent standards of quality and delivery. CTS believes that the relative breadth of its product lines and relative consistency in quality and delivery across product lines is an advantage to CTS in selling products to customers. CTS believes that it is one of the largest manufacturers of automotive throttle position sensors. FINANCIAL INFORMATION ABOUT FOREIGN AND DOMESTIC OPERATIONS AND EXPORT SALES Information about revenue from sales to unaffiliated customers, operating profit and identifiable assets, by geographic area, is contained in "Note I - Business Segment and Non-U.S. Operations," pages 21-22 of the CTS Corporation 1993 Annual Report, and is incorporated herein by reference. In 1993 approximately 28% of net sales to unaffiliated customers, after eliminations, were attributable to non-U.S. operations. This represents an increase from 24% of net sales attributable to non-U.S. operations in 1992. About 39% of total CTS assets, after eliminations, are non-U.S. Except for cash and equivalents, a substantial portion of these assets cannot readily be liquidated. CTS believes that the business risks attendant to its present non-U.S. operations, though substantial, are normal risks for non-U.S. businesses, including expropriation, currency controls and changes in currency exchange rates and government regulations. RESEARCH AND DEVELOPMENT ACTIVITIES In 1993, 1992 and 1991, CTS spent $5.7, $6.1 and $5.7 million, respectively, for research and development. Most CTS research and development activities relate to new product and process developments or the improvement of product materials. Many such research and development activities are for the benefit of one or a limited number of customers or potential customers. During 1993, the Company did not enter into any new, significant product lines, but continued to introduce additional versions of existing products in response to present and future customer requirements. ENVIRONMENTAL PROTECTION LAWS In complying with federal, state and local environmental protection laws, CTS has modified certain manufacturing processes and expects to continue to make additional modifications. Such modifications that have been performed have not materially affected the capital expenditures, earnings or competitive position of CTS. Certain processes in the manufacture of the Company's current and past products create hazardous waste by-products as currently defined by federal and state laws and regulations. The Company has been notified by the U.S Environmental Protection Agency, state environmental agencies and, in some cases, generator groups, that it is or may be a Potentially Responsible Party (PRP) regarding hazardous waste remediation at several non-CTS sites. The factual circumstances of each site are different; the Company has determined that its role as a PRP with respect to these sites, even in the aggregate, will not have a material adverse effect on the Company's business or financial condition, based on the following: 1) the Company's status as a de minimis party; 2) the large number of other PRPs identified; 3) the identification and participation of many larger PRPs who are financially viable; 4) defenses concerning the nature and limited quantities of materials sent by the Company to certain of the sites; and 5) the Company's experience to-date in relation to the determination of its allocable share. In addition to these non- CTS sites, the Company has an ongoing practice of providing reserves for probable remediation activities at certain of its manufacturing locations and for claims and proceedings against the Company with respect to other environmental matters. In the opinion of management, based upon presently available information, either adequate provision for probable costs has been made, or the ultimate costs resulting will not materially affect the consolidated financial position or results of operations of the Company. There are claims against the Company with respect to environmental matters which the Company contests. In the opinion of management, based upon presently available information, either adequate provision for potential costs has been made, or the costs which ultimately might result will not materially affect the consolidated financial position or results of operations of the Company. EMPLOYEES CTS employed an average of 3,975 persons during 1993. About 47% of these persons were employed outside the United States at the end of 1993. Approximately 309 employees in the United States were covered by collective bargaining agreements as of December 31, 1993. The two collective bargaining agreements covering these employees will expire in 1996. Item 2.		Item 2. Properties CTS operations or facilities are at the following locations. The owned properties are not subject to material liens or encumbrances. Lease Approximate Owned or Expiration Location Square Feet Leased Date Elkhart, IN 521,813 Owned - Berne, IN 248,726 Owned - Singapore 158,926 Owned* - Kaohsiung, Taiwan 132,887 Owned* - Streetsville, Ontario, Canada 111,740 Owned - West Lafayette, IN 105,983 Owned - Sandwich, IL 94,173 Owned - Brownsville, TX 84,679 Owned - Bentonville, AR 72,000 Owned - Glasgow, Scotland 75,000 Owned - New Hope, MN December, (Science Center Dr.) 55,000 Leased 1998 Bangkok, Thailand 53,000 Owned - Matamoros, Mexico 50,590 Owned* - Baldwin, WI 39,050 Owned - Cokato, MN 36,000 Owned - TOTAL 1,839,567 * Buildings are located on land leased under renewable leases. The Company is currently seeking to sell some, or all, of the Streetsville, Ontario, Canada, facility and related property, and the Brownsville, Texas, manufacturing building. The Company constructed the Bangkok, Thailand, facility during 1991. This facility was idled during 1992 and was idle for all of 1993. The Company regularly assesses the adequacy of its manufacturing facilities for manufacturing capacity, available labor and location to the markets and major customers for the Company's products. CTS also reviews the operating costs of its facilities and may from time to time relocate facilities or certain manufac- turing activities in order to achieve operating cost reductions and improved asset utilization and cash flow. Item 3.	Item 3. Legal Proceedings Contested claims involving various matters, including environmental claims brought by government agencies, are being litigated by CTS, both in legal and administrative forums. In the opinion of management, based upon currently available information, adequate provision for potential costs has been made, or the costs which might ultimately result from such litigation or administrative proceedings will not materially affect the consolidated financial position of the Company or the results of operations. Item 4.	Item 4. Submission of Matters to a Vote of Security Holders During the fourth quarter of 1993, no issue was submitted to a vote of CTS stockholders. PART II Item 5.	Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters The principal market for CTS common stock is the New York Stock Exchange. Information relative to the high and low trading prices for CTS Common Stock for each quarter of the past two years and the frequency and amount of dividends declared during the previous two years can be located in "Stockholder Information," page 10, of the CTS Corporation 1993 Annual Report, incorporated herein by reference. On March 11, 1994, there were approximately 1,182 holders of record of CTS common stock. The Company intends to continue a policy of considering dividends on a quarterly basis. The declaration of a dividend and the amount of any such dividend are subject to earnings, anticipated working capital, capital expenditure and other investment requirements, the financial condition of CTS and such other factors as the Board of Directors deems relevant. Item 6.	Item 6. Selected Financial Data A summary of selected financial data for CTS, for each of the previous five fiscal years, is contained in the "Five-Year Summary," page 11, of the CTS Corporation 1993 Annual Report, incorporated herein by reference. Certain divestitures and closures of businesses and certain accounting changes affect the comparability of information con- tained in the "Five-Year Summary." Item 7.	Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Information about liquidity, capital resources and results of operations, for the three previous fiscal years, is contained in "Management's Discussion and Analysis of Financial Condition and Results of Operations (1991-1993)," pages 25-27, of the CTS Corporation 1993 Annual Report, incorporated herein by reference. Item 8.	Item 8. Financial Statements and Supplementary Data Consolidated financial statements, meeting the requirements of Regulation S-X, and the Report of Independent Accountants, are contained in pages 12-24 of the CTS Corporation 1993 Annual Report, incorporated herein by reference. Quarterly per share financial data is provided in "Stockholder Information," under the subheading, "Quarterly Results of Operations", and "Per Share Data," on page 10 of the CTS Corporation 1993 Annual Report, and is incorporated herein by reference. Item 9.	Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure There were no disagreements. PART III Item 10.	Item 10. Directors and Executive Officers of the Registrant Information responsive to Items 401(a) and 401(e) of Regulation S-K pertaining to directors of CTS is contained in the 1994 Proxy Statement under the caption "Election of Directors," pages 4-5, filed with the Securities and Exchange Commission, and is incorporated herein by reference. Information responsive to Item 405 of Regulation S-K pertaining to compliance with Section 16(a) of the Securities Exchange Act of 1934 is contained in the 1994 Proxy Statement under the caption "Compliance with Section 16(a) of the Securities Exchange Act of 1934," page 5, filed with the Securities and Exchange Commission, and is incorporated herein by reference. The individuals listed were elected as executive officers of CTS at the annual meeting of the Board of Directors on April 30, 1993, and are expected to serve as executive officers until the next annual meeting of the Board of Directors, scheduled on April 29, 1994, at which time the election of officers will be considered again by the Board of Directors. Name Age Position and Offices Joseph P. Walker 55 Director, Chairman, President and Chief Executive Officer Philip T. Christ 62 Group Vice President Stanley J. Aris 53 Vice President Finance and Chief Financial Officer Jeannine M. Davis 45 Vice President, Secretary and General Counsel Gary N. Hoipkemier 39 Treasurer George T. Newhart 51 Corporate Controller Joseph P. Walker has served as Chairman of the Board, President and Chief Operating Officer of CTS since 1988. Mr. Walker is a Director of NBD Bank and NBD Bank,N.A. and the National Association of Manufacturers. Philip T. Christ was elected Group Vice President, effective July 2, 1990. Mr. Christ served as a Senior Vice President at Simplex Time Recorder from 1976-1986. Stanley J. Aris was elected Vice President, Finance and Chief Financial Officer, effective May 18, 1992. Prior to joining CTS, Mr. Aris worked for two years as a business consultant. From 1989 to 1990 Mr. Aris served as Vice President, Finance of Hypres Corporation. Jeannine M. Davis, an employee since 1980, served as legal counsel from 1980-1983, Assistant Secretary from 1982-1983 and Assistant General Counsel from 1983-1984. She was elected Secretary in 1983, General Counsel in 1984 and Vice President in 1988. Gary N. Hoipkemier became an employee in November 1989 and was elected Treasurer on December 15, 1989. He served as Chief Financial Officer of Riblet Products Corporation from 1988-1989. George T. Newhart was elected Corporate Controller on June 19, 1989. Prior to joining the Company in June 1989, he was Chief Financial and Administrative Officer of the Chelsea Electronic Distribution Group from 1987-1989. Item 11.	Item 11. Executive Compensation Information responsive to Item 402 of Regulation S-K pertaining to management remuneration is contained in the 1994 Proxy Statement in the captions "Executive Compensation," pages 6-7 and "Director Compensation," page 11, filed with the Securities and Exchange Commission, and is incorporated herein by reference. Item 12.	Item 12. Security Ownership of Certain Beneficial Owners and Management Information responsive to Item 403 of Regulation S-K pertaining to security ownership of certain beneficial owners and management is contained in the 1994 Proxy Statement in the caption "Securities Beneficially Owned by Principal Stockholders and Management," pages 2-4 filed with the Securities and Exchange Commission, and is incorporated herein by reference. Item 13.	Item 13. Certain Relationships and Related Transactions DCA owned 1,920,900 (37.3%) of the Company's outstanding common stock as of December 31, 1993. CTS purchased products from DCA totalling about $145,000 in 1993, $93,000 in 1992 and $192,000 in 1991, principally consisting of certain component parts used by CTS in the manufacture of frequency control devices. CTS had no sales to DCA in 1993 or 1992, and sales to DCA were under $70,000 in 1991. PART IV Item 14.	Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) (1) and (2) The list of financial statements and financial statement schedules required by Item 14 (a)(1) and (2) is contained on page S-1 herein. (a)(3) Exhibits (3)(a) Articles of Incorporation, as amended April 16, 1973, previously filed as exhibit (3)(a) to the Company's Form 10-K for 1987, and incorporated herein by reference. (3)(b) Bylaws, as amended and effective June 25, 1992, previously filed as exhibit (3)(b) to the Company's Form 10-K for 1992, and incorporated herein by reference. (10)(a) Employment agreement dated June 28, 1991, between CTS and Joseph P. Walker, previously filed as exhibit (10)(a) to the Company's Form 10-K for 1991, and incorporated herein by reference. (10)(b) Prototype indemnification agreement, with Lawrence J. Ciancia, Gerald H. Frieling, Jr., Andrew Lozyniak, Edward J. Mooney, Joseph P. Walker, Philip T. Christ, Stanley J. Aris, Jeannine M. Davis, Gary N. Hoipkemier and George T. Newhart, previously filed as exhibit (10)(b) to the Company's Form 10-K for 1991, and incorporated herein by reference. (10)(c) CTS Corporation 1982 Stock Option Plan, as amended February 24, 1989, was previously filed as exhibit (10)(d) to the Company's Form 10-K for 1989, and is incorporated herein by reference. (10)(d) CTS Corporation 1986 Stock Option Plan, approved by the stockholders at the reconvened annual meeting on May 30, 1986. The CTS Corporation 1986 Stock Option Plan is contained in Exhibit 4 to Registration Statement No. 33-27749, effective March 23, 1989, and is incorporated herein by reference. (10)(e) CTS Corporation 1988 Restricted Stock and Cash Bonus Plan, as adopted by the CTS Board of Directors on December 16, 1988, and approved by stockholders at the 1989 annual meeting of stock- holders on April 28, 1989. The CTS Corporation 1988 Restricted Stock and Cash Bonus Plan is contained in Appendix A, pages 11-15, of the 1989 Proxy Statement for the annual meeting of stockholders held April 28, 1989, under the caption "CTS Corporation 1988 Restricted Stock and Cash Bonus Plan," previously filed with the Securities and Exchange Commission, and is incorporated herein by reference. (13) CTS Corporation 1993 Annual Report. (21) Subsidiaries of CTS Corporation. (23) Consent of Price Waterhouse to incorporation by reference of this Annual Report on Form 10-K for the fiscal year 1993 to Registration Statement 2- 84230 on Form S-8 and Registration Statement 33- 27749 on Form S-8. Indemnification Undertaking For the purposes of complying with the amendments to the rules governing Form S-8 (effective July 13, 1990) under the Securities Act of 1933, the undersigned registrant hereby undertakes as follows, which undertaking shall be incorporated by reference into registrant's Registration Statements on Form S-8 Nos. 2-84230 (filed June 13, 1983) and 33-27749 (filed March 23, 1989): Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers and controlling persons of the registrant pursuant to the foregoing provision, or otherwise, the registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Securities Act of 1933 and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the registrant of expenses incurred or paid by a director, officer or controlling person of the registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Date By_______________________________ Stanley J. Aris Vice President Finance and Chief Financial 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. Date B y _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ Lawrence J. Ciancia, Director Date B y _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ Patrick J. Dorme, Director Date By______________________________________________________________ Gerald H. Frieling, Jr., Director Date B y _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ Andrew Lozyniak, Director Date B y _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ Joseph P. Walker, Director Date B y _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ George T. Newhart, Corporate Controller and principal accounting officer Date B y _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ Jeannine M. Davis, Vice President, Secretary and General Counsel ANNUAL REPORT ON FORM 10-K ITEM 14(a) (1) AND (2) AND ITEM 14(d) LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES FINANCIAL STATEMENT SCHEDULES YEAR ENDED DECEMBER 31, 1993 CTS CORPORATION AND SUBSIDIARIES ELKHART, INDIANA FORM 10-K - ITEM 14(a) (1) AND (2) CTS CORPORATION AND SUBSIDIARIES LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES The following consolidated financial statements of CTS Corpora- tion and subsidiaries included in the annual report of the registrant to its shareholders for the year ended December 31, 1993, are incorporated by reference in Item 8: Consolidated balance sheets - December 31, 1993, and December 31, 1992 Consolidated statements of earnings - Years ended December 31, 1993, December 31, 1992, and December 31, Consolidated statements of stockholders' equity - Years ended December 31, 1993, December 31, 1992, and Decem- ber 31, 1991 Consolidated statements of cash flows - Years ended December 31, 1993, December 31, 1992, and December 31, Notes to consolidated financial statements The following consolidated financial statement schedules of CTS Corporation and subsidiaries, are included in item 14(d): Page Schedule V - Property, plant and equipment S-3 Schedule VI - Accumulated depreciation of property, plant and equipment S-4 Schedule VIII - Valuation and qualifying accounts S-5 All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission have been omitted because they are inapplicable, not required or the information is included in the consolidated financial state- ments or notes thereto. S-1 EXHIBIT 22 CTS CORPORATION AND SUBSIDIARIES CTS Corporation (Registrant), an Indiana corporation Subsidiaries CTS Corporation, a Delaware corporation CTS Singapore, Pte. Ltd., a Republic of Singapore corporation CTS of Panama, Inc., a Republic of Panama corporation CTS Components Taiwan, Ltd.,1 a Taiwan, Republic of China corporation CTS de Mexico S.A.,1 a Republic of Mexico corporation CTS Export Corporation, a Virgin Islands corporation CTS of Canada, Ltd., a Province of Ontario (Canada) corporation CTS Manufacturing (Thailand) Ltd.,1 a Thailand corporation CTS Electronics Hong Kong Ltd.,1 a Republic of Hong Kong corporation CTS Corporation U.K. Ltd., a United Kingdom corporation CTS Printex, Inc., a California corporation CTS Micro Peripherals, Inc., a California corporation Micro Peripherals Singapore (Private) Limited, a Republic of Singapore corporation Corporations whose names are indented are subsidiaries of the preceding non-indented corporations. Except as indicated, each of the above subsidiaries is 100% owned by its parent company. Operations of all subsidiaries and divisions are consolidated in the financial statements. 1 Less than 1% of the outstanding shares of stock is owned of record by nominee shareholders pursuant to national laws regarding resident or nominee ownership. [FN] (a) Changes in classification and miscellaneous adjustments. (b) Items transferred to Property Not Used in Business. (c) Currency translation adjustment. S-3 S-5
48681_1993.txt	48681	1993	ITEM 1. BUSINESS. Household Finance Corporation ("HFC" or the "Company") is a subsidiary of Household International, Inc. ("Household International"). HFC and its subsidiaries offer a diversified range of financial services. The principal products of HFC's consumer financial services business is the making of cash loans, including home equity loans secured by first and second mortgages and unsecured credit advances (including revolving and closed-end personal loans) to middle-income consumers in the United States and Australia. Loans are made through branch lending offices and through direct marketing efforts. In 1992, HFC launched a new portfolio acquisition business focusing on open-end and closed-end home equity loan products. In 1993, HFC acquired approximately 3,800 new accounts aggregating $430 million in such receivables. In addition, in 1993 HFC acquired the right to service without recourse approximately 1.1 million accounts aggregating approximately $2.0 billion in unsecured loans. The Company believes that the portfolio acquisition business provides an additional source for developing new customer relationships. Through banking subsidiaries located in Salinas, California and Wood Dale, Illinois, the Company issues both VISA* and Mastercard* credit cards. These banks engage only in consumer credit card operations. Household Retail Services ("HRS") is a revolving credit merchant participation business. Through subsidiaries of HFC, HRS provides sales financing and purchases, originates and services merchants' private-label revolving charge accounts. In conjunction with its consumer finance operations and where applicable laws permit, HFC makes available to customers credit life, credit accident and health, and household contents insurance. Credit life and credit accident and health insurance are generally written directly by, or reinsured with, HFC's insurance subsidiary, Alexander Hamilton Life Insurance Company of America ("Alexander Hamilton"). Alexander Hamilton is also engaged in the sale of ordinary life, annuity, and specialty insurance products to the general public through approximately 16,300 independent agents throughout the United States. HFC also is engaged in commercial finance involving leveraged leases, privately-placed, limited-term preferred stocks, and selected commercial financing of equipment or property. At December 31, 1991 the Company discontinued lending in certain commercial product lines. See "Management's Discussion and Analysis" on pages 13 and 14 for further discussion of discontinued commercial product lines. ITEM 2.		ITEM 2. PROPERTIES. Substantially all of HFC's branch office and headquarters space is rented with the exception of its corporate headquarters in Prospect Heights, Illinois; Alexander Hamilton's headquarters in Farmington Hills, Michigan; and administration buildings in Northbrook, Illinois and Salinas, California. ITEM 3.	ITEM 3. LEGAL PROCEEDINGS. There is no litigation pending which management and counsel for the Company consider to be material. ITEM 4.	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Omitted. PART II. ITEM 5.	ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. All 1,000 shares of HFC's outstanding common stock are owned by Household International. Consequently, there is no market in HFC's common stock. HFC also has outstanding 1 million depositary shares which represent 1/3,000 share of term cumulative preferred stock (with a liquidation value of $.3 million per share) to institutional investors not affiliated with HFC. - ------------ * VISA and MasterCard are registered trademarks of VISA USA, Inc. and MasterCard International Incorporated, respectively. During 1993 HFC did not pay cash dividends on its common stock. During 1992 HFC paid cash dividends on its common stock to Household International totaling $175.3 million. In addition, HFC paid cash dividends on its preferred stock totaling $8.7 and $10.3 million in 1993 and 1992, respectively. ITEM 6.	ITEM 6. SELECTED FINANCIAL DATA. Omitted. ITEM 7.	ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. MANAGEMENT'S DISCUSSION AND ANALYSIS BUSINESS SEGMENT DATA HOUSEHOLD FINANCE CORPORATION AND SUBSIDIARIES The combination of the Company's consumer and continuing commercial product lines are referred to as Finance and Banking. Assets of liquidating commercial product lines, which are separately managed as receivables are collected or otherwise disposed of, have been disclosed separately in the consolidated balance sheets and as a separate business segment, referred to as Liquidating Commercial Lines. To define and report the results of operations, the Company refers to its Finance and Banking and Individual Life Insurance segments as its Core Business. CONSOLIDATED RESULTS OF OPERATIONS Net income in 1993 was $220.4 million, down from 1992 net income of $239.5 million. Net income in 1992 was 53 percent higher than 1991 earnings of $156.7 million when the Company reported a large loss in the Liquidating Commercial Lines segment associated with its decision to withdraw from the higher-risk portion of its commercial business. During 1993, net income was negatively impacted by the following: - The enactment of new Federal tax legislation which increased the statutory corporate income tax rate from 34 percent to 35 percent retroactive to January 1, 1993 and decreased net income by $5.8 million. - Implementation of Statement of Financial Accounting Standards No. 106 on postretirement benefits, which the Company adopted effective January 1, 1993, which reduced net income by $7 million. The following summarizes key highlights of the Company's operations during 1993: - Domestic consumer finance earnings increased over the prior year primarily due to wider interest spreads on variable rate products and growth in the managed portfolio. This improvement was more than offset by lower earnings in the Company's bankcard and continuing commercial businesses. Lower bankcard earnings were caused by higher provisions related to the strengthening of credit loss reserves and higher operating expenses. Earnings from the continuing commercial business declined due to reduced margin, lower levels of earning assets in the aircraft portfolio and lower gains on the dispositions of assets. - Consumer two-months-and-over contractual delinquency ("delinquency") continued to decline throughout the year due to tighter credit standards implemented in prior years and an improving economic environment. Total consumer delinquency as a percent of managed consumer receivables was 4.33 percent at December 31, 1993, down significantly from 5.37 percent at December 31, 1992 and was at the lowest level since 1988. The full year chargeoff ratio for the managed consumer portfolio declined to 3.61 percent from 3.81 percent in 1992. The Company increased credit loss reserves for Finance and Banking managed receivables by $33.4 million, or 9 percent over 1992, despite a $142.4 million decrease in delinquency. The increase was due to continued caution regarding the uncertainty of the economic outlook, continued relatively high chargeoff levels and more conservative recognition of recourse obligations for receivables serviced with limited recourse. Reserves, as a percent of the managed Finance and Banking receivable portfolio, were at their highest level since the Company adopted the contractual basis of delinquency in 1990. - The Liquidating Commercial Lines ("LCL") segment experienced an increased loss due to the resolution of the Company's largest problem loan in the third quarter. The Company reached a cash settlement on a nonaccrual equipment finance loan which resulted in a higher chargeoff than expected and a complete disposition of the loan, with no continuing involvement on the part of the Company. The Company anticipates that future LCL results will improve. LCL assets totaled $1.6 billion, down $295.5 and $474.8 million from year-end 1992 and 1991, respectively. This trend is consistent with management's strategy to dispose of these assets over several years. Nonperforming LCL assets declined $191.6 million during the year and reached their lowest level since June 1991. Credit loss reserves at December 31, 1993 as a percent of both LCL receivables and nonperforming loans increased over the year-ago period. - Owned assets totaled $19.9 billion at December 31, 1993, up 9 percent from year-end 1992. The increase primarily was due to a 20 percent increase in the investment securities portfolio, principally in the Individual Life Insurance segment, and a 14 percent increase in owned Finance and Banking receivables. Total managed assets (owned assets plus receivables serviced with limited recourse) were $27.0 billion, up 3 percent from year-end 1992. Household International invested an additional $70 million of capital into HFC in 1993. As a result, the Company's debt to equity ratio declined from 6.8 at December 31, 1992 to 6.2 at December 31, 1993. - In July 1993 Standard & Poor's Corporation upgraded its credit rating outlook for the Company, and in November 1993 Moody's Investor Services, Inc. upgraded the Company's credit rating. These upgrades were a result of improving trends in both capital levels and asset quality. CONSOLIDATED CREDIT LOSS RESERVES Total managed credit loss reserves, which include reserves for recourse obligations for receivables serviced, were as follows: The level of reserves for credit losses is based on delinquency and chargeoff experience by product and management's evaluation of economic conditions, including regional considerations. See Note 1, "Summary of Significant Accounting Policies" on pages and in the accompanying financial statements for further description of the basis for establishing such reserves. See Note 5, "Credit Loss Reserves" in the accompanying financial statements for an analysis of credit loss reserves. While management allocates reserves among the Company's various products and segments, all reserves are considered to be available to cover total loan losses. CONSOLIDATED CREDIT LOSS RESERVES (AS A PERCENT OF RECEIVABLES) During 1993 the Company strengthened its managed credit loss reserves for Finance and Banking receivables as described on page 3. Reserves for Liquidating Commercial Lines decreased from year-end 1992 levels primarily due to the continued disposition of LCL receivables, including the resolution of a large nonaccrual equipment finance loan as described earlier. Despite the dollar decrease in LCL reserve levels, credit loss reserves at December 31, 1993 as a percent of both LCL receivables and nonperforming loans increased over December 31, 1992 and 1991. CREDIT MANAGEMENT POLICIES The Company's credit portfolios and credit management policies historically have been divided into two distinct components -- consumer and commercial. For consumer products, credit policies focus on product type and specific portfolio risk factors. The consumer credit portfolio is diversified by product and geographic location. The commercial credit portfolio is monitored by individual transaction as well as being evaluated by overall risk factors. See Note 3, "Finance and Banking Receivables" and Note 4, "Liquidating Commercial Assets" in the accompanying financial statements for receivables by product type. CONSUMER The consumer credit risk management process has four key elements: - Computerized scoring systems to assess the risk characteristics of new applicants and monitor the payment behavior of existing customers for early warning signs of troubled accounts. - A centralized credit system for past due accounts to make the collection process more productive and provide the analytical capability to measure the effectiveness of collection strategies. - A chargeoff policy intended to eliminate problem loans early and improve the quality of the remaining portfolio. - A senior executive position of credit risk manager in each consumer lending operation which places credit management at a high level of priority and provides the means for the credit function to interact more productively with other business functions. Based on this credit risk management process, expected credit losses for each consumer product are estimated on a statistical basis. The Company suspends accrual of interest on all consumer receivables when payments are three months contractually past due, except for bankcards and private-label credit cards. On these credit card receivables, consistent with industry practice, interest continues to accrue until the receivable is charged off. Consumer loans are charged off when an account is contractually delinquent for a pre-established period of time. The period of time is dependent on the terms, collateral and credit loss experience of each consumer product category. This period ranges from 6 to 9 months. The Company's domestic consumer businesses lend funds nationwide, with California accounting for 22 percent of total managed domestic consumer receivables. It is the only state with receivables in excess of 10 percent of domestic managed receivables. The Company's Australian operations accounted for 2 percent of managed consumer receivables at December 31, 1993. Due to its centralized underwriting, collection and processing functions, the Company can quickly revise underwriting standards and intensify collection efforts for specific geographic locations. COMMERCIAL Commercial loans, in continued or discontinued product lines, are underwritten based upon specific criteria by product, which include the following items: borrower's financial strength, underlying value of collateral, ability of the property/business to generate cash flow and pricing considerations. For financing commitments in excess of $1 million, the loan request must be approved by an investment committee consisting of senior management. The financial and operating performance of all borrowers is monitored and reported to management on an ongoing basis. Additionally, the conclusions of this monitoring process are reported to senior management on a quarterly basis. Substantially all commercial chargeoffs have related to the product lines which are being liquidated. The Company administers a classification of assets policy whereby, on a quarterly basis, all commercial credits are reviewed and assigned a rating based on a process similar to that used by bank regulatory authorities. The review process specifically addresses whether any commercial loans need to be charged off and uses the following criteria: (a) ability of the borrower to make loan payments; (b) ability of the property or business to generate cash flow; (c) value of collateral; (d) other debt associated with the property or business; and (e) passage of title or in-substance possession of collateral. The quarterly evaluation of the adequacy of the credit loss reserve is based on this review process and management's evaluation of probable future losses in the portfolio as a whole given its geographic and industry diversification and historical loss experience. Management also evaluates the potential impact of existing and anticipated economic conditions on the portfolio in establishing credit loss reserves. Commercial loans are placed on nonaccrual when they become 90 days past due, or sooner if the Company believes that the loan has experienced significant adverse developments that could result in a loss of interest or principal. There are no commercial loans that are 90 days past due and on full accrual status. Loans are disclosed as renegotiated loans or troubled debt restructurings if the rate of interest has been reduced because of the inability of the borrower to meet the original terms of the loan. Such loans continue to accrue interest at the renegotiated rate, unless they become 90 days past due, because the Company believes the borrowers will be able to meet their obligations following the restructuring. Commercial loans that are modified in the normal course of business, for which additional consideration is received or significant concessions are not made, are not reported as renegotiated loans or troubled debt restructurings. Real estate owned is recorded at the lower of cost or fair value less estimated costs to sell. These values are periodically reviewed and reduced, if appropriate. FINANCE AND BANKING STATEMENTS OF INCOME OVERVIEW Finance and Banking earnings decreased to $196.7 million from $210.1 million in 1992. As described earlier, improved earnings in the domestic consumer finance operations were more than offset by lower earnings in the bankcard and continuing commercial operations. RECEIVABLES Managed receivables at December 31, 1993 were $16.1 billion, up 2 percent compared to December 31, 1992 and up 7 percent from year-end 1991 as all businesses continued to apply conservative underwriting standards because of continued economic uncertainty. In addition, domestic growth was limited by lower market demand than seen in previous years and by additional run-off of second mortgages from customer loan refinancings. Changes in owned receivables and receivables serviced with limited recourse may vary from period to period depending on the timing and significance of securitization transactions in a particular period. The Company securitized and sold with limited recourse approximately $1.7 billion of receivables in 1993 compared to $2.2 billion in 1992. NET INTEREST MARGIN Net interest margin was $799.0 million in 1993, up from $711.3 million in 1992 due to higher levels of interest-earning assets, wider spreads on variable rate products and a shift in product mix towards higher yielding bankcard, merchant participation and other unsecured receivables. Spreads on variable rate products in 1993 exceeded those achieved in the prior year periods. The Company does not anticipate that spreads in 1994 will remain at the level reached in 1993 because of overall conditions in the capital markets. Due to the growth in securitized assets over the past several years, the comparability of net interest margin between years may be affected by the level and type of assets securitized. As receivables are securitized and sold rather than held in portfolio, net interest income is shifted to securitization and servicing fee income. Net interest margin on an owned basis as a percent of average owned interest-earning assets was 8.9 percent, compared to 8.1 percent in 1992 and 7.8 percent in 1991. Net interest margin on a managed basis, assuming receivables securitized and sold were instead held in the portfolio, increased to $1.3 billion in 1993 from $1.2 billion in 1992 and, as a percent of average managed interest-earning assets, increased to 8.1 percent from 8.0 percent in 1992 and 7.8 percent in 1991. Net interest margin on an owned basis was greater than on a managed basis because home equity receivables, which have lower spreads, are a larger portion of the portfolio serviced with limited recourse than of the owned portfolio. OTHER REVENUES SECURITIZATION AND SERVICING FEE INCOME consists of two components: income associated with the securitization and sale of receivables with limited recourse and servicing fee income related to the servicing of unsecured receivables. Securitization income increased in 1993 as the total managed receivables portfolio continued to grow. Securitization income as a percent of average receivables serviced with limited recourse was 4.94 percent in 1993, compared to 5.23 percent in 1992 and 7.16 percent in 1991. This decrease primarily was due to a shift toward home equity loans in the securitized portfolio, resulting in narrower spreads. Servicing fee income increased over 1992 despite little year-over-year change in average receivables serviced with no recourse. This increase primarily was due to a change in the composition of the serviced portfolio which occurred in the third quarter of 1993 when the Company began servicing an unsecured consumer loan portfolio without recourse which provided a higher servicing fee. This portfolio totaled $1.3 billion at December 31, 1993. INSURANCE PREMIUMS AND CONTRACT REVENUES were $114.7 million, up from $109.2 million in 1992, but down slightly from $115.4 million in 1991 due to changes in sales volumes of specialty and credit insurance. INVESTMENT INCOME was $11.7 million, up 11 percent compared to $10.5 million in both 1992 and 1991 due to higher gains on sales of investments from the specialty and credit insurance portfolio. FEE INCOME includes revenues from fee-based products such as bankcards and private-label credit cards. Fee income was $58.9 million, up from $49.6 million in 1992 and $45.3 million in 1991 primarily due to interchange and other fees related to growth in owned bankcard receivables. OTHER INCOME was essentially flat compared to 1992 and 1991. PROVISION FOR CREDIT LOSSES The provision for credit losses for receivables on an owned basis totaled $404.4 million, up 21 percent from $333.0 million in 1992 and up 19 percent from 1991's level due to continued caution regarding the uncertainty of the economic outlook and continued relatively high chargeoff levels. EXPENSES Operating expenses, which the Company defines as salaries and fringe benefits plus other operating expenses, were $673.0 million, up 7 percent over 1992. Operating expenses as a percent of average receivables owned or serviced were 3.96 percent, up slightly from 3.93 percent in 1992 and 3.88 percent in 1991 due to higher costs associated with servicing a larger average managed portfolio and additional expenses related to real estate owned. The effective tax rate in 1993 was 31.3 percent compared to 27.3 percent in 1992 and 29.3 percent in 1991. The increase in the effective tax rate over 1992 primarily was due to the impact of the increase in the statutory Federal income tax rate from 34 percent to 35 percent and a change in the treatment of purchase accounting adjustments resulting from the adoption of FAS No. 109. CREDIT QUALITY The Company generally experienced improved credit quality during 1993. This improvement was a result of better domestic economic conditions and the higher quality of recently originated receivables. At year-end 1993 delinquency had fallen for seven consecutive quarters. Chargeoffs in 1993 were below the prior year. DELINQUENCY Delinquency levels are monitored for both receivables owned and receivables managed. The Company looks at delinquency levels which include receivables serviced with limited recourse because this portfolio is subjected to underwriting standards comparable to the owned portfolio, is managed by operating personnel without regard to portfolio ownership and results in a similar credit loss exposure for the Company. TWO-MONTHS-AND-OVER CONTRACTUAL DELINQUENCIES (AS A PERCENT OF MANAGED CONSUMER RECEIVABLES) Total delinquent receivables at December 31, 1993 were $142 million lower than a year earlier despite higher receivable levels. This improvement consisted of a $124 million decrease in the domestic operations and a $18 million decrease in the Australian operations. Delinquency as a percent of managed consumer receivables fell 19 percent in 1993 and was the lowest since 1988. The Company currently believes the positive trend in delinquency ratios will continue but recognizes the trend may moderate in future periods. Further improvement will depend on the extent and timing of improvement in economic conditions in both countries where the Company operates and the composition of the managed receivables base. DOMESTIC DELINQUENCY HOME EQUITY delinquency declined during the fourth quarter of 1993 and remained below the year-end 1992 level. Home equity delinquency was the lowest since December 1990 and was down approximately 44 percent from the peak in the first quarter of 1992. The improvement was a result of tighter underwriting standards instituted at the start of the recent economic downturn and improvements in the economy. Vintage analysis of home equity loans originated after June 1991 continued to demonstrate the favorable performance of recently underwritten receivables. The delinquency level for OTHER SECURED RECEIVABLES at December 31, 1993 decreased from the prior quarter and prior year, but did not impact total delinquency due to the small size of the portfolio. BANKCARD delinquency declined compared to the prior quarter and was below the December 1992 level. The improvement was due to higher quality bankcard receivables recently underwritten, which have higher credit scores and lower early delinquency. MERCHANT PARTICIPATION delinquency levels continued to decline in the fourth quarter of 1993 and were below the year-end 1992 level. The steady decline during 1993 was the result of an improved economy coupled with tighter underwriting standards and a greater focus on association with low delinquency merchants. The delinquency level for OTHER UNSECURED receivables decreased in the 1993 fourth quarter and has fallen for eight consecutive quarters. This steady decline was due to the improvement of the quality of receivables recently underwritten combined with improved economic conditions. Since chargeoff rates on unsecured receivables are much higher than secured receivables, improvements in delinquency are significant in evaluating potential future credit losses. FOREIGN DELINQUENCY Delinquency levels in AUSTRALIA continued to improve; however, due to the relatively small size of the receivable portfolio, the decrease in delinquency had a relatively small impact on total delinquencies for the Company. NONPERFORMING ASSETS The following table details the components of nonperforming assets for the Finance and Banking segment: The decrease in nonaccrual managed receivables during 1993 primarily was due to improvements in the domestic consumer finance operations. Consumer real estate owned was essentially flat compared to both the 1992 year-end level and third quarter level. As part of continuing commercial activities, the Company held at December 31, 1993 approximately $83 million of aircraft acquired through foreclosure of loans and leases. The Company is actively marketing these aircraft for sale or lease. However, due to the current economic condition of the airline industry, the Company is uncertain about the timing of the disposition of these aircraft. These aircraft were recorded at date of acquisition at the lower of cost or fair value, with such values subsequently being depreciated over their estimated remaining useful lives. CHARGEOFFS Chargeoffs decreased in 1993 as a result of improved delinquency trends and better domestic economic conditions. The following table presents chargeoffs on a full year and quarterly basis, by product: NET CHARGEOFFS OF CONSUMER RECEIVABLES (AS A PERCENT OF AVERAGE CONSUMER RECEIVABLES MANAGED) Net chargeoffs as a percent of average consumer receivables managed were 3.61 percent, down from 3.81 percent in 1992, primarily due to improvements in the unsecured portfolios. Chargeoffs are a lagging indicator of credit quality and generally reflect prior delinquency trends. As previously discussed, overall delinquency levels have continued to decline. The decline has been a result of improved economic conditions and the effect of the Company's strategy to improve overall credit quality by tightened underwriting standards. The Company expects that chargeoff trends will continue to follow the downward trend in consumer delinquency. However, future improvement in net chargeoffs may be impacted by factors such as product mix, economic conditions and the impact of personal bankruptcies. Consequently, the extent and timing of an overall improved chargeoff trend remains uncertain. Domestic net chargeoffs were 3.60 percent for the year, down from 3.83 percent a year ago, due to improvements in the unsecured portfolios. HOME EQUITY chargeoffs increased slightly on both a year-over-year basis and in the fourth quarter as this portfolio continued to be impacted by weak economic conditions in the western region. Net chargeoffs for OTHER SECURED receivables did not significantly impact total chargeoffs as these receivables represented approximately 2 percent of total managed receivables at year end. In the domestic unsecured portfolios, BANKCARD net chargeoffs declined in 1993 compared to the prior year due to improved economic conditions and a decrease in personal bankruptcies. Net chargeoffs of MERCHANT PARTICIPATION and OTHER UNSECURED receivables were below both the 1992 level and the prior quarter. These improvements were consistent with the downward trend in delinquency in these portfolios. Chargeoffs in AUSTRALIA increased year-over-year and during the fourth quarter. However, due to the size of the receivable portfolio, Australia's chargeoffs did not significantly impact the overall chargeoff level of the Company. INDIVIDUAL LIFE INSURANCE Individual Life Insurance net income was $45.2 million, up 8 percent from 1992 due to higher investment income resulting from gains on the sale of available-for-sale investments, a larger investment portfolio and higher levels of contract revenues from individual life and annuity contracts. STATEMENTS OF INCOME Investment securities for the Individual Life Insurance segment totaled $6.4 billion, up from $5.3 billion at December 31, 1992. This portfolio represented 90 percent of the Company's total investment portfolio at December 31, 1993. During 1993 the Company continued to emphasize conservative investment strategies. Higher-risk securities, which include non-investment grade bonds, common and preferred stocks, commercial mortgage loans and real estate, represented 7 percent of the insurance investment portfolio at December 31, 1993, compared to 9 percent at December 31, 1992. Commercial real estate loans totaled less than 2 percent of Individual Life Insurance segment investments at December 31, 1993. At December 31, 1993 there were no significant nonaccrual or renegotiated loans in this portfolio. Commercial real estate acquired through foreclosure, which is included in the investment portfolio, totaled $12.4 million. Underwriting standards and credit monitoring procedures for these residential and commercial real estate loans are similar to those described in the credit management policy section on pages 5 and 6. At December 31, 1993 the market value of the insurance held-to-maturity investment portfolio was 108 percent of the amortized cost. Reductions in market value which are determined to be other than temporary are charged to income as realized losses. There were no unrealized losses in the insurance investment portfolio at December 31, 1993 which would materially impact current or future earnings or the capital position of the Company. Investment and other income was $540.4 million in 1993, a 12 percent increase over 1992. The improvement was primarily due to higher gains on sales of available-for-sale investments. These investments were sold consistent with pre-established interest rate and exchange rate policies. A substantially larger investment portfolio, partially offset by lower yields on investments, also contributed to the increase in investment income. Contract revenues also increased in 1993 due to higher levels of insurance in force. Policyholders' benefits were $456.9 million, a 7 percent increase over 1992 due to increased life insurance and annuity contracts. Operating expenses for 1993 were $140.2 million compared with $102.1 and $95.2 million in 1992 and 1991, respectively. Both the 1993 and 1992 increases were due to higher amortization of deferred insurance policy acquisition costs ("DAC"). The higher levels of DAC amortization resulted from increased gross profits on universal life and deferred annuity products. Amortization rates are based on estimated lifetime gross profits and are periodically adjusted as required by generally accepted accounting principles. Unamortized insurance policy acquisition costs totaled $381.6 million at December 31, 1993. In the event of policy surrender, the write-off of unamortized insurance policy acquisition costs would be offset by surrender charges to the policyholder. Surrender charges on policies for which acquisition costs have been capitalized approximated $490 million at December 31, 1993. The effective income tax rate for 1993 was 36.5 percent compared to 34.0 and 26.5 percent in 1992 and 1991, respectively. The 1993 effective tax rate included the impact of the retroactive increase to January 1, 1993 in the statutory Federal corporate income tax rate from 34 percent to 35 percent. The 1991 income tax rate was favorably impacted as a result of the resolution of prior years' tax matters. LIQUIDATING COMMERCIAL LINES The 1993 net loss for the Liquidating Commercial Lines segment was $21.5 million, compared to a loss of $12.3 million in 1992. The net loss was higher primarily due to the previously described resolution of the Company's largest problem loan. The Company expects future results of operations for this segment to improve. STATEMENTS OF OPERATIONS Interest margin increased over 1992 primarily due to wider spreads and gains on terminating debt and related hedges associated with assets which have been liquidated. Other revenues increased due to the Company's 25 percent equity investment in a commercial joint venture of liquidating assets made in 1993. See pages 5 and 6 for a discussion of factors impacting the determination of provision for credit losses. Operating expenses declined 37 percent due to lower write-downs and net expenses for real estate owned and other expenses. Loans decreased 27 percent in 1993 to $1.2 billion. Commercial real estate and highly leveraged acquisition finance and other loans declined during the year. Highly leveraged acquisition finance receivables at December 31, 1993 totaled $717.3 million and consisted of 27 individual credit extensions. The average credit extension was $27 million and the largest credit extension was $50 million. The Company defines highly leveraged acquisition finance receivables as corporate loans to finance the buyout, acquisition or recapitalization of an existing business, in which the debt and equity subordinated to the Company's claims in a borrower are less than 25 percent of the borrower's total assets. The Company had unfunded secured working capital lines and letters of credit related to these acquisition finance borrowers of $98 million at December 31, 1993. Lending for highly leveraged acquisition finance loans was discontinued in 1991. COMMERCIAL NONPERFORMING LOANS AND REAL ESTATE OWNED Nonperforming commercial assets decreased 27 percent during 1993 to $514.0 million. Nonaccrual loans at December 31, 1993 were down 12 percent compared to the December 31, 1992 level, while renegotiated loans declined by $168.1 million during the year. The previously mentioned problem equipment finance loan was transferred during the year from renegotiated loan status to nonaccrual loan status prior to being resolved. Despite the resolution of this credit, the ratio of reserves to nonperforming loans increased to 67.2 percent at December 31, 1993 from 44.6 percent at December 31, 1992. Real estate owned was flat with the prior year. The Company expects the longer term downward trend in nonperforming assets to continue, although it may stabilize in the near future before decreasing. The future level of nonperforming assets will depend, in part, on the timing and extent of economic recovery. In addition, comparisons between periods may be impacted by individual transactions which mask the overall trend. The Company continues to estimate its ultimate loss exposure for nonperforming assets based upon performance and specific reviews of individual loans and its outlook for economic conditions. Because the portfolio consists of a number of loans with relatively large balances, changes in individual borrower circumstances which currently are unforeseen have the potential to change the estimate of ultimate loss exposure in the future. There were no significant potential problem loans not classified as nonperforming assets at December 31, 1993. Management believes that commercial real estate markets began to stabilize in the second half of 1993. The level of future write-downs will continue to depend heavily on changes in overall market conditions as well as circumstances surrounding individual properties. To preserve value in liquidating the real estate portfolio over time, the Company has segregated its portfolio into two categories. Properties in weak markets or with poor cash flow will be divested in an expeditious, orderly fashion. These properties, which have been written down an average of 51 percent, represent 19 percent of the commercial real estate owned portfolio at December 31, 1993. The average carrying value of a property in this portfolio at December 31, 1993 was $2 million. Properties with positive and/or improved cash flows and in markets which, the Company believes, have potential for improvement are being held for sale at prices which reflect this value and may, therefore, take longer to divest. Net operating income on all commercial real estate properties in 1993 was $17.7 million, up from $8.5 million in 1992. Commercial real estate write-downs and carrying costs on all commercial real estate properties were $30.8 million in 1993, compared to $23.3 million in 1992. LIQUIDITY AND CAPITAL RESOURCES The Company generally is funded independently with cash flows, liquidity and capital resources monitored at both the Company and Household International levels. The decision to invest in or to withdraw capital from specific business segments is based on their profitability, growth potential and target capital structure. Household International invested additional capital in HFC of approximately $70 million in 1993 to strengthen the Company's capital position and to fund asset growth. The Company received no capital contributions from Household International in 1992. HFC paid cash dividends to Household International of $175.3 and $63.0 million in 1992 and 1991, respectively. The Company paid no cash dividends to Household International in 1993. The Company employs an integrated and comprehensive program to manage liquidity and capital resources. The major usage of cash by the Company is the origination or purchase of receivables or investment securities. During 1993 and 1992 the Company purchased $430 and $364 million of home equity loan portfolios, respectively. During 1993 and 1992 the Company purchased $33 and $437 million, respectively, of bankcard portfolios. The main sources of cash for the Company are the collection and sales of receivable balances, maturities or sales of investment securities, proceeds from the issuance of debt, cash received from policyholders and cash provided from operations. The Company obtains a majority of its funding through the issuance of commercial paper and long-term debt as well as through the securitizations and sales of consumer receivables. At December 31, 1993 outstanding commercial paper of the Company was $3.7 billion compared to $3.2 billion at December 31, 1992. HFC markets its commercial paper through an in-house sales force, directly reaching more than 165 investors. HFC also markets medium-term notes through its in-house sales force and investment banks and issued a total of $1.6 billion in 1993. During 1993 HFC also issued $626 million of intermediate and long-term debt to the public through investment banks and brokerage houses. To facilitate liquidity, HFC had committed back-up lines of credit totaling $3.5 billion at December 31, 1993, 76 percent of which did not contain a material adverse change clause which could restrict availability. Securitizations and sales of consumer receivables have been, and will continue to be, an important source of liquidity for HFC. During 1993 the Company securitized and sold, including replenishments of certificate holder interests, approximately $3.8 billion of home equity, merchant participation and bankcard receivables compared to $4.8 billion in 1992. Household International has a comprehensive program which addresses the management and diversification of financial risk, such as interest rate, funding, liquidity and currency risk. Household International manages these risks for the Company through an asset/liability management committee ("ALCO") composed of senior management. Interest rate risk is the exposure of earnings to changes in interest rates. The ALCO sets and monitors policy so that the potential impact on earnings from future changes in interest rates is managed within approved limits. Simulation models are utilized to measure the impact on net interest margin of changes in interest rates. The Company, whenever possible, funds its assets with liability instruments of similar interest rate sensitivity, thereby reducing structural interest rate risk. To manage its liquidity position, the Company may synthetically create liabilities with similar characteristics to its assets. As a result of changing market conditions over the last few years, the Company's balance sheet composition has changed dramatically. This shift primarily has been driven by the conversion of fixed rate credit card receivables to a floating rate and the success of variable rate home equity loan products. At December 31, 1993 the Company owned approximately $6.0 billion of domestic receivables with variable interest rates based on the prime rate. To manage liquidity to acceptable levels, these receivables have been funded with $4.0 billion of short-term debt with the remainder funded by longer duration liabilities creating an asset-sensitive position. Through the use of derivatives, primarily interest rate swaps, the Company has been able to offset the asset sensitivity of its balance sheet and achieve a cost of funds based on shorter-term interest rates, thereby reducing interest rate risk while also preserving liquidity. As a result of this strategy and the change in the pricing characteristics of the receivable portfolio, the Company's portfolio of off- balance sheet risk instruments increased significantly during the year. These instruments also are used to manage basis risk or the risk due to the difference in movement of market rate indices on which assets and liabilities are priced (primarily prime and LIBOR, respectively). The Company does not serve as a financial intermediary to make markets in any off-balance sheet financial instruments. While the notional amount of the Company's synthetic portfolio is large, the economic exposure underlying these instruments is substantially less. The notional amount is used to determine the fixed or variable rate interest payment due by each counterparty but does not result in an exchange of principal payments. The Company's exposure on its synthetic portfolio is counterparty risk, or the risk that a counterparty may default on a contract when the Company is owed money. The potential for economic loss is the present value of the interest rate differential determined by reference to the notional amount, discounted using current interest rates. Counterparty limits have been established and are closely monitored as part of the overall risk management process. At December 31, 1993 approximately 99 percent of the Company's derivative instrument counterparties were rated A-or better, and 56 percent were rated AA-or better. The Company has never suffered a loss due to counterparty failure. While attempting to eliminate structural interest rate risk, the Company also strives to take advantage of the profit opportunities available in short-term interest rate movements principally using exchange-traded options. Limits have been established for each instrument based on potential daily changes in market values due to interest rate movements, volatility and market liquidity. Positions are monitored daily to ensure compliance with established policies and limits. Income from these trading activities has not been, nor is anticipated to be, material to the Company. See Note 8, "Financial Instruments With Off-Balance Sheet Risk and Concentrations of Credit Risk" for additional information related to interest rate risk management. During 1993, the Company's credit rating was upgraded by one nationally recognized rating agency and its credit rating outlook was upgraded by another. At December 31, 1993, the long-term debt of the Company had been assigned an investment grade rating by four "nationally recognized" rating agencies. Furthermore, these agencies included the commercial paper of HFC in their highest rating category. With these ratings the Company believes it has substantial capacity to raise capital from wholesale sources to refinance maturing obligations and fund business growth. Total assets of Australia were $419.6 million at year-end 1993. The Company enters into foreign exchange contracts to partially hedge its investment in Australia. Foreign currency translation adjustments, net of gains and losses on contracts used to hedge foreign currency fluctuations, totaled $5.0 and $10.3 million in net losses in 1993 and 1992, respectively, and are included as a component of common shareholder's equity. The functional currency for Australia is its local currency, and the Australian operation borrows funds in local currency. The Company's net realized gains and losses in foreign currency transactions were not material to results of operations or financial position in 1993 or 1992. The Company's life insurance subsidiary, Alexander Hamilton Life Insurance Company ("Alexander Hamilton"), plans for capital needs based on target leverage ratios determined in consultation with key rating agencies. The target leverage ratios are based on Alexander Hamilton's statutory financial position. At the end of 1993 Alexander Hamilton's operating leverage ratio, as defined statutorily, was consistent with its target. Alexander Hamilton has an A+ (Superior) rating from A.M. Best and has an "AA" claims-paying ability rating from Standard & Poor's Corporation, Duff and Phelps Credit Rating Co. and Fitch Investors Services, Inc. The Company believes that future growth of Alexander Hamilton can be funded through its own operations. During 1993, the Company invested $30.5 million in capital expenditures, compared to the prior year level of $37.5 million. In the accompanying financial statements, Note 10 provides information regarding the fair value of certain financial instruments. ITEM 8.	ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. Reference is made to the list of financial statements under Item 14(a) herein for the financial statements required by this Item. ITEM 9.	ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. Inapplicable. PART III. ITEM 10.	ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. Omitted. ITEM 11.	ITEM 11. EXECUTIVE COMPENSATION. Omitted. ITEM 12.	ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Omitted. ITEM 13.	ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Omitted. PART IV. ITEM 14.	ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) Financial Statements. Report of Independent Public Accountants. Statements of Income for the Three Years Ended December 31, 1993. Balance Sheets, December 31, 1993 and 1992. Statements of Cash Flows for the Three Years Ended December 31, 1993. Statements of Changes in Preferred Stock and Common Shareholder's Equity for the Three Years Ended December 31, 1993. Business Segment Data for the Three Years Ended December 31, 1993. Notes to Financial Statements. Selected Quarterly Financial Data (Unaudited). (b) Reports on Form 8-K During the three months ended December 31, 1993, HFC did not file with the Securities and Exchange Commission any Current Report on Form 8-K. (c) Exhibits. 3(i) Restated Certificate of Incorporation of Household Finance Corporation ("HFC"), as amended (incorporated by reference to Exhibit 3(a) of HFC's Annual Report on Form 10-K for the fiscal year ended December 31, 1992). 3(ii) Bylaws of Household Finance Corporation (incorporated by reference to Exhibit 3(b) of HFC's Annual Report on Form 10-K for the fiscal year ended December 31, 1992). 4(a) Indenture dated as of May 15, 1989, between HFC and Bankers Trust Company, as Trustee (incorporated by reference to Exhibit 4 to HFC's Current Report on Form 8-K dated August 3, 1989), as supplemented by a First Supplemental Indenture dated as of June 15, 1989 (incorporated by reference to Exhibit 4 of HFC's Current Report on Form 8-K dated June 15, 1989), as amended by Amendment No. 1 dated October 18, 1990 to the First Supplemental Indenture dated as of June 15, 1989 (incorporated by reference to Exhibit 4 of HFC's Current Report on Form 8-K dated October 18, 1990). 4(b) The principal amount of debt outstanding under each other instrument defining the rights of holders of long-term debt of HFC and its subsidiaries does not exceed 10 percent of the total assets of HFC and its subsidiaries on a consolidated basis. HFC agrees to furnish to the Securities and Exchange Commission, upon request, a copy of each instrument defining the rights of holders of long-term debt of HFC and its subsidiaries. 12 Statement of Computation of Ratios of Earnings to Fixed Charges and to Combined Fixed Charges and Preferred Stock Dividends. 23 Consent of Arthur Andersen & Co. Certified Public Accountants. (d) Schedules. Household Finance Corporation and Subsidiaries: VIII Valuation and Qualifying Accounts. X Supplementary Income Statement Information. SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934, HOUSEHOLD FINANCE CORPORATION HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED. HOUSEHOLD FINANCE CORPORATION Dated: March 29, 1994 By: R. F. ELLIOTT --------------------------------- R. F. Elliott, 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 HOUSEHOLD FINANCE CORPORATION AND IN THE CAPACITIES AND ON THE DATES INDICATED. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS HOUSEHOLD FINANCE CORPORATION: We have audited the accompanying balance sheets of Household Finance Corporation (a Delaware corporation) and subsidiaries as of December 31, 1993 and 1992, and the related statements of income, changes in preferred stock and common shareholder's equity and cash flows for each of the three years in the period ended December 31, 1993. These financial statements and the schedules referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Household Finance Corporation and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The supplemental schedules listed in Item 14(d) are presented for purposes of complying with the Securities and Exchange Commission's rules and are not a required part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state 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 & CO. Chicago, Illinois February 1, 1994 HOUSEHOLD FINANCE CORPORATION AND SUBSIDIARIES STATEMENTS OF INCOME The accompanying notes are an integral part of these financial statements. HOUSEHOLD FINANCE CORPORATION AND SUBSIDIARIES BALANCE SHEETS - ------------ * See the Statements of Changes in Preferred Stock and Common Shareholder's Equity on page for the number of shares authorized, issued and outstanding. The accompanying notes are an integral part of these financial statements. HOUSEHOLD FINANCE CORPORATION AND SUBSIDIARIES STATEMENTS OF CASH FLOWS The accompanying notes are an integral part of these financial statements. HOUSEHOLD FINANCE CORPORATION AND SUBSIDIARIES STATEMENTS OF CHANGES IN PREFERRED STOCK AND COMMON SHAREHOLDER'S EQUITY The accompanying notes are an integral part of these financial statements. HOUSEHOLD FINANCE CORPORATION AND SUBSIDIARIES PRESENTATION OF INCOME DATA The combination of the Company's consumer and continuing commercial product lines are referred to as Finance and Banking. Assets of the liquidating commercial product lines, which are separately managed as receivables are collected or otherwise disposed of, have been disclosed separately in the consolidated balance sheets and as a separate business segment, referred to as Liquidating Commercial Lines. To better define and report the results of operations, the Company refers to its Finance and Banking and Individual Life Insurance segments as its Core Business. Operating profits represent income before income taxes but include interest expense, as financing costs are integral to the Company's operations. Income by segment assumes each business services its own debt. The segments generally provide for income taxes as if separate tax returns were filed subject to certain consolidated return limitations and benefits. Equity is allocated to the business segments based on the underlying regulatory and business requirements. PRESENTATION OF BUSINESS SEGMENT DATA The Finance and Banking segment markets home equity receivables, other secured consumer receivables, bankcards, merchant participation receivables, other unsecured consumer receivables, equipment and other secured commercial loans and leases, and credit and specialty insurance. The Individual Life Insurance segment provides ordinary life, universal life and annuity insurance products. The Liquidating Commercial Lines segment manages the discontinued product lines which consist of commercial real estate, acquisition finance and other loans and other commercial assets being liquidated. HOUSEHOLD FINANCE CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS Household Finance Corporation ("HFC" or the "Company") is a subsidiary of Household International, Inc. ("Household International" or the "parent company"). 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION. The financial statements include the accounts of the Company and all subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. Certain prior year amounts have been reclassified to conform with the current year's presentation. INVESTMENT SECURITIES. The Company maintains investment portfolios in both its noninsurance and insurance operations. These portfolios are comprised primarily of debt securities. The insurance portfolio also includes mortgage and policyholder loans and other real estate investments. Effective December 31, 1993 the Company adopted Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" ("FAS No. 115"). In accordance with FAS No. 115, investment securities in both the noninsurance and insurance operations are classified in three separate categories: trading, available-for-sale or held-to-maturity. Trading investments are bought and held principally for the purpose of selling them in the near term and are carried at fair value. Adjustments to the carrying value of trading investments are included in current earnings. Investments which the Company has the positive intent and ability to hold to maturity are classified as held-to-maturity and carried at amortized cost. Investments not classified as trading or held-to-maturity are classified as available-for-sale. They are intended to be invested for an indefinite period but may be sold in response to events reasonably expected in the foreseeable future. These investments are carried at fair value. Unrealized holding gains and losses on available-for-sale investments are recorded as adjustments to common shareholder's equity, net of income taxes and, for certain investments in the insurance operation, related unrealized deferred insurance policy acquisition cost adjustments (see 'Insurance' accounting policies on pages and). Prior to the adoption of FAS No. 115, available-for-sale investments were carried at the lower of aggregate amortized cost or fair value, and any adjustments to carrying value for the noninsurance operations were included in earnings, while any adjustments to carrying value for the insurance operation were included in common shareholder's equity. Any decline in the fair value of available-for-sale or held-to-maturity investments which is deemed to be other than temporary is charged against current earnings. Cost of investment securities sold by the insurance operation generally is determined using the first-in, first-out ("FIFO") method, and cost of noninsurance investment securities sold is determined by specific identification. Interest income earned on the noninsurance investment portfolio is classified in the statements of income in net interest margin. Realized gains and losses from the noninsurance portfolio and investment income from the insurance portfolio are recorded in investment income. Gains and losses on trading investments are recorded in other income. Accrued investment income is classified with investment securities. RECEIVABLES. Receivables are carried at amortized cost. The Company periodically sells receivables from its home equity, bankcard and merchant participation portfolios. Because these receivables were originated with variable rates of interest or rates comparable to those currently offered by the Company for such receivables, carrying value approximates market value. Finance income is earned using the effective yield method and classified on the balance sheets, to the extent not collected, with the related receivables. Origination fees are deferred and amortized to finance income over the estimated life of the related receivables, except to the extent they offset directly related lending costs. Annual fees on bankcards are netted with direct lending costs associated with the issuance of the cards. The net amount is deferred and amortized on a straight-line basis over one year. Net deferred direct lending costs related to bankcard receivables totaled $7 and $8 million at December 31, 1993 and 1992, respectively. Insurance reserves applicable to credit risks on consumer receivables are treated as a reduction of receivables in the balance sheets since payments on such policies generally are used to reduce outstanding receivables. Provisions for credit losses are made in amounts sufficient to maintain reserves at a level considered adequate to cover probable losses of principal and earned interest in the existing portfolio of owned receivables. Probable losses are estimated for consumer receivables based on contractual delinquency status and historical loss experience and, for commercial loans, based on a specific loan review process as well as management's assessment of general reserve requirements. These estimates are reviewed periodically, and adjustments are reported in earnings in the periods in which they become known. The Company's chargeoff policy for all consumer receivables is based on contractual delinquency over periods ranging from 6 to 9 months. Commercial loans are written off when it becomes apparent that an account is uncollectible. LIQUIDATING COMMERCIAL ASSETS. The Company has discontinued selected, high-risk commercial product lines. These assets are managed separately from the continuing core businesses and therefore have been presented separately for financial reporting purposes. Liquidating commercial assets are recorded in the accompanying balance sheets at amortized cost net of reserves for credit losses. The carrying value recorded does not exceed amounts estimated to be recoverable, which is consistent with the current intent to hold these assets and collect or otherwise dispose of them in the normal course of business. These assets are accounted for consistent with accounting policies discussed herein. NONACCRUAL LOANS. Nonaccrual loans are loans on which accrual of interest has been suspended. Interest income is suspended on all consumer and commercial loans when principal or interest payments are more than three months contractually past due, except for bankcards and private-label credit cards, which are included in the merchant participation product line. On these credit card receivables, interest continues to accrue until the receivable is charged off. There were no commercial loans at December 31, 1993 which were 90 days or more past due which remained on accrual status. Accrual of income on nonaccrual consumer receivables is not resumed until such receivables become less than three months contractually past due. Accrual of income on nonaccrual commercial loans is not resumed until such loans become contractually current. RECEIVABLES SOLD AND SERVICED WITH LIMITED RECOURSE AND SECURITIZATION INCOME. Certain home equity, bankcard and merchant participation receivables have been securitized and sold to investors with limited recourse. The servicing rights to these receivables have been retained by the Company. Upon sale, the receivables are removed from the balance sheet, and a gain on sale is recognized for the difference between the carrying value of the receivables and the adjusted sales proceeds. The adjusted sales proceeds are based on a present value estimate of future cash flows to be recognized over the life of the receivables. Future cash flows are based on estimates of prepayments, the impact of interest rate movements on yields of receivables sold and securities issued, delinquency of receivables sold, normal servicing fees, operating expenses and other factors. The resulting gain is reduced by establishing a reserve for estimated probable losses under the recourse provisions. Gains on sale, recourse provisions and servicing cash flows on receivables sold are reported in the accompanying statements of income as securitization and servicing fee income. PURCHASED MORTGAGE SERVICING RIGHTS. In 1993, the Company acquired purchased mortgage servicing rights ("PMSR") from an affiliate (see Note 14, "Transactions With Parent Company and Affiliates" for a description of the transaction). PMSR are amortized in a manner which corresponds to the estimated net servicing revenue stream over their estimated useful life not to exceed 15 years. The Company periodically evaluates the carrying value of its PMSR in light of the actual repayment experience of the underlying loans and makes adjustments to reduce the carrying value where appropriate. Servicing income and amortization of PMSR are included in securitization and servicing fee income in the statements of income. PROPERTIES AND EQUIPMENT. Properties and equipment are recorded at cost and depreciated over their estimated useful lives principally using the straight-line method for financial reporting purposes and accelerated methods for tax purposes. REAL ESTATE OWNED. Real estate owned, which is included in assets acquired through foreclosure on the accompanying balance sheets, is valued at the lower of cost or fair value less estimated costs to sell. Costs of holding this real estate, and related gains and losses on disposition, are credited or charged to operations as incurred. These values are periodically reviewed and reduced, if appropriate. INSURANCE. Premiums for ordinary life policies are recognized when due. Premiums for credit insurance are recognized over the period at risk in relationship to anticipated claims. Premiums received on single premium life, universal life and annuity policies ("interest sensitive policies") are considered insurance deposits. Revenues on interest sensitive insurance policies consist of contract charges against policyholders' accounts and are reported in the period assessed. Costs associated with acquisition of insurance risks are deferred and generally amortized in relation to premium revenues on ordinary and credit insurance and in relation to gross profits on interest sensitive policies. Amortization of deferred insurance policy acquisition costs has been adjusted for unrealized gains or losses on available-for-sale investments on the same basis as if the gains or losses were realized. Such amortization related to unrealized gains or losses has been netted against the unrealized gains or losses as an adjustment to common shareholder's equity. Liability for future contract benefits on interest sensitive policies is computed in accordance with the retrospective deposit method using interest rates which vary with rates credited to policyholders' accounts. Liabilities for future policy benefits on other life insurance products generally are computed using the net level premium method, based upon estimated future investment yields, mortality, and withdrawals appropriate when the policies were issued. Mortality and withdrawal assumptions principally are based on industry tables. Policy and contract claim reserves are based on estimated settlement amounts for both reported and incurred but not reported losses. ACQUIRED INTANGIBLES. Acquired intangibles consist of the cost of investments in excess of net tangible assets acquired and acquired credit card relationships. Acquired credit card relationships are amortized on a straight-line basis over their estimated remaining lives, not to exceed 10 years. Other intangible assets are amortized using straight-line and other methods over their estimated useful lives, not to exceed 15 years. The average remaining amortization period for acquired intangibles was approximately 6, 7 and 8 years at December 31, 1993, 1992 and 1991, respectively. INTEREST RATE CONTRACTS. The Company enters into a variety of interest rate contracts in the management of its interest rate exposure and in its trading activities. For interest rate swaps that are designated as hedges, the interest rate differential to be paid or received is accrued and included in interest expense. For interest rate futures, options, caps and floors, and forward contracts that qualify as hedges, realized and unrealized gains and losses are deferred and amortized over the lives of the hedged items as adjustments to interest expense. Realized and unrealized gains and losses on contracts that do not qualify as hedges are included in other income. FOREIGN CURRENCY TRANSLATION. Foreign subsidiary assets and liabilities are located in Australia. The functional currency for Australia is its local currency. Foreign subsidiary financial data are translated into U.S. dollars at the current exchange rate, and translation adjustments are accumulated as a separate component of common shareholder's equity. The Company enters into forward exchange contracts to hedge its investment in foreign subsidiaries. After-tax gains and losses on contracts to hedge foreign currency fluctuations are included in the foreign currency translation adjustment in common shareholder's equity. Effects of foreign currency translation in the statements of cash flows are offset against the cumulative foreign currency adjustment, except for the impact on cash. Foreign currency transaction gains and losses are included in income as they occur. INCOME TAXES. The Company and its eligible subsidiaries are included in Household International's consolidated Federal income tax return and in various consolidated state income tax returns. In addition, the Company files some unconsolidated state tax returns. Under the tax-sharing agreement with Household International, the Company's Federal and consolidated state tax provisions are determined based on the Company's effect on Household International's consolidated return. Tax benefits are paid to the Company as they are utilized in Household International's consolidated return. Investment tax credits generated by leveraged leases are accounted for by the deferral method. The Company adopted Statement of Financial Accounting Standards No. 109, "Accounting For Income Taxes" ("FAS No. 109") effective January 1, 1993 which requires that deferred tax assets and liabilities, other than those associated with leveraged leasing transactions, be adjusted to the tax rates expected to apply in the periods in which the deferred tax assets and liabilities are expected to be realized or settled. 2. INVESTMENT SECURITIES Investment securities at December 31 were as follows: The Company's insurance subsidiaries held $6.5 and $5.5 billion of the investment securities at December 31, 1993 and 1992, respectively. Policy loans and mortgage loans on real estate held by the Company's insurance subsidiaries are classified as investment securities, consistent with insurance industry practice. Included in the Company's earnings for 1993, 1992 and 1991 are changes in net unrealized holding gains(losses) of $.7, $(3.4) and $3.1 million, respectively, from trading investments. Proceeds from the sale of available-for-sale investments totaled $448.3 and $235.1 million in 1993 and 1992, respectively. Gross gains of $35.8 and $8.8 million and gross losses of $7.5 and $18.1 million in 1993 and 1992, respectively, were realized on those sales. There were no investments classified as available-for-sale in 1991. The amortized cost of held-to-maturity investments transferred to available-for-sale in 1993 was $2.8 billion. Proceeds from sales of held-to-maturity investments were $756.9 million, $825.4 million and $1.3 billion during 1993, 1992 and 1991, respectively. Sales and transfers of held-to-maturity investments in 1993 were due to restructuring of the investment security portfolio in anticipation of the adoption of FAS No. 115 on December 31, 1993. Approximately $400 and $800 million of sales proceeds in 1992 and 1991 were related to a decision made in 1991 to restructure the held-to-maturity investments to significantly reduce exposure in the Company's non-investment grade bond portfolio. Gross gains of $46.5, $34.9 and $36.7 million and gross losses of $9.6, $15.8 and $27.9 million were realized on sales of held-to-maturity investments in 1993, 1992 and 1991, respectively. The gross unrealized gains (losses) on investment securities were as follows: See Note 10, "Fair Value of Financial Instruments" for further discussion of the relationship between the fair value of the Company's assets, liabilities and off-balance sheet financial instruments. As of December 31, 1993 the Company did not hold any debt or equity securities from a single issuer that exceeded 10 percent of common shareholder's equity. Contractual maturities and yields of investments in debt securities available-for-sale and held-to-maturity were as follows: 3. FINANCE AND BANKING RECEIVABLES Finance and Banking receivables of the Australian operations included in receivables owned were as follows: The Company has securitized and sold certain receivables which it services with limited recourse. Securitizations and sales of receivables, including replenishments of certificate holder interests were as follows: The outstanding balance of receivables serviced with limited recourse consisted of the following: The combination of receivables owned and receivables serviced with limited recourse, which the Company considers its managed portfolio, is shown below: For certain securitizations, wholly-owned subsidiaries were created (HRSI Funding, Inc., HFS Funding Corporation, Household Finance Receivables Corporation II, Household Receivables Funding Corporation, Household Receivables Funding Corporation II, and HFC Funding Corporation) for the limited purpose of consummating such transactions. The amount due and deferred from receivables sales of $675.2 million at December 31, 1993 included unamortized excess servicing assets and funds established pursuant to the recourse provisions and holdback reserves for certain sales totaling $539.0 million. The amount due and deferred also included customer payments not yet remitted by the securitization trustee to the Company. In addition, the Company has made guarantees relating to certain securitizations of $281.3 million plus unpaid interest and has subordinated interests in certain transactions, which are recorded as receivables, for $83.9 million at December 31, 1993. The Company maintains credit loss reserves pursuant to the recourse provisions for receivables serviced with limited recourse which are based on estimated probable losses under such provisions. These reserves totaled $134.5 million at December 31, 1993 and represent the Company's best estimate of probable losses on receivables serviced with limited recourse. Contractual maturities of owned receivables at December 31, 1993 were as follows: A substantial portion of all consumer receivables, based on the Company's experience, will be paid prior to contractual maturity. This tabulation, therefore, is not to be regarded as a forecast of future cash collections. The ratio of annual cash collections of principal to average principal balances, excluding bankcard receivables, approximated 40 and 38 percent in 1993 and 1992, respectively. The following table summarizes contractual maturities of owned receivables at December 31, 1993 due after one year by repricing characteristic: Finance and Banking nonaccrual owned receivables totaled $221.3 million at December 31, 1993 including $29.4 million relating to the foreign operation. Interest income that would have been recorded in 1993 if such nonaccrual receivables had been current and in accordance with contractual terms was approximately $36 million. Interest income that was included in net income for 1993 on those receivables was approximately $19 million. For further information on nonperforming assets, see pages 10 and 11 in Management's Discussion and Analysis of Results of Operations. See Note 5, "Credit Loss Reserves" for an analysis of credit loss reserves for Finance and Banking receivables. 4. LIQUIDATING COMMERCIAL ASSETS At December 31, 1993 contractual maturities of receivables were: Within 1 year--$207.3 million; 1 - 2 years--$99.1 million; 2 - 3 years--$249.1 million; 3 - -4 years--$158.9 million; 4 - 5 years--$129.9 million and over 5 years--$345.6 million. Receivables with predetermined interest rates maturing in over 1 year but within 5 years were $331.1 million, and those maturing in over 5 years were $288.2 million. Receivables with floating or adjustable rates maturing in over 1 year but within 5 years were $305.9 million and those maturing in over 5 years were $57.4 million. See Note 5, "Credit Loss Reserves" for an analysis of credit loss reserves for liquidating commercial assets. Liquidating commercial nonaccrual loans totaled $228.7 million at December 31, 1993. See page14 for nonaccrual data for prior years. Interest income that would have been recorded in 1993 if such nonaccrual receivables had been current and in accordance with contractual terms was approximately $33 million. Interest income that was included in net income in 1993 on those receivables was approximately $2 million. Renegotiated loans included in liquidating commercial assets at December 31, 1993 totaled $28.7 million. The Company recorded $2.5 million of interest earned on such loans in 1993. Had the loans been performing in accordance with their original terms, interest income in 1993 would have been approximately $4 million higher. There were $.7 million of commitments at December 31, 1993 to lend additional funds to borrowers whose loans were renegotiated. See page 14 for further information on nonperforming assets. 5. CREDIT LOSS RESERVES 6. COMMERCIAL PAPER, BANK AND OTHER BORROWINGS Interest expense for commercial paper, bank and other borrowings totaled $151.0, $174.2 and $260.0 million for 1993, 1992 and 1991, respectively. The Company maintains various bank credit agreements primarily to support commercial paper borrowings. At December 31, 1993 the Company had total bank credit agreements of $4.0 billion, of which $3.7 billion were unused. Formal credit lines are reviewed annually and revolving credit agreements expire at various dates from 1994 to 1996. Borrowings under credit agreements generally are available at the prime rate or at a surcharge over the London Interbank Offered Rate (LIBOR). Annual commitment fee requirements to support availability of credit agreements at December 31, 1993 totaled $7.9 million. 7. SENIOR AND SENIOR SUBORDINATED DEBT (WITH ORIGINAL MATURITIES OVER ONE YEAR) Weighted average interest rates, excluding the impact of interest rate swap agreements, were 7.1, 7.7 and 8.4 percent at December 31, 1993, 1992 and 1991, respectively. Including the impact of interest rate swap agreements, weighted average interest rates were 4.8, 5.5 and 7.6 percent at December 31, 1993, 1992 and 1991, respectively. Maturities of senior and senior subordinated debt at December 31, 1993 were as follows (in millions): At December 31, 1993 there were no significant restrictions on retained earnings in any of HFC's various indentures and agreements. Cash dividends or advances to HFC by certain of its subsidiaries are limited by government or statutory regulation. At December 31, 1993 approximately $1.3 billion of consolidated net assets were so restricted. 8. FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK AND CONCENTRATIONS OF CREDIT RISK In connection with its asset/liability management program and in the normal course of business, the Company enters into various transactions involving off-balance sheet financial instruments. These instruments are used to reduce the Company's exposure to fluctuations in interest rates and foreign exchange rates, and to a lesser extent for proprietary trading purposes, or to meet the financing needs of its customers. The Company does not serve as a financial intermediary to make markets in any off-balance sheet financial instruments. These financial instruments, which include interest rate contracts, foreign exchange rate contracts, commitments to extend credit, financial guarantees and recourse obligations have varying degrees of credit risk and/or market risk. CREDIT RISK Credit risk is the possibility that a loss may occur because the counterparty to a transaction fails to perform according to the terms of the contract. The Company's exposure to credit loss under commitments to extend credit, financial guarantees and recourse obligations is represented by the contract amount. The Company's credit quality and collateral policies for commitments and guarantees are the same as those for receivables that are recorded on the balance sheet. The Company's exposure to credit loss related to interest rate swaps, cap and floor transactions, forward and futures contracts and options is the amount of uncollected interest or premium related to these instruments. These interest rate related instruments are generally expressed in terms of notional principal or contract amounts which are much larger than the amounts potentially at risk for nonpayment by counterparties. The Company controls the credit risk of its off-balance sheet financial instruments through established credit approvals, risk control limits and ongoing monitoring procedures. The Company has never experienced nonperformance by any counterparty. MARKET RISK Market risk is the possibility that a change in interest rates or foreign exchange rates will cause a financial instrument to decrease in value or become more costly to settle. The Company mitigates this risk by establishing limits for positions and other controls and by entering into counterbalancing positions. OFF-BALANCE SHEET INTEREST RATE AND FOREIGN EXCHANGE CONTRACTS The accompanying tables summarize the notional amounts of the Company's off-balance sheet interest rate and foreign exchange contracts: - --------------- * Bracketed amounts at year end represent net short positions. Interest rate swaps are contractual agreements between two counterparties for the exchange of periodic interest payments generally based on a notional principal amount and agreed-upon fixed or floating rates. The Company utilizes interest rate swaps to allow it to match fund its receivables, which are primarily floating rate, with its liabilities, which are primarily fixed rate. Credit and market risk exist with respect to these instruments. The following table summarizes the interest rate swaps outstanding: Forwards and futures are contracts for delivery at a future date in which the buyer agrees to take delivery of a specified instrument or cash at a specified price. The Company has both interest rate and foreign exchange rate forward contracts and interest rate futures contracts. Foreign exchange contracts are utilized by the Company to reduce exposure in its Australian operation to fluctuations in exchange rates. Interest rate forward and interest rate futures contracts primarily are used in the Company's proprietary trading activities. Interest rate forward and futures contracts also are used to mitigate basis risk which arises due to the difference in movement of market rate indices (prime and LIBOR) on which a large portion of the Company's assets and liabilities are priced. For futures, the Company's exposure to credit risk is limited as these contracts are traded on organized exchanges and are settled on a daily basis with the exchanges. In contrast, forward contracts have credit risk relating to the performance of the counterparty. These instruments also are subject to market risk. For forward and futures contracts entered into as hedging activities, the Company had commitments to purchase of $3.4 and $197.5 million and commitments to sell of $91.7 and $108.5 million at December 31, 1993 and 1992, respectively. In connection with its trading activities, the Company had commitments to purchase of $332.0 and $2,710.2 million and commitments to sell of $877.0 and $3,108.0 million at December 31, 1993 and 1992, respectively. Options grant the purchaser the right to either purchase or sell a financial instrument at a specified price within a specified period. The Company primarily uses options, both written and purchased, for its proprietary trading activities. Gains and losses from the Company's trading activities were immaterial to the financial results of the Company. For written options, the Company is exposed to market risk but generally not credit risk. The credit risk and market risk associated with purchased options is limited to the premium paid which is recorded on the balance sheet. The Company had options purchased for trading activities of $9.7 and $2.7 billion and options written for trading activities of $16.4 and $10.6 billion at December 31, 1993 and 1992, respectively. The Company also had options purchased for hedging activities of $29.6 million and options written for hedging activities of $40.0 million at December 31, 1993. The Company had no options written or purchased for hedging activities at December 31, 1992. Other risk management instruments consist of caps and floors and foreign currency swaps. Caps and floors written expose the Company to market risk but not to credit risk. Credit and market risk associated with caps and floors purchased is limited to the premium paid which is recorded on the balance sheet. Deferred gains of $9.7 and $14.2 million and deferred losses of $7.8 and $11.1 million were recorded on the balance sheet from interest rate risk management instruments at December 31, 1993 and 1992, respectively. The weighted average amortization periods were 3.8 and 4.0 years associated with the deferred gains and 4.2 and 2.4 years associated with the deferred losses at December 31, 1993 and 1992, respectively. Interest margin was increased by $166.7, $101.4 and $37.9 million in 1993, 1992 and 1991, respectively, through the use of off-balance sheet interest rate risk management instruments. At December 31, 1993 the accrued interest, unamortized premium and other assets recorded for agreements which would be written off should all related counterparties fail to meet the terms of their contracts was $50.7 million. COMMITMENTS AND GUARANTEES The Company enters into various commitments and guarantees to meet the financing needs of its customers. However, the Company expects a substantial portion of these contracts to expire unexercised. The Company's significant commitments and guarantees consisted of the following: Commitments to extend credit to consumers represent the unused credit limits on bank and private-label credit cards and on other lines of credit. Commitments on bank and private-label credit cards are cancelable at any time. The Company does not require collateral to secure credit card agreements. Other consumer lines of credit include home equity lines of credit, which are secured by residential real estate, and other unsecured lines of credit. Commitments on these lines of credit generally are cancelable by the Company when a determination is made that a borrower may not be able to meet the terms of the credit agreement. Other loan commitments include commitments to fund commercial loans and letters of credit and guarantees for the payment of principal and interest on municipal industrial development bonds. Commercial loan commitments, primarily related to the Liquidating Commercial Lines segment, including working capital lines and letters of credit, totaled $150.7 and $168.9 million at December 31, 1993 and 1992, respectively. These commitments are collateralized to varying extents by inventory, receivables, property and equipment and other assets of the borrowers and were entered into prior to the Company's decision to exit these product lines. The Company has issued guarantees of $136 million at both December 31, 1993 and 1992 for the payment of principal and interest on municipal industrial development bonds. The guarantees expire from 1994 through 1997. The Company has security interests in underlying properties for these guarantees, with an average collateral value of 101 percent of the guarantees at both December 31, 1993 and 1992. The Company also has guaranteed payment of all debt obligations issued prior to 1989, excluding deposits, of Household Financial Corporation Limited ("HFCL"), a Canadian affiliate. The amount of guaranteed debt issued by HFCL prior to 1989 and still outstanding was approximately $113 million. OTHER FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK Certain receivables securitized and serviced with limited recourse include floating interest rate provisions whereby the underlying receivables pay a fixed (floating) rate and the pass-through rate to the investor is floating (fixed). Further, in other transactions the underlying receivables reprice based on one index while the pass-through rate reprices on another index. The Company manages its exposure to interest rate risk on these financial instruments primarily through the use of interest rate swaps. See Note 3, "Finance and Banking Receivables" for additional information on securitizations and sales of receivables. CONCENTRATIONS OF CREDIT RISK A concentration of credit risk is defined as a significant credit exposure with an individual or group engaged in similar activities or affected similarly by economic conditions. Because the Company primarily lends to consumers, it does not have receivables from any industry group that equal or exceed 10 percent of total managed receivables at December 31, 1993 and 1992. The Company lends nationwide; the following geographic areas comprised more than 10 percent of total managed domestic receivables at December 31, 1993: California--22 percent, Midwest (IL, IN, IA, KS, MI, MN, MO, NE, ND, OH, SD, WI)--23 percent, Middle Atlantic (DE, DC, MD, NJ, PA, VA, WV) - 15 percent, Northeast (CT, ME, MA, NH, NY, RI, VT)--14 percent and Southeast (AL, FL, GA, KY, MS, NC, SC, TN)--13 percent. 9. PREFERRED STOCK The Company is authorized to issue up to 1,000 shares of preferred stock, with no stated par value. Preferred stock consisted of the following: The term cumulative preferred stock is non-voting and has a dividend rate of 7.25 percent, is not redeemable at the option of the Company prior to the mandatory redemption date of August 15, 1997, and has a liquidation value of $300,000 per share. On October 1, 1993 the Company's exchangeable money market cumulative preferred stock was redeemed in whole for $500,000 per share plus accrued and unpaid dividends. 10. FAIR VALUE OF FINANCIAL INSTRUMENTS The Company has estimated the fair value of its financial instruments in accordance with Statement of Financial Accounting Standards No. 107, "Disclosures About Fair Value of Financial Instruments" ("FAS No. 107"). The estimates were made as of December 31, 1993 and 1992 based on relevant market information. Financial instruments include cash, receivables, investments, liquidating commercial assets, debt, certain insurance reserves and off-balance sheet instruments. Accordingly, a number of other assets recorded on the balance sheet (such as acquired credit card relationships) and other intangible assets not recorded on the balance sheet (such as the value of consumer lending relationships for originated receivables and the franchise values of the Company's business units) are not required to be valued for purposes of this disclosure. The Company believes there is substantial value associated with these assets based on current market conditions and historical experience. Approximately 30 percent in 1993 and 35 percent in 1992 of the fair value of financial instruments disclosed were determined using quoted market prices. Because no actively traded market exists, however, for a significant portion of the Company's financial instruments, fair values for items lacking a quoted market price were estimated by discounting estimated future cash flows at estimated current market discount rates. Assumptions used to estimate future cash flows are consistent with management's assessments regarding ultimate collectability of assets and related interest and with estimates of product lives and repricing characteristics used in the Company's asset/liability management process. All assumptions are based on historical experience adjusted for future expectations. Assumptions used to determine fair values for financial instruments for which no active market exists are inherently judgmental and changes in these assumptions could significantly affect fair value calculations. The following is a summary of the carrying value and estimated fair value of the Company's financial instruments: The estimated fair value in excess of carrying value (the "Difference") of the Company's financial instruments was $19 million at December 31, 1993 an increase of $6 million from year-end 1992. The adoption of FAS No. 115 on December 31, 1993 reduced the Difference associated with investment securities, as available-for-sale investment securities are now carried at estimated fair value. Excluding the impact of FAS No. 115, the Difference for investment securities at December 31, 1993 would have been approximately $381 million. The excess of carrying value over estimated fair value of liquidating commercial assets declined in 1993, as discussed more fully below. Recently adopted generally accepted accounting principles (FAS No. 115) require recognition of the difference between fair market and carrying values of certain debt and equity securities. As previously disclosed, the differential increased common shareholder's equity by $35.1 million after partially offsetting adjustments for the impact of income taxes and deferred insurance policy acquisition costs. The Company believes it is not meaningful to evaluate the difference between fair market and carrying values for assets without evaluating similar differences for all liabilities and off-balance sheet financial instruments utilized in the Company's asset/liability management process. As market interest rates change, application of this new accounting principle will result in volatility of the reported capital base that is inconsistent with economic value. The analysis presented on the previous page presents a more complete view of the differences between fair market and carrying values of both assets and liabilities. Although the disclosed pretax excess of fair value over carrying value of $19 million at December 31, 1993 covers a substantial portion of the elements of the Company's financial position, it excludes the substantial value associated with other intangible values described earlier. In addition, the disclosures presented previously exclude fair market valuation of certain insurance reserves and leases as prescribed by generally accepted accounting principles. Both the analysis of the fair value information presented previously, as well as the adjustments required by FAS No. 115, therefore have inherent limitations. The following methods and assumptions were used to estimate the fair value of the Company's financial instruments: CASH: The carrying value approximates fair value for this instrument due to its liquid nature. INVESTMENT SECURITIES: Quoted market prices were used to determine fair value for investment securities. FINANCE AND BANKING RECEIVABLES: The fair value of adjustable rate consumer receivables was determined to approximate existing carrying value because interest rates on these receivables adjust with changing market interest rates. The fair value of fixed rate consumer receivables was estimated by discounting future expected cash flows at interest rates approximating those offered by the Company on such products at the respective valuation dates. This approach to estimating fair value for fixed rate consumer receivables results in a disclosed fair value that is less than amounts the Company believes could be currently realizable on a sale of these receivables. These receivables are relatively insensitive to changes in overall market interest rates and therefore have additional value compared to alternative uses of funds in a low interest rate environment. The fair value of consumer receivables included an estimate, on a present value basis, of future excess servicing cash flows associated with securitizations and sales of certain home equity, bankcard and merchant participation receivables. LIQUIDATING COMMERCIAL ASSETS: The fair value of liquidating commercial assets was determined by discounting estimated future cash flows at an estimated market interest rate. The assumptions used in the estimate were consistent with the Company's intention to manage this portfolio of assets separately from the Core Business and to dispose of the assets in the normal course of business. The estimated fair value for liquidating commercial assets was below carrying value due to increases in current market discount rates, adjusted for changes in overall market rates, from rates in effect when assets were originated. This change in discount rates impacts all assets regardless of whether any uncertainty exists over collectability of future principal and interest payments. The Company believes the relative increase in current market discount rates is due to economic conditions and market perceptions towards the types of commercial assets which the Company decided to discontinue in 1991. While these market perceptions improved slightly during 1993, they still remain unfavorable, which has resulted in illiquid and sluggish markets for these assets. Because of these current market conditions, the Company currently intends to collect or otherwise dispose of its liquidating commercial assets over several years. The decrease in the difference between estimated fair value and carrying value in 1993 compared to 1992 reflects the belief that current market conditions, while depressed, have improved and will continue to improve over the next several years. Accordingly, the Company does not believe that the differential between estimated fair and carrying values for liquidating commercial assets represents a permanent impairment of value. COMMERCIAL PAPER, BANK AND OTHER BORROWINGS: The fair value of these instruments was determined to approximate existing carrying value because interest rates on these instruments adjust with changes in market interest rates due to their short-term maturity or repricing characteristics. SENIOR AND SENIOR SUBORDINATED DEBT: Quoted market prices where available were used to determine fair value. For those instruments for which quoted market prices were not available, the estimated fair value was computed by discounting future expected cash flows at interest rates offered for similar types of debt instruments. INSURANCE RESERVES: The fair value of insurance reserves for periodic payment annuities and guaranteed investment contracts was estimated by discounting future expected cash flows at interest rates offered by the Company on such products at December 31, 1993 and 1992. The fair value of other insurance reserves is not required to be determined in accordance with FAS No. 107. The Company believes the fair value of such reserves approximates existing carrying value because interest rates on these instruments adjust with changes in market interest rates due to their short-term maturity or repricing characteristics. INTEREST RATE AND FOREIGN EXCHANGE CONTRACTS: Quoted market prices were used to determine fair value of these instruments. See Note 8, "Financial Instruments with Off-Balance Sheet Risk and Concentrations of Credit Risk" for a discussion of the nature of these items. COMMITMENTS TO EXTEND CREDIT AND GUARANTEES: These commitments were valued by considering the Company's relationship with the counterparty, the creditworthiness of the counterparty and the difference between committed and current interest rates. 11. LEASES AND OTHER SIMILAR ARRANGEMENTS The Company leases certain offices, buildings and equipment for periods of up to 10 years with various renewal options. The majority of such leases are noncancelable operating leases. Net rental expense under operating leases was $26.6, $25.9 and $27.9 million for 1993, 1992 and 1991, respectively. In the fourth quarter of 1991, the Company purchased credit card receivables of approximately $1 billion from CoreStates Financial Corporation. An unaffiliated third party acquired the rights to the account relationships associated with the receivables. The Company is entitled to utilize the account relationships under a licensing agreement with the third party. This licensing arrangement is noncancelable and has an initial term expiring in 1998. Net expense under this licensing arrangement was $32.9, $32.9 and $2.7 million in 1993, 1992 and 1991, respectively. Future net minimum lease and other commitments under noncancelable operating lease and licensing arrangements were: 12. EMPLOYEE BENEFIT PLANS The Company and its U.S. subsidiaries participate in Household International's Retirement Income Plan ("RIP"), which covers substantially all U.S. full-time employees. No separate actuarial valuation has been made for the Company's participation in RIP. The fair value of plan assets in RIP exceeded Household International's projected benefit obligation by $212.6 and $208.4 million at December 31, 1993 and 1992, respectively. The 1993 and 1992 projected benefit obligations for RIP were determined using an assumed weighted average discount rate of 7.25 and 8.00 percent, respectively, an assumed compensation increase of 3.75 and 4.25 percent, respectively, and an assumed weighted average long-term rate of return on plan assets of 9.50 and 9.75 percent, respectively. At December 31, 1993 and 1992, the Company's estimated share of prepaid pension cost was $113.2 and $101.8 million, respectively. Plan benefits are based primarily on years of service and compensation of participants. The Company's share of total pension income due to the over-funded status of RIP was $11.4, $22.4 and $25.1 million for 1993, 1992 and 1991, respectively. The Company's Australian subsidiary also has a defined benefit pension plan covering substantially all of its employees. The projected benefit obligation, pension income and funded status of the foreign plan is not significant to the Company. The Company participates in Household International's defined contribution plan where each participant's contribution is matched by the Company up to a maximum of 6 percent of the participant's compensation. For 1993, 1992 and 1991 the Company's costs totaled $9.2, $9.2 and $8.5 million, respectively. The Company also participates in Household International's plans which provide medical, dental and life insurance benefits to retirees and eligible dependents. The plans are funded on a pay-as-you-go basis and cover substantially all employees who meet certain age and vested service requirements. Household International has instituted dollar limits on its payments under the plans to control the cost of future medical benefits. Effective January 1, 1993 Household International adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("FAS No. 106"). FAS No. 106 requires the recognition of the expected postretirement costs on an accrual basis, similar to pension accounting. The expected cost of postretirement benefits is required to be recognized over the employees' years of service with the Company instead of the period in which the benefits are paid. Household International is recognizing the transition obligation, which represents the unfunded and unrecognized accumulated postretirement benefit obligation at that date, over 20 years. While no separate actuarial valuation has been made for the Company's participation in Household International's plans for postretirement medical, dental and life benefits, its share of the liability and expense has been estimated. Household International's accumulated postretirement benefit obligation was $152.5 million at December 31, 1993. The Company's estimated share of Household International's accrued postretirement benefit obligation was $10.1 million at December 31, 1993. In addition, the Company's estimated share of postretirement benefit expense recognized in 1993 was $13.9 million. Through 1992, it had been the Company's policy to charge the cost of retiree health care and life insurance benefits to expense when benefits were paid. The cost of these plans to Household International totaled $2.9 and $2.5 million in 1992 and 1991, respectively. The cost of plans which cover retirees and eligible dependents in Australia is not significant to the Company. Household International's accumulated postretirement benefit obligation at December 31, 1993 was determined using an assumed weighted average discount rate of 7.50 percent and an assumed annual compensation increase of 3.75 percent. A 15 percent annual rate of increase in the gross cost of covered health care benefits is assumed for 1993 and 1994. This rate of increase is assumed to decline by 1 percentage point in each year after 1994. The health care cost trend rate assumption has an effect on the amounts reported. To illustrate, increasing the assumed health care cost trend rate by 1 percentage point would have increased the Company's share of the 1993 net periodic postretirement benefit cost by $.7 million and its share of the accumulated postretirement benefit obligation at December 31, 1993 by $8.5 million. A 1 percentage point increase would have increased Household International's accumulated postretirement benefit obligation by $12.3 million. 13. INCOME TAXES Effective January 1, 1993 the Company adopted FAS No. 109. As a result of implementing FAS No. 109, retained earnings for all periods between 1986 and 1992 have been reduced by approximately $62 million from amounts previously reported. The statements of income for those periods subsequent to December 31, 1986 have not been restated as the impact of FAS No. 109 on net income was immaterial to any such year and in total. Total income taxes were allocated as follows: Provisions for income taxes related to operations were: The significant components of deferred income tax provisions attributable to income from operations were: Income before income taxes from foreign operations was $1.0, $14.0 and $6.0 million in 1993, 1992 and 1991, respectively. Effective tax rates are analyzed as follows: In accordance with the Company's accounting policy, provisions for U.S. income taxes had not been made at December 31, 1993 on $85.9 million of undistributed earnings of its U.S. life insurance subsidiary accumulated as policyholders' surplus under tax laws in effect prior to 1984. Because this amount would become taxable only in the event of certain circumstances which the Company does not expect to occur within the foreseeable future, no deferred tax liability has been established for this item. The amount of deferred tax liability not recognized was $30.1 million at December 31, 1993. At December 31, 1993 the Company had net operating loss carryforwards for tax purposes of $39.3 million which have no expiration date. The realization of these carryforwards will reduce future income tax payments. Temporary differences which gave rise to a significant portion of deferred tax assets and liabilities were as follows: 14. TRANSACTIONS WITH PARENT COMPANY AND AFFILIATES HFC periodically advances funds to Household International and affiliates or receives amounts in excess of the parent company's current requirements. Advances to parent company and affiliates consisted of the following: These advances bear interest at various interest rates which approximate market. Interest income on advances to parent company and affiliates is included with interest expense and includes the following: During 1993 and 1992, Household Bank, National Association ("HBNA"), a wholly-owned subsidiary of the Company, borrowed monies from Household Bank, f.s.b. ("the Bank") at arm's length interest rates. The balance at December 31, 1992 was $450 million and was included in commercial paper, bank and other borrowings for financial statement purposes. This loan was paid in full in the first quarter of 1993. HBNA paid approximately $2.6 and $18.2 million of interest expense on this loan during 1993 and 1992, respectively. In November 1993 the Company purchased approximately $133 million of purchased mortgage servicing rights from the Bank. The Bank will continue to act as a subservicer for the Company and will be paid a subservicing fee based on the Bank's estimated costs of servicing the loans. These rights were purchased at net book value which approximated market value. The Company has an agreement with the Bank to originate unsecured nonmortgage consumer loans using the Bank's lending criteria. These loans are originated via direct mail programs, and are serviced by the Company for an arm's length fee. In 1993, the Company originated approximately $73 million of loans for the Bank under this program. Household International has entered into a Regulatory Capital Maintenance/Dividend Agreement with the Office of Thrift Supervision. Under this agreement, as amended, as long as Household International is the parent company of the Bank, Household International and the Company agree to maintain the capital of the Bank at the levels currently required or any subsequent regulatory capital requirements. The agreement also requires that any capital deficiency be cured by Household International and/or the Company within thirty days. In 1993, 1992 and 1991, Household International made cash capital contributions of $70, $54 and $20 million, respectively, to maintain the regulatory capital of the Bank at levels consistent with management's objectives and minimum regulatory capital requirements. During the fourth quarter of 1992 the Company purchased approximately $290 million of home equity loans from the Bank which were subsequently securitized and sold. These loans were purchased by the Bank from a third party. Certain support services of the Company are performed by a wholly-owned subsidiary of Household International. This subsidiary was established to maximize the efficiency and consolidate the back room operating functions of various subsidiaries of Household International. The Company has negotiated an arms-length agreement with this subsidiary for services such as item processing, collections and billings, accounts payable, and payroll processing. Additionally, the Company was allocated and/or billed for costs incurred on its behalf by Household International for expenses including insurance, credit, and legal and other fees. These expenses were recorded in other operating expenses and totaled approximately $261, $207 and $250 million in 1993, 1992 and 1991, respectively. 15. COMMITMENTS AND CONTINGENT LIABILITIES In the ordinary course of business there are various legal proceedings pending against the Company. Management considers that the aggregate liabilities, if any, resulting from such actions would not have a material adverse effect on the consolidated financial position of the Company. See Note 8 for a discussion regarding commitments and contingent liabilities related to off-balance sheet financial instruments. See Note 11 for discussion of lease commitments. HOUSEHOLD FINANCE CORPORATION AND SUBSIDIARIES SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) (IN MILLIONS) FOURTH QUARTER RESULTS Net income for the 1993 fourth quarter was $71.2 million, up 42 percent from the third quarter but down 6 percent from the prior year fourth quarter. The improvement over the third quarter resulted from higher earnings from the domestic consumer finance and bankcard businesses. The domestic consumer finance operations benefited primarily from wider spreads on variable rate products and growth in the managed portfolio, while the bankcard business benefited from higher revenues associated with seasonality. Earnings in the quarter also benefited from lower losses in the Liquidating Commercial Lines segment due to reduced credit losses. Net interest margin was $217.4 million, essentially flat with the prior quarter and up 9 percent from the prior year fourth quarter primarily due to higher average owned receivables and wider spreads on variable rate products. The level of earning assets is dependent on the timing of securitizations and sales of receivables. The Company securitized and sold $.6 billion of receivables in the fourth quarter of 1993 compared to $2.1 billion in the year-ago period. The provision for credit losses on owned receivables declined by $21.6 million in the fourth quarter of 1993 compared to the third quarter due to lower loss provision on liquidating commercial receivables. The third quarter amount reflected the disposition of the Company's largest problem loan. The increase compared to the prior year was primarily due to higher loss provision associated with increased year-over-year receivable balances. Securitization and servicing fee income declined 11 and 29 percent from 1993 third quarter and 1992 fourth quarter amounts due to lower average receivables serviced with limited recourse and a shift toward home equity loans in the securitized portfolio, resulting in narrower spreads. Investment income fell 15 percent from the prior quarter primarily due to higher gains resulting from the sale of investments classified in the available-for-sale portfolios in the third quarter of 1993 compared to the fourth quarter and increased 10 percent over the prior year fourth quarter due to lower realized gains in 1992. The higher levels of fee income in the fourth quarter compared to the prior and year-ago quarters primarily related to interchange and other fee income resulting from growth in the owned credit card portfolios and seasonality. Other income increased in the fourth quarter over the previous quarter and the prior year fourth quarter due to increased income on the Company's 25 percent equity investment in a commercial joint venture and prepayment fees received upon the payoff of commercial assets. Total costs and expenses declined 9 percent compared to the third quarter of 1993 but were up 5 percent compared to the year-ago period. Costs and expenses in the third quarter of 1993 were up due to previously mentioned gains on available-for-sale investments which resulted in higher levels of deferred insurance policy acquisition cost amortization. The effective tax rate in the 1993 fourth quarter was essentially flat compared to the previous quarter and up from 29.6 percent in the prior year. The higher tax rate in 1993 primarily was due to the impact of the enactment of new Federal tax legislation and a change in the treatment of purchase accounting adjustments resulting from the adoption of FAS No. 109. SCHEDULE VIII HOUSEHOLD FINANCE CORPORATION AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS FOR THE THREE YEARS ENDED DECEMBER 31, 1993 SCHEDULE X HOUSEHOLD FINANCE CORPORATION AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE THREE YEARS ENDED DECEMBER 31, 1993 * Represents less than 1 percent of total revenues as reported in the related statements of income. EXHIBIT INDEX
320335_1993.txt	320335	1993	ITEM 1. BUSINESS Torchmark Corporation ("Torchmark"), an insurance and diversified financial services holding company, was incorporated in Delaware on November 19, 1979, as Liberty National Insurance Holding Company. Through a plan of reorganization effective December 30, 1980, it became the parent company for the businesses operated by Liberty National Life Insurance Company ("Liberty") and Globe Life And Accident Insurance Company ("Globe"). United American Insurance Company ("United American"), Waddell & Reed, Inc. ("W&R") and United Investors Life Insurance Company ("UILIC") along with their respective subsidiaries were acquired in 1981. The name Torchmark Corporation was adopted on July 1, 1982. Family Service Life Insurance Company ("Famlico") was purchased in July, 1990. The following list itemizes Torchmark's principal subsidiaries and a description of the subsidiaries' business: Liberty--offers individual life and health insurance and annuities through a home service sales force. Globe--offers individual life and health insurance through direct response and independent agents. United American--offers Medicare Supplement and other individual health and life products through independent agents. Famlico--markets life insurance and annuities to fund prearranged funerals. Liberty Fire--offers industrial fire insurance, collateral protection insurance, personal and commercial property and casualty insurance, and domestic reinsurance. In 1993, 73% of this subsidiary was sold through an initial public offering of Vesta Insurance Group, Inc. ("Vesta"). United Investors Management Company ("United Management")--owns UILIC, W&R, and Torch Energy Advisors Incorporated ("Torch Energy"). W&R--engages in institutional investment management services, and offers individual financial planning and products, including life insurance, annuities, and mutual funds through an exclusive sales force. UILIC--offers individual life and annuity products sold by W&R agents. Torch Energy--provides management services with respect to oil and gas production and development; and engages in energy property acquisitions and dispositions, oil and gas product marketing, and well operations Additional information concerning industry segments may be found in Management's Discussion and Analysis and in Note 16--Industry Segments in the Notes to Consolidated Financial Statements. INSURANCE LIFE INSURANCE Torchmark's insurance subsidiaries; Liberty, Globe, United American, UILIC, and Famlico, write a variety of nonparticipating ordinary life insurance products. These include whole-life insurance in the form of traditional, and interest-sensitive, trusteed group products, term life insurance, and other life insurance. The following tables present selected information about Torchmark's life products: Life insurance products are sold through a variety of distribution channels, including home service agents, independent agents, exclusive agents, and direct response. These methods are discussed in more depth under the heading "Marketing." The following table presents life annualized premium issued by marketing method: Permanent insurance products sold by Torchmark affiliates build cash values which are available to policyholders. Policyholders may borrow such funds using the policies as collateral. The aggregate value of policy loans outstanding at December 31, 1993 was $150 million and the average interest rate earned on these loans was 6.16% in 1993. Interest income earned on policy loans was $9.1 million in 1993, $8.6 million in 1992 and $8.2 million in 1991. Torchmark had 140 thousand and 143 thousand policy loans outstanding at year- end 1993 and 1992, respectively. The availability of cash values contributes to voluntary policy terminations by policyholders through surrenders. Torchmark's life insurance products may be terminated or surrendered at the election of the insured at any time, generally for the full cash value specified in the policy. Specific surrender procedures vary with the type of policy. For certain policies this cash value is based upon a fund less a surrender charge which decreases with the length of time the policy has been in force. This surrender charge is either based upon a percentage of the fund or a charge per $1,000 of face amount of insurance. The schedule of charges may vary by plan of insurance and, for some plans, by age of the insured at issue. Torchmark's ratio of aggregate face amount voluntary terminations to the mean amount of individual life insurance in force was 14.9% in 1993, 15.4% in 1992, and 17.2% in 1991. The following table presents an analysis of changes to Torchmark's life insurance business in force: HEALTH INSURANCE Liberty, Globe, and United American offer an assortment of health insurance products. These products are generally classified into three categories: (1) Medicare Supplement, (2) cancer and (3) hospital, surgical, accident, and other. United American Medicare Supplement products are sold by United American, Globe, Liberty and W&R agents. They provide reimbursement for certain expenses not covered under the national Medicare program. One feature available under United American's policy is an automatic claim processing system for Medicare Part B benefits, whereby policyholders do not have to file claim forms because they are paid directly by United American from Medicare records. Liberty, Globe and United American offer cancer policies on a guaranteed- renewable basis. These policies provide benefits for hospital stay, radiation, chemotherapy, surgery, physician, medication, and other expenses related to cancer. There are certain per diem, per procedure, and other payment limitations. A variety of hospital, surgical, and other medical expense policies are issued on a guaranteed-renewable basis by Liberty, Globe, and United American. In addition, certain accident policies are issued by Liberty and Globe. The following table presents health annualized premium information for the three years ending December 31, 1993 by product category: ANNUITIES Annuity products are offered through UILIC, Liberty, Famlico, and United American. These products include single-premium deferred annuities, flexible- premium deferred annuities, and variable annuities. Single-premium and flexible-premium annuities are fixed annuities where a portion of the interest credited is guaranteed. Additional interest may be credited on certain contracts. Variable annuity policyholders may select from a variety of mutual funds managed by W&R which offer different degrees of risk and return. The ultimate benefit on a variable annuity results from the account performance. The following table presents Torchmark subsidiaries' annuity collections and deposit balances by product type: OTHER INSURANCE Until November, 1993, Torchmark offered, through Liberty Fire and its subsidiaries, property and casualty insurance, consisting of both primary and reinsurance business. The following table presents an analysis of property and casualty insurance premium earned in each of the years 1991 through 1993. INVESTMENTS The nature, quality, and percentage mix of insurance company investments are regulated by state laws that generally permit investments in qualified municipal, state, and federal government obligations, corporate bonds, preferred and common stock, real estate, and mortgages where the value of the underlying real estate exceeds the amount of the loan. The investments of Torchmark's insurance subsidiaries, which are substantially all of Torchmark's investments, consist predominantly of high-quality, investment-grade securities. Fixed maturities represented 84% of total investments at December 31, 1993. Approximately 59% of fixed maturity investments were securities guaranteed by the United States Government or its agencies or investments that were collateralized by U.S. government securities. More than 75% of these investments were in GNMA securities that are backed by the full faith and credit of the United States government. Practically all of the remainder of these government investments were collateralized mortgage obligations ("CMO's") that are fully collateralized by GNMA's or by United States agency securities. (See Note 3--Investment Operations in Notes to Consolidated Financial Statements and Management's Discussion and Analysis.) The following table presents an analysis of the fixed maturity investments of Torchmark's insurance subsidiaries at December 31, 1993. All of the securities are classified as held for sale and are, therefore, reported at market value. The following table presents the fixed maturity investments of Torchmark's insurance subsidiaries at December 31, 1993 on the basis of ratings as determined primarily by Moody's Investors Services. Standard and Poor's Bond Ratings are used where Moody's ratings were not available. Ratings of BAA and higher (or their equivalent) are considered to be investment grade by rating services. The following table presents the investment of Torchmark's insurance subsidiaries in fixed maturities at December 31, 1993 on the basis of ratings as determined by the National Association of Insurance Commissioners ("NAIC"): Categories one and two are considered investment grade by the NAIC. Securities in Torchmark's investment portfolio are assigned their ratings when acquired. They are reviewed and updated at least annually. Additionally, when Torchmark learns that the rating of a specific security has been changed, that security's rating is updated promptly. PRICING Premium rates for life and health insurance products are established by each subsidiary company's management using assumptions as to future mortality, morbidity, persistency, and expenses, all of which are generally based on that company's experience, and on projected investment earnings. Revenues for individual life and health insurance products are primarily derived from premium income, and, to a lesser extent, through policy charges to the policyholder account values on certain individual life products. Profitability is affected to the extent actual experience deviates from that which has been assumed in premium pricing and to the extent investment income exceeds that which is required for policy reserves. Collections for annuity products are not recognized as revenues but are added to policyholder account values. Revenues from these products are derived from charges to the account balances for insurance risk and administrative costs. Profits are earned to the extent these revenues exceed actual costs. Profits are also earned from investment income on annuity funds invested in excess of the amounts credited to policy accounts. UNDERWRITING The underwriting standards of Torchmark's life insurance subsidiaries are established by each subsidiary's respective management. The companies use information from the application and, in some cases, inspection reports, doctors' statements and/or medical examinations to determine whether a policy should be issued in accordance with the application, with a different rating, with a rider, with reduced coverage or rejected. Each life insurance subsidiary requires medical examinations of applicants for life insurance in excess of certain prescribed amounts. These are graduated according to the age of the applicant and may vary with the kind of insurance. The maximum amount of insurance issued without medical examination varies by company: for Globe, it is $150,000 through age 40; and for Liberty and UILIC, it is $99,999 through age 50. These maximums decrease at higher ages, with medical examinations becoming mandatory at the respective companies at ages 51, 61, and 80. The companies request medical examinations of all applicants, regardless of age or amount, if information obtained from the application or other sources indicates that such an examination is warranted. In recent years, there has been considerable concern regarding the impact of the HIV virus associated with Acquired Immune Deficiency Syndrome ("AIDS"). Liberty and UILIC have implemented certain underwriting tests to detect the presence of the HIV virus and continue to assess the utility of other appropriate underwriting tests to detect AIDS in light of medical developments in this field. To date, AIDS claims have not had a material impact on claims experience. REINSURANCE As is customary among insurance companies, Torchmark's insurance subsidiaries cede insurance to other unaffiliated insurance companies on policies they issue in excess of the companies' retention limits. Reinsurance is an effective method for keeping insurance risk within acceptable limits. In the event insurance business is ceded, the insurance subsidiary remains contingently liable with respect to ceded insurance should any reinsurer be unable to meet the obligations it assumes (See Note 13--Commitments and Contingencies in Notes to Consolidated Financial Statements and Schedule VI-- Reinsurance [Consolidated]). RESERVES The life insurance policy reserves reflected in Torchmark's financial statements as future policy benefits are calculated based on generally accepted accounting principles. These reserves, with the addition of premiums to be received and the interest thereon compounded annually at assumed rates, must be sufficient to cover policy and contract obligations as they mature. Generally, the mortality and persistency assumptions used in the calculations of reserves are based on company experience. Similar reserves are held on most of the health policies written by Torchmark's insurance subsidiaries, since these policies generally are issued on a guaranteed-renewable basis. A complete list of the assumptions used in the calculation of Torchmark's reserves are reported in the financial statements (See Note 8--Future Policy Benefit Reserves in the Notes to Consolidated Financial Statements). Reserves for annuity products consist of the policyholders' account values and are increased by policyholder deposits and interest credits and are decreased by policy charges and benefit payments. MARKETING Collectively, the insurance subsidiaries of Torchmark are licensed to sell insurance in all 50 states, the District of Columbia, Puerto Rico, the Virgin Islands, Guam, and Canada. Distribution is through home service agents, independent agents, exclusive agents and direct response methods. Home service agents of Liberty are employees and are primarily compensated by commissions based on sales and by a salary based on the amount of premiums collected on policies assigned to them for servicing. All other agents are independent contractors and are compensated by commission only. Torchmark's insurance subsidiaries are not committed or obligated in any way to accept a fixed portion of the business submitted by any independent agents. All policy applications, both new and renewal, are subject to approval and acceptance by the particular subsidiary. Torchmark is not dependent on any single or any small group of independent agents, the loss of which would have a materially adverse effect on insurance sales. Liberty markets its products through home service agents operating in Alabama, Florida, Georgia, Mississippi, South Carolina and Tennessee. Home service agents are responsible for sales in a geographical area and remain in contact with policyholders to provide continuing service. Within these states, Liberty maintained 110 district offices which employed approximately 3,100 agency personnel as of December 31, 1993. Almost all of the Liberty agency personnel are also licensed to sell property insurance issued by Liberty Fire. Globe's agents, who primarily sell health insurance, are independent contractors working out of branch offices. Globe's sales organization consists of 71 branch sales offices from which approximately 1,100 licensed agents operate and approximately 4,200 agents sell life insurance in special markets. Globe markets modified whole-life and term insurance primarily through direct response solicitation. In 1993, over $4.9 billion or 92% of the face amount of life insurance sold by Globe was sold through direct response methods. UILIC's sales are generated principally through the W&R sales force under a general agency contract in conjunction with W&R's financial planning services. In addition, UILIC sells through unaffiliated brokers. In 1993 W&R sales representatives produced 93% of UILIC's annualized life insurance premium and 99% of annuity deposits. United American markets its products through approximately 57,000 licensed representatives in 49 states, the District of Columbia, Puerto Rico and Canada. United American's Medicare Supplement insurance products are also marketed by Globe, W&R and Liberty. Famlico markets its life insurance and annuity products to fund prearranged funeral agreements through a force of approximately 725 independent career agents representing approximately 300 funeral homes in 22 states. RATINGS The following list indicates the ratings currently held by Torchmark's four largest insurance companies as rated by A.M. Best Company: These same four insurance companies are each rated by Standard & Poor's Corporation as AAA(Superior), which is their highest rating. A.M. Best states that it assigns A++ and A+ (Superior) ratings to those companies which, in its opinion, have achieved superior overall performance when compared to the norms of the life/health insurance industry. A++ and A+ (Superior) companies have a very strong ability to meet their policyholder and other contractual obligations over a long period of time. Standard & Poor's Corporation assigns a superior or AAA rating to those companies who have superior financial security on an absolute and relative basis and whose capacity to meet policyholder obligations is overwhelming under a variety of economic and underwriting conditions. ASSET MANAGEMENT Torchmark conducts its asset management and financial services businesses through United Management and its subsidiaries. This segment consists of two primary activities: (1) mutual fund distribution and management and (2) energy operations. MUTUAL FUNDS Torchmark's mutual fund operations are carried out by W&R, a subsidiary of United Management, which markets and manages the sixteen mutual funds in the United Group of Mutual Funds, the five mutual funds in the Waddell & Reed Fund, Inc. ("W&R Funds"), the five mutual funds in the TMK/United Fund ("TMK/United Funds"), and the two mutual funds in the Torchmark Fund ("Torchmark Funds"). These funds were valued as follows at December 31, 1993 and 1992: FUND ASSETS UNDER MANAGEMENT W&R's revenues consist of the following: (1) fees for managing the assets, which are based on the value of the assets managed, (2) commissions for the sale of products, and (3) fees for accounting and administration, which are based primarily on an annual charge per account. In addition to its mutual fund management and distribution activities, W&R manages accounts for individual and institutional investors for which asset management fees are received. Asset management activities are conducted by an experienced and qualified staff. As of December 31, 1993, the average industry experience of the fund managers for W&R was 20 years, and average company experience was 13 years. The following table indicates W&R revenues by component for the three years ending December 31, 1993: Commissions paid to W&R by affiliates for variable annuities and insurance products are eliminated in consolidation. W&R markets its mutual funds and other financial products, including life insurance issued by UILIC and Medicare Supplement insurance issued by United American, through a sales force of approximately 2,800 registered representatives in 50 states and the District of Columbia. These representatives concentrate on product sales of W&R and other Torchmark affiliates. W&R maintained 169 sales offices at December 31, 1993. W&R conducts money management seminars on a national scale to reach numerous potential clients every year. Individual financial plans are developed for clients through one-on-one consultations with the W&R sales representatives. Emphasis is placed on a long-term relationship with a client rather than a one-time sale. ENERGY Torchmark engages in energy operations through Torch Energy and its subsidiaries. Torch Energy is a wholly-owned subsidiary of United Management. Torch Energy manages oil and gas properties and investments, primarily in the form of limited partnerships, for affiliated Torchmark companies as well as for unrelated institutions. Additionally, Torch Energy manages energy properties for Nuevo Energy Company ("Nuevo"), a publicly-traded corporation which was 14% owned by Torch Energy at December 31, 1993. Torch Energy also makes direct investments in energy properties from time to time and markets production for the properties it manages and for unrelated third parties. The following table presents an analysis of the $1.2 billion in energy properties under management: Includes Nuevo and general partnership interests Torch Energy manages investments which are made primarily in proven producing properties. These properties consist of oil and gas working and royalty interests in approximately 4,500 wells and are primarily located in seven states and offshore in the Gulf of Mexico. Included in other energy investments of Torchmark is a coalbed methane development in Alabama's Black Warrior Basin in the amount of approximately $234 million. In addition to energy asset management, Torch Energy also engages in energy property acquisition, energy product marketing, and operates approximately 1,200 wells. Energy product marketing involves the sale of oil and gas production, which is acquired through purchase agreements with affiliates and unrelated third parties. The following table presents revenues for energy operations by component: * Includes fees from affiliates COMPETITION The insurance industry is highly competitive. Torchmark's insurance subsidiaries compete with other insurance carriers through policyholder service, price, product design, and sales effort. In addition to competition with other insurance companies, Torchmark's insurance subsidiaries also face increasing competition from other financial services organizations. While there are a number of larger insurance companies competing with Torchmark that have greater resources and have considerable marketing forces, there is no individual company dominating any of Torchmark's life or health markets. Torchmark's health insurance products compete with, in addition to the products of other health insurance carriers, health maintenance organizations, preferred provider organizations, and other health care related institutions which provide medical benefits based on contractual agreements. Generally, Torchmark's insurance companies operate at lower administrative expense levels than their peer companies, allowing Torchmark companies to have competitive rates while maintaining margins, or, in the case of Medicare Supplement business, to remain in the business while some companies have ceased new writings. Torchmark's years of experience in direct response business are a valuable asset in designing direct response products. Similarly, Liberty's concentration of business has been considered a competitive advantage in hiring and retaining agents. On the other hand, Torchmark's insurance subsidiaries do not have the same degree of national name recognition as some other companies with which they compete. W&R competes with hundreds of other registered institutional investment advisers and mutual fund management and distribution companies which distribute their fund shares through a variety of methods including affiliated and unaffiliated sales forces, broker-dealers, and direct sales to the public. Although no one company or group of companies dominates the mutual fund industry, some are larger than W&R and have greater resources. Competition is based on the methods of distribution of fund shares, tailoring investment products to meet certain segments of the market, changing needs of investors, the ability to achieve superior investment management performance, the type and quality of shareholder services, and the success of sales promotion efforts. Torchmark's energy subsidiaries compete with a large number of institutional investment advisors in the asset management business, although only a limited number of these institutions manage energy assets. There is very little competition from other specialized energy asset managers in terms of institutional assets under management. These energy subsidiaries also face strong competition in their businesses of well operations, product marketing, and energy asset direct ownership. Competitors include independent producers and major oil and gas companies, some of which are quite large and well established with substantial capital, resources, and capabilities exceeding those of Torchmark's energy subsidiaries. REGULATION INSURANCE. Insurance companies are subject to regulation and supervision in the states in which they do business. The laws of the various states establish agencies with broad administrative and supervisory powers which include, among other things, granting and revoking licenses to transact business, regulating trade practices, licensing agents, approving policy forms, approving certain premium rates, setting minimum reserve and loss ratio requirements, determining the form and content of required financial statements, and prescribing the type and amount of investments permitted. Insurance companies can also be required under the solvency or guaranty laws of most states in which they do business to pay assessments up to prescribed limits to fund policyholder losses or liabilities of insolvent insurance companies. They are also required to file detailed annual reports with supervisory agencies, and records of their business are subject to examination at any time. Under the rules of the NAIC, insurance companies are examined periodically by one or more of the supervisory agencies. The most recent examinations of Torchmark's insurance subsidiaries were: Famlico, as of September 30, 1990; Globe, as of December 31, 1991; Liberty and Liberty Fire, as of December 31, 1991; and UILIC and United American, as of December 31, 1990. NAIC Ratios. The NAIC developed the insurance Regulatory Information System ("IRIS"), which is intended to assist state insurance regulators in monitoring the financial condition of insurance companies. IRIS identifies twelve insurance industry ratios from the statutory financial statements of insurance companies, which statements are based on regulatory accounting principles and are not based on generally accepted accounting principles ("GAAP"). IRIS specifies a standard or "usual value" range for each ratio, and a company's variation from this range may be either favorable or unfavorable. Departure from this "usual value" on four or more ratios leads to inquiries from state regulators. None of Torchmark's primary insurance subsidiaries have exceeded the "usual values" on more than three ratios for the periods considered. The following table presents the IRIS ratios for three of Torchmark's four largest insurance subsidiaries, which varied unfavorably from the "usual value" range for the years 1992 and 1991. Explanation of Ratios: Investment in Affiliate to Capital and Surplus--This ratio is determined by measuring total investment in affiliates against the capital and surplus of the company. The NAIC considers a ratio of more than 100% to be high, and to possibly impact a company's liquidity, yield, and overall investment risk. The large ratios in Liberty and Globe are brought about by their ownership of other large Torchmark insurance companies and the ownership by Liberty of 83% of the stock of United Management. Profitability and growth in these subsidiaries have caused this ratio to gradually rise. All intercompany investment is eliminated in consolidation, and the internal organizational structure has no bearing on consolidated results. Intercompany ownership by Liberty and Globe were reduced during 1993 due to restructuring and the sale of Vesta. Change in Reserving--The change in reserving ratio is computed as the aggregate increase in statutory reserves for individual life insurance taken as a percentage of individual life renewal and single premium. The reserving ratio is then measured against the same ratio for the prior year to determine the degree of change. The NAIC considers a variance of more than 20% to be unusual. The 21% variance in 1991 and the 22% offsetting variance in 1992 for United Investors Life Insurance Company was caused by the one-time correction of reserves in 1991 on a block of individual life policies to recognize their decreasing guaranteed death benefits. These ratios are computed utilizing regulatory reserving techniques and not on the basis of calculating policy reserves as determined by GAAP. Because the modifications to statutory reserves had no bearing on reserves calculated in accordance with GAAP, those modifications had no effect on Torchmark's consolidated financial statements. Adequacy of Investment Income--This ratio indicates that an insurer's investment income is adequate to meet interest requirements of policy reserves and is measured as a percentage of investment income to required interest. A ratio higher than 900% is considered to be too high and a ratio lower than 125% is considered to be too low by the NAIC. The 999% ratio in Globe for 1992 was brought about by the NAIC's inclusion of dividends of various Torchmark subsidiaries in Globe's investment income. These dividends are generally passed through Globe to the parent company and should not be considered in meeting interest requirements. Intercorporate dividends are eliminated in consolidation and have no effect on consolidated results. Had these dividends been excluded, Globe's 1992 ratio would have been 246%, which was within the usual range. Risk Based Capital: In December 1992, the NAIC adopted a model act that requires a risk based capital formula be applied to all life and health insurers. The requirement begins in 1994 for information based on the 1993 annual statements. The risk based capital formula is a threshold formula rather than a target capital formula. It is designed only to identify companies that require regulatory attention and is not to be used to rate or rank companies that are adequately capitalized. All of the insurance subsidiaries of Torchmark are adequately capitalized under the risked based capital formula. Guaranty Assessments. State solvency or guaranty laws provide for the assessment of insurance companies into a fund which is used, in the event of failures or insolvency of an insurance company, to fulfill the obligations of that company to its policyholders. The amount by which a company is assessed for these state funds is determined according to the extent of these unsatisfied obligations in each state. These assessments are recoverable to a great extent as offsets against state premium taxes. HOLDING COMPANY. States have enacted legislation requiring registration and periodic reporting by insurance companies domiciled within their respective jurisdictions that control or are controlled by other corporations so as to constitute a holding company system. Torchmark and its subsidiaries have registered as a holding company system pursuant to such legislation in Alabama, Delaware, Missouri, New York, and Texas. Insurance holding company system statutes and regulations impose various limitations on investments in subsidiaries, and may require prior regulatory approval for the payment of certain dividends and other distributions in excess of statutory net gain from operations on an annual noncumulative basis by the registered insurer to the holding company or its affiliates. MUTUAL FUNDS. Torchmark's mutual fund management and distribution activities, as well as its investment advisory services, are subject to state and federal regulation and oversight by the National Association of Securities Dealers, Inc. Each of the funds in the United Group of Mutual Funds, the W&R Funds, the TMK/United Funds and the Torchmark Funds is a registered investment company under the Investment Company Act of 1940. W&R and WRAM are registered pursuant to the Investment Advisers Act of 1940. Additionally, W&R is regulated as a broker-dealer under the Securities Exchange Act of 1934. ENERGY. Torch Energy, on behalf of itself as well as its affiliated insurance clients and unrelated institutions, is engaged in oil and gas leasing and production activities which are regulated by the Federal Energy Regulatory Commission and the appropriate state authorities in the states in which Torch Energy does business. These governmental authorities regulate production, the drilling and spacing of wells, conservation, environmental concerns, and various other matters affecting oil and gas production. Torch Energy is also registered under the Investment Advisers Act of 1940. HEALTH CARE REFORM. The Clinton Administration has recently made proposals in the area of health insurance and health care reform. These proposals, along with various alternative proposals, are currently being considered by Congress. At this time, it is not possible to ascertain whether these reform initiatives will negatively impact Torchmark or will positively impact Torchmark's operations by increasing demand for supplemental coverages marketed by Torchmark subsidiaries. Based on the Administration's current proposals, it does not appear that Torchmark's Medicare Supplement business will be affected. PERSONNEL At the end of 1993, Torchmark had 2,653 employees and 3,399 licensed employees under sales contracts. Additionally, approximately 68,000 independent agents and brokers, who were not employees of Torchmark, were associated with Torchmark's marketing efforts. ITEM 2.		ITEM 2. PROPERTIES Torchmark, through its subsidiaries, owns or leases buildings that are used in the normal course of business. Liberty owns a 487,000 sq. ft. building at 2001 Third Avenue South, Birmingham, Alabama, which currently serves as Liberty's, UILIC's, and Torchmark's home office. Liberty leases approximately 143,000 sq. ft. of this building to unrelated tenants and has another 15,000 sq. ft. available for lease. Liberty also operates from 69 company-owned district office buildings used for agency sales personnel. Globe owns a 300,000 sq. ft. office building at 204 North Robinson, Oklahoma City, Oklahoma, of which it occupies 85,647 sq. ft. as its home office and the balance is available for lease. Globe also owns a 330,000 sq. ft. office building complex at 14000 Quail Springs Parkway Plaza Boulevard, Oklahoma City, and a 110,000 sq. ft. office building at 120 Robert S. Kerr Avenue, Oklahoma City, which are available for lease to other tenants. United American owns and occupies a 125,000 sq. ft. home office building at 2909 North Buckner Boulevard, Dallas, Texas. W&R owns and occupies a 116,000 sq. ft. office building located in United Investors Park, a commercial development at 6300 Lamar Avenue, Shawnee Mission, Kansas. In addition, W&R owns three other office buildings in this development, each containing approximately 48,000 sq. ft., which are leased or are available for lease. Liberty, Globe and W&R also lease district office space for their agency sales personnel. All of the other Torchmark companies lease their office space in various cities in the U.S. A Torchmark subsidiary has completed a 185,000 sq. ft. office building as the initial phase of a 100-acre commercial development at Liberty Park along I-459 in Birmingham, Alabama of which a total of approximately 180,000 sq. ft. is currently leased. It also owns and manages a 70,000 sq. ft. office and retail complex adjacent to Liberty Park, of which 30,000 sq. ft. are leased to Liberty Fire. As a part of a joint venture with unaffiliated entities, it is also developing 2,200 contiguous acres. Torchmark and its primary subsidiaries have significant automated information processing capabilities, supported by centralized computer systems. Torchmark also uses personal computers to support the user-specific information processing needs of its professional and administrative staff. All centralized computer software support, information processing schedules and computer-readable data management requirements are supported by company specific policies and procedures which ensure that required information processing results are produced and distributed in a timely manner and provide for the copying, off-site physical storage and retention of significant company computer programs and business data files for backup purposes. ITEM 3.	ITEM 3. LEGAL PROCEEDINGS Torchmark and Torchmark's subsidiaries continuously are parties to pending or threatened legal proceedings. These suits involve tax matters, alleged breaches of contract, torts, including bad faith and fraud claims based on alleged wrongful or fraudulent acts of agents of Torchmark's subsidiaries, employment discrimination, and miscellaneous other causes of action. Most of these lawsuits include claims for punitive damages in addition to other specified relief. In May 1992, litigation was filed against Liberty in the Circuit Court for Barbour County, Alabama (Robertson v. Liberty National Life Insurance Company, Case No.: CV-92-021). This suit was amended in October 1992 to include claims on behalf of a class of Liberty policyholders alleging fraud in the exchange of certain cancer insurance policies. It seeks substantial equitable and injunctive relief together with unspecified compensatory and punitive damages. A policyholder class was certified by the Barbour County Court in March 1993. Additionally, subsequent to the class certification, a number of separate lawsuits based on substantially the same allegations as in Robertson were filed by plaintiffs in Alabama, Georgia, Florida and Mississippi. Additional class action suits also based upon substantially the same allegations as in Robertson were filed after the class certification in Mobile County, Alabama (Adair v. Liberty National Life Insurance Company, Case No.: CV-93-958 and Lamey v. Liberty National Life Insurance Company, Case No.: CV-93-1256) and in Polk County, Florida (Howell v. Liberty National Life Insurance Company, Case No.: GC-G 93-2023 and Scott v. Liberty National Life Insurance Company, Case No.: GC-G 93-2415). On October 25, 1993, a jury in the Circuit Court for Mobile County rendered a one million dollar verdict against Liberty in McAllister v. Liberty National Life Insurance Company (Case No.: CV-82-4085), one of twenty-five suits involving cancer policy exchanges which were filed prior to class certification in the Barbour County litigation. Liberty has filed appropriate post-judgment motions and, if necessary, will appeal the McAllister verdict. Previously, another judge in the Mobile Circuit Court had granted a summary judgment in favor of Liberty in another substantially similar suit, which is on appeal. The Robertson litigation was tentatively settled pending a fairness determination by the Court after a hearing. The fairness hearing took place January 20, 1994. Class members were previously mailed notice of the hearing and the proposed settlement. On February 4, 1994, the Circuit Court for Barbour County, Alabama ruled that with a $16 million increase in the value of the proposed Robertson settlement from approximately $39 million to $55 million, the settlement would be fair and would be approved, provided that the parties to the litigation accepted the amended settlement within fourteen days of the issuance of the ruling. On February 17, 1994, the Court extended for two weeks the period for filing objections to or accepting the court's order conditionally approving the class action settlement. On February 22, 1994, the Court entered an order in the Robertson litigation, which delayed any final decision on the proposed class action settlement and various motions to modify it (including motions to delete Torchmark from the settlement release), pending certain specified discovery to be completed within 90 days from the date the order was entered. In the order, the Court directed limited additional discovery regarding whether Torchmark had any active involvement in the cancer policy exchanges. Pending completion of limited additional discovery, the Court has reserved jurisdiction and extended the deadline for acceptance or rejection of the modifications set forth in the February 4, 1994 order. Torchmark has provided for the $55 million proposed amended settlement charge in its 1993 financial reports, although it believes that it is highly likely that intervenors will pursue an appeal of the ruling to the Supreme Court of Alabama. In the event a settlement is not agreed to and approved, Torchmark and Liberty intend to aggressively defend the various cases. In June 1993, a purported class action alleging fraud in the replacement of certain hospital intensive care policies with policies alleged to have less value with lower benefits was filed seeking unspecified compensatory and punitive damages against Liberty and Torchmark in the Circuit Court for Mobile County, Alabama (Smith v. Liberty National Life Insurance Company, Case No.: CV-93-2066). A second purported class action with substantially the same allegations as in the Smith litigation was also filed in the Mobile County Circuit Court in December 1993 (Maples v. Liberty National Life Insurance Company, Case No.: CV-93-3694). Three other separate lawsuits based upon the replacement of certain hospital intensive care policies have also been filed. The Smith litigation has been settled, while a class has not yet been certified and discovery is proceeding in the Maples case. Purported class action litigation was filed in December 1993 against Liberty in the Circuit Court for Mobile County, Alabama asserting fraud and misrepresentation in connection with exclusionary provisions of accident and hospital accident policies sold to persons holding multiple accident type policies (Cofield v. Liberty National Life Insurance Company, Case No.: CV-93- 3667 and Kelly v. Liberty National Life Insurance Company, Case No.: CV-93- 3759). The Kelly case has been settled. No class has been certified in Cofield although discovery is proceeding. In 1978, the United States District Court for the Northern District of Alabama entered a final judgement in Battle v. Liberty National Insurance Company, et al (CV-70-H-752-S), class action litigation involving Liberty, a class composed of all owners of funeral homes in Alabama and a class composed of all insureds (Alabama residents only) under burial or vault policies issued, assumed or reinsured by Liberty. The final judgement fixed the rights and obligations of Liberty and the funeral directors authorized to handle Liberty burial and vault policies as well as reforming the benefits available to the policyholders under the policies. It remains in effect to date. A motion was filed to challenge the final judgement under Federal Rule of Civil Procedure 60(b) in February of 1990, but the final judgement was upheld and the Rule 60(b) challenge was rejected by both the District Court and the Eleventh Circuit Court of Appeals. In November, 1993, an attorney (purporting to represent the funeral director class) filed a petition in the District Court seeking "alternative relief" under the final judgement. The relief sought is unclear, but includes a request that the District Court rule that the final judgement no longer has prospective application. Liberty has filed discovery requests seeking the identity of the funeral directors involved in the petition and information and materials necessary to evaluate the funeral directors' allegations and to clarify the relief sought. Based upon information presently available, and in light of legal and other defenses available to Torchmark and its subsidiaries, contingent liabilities arising from threatened and pending litigation are not considered material. It should be noted, however, that the frequency of large punitive damage awards bearing little or no relation to actual damages awarded by juries in jurisdictions in which Torchmark has substantial business, particularly Alabama, and continues to increase universally. ITEM 4.	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matter was submitted to a vote of shareholders, through the solicitation of proxies or otherwise, during the fourth quarter of 1993. PART II ITEM 5.	ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS The principal market in which Torchmark's common stock is traded is the New York Stock Exchange. There were 8,160 shareholders of record on December 31, 1993, excluding shareholder accounts held in nominee form. On August 19, 1992, Torchmark effected a 3 for 2 stock split in the form of a stock dividend to its common shareholders of record on August 5, 1992. Accordingly, all market prices and dividends per share have been adjusted. Information concerning restrictions on the ability of Torchmark's subsidiaries to transfer funds to Torchmark in the form of cash dividends is set forth in Note 12--Shareholders' Equity in the Notes to the Consolidated Financial Statements. The market price and cash dividends paid by calendar quarter for the past two years are as follows: Year-end closing price..................$45.000 Year-end closing price..................$57.125 ITEM 6.	ITEM 6. SELECTED FINANCIAL DATA The following information should be read in conjunction with Torchmark's Consolidated Financial Statements and related notes reported elsewhere in this Form 10-K: (AMOUNTS IN THOUSANDS EXCEPT PER SHARE AND PERCENTAGE DATA) (1) The increase in individual life insurance in force is adjusted by $55 million, and the increase in individual life annualized premium in force is adjusted by $2.7 million, representing the business acquired in the acquisition of Sentinel American Life Insurance Company. (2) The increase in individual life insurance in force is adjusted by $337 million, and the increase in individual life annualized premium in force is adjusted by $28.1 million, representing the business acquired in the Family Service Life Insurance Company acquisition. (3) Includes accrued investment income. (4) Computed after deduction of preferred shareholders' equity. ITEM 7.	ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following should be read in conjunction with the Selected Financial Data and Torchmark's Consolidated Financial Statements and Notes thereto appearing elsewhere in this report. RESULTS OF OPERATIONS Torchmark's net income for 1993 was $298 million, increasing 12.2% over the $265 million reported in 1992. On a per share basis, net income was $4.01, rising 12% over 1992 net income per share of $3.58. Per share earnings for 1992 also rose 14% over the prior year from $3.13 per share. Excluding the after-tax effect of realized investment gains (and losses), per share earnings were $3.94 in 1993 compared to $3.59 in 1992, an increase of 9.7%. The 1992 increase in per share earnings excluding realized investment gains and losses was 16%. In a comparison of 1993 results with those of 1992, several nonrecurring items should be considered. In November, 1993 Torchmark sold 73% of its interest in Vesta, which was Torchmark's wholly-owned property and casualty subsidiary prior to the sale, retaining an approximate 27% interest. Such interest was sold for proceeds of $161 million and a $57 million pretax gain from the sale was recognized. Results for 1993 include an $82 million pretax charge for nonoperating expenses, compared to $5.7 million for 1992. This charge relates to legal and litigation expenses, guaranty assessments, and directors' and officers' liability. Two new accounting standards which dealt with postretirement benefits and accounting for income taxes were implemented, increasing 1993 earnings to $18.4 million. Enactment of the Administration's tax reform package, which increased corporate tax rates in 1993 from 34% to 35%, resulted in an additional charge to 1993 earnings of $13.7 million. Of this charge, $4.3 million related to 1993 earnings and $9.4 million was the effect of a one-time adjustment to the deferred tax liability relating to prior years. Adjusting for these nonrecurring items, Torchmark's 1993 per share earnings after realized capital gains and losses would have been $4.04, compared to $3.64 for 1992, an increase of 11%. Revenues climbed 6.4% in 1993 to $2.18 billion, up from $2.05 billion for the previous year. After adjusting for the above-mentioned gain on the sale of Vesta, the increase in revenues for 1993 would have been 3.6%. Revenues for 1992 increased 7.3% over 1991 revenues of $1.91 billion. Premium income for 1993 grew 2.7% or $39 million, largely accounted for by the $25 million growth in premium at Vesta. Financial services revenues rose 3% in 1993 and 17% in 1992 as a result of strong financial markets and increased investor demand. The lower rate of growth in 1993 was attributable to decreased front-end load mutual funds and the increase in the sale of funds with deferred sales charges. Lower investment yields available on new investments and the increased use of tax advantaged investments have had a negative effect on growth in net investment income in recent periods. Net investment income grew 5% in 1992 and declined 2.7% in 1993. On a tax equivalent basis, investment income increased 1.5%. Energy operations experienced strong growth in both periods, rising 43% in 1993 after gaining 35% in 1992. A more in-depth discussion of each of Torchmark's segments and investment operations is found on pages 18 through 25 of this report. Other operating expenses increased 3% in 1993, after excluding the above- mentioned nonoperating expense charges in both 1993 and 1992. As a percentage of total revenues, adjusting for the previously-mentioned gain from the Vesta sale, adjusted operating expenses were 8.2% of revenues in 1993, compared to 8.3% in both 1992 and 1991. Interest expense rose 21% in 1993 to $67.3 million, primarily as a result of $300 million in new debt issues in 1993, which also caused average indebtedness to rise in 1993. These new issues were used mainly to fund the 1993 acquisition of the remaining 18% of United Management which Torchmark did not own. These debt issuances and the United Management transaction are discussed further as a part of the capital resources discussion found on pages 26 through 27 of this report. Average indebtedness also rose in 1992, resulting in increased interest expense of 11% or $55.7 million. The increase in 1992 debt was primarily the result of borrowings to fund common and preferred share purchases through line-of-credit borrowings. Capitalized interest deducted from interest expense was $.9 million in 1993, $4.3 million in 1992, and $9.1 million in 1991. The following is a discussion of Torchmark's operations by segment. INSURANCE OPERATIONS LIFE INSURANCE Summary of Results (DOLLAR AMOUNTS IN THOUSANDS) Life Insurance. Life insurance premium, including policy charges, increased 2.1% to $556 million in 1993, after having risen 3.9% to $544 million in 1992. Annualized life premium in force was $613 million at December 31, 1993, gaining 4.2% over the prior year end amount of $588 million. In 1992, annualized life premium grew 4.5% from $563 million. Annualized premium in force data includes amounts collected on certain interest-sensitive life products which are not recorded as premium income but excludes single premium income and policy charges. Sales of life products, as measured by annualized premium issued, were $128 million in 1993, compared to $132 million in 1992 and $134 million in 1991. Profitability in the life product line has increased in each of the years considered, as evidenced by the growth in insurance operating income as a percentage of premium. This percentage grew from 26.3% in 1991 to 27.9% in 1992 to 29.4% in 1993. The primary reason for the improvement in both years was improved persistency. Persistency improvements have resulted, at least in part, from revisions in agents' compensation formulas to encourage persistency. Lower lapses have also been attributable to a large portion of agent-collected home service business having been converted to bank draft premium, which has higher persistency. The proportion of bank draft premium to total home service premium increased from 61% in 1991 to 69% in 1992 to 78% in 1993. One factor in the 1992 increase in the policy obligations to premium ratio was increased mortality over the prior period. Fluctuations in mortality are normal and such an increase is not indicative of a pattern. Other expense margins have improved in each of the years considered, which have had the effect of further improving margins. HEALTH INSURANCE Summary of Results (DOLLAR AMOUNTS IN THOUSANDS) Health Insurance: Torchmark's health products include Medicare Supplement insurance, cancer insurance, and other under-age 65 medical and hospitalization products. As a percentage of annualized health premium in force at December 31, 1993, Medicare Supplement accounted for 73%, cancer accounted for 13%, and other products accounted for 14%. Total health premium was $800 million in 1993, compared to $798 million in 1992, after having grown 3.6% over 1991 premium of $770 million. Annualized health premium in force stood at $823 million at December 31, 1993, declining 1.1% over the 1992 amount of $832 million. The 1992 annualized health premium in force rose 4.3% over the December 31, 1991 amount of $798 million. Sales of health products in terms of annualized premium issued declined 22% to $176 million in 1993 after having increased 3.7% in 1992 to $225 million from $217 million in 1991. The decline in 1993 sales was affected by the uncertainty surrounding the Administration's and other health care reform proposals during the year. Medicare Supplement sales were also impacted by competition which offered products with a premium that increases with age as well as medical costs, while Torchmark's premium is increased with medical costs only. This resulted in Torchmark's product being initially more expensive while the competing products would have substantially larger premium increases in the future. In terms of annualized premium issued, sales of Medicare Supplement insurance declined 13% to $136 million in 1993. Sales rose 43% to $156 million in 1992 over the prior year. In addition to the previously-mentioned uncertainty regarding various health care reforms which might have bearing on the Medicare Supplement market, this market has also experienced a great deal of regulatory change in recent years. These changes include increased government regulation in the form of mandated policy forms, a required minimum 65% loss ratio on products sold, and a required leveling of agents' commissions. Implementation of the stringent loss ratio and policy form regulations in 1992 has put pressure on margins for all Medicare Supplement providers. Medicare Supplement annualized premium in force grew 3.4% in 1993 and stood at $601 million at December 31, 1993. In 1992, Medicare Supplement annualized premium in force grew almost 11% and was $581 million at December 31, 1992. Cancer insurance annualized premium in force declined 3.4% to $106 million at December 31, 1993 from $109 million at December 31, 1992. Cancer annualized premium in force grew 5.9% in 1992. Sales of this product in 1992 of $18 million were level, compared with the prior year but declined 45% in 1993 to $10 million. Under age 65 health insurance annualized premium in force declined 19% in 1993 to $113 million after having declined 17% in 1992 to $141 million. Sales of a number of these products were discontinued in 1992 because of poor margins, causing the premium in force to decline in both years. Margins have improved in each of the years considered. As a percentage of premium, insurance operating income for individual health grew from 9.9% in 1991 to 11.2% in 1992 to 13.2% in 1993, representing an increase of 13% in 1992 and 18% in 1993. There were two primary reasons for this improvement. First, improved persistency has contributed to the decline in amortization of acquisition costs. One reason for the improvement in persistency is that many states now require levelized commissions on Medicare Supplement products. This has encouraged persistency through the payment of a higher renewal commission. In addition, the payment of a lower first-year commission discourages replacement. Also, net policy obligations for individual health products as a percentage of premium were stable in each of the years 1991 and 1992, but declined .9% in 1993. This decline was a result of the decline in lower margin non-Medicare business in 1993. The Clinton Administration has recently made various proposals in the area of health insurance and health care reform. These proposals, along with various alternative proposals, are currently being considered by Congress. Based on the Administration's current proposals, it does not appear that Torchmark's Medicare Supplement business will be affected. ANNUITIES Summary of Results (DOLLAR AMOUNTS IN THOUSANDS) - -------- Investment income in excess of required. Annuities: Torchmark's annuity products serve a wide range of markets, such as providing retirement income, funding prearranged funerals, and offering long-term tax deferred growth opportunities. Annuity products are sold on both a fixed and a variable basis. The premium is accounted for as a deposit and is not reflected in income. Amounts deposited for variable annuities are invested at the policyholder's direction into his choice among five W&R managed mutual funds which vary in degree of risk and return. These investments are reported as Separate Account Assets and the corresponding deposit balances for variable annuities are reported as Separate Account Liabilities. Fixed annuity deposits are added to policy reserves and the funds collected are invested by Torchmark. Revenues on fixed and variable annuity products are derived from charges to the annuity account balances for insurance risk, administration, and surrender, depending on the contract's structure. Variable accounts are also charged an investment management fee and a sales charge. Torchmark profits to the extent these policy charges exceed actual costs and to the extent actual investment income exceeds the investment income which is credited to policyholders on fixed annuities. Since investment yields have decreased on fixed annuity funds, margins have also decreased. Growth in the annuity account balance in each year is illustrated below: ANNUITY DEPOSIT BALANCES (DOLLAR AMOUNTS IN MILLIONS) Annuity collections on a combined basis for both fixed and variable annuities have grown in each of the last three years and were as follows: ANNUITY COLLECTIONS (DOLLAR AMOUNTS IN THOUSANDS) Growth in the variable annuity collections has been a result of increased customer interest in these investment-type products, due, at least in part, to lower interest rates on fixed investments. Greater sales efforts were also made through compensation incentives and sales promotional activities. Sales of fixed annuities have declined in each year primarily because of the pattern of falling interest rates available in recent years and to the switch to variable annuities. Annuity policy charges, which are included in other premium in the financial statements, rose 8% in 1993 to $9.5 million after having grown 19% in 1992 to $8.8 million. Allocated investment income, or investment income earned in excess of policy requirements, was $8.4 million in 1993, a slight decline. Allocated investment income gained 5% in 1992 to $8.9 million over $8.5 million in 1991. Because of the difference in structure in the various annuity contracts, whereby certain policy charges relate to account value and others relate to annuity collections, the policy charges and allocated investment income remained relatively stable in 1993. Charges relating to the growth in the policy account value were offset somewhat in 1993 by the decline in charges based on fixed annuity sales. Insurance operating income for the annuity line has grown in each of the years 1991 through 1993, increasing 25% to $10 million in 1992 and 19% to $11.9 million in 1993. Profitability margins as measured by the mean reserve were stable in 1992 as compared to 1991 but declined slightly in 1993. The primary factor in this decline was the reduction in allocated investment income assigned to fixed products, even though the fixed annuity reserve grew 3.6%. The 1993 decline was offset by a decline in acquisition expense. PROPERTY AND CASUALTY INSURANCE Summary of Results (DOLLAR AMOUNTS IN THOUSANDS) - -------- Includes operations through November 11, 1993. Property and Casualty: Torchmark sold a 73% interest in its property and casualty operations as of November 11, 1993. It reports its 27% remaining interest as equity in the earnings of affiliates after November 10. Property and casualty premium rose 25% in 1993 to $123 million even though 73% of Torchmark's property and casualty operations were sold in November, 1993. Property and casualty premium gained 62% in 1992 to $98.4 million. Additional writings in the reinsurance line accounted for most of the growth in both years. In 1993, reinsurance premium growth accounted for 80% of total premium growth, compared to 82% of total premium growth in 1992. Growth in reinsurance premium was a result of Liberty Fire's increased emphasis in sales of quota- share reinsurance business. Quota-share business is a higher quality and less volatile type of business. Loss ratios have remained stable on quota-share reinsurance and even declined from 51% in 1991 to 50% in both 1992 and 1993. Insurance underwriting income before excess investment income for property and casualty gained 58% to $12.8 million in 1993 and 61% to $8.1 million in 1992, primarily as a result of the increased reinsurance volume. ASSET MANAGEMENT FINANCIAL SERVICES Summary of Results (DOLLAR AMOUNTS IN THOUSANDS) - -------- Financial services revenue includes $26.2 million in 1993, $19.7 million in 1992, and $15.1 million in 1991 representing revenues from other Torchmark segments which are eliminated in consolidation. Financial services: Total revenues for financial services operations grew 7% in 1993 to $167 million from the prior-year amount of $156 million, which reflected a 17% increase over 1991. Financial services revenue consists of commission revenue derived primarily from the sale of mutual funds, insurance, and variable and fixed annuity products by the W&R sales representatives. It is also comprised of asset management and service fees. Commission revenue from sales of investment products, which include mutual funds and variable annuity products, represented 84% of total commission revenue. The remaining source of commission revenue is from insurance product sales, which are derived primarily from UILIC. Insurance and variable annuity product commissions are eliminated in consolidation. Investment product commissions rose 2% in 1993 to $66 million, after having increased 33% in 1992 to $65 million from $49 million. Investment product sales were $1.25 billion in 1993, climbing 9% over 1992 sales of $1.14 billion. Sales of these products rose 40% in 1992. Investment product sales for 1993 consisted of United Funds (75%), variable annuities (16%), Waddell & Reed Funds (8%), and other products (1%). Sales of the United Funds declined 5% to $939 million in 1993, while sales of the Waddell & Reed Funds, which were introduced in 1992 as a deferred-load product to give investors five new mutual funds as additional investment alternatives, almost tripled to $94 million. Sales of variable annuities grew 74% to $204 million. Growth in 1993 commission revenue for investment products has been less than the growth in sales because 1993 sales of the United Funds, for which commission revenue is earned at the point of sale, declined from 1992 while sales of the Waddell & Reed Funds, for which distribution revenues are earned subsequent to the point of sale, increased. Waddell & Reed Funds' distribution fees are derived from an annual asset-based charge. In addition, the maximum sales charge on the United Funds was reduced in August, 1993 to improve their competitive position partially offset by an increased annual fee. As of October 1, 1993, the United Fund instituted a Section 12b-(1) service fee to reimburse W & R for expenses it incurs in servicing shareholder accounts. Asset management fees increased 14% in 1993 to $64 million, after an increase of 16% in 1992 to $56 million. Growth in management fees in both periods was caused by the increase in average mutual fund and institutional assets under management. The increase in assets under management resulted from the stronger financial markets experienced in 1993 and 1992 over the prior periods, and from additional product sales. Assets under management were $14.5 billion at December 31, 1993, $12.1 billion at December 31, 1992, and $10.7 billion at December 31, 1991. Service fees grew 7% to $21.2 million in 1993. Service fees were $19.9 million in 1992, increasing 6% over 1991 fees of $18.8 million. The number of accounts serviced was 1.09 million at December 31, 1993, compared to 1.03 million a year earlier. Commissions and selling expenses as a percentage of commission revenue were stable at 91% in both 1993 and 1992, after having declined from 93% in 1991. The 1992 decline was a result of the fixed nature of a large portion of these expenses which remained constant while commission revenues grew in 1992. Margin improvement in 1993 was mainly caused by the increase in proportion of asset management fees to total revenues, which have a significantly higher margin than commission revenues. ENERGY Summary of Results (DOLLAR AMOUNTS IN THOUSANDS) - -------- Included in energy operations revenues. Energy operations: The energy operations of Torchmark include the management of proven producing oil and gas properties for both affiliates and unrelated parties by its subsidiary Torch Energy. Energy operations also include drilling of developmental wells, acquisition of properties and facilities, and marketing of oil and gas products by Torch Energy. A further discussion of the energy property investments of Torchmark's insurance subsidiaries, which are are not included in the above table, is included under "Investment operations." Energy operations revenues rose $32 million or 43% in 1993 over the prior year to $106 million. Included in 1993 revenue was a one-time gain from the sale of a large offshore producing property in the amount of $22 million. Excluding this gain, the revenue increase was 13.5%. Revenues for 1992 were $74 million, increasing 35% over 1991. Profitability in energy operations improved in each of the periods considered, with recurring pretax income rising from $5.8 million in 1991 to $10.5 million in 1992 and $11.3 million in 1993, an increase of 81% in 1992 and 8% in 1993. All phases of energy operations have grown consistently in each of the years 1991 through 1993. The largest percentage growth in revenues in 1993 was derived from product-marketing activities, which grew by 29% in 1993 after having more than doubled in 1992. Product marketing was also the major contributor to recurring energy profit margins in 1993. This activity involves selling certain energy products, which were acquired through purchase agreements with affiliated and unaffiliated parties. Net product revenues are computed after deducting the costs of the production sold from the gross marketing revenues. Production properties were another source of energy operation profits throughout the period 1991 through 1993. Torch Energy's participation as a working interest owner, in properties purchased for certain institutional clients as well as drilling and workover activities in directly-owned properties, contributed to the increases in production revenues for 1993 and 1992. These activities have generally been centered around offshore producing properties acquired from Placid Oil Company ("Placid") in 1991. These properties were sold in late 1993, resulting in the previously-mentioned $22 million gain. Higher interest rates associated with the refinancing of property-related debt resulted in approximately $2.2 million in additional interest expense in 1993 as compared to 1992 amounts. A general decline in interest rates during 1992 and principal payments resulted in the decrease in interest expense from 1992 to 1991. Torch Energy and its subsidiaries are also involved in asset management and well operations. Revenues in these categories also increased in each period. Assets under management increased from $929 million at year-end 1991 to $1.2 million at year-end 1992 and 1993. Investment operations: Torchmark's investment strategy continues to emphasize high-quality fixed income securities. Attractive investment opportunities in the municipal sector of the bond market in 1993 resulted in significant purchases of insured municipal bonds during the year, complementing purchases of government-guaranteed GNMA securities and high- quality corporate bonds, the traditional backbone of the Torchmark investment program. Fixed income acquisitions for insurance companies totalled $1.7 billion, evenly divided between mortgage-backed securities, municipals and corporates. With its emphasis on fixed-income assets, the distribution of Torchmark investments varies substantially with the industry, as evidenced by the latest information provided by the ACLI: - -------- (1) Estimated December 31, 1993 percentages provided by ACLI (2) Includes private label CMO's with GNMA collateral (3) Includes $183 million in short-term investments At 1993 year end, government or government-guaranteed securities and invested cash totalled $2.9 billion, 61% of the bond and short-term portfolio. Investment-grade holdings represented 99.7% of fixed income portfolio and 68.7% were rated "AAA" by Moody's or Standard & Poor's. Investments in noninvestment-grade bonds, which continue to decline, totalled only $13.7 million at year end with a market value of $14.4 million. The considerable volatility in GNMA prepayments experienced over the past several years continued throughout 1993. As a result, emphasis was placed on the acquisition of noncallable medium-term fixed income investments. With the continued decline in long-term rates, the slightly longer average life of newly acquired investments generally offset the shortening of GNMA holdings. The estimated average life of the total fixed income portfolio has remained stable at 6.0, 6.1, and 5.9 years for December 31, 1993, 1992, and 1991, respectively. The emphasis on medium-term maturities has impacted the estimated repayment of the portfolio only slightly. The following table presents an estimated maturity schedule as of December 31, 1993, incorporating unscheduled repayments on mortgage-backed securities: Net investment income declined 2.7% in 1993 to $372 million, after having risen 5.1% in 1992 to $383 million. Several factors were involved in the 1993 decrease. Energy investment income accounted for $18.7 million of the total decline, caused primarily by completion of development of Torchmark's coalbed methane development discussed below for which earnings are derived primarily from tax credits. Also, lower energy prices were a factor. A second major factor in the decline was the lower rates available on new investments in 1993 when compared to prior years. Additionally, the increased GNMA prepayment activity resulted in substantial reinvestments at prevailing lower rates. The increased investments in tax-advantaged products also contributed to the lower investment income. On a tax-equivalent basis, net investment income actually increased 1.5%. At book value, average invested assets grew 9.9% in 1993, compared to an increase of 9.4% in 1992. With the continuing decline in interest rates during 1993, acquisition of new investments had an expected taxable equivalent yield of 6.68%, compared with 7.75% in 1992 and 8.60% in 1991. In 1992, Torchmark designated approximately 26% of its total bond portfolio as "available for sale." In order to preserve total flexibility, it was decided to designate the entire fixed income portfolio as "available for sale." These securities, with a book value of $4.4 billion and a market value of $4.6 billion, will be available for active investment management in the future. Torchmark's holdings in energy investments declined 12% to $346 million at December 31, 1993, representing 6.4% of total investments, compared to $393 million or 8% of total investments at December 31, 1992. Energy investments were $335 million at year-end 1991. The 1992 increase was in large part a result of additional investment and capitalized development costs in the coalbed methane gas development in the Black Warrior Basin in Alabama. The decrease in 1993 primarily resulted from the sale of property to a royalty trust and the disposition of $13 million of Nuevo stock. Wells in the Black Warrior Basin produce methane gas from coal seam formations. This production increases as wells are dewatered and for a period thereafter, after which time gas production declines. Prior to 1993, all the wells were being dewatered and development costs including interest were capitalized. During 1993, production increased and the capitalization of interest was phased out. Gas production from wells in the Black Warrior Basin qualify for a Federal income tax credit which is estimated to be $.97 per thousand cubic feet of gas produced for 1993 and will continue through 2003. The credit phases out if the price of crude oil exceeds $43.58 per barrel, which was substantially higher than the price of crude oil at December 31, 1993. Credits were recognized as a reduction in taxes in the amount of $6.5 million in 1993, $2.9 million in 1992 and $.4 million in 1991. An additional $4.4 million in tax credits were recognized in 1993 on other energy investments. LIQUIDITY AND CAPITAL RESOURCES Liquidity: Torchmark's high level of liquidity is represented by its strong positive cash flow, its liquid assets, and the availability of a line of credit facility. As is typical of established life insurance companies, Torchmark generates cash flow from premium, investment, and other income generally well in excess of its immediate needs for policy obligations, expenses, and other requirements. Additionally, because of the nature of the life insurance business, cash flow is also quite stable and predictable. Torchmark's cash flow has been strong and more than adequate to meet current needs. Cash provided from operations, including cash provided from deposit- product operations, was $488 million in 1993, compared to $554 million in 1992, and $479 million in 1991. In addition, Torchmark received $1.16 billion in 1993, $808 million in 1992, and $392 million in 1991 from scheduled investment maturities as well as unscheduled GNMA and other principal repayments. Cash flow from operations and investment repayments in excess of debt service and shareholder dividends are generally invested to enhance return. Cash and short-term investments were $237 million at December 31, 1993, compared to $139 million at December 31, 1992, an increase of 70%. These liquid assets represented over 3% of total assets at December 31, 1993, compared to 2% at the prior year end. In addition to Torchmark's liquid assets, Torchmark has marketable fixed and equity securities with a value of $4.6 billion at December 31, 1993 which are available for sale should the need arise. Torchmark maintains a line of credit facility with a group of banks which allows borrowings up to $250 million, of which $107 million was borrowed at year-end 1993. This line is available to Torchmark at any time up to the maximum amount, although Torchmark is subject to certain covenants regarding capitalization and earnings. At December 31, 1993, Torchmark was in full compliance with these covenants. Liquidity of the parent company is affected by the ability of the subsidiaries to pay dividends. Dividends are paid by subsidiaries to the parent in order to meet its dividend payments on common and preferred stock, interest and principal repayment requirements on parent company debt, and operating expenses of the parent company. Dividends from insurance subsidiaries of Torchmark are limited to the greater of statutory net gain from operations on an annual noncumulative basis or 10% of surplus, not to exceed earned surplus, in the absence of special approval. Although these restrictions exist, dividend availability from subsidiaries has been and is expected to be more than adequate for parent-company operations. At December 31, 1993 a maximum amount of $388 million was available to Torchmark from insurance subsidiaries without regulatory approval. Capital Resources: Torchmark's long-term debt stood at $792 million at December 30, 1993, compared to $498 million at December 31, 1992. Two new major debt issuances in 1993 accounted for this increase. In May, 1993, Torchmark issued $200 million principal amount 7 7/8% Notes due 2023 for net proceeds of $196 million after issue costs. This issue was registered in a 1992 shelf registration. In July, 1993, Torchmark issued notes with a principal amount of $100 million due in the year 2013 which bear interest at a rate of 7 3/8%. Proceeds of this issue, net of issue costs, were $98.3 million. A substantial portion of the proceeds from these new debt issuances was used to acquire the remaining interest in United Management. In addition to these new issues outstanding at December 31, 1993, Torchmark had three other major debt issues outstanding at both year-end 1993 and 1992. These issues consisted of: (1) 8 5/8% Sinking Fund Debentures due 2017, $200 million principal amount; (2) 9 5/8% Senior Notes due 1998, $200 million principal amount; and (3) 8 1/4% Senior Debentures due 2009, $100 million principal amount. All major debt issues, including the newly-issued 1993 Notes, were carried at a balance of $790 million at December 31, 1993, after deducting the unamortized discount, compared to $496 million at December 31, 1992. During 1993, Torchmark's short-term debt declined from $277 million at year- end 1992 to $107 million at December 31, 1993. Torchmark paid down $88 million on its line of credit facility, net of borrowings. Additionally, energy subsidiaries repaid $82 million of debt related to previously-acquired energy properties which has been repaid in full. In 1993, Torchmark acquired 850 thousand shares of its common stock on the open market at an aggregate cost of $42 million. While Torchmark is not actively acquiring shares of its common stock at the current time, it may do so from time to time at favorable prices. Torchmark acquired 4.2 million shares at a cost of $158 million in 1992 and 1.3 million shares at a cost of $44 million in 1991. In early 1992, Torchmark acquired $33.7 million face amount of its adjustable-rate preferred stock at a cost of $31.5 million. In 1991, Torchmark also acquired $6.1 million face value at a cost of $5.3 million, and in 1990, $13.1 million face value of the preferred stock was acquired at a price of $11 million. This stock is reported in the financial statements as treasury stock at a cost of $47.8 million. No preferred shares were acquired in 1993. Torchmark has announced it will acquire the balance of its adjustable-rate preferred stock outstanding at face amount plus accrued dividends of $1.13 per share on March 31, 1994. In January, 1994, Torchmark filed with the Securities and Exchange Commission a Form S-3 registering up to $200 million in securities in the form of preferred stock, depository shares, or some combination thereof. The net proceeds from the sale of these securities will be used for general corporate purposes, which may include repayment of bank debt, additional capitalization of insurance subsidiaries, the repurchase of shares of Torchmark's adjustable- rate preferred stock and common stock, and possible acquisitions. Shareholders' equity was $1.42 billion at December 31, 1993, an increase of 27% over the $1.12 billion at December 31, 1992. Approximately 10% of this increase was due to Torchmark's election to classify all fixed maturities as available for sale. Book value per share was $18.80 at December 31, 1993, compared to $14.54 at December 31, 1992. Return on common shareholders' equity was 24.2% in 1993, compared to 26.4% in 1992. Long-term debt as a percentage of equity was 56% at December 31, 1993, compared to 45% at December 31, 1992, as a result of the new debt issuances. Total debt as a percentage of total capitalization was 39% at December 31, 1993 versus 41% at year-end 1992. The multiple of earnings before interest and taxes to interest requirements was 7.5 for 1993, compared to 8.0 for 1992 and 7.4 for 1991. Purchase of United Management Minority Interest. In February, 1993, Torchmark submitted a merger proposal to the United Management Board of Directors to acquire the approximately 17% of the nonvoting common stock of United Management then held by the public in exchange for a new issue of Torchmark convertible debentures, subject to an evaluation by a committee comprised of the independent members of the United Management Board (the "Special Committee") and to approval by a majority vote of the holders of the publicly-held nonvoting common shares. In May, 1993, Torchmark modified its proposal to provide that United Management shareholders would receive $31.25 per share in cash in exchange for their shares if the transaction were to be completed. In May, 1993, the Special Committee recommended proceeding with the merger to the United Management Board of Directors, who then approved the merger. Accordingly, United Management and Torchmark executed an Agreement and Plan of Merger which was to be completed on October 1, 1993. During the third quarter of 1993, Torchmark acquired 306 thousand United Management shares on the open market at an aggregate price of $9.4 million. On October 1, 1993, United Management was merged into a wholly-owned subsidiary of Torchmark. As a result of the merger, Torchmark acquired the approximately 16% of United Management that it did not already own through the payment of $31.25 per share in cash for the remaining outstanding shares. Including the third quarter purchases, the total amount of consideration paid for the publicly held shares of the United Management shareholders was approximately $234 million. Divestiture of Vesta Insurance Group. On July 23, 1993, Torchmark announced that it was considering a public offering of shares of common stock of its wholly-owned subsidiary, Vesta Insurance Group, Inc. ("Vesta"), which had been recently formed to be the holding company for Torchmark's property and casualty operations. On August 31, 1993, a Form S-1 registration statement was filed by Vesta with the Securities and Exchange Commission. On October 20, 1993, Vesta filed an amendment to this Form S-1 to offer for sale up to 9.9 million shares of its common stock at an estimated price of $24.50 to $26.50 per share, of which 2.2 million would be newly issued shares and the balance would be shares previously owned by Torchmark. On November 10, 1993, the Form S-1 registration statement became effective and on November 11, 1993, a total of 9 million shares of Vesta common stock was sold. Of the total number of Vesta shares sold, Torchmark sold 6.8 million shares for net proceeds of approximately $161 million or $25 per share less expenses, resulting in a $57 million gain. After the transaction, Torchmark continued to own 3.4 million shares of Vesta outstanding common stock or approximately 27% of the company. Torchmark also loaned Vesta $28 million in December, 1993. NEW ACCOUNTING RULES Accounting by Creditors for Impairment of a Loan (FASB Statement No. 114) for fiscal years beginning after December 15, 1994. This Statement addresses the accounting by creditors for impairment of certain loans. It essentially requires that impaired loans that are within the scope of this Statement be measured based on the present value of expected future cash flows discounted at the loan's effective interest rate or at the loan's observable market price or the fair value of the collateral if the loan is collateral dependent. The effect of adoption of this Standard will be immaterial to Torchmark. ITEM 8.	ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEPENDENT AUDITORS' REPORT The Board of Directors and Shareholders Torchmark Corporation Birmingham Alabama We have audited the consolidated financial statements of Torchmark Corporation and subsidiaries as listed in item 8 and the supporting schedules as listed in Item 14(a). These financial statements and financial statement schedules are the responsibility of Torchmark's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements and financial statement schedules are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Torchmark Corporation and subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in Notes 1 and 9 to the consolidated financial statements, Torchmark changed its method of accounting for income taxes to adopt the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards (Statement) No. 109, Accounting for Income Taxes, in 1993. As discussed in Note 3, Torchmark adopted the provisions of the Financial Accounting Standards Board's Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities at December 31, 1993. Also, as discussed in Note 11, Torchmark adopted the provisions of the Financial Accounting Standards Board's Statement No. 106, Employers' Accounting for Postretirement Benefits Other than Pensions, in 1993. KPMG PEAT MARWICK Birmingham, Alabama February 4, 1994 TORCHMARK CORPORATION CONSOLIDATED BALANCE SHEET (DOLLAR AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA) See accompanying Notes to Consolidated Financial Statements. TORCHMARK CORPORATION CONSOLIDATED STATEMENT OF OPERATIONS (AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA) See accompanying Notes to Consolidated Financial Statements. TORCHMARK CORPORATION CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY (AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA) See accompanying Notes to Consolidated Financial Statements. TORCHMARK CORPORATION CONSOLIDATED STATEMENT OF CASH FLOW (AMOUNTS IN THOUSANDS) See accompanying Notes to Consolidated Financial Statements. TORCHMARK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATE) NOTE 1--SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation: The accompanying financial statements have been prepared in conformity with generally accepted accounting principles ("GAAP"). Principles of Consolidation: The financial statements include the results of Torchmark Corporation ("Torchmark") and its wholly-owned subsidiaries and United Investors Management Company ("United Management"). United Management was approximately 83% owned through October 1, 1993 at which time Torchmark acquired all of the publicly held shares. Torchmark deducts the interests of minority shareholders from its shareholders' equity and operating results. Subsidiaries which are not majority-owned are reported on the equity method. All significant intercompany accounts and transactions have been eliminated in consolidation. Investments. Investments in fixed maturities include bonds and redeemable preferred stocks. These fixed maturity investments are segregated as to those which are available for sale and those which are held to maturity. In 1993, Torchmark chose to classify all of its fixed maturity investments as available for sale. These investments are carried at market value with unrealized gains and losses, net of deferred taxes, reflected directly in shareholders' equity. In 1992, the investments which were classified as available for sale were carried at the lower of cost or market with unrealized losses, net of deferred taxes, reflected in shareholders' equity. Fixed maturities held to maturity are carried at amortized cost. Investments in equity securities, which include common and nonredeemable preferred stocks, are reported at market value. Policy loans are carried at unpaid principal balances. Mortgage loans are carried at amortized cost. Investments in real estate are reported at cost less allowances for depreciation, which are calculated on the straight line method. Short-term investments include investments in certificates of deposit and other interest- bearing time deposits with original maturities within one year. If an investment becomes permanently impaired, such impairment is treated as a realized loss and the investment is adjusted to net realizable value. Gains and losses realized on the disposition of investments are recognized as revenues and are determined on a specific identification basis. Unrealized gains and losses on equity securities and fixed maturities available for sale, net of deferred income taxes, are reflected directly in shareholders' equity. Realized investment gains and losses and investment income attributable to separate accounts are credited to the separate accounts and have no effect on Torchmark's net income. Investment income attributable to other policyholders is included in Torchmark's net investment income. Net investment income for the years ended December 31, 1993, 1992 and 1991 included $229.5 million, $221.2 million, and $209.5 million, respectively, which was allocable to policyholder reserves or accounts. Realized investment gains and losses are not allocable to policyholders. Determination of Fair Values of Financial Instruments: Fair value for cash, short-term investments, receivables and payables approximates carrying value. Fair values for investment securities are based on quoted market prices, where available. Otherwise, fair values are based on quoted market prices of comparable instruments. Mortgages are valued using discounted cash flows. The carrying amounts of short-term borrowings approximate their fair value. Substantially all of Torchmark's long-term debt is valued based on quoted market prices. Cash: Cash consists of balances on hand and on deposit in banks and financial institutions. Recognition of Premium Revenue and Related Expenses: Premiums for insurance contracts which are not defined as universal life-type according to SFAS 97 are recognized as revenue over the premium-paying period of the policy. Profits for limited-payment life insurance contracts as defined by SFAS 97 are recognized over the contract period. Premiums for universal life-type and annuity contracts are added to the policy account value, and revenues for such products are recognized as charges to the policy account value for mortality, administration, and surrenders (retrospective deposit method). Life premium includes policy charges of $76.2 million, $79.8 million, and $83.4 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (DOLLAR AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA) NOTE 1--SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) million for the years ended December 31, 1993, 1992 and 1991, respectively. Other premium includes annuity policy charges for the years ended December 31, 1993, 1992 and 1991 of $9.5 million, $8.8 million and $7.4 million, respectively. Profits are also earned to the extent that investment income exceeds policy requirements. The related benefits and expenses are matched with revenues by means of the provision of future policy benefits and the amortization of deferred acquisition costs in a manner which recognizes profits as they are earned over the same period. Future Policy Benefits: The liability for future policy benefits for universal life-type products according to SFAS 97 is represented by policy account value. The liability for future policy benefits for all other life and health products is provided on the net level premium method based on estimated investment yields, mortality, morbidity, persistency and other assumptions which were appropriate at the time the policies were issued. Assumptions used are based on Torchmark's experience as adjusted to provide for possible adverse deviation. These estimates are periodically reviewed and compared with actual experience. If it is determined future experience will probably differ significantly from that previously assumed, the estimates are revised. Deferred Acquisition Costs: The costs of acquiring new insurance business are deferred. Such costs consist of sales commissions, underwriting expenses, and certain other selling expenses. The costs of acquiring new business through the purchase of other companies and blocks of insurance business are also deferred. Deferred acquisition costs, including the value of life insurance purchased, for policies other than universal life-type policies according to SFAS 97 are amortized with interest over an estimate of the premium-paying period of the policies in a manner which charges each year's operations in proportion to the receipt of premium income. For universal life-type policies, acquisition costs are amortized with interest in proportion to estimated gross profits. The assumptions used as to interest, persistency, morbidity and mortality are consistent with those used in computing the liability for future policy benefits and expenses. If it is determined that future experience will probably differ significantly from that previously assumed, the estimates are revised. Deferred acquisition costs are adjusted to reflect the amounts associated with unrealized investment gains and losses pertaining to universal life-type products. Income Taxes: In February 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes. Statement 109 requires a change from the deferred method of accounting for income taxes of APB Opinion 11 to the asset and liability method of accounting for income taxes. Under the asset and liability method of Statement 109, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under Statement 109, the effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Effective January 1, 1993, Torchmark adopted Statement 109 and has reported the cumulative effect of that change in the method of accounting for income taxes in the 1993 consolidated statement of operations. Prior years' financial statements have not been restated to reflect Statement 109's provisions. Pursuant to the deferred method under APB Opinion 11, which was applied in 1992 and prior years, deferred income taxes were recognized for revenue and expense items that were reported in different years for financial reporting purposes and income tax purposes using the tax rate applicable for the year of the calculation. Under the deferred method, deferred taxes were not adjusted for subsequent changes in tax rates. Property and Equipment: Property and equipment is reported at cost less allowances for depreciation. Depreciation is recorded primarily on the straight line method over the estimated useful lives of these assets which range from two to twelve years for equipment and five to forty years for buildings. Ordinary maintenance and repairs are charged to income as incurred. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (DOLLAR AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA) NOTE 1--SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Energy: Torchmark uses the successful-efforts method of accounting for its energy operations. All costs associated with property acquisitions and development of proved oil and gas reserves are capitalized. Capitalized costs are amortized by the unit-of-production method based on estimated proved oil and gas reserves. All costs relating to production activities are charged to income as incurred. Energy properties owned by Torchmark's energy subsidiaries are accounted for as "properties" and revenue therefrom is accounted for as "energy operations revenues." Investments in oil and gas properties by Torchmark's insurance subsidiaries are accounted for as "investments" and income therefrom is accounted for as "investment income." Goodwill: The excess cost of businesses acquired over the fair value of their net assets is reported as goodwill and is amortized on a straight-line basis over a period not exceeding 40 years. Treasury Stock: Torchmark accounts for purchases of treasury stock on the cost method. Reclassification: Certain amounts in the financial statements presented have been reclassified from amounts previously reported in order to be comparable between years. These reclassifications have no effect on previously reported shareholders' equity or net income during the periods involved. Stock Split: On August 19, 1992, Torchmark distributed one share for every two shares owned by shareholders on record as of August 5, 1992 in the form of a stock dividend. The dividend was accounted for as a stock split. All prior- year share and per share data have been restated to give effect for this split. Earnings Per Share: Earnings available to holders of common stock are computed after deducting dividends on the Adjustable Rate Cumulative Preferred Stock. Primary earnings per share are then calculated by dividing the earnings available to holders of common stock by the weighted average number of common shares outstanding during the period. The weighted average numbers of common shares outstanding for each period are as follows: 1993--73,501,654, 1992-- 73,236,849, 1991--76,728,267 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (DOLLAR AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA) NOTE 2--STATUTORY ACCOUNTING Insurance subsidiaries of Torchmark are required to file statutory financial statements with state insurance regulatory authorities. Accounting principles used to prepare these statutory financial statements differ from GAAP. Consolidated net income and shareholders' equity on a statutory basis for the insurance subsidiaries were as follows: *Includes equity in earnings of property and casualty subsidiaries The excess, if any, of shareholders' equity of the insurance subsidiaries on a GAAP basis over that determined on a statutory basis is not available for distribution to Torchmark without regulatory approval. A reconciliation of Torchmark's insurance subsidiaries' statutory net income to Torchmark's consolidated GAAP net income is as follows: A reconciliation of Torchmark's insurance subsidiaries' statutory shareholders' equity to Torchmark's consolidated GAAP shareholders' equity is as follows: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (DOLLAR AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA) NOTE 3--INVESTMENT OPERATIONS In May, 1993, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities. Statement 115 requires that investments be classified in three categories and accounted for as follows: (i) Debt securities which are purchased with the positive intent and ability to hold to maturity should be classified as held-to-maturity and should be reported at amortized cost; (ii) Debt and equity securities which are bought and held principally for the purpose of selling them in the near term should be classified as trading securities and should be reported at fair value, with unrealized gains and losses included in earnings; and (iii) Debt and equity securities which are not classified as either held-to-maturity or trading securities should be classified as available for sale and should be reported at fair value, with unrealized gains and losses excluded from earnings and reported in a separate component of shareholders' equity. Torchmark adopted Statement 115 at December 31, 1993 and chose to classify all of its fixed maturity investments as available for sale. Prior year financial statements have not been restated. At December 31, 1992, fixed maturities held-to-maturity were carried at amortized cost and fixed maturities available for sale were carried at the lower of amortized cost or market. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (DOLLAR AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA) NOTE 3--INVESTMENT OPERATIONS (CONTINUED) A summary of fixed maturities held for investment and available for sale and equity securities by amortized cost and estimated market value at December 31, 1993 and 1992 is as follows: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (DOLLAR AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA) NOTE 3--INVESTMENT OPERATIONS (CONTINUED) A schedule of fixed maturities by contractual maturity at December 31, 1993 is shown below on an amortized cost basis and on a market value basis. Actual maturities could differ from contractual maturities due to call or prepayment provisions. Proceeds from sales of fixed investments held to maturity were $63 million in 1993, $403 million in 1992, and $631 million in 1991. Gross gains realized on those sales were $2.6 million in 1993, $8.6 million in 1992, and $12.7 million in 1991. Gross losses on those sales were $138 thousand in 1993, $1.7 million in 1992, and $6.4 million in 1991. The 1993 sales of fixed investments held to maturity were made for various reasons including changes in regulatory requirements, credit deterioration, and sales within 90 days of maturity. Proceeds from sales of fixed maturities available for sale were $241 million in 1993. Gross gains realized on those sales were $8.3 million and gross losses were $176 thousand. Torchmark had $22.0 million and $38.5 million in investment real estate at December 31, 1993 and 1992, respectively, which was nonincome producing during the previous twelve months. These properties included primarily construction in process and land. Fixed investments and mortgage loans which were nonincome producing during the previous twelve months were $.4 million at both December 31, 1993 and 1992. NOTE 4--PROPERTY AND EQUIPMENT A summary of property and equipment used in the business is as follows: Depreciation expense on property and equipment used in the business was $9.6 million, $10.4 million, and $10.3 million in each of the years 1993, 1992 and 1991. Depletion of energy properties was $22.4 million, $19.6 million, and $12.6 million in 1993, 1992 and 1991, respectively. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (DOLLAR AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA) NOTE 5--DEFERRED ACQUISITION COSTS AND VALUE OF INSURANCE PURCHASED An analysis of deferred acquisition costs and the value of insurance purchased is as follows: - -------- (1)Represents amounts pertaining to universal life-type products. The amount of interest accrued on the unamortized balance of value of insurance purchased was $10.8 million, $12.7 million, and $14.1 million for the years ended December 31, 1993, 1992 and 1991, respectively. The average interest accrual rates used for the years ended December 31, 1993, 1992 and 1991 were 7.57%, 7.81% and 7.92%, respectively. The estimated amount of the unamortized balance of the value of business purchased balance at December 31, 1993 to be amortized during each of the next five years is: 1994, $15.8 million; 1995, $15.0 million; 1996, $12.7 million; 1997, $11.0 million; and 1998, $9.3 million. In the event of lapses or early withdrawals in excess of those assumed, deferred acquisition costs and the value of insurance purchased may not be recoverable. NOTE 6--SALE OF SUBSIDIARY In July, 1993, Torchmark created a new company called Vesta Insurance Group, Inc. ("Vesta") for the purpose of becoming the new holding company of Torchmark's property and casualty insurance subsidiaries, principally Liberty Fire. In November, 1993, Torchmark sold approximately 73% of its ownership in Vesta through an initial public offering of common stock for net proceeds of $160.7 million or a pretax gain of $57.2 million. Torchmark maintained a 27% interest in Vesta and accounts for its investment on the equity method. In connection with the public offering, Torchmark loaned Vesta $28 million at an interest rate of 6.1% for a term of five years. Torchmark's remaining investment in Vesta was recorded as an investment in unconsolidated subsidiary. NOTE 7--PURCHASE OF UNITED MANAGEMENT MINORITY INTEREST On October 1, 1993, the United Management public shareholders approved Torchmark's offer to acquire the remaining approximately 17% of United Management which it did not already own for cash consideration of $31.25 per share. The transaction was completed for a total purchase price of $234 million resulting in goodwill of $130.7 million which will be amortized over approximately 28 years, which is the period remaining for the amortization of the goodwill originated in the 1981 acquisition of United Management. All other purchase accounting adjustments were immaterial. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (DOLLAR AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA) NOTE 8--FUTURE POLICY BENEFIT RESERVES A summary of the assumptions used in determining the liability for future policy benefits at December 31, 1993 is as follows: INDIVIDUAL LIFE INSURANCE INTEREST ASSUMPTIONS: MORTALITY ASSUMPTIONS: For individual life, the mortality tables used are various statutory mortality tables and modifications of: 1950-54 Select and Ultimate Table 1954-68 Industrial Experience Table 1955-60 Ordinary Experience Table 1965-70 Select and Ultimate Table 1955-60 Inter-Company Table 1970 United States Life Table 1979-81 United States Life Table 1975-80 Select and Ultimate Table X-18 Ultimate Table WITHDRAWAL ASSUMPTIONS: Withdrawal assumptions are based on Torchmark's experience. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (DOLLAR AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA) NOTE 8--FUTURE POLICY BENEFIT RESERVES (CONTINUED) HEALTH INSURANCE INTEREST ASSUMPTIONS: MORBIDITY ASSUMPTIONS: For health, the morbidity assumptions are based on either Torchmark's experience or the assumptions used in calculating statutory reserves. TERMINATION ASSUMPTIONS: Termination assumptions are based on Torchmark's experience. OVERALL INTEREST ASSUMPTIONS: The overall average interest assumption for determining the liability for future life and health insurance benefits in 1993 was 6.1%. NOTE 9--INCOME TAXES Torchmark and its eligible subsidiaries file a life-nonlife consolidated federal income tax return. Famlico and Sentinel file a separate federal income tax return and will not be eligible to join the consolidated return group until 1996 and 1997, respectively. As discussed in Note 1, Torchmark adopted Statement 109 on January 1, 1993. The cumulative effect of this change in accounting for income taxes is a $26.1 million addition to net income for the year ended December 31, 1993. This amount is included in the cumulative effect of changes in accounting principles line on the consolidated statement of operations. Total income tax expense for the year ended December 31, 1993 was allocated as follows: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (DOLLAR AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA) NOTE 9--INCOME TAXES (CONTINUED) Income tax expense before the cumulative effect of the change in accounting principles and adjustments to shareholders' equity is summarized as follows: The effective income tax rate differed from the expected 35% rate in 1993 and 34% rate in 1992 and 1991 as shown below: The significant components of deferred income tax expense before the cumulative effect of the change in accounting principles and adjustments to shareholders' equity for the year ended December 31, 1993 are as follows: For the years ended December 31, 1992 and 1991, deferred income tax expense (benefit) of $16,062 and ($3,672), respectively, resulted from timing differences in the recognition of revenue and expense for financial reporting and income tax purposes. The sources and tax effect of those timing differences are presented below: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (DOLLAR AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA) NOTE 9-- INCOME TAXES (CONTINUED) The tax effects of temporary differences that gave rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 1993 are presented below: In Torchmark's opinion, all deferred tax assets will be recoverable. Torchmark has not recognized a deferred tax liability for the undistributed earnings of its wholly-owned subsidiaries because such earnings are remitted to Torchmark on a tax-free basis. A deferred tax liability will be recognized in the future if the remittance of such earnings becomes taxable to Torchmark. In addition, Torchmark has not recognized a deferred tax liability of approximately $58 million that arose prior to 1984 on temporary differences related to the policyholders' surplus accounts in the life insurance subsidiaries. A current tax expense will be recognized in the future if and when these amounts are distributed. NOTE 10--NOTES PAYABLE An analysis of notes payable is as follows: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (DOLLAR AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA) NOTE 10--NOTES PAYABLE (CONTINUED) The amount of debt that becomes due during each of the next five years is: 1994, $107.1 million; 1995, $116 thousand; 1996, $123 thousand; 1997, $132 thousand; and 1998, $199 million. Additionally, during the thirty-day period beginning June 15, 1996, senior debenture debt holders have the option to require Torchmark to repay $100 million. The Sinking Fund Debentures, due March 1, 2017, are carried at $200 million principal amount less unamortized issue expenses and bear interest at 8 5/8%, payable on March 1 and September 1. A sinking fund provides for mandatory repayment at par of not less than $8 million principal amount per year from March 1, 1998 through March 1, 2016. At Torchmark's option, an additional $12 million principal amount per year may be redeemed at par according to the same schedule. The option to make such additional repayments is not cumulative and if not availed of in any year will terminate. Furthermore, Torchmark may, at its option, redeem the entire issue at prices ranging from 107.9% to 100.0% of par, subject to certain restrictions. The Sinking Fund Debentures have equal priority with other Torchmark unsecured indebtedness. The Senior Notes, due May 1, 1998, are not redeemable prior to maturity. They were issued in May, 1988 in the principal amount of $200 million. Interest is payable on May 1 and November 1 of each year at a rate of 9 5/8%. These notes have equal priority with other Torchmark unsecured indebtedness. The Senior Debentures, principal amount of $100 million, are due August 15, 2009. They were issued in August, 1989, bearing interest at the rate of 8 1/4%, with interest payable on February 15 and August 15 of each year. The Senior Debentures, which are not redeemable at the option of Torchmark prior to maturity, provide the holder with an option to require Torchmark to repurchase the debentures on August 15, 1996 at principal amount plus accrued interest. The Senior Debentures have equal priority with other Torchmark unsecured indebtedness. The Notes, due May 15, 2023, were issued in May, 1993 in the principal amount of $200 million. Proceeds of the issue, net of issue costs, were $196 million. Interest is payable on May 15 and November 15 of each year at a rate of 7 7/8%. These notes are not redeemable prior to maturity and have equal priority with other Torchmark unsecured indebtedness. The Notes, due August 1, 2013, were issued in July, 1993 in the principal amount of $100 million for net proceeds of $98 million. Interest is payable on February 1 and August 1 of each year at a rate of 7 3/8%. These notes are not redeemable prior to maturity and have equal priority with other Torchmark unsecured indebtedness. Torchmark maintains a line of credit agreement which is unsecured and at December 31, 1993 and 1992 allowed borrowings up to $250 million from participating banks. The agreement terminates in December, 1994. The interest rate is determined at the option of Torchmark utilizing a formula based on either prime, Libor or secondary certificate of deposit rates and was 3.51% at December 31, 1993 and 4.21% at December 31, 1992. A commitment fee on the unused balance is charged for its availability. There was $107 million and $195 million in borrowings outstanding under the line of credit as of December 31, 1993 and December 31, 1992, respectively. Torchmark is subject to certain covenants regarding capitalization and earnings, for which Torchmark was in compliance at December 31, 1993. Torch Energy Advisors Incorporated ("Torch Energy"), a wholly-owned subsidiary of Torchmark, also maintains a line of credit agreement which at December 31, 1993 allowed borrowings up to $30 million. The interest rate is charged at variable rates and is based on the prime or Libor rates, and a commitment fee is charged for the unused balance. The agreement terminates in September, 1994 and is secured by any acquired assets and by the approximately 1.5 million shares of Nuevo common stock owned by Torch Energy. There were no borrowings outstanding on this line of credit at December 31, 1993. At December 31, 1992 Torch Energy had another line of credit available up to $95 million, of which $81.7 million was outstanding at December 31, 1992. Interest was charged at a variable rate based on the prime or Libor rates, and was approximately 5.99% at December 31, 1992. It was repaid and NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (DOLLAR AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA) NOTE 10--NOTES PAYABLE (CONTINUED) terminated on January 31, 1993, with $15 million financed by another energy credit facility. The note was collateralized by properties and was guaranteed up to $54.1 million by United Management. Interest in the amount of $10.5 million, $20.4 million, and $16.8 million was capitalized during 1993, 1992, and 1991, respectively. NOTE 11--POSTRETIREMENT BENEFITS Pension Plans: Torchmark has retirement benefit plans and savings plans which cover substantially all employees. There is also a nonqualified excess benefit plan which covers certain employees. The total cost of these retirement plans charged to operations was as follows: Cost for the defined benefit pension plans has been calculated on the projected unit credit actuarial cost method. Contributions are made to the pension plans subject to minimums required by regulation and maximums allowed for tax purposes. Accrued pension expense in excess of amounts contributed has been recorded as a liability in the financial statements and was $10.1 million and $11.0 million at December 31, 1993 and 1992, respectively. The plans are organized as trust funds whose assets consist primarily of investments in marketable long-term fixed maturities and equity securities which are valued at market. The excess benefit pension plan provides the benefits that an employee would have otherwise received from a defined benefit pension plan in the absence of the Internal Revenue Code's limitation on benefits payable under a qualified plan. Although this plan is unfunded, pension cost is determined in a similar manner as for the funded plans. Liability for the excess benefit plan was $1.5 million and $1.1 million as of December 31, 1993 and 1992, respectively. Net periodic pension cost for the defined benefit plans by expense component was as follows: A reconciliation of the funded status of the defined benefit plans with Torchmark's pension liability was as follows: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (DOLLAR AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA) NOTE 11--POSTRETIREMENT BENEFITS (CONTINUED) The weighted average assumed discount rates used in determining the actuarial benefit obligations were 7.25% in 1993 and 8.5% in 1992. The rate of assumed compensation increase was 5.0% in 1993 and 5.5% in 1992 and the expected long-term rate of return on plan assets was 8.0% in 1993 and 8.5% in 1992. Torchmark accrues expense for the defined contribution plans based on a percentage of the employees' contributions. The plans are funded by the employee contributions and a Torchmark contribution equal to the amount of accrued expense. Post Retirement Benefit Plans Other Than Pensions; Torchmark provides postretirement life insurance benefits for most retired employees, and also provides additional postretirement life insurance benefits for certain key employees. The majority of the life insurance benefits are accrued over the working lives of active employees. For retired employees over age sixty-five, Torchmark does not provide postretirement benefits other than pensions. Torchmark does provide a portion of the cost for health insurance benefits for employees who retired before February 1, 1993 and before age sixty-five, covering them until they reached age sixty-five. Eligibility for this benefit was generally achieved at age fifty-five with at least fifteen years of service. This subsidy is minimal to employees who did not retire before February 1, 1993. This plan is unfunded. Torchmark adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," in 1993. This statement requires that the expected cost of providing future benefits to employees be accrued during the employees' service period until each employee reaches full eligibility. Two options for recognizing the accumulated benefit obligation are provided upon adoption of Statement 106 for participants. The employer can either recognize the transition obligation immediately as the effect of an accounting change, or it can recognize the obligation in the financial statements on a delayed basis, amortizing the obligation on a straight-line basis over the greater of the participants' future service period or twenty years. Torchmark elected to recognize the effect of the obligation immediately as a change in accounting principle. The cumulative effect of this change in accounting resulted in a $7.7 million after-tax charge to net income. It was reported as part of the cumulative effect of changes in accounting principles. In accordance with the provisions of SFAS 106, prior years' financial statements have not been restated to apply the provisions of this statement. Net periodic postretirement benefit cost for 1993 included the following components: The following table sets forth the plans' combined funded status with the amount shown in Torchmark's balance sheet at December 31, 1993: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (DOLLAR AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA) NOTE 11--POSTRETIREMENT BENEFITS (CONTINUED) For measurement purposes, a 12% to 14% annual rate of increase in a per capita cost of covered health care benefits was assumed for 1994; the rate was assumed to decrease gradually to 4.5% by the year 2008 and remain at that level thereafter. The health care cost trend rate assumption has a significant effect on the amounts reported. To illustrate, increasing the health care cost trend by one percentage point in each year would increase the accumulated postretirement benefit obligation as of December 31, 1993 by $1.1 million and would increase the net periodic postretirement cost for the year ended December 31, 1993 by approximately $260 thousand. The weighted average discount rate used in determining the accumulated postretirement benefit obligation was 7.25%. NOTE 12--SHAREHOLDERS' EQUITY Share Data: A summary of preferred and common share activity is as follows: Adjustable Rate Preferred Stock: One million shares of adjustable rate preferred stock were issued in 1983 at an issue price of $100 per share. Dividends are cumulative and are payable quarterly. The dividend rate is adjustable, being determined in advance of each period at 1.25% less than the highest of the treasury bill rate, the ten year constant maturity rate, or the twenty year constant maturity rate. However, the dividend rate will never be less than 7% nor greater than 13%. The January 31, 1994 dividend was paid at a rate of 7.00%. The preferred stock is redeemable, at Torchmark's option, from NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (DOLLAR AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA) NOTE 12--SHAREHOLDERS' EQUITY (CONTINUED) January 1, 1989 through December 31, 1993 at a price of $103 per share, and thereafter at $100 per share. Torchmark has announced that it will redeem all of the outstanding preferred stock on March 31, 1994. The price will be $100 a share plus accrued dividends. The preferred shareholders have preference and priority over common shareholders in the event of liquidation equal to $100 per share plus accrued and unpaid dividends. During the first quarter of 1990, Torchmark acquired 131 thousand shares of this preferred stock, redemption value $13.1 million, at a purchase price of $11 million. In 1991, an additional 61 thousand shares or $6.1 million redemption value were acquired at a price of $5.3 million. Torchmark acquired an additional 338 thousand shares in 1992 at a cost of $31.5 million, representing a redemption value of $33.7 million. These shares are reported as treasury stock and have a total cost basis of $47.8 million and a total redemption value of $52.9 million. Additional shares may be acquired from time to time at favorable prices. Acquisition of Common Shares: Torchmark commenced a program in 1986 to purchase shares of its common stock from time to time. Under this program, Torchmark purchased 1.3 million shares in 1991 at a cost of $44 million, 4.2 million shares in 1992 at a cost of $157.7 million and 850 thousand shares in 1993 at a cost of $41.9 million. The other common treasury stock acquired was primarily received by Torchmark from employees for the exercise proceeds and payment of taxes for stock options. In October, 1993, Torchmark implemented a policy to issue shares in conjunction with the exercise of stock options out of treasury stock. Stock Options: Under the provisions of the 1984 Torchmark Corporation Stock Option Plan ("1984 Option Plan") and the Torchmark Corporation 1987 Stock Incentive Plan ("1987 Option Plan"), certain employees and directors have been granted options to buy shares of Torchmark stock at the market value of the stock on the date of grant. In conjunction with the buyback of the minority interest of United Management, the United Investors Management Company 1986 Employee Stock Incentive Plan was amended to allow the granting of Torchmark stock options. The options are exercisable during the period commencing from three months to three years after grant until expiring ten years or ten years and two days after grant. A summary of option activity in terms of shares is as follows: Option information by exercise price is listed in the following table. Those options shown as granted on October 1, 1993 represent United Management options which were converted to Torchmark options in conjunction with the merger. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (DOLLAR AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA) NOTE 12--SHAREHOLDERS' EQUITY (CONTINUED) (1) Options to purchase 1,098,090 shares previously granted December 31, 1989 at $37.13 per share, 521,100 shares previously granted January 25, 1990 at $33.13 per share, and 389,870 shares originally granted August 1, 1990 at $33.88 per share were allowed by recipients to expire voluntarily and were reissued October 11, 1990 along with 675,200 additional shares at $25.63 per share. (2) Includes 173,650 shares granted under the United Investors Management Company 1986 Employee Stock Incentive Plan. (3) Issued from the United Investors Management Company 1986 Employee Stock incentive plan. Grant of Restricted Stock: A grant of 60,000 Torchmark shares was made on May 1, 1991 to a Torchmark senior officer. The shares are restricted as to resale, vesting 6,000 shares per year for 10 years on the anniversary date of the grant. The market value of Torchmark stock was $34.92 per share on the grant date. Restrictions: Restrictions exist on the flow of funds to Torchmark from its insurance subsidiaries. Statutory regulations require life insurance subsidiaries to maintain certain minimum amounts of capital and surplus. These restrictions generally limit the payment of dividends by insurance subsidiaries to statutory net gain from operations on an annual noncumulative basis in the absence of special approval. Additionally, insurance companies are not permitted to distribute the excess of shareholders' equity as determined on a GAAP basis over that determined on a statutory basis. In 1994, $388 million will be available to Torchmark for dividends from insurance subsidiaries in compliance with statutory regulations without prior regulatory approval. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (DOLLAR AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA) NOTE 13--COMMITMENTS AND CONTINGENCIES Reinsurance: Insurance affiliates of Torchmark reinsure that portion of insurance risk which is in excess of their retention limits. Retention limits for ordinary life insurance range up to $2 million per life. Life insurance ceded represents 1% of total life insurance in force at December 31, 1993. Insurance ceded on life and accident and health products represents 1.5% of premium income for 1993. Torchmark would be liable for the reinsured risks ceded to other companies to the extent that such reinsuring companies are unable to meet their obligations. Insurance affiliates also assume insurance risks of other companies. Life reinsurance assumed represents less than 0.1% of life insurance in force at December 31, 1993 and reinsurance assumed on life and accident and health products represents less than 0.1% of premium income for 1993. Leases: Torchmark leases office space and office equipment under a variety of operating lease arrangements. These leases contain various renewal options, purchase options, and escalation clauses. Rental expense for operating leases was $7.6 million, $8.2 million, and $7.6 million for 1993, 1992, and 1991, respectively. Future minimum rental commitments required under operating leases having remaining noncancelable lease terms in excess of one year at December 31, 1993 are as follows: 1994, $5.6 million; 1995, $4.1 million; 1996, $3.1 million; 1997, $2.5 million; 1998, $1.4 million; and in the aggregate, $16.7 million. Restrictions on cash: A portion of the cash held in financial service subsidiaries that function as broker-dealers has been segregated for the benefit of customers in compliance with security regulations. This amount was $18.2 million at December 31, 1993 and $13.2 million at December 31, 1992. Concentrations of Credit Risk: Torchmark maintains a highly-diversified investment portfolio with limited concentration in any given region, industry, or economic characteristic. At December 31, 1993, the investment portfolio consisted of securities of the U.S. government or U.S. government-backed securities (50%); short-term investments, which generally mature within one month (3%); securities of state and municipal governments (12%); securities of foreign governments (1%); and investment-grade corporate bonds (21%). The remainder of the portfolio was in oil and gas investments (6%) and real estate (2%), which are not considered financial instruments according to GAAP; equity securities (1%); policy loans (3%), which are secured by the underlying insurance policy values; and mortgages, noninvestment grade corporate securities and other long-term investments (1%). Investments in municipal governments and corporations are made throughout the U.S. with no concentration in any given state. All investments in foreign government securities are in Canadian government issues. Corporate equity and debt investments are made in a wide range of industries. At December 31, 1993, approximately 6% of the portfolio was invested in regulated utilities; 4% was invested in financial institutions; 3% was invested in finance companies; 2% was invested in oil and gas companies; 1% was invested in the transportation industry, and 1% was invested in retail companies. Otherwise, no individual industry represented more than 1% of Torchmark's investments. Of Torchmark's investments at year-end 1993, less than 1% of the carrying value of securities was rated below investment grade (Ba or lower as rated by Moody's serivce or the equivalent NAIC designation). Par value of these investments was $14.9 million, amortized cost was $13.7 million, and market value was $14.4 million. While these investments could be subject to additional credit risk, such risk should generally be reflected in market value. Collateral Requirements: Torchmark requires collateral for investments in instruments where collateral is available and is typically required because of the nature of the investment. Since the majority of Torchmark's investments are in government, government-secured, or corporate securities, the requirement for collateral is rare. Torchmark's mortgages are secured by collateral, although new mortgages are no longer being acquired. Litigation: Torchmark and Torchmark's subsidiaries are continuously parties to pending or threatened legal proceedings. These suits involve tax matters, alleged breaches of contract, torts, including bad faith and fraud claims based on alleged wrongful or fraudulent acts of agents of Torchmark's subsidiaries, employment discrimination, and miscellaneous other causes of action. Most of these lawsuits include claims for punitive damages in addition to other specified relief. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (DOLLAR AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA) NOTE 13--COMMITMENTS AND CONTINGENCIES (CONTINUED) A class action lawsuit has been filed against Liberty (Robertson v. Liberty National Life Insurance Company) in the Circuit Court of Barbour County, Alabama alleging fraud in the exchange of certain cancer insurance policies. It seeks substantial equitable and injunctive relief together with compensatory and punitive damages. Also, a number of separate lawsuits as well as additional class action suits have been filed which are based upon substantially the same allegations. On October 25, 1993, a jury in the Circuit Court of Mobile County, Alabama rendered a one million dollar verdict against Liberty, one of twenty-five suits involving cancer policy exchanges which were filed prior to class certification. Liberty has filed appropriate post-judgment motions and, if necessary, will appeal the verdict. Previously, another judge in the same state court system had granted a summary judgment in favor of Liberty in another substantially similar suit which is on appeal. The Robertson litigation was tentatively settled pending a fairness determination by the Barbour County Court after a hearing. The fairness hearing took place on January 20, 1994. Class members were previously mailed notice of the hearing and the proposed settlement. On February 4, 1994, the court ruled that with a $16 million increase in the value of the proposed Robertson settlement from approximately $39 million to $55 million, the settlement would be fair and would be approved, provided that the parties to the litigation accepted the amended settlement within fourteen days of the issuance of the ruling. On February 17, 1994, the Barbour County Court extended for two weeks the period for filing objections to or accepting the Court's order conditionally approving the class action settlement. On February 22, 1994, the Court entered an order in the Robertson litigation which delayed any final decision on the proposed class action settlement and various motions to modify it (including motions to delete Torchmark from the settlement release), pending certain specified discovery to be completed within 90 days from the date the order was entered. In the order, the Barbour County Court directed limited additional discovery regarding whether Torchmark had any active involvement in the cancer policy exchange. Pending completion of limited additional discovery, the Barbour County Court has reversed jurisdiction and extended the deadline for acceptance or rejection of the modifications set forth in the February 4, 1994 order. Torchmark has provided for the $55 million proposed amended settlement charge in its 1993 financial reports, although it believes that it is highly likely that intervenors will pursue an appeal of the ruling to the Supreme Court of Alabama. In the event a settlement is not agreed to and approved, Torchmark and Liberty intend to aggressively defend the various cases. In June, 1993, a purported class action alleging fraud in the replacement of certain hospital intensive care policies with policies alleged to have less value with lower benefits was filed seeking unspecified compensatory and punitive damages against Liberty and Torchmark in the state court system of Alabama (Smith v. Liberty National Life Insurance Company). A second purported class action (Maples v. Liberty National Life Insurance Company) with substantially the same allegations as in the Smith litigation was also filed in state court in December, 1993. Three other separate lawsuits based upon the replacement of certain hospital intensive care policies have also been filed. The Smith litigation has been settled, while a class has not yet been certified and discovery is proceeding in the Maples case. Two purported class action lawsuits were filed in December, 1993, against Liberty in the state court system of Alabama asserting fraud and misrepresentation in connection with exclusionary provisions of accident and hospital accident policies sold to persons holding multiple accident-type policies. One of the cases has been settled. In the other case, no class has been certified although discovery is proceeding. In 1978, the United States District Court for the Northern District of Alabama entered a final judgement in Battle v. Liberty National Insurance Company, et al., (CV-70-H-752-S), class action litigation involving Liberty, a class composed of all owners of funeral homes in Alabama and a class composed of all insureds (Alabama residents only) under burial or vault policies issued, assumed or reinsured by Liberty. The final judgement fixed the rights and obligations of Liberty and the funeral directors authorized to handle Liberty burial and vault policies as well as reforming the benefits available to the policyholders under the policies. It remains in effect to date. A motion was filed to challenge the final judgement under Federal Rule of Civil Procedure 60(b) in February of 1990, but the final judgement was upheld and the Rule 60(b) challenge was rejected by both the District Court and the Eleventh Circuit Court of Appeals. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (DOLLAR AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA) In November, 1993, an attorney (purporting to represent the funeral director class) filed a petition in the District Court seeking "alternative relief" under the final judgement. The relief sought is unclear, but includes a request that the District Court rule that the final judgement no longer has prospective application. Liberty has filed discovery requests seeking the identity of the funeral directors involved in the petition and information and materials necessary to evaluate the funeral directors' allegations and to clarify the relief sought. Based upon information presently available, and in light of legal and other defenses available to Torchmark and its subsidiaries, contingent liabilities arising from threatened and pending litigation are not considered material. It should be noted, however, that the frequency of large punitive damage awards bearing little or no relation to actual damages awarded by juries in jurisdictions in which Torchmark has substantial business, particularly Alabama, continues to increase. NOTE 14--RELATED PARTY TRANSACTIONS Investment in Related Parties: Other long-term investments include investment by Torchmark subsidiaries in the United Group of Mutual Funds and certain other funds for which Waddell & Reed, Inc., a wholly-owned subsidiary of United Management, is sole advisor. These investments were $26.2 million and $18.8 million at December 31, 1993 and 1992, respectively. Investment income derived from these investments is included in net investment income. Ownership of Nuevo Stock: Torchmark, through United Management, made open market purchases of the outstanding common stock of Nuevo Energy Company ("Nuevo") during the period from October, 1990 to July, 1991. Nuevo is a public company formed by energy subsidiaries during 1990 for the purpose of gaining operating efficiencies, enhancing liquidity for investors, and providing greater investment opportunity and diversification. Purchases of 230 thousand shares at a cost of $2 million were made during 1990 and purchases of 419 thousand shares at a cost of $4 million were made during 1991. In 1993, Torchmark sold 1.3 million shares of Nuevo stock in the open market resulting in a net gain of $14.3 million. Torchmark, through its subsidiaries, owned approximately 14% and 32% of the outstanding Nuevo stock at December 31, 1993 and 1992, respectively. Torchmark's investment in Nuevo is recorded as an investment in unconsolidated subsidiaries. NOTE 15--SUPPLEMENTAL DISCLOSURES FOR CASH FLOW STATEMENT The following table summarizes Torchmark's noncash transactions, which are not reflected on the Statement of Cash Flow as required by GAAP: Investment in subsidiaries and affiliates is itemized as follows: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (DOLLAR AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA) NOTE 16--INDUSTRY SEGMENTS The following table summarizes certain amounts paid during the period as required by GAAP: Torchmark operates primarily in two industry segments, insurance and asset management. Operations in the insurance industry involve the sale and administration of individual life, individual health, annuities, and property and casualty insurance. It also includes investment operations related to insurance segment investments. Operations in the asset management industry include the management, distribution, and servicing of various mutual funds, the management of energy properties, the direct ownership of energy properties, and other energy related activities. Certain insurance company investments are managed by the asset management segment. Included in these investments are energy investments in the amount of $346 million and $393 million at December 31, 1993 and 1992, respectively. Additionally, the asset management segment markets certain insurance products for the insurance segment and manages the mutual funds for the insurance segment's variable products. Total revenues by segment include revenues from other segments in addition to unaffiliated parties. Intersegment revenues include commission revenue and investment income which eliminate in consolidation. Pre-tax income for operating segments is total revenue less operating costs and expenses for the segment. Corporate pre-tax income includes transactions which are non- operating in nature such as parent company interest expense, goodwill amortization, and similar items not related to the activities of a segment. A summary of segment data is as follows: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (DOLLAR AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA) NOTE 17--SELECTED QUARTERLY DATA (UNAUDITED) The following is a summary of quarterly results for the two years ended December 31, 1993. The information is unaudited but includes all adjustments (consisting of normal accruals) which management considers necessary for a fair presentation of the results of operations for these periods. ITEM 9.	ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE No disagreements with accountants on any matter of accounting principles or practices or financial statement disclosure have been reported on a Form 8-K within the twenty-four months prior to the date of the most recent financial statements. PART III ITEM 10.	ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF REGISTRANT Information required by this item is incorporated by reference from the sections entitled "Election of Directors," "Profiles of Directors and Nominees," "Executive Officers" and "Compliance with Section 16(a) of the Securities Exchange Act" in the Proxy Statement for the Annual Meeting of Stockholders to be held April 28, 1994 (the "Proxy Statement"), which is to be filed with the Securities and Exchange Commission. ITEM 11.	ITEM 11. EXECUTIVE COMPENSATION Information required by this item is incorporated by reference from the section entitled "Compensation and Other Transactions with Executive Officers and Directors" in the Proxy Statement. ITEM 12.	ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS OF MANAGEMENT (a)Security ownership of certain beneficial owners: Information required by this item is incorporated by reference from the section entitled "Principal Stockholders" in the Proxy Statement. (b)Security ownership of management: Information required by this item is incorporated by reference from the section entitled "Stock Ownership" in the Proxy Statement. (c)Changes in control: Torchmark knows of no arrangements, including any pledges by any person of its securities, the operation of which may at a subsequent date result in a change of control. ITEM 13.	ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information required by this item is incorporated by reference from the section entitled "Compensation and Other Transactions with Executive Officers and Directors" in the Proxy Statement. PART IV ITEM 14.	ITEM 14. EXHIBITS, FINANCIAL STATEMENTS SCHEDULES, AND REPORTS ON FORM 8-K (a)Index of documents filed as a part of this report: Schedules not referred to have been omitted as inapplicable or not required by Regulation S-X. EXHIBITS - -------- To be filed under cover of a Form 8 as an Amendment to Form 10-K for the fiscal year ended December 31, 1992. (b) Reports on Form 8-K During the fourth quarter of 1993, Torchmark filed a Form 8-K dated October 14, 1993 reporting consumation of the merger of United Investors Management Company with and into a wholly-owned subsidiary of Torchmark. The following financial statements were incorporated by reference into the Form 8-K from the Schedule 14A, as amended filing the definitive proxy materials for the special meeting of holders of nonvoting common stock of United Investors Management Company held September 29, 1993: Audited Financial Statements: Independent Auditors' Report Consolidated Balance Sheet of United Investors Management Company at December 31, 1992 and 1991 Consolidated Statement of Operations of United Investors Management Company for the years ended December 31, 1992, 1991 and 1990 Consolidated Statement of Shareholders' Equity of United Investors Management Company for the years ended December 31, 1992, 1991 and 1990 Consolidated Statement of Cash Flow of United Investors Management Company for the years ended December 31, 1992, 1991 and 1990 Notes to Consolidated Financial Statements Unaudited Financial Statements: Consolidated Balance Sheet of United Investors Management Company at June 30, 1993 and December 31, 1992 Consolidated Statement of Operations of United Investors Management Company for the six months and the three months ended June 30, 1993 and 1992 Consolidated Statement of Cash Flow of United Investors Management Company for the six months ended June 30, 1993 and 1992 Consolidated Statement of Cash Flow of United Investors Management Company for the six months ended June 30, 1993 and 1992 Notes to Consolidated Financial Statements (c) Exhibits Exhibit 11. Statement re computation of per share earnings TORCHMARK CORPORATION COMPUTATION OF EARNINGS PER SHARE (1) Restated to give effect for the three-for-two stock split in the form of a dividend which was effective August 5, 1992. Exhibit 22. Subsidiaries of the Registrant The following table lists subsidiaries of the registrant which meet the definition of "significant subsidiary" according to Regulation S-X: All other exhibits required by Regulation S-K are listed as to location in the "Index of documents filed as a part of this report" on pages 60 through 62 of this report. Exhibits not referred to have been omitted as inapplicable or not required. TORCHMARK CORPORATION SCHEDULE II. AMOUNTS RECEIVABLE FROM RELATED PARTIES, UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES (CONSOLIDATED) (AMOUNTS IN THOUSANDS) - -------- (1) Advance to a limited partnership managed by a Torchmark subsidiary which was repaid on November 4, 1993. Interest was charged at a rate of 6.00% with no collateral. (2) Advance to a limited partnership managed by a Torchmark subsidiary which was repaid on June 15, 1993. Interest was charged at a rate of 6.00%. (3) Advance to a limited partnership managed by a Torchmark subsidiary which was repaid on July 14, 1993. Interest was charged at a rate of 6.00%. (4) Advance to a limited partnership managed by a Torchmark subsidiary which was repaid October 5, 1993. Interest was charged at a rate of 6.00%. TORCHMARK CORPORATION (PARENT COMPANY) SCHEDULE III. CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONDENSED BALANCE SHEET (AMOUNTS IN THOUSANDS) See accompanying Notes to Condensed Financial Statements. TORCHMARK CORPORATION (PARENT COMPANY) SCHEDULE III. CONDENSED FINANCIAL INFORMATION OF REGISTRANT (continued) CONDENSED STATEMENT OF OPERATIONS (AMOUNTS IN THOUSANDS) TORCHMARK CORPORATION (PARENT COMPANY) SCHEDULE III. CONDENSED FINANCIAL INFORMATION OF REGISTRANT--(continued) CONDENSED STATEMENT OF CASH FLOW (AMOUNTS IN THOUSANDS) See accompanying Notes to Condensed Financial Statements. TORCHMARK CORPORATION (PARENT COMPANY) NOTES TO CONDENSED FINANCIAL STATEMENTS (AMOUNTS IN THOUSANDS) NOTE A--DIVIDENDS FROM SUBSIDIARIES Cash dividends paid to Torchmark from the consolidated subsidiaries were as follows: TORCHMARK CORPORATION SCHEDULE V. SUPPLEMENTARY INSURANCE INFORMATION (CONSOLIDATED) (AMOUNTS IN THOUSANDS) TORCHMARK CORPORATION SCHEDULE VI. REINSURANCE (CONSOLIDATED) (AMOUNTS IN THOUSANDS) - -------- Excludes policy charges TORCHMARK CORPORATION SCHEDULE IX. SHORT-TERM BORROWINGS (CONSOLIDATED) (AMOUNTS IN THOUSANDS) - -------- /1/Weighted average daily balance. /2/Annualized weighted average daily interest rate. SIGNATURES Pursuant to the requirements of Section 12 or 15(d) of the Securities Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Torchmark Corporation By: /s/ R.K. Richey --------------------------------------------- R.K. RICHEY, CHAIRMAN, CHIEF EXECUTIVE OFFICER AND DIRECTOR By: /s/ Keith A. Tucker --------------------------------------------- KEITH A. TUCKER, VICE CHAIRMAN AND DIRECTOR (PRINCIPAL FINANCIAL OFFICER) By: /s/ William T. Graves --------------------------------------------- WILLIAM T. GRAVES, EXECUTIVE VICE PRESIDENT (PRINCIPAL ACCOUNTING OFFICER) Date: March 15, 1994 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. By: /s/ J.P. Bryan* By: /s/ Joseph L. Lanier, Jr.* ------------------------------ ------------------------------ J.P. BRYAN JOSEPH L. LANIER, JR. DIRECTOR DIRECTOR By: /s/ Robert P. Davison* By: /s/ Harold T. McCormick* ------------------------------ ------------------------------ ROBERT P. DAVISON HAROLD T. MCCORMICK DIRECTOR DIRECTOR By: /s/ Joseph M. Farley* By: /s/ Joseph W. Morris* ------------------------------ ------------------------------ JOSEPH M. FARLEY JOSEPH W. MORRIS DIRECTOR DIRECTOR By: /s/ Louis T. Hagopian* By: /s/ George J. Records* ------------------------------ ------------------------------ LOUIS T. HAGOPIAN GEORGE J. RECORDS DIRECTOR DIRECTOR By: /s/ C.B. Hudson* By: /s/ Yetta G. Samford, Jr.* ------------------------------ ------------------------------ C.B. HUDSON YETTA G. SAMFORD, JR. DIRECTOR DIRECTOR Date: March 15, 1994 *By: /s/ William T. Graves ------------------------------ WILLIAM T. GRAVES ATTORNEY-IN-FACT Date: March 15, 1994
81362_1993.txt	81362	1993	ITEM 1. BUSINESS. -------- General Description - ------------------- Quaker develops, produces, and markets a broad range of formulated chemical specialty products for various heavy industrial, institutional, and manufacturing applications. Quaker's principal products include: (i) rolling lubricants (used by manufacturers of steel in the hot and cold rolling of steel); (ii) corrosion preventives (used by steel and metalworking customers to protect metal during manufacture, storage, and shipment); (iii) metal finishing compounds (used to prepare metal surfaces for special treatments such as galvanizing and tin plating and to prepare metal for further processing); (iv) machining and grinding compounds (used by metalworking customers in cutting, shaping, and grinding metal parts which require special treatment to enable them to tolerate the manufacturing process); (v) forming compounds (used to facilitate the drawing and extrusion of metal products); (vi) paper production products (used as defoamers, release agents, softeners, debonders, and dispersants); (vii) hydraulic fluids (used by steel, metalworking, and other customers to operate hydraulically activated equipment); (viii) products for the removal of hydrogen sulfide in various industrial applications. During 1993, Quaker developed programs to provide recycling and chemical management services. In 1994, Quaker entered into an agreement for the creation of a joint venture which is expected to enhance the Total Fluid Management (TFM) service capabilities of Quaker. An initial cash investment of approximately $3,000,000 has been made with additional investments expected based on the growth of the venture. Other specialty products and services are produced and marketed by Quaker's domestic subsidiaries. AC Products, Inc., Quaker Construction Products, Inc., QSC Products, Ltd., and Multi-Chemical Products, Inc. manufacture and/or sell sealants and coatings for aerospace, construction, and industrial use. Selby, Battersby & Co. manufactures and sells trowel-applied flooring systems which derive their specialty characteristics from the different resins used and the methods of their application. During the third quarter 1992, as part of a plan to exit from the petroleum production chemicals market, Quaker entered into an agreement to sell certain of its petroleum production chemical operations assets, the principal component of which is technology used in the removal of hydrogen sulfide and organic sulfides from liquid and gaseous streams, embodied in the SULFA-SCRUB(R) product series. This transaction was consummated in 1993. Quaker acquired in May 1993 a French producer of metalworking fluids at a price of approximately French Francs 53,000,000 (approximately US $10,700,000), to reinforce Quaker's existing metalworking operations in Europe. Substantially all of Quaker's sales worldwide are made directly through its own sales forces. Quaker salesmen visit the plants of customers regularly and through training and experience identify production needs which can be resolved or alleviated either by adapting Quaker's existing products or by new formulations developed in Quaker's laboratories. Salesmen may call upon Quaker's regional managers, product managers, and members of its laboratory staff for assistance in obtaining and setting up product tests and evaluating the results of such tests. In 1993, certain products were also sold in Canada, Korea, India, and Argentina by exclusive licensees under long-term royalty agreements. Generally, separate manufacturing facilities of a single customer are served by different salesmen. Competition - ----------- The chemical specialty industry is composed of a number of companies of similar size as well as companies larger and smaller than Quaker. Quaker cannot readily determine its precise position in the industry. Many competitors are in fewer and more specialized product classifications or provide different levels of technical services in terms of specific formulations for individual customers. Competition in the industry is based primarily on the ability to provide products which meet the needs of the customer and render technical services and laboratory assistance to customers and, to a lesser extent, on price. Major Customers - --------------- During 1993, Quaker's five largest customers (each composed of multiple subsidiaries or divisions with semi-autonomous purchasing authority) accounted for approximately 16% of its consolidated net sales with the largest of these customers accounting for approximately 4% of consolidated net sales. No one subsidiary or division of these five customers accounted for more than 3% of consolidated net sales. During the same period, approximately 46% of consolidated net sales were made to customers engaged in the manufacture of cold-rolled steel. Raw Materials - ------------- Quaker uses over 500 raw materials, including mineral oils, fats and fat derivatives, ethylene derivatives, solvents, surface active agents, chlorinated paraffinic compounds, and a wide variety of organic and inorganic compounds. In 1993, only one raw material accounted for as much as 11% of the total cost of Quaker's raw material purchases. Quaker has multiple sources of supply for most materials, and Management believes that the failure of any single supplier would not have a material adverse effect upon its business. Patents and Trademarks - ---------------------- Quaker has a limited number of patents and patent applications, including patents issued, applied for, or acquired in the United States and in various foreign countries, some of which may prove to be material to its business. Principal reliance is placed upon Quaker's proprietary formulae and the application of its skills and experience to meet customer needs. Quaker's products are identified by trademarks which are registered throughout its marketing area. Quaker makes little use of advertising but relies heavily upon its reputation in the markets which it serves. Research and Development -- Laboratories - ---------------------------------------- Quaker's research and development laboratories support its sales organization. Accordingly, the activities of Quaker's laboratory staff are directed primarily toward applied research and development since the nature of Quaker's business requires continuing modification and improvement of formulations to provide chemical specialties to satisfy customer requirements. Quaker maintains quality control laboratory facilities in each of its manufacturing locations. In addition, Quaker maintains in Conshohocken, Pennsylvania, laboratory facilities which are devoted primarily to applied research and development. Most of Quaker's affiliates also have research and development facilities. Although not as complete as the Conshohocken laboratories, these facilities are generally sufficient for the requirements of the customers being served. If problems are encountered which cannot be resolved by local research and development facilities, such problems are referred to the Conshohocken laboratory staff. Approximately 195 persons, of whom 98 have B.S. degrees and 44 have B.S. and advanced degrees, are employed in Quaker's laboratories. Number of Employees - ------------------- On December 31, 1993, Quaker had 1,006 full-time employees, of whom 369 were employed by the parent company, 548 were employed by its international subsidiaries and associates, and 89 were employed by all domestic subsidiaries. Product Classification - ---------------------- Incorporated by reference is the information concerning product classification by markets served appearing under the caption "Supplemental Financial Information" on page 27 of the Registrant's 1993 Annual Report to Shareholders, the incorporated portions of which are included as Exhibit 13 to this Report. International Activities - ------------------------ Incorporated by reference is the information concerning international activities appearing in Note 9 to Notes to Consolidated Financial Statements and under the caption "General" of the Operations section of Management's Discussion and Analysis of Financial Condition and Results of Operations which appear on pages 30 and 31, respectively, of the Registrant's 1993 Annual Report to Shareholders, the incorporated portions of which are included as Exhibit 13 to this Report. ITEM 2.		ITEM 2. PROPERTIES. ---------- Quaker's principal facilities in the United States are located in Conshohocken, Pennsylvania and Detroit, Michigan. Quaker also owns a non-operating facility in Pomona, California. Quaker's international subsidiaries own facilities in Woodchester, England; Uithoorn, The Netherlands; Verona, Italy; Villeneuve, France; Santa Perpetua de Mogoda, Spain; and Seven Hills, N.S.W., Australia. Quaker Construction Products, Inc. has a manufacturing facility in Sapulpa, Oklahoma that also serves QSC Products, Ltd. and Selby, Battersby & Co. All of these facilities are owned mortgage free. Financing for the Corporate Technical Center in Conshohocken, Pennsylvania was arranged through the use of industrial revenue and development bonds with an outstanding balance at December 31, 1993 of $5,000,000. Quaker's aforementioned facilities consist of various manufacturing, administrative, warehouse, and laboratory buildings. Substantially all of the buildings are of fire-resistant construction and are equipped with sprinkler systems. All facilities are primarily of masonry and/or steel construction and are adequate and suitable for Quaker's present operations. The Company has a program to identify needed capital improvements which will be implemented as Management considers necessary or desirable. Most locations have various numbers of raw material storage tanks ranging from six to 63 having a capacity from 500 to 80,000 gallons each and processing or manufacturing vessels ranging in capacity from 50 to 12,000 gallons each. In order to facilitate compliance with applicable federal, state, and local statutes and regulations relating to occupational health and safety and protection of the environment, the Company has implemented a program of site assessment, currently directed primarily to facilities in the United States for the purpose of identifying capital expenditures or other actions that may be necessary to comply with such requirements. The program includes periodic inspections of each facility in the United States by Quaker and/or independent environmental experts, as well as ongoing inspections by on-site personnel. Such inspections are addressed to operational matters, record keeping, reporting requirements, and capital improvements. In 1993, capital expenditures directed solely or primarily to regulatory compliance amounted to approximately $1,000,000. Quaker's executive offices are located in a four-story building containing a total of approximately 47,000 square feet. A corporate technical center containing approximately 28,700 square feet houses the laboratory facility. Both of these facilities are adjacent to Quaker's manufacturing facility in Conshohocken. Multi-Chemical Products, Inc. has a ten-year lease on its facility in Fontana, California which expires in 2001. AC Products, Inc. has a ten-year lease on its facility in Placentia, California that expires in 1997. Quaker's Mexican associate (40% owned) owns a plant in Monterrey, Mexico. ITEM 3.	ITEM 3. LEGAL PROCEEDINGS. ----------------- The Company is a party to proceedings, cases, and requests for information from, and negotiations with, various claimants and federal and state agencies relating to various matters including environmental matters, none of which are expected to result in monetary sanctions in any amount or in awards that would have a material adverse effect on the Company's financial condition. Reference is made to Note 11 to Notes to Consolidated Financial Statements which appears on page 26 in the Registrant's 1993 Annual Report to Shareholders, the incorporated portions of which are included as Exhibit 13 to this report, for information concerning pending asbestos-related cases against a subsidiary. ITEM 4.	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. --------------------------------------------------- No matters were submitted to a vote of security holders during the last quarter of the period covered by this Report. ITEM 4(A). EXECUTIVE OFFICERS OF THE REGISTRANT. ------------------------------------ YEAR FIRST ELECTED AS AN EXECUTIVE NAME OFFICE (SINCE) AGE OFFICER ---- -------------- --- ------------ Peter A. Benoliel Chairman of the Board (1980) 62 1963 S. W. W. Lubsen President (1988) and Chief 50 1988 Executive Officer (1993) John E. Burrows, Jr. Vice President-North America 47 1990 (1992) Jose Luiz Bregolato Vice President-South America 48 1993 (1993) Ira R. Dolich Vice President-Quality and 58 1981 Training (1990) (Retired December 31, 1993) William G. Hamilton Corporate Treasurer (1985) 57 1985 (Retired December 31, 1993) Marcus C. J. Meijer Vice President-Europe (1990) 46 1990 Clifford E. Montgomery Vice President-Human Resources 46 1990 (1990) Karl H. Spaeth Vice President (1981) and 65 1972 Corporate Secretary (1972) Joseph F. Spanier Vice President (1990), 47 1985 Corporate Controller (1985), and Corporate Treasurer (1994) All of the Executive Officers with the exception of Mr. Bregolato, Mr. Meijer, Mr. Burrows, and Mr. Montgomery have served as an officer of the Registrant for more than the past five years. Prior to being elected Chief Executive Officer of the Registrant, Mr. Lubsen served as Managing Director of Quaker Chemical B.V., a position to which he was appointed in 1984, and President and Chief Operating Officer to which he was elected in 1988. Prior to his election as an officer of the Registrant, Mr. Bregolato served as Financial Consultant and Administrative Director of Fabrica Carioca de Catalisadores, S.A. to which he was appointed in 1985. Prior to his election as an officer of the Registrant, Mr. Meijer served as Managing Director of Quaker Chemical B.V. to which he was appointed in 1988. Prior to that, he served as President of a Brazilian subsidiary and subsequently as Commercial Director, Chemical Division of the Akzo N.V. group. Prior to his election as an officer of the Registrant, Mr. Burrows served as Division Manager, Marine Colloids Division of FMC Corporation, a position to which he was appointed in 1986. Prior to being elected Vice President-Human Resources, Mr. Montgomery served as Manager of Human Resources, General Electric's Worldwide Marketing and Product Management Organization, and, prior to that, he served as Director, Human Resources, GE Plastics Europe. Mr. Spanier was elected Treasurer effective January 1, 1994 on the retirement of Mr. Hamilton. There is no family relationship between any of the Registrant's Executive Officers. Each Officer is elected for a term of one year. PART II ITEM 5.	ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. ----------------------------------------- Incorporated by reference is the information appearing under the caption "Stock Market and Related Security Holder Matters" on page 28 of the Registrant's 1993 Annual Report to Shareholders, the incorporated portions of which are included as Exhibit 13 to this Report. ITEM 6.	ITEM 6. SELECTED FINANCIAL DATA. ----------------------- Incorporated by reference is the information appearing under the caption "Selected Financial Information" on page 29 of the Registrant's 1993 Annual Report to Shareholders, the incorporated portions of which are included as Exhibit 13 to this Report. ITEM 7.	ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. ------------------------------------------------- Incorporated by reference is the information appearing under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 30 and 31 of the Registrant's 1993 Annual Report to Shareholders, the incorporated portions of which are included as Exhibit 13 to this Report. ITEM 8.	ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. ------------------------------------------- Incorporated by reference is the information appearing on pages 14 through 27 of the Registrant's 1993 Annual Report to Shareholders, the incorporated portions of which are included as Exhibit 13 to this Report. 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. -------------------------------------------------- Incorporated by reference is the information beginning immediately following the caption "Election of Directors" to, but not including, the caption "Executive Compensation" contained in the Registrant's definitive Proxy Statement to be filed no later than 120 days after the close of its fiscal year ended December 31, 1993 and the information appearing in Item 4(a) of this Report. Based on the Company's review of certain reports filed with the Securities and Exchange Commission pursuant to Section 16(a) of the Securities Exchange Act of 1934, as amended, and written representations of the Company's officers and directors, the Company believes that all of such reports were filed on a timely basis, except for one filing on Form 4 covering one transaction each for Mr. Benoliel and Mr. Delattre. ITEM 11.	ITEM 11. EXECUTIVE COMPENSATION. ---------------------- Incorporated by reference is the information beginning immediately following the caption "Executive Compensation" to, but not including, the caption "Compensation/Management Development Committee and Long-Term Performance Incentive Plan Committee Report on Executive Compensation" contained in the Registrant's definitive Proxy Statement to be filed no later than 120 days after the close of its fiscal year ended December 31, 1993. ITEM 12.	ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. ----------------------------------------------- Incorporated by reference is the information beginning immediately following the caption "Security Ownership of Certain Beneficial Owners and Management" to, but not including, the caption "Election of Directors" contained in the Registrant's definitive Proxy Statement to be filed no later than 120 days after the close of its fiscal year ended December 31, 1993. ITEM 13.	ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. ---------------------------------------------- No information is required to be provided in response to this Item 13. PART IV ITEM 14.	ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. -------------------------------------------- (a) Exhibits and Financial Statement Schedules 1. FINANCIAL STATEMENTS The following is a list of the Financial State- ments which have been incorporated by reference from the Registrant's Annual Report to Shareholders for the fiscal year ended December 31, 1993, as set forth in Item 8: Consolidated Statement of Operations Consolidated Statement of Cash Flows Consolidated Balance Sheet Notes to Consolidated Financial Statements Report of Independent Accountants 2. FINANCIAL STATEMENT SCHEDULES The following is a list of the Financial State- ment Schedules filed herewith, all of which should be read in conjunction with the financial statements listed in Item 14(a) 1, above: Report of Independent Accountants on Financial Statement Schedules Schedule V-Property, plant, and equipment Schedule VI-Accumulated depreciation of proper- ty, plant, and equipment Schedule VIII-Valuation and qualifying accounts Schedule IX-Short-term borrowings All other schedules are omitted because they are not applicable or the required information is shown in the financial statements or notes thereto. Financial statements of 50% or less owned companies have been omitted because none of the companies meets the criteria requiring inclusion of such statements. 3. EXHIBITS (NUMBERED IN ACCORDANCE WITH ITEM 601 OF REGULATION S-K) 3(a)--Articles of Incorporation. Incorporated by reference to Exhibit 3(a) to Form 10-Q as filed by the Regis- trant for the Quarter ended March 31, 1987. 3(b)--By-Laws. Incorporated by reference to Exhibit 3(b) to Form 10-Q as filed by the Registrant for the Quarter ended March 31, 1987. 3(c)--Amendment to Section 3.13 of the By-Laws dated May 2, 1990 and Amendment to Sec- tion 8.1 of the By-Laws dated July 11, 1990. Incorporated by reference to Exhib- it 3(c) as filed by Registrant with Form 10-K for the year 1990. 4 --Shareholder Rights Plan. Incorporated by reference to Form 8-K as filed by the Registrant, February 20, 1990. 10(a)--Long-Term Performance Incentive Plan as approved May 5, 1993. 10(b)--Employment agreement by and between the Registrant and Peter A. Benoliel, as amended July 1, 1989. Incorporated by reference to Exhibit 10(b) as filed by Registrant with Form 10-K for the year 1989.* 10(c)--Employment agreement by and between the Registrant and S. W. W. Lubsen. Incor- porated by reference to Exhibit 10(c) as filed by Registrant with Form 10-K for the year 1989.* 10(d)--Restricted Stock and Cash Bonus Plan and Agreement by and between the Registrant and S. W. W. Lubsen. Incorporated by reference to Exhibit 10(d) as filed by Registrant with Form 10-K for the year 1989.* 10(e)--Employment agreement by and between Reg- istrant and John E. Burrows, Jr. Incor- porated by reference to Exhibit 10(h) as filed by Registrant with Form 10-K for the year 1990.* 10(f)--Employment agreement by and between Registrant and Clifford E. Montgomery. Incorporated by reference to Exhibit 10(i) as filed by Registrant with Form 10-K for the year 1990.* 10(g)--Employment agreement by and between Registrant and Joseph F. Spanier. Incor- porated by reference to Exhibit 10(g) as filed by Registrant with Form 10-K for the year 1992.* 10(h)--Documents constituting employment contract by and between Quaker Chemical Europe B.V. and M. C. J. Meijer.* 10(i)--Documents constituting retirement agreement by and between Registrant and Ira R. Dolich.* 13 --Portions of the 1993 Annual Report to Shareholders incorporated by reference. 21 --Subsidiaries and Affiliates of the Registrant. 23 --Consent of Independent Accountants. * A management contract or compensatory plan or arrange- ment required to be filed as an exhibit to this report. (b) Reports on Form 8-K. No reports on Form 8-K were filed by the Registrant during the last quarter of the period covered by this Report. (c) The exhibits required by Item 601 of Regulation S-K filed as part of this Report or incorporated herein by refer- ence are listed in subparagraph (a)(3) of this Item 14. (d) The financial statement schedules filed as part of this Report are listed in subparagraph (a)(2) of this Item 14. SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED. QUAKER CHEMICAL CORPORATION --------------------------- Registrant Date: March 30, 1994 By: S. W. W. LUBSEN -------------------------------- S. W. W. Lubsen 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 CAPACITY DATE --------- -------- ---- PETER A. BENOLIEL - ------------------------------ Director March 30, 1994 Peter A. Benoliel, Chairman of the Board JOSEPH F. SPANIER - ------------------------------ Principal Financial March 30, 1994 Joseph F. Spanier, Vice and Accounting Officer President, Corporate Controller, and Corporate Treasurer SIGISMUNDUS W. W. LUBSEN - ------------------------------ Principal Executive March 30, 1994 Sigismundus W. W. Lubsen Officer and Director President and Chief Executive Officer - ------------------------------ Director Joseph B. Anderson, Jr. PATRICIA C. BARRON - ------------------------------ Director March 30, 1994 Patricia C. Barron WILLIAM L. BATCHELOR - ------------------------------ Director March 30, 1994 William L. Batchelor - ------------------------------ Director Lennox K. Black EDWIN J. DELATTRE - ------------------------------ Director March 30, 1994 Edwin J. Delattre FRANCIS J. DUNLEAVY - ------------------------------ Director March 30, 1994 Francis J. Dunleavy ROBERT P. HAUPTFUHRER - ------------------------------ Director March 30, 1994 Robert P. Hauptfuhrer FREDERICK HELDRING - ------------------------------ Director March 30, 1994 Frederick Heldring RONALD J. NAPLES - ------------------------------ Director March 30, 1994 Ronald J. Naples ALEX SATINSKY - ------------------------------ Director March 30, 1994 Alex Satinsky - ------------------------------ Director D. Robert Yarnall, Jr. REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Shareholders and Board of Directors Quaker Chemical Corporation Our audits of the consolidated financial statements referred to in our report dated February 18, 1994 appearing on page 26 of the 1993 Annual Report to Shareholders of Quaker Chemical Corporation (which report and financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an examination of the Financial Statement Schedules listed in Item 14(a) of this Form 10-K. In our opinion, these Financial Statement Schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. PRICE WATERHOUSE Thirty South Seventeenth Street Philadelphia, Pennsylvania 19103 February 18, 1994 QUAKER CHEMICAL CORPORATION SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 BALANCE AT ADDITIONS RETIREMENTS OTHER BALANCE AT BEGINNING AT OR CHANGES, ADD END OF CLASSIFICATION OF PERIOD COST SALES (DEDUCT)(1) PERIOD - --------------- ---------- --------- ----------- ------------ ---------- YEAR ENDED DECEMBER 31, 1993 Land........... $ 6,042,000 $ 144,000 $ (61,000) $ 315,000 $ 6,440,000 Buildings and improvements. 32,873,000 2,234,000 (1,261,000) 1,744,000 35,590,000 Machinery and equipment.... 57,306,000 6,174,000 (1,295,000) 881,000 63,066,000 Construction in progress.. 1,477,000 408,000 95,000 1,980,000 ----------- ----------- ----------- ----------- ------------ $97,698,000 $ 8,960,000 $(2,617,000) $ 3,035,000 $107,076,000 =========== =========== =========== =========== ============ YEAR ENDED DECEMBER 31, 1992 Land........... $ 3,169,000 $ 488,000 $ 2,385,000 $ 6,042,000 Buildings and improvements. 31,284,000 355,000 $ (6,000) 1,240,000 32,873,000 Machinery and equipment.... 52,474,000 6,257,000 (3,506,000) 2,081,000 57,306,000 Construction in progress.. 2,077,000 126,000 (726,000) 1,477,000 ----------- ----------- ----------- ----------- ------------ $89,004,000 $ 7,226,000 $(3,512,000) $ 4,980,000 $ 97,698,000 =========== =========== =========== =========== ============ YEAR ENDED DECEMBER 31, 1991 Land........... $ 3,152,000 $ (43,000) $ 60,000 $ 3,169,000 Buildings and improvements. 29,414,000 $ 332,000 (659,000) 2,197,000 31,284,000 Machinery and equipment.... 48,385,000 2,567,000 (2,048,000) 3,570,000 52,474,000 Construction in progress.. 2,746,000 5,521,000 (6,190,000) 2,077,000 ----------- ----------- ----------- ----------- ------------ $83,697,000 $ 8,420,000 $(2,750,000) $ (363,000) $ 89,004,000 =========== =========== =========== =========== ============ - --------------- (1) Represents primarily companies acquired and fluctuations resulting from the translation of foreign currencies in 1993 and 1992, and fluctuations resulting from the translation of foreign currencies in 1991. QUAKER CHEMICAL CORPORATION SCHEDULE VI -- ACCUMULATED DEPRECIATION YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 BALANCE AT ADDITIONS RETIREMENTS OTHER BALANCE AT BEGINNING AT OR CHANGES, ADD END OF CLASSIFICATION OF PERIOD COST SALES (DEDUCT)(1) PERIOD - --------------- ---------- --------- ----------- ------------ ---------- YEAR ENDED DECEMBER 31, 1993 Buildings and improvements. $12,144,000 $ 1,203,000 $ (560,000) $ (296,000) $ 12,491,000 Machinery and equipment.... 33,375,000 5,342,000 (578,000) (105,000) 38,034,000 ----------- ----------- ----------- ----------- ------------ $45,519,000 $ 6,545,000 $(1,138,000) $ (401,000) $ 50,525,000 =========== =========== =========== =========== ============ YEAR ENDED DECEMBER 31, 1992 Buildings and improvements. $11,105,000 $ 1,183,000 $ (6,000) $ (138,000) $ 12,144,000 Machinery and equipment.... 29,238,000 5,244,000 (1,864,000) 757,000 33,375,000 ----------- ----------- ----------- ----------- ------------ $40,343,000 $ 6,427,000 $(1,870,000) $ 619,000 $ 45,519,000 =========== =========== =========== =========== ============ YEAR ENDED DECEMBER 31, 1991 Buildings and improvements. $10,552,000 $ 1,012,000 $ (446,000) $ (13,000) $ 11,105,000 Machinery and equipment.... 26,829,000 4,176,000 (1,675,000) (92,000) 29,238,000 ----------- ----------- ----------- ----------- ------------ $37,381,000 $ 5,188,000 $(2,121,000) $ (105,000) $ 40,343,000 =========== =========== =========== =========== ============ - --------------- (1) Represents primarily companies acquired and fluctuations resulting from the translation of foreign currencies in 1993 and 1992, and fluctuations resulting from the translation of foreign currencies in 1991. QUAKER CHEMICAL CORPORATION AND SUBSIDIARIES -------------------------------------------- SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS ALLOWANCE FOR DOUBTFUL ACCOUNTS ------------------------------- ADDITIONS ---------------------- CHARGED OR BALANCE AT CHARGED TO (CREDITED) BALANCE AT FOR THE YEAR BEGINNING TO TO OTHER END OF ENDED OF PERIOD INCOME ACCOUNTS DEDUCTIONS PERIOD - ------------ ---------- ---------- ---------- ---------- ---------- 1993 $ 834,000 $693,000 ($68,000)(1) $215,000 $1,244,000 1992 837,000 772,000 84,000 (2) 859,000 834,000 1991 1,101,000 358,000 (20,000)(1) 602,000 837,000 - ------------ (1) Represents primarily fluctuations resulting from the translation of foreign currencies. (2) Represents primarily additions due to companies acquired and fluctuations resulting from the translation of foreign currencies. QUAKER CHEMICAL CORPORATION AND SUBSIDIARIES SCHEDULE IX -- SHORT-TERM BORROWINGS(1) YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 WEIGHTED MAXIMUM AVERAGE AVERAGE CATEGORY OF BALANCE WEIGHTED AMOUNT OUT- AMOUNT OUT- INTEREST AGGREGAGE AT AVERAGE STANDING STANDING RATE SHORT-TERM END OF INTEREST DURING THE DURING THE DURING THE BORROWINGS PERIOD RATE PERIOD(2) PERIOD(2) PERIOD(3) - ---------- ------- -------- ----------- ----------- ---------- Bank loans: Parent and subsidiary companies.. $ 1,168,000 10.0% $ 3,168,000 $ 619,000 6.1% Bank loans: Parent and subsidiary companies.. 971,000 6.6% 21,264,000 10,042,000 6.0% Bank loans: Parent and subsidiary companies.. 14,500,000 7.0% 22,398,000 17,607,000 7.8% - ---------- (1) Short-term borrowings are principally short-term notes payable to banks and, in the case of certain subsidiary companies, various revolving lines of credit available to the subsidiary. Generally they may be renewed or extended beyond the maturity period as specified in the agreement. (2) Based on amounts outstanding at the end of each monthly accounting period. (3) The weighted average interest rate was calculated by dividing the interest expense for the period by the average amount outstanding during the period. EXHIBIT INDEX EXHIBIT NO. DESCRIPTION ----------- ----------- 10(a) Long-Term Performance Incentive Plan 10(h) Documents constituting employment contract by and between Quaker Chemical Europe B.V. and M. C. J. Meijer. 10(i) Documents constituting retirement agreement by and between Registrant and Ira R. Dolich. 13 Portions of the 1993 Annual Report to Shareholders Incorporated by Reference 21 Subsidiaries and Affiliates of the Registrant 23 Consent of Independent Accountants
71508_1993.txt	71508	1993	Item 1. Business BUSINESS OF ENTERGY General Entergy Corporation was originally incorporated under the laws of the State of Florida on May 27, 1949. On December 31, 1993, in connection with the Merger (see "Entergy Corporation-GSU Merger," below), Entergy Corporation merged with and into Entergy-GSU Holdings, Inc., a Delaware corporation (Holdings), and Holdings was renamed Entergy Corporation. Entergy Corporation is a holding company registered under the Holding Company Act and does not own or operate any physical properties. Entergy Corporation owns all of the outstanding common stock of five retail operating electric utility subsidiaries, AP&L, GSU, LP&L, MP&L, and NOPSI. AP&L was incorporated under the laws of the State of Arkansas in 1926; GSU was incorporated under the laws of the State of Texas in 1925; LP&L and NOPSI were incorporated under the laws of the State of Louisiana in 1974 and 1926, respectively; and MP&L was incorporated under the laws of the State of Mississippi in 1963. As of December 31, 1993, these operating companies provided electric service to approximately 2.3 million customers in the States of Arkansas, Louisiana, Mississippi, Missouri, and Texas. In addition, GSU furnished gas service in the Baton Rouge, Louisiana area, and NOPSI furnished gas service in the City of New Orleans. GSU's steam products department produces and sells, on an unregulated basis, process steam and by- product electricity supplied from its steam electric extraction plant to a large industrial customer. The business of the System is subject to seasonal fluctuations with the peak period occurring during the third quarter. During 1993, the System's (excluding GSU) electricity sales as a percentage of total System energy sales were: residential - 28.1%; commercial - 19.9%; and industrial - 36.9%. Electric revenues from these sectors as a percentage of total System electric revenues were: 36.3% - residential; 24.4% - commercial; and 27.3% - industrial. Sales to governmental and municipal sectors and to nonaffiliated utilities accounted for the balance of energy sales. During 1993, GSU's electric department sales as a percentage of total GSU energy sales were: residential - 25.5%; commercial - 20.3%; and industrial - 50.8%. Electric revenues from these sectors as a percentage of total GSU electric revenues were: 33.5% - residential; 23.8% - commercial; and 37.2% - industrial. Sales to governmental and municipal sectors and to nonaffiliated utilities accounted for the balance of GSU's energy sales. The System's major industrial customers are in the chemical processing, petroleum refining, paper products, and food products industries. Entergy Corporation also owns all of the outstanding common stock of System Energy, Entergy Services, Entergy Operations, Entergy Power, and Entergy Enterprises. System Energy is a nuclear generating company that was incorporated under the laws of the State of Arkansas in 1974. System Energy sells the capacity and energy at wholesale from its 90% interest in Grand Gulf 1 to its only customers, AP&L, LP&L, MP&L, and NOPSI (see "Capital Requirements and Future Financing - - Certain System Financial and Support Agreements - Unit Power Sales Agreement," below). System Energy has approximately a 78.5% ownership interest and an 11.5% leasehold interest in Grand Gulf 1. Entergy Services provides general executive and advisory services, and accounting, engineering, and other technical services to certain of the System companies, generally at cost. Entergy Operations is a nuclear management company that operates ANO, River Bend, Waterford 3, and Grand Gulf 1, subject to the owner oversight of AP&L, GSU, LP&L, and System Energy, respectively. Entergy Power, an independent power producer, owns 809 MW of generating capacity and markets its capacity and energy in the wholesale market outside Arkansas and Missouri and in markets not otherwise presently served by the System. (For further information on regulatory proceedings related to Entergy Power, see "Rate Matters and Regulation - Rate Matters - Wholesale Rate Matters - Entergy Power," below). Entergy Enterprises is a nonutility company that invests in businesses whose products and activities are of benefit to the System's utility business (see "Corporate Development," below). Entergy Enterprises also markets technical expertise developed by the System companies when it is not required in the System's operations. Entergy Enterprises has received SEC approval to provide services to certain nonutility companies in the System. In 1992 and 1993, several new Entergy Corporation subsidiaries were formed to participate in utility projects located outside the System's retail service territory, both domestically and in foreign countries (see "Corporate Development," below). AP&L, LP&L, MP&L, and NOPSI own, in ownership percentages of 35%, 33%, 19%, and 13%, respectively, all of the common stock of System Fuels, a non-profit subsidiary, that implements and/or maintains certain programs to procure, deliver, and store fuel supplies for the System. GSU has four wholly-owned subsidiaries: Varibus Corporation, GSG&T, Inc., Southern Gulf Railway Company, and Prudential Oil & Gas, Inc. Varibus Corporation operates intrastate gas pipelines in Louisiana, which are used primarily to transport fuel to two of GSU's generating stations, and has marketed computer-aided engineering and drafting technologies and related computer equipment and services. GSG&T, Inc. owns the Lewis Creek Station, a 532 MW (as of December 31, 1993) gas-fired generating plant, which is leased and operated by GSU. Southern Gulf Railway Company will own and operate several miles of rail track being constructed in Louisiana for the purpose of transporting coal for use as a boiler fuel at Nelson Unit 6. Prudential Oil & Gas, Inc., which was formerly in the business of exploring, developing, and operating oil and gas properties in Texas and Louisiana, is presently inactive. Entergy Corporation-GSU Merger On December 31, 1993, Entergy Corporation consummated its acquisition of GSU. Entergy Corporation merged with and into Holdings, and Holdings was renamed Entergy Corporation. GSU became a wholly-owned subsidiary of Entergy Corporation and continues to operate as a public utility under the regulation of the PUCT and the LPSC. As consideration to GSU's shareholders, Entergy Corporation paid $250 million in cash and issued 56,667,726 shares of its common stock at a price of $35.8417 per share, in exchange for outstanding shares of GSU common stock. In addition, $33.5 million of transaction costs were capitalized in connection with the Merger. See "Rate Matters and Regulation - Regulation - Other Regulation and Litigation," for, information on requests for rehearing and appeals of certain regulatory approvals of the Merger. The information contained in this Form 10-K is filed on behalf of all the registrants of Entergy, including GSU. Unless otherwise noted, consolidated financial and statistical information contained in this report that is stated as of December 31, 1993 (such as assets, liabilities, and property), includes the associated GSU amounts, and consolidated financial and statistical information for periods ending before January 1, 1994 (such as revenues, sales, and expenses), does not include GSU amounts; those amounts are presented separately for GSU herein. Certain Industry and System Challenges The System's business is affected by various challenges and issues including those that confront the electric utility industry in general. These issues and challenges include: - an increasingly competitive environment (see "Competition," below); - compliance with regulatory requirements with respect to nuclear operations (see "Rate Matters and Regulation - Regulation - Regulation of the Nuclear Power Industry," below) and environmental matters (see "Rate Matters and Regulation - Regulation - Environmental Regulation," below); - adaptation to structural changes in the electric utility industry, including increased emphasis on least cost planning and changes in the regulation of generation and transmission of electricity (see "Competition - General" and "Competition - Least Cost Planning," below); - continued cost management (particularly in the area of operation and maintenance costs at nuclear units) to improve financial results and to delay or to minimize the need for rate increase requests in light of current rate freezes and rate caps at the System operating companies (see "Rate Matters and Regulation - Rate Matters - Retail Rate Matters," below); - integrating GSU into the System's operations and achieving cost savings (see "Entergy Corporation-GSU Merger," above); - achieving enhanced earnings in light of lower returns and slow growth in the domestic utility business (see "Corporate Development," below); and - resolving GSU's major contingencies, including potential write- offs and refunds related to River Bend (see "Rate Matters and Regulation - Rate Matters - Retail Rate Matters - GSU," below) and litigation with Cajun relating to its ownership interest in River Bend (see "Rate Matters and Regulation - Regulation - Other Regulation and Litigation - GSU," below). Corporate Development Entergy continues to consider new opportunities to expand its regulated electric utility business, as well as to expand into utility and utility-related businesses that are not regulated by state and local regulatory authorities (nonregulated businesses). Investments in nonregulated businesses are likely to draw upon the System's skills in power generation and customer service as well as its strengths in the fuels area. Entergy Corporation's investment strategy with respect to nonregulated businesses is to invest in nonregulated business opportunities wherein Entergy Corporation has the potential to earn a greater rate of return compared to its regulated utility operations. Entergy Corporation's nonregulated businesses fall into two broad categories: overseas power development and new electro- technologies. Entergy Corporation has made investments in Argentina's electric energy infrastructure, as described below, and is pursuing additional projects in Central America, South America, South Africa, and Asia. Entergy Corporation will also open offices in Buenos Aires, Argentina and Hong Kong in 1994. In addition, Entergy Corporation is seeking to provide telecommunications services based upon its experience with interactive communications systems that allow customers to control energy usage. Entergy Corporation expects to invest approximately $150 million per year in nonregulated businesses. Current investments in nonregulated businesses include the following: (1) Entergy Corporation's subsidiary, Entergy Power Development Corporation (an EWG under the provisions of the Energy Act), through its subsidiary (which is also an EWG) Entergy Richmond Power Corporation, owns a 50% interest in an independent power plant in Richmond, Virginia. The power plant is jointly-owned and operated by the Enron Power Corporation, a developer of independent power projects. The plant owners have a 25-year contract to sell electricity to Virginia Electric & Power Company. Entergy Corporation's investment in the project totals approximately $12.5 million. (2) Entergy Enterprises has a 9.95% equity interest in First Pacific Networks, Inc. (FPN), a communications company, and a license from FPN in connection with utility applications, being jointly developed by Entergy Enterprises and FPN, for FPN's patented communications technology. Entergy Enterprises' investment in FPN is approximately $20.1 million, of which $9.7 million is equity investment. (3) Entergy Enterprises' subsidiary, Entergy Systems and Service, Inc. (Entergy SASI), holds a 9.95% equity interest in Systems and Service International, Inc. (SASI), a manufacturer of efficient lighting products. This subsidiary also made a loan to SASI, acquired the business and assets of SASI's distribution subsidiary, and entered into an agreement to distribute SASI's products. Entergy Enterprises' initial investment in this business was approximately $11 million (of which $2.3 million is invested in SASI common stock). Entergy Corporation has provided to Entergy SASI $6.0 million in loans, as of December 31, 1993, to fund Entergy SASI's installment sale agreements with its customers. (4) Entergy Corporation's subsidiary, Entergy, S.A., participated in a consortium with other nonaffiliated companies that acquired a 60% interest in Argentina's Costanera steam electric generating facility consisting of seven natural gas- and oil-fired generating units, with a total installed capacity of 1,260 MW. Entergy Corporation's initial investment to acquire its 10% interest in the consortium was approximately $11 million and its maximum financial obligation currently authorized by the SEC in connection with this investment is $22.5 million. (5) In January 1993, Entergy Corporation, through a new subsidiary, Entergy Argentina, S.A., participated in a consortium with other nonaffiliated companies that acquired a 51% interest in a foreign electric distribution company providing service to Buenos Aires, Argentina. Entergy Corporation's initial investment to acquire its 10% interest in the consortium was approximately $58 million and its maximum financial obligation currently authorized by the SEC in connection with this investment is $77.5 million. (6) In July 1993, Entergy Corporation, through a new subsidiary, Entergy Transener, S.A., participated in a consortium with other nonaffiliated companies that acquired a 65% interest in a foreign transmission system providing service in the country of Argentina. Entergy Corporation's initial investment to acquire its 15% interest in the consortium was $18.5 million. In the near term, these investments are likely to have a minimal effect on earnings; but the possibility exists that they could contribute to future earnings growth. However, due to the absence of an allowed rate of return, these investments involve a higher degree of risk. International operations are subject to certain risks that are inherent in conducting business abroad, including possible nationalization or expropriation, price and exchange controls, limitations on foreign participation in local governmental enterprises, and other restrictive actions. Changes in the relative value of currencies take place from time to time and their effects may be favorable or unfavorable on results of operations. In addition, there are exchange control restrictions in certain countries relating to repatriation of earnings. Selected Data Selected customer and sales data for 1993 are summarized in the following tables: 1993 - Selected Customer Data Customers as of December 31, 1993 ------------------ Area Served Electric Gas ----------- -------- --- AP&L Portions of State of Arkansas 590,862 - GSU Portions of the States of Texas 593,975 85,040 and Louisiana LP&L Portions of State of Louisiana 599,991 - MP&L Portions of State of Mississippi 361,692 - NOPSI City of New Orleans, except Algiers, is provided electric service by LP&L 190,613 154,251 --------- ------- System 2,337,133 239,291 ========= ======= NOPSI sold 17,437,292 MCF of natural gas to retail customers in 1993. Revenues from natural gas operations for each of the three years in the period ended December 31, 1993, were material for NOPSI, but not material for the System (see "Industry Segments," below, for a description of NOPSI's business segments). GSU sold 6,786,794 MCF of natural gas to retail customers in 1993. Revenues from natural gas operations for each of the three years in the period ended December 31, 1993, were not material for GSU. See "Entergy Corporation and Subsidiaries Selected Financial Data - - Five-Year Comparison," "AP&L Selected Financial Data - Five-Year Comparison," "GSU Selected Financial Data - Five-Year Comparison," "LP&L Selected Financial Data - Five-Year Comparison," "MP&L Selected Financial Data - Five-Year Comparison," "NOPSI Selected Financial Data - - Five-Year Comparison," and "System Energy Selected Financial Data - Five-Year Comparison," (which follow each company's notes to financial statements herein) incorporated herein by reference, for further information with respect to operating statistics of the System and of AP&L, GSU, LP&L, MP&L, NOPSI, and System Energy, respectively. Employees As of December 31, 1993, Entergy had 16,679 employees as follows: Full-time: Entergy Corporation 6 AP&L 2,557 GSU (1) 4,765 LP&L 1,727 MP&L 1,236 NOPSI 716 System Energy - Entergy Operations 3,508 Entergy Services (2) 1,986 Other Subsidiaries 24 ------ Total Full-time 16,525 Part-time 154 ------ Total Entergy System 16,679 ====== __________________ (1) As of December 31, 1993, GSU had not been functionally aligned into Entergy. In December 1993, GSU recorded $17 million for an announced early retirement program in connection with the Merger. Of the 503 employees eligible, 369 employees elected to participate in the program. (2) As a result of System realignment of operations along functional lines, certain employees of AP&L, LP&L, MP&L, and NOPSI transferred to Entergy Services during 1993. Competition General. Entergy and the electric utility industry are experiencing increased competitive pressures both in the retail and wholesale markets. The economic, social, and political forces behind these competitive pressures are numerous and complex. They include legislative and regulatory changes, technological advances, consumer demands, greater availability of natural gas, environmental needs, and others. Entergy looks at these competitive pressures both as opportunities to compete for new customers and as risks for loss of customers. On October 24, 1992, Congress passed the Energy Act. The Energy Act addresses a wide range of energy issues and alters the way Entergy and the rest of the electric utility industry will operate in the future. The Energy Act creates exemptions from regulation under the Holding Company Act and creates a class of EWG's consisting of utility affiliates and nonutilities that are owners and operators of facilities for the generation and transmission of power for sales at wholesale. These exemptions offer an incentive for Entergy to participate in the development of wholesale power generation. In addition, the Holding Company Act has been amended to allow utilities to compete on a global scale with foreign entities to own and operate generation, transmission, and distribution facilities. The Energy Act also gives FERC the authority to order investor-owned utilities, including the System operating companies, to transmit power and energy to or for wholesale purchasers and sellers. The law creates the potential for electric utilities and other power producers to gain increased access to the transmission systems of other entities to facilitate wholesale sales. FERC may also require electric utilities to increase their transmission capacity to provide these services. The impact of this provision on the System operating companies should be lessened by their joint filing of open access transmission service tariffs with FERC in 1991 (see "Rate Matters and Regulation - Rate Matters - Wholesale Rate Matters," below). The Energy Act also amends PURPA by requiring states to consider (1) new regulatory standards that would require electric utilities to undertake integrated resource planning, and (2) allowing energy efficiency programs to be at least as profitable as new energy supply options. Entergy is unable to predict the ultimate impact the Energy Act will have on its operations. Wholesale Competition. Entergy has, like other utility systems, generating capacity (most of which is owned by Entergy Power) and energy available for a period of time for sale to other utility systems. The System is in competition with neighboring systems, as well as EWG's, to sell such capacity and energy. Given this competition, the ability of the System to sell this capacity and energy is limited. However, in 1993, the System sold 8,291 million KWH of energy (compared to 7,979 million KWH in 1992) to nonaffiliated utilities. The System also sold 1,234 MW of long-term capacity (compared to 1,048 MW in 1992) to nonaffiliated utilities outside of the System's service area. These capacity sales represent 8% of the System's net capability (excluding GSU) at year-end 1993. Under AP&L's and LP&L's Grand Gulf 1 rate orders, and under GSU's River Bend rate order in Louisiana, a portion of the capacity of Grand Gulf 1 and River Bend represents capacity that is available for sale, subject to regulatory approval, to nonaffiliated parties. In some cases, profits from such sales must be shared between ratepayers and shareholders. As discussed in "Rate Matters and Regulation - Rate Matters - Wholesale Rate Matters - Open Access Transmission," below, Entergy Power and the System operating companies will be permitted by FERC to make wholesale capacity sales in bulk power markets at rates based primarily upon negotiation and market conditions rather than cost of service. In order to receive authorization to make such sales, AP&L, LP&L, MP&L, and NOPSI also filed with FERC open access transmission service tariffs. FERC has approved this filing, subject to certain modifications. Revisions to the tariffs were filed in December 1993 to recognize GSU's inclusion in the Entergy System. When the modified tariffs are made effective, Entergy Power and the System operating companies may engage in sales at market prices. It is anticipated that these tariffs will enable any electric utility (as defined in such tariffs) to use Entergy 's integrated transmission system for the transmission of capacity and energy produced and sold by such electric utility or by third parties. Other similar open access transmission tariffs have also been filed with FERC for several large utility companies or systems and more open access transmission tariffs are anticipated. Concurrently, capacity resources are being developed and used to make wholesale sales from a range of non-traditional sources, including nonutility generators as well as cogenerators and small power producers qualifying under PURPA. These developments simultaneously produce increased marketing opportunities for utility systems such as Entergy and expose the System to loss of load or reduced sales revenues due to displacement of System sales by alternative suppliers with access to the System's primary areas of service. Entergy Power, which owns 809 MW of capacity, was formed to compete with other utilities and independent power producers in the bulk power market. As of December 31, 1993, Entergy Power has accumulated total losses from operations of $52.5 million. Entergy Power has entered into several long-term contracts for the sale of capacity and associated energy from its resources and has also made short-term capacity and energy sales. Entergy Power continues to actively market its capacity and energy in the bulk power market. (See "Corporate Development," above, for information with respect to a wholly-owned subsidiary of Entergy, Entergy Power Development Corporation, organized as an EWG to compete in the wholesale power market.) Retail Competition. Scheduled increases in the price of power sold by the System pursuant to the operation of phase-in plans (see "Rate Matters and Regulation - Rate matters - Retail Rate Matters," below) will affect the competitiveness of certain classes of industrial customers whose costs of production are energy-sensitive. Entergy is constantly working with these customers to address their concerns. It is the practice of the System operating companies to negotiate the renewal of contracts with large industrial customers prior to their expiration. In certain cases (particularly for GSU), contracts or special tariffs that use incentive pricing below total cost have been negotiated with industrial customers to keep these customers on the System. These contracts and tariffs have generally resulted in increased KWH sales at lower margins over incremental cost. While the System operating companies anticipate they will be successful in renegotiating such contracts, they cannot assure that they will be successful or that future revenues will not be lost to other forms of generation. To date, through these efforts, Entergy has been largely successful in retaining its industrial load. This competitive challenge could increase. Cogeneration is generally defined as the combined production of electricity and steam. Cogenerated power may be either sold by its producer to the local utility at its avoided cost under PURPA, or utilized by the cogenerator to displace purchases from the utility. To the extent that cogeneration is used by industrial customers to meet their own power requirements, the System may suffer loss of industrial load. Cogenerated power delivered to the System would be purchased at avoided cost, which for a number of years is expected to be equivalent to avoided energy cost, and as such, the cost of these purchases would not impact earnings. To date, only a few cogeneration facilities have been installed in areas served by the System, excluding GSU. The primary purpose of these facilities is to displace power that was purchased from the System. The economic advantage to the customer is generally due to the customer having waste products that can be used as fuel. Presently, the loss of load to cogeneration and the amount of cogenerated power delivered under PURPA to the System (excluding GSU) is not significant. The System is prepared to participate (subject to regulatory approval) in various phases of the design, construction, procurement, and ownership of cogeneration facilities. The System has entered into several cogeneration deferral agreements with certain of its retail customers, which give the System the right of first refusal to participate in any of such customers' cogeneration activities. Such participation could occur in the event there are individual customers whose long-term interests, along with Entergy's, can best be served by installing cogeneration facilities. No such participation has occurred to date, except by GSU. Existing qualifying facilities in the GSU service territory are estimated to total approximately 2,400 MW's or over 10% of Entergy's total owned and leased generating capability as of December 31, 1993. GSU currently believes that no significant load will be lost to cogeneration projects during the next several years; however, GSU is currently negotiating a contract with a large industrial customer, which is scheduled to expire in 1996. If the contract is not renewed, GSU would lose approximately $40 million in base revenues. Although GSU has competed in the past for various retail and wholesale customers, the System (excluding GSU) generally is not in direct competition with privately-owned or municipally-owned electric utilities for retail sales. However, a few municipalities distribute electricity within their corporate limits and some of these generate all or a portion of their requirements. A number of electric cooperative associations or corporations serve a substantial number of retail customers in or adjacent to areas served by the System . Sales of energy by the System to privately- or municipally-owned utilities amounted to approximately 4.6% of total System energy sales in 1993 (excluding GSU). Legislatures and regulatory commissions in several states have considered, or are considering, retail wheeling, which is the transmission by an electric utility of energy produced by another entity over the utility's transmission and distribution system to a retail customer in the electric utility's service territory. Retail wheeling would permit retail customers to elect to purchase electric capacity and/or energy from the electric utility in whose service area they are located or from any other electric utility or independent power producer. Retail wheeling is not currently required within the Entergy System service area. See "Rate Matters and Regulation - Regulation - Other Regulation and Litigation," below for information on proceedings brought by Cajun seeking transmission access to certain of GSU's industrial customers. Least Cost Planning. The System continues to pursue least cost planning, also known as integrated resource planning, in order to compete more effectively in both retail and wholesale markets. Least cost planning is the development of strategies to add resources to meet future electricity demands reliably and at the lowest possible cost. The least cost planning process includes the study of electric supply- and demand-side options. The resultant plan uses demand-side options, such as changing customer consumption patterns, to limit electricity usage during times of peak demand, thus delaying the need for new capacity resources. Least cost planning offers the potential for the System to minimize customer costs, while providing an opportunity to earn a return. On December 1, 1992, AP&L, LP&L, MP&L, and NOPSI each filed a Least Cost Plan with its respective regulator, and on July 1, 1993, each company filed a near-term revision to such plan. Each Least Cost Plan details the resources that the System intends to use to provide reasonably priced, reliable electric service to its customers over the next 20 years. Such plan includes 925 MW of DSM resources, such as programs for efficient air conditioning and heating, high efficiency lighting, and CCLM. CCLM is the subject of recent Entergy proposals (filed, or to be filed, by AP&L, LP&L, MP&L, and NOPSI with their respective regulators) requesting the CCLM pilot be withdrawn from consideration in the existing Least Cost Plan dockets on the basis of a new proposal by Entergy to undertake the initial pilot development of CCLM at Entergy stockholder expense. To date, the Council and the LPSC are the only regulators that have addressed the proposal. The System expects to spend a total of approximately $800 million for DSM resources over the next 20 years. Such plan also includes significant resource additions, but does not contemplate construction of any generating facilities at new sites. All incremental supply-side resources will come from either delayed retirements or repowering of existing generating units. The System estimates that, over the next 20 years, least cost planning, if implemented in accordance with the terms of each filed Least Cost Plan, will reduce revenue requirements by approximately $2.3 billion ($600 million on a net present value basis), thereby avoiding the need for related rate increase requests. Each Least Cost Plan includes specific actions that the System will undertake pursuant to regulatory approval, including the recovery of costs associated with DSM (for further information, see "Rate Matters and Regulation - Rate Matters - Retail Rate Matters," below). CAPITAL REQUIREMENTS AND FUTURE FINANCING Construction expenditures for the System are estimated to aggregate $586 million, $560 million, and $550 million for the years 1994, 1995, and 1996, respectively. No significant costs are expected in connection with the System's generating facilities. Actual construction costs may vary from these estimates because of a number of factors, including changes in load growth estimates, changes in environmental regulations, modifications to nuclear units to meet regulatory requirements, increasing costs of labor, equipment and materials, and cost of capital. Construction expenditures by company (including immaterial environmental expenditures and AFUDC, but excluding nuclear fuel and the impact of the ice storm that occurred in February 1994) for the period 1994-1996 are estimated as follows: 1994 1995 1996 Total ---- ---- ---- ----- (In Millions) AP&L $181 $172 $175 $528 GSU 134 128 119 381 LP&L 156 143 142 441 MP&L 61 63 63 187 NOPSI 26 26 26 78 System Energy 26 22 23 71 Entergy Power 2 6 2 10 System $586 $560 $550 $1,696 In addition to construction expenditure requirements, the estimated amounts required during 1994-1996 to meet scheduled long- term debt and preferred stock maturities and cash sinking fund requirements are: AP&L - $83 million; GSU - $214 million; LP&L - $158 million; MP&L - $212 million; NOPSI - $80 million; and System Energy - $615 million. A substantial portion of the above capital and refinancing requirements is expected to be satisfied from internally generated funds and cash on hand supplemented by the issuance of debt and preferred stock. Certain System companies may also continue with the acquisition or refinancing of all, or a portion of, certain outstanding series of preferred stock and long-term debt. In early February 1994, an ice storm left more than 221,000 Entergy customers without electric power across the System's four- state service area. The storm was the most severe natural disaster ever to affect the System, causing damage to transmission and distribution lines, equipment, poles, and facilities in certain areas, particularly in Mississippi. A substantial portion of the related costs, which are estimated to be $110 million - $140 million, are expected to be capitalized. The MPSC acknowledged that there is precedent in Mississippi for recovery of certain costs associated with storms and natural disasters and the restoration of service resulting from such events. MP&L plans to immediately file for rate recovery of the costs related to the ice storm (see "Rate Matters and Regulation - Rate Matters - Retail Rate Matters - MP&L," below). Entergy Corporation's current primary capital requirements are to periodically invest in, or make loans to, its subsidiaries. Entergy Corporation has SEC authorization to make additional investments in Entergy Power, Entergy S.A., Entergy Argentina, S.A., Entergy Transener, S.A., Entergy SASI, and FPN. Entergy Corporation expects to meet these requirements in 1994-1996 with internally generated funds and cash on hand. Entergy receives funds through dividend payments from its subsidiaries. Certain restrictions may limit the amount of these distributions. See Entergy Corporation and Subsidiaries' Notes to Consolidated Financial Statements, Note 2, "Rate and Regulatory Matters" and Note 8, "Commitments and Contingencies," incorporated herein by reference, regarding River Bend rate appeals and pending litigation with Cajun. Substantial write- offs or charges resulting from adverse rulings in these matters could adversely affect GSU's ability to continue to pay dividends. Entergy Corporation continues to consider new opportunities to expand its electric energy business, including expansion into related nonregulated businesses. Entergy Corporation expects to invest up to approximately $150 million per year over the next three years in nonregulated business opportunities. Entergy Corporation may finance any such expansion with cash on hand. Further, shareholder and/or regulatory approvals may be required for such acquisitions to take place. Also, Entergy Corporation has SEC authorization to repurchase shares of its outstanding common stock. Market conditions and board authorization determine the amount of repurchases. Entergy Corporation has requested SEC authorization for a $300 million bank line of credit, the proceeds of which are expected to be used for common stock repurchases and other optional activities. (For further information on the capital and refinancing requirements, capital resources, and short-term borrowing arrangements of AP&L, GSU, LP&L, MP&L, NOPSI, and System Energy, respectively, refer in each case to AP&L's, GSU's, LP&L's, MP&L's, NOPSI's, and System Energy's "Management's Financial Discussion and Analysis - Liquidity and Capital Resources," Note 4 of AP&L's, GSU's, LP&L's, MP&L's, NOPSI's, and System Energy's Notes to Financial Statements, "Lines of Credit and Related Borrowings," Note 5 of AP&L's and NOPSI's Notes to Financial Statements, "Preferred Stock", Note 5 of GSU's Notes to Financial Statements, "Preferred, Preference and Common Stock", Note 5 of LP&L's and MP&L's Notes to Financial Statements, "Preferred and Common Stock," Note 6 of AP&L's, GSU's, LP&L's, MP&L's, and NOPSI's and Note 5 of System Energy's Notes to Financial Statements, "Long-Term Debt," and Note 8 of AP&L's, GSU's, LP&L's, MP&L's, and NOPSI's and Note 7 of System Energy's Notes to Financial Statements, "Commitments and Contingencies - Capital Requirements and Financing," each incorporated herein by reference. For further information concerning Entergy Corporation's capital requirements and resources, refer to Entergy Corporation and Subsidiaries' "Management's Financial Discussion and Analysis - Liquidity and Capital Resources," and Note 4 of Entergy Corporation and Subsidiaries' Notes to Consolidated Financial Statements, "Lines of Credit and Related Borrowings," incorporated herein by reference. For further information on the subsequent event, see Note 12 of AP&L's and Note 11 of MP&L's Notes to Financial Statements, "Subsequent Event (Unaudited)," incorporated herein by reference.) Certain System Financial and Support Agreements Unit Power Sales Agreement. The Unit Power Sales Agreement allocates capacity and energy from System Energy's 90% ownership and leasehold interest in Grand Gulf 1 (and the costs related thereto) to AP&L (36%), LP&L (14%), MP&L (33%), and NOPSI (17%). AP&L, LP&L, MP&L, and NOPSI pay rates to System Energy for their respective entitlements of capacity and energy on a full cost-of-service basis regardless of the quantity of energy delivered, so long as Grand Gulf 1 remains in commercial operation. Payments under the Unit Power Sales Agreement are System Energy's only source of operating revenues. The financial condition of System Energy depends upon the continued commercial operation of Grand Gulf 1 and upon the receipt of payments from AP&L, LP&L, MP&L, and NOPSI. (See "Rate Matters and Regulation - Rate Matters - Wholesale Rate Matters - System Energy," below for further information with respect to proceedings relating to the Unit Power Sales Agreement.) Availability Agreement. The Availability Agreement was entered into among System Energy and AP&L, LP&L, MP&L, and NOPSI in 1974 in connection with the financing by System Energy of the Grand Gulf Station. The agreement provided that System Energy would join in the agreement among AP&L, LP&L, MP&L, and NOPSI for the sharing of generating capacity and other capacity and energy resources on or before the date on which Grand Gulf 1 was placed in commercial operation. It also provided that System Energy would make available to AP&L, LP&L, MP&L, and NOPSI all capacity and energy available from System Energy's share of the Grand Gulf Station. System Energy and AP&L, LP&L, MP&L, and NOPSI further agreed that if this agreement were terminated, or if any of the parties thereto withdrew from it, then System Energy would enter into a separate agreement with all of such parties or the withdrawing party, as the case may be, with respect to the purchase of capacity and energy on the same terms as if this agreement were still controlling. AP&L, LP&L, MP&L, and NOPSI also agreed severally to pay System Energy monthly for the right to receive capacity and energy available from the Grand Gulf Station in amounts that (when added to any amounts received by System Energy under the Unit Power Sales Agreement, or otherwise) would be at least equal to System Energy's total operating expenses for the Grand Gulf Station (including depreciation at a specified rate) and interest charges. As amended to date, the Availability Agreement provides that: - the obligation of AP&L, LP&L, MP&L, and NOPSI for payments for Grand Gulf 1 became effective upon commercial operation of Grand Gulf 1 on July 1, 1985; - the sale of capacity and energy generated by the Grand Gulf Station may be governed by a separate power purchase agreement among System Energy and AP&L, LP&L, MP&L, and NOPSI; - the September 1989 write-off of System Energy's investment in Grand Gulf 2, amounting to approximately $900 million, will be amortized for Availability Agreement purposes over 27 years rather than in the month the write-off was recognized on System Energy's books; and - the allocation percentages under the Availability Agreement are fixed as follows: AP&L - 17.1%; LP&L - 26.9%; MP&L - 31.3%; and NOPSI - 24.7%. As noted above, the Unit Power Sales Agreement provides for different allocation percentages for sales of capacity and energy from Grand Gulf 1. However, the allocation percentages under the Availability Agreement remain in effect and would govern payments made thereunder in the event of a shortfall of funds available to System Energy from other sources, including payments by AP&L, LP&L, MP&L, and NOPSI to System Energy under the Unit Power Sales Agreement. System Energy has assigned its rights to payments and advances from AP&L, LP&L, MP&L, and NOPSI under the Availability Agreement as security for its first mortgage bonds and reimbursement obligations to certain banks providing the letters of credit in connection with the equity funding of the sale and leaseback transactions described under "Sale and Leaseback Arrangements - System Energy," below. In these assignments, AP&L, LP&L, MP&L, and NOPSI further agreed that in the event they were prohibited by governmental action from making payments under the Availability Agreement (if, for example, FERC reduced or disallowed such payments as constituting excessive rates; see the second succeeding paragraph), they would then make subordinated advances to System Energy in the same amounts and at the same times as the prohibited payments. System Energy would not be allowed to repay these subordinated advances so long as it remained in default under the related indebtedness or in other similar circumstances. Each of the assignment agreements relating to the Availability Agreement provides that AP&L, LP&L, MP&L, and NOPSI shall make payments directly to System Energy. However, if there is an event of default, AP&L, LP&L, MP&L, and NOPSI shall make those payments directly to the holders of indebtedness secured by such assignment agreements. The payments shall be made pro rata according to the amount of the respective obligations secured. The obligations of AP&L, LP&L, MP&L, and NOPSI to make payments under the Availability Agreement are subject to receipt and continued effectiveness of all necessary regulatory approvals. Sales of capacity and energy under the Availability Agreement would require that the Availability Agreement be submitted to FERC for approval with respect to the terms of such sale. No filing with FERC has been required because sales of capacity and energy from the Grand Gulf Station are being made under the Unit Power Sales Agreement. Other aspects of the Availability Agreement, including the obligations of AP&L, LP&L, MP&L, and NOPSI to make subordinated advances, are subject to the jurisdiction of the SEC under the Holding Company Act, which approval has been obtained. If, for any reason, sales of capacity and energy are made in the future pursuant to the Availability Agreement, the jurisdictional portions of the Availability Agreement would be submitted to FERC for approval. (Refer to the second preceding paragraph.) Amounts that have been received by System Energy under the Unit Power Sales Agreement have exceeded the amounts payable under the Availability Agreement. Consequently, no payments under the Availability Agreement by AP&L, LP&L, MP&L, and NOPSI have ever been required. If AP&L, LP&L, MP&L, or NOPSI became unable in whole or in part to continue making payments to System Energy under the Unit Power Sales Agreement, and System Energy were unable to procure funds from other sources sufficient to cover any potential shortfall between the amount owing under the Availability Agreement and the amount of continuing payments under the Unit Power Sales Agreement plus other funds then available to System Energy, LP&L and NOPSI could become subject to claims or demands by System Energy or its creditors for payments or advances under the Availability Agreement or the assignments thereof for the difference between their required Unit Power Sales Agreement payments and their required Availability Agreement payments. The amount, if any, which these companies would become liable to pay or advance, over and above amounts they would be paying under the Unit Power Sales Agreement for capacity and energy from Grand Gulf 1, would depend on a variety of factors (especially the degree of any such shortfall and System Energy's access to other funds). It cannot be predicted whether any such claims or demands, if made and upheld, could be satisfied. In NOPSI's case, if any such claims or demands were upheld, the holders of certain of NOPSI's outstanding general and refunding mortgage bonds could require redemption of their bonds at par. The ability of AP&L, LP&L, MP&L, and NOPSI to sustain payments under the Availability Agreement and the assignments thereof in material amounts without substantially equivalent recovery from their customers would be limited by their respective available cash resources and financing capabilities at the time. The ability of AP&L, LP&L, MP&L, and NOPSI to recover from their customers payments made under the Availability Agreement, or under the assignments thereof, would depend upon the outcome of regulatory proceedings before the state and local regulatory authorities having jurisdiction. In view of the controversies that arose over the allocation of capacity and energy from Grand Gulf 1 pursuant to the Unit Power Sales Agreement, opposition to recovery would be likely and the outcome of such proceedings, should they occur, is not predictable. Reallocation Agreement. On November 18, 1981, the SEC authorized LP&L, MP&L, and NOPSI to indemnify AP&L against principally its responsibilities and obligations with respect to the Grand Gulf Station contained in the Availability Agreement and the assignments thereof. The revised percentages of allocated capacity of System Energy's share of Grand Gulf 1 and Grand Gulf 2 were, respectively: LP&L - 38.57% and 26.23%; MP&L - 31.63% and 43.97%; and NOPSI - 29.80% and 29.80%. FERC's decision allocating the capacity and energy of Grand Gulf 1 to AP&L, LP&L, MP&L, and NOPSI supersedes the Reallocation Agreement insofar as it relates to Grand Gulf 1. However, responsibility for any Grand Gulf 2 amortization amounts (see "Availability Agreement," above) has been allocated to LP&L - 26.23%, MP&L - 43.97%, and NOPSI - 29.80% under the terms of the Reallocation Agreement. The Reallocation Agreement does not affect the obligation of AP&L to System Energy's lenders under the assignments referred to in the fifth preceding paragraph, and AP&L would be liable for its share of such amounts if LP&L, MP&L, and NOPSI were unable to meet their contractual obligations. No payments of any amortization amounts will be required as long as amounts paid to System Energy under the Unit Power Sales Agreement, together with other funds available to System Energy, exceed amounts required under the Availability Agreement, which is expected to be the case for the foreseeable future. Capital Funds Agreement. System Energy and Entergy Corporation have entered into the Capital Funds Agreement whereby Entergy Corporation has agreed to supply to System Energy sufficient capital to (1) maintain System Energy's equity capital at an amount equal to a minimum of 35% of its total capitalization (excluding short-term debt), and (2) permit the continuation of commercial operation of Grand Gulf 1 and to pay in full all indebtedness for borrowed money of System Energy when due under any circumstances. Entergy Corporation has entered into various supplements to the Capital Funds Agreement, and System Energy has assigned its rights thereunder as security for its first mortgage bonds and reimbursement obligations to certain banks providing letters of credit in connection with the equity funding of the sale and leaseback transactions described under "Sale and Leaseback Arrangements - System Energy," below. Each such supplement provides that permitted indebtedness for borrowed money incurred by System Energy in connection with the financing of the Grand Gulf Station may be secured by System Energy's rights under the Capital Funds Agreement on a pro rata basis (except for the Specific Payments, as hereinafter defined). In addition, in the particular supplements to the Capital Funds Agreement relating to the specific indebtedness being secured, Entergy Corporation has agreed to make cash capital contributions to System Energy sufficient to enable System Energy to make payments when due on such indebtedness (Specific Payments). Except with respect to the Specific Payments, which have been approved by the SEC under the Holding Company Act, the performance by both Entergy Corporation and System Energy of their obligations under the Capital Funds Agreement, as supplemented, is subject to the receipt and continued effectiveness of all governmental authorizations necessary to permit such performance, including approval by the SEC under the Holding Company Act. Each of the supplemental agreements provides that Entergy Corporation shall make its payments directly to System Energy. However, if there is an event of default, Entergy Corporation shall make those payments directly to the holders of indebtedness secured by the supplemental agreements. The payments (other than the Specific Payments) shall be made pro rata according to the amount of the respective obligations secured by the supplemental agreements. Sale and Leaseback Arrangements LP&L. On September 28, 1989, LP&L entered into arrangements for the sale and leaseback of an approximate aggregate 9.3% ownership interest in Waterford 3. LP&L has options to terminate the leases and to repurchase the sold interests in Waterford 3 at certain intervals during the basic terms of the leases. Further, at the end of the terms of the leases, LP&L has options to renew the leases or to repurchase the interests in Waterford 3. If LP&L does not exercise its options to repurchase the interests in Waterford 3 on the fifth anniversary (September 28, 1994) of the closing date of the sale and leaseback transactions, LP&L will be required to provide collateral to the owner participants for the equity portion of certain amounts payable by LP&L under the lease. The required collateral is either a bank letter or letters of credit or the pledging of new series of first mortgage bonds issued by LP&L under its first mortgage bond indenture. (For further information on LP&L's sale and leaseback arrangements, including the required maintenance by LP&L of specified capitalization and fixed charge coverage ratios, see Note 9 of LP&L's Notes to Financial Statements, "Leases - Waterford 3 Lease Obligations," incorporated herein by reference.) System Energy. On December 28, 1988, System Energy entered into arrangements for the sale and leaseback of an 11.5% ownership interest in Grand Gulf 1. System Energy has options to terminate the leases and to repurchase the undivided interest in Grand Gulf 1 at certain intervals during the basic lease term. Further, System Energy has an option at the end of the basic lease term to renew the leases or to repurchase the undivided interest in Grand Gulf 1. In connection with the equity funding of the sale and leaseback arrangements, letters of credit are required to be maintained by System Energy under the leases to secure certain amounts payable for the benefit of the equity investors. The letters of credit currently maintained are effective until January 15, 1997. Under the provisions of a reimbursement agreement, dated December 1, 1988, as amended, entered into by System Energy and various banks in connection with the sale and leaseback arrangements related to the letters of credit, System Energy has agreed to a number of covenants relating to, among other things, the maintenance of certain capitalization and fixed charge ratios. In connection with an audit of System Energy by FERC, if a decision of FERC issued on August 4, 1992 (August 4 Order) is ultimately sustained and implemented, System Energy would need to obtain the consent of certain banks to waive the capitalization and fixed charge coverage covenants for a limited period of time in order to avoid violation of such covenants. System Energy has obtained the consent of the banks to waive these covenants for the twelve-month period beginning with the earlier of the write-off or the first refund, if the August 4 Order is implemented prior to December 31, 1994. Absent a waiver, failure by System Energy to perform these covenants could give rise to a draw under the letters of credit and/or an early termination of the letters of credit, and, if such letters of credit were not replaced in a timely manner, could result in a default under, or other early termination of, System Energy's leases. (For further information on the potential effects of the August 4 Order on System Energy's financial condition, see Note 2 of System Energy's Notes to Financial Statements, "Rate and Regulatory Matters - FERC Audit," incorporated herein by reference, and for a further discussion of the provisions of System Energy's Reimbursement Agreement, see System Energy's Notes to Financial Statements, Note 6, "Dividend Restrictions" and Note 7, "Commitments and Contingencies - Reimbursement Agreement," incorporated herein by reference.) RATE MATTERS AND REGULATION RATE MATTERS The System operating companies' retail rates are regulated by their respective state and/or local regulatory authorities, as described below, and their rates for wholesale sales (including intrasystem sales pursuant to the System Agreement) and interstate transmission of electricity are regulated by FERC. Rates for System Energy's sales of capacity and energy from Grand Gulf 1 to AP&L, LP&L, MP&L, and NOPSI pursuant to the Unit Power Sales Agreement are also regulated by FERC. Wholesale Rate Matters GSU. For information, see "Retail Rate Matters - GSU," below and "Regulation - Other Regulation and Litigation - GSU," below. System Energy. As described above under "Certain System Financial and Support Agreements," System Energy recovers costs related to its interest in Grand Gulf 1 through rates charged to AP&L, LP&L, MP&L, and NOPSI for Grand Gulf 1 capacity and energy under the Unit Power Sales Agreement. Several proceedings currently pending or recently concluded at FERC affect these rates. In connection with an audit report covering a review of System Energy's books and records for the years 1986-1988, on August 4, 1992, FERC issued an opinion and order (1) finding that System Energy overstated its Grand Gulf 1 utility plant by approximately $95 million for costs included in utility plant that are related to the System's income tax allocation procedures, and (2) requiring System Energy to make adjusting accounting entries and refunds, with interest, to AP&L, LP&L, MP&L, and NOPSI within 90 days from the date of the order. System Energy requested a rehearing of the order, and on October 5, 1992, FERC issued an order allowing additional time for its consideration of such request and deferring System Energy's refund obligation until 30 days following issuance of FERC's order on rehearing. (For further information on FERC's order and its potential effect on System Energy's and Entergy's consolidated financial position, see Note 2 of System Energy's Notes to Financial Statements and Note 2 of Entergy Corporation and Subsidiaries' Notes to Consolidated Financial Statements, "Rate and Regulatory Matters - FERC Audit," incorporated herein by reference.) In a separate proceeding, on August 24, 1992, FERC instituted an investigation of the justness and reasonableness of certain of Entergy's formula wholesale rates, including System Energy's rates under the Unit Power Sales Agreement. Various regulatory authorities intervened in the proceeding. On August 2, 1993, Entergy and the intervenors settled the proceeding and agreed that System Energy's rate of return on equity would be reduced from 13% to 11%, and such rate would remain in effect until at least August 1995. Refunds were payable by System Energy with respect to the period from November 2, 1992, through the effective date of the settlement. FERC approved the settlement on October 25, 1993, and System Energy credited AP&L, LP&L, MP&L, and NOPSI with an aggregate of $29.6 million on their October 1993 bills. This matter is now final. (See Note 2 of System Energy's Notes to Financial Statements, "Rate and Regulatory Matters - FERC Return on Equity Case," incorporated herein by reference.) Entergy Power. In 1990, authorizations were obtained from the SEC, FERC, the APSC, and the Public Service Commission of Missouri for Entergy Power to purchase AP&L's interests in Independence 2 and Ritchie 2, and to begin marketing the capacity and energy from the units in certain wholesale markets. The SEC order approving various aspects of the transaction was appealed by various intervenors in the proceeding to the D.C. Circuit, which reversed a portion of the order and remanded the case to the SEC for consideration of the effect of the transfers on the System's future costs of replacement generating capacity and fuel. In response to a June 24, 1993 SEC order setting a procedural schedule for the filing of further pleadings in the proceeding, in July 1993, the Entergy parties filed a post-effective amendment to their application addressing the issues specified in the SEC order. On September 9, 1993, the City of New Orleans and the LPSC each requested a hearing. However, on January 5, 1994, the City of New Orleans withdrew from the proceeding, as agreed in its settlement with NOPSI of various issues related to the Merger. System Agreement. AP&L, LP&L, MP&L, and NOPSI engage in the coordinated planning, construction, and operation of generation and transmission facilities pursuant to the terms of the System Agreement (described under "Property - Generating Stations," below). GSU became a party to the System Agreement upon consummation of the merger of Entergy's and GSU's electric systems, and GSU now participates in this System-wide coordination. For further information, see Note 2 of GSU's Notes to Financial Statements and Note 2 of Entergy Corporation and Subsidiaries' Notes to Consolidated Financial Statements, "Rate and Regulatory Matters - Merger-Related Rate Agreements." In connection with the Merger, FERC approved certain rate schedule changes to integrate GSU into the System Agreement. Certain commitments were adopted to provide reasonable assurance that the ratepayers of the existing Entergy operating companies will not be allocated higher costs, including, among other things: (1) a tracking mechanism to protect operating companies from certain unexpected increases in fuel costs; (2) excluding GSU from the distribution of profits from power sales contracts entered into prior to the Merger; (3) a methodology to estimate the cost of capital in future FERC proceedings; and (4) a stipulation that the operating companies will be insulated from certain direct effects on capacity equalization payments should GSU, due to a finding of imprudent GSU management prior to the Merger, be required to purchase Cajun's 30% share in River Bend. See "Regulation - Other Regulation and Litigation," for information on requests for rehearing of FERC's approval. On August 20, l990, the City of New Orleans filed a complaint against Entergy Corporation, AP&L, LP&L, MP&L, NOPSI, and System Energy requesting that FERC investigate AP&L's transfer of its interest in Independence 2 and Ritchie 2 to Entergy Power (see "Entergy Power," above) and the effect of the transfer on AP&L, LP&L, MP&L, and NOPSI and their ratepayers. Various parties, including certain of the System's state regulators, intervened in the proceeding. FERC issued an order on March 19, 1991, setting for investigation (l) the question of whether overall billings under the System Agreement will increase as a result of the transfer to Entergy Power, and (2) if so, whether such increased billings reflect prudently incurred costs that may reasonably be charged under the System Agreement. In two separate decisions with respect to these issues, the FERC ALJ assigned to the matter ruled on May 14, l992 and October 30, 1992, respectively, that there was sufficient evidence to show that overall billings would increase as a result of the transfer, but that the transfer was prudent. On December 15, 1993, FERC issued an opinion declining to address the prudence issue until a future time when replacement capacity has been added or planned and finding that, until such time, billings under the System Agreement as affected by the transfer of the two units are reasonable. The Entergy parties and the City of New Orleans each filed a request for rehearing of this order. If FERC's decision were reversed and any refunds were ordered, they would be retroactive to October 19, 1990. Open Access Transmission. On August 2, 1991, Entergy Services, as agent for AP&L, LP&L, MP&L, NOPSI, and Entergy Power, submitted to FERC (1) proposed tariffs that, subject to certain conditions, would provide to electric utilities "open access" to the System's integrated transmission system, and (2) rate schedules providing for sales of wholesale power at market-based rates. Under FERC policy, sales of power at market-based rates would be permitted only if FERC found, among other things, that Entergy did not have market power over transmission. Permitting "open access" to the System's transmission system helps support such a finding. Various parties, including the Council, the APSC, the MPSC, and the LPSC, intervened in the proceeding. On March 3, 1992, FERC approved the filing, with some modifications, and on August 7, l992, FERC denied rehearing of its March 1992 order. On August 24, l992, various parties filed petitions with the D.C. Circuit for review of FERC's 1992 orders, and these petitions have been consolidated. The revised tariffs, submitted by Entergy Services in response to FERC's 1992 orders, were accepted for filing and made effective, subject to further modifications, by order dated April 5, l993. Entergy Services made a further compliance filing on May 5, l993, reflecting these modifications and requesting reconsideration of certain limited matters, which is subject to approval by FERC. On December 31, 1993, Entergy Services filed revisions to the transmission service tariff to recognize GSU's inclusion in the Entergy System. These matters are pending. Retail Rate Matters General. AP&L, LP&L, MP&L, and NOPSI currently have retail rate structures sufficient to recover their costs, including costs associated with their allocated shares of capacity and energy from Grand Gulf 1 under the Unit Power Sales Agreement, and a return on equity. Certain costs related to Grand Gulf 1 (and in LP&L's case, Waterford 3 are being phased-into retail rates over a period of time, in order to avoid the "rate shock" associated with increasing rates to reflect all of such costs at once. The deferral period in which costs are incurred but not currently recovered has expired for all of these programs, and AP&L, LP&L, MP&L, and NOPSI are now recovering those costs that were previously deferred. Also, AP&L and LP&L have retained a portion of their shares of Grand Gulf 1 capacity and GSU is operating under a deregulated asset plan for a portion of its share of River Bend. GSU is involved in several rate proceedings involving recovery, among other things, of costs associated with River Bend. Some rate relief has been received, but GSU has been unable to obtain recognition in rates for a substantial portion of its River Bend investment. Recovery of certain costs has been disallowed, while other costs are being deferred for future recovery, held in abeyance pending further regulatory action, or treated as investments in deregulated assets. There are ongoing rate proceedings and appeals relating to these issues (see "GSU," below). The System is committed to taking actions that will stabilize retail rates and avoid the need for future rate increases. In the short-term, this involves containing costs to the greatest degree practicable, thereby avoiding erosion of earnings and delaying for as long as possible the need for general rate increases. In accordance with this retail rate policy, the System operating companies have agreed to retail rate caps and/or rate freezes for specified periods of time. In the longer term, as discussed in "Business of Entergy - Competition - Least Cost Planning" above, and also as discussed specifically for each applicable company below, the System is pursuing implementation of least cost planning to minimize the cost of future sources of energy. Effective January 1, 1993, the System adopted SFAS No. 106 (SFAS 106), an accounting standard that requires accrual of the costs of postretirement benefits other than pensions prior to the time these costs are actually incurred. In 1992, the System operating companies requested from their retail rate regulators authorization to recognize in rates the costs associated with implementation of SFAS 106. For further information, see Note 10 of Entergy Corporation and Subsidiaries', Note 9 of MP&L's and NOPSI's, and Note 10 of AP&L's, GSU's, and LP&L's Notes to Financial Statements, "Postretirement and Postemployment Benefits," incorporated herein by reference. AP&L Rate Freeze. In connection with the settlement of various issues related to the Merger, AP&L agreed that it will not request any general retail rate increase that would take effect before November 3, 1998, except, among other things, for increases associated with the Least Cost Plan (discussed below); recovery of certain Grand Gulf 1- related costs, excess capacity costs, and costs related to the adoption of SFAS 106 that were previously deferred; recovery of certain taxes; fuel adjustment recoveries; recovery of nuclear decommissioning costs; and force majeure (defined to include, among other things, war, natural catastrophes, and high inflation). Recovery of Grand Gulf 1 Costs. Under the settlement agreement entered into with the APSC in 1985 and amended in 1988, AP&L agreed to retain a portion of its Grand Gulf l-related costs, recover a portion of such costs currently, and defer a portion of such costs for future recovery. In 1994 and subsequent years, AP&L will retain 7.92% of such costs (stated as a percentage of System Energy's 90% share of the unit) and will recover 28.08% currently. Deferrals ceased in l990, and AP&L is recovering a portion of the previously deferred costs each year through l998. As of December 31, l993, the balance of deferred uncollected costs was $568.0 million. AP&L is permitted to recover on a current basis the incremental costs of financing the unrecovered deferrals. AP&L has the right to sell capacity and energy from its retained share of Grand Gulf 1 to third parties and to sell such energy to its retail customers at a price equal to AP&L's avoided energy cost. Proceeds of sales to third parties of AP&L's retained share of Grand Gulf l capacity and energy generally accrue to the benefit of AP&L's stockholder; however, half of the proceeds of such sales to third parties prior to January 1, 1996, are used to reduce the balance of uncollected deferrals and thus accrue to the benefit of retail ratepayers. If AP&L makes sales to third parties prior to that date in excess of the retained share, the proceeds of such excess are also split between the stockholder and the ratepayers, except that the portion of the sale that accrues to the stockholder's benefit cannot exceed the retained share. Least Cost Planning. On December 1, 1992 and July 1, 1993, AP&L filed with the APSC the Least Cost Plan described in "Business of Entergy - Competition - Least Cost Planning," above. AP&L also requested authorization to recover development and implementation costs and costs and incentives related to the DSM aspects of the plan. On October 13, 1993, the APSC found AP&L's plan to be complete and directed the APSC staff to conduct a series of public forums in late 1993, including focus groups, town meetings, and collaborative workshops, before it would establish a procedural schedule that would include evidentiary hearings and the issuance of a Least Cost Plan order. Several of these meetings were delayed into 1994, but are expected to be completed by March 1994. At or before that time, AP&L expects the APSC to issue a procedural schedule that will allow the APSC to issue an order before the end of 1994. On January 19, 1994, AP&L filed a request with the APSC for permission to withdraw the CCLM portion of the filing and to continue such programs on a pilot basis at shareholder expense. The APSC has not yet ruled on AP&L's request. Fuel Adjustment Clause. AP&L's retail rate schedules have a fuel adjustment clause that provides for recovery of the excess cost of fuel and purchased power incurred in the second preceding month. The fuel adjustment clause also contains a nuclear reserve fund designed to cover the cost of replacement energy during scheduled maintenance and refueling outages at ANO, and an incentive provision that permits over- or under-recovery of the excess cost of replacement energy when ANO is operating or down for reasons other than refueling. GSU Rate Cap and Other Merger-Related Rate Agreements. The LPSC and the PUCT approved separate regulatory proposals that include the following elements: (1) a five-year rate cap on GSU's retail electric base rates in the respective states, except for force majeure (defined to include, among other things, war, natural catastrophes, and high inflation); (2) a provision for passing through to retail customers in the respective states the jurisdictional portion of the fuel savings created by the Merger; and (3) a mechanism for tracking nonfuel operation and maintenance savings created by the Merger. The LPSC regulatory plan provides that such nonfuel savings will be shared 60% by the shareholder and 40% by ratepayers during the eight years following the Merger. The LPSC plan requires regulatory filings each year by the end of May through 2001. The PUCT regulatory plan provides that such savings will be shared equally by the shareholder and ratepayers, except that the shareholder's portion will be reduced by $2.6 million per year on a total company basis in years four through eight. The PUCT plan also requires a series of regulatory filings, currently anticipated to be in June 1994, and February 1996, 1998, and 2001, to ensure that the ratepayers' share of such savings be reflected in rates on a timely basis and requires Entergy Corporation to hold GSU's Texas retail customers harmless from the effects of the removal by FERC of a 40% cap on the amount of fuel savings GSU may be required to transfer to other Entergy operating companies under the FERC tracking mechanism (see "Rate Matters - Wholesale Rate Matters - System Agreement," above). On January 14, 1994, Entergy Corporation filed a request for rehearing of FERC's December 15, 1993 order approving the Merger, requesting that FERC restore the 40% cap provision in the fuel cost protection mechanism (see "Regulation - Other Litigation and Regulation," below). The matter is pending. Recovery of River Bend Costs. GSU deferred approximately $369 million of River Bend operating costs, purchased power costs, and accrued carrying charges pursuant to a 1986 PUCT accounting order. Approximately $182 million of these costs are being amortized over a 20-year period, and the remaining $187 million are not being amortized pending the ultimate outcome of the Rate Appeal (see "Texas Jurisdiction - River Bend," below). As of December 31, 1993, the unamortized balance of these costs was $330.3 million. Further, GSU deferred approximately $400.4 million of similar costs pursuant to a 1986 LPSC accounting order. These costs, of which approximately $160.4 million are unamortized as of December 31, 1993, are being amortized over a 10-year period. In accordance with a phase-in plan approved by the LPSC, GSU deferred $324.7 million of its River Bend costs related to the period December 1987 through February 1991. GSU has amortized $86.6 million through December 31, 1993, and the remainder of $238.1 million will be recovered over approximately 3.8 years. Texas Jurisdiction - River Bend. In May 1988, the PUCT granted GSU a permanent increase in annual revenues of $59.9 million resulting from the inclusion in rate base of approximately $1.6 billion of company-wide River Bend plant investment and approximately $182 million of related Texas retail jurisdiction deferred River Bend costs (Allowed Deferrals). In addition, the PUCT disallowed as imprudent $63.5 million of company-wide River Bend plant costs and placed in abeyance, with no finding of prudency, approximately $1.4 billion of company-wide River Bend plant investment and approximately $157 million of Texas retail jurisdiction deferred River Bend operating and carrying costs. The PUCT affirmed that the ultimate rate treatment of such amounts would be subject to future demonstration of the prudency of such costs. GSU and intervening parties appealed this order (Rate Appeal) and GSU filed a separate rate case asking that the abeyed River Bend plant costs be found prudent (Separate Rate Case). Intervening parties filed suit in district court to prohibit the Separate Rate Case. The district court's decision was ultimately appealed to the Texas Supreme Court which ruled in 1990 that the prudence of the purported abeyed costs could not be relitigated in a separate rate proceeding. Further, the Texas Supreme Court's decision stated that all issues relating to the merits of the original order of the PUCT, including the prudence of all River Bend-related costs, should be addressed in the Rate Appeal. In October 1991, the district court in the Rate Appeal issued an order holding that, while it was clear the PUCT made an error in assuming it could set aside $1.4 billion of the total costs of River Bend and consider them in a later proceeding, the PUCT, nevertheless, found that GSU had not met its burden of proof related to the amounts placed in abeyance. The court also ruled that the Allowed Deferrals should not be included in rate base under a 1991 decision regarding El Paso Electric Company's similar deferred costs (El Paso Case). The court further stated that the PUCT erred in reducing GSU's deferred costs by $1.50 for each $1.00 of revenue collected under the interim rate increases authorized in 1987 and 1988. The court remanded the case to the PUCT with instructions as to the proper handling of the Allowed Deferrals. GSU's motion for rehearing was denied, and in December 1991, GSU filed an appeal of the October 1991 district court order. The PUCT also appealed the October 1991 district court order, which served to supersede the district court's judgment, rendering it unenforceable under Texas law. In August 1992, the court of appeals in the El Paso Case handed down its second opinion on rehearing modifying its previous opinion on deferred accounting. The court's second opinion concluded that the PUCT may lawfully defer operating and maintenance costs and subsequently include them in rate base, but that the Public Utility Regulatory Act prohibits such rate base treatment for deferred carrying costs. The court stated, however, its opinion would not preclude the recovery of deferred carrying costs. The August 1992 court of appeals opinion was appealed to the Texas Supreme Court where arguments were heard in September 1993. The matter is still pending. In September 1993, the Texas Third District Court of Appeals (the Third District Court) remanded the October 1991 district court decision to the PUCT "to reexamine the record evidence to whatever extent necessary to render a final order supported by substantial evidence and not inconsistent with our opinion." The Third District Court specifically addressed the PUCT's treatment of certain costs, stating that the PUCT's order was not based on substantial evidence. The Third District Court also applied its most recent ruling in the El Paso Case to the deferred costs associated with River Bend. However, the Third District Court cautioned the PUCT to confine its deliberations to the evidence addressed in the original rate case. Certain parties to the case have indicated their position that, on remand, the PUCT may change its original order only with respect to matters specifically discussed by the Third District Court which, if allowed, would increase GSU's allowed River Bend investment, net of accumulated depreciation and related taxes, by approximately $48 million as of December 31, 1993. GSU believes that under the Third District Court's decision, the PUCT would be free to reconsider any aspect of its order concerning the abeyed $1.4 billion River Bend investment. GSU has filed a motion for rehearing asking the Third District Court to modify its order so as to permit the PUCT to take additional evidence on remand. The PUCT and other parties have also moved for rehearing on various grounds. The Third District Court has not yet ruled on any of these motions. As of December 31, 1993, the River Bend plant costs disallowed for retail ratemaking purposes in Texas, and the River Bend plant costs held in abeyance and the related cost deferrals totaled (net of taxes) approximately $14 million, $300 million (both net of depreciation), and $171 million, respectively. Allowed Deferrals were approximately $95 million, net of taxes and amortization, as of December 31, 1993. GSU estimates it has collected approximately $139 million of revenues as of December 31, 1993, as a result of the originally ordered rate treatment of these deferred costs. However, if the PUCT adopts the most recent decision in the El Paso Case, the possible refunds approximate $28 million as a result of the inclusion of deferred carrying costs in rate base for the period July 1988 through December 1990. However, if the PUCT reverses its decision to reduce GSU's deferred costs by $1.50 for each $1.00 of revenue collected under the interim rate increases authorized in 1987 and 1988, the potential refund of amounts described above could be reduced by an amount ranging from $7 million to $19 million. No assurance can be given as to the timing or outcome of the remands or appeals described above. Pending further developments in these cases, GSU has made no write-offs for the River Bend related costs. Management believes, based on advice from Clark, Thomas & Winters, a Professional Corporation, legal counsel of record in the Rate Appeal, that it is reasonably possible that the case will be remanded to the PUCT, and the PUCT will be allowed to rule on the prudence of the abeyed River Bend plant costs. Rate caps imposed by the PUCT's regulatory approval of the Merger could result in GSU being unable to use the full amount of a favorable decision to immediately increase rates; however, a favorable decision could permit some increases and/or limit or prevent decreases during the period the rate caps are in effect. At this time, management and legal counsel are unable to predict the amount, if any, of the abeyed and previously disallowed River Bend plant costs that ultimately may be disallowed by the PUCT. A net of tax write-off as of December 31, 1993, of up to $314 million could be required based on the PUCT's ultimate ruling. In prior proceedings, the PUCT has held that the original cost of nuclear power plants will be included in rates to the extent those costs were prudently incurred. Based upon the PUCT's prior decisions, management believes that its River Bend construction costs were prudently incurred and that it is reasonably possible that it will recover in rate base, or otherwise through means such as a deregulated asset plan, all or substantially all of the abeyed River Bend plant costs. However, management also recognizes that it is reasonably possible that not all of the abeyed River Bend plant costs may ultimately be recovered. As part of its direct case in the Separate Rate Case, GSU filed a cost reconciliation study prepared by Sandlin Associates, management consultants with expertise in the cost analysis of nuclear power plants, which supports the reasonableness of the River Bend costs held in abeyance by the PUCT. This reconciliation study determined that approximately 82% of the River Bend cost increase above the amount included by the PUCT in rate base was a result of changes in federal nuclear safety requirements and provided other support for the remainder of the abeyed amounts. There have been four other rate proceedings in Texas involving nuclear power plants. Investment in the plants ultimately disallowed ranged from 0% to 15%. Each case was unique, and the disallowances in each were made on a case-by-case basis for different reasons. Appeals of most, if not all, of these PUCT decisions are currently pending. The following factors support management's position that a loss contingency requiring accrual has not occurred, and its belief that all, or substantially all, of the abeyed plant costs will ultimately be recovered: 1. The $1.4 billion of abeyed River Bend plant costs have never been ruled imprudent and disallowed by the PUCT. 2. Sandlin Associates' analysis which supports the prudence of substantially all of the abeyed construction costs. 3. Historical inclusion by the PUCT of prudent construction costs in rate base. 4. The analysis of GSU's internal legal staff, which has considerable experience in Texas rate case litigation. Additionally, management believes, based on advice from Clark, Thomas & Winters, a Professional Corporation, legal counsel of record in the Rate Appeal, that it is probable that the deferred costs will be allowed. However, assuming the August 1992 court of appeals' opinion in the El Paso Case is upheld and applied to GSU and the deferred River Bend costs currently held in abeyance are not allowed to be recovered in rates as allowable costs, a net-of-tax write-off of up to $171 million could be required. In addition, future revenues based upon the deferred costs previously allowed in rate base could also be lost and no assurance can be given as to whether or not refunds (up to $28 million as of December 31, 1993) of revenue received based upon such deferred costs previously recorded will be required. See Note 12 of GSU's Notes to Financial Statements, "Entergy Corporation-GSU Merger," for the accounting treatment of preacquistion contingencies, including a River Bend write-down. Texas Jurisdiction - Fuel Reconciliation. In January 1992, GSU applied with the PUCT for a new fixed fuel factor and requested a final reconciliation of fuel and purchased power costs incurred between December 1, 1986 and September 30, 1991. GSU proposed to recover net underrecoveries and interest (including underrecoveries related to NISCO, discussed below) over a twelve month period. In April 1993, the presiding PUCT ALJ issued a report which concluded that GSU incurred approximately $117 million of nonreimbursable fuel costs on a company-wide basis (approximately $50 million on a Texas retail jurisdictional basis) during the reconciliation period. Included in the nonreimbursable fuel costs were payments above GSU's avoided cost rate for power purchased from NISCO. The PUCT ordered in 1986 that the purchased power costs from NISCO in excess of GSU's avoided costs be disallowed. The PUCT disallowance resulted in approximately $12 million to $15 million of unrecovered purchased power costs on an annual basis, which GSU continued to expense as the costs were incurred. In April 1991, the Texas Supreme Court, in the appeal of such order, ordered the PUCT to allow GSU to recover purchased power payments in excess of its avoided cost in future proceedings, if GSU established to the PUCT's satisfaction that the payments were reasonable and necessary expenses. In June 1993, the PUCT, in the fuel reconciliation case, concluded that the purchased power payments made to NISCO in excess of GSU's avoided cost were not reasonably incurred. As a result of the order, GSU recorded additional fuel expenses (including interest) of $2.8 million for non-NISCO related items. The PUCT's order resulted in no additional expenses related to the NISCO issue, or for overcollections related to the fixed fuel factor, as those charges were expensed by GSU as they were incurred. The PUCT concluded that GSU had over-collected its fuel costs in Texas and ordered GSU to refund approximately $33.8 million to its Texas retail customers, including approximately $7.5 million of interest. The PUCT reduced GSU's fixed fuel factor in Texas from about 2.1 cents per KWH to approximately 1.84 cents per KWH. GSU had requested a new fixed fuel factor of about 2.02 cents per KWH. Based on current sales forecasts, adoption of the PUCT's recommended fixed fuel factor would reduce GSU's revenues by approximately $34 million annually. In October 1993, GSU appealed the PUCT's order to the Travis County District Court. No assurance can be given as to the timing or outcome of the appeal. Texas - Cities Rate Settlement. In June 1993, thirteen cities within GSU's Texas service area instituted an investigation to determine whether GSU's current rates were justified. In October 1993, the general counsel of the PUCT instituted an inquiry into the reasonableness of GSU's rates. In November 1993, a settlement agreement was filed with the PUCT which provides for an initial reduction in annual retail base revenues in Texas of approximately $22.5 million effective for electric usage on or after November 1, 1993, and a second reduction of $20 million to be effective September 1994. Further, the settlement provided for GSU to reduce rates with a $20 million one-time bill credit in December 1993, and to refund approximately $3 million to Texas retail customers on bills rendered in December 1993. The cities rate inquiries had been settled earlier on the same terms. In November 1993, in association with the settlement of the above- described rate inquiries, GSU entered into a settlement covering issues related to a March 1991 non-unanimous settlement in another proceeding. Under this settlement, a $30 million rate increase approved by the PUCT in March 1991, became final and the PUCT's treatment of GSU's federal tax expense was settled, eliminating the possibility of refunds associated with amounts collected resulting from the disputed tax calculation. In December 1993, a large industrial customer of GSU announced its intention to oppose the settlement of the PUCT rate inquiry. The customer's opposition does not affect the cities' rate settlement. The customer's opposition requires the PUCT to conduct a hearing concerning GSU's rates charged in areas outside the corporate limits of the cities in its Texas service territory to determine whether the settlement's rates are just and reasonable. A hearing has been set for July 8, 1994. GSU believes that the PUCT will ultimately approve the settlement, but no assurance can be provided in this regard. Louisiana Jurisdiction - River Bend. Previous rate orders of the LPSC have been appealed, and pending resolution of various appellate proceedings, GSU has made no write-off for the disallowance of $30.6 million of deferred revenue requirement that GSU recorded for the period December 16, 1987 through February 18, 1988. In January 1992, the LPSC ordered a deregulated asset plan for $1.4 billion of River Bend plant costs not allowed in rates. The plan allows GSU to sell the generation from the approximately 22% of River Bend to Louisiana customers at 4.6 cents per KWH, or off-system at higher prices. Incremental revenues from off-system sales above 4.6 cents per KWH will be shared 60% by shareholders and 40% by ratepayers (see GSU's "Management's Financial Discussion and Analysis," incorporated herein by reference, for the effects of the plan on GSU's 1993 results of operations). LPSC - Return on Equity Review. In the June 1993 open session, a preliminary report was made comparing the authorized and actual earned rates of return for electric and gas utilities subject to the LPSC's jurisdiction. The preliminary report indicated that several electric utilities, including GSU, may be over-earning based on current estimated costs of equity. The LPSC requested those utilities to file responses indicating whether they agreed with the preliminary report, and to provide their reasons if they did not agree. GSU provided the LPSC with information that GSU believes supports the current rate level. The LPSC decided at its September 7, 1993 open session to defer review of GSU's base rates until the first earnings analysis after the Merger, scheduled for mid-1994. LPSC Fuel Cost Review. In November 1993, the LPSC ordered a review of GSU's fuel costs. The LPSC stated that fuel costs for the period October 1988 through September 1991 would be reviewed based on the number of outages at River Bend and the findings in the June 1993 PUCT fuel reconciliation case. Hearings are scheduled to begin in March 1994. Least Cost Planning. Currently, the PUCT does not have least cost planning rules in place, and GSU has not filed a Least Cost Plan with the PUCT. However, the PUCT staff has begun a rulemaking process for such rules, and GSU is actively participating in this process. GSU has not yet filed a Least Cost Plan with the LPSC. Fuel Recovery. In January 1993, the PUCT adopted a new rule for setting a fixed fuel factor that is intended to recover projected allowable fuel and purchased power costs not covered by base rates. To the extent actual costs vary from the fixed factor, the PUCT may require refunds of overcharges or permit recovery of undercharges. Under the new rule, fuel factors are to be revised every six months, and GSU is on a schedule providing for revision each March and September. The PUCT is required to act within 60 or 90 days, depending on whether or not a hearing is required, and refunds and surcharges will be required based upon a materiality threshold of 4% of Texas retail fuel revenues. Fuel charges will also be subject to reconciliation proceedings every three years, at which time additional adjustments may be required (see "Texas Jurisdiction - Fuel Reconciliation," above). All of GSU's rate schedules in Louisiana include a fuel adjustment clause to recover the cost of fuel and purchased power energy costs. The fuel adjustment reflects the delivered cost of fuel for the second preceding month. LP&L LPSC Jurisdiction. In a series of LPSC orders, court decisions, and agreements from late 1985 to mid-1988, LP&L was granted rate relief with respect to costs associated with Waterford 3 and LP&L's share of capacity and energy from Grand Gulf l, subject to certain terms and conditions. With respect to Waterford 3, LP&L was granted an increase aggregating $170.9 million over the period 1985-1988, and LP&L agreed to permanently absorb, and not recover from retail ratepayers, $284 million of its investment in the unit and to defer $266 million of its costs related to the years 1985-1988 to be recovered over approximately 8.6 years beginning in April 1988. As of December 31, 1993, LP&L's unrecovered deferral balance was $82.5 million. With respect to Grand Gulf l, LP&L agreed to absorb, and not recover from retail ratepayers, 18% of its 14% share (approximately 2.52%) of the costs of Grand Gulf l capacity and energy. LP&L is allowed to recover, through the fuel adjustment clause, 4.6 cents per KWH (currently 2.55 cents per KWH through May 1994) for the energy related to the permanently absorbed percentage, with LP&L's permanently absorbed retained percentage to be available for sale to non-affiliated parties, subject to LPSC approval. (See Note 2 of LP&L's Notes to Financial Statements, "Rate and Regulatory Matters - Waterford 3 and Grand Gulf 1," incorporated herein by reference, for further information on LP&L's Grand Gulf 1 and Waterford 3-related rates.) In a subsequent rate proceeding, on March 1, l989, the LPSC issued an order providing that, in effect, LP&L was entitled to an approximately $45.9 million annual retail rate increase, but that, in lieu of a rate increase, LP&L would be permitted to retain $188.6 million of the proceeds of a 1988 settlement of litigation with a gas supplier, and to amortize such proceeds into revenues over a period of approximately 5.3 years. The amortization of the proceeds will expire in mid-1994 and this source of revenue will no longer be available to LP&L. LP&L believes that the amortization has resulted in approximately the same amount of additional net income as an annual rate increase of $45.9 million would have provided over the same period. In connection with this order, LP&L agreed to a five-year base rate freeze scheduled to expire in March 1994 at then current levels subject to certain conditions. (See Note 2 of LP&L's Notes to Financial Statements, "Rate and Regulatory Matters - March 1989 Order," incorporated herein by reference, for further information on the terms of this order.) By letter dated July 27, 1993, the LPSC requested LP&L to explain its "relatively high cost of debt" compared to other electric utilities subject to LPSC jurisdiction. LP&L responded to the request on August 11, 1993. On August 14, 1993, the LPSC's consultants acknowledged LP&L's rationale for its cost of debt and suggested that certain aspects of LP&L's cost of debt could be taken up in rate proceedings after the expiration of LP&L's rate freeze. On October 7, 1993, the LPSC approved a schedule to conduct a review of LP&L's rates and rate structure upon the expiration of the rate freeze in March 1994. Council Jurisdiction. Under the Algiers rate settlement entered into with the Council in l989, LP&L was granted rate relief with respect to its Grand Gulf l and Waterford 3-related costs, subject to certain terms and conditions. LP&L was granted an annual rate increase of $9.5 million that was phased-in over the two-year period beginning in July 1989, and was permitted to retain $4.2 million (the Council's jurisdictional portion) of the proceeds of litigation with a gas supplier and to amortize such proceeds plus interest into revenues over the same two-year period. LP&L agreed to absorb and not recover from Algiers retail ratepayers $17 million of fixed costs associated with Grand Gulf l and Waterford 3 incurred prior to the date of the settlement, $5.9 million of its investment in Waterford 3, and 18% of the Algiers portion of LP&L's Grand Gulf l-related costs incurred after the settlement. However, LP&L is allowed to recover 4.6 cents per KWH or the avoided cost, whichever is higher, for the energy related to the permanently absorbed percentage through the fuel adjustment clause, with the permanently absorbed percentage to be available for sale to non-affiliated parties, subject to the Council's right of first refusal. LP&L also agreed to a rate freeze for Algiers customers until July 6, l994, except in the case of catastrophic events, changes in federal tax laws, or changes in LP&L's Grand Gulf l costs resulting from FERC proceedings. Least Cost Planning. On December l, l992, and July 1, l993, LP&L filed with the LPSC and the Council the Least Cost Plan described under "Business of Entergy - Competition - Least Cost Planning," above. LP&L also requested authorization to recover development and implementation costs and costs and incentives related to the DSM aspects of the plan. Discovery in the LPSC review of LP&L's Least Cost Plan filing is continuing, and the current procedural schedule (which maybe extended) contemplates that, after hearings and briefings, a report of the LPSC special counsel will be issued on June 14, 1994. The LPSC could render a decision on the basis of this report. On January 19, 1994, LP&L filed a motion with the LPSC to dismiss or withdraw without prejudice the CCLM and to proceed with a pilot CCLM at shareholder expense. The LPSC granted LP&L's motion on February 2, 1994, subject to LP&L, among other things, keeping the LPSC timely informed as to LP&L's CCLM activities. (See "NOPSI - Least Cost Planning," below, for further information on LP&L's and NOPSI's proceedings pending before the Council.) Fuel Adjustment Clause. LP&L's rate schedules include a fuel adjustment clause to reflect the delivered cost of fuel in the second preceding month and purchased power energy costs. The fuel adjustment also reflects a surcharge for deferred fuel expense arising from the monthly reconciliation of actual fuel cost incurred with fuel cost revenues billed to customers. LP&L defers on its books fuel costs that will be reflected in customer billings in the future under the fuel adjustment clause. MP&L Rate Freeze. In a stipulation entered into by MP&L in connection with the settlement of various issues related to the Merger, MP&L agreed that (1) for a period of five years beginning on November 9, 1993, retail base rates under the FRP (see "Incentive Rate Plan," below) would not be increased above the level of rates in effect on November 1, 1993, and (2) MP&L would not request any general retail rate increase that would increase retail rates above the level of MP&L's rates in effect as of November l, 1993, and that would become effective in such five-year period except, among other things, for increases associated with the Least Cost Plan (discussed below), recovery of deferred Grand Gulf 1-related costs, recovery under the fuel adjustment clause, adjustments for certain taxes, and force majeure (defined to include, among other things, war, natural catastrophes, and high inflation). Recovery of Grand Gulf 1 Costs. The MPSC's Final Order on Rehearing, issued in 1985, affirmed by the United States Supreme Court in 1988, and subsequently revised in 1988, granted MP&L an annual base rate increase of approximately $326.5 million in connection with its allocated share of Grand Gulf 1 costs. The Final Order on Rehearing also provided for the deferral of a portion of such costs that were incurred each year through 1992, and recovery of these deferrals over a period of six years ending in 1998. As of December 31, 1993, the uncollected balance of MP&L's deferred costs was approximately $601.4 million. MP&L is permitted to recover the carrying charges on all deferred amounts on a current basis. Incentive Rate Plan. In July 1993, the MPSC ordered MP&L to file a formulary incentive rate plan designed to allow for periodic small adjustments in rates based upon a comparison of earned to benchmark returns and upon performance factors incorporated in the plan. Pursuant to this order, on November 1, 1993, MP&L filed a proposed formula rate plan. MPSC was also expected to conduct a general review of MP&L's current rates in the course of approving an incentive rate plan. On January 28, 1994, MP&L and the Mississippi Public Utilities Staff (MPUS) entered into a Joint Stipulation in this proceeding. Under the Joint Stipulation, MP&L and the MPUS agreed on a number of accounting adjustments for the test year ending June 30, 1993, (June 30 Test Year) that resulted in a reduction to MP&L's base rate revenues in the June 30 Test Year of approximately 4.3%, or $28.1 million. This translates into approximately a 3.7% decrease in overall revenues from sales to retail customers, which include revenues related to fuel, taxes, and Grand Gulf. MP&L and the MPUS agreed on a required return on equity of 11% for the June 30 Test Year. MP&L and the MPUS also stipulated to a revised Formula Rate Plan (FRP). The stipulated FRP is essentially the same as the proposed plan filed by MP&L on November 1, 1993. Certain of the accounting changes agreed to by the MPUS and MP&L for the June 30 Test Year are incorporated into the stipulated FRP. Also, the formula in the stipulated FRP for determining required return on equity would have produced a required return on equity for MP&L of 11.07% for the June 30 Test Year. The stipulated return on equity formula will be applied for the first time in the first Evaluation Report under the stipulated FRP. The first Evaluation Report will be filed in March 1995 for the Evaluation Period ending December 31, 1994. On February 10, 1994, MP&L, the Mississippi Industrial Energy Group (MIEG), and the MPUS entered into and filed with the MPUS, a Joint Stipulation (MIEG Joint Stipulation) resolving the issues raised by the MIEG in the docket. On February 16, 1994, MP&L and the Mississippi Attorney General entered into a Joint Stipulation that resolved the issues raised by the Mississippi Attorney General in the docket. Other parties in the case, including two gas utility intervenors, were not parties to the Joint Stipulations. In late February 1994, the MPSC conducted a general review of MP&L's current rates and on March 1, 1994, issued a final order in which the MPSC approved each of the Joint Stipulations. The MPSC ordered MP&L to file rates designed to provide a reduction of $28.1 million in operating revenues for the June 30 Test Year on or before March 18, 1994, to become effective for service rendered on and after March 25, 1994. The FRP also was approved and will be effective on March 25, 1994, with any initial adjustment to base rates, if any, in May 1995. Under the FRP, a formula will be established under which MP&L's earned rate of return will be calculated automatically every 12 months and compared to a benchmark rate of return calculated under a separate formula within the FRP. If MP&L's earned rate of return falls within a bandwidth around the benchmark rate of return, there will be no adjustment in rates. If MP&L's earnings are above the bandwidth, the FRP will automatically reduce MP&L's base rates. Alternatively, if MP&L's earnings are below the bandwidth, the FRP will automatically increase MP&L's base rates (see "Rate Freeze" above for information on a cap on base rates at November 1993 levels for a period of five years). The reduction or increase in base rates will be an amount representing 50% of the difference between the earned rate of return and the nearest limit of the bandwidth. In no event will the annual adjustment in rates exceed the lesser of 2% of MP&L's aggregate annual retail revenues, or $14.5 million. Under the FRP the benchmark rate of return, and consequently the bandwidth, will be adjusted slightly upward or downward based upon MP&L's performance on three performance factors: customer reliability, customer satisfaction, and customer price. In its Final Order, the MPSC also recognized that on February 9 and 10, 1994, a severe ice storm struck northern Mississippi causing extensive and widespread damage to MP&L's transmission and distribution facilities in approximately 15 counties. Although the MPSC made no findings in the final order as to MP&L's costs associated with the ice storm and restoration of service, the MPSC acknowledged that there is precedent in Mississippi for recovery of certain costs associated with storms and natural disasters and restoration of service. The MPSC stated the recovery of MP&L's ice storm costs should be addressed in a separate docket. MP&L plans to immediately file for rate recovery of the costs related to the ice storm. Least Cost Planning. On December 1, 1992 and July 1, 1993, MP&L filed with the MPSC the Least Cost Plan described in "Business of Entergy - Competition - Least Cost Planning," above. MP&L also requested a finding by the MPSC that the plan's cost recovery methodology is reasonable and appropriate. MP&L will request approval of cost recovery mechanisms after the plan has been approved by the MPSC. On October 6, 1993, the MPSC, on its own motion, stayed all proceedings in this docket. The MPSC stay order regarding MP&L's Least Cost Plan filing remains in effect even though MP&L and the MPUS have stipulated to an FRP (see "Incentive Rate Plan," above). Because the stay order remains in effect, MP&L has not yet filed a request that the CCLM portion of the filing be withdrawn and that a pilot CCLM program be implemented. Fuel Adjustment Clause. MP&L's rate schedules include a fuel adjustment clause that permits recovery from customers of changes in the cost of fuel and purchased power. The monthly fuel adjustment rate is based on projected sales and costs for the month, adjusted for differences between actual and estimated costs for the second prior month. NOPSI Electric Retail Rate Reduction. On November 18, 1993, in connection with the settlement of various issues related to the Merger, the Council adopted a resolution requiring NOPSI to reduce its annual electric base rates by $4.8 million on bills rendered on or after November 1, 1993. Recovery of Grand Gulf 1 Costs. Under NOPSI's various Rate Settlements with the Council (which include the 1986 NOPSI Settlement, the February 4 Resolution relating to prudence issues, and the 1991 NOPSI Settlement of the issues raised in the February 4 Resolution), NOPSI agreed to absorb and not recover from ratepayers a total of $186.2 million of its Grand Gulf 1 costs. NOPSI was permitted to implement annual rate increases in decreasing amounts each year through 1995, and to defer certain costs, and related carrying charges, for recovery on a schedule extending from 1991 through 2001. As of December 31, 1993, the uncollected balance of NOPSI's deferred costs was $228.8 million. NOPSI also agreed to a base rate freeze through October 31, 1996, excluding the scheduled increases, certain changes in tax rates, and increases related to catastrophic events. (See Note 2 of NOPSI's Notes to Financial Statements, "Rate and Regulatory Matters - Prudence Settlement and Finalized Phase-In Plan," incorporated herein by reference, for further information.) Gas Rates. In May 1992, NOPSI and the Council settled a pending application for gas rate increases. The settlement provided for annual rate increases of approximately $3.8 million in May 1992 and 1993, and the deferral of an additional $3 million for recovery in the years beginning in May 1993 through May 1996. NOPSI also agreed to a base rate freeze, except for the scheduled increases and certain other exceptions, through October 31, 1996. Least Cost Planning. On December 1, 1992, and July 1, 1993, NOPSI filed with the Council the Least Cost Plan described under "Business of Entergy - Competition - Least Cost Planning," above. NOPSI also requested authorization to recover development and implementation costs and costs and incentives related to DSM aspects of the plan. After hearings and briefings, the Council issued, on November 22, 1993, a resolution that requires NOPSI and LP&L to provide, within certain time frames, additional information, among other things, on how the seven full scale DSM programs approved by the Council in the resolution will be implemented. Such programs are estimated to cost approximately $13 million over the next three years. The Council provided in the resolution certain assurances regarding recovery of costs associated with these programs. Discovery is proceeding and testimony is being filed, with the second round of hearings to begin in February 1994. After the hearings are concluded and briefs have been filed, the Council will address the second round issues in early April 1994. On February 3, 1994, the Council issued a resolution and order granting the motions of NOPSI and LP&L to dismiss without prejudice the CCLM portion of the filing, authorizing NOPSI and LP&L to proceed with a pilot CCLM (other than the construction of a fiber optics/coaxial cable network) in New Orleans at shareholder expense (subject to certain conditions). The Council also opened a new docket to expeditiously address issues related to the CCLM pilot, and directing NOPSI and LP&L to obtain Council authorization in the new docket before constructing such a fiber optics/coaxial cable network. In connection with the settlement of various issues related to the Merger, the Council adopted a resolution on November 18, 1993, that provides that the Council will not disallow the first $3.5 million of costs incurred by NOPSI through October 31, 1993, in connection with the Least Cost Plan. Fuel Adjustment Clause. NOPSI's electric rate schedules include a fuel adjustment clause to reflect the delivered cost of fuel in the second preceding month, adjusted by a surcharge for deferred fuel expense arising from the monthly reconciliation of actual fuel cost incurred with fuel cost revenues billed to customers. The adjustment clause, on a monthly basis, also reflects the difference between nonfuel Grand Gulf 1 costs paid by NOPSI and the estimate of such costs provided in NOPSI's Grand Gulf 1 Rate Settlements. NOPSI's gas rate schedules include a gas cost adjustment to reflect gas costs in excess of those collected in rates, adjusted by a surcharge similar to that included in the electric adjustment clause. NOPSI defers on its books fuel and purchased gas costs to be reflected in billings to customers in the future under the fuel adjustment clause. REGULATION Federal Regulation Holding Company Act. Entergy Corporation is a registered public utility holding company under the Holding Company Act. As such, Entergy Corporation and its various direct and indirect subsidiaries (with the exception of its independent power/EWG subsidiaries) are subject to the broad regulatory provisions of that Act. Except with respect to investments in certain EWG projects and foreign utility company projects (see "Business of Entergy - Competition - General," above for a discussion of the Energy Act), Section 11(b)(1) of the Holding Company Act limits the operations of a registered holding company system to a single, integrated public utility system, plus additional systems and businesses as provided by that section. Federal Power Act. The System operating companies, System Energy, and Entergy Power are subject to the Federal Power Act as administered by FERC and the DOE. The Federal Power Act provides for regulatory jurisdiction over the licensing of certain hydroelectric projects, the business of, and facilities for, the transmission and sale at wholesale of electric energy in interstate commerce and certain other activities of the System operating companies, System Energy, and Entergy Power as interstate electric utilities, including accounting policies and practices. Such regulation includes jurisdiction over the rates charged by System Energy for capacity and energy provided to AP&L, LP&L, MP&L, and NOPSI, or others, from Grand Gulf 1. AP&L holds a license for two hydroelectric projects (70 MW) that was renewed on July 2, 1980. This license, granted by FERC, will expire in February 2003. Regulation of the Nuclear Power Industry General. Under the Atomic Energy Act of 1954 and Energy Reorganization Act of 1974, operation of nuclear plants is intensively regulated by the NRC, which has broad power to impose licensing and safety-related requirements. In the event of non-compliance, the NRC has the authority to impose fines or shut down a unit, or both, depending upon its assessment of the severity of the situation, until compliance is achieved. AP&L, GSU, LP&L, and System Energy, as owners of all or a portion of ANO, River Bend, Waterford 3, and Grand Gulf 1, respectively, and Entergy Operations, as the operator of these units, are subject to the jurisdiction of the NRC. Revised safety requirements promulgated by the NRC have, in the past, necessitated substantial capital expenditures at System nuclear plants and additional such expenditures could be required in the future. The nuclear power industry faces uncertainties with respect to the cost and availability of long-term arrangements for disposal of spent nuclear fuel and other radioactive waste, nuclear plant operational issues, the technological and financial aspects of decommissioning plants at the end of their licensed lives, and the effect of certain requirements relating to nuclear insurance. These matters are briefly discussed below. Spent Fuel and Other High-Level Radioactive Waste. Under the Nuclear Waste Policy Act of 1982, the DOE is required, for a specified fee, to construct storage facilities for, and to dispose of, all spent nuclear fuel and other high-level radioactive waste generated by domestic nuclear power reactors. The NRC, pursuant to this Act, also requires operators of nuclear power reactors to enter into spent fuel disposal contracts with the DOE, and the affected System companies have entered into such disposal contracts. However, the DOE has not yet identified a permanent storage repository and, as a result, future expenditures may be required to increase spent fuel storage capacity at the plant sites. (For further information concerning spent fuel disposal contracts with the DOE, schedules for initial shipments of spent nuclear fuel, current on-site storage capacity, and costs of providing additional on-site storage capacity, with respect to AP&L, GSU, LP&L, and System Energy, respectively, see Note 8 of AP&L's, GSU's, and LP&L's, and Note 7 of System Energy's, Notes to Financial Statements, "Commitments and Contingencies - Spent Nuclear Fuel and Decommissioning Costs," incorporated herein by reference.) Low-Level Radioactive Waste. The availability and cost of disposal facilities for low-level radioactive waste resulting from normal operation of nuclear units are subject to a number of uncertainties. Under the Low-Level Radioactive Waste Policy Act of 1980, as amended, each state is responsible for disposal of its own waste, and states may join in regional compacts to jointly fulfill their responsibilities. The States of Arkansas and Louisiana participate in the Central States Compact, and the State of Mississippi participates in the Southeast Compact. Two disposal sites are currently operating in the United States, and one of them, which is located in Washington, is closed to out-of-region generators. The second site, the Barnwell Disposal Facility (Barnwell) located in South Carolina, is operated by the Southeast Compact and the State of Mississippi is expected to have access to this site through December 1995. Barnwell had been open to out-of-region generators (including generators in Arkansas and Louisiana) in the past; however, on April 14, 1993, the Southeast Compact voted to deny access to Barnwell to members of the Central States Compact. Such access was reinstated for the period from October 1993 through June 1994, at which time legislative action by the State of South Carolina would be required to permit further access to out-of-region generators. Beginning in July 1994, low-level radioactive waste generators in the Central States Compact, including AP&L, GSU, and LP&L, will be required to store such waste on-site until a Central States Compact facility becomes operational or another site becomes accessible. Both the Central States Compact and the Southeast Compact are working to establish additional disposal sites. The System, along with other waste generators, funds the development costs for new disposal facilities. The System's expenditures to date are approximately $30 million; and future levels of expenditures cannot be predicted. Until such facilities are established, the System will continue to seek access to existing facilities, which may be available at costs that are higher than those incurred in the past, or which may be unavailable. If such access is unavailable, the System will store low-level waste on-site at the affected units. ANO has on-site storage that is estimated to be sufficient until 1999. Construction of on-site storage at the other nuclear units is being considered, along with other alternatives. A coordinated design concept that can be utilized at both Waterford 3 and River Bend is being evaluated. Grand Gulf 1 will have continued disposal access through December 1995; therefore, no immediate plans for on-site storage are needed for Grand Gulf 1. The estimated construction costs for storage sufficient for approximately five years at Grand Gulf 1, Waterford 3, and River Bend are in the range of $2.0 million to $5.0 million for each site. As an alternative to on-site storage, Entergy is working with other industry groups to influence the continued operation of the Barnwell disposal facility for out-of-region generators. Decommissioning. AP&L, GSU, LP&L, and System Energy are recovering portions of their estimated decommissioning costs for ANO, River Bend, Waterford 3, and Grand Gulf 1, respectively. These amounts are being deposited in external trust funds that, together with the earnings thereon, can only be used for future decommissioning costs. Estimated decommissioning costs are regularly reviewed and updated to reflect inflation and changes in regulatory requirements and technology, and applications will be made to appropriate regulatory authorities to recover in rates any projected increase in decommissioning costs above that currently being recovered. (For additional information with respect to decommissioning costs for ANO, River Bend, Waterford 3, and Grand Gulf 1, respectively, see Note 8 of AP&L's, GSU's, and LP&L's and Note 7 of System Energy's Notes to Financial Statements, "Commitments and Contingencies - Spent Nuclear Fuel and Decommissioning Costs," incorporated herein by reference.) Uranium Enrichment Decontamination and Decommissioning Fees. The Energy Act requires all electric utilities (including AP&L, GSU, LP&L, and System Energy) that have purchased uranium enrichment services from the DOE to contribute up to a total of $150 million annually, adjusted for inflation, up to a total of $2.25 billion over approximately 15 years, for decommissioning and decontamination of enrichment facilities. AP&L's, GSU's, LP&L's, and System Energy's estimated annual contributions to this fund are $3.3 million, $0.6 million, $1.2 million, and $1.3 million, respectively, in 1993 dollars over approximately 15 years. Contributions to this fund are to be recovered through rates in the same manner as other fuel costs. Nuclear Insurance. The Price-Anderson Act provides for a limit of public liability for a single nuclear incident. As of December 31, 1993, the limit of public liability for such type of incident was approximately $9.4 billion. AP&L, GSU, LP&L, and System Energy have protection with respect to this liability through a combination of private insurance and an industry assessment program, and also have insurance for property damage, costs of replacement power, and other risks relating to nuclear generating units. (For a discussion of insurance applicable to nuclear programs of AP&L, GSU, LP&L, and System Energy, see Note 7 of System Energy's and Note 8 of AP&L's, GSU's, and LP&L's Notes to Financial Statements, and Note 8 of Entergy Corporation and Subsidiaries, Notes to Consolidated Financial Statements, "Commitments and Contingencies - Nuclear Insurance," incorporated herein by reference.) Nuclear Operations General. Entergy Operations operates ANO, River Bend, Waterford 3, and Grand Gulf 1, subject to the owner oversight of AP&L, GSU, LP&L, and System Energy, respectively. AP&L, GSU, LP&L, and System Energy, and the other Grand Gulf 1, Waterford 3, and River Bend co- owners, have retained their ownership interests in their respective nuclear generating units. AP&L, GSU, LP&L, and System Energy have also retained their associated capacity and energy entitlements, and pay directly or reimburse Entergy Operations at cost for its operation of the units. On June 24, 1992, the NRC issued a bulletin requiring all utilities using a certain fire barrier material in a nuclear power plant to take certain actions related to the material. This material may have been used in as many as 87 nuclear plants in the United States, including ANO, River Bend, Waterford 3, and Grand Gulf 1 (see "River Bend," below for additional information). ANO. In 1990, in response to a special diagnostic evaluation report by the NRC, AP&L implemented a comprehensive action plan for ANO designed to correct certain management, organizational, and technical problems, and to improve the long-term operational effectiveness and safety of the units. This action plan was largely completed in 1993. Leaks in certain steam generator tubes at ANO 2 were discovered and repaired during an outage in March 1992; and during a refueling outage in September 1992, a comprehensive inspection of all steam generator tubing was conducted and necessary repairs were made. During a mid-cycle outage in May 1993, a scheduled special inspection of certain steam generator tubing was conducted by Entergy Operations and additional repairs were made. Entergy Operations proposes to operate ANO 2 with no further steam generator inspections until the next refueling outage, which is scheduled for the spring of 1994, and the NRC has concurred with this proposal. The operations and power output of the unit have not been adversely affected to date by these repairs. River Bend. The Nuclear Information and Resource Service petitioned the NRC to shut down the River Bend plant in July 1992 because of alleged defects in a fire barrier material. GSU has used this material in its River Bend plant and is in compliance with the requirements of the bulletin. On August 19, 1992, the NRC denied the petitioner's request. In a December 1993 letter, the NRC requested additional technical information on the use of the material in the plant, and requested GSU's plans and schedules for resolving technical issues associated with the use of the material in certain configurations. GSU has provided the information requested in the NRC letter. On January 13, 1993, in connection with the Merger, GSU filed two applications with the NRC to amend the River Bend operating license. The applications sought the NRC's consent to the Merger and to a change in the licensed operator of the facility from GSU to Entergy Operations. On August 6, 1993, Cajun filed a petition to intervene and request for a hearing in the proceedings. On January 27, 1994, the presiding NRC Atomic Safety and Licensing Board (ASLB) issued an order granting Cajun's petition to intervene and ordered a hearing on one of Cajun's contentions. On February 15, 1994, GSU filed an appeal of the ASLB Order with the NRC. On December 16, 1993, prior to this ASLB ruling, the NRC Staff issued the two license amendments for River Bend, making them effective immediately upon consummation of the Merger. On February 16, 1994, Cajun filed with the D.C. Circuit petitions for review of the two license amendments issued by the NRC. These two amendments are in full force and effect, but are subject to the outcome of the two proceedings. A hearing on the proceeding before the ALSB is not expected to begin prior to the fall of 1994. In February 1993, GSU and the other affected utilities were served with a federal grand jury subpoena to produce documents and other information relating to the fire barrier material used in the plant. Nothing in the subpoena indicates that GSU or any employee is a target of the grand jury investigation. GSU is cooperating fully with the government in its investigation. The requested documentation and other information were produced in March 1993, and no additional requests have been received. On October 25, 1993, the NRC staff began an operational safety team inspection at River Bend that was concluded by mid-November 1993. The NRC held the inspection to verify that the plant is being operated safely and in conformance with regulatory requirements. The team's findings were discussed at a public meeting in November 1993, and a written inspection report was issued in January 1994. The inspection team found apparent violations in two categories: (1) procedure adequacy, and (2) concerns with the corrective action program. Due to the nature of these apparent violations, an enforcement conference was not warranted and no fine was proposed. State Regulation General. Each of the System operating companies is subject to regulation by its respective state and/or local regulatory authorities with jurisdiction over the service areas in which each company operates. Such regulation includes authority to set rates for electric and gas service provided at retail. (See "Rate Matters and Regulation - Rate Matters - Retail Rate Matters," above) AP&L is subject to regulation by the APSC and the Tennessee Public Service Commission (TPSC). APSC regulation includes the authority to set rates, determine reasonable and adequate service, fix the value of property used and useful, require proper accounting, control leasing, control the acquisition or sale of any public utility plant or property constituting an operating unit or system, set rates of depreciation, issue certificates of convenience and necessity and certificates of environmental compatibility and public need, and control the issuance and sale of securities. Regulation by the TPSC includes the authority to set standards of service and rates for service to customers in the state, require proper accounting, control the issuance and sale of securities, and issue certificates of convenience and necessity. GSU is subject to the jurisdiction of the municipal authorities of incorporated cities in Texas as to retail rates and services within their boundaries, with appellate jurisdiction over such matters residing in the PUCT. GSU is also subject to regulation by the PUCT as to retail rates and services in rural areas, certification of new generating plants, and extensions of service into new areas. GSU is subject to regulation by the LPSC as to electric and gas service, rates and charges, certification of generating facilities and power or capacity purchase contracts, and other matters. LP&L is subject to the jurisdiction of the LPSC as to rates and charges, standards of service, depreciation, accounting, and other matters, and is subject to the jurisdiction of the Council with respect to such matters within Algiers. MP&L is subject to regulation as to service, service areas, facilities, and retail rates by the MPSC. MP&L is also subject to regulation by the APSC as to the certificate of environmental compatibility and public need for the Independence Station. NOPSI is subject to regulation as to electric and gas service, rates and charges, standards of service, depreciation, accounting, issuance of certain securities, and other matters by the Council. Franchises. AP&L holds franchises to provide electric service in 301 incorporated cities and towns in Arkansas, all of which are unlimited in duration and terminable by either party. GSU holds non-exclusive franchises, permits, or certificates of convenience and necessity to provide electric and gas service in 55 incorporated villages, cities, and towns in Louisiana and 64 incorporated cities and towns in Texas. GSU ordinarily holds 50-year franchises in Texas towns and 60-year franchises in Louisiana towns. The present terms of GSU's electric franchises will expire in the years 2007-2036 in Texas and in the years 2015-2046 in Louisiana. The natural gas franchise in the City of Baton Rouge will expire in the year 2015. LP&L holds franchises to provide electric service in 116 incorporated villages, cities, and towns. Most of these franchises have 25-year terms expiring during the period 1995-2015. However, six of these municipalities have granted 60-year franchises, with the last one expiring in the year 2040. Of these franchises, none has expired to date, one is scheduled to expire as early as 1995, and 37 are scheduled to expire by year-end 2000. LP&L also supplies electric service in 353 unincorporated communities, all of which are located in parishes (counties) from which LP&L holds franchises to serve the areas in which the unincorporated communities are located. MP&L has received from the MPSC certificates of public convenience and necessity to provide electric service to the areas of Mississippi that MP&L serves, which include a number of municipalities. MP&L continues to serve in such municipalities upon payment of a statutory franchise fee, regardless of whether an original municipal franchise is still in existence. NOPSI provides electric and gas service in the City of New Orleans pursuant to city ordinances, which state, among other things, that the City has a continuing option to purchase NOPSI's electric and gas utility properties. System Energy has no franchises from any municipality or state. Its business is currently limited to wholesale sales of power. Environmental Regulation General. In the areas of air quality, water quality, control of toxic substances and hazardous and solid wastes, and other environmental matters, the System operating companies, System Energy, Entergy Power, and Entergy Operations are subject to regulation by various federal, state, and local authorities. Each of the Entergy companies considers itself to be in substantial compliance with those environmental regulations currently applicable to its business and operations. Entergy has incurred increased costs of construction and other increased costs in meeting environmental protection standards. Because environmental regulations are continually changing, the ultimate compliance costs to Entergy cannot be precisely estimated at any one time. However, Entergy currently estimates that its potential capital expenditures for environmental control purposes, including those discussed in "Clean Air Legislation," below, will not be material for the System as a whole. Clean Air Legislation. The Clean Air Act Amendments of 1990 (the Act) place limits on emissions of sulfur dioxide and nitrogen oxide from fossil-fueled generating plants. Entergy has evaluated the Act to determine the impact on the System's overall cost of emission control and monitoring equipment. Based upon such evaluation in connection with existing generating facilities, the System has determined that no additional control equipment will be required to control sulfur dioxide. In the area served by GSU, control equipment will be required for nitrogen oxide reductions due to the ozone nonattainment status of the Baton Rouge, Louisiana and Beaumont and Houston, Texas air quality control regions no later than May 1995. The cost of such control equipment is estimated at $16.0 million. The remainder of the System may be required to install nitrogen oxide emission controls on its coal units by the year 2000. The EPA is currently drafting rules that will determine the levels of nitrogen oxide emissions that will be allowed by affected units. Under the latest EPA-proposed regulations on nitrogen oxide, Entergy would not have to install additional controls. It is not possible to determine at this time if the final regulations promulgated by EPA would require the System's coal units to install nitrogen oxide emission controls. Should additional controls be required, the overall cost would vary depending on the eventual emission levels that are set. In addition, the System will be required to install additional continuous emission monitoring equipment at its coal units to comply with final EPA regulations. It is estimated that the continuous emission monitoring systems could cost as much as $1.0 million for all of the coal units. Final EPA regulations established the acceptable continuous monitoring methods, as well as alternative monitoring methods, that make it possible to determine the compliance of the units with respect to emission levels through fuel sampling and other estimation methods. Capital expenditures of approximately $11.0 million are estimated for continuous emission monitoring systems at the other fossil-fueled units. The authority to impose permit fees has been delegated to the states by EPA and, depending on the extent of the state program and the fees imposed by each state regulatory authority, permit fees for the System could range from $1.6 to $5.0 million annually. There are several other areas, such as air toxins and visibility, that will require regulatory study and rule promulgation to determine whether pollution control equipment is necessary. Regarding sulfur dioxide emissions, the Act provides "allowances" to most Entergy units based upon past emission levels and operating characteristics. Each unit of allowance is an entitlement to emit one ton of sulfur dioxide per year. Under the Act, utilities will be required to possess allowances for sulfur dioxide emissions from affected units. Based on Entergy's past operating history, it is considered a "clean" utility and as such will receive more allowances than are currently necessary for normal operations. The System believes that it will be able to operate its units efficiently without installing scrubbers or purchasing allowances from outside sources, and the System may have excess allowances available for sale to other utilities. Entergy currently estimates that total capital costs of approximately $39.4 million could be required to comply with the Act. These estimated costs for each legal entity are as follows: Nitrogen Continuous Company Oxide Emissions Control Monitors Total ---------------------- -------- ---------- ----- (In Thousands) AP&L $ 7,275 $ 3,300 $10,575 GSU 16,000 4,900 20,900 LP&L - 2,300 2,300 MP&L 2,500 1,500 4,000 NOPSI - - - System Energy - - - Entergy Power 1,575 - 1,575 ------- ------- ------- Total Entergy System $27,350 $12,000 $39,350 ======= ======= ======= Other Environmental Matters. The provisions of the Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended (Superfund), among other things, authorize the EPA and, indirectly, the states to require the generators and certain transporters of certain hazardous substances released from or at a site, and the owners or operators of such site, to clean up the site or reimburse the costs therefor. This statute has been interpreted to impose joint and several liability on responsible parties. In compliance with applicable laws and regulations at the time, the System operating companies have sent waste materials to various disposal sites over the years. Also, past operating procedures and maintenance practices, which were not subject to regulation at that time, are now regulated by various environmental laws. Some of these sites have been the subject of governmental action, thereby causing one or more of the System operating companies to be involved with site cleanup activities. The System operating companies have participated to various degrees in accordance with their potential liability with these site cleanups and have, therefore, developed experience with cleanup costs. Their experience in these matters, and their judgments related thereto, are utilized by them in evaluating these sites. In addition, the System operating companies have established reserves for environmental clean-up/restoration activities. AP&L. AP&L has received notices from time to time between 1989 and 1993, from the EPA, the Arkansas Department of Pollution Control and Ecology (ADPC&E), and others that it (among numerous others, including various utilities, municipalities and other governmental units, and major corporations) may be a PRP for cleanup costs associated with various sites in Arkansas. Most of these sites are neither owned nor operated by any System company. Contaminants at the sites include principally polychlorinated biphenyls (PCB's), lead, and other hazardous wastes. These sites and others are described below. AP&L received notices from the EPA and ADPC&E in 1990 and 1991, identifying it as one of 30 PRP's (along with LP&L and GSU) at two Saline County sites in Arkansas. Both sites are believed to be contaminated with PCB's and lead. Cleanup costs for both sites are estimated at $6.0 million, with AP&L's total share of the costs being estimated at approximately $2.0 million. AP&L to date has expended approximately $1.0 million for remediation at one of these sites. The total liability cannot be precisely determined until remediation is complete at both sites. AP&L believes its potential liability for these sites will not be material. Reynolds Metals Company (RMC) and AP&L notified the EPA in 1989, of possible PCB contamination at two former RMC plant sites in Arkansas to which AP&L had supplied power. AP&L completed remediation at the substations serving the plant sites at a cost of $1.7 million. Additional PCB contamination was found in a portion of a drainage ditch that flows from the RMC's Patterson facility to the Ouachita River. RMC has demanded that AP&L participate in the remediation efforts with respect to the ditch. AP&L and independent contractors engaged by AP&L conducted an investigation of the ditch contamination and the potential migration of PCB's from the electrical equipment that AP&L maintained at the plant. The investigation concluded that little, if any, of the contamination was caused by AP&L. AP&L's expenditures thus far on the ditch have been approximately $150,000. It is AP&L's understanding that RMC has spent approximately $10.0 million to complete remediation of the ditch contamination. AP&L has not received a notice from the EPA that it may be a PRP with respect to remediation costs for this site. However, RMC is seeking reimbursement of $5.0 million (50% of expenditures) from AP&L. AP&L continues to deny responsibility for any of such remediation costs and believes that its potential liability, if any, for this site will not be material. AP&L entered into a Consent Administrative Order dated February 21, 1991, with the ADPC&E that named AP&L as a PRP for cleanup of contamination associated with the Utilities Services, Inc. state Superfund site located near Rison, Arkansas. Such site was found to have soil contaminated by PCB's and pentachlorophenol (a wood preservative chemical). Also, containers and drums that contained PCB's and other hazardous substances were found at the site. AP&L's share of total remediation costs are estimated to range between $3.0 million and $5.0 million. AP&L is attempting to identify and notify other PRP's. AP&L has received assurances from the ADPC&E that it will use its enforcement authority to allocate remediation expenses among AP&L and any other PRP's that can be identified (approximately 30 - 35 have been identified to date). AP&L has performed the activities necessary to stabilize the site, which to date has cost approximately $114,000. AP&L believes that its potential liability for this site will not be material. AP&L received Notice of Potential Liability and a Demand for Payment in November 1992 from the EPA in conjunction with a contaminated site in Union County, Arkansas. AP&L was identified as one of eleven PRP's, which also include LP&L. The EPA has already completed cleanup of the site. An agreement has been negotiated with the EPA which determined AP&L to be a de minimis party with total liability of approximately $47,000. As a result of an internal investigation, AP&L has discovered soil contamination at two AP&L-owned sites located in Blytheville, Arkansas and Pine Bluff, Arkansas. The contamination appears to be a result of past operating procedures that were performed prior to any applicable environmental regulation. AP&L is still investigating these sites to determine the full extent of the contamination. Until the investigations are complete, AP&L cannot estimate the liabilities associated with these sites. However, AP&L believes its potential liability for both of the sites should not be material. For all of these sites and for certain sites in which remediation has been completed, AP&L has expended approximately $3.2 million for cleanup costs since 1989. GSU. GSU has been notified by the EPA that it has been designated as a PRP for the cleanup of sites on which GSU and others have, or have been alleged to have, disposed of hazardous materials. GSU is currently negotiating with the EPA and various state authorities regarding the cleanup of some of these sites. Several class action and other suits have been filed seeking relief from GSU and others for damages caused by the disposal of hazardous waste and for asbestos-related disease that allegedly occurred from exposure on GSU premises or on premises on which GSU allegedly disposed of materials (see "Other Regulation and Litigation - GSU," below). While the amounts at issue in the cleanup efforts and suits may be very substantial sums, management believes that its financial condition and results of operations will not be materially affected by the outcome of the suits. These environmental liabilities are described below. In 1971, GSU purchased certain property near its Sabine generating station for possible cooling water capability expansion. Although it was not known to GSU at the time of the purchase, the property was utilized by area industries in the 1950's and 1960's as an industrial waste dump. GSU sold the property in 1984. In October 1984 the abandoned waste site on the property was included on the Superfund National Priorities List (NPL) by the EPA. The EPA has indicated that it believes GSU to be a PRP for cleanup of the site based on its past ownership. GSU has advised the EPA that it does not believe that it has such responsibility. GSU has pursued negotiations with the EPA and is a member of a task force made up of other PRP's for the voluntary cleanup of the waste site. A Consent Decree has been signed by all parties. Because additional wastes have been discovered at the site since the original cleanup costs were estimated, the total costs for the voluntary cleanup are unknown. However, it is estimated that cleanup will exceed $15.0 million. GSU has negotiated a responsible share of 2.26% of the estimated cleanup cost. Federal and state agencies are presently examining potential liabilities associated with natural resource damages. This matter is currently under negotiation with the other PRP's and the agencies. Remediation of the site is expected to be completed in 1996. In March 1993, GSU completed its cleanup activities at a site in Houston, Texas, which is included in the NPL. On September 20, 1993, GSU received formal notification from the EPA of its acceptance of the remedial activities conducted at the site. Currently, other parties are conducting cleanup activities at the site. However, these cleanup activities are unrelated to GSU's involvement at the site. Through 1993, GSU incurred cleanup costs of approximately $3.3 million. Pursuant to the Consent Decree, GSU is responsible for oversight costs incurred by the EPA. GSU has not received a reimbursement request for outstanding oversight costs, but anticipates these costs may total between $250,000 and $500,000. GSU is pursuing contribution for the cleanup costs at the site from other parties believed to be potentially responsible. GSU is currently involved in a multi-phased remedial investigation of an abandoned manufactured gas plant (MGP) site located in Lake Charles, Louisiana. The property was the site of an MGP that is believed to have operated during the period from approximately 1916 to 1931. Coal tar, a by-product of the distillation process, was apparently routed to a portion of the property for disposal. Since GSU purchased the property in 1926, the same area has been filled with soil and used as a landfill for miscellaneous items including electrical poles, electrical equipment, and other debris. Under an Order by the Louisiana Department of Environmental Quality (LDEQ), which is currently stayed, GSU was required to investigate and, if necessary, take remedial action at the site. The EPA has notified GSU that it is performing an independent review and ranking of the site to determine whether the site should be listed on the NPL. Another PRP has been identified and is believed to have had a role in the ownership and operation of the MGP. Negotiations with that company for joint participation and any remedial action are expected to continue. GSU currently is awaiting notification from the EPA before initiating additional cleanup negotiations or actions. While studies to determine the location of the coal tar have been conducted, the cleanup costs of the site are unknown. GSU does not presently believe that its ultimate responsibility with respect to this site will be material. GSU has also been advised that it has been named as a PRP, along with a number of other companies (including LP&L), for an abandoned waste oil recycling plant site in Livingston Parish, Louisiana, which is included on the NPL. Although significant remediation has been completed, additional studies are expected to continue in 1994. GSU and LP&L have been named as defendants in a class action lawsuit lodged against a group of PRP's associated with the site. (For information regarding litigation in connection with the Livingston Parish site, see "Other Regulation and Litigation - GSU," below.) GSU does not presently believe that its ultimate responsibility with respect to this site will be material. GSU received notification in 1992 from the EPA of potential liability at a site located in Iota, Louisiana. This site accepted a variety of wastes, including medical and chemical wastes. In addition to GSU, over 200 parties have been named as PRP's. The EPA is continuing its investigation of the site and has notified the PRP's of the possibility of this site being linked to another site. To date, GSU has not received notification of liability with regard to the other site. GSU does not presently believe its ultimate responsibility with respect to this site will be material. GSU has also been notified by the EPA of potential liability at two sites located in Saline County, Arkansas. It is believed that both sites served as a salvaging facility for transformers and batteries. In addition to GSU, 32 other parties (including AP&L and LP&L) have been named as PRP's. At this time, GSU's involvement with the site is unknown. GSU does not presently believe that its ultimate responsibility with respect to this site will be material. In November 1993, GSU received informal notification from the Rhode Island Department of Environmental Management regarding a site at which electrical capacitors had been located. The State traced several of these capacitors to GSU. GSU records indicate these capacitors were returned under warranty to the manufacturer in the 1960's due to defects. GSU does not presently believe it is responsible for any alleged activities occurring at this site. As of December 31, 1993, GSU had expended $7.0 million toward the cleanup of such sites. In 1990, GSU received an order from the LDEQ to reduce emissions of nitrogen oxides and reactive hydrocarbons at its Willow Glen and Louisiana Station plants located near Baton Rouge, Louisiana. GSU has requested an adjudicatory hearing on the matter, which the LDEQ secretary has deemed as staying the order. In the interim, GSU has joined several other Baton Rouge industries to develop and submit to LDEQ a comprehensive set of short- and long-range reduction plans. In 1993, LDEQ adopted regulations requiring permanent reductions in nitrogen oxides emissions at Willow Glen and Louisiana Station and is considering requirements for further reductions. The estimates for actions necessary to comply with these regulations are included in the discussion under "Clean Air Legislation," above. GSU believes these regulations implement the intent of the 1990 order, and actions beyond those required by the regulations will not be required. LP&L and NOPSI. LP&L and NOPSI have received notices from time to time between 1986 and 1993 from the EPA and/or the states of Louisiana and Mississippi that each or either of the companies may be a PRP for cleanup costs associated with disposal sites that are currently in various stages of remediation in Arkansas, Illinois, Louisiana, Mississippi, and Missouri that are neither owned nor operated by any System company. As to one Missouri site, LP&L's and NOPSI's aggregate liability is currently estimated not to exceed $558,000, and because of the type and the large number of PRP's (over 700, including many large utilities and national and international corporations), LP&L and NOPSI do not expect liabilities in excess of this amount. For the other Missouri site, LP&L and the other 64 PRP's (including several large, creditworthy utility companies) have received an EPA demand to pay approximately $1.2 million expended by the EPA. In June of 1993, LP&L paid $12,392 in full payment of its share of the cleanup costs. LP&L considers cleanup at this site to be complete. As to the two Saline County, Arkansas sites (involving AP&L, GSU, and LP&L), LP&L has been advised that current estimates for total cleanup are approximately $6.0 million. LP&L believes that, because of the number and nature of the PRP's, its exposure for these sites will not be material. Initial indications are that LP&L was involved in the Saline sites, but LP&L believes that because of the limited scope of its involvement and the number and nature of PRP's, its exposure for these sites will not be material. LP&L received notice from the EPA in November 1992, that it (along with AP&L) was involved in the Union County, Arkansas site. An agreement has been negotiated with the EPA that determined LP&L to be a de minimis party with a total liability of approximately $47,000 (see "AP&L," above.) As to the Mississippi site, LP&L (along with System Energy) understands that EPA has expended approximately $740,000 for this site (three separate locations being treated administratively as one). The State of Mississippi has indicated it intends to have PRP's conduct a cleanup of the site but has not yet taken formal action. LP&L has expended $22,300 to settle with the EPA for its costs for this site and, because there are 44 PRP's for this site (including a number of major oil companies), does not expect its share of future costs to be material. For a Livingston Parish, Louisiana site (involving at least 70 PRP's, including GSU and many other large and creditworthy corporations), LP&L has found in its records no evidence of its involvement. (For information regarding litigation in connection with the Livingston Parish site, see "Other Regulation and Litigation - LP&L," below.) At a second Louisiana site (also included on the NPL and involving 57 PRP's, including a number of major corporations), NOPSI believes it has no liability for the site because the material it sent to the site was not a hazardous substance. For the Illinois site, NOPSI, upon its review of the site documentation and of its own records, has asserted to the EPA that it has no involvement in this site. However, NOPSI is participating with other PRP's (including many large and creditworthy corporations) as a prudent means of resolving potential liability, if any. For all these sites, LP&L has expended approximately $349,000 and NOPSI has expended approximately $172,000 for cleanup costs (commencing in 1986) to date. During 1993, LP&L performed preliminary site assessments at the locations of two retired power plants previously owned and operated by two Louisiana municipalities. LP&L had purchased the power plants by agreement (as part of the municipal electric systems) after operating them for the last few years of their useful lives. The assessments indicated some subsurface contamination from fuel oil. LP&L and the LDEQ are now reviewing site remediation procedures that LP&L estimates will not exceed $650,000 in the aggregate. During 1993, the LDEQ issued new rules for solid waste regulation, including waste water impoundments. LP&L has determined that certain of its power plant waste water impoundments are affected by these regulations and has chosen to close them rather than retrofit and permit them. The aggregate cost of the impoundment closures, to be completed by 1996, is estimated to be $7.3 million. System Energy. In February 1990, System Energy received an EPA notice that it (among numerous other companies) may be a PRP for cleanup costs associated with the same site in Mississippi in which LP&L is involved. Potential liability is based on the alleged shipment of waste oil to the site from 1981 to 1985. System Energy does not expect its share of the total expenditures to be material because there are 44 PRP's for this site, including a number of major oil companies. Other Regulation and Litigation Entergy Corporation and GSU. In July and August 1992, Entergy Corporation and GSU filed applications with FERC, the LPSC, and the PUCT, and Entergy Corporation, Entergy Operations, and Entergy Services filed an application with the SEC under the Holding Company Act, seeking authorization of various aspects of the Merger. In January 1993, GSU filed two applications with the NRC seeking approval of the change in ownership of GSU and an amendment to the operating license for River Bend to reflect its operation by Entergy Operations. All regulatory approvals were obtained in 1993 and the Merger was consummated on December 31, 1993 (see "Business of Entergy - Entergy Corporation-GSU Merger," above, for further information). Requests for rehearing of certain aspects of the FERC order were filed on January 14, 1994, by 14 parties, including Entergy Corporation, the APSC, the Mississippi Attorney General, the LPSC, the MPSC, the Texas Office of Public Utility Counsel, and the PUCT. Entergy Corporation, the LPSC, the Texas Office of Public Utility Counsel, and the PUCT are requesting FERC to restore a 40% cap on the amount of fuel savings GSU may be required to transfer to other Entergy operating companies under a tracking mechanism designed to protect the other companies from certain unexpected increases in fuel costs. The other parties are seeking to overturn FERC's decision on various grounds. Requests for rehearing of the SEC order were filed with the SEC by Houston Industries Incorporated and Houston Lighting & Power Company on December 28, 1993, and petitions for review seeking to set aside the SEC order were filed with the D.C. Circuit by these parties on February 15, 1994 and by Cajun on February 14, 1994. See "Nuclear Operations - River Bend," above for information on challenges to the NRC's approval of GSU's applications. Appeals seeking to set aside the LPSC order related to the Merger were filed in the 19th Judicial District Court for the Parish of East Baton Rouge, Louisiana, by Houston Lighting & Power Company on August 13, 1993, and by the Alliance for Affordable Energy, Inc. on August 20, 1993. Subsequently, on February 9, 1994, Houston Lighting & Power Company filed a motion voluntarily dismissing its appeal. AP&L. Three lawsuits (which have been consolidated) were filed in the Arkansas District Court by numerous plaintiffs against AP&L and Entergy Services in connection with the operation of two dams during a period of heavy rainfall and flooding in May 1990. The consolidated lawsuits sought approximately $14.4 million in property losses and other compensatory damages, and $500 million in punitive damages. In their responses to these complaints, AP&L and Entergy Services asserted, among other things, that AP&L owns flowage easements giving it the permanent right to inundate the lands owned or occupied by the plaintiffs in connection with the operation of the dams. In June 1991, the Arkansas District Court granted summary judgment to AP&L with respect to the enforceability of its flowage easements. In November 1991, the Arkansas District Court ruled that Entergy Services was entitled to the benefit of AP&L's flowage easements, in effect, removing from consideration damages in the approximate amount of $13.5 million alleged to have occurred within the areas covered by the easements. As a result, over 300 plaintiffs claiming damage within the easements were dismissed from the consolidated case in December 1991. Certain plaintiffs appealed these orders to the Eighth Circuit, which appeal was denied in March 1992. Following the Eighth Circuit's denial of their interlocutory appeal from the Arkansas District Court's orders, certain of the plaintiffs, without prejudice to their right to refile, voluntarily dismissed their claims which had not been disposed of in the Arkansas District Court's orders, thus making the orders a final adjudication, and appealed these orders to the Eighth Circuit. The remaining plaintiffs obtained a stay and an administrative termination of their claims, pending the outcome of the appeal. In December 1993, a three-judge panel of the Eighth Circuit filed its opinion affirming the judgment of the Arkansas District Court and entered judgment accordingly. The plaintiffs appealing the Arkansas District Court's orders filed petitions with the Eighth Circuit for a rehearing by the entire Court sitting en banc, which petitions were denied. The plaintiffs may petition the U.S. Supreme Court to issue a writ of certiorari to permit its review of the Eighth Circuit's decisions. Neither AP&L nor Entergy Services can predict whether the U.S. Supreme Court will grant such a petition, if one is filed. GSU. Between 1986 and 1993, GSU and approximately 70 other defendants, including many national and international corporations, including LP&L, have been sued in 17 suits in the Livingston Parish, Louisiana District Court (State District Court) by a number of plaintiffs who allegedly suffered damage or injury, or are survivors of persons who allegedly died, as a result of exposure to "hazardous toxic waste" that emanated from a site in Livingston Parish. The plaintiffs alleged that the defendants generated, transported, or participated in the storage of such wastes at the facility, which was previously operated as a waste oil recycling facility. These State District Court suits, which seek damages in total amounts ranging from $1.0 million to $10.0 billion and are now consolidated in a class action, and three federal suits in three states other than Louisiana involving issues arising from the same facility, have been removed and transferred, respectively, to the U.S. District Court for the Middle District of Louisiana (Federal District Court). Motions to remand the class action to the State District Court have been filed, and procedural issues regarding the federal suits are being considered as well. It is not known what effect any action taken on these motions and issues, whenever taken by the Federal District Court, would have on the April 11, 1994 State District Court trial date that was established before the suits were removed to Federal District Court; but it is unlikely such trial date will be met. The matter is pending. In October 1989, an amended lawsuit petition was filed on behalf of 985 plaintiffs in the District Court of Jefferson County, Texas, 60th Judicial District in Beaumont, Texas, naming 55 defendants including GSU. In February 1990, another amended lawsuit petition was filed in a different state District Court in Jefferson County, Texas, on behalf of over 200 plaintiffs (subsequently amended to include a total of 660) naming 127 defendants including GSU. Possibly 300 to 400 or more of the plaintiffs in Texas may have worked at GSU's premises. At least five other individual suits have been filed in Beaumont against GSU and others, seeking damages for alleged asbestos exposure. All of the plaintiffs in such suits are also suing GSU and all other defendants on a conspiracy count. There are 25 asbestos- related law suits filed in the 14th Judicial District Court of Calcasieu Parish in Lake Charles, Louisiana, on behalf of an aggregate of 53 plaintiffs naming from 16 to 24 defendants including GSU, and GSU is aware of as many as 61 additional cases that may be filed. The suits allege that each plaintiff contracted an asbestos-related disease from exposure to asbestos insulation products on the premises of such defendants. Management believes that GSU has meritorious defenses, but there can be no assurance as to the outcome of these cases or that additional claims may not be asserted. In asbestos- related suits against the manufacturers, very substantial recoveries have been achieved by large groups of claimants. GSU does not presently believe that the ultimate resolution of these cases will materially adversely affect the financial position of GSU. On February 3, 1984, Dow Chemical Company filed a request with the LPSC for a hearing to consider issues related to the purchase of cogenerated power by GSU. Other industries subsequently filed similar requests and the matters were consolidated. In November 1984, the LPSC completed hearings on rules, policies, and pricing methodologies applicable to cogeneration. Key issues were whether or not (1) GSU should be required to pay the industries for avoided capacity costs, and (2) GSU should be required to wheel power to or from the industrial plants. While the matter is still pending before the LPSC, the LPSC did set interim rates, subject to refund by either Dow or GSU, which exclude capacity costs. GSU has significant business relationships with Cajun, primarily co-ownership of River Bend and Big Cajun 2 Unit 3. GSU and Cajun own 70% and 30% of River Bend, respectively, while Big Cajun 2 Unit 3 is owned 42% and 58% by GSU and Cajun, respectively. GSU operates River Bend and Cajun operates Big Cajun 2 Unit 3. GSU was requested by Cajun and Jefferson Davis Electric Cooperative, Inc., (Jefferson Davis) to provide transmission of power over GSU's system for delivery to the Industrial Road area near Lake Charles, Louisiana. GSU provides electric service to industrial and other customers in such area, and Cajun and Jefferson Davis do not. On October 10, 1989, Cajun filed a complaint at FERC contending that GSU wrongfully refused to provide Cajun certain transmission services so that its member, Jefferson Davis, could provide service to certain industrial customers, and it requested FERC to order GSU to provide the service. On October 26, 1989, FERC summarily dismissed Cajun's complaint, but the D.C. Circuit reversed FERC's summary determination and remanded the case to FERC for a hearing. On June 24, 1992, after a hearing, an ALJ issued an Initial Decision, again dismissing Cajun's complaint. The ALJ found that the parties' contract did not require GSU to provide the service and that Cajun's member, Jefferson Davis, had not sought permission from the LPSC to serve the end-use customers in question. If Jefferson Davis secured permission from the LPSC, the ALJ believed (but did not decide) that FERC would require GSU to provide the requested transmission service. Both Cajun and GSU have filed exceptions to the ALJ's decision, and the matter is pending before FERC. Cajun and Jefferson Davis also brought a related action in federal court in the Western District of Louisiana alleging that GSU breached its obligations under the parties' contract and violated the antitrust laws by refusing to provide the transmission service described above. Cajun and Jefferson Davis seek an injunction requiring GSU to provide the requested service and unspecified treble damages for GSU's refusal to provide the service. On November 9, 1989, the district court judge denied Cajun's and Jefferson Davis' motion for a preliminary injunction. On May 3, 1991, the judge stayed the proceeding pending final resolution of the matters still pending before FERC. GSU and Cajun are parties to FERC proceedings regarding certain long-standing disputes relating to transmission service charges. Cajun asserts that GSU has improperly applied the terms of a rate schedule, Service Schedule CTOC, to its billings to Cajun and it seeks an order from FERC directing GSU to recompute the bills. GSU asserts that Cajun underpaid its bills, and it seeks an order directing Cajun to pay surcharges to make up the underpayments. On April 10, 1992, FERC issued an order affirming in part and reversing in part an ALJ's recommendations. Both GSU and Cajun have requested rehearing, and the requests are still pending. In addition, on August 25, 1993, the United States Court of Appeals for the Fifth Circuit reversed portions of FERC's order previously decided adversely to GSU, and remanded the case to FERC for further proceedings. On January 13, 1994, FERC rejected GSU's proposal to collect an interim surcharge while FERC considers the court's remand. GSU interprets FERC's 1992 order and the Court of Appeals decision to mean that Cajun owes GSU approximately $85 million through December 31, 1993. If GSU also prevails on all of the issues raised in its pending request for rehearing of FERC's earlier orders, then GSU estimates that Cajun would owe GSU approximately $118 million through December 31, 1993. If GSU does not prevail on its rehearing request, and Cajun prevails on its rehearing request, and if FERC rejects the modifications GSU interprets the court of appeals to have directed, then GSU would owe Cajun an estimated $76 million through December 31, 1993. Pending FERC's ruling on the May 1992 motions for rehearing, GSU has continued to bill Cajun utilizing the historical billing methodology and has booked underpaid transmission charges, including interest, in the amount of $140.8 million as of December 31, 1993. This amount is reflected in long-term receivables and in other deferred credits, with no effect on net income. On December 7, 1993, Cajun filed a complaint in the Middle District of Louisiana alleging that GSU failed to provide Cajun an opportunity to construct certain facilities that allegedly would have reduced its rates under Service Schedule CTOC, and Cajun seeks an order compelling the conveyance of certain facilities and unspecified damages. GSU has moved to dismiss the complaint on the basis, among others, that FERC has already addressed the matter in the proceedings described above. In May 1990, GSU received a subpoena from the Office of Inspector General - Investigations, United States Department of Agriculture, seeking production of documents relating to the construction costs of River Bend. Such office is authorized to investigate matters relating to programs of the Department of Agriculture. GSU has been sued by Cajun with respect to its participation in River Bend with funds made available through Department programs administered by the REA. GSU has failed in its efforts to have the REA made a party to the Cajun litigation. GSU does not know the purpose of such Office's investigation, but presently assumes that it relates to the Cajun civil litigation since the production of documents sought by such Office is similar to that sought by Cajun in its action against GSU. However, there can be no assurance given by GSU as to the real purpose of such Office's investigation. Among other areas of responsibility, such office is authorized to investigate possible violations of law. GSU believes the subpoena proceeding has been administratively dismissed without prejudice to the parties. On December 2, 1991, Cajun filed a complaint seeking declaratory and injunctive relief from the U. S. District Court for the Middle District of Louisiana. The complaint concerns GSU's position that Cajun is in default with respect to paying its share of certain expenditures to repair corrosion damage in the service water system, to repair a feedwater nozzle crack, and to repair a turbine rotor. Cajun alleges that it has no obligation to pay its share of such costs and seeks a declaration that it may elect not to participate in the funding of such costs and enjoining GSU from demanding payment therefor or attempting to implement default provisions in the Operating Agreement with respect thereto. Cajun alleges that if it is required to pay its share of such costs it would be forced to default on other obligations and would be forced to seek relief in bankruptcy. GSU believes that Cajun is in default under the provisions of the Operating Agreement. No assurance can be given as to the outcome or timing of this action brought by Cajun. On November 25, 1992, Dixie Electric Membership Corporation and Southwest Louisiana Electric Membership Corporation, both members of Cajun, filed suit in the U.S. District Court for the Western District of Louisiana seeking a declaration that the River Bend Joint Ownership Agreement between GSU and Cajun is void because an allegedly required approval of the LPSC was not obtained. This suit has been transferred from the Western District to the Middle District, and is being processed in conjunction with the suit described in the following paragraph. GSU believes the suit is without merit. In June 1989, Cajun filed a civil action against GSU in the U. S. District Court for the Middle District of Louisiana. Cajun stated in its complaint that the object of the suit is to annul, rescind, terminate, and/or dissolve the Joint Ownership Participation and Operating Agreement entered into on August 28, 1979 (Operating Agreement), related to River Bend. Cajun alleges fraud and error by GSU, breach of its fiduciary duties owed to Cajun, and/or GSU's repudiation, renunciation, abandonment, or dissolution of its core obligations under the Operating Agreement, as well as the lack or failure of cause and/or consideration for Cajun's performance under the Operating Agreement. The suit seeks to recover Cajun's alleged $1.6 billion investment in the unit as damages, plus attorneys' fees, interest, and costs. In March 1992, the district court appointed a mediator to engage in settlement discussions and to schedule settlement conferences between the parties. Discussions with the mediator began in July 1992, however, GSU cannot predict what effect, if any, such discussions will have on the timing or outcome of the case. A trial without a jury is set for April 12, 1994, on the portion of the suit by Cajun to rescind the Operating Agreement. GSU believes the suits are without merit and is contesting them vigorously. No assurance can be given as to the outcome of this litigation. If GSU were ultimately unsuccessful in this litigation and were required to make substantial payments, GSU would probably be unable to make such payments and would probably have to seek relief from its creditors under the Bankruptcy Code. See Note 12 of GSU's Notes to Financial Statements, "Entergy Corporation-GSU Merger," for the accounting treatment of preacquisition contingencies, including a charge resulting from an adverse resolution of the litigation with Cajun related to River Bend. In July 1992, Cajun notified GSU that it would fund a limited amount of costs related to the fourth refueling outage at River Bend, completed in September 1992. Cajun has also not funded its share of the costs associated with certain additional repairs and improvements at River Bend completed during the refueling outage. GSU has paid the costs associated with such repairs and improvements without waiving any rights against Cajun. GSU believes that Cajun is obligated to pay its share of such costs under the terms of the applicable contract. Cajun has filed a suit seeking a declaration that it does not owe such funds and seeking injunctive relief against GSU. GSU is contesting such suit and is reviewing its available legal remedies. In September 1992, GSU received a letter from Cajun alleging that the operating and maintenance costs for River Bend are "far in excess of industry averages" and that "it would be imprudent for Cajun to fund these excessive costs." Cajun further stated that until it is satisfied it would fund a maximum of $700,000 per week under protest for the remainder of 1992. In a December 1992 letter, Cajun stated that it would also withhold costs associated with certain additional repairs, of which the majority will be incurred during the next refueling outage, currently scheduled for April 1994. GSU believes that Cajun's allegations are without merit and is considering its legal and other remedies available with respect to the underpayments by Cajun. The total resulting from Cajun's failure to fund repair projects, Cajun's funding limitation on the fourth refueling outage, and the weekly funding limitation by Cajun was $33.3 million as of December 31, 1993, compared with a $28.4 million unfunded balance as of December 31, 1992. During 1994, and for the next several years, it is expected that Cajun's share of River Bend-related costs will be in the range of $60 million to $70 million per year. Cajun's weak financial condition could have a material adverse effect on GSU, including a possible NRC action with respect to the operation of River Bend and a need to bear additional costs associated with the co-owned facilities. If GSU were required to fund Cajun's share of costs, there can be no assurance that such payments could be recovered. Cajun's weak financial condition could also affect the ultimate collectibility of amounts owed to GSU. Since 1986, GSU had been in litigation with the Southern Company regarding unit power and long-term power purchase contracts with the Southern Company. GSU entered into a settlement agreement dated December 21, 1990, which was consummated on November 7, 1991, and the settlement obligations were fully satisfied in 1993. In 1986, the PUCT and the LPSC disallowed the pass-through by GSU in its retail rates of the costs of the capacity purchases from the Southern Company, which were being incurred by GSU. GSU appealed the actions of the PUCT and the LPSC disallowing pass-through of Southern Company capacity charges to the appropriate state courts. The appeal from the LPSC is pending. As part of a settlement of a retail rate case in Texas during the fourth quarter of 1993, GSU has discontinued its appeal of the PUCT disallowance. Following the announcement of the execution of the Reorganization Agreement, a purported class action complaint was filed on June 9, 1992, in the District Court 60th Judicial District in Jefferson County, Texas (District Court) against GSU and its directors relating to the then proposed business combination with Entergy Corporation. On June 11, 1992, two additional purported class action complaints were filed against such defendants in the District Court. All three of the complaints (the Shareholder Actions) were filed by persons alleged to be shareholders of GSU and seeking declaration of a class action on behalf of all persons owning common stock of GSU. GSU has executed a Memorandum of Understanding with counsel for the plaintiffs in these suits agreeing in principle to settle such actions subject to execution of an appropriate stipulation of settlement, approval by the court, and certain other conditions. In the Memorandum, the defendants have denied any actionable acts or omissions and state that they have entered into the Memorandum solely to eliminate the burden and expense of further litigation and to facilitate the consummation of the business combination. The Memorandum memorialized certain agreements by GSU and Entergy Corporation for the benefit of shareholders principally in the event the business combination were not consummated, including a covenant to consider reinstitution of dividends on the common stock of GSU in such event. The business combination was consummated on December 31, 1993. Incident to the settlement, the defendants agreed not to oppose an application for attorneys' fees by plaintiffs' counsel that do not exceed $500,000 or for an award of expenses not to exceed $50,000. The individual directors named as defendants in these complaints are entitled to indemnification pursuant to GSU's Restated Articles of Incorporation, By-laws, and individual indemnity agreements, provided that the terms and conditions of the indemnities are satisfied. LP&L. For information regarding litigation in connection with an abandoned waste oil recycling plant site in Livingston Parish, Louisiana, in which LP&L and GSU are defendants, see "GSU," above. LP&L does not believe that it was a generator of any material delivered to this facility and is defending vigorously against the claims in these suits. Since the mid-1980's, LP&L and the tax authorities of St. Charles Parish, Louisiana (Parish), in which Parish Waterford 3 is located, have disputed use taxes paid on nuclear fuel ($4.9 million through 1989) under protest by LP&L. LP&L has been successful in a lawsuit in the Parish with regard to recovering these taxes, plus interest, and also with regard to Parish lease tax issues pertaining to fuel financing arrangements. On the grounds of the previous favorable court decisions, LP&L continues to challenge in the courts additional use tax assessments that it has paid to the Parish and to seek additional interest that LP&L claims it is due. Also, in early procedural stages are (1) suits by LP&L with regard to the state use tax on nuclear fuel, and (2) LP&L's defense (and indemnification, if necessary) of nuclear fuel lessors under LP&L's fuel financing arrangements in the suits filed by the Parish use tax authorities claiming approximately $64.0 million in lease and use taxes. These matters are pending. System Energy. In connection with an IRS audit of Entergy's 1988, 1989, and 1990 consolidated federal income tax returns, the IRS is proposing that adjustments be made to the Grand Gulf 2 abandonment loss deduction claimed on Entergy's 1989 consolidated federal income tax return. If any such adjustments are necessary, the effect on System Energy's net income should be immaterial. Entergy intends to contest the proposed adjustments if finalized by the IRS. The outcome of such proceedings cannot be predicted at this time. EARNINGS RATIOS OF SYSTEM OPERATING COMPANIES AND SYSTEM ENERGY The System operating companies and System Energy have calculated ratios of earnings to fixed charges and ratios of earnings to fixed charges and preferred dividends pursuant to Item 503 of Regulation S-K of the SEC as follows: ____________________ (a) "Earnings" as defined by SEC Regulation S-K represent the aggregate of (1) net income, (2) taxes based on income, (3) investment tax credit adjustments-net, and (4) fixed charges. "Fixed Charges" include interest (whether expensed or capitalized), related amortization, and interest applicable to rentals charged to operating expenses. (b) "Preferred Dividends" as defined by SEC Regulation S-K are computed by dividing the preferred dividend requirement by one hundred percent (100%) minus the income tax rate. (c) System Energy's Amended and Restated Articles of Incorporation do not currently provide for the issuance of preferred stock. (d) "Preferred Dividends" in the case of GSU also include dividends on preference stock. (e) Earnings for the year ended December 31, 1989, include the impact of the write-off of $60 million of deferred Grand Gulf 1-related costs pursuant to an agreement between MP&L and the MPSC. (f) Earnings for the year ended December 31, 1989, were inadequate to cover fixed charges due to System Energy's cancellation and write- off of its investment in Grand Gulf 2 in September 1989. The amount of the coverage deficiency for fixed charges was $745.2 million. (g) Earnings for the year ended December 31, 1991, include the $90 million effect of the 1991 NOPSI Settlement. (h) Earnings for the year ended December 31, 1993, include approximately $81 million, $52 million, and $18 million for AP&L, MP&L, and NOPSI, respectively, related to the change in accounting principle to provide for the accrual of estimated unbilled revenues. (i) Earnings for the year ended December 31, 1990, for GSU were not adequate to cover fixed charges by $60.6 million. Earnings for the years ended December 31, 1990 and 1989, were not adequate to cover fixed charges and preferred dividends by $165.1 million and $190.8 million, respectively. Earnings in 1990 include a $205 million charge for the settlement of a purchased power dispute. INDUSTRY SEGMENTS NOPSI Narrative Description of NOPSI Industry Segments Electric Service. NOPSI supplied electric service to 190,613 customers as of December 31, 1993. During 1993, 36% of electric operating revenues was derived from residential sales, 40% from commercial sales, 6% from industrial sales, 15% from sales to governmental and municipal customers, and 3% from sales to public utilities and other sources. Natural Gas Service. NOPSI supplied natural gas service to 154,251 customers as of December 31, 1993. During 1993, 56% of gas operating revenues was derived from residential sales, 18% from commercial sales, 9% from industrial sales, and 17% from sales to governmental and municipal customers. (See "Fuel Supply - Natural Gas Purchased for Resale," incorporated herein by reference.) Selected Financial Information Relating to Industry Segments For selected financial information relating to NOPSI's industry segments, see NOPSI's financial statements and Note 11 of NOPSI's Notes to Financial Statements, "Business Segment Information," incorporated herein by reference. Employees by Segment NOPSI's full-time employees by industry segment as of December 31, 1993, were as follows: Electric 568 Natural Gas 148 --- Total 716 (For further information with respect to NOPSI's segments, see "Property.") GSU For the year ended December 31, 1993, 96% of GSU's operating revenues were derived from the electric utility business. The remainder of operating revenues were derived 2% from the steam business and 2% from the natural gas business. Segment information for GSU is not provided. PROPERTY Generating Stations The total capability of Entergy 's owned and leased generating stations as of December 31, 1993, by company, is indicated below: _______________________ (1) "Owned and Leased Capability" is the dependable load carrying capability of the stations, as demonstrated under actual operating conditions based on the primary fuel (assuming no curtailments) that each station was designed to utilize. (2) Excludes the capacity of fossil-fueled generating stations placed on extended reserve as follows: AP&L - 506 MW; GSU - 405 MW; LP&L - 19 MW; MP&L - 73 MW; and NOPSI - 143 MW. Generating stations that are not expected to be utilized in the near-term to meet load requirements are placed in extended reserve shutdown in order to minimize operating expenses. (3) Excludes net capability of Entergy Power, which owns 809 MW of fossil-fueled capacity (see "Rate Matters and Regulation - Rate Matters - Wholesale Rate Matters - Entergy Power," above). (4) Independence 2, a coal unit operated by AP&L and jointly owned 25% by MP&L (210 MW), 31.5% by Entergy Power (265 MW), and the balance by various municipalities and a cooperative. The unit was out of service, due to an explosion from August 11, 1993 to February 18, 1994. (5) GSU's nuclear capability represents its 70% ownership interest in River Bend; Cajun owns the remaining 30% undivided interest. (6) LP&L's nuclear capability represents its 90.7% ownership interest and 9.3% leasehold interest in Waterford 3. (7) System Energy's capability represents its 90% interest in Grand Gulf 1 (78.5% ownership interest and 11.5% leasehold interest). South Mississippi Electric Power Association has the remaining 10% undivided ownership interest in Grand Gulf 1. Entitlement to System Energy's capacity has been allocated to AP&L, LP&L, MP&L, and NOPSI pursuant to the Unit Power Sales Agreement. (8) Includes 188 MW of capacity leased by AP&L through 1999. Representatives of the System regularly review load and capacity projections in order to coordinate and recommend the location and time of installation of additional generating capacity and of interconnections in light of the availability of power, the location of new loads, and maximum economy to the System. Based on load and capability projections, the System has no need to install additional generating capacity until 1999. To delay the need for new capacity, the System is engaging in conservation and DSM programs, as discussed in "Business of Entergy - Competition - Least Cost Planning," above. When new generation resources are needed, the System plans to meet this need with a variety of sources other than construction of new base load generating capacity. In the meantime, the System will meet capacity needs by, among other things, removing generating stations from extended reserve shutdown. Generating stations brought out of extended reserve shutdown during 1993 added 248 MW to meet operating requirements. Under the terms of the System Agreement, some of the generating capacity and other power resources are shared among the System operating companies. Among other things, the System Agreement provides that parties having generating capacity greater than their load requirements sell such capacity to those parties having deficiencies in generating capacity and that the purchasers pay to the sellers a charge sufficient to cover certain of the sellers' ownership costs, including operating expenses, fixed charges on debt, dividend requirements on preferred and preference stock, and a fair rate of return on common equity investment. Under the System Agreement, these charges are based on costs associated with the sellers' steam electric generating units fueled by oil or gas. In addition, for all energy to be exchanged among the System operating companies under the System Agreement, the purchasers are required to pay the cost of fuel consumed in generating such energy plus a charge to cover other associated costs (see "Rate Matters and Regulation - Rate Matters - Wholesale Rate Matters - System Agreement," above, for a discussion of FERC proceedings relating to the System Agreement). The System's business is subject to seasonal fluctuations with the peak period occurring in the summer months. Excluding GSU, Entergy 's 1993 peak demand of 12,858 MW occurred on August 19, 1993. The net System capability at the time of peak was 14,029 MW, which reflects a reduction of the System's total 14,765 MW of owned and leased capability by net off-system firm sales of 736 MW. The capacity margin at the time of the peak was approximately 8.4%, not including units placed on extended reserve and capacity owned by Entergy Power. GSU's 1993 peak demand of 5,612 MW occurred on August 18, 1993. The net GSU capability at the time of peak was 6,704 MW, which reflects an increase of GSU's total 6,420 MW of owned and leased capability by net off-system purchases of 284 MW. The capacity margin at the time of the peak was approximately 18.2%, not including units placed on extended reserve. Interconnections The electric power supply facilities of Entergy consist principally of steam-electric production facilities strategically located with reference to availability of fuel, protection of local loads, and other controlling economic factors. These are interconnected by a transmission system operating at various voltages up to 500 KV. Generally, with the exception of Grand Gulf 1, Entergy Power's capacity and a small portion of MP&L's capacity, operating facilities or interests therein are owned by the System operating company serving the area in which the facilities are located. However, all of the System's generating facilities are centrally dispatched and operated with a view to realizing the greatest economy. This operation seeks, among other things, the lowest cost sources of energy from hour to hour. The minimum of investment and the most efficient use of plant are sought to be achieved, in part, through the coordinated scheduling of maintenance, inspection, and overhaul. The System operating companies have direct interconnections with neighboring utilities including, in individual cases, Mississippi Power Company, Southwestern Electric Power Company, Southwest Power Administration, Central Louisiana Electric Company, Inc., Oklahoma Gas and Electric Company, The Empire District Electric Company, Union Electric Company, Arkansas Electric Cooperative Corporation, Tennessee Valley Authority, Cajun, Sam Rayburn Dam Electric Cooperative, Inc., SRG&T, SRMPA, Associated Electric Cooperative, Inc., Municipal Energy Agency of Mississippi, Louisiana Energy and Power Authority, Farmers Electric Cooperative, South Mississippi Electric Power Authority, and the cities of Lafayette, Plaquemine, and New Roads, Louisiana. GSU also has an interconnection agreement with Houston Lighting and Power Company providing a minor amount of emergency service only. The System operating companies also have interchange agreements with Alabama Electric Cooperative, Big Rivers Electric Cooperative, Northeast Texas Electric Cooperative, Inc., Sam Rayburn G&T Electric Cooperative, Inc., Florida Power Corporation, Florida Power & Light Company, Jacksonville Electric Authority, Oglethorpe Power Cooperative, the City of Lafayette, Louisiana, the City of Springfield, Missouri, and East Kentucky Electric Cooperative. The System operating companies are members of the Southwest Power Pool, the primary purpose of which is to ensure the reliability and adequacy of the electric bulk power supply in the southwest region of the United States. The Southwest Power Pool is a member of the North American Electric Reliability Council. AP&L, LP&L, MP&L, and NOPSI are also members of the Western Systems Power Pool. Gas Property As of December 31, 1993, NOPSI distributed and transported natural gas for distribution solely within the limits of the City of New Orleans through a total of 1,422 miles of gas distribution mains and 32 miles of gas transmission lines. NOPSI receives deliveries of natural gas for distribution purposes at 14 separate locations, including deliveries from United Gas Pipe Line Company (United) at six of these locations. Of the remaining delivery points, two are principally served by interstate suppliers and the remaining are served by intrastate suppliers. As of December 31, 1993, the gas property of GSU was not material to GSU. Titles The System's generating stations are generally located on lands owned in fee simple. The greater portion of the transmission and distribution lines of the System operating companies has been constructed over lands of private owners pursuant to easements or on public highways and streets pursuant to appropriate permits. The rights of each company in the realty on which its properties are located are considered by it to be adequate for its use in the conduct of its business. Minor defects and irregularities customarily found in properties of like size and character exist, but such defects and irregularities do not materially impair the use of the properties affected thereby. The System operating companies generally have the right of eminent domain whereby they may, if necessary, perfect or secure titles to, or easements or servitudes on, privately-held lands used or to be used in their utility operations. Substantially all the physical properties owned by each System operating company and System Energy are subject to the lien of the mortgage and deed of trust securing the first mortgage bonds of such company. The Lewis Creek generating station is owned by GSG&T, Inc., and is not subject to the lien of the GSU mortgage securing the first mortgage bonds of GSU, but is leased and operated by GSU. In the case of LP&L, certain properties are subject to the liens of second mortgages securing other obligations of LP&L. In the case of MP&L and NOPSI, substantially all of their properties and assets are subject to the second mortgage lien of their respective general and refunding mortgage bond indentures. FUEL SUPPLY The following tabulation shows the percentages of natural gas, fuel oil, nuclear fuel, and coal used in generation, excluding that of Entergy Power, during the past three years. It also shows the average fuel cost per KWH generated by each type of fuel during that period. The balance of generation, which was immaterial, was provided by hydroelectric power. ENTERGY EXCLUDING GSU GSU The following tabulation shows the percentages of generation by fuel type used in generation, excluding that of Entergy Power, for 1993 (actual) and 1994 (projected). _______________________ (a) The System's 1993 actual generation by fuel type excludes GSU; 1994 estimated generation by fuel type includes GSU. (b) Capacity and energy from System Energy's interest in Grand Gulf 1 is allocated as follows: AP&L - 36%; LP&L - 14%; MP&L - 33%; and NOPSI - 17%. Natural Gas The System operating companies have various long-term gas contracts that will satisfy a significant percentage of each operating company's needs; however, such contracts typically require the operating companies to purchase less than half of their annual gas requirements under such contracts. Additional gas requirements are satisfied under less expensive short-term contracts and spot-market purchases. In November 1992, GSU entered into a transportation service agreement with a gas supplier that obligates such supplier to provide GSU with flexible natural gas swing service to certain generating stations by using such supplier's pipeline and salt dome gas storage facility. Many factors influence the availability and price of natural gas supplies for power plants including wellhead deliverability, storage and pipeline capacity, and the demand requirements of the end users. This demand is closely tied to the severity of the weather conditions in the region. Furthermore, pricing relative to other energy sources (i.e. fuel oil, coal, purchased power, etc.) will affect the demand for natural gas for power plants. Supplies of natural gas are expected to be adequate in 1994. Pursuant to FERC and state regulations, gas supplies may be interrupted to power plants during periods of shortage. To the extent natural gas supplies may be disrupted, the System operating companies will use alternate sources of energy such as fuel oil. Coal AP&L has long-term contracts for the supply of low-sulfur coal for the White Bluff Steam Electric Generating Station and the Independence Steam Electric Station (which is owned 25% by MP&L). Coal for the White Bluff Station is supplied under a contract from a mine in the State of Wyoming. The coal contract provides for the delivery of sufficient coal to operate the White Bluff Station through approximately 2002. Coal for the Independence Station is also supplied under a contract from a mine in the State of Wyoming. Coal supplied under this contract is expected to meet the requirements of the Independence Station through at least 2014. GSU has a contract for a supply of low-sulfur Wyoming coal for Nelson Unit 6, which should be sufficient to satisfy the fuel requirements at Nelson Unit 6 through 2004. Cajun has advised GSU that it has contracts that should provide an adequate supply of coal until 1997 for the operation of Big Cajun 2, Unit 3 (which is operated by Cajun and of which GSU owns 42%). Nuclear Fuel Generally, the supply of fuel for nuclear generating units involves the mining and milling of uranium ore to produce a concentrate, the conversion of uranium concentrate to uranium hexafluoride gas, enrichment of that gas, fabrication of the nuclear fuel assemblies, and disposal of the spent fuel. System Fuels is responsible for contracts to acquire nuclear fuel to be used in AP&L's, LP&L's, and System Energy's nuclear units and for maintaining inventories of such materials during the various stages of processing. Each of these companies is currently responsible for contracting for the fabrication of its own nuclear fuel and for purchasing the required enriched uranium hexafluoride from System Fuels. Currently, the requirements for GSU's River Bend plant are covered by contracts made by GSU. On October 3, 1989, System Fuels entered into a revolving credit agreement with banks permitting it to borrow up to $45 million to finance its nuclear materials and services inventory. AP&L, LP&L, and System Energy agreed to purchase from System Fuels the nuclear materials and services financed under the agreement if System Fuels should default in its obligations thereunder. Such purchases would be allocated based on percentages agreed upon among the parties. In the absence of such agreement, AP&L, LP&L, and System Energy would each be obligated to purchase one-third of the nuclear materials and services. Based upon the planned fuel cycles for the System's nuclear units, the following tabulation shows the years through which existing contracts and inventory will provide materials and services: Acquisition of or Conversion Spent Uranium to Uranium Enrich- Fabri- Fuel Concentrate Hexafluoride ment(3) cation Disposal ----------- ------------ ------- ------ -------- ANO 1 (1) (1) 1995 1997 (4) ANO 2 (1) (1) 1995 1994 (4) River Bend (2) (2) 2000 1995 (4) Waterford 3 (1) (1) 1995 1999 (4) Grand Gulf 1 (1) (1) 1995 1995 (4) __________________________ (1) Current contracts will provide these materials and services through termination dates ranging from 1994-1997. Additional materials and services required beyond these dates are estimated to be available for the foreseeable future. (2) Current GSU contracts will provide a significant percentage of these materials and services for River Bend through 1995. (3) Enrichment services for ANO 1, ANO 2, Waterford 3, and Grand Gulf 1 are provided by a System Fuels contract with the United States Enrichment Corporation (USEC). The contract has been terminated after 1995 to permit flexibility on future pricing and terms that could be obtained. Enrichment services for River Bend are provided by a GSU contract with USEC that may be partially terminated after 1998 and fully terminated after 2000. (See "Rate Matters and Regulation - Regulation - Regulation of the Nuclear Power Industry - Decommissioning," above for information on annual contributions to a federal decontamination and decommissioning fund required by the Energy Act to be made by AP&L, GSU, LP&L, and System Energy as a result of their enrichment contracts with DOE.) (4) The Nuclear Waste Policy Act of 1982 provides for the disposal of spent nuclear fuel or high level waste by the DOE. Under this Act, the DOE was to begin accepting spent fuel in 1998 and to continue until the disposal of all spent fuel from reactor sites has been accomplished. In November 1989, the DOE indicated that the repository program will be delayed. Current on-site spent fuel storage capacity at ANO, River Bend, Waterford 3, and Grand Gulf 1 is estimated to be sufficient to store fuel from normal operations until 1995, 2003, 2000, and 2004, respectively. It is expected that any additional storage capacity required, due to delay of the DOE repository program, will have to be provided by the affected companies (see "Rate Matters and Regulation - Regulation - Regulation of the Nuclear Power Industry - Spent Fuel and Other High-Level Radioactive Waste," above). The System will require additional arrangements for segments of the nuclear fuel cycle beyond the dates shown above. Except as noted above, Entergy cannot predict the ultimate availability or cost of such arrangements at this time. AP&L, GSU, LP&L, and System Energy currently have nuclear fuel leasing arrangements that provide that AP&L, GSU, LP&L, and System Energy may lease up to $125 million, $105 million, $95 million, and $105 million of nuclear fuel, respectively. As of December 31, 1993, the unrecovered cost base of AP&L's, GSU's, LP&L's, and System Energy's nuclear fuel leases amounted to approximately $93.6 million, $96.5 million, $61.3 million, and $79.7 million, respectively. Each lessor finances its acquisition and ownership of nuclear fuel under a credit agreement and through the issuance of intermediate-term notes. The credit agreements, which were entered into by AP&L in 1988, by LP&L and System Energy in 1989, and GSU in 1993, had initial terms of five years, with the exception of GSU, which has an initial term of three years. These agreements are subject to annual renewal with, in LP&L's and GSU's case, the consent of the lenders. The credit agreements for AP&L, LP&L, and System Energy have all been extended and now have termination dates of December 1996, January 1997, and February 1997, respectively. The credit agreement for GSU was entered into in December 1993 and has a termination date of December 1996. The intermediate-term notes have varying maturities through January 31, 1999. It is expected that the credit agreements will be extended, or alternative financing will be secured by each lessor, based on the particular lessee's nuclear fuel requirements. If extensions or alternative financing cannot be arranged, the particular lessee must purchase sufficient nuclear fuel to allow the lessor to retire such borrowings. Natural Gas Purchased for Resale NOPSI has several suppliers of natural gas for resale. Its system is interconnected with three interstate and three intrastate pipelines. Presently, NOPSI's primary suppliers of natural gas for resale are United, an interstate pipeline, and Bridgeline and Pontchartrain, intrastate pipelines. NOPSI has a firm gas purchase contract with United and receives this service subject to FERC- approved rates pursuant to a certificate granted by FERC. NOPSI also has firm contracts with its two intrastate suppliers and also makes interruptible spot market purchases when economically attractive. In recent years, natural gas deliveries have been subject primarily to weather-related curtailments. However, NOPSI has experienced no such curtailments. In April 1992, FERC issued Order No. 636, which mandated interstate pipeline restructuring. The order requires interstate pipelines to cease selling gas to local distribution customers at the city-gate interconnection although transportation service can be provided in lieu of the former sale. As a result, in the future, NOPSI must substitute sources upstream of the United system for its current gas supply from United. NOPSI is considering purchases from independent intrastate or interstate supply aggregators and/or from intrastate pipeline sources in a manner consistent with its economic and supply reliability objectives. Prior to the effectiveness of Order No. 636, discussed above, in the event of a natural gas shortage on the United system, NOPSI would have received a portion of the available gas supply from United and its other suppliers. After Order No. 636 mandated restructuring (October 31, 1993), curtailments of supply could occur if NOPSI's suppliers failed to perform their obligations to deliver gas under their supply agreements with NOPSI. United could curtail transportation capacity only in the event of pipeline system constraints. Based on the current supply of natural gas, and absent extreme weather related curtailments, NOPSI does not anticipate that there will be any interruptions in natural gas deliveries to its customers. GSU purchases natural gas for resale from a single interstate supplier. Abandonment of service by the present supplier would be subject to abandonment proceedings by FERC. Research AP&L, GSU, LP&L, MP&L, and NOPSI are members of the Electric Power Research Institute (EPRI). EPRI conducts a broad range of research in major technical fields related to the electric utility industry. Entergy participates in various EPRI projects, based on its needs and available resources. During 1991, 1992, and 1993, the System, including GSU, contributed approximately $12 million, $16 million, and $17 million, respectively, for the various research programs in which Entergy was involved. Item 2.		Item 2. Properties Refer to Item 1. "Business - Property," incorporated herein by reference, for information regarding the properties of the registrants. Item 3.	Item 3. Legal Proceedings Refer to Item 1. "Business - Rate Matters and Regulation," incorporated herein by reference, for details of the registrants' material rate proceedings and other regulatory proceedings and litigation that are pending or that terminated in the fourth quarter of 1993. Item 4.	Item 4. Submission of Matters to a Vote of Security Holders A consent in lieu of a special meeting of common stockholders of Entergy-GSU Holdings, Inc. (Holdings) was executed on December 30, 1993, pursuant to a Delaware statute that permits such a procedure. The consent was signed on behalf of Entergy Corporation and GSU, which at that time owned all of the outstanding common stock of Holdings. The common stockholders acted to: (1) increase the number of directors from 2 to 18 upon the occurrence of the combination of Entergy Corporation and GSU, such expanded board to consist of Edwin Lupberger and Joseph Donnelly, who continued as directors, and the following new directors: W. Frank Blount; John A. Cooper, Jr.; Brooke H. Duncan; Lucie J. Fjeldstad; Kaneaster Hodges, Jr.; Robert v.d. Luft; Adm. Kinnaird R. McKee; Paul W. Murrill; James R. Nichols; Eugene H. Owen; John N. Palmer, Sr.; Robert D. Pugh; H. Duke Shackelford; Wm. Clifford Smith; Bismark A. Steinhagen; and Dr. Walter Washington; (2) approve the terms and provisions of certain agreements related to such combination; (3) approve the actions of the officers in connection with those agreements and the transactions contemplated thereby; (4) approve the assumption and adoption by Holdings of certain benefit plans of Entergy Corporation; and (5) approve the taking of actions to issue stock with respect to such plans, including the listing of Holdings' common stock on the New York, Pacific, and Midwest Stock Exchanges and the filing of registration statements with the Securities and Exchange Commission. After the consummation of the transactions involved in the combination, the name of Holdings was changed to Entergy Corporation. On January 22, 1994, Mr. Donnelly resigned from the position of director of Entergy Corporation. PART II Item 5.	Item 5. Market for Registrants' Common Equity and Related Stockholder Matters Entergy Corporation. The shares of Entergy Corporation's common stock are listed on the New York, Midwest, and Pacific Stock Exchanges. The high and low prices for each quarterly period in 1993 and 1992, were as follows: 1993 1992 --------------- ---------------- High Low High Low ------ ------ ------ ------ (In Dollars) First 36 1/2 32 1/2 29 5/8 27 1/8 Second 38 1/4 33 1/4 28 1/2 26 1/8 Third 39 7/8 36 1/4 31 7/8 28 1/4 Fourth 39 1/4 35 1/8 33 5/8 30 1/2 Four consecutive quarterly cash dividends on common stock were paid to stockholders of Entergy Corporation in each of 1993 and 1992. In 1993, dividends of 40 cents per share were paid in each of the first three quarters and dividends of 45 cents per share were paid in the last quarter. Dividends of 35 cents per share were paid in each of the first three quarters of 1992, and dividends of 40 cents per share were paid in the last quarter of 1992. As of February 24, 1994, there were 63,779 stockholders of record of Entergy Corporation. For information with respect to Entergy Corporation's future ability to pay dividends, refer to Note 7 of Entergy Corporation and Subsidiaries' Notes to Consolidated Financial Statements, "Dividend Restrictions," incorporated herein by reference. In addition to the restrictions described in Note 7, the Holding Company Act provides that, without approval of the SEC, the unrestricted, undistributed retained earnings of any Entergy Corporation subsidiary are not available for distribution to Entergy Corporation's common stockholders until such earnings are made available to Entergy Corporation through the declaration of dividends by such subsidiaries. AP&L, GSU, LP&L, MP&L, NOPSI, and System Energy. There is no market for the common stock of System Energy and the System operating companies, all of which is owned by Entergy Corporation. Prior to December 31, 1993, GSU's common stock was publicly held. Effective with the Merger, all shares of GSU common stock were acquired by Entergy Corporation. No cash dividends on common stock were paid by GSU to its stockholders in 1992-1993. Cash dividends on common stock paid by AP&L, LP&L, MP&L, NOPSI, and System Energy to Entergy Corporation during 1993 and 1992, were as follows: 1993 1992 ------ ------ (In Millions) AP&L $156.3 $ 75.0 LP&L 167.6 174.6 MP&L 85.8 68.4 NOPSI 43.9 32.2 System Energy 233.1 137.7 For information with respect to restrictions that limit the ability of System Energy and the System operating companies to pay dividends, and for information with respect to dividends paid to Entergy Corporation by its subsidiaries subsequent to December 31, 1993, refer respectively, to Note 6 of System Energy's and Note 7 of AP&L's, GSU's, LP&L's, MP&L's, and NOPSI's Notes to Financial Statements, "Dividend Restrictions," incorporated herein by reference. Item 6.	Item 6. Selected Financial Data Entergy Corporation. Refer to information under the heading "Entergy Corporation and Subsidiaries Selected Financial Data - Five- Year Comparison," which information is incorporated herein by reference. AP&L. Refer to information under the heading "Arkansas Power & Light Company Selected Financial Data - Five-Year Comparison," which information is incorporated herein by reference. GSU. Refer to information under the heading "Gulf States Utilities Company Selected Financial Data - Five-Year Comparison," which information is incorporated herein by reference. LP&L. Refer to information under the heading "Louisiana Power & Light Company Selected Financial Data - Five-Year Comparison," which information is incorporated herein by reference. MP&L. Refer to information under the heading "Mississippi Power & Light Company Selected Financial Data - Five-Year Comparison," which information is incorporated herein by reference. NOPSI. Refer to information under the heading "New Orleans Public Service Inc. Selected Financial Data - Five-Year Comparison," which information is incorporated herein by reference. System Energy. Refer to information under the heading "System Energy Resources, Inc. Selected Financial Data - Five-Year Comparison," which information is incorporated herein by reference. Item 7.	Item 7 "Financial Statements and Exhibits". A current report on Form 8-K, dated January 18, 1994, was filed with the SEC on January 18, 1994, reporting information under Item 5 "Other Materially Important Events". A current report on Form 8-K, dated February 1, 1994, was filed with the SEC on February 8, 1994, reporting information under Items 2 and 7. Entergy Corporation, AP&L, GSU, LP&L, MP&L and NOPSI Current Reports on Form 8-K, dated December 31, 1993, were filed by these companies on January 3, 1994 reporting the consummation of the Entergy Corporation - GSU merger under Item 5 (in the case of AP&L, LP&L, MP&L and NOPSI), Items 2 and 7 (in the case of Entergy Corporation and GSU). EXPERTS All statements in Part I of this Annual Report on Form 10-K as to matters of law and legal conclusions, based on the belief or opinion of System Energy or any System operating company or otherwise, pertaining to the titles to properties, franchises and other operating rights of certain of the registrants filing this Annual Report on Form 10-K, and their subsidiaries, the regulations to which they are subject and any legal proceedings to which they are parties are made on the authority of Friday, Eldredge & Clark, 2000 First Commercial Building, 400 West Capitol, Little Rock, Arkansas, as to AP&L and as to Entergy Services in regards to flood litigation; Monroe & Lemann (A Professional Corporation), 201 St. Charles Avenue, Suite 3300, New Orleans, Louisiana, as to LP&L and NOPSI; and Wise Carter Child & Caraway, Professional Association, Heritage Building, Jackson, Mississippi, as to MP&L and System Energy. The statements attributed to Clark, Thomas & Winters, a professional corporation, as to legal conclusions with respect to GSU's rate regulation in Texas under Item 1. "Rate Matters and Regulation - Rate Matters - Retail Rate Matters - GSU" and in Note 2 to Entergy Corporation and Subsidiaries Consolidated Financial Statements and GSU's Financial Statements, "Rate and Regulatory Matters," have been reviewed by such firm and are included herein upon the authority of such firm as experts. The statements attributed to Sandlin Associates regarding the analysis of River Bend Construction costs of GSU under Item 1. "Rate Matters and Regulation - Rate Matters - Retail Rate Matters - GSU" and in Note 2 to Entergy Corporation and Subsidiaries Consolidated Financial Statements and GSU's Financial Statements, "Rate and Regulatory Matters", have been reviewed by such firm and are included herein upon the authority of such firm as experts. ENTERGY CORPORATION SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. ENTERGY CORPORATION By /s/ Lee W. Randall Lee W. Randall, Vice President and Chief Accounting Officer Date: March 14, 1994 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. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date /s/ Lee W. Randall Vice President and March 14, 1994 Lee W. Randall Chief Accounting Officer (Principal Accounting Officer) Edwin Lupberger (Chairman of the Board, Chief Executive Officer and Director; Principal Executive Officer); Gerald D. McInvale (Senior Vice President and Chief Financial Officer; Principal Financial Officer); W. Frank Blount, John A. Cooper, Jr., Brooke H. Duncan, Lucie J. Fjeldstad, Kaneaster Hodges, Jr., Robert v.d. Luft, Kinnaird R. McKee, Paul W. Murrill, James R. Nichols, Eugene H. Owen, John N. Palmer, Robert D. Pugh, H. Duke Shackelford, Wm. Clifford Smith, Bismark A. Steinhagen, and Walter Washington (Directors). By: /s/ Lee W. Randall March 14, 1994 (Lee W. Randall, Attorney-in-fact) ARKANSAS POWER & LIGHT COMPANY SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. ARKANSAS POWER & LIGHT COMPANY By /s/ Lee W. Randall Lee W. Randall, Vice President and Chief Accounting Officer Date: March 14, 1994 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. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date /s/ Lee W. Randall Lee W. Randall Vice President and Chief March 14, 1994 Accounting Officer (Principal Accounting Officer) Edwin Lupberger (Chairman of the Board, Chief Executive Officer and Director; Principal Executive Officer); Gerald D. McInvale (Senior Vice President and Chief Financial Officer; Principal Financial Officer); Michael B. Bemis, John A. Cooper, Jr., Cathy Cunningham, Richard P. Herget, Jr., Tommy H. Hillman, Donald C. Hintz, Kaneaster Hodges, Jr., Jerry D. Jackson, R. Drake Keith, Jerry L. Maulden, Raymond P. Miller, Sr., Roy L. Murphy, William C. Nolan, Jr., Robert D. Pugh, Woodson D. Walker, Gus B. Walton, Jr., Michael E. Wilson (Directors). By: /s/ Lee W. Randall March 14, 1994 (Lee W. Randall, Attorney-in-fact) GULF STATES UTILITIES COMPANY SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. GULF STATES UTILITIES COMPANY By /s/ Lee W. Randall Lee W. Randall, Vice President and Chief Accounting Officer Date: March 14, 1994 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. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date /s/ Lee W. Randall Vice President and March 14, 1994 Lee W. Randall Chief Accounting Officer (Principal Accounting Officer) Edwin Lupberger (Chairman of the Board, Chief Executive Officer and Director; Principal Executive Officer); Gerald D. McInvale (Senior Vice President and Chief Financial Officer; Principal Financial Officer); Robert H. Barrow, Frank F. Gallaher, Frank W. Harrison, Jr., Donald C. Hintz, Jerry L. Maulden, Paul W. Murrill, Eugene H. Owen, M. Bookman Peters, Monroe J. Rathbone, Jr., Sam F. Segnar, Bismark A. Steinhagen, James E. Taussig, II. (Directors). By: /s/ Lee W. Randall March 14, 1994 (Lee W. Randall, Attorney-in-fact) LOUISIANA POWER & LIGHT COMPANY SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. LOUISIANA POWER & LIGHT COMPANY By /s/ Lee W. Randall Lee W. Randall, Vice President and Chief Accounting Officer Date: March 14, 1994 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. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date /s/ Lee W. Randall Lee W. Randall Vice President and Chief March 14, 1994 Accounting Officer (Principal Accounting Officer) Edwin Lupberger (Chairman of the Board, Chief Executive Officer and Director; Principal Executive Officer); Gerald D. McInvale (Senior Vice President and Chief Financial Officer; Principal Financial Officer); Michael B. Bemis, John J. Cordaro, Donald C. Hintz, William K. Hood, Jerry D. Jackson, Tex R. Kilpatrick, Joseph J. Krebs, Jr., Jerry L. Maulden, H. Duke Shackelford, Wm. Clifford Smith (Directors). By: /s/ Lee W. Randall March 14, 1994 (Lee W. Randall, Attorney-in-fact) MISSISSIPPI POWER & LIGHT COMPANY SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. MISSISSIPPI POWER & LIGHT COMPANY By /s/ Lee W. Randall Lee W. Randall, Vice President and Chief Accounting Officer Date: March 14, 1994 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. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date /s/ Lee W. Randall Lee W. Randall Vice President and Chief March 14, 1994 Accounting Officer (Principal Accounting Officer) Edwin Lupberger (Chairman of the Board, Chief Executive Officer and Director; Principal Executive Officer); Gerald D. McInvale (Senior Vice President and Chief Financial Officer; Principal Financial Officer); Michael B. Bemis, Frank R. Day, John O. Emmerich, Jr., Norman B. Gillis, Jr., Donald C. Hintz, Jerry D. Jackson, Robert E. Kennington, II, Jerry L. Maulden, Donald E. Meiners, John N. Palmer, Sr., Clyda S. Rent, Walter Washington, Robert M. Williams, Jr. (Directors). By: /s/ Lee W. Randall March 14, 1994 (Lee W. Randall, Attorney-in-fact) NEW ORLEANS PUBLIC SERVICE INC. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. NEW ORLEANS PUBLIC SERVICE INC. By /s/ Lee W. Randall Lee W. Randall, Vice President and Chief Accounting Officer Date: March 14, 1994 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. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date /s/ Lee W. Randall Lee W. Randall Vice President and Chief March 14, 1994 Accounting Officer (Principal Accounting Officer) Edwin Lupberger (Chairman of the Board, Chief Executive Officer and Director; Principal Executive Officer); Gerald D. McInvale (Senior Vice President and Chief Financial Officer; Principal Financial Officer); Michael B. Bemis, James M. Cain, John J. Cordaro, Brooke H. Duncan, Norman C. Francis, Donald C. Hintz, Jerry D. Jackson, Jerry L. Maulden, Anne M. Milling, John B. Smallpage, Charles C. Teamer, Sr. (Directors). By: /s/ Lee W. Randall March 14, 1994 (Lee W. Randall, Attorney-in-fact) SYSTEM ENERGY RESOURCES, INC. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. SYSTEM ENERGY RESOURCES, INC. By /s/ Lee W. Randall Lee W. Randall, Vice President and Chief Accounting Officer Date: March 14, 1994 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. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date /s/ Lee W. Randall Lee W. Randall Vice President and Chief March 14, 1994 Accounting Officer (Principal Accounting Officer) Donald C. Hintz (President, Chief Executive Officer and Director; Principal Executive Officer); Gerald D. McInvale (Senior Vice President and Chief Financial Officer; Principal Financial Officer); Edwin Lupberger (Chairman of the Board), Jerry D. Jackson, Jerry L. Maulden (Directors). By: /s/ Lee W. Randall March 14, 1994 (Lee W. Randall, Attorney-in-fact) EXHIBIT 23(a) INDEPENDENT AUDITORS' CONSENT We consent to the incorporation by reference in Post-Effective Amendment Nos. 2, 3, 4A, and 5A on Form S-8 to Registration Statement No. 33-54298 of Entergy Corporation on Form S-4, and the related Prospectuses, of our reports dated February 11, 1994 (which express an unqualified opinion and include explanatory paragraphs as to uncertainties because of certain regulatory and litigation matters), appearing in this Annual Report on Form 10-K of Entergy Corporation for the year ended December 31, 1993. We also consent to the incorporation by reference in Registration Statements Nos. 33-36149, 33-48356 and 33-50289 of Arkansas Power & Light Company on Form S-3, and the related Prospectuses, of our reports dated February 11, 1994, appearing in this Annual Report on Form 10-K of Arkansas Power & Light Company for the year ended December 31, 1993. We also consent to the incorporation by reference in Registration Statements Nos. 33-46085, 33-39221 and 33-50937 of Louisiana Power & Light Company on Form S-3, and the related Prospectuses, of our reports dated February 11, 1994, appearing in this Annual Report on Form 10-K of Louisiana Power & Light Company for the year ended December 31, 1993. We also consent to the incorporation by reference in Registration Statements Nos. 33-53004, 33-55826 and 33-50507 of Mississippi Power & Light Company on Form S-3, and the related Prospectuses, of our reports dated February 11, 1994, appearing in this Annual Report on Form 10-K of Mississippi Power & Light Company for the year ended December 31, 1993. We also consent to the incorporation by reference in Registration Statement No. 33-57926 of New Orleans Public Service Inc. on Form S-3, and the related Prospectus, of our reports dated February 11, 1994, appearing in this Annual Report on Form 10-K of New Orleans Public Service Inc. for the year ended December 31, 1993. We also consent to the incorporation by reference in Registration Statement No. 33-47662 of System Energy Resources, Inc. on Form S-3, and the related Prospectus, of our reports dated February 11, 1994 (which express an unqualified opinion and include an explanatory paragraph as to an uncertainty resulting from a regulatory proceeding), appearing in this Annual Report on Form 10-K of System Energy Resources, Inc. for the year ended December 31, 1993. /s/ Deloitte & Touche DELOITTE & TOUCHE New Orleans, Louisiana March 14, 1994 EXHIBIT 23(b) CONSENT OF INDEPENDENT ACCOUNTANTS We consent to the incorporation by reference in the registration statements of Gulf States Utilities Company on Form S-3 (File Numbers 33-49739 and 33-51181) and Form S-8 (File Numbers 2-76551 and 2-98011) of our reports, dated February 11, 1994, on our audits of the financial statements and financial statement schedules of Gulf States Utilities Company as of December 31, 1993 and 1992, and for the years ended December 31, 1993, 1992 and 1991, which reports include explanatory paragraphs related to rate-related contingencies, legal proceedings and changes in accounting for income taxes, postretirement benefits, unbilled revenue and power plant materials and supplies and are included in this Annual Report on Form 10-K. /s/ Coopers & Lybrand Coopers & Lybrand Houston, Texas March 14, 1994 EXHIBIT 23(c) CONSENT OF EXPERTS We consent to the reference to our firm under the heading "Experts" in this Annual Report on Form 10-K. We further consent to the incorporation by reference of such reference to our firm into Arkansas Power & Light Company's ("AP&L") Registration Statements (Form S-3, File Nos. 33-36149, 33-48356 and 33-50289) and related Prospectuses, pertaining to AP&L's First Mortgage Bonds and Preferred Stock. Very truly yours, /s/ Friday, Eldredge & Clark FRIDAY, ELDREDGE & CLARK Date: March 14, 1994 EXHIBIT 23(d) CONSENT We consent to the reference to our firm under the heading "Experts", and to the inclusion in this Annual Report on Form 10-K of Gulf States Utilities Company ("GSU") of the statements of legal conclusions attributed to us herein (the Statements of Legal Conclusions) under Part I, Item 1. Business - "Rate Matters and Regulation" and in the discussion of Texas jurisdictional matters set forth in Note 2 to GSU's Financial Statements and Note 2 to Entergy Corporation and Subsidiaries Consolidated Financial Statements appearing as Item 8.
40867_1993.txt	40867	1993	Item 1. Business GTE North Incorporated (the Company) was incorporated in Wisconsin on January 27, 1987 and was the successor to the merger of eight telephone companies into the Company on March 31, 1987. All of the Common Stock of the Company was owned by GTE Corporation (GTE). Prior to March 31, 1993, the Company provided communication services in the states of Ilinois, Indiana, Iowa, Michigan, Minnesota, Missouri, Nebraska, Ohio, Pennsylvania and Wisconsin. On March 31, 1993, the Company transferred its assets and operations in Iowa, Minnesota, Missouri and Nebraska to GTE Midwest Incorporated, which is a wholly-owned subsidiary of GTE (the Midwest Transfer). Contel North Incorporated was incorporated in Wisconsin on June 22, 1992. Prior to April 1, 1993, Contel North Incorporated had no business operations and no material assets. On April 1, 1993, the Company, along with Contel of Illinois, Inc., Contel of Indiana, Inc. and Contel of Pennsylvania, Inc. (the Contel Subsidiaries), merged with and into Contel North Incorporated. On April 2, 1993, Contel North Incorporated changed its name to GTE North Incorporated. The Contel Subsidiaries were wholly-owned subsidiaries of GTE. They provided communication services in the states of Illinois, Indiana and Pennsylvania. The Contel Subsidiaries were, individually and in the aggregate, significantly smaller in terms of operating revenues, net income and total assets than the Company prior to the Midwest Transfer. There is no public trading market for the Common Stock of the Company because all of the Common Stock is owned by GTE, a New York corporation. The Company has one wholly-owned subsidiary, GTW Telephone Systems Incorporated, which markets and services telecommunications customer premises equipment. The Company provides local telephone service within its franchise areas and intraLATA (Local Access Transport Area) long distance service between the Company's facilities and the facilities of other telephone companies within the Company's LATAs. InterLATA service to other points in and out of the states in which the Company operates is provided through connection with interexchange (long distance) common carriers. These common carriers are charged fees (access charges) for interconnection to the Company's local facilities. End user business and residential customers are also charged access charges for access to the facilities of the long distance carriers. The Company also earns other revenues by leasing interexchange plant facilities and providing such services as billing and collection and operator services to interexchange carriers, primarily the American Telephone and Telegraph Company (AT&T). The number of access lines served has grown steadily from 3,537,907 on January 1, 1989 to 4,031,547 on December 31, 1993. The following table denotes the access lines in the states in which the Company operates as of December 31, 1993: Access State Lines Served ------------ ------------- Ohio 763,545 Indiana 838,220 Illinois 787,016 Michigan 605,126 Pennsylvania 598,781 Wisconsin 438,859 ------------ Total 4,031,547 ============ The Company's principal line of business is providing telecommunication services. These services fall into five major classes: local network, network access, long distance, equipment sales and services, and other. Revenues from each of these classes over the last three years are as follows: Years Ended December 31 --------------------------------------------- 1993 1992 1991 ----- ---- ---- (Thousands of Dollars) Local Network Services $ 980,039 $ 945,175 $ 916,302 % of Total Revenues 38% 37% 36% Network Access Services $ 963,918 $ 973,661 $ 966,500 % of Total Revenues 37% 38% 39% Long Distance Services $ 391,050 $ 332,150 $ 319,674 % of Total Revenues 15% 13% 13% Equipment Sales and Services $ 106,288 $ 103,607 $ 127,485 % of Total Revenues 4% 4% 5% Other $ 160,952 $ 205,449 $ 175,026 % of Total Revenues 6% 8% 7% Telephone Competition At December 31, 1993, the Company had 17,382 employees. In 1993, agreements were reached on six contracts with the International Brotherhood of Electrical Workers (IBEW), two contracts with the Communication Workers of America (CWA) and one contract with the Bakers, Confectioners and Chocolate Workers (BCT). During 1994, five contracts with the IBEW and one contract with the CWA will expire. The Company holds franchises, licenses and permits adequate for the conduct of its business in the territory which it serves. The Company is subject to regulation by the regulatory bodies of the states of Illinois, Indiana, Michigan, Ohio, Pennsylvania and Wisconsin as to its intrastate business operations and by the Federal Communications Commission (FCC) as to its interstate business operations. Information regarding the Company's activities with the various regulatory agencies and revenue arrangements with other telephone companies can be found in Note 11 of the Company's Annual Report to Shareholders for the year ended December 31, 1993, incorporated herein and filed as Exhibit 13. The year was marked by important changes in the U.S. telecommunications industry. Rapid advances in technology, together with government and industry initiatives to eliminate certain legal and regulatory barriers are accelerating and expanding the level of competition and opportunities available to the Company. As a result, the Company faces increasing competition in virtually all aspects of its business. Specialized communications companies have constructed new systems in certain markets to bypass the local exchange network. Additional competition from interexchange carriers as well as wireless companies continues to evolve for both intrastate and interstate communications. During 1994, the Company will begin implementation of a re-engineering plan that will redesign and streamline processes. Implementation of its re- engineering plan will allow the Company to continue to respond aggressively to these competitive and regulatory developments through reduced costs, improved service quality, competitive prices and new product offerings. Moreover, implementation of this program will position the Company to accelerate delivery of a full array of voice, video and data services. The re-engineering program will be implemented over three years. During the year, the company continued to introduce new business and consumer services utilizing advanced technology, offering new features and pricing options while at the same time reducing costs and prices. During 1993, the FCC announced its decision to auction licenses during 1994 in 51 major markets and 492 basic trading areas across the United States to encourage the development of a new generation of wireless personal communications services (PCS). These services will both complement and compete with the Company's traditional wireline services. The Company will be permitted to fully participate in the license auctions in areas outside of GTE's existing cellular service areas. Limited participation will be permitted in areas in which GTE has an existing cellular presence. In 1992, the FCC issued a "video dialtone" ruling that allows telephone companies to transmit video signals over their networks. The FCC also recommended that Congress amend the Cable Act of 1984 to permit telephone companies to supply video programming in their service areas. Activity directed toward changing the traditional cost-based rate of return regulatory framework for intrastate and interstate telephone services has continued. Various forms of alternative regulation have been adopted, which provide economic incentives to telephone service providers to improve productivity and provide the foundation for the pricing flexibility necessary to address competitive entry into the markets the Company serves. In September 1993, the FCC released an order allowing competing carriers to interconnect to the local-exchange network for the purpose of providing switched access transport services. This ruling complements similar interconnect arrangements for private line services ordered during 1992. The order encourages competition for the transport of telecommunications traffic between local exchange carriers' (LECs) switching offices and interexchange carrier locations. In addition, the order allows LECs flexibility in pricing competitive services. The GTE Consent Decree, which was issued in connection with the 1983 acquisition of GTE Sprint (since divested) and GTE Spacenet, prohibits GTE's domestic telephone operating subsidiaries from providing long distance service beyond the boundaries of the LATA. This prohibition restricts their direct provision of long distance service to relatively short distances. The degree of competition allowed in the intraLATA market is subject to state regulation. However, regulatory constraints on intraLATA competition are gradually being relaxed. In fact, some form of intraLATA competition is authorized in many of the states in which the Company provides service. These and other actions to eliminate the existing legal and regulatory barriers, together with rapid advances in technology, are facilitating a convergence of the computer, media and telecommunications industries. In addition to allowing new forms of competition, these developments are also creating new opportunities to develop interactive communications networks. The Company supports these initiatives to assure greater competition in telecommunications, provided that overall the changes allow an opportunity for all service providers to participate equally in a competitive marketplace under comparable conditions. Item 2.		Item 2. Properties The Company's property consists of network facilities (81%), company facilities (13%), customer premises equipment (3%) and other (3%). From January 1, 1989 to December 31, 1993, the Company made gross property additions in the amount of $2.8 billion and property retirements of $1.7 billion. Substantially all of the Company's property is subject to liens securing long-term debt. In the opinion of management, the Company's telephone plant is substantially in good repair. Item 3.	Item 3. Legal Proceedings There are no pending legal proceedings, either for or against the Company, which would have a material impact on the Company's financial statements. Item 4.	Item 4. Submission of Matters to a Vote of Security Holders None. PART II Item 5.	Item 5. Market for the Registrant's Common Equity and Related Shareholder Matters Market information is omitted since the Company's common stock is wholly-owned by GTE Corporation. Item 6.	Item 6. Selected Financial Data Reference is made to the Registrant's Annual Report to Shareholders, page 32, for the year ended December 31, 1993, incorporated herein and filed as Exhibit 13. Item 7.	Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Reference is made to the Registrant's Annual Report to Shareholders, pages 27 to 31, for the year ended December 31, 1993, incorporated herein and filed as Exhibit 13. Item 8.	Item 8. Financial Statements and Supplementary Data Reference is made to the Registrant's Annual Report to Shareholders, pages 5 to 25, for the year ended December 31, 1993, incorporated herein and filed as Exhibit 13. Item 9.	Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. PART III Item 10.	Item 10. Directors and Executive Officers of the Registrant The names, ages and positions of all the directors and executive officers of the Company as of March 21, 1994, are listed below along with their business experience during the past five years. a. Identification of Directors Director Name Age Since Business Experience - --------------- ---- -------- ------------------------------------------ Kent B. Foster 50 1993 Vice Chairman of the Board of Directors of GTE Corporation, October 1993. President, GTE Telephone Operations, 1989; Director, GTE Corporation, 1992; Director, all GTE domestic telephone subsidiaries, 1993; Director, BC Telecom, Inc.; Director, Compania Anonima Nacional Telefonos de Venezuela; Director, National Bank of Texas. Richard M. Cahill 55 1993 Vice President - General Counsel of GTE Telephone Operations, 1988; Director, all GTE domestic telephone subsidiaries, 1993; Director, GTE Vantage Incorporated, 1991; Director, GTE Intelligent Network Services Incorporated, 1993. Gerald K. Dinsmore 44 1993 Senior Vice President - Finance and Planning for GTE Telephone Operations, 1994. Vice President - Finance, GTE Telephone Operations, 1993; Vice President - Intermediary Customer Markets, GTE Telephone Operations, 1991. President, South Area, GTE Telephone Operations, 1992; Director, all GTE domestic telephone subsidiaries, 1993. Michael B. Esstman 47 1993 Executive Vice President-Operations, GTE Telephone Operations, 1993; President, Central Area, GTE Telephone Operations, 1991. President, Contel Eastern Region, Telephone Operations Sector, 1983; Director, AG Communications System; Director, all GTE domestic telephone subsidiaries, 1993. Earl A. Goode 53 1991 President, GTE North Incorporated; Various positions with GTE including President - GTE Southwest and Vice President - General Manager/Wisconsin; Director, Legacy Fund, COMMIT, NBD Financial Corporation, Indiana State Symphony Society, United Way of Central Indiana, Goodwill Industries of Central Indiana, Indianapolis Chamber of Commerce, Indianapolis Community Hospital Foundation, Indiana Fiscal Policy Institute, National Art Museum of Sport, Corporate Community Council and the Georgetown College Foundation Board; Executive Committee, GTE North Classic; President's Advisory Council, Purdue University; Dean's Advisory Council, Purdue University Krannert School of Management and the State of Indiana Commission for Higher Education. Thomas W. White 47 1993 Executive Vice President of GTE Telephone Operations, 1993; Senior Vice President - General Office Staff, GTE Telephone Operations, 1989; Director, all GTE domestic telephone subsidiaries, 1993; Director, Quebec-Telephone. Directors are elected annually. The term of each director expires on the date of the next annual meeting of shareholders, which may be held on any day during March, as specified in the notice of the meeting. There are no family relationships between any of the directors or executive officers of the Company. All of the directors, with the exception of Mr. Goode, were elected December 16, 1993 following the resignations from the Board of Raymond C. Burroughs, Gilbert L. Homstad, James C. McGill, Don W. Montgomery, James D. Reigle, Ian M. Rolland, Donald E. Smith and Jane Theuerkauf. Long-Term Incentive Plan - Awards in Last Fiscal Year The GTE Long-Term Incentive Plan (LTIP) provides for awards, currently in the form of stock options with tandem stock appreciation rights and cash bonuses, to participating employees. The stock options and stock appreciation rights awarded under the LTIP to the five most highly compensated individuals in 1993 are shown in the table on page 10. Under the LTIP, performance bonuses are paid in cash based on the achievement of pre-established goals for GTE's return on equity (ROE) over a three-year award cycle. Performance bonuses are denominated in units of GTE Common Stock ("Common Stock Units") and are maintained in a Common Stock Unit Account. At the time performance targets are established for the three-year cycle, a Common Stock Unit Account is set up for each participant who is eligible to receive a cash award under the LTIP. An initial dollar amount for each account is determined based on the competitive performance bonus grant practices of other major companies in the telecommunications industry and with other selected corporations that are comparable to GTE in terms of revenue, market value and other quantitative measures. That amount is then divided by the average market price of GTE Common Stock for the calendar week preceding the day the account is established to determine the number of Common Stock Units in the account. The value of the account increases or decreases based on the market price of the GTE Common Stock. An amount equal to the dividends declared on an equivalent number of shares of GTE Common Stock is added each time a dividend is paid. This amount is then converted into the number of Common Stock Units obtained by dividing the amount of the dividend by the average price of the GTE Common Stock on the composite tape of the New York Stock Exchange on the dividend payment date and added to the Common Stock Unit Account. Messrs. Goode and Foster are the only individuals of the five most highly compensated individuals eligible to receive a cash award under the LTIP. The number of Common Stock Units initially allocated in 1993 to their accounts and estimated future payouts under the LTIP are shown in the following table. Executive Agreements GTE has entered into agreements (the Agreements) with Messrs. Goode and Foster regarding benefits to be paid in the event of a change in control of GTE (a "Change in Control"). A Change in Control is deemed to have occurred if a majority of the members of the Board do not consist of members of the incumbent Board (as defined in the Agreements) or if, in any 12-month period, three or more directors are elected without the approval of the incumbent Board. An individual whose initial assumption of office occurred pursuant to an agreement to avoid or settle a proxy or other election contest is not considered a member of the incumbent Board. In addition, a director who is elected pursuant to such a settlement agreement will not be deemed a director who is elected or nominated by the incumbent Board for purposes of determining whether a Change in Control has occurred. A Change in Control will not occur in the following situations: (1) certain merger transactions in which there is at least 50% GTE shareholder continuity in the surviving corporation, at least a majority of the members of the board of directors of the surviving corporation consists of members of the Board of GTE and no person owns more than 20% (or under certain circumstances, a lower percentage, not less than 10%) of the voting power of the surviving corporation following the transaction, and (2) transactions in which GTE's securities are acquired directly from GTE. The Agreements provide for benefits to be paid in the event this individual separates from service and has a "good reason" for leaving or is terminated without "cause" within two years after a Change in Control of GTE. Good reason for leaving includes but is not limited to the following events: demotion, relocation or a reduction in total compensation or benefits, or the new entity's failure to expressly assume obligations under the Agreements. Termination for cause includes certain unlawful acts on the part of the executive or a material violation of his or her responsibilities to the Corporation resulting in material injury to the Corporation. An executive who experiences a qualifying separation from service will be entitled to receive up to two times the sum of (i) base salary and (ii) the average of his or her other percentage awards under the EIP for the previous three years. The executive will also continue to receive medical and life insurance coverage for up to two years and will be provided with financial and outplacement counseling. In addition, the Agreements with Messrs. Goode and Foster provide that in the event of a separation from service, they will receive service credit in the following amounts: two times years of service otherwise credited if the executive has five or fewer years of credited service; 10 years if credited service is more than five and not more than 10 years; and, if the executive's credited service exceeds 10 years, the actual number of credited years of service. These additional years of service will apply towards vesting, retirement eligibility, benefit accrual and all other purposes under the Supplemental Executive Retirement Plan and the Executive Retired Life Insurance Plan. In addition, each executive will be considered to have not less than 76 points and 15 years of accredited service for the purpose of determining his or her eligibility for early retirement benefits. However, there will be no duplication of benefits. The Agreements remain in effect until the earlier of July 1 of each successive year or the date on which the executive reaches age 65, unless the Agreement is terminated earlier pursuant to its terms. The Agreements will be automatically renewed on each successive July 1 unless, not later than December 31 of the preceding year, one of the parties notifies the other that he does not wish to extend the Agreement. If a Change in Control occurs, the Agreements will remain in effect until the obligations of GTE (or its successor) under the Agreements have been satisfied. Retirement Programs Pension Plans The estimated annual benefits payable, calculated on a single life annuity basis, under GTE's defined benefit pension plans at normal retirement at age 65, based upon final average earnings and years of employment, are illustrated in the table below: PENSION PLAN TABLE Years of Service Final Average -------------------------------------------------------------- Earnings 15 20 25 30 35 - ------------------------------------------------------------------------------ $ 150,000 $ 31,604 $ 42,138 $ 52,672 $ 63,207 $ 73,742 200,000 42,479 56,638 70,797 84,957 99,117 300,000 64,229 85,638 107,048 128,457 149,867 400,000 85,979 114,638 143,298 171,957 200,617 500,000 107,729 143,638 179,548 215,457 251,367 600,000 129,479 172,638 215,798 258,957 302,117 700,000 151,229 201,638 252,048 302,457 352,867 800,000 172,979 230,638 288,298 345,957 403,617 900,000 194,729 259,638 324,548 389,457 454,367 1,000,000 216,479 288,638 360,798 432,957 505,117 1,200,000 259,979 346,638 433,298 519,957 606,617 GTE Service Corporation, a wholly-owned subsidiary of GTE, maintains a noncontributory pension plan for the benefit of GTE employees based on years of service. Pension benefits to be paid from this plan and contributions to this plan are related to basic salary exclusive of overtime, differentials, incentive compensation (except as otherwise described) and other similar types of payment. Under this plan, pensions are computed on a two-rate formula basis of 1.15% and 1.45% for each year of service, with the 1.15% service credit being applied to that portion of the average annual salary for the five highest consecutive years that does not exceed the Social Security Integration Level (the portion of salary subject to the Federal Security Act), and the 1.45% service credit being applied to that portion of the average annual salary that exceeds said level. As of March 21, 1994, the credited years of service under the plan for Messrs. Goode, Foster, Keith, Blanchard and Zeilke are 31, 23, 27, 31 and 22, respectively. Under Federal law, an employee's benefits under a qualified pension plan such as the GTE Service Corporation plan are limited to certain maximum amounts. GTE maintains a Supplemental Executive Retirement Plan (SERP), which supplements the benefits of any participant in the qualified pension plan by direct payment of a lump sum or by an annuity, on an unfunded basis, of the amount by which any participant's benefits under the GTE Service Corporation pension plan are limited by law. In addition, the SERP includes a provision permitting the payment of additional retirement benefits determined in a similar manner as under the qualified pension plan on remuneration accrued under management incentive plans as determined by the Executive Compensation and Organizational Structure Committee. Executive Retired Life Insurance Plan The Executive Retired Life Insurance Plan (ERLIP) provides Messrs. Goode, Foster, Keith, Blanchard and Zeilke a maximum postretirement life insurance benefit of three times final base salary. Upon retirement, ERLIP benefits may be paid as life insurance or optionally, an equivalent amount may be paid as a lump sum payment equal to the present value of the life insurance amount (based on actuarial factors and the interest rate then in effect), as an annuity or as installment payments. If an optional payment method is selected, the ERLIP benefit will be based on the actuarial equivalent of the present value of the insurance amount. Directors' Compensation The current directors, all of whom are employees of GTE, are not paid any fees or remuneration, as such, for service on the Board. Item 12.		Item 12. Security Ownership of Certain Beneficial Owners and Management (a) Security Ownership of Certain Beneficial Owners as of February 28, 1994: Name and Shares of Title Address of Beneficial Percent of Class Beneficial Owner Ownership of Class --------------- ---------------------- ------------ ------------- Common Stock of GTE Corporation 978,351 100% GTE North One Stamford Forum shares of Incorporated Stamford, Connecticut record (b) Security Ownership of Management as of December 31, 1993: Common Stock of Name of Director or Nominee All less GTE Corporation ---------------------------- than 1% Richard M. Cahill 37,188 Gerald K. Dinsmore 18,503 Michael B. Esstman 54,051 Thomas W. White 83,071 Earl A. Goode 56,634 Kent B. Foster 168,299 ------- 417,746 ======= Executive Officers(1)(2) --------------------------- Earl A. Goode 56,634 Kent B. Foster 168,299 M. L. Keith, Jr. 9,904 James D. Blanchard 17,933 William A. Zielke 15,283 ------- 268,053 ======= All directors and executive officers as a group(1)(2) 824,013 ======= (1) Includes shares acquired through participation in GTE's Consolidated Employee Stock Ownership Plan and/or the GTE Savings Plan. (2) Included in the number of shares beneficially owned by Messrs. Goode, Foster, Keith, Blanchard and Zeilke and all directors and executive officers as a group are 48,833; 115,583; 7,132; 7,300; 14,278 and 559,603 shares, respectively, which such persons have the right to acquire within 60 days pursuant to stock options. (c) There were no changes in control of the Company during 1993. Item 13.	Item 13. Certain Relationships and Related Transactions The Company`s executive officers or directors were not materially indebted to the Company or involved in any material transaction in which they had a direct or indirect material interest. None of the Company's directors were involved in any business relationships with the Company. PART IV Item 14.	Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a)(1) Financial Statements - Reference is made to the Registrant's Annual Report to Shareholders, pages 5 - 25 for the year ended December 31, 1993, incorporated herein and filed as Exhibit 13. Report of Independent Public Accountants. Consolidated Balance Sheets - December 31, 1993 and 1992. Consolidated Statements of Income for the years ended December 31, 1993-1991. Consolidated Statements of Reinvested Earnings for the years ended December 31, 1993-1991. Consolidated Statements of Cash Flows for the years ended December 31, 1993-1991. Notes to Consolidated Financial Statements. (2) Financial Statement Schedules - Included in Part IV of this report for the years ended December 31, 1993-1991: Page(s) --------- Report of Independent Public Accountants 21 Schedules: V - Property, Plant and Equipment 22-24 VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment 25 VIII - Valuation and Qualifying Accounts 26 X - Supplementary Income Statement Information 27 Note: Schedules other than those listed above are omitted as not applicable, not required, or the information is included in the financial statements or notes thereto. (3) Exhibits - Included in this report or incorporated by reference. 3* Bylaws. Articles of Incorporation and amendments are referenced in the 1986 and 1987 Form 10-K's, respectively. 13 Annual Report to Shareholders for the year ended December 31, 1993, filed herein as Exhibit 13. (b) Reports on Form 8-K - No reports on Form 8-K were filed during the fourth quarter of 1993. - ---------- * Denotes exhibits incorporated herein by reference to previous filings with the Securities and Exchange Commission as designated. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To GTE North Incorporated: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements included in GTE North Incorporated and subsidiary's annual report to shareholders incorporated by reference in this Form 10-K, and have issued our report thereon dated January 28, 1994. Our report on the consolidated financial statements includes an explanatory paragraph with respect to the change in the method of accounting for income taxes in 1992 as discussed in Note 1 to the consolidated financial statements. Our audit was made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed under Item 14 are the responsibility of the Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly state 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 & CO. Dallas, Texas January 28, 1994. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. GTE NORTH INCORPORATED ---------------------- (Registrant) Date March 21, 1994 By EARL A. GOODE --------------------- ----------------------------- EARL A. GOODE President Pursuant to the requirements of the Securities Exchange Act of 1934, this report is signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. EARL A. GOODE President and Director March 21, 1994 - ----------------------- (Principal Executive Officer) EARL A. GOODE GERALD K. DINSMORE Senior Vice President - Finance March 21, 1994 - ------------------------ and Planning and Director GERALD K. DINSMORE (Principal Financial Officer) WILLIAM M. EDWARDS, III Controller March 21, 1994 - ------------------------ (Principal Accounting Officer) WILLIAM M. EDWARDS, III RICHARD M. CAHILL Director March 21, 1994 - ------------------------ RICHARD M. CAHILL MICHAEL B. ESSTMAN Director March 21. 1994 - ----------------------- MICHAEL B. ESSTMAN KENT B. FOSTER Director March 21, 1994 - ----------------------- KENT B. FOSTER THOMAS W. WHITE Director March 21, 1994 - ---------------------- THOMAS W. WHITE
710979_1993.txt	710979	1993	Item 1. Business GENERAL The Company is an international entertainment company with businesses operating in the home video, music retailing and filmed entertainment industries. The Company also has investments in other entertainment related businesses. The Company was incorporated in the State of Delaware in December 1982. HOME VIDEO RETAILING Since July 1985, the Company has been engaged in the home video retailing business, which accounted for 72%, 94% and 100% of the Company's total revenue in 1993, 1992 and 1991, respectively. Over the past five years, the Company has rapidly expanded its home video operations through the development, acquisition and franchising of stores. The following table sets forth the number of video stores in operation as of December 31 for each of the years indicated: Company-owned video stores at December 31, 1993 included 1,803 stores operating under the "Blockbuster Video" trade name, 775 stores operating under the "Ritz" trade name and 120 stores operating under the "Video Towne," "Alfalfa," "Movies at Home" and "Movieland" trade names which the Company acquired in November 1993 as a result of its acquisition of Super Club Retail Entertainment Corporation and subsidiaries ("Super Club"). The Blockbuster video system operates in 49 states in the United States and in nine foreign countries. All financial data, including the number of stores, has been restated to reflect the Company's merger with WJB Video Limited Partnership and certain of its affiliates ("WJB") in August 1993 in a transaction accounted for under the pooling of interests method of accounting. THE HOME VIDEO INDUSTRY The home video industry has experienced substantial growth since 1980. This growth is largely a result of the increase in the number of videocassette recorders ("VCRs") in use both domestically and internationally. Technological advances have improved the dependability, portability, picture quality and convenience of VCRs. Furthermore, many VCRs are now moderately priced. These factors have enhanced significantly the consumer appeal of VCRs. According to Paul Kagan Associates, Inc., VCR unit sales in the United States have remained relatively constant during the past five years, averaging approximately 12,000,000 units per year, while VCR market penetration in the United States has grown significantly, increasing from 53.3% in 1987 to 80.5% in 1993. VCR penetration continues to increase in many areas of the world in which the Company currently has operations, including Europe, the Pacific Rim and Central and South America. By the end of 1994, VCR penetration is expected to increase to approximately 77% in Australia, 74% in the United Kingdom, 75% in Canada and 72% in Japan, according to industry analysts. The Company believes that VCR unit sales in 1994 will continue to remain strong both in the United States and foreign countries as VCR penetration and the number of households owning more than one VCR continue to increase. However, annual increases in VCR penetration levels may continue to be less than in the past as a result of the constantly increasing base of VCRs. There can be no assurance that VCR penetration will continue to increase. The consumer market for feature and other films on prerecorded videocassette is a rental and sales market. An analysis of estimated historical and projected retail home video revenue in the United States (in billions) is as follows: _____________________ Source: Paul Kagan Associates, Inc. According to Paul Kagan Associates, Inc., total worldwide retail home video revenue was $25.3 billion in 1993, up from $23.6 billion in 1992, $22.1 billion in 1991 and $20.7 billion in 1990. New release feature films on videocassette have generally been priced for retail sale in the United States at approximately $60 to $99. This price range tends to discourage retail consumer purchases. In recent years, movie producers have released certain new release feature films priced for retail sale at approximately $15 to $30. This price level has resulted in more unit sales in the United States for these new release feature films than would have been the case at higher retail prices. The Company believes that in the absence of additional significant reductions in feature film retail sales prices, the consumer market in the United States for videocassettes will be primarily a rental market in the foreseeable future. In the event of a significant reduction in retail sales prices, the Company would be able to devote more space in its stores for display of prerecorded videocassettes for sale, although there can be no assurance that such a change would not have a material adverse effect on the Company's results of operations. The Company intends to increase its share of the domestic home video market as the industry continues to grow. Additional video stores are also scheduled to be opened in 1994 in various international markets, including Japan, Europe, Australia, Canada and Mexico and in other areas of Central and South America, by the Company and its franchise owners. COMPANY HOME VIDEO OPERATIONS The Company owns, operates and franchises Blockbuster Video stores. These stores rent and sell prerecorded videocassettes and other entertainment software, as well as sell confectionary items and video accessories. Blockbuster Video stores generally carry a comprehensive selection of 7,000 to 13,000 prerecorded videocassettes, consisting of more than 5,000 titles. The Company believes, based on industry trade publications and its informal inspection of competitors, that Blockbuster Video stores generally offer a greater number of copies of the more popular titles, have greater selection, stay open for longer hours and have faster and more convenient computerized check-in/check-out procedures than most of its competitors. The Company's home video stores do not sell video hardware. Blockbuster Video stores, however, offer customers a limited number of video hardware units for rental. Based on a survey published in the December 1993 issue of Video Store Magazine, the Company believes that the Company's and its franchise owners' systemwide revenue from the rental and sale of prerecorded videocassettes is significantly greater than that of any other home video retail chain in the United States. The Company believes that Blockbuster Video stores are generally larger than most home video retail stores, ranging in size from approximately 3,800 to 11,500 square feet. It is the Company's current intention that all new Company-opened Blockbuster Video stores will be no less than 5,500 square feet in size and that the square footage of its smaller Blockbuster Video stores will be increased where appropriate. Company-owned Blockbuster Video stores generally are, and it is anticipated that most future stores developed by the Company will be, highly visible and located in free-standing structures or at the end of strip shopping centers with ample parking facilities. Blockbuster Video stores are designed and located to be highly visible and to attract their own customers rather than to rely solely on customers generated by neighboring stores. Based on current Blockbuster Video store design and operating criteria, each Company-owned Blockbuster Video store generally requires a capital expenditure, including purchase of initial inventories, of between $375,000 and $700,000, depending on the size and location of the store, leasehold improvement costs and the number of videocassettes and other products stocked for rental and sale. The proprietary computer software used in each Blockbuster Video store has been designed and developed by the Company, and is available only to Company-owned and franchise-owned Blockbuster Video stores and to other video stores which are to be converted to the Blockbuster Video format. The Company developed its computerized point-of-sale system to simplify rental and sale transactions. This system utilizes a laser bar code scanner to read key data from products and from the member's identification card. This system provides management with a daily summary report for financial control of each store and considerable information concerning demographics of each Blockbuster Video store's membership, rental and sale patterns and the number of times each item or title in inventory has been rented or sold. The Company believes this information to be a valuable asset as it relates to its buying and marketing decisions. Since the acquisition of Cityvision plc ("Cityvision") in February 1992, the Company has operated video stores under the trade name "Ritz" in the United Kingdom. These stores average approximately 1,100 square feet in size with, on average, approximately 3,000 videocassettes available for rental and sale. Since the acquisition of Super Club in November 1993, the Company has operated video stores under the trade names "Video Towne", "Alfalfa", "Movies at Home" and "Movieland" in the United States. These stores average approximately 6,700 square feet in size with, on average, approximately 5,000 videocassettes available for rental and sale. The Company has a policy of excluding titles which have been rated either "X" or "NC-17" by the Motion Picture Association of America ("MPAA") from the videocassette inventory of each of its Blockbuster Video stores. The Company also has a Youth Restricted Viewing Program that allows parents to restrict their children under 17 years of age from renting movies that have been rated "R" by the MPAA or movies that have similar themes or content. FRANCHISING In order to maximize its ability to expand rapidly in the home video business, the Company has employed a strategy of developing Blockbuster Video stores through a combination of Company and franchise development. The extent to which a domestic or international market is to be developed, and the balance between Company and franchise development in a given market, is determined by evaluating a number of different criteria, including resources available and operating efficiencies. As of March 1994, the Company's franchise owners are committed under their franchise agreements to open 558 additional Blockbuster Video stores. Under the Company's current franchising program, the Company will grant to a franchise owner the right to develop one or a specified number of Blockbuster Video stores at an approved location or locations within a defined geographic area pursuant to the terms of a development agreement. The franchise owner generally is charged a development fee in advance for each Blockbuster Video store to be developed during the term of the development agreement. Each of the Company's development agreements provides that if a franchise owner fails to open the minimum number of Blockbuster Video stores required by the agreement, the franchise owner may lose exclusivity for the development area as well as the right to open additional Blockbuster Video stores. Prior to the opening of a Blockbuster Video store, the franchise owner enters into the Company's standard franchise agreement. This form of agreement governs the operation of a single Blockbuster Video store during a term of 20 years and in certain circumstances gives the franchise owner the right to renew the franchise agreement for an additional five-year term. At the time the franchise agreement is executed, the franchise owner generally is required to pay to the Company a franchise fee for the right to operate under the Blockbuster Video service marks and a software license fee for the right to use required proprietary software. After a Blockbuster Video store is opened, the franchise agreement requires the franchise owner to pay the Company a continuing royalty and service fee (currently, franchise owners pay fees ranging from 3% to 8% of gross revenue) and a continuing monthly payment for maintenance of the proprietary software. Franchise owners are also required to contribute funds for the development of national advertising and marketing programs and are required to spend an additional amount for local advertising. Each franchise owner has sole responsibility for all financial commitments relating to the opening and operation of Blockbuster Video stores in the franchised territory, including rent, utilities, payroll and other incidental expenses. The Company provides extensive product and support services to its franchise owners and derives income from providing these services. These products and support services include, among other things, site selection reviews, the packaging of the initial rental inventory and providing computer hardware and software. DISTRIBUTION AND INVENTORY MANAGEMENT ACTIVITIES The Company believes that the success of Blockbuster Video stores depends, in part, on effective and timely distribution and inventory management activities. For its distribution center, the Company leases a facility of approximately 69,000 square feet in Dallas, Texas. The Dallas facility, which has storage capacity for over 400,000 videocassettes, is used for shipping, receiving and packaging rental inventories according to the Company's uniform standards. This packaging process involves removing each rental videocassette from its original carton, applying labels and security devices to each videocassette, matching each videocassette with its bar coded information and placing the videocassette into its hard plastic rental case. In addition, a display carton is created for each videocassette by inserting foam and a security device into the original videocassette carton and shrink wrapping the carton. The end result of the packaging process for a Blockbuster Video store's initial rental inventory is a shipment that arrives already sorted alphabetically within categories and ready to be placed on display shelves. This level of packaging and distribution service is enhanced by the Company's automated packaging lines. The Company also provides computer software and hardware, and substantially all related items and fixtures necessary to equip and operate a Blockbuster Video store. The Company has established an inventory management department to select and purchase titles to be carried in Blockbuster Video stores. Several hundred new titles are released every month which are reviewed and evaluated by the inventory management department. This department selects appropriate titles for inclusion in the Company-owned Blockbuster Video stores and recommends to the Company's franchise owners and managers of Company-owned stores the number of copies to be placed in their inventories. Prerecorded videocassettes and other entertainment software rented and sold by the Company are generally purchased directly from distributors. For new release videocassettes, the Company, like others in the home video industry, places a pre-order with a distributor specifying the number of copies of the new title it desires to purchase. Approximately three to four weeks thereafter, the new release becomes available for shipment on an industry-wide basis. On average, home video businesses are currently able to purchase a title for rent or sale about six months after its release to motion picture theaters. Prerecorded videocassettes which exceed the number needed in a particular store because of changing customer demand may be moved to other stores or sold to customers. The Company believes that its ability to move videocassettes from store to store and to sell previously viewed rental videocassettes assists it in effectively controlling videocassette inventories. The Company has been able to negotiate certain favorable terms from one particular distributor, which the Company uses on an exclusive basis. These terms include discounts from suggested retail prices on certain titles, and the ability to return defective merchandise under certain circumstances. The Company is able to return to this distributor a pre-determined number of video cassettes purchased for sale (whether or not defective) within a certain amount of time. SERVICE MARKS The Company owns United States federal registrations for its service marks "Blockbuster", "Blockbuster Video", a torn ticket design, "Blockbuster Video" with the torn ticket design, and other related marks. The federal registrations for "Blockbuster", "Blockbuster Video" and "Blockbuster Video" with the torn ticket design have become incontestable. The Company is in the process of federally registering "Blockbuster Entertainment" and various other trademarks, service marks and slogans. In addition, the Company has registered the service mark "Blockbuster", "Blockbuster Video" and "Blockbuster Video" with torn ticket design in certain foreign jurisdictions and is in the process of registering other related marks in such jurisdictions. The Company considers its service marks important to its continued success. COMPETITION The home video business is highly competitive. The Company believes that the principal competitive factors in the business are title selection, number of copies of titles available, the quality of customer service and, to a lesser extent, pricing. The Company believes that it has generally addressed the selection and service demands of consumers more adequately than most of its competitors. The Company and its franchise owners compete with video retail stores, as well as supermarkets, drug stores, convenience stores, book stores, mass merchandisers and others. According to industry analysts, video retail stores alone have grown from approximately 7,000 outlets in 1983 to approximately 28,000 outlets in 1993. The Company believes that the success of its business depends in part on its large and attractive Company-owned and franchise-owned Blockbuster Video stores offering a wider selection of titles and larger and more accessible inventory than its competitors, in addition to more convenient store locations, faster and more efficient computerized check-in/check-out procedures, extended operating hours, effective customer service and competitive pricing. In addition to competing with other home video retailers, the Company and its franchise owners compete with all other forms of entertainment and recreational activities including, but not limited to movie theaters, network television and other events, such as sporting events. The Company also competes with cable television, which includes pay-per-view television. Currently, pay-per-view television provides less viewing flexibility to the consumer than videocassettes, and the more popular movies are generally available on videocassette prior to appearing on pay-per-view television. However, technological advances could result in greater viewing flexibility for pay-per-view or in other methods of electronic delivery, and such industry developments could have an adverse impact on the Company and its franchise owners' businesses. Notwithstanding these possible technological advances, the Company believes that home video will continue to have the competitive advantages of being not only the first source of filmed entertainment in the home before pay-per-view but also the most convenient source. The Company's corporate marketing department, with the assistance of its advertising agencies, has developed advertising campaigns for implementation systemwide. The Company aggressively uses both local and national advertising, including television commercials. The Company uses vendor advertising allowances, cooperative advertising and promotional programs that are currently made available to the home video industry by producers and distributors of home video products. Generally, these programs provide an allowance to the industry as a whole of approximately 1% to 2% of industry-wide purchases of a particular title for use in advertising and promoting the title. Recently, advertising expense (net of cooperative advertising allowances and amounts received from franchise owners pursuant to various franchise agreements) has averaged between 3% and 5% of the revenue generated by Company-owned video stores. The Company believes that cooperative advertising and promotional programs will continue to be provided by producers and distributors in the future, but such allowances might not continue at current levels. AVAILABILITY OF PRODUCT Prerecorded videocassettes and other entertainment software are readily available from numerous distributors and other suppliers. Although a specific title may only be available from a single source, the Company does not anticipate that the Company or its franchise owners will experience difficulty in obtaining these products. SEASONALITY The Company's home video business may be affected by a variety of factors, including, but not limited to, general economic trends, acquisitions made by the Company, additional and existing competition, marketing programs, weather, special or unusual events, variations in the number of store openings, the quality of new release titles available for rental and sale, and similar factors that may affect retailers in general. As compared to other months of the year, revenue from Blockbuster Video stores in the United States has been, and the Company believes will continue to be, subject to a decline during the months of April and May, due in part to the change to Daylight Savings Time, and during the months of September, October and November, due in part to the start of school and introduction of new television programs. REGULATION Certain states, the United States Federal Trade Commission and certain foreign jurisdictions require a franchisor to transmit specified disclosure statements to potential owners before issuing a franchise. Additionally, some states and foreign jurisdictions require the franchisor to register its franchise before its issuance. The Company believes the offering circulars used to market its franchises comply with the Federal Trade Commission guidelines and all applicable laws of states in the United States and foreign jurisdictions regulating the offering and issuance of franchises. The Company's home video business, other than the franchising aspect thereof, is not generally subject to any government regulation other than customary laws and local zoning and permit requirements. MUSIC RETAILING As of December 31, 1993, the Company was one of the largest specialty retailers of prerecorded music in the United States with 511 retailing outlets operating throughout the country. The Company has been engaged in the music retailing business since November 1992, when it acquired 235 stores in connection with its acquisition of Sound Warehouse, Inc. and subsidiary and Show Industries, Inc. ("Sound Warehouse" and "Music Plus"). In connection with its acquisition of Super Club in November 1993, the Company acquired 270 stores operating under the trade names "Record Bar", "Tracks", "Turtles" and "Rhythm and Views". The Company also owns and operates music stores under the trade name "Blockbuster Music Plus". Additionally, the Company is a partner in an international joint venture with Virgin Retail Group Limited ("Virgin") to develop and operate "Megastores" in continental Europe, Australia and the United States. Through its purchase of Sound Warehouse, Music Plus and Super Club and its joint venture with Virgin, the Company has embarked on a major new expansion effort in the music retailing industry. THE MUSIC RETAILING INDUSTRY In the last decade, the music retailing industry has experienced substantial growth. According to industry analysts, worldwide retail revenue generated by the music industry increased from approximately $12 billion in 1983 to approximately $29 billion in 1992. Retail music revenue in the United States alone was approximately $10 billion in 1993, and is projected by industry analysts to reach approximately $13 billion by the year 1997. An important element of this growth in the music retailing industry has been the increasing worldwide penetration of compact disc players. According to industry analysts, approximately 43% of households in the United States presently have a compact disc player. Industry sources place compact disc player penetration at approximately 40% in Europe and nearly 100% in Japan. Compact discs, the top selling prerecorded music format, are generally more expensive than audiocassette tapes but are considered to be superior due to the higher quality of the sound reproduction and the durability of the discs. Audiocassette tapes were the top selling prerecorded music format prior to the introduction and acceptance of the compact disc. Audiocassette tapes continue to comprise a large percentage of prerecorded music sales due to the large number of audiocassette players in use in homes and automobiles and the large base of portable cassette players in active use. Technology may produce new format media which could affect the Company's future sales. The compact disc has had a positive impact on the prerecorded music retailing business. There is no assurance, however, that other new technologies will gain significant consumer acceptance generally or among the Company's customers. Also, past experience with new technology indicates that, even if successful in gaining acceptance, any significant impact on sales would not be experienced for several years. COMPANY MUSIC OPERATIONS The Company's music stores sell compact discs and audiocassettes manufactured by all major domestic and certain foreign manufacturers. These stores offer a wide selection of prerecorded music. The number of prerecorded music titles offered for sale in the Company's music stores averages approximately 17,400 per music store. The assortment of music titles offered by the Company includes those of prominent artists and established labels. Music selections cover a broad range including, among others, pop, rock, country, classical, jazz and soul. The Company believes that its music stores generally offer a wider selection of prerecorded music than most of its competitors in the markets in which these stores operate. The Company currently also rents and sells prerecorded videocassettes in most of its music stores, but on a much more limited basis than in its Company-owned video stores. The Company anticipates that most future music stores developed by the Company will be highly visible and located in free-standing structures or strip shopping centers with ample parking facilities. Such music stores are designed and located to be highly visible and to attract their own customers rather than relying solely on customers generated by neighboring stores. At December 31, 1993, the Company operated 331 music stores which are located in free-standing structures or strip shopping centers and 180 music stores located in shopping malls. The average size of the Company's music stores is approximately 6,400 square feet. The Company has recently developed its own prototype music store called "Blockbuster Music Plus". New Blockbuster Music Plus stores offer personal listening posts which allow the customer to preview selections prior to purchase and other state-of-the-art features as well as a broad range of musical selections. The Company currently projects that the cost to open a new "Blockbuster Music Plus" store will require an initial investment, including capital expenditures and merchandise inventory of generally between $700,000 and $1,000,000. Retail point-of-sale computer systems at the Company's music stores are currently being standardized for uniformity of use in all of the Company's music stores. Similar to the system in use at the Company's video stores, the Company's music store systems use an optical scanner to read the product's unique bar code, record the appropriate price or charge, and create a customer receipt. Product information is stored on the system for retrieval and analysis, providing valuable information about inventory movement and customer tastes which is considered in subsequent stocking of product inventories. The Company is currently examining the feasibility of integrating its video and music store computer systems. In December 1992, the Company formed an international joint venture with Virgin to take advantage of opportunities in the retailing of music and related products through the ownership and development of Megastores. As of December 31, 1993, the joint venture owned interests in and operated 20 Megastores in France, Germany, Austria, Spain, Italy, Holland, Australia and Los Angeles, California. These Megastores, ranging in size from approximately 25,000 to 40,000 square feet, are generally larger than most retail music stores. The Megastores offer an extremely wide range of music, video and game products, as well as special interest departments, interactive entertainment facilities, personal listening posts, video viewing posts, information centers and even cafes. The Company and Virgin will continue to build Megastores in major metropolitan areas throughout Continental Europe, Australia and the United States. DISTRIBUTION AND INVENTORY MANAGEMENT ACTIVITIES Sound Warehouse, Music Plus and Blockbuster Music Plus operate a central warehouse distribution center located in Dallas, and the Company's remaining music retailing chains operate a central distribution center in Atlanta. Generally, these distribution centers maintain large quantities of popular music titles available for immediate shipment to their respective music stores. The Company believes that the maintenance of the distribution centers allows it to support a wide selection of merchandise within its music stores, minimize music store inventory requirements and labor costs, and maintain effective controls. The Company is currently examining the feasibility of consolidating the Dallas and Atlanta distribution centers. Each of the Company's music chains have product buyers who make initial purchasing decisions on new titles and products for each music store and for the central warehouse distribution centers. In making purchasing decisions, the product buyers consider such factors as knowledge of the new title or product, product background and historical sales from each store. Music store personnel reorder products for the store as needed based upon recent sales of each item compared to the amounts on hand in the store's inventory. Centralized product buyers reorder products for the warehouses by monitoring both detailed sales information and the reorders placed by music store personnel. The Company is in the process of further centralizing purchasing decisions. Most of the products sold by the Company through its music stores are purchased directly from manufacturers. The Company is generally able to lower its cost per product due to favorable volume purchasing terms from its suppliers. Under current trade practices, retailers of prerecorded music are entitled to return products they have purchased from major suppliers. Generally, prerecorded music may be returned as long as it remains in the current catalog of its manufacturer. Suppliers will typically notify retailers before titles are removed from the manufacturer's current catalog. This industry practice permits the Company to carry a wide selection of music, and at the same time reduce the risk of obsolete inventory. Major manufacturers of prerecorded music typically do not limit the amount of merchandise that may be returned by a customer although certain manufacturers penalize the customer through return handling charges. The Company currently does not have any significant amounts of excess prerecorded music inventory that could not be returned to manufacturers under current return policies. The manufacturers' exchange privilege policies have previously been subject to change and may change in the future. Any change in these policies could adversely affect the value of the Company's inventory and affect its business policies. SERVICE MARKS The Company owns United States federal registrations for its service marks "Music Plus", "Music Plus" with design, "Sound Warehouse", "Sound Warehouse" with design and other related marks. The Company is in the process of registering "Blockbuster Music", "Blockbuster Music Plus" with design and various other trademarks, service marks and slogans relating to its music business in the United States and certain foreign jurisdictions. COMPETITION The retail sale of prerecorded music and related products is highly competitive among numerous chain and department stores, discount stores, mail order clubs and specialty music stores. Some mail order clubs are affiliated with major manufacturers of prerecorded music and may have advantageous marketing arrangements with their affiliates. Since music stores generally serve individual or local markets, competition is fragmented and varies substantially from one location or geographic area to another. The Company believes that its ability to compete successfully in the music retailing business depends on its ability to secure and maintain attractive and convenient locations, manage merchandise efficiently, offer broad merchandise selections at competitive prices and provide effective service to its customers. The Company frequently advertises its music stores and products which they carry in newspapers, on radio and television and by direct mail. In addition, the Company frequently engages in promotions which offer products at reduced prices. The Company's advertising emphasizes price, breadth and depth of merchandise, and the convenience of music store locations. Most of the vendors from whom the Company purchases its music store products offer their customers, including the Company, an advertising allowance which is often based on a percentage of a customer's purchases. The Company also receives significant advertising allowances from suppliers of prerecorded music products to promote new artists. The terms of such advertising allowances generally require the Company to submit advertising campaigns to the vendor for approval prior to their use. The Company currently takes full advantage of vendors' advertising allowances. AVAILABILITY OF PRODUCTS The Company has no long-term agreements for the purchase of prerecorded music and related products and deals with its suppliers principally on an order-by-order basis. The Company has not experienced difficulty in obtaining satisfactory sources of supply and believes that adequate sources of supply will continue to exist for the products sold in its music stores. SEASONALITY The Company's music business may be affected by a variety of factors including, but not limited to, general economic trends and conditions in the music industry, including the quality of new titles and artists, existing and additional competition, changes in technology and similar factors that may affect retailers in general. The Company's music business is seasonal, with higher than average monthly revenue experienced during the Thanksgiving and Christmas seasons, and lower than average monthly revenue experienced in September and October. REGULATION The Company's retail music business is not generally subject to any governmental regulation other than customary laws and local zoning and permit requirements. FILMED ENTERTAINMENT In April 1993, the Company expanded into the filmed entertainment business through the acquisition of a majority of the common stock of Spelling Entertainment Group Inc. ("Spelling"). The operations of Spelling encompass a broad range of businesses in the filmed entertainment industry, supported by an extensive library of television series, mini-series, movies-for-television, pilots and feature films (collectively "film product"). At December 31, 1993, the Company owned 45,658,640 shares, or approximately 70.5% of Spelling's outstanding common stock. The Company owns 2,550,000 shares, and warrants to acquire an additional 810,000 shares, of the common stock of Republic Pictures Corporation ("Republic"). At December 31, 1993, the Company's investment in Republic represented approximately 39% of Republic's outstanding common stock, including shares subject to such warrants. Republic is engaged in the development and production of television programming and the distribution of this programming and its extensive library of feature films, television movies and mini-series. In December 1993, Spelling and Republic entered into a definitive agreement pursuant to which a wholly-owned subsidiary of Spelling would be merged with Republic and Republic, as a result of the merger, would become a wholly-owned subsidiary of Spelling. Spelling will exchange $13.00 in cash for each share of Republic common stock issued and outstanding at the effective time of the merger. Options and warrants to acquire shares of Republic common stock will be converted into the right to receive upon payment of the exercise price 1.6508 shares of Spelling common stock for each share of Republic common stock into which such option or warrant was exercisable immediately prior to the effective time of the merger. Consummation of the merger, which is currently anticipated to occur in April 1994, is subject, among other things, to approval by the stockholders of Republic and other customary conditions. Following the merger, the operations of Spelling and Republic will be substantially consolidated. With the Company's ownership of a majority interest in Spelling, the Company has a significant presence in the development, production and distribution of television programming and filmed entertainment. COMPANY FILMED ENTERTAINMENT OPERATIONS Spelling is engaged primarily in the development, production, acquisition and distribution of television programming. Spelling also produces feature films for others, distributes films in international markets and licenses music and merchandising rights associated with its television programming. Television programming is developed and produced by Spelling primarily through two subsidiaries, Spelling Television and Laurel Entertainment ("Laurel"). Spelling's distribution activities are carried out by its Worldvision Enterprises subsidiary ("Worldvision"). Additionally, Worldvision engages in production by advancing funds to producers in exchange for all or a portion of the distribution rights. The primary markets for the television programming produced, funded or otherwise acquired by the Company include first-run network exhibition, domestic first-run and repeat syndication (including cable), international syndication and home video. NETWORK PROGRAMMING Scripts written for network television programming are submitted to the network for review. If the network accepts the script, it will typically order production of a pilot or a prototype episode, for which it will pay Spelling a negotiated fixed license fee. Spelling's cost of producing such a pilot usually exceeds the network license fee. As of March 1994, Spelling had received orders for two new series projects. One is an eight episode order of a one-hour series for the Fox network, tentatively titled "Models, Inc." and the other is a six episode order of a one-hour series for the Fox network, tentatively titled "Shock Rock". The Company has other projects under network consideration. Spelling is currently producing the television series "Beverly Hills, 90210" and "Melrose Place" which are being aired on the Fox network. "Beverly Hills, 90210" is in its fourth season and has been renewed for the 1994-95 television season. "Melrose Place", which debuted during the summer of 1992, is in its second full season, and has also been renewed for the 1994-95 television season. Spelling is also producing the television series "Winnetka Road" and "Burke's Law", both mid-season replacements, and has received an order for an additional 13 episodes of "Burke's Law" from the CBS network for the 1994-95 television season. In 1993, Laurel produced "The Stand", an eight-hour mini-series based on one of Stephen King's best selling books, which was delivered to the ABC network in December 1993 and is scheduled to air in May 1994. Spelling has recently received orders for two four-hour mini-series from the ABC network, one based on James Michener's novel, "Texas" and the other based on Stephen King's novel, "The Langoliers". Laurel has also produced a movie-for-television, "Precious Victims", which aired on the CBS network in September 1993. As with television series, the network license fees received for mini-series and movies-for-television are normally less than the costs of production, and such deficits must be covered by revenue derived from other sources of distribution, primarily through the exploitation of rights in international markets. Spelling had revenue from one customer, the Fox network, representing 22%, 22% and 13% of Spelling's revenues in 1993, 1992 and 1991, respectively. FIRST-RUN SYNDICATED PROGRAMMING First-run syndicated television series are produced and sold directly to television stations in the United States without any prior network broadcast. These programs are licensed to individual or groups of television stations, on a market by market basis, in contrast to network distribution, which provides centralized access to a national audience. In first run syndication, Spelling licenses its film product in exchange for cash payments, advertising time (barter) or a combination of both. In cash licensing, a broadcaster normally agrees to pay a fixed licensing fee in one or more installments in exchange for the right to broadcast the product a specified number of times over an agreed upon period of time. Where product is licensed in exchange for advertising time, through what are known as "barter agreements", a broadcaster agrees to give Spelling a specified amount of advertising time, which Spelling subsequently sells. Particuarly in the initial years of such programming, domestic syndication revenue can be less than Spelling's costs of producing the programming. Worldvision is currently marketing for first-run barter syndication 22 episodes each of two series, currently titled "Robin's Hoods" and "Heaven Help Us", to be produced by Spelling Television. Worldvision has also begun to distribute these programs to international television markets for cash license fees. In first-run syndication, the Company retains greater control over creative and production decisions than is the case with network programming; however, there is a greater financial risk associated with such programming, and potentially greater financial upside. Fixed license fees paid by networks usually cover at least 75% of Spelling's production costs; however, Spelling does not share in the network's advertising revenue which can be substantial. Barter revenue is not fixed but is dependent on the viewing public's acceptance or rejection of the show as reflected in the ratings. If a show's ratings are high, the advertising revenue received by the Company through its barter arrangement could be substantial. ACQUIRING DISTRIBUTION RIGHTS A substantial portion of Worldvision's revenue is derived from fees earned from the distribution and licensing of television programming produced by Spelling. In addition, since 1989, Worldvision has invested approximately $150 million in the acquisition of distribution rights to film product from third parties. Worldvision acquires the exhibition rights to television programming and feature films through contracts with the producers or other owners of such products. These contracts generally give Worldvision the exclusive distribution rights to license an unlimited number of exhibitions of the film products over a period of time, typically in excess of twenty years. Worldvision also acquires distribution rights from third party producers by partially financing production costs through advances to such producers which are recovered by Worldvision from revenue earned from distribution. Usually Worldvision recovers its distribution fees, expenses and advances before the producers or owners receive any additional proceeds. Worldvision currently distributes programming in 110 countries through offices in New York, Chicago, Atlanta, Los Angeles, London, Paris, Rome, Toronto, Sydney, Tokyo and Rio de Janeiro. In September 1992, Worldvision purchased from Carolco Television Inc. the domestic television rights to a film library of more than 150 feature films along with certain related receivables. The library includes box-office hits such as "Terminator 2", "Basic Instinct", the "Rambo" trilogy, "L.A. Story", "Red Heat", "Total Recall", "Platoon", "The Last Emperor" and "Universal Soldier". Due to pre-existing licensing agreements covering these films, the Company will not recognize significant revenue from the exploitation of the rights until after 1996. LICENSING AND MERCHANDISING Hamilton Projects, Inc. ("Hamilton Projects"), a subsidiary of Spelling, merchandises products and licenses music associated with several of the Company's television properties, including "Beverly Hills, 90210", and "Melrose Place". Hamilton Projects is a full-service licensing and merchandising company, providing strategic planning, concept development and program execution to the Company as well as third parties. SERVICE MARKS Spelling or its subsidiaries own various United States federal trademark or service mark registrations including "Spelling", "Beverly Hills, 90210", "Melrose Place", and has applied for registration for numerous other marks relating to its film products in the United States and foreign countries. Spelling or its subsidiaries own various foreign trademark or service mark registrations or have applied for trademark or service mark registrations including "Tele Uno". COMPETITION The motion picture and television industry is highly competitive. Many companies compete to obtain access to the available literary properties, creative personnel, talent, production personnel, television acceptance, distribution commitments and financing, which are essential to produce and sell their film products. Certain of Spelling's competitors have greater available resources for promotion and marketing and more people engaged in the acquisition, development, production and distribution of both television programming and feature films. Spelling must continue to acquire distribution rights to television programming and feature films to maintain its competitive position. In order to acquire rights to distribute new third party film product, Spelling may be required to increase its advances to producers or to reduce its distribution fees. Spelling's arrangements with the networks provide it with pilot, series and movies-for-television commitments; however, the networks are under no obligation to actually broadcast Spelling's product. Spelling's sucessful domestic repeat syndication of a network series generally depends upon the ratings achieved through network exhibition of such a series over a number of years sufficient to generate a minimum of 65 episodes. In turn, Spelling's overall success in achieving multiple years of network exhibition of a series is dependent upon factors such as the viewing public's taste (as reflected in the ratings) and critical reviews. Licensing television programming to broadcasters and cable networks has also become increasingly competitive as new products continually enter the syndication market and certain producers attempt to develop an additional network to distribute their product. Likewise, Spelling is competing with numerous well-financed, experienced companies engaged in feature film production and international feature film distribution. Spelling's relative lack of experience and financial strength in distributing feature films in the international market may hinder its ability to compete effectively with companies which are more experienced and have greater financial capabilities. GOVERNMENT REGULATION The production and distribution of television programming by independent producers is not directly regulated by the federal or state governments, but the marketplace for television programming is substantially affected by regulations of the Federal Communications Commission ("FCC") applicable to television stations, television networks and cable television systems. In 1993, the FCC further relaxed its rules governing financial interests in and syndication of programming by the broadcast television networks (known as the "fin syn" rules). The relaxed rules still prohibit the three largest broadcast networks from (i) holding or acquiring financial interests and syndication rights in any first-run program, except in programs produced solely by the network and in programs distributed only outside the United States, (ii) domestically syndicating any prime time network or first-run non-network program, and (iii) withholding a prime time program in which it has syndication rights from syndication for more than a specified period. However, these remaining restrictions on program syndication by the networks are set to expire in November 1995, and are currently the subject of judicial review. In addition, in November 1993 a Federal district court vacated certain provisions of consent decrees which prohibited television networks from acquiring financial interests and syndication rights in television programming developed or created by non-network suppliers such as the Company. The effect of the relaxed fin syn rules and the district courts' action on the operations of the Company is as yet unclear; however, these regulatory changes could result in increased competition for the Company's filmed entertainment business. Foreign regulations may also affect the Company's filmed entertainment business. In 1989, the twelve-member European Community ("EC") adopted a "directive" that its member states ensure that more than 50% of the programming shown on their television stations be European-produced "where practicable". These guidelines could restrict the amount of American television programming and feature films that are shown on European television. In addition, certain European countries have adopted individual national restrictions on broadcasting of programming based on country of origin. Other countries in which the Company distributes its programming may adopt similar restrictions, which may have an adverse effect on its ability to distribute its programs or create stronger incentives for the Company to establish ventures with international films. OTHER ENTERTAINMENT In October 1993, the Company purchased 24,000,000 shares of newly-issued Series A Cumulative Convertible Preferred Stock ("Preferred Stock") of Viacom Inc. ("Viacom") for an aggregate purchase price of $600,000,000. The Preferred Stock provides for dividends at an annual rate of 5% and is convertible into non-voting Viacom Class B common stock at a conversion price of $70 per share. In January 1994, the Company and Viacom entered into a subscription agreement ("the Subscription Agreement") pursuant to which, in March 1994, the Company purchased from Viacom 22,727,273 shares of non-voting Viacom Class B common stock for an aggregate purchase price of $1,250,000,000 or $55 per share. Under the terms of the Subscription Agreement, the Company was granted certain rights to a make-whole amount in the event that the Merger Agreement discussed below under the caption "Viacom Merger Agreement" is terminated and the highest average trading price of the non-voting Viacom Class B common stock during any consecutive 30 trading day period prior to the first anniversary of such termination is below $55 per share. Such make-whole amount would be based on the difference between $55 per share and such highest average trading price but may not exceed $275,000,000. See "Viacom Inc. Agreements" of Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations and Note 12, Other Matters, of Notes to Consolidated Financial Statements for further discussion of the Company's investment in Viacom. At December 31, 1993, the Company owned 7,153,750 shares or approximately 19.1% of the outstanding common stock, of Discovery Zone, Inc. ("Discovery Zone"). Discovery Zone owns, operates and franchises indoor recreational facilities for children. The Company currently operates 34 Discovery Zone facilities and has franchise rights to develop an additional 91 Discovery Zone facilities. The Company has also entered into a joint venture agreement with Discovery Zone pursuant to which the joint venture has been granted the right to develop an additional 10 Discovery Zone facilities in the United Kingdom. EMPLOYEES In March 1994, the Company had approximately 46,000 employees, including 43 officers, 37,000 video and music retail employees in the United States and 9,000 other employees. Other employees consist principally of the Company's international employees. Of the retail employees in the United States, the Company had approximately 8,800 full-time and 28,200 part-time store employees. The total staffing for a Blockbuster Video store is generally 10 to 15 employees (full-time and part-time), including a store manager. The total staffing for a music store is generally 15 to 18 employees (full-time and part-time), including a store manager. The required staffing in the Company's video and music stores at any one point in time generally ranges between 2 to 10 employees, and is dependant upon the time of season, day of the week and time of the day. At December 31, 1993, Spelling employed or had service agreements with approximately 223 employees who were employed in administrative or other positions which are relatively independent of the Company's current level of production activities. In addition, Spelling employs individuals for particular production projects. As a result, the number of employees and production project employees providing services to Spelling can vary substantially during the course of a year depending upon the number and scheduling of its productions. Certain subsidiaries of Spelling are signatories to certain collective bargaining agreements relating to the various types of employees and independent contractors required to produce the television programming and feature films. The Company's other employees are not represented by a labor union or covered by a collective bargaining agreement. The Company believes its relationship with employees to be good. VIACOM MERGER AGREEMENT In January 1994, the Company and Viacom entered into a merger agreement under which the Company would merge with and into Viacom, with Viacom being the surviving corporation. Under the terms of the merger agreement, each outstanding share of the Company's common stock, other than shares owned by Viacom or any subsidiary of Viacom or the Company and any dissenting shares (if applicable), shall be converted into the right to receive (i) .08 of one share of Viacom Class A common stock, (ii) .60615 of one share of non-voting Viacom Class B common stock, and (iii) up to an additional .13829 of one share of non-voting Viacom Class B common stock, with such amount to be determined in accordance with, and the right to receive such shares evidenced by, one variable common right (a "VCR") issued by Viacom. Employee stock options and warrants to acquire Company common stock outstanding as of the effective time of the merger will become exercisable thereafter for the merger consideration described above. The number of shares of non-voting Viacom Class B common stock into which the VCRs convert will generally be based upon the highest 30 consecutive trading day average price of the non-voting Viacom Class B common stock during the 90 trading day period prior to the conversion date, which occurs on the first anniversary of the completion of the merger. In the event that such value is more than $40.00 per share but less than $48.00 per share, the VCRs will convert into the right to receive .05929 of a share of non-voting Viacom Class B common stock. If such value is below $40.00 per share, such number of shares will increase ratably to the maximum of .13829 of a share of non-voting Viacom Class B common stock at a value of $36.00 per share or, if such value is above $48.00 per share, the number of shares into which the VCR will convert will decrease ratably to have no value at a price of $52.00 per share. The upward adjustment in the value of the VCR in excess of .05929 of a share of non-voting Viacom Class B common stock will not be made in the event that, during any 30 trading day period following the completion of the merger and prior to the conversion date, the average closing price exceeds $40.00 per share. In the event that during any such period such average price exceeds $52.00 per share, the VCR will terminate. Consummation of the merger is subject to certain conditions, including, among other things, approval by the stockholders of the Company and Viacom. Item 2.		Item 2. Properties The Company owns its corporate headquarters which total approximately 133,200 square feet located in Fort Lauderdale, Florida. The Company owns the land and building for 54 of its Blockbuster Video stores and leases all of the remaining real estate sites (including the buildings and improvements thereon) upon which Company-owned video stores are located. The Company's principal home video distribution and warehouse facility is located in Dallas, Texas in a leased facility of approximately 69,000 square feet. The lease for the distribution center expires on December 31, 1995. The Company also has leased office facilities in eleven cities in the United States serving as regional and district offices and has leased office space in Toronto, Canada, in London, England and in Tokyo, Japan in connection with its home video businesses. The Company owns the land and building for two of its retail music stores and owns the building of a third music store location which is located on leased land. The Company leases the remaining real estate sites (including the buildings and improvements thereon) upon which the Company's music stores are located. The Company leases space for offices and a distribution center in Dallas, Texas relating to the operations of Sound Warehouse, Music Plus and Blockbuster Music Plus. The space consists of two buildings in which the Company leases approximately 155,000 square feet of total floor space. The Company also has leased office space in Los Angeles, California and Atlanta, Georgia and distribution centers in Atlanta, Georgia and Durham, North Carolina in connection with its music business. Spelling leases office space of approximately 51,000 square feet in Los Angeles and approximately 63,000 square feet in New York. In addition, Spelling leases offices in other cities in the United States and in various other countries throughout the world in connection with its international distribution activities. Spelling also rents facilities on a short-term basis for the production of its film product, including approximately 80,000 square feet in Vancouver, British Columbia. The Company owns approximately 1,770 acres of land in Southeast Florida upon which it is considering the development of a sports and entertainment complex. The Company is currently undertaking various studies and analyses to determine whether such a project would be feasible. Management believes that the Company's distribution, warehouse and office facilities will be adequate for its home video, music retailing and filmed entertainment businesses in the foreseeable future. Item 3.	Item 3. Legal Proceedings The Company has become subject to various lawsuits, claims and other legal matters in the course of conducting its business, including its business as a franchisor. The Company believes that such lawsuits, claims and other legal matters should not have a material adverse effect on the Company's consolidated results of operations or financial condition. Spelling is involved in a number of legal actions including threatened claims, pending lawsuits and contract disputes, environmental clean-up assessments, damages from alleged dioxin contamination and other matters. While the outcome of these suits and claims cannot be predicted with certainty, the Company believes based upon its knowledge of the facts and circumstances and applicable law that the ultimate resolution of such suits and claims will not have a material adverse effect on the Company's results of operations or financial condition. This belief is also based upon the adequacy of approximately $30,000,000 of accruals that have been established for estimated losses on disposal of former operations and remaining Chapter 11 disputed claims, and an insurance-type indemnity agreement which covers up to $35,000,000 of certain such liabilities in excess of a threshold amount of $25,000,000, subject to certain adjustments. Substantial portions of such accruals are intended to cover environmental costs associated with Spelling's former operations. Such accruals are recorded without discount or offset for either the time value of money prior to the anticipated date of payment or expected recoveries from insurance or contribution claims against unaffiliated entities. Item 4.	Item 4. Submission of Matters to a Vote of Security Holders No matters were submitted to a vote of security holders. EXECUTIVE OFFICERS OF THE COMPANY See Part III, Item 10 of this report. PART II. Item 5.	Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters The common stock, $.10 par value ("Common Stock"), of the Company is listed on the New York Stock Exchange and the London Stock Exchange. The following table sets forth the quarterly high and low prices of the Common Stock for the period from January 1, 1992 through December 31, 1993 on the New York Stock Exchange Composite Tape as reported by the Wall Street Journal (Southeast Edition). At March 18, 1994, there were 12,728 holders of record of the Common Stock. In April 1992, the Board of Directors of the Company adopted a policy providing for the payment of quarterly cash dividends to the Company's stockholders and declared a cash dividend of two cents per share which was paid on July 1, 1992 to stockholders of record on May 4, 1992. On May 11, 1993, the Board of Directors of the Company amended such policy to provide for the payment of quarterly cash dividends to the Company's stockholders of two and one half cents per share. Item 6.	Item 6. Selected Financial Data In August 1993, the Company merged with WJB. This transaction has been accounted for under the pooling of interests method of accounting and, accordingly, the Company's financial statements have been restated for all periods as if the companies had operated as one entity since inception. The following Selected Financial Data should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations", the Company's Consolidated Financial Statements and Notes thereto, and other financial information appearing elsewhere in this Form 10-K. See Notes 2 and 12, Business Combinations and Investments and Other Matters, of Notes to Consolidated Financial Statements for a discussion of business combinations and their effect on comparability of year-to-year data as well as events occurring subsequent to December 31, 1993. Item 7.	Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations VIACOM INC. AGREEMENTS In January 1994, the Company entered into a merger agreement pursuant to which the Company has agreed to merge into Viacom Inc. ("Viacom"), with Viacom being the surviving corporation. The closing of the merger is subject to customary conditions, including approval of the merger by the Company's stockholders. Concurrently with the merger agreement, the Company entered into a subscription agreement pursuant to which in March 1994 the Company purchased from Viacom 22,727,273 shares of non-voting Viacom Class B common stock for an aggregate purchase price of $1,250,000,000, or $55 per share. Under the terms of the subscription agreement, the Company was granted certain rights to a make-whole amount in the event that the merger agreement is terminated and the highest average trading price of the non-voting Viacom Class B common stock during any consecutive 30 trading day period prior to the first anniversary of such termination is below $55 per share. Such make-whole amount would be based on the difference between $55 per share and such highest average trading price per share. However, the aggregate make-whole amount may not exceed $275,000,000. Viacom is entitled to satisfy its obligation with respect to any such make-whole amount, at Viacom's option, either through the payment to the Company of cash or marketable equity or debt securities of Viacom, or a combination thereof, with an aggregate value equal to the make-whole amount or through the sale to the Company of the theme parks currently owned and operated by Paramount Communications Inc., a subsidiary of Viacom. In the event that Viacom were to elect to sell the theme parks to the Company, the purchase price would be $750,000,000, payable through delivery to Viacom of shares of non-voting Viacom Class B common stock valued at $55 per share. If the theme parks were so purchased by the Company, the subscription agreement further provides that the Company would grant an option to Viacom, exercisable for a period of two years after the date of grant, to purchase a 50% equity interest in the theme parks at a purchase price of $375,000,000. See "Capital Structure" under the heading of "Financial Condition" and "Recently Issued Accounting Standards" of Management's Discussion and Analysis of Financial Condition and Results of Operations and Note 12, Other Matters, of Notes to Consolidated Financial Statements for a further discussion related to these transactions. BUSINESS COMBINATIONS AND INVESTMENTS The Company makes its decisions to acquire or invest in businesses based on financial and strategic considerations. All business combinations discussed below, except for the merger with WJB Video Limited Partnership and certain of its affiliates ("WJB"), were accounted for under the purchase method of accounting and, accordingly, are included in the Company's financial statements from the date of acquisition. In November 1993, the Company acquired all of the outstanding capital stock of Super Club Retail Corporation and subsidiaries ("Super Club") from certain subsidiaries of Philips Electronics N.V. ("Philips"). The purchase price paid by the Company was approximately $150,000,000 and consisted of 5,245,211 shares of Common Stock and warrants to acquire additional shares of Common Stock. The warrants give Philips the right to acquire 1,000,000 and 650,000 shares of Common Stock at exercise prices of $31.00 and $32.42 per share, respectively. As a result of the acquisition, the Company added to its system 270 music stores and 120 video stores operating primarily in the southeastern United States. In October 1993, the Company purchased 24,000,000 shares of newly-issued Series A cumulative convertible preferred stock of Viacom for an aggregate purchase price of $600,000,000, representing a purchase price of $25 per share. The preferred stock provides for the payment of quarterly dividends at an annual rate of 5% and is convertible into non-voting Viacom Class B common stock at a conversion price of $70 per share. The preferred stock is redeemable at the option of Viacom beginning in October 1998. In August 1993, the Company merged with WJB, the Company's then largest franchise owner with 209 stores operating in the southeastern United States. In connection with the merger, the Company issued 7,214,192 shares of its Common Stock in exchange for the equity interests of WJB. This transaction has been accounted for under the pooling of interests method of accounting and, accordingly, the Company's financial statements have been restated for all periods as if the companies had operated as one entity since inception. During the second quarter of 1993, the Company acquired a majority of the common stock of Spelling Entertainment Group Inc. ("Spelling"), a producer and distributor of filmed entertainment. The aggregate consideration paid by the Company was approximately $163,369,000 and consisted of cash and 9,278,034 shares of Common Stock. The Company also issued to certain sellers of Spelling's common stock, warrants to acquire an aggregate of 2,000,000 shares of the Company's Common Stock, at an exercise price of $25 per share. Additionally, in October 1993, the Company exchanged 3,652,542 shares of Common Stock for 13,362,215 newly issued shares of Spelling's common stock. See Note 7, Shareholders' Equity, of Notes to Consolidated Financial Statements for a further discussion of this transaction. As a result of the transactions described above, the Company owned approximately 70.5% of the outstanding common stock of Spelling at December 31, 1993. During 1993, the Company also acquired or invested in businesses that own and operate video stores, are involved in the production and distribution of filmed entertainment, and own, operate and franchise indoor recreational facilities for children. The aggregate purchase price paid by the Company was approximately $195,610,000 and consisted of cash and 5,631,180 shares of Common Stock. In November 1992, the Company acquired Sound Warehouse, Inc. and subsidiary and Show Industries, Inc. ("Sound Warehouse" and "Music Plus"). Sound Warehouse and Music Plus are among the largest specialty retailers of prerecorded music in the United States with 235 stores operating in 40 metropolitan areas in 15 states at December 31, 1993. The purchase price paid by the Company was approximately $190,000,000 and consisted of cash and 4,142,051 shares of Common Stock. In February 1992, the Company acquired Cityvision plc ("Cityvision"), the largest home video retailer in the United Kingdom. The purchase price paid by the Company was approximately $125,000,000 and consisted of cash and 3,999,672 shares of Common Stock. At December 31, 1993, Cityvision operated 775 stores under the trade name "Ritz". During 1992, the Company also acquired or invested in several other businesses that own and operate video and music stores. The aggregate purchase price paid by the Company was approximately $103,774,000 and consisted of cash and 2,112,977 shares of Common Stock. During 1991, the Company acquired several businesses that own and operate video stores. The aggregate purchase price paid by the Company was approximately $89,614,000 and consisted of cash and 6,492,757 shares of Common Stock. The Company may from time to time invest in or acquire other businesses, properties or securities. See "Capital Structure" under the heading "Financial Condition" of Management's Discussion and Analysis of Financial Condition and Results of Operations and Notes 2 and 12, Business Combinations and Investments and Other Matters, of Notes to Consolidated Financial Statements for a further discussion of business combinations and their effect on comparability of year-to-year data. RESULTS OF OPERATIONS The Company continued its record of profitable growth during 1993. Revenue was $2,227,003,000, an increase of 69% over the prior year. Net income was $243,646,000 and net income per share was $1.10, increases of 64% and 45%, respectively, over 1992. The strong performance of a greater number of stores in operation, including newly acquired video and music stores, the addition of the Company's filmed entertainment business and a 9.2% increase in same store revenue for video stores in operation for more than one year contributed to the significant increases in revenue, net income and net income per share. The following table reflects the Company's operating performance ratios (shown as a percentage of revenue or average investment) as of December 31 for each of the years indicated: The ratios presented above generally met or exceeded the Company's performance goals. Returns on average capital, equity and assets declined in 1993 due primarily to the Company's strategic $600,000,000 investment in Series A cumulative convertible preferred stock of Viacom which provides a fixed rate of return which is less than the return historically achieved by the Company's video, music and filmed entertainment businesses. Return on average equity also decreased due to the increase in equity resulting from the conversion of the Company's Liquid Yield Option Notes ("LYONs") to shares of Common Stock. There can be no assurance that the ratios presented above will continue at the same levels. See also "Capital Structure" under the heading "Financial Condition" of Management's Discussion and Analysis of Financial Condition and Results of Operations. The following table sets forth the number of video and music stores in operation as of December 31 for each of the years indicated: Company-owned video stores at December 31, 1993 included 775 stores operating under the "Ritz" trade name and 120 Super Club stores operating under the "Video Towne", "Alfalfa", "Movies at Home" and "Movieland" trade names. Company-owned music stores at December 31, 1993 consist of 511 retailing outlets currently operating under the "Blockbuster Music Plus", "Sound Warehouse", "Music Plus", "Record Bar", "Tracks", "Turtles" and "Rhythm and Views" trade names. Joint venture music stores at December 31, 1993 consist of "Megastores" operating under joint ventures with the Virgin Retail Group Limited ("Virgin"). The Company may from time-to-time convert certain Company-owned video and music stores operating under non-Blockbuster trade names to Blockbuster format stores. Additionally, the Company may decide to close or relocate certain Company-owned stores for various strategic reasons. As a franchisor of video stores, the Company may from time-to-time purchase certain franchise-owned stores or sell certain Company-owned stores to franchise owners in order to achieve the optimum mix of franchise-owned and Company-owned video stores within specific markets and the optimum division of geographic territory between the Company and its franchise owners. The Company's video business may be affected by a variety of factors including, but not limited to, general economic trends, acquisitions made by the Company, additional and existing competition, marketing programs, weather, special or unusual events, variations in the number of store openings, the quality of new release titles available for rental and sale, and similar factors that may affect retailers in general. As compared to other months of the year, revenue from Company-owned video stores in the United States has been, and the Company believes will continue to be, subject to a decline during the months of April and May, due in part to the change to Daylight Savings Time, and during the months of September, October and November, due in part to the start of school and introduction of new television programs. The Company's video business may also be affected by technological advances including, but not limited to, those relating to pay-per-view television. Currently, pay-per-view television provides less viewing flexibility to the consumer than videocassettes, and the more popular movies are generally available on videocassette prior to appearing on pay-per-view television. However, technological advances could result in greater viewing flexibility for pay-per-view television or in other methods of electronic delivery, and such industry developments could have an adverse impact on the Company and its franchise owners' businesses. Notwithstanding these possible technological advances, the Company believes that home video will continue to have the competitive advantages of being not only the first source of filmed entertainment in the home before pay-per-view but also the most convenient source. The Company's music business in general may be affected by economic conditions and conditions in the music industry including, but not limited to, the quality of new titles and artists, existing and additional competition, changes in technology and similar factors that may affect retailers in general. The Company's music business is seasonal with higher than average monthly revenue normally experienced during the Thanksgiving and Christmas seasons, and somewhat lower than average revenue normally experienced in September and October. The Company believes that as it continues to open and acquire video and music stores in areas in which there are existing Company stores, revenue and operating income of such existing stores may decline. The Company believes such a decline could result from certain customers of existing stores choosing to become customers of new Company stores due to more convenient locations. The Company, however, believes that aggregate revenue and operating income generated by all stores in operation will most likely increase because newly-opened and acquired Company stores typically not only draw customers from existing Company stores, but may also draw customers of competitors' stores who prefer the more favorable selection, convenience and shopping experience of a nearby Company store. The success of the Company's filmed entertainment business depends, in part, upon the network exhibition of its television series over several years to allow for more profitable licensing and syndication arrangements. During the initial years of a television series, network and international license fees normally approximate the production costs of the series, and accordingly, the Company recognizes only minimal profit or loss during this period. If a sufficient number of episodes of a series are produced, the Company is reasonably assured that it will also be able to sell the series in the domestic off-network market, and the Company would then expect to realize a more substantial profit with respect to the series. The Company's filmed entertainment business in general may also be affected by the public taste, which is unpredictible and subject to change, and by conditions within the filmed entertainment industry including, but not limited to, the quality and availability of creative talent and the negotiation and renewal of union contracts relating to writers, directors, actors, musicians and studio craftsmen, as well as any changes in the law and governmental regulation. In 1993, a Federal district court vacated certain provisions of consent decrees which prohibited television networks from acquiring financial interests and syndication rights in television programming developed or created by non-network suppliers such as the Company. Accordingly, subject to certain restrictions imposed by the Federal Communications Commission, the networks will be able to negotiate with program suppliers to acquire financial interests and syndication rights in television programs that air on the networks and therefore could become competitors of the Company. The following is a discussion of significant items in the Consolidated Statements of Operations for the three years ended December 31, 1993: RENTAL REVENUE Rental revenue consists primarily of the rental of videocassettes and was $1,285,412,000 in 1993, as compared to $969,333,000 in 1992 and $742,013,000 in 1991, representing annual increases of 33% and 31%, respectively. The significant increases in rental revenue in 1993 and 1992 are primarily the result of the increased number of Company-owned video stores in operation and increased same store rental revenue for video stores in operation for more than one year. PRODUCT SALES The following table sets forth the components of product sales revenue for the years ended December 31 (in thousands): Product sales at music stores, which consist principally of the sales of compact discs, audiocassettes and other music related items, represent sales made at Sound Warehouse and Music Plus stores which were acquired by the Company in November 1992 and Super Club music stores which were acquired in November 1993. The significant increases in product sales at Company-owned video stores, which consist principally of the sales of prerecorded videocassettes, confectionery items and video accessories, are primarily due to a greater number of stores in operation and an increase in product sales on a per store basis. Revenue from product sales in Company-owned video stores represented approximately 16% of total video store revenue for 1993 and 1992 and 15% for 1991. See Revenue Recognition of Note 1, Summary of Significant Accounting Policies, of Notes to Consolidated Financial Statements for a further discussion of product sales. OTHER REVENUE Other revenue consists primarily of programming and distribution revenue generated by the Company's filmed entertainment business, which was acquired during 1993, and royalties from video franchising activities. Programming and distribution revenue is derived primarily from network license fees, first run syndication sales and fees arising from domestic and international television licensing agreements. The following table sets forth the components of other revenue for the years ended December 31 (in thousands): See Revenue Recognition of Note 1, Summary of Significant Accounting Policies, of Notes to Consolidated Financial Statements for a further discussion of other revenue. OPERATING COSTS AND EXPENSES The following table sets forth the cost of product sales as a percentage of product sales revenue and programming and distribution expenses as a percentage of programming and distribution revenue. All other operating expenses and selling, general and administrative expenses are shown as a percentage of total revenue for the years ended December 31: The above table represents consolidated percentages of operating costs and expenses which include the addition of the Company's music business in November 1992 and its expansion during 1993 and the addition of the Company's programming and distribution business in April 1993. The inclusion of these businesses affect the comparability of year-to-year data as more fully described below. COST OF PRODUCT SALES Cost of product sales was $430,171,000, $196,175,000 and $126,746,000 for the years ended December 31, 1993, 1992 and 1991, respectively. These increases are consistent with the increases in product sales revenue for such periods. The decrease in cost of product sales as a percentage of product sales revenue for the years ended December 31, 1993 and 1992 is primarily attributable to the addition of the Company's music business in late 1992 and its expansion during 1993. The sale of music products generated higher gross margins than those historically achieved from the sale of video related products. OPERATING EXPENSES Programming and distribution expenses were $151,610,000 for the year ended December 31, 1993. Such expenses relate to the Company's filmed entertainment business and include amortization of film costs and program rights, amounts paid or due to producers, and other residual and profit participation expenses. See Film Costs and Program Rights of Note 1, Summary of Significant Accounting Policies, of Notes to Consolidated Financial Statements for a further discussion of programming and distribution expenses. Compensation, occupancy, and depreciation and amortization expenses, as percentages of revenue, declined in 1993 compared to 1992. These decreases relate principally to the addition of the Company's music and filmed entertainment businesses for the 1993 periods. The ratios of compensation, occupancy, and depreciation and amortization expenses to the revenue of such businesses were lower than the ratios historically achieved in the Company's video business. Compensation expenses were $349,798,000, $238,531,000 and $187,199,000 for the years ended December 31, 1993, 1992 and 1991, respectively. These increases are primarily a result of the continued expansion of the Company's business through the development and acquisition of video stores and the addition of the Company's music and filmed entertainment businesses. Occupancy expenses were $297,953,000, $217,860,000 and $154,289,000 for the years ended December 31, 1993, 1992 and 1991, respectively. These increases are primarily the result of the continued expansion of the Company's business through the development and acquisition of video and music stores. Depreciation and amortization expenses were $396,122,000, $306,829,000 and $223,672,000 for the years ended December 31, 1993, 1992 and 1991, respectively. The increases are primarily the result of the Company's continued investment in capital additions, particularly videocassette rental inventory, and, in 1992, the Company's adoption of a shorter economic life for certain videocassettes purchased after December 31, 1991. See Videocassette Rental Inventory and Property and Equipment of Note 1, Summary of Significant Accounting Policies, of Notes to Consolidated Financial Statements for a further discussion of depreciation and amortization. SELLING, GENERAL AND ADMINISTRATIVE Selling, general and administrative expenses were $178,322,000, $113,587,000 and $108,607,000 for the years ended December 31, 1993, 1992 and 1991, respectively. These increases primarily reflect the expansion of the Company's business through the development and acquisition of video and music stores. However, as a percentage of revenue, these expenses declined due to the addition of the Company's music businesses in November 1992 and 1993 and filmed entertainment business in April 1993. The ratio of selling, general and administrative expenses to the revenue of such businesses is lower than the ratio historically achieved in the Company's video business. INTEREST EXPENSE Interest expense was $33,773,000, $17,793,000 and $21,780,000 for the years ended December 31, 1993, 1992 and 1991, respectively. The increase in 1993 is primarily attributable to increases in average indebtedness resulting from the expansion of the Company's business. GAIN FROM EQUITY INVESTMENT The Company's consolidated results of operations for the year ended December 31, 1993 include a gain before income taxes of $2,979,000 resulting from the Company's investment in Discovery Zone, Inc. ("Discovery Zone") and a subsequent initial public offering of 5,000,000 common shares by Discovery Zone in June 1993. See Gain on Equity Investment of Note 1, Summary of Significant Accounting Policies, of Notes to Consolidated Financial Statements for a further discussion of this transaction. OTHER EXPENSE Other expense, net, was $9,217,000, $893,000 and $2,345,000 for the years ended December 31, 1993, 1992 and 1991, respectively. The increase in 1993 is primarily a result of minority interest expense arising from the Company's filmed entertainment business, which is less than 100% owned. PROVISION FOR INCOME TAXES The Company's effective tax rate was 37.5%, 35.9% and 36.8% for the years ended December 31, 1993, 1992 and 1991, respectively. The increased rate in 1993 is primarily attributable to the increase in the statutory federal corporate tax rate. The decreased rate in 1992 is primarily the result of reductions in the Company's effective foreign income tax rate. See Note 5, Income Taxes, of Notes to Consolidated Financial Statements for a further discussion of income taxes. FINANCIAL CONDITION The Company believes that its financial condition remains strong and that it has sufficient operating cash flow and other financial resources necessary to meet its anticipated capital requirements and obligations as they come due. WORKING CAPITAL Working capital at December 31, 1993 amounted to $105,485,000 as compared to a deficit of $54,992,000 at December 31, 1992. The increase of $160,477,000 during 1993 was due primarily to cash provided by operating and financing activities and working capital resulting from the addition of the Company's filmed entertainment business. Videocassette rental inventories are deemed non-current assets under generally accepted accounting principles as they are not assets which are reasonably expected to be completely realized in cash or sold in the normal business cycle. Although the rental of such inventory generates a significant portion of the Company's revenue, the classification of such assets as non-current under generally accepted accounting principles requires their exclusion from the computation of working capital. For this reason, the Company believes working capital is not as significant as a measurement of financial condition for companies operating in the home video industry as it is for companies without operations in the home video industry. Accounts and notes receivable consist primarily of amounts due from customers. At December 31, 1993, accounts and notes receivable were $135,172,000, an increase of $91,022,000 over December 31, 1992. This increase relates primarily to the addition of receivables from licensing agreements related to the Company's filmed entertainment business. The current portion of film costs and program rights was $117,324,000 at December 31, 1993 and also relates to the addition of the Company's filmed entertainment business. Other current assets were $50,210,000 at December 31, 1993, an increase of $27,111,000 as compared to December 31, 1992. This increase was primarily due to the expansion of the Company's music business and an increase in current deferred income tax assets related to the Company's foreign operations. Merchandise inventories and accounts payable at December 31, 1993 were $350,763,000 and $369,815,000, respectively, an increase of $170,761,000 and $153,453,000 over December 31, 1992. These increases are primarily a result of the Company's expanded music business where it is customary to carry larger merchandise inventories as compared to Company-owned video stores, as well as its expanding video operations. Accrued liabilities were $177,695,000 at December 31, 1993, an increase of $78,177,000 as compared to December 31, 1992. This increase primarily reflects the Company's addition of its filmed entertainment business and expansion of its music business. Accrued participation expenses were $43,013,000 at December 31, 1993 and relate to the addition of the Company's filmed entertainment business. VIDEOCASSETTE RENTAL INVENTORY AND PROPERTY AND EQUIPMENT See "Cash Flows From Investing Activities" under the heading "Cash Flows" of Management's Discussion and Analysis of Financial Condition and Results of Operations and Videocassette Rental Inventory and Property and Equipment of Note 1, Summary of Significant Accounting Policies, of Notes to Consolidated Financial Statements for a discussion of videocassette rental inventory and property and equipment policies and other information. INTANGIBLE ASSETS Intangible assets increased approximately $434,163,000 during 1993 primarily as a result of acquisitions made by the Company during the year. See Intangible Assets of Note 1, Summary of Significant Accounting Policies and Note 2, Business Combinations and Investments, of Notes to Consolidated Financial Statements for a further discussion of intangible assets. OTHER ASSETS Other assets consist primarily of equity investments in less than majority-owned businesses and the non-current portion of film costs and program rights and increased approximately $205,824,000 during 1993 primarily as a result of the addition of the Company's filmed entertainment business and investments in less than majority-owned businesses. See Other Assets of Note 1, Summary of Significant Accounting Policies, of Notes to Consolidated Financial Statements for a further discussion of other assets. MINORITY INTERESTS IN SUBSIDIARIES Minority interests in subsidiaries increased during 1993 as a result of the Company's acquisition of its filmed entertainment business which is less than 100% owned. CAPITAL STRUCTURE In February 1994, the Company entered into a credit agreement with certain banks pursuant to which such banks advanced the Company on an unsecured basis $1,000,000,000 for a term of twelve months. In March 1994, the Company used the proceeds from such borrowing along with $250,000,000 of proceeds from borrowings under its existing credit facility for the purchase of shares of non-voting Viacom Class B common stock. See "Business Combinations and Investments" of Management's Discussion and Analysis of Financial Condition and Results of Operations and Note 12, Other Matters, of Notes to Consolidated Financial Statements for a further discussion of the Viacom transactions. The following table sets forth the components of the Company's capital structure, as a percentage of total capital, at December 31: The changes in long-term debt, subordinated convertible debt and shareholders' equity as a percentage of total capital in 1993 primarily reflects the conversion of substantially all of the Company's subordinated convertible debt into shares of Common Stock during 1993. Significant transactions affecting long-term debt, subordinated convertible debt and shareholders' equity are discussed below. In December 1993, the Company entered into a credit agreement (the "Credit Agreement") with certain banks pursuant to which such banks have agreed to advance the Company on an unsecured basis an aggregate of $1,000,000,000 for a term of 40 months. The Credit Agreement significantly increased the Company's committed borrowing capacity and contains terms and conditions generally consistent with those existing under the prior 1992 revolving credit facility which the Credit Agreement replaced. At December 31, 1993, approximately $411,000,000 was outstanding under the Credit Agreement. In November 1993, the Company completed an underwritten public offering of 14,650,000 shares of Common Stock, realizing net proceeds of approximately $424,118,000 which were used to reduce existing indebtedness. Subordinated convertible debt represented the Company's issuance of $300,000,000 principal amount at maturity of LYONs. The LYONs were zero-coupon notes subordinated to all existing and future senior indebtedness. In August 1993, the Company called the LYONs for redemption. As a consequence of the call, substantially all such LYONs were converted to approximately 8,303,000 shares of Common Stock. In December 1992, the Company filed with the Securities and Exchange Commission a shelf registration statement covering up to $300,000,000 of unsecured senior and unsecured subordinated debt securities. In February 1993, the Company issued $150,000,000 of 6.625% senior notes under the registration statement, which notes mature in February 1998 and pay interest semi-annually. The proceeds from such issuance were used to refinance existing indebtedness. In January 1992, the Company received approximately $66,000,000 from Philips for the purchase of 6,000,000 shares of Common Stock. Philips subsequently exercised an option to acquire an additional 5,000,000 shares of Common Stock at $11.00 per share. The sale of the additional 5,000,000 shares of Common Stock was completed in July 1992 with the Company receiving from Philips a $54,500,000 promissory note which was paid on June 30, 1993. During 1992, in addition to the option exercised by Philips, the Company received net proceeds of approximately $15,808,000 in connection with the exercise of warrants and options to acquire 7,371,084 shares of Common Stock. During 1993 and 1992, the Company issued Common Stock valued at approximately $369,407,000 and $113,974,000, respectively, in connection with its acquisitions and investments. See Notes 2, 3, 4 and 7, Business Combinations and Investments, Long-Term Debt, Subordinated Convertible Debt and Shareholders' Equity, of Notes to Consolidated Financial Statements for a further discussion of business combinations, investments, indebtedness and shareholders' equity. CASH FLOWS Cash and cash equivalents increased by $51,896,000 in 1993 compared to decreases of $8,306,000 in 1992 and $94,000 in 1991. The major components of these changes are discussed below. CASH FLOWS FROM OPERATING ACTIVITIES Cash flows provided by operating activities increased to $522,284,000 in 1993 from $450,785,000 in 1992 and $350,351,000 in 1991. Such increases are primarily a result of the increased number of Company-owned video stores in operation. Cash provided by operating activities combined with cash provided by financing activities in 1993, 1992 and 1991 were used to fund capital additions and acquisitions as the Company's business expanded during these years. Cash provided by operating activities generated substantially all of the cash needed for capital additions, net of disposals of videocassette rental inventory, during the three years ended December 31, 1993, 1992 and 1991. CASH FLOWS FROM INVESTING ACTIVITIES Capital additions for new and existing stores and cash used in business combinations and investments comprise most of the Company's investing activities. Capital additions, which consist primarily of purchases of videocassette rental inventory and property and equipment, were $615,657,000, $394,532,000 and $300,694,000 in 1993, 1992 and 1991, respectively. Cash used in business combinations and investments was $673,241,000, $252,888,000 and $8,244,000 in 1993, 1992 and 1991, respectively, and includes the $600,000,000 investment in Series A cumulative convertible preferred stock of Viacom as well as acquisitions of Spelling and Super Club in 1993 and the acquisitions of Cityvision, Sound Warehouse and Music Plus in 1992. See "Viacom Inc. Agreements" and "Business Combinations and Investments" of Management's Discussion and Analysis of Financial Condition and Results of Operations and Note 2, Business Combinations and Investments and Note 12, Other Matters, of Notes to Consolidated Financial Statements for a further discussion of businesses acquired and other investments. During 1993, 1992 and 1991 the Company opened or acquired a net of 483, 980 (including 775 stores related to the Cityvision acquisition) and 307 video stores, respectively. During 1993 and 1992, the Company also opened or acquired a net of 273 and 238 music stores, respectively. Company-opened video stores require initial capital expenditures, including the purchase of videocassettes for rental, of generally between $375,000 to $700,000 per store. The Company has recently developed its own prototype music store called "Blockbuster Music Plus". The Company currently projects that the cost to open a new "Blockbuster Music Plus" store will require an initial investment, including capital expenditures and merchandise inventory, of generally between $700,000 to $1,000,000. The cost of acquiring video and music stores varies, depending upon the size, location, operating history of the store, and, in the case of video stores, the value associated with any reacquisition of franchise rights for the territory related to the video store acquired. Thus, although the Company can reasonably estimate the dollar amount necessary to open a new video or music store, it is impossible to know the cost of each acquisition or what mix of new store openings and acquisitions will occur in the future. The Company believes that during 1994 it will continue to purchase new release videocassettes and property and equipment in a manner substantially consistent with historical practices. The Company currently intends to continue to expand in the entertainment industry, which may include acquiring and opening additional video and music stores, as well as developing, making investments in or acquiring other entertainment related concepts or businesses. In addition, the Company plans on converting a substantial number of its existing music stores to the "Blockbuster Music Plus" format during 1994. The Company believes that cash provided by operating activities as well as cash available under the Company's Credit Agreement will be adequate to finance capital additions and other funding requirements during 1994. The Company from time to time may seek additional or alternate sources of financing. See Note 3, Long-Term Debt, of Notes to Consolidated Financial Statements for a further discussion of financing available under the Company's credit facilities and from other sources. CASH FLOWS FROM FINANCING ACTIVITIES Cash flows from financing activities during 1993, 1992 and 1991 resulted from commercial bank borrowings, repayments of such bank borrowings, issuances of Common Stock and, in 1993 and 1992, the payment of cash dividends. Proceeds from the issuance of Common Stock were $595,698,000 in 1993 and primarily consisted of the sale of 14,650,000 shares of Common Stock in an underwritten public offering. These financing activities combined with cash provided by operating activities were used to fund capital additions and the development and acquisition of stores as the Company's business expanded during these years. See "Capital Structure" under the heading "Financial Condition" of Management's Discussion and Analysis of Financial Condition and Results of Operations and Notes 3, 4, 6 and 7, Long-Term Debt, Subordinated Convertible Debt, Stock Options and Warrants and Shareholders' Equity, of Notes to Consolidated Financial Statements for a further discussion of indebtedness and shareholders' equity transactions. INFLATION The Company anticipates that its business will be affected by general economic trends. While the Company has not operated in the videocassette rental industry, the music retailing industry or filmed entertainment industry during a period of high inflation, the Company believes that if costs increase, it should be able to pass such increases on to its customers. FOREIGN EXCHANGE The Company has foreign operations, primarily in the United Kingdom and Canada. Exchange rate fluctuations between the currencies of these countries and the U.S. Dollar may result in the translation and reporting of varying amounts of U.S. Dollars in the Company's consolidated financial statements. Based on the current scope of its foreign operations, the Company believes that any such fluctuations would not have a material adverse effect on the Company's consolidated financial condition or results of operations as reported in U.S. Dollars. RECENTLY ISSUED ACCOUNTING STANDARDS Effective January 1, 1994, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 112, Employers' Accounting for Postemployment Benefits, and SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities. The Company believes the adoption of SFAS No. 112 will not have a material effect on its results of operations or financial condition. However, the adoption of SFAS No. 115 will require the Company to adjust its investment in non-voting Viacom Class B common stock to fair value. Pursuant to the provisions of SFAS No. 115, the Company has classified such investment as an "available-for-sale security". Accordingly, any adjustment to fair value will be excluded from net income and reported as a separate component of shareholders' equity. Based on the quoted market price at March 23, 1994 and after satisfaction of Viacom's make-whole obligation, the maximum adjustment to fair value would result in a reduction of total assets and shareholders' equity of approximately $186,000,000, net of income taxes, at such date. See "Viacom Inc. Agreements" of Management's Discussion and Analysis of Financial Condition and Results of Operations for a further discussion of the Viacom investment. Item 8.	Item 8. Financial Statements and Supplementary Data Index to Consolidated Financial Statements All other schedules are omitted as not applicable or not required. REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS To Blockbuster Entertainment Corporation: We have audited the accompanying consolidated balance sheets of Blockbuster Entertainment Corporation (a Delaware corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, changes in shareholders' equity and cash flows for each of the three years in the period ended December 31, 1993. These financial statements and the schedules referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Blockbuster Entertainment Corporation and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules included in Item 14.(a)(2) are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state, 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 & CO. Fort Lauderdale, Florida, March 23, 1994. The accompanying notes are an integral part of these statements. The accompanying notes are an integral part of these statements. The accompanying notes are an integral part of these statements. The accompanying notes are an integral part of these statements. BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (000's omitted in all tables except per share amounts) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The accompanying consolidated financial statements present the consolidated financial position and results of operations of Blockbuster Entertainment Corporation and subsidiaries (the "Company"). All material intercompany accounts and transactions have been eliminated. In order to maintain consistency and comparability between periods presented, certain amounts have been reclassified from the previously reported financial statements in order to conform with the financial statement presentation of the current period. The accompanying consolidated financial statements also include the financial position and results of operations of WJB Video Limited Partnership and certain of its affiliates ("WJB"), with which the Company merged in August 1993. This transaction has been accounted for under the pooling of interests method of accounting and, accordingly, these financial statements and notes thereto have been restated as if the companies had operated as one entity since inception. See Note 2, Business Combinations and Investments, for a further discussion of this transaction. Accounts and Notes Receivable: Accounts and notes receivable, which are stated net of an allowance for doubtful accounts, consist primarily of amounts due from customers. The current portion of notes receivable was approximately $13,298,000 and $15,432,000 at December 31, 1993 and 1992, respectively. The Company believes that the carrying amounts of accounts and notes receivable at December 31, 1993 and 1992 approximate fair value at such dates. Merchandise Inventories: Merchandise inventories, consisting primarily of prerecorded music and videocassettes, are stated at the lower of cost or market. Cost is determined using the moving weighted average or the retail inventory method, the uses of which approximate the first-in, first-out basis. Film Costs and Program Rights: Film costs and program rights relate to the operations of the Company's filmed entertainment business. See Note 2, Business Combinations and Investments. Film costs and program rights include production or acquisition costs (including advance payments to producers), capitalized overhead and interest, prints, and advertising expected to benefit future periods. These costs are amortized, and third party participations and residuals are accrued, in the ratio that the current year's gross revenue bears to estimated future gross revenue, calculated on an individual product basis. BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Film costs and program rights are stated at the lower of cost, net of amortization, or estimated net realizable value on an individual film product basis. Estimates of total gross revenue, costs and participation expenses are reviewed quarterly and write-downs to net realizable value are recorded and future amortization expense is revised as necessary. Based on the Company's estimates of future gross revenue as of December 31, 1993, approximately 60% of unamortized released film costs and program rights will be amortized within the next three years. The components of film costs and program rights, net of amortization, at December 31, 1993 are as follows: The non-current portion of film costs and program rights is included in other assets. Videocassette Rental Inventory: Videocassettes are recorded at cost and amortized over their estimated economic life with no provision for salvage value. Videocassettes which are considered base stock are amortized over thirty-six months on a straight-line basis. Videocassettes which are considered new release feature films frequently ordered in large quantities to satisfy initial demand ("hits") are, except as discussed below, amortized over thirty-six months on an accelerated basis. "Hit" titles for which twelve or more copies per store were purchased during the period from January 1, 1990 through December 31, 1991 were, for the twelfth and any succeeding copies, amortized over twelve months on an accelerated basis. Effective January 1, 1992, "hit" titles for which ten or more copies per store are purchased are, for the tenth and any succeeding copies, amortized over nine months on an accelerated basis. For the twelve months ended December 31, 1992, the adoption of this shorter economic life had the effect of reducing net income by approximately $9,556,000 and net income per common and common equivalent share by approximately five cents per share. BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Videocassette rental inventory and related amortization at December 31 are as follows: Amortization expense related to videocassette rental inventory was $295,729,000, $234,862,000 and $171,509,000 in 1993, 1992 and 1991, respectively. As videocassette rental inventory is sold or retired, the applicable cost and accumulated amortization are eliminated from the accounts and any gain or loss thereon is recorded. Property and Equipment: Property and equipment is stated at cost. Depreciation and amortization expense is provided over the estimated lives of the related assets using the straight-line method. Property and equipment at December 31 consists of the following: Depreciation and amortization expense related to property and equipment was $74,772,000, $59,094,000 and $43,868,000 in 1993, 1992 and 1991, respectively. Additions to property and equipment are capitalized and include acquisitions of property and equipment, costs incurred in the development and construction of new stores, major improvements to existing property and management information systems. As property and equipment is sold or retired, the applicable cost and accumulated depreciation and amortization are eliminated from the accounts and any gain or loss thereon is recorded. Intangible Assets: Intangible assets primarily consist of the cost of acquired businesses in excess of the market value of net tangible assets acquired. The cost in excess of the market value of net tangible assets is amortized on a straight-line basis over periods ranging from 15 to 40 years. Subsequent to its acquisitions, the Company continually evaluates factors, events and circumstances which include, but are not limited to, the historical and projected operating performance of acquired businesses, specific industry trends and general economic conditions to assess whether the BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) remaining estimated useful life of intangible assets may warrant revision or that the remaining balance of intangible assets may not be recoverable. If such factors, events or circumstances indicate that intangible assets should be evaluated for possible impairment, the Company uses an estimate of undiscounted net income over the remaining life of the intangible assets in measuring their recoverability. Accumulated amortization of intangible assets at December 31, 1993 and 1992 was $45,286,000 and $20,168,000, respectively. Other Assets: Other assets consist primarily of equity investments in less than majority-owned businesses, the non-current portion of film costs and program rights related to the Company's filmed entertainment business and the non-current portion of accounts and notes receivable. The non-current portion of such receivables was approximately $39,153,000 and $47,288,000 at December 31, 1993 and 1992, respectively. The Company believes the carrying amounts of the non-current portion of accounts and notes receivable approximate fair value at such dates. Accrued Participation Expenses: Accrued participation expenses relate to the Company's filmed entertainment business and include amounts due to producers and other participants for their share of programming and distribution revenue. Foreign Currency Translation: Foreign subsidiaries' assets and liabilities are translated at the rates of exchange at the balance sheet date while income statement accounts are translated at the average exchange rates in effect during the periods presented. The resulting translation adjustments are reported as a separate component of shareholders' equity. Gains and losses resulting from foreign currency transactions are included in net income. The aggregate transaction gain included in the determination of net income for the year ended December 31, 1992 was $6,778,000. There were no transaction gains or losses during the years ended December 31, 1993 and 1991. Revenue Recognition: Revenue from Company-owned video and music stores is recognized at the time of rental or sale. Revenue from franchise owners is recognized when all material services or conditions required under the Company's franchise agreements have been performed by the Company. Revenue from programming and distribution is recognized as follows: (1) revenue from licensing agreements covering film product owned by the Company is recognized when the film product is available to the licensee for telecast, exhibition or distribution, and other conditions of the licensing agreements have been met and (2) revenue from television distribution of film product which is not owned by the Company is recognized when billed. BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Gain From Equity Investment: It is the Company's policy to record gains or losses from the sale or issuance of previously unissued stock by its subsidiaries or by companies in which the Company is an equity investor and accounts for its investment using the equity method. The Company's consolidated results of operations for the year ended December 31, 1993 include a gain before income taxes of $2,979,000, resulting from the Company's investment in Discovery Zone, Inc. ("Discovery Zone") and a subsequent initial public offering of 5,000,000 common shares by Discovery Zone in June 1993. Discovery Zone owns, operates and franchises indoor recreational facilities for children. Cash Flow Information: Cash equivalents consist of interest bearing securities with original maturities of less than ninety days. See Notes 2, 3, 5 and 7, Business Combinations and Investments, Long-term Debt, Income Taxes and Shareholders' Equity, of Notes to Consolidated Financial Statements for a discussion of supplemental cash flow information. 2. BUSINESS COMBINATIONS AND INVESTMENTS All business combinations discussed below, except for the merger with WJB, were accounted for under the purchase method of accounting and, accordingly, are included in the Company's financial statements from the date of acquisition. In November 1993, the Company acquired all of the outstanding capital stock of Super Club Retail Entertainment Corporation and subsidiaries ("Super Club"), which owns and operates video and music stores. The purchase price paid by the Company was approximately $150,000,000 and consisted of 5,245,211 shares of the Company's common stock, $.10 par value ("Common Stock") and warrants to acquire shares of Common Stock. The warrants give the holders the right to acquire 1,000,000 and 650,000 shares of Common Stock at exercise prices of $31.00 and $32.42 per share, respectively. In October 1993, the Company purchased 24,000,000 shares of newly-issued Series A cumulative convertible preferred stock of Viacom Inc. ("Viacom") for an aggregate purchase price of $600,000,000, representing a purchase price of $25 per share. The preferred stock provides for the payment of quarterly dividends at an annual rate of 5% and is convertible into non-voting Viacom Class B common stock at a conversion price of $70 per share. The preferred stock is redeemable at the option of Viacom beginning in October 1998. Although the preferred stock is currently an unlisted equity security, based upon a valuation which considered the terms and conditions of the preferred stock as well as comparisons to other similar securities, the Company estimates the fair BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) value of such investment to be approximately $552,000,000 at December 31, 1993. In August 1993, the Company merged with WJB, its largest franchise owner. In connection with the merger, the Company issued 7,214,192 shares of its Common Stock in exchange for the equity interests of WJB. This transaction has been accounted for under the pooling of interests method of accounting and, accordingly, the Company's financial statements have been restated for all periods as if the companies had operated as one entity since inception. Revenue and net income of the previously separate companies for the periods before the pooling of interests business combination was consummated (after reflecting the effects of intercompany eliminations) are as follows: During the second quarter of 1993, the Company acquired a majority of the common stock of Spelling Entertainment Group Inc. ("Spelling"), a producer and distributor of filmed entertainment. The aggregate consideration paid by the Company totaled approximately $163,369,000 and consisted of cash and 9,278,034 shares of Common Stock. The Company also issued to certain sellers of Spelling's common stock, warrants to acquire an aggregate of 2,000,000 shares of its Common Stock at an exercise price of $25 per share. Additionally, in October 1993, the Company exchanged 3,652,542 shares of Common Stock for 13,362,215 newly issued shares of Spelling's common stock as more fully discussed in Note 7, Shareholders' Equity. As a result of the transactions described above, the Company owned approximately 70.5% of the outstanding common stock of Spelling at December 31, 1993. During 1993, the Company acquired or invested in businesses that own and operate video stores, are involved in the production and distribution of filmed entertainment, and own, operate and franchise indoor recreational facilities for children. The aggregate purchase price paid by the Company was approximately $195,610,000 and consisted of cash and 5,631,180 shares of Common Stock. BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) In November 1992, the Company acquired Sound Warehouse, Inc. and subsidiary and Show Industries, Inc. ("Sound Warehouse" and "Music Plus") which own and operate music stores. The purchase price paid by the Company was approximately $190,000,000 and consisted of cash and 4,142,051 shares of Common Stock. In February 1992, the Company acquired Cityvision plc ("Cityvision"), the largest home video retailer in the United Kingdom. The purchase price paid by the Company was approximately $125,000,000 and consisted of cash and 3,999,672 shares of Common Stock. At December 31, 1993, Cityvision operated 775 stores under the trade name "Ritz". During 1992, the Company also acquired or invested in several other businesses that own and operate video and music stores. The aggregate purchase price paid by the Company was approximately $103,774,000 and consisted of cash and 2,112,977 shares of Common Stock. During 1991, the Company acquired several businesses that own and operate video stores. The aggregate purchase price paid by the Company was approximately $89,614,000 and consisted of cash and 6,492,757 shares of Common Stock. Such shares of Common Stock include 1,297,921 shares issued by the Company in connection with the repayment of a $12,586,000 short-term promissory note which was issued by the Company in connection with an acquisition during 1991. The Company's consolidated results of operations for the years ended December 31 on an unaudited pro forma basis assuming the acquisitions of Super Club, Spelling, Sound Warehouse and Music Plus had occurred as of January 1, 1992, are as follows: BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) The purchase price allocations for all business combinations and investments discussed above, except for the merger with WJB which was accounted for under the pooling of interests method of accounting, were as follows for the years ended December 31: The amounts presented above for 1993 reflect the preliminary purchase price allocations for business combinations. BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) 3. LONG-TERM DEBT Long-term debt at December 31 is as follows: In December 1993, the Company entered into a credit agreement (the "Credit Agreement") with certain banks pursuant to which such banks have agreed to advance the Company on an unsecured basis an aggregate of $1,000,000,000 for a term of 40 months. Outstanding advances, if any, are payable at the expiration of the 40-month term. The Credit Agreement requires, among other items, that the Company maintain certain financial ratios and comply with certain financial covenants. Interest is generally determined and payable monthly using a competitive bid feature. The Credit Agreement replaces a 1992 revolving credit arrangement among the Company and certain other banks. BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) In December 1992, the Company filed with the Securities and Exchange Commission a shelf registration statement covering up to $300,000,000 of unsecured senior debt securities and unsecured subordinated debt securities. In February 1993, the Company issued $150,000,000 of 6.625% senior notes under the registration statement. Such notes mature in February 1998 and pay interest semi- annually. The proceeds from such issuance were used to refinance existing indebtedness. The notes are registered on the New York Stock Exchange and at December 31, 1993 had a quoted market price of approximately $101.25 per note resulting in a fair value for all outstanding notes of approximately $151,875,000. All outstanding advances under the bank term loan, which were related to the Company's filmed entertainment business, were repaid and such loan terminated in January 1994. Excluding the unsecured senior notes discussed above, substantially all of the Company's long-term debt at December 31, 1993 and 1992 carried interest rates that were adjusted regularly to reflect current market conditions. Accordingly, the Company believes the carrying amount of such indebtedness approximated fair value at such dates. The Company made interest payments of $26,301,000, $9,707,000 and $12,913,000 in 1993, 1992 and 1991, respectively. 4. SUBORDINATED CONVERTIBLE DEBT In August 1993, the Company called its Liquid Yield Option Notes ("LYONs") for redemption. As a consequence of the call, substantially all such LYONs were converted to approximately 8,303,000 shares of Common Stock resulting in an increase to shareholders' equity of approximately $122,272,000. The LYONs were issued initially in November 1989 in the aggregate principal amount at maturity of $300,000,000 and required no periodic interest payments. Each LYON had an issue price of $308.32 and would have had a principal amount due at maturity of $1,000 (representing a yield to maturity of 8% per annum computed on a semi-annual bond equivalent basis). Each LYON was convertible into 27.702 shares of Common Stock, at the option of the holder, at any time on or prior to maturity, was subordinated to all existing and future Senior Indebtedness (as defined in the LYONs indenture agreement) of the Company, and was redeemable under certain circumstances in whole or in part, at the option of the Company, for cash in an amount equal to the issue price plus accrued original issue discount to the date of redemption. The LYONs were registered on the New York Stock Exchange and at December 31, 1992 had a quoted market price of approximately $530 per LYON resulting in a fair value for all outstanding LYONs of approximately $159,000,000. BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) 5. INCOME TAXES In February 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards ("SFAS") No. 109 - Accounting for Income Taxes, which superceded SFAS No. 96. The Company adopted SFAS No. 109 in 1991. The income tax provision for the years ended December 31 consists of the following components: A reconciliation of the federal income tax rate to the Company's effective income tax rate for the years ended December 31 is as follows: BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31 are as follows: During 1993, the Company's valuation allowance increased by $43,544,000 to $47,275,000. Such increase relates primarily to certain deferred tax assets of acquired businesses which consist principally of net operating loss carryforwards. Should future circumstances result in a change in the valuation allowance, such change may be allocated so as to increase or decrease intangible assets. The foreign component of income before income taxes for the years ended December 31, 1993 and 1992 was approximately $15,200,000 and $22,723,000, respectively. At December 31, 1993, the Company had approximately $210,000,000 of operating and capital loss carryforwards available to reduce future income taxes, of which approximately $29,000,000 have unlimited carryforward periods and approximately $181,000,000 expire in varying amounts commencing in 2001. These carryforwards relate primarily to businesses acquired by the Company and to periods prior to their respective acquisition dates. The Company made income tax payments of approximately $63,621,000, $61,002,000 and $14,857,000 in 1993, 1992 and 1991, respectively. BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) 6. STOCK OPTIONS AND WARRANTS The Company has various stock option plans under which shares of Common Stock may be granted to key employees and directors of the Company. Options granted under the plans are non-qualified and are granted at a price equal to the fair market value of the Common Stock at the date of grant. A summary of stock option and warrant transactions for the years ended December 31 is as follows: In February 1992, warrants to acquire 5,138,323 shares of Common Stock, originally issued in 1987 in connection with the initial equity investment in the Company by its Chairman, were exercised with the Company receiving proceeds of approximately $6,293,000. In April 1992, the Company granted a call option, for 5,000,000 shares of Common Stock, to Philips Electronics N.V. ("Philips") that was subsequently exercised as more fully described in Note 7, Shareholders' Equity. 7. SHAREHOLDERS' EQUITY The Board of Directors has the authority to issue up to 500,000 shares of $1 par value preferred stock at such time or times, in such series, with such designations, preferences, special rights, limitations or restrictions thereof as it may determine. No shares of preferred stock have been issued. BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) In November 1993, the Company registered with the Securities and Exchange Commission 14,650,000 shares of its Common Stock to be offered in an underwritten public offering. Upon the sale of such shares, the Company realized net proceeds of approximately $424,118,000 which were used to reduce existing indebtedness. In October 1993, the Company issued 3,652,542 shares of its Common Stock to Spelling in exchange for 13,362,215 newly issued shares of Spelling's common stock increasing the Company's ownership to approximately 70.5% of the outstanding common stock of Spelling. Spelling subsequently resold such shares of the Company's Common Stock resulting in an increase to the Company's shareholders' equity of approximately $100,445,000. In 1993, the Company received net proceeds of approximately $16,635,000 in connection with the exercise of warrants and options to acquire 2,674,933 shares of Common Stock. Sales of Common Stock as shown on the Consolidated Statements of Changes in Shareholders' Equity for the year ended December 31, 1992 include $66,000,000 received in January 1992 from Philips for the purchase of 6,000,000 shares of Common Stock and $55,000,000 from Philips related to the exercise of an option to purchase 5,000,000 shares of Common Stock. The sale of the additional 5,000,000 shares of Common Stock was completed in July 1992 with the Company receiving from Philips a $54,500,000 promissory note which was subsequently collected in June 1993. In addition to the option exercised by Philips, the Company received net proceeds of approximately $15,808,000 in connection with the exercise of warrants and options to acquire 7,371,084 shares of Common Stock in 1992. In April 1992, the Board of Directors of the Company adopted a policy providing for the payment of quarterly cash dividends to the Company's shareholders. Cash dividends of nine and one half and six cents per common share were declared during 1993 and 1992, respectively. In 1991, the Company received net proceeds of approximately $11,516,000 in connection with the exercise of warrants and options to acquire 6,439,748 shares of Common Stock. As of December 31, 1993, approximately 34,624,000 shares of Common Stock were reserved for issuance under employee benefit and dividend reinvestment plans, upon exercise of certain warrants and options and in connection with potential acquisitions of other businesses, properties or securities. BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) 8. COMMITMENTS AND CONTINGENCIES The Company leases substantially all of its retail, distribution and administration facilities under non-cancellable operating leases, which in most cases contain renewal options. Rental expense was approximately $212,803,000, $153,522,000 and $106,608,000 for the years ended December 31, 1993, 1992 and 1991, respectively. Future minimum lease payments under non-cancellable operating leases at December 31, 1993 are due as follows: The Company has guaranteed obligations of certain of its joint ventures aggregating approximately $53,755,000 at December 31, 1993. After considering its interest in the underlying assets of such joint ventures, the Company believes it is not exposed to any potential material losses in connection with these guarantees. Subject to certain conditions, the Company is committed to purchase all of the outstanding common stock of Republic Pictures Corporation ("Republic") for approximately $68,000,000 in cash in connection with the merger of Republic into Spelling. The Company has become subject to various lawsuits, claims and other legal matters in the course of conducting its business, including its business as a franchisor. The Company believes that such lawsuits, claims and other legal matters will not have a material adverse effect on the Company's consolidated results of operations or financial condition. Spelling is involved in a number of legal actions including threatened claims, pending lawsuits and contract disputes, environmental clean-up assessments, damages from alleged dioxin contamination and other matters primarily resulting from its discontinued operations. Some of the parties involved in such actions seek significant amounts of damages. While the outcome of these suits and claims cannot be predicted with certainty, the Company believes based upon its knowledge of the facts and circumstances and applicable law that the ultimate resolution of such suits and claims will not have a material adverse effect on the Company's results of operations or financial condition. This belief is also based upon the adequacy of approximately $30,000,000 of accruals that have been established for probable losses on disposal of former operations and remaining Chapter 11 disputed claims and an insurance-type indemnity agreement which covers up to $35,000,000 of certain possible liabilities in excess of a threshold amount of $25,000,000, subject to certain adjustments. Substantial portions of such accruals are intended to cover environmental costs associated with Spelling's former operations. Such accruals are recorded without discount or offset for either the time value of money prior to the BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) anticipated date of payment or expected recoveries from insurance or contribution claims against unaffiliated entities. Although there are significant uncertainties inherent in estimating environmental liabilities, based upon the Company's experience it is considered unlikely that the amount of possible environmental liabilities and Chapter 11 disputed claims would exceed the amount of accruals by more than $50,000,000. 9. NET INCOME PER SHARE Net income per common and common equivalent share is based on the combined weighted average number of common shares and common share equivalents outstanding which include, where appropriate, the assumed exercise or conversion of warrants and options. In computing net income per common and common equivalent share, the Company utilizes the treasury stock method. For the year ended December 31, 1992, computation of net income per common and common equivalent share on a fully diluted basis assumes conversion of the LYONs, resulting in an increase to net income for the hypothetical elimination of interest expense, net of tax, related to the LYONs. No such adjustment was necessary for 1993 as the LYONs were converted to shares of Common Stock as more fully described in Note 4, Subordinated Convertible Debt. The information required to compute net income per share on a primary and fully diluted basis for the years ended December 31 is presented below: 10. BUSINESS SEGMENT INFORMATION Prior to 1992, the Company's operations consisted primarily of operating and franchising video stores. With the acquisition of Sound Warehouse and Music Plus in November 1992, the acquisition of a majority interest in Spelling in April 1993 and the acquisition of Super Club in November 1993, the Company's operations were expanded to include the sale BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) of prerecorded music and related items and the production and distribution of filmed entertainment. Financial information about the Company's operations by industry segment for the years ended December 31 is as follows: BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) 11. SELECTED QUARTERLY FINANCIAL DATA (Unaudited) The following is an analysis of certain items in the Consolidated Statements of Operations by quarter for 1993 and 1992. 12. OTHER MATTERS In January 1994, the Company entered into a merger agreement pursuant to which the Company has agreed to merge with and into Viacom, with Viacom being the surviving corporation. Under the terms of the agreement each share of Common Stock shall be converted into the right to receive .08 shares of Viacom Class A common stock, .60615 shares of non-voting Viacom Class B common stock and under certain circumstances, up to an additional .13829 shares of non-voting Viacom Class B common stock. The closing of the merger is subject to customary conditions including approval of the merger by the Company's shareholders. Concurrently with the merger agreement, the Company entered into a subscription agreement pursuant to which, in March 1994, the Company purchased from Viacom 22,727,273 shares of non-voting Viacom Class B common stock for an aggregate purchase price of $1,250,000,000, or $55 per share. In February 1994, the Company entered into a credit agreement with certain banks pursuant to which such banks advanced the Company on an unsecured basis $1,000,000,000 for a term of twelve months. In March 1994, the Company used the proceeds from such borrowing along with $250,000,000 of proceeds from borrowings under its existing Credit Agreement for the purchase of shares of non-voting Viacom Class B common stock. BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Under the terms of the subscription agreement the Company was granted certain rights to a make-whole amount in the event that the merger agreement is terminated and the highest average trading price of the non-voting Viacom Class B common stock during any consecutive 30 trading day period prior to the first anniversary of such termination is below $55 per share. Such make-whole amount would be based on the difference between $55 per share and such highest average trading price per share. However, the aggregate make-whole amount may not exceed $275,000,000. Viacom is entitled to satisfy its obligation with respect to any such make-whole amount, at Viacom's option, either through the payment to the Company of cash or marketable equity or debt securities of Viacom, or a combination thereof, with an aggregate value equal to the make-whole amount or through the sale to the Company of the theme parks currently owned and operated by Paramount Communications Inc., a subsidiary of Viacom. In the event that Viacom were to elect to sell the theme parks to the Company, the purchase price would be $750,000,000, payable through delivery to Viacom of shares of non-voting Viacom Class B common stock valued at $55 per share. If the theme parks were so purchased by the Company, the subscription agreement further provides that the Company would grant an option to Viacom, exercisable for a period of two years after the date of grant, to purchase a 50% equity interest in the theme parks at a purchase price of $375,000,000. Effective January 1, 1994, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 115, Accounting for Certain Investments in Debt and Equity Securities. The adoption of SFAS No. 115 will require the Company to adjust its investment in non- voting Viacom Class B common stock to fair market value. Pursuant to the provisions of SFAS No. 115, the Company has classified such investment as an "available-for-sale security". Accordingly, any adjustment to fair value will be excluded from net income and reported as a separate component of shareholders' equity. Based on the quoted market price at March 23, 1994 and after satisfaction of Viacom's make-whole obligation, the maximum adjustment to fair value would result in a reduction of total assets and shareholders' equity of approximately $186,000,000, net of income taxes, at such date. 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 following table sets forth as of March 18, 1994, the names of the directors and executive officers of the Company, their respective ages and their respective positions with the Company. Each director holds office until the next annual meeting of stockholders and until his successor has been elected and qualified. Officers are elected by the Board of Directors and serve at its discretion. Mr. Huizenga became a Director of the Company in February 1987, was elected as Chairman of the Board, Chief Executive Officer and President of the Company in April 1987 and is Chairman of the Executive Committee. Mr. Huizenga served as President of the Company until June 1988. He is a co-founder of Waste Management, Inc. (now known as WMX Technologies, Inc. ("WMX")), a waste disposal and collection company, where he served in various capacities, including President, Chief Operating Officer and a Director, until May 1984. From May 1984 to present, Mr. Huizenga has been an investor in other businesses and is the sole stockholder and Chairman of the Board of Huizenga Holdings, Inc. ("Holdings"), a holding and management company with various business interests. In connection with these business interests, Mr. Huizenga has been actively involved in strategic planning for, and executive management of, these businesses. Mr. Huizenga also has a majority ownership interest in Florida Marlins Baseball, Ltd. ("the "Florida Marlins"), a Major League Baseball sports franchise, owns the Florida Panthers Hockey Club, Ltd., a National Hockey League sports franchise (the "Florida Panthers"), a limited partnership interest in Miami Dolphins, Ltd. (the "Miami Dolphins"), a National Football League sports franchise, and an ownership interest in Robbie Stadium Corporation and certain affiliated entities, which own and operate Joe Robbie Stadium in South Florida. Mr. Huizenga has entered into an agreement to purchase the remaining ownership interest in the Miami Dolphins. Mr. Huizenga is Chairman of the Board of Directors of Spelling. Mr. Huizenga is also a member of the Boards of Directors of Republic, Discovery Zone, Viacom, Viacom International Inc. and Paramount Communications, Inc. Mr. Allen became a Director of the Company in July 1986 and is Chairman of the Compensation Committee. Since October 1988, Mr. Allen has served as Chairman and Chief Executive Officer of A.C. Allen & Co., a financial services consulting firm. He also is a Director and Vice Chairman of both Psychemedics Corporation ("Psychemedics") and the DeWolfe Companies, Inc. He is also a director of the Forschner Group. Prior to October 1988, Mr. Allen was Executive Vice President of Advest Group, Inc., an investment banking firm. Mr. Allen was Chairman and Chief Executive Officer of Burgess and Leith, a New York Stock Exchange member firm from 1984 to 1986. Mr. Barrett joined the Company in July 1989 as Director of Information Services and became Vice President of Corporate Information Systems in February 1992. He became Senior Vice President of Information Services in February 1994. From January 1983 until July 1989, he was a management consultant with Andersen Consulting in Dallas, Texas. Mr. Berrard joined the Company in June 1987 as Senior Vice President, Treasurer and Chief Financial Officer and became a Director of the Company in May 1989. Mr. Berrard became Vice Chairman of the Board in November 1989 and President and Chief Operating Officer in January 1993. He served as Treasurer of the Company from June 1987 until February 1989, as Senior Vice President of the Company from June 1987 until November 1989 and as Chief Financial Officer of the Company from June 1987 to June 1992. Mr. Berrard is President, Chief Executive Officer and a Director of Spelling. He is also a member of the Board of Directors of Republic. He is also a limited partner of the Florida Marlins. Prior to his tenure with the Company, Mr. Berrard served as President of Holdings, which was known prior to June 1988 as Waco Services, Inc. From January 1983 to April 1985, Mr. Berrard served in various positions with Waco Leasing Company and Port-O-Let International, Inc., including President, Chief Financial Officer, Treasurer and Secretary. Prior to January 1983, Mr. Berrard was employed by Coopers & Lybrand, an international public accounting firm, for over five years. Mr. Castell joined the Company in February 1989 as Senior Vice President of Programming and Merchandising and became Senior Vice President of Programming and Communications in August 1991. From October 1985 to February 1989, he was Vice President of Marketing and Merchandising at Erol's Inc., then a chain of two hundred video stores headquartered in the Washington, D.C. area. From October 1984 to October 1985, Mr. Castell was the President and sole stockholder of Big Think, Inc., a marketing consulting company. Mr. Castell is also Vice President of Spelling. Mr. Croghan became a Director of the Company in July 1987 and is currently Chairman of the Audit and Finance Committee. He is also a Director of Lindsay Manufacturing Company, St. Paul Bancorp, Inc. and the Morgan Stanley Emerging Markets Fund. Mr. Croghan is, and has been for more than the past five years, the Chairman of Lincoln Capital Management Company, an investment advisory firm. Mr. Detz joined the Company in January 1991 as Assistant Corporate Controller and became Vice President and Corporate Controller in February 1992. From 1980 until he joined the Company, Mr. Detz served in various finance related positions with Encore Computer Corporation, including Vice President and Corporate Controller. Prior to 1980, Mr. Detz was employed by Coopers and Lybrand, an international public accounting firm, for four years. Mr. Fairbanks joined the Company in June 1992 as Senior Vice President and Chief Financial Officer and became Treasurer of the Company in March 1993. From October 1980 until the time he joined the Company, Mr. Fairbanks served in a number of finance related capacities, including Executive Vice President and Chief Financial Officer of Waste Management International plc. Prior to October 1980, Mr. Fairbanks was employed by Arthur Andersen & Co., an international public accounting firm, for approximately four years. Mr. Fairbanks is also Senior Vice President of Spelling. Mr. Flynn became a Director of the Company in February 1987 and is Chairman of the Nominating Committee. He is Chairman and Chief Executive Officer of Flynn Enterprises, Inc., a business consulting and venture capital company, and since July 1992 has been Chairman and Chief Executive Officer of Discovery Zone, a franchisor and operator of fun and fitness centers for children. Mr. Flynn also currently serves as a Director of WMX, Chemical Waste Management, Inc., Waste Management International plc., Wheelabrator Technologies, Inc. and Psychemedics. From 1972 to 1990, Mr. Flynn served in various positions with WMX, including Senior Vice President and Chief Financial Officer. Mr. Guerin became Senior Vice President of Domestic Franchising of the Company in January 1992. From October 1989 until December 1991, Mr. Guerin was Senior Vice President of Administration and Development for the Company. He joined the Company as a Vice President in March 1988. From March 1986 to March 1988, he served as Vice President and Region Manager of Waste Management of North America, Inc., a subsidiary of WMX, where he was responsible for operations with over 6,000 employees. From June 1982 to March 1986, he served as President of Wells Fargo Armored Service Corp., a transporter of currency and valuables with over 7,000 employees. Mr. Hawkins joined the Company in November 1989 as Senior Corporate Counsel and became Associate General Counsel and Secretary in August 1991 and Vice President, General Counsel and Secretary in February 1993. He became Senior Vice President, General Counsel and Secretary in February 1994. He is also Vice President, General Counsel and Secretary of Spelling. From May 1986 until October 1989, he was associated with the law firm of Bell, Boyd & Lloyd in Chicago, Illinois. Mr. Hilmer joined the Company in February 1993 as Senior Vice President and Chief Marketing Officer. From 1984 to 1992, he served as Division President and Managing Partner as well as a member of the Board of Directors of Whittle Communications L.P., a media and education company. From 1969 to 1984, Mr. Hilmer held various senior marketing-related positions including Senior Vice President and Management Director at Leo Burnett & Co., a worldwide advertising agency. Mr. Johnson became a director and President - Consumer Division of the Company in August 1993. From 1987 until August 1993, Mr. Johnson was managing general partner of WJB, which prior to its consolidation with the Company in August 1993 was the Company's largest franchise owner. From 1967 through 1987, Mr. Johnson served as counsel to the law firm of Johnson, Smith, Hibbard & Wildman in Spartanburg, South Carolina. Mr. Johnson is a member of the Board of Directors of Duke Power Company. Mr. Martin-Busutil joined the Company in July 1992 as President - International Division. From 1981 to 1992, Mr. Martin-Busutil held various positions with Cadbury-Schweppes, including President of Cadbury Beverages in Europe. From 1961 to 1981, Mr. Martin-Busutil served in a number of international management and marketing related capacities with General Foods. Mr. Melk was re-elected a director of the Company in May 1993. Since 1988, Mr. Melk has been Chairman and Chief Executive Officer of H20 Plus Inc., which develops and manufactures health and beauty aid products. Mr. Melk has been a private investor in various businesses since March 1984 and prior to March 1984, he held various positions with WMX and its subsidiaries, including President of Waste Management International, plc. Mr. Melk also currently serves as a director of Psychemedics and Discovery Zone. From February 1987 until March 1989, Mr. Melk served as a director and Vice Chairman of the Company. Mr. Weber joined the Company in January 1988 as Regional Manager, became Zone Vice President in May 1989, was promoted to Vice President of Operations in June 1990 and became Senior Vice President of Operations in February 1991. From January 1986 to December 1987 he was President and Chief Operating Officer of Spirits, Inc., a Ft. Lauderdale, Florida company. From November 1982 to January 1986, he held the position of Vice President of the Gray/Drug Fair Division of Sherwin-Williams Co. Prior to that, Mr. Weber held various management positions with the Shoppers Drug Mart division of the Imasco Corporation. In 1993, the Board of Directors held an aggregate of 13 regular and special meetings. Each member of the Board who is not an employee of the Company is currently paid a quarterly fee of $6,250 plus $1,250 for each meeting attended. In addition, each non-employee member of the Board who serves as the Chairman of a Board Committee is paid $625 for each meeting of such committee attended. Item 11.	Item 11. Executive Compensation The information required by this item will be set forth in the Proxy Statement of the Company relating to the 1994 Annual Meeting of Stockholders, and is incorporated herein by reference. Item 12.	Item 12. Security Ownership of Certain Beneficial Owners and Management The information required by this item will be set forth in the Proxy Statement of the Company relating to the 1994 Annual Meeting of Stockholders, and is incorporated herein by reference. Item 13.	Item 13. Certain Relationships and Related Transactions The information required by this item will be set forth in the Proxy Statement of the Company relating to the 1994 Annual Meeting of Stockholders, and is incorporated herein by reference. PART IV. Item 14.	Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) (1) Financial Statements of the Company are set forth in Part II, Item 8. (2) The following financial statement schedules for each of the three years ended December 31, 1993 are submitted herewith: Schedule V - Property, Plant and Equipment. Schedule VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment. Schedule VIII - Valuation and Qualifying Accounts. Schedule X - Supplementary Statements of Operations Information. (3) Exhibits - (See the Index to Exhibits included elsewhere herein). (b) Form 8-K dated October 6, 1993 relating to an agreement in principle pursuant to which the Company will purchase Super Club Retail Entertainment Corporation from Philips Electronics N.V. for approximately $150,000,000. Form 8-K dated October 22, 1993 relating to the Company's restated financial information which reflects the consolidation with WJB Video Limited Partnership and certain of its affiliates which was accounted for under the pooling of interests method of accounting, and a $600,000,000 credit agreement obtained by the Company. Form 8-K dated November 1, 1993 relating to the consummation of the investment in Viacom Inc. and pro forma capitalization information. Form 8-K dated November 5, 1993 relating to certain financial statements and pro forma financial information related to the Company's proposed acquisition of Super Club Retail Entertainment Corporation. Form 8-K dated November 19, 1993 relating to the completion of the acquisition of Super Club Retail Entertainment Corporation and related pro forma information. Form 8-K dated December 22, 1993 relating to the Company's amended and restated Credit Agreement pursuant to which certain financial institutions have agreed to advance the Company and/or certain subsidiaries of the Company on an unsecured basis an aggregate of $1,000,000,000. Form 8-K dated January 7, 1994 relating to the Company's Agreement and Plan of Merger with Viacom Inc. and Subscription Agreement pursuant to which the Company will purchase from Viacom Inc. 22,727,273 shares of non-voting Viacom Class B common stock for an aggregate purchase price of $1,250,000,000. Form 8-K dated February 15, 1994 relating to the Company's Credit Agreement pursuant to which certain financial institutions have agreed to advance the Company on an unsecured basis an aggregate of $1,000,00,000 for the purchase of shares of capital stock of Viacom Inc. pursuant to the Subscription Agreement dated January 7, 1994 between the Company and Viacom Inc. Form 8-K dated March 10, 1994 relating to the Company's completed purchase from Viacom Inc. of 22,727,273 shares of non-voting Viacom Class B common stock pursuant to the Subscription Agreement dated January 7, 1994, between the Company and Viacom for an aggregate purchase price of $1,250,000,000. BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES SCHEDULE V PROPERTY, PLANT AND EQUIPMENT (In Thousands) For the year ended December 31, 1993 (1) Assets acquired in business combinations accounted for under the purchase method of accounting. (2) Primarily represents the effects of foreign currency translation. BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES SCHEDULE V PROPERTY, PLANT AND EQUIPMENT (In Thousands) For the year ended December 31, 1992 (1) Assets acquired in business combinations accounted for under the purchase method of accounting. (2) Primarily represents the effects of foreign currency translation. BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES SCHEDULE V PROPERTY, PLANT AND EQUIPMENT (In Thousands) For the year ended December 31, 1991 (1) Assets acquired in business combinations accounted for under the purchase method of accounting. BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES SCHEDULE VI ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (In Thousands) For the year ended December 31, 1993 (1) Primarily represents the effects of foreign currency translation. BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES SCHEDULE VI ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (In Thousands) For the year ended December 31, 1992 (1) Primarily represents the effects of foreign currency translation. BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES SCHEDULE VI ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (In Thousands) For the year ended December 31, 1991 BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES SCHEDULE VIII VALUATION AND QUALIFYING ACCOUNTS (In Thousands) For the years ended December 31, BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES SCHEDULE X SUPPLEMENTARY STATEMENTS OF OPERATIONS INFORMATION (In Thousands) For the years ended December 31, (1) Items not presented are less than one percent of revenue. SIGNATURES Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. BLOCKBUSTER ENTERTAINMENT CORPORATION Date: March 30, 1994 By: /S/ H. Wayne Huizenga ---------------------------------- H. Wayne Huizenga Chairman of the Board 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. Date: March 30, 1994 By: /S/ H. Wayne Huizenga ---------------------------------- H. Wayne Huizenga Chairman of the Board and Chief Executive Officer (Principal Executive Officer) March 30, 1994 By: /S/ Steven R. Berrard ---------------------------------- Steven R. Berrard Vice Chairman of the Board, President and Chief Operating Officer March 30, 1994 By: /S/ Gregory K. Fairbanks ---------------------------------- Gregory K. Fairbanks Senior Vice President, Chief Financial Officer and Treasurer (Principal Financial Officer) March 30, 1994 By: /S/ Albert J. Detz ---------------------------------- Albert J. Detz Vice President and Corporate Controller (Principal Accounting Officer) March 30, 1994 By: /S/ A. Clinton Allen, III ---------------------------------- A. Clinton Allen, III Director March 30, 1994 By: /S/ John W. Croghan ---------------------------------- John W. Croghan Director March 30, 1994 By: /S/ Donald F. Flynn --------------------------------- Donald F. Flynn Director March 30, 1994 By: /S/ George D. Johnson, Jr. --------------------------------- George D. Johnson, Jr. Director March 30, 1994 By: /S/ John J. Melk --------------------------------- John J. Melk Director EXHIBIT INDEX - ---------------- * Not applicable
74260_1993.txt	74260	1993	Item 1 - Business (a) General Development of Business. Old Republic International Corporation is a Chicago-based insurance holding company with subsidiaries engaged in the general (property & liability), title, mortgage guaranty, and life (life & disability) insurance businesses. In this report, "Old Republic", "the Corporation", or "the Company" refers to Old Republic International Corporation and its subsidiaries as the context requires. The aforementioned insurance segments are organized as the Old Republic General, Title, Mortgage Guaranty, and Life Groups, and references herein to such groups apply to the Company's subsidiaries engaged in the respective segments of business. Financial Information Relating to Segments of Business (a) The contributions to net revenues, income (loss) before taxes and before the cumulative effect of accounting changes of each Old Republic segment are set forth below for the years shown, together with their respective assets at the end of each year. The information below should be read in conjunction with the consolidated financial statements, the notes thereto, and the "Management Analysis of Financial Position and Results of Operations" appearing elsewhere herein. General Insurance Group Through its General Insurance Group subsidiaries, the Corporation assumes risks and performs related risk management and marketing services pertaining to a large variety of property and liability commercial insurance coverages. Old Republic does not have a meaningful participation in personal lines of insurance. Liability Coverages: Workers' compensation, general liability (including the general liability portion of commercial package policies), and commercial automobile full coverage protection are the major classes of insurance underwritten for businesses and public entities such as municipalities. Within these classes of insurance, Old Republic specializes in a number of industries, most prominently the transportation, coal and energy services, construction and forest product industries. Such business is primarily produced through agency and brokerage channels. The rates charged for all workers' compensation insurance are generally regulated by the various states. It is therefore possible that the rate increases necessary to cover any expansion of benefits under state laws or increases in claim frequency or severity may not always be granted soon enough to enable insurers to fully recover the amount of the benefits they must pay. During the past ten years, the Corporation has steadily diversified its General Insurance Group business. This diversification has been achieved through a combination of internal growth, the establishment of new subsidiaries, and through selective mergers with other companies. For 1993, production of direct workers' compensation premiums accounted for 34.0% of consolidated direct premiums written by the General Insurance Group. For the same year, general liability and commercial automobile direct insurance premiums amounted to 11.3% and 31.0%, respectively, of consolidated direct premiums written. During the past decade, specialty programs have also been expanded or initiated to insure corporations' exposures to directors' and officers' and errors and omissions liability, to cover owners and operators of private aircraft for hull and liability exposures, and insurance for grain elevators and LPG gas operations. The Corporation assumes (on both treaty and facultative bases) a moderate amount of reinsurance business underwritten by other insurance or reinsurance companies. Most of this business encompasses workers' compensation, general and automobile liability lines, as well as a moderate amount of property exposures. Property and Other Coverages: Old Republic's property insurance business includes physical damage insurance on commercial automobile and trucking risks. A small volume of business is represented by fire and other physical perils for houses, mobile homes and commercial properties. All such insurance is produced either directly, through agents or financial intermediaries, such as finance companies, and on a reinsurance assumed basis. Fidelity and surety coverages are underwritten through agents by the Old Republic Surety Group, Inc. Old Republic Insured Credit Services, Inc., a wholly-owned subsidiary, has marketed loan and retail installment sales credit guaranty insurance since 1955 through commercial banks and thrift institutions. This coverage provides lenders with a guaranty against defaults on home equity and home improvement loans and installment sales contracts. Auto Warranty and Home Warranty, while still relatively small businesses, are marketed directly by the Corporation. Title Insurance Group The title insurance business consists primarily of the issuance of policies to real estate purchasers and investors based upon searches of the public records which contain information concerning interests in real property. The policy insures against losses arising out of defects, liens and encumbrances affecting the insured title and not excluded or excepted from the coverage of the policy. There are two basic types of title insurance policies: lenders' policies and owners' policies. Both are issued for a onetime premium. Most mortgages made in the United States are extended by savings and loan associations, mortgage bankers, savings and commercial banks, state and federal agencies, and life insurance companies. The financial institutions secure title insurance policies to protect their mortgagees' interest in the real property. This protection remains in effect for as long as the mortgagee has an interest in the property. A separate title insurance policy is issued to the owner of the real estate. An owner's policy of title insurance protects an owner's interest in the title to the property. The premiums charged for the issuance of title insurance policies vary with the policy amount and the type of policy issued. The premium is collected in full when the real estate transaction is closed, there being no recurring fee thereafter. In many areas, premiums charged on subsequent policies on the same land may be reduced, depending generally upon the time elapsed between issuance of the previous policies and the nature of the transactions for which the policies are issued. Most of the charge to the consumer relates to title services rendered in conjunction with the issuance of a policy rather than to the possibility of loss due to risks insured against. Accordingly, the service performed by a title insurer relates for the most part to the prevention of loss rather than to the assumption of the risk of loss. In connection with its title insurance operations, the Corporation also provides escrow facilities, services for the disbursement of construction funds, and other services pertaining to real estate transfers. Mortgage Guaranty Group Real estate mortgage loan insurance protects lending institutions against certain losses, generally to the extent of 10% to 30% of the sum of the outstanding amount of each insured mortgage loan, and allowable costs incurred in the event of default by the borrower. The Corporation insures only first mortgage loans, primarily on residential properties having one-to-four family dwelling units. Mortgage guaranty insurance premiums originate from savings and loan associations and other lending institutions. Approximately 21% of the Corporation's residential real estate loan insurance business is currently originated by savings and loan associations, and the remaining 79% is produced through other lenders. Increased failures of savings and loan associations and other lending institutions have not had and should not have a bearing on the mortgage guaranty or other coverages in the Corporation's business since the profitability of its insurance products is not tied to any significant degree to the financial well-being of these institutions. While it is possible that the failure of a large number of such institutions could increase the competition for sales of certain insurance products to the surviving institutions, it is also likely that other institutions or providers of financial services would emerge to take their place. The Corporation's mortgage guaranty insurance in force at December 31, 1993 was originally produced by about 2,800 different lending institutions, and 1,500 such institutions originated business in 1993. Both annual and single premium plans for residential real estate loan insurance are offered. Annual plans provide coverage on a year-to-year basis with first-year premiums being dependent on the loan-to-value ratio and the coverage offered. Annual renewal premiums are charged on the basis of the outstanding loan balance on the anniversary date or, if selected, on the original loan balance. Single premium plans provide coverage for a period of from three to fifteen years, or the number of years required to amortize a standard mortgage to an 80% loan-to-value ratio, if selected. The premium charge similarly depends on the loan-to-value ratio, the coverage offered, the type of loan instrument (whether fixed rate/fixed payment or an adjustable mortgage loan) and whether the property is to be owner occupied. Approximately 98% of the residential real estate loan insurance in force at December 31, 1993 has been written under annual premium plans. The Corporation limits its residential real estate insurance to lenders approved by it and supervised or regulated by federal or state authorities in order to obtain reasonable assurance as to the effectiveness of such institutions' lending practices. A master policy is issued to each approved lender, but the master policy does not obligate the Corporation to issue insurance on any particular loan. To obtain insurance on a specific mortgage loan, an approved lender submits an application, supported by a copy of the borrower's loan application, an appraisal report on the property by either the lender or an independent appraiser, a written credit report on the borrower, an affidavit of the borrower's equity and certain other information. The underwriting department reviews this material and approves or rejects the application, usually on the day it is received. The Corporation generally adheres to the underwriting guidelines published by the Federal Home Loan Mort- gage Corporation. Upon approval of an application for insurance of a loan, the Corporation issues a commitment to insure the loan; this is followed by a certificate of insurance when the loan is consummated. Life Insurance Group Credit & Other Life and Disability: Old Republic markets and writes consumer credit life and disability insurance primarily through consumer finance companies, banks, savings and loan associations and automobile dealers. Approx- imately one-half of the borrowers insured under consumer credit life insurance are also covered by consumer credit disability protection. Credit life insurance provides for the repayment of a loan, installment purchase, or other debt obligation in the event of the death of the borrower, while credit disability insurance provides for the payment of installments due on such debt while the borrower is disabled. Old Republic has written various conventional disability/accident and health insurance coverages for many years, principally on a direct marketing basis through banks and other financial services institutions. Ordinary term life insurance is sold through independent agents and brokers for relatively large face amounts, in both the United States and Canada. Marketing of term life insurance products is aimed principally toward self-employed individuals, professionals, and owners of small businesses. Annuities: In the past, Old Republic marketed annuity policies, some of which remain outstanding, through securities dealers in New York State. These policies provide for annuity benefits based on premiums paid and accumulating with interest over time. Since 1985, the volume of annuity business has been inconsequential because the Corporation has been unwilling to invest in so-called "junk bonds" or illiquid investments to help assure higher, more competitive guaranteed rates. Consolidated Underwriting Statistics The following table reflects underwriting statistics covering: 1) premiums together with loss, expense, and policyholders' dividend ratios for the major coverages underwritten solely in the General, Title, and Mortgage Guaranty in- surance groups, and disability/accident & health coverages underwritten directly or through reinsurance in both the Life and General Insurance groups; 2) a summary of net retained life insurance in force at the end of the years shown: Variations in the loss (including related claim settlement expense) ratios are caused by changes in the frequency and severity of claims incurred, changes in premium rates and the level of premium refunds, and periodic changes in claim and claim expense reserve estimates resulting from ongoing reevaluations of reported and unreported claims and claim expenses. Loss, expense, policyholders' dividends, and composite ratios have been rounded to the nearest percentage point. The loss ratios include loss adjustment expenses where appropriate. Policyholders' dividends are a reflection of changes in loss experience for individual or groups of policies, rather than overall results, and should be viewed in conjunction with loss ratio trends; policyholders' dividends apply principally to workers' compensation insurance. General Insurance Group loss ratios for workers' compensation and liability insurance coverages in particular may fluctuate due to a variety of factors. The inherent volatility of claims experience due to chance events in any one year, greater loss costs emanating from involuntary business (i.e. from industry-wide insurance pools and associations in which participation is basically mandatory), and added provisions for loss costs not recoverable from assuming reinsurers which have experienced financial difficulties are some of the major factors influencing comparisons of loss ratios between years. The Company generally underwrites concurrently workers' compensation, commercial automobile (liability and physical damage), and general liability insurance coverages for a large number of customers. Accordingly, an evaluation of trends in premiums, loss and dividend ratios for these coverages should take such concurrent underwriting assumptions into account. The Title Insurance Group loss ratios for the years presented are relatively the same as there has been no material change in frequency and severity trends in the last three years. In 1993 and 1992, however, additional claim provisions of $13.3 million and $15.0 million, respectively, covering various escrow losses in process of final settlement increased the loss ratio compared to premiums and fees earned by 3% and 4%, respectively. The improvement in recent years in the mortgage guaranty loss ratio is due to lower claim frequency and the beneficial effects of higher premium rates. The increases in net ordinary life insurance in force, is attributed to the introduction beginning in 1990 of more favorably priced life products that have received greater market acceptance. General Insurance Claim Reserves The Corporation's property and liability insurance subsidiaries establish claim reserves which consist of estimates to settle: a) reported claims; b) claims which have been incurred as of each balance sheet date but have not as yet been reported ("IBNR") to the insurance subsidiaries; and c) the direct costs, (such as attorneys' fees which are allocable to individual claims) and indirect costs (such as salaries and rent applicable to the overall administration of the claim department) to administer known and IBNR claims. Such claim reserves, except as to classification in the Consolidated Balance Sheet as of December 31, 1993 in terms of gross and reinsured portions, are reported for financial and regulatory reporting purposes at amounts that are substantially the same. The establishment of claim reserves by property and liability insurers, such as the Corporation's General Insurance Group, is a reasonably complex and dynamic process influenced by a large variety of factors. These include past experience applicable to the anticipated costs of various types of claims, continually evolving and changing legal theories emanating from the judicial system, actuarial studies, the professional experience and expertise of the Company's claim departments' personnel or attorneys and independent adjusters retained to handle individual claims, the effect of inflationary trends on future claim settlement costs, and periodic changes in claim frequency patterns such as those caused by natural disasters, illnesses, accidents, or work-related injuries. Consequently, the reserve-setting process relies on the judgments and opinions of a large number of persons, on historical precedent and trends, and on expectations as to future developments. At any point in time, the Company and the industry are exposed to possibly higher than anticipated claim costs due to the aforementioned factors, the evolution, interpretation, and expansion of tort law, and the effects of unexpected jury verdicts. In establishing claim reserves, the possible increase in future loss settlement costs caused by inflation is considered implicitly, along with the many other factors cited above. Reserves are generally set to provide for the ultimate cost of all claims. With regard to workers' compensation reserves, however, the ultimate cost of long-term disability or pension-type claims is discounted to present value based on interest rates ranging from 3.5% to 4% as permitted by insurance regulatory authorities. The Company, where applicable, uses only such discounted reserves in evaluating the results of its operations, in pricing its products and settling retrospective and reinsured accounts, in evaluating policy terms and experience, and for other general business purposes. Solely to comply with reporting rules mandated by the Securities and Exchange Commission, however, Old Republic has made statistical studies of applicable workers' compensation reserves to obtain estimates of the amounts by which claim and claim adjustment expense reserves, net of reinsurance, have been discounted. These studies have resulted in estimates of such amounts of approximately $115.9, $129.3 and $152.7 million, as of December 31, 1993, 1992, and 1991, respectively. It should be noted, however, that these differences between discounted and non-discounted (terminal) reserves are, fundamentally, of an informational nature, and are not indicative of an effect on operating results for any one or series of years for the above-noted reasons, and for the effect of retrospective rating and similar plans as discussed under "Reserves, Reinsurance, and Retrospective Adjustments" elsewhere herein. The Company believes that its overall reserving practices have been consistently applied over many years, and that its aggregate net reserves have resulted in reasonable approximations of the ultimate net costs of claims incurred. However, no representation is made that ultimate net claim and related costs will not be greater or lower than previously established reserves. The following table shows a reconciliation of consolidated property and liability beginning and ending claim reserves, and the indicated deficiencies or redundancies for the years 1983 to 1993. In reviewing this tabular data, it should be recognized that prior periods' loss payment and development trends may not be repeated in the future due to the large variety of factors influencing the reserving process outlined herein above. With respect to the 1985 and 1986 data in particular, the indicated deficiency pertains largely to adverse claim development for reinsurance assumed business which the Company has de-emphasized since 1986 due to unacceptably high loss ratios. Further, the reserve redundancies or deficiencies shown are not necessarily indicative of the effect on reported results of any one or series of years since retrospective premium and commission adjustments employed in various parts of the Company's business tend to partially or fully offset or negate such effects. (See "Consolidated Underwriting Statistics" above, and "Reserves, Reinsurance, and Retrospective Adjustments" elsewhere herein). The subject of property and liability insurance claim reserves has been written about and analyzed extensively by a large number of professionals and regulators. Accordingly, the above discussion summary must, of necessity, be regarded as a basic outline of the subject and not as a definitive presentation. (c) Marketing. Workers' compensation, general liability and commercial automobile insurance underwritten for larger commercial enterprises and public entities is marketed primarily through independent insurance agents and brokers with the assistance of Old Republic's trained sales, underwriting, actuarial, and loss control personnel. The remaining property and liability commercial insurance written by Old Republic is obtained through insurance agents or brokers who are independent contractors and generally represent other insurance companies, by direct sales, and through marketing and underwriting joint ventures. A portion of Old Republic's consolidated insurance premium volume, particularly in its General and Life Insurance Groups, is produced by the mass marketing of specially designed insurance products through consumer-oriented businesses such as consumer finance companies, banks, savings and loan associations, mortgage bankers, automobile and mobile home dealers, and consumer products dealers. The Corporation has designed ancillary products, such as credit disability, joint life, loan credit guaranty insurance, and property insurance on loan collateral, for sale through the same sources as its other products. Through the combination of these marketing channels, Old Republic is afforded access to large volume markets without having to invest large sums for mailing, advertising, and other acquisition expenses, or for establishing and administering a large sales organization. No single source accounted for over 10% of Old Republic's premium volume in 1993. A substantial portion of the Company's title insurance business is referred to it by title insurance agents, builders, lending institutions, real estate developers, realtors, and lawyers. Title insurance is sold through 208 Company offices located in 30 states and through agencies and underwritten title companies in the District of Columbia and all states except Iowa and Oregon. The issuing agents are authorized to issue binders and title insurance policies based on their own search and examination, or on the basis of abstracts and opinions of approved attorneys. Policies are also issued through independent abstract companies (not themselves title insurers) pursuant to underwriting agreements. These agreements generally provide that the underwritten company may cause title policies of the Company to be issued, and the latter is responsible under such policies for any payments to the insured. Typically, the agency or underwritten title company deducts the major portion of the title insurance charge to the consumer as its commission and for the services. During 1993, approximately 45% of title insurance premiums and fees was accounted for by policies issued by agents and underwritten title companies. Existing differences in various parts of the country with respect to the acceptance and use of title insurance in real estate sales and loan transactions have a material effect on title insurance growth and operations in the areas concerned. In the Western states and certain urban areas of the East and Midwest, title insurance is widely accepted, with the result that the potential volume of title insurance premium income is large in relation to the volume of real estate activity in those areas. In some other parts of the country, title insurance is not as generally used, particularly in transactions involving residential real estate. Consequently, in those areas, the growth of title insurance depends not only upon market share of the title insurance business within the industry, but also upon the increased use of title insurance in real estate transactions. The volume of real estate activity is also affected by the availability and cost of financing, population growth, family movements and other factors. Also, the title insurance business is seasonal. During the winter months, new building activity is reduced and, accordingly, the Company does less title insurance business relative to new construction during such months than during the rest of the year. The most important factor, insofar as Old Republic's title business is concerned, however, is the rate of activity in the resale market for residential properties. Mortgage guaranty insurance is marketed primarily through a direct sales force which calls on savings and loan associations and other lending institutions. No sales commissions or other forms of remuneration are paid to the lending institutions or affiliated persons for the procurement or development of business. The personal contacts, relationships, and reputations of Old Republic's key executives are a vital element in obtaining and retaining business. Many of the Company's customers produce large amounts of premiums and therefore warrant substantial levels of top executive attention and involvement. In this respect, Old Republic's mode of operation is similar to that of professional reinsurers and commercial insurance brokers, and relies on the marketing, underwriting, and management skills of relatively few key people. Several types of insurance coverages underwritten by Old Republic, such as credit life and disability, loan credit guaranty, title, and mortgage guaranty insurance, are affected in varying degrees by changes in national economic conditions. During periods of economic recession, operating and claim costs pertaining to such coverages tend to rise disproportionately to revenues and generally result in reduced levels of profitability. At least one insurance subsidiary of Old Republic is licensed to do business in each of the 50 states, the District of Columbia, Puerto Rico, Virgin Islands, Guam, and each of the Canadian provinces; title insurance operations, however, are licensed to do business in 48 states and the District of Columbia, while mortgage insurance subsidiaries are licensed in 49 states and the District of Columbia. Consolidated direct premium volume distributed among the various geographical regions shown was as follows for the past three years: (d) Reserves, Reinsurance, and Retrospective Adjustments. Old Republic's insurance subsidiaries establish reserves for future policy benefits, unearned premiums, reported claims, claims incurred but not reported, and claim adjustment expenses, as required in the circumstances. Such reserves are based on regulatory accounting requirements and generally accepted accounting principles. In accordance with insurance industry practices, claim reserves are based on estimates of the amounts that will be paid over a period of time and changes in such estimates are reflected in the financial statements when they occur. See "General Insurance Claim Reserves" herein. To maintain premium production within its capacity and limit maximum losses and risks for which it might become liable under its policies, Old Republic, as is the practice in the insurance industry, may cede a portion or all of its premiums and liabilities on certain classes of insurance or blocks of business to other insurers and reinsurers. Although the ceding of insurance does not generally discharge an insurer from its direct liability to a policyholder, it is industry practice to establish the reinsured part of risks as the liability of the reinsurer. Old Republic also employs retrospective premium adjustments, contingent commissions, agency profit and risk-sharing arrangements, and joint ventures for parts of its business in order to minimize losses for which it might become liable under its insurance policies, and to afford its clients or producers a degree of participation in the risks and rewards associated with such business. Under retrospective arrangements, Old Republic collects additional premiums if losses are greater than originally anticipated and refunds a portion of original premiums if loss costs are lower. Pursuant to contingent commissions, agency profit and other risk-sharing arrangements, the Company adjusts commissions or premiums retroactively to likewise reflect deviations from originally expected loss costs. The amount of premium, commission, or other retroactive adjustments which may be made is either limited or unlimited depending on the Company's evaluation of risks and related contractual arrangements. To the extent that any reinsurance companies, retrospectively rated risks, or producers might be unable to meet their obligations under existing reinsurance or retrospective insurance and commission agreements, Old Republic would be liable for the defaulted amounts. In these regards, however, the Company generally protects itself by withholding funds, or by otherwise collateralizing reinsurance obligations through irrevocable letters of credit, cash, and securities. Old Republic's reinsurance practices with respect to portions of its business also result from its desire to bring its sponsoring organizations and clients into some degree of joint venture relationship. The Corporation may, in exchange for a ceding commission, reinsure up to 100% of the underwriting risk, and the premium applicable to such risk, to insurers owned by or affiliated with lending institutions, sponsors whose customers are insured by Old Republic, or individual clients who have formed "captive" insurance companies. The ceding commissions received compensate Old Republic for performing the direct insurer's functions of underwriting, actuarial, claim settlement, loss control, legal, reinsurance, and administrative services to comply with local and federal regulations, and for providing appropriate risk management services. Remaining portions of Old Republic's business are reinsured with independent insurance or reinsurance companies under various quota share, and excess of loss agreements. Reinsurance protection on property and liability operations generally limits the net loss on any one risk to a maximum of (in whole dollars): fire and other physical perils-$20,000; accident and health-$15,000; workers' compensation-$1,000,000; other liability coverages-$600,000; and loan credit guaranty-$200,000. Title insurance risk assumptions, based on the title insurance subsidiaries' financial resources, are limited to a maximum of $15,000,000 as to any one policy. Substantially all the mortgage guaranty insurance business is retained, with the exposure on any one risk currently averaging less than $20,000. The maximum amount of ordinary life insurance retained on any one life by the Life Insurance Group (without reinsurance) is $250,000. (e) Competition. The insurance business is highly competitive and Old Republic competes with many stock and mutual insurance companies. Many of these competitors offer more insurance coverages and have substantially greater financial resources than the Corporation. The rates charged for many of the insurance coverages in which the Corporation specializes, such as credit life and disability insurance, workers' compensation insurance, other property and liability insurance, and title insurance, are primarily regulated by the states and are also subject to extensive competition among major insurance organizations. The basic methods of competition available to Old Republic, aside from rates, are service to customers, expertise in tailoring insurance programs to the specific needs of its clients, efficiency and flexibility of operations, personal involvement by its key executives, and, as to title insurance, accuracy and timely delivery of evidences of title issued. For certain types of coverages, including loan credit guaranty and mortgage guaranty insurance, the Company also competes in varying degrees with the Federal Housing Administration ("FHA") and the Veterans Administration ("VA"). In these regards, the Corporation's insurance subsidiaries compete with the FHA and VA by offering different coverages and by establishing different requirements relative to such factors as interest rates, closing costs, and loan processing charges. The Corporation believes its experience and expertise have enabled it to develop a variety of specialized insurance programs for its customers and to secure state insurance departments' approval of these programs. (f) Government Regulation. In common with all insurance companies, the Corporation's insurance subsidiaries are subject to the regulation and supervision of the jurisdictions in which they do business. The method of such regulation varies, but, generally, regulation has been delegated to state insurance commissioners who are granted broad administrative powers relating to: the licensing of insurers and their agents; the nature of and limitations on investments; approval of policy forms; reserve requirements; and trade practices. In addition to these types of regulation, many classes of insurance, including most of the Corporation's insurance coverages, are subject to rate regulations which require that rates be reasonable, adequate, and not unfairly discriminatory. The National Association of Insurance Commissioners has promulgated a model law providing stringent regulation of credit life and disability insurance which has been adopted in various forms by most states. An important interpretation of the model law stipulates that a loss ratio below 60% would be construed as producing an excessive premium rate, thereby indirectly defining the maximum rate that can be charged by an insurer. Some states now require a substantially higher loss ratio on these coverages. Although one of the general effects of the model law has been to reduce rates significantly, in some states where the rates were excessively reduced, Old Republic has been able in some cases to obtain higher rates by demonstrating that actual loss ratios incurred have been in excess of a permissible loss ratio required by regulatory authorities as a condition for obtaining rate increases. Credit life and disability insurance practices are further regulated by the federal "Truth-in-Lending Law" which requires, among other things, that a borrower be specifically informed of the existence and cost of credit life and disability insurance, execute a written acknowledgement of his understanding of such insurance, and give a written order for the insurance as a condition of his incurring any charge for the coverage. There have been various proposals from time to time with respect to additional regulation of credit life and disability insurance which could have an adverse effect on the consumer credit insurance business. The financial institutions whose customers are insured by Old Republic are also regulated by federal and state authorities whose regulations have a direct effect on certain forms of credit life and disability insurance. The Federal National Mortgage Association ("FNMA") and the Federal Home Loan Mortgage Corporation ("FHLMC") have various qualifying requirements for private mortgage guaranty insurers which write mortgage insurance on loans acquired by the FNMA and FHLMC from mortgage lenders. These requirements include a basic standard calling for the maintenance of a ratio of aggregate insured risk to policyholders' surplus (defined as total statutory capital and surplus plus statutory contingency reserves) of not more than 25 to 1. Other qualifying requirements are designed to insure the financial stability of a private mortgage insurance company by limiting the geographic concentration of insurance risks, by limiting risks on nonresidential real estate insurance to 10% of policyholders' surplus, by maintaining 85% of total admitted assets in marketable securities and other highly liquid investments, and by maintaining a minimum policyholders' surplus of $5 million. Most of the Company's savings and loan association customers for mortgage guaranty insurance are governed by the regulations of the Federal Home Loan Bank Board. A regulation of that Board prohibits savings and loan associations from insuring any loan with a mortgage insurance company if certain relationships exist between such mortgage insurance company and the savings and loan association. Generally, a savings and loan association may not obtain insurance from any mortgage insurance company if (1) any commission, fee or other compensation is paid to the savings and loan association or any of its officers, directors, employees or affiliates, (2) a savings account is maintained by the mortgage insurance company with such savings and loan association, (3) any officer or employee of the mortgage insurance company or its parent company is a director, officer or controlling person of the savings and loan association, or (4) either (a) the association or any director, officer, controlling person or affiliate holds equity securities of the mortgage insurance company or any parent company thereof having a cost in excess of $50,000 or representing more than one percent of any class of equity securities of the company, if its assets are less than $50 million, or one-half percent, if the assets equal or exceed $50 million, or (b) the association and all of its directors, officers, controlling persons or affiliates in the aggregate own equity securities of the mortgage insurance company having a cost in excess of $100,000, or two percent of a company the assets of which are less than $50 million, or one percent, if the assets equal or exceed $50 million. The majority of states have also enacted insurance holding company laws which require registration and periodic reporting by insurance companies controlled by other corporations licensed to transact business within their respective jurisdictions. Old Republic's insurance subsidiaries are subject to such legislation and are registered as controlled insurers in those jurisdictions in which such registration is required. Such legislation varies from state to state but typically requires periodic disclosure concerning the corporation which controls the registered insurers, or ultimate holding company, and all subsidiaries of the ultimate holding company, and prior approval of certain intercorporate transfers of assets (including payments of dividends in excess of specified amounts by the insurance subsidiary) within the holding company system. Each state has established minimum capital and surplus requirements to conduct an insurance business. All of the Company's subsidiaries meet or exceed these requirements, which vary from state to state. (g) Employees. As of December 31, 1993, Old Republic employed approximately 6,100 persons on a full time basis. Eligible full time employees participate in various pension plans which provide annuity benefits payable upon retirement. Eligible employees are also covered by hospitalization and major medical insurance, group life insurance, and various profit sharing and deferred compensation plans. The Company considers its employee relations to be good. Item 2		Item 2 - Properties The principal executive offices of the Company are located in the Old Republic Building in Chicago, Illinois. This Company owned building contains 151,000 square feet of floor space of which approximately 50% is occupied by Old Republic, and the remainder is leased to others. In addition to the Company-owned principal executive offices, a subsidiary of the Title Insurance Group partially occupies its headquarters building. This building contains 110,000 square feet of floor space of which approximately 62% is occupied by the Old Republic National Title Insurance Company. The remainder of the building is leased to others. Nine smaller buildings are owned by Old Republic and its subsidiaries in various parts of the country and are primarily used for its business. The carrying value of all buildings and related land at December 31, 1993 was approximately $12.6 million, and mortgages thereagainst aggregated $.4 million as of the same date. Certain other operations of the Company and its subsidiaries are directed from leased premises. See Note 5(b) of the Notes to Consolidated Financial Statements for a summary of all material lease obligations. Item 3	Item 3 - Legal Proceedings There are no material legal proceedings against the Company other than those arising in the normal course of business and which generally pertain to claim matters related to insurance policies and contracts issued by the Corporation's insurance subsidiaries. Item 4	Item 4 - Submission of Matters to a Vote of Security Holders None Item 4(a)-Executive Officers of the Registrant Name AgePosition Paul D. Adams 48 Senior Vice President, Chief Financial Officer since 1990 and Treasurer since 1993. Executive Vice President, Finance and Secretary from 1982 to 1989 of Great West Casualty Company, a wholly-owned subsidiary. Anthony F. Colao 66 Senior Vice President, and Director since 1987. Spencer LeRoy, III 47 Senior Vice President, General Counsel, and Secretary since 1992. William F. Schumann 54 Senior Vice President since 1989. President since 1974 of Old Republic Insured Credit Services, Inc., a wholly-owned subsidiary. William A. Simpson 52 Senior Vice President/Mortgage Guaranty, and Director since 1980. President since 1972 of Republic Mortgage Insurance Company, a wholly-owned subsidiary. A. C. Zucaro 54 Chief Executive Officer, President, Director and Chairman of the Board since 1990, 1981, 1976 and 1993, respectively. The term of office of each officer of the Company expires on the date of the annual meeting of the board of directors, which is generally held in May of each year. There is no family relationship between any of the executive officers named above. Each of these named officers, except Mr. LeRoy, has been employed in executive capacities with the Company and/or its subsidiaries for the past five years. PART II Item 5	Item 5 - Market for the Registrant's Common Stock and Related Security Holder Matters The Company's common stock is traded on the New York Stock Exchange under the symbol "ORI". The high and low closing prices as reported on the New York Stock Exchange, and cash dividends declared for each quarterly period during the past two years were as follows: Closing Price Cash High Low Dividends 1st quarter 1992. . . . . $20.88 $17.50 $ .093 2nd quarter 1992. . . . . 22.38 19.00 .100 3rd quarter 1992. . . . . 24.38 19.63 .100 4th quarter 1992. . . . . $26.50 $23.50 $ .100 1st quarter 1993. . . . . $27.00 $24.50 $ .100 2nd quarter 1993. . . . . 26.13 21.63 .110 3rd quarter 1993. . . . . 27.38 23.00 .110 4th quarter 1993. . . . . $25.50 $21.88 $ .110 As of January 31, 1994, there were 3,973 registered holders of the Company's Common Stock. See Notes 4(b) and 4(c) of the Notes to Consolidated Financial Statements for a description of certain regulatory restrictions on the payment of dividends by Old Republic's insurance subsidiaries and certain restrictions under the terms of Old Republic's loan agreements. Closing prices have been restated, as necessary, to reflect all stock dividends and splits declared through December 31, 1993. Item 7		Item 7 - Management Analysis of Financial Position and Results of Operations ($ in Millions, Except Share Data) OVERVIEW This analysis pertains to the consolidated accounts of Old Republic International Corporation. The Company conducts its business through four major segments, namely its General (property and liability coverages), Title, Mortgage Guaranty, and Life insurance groups. CHANGES IN ACCOUNTING POLICIES In 1993, the Company adopted several changes in accounting policies to comply with Financial Accounting Standards Board (FASB) pronouncements that have been mandated. The adoption of the asset and liability method for calculating deferred income taxes and the recognition of present value liabilities pertaining to post-retirement health benefits under retirement plans maintained by a few Old Republic subsidiaries increased net income by $8.6 or 15 cents per share (14 cents fully diluted) in the first quarter of 1993. Accounting for reinsurance ceded transactions affected the Company's balance sheet but not the consolidated income statement; assets and liabilities at December 31, 1993, were increased by corresponding amounts of approximately $1,524.2 due to the reclassification change for these transactions. Finally, the Company reexamined the classification of its invested assets which led to reporting such assets as either "held to maturity" or "available for sale"; the effect of these classification changes was to increase assets and the liability for deferred taxes by $25.2 and $8.7, respectively, and common shareholders' equity for the net unrealized appreciation of securities newly reclassified at fair value by $16.4 or 32 cents per common share as of December 31, 1993. See Note 1 of the Notes to Consolidated Financial Statements for further details relating to these changes. Prior years' financial statements have not been restated nor reclassified to reflect these changes as permitted by the pertinent FASB pronouncements. FINANCIAL POSITION Exclusive of the classification changes noted above, Old Republic's financial position at December 31, 1993 reflected increases in assets of 9.8%, liabilities of 8.6%, and common shareholders' equity of 13.5% when compared to the immediately preceding year-end. At December 31, 1993 and 1992, cash and invested assets represented 81.2% and 80.5% of consolidated assets, respectively. Relatively high short-term maturity investment positions were maintained as of the most recent year-ends to provide necessary liquidity for specific operating needs and to enhance flexibility in investment strategy. Changes in short-term investments reflect a large variety of seasonal and intermediate-term factors including seasonal operating cash needs, investment strategy, and expectations as to trends in interest yields. Accordingly, the future level of short-term investments will vary and respond to the dynamics of these factors and may, as a result, increase or decrease from current levels. During 1993 and 1992, the Corporation committed substantially all investable funds in short to intermediate-term fixed maturity securities. Old Republic continues to adhere to its long-term policy of investing primarily in investment grade, marketable securities; the Corporation has not directed its investable funds to so-called "junk bonds". During 1993, however, Old Republic increased its commitment to common stock investments which reflected an increase of 50% vis-a-vis the related invested balance at year-end 1992. As of December 31, 1993, the carrying value of fixed maturity securities in default as to principal or interest was immaterial in relation to consolidated assets or shareholders' equity. Consolidated operations produced positive cash flows for the latest three years. The parent holding company has met its liquidity and capital needs for the past three years through dividends paid by its subsidiaries and through the issuance of debt and equity securities. The insurance subsidiaries' ability to pay cash dividends to the parent company is generally restricted by law or subject to approval of the insurance regulatory authorities of the states in which they are domiciled. Additionally, the terms of guarantees by the Company of bank loans to the trustee of the Company's Employees Savings and Stock Ownership Plan require the Company to maintain a minimum consolidated tangible net worth and restrict the amount of debt the Company may incur, both of which covenants are being met. In August 1992, the Company issued $110 of 5 3/4% convertible debentures maturing in 2002. Net proceeds from this offering were used to redeem approximately $50 of commercial paper debt, with the remainder allocated to the capital of several insurance subsidiaries. Convertible debt of approximately $41.3 outstanding at December 31, 1991 was converted into 2,676,284 shares of Old Republic common stock during 1992. Old Republic's capitalization of $1,617.7 at December 31, 1993 consisted of debt and debt equivalents of $282.7, redeemable convertible preferred stock of $16.6 (excluding $15.1 of such stock classified as a debt equivalent), conver- tible preferred stock of $3.9, cumulative preferred stock of $57.5, and common shareholders' equity of $1,256.9. The rise in the common shareholders' equity account during the past three years reflects primarily the retention of earnings in excess of dividends declared on outstanding preferred and common shares, the conversion of debt and preferred stock to common stock, and the previously noted net unrealized appreciation of securities. RESULTS OF OPERATIONS Revenues: Net premiums and fees earned increased by 12%, 16%, and 10% in 1993, 1992 and 1991, respectively. For each of the past three years, property and liability insurance premium increases were due to varying levels of growth in certain parts of the Company's business, but principally among liability coverages. During these years, the Corporation has cancelled periodically certain property and liability insurance business not meeting its underwriting expectations. Greater real estate financing activity during the three most recent calendar years led to higher revenues in the title segment. For the past three years, mortgage guaranty premiums also increased due to a rise in the amount of renewal and new business, and greater market penetration. Life and disability premium volume has generally trended down during the years 1992 and 1991 as the Corporation has continued to de-emphasize this business until greater returns are possible. An increase in 1993 of life and disability premium is attributed to the introduction of more favorably priced term life insurance products that received greater market acceptance. Net investment income was relatively flat in 1993 and grew by 1% and 6% in 1992 and 1991, respectively. For each of the past three years, the growth in this revenue source was bolstered by positive consolidated operating cash flows and a concentration of investable assets in interest-bearing, fixed maturity securities. The average annual yield on investments was 6.4%, 7.3%, and 8.1% for the years ended December 31, 1993, 1992 and 1991, respectively; the downward trend reflects principally the declining current yields in the securities markets. While the Company's investment policies have not been designed to maximize capital gains, during 1992 such gains were much higher than those realized in 1993 and 1991. Dispositions of securities have been caused principally by: (1) calls prior to maturity by issuers, (2) a desire to reduce investments in tax exempt securities, (3) a desire to extend moderately the average life of the portfolio, and (4) the Company's ongoing process of continually monitoring its investments with a view toward maximizing the quality ratings and diversification of its portfolio. For the year 1993, approximately 58% of total dispositions represented maturities and early calls of existing holdings; for the year 1992 these amounted to approximately 37% of all securities sales and dispositions. Expenses: Consolidated benefit, claim, and related settlement costs, as a percentage of net premiums and fees earned, were approximately 56% in 1993, 58% in 1992 and 62% in 1991. This consolidated ratio was affected principally by a slightly improving claim ratio for property and liability insurance coverages. In the most recent three years, the Corporation's property and liability insurance subsidiaries, along with other companies in the industry, have also sustained higher loss assessments for residual market (assigned risk) business. Policyholders' dividends incurred in the Corporation's property and liability lines for each year reflect changes in the loss ratio for experience-rated policies. The title insurance loss ratio was affected by higher than normal claims provisions in both 1993 and 1992 which added approximately 3.0% and 3.8%, respectively, to this group's loss ratio. The loss ratio declined or remained relatively stable in the mortgage guaranty insurance line due to a reduction of frequency of claim occurrences. The ratio of consolidated underwriting, acquisition, and insurance expenses to net premiums and fees earned was approximately 45% in 1993, 46% in 1992 and 43% in 1991. Variations in these ratios reflect a continually changing mix of coverages sold and attendant costs of producing business. In years during which title insurance premiums and fees grow significantly, as in 1993 and 1992, in particular, the consolidated expense ratio tends to rise as production costs for this line are higher than those for most other types of insurance. Income from Operations: During 1992 the Company's Title Insurance Group established greater than normal loss provisions of $15.0 as additional funding for various title escrow claims in process of disposition. In 1992, the Company's life insurance subsidiaries recorded previously unrecognized tax recoveries of $1.1 and related interest credits of approximately $12.4 stemming from resolution of various long-standing Internal Revenue Service disputes applicable to taxable years 1969 to 1981. These charges and credits served to increase consolidated revenues by $12.4 and claim costs by $15.0, and to record net current and deferred income tax credits of $1.1. Above normal additions to Title Insurance Group claim reserves during 1993 affected adversely pre-tax income by approximately $13.3. Income before taxes decreased by 3% in 1993 and increased by 43% in 1992 and 32% in 1991. General insurance results have trended up slightly during the past five years and have continued as the major contributor to consolidated earnings, principally as a result of growing investment income. Title insurance operating results have improved over the past three years due to the previously discussed increase in revenues. The mortgage guaranty segment reflected significantly improved results due to increased revenues and favorable claims experience in each of the past three years, while life and disability operations have reflected a secular downward trend in the past three years. Consolidated pre-tax income for 1993 and 1992 in particular was affected positively by greater than normal realization of investment gains. The effective consolidated income tax rates were 32% in 1993, 30% in 1992 and 26% in 1991. The rates for each year reflect primarily the varying proportions of pre-tax operating income derived from tax-exempt investment income, on the one hand, and the combination of fully taxable investment income, realized investment gains, and underwriting and service income, on the other hand. In August 1993, the corporate federal income tax rate was increased from 34% to 35% retroactive to January 1, 1993. In recent years the Corporation has emphasized purchases of taxable investment securities. Amortization of fresh start benefits stemming from the Tax Reform Act of 1986 (the "TRA") reduced income taxes by $1.9 in 1992 and $3.6 in 1991. The Revenue Reconciliation Act of 1990 (the "RRA") provided for a number of changes affecting the taxation of the Corporation and a number of its subsidiaries. Among such changes are acceleration in the recognition of salvage and subrogation recoveries and deferral of costs associated with the production of life and disability business and the subsequent amortization of those costs. The TRA also provided for a number of changes affecting the taxation of the Corporation and a number of its subsidiaries. Among such changes are reductions in corporate tax rates, the discounting of loss reserves, the acceleration of premium income recognition, and the inclusion in taxable income of a portion of certain tax-exempt investment income previously not subject to tax. In addition, the TRA calls for the calculation of an alternative minimum tax. The RRA and TRA are likely to result in accelerated payment of federal income taxes. However, most of the additional tax payments are treated as timing differences for financial accounting purposes. Consequently, such payments are expected to have minimal effects on consolidated results of operations and financial position determined in accordance with generally accepted accounting principles. OTHER INFORMATION Reference is here made to "Financial Information Relating to Segments of Business" appearing elsewhere herein. Historical data pertaining to the operating results, liquidity, and other financial matters applicable to an insurance enterprise such as the Corporation, are not necessarily indicative of results to be achieved in succeeding years. The long-term nature of the insurance business, seasonal and annual patterns in premium production and incidence of claims, changes in yields obtained on invested assets, and changes in government policies and free markets affecting inflation rates and general economic conditions are some of the factors which have a bearing on year-to-year comparisons and future operating results. Item 8	Item 8 - Financial Statements Listed below are the financial statements included herein: OLD REPUBLIC INTERNATIONAL CORPORATION AND SUBSIDIARIES Consolidated Balance Sheets Consolidated Statements of Income Consolidated Statements of Preferred Stock and Common Shareholders' Equity Consolidated Statements of Cash Flows Notes to Consolidated Financial Statements Report of Independent Accountants Proceeds from sales of fixed maturity securities-available for sale were $188.3 and fixed maturity securities-held to maturity were $486.8 during 1993 while proceeds from sales of fixed maturity securities were $1,473.0 in 1992. Gross gains of $19.5 and gross losses of $4.1 were realized on sales of fixed maturity securities-available for sale during 1993, and gross gains of $68.8 and gross losses of $7.8 were realized on the sales of fixed maturity securities during 1992. Investment income is reported net of allocated expenses and includes appropriate adjustments for amortization of premium and accretion of discount on bonds and notes acquired at other than par value. Dividends on stock are credited to income on the ex-dividend date. Realized investment gains and losses are reflected in the income statement and are determined on the basis of amortized value at date of sale for bonds and notes, and cost in regard to stocks; such bases apply to the specific securities sold. Unrealized investment gains and losses, net of any deferred income taxes, are recorded directly in a separate account of shareholders' equity. Net unrealized appreciation of securities at December 31, 1993 included gross unrealized gains and losses of $41.6 and $3.6, respectively. At December 31, 1993, the Corporation and its subsidiaries had non-income producing investments aggregating $1.5. (d) Revenue Recognition-Pursuant to generally accepted accounting principles applicable to the insurance industry, benefits, claims, and expenses are associated with the related revenues by means of the provision for policy benefits, the deferral and subsequent amortization of acquisition costs, and the recognition of incurred benefits, claims and operating expenses. General insurance (property and liability) and level-term credit life insurance premiums are reflected in income on a pro-rata basis. Earned but unbilled premiums are generally taken into income on the billing date, and adjustments for retrospective premiums, commissions and similar charges are accrued on the basis of periodic evaluations of current underwriting experience and contractual obligations. Title insurance premiums are recognized as income upon the substantial completion of the policy issuance process. Title abstract, escrow, service, and other fees are taken into income at the time that the services are performed. First year and renewal mortgage guaranty premiums are recognized as income on a straight-line basis except that a portion of first year premiums received for certain high risk policies is deferred and reported as earned over the estimated policy life, including renewal periods. Single premiums for mortgage guaranty policies covering more than one year are earned on an accelerated basis over the policy term. Ordinary life and annuity premiums are recognized as revenue when due. Decreasing term credit life and credit disability/accident & health insurance premiums are generally earned on a sum-of-the-years-digits or similar method. (e) Deferred Policy Acquisition Costs-The Corporation's insurance subsidiaries, other than title companies, defer certain costs which vary with and are primarily related to the production of business. Deferred costs consist principally of commissions, premium taxes, marketing, and policy issuance expenses. With respect to most coverages, defer- red acquisition costs are amortized on the same basis as the related premiums are earned or, alternatively, over the periods during which premiums will be paid or underwriting and claim services performed. The following table summarizes deferred policy acquisition costs and related data for the years shown: Years Ended December 31, (f) Future Policy Benefits/Unearned Premiums-See note 1(g) for discussion of FAS No. 113 "Accounting and Reporting for Reinsurance of Short Duration and Long-Duration Contracts". General insurance and level term credit life insurance policy liabilities represent unearned premium reserves developed by application of monthly pro-rata factors to premiums in force. Disability/accident & health and decreasing term credit life insurance policy liabilities are calculated primarily on a sum-of-the-years-digits method. Mortgage guaranty unearned premium reserves are calculated primarily on a pro-- rata basis. Ordinary life policy liabilities are determined on a level premium method and take into account mortality and withdrawal rates based principally on anticipated company experience; assumed interest rates range from 3.0% to 6.0%. With respect to annuity policies, the liabilities represent the surrender value of such policies during deferral periods, without adjustment for surrender charges; such values are deemed appropriate to provide for ultimate benefit reserves in the event policyholders exercise an annuity benefit option at a later date. At December 31, 1993 and 1992, the Life Insurance Group had $4,286.7 and $3,515.5, respectively, of net life insurance in force. Future policy liabilities and unearned premiums, consisted of the following: At December 31, 1992, future policy benefit liabilities and unearned premiums are included net of reinsurance ceded to other companies of $121.5. The Company issues, directly or as a reinsurer, certain insurance policies generally categorized as financial guarantees. The major types of guarantees pertain to (a) state, municipal and other general or special revenue bonds, (b) variable interest rate guarantees, and (c) insurance of the future residual value of fixed assets. The types of risks involved include failure by the bond issuer to make timely payment of principal and interest, changes in interest rates, and changes in the future value of fixed assets. The degree of risk pertaining to these insurance products is largely dependent on the effects of general economic cycles and changes in the credit worthiness of issuers whose obligations have been guaranteed. During the past three years, new commitments have been limited to those identified at (a) immediately above. Premiums received for financial guarantee policies are generally earned over the terms of the contract (which may range between 5 and 30 years) or on the basis of current exposure relative to maximum exposure in force; with respect to residual value insurance, that portion of the premium in excess of certain initial underwriting costs is deferred and taken into income when all events leading to the determination of exposure, if any, have occurred. Since losses on financial guarantee insurance products cannot be predicted reliably, the Company's unearned premium reserves serve as the primary income recognition and loss reserving mechanism. When losses become known and determinable, they are paid or placed in reserve and the remaining directly-related unearned premiums are taken into income. No assurance can be given that unearned premiums will be greater or less than ultimate incurred losses on these policies. The following table reflects certain data pertaining to net insurance in force for the Company's financial guarantee business at the dates shown: With respect to mortgage guaranty insurance (net insurance in force of $24,026.1 and $16,647.0, at December 31, 1993 and 1992, respectively) the Company's reserving policies are set forth below in Note l(g). (g) Losses, Claims and Settlement Expenses-Reserves are provided for the ultimate expected cost of settling unpaid losses and claims reported at each balance sheet date. Losses and claims incurred but not reported, as well as expenses required to settle losses and claims are established on the basis of various criteria, including historical cost experience and anticipated costs of servicing reinsured and other risks. Long-term disability-type workers' compen- sation reserves, however, are discounted to present value based on interest rates ranging from 3.5% to 4% as permitted by regulatory authorities. All reserves are necessarily based on estimates which are periodically reviewed and evaluated in the light of emerging claim experience and existing circumstances. The resulting changes in estimates are recorded in operations of the periods during which they are made. Consistent with industry practice, total loss and claim reserves are stated net of reinsurance ceded to other companies in the amount of $1,244.1 at December 31, 1992. Effective January 1, 1993 the Company adopted Financial Accounting Standard (FAS) No. 113 "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts" which eliminates the reporting of assets and liabilities relating to reinsured contracts net of reinsurance ceded balances. Accordingly, reinsured losses and unearned premiums are to be reported as assets. At December 31, 1993, assets and liabilities were, as a result, increased by corresponding amounts of approximately $1.5 billion. FAS No. 113 did not have any effect on the Company's results of operations. (h) Income Taxes-The Corporation and most of its subsidiaries file a consolidated tax return and provide for income taxes payable currently. The tax benefits of net operating losses are recognized in the periods during which they become recoverable. Deferred income taxes included in the accompanying consolidated financial statements pursuant to generally accepted accounting principles will not necessarily become payable/recoverable in the future. Effective January 1, 1993 the Company adopted Financial Accounting Standard (FAS) No. 109 "Accounting for Income Taxes." FAS No. 109 requires a change to the asset and liability method of calculating deferred income taxes. The cumulative effect of this change resulted in an increase in net income of $13.3, or $.23 per share ($.22 fully diluted) in 1993. This method requires the establishment of a deferred tax, calculated at currently effective tax rates, for the cumulative temporary differences between financial statement and tax bases of assets and liabilities. Prior to January 1, 1993 deferred income taxes applicable to income and expense items reported in the consolidated financial statements in different periods than for tax purposes were established. The provision for combined current and deferred income taxes reflected in the consolidated statements of income does not bear the usual relationship to operating income before taxes as the result of permanent and other differences between pre-tax income and taxable income determined under existing tax regulations. The more significant differences, their effect on the statutory income tax rate, and the resulting effective income tax rates are summarized below: A summary of deferred income taxes applicable to the following years: Years Ended December 31, 1992 1991 Deferred policy acquisition costs $ 5.7 $ 1.2 Future policy benefits 3.5 (1.0) Loss and unearned premium reserve discounting and amortization (4.9) (16.4) Fresh start amortization of discounted loss reserves (1.9) (3.6) Contingency reserves 17.2 5.0 Other items - net .9 (.3) Total $ 20.5 $ (15.1) The tax effects of temporary differences that give rise to significant portions of the Company's net deferred tax recoverable are as follows at the dates shown: December 31, 1993 January 1, 1993 Deferred Tax Assets: Future policy benefits $ 1.7 $ 1.5 Losses, claims, and settlement expenses 182.2 165.4 Unearned premium reserves 6.2 3.4 Other 8.7 8.6 Total gross deferred tax assets 199.0 178.9 Less-valuation allowance 3.9 4.1 Net deferred tax assets 195.0 174.8 Deferred Tax Liabilities: Deferred policy acquisition costs 34.2 27.8 Mortgage Guaranty insurers contingency reserves 43.2 25.1 Fixed maturity securities adjusted to costs 4.8 3.4 Unrealized investment gains 10.2 2.6 Title plants and records 3.4 3.3 Other 15.7 18.8 Total deferred tax liability $111.9 81.3 Net deferred tax asset $ 83.2 $ 93.4 Pursuant to special provisions of the Internal Revenue Code pertaining to mortgage guaranty insurers, a contingency reserve (established in accordance with insurance regulations designed to protect policyholders against extraordinary volumes of claims) is deductible from gross income. The tax benefits obtained from such deductions must, however, be invested in a special type of non-interest bearing U.S. Government Tax and Loss Bond. For Federal income tax purposes, the amounts deducted for the contingency reserve are taken into gross statutory taxable income (a) when the contingency reserve is permitted to be charged for losses under state law or regulation, (b) in the event operating losses are incurred, or (c) in any event upon the expiration of ten years. Life Insurance companies domiciled in the United States and qualifying as life insurers for tax purposes are taxed under special provisions of the Internal Revenue Code. As a result of legislation, 1983 and prior years' tax deferred earnings (cumulatively $20.7 at December 31, 1993) credited to the former memorandum "policyholders' surplus account" will not be taxed unless they are subsequently distributed to shareholders. The Company does not presently anticipate any distribution or payment of taxes on such earnings in the future. As a result of regular examinations of the tax returns for the Corporation and its subsidiaries, the Internal Revenue Service ("IRS") has proposed certain adjustments for additional taxes applicable to the years 1982 to 1990. The proposed adjustments pertain to the timing of certain deductions, the IRS's contention that contractually obligated premium refunds should be treated as dividends, deductions for certain loss and related reserves, a reinsurance transaction, and several other issues not involving material amounts. The Company and its tax counsel believe that substantially all of the proposed material adjustments are without merit, that the Company will be successful in vigorously defending its positions, and that the ultimate adjustments, if any, will not significantly affect its financial condition or results of operations. During 1993 and 1992, certain of the proposed adjustments were finally settled for immaterial amounts. In 1992, the Company's life insurance subsidiaries recorded previously unrecognized tax recoveries of $1.1 and related interest credits of approximately $12.4 stemming from resolution of various long-standing Internal Revenue Service disputes applicable to taxable years 1969 to 1981. (i) Property and Equipment-Property and equipment is generally depreciated or amortized over the estimated useful lives of the assets, (2 to 45 years), substantially by the straight-line method. Expenditures for maintenance and repairs are charged to income as incurred, and expenditures for major renewals and additions are capitalized. (j) Title Plants and Records-Title plants and records are carried at original cost or appraised value at date of purchase. Such values represent the cost of producing or acquiring interests in title records and indexes and the appraised value of purchased subsidiaries' title records and indexes at dates of acquisition. The cost of maintaining, updating, and operating title records is charged to income as incurred. Title records and indexes are not being amortized since they have an indefinite life and do not diminish in value. (k) Goodwill-The costs of certain purchased subsidiaries in excess of related book values (goodwill) at date of acquisition are being amortized against operations principally over 40 years using the straight-line method. Amortization of goodwill amounted to $3.2 in 1993, $3.0 in 1992, and $2.9 in 1991. (l) Employee Benefit Plans- The Corporation has several pension plans covering approximately half of its employees. The plans are defined benefit plans in which the benefits are based primarily on years of service and employee com- pensation near retirement. It is the Corporation's policy to fund the plans' costs as they accrue. Plan assets are comprised principally of bonds, common stocks and short-term investments. The components of annual net periodic pension cost (credit) for the plans consisted of the following: Years Ended December 31, 1993 1992 1991 Service cost $ 3.0 $ 2.9 $ 2.5 Interest cost 6.7 6.2 5.7 Return on assets (8.0) (10.5) (9.2) Net amortization and deferral (1.7) 1.4 1.0 Net cost (credit) $ - $ - $ .1 The reconciliation of the funded status of the plans is as follows: The projected benefit obligations for the plans were determined using the following at: December 31, 1993 1992 Settlement discount rates 7.5 - 8.0% 7.5 - 8.75% Rates of compensation increase 4.0 - 5.5% 5.0 - 6.0% Long-term rates of return on assets 8.0 - 9.0% 8.0 - 9.0% The Corporation has a number of profit sharing and other incentive compensation programs for the benefit of a substantial number of its employees. The costs related to such programs are summarized below: (p) Concentration of Credit Risk-Excluding U.S. government bonds and notes, the Company is not exposed to any significant credit concentration risk. (q) Statement Presentation-Amounts shown in the consolidated financial statements and applicable notes are stated (except as otherwise indicated and as to share data) in millions, which amounts may not add to totals shown due to rounding. Necessary reclassifications are made in prior periods' financial statements whenever appropriate to conform to current presentation. Note 2-Investments - Bonds and other investments carried at $160.7 as of December 31, 1993 were on deposit with governmental authorities by the Corporation's insurance subsidiaries to comply with insurance laws. Note 3-Debt and Debt Equivalents-Consolidated debt of Old Republic and its subsidiaries is summarized below: (b) Cash Dividend Restrictions-The payment of cash dividends by the Corporation is principally dependent upon the amount of its insurance subsidiaries' statutory policyholders' surplus available for dividend distribution. The insurance subsidiaries' ability to pay cash dividends to the Corporation is in turn generally restricted by law or subject to approval of the insurance regulatory authorities of the states in which they are domiciled. These authorities recognize only statutory accounting practices for determining financial position, results of operations, and the ability of an insurer to pay dividends to its shareholders. Based on 1993 data, the maximum amount of dividends payable to the Corporation by its insurance and other wholly-owned subsidiaries during 1994 without the prior approval of their respective regulatory authorities is approximately $192.4. However, management does not expect to distribute all such dividends since reinvested earnings are the Corporation's major source of capital to promote its growth and support its obligations to policyholders. (c) Debt Restrictions-Under the most restrictive covenants, the terms of Old Republic's guaranties relative to loan agreements described in Note 3(a) provide that while loans under such agreements are outstanding, Old Republic will maintain a minimum consolidated tangible net worth (excluding goodwill and net unrealized capital gains or losses, but including title plants and records) of at least $400.0. Such agreements also, among other things, restrict Old Republic from permitting "Debt" to exceed 25% of its consolidated tangible net worth (as adjusted for goodwill and net unrealized capital gains or losses on equity securities) without approval of the lenders. (d) Stock Option Plans-The Corporation has had non-qualified, stock option plans (the 1979, 1985 and 1992 plans) for its key employees and those of its eligible subsidiaries since 1979. The plans provide for the issuance of options for up to 5% of the Old Republic common stock issued and outstanding at any one time. The term of each option is 10 years from the date of grant, although some options have a 15 year term. Under ordinary circumstances, options may be exercised to the extent of 10% of the number of shares covered thereby on and after the date of grant and cumulatively to the extent of an additional 10% on and after each of the first through ninth anniversaries of the date of grant. The Corporation may extend 15 year loans at a prevailing market rate of interest for a portion of the exercise price. Amendments to the plans also enable optionees to, alternatively, exercise their options into Series "G" or Series "G-2" Convertible Preferred Stock. The exercise of options into such Series "G" or Series "G-2" Convertible Preferred stock reduces by 5% the number of equivalent common shares which would have otherwise been obtained from the exercise of options. Under the 1979 plan, the employee's right to exercise his options is accelerated if the Corporation is dissolved or liquidated, merges or consolidates with another company and the Corporation is not the surviving corporation, or more than 50% of the members of the Board of Directors of the Corporation change in any one year unless one or more of the new directors was nominated by the Board of Directors of the Corporation. Under the 1985 and 1992 plans, in the event the market price of Old Republic common stock reaches a preestablished value ("vesting acceleration price"), optionees may exercise their options to the extent of 10% of the number of shares covered by the option for each year that the optionee has been employed by the Corporation or its subsidiaries. Changes in stock options and related information are reflected in the following table (See Note 4(a)(1) above). Option prices represent the per share market price on the date of grant. No charge is made to earnings in connection with the granting or exercise of nonqualified stock options. In conjunction with the purchase or merger of various companies, the Corporation has assumed the stock option obligations under various qualified and nonqualified stock option plans previously adopted by such companies. These plans were terminated as of the merger dates, and existing options at that date became exercisable into Old Republic common shares at their original price adjusted for the appropriate exchange ratios pertaining to each merger. At December 31, 1993, options for 23,822 shares were outstanding and 21,960 shares were exercisable under all of these plans at prices ranging between $7.72 and $10.00 per share. Options for 24,568; 74,440; and 42,452 were exercised for a total consideration of approximately $0.1, $0.5 and $0.5 during 1993, 1992 and 1991, respectively. (e) Common Stock-There were 100,000,000 shares of common stock authorized at December 31, 1993. At the same date, there were 20,000,000 shares of Class "B" common stock authorized but none were issued or outstanding. Class "B" common shares have the same rights as common shares except for being entitled to 1/10th of a vote per share. (f) Undistributed Earnings-The equity of the Corporation in the undistributed earnings, determined in accordance with generally accepted accounting principles, and in the net unrealized investment gains (losses) of its respective subsidiaries at December 31, 1993 amounted to $921.5 and $23.7, respectively. Common stock dividends declared during 1993, 1992 and 1991, to the Corporation by its subsidiaries amounted to $53.9, $50.6, and $38.6, respectively. (g) Treasury Stock-A total of 5,540,360 common shares issued and outstanding are held by consolidated affiliates. See "Related Party Transactions" herein. (h) Statutory Data-The shareholders' equity and net income, determined in accordance with statutory accounting practices, of the Corporation's insurance subsidiaries was as follows at the dates and for the periods shown: Reinsurance protection for General Insurance operations generally limits the net loss on any one risk as follows (in thousands): fire and other physical perils-$20; accident and health-$15; workers' compensation-$1,000 and other liability-$600; loan credit guaranty-$200. Title insurance risk assumptions, based on the title insurance subsidiary's financial resources, are currently limited to $15,000 as to any one policy. A substantial portion of the mortgage guaranty insurance business is retained, with the exposure on any one risk currently averaging less than $20. The maximum amount of ordinary life insurance retained on any one life by the Life Insurance Group (without reinsurance) is $250. Most of the reinsurance ceded by the Corporation's insurance subsidiaries in the ordinary course of business is placed on a quota share or excess of loss basis. Under quota share reinsurance, the companies remit an agreed upon percentage of their premiums written to assuming companies and are reimbursed for a pro-rata share of claims and commissions incurred and for a ceding commission to cover expenses and costs for underwriting and claim services performed. Under excess of loss reinsurance agreements, the companies are generally reimbursed for losses exceeding contractually agreed-upon levels. The following information relates to reinsurance and related data for the General Insurance, Mortgage Guaranty and Life Insurance Groups for the three years ended December 31, 1993. For the years 1991 to 1993, reinsurance transactions of the Title Insurance Group have not been material. (b) Leases-Some of the Corporation's subsidiaries maintain their offices in leased premises. Certain of these leases provide for the payment of real estate taxes, insurance, and other operating expenses. At December 31, 1993, aggregate minimum rental commitments (net of expected sub-lease receipts) under noncancellable operating leases of $106.2 are summarized as follows: 1994: $25.8; 1995: $20.2; 1996: $13.8: 1997: $9.5; 1998: $6.5; 1999 and after: $30.0. (c) General-In the normal course of business, the Corporation and its subsidiaries are subject to various contingent liabilities, including possible income tax assessments resulting from tax law interpretations or issues raised by taxing authorities in their regular examinations. Management does not anticipate any significant losses or costs to result from any known or existing contingencies. (d) Legal Proceedings-There are no material legal proceedings other than those arising in the normal course of business and which generally pertain to claim matters related to insurance policies and contracts issued by the Corporation's insurance subsidiaries. Note 6-Consolidated Quarterly Results-Unaudited - Old Republic's consolidated quarterly operating data for the two years ended December 31, 1993 is presented below. In the opinion of management, all adjustments consisting of normal recurring adjustments necessary to a fair presentation of quarterly results have been reflected in the data which follows. It is also management's opinion, however, that quarterly operating data for insurance enterprises is not indicative of results to be achieved in succeeding quarters or years. The long-term nature of the insurance business, seasonal patterns in premium production and incidence of claims, and changes in yields on invested assets are some of the factors necessitating a review of operating results, changes in shareholders' equity, and cash flows for periods of several years to obtain a proper indicator of performance. The data below should be read in conjunction with the "Management Analysis of Financial Position and Results of Operations": Note 7-Information About Segments of Business - The contributions of Old Republic's insurance industry segments to consolidated revenues and operating results, and certain balance sheet data pertaining thereto are shown in the following tables on the basis of generally accepted accounting principles ("GAAP"). Each of the Corporation's segments underwrites and services only those insurance coverages which may be written by it pursuant to state insurance regulations and corporate charter provisions, although disability/accident & health coverages may be written directly or indirectly through reinsurance in either the General or Life Insurance segments. In computing the profit or loss before taxes for each segment, the following items have not been added or deducted: general corporate revenues and expenses, parent company interest expense, income taxes, and equity in operating results of, or dividends from, unconsolidated subsidiaries and affiliates. To reconcile the total assets shown for the General, Title, Mortgage Guaranty and Life Groups with total consolidated assets at December 31, 1993 and 1992, adjustments must be made for the parent company assets of $1,650.1 and $1,474.4, and consolidating eliminations of $2,022.9 and $1,578.8, respectively. Revenues and assets connected with foreign operations are not significant in relation to consolidated totals. Note 8-Related Party Transactions - At December 31, 1993 and 1992, the Corporation owned 98.79% of the non-voting common shares, and 40% of the voting common and preferred shares of the American Business & Mercantile Insurance Group, Inc., ("AB&M Group" or "Group"), an affiliated insurance holding company engaged in the property and liability reinsurance business. As of the same dates, the American Business & Mercantile Insurance Mutual, Inc. ("Mutual"), a property & liability mutual insurer owned by its policyholders, held directly or through a subsidiary 0.10% of the non-voting common shares and 60% of the Group's voting common and preferred shares. At both dates, 1.11% of the Group's non-voting common shares were held by public shareholders. Pursuant to underwriting and investment management agreements, Old Republic receives management fees for administering the affairs of the Group's reinsurance subsidiary and those of the Mutual. Pursuant to reinsurance treaties, the Group is a quota share participant in various types of primary and assumed reinsurance contracts produced through Old Republic underwriting facilities. Fees received in the past three years by Old Republic were im- material. The following table shows reinsurance cessions and retrocessions to the Group's reinsurance subsidiary and assumptions by Old Republic of business ceded by the Mutual for the last three years. Certain subsidiaries of the Company have sold various accounts receivable to a finance company subsidiary of the Mutual. Total receivables sold as of December 31, 1993 and 1992 amounted to approximately $8.5 and $12.6, respectively. At December 31, 1993 and 1992, the Group held approximately 8.0% and 8.2%, respectively, of Old Republic's issued and outstanding common shares. For financial accounting purposes only, 4,439,267 of such shares have been treated as treasury shares at each respective date in consolidating the Group's accounts with those of the Corporation. In the normal course of business, the Company cedes, on the same terms as apply to unrelated reinsurers, certain parts of its outgoing reinsurance to a foreign reinsurer in which it has an equity interest. Total premiums ceded to this reinsurer amounted to approximately $5.6 in 1993, $5.8 in 1992, and $3.3 in 1991. As of December 31, 1993 and 1992, total premium and loss reserve credits taken on account of cumulative cessions aggregated $63.7 and $50.6, respectively, all of which credits were collateralized by cash, investments and funds held amounting to $70.7 and $56.7, respectively. At December 31, 1993, the Corporation owned 80.0% of the voting common stock of Employers General Insurance Group, Inc. ("EGI") an affiliated insurance holding company engaged in the property and liability insurance and reinsurance business, primarily in Texas. At such date, 20.0% of EGI's voting common stock was held by public shareholders. Pursuant to a branch management agreement, EGI supervises the solicitation and underwriting of all lines of insurance that two insurance subsidiaries of Old Republic are authorized to write. EGI's Texas domiciled insurance subsidiary has entered into a quota share reinsurance treaty with an insurance subsidiary of Old Republic. Under the reinsurance treaty, EGI's insurance subsidiary will reinsure the net retained amount of business produced by EGI and its subsidiaries. EGI commenced operations in May, 1992, its insurance subsidiary received its license in December, 1993. The following table is a summary of intercompany transactions: Ceded to EGI 1993 1992 Premiums written $ 47.6 $ - Losses and loss expenses 30.4 - Loss and loss expense reserves 22.9 - Unearned premiums $ 13.1 $ - EGI has also entered into an investment counsel agreement with Old Republic. Old Republic provides investment advise, accounting services and assists EGI in executing purchases and sales of investments. Fees received by Old Republic were immaterial. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareholders of Old Republic International Corporation Chicago, Illinois We have audited the accompanying consolidated balance sheets of Old Republic International Corporation and subsidiaries (the "Company") as of December 31, 1993 and 1992, and the related consolidated statements of income, preferred stock and common shareholders' equity and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Old Republic International Corporation and subsidiaries as of December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. As discussed in footnote 1(g), 1(h) and 1(l) to the consolidated financial statements, the Company changed its method of accounting for ceded reinsurance, income taxes and post retirement benefits other than pensions in 1993. Coopers & Lybrand Chicago, Illinois March 15, 1994 Item 9	Item 9 - Disagreements on Accounting and Financial Disclosure None. PART III Item 10	Item 10 - Directors and Executive Officers of the Registrant Omitted pursuant to General Instruction G(3). The Company will file with the Commission prior to April 1, 1994 a definitive proxy statement pursuant to Regulation 14A in connection with its Annual Meeting of shareholders to be held on May 13, 1994. See also Item 4(a) in Part I of this report. A list of Directors appears on the "Signature" page of this report. Item 11	Item 11 - Executive Compensation Omitted pursuant to General Instruction G(3). The Company will file with the Commission prior to April 1, 1994 a definitive proxy statement pursuant to Regulation 14A in connection with its Annual Meeting of shareholders to be held on May 13, 1994. Item 12	Item 12 - Security Ownership of Certain Beneficial Owners and Management Omitted pursuant to General Instruction G(3). The Company will file with the Commission prior to April 1, 1994 a definitive proxy statement pursuant to Regulation 14A in connection with its Annual Meeting of shareholders to be held on May 13, 1994. Item 13	Item 13 - Certain Relationships and Related Transactions Omitted pursuant to General Instruction G(3). The Company will file with the Commission prior to April 1, 1994 a definitive proxy statement pursuant to Regulation 14A in connection with its Annual Meeting of shareholders to be held on May 13, 1994. PART IV Item 14	Item 14 - Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) Documents filed as a part of this report: 1. Financial statements: See Item 8, Index to Financial Statements. 2. Financial statement schedules will be filed on or before April 30, 1994 under cover of Form 8. 3. See exhibit index of this report. (b) Reports on Form 8-K: 1. No reports on Form 8-K were filed during the fourth quarter of 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized (Name, Title or Principal Capacity, and Date). (Registrant): Old Republic International Corporation /s/ A.C. Zucaro 3/30/94 A. C. Zucaro, Chairman of the Board, Date Chief Executive Officer, President and Director /s/ Paul D. Adams 3/30/94 Paul D. Adams, Senior Vice President, Date Chief Financial Officer and Treasurer 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 (Name, Title or Principal Capacity, and Date). Anthony F. Colao, DirectorJohn W. Popp, Director Senior Vice President John C. Collopy, DirectorWilliam A. Simpson, Director President of Republic Mortgage Insurance Company Jimmy A. Dew, DirectorArnold L. Steiner, Director Executive Vice President of Republic Mortgage Insurance Company Darrel M. Holt, Director* William R. Stover, Director* Kurt W. Kreyling, Director* David Sursa, Director* Peter Lardner, Director* William G. White, Jr., Director* President of Bituminous Casualty Corporation Wilbur S. Legg, Director* * By/S/A. C. Zucaro Attorney-in-fact Date: March 16, 1994 EXHIBIT INDEX An index of exhibits required by item 601 of Regulation S-K follows: (3) Articles of incorporation and by-laws. (A) Restated Certificate of Incorporation, as amended. (B) By-laws, as amended. (4) Instruments defining the rights of security holders, including indentures. (A) * Certificates of Designations, as amended, with respect to Series A Preferred Stock, Series B Cumulative Convertible Preferred Stock, Series C Cumulative Convertible Preferred Stock, Series D Cumulative Convertible Preferred Stock, Series E Cumulative Convertible Preferred Stock, Series F Convertible Exchangeable Preferred Stock, Series G Convertible Preferred Stock and Series H Cumulative Preferred Stock. (Exhibit 4(A) to Registrant's Annual Report on Form 10-K for 1991). (B) * Form of Indenture dated June 1, 1985 between Old Republic International Corporation and Morgan Guaranty Trust Company of New York, as Trustee, regarding the 11 1/2% Sinking Fund Debentures due 2015 (Exhibit 4.3 to Form S-3 Registration Statement No. 2-98167). (C) * Form of Indenture dated as of January 15, 1988 between Old Republic International Corporation and Morgan Guaranty Trust Company of New York, as Trustee, regarding the 10% Sinking Fund Debentures due 2018 (Exhibit 4(D) to Registrant's Annual Report on Form 10-K for 1987). (D) * Agreement to furnish certain long term debt instruments to the Securities & Exchange Commission upon request (Exhibit 4(D) to Form 8 dated August 28, 1987). (E) * Rights Agreement dated as of June 26, 1987 between Old Republic International Corporation and Morgan Shareholder Services Trust Company (Exhibit 4 to Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1987). (F) * Form of Indenture dated as of August 15, 1992 between Old Republic International Corporation and Wilmington Trust Company, as Trustee, regarding the 5 3/4% Convertible Subordinated Debentures due August 15, 2002. (Exhibit 4(G) to Registrant's Annual Report on Form 10-K for 1993). (10) Material contracts. (A) * Copy of Old Republic International Corporation Employees Savings and Stock Ownership Plan (Exhibit 10(A) to Registrant's Annual Report on Form 10-K for 1991). (B) Form 11 -K for Registrant's Employee Savings and Stock Ownership Plan for the year ended December 31, 1993 (To be filed by amendments). ** (C) * Copy of Old Republic International Corporation Key Employees Performance Recognition Plan, as restated and amended (Exhibit 10(C) to Registrant's Annual Report on Form 10-K for 1991). ** (D) * Copy of Old Republic International Corporation Non-qualified Stock Option Plan (Exhibit to Form S-8 Registration Statement No. 2-66302). ** (E) * Amendments to Old Republic International Corporation Non-qualified Stock Option Plan (Exhibit 10(E) to Registrant's Annual Report on Form 10-K for 1991). ** (F) * 1985 Old Republic International Corporation Non-qualified Stock Option Plan A (Exhibit 10.1 to Form S-3 Registration Statement No. 2-98166). ** (G) * Amendments to 1985 Old Republic International Corporation Non-qualified Stock Option Plan A (Exhibit 10(G) to Registrant's Annual Report on Form 10-K for 1991). ** (H) * 1985 Old Republic International Corporation Non-qualified Stock Option Plan B (Exhibit 10.2 to Form S-3 Registration Statement No. 2-98166). ** (I) * 1990 Old Republic International Corporation Non-qualified Stock Option Plan (Exhibit 10 to Form S-8 Registration Statement No. 33-37692). ** (J) * 1992 Old Republic International Corporation Non-qualified Stock Option Plan (Exhibit 10 to Form S-8 Registration Statement No. 33-49646). (K) * Old Republic International Corporation Employees Retirement Plan (Exhibit 10(J) to Registrant's Annual Report on Form 10-K for 1991). ** (L) * Old Republic International Corporation Executives Excess Benefits Pension Plan (Exhibit 10.16 to Registration Statement No. 2-95243). ** (M) * Form of Indemnity Agreement between Old Republic International Corporation and each of its directors and certain officers (Exhibit 10 to Form S-3 Registration Statement No. 33-16836). ** (N) * Copy of directors and officers liability and company reimbursement policy dated October 6, 1970 (Exhibit 12(A) to Form S-1 Registration Statement No. 2-41089). (O) * Copy of Bitco Savings Plan (Exhibit 4.3 to Form S-8 Registration Statement No. 33-32439). (P) Form 11-K for Bitco Savings Plan for the year ended December 31, 1993 (To be filed by amendments). (Q) * Copy of RMIC Corporation Profit-Sharing Plan (Exhibit 10(M) to Registrant's Annual Report on Form 10-K for 1980). ** (R) * Copy of a written description of the RMIC Key Employees Performance Recognition Plan (Exhibit 10(Q) to Registrant's Annual Report on Form 10-K for 1991). (S) Form 11-K for the Great West Casualty Company Profit Sharing Plan for the year ended December 31, 1993 (To be filed by amendments). ** (T) * Copy of deferred compensation agreement dated November 4, 1976, as amended, between RMIC Corporation and William A. Simpson (Exhibit 10(J) to Registrant's Annual Report on Form 10-K for 1980). ** (U) * Copy of deferred compensation agreement dated November 4, 1976, as amended, between RMIC Corporation and Jimmy A. Dew (Exhibit 10(K) to Registrant's Annual Report on Form 10-K for 1980). ** (V) * Copy of Incentive Compensation Plan of The Founders Title Group, Inc. (Exhibit 10(N) to Registrant's Annual Report on Form 10-K for 1980). ** (W) Copy of part time employment agreement between Old Republic Title Company and John C. Collopy. (X) * Placement Agency Agreement dated November 16, 1987 among Old Republic International Corporation, Old Republic Capital Corporation and Merrill Lynch Money Markets Inc. (Exhibit 10.1 to Form S-3 Registration Statement No. 33-16836). (Y) * Issuing and Paying Agency Agreement dated November 16, 1987 among Old Republic International Corporation, Old Republic Capital Corporation and Morgan Guaranty Trust Company of New York (Exhibit 10.2 to Form S-3 Registration Statement No. 33-16836). (11) Schedule showing computations of average number of common shares outstanding, as used in the calculations of per share earnings for each of the three years ended December 31, 1993, 1992 and 1991. (21) Subsidiaries of the registrant. (23) Consent of Coopers & Lybrand. (24) Powers of attorney (28) Consolidated Schedule P (To be filed by amendment.) * Exhibit incorporated herein by reference. ** Denotes a management or compensatory plan or arrangement required to be filed as an exhibit pursuant to Item 601 of Regulation S-K. Exhibit (23) CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS We consent to the incorporation by reference in the registration statements of Old Republic International Corporation on Form S-8 (File Nos. 2-66302, 33-38528, 33-38525, 33-37692, 33-49646, 33-32439 and 2-80883) and on Form S-3 (File Nos 33-29220, 33-49864 and 33-54104) of our report dated March 15, 1994 on our audits of the consolidated financial statements of Old Republic International Corporation as of December 31, 1993 and 1992, and for the years ended December 31, 1993, 1992, and 1991, which report is included in this Annual Report on Form 10-K. Coopers & Lybrand Chicago, Illinois March 15, 1994 Exhibit (24) POWER OF ATTORNEY KNOWN ALL MEN BY THESE PRESENTS, that the undersigned, being a member of the Board of Directors of Old Republic International Corporation, a corporation duly organized under the laws of the State of Delaware and having its principal place of business in Chicago, Illinois, does hereby make, constitute, and appoint A.C. Zucaro, President of the said corporation, as his true and lawful attorney, for him, and in his name, place, and stead to execute, sign, acknowledge, confirm or ratify all documents, papers, forms, statements, certificates and filings of any kind whatsoever required to be filed by the said corporation with the Securities and Exchange Commission, giving and granting to said attorney full power and authority to do and perform all and every act whatsoever requisite and necessary to be done in and about the premises as fully, to all intents and purposes, as he might or could do if personally present, with full power of substitution and revocation, hereby ratifying and confirming all that said attorney or his substitute shall lawfully do or cause to be done by virtue hereof. The power of attorney aforesaid shall expire as of the anniversary of the date shown below. IN WITNESS WHEREOF, the undersigned has hereunto set his hand and seal this 16th day of March, 1994. /s/ Darrel M. Holt Darrel M. Holt WITNESS: /s/ Spencer LeRoy, III /s/ Paul D. Adams Exhibit (24) POWER OF ATTORNEY KNOWN ALL MEN BY THESE PRESENTS, that the undersigned, being a member of the Board of Directors of Old Republic International Corporation, a corporation duly organized under the laws of the State of Delaware and having its principal place of business in Chicago, Illinois, does hereby make, constitute, and appoint A.C. Zucaro, President of the said corporation, as his true and lawful attorney, for him, and in his name, place, and stead to execute, sign, acknowledge, confirm or ratify all documents, papers, forms, statements, certificates and filings of any kind whatsoever required to be filed by the said corporation with the Securities and Exchange Commission, giving and granting to said attorney full power and authority to do and perform all and every act whatsoever requisite and necessary to be done in and about the premises as fully, to all intents and purposes, as he might or could do if personally present, with full power of substitution and revocation, hereby ratifying and confirming all that said attorney or his substitute shall lawfully do or cause to be done by virtue hereof. The power of attorney aforesaid shall expire as of the anniversary of the date shown below. IN WITNESS WHEREOF, the undersigned has hereunto set his hand and seal this 16th day of March, 1994. /s/ William G. White, Jr. William G. White, Jr. WITNESS: /s/ Spencer LeRoy, III /s/ Paul D. Adams Exhibit (24) POWER OF ATTORNEY KNOWN ALL MEN BY THESE PRESENTS, that the undersigned, being a member of the Board of Directors of Old Republic International Corporation, a corporation duly organized under the laws of the State of Delaware and having its principal place of business in Chicago, Illinois, does hereby make, constitute, and appoint A.C. Zucaro, President of the said corporation, as his true and lawful attorney, for him, and in his name, place, and stead to execute, sign, acknowledge, confirm or ratify all documents, papers, forms, statements, certificates and filings of any kind whatsoever required to be filed by the said corporation with the Securities and Exchange Commission, giving and granting to said attorney full power and authority to do and perform all and every act whatsoever requisite and necessary to be done in and about the premises as fully, to all intents and purposes, as he might or could do if personally present, with full power of substitution and revocation, hereby ratifying and confirming all that said attorney or his substitute shall lawfully do or cause to be done by virtue hereof. The power of attorney aforesaid shall expire as of the anniversary of the date shown below. IN WITNESS WHEREOF, the undersigned has hereunto set his hand and seal this 16th day of March, 1994. /s/ Peter Lardner Peter Lardner WITNESS: /s/ Spencer LeRoy, III /s/ Paul D. Adams Exhibit (24) POWER OF ATTORNEY KNOWN ALL MEN BY THESE PRESENTS, that the undersigned, being a member of the Board of Directors of Old Republic International Corporation, a corporation duly organized under the laws of the State of Delaware and having its principal place of business in Chicago, Illinois, does hereby make, constitute, and appoint A.C. Zucaro, President of the said corporation, as his true and lawful attorney, for him, and in his name, place, and stead to execute, sign, acknowledge, confirm or ratify all documents, papers, forms, statements, certificates and filings of any kind whatsoever required to be filed by the said corporation with the Securities and Exchange Commission, giving and granting to said attorney full power and authority to do and perform all and every act whatsoever requisite and necessary to be done in and about the premises as fully, to all intents and purposes, as he might or could do if personally present, with full power of substitution and revocation, hereby ratifying and confirming all that said attorney or his substitute shall lawfully do or cause to be done by virtue hereof. The power of attorney aforesaid shall expire as of the anniversary of the date shown below. IN WITNESS WHEREOF, the undersigned has hereunto set his hand and seal this 16th day of March, 1994. /s/ Anthony F. Colao Anthony F. Colao WITNESS: /s/ Spencer LeRoy, III /s/ Paul D. Adams Exhibit (24) POWER OF ATTORNEY KNOWN ALL MEN BY THESE PRESENTS, that the undersigned, being a member of the Board of Directors of Old Republic International Corporation, a corporation duly organized under the laws of the State of Delaware and having its principal place of business in Chicago, Illinois, does hereby make, constitute, and appoint A.C. Zucaro, President of the said corporation, as his true and lawful attorney, for him, and in his name, place, and stead to execute, sign, acknowledge, confirm or ratify all documents, papers, forms, statements, certificates and filings of any kind whatsoever required to be filed by the said corporation with the Securities and Exchange Commission, giving and granting to said attorney full power and authority to do and perform all and every act whatsoever requisite and necessary to be done in and about the premises as fully, to all intents and purposes, as he might or could do if personally present, with full power of substitution and revocation, hereby ratifying and confirming all that said attorney or his substitute shall lawfully do or cause to be done by virtue hereof. The power of attorney aforesaid shall expire as of the anniversary of the date shown below. IN WITNESS WHEREOF, the undersigned has hereunto set his hand and seal this 16th day of March, 1994. /s/ Kurt W. Kreyling Kurt W. Kreyling WITNESS: /s/ Spencer LeRoy, III /s/ Paul D. Adams Exhibit (24) POWER OF ATTORNEY KNOWN ALL MEN BY THESE PRESENTS, that the undersigned, being a member of the Board of Directors of Old Republic International Corporation, a corporation duly organized under the laws of the State of Delaware and having its principal place of business in Chicago, Illinois, does hereby make, constitute, and appoint A.C. Zucaro, President of the said corporation, as his true and lawful attorney, for him, and in his name, place, and stead to execute, sign, acknowledge, confirm or ratify all documents, papers, forms, statements, certificates and filings of any kind whatsoever required to be filed by the said corporation with the Securities and Exchange Commission, giving and granting to said attorney full power and authority to do and perform all and every act whatsoever requisite and necessary to be done in and about the premises as fully, to all intents and purposes, as he might or could do if personally present, with full power of substitution and revocation, hereby ratifying and confirming all that said attorney or his substitute shall lawfully do or cause to be done by virtue hereof. The power of attorney aforesaid shall expire as of the anniversary of the date shown below. IN WITNESS WHEREOF, the undersigned has hereunto set his hand and seal this 16th day of March, 1994. /s/ John C. Collopy John C. Collopy WITNESS: /s/ Spencer LeRoy, III /s/ Paul D. Adams Exhibit (24) POWER OF ATTORNEY KNOWN ALL MEN BY THESE PRESENTS, that the undersigned, being a member of the Board of Directors of Old Republic International Corporation, a corporation duly organized under the laws of the State of Delaware and having its principal place of business in Chicago, Illinois, does hereby make, constitute, and appoint A.C. Zucaro, President of the said corporation, as his true and lawful attorney, for him, and in his name, place, and stead to execute, sign, acknowledge, confirm or ratify all documents, papers, forms, statements, certificates and filings of any kind whatsoever required to be filed by the said corporation with the Securities and Exchange Commission, giving and granting to said attorney full power and authority to do and perform all and every act whatsoever requisite and necessary to be done in and about the premises as fully, to all intents and purposes, as he might or could do if personally present, with full power of substitution and revocation, hereby ratifying and confirming all that said attorney or his substitute shall lawfully do or cause to be done by virtue hereof. The power of attorney aforesaid shall expire as of the anniversary of the date shown below. IN WITNESS WHEREOF, the undersigned has hereunto set his hand and seal this 16th day of March, 1994. /s/ David Sursa David Sursa WITNESS: /s/ Spencer LeRoy, III /s/ Paul D. Adams Exhibit (24) POWER OF ATTORNEY KNOWN ALL MEN BY THESE PRESENTS, that the undersigned, being a member of the Board of Directors of Old Republic International Corporation, a corporation duly organized under the laws of the State of Delaware and having its principal place of business in Chicago, Illinois, does hereby make, constitute, and appoint A.C. Zucaro, President of the said corporation, as his true and lawful attorney, for him, and in his name, place, and stead to execute, sign, acknowledge, confirm or ratify all documents, papers, forms, statements, certificates and filings of any kind whatsoever required to be filed by the said corporation with the Securities and Exchange Commission, giving and granting to said attorney full power and authority to do and perform all and every act whatsoever requisite and necessary to be done in and about the premises as fully, to all intents and purposes, as he might or could do if personally present, with full power of substitution and revocation, hereby ratifying and confirming all that said attorney or his substitute shall lawfully do or cause to be done by virtue hereof. The power of attorney aforesaid shall expire as of the anniversary of the date shown below. IN WITNESS WHEREOF, the undersigned has hereunto set his hand and seal this 16th day of March, 1994. /s/ Jimmy A. Dew Jimmy A. Dew WITNESS: /s/ Spencer LeRoy, III /s/ Paul D. Adams Exhibit (24) POWER OF ATTORNEY KNOWN ALL MEN BY THESE PRESENTS, that the undersigned, being a member of the Board of Directors of Old Republic International Corporation, a corporation duly organized under the laws of the State of Delaware and having its principal place of business in Chicago, Illinois, does hereby make, constitute, and appoint A.C. Zucaro, President of the said corporation, as his true and lawful attorney, for him, and in his name, place, and stead to execute, sign, acknowledge, confirm or ratify all documents, papers, forms, statements, certificates and filings of any kind whatsoever required to be filed by the said corporation with the Securities and Exchange Commission, giving and granting to said attorney full power and authority to do and perform all and every act whatsoever requisite and necessary to be done in and about the premises as fully, to all intents and purposes, as he might or could do if personally present, with full power of substitution and revocation, hereby ratifying and confirming all that said attorney or his substitute shall lawfully do or cause to be done by virtue hereof. The power of attorney aforesaid shall expire as of the anniversary of the date shown below. IN WITNESS WHEREOF, the undersigned has hereunto set his hand and seal this 16th day of March, 1994. /s/ John W. Popp John W. Popp WITNESS: /s/ Spencer LeRoy, III /s/ Paul D. Adams Exhibit (24) POWER OF ATTORNEY KNOWN ALL MEN BY THESE PRESENTS, that the undersigned, being a member of the Board of Directors of Old Republic International Corporation, a corporation duly organized under the laws of the State of Delaware and having its principal place of business in Chicago, Illinois, does hereby make, constitute, and appoint A.C. Zucaro, President of the said corporation, as his true and lawful attorney, for him, and in his name, place, and stead to execute, sign, acknowledge, confirm or ratify all documents, papers, forms, statements, certificates and filings of any kind whatsoever required to be filed by the said corporation with the Securities and Exchange Commission, giving and granting to said attorney full power and authority to do and perform all and every act whatsoever requisite and necessary to be done in and about the premises as fully, to all intents and purposes, as he might or could do if personally present, with full power of substitution and revocation, hereby ratifying and confirming all that said attorney or his substitute shall lawfully do or cause to be done by virtue hereof. The power of attorney aforesaid shall expire as of the anniversary of the date shown below. IN WITNESS WHEREOF, the undersigned has hereunto set his hand and seal this 16th day of March, 1994. /s/ Wilbur S. Legg Wilbur S. Legg WITNESS: /s/ Spencer LeRoy, III /s/ Paul D. Adams Exhibit (24) POWER OF ATTORNEY KNOWN ALL MEN BY THESE PRESENTS, that the undersigned, being a member of the Board of Directors of Old Republic International Corporation, a corporation duly organized under the laws of the State of Delaware and having its principal place of business in Chicago, Illinois, does hereby make, constitute, and appoint A.C. Zucaro, President of the said corporation, as his true and lawful attorney, for him, and in his name, place, and stead to execute, sign, acknowledge, confirm or ratify all documents, papers, forms, statements, certificates and filings of any kind whatsoever required to be filed by the said corporation with the Securities and Exchange Commission, giving and granting to said attorney full power and authority to do and perform all and every act whatsoever requisite and necessary to be done in and about the premises as fully, to all intents and purposes, as he might or could do if personally present, with full power of substitution and revocation, hereby ratifying and confirming all that said attorney or his substitute shall lawfully do or cause to be done by virtue hereof. The power of attorney aforesaid shall expire as of the anniversary of the date shown below. IN WITNESS WHEREOF, the undersigned has hereunto set his hand and seal this 16th day of March, 1994. /s/ William A. Simpson William A. Simpson WITNESS: /s/ Spencer LeRoy, III /s/ Paul D. Adams Exhibit (24) POWER OF ATTORNEY KNOWN ALL MEN BY THESE PRESENTS, that the undersigned, being a member of the Board of Directors of Old Republic International Corporation, a corporation duly organized under the laws of the State of Delaware and having its principal place of business in Chicago, Illinois, does hereby make, constitute, and appoint A.C. Zucaro, President of the said corporation, as his true and lawful attorney, for him, and in his name, place, and stead to execute, sign, acknowledge, confirm or ratify all documents, papers, forms, statements, certificates and filings of any kind whatsoever required to be filed by the said corporation with the Securities and Exchange Commission, giving and granting to said attorney full power and authority to do and perform all and every act whatsoever requisite and necessary to be done in and about the premises as fully, to all intents and purposes, as he might or could do if personally present, with full power of substitution and revocation, hereby ratifying and confirming all that said attorney or his substitute shall lawfully do or cause to be done by virtue hereof. The power of attorney aforesaid shall expire as of the anniversary of the date shown below. IN WITNESS WHEREOF, the undersigned has hereunto set his hand and seal this 16th day of March, 1994. /s/ Arnold L. Steiner Arnold L. Steiner WITNESS: /s/ Spencer LeRoy, III /s/ Paul D. Adams Exhibit (24) POWER OF ATTORNEY KNOWN ALL MEN BY THESE PRESENTS, that the undersigned, being a member of the Board of Directors of Old Republic International Corporation, a corporation duly organized under the laws of the State of Delaware and having its principal place of business in Chicago, Illinois, does hereby make, constitute, and appoint A.C. Zucaro, President of the said corporation, as his true and lawful attorney, for him, and in his name, place, and stead to execute, sign, acknowledge, confirm or ratify all documents, papers, forms, statements, certificates and filings of any kind whatsoever required to be filed by the said corporation with the Securities and Exchange Commission, giving and granting to said attorney full power and authority to do and perform all and every act whatsoever requisite and necessary to be done in and about the premises as fully, to all intents and purposes, as he might or could do if personally present, with full power of substitution and revocation, hereby ratifying and confirming all that said attorney or his substitute shall lawfully do or cause to be done by virtue hereof. The power of attorney aforesaid shall expire as of the anniversary of the date shown below. IN WITNESS WHEREOF, the undersigned has hereunto set his hand and seal this 16th day of March, 1994. /s/ William R. Stover William R. Stover WITNESS: /s/ Spencer LeRoy, III /s/ Paul D. Adams
71428_1993.txt	71428	1993	ITEM 1. BUSINESS GENERAL Bell Atlantic - New Jersey, Inc. (formerly New Jersey Bell Telephone Company) (the "Company") is incorporated under the laws of the State of New Jersey and has its principal offices at 540 Broad Street, Newark, New Jersey 07101 (telephone number 201-649-9900). The Company is a wholly owned subsidiary of Bell Atlantic Corporation ("Bell Atlantic"), which is one of the seven regional holding companies ("RHCs") formed in connection with the court-approved divestiture (the "Divestiture"), effective January 1, 1984, of those assets of the American Telephone and Telegraph Company ("AT&T") related to exchange telecommunications, exchange access functions, printed directories and cellular mobile communications. The Company presently serves a territory consisting of three Local Access and Transport Areas ("LATAs"). These LATAs are generally centered on a city or based on some other identifiable common geography and, with certain limited exceptions, each LATA marks the boundary within which the Company may provide telephone service. The Company provides two basic types of telecommunications services. First, the Company transports telecommunications traffic between subscribers located within the same LATA ("intraLATA service"), including both local and toll services. Local service includes the provision of local exchange ("dial tone"), local private line and public telephone services (including dial tone service for pay telephones owned by the Company and other pay telephone providers). Among other local services provided are Centrex (telephone company central office-based switched telephone service enabling the subscriber to make both intercom and outside calls) and a variety of special and custom calling services. Toll service includes message toll service (calling service beyond the local calling area) within LATA boundaries, and intraLATA Wide Area Toll Service (WATS)/800 services (volume discount offerings for customers with highly concentrated demand). The Company also earns toll revenue from the provision of telecommunications service between LATAs ("interLATA service") in the corridors between the cities (and certain surrounding counties) of (i) New York, New York and Newark, New Jersey, and (ii) Philadelphia, Pennsylvania and Camden, New Jersey. Second, the Company provides exchange access service, which links a subscriber's telephone or other equipment to the transmission facilities of interexchange carriers which, in turn, provide interLATA telecommunications service to their customers. See "Competiton - IntraLATA Toll Competition". The communications industry is currently undergoing fundamental changes driven by the accelerated pace of technological innovation, the convergence of the telecommunications, cable television, information services and entertainment businesses, and a regulatory environment in which many traditional regulatory barriers are being lowered and competition permitted or encouraged. Although no definitive predictions can be made of the market opportunities these changes will present or whether Bell Atlantic and its subsidiaries, including the Company, will be able successfully to take advantage of these opportunities, Bell Atlantic is positioning itself to be a leading communications, information services and entertainment company. OPERATIONS During 1993, Bell Atlantic reorganized certain functions formerly performed by each of the seven Bell System operating companies ("BOCs") transferred to it pursuant to the Divestiture, including the Company (collectively, the "Network Services Companies"), into nine lines of business ("LOBs") organized across the Network Services Companies around specific market segments. The Network Services Companies, however, remain responsible within their respective service areas for the provision of telephone services, for financial performance and for regulatory matters. The nine LOBs are: BELL ATLANTIC - NEW JERSEY, INC. The Consumer Services LOB markets communications services to residential ----------------- customers within the service territories of the Network Services Companies, including the service territory of the Company, and plans in the future to market information services and entertainment programming. The Carrier Services LOB markets (i) switched and special access to the ---------------- Company's local exchange network, and (ii) billing and collection services, including recording, rating, bill processing and bill rendering. The principal customers of this LOB are interexchange carriers; AT&T is the largest single customer. Other customers include business customers and government agencies with their own special access network connections, wireless customers and other local exchange carriers ("LECs") which resell network connections to their own customers. The Small Business Services LOB markets communications and information ----------------------- services to small businesses (customers having up to 20 access lines or 100 Centrex lines). The Large Business Services LOB markets communications and information ----------------------- services to large businesses (customers having more than 20 access lines or more than 100 Centrex lines). These services include voice switching/processing services (e.g., dedicated private lines, custom Centrex, call management and voice messaging), end-user networking (e.g., credit and debit card transactions, and personal computer-based conferencing, including data and video), internetworking (establishing links between the geographically disparate networks of two or more companies or within the same company), network integration (integrating multiple geographically disparate networks into one system), network optimization (disaster avoidance, 911, intelligent vehicle highway systems), video services (distance learning, telemedicine, surveillance, videoconferencing) and integrated multi-media applications services. The Directory Services LOB manages the provision of (i) advertising and ------------------ marketing services to advertisers, and (ii) listing information (e.g., White Pages and Yellow Pages). These services are currently provided primarily through print media, but the Company expects that use of electronic formats will increase in the future. In addition, the Directory Services LOB manages the provision of photocomposition, database management and other related products and services to publishers. The Public and Operator Services LOB markets pay telephone and operator ---------------------------- services in the service territories of the Network Services Companies to meet consumer needs for accessing public networks, locating and identifying network subscribers, providing calling assistance and arranging billing alternatives (e.g., calling card, collect and third party calls). The Federal Systems LOB markets communications and information technology and --------------- services to departments, agencies and offices of the executive, judicial and legislative branches of the federal government. The Information Services LOB has been established to provide programming -------------------- services, including on-demand entertainment, transactions and interactive multimedia applications within the Territory and in selected other markets. See "FCC Regulation and Interstate Rates - Telephone Company Provision of Video Dial Tone and Video Programming". The Network LOB manages the technologies, services and systems platforms ------- required by the other eight LOBs and the Network Services Companies, including the Company, to meet the needs of their respective customers, including, without limitation, switching, feature development and on-premises installation and maintenance services. The Company has been making and expects to continue to make significant capital expenditures on its networks to meet the demand for communications services and to further improve such services. Capital expenditures of the Company were approximately $609 million in 1991, $596 million in 1992 and $590 million in 1993. The total investment of the Company in plant, property and equipment decreased from approximately $8.39 billion at December 31, 1991 to BELL ATLANTIC - NEW JERSEY, INC. approximately $8.08 billion at December 31, 1992, and increased to approximately $8.38 billion at December 31, 1993, in each case after giving effect to retirements, but before deducting accumulated depreciation at such date. The Company is projecting construction expenditures for 1994 of approximately $630 million. However, subject to regulatory approvals, the Network Services Companies, including the Company, plan to allocate capital resources to the deployment of broadband network platforms (technologies ultimately capable of providing a switched facility for access to and transport of high-speed data services, video-on-demand, and image and interactive multimedia applications). Most of the funds for these expenditures are expected to be generated internally. Some additional external financing may be necessary or desirable. LINE OF BUSINESS RESTRICTIONS The consent decree entitled "Modification of Final Judgment" ("MFJ") approved by the United States District Court for the District of Columbia (the "D.C. District Court") which, together with the Plan of Reorganization ("Plan") approved by the D.C. District Court, set forth the terms of Divestiture also established certain restrictions on the post-Divestiture activities of the RHCs, including Bell Atlantic. The MFJ's principal restrictions on post-Divestiture RHC activities included prohibitions on (i) providing interexchange telecommunications, (ii) providing information services, (iii) engaging in the manufacture of telecommunications equipment and customer premises equipment ("CPE"), and (iv) entering into any non-telecommunications businesses, in each case without the approval of the D.C. District Court. Since Divestiture, the D.C. District Court has retained jurisdiction over the construction, modification, implementation and enforcement of the MFJ. In September 1987, the D.C. District Court rendered a decision which eliminated the need for the RHCs to obtain its approval prior to entering into non-telecommunications businesses. However, the D.C. District Court refused to eliminate the restrictions relating to equipment manufacturing or providing interexchange services. With respect to information services, the Court issued a ruling in March 1988 which permitted the RHCs to engage in a number of information transport functions as well as voice storage and retrieval services, including voice messaging, electronic mail and certain information gateway services. However, the RHCs were generally prohibited from providing the content of the data they transmitted. As the result of an appeal of the D.C. District Court's September 1987 and March 1988 decisions by the RHCs and other parties, the United States Court of Appeals for the District of Columbia Circuit ordered the D.C. District Court to reconsider the RHCs' request to provide information content and determine whether removal of the restrictions thereon would be in the public interest. In July 1991, the D.C. District Court removed the remaining restrictions on RHC participation in information services, but imposed a stay pending appeal of that decision. In October 1991, the United States Court of Appeals for the District of Columbia Circuit vacated the stay, thereby permitting the RHCs to provide information services, and in May 1993 affirmed the D.C. District Court's July 1991 decision. The United States Supreme Court denied certiorari in November 1993. Several bills have been introduced in the current session of Congress pursuant to which the line of business restrictions established by the MFJ could be eliminated or modified. No definitive prediction can be made as to whether or when any such legislation will be enacted, the provisions thereof or their impact on the business or financial condition of the Company. FCC REGULATION AND INTERSTATE RATES The Company is subject to the jurisdiction of the Federal Communications Commission ("FCC") with respect to interstate services and certain related matters. The FCC prescribes a uniform system of accounts for telephone companies, interstate depreciation rates and the principles and standard procedures used to separate plant investment, expenses, taxes and reserves BELL ATLANTIC - NEW JERSEY, INC. between those applicable to interstate services under the jurisdiction of the FCC and those applicable to intrastate services under the jurisdiction of the respective state regulatory authorities ("separations procedures"). The FCC also prescribes procedures for allocating costs and revenues between regulated and unregulated activities. Interstate Access Charges The Company provides intraLATA service and, with certain limited exceptions, does not participate in the provision of interLATA service except through offerings of exchange access service. The FCC has prescribed structures for exchange access tariffs to specify the charges ("Access Charges") for use and availability of the Company's facilities for the origination and termination of interstate interLATA service. Access Charges are intended to recover the related costs of the Company which have been allocated to the interstate jurisdiction ("Interstate Costs") under the FCC's separations procedures. In general, the tariff structures prescribed by the FCC provide that Interstate Costs of the Company which do not vary based on usage ("non-traffic sensitive costs") are recovered from subscribers through flat monthly charges ("Subscriber Line Charges"), and from interexchange carriers through usage- sensitive Carrier Common Line ("CCL") charges. See "FCC Regulation and Interstate Rates - FCC Access Charge Pooling Arrangements". Traffic-sensitive Interstate Costs are recovered from carriers through variable access charges based on several factors, primarily usage. In May 1984, the FCC authorized the implementation of Access Charge tariffs for "switched access service" (access to the local exchange network) and of Subscriber Line Charges for multiple line business customers (up to $6.00 per month per line). In 1985, the FCC authorized Subscriber Line Charges for residential and single-line business customers at the rate of $1.00 per month per line, which increased in installments to $3.50 effective April 1, 1989. As a result of the phasing in of Subscriber Line Charges, a substantial portion of non-traffic sensitive Interstate Costs is now recovered directly from subscribers, thereby reducing the per-minute CCL charges to interexchange carriers. This significant reduction in CCL charges has tended to reduce the incentive for interexchange carriers and their high-volume customers to bypass the Company's switched network via special access lines or alternative communications systems. However, competition for this access business has increased in recent years. See "Competition - Alternative Access and Local Services". FCC Access Charge Pooling Arrangements The FCC previously required that all LECs, including the Company, pool revenues from CCL and Subscriber Line Charges that cover the non-traffic sensitive costs of the local exchange network, that is, the Interstate Costs associated with the lines from subscribers' premises to telephone company central offices. To administer such pooling arrangements, the FCC mandated the formation of the National Exchange Carrier Association, Inc. Some LECs received more revenue from the pool than they billed their interexchange carrier customers using the nationwide average CCL rate. Other companies, including the Company, received substantially less from the pool than the amount billed to their interexchange carrier customers. By an order adopted in 1987, the FCC changed its mandatory pooling requirements. These changes, which became effective April 1, 1989, permitted all of the Network Services Companies as a group to withdraw from the pool and to charge CCL rates which more closely reflect their non-traffic sensitive costs. The Network Services Companies, including the Company, are still obligated to make contributions of CCL revenues to companies who choose to continue to pool non-traffic sensitive costs so that the pooling companies can charge a CCL rate no greater than the nationwide average CCL rate. In addition to this continuing obligation, the Network Services Companies, including the Company, have a transitional support obligation to high cost companies who left the pool in 1989 and 1990. This transitional support obligation phases out over five years. BELL ATLANTIC - NEW JERSEY, INC. These long-term and transitional support requirements will be recovered in the Network Services Companies' (including the Company's) CCL rates. Depreciation Depreciation rates provide for the recovery of the Company's investment in telephone plant and equipment, and are revised periodically to reflect more current estimates of remaining service lives and future net salvage values. In October 1993, the FCC issued an order simplifying the depreciation filing process by reducing the information required for certain categories of plant and equipment whose remaining service life, salvage estimates and depreciatation rates fall within an approved range. Petitions for reconsideration of that order were filed in December 1993. In November 1993, the FCC issued a further order inviting comments on proposed ranges for an initial group of categories of plant and equipment. Price Caps In September 1990, the FCC adopted "price cap" regulation to replace the traditional rate of return regulation of LECs. LEC price cap regulation became effective on January 1, 1991. The price cap system places a cap on overall prices for interstate services and requires that the cap decrease annually, in inflation-adjusted terms, by a fixed percentage which is intended to reflect expected increases in productivity. The price cap level can also be adjusted to reflect "exogenous" changes, such as changes in FCC separations procedures or accounting rules. LECs subject to price caps have somewhat increased flexibility to change the prices of existing services within certain groupings of interstate services, known as "baskets". Under price cap regulation, the FCC set an authorized rate of return of 11.25% for the years 1991 and beyond. To the extent that a company is able to earn a higher rate of return through improved efficiency, the FCC's price cap rules permit them to retain the full amount of this higher return up to 100 basis points above the authorized rate of return (currently, up to a 12.25% rate of return). If a company's rate of return is between 100 and 500 basis points above the authorized rate of return (that is, currently, between 12.25% and 16.25%), the company must share 50% of the earnings above the 100-basis-point level with customers by reducing rates prospectively. All earnings above the 500-basis-point level must be returned to customers in the form of prospective rate decreases. If, on the other hand, a company's rate of return is more than 100 basis points below the authorized rate of return (that is, currently, below 10.25%), the company is permitted to increase rates prospectively to make up the deficiency. Under FCC-approved tariffs, the Network Services Companies are charging uniform rates for interstate access services (with the exception of Subscriber Line Charges) throughout their service areas and are regarded as a single unit by the FCC for rate of return measurement. On February 16, 1994, the FCC initiated a rulemaking proceeding to determine the effectiveness of LEC price cap rules and decide what changes, if any, should be made to those rules. This rulemaking is expected to be concluded by the end of 1994. In January 1993, the FCC denied the Company exogenous treatment of the increased expense for postretirement benefits required under Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", which the Company adopted effective January 1, 1991. The Company has appealed this decision. The appeal is likely to be decided during the second half of 1994. BELL ATLANTIC - NEW JERSEY, INC. Computer Inquiry III In August 1985, the FCC initiated Computer Inquiry III to re-examine its regulations requiring that "enhanced services" (e.g., voice messaging services, electronic mail, videotext gateway, protocol conversion) be offered only through a structurally separated subsidiary. In 1986, the FCC eliminated this requirement, permitting the Company to offer enhanced services, subject to compliance with a series of nonstructural safeguards designed to promote an effectively competitive market. These safeguards include detailed cost accounting, protection of customer information and certain reporting requirements. In June 1990, the United States Court of Appeals for the Ninth Circuit vacated and remanded the Computer Inquiry III decisions to the FCC, finding that the FCC had not fully justified those decisions. In December 1991, the FCC adopted an order which reinstated relief from the separate subsidiary requirement upon a company's compliance with the FCC's Computer III Open Network Architecture ("ONA") requirements and strengthened some of the nonstructural safeguards. In the interim, the Network Services Companies, including the Company, had filed interstate tariffs implementing the ONA requirements. Those tariffs became effective in February 1992, subject to further investigation. That investigation was completed on December 15, 1993, when an order was released making minor changes to the Network Services Companies' ONA rates. In March 1992, the Company certified to the FCC that it had complied with all initial ONA obligations and therefore should be granted structural relief for enhanced services. The FCC granted the Company structural relief in June 1992. Other parties have appealed this decision, which remains in effect pending the outcome of the appeal. A decision on the appeal is likely by the end of 1994. The FCC's December 1991 order has been appealed to the United States Court of Appeals for the Ninth Circuit by several parties. Pending decision on those appeals, the FCC's decision remains in effect. If a court again reverses the FCC, the Company's right to offer enhanced services could be impaired. FCC Cost Allocation and Affiliate Transaction Rules In 1987, the FCC adopted rules governing (i) the allocation of costs between the regulated and unregulated activities of a communications common carrier and (ii) transactions between the regulated and unregulated affiliates of a communications common carrier. The cost allocation rules apply to certain unregulated activities: activities that have never been regulated as communications common carrier offerings and activities that have been preemptively deregulated by the FCC. The costs of these activities are removed prior to the separations procedures process and are allocated to unregulated activities in the aggregate, not to specific services for pricing purposes. Other activities must be accounted for as regulated activities, and their costs are subject to separations procedures. These activities include (i) those which have been deregulated by the FCC without preempting state regulation, (ii) those which have been deregulated by a state but not the FCC and (iii) "incidental activities," which cannot, in the aggregate, generate more than 1% of a company's revenues. Since the Network Services Companies, including the Company, engage in these types of activities, the Network Services Companies, including the Company, pursuant to the FCC's cost allocation rules, filed a cost allocation manual, which has been approved by the FCC. The affiliate transaction rules govern the pricing of assets transferred to and services provided by affiliates. These rules generally require that assets be transferred between affiliates at "market price", if such price can be established through a tariff or a prevailing price actually charged to third parties. In the absence of a tariff or prevailing price, "market price" cannot be established, in which case (i) asset transfers from a regulated to an unregulated affiliate must be valued at the higher of cost or fair market value, and (ii) asset transfers from an unregulated to a regulated affiliate must be valued at the lower of cost or fair market value. The affiliate transaction rules require that a service provided by one affiliate to another affiliate, BELL ATLANTIC - NEW JERSEY, INC. which service is also provided to unaffiliated entities, must be valued at tariff rates or market prices. If the affiliate does not also provide the service to unaffiliated entities the price must be determined in accordance with the FCC's cost allocation principles. In October 1993, the FCC proposed new affiliate transaction rules which would essentially eliminate the different rules for the provision of services and apply the asset transfer rules to all affiliate transactions. The Network Services Companies, including the Company, have filed comments opposing the proposed rules. The FCC has not attempted to make its cost allocation or affiliate transaction rules preemptive. State regulatory authorities are free to use different cost allocation methods and affiliate transaction rules for intrastate ratemaking and to require carriers to keep separate allocation records. Telephone Company Provision of Video Dial Tone and Video Programming In 1987, the FCC initiated an inquiry into whether developments in the cable and telephone industries warranted changes in the rules prohibiting telephone companies such as the Company from providing video programming in their respective service territories directly or indirectly through an affiliate. In November 1991, the FCC released a Further Notice of Proposed Rulemaking in these proceedings. In August 1992, the FCC issued an order permitting telephone companies such as the Company to provide "video dial tone" service. Video dial tone permits telephone companies to provide video transport to multiple programmers on a non-discriminatory common carrier basis. The FCC has also ruled that neither telephone companies that provide video dial tone service, nor video programmers that use these services, are required to obtain local cable franchises. Other parties have appealed these orders, which remain in effect pending the outcome of the appeal. In late 1992, the Company entered into agreements pursuant to which, pending regulatory approval, it would provide video dial tone transport services to two video programmers in New Jersey. As contemplated by its contract with Sammons Communications, Incorporated ("Sammons"), the Company will deploy fiber optic technology that will enable Sammons and other video information providers to deliver video programming in three Morris County, New Jersey communities over a video dial tone platform. The Company's contract with Future Vision of America Corporation ("Future Vision") contemplates that the Company will deploy fiber optic technology in the Dover Township, New Jersey telephone network to establish a video dial tone platform that will allow Future Vision and other video information providers to deliver competitive video programming services in that community. Applications for approval to deploy these video dial tone systems are pending at the FCC. In December 1992, two Bell Atlantic Companies, Bell Atlantic - Virginia, Inc. and Bell Atlantic Video Services Company, filed a lawsuit against the federal government in the United States District Court for the Eastern District of Virginia seeking to overturn the prohibition in the Cable Communications Policy Act of 1984 against LECs providing video programming in their respective service areas. In a decision rendered in August 1993 and clarified in October 1993, the court struck down this prohibition as a violation of the First Amendment's freedom of speech protections and enjoined its enforcement against Bell Atlantic, the Network Services Companies, including the Company, and Bell Atlantic Video Services Company. This decision has been appealed to the United States Court of Appeals for the Fourth Circuit. In early 1993, the FCC granted Bell Atlantic authority to test a new technology known as Asynchronous Digital Subscriber Line ("ADSL") for use in delivering video entertainment and information over existing copper telephone lines. Beginning in March 1993, Bell Atlantic began a one-year technical trial of ADSL serving up to 400 Bell Atlantic employees in northern Virginia. In the Fall of 1993, Bell Atlantic petitioned the FCC for authorization to expand and convert this technical trial upon its completion into a six month market trial serving up to 2000 customers. Bell Atlantic also requested authority to offer a commercial video dial tone service to customers served by 25 central offices in parts of northern Virginia and southern Maryland BELL ATLANTIC - NEW JERSEY, INC. upon completion of the six month market trial. These applications are pending at the FCC. Interconnection and Collocation In October 1992, the FCC issued an order allowing third parties to collocate their equipment in telephone company offices to provide special access (private line) services to the public. The FCC's stated purpose was to encourage greater competition in the provision of interstate special access services. The order permits collocating parties to pay LECs an interconnection charge that is lower than the existing tariffed rates for similar non-collocated services; it allows LECs limited additional pricing flexibility for their own special access services when collocated interconnection is operational. In February 1993, Bell Atlantic's seven telephone subsidiaries, including the Company, filed an interstate tariff to allow collocation for special access services. This tariff is currently effective. Bell Atlantic and certain other parties have appealed the FCC's special access collocation order. Bell Atlantic expects the appeal to be decided in 1994. On September 2, 1993, the FCC extended collocation to switched access services. The terms and conditions for switched access collocation are similar to those for special access collocation. On November 18, 1993, Bell Atlantic's seven telephone subsidiaries, including the Company, filed an interstate tariff to allow collocation for switched access services. This tariff became effective on February 16, 1994. Bell Atlantic and certain other parties have appealed the FCC's switched access collocation order. Appeals of this order have been stayed pending a decision on the appeals of the special access collocation order. Increased competition through collocation will adversely affect the revenues of the Company, although some of the lost revenues could be offset by increased demand of the Company's own special access services as a result of the slightly increased pricing flexibility that the FCC has permitted. The Company does not expect the net revenue impact of special access collocation to be material. Revenue losses from switched access collocation, however, may be larger than from special access collocation. Intelligent Networks In December 1991, the FCC issued a Notice of Inquiry into the plans of the BOCs, including the Company, to deploy new "modular" network architectures, such as Advanced Intelligent Network ("AIN") technology. The Notice of Inquiry asks what, if any, regulatory action the FCC should take to assure that such architectures are deployed in a manner that is "open, responsive, and procompetitive". On August 31, 1993, the FCC issued a Notice of Proposed Rulemaking proposing a schedule for AIN deployment. The proposals in that Notice of Proposed Rulemaking generally follow those that Bell Atlantic proposed in its response to the Notice of Inquiry. The Company cannot estimate when the FCC will conclude this proceeding. The results of this proposed rulemaking could include a requirement that the Company offer individual components of its services, such as switching and transport, to competitors who will provide the remainder of such services through their own facilities. Such increased competition could divert revenues from the Company. However, deployment of AIN technology may also enable the Company to respond more quickly and efficiently to customer requests for new services. This could result in increased revenues from new services that could at least partially offset losses resulting from increased competition. STATE REGULATION AND INTRASTATE RATES The communications services of the Company are subject to regulation by the New Jersey Board of Regulatory Commissioners (formerly the Board of Public Utilities) (the "BRC") with respect to intrastate rates and services and other matters. BELL ATLANTIC - NEW JERSEY, INC. In June 1987, the BRC issued an order approving a Rate Stability Plan ("RSP") that modified the way the BRC monitors the Company's intrastate earnings. Rather than continue to monitor overall company financial performance, the RSP authorized financial performance surveillance only of less competitive services. The RSP also capped intrastate tariffed rates for its six year duration (July 1, 1987 through June 30, 1993), subject, however, to certain exceptions which would permit the Company to seek increases in tariffed rates during the RSP's fourth through sixth years. The RSP separated the Company's intrastate services into two categories: Group I (more competitive) services such as directory advertising, Centrex, pay telephone services, billing and collection services, high capacity channel and special access services, public data networks, central office local area networks, pay-per-view ordering service, high capacity digital hand-off service, Bellboy/(R)/ paging service, 911 enhanced terminal equipment and Home Intercom; and Group II (less competitive) services such as local exchange service, local usage, message toll service, 800 data base complementary service, and Repeat Call and Return Call. Only the Group II services were subject to financial performance monitoring by the BRC for the purpose of determining whether or not the Company was earning the target rate of return for those services. In January 1989, the BRC issued an order which established a target rate of return on equity of 12.9% for the purpose of monitoring the financial performance of the Group II category of services. Under the RSP, the Company was allowed to charge competitive rates for Group I services, without restriction and without financial performance monitoring. The New Jersey Telecommunications Act of 1992 (the "NJ Telecommunications Act") became effective in January 1992. The NJ Telecommunications Act authorized the BRC to adopt alternative regulatory frameworks that provide incentives to telecommunications companies for aggressive deployment of new technologies. It also deregulated services which the BRC has found to be competitive. Pursuant to that legislation, the Company filed its Plan for Alternative Form of Regulation in March 1992, and a revised plan in May 1992. This revised plan was unanimously approved by the BRC in December 1992, with certain modifications the written order reflecting that approval was issued on May 6, 1993. The Company filed a plan conforming to the BRC's order (the "NJ PAR"), which became effective on May 20, 1993. Several parties have filed judicial appeals of the BRC's order. The briefing schedule for this appeal extends through the middle of August 1994. The NJ PAR, which supersedes the RSP, divides the Company's services into Rate-Regulated Services (formerly Group II services) and Competitive Services (formerly Group I and services which have never been regulated by the BRC). Under this Plan, the Company's Rate-Regulated Services are grouped in two categories: - "Protected Services": Basic residence and business service, Touch-Tone, access services, message toll services and the ordering, installation and restoration of these services. Rates for Protected Services, other than basic residence service, may be increased beginning January 1996 in an amount limited to the prior year's increase in the Gross National Product-Price Index ("GNP- PI") less a 2% productivity offset, as long as the return on equity for Rate- Regulated Services does not exceed 11.7%. Basic residence service rates are frozen through December 1999. - "Other Services": Custom calling, Custom Local Area Signaling Services ("CLASS" services which utilize Signaling System 7), operator services and 911 enhanced service. Rates for Other Services may be increased beginning January 1996 in an amount limited to the prior year's increase in the GNP-PI less a 2% productivity offset, as long as the return on equity for Rate-Regulated Services does not exceed 12.7%. All earnings above a return on equity of 13.7% for Rate-Regulated Services will be shared equally with customers. There is no point at which the earnings are capped. Competitive Services are deregulated under the NJ Telecommunications Act. Other services such as premises wire maintenance, Answer Call and electronic BELL ATLANTIC - NEW JERSEY, INC. messaging, which have never been regulated by the BRC, continue to be deregulated under the NJ Telecommunications Act. NEW PRODUCTS AND SERVICES The following were among the new products and services introduced by the Company in 1993: IntelliLinQ PRI (Integrated Service Digital Network - Primary Rate Interface --------------- (ISDN-PRI) is an optional arrangement for local exchange access, directed at medium and large business customers with PBX service, which enables customers to increase the efficacy of their current trunking and to transmit 64Kbps circuit- switch data over the public network. 64 Clear Channel Capability is a new option of Feature Group D Access Service --------------------------- which increases a channel's traffic capacity and provides customers with the ability to establish interLATA calls to and from end-users who are served by ISDN-equipped switches and access lines. Three-Way Calling Usage Service is an interim limited product offering ------------------------------- providing the ability to add another party to an established call and conduct a three-way conference or after establishing the conference call allowing the initiating party to hang up without disconnecting the remaining two parties; Centrex Extend permits multi-location Centrex intercom service for a closed -------------- end user group of a single Centrex customer. The Company also introduced Flexible Automatic Number Identification Service, ------------------------------------------------ Call Restriction, Expanded Calling Area Service and Connect Request Service. - ---------------- ----------------------------- ----------------------- COMPETITION Regulatory proceedings, as well as new technology, are continuing to expand the types of available communications services and equipment and the number of competitors offering such services. An increasing amount of this competition is from large companies which have substantial capital, technological and marketing resources, many of which do not face the same regulatory constraints as the Company. Alternative Access and Local Services A substantial portion of the Company's revenues from business and government customers is derived from a relatively small number of large, multiple-line subscribers. The Company faces competition from alternative communications systems, constructed by large end users, interexchange carriers, and alternative access vendors which are capable of originating and/or terminating calls without the use of the local telephone company's plant. Teleport Communications Group Inc. ("Teleport") provides competitive access service in the New York metropolitan area, including northern New Jersey. The ability of such alternative access providers to compete with the Company has been enhanced by the FCC's orders requiring the Company to offer collocated interconnection for special and switched access services. Other potential sources of competition are cable television systems, shared tenant services and other non-carrier systems which are capable of bypassing the Company's local plant, either partially or completely, through substitution of special access for switched access or through concentration of telecommunications traffic on fewer of the Company's lines. Well-financed competitors may soon seek authority to offer competing local exchange services, such as dial tone and local usage, in some of the most lucrative of the Company's local telephone service areas. BELL ATLANTIC - NEW JERSEY, INC. Teleport and MFS Communications Company, Inc. ("MFS") both offer local exchange service in metropolitan New York and may seek to extend that service into northern New Jersey. The two largest long-distance carriers are also positioning themselves to begin to offer services that will compete with the Company's local exchange services. In November 1992, AT&T announced its intention to acquire a controlling interest in McCaw Cellular Communications Inc. ("McCaw"), the largest cellular company in the United States, and to integrate McCaw's wireless local service network with AT&T's long distance network. In December 1993, MCI Communications Corporation ("MCI") announced its intention to invest $2 billion to begin building competing local exchange and access networks in twenty major markets in the United States, some of which are likely to be in the Company's service territory. In March 1994, MCI also announced its intention to acquire a substantial interest in Nextel Communications Inc. (formerly Fleet Call Inc.), and to integrate Nextel's wireless local service network with MCI's long distance network in at least 10 major markets, one or more of which might be in the Company's service territory. The entry of these and other local exchange service competitors will almost certainly reduce the local exchange service revenues of the Company, at least in the market segments and geographical areas in which the competitors operate. Depending on such competitors' success in marketing their services, and the conditions of interconnection established by the regulatory commissions, these reductions could be significant. These revenue reductions may be offset to some extent by revenues from interconnection charges to be paid to the Company by these competitors. The Company seeks to meet such competition by establishing and/or maintaining competitive cost-based prices for local exchange services (to the extent the FCC and state regulatory authorities permit the Company's prices to move toward costs), by keeping service quality high and by effectively implementing advances in technology. See "FCC Regulation and Interstate Rates -Interstate Access Charges" and "- FCC Access Charge Pooling Arrangements". Personal Communications Services Radio-based personal communications services ("PCS") also constitute potential sources of competition to the Company. PCS consists of wireless portable telephone services which would allow customers to make and receive telephone calls from any location using small handsets, and which could also be used for data transmission. The FCC has authorized trials of such services, using a variety of technologies, by numerous companies. In September 1993, the FCC issued a report and order allocating radio spectrum to be licensed for use in providing PCS. Under the order, seven separate bandwidths of spectrum, ranging in size from 10 MHz to 30 MHz, would be auctioned to potential PCS providers in each geographic area of the United States; five of the spectrum blocks would be auctioned by "basic trading area" and the remaining two would be auctioned by larger "major trading area" (as such trading areas are defined by Rand McNally). LECs and companies with LEC subsidiaries, such as Bell Atlantic, are eligible to bid for PCS licenses, except that cellular carriers, such as Bell Atlantic, are limited to obtaining only 10 MHz of PCS bandwidth in areas where they provide cellular service. Bidders other than cellular providers may obtain multiple licenses aggregating up to 40 MHz of bandwidth in any area. Bell Atlantic has stated that it intends to pursue PCS licenses in the auctions, which are expected to be held in 1994 or in early 1995. In December 1993, the FCC awarded Pioneer's preference PCS licenses to, among other entities, Omnipoint Communications, Inc. ("Omnipoint"), whose license authorizes it to provide service in the New York metropolitan area, which includes the northern New Jersey areas served by the Company. If implemented, PCS and other similar services would compete with services currently offered by the Company, and could result in losses of revenues. BELL ATLANTIC - NEW JERSEY, INC. Centrex The Company offers Centrex service, which is a telephone company central office-based communications system for business, government and other institutional customers consisting of a variety of integrated software-based features located in a centralized switch or switches and extended to the customer's premises primarily via local distribution facilities. In the provision of Centrex, the Company is subject to significant competition from the providers of CPE systems, such as private branch exchanges ("PBXs"), which perform similar functions with less use of the Company's switching facilities. Users of Centrex systems generally require more subscriber lines than users of PBX systems of similar capacity. The FCC increased the maximum Subscriber Line Charge on embedded Centrex lines to $6.00 per month per line effective April 1, 1989. Increases in Subscriber Line Charges result in Centrex users incurring higher charges than users of comparable PBX systems. The BRC has permitted flexible pricing of certain Centrex services, which helps offset the effects of higher Subscriber Line Charges. IntraLATA Toll Competition The ability of interexchange carriers to engage in the provision of intrastate intraLATA toll service in competition with the Company is subject to state regulation. Such competition has not been permitted in New Jersey, but the BRC has initiated a proceeding in response to petitions filed by interexchange carriers to consider whether and on what terms to permit intraLATA competition. The Company does not oppose competition in principle, but has urged the BRC to implement certain required fundamental regulatory changes necessary for competition to be fair and effective. Parties participating in the proceeding include, among others, AT&T, MCI, Sprint Communications Company, L.P.and MFS, all of which are urging the BRC to revise its current policy and permit competition. A comment phase of the proceeding was completed in October, 1993. Evidentiary hearings will be held over the next several months and a BRC decision is expected in mid-1994. Directories The Company continue to face significant competition from other providers of directories as well as competition from other advertising media. In particular, the former sales representative of several of the Network Services Companies, including the Company, publishes directories in competition with those published by the Company in its service territory. Public Telephone Services The Company faces increasing competition in the provision of pay telephone services from other pay telephone service providers. In addition, the growth of wireless communications negatively impacts usage of public telephones. Operator Services Alternative operator services providers have entered into competition with the Company's operator services product line. CERTAIN CONTRACTS AND RELATIONSHIPS Certain planning, marketing, procurement, financial, legal, accounting, technical support and other management services are provided on behalf of the Company on a centralized basis by Bell Atlantic's wholly owned subsidiary, Bell Atlantic Network Services, Inc. ("NSI"). Bell Atlantic Network Funding Corporation provides short-term financing and cash management services to the Company. The seven RHCs each own (directly or through subsidiaries) a one-seventh interest in Bell Communications Research, Inc. ("Bellcore"). Pursuant to the Plan, Bellcore furnishes the RHCs and their BOC subsidiaries with technical BELL ATLANTIC - NEW JERSEY, INC. assistance such as network planning, engineering and software development, as well as various other consulting services that can be provided more effectively on a centralized basis. Bellcore is the central point of contact for coordinating the efforts of the RHCs in meeting the national security and emergency preparedness requirements of the federal government. It also helps to mobilize the combined resources of the RHCs in times of natural disasters. EMPLOYEE RELATIONS As of December 31, 1993, the Company employed approximately 15,000 persons, including employees of the centralized staff at NSI. This represents approximately a 1% decrease from the number of employees at December 31, 1992. The Company's workforce is augmented by members of the centralized staff of NSI, who perform services for the Company on a contract basis. Approximately 85% of the employees of the Company are represented by unions. Of those so represented, approximately 39% are represented by the Communications Workers of America, and approximately 61% are represented by the International Brotherhood of Electrical Workers, which are both affiliated with the American Federation of Labor - Congress of Industrial Organizations. Under the terms of the three-year contracts ratified in October 1992 by unions representing associate employees of the Network Services Companies, including the Company, and NSI, represented associates received a base wage increase of 3.74% in August 1993. Under the same contracts, associates received a Corporate Profit Sharing payment of $495 per person in 1994 based upon Bell Atlantic's 1993 financial performance. BELL ATLANTIC - NEW JERSEY, INC. ITEM 2.		ITEM 2. PROPERTIES The principal properties of the Company do not lend themselves to simple description by character and location. At December 31, 1993, the Company's investment in plant, property and equipment consisted of the following: "Connecting lines" consists primarily of aerial cable, underground cable, poles, conduit and wiring. "Central office equipment" consists of switching equipment, transmission equipment and related facilities. "Land and buildings" consists of land owned in fee and improvements thereto, principally central office buildings. "Telephone instruments and related equipment" consists primarily of public telephone terminal equipment and other terminal equipment. "Other" property consists primarily of furniture, office equipment, vehicles and other work equipment, capital leases, leasehold improvements and plant under construction. The Company's central offices are served by various types of switching equipment. At December 31, 1993 and 1992, the number of local exchanges and the percent of subscriber lines served by each type of equipment were as follows: BELL ATLANTIC - NEW JERSEY, INC. ITEM 3.	ITEM 3. LEGAL PROCEEDINGS PRE-DIVESTITURE CONTINGENT LIABILITIES AND LITIGATION The Plan provides for the recognition and payment by AT&T and the former BOCs (including the Company) of liabilities that are attributable to pre- Divestiture events but do not become certain until after Divestiture. These contingent liabilities relate principally to litigation and other claims with respect to the former Bell System's rates, taxes, contracts and torts (including business torts, such as alleged violations of the antitrust laws). Except to the extent that affected parties otherwise agree, contingent liabilities that are attributable to pre-Divestiture events are shared by AT&T and the BOCs in accordance with formulas prescribed by the Plan, whether or not an entity was a party to the proceeding and regardless of whether an entity was dismissed from the proceeding by virtue of settlement or otherwise. Each company's allocable share of liability under these formulas depends on several factors, including the type of contingent liability involved and each company's relative net investment as of the effective date of Divestiture. Under the formula generally applicable to most of the categories of these contingent liabilities, the Company's aggregate allocable share of liability is approximately 2.8%. AT&T and various of its subsidiaries and the BOCs (including, in some cases, the Company) have been and are parties to various types of litigation relating to pre-Divestiture events, including actions and proceedings involving environmental claims and allegations of violations of equal employment laws. Damages, if any, ultimately awarded in the remaining actions relating to pre- Divestiture events could have a financial impact on the Company whether or not the Company is a defendant since such damages will be treated as contingent liabilities and allocated in accordance with the allocation rules established by the Plan. While complete assurance cannot be given as to the outcome of any contingent liabilities or litigation, in the opinion of the Company's management, any monetary liability or financial impact to which the Company would be subject after final adjudication of all of the remaining potential or actual pre- Divestiture claims would not be material in amount to the financial position of the Company. BELL ATLANTIC - NEW JERSEY, INC. PART I ITEM 4.	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS (Omitted pursuant to General Instruction J(2).) PART II ITEM 5.	ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS (Inapplicable.) ITEM 6.	ITEM 6. SELECTED FINANCIAL DATA (Omitted pursuant to General Instruction J(2).) BELL ATLANTIC - NEW JERSEY, INC. ITEM 7.	ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS (Abbreviated pursuant to General Instruction J(2).) This discussion should be read in conjunction with the Financial Statements and Notes to the Financial Statements included in the index set forth on page. RESULTS OF OPERATIONS Net income for 1993 increased $6.0 million or 1.4% from the same period last year. Results for 1993 reflect an after-tax charge of $30.0 million for the adoption of Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" (Statement No. 112) and an extraordinary charge, net of tax, of $6.9 million for the early extinguishment of debt. Results for 1992 included a $16.7 million extraordinary charge, net of tax, for the early extinguishment of debt. OPERATING REVENUES Operating revenues increased $69.6 million or 2.2% in 1993. The increase in total operating revenues was comprised of the following: Local service revenues are earned from the provision of local exchange, local private line, and public telephone services. Local service revenues increased $43.6 million or 4.0% in 1993. The increase resulted primarily from growth in network access lines and higher demand for value-added central office services such as Custom Calling and Caller ID. The growth in access lines in service was approximately 139,000 lines or a 2.8% increase in 1993. Network access revenues are received from interexchange carriers (IXCs) for their use of the Company's local exchange facilities in providing long-distance services to IXCs' customers and from end-user subscribers. Switched access revenues are derived from usage-based charges paid by IXCs for access to the Company's network. Special access revenues arise from access charges paid by customers who have private lines, and end-user access revenues are earned from local exchange carrier customers who pay for access to the network. Network access revenues increased $24.5 million or 3.0% in 1993, primarily due to lower support payments to the National Exchange Carrier Association (NECA) interstate common line pool and a 3.9% growth in access minutes of use. Also contributing to this increase were higher end-user revenues principally due to growth in network access lines. These increases were partially offset by the effect of interstate rate reductions filed by the Company with the Federal Communications Commission (FCC), which became effective on July 2, 1993 and July 1, 1992, and by related estimated price cap sharing liabilities. Toll service revenues are earned from interexchange usage services such as Message Toll Services (MTS), Unidirectional Services (Wide Area Telecommunications Services (WATS) and 800 services), Corridor Services between northern New Jersey and New York City and southern New Jersey and southeastern Pennsylvania, and private line services. Toll service revenues increased $15.6 million or 2.2% in 1993. Total message volumes were 4.5% higher than the prior year. Toll service revenues increased principally due to increased demand for MTS, Corridor, WATS, and private line services. BELL ATLANTIC - NEW JERSEY, INC. Directory advertising, billing services and other revenues include amounts earned from directory advertising, billing and collection services provided to IXCs, premises services such as inside wire installation and maintenance, intraLATA toll compensation, rent of Company facilities by affiliates and non- affiliates, and certain nonregulated enhanced network services. Directory advertising, billing services and other revenues in 1993 increased $9.4 million or 1.7%. This increase was primarily due to higher intraLATA toll compensation; an increase in revenues from Answer Call, a nonregulated enhanced network service; and higher business volumes for premises services. Also contributing to this increase was higher directory advertising revenue due to volume growth. Partially offsetting these increases were lower billing and collection revenues in 1993, primarily as a result of the effect of favorable claim adjustments recorded in 1992 and reductions in services provided under long-term contracts with certain IXCs, and lower rent revenue. The provision for uncollectibles, expressed as a percentage of total revenue, was 1.7% in 1993 and 1.1% in 1992. The increase in the provision reflects unfavorable collection experience principally related to directory revenues. OPERATING EXPENSES Operating expenses increased $23.1 million or 1.0% in 1993. The increase in total operating expenses was comprised of the following: Employee costs consist of salaries, wages and other employee compensation, employee benefits and payroll taxes paid directly by the Company. Similar costs incurred by employees of Bell Atlantic Network Services, Inc. (NSI), who provide centralized services on a contract basis, are allocated to the Company and are included in other operating expenses. Employee costs decreased $10.6 million or 1.4% in 1993. The decrease in employee costs is principally due to savings resulting from workforce reduction programs implemented in 1992, partially offset by higher costs from salary and wage increases and overtime. The Company continues to evaluate ways to streamline and restructure its operations and reduce its workforce requirements in an effort to improve its cost structure. Depreciation and amortization expense increased $60.8 million or 11.3% in 1993 due primarily to approximately $58 million of additional expense resulting from represcribed intrastate depreciation rates in 1993. Also contributing to the increase was growth in the level of depreciable plant in 1993. These increases were partially offset by the completion of the FCC-ordered Reserve Deficiency Amortization in June 1992. Pursuant to the Plan for Alternative Regulation (PAR), approved by the Board of Regulatory Commissioners (BRC), the Company plans to annually adjust intrastate depreciation rates in connection with the Company's technology deployment program and BRC-approved depreciation methods and techniques. Taxes other than income increased $6.7 million or 3.8% in 1993, primarily due to an increase in property taxes and higher gross receipts tax resulting from an increase in operating revenues. BELL ATLANTIC - NEW JERSEY, INC. Other operating expenses consist primarily of contracted services including centralized service expenses allocated from NSI, rent, network software costs, and other general and administrative expenses. Other operating expenses decreased $33.8 million or 3.7% in 1993. The decrease was principally due to decreases in contracted services and the effect of the reversal of accruals in 1993 for certain liabilities. Also contributing to these decreases were lower rent expense and a reduction in network software costs. OPERATING INCOME TAXES The provision for income taxes increased $33.8 million or 18.3% in 1993. The Company's effective income tax rate was 30.7% in 1993, compared to 28.7% in 1992. The increase in the 1993 effective tax rate is principally the result of federal tax legislation enacted in 1993, which increased the federal corporate tax rate from 34% to 35%, a decrease in the amortization of investment tax credits, and the effect of recording in 1992 an adjustment to deferred taxes associated with the retirement of certain plant investment. A reconciliation of the statutory federal income tax rate to the effective rate for each period is provided in Note 5 of Notes to Financial Statements. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (Statement No. 109). In connection with the adoption of Statement No. 109, the Company recorded a charge to income of $.8 million in the first quarter of 1993. (see Note 5 of Notes to Financial Statements). OTHER INCOME AND EXPENSE Other income, net of expense, increased $8.1 million in 1993, primarily as a result of the reversal in 1993 of an accrual related to a tax issue. Partially offsetting this increase was the effect of interest income recognized in 1992 in connection with the settlement of various federal income tax matters related to prior periods. INTEREST EXPENSE Interest expense decreased $5.4 million or 4.6% in 1993, principally due to the effects of long-term debt refinancings in 1993 and 1992. EXTRAORDINARY ITEM The Company called $200.0 million in 1993 of long-term debentures which were refinanced at more favorable interest rates. As a result of these early retirements, the Company incurred after-tax charges of $6.9 million in 1993. These debt refinancings will reduce interest costs on the refinanced debt by approximately $3 million annually. CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE In connection with the adoption of Statement No. 112, effective January 1, 1993, the Company recorded a one-time, cumulative effect after-tax charge of $30.0 million in 1993 (see Note 4 of Notes to Financial Statements). The adoption of Statement No. 112 did not have a significant effect on the Company's ongoing level of expense in 1993 and is not expected to have a significant effect in future periods. COMPETITION AND REGULATORY ENVIRONMENT The telecommunications industry is currently undergoing fundamental changes which may have a significant impact on future financial performance of all telecommunications companies. These changes are driven by a number of factors, including the accelerated pace of technology change, customer requirements, a changing industry structure characterized by strategic alliances and the convergence of telecommunications and cable television, and a changing regulatory BELL ATLANTIC - NEW JERSEY, INC. environment in which traditional regulatory barriers are being lowered and competition encouraged. The convergence of cable television, computer technology, and telecommunications can be expected to dramatically increase competition in the future. The Company is already subject to competition from numerous sources, including competitive access providers for network access services, competing cellular telephone companies and others. During 1993, a number of business alliances were announced that have the potential to significantly increase competition both within the industry and within the areas currently served by Bell Atlantic. Over the past several years, Bell Atlantic has taken a number of actions in anticipation of the increasingly competitive environment. Cost reductions have been achieved, giving greater pricing flexibility for services exposed to competition. A new lines of business organization structure was adopted. Subject to regulatory approval, the Company plans to allocate capital resources to the deployment of broadband network platforms. On the regulatory front, the BRC has approved a plan for alternative regulation, which will be in effect through 1999, pending appeals. The Company conducts ongoing evaluations of its accounting practices, many of which have been prescribed by regulators. These evaluations include the assessment of whether costs that have been deferred as a result of actions of regulators and the cost of the Company's telephone plant will be recoverable in the future. In the event recoverability of costs becomes unlikely due to decisions by the Company to accelerate deployment of new technology, in response to specific regulatory actions or increasing levels of competition, the Company may no longer apply the provisions of Statement of Financial Accounting Standards No. 71, "Accounting for the Effects of Certain Types of Regulation" (Statement No. 71). The discontinued application of Statement No. 71 would require the Company to write off its regulatory assets and liabilities and may require the Company to adjust the carrying amount of its telephone plant should it determine that such amount is not recoverable. The Company believes that it continues to meet the criteria for continued financial reporting under Statement No. 71. A determination in the future that such criteria are no longer met may result in a significant one-time, non-cash, extraordinary charge, if the Company determines that a substantial portion of the carrying value of its telephone plant may not be recoverable. In September 1993, the FCC issued a report and order allocating radio spectrum to be licensed for use in providing personal communications services (PCS). Under the order, seven separate bandwidths of spectrum, ranging in size from 10 MHz to 30 MHz, would be auctioned to potential PCS providers in each geographic area of the United States. The geographical units by which the licenses would be allocated will be "basic trading areas" or larger "major trading areas." Five of the spectrum blocks are to be auctioned on a basic trading area basis, and the remaining two are to be auctioned by major trading area. Local exchange carriers such as the Company are eligible to bid for PCS licenses, except that cellular carriers are limited to obtaining 10 MHz of PCS bandwidth in areas where they provide cellular service. Bidders other than cellular providers may obtain multiple licenses aggregating up to 40 MHz of bandwidth in any area. Bell Atlantic has stated that it intends to pursue PCS licenses in the auctions, which are expected to be held in 1994. In August 1993, the United States District Court for the Eastern District of Virginia ruled unconstitutional the 1984 Cable Act's limitation on in-territory provision of programming by local exchange carriers such as the Company. The Cable Act currently prohibits local exchange carriers from owning more than 5% of any company that provides cable programming in their local service area. In a case originally brought by two Bell Atlantic subsidiaries, the court ruled that this prohibition violates the First Amendment's freedom of speech protections, and enjoined enforcement of the prohibition against Bell Atlantic and its telephone subsidiaries. The ruling has been appealed. BELL ATLANTIC - NEW JERSEY, INC. STATE REGULATORY ENVIRONMENT The communications services of the Company are subject to regulation by the New Jersey Board of Regulatory Commissioners (formerly the Board of Public Utilities) (the BRC) with respect to intrastate rates and services and other matters. In June 1987, the BRC issued an order approving a Rate Stability Plan ("RSP") that modified the way the BRC monitors the Company's intrastate earnings. Rather than continue to monitor overall company financial performance, the RSP authorized financial performance surveillance only of less competitive services. The RSP also capped intrastate tariffed rates for its six year duration (July 1, 1987 through June 30, 1993), subject, however, to certain exceptions which would permit the Company to seek increases in tariffed rates during the RSP's fourth through sixth years. The RSP separated the Company's intrastate services into two categories: Group I (more competitive) services such as directory advertising, Centrex, pay telephone services, billing and collection services, high capacity channel and special access services, public data networks, central office local area networks, pay-per-view ordering service, high capacity digital hand-off service, Bellboy/(R)/ paging service, 911 enhanced terminal equipment and Home Intercom; and Group II (less competitive) services such as local exchange service, local usage, message toll service, 800 data base complementary service, and Repeat Call and Return Call. Only the Group II services were subject to financial performance monitoring by the BRC for the purpose of determining whether or not the Company was earning the target rate of return for those services. In January 1989, the BRC issued an order which established a target rate of return on equity of 12.9% for the purpose of monitoring the financial performance of the Group II category of services. Under the RSP, the Company was allowed to charge competitive rates for Group I services, without restriction and without financial performance monitoring. The New Jersey Telecommunications Act of 1992 (the "NJ Telecommunications Act") became effective in January 1992. The NJ Telecommunications Act authorized the BRC to adopt alternative regulatory frameworks that provide incentives to telecommunications companies for aggressive deployment of new technologies. It also deregulated services which the BRC has found to be competitive. Pursuant to that legislation, the Company filed its Plan for Alternative Form of Regulation in March 1992, and a revised plan in May 1992. This revised plan was unanimously approved by the BRC in December 1992, with certain modifications the written order reflecting that approval was issued on May 6, 1993. The Company filed a plan conforming to the BRC's order (the "NJ PAR"), which became effective on May 20, 1993. Several parties have filed judicial appeals of the BRC's order. The briefing schedule for this appeal extends through the middle of August 1994. The NJ PAR, which supersedes the RSP, divides the Company's services into Rate-Regulated Services (formerly Group II services) and Competitive Services (formerly Group I and services which have never been regulated by the BRC). Under this Plan, the Company's Rate-Regulated Services are grouped in two categories: - "Protected Services": Basic residence and business service, Touch-Tone, access services, message toll services and the ordering, installation and restoration of these services. Rates for Protected Services, other than basic residence service, may be increased beginning January 1996 in an amount limited to the prior year's increase in the Gross National Product-Price Index (GNP- PI) less a 2% productivity offset, as long as the return on equity for Rate- Regulated Services does not exceed 11.7%. Basic residence service rates are frozen through December 1999. - "Other Services": Custom calling, Custom Local Area Signaling Services ("CLASS" services which utilize Signaling System 7), operator services and 911 enhanced service. Rates for Other Services may be increased beginning January 1996 in an amount limited to the prior year's increase in the GNP-PI less a 2% BELL ATLANTIC - NEW JERSEY, INC. productivity offset, as long as the return on equity for Rate-Regulated Services does not exceed 12.7%. All earnings above a return on equity of 13.7% for Rate-Regulated Services will be shared equally with customers. There is no point at which the earnings are capped. Competitive Services are deregulated under the NJ Telecommunications Act. Other services such as premises wire maintenance, Answer Call and electronic messaging, which have never been regulated by the BRC, continue to be deregulated under the NJ Telecommunications Act. The BRC has initiated a proceeding to consider whether to continue its existing policy that prohibits intraLATA toll service competition. The Company does not oppose competition in principle, but has urged the BRC to implement certain required fundamental regulatory changes necessary for competition to be fair and effective. Parties participating in the proceeding include, among others, AT&T, MCI Communications Corporation, Sprint Communications Company, L.P. and MFS Communications Company, Inc., all of which are urging the BRC to revise its current policy and permit competition. A comment phase of the proceeding was completed in October, 1993. Evidentiary hearings will be held over the next several months and a BRC decision is expected in mid-1994. OTHER MATTERS The Company has been designated as a potentially responsible party by the U.S. Environmental Protection Agency in connection with one Superfund site. Designation as a potentially responsible party subjects the named company to potential liability for costs relating to cleanup of the affected sites. Management believes that the aggregate amount of any potential liability would not have a material effect on the Company's financial condition or results of operations. FINANCIAL CONDITION Management believes that the Company has adequate internal and external resources available to meet ongoing operating requirements including network expansion and modernization, and payment of dividends. Management expects that presently foreseeable capital requirements will be financed primarily through internally generated funds, although additional long-term debt may be needed to fund development activities and to maintain the Company's capital structure within management's guidelines. During 1993, as in prior years, the Company's primary source of funds continued to be cash generated from operations. Revenue growth, cost containment measures and savings on interest costs contributed to cash provided from operations of $1,105.6 million for the year ended December 31, 1993. The primary use of capital resources continued to be capital expenditures. The Company invested $590.0 million in 1993 in the network. This level of investment is expected to continue in 1994. The Company plans to allocate capital resources to the deployment of broadband network platforms, subject to regulatory approval. The Company's debt ratio was 39.6% as of December 31, 1993 compared to 39.6% at December 31, 1992. On March 11, 1993, the Company sold $100.0 million of Thirty Year 7 1/4% Debentures through a public offering. The debentures are not redeemable prior to March 1, 2003. The net proceeds from this issuance were ultimately used on April 7, 1993 to redeem $100.0 million of Forty Year 8 3/4% Debentures. This refinancing will reduce annual interest costs on the refinanced debt by approximately $2 million. On December 22, 1993, the Company sold $100.0 million of Thirty-one Year 6.8% Debentures through a public offering. The debentures are not redeemable prior to December 15, 2008. The net proceeds from this issuance were used on January 7, 1994 to redeem $100.0 million of Forty Year 8 1/4% Debentures. This BELL ATLANTIC - NEW JERSEY, INC. refinancing will reduce annual interest costs on the refinanced debt by approximately $1 million. On February 14, 1994, the Company sold $250.0 million of Ten Year 5 7/8% Debentures through a public offering. The debentures are not redeemable prior to maturity. The net proceeds from this issuance were used on March 2, 1994 to redeem $150.0 million of Forty Year 7 3/4% Debentures and $100.0 million of Forty Year 8% Debentures. These refinancings will reduce annual interest costs on the refinanced debt by approximately $5 million. As of December 31, 1993, the Company had $300.0 million outstanding under an a shelf registration statement filed with the Securities and Exchange Commission. After the $250.0 million debt issuance on February 14, 1994, the total debt securities outstanding under the shelf registration statement is $50.0 million. BELL ATLANTIC - NEW JERSEY, INC. PART II ITEM 8.	ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required by this Item is set forth on pages through . 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 (Omitted pursuant to General Instruction J(2).) ITEM 11.	ITEM 11. EXECUTIVE COMPENSATION (Omitted pursuant to General Instruction J(2).) ITEM 12.	ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT (Omitted pursuant to General Instruction J(2).) ITEM 13.	ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS (Omitted pursuant to General Instruction J(2).) PART IV ITEM 14.	ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The following documents are filed as a part of this report: (1) Financial Statements See Index to Financial Statements and Financial Statement Schedules appearing on Page. (2) Financial Statement Schedules See Index to Financial Statements and Financial Statement Schedules appearing on Page. (3) Exhibits Exhibits identified in parentheses below, on file with the Securities and Exchange Commission (SEC), are incorporated herein by reference as exhibits hereto. BELL ATLANTIC - NEW JERSEY, INC. Exhibit Number (Referenced to Item 601 of Regulation S-K) --------------------------------------------------------- 3a Restated Certificate of Incorporation of the registrant, dated September 28, 1989 and filed November 28, 1989. (Exhibit 3a to the registrant's Annual Report on Form 10-K for the year ended December 31, 1989, File No. 1-3488. 3a(i) Certificate of Amendment to the Certificate of Incorporation of the registrant, dated January 7, 1994 and filed January 13, 1994. 3b By-Laws of the registrant, as amended March 31, 1988. (Exhibit 3b to the registrant's Annual Report on Form 10-K for the year ended December 31, 1988, File No. 1-3488.) 3b(i) By-Law resolution, dated June 25, 1992, amending Article VI, Section 6:1, of the Company's By-Laws (re: the indemnification by the Company of reasonable costs and expenses incurred for actions brought against Directors, Trustees and Officers of the Company). (Exhibit 3b to the registrant's Annual Report on Form 10-K for the year ended December 31, 1992, File No. 1-3488.) 3b(ii) By-Law resolution, dated November 19, 1992, amending Article III, Section 3:1, of the Company's By-Laws (re: the establishment of a Dividend Committee). (Exhibit 3b to the registrant's Annual Report on Form 10-K for the year ended December 31, 1992, File No. 1-3488.) 3b(iii) By-Law resolution, dated January 28, 1993, amending Article V, Section 5:7, of the Company's By-Laws (re: the elimination of the title "Vice President - External Affairs and Chief Financial Officer" and the substitution therein of the title "Chief Financial Officer"). (Exhibit 3b to the registrant's Annual Report on Form 10-K for the year ended December 31, 1992, File No. 1-3488.) 4 No instrument which defines the rights of holders of long and intermediate term debt of the registrant is filed herewith pursuant to Regulation S-K, Item 601(b)(4)(iii)(A). Pursuant to this regulation, the registrant hereby agrees to furnish a copy of any such instrument to the SEC upon request. 10a Agreement Concerning Contingent Liabilities, Tax Matters and Termination of Certain Agreements among AT&T, Bell Atlantic Corporation, and the Bell Atlantic Corporation telephone subsidiaries, and certain other parties, dated as of November 1, 1983. (Exhibit 10a to Bell Atlantic Corporation Annual Report on Form 10-K for the year ended December 31, 1993, File No. 1-8606). 10b Agreement among Bell Atlantic Network Services, Inc. and the Bell Atlantic Corporation telephone subsidiaries, dated November 7, 1983. (Exhibit 10b to Bell Atlantic Corporation Annual Report on Form 10-K for the year ended December 31, 1993, File No. 1-8606). 23 Consent of Coopers & Lybrand. 24 Powers of attorney. (b) Reports on Form 8-K: A Current Report on Form 8-K, dated December 8, 1993, was filed reporting on Item 7 (Financial Statements and Exhibits) in connection with the sale of debt securities. BELL ATLANTIC - NEW JERSEY, INC. SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED. Bell Atlantic - New Jersey, Inc. By /s/ Michael J. Losch ------------------------------------ Michael J. Losch Controller and Treasurer and Chief Financial Officer March 29, 1994 PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATE INDICATED. Principal Executive Officer: ____ Alfred C. Koeppe President and Chief ) Executive Officer ) ) Principal Accounting and Financial Officer: ) ) Michael J. Losch Controller and Treasurer ) and Chief Financial ) Officer ) ) ) ) By /s/ Michael J. Losch ) --------------------------- ) Michael J. Losch ) (individually and as ) attorney-in-fact) ) March 29, 1994 ) Directors: ) ) Brendan T. Byrne ) Robert E. Campbell ) Bruce S. Gordon ) Jon F. Hanson ) Alfred C. Koeppe ) James M. Seabrook ) Anthony P. Terracciano ) Leslie A. Vial ____) (constituting a majority of the registrant's Board of Directors) BELL ATLANTIC - NEW JERSEY, INC. INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES Financial statement schedules other than those listed above have been omitted either because the required information is contained in the financial statements and the notes thereto, or because such schedules are not required or applicable. BELL ATLANTIC - NEW JERSEY, INC. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareowner of Bell Atlantic - New Jersey, Inc. We have audited the financial statements and financial statement schedules of Bell Atlantic - New Jersey, Inc. as listed in the index on page of this Form 10-K. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Bell Atlantic - New Jersey, Inc. as of December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. As discussed in Notes 1, 4 and 5 to the financial statements, the Company changed its method of accounting for income taxes and postemployment benefits in 1993 and postretirement benefits other than pensions in 1991. /s/ Coopers & Lybrand 2400 Eleven Penn Center Philadelphia, Pennsylvania February 7, 1994, except as to the information presented in paragraph 6 of Note 2, for which the date is March 2, 1994 BELL ATLANTIC - NEW JERSEY, INC. STATEMENTS OF INCOME AND REINVESTED EARNINGS FOR THE YEARS ENDED DECEMBER 31 (DOLLARS IN MILLIONS) The accompanying notes are an integral part of these financial statements. BELL ATLANTIC - NEW JERSEY, INC. BALANCE SHEETS (DOLLARS IN MILLIONS) The accompanying notes are an integral part of these financial statements. BELL ATLANTIC - NEW JERSEY, INC. BALANCE SHEETS (DOLLARS IN MILLIONS) The accompanying notes are an integral part of these financial statements. BELL ATLANTIC - NEW JERSEY, INC. STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31 (DOLLARS IN MILLIONS) The accompanying notes are an integral part of these financial statements. BELL ATLANTIC - NEW JERSEY, INC. NOTES TO FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION Bell Atlantic - New Jersey, Inc. (formerly New Jersey Bell Telephone Company) (the Company), a wholly owned subsidiary of Bell Atlantic Corporation (Bell Atlantic), maintains its accounts in accordance with the Uniform System of Accounts (USOA) prescribed by the Federal Communications Commission (FCC) and makes certain adjustments necessary to present the accompanying financial statements in accordance with generally accepted accounting principles applicable to regulated entities. Such principles differ in certain respects from those used by unregulated entities, but are required to appropriately reflect the financial and economic impacts of regulation and the ratemaking process. Significant differences resulting from the application of these principles are disclosed elsewhere in these Notes to Financial Statements where appropriate. REVENUE RECOGNITION Revenues are recognized as earned on the accrual basis, which is generally when services are rendered based on the usage of the Company's local exchange network and facilities. CASH AND CASH EQUIVALENTS The Company considers all highly liquid investments with a maturity of 90 days or less when purchased to be cash equivalents. Cash equivalents are stated at cost, which approximates market value. MATERIAL AND SUPPLIES New and reusable materials are carried in inventory, principally at average original cost, except that specific costs are used in the case of large individual items. Nonreusable material is carried at estimated salvage value. PREPAID DIRECTORY Costs of directory production and advertising sales are deferred until the directory is published. Such costs are amortized to expense and the related advertising revenues are recognized over the average life of the directory, which is generally 12 months. PLANT AND DEPRECIATION The Company's provision for depreciation is based principally on the remaining life method of depreciation and straight-line composite rates. The provision for depreciation is based on the following estimated remaining service lives: buildings, 25 to 35 years; central office equipment, 2 to 11 years; telephone instruments and related equipment, 4 to 7 years; poles, 21 to 25 years; cable and wiring, 10 to 18 years; conduit, 44 to 45 years; office equipment and furniture, 4 to 14 years; and vehicles and other work equipment, 3 to 7 years. This method provides for the recovery of the remaining net investment in telephone plant, less anticipated net salvage value, over the remaining service lives authorized by regulatory commissions. Depreciation expense also includes amortization of certain classes of telephone plant (and certain identified depreciation reserve deficiencies) over periods authorized by regulatory commissions. When depreciable plant is replaced or retired, the amounts at which such plant has been carried in plant, property and equipment are removed from the respective accounts and charged to accumulated depreciation, and any gains or losses on disposition are amortized over the remaining service lives of the remaining net investment in telephone plant. BELL ATLANTIC - NEW JERSEY, INC. MAINTENANCE AND REPAIRS The cost of maintenance and repairs of plant, including the cost of replacing minor items not constituting substantial betterments, is charged to operating expenses. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION Regulatory commissions allow the Company to record an allowance for funds used during construction, which includes both interest and equity return components, as a cost of plant and as an item of other income. Such income is not recovered in cash currently, but will be recoverable over the service life of the plant through higher depreciation expense recognized for regulatory purposes. EMPLOYEE BENEFITS Pension Plans Substantially all employees of the Company are covered under noncontributory multi-employer defined benefit pension plans sponsored by Bell Atlantic and its subsidiaries, including the Company. The Company uses the projected unit credit actuarial cost method for determining pension cost for financial reporting purposes. Amounts contributed to the Company's pension plans are actuarially determined principally under the aggregate cost actuarial method, and are subject to applicable federal income tax regulations. Postretirement Benefits Other Than Pensions Substantially all employees of the Company are covered under postretirement health and life insurance benefit plans. Effective January 1, 1991, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," which requires accrual accounting for all postretirement benefits other than pensions. Under the prescribed accrual method, the Company's obligation for these postretirement benefits is to be fully accrued by the date employees attain full eligibility for such benefits. A portion of the postretirement accrued benefit obligation is contributed to 501(c)(9) trusts and 401h accounts under applicable federal income tax regulations. The amounts contributed to these trusts and accounts are actuarially determined, principally under the aggregate cost actuarial method. Postemployment Benefits The Company provides employees with postemployment benefits such as disability benefits, workers' compensation, and severance pay. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits," which requires accrual accounting for the estimated cost of benefits provided to former or inactive employees after employment but before retirement. Prior to 1993, the cost of these benefits was primarily charged to expense as the benefits were paid. INCOME TAXES Bell Atlantic and its domestic subsidiaries, including the Company, file a consolidated federal income tax return. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (Statement No. 109), which requires the determination of deferred taxes using the liability method. BELL ATLANTIC - NEW JERSEY, INC. Under the liability method, deferred taxes are provided on book and tax basis differences and deferred tax balances are adjusted to reflect enacted changes in income tax rates. The consolidated amount of current and deferred tax expense is allocated by applying the provisions of Statement No. 109 to each subsidiary as if it were a separate taxpayer. Prior to 1993, the Company accounted for income taxes based on the provisions of Accounting Principles Board Opinion No. 11, "Accounting for Income Taxes" (APB No. 11). Under APB No. 11, deferred taxes were generally provided to reflect the effect of timing differences on the recognition of revenue and expense determined for financial and income tax reporting purposes. The Tax Reform Act of 1986 repealed the investment tax credit (ITC) as of January 1, 1986, subject to certain transitional rules. ITCs were deferred and are being amortized as a reduction to income tax expense over the estimated service lives of the related assets. RECLASSIFICATIONS Certain reclassifications of prior years' data have been made to conform to 1993 classifications. 2. DEBT LONG-TERM Long-term debt consists principally of debentures issued by the Company. Interest rates and maturities of the amounts outstanding at December 31 are as follows: BELL ATLANTIC - NEW JERSEY, INC. Long-term debt outstanding at December 31, 1993 includes $640.0 million that is callable by the Company. The call prices range from 104.1% to 100% of face value, depending upon the remaining term to maturity of the issue. In addition, long-term debt includes $150.0 million that will become redeemable only on November 15, 1999 at the option of the holders. The redemption prices will be 100% of face value plus accrued interest. On March 11, 1993, the Company sold $100.0 million of Thirty Year 7 1/4% Debentures, due March 1, 2023, through a public offering. The debentures are not redeemable by the Company prior to March 1, 2003. The net proceeds of this debt issuance were ultimately used to redeem $100.0 million of Forty Year 8 3/4% Debentures due in 2018, which were redeemed by the Company on April 7, 1993 at a call price equal to 104.59% of the principal amount, plus accrued interest from December 1, 1992. As a result of the early extinguishment of this debt, which was called on March 8, 1993, the Company recorded a charge of $5.7 million, before an income tax benefit of $1.9 million, in the first quarter of 1993. On December 22, 1993, the Company sold $100.0 million of Thirty-one Year 6.8% Debentures, due December 15, 2024, through a public offering. The debentures are not redeemable by the Company prior to December 15, 2008. The net proceeds from this issuance were used to redeem $100.0 million of Forty Year 8 1/4% Debentures with an original maturity date of 2016, which were redeemed by the Company on January 7, 1994 at a call price equal to 103.7% of the principal amount, plus accrued interest from August 15, 1993. As a result of the early extinguishment of this debt, which was called on December 8, 1993, the Company recorded a charge of $4.8 million, before an income tax benefit of $1.7 million, in the fourth quarter of 1993. In 1992, the Company recorded extraordinary charges associated with the early extinguishment of debentures called by the Company of $25.3 million, before an income tax benefit of $8.6 million. On February 14, 1994, the Company sold $250.0 million of Ten Year 5 7/8% Debentures, due February 1, 2004, through a public offering. The debentures are not redeemable by the Company prior to maturity. The net proceeds from this issuance were used on March 2, 1994, to redeem $150.0 million of Forty Year 7 3/4% Debentures due in 2013, and $100.0 million of Forty Year 8% Debentures due in 2016. The Company redeemed the $150.0 million 7 3/4% debentures at a call price equal to 102.8% of the principal amount, plus accrued interest from March 1, 1994, and the $100 million 8% debentures at a call price equal to 104.1% of the principal amount, plus accrued interest from September 15, 1993. As a result of the early extinguishment of these debentures, which were called on January 31, 1994, the Company recorded a charge of $10.3 million, before an income tax benefit of $3.6 million, in the first quarter of 1994. At December 31, 1993, the Company had $300.0 million outstanding under a shelf registration statement filed with the Securities and Exchange Commission. After the $250.0 million debt issuance in February 1994, the total debt securities outstanding under the shelf registration is $50.0 million. The fair value of long-term debt is estimated based on the quoted market prices for the same or similar issues. At December 31, 1993 and 1992, the fair value of the Company's long-term debt, excluding the amount maturing within one year, unamortized discount and premium and capital lease obligations, is estimated at $1,345 million and $1,271 million, respectively. BELL ATLANTIC - NEW JERSEY, INC. MATURING WITHIN ONE YEAR Debt maturing within one year consists of the following at December 31: * Amounts represent average daily face amount of the note. ** Weighted average interest rates are computed by dividing the average daily face amount of the note into the aggregate related interest expense. At December 31, 1993, the Company had an unused line of credit balance of $472.1 million with an affiliate, Bell Atlantic Network Funding Corporation (BANFC) (Note 7). The fair value of debt maturing within one year, excluding capital lease obligations, is estimated based on quoted market prices for the same or similar issues. At December 31, 1993, the fair value of debt maturing within one year, excluding capital lease obligations, is estimated at $104 million. At December 31, 1992, the carrying amount of debt maturing within one year, excluding capital lease obligations, approximates fair value. 3. LEASES The Company has entered into both capital and operating leases for facilities and equipment used in operations. Plant, property and equipment included capital leases of $85.4 million and $87.7 million and related accumulated amortization of $47.1 million and $36.9 million at December 31, 1993 and 1992, respectively. The Company incurred no initial capital lease obligations in 1993, as compared to $.3 million in 1992 and $20.3 million in 1991. Total rent expense amounted to $53.6 million in 1993, $55.1 million in 1992, and $50.7 million in 1991. Of these amounts, the Company incurred rent expense of $6.8 million, $3.6 million, and $2.9 million in 1993, 1992, and 1991, respectively, from affiliated companies. BELL ATLANTIC - NEW JERSEY, INC. At December 31, 1993, the aggregate minimum rental commitments under noncancelable leases for the periods shown are as follows: 4. EMPLOYEE BENEFITS PENSION PLANS Substantially all of the Company's management and associate employees are covered under multi-employer noncontributory defined benefit pension plans sponsored by Bell Atlantic and its subsidiaries, including the Company. The pension benefit formula is based on a flat dollar amount per year of service according to job classification under the associate plan and a stated percentage of adjusted career average earnings under the plans for management employees. The Company's objective in funding the plans is to accumulate funds at a relatively stable level over participants' working lives so that benefits are fully funded at retirement. Plan assets consist principally of investments in domestic and foreign corporate equity securities, U.S. and foreign Government and corporate debt securities, and real estate. Aggregate pension cost for the plans is as follows: The decrease in pension cost in 1993 is due to the net effect of the elimination of one-time charges associated with special termination benefits that were recognized in the preceding years, favorable investment experience and changes in plan demographics due to retirement and severance programs. In 1992, the Company recognized $14.6 million of special termination benefit costs related to the early retirement of associate employees. The special termination benefit costs and the net effect of changes in plan provisions, certain actuarial assumptions, and the amortization of actuarial gains and losses related to demographic and investment experience increased pension cost in 1992. A change in the expected long-term rate of return on plan assets resulted in a reduction of $16.6 million in pension cost (which reduced operating expenses by $14.4 million after capitalization of amounts related to the construction program) and substantially offset the 1992 cost increase. BELL ATLANTIC - NEW JERSEY, INC. Statement of Financial Accounting Standards No. 87, "Employers' Accounting for Pensions" (Statement No. 87) requires a comparison of the actuarial present value of projected benefit obligations with the fair value of plan assets, the disclosure of the components of net periodic pension costs and a reconciliation of the funded status of the plans with amounts recorded on the balance sheets. The Company participates in multi-employer plans and therefore, such disclosures are not presented for the Company because the structure of the plans does not allow for the determination of this information on an individual participating company basis. Significant actuarial assumptions are as follows: The Company has in the past entered into collective bargaining agreements with unions representing certain employees and expects to do so in the future. Pension benefits have been included in these agreements and improvements in benefits have been made from time to time. Additionally, the Company has amended the benefit formula under pension plans maintained for its management employees. Expectations with respect to future amendments to the Company's pension plans have been reflected in determining the Company's pension cost under Statement No. 87. POSTRETIREMENT BENEFITS OTHER THAN PENSIONS Effective January 1, 1991, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" (Statement No. 106). Statement No. 106 requires accrual accounting for all postretirement benefits other than pensions. Under the prescribed accrual method, the Company's obligation for these postretirement benefits is to be fully accrued by the date employees attain full eligibility for such benefits. In conjunction with the adoption of Statement No. 106, the Company elected for financial reporting purposes, to recognize immediately the accumulated postretirement benefit obligation for current and future retirees, net of the fair value of plan assets and recognized accrued postretirement benefit cost (transition obligation), in the amount of $469.1 million, net of a deferred income tax benefit of $241.7 million. For purposes of measuring the interstate rate of return achieved by the Company, the FCC permits recognition of postretirement benefit costs, including amortization of the transition obligation, in accordance with the prescribed accrual method included in Statement No. 106. In January 1993, the FCC denied adjustments to the interstate price cap formula which would have permitted tariff increases to reflect the incremental postretirement benefit cost resulting from the adoption of Statement No. 106. For the purposes of measuring intrastate rate of return, the Company recognizes the accrued postretirement benefit cost, including amortization of the transition obligation, in accordance with the prescribed method in Statement No. 106. This method is subject to authoritative approval by the Board of Regulatory Commissioners. Pursuant to Statement of Financial Accounting Standards No. 71, "Accounting for the Effects of Certain Types of Regulation" (Statement No. 71), a regulatory asset associated with the recognition of the transition obligation was not recorded because of uncertainties as to the timing and extent of recovery given the Company's assessment of its long-term competitive environment. BELL ATLANTIC - NEW JERSEY, INC. Substantially all of the Company's management and associate employees are covered under multi-employer postretirement health and life insurance benefit plans sponsored by Bell Atlantic and certain of its subsidiaries, including the Company. The determination of benefit cost for postretirement health benefit plans is based on comprehensive hospital, medical, surgical and dental benefit plan provisions. The postretirement life insurance benefit formula used in the determination of postretirement benefit cost is primarily based on annual basic pay at retirement. The Company funds the postretirement health and life insurance benefits of current and future retirees. Plan assets consist principally of investments in domestic and foreign corporate equity securities, and U.S. Government and corporate debt securities. The aggregate postretirement benefit cost for the year ended December 31, 1993, 1992, and 1991, was $64.1 million, $59.7 million, and $57.8 million, respectively. As a result of the 1992 collective bargaining agreements, Bell Atlantic amended the postretirement medical benefit plan for associate employees and certain associate retirees of the Company. The increases in the postretirement benefit cost between 1993 and 1991 were primarily due to the change in benefit levels and claims experience. Also contributing to these increases were changes in actuarial assumptions and demographic experience. Statement No. 106 requires a comparison of the actuarial present value of projected benefit obligations with the fair value of plan assets, the disclosure of the components of net periodic postretirement benefit costs, and a reconciliation of the funded status of the plan with amounts recorded on the balance sheets. The Company participates in multi-employer plans and therefore, such disclosures are not presented for the Company because the structure of the plans does not provide for the determination of this information on an individual participating company basis. The assumed discount rate used to measure the accumulated postretirement benefit obligation was 7.25% at December 31, 1993 and 7.75% at December 31, 1992. The assumed rate of future increases in compensation levels was 5.25% at December 31, 1993 and 1992. The expected long-term rate of return on plan assets was 8.25% for 1993 and 1992 and 7.5% for 1991. The medical cost trend rate in 1993 was approximately 13.0%, grading down to an ultimate rate in 2003 of approximately 5.0%. The dental cost trend rate in 1993 and thereafter is approximately 4.0%. Postretirement benefits other than pensions have been included in collective bargaining agreements and have been modified from time to time. The Company has periodically modified benefits under the plans maintained for its management employees. Expectations with respect to future amendments to the Company's postretirement plans have been reflected in determining the Company's postretirement benefit costs under Statement No. 106. POSTEMPLOYMENT BENEFITS Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" (Statement No. 112). Statement No. 112 requires accrual accounting for the estimated cost of benefits provided to former or inactive employees after employment but before retirement. This change principally affects the Company's accounting for disability and workers' compensation benefits, which previously were charged to expense as the benefits were paid. The cumulative effect at January 1, 1993 of adopting Statement No. 112 reduced net income by $30.0 million, net of a deferred income tax benefit of $15.4 million. The adoption of Statement No. 112 did not have a significant effect on the Company's ongoing level of operating expense in 1993. BELL ATLANTIC - NEW JERSEY, INC. 5. INCOME TAXES Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (Statement No. 109). Statement No. 109 requires the determination of deferred taxes using the liability method. Under the liability method, deferred taxes are provided on book and tax basis differences and deferred tax balances are adjusted to reflect enacted changes in income tax rates. Prior to 1993, the Company accounted for income taxes based on the provisions of Accounting Principles Board Opinion No. 11. Statement No. 109 has been adopted on a prospective basis and amounts presented for prior years have not been restated. As of January 1, 1993, the Company recorded a charge to income of $.8 million, representing the cumulative effect of adopting Statement No. 109, which has been reflected in Federal Operating Income Taxes in the Statement of Income and Reinvested Earnings. Upon adoption of Statement No. 109, the effects of required adjustments to deferred tax balances were primarily deferred on the balance sheet as regulatory assets and liabilities in accordance with Statement of Financial Accounting Standards No. 71, "Accounting for the Effects of Certain Types of Regulation" (Statement No. 71). At January 1, 1993, the Company recorded income tax-related regulatory assets totaling $130.6 million in Other Assets. These regulatory assets represent the anticipated future regulatory recognition of the Statement No. 109 adjustments to recognize temporary differences for which deferred income taxes had not been provided. In addition, income tax-related regulatory liabilities totaling $228.6 million were recorded in Deferred Credits and Other Liabilities - Other. These regulatory liabilities represent the anticipated future regulatory recognition of the Statement No. 109 adjustments to recognize (i) a reduced deferred tax liability resulting from decreases in federal income tax rates subsequent to the dates the deferred taxes were recorded and (ii) a deferred tax benefit required to recognize the effects of the temporary differences attributable to the Company's policy of accounting for investment tax credits using the deferred method. These deferred taxes and regulatory assets and liabilities have been increased for the tax effect of future revenue requirements. These regulatory assets and liabilities are amortized at the time the related deferred taxes are recognized in the ratemaking process. Prior to the adoption of Statement No. 109, the Company had income tax timing differences for which deferred taxes had not been provided pursuant to the ratemaking process of $197.8 million and $177.5 million at December 31, 1992 and 1991, respectively. These timing differences principally related to the allowance for funds used during construction and certain taxes and payroll- related construction costs capitalized for financial statement purposes, but deducted currently for income tax purposes, net of applicable depreciation. The Omnibus Budget Reconciliation Act of 1993, which was enacted in August 1993, increased the federal corporate income tax rate from 34% to 35%, effective January 1, 1993. In the third quarter of 1993, the Company recorded a net charge to the tax provision of $.1 million, which included a $6.7 million charge for the nine month effect of the 1% rate increase, largely offset by a one-time net benefit of $6.6 million related to adjustments to deferred tax assets associated with the postretirement benefit obligation. Pursuant to Statement No. 71, the effect of the income tax rate increase on the deferred tax balances was primarily deferred through the establishment of regulatory assets of $5.9 million and the reduction of regulatory liabilities of $21.7 million. The Company did not recognize regulatory assets and liabilities related to the postretirement benefit obligation or the associated deferred income tax asset. BELL ATLANTIC - NEW JERSEY, INC. The components of income tax expense are as follows: Income tax expense (benefit) which relates to non-operating income and expense and is included in Miscellaneous-net was $(2.5) million, $1.1 million, and $1.6 million in 1993, 1992, and 1991, respectively. For the years ended December 31, 1992 and 1991, deferred income tax expense resulted from timing differences in the recognition of revenue and expense for financial and income tax accounting purposes. The sources of these timing differences and the tax effects of each were as follows: The provision for income taxes varies from the amount computed by applying the statutory federal income tax rate to income before provision for income taxes. The difference is attributable to the following factors: At December 31, 1993, the significant components of deferred tax assets and liabilities were as follows: BELL ATLANTIC - NEW JERSEY, INC. Total deferred tax assets include approximately $257 million related to postretirement benefit costs recognized in accordance with Statement No. 106. This deferred tax asset will gradually be realized over the estimated lives of current retirees and employees. 6. SUPPLEMENTAL CASH FLOW AND ADDITIONAL FINANCIAL INFORMATION For the years ended December 31, 1993, 1992, and 1991, revenues generated from services provided to AT&T, principally network access, billing and collection, and sharing of network facilities, were $423.8 million, $470.1 million, and $474.5 million, respectively. At December 31, 1993 and 1992, Accounts receivable, net, included $66.1 million and $54.8 million, respectively, from AT&T. Financial instruments that potentially subject the Company to concentrations of credit risk consist of trade receivables with AT&T, as noted above. Credit risk with respect to other trade receivables is limited due to the large number of customers included in the Company's customer base. At December 31, 1993 and 1992, $22.0 million and $90.6 million, respectively, of negative cash balances were classified as Accounts payable. 7. TRANSACTIONS WITH AFFILIATES The Company has contractual arrangements with an affiliated company, Bell Atlantic Network Services, Inc. (NSI), for the provision of various centralized corporate, administrative, planning, financial and other services. These arrangements serve to fulfill the common needs of Bell Atlantic's telephone subsidiaries on a centralized basis. In connection with these services, the Company recognized $498.7 million, $512.0 million, and $479.0 million in operating expenses for the years ended December 31, 1993, 1992, and 1991, respectively. Included in these expenses were $39.9 million in 1993, $55.0 million in 1992, and $45.2 million in 1991 billed to NSI and allocated to the Company by Bell Communications Research, Inc., another affiliated company owned jointly by the seven regional holding companies. In 1991, these charges included $12.7 million associated with NSI's adoption of Statement No. 106. In addition, in 1991, the Company recognized $128.0 million representing the Company's proportionate share of NSI's accrued transition obligation under Statement No. 106. In connection with the adoption of Statement No. 112 in 1993, the cumulative effect included $2.5 million, net of a deferred income tax benefit of $1.3 million, representing the Company's proportionate share of NSI's accrued cost of postemployment benefits at January 1, 1993. BELL ATLANTIC - NEW JERSEY, INC. The Company has a contractual agreement with an affiliated company, BANFC, for the provision of short-term financing and cash management services. BANFC issues commercial paper and secures bank loans to fund the working capital requirements of the telephone subsidiaries and NSI and invests funds in temporary investments on their behalf. In connection with this arrangement, the Company recognized interest expense of $3.1 million, $3.0 million, and $8.4 million in 1993, 1992, and 1991, respectively, and $.1 million in interest income in 1993. In 1993, the Company received $54.3 million in revenue from affiliates, principally related to rent received for the use of Company facilities and equipment, and paid $12.8 million in other operating expenses to affiliated companies. These amounts were $46.0 million and $3.6 million, respectively, in 1992 and $37.9 million and $2.9 million, respectively, in 1991. On February 1, 1994, the Company declared and paid a dividend in the amount of $91.7 million to Bell Atlantic. 8. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) Net income for the first quarter of 1993 has been restated to include a charge of $30.0 million, net of a deferred income tax benefit of $15.4 million, related to the adoption of Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" (Note 4). BELL ATLANTIC - NEW JERSEY, INC. SCHEDULE V - PLANT, PROPERTY AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1993 (DOLLARS IN MILLIONS) The notes on page are an integral part of this schedule. BELL ATLANTIC - NEW JERSEY, INC. SCHEDULE V - PLANT, PROPERTY AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1992 (DOLLARS IN MILLIONS) The notes on page are an integral part of this schedule. BELL ATLANTIC - NEW JERSEY, INC. SCHEDULE V - PLANT, PROPERTY AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1991 (DOLLARS IN MILLIONS) The notes on page are an integral part of this schedule. BELL ATLANTIC - NEW JERSEY, INC. NOTES TO SCHEDULE V - PLANT, PROPERTY AND EQUIPMENT - ---------------- (a) These additions include (1) the original cost (estimated if not specifically determinable) of reused material, which is concurrently credited to material and supplies, and (2) allowance for funds used during construction. Transfers between Plant in Service, Plant Under Construction and Other are also included in Additions at Cost. (b) Items of plant, property and equipment are deducted from the property accounts when retired or sold at the amounts at which they are included therein, estimated if not specifically determinable. (c) The Company's provision for depreciation is principally based on the remaining life method and straight-line composite rates prescribed by regulatory authorities. The remaining life method provides for the full recovery of the remaining net investment in plant, property and equipment. In 1993 and 1991, the Company implemented changes in depreciation rates approved by regulatory authorities. These changes reflect reductions in estimated service lives of the Company's plant, property and equipment in service. The rulings will allow a more rapid recovery of the Company's investment in plant, property and equipment through closer alignment with current estimates of its remaining economic useful life. For the years 1993, 1992, and 1991, depreciation expressed as a percentage of average depreciable plant was 7.5%, 6.5%, and 6.3%, respectively. (d) See Note 1 of Notes to Financial Statements for the Company's depreciation policies. BELL ATLANTIC - NEW JERSEY, INC. SCHEDULE VI - ACCUMULATED DEPRECIATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 (DOLLARS IN MILLIONS) - --------------------------- (a) Includes any gains or losses on disposition of plant, property and equipment. These gains and losses are amortized to depreciation expense over the remaining service lives of remaining net investment in plant, property and equipment. Consists primarily of salvage and cost of removal amounts related to the retirement of plant assets. BELL ATLANTIC - NEW JERSEY, INC. SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 (DOLLARS IN MILLIONS) - --------------------------- (a) (i) Amounts previously written off which were credited directly to this account when recovered; and (ii) accruals charged to accounts payable for anticipated uncollectible charges on purchases of accounts receivable from others which were billed by the Company. (b) Amounts written off as uncollectible. BELL ATLANTIC - NEW JERSEY, INC. SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 (DOLLARS IN MILLIONS) Advertising costs for 1993 are not presented, as such amounts are less than 1 percent of total operating revenues. Amounts reported for 1992 and 1991 for maintenance and repairs have been revised to include certain additional costs. EXHIBITS FILED WITH ANNUAL REPORT FORM 10-K UNDER THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 1993 Bell Atlantic - New Jersey, Inc. COMMISSION FILE NUMBER 1-3488 Form 10-K for 1993 File No. 1-3488 Page 1 of 1 EXHIBIT INDEX Exhibits identified in parentheses below, on file with the Securities and Exchange Commission (SEC), are incorporated herein by reference as exhibits hereto. Exhibit Number (Referenced to Item 601 of Regulation S-K) --------------------------------------------------------- 3a Restated Certificate of Incorporation of the registrant, dated September 28, 1989 and filed November 28, 1989. (Exhibit 3a to the registrant's Annual Report on Form 10-K for the year ended December 31, 1989, File No. 1-3488.) 3a(i) Certificate of Amendment to the Certificate of Incorporation of the registrant, dated January 7, 1994 and filed January 13, 1994. 3b By-Laws of the registrant, as amended March 31, 1988. (Exhibit 3b to the registrant's Annual Report on Form 10-K for the year ended December 31, 1988, File No. 1-3488.) 3b(i) By-Law resolution, dated June 25, 1992, amending Article VI, Section 6:1, of the Company's By-Laws (re: the indemnification by the Company of reasonable costs and expenses incurred for actions brought against Directors, Trustees and Officers of the Company). (Exhibit 3b to the registrant's Annual Report on Form 10-K for the year ended December 31, 1992, File No. 1-3488.) 3b(ii) By-Law resolution, dated November 19, 1992, amending Article III, Section 3:1, of the Company's By-Laws (re: the establishment of a Dividend Committee). (Exhibit 3b to the registrant's Annual Report on Form 10-K for the year ended December 31, 1992, File No. 1-3488.) 3b(iii) By-Law resolution, dated January 28, 1993, amending Article V, Section 5:7, of the Company's By-Laws (re: the elimination of the title "Vice President - External Affairs and Chief Financial Officer" and the substitution therein of the title "Chief Financial Officer"). (Exhibit 3b to the registrant's Annual Report on Form 10-K for the year ended December 31, 1992, File No. 1-3488.) 4 No instrument which defines the rights of holders of long and intermediate term debt of the registrant is filed herewith pursuant to Regulation S-K, Item 601(b)(4)(iii)(A). Pursuant to this regulation, the registrant hereby agrees to furnish a copy of any such instrument to the SEC upon request. 10a Agreement Concerning Contingent Liabilities, Tax Matters and Termination of Certain Agreements among AT&T, Bell Atlantic Corporation, and the Bell Atlantic Corporation telephone subsidiaries, and certain other parties, dated as of November 1, 1983. (Exhibit 10a to Bell Atlantic Corporation Annual Report on Form 10-K for the year ended December 31, 1993, File No. 1-8606.) 10b Agreement among Bell Atlantic Network Services, Inc. and the Bell Atlantic Corporation telephone subsidiaries, dated November 7, 1983. (Exhibit 10b to Bell Atlantic Corporation Annual Report on Form 10-K for the year ended December 31, 1993, File No. 1-8606.) 23 Consent of Coopers & Lybrand. 24 Powers of attorney.
78100_1993.txt	78100	1993	ITEM 1. BUSINESS The Company PECO Energy Company (Company), formerly known as Philadelphia Electric Company, incorporated in Pennsylvania in 1929, is an operating utility which provides electric and gas service to the public in southeastern Pennsylvania. Two subsidiaries own, and a third subsidiary operates, the Conowingo Hydro-Electric Project (Conowingo Project), and one distribution subsidiary provides electric service to the public in certain areas of northeastern Maryland adjacent to the Conowingo Project. The total area served by the Company and its subsidiaries covers 2,475 square miles. Electric service is supplied in an area of 2,340 square miles with a population of about 3,700,000, including 1,600,000 in the City of Philadelphia. Approximately 95% of the electric service area and 64% of retail kilowatthour (kWh) sales are in the suburbs around Philadelphia and in northeastern Maryland, and 5% of the service area and 36% of such sales are in the City of Philadelphia. In 1993, approximately 60% of the Company's electric output was generated from nuclear sources. The Company estimates for 1994 that 59% of its electric output will be generated from nuclear sources (see "Fuel"). Natural gas service is supplied in a 1,475-square-mile area of southeastern Pennsylvania adjacent to Philadelphia with a population of 1,900,000. The Company and its subsidiaries hold franchises to the extent necessary to operate in the areas served. The Company is subject to regulation by the Pennsylvania Public Utility Commission (PUC) as to rates, issuances of securities and certain other aspects of the Company's operations and by the Federal Energy Regulatory Commission (FERC) as to wholesale and interstate electric rates and as to licensing jurisdiction over the Company's Muddy Run Pumped Storage Project. Specific operations of the Company are also subject to the jurisdiction of various other federal, state, regional and local agencies, including the United States Nuclear Regulatory Commission (NRC), the United States Environmental Protection Agency (EPA), the United States Department of Energy (DOE), the Delaware River Basin Commission and the Pennsylvania Department of Environmental Resources (PDER). The Company's utility subsidiaries are subject to similar regulation, including the licensing jurisdiction of the FERC over the Conowingo Project. Due to its ownership of subsidiary-company stock, the Company is a holding company as defined by the Public Utility Holding Company Act of 1935 (1935 Act); however, it is predominantly an operating company and, by filing an exemption statement annually, is exempt from all provisions of the 1935 Act, except Section 9(a)(2) relating to the acquisition of securities of a public utility company. Electric Operations General During 1993, 90.4% of the Company's operating revenues and 94.3% of its operating income were from electric operations. Electric sales and operating revenues for 1993 by classes of customers are set forth below: In 1993, 97.7% of the Company's service territory operating revenues were from Company sales in Pennsylvania and 2.3% were from sales by the Company's wholly owned subsidiary Conowingo Power Company (COPCO) in Maryland. On February 15, 1994, the Company announced that it is evaluating strategic alternatives with respect to COPCO, including the possible sale of COPCO to other companies. The Company has made no determination at this time to sell COPCO and may, in fact, retain ownership of COPCO. See "Rate Matters." For 1993, sales to other utilities consisted of negotiated agreements to sell 799 megawatts (MW) of near-term excess capacity and/or associated energy. See "Rate Matters." All of these agreements are either for ongoing, short-duration purchases of energy only or expire during 1994. The Company expects to renew these agreements or negotiate new agreements in 1994. The net installed electric generating capacity (summer rating) of the Company and its subsidiaries at December 31, 1993 was as follows: ---------- (1) Includes capacity sold to other utilities. (2) See "Fuel" for sources of fuels used in electric generation. The maximum hourly demand on the Company's system was 7,100 MW which occurred on July 8, 1993. The Company estimates its generating reserve margin for 1994 to be 28%. This is based on the most recent annual peak-load forecast, which assumes normal peak weather conditions and the sale to other utilities of 400 MW of capacity not included in rate base. The Company is a member of the Pennsylvania-New Jersey-Maryland Interconnection (PJM), which fully integrates, on the basis of relative cost of generation, the bulk-power generating and transmission operations of eleven investor-owned electric utilities serving more than 22 million people in a 50,000-square-mile territory. In addition, PJM companies coordinate planning and install facilities to obtain the greatest practicable degree of reliability, compatible economy, and other advantages from the pooling of their respective electric system loads, transmission facilities and generating capacity. PJM uses the split-savings method in pricing and accounting to provide an economic method of energy interchange among its members. Under this arrangement, PJM energy is exchanged among PJM member utilities at a price which represents the average of the producer's cost of generating the electricity dispatched and the buyer's replacement cost, or the cost avoided by making the purchase. The maximum PJM demand of 46,429 MW occurred on July 8, 1993 when PJM's installed capacity (summer rating) was 55,440 MW. The Company's installed capacity for 1994-97 is expected to be sufficient to supply its PJM reserve margin share during that period. The Company has made arrangements for the purchase of other companies' power during 1994. The source of the amount reserved each week depends on the availability of excess coal-fired capacity, PJM's import capability from these companies and the Company's economic need for additional power. The Company's nuclear energy is generated by Limerick Generating Station (Limerick) Units No. 1 and No. 2 and Peach Bottom Atomic Power Station (Peach Bottom) Units No. 2 and No. 3, which are operated by the Company, and by Salem Generating Station (Salem) Units No. 1 and No. 2, which are operated by Public Service Electric and Gas Company (PSE&G). The Company owns 100% of Limerick, 42.49% of Peach Bottom and 42.59% of Salem. Limerick Units No. 1 and No. 2 each has a capacity of 1,055 MW; Peach Bottom Unit No. 2 has a capacity of 1,051 MW, of which the Company is entitled to 447 MW; Peach Bottom Unit No. 3 has a capacity of 1,035 MW, of which the Company is entitled to 439 MW; and Salem Units No. 1 and No. 2 each has a capacity of 1,106 MW, of which the Company is entitled to 471 MW of each unit. The Price-Anderson Act, as amended (Price-Anderson Act), sets the limit of liability of approximately $9.4 billion for claims that could arise from an incident involving any licensed nuclear facility in the nation. The limit is subject to increase to reflect the effects of inflation and changes in the number of licensed reactors. All utilities with nuclear generating units, including the Company, have obtained coverage for these potential claims through a combination of private insurances of $200 million and mandatory participation in a financial protection pool. Under the Price-Anderson Act, all nuclear reactor licensees can be assessed up to $76 million per reactor per incident, payable at no more than $10 million per reactor per incident per year. This assessment is subject to inflation, state premium taxes and an additional surcharge of 5% if the total amount of claims and legal costs exceeds the basic assessment. If the damages from an incident at a licensed nuclear facility exceed $9.4 billion, the President of the United States is to submit to Congress a plan for providing additional compensation to the injured parties. Congress could impose further revenue-raising measures on the nuclear industry to pay claims. The Price-Anderson Act and the extensive regulation of nuclear safety by the NRC do not preempt claims under state law for personal, property or punitive damages related to radiation hazards. Although the NRC requires the maintenance of property insurance on nuclear power plants in the amount of $1.06 billion or the amount available from private sources, whichever is less, the Company maintains coverage in the amount of its $2.75 billion proportionate share for each station. The Company's insurance policies provide coverage for decontamination liability expense, premature decommissioning, and loss or damage to its nuclear facilities. These policies require that insurance proceeds first be applied to assure that the facility, following an accident, is in a safe and stable condition and can be maintained in such condition. Within 30 days of stablizing the reactor, the licensee must submit a report to the NRC which provides a clean-up plan including the identification of all clean-up operations necessary to decontaminate the reactor to either permit the resumption of operations or decommissioning of the facility. Under the Company's insurance policies, proceeds not already expended to place the reactor in a stable condition must be used to decontaminate the facility. If the decision is made to decommission the facility, a portion of the insurance proceeds must be allocated to a fund which the Company is required by the NRC to maintain to provide funds for decommissioning the facility. These proceeds would be paid to the fund to make up any difference between the amount of money in the fund at the time of the early decommissioning and the amount that would be in the fund if contributions had been made over the normal life of the facility. The Company is unable to predict what effect these requirements may have on when insurance proceeds would be made available to the Company for the Company's bondholders and the amount of such proceeds which would be available. Under the terms of the various insurance agreements, the Company could be assessed up to $35 million for losses incurred at any plant insured by the insurance companies. The Company is self-insured to the extent that any losses may exceed the amount of insurance maintained. Any such losses, if not recovered through the ratemaking process, could have a material adverse effect on the Company's financial condition. The Company is a member of an industry mutual insurance company which provides replacement power cost insurance in the event of a major accidental outage at a nuclear station. The policy contains a twenty-one week waiting period before recovery of costs can commence. The premium for this coverage is subject to an assessment for adverse loss experience. The Company's maximum share of any assessment is $17 million per year. NRC regulations require that licensees of nuclear generating facilities must demonstrate that funds will be available in certain minimum amounts, established by a formula provided in the regulations, at the end of the life of the facility to decommission the facility. The PUC, based on estimates of decommissioning costs for each of the nuclear facilities in which the Company has an ownership interest, permits the Company to collect from its customers and deposit in segregated accounts amounts which, together with earnings thereon, will be necessary to decommission such nuclear facilities. The Company's ownership portion of decommissioning costs is approximately $643 million, expressed in 1990 dollars, which the Company believes would be substantially unchanged at December 31, 1993. The Company believes that the ultimate cost of decommissioning these facilities will continue to be recoverable through rates, but such recovery is not assured. Limerick Generating Station Limerick Unit No. 1 achieved a capacity factor of 95% in 1993 and 68% in 1992. Limerick Unit No. 2 achieved a capacity factor of 81% in 1993 and 91% in 1992. Limerick Units No. 1 and No. 2 are each on a 24-month refueling cycle. The last refueling outages for Units No. 1 and No. 2 were in 1994 and 1993, respectively. On November 5, 1993, the NRC issued its periodic Systematic Assessment of Licensee Performance (SALP) Report for Limerick for the period March 15, 1992 to September 25, 1993. The Report was issued under the revised SALP process in which the number of assessment areas has been reduced from seven to four: Operations, Engineering, Maintenance, and Plant Support. The area of Plant Support includes: radiological controls, security, emergency preparedness, fire protection, chemistry and housekeeping. Limerick received ratings of "1," the highest of the three rating categories, in the two functional areas of Operations and Engineering. The areas of Maintenance and Plant Support received ratings of "2." The NRC stated that overall, it observed an excellent level of performance at Limerick. It noted continued strong performance in the Operations and Engineering areas and improvement in the Maintenance area. The NRC noted, however, that in the Maintenance area, personnel errors, a weakness from the last SALP period, continued throughout the SALP period. Although the NRC recognized the implementation of initiatives by the Company to improve maintenance performance, it stated that such initiatives had not been in place long enough to be judged effective. In the area of Plant Support, the NRC stated that security, emergency preparedness, fire protection, chemistry and housekeeping continue to be very effective and contributed to safe plant performance. The NRC noted, however, performance weaknesses in the radiation controls area through the SALP period. The Company has taken and is taking actions to address the weaknesses discussed in the SALP Report. By letter dated December 8, 1992, the NRC imposed a civil penalty of $25,000 on the Company based upon a decision by a United States Department of Labor Administrative Law Judge (ALJ) that the Company's security subcontractor unlawfully discriminated against one of its former employees. The ALJ concluded that the employee was required to undergo a psychological evaluation and subsequently was discharged by the security subcontractor in retaliation for raising safety concerns regarding security operations at Limerick. The security subcontractor is appealing the decision of the ALJ to the Secretary of Labor. The Company has not paid the NRC penalty pending the final decision in the matter. On July 24, 1992, the NRC issued an information notice alerting utilities owning boiling water reactors (BWRs) to potential inaccuracies in water-level instrumentation during and after rapid depressurization events. On May 28, 1993, the NRC issued a bulletin requesting utilities owning BWRs to, among other things, install certain hardware modifications at the next cold shutdown of the BWR after July 30, 1993 to ensure accurate functioning of the water-level instrumentation. These hardware modifications were made on Peach Bottom Unit No. 2 in August 1993, Peach Bottom Unit No. 3 in November 1993 and Limerick Unit No. 1 in September 1993. The hardware modifications for Limerick Unit No. 2 will be made during the next cold shutdown of that unit. The NRC has raised concerns that the Thermo-Lag 330 fire barrier systems used to protect cables and equipment may not provide the necessary level of fire protection and requested licensees to describe short- and long-term measures being taken to address this concern. The Company has informed the NRC that it has taken short-term compensatory actions to address the inadequacies of the Thermo-Lag barriers installed at Limerick and Peach Bottom and is participating in an industry-coordinated program to provide long-term corrective solutions. By letter dated December 21, 1992, the NRC stated that the Company's interim actions were acceptable. By letter dated December 22, 1993, the NRC requested additional information on the Company's long-term measures to address Thermo-Lag 330 fire barrier issues. The Company provided a response outlining its Thermo-Lag program and committing to provide a status report to the NRC by September 30, 1994. The Company cannot predict, at this time, what effect this matter will have on the operations of Limerick and Peach Bottom. Water for the operation of Limerick is drawn from the Schuylkill River adjacent to Limerick and from the Perkiomen Creek, a tributary of the Schuylkill River. During certain periods of the year, generally the summer months but possibly for as much as six months or more in some years, the Company would not be able to operate Limerick without the use of supplemental cooling water due to existing regulatory water withdrawal constraints applicable to the Schuylkill River and the Perkiomen Creek. Supplemental cooling water for Limerick is provided by a supplemental cooling water system which draws water from the Delaware River. The supplemental cooling water system for Limerick includes the following components: (1) the Point Pleasant Pumping Station (to withdraw water from the Delaware River) and a two and one-half-mile transmission main from the Point Pleasant Pumping Station to the Bradshaw Reservoir (Point Pleasant Project); (2) the Bradshaw Reservoir, a 25-million-gallon reservoir and pumping station which receives water from the Point Pleasant Project and acts as a dividing point for water for Limerick and for the public supply systems of two Montgomery County water authorities; (3) a seven-mile pipeline between the Bradshaw Reservoir and the east branch of the Perkiomen Creek (East Branch); (4) a water treatment facility to provide disinfection of Delaware River water; (5) approximately 24 miles of the East Branch and the main branch of the Perkiomen Creek; (6) a pumping station on the main branch of the Perkiomen Creek; and (7) an eight-mile transmission main from the pumping station on the Perkiomen Creek to Limerick. Opposition to the Point Pleasant Project from various groups, including Bucks County and the Neshaminy Water Resources Authority (NWRA), a municipal authority created by Bucks County which had contracted to construct the Point Pleasant Project, resulted in protracted litigation in the Court of Common Pleas of Bucks County (Court of Common Pleas) and numerous appeals of the decisions of that court. In May 1988, the Bucks County Commissioners voted to end their opposition to the Point Pleasant Project and enacted an ordinance to enable Bucks County to acquire and manage the NWRA's projects, including the Point Pleasant Project. On May 26, 1988, in an action brought by Bucks County against the NWRA and its board members to enforce the ordinance, the Court of Common Pleas ordered the NWRA to transfer its projects, including the Point Pleasant Project, to Bucks County. Certain intervenors appealed to the Commonwealth Court, which dismissed the appeal on procedural grounds. The intervenors have filed a petition in the Court of Common Pleas to cure the procedural defect. All permits for the construction and operation of the supplemental cooling water system have been obtained. As described below, the issuances of certain permits have been appealed. Certain of the permits relating to operation of the system must be renewed periodically. On July 14, 1988, the PDER issued a National Pollutant Discharge Elimination System (NPDES) permit to the Company relating to the discharge of Delaware River water into the East Branch. The Company filed an appeal with respect to the temperature constraints and the limitations on discharges of certain impurities of the NPDES permit with the Environmental Hearing Board (EHB) on August 12, 1988. Certain environmental groups also filed permit appeals with the EHB. In order to comply with the conditions of its NPDES permit, the Company installed a water treatment facility to provide seasonal cooling and disinfection of the Delaware River water discharged into the East Branch. On March 31, 1992, the Company and PDER agreed to a settlement of the Company's appeal by entering into a Consent Adjudication, which is subject to approval by the EHB. The Consent Adjudication would resolve all issues in the Company's appeal but would not affect the appeal by certain environmental groups from the NPDES permit. No action on the Company's Consent Adjudication has been taken by the EHB. In July 1993, the PDER reissued the Company's NPDES permit. The reissued permit has conditions that are in certain instances less stringent than those set forth in the original permit. On February 12, 1988, the PDER extended various existing permits and issued new stream encroachment permits and water allocation permits with respect to the supplemental cooling water system. Intervenors appealed the February 12, 1988 order to the EHB, which dismissed all appeals except certain appeals relating to the erosive impact of the supplemental cooling water system on the East Branch. These appeals have been stayed pending disposition of other litigation concerning the erosion issue, which was concluded in April 1992. In addition, appeals by an intervenor from interim permit extension decisions of the PDER on June 26, 1987 and an appeal of a 1982 water quality certification remain pending before the EHB but have been inactive. The Company has also entered into an agreement which expires on December 31, 1994 with a municipality to secure a backup source of water for the interim operation of Limerick should water from the supplemental cooling water system not be available; however, this backup source is capable of providing only enough cooling water to operate both Limerick units simultaneously at 70% of rated capacity for short periods of time. Peach Bottom Atomic Power Station Peach Bottom Unit No. 2 achieved a capacity factor of 84% in 1993 and 61% in 1992. Peach Bottom Unit No. 3 achieved a capacity factor of 70% in 1993 and 78% in 1992. Peach Bottom Units No. 2 and No. 3 are each on a 24-month refueling cycle. The last refueling outages for Units No. 2 and No. 3 were in 1992 and 1993, respectively. On March 19, 1993, the NRC issued its periodic SALP Report on the performance of activities at Peach Bottom for the period August 4, 1991 through October 31, 1992. Peach Bottom received ratings of "1" in the area of Emergency Preparedness and the area of Security and Safeguards. The areas of Plant Operations and Radiological Controls received ratings of "2, Improving." Each of the other three functional areas (Maintenance/Surveillance; Engineering/Technical Support; and Safety Assessment/Quality Verification) received ratings of "2." Except for the ratings in the areas of Plant Operations and Radiological Controls (each previously rated "2"), these were the same ratings as those received in the prior SALP Report. The SALP Report stated that management continued to maintain a strong safety perspective throughout the assessment period and fostered broad-based performance improvements that led to stronger programs in most functional areas. The SALP Report further stated that many of the programmatic weaknesses identified during the previous assessment period have either been eliminated or performance has been improved. For example, the SALP Report stated that fundamental problems with the quality of root-cause analysis noted during the last two periods have been resolved and that Peach Bottom's root-cause analysis capabilities now constitute a strength. In addition, the SALP Report stated that licensed operators staffing and training continued to strengthen, contributing to improved Plant Operations performance. The SALP Report noted, however, that while overall progress in improving performance was clearly evident throughout the period, several weaknesses warranting continued management attention were identified. Among the areas identified for improvement were plant performance monitoring and engineering and technical support. During 1983 outages, cracks in the piping of the residual heat removal and reactor recirculating water systems were discovered at Peach Bottom Unit No. 3 resulting from a generic problem with BWRs. Repairs, which involved the replacement of piping, required extended outages at the Unit. In February 1989, the Company, on behalf of the co-owners of Peach Bottom, filed a proof of loss with Nuclear Electric Insurance Limited (NEIL) for replacement power costs associated with Unit No. 3 outages. On January 19, 1993, the arbitrators issued a decision in favor of NEIL and denied the Company's claim. On April 19, 1993, the Company filed a motion in the United States District Court for the Southern District of New York to vacate the arbitration decision. On May 21, 1992, the Company filed a request with the NRC to amend its Facility Operating Licenses for Peach Bottom Units No. 2 and No. 3 to extend the expiration dates to August 2013 and July 2014, respectively, 40 years from the dates of issuance. The current operating licenses expire 40 years from the dates of issuance of the construction permits for the Units. If the NRC grants the Company's request, the operating license for Unit No. 2 will be extended approximately five years, six months and the operating license for Unit No. 3 will be extended approximately six years, five months. By letter dated June 23, 1993, the Company submitted a request to the NRC to rerate the authorized maximum reactor core power levels of both Peach Bottom units by 5% to 3,458 megawatts thermal (Mwt) from the current limits of 3,293 Mwt. The analyses and evaluations supporting this request were completed using generic guidelines approved by the NRC. If the request is approved, the associated hardware changes will be made on Unit No. 2 during the planned fall 1994 refueling outage and on Unit No. 3 during the planned fall 1995 refueling outage. In addition to the matters discussed above, see "Electric Operations- Limerick Generating Station" for a discussion of certain matters which affect both Peach Bottom and Limerick. Salem Generating Station Salem Unit No. 1 achieved a capacity factor of 60% in 1993 and 54% in 1992. Salem Unit No. 2 achieved a capacity factor of 57% in 1993 and 49% in 1992. Salem Units No. 1 and No. 2 are each on an 18-month refueling cycle. The last refueling outages for Units No. 1 and No. 2 were in 1993. The Company has been informed by PSE&G that on September 1, 1993, the NRC furnished PSE&G with its periodic SALP Report for Salem. The operating period reviewed was from December 29, 1991 through June 19, 1993. Salem received ratings of "1" in the areas of Radiological Controls and Security. The area of Emergency Preparedness received a rating of "1, Declining." The areas of Plant Operations; Maintenance/ Surveillance; Engineering/Technical Support; and Safety Assessment/ Quality Verification received ratings of "2." The NRC concluded that PSE&G's performance during the period was good and noted an improvement over the last rating period in the area of Radiological Controls. The NRC noted, however, that Salem had a number of substantial operational challenges during the period and that additional management attention is warranted to reduce the frequency of such operational challenges. The Company has been informed by PSE&G that, by letter dated March 9, 1994, the NRC imposed a civil penalty of $50,000 for eight violations for failure to follow procedures at Salem related to the control of maintenance of work activities. The NRC stated that, while none of the violations were significant from a nuclear safety perspective, some of the violations demonstrated the potential to cause physical harm to individuals. In addition, the NRC stated that collectively, the violations demonstrated that weaknesses exist in the maintenance and control of work process activities, which could, under other circumstances, adversely affect the operability of safety related equipment at Salem. The NRC required PSE&G to respond to the alleged violations within 30 days and document the specific corrective actions that have been and will be taken. In order to improve Salem's materiel condition, plant and personnel performance and address the NRC's concerns expressed in its October 1990 SALP Report, the Salem owners, including the Company, are in the process of augmenting plans to improve Salem's materiel condition, upgrade procedures and enhance personnel performance. The Company's share of the plan's capital requirements for 1994 and for 1995-97 are reflected in the Company's most recent estimates of capital expenditures for plant additions and improvements for such periods. The planned improvements are being managed by PSE&G as a discrete project and are expected to coincide with plant operating schedules. In addition to the matters discussed above, see "Environmental Regulations-Water" for a discussion of possible installation of cooling towers at Salem. Fuel The following table shows the Company's sources of electric output for 1993 and as estimated for 1994: The following table shows the Company's average fuel cost used to generate electricity: ---------- (1) British thermal unit. (2) Reflects reclassification of spent-fuel cost for comparative purposes. Nuclear The cycle of production and utilization of nuclear fuel includes the mining and milling of uranium ore; the conversion of uranium concentrates to uranium hexafluoride; the enrichment of the uranium hexafluoride; the fabrication of fuel assemblies; and the utilization of the nuclear fuel in the generating station reactor. The Company has contracts for uranium concentrates which will satisfy the fuel requirements of Limerick and Peach Bottom through 1996. The Company's contracts for uranium concentrates are allocated to Limerick and Peach Bottom on an as-needed basis. PSE&G has informed the Company that it presently has under contract sufficient uranium concentrates to fully meet the current projected requirements for Salem through 2000 and 60% of the requirements through 2002. The following table summarizes the years through which the Company and PSE&G have contracted for the other segments of the nuclear fuel supply cycle. ---------- (1) The Company has exercised its option to remain uncommitted under the United States Enrichment Corporation (USEC) enrichment contract from 2000 to 2002. This action, however, does not exclude USEC enrichment services from consideration in this period. The Company does not anticipate any difficulties in obtaining necessary enrichment services for its Limerick and Peach Bottom Units. (2) Represents 100% of enrichment requirements through 1998 and 30% through 2001. Similar to the Company's actions discussed in note (1) above, the Company has been informed by PSE&G that PSE&G has exercised its option to remain uncommitted under its USEC enrichment contract from 1999 to 2002. On March 1, 1993, the Company entered into an agreement with the Long Island Power Authority (LIPA) and other parties, subsequently revised on September 14, 1993, to receive $46 million as compensation for accepting slightly irradiated fuel from the Shoreham Nuclear Power Station on Long Island, New York, for use at Limerick. The Company is to receive the $46 million in installments as the shipments of nuclear fuel are accepted. The first of the 33 shipments arrived at Limerick on September 28, 1993. Nineteen shipments of fuel were completed prior to the suspension of shipments to accommodate the refueling outage of Limerick Unit No. 1. Shipments of the remaining fuel are scheduled to resume after completion of the refueling outage. The Company estimates that the acquisition of the fuel will result in benefits to the Company's customers of $70 million over the next 12 to 15 years due to reduced fuel-purchase requirements. The fuel will be stored at Limerick's spent-fuel pool pending its use at Limerick beginning in 1994 and extending beyond 2005. On September 21, 1993, the State of New Jersey filed suit in the United States District Court for the District of New Jersey (New Jersey District Court) seeking a stay of shipments of fuel because of alleged failures of federal agencies to fully review the proposed shipping plan under the National Environmental Policy Act (NEPA) and the Coastal Zone Management Act (CZMA). The New Jersey District Court refused to halt the shipments and New Jersey has appealed to the United States Court of Appeals for the Third Circuit (Appeals Court). The Appeals Court affirmed the New Jersey District Court decision to dismiss the suit and subsequently denied a request for rehearing. New Jersey has also requested that the NRC halt shipments until the NRC further reviews the fuel transfer under the NEPA and CZMA. The NRC has refused these requests. The commercial reprocessing and recycling of the plutonium produced in the United States nuclear power programs have been delayed indefinitely. There are no commercial facilities for the reprocessing of spent nuclear fuel currently in operation in the United States, nor has the NRC licensed any such facilities. The spent-fuel storage pools for Limerick have sufficient capacity to permit storage through 1999. Reracking of the spent-fuel storage pools at Limerick, which will extend storage capacity to approximately 2010, is in the preliminary stages. The new configuration will be designed to accommodate rod consolidation. Spent-fuel racks at Peach Bottom have storage capacity until 1998 for Unit No. 2 and 1999 for Unit No. 3. Options for expansion of storage capacity at both Limerick and Peach Bottom beyond the pertinent dates, including the viability of rod consolidation, are being investigated. The Company has been informed by PSE&G that the spent-fuel storage capacity at Salem will permit storage of spent fuel through March 1998 for Salem Unit No. 1 and March 2002 for Salem Unit No. 2. PSE&G has developed an integrated strategy to meet the longer-term spent-fuel storage needs for Salem. PSE&G plans to replace the existing high-density racks in the spent-fuel storage pools of Salem Units No. 1 and No. 2 with maximum density racks. The reracking project commenced in early 1992 and is expected to extend the storage capability of Salem Units No. 1 and No. 2 through March 2008 and March 2012, respectively. Under the Nuclear Waste Policy Act of 1982 (NWPA), the federal government was to begin accepting spent fuel for permanent off-site storage no later than 1998. The DOE has stated that there is no legal obligation under the NWPA to begin accepting spent fuel absent an operational repository or other facility constructed under the NWPA. The DOE acknowledges, however, that it may have created the expectation of such a commitment on the part of utilities by issuing certain regulations and projected waste acceptance schedules. The DOE has stated that it will not be able to open a permanent, high-level nuclear waste repository until 2010, at the earliest. The DOE stated that the delay was a result of its seeking new data about the suitability of the proposed repository site at Yucca Mountain, Nevada, opposition to this location for the repository and the DOE's revision of its civilian nuclear waste program. The DOE stated that it would seek legislation from Congress for the construction of a temporary storage facility which would accept spent nuclear fuel from utilities beginning in 1998 or soon thereafter. Although progress is being made at Yucca Mountain and several communities have expressed interest in providing a temporary storage site, the Company cannot predict when the temporary federal storage facilities or permanent repository will become available. The DOE is exploring options to address delays in the currently projected waste acceptance schedules. The options under consideration by the DOE include offsetting a portion of the financial burden associated with the costs of continued on-site storage of spent fuel after 1998 and the issuance by the DOE to utilities of multi-purpose canisters for on-site storage. Under the NWPA, the DOE is authorized to assess utilities for the cost of nuclear fuel disposal. The current cost of such disposal is one mill per kWh of net nuclear generation. The 1993 charge collected by the Company from its customers for spent-fuel disposal was $23 million. The DOE may revise this charge as necessary for full-cost recovery of nuclear fuel disposal. The National Energy Policy Act of 1992 (Energy Act) states, among other things, that utilities with nuclear reactors must pay for the decommissioning and decontamination of the DOE nuclear fuel enrichment facilities. The total costs to domestic utilities are estimated to be $150 million per year for 15 years, of which the Company's share is $5 million per year. The Energy Act provides that these costs are to be recoverable in the same manner as other fuel costs. The Company has recorded the liability and a related regulatory asset of $69 million for such costs at December 31, 1993. The Company is currently recovering these costs through the Energy Cost Adjustment (ECA). The Company believes that the ultimate costs of decommissioning and decontamination, spent-fuel disposal and any assessment under the Energy Act will continue to be recoverable through rates, although such recovery is not assured. Coal The Company has a 20.99% ownership interest in Keystone Station (Keystone) and a 20.72% ownership interest in Conemaugh Station (Conemaugh), coal-fired, mine-mouth generating stations in western Pennsylvania, operated by Pennsylvania Electric Company. A majority of Keystone's fuel requirements is supplied by one coal company under a contract which expires on December 31, 2004. The contract calls for varying amounts of coal purchases as follows: between 3,000,000 and 3,500,000 tons for each of the years 1994 through 1999; and a total of 6,500,000 tons for the years 2000 through 2004. At December 31, 1993, approximately 63% of Conemaugh's fuel requirements were secured by a long-term contract and several short-term contracts. The Company customarily enters into medium-term contracts for a significant portion of its coal requirements and makes spot purchases for the balance of coal required by its Philadelphia-area, coal-fired units at Eddystone Station (Eddystone) and Cromby Station (Cromby). At January 1, 1994, the Company had contracts with two suppliers for 600,000 tons per year or approximately 55% of expected annual requirements. One contract expires on September 30, 1994 and the other expires on December 31, 1994 with an option to extend for one additional year if the Company and the supplier so agree. The coal requirements of each station not covered by existing contracts are met through additional short-term contracts or spot purchases from local suppliers. Oil The Company customarily enters into yearly purchase orders with its various oil suppliers for the bulk of its requirements and makes spot purchases for the balance. At present, the Company's purchase orders are sufficient to meet the estimated residual fuel oil needs of its oil-fired generating units through April 1994, when current orders end and new yearly orders begin. Purchase orders for distillate fuel oil are expected to meet the Company's needs through September 1994, when current orders end and new yearly orders begin. Natural Gas The Company supplies natural gas for Cromby Unit No. 2 under a City Gate Sales tariff approved by the PUC and through spot purchases made on the open market. A limited amount of natural gas is used in auxiliary boilers and pollution control equipment at Eddystone. In 1993, the Company began converting Eddystone Units No. 3 and No. 4 to allow the use of oil or natural gas. Gas Operations During 1993, 9.6% of the Company's operating revenues and 5.7% of its operating income were from gas operations. Gas sales and operating revenues for 1993 by classes of customers are set forth below: The Company's natural gas supply is provided by purchases from a number of suppliers for terms ranging from 2 to 10 years. These purchases are delivered under several long-term firm transportation contracts with Texas Eastern Transmission Corporation (Texas Eastern) and Transcontinental Gas Pipe Line Corporation (Transcontinental). The Company's aggregate annual entitlement under these firm contracts is 69.3 million dekatherms. Peak gas is provided by the Company's liquefied natural gas facility and propane-air plant (see "ITEM 2.		ITEM 2. PROPERTIES The principal plants and properties of the Company are subject to the lien of the Mortgage under which the Company's First and Refunding Mortgage Bonds are issued. The following table sets forth the Company's net electric generating capacity by station at December 31, 1993: ---------- (1) Summer rating. (2) Company portion. (3) Retirement dates are under on-going review by the Company. Current plans call for the continued operation of these plants beyond 1994. The following table sets forth the Company's major transmission and distribution lines in service at December 31, 1993: At December 31, 1993, the Company's principal electric distribution system included 12,294 pole-line miles of overhead lines and 19,595 cable miles of underground cables. The Company has undertaken a 10-year program to implement a 34 Kv distribution system for a large portion of outlying suburban areas. These areas are now primarily served by a combination of 4 Kv distribution circuits, which are being phased out, and direct connections to 34 Kv subtransmission lines, which are being converted to 34 Kv distribution circuits. The new system is designed to improve the Company's ability to meet the growing load requirements of suburban areas, improve system reliability and reduce service interruptions. The following table sets forth the Company's gas pipeline miles at December 31, 1993: Pipeline Miles -------------- Transmission................................................ 35 Distribution................................................ 5,285 Service Piping.............................................. 4,448 ----- Total................................................... 9,768 ===== The Company has a liquefied natural gas facility located in West Conshohocken, Pennsylvania which has a storage capacity of 1,200,000 mcf and a sendout capacity of 200,000 mcf/day and a propane-air plant located in Chester, Pennsylvania, with a tank storage capacity of 1,980,000 gallons and a peaking capability of 30,000 mcf/day. In addition, the Company owns 19 natural gas city gate stations at various locations throughout its gas service territory. The Company owns an office building in downtown Philadelphia, in which it maintains its headquarters, and also owns or leases elsewhere in its service area a number of properties which are used for office, service and other purposes. Information regarding rental and lease commitments is incorporated herein by reference to note 14 of Notes to Consolidated Financial Statements included in the Company's Annual Report to Shareholders for the year 1993. The Company maintains property insurance against loss or damage to its principal plants and properties by fire or other perils, subject to certain exceptions. Although it is impossible to determine the total amount of the loss that may result from an occurrence at a nuclear generating station, the Company maintains its $2.75 billion proportionate share for each station. Under the terms of the various insurance agreements, the Company could be assessed up to $35 million for property losses incurred at any plant insured by the insurance companies (see "ITEM 1. BUSINESS-Electric Operations"). The Company is self-insured to the extent that any losses may exceed the amount of insurance maintained. Any such losses, if not recovered through the ratemaking process, could have a material adverse effect on the Company's financial condition. ITEM 3.	ITEM 3. LEGAL PROCEEDINGS On April 11, 1991, 33 former employees of the Company filed an amended class action suit against the Company in the Eastern District Court on behalf of approximately 141 persons who retired from the Company between January and April 1990. The lawsuit, filed under the Employee Retirement Income Security Act (ERISA), alleges that the Company fraudulently and/or negligently misrepresented or concealed facts concerning the Company's 1990 Early Retirement Plan and thus induced the plaintiffs to retire or not to defer retirement immediately before the initiation of the Early Retirement Plan, thereby depriving the plaintiffs of substantial pension and salary benefits. On June 6, 1991, the plaintiffs filed amended complaints adding additional plaintiffs. The lawsuit names the Company, the Company's Service Annuity Plan (SAP) and two Company officers as defendants. The plaintiffs seek approximately $20 million in damages representing, among other things, increased pension benefits and nine months' salary pursuant to the terms of the Early Retirement Plan, as well as punitive damages. On July 29, 1992, the Eastern District Court granted the Company's motion for summary judgment and entered judgment in favor of the Company. On May 26, 1993, the Appeals Court reversed the grant of summary judgment and remanded the case to the Eastern District Court. On October 18, 1993, the Company filed a petition for a writ of certiorari to the United States Supreme Court, asking the Court to hear the case, which petition was denied. The ultimate outcome of this matter is not expected to have a material adverse effect on the Company's financial condition. On May 2, 1991, 37 former employees of the Company filed an amended class action suit against the Company, the SAP and three former Company officers in the Eastern District Court on behalf of 147 former employees who retired from the Company from January through June 1987. The lawsuit was filed under ERISA and concerns the August 1, 1987 amendment to the SAP. The plaintiffs claim that the Company concealed or misrepresented the fact that the amendment to the SAP was planned to increase retirement benefits and, as a consequence, they retired prior to the amendment to the SAP and were deprived of significant retirement benefits. The complaint does not specify any dollar amount of damages. On July 29, 1992, the Eastern District Court granted the Company's motion for summary judgment and entered judgment in favor of the Company. On May 26, 1993, the Appeals Court reversed the grant of summary judgment and remanded the case to the Eastern District Court. On October 18, 1993, the Company filed a petition for a writ of certiorari to the United States Supreme Court, asking the Court to hear the case, which petition was denied. The ultimate outcome of this matter is not expected to have a material adverse effect on the Company's financial condition. On May 25, 1993, the Company received a letter from attorneys on behalf of a shareholder demanding that the Company's Board of Directors commence legal action against certain Company officers and directors with respect to the Company's credit and collections practices. The basis of the demand is the findings and conclusions contained in the Credit and Collection section of the May 1991 PUC Management Audit Report prepared by Ernst & Young. At its June 28, 1993 meeting, the Board of Directors appointed a Special Committee of Directors to consider whether such legal action is the best interests of the Company and its shareholders. On March 14, 1994, upon the recommendation of the report of the Special Committee, the Board of Directors adopted a resolution refusing the shareholder demand set forth in the May 25, 1993 demand letter, and authorizing and directing officers of the Company to take all steps necessary to terminate the derivative suit discussed below. On July 26, 1993, attorneys on behalf of two shareholders filed a shareholder derivative action in the Court of Common Pleas of Philadelphia County against several of the Company's present and former officers alleging mismanagement, waste of corporate assets and breach of fiduciary duty in connection with the Company's credit and collections practices. A similar suit by the same plaintiffs previously had been withdrawn while on appeal after dismissal by the court for failure to first serve a demand on the Company's Board of Directors. This action is also based on the findings and conclusions contained in the Credit and Collection section of the May 1991 PUC Management Audit Report prepared by Ernst & Young. The plaintiffs seek, among other things, an unspecified amount of damages and the awarding to the plaintiffs of the costs and disbursements of the action, including attorneys' fees. On September 30, 1993, the Company filed preliminary objections asking that the action be dismissed on the grounds that it is premature. On December 6, 1993, the court denied the Company's preliminary objections. Any monetary damages which may be recovered, net of expenses, would be paid to the Company because the lawsuit is brought derivatively by shareholders on behalf of the Company. ITEM 4.	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. PART II ITEM 5.	ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's common stock is listed on the New York and Philadelphia Stock Exchanges. At January 31, 1994, there were 219,644 owners of record of the Company's common stock. The information with respect to the prices of and dividends on the Company's common stock for each quarterly period during 1992 and 1993 is incorporated herein by reference to "Operating Statistics" in the Company's Annual Report to Shareholders for the year 1993. The book value of the Company's common stock at December 31, 1993 was $19.25 per share. Dividends may be declared on common stock out of funds legally available for dividends whenever full dividends on all series of preferred stock outstanding at the time have been paid or declared and set apart for payment for all past quarter-yearly dividend periods. No dividends may be declared on common stock, however, at any time when the Company has failed to satisfy the sinking fund obligations with respect to certain series of the Company's preferred stock. Future dividends on common stock will depend upon earnings, the Company's financial condition and other factors, including the availability of cash. The Company's Articles prohibit payment of any dividend on, or other distribution to the holders of, common stock if, after giving effect thereto, the capital of the Company represented by its common stock together with its Other Paid-In Capital and Retained Earnings is, in the aggregate, less than the involuntary liquidating value of its then outstanding preferred stock. At December 31, 1993, such capital ($4.26 billion) amounted to about 7 times the liquidating value of the outstanding preferred stock ($609 million). ITEM 6.	ITEM 6. SELECTED FINANCIAL DATA Selected financial data for each of the last five years for the Company and its subsidiaries is incorporated herein by reference to "Financial Statistics" and "Operating Statistics" in the Company's Annual Report to Shareholders for the year 1993. ITEM 7.	ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information with respect to this caption is incorporated herein by reference to "Management's Discussion and Analysis of Financial Condition and Results of Operations" in the Company's Annual Report to Shareholders for the year 1993. ITEM 8.	ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information with respect to this caption is incorporated herein by reference to "Consolidated Financial Statements" and "Financial Statistics" in the Company's Annual Report to Shareholders for the year 1993. 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 (a) Identification of Directors. The information required for Directors is included in the Proxy Statement of the Company in connection with its 1994 Annual Meeting of Shareholders to be held April 13, 1994, under the heading "Proposal 1. Election of Directors" and is incorporated herein by reference. (b) Identification of Executive Officers. The information required for Executive Officers is set forth in "ITEM 1. BUSINESS-Executive Officers of the Registrant" of this Form 10-K. ITEM 11.	ITEM 11. EXECUTIVE COMPENSATION The information with respect to this caption is included in the Proxy Statement of the Company in connection with its 1994 Annual Meeting of Shareholders to be held April 13, 1994, under the heading "Proposal 1. Election of Directors" and is incorporated herein by reference. ITEM 12.	ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information with respect to this caption is included in the Proxy Statement of the Company in connection with its 1994 Annual Meeting of Shareholders to be held April 13, 1994, under the heading "Proposal 1. Election of Directors" and is incorporated herein by reference. ITEM 13.	ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information with respect to this caption is included in the Proxy Statement of the Company in connection with its 1994 Annual Meeting of Shareholders to be held April 13, 1994, under the heading "Proposal 1. Election of Directors" and is incorporated herein by reference. PART IV ITEM 14.	ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K Financial Statements and Financial Statement Schedules All other schedules are omitted since the required information is not present or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements and notes thereto. With the exception of the consolidated financial statements and the independent accountants' report listed in the above index and the information referred to in Items 1, 2, 5, 6, 7 and 8, all of which is included in the Company's Annual Report to Shareholders for the year 1993 and incorporated by reference into this Form 10-K Annual Report, the Annual Report to Shareholders for the year 1993 is not to be deemed "filed" as part of this Form 10-K. REPORT OF INDEPENDENT ACCOUNTANTS To the Shareholders and Board of Directors PECO Energy Company: Our report on the consolidated financial statements of PECO Energy Company has been incorporated by reference in this Form 10-K from page 18 of the 1993 Annual Report to Shareholders of PECO Energy Company. In connection with our audits of such financial statements, we have also audited the related financial statement schedules listed in the index in Item 14 of this Form 10-K. In our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. COOPERS & LYBRAND 2400 Eleven Penn Center Philadelphia, Pennsylvania January 31, 1994 PECO ENERGY COMPANY AND SUBSIDIARY COMPANIES SCHEDULE V-UTILITY PLANT (Thousands of Dollars) FOR THE YEAR ENDED DECEMBER 31, 1993 PECO ENERGY COMPANY AND SUBSIDIARY COMPANIES SCHEDULE V- UTILITY PLANT (Thousands of Dollars) FOR THE YEAR ENDED DECEMBER 31, 1992 PECO ENERGY COMPANY AND SUBSIDIARY COMPANIES SCHEDULE V-UTILITY PLANT (Thousands of Dollars) FOR THE YEAR ENDED DECEMBER 31, 1991 PECO ENERGY COMPANY AND SUBSIDIARY COMPANIES SCHEDULE VI-ACCUMULATED DEPRECIATION OF UTILITY PLANT (Thousands of Dollars) FOR THE YEAR ENDED DECEMBER 31, 1993 Depreciation charged to transportation ..................... (851) Amortization of anti-trust.................................. (16) Amortization of Conowingo Project relicensing costs......... 100 Limerick Unit No. 1 disallowance............................ (10,319) Limerick Unit No. 2 disallowance............................ (4,424) Amortization of Limerick Unit No. 1 declaratory order..................................................... 14,750 Amortization of Limerick 50% common facilities deferred depreciation and carrying charges................ 7,897 Amortization of nuclear design basis ....................... 1,460 -------- Depreciation charged to operating expenses (2)..............$424,952 ======== ---------- (1) Other Changes Limerick disallowance............................ $(14,743) Removal cost net of salvage...................... (15,257) Amortization of Conowingo Project relicensing costs............................. 100 Interest on decommissioning funds................ 5,708 Miscellaneous.................................... (775) -------- Total Other Changes ......................... $(24,967) ======== (2) Includes the provision for decommissioning nuclear plants of $20,255. PECO ENERGY COMPANY AND SUBSIDIARY COMPANIES SCHEDULE VI-ACCUMULATED DEPRECIATION OF UTILITY PLANT (Thousands of Dollars) FOR THE YEAR ENDED DECEMBER 31, 1992 Depreciation charged to transportation ..................... (452) Amortization of anti-trust.................................. (19) Amortization of Conowingo Project relicensing costs......... 100 Limerick Unit No. 1 disallowance............................ (10,319) Limerick Unit No. 2 disallowance............................ (4,424) Amortization of Limerick Unit No. 1 declaratory order....... 14,750 Amortization of Limerick 50% common facilities deferred depreciation and carrying charges................ 7,897 Amortization of nuclear design basis........................ 856 -------- Depreciation charged to operating expenses (2)..............$413,779 ======== ---------- (1) Other Changes Limerick disallowance................................. $(14,743) Removal cost net of salvage........................... (17,456) Amortization of Conowingo Project relicensing costs... 100 Interest on decommissioning funds..................... 6,932 -------- Total Other Changes .............................. $(25,167) ======== (2) Includes the provision for decommissioning nuclear plants of $20,255. PECO ENERGY COMPANY AND SUBSIDIARY COMPANIES SCHEDULE VI-ACCUMULATED DEPRECIATION OF UTILITY PLANT (Thousands of Dollars) FOR THE YEAR ENDED DECEMBER 31, 1991 Depreciation charged to transportation ..................... (632) Amortization of anti-trust.................................. (34) Amortization of Conowingo Project relicensing costs......... 100 Limerick Unit No. 1 disallowance............................ (10,319) Limerick Unit No. 2 disallowance............................ (4,424) Amortization of Limerick Unit No. 1 declaratory order....... 14,750 Amortization of Limerick 50% common facilities' deferred depreciation and carrying charges................ 7,897 Other....................................................... 18 -------- Depreciation charged to operating expenses (2)..............$400,572 ======== ---------- (1) Other Changes: Limerick disallowances..................................$(14,743) Removal cost, net of salvage............................ (14,933) Amortization of Conowingo Project relicensing costs..... 100 Interest on decommissioning funds....................... 5,796 -------- Total Other Changes ................................$(23,780) ======== (2) Includes the provision for decommissioning nuclear plants of $20,027. PECO ENERGY COMPANY AND SUBSIDIARY COMPANIES SCHEDULE VIII-VALUATION AND QUALIFYING ACCOUNTS (Thousands of Dollars) Exhibits Certain of the following exhibits have been filed with the Securities and Exchange Commission (Commission) pursuant to the requirements of the Acts administered by the Commission. Such exhibits are identified by the references following the listing of each such exhibit and are incorporated herein by reference under Rule 24 of the Commission's Rules of Practice. Certain other instruments which would otherwise be required to be listed below have not been so listed because such instruments do not authorize securities in an amount which exceeds 10% of the total assets of the Company and its subsidiaries on a consolidated basis and the Company agrees to furnish a copy of any such instrument to the Commission upon request. Exhibit No. Description - -------------------------- 3-1 Amended and Restated Articles of Incorporation of PECO Energy Company. 3-2 Bylaws of the Company, adopted February 26, 1990 and amended January 24, 1994. 4-1 First and Refunding Mortgage dated May 1, 1923 between The Counties Gas and Electric Company (predecessor to the Company) and Fidelity Trust Company, Trustee (First Fidelity Bank, National Association, successor), (Registration No. 2-2881, Exhibit B-1). 4-2 Supplemental Indentures to the Company's First and Refunding Mortgage: Dated as of File Reference Exhibit No. - ------------------------------------------------------------------------------ September 1, 1926 2-2881 B-1(a) May 1, 1927 2-2881 B-1(b) May 1, 1927 2-2881 B-1(c) November 1, 1927 2-2881 B-1(d) January 31, 1931 2-2881 B-1(e) February 1, 1931 2-2881 B-1(f) March 1, 1937 2-2881 B-1(g) December 1, 1941 2-4863 B-1(h) November 1, 1944 2-5472 B-1(i) December 1, 1946 2-6821 7-1(j) February 1, 1948 2-7381 7-1(k) January 1, 1952 2-9329 4(b)-13 May 1, 1953 2-10201 4(b)-14 December 1, 1953 2-10568 4(b)-15 April 1, 1955 2-11536 2(b)-16 September 1, 1957 2-13562 2(b)-17 May 1, 1958 2-14020 2(b)-18 December 1, 1958 2-14528 2(b)-19 October 1, 1959 2-15609 2(b)-20 May 1, 1964 2-25628 4(b)-21 October 15, 1966 2-25628 4(b)-22 June 1, 1967 2-26430 2(b)-23 October 1, 1967 2-28242 2(b)-23 March 1, 1968 2-34051 2(b)-24 September 10, 1968 2-34051 2(b)-25 August 15, 1969 2-35939 2(b)-26 February 1, 1970 2-37020 2(b)-27 May 1, 1970 2-38849 2(b)-28 December 15, 1970 2-41081 2(b)-29 August 1, 1971 2-42402 2(b)-30 December 15, 1971 2-44195 2(b)-31 June 15, 1972 2-46625 2(b)-32 January 15, 1973 2-49842 2(b)-33 January 15, 1974 2-49849 2(b)-34 October 15, 1974 2-51887 2(b)-35 April 15, 1975 2-54182 2(b)-36 August 1, 1975 2-55423 2(b)-37 March 1, 1976 2-56749 2(b)-38 August 1, 1976 2-58198 2(b)-39 February 1, 1977 2-58198 2(b)-40 March 15, 1977 2-59177 2(b)-41 July 15, 1977 2-60743 2(b)-42 March 15, 1978 2-65604 2(b)-43 October 15, 1979 2-69086 (b)(1)-49 October 15, 1980 2-72802 4-45 March 1, 1981 2-72802 4-46 March 1, 1981 2-72802 4-47 July 1, 1981 2-76238 4-48 Dated as of File Reference Exhibit No. - ----------------------------------------------------------------------------- September 15, 1981 2-76238 4-49 April 1, 1982 2-79269 4-50 October 1, 1982 2-83875 4-51 June 15, 1983 1983 Form 10-K 4-2(a) November 15, 1984 1984 Form 10-K 4-2(a) December 1, 1984 1984 Form 10-K 4-2(b) May 15, 1985 1985 Form 10-K 4-2(a) October 1, 1985 1985 Form 10-K 4-2(b) November 15, 1985 1985 Form 10-K 4-2(c) November 15, 1985 1985 Form 10-K 4-2(d) June 1, 1986 1986 Form 10-K 4-2(a) November 1, 1986 1986 Form 10-K 4-2(b) November 1, 1986 1986 Form 10-K 4-2(c) April 1, 1987 33-14613 4(c)-62 July 15, 1987 Form 8-K dated July 21, 1987 4(c)-63 July 15, 1987 Form 8-K dated July 21, 1987 4(c)-64 August 1, 1987 33-17438 4(c)-65 October 15, 1987 Form 8-K dated October 7, 1987 4(c)-66 October 15, 1987 Form 8-K dated October 7, 1987 4(c)-67 April 15, 1988 Form 8-K dated April 11, 1988 4(e)-68 April 15, 1988 Form 8-K dated April 11, 1988 4(e)-69 June 15, 1989 33-31289 4(e)-70 October 1, 1989 Form 8-K dated October 6, 1989 4(e)-71 October 1, 1989 Form 8-K dated October 6, 1989 4(e)-72 October 1, 1989 Form 8-K dated October 18, 1989 4(e)-73 October 15, 1990 1990 Form 10-K 4(e)-74 October 15, 1990 1990 Form 10-K 4(e)-75 April 1, 1991 1991 Form 10-K 4(e)-76 December 1, 1991 1991 Form 10-K 4(e)-77 January 15, 1992 Form 8-K dated January 27, 1992 4(e)-78 April 1, 1992 March 31, 1992 Form 10-Q 4(e)-79 April 1, 1992 March 31, 1992 Form 10-Q 4(e)-80 June 1, 1992 June 30, 1992 Form 10-Q 4(e)-81 June 1, 1992 June 30, 1992 Form 10-Q 4(e)-82 July 15, 1992 June 30, 1992 Form 10-Q 4(e)-83 September 1, 1992 1992 Form 10-K 4(e)-84 September 1, 1992 1992 Form 10-K 4(e)-85 March 1, 1993 1992 Form 10-K 4(e)-86 March 1, 1993 1992 Form 10-K 4(e)-87 May 1, 1993 March 31, 1993 Form 10-Q 4(e)-88 May 1, 1993 March 31, 1993 Form 10-Q 4(e)-89 May 1, 1993 March 31, 1993 Form 10-Q 4(e)-90 August 15, 1993 Form 8-A dated August 19, 1993 4(e)-91 August 15, 1993 Form 8-A dated August 19, 1993 4(e)-92 August 15, 1993 Form 8-A dated August 19, 1993 4(e)-93 November 1, 1993 Form 8-A dated October 27, 1993 4(e)-94 November 1, 1993 Form 8-A dated October 27, 1993 4(e)-95 4-3 Deposit Agreement with respect to $7.96 Cumulative Preferred Stock (Form 8-K dated October 20, 1992, Exhibit 4-5). 4-4 PECO Energy Company Dividend Reinvestment and Stock Purchase Plan, as amended January 28, 1994 (Post-Effective Amendment No. 1 to Registration No. 33-43523, Exhibit 28). 10-1 Pennsylvania-New Jersey-Maryland Interconnection Agreement dated September 26, 1956 (Registration No. 2-13340, Exhibit 13-40) and agreements supplemental thereto: Dated as of File Reference Exhibit No. ----------------------------------------------------------------------------- March 1, 1965 2-38342 5-1(a) January 1, 1971 2-40368 5-1(b) June 1, 1974 2-51887 5-1(c) September 1, 1977 1989 Form 10-K 10-1(a) October 1, 1980 1989 Form 10-K 10-1(b) June 1, 1981 1989 Form 10-K 10-1(c) 10-2 Agreement, dated November 24, 1971, between Atlantic City Electric Company, Delmarva Power & Light Company, Public Service Electric and Gas Company and the Company for ownership of Salem Nuclear Generating Station (1988 Form 10-K, Exhibit 10-3); supplemental agreement dated September 1, 1975; and supplemental agreement dated January 26, 1977 (1991 Form 10-K, Exhibit 10-3). 10-3 Agreement, dated November 24, 1971, between Atlantic City Electric Company, Delmarva Power & Light Company, Public Service Electric and Gas Company and the Company for ownership of Peach Bottom Atomic Power Station; supplemental agreement dated September 1, 1975; and supplemental agreement dated January 26, 1977 (1988 Form 10-K, Exhibit 10-4). 10-4 Deferred Compensation and Supplemental Pension Benefit Plan (1981 Form 10-K, Exhibit 10-16).* 10-5 Philadelphia Electric Company Stock Price Appreciation Plan, effective June 1, 1988 (1988 Form 10-K, Exhibit 4-7).* 10-6 Philadelphia Electric Company 1989 Long-Term Incentive Plan (Registration No. 33-30317, Exhibit 28).* 12-1 Ratio of Earnings to Fixed Charges. 12-2 Ratio of Earnings to Combined Fixed Charges and Preferred Dividends. 13 Management's Discussion and Analysis of Financial Condition and Results of Operations, Consolidated Financial Statements, Notes to Consolidated Financial Statements, Financial Statistics, and Operating Statistics of the Annual Report to Shareholders for the year 1993. 22 Subsidiaries of the Registrant. 23 Consent of Independent Accountants. 24 Powers of Attorney. ---------- * Compensatory plans or arrangements in which directors or officers of the Company participate and which are not available to all employees. Reports on Form 8-K During the quarter ended December 31, 1993, the Company filed a Current Report on Form 8-K, dated December 28, 1993 reporting information under "ITEM 5. OTHER EVENTS" relating to the Company's name change. Subsequent to December 31, 1993, the Company filed no Current Reports on Form 8-K. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant, PECO ENERGY COMPANY, has duly caused this annual report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Philadelphia, and Commonwealth of Pennsylvania, on the 16th day of March 1994. PECO ENERGY COMPANY By /s/ J. F. PAQUETTE, JR. ------------------------------------------ J. F. Paquette, Jr., Chairman of the Board Pursuant to the requirements of the Securities Exchange Act of 1934, this annual report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
354707_1993.txt	354707	1993	ITEM 1. BUSINESS HEI HEI was incorporated in 1981 under the laws of the State of Hawaii and is a holding company with subsidiaries engaged in the electric utility, financial services, freight transportation, real estate development and other businesses, in each case primarily or exclusively in the State of Hawaii. HEI's predecessor, HECO, was incorporated under the laws of the Kingdom of Hawaii (now the State of Hawaii) on October 13, 1891. As a result of a 1983 corporate reorganization, HECO became an HEI subsidiary and common shareholders of HECO became common shareholders of HEI. HECO and its subsidiaries, MECO and HELCO, are regulated operating public utilities providing the only public utility electric service on the islands of Oahu, Maui, Lanai, Molokai and Hawaii. HEI also owns directly or indirectly the following nonelectric public utility subsidiaries which comprise its diversified companies: HEIDI and its subsidiary, ASB, and ASB's subsidiaries; HTB and its subsidiary; MPC and its subsidiaries; HEIIC; and LVI. HEIDI is also the holder of record of the common stock of HIG, which was acquired in 1987 and provided property and casualty insurance primarily in Hawaii. HIG is currently in rehabilitation proceedings and it is expected that HEIDI will relinquish all ownership rights in HIG and its subsidiaries during 1994. See "Discontinued operations--The Hawaiian Insurance & Guaranty Co., Limited." ASB was acquired in 1988, is the second largest savings bank in Hawaii as measured by total assets as of September 30, 1993, and has 45 retail branches as of December 31, 1993. HTB was acquired in 1986 and provides ship assist and charter towing services and owns YB, a regulated intrastate public carrier of waterborne freight among the Hawaiian Islands. MPC was formed in 1985 and develops and invests in real estate. HEIIC was formed in 1984 and is a passive investment company which has sold substantially all of its investments in marketable securities over the last few years and currently plans no new investments. In March of 1993, pursuant to the decision made at the end of the third quarter of 1992, the stock of HERS, formerly an HEI wind energy subsidiary, was sold to The New World Power Corporation and LVI became a direct subsidiary of HEI. See "Discontinued operations -- Hawaiian Electric Renewable Systems, Inc." The financial information about the Company's industry segments is incorporated herein by reference to page 28 of HEI's 1993 Annual Report to Stockholders, portions of which are filed herein as HEI Exhibit 13(a). For additional information about the Company, reference is made to "Management's Discussion and Analysis of Financial Condition and Results of Operations," incorporated herein by reference to pages 29 to 39 of HEI's 1993 Annual Report to Stockholders, portions of which are filed herein as HEI Exhibit 13(a). RATING AGENCIES' ACTIONS On February 8, 1993, Standard & Poor's (S&P) lowered HEI's and HECO's long- term credit ratings. S&P lowered HEI's medium-term note credit rating to BBB from BBB+, citing HECO's reduced credit worthiness and the write-off of HEI's investment in HIG. S&P noted that considerable political and financial uncertainty will remain until the ultimate impact of HIG on HEI is determined. S&P maintained a negative rating outlook reflecting downward pressure on HEI's and HECO's earnings which could intensify in the absence of adequate rate relief for HECO. HEI's commercial paper rating of A-2 was reaffirmed. On February 26, 1993, Duff & Phelps Credit Rating Co. (D&P) lowered HEI's medium-term note rating to BBB+ from A- due to the continuing uncertainty surrounding HEI and its decision to cease operations at HIG. D&P noted that the extent of additional financial responsibility ultimately required, if any, is unknown, which adds risk that was not reflected in D&P's prior rating. HEI's commercial paper rating of Duff 1- (one-minus) was reaffirmed. On February 11, 1994, in response to HEI's announcement that it signed an agreement to settle the lawsuit filed by the Hawaii Insurance Commissioner and Hawaii Insurance Guaranty Association against HEI relating to losses sustained by HIG from Hurricane Iniki, D&P stated that the settlement and additional charge to income fit within the assumptions pertinent to D&P's current ratings for HEI. The settlement agreement is subject to court approval. (See "Discontinued operations -- The Hawaiian Insurance & Guaranty Co., Ltd. for a further discussion on the settlement agreement.) On April 28, 1993, Moody's Investor Service (Moody's) confirmed the credit ratings of HEI, citing HEI's plans to issue additional common equity in order to rebalance its capital structure. Moody's stated that its concerns regarding a lawsuit associated with HIG and stemming from Hurricane Iniki are partially mitigated by the possible long period before a fully litigated decision is reached. The confirmation concluded a review for possible downgrade initiated on December 4, 1992. In October 1993, S&P completed its review of the U.S. investor-owned electric utility industry and concluded that more stringent financial risk standards are appropriate to counter mounting business risk. "S&P believes the industry's credit profile is threatened chiefly by intensifying competitive pressures," the agency said in a statement. It also cited sluggish demand expectations, slow earnings growth prospects, high dividend payouts and environmental cost pressures. Under the new guidelines, S&P rated HECO's business position as average. As of February 11, 1994, HEI's and HECO's S&P, Moody's and D&P security ratings were as follows: N/A Not applicable. (1) S&P. Debt rated BBB or BBB+ is regarded as having an adequate capacity to pay interest and repay principal. Whereas it normally exhibits adequate protection parameters, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity to pay interest and repay principal for debt in this category than in higher rated categories. The ratings may be modified by the addition of a plus or minus sign to show relative standing within the major categories. A commercial paper rating is a current assessment of the likelihood of timely payment of debt having an original maturity of no more than 365 days. Commercial paper rated A-2 indicates that capacity for timely payment on issues is satisfactory. (2) Moody's. Bonds which are rated Baa2 or Baa1 are considered as medium grade obligations, i.e., they are neither highly protected nor poorly secured. Interest payment and principal security appear adequate for the present but certain protective elements may be lacking or may be characteristically unreliable over any great length of time. Such bonds lack outstanding investment characteristics and in fact have speculative characteristics as well. Bonds which are rated A3 possess many favorable investment attributes and are to be considered as upper medium grade obligations. Factors giving security to principal and interest are considered adequate but elements may be present which suggest a susceptibility to impairment sometime in the future. Preferred stock rated baa1 is considered to be a medium grade preferred stock, neither highly protected nor poorly secured. Earnings and asset protection appear adequate at present but may be questionable over a great length of time. Numeric modifiers are added to debt and preferred stock ratings. Numeric modifier 1 indicates that the security ranks in the higher end of its generic rating category and numeric modifier 2 indicates a mid-range ranking. Commercial paper rated P-2 is considered to have a strong ability for repayment of senior short-term obligations. This will normally be evidenced by the following characteristics: a) leading market positions in well- established industries, b) high rates of return on funds employed, c) conservative capitalization structure with moderate reliance on debt and ample asset protection, d) broad margins in earnings coverage of fixed financial charges and high internal cash generation and e) well established access to a range of financial markets and assured sources of alternate liquidity. Earnings trends and coverage ratios, while sound, may be more subject to variation. Capitalization characteristics, while still appropriate, may be more affected by external conditions. Ample alternate liquidity is maintained. (3) Duff & Phelps. Debt rated BBB+ is regarded as having below average protection factors, but still considered sufficient for prudent investment. There may be considerable variability in risk during economic cycles. Debt rated A or A- is considered to have protection factors that are average but adequate. However, risk factors are more variable and greater in periods of economic stress. Commercial paper rated Duff 1- indicates a high certainty of timely payment. Liquidity factors are strong and supported by good fundamental protection factors. Risk factors are very small. Each security rating listed above is not a recommendation to buy, sell or hold securities. Each rating may be subject to revision or withdrawal at any time by the assigning rating organization and should be evaluated independently of any other rating. Neither HEI nor HECO management can predict with certainty future rating agency actions or their effects on the future cost of capital of HEI or HECO. ELECTRIC UTILITY HECO AND SUBSIDIARIES AND SERVICE AREAS HECO, MECO and HELCO are regulated operating electric public utilities engaged in the production, purchase, transmission, distribution and sale of electricity on the islands of Oahu; Maui, Lanai and Molokai; and Hawaii, respectively. HECO acquired MECO in 1968 and HELCO in 1970. In 1993, the electric utilities contributed approximately 77% of HEI's consolidated revenues from continuing operations and approximately 76% of HEI's consolidated operating income from continuing operations, excluding unallocated corporate expenses and eliminations. At December 31, 1993, the assets of the electric utilities represented approximately 38% of the total assets of the Company, excluding assets at the corporate level and eliminations. For additional information about the electric utilities, see "Management's Discussion and Analysis of Financial Condition and Results of Operations," incorporated herein by reference to pages 29 to 39 of HEI's 1993 Annual Report to Stockholders, portions of which are filed herein as HEI Exhibit 13(a) and pages 3 to 9 of HECO's 1993 Annual Report to Stockholder, portions of which are filed herein as HECO Exhibit 13(b). The islands of Oahu, Maui, Lanai, Molokai and Hawaii have a combined population estimated at 1,104,000, or approximately 95% of the population of the State of Hawaii, and cover a service area of 5,766 square miles. The principal communities served include Honolulu (on Oahu), Wailuku and Kahului (on Maui) and Hilo and Kona (on Hawaii). The service areas also include numerous suburban communities, resorts, U.S. Armed Forces installations and agricultural operations. HECO, MECO and HELCO have nonexclusive franchises from the state covering certain areas and authorizing them to construct, operate and maintain facilities over and under public streets and sidewalks. HECO's franchise covers the City & County of Honolulu, MECO's franchises cover the islands of Maui, Lanai and Molokai in the County of Maui and the small County of Kalawao on the island of Molokai, and HELCO's franchise covers the County of Hawaii. Each of these franchises will continue in effect for an indefinite period of time until forfeited, altered, amended or repealed. SALES OF ELECTRICITY HECO, MECO and HELCO provide the only electric public utility service on the islands they serve. The following table sets forth the numberEof their electric customer accounts as of December 31, 1993, 1992 and 1991 and their electric sales revenues for each of the years then ended: (1) Includes the effect of the change in the method of estimating unbilled kilowatthour sales and revenues. Revenues from the sale of electricity in 1993 were from the following types of customers in the proportions shown: Total electricity sales for all three utilities in 1993 were 8,325 million kilowatthours (KWH), a 0.1% decrease from 1992 sales. The relatively low sales in 1993 reflect cooler weather, the slowing in the state economy and conservation efforts. Approximately 10% of consolidated operating revenues of HECO and its subsidiaries was derived from the sale of electricity to various federal government agencies in 1993, 1992 and 1991. HECO's fifth largest customer, the Naval Base at Barbers Point, Oahu, is expected to be closed within the next four to five years. On March 8, 1994, President Clinton signed an Executive Order which mandates that each federal agency develop and implement a program with the intent of reducing energy consumption by 30% by the year 2005 to the extent that these measures are cost-effective. The 30% reductions will be measured relative to the agency's 1985 energy use. HECO is working with various Department of Defense installations to implement demand-side management programs which will help them achieve their energy reduction objectives. It is expected that several Department of Defense installations will sign a Basic Ordering Agreement under which HECO will implement the energy conservation projects. Neither HEI nor HECO management can predict with certainty the impact of President Clinton's Executive Order on the Company's or consolidated HECO's future results of operations. SELECTED CONSOLIDATED ELECTRIC UTILITY OPERATING STATISTICS * Sum of the peak demands on all islands served, noncoincident and nonintegrated. Includes the effect of the change in the method of estimating unbilled KWH sales and revenues. * Excluding the effect of the change in the method of estimating unbilled KWH sales and revenues, losses and system uses would have been 5.6%. GENERATION STATISTICS The following table contains certain generation statistics as of December 31, 1993, and for the year ended December 31, 1993. The capability available for operation at any given time may be less than the generating capability shown because of temporary outages for inspection, maintenance, repairs or unforeseen circumstances. (1) HECO units at normal ratings less 14.0 MW due to capability restrictions, and MECO and HELCO units at reserve ratings. (2) Noncoincident and nonintegrated. (3) Independent power producers - 180.0 MW (Kalaeloa), 180.0 MW (AES-BP) and 46.0 MW (HRRV). (4) Non-utility generation-MECO: 16.0 MW (Hawaiian Commercial & Sugar Company) and HELCO: 25.0 MW (Puna Geothermal Ventures), 18.0 MW (HCPC) and 8.0 MW (Hamakua Sugar Company). Hamakua Sugar Company filed for bankruptcy in 1992 and is expected to discontinue operations in 1994. REQUIREMENTS AND PLANS FOR ADDITIONAL GENERATING CAPACITY Each of the three utilities completed its first Integrated Resource Plan (IRP) in 1993. These plans identified and evaluated a mix of resources to meet near- and long-term consumer energy needs in an efficient and reliable manner at the lowest reasonable cost. The IRPs include demand-side management (DSM) programs to reduce load and fuel consumption and consider the impact on the environment, culture, community lifestyles and economy of the state. On July 1, 1993, HECO filed its first Integrated Resource Plan with the Hawaii Public Utilities Commission (PUC). This plan was subsequently modified in January 1994 due to a change in load forecast. The decrease in the load forecast, the inclusion of the impact of proposed DSM programs, and the deferred retirement of Honolulu Unit Nos. 8 & 9 until 2004, allowed HECO to defer its next generating unit addition to the year 2005. In its plan, HECO recommended that this next generating unit be a coal-fired atmospheric fluidized bed combustion unit to provide a fuel alternative to oil. Because of the uncertainty of the impact of new environmental regulations and the political pressure to remove Honolulu Power Plant from downtown Honolulu earlier than the 2004 time frame, alternate plans are being developed to add generating capacity earlier if necessary. MECO completed construction of its first 58-MW dual-train combined-cycle facility in 1993 at a cost of $78 million. On December 15, 1993, MECO filed its first IRP with the PUC. MECO plans to add a second dual-train combined-cycle unit with the addition of a 20-MW combustion turbine (CT) in 1996, another 20-MW CT in 1999 and the conversion of these units into a 58-MW combined-cycle unit with the addition of an 18-MW steam turbine in 2000. MECO's Molokai Division plans to purchase three 2.2-MW diesel units; two in 1995 and one in 1996. MECO's Lanai Division plans to add three 2.2-MW diesel units in 1996. On October 15, 1993, HELCO filed its first IRP with the PUC. HELCO has a power purchase agreement with Puna Geothermal Ventures (PGV) for 25 MW which became a firm source of power on June 27, 1993. Hamakua Sugar Company filed for bankruptcy in 1992 and ceased power production on May 7, 1993, but resumed on July 15, 1993, under a court-approved harvest plan which is expected to continue over a period of 10 to 16 months. It is expected that Hamakua's capacity of 8MW will be unavailable to HELCO by the end of 1994. Hilo Coast Processing Company (HCPC) will discontinue harvesting sugar cane in late 1994 and has indicated that it may increase its power export capability and switch its primary fuel from bagasse (sugarcane waste) to coal. This would require a new modified power purchase agreement, which would be subject to PUC approval. For capacity planning, HELCO assumed that HCPC would continue to provide 18 MW of firm power to HELCO under the existing power purchase agreement. The installation of a phased combined-cycle unit is proceeding. The service date for the first CT, CT-4, is scheduled for July 1, 1995 pending Conservation District Use Application approval at the existing Keahole Power Plant site. Although capacity after CT-4 is not required until April 1996, CT-5 is scheduled to be installed immediately after CT-4 in September 1995 based on economies of the earlier schedule which allows HELCO to use the same construction contract as CT-4. In addition, the earlier schedule permits HELCO to proceed with the planned retirements of its older, less efficient units and to mitigate uncertainties with respect to deliveries from HELCO's power purchase producers. Conversion of CT-4 and CT-5 to combined-cycle operation with the addition of a steam unit, ST-7 is expected to occur by October 1997. NONUTILITY GENERATION The Company has supported state and federal energy policies which encourage the development of alternate energy sources that reduce dependence on fuel oil. Alternate energy sources range from wind, geothermal and hydroelectric power, to energy produced by the burning of bagasse. Other nonoil projects include a generating unit burning municipal waste and a fluidized bed unit burning coal. HECO currently has three major power purchase agreements. In general, HECO's payments under these power purchase agreements are based upon available capacity and energy. Payments for capacity generally are not required if the contracted capacity is not available, and payments are reduced, under certain conditions, if available capacity drops below contracted levels. In general, the payment rates for capacity have been predetermined for the terms of the agreements. The energy charges will vary over the terms of the agreements and HECO may pass on changes in the fuel component of the energy charges to customers through energy cost adjustment clauses in its rate schedules. HECO does not operate nor does it participate in the operation of any of the facilities that provide power under the three agreements. Title to the facilities does not pass to HECO upon expiration of the agreements, and the agreements do not contain bargain purchase options with respect to the facilities. In March 1988, HECO entered into a power purchase agreement with AES Barbers Point, Inc. (AES-BP), a Hawaii-based cogeneration subsidiary of Applied Energy Services, Inc. (AES) of Arlington, Virginia. The agreement with AES-BP, as amended in August 1989, provides that, for a period of 30 years, HECO will purchase 180 MW of firm capacity, under the control of HECO's system dispatcher. The AES-BP 180-MW coal-fired cogeneration plant utilizes a "clean coal" technology and became operational in September 1992. The facility is designed to sell sufficient steam to qualify under the Public Utility Regulatory Policies Act of 1978 (PURPA) as an unregulated cogenerator. HECO entered into an agreement in October 1988 with Kalaeloa Partners, L.P. (Kalaeloa) a limited partnership whose sole general partner is an indirect, wholly owned subsidiary of ASEA Brown Boveri, Inc., which has guaranteed certain of Kalaeloa's obligations and, through affiliates, has contracted to design, build, operate and maintain the facility. The agreement with Kalaeloa, as amended, provides that HECO will purchase 180 MW of firm capacity for a period of 25 years. The Kalaeloa facility, which was completed in the second quarter of 1991, is a combined-cycle operation, consisting of two oil-fired combustion turbines and a steam turbine which utilizes waste heat from the combustion turbines. The facility is designed to sell sufficient steam to qualify under PURPA as an unregulated cogenerator. HECO has also entered into a power purchase contract and a firm capacity amendment with Honolulu Resource Recovery Venture (HRRV), which has built a 60- MW refuse-fired plant. The HRRV unit began to provide firm energy in the second quarter of 1990 and currently supplies HECO with 46 MW of firm capacity. The PUC has approved and allowed rate recovery for the costs related to HECO's three major power purchase agreements, which provide a total of 406 MW of firm capacity, representing 24% of HECO's total generating and firm purchased capability on the island of Oahu as of December 31, 1993. Assuming that the three independent power producers operate at the minimum availability criteria in the power purchase agreements, aggregate fixed capacity charges under the three major agreements are expected to be between approximately $95 million and $98 million annually from 1994 through 2015, $73 million in 2016, between $59 million and $62 million annually from 2017 through 2021, and $46 million in 2022. As of December 31, 1993, HELCO and MECO had power purchase agreements for 51 MW and 16 MW of firm capacity, respectively, representing 25% and 7% of their respective total generating and firm purchased capabilities. Assuming that the independent power producers operate at the minimum availability criteria in the power purchase agreements, aggregate fixed capacity charges are expected to be approximately $9 million annually in 1994 and 1995, $8 million from 1996 through 1999, $6 million from 2000 through 2002 and $4 million annually from 2003 through 2028. HELCO has a power purchase agreement with PGV for 25 MW of firm capacity. PGV, an independent geothermal power producer which experienced substantial delays in commencing commercial operations, passed an acceptance test in June 1993 and is now considered to be a firm capacity source for 25 MW. HERS owned and operated a windfarm on the island of Oahu and sold the electricity it generated to HECO. The windfarm consisted of 14 600-KW and one 3,200-KW wind turbines. In March 1993, HEI sold the stock of HERS to The New World Power Corporation with the power purchase agreements between HERS and HECO continuing in effect. The stock of LVI was transferred to HEI prior to the sale of HERS. LVI's windfarm on the island of Hawaii consists of 54 20-KW and 34 17.5-KW wind turbines. LVI sells its electricity to HELCO and the Hawaii County Department of Water Supply. See "Discontinued operations--Hawaiian Electric Renewable Systems, Inc." Hamakua Sugar Company has been operating under Federal Bankruptcy Court protection since August 1992. Hamakua is presently in a Chapter 11 bankruptcy proceeding and is conducting a final sugar cane harvest over a period of 10 to 16 months, which began in July 1993. During the harvest, Hamakua has agreed to supply HELCO with 8 MW of firm capacity under an amendment to HELCO's existing power purchase agreement. HELCO has a power purchase agreement with Hilo Coast Processing Company (HCPC) for 18 MW of firm capacity. On July 31, 1992, C. Brewer and Company, Limited publicly announced that Mauna Kea Agribusiness, which is the primary supplier of sugar cane processed by HCPC, will begin converting its acreage to macadamia nuts, eucalyptus trees and other diversified crops as of November 1, 1992, and will discontinue harvesting sugar cane in late 1994. The announcement also indicated that, after the last sugar harvest, HCPC's primary fuel would be coal, supplemented by macadamia nut husks and other biomass material. It is HELCO's understanding that HCPC plans to continue supplying power after 1994 (and may even be in a position to supply more than 18 MW after its sugar processing operations are discontinued), and HELCO has assumed that HCPC's commitment to provide 18 MW of capacity will remain in effect for the current term of the contract, which ends December 31, 2002. BHP Petroleum Americas (Hawaii) Inc. (BHPH), formerly Pacific Resources, Inc., stopped hauling heavy fuel oil from Oahu to the other Hawaiian Islands at the end of May 1992. This may continue to affect the ability of the sugar companies, which relied on the oil delivered by BHPH, to supply power to HELCO and MECO. In light of this situation, some of the sugar companies have or are considering conversion to alternative fuels. Although it currently appears that heavy fuel oil will continue to be commercially available, in the event of the unavailability of heavy fuel oil, certain nonutility generators of electricity with contracts with HELCO and MECO may need to use a more expensive alternative fuel such as diesel. The legislation amending the state Environmental Response Law allows these producers, subject to PUC approval, to charge the utilities rates for energy purchases reflecting their higher fuel costs rather than the currently approved rates and, in turn, permits each utility to pass on the increases to its customers through an automatic rate adjustment clause. To minimize the rate increase of any one utility, the legislation permits the PUC, under certain conditions, to utilize a statewide automatic adjustment clause. In 1993, HELCO received PUC approval for recovery of the higher fuel costs incurred by HCPC. FUEL OIL USAGE AND SUPPLY All rate schedules of the Company's electric utility subsidiaries contain energy cost adjustment clauses whereby the charges for electric energy (and consequently the revenues of the subsidiaries generally) automatically vary with the weighted average price paid for fuel oil and certain components of purchased energy, and the relative amounts of company-generated and purchased power. Accordingly, changes in fuel oil and purchased energy costs are passed on to customers. See "Electric utility -- Rates." HECO's steam power plants burn low sulfur residual fuel oil. HECO's combustion turbines (peaking units) on Oahu burn diesel fuel. MECO and HELCO burn medium sulfur industrial fuel oil in their steam generating plants and diesel fuel in their diesel engine and combustion turbine generating units. In the second half of 1993, HECO concluded agreements with Chevron, U.S.A., Inc. (CUSA) and BHP Petroleum Americas Refining Inc. (BHP), formerly Hawaiian Independent Refinery, Inc., to purchase supplies of low sulfur fuel oil for a two-year term commencing January 1, 1994. The PUC approved these agreements and issued a final order in December 1993 permitting inclusion of costs under the contracts in the energy cost adjustment clause. HECO pays market-related prices for fuel purchases made under these contracts. HECO, MECO and HELCO have extended a contract with CUSA under which they will purchase No. 2 diesel fuel over a period of two years beginning January 1, 1994. The Company's utility subsidiaries jointly purchase medium sulfur residual fuel oil under this same contract and together purchase diesel fuel and residual fuel oil under a recently extended contract with BHP. The contracts with CUSA and BHP have been approved by the PUC which issued a final order in December 1993 permitting inclusion of costs under the contracts in the respective utility's energy cost adjustment clause. Diesel fuel and residual fuel oil supplies purchased under these agreements are priced on a market-related basis. The diesel fuel supplied to the Lanai Division of MECO is provided under an agreement with the CUSA jobber (i.e., wholesale merchant) on Lanai. The Molokai Division of MECO receives diesel fuel supplies through the joint purchase contract between HECO, MECO and HELCO and CUSA referred to above. The low sulfur residual fuel oil burned by HECO on Oahu is derived primarily from Indonesian and domestic crude oils. The medium sulfur residual fuel oil burned by MECO and HELCO is generally derived from domestic crude oil. The fuel oil commitments information in Note 11 to HECO's Consolidated Financial Statements is incorporated herein by reference to page 24 of HECO's 1993 Annual Report to Stockholder, portions of which are filed herein as HECO Exhibit 13(b). The following table sets forth the average costs of fuel oil used to generate electricity in the years 1993, 1992 and 1991: The average cost per barrel of fuel oil used to generate electricity for HECO, MECO and HELCO reflects the different fuel mix of each company. HECO uses primarily low sulfur residual fuel oil, MECO uses a significant amount of diesel fuel and HELCO uses primarily medium sulfur residual fuel oil and a lesser amount of diesel fuel. In general, medium sulfur fuel oil is the least costly per barrel and diesel fuel is the most expensive. During 1993, the prices of diesel fuel and low sulfur oil declined, while the price of medium sulfur fuel oil displayed no sustained trend. HTB was contractually obligated to ship heavy fuel oil for HELCO and MECO through December 1993. Effective December 31, 1993, HTB exited the heavy fuel oil shipping business. See "Regulation and other matters -- Environmental regulation -- Water quality controls." HELCO and MECO carried out a bidding process to determine who would ship heavy fuel oil beyond 1993. Several bids were received and evaluated and two contracts have been signed with Hawaiian Interisland Towing, Inc., subject to PUC approval (which has been obtained on an interim basis). HELCO and MECO have also begun to convert their generating plants from burning heavy fuel oil to burning either heavy fuel oil or diesel fuel in the event heavy fuel oil is no longer available in the future. Diesel fuel does not pose the same environmental liability concerns as heavy fuel oil, but it is more expensive and the use of diesel fuel could significantly increase HELCO's and MECO's electric rates. Conversion would assure HELCO and MECO more flexibility by permitting use of another type of fuel besides heavy fuel oil. In 1994, it is estimated that 75% of the net energy generated and purchased by HECO and its subsidiaries will come from oil, down from 77% in 1993. Failure by the Company's oil suppliers to provide fuel pursuant to the supply contracts and/or extremely high fuel prices could adversely affect HECO and its subsidiaries' and the Company's financial condition and results of operations. RATES HECO, MECO and HELCO are subject to the regulatory jurisdiction of the PUC with respect to rates, standards of service, issuance of securities, accounting and certain other matters. See "Regulation and other matters -- Electric utility regulation." All rate schedules of HECO and its subsidiaries contain an energy cost adjustment clause to reflect changes in the price paid for fuel oil and certain components of purchased power, and the relative amounts of company-generated and purchased power. Under current law and practices, specific and separate PUC approval is not required for each rate change pursuant to automatic rate adjustment clauses previously approved by the PUC. Rate increases, other than pursuant to such automatic adjustment clauses, require the prior approval of the PUC after public and contested case hearings. PURPA requires the PUC to periodically review the energy cost adjustment clauses of electric and gas utilities in the state, and such clauses, as well as the rates charged by the utilities generally, are subject to change. The PUC has broad discretion in its regulation of the rates charged by the Company's utility subsidiaries. Any adverse decision by the PUC concerning the level or method of determining electric utility rates, the authorized returns on equity or other matters or any delay in rendering a decision in a rate proceeding could have a material adverse effect on consolidated HECO's and the Company's financial condition and results of operations. Upon a showing of probable entitlement, the PUC is required to issue an interim decision in a rate case within 10 months from the date of filing a complete application if the evidentiary hearing is completed -- subject to extension for 30 days if the evidentiary hearing is not completed. However, there is no time limit for rendering a final decision. HECO Rate increase. On July 29, 1991, HECO applied to the PUC for permission to increase electric rates on the island of Oahu in 1992. The rates requested would have provided approximately $138 million in annual revenues, or approximately 26.4% over HECO's then existing rates, based on January 1, 1992 fuel oil and purchased energy prices. The request was based on a 13.5% return on average common equity. On June 30, 1992, HECO received a final decision and order from the PUC. The decision and order granted an increase of $124 million in annual revenues, based on a 13.0% return on average common equity. The increase took effect in steps in 1992. $28 million of the $124 million increase was granted in the interim decision effective April 1, 1992. A step increase of $2.3 million in annual revenues became effective July 8, 1992. Approximately $93 million of the $124 million increase represented a pass-through of costs when HECO began purchasing generating capacity from independent power producer AES-BP in September 1992. The increase is subject to possible adjustments for postretirement benefits other than pensions. The major reason for the difference between revenues requested in HECO's application and the revenues granted by the PUCO's final decision and order relates to postretirement benefits other than pensions expense. HECO requested $11 million in annual revenues to cover the additional expense required under SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." The PUC has opened a separate generic docket on postretirement benefits other than pensions and indicated that the total increase granted in the final decision and order will be adjusted to reflect its decision in that docket. The PUC has not yet issued a final decision and order in this generic docket. The information on postretirement benefits other than pensions in Note 10 to HECO's Consolidated Financial Statements is incorporated herein by reference to pages 23 to 24 of HECO's 1993 Annual Report to Stockholder, portions of which are filed herein as HECO Exhibit 13(b). Pending rate requests. On July 26, 1993, HECO applied to the PUC for permission to increase electric rates, using a 1994 test year and requesting rates designed to produce an increase of approximately $62 million in annual revenues over the revenues provided by rates currently in effect. HECO subsequently revised its rate request from $62 million to approximately $54 million by the close of the evidentiary hearings held in March 1994. The revision resulted primarily from rescheduling certain capital projects from 1994 to 1995, and agreements among the parties with respect to certain issues. The requested increase, as revised, is based on a 12.75% return on average common equity and is needed to cover rising operating costs and the cost of new capital projects to maintain and improve service reliability. In addition, the requested increase includes approximately $9 million for costs arising out of the change to accrual accounting for postretirement benefits other than pensions, and the amount of the required increase will be reduced to the extent that rate relief for these costs is received in another proceeding. The information on postretirement benefits other than pensions in Note 10 to HECO's Consolidated Financial Statements is incorporated herein by reference to pages 23 to 24 of HECO's 1993 Annual Report to Stockholder, portions of which are filed herein as HECO Exhibit 13(b). HECO has requested an interim increase of approximately $39 million by April 1994, and the remainder of the requested increase in steps in 1994. On December 27, 1993, HECO applied to the PUC for permission to increase electric rates, using a 1995 test year and requesting rates designed to produce an increase of approximately $44 million in annual revenues over revenues provided by the initially proposed 1994 rates. As a result of revisions to the rate increase requested in 1994, the requested increase would be approximately $52 million over revenues provided by proposed 1994 rates. The increase requested by HECO is based on a 12.3% return on average common equity. The rate request based on a 1995 test year is in addition to HECO's pending $54 million rate increase requested for 1994. Both requests combined represent a 16.7% increase, or $106 million, over present rates. Revenue from the proposed increase would be used in part to cover the costs of major transmission and distribution projects on Oahu, including an important transmission corridor to connect power plants on the island's west side with customers throughout Oahu. The 1995 application includes requests for approximately $15 million for additional expenses associated with proposed changes in depreciation rates and methods and $7 million to establish a self-insured property damage reserve for transmission and distribution property in the event of catastrophic disasters. HECO seeks to establish the requested reserve because HECO is self-insured for damage to its transmission and distribution property, except substations. (HECO's subsidiaries are similarly self-insured.) Also, a heightened concern for the risk of loss of this property has grown out of the loss of virtually the entire transmission and distribution system of the unaffiliated electric utility serving the island of Kauai as a result of Hurricane Iniki in September 1992. HECO anticipates that evidentiary hearings on the 1995 application will be held in late 1994. HELCO Rate increase. On July 31, 1991, HELCO asked the PUC to increase rates by $7.5 million a year, or 7.5%. The request was based on a 13.5% return on average common equity and a 1992 test year. On October 2, 1992, HELCO received a final decision and order from the PUC authorizing a total increase of $3.9 million in annual revenues, based on a 13.0% return on average common equity. HELCO's original request for rate increase included approximately $1.9 million to cover the increased cost of postretirement benefits other than pensions, and this request will be considered in a separate generic docket. The PUC has not yet issued a final decision and order in this generic docket. The information on postretirement benefits other than pensions in Note 10 to HECO's Consolidated Financial Statements is incorporated herein by reference to pages 23 to 24 of HECO's 1993 Annual Report to Stockholder, portions of which are filed herein as HECO Exhibit 13(b). Other rate adjustments could be made based on the results of the PUC's study of HELCO's service reliability. See "Item 3. Legal Proceedings--HELCO reliability investigation." Pending rate request. On November 30, 1993, HELCO applied to the PUC for permission to increase electric rates, using a 1994 test year and requesting rates designed to produce an increase of approximately $15.8 million in annual revenues, or 13.4%, over revenues provided by rates currently in effect. The requested increase is based on a 12.4% return on average common equity and is needed to cover plant, equipment and operating costs to maintain and improve service and provide reliable power for its customers. HELCO anticipates that evidentiary hearings will be held later this year. MECO Pending rate request. In November 1991, MECO filed a request to increase rates by approximately $18.3 million annually, or approximately 17% above the rates in effect at the time of the filing, in several steps. Most of the proposed increase reflected the costs of adding a 58-MW combined-cycle generating unit on Maui in three phases and the costs related to the change in the method of accounting for postretirement benefits other than pensions. Evidentiary hearings were held in January 1993. At the conclusion of the hearings, MECO's final requested increase was adjusted to approximately $11.4 million annually, or approximately 10%, in several steps in 1993. The decrease in the requested rate increase resulted primarily from a reduced cost of capital, lower administrative and general expenses and other revisions to MECO's estimated revenue requirements for the 1993 test year used in the rate case. MECO's revised request reflected a return on average common equity of 13.0%. On January 29, 1993, MECO received an initial interim decision authorizing an annual increase of $2.8 million, or 2.4%, effective February 1, 1993. This interim decision covered, among other things, the costs associated with the first phase of the 58-MW combined-cycle generating unit, which had been placed in service on May 1, 1992. In the interim decision the PUC used a rate of return on average common equity of 12.75% in light of a drop in interest rates and changes in economic conditions since HECO's and HELCO's most recent rate case decisions and orders. The PUC also stated that MECO is less dependent on purchased power than HECO or HELCO, and that MECO's return on average common equity will be more extensively reviewed for purposes of the final decision and order. On May 7, 1993, MECO received a second interim decision authorizing a step increase of an additional $4 million in annual revenues, or 3.6%, effective May 8, 1993. This step increase covered the estimated annual costs of the second phase of the 58-MW combined-cycle generating unit, a combustion turbine which was placed into service on May 1, 1993. On October 21, 1993, MECO received a third interim decision authorizing a step increase of an additional $1 million in annual revenues, or 0.9%, effective October 21, 1993. This step increase covered the estimated annual costs of the third and final phase of the combined-cycle generating unit, which was placed into service on October 1, 1993. On December 9, 1993, MECO received a fourth interim decision authorizing a step increase of an additional $0.4 million in annual revenues, effective December 10, 1993, to cover wage increases that became effective on November 1, 1993. These interim increases are subject to refund with interest, pending the final outcome of the case. MECO's management cannot predict with certainty when a final decision in MECO's rate case will be rendered or the amount of the final rate increase that will be granted. SAVINGS BANK -- AMERICAN SAVINGS BANK, F.S.B. GENERAL ASB was granted a charter as a federal savings bank in January 1987. Prior to that time, ASB operated as the Hawaii division of American Savings & Loan Association of Salt Lake City, Utah since 1925. At September 30, 1993, ASB's total assets were $2.5 billion and it was the second largest savings and loan institution in Hawaii based on total assets. ASB was acquired by the Company for approximately $115 million on May 26, 1988. The acquisition was accounted for using the purchase method of accounting. Accordingly, tangible assets and liabilities were recorded at their estimated fair values at the acquisition date. The acquisition was approved by the Federal Home Loan Bank Board (FHLBB) which required HEI to enter into a Regulatory Capital Maintenance/Dividend Agreement (the FHLBB Agreement). Under the FHLBB Agreement, HEI agreed that ASB's regulatory capital would be maintained at a level of at least 6% of ASB's total liabilities, or at such greater amount as may be required from time to time by regulation. Under the FHLBB Agreement, HEI's obligation to contribute additional capital was limited to a maximum aggregate amount of approximately $65.1 million. HEI elected to contribute additional capital of $0.8 million and $24.0 million to ASB during 1993 and 1992, respectively. The FHLBB Agreement also included limitations on ASB's ability to pay dividends. Under the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA), the regulations of the FHLBB and the FHLBB Agreement were transferred to the Office of Thrift Supervision (OTS). Effective December 23, 1992, ASB was granted a release from the dividend limitations imposed under the FHLBB Agreement. ASB is subject to the OTS regulations for dividends and other distributions applicable to financial institutions regulated by the OTS. ASB acquired First Nationwide Bank's Hawaii branches and deposits on October 6, 1990. The acquisition increased ASB's statewide retail branch network from 36 to 45 branches and its deposit base by $247 million, and provided approximately $239 million in cash. ASB's earnings depend primarily on its net interest income -- the difference between the interest income earned on interest-earning assets (loans receivable, mortgage-backed securities and investments) and the interest expense incurred on interest-bearing liabilities (deposit liabilities and borrowings). Deposits traditionally have been the principal source of ASB's funds for use in lending, meeting liquidity requirements and making investments. ASB also derives funds from receipt of interest and principal on outstanding loans receivable, borrowings from the Federal Home Loan Bank (FHLB) of Seattle, securities sold under agreements to repurchase and other sources, including collateralized medium-term notes. For additional information about ASB, reference is made to Note 5 to HEI's Consolidated Financial Statements, incorporated herein by reference to pages 53 through 57 of HEI's 1993 Annual Report to Stockholders, portions of which are filed herein as HEI Exhibit 13(a). The following table sets forth selected data for ASB for the periods indicated: (1) Net income includes amortization of goodwill and core deposit intangibles. (2) Reflects allocation of corporate-level expenses for segment reporting purposes, which were not billed to ASB. In the second quarter of 1992, HEI changed its method of billing corporate-level expenses to ASB. Under the new billing procedure, only certain direct charges, rather than fully-allocated costs, are billed to ASB. However, no change was made by HEI in the manner in which corporate-level expenses were allocated for segment reporting purposes. CONSOLIDATED AVERAGE BALANCE SHEET The following table sets forth average balances of major balance sheet categories for the periods indicated. Average balances for each period have been calculated using the average month-end balances during the period. ASSET/LIABILITY MANAGEMENT Interest rate sensitivity refers to the relationship between market interest rates and net interest income resulting from the repricing of interest-earning assets and interest-bearing liabilities. Interest rate risk arises when an interest-earning asset matures or when its interest rate changes in a time frame different from that of the supporting interest-bearing liability. Maintaining an equilibrium between rate sensitive interest-earning assets and interest-bearing liabilities will reduce some interest rate risk but it will not guarantee a stable net interest spread because yields and rates may change simultaneously or at different times and such changes may occur in differing increments. Market rate fluctuations could materially affect the overall net interest spread even if interest-earning assets and interest-bearing liabilities were perfectly matched. The difference between the amounts of interest-earning assets and interest-bearing liabilities that reprice during a given period is called "gap." An asset-sensitive position or "positive gap" exists when more assets than liabilities reprice within a given period; a liability-sensitive position or "negative gap" exists when more liabilities than assets reprice within a given period. A positive gap generally produces more net interest income in periods of rising interest rates and a negative gap generally produces more net interest income in periods of falling interest rates. As rates in 1993 have remained at low levels, the gap in the near term (0-6 months) was a negative 4.1% of total assets as compared to a cumulative one-year positive gap position of 3.2% of total assets as of December 31, 1993. The negative near-term gap position reflects customers moving more interest sensitive funds into liquid passbook deposits. The cumulative one-year 1993 "positive gap" was primarily due to a very low interest rate environment that led to faster prepayments of fixed rate loans with high interest rates coupled with the increase of noninterest rate sensitive passbook deposits with a life expectancy of greater than a year. The following table shows ASB's interest rate sensitivity at December 31, 1993: (1) The table does not include $183 million of noninterest-earning assets and $53 million of noninterest-bearing liabilities. (2) The difference between the total interest-earning assets and the total interest-bearing liabilities. INTEREST INCOME AND INTEREST EXPENSE The following table sets forth average balances, interest and dividend income, interest expense and weighted average yields earned and rates paid, for certain categories of interest-earning assets and interest-bearing liabilities for the periods indicated. Average balances for each period have been calculated using the average month-end balances during the period. (1) ASB has no material amount of tax-exempt investments for periods shown. (2) Excludes nonrecurring items. The following table shows the effect on net interest income of (1) changes in interest rates (change in weighted average interest rate multiplied by prior period average portfolio balance) and (2) changes in volume (change in average portfolio balance multiplied by prior period rate). Any remaining change is allocated to the above two categories on a pro rata basis. OTHER INCOME In addition to net interest income, ASB has various sources of other income, including fee income from servicing loans, fees on deposit accounts, rental income from premises and other income. Other income totaled approximately $11.1 million in 1993, compared to $10.4 million in 1992 and $9.7 million in 1991. LENDING ACTIVITIES General. ASB's net loan and mortgage-backed securities portfolio totaled approximately $2.4 billion at December 31, 1993, representing 90.3% of its total assets, compared to $2.2 billion, or 88.3%, and $2.0 billion, or 89.7%, at December 31, 1992 and 1991, respectively. ASB's loan portfolio consists primarily of conventional residential mortgage loans which are not insured by the Federal Housing Administration (FHA) nor guaranteed by the Veterans Administration. At December 31, 1993, mortgage-backed securities represented 26.7% of the loan and mortgage-backed securities portfolio, compared to 32.7% at December 31, 1992 and 41.1% at December 31, 1991. The following tables set forth the composition of ASB's loan and mortgage- backed securities portfolio: (1) Includes renegotiated loans. (1) Includes renegotiated loans. Origination, purchase and sale of loans. Generally, loans originated and purchased by ASB are secured by real estate located in Hawaii. As of December 31, 1993, approximately $11.9 million of loans which were purchased from other lenders were secured by properties located in the continental United States. For additional information, including information concerning the geographic distribution of ASB's mortgage-backed securities portfolio, reference is made to Note 20 to HEI's Consolidated Financial Statements, incorporated herein by reference to page 67 of HEI's 1993 Annual Report to Stockholders, portions of which are filed herein as HEI Exhibit 13(a). The following table shows the amount of loans originated for the years indicated: Residential mortgage lending. During 1993, the demand for adjustable rate mortgage (ARM) loans over fixed rate loans decreased compared with 1992. ARM loans carry adjustable interest rates which are typically set according to a short-term index. Payment amounts may be adjusted periodically based on changes in interest rates. ARM loans represented approximately 24.7% of the total originations of first mortgage loans in 1993, compared to 34.0% and 27.4% in 1992 and 1991, respectively. ASB intends to continue to emphasize the origination and purchase of ARM loans to further improve its asset/liability management. ASB is permitted to lend up to 100% of the appraised value of the real property securing a loan. Its general policy is to require private mortgage insurance when the loan-to-value ratio of owner-occupied property exceeds 80% of the lower of the appraised value or purchase price. On nonowner-occupied residential properties, the loan-to-value ratio may not exceed 80% of the lower of the appraised value or purchase price. Construction and development lending. ASB provides both fixed and adjustable rate loans for the construction of one-to-four residential unit and commercial properties. Construction and development financing generally involves a higher degree of credit risk than long-term financing on improved, occupied real estate. Accordingly, all construction and development loans are priced higher than loans secured by completed structures. ASB's underwriting, monitoring and disbursement practices with respect to construction and development financing are designed to ensure sufficient funds are available to complete construction projects. As of December 31, 1993, 1992 and 1991, construction and development loans represented 1.5%, 2.2% and 2.1%, respectively, of ASB's gross loan portfolio. See "Loan portfolio risk elements." Multi-family residential and commercial real estate lending. Permanent loans secured by multi-family properties (generally apartment buildings), as well as commercial and industrial properties (including office buildings, shopping centers and warehouses), are originated by ASB for its own portfolio as well as for participation with other lenders. In 1993, 1992 and 1991, loans on these types of properties accounted for approximately 6.0%, 8.2% and 7.5%, respectively, of ASB's total mortgage loan originations. The objective of commercial real estate lending is to diversify ASB's loan portfolio to include sound, income-producing properties. Consumer lending. ASB offers a variety of secured and unsecured consumer loans. Loans secured by deposits are limited to 90% of the available account balance. ASB also offers VISA cards, automobile loans, general purpose consumer loans, second mortgage loans, home equity lines of credit, checking account overdraft protection and unsecured lines of credit. In 1993, 1992 and 1991, loans of these types accounted for approximately 4.3%, 4.9% and 11.1%, respectively, of ASB's total loan originations. Corporate banking/commercial lending. ASB is authorized to make both secured and unsecured corporate banking loans to business entities. This lending activity is designed to diversify ASB's asset structure, shorten maturities, provide rate sensitivity to the loan portfolio and attract business checking deposits. As of December 31, 1993, 1992 and 1991, corporate banking loans represented 1.2%, 1.2% and 1.67%, respectively, of ASB's total net loan portfolio. Loan origination fee and servicing income. In addition to interest earned on loans, ASB receives income from servicing of loans, for late payments and from other related services. Servicing fees are received on loans originated and subsequently sold by ASB and also on loans for which ASB acts as collection agent on behalf of third-party purchasers. ASB generally charges the borrower at loan settlement a loan origination fee ranging from 2% to 3% of the amount borrowed. Loan origination fees (net of direct loan origination costs) are deferred and recognized as an adjustment of yield over the life of the loan. Nonrefundable commitment fees (net of direct loan origination costs, if applicable) to originate or purchase loans are deferred. The nonrefundable commitment fees are recognized as an adjustment of yield over the life of the loan if the commitment is exercised. If the commitment expires unexercised, nonrefundable commitment fees are recognized in income upon expiration of the commitment. Loan portfolio risk elements. When a borrower fails to make a required payment on a loan and does not cure the delinquency promptly, the loan is classified as delinquent. If delinquencies are not cured promptly, ASB normally commences a collection action, including foreclosure proceedings in the case of secured loans. In a foreclosure action, the property securing the delinquent debt is sold at a public auction in which ASB may participate as a bidder to protect its interest. If ASB is the successful bidder, the property is classified in a real estate owned account until it is sold. At December 31, 1993, there was only one real estate property, a residential property, acquired in settlement of a loan totaling $0.2 million, or 0.01% of total assets. At December 31, 1992 there was only one real estate property, a commercial property, acquired in settlement of a loan totaling $2.0 million, or 0.08% of total assets. There was no real estate owned at December 31, 1991, 1990 and 1989. In addition to delinquent loans, other significant lending risk elements include: (1) accruing loans which are over 90 days past due as to principal or interest, (2) loans accounted for on a nonaccrual basis (nonaccrual loans), and (3) loans on which various concessions are made with respect to interest rate, maturity, or other terms due to the inability of the borrower to service the obligation under the original terms of the agreement (renegotiated loans). ASB has no loans which are over 90 days past due on which interest is being accrued for the years presented in the table below. The level of nonaccrual and renegotiated loans represented 0.5%, 1.0%, 0.1%, 0.1% and 0.2%, of ASB's total net loans outstanding at December 31, 1993, 1992, 1991, 1990 and 1989, respectively. The following table sets forth certain information with respect to nonaccrual and renegotiated loans for the dates indicated: ASB's policy generally is to place mortgage loans on a nonaccrual status (interest accrual is suspended) when the loan becomes more than 90 days past due or on an earlier basis when there is a reasonable doubt as to its collectability. Loans on nonaccrual status amounted to $5.7 million (0.32% of total loans) at December 31, 1993, $14.2 million (0.94% of total loans) at December 31, 1992, $1.0 million (0.08% of total loans) at December 31, 1991, $1.0 million (0.10% of total loans) at December 31, 1990 and $1.2 million (0.14% of total loans) at December 31, 1989. The significant increase in loans on nonaccrual status from year-end 1991 to 1992 was primarily due to the effects of Hurricane Iniki on the island of Kauai, such as higher unemployment. As of December 31, 1992, real estate loans with remaining principal balances of $8.9 million were restructured to defer monthly contractual principal and interest payments for three months with repayments of the entire deferred amounts due at the end of the three-month period. These loans had been classified as nonaccrual loans as of December 31, 1992. Substantially all of these loans have resumed their normal repayment schedule and are classified as performing loans as of December 31, 1993. For additional information, see "Potential problem loans." There were no loan loss provisions with respect to renegotiated loans in 1993, 1992, 1991, 1990 and 1989 because the estimated net realizable value of the collateral for such loans was determined to be in excess of the outstanding principal amounts of these loans. For additional information, see "Potential problem loans." Potential problem loans. A loan is classified as a potential problem loan when the ability of the borrower to comply with present loan covenants is in doubt. In September 1992, the island of Kauai suffered substantial property damage from Hurricane Iniki. The high unemployment rate on Kauai due to Hurricane Iniki resulted in loan payment defaults or deferrals requiring such loans to be placed on a nonaccrual status. As of December 31, 1992, delinquencies of ASB's Kauai loans were $2.2 million, $2.5 million, $3.1 million and $0.4 million for 1-29 days, 30-59 days, 60-89 days and 90 days and over delinquent, respectively. In anticipation of additional loans falling into the 90 days and over category, ASB added reserves during 1992 of $0.6 million for Kauai loans. As of December 31, 1993, substantially all of these loans have resumed their normal repayment schedule improving delinquencies of ASB's Kauai loans to $2.1 million, $0.5 million, $0.3 million and $0.7 million for 1-29 days, 30-59 days, 60-89 days and 90 days and over delinquent, respectively. Due to the losses created by Hurricane Iniki, several insurance companies have discontinued the sale and/or renewal of homeowners' insurance on real estate in Hawaii. If a borrower is unable to obtain insurance, ASB has procedures to "force place" insurance coverage. The "force place" policies are underwritten by two U.S. insurance companies and would protect ASB, as lender, for loans secured by real estate covered by such policies. The cost of the policy is charged to the borrower. Based on the current circumstances, management believes that the current shortage of homeowners' insurance in Hawaii and the effect of Hurricane Iniki on ASB's future earnings will not be material to the Company's financial condition or results of operations. Allowance for loan losses. The provision for loan losses is dependent upon management's evaluation as to the amount needed to maintain the allowance for loan losses at a level considered appropriate in relation to the risk of future losses inherent in the loan portfolio. While management attempts to use the best information available to make evaluations, future adjustments may be necessary as circumstances change and additional information becomes available. The following table presents the changes in the allowance for loan losses for the periods indicated. ASB's ratio of provisions for loan losses during the period to average loans outstanding was 0.05%, 0.11%, 0.06%, 0.07% and 0.06% for the years ended December 31, 1993, 1992, 1991, 1990 and 1989, respectively. The increase in provisions for loan losses during 1992 was primarily due to the 27% increase in average loans outstanding and a $0.6 million additional provision for Kauai loans anticipated to be affected by Hurricane Iniki. See "Potential problem loans." Without the additional $0.6 million provision on Kauai loans, the ratio of provision for loan losses to average loans outstanding for the year ended December 31, 1992 would have been 0.07%, which would be consistent with prior years. The allowance for loan losses for the year ended December 31, 1993 includes the additional provision and charge-off of a single commercial loan of $0.3 million, offset by the reversal of $0.6 million in provisions for Kauai loans reclassified as performing. The ratio of provision for loan losses to average loans outstanding for the year ended December 31, 1993 would have been 0.07%, if the reversal of the $0.6 million in provisions for Kauai loans and the additional provision of $0.3 million for the commercial loan were excluded. INVESTMENT ACTIVITIES In recent years, ASB's investment portfolio has consisted primarily of mortgage-backed securities, federal agency obligations and stock of the FHLB of Seattle. The following table sets forth the composition of ASB's investment portfolio, excluding mortgage-backed securities to be held-to-maturity, at the dates indicated: (1) On investments during the year ended December 31. DEPOSITS AND OTHER SOURCES OF FUNDS General. Deposits traditionally have been the principal source of ASB's funds for use in lending and other investments. ASB also derives funds from receipt of interest and principal on outstanding loans, borrowings from the FHLB of Seattle, securities sold under agreements to repurchase and other sources. ASB borrows on a short-term basis to compensate for seasonal or other reductions in deposit flows. ASB also may borrow on a longer-term basis to support expanded lending or investment activities. Deposits. ASB's deposits are obtained primarily from residents of Hawaii. In 1993, ASB had average deposits aggregating $2.1 billion. Savings outflow for 1993 was approximately $9 million excluding interest credited to deposit accounts. Savings inflows for 1992 and 1991 were approximately $343 million and $31 million, respectively, excluding interest credited to deposit accounts. The substantial decrease in savings flow for 1993 was due primarily to the low interest rate environment and the withdrawal of a trust company deposit account of $92 million. The trust company was recently acquired by another financial institution. The substantial increase in savings inflow for 1992 was due to ASB's strategy to increase its retail market by paying higher rates of interest on savings accounts than most of its competitors in Hawaii during this period. The weighted average rate paid on deposits during 1993 decreased to 3.74%, compared to 5.01% and 6.36% in 1992 and 1991, respectively. In the three years ended December 31, 1993, ASB had no deposits placed by or through a broker. The following table shows the distribution of ASB's average deposits and average daily rates by type of deposit for the years indicated. Average balances for a period have been calculated using the average of month-end balances during the period. At December 31, 1993, ASB had $166 million in certificate accounts of $100,000 or more maturing as follows: Borrowings. ASB obtains advances from the FHLB of Seattle, provided certain standards related to credit-worthiness have been met. Advances are secured under a blanket pledge of the common stock ASB owns in the FHLB of Seattle and each note or other instrument held by ASB and the mortgage securing it. FHLB advances generally are available to meet seasonal and other withdrawals of deposit accounts, to expand lending and to assist in the effort to improve asset and liability management. FHLB advances are made pursuant to several different credit programs offered from time to time by the FHLB of Seattle. At December 31, 1993, 1992 and 1991, advances from the FHLB amounted to $290 million, $194 million and $259 million, respectively. The weighted average rate on the advances from the FHLB outstanding at December 31, 1993, 1992 and 1991 were 6.24%, 7.39% and 7.60%, respectively. The maximum amount outstanding at any month-end during 1993, 1992 and 1991 was $290 million, $259 million and $259 million, respectively. Advances from the FHLB averaged $210 million, $221 million and $203 million during 1993, 1992 and 1991, respectively, and the approximate weighted average rate thereon was 6.84%, 7.65% and 7.99%, respectively. At December 31, 1992 and 1991, securities sold under agreements to repurchase consisted of mortgage-backed securities sold to brokers/dealers under fixed- coupon agreements. The agreements are treated as financings and the obligations to repurchase securities sold are reflected as a liability in the consolidated balance sheets. The dollar amount of securities underlying the agreements remains in the asset accounts. There were no outstanding securities sold under agreements to repurchase as of December 31, 1993. At December 31, 1992 and 1991, $27.2 million (including accrued interest of $0.2 million) and $131.0 million (including accrued interest of $1.8 million), respectively, of the agreements were to repurchase identical securities. The weighted average rates on securities sold under agreements to repurchase outstanding at December 31, 1992 and 1991 were 3.34% and 5.78%, respectively. The maximum amount outstanding at any month-end during 1993, 1992 and 1991 was $27 million, $125 million and $136 million, respectively. Securities sold under agreements to repurchase averaged $20 million, $66 million and $124 million during 1993, 1992 and 1991, respectively, and the approximate weighted average interest rate thereon was 3.39%, 5.15% and 6.67%, respectively. Subject to obtaining certain approvals from the FHLB of Seattle, ASB may offer collateralized medium-term notes due from nine months to 30 years from the date of issue and bearing interest at a fixed or floating rate established at the time of issue. At December 31, 1993, 1992 and 1991, ASB had no outstanding collateralized medium-term notes. The following table sets forth information concerning ASB's advances from FHLB and other borrowings at the dates indicated: (1) On borrowings at December 31. COMPETITION The primary factors in competing for deposits are interest rates, the quality and range of services offered, marketing, convenience of office locations, office hours and perceptions of the institution's financial soundness and safety. Competition for deposits comes primarily from other savings institutions, commercial banks, credit unions, money market and mutual funds and other investment alternatives. Additional competition for deposits comes from various types of corporate and government borrowers, including insurance companies. To meet the competition, ASB offers a variety of savings and checking accounts at competitive rates, convenient business hours, convenient branch locations with interbranch deposit and withdrawal privileges at each office and conducts advertising and promotional campaigns. The primary factors in competing for first mortgage and other loans are interest rates, loan origination fees and the quality and range of lending services offered. Competition for origination of first mortgage loans comes primarily from other savings institutions, mortgage banking firms, commercial banks, insurance companies and real estate investment trusts. ASB believes that it is able to compete for such loans primarily through the interest rates and loan fees it charges, the type of mortgage loan programs it offers and the efficiency and quality of the services it provides its borrowers and the real estate business community. OTHER FREIGHT TRANSPORTATION -- HAWAIIAN TUG & BARGE CORP. AND YOUNG BROTHERS, LIMITED GENERAL HTB and its wholly owned subsidiary, YB, were acquired from Dillingham Corporation in 1986 for $18.7 million. HTB provides interisland marine transportation services in Hawaii and the Pacific area, including charter tug and barge and harbor tug operations. YB, which is a regulated interisland cargo carrier, transports general freight and containerized cargo by barge on a regular schedule between all major ports in Hawaii. YB moved 3.1 million revenue tons of cargo between the islands in 1993, compared to 3.2 million tons of cargo in 1992. A substantial portion of the state's commodities are imported, and almost all of Hawaii's overseas inbound and outbound cargo moves through Honolulu. Cargo destined for the neighbor islands is trans-shipped through the Honolulu gateway. Access to the interisland freight transportation market is generally subject to state or federal regulation, and HTB and YB have active competitors, such as interstate common carriers and, in certain instances, unregulated contract carriers. YB has a nonexclusive Certificate of Public Convenience and Necessity from the PUC to operate as an intrastate common carrier by water. The Certificate will remain in effect for an indefinite period unless suspended or terminated by the PUC. Although YB encounters competition from, among others, interstate carriers and unregulated contract carriers, YB is the only authorized common carrier under the Hawaii Water Carrier Act. YB RATES YB generally must accept for transport all cargo offered. YB rates and charges must be approved by the PUC and the PUC has broad discretion in its regulation of the rates charged by YB. In June 1987, the PUC commenced a proceeding to determine whether YB's rates and charges should be reduced to reflect the effect of the Tax Reform Act of 1986 (TRA). During the period from January 1, 1988 through June 30, 1993, several rate reductions were imposed by the PUC as well as YB voluntarily reducing its rates for selected commodities. On February 13, 1992, YB filed a motion to rescind a 1.1% interim rate reduction which was implemented on January 1, 1989. On June 30, 1993, the PUC approved YB's motion to rescind the 1.1% interim rate reduction, effective July 8, 1993, and in January 1994, the PUC rendered a decision to close the TRA docket. In September 1992, YB filed an application for a tariff change in its minimum bill of lading from $10.43 to $21.03 (later increased to $21.62). This application was suspended on October 7, 1992. On November 5, 1992, YB filed a general rate increase application with the PUC for a 17.1% across the board increase in rates effective December 20, 1992. On December 18, 1992, the PUC ordered that the two applications be consolidated and that the consolidated application be suspended for a period of six months to and including June 19, 1993. On February 12, 1993, YB reduced its general rate increase request to 15.7% from the 17.1% originally requested. The decrease in the request was primarily due to a decrease in rate base resulting from the change in the test year period and an adjustment to YB's capital structure to reflect more leverage. The revised request was based on a rate of return of 16.7% on an imputed equity of 55%. Hearings for this general rate increase and the tariff change were held in May 1993. On June 30, 1993, the PUC issued a decision granting an $18.00 minimum bill of lading charge and a 4.3% general rate increase on all rates excluding the Minimum Bill of Lading and Marine Cargo Insurance rates. The new rates and charges became effective on July 8, 1993. This decision was based on a rate of return of 15.15% on an imputed equity of 55%. YB is also participating in the PUC's generic docket to determine whether SFAS No. 106 should be adopted for rate-making purposes. The information on postretirement benefits other than pensions in Note 18 to HEI's Consolidated Financial Statements is incorporated herein by reference to pages 64 to 66 of HEI's 1993 Annual Report to Stockholders, portions of which are filed herein as HEI Exhibit 13(a). On March 15, 1994, YB filed a Notice of Intent with the PUC informing them that YB will be filing an application for a general rate increase. REAL ESTATE-MALAMA PACIFIC CORP. GENERAL MPC was incorporated in 1985 and engages in real estate development activities, either directly or through joint ventures. MPC's real estate development investments in residential projects are targeted for Hawaii's owner-occupant market. MPC's subsidiaries are currently involved in the active development of five residential projects (Kipona Hills, Kua' Aina Ridge, Westpark, Piilani Village Phase 1 and Sunrise Estates Phase 1) on the islands of Oahu, Maui and Hawaii encompassing approximately 500 homes or lots, of which more than 260 have been completed and sold. Either directly or through its joint ventures, MPC's subsidiaries have access to nearly 450 acres of land for future residential development. Residential development generally requires long lead time to obtain necessary zoning changes, building permits and other required approvals. MPC's projects are subject to the usual risks of real estate development, including fluctuations in interest rates, the receipt of timely and appropriate state and local zoning and other necessary approvals, possible cost overruns and construction delays, adverse changes in general commerce and local market conditions, compliance with applicable environmental and other regulations, and potential competition from other new projects and resales of existing residences. In 1993, Malama's real estate development activities continued to be impacted by the economic conditions affecting the entire nation. Although interest rates remained low, the real estate market experienced slowdowns due to the weakness in the U.S. and Hawaii economies and lack of consumer confidence. Sales prices and velocities are expected to remain relatively flat through most of 1994, with improvement anticipated in late 1994 or 1995. For a discussion of MPC's transactions with related parties, pages 21 to 23 of HEI's Definitive Proxy Statement, prepared for the Annual Meeting of Stockholders to be held on April 19, 1994 and filed herein as HEI Exhibit 22, are incorporated herein by reference. JOINT VENTURE DEVELOPMENTS Makakilo Cliffs. In 1990, MDC and JGL Enterprises Inc. formed Makakilo Cliffs Joint Venture for the development of a 280-unit multi-family residential project on approximately 26 acres in Makakilo, Hawaii (island of Oahu). MDC's partnership interest was assigned to Malama Makakilo Corp., another wholly owned subsidiary of MPC, in August 1990. Sales of the first 81 units closed in 1991 and all remaining units closed in 1992. The joint venture was dissolved in December 1993. Sunrise Estates. In 1990, MDC and HSC, Inc. formed Sunrise Estates Joint Venture to develop and sell 165 one-acre house lots in Hilo, Hawaii (island of Hawaii). In 1993 and 1992, sales of three lots and 153Elots closed, respectively. Sales of the remaining nine lots are expected in 1994. In 1991, HSC, Inc. and Malama Elua Corp., a wholly owned subsidiary of MPC, formed Sunrise Estates II Joint Venture to develop and sell approximately 140 one-acre house lots in Hilo, Hawaii, adjacent to the Sunrise Estates Joint Venture project. Rezoning was completed in 1993 and site work is expected to commence in late 1994 or early 1995. Ainalani Associates. In 1990, MDC and MDT-BF Limited Partnership (MDT) formed a joint venture known as Ainalani Associates for the acquisition and development of five residential projects on the islands of Kauai, Maui and Hawaii. In 1990, the project on the island of Kauai was completed and sold. In 1992, the land for a project on the island of Maui was sold in bulk. Ainalani Associates also acquired a 50% interest in Palailai Associates, a partnership for the development of residential housing on Oahu. The five projects and partnership interest originally (i.e., before sales) encompassed approximately 270 acres of land. During 1990, MDC assigned its interest in Ainalani Associates to MMO, another wholly owned subsidiary of MPC. On August 17, 1992, MMO acquired MDT's 50% interest in Ainalani Associates. Upon closing of the purchase, Ainalani Associates was dissolved. The amount of consideration for the transfer, which was not material to the Company's financial condition, was determined by arbitration which ended on March 31, 1993 and was based primarily on the net present value of MDT's partnership interest in Ainalani Associates as of June 30, 1992. MMO plans to complete the development and sale of Ainalani Associates three projects on the islands of Maui and Hawaii, described below under "MMO projects," and has assumed Ainalani Associates' 50% partnership interest in Palailai Associates, a partnership with Palailai Holdings, Inc. BaldwinMalama. In 1990, MDC acquired a 50% general partnership interest in BaldwinMalama, a partnership with Baldwin Pacific Properties, Inc. (BPPI) established to acquire about 172 acres of land for potential development of about 780 single and multi-family residential units in Kihei on the island of Maui. The project has completed site work for the first phase of single family units. At December 31, 1993, 23 homes were completed and sold, four homes were under construction and six completed units were available for sale. In May 1993, BaldwinMalama was reorganized as a limited partnership in which MDC is the sole general partner and BPPI is the sole limited partner. In conjunction with the dissolution of the BaldwinMalama general partnership and formation of the limited partnership, MPC agreed to loan $1.6 million to BPPI and up to $15 million to the limited partnership, and beginning in May 1993, MDC consolidated the accounts of BaldwinMalama. Previously, MDC accounted for its investment in BaldwinMalama under the equity method. At December 31, 1993, the outstanding balance on MPC's loan to BPPI was $1.6 million. Palailai Associates. MMO assumed Ainalani Associates' interest in Palailai Associates on August 17, 1992 upon acquiring MDT's 50% interest in Ainalani Associates. In 1993, Palailai Associates completed the development and sale of the first increment of 107 homes and lots and completed the bulk sale of its 38.8 acres of multi-family zoned land in Makakilo, Oahu. The second increment of 69 single family homes is currently in progress, with 35 homes completed and sold as of December 31, 1993. Palailai Associates owns approximately 62 acres of adjacent land zoned for residential development. MMO PROJECTS On August 17, 1992, MMO acquired the Kipona Hills, Kua' Aina Ridge and Hanohano projects of Ainalani as a result of MMO's acquisition of MDT's 50% interest in Ainalani Associates and Ainalani Associates' subsequent dissolution. Kipona Hills is a 66-unit subdivision located in Waikoloa on the island of Hawaii. Through December 31, 1993, 42 homes or lots were completed and sold, and five completed homes and 19 lots were available for sale. Kua' Aina Ridge is a 92-lot-only subdivision in Pukalani, Maui. Subdivision improvements have been completed and sales closings commenced in 1993. As of December 31, 1993, five lots were sold. Kehaulani Place (formerly known as Hanohano), consisting of approximately 50 acres of land in Pukalani, Maui, is currently zoned for agriculture. Rezoning and land-use reclassification will be required before development can commence. Land planning and presentations to local community groups commenced in 1993. PROJECT FINANCING At December 31, 1993, MPC or its subsidiaries were directly liable for $11.5 million of outstanding construction loans and had additional construction loan facilities of $5.8 million. In addition, at December 31, 1993, MPC or its subsidiaries had issued (i) guaranties under which they were jointly and severally contingently liable with their joint venture partners for $2.1 million of outstanding construction loans and (ii) payment guaranties under which MPC or its subsidiaries were severally contingently liable for $4.6 million of outstanding construction loans and $4.7 million of additional undrawn construction loan facilities. In total, at December 31, 1993, MPC or its subsidiaries were liable or contingently liable for $18.2 million of outstanding construction loans and $10.5 million in undrawn construction loan facilities. At December 31, 1993, HEI had agreed with the lenders of construction loans and loan facilities, of which approximately $10.5 million was undrawn and $16.1 million was outstanding, that it will maintain ownership of 100% of the stock of MPC and that it intends, subject to good and prudent business practices, to keep MPC financially sound and responsible to meet its obligations. MPC or its subsidiaries may enter into additional commitments in connection with the financing of future phases of development of MPC's projects and HEI may enter into similar agreements regarding the ownership and financial condition of MPC. MALAMA WATERFRONT CORP. Malama Waterfront Corp., a wholly owned subsidiary of MPC, entered into an agreement to purchase HECO's Honolulu Power Plant in a sale and leaseback transaction. However, HECO is reconsidering the sale of the plant. See a further discussion in "Item 2.		ITEM 2. PROPERTIES HEI leases 17,612 square feet of office space in downtown Honolulu. The leases expire at various dates from March 31, 1996 to April 30, 1999 (with an option for HEI to extend one of the leases on most of the office space to March 31, 2001). The properties of HEI's subsidiaries are as follows: ELECTRIC UTILITY HECO owns and operates three generating plants on the island of Oahu at Honolulu, Waiau and Kahe, with an aggregate generating capability of 1,263 MW at December 31, 1993. The three plants are situated on HECO-owned land having a combined area of 535 acres. In addition, HECO owns a total of 114 acres of land on which are located substations, transformer vault sites, distribution base yards and the Kalaeloa cogeneration facility site. Electric lines are located over or under public and nonpublic properties. Most of HECO's leases, easements and licenses have been recorded. At December 31, 1993, HECO owned approximately 828 miles of overhead transmission lines, 1,171 miles of overhead distribution lines, 2,007 miles of underground cables, 70,395 fully-owned or jointly-owned poles and 194 steel or aluminum high voltage transmission towers. The transmission system operates at 46,000 and 138,000 volts. The total capacity of HECO's transmission and distribution substations was 5,414,000 kilovoltamperes at December 31, 1993. HECO owns a building and approximately 11.5 acres of land located in Honolulu which houses its operating, engineering and information services departments and a warehousing center. It also leases an office building and certain office spaces in Honolulu. The lease for the office building expires in November 2002, with an option to further extend the lease to November 2012. The leases for certain office spaces expire on December 31, 1996 with options to extend to December 31, 2001. HECO owns 19.2 acres of land at Barbers Point used to situate fuel oil storage facilities with a combined capacity of 970,700 barrels. HECO also owns fuel oil tanks at each plant site with a total maximum usable capacity of 915,400 barrels. The properties of HECO are subject to a first mortgage securing HECO's outstanding first mortgage bonds. On December 20, 1989, HECO applied to the PUC for the approval of the sale to Malama Waterfront Corp. and leaseback of the Honolulu power plant and Iwilei tank farm, the approval of the transfer values and the approval of the accounting and rate-making treatments thereof. Prior to the PUC rendering a decision on this application, HECO determined that changing conditions altered the economics of the proposed sale such that a later retirement of the Honolulu power plant may be more favorable. As such, HECO withdrew its application for the sale and leaseback of the plant in July 1993. A brief description of the properties of HECO's two electric utility subsidiaries follows: MECO owns and operates two generating plants on the island of Maui, at Kahului and Maalaea, with an aggregate capability of 201.3 MW. The plants are situated on MECO-owned land having a combined area of 28.6 acres. MECO also owns fuel oil storage facilities at these sites with an aggregate maximum usable storage capacity of 145,300 barrels. MECO's administrative offices and engineering and distribution departments are located on 9.1 acres of MECO-owned land in Kahului. MECO also owns and operates smaller distribution and generation systems on the islands of Lanai and Molokai. The properties of MECO are subject to a first mortgage securing MECO's outstanding first mortgage bonds. HELCO owns and operates five generating plants on the island of Hawaii. These plants at Hilo (2), Waimea, Kona and Puna have an aggregate generating capability of 154.6 MW (excluding two small run-of-river hydro units). The plants are situated on HELCO-owned land having a combined area of approximately 43 acres. HELCO owns 6.0 acres of land in Kona, which are used for a baseyard, and it leases 4.0 acres of land for its baseyard in Hilo. The lease expires in 2030. The deeds to the sites located in Hilo contain certain restrictions which do not materially interfere with the use of the sites for public utility purposes. The properties of HELCO are subject to a first mortgage securing HELCO's outstanding first mortgage bonds. SAVINGS BANK ASB owns its executive office building located in downtown Honolulu. The following table sets forth certain information with respect to offices owned and leased by ASB and its subsidiaries at December 31, 1993. The net book value of office facilities is approximately $31 million. Of this amount, $25 million represents the net book value of the land and improvements for the 13 offices owned by ASB. The remaining $6 million represents the net book value of ASB's leasehold improvements. OTHER FREIGHT TRANSPORTATION HTB, currently owns seven tugboats ranging from 1,430 to 2,668 HP, two tenders of 500 HP and three flatdecked barges. HTB owns no real property, but rents on a month-to-month basis or leases its pier property used in its operations from the State of Hawaii under a revocable permit and two-year lease. It is expected that expiring leases will be renewed as necessary. YB, HTB's subsidiary, currently owns four charter tugs, two doubledecked and six flatdecked barges and most of its shoreside equipment, including 20-foot containers, chassis, refrigerated containers, container vans, hi-lifts, flatracks, automobile racks and other related equipment. YB has three- and four-year leases expiring at various dates in 1994 through 1995 for shoreside equipment (containers, flatracks and chassis) at a monthly cost of approximately $8,500. YB owns no real property, but rents on a month-to-month basis or leases various pier property and warehouse facilities from the State of Hawaii under a revocable permit, or under a two-year or five-year lease. All lease terms began on January 1, 1992. It is expected that expiring leases will be renewed as necessary. REAL ESTATE DEVELOPMENT MPC. See Item 1, "Business--Other--Real estate--Malama Pacific Corp." OTHER HEIIC. See Item 1, "Business--Other--HEI Investment Corp." LVI operates a windfarm on the island of Hawaii with a generating capability of 1.7 MW. LVI leases 78 acres of land for its windfarm. ITEM 3.	ITEM 3. LEGAL PROCEEDINGS Except as provided for below and in "Item 1. Business," there are no known pending legal proceedings, other than ordinary routine litigation incidental to their respective businesses, to which HEI or any of its subsidiaries is a party or of which any of their property is the subject. HECO POWER OUTAGE On April 9, 1991, HECO experienced a power outage that affected all customers on the island of Oahu. One major transmission line was de-energized for routine maintenance when two major transmission lines tripped, causing another major transmission line to become overloaded and automatically trip. An island-wide power outage resulted. Power was restored over the next twelve hours. The PUC initiated an investigation of the outage by its order dated April 16, 1991. This investigation was consolidated with a pending investigation of an outage that occurred in 1988. The PUC held an initial hearing on the April 9, 1991 outage in May 1991. In July 1991, HECO filed a report of its internal investigative task force with the PUC. The report indicated that the results of the investigation were inconclusive with respect to why one of the major lines tripped and recommended actions to strengthen system reliability. The parties to the investigation (HECO, Consumer Advocate and U.S. Department of Defense) agreed that HECO should retain an independent consultant to investigate the cause of the line trip. By an order dated October 23, 1991, the PUC approved HECO's retention of Power Technologies, Inc. (PTI) and directed that the objectives of the study be to assess the reliability and overall stability of HECO's electric power system, to identify possible weaknesses, deficiencies and conditions within the system that contributed to the island-wide power outage, and to recommend a plan to increase the reliability of HECO's system and minimize the occurrence of future island-wide outages. In its order, the PUC also stated that: "[n]either the [PUC] nor HECO nor any of the other parties to this docket is bound by PTI's report or analysis or is precluded from retaining other consultants." In August 1993, PTI's report was submitted to the PUC. In its report, PTI made more than 100 recommendations for HECO to improve reliability, including selective use of herbicides to control the growth of trees under power lines. PTI said some recommendations are for implementation, some are for further study and possible implementation and some are for consideration. Some of the recommendations relate to the 1991 outage and some do not. PTI identified four recommendations as deserving immediate attention: (1) perform a detailed inspection of 138-kilovolt overhead transmission lines to ensure that present clearance distances to trees, wire crossings and other conductive objects are sufficient for at least one year; (2) determine relationships between tree clearances and "line sag" changes that result from lines carrying different amounts of electricity; (3) build the Waiau-Campbell Industrial Park 138-kilovolt transmission line as soon as possible and consider building the line to operate at higher voltage in the future; and (4) increase the number of "live-line" overhead transmission linemen and engineering and management personnel to support line and right-of-way functions. Regarding the outage, PTI concluded that the fault on the third of four transmission lines was the result of tree contact. This conclusion conflicts with the finding of another consultant who found that certain evidence favored a fault in the line over a pineapple field with no trees. Other PTI recommendations include (1) reviewing reporting systems used by co-generators and independent power producers from whom HECO buys power to be sure they are adequate to reveal problems that could affect system reliability, and (2) keeping in service the downtown Honolulu power plant previously scheduled for retirement in 1996. HECO filed its comments on the PTI recommendations with the PUC in November 1993. Further proceedings have not been scheduled at this time. Management cannot predict the timing and outcome of any decision and order to be issued by the PUC with respect to the outages or with respect to the recommendations made by PTI. HECO's PUC-approved tariff rule states that "[t]he Company will not be liable for interruption or insufficiency of supply or any loss, cost, damage or expense of any nature whatsoever, occasioned thereby if caused by accident, storm, fire, strikes, riots, war or any cause not within the Company's control through the exercise of reasonable diligence and care." Under the rule, customers had 30 days from the date of the power outage to file claims. HECO received approximately 2,900 customer claims which totaled approximately $7 million. Of the 2,900 claims, approximately 1,450 are for property damage. As of December 31, 1993, HECO had settled approximately 542 of these property damage claims, had settlement offers outstanding with respect to approximately 119 more of these claims and anticipates making settlement offers with respect to the remaining property claims upon receipt and review of appropriate supporting documentation. The settlement offers are being made for purposes of settlement and compromise only, and without any admission by HECO of liability for the outage. Not covered in the settlement offers and requests for documentation are approximately 1,450 claims involving alleged personal injury or economic losses, such as lost profits. On April 19, 1991, seven direct or indirect business customers on the island of Oahu filed a lawsuit against HECO on behalf of themselves and an alleged class, claiming $75 million in compensatory damages and additional unspecified amounts for punitive damages because of the April 9, 1991 outage. The lawsuit was dismissed without prejudice in March 1993 and subsequently refiled by the plaintiffs. HECO has filed an answer which denies the principal allegations in the complaint, sets forth affirmative defenses, and asserts that the suit should not be maintained as a class action. Discovery proceedings have been initiated. No trial date has been set. A motion for an order denying class certification of the lawsuit has been filed and is set for hearing in March 1994. A reserve equal to the deductible limits with respect to HECO's insurance coverage has been recorded with respect to claims arising out of the April 1991 outage. In the opinion of management, losses (if any), net of estimated insurance recoveries, resulting from the ultimate outcome of the lawsuit and claims related to the April 9, 1991 outage will not have a material adverse effect on the Company or consolidated HECO. HELCO RELIABILITY INVESTIGATION In July 1991, following service interruptions and rolling blackouts instituted on the island of Hawaii, the PUC issued an order calling for an investigation into the reliability of HELCO's system. An evidentiary hearing was held in September 1991 and public hearings were held in October 1991. In light of approximately 20 subsequent incidents of rolling blackouts and service interruptions resulting from insufficient generation margin, further evidentiary hearings were held in July 1992. With the input from an independent consultant and the parties to the proceedings, the PUC may formulate minimum reliability standards for HELCO, use the standards to assess HELCO's system reliability, and re-examine the rate increase approved in October 1992 to see whether any adjustments are appropriate. HELCO's generation margin has improved with the addition of a 20-MW combustion turbine in August 1992, PGV's commencement of commercial operations and Hamakua's temporary return to commercial operation (see "Item 1. Business--Electric utility-Nonutility generation"). HELCO is proceeding with plans to install two 20-MW combustion turbines in 1995, followed by an 18-MW heat steam recovery generator in 1997, at which time these units will be converted to a combined-cycle unit, subject in each case to obtaining necessary permits. In the opinion of management, the PUC's adjustment, if any, resulting from the reliability investigation will not have a material adverse effect on the Company's or HECO's consolidated financial condition or results of operations. HECO POWER PURCHASE AGREEMENTS DISPUTES HECO is disputing certain amounts billed each month under its power purchase agreements with Kalaeloa Partners, L.P. (Kalaeloa) and AES Barbers Point, Inc. (AES-BP) and has withheld payment of some of the disputed amounts pending resolution. With respect to the billings from Kalaeloa, HECO believes that it has counterclaims which would mitigate, if not more than offset, the disputed amounts billed by Kalaeloa. Disputed amounts billed by Kalaeloa and AES-BP through December 31, 1993 totaled approximately $2.1 million and $1.5 million, respectively. Approximately $0.5 million of the total disputed amounts, if paid, are includable in HECO's energy cost adjustment clause, and would be passed through to customers. HECO has not recognized any portion of the disputed amounts as an expense or liability in its financial statements. Discussions between HECO and Kalaeloa, and HECO and AES-BP to resolve the disputed billing amounts are continuing. In the event the parties are unable to settle the disputes, both the Kalaeloa and AES-BP power purchase agreements contain provisions whereby either party to the agreement may cause the dispute to be submitted to binding arbitration. Kalaeloa has requested that its dispute with HECO be arbitrated and this arbitration process has commenced. Based on information currently available, HECO's management believes that the ultimate outcome of these disputes will not have a material adverse effect on the Company's or HECO's consolidated financial condition or results of operations. ITEM 4.	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS HEI and HECO: During the fourth quarter of 1993, no matters were submitted to a vote of security holders of the Registrants. PART II ITEM 5.	ITEM 5. MARKET FOR REGISTRANTS' COMMON EQUITY AND RELATED STOCKHOLDER MATTERS HEI: The information required by this item is incorporated herein by reference to pages 67 and 69 (Note 19, "Regulatory restrictions on net assets" and Note 22, "Quarterly information (unaudited)," of the Notes to HEI's Consolidated Financial Statements) and page 27 of HEI's 1993 Annual Report to Stockholders, portions of which are filed herein as HEI Exhibit 13(a). Certain restrictions on dividends and other distributions of HEI are described in "Item 1. Business--Regulation and other matters--Restrictions on dividends and other distributions." The total number of holders of record of HEI common stock as of March 21, 1994, was 24,672. HECO: Market information and holders--not applicable. Since the corporate restructuring on July 1, 1983, all the common stock of HECO has been held solely by its parent, HEI, and is not publicly traded. The dividends declared and paid on HECO's common stock for the four quarters of 1993 and 1992 are as follows: The regulatory restrictions on net assets are incorporated herein by reference to page 27 (Note 12 to HECO's Consolidated Financial Statements, "Regulatory restrictions on distributions to parent") of HECO's 1993 Annual Report to Stockholder, portions of which are filed herein as HECO Exhibit 13(b). ITEM 6.	ITEM 6. SELECTED FINANCIAL DATA HEI: The information required by this item is incorporated herein by reference to page 27 of HEI's 1993 Annual Report to Stockholders, portions of which are filed herein as HEI Exhibit 13(a). HECO: The information required by this item is incorporated herein by reference to page 2 of HECO's 1993 Annual Report to Stockholder, portions of which are filed herein as HECO Exhibit 13(b). ITEM 7.	ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS HEI: The information required by this item is incorporated herein by reference to pages 29 to 39 of HEI's 1993 Annual Report to Stockholders, portions of which are filed herein as HEI Exhibit 13(a). HECO: The information required by this item is incorporated herein by reference to pages 3 to 9 of HECO's 1993 Annual Report to Stockholder, portions of which are filed herein as HECO Exhibit 13(b). ITEM 8.	ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA HEI: The information required by this item is incorporated herein by reference to the section entitled "Segment financial information" on page 28 and to pages 41 to 69 of HEI's 1993 Annual Report to Stockholders, portions of which are filed herein as HEI Exhibit 13(a). HECO: The information required by this item is incorporated herein by reference to pages 10 to 29 and to the section entitled "Consolidated quarterly financial information (unaudited)" on page 31 of HECO's 1993 Annual Report to Stockholder, portions of which are filed herein as HECO Exhibit 13(b). ITEM 9.	ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE HEI AND HECO: None PART III ITEM 10.	ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANTS HEI: The following persons are, or may be deemed, executive officers of HEI. Their ages are given as of March 10, 1994. Officers are appointed to serve until the meeting of the Board of Directors following the next Annual Meeting of Stockholders (which shall occur on April 19, 1994) and/or until their successors have been appointed and qualified (or until their earlier resignation or removal). Company service includes service with an HEI subsidiary. HEI's executive officers, with the exception of Peter C. Lewis, Charles F. Wall and Andrew I. T. Chang, are officers and/or directors of one or more of HEI's subsidiaries. There are no family relationships between any executive officer or director of HEI and any other executive officer or director of HEI. The list of current directors of HEI is incorporated herein by reference to page 70 of HEI's 1993 Annual Report to Stockholders, portions of which are filed herein as HEI Exhibit 13(a). Information on their business experience and directorships is incorporated herein by reference to pages 3 to 5 of the registrant's Definitive Proxy Statement, prepared for the Annual Meeting of Stockholders to be held on April 19, 1994, and filed herein as HEI Exhibit 22. Thurston Twigg-Smith (who is not standing for reelection as a Director) is President, Chief Executive Officer and Director of Persis Corporation; Chairman, Chief Executive Officer and Director of Northwest Media, Inc., and Maryville Alcoa Daily Times; Chairman of the Board of The Honolulu Advertiser; Director of HECO, ASB and The Museum of Contemporary Art (Los Angles); Trustee of the McInerny Foundation, Punahou School, Honolulu Academy of Arts, The Contemporary Museum (Honolulu), Old Sturbridge Village (Massachusetts), The Skowhegan School (Maine) and The Philatelic Foundation, N.Y.; and member of the Governing Board of The Yale Art Gallery (Connecticut). HECO: The following table sets forth certain information concerning the executive officers of HECO. Their ages are given as of March 10, 1994. Officers are appointed to serve until the meeting of the Board of Directors following the next Annual Meeting and/or until their respective successors have been appointed and qualified. Company service includes service with HECO affiliates. HECO's executive officers, Robert F. Clarke, Harwood D. Williamson, Edward Y. Hirata, Paul A. Oyer and Molly M. Egged, are officers of one or more of the affiliated HEI companies. There are no family relationships between any executive officer or director of HECO and any other executive officer or director of HECO. The list of current directors of HECO is incorporated herein by reference to page 33 of HECO's 1993 Annual Report to Stockholder, portions of which are filed herein as HECO Exhibit 13(b). Information on the business experience and directorships of directors of HECO who are also directors of HEI is incorporated herein by reference to pages 3 through 5 of HEI's Definitive Proxy Statement, prepared for the Annual Meeting of Stockholders to be held on April 19, 1994, and filed herein as HEI Exhibit 22. Mildred D. Kosaki, age 69, and Paul C. Yuen, age 65, as of March 10, 1994, are the only outside directors of HECO who are not directors of HEI. Mrs. Kosaki has been a Director of HECO from 1973 to the present. She resigned from the HEI Board in 1987. She was also a Director of the International Pacific University from 1989 to 1991 and a Director on the Board of The Honolulu Advertiser from 1983 to 1989. She is a specialist in education research. Dr. Yuen, who was elected a Director of HECO in April 1993, is Senior Vice President for the University of Hawaii and Executive Vice Chancellor for the University of Hawaii-Manoa. In the past five years, he has had various administrative positions at the University of Hawaii-Manoa. He also serves on the Boards of Cyanotech Corporation, the Pacific International Center for High Technology Research and Hawaii Cultured Pearls, Inc. Information on Mr. Oyer's business experience and directorship is indicated above. The information required under this item by Item 405 of Regulation S-K is incorporated by reference to page 9 of HEI's Definitive Proxy Statement, prepared for the Annual Meeting of Stockholders to be held on April 19, 1994, and filed herein as HEI Exhibit 22. ITEM 11.	ITEM 11. EXECUTIVE COMPENSATION HEI: The information required under this item for HEI is incorporated by reference to pages 6 to 7 and 9 to 22 of HEI's Definitive Proxy Statement, prepared for the Annual Meeting of Stockholders to be held on April 19, 1994, and filed herein as HEI Exhibit 22. HECO: The following tables set forth the information required for the chief executive officer of HECO and the four other most highly compensated HECO executive officers serving at the end of 1993. All executive compensation amounts presented for Harwood D. Williamson are duplicative of the amounts presented in HEI's Definitive Proxy Statement, prepared for the Annual Meeting of Stockholders to be held on April 19, 1994, and filed herein as HEI Exhibit 22. SUMMARY COMPENSATION TABLE The following is the summary compensation table which sets forth the annual and long-term compensation of the chief executive officer of HECO and the four other most highly compensated executive officers of HECO serving at the end of 1993. SUMMARY COMPENSATION TABLE (1) Includes directors' fees of $28,000 in 1993 and $25,000 in 1992 for Mr. Williamson and directors' fees of $5,600 in 1993 and $4,700 in 1992 for Mr. Oyer. (2) The named executive officers are eligible for an incentive award under the Company's annual Executive Incentive Compensation Plan (EICP). A decision on EICP bonus payouts is made at the beginning of each year for the previous year's performance period. (3) Covers interest earned on deferred compensation and includes above-market earnings in the amount of $63,467 for 1993 and $57,498 for 1992 on deferred annual and Long-Term Incentive Plan (LTIP) payouts for Mr. Williamson. Also includes above-market earnings in the amount of $10,806 for 1993 and $9,790 for 1992 on deferred annual payouts for Mr. Oyer. (4) Includes a special one-time, premium-priced grant of 40,000 shares without dividend equivalents for Mr. Williamson in 1992. Other options granted in each of the three years for Mr. Williamson included dividend equivalents. For each of the other named executive officers, options granted in 1993 and 1991 did not include dividend equivalents. (5) LTIP payouts are determined in April each year for the three-year cycle ending on December 31 of the previous calendar year. In 1993, only Mr. Williamson was eligible to receive a LTIP payout; however, no LTIP payout was received for the 1990-1992 performance cycle because none of the minimum earnings threshold levels were achieved. The determination of whether there will be a payout for Mr. Williamson under the 1991-1993 LTIP will not be made until April 1994. (6) Represents amounts accrued by the Company in 1993 for certain death benefits provided to the named executive officers. In 1992 and 1991, the Company did not accrue for these benefits. Additional information is incorporated by reference to page 19 of HEI's Definitive Proxy Statement, prepared for the Annual Meeting of Stockholders to be held on April 19, 1994, and filed herein as HEI Exhibit 22. Covers reimbursement of moving expenses for Mr. May in 1992. (7) Mr. May joined HECO as the Senior Vice President on February 1, 1992. OPTION GRANTS IN LAST FISCAL YEAR The following table shows the HEI stock options which were granted in 1993 to the executives named in the HECO Summary Compensation Table, all of which are nonqualified stock options. The practice of granting stock options, which may include dividend equivalent shares, has been followed each year since 1987. (1) For the 20,000 option shares granted with an exercise price of $38.27 per share, additional dividend equivalent shares are granted to Mr. Williamson at no additional cost throughout the four-year vesting period (vesting in equal installments) which begins on the date of grant. Dividend equivalents are computed, as of each dividend record date, both with respect to the number of shares under the option and with respect to the number of dividend equivalent shares previously credited to the participant and not issued during the period prior to the dividend record date. Accelerated vesting is provided in the event a Change-in-Control occurs. No stock appreciation rights have been granted under the Company's current benefit plans. (2) Based on a Binomial Option Pricing Model which is a variation of the Black-Scholes Option Pricing Model. For the stock options granted with a 10-year option period, an exercise price of $38.27, and with additional dividend equivalent shares granted for the first four years of the option, the Binomial Value is $9.66 per share. The following assumptions were used in the model: Stock Price: $38.27; Exercise Price: $38.27; Term: 10 years; Volatility: .55; Interest Rate: 6.0%; and Dividend Rate: 6.4%. The following were the valuation results: Binomial Option Value: $5.03; Dividend Credit Value: $4.63; and Total Value: $9.66. AGGREGATED OPTION EXERCISES AND FISCAL YEAREND OPTION VALUE TABLE The following table shows the HEI stock options, including dividend equivalents, exercised in 1993 by the named executive officers in the HECO Summary Compensation Table. Also shown is the number and value of unexercised options and dividend equivalents at the end of 1993. Under the Stock Option and Incentive Plan, dividend equivalents were granted to Mr. Williamson as part of the stock option award, except for the one-time, premium-priced grant in May 1992. For each of the other named executive officers, options granted in 1993 and 1991 did not include dividend equivalents. Dividend equivalents permit a participant who exercises a stock option to obtain at no additional cost, in addition to the option shares, the amount of dividends declared on the number of shares of common stock with respect to which the option is exercised during the period between the grant and the exercise of the option. Dividend equivalents are computed, as of each dividend record date throughout the four-year vesting period (vesting in equal installments), which begins on date of grant, both with respect to the number of shares underlying the option and with respect to the number of dividend equivalent shares previously credited to the executive officer and not issued during the period prior to the dividend record date. AGGREGATED OPTION EXERCISES IN LAST FISCAL YEAR AND FISCAL YEAREND OPTION VALUES (1) Includes dividend equivalents of $79,916 exercisable and $26,296 unexercisable for Mr. Williamson and dividend equivalents of $25,830 exercisable for Mr. Oyer. All options were in the money (where the option price is less than the closing price on December 31, 1993) except the 1990 stock option grant at $36.01 per share, the 1992 stock option grant at $35.94 per share, and the 1993 stock option grant at $38.27 per share and the 1992 premium-priced grant at $41.00 per share. Value based on closing price of $35.875 per share on the New York Stock Exchange on December 31, 1993. LONG-TERM INCENTIVE PLAN AWARDS TABLE A Long-Term Incentive Plan award was made to one of the named executive officers in the HECO Summary Compensation Table, Mr. Williamson. Additional information required under this item is incorporated by reference to page 13 of HEI's Definitive Proxy Statement, prepared for the Annual Meeting of Stockholders to be held on April 19, 1994, and filed herein as HEI Exhibit 22. PENSION PLAN The Retirement Plan for Employees of Hawaiian Electric Industries, Inc. and Participating Subsidiaries (the Retirement Plan) provides a monthly retirement pension for life. Additional information required under this item is incorporated by reference to pages 14 to 15 of HEI's Definitive Proxy Statement, prepared for the Annual Meeting of Stockholders to be held on April 19, 1994, and filed herein as HEI Exhibit 22. As of December 31, 1993, the named executive officers in the HECO Summary Compensation Table had the following number of years of credited service under the Retirement Plan: Mr. Williamson, 37 years; Mr. May, 1 year; Mr. Oyer, 27 years; Mr. Rodrigues, 23 years; and Mr. Iwahiro, 34 years. CHANGE-IN-CONTROL AGREEMENT Messrs. Williamson and May are the only named executive officers in the HECO Summary Compensation Table in which HEI has entered into a Change-in-Control Agreement. Additional information required under this item is incorporated by reference to page 15 of HEI's Definitive Proxy Statement, prepared for the Annual Meeting of Stockholders to be held on April 19, 1994, and filed herein as HEI Exhibit 22. Based on W-2 earnings for the five most recent years (1989-1993) or the portion of such period during which the executive performed personal service for HEI and its subsidiaries, the lump sum severance would be as follows: Mr. Williamson - $1,035,551 and Mr. May - $869,890. COMPENSATION COMMITTEE REPORT ON EXECUTIVE COMPENSATION INTRODUCTION Decisions on executive compensation for the named executive officers are made by the Compensation Committee of the HEI Board of Directors which is composed of six independent nonemployee directors. All decisions by the Compensation Committee are reviewed by the full HEI Board except for decisions about HEI's stock based plans, which must be made solely by the Committee in order to satisfy Securities Exchange Act Rule 16b-3. The Committee has retained the services of an independent compensation consulting firm to assist in executive compensation matters. Except for specific compensation decisions regarding Mr. Williamson which are discussed below, additional information required under this item is incorporated by reference to pages 16 through 19 of HEI's Definitive Proxy Statement, prepared for the Annual Meeting of Stockholders to be held on April 19, 1994, and filed herein as HEI Exhibit 22. BASE SALARY Mr. Williamson's base salary is determined based on the recommendation of Robert F. Clarke, President and Chief Executive Officer of HEI and Chairman of the Board of HECO, within the recommended salary range and the Committee's approval. Mr. Clarke's recommendation is based on an overall evaluation of Mr. Williamson's performance during the preceding year. This evaluation is subjective in nature and takes into account all aspects of Mr. Williamson's responsibilities at the discretion of Mr. Clarke. Mr. Williamson's base salary was raised from an annual rate of $300,000 to an annual rate of $320,000, effective May 1, 1993. This action by the Committee was subsequently ratified by the HECO Board of Directors. STOCK OPTIONS The 1993 stock option award to Mr. Williamson of 8,000 shares of HEI Common Stock plus dividend equivalents was based on the consultant's recommendation and the independent evaluation of an appropriate award level by Mr. Clarke and the HEI Compensation Committee. In this evaluation, the Committee took into account prior awards to Mr. Williamson and an overall subjective evaluation of Mr. Williamson's job performance. HECO BOARD OF DIRECTORS COMMITTEES OF THE HECO BOARD The Board of Directors of HECO has only one standing committee, the Audit Committee, which is comprised of three nonemployee directors: Ben F. Kaito, Chairman, and Mildred D. Kosaki and Diane J. Plotts. In 1993, the Audit Committee held four meetings to review with management, the internal auditor and HECO's independent auditors the activities of the internal auditor, the results of the annual audit by the independent auditor and the financial statements which are included in HECO's 1992 Annual Report to Stockholder. The Audit Committee holds such meetings as it deems advisable to review the financial operations of HECO. REMUNERATION OF THE HECO DIRECTORS AND ATTENDANCE AT MEETINGS In 1993, William G. Foster (who passed away in October 1993), Mildred D. Kosaki and Paul C. Yuen were the only nonemployee directors of HECO who were not also directors of HEI. They were paid a retainer of $12,000, one-half of which was distributed in the common stock of HEI pursuant to the HEI Nonemployee Director Stock Plan and one-half of which was distributed in cash. The number of shares of stock distributed was based on a price of $38.27 per share, which is equal to the average of the daily high and low sales prices of HEI common stock for all trading days in March 1993, divided into $6,000, with a cash payment made in lieu of any fractional share. In addition, a fee of $700 was paid in cash to each director for each Board and Committee meeting attended by the director. The Chairman of the Audit Committee was paid an additional $100 for each Committee meeting attended. In 1993, there were six regular bi-monthly meetings and one special meeting of the Board of Directors. All incumbent directors, except William G. Foster, attended at least 75% of the total number of meetings of the Board and Committee on which they served. HECO participates in the Nonemployee Director Retirement Plan described on page 7 of HEI's Definitive Proxy Statement, prepared for the Annual Meeting of Stockholders to be held on April 19, 1994, and filed herein as HEI Exhibit 22. ITEM 12.	ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT HEI: The information required under this item is incorporated by reference to pages 8 and 9 of HEI's Definitive Proxy Statement, prepared for the Annual Meeting of Stockholders to be held on April 19, 1994, and filed herein as HEI Exhibit 22. HECO: HEI owns all of the common stock of HECO, which is HECO's only class of voting securities. HECO has also issued and has outstanding various series of preferred stock, the holders of which, upon certain defaults in dividend payments, have the right to elect a majority of the directors of HECO. The following table shows the shares of HEI common stock beneficially owned by each HECO director, named HECO executive officers as listed in the Summary Compensation Table on page 57 and by HECO directors and officers as a group, as of February 10, 1994, based on information furnished by the respective individuals. * Also a named executive officer listed in the Summary Compensation Table on page 57. Excludes HECO directors Messrs. Clarke, Henderson, Kaito, and Williamson and Ms. Plotts, who also serve on the HEI Board of Directors. The information required is incorporated by reference to pages 8 and 9 of HEI's Definitive Proxy Statement, prepared for the Annual Meeting of Stockholders to be held on April 19, 1994, and filed herein as HEI Exhibit 22. Messrs. Clarke and Williamson are also named executive officers listed in the Summary Compensation Table on page 10 of the above-referenced Definitive Proxy Statement of HEI. *The number of shares of common stock beneficially owned by any HECO director or by all HECO directors and officers as a group does not exceed 1% of the outstanding common stock of HEI. (1) Sole voting and investment power. (2) Shared voting and investment power (shares registered in name of respective individual and spouse). (3) Shares owned by spouse, children or other relatives sharing the home of the director or an officer in the group and in which personal interest of the director or officer is disclaimed. (4) Stock options exercisable within 60 days after February 10, 1994, under the 1987 Stock Option and Incentive Plan, as amended. Shares for Mr. Oyer include accompanying dividend equivalents (720 shares) for stock options awarded in 1988 only. ITEM 13.	ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS HEI: The information required under this item is incorporated by reference to pages 21 to 23 of HEI's Definitive Proxy Statement, prepared for the Annual Meeting of Stockholders to be held on April 19, 1994, and filed herein as HEI Exhibit 22. HECO: As of December 31, 1992, T. Michael May, Senior Vice President of HECO, was indebted to HECO in the amount of $290,000 by reason of loans made to him by HECO in 1992 for relocation purposes. The noninterest-bearing notes were due in 1993. In 1993, $110,000 of Mr. May's indebtedness was paid and the remaining $180,000 was converted to a 15-year note bearing interest at 6.28%. The note is due in 2008 or upon demand, if Mr. May ceases to be employed by HECO, and is secured by a second mortgage on real estate. As of December 31, 1993, Mr. May was indebted to HECO in the amount of $180,000. PART IV ITEM 14.	ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a)(1) FINANCIAL STATEMENTS The following financial statements contained in HEI's 1993 Annual Report to Stockholders and HECO's 1993 Annual Report to Stockholder, portions of which are filed by HEI as Exhibit 13(a) and, portions of which are filed by HECO as Exhibit 13(b), respectively, are incorporated by reference in Part II, Item 8, of this Form 10-K: (a)(2) FINANCIAL STATEMENT SCHEDULES The following financial statement schedules for HEI and HECO are included in this Report on the pages indicated below: Certain Schedules, other than those listed, are omitted because they are not required, or are not applicable, or the required information is shown in the consolidated financial statements or notes included in HEI's 1993 Annual Report to Stockholders and HECO's 1993 Annual Report to Stockholder, which financial statements are incorporated herein by reference. (a)(3) EXHIBITS Exhibits for HEI and HECO and their subsidiaries are listed in the "Index to Exhibits" found on pages 87 through 94 of this Form 10-K. The exhibits listed for HEI and HECO are listed in the index under the headings "HEI" and "HECO," respectively, except that the exhibits listed under "HECO" are also considered exhibits for HEI. (b) REPORTS ON FORM 8-K HEI AND HECO: During the fourth quarter of 1993, HEI and HECO filed three Current Reports, Forms 8-K, with the SEC. In the Form 8-K dated October 5, 1993, HEI and HECO filed information under Item 5 regarding HECO and its subsidiaries kilowatthour sales forecast, PTI's report on HECO's power outage, and income taxes. In the Form 8-K dated November 17, 1993, HEI and HECO filed information under Item 5 regarding the HELCO rate case filed in November 1993, MECO rate case filed in November 1991, HECO's comments on PTI's report on HECO's power outage, HELCO and MECO transportation of heavy fuel oil, liquidity and capital resources- electric utility, Kalaeloa Partners, L.P. and AES Barbers Point, Inc. and discontinued operations-insurance companies. In the Form 8-K dated December 27, 1993, HEI and HECO filed information under Item 5 regarding HECO filing its 1995 rate case. (KPMG Peat Marwick Letterhead) INDEPENDENT AUDITORS' REPORT The Board of Directors and Shareholders Hawaiian Electric Industries, Inc.: Under date of February 11, 1994, we reported on the consolidated balance sheets of Hawaiian Electric Industries, Inc. and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, retained earnings and cash flows for each of the years in the three-year period ended December 31, 1993, as contained in the 1993 annual report to shareholders. These consolidated financial statements and our report thereon are incorporated by reference in the annual report on Form 10-K for the year 1993. In connection with our audits of the aforementioned consolidated financial statements, we also have audited the related financial statement schedules as listed in the accompanying index. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in note 15 to the consolidated financial statements, effective January 1, 1993, the Company changed its method of accounting for income taxes. Additionally, as discussed in note 18 to the consolidated financial statements, effective January 1, 1993, the Company changed its method of accounting for postretirement benefits other than pensions. /s/ KPMG Peat Marwick Honolulu, Hawaii February 11, 1994 [KPMG Peat Marwick letterhead] The Board of Directors and Shareholder Hawaiian Electric Company, Inc.: Under date of February 11, 1994, we reported on the consolidated balance sheets and consolidated statements of capitalization of Hawaiian Electric Company, Inc. (a wholly-owned subsidiary of Hawaiian Electric Industries, Inc.) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, retained earnings and cash flows for each of the years in the three-year period ended December 31, 1993, as contained in the 1993 annual report to shareholder. These consolidated financial statements and our report thereon are incorporated by reference in the annual report on Form 10-K for the year 1993. In connection with our audits of the aforementioned consolidated financial statements, we also have audited the related financial statement schedules as listed in the accompanying index. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in note 7 to the consolidated financial statements, effective January 1, 1993, the Company changed its method of accounting for income taxes. Additionally, as discussed in note 10 to the consolidated financial statements, effective January 1, 1993, the Company changed its method of accounting for postretirement benefits other than pensions. /s/ KPMG Peat Marwick Honolulu, Hawaii February 11, 1994 Hawaiian Electric Industries, Inc. SCHEDULE I -- MARKETABLE SECURITIES - OTHER INVESTMENTS December 31, 1993 * Represents cost of each issue, except for: ASB's other securities held for trading, which are stated at market, and mortgage-backed securities, which are stated at amortized cost; and MPC's investment in real estate partnerships, which are stated in accordance with the equity method of accounting. Secured by residential property. * Not actively traded. Fair value considered to equal cost basis or amount at which security is carried in the balance sheet. Hawaiian Electric Industries, Inc. and Hawaiian Electric Company, Inc. SCHEDULE II--AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES December 31, 1993 (a) Two unsecured promissory notes payable. Interest rate is based on Bank of Hawaii's prime rate plus 2% for the first note and Bank of Hawaii's prime rate plus 0.75% for the second note. (b) In May 1993, BaldwinMalama (BM) was reorganized as a limited partnership in which Malama Development Corp. (MDC) is the sole general partner and Baldwin Pacific Properties, Inc. (BPPI) is the sole limited partner. In conjunction with the dissolution of the BM general partnership and formation of the limited partnership, MPC agreed to loan $1.6 million to BPPI and up to $15 million to the limited partnership, and beginning in May 1993, MDC consolidated the accounts of BM. Previously, MDC accounted for its investment in BM under the equity method. At December 31, 1993, the outstanding balances on MPC's loan to BM was $10.6 million, which was eliminated in consolidation as an intercompany account. The interest rate is based on one-half of Bank of Hawaii's prime plus 8.5%. The loan matures in May 1995 and is secured by security interest in real property, option to purchase land, and assignments of BPPI and MDC's partnership interests. (c) Two unsecured noninterest-bearing notes payable from T. Michael May, Senior Vice President of Hawaiian Electric Company, Inc. (HECO), due and collected in 1993. (d) Unsecured noninterest-bearing note payable from Warren H. W. Lee, President of Hawaii Electric Light Co., Inc. (HELCO), which note was extended and is currently due in 1995 or upon demand, if he ceases to be employed by HELCO. Hawaiian Electric Industries, Inc. and Hawaiian Electric Company, Inc. SCHEDULE II - AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES December 31, 1992 (a) On August 17, 1992, Malama Mohala Corp. (MMO), a wholly owned subsidiary of Malama Pacific Corp. (MPC), acquired MDT BF Limited Partnership's (MDT) 50% interest in Ainalani Associates (Ainalani), a joint venture between MMO and MDT. Prior to the acquisition of MDT's interest in Ainalani, MMO accounted for its investment in Ainalani under the equity method. Subsequent to the acquisition, MMO consolidated all of Ainalani's assets and liabilities. Consequently, $19,497,000 of accounts receivable from Ainalani was eliminated as a result of the acquisition. Thus, only $1,001,000 of cash was actually collected. (b) Two unsecured promissory notes payable, due December 31, 1992, extension of maturity dates are being arranged. Interest rate is based on Bank of Hawaii's prime rate plus 2% for the first note and Bank of Hawaii's prime rate plus 0.75% for the second note. (c) Two unsecured noninterest-bearing notes payable from T. Michael May, Senior Vice President of Hawaiian Electric Company, Inc. (HECO), due in 1993 or upon demand, if he ceases to be employed by HECO. (d) Unsecured noninterest-bearing note payable from Warren H. W. Lee, President of Hawaii Electric Light Co., Inc. (HELCO), due in 1993 or upon demand, if he ceases to be employed by HELCO. Hawaiian Electric Industries, Inc. SCHEDULE II--AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES December 31, 1991 (a) Promissory note payable, due July 1992 with an option to extend to July 1993. Interest rate is based on Bank of Hawaii's prime rate plus 3.5%. Promissory note is secured by real estate, the joint venture's interest in a partnership and contract rights. (b) Promissory note payable, due in 1995, except certain events may trigger earlier partial repayment. Interest rate is based on Bank of Hawaii's prime rate plus 2%. Promissory note is secured by real estate, the joint venture's interest in a partnership and contract rights. (c) Unsecured promissory note payable, due December 1992. Interest rate is based on Bank of Hawaii's prime rate plus 2%. Hawaiian Electric Industries, Inc. SCHEDULE III -- CONDENSED FINANCIAL INFORMATION OF REGISTRANT HAWAIIAN ELECTRIC INDUSTRIES, INC. (PARENT COMPANY) BALANCE SHEETS As of December 31, 1993, HEI guaranteed debt of its subsidiaries and affiliates amounting to $13 million. In addition, in connection with the acquisition of HIG, HEI has agreed to indemnify HIG with respect to 1985 and 1986 claims that exceed an aggregate of $10.8 million up to $12.8 million and 50% of the claims that exceed an aggregate of $12.8 million up to $13.8 million. HEIDI has made a provision for the estimated liability related to these claims. Pursuant to the settlement agreement with the Rehabilitator of HIG entered into in early 1994, which agreement is subject to court approval, HEI will be relieved of all obligations with respect to the indemnification of HIG. The aggregate payments of principal required on long-term debt subsequent to December 31, 1993 are $26 million in 1994, $1 million in 1995, $37 million in 1996, $51 million in 1997, $21 million in 1998 and $65 million thereafter. Hawaiian Electric Industries, Inc. SCHEDULE III--CONDENSED FINANCIAL INFORMATION OF REGISTRANT (continued) HAWAIIAN ELECTRIC INDUSTRIES, INC. (PARENT COMPANY) STATEMENTS OF INCOME Hawaiian Electric Industries, Inc. SCHEDULE III -- CONDENSED FINANCIAL INFORMATION OF REGISTRANT (continued) HAWAIIAN ELECTRIC INDUSTRIES, INC. (PARENT COMPANY) STATEMENTS OF CASH FLOWS Supplemental disclosures of noncash activities: In December 1992, the Board of Directors of HEI adopted a resolution which converted $9.5 million of long-term debt of HERS to equity. HEI assumed the $9.5 million of HERS' long-term debt in a noncash transaction. Common stock dividends reinvested by stockholders in HEI common stock in noncash transactions amounted to $17 million in 1993, $15 million in 1992 and $14 million in 1991. Hawaiian Electric Industries, Inc. SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT Year ended December 31, 1993 (a) Additions at cost include a $7.0 million allowance for equity funds used during construction and noncash contributions in aid of construction received in 1993 with an estimated fair value of $2.8 million. (b) Includes transfers, adjustments and other charges and credits. (c) Includes the estimated fair value of noncash contributions in aid of construction of $23 million received in prior years, but recognized in 1993. Hawaiian Electric Industries, Inc. SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT December 31, 1992 and 1991 (a) Neither additions nor retirements in 1992 and 1991 amounted to more than 10% of the ending balance as of the end of each of those respective years. (b) Additions at cost and retirements amounted to $197.4 million and $13.4 million, respectively, in 1992. The additions include a $6.8 million allowance for equity funds used during construction. (c) Additions at cost and retirements amounted to $161.5 million and $6.9 million respectively, in 1991. The additions include a $4.0 million allowance for equity funds used during construction. Hawaiian Electric Company, Inc. SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT Year ended December 31, 1993 (a) Additions at cost include a $7.0 million allowance for equity funds used during construction and noncash contributions in aid of construction received in 1993 with an estimated fair value of $2.8 million. (b) Includes transfers, adjustments and other charges and credits. (c) Includes the estimated fair value of noncash contributions in aid of construction of $23 million received in prior years, but recognized in 1993. Hawaiian Electric Company, Inc. SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT Year ended December 31, 1992 (a) Additions at cost include a $6.8 million allowance for equity funds used during construction. (b) Includes transfers, adjustments and other charges and credits. Hawaiian Electric Company, Inc. SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT December 31, 1991 (a) Neither additions nor retirements in 1991 amounted to more than 10% of the ending balance as of December 31, 1991. (b) Additions at cost and retirements amounted to $145.9 million and $4.9 million, respectively, in 1991. The additions include a $4.0 million allowance for equity funds used during construction. Hawaiian Electric Industries, Inc. and Hawaiian Electric Company, Inc. SCHEDULE VI--ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT Year ended December 31, 1993 (a) Gross salvage on plant retired, cost of removal, transfers and adjustments. Hawaiian Electric Industries, Inc. and Hawaiian Electric Company, Inc. SCHEDULE VI--ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT Year ended December 31, 1992 (a) Gross salvage on plant retired, cost of removal, transfers and adjustments. Hawaiian Electric Industries, Inc. and Hawaiian Electric Company, Inc. SCHEDULE VI--ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT Year ended December 31, 1991 (a) Gross salvage on plant retired, cost of removal, transfers and adjustments. Hawaiian Electric Industries, Inc. and Hawaiian Electric Company, Inc. SCHEDULE VIII--VALUATION AND QUALIFYING ACCOUNTS Years ended December 31, 1993, 1992 and 1991 (a) Primarily bad debts recovered. (b) Bad debts charged off. (c) Net charge-offs. Hawaiian Electric Industries, Inc. SCHEDULE IX--SHORT-TERM BORROWINGS Years ended December 31, 1993, 1992 and 1991 (a) Unsecured promissory notes sold through dealers with a term of three months or less. (b) Borrowed under a formal credit arrangement with a bank with a term of six months. (c) Borrowed under formal credit agreements which, as of yearend, had maturities of less than twelve months. (d) Computed by multiplying the principal amounts of short-term borrowings by the number of days during which those borrowings were outstanding and dividing the sum of the products by the number of days in the year. (e) Computed by dividing interest expense on short-term borrowings for the period by the average amount of short-term borrowings outstanding during the period. Hawaiian Electric Company, Inc. SCHEDULE IX--SHORT-TERM BORROWINGS Years ended December 31, 1993, 1992 and 1991 (a) Unsecured promissory notes sold through dealers with a term of three months or less. (b) Computed by multiplying the principal amounts of short-term borrowings by the number of days during which those borrowings were outstanding and dividing the sum of the products by the number of days in the year. (c) Computed by dividing interest expense on short-term borrowings for the period by the average amount of short-term borrowings outstanding during the period. Hawaiian Electric Industries, Inc. and Hawaiian Electric Company, Inc. SCHEDULE X--SUPPLEMENTARY INCOME STATEMENT INFORMATION Years ended December 31, 1993, 1992 and 1991 INDEX TO EXHIBITS The exhibits designated by an asterisk () are filed herein. The exhibits not so designated are incorporated by reference to the indicated filing. A copy of any exhibit may be obtained upon written request for a $0.20 per page charge from the HEI Stock Transfer Division, P.O. Box 730, Honolulu, Hawaii 96808-0730. Hawaiian Electric Industries, Inc. EXHIBIT 11 -- COMPUTATION OF EARNINGS PER SHARE OF COMMON STOCK Years ended December 31, 1993 1992,1991, 1990 AND 1989 Note: The dilutive effect of stock options is not material. Hawaiian Electric Industries, Inc. EXHIBIT 12(a) -- COMPUTATION OF RATIO OF EARNINGS TO FIXED CHARGES Years ended December 31, 1993, 1992, 1990 AND 1989 (1) Excluding interest on ASB deposits. (2) Including interest on ASB deposits. (3) Total interest charges exclude interest on nonrecourse debt from leveraged leases which is not included in interest expense in HEI's consolidated statements of income. Hawaiian Electric Industries, Inc. EXHIBIT 12(a) -- COMPUTATION OF RATIO OF EARNINGS TO FIXED CHARGES Years ended December 31, 1993, 1992, 1991, 1990 and 1989--Continued (1) Excluding interest on ASB deposits. (2) Including interest on ASB deposits. (3) Total interest charges exclude interest on nonrecourse debt from leveraged leases which is not included in interest expense in HEI's consolidated statements of income. Hawaiian Electric Company, Inc. EXHIBIT 12(b) -- COMPUTATION OF RATIO OF EARNINGS TO FIXED CHARGES Years ended December 31, 1993, 1992, 1991, 1990 and 1989 Does not reflect corporate-level segment cost and tax allocation policy adjustments in 1990. Hawaiian Electric Industries, Inc. EXHIBIT 21(a) -- LIST OF SUBSIDIARIES The following is a list of all subsidiary corporations of the registrant as of March 21, 1994: Hawaiian Electric Company, Inc. EXHIBIT 21(b) -- LIST OF SUBSIDIARIES The following is a list of all subsidiary corporations of the registrant as of March 21, 1994: [KPMG Peat Marwick letterhead] HEI EXHIBIT 23 The Board of Directors Hawaiian Electric Industries, Inc.: We consent to incorporation by reference in Registration Statement Nos. 33-52520 and 33-58820 on Form S-3 and in Registration Statement Nos. 33-65234 and 33-43892 on Form S-8 of Hawaiian Electric Industries, Inc. of our report dated February 11, 1994, relating to the consolidated balance sheets of Hawaiian Electric Industries, Inc. and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, retained earnings and cash flows for each of the years in the three-year period ended December 31, 1993, which report is incorporated by reference in the 1993 annual report on Form 10-K of Hawaiian Electric Industries, Inc. Our report refers to changes in the method of accounting for income taxes and postretirement benefits other than pensions effective January 1, 1993. We also consent to incorporation by reference of our report dated February 11, 1994 relating to the financial statement schedules of Hawaiian Electric Industries, Inc. in the aforementioned 1993 annual report on Form 10-K, which report is included in said Form 10-K. /s/ KPMG Peat Marwick Honolulu, Hawaii March 22, 1994 Hawaiian Electric Company, Inc. EXHIBIT 99(b) -- RECONCILIATION OF ELECTRIC UTILITY OPERATING INCOME PER HEI AND HECO CONSOLIDATED STATEMENTS OF INCOME SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrants have duly caused this report to be signed on their behalf by the undersigned, thereunto duly authorized. The signatures of the undersigned companies shall be deemed to relate only to matters having reference to such companies and any subsidiaries thereof. 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 registrants and in their capacities at March 22, 1994. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named companies and any subsidiaries thereof. SIGNATURES (continued) SIGNATURES (continued)
751190_1993.txt	751190	1993	ITEM 1. BUSINESS General Measurex Corporation provides its customers computer-integrated manufacturing through design, production, marketing and servicing of sensor- based information and control systems. The Company's broad, integrated product line ensures economic results for customers by increasing productivity, reducing raw material usage and energy consumption, and improving product quality and uniformity. Measurex's primary marketplace is within the manufacturing industries that produce products by continuous or batch processes. The principal industries served by the Company are: pulp and paper, plastics, metals, rubber and chemicals. Measurex supports its installed systems with a worldwide field service organization of approximately 1,100 employees. Service technicians work directly with customers, in their plants and mills, providing an important and stable source of revenue. The service teams provide quality installations, training and continuing service support to ensure results for the Company's customers. Measurex was originally incorporated in California in 1968. The Company's state of incorporation was changed from California to Delaware in 1984. Measurex's principal executive offices are located at One Results Way, Cupertino, California, 95014-5991; its telephone number is (408) 255-1500. Unless the context otherwise indicates, the terms "Measurex" and "the Company" include Measurex Corporation, the predecessor California corporation, and its subsidiaries. Current Year's Development On April 7, 1993, the Company acquired Roibox Oy for approximately $1.7 million, net of cash acquired. Located in Kuopio, Finland, Roibox is a worldwide supplier of web-inspection products for the paper industry. The acquisition was accounted for using the purchase method. Product Information The following table shows the annual shipment revenues (in millions of dollars) and the percentages of annual shipment revenues during the last three fiscal years, attributable to the delivery of systems used in the pulp and paper and industrial systems industries. "Industrial Systems" includes systems for plastics, metals, rubber, and other products. For information regarding sales by geographic location see the section "Business Segments" under Notes to Consolidated Financial Statements in the Company's 1993 Annual Report to Shareholders. MXOpen In March 1992 the MXOpen(TM) product line was introduced at the Technical Association of the Pulp and Paper Institute (TAPPI) trade show in Atlanta, Georgia. MXOpen is an integrated information and control system that uses industry-standard computer and communication protocols. The product line was developed over a three-year period and represents a substantial investment in research and development, manufacturing and marketing expenses. In January 1993, at the Canadian Pulp and Paper Association (CPPA) trade show in Montreal, Quebec, Canada, the Company launched the MXOpen PrecisionPLUS(TM) intelligent measurement system. PrecisionPLUS features new distributed sensor intelligence, advanced sensor technology and faster scanning capabilities. The InfrandPlus moisture sensor uses principles of optical physics to ensure accurate moisture measurement consistently on every grade. The MXOpen Integrated Control System provides end-users with a combination of integration and open architecture. MXOpen features: [] Modular systems with capability for total machine optimization; [] Open systems architecture based on international industry standards for flexibility and expandability; and [] Integrated information and control with real-time millwide visibility for management decision-making. The MXOpen millwide product line includes: [] Intelligent Sensors and Scanners [] Distributed Control System [] Profile Actuation [] Web Inspection [] Millwide Information [] Integrated Machine Monitoring [] Complete Integrated Control System The MXOpen Measurement Control System (MCS) was introduced to industrial system customers in October 1992. For plastics, non-wovens and makers of coated materials such as flooring and building products, the MCS is an affordable solution for process improvement - all in a competitive, technologically advanced control system. Measurex 2002 ET Systems Measurex 2002 ET(TM) supervisory systems feature consolidated electronics, operator stations designed for ease of use with a broad range of graphic displays, fiber optic communications and proprietary software. A number of proprietary sensors are offered with these systems to address specific needs of the individual industries. This system provides specific solutions for the aluminum foil and sheet producers and tire manufacturers. The CMU (Computer Management Unit) 2002 ET Configuration is a pre-packaged set of features that offers a low cost option for small paper machines. Proprietary Sensors Measurex provides sensor technology for the process industries, currently offering more than 70 sensors. Its sensors include those that monitor the basis weight, moisture, caliper, ash content, coating, smoothness, gloss, formation, opacity, strength and color of processed paper, as well as the physical properties of other processed products, such as the wire spacing faults on steel belted tires. These sensors use a variety of proprietary applications involving technologies which include microwave, infrared, visible light, ultraviolet, beta, X-ray and gamma radiation. Cross-Direction Controls Measurex is a leader in the complex technology of cross-direction (CD) profile control. The center of this business is in the Measurex Devron Division, based in Vancouver, British Columbia, Canada. CD control, as used for example in the pulp and paper industry, allows precise control of paper characteristics in small segments across the entire width of the paper sheet. Cross-direction controls are complementary to the average profile taken along the paper's direction of travel, referred to as machine direction. The combined control strategy significantly enhances a customer's ability to achieve optimum quality levels, thus reducing raw material and energy usage, lowering scrappage rates and enhancing the customer's competitive position. Measurex has a variety of CD control products including AutoSlice(TM), ThermaTrol(TM), AquaTrol(R), Devronizer(TM), InfraTrol(TM), CalTrol(TM), Calcoil(TM), Calendizer(TM), and GlossTrol(TM) actuators. CD controls can be ordered with new systems or can be integrated into existing installed systems. The CDOpen(TM) System allows Measurex's cross- direction control products to be integrated with non-Measurex measurement systems. Millwide Information Measurex's Management Systems Division (MSD), provides plant level computing expertise for production processes. The Division's OptiVISION(TM) Full Spectrum Production and Quality Management System (PQMS) gives Measurex the ability to offer a system that manages processes from long-term planning and order entry through scheduling, product tracking, shipping and invoicing the product. The OptiVISION system provides users with a modular design that reduces development and installation time. Integrated Machine Monitoring The Integrated Monitoring System (IMS), marketed as a part of the MXOpen product line, consists of digital systems for on-line process and machine monitoring and analysis of the papermaking process and production machinery. IMS products provide process and machine-condition diagnosis and trending, giving papermakers tools to address maintenance problems before failure. Web Inspection Systems The Roibox-developed web inspection system analyzes the moving paper web by measuring the intensity variations of light transmitted through the sheet or reflected from the sheet. The system uses Charge Coupled Device (CCD) camera technology to continuously detect - on line - visual defects in paper or other web-produced material. Like other MXOpen Systems, this web-inspection product helps customers to produce superior quality products at lower cost, adding significantly to the basic value of an Integrated Control System. Strategic Alliances Beloit Corporation In 1990, Measurex and Beloit Corporation, agreed to expand and strengthen their 1987 strategic alliance. This cooperative agreement includes provisions for integrated marketing and sales of all Measurex paper industry products with Beloit's full line of pulp and paper machinery. Simultaneously executed was a seven-year "standstill" agreement between Measurex and Harnischfeger Industries, Inc., Beloit's parent company. Harnischfeger purchased 20 percent of Measurex's stock on the open market, the maximum allowed under the agreement. Mitsubishi Heavy Industries, Ltd. In 1988, Measurex and Mitsubishi Heavy Industries, Ltd. (MHI) entered into an agreement whereby the two companies offered certain products and services to the pulp and papermaking industry of Asia. In 1991, MHI became a signatory to the Measurex/Beloit strategic alliance, and a full participant in that agreement. All Measurex products for the pulp and paper industry are now made available to MHI on the same basis as they are made to Beloit. Siemens AG In June 1993, Siemens AG, pulp and paper division, selected Measurex as its Original Equipment Manufacturer (OEM) for certain MXOpen products. Siemens will integrate these products with other Siemens products for their total turnkey pulp and paper automation projects. Sales and Service Measurex offers its systems, related products and services principally through its own worldwide marketing and service organization. This organization offers customers a broad range of on-site and on-call services including 24- hour-a-day, 365-days-a-year service contracts. To support the Company's product line, Measurex has 47 regional sales offices and service centers which are located in 30 countries throughout the world. The Company has sold over 4,000 systems in 45 countries, primarily located in North America, Latin America, Europe and the Pacific Rim. The sales and service organization consists of regional and area managers who are responsible for selling Measurex's products and supervising service at customer sites. Under their supervision are software control and application engineers who assist customers in making the most efficient use of their systems, technical service engineers and supervisory personnel who are responsible for the installation, start-up and routine preventive maintenance of the systems, as well as any emergency services that may be required. Customers may acquire Measurex systems either by direct purchase or through Measurex lease plans. For additional information, see the Notes to Consolidated Financial Statements in the Company's 1993 Annual Report to Shareholders. Research and Product Development Measurex's systems are the result of the integration of a number of complex technologies including electronics, physics, mechanical design and software. Central to the Company's strategic goals is a commitment to research and development. The Company strongly believes the continued investment in new product development is key to its long-term success. Product development costs were $22.9 million in 1993, 9% of total reveneues and 15% of system revenue. Product development costs were $25.2 million in 1992 and $25.3 million in 1991. Of this total, Measurex capitalized $1.7 million, $4.6 million, and $2.3 million of software development costs in fiscal 1993, 1992 and 1991, respectively. Measurex amortized $3.4 million, $1.7 million and $2.8 million of capitalized software to systems costs in 1993, 1992 and 1991, respectively. The decrease in capitalized software and increase in amortization in 1993 were attributable to the general release of MXOpen software in late 1992. Backlog System backlog at November 28, 1993, was $91 million, 4% lower than the backlog of $95 million at the end of 1992. Approximately 80% of the $91 million year-end 1993 backlog is scheduled to be shipped during fiscal 1994. Patents Measurex follows a policy of filing appropriate patent applications on inventions it considers significant. As of November 28, 1993, the Company had 121 United States patents and 270 foreign patents in effect. Although important to the business, Measurex believes that the invalidity or expiration of any single such patent would not have a material adverse effect on its operations. Supply of Materials and Purchased Components Measurex produces most of the software, sensors, scanners, digital logic circuits, peripheral devices and various terminals used in its systems. Many components, such as integrated circuits, video monitors, printers, disks, and microcomputers are purchased from other manufacturers and integrated into the systems. Measurex currently purchases certain components from single sources of supply. In each instance, components performing similar functions are available from alternative sources, except for radioactive source material which is available from only two suppliers. Use of these alternative components might require a change in the design of certain portions of the system which could result in production delays, additional expenses and contract cancellations while changing vendors. The Company has contracts with certain vendors which entitle, but do not require, Measurex to purchase specific quantities of components. Manufacturing Systems are manufactured at Measurex's facilities in Cupertino, California; Waterford, Republic of Ireland; and Vancouver, British Columbia, Canada. Measurex Management Systems Division products are configured and tested at facilities in Cincinnati, Ohio. The facility in Ireland is primarily used to produce systems for customers in Europe. Web-inspection products are manufactured by Measurex's Roibox subsidiary in Kuopio, Finland. Certain subassemblies are manufactured in Cupertino and shipped to Ireland for incorporation in the final systems. The systems are generally installed at the customer's site under the supervision of Measurex personnel. Competition The market for process measurement and control is highly competitive and is subject to technological change in both hardware and software development. The principal competitive factors in this market are product quality and reliability, product features, customer support, corporate reputation and relative price/performance. Measurex's competitive strategy is to provide customers with greater economic results than available from competitors by focusing on the quality and performance characteristics of systems. However, any inability of the Company to match or exceed the price/performance or other features of the systems offered by its competitors could adversely affect future operating results. The Company's principal competition is from distributed control systems suppliers and packaged system suppliers, as well as factory automation system suppliers. In the supervisory measurement and process control business area, competition includes ABB Asea Brown Boveri Process Automation Inc.; Lippke, a wholly owned subsidiary of Honeywell; the Valmet Automation Group, a division of Valmet Oy; and Yokogawa-YEW in Japan. The distributed control system business area competition includes Honeywell, Fisher, Foxboro (a subsidiary of Siebe, Inc.), Siemens, and many other companies. In the web-inspection products area, the Company faces competition from ABB and other smaller companies. Competition for production management and process analysis and quality management is very fragmented. Employees As of November 28, 1993, Measurex had 2,250 full-time employees, of whom 1,120 were located outside of the United States. Measurex has various employee benefit plans, including a stock purchase plan for all United States and Canadian employees, stock option plans for key employees, a Savings and Deferred Profit Sharing Plan, management incentive programs, pension plans in certain foreign countries, and health, dental, life and disability plans. Nuclear Regulatory Licenses In the United States, Measurex and its customers are subject to licensing and regulation by the United States Nuclear Regulatory Commission (NRC) under the Atomic Energy Act of 1954 (the Act) with respect of those parts of its products and systems which utilize nuclear radiation. The NRC has transferred a portion of its licensing and regulatory functions to several state governments, including California, pursuant to Section 274 of the Act. Measurex holds all such licenses necessary for its current operations. Licenses are renewed periodically as required. Measurex also holds all necessary foreign licenses regarding nuclear radiation for the applicable countries in which it operates. United States customers possessing Measurex systems containing radioactive sources hold the radioactive material under a General or Specific License issued by their state or federal regulatory authority. Similarly, foreign customers hold licenses issued by their local authorities for radioactive material in Measurex systems. Licenses to Export from the United States Measurex is subject to licensing and regulation by the United States Department of Commerce under the Export Administration Act of 1969, as amended and extended, with respect to Measurex systems or parts thereof, exported from the United States or by any of its subsidiaries. Industry Segments Measurex operates within the computer-integrated control and information systems industry. All necessary disclosures regarding revenues, earnings from operations and identifiable assets are included in "Business Segments" under Notes to Consolidated Financial Statements in the Company's 1993 Annual Report to Shareholders. Geographic Segments For information regarding geographic operations in 1993, 1992, and 1991, see "Business Segments" included in the Notes to Consolidated Financial Statements in the Company's 1993 Annual Report to Shareholders. Measurex is subject to the normal risks of foreign currency fluctuations; however, to the extent practical, Measurex attempts to minimize the exposure from losses associated with such risks with foreign exchange contracts and other hedging activities. See Summary of Significant Accounting Policies (Foreign Currency Translation and Foreign Exchange Contracts) and Interest Income and Other in the Notes to the Consolidated Financial Statements in the Company's 1993 Annual Report to Shareholders. ITEM 2.		ITEM 2. PROPERTIES Located in Cupertino, California, the Company's headquarters, offices, research and manufacturing plant total 360,000 square feet. The offices, research and manufacturing operations of Measurex Management Systems Division are located in a 43,000 square-foot facility in Cincinnati, Ohio. The U.S. Sales and Service Headquarters are located in a 32,000 square-foot facility in Atlanta, Georgia. All of these facilities are owned by the Company. Measurex leases office space for sales and service operations throughout the United States and various other countries. The Measurex Devron Division owns two facilities for its offices, research and manufacturing operations, totaling 94,000 square feet in Vancouver, British Columbia, Canada. In Waterford, Ireland, the Company owns a 60,000 square-foot manufacturing facility and leases 20,000 square feet for manufacturing and storage facilities. Roibox Oy leases an 11,000 square-foot facility in Kuopio, Finland for manufacturing, engineering, and sales support. During 1993, the Company was productively utilizing the space in its facilities, while disposing of space determined to be under-utilized. The Company believes current facilities provide adequate production capacity to meet the Company's planned business activities. ITEM 3.	ITEM 3. LEGAL PROCEEDINGS There are no material pending legal proceedings to which the Company or any of its subsidiaries are a party or of which any of their property is the subject, other than ordinary routine litigation incidental to the business. Management believes that the final outcome of such matters will not have a material adverse effect on the Company's consolidated financial position and results of operations. ITEM 4.	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS The Company has not submitted any matters to a vote of security holders during the fourth quarter of the fiscal year ended November 28, 1993. EXECUTIVE OFFICERS OF REGISTRANT The following table shows the executive officers of Measurex Corporation as of January 28, 1994, (ages are as of November 28, 1993), their positions with Measurex, their business experience for the last five years, and the number of years during which they have been executive officers of the Company. Officers are elected annually but may be removed at any time at the discretion of the Board of Directors. There are no family relationships among any of the above officers. PART II ITEM 5.	ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS The information under the heading "Market for the Registrant's Common Stock and Related Security Holder Matters," which appears on page 31 of Registrant's 1993 Annual Report to Shareholders, is incorporated by reference in this Form 10-K Annual Report. The Company paid quarterly dividends of $0.11 per quarter in 1993 and 1992. While the Company intends to pay regular quarterly dividends, the payment of any future dividends is within the discretion of the Board of Directors of the Company. ITEM 6.	ITEM 6. SELECTED FINANCIAL DATA The information under the heading "Selected Financial Data," which appears on page 32 of Registrant's 1993 Annual Report to Shareholders, is incorporated by reference in this Form 10-K Annual Report. ITEM 7.	ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information under the heading "Management's Discussion and Analysis of Financial Condition and Results of Operations," which appears on pages 15 to 17 of Registrant's 1993 Annual Report to Shareholders, is incorporated by reference in this Form 10-K Annual Report. ITEM 8.	ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information under the heading "Financial Statements and Supplementary Data," which appears on pages 18 to 31 of Registrant's 1993 Annual Report to Shareholders, is incorporated by reference in this Form 10-K Annual Report. ITEM 9.	ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10.	ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information concerning the directors of the Company appears in Registrant's definitive Proxy Statement for the annual meeting of shareholders to be held April 19, 1994, under the caption "Election of Directors" and is incorporated herein by reference. Information concerning the executive officers of the Company appears at the end of Part I, pages 10 and 11, of this Form 10-K Annual Report. ITEM 11.	ITEM 11. EXECUTIVE COMPENSATION Incorporated by reference to Registrant's definitive Proxy Statement for its annual meeting of shareholders to be held April 19, 1994. ITEM 12.	ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Incorporated by reference to Registrant's definitive Proxy Statement for its annual meeting of shareholders to be held April 19, 1994. ITEM 13.	ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Incorporated by reference to Registrant's definitive Proxy Statement for its annual meeting of shareholders to be held April 19, 1994. PART IV ITEM 14.	ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a.) 1. The consolidated financial statements of Measurex Corporation included herein are set forth in the Index to Financial Statements and Schedules submitted as a separate section of this Report. 2. The Financial Statement Schedules are contained in the accompanying Index to Financial Statements and Schedules submitted as a separate section of this Report. 3. Exhibits See Index to Exhibits, page 20 and 21 (b.) Reports on Form 8-K. No report on Form 8-K was filed in the fourth quarter of fiscal year 1993 and through the date of this filing. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. MEASUREX CORPORATION (Registrant) Date February 24, 1994 By /S/ DAVID A. BOSSEN ------------------- --------------------------- David A. Bossen Chairman Know all persons by these presents, that each person whose signature appears below constitutes and appoints David A. Bossen and Carl A. Thomsen jointly and severally, his attorneys-in-fact, each with the power of substitution, for him in any and all capacities, to sign any amendments to this Report on Form 10-K, and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his substitute or substitutes, may do or cause to be done by virtue hereof. 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. MEASUREX CORPORATION INDEX TO FINANCIAL STATEMENTS AND SCHEDULES Fiscal Year 1993 ------------------ With the exception of the aforementioned information, the 1993 Annual Report to Shareholders is not to be deemed filed as part of this report unless otherwise noted. Other schedules have not been filed because the conditions requiring the filing do not exist or the required information is given in the financial statements or notes thereto. REPORT OF INDEPENDENT ACCOUNTANTS To the Shareholders Measurex Corporation Our report on the consolidated financial statements of Measurex Corporation and Subsidiaries as of November 28, 1993 and November 29, 1992 and for each of the three fiscal years in the period ended November 28, 1993, has been incorporated by reference in this Form 10-K from page 30 of Measurex Corporation's 1993 Annual Report to Shareholders. In connection with our audits of such financial statements, we have also audited the related financial statement schedules listed in the index on page 16 of this Form 10-K. In our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information required to be included therein. /S/ COOPERS & LYBRAND ------------------------- COOPERS & LYBRAND San Jose, California December 15, 1993 SCHEDULE VIII MEASUREX CORPORATION VALUATION AND QUALIFYING ACCOUNTS (1) Fiscal years 1993, 1992 and 1991 (Amounts in thousands) Notes: (1) See the Notes to Consolidated Financial Statements. (2) Represents write-offs and deductions, net of recoveries. (3) Deductions for returns of systems or parts of systems and for write-off of noncollectible amounts. (4) Deductions for write-offs of obsolete and scrapped parts and translation adjustments. (5) Represents the reclassification of reserves from non-current to current inventories. (6) Includes allowance on contracts receivable. SCHEDULE X MEASUREX CORPORATION SUPPLEMENTARY INCOME STATEMENT INFORMATION Fiscal Years 1993, 1992, and 1991 (Amounts in thousands) Notes: (1) Intangible assets include goodwill, patents and capitalized software. (2) Items omitted are less than 1% of net sales. MEASUREX CORPORATION INDEX TO EXHIBITS Fiscal Year 1993 MEASUREX CORPORATION INDEX TO EXHIBITS Fiscal Year 1993 Other exhibits have not been filed because conditions requiring the filing do not exist.
313058_1993.txt	313058	1993	ITEM 1. BUSINESS. GENERAL Southdown, Inc. (Southdown or the Company) was organized in Louisiana in 1930 and maintains its principal executive offices at 1200 Smith Street, Suite 2400, Houston, Texas 77002-4486, telephone (713) 650-6200. Unless the context indicates to the contrary, the terms "Southdown" and the "Company" as used herein should be understood to include subsidiaries of Southdown and predecessor corporations. The Company is one of the leading United States cement and ready-mixed concrete companies. The Company operates eight quarrying and manufacturing facilities and a network of 17 terminals for the production and distribution of portland and masonry cements, primarily in the Ohio valley and the southwestern and southeastern regions of the United States. The Company is also vertically integrated, with ready-mixed concrete operations serving markets in Florida, southeast Georgia and southern California. Substantially all of Southdown's cement and concrete products operations are conducted at the parent company level. The Company is also engaged in the environmental services business, which involves the collection of hazardous waste and processing it into hazardous waste derived fuel (HWDF) that, together with tires and other waste materials, is utilized in certain of the Company's cement kilns as supplements to conventional fuels. (See "Cement Operations - Resource Recovery", "Environmental Services" and Note 18 of Notes to Consolidated Financial Statements.) The environmental services business is conducted by Southdown Environmental Systems, Inc. (SES) through a number of operating subsidiaries. INDUSTRY SEGMENT INFORMATION The following table presents revenues and earnings before interest expense and income taxes contributed by each of the Company's industry segments during the periods indicated. Identifiable assets, depreciation, depletion and amortization and capital expenditures by segment are presented in Note 3 of Notes to Consolidated Financial Statements. - ---------------- (1) The Company sold its oil and gas operations on November 15, 1989. Revenues and operating earnings attributable to the oil and gas segment have, therefore, been excluded. (See Note 20 of Notes to Consolidated Financial Statements.) (2) Initial facilities acquired in the third quarter of 1990. (3) Includes a net charge of $2.5 million to accrue the estimated postretirement health care benefits calculated under SFAS No. 106 in excess of claims incurred. (See Note 2 of Notes to Consolidated Financial Statements.) (4) Includes a $6.6 million credit to pension expense and a $2.0 million credit to stock appreciation rights expense. (5) Includes a $3.0 million charge for remediation of an inactive cement kiln dust disposal site. (See Note 17 of Notes to Consolidated Financial Statements.) (6) Includes a $3.0 million charge to write down the carrying value of certain aggregate assets and a $3.6 million charge for remediation of an inactive cement kiln dust disposal site. (7) Includes a $5.9 million charge to write down the carrying value of certain aggregate assets and a $3.1 million charge for remediation of an inactive cement kiln dust disposal site. (8) Includes a $10.0 million charge attributable to an unfavorable arbitration ruling. Revenues for the past three years from each of the Company's industry segments, expressed as a percentage of total consolidated revenues, were as follows: CEMENT OPERATIONS Company Operations - The Company's cement production facilities are located in or near Victorville, California; Brooksville, Florida; Kosmosdale, Kentucky; Fairborn, Ohio; Knoxville, Tennessee; Odessa, Texas; Lyons, Colorado; and Pittsburgh, Pennsylvania. All of the facilities are wholly-owned except for the Kosmosdale and Pittsburgh plants. These two plants are owned by Kosmos Cement Company (Kosmos), a joint venture owned 75% by the Company, which is also the operator of both plants. The remaining 25% of Kosmos is owned by Lone Star Cement, Inc., a subsidiary of Lone Star Industries, Inc. (Lone Star). Cement is the basic binding agent for concrete, a primary construction material. The Company's cement products are produced primarily from raw materials found at or near the Company's plant locations. Depending upon the process at individual plants, production of one ton of finished product consumes approximately 1.6 tons of raw material. The principal raw material used in the production of portland cement is calcium carbonate found in the form of limestone. The Company's total estimated recoverable reserves of limestone are approximately 700 million tons located on approximately 19,000 acres, most of which are owned by the Company in fee. Other raw materials, used in substantially smaller portions than limestone, include sand, iron, clay and gypsum. When not found in adequate amounts in the Company's quarries, these materials are available for purchase from outside suppliers at acceptable prices. The manufacture of portland cement primarily involves the crushing, grinding and blending of limestone and other raw materials into a chemically proportioned mixture which is then burned in a rotary kiln at extremely high temperatures to produce an intermediate product known as clinker. The clinker is cooled and interground with a small amount of gypsum to produce finished cement. As fuel is a major component in the cost of producing clinker, most modern cement plants, including seven of the eight plants operated by the Company, incorporate the more fuel efficient "dry process" technology. In the most modern application of this technology, the raw materials are processed through a preheater tower that utilizes hot exhaust gases from the kiln to effect partial calcination of the raw materials before they enter the rotary kiln. At present, approximately 80% of the Company's clinker capacity is from preheater or preheater/precalciner kilns, and approximately 15% of its capacity is from long dry kilns. Only the Pittsburgh plant uses the less fuel efficient "wet process" technology. The following tables set forth certain information regarding the Company's cement plants and locations of the cement terminals and sales offices at December 31, 1993. - --------------- (1) Owned by Kosmos, which is 75% owned by the Company and 25% owned by Lone Star Cement, Inc. The Company operates the joint venture's plants, sales offices and terminals. (2) Limestone is barged from a quarry located approximately 30 miles from the plant facility. Additional reserves are available for purchase adjacent to the existing quarry. (3) The Company currently has permits to mine approximately 5-6 years of these reserves and expects to receive additional permits in 1994 to mine the balance. (4) Limestone is barged from an underground quarry located approximately 100 miles from the plant facility. The ratio of clinker produced to kiln capacity was 94% in 1993, 92% in 1992 and 84% in 1991. During the past three years, the Company has also purchased minimal amounts of cement from others to be resold at relatively low margins. In 1993, 5.5% of the cement sold by the Company was acquired from outside sources compared with 3.2% in 1992 and 2% in 1991. Cost Saving Initiatives - In 1990, the Company undertook a comprehensive assessment of all phases of its cement operations, including a detailed review of production and maintenance practices, organizational structure, labor utilization efficiency and materials purchasing procedures, and began implementing a cost reduction program related to its Cement segment. Specifically, these programs were designed to improve labor productivity, fuel and power consumption and repair parts utilization, and to result in an estimated annual cement production capacity increase of 250,000 tons. Based on management's analysis of Cement segment costs (including fixed and variable manufacturing costs, selling expenses, plant general and administrative costs, other plant overhead and miscellaneous costs), these initiatives resulted in estimated cost savings of approximately $16 million in 1992 compared with 1991 and additional savings of $3 million in 1993 compared with 1992. The Company has incurred approximately $6.0 million in severance and relocation expenses and approximately $2.2 million in capital expenditures through 1993 related to implementation of the program and has budgeted approximately $2.8 for such capital expenditures in 1994. The Company's cement plants generally use coal as their primary fuel, but most of the plants are equipped to burn natural gas and/or fuel oil as an alternative. Petroleum coke is also used at certain locations from time to time in conjunction with other fuels. At times during 1993, 1992 and 1991, the price of natural gas made it more economical than other available fuels at some plants. Coal and petroleum coke are generally purchased under agreements which do not exceed a term of one year. The Company has also utilized HWDF, tires and other waste materials as supplements to conventional fuels in some of its cement plants since 1987. During 1991, the Company significantly expanded its activities in the area of alternative fuel utilization. (See "Resource Recovery".) Because electric power is also a major cost component in the manufacture of cement, the Company is vulnerable to escalating power costs. The Company has sought to diminish overall power costs at certain plants by either adopting interruptible power supply agreements or implementing more stringent interruptible clauses. While interruptible power supply agreements result in reduced power costs, they may expose the Company to some increased risk of production interruptions during periods of power curtailment. Market Overview - Demand for cement is highly cyclical and derived from the demand for concrete products which, in turn, is derived from demand for construction. According to estimates of the Portland Cement Association (PCA), the industry's leading trade organization, the three construction sectors that are the major components of cement consumption are (i) public works or infrastructure construction, (ii) commercial and industrial construction and (iii) residential construction, which comprised 54%, 22% and 24%, respectively, of U.S. cement consumption in 1992, the most current period for which such data is available. Construction spending and cement consumption have historically fluctuated widely. The construction sector is affected by the general condition of the economy and can exhibit substantial variations across the country as a result of the differing structures of the regional economies. Regional cement markets experience peaks and valleys correlated with regional construction cycles. While the impact on the Company of construction cycles in individual regions may be mitigated to some degree by the geographic diversification of the Company, profitability is very sensitive to small shifts in the balance between supply and demand. New construction activity stagnated as the U.S. economy entered a recession during the later half of 1990, declined in 1991 in most areas and, in California, continued to decline in 1992. Construction activity was flat to slightly higher in most other regions of the country during 1992 and, at least in some regions, began to rebound in 1993. As a consequence, the Company's cement segment sales and earnings followed a similar cyclical pattern. The following table presents information regarding the market area served by each of the Company's plants and the number of competitors serving the same market area. Various characteristics of the cement industry are relevant to an understanding of the conditions of competition and the nature of the Company's business: (i) Cement is a homogeneous commodity that is manufactured to meet standardized technical specifications and is marketed primarily in bulk quantities without special packaging or labeling. Bagged cement, however, is differentiated by brand name. The Company's bagged cement products are marketed under the "Victor," "Miami," "El Toro," "Mountain," "Broco," "Kosmos" and "Dixie" labels. (ii) Because transportation costs are high relative to the value of the product, cement markets are generally regional. During the 1980s, however, certain foreign cement producers significantly increased their shipments into the United States (see "Cement Operations - Competition"). The majority of the Company's cement sales are made directly to users of portland and masonry cement, generally within a radius of 300 miles of each plant, although the Kosmos joint venture's access to navigable rivers permits it to expand its markets beyond the traditional 300 mile radius. (iii) The primary end-users of cement in each regional market include numerous small and sometimes one or more large ready-mixed concrete companies. Other principal customers are manufacturers of concrete products such as blocks, roof tiles, pipes and prefabricated building components. Sales are also made to building materials dealers, construction contractors and, particularly from the Odessa plant, oil well cementing companies. During 1993, 1992 and 1991 approximately 52%, 49% and 50%, respectively, of the Odessa plant's cement sales volume consisted of sales to oil well cementing companies and the balance represented sales of construction grade cement. The Company also manufactures limited amounts of premium priced, specialty cement products. The Company is integrated vertically in the regional vicinity of its two largest cement plants with ready- mixed concrete operations principally in southern California and in Florida. Approximately 15%, 13% and 21% of the cement sold by the Company's Victorville plant in 1993, 1992 and 1991, respectively, and approximately 37%, 42% and 52% of the cement sold by the Company's Brooksville plant in 1993, 1992 and 1991, respectively, was sold to the Company's ready-mixed concrete operations. (iv) As is common in the industry, the Company has not typically entered into long-term sales contracts except with respect to certain major construction projects. However, as a result of successful antidumping petitions filed by a group of domestic cement producers, including the Company, various importers have decreased the volumes of cement imported from foreign countries. The Company has become the replacement supplier for some of these imported volumes and, during the past several years, has contracted for terms up to fifteen months under large volume sales contracts with as many as six other cement manufacturers or distributors, both foreign and domestic. Some of the contracts have take-or-pay provisions. In exchange for guarantees of minimum annual sales volumes, these contracts generally provide for sales prices lower than the Company's customary sales arrangements. In 1993 and 1992 these contracts, assuming they represented only incremental sales (i.e., that fixed costs were fully covered by other production), accounted for approximately 25% and 31% of the Cement segment's operating earnings, respectively. For 1994 and beyond the Company has renegotiated certain of these contracts providing for, among other things, similar minimum annual sales volumes, price escalation clauses and, in one instance, a multi-year term. No one customer represents 10% or more of the Company's consolidated revenues. Nonetheless, the loss of a significant portion of these large volume contracts would have a material adverse effect on the Company's results of operations. The Company believes, however, that at least a portion of the volumes covered by these contracts could be replaced by direct sales to cement consumers in the Company's existing markets. (v) The Company's cement business is seasonal to the extent that construction activity and hence, the demand for cement, tends to diminish during the first and fourth calendar quarters because of inclement weather conditions, such as those experienced during January and February 1994. (vi) During 1993, 1992 and 1991 the Company shipped approximately 6.2 million, 5.8 million and 5.3 million tons of cement, respectively. The overall demand for cement is relatively price inelastic since cement represents only a small portion of total construction costs and cement has few substitutes in many applications. Cement demand varies directly with the level of construction activity which is a function of a number of socioeconomic factors, including growth in the U.S. economy and interest rates, as well as individual regional market factors. Competition - The cement industry is extremely competitive as a result of multiple domestic suppliers and, beginning in the 1980s, the importation of foreign cement through various terminal operations. Despite price inelasticity of overall cement demand, competition among producers and suppliers of cement is based primarily on price, with consistency of quality and service to customers being of lesser significance. Price competition among individual producers and suppliers of cement within a marketing area is intense because of the fungible nature of the product. On the basis of statistics published by the PCA, the Company believes that, as of the end of 1992, the most recent period for which such data is available, it ranked third in total active cement manufacturing capacity among the 46 cement companies in the United States. The U.S. cement industry, however, is fragmented into regional markets rather than a single national market. Because of its low value-to-weight ratio, the relative cost of transporting cement is high and limits the geographic area in which each company can market its products economically. No one cement company has a distribution of plants extensive enough to serve all markets. Source: Portland Cement Association, adjusted for recent transactions. Clinker capacity for joint venture operations is based on each company's ownership interest. During the 1980s, competition from imported cement along most coastal and border areas grew significantly, including the Company's markets in Texas, Florida and southern California, which are easily accessible to many foreign producers. The large volume of low priced imported cement entering these markets caused prices to fall despite strong growth in cement consumption. According to the PCA, total U.S. consumption of foreign cement increased from approximately 4.5% of total U.S. consumption in 1982 to a peak of approximately 19.1% in 1987. Foreign cement producers began to export to the U.S. primarily because of (i) slowdowns in their domestic economies, (ii) a cost advantage created by a strengthening of the U.S. dollar relative to certain foreign currencies and (iii) a decline in ocean shipping rates. In recent years, the influx of foreign cement imports has begun to reverse as a result of, in large part, successful antidumping actions. Other contributing factors include (i) increases in foreign consumption of cement, (ii) a decline in the value of the U.S. dollar relative to other currencies and (iii) rising ocean shipping rates. The PCA has estimated that imports represented approximately 8% of U.S. consumption in 1992, the most recent data available, as compared with 17% of total U.S. consumption in 1989. Antidumping petitions filed by a group of industry participants, including the Company (Ad Hoc Committee), resulted in favorable determinations by the International Trade Commission (ITC) against manufacturers of cement in Mexico and Japan in August 1990 and April 1991, respectively. As a result, significant antidumping duty cash deposits have been imposed on cement imports from these two nations. In addition, in February 1992, the Commerce Department announced that it had signed a five-year agreement with Venezuelan cement producers designed to eliminate the dumping of gray portland cement from Venezuela into Florida and the United States generally. The agreement requires Venezolana de Cementos, S.A.C.A. (Vencemos) and Cementos Caribe, C.A. (Caribe) to price their U.S. sales no lower than their fully-absorbed cost of production, plus profit of at least 8 percent, plus shipping costs to the United States, plus distribution costs in the United States if the importer of record is related to the foreign exporter. To allow the Commerce Department to monitor compliance with the agreement, Vencemos and Caribe must submit quarterly reports of their cost of production and home market profit, as well as their pricing of all sales to the United States. An intentional violation would expose the Venezuelan producers to civil fraud penalties. The success of these antidumping suits has, by substantially eliminating unfair pricing of foreign cement, prevented prices from declining more precipitously in the Company's two largest markets, Florida and southern California, despite a decline of approximately 30% in consumption from 1989 to 1992. In addition, the antidumping suits have provided an opportunity for domestic producers to displace large volumes of imported cement. The antidumping duties are subject to annual review by the Department of Commerce and appeal to the U.S. Court of International Trade. The determinations to impose substantial tariffs on gray portland cement and clinker imported from Mexico and Japan have been appealed at various levels by the foreign producers. The ITC determination against Japanese cement is pending on appeal before the U.S. Court of International Trade. The antidumping order remains in effect pending appeal. In response to the Mexican government's challenge of the ITC's injury determination, a dispute resolution panel of the General Agreement on Tariffs and Trade (GATT) recommended in July 1992 that the antidumping order be vacated and that all duties collected under the order be returned. The GATT panel determined that the antidumping order violates the GATT antidumping code because the U.S. Commerce Department initiated the investigation without first verifying that the petition was filed on behalf of the domestic cement producers in the region. Under GATT rules, the full Antidumping Code Committee, of which the U.S. is a member, must unanimously adopt the panel's recommendation before it becomes a binding GATT obligation. The decision whether the U.S., as a member of the Antidumping Code Committee, would vote to adopt the GATT dispute panel report would be made by the Office of the U.S. Trade Representative (USTR). Even if the USTR were to adopt the adverse panel report, the industry petitioners have been advised that an act of the U.S. Congress would be required to vacate the antidumping order. In February 1993, the U.S. Court of Appeals for the Federal Circuit affirmed the ITC's August 1990 decision that U.S. cement producers were injured by Mexican cement imports that were dumped at unfair prices in the southern tier of the United States. In April 1993, the Commerce Department reduced the antidumping duty cash deposit rate of Mexico's primary cement producer from 58 percent to 30 percent. In August 1993, the Department of Commerce determined that Mexico's primary cement producer was selling various types of cement outside the ordinary course of trade in Mexico. As no information was available to perform a "difference in merchandise" calculation between the types of cement sold in the ordinary course of trade in Mexico and sold in the United States, the Department of Commerce used a constructed value approach to determine a 43 percent dumping margin for cement imported from Mexico's primary exporter between August 1991 and July 1992 and established a new cash deposit rate of 43% on future entries. In September 1993, the Department of Commerce amended its final determination of the dumping margin for cement imported from Mexico's primary exporter between April 1990 and July 1991, raising the margin from 30 percent to 41 percent on these entries. The Department of Commerce is currently reviewing imported Mexican cement for the period August 1992 through July 1993. The antidumping cash deposit rate on imported cement from Mexico is now 43 percent for the primary exporter and between 53 and 60 percent for all other exporters. The Ad Hoc Committee challenged the Department of Commerce's original final determination of the dumping margins against Mexican cement in the Court of International Trade, which largely affirmed the findings of the Department of Commerce. The Ad Hoc Committee thereupon appealed to the U.S. Court of Appeals for the Federal Circuit. On January 5, 1994 the U.S. Court of Appeals of the Federal Circuit reversed the judgment of the Court of International Trade and remanded the case with direction that the Department of Commerce recalculate the dumping margins without allowing certain deductions for home-market transportation costs. Mexico's primary exporter has filed a petition for rehearing. If the petition is denied, the recalculated dumping margins (and thus antidumping duties levied) should be greater as a result of this ruling. In October 1993, the Department of Commerce reduced the antidumping cash deposit rate of Japan's primary cement exporter from 45 percent to 18 percent. In February 1994, the Department of Commerce preliminarily determined to reduce that exporter's cash deposit rate to 8 percent. The Company and other petitioners have appealed the October 1993 determination to the Court of International Trade and are vigorously contesting the February 1994 preliminary determination before the Department of Commerce. Effective July 1995, the Antidumping Code of the GATT will be substantially altered pursuant to the recently completed Uruguay Round of multilateral trade negotiations. The new Code applies to new investigations initiated after July 1995 and to administrative reviews of outstanding orders that are initiated after July 1995. If the Congress passes legislation to approve and implement the Uruguay Round agreement, changes will necessarily be made to U.S. antidumping law. While the antidumping orders outstanding against cement and clinker from Mexico and Japan and the suspension agreement on cement and clinker from Venezuela will remain in force, the new Code will require the initiation of "sunset" reviews of the antidumping orders against Mexico and Japan prior to July 2000 to determine whether they should terminate or remain in effect, unless an earlier date is mandated by Congress. Under the new Code, it could be more difficult to obtain antidumping orders against other countries. A substantial reduction or elimination of the existing antidumping duties could adversely affect the Company's results of operations. The Company does not believe that the North American Free Trade Agreement will have a material adverse effect on the foregoing antidumping duties. The supply of cement has also been impacted by the retirement of a substantial amount of industry capacity in the U.S. since 1981. Although the decline in industry capacity has slowed in recent years, total U.S. clinker capacity at the end of 1992, the most recent data available, had declined by 6.8 million tons from 1981. Capacity expansions in the future would require three to five years from initial planning to commencement of operations as a result of the time required for permitting, financing, fabrication and construction. Resource Recovery - As fuel is one of the largest variable costs in the manufacture of cement, many members of the cement industry have investigated the use of alternative sources of fuel as a means of mitigating this cost factor. The Company obtained the requisite permits for the storage and burning of HWDF at two of its cement plants and is burning, or pursuing permits to burn, tires or non-hazardous industrial wastes at certain other cement plants. (See "Environmental Services".) The Company began substituting liquid HWDF for a portion of the fossil fuel requirements at its Fairborn cement plant in 1987. Since that time the Company has significantly expanded its commitment to the recovery of the energy value in organic hazardous wastes. Beginning in mid-1990, the Company acquired a total of seven facilities to process hazardous wastes into liquid and solid HWDF for introduction into the Company's permitted cement kilns and the permitted kilns of other cement manufacturers. The initial marketing plan was predicated on a nationwide system of these treatment, storage and disposal facilities (TSDs) to collect and process diverse waste streams from a number of small volume generators. After suffering two and one-half years of start-up losses totaling approximately $16 million, exclusive of write-downs, however, management reorganized this business in late 1992. Subsequently, the Company's Board of Directors approved a revised reorganization plan pursuant to which the Company is narrowing its marketing focus to larger volume generators and its waste processing to primarily one cost-efficient, high volume processing facility which would mainly provide HWDF for the Company's own cement kilns. Accordingly, management announced its intention to sell all but two of the Company's TSD facilities, one of which is being upgraded and expanded to provide increased capacity for blending HWDF. Although the Company will no longer pursue the development of a nationwide network of TSDs, it will continue to pursue marketing efforts in most regions of the country to acquire such wastes. Cement kilns that burn HWDF are currently regulated under the Boiler and Industrial Furnace Rule (BIF Rule), relevant Clean Air Act and Clean Water Act regulations and other federal, state and local environmental laws and regulations. The Company's cement kilns that burn HWDF may be required to remediate onsite contamination, if any, under the Resource Conservation and Recovery Act (RCRA) corrective action program or the Comprehensive Environmental Response, Compensation, and Liability Act of 1980 (CERCLA) or the Superfund Amendments and Reauthorization Act of 1986 (SARA) programs. Such clean-ups can be very costly. The BIF Rule requires permits similar to those required of commercial hazardous waste incinerators. Cement kilns that had burned HWDF by August 21, 1991 were eligible to achieve interim status and thus continue to burn HWDF while pursuing RCRA Part B permits under the BIF Rule. In addition, those cement kiln operators that demonstrated an intent to burn HWDF, obtained all federal, state and local permits regulating the use and management of such fuels and committed to or commenced the construction of all such kiln modifications, in each case no later than August 21, 1991, also were eligible to achieve interim status. The regional Environmental Protection Agency offices have confirmed the interim status of the Company's cement plants in Tennessee and Ohio and denied the Company's claim for interim status for its plant in Texas. The Company voluntarily withdrew its interim status claims for its Pennsylvania and Florida plants in February 1992 and for its Kentucky plant in December 1993. The Tennessee and Ohio plants have completed compliance testing and appropriate certification under the BIF Rule. The Tennessee plant has also obtained the requisite air permits to burn both liquid and solid HWDF and began utilizing liquid and solid HWDF in 1990. The Tennessee plant also has a RCRA Part B permit for storage under which a new liquids HWDF tank farm and related handling systems have been constructed. The Ohio plant commenced burning liquid HWDF in 1987 and from time-to-time between 1987 and late 1991 utilized liquid HWDF as a fuel supplement. The Ohio plant is presently permitted to utilize liquid HWDF and tires as fuel supplements under the terms and conditions of an air permit renewal issued in late 1993. It is anticipated that the Ohio Hazardous Waste Facilities Board will issue the RCRA Part B permit for the Ohio plant's HWDF storage facility in late March 1994. Permit modifications are also in hand or in process to allow for the burning of tires or other non-hazardous industrial waste materials at five of the Company's cement plants including the Tennessee plant. Although the Company has no current plans to do so, it may also initiate new federal and state permitting efforts covering the burning of HWDF at other cement plants in the future. Such new permitting processes, however, would take several years and the Company cannot commence burning HWDF at these plants until all requisite permits are received. Cement plants and quarries are subject to regulations and safety standards established by the federal government under the Mine Safety and Health Act as well as the safety codes of state and local governments. The Company's utilization of HWDF in some of its cement kilns has also necessitated the familiarization of its work force with the more exacting requirements of applicable environmental laws and regulations with respect to human health and the environment. The failure to observe the exacting requirements of these laws and regulations could jeopardize the Company's hazardous waste management permits and, under certain circumstances, expose the Company to significant liabilities and costs of cleaning up releases of hazardous wastes into the environment. The regulatory status of cement kiln dust (CKD) is governed by the Bevill amendment, enacted by Congress as part of the Solid Waste Disposal Act Amendments of 1980 (Act). Under the Bevill amendment, CKD, along with several other low hazard, high volume wastes identified by Congress, is excluded from regulation as hazardous waste under the RCRA, Subtitle C, pending completion of a study and recommendations to Congress by the U.S. Environmental Protection Agency (U.S. EPA). During 1992 the U.S. EPA collected CKD samples from 15 cement plants, including two of the Company's plants, and analyzed various samples for organics and metals, dioxins and furans, radionuclides and other parameters. The U.S. EPA's Report to Congress on CKD (CKD Report) was made in December 1993 and hearings were held on February 15, 1994. Under the BIF Rule, the Bevill exclusion also applies to CKD generated by kilns that utilize HWDF if the concentration of certain constituents in the CKD is not significantly greater than in the CKD generated when fossil fuels are used, or if these constituents are present in the CKD at levels determined by U.S. EPA to present no significant risk to human health. CKD from kilns burning HWDF that fails to meet both of these requirements is not entitled to the Bevill exclusion and requires appropriate management. In September 1992 the U.S. EPA announced it was temporarily withdrawing its proposed waste identification rule which would have replaced existing rules determining which materials must be managed as a hazardous waste. The proposed rule, drafted and released for comment in February 1992, was intended as the replacement for the U.S. EPA's so-called "mixture" and "derived from" rules which have been held invalid by a federal appeals court. The mixture and derived from rules recognized by the U.S. EPA and many states generally classify any solid waste as hazardous if it is mixed with or derived from any substance listed by the U.S. EPA as hazardous, without regard to the actual toxicity or other hazardous characteristics of the resultant mixture or residual, and thereby subject these materials to the same stringent disposal rules that apply to U.S. EPA listed wastes. If these regulations or others are modified in the future, the volume and type of hazardous wastes available to SES's processors could be altered. Certain critics of the cement industry have asserted that cement manufactured with HWDF is a hazardous waste under the "derived from" rule and that such cement contains materially higher levels of organics and metals than cement manufactured with fossil fuels and have proposed the labeling of such cement on bulk invoices and on cement bags. At least one locality has banned the use of such cement in public works projects. However, tests conducted by the Company and other entities located in the United States and abroad indicate that the levels of organic constituents detected in cements produced with conventional fossil fuels and with HWDF are not materially different. Similar testing also indicates that there is no material difference in the rates at which metals leach from cement produced with HWDF as compared with cement produced with conventional fossil fuels, and neither type of cement typically exhibits hazardous characteristics under U.S. EPA's Toxicity Characteristic Leaching Procedure test. To date, the U.S. EPA has not indicated that it intends to regulate cement produced using HWDF as a fuel supplement. The Company has encountered intense levels of public resistance to the use of HWDF in its cement kilns. In some cases this resistance has resulted in the adoption of onerous, and sometimes unenforceable, laws and local ordinances, including moratoria on burning hazardous waste in cement kilns, ordinances banning the purchase of cement fired with HWDF and local siting ordinances. The sources of such resistance vary from groups who desire to stop the generation of all industrial hazardous waste by preventing its disposal, to groups of local citizens who have concerns about the impact of the use of HWDF upon human health and the environment in their community. The Company is endeavoring to satisfy the concerns of local citizenry through effective communication programs and, in some cases, public participation in citizen oversight committees. The Company believes that it can substitute HWDF for a portion of fossil fuel requirements at its cement plants without endangering human health and the environment. According to estimates compiled by the Cement Kiln Recycling Coalition, a trade association of cement manufacturers actively pursuing the use of HWDF, there are 108 cement plants with a total of 210 cement kilns operating in the United States of which approximately 25 kilns actively participate in the hazardous waste management industry by utilizing HWDF in resource recovery programs. Based on industry information available to the Company, the Company believes that approximately five additional kilns may be seeking authorization to burn HWDF. The Company cannot predict how many of these additional kilns, if any, will ever engage in resource recovery programs. Capital Expenditures - Capital expenditures during 1993 amounted to $8.5 million for the Cement segment compared with $4.9 million and $13 million in 1992 and 1991, respectively. Capital outlays in 1994 have been budgeted at approximately $17.5 million. Approximately 14% of the budgeted 1994 total is related to compliance with environmental regulations. Environmental Matters - The cement manufacturing industry, including the operations of the Company, is regulated by federal, state and local laws and regulations pertaining to several areas including human health and safety and environmental compliance. CERCLA, as amended by the SARA, as well as analogous laws in certain states, create joint and several liability for the cost of cleaning up or correcting releases to the environment of designated hazardous substances. Among those who may be held jointly and severally liable are those who generated the waste, those who arranged for disposal, those who owned the disposal site or facility at the time of disposal and current owners. In general, this liability is imposed in a series of governmental proceedings initiated by the identification of a site for initial listing as a "Superfund site" on the National Priorities List or a similar state list and the identification of potentially responsible parties who may be liable for cleanup costs. Certain of the Company's disposal sites in Victorville, California and Fairborn, Ohio are in the preliminary stages of evaluation for inclusion on the National Priorities List compiled under the U.S. EPA's Comprehensive Environmental Response, Compensation and Liability Information System (CERCLIS). Inclusion in CERCLIS is designation for further evaluation only and not a determination of liability or a finding that any response action is necessary. The Clean Air Act Amendments of 1990 provided comprehensive federal regulation of all sources of air pollution and established a new federal operating permit and fee program for virtually all manufacturing operations. The Clean Air Act Amendments will likely result in increased capital and operational expenses for the Company in the future, the amounts of which are not presently determinable. By 1995, the Company's U.S. operations will have to submit detailed permit applications and pay recurring permit fees. In addition, the U.S. EPA is developing air toxics regulations for a broad spectrum of industrial sectors, including portland cement manufacturing. The U.S. EPA has indicated that the new maximum available control technology standards could require significant reduction of air pollutants below existing levels prevalent in the industry. Management has no reason to believe, however, that these new standards would place the Company at a competitive disadvantage. The Federal Water Pollution Control Act, commonly known as the Clean Water Act (Clean Water Act), provides comprehensive federal regulation of all sources of water pollution. In September 1992 the Company filed a number of applications under the Clean Water Act for National Pollutant Discharge Elimination System (NPDES) stormwater permits. The Company now believes that some of its existing NPDES permits or pending applications relating to its cement plants and raw materials quarries may not cover all process water and stormwater discharges. Legal counsel has advised the Company, based upon its preliminary review of the matter, that while the Clean Water Act authorizes, among other remedies, the imposition of civil penalties of up to $25,000 per day for unpermitted discharges of pollutants to the waters of the United States, several factors may mitigate against the impositions of substantial fines. First, the Company is moving forward as expeditiously as practicable to correct all NPDES permitting deficiencies. Second, some of the permitting issues arise from mere technical deficiencies in permit applications or from changes in discharge patterns after submission of permit applications. In each such case, legal counsel believes that such deficiencies are neither unusual nor difficult to rectify. Finally, some of the deficiencies relate to questions of the scope of the Clean Water Act's jurisdiction that are, at best, unclear. Management believes that the Company's current procedures and practices for handling and management of materials are consistent with industry standards and legal requirements and that appropriate precautions are taken to protect employees and others from harmful exposure to hazardous materials. However, because of the complexity of operations and legal requirements, there can be no assurance that past or future operations will not result in operational errors, violations, remediation liabilities or claims by employees or others alleging exposure to toxic or hazardous materials. Industrial operations have been conducted at some of the Company's cement manufacturing facilities for almost 100 years. Many of the raw materials, products and by-products associated with the operation of any industrial facility, including those for the production of cement or concrete products, may contain chemical elements or compounds that are designated as hazardous substances. Some examples of such materials are the trace metals present in CKD, chromium present in refractory brick used to line cement kilns and general purpose solvents. In the past, the Company disposed of various materials, including used refractory brick and other products generally used in its cement manufacturing and concrete products operations, in onsite and offsite facilities. Some of these residuals, when discarded, are now classified as hazardous wastes and subject to regulation under federal and state environmental laws and regulations, which may require the Company to remediate some or all of the affected disposal sites. During the same period, the Company placed CKD in abandoned quarries or other locations at its plant sites and elsewhere. CKD is currently exempt from management as a hazardous waste, except CKD which is produced by kilns burning HWDF and which fails to meet certain criteria. However, CKD that comes in contact with water may produce a leachate with an alkalinity high enough to classify the leachate as hazardous and may also leach the hazardous trace metals present therein. Leaching has led to the classification of at least three CKD disposal sites of other companies as federal Superfund sites. Several of the Company's inactive CKD disposal sites around the country are under study to determine if remedial action is required and, if so, the extent of any such remedial action required. These studies may take some time to complete. Thereafter, remediation plans, if required, will have to be devised and implemented, which could take several additional years. An inactive CKD disposal site in Ohio is currently under investigation by the Company and state environmental agencies to determine appropriate remedial action required at the site. In late July 1991, the Company submitted to the Ohio Environmental Protection Agency (Ohio EPA) for evaluation an initial remediation study indicating the potential extent and nature of a remediation problem at this site. The initial study revealed that the leachate from the site was negatively impacting the environment in the vicinity through ground and surface water pathways. The full extent of the environmental impact, however, was not determined during the first phase of the investigation and a reliable estimate of total remedial costs could not be made at that time. However, the Company recorded a charge of $3.1 million as its initial estimate of the minimum remediation cost. In May 1992, a second phase investigation report related to this site was finalized by the Company's consultant. The report described the results of a hydrogeological investigation and provided background data for the assessment of probable remedial alternatives. In addition, in July 1992 the Ohio EPA issued an administrative order (Director's Order) with respect to this inactive CKD disposal site. The Director's Order formalized the Company's own investigation and remediation plans and required the Company to implement an approved remediation workplan to be directed and monitored by the Ohio EPA. Because of the Director's Order and the additional information produced by the ongoing environmental and preliminary engineering investigations, the Company recorded an additional $3.6 million pre-tax charge in the second quarter of 1992 to increase its reserve with respect to this site to $6.7 million. In October 1993, the Company received a consulting report proposing additional refinements of earlier remediation estimates which increased the total estimated cost to remediate this site from $6.7 million to $9.7 million. Accordingly, the Company recorded an additional $3.0 million charge in the third quarter of 1993 to recognize what the Company believes will be the final change in the estimate. On a voluntary basis, without administrative or legal action being taken, the Company is also investigating two other inactive Ohio CKD disposal sites. The two additional sites in question were part of a cement manufacturing facility that was owned and operated by a now dissolved cement company from 1924 to 1945 and by a division of USX Corporation (USX) from 1945 to 1975. The facility was acquired by the Company in December 1976. The former owners disposed of CKD and other plant waste materials at both sites but conditions at the two sites in question have remained virtually unchanged from when they were acquired by the Company. In 1991 the Company contracted to have an evaluation performed of surface and groundwater characteristics in the vicinity of the larger of the two sites (the Site). In general, the surface and groundwater samples downstream from the Site showed elevated levels of alkalinity and heavy metals classified as hazardous substances under CERCLA. The Company notified the proper authorities and the U.S. EPA has conducted a preliminary assessment to determine if the Site warrants further governmental action. In July 1993, the Ohio EPA placed the Site on its Master Sites List of sites that potentially pose a threat to public health or the environment from the release or potential release of hazardous wastes or substances into the environment. On September 24, 1993, the Company filed a complaint (Complaint) in U.S. District Court in Ohio against USX, alleging that USX is a potentially responsible party under CERCLA and under applicable Ohio law, and therefore jointly and severally liable for costs associated with cleanup of the Site. On November 12, 1993, USX responded to the Complaint by filing a motion to dismiss asserting that no liability for cleanup costs relating to the cement kiln dust in the Site could be asserted by the Company against USX under CERCLA. The Company filed a response to the motion to dismiss in December 1993 and, on January 14, 1994, USX filed a reply to the Company's response to USX's motion to dismiss. The Company intends to vigorously pursue its right to contribution from USX for cleanup costs under CERCLA and Ohio law. Based upon the advice of counsel, the Company believes (i) that USX should not prevail as a matter of law on a motion to dismiss the Complaint; (ii) it is probable that the court should find the Site constitutes a facility from which a release or threatened release of a hazardous substance has occurred; (iii) the release or threatened release has caused the Company to incur response costs necessary and consistent with CERCLA and (iv) that USX is a responsible party because it owned and operated the Site at the time of disposal of the hazardous substance, arranged for the disposal of the hazardous substance and transported the hazardous substance to the Site. Therefore, counsel to the Company has advised that it appears there is a reasonable basis for the apportionment of cleanup costs relating to the Site between the Company and USX, with USX shouldering substantially all of the cleanup costs because, based on the facts known at this time, the Company itself disposed of no cement kiln dust at the Site and is potentially liable under CERCLA because of its current ownership of the Site. These determinations, however, are preliminary, and are based only upon facts available to the Company prior to any discovery. Based on the limited information available as of December 31, 1993 the Company has received two preliminary engineering estimates of the potential magnitude of the remediation costs for the Site, $8 million and $32 million, depending on the assumptions used. Given the preliminary nature of these estimates, neither alternative seems more likely than the other. Under CERCLA and applicable Ohio law a court generally applies equitable principles in determining the amount of contribution which a potentially responsible party must provide with respect to a cleanup of hazardous substances and such determination is within the sole discretion of the court. In addition, no regulatory agency has directly asserted a claim against the Company as the owner of the Site requiring it to remediate the property, and no cleanup of the Site has yet been initiated. The previously mentioned CKD Report, however, expressly cites the Site as an example of a facility from which a release or threatened release of a hazardous substance has occurred. In late July 1993, a citizens' environmental group brought suit in U.S. District Court in Ohio, alleging that the Company is in violation of the Clean Water Act by virtue of the discharge of pollutants in connection with the runoff of stormwater and groundwater from the Site and is seeking injunctive relief, unspecified civil penalties and attorneys' fees, including expert witness fees. On November 12, 1993 the Company rejected the environmental group's settlement demand without offering a counterproposal. Accordingly, the Company is unable to determine at this time what liability, if any, it may have with respect to this matter. No substantial investigative work has been undertaken at other CKD sites in Ohio. Although data necessary to enable the Company to estimate total remediation costs is not available, the Company acknowledges that the ultimate cost to remediate the CKD disposal problem in Ohio could be significantly more than the amounts reserved. U.S. EPA's Combustion Industry Strategy - On May 18, 1993, the U.S. EPA promulgated the agency's combustion strategy and waste minimization policy. Under the combustion strategy, the U.S. EPA essentially imposed an 18-month moratorium on the permitting of new thermal treatment capacity and ordered all available agency resources be applied to issuing final burning permits to offsite boilers and industrial furnaces, including cement kilns. In addition, the U.S. EPA stated that it would use its omnibus permitting authority to reduce the particulate standard, to establish a dioxin standard and to require risk assessments of direct and indirect pathways of exposure. Furthermore, the U.S. EPA indicated that there was substantial excess thermal treatment capacity in the United States and that the U.S. EPA should reduce such permitted capacity by 25% over the next ten years. The Cement Kiln Recycling Coalition (CKRC), an organization of cement manufacturers that burn HWDF as a fuel substitute and of which the Company is a member, sued to set aside the combustion strategy largely because it was, in effect, a rule making without notice and an opportunity for public hearing. The CKRC supports a legislative program that would result in technology based standards for particulate and dioxin controls applicable to all thermal treatment devices and risk assessment standards that have been exhaustively reviewed during public hearing process. The U.S. EPA has advised its regional administrators that the particulate and dioxin standards set forth in the combustion strategy were for discussion purposes, and would be definitively determined pursuant to subsequent rulemakings. Therefore, the U.S. EPA and the CKRC have agreed to a nine-month stay of the CKRC's suit. Owners and operators of industrial facilities and those who handle, store or dispose of hazardous substances may be subject to fines and other sanctions imposed by the U.S. EPA and corresponding state regulatory agencies for violations of laws or regulations relating to those substances. The Company has incurred fines imposed by those agencies in the past. As a result of an aggressive inspection and enforcement initiative targeting combustion industry facilities, the Company was among a group of owners and operators of 28 boilers and industrial furnaces, including several other major cement manufacturers, from which the U.S. EPA is seeking over $19.8 million in penalties. On September 27, 1993, the U.S. EPA issued a Complaint and Compliance Order (Order) (United States Environmental Protection Agency, Region 5 v. Southdown, Inc. d/b/a Southwestern Portland Cement - Docket No. VW 27- 93) alleging certain violations of the RCRA applicable to the burning or processing of hazardous waste in an industrial furnace. The alleged violations included, among others, exceedence of certified feed rates for total hazardous waste at the Company's Ohio cement manufacturing facility, failure to demonstrate that CKD generated at the facility is excluded from the definition of hazardous waste and storage at the facility without a permit of CKD alleged to be hazardous by virtue of that failure to demonstrate its exclusion from the definition. The Order proposed the assessment of a civil penalty in the amount of $1.1 million and closure of certain storage silos containing the CKD that allegedly is hazardous waste. The Company has engaged counsel to respond to the U.S. EPA Order and believes, after reviewing the complaint and the Company's compliance with the applicable regulations, there are substantial mitigating factors to the interpretations and allegations contained in the Order. For additional discussion of environmental matters related to resource recovery operations see "Environmental Services - Environmental Matters" and "Management's Discussion and Analysis of Financial Condition and Results of Operations - Known Events, Trends and Uncertainties - Environmental Matters", which are incorporated herein by reference. CONCRETE PRODUCTS Company Operations - The Company has vertically integrated its operations in the regional vicinity of its two largest cement plants, which are located in southern California and in Florida. The Company, doing business as Transit Mixed Concrete Company (Transmix), is a major producer of ready-mixed concrete and a supplier of aggregate in the southern California counties of Los Angeles and Orange. The Company, doing business as Florida Mining & Materials Concrete Corp. (Florida Mining), is a major producer and supplier of ready-mixed concrete and other concrete products in Florida and southeastern Georgia. The Company believes that vertical integration into concrete products enhances its overall competitive position in these markets. The Company's combined annual concrete production capacity is over 5.0 million cubic yards. Transmix sells concrete primarily to commercial and industrial builders, as well as contractors on public construction projects, while Florida Mining's sales include a high percentage of sales to residential builders. Florida Mining also manufactures and sells concrete blocks and certain related concrete products. Concrete is formed by mixing sand, water and gravel with cement, the basic binding agent. Transmix and Florida Mining each purchases the majority of its cement from one of the Company's cement plants. Alternative supplies of cement are readily available from other sources, if necessary. Transmix extracts sand and gravel for use in its operations from two active aggregate quarries, one of which is under a long-term lease. The Company sold its three Florida aggregate operations and presently purchases sand and gravel for use in its Florida ready-mixed concrete operations under an aggregate supply contract negotiated in conjunction with the sale. The Company's Concrete Products operations consist of approximately 550 ready-mixed concrete trucks, 68 batch plants, two active aggregate quarries, one of which is under long-term lease and 12 concrete block plants. In conjunction with the sale of the Company's Florida aggregates business in late 1991 and 1992, the parties entered into a long-term supply contract under which the Company's ready-mixed concrete operations in Florida purchase their requirements for aggregate from Vulcan/ICA Distribution Company (Vulcan/ICA). Since the sale of the Florida aggregates business operating results of the Concrete Products segment have been affected by the difference in the costs to produce these aggregates and the price paid by the Company's Florida ready-mixed concrete operations to purchase aggregates from Vulcan/ICA under the long-term supply contract. A slowdown in construction activity in both Florida and southern California began in 1990 and resulted in lower sales volume in these market areas which continued throughout 1992. In 1993 ready-mixed concrete volumes improved approximately 8% to a total of 3.3 million cubic yards, primarily because of improved volumes in Florida while sales volumes for the Company's southern California aggregate operation improved approximately 20%. In 1992, the Company sold approximately 3.0 million cubic yards of concrete and approximately 750,000 tons of aggregates compared with 3.5 million cubic yards of concrete and 1.6 million tons of aggregates in 1991. Market Overview - The demand for concrete products is derived from the demand for construction. The construction sector is subject to the vagaries of weather conditions, the availability of financing at reasonable interest rates and overall fluctuations in regional economies, which tend to be cyclical. The burden of relatively high fixed costs results in a disproportionate impact on profits with only minor variations in sales volume. Seasonal factors are not as significant in the market areas served by the Company's concrete products businesses as in some markets, but construction activity tends to diminish during prolonged periods of inclement weather. New construction activity experienced a slowdown in both market areas in the latter half of 1990 which continued throughout 1992. While the Florida market stabilized in 1992 and gave indications of improvement in 1993, the southern California market slowdown continued during 1993 despite some small signs of improvement and sales volume increases late in the year. Competition - Competition within each market includes numerous small and several large ready-mixed operators. Competition for sales volume is strong, based primarily on price, with consistency of quality and service to customers being of lesser significance. In Florida, Florida Mining's principal competitors include Tarmac Florida, Inc., Rinker Materials Corp., and Florida Rock Industries, Inc. In California, Transmix's principal competitors include Beazer West, Inc., A&A Ready-mixed Concrete, Inc. and Catalina Pacific Concrete, Inc. Capital Expenditures - Capital expenditures during 1993 amounted to $3.5 million for the Concrete Products segment compared with $1.5 million and $5.2 million in 1992 and 1991, respectively. The 1991 downturn in the ready-mixed concrete business obviated the need for capital expenditures for mobile equipment. In certain instances equipment is being leased instead of purchased. Capital outlays in 1994 have been budgeted at approximately $11 million, including approximately $2.5 million in mobile equipment, $1.3 million in quarry development, $3 million related to compliance with environmental regulations and the balance for batch plant equipment replacement and modernization. Environmental Matters - The concrete products industry is subject to environmental regulations similar to those governing the Company's cement operations. As with the cement operations, certain of the concrete products operations are presently the subject of various local, state and federal environmental proceedings and inquiries. The Company along with other entities with activities and operations in the vicinity of Azusa, California, received notices of potential responsibility and requests for information by the U.S. EPA. The Company does not believe that, among the many potential responsible parties (PRPs) in the San Gabriel basin where the Azusa quarry leased and operated by the Company is located, the Company will become a primary target of the U.S. EPA's investigation. In October 1991, the U.S. EPA advised that a former owner/operator of the majority of the area in question had agreed to conduct a site assessment for possible soil and groundwater contamination and to reimburse U.S. EPA for costs incurred to date by the agency on this matter. At that time the U.S. EPA had advised that proper and timely completion of this site assessment would obviate the need for U.S. EPA to issue a special notice letter to commence other enforcement actions during this phase of the investigation process. In February 1994, the Company learned that the U.S. EPA has made public a Feasibility Study and Proposed Plan for taking interim groundwater remedial actions in the Baldwin Park Operable Unit located in the San Gabriel basin, and has indicated its intent to issue a Record of Decision (ROD) regarding the proposed plan. In addition, the U.S. EPA has indicated its intent to issue special notice letters requiring the Baldwin Park PRPs, including the Company, to make a good faith offer to perform the actions described in the Plan and the ROD. A coalition of PRPs is pursuing efforts to design and present to EPA a cost effective response to water quality concerns in the Baldwin Park Operable Unit. Browning-Ferris Industries, Inc. (BFI) is contractually obligated to indemnify the Company for any environmental liability arising from the Company's ownership of the land comprising its current aggregate and ready-mix plant and the landfill site. BFI is also contractually obligated to indemnify the Company for any environmental liability arising from its operation of the Azusa landfill prior to the sale of the property and the landfill operations to BFI in 1987. On November 17, 1992, Region IV of the U.S. EPA advised the Company of certain alleged violations of the NPDES permit issued to a ready-mixed concrete facility operated by the Company in Tallahassee, Florida. (See also "Legal Proceedings", "Cement Operations - Environmental Matters" and "Management's Discussion and Analysis of Financial Condition and Results of Operations - Environmental Matters".) ENVIRONMENTAL SERVICES Company Operations - During 1993, the Company's environmental services business generated revenues of $36.1 million and reported an operating loss of $2.2 million, excluding a $3.1 million write-down of certain environmental assets, compared with revenues of $43.4 million and an operating loss of $10.6 million in 1992, excluding a $21.4 million write-down of certain environmental assets, and revenues of $36.8 million and an operating loss of $4.4 million in 1991. The Company began substituting liquid HWDF for a portion of the fossil fuel requirements at its Fairborn cement plant in 1987. The Company significantly expanded its commitment to the recovery of the energy value in organic hazardous wastes beginning in mid-1990 with the acquisition of a total of seven facilities to process hazardous wastes into liquid and solid HWDF for introduction into permitted cement kilns as a partial substitute for conventional fuels. The Company receives processing revenues from generators of hazardous waste and is also able to reduce outside purchases of fossil fuels, one of the Company's largest variable costs in its cement operations, by utilizing HWDF. Contrary to management's expectations, however, the Company experienced start-up losses totaling approximately $16 million, exclusive of write-downs, in its first two and one-half years in the business. Accordingly, the Company restructured this business in late 1992, narrowing its focus by selling, or planning to sell, all but two of its HWDF processing facilities. The Tennessee facility, one of those being retained, is being upgraded and expanded to provide increased capacity for blending HWDF. As of December 31, 1993, the Company had sold three of its original seven TSDs and is continuing efforts to sell two additional TSDs. After trying unsuccessfully to sell its Alsip, Illinois facility for almost a year, the Company recorded a $3.1 million pretax charge in the fourth quarter of 1993 to record an estimated $1 million in remediation costs at that facility and to write down the carrying value of this facility to reflect the Company's revised estimate of net realizable value. In January 1994 the Company negotiated a letter of intent for a proposed sale of this facility that would generate neither a gain or a loss. In connection with restructuring this segment, the Company recorded a $21.4 million pretax charge in 1992 to write down the difference between book value, including intangible assets, and the estimated realizable value of the TSDs, net of operating losses expected to occur prior to disposition, and to expense the non-recoverable portion of previously deferred environmental permitting costs incurred in the development of the environmental services business. SES also owns a TSD facility in Inglewood, California that is primarily a recycling facility for solvents and other organics. Although these operations do not coincide with SES's long-term strategy for its environmental services business, the ultimate disposition of the property is unclear because of the resolution of a conditional deferred payment obligation and other issues. (See "Legal Proceedings".) SES will continue to operate the Inglewood location as a TSD facility until such time as these matters are resolved. Although SES will no longer pursue the development of a nationwide network of TSD facilities, it has reaffirmed its initial concept of recovering the energy value of certain organic hazardous wastes both as a cost saving alternative source of fuel and as a revenue producing service. SES will continue to collect hazardous waste from most of the major markets in the country for processing at the two remaining facilities. SES has retained and is continuing to develop its sales force and remains committed to the environmental services business. The segment's results improved significantly in 1993 compared with 1992 as a result of the processor dispositions and the related restructuring of the environmental services business. The two TSD facilities that SES will retain process and dispose of various hazardous waste streams for a variety of commercial, governmental and industrial customers. The Tennessee TSD facility is being designed to ultimately provide capacity to process approximately 90,000 tons of solid and liquid hazardous waste annually compared with approximately 30,000 tons of liquid and solid HWDF blended by SES's processor network in 1993. Certain organic materials are processed and blended into HWDF for use in cement kilns including some of those operated by the Company. Under the HWDF program, the energy value of a wide variety of waste materials, including cleaning solvents and degreasers, paint residues, inks, varnishes, storage tank sludges and sediments, as well as the protective clothing and equipment for handling such items, is recovered and used in the cement manufacturing process in a way that the Company believes can be both economically beneficial and environmentally sound. Certain non-recyclable residual materials from hazardous waste treatment processes are disposed of by third-party incineration or land disposal. The ability of the Company's environmental services business to generate operating earnings is dependent on a number of factors, including the renewal of treatment, storage and disposal permits to authorize the processing of hazardous waste, the availability of sufficient volumes of hazardous wastes for processing and the renewal of permits to burn HWDF in certain of the Company's cement kilns. In May 1993 the U.S. EPA essentially imposed an 18 month moratorium on the permitting of new thermal treatment capacity and began an aggressive inspection and enforcement initiative targeting combustion industry facilities, including cement kilns. See "Cement Operations, Environmental Matters -- U.S. EPA's Combustion Industry Strategy". The following table presents current information for the TSD facilities to be retained by SES regarding the location, regulatory status, waste-processing technologies and types of wastes accepted. The Birmingham TSD facility's RCRA Part B permit renewal application was submitted during 1993. There is no assurance that SES's existing TSD permits or the Company's permits to utilize HWDF at two of its cement plants will be renewed upon their expiration. It is also possible that existing permits could be revoked or suspended for a variety of reasons. Market Overview - The vast majority of organic hazardous waste produced by U.S. industry, in both liquid and solid forms, is disposed of onsite by large companies that generate the waste. However, there is a substantial market for offsite commercial disposal services to be provided to small and medium sized companies that cannot economically justify the cost of onsite disposal or to companies, regardless of their size, who choose not to accept the risks inherent in onsite hazardous waste management. The demand for offsite hazardous waste management services is primarily driven by two Federal statutes: RCRA, which was enacted in 1976 to address the management of currently generated hazardous waste, and CERCLA or Superfund, which was enacted in 1980 to clean up past mismanagement of hazardous wastes. As a result of the Hazardous and Solid Waste Amendments of 1984 (HSWA), the U.S. EPA has been implementing restrictions on land disposal of certain hazardous wastes and treatment standards as well as establishing an ongoing waste evaluation program. These restrictions and standards have created a demand for commercial treatment and disposal capacity for hazardous wastes. Competition - SES has three principal sources of competition: (i) offsite hazardous waste service companies, including incinerators, that offer technologies similar to those offered by SES; (ii) generators that process their own hazardous wastes onsite; and (iii) hazardous waste treatment companies that offer treatment technologies, such as detoxification, not offered by SES. SES competes with commercial offsite hazardous waste companies including Chemical Waste Management, Inc. (Chemical Waste), Environmental Systems Company, Rollins Environmental Systems Company, Inc. (Rollins) and others which provide environmental services including the incineration of hazardous waste. Chemical Waste and Rollins also operate landfills as an alternative means of hazardous waste disposal. In addition, the Company competes with certain other cement companies including Holnam, Inc. (Holnam), LaFarge Corporation (LaFarge), Essroc Corporation, Ash Grove Cement Company, Giant Group Ltd., Continental Cement Company, Inc. and others which utilize HWDF in cement kilns. Holnam and LaFarge are also engaged in the collection, processing, treatment and disposal of hazardous waste. In mid-1991, Chemical Waste and Holnam established a joint venture under which Chemical Waste would provide HWDF for introduction into certain of Holnam's cement kilns. Operating costs and collection and disposal fees for hazardous wastes vary geographically. Prices for hazardous waste collection and disposal services are determined by volume, weight and characteristics of the wastes collected, treatment requirements, risks involved in the handling and disposal, competitive factors, costs of disposal and the distance to final disposal sites. Competition in pricing and type and quality of services offered is intense. Excess thermal treatment capacity has resulted in spot shortages of certain types of qualified hazardous wastes and a decline in disposal fees. Hazardous waste services are typically provided to customers under contracts which can be one-time processing agreements or agreements continuing for a period of months or years, and usually provide, among other things, for periodic price adjustments and for the customer to retain legal responsibility for any wastes that are rejected by SES because the wastes do not conform to agreed upon criteria. Capital Expenditures - Capital expenditures amounted to $11 million during 1993, including $3.1 million for resource recovery operations, compared with 1992 expenditures of $9.7 million and 1991 expenditures of $10.4 million subsequent to the acquisitions. Capital outlays in 1994 have been budgeted at approximately $10.4 million, including approximately $4.6 million for resource recovery and $4.6 million to complete the expansion of one of the remaining processing facilities. Approximately $1.4 million of the total is related to compliance with environmental regulations. Although a significant portion of the Company's capital and other expenditures for the Environmental Services segment relate to complying with the laws and regulations concerning the protection of human health and the environment, these expenditures have neither materially adversely affected the earnings of the Company nor placed SES at a competitive disadvantage. The amounts expended by the Company on its facilities for compliance with laws relating to human health and the environment did not have a material impact on the consolidated financial position of the Company in 1993, and the Company does not currently expect the rate of such expenditures to increase significantly during the ensuing fiscal years. However, regulatory changes, enforcement activities or other factors could alter this expectation at any time. Future changes in regulatory requirements related to the protection of human health and the environment may require the Company and others engaged in the hazardous waste management industry to modify various waste processing facilities and alter methods of operations at costs that may be substantial. Environmental Matters - Management believes that the Company's current procedures and practices for handling and management of hazardous wastes are consistent with industry standards and legal requirements and that appropriate precautions are taken to protect employees and others from harmful exposure to such materials. However, because of the complexity of operations and legal requirements, there can be no assurance that past or future operations will not result in violations or claims by employees or others alleging exposure to toxic or hazardous substances. TSD facilities, including cement plants that burn HWDF, are highly regulated by federal, state and local environmental regulations. By definition, the activities of the Environmental Services segment involve materials that have been designated as hazardous wastes. CERCLA and SARA, as well as analogous laws in certain states, create joint and several liability for the cost of cleaning up or correcting releases to the environment of designated hazardous wastes. If contamination occurs, the Company's TSD facilities may be required to conduct costly remediation programs under RCRA, CERCLA or SARA. The U.S. EPA's financial responsibility regulations require owners or operators of TSD facilities to demonstrate financial assurance for sudden and accidental pollution occurrences. Many states have imposed similar requirements on the owners or operators of TSD facilities and underground storage tanks. To meet existing governmental requirements, the Company has been able to secure Environmental Impairment Liability insurance coverage issued by an insurance carrier in amounts substantially in excess of legal requirements. It is possible that the Company's earnings could be adversely affected in the event of significant environmental impairment claims not covered by insurance. Federal and state regulations also require owners or operators of TSD facilities to provide financial assurance of their ability to cover the estimated costs of proper closure and post-closure monitoring and maintenance of these facilities. The Company has been able to rely upon its consolidated financial position in many instances, rather than upon other, more costly financial assurance mechanisms, to satisfy these requirements. Regulatory limitations on the use of the consolidated financial position, however, may restrict the use of this financial assurance mechanism, in which case the Company could be required to resort to other, more costly financial assurance mechanisms available. (See also "Management's Discussion and Analysis of Financial Condition and Results of Operations - Known Events, Trends and Uncertainties - Environmental Matters".) EMPLOYEES The Company employs approximately 2,650 persons, including approximately 1,100 in the cement manufacturing operations, 1,200 in the concrete products operations, 200 in environmental services and the remainder in the corporate office. Approximately 38% of the employees are represented by collective bargaining units. Collective bargaining agreements are in effect at all the Company's cement plants, except for the facility located in Brooksville, Florida, and are in effect at the southern California ready-mixed operations and at the TSD facility located in Inglewood, California. ITEM 2.		ITEM 2. PROPERTIES The material appearing under Item 1 herein is incorporated hereunder by reference, pursuant to Rule 12b-23. Substantially all of the assets of the Company are pledged as security for long-term debt. (See Note 11 of Notes to Consolidated Financial Statements.) ITEM 3.	ITEM 3. LEGAL PROCEEDINGS (a) On November 17, 1992, Region IV of the U.S. EPA advised the Company of certain alleged violations of the NPDES permit issued to a ready-mixed concrete facility operated by the Company in Tallahassee, Florida. The letter requested that Company representatives attend a meeting on December 15, 1992 to show cause why an enforcement action should not be commenced on account of the alleged violations. U.S. EPA officials indicated at the meeting that they would evaluate the information provided by the Company and would determine what, if any, enforcement action they believe is warranted. On January 27, 1993, the Company's attorneys were informed through a telephone call that the U.S. EPA is planning to refer the matter to the Department of Justice (DOJ) for consideration of civil enforcement. No formal letter or complaint has been filed. In October 1993, the site was sold and operations were discontinued. It is not possible to predict the course of the enforcement response U.S. EPA and DOJ ultimately may select. (b) Litigation was initiated by former shareholders of a BFI subsidiary acquired from BFI by the Company and includes claims asserting, among other things, that an installment of a conditional deferred payment obligation which the Company believed to be in the amount of $9.0 million is actually in the amount of $10.0 million, that adjustments to the purchase price and certain additional amounts aggregating approximately $500,000 are payable to such shareholders, that an accounting must be provided to such shareholders, and that the defendants acted intentionally and maliciously and therefore that the shareholders are entitled to punitive damages. (Benita H. O'Meara, an individual; Ernest O. Roehl, an individual, v. Southdown Environmental Systems, Inc., a Delaware corporation, aka BFI Environmental Treatment Systems, Inc., a Delaware corporation, aka Southdown Environmental Treatment Systems, Inc., a corporation; Does 1 through 50, inclusive) (Superior Court of the State of California for the County of Los Angeles - Case No. BC 056904) The Company notified BFI of its claim for indemnity under the stock purchase agreement but BFI denied the Company's claim. The Company responded timely to the suit and filed a cross-complaint against BFI seeking judicial clarification as to BFI's liability under the indemnity agreement, damages and other relief. (Southdown, Inc., a Louisiana corporation, v. Browning-Ferris Industries, Inc., a Delaware corporation; CECOS International, Inc., a New York corporation; and Does 1 through 50, inclusive) (Superior Court of the State of California for the County of Los Angeles - Case No. BC 063261) On January 3, 1994 all parties orally agreed to an out-of-court settlement whereby (i) all actions and cross-actions will be dismissed; (ii) BFI agreed to assume responsibility for the additional $1 million potentially owed to the former shareholders and (iii) BFI and the Company agreed to indemnify each other for certain other claims. (c) U.S. EPA Region IV issued a Complaint and Compliance Order, dated August 31, 1992, to the Company's Knoxville cement plant. Based on the U.S. EPA's Compliance Evaluation Inspections conducted in January and July 1992, the U.S. EPA asserts that the Knoxville cement plant violated certain requirements of the BIF Rule, promulgated pursuant to the Hazardous and Solid Waste Amendments to the RCRA, and assessed a civil penalty of $171,250. The Company is currently negotiating the resolution of the issues with representatives of the U.S. EPA and has reached an agreement in principle to pay a penalty of $97,300. (d) The Antitrust Division of the DOJ has convened a Grand Jury investigation of certain ready-mixed concrete companies in the Tampa Bay Area. On August 1, 1990, the Company was served with a subpoena for the production of documents to the United States District Court, Middle District of Florida. No charges have been filed against the Company, any of its subsidiaries, or any of its employees. The Company complied with the request for documents in November 1990. A number of employees were interviewed or testified before the Grand Jury in 1991 and 1992. In 1993, the investigation was terminated without handing down an indictment. (e) In March 1991, SES received notice that the U.S. EPA had initiated an enforcement action under RCRA against the previous owners of an Avalon, Texas TSD facility, which SES acquired from BFI in 1990. In its complaint, the U.S. EPA has alleged that the entity failed to file appropriate reports with the Texas Water Commission in advance of importing foreign waste materials for processing at the facility. The U.S. EPA is seeking a civil penalty of $229,500 based on alleged violations occurring as a result of practices of the predecessor owners which were discontinued in 1989. Pursuant to the purchase agreement between SES and BFI, BFI agreed to indemnify the Company against environmental damages originating prior to SES's acquisition of the processing facilities. The Company has notified BFI that it intends to exercise its indemnification rights with respect to any damages arising from the U.S. EPA action. While BFI acknowledges certain liabilities under the indemnification provisions of the purchase agreement, BFI contends that the predecessor owners also bear liability. The Company and BFI have engaged joint counsel to contest the proposed penalty and pursue indemnities given in favor of BFI by these previous owners. Counsel has filed an original answer and request for hearing with the U.S. EPA. In its answer, the Company has asserted numerous legal and factual defenses including that the regulations allegedly violated are legal and inapplicable to the given circumstances. (f) In connection with the acquisition of a hazardous waste processor in 1990, SES entered into an Oil Purchase Agreement with the seller and a Consulting Agreement with the sole stockholder of the seller. Based upon the seller's failure to pay invoices for fuel oil delivered under the Oil Purchase Agreement, SES terminated the agreement in September 1991. On September 26, 1991, SES sold the assets of the processor relating to the business of collecting waste oil. In October 1991, SES filed suit in Texas state court against the seller for collection of amounts due under the Oil Purchase Agreement and the Stock Purchase Agreement pursuant to which the Company acquired the processor and sought a declaratory judgment against the seller and the stockholder with respect to the rights of the parties under the Stock Purchase Agreement, the Oil Purchase Agreement and the Consulting Agreement. The defendants filed counterclaims against the Company seeking a declaratory judgment concerning the Consulting Agreement, the Stock Purchase Agreement and the Oil Purchase Agreement and seeking monetary damages in the amount of approximately $30 million for alleged breach of the Consulting Agreement and the Oil Purchase Agreement and approximately $10 million in punitive damages. (Century Resources, Inc. and Southdown Environmental Treatment Systems, Inc. v. Torco Oil Company and Anthony M. Tortoriello) (333rd Judicial District Court of Harris County, Texas - Cause No. 91-54262) In 1992, the stockholder and the seller filed suit against the Company in Illinois asserting claims comparable to those made in their counterclaim in the Texas case and seeking an injunction forbidding the Company to sell any assets of the processor. In May 1993, the Illinois cases were stayed by agreement of the parties, pending final resolution of the Texas lawsuit. The Company believes that it has meritorious defenses to these claims, and that its ultimate liability thereunder, if any, will not be material to its consolidated financial position. (Anthony M. Tortoriello v. Southdown Environmental Treatment Systems, Inc., a Delaware corporation, and Century Resources, Inc., an Illinois corporation) (Circuit Court of Cook County, Illinois, Chancery Division - Case No. 92-CH-09365) (Torco Oil Company, an Illinois corporation v. Southdown Environmental Treatment Systems, Inc., a Delaware corporation, and Century Resources, Inc., an Illinois corporation) (Circuit Court of Cook County, Illinois, Chancery Division - Case No. 92-CH-9874). (g) In late July 1993 a citizens' environmental group brought suit in U.S. District Court for the Southern District of Ohio, Western Division (Greene Environmental Coalition, Inc., an Ohio not-for-profit corporation v. Southdown, Inc., a Louisiana corporation - Case No. C-3-93-270) alleging the Company is in violation of the Clean Water Act by virtue of the discharge of pollutants in connection with the runoff of stormwater and groundwater from the Site and is seeking injunctive relief, unspecified civil penalties and attorneys' fees, including expert witness fees. In August the Company moved to dismiss the complaint. The environmental group responded on October 22, 1993. On November 4, 1993 the Company filed a reply to the environmental group's response and the matter is now pending before the court for final disposition. Pursuant to a preliminary pretrial conference order issued by the court, the environmental group provided the Company with a written settlement demand in early October 1993. On November 12, 1993 the Company rejected the environmental group's settlement demand without offering a counterproposal. Accordingly, the Company is unable to determine at this time what liability, if any, it may have with respect to this matter. (h) The information appearing under Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations - Known Events, Trends and Uncertainties - Environmental Matters" is incorporated hereunder by reference, pursuant to Rule 12b-23. ITEM 4.	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. There were no matters submitted to a vote of security holders during the quarter ended December 31, 1993. PART I I ITEM 5.	ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SECURITY HOLDER MATTERS. MARKET PRICES AND DIVIDENDS ON COMMON STOCK AND SHAREHOLDER INFORMATION The Company's Common Stock is traded on the New York Stock Exchange (Symbol:SDW). The following table sets forth the high and low sales prices of the stock for the indicated periods as reported by the NYSE. - -------------- * On April 25, 1991, the Board of Directors suspended the dividend on the Company's Common Stock. For certain information describing the Company's capital stock, rights plan and change in control provisions, see Note 21 of Notes to Consolidated Financial Statements. On January 31, 1994 there were 1,937 holders of record of the Company's Common Stock. On February 23, 1994, the closing price of the stock was $27.75. ITEM 6.	ITEM 6. SELECTED FINANCIAL DATA. - --------------------- (1) Includes a $21.4 million pretax write-down of certain environmental services assets. (See Note 18 of Notes to Consolidated Financial Statements.) (2) Includes $16 million equity in pretax loss of unconsolidated joint venture. (See Note 19 of Notes to Consolidated Financial Statements.) (3) Includes a $10 million pretax charge attributable to an unfavorable arbitration ruling and a $6.6 million pretax credit to pension expense. (4) The Company's oil and gas operations, which were sold on November 15, 1989, are reflected as discontinued operations. (See Note 20 of Notes to Consolidated Financial Statements.) (5) Premium on early extinguishment of debt. (6) Cumulative after-tax effect of change in accounting for initial obligation for estimated postretirement health care benefits as required by adoption of Statement of Financial Accounting Standards No. 106 effective January 1, 1993. (See Note 2 of Notes to Consolidated Financial Statements.) Management's Discussion and Analysis of Financial Condition and Results of Operations related to this information appears on Page 29 of this report. Total capitalization represents the sum of total debt, preferred stock subject to mandatory redemption and shareholders' equity. ITEM 7.	ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. RESULTS OF OPERATIONS CONSOLIDATED EARNINGS 1993 compared with 1992 Operating earnings for the year ended December 31, 1993 were $39 million compared with an operating loss of $16.6 million for the prior year. The years ended December 31, 1993 and 1992 include write-downs of $3.1 million and $21.4 million, respectively, to adjust the carrying value of certain environmental services assets. Including a $48.5 million, $2.86 per share, first quarter charge related to adoption of Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" (SFAS No. 106) and a $1 million redemption premium (net of tax) resulting from the early retirement of $45 million of 12% Senior Subordinated Notes, the net loss for the year ended December 31, 1993 was $49.5 million, $3.22 per share, primary and fully diluted. The net loss for the prior year period was $40.6 million, $2.69 per share, primary and fully diluted, including an $800,000 after-tax gain on discontinued operations, $0.05 per share fully diluted. Consolidated revenues in 1993 increased 7% over the prior year primarily because of improvements in sales volumes and sales prices from the Cement and Concrete Products operating segments. Excluding the write-down of environmental services assets in both years, 1993 operating earnings increased $37.3 million over the prior year. This increase was attributable to improvements in each of the operating segments because of: (i) improved sales volumes and operating margins from the Cement and Concrete Products operations; (ii) the sale or prior year classification as "Held for Sale" of four hazardous waste processing facilities that generated operating losses in the prior year and (iii) improved operating results from the remaining waste processors. The current year included (i) a $3 million charge to increase the estimated liability for remediation of an inactive cement kiln dust (CKD) disposal site; (ii) a $1.7 million charge for proxy contest fees and expenses and (iii) a $1.2 million gain from the sale of the Company's right to receive its portion of the settlement of bankruptcy claims against LTV Corporation. The prior year included (i) a $3.6 million charge related to remediation of the inactive CKD disposal site previously mentioned; (ii) $1.1 million in charges to decontaminate hazardous waste processing equipment and incinerate waste contaminated with polychlorinated byphenyls (PCB), which was accepted and processed in error at two of the Company's hazardous waste processors; (iii) a $3.0 million charge to record the loss realized upon closing of the final phase of the Florida aggregate operation sale; (iv) an $853,000 charge for unpaid use taxes and penalty and interest due thereon; (v) a $2.7 million gain recognized on the sale of a cement terminal and (vi) a $2.7 million gain representing a fee earned for approval of a non-affiliated debt refinancing. Although 1993 revenues increased 7% over 1992, operating costs increased only approximately 1% because of a favorable impact of continued cost savings measures and because of the elimination of operating costs attributable to the four hazardous waste processing facilities which were sold or classified as "Held for Sale" by the end of 1992. Depreciation, depletion and amortization for 1993 declined compared with the prior year because of the 1992 write-down of certain goodwill and non-compete contracts and the decision to lease, rather than purchase, new mobile equipment. Primarily because of cost reduction measures imposed during 1993, general and administrative expenses for the year ended December 31, 1993 decreased by $5 million despite a $2.5 million charge to accrue the estimated cost of providing postretirement health care benefits in excess of claims incurred as required by the 1993 adoption of SFAS No. 106. Interest expense for the year ended December 31, 1993 was $5.7 million lower than the prior year primarily because of lower outstanding debt. The effective rate of the tax benefit on the operating loss for 1993 was 100% because of the interaction of the increase of corporate federal income tax rate, permanent differences between book and tax loss for the year and state income tax benefit. (See Note 12 of Notes to Consolidated Financial Statements.) The $48.5 million charge as a result of the adoption of SFAS No. 106 is reported as the "Cumulative effect of a change in accounting principle", and represents the estimated liability based on benefit plans in effect at January 1, 1993 for postretirement benefits, other than pensions, attributable to employee services provided in prior years. (See Notes 2 and 16 of Notes to Consolidated Financial Statements.) 1992 compared with 1991 Operating earnings for the year ended December 31, 1992 were $4.8 million, excluding the $21.4 million write-down of certain environmental services assets, compared with an operating loss of $15.7 million in the prior year. The net loss for 1992 was $40.6 million, $2.69 per share fully diluted, compared with a 1991 net loss of $44.6 million, $2.94 per share. Both years had a number of significant, miscellaneous items. The 1992 write-down of environmental services assets consisted primarily of the difference between the book value and the estimated fair value of the four of the Company's six hazardous waste processors to be sold, estimated losses related to such assets until sold and the write-off of capitalized environmental permitting costs deemed not to be recoverable. (See Note 18 of Notes to Consolidated Financial Statements.) Significant miscellaneous items included in 1992 results are described in detail above. In the third quarter of 1992, the Company also recognized an $800,000 after-tax gain on discontinued operations, $0.05 per share fully diluted, resulting from recognition of the final portion of the gain deferred from the 1989 sale of the Company's oil and gas operations. The 1991 operating loss included a number of significant, miscellaneous charges including: (i) a $5.9 million write-down of the Florida aggregate operations in connection with the sale of those operations; (ii) a $3.1 million charge to establish a reserve for estimated remediation costs of the previously discussed inactive CKD site in Ohio; (iii) a $1.1 million charge representing the estimated loss on a reverse interest rate swap transaction and (iv) a $3.6 million charge to increase the allowance for doubtful accounts. In 1991 the Company also recorded a $12.3 million pretax write-off of the Company's remaining investment in a thermal distillation joint venture. The write-down of the environmental services assets in 1992 resulted in an after-tax charge of $1.01 per share in 1992 compared with the $0.47 per share charge in 1991 as a result of the write-off of the investment in the joint venture. Also included in 1991 was a $1.4 million after-tax extraordinary charge for the prepayment penalty on the early retirement of certain debt. Consolidated revenues in 1992 were essentially the same as revenues in the prior year. A 3% increase in Cement segment revenues and an 18% increase in Environmental Services segment revenues were offset by a 13% decline in Concrete Products segment revenues. Lower Concrete Products revenues resulted from declining ready-mixed concrete sales volume and prices in the face of the ongoing recession in the southern California construction industry. An increase in Florida ready-mixed concrete revenues was offset by the loss of revenues from the two Florida aggregate operations sold in late 1991. Consolidated operating earnings in 1992, excluding the $21.4 million write-down of environmental services assets, improved significantly over the prior year as a strong recovery in Cement segment earnings and reduced losses from the Concrete Products segment more than offset increased losses experienced by the Environmental Services segment. The improvement in Cement segment earnings resulted from the favorable impact of increased margins and higher sales volume. Margins increased despite lower average cement sales prices because of lower operating costs reflecting the impact of a cost reduction program, as well as the positive impact of spreading fixed costs over higher production levels needed to fulfill sales demand. Losses in the Concrete Products segment were lower because the decline in southern California sales volume was offset by improved margins in the Florida ready-mixed concrete operations. The Environmental Services segment, excluding the write-down of certain assets, experienced increased operating losses in 1992 primarily because of: (i) losses incurred at the Spring Grove, Ohio facility subsequent to its acquisition in January 1992; (ii) special charges incurred to decontaminate equipment and incinerate PCB contaminated wastes that were accepted and processed in error; (iii) lower sales volume and throughput of liquid hazardous waste derived fuels (HWDF); (iv) higher operating costs in the Environmental Services segment generally, and (v) higher sales and marketing expenses incurred as a result of the development of a larger sales force for the segment. Interest expense in 1992 increased $4.3 million compared with 1991 primarily because of higher borrowing costs resulting from the issuance of $125 million of 14% Senior Subordinated Notes in late 1991, partially offset by lower interest rates on the Company's variable rate debt. The estimated effective income tax rate of 33% for 1992 reflected the impact of permanent differences between book income and taxable income for the year. The estimated effective tax rate of 40% for 1991 was higher than the statutory rate because of the nature of the permanent differences which resulted in an increase in the effective rate of the tax benefit associated with the loss for that year. SEGMENT OPERATING EARNINGS Cement - Operating earnings for the year ended December 31, 1993 were $81.9 million on revenues of $370.9 million compared with operating earnings and revenues of $62.6 million and $339.5 million, respectively, in the prior year. Operating results improved over the prior year primarily as a result of a 7% increase in sales volumes and a 27% improvement in margins. The Company realized price increases in most of the Company's cement markets throughout the year resulting in a 3% improvement in the average price per ton on a year-to-year comparison and a 6% increase in average price per ton on a year-end to year-end comparison. The average operating cost per ton in 1993 declined approximately 3% from 1992 as the segment's cost reduction program produced additional savings in 1993 operating costs compared with the prior year. Improvements in operating earnings over the prior year were realized at six of the Company's cement plants. Operating earnings declined at the Pittsburgh and Knoxville plants primarily because of higher operating costs resulting from longer than expected maintenance shutdowns and various other operating problems during the year. As a result of successful antidumping petitions filed by a group of domestic cement producers, including the Company, cement imports into the U.S. have declined significantly over the past several years. Consequently, the Company has, in some instances, been able to sell cement to customers who previously bought cement imported from outside the U.S. During the past several years, the Company has contracted to sell cement for up to fifteen months under large volume sales contracts with as many as six other cement manufacturers or distributors. Some of the contracts have take-or-pay provisions. In exchange for guarantees of minimum annual sales volumes, these contracts generally provide for lower sales prices than the Company's customary sales arrangements. In 1993 and 1992 these contracts, assuming they represented only incremental sales (i.e., that fixed costs were fully covered by other sales), accounted for approximately 25% and 31% of the Cement segment's operating earnings, respectively. For 1994 and beyond, the Company has renegotiated certain of these contracts, providing for, among other things, similar minimum annual sales volumes, price escalation clauses and, in one instance, a multi-year term. The loss of a significant portion of the sales from these large volume contracts would have a material adverse effect on the Company's results of operations although the Company believes that at least a portion of the volumes covered by these contracts could be replaced by direct sales to cement consumers in the Company's existing markets. Cement segment operating earnings for the year ended December 31, 1992 were $62.6 million compared with $44.9 million in the prior year. Earnings improved primarily because of an 8% increase in sales volume compared with the prior year and because of increased margins resulting from lower unit costs. Unit costs declined in 1992 primarily because of cost saving measures and higher volumes over which to spread fixed costs. The year ended December 31, 1991 included a special one-time $3.6 million Cement segment charge to increase the allowance for doubtful accounts while 1992 included an $853,000 charge for prior year unpaid use taxes and related penalties. Cement segment revenues were $339.5 million and $328.4 million in 1992 and 1991, respectively. The increase in 1992 revenues over the prior year resulted from the previously mentioned 8% increase in sales volume, but was partially offset by a $2.28 per ton decline in average selling prices from 1991 levels. An increase in large volume, lower-priced shipments combined with competitive price reductions was largely responsible for the 1992 decline in average selling prices. Cement segment operating earnings improved in 1992 because of the increase in sales volume and because of the improvement in margins. Sales volumes increased at six of the eight cement plants with only the Pittsburgh, Pennsylvania and Fairborn, Ohio plants registering decreases from 1991. The Lyons, Colorado cement plant experienced a 38% increase in sales volume as the effects of airport construction and an improving regional economy resulted in increased 1992 demand. Only the Lyons, Colorado and Pittsburgh, Pennsylvania cement plants reported an increase in 1992 average selling prices over 1991. Margins improved, however, because of the better than 9% decrease in unit operating costs. Sales volumes and average unit prices, manufacturing and other plant operating costs and margins relating to cement plant operations for the past three years appear in the table below: -------------- (1) Includes fixed and variable manufacturing costs, selling expenses, plant general and administrative costs, other plant overhead and miscellaneous costs. (2) Excludes the effect of an $853,000 charge for unpaid use taxes related to prior years. Operating costs per ton have declined in each of the last two years compared with the prior year primarily because of the favorable impact of: (i) higher sales volume and higher production levels which resulted in fixed costs being spread over more units and (ii) the effect of a cost reduction program. Clinker production increased 3% in 1993 compared with the prior year and 9% in 1992 from 1991 levels in response to increased sales demand. The increase in the average sales price per ton for 1993 compared with the prior year reflects a general firming of cement prices throughout the industry and at least the partial realization of price increases implemented at most of the Company's cement plants during 1993. The average sales price per ton was lower for 1992 compared with 1991 because of an increase in the proportion of large volume, lower-priced shipments to total sales combined with the impact of other competitive price concessions granted during a recessionary period. Concrete Products Operations - The concrete products segment's operating loss for 1993 improved to $1.6 million from the $11.6 million loss reported in the prior year. Revenues increased approximately 12% over the prior year primarily because of higher sales volumes and prices from the Florida concrete products operation. In spite of lower sales prices and unusual, extremely heavy rains during the first two months of 1993, the operating loss for the southern California ready-mixed concrete operation declined significantly because cost reduction measures were successful. Results also improved from higher aggregates sales volumes and prices. Operating results for the Florida ready-mixed concrete operation improved because of a 4% increase in the average sales price per cubic yard combined with higher operating earnings from the concrete block, resale and fly ash operations. The period-to-period comparison was also aided by the late 1992 sale of certain Florida aggregate operations which lost $1.7 million in the course of that year. The operating loss for 1992 was $11.6 million compared with $12.7 million in 1991. Revenues in 1992 decreased $23 million compared with 1991. The smaller loss in 1992 compared with 1991 was the result of improved concrete prices in Florida which more than offset lower volumes and prices in southern California which continued to worsen as the California economy stagnated. The 13% decline in ready-mixed concrete sales volume was responsible for the decrease in 1992 revenues compared with 1991. The majority of the decline occurred as a result of the slumping southern California market. Sales volumes, average unit prices and cost data and margins relating to the Company's ready-mixed concrete operations for the past three years appear in the following table: -------------- (1) Includes variable and fixed plant costs, delivery, selling, general and administrative and miscellaneous operating costs. The increase in the weighted average sales price per yard for the year ended December 31, 1993 compared with the 1992 period reflects higher sales prices in the Company's Florida market partially offset by lower prices in the Company's southern California market. The decrease in the weighted average operating costs per yard for the year ended December 31, 1993 compared with the 1992 periods is attributable to lower material costs and the implementation of an automated truck-tracking system which has resulted in increased productivity for the southern California operation. Effective September 30, 1991, the Company sold its construction aggregates businesses in Hernando and Polk Counties, Florida to Vulcan/ICA distribution Company (Vulcan/ICA) for $17 million. The Company also agreed to sell, subject to the satisfaction of certain conditions, its one remaining Florida aggregate quarry, located in Charlotte County. The Company recorded charges totaling $8.9 million 1991 and $3 million in the fourth quarter of 1992 when the sale of the Charlotte County property was concluded. The charges represent (i) the difference in the selling price and the book value and (ii) the accrual of certain transaction costs and contingencies. In conjunction with these sales, the parties entered into a long-term supply contract under which the Company's ready-mixed concrete operations in Florida purchase their requirements for aggregates from Vulcan/ICA. The operating results of the Company's aggregate operations have been included for financial reporting purposes in the concrete products segment. As a result of the 1991 and 1992 sales of the Florida aggregate operations, operating results have been affected by the difference in the costs to produce these aggregates and the price paid by the Company's Florida ready-mixed concrete operations to purchase aggregates from Vulcan/ICA under the long-term supply contract. Environmental Services - Excluding a $3.1 million write-down of certain assets in 1993 and a $21.4 million write-down in 1992, the Environmental Services segment reported an operating loss of approximately $2.2 million for the year ended December 31, 1993 compared with a loss of $10.6 million in the prior year. Segment operating losses improved in 1993 because: (i) the prior year included $4.9 million in operating losses from four hazardous waste processing facilities which were sold or reclassified as "held for sale" by the end of 1992; (ii) the prior year period included $1.1 million in charges related to decontamination of equipment and incineration of pcb contaminated wastes that were accepted and processed in error; (iii) improved operating results from the Tennessee, Alabama and California hazardous waste processing facilities and (iv) a $2.4 million decline in 1993 amortization costs as a result of the fourth quarter 1992 write-down. In addition to the operating loss, ses recognized a $3.1 million charge in the fourth quarter of 1993 to reflect a revised estimate of the fair value of its Illinois TSD facility after trying unsuccessfully for a year to sell the facility. In January 1994 the Company negotiated a letter of intent for a proposed sale of this facility that would generate neither a gain or a loss. Operating results for 1992, excluding a $21.4 million write-down of certain environmental services assets, were a $10.6 million loss compared with a 1991 operating loss of $4.4 million. Revenues in 1992 increased to $43.4 million from $36.8 million in 1991. Although income from the burning of HWDF increased in 1992 by $400,000 compared with 1991 and segment revenues increased 18% over 1991, segment losses increased as a result of: (i) losses incurred at the Spring Grove, Ohio facility subsequent to its acquisition in January 1992; (ii) a $1.1 million decontamination and incineration charge mentioned previously; (iii) lower sales volume and throughput of liquid HWDF, and higher operating costs in the environmental services segment generally and (iv) higher sales and marketing expenses incurred to create a larger sales force. Corporate Overhead - Corporate general and administrative costs consist primarily of costs attributable to the Company's Houston, Texas office which are not generally allocated to the business segments. In contrast, the cost caption "general and administrative" as it appears on the Company's statement of consolidated earnings includes not only general and administrative expenses incurred at the Company's corporate office, but also amounts incurred at the Company's various operating locations. Since 1990 the Company has pursued centralization of general and administrative functions where practicable and has significantly expanded the level of support provided to its operating locations from the corporate office. The large increase in corporate expenses, which includes the establishment of a corporate office environmental services support staff, has been partially offset by lower general and administrative expenses at other operating levels as certain functions were transferred to the corporate office or eliminated entirely. Excluding the $2.5 million charge accrued as a result of the adoption of SFAS No. 106, Corporate general and administrative expenses were $26.4 million for the year ended December 31, 1993 compared with $32.7 million in 1992. General and administrative expenses during 1993 were lower than the prior year for almost all cost categories as a result of cost reduction measures imposed during 1993. Corporate general and administrative expenses for 1992 were $32.7 million compared with $34.1 million in 1991 primarily because of a $1.4 million credit to pension expense in 1992. Miscellaneous income (losses) - Miscellaneous income (losses) includes interest income on invested funds as well as miscellaneous other income and expense items. Miscellaneous income (losses) was a net loss of $2.8 million in 1993, a net $1.5 million of income in 1992 and a net loss of $5.1 million in 1991. Miscellaneous income (loss) in 1993 included: (i) a $3 million charge for estimated remediation costs for an inactive CKD disposal site; (ii) a $1.7 million charge for proxy contest fees and expenses and (iii) a $1.2 million gain from the sale of the Company's right to receive its portion of the settlement of bankruptcy claims against ltv corporation. Miscellaneous income (loss) in 1992 included: (i) a $3.6 million charge for estimated remediation costs for the previously mentioned CKD disposal site; (ii) a $3 million write-down of the Florida aggregate operation; (iii) a $2.7 million gain recognized on the sale of a cement terminal and (iv) a $2.7 million gain representing a fee earned for approval of a non-affiliated debt refinancing. Miscellaneous income (loss) in 1991 included: (i) a $5.9 million write-down of the Florida aggregate operations; (ii) a $3.1 million charge to remediate the previously mentioned CKD disposal site and (iii) $1.6 million gain recognized on the sale of a cement terminal. LIQUIDITY AND CAPITAL RESOURCES The Company's short-term liquidity needs have generally been satisfied by: (i) internally generated cash flow from operations, (ii) borrowings under the Company's revolving credit facility or (iii) a combination of these two sources. Internally generated cash flow from operations, a $15.7 million federal income tax refund from the carryback to prior years of the 1992 tax loss and $7.6 million in cash generated from asset sales, were utilized to meet all of the Company's cash requirements for the year ended December 31, 1993. Such cash flow was utilized to: (i) invest approximately $24 million in property, plant and equipment; (ii) reduce long-term debt by approximately $25 million and (iii) pay dividends on preferred stock. Although effective January 1, 1993 the Company adopted an accrual basis of accounting for postretirement health care benefit costs as required by SFAS No. 106, The Company continues to pay for such costs as incurred. During 1992 the Company generated approximately $10 million in miscellaneous asset sales to supplement cash flow and received an $18.7 million federal income tax refund. On November 19, 1993, the Company entered into a $200 million restated Revolving Credit Facility (Restated Revolving Credit Facility) with a group of eight commercial banks. The Restated Revolving Credit Facility includes $20 million of borrowing capacity that is restricted solely for potential funding of obligations under an agreement between the Company and the U.S. Maritime Administration related to certain shipping operations owned previously by Moore McCormack Resources, Inc. (Moore McCormack), an entity acquired by the Company in 1988. (See Notes 11 and 14 of Notes to consolidated Financial Statements.) The facility also includes the issuance of standby letters of credit up to a maximum of $95 million. The Restated Revolving Credit Facility remains the same size as a previously existing revolving credit facility between the Company and its lending banks but (i) extends the maturity of the facility to November 1996 and (ii) provides the Company with enhanced flexibility under the restrictive covenants. Substantially all of the Company's assets remain pledged to secure this facility. At January 31, 1994, $24 million of letters of credit and $75 million of borrowings, excluding any amounts restricted for funding the maritime obligations, were available for the Company's use under the Restated Revolving Credit Facility. In late January 1994 the Company realized approximately $83 million in net proceeds from the sale of 1,725,000 shares of a new issue of preferred stock. (See Note 21 of Notes to Consolidated Financial Statements.) The net proceeds were used to prepay an $18 million promissory note due in March 1994 and to reduce borrowings under the Company's Restated Revolving Credit Facility, $47 million of which was incurred in early January 1994 to redeem $45 million principal amount of the Company's 12% Senior Subordinated Notes Due 1997 (12% Notes). The Company intends to prepay the remaining $45 million outstanding principal amount of the 12% Notes as promptly as practicable after May 1, 1994 with additional borrowings under the restated revolving credit facility. The prepayment of the promissory note enabled the Company to retire a like amount letter of credit which had served as collateral for the promissory note. In addition, the Company is actively considering calling for redemption all of the outstanding shares of its Series B Preferred Stock at the redemption price of $50.00 Per share plus accrued and unpaid dividends to the redemption date. Each share of Series B Preferred Stock is convertible into 2.5 Shares of the Company's common stock (equivalent to a conversion price of $20.00 Per share of common stock). The Company's earnings typically follow the cyclical activity of the construction industry. The Company's earnings have been negatively impacted since mid-1990 because of the severe downturn in construction activity in most of the Company's market areas through 1991 and, in southern California through 1992. Construction activity, at least in some regions of the country, began to give indications of a slight rebound in 1993. CASH FLOWS Operating Activities - In spite of the large net losses, cash provided by operating activities was $54.7 million for 1993 and, $33.7 million for 1992, compared with $9.7 million in 1991. The increase was attributable to large non-cash charges and federal income tax refunds in 1993 and 1992. During 1993 the Company received a $15.7 million federal income tax refund from the carryback to prior years of the 1992 tax loss. During 1992 the Company received an $18.7 million income tax refund from the carryback to prior years of the 1991 tax loss. Investing Activities - In addition to routine capital expenditures, investing activities in 1993 included $7.6 million in net cash proceeds from the sale of miscellaneous assets and two hazardous waste processors. Investing activities in 1992 included $9.8 million in net cash proceeds from the sale of miscellaneous assets, including the last of the Florida aggregate operations, compared with $23.7 million of miscellaneous asset sales in 1991. Approximately $17.4 million was invested in capital expenditures during 1992 compared with a 1991 investment of $30 million in capital expenditures and $6.2 million invested in a thermal distillation joint venture. Financing Activities - Funds provided by operating activities were utilized to reduce long-term debt by $25.4 million and to pay dividends during 1993. In spite of adverse economic conditions, the Company was able to achieve an almost $18 million net reduction in long-term debt in 1992. During 1991, the Company issued $125 million in 14% Senior Subordinated Notes to refinance $77 million of senior secured notes and reduce borrowings utilized under the Company's 1991 credit facility for capital expenditures, scheduled debt repayments, dividends and redemption of $6 million of redeemable preferred stock. CHANGES IN FINANCIAL CONDITION The change in financial condition of the Company between December 31, 1992 and December 31, 1993 reflects the utilization of the federal income tax refund of $15.7 million and cash provided by operating activities to primarily reduce outstanding long-term debt and to fund capital expenditures. The improved demand for cement and related products in 1993 has resulted in a decrease in inventories. The increase in the current deferred income tax asset reflects the expected utilization of net operating loss carryforwards in 1994. The decline in prepaid expenses and other current assets reflects the 1993 sale of two hazardous waste processing facilities which had been classified as current assets held for sale. Current maturities of long-term debt increased because of the reclassification of the final scheduled payment of $18 million on a promissory note due on March 31, 1994. Accounts payable and accrued liabilities increased because of the timing of payments on normal trade and other obligations including the aforementioned increase in the estimated liability for remediation of an inactive CKD disposal site. The large decrease in the deferred income tax liability and reinvested earnings and the large increase in the long-term portion of postretirement benefit obligation reflects the recording of the initial liability for postretirement benefits and the associated charges to income and deferred income taxes as a result of the Company's adoption of SFAS No. 106 effective January 1, 1993. (See Note 2 of Notes to Consolidated Financial Statements.) The decrease in other long-term liabilities and deferred credits reflects payments made in accordance with estimated liabilities on the Moore McCormack discontinued operations. CAPITAL EXPENDITURES The Company invested $24.4 million in property, plant and equipment in 1993 including approximately $8.5 million for the Cement operations, $3.5 million for Concrete Products and $11.0 million for Environmental Services. In addition to the Concrete Products segment's 1993 capital budget, $2.9 million was expended as partial consideration for the acquisition of five ready-mixed concrete batch plants and one aggregate quarry in 1993. In 1992, the Company invested approximately $17.4 million in property, plant and equipment. The Company's 1994 planned capital expenditures are approximately $42 million, of which $17.5 million is allocated for the Cement segment, $11.1 million for the Concrete Products segment and $10.4 million for the Environmental Services segment. The balance of the 1994 capital expenditures budget has been allocated primarily for computer related hardware and software costs. Capital expenditures in the Cement and Concrete Products segments were held to maintenance and strategic necessity levels during 1992 and 1993. The Cement segment's estimated capital budget for 1994 provides for high priority expenditures. The Concrete Products segment's estimated capital budget for 1994 includes approximately $2.5 million for mobile equipment and approximately $8 million for batch plant improvements and equipment, including approximately $3 million of expenditures related to environmental compliance. The Environmental Services segment's capital budget for 1994 includes approximately $4.6 million allocated for improvements and completion of the expansion of one of the existing TSD facilities to provide increased production capabilities, and approximately $1.4 million in capital projects related to compliance with environmental regulations. While the Company commits substantial resources to complying with the laws and regulations concerning the protection of human health and the environment, management does not believe these expenditures have placed the Company at a competitive disadvantage. The amounts expended by the Company on its facilities for compliance with laws relating to human health and the environment did not have a material impact on the consolidated financial position of the Company in 1993, and the Company does not currently expect the rate of such expenditures to increase significantly during the ensuing two fiscal years. However, regulatory changes, enforcement activities or other factors could alter this expectation at any time. Future changes in regulatory requirements related to the protection of human health and the environment may require the Company and others engaged in industry to modify various facilities and alter methods of operations at costs that may be substantial. KNOWN EVENTS, TRENDS AND UNCERTAINTIES Environmental Matters The Company is subject to extensive Federal, state and local air, water and other environmental laws and regulations. These constantly changing laws regulate the discharge of materials into the environment and may require the Company to remove or mitigate the environmental effects of the disposal or release of certain substances at the Company's various operating facilities. Industrial operations have been conducted at some of the Company's cement manufacturing facilities for almost 100 years. Many of the raw materials, products and by-products associated with the operation of any industrial facility, including those for the production of cement or concrete products, may contain chemical elements or compounds that are designated as hazardous substances. Owners and operators of industrial facilities and those who handle, store or dispose of hazardous substances may be subject to fines or other actions imposed by the U.S. Environmental Protection Agency (U.S. EPA) and corresponding state regulatory agencies for violations of laws or regulations relating to those substances. Hazardous waste processing facilities and the cement plants that burn HWDF, by definition, involve materials that have been designated as hazardous wastes. The Company's utilization of HWDF in some of its cement kilns has necessitated the familiarization of its work force with the more exacting requirements of applicable environmental laws and regulations with respect to human health and the environment. The failure to observe the exacting requirements of these laws and regulations could jeopardize the Company's hazardous waste management permits and, under certain circumstances, expose the Company to significant liabilities and costs of cleaning up releases of hazardous wastes into the environment or claims by employees or others alleging exposure to toxic or hazardous substances. The Company has incurred fines imposed by various environmental regulatory agencies in the past. The Comprehensive Environmental Response, Compensation, and Liability Act of 1980 (CERCLA), as amended by the Superfund Amendments and Reauthorization Act of 1986 (SARA), as well as analogous laws in certain states, create joint and several liability for the cost of cleaning up or correcting releases to the environment of designated hazardous substances. Among those who may be held jointly and severally liable are those who generated the waste, those who arranged for disposal, those who owned the disposal site or facility at the time of disposal and current owners. Management believes that the Company's current procedures and practices for handling and management of materials are consistent with industry standards and legal requirements and that appropriate precautions are taken to protect employees and others from harmful exposure to hazardous materials. However, because of the complexity of operations and legal requirements, there can be no assurance that past or future operations will not result in operational errors, violations, remediation liabilities or claims by employees or others alleging exposure to toxic or hazardous materials. Whenever it is determined that an environmental liability is both probable and reasonably estimatable, at least within a reasonable range of estimates, an appropriate charge and estimated liability are accrued. Such estimates are revised periodically as additional information becomes known. Actual costs incurred in future periods may vary from these estimates and there can be no assurances that additional accrual amounts will not be required in the future. The Clean Air Act Amendments of 1990 provided comprehensive federal regulation of all sources of air pollution and established a new federal operating permit and fee program for virtually all manufacturing operations. The Clean Air Act Amendments will likely result in increased capital and operational expenses for the Company in the future, the amounts of which are not presently determinable. By 1995, the Company's U.S. operations will have to submit detailed permit applications and pay recurring permit fees. In addition, the U.S. EPA is developing air toxics regulations for a broad spectrum of industrial sectors, including portland cement manufacturing. U.S. EPA has indicated that the new maximum available control technology standards could require significant reduction of air pollutants below existing levels prevalent in the industry. Management has no reason to believe, however, that these new standards would place the Company at a competitve disadvantage. The Federal Water Pollution Control Act, commonly known as the Clean Water Act (Clean Water Act), provides comprehensive federal regulation of all sources of water pollution. In September 1992 the Company filed a number of applications under the Clean Water Act for National Pollutant Discharge Elimination System (NPDES) stormwater permits. The Company now believes that some of its existing NPDES permits or pending applications relating to its cement plants and raw materials quarries may not cover all process water and stormwater discharges. Legal counsel has advised the Company, based upon its preliminary review of the matter, that while the Clean Water Act authorizes, among other remedies, the imposition of civil penalties of up to $25,000 per day for unpermitted discharges of pollutants to the waters of the United States, several factors may mitigate against the impositions of substantial fines. First, the Company is moving forward as expeditiously as practicable to correct all NPDES permitting deficiencies. Second, some of the permitting issues arise from mere technical deficiencies in permit applications or from changes in discharge patterns after submission of permit applications. In each such case, legal counsel believes that such deficiencies are neither unusual nor difficult to rectify. Finally, some of the deficiencies relate to questions of the scope of the Clean Water Act's jurisdiction that are, at best, unclear. Under the Bevill amendment, CKD is currently exempt from management as a hazardous waste, except CKD which is produced by kilns burning HWDF and which fails to meet certain criteria. In December 1993, as required by the Bevill amendment, the U.S. EPA issued a Report to Congress on CKD (CKD Report) and hearings were held on February 15, 1994. A change in the status of CKD would require the cement industry to develop new methods for handling this high volume, low toxicity waste. Although not presently classified as a hazardous waste, CKD that comes in contact with water may produce a leachate with an alkalinity high enough to be classified as hazardous and may also leach the hazardous trace metals present therein. Leaching has led to the classification of at least three CKD disposal sites of other companies as federal Superfund sites. Several of the Company's inactive CKD disposal sites around the country are under study to determine if remedial action is required and, if so, the extent of any such remedial action required. These studies may take some time to complete. Thereafter, remediation plans, if required, will have to be devised and implemented, which could take several additional years. An inactive CKD disposal site in Ohio is currently under investigation by the Company and state environmental agencies to determine appropriate remedial action required at the site and the Company has recorded charges aggregating $9.7 million as the total estimated cost to remediate this site. Approximately $2.6 million of the reserved amount had been expended through December 31, 1993 with the balance to be spent by early or mid-1995. The Company believes it currently has sufficient cash flow from current operating activities or borrowing capacity under its Restated Revolving Credit Facility to fund this remediation. The Company also owns two inactive CKD disposal sites in Ohio that were formerly owned by a division of USX Corporation (USX). In September 1993, the Company filed a complaint against USX alleging that with respect to the larger of these two sites (the Site), USX is a potentially responsible party and therefore jointly and severally liable for costs associated with cleanup of the Site. (Southdown, Inc. v. USX Corporation, Case No. C-3-93-354, U.S. District Court, Southern District of Ohio Western Division) USX answered the complaint in November 1993 by filing a motion to dismiss the lawsuit. Based on the limited information available as of December 31, 1993 the Company has received two preliminary engineering estimates of the potential magnitude of the remediation costs for the Site, $8 million and $32 million, depending on the assumptions used. Counsel to the Company on the USX matter has advised that it believes USX should not prevail on its motion to dismiss and that it appears there is a reasonable basis for the apportionment of cleanup costs relating to the Site between the Company and USX, with USX shouldering substantially all of the cleanup costs because, based on the facts known at this time, the Company itself disposed of no CKD at the Site and is potentially liable under CERCLA because of its current ownership of the Site. These determinations, however, are preliminary, and are based only upon facts available to the Company prior to any discovery. No substantial investigative work has been undertaken at other CKD sites in Ohio. Although data necessary to enable the Company to estimate total remediation costs is not available, the Company acknowledges that the ultimate cost to remediate the CKD disposal problem in Ohio could be significantly more than the amounts reserved. As a result of an aggressive inspection and enforcement initiative targeting combustion industry facilities, the Company was among a group of owners and operators of 28 boilers and industrial furnaces, including several other major cement manufacturers, from which the U.S. EPA is seeking over $19.8 million in penalties. On September 27, 1993, the U.S. EPA issued a Complaint and Compliance Order (Order) (United States Environmental Protection Agency, Region 5 v. Southdown, Inc. d/b/a Southwestern Portland Cement - Docket No. VW 27-93) alleging certain violations of the Resource Conservation and Recovery Act (RCRA) applicable to the burning or processing of hazardous waste in an industrial furnace. The alleged violations included, among others, exceedence of certified feed rates for total hazardous waste at the Company's Ohio cement manufacturing facility, failure to demonstrate that CKD generated at the facility is excluded from the definition of hazardous waste and storage at the facility without a permit of CKD alleged to be hazardous by virtue of that failure to demonstrate its exclusion from the definition. The Order proposed the assessment of a civil penalty in the amount of $1.1 million and closure of certain storage silos containing the CKD that allegedly is hazardous waste. The Company has engaged counsel to respond to the U.S. EPA Order and believes, after reviewing the complaint and the Company's compliance with the applicable regulations, there are substantial mitigating factors to the interpretations and allegations contained in the Order. The Company believes, based on the information currently available, the Order can be resolved without material adverse effect on the consolidated financial condition of the Company. The Company recorded loss reserves for pre-acquisition contingencies in conjunction with its acquisition of the hazardous waste processing facilities and received certain indemnifications for environmental matters from the former owners. However, there can be no assurance that such reserves and indemnifications will be adequate to cover all potential environmental losses that may occur with respect to these acquired entities. To the extent that reserves were not established, are insufficient, or recovery under indemnifications are not realizable, remediation amounts are charged to expense. While the Company's facilities at several locations are presently the subject of various local, state and federal environmental proceedings and inquiries, including being named a potentially responsible party (PRP) with regard to Superfund sites, primarily at several locations to which they are alleged to have shipped materials for disposal, most of these matters are in their preliminary stages and final results may not be determined for years. Management of the Company believes, however, based solely upon the information the Company has developed to date, that known matters can be successfully resolved in cooperation with local, state and federal agencies without having a material adverse effect upon the consolidated financial condition of the Company, either individually or in the aggregate. This assessment is reviewed periodically as additional information becomes available. In forming its belief that the matters described will not have a material adverse effect on its consolidated financial condition, the Company considers, among other things, the nature of the matters, the likelihood that a future event or events will confirm the loss, impairment or the incurrence of a liability, the response of environmental authorities to date and the experience of the Company and others with the response of environmental authorities to similar matters. The Company further evaluates various engineering, operational and other options which might be available to address these matters. Estimates of the future cost of environmental issues, however, are necessarily imprecise as a result of numerous uncertainties including, among others, the impact of new laws and regulations and the availability of new technologies. With respect to matters which require fixed or reasonably determinable expenditures by the Company, the Company also considers the period of time over which those expenditures might be made. Independently of the evaluation of any liabilities, the Company also considers whether such matters are within the scope of contractual indemnities provided by others, the applicability of insurance coverage or other potential recoveries from third parties, whether such potential sources of recovery could be considered probable of realization and, if so, how those indemnities would impact any cost to the Company. Accordingly, until all environmental studies, investigations, remediation work and negotiations with potential sources of recovery have been completed, it is impossible to determine the ultimate cost of resolving these environmental matters. Other Contingencies Status of Additional Sources of Cement Supply - The supply of cement in the U.S. has declined in recent years primarily because of a decrease in the volume of imported cement entering the country. During the 1980s, imported cement flooded U.S. markets, causing prices to fall despite strong growth in cement consumption. This situation has substantially changed as evidenced by the reduction in imported cement to an estimated 8% of total U.S. consumption in 1992 according to the Portland Cement Association, as compared with an estimated 17% of total U.S. consumption in 1989. This decline is largely the result of successful antidumping actions filed against importers from Mexico, Japan and Venezuela. With respect to the California, Florida and Texas markets, the antidumping suits have provided an opportunity during the current recession for domestic producers to displace large volumes of imported cement. A group of domestic cement producers, including the Company, filed antidumping petitions which have resulted in the imposition of significant antidumping duty cash deposits on cement imported from Mexico and Japan. In addition, the U.S. Department of Commerce has signed an agreement with Venezuelan cement producers, which is designed to eliminate the dumping of gray portland cement from Venezuela into Florida and the United States generally. The antidumping duties are subject to annual review by the Department of Commerce and appeal to the U.S. Court of International Trade. Effective July 15, 1995, the Anti-dumping Code of the General Agreement on Tariffs and Trade will be substantially altered pursuant to the recently completed Uruguay Round of multilateral trade negotiations. The new Code applies to investigations initiated after July 1995 and to administrative reviews of outstanding orders that are initiated after July 1995. If Congress passes legislation to approve and implement the Uruguay Round agreement, changes will necessarily be made to U.S. antidumping law. While the antidumping orders outstanding against cement and clinker from Mexico and Japan and the suspension agreement on cement and clinker from Venezuela will remain in force, the new Code will require the initiation of "sunset" reviews of the antidumping orders against Mexico and Japan prior to July 2000 to determine whether they should terminate or remain in effect, unless an earlier date is mandated by Congress. Under the new Code, it could be more difficult to obtain antidumping duties against other countries. A substantial reduction or elimination of the existing antidumping duties could adversely affect the Company's results of operations. The Company does not believe that the North American Free Trade Agreement will have a material adverse effect on the existing antidumping duties. Discontinued Moore McCormack Operations - In conjunction with the acquisition of Moore McCormack in 1988, the Company assumed certain liabilities for operations that Moore McCormack had previously discontinued. These liabilities, some of which are contingent, represent guarantees and undertakings related to Moore McCormack's divestiture of certain businesses in 1986 and 1987. Payments relating to liabilities from these discontinued operations were $2.4 million in 1993, $2.5 million in 1992 and $2.4 million in 1991. The Company is either a guarantor or directly liable under certain charter hire debt agreements totaling approximately $11 million at December 31, 1993, declining by approximately $4 million per year thereafter through February 1997. Although the estimated liability under these guaranties has been included in the liability for discontinued Moore McCormack operations, enforcement of the guaranty, while not resulting in a charge to earnings, would result in a substantial cash outlay by the Company. However, the Company believes it currently has sufficient borrowing capacity under its Restated Revolving Credit Facility to fund these guaranties, if required, as well as meet its other borrowing needs for the foreseeable future. The Company's Restated Revolving Credit Facility includes $20 million of borrowing capacity that is reserved solely for potential funding of obligations under a Keepwell Agreement between the Company and MARAD related to certain Great Lakes shipping operations owned previously by Moore McCormack. During the second quarter of 1993, the Great Lakes shipping operation sold its right to receive its portion of the settlement of bankruptcy claims against LTV Corporation, which has been operating under the protection of Chapter 11 of the United States Bankruptcy Code since July 17, 1986, and received approximately $14 million in gross proceeds before expenses and taxes. The net proceeds of approximately $9 million are available and required to be used to fund the Great Lakes shipping operation's cash flow deficiencies before the Keepwell is utilized for such purposes. Restructured Accounts Receivable - For many years, the Company has from time-to-time offered extended credit terms to certain of its customers, including converting trade receivables into longer term notes receivable. This practice became more prevalent during 1992 and continued during 1993, particularly in the southern California market area where many of the Company's customers have been adversely affected by the prolonged recession in the construction industry in that region. A group of five such customers were indebted to the Company at December 31, 1993 in the amount of $20.6 million. All of the notes and a portion of the accounts receivable, approximately 78% of the $20.6 million, are collateralized. During 1993, two of these customers defaulted on the payment terms of their notes. The Company restructured its agreement with one of the defaulting customers late in the second quarter of 1993 and that customer was in compliance with the terms of the restructured agreement as of December 31, 1993. The Company has stopped selling cement on credit to the other customer in default and is presently evaluating its options for collection of outstanding balances. A third customer in this group, while not in default on its note, had difficulty in maintaining prompt payment for its cement purchases and restructuring discussions were commenced in late 1993. The Company is contractually committed to supply up to 90% of the cement requirements of one of the three non-defaulting customers on extended credit terms, provided this customer remains current with respect to both current purchases and payments on its note. During the final quarter of 1993, the Company purchased most of the ready-mixed concrete and aggregate assets of two other customers then in default for forgiveness of a total of approximately $9.2 million owed the Company, assumption of certain liabilities and other consideration. The Company realized no gain or loss on either of these transactions. In January 1994, the Company made a preliminary purchase proposal to acquire certain ready-mixed concrete and aggregate assets of the customer with which it was engaged in restructuring discussions. The proposal included, as partial consideration for the acquisition, forgiveness of the $5.8 million owed the Company as of December 31, 1993. In the opinion of management, the Company is adequately reserved for credit risks related to its potentially uncollectible receivables. However, the Company continues to assess its allowance for doubtful accounts and may increase or decrease its periodic provision for doubtful accounts as additional information regarding the collectibility of these and other accounts becomes available. Claims for Indemnification - In late August 1993 the Company was notified by Energy Development Corporation (EDC), the 1989 purchaser of the common stock of the Company's then oil and gas subsidiary, Pelto Oil Company (Pelto), that EDC was exercising its indemnification rights under the 1989 stock purchase agreement with respect to a Department of Energy (DOE) Remedial Order regarding the audit of crude oil produced and sold during the period September 1973 through January 1981 from an offshore, federal waters field in which the Company's oil and gas subsidiary owned an interest. The DOE alleged certain price overcharges and sought to recover a total of $68 million in principal and interest from Murphy Oil Corporation (Murphy), as operator of the property. Murphy estimated the Company's share of this total to be approximately $4 million. On January 24, 1994 the presiding Administrative Law Judge at the Federal Energy Regulatory Commission (FERC) rendered a favorable decision for Murphy, materially reducing the amount it potentially owed to the DOE. This decision also had the effect of precluding the DOE from recovering from Murphy for any alleged overcharges attributable to Pelto's "in-kind" production. Murphy has indicated that if the FERC adopts the Administrative Law Judge's opinion, Pelto will not owe anything to Murphy as a result of the DOE's claim, other than its pro rata share of attorneys' fees. The Company cannot assess the likelihood that the DOE would seek to recover sums from Pelto directly due to Pelto's "in-kind" production, but the Company believes, based on advice of counsel, that, if it did, any such claim by the DOE would be barred by limitations. Prior to the sale of Pelto in 1989, Pelto entered into certain gas settlement agreements, including one with Transcontinental Gas Pipe Line Corporation (Transco). The Minerals Management Service (MMS) of the Department of the Interior has reviewed the agreement entered into with Transco in 1988 to determine whether a payment to Pelto thereunder is associated with Federal or Indian leases and whether, in their view, any additional royalties may be due as a result of that payment. MMS has advised EDC of a preliminary royalty underpayment determination resulting from its review, and that MMS proposes to direct EDC to compute any gas royalties attributable to what MMS characterizes as a "contract buydown". This does not constitute a final action by MMS; its stated purpose is to give an opportunity to comment or provide additional documentation that would refute or alter MMS's preliminary determination. In late December 1993, the Company was notified by EDC that EDC was exercising its indemnification rights under the 1989 stock purchase agreement for Pelto with respect to this matter. The Company is unable to determine what liability it may have, if any, with respect to this matter, but should the Company be required to make any payments to the MMS, such expenditures would result in a charge to discontinued operations. Macroeconomic Factors - The demand for cement and concrete products is derived from construction activity which, in turn, is a function of general economic conditions over which the Company has no control. As a result of the high operating leverage of the cement industry, profitability is very sensitive to slight shifts in the balance of supply and demand, which are driven by general macroeconomic variables. A significant portion of cement and concrete consumption is for public construction projects including roads, bridges, airports and similar projects. In the event major construction projects to repair and replace large parts of the national infrastructure are undertaken over the next decade, the cement and concrete products industry should benefit. New construction activities stagnated as the U.S. economy entered a recession in early-to-mid 1990 and, as a consequence, the Company's sales and earnings declined from the previous cyclical peak in 1989. Construction activity in some regions rebounded slightly in 1993. Because transportation costs are high relative to the value of the product, cement markets are generally regional. Any improvement in operating earnings will be aided by the recovery of the regional economies in which the Company operates. Florida, the Company's second largest market area, experienced an upturn in prices and sales volume as demand improved somewhat in 1993. Southern California, the Company's largest market area, showed little or no improvement in 1993. Potential benefits of any increase in infrastructure spending are dependent upon the extent to which such expenditures may occur within the market areas served by the Company's plants and facilities and, therefore, cannot be estimated at this time. In January 1994, Los Angeles, California and the surrounding environs experienced a major earthquake. Although neither the Company's cement plant in Victorville, California nor the Company's concrete products facilities in Orange and Los Angeles Counties suffered any significant amounts of damage, commerce and transportation in the area have been disrupted. Changes in Accounting Principle Postretirement benefits - Effective January 1, 1993 the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" (SFAS No. 106) and recorded a $48.5 million after-tax, non-cash charge which represented the estimated initial liability for postretirement benefits attributable to employee services provided prior to 1993. SFAS No. 106 requires the Company to accrue the estimated cost of retiree benefit payments as the employee provides services to the Company. The Company previously expensed the cost of these benefits as claims were incurred and continues to pay for postretirement benefit costs as incurred. (See Note 2 of Notes to Consolidated Financial Statements.) Postemployment benefits - In November 1992 the Financial Accounting Standards Board issued a Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" (SFAS No. 112), which requires that the cost of benefits provided to employees after employment, but before retirement, be recognized in the financial statements on an accrual basis. The required date of adoption of this new accounting standard was January 1, 1994. The impact of SFAS No. 112 on the Company did not result in a material charge to earnings. INFLATION AND CHANGING PRICES Inflation has become less of a factor in the U. S. economy as the rate of increase has moderated during the last several years. The Consumer Price Index rose 2.6% in 1993, 2.9% in 1992 and 3.1% in 1991. Prices of materials and services have remained relatively stable over the three-year period. Strict cost control and improving productivity also minimize the impact of inflation. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) The following tables set forth certain unaudited selected quarterly financial data for each of the last three years: - --------------- (1) Prepayment penalty on early retirement of $45 million of 12% Senior Subordinated Notes. (2) Cumulative after-tax effect of change in accounting principle for initial obligation for estimated postretirement health care benefits as required by adoption of SFAS No. 106 effective January 1, 1993. (1) Final portion of the gain deferred from the 1989 sale of the Company's oil and gas operations. (1) Represents prepayment penalty on early retirement of Senior Secured Notes, net of income tax effect. The businesses of the Company's Cement and Concrete Products segments are seasonal to the extent that construction activity and hence, the demand for cement and concrete products, tends to diminish during the first and fourth calendar quarters of each year because of inclement weather conditions. ITEM 8.	ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. SOUTHDOWN, INC. AND SUBSIDIARY COMPANIES STATEMENT OF CONSOLIDATED EARNINGS See Notes to Consolidated Financial Statements SOUTHDOWN, INC. AND SUBSIDIARY COMPANIES CONSOLIDATED BALANCE SHEET See Notes to Consolidated Financial Statements SOUTHDOWN, INC. AND SUBSIDIARY COMPANIES STATEMENT OF CONSOLIDATED CASH FLOWS See Notes to Consolidated Financial Statements SOUTHDOWN, INC. AND SUBSIDIARY COMPANIES STATEMENT OF CONSOLIDATED SHAREHOLDERS' EQUITY - ------------------ (1) On April 25, 1991, the Board of Directors s spended the dividend on the Company's Common Stock. See Notes to Consolidated Financial Statements SOUTHDOWN, INC. AND SUBSIDIARY COMPANIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 - THE COMPANY AND SIGNIFICANT ACCOUNTING POLICIES: Southdown, Inc. (Southdown or the Company) engages in the production and marketing of cement and concrete products. The Company also engages in the processing, treatment and disposal of hazardous wastes. The operations of the hazardous waste processing facilities are conducted through Southdown Environmental Systems, Inc., a wholly-owned subsidiary of the Company, and several indirect wholly-owned subsidiaries. Consolidation - The consolidated financial statements of the Company include the accounts of its divisions, its wholly-owned subsidiaries and its majority-owned joint venture after elimination of significant intercompany transactions and balances. Certain data for prior years have been reclassified for purposes of comparison. Statement of Consolidated Cash Flows Supplemental Disclosures - For purposes of the Statement of Consolidated Cash Flows, short-term investments which have an original maturity of three months or less are considered cash equivalents. Cash payments for income taxes totaled $2.8 million in 1993, $200,000 in 1992 and $1.7 million in 1991. During 1993 and 1992 the Company received a $15.7 million and an $18.7 million federal income tax refund, respectively, from the carryback to prior years of the previous year's tax losses. Interest paid, net of amounts capitalized in years 1993 and 1991, was $36.4 million, $40.4 million and $38.5 million in 1993, 1992 and 1991, respectively. The $48.5 million noncash charge for the cumulative effect of a change in accounting principle also resulted in a charge to deferred income taxes of $25.9 million and a credit to postretirement benefit obligations of $74.4 million. Noncash investing activities in 1993 included the sale of a hazardous waste processing facility for preferred stock which the Company valued at $4.8 million (see Note 18 of Notes to Consolidated Financial Statements) and the exchange of $9.2 million in accounts and notes receivable and the assumption of $6.8 million in liabilities as partial consideration for the acquisition from the debtors of five ready-mixed concrete products batch plants and one aggregate quarry. Noncash investing activities in 1992 included receipt of a $1.9 million note as partial consideration for the sale of all of the common stock of a hazardous waste processor sold effective June 30, 1992 and the assumption of $1.1 million of noncash liabilities in the January 1992 acquisition of a hazardous waste processor. Noncash investing activities in 1991 included an accrual for the acquisition of a seventh hazardous waste processing facility (also referred to as treatment, storage and disposal (TSD) facilities or simply, as TSDs) for $4.4 million effective January 1, 1992 and an additional $1 million of acquisitions for notes. Inventories - Inventories are valued at the lower of cost (which includes material, labor and manufacturing overhead) or market. The valuation of cement inventories is determined on the last-in, first-out (LIFO) method. The valuation of the remaining inventories, primarily parts and supplies, is determined on the first-in, first-out (FIFO) or average cost method. Property, Plant and Equipment - The Company capitalizes all direct and certain indirect expenditures incurred in conjunction with the acquisition or construction of major facilities. Depreciation and amortization of these capitalized costs commence when the completed facility is placed in service. Depreciation and amortization of property, plant and equipment are computed primarily on a straight-line basis over estimated useful lives of the related assets, ranging from three to fifty years. Depletion of mineral rights is computed on the units-of-production method. Certain costs and expenses associated with the acquisitions of various facilities have been capitalized and are being amortized over the estimated useful lives of the related assets. Gain or loss is generally reflected in earnings upon the retirement or sale of property, plant and equipment. Environmental Expenditures - Environmental expenditures that relate to current operations are expensed or capitalized as appropriate. Environmental expenditures that extend the life, increase the capacity, improve the safety or efficiency of property owned by the Company, mitigate or prevent environmental contamination that has yet to occur, or that are incurred in anticipation of a sale of property are capitalized. Expenditures that relate to an existing condition caused by past operations, and which do not contribute to current or future revenue generation, are expensed. The Company's policy is to accrue environmental and clean-up related costs of a non-capital nature when it is both probable that a liability has been incurred and the amount can be reasonably estimated whether or not this coincides with the completion of a remediation investigation/feasibility study or the Company's commitment to a formal plan of action. Such estimates are revised as additional information becomes known. Goodwill - The excess of cost over the fair value of net assets of businesses acquired is amortized on a straight-line basis over periods ranging from 15 to 40 years. Such amortization amounted to $2.4 million, $3.3 million and $3.1 million in 1993, 1992 and 1991, respectively. In addition, goodwill was further reduced by approximately $12.3 million in the fourth quarter of 1992 in conjunction with the pending and proposed disposition of certain TSD facilities. (See Note 18 of Notes to Consolidated Financial Statements.) Accumulated amortization of goodwill was $12.9 million and $10.5 million as of December 31, 1993 and 1992, respectively. Income Taxes - In computing its federal and state income tax liabilities, the Company uses accelerated depreciation and deducts currently certain expenditures that are capitalized for financial reporting purposes. Deferred income taxes are provided on these and other temporary differences between the tax bases of assets and liabilities and their bases for financial statement purposes. Investment tax credit carryforwards are accounted for under the flow-through method and, accordingly, reduce federal income taxes in the years in which their utilization is assured. Effective January 1, 1993, the Company revised its method of accounting for income taxes to conform to Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS No. 109). SFAS No. 109 requires recognition of deferred tax assets for all existing potential future tax benefits and then subjection of these deferred tax assets to an impairment valuation based on the likelihood of realization. (See Note 2 of Notes to Consolidated Financial Statements.) Interim Periods - For its cement manufacturing operations, the Company utilizes a standard manufacturing cost to identify favorable or unfavorable variances from predetermined cost estimates established by management. For interim reporting purposes, the Company charges cost of goods sold on the basis of such estimated costs for the year deferring as a charge or credit to inventory any difference between actual manufacturing costs and the standard. At year-end, any variation between the result at standard cost and actual cost is charged or credited to cost of goods sold. NOTE 2 - CHANGES IN ACCOUNTING PRINCIPLES: Postretirement benefits - Postretirement benefits other than pensions (postretirement benefits) currently provided by the Company to its eligible retirees consist primarily of health care and life insurance benefits. In certain instances, retirees under the age of sixty-five and their dependents are offered health care benefits which are essentially the same as benefits available to active employees. However, benefit payments for covered retirees over the age of sixty-five are reduced to the extent that such benefits are paid by Medicare. Most of the Company's health care benefits are self-insured and administered on cost plus fee arrangements with a major insurance company or provided through health maintenance organizations. Generally life insurance benefits for retired employees are reduced over a number of years from the date of retirement to a specified minimum level. Effective January 1, 1993 the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" (SFAS No. 106) and recorded a $48.5 million after-tax, non-cash charge which represented the initial estimated liability for postretirement benefits attributable to employee services provided prior to 1993. SFAS No. 106 requires the Company to accrue the estimated cost of retiree benefit payments as the employee provides services to the Company. The Company previously expensed the cost of these benefits as claims were incurred, and it continues to pay for postretirement benefit costs as incurred. General and administrative expenses for 1993 included a charge of approximately $1.8 million in each of the first two quarters of the year ($3.5 million in the aggregate) representing the estimated cost of postretirement health care benefits in excess of claims incurred. The Company amended its plan for postretirement health care benefits in the latter part of the second quarter. Effective with the third quarter of 1993, the Company's accrual for estimated future postretirement benefit costs was reduced by approximately $47 million under the amended plan which the Company will amortize over the 16 years remaining average service life of its active employees as required by SFAS No. 106. These changes have eliminated the quarterly charge of approximately $1.8 million as incurred in each of the first and second quarters of 1993. Income Taxes - The Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS No. 109) effective January 1, 1993. SFAS No. 109 supersedes SFAS No. 96, "Accounting for Income Taxes" which was adopted by the Company in 1988. There was no cumulative effect on the Company's financial statements resulting from the adoption of SFAS No. 109. In early August 1993, the President signed into law a bill that includes, among other provisions, a one percent increase in the maximum federal income tax rate for corporations retroactive to January 1, 1993. Under the requirements of SFAS No. 109, the Company recorded a charge of approximately $2.2 million in the third quarter of 1993 to recognize the increase in the deferred tax liability as a result of the change in the corporate income tax rate. NOTE 3 - BUSINESS SEGMENT INFORMATION: Operating results and certain other financial data for the Company's principal business segments for and at the end of each year presented are as follows: The Cement segment includes the operations of eight quarrying and manufacturing facilities and a network of 17 terminals for the production and distribution of portland and masonry cement. The Concrete Products segment includes primarily the production and sale of ready-mixed concrete, and to a lesser extent, the sale of construction aggregate and concrete block. The Environmental Services segment includes the results from collection, treatment and processing of hazardous wastes and burning of hazardous waste derived fuel (HWDF). No allocation of corporate overhead is made to the operating segments. Substantially all of the Company's operations are conducted in the United States. Intersegment sales occur primarily between the Company's Florida cement manufacturing plant and the Florida concrete products operations and the Company's southern California cement manufacturing plant and the related concrete operations. Intersegment sales are accounted for at prices which approximate market prices and are eliminated for purposes of preparing consolidated financial statements. Capital expenditures shown above for 1993 for the Concrete Products segment exclude $14.6 million in property, plant and equipment additions resulting from the purchase of five ready-mixed concrete batch plants and one aggregate quarry during the year. Capital expenditures shown above for the Environmental Services segment exclude $2.5 million in 1991 which was accrued as property, plant and equipment in conjunction with the $4.9 million acquisition of a seventh TSD completed in January 1992. NOTE 4 - CASH AND CASH EQUIVALENTS: There is no requirement for the Company to maintain compensating balances under any of the agreements with the Company's lending banks. NOTE 5 - ACCOUNTS AND NOTES RECEIVABLE: Significant Group Concentrations of Credit Risk - The majority of the Company's receivables are from users of portland cement, such as ready-mixed concrete producers and manufacturers of concrete products such as blocks, roof tile, pipe and prefabricated building components. Sales are also made to building materials dealers, construction contractors and, particularly from the Odessa plant, oil well cementing companies. During 1993, 1992 and 1991 approximately 52%, 49% and 50%, respectively, of the Odessa plant's cement sales volume consisted of oil well cement and the balance represented sales to local construction markets. Approximately 15%, 13% and 21% of the cement sold by the Company's Victorville, California plant in 1993, 1992 and 1991, respectively, was sold to the Company's ready-mixed concrete operations in California and approximately 37%, 42% and 52% of the cement sold by the Brooksville, Florida plant in 1993, 1992 and 1991, respectively, was sold to the Company's Florida concrete products operations. The Company is a major producer of ready-mixed concrete in the southern California counties of Los Angeles and Orange and a major producer and supplier of such products throughout Florida and southeastern Georgia. There were no sales to any single third-party customer which aggregated in excess of 10% of consolidated revenues for 1993, 1992 or 1991. Because both Florida and southern California were experiencing an economic downturn and a significant slowing of new construction activities, the Company recorded a supplemental $3.6 million charge to earnings in 1991 to increase its allowance for doubtful accounts in addition to the Company's customary provision. The Company has and may continue to offer extended credit terms to certain of its customers, including converting certain trade receivables into collateralized, interest-bearing notes receivable. This practice became more prevalent during 1992 in southern California where many of the Company's customers have been adversely affected by the severe recession in the construction industry in that region. A group of five such customers were indebted to the Company at December 31, 1993 for a total of $20.6 million, of which $5.2 million was included in current accounts and notes receivable with the balance in long-term assets. All of the notes and a portion of the accounts receivable, approximately 78% of the $20.6 million, are collateralized primarily by real and personal property of the businesses and, for certain receivables, by a personal guaranty of the owners. During 1993 approximately $788,000 in interest income, the majority of which has been collected, was recognized on these notes. The five customers purchased a total of approximately 252,000 tons of cement from the Company during 1993. During 1993 two of the customers defaulted in the payment terms of their notes. The Company restructured its agreement with one of the defaulting customers in the second quarter of 1993 and that customer was in compliance with the terms of the restructured agreement as of December 31, 1993. The Company has stopped selling cement on credit to the other customer in default and is presently evaluating its options for collection of outstanding balances. A third customer in this group, while not in default on its note, had difficulty in maintaining prompt payment for its cement purchases and restructuring discussions were commenced in late 1993. The Company is contractually committed to supply up to 90% of the cement requirements of one of the two non-defaulting customers on extended credit terms, provided this customer remains current with respect to both current purchases and payments on its note. During the final quarter of 1993, the Company purchased most of the primary ready-mixed concrete and aggregate assets of two other customers then in default for forgiveness of a total of approximately $9.2 million owed the Company, assumption of certain liabilities and other consideration. The Company realized no gain or loss on either of these transactions. In January 1994, the Company made a preliminary purchase proposal to acquire certain ready-mixed concrete and aggregate assets of the customer with which it was engaged in restructuring discussions. The proposal included, as partial consideration for the acquisition, forgiveness of the $5.8 million owed the Company as of December 31, 1993. NOTE 6 - INVENTORIES: Inventories valued on the LIFO method were $20.4 million at December 31, 1993 and $22.8 million at December 31, 1992 compared with current costs of $28.3 million and $32.2 million, respectively. NOTE 7 - PROPERTY, PLANT AND EQUIPMENT: NOTE 8 - OTHER LONG-TERM ASSETS: - --------------------- (1) Costs and expenses associated with the issuance of certain of the Company's senior debt and senior subordinated notes. Debt issuance costs are being amortized over the respective terms of the debt. (2) Includes various non-income producing real estate parcels offered for sale. (3) Two contracts to supply flyash through 1997 and 1999, respectively, were acquired in conjunction with the Moore McCormack Resources, Inc. purchase in 1988. The supply contracts were recorded at their net present values at the date of acquisitiion and are being amortized over the respective lives of the contracts. NOTE 9 - ACCOUNTS PAYABLE AND ACCRUED LIABILITIES: NOTE 10 - DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS The estimated fair value amounts for all financial instruments have been determined by the Company using appropriate valuation methodologies and information available to management as of December 31, 1993 and 1992. Considerable judgment is required in developing these estimates, however, and accordingly no assurance can be given that the estimated values presented herein are indicative of the amounts that would be realized in a free market exchange. Except for the following, the carrying amounts of the Company's assets and liabilities which are considered to be financial instruments approximate their value: The following methods and assumptions were used to estimate the fair value of each class of financial instruments as of December 31, 1993 and 1992 for which it is practicable to estimate that value: Long-term debt - The fair value of the Company's long-term debt was estimated based on the quoted market prices for the same or similar issues or on the current rates available to the Company for debt with similar terms and remaining maturities. Interest rate swap agreements - The fair value of the interest rate swap was the amount at which it could be settled based on estimates obtained from dealers. NOTE 11 - LONG-TERM DEBT: Restated Revolving Credit Facility - The Company's primary revolving credit facility is with Wells Fargo Bank, N.A., in its individual capacity and as agent; Societe Generale, Southwest Agency; Credit Suisse; Caisse Nationale De Credit Agricole; an affiliate of Canadian Imperial Bank of Commerce; Banque Paribas; The Bank of Nova Scotia and The First National Bank of Boston. Substantially all of the Company's assets are pledged to secure the revolving credit facility. On November 19, 1993, the Company and its lending banks entered into a $200 million Restated Revolving Credit Facility (Restated Revolving Credit Facility). This facility includes the issuance of standby letters of credit up to a maximum of $95 million and also includes $20 million of borrowing capacity that is reserved solely for potential funding obligations under a Keepwell Agreement with the U.S. Maritime Administration (MARAD). (See Note 14 of Notes to Consolidated Financial Statements.) The Restated Revolving Credit Facility remains the same size as the previously existing revolving credit facility and matures in November 1996. The Restated Revolving Credit Facility contains various negative and affirmative covenants and cross-default provisions and customary conditions to borrowing. Borrowings under the Restated Revolving Credit Facility bear interest at margins above either a prime rate or LIBOR as selected by the Company from time to time. On December 31, 1993, the interest rate under the Restated Revolving Credit Facility was approximately 6.0%. As of December 31, 1993, there were $19 million of borrowings and $71 million in letters of credit outstanding under the Restated Revolving Credit Facility leaving $90 million of unused capacity, excluding the $20 million reserved under the Keepwell Agreement. On January 5, 1994 the Company borrowed $47 million under the Restated Revolving Credit Facility to redeem $45 million principal amount of 12% Senior Subordinated Notes Due 1997 (12% Notes) and to pay the redemption premium and accrued interest thereon. On January 27, 1994 the Company used approximately $65 million of the proceeds of a January 27, 1994 sale of Series D Preferred Stock to reduce borrowings under the Restated Revolving Credit Facility. (See Note 21 of Notes to Consolidated Financial Statements.) The Company intends to use the Restated Revolving Credit Facility to redeem at par the remaining $45 million outstanding principal amount of 12% Notes as promptly as practicable after May 1, 1994. Promissory Note - The promissory note for $18 million as of December 31, 1993 was payable on March 31, 1994 with interest at margins above either a prime rate basis or a Eurodollar rate basis as selected by the Company from time-to-time and secured by an irrevocable letter of credit issued under the Restated Revolving Credit Facility. The face amount of the letter of credit reduces ratably with the promissory note balance. On January 27, 1994 the note was prepaid without penalty using a portion of the proceeds from the Company's sale of the Series D Preferred Stock. (See Note 21 of Notes to Consolidated Financial Statements.) Industrial Development and Pollution Control Bonds - The industrial development and pollution control bonds were issued by various state or local financing authorities and are due on various dates through the year 2006. The obligations bear interest, which is nontaxable to the payees, at varying rates ranging from approximately 50% of the prevailing prime rate to 5.5%. The obligations are secured by irrevocable letters of credit issued under the Restated Revolving Credit Facility or by liens on the pollution control equipment. 9% Bank Note - The 9% bank note included in current maturities of long-term debt at December 31, 1993 was payable to a commercial bank by a subsidiary of the Company and unconditionally guaranteed by the Company. The note was paid in full as scheduled in early January 1994. 12% Senior Subordinated Notes - As of December 31, 1993 long-term debt included $90 million principal amount of 12% Notes due in 1997, but redeemable at the option of the Company, in whole or in part, at redemption prices (plus accrued interest to the date of redemption) equal to 101.714% of the principal amount through April 30, 1994 and 100% of the principal amount thereafter. On January 5, 1994 the Company borrowed $47 million under the Restated Revolving Credit Facility to redeem $45 million principal amount of 12% Notes and to pay the redemption premium and accrued interest thereon. The Company recorded a $1.6 million extraordinary charge ($1.0 million net of tax) as of December 31, 1993 to reflect the redemption premium on the early extinguishment of the debt. The Company intends to redeem at par the remaining $45 million outstanding principal amount of 12% Notes as promptly as practicable after May 1, 1994 with borrowings under the Restated Revolving Credit Facility. 14% Senior Subordinated Notes - On October 31, 1991, the Company issued an aggregate of $125 million principal amount of 14% Senior Subordinated Notes due 2001 (Notes) and warrants to purchase 1,250,000 shares of the Company's Common Stock (Warrants) in a private placement transaction. The net proceeds of the offering were used to repay certain other Company notes in full and the balance of the proceeds was used to reduce borrowings outstanding under the Company's then existing revolving credit facility. The Notes were issued pursuant to an Indenture dated as of October 15, 1991 between the Company and State Street Bank and Trust Company of Connecticut, National Association, as Trustee. Pursuant to a Registration Rights Agreement entered into at the time of the private placement, during 1992 all of the Notes were exchanged in a registered exchange offer for $125 million aggregate principal amount of the Company's 14% Senior Subordinated Notes Due 2001, Series B (Series B Notes). The Series B Notes were also issued under an indenture dated as of October 15, 1991 between the Company and State Street Bank and Trust Company of Connecticut, National Association, as Trustee, (Indenture) and the terms of the Series B Notes and such Indenture are substantially identical to those of the Notes and the original indenture. The Series B Notes pay interest semiannually, mature in ten years and are noncallable for five years, after which the Series B Notes are callable at the option of the Company, in whole or in part, at any time upon thirty days' notice at 105.25% of the principal amount, declining ratably to par on or after October 15, 1999. The Series B Notes are subordinate in right of payment to all existing and future senior debt, as defined, of the Company, rank on a parity with all existing and future senior subordinated debt, as defined, of the Company, and rank senior to all other existing and future subordinated debt of the Company. The Indenture includes affirmative and negative covenants which in certain instances restrict, among other things, incurrence of additional indebtedness, certain sales of assets and subsidiary stock, certain mergers and consolidations and dividends and distributions. Each Warrant is initially exercisable for one share of Common Stock of the Company at a price of $16.00, subject to certain anti-dilution adjustments. (See Note 21 of Notes to Consolidated Financial Statements.) The Warrants expire on October 31, 1996. Annual Aggregate Maturities of Long-term Debt - The approximate aggregate payments due in future years on long-term debt as of December 31, 1993 are as follows: Interest Rate Hedging Transactions - In March 1989, the Company entered into an interest rate hedging transaction with two commercial banks based on $100 million of notional principal amount that limited the Company's exposure to LIBOR interest rate fluctuations through the termination of the agreement in March 1992. The Company entered into an interest rate swap agreement with a commercial bank in January 1988 which, in effect, converted the interest rate on the $18 million promissory note referred to under "Promissory Note" above from a floating rate to a fixed rate of 9.225% through March 31, 1992 and 9.35% thereafter. The notional principal amount, which was $18 million and $22.5 million at December 31, 1993 and 1992, respectively, reduces ratably with the promissory note balance. The net gain or loss from the exchange of interest payments is included in interest expense. The Company recorded $1 million, $2.2 million and $2.8 million of interest expense in 1993, 1992 and 1991, respectively, as a result of these two agreements. NOTE 12 - INCOME TAXES: The following table provides a breakdown of the current and deferred components of the provisions for federal and state income taxes attributable to the loss from continuing operations before income taxes and before extraordinary charges and the cumulative effect of a change in accounting principle. A reconciliation between the income tax benefit recognized in the Company's Statement of Consolidated Earnings and the income tax benefit computed by applying the statutory federal income tax rate to the loss from continuing operations before income taxes and before extraordinary charges and the cumulative effect of a change in accounting principle follows: The provision for deferred income taxes is based on the liability method prescribed by SFAS No. 109, and represents the change in the Company's deferred income tax liability during each year, including the effect of any enacted tax rate changes. A deferred income tax liability or asset is recognized for temporary differences between the tax basis of assets and liabilities and their reported amounts in the financial statements that will result in net taxable or deductible amounts in future years as well as the recognition, in certain instances, of the tax effects of operating loss and tax credit carryforwards. Significant components of the Company's net deferred tax liability as of December 31, 1993 were as follows: The Company has provided a valuation allowance of $21.0 million against deferred tax assets recorded as of December 31, 1993. There was no change in the valuation allowance for the year ended December 31, 1993. Approximately $5.5 million of the valuation allowance will be allocated to reduce goodwill and other noncurrent intangible assets in future periods if realization of tax credit carryforwards acquired as a result of business combinations that occurred in prior years becomes more likely than not. The Company has included in its calculation of the deferred income tax liability the tax benefits of net operating loss carryforwards of $44.2 million, net investment tax credit carryforwards after valuation allowance of $2.6 million and an alternative minimum tax carryforward of $1.5 million. If not used, the net operating loss and investment tax credit carryforwards will expire between 1998 and 2007 and between 1994 and 2005, respectively. The consolidated federal income tax returns of the Company and Moore McCormack Resources, Inc. (Moore McCormack) for years 1988 through 1992 and various state income tax returns are presently under examination. In the opinion of management, adequate provision has been made for income taxes that might be due as a result of these audits. NOTE 13 - MINORITY INTEREST IN CONSOLIDATED JOINT VENTURE: Kosmos Cement Company (Kosmos) is a partnership which includes a cement plant located in Kosmosdale, Kentucky and a cement plant located near Pittsburgh, Pennsylvania along with related terminals and facilities. The partnership is 25% owned by Lone Star Cement, Inc. (Lone Star) and operated and 75% owned by the Company. The Company's Consolidated Balance Sheet includes 100% of the assets and liabilities of Kosmos. Lone Star's 25% interest in Kosmos and the earnings therefrom have been reflected as "Minority interest in consolidated joint venture" and "Minority interest in earnings of consolidated joint venture" on the Company's Consolidated Balance Sheet and Statement of Consolidated Earnings, respectively. NOTE 14 - OTHER LONG-TERM LIABILITIES AND DEFERRED CREDITS: Discontinued Moore McCormack Operations - As part of the acquisition of Moore McCormack in 1988, the Company assumed certain fixed and contingent liabilities pursuant to certain guarantees and undertakings related to operations previously discontinued by Moore McCormack. As of December 31, 1993 and 1992 such estimated liabilities totaled $15.1 million and $18.5 million, respectively, $2.2 million of which were included in current liabilities in both years. In conjunction with the acquisition, Southdown assumed an obligation to MARAD under a Keepwell Agreement whereby the Company would keep up to $20 million available under its revolving credit facility for cash flow deficiencies of the former Moore McCormack shipping operations equal to certain of Moore McCormack's obligations to MARAD. Since that time, the shipping operations have required only seasonal advances from time-to-time under the Keepwell Agreement. There were no outstanding advances under the Keepwell Agreement as of December 31, 1993 and 1992. The Company's contingent obligation to MARAD declines to under $20 million in 1994 and by approximately $2.5 million annually thereafter. Supplemental Pension Liabilities - In order to provide additional retirement benefits and incentives for certain employees to remain with the Company, the Company has entered into supplemental pension agreements with those individuals. The present value of probable future cash outlays is accrued during the expected service life of the employee and charged to earnings for financial reporting purposes. NOTE 15 - PENSION PLANS: The Company has a defined benefit pension plan covering substantially all salaried employees. The benefits are based on years of service and the employee's compensation and are integrated with Social Security. The Company's union employees are covered by either a multi- employer plan, a salaried plan, or a collectively bargained Company-sponsored plan providing a flat dollar benefit for each year of service. The Company's policy is to fund its pension plans in accordance with sound actuarial principles. Under rules promulgated by the Financial Accounting Standards Board and adopted by the Company in 1987, the funded status of the Company's pension plans is based on a comparison of the market value of the plans' assets at the end of the year with actuarial estimates of the projected benefit obligation. The assumed weighted average discount rate used to measure the projected benefit obligation was 7.5% in 1993 and 8.5% in 1992 and 1991. The rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligation was 4% in 1993 and 5.5% in 1992 and 1991. The expected long-term rate of return on assets was 8.5% in 1993, 1992 and 1991. Differences in estimates used and actual experience along with changes in assumptions from year-to-year are included in net deferred gains or losses. The Company amortizes the unrecognized net gains or losses whenever such amount exceeds 10% of the greater of the projected benefit obligation or the market value of plan assets. The unrecognized net obligation or net asset, unrecognized net gain or loss and prior service costs were amortized over periods of 9 to 14 years for 1993, over periods of 10 to 16 years for 1992 and over periods of 9 to 15 years for 1991 which approximated the estimated average remaining service periods of employees expected to receive benefits under the plans. The Company recognized pension income of approximately $1.6 million in 1993, pension income of $1.4 million in 1992 and pension expense of $500,000 in 1991 under such Company-sponsored plans. In addition to Company-sponsored plans, certain union employees of the Company's concrete operations in southern California and the Colorado cement operations are covered under multi-employer defined benefit plans administered by the respective unions. Amounts contributed to the multi-employer plans and included in pension expense were $1.8 million in 1993 and 1992 and $2.4 million in 1991. As of December 31, 1993 and 1992 there were no pension plans in which the accumulated benefit obligation exceeded plan assets. The following table sets forth information regarding the plans' funded status and amounts recognized in the Company's Consolidated Balance Sheet at December 31, 1993 and 1992: (1) Plan assets include 449,000 shares of the Company's Series A Preferred Stock. The components of net periodic pension cost included in the results of operations for the years ended December 31, 1993, 1992 and 1991 under Company-sponsored plans were as follows: Retirement Savings Plan - The Company maintains a retirement savings plan (Savings Plan) in which substantially all employees are eligible to participate. The Savings Plan is designed to qualify under Sections 401(a) and 401(k) of the Internal Revenue Code of 1986 (Code). Under the Savings Plan, a participating employee may elect to defer taxation on a portion of his or her eligible earnings up to a maximum amount defined by the Code, by directing the Company to contribute such earnings to the Savings Plan on the employee's behalf. A participating employee may also make after-tax contributions to the Savings Plan. The Company contributes an amount to the Savings Plan equal to 50% of an employee's contributions, subject to certain limitations. The Company's matching contributions are invested solely in its common stock acquired in open market purchases. All employee contributions and Company matching contributions are fully vested when made. Amounts held by the Savings Plan for the account of a participating employee are distributable as a lump-sum upon termination of employment for any reason. Subject to certain conditions and restrictions, a participating employee may receive a distribution or a loan of a portion of his account balance while employed by the Company. The Company contributed $1.7 million in 1993 and $1.6 million each year in 1992 and 1991, in matching contributions that were charged to compensation expense and invested in the Company's common stock. NOTE 16 - HEALTH CARE AND LIFE INSURANCE BENEFITS: The Company offers health care benefits to active employees and their dependents. Certain retirees under the age of sixty-five and their dependents are also offered health care benefits which are essentially the same as benefits available to active employees. However, benefit payments for covered retirees over the age of sixty-five are reduced by benefits paid by Medicare. Postretirement benefits currently provided by the Company to its eligible retirees consist primarily of medical and life insurance benefits. Through December 31, 1992 the Company accounted for postretirement benefits as costs were incurred. In December 1990, the Financial Accounting Standards Board issued SFAS No. 106, establishing a new standard for accounting for postretirement benefits. Under this new accounting standard, companies are required to recognize the full liability for postretirement benefits in their financial statements by the date the employee is eligible to receive the benefits. The new standard, which the Company adopted as of January 1, 1993, required immediate recognition of an initial liability for postretirement benefits attributable to employee services provided in years prior to 1993 and, thereafter, the annual cost of the actuarially determined benefit attributable to employee service in the current year. (See Note 2 of Notes to Consolidated Financial Statements.) The following table sets forth the Company's accumulated postretirement benefit obligation, none of which has been funded, reconciled with the amount shown in the Company's balance sheet at December 31, 1993. The components of net periodic postretirement benefit costs included in the results of operations for the year ended December 31, 1993 were as follows: The assumed health care cost trend rate used in measuring the accumulated postretirement benefit obligation as of December 31, 1993 was 9.5% for general health care and 14% for prescription drugs in 1994, decreasing each successive year until it reaches 6% in 2017 and thereafter. The health care trend rate assumption has a significant effect on the amount of the obligation and periodic cost reported. For example, a one-percentage-point increase in the assumed health care cost trend rate for each year would increase the APBO as of December 31, 1993 and net periodic postretirement health care cost by approximately 7%. The assumed discount rate used in determining the APBO was 7.5%. Most of the Company's health care benefits are self-insured and administered on cost plus fee arrangements with a major insurance company or provided through health maintenance organizations. Claims, premiums and administrative costs incurred for active employees and their dependents were $12.3 million, $9.9 million and $10.3 million in 1993, 1992 and 1991, respectively. For retirees and their dependents these costs were $3.2 million in 1993 and $2.3 million in 1992 and 1991. In 1993, expenses recognized under SFAS No. 106 include a net charge of $2.5 million to accrue estimated postretirement health care benefits in excess of claims incurred. The Company provides life insurance benefits to its active and retired employees. Generally, life insurance benefits for retired employees are reduced over a number of years from the date of retirement to a minimum level. Costs accrued or paid for life insurance benefits for both active and retired employees were approximately $984,000 in 1993, $732,000 in 1992 and $800,000 in 1991. The costs of providing such benefits for retired employees were approximately $35,000 in 1993, $41,000 in 1992 and $39,000 in 1991. In 1990, the Company established a Voluntary Employee Beneficiary Association (VEBA) to fund its health care benefit payments to employees, retirees and their dependents. As a result, the Company made annual contributions to a tax-exempt irrevocable trust established to make such benefit payments. The Company made payments to the trust of $15.5 million in 1991. No such payments were made in 1992 or 1993. NOTE 17 - COMMITMENTS AND CONTINGENT LIABILITIES: Operating Leases - Rental expense covering manufacturing, transportation and certain other facilities and equipment for the years 1993, 1992 and 1991 aggregated $9.9 million, $9.2 million and $7.9 million, respectively. Minimum annual rental commitments as of December 31, 1993 under noncancellable leases are set forth as follows: Environmental Matters - Many of the raw materials, products and by-products associated with the operation of any industrial facility, including those for the production of cement or concrete products, contain chemical elements or compounds that are designated as hazardous substances. In addition, the Company has entered the environmental services business. All of these activities are regulated by federal, state and local laws and regulations pertaining to human health and the environment. Federal environmental laws as well as analogous laws in certain states, create joint and several liability for the cost of cleaning up or correcting releases into the environment of designated hazardous wastes. Among those who may be held jointly and severally liable are those who generated the hazardous waste, those who arranged for disposal of the hazardous wastes, those who owned the disposal site or facility at the time of disposal, and current owners. The Company has both given indemnification to and received indemnification from others for properties previously owned although some courts have held that indemnification for such environmental liabilities is unenforceable. Industrial operations have been conducted at some of the Company's facilities for almost 100 years. In the past, the Company disposed of various materials, both onsite and offsite, in a manner which would not be permitted under current environmental regulations. Certain of these materials are today categorized as hazardous wastes when discarded. The Company's cement kilns that burn hazardous waste, as well as its TSD facilities, are subject to extensive federal, state and local environmental laws and regulations and may be required to clean up onsite waste disposal areas under the Resource Conservation and Recovery Act (RCRA)'s corrective action program. Such clean-ups can be costly. While the Company's facilities at several locations are the subject of various local, state and federal environmental proceedings and inquiries, including being named a potentially responsible party (PRP) at several of its locations, most of these investigations are in their preliminary stages and final results may not be determined for years. Management of the Company believes, however, based solely upon the preliminary information the Company has developed to date, that known matters can be successfully resolved in cooperation with the local, state and federal regulating agencies and that the ultimate resolution of these matters will not have a material adverse effect upon the consolidated financial condition of the Company. Until all environmental studies and investigations have been completed, however, it is impossible to determine the ultimate costs of resolving these environmental issues. In conjunction with the acquisition of the TSD facilities, the Company established pre-acquisition contingency reserves which, in the opinion of management, are sufficient to cover the costs of correcting any known pre-acquisition environmental deficiencies at these facilities. There can be no assurances, however, that such reserves are adequate to allow for any unknown conditions that may exist. CKD Remediation in Ohio - As discussed in more detail under "Management's Discussion and Analysis of Financial Condition and Results of Operations" under the caption "Liquidity and Capital Resources - Known Events, Trends and Uncertainties - Environmental Matters", three of a number of inactive cement kiln dust (CKD) disposal sites near the Company's Fairborn, Ohio cement plant have been under investigation by the Company, as well as in some cases by federal and state environmental agencies, to determine if remedial action is required at any or all of these sites. The Company as well as state environmental agencies have conducted investigations to determine appropriate remedial action required at an inactive CKD disposal site in Ohio. Based on various remediation investigations, hydrogeological analyses and feasibility studies performed in prior years, the Company had recorded charges totaling $6.7 million through the end of 1992 as the estimated remediation cost for the site, increasing the initial estimates as additional information became known. In October 1993, the Company received a consulting report proposing additional refinements of earlier estimates which increased the total estimated cost to remediate this site from $6.7 million to $9.7 million. Accordingly, the Company recorded an additional $3 million charge in the third quarter of 1993 to recognize the change in the estimate. On a voluntary basis, without administrative or legal action being taken, the Company is also investigating two other inactive Ohio CKD disposal sites. The two additional sites in question were part of a cement manufacturing facility that was owned and operated by a now dissolved cement company from 1924 to 1945 and by a division of USX Corporation (USX) from 1945 to 1975. On September 24, 1993, the Company filed a complaint (Complaint) against USX, alleging that USX is a PRP under the Comprehensive Environmental Response, Compensation and Liability Act of 1980 (CERCLA) and under applicable Ohio law, and therefore jointly and severally liable for costs associated with cleanup of the larger of the two sites (Site). USX answered the complaint in November 1993 by filing a motion to dismiss the lawsuit. Based on advice of counsel, the Company believes that USX should not prevail on its motion to dismiss the lawsuit. Based on the limited information available as of December 31, 1993, the Company has received two preliminary engineering estimates of the potential magnitude of the remediation costs for the Site, $8 million and $32 million, depending on the assumptions used. The Company intends to vigorously pursue its right to contribution from USX for cleanup costs under CERCLA and Ohio law. Based upon the advice of counsel, the Company believes that USX is a responsible party because it owned and operated the site at the time of disposal of the hazardous substance, arranged for the disposal of the hazardous substance and transported the hazardous substance to the Site. Therefore, counsel to the Company has advised that it appears there is a reasonable basis for the apportionment of cleanup costs relating to the Site between the Company and USX, with USX shouldering substantially all of the cleanup costs because, based on the facts known at this time, the Company itself disposed of no CKD at the Site and is potentially liable under CERCLA because of its current ownership of the Site. These determinations, however, are preliminary, and are based only upon facts available to the Company prior to any discovery. Under CERCLA and applicable Ohio law a court generally applies equitable principles in determining the amount of contribution which a potentially responsible party must provide with respect to a cleanup of hazardous substances and such determination is within the sole discretion of the court. In addition, no regulatory agency has directly asserted a claim against the Company as the owner of the Site requiring it to remediate the property, and no cleanup of the Site has yet been initiated. Other - The Company has certain other commitments and contingent liabilities incurred in the ordinary course of business which, in the judgment of management, will not result in losses which would materially affect its consolidated financial position. NOTE 18 - WRITE-DOWN OF CERTAIN ENVIRONMENTAL ASSETS: The Company entered the environmental services business in June 1989 with the signing of an agreement involving as co- participants Browning-Ferris Industries, Inc. (BFI) and Cadence Chemical Resources (Cadence). The Company significantly expanded its commitment to the recovery of the energy value in organic hazardous wastes beginning in mid-1990 with the acquisition of a total of seven facilities to process hazardous wastes into liquid and solid hazardous waste derived fuels (HWDF) for introduction into permitted cement kilns as a partial substitute for conventional fuels. Contrary to management's expectations, however, the Company experienced start-up losses totaling approximately $16 million, exclusive of write-downs, in its first two and one-half years in the business. Accordingly, the Company restructured this business in late 1992, narrowing its focus by selling, or planning to sell, all but two of its TSD processing facilities. The Tennessee facility, one of those being retained, is being upgraded and expanded to provide increased capacity for blending HWDF. As of December 31, 1993, the Company had sold three of its original seven TSDs and is continuing efforts to sell two additional TSDs. After trying unsuccessfully to sell its Alsip, Illinois facility for almost a year the Company recorded a $3.1 million pretax charge in the fourth quarter of 1993 to record an estimated $1 million in remediation costs at that facility and to write down the Illinois TSD held for sale to reflect the Company's revised estimate of net realizable value of that facility. In January 1994 the Company negotiated a letter of intent for a proposed sale of this facility that would generate neither a gain or a loss. In 1992 the Company recorded a $21.4 million pretax charge to write down the difference between book value, including intangible assets, and the estimated realizable value of the TSDs, net of operating losses expected to occur prior to disposition, and to expense the non- recoverable portion of previously deferred environmental permitting costs incurred in the development of the environmental services business. NOTE 19 - UNCONSOLIDATED JOINT VENTURE In August 1990, the Company contributed to Southdown Thermal Dynamics (STD), a Texas general partnership, in exchange for a 50% partnership interest, the two thermal distillation processing units and certain associated assets it had acquired from BFI in conjunction with SES's purchase of the TSDs in June 1990. STD was established to construct and operate thermal distillation units for onsite treatment and remediation of refinery and other organic waste streams. Because STD was unable to establish the commercial viability of the process without substantial additional funding and because of the Company's capital commitments in its other businesses, the Company notified its joint venture partner in early August 1991 of the Company's intent to dispose of its interest in this joint venture. On January 6, 1992 a subsidiary of the Company sold its interest in the partnership to an affiliate of the other 50% partner for a note which was later exchanged for a replacement note which on November 18, 1992 was, in turn, forgiven in exchange for an indemnification and hold harmless agreement with a third party. The Company accounted for STD under the equity method as an unconsolidated joint venture and, as of December 31, 1991 wrote off its remaining capitalized investment in the joint venture with a $12.3 million pretax charge to earnings recognized in the final quarter of 1991. NOTE 20 - DISCONTINUED OPERATIONS: In connection with the 1989 sale of the Company's oil and gas operations, the Company deferred recognition of a portion of its realized gain until certain potential loss contingencies were resolved. Upon expiration of the contingency period in 1992, the Company recognized an additional gain on the sale of the Company's discontinued oil and gas operations of approximately $1.4 million, $800,000, net of income taxes. In late August 1993 the Company was notified by Energy Development Corporation (EDC), the 1989 purchaser of the common stock of the Company's then oil and gas subsidiary, Pelto Oil Company (Pelto), that EDC was exercising its indemnification rights under the 1989 stock purchase agreement with respect to a Department of Energy (DOE) Remedial Order regarding the audit of crude oil produced and sold during the period September 1973 through January 1981 from an offshore, federal waters field known as Ship Shoal Block 113 Unit./South Pelto 20 of which the Company's oil and gas subsidiary was part owner. The DOE has alleged certain price overcharges and is seeking to recover a total of $68 million dollars in principal and interest from Murphy Oil Company (Murphy), as operator of the property. Murphy estimated the Company's share of this total to be approximately $4 million. On January 24, 1994 the presiding Administrative Law Judge at the Federal Energy Regulatory Commission (FERC) rendered a favorable decision for Murphy, materially reducing the amount it potentially owed to the DOE. This decision also had the effect of precluding the DOE from recovering from Murphy for any alleged overcharges attributable to Pelto's "in-kind" production. Murphy has indicated that if the FERC adopts the Administrative Law Judge's opinion, Pelto will not owe anything to Murphy as a result of the DOE's claim, other than its pro rata share of attorneys' fees. The Company cannot assess the likelihood that the DOE would seek to recover sums from Pelto directly due to Pelto's "in-kind" production, but the Company believes, based on advice of counsel, that, if it did, any such claim by the DOE would be barred by limitations. Prior to the sale of Pelto in 1989, Pelto entered into certain gas settlement agreements, including one with Transcontinental Gas Pipe Line Corporation (Transco). The Minerals Management Service (MMS) of the Department of the Interior has reviewed the agreement entered into with Transco in 1988 to determine whether a payment to Pelto thereunder is associated with federal or Indian leases and whether, in their view, any additional royalties may be due as a result of that payment. MMS has advised EDC of a preliminary royalty underpayment determination resulting from its review, and that MMS proposes to direct EDC to compute any gas royalties attributable to what MMS characterizes as a "contract buydown". This does not constitute a final action by MMS; its stated purpose is to give an opportunity to comment or provide additional documentation that would refute or alter MMS's preliminary determination. In late December 1993, the Company was notified by EDC that EDC was exercising its indemnification rights under the 1989 stock purchase agreement for Pelto with respect to this matter. The Company is unable to determine what liability it may have, if any, with respect to this matter, but should the Company be required to make any payments to the MMS, such expenditures would result in a charge to discontinued operations. NOTE 21 - EARNINGS PER SHARE AND CAPITAL STOCK: EARNINGS PER SHARE Earnings used to compute primary per share earnings in 1993, 1992 and 1991 were net of preferred stock dividends of approximately $5.0 million, $5.0 million and $5.1 million, respectively. Primary earnings per share were computed using the average number of shares of common stock for 1993, 1992 and 1991. Because of the net losses in 1991 through 1993, the effect of an assumed conversion of the Series A and Series B Preferred Stock referred to below was anti-dilutive and, therefore, fully diluted earnings per share for those years is the same as primary earnings per share. The authorized capital stock of Southdown comprises 40,000,000 shares of Common Stock, $1.25 par value (Common Stock), and 10,000,000 shares of Preferred Stock, $.05 par value (the Preferred Stock). Chemical Shareholder Services Group, Inc., a subsidiary of Chemical Banking Corporation, serves as the registrar and transfer agent for the Common Stock, the Series B Preferred Stock and the Series D Preferred Stock described below and as Warrant Agent and Rights Agent for the Warrants and Rights, respectively. The Company serves as the registrar and transfer agent for the Series A Preferred Stock. COMMON STOCK At December 31, 1993, 17,045,809 shares of Common Stock were issued and outstanding and held of record by approximately 1,956 shareholders, and approximately 7.6 million shares were reserved for future issuance upon exercise of options granted under employee benefit plans or warrants or upon conversion of convertible securities. Approximately 2.6 million more shares were subsequently reserved in January 1994 for issuance upon conversion of the Series D Preferred Stock. On April 25, 1991 the Board of Directors suspended the dividend on the Company's Common Stock. WARRANTS TO PURCHASE COMMON STOCK In October 1991, the Company issued and sold an aggregate of 1,250,000 Warrants to purchase Common Stock (the Warrants) pursuant to the terms of a Warrant Agreement dated as of October 31, 1991 (the Warrant Agreement), between the Company and First City, Texas - Houston, N.A., as Warrant Agent. Chemical Shareholder Services Group, Inc. is now the Warrant Agent. Each Warrant entitles the holder to purchase one share of Common Stock at a price of $16 per share, subject to adjustment in certain circumstances, until 5:00 p.m. New York City on October 31, 1996. The number and kind of securities purchasable upon exercise of the Warrants are subject to adjustment from time-to-time upon the occurrence of certain reclassifications, mergers or consolidations, stock splits, stock dividends, certain other distributions and events and certain issuances or sales of Common Stock at prices less than market value (as defined in the Warrant Agreement). In lieu of an adjustment to the number of shares of Common Stock issuable pursuant to the exercise of the Warrants, the Company may elect to issue additional Warrants. RIGHTS On March 4, 1991, the Board of Directors of the Company declared a dividend of one right to purchase preferred stock (Right) for each outstanding share of the Company's Common Stock, to shareholders of record at the close of business on March 14, 1991. Each Right entitles the registered holder to purchase from the Company a unit consisting of one one-hundredth of a share (a Unit) of Preferred Stock, Cumulative Junior Participating Series C, par value $.05 per share (the Series C Preferred Stock), at a purchase price of $60 per Unit, subject the adjustment (the Purchase Price). The description and terms of the Rights are set forth in a Rights Agreement dated as of March 4, 1991 (the Rights Agreement) between the Company and First City, Texas-Houston, N.A., as Rights Agent. Chemical Shareholders Services Group, Inc. now serves as Rights Agent. The Rights are attached to all certificates representing outstanding shares of Common Stock, and no separate certificates for the Rights have been distributed. The Rights will separate from the Common Stock and a "Distribution Date" will occur upon the earlier of (i) ten days following a public announcement that a person or group of affiliated or associated persons (an Acquiring Person) has acquired, or obtained the right to acquire, beneficial ownership of 15% or more of the outstanding shares of Common Stock (the date of the announcement being the Stock Acquisition Date), or (ii) ten business days (or such later date as may be determined by the Company's Board of Directors before the Distribution Date occurs) following the commencement of a tender offer or exchange offer that would result in a person's becoming an Acquiring Person. The Rights are not exercisable until the Distribution Date and will expire at the close of business on March 14, 2001, unless earlier redeemed or exchanged by the Company as described below. In the Rights Agreement, the Company has generally agreed to use its best efforts to cause the securities of the Company issuable pursuant to the exercise of Rights to be registered under the Securities Act, as soon as practicable after the Rights become exercisable, and to take such action as may be necessary to ensure compliance with applicable state securities laws. In the event (a Flip-In Event) that a person becomes an Acquiring Person (except pursuant to certain Permitted Offers as defined in the Rights Agreement) each Right will then entitle the holder to receive, upon exercise of such Right, a number of shares of Common Stock (or, in certain circumstances, cash, property or other securities of the Company) having a Current Market Price (as defined in the Rights Agreement) equal to two times the exercise price of the Right. Notwithstanding the foregoing, all Rights that are, or under certain circumstances were, beneficially owned by any Acquiring Person (or by certain related parties) will be null and void. The Purchase Price payable, and the number of Units, or other securities or property issuable, upon exercise of the Rights are subject to adjustment from time-to-time to prevent dilution. For example, at an exercise of $60 per Right, each Right not owned by an Acquiring Person (or by certain related parties) following an event set forth in the preceding paragraph would entitle its holder to purchase $120 worth of Common Stock (or other consideration, as noted above), based upon its then Current Market Price, for $60. Assuming that the Common Stock had a Current Market Price of $15 per share at such time, the holder of each valid Right would be entitled to purchase 8 shares of Common Stock for $60. In the event (a Flip-Over Event) that, at any time on or after the Stock Acquisition Date, (i) the Company is acquired in a merger or other business combination transaction (other than a specified type of merger that follows a Permitted Offer), or (ii) 50% or more of the Company's assets or earnings power is sold or transferred, each holder of a Right (except Rights that previously have been voided as set forth above) shall thereafter have the right to receive, upon exercise, a number of shares of common stock of the acquiring company (or in certain cases its controlling person) having a Current Market Price equal to two times the exercise price of the Right. At any time until ten days following a Stock Acquisition Date, the Company may redeem the Rights in whole, but not in part, at a price of $.01 per Right, payable, at the option of the Company, in cash, shares of Common Stock or such other consideration as the Board of Directors may determine. The provisions of the Rights and the Rights Agreement may in some cases discourage or make more difficult the acquisition of control of the Company by means of a tender offer, open market purchase or similar means. These provisions are intended to discourage, or may have the effect of discouraging, partial tender offers, front-end loaded two-tier tender offers and certain other types of coercive takeover tactics and inadequate takeover bids and to encourage persons seeking to acquire control of the Company first to negotiate with the Company. The Company believes that these provisions, which are similar to those of many other publicly held companies, provide benefits by enhancing the Company's potential ability to negotiate with the proponent of any unfriendly or unsolicited proposal to take over or restructure the Company that outweigh the disadvantages of discouraging such proposals because, among other things, negotiation of such proposals could result in an improvement in their terms. PREFERRED STOCK The Board of Directors is authorized to designate series of Preferred Stock and fix the powers, preferences and rights of the shares of such series and the qualifications, limitations or restrictions thereon. Series A Preferred Stock - Pursuant to the terms of the Restated Articles of Incorporation (Restated Articles), the Board of Directors has created a series of Preferred Stock consisting of 1,999,998 shares of Preferred Stock, $.70 Cumulative Convertible Series A (Series A Preferred Stock). The Series A Preferred Stock is senior to the Series B Preferred Stock with respect to dividends and assets. As of December 31, 1993, 1,999,000 shares of Series A Preferred Stock were issued and outstanding. All such shares are fully paid and nonassessable. The Series A Preferred Stock (a) has a stated value and liquidation preference of $10 per share, plus accrued and unpaid dividends, (b) carries a cumulative dividend of $.70 per year, payable quarterly, and entitle the holders of a majority thereof to elect two directors if dividends are in arrears for at least 540 days, (c) is initially convertible into one-half of a share of Common Stock for each share of Series A Preferred Stock, subject to adjustment, (d) is redeemable at the option of the Company at 120% of the $10 stated value thereof (declining to 100% of the stated value after April 30, 1997) plus accrued and unpaid dividends, and (e) is entitled to one vote per share, voting as a class with the Common Stock and any other capital stock of the Company entitled to vote, on all matters submitted to shareholders. In addition, the holders of Series A Preferred Stock have certain class voting rights, including the right to approve certain mergers, consolidations and sales of assets; however, if a holder of Series A Preferred Stock does not grant a proxy to the Board of Directors to vote in favor of any such merger, consolidation or sales of assets, the Company may redeem such holder's shares of Series A Preferred Stock without the payment of any redemption premium. The Company has reserved 999,500 shares of Common Stock for issuance upon conversion of the Series A Preferred Stock. Dividends paid on the Series A Preferred Stock amounted to approximately $1.4 million in each of the last three years. Series B Preferred Stock- Pursuant to the terms of the Restated Articles, the Board of Directors has created a series of Preferred Stock consisting of 960,000 shares of Preferred Stock, $3.75 Convertible Exchangeable Series B (the "Series B Preferred Stock"). The Series B Preferred Stock is junior to the Series A Preferred Stock with respect to dividends and assets. As of December 31, 1993, 959,000 shares of Series B Preferred Stock were issued and outstanding. All such shares are fully paid and nonassessable. Dividends paid on the Series B Preferred Stock amounted to approximately $3.6 million in each of the last three years. The Series B Preferred Stock (a) has a stated value and liquidation preference of $50 per share, plus accrued and unpaid dividends, (b) carries a cumulative dividend of $3.75 per year, payable semi-annually, and entitles the holders of a majority thereof to elect two directors if dividends are in arrears for at least 180 days, (c) is initially convertible into two and one-half shares of Common Stock for each share of Series B Preferred Stock, subject to adjustment, (d) is redeemable at the option of the Company at 100% of the $50 stated value thereof plus accrued and unpaid dividends, and (e) is entitle to one vote per share, voting as a class with the Common Stock and any other capital stock of the Company entitled to vote, on all matters submitted to shareholders. In addition, the holders of the Series B Preferred Stock have certain class voting rights. The Company has reserved 2,397,500 shares of Common Stock for issuance upon conversion of the Series B Preferred Stock. In addition, the Series B Preferred Stock is exchangeable, in whole but not in part, at the option of the Company at any time for the Company's 7 1/2% Convertible Subordinated Debentures Due 2013 (the "Debentures") at a rate of $50 in principal amount of Debentures per share of Series B Preferred Stock, provided that all dividends on the Series B Preferred Stock have been paid through the date of such exchange. The Company's Restated Revolving Credit Facility requires the Company to obtain the consent of the lenders thereunder as a condition to the exchange of the Series B Preferred Stock for the Debentures. In addition, the Company is actively considering calling for redemption all of the oustanding shares of its Series B Preferred Stock at the redemption price of $50.00 per share plus accrued and unpaid dividends to the redemption date. Each share of Series B Preferred Stock is convertible into 2.5 shares of the Company's common stock (equivalent to a conversion price of $20.00 per share of common stock). Series C Preferred Stock - In connection with the distribution of the Rights on March 14, 1991, the Board of Directors of the Company authorized 400,000 shares of Series C Preferred Stock, none of which are outstanding. The Series C Preferred Stock would be issued only upon the exercise of Rights and only if the Rights were exercised. The Rights are not exercisable as of the date hereof. See "-- Rights". If issued, the Series C preferred Stock would be junior to the Series A Preferred Stock, the Series B Preferred Stock and the Series D Preferred Stock with respect to dividends and assets. Series D Preferred Stock - Pursuant to the terms of the Restated Articles, the Board of Directors in 1994 authorized creation of a series of Preferred Stock consisting of 1,725,000 shares of Preferred Stock, $2.875 Cumulative Convertible Series D. The Series D Preferred Stock ranks junior to the Series A Preferred Stock, pari passu with the Series B Preferred Stock, and will be senior to any Series C Preferred Stock that may be issued. A total of 1,725,000 shares of Series D Preferred Stock were sold on January 27, 1994. Dividends on the Series D Preferred Stock will be approximately $5 million per year. The Series D Preferred Stock (a) has a stated value and liquidation preference of $50 per share, plus accrued and unpaid dividends, (b) carries a cumulative annual dividend of $2.875 per share, payable quarterly, and entitles the holders thereof, voting together as a single class with all other series or classes of preferred stock which are pari passu with the Series D Preferred Stock as to dividends and which specifically state that they shall vote with the Series D Preferred Stock in such a case (which does not include the Series A Preferred Stock, the Series B Preferred Stock or, if any is issued, the Series C Preferred Stock), to elect two directors if dividends are in arrears for at least six quarterly dividend periods, (c) is initially convertible into 1.511 shares of Common Stock for each share of Series D Preferred Stock, subject to adjustment, (d) may be converted at the option of the Company, in whole but not in part, at any time on and after January 27, 1997 and until January 27, 2001, if for at least 20 trading days within a period of 30 consecutive trading days, including the last trading day of such 30 trading day period, the closing price of the Common Stock equals or exceeds 130% of the conversion price, into 1.511 shares of Common Stock, subject to adjustment, (e) is redeemable at the option of the Company at 100% of the started value thereof plus accrued and unpaid dividend on and after January 27, 2001, and (f) is entitled to one vote per share, voting as a class with the Common Stock and any other capital stock of the Company entitled to vote, on all matters submitted to shareholders. In addition, the Series D Preferred Stock has certain class voting rights. The Company has initially reserved 2,606,475 shares of Common Stock for issuance upon conversion of the Series D Preferred Stock. NOTE 22 - STOCK OPTION AND INCENTIVE PLANS: 1991 Directors' Plan - Under the 1991 Nonqualified Stock Option Plan for Non-Employee Directors (1991 Directors' Plan), options for a total of up to 150,000 shares of the Company's common stock are available for grant to directors of the Company who are not employed by the Company or any of the Company's subsidiaries. In 1991, the Board of Directors awarded to each of the Company's five non-employee directors an option to purchase 10,000 shares of the Company's common stock in the future. Newly elected non-employee directors shall be automatically granted an option to acquire 10,000 shares of the Company's common stock upon the date of a director's election to the Board of Directors. An additional option to acquire 5,000 shares of the Company's common stock shall be awarded to each non-employee director on the date of the annual meeting of shareholders at which the non-employee director is reelected to serve an additional three-year term. As provided in the 1991 Directors' Plan, options vest immediately to the extent of 25% of the total options and an additional 25% on each of the first through the third anniversaries from the date of the grant. Options granted under the 1991 Directors' Plan expire not more than ten years from the date of grant. Unoptioned shares available for grant as of December 31, 1993 under the 1991 Director's Plan were 45,000. 1989 Plan - Under the 1989 Stock Option Plan (1989 Plan) for officers and certain key employees of the Company and its subsidiaries, options for a total of up to 2,000,000 shares of the Company's common stock were initially available for award of which 869,800 options had been awarded as of December 31, 1993. As provided in the 1989 Plan, 20% of the options vest 90 days after the date of grant and an additional 20% vest on each of the first through the fourth anniversaries from the date of grant. Options granted under the 1989 Plan expire not more than ten years from the date of grant. Unoptioned shares available for grant as of December 31, 1993 under the 1989 Plan were 1,130,200. 1987 Plan - Under the 1987 Stock Option Plan (1987 Plan) for officers and certain key employees of the Company and its subsidiaries, a total of up to 2,000,000 shares of the Company's common stock were initially available for award of which 1,798,822 shares had been awarded as of December 31, 1992. As provided in the 1987 Plan, options vest immediately upon grant to the extent of 40% of the total. An additional 30% of the options vest on each of the first and second anniversaries from the date of grant. Options granted under the 1987 Plan expire not more than ten years from the date of grant. Unoptioned shares available for grant as of December 31, 1993 under the 1987 Plan were 201,178. Information with respect to the Company's stock option plans is as follows: INDEPENDENT AUDITORS' REPORT TO THE SHAREHOLDERS AND BOARD OF DIRECTORS OF SOUTHDOWN, INC. Southdown, Inc. Houston, Texas We have audited the accompanying consolidated balance sheet of Southdown, Inc. and subsidiary companies as of December 31, 1993 and 1992, and the related statements of consolidated earnings, shareholders' equity and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the consolidated financial statement schedules listed in the "Index to Other Required Schedules". These consolidated financial statements and consolidated financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and consolidated financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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 consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Southdown, Inc. and subsidiary companies as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, such consolidated financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note 2 of Notes to Consolidated Financial Statements, the Company changed its method of accounting for postretirement benefits other than pensions and income taxes effective January 1, 1993 to conform with Statements of Financial Accounting Standards No. 106 and 109, respectively. DELOITTE & TOUCHE Houston, Texas January 27, 1994 ITEM 9.	ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING OF FINANCIAL DISCLOSURE. None PART I I I ITEM 10.	ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The information required by this Item will be included in a definitive proxy statement, pursuant to Regulation 14A, to be filed not later than 120 days after the close of the Company's fiscal year. Such information is incorporated herein by reference. ITEM 11.	ITEM 11. EXECUTIVE COMPENSATION. The information required by this Item will be included in a definitive proxy statement, pursuant to Regulation 14A, to be filed not later than 120 days after the close of the Company's fiscal year. Such information is incorporated herein by reference. ITEM 12.	ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information required by this Item will be included in a definitive proxy statement, pursuant to Regulation 14A, to be filed not later than 120 days after the close of the Company's fiscal year. Such information is incorporated herein by reference. ITEM 13.	ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information required by this Item will be included in a definitive proxy statement, pursuant to Regulation 14A, to be filed not later than 120 days after the close of the Company's fiscal year. Such information is incorporated herein by reference. PART I V ITEM 14.	ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) 1. and 2. FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES Item 8 of this report lists certain consolidated financial statements and supplementary data of the Company and its subsidiaries. For other required schedules, see "Index to Other Required Schedules" on Page S-1 of this document. 3. Exhibits - -------------------- * Filed herewith + Compensatory plan or management agreement. (b) REPORTS ON FORM 8-K. No reports on Form 8-K were filed during the quarter ended December 31, 1993. On January 4, 1994 a Current Report on Form 8-K was filed relating to (i) two inactive cement kiln dust disposal sites owned by the Company and (ii) a claim for indemnification by Energy Development Corporation. SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED. SOUTHDOWN, INC. (Registrant) By CLARENCE C. COMER ----------------------------------- Clarence C. Comer President and Chief Executive Officer Date: February 24, 1994 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. SOUTHDOWN, INC. AND SUBSIDIARY COMPANIES INDEX TO OTHER REQUIRED SCHEDULES All other schedules are omitted because they are not applicable or the required information is shown in the financial statements or notes thereto. S - 1 SCHEDULE II SOUTHDOWN, INC. AND SUBSIDIARY COMPANIES AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES (IN THOUSANDS) - -------------- (1) The Company's Employment Agreement with Mr. Marston extended a loan of $500,000 to Mr. Marston on an interest-free basis to be repaid in ten annual installments of $50,000 beginning June 1, 1988, subject to the outstanding indebtedness being forgiven in the event that Mr. Marston becomes disabled. (2) Non-interest bearing note secured by Mr. Webber's personal residence in Florida payable upon sale of said residence. (3) Note secured by 21,000 shares of the Company's Series B preferred stock payable December 15, 1996 with interest payable semi- annually at the Company's borrowing rate on the Restated Revolving Credit Facility plus 1/8%. (4) Loan made to a partnership in which a subsidiary of the Company owned a 50% interest. On January 6, 1992 the Company forgave this loan in conjunction with the sale ofthe Company's interest in the joint venture to an affiliate of the other 50% partner. (See Note 19 of Notes to Consolidated Financial Statements.) S - 2 SCHEDULE V SOUTHDOWN, INC. AND SUBSIDIARY COMPANIES PROPERTY, PLANT AND EQUIPMENT 1 (IN THOUSANDS) - ------------- (1) See Note 1 of Notes to Consolidated Financial Statements for depreciation method, useful lives and rates. (2) Primarily reclassification between segments and Other Assets. (3) Miscellaneous reclassification. (4) See Note 18 of Notes to Consolidated Financial Statements for information regarding the purchase of hazardous waste processing facilities. (5) Relates primarily to the sale of the Company's Florida aggregate operation. (6) Deductions include the write-down of certain Environmental Services assets to net realizable value and the reclassification of three hazardous waste processing facilities' property, plant and equipment to current assets held for sale. (See Note 18 of Notes to Consolidated Financial Statements.) (7) Relates to the acquisition of various ready-mixed concrete batch plants and one aggregate quarry. (8) Includes the reclassification of one hazardous waste processing facilities' property, plant and equipment from current assets held for sale. S - 3 SCHEDULE VI SOUTHDOWN, INC. AND SUBSIDIARY COMPANIES ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (IN THOUSANDS) - --------- (1) Miscellaneous reclassification. (2) Relates to the sale of the Company's Florida aggregate operation. (3) Deductions include the write-down of certain Environmental Services assets to net realizable value and the reclassification of three hazardous waste processing facilities' property, plant and equipment to current assets held for sale. (See Note 18 of Notes to Consolidated Financial Statements.) (4) Includes the reclassification of one hazardous waste processing facilities' property, plant and equipment from current assets held for sale. S - 4 SCHEDULE VII SOUTHDOWN, INC. AND SUBSIDIARY COMPANIES GUARANTEES OF SECURITIES OF OTHER ISSUERS S - 5 SCHEDULE VIII SOUTHDOWN, INC. AND SUBSIDIARY COMPANIES VALUATION AND QUALIFYING ACCOUNTS (IN THOUSANDS) - -------------- (1) Amounts written off. (2) Discharge of pre-acquisition contingencies and other. (3) Related to the acquisition of the hazardous waste processing facilities. (4) Related to remediation of a CKD disposal site. S - 6 SCHEDULE X SOUTHDOWN, INC. AND SUBSIDIARY COMPANIES SUPPLEMENTAL STATEMENT OF EARNINGS INFORMATION (IN THOUSANDS) S - 7
314459_1993.txt	314459	1993	ITEM 1. BUSINESS All references to "Notes" are to Notes to Consolidated Financial Statements contained in this report. The registrant, Carlyle Real Estate Limited Partnership - X (the "Partnership"), is a limited partnership formed in 1979 and currently governed by the Revised Uniform Limited Partnership Act of the State of Illinois to invest in improved income-producing commercial and residential real property. The Partnership sold $82,500,000 in Limited Partnership Interests (the "Interests") commencing in May 1980 pursuant to a Registration Statement on Form S-11 under the Securities Act of 1933 (Registration No. 2-66350), which offering was increased by $17,500,000 pursuant to a new Registration Statement (No. 2-69818). A total of 100,000 Interests were sold to the public at $1,000 per Interest. The offering closed in February 1981. No Limited Partner has made any additional capital contribution after such date. The Limited Partners of the Partnership share in their portion of the benefits of ownership of the Partnership's real property investments according to the number of Interests held. The Partnership is engaged solely in the business of the acquisition, operation and sale and disposition of equity real estate investments. Such equity investments are held by fee title, leasehold estates and/or through joint venture partnership interests. The Partnership's real property investments are located throughout the nation and it has no real estate investments located outside of the United States. A presentation of information about industry segments, geographic regions, raw materials or seasonality is not applicable and would not be material to an understanding of the Partnership's business taken as a whole. Pursuant to the Partnership Agreement, the Partnership is required to terminate on or before December 31, 2030. Accordingly, the Partnership intends to hold the real properties it acquires for investment purposes until such time as sale or other disposition appears to be advantageous. Unless otherwise described, the Partnership expects to hold its properties for long-term investment where, due to current market conditions, it is impossible to forecast the expected holding period. At sale of a particular property, the proceeds, if any, are generally distributed or reinvested in existing properties rather than invested in acquiring additional properties. The Partnership has made the real property investments set forth in the following table: On March 18, 1993, the Partnership sold the land, building, related improvements and personal property of the Double Tree Apartments located in El Paso, Texas. Reference is made to the Partnership's report on Form 8-K (File No. 0-9726) dated April 26, 1993 and hereby incorporated herein by reference and also to Note 7(c) for a further description of the transaction. On August 31, 1993, the lender for the Union Plaza Office Building realized upon its mortgage security interest and took title to the property. Reference is made to the description of such transaction in the Partnership's report on Form 8-K (File No. 0-9726) dated September 15, 1993 and hereby incorporated herein by reference and also to Note 4(b)(7) for a further description of the transaction. On October 31, 1993, the Partnership and an affiliate sold their interests in the Frontier Mall Venture. Reference is made to the description of such transaction in the Partnership's report on Form 8-K (File No. 0-9726) dated November 12, 1993 and hereby incorporated herein by reference and also to Note 7(d) for a further description of the transaction. The Partnership's real property investments are subject to competition from similar types of properties (including in certain areas properties owned or advised by affiliates of the General Partner) in the respective vicinities in which they are located. Such competition is generally for the retention of existing tenants. Additionally, the Partnership is in competition for new tenants in markets where significant vacancies are present. Approximate occupancy levels for the properties are set forth in the table in Item 2			ITEM 3. LEGAL PROCEEDINGS The Partnership is not subject to any pending material legal proceedings. ITEM 4.	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted to a vote of security holders during 1992 and 1993. PART II ITEM 5.	ITEM 5. MARKET FOR THE PARTNERSHIP'S LIMITED PARTNERSHIP INTERESTS AND RELATED SECURITY HOLDER MATTERS As of December 31, 1993, there were 10,392 record holders of Interests of the Partnership. There is no public market for Interests, and it is not anticipated that a public market for Interests will develop. Upon request, the Corporate General Partner may provide information relating to a prospective transfer of Interests to an investor desiring to transfer his Interests. The price to be paid for the Interests, as well as, any economic aspects of the transaction, will be subject to negotiation by the investor. Reference is made to Item 6		ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS LIQUIDITY AND CAPITAL RESOURCES On May 29, 1980, the Partnership commenced an offering of $82,500,000 pursuant to a Registration Statement on Form S-11 under the Securities Act of 1933, which offering was increased by $17,500,000 by a new Registration Statement. All Interests were subscribed and issued between May 29, 1980 and February 11, 1981 from which the Partnership received gross proceeds of $100,000,000. After deducting selling expenses and other offering costs, the Partnership had approximately $90,000,000 with which to make investments in income-producing commercial and residential real property, to pay legal fees and other costs (including acquisition fees) related to such investments and for working capital reserves. A portion of such proceeds was utilized to acquire the properties described in Item 1 above. At December 31, 1993, the Partnership and its consolidated ventures had cash and cash equivalents of approximately $976,000. Such cash and cash equivalents and short-term investments of approximately $17,287,000 are available for capital improvements, distributions to partners, and for working capital requirements including operating deficits at Sunrise Mall and possibly operating deficits at Garret Mountain Office Center in future periods. The Partnership and its consolidated ventures have currently budgeted approximately $408,000 for tenant improvements and other capital expenditures in 1994. The Partnership's share of such items and its share of such similar items for its unconsolidated ventures is currently budgeted to be approximately $619,000 in 1994. Actual amounts expended in 1994 may vary depending on a number of factors including actual leasing activity, results of property operations, liquidity considerations and other market conditions over the course of the year. The Partnership's interest in Frontier Mall Associates was sold on October 31, 1993. Reference is made to Note 7(d). The Partnership is undertaking a study to determine the financial and competitive feasibility of an expansion of Sunrise Mall to accommodate certain retail tenants who have indicated an interest in possibly opening stores at the mall. In addition, Greenway Towers Office Building is incurring capital improvements and operating deficits, which amounts were being funded from its mortgage loan. This loan was refinanced in October 1992 with a new first mortgage that allows for advances for tenant improvements, leasing commissions, interest advances and capital improvements. As of December 31, 1993, $2,512,285 was available for future advances Reference is made to Note 4(b)(10). The Greenway Towers Office Building in Dallas, Texas was 80% occupied at December 31, 1993. The second mortgage loan secured by both the Garret Mountain Office Center and the venture was extended to July 31, 1996 in October 1993. Reference is made to note 4(b)(11). Many of the Partnership's investment properties currently operate in overbuilt markets which are characterized by lower than normal occupancies and/or reduced rent levels. Such competitive conditions have resulted in the operating deficits described above. Although new construction in the Seattle office market has virtually ceased the overall market remains very competitive due to a significant amount of sublease space in the market. Although, the occupancy (97% at December 31, 1993) of First Interstate Center has not been adversely affected to date by the competitive office market, effective rental rates have decreased as a result. Due to the competitive market conditions and the significant amounts of expiring square footage over the next several years, the property will reserve a portion of its cash flow in order to cover the re-leasing costs required. The first mortgage loan secured by the property is scheduled to mature in December 1995. The venture anticipates approaching the mortgage lender regarding an extension or modification of the existing mortgage loan. There can be no assurance that any such extension or modification will be obtained. As described more fully in Notes 3 and 4(b), the Partnership is negotiating or has received mortgage loan modifications on certain of its properties. The existing modifications expire at various dates beginning in December 1995. There can be no assurance that the Partnership will be able to secure the modifications for which it is negotiating, or that upon the expiration of the existing modifications the Partnership will be able to secure further modifications to these loans. Commencing in December 1995, certain of the mortgage loans securing the properties will begin to mature. At maturity, there can be no assurances that the Partnership will be able to obtain replacement financing. If the Partnership does not seek or is unable to secure new or additional modifications or extensions to the loans, based upon current and expected future market conditions, the Partnership would likely decide not to commit any significant additional amounts to any of the properties which are incurring or in the future do incur, operating deficits. This would result in the Partnership no longer having an ownership interest in such properties. Such decisions would be made on a property-by-property basis and result in gain for financial reporting and Federal income tax purposes to the Partnership with no corresponding distributable proceeds. In August 1990, the Holly Pond venture suspended debt service payments at the Holly Pond Office Building. In addition, the Partnership has accrued $36,000 for potential future environmental clean-up costs at the Holly Pond property. (Reference is made to Note 4(b)(6)). In November 1991, the Energy Plaza venture reduced debt service payments to the extent of cash flow at the Union Plaza Office Building. On May 27, 1993, the lender posted the property for acceleration of the mortgage and all accrued interest. Based upon current market conditions and other considerations relating to the property and the Partnership's portfolio, the Partnership had decided not to commit any significant additional amounts to the property. Consequently, the lender realized upon its mortgage security interest in the property on August 31, 1993. Reference is made to Note 4(b)(7). The mortgage loan secured by the Double Tree Apartments was scheduled to mature in April 1992. The Partnership had obtained a one year extension. Debt service payments were ceased beginning April 1, 1992 in conjunction with the modification negotiations, but payments were remitted in full upon the finalization of the extension agreement. The Partnership continued to pay debt service in accordance with the previously modified terms until the property was sold in March 1993. Reference is made to Notes 4(b)(5) and 7(c). The Garret Mountain venture has approached the mortgage lender in an effort to negotiate debt service relief on the 12-5/8% first mortgage note secured by the Garret Mountain office building in West Paterson, New Jersey. Effective November 1, 1993, the venture began making cash flow debt service payments. The venture will continue to remit cash flow from the property to the lender; however, such amount will be less than the terms of the current mortgage loan. If the venture is unable to secure additional relief, the Partnership may decide, based upon current market conditions and other considerations relating to the property and the Partnership's portfolio, not to commit any significant additional amounts to the property. This would result in the Partnership no longer having an ownership interest in the property. As a result, the Partnership recorded a provision for value impairment of $785,084 in the accompanying consolidated financial statements. Such provision, made as of December 31, 1993 is recorded to reduce the net carrying value of the investment property to the outstanding balance of the related non-recourse debt. The loan has been classified at December 31, 1993 as a current liability in the accompanying consolidated Balance Sheet. In addition, approximately 32% (based on square footage) of tenant leases at the Garret Mountain office building expire in 1994. There can be no assurance that all of the expiring tenant space will be renewed. The sources of capital for items described above and for both short-term and long-term future liquidity and distributions are expected to be through net cash generated by the operations of the investment properties and through the sale of such investments. The Partnership's and its Ventures' mortgage obligations are all non-recourse except for the second mortgage secured by both the Garret Mountain Office Center and the venture. Therefore, the Partnership and its Ventures are not obligated to pay mortgage indebtedness on the non-recourse obligations unless the related property produces sufficient net cash flow from operations or sale. There are certain risks associated with the Partnership's investments made through joint ventures including the possibility that the Partnership's joint venture partner(s) in an investment might become unable or unwilling to fulfill its (their) financial or other obligations, or that such joint venture partner(s) may have economic or business interests or goals that are inconsistent with those of the Partnership. In response to the weakness of the economy and the limited amount of available real estate financing in particular, the Partnership is taking steps to preserve its working capital. Therefore, the Partnership is carefully scrutinizing the appropriateness of any discretionary expenditures, particularly in relation to the amount of working capital it has available. By conserving working capital, the Partnership will be in a better position to meet future needs of its properties without having to rely on external financing sources. Due to the factors discussed above and the general lack of buyers of real estate today, it is likely that the Partnership may hold some of its investment properties longer than originally anticipated in order to maximize the return to the Limited Partners. Although sale proceeds from the disposition of the Partnership's remaining assets are expected, in light of the current severely depressed real estate markets, without a dramatic improvement in market conditions, the Limited Partners will not receive a full return of their original investment. RESULTS OF OPERATIONS At December 31, 1993, 1992 and 1991, the Partnership owned six, nine and ten operating properties, respectively. Reference is made to Notes 3 and 6 for a description of agreements which the Partnership has entered into with sellers or affiliates of sellers of the Partnership's properties for the operation and management of such properties. The decrease in cash and cash equivalents and corresponding increase in short-term investments at December 31, 1993 as compared to December 31, 1992 is primarily due to the purchase of short-term investments. The increase in short-term investments is also due to the receipt and temporary investment of net proceeds of $3,308,699 from the sale of the Partnership's interest in the Frontier Mall Venture. Reference is made to Note 7(d). A portion of such proceeds were distributed to the Limited Partners in February 1994. Reference is made to Note 11. The decreases in rents and other receivables, land, buildings and improvements, accumulated depreciation, deferred expenses, current portion of long-term debt, and tenant security deposits at December 31, 1993 as compared to December 31, 1992 is due primarily to the sale of Double Tree Apartments in March 1993 and to the lenders obtaining legal title to the Union Plaza office building in August 1993. Reference is made to Notes 4(b)(7) and 7(c). The decrease in escrow deposits at December 31, 1993 as compared to December 31, 1992 is due primarily to timing of real estate tax payments of certain investment properties. The decrease in investment in unconsolidated ventures reflected as assets at December 31, 1993 as compared to December 31, 1992 is due to losses and distributions from the Greenway Tower Office Building. The increase in accrued rents receivable at December 31, 1993 as compared to December 31, 1992 is due primarily to the Partnership's accrual of rental income for certain tenant leases over the full period of occupancy rather than as due per the terms of their respective leases at the Garret Mountain Office Center. The decrease in venture partners' deficits in ventures at December 31, 1993 as compared to December 31, 1992 is primarily due to the lenders obtaining legal title to the Union Plaza office building in August 1993. Reference is made to Note 4(b)(7). The increases in accrued interest and accrued real estate taxes at December 31, 1993 as compared to December 31, 1992 are due primarily to the suspension of real estate tax payments and debt service payments on the long- term mortgage loan secured by the Holly Pond Office Center. Reference is made to Note 4(b)(6). The increases are partially offset by the lenders obtaining legal title to the Union Plaza office building in August 1993. Reference is made to Note 4(b)(7). The increase in investment in unconsolidated ventures reflected as liabilities at December 31, 1993 as compared to December 31, 1992 is due to losses and distributions from the First Interstate Center, partially offset by the sale of the Partnership's interest in the Frontier Mall Venture. Reference is made to Note 7(d). The decrease in long-term debt, less current portion at December 31, 1993 as compared to December 31, 1992 is due to the classification of the first mortgage secured by the Garret Mountain office center as a current liability in 1993 as described above. The decreases in rental income, mortgage and other interest, depreciation, and property operating expenses for the year ended December 31, 1993 as compared to the year ended December 31, 1992 are due primarily to the sales of Windmill Park Apartments in September 1992 and Double Tree Apartments in March 1993 and to the lender obtaining legal title to the Union Plaza office building in August 1993. Reference is made to Notes 4(b)(7) and 7. The decreases in rental income, mortgage and other interest, depreciation, property operating expenses, professional services and general and administrative expenses for the year ended December 31, 1992 as compared to the year ended December 31, 1991 are due primarily to the lender obtaining title to the Highpoint Shopping Center in February 1991 and to the Park Place Towers Office Building in June 1991, the sale of the Centroplex Office Building in July 1991 and the sale of Windmill Park Apartments in September 1992. The decrease in interest income for the year ended December 31, 1993 as compared to the year ended December 31, 1992 and December 31, 1992 as compared to December 31, 1991 is primarily due to lower interest rates being earned on U.S. government obligations in 1993 and 1992. The decrease in amortization of deferred expenses for the years ended December 31, 1993 and 1992 as compared to the year ended December 31, 1991 is due primarily to the completion of the amortization periods for deferred leasing costs of the Greenway Associates investment property. The decrease in management fees to the Corporate General Partner for the years ended December 31, 1993 and 1992 as compared to the year ended December 31, 1991 is due primarily to operating distributions being reduced in 1992 and 1993. The provision for unrealizable venture partner deficit in 1992 is a result of the elimination of the venture partners' deficit capital account as of June 30, 1992 at Garret Mountain Office Center. The decrease in partnership's share of operations of unconsolidated ventures for the year ended December 31, 1993 as compared to 1992 and increase for 1992 as compared to 1991 is due primarily to the $410,249 gain recognized on the refinancing of debt secured by the Greenway Tower Office Building in 1992. Reference is made to Note 4(b)(10). The decrease in venture partners' share of ventures' operations for the year ended December 31, 1992 as compared to the year ended December 31, 1991 is due primarily to the venture's sale of the Centroplex Office Building in July 1991 and the gain recognized on the refinancing of debt secured by the Greenway Tower Office Building. Reference is made to Notes 7(a) and 4(b)(10). The $785,084 provision for value impairment for 1993 is due to the Partnership recording a provision for value impairment at the Garret Mountain office building at December 31, 1993 to reduce the net carrying value and the related deferred expenses to the outstanding balance of the related non- recourse financing due to the uncertainty of the Partnership's ability to recover the net carrying value of the investment property through future operations or sale. Reference is made to Note 1. The gain on sale or disposition of investment properties for 1993 is related to the sales of the Double Tree Apartment Complex and the Partnership's interest in the Frontier Mall Venture and to the lenders obtaining legal title to the Union Plaza Office Building. Reference is made to Notes 7(c), 7(d) and 4(b)(7). The loss on sale of investment property for 1992 is related to the sale of Windmill Park Apartments. Reference is made to Note 7(b). The gain on sale or disposition of investments properties for 1991 is related to the lenders obtaining title to the Highpoint Shopping Center and the Park Place Tower Office Building and the sale of the Centroplex Office Building. Reference is made to Notes 4(b)(2), 4(b)(9) and 7(a), respectively. The extraordinary item for 1992 relates to the cancellation of the first mortgage note secured by Windmill Park Apartments. Reference is made to Note 7(b). The extraordinary item for 1991 relates to a prepayment penalty related to the retirement of the first mortgage note secured by the Centroplex Office Building upon the sale of the property and the discounted payment of the mortgage note secured by the Silvermine Apartments upon refinancing. Reference is made to Notes 4(b)(4) and 7(a). INFLATION Due to the decrease in the level of inflation in recent years, inflation generally has not had a material effect on rental income or property operating expenses. To the extent that inflation in future periods does have an adverse impact on property operating expenses, the effect will generally be offset by amounts recovered from tenants as many of the long-term leases at the Partnership's commercial properties have escalation clauses covering increases in the cost of operating and maintaining the properties as well as real estate taxes. Therefore, there should be little effect on operating earnings if the properties remain substantially occupied. In addition, substantially all of the leases at the Partnership's shopping center investment contain provisions which entitle the Partnership to participate in gross receipts of tenants above fixed minimum amounts. Future inflation may also cause capital appreciation of the Partnership's investment properties over a period of time to the extent that rental rates and replacement costs of properties increase. ITEM 8.	ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA CARLYLE REAL ESTATE LIMITED PARTNERSHIP - X (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES INDEX Independent Auditors' Report Consolidated Balance Sheets, December 31, 1993 and 1992 Consolidated Statements of Operations, years ended December 31, 1993, 1992 and Consolidated Statements of Partners' Capital Accounts (Deficits), years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows, years ended December 31, 1993, 1992 and Notes to Consolidated Financial Statements Schedule -------- Supplementary Income Statement Information X Consolidated Real Estate and Accumulated Depreciation XI CARLYLE-SEATTLE AN UNCONSOLIDATED VENTURE OF CARLYLE REAL ESTATE LIMITED PARTNERSHIP - X INDEX Independent Auditors' Report Balance Sheets, December 31, 1993 and 1992 Statements of Operations, years ended December 31, 1993, 1992 and 1991 Statements of Partners' Capital Accounts (Deficits), years ended December 31, 1993, 1992 and 1991 Statements of Cash Flows, years ended December 31, 1993, 1992 and 1991 Notes to Financial Statements Schedule -------- Supplementary Income Statement Information X Real Estate and Accumulated Depreciation XI SCHEDULES NOT FILED: All schedules other than those indicated in the index have been omitted as the required information is inapplicable or the information is presented in the financial statements or related notes. INDEPENDENT AUDITORS' REPORT The Partners CARLYLE REAL ESTATE LIMITED PARTNERSHIP - X: We have audited the consolidated financial statements of Carlyle Real Estate Limited Partnership - X (a limited partnership) and consolidated ventures as listed in the accompanying index. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedules as listed in the accompanying index. These consolidated financial statements and financial statement schedules are the responsibility of the General Partners of the Partnership. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by the General Partners of the Partnership, 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 Carlyle Real Estate Limited Partnership - X and consolidated ventures at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1993, in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. KPMG PEAT MARWICK Chicago, Illinois March 25, 1994 CARLYLE REAL ESTATE LIMITED PARTNERSHIP - X (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 (1) BASIS OF ACCOUNTING The accompanying consolidated financial statements include the accounts of the Partnership and its ventures (note 3), Midland-Carlyle Partnership ("Midland") (note 4(b)(3)), Park Place Associates ("Park Place") (note 4(b)(8)), Centroplex Associates ("Centroplex") (note 7(a)), Holly Pond Associates ("Holly Pond"), Sunrise Brownsville Associates, Ltd. ("Sunrise"), Garret Mountain Office Center Associates I ("Garret Mountain"), Victoria Apartments Partnership ("Victoria"), Energy Plaza Associates Limited Partnership ("Energy Plaza") (note 4(b)(7)), and Greenway Associates ("Greenway"). The effect of all transactions between the Partnership and the ventures has been eliminated. The equity method of accounting has been applied in the accompanying consolidated financial statements with respect to the Partnership's interests in Carlyle Seattle Associates ("Carlyle Seattle"), Carlyle Frontier Associates ("Carlyle/Frontier") (note 7(c)) and Greenway Tower Joint Venture ("Greenway Tower"). Accordingly, the accompanying consolidated financial statements do not include the accounts of Carlyle Seattle and Carlyle Seattle's venture, Wright-Carlyle Seattle ("First Interstate"), Carlyle/Frontier and Carlyle/Frontier's venture, Frontier Mall Associates, or Greenway's venture, Greenway Tower. The Partnership records are maintained on the accrual basis of accounting as adjusted for Federal income tax reporting purposes. The accompanying consolidated financial statements have been prepared from such records after making appropriate adjustments to present the Partnership's accounts in accordance with generally accepted accounting principles ("GAAP") and to consolidate the accounts of the ventures as described above. Such adjustments are not recorded on the records of the Partnership. The effect of these items is summarized as follows: CARLYLE REAL ESTATE LIMITED PARTNERSHIP - X (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED The net earnings (loss) per limited partnership interest is based upon the Interests outstanding at the end of each period (100,005). Deficit capital accounts will result, through the duration of the Partnership, in net gain for financial reporting and income tax purposes. Statement of Financial Accounting Standards No. 95 requires the Partnership to present a statement which classifies receipts and payments according to whether they stem from operating, investing or financing activities. The required information has been segregated and accumulated according to the classification specified in the pronouncement. Partnership distributions from unconsolidated ventures are considered cash flow from operating activities only to the extent of the Partnership's cumulative share of net earnings. The Partnership records amounts held in U.S. Government obligations at cost which approximates market. For the purposes of these statements, the Partnership's policy is to consider all such amounts held with original maturities of three months or less as cash equivalents with any remaining amounts reflected as short-term investments. The Partnership's investments at December 31, 1993 and 1992 all have original maturities of greater than three months and have been classified as short-term investments. Deferred expenses consist primarily of leasing fees incurred in connection with procuring tenants and loan fees incurred in connection with the acquisition of the properties. Deferred leasing fees are amortized using the straight-line method over the terms stipulated in the related agreements. Deferred loan fees are amortized over the related loan periods. Although certain leases of the Partnership provide for tenant occupancy during periods for which no rent is due and/or increases in minimum lease payments over the term of the lease, the Partnership accrues rental income for the full period of occupancy on a straight-line basis. Certain 1992 and 1991 amounts have been reclassified to conform to the 1993 presentation. Due to the uncertainty of the Partnership's ability to recover the net carrying value of the Garret Mountain office building through future operations or sale, the Partnership made a provision for value impairment on such investment property of $785,084. Such provision at December 31, 1993 was recorded to reduce the net carrying value of the investment property to the outstanding balance of the related non-recourse debt (note 4(b)(11)). Also, as a result of the deteriorated economic condition of the West Paterson, New Jersey real estate market and the uncertainty of the venture recovering its deficit capital account from future operations and ultimate sale of the property, the Partnership made a provision for unrealizable venture partner deficit capital of $1,102,925. Such provision was recorded as of June 30, 1992 to eliminate the venture partners' deficit capital account. No provision for state or Federal income taxes has been made as the liability for such taxes is that of the Partners rather than the Partnership. However, in certain instances, the Partnership has been required under applicable law to remit directly to the taxing authorities amounts representing withholding from distributions paid to Partners. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - X (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (2) INVESTMENT PROPERTIES The Partnership originally acquired, either directly or through joint ventures (note 3), six apartment complexes, four shopping centers, ten office buildings and one office/warehouse center. Fifteen properties have been sold or disposed by the Partnership. All of the Partnership's remaining property investments at December 31, 1993 were operating. The cost of the investment properties represents the total cost to the Partnership and its ventures plus miscellaneous acquisition costs. Depreciation on the operating properties has been provided over the estimated useful lives of 5 to 30 years using the straight-line method. All investment properties are pledged as security for the long-term debt (note 4), for which there is no recourse to the Partnership. Maintenance and repair expenses are charged to operations as incurred. Significant betterments and improvements are capitalized and depreciated over their estimated useful lives. (3) VENTURE AGREEMENTS (a) General The Partnership originally entered into eighteen joint venture agreements of which twelve, Arcade Associates, Lone Pine/Bloomfield Office Center Associates, Carlyle-Graystone Associates, Summit North Associates, Ltd., Place VIII Associates, 13th and L Associates, Consut Westwood Associates, Park Place Associates, Centroplex Associates, Midland-Carlyle Partnership, Energy Plaza Associates, and Carlyle Frontier Associates have been terminated. Pursuant to such venture agreements, the Partnership made capital contributions aggregating $79,625,550 through December 31, 1993. In general, the joint venture partners, who were either the sellers (or their affiliates) of the property investments acquired, or parties who contributed an interest in the property being developed, made no cash contributions to the ventures, but their retention of an interest in the property, through the joint venture, was taken into account in determining the purchase price of the Partnership's interest, which was determined by arm's-length negotiations. Under certain circumstances, either pursuant to the venture agreements or due to the Partnership's obligations as a general partner, the Partnership may be required to make additional cash contributions to the ventures. The Partnership has acquired, through the above ventures, four apartment complexes, three shopping centers, ten office buildings and one office/- warehouse center. In most instances, the properties were acquired (as completed) for a fixed purchase price. However, certain properties were developed by the ventures and in those instances, the contributions of the Partnership were generally fixed. The joint venture partner (who was primarily responsible for constructing the property) contributed any excess of cost over the aggregate amount available from Partnership contributions and financing and, to the extent such funds exceeded the aggregate costs, was entitled to retain such excesses. The venture properties have been financed under various long-term debt arrangements as described in note 4. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - X (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED The Partnership generally has a cumulative preferred interest in net cash receipts (as defined) from the properties. Such preferential interest relates to a negotiated rate of return on contributions made by the Partnership. After the Partnership receives its preferential return, the venture partner is generally entitled to a non-cumulative return on its interest in the venture; net cash receipts are generally shared in a ratio relating to the various ownership interests of the Partnership and its venture partners. During 1993, 1992 and 1991, two, five and six, respectively, of the ventures' properties produced net cash receipts. In addition, the Partnership generally has preferred positions (related to the Partnership's cash investment in the ventures) with respect to distribution of sale or refinancing proceeds from the ventures. In general, operating profits and losses are shared in the same ratio as net cash receipts; however, if there are no net cash receipts, substantially all profits or losses are allocated to the partners in accordance with their respective economic interests. There are certain risks associated with the Partnership's investments made through joint ventures including the possibility that the Partnership's joint venture partner(s) in an investment might become unable or unwilling to fulfill its (their) financial or other obligations, or that such joint venture partner(s) may have economic or business interests or goals that are inconsistent with those of the Partnership. (b) Carlyle Seattle During 1982, the Partnership acquired, through a joint venture ("First Interstate") between a joint venture ("Carlyle Seattle") described below and the developer, a fee ownership of improvements and a leasehold interest in an office building in Seattle, Washington. Carlyle Seattle is a joint venture between the Partnership and Carlyle Real Estate Limited Partnership - XII, an affiliated partnership sponsored by the Corporate General Partner of the Partnership. Under the terms of the First Interstate venture agreement, Carlyle Seattle made initial cash contributions aggregating $30,000,000. The terms of the Carlyle Seattle venture agreement provide that all the capital contributions will be made in the proportion of 26.7% by the Partnership and 73.3% by the affiliated partner. The initial required contribution by the Partnership to the Carlyle Seattle venture was $10,125,000. The Carlyle Seattle venture agreement further provides that all of the venture's share of the First Interstate joint venture's annual cash flow, sale or refinancing proceeds, operating profits and losses, and tax items will be allocated 26.7% to the Partnership and 73.3% to the affiliated partner. Carlyle Seattle will generally be entitled to receive a preferred distribution (on a cumulative basis) of annual cash flow equal to 8% of its capital contributions to the First Interstate joint venture. Cash flow in excess of this preferred distribution will be distributable to the First Interstate joint venture partner up to the next $400,000 and any remaining annual cash flow will be distributable 50% to Carlyle Seattle and 50% to the First Interstate joint venture partner. Operating deficits, if any, will be shared 50% by Carlyle Seattle and 50% by the First Interstate joint venture partner. Operating profits or losses of the First Interstate joint venture generally are allocated in the same ratio as the allocation of annual cash flow; however, the joint venture partner will be allocated not less than 25% of such profits and losses. As of December 31, 1993, $20,049,000 of cumulative preferred distributions due to Carlyle Seattle were unpaid. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - X (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED The First Interstate joint venture agreement provides that upon sale of the property, Carlyle Seattle will be, in general, entitled to receive the first $39,000,000 of net sale proceeds plus an amount equal to any deficiencies (on a cumulative basis) in distributions of Carlyle Seattle's preferred return of annual cash flow. The First Interstate joint venture partner will be entitled to receive the next $5,000,000 and any remaining proceeds will be distributable 50% to Carlyle Seattle and 50% to the First Interstate joint venture partner. The First Interstate venture owns a net leasehold (which expires in 2052) in the land underlying the Seattle, Washington office building subject to a 20-year extension. The lease provides for an annual rental of $670,000 and has been determined to be an operating lease. The office building is managed by an affiliate of the First Interstate joint venture partner for a fee computed at 2% of base and percentage rents. (c) Greenway Effective July 31, 1985, Greenway's venture agreement was amended concurrent with the admission of a new venture partner. In conjunction with this amendment to the venture agreement, the venture obtained a commitment for financing in the amount of $3,471,000. The initial proceeds received from such financing were used to pay deferred mortgage interest of $974,872 in 1985. In July 1987, the Partnership, through a capital contribution to the venture, retired such financing plus accrued interest. In September 1987, Greenway entered into an agreement with an additional venture partner to form a new venture, Greenway Tower. The terms of the Greenway Tower agreement called for contributions of the property, subject to the amounts due on the original first mortgage loan (which was retired in 1987), plus $525,000 by Greenway and $525,000 by the additional venture partner. Profits and losses were allocated 50% to Greenway and 50% to the additional venture partner. Net cash flow and net sale or refinancing proceeds (as defined) would have generally be distributed 50% to Greenway and 50% to the additional venture partner. Additionally, in September 1987, the Greenway Tower venture obtained a commitment to fund a new first mortgage loan up to $11,600,000. The loan bore interest at a floating rate and contained certain accrual provisions. In addition, the venture obtained a second mortgage note in the amount of $2,650,000 in September 1987. This loan also bore interest at a floating rate. Both loans matured in September 1992. In October 1992, the Greenway Tower venture refinanced the outstanding first and second mortgage notes. The notes were satisfied in full through a discounted payment (see note 4(b)(10)). Pursuant to the replacement financing, the Greenway Tower venture agreement was amended to reflect a 45% interest for Greenway and 55% interest for the additional venture partner. In conjunction with the formation of Greenway Tower, management responsibilities were assumed in September 1987 by an affiliate of the additional venture partner for a fee based on a percentage of gross receipts. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - X (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (d) Park Place In April 1986, as a result of defaults by the venture partner in its obligations under the joint venture partnership and related agreements, the venture partner transferred its interest in the joint venture to the Partnership and the two individual principals of the venture partner signed non-interest bearing promissory notes in the aggregate amount of $1,000,000 payable to the joint venture on April 24, 1991. The notes have not been recorded in the accompanying consolidated financial statements due to the unlikelihood of their collection. However, the Partnership is pursuing collection and has obtained judgments against the makers of the notes aggregating $1,024,000 for which enforcement is now being pursued. However, it is uncertain whether these individuals have sufficient assets to satisfy these judgments in whole or in part. As of December 31, 1993, no amounts have been collected from the makers of the notes (see also note 4(b)(8)). (e) Union Plaza On August 31, 1993, the lender concluded proceedings to realize upon its security and took title to the property (see note 4(b)(7)). Effective October 1, 1985, the joint venture agreement was amended concurrent with the admission of an additional venture partner. The terms of the amended agreement provided for contributions by the new venture partner of $2,500,000 through March 1988, all of which were received through December 31, 1989. The capital contributions of the new venture partner were used by the venture to first fund operating deficits at the Union Plaza Office Building and secondly to the extent available, to repay any advances from the Partnership plus interest. Due to the inability of the original venture partner to meet its ongoing obligation to contribute capital to fund the aforementioned operating deficits and tenant improvement and lease commission costs, the Partnership advanced funds to the venture. As of August 31, 1993, the Partnership had advanced approximately $4,000,000 to the venture. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - X (a limited partnership) and Consolidated Ventures Notes to Consolidated Financial Statements - Continued Included in the above current portion of long-term debt is $3,944,875 at December 31, 1992, which represents the deferred balance of mortgage interest accrued but currently payable due to the maturities of the long-term notes. Five year maturities of long-term debt are as follows: 1994 . . . . . . . . . $12,651,424 1995 . . . . . . . . . 352,679 1996 . . . . . . . . . 920,819 1997 . . . . . . . . . 337,774 1998 . . . . . . . . . 4,025,489 ========== (b) Modifications/Refinancings (1) General As described below, the Partnership is seeking or has received mortgage note modifications on certain properties which expire on various dates commencing December 1995. Upon expiration of such modifications, should the Partnership not seek or be unable to secure new or additional modifications to the loans, based upon current and anticipated future market conditions and other considerations relating to the properties and the Partnership's portfolio, the Partnership may decide not to commit any significant additional amounts to these properties. This would result in the Partnership no longer having an ownership interest in such properties and may result in gain for financial reporting and federal income tax purposes without any net distributable proceeds. Such decisions would be made on a property-by- property basis. (2) Highpoint Shopping Center Effective July 1, 1988, the long-term mortgage note secured by the Highpoint Shopping Center located in Harris County, Texas was modified for a twenty-four month period. The modification required monthly payments of $9,053 through June 30, 1990, and monthly payments of $9,726 thereafter. Additionally, annual payments were due on the first day of July equal to the lesser of cash flow (as defined) or unpaid interest. Interest accrued on the principal and unpaid interest at a rate of 10-3/8% per annum. On July 1, 1993, the entire unpaid balance of the note plus any accrued but unpaid interest was scheduled to be due. Because the modification on the underlying indebtedness (which expired in June 1990) was not extended and other considerations related to the property, the market in which the property is located and the Partnership's portfolio, the Partnership ceased making the scheduled debt service payments effective May 1990. The Partnership was served in December 1990 with a notice to cure the default. The Partnership's negotiations for further debt relief were not successful and on February 5, 1991, the lender concluded proceedings to realize upon its security and took title to the property. Since the Partnership had received, through the date of disposition, losses and distributions from the property in the aggregate in excess of its original cash investment in the property, the Partnership has recognized a gain of approximately $174,000 for financial reporting purposes. The Partnership also recognized a gain of approximately $460,000 for tax reporting purposes in 1991 with no corresponding distributable proceeds. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - X (a limited partnership) and Consolidated Ventures Notes to Consolidated Financial Statements - Continued (3) Windmill Park Apartments Effective June 1, 1986, the long-term mortgage note secured by the Windmill Park Apartments located in Midland, Texas was modified from a 12% note, payable in monthly installments of principal and interest, to an 8% note, payable in monthly installments of interest only. Pursuant to this modification, as extended, monthly interest payments from late 1988 to August 1, 1991 had been limited to the operating cash flow generated from the property. In 1991, the modification period was further extended through August 1, 1992 by an agreement in principle with the lender. In the event that the property did not generate cash flow sufficient to cover the modified interest payments during the forty-eight month period ending August 1, 1992, the difference between the amount paid and the modified rate would accrue and would be due upon subsequent sale of the property or maturity of the note. In conjunction with the extension of the modification period, the maturity date of the long-term note (November 3, 1991) had been extended to August 1, 1992. The lender notified the venture that it was unwilling to further extend the modification or maturity date of the note. The joint venture continued to pay debt service in accordance with the previously modified terms until the property was sold in September 1992 (see note 7(b)). (4) Silvermine Apartments In November 1991, the Victoria venture refinanced the outstanding first mortgage note with a new first mortgage note of $3,914,700 secured by the Silvermine Apartments located in Victoria, Texas. The refinanced note had an outstanding balance at the date of refinancing of approximately $3,768,000 and was satisfied in full through a discounted payment of approximately $3,547,000. The discounted payment resulted in a gain of approximately $221,000 on the extinguishment of the mortgage note and the Partnership's share was fully recognized in 1991 as an extraordinary item. The Partnership received net refinancing proceeds of $29,255 (after retirement of the original first mortgage note, payment of loan fees, certain other costs and the venture partner's distribution). (5) Double Tree Apartments Effective June 1, 1987, the wrap-around mortgage note secured by Double Tree Apartments located in El Paso, Texas was modified, and this modification was further extended in 1990. Monthly installments of interest only from June 1, 1990 through May 1, 1991 were agreed to be $29,078 (9% per annum), then $34,458 (10-1/2% per annum) from June 1, 1991 through April 1, 1992 when the entire unpaid balance of the note plus any previously deferred interest was due. In September 1992, the underlying mortgage note holder agreed to extend the maturity date by one year to April 1, 1993 with monthly installments of principal and interest in the amount of $43,532 based on a 10.5%, 15-year amortization retroactive to April 1, 1992. An agreement to extend the wrap- around mortgage note maturity by one year to April 1, 1993 was also obtained and was retroactive to April 1, 1992. In addition, beginning April 1, 1992, the Partnership had been required to remit monthly installments of principal in the amount of $4,482 to the wrap-around mortgage note holder. Debt service payments were ceased, beginning April 1, 1992, in conjunction with the modification negotiations, but payments were remitted in full upon the finalization of the extension agreement. The Partnership had initiated discussions with the note holders to extend further the terms of the loans and, in addition, the Partnership had been pursuing other financing alternatives. The Partnership continued to pay debt service in accordance with the previously modified terms until the property was sold in March 1993 (see note 7(c)). CARLYLE REAL ESTATE LIMITED PARTNERSHIP - X (a limited partnership) and Consolidated Ventures Notes to Consolidated Financial Statements - Continued (6) Holly Pond Office Center The Holly Pond venture ceased making debt service payments, effective August 1, 1990, on the long-term, non-recourse mortgage note secured by Holly Pond Office Center located in Stamford, Connecticut and sought a modification of the note terms. In November 1991, the lender posted the property for acceleration of the mortgage and commenced proceedings to obtain title to the property. In conjunction with the lender's actions, it came to the venture's attention that there are traces of petroleum-based contaminant on a small portion of the property. The venture's initial environmental investigation indicated that, although the contamination is currently on the property, the cause of the problem was most likely a result of certain activities of the owner of a neighboring land parcel. The Partnership has notified the owner of the neighboring land parcel regarding its responsibility for the clean-up of the contaminant. As a result, the lender has temporarily suspended its efforts to obtain title to the property pending the results of the venture's investigation. Although the Partnership believes the owner of the neighboring parcel will ultimately bear financial responsibility for the clean-up, the Partnership has accrued $36,000 for potential future costs related to the clean-up. Such accrual is reflected in accounts payable in the accompanying 1993 consolidated balance sheet. Because the venture has been unable to secure debt service relief, the Partnership has decided, based upon current and anticipated future market conditions and other considerations relating to the property and the Partnership's portfolio, not to commit any additional amounts to the property. This will result in the Partnership no longer having an ownership interest in the property. When the lender realizes upon its security in the property, the Partnership will recognize a gain for financial reporting and federal income tax purposes without any corresponding distributable proceeds. Therefore, the loan has been classified at December 31, 1993 and December 31, 1992 as a current liability in the accompanying consolidated financial statements. (7) Union Plaza Office Building On August 31, 1993, the lender concluded proceedings to realize upon its security and took title to the property as described below. Effective October 1, 1988, the long-term mortgage secured by the Union Plaza office building in Oklahoma City, Oklahoma was modified. The maturity date of the note was changed from December 1, 1993 to December 1, 1998, when the outstanding principal balance and any unpaid interest was scheduled to be due. The modification reduced the interest accrual rate from 13-1/2% to 6% through September 30, 1990, then 7% as of October 1, 1990 and increasing annually to 8% and 8.5% through September 30, 1993. The monthly installments of $217,629 were reduced to $52,721 commencing November 1988, and were to increase annually to $64,821, $77,875, $108,555 and $125,028 through October 31, 1993. Thereafter, the accrual rate and the pay rate would be a specified market rate plus 3% adjusted annually. The excess of the interest accrued over amounts paid would be deferred without interest. The Partnership, through the Energy Plaza venture, had agreed to deposit all "excess cash flow", as defined, into a savings account with the lender. Any amount in excess of $500,000 in this account would have been used to pay deferred interest. As of August 31, 1993 (the title transfer date), no such excess cash flow had been deposited. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - X (a limited partnership) and Consolidated Ventures Notes to Consolidated Financial Statements - Continued The Energy Plaza venture approached the mortgage lender in an effort to negotiate further debt service relief. Effective November 1, 1991, the debt service payment increased and the venture began making cash flow debt service payments. The Partnership decided, based upon current market conditions and other considerations relating to the property and the Partnership's portfolio, not to commit any significant additional amounts to this property. On May 27, 1993, the lender posted the property for acceleration of the mortgage and all accrued interest. The lender subsequently commenced proceedings to realize upon its mortgage security and appointed a receiver to take over management of the property upon foreclosure. On August 31, 1993, the lender concluded such proceedings and took title to the property. Since the Partnership had received, through the date of disposition, losses and distributions from the property in the aggregate in excess of its original cash investment in the property, the Partnership recognized a gain for financial reporting purposes of $4,643,220 (net of the venture partner's share of $2,048,668) in 1993. In addition, the Partnership recognized a gain in 1993 of $2,921,252 (net of the venture partner's share of $9,011,723) for federal income tax purposes, with no corresponding distributable proceeds. The loan was classified at December 31, 1992 as a current liability in the accompanying consolidated balance sheet. The venture remitted approximately $854,000 of cash flow debt service payments in 1993. (8) Park Place Towers Office Center The venture had been negotiating with the lender to modify the long-term mortgage note secured by the Park Place Towers Office Center located in Birmingham, Alabama. Due to these negotiations and other considerations related to the property and the Partnership's portfolio, the Park Place venture ceased making the scheduled debt service payments effective November 1, 1990. The venture was notified on February 20, 1991 of its default on the long-term mortgage note. Park Place venture's negotiations for further debt relief were not successful and, on June 13, 1991, the venture transferred title of the Park Place Tower Office Center to the lender pursuant to legal action by the lender to realize upon its security interest in the property. Since the Partnership had received, through the date of disposition, losses and distributions from the property in the aggregate in excess of its original cash investment in the property, the Partnership recognized a gain in 1991 of approximately $1,055,000 for financial reporting purposes. The Partnership also recognized a gain of approximately $6,912,000 for tax reporting purposes in 1991 with no corresponding distributable proceeds. (9) Carlyle/Frontier On October 31, 1993, the Partnership sold its interest in Frontier Mall Associates (see note 7(d)). In November 1991, Frontier Mall Associates refinanced the existing first mortgage notes (originally due August 1, 1991 but extended through December 31, 1991) secured by Frontier Mall located in Cheyenne, Wyoming, which had a balance at the date of refinancing of approximately $13,400,000 (including accrued interest). The new first mortgage note of $14,000,000 provided for monthly payments of principal and interest of $185,012, computed at the rate of 10% per annum, until maturity on December 1, 2001. Pursuant to the Frontier Mall Associates venture agreement, Carlyle/Frontier received net refinancing proceeds of approximately $235,000 (after retirement of the existing first mortgage notes, payment of loan fees, certain other costs and the venture partner's share of refinancing proceeds), $117,000 of which was allocated to the Partnership. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - X (a limited partnership) and Consolidated Ventures Notes to Consolidated Financial Statements - Continued (10) Greenway In October 1992, the Greenway Tower venture refinanced the first and second mortgage notes with a new first mortgage note of $9,000,000. The initial advance of the note was $5,750,000 and allows for additional advances of up to $3,250,000 for approved tenant improvements, leasing commissions, interest advances, capital improvements and under certain circumstances borrower equity repayments. As of December 31, 1993, the balance of the note is $6,487,715 and $2,512,285 is available for future advances. Such replacement financing matures October 31, 1999 and requires monthly installments of interest equal to 3.75% per annum in excess of the lender's composite commercial paper rate ("Contract Index Rate", 6.94% at December 31, 1993). To the extent such rate exceeds 9% in year one, 9.5% in year two, 10% in years three and four and 10.5% in years five through seven ("Applicable Base Percentage Rate"), the venture may defer the difference for a given month provided that the total interest deferred does not exceed 10% of the existing loan balance. Any deferred interest is due when and to the extent that in any one month the Contract Index Rate is less than the Applicable Base Percentage Rate along with the existing principal balance upon maturity of the loan. In addition, the lender participates in 50% of the net cash flow from the property as well as in 50% of any net proceeds resulting from the sale of the property. In order to secure the replacement financing, the venture has been required to make a capital contribution of $635,574 ($286,008 of which was paid by the Partnership); however, portions of this contribution may be refunded to the venture. In 1993, the Partnership received a partial refund (approximately $104,000) of its original contribution. The refinanced notes had outstanding balances at the date of refinancing of approximately $14,255,000 and were satisfied in full through a discounted payment of $6,050,000. The discounted payment resulted in a gain in 1992 of approximately $8,204,000 on the extinguishment of the mortgage note and the Partnership's share of $410,249 was recognized for financial reporting purposes in 1992. In addition, the Partnership recognized a gain for Federal income tax purposes in 1992 without the Partnership receiving any distributable proceeds. (11) Garret Mountain Office Center The Garret Mountain venture has approached the mortgage lender in an effort to negotiate debt service relief on the 12-5/8% first mortgage note secured by the Garret Mountain office building in West Paterson, New Jersey. Effective November 1, 1993, the venture began making cash flow debt service payments. The venture will continue to remit cash flow from the property to the lender; however, such amount will be less than the terms of the current mortgage loan. If the venture is unable to secure additional relief, the Partnership may decide, based upon current market conditions and other considerations relating to the property and the Partnership's portfolio, not to commit any significant additional amounts to the property. This would result in the Partnership no longer having an ownership interest in the property. As a result, the Partnership recorded a provision for value impairment of $785,084 in the accompanying consolidated financial statements. Such provision, made as of December 31, 1993, is recorded to reduce the net carrying value of the investment property to the outstanding balance of the related non-recourse debt. The loan has been classified at December 31, 1993 as a current liability in the accompanying consolidated Balance Sheet. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - X (a limited partnership) and Consolidated Ventures Notes to Consolidated Financial Statements - Continued In October 1989, the venture obtained a short-term (one year) second mortgage in the amount of $1,000,000 secured by the Garret Mountain Office Center located in West Paterson, New Jersey. The second mortgage was subsequently extended to September 1, 1991, August 1, 1992, August 1, 1993 and July 31, 1996. The second mortgage balance as of December 31, 1993 is $736,914. The second mortgage is payable in monthly installments of interest at the rate of 8% along with monthly payments of principal of $1,000 through April 30, 1994 and $6,000 thereafter until maturity and is classified as long- term debt, less current portion as of December 31, 1993 and December 31, 1992. (5) PARTNERSHIP AGREEMENT Pursuant to the terms of the Partnership Agreement, net profits and losses of the Partnership from operations are allocated 96% to the Limited Partners and 4% to the General Partners. Profits from the sale, refinancing or other disposition of investment properties are to be allocated to the General Partners to the greater of any cash distributions of the proceeds of any such sale, refinancing or other disposition (as described below) or 1% of the profits from the sale, refinancing or other disposition. Losses from the sale, refinancing or other disposition of investment properties are to be allocated 1% to the General Partners. The remaining sale, refinancing or other disposition profits and losses are to be allocated to the Limited Partners. The General Partners are not required to make any capital contributions except under certain limited circumstances upon dissolution and termination of the Partnership. Distributions of "net cash receipts" of the Partnership are to be allocated 90% to the Limited Partners and 10% to the General Partners (of which 6.25% constitutes a management fee to the Corporate General Partner for services in managing the Partnership). Distributions of "sale proceeds" and "financing proceeds" are to be allocated to the General Partners in an amount equal to 3% of the gross sales price of any property sold, then the balance 15% to the General Partners and 85% to the Limited Partners. However, distribution of "sale proceeds" and "financing proceeds" to the General Partners is subordinated to the Limited Partners' receipt of their contributed capital plus a stipulated return thereon. The Partnership Agreement provides that the General Partners shall receive as a distribution from the sale of a real property by the Partnership 3% of the selling price, and that the remaining proceeds (net after expenses and retained working capital) be distributed 85% to the Limited Partners and 15% to the General Partners. However, the Limited Partners shall receive 100% of such net sale proceeds until the Limited Partners (i) have received cash distributions of sale or refinancing proceeds in an amount equal to the Limited Partners' aggregate initial capital investment in the Partnership and (ii) have received cumulative cash distributions from the Partnership's operations which, when combined with sale or refinancing proceeds previously distributed, equal a 6% annual return on the Limited Partners' average capital investment for each year (their initial capital investment as reduced by sale or refinancing proceeds previously distributed) commencing with the third calendar quarter of 1981. The Limited Partners have not received cash distributions to satisfy the requirements above. An amendment to the Partnership Agreement, effective January 1, 1991, generally provides that notwithstanding any allocation contained in this Agreement, if, at any time profits are realized by the Partnership, any current or anticipated event would cause the deficit balance in absolute amount in the Capital Account of the General Partners to be greater than their CARLYLE REAL ESTATE LIMITED PARTNERSHIP - X (a limited partnership) and Consolidated Ventures Notes to Consolidated Financial Statements - Continued share of the Partnership's indebtedness (as defined) after such event, then the allocation of Profits to the General Partners shall be increased to the extent necessary to cause the deficit balance in the Capital Account of the General Partners to be no less than their respective shares of the Partnership's indebtedness after such event. A portion of the 1991 and 1993 Partnership gains for Federal income tax purposes were reallocated to the General Partners in accordance with this provision. In general, the effect of this amendment is to allow the deferral of recognition of taxable gain to the Limited Partners. (6) MANAGEMENT AGREEMENTS Physical management of the properties is performed by the joint venture partners or their affiliates or by an affiliate of the General Partners. Cash flow deficits are normally the responsibility of each of the ventures and compensation to the managers is generally calculated at a percentage of gross receipts, a portion of which may be subordinated to the Partnership's receipt of its preferential returns. At December 31, 1993, an affiliate of the General Partners of the Partnership was managing the Sunrise Mall in Brownsville, Texas. Management fees are calculated at a percentage of the gross income from the property. (7) SALE OF INVESTMENT PROPERTIES (a) Centroplex Office Building On July 10, 1991, the Partnership through its venture, Centroplex Associates, sold the land, building, related improvements and personal property of the Centroplex Office Building located in White Plains, New York pursuant to a purchase agreement dated June 19, 1991. The purchaser, Power Authority of the State of New York (a major tenant), was not affiliated with the Partnership or its General Partners and the sale price was determined by arm's-length negotiations. The sale price of the land, building, related improvements and personal property was $61,750,000 (before selling costs and prorations), all of which was paid in cash at closing. A portion of the cash proceeds ($25,925,514, including a $1,853,000 prepayment penalty) was utilized to retire the first mortgage note secured by the property. The penalty (net of the venture partner's share) resulted in an extraordinary item of $926,500. As a result of the sale, the Partnership recognized a gain in 1991 of $14,774,000 and $24,764,000 (net of the venture partner's share of $14,298,000 and $18,882,000) for financial reporting and Federal income tax purposes, respectively. (b) Windmill Park Apartments Based upon the current and anticipated future market conditions in Midland, Texas and the venture's inability to obtain suitable replacement financing, the Partnership decided not to commit any significant additional amounts to this property. This prompted the venture to enter into a sale contract on September 23, 1992 under which the venture received $500,000 of cash sale proceeds from this disposition and the Partnership earned a $25,000 fee for providing consultation to the venture regarding the sale. As a condition precedent to the sale, the Partnership's existing mortgage indebtedness and deferred accrued mortgage interest (net of the Partnership's payments of such interest totaling $2,478 in 1992) secured by the property was CARLYLE REAL ESTATE LIMITED PARTNERSHIP - X (a limited partnership) and Consolidated Ventures Notes to Consolidated Financial Statements - Continued discharged by the mortgage lender upon payment of $500,000 consideration to the lender. Accordingly, the Partnership, the venture and the purchaser have no further liability or obligations under such mortgage note. The sale of this property has resulted in the Partnership's recognition in 1992 of a net gain of $1,647,548 (comprised of an extraordinary gain of $2,411,425 due to the discharge of the mortgage indebtedness and a loss on sale of investment property of $763,877) in 1992 for financial reporting purposes, net of the venture partner's share of $1,647,547. In addition, the Partnership recognized a gain in 1992 of approximately $1,833,000 for Federal income tax purposes without the Partnership receiving any distributable sale proceeds. (c) Double Tree Apartments On March 18, 1993, the Partnership sold the land, building, related improvements and personal property of the Double Tree Apartments located in El Paso, Texas. The sale price of the land, building, related improvements and personal property was $5,550,000 (before selling costs and prorations), all of which was paid in cash at closing. A portion of the cash proceeds was utilized to retire the first mortgage note with an outstanding balance including principal and deferred interest of $4,496,984. As a result of the sale, the Partnership recognized gains in 1993 of $2,070,917 for financial reporting purposes and $4,026,621 for federal income tax purposes. Pursuant to the sale, the Partnership received net sale proceeds of approximately $1,022,000 (after retirement of the existing first mortgage note, payment of loan fees, and certain other costs). (d) Carlyle Frontier Effective October 31, 1993, the Partnership and an affiliate (Carlyle Real Estate Limited Partnership - IX, a partnership sponsored by the General Partners) sold through Carlyle/Frontier their interests in Frontier Mall Associates, L.P. representing a total of a 70% interest in the Frontier Mall property, to the Partnership's unaffiliated joint venture partner. The sale price of the Partnership's 35% interest in Frontier Mall was $7,825,030 of which $4,325,030 represented the Partnership's 35% portion of the first mortgage note and $3,500,000 represented sale proceeds (before costs of sale and prorations). Approximately $3,300,000 was received in cash on November 3, 1993. As a result of the sale, the Partnership recognized a gain of $3,652,935 for financial reporting purposes and $5,825,970 for federal income tax purposes. (8) LEASES - AS PROPERTY LESSOR At December 31, 1993, the Partnership and its consolidated ventures' principal assets are one shopping center, two office buildings and one apartment complex. The Partnership has determined that all leases relating to these properties are properly classified as operating leases; therefore, rental income is reported when earned, and the cost of each of the properties, excluding the cost of land, is depreciated over their estimated useful lives. Leases with office and shopping center tenants range in term from one to twenty-eight years and provide for fixed minimum rent and partial reimbursement of operating costs. In addition, leases with shopping center tenants generally provide for additional rent based upon percentages of tenants' sales volumes. With respect to the Partnership's shopping center investments, a substantial portion of the ability of retail tenants to honor their leases is dependent upon the retail economic sector. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - X (a limited partnership) and Consolidated Ventures Notes to Consolidated Financial Statements - Continued Costs and accumulated depreciation of the leased assets are summarized as follows at December 31, 1993: Apartment complex: Cost . . . . . . . . . . . . . . . . $ 4,509,867 Accumulated depreciation . . . . . . 1,892,568 ----------- 2,617,299 ----------- Shopping center: Cost . . . . . . . . . . . . . . . . 18,603,606 Accumulated depreciation . . . . . . 11,370,772 ----------- 7,232,834 ----------- Office Buildings: Cost. . . . . . . . . . . . . . . . . 18,350,929 Accumulated depreciation. . . . . . . 6,317,355 ----------- 12,033,574 ----------- Total cost less accumulated depreciation. . . . . . . . . . . . $21,883,707 =========== Minimum lease payments including amounts representing executory costs (e.g., taxes, maintenance, insurance) and any related profit in excess of specific reimbursements, to be received in the future under the operating leases at the shopping center and office buildings are as follows: 1994. . . . . . . . . . . . . . $ 4,385,434 1995. . . . . . . . . . . . . . 3,525,459 1996. . . . . . . . . . . . . . 3,125,842 1997. . . . . . . . . . . . . . 2,309,097 1998. . . . . . . . . . . . . . 1,795,152 Thereafter. . . . . . . . . . . 5,688,731 ----------- Total . . . . . . . . . . $20,829,715 =========== Apartment complex leases in effect at December 31, 1993 are generally for a term of one year or less and provide for annual rents of approximately $1,112,000. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - X (a limited partnership) and Consolidated Ventures Notes to Consolidated Financial Statements - Continued In November 1991, the Partnership paid all the previously deferred items as follows: approximately $2,525,000 of property management fees to an affiliate of the General Partners and $1,027,832 of management fees to the General Partners. Any amounts currently payable to the General Partners and their affiliates do not bear interest and are expected to be paid in future periods. (10) INVESTMENT IN UNCONSOLIDATED VENTURE Summary financial information for the Carlyle-Seattle venture (note 3) as of and for the years ended December 31, 1993 and 1992, follows: 1993 1992 ------------ ------------ Current assets . . . . . . . . . . . $ 2,088,736 2,251,082 Current liabilities. . . . . . . . . 1,502,843 2,369,456 ------------ ------------ Working capital surplus (deficit) 585,893 (118,374) ------------ ------------ Investment property, net . . . . . . 69,926,060 73,654,677 Long-term accrued rent receivable . . . . . . . . . . . . 5,114,243 4,742,285 Deferred expenses. . . . . . . . . . 4,885,802 5,880,276 Long-term debt . . . . . . . . . . . (97,131,235) (97,493,927) Other liabilities. . . . . . . . . . (2,117,311) (2,198,921) Venture partners' equity . . . . . . 14,932,465 12,409,680 ------------ ------------ Partner's capital deficit. . . . $ (3,804,083) (3,124,304) ============ ============ Represented by: Invested capital . . . . . . . . . $ 8,000,000 8,000,000 Cumulative distributions . . . . . (1,653,978) (1,404,149) Cumulative loss. . . . . . . . . . (10,150,105) (9,720,155) ------------ ------------ $ (3,804,083) (3,124,304) ============ ============ Total income . . . . . . . . . . . . $ 20,796,157 20,101,736 ============ ============ Expenses applicable to operating loss . . . . . . . . . . $ 23,027,341 23,558,049 ============ ============ Net loss . . . . . . . . . . . . . . $ 2,231,184 3,456,313 ============ ============ CARLYLE REAL ESTATE LIMITED PARTNERSHIP - X (a limited partnership) and Consolidated Ventures Notes to Consolidated Financial Statements - Concluded Total income, expenses applicable to operating loss and net loss from the above-mentioned venture for the year ended December 31, 1991 were $20,546,658, $23,077,480 and $2,530,822, respectively. (11) SUBSEQUENT EVENTS Distributions In February 1994, the Partnership paid an operating distribution of $150,007 ($1.50 per interest) to the Limited Partners and $6,250 to the General Partners. Also, in February 1994, the Partnership paid a sales distribution of $3,300,165 ($33 per interest) to the Limited Partners. SCHEDULE X CARLYLE REAL ESTATE LIMITED PARTNERSHIP - X (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES SUPPLEMENTARY INCOME STATEMENT INFORMATION YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 CHARGED TO COSTS AND EXPENSES ---------------------------------------------- 1993 1992 1991 ------------ ------------ ------------ Maintenance and repairs. . . . . . . . $ 996,069 1,166,046 2,615,946 Depreciation . . . . . . 1,826,311 2,258,584 3,367,283 Taxes: Real Estate. . . . . 974,857 875,850 1,537,941 Other. . . . . . . . 29,360 4,796 2,778 Advertising. . . . . . . 80,536 91,193 115,396 ========== =========== ========== INDEPENDENT AUDITORS' REPORT The Partners CARLYLE REAL ESTATE LIMITED PARTNERSHIP - X: We have audited the financial statements of Carlyle-Seattle (First Interstate), an unconsolidated venture of Carlyle Real Estate Limited Partnership - X (Partnership) as listed in the accompanying index. In connection with our audits of the financial statements, we also have audited the financial statement schedules as listed in the accompanying index. These financial statements and financial statement schedules are the responsibility of the General Partners of the Partnership. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by the General Partners of the Partnership, 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 financial statements referred to above present fairly, in all material respects, the financial position of First Interstate, an unconsolidated joint venture of Carlyle Real Estate Limited Partnership - X as of December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 1993, in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. KPMG PEAT MARWICK Chicago, Illinois March 25, 1994 CARLYLE-SEATTLE (AN UNCONSOLIDATED VENTURE OF CARLYLE REAL ESTATE LIMITED PARTNERSHIP-X) NOTES TO FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 (1) BASIS OF ACCOUNTING The accompanying financial statements have been prepared for the purpose of complying with Rule 3.09 of Regulation S-X of the Securities and Exchange Commission. They include the accounts of the unconsolidated joint venture, First Interstate ("Venture"), in which Carlyle Real Estate Limited Partnership - X ("Carlyle-X") owns a direct interest. The records of the Venture are maintained on the accrual basis of accounting as adjusted for Federal income tax reporting purposes. The accompanying financial statements have been prepared from such records after making appropriate adjustments to present the Venture's accounts in accordance with generally accepted accounting principles ("GAAP"). Such adjustments are not recorded on the records of the Venture. The net effect of these items for the years ended December 31, 1993 and 1992 is summarized as follows: CARLYLE-SEATTLE (AN UNCONSOLIDATED VENTURE OF CARLYLE REAL ESTATE LIMITED PARTNERSHIP-X) NOTES TO FINANCIAL STATEMENTS - CONTINUED Statement of Financial Accounting Standards No. 95 requires the Venture to present a statement which classifies receipts and payments according to whether they stem from operating, investing or financing activities. The required information has been segregated and accumulated according to the classification specified in the pronouncement. For the purposes of these statements, the Venture's policy is to consider all short-term investments held with maturities of three months or less as cash equivalents. Deficit capital accounts will result, through the duration of the Partnership, in net gain for financial reporting and income tax purposes. Deferred expenses are comprised of deferred leasing costs, which are amortized using the straight-line method over the terms of the related leases and financing costs which are amortized over the term of the related loan agreement. Although certain leases of the Venture provide for increases in minimum lease payments over the term of the lease, the Venture accrues rental income for the full period of occupancy on a straight-line basis. Depreciation on the investment property has been provided over the estimated useful lives of 5 to 40 years using the straight-line method. The investment property has been pledged as security for the long-term debt, for which there is generally no recourse to the venture partners. As of December 31, 1993, total lease assumptions payable are reflected net of estimated sublease revenues of $2,612,000. Maintenance and repair expenses are charged to operations as incurred. Significant betterments and improvements are capitalized and depreciated over their estimated useful lives. No provision for state or Federal income taxes has been made as the liability for such taxes is that of the venture partners rather than the Venture. (2) VENTURE AGREEMENTS A description of the venture agreement and the management agreement is contained in Note 3(b) of Carlyle Real Estate Limited Partnership - X for the year ended December 31, 1993. Such note is incorporated herein by reference. Under certain circumstances, Carlyle-X may be required to make additional cash contributions to the Venture. There are certain risks associated with Carlyle-X's investment made through the joint venture including the possibility that the joint venture partners in an investment might become unable or unwilling to fulfill their financial or other obligations, or that such joint venture partners may have economic or business interests or goals that are inconsistent with those of Carlyle-X. CARLYLE-SEATTLE (AN UNCONSOLIDATED VENTURE OF CARLYLE REAL ESTATE LIMITED PARTNERSHIP-X) NOTES TO FINANCIAL STATEMENTS - CONTINUED (3) LONG-TERM DEBT Long-term debt consists of the following at December 31, 1993 and 1992: 1993 1992 ----------- ----------- 11% mortgage note, secured by the First Interstate Center office building in Seattle, Washington; payable in monthly installments of principal and interest of $922,425 until December 15, 1995 at which time the remaining principal balance of $96,275,082 will be payable . . . . . . . . . . . . . . $97,493,927 97,819,002 Less current portion of long-term debt . . . . . . . . . . . . 362,692 325,075 ----------- ----------- Total long-term debt . . . . . . . $97,131,235 97,493,927 =========== =========== Five year maturities of long-term debt are summarized as follows: 1994. . . . . . . . . . . $ 362,692 1995. . . . . . . . . . . 97,131,235 1996. . . . . . . . . . . -- 1997. . . . . . . . . . . -- 1998. . . . . . . . . . . -- =========== - ------------------- The venture anticipates approaching the lender regarding an extension or modification of the existing mortgage loan. There can be no assurance that the venture will be successful in replacing or refinancing the loan when it comes due. (4) LEASES (a) As Property Lessor At December 31, 1993, the Venture's principal asset is an office building. The Venture has determined that all leases relating to this property are properly classified as operating leases; therefore, rental income is reported when earned and the cost of the property, excluding cost of land, is depreciated over the estimated useful life. Leases with tenants range in terms from one to twenty years and provide for fixed minimum rent and partial reimbursement of operating costs. Minimum lease payments including amounts representing executory costs (e.g., taxes, maintenance, insurance), and any related profit to be received in the future under the above operating leases are as follows: 1994. . . . . . . . . . . $ 16,442,301 1995. . . . . . . . . . . 15,425,851 1996. . . . . . . . . . . 13,859,082 1997. . . . . . . . . . . 12,531,286 1998. . . . . . . . . . . 12,171,318 Thereafter. . . . . . . . 50,292,685 ------------ $120,722,523 ============ CARLYLE-SEATTLE (AN UNCONSOLIDATED VENTURE OF CARLYLE REAL ESTATE LIMITED PARTNERSHIP-X) NOTES TO FINANCIAL STATEMENTS - CONCLUDED (b) As Property Lessee The Venture owns a net leasehold interest which expires in 2052 in the land underlying the Seattle, Washington office building, subject to a 20-year extension. The lease provides for an annual rental of $670,000 and has been determined to be an operating lease. (c) Capital Lease The Venture is obligated on a capital lease obligation relating to the net cost associated with a lighting retrofit program performed in 1993. The total cost of this program was approximately $1,065,000, and the Venture received energy rebates totalling $781,000 from Seattle City Light. The rebates were used as a reduction to the basis of the equipment. The capital lease obligation is payable in monthly installments through 1996. SCHEDULE X CARLYLE-SEATTLE (AN UNCONSOLIDATED VENTURE OF CARLYLE REAL ESTATE LIMITED PARTNERSHIP-X) SUPPLEMENTARY INCOME STATEMENT INFORMATION YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 CHARGED TO COSTS AND EXPENSES ---------------------------------------------- 1993 1992 1991 ---------- ------------ ------------ Maintenance and repairs. . . . . . . . $1,809,109 1,666,240 1,562,805 Depreciation . . . . . . 4,585,711 4,461,680 4,365,782 Amortization of deferred expenses. . . 1,064,774 1,093,358 1,157,952 Taxes: Real estate taxes. . . 1,704,719 2,097,359 2,171,029 Other. . . . . . . . . 640 444,891 275 ========== ============ ============ ITEM 9.	ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE There were no changes of or disagreements with accountants during fiscal year 1992 and 1993. PART III ITEM 10.	ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE PARTNERSHIP The Corporate General Partner of the Partnership is JMB Realty Corporation ("JMB"), a Delaware corporation. JMB has responsibility for all aspects of the Partnership's operations, subject to the requirement that sales of real property must be approved by the Associate General Partner of the Partnership, Realty Associates-X, L.P., an Illinois limited partnership with JMB as the sole general partner. The Associate General Partner shall be directed by a majority in interest of its limited partners (who are generally officers, directors and affiliates of JMB or its affiliates) as to whether to provide its approval of any sale of real property (or any interest therein) of the Partnership. Various relationships of the Partnership to the Corporate General Partner and its affiliates are described under the caption "Conflicts of Interest" at pages 9-13 of the Prospectus, which descriptions are incorporated herein by reference to Exhibit 3-A to the Partnership's Report for December 31, 1992 on Form 10-K (File No. 0-9726) dated March 19, 1993. The names, positions held and length of service therein of each director and executive officer and certain officers of the Managing General Partner of the Partnership are as follows: SERVED IN NAME OFFICE OFFICE SINCE - ---- ------ ------------ Judd D. Malkin Chairman 5/03/71 Director 5/03/71 Neil G. Bluhm President 5/03/71 Director 5/03/71 Jerome J. Claeys III Director 5/09/88 Burton E. Glazov Director 7/01/71 Stuart C. Nathan Executive Vice President 5/08/79 Director 3/14/73 A. Lee Sacks Director 5/09/88 John G. Schreiber Director 3/14/73 H. Rigel Barber Chief Executive Officer 8/01/93 Jeffrey R. Rosenthal Chief Financial Officer 8/01/93 Gary Nickele Executive Vice President 1/01/92 General Counsel 2/27/84 Ira J. Schulman Executive Vice President 6/01/88 Gailen J. Hull Senior Vice President 6/01/88 Howard Kogen Senior Vice President 1/02/86 Treasurer 1/01/91 There is no family relationship among any of the foregoing directors or officers. The foregoing directors have been elected to serve one-year terms until the annual meeting of the Corporate General Partner to be held on June 7, 1994. All of the foregoing officers have been elected to serve one-year terms until the first meeting of the Board of Directors held after the annual meeting of the Corporate General Partner to be held on June 7, 1994. There are no arrangements or understandings between or among any of said directors or officers and any other person pursuant to which any director or officer was elected as such. JMB is the corporate general partner of Carlyle Real Estate Limited Partnership-VII ("Carlyle-VII"), Carlyle Real Estate Limited Partnership-IX ("Carlyle -IX"), Carlyle Real Estate Limited Partnership-XI ("Carlyle-XI"), Carlyle Real Estate Limited Partnership-XII ("Carlyle-XII"), Carlyle Real Estate Limited Partnership-XIII ("Carlyle-XIII"), Carlyle Real Estate Limited Partnership-XIV ("Carlyle-XIV"), Carlyle Real Estate Limited Partnership-XV ("Carlyle-XV"), Carlyle Real Estate Limited Partnership-XVI ("Carlyle-XVI"), Carlyle Real Estate Limited Partnership-XVII ("Carlyle-XVII"), JMB Mortgage Partners, Ltd. ("Mortgage Partners"), JMB Mortgage Partners, Ltd.-II ("Mortgage Partners -II"), JMB Mortgage Partners, Ltd.-III ("Mortgage Partners-III"), JMB Mortgage Partners, Ltd.-IV ("Mortgage Partners-IV"), Carlyle Income Plus, Ltd. ("Carlyle Income Plus"), Carlyle Income Plus, Ltd.- II ("Carlyle Income Plus-II"), and the managing general partner of JMB Income Properties, Ltd.-II ("JMB Income-II"), JMB Income Properties, Ltd.-IV ("JMB Income-IV"), JMB Income Properties, Ltd.-V ("JMB Income-V"), JMB Income Properties, Ltd.-VI ("JMB Income-VI"), JMB Income Properties, Ltd.-VII ("JMB Income-VII"), JMB Income Properties, Ltd.-VIII ("JMB Income-VIII"), JMB Income Properties, Ltd.-IX ("JMB Income-IX"), JMB Income Properties, Ltd. -X ("JMB Income-X"), JMB Income Properties, Ltd.-XI ("JMB Income-XI"), JMB Income Properties, Ltd.-XII ("JMB Income-XII") and JMB Income Properties, Ltd.-XIII ("JMB Income-XIII"). Most of the foregoing directors and officers are also officers and/or directors of various affiliated companies of JMB including Income Growth Managers, Inc. (the corporate general partner of IDS/JMB Balanced Income Growth, Ltd. ("IDS/BIG")), Arvida/JMB Managers, Inc. (the general partner of Arvida/JMB Partners, L.P. ("Arvida")) and Arvida/JMB Managers-II, Inc. (the general partner of Arvida/JMB Partners, L.P.-II ("Arvida-II")). Most of such directors and officers are also partners of certain partnerships which are associate general partners in the following real estate limited partnerships: Carlyle-VII, Carlyle-IX, Carlyle-XI, Carlyle-XII, Carlyle-XIII, Carlyle-XIV, Carlyle-XV, Carlyle-XVI, Carlyle-XVII, JMB Income-VI, JMB Income-VII, JMB Income-VIII, JMB Income-IX, JMB Income-X, JMB Income-XI, JMB Income-XII, JMB Income-XIII, Mortgage Partners, Mortgage Partners-II, Mortgage Partners-III, Mortgage Partners-IV, Carlyle Income Plus, Carlyle Income Plus-II and IDS/BIG. The business experience during the past five years of each such director and officer of the Corporate General Partner of the Partnership in addition to that described above is as follows: Judd D. Malkin (age 56) is an individual general partner of JMB Income-IV and JMB Income-V. Mr. Malkin has been associated with JMB since October 1969. He is a Certified Public Accountant. Neil G. Bluhm (age 56) is an individual general partner of JMB Income-IV and JMB Income-V. Mr. Bluhm has been associated with JMB since August 1970. He is a member of the Bar of the State of Illinois and a Certified Public Accountant. Jerome J. Claeys III (age 51) (Chairman and Director of JMB Institutional Realty Corporation) has been associated with JMB since September 1977. He holds a Masters degree in Business Administration from the University of Notre Dame. Burton E. Glazov (age 55) has been associated with JMB since June 1971 and served as an Executive Vice President of JMB until December 1990. He is a member of the Bar of the State of Illinois and a Certified Public Accountant. Stuart C. Nathan (age 52) has been associated with JMB since July 1972. He is a member of the Bar of the State of Illinois. A. Lee Sacks (age 60) (President and Director of JMB Insurance Agency, Inc.) has been associated with JMB since December 1972. John G. Schreiber (age 47) has been associated with JMB since December 1970 and served as an Executive Vice President of JMB until December 1990. He holds a Masters degree in Business Administration from Harvard University Graduate School of Business. H. Rigel Barber (age 44) has been associated with JMB since March, 1982. He holds a J.D. degree from the Northwestern Law School and is a member of the Bar of the State of Illinois. Jeffrey R. Rosenthal (age 42) has been associated with JMB since December, 1987. He is a Certified Public Accountant. Gary Nickele (age 41) has been associated with JMB since February, 1984. He holds a J.D. degree from the University of Michigan Law School and is a member of the Bar of the State of Illinois. Ira J. Schulman (age 42) has been associated with JMB since February, 1983. He holds a Masters degree in Business Administration from the University of Pittsburgh. Gailen J. Hull (age 45) has been associated with JMB since March, 1982. He holds a Masters degree in Business Administration from Northern Illinois University and is a Certified Public Accountant. Howard Kogen (age 58) has been associated with JMB since March, 1973. He is a Certified Public Accountant. ITEM 11.	ITEM 11. EXECUTIVE COMPENSATION The Partnership has no officers or directors. The Partnership is required to pay a management fee to the Corporate General Partner and the General Partners are entitled to receive a share of cash distributions, when and as cash distributions are made to the Limited Partners, and a share of profits or losses as described under the caption "Compensation and Fees" at pages 6-9, "Cash Distributions" at pages 101-103, "Allocation of Profits or Losses for Tax Purposes" at page 101 and "Distributions and Compensations; Allocations of Profits and Losses" at pages A-5 to A-9 of the Prospectus, which descriptions are incorporated herein by reference to Exhibit 3-A to the Partnership's Report for December 31, 1992 on Form 10-K (File No. 0-9726) dated March 19, 1993. Reference is also made to Notes 5 and 9 for a description of such transactions, distributions and allocations. In 1993 and 1992, the General Partners received distributions of $25,001. The General Partners received a distribution of $616,698 in 1991. Management fees earned by the Corporate General Partner in 1993, 1992 and 1991 were $41,669, $41,669 and $62,500, respectively. Reference is made to Note 9. In addition, the General Partners received a share of Partnership operating losses in 1993. Such losses may benefit the General Partners to the extent that such losses may be offset against taxable income from the Partnership or other sources. The Partnership is permitted to engage in various transactions involving affiliates of the Corporate General Partner of the Partnership, as described under the captions "Compensation and Fees" at pages 6-9, "Conflicts of Interest" at pages 9-13 and "Powers, Rights and Duties of the General Partners" at pages A-11 to A-17 of the Prospectus, which descriptions are hereby incorporated herein by reference to Exhibit 3-A to the Partnership's Report for December 31, 1992 on Form 10-K (File No. 0-9726) dated March 19, 1993. The relationship of the Corporate General Partner to its affiliates is set forth in Item 10 above. JMB Properties Company, an affiliate of the Corporate General Partner, provided property management services to the Partnership for all or part of 1993, the Double Tree Apartments, the Sunrise Mall and the Union Plaza Office Building. In 1993, such affiliate earned property management fees amounting to $221,779 for such services, all of which were paid as of December 31, 1993. As set forth in the Prospectus of the Partnership, the Corporate General Partner must negotiate such agreements on terms no less favorable to the Partnership than those customarily charged for similar services in the relevant geographical area (but in no event at rates greater than 5% of the gross income from a property), and such agreements must be terminable by either party thereto, without penalty, upon 60 days' notice. JMB Insurance Agency, Inc., an affiliate of the Corporate General Partner, earned and received insurance brokerage commissions in 1993 aggregating $28,343 in connection with the provision of insurance coverage for certain of the real property investments of the Partnership. Such commissions are at rates set by insurance companies for the classes of coverage provided. The General Partners may be reimbursed for their direct expenses relating to the administration of the Partnership and the operation of the Partnership's real property investments. In 1993, the Corporate General Partner of the Partnership was due reimbursement for such out-of-pocket expenses in the amount of $117,756, all of which was paid at December 31, 1993. Additionally, the General Partners may be reimbursed for salaries and direct expenses of officers and employees of the Corporate General Partner and its affiliates while directly engaged in the administration of the Partnership and in the operation of the Partnership's real property investments. In 1993, such costs were approximately $84,426, all of which were unpaid as of December 31, 1993. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS There were no significant transactions or business relationships with the Corporate General Partner, affiliates or their management other than those described in Items 10 and 11 above. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The following documents are filed as part of this report: (1) Financial Statements (See Index to Financial Statements filed with this annual report). (2) Exhibits. 3-A. The Prospectus of the Partnership dated May 29, 1980, as supplemented on August 4, 1980, November 12, 1980, November 24, 1980, January 30, 1981 and February 10, 1981, as filed with the Commission pursuant to Rules 424(b) and 424(c), is incorporated herein by reference to Exhibit 3-A to the Partnership's Report for December 31, 1992 on Form 10-K (File No. 0- 9726) dated March 19, 1993. Copies of pages 6-13, 101-103, A-5 to A-9 and A- 11 to A-17 are hereby incorporated herein by reference to Exhibit 3-A to the Partnership's Report for December 31, 1992 on Form 10-K (File No. 0-9726) dated March 19, 1993. 3-B. Amended and Restated Agreement of Limited Partnership set forth as Exhibit A to the Prospectus incorporated herein by reference to the Partnership's Registration Statement on Form S-11 (File No. 0-9726) dated November 24, 1980. 4-A. Modification documents relating to the long-term mortgage note secured by the Union Plaza Office Building are incorporated herein by reference to Exhibit 4-A to the Partnership's report on Form 10-K for December 31, 1992 (File No. 0-9726) dated March 19, 1993. 4-B. Long-term mortgage note documents relating to the note secured by the Sunrise Mall located in Brownsville, Texas are incorporated herein by reference to the Partnership's Registration Statement on Post-Effective Amendment No. 2 dated November 24, 1980 to Form S-11 (File No. 0-9726). 4-C. Long-term mortgage note documents relating to the first mortgage note secured by the Garret Mountain Office Center located in West Paterson, New Jersey are incorporated herein by reference to the Partnership's Registration Statement on Post-Effective Amendment No. 2 dated November 24, 1980 to Forms S-11 (File No. 0-9726). 4-D. Long-term mortgage note documents relating to the second mortgage note secured by the Garret Mountain Office Center located in West Paterson, New Jersey and by the Garret Mountain venture are incorporated herein by reference to Exhibit 4-D to the Partnership's Report for December 31, 1992 on Form 10-K (File No. 0-9726) dated March 19, 1993. 4-E. Modification documents relating to the long term second mortgage note secured by the Garret Mountain Office Center located in West Paterson, New Jersey are incorporated herein by reference to Exhibit 4-E to the Partnership's Report for December 31, 1992 on Form 10-K (File No. 0- 9726) dated March 19, 1993. 10-A. Acquisition documents relating to the purchase by the Partnership of an interest in the Union Plaza Office Building located in Oklahoma City, Oklahoma are incorporated herein by reference to the Partnership's Registration Statement on Post-Effective Amendment No. 3 to Form S-11 (File No. 0-9726) dated May 29, 1980. 10-B. Acquisition documents relating to the purchase by the Partnership of an interest in the Sunrise Mall located in Brownsville, Texas are incorporated herein by reference to the Partnership's Registration Statement on Post-Effective Amendment No. 2 dated November 24, 1980 to Form S- 11 (File No. 0-9726). 10-C. Acquisition documents relating to the purchase by the Partnership of an interest in the Garret Mountain Office Center located in West Paterson, New Jersey are incorporated by reference herein to the Partnership's Registration Statement on Post-Effective Amendment No. 2 dated November 24, 1980 to Form S-11 (File No. 0-9726). 21. List of Subsidiaries. 24. Powers of Attorney --------------- Although certain additional long-term debt instruments of the Registrant have been excluded from Exhibit 4 above, pursuant to Rule 601(b)(4)(iii), the Registrant commits to provide copies of such agreements to the Securities and Exchange Commission upon request. (b) The following report on Form 8-K was filed since the beginning of the last quarter of the period covered by this report. (i) The Partnership's Report on Form 8-K for October 31, 1993 (describing the sale of the Partnership's interest in Frontier Mall in Cheyenne, Wyoming) was filed. This report was dated November 12, 1993. No annual report for the fiscal year 1993 or proxy material has been sent to the Partners of the Partnership. An annual report will be sent to the Partners subsequent to this filing. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Partnership has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - X By: JMB Realty Corporation Corporate General Partner GAILEN J. HULL By: Gailen J. Hull Senior Vice President Date: March 25, 1994 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. By: JMB Realty Corporation Corporate General Partner JUDD D. MALKIN* By: Judd D. Malkin, Chairman and Director Date: March 25, 1994 NEIL G. BLUHM* By: Neil G. Bluhm, President and Director Date: March 25, 1994 H. RIGEL BARBER* By: H. Rigel Barber, Chief Executive Officer Date: March 25, 1994 JEFFREY R. ROSENTHAL* By: Jeffrey R. Rosenthal, Chief Financial Officer Principal Financial Officer Date: March 25, 1994 GAILEN J. HULL By: Gailen J. Hull, Senior Vice President Principal Accounting Officer Date: March 25, 1994 A. LEE SACKS* By: A. Lee Sacks, Director Date: March 25, 1994 STUART C. NATHAN* By: Stuart C. Nathan, Executive Vice President and Director Date: March 25, 1994 *By: GAILEN J. HULL, Pursuant to Powers of Attorney GAILEN J. HULL By: Gailen J. Hull, Attorney-in-Fact Date: March 25, 1994 CARLYLE REAL ESTATE LIMITED PARTNERSHIP - X EXHIBIT INDEX DOCUMENT INCORPORATED BY REFERENCE PAGE 3-A. Pages 6-13, 101-103, A-5 to A-9 and A-11 to A-17 of the Prospectus of the Partnership dated May 29, 1980 Yes 3-B. Amended and Restated Agreement of Limited Partnership Yes 4-A. Modification documents related to the Union Plaza Office Building Yes 4-B. Long-term mortgage note documents related to the Sunrise Mall Yes 4-C. Long-term first mortgage note related to the Garret Mountain Office Center Yes 4-D. Long-term second mortgage note related to the Garret Mountain Office Center Yes 4-E. Modification documents related to the Garret Mountain Office Center Yes 10-A. Acquisition documents related to the Union Plaza Office Building Yes 10-B. Acquisition documents related to the Sunrise Mall Yes 10-C. Acquisition documents related to the Garret Mountain Office Center Yes 21. List of Subsidiaries No 24. Powers of Attorney No		ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS There were no significant transactions or business relationships with the Corporate General Partner, affiliates or their management other than those described in Items 10 and 11 above. PART IV ITEM 14.	ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The following documents are filed as part of this report: (1) Financial Statements (See Index to Financial Statements filed with this annual report). (2) Exhibits. 3-A. The Prospectus of the Partnership dated May 29, 1980, as supplemented on August 4, 1980, November 12, 1980, November 24, 1980, January 30, 1981 and February 10, 1981, as filed with the Commission pursuant to Rules 424(b) and 424(c), is incorporated herein by reference to Exhibit 3-A to the Partnership's Report for December 31, 1992 on Form 10-K (File No. 0- 9726) dated March 19, 1993. Copies of pages 6-13, 101-103, A-5 to A-9 and A- 11 to A-17 are hereby incorporated herein by reference to Exhibit 3-A to the Partnership's Report for December 31, 1992 on Form 10-K (File No. 0-9726) dated March 19, 1993. 3-B. Amended and Restated Agreement of Limited Partnership set forth as Exhibit A to the Prospectus incorporated herein by reference to the Partnership's Registration Statement on Form S-11 (File No. 0-9726) dated November 24, 1980. 4-A. Modification documents relating to the long-term mortgage note secured by the Union Plaza Office Building are incorporated herein by reference to Exhibit 4-A to the Partnership's report on Form 10-K for December 31, 1992 (File No. 0-9726) dated March 19, 1993. 4-B. Long-term mortgage note documents relating to the note secured by the Sunrise Mall located in Brownsville, Texas are incorporated herein by reference to the Partnership's Registration Statement on Post-Effective Amendment No. 2 dated November 24, 1980 to Form S-11 (File No. 0-9726). 4-C. Long-term mortgage note documents relating to the first mortgage note secured by the Garret Mountain Office Center located in West Paterson, New Jersey are incorporated herein by reference to the Partnership's Registration Statement on Post-Effective Amendment No. 2 dated November 24, 1980 to Forms S-11 (File No. 0-9726). 4-D. Long-term mortgage note documents relating to the second mortgage note secured by the Garret Mountain Office Center located in West Paterson, New Jersey and by the Garret Mountain venture are incorporated herein by reference to Exhibit 4-D to the Partnership's Report for December 31, 1992 on Form 10-K (File No. 0-9726) dated March 19, 1993. 4-E. Modification documents relating to the long term second mortgage note secured by the Garret Mountain Office Center located in West Paterson, New Jersey are incorporated herein by reference to Exhibit 4-E to the Partnership's Report for December 31, 1992 on Form 10-K (File No. 0- 9726) dated March 19, 1993. 10-A. Acquisition documents relating to the purchase by the Partnership of an interest in the Union Plaza Office Building located in Oklahoma City, Oklahoma are incorporated herein by reference to the Partnership's Registration Statement on Post-Effective Amendment No. 3 to Form S-11 (File No. 0-9726) dated May 29, 1980. 10-B. Acquisition documents relating to the purchase by the Partnership of an interest in the Sunrise Mall located in Brownsville, Texas are incorporated herein by reference to the Partnership's Registration Statement on Post-Effective Amendment No. 2 dated November 24, 1980 to Form S- 11 (File No. 0-9726). 10-C. Acquisition documents relating to the purchase by the Partnership of an interest in the Garret Mountain Office Center located in West Paterson, New Jersey are incorporated by reference herein to the Partnership's Registration Statement on Post-Effective Amendment No. 2 dated November 24, 1980 to Form S-11 (File No. 0-9726). 21. List of Subsidiaries. 24. Powers of Attorney --------------- Although certain additional long-term debt instruments of the Registrant have been excluded from Exhibit 4 above, pursuant to Rule 601(b)(4)(iii), the Registrant commits to provide copies of such agreements to the Securities and Exchange Commission upon request. (b) The following report on Form 8-K was filed since the beginning of the last quarter of the period covered by this report. (i) The Partnership's Report on Form 8-K for October 31, 1993 (describing the sale of the Partnership's interest in Frontier Mall in Cheyenne, Wyoming) was filed. This report was dated November 12, 1993. No annual report for the fiscal year 1993 or proxy material has been sent to the Partners of the Partnership. An annual report will be sent to the Partners subsequent to this filing. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Partnership has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - X By: JMB Realty Corporation Corporate General Partner GAILEN J. HULL By: Gailen J. Hull Senior Vice President Date: March 25, 1994 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. By: JMB Realty Corporation Corporate General Partner JUDD D. MALKIN* By: Judd D. Malkin, Chairman and Director Date: March 25, 1994 NEIL G. BLUHM* By: Neil G. Bluhm, President and Director Date: March 25, 1994 H. RIGEL BARBER* By: H. Rigel Barber, Chief Executive Officer Date: March 25, 1994 JEFFREY R. ROSENTHAL* By: Jeffrey R. Rosenthal, Chief Financial Officer Principal Financial Officer Date: March 25, 1994 GAILEN J. HULL By: Gailen J. Hull, Senior Vice President Principal Accounting Officer Date: March 25, 1994 A. LEE SACKS* By: A. Lee Sacks, Director Date: March 25, 1994 STUART C. NATHAN* By: Stuart C. Nathan, Executive Vice President and Director Date: March 25, 1994 *By: GAILEN J. HULL, Pursuant to Powers of Attorney GAILEN J. HULL By: Gailen J. Hull, Attorney-in-Fact Date: March 25, 1994 CARLYLE REAL ESTATE LIMITED PARTNERSHIP - X EXHIBIT INDEX DOCUMENT INCORPORATED BY REFERENCE PAGE 3-A. Pages 6-13, 101-103, A-5 to A-9 and A-11 to A-17 of the Prospectus of the Partnership dated May 29, 1980 Yes 3-B. Amended and Restated Agreement of Limited Partnership Yes 4-A. Modification documents related to the Union Plaza Office Building Yes 4-B. Long-term mortgage note documents related to the Sunrise Mall Yes 4-C. Long-term first mortgage note related to the Garret Mountain Office Center Yes 4-D. Long-term second mortgage note related to the Garret Mountain Office Center Yes 4-E. Modification documents related to the Garret Mountain Office Center Yes 10-A. Acquisition documents related to the Union Plaza Office Building Yes 10-B. Acquisition documents related to the Sunrise Mall Yes 10-C. Acquisition documents related to the Garret Mountain Office Center Yes 21. List of Subsidiaries No 24. Powers of Attorney No
796370_1993.txt	796370	1993	ITEM 1. BUSINESS - ------- GENERAL United Asset Management Corporation ("UAM" or the "Company") is a holding company organized in December, 1980 to acquire and to own firms engaged primarily in institutional investment management. Its 37 wholly-owned operating subsidiaries (the "Affiliated Firms" or the "Firms") are managers of investment portfolios for corporate, public and union pension funds and profit sharing plans, mutual funds, endowments, foundations and, to a lesser extent, individuals and other investors. UAM intends to continue expanding through the internal growth of its present Affiliated Firms and through the acquisition or organization of additional firms in the future (see "Affiliated Firms"). In addition, UAM plans to continue to diversify, both domestically and internationally, with respect to both the classes of assets managed for institutional investors and the firm's client base. While UAM's Affiliated Firms primarily specialize in the management of U.S. equities, bonds and cash, other asset classes under management have grown significantly over the past two years to include international equities, bonds and cash, as well as real estate. Management fees based on the assets of pension plans, profit sharing plans, endowments and foundations provide substantially all of the Company's revenues. Such clients are sometimes referred to as "institutional" clients, and they are generally "tax-exempt" in that the income and any capital gains which result from their portfolio investments are not taxable to them under present law. Advisory fees are primarily based on the value of assets under management. Fee rates typically decline as account size increases. The assets of institutional clients have generally been growing, with the most rapid growth achieved by pension and profit sharing plans (sometimes called employee benefit plans). For the year ended December 31, 1993, no single client of any Affiliated Firm provided more than 2% of the Company's consolidated revenues. Accordingly, the loss of any single client would not have a material adverse effect on the Company's total investment management business. Each Affiliated Firm operates under its own name, with its own investment philosophy and approach. Each conducts its own investment analysis, portfolio selection, marketing, and client service. During any given period, investment results may vary among Firms. Each Firm competes independently and sets its client fees based on its own judgment concerning the market for the services it renders. Each Firm is separately regulated under applicable federal, state or foreign law. UAM has established revenue sharing agreements with the Affiliated Firms which are described more fully under "Revenue Sharing." These agreements provide for UAM to derive increased or decreased income from each Affiliated Firm, based on a percentage of the change in each Firm's revenues from year to year, starting from a base amount agreed upon in the year of acquisition. These arrangements allow each Firm to set its own operating expense budget and compensation practices, limited by the share of the Firm's revenues available to it. - 1 - THE INDUSTRY Revenues in the institutional investment management industry are determined primarily by fees based on assets under management. Therefore, the principal determinant of growth in the industry is the growth of institutional assets under management. In management's judgment, the major factors which influence changes in institutional assets under management are: (a) changes in the market value of securities; (b) net cash flow into or out of existing accounts; (c) gains of new or losses of existing accounts by specific firms or segments of the industry; and (d) the introduction of new products by the industry or by particular firms. In general, assets under management in the institutional segments of the industry have increased steadily. For example, Money Market Directories, Inc. recorded in its 1994 Directory $3.2 trillion in assets under management in accounts of employee benefit plans, foundations and endowments within the United States as of mid-1993, which represents an increase at an average compound five- year annual growth rate of 11.0% over the corresponding figure as of mid-1988. The largest institutional segment of assets under management has been employee benefit plan assets. The 1994 Directory reported $3.0 trillion of employee benefit plan assets under management as of mid-1993, which represents an increase at an average compound five-year annual growth rate of 10.8% over the corresponding figure as of mid-1988. The employee benefit plan market includes two principal sectors: defined benefit and defined contribution plans. The majority of U.S. retirement plan assets are in defined benefit plans, which assure workers of a particular level of pension benefits when they retire. The Employee Retirement Income Security Act of 1974 (ERISA) and the Internal Revenue Code of 1986 (the "Code") require employers to fund their defined benefit plans sufficiently to generate the benefits they have promised. However, the Code also prohibits overfunding of defined benefit plans by employers. In management's opinion, high investment returns through the 1980's resulted in many defined benefit retirement plans approaching or even reaching their full funding limits by the end of the 1980's, based on actuarial calculations, so corporations were not called upon to contribute any more cash to the plans. However, if the value of plan assets declines due to market factors, employers will generally be obligated to step up payments into their defined benefit pension plans. This counter-cyclical funding pattern for defined benefit plans helps to smooth out fluctuations in the growth of plan assets under management by firms that provide investment advisory services to sponsors of defined benefit plans, and therefore, it helps to smooth out fluctuations in the revenues of these investment managers. Under defined contribution plans, on the other hand, employers may contribute to their employees' retirement funds on a tax-advantaged basis, but individual employees often decide how their plan assets will be invested. Defined contribution plans are the fastest growing sector of the employee benefit plan market. The number and size of investment management firms which UAM has been acquiring have grown in the past five years. The 1989 Money Market Directory showed 930 investment counseling firms (including branch offices) within the United States managing $2.3 trillion as of mid-1988. The 1994 Directory showed 1,346 such firms (including branch offices) within the United States managing approximately $4.5 trillion of assets as of mid-1993 which represents an increase at an average compound five-year annual growth rate of 14.4% over the corresponding assets of mid-1988. - 2 - COMPETITION The Affiliated Firms compete with a large number of investment management firms, principally those engaged in the management of "institutional" accounts. In addition, the Affiliated Firms compete with commercial banks and insurance companies, many of which have substantially greater capital and other resources and some of which offer a wider range of financial services. Furthermore, each of the Affiliated Firms may compete with other Affiliated Firms for clients. Management believes that the most important factors affecting competition in the investment management industry are the abilities and reputations of investment managers, differences in the investment performance of investment management firms, and the development of new investment strategies and information technologies, rather than differences in advisory fees. Barriers to entry are low, and firms are relatively long-lived in the investment management business. A new investment management firm has very low capital requirements. Maintaining the firm requires only the continued involvement of its professional personnel. A major portion of profits may be regularly withdrawn because new capital commitments are limited and rarely necessary. UAM competes, with respect to the acquisition of investment management firms, with many other potential purchasers of investment management firms, including insurance companies, banks and foreign investment groups that wish to be represented in the United States. For the most part, these acquirers have sought a single firm rather than undertaking a program of acquisitions similar to UAM's. As a result of its continuing acquisition activities, including regular contacts with potential acquisition candidates, UAM has an extensive knowledge of the candidate population both domestically and internationally. UAM'S ACQUISITION PROGRAM AND METHOD OF OPERATION Since its inception, UAM has sought to acquire or to organize institutional investment management firms. Once it has acquired or organized such firms, UAM seeks to preserve their autonomy by allowing their key employees to retain control of investment decisions and day-to-day operations. Where the Affiliated Firm is acquired from its employee-stockholders, the former stockholders receive the added benefits of a more diversified company by virtue of their equity ownership in UAM. UAM conducts its own acquisition activities rather than relying primarily upon outside agents to find and develop acquisition candidates for it. UAM's activities include regular mailing and calling programs through which UAM seeks to contact and visit potential acquisition candidates on a regular basis. UAM is willing to use finders to locate suitable candidates and has paid finders' fees on four occasions. Once acquisition negotiations begin, UAM utilizes its own staff and outside legal counsel to negotiate price, terms and the wording of specific documents required. Typically, a definitive purchase agreement is signed, and then each of the clients of the firm to be acquired is contacted by a principal of that firm in order to obtain the client's consent to the transaction (which constitutes an assignment of its advisory contract) as required by the Investment Advisers Act of 1940. Once sufficient consents have been received, the acquisition is completed. Consent of all of a - 3 - firm's clients has been obtained in connection with virtually all of UAM's acquisitions to date. After acquisition by UAM, Affiliated Firms continue to operate under their own firm name, with their own leadership and individual investment philosophy and approach. UAM seeks to achieve diversity by acquiring investment management firms having different investment philosophies and strategies and specializing in different asset classes. In addition, UAM has acquired or organized firms at various stages of their development, from start-up to relatively mature firms and has acquired both employee-stockholder firms and subsidiaries or divisions of financial institutions. UAM itself does not manage portfolio investments for clients and does not provide any investment advisory services to Affiliated Firms and therefore is not registered as an investment adviser under federal, state or foreign law. UAM respects the individual character of each Affiliated Firm and seeks to preserve an environment in which each Firm may continue to provide investment management services which are intended to meet the particular needs of each Firm's clients. UAM's name does not appear on the office doors of any Affiliated Firm. UAM provides assistance to the Affiliated Firms in connection with the preparation of consolidated financial statements, consolidated tax matters, insurance and maintenance of a company-wide profit sharing retirement plan. UAM believes that the professional independence of the Affiliated Firms and the continuing diversification of investment philosophies and approaches within the company are necessary ingredients of UAM's success and that of the Affiliated Firms. The key employees of each Affiliated Firm at the time of acquisition by UAM have continued with their Firm in accordance with employment agreements executed in connection with each acquisition, have remained on their Firm's board of directors, and have continued to serve as its executive officers. UAM intends to continue the method of operation described above as it acquires or organizes additional firms. Each Affiliated Firm's directors and officers are responsible for reviewing their respective Firm's results, plans and budgets. The Company also has a Management Council composed of senior executives from each of the Affiliated Firms and from UAM which serves as a forum for sharing business information. UAM seeks to assist the Affiliated Firms in their marketing activities by providing resources and support for developing new products and reaching new markets. As a part of these efforts, UAM has organized The Regis Fund, Inc., a series mutual fund in which Affiliated Firms may open portfolios to pool client accounts in an efficient, cost-effective manner and to provide additional investment styles. As of December 31, 1993, nine of the Affiliated Firms had opened in the aggregate 25 Regis Fund portfolios, and such portfolios held assets totaling $1.7 billion. UAM has responded to the growth in the defined contribution plan sector of the market by establishing Regis Retirement Plan Services, Inc. in 1993 to offer bundled products, including investment management through the offering of Regis Fund portfolios, recordkeeping and trustee services to the sponsors of these plans. - 4 - UAM has observed that the major reasons that employee-owned firms consider selling to UAM include: (a) the high value of the firm relative to its principals' total net worth; (b) the need for liquidity on the part of the principals; and (c) their desire for diversification and a reduction in their exposure to a single firm's results. Substantially all the key employees of Affiliated Firms continue to be vigorously involved in their Firm long after its acquisition by UAM. In purchasing investment management firms, UAM has structured the consideration of the transactions in order to create incentives for the key personnel to remain with their firm after the expiration of their employment agreements. The key employees have entered into employment and non-competition agreements for terms ranging primarily from five to twelve years, which also prohibit the employees from competing with their Firm for a substantial period after termination of employment. Most of the key employees of the Affiliated Firms were stockholders of such Firms prior to their acquisition by UAM. In connection with the purchases, the former stockholders and/or key employees have typically received consideration in the form of cash, subordinated notes and warrants to purchase UAM Common Stock, or UAM Common Stock. The subordinated notes, which may be used to exercise the warrants, generally have terms between five and ten years. The key employees of each Affiliated Firm also participate directly, through a revenue sharing arrangement, in revenues of their Firm and meet the Firm's expenses from their share of these revenues, as described more fully under "Revenue Sharing." UAM has over the past several years identified a substantial number of institutional investment management firms both domestically and internationally which it believes may be candidates for future acquisition on the basis of an evaluation of their personnel, investment approach, client base, revenues and profitability. Borrowings under UAM's $225,000,000 Reducing Revolving Credit Agreement (as more fully described in Note 3 to the Consolidated Financial Statements, see Items 8 and 14) are secured by the stock of the Company's subsidiaries. REVENUE SHARING UAM operates with the Affiliated Firms under "revenue sharing" agreements. The agreements permit each Firm to retain a specified percentage of its revenues (typically 50-70%) for use by its principals at their discretion in paying expenses of operation, including salaries and bonuses. The purposes of the plans are to provide significant ongoing incentives for the principals of the Affiliated Firms to continue working as they did prior to the sale of their Firm to UAM and to allow UAM to participate in the growth of revenues of each Affiliated Firm. The plans are designed to allow each Firm's principals to participate in that Firm's growth in a substantial manner and to make operating decisions freely within the limits of that portion of the Firm's revenues which is retained under the Firm's control. In effect, the portion of its revenues retained by each Firm that is not used to pay salaries and other operating expenses is available for payment to the principals of such Firm in the form of bonuses. Thus, the portion of Affiliated Firm revenues retained by the Firms is included in operating expenses in the UAM Consolidated Statement of Income. - 5 - Under each plan, when an Affiliated Firm is acquired by UAM, the "base revenues" of the Firm are established, and a share of such revenues is allocated to UAM, with the balance being reserved as the acquired Firm's share of revenues. In addition, agreement is reached on the Firm's and UAM's respective percentage shares of changes in such Firm's revenues compared to its base revenues. The Affiliated Firm is required to pay for all of its business expenses out of its share of its revenues. Each year, the amount of the Affiliated Firm's revenues that is paid to UAM and the amount that is retained by the Firm are adjusted upwards in the case of growth in such Firm's revenues over its base, or downwards in the case of decreases in such Firm's revenues below its base, in amounts determined with respect to UAM and the Affiliated Firm by applying the agreed-upon percentages to the total increase or decrease in the Firm's revenues. Under most of the existing revenue sharing agreements, UAM's share of increases above a Firm's base revenues is between 30% and 50%, and UAM's share of decreases below a Firm's base revenues is between 50% and 70%. Thus, in any year in which the Affiliated Firm's revenues increase over its base revenues, the Firm retains a portion of such additional amounts to use as its principals may decide (such as to pay for employees' services). The balance of the increase in the Affiliated Firm's revenues is paid to UAM, in addition to UAM's share of such Firm's base revenues. In any year in which the Affiliated Firm's revenues decrease to a level below its base revenues, the Firm's share of its base revenues is reduced by the Firm's portion of the decrease, and therefore, the Firm may need to reduce its expenses. Similarly, the revenue sharing amount paid to UAM will be reduced by UAM's share of any decline in the Affiliated Firm's revenues below its base. AFFILIATED FIRMS Each of the Affiliated Firms conducts its own marketing, client relations, research, and portfolio management. Each Firm sets its own investment advisory fees and manages its business independently on a day-to-day basis. The investment philosophy, style and approach of each Affiliated Firm are independently determined by it, and these philosophies, styles and approaches may vary substantially from Firm to Firm. As a consequence, more than one Affiliated Firm may be retained by a single client since many clients employ multiple investment advisers. The strategies employed and securities selected by Affiliated Firms are separately chosen by each of them, with the result that any one UAM Firm may be bullish on the stock or bond market while another Firm is bearish. Two of the Affiliated Firms are full-service institutional real estate investment management firms with $7.9 billion of assets under management at year end. These Firms invest in real estate properties in the U.S. and overseas for their U.S. and foreign clients and provide a broad spectrum of real estate services, including research and acquisition, financing and asset and property management. All of these differences, when combined with the separate names and identities of the various Affiliated Firms may; (a) tend to insulate UAM from the various cycles of under- or over-performance of individual Firms; (b) permit more than one Affiliated Firm to serve any single client; and (c) mean that some Affiliated Firms may attract substantial new business while other Firms may be growing more slowly or losing business. - 6 - On December 31, 1993, UAM's 37 Affiliated Firms had nearly 5,500 clients with $100.1 billion of assets under management for an average account size of $18.3 million. The 20 largest clients of the Firms represented 18% of total assets under management and the 100 largest clients represented 38% of total assets under management. The client list includes many of the nation's largest corporate, public, charitable and union funds along with the funds of many individuals, several mutual fund organizations and a number of professional groups. As of December 31, 1993, UAM subsidiaries managed approximately $4.0 billion in wrap-fee programs through relationships with 22 brokerage firms. Additional information regarding the number of clients and types and amounts of assets under management is found as exhibit 13.1.1 of this filing, which table is incorporated herein by reference. The following table summarizes UAM's asset mix: In January, 1994, UAM acquired Dwight Asset Management Company, a Burlington, Vermont-based specialist in stable value assets with $5 billion in assets under management, further diversifying the asset mix. As previously described, each of the Affiliated Firms is responsible for and provides its own marketing of its investment management services. Typically, one or more of the employees at each Firm is responsible for making an initial contact with prospective clients. Most Firms have brochures describing the Firm, its principals and its investment approach. These brochures are mailed to prospective clients. In addition, clients are solicited by telephone and in person. Once an initial contact is made, several face-to- face meetings between the principals of such Firm and the prospective client take place at which investment philosophy, management fees and a variety of other related matters are discussed. REGULATION UAM's domestic investment advisory subsidiaries are registered with and subject to regulation by the Securities and Exchange Commission ("SEC") under the Investment Advisers Act of 1940 and, where applicable, under state advisory laws. The Company's U.K. investment advisory affiliates are members of and subject to regulation by the Investment Management Regulatory Organization, a self-regulatory body organized under the U.K. Financial Services Act. The Company's brokerage subsidiaries are registered as broker-dealers with the SEC under the Securities Exchange Act of 1934 (the "Exchange Act") and, where applicable, under state securities laws, and are regulated by the SEC, state securities administrators, and the National Association of Securities Dealers, Inc. One Affiliated Firm is regulated by the Commodities Futures Trading Commission, and two own trust companies which are subject to regulation by the Office of Comptroller of the Currency or applicable state law. - 7 - UAM's domestic investment advisory subsidiaries are subject to ERISA and to regulations promulgated thereunder to the extent they are "fiduciaries" under ERISA with respect to their clients. Registrations, reporting, maintenance of books and records and compliance procedures required by these laws and regulations promulgated thereunder are maintained by each UAM subsidiary on an independent basis. The officers, directors and employees of UAM's investment advisory subsidiaries may from time to time own securities which are also owned by one or more of their clients. Each such firm has internal guidelines and codes of ethics with respect to individual investments, and requires reporting of securities transactions and restricts certain transactions so as to minimize possible conflicts of interest. - 8 - UAM's Affiliated Firms as of December 31, 1993 are listed below in the order in which they were acquired or organized. - 9 - EMPLOYEES The UAM holding company has thirty-two employees, five of whom are executive officers of UAM (see Item 10, Directors and Executive Officers). Each Affiliated Firm employs its own administrative and operations personnel as needed to provide advisory services to its clients and to maintain necessary records in accordance with the Investment Advisers Act of 1940 and applicable state laws. See "Affiliated Firms." At December 31, 1993, the Company as a whole employed 1,549 persons. These numbers exclude 1,075 individuals who are employed by the property management subsidiaries of The L&B Group and Heitman Financial Ltd. and whose total compensation is billed directly to clients of these affiliates. ITEM 2.		ITEM 2. PROPERTY - ------- UAM's only offices are its executive offices in Boston, Massachusetts, which occupy approximately 15,000 square feet under a lease which expires in 1997. Affiliated Firms are likewise lessees of their respective offices under leases which expire at various dates. ITEM 3.	ITEM 3. LEGAL PROCEEDINGS - ------ Certain of the Company's subsidiaries are subject to legal proceedings arising in the ordinary course of business. On the basis of information presently available and advice received from counsel, it is the opinion of management that the disposition or ultimate determination of such legal proceedings will not have a material adverse effect on the financial position of the Company. ITEM 4.	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - ------- No matters were submitted to the vote of the security holders of the Company during the fourth quarter of the fiscal year covered by this report. PART II ITEM 5.	ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS - ------- As of December 31, 1993, there were 538 shareholders of record. As of March 15, 1994, there were 540 shareholders of record. The balance of the information required by this item is incorporated herein by reference to the "Common Stock Information" appearing as exhibit 13.1.2 of this filing. ITEM 6.	ITEM 6. SELECTED FINANCIAL DATA - ------- The information required by this item is incorporated herein by reference to the "Nine Year Review" appearing as exhibit 13.1.3 of this filing. ITEM 7.	ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND - ------- RESULTS OF OPERATIONS The information required by this item is incorporated herein by reference to the "Management's Discussion and Analysis" appearing as exhibit 13.1.4 of this filing. - 10 - ITEM 8.	ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - ------- The information required by this item is incorporated herein by reference to the "Selected Quarterly Financial Data" appearing as exhibit 13.1.5 of this filing, "Consolidated Financial Statements" of United Asset Management Corporation and "Notes to Consolidated Financial Statements" appearing as exhibits 13.1.6 through 13.1.10 and also the "Report of Independent Accountants" appearing as exhibit 13.1.11 of this filing. (See also the "Financial Statement Schedules" filed under Item 14 of this Form 10-K.) ITEM 9.	ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE - ------- None PART III ITEM 10.	ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT - -------- The information required by this item is incorporated herein by reference to the sections entitled "Nominees for Election as Directors," "Certain Transactions" and "Executive Officers" included in the Company's Proxy Statement for the Annual Meeting of Stockholders to be held on May 19, 1994 (the "Proxy Statement"). ITEM 11.	ITEM 11. EXECUTIVE COMPENSATION - -------- The information required by this item is incorporated herein by reference to the sections entitled "Executive Compensation-Summary Compensation Table," "Executive Compensation-Option Grants in 1993," "Executive Compensation- Aggregated Option Exercises in 1993 and Option Values at December 31, 1993" and "Directors' Fees" included in the Proxy Statement. ITEM 12.	ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT - -------- The information required by this item is incorporated herein by reference to the section entitled "Voting Securities" included in the Proxy Statement. ITEM 13.	ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - -------- The information required by this item is incorporated herein by reference to the section entitled "Certain Transactions" included in the Proxy Statement. - 11 - PART IV ITEM 14.	ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS - -------- ON FORM 8-K (a) 1. Financial Statements The following consolidated financial statements of United Asset Management Corporation and report of independent accountants, included as exhibits 13.1.6 through 13.1.11, are incorporated herein by reference as a part of this Form 10-K: Title - ----- Report of Independent Accountants 13.1.11 Consolidated Balance Sheet as of December 31, 1993 and 1992 13.1.6 Consolidated Statement of Income for the three years ended December 31, 1993 13.1.7 Consolidated Statement of Cash Flows for the three years ended December 31, 1993 13.1.8 Consolidated Statement of Changes in Stockholders' Equity for the three years ended December 31, 1993 13.1.9 Notes to Consolidated Financial Statements 13.1.10 (a) 2. Financial Statement Schedules The following consolidated financial statement schedules and report of independent accountants are filed as a part of this Form 10-K and are located on the following pages: Page(s) ------- Report of Independent Accountants on Financial Statement Schedules For the three years ended December 31, 1993: Schedule II Amounts Receivable from Related Parties, Underwriters, Promoters, and Employees Other than Related Parties Schedule IV Indebtedness of and to Related Parties - Not Current Schedule VIII Valuation and Qualifying Accounts All other schedules have been omitted since they are not required, not applicable or the information is contained in the Financial Statements or Notes thereto. - 12 - (a) 3. EXHIBIT INDEX Exhibit Number Title ------ ----- (1) 3.1 Restated Certificate of Incorporation of the Registrant, as amended. 3.2 By-Laws of the Registrant. (2) 4.1 Specimen Certificate of Common Stock, $.01 par value, of the Registrant. (3) 4.2 Agreement to furnish copies of subordinated debt instruments to the Commission. 9.0 Not Applicable (4) 10.1 Acquisition Agreement by and among United Asset Management Corporation, NWQ Investment Management Company, NIMC Newco, Inc., the partners of NWQ Investment Management Company and David A. Polak dated as of October 21, 1992, including an Agreement to Furnish Copies of Omitted Schedules and Exhibits to Acquisition Agreement. (5) 10.2 Credit Agreement dated as of May 18, 1992 among United Asset Management Corporation, Morgan Guaranty Trust Company of New York, The First National Bank of Boston, Credit Lyonnais New York Branch, Credit Lyonnais Cayman Island Branch, Mellon Bank, N.A., Manufacturers Hanover Trust Company, Morgan Guaranty Trust Company of New York, as Agent, and The First National Bank of Boston, as Collateral Agent. (5) 10.3 First Amendment dated October 8, 1992 to the Credit Agreement. (5) 10.4 Second Amendment dated November 25, 1992 to the Credit Agreement. (5) 10.5 Third Amendment dated December 1, 1992 to the Credit Agreement. (5) 10.6 Fourth Amendment dated as of January 8, 1993 to the Credit Agreement. 10.7 Fifth Amendment dated as of August 25, 1993 to the Credit Agreement. 10.8 Sixth Amendment dated as of November 16, 1993 to the Credit Agreement. (1) 10.9 1987 Stock Option Plan. - 13 - (6) 10.10 United Asset Management Corporation Profit Sharing and 401(k) Plan dated as of May 11, 1989 and amended and restated as of November 26, 1990. 10.11 Revised First Amendment to United Asset Management Corporation Profit Sharing and 401(k) Plan effective as of January 1, 1992. 10.12 Second Amendment to United Asset Management Corporation Profit Sharing and 401(k) Plan effective as of January 1, 1993. (7) 10.13 1989 Stock Option Plan. (5) 10.14 1992 Stock Option Plan. (5) 10.15 Consulting Agreement between United Asset Management Corporation and David I. Russell dated as of January 1, 1993. 11.1 Calculation of Earnings Per Share. 12.0 Not Applicable 13.1 Portions of the United Asset Management Corporation Annual Report to shareholders for the year ended December 31, 1993 are incorporated herein by reference: 13.1.1 "United Asset Management's Clients" 13.1.2 "Common Stock Information" 13.1.3 "Nine Year Review" 13.1.4 "Management's Discussion and Analysis" 13.1.5 "Selected Quarterly Financial Data" 13.1.6 "Consolidated Balance Sheet" 13.1.7 "Consolidated Statement of Income" 13.1.8 "Consolidated Statement of Cash Flows" 13.1.9 "Consolidated Statement of Changes in Stockholders' Equity" 13.1.10 "Notes to Consolidated Financial Statements" 13.1.11 "Report of Independent Accountants" 16.0 Not Applicable 18.0 Not Applicable 21.1 Subsidiaries of the Registrant. 22.0 Not Applicable 23.1 Consent of Independent Accountants. 24.0 Not Applicable 27.0 Not Applicable 28.0 Not Applicable ___________ - 14 - (1) Filed as an Exhibit to the Company's Form S-4 as filed with the Commission and which became effective on July 7, 1987, and incorporated herein by reference (Registration No. 33-14565). (2) Filed as an Exhibit to the Company's Form S-1 as filed with the Commission and which became effective on August 22, 1986, and incorporated herein by reference (Registration No. 33-6874). (3) Filed as an Exhibit to the Company's Annual Report on Form 10-K for the year ended December 31, 1988, and incorporated herein by reference. (4) Filed as an Exhibit to the Company's Current Report on Form 8-K as filed with the Commission on November 5, 1992, and incorporated herein by reference. (5) Filed as an Exhibit to the Company's Annual Report on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. (6) Filed as an Exhibit to the Company's Annual Report on Form 10-K for the year ended December 31, 1990, and incorporated herein by reference. (7) Filed as an Exhibit to the Company's Annual Report on Form 10-K for the year ended December 31, 1989, and incorporated herein by reference. Location of Documents Pertaining to Executive Compensation Plans and Arrangements: (1) 1987 Stock Option Plan - Form S-4 Registration Statement No. 33-14565, Exhibit 10.9 to this Form 10-K. (2) 1989 Stock Option Plan - Form 10-K for fiscal year ended December 31, 1989, Exhibit 10.13 to this Form 10-K. (3) 1992 Stock Option Plan - Form 10-K for fiscal year ended December 31, 1992, Exhibit 10.14 to this Form 10-K. (4) Consulting Agreement between United Asset Management Corporation and David I. Russell dated as of January 1, 1993 - Form 10-K for fiscal year ended December 31, 1992, Exhibit 10.15 to this Form 10-K. (b) Reports on Form 8-K A report on Form 8-K was filed on December 8, 1993. The items reported and financial statements filed were as follows: Item 5. Other Events. ------------ The report announced the acquisitions by UAM of Heitman Financial Ltd. and Murray Johnstone Holdings Limited. Item 7. Financial Etatements and Exhibits. --------------------------------- (a) Restated financial statements reflecting acquisitions of Heitman Financial Ltd. and Murray Johnstone Holdings Limited through transactions accounted for as poolings of interests. - 15 - (i) Consolidated Balance Sheet as of December 31, 1992 and 1991. (ii) Consolidated Statement of Income for the three years ended December 31, 1992. (iii) Consolidated Statement of Cash Flows for the three years ended December 31, 1992. (iv) Consolidated Statement of Changes in Stockholders' Equity for the three years ended December 31, 1992. (v) Notes to Consolidated Financial Statements. - 16 - SIGNATURES ---------- Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. UNITED ASSET MANAGEMENT CORPORATION ----------------------------------- (Registrant) Date: March 22, 1994 By /s/ Norton H. Reamer -------------------------------- Norton H. Reamer President By /s/ William H. Park -------------------------------- William H. Park Senior Vice President and Treasurer (Principal Financial and Accounting 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 in the capacities and on the dates indicated. /s/ Norton H. Reamer - ----------------------------------- (Norton H. Reamer) Director March 22, 1994 /s/ Robert J. Greenebaum - ----------------------------------- (Robert J. Greenebaum) Director March 22, 1994 /s/ Jay O. Light - ----------------------------------- (Jay O. Light) Director March 22, 1994 /s/ John F. McNamara - ----------------------------------- (John F. McNamara) Director March 22, 1994 /s/ Michael C. Mewhinney - ----------------------------------- (Michael C. Mewhinney) Director March 22, 1994 /s/ W. Olin Nisbet, III - ----------------------------------- (W. Olin Nisbet, III) Director March 22, 1994 /s/ Norman Perlmutter - ----------------------------------- (Norman Perlmutter) Director March 22, 1994 /s/ David A. Polak - ----------------------------------- (David A. Polak) Director March 22, 1994 /s/ David I. Russell - ----------------------------------- (David I. Russell) Director March 22, 1994 /s/ Philip Scaturro - ----------------------------------- (Philip Scaturro) Director March 22, 1994 /s/ John A. Shane - ----------------------------------- (John A. Shane) Director March 22, 1994 /s/ John T. Siegel - ----------------------------------- (John T. Siegel) Director March 22, 1994 /s/ Barbara S. Thomas - ----------------------------------- (Barbara S. Thomas) Director March 22, 1994 - 17 - REPORT OF INDEPENDENT ACCOUNTANTS ON ------------------------------------ FINANCIAL STATEMENT SCHEDULES ----------------------------- To the Board of Directors of United Asset Management Corporation Our audits of the consolidated financial statements referred to in our report dated February 7, 1994 appearing on page 79 of the 1993 Annual Report to Shareholders of United Asset Management Corporation (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the Financial Statement Schedules listed in Item 14(a) of this Form 10-K. In our opinion, these Financial Statement Schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. /s/ Price Waterhouse PRICE WATERHOUSE Boston, Massachusetts February 7, 1994 Exhibit 23.1 CONSENT OF INDEPENDENT ACCOUNTANTS ---------------------------------- We hereby consent to the incorporation by reference in the Prospectuses constituting part of the Registration Statements on Form S-3 (Nos. 33-36928, 33-44215, 33-46310, 33-63350, 33-69034, 33-51443 and 33-52517) and in the Registration Statements on Form S-8 (Nos. 33-10621, 33-21756, 33-34288 and 33-48858) of United Asset Management Corporation of our report dated February 7, 1994 appearing on page 79 of the Annual Report to Shareholders which is incorporated in this Annual Report on Form 10-K. We also consent to the incorporation by reference of our report on the Financial Statement Schedules, which appears on page of this Form 10-K. /s/ Price Waterhouse PRICE WATERHOUSE Boston, Massachusetts March 22, 1994
829732_1993.txt	829732	1993	Item 1. Business The Bancorp. NBB Bancorp, Inc. (Bancorp) is a corporation, formed at the direction of New Bedford Institution for Savings (the Bank) under the laws of the State of Delaware. Bancorp became the holding company for the Bank on December 1, 1988, and is a one-bank holding company registered with the Federal Reserve Board under the Bank Holding Company Act of 1956. The only office of Bancorp, and its principal place of business, is located at the main office of the Bank at 174 Union Street, New Bedford, MA 02740, and its telephone number is (508) 996-5000. Bancorp's principal business consists of the business of the Bank. Bancorp is a legal entity separate from the Bank, and its principal source of revenue on an unconsolidated basis is dividends transferred from the Bank from time to time. Bancorp's assets on an unconsolidated basis at December 31, 1993 were represented by its investment in the Bank of $254.2 million and other assets of $1.2 million. At December 31, 1993, Bancorp on a consolidated basis had total assets of $2.5 billion, deposits of $2.2 billion, and stockholders' equity of $255.0 million which represents 10.40% of total assets. Book value per share at December 31, 1993 was $29.45. The Bank. New Bedford Institution for Savings is a Massachusetts-chartered savings bank organized in 1825. It is headquartered in New Bedford, Massachusetts, approximately 60 miles south of Boston and 30 miles east of Providence, Rhode Island. The Bank's market area includes a significant portion of Southeastern Massachusetts, Cape Cod and eastern Rhode Island and is served by a network of 52 offices, 10 of which are located in the eastern part of Rhode Island, 30 in the southeastern area of Massachusetts, and 12 throughout Cape Cod. The Bank is a franchisee of an ATM network which provides customers access to their accounts from automated teller machines located throughout the United States, Canada and many other foreign countries. The Bank is a member of the Federal Home Loan Bank of Boston which qualifies it to borrow funds when needed to finance lending activities. The Bank's deposits are insured by the Federal Deposit Insurance Corporation (FDIC) up to $100,000 per separately insured account and deposits in excess of $100,000 are insured by the Deposit Insurance Fund of the Mutual Savings Central Fund, Inc. (the Central Fund). The Bank is engaged principally in the business of attracting deposits from the general public, originating residential and commercial real estate mortgages, construction, commercial and consumer loans, and investing in various securities. Acquisitions In August 1992, the Bank acquired all deposits and certain assets of Attleboro Pawtucket Savings Bank from the FDIC. The Bank received approximately $12.3 million for the acquisition. Deposits and loans acquired totaled $559.3 million and $378.5 million, respectively. In order to realize some of the cost savings that result from acquisitions, the operating departments of the Bank and those of Attleboro Pawtucket Savings Bank have been consolidated. There has been a consolidation of management in all areas. In addition, the overlap of certain branch locations and markets has caused deposit and loan business to be serviced at branch locations other than where it may have originated. All of these factors impact the income generated by the business acquired, and, as a result, there is not a practical method to meaningfully determine the income generated by this acquisition. In July 1991, the Bank acquired the insured deposits and certain of the assets of Sentry Savings Bank, FSB from the Resolution Trust Corporation (RTC) for a bid price of $13.1 million. Deposits and loans acquired totaled $397.7 million and $153.9 million, respectively. Both acquisitions were accounted for by the purchase method of accounting. Core deposit intangibles of $5.2 million and $2.8 million were recorded as a result of the Attleboro Pawtucket and Sentry Savings Bank, FSB acquisitions, respectively, with both being amortized over ten years using the interest method. Regulation General. Both Bancorp and the Bank are regulated extensively under federal and state statutes and regulations. The following summaries of the statutes and regulations affecting banks and bank holding companies are qualified in their entirety by reference to such statutes and regulations. Federal Reserve Board. Bancorp is registered as a bank holding company under the federal Bank Holding Company Act of 1956, as amended (BHCA), and is required to file annual and periodic reports and such other information as the Federal Reserve may require. Bancorp and the Bank's nonbanking subsidiaries are subject to limitations on the scope of their activities and to continuing regulation, supervision and examination by the Federal Reserve Board under the BHCA and related federal statutes. Bancorp is subject to capital standards based on Tier 1 capital and on risk weighting of assets. The minimum Tier 1 capital ratio (adjusted stockholders' equity divided by risk-weighted assets) required for bank holding companies with the highest regulatory rating is 4.00%. Bancorp must also have a minimum risk-based capital ratio of 8.00%. In addition, leverage capital standards (Tier 1 capital to adjusted total assets) require a minimum of 3.0% for the most highly rated companies. All others will need to meet a minimum leverage ratio that is at least 100 to 200 basis points above the minimum requirement. At December 31, 1993, the capital ratios of Bancorp substantially exceeded the minimum requirements for these capital standards. Delaware Corporate Law. As a Delaware corporation, Bancorp must comply with the General Corporation Laws of Delaware. Federal Deposit Insurance Corporation. As a Massachusetts- chartered, FDIC-insured savings bank, the Bank is subject to regulation, examination and supervision by the FDIC. The FDIC insures the Bank's deposit accounts up to a maximum of $100,000 per separately insured account; therefore, the Bank is subject to regulation, supervision and reporting requirements of the FDIC. The FDIC has adopted a regulation that defines and sets the minimum requirements for capital adequacy. Under this regulation, insured state banks, such as the Bank, are required to maintain Tier 1, risk-based and leverage capital ratios that are substantially the same as the Federal Reserve guidelines discussed above. The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) makes significant changes in the federal laws governing depository institutions and the FDIC. Among other changes, FDICIA requires federal bank regulatory agencies to take prompt corrective action to address the problems of undercapitalized banks. With certain exceptions, FDICIA prohibits banks from engaging, as principals, in activities that are not permissible for national banks, such as equity investments and insurance underwriting. In addition, FDICIA amends federal statutes governing extensions of credit to directors, executive officers and principal shareholders of banks, savings associations and their holding companies, limits the aggregate amount of a depository institution's loans to insiders to the amount of the institution's unimpaired capital and surplus, restricts depository institutions that are not well capitalized from accepting brokered deposits without an express waiver from the FDIC and imposes certain advance notice requirements before closing a branch. FDICIA also requires a system of risk-based deposit insurance assessments that takes into account different categories and concentrations of bank assets and liabilities. Massachusetts Commissioner of Banks. The Bank is subject to regulation and examination by the Commissioner of Banks of the Commonwealth of Massachusetts (the Commissioner). Massachusetts statutes and regulations govern, among other things, investment powers, lending powers, deposit activities, borrowings, maintenance of surplus reserve accounts, distribution of earnings and payment of dividends. The Bank is also subject to regulatory provisions covering such matters as issuance of capital stock, branching, and mergers and consolidations. Mutual Savings Central Fund, Inc. Deposit accounts that are not covered by federal insurance are insured by the Central Fund, a corporation created by the Massachusetts Legislature for the purpose of insuring the deposits of savings banks not covered by federal deposit insurance. All Massachusetts-chartered savings banks, including the Bank, are required to be members of the Central Fund. Lending Activities General. The Bank offers various types of real estate loans, commercial loans and consumer loans. The Bank is a major originator of residential loans in its market area and has traditionally focused its lending activities on the origination of first mortgage loans for the purchase, refinancing and construction of residential properties in its market area. For a fuller description of current conditions in the Bank's primary lending market area, see "Management's Discussion and Analysis of Financial Condition and Results of Operations" in the Annual Report to Stockholders for the year ended December 31, 1993 attached as an exhibit hereto. Total loans at December 31, 1993 were $1.3 billion or 53.8% of total assets. An analysis of the loan portfolio by type of loan is presented in Section III. A. and a percentage distribution of the loan portfolio is presented in Section IV. The following discussion and analysis should be read in light of the fact that the Bank's operating results are dependent upon the real estate market in Massachusetts and the economy which has been in a recession. The Bank's operating results are adversely affected by the loss of interest income from nonaccruing loans and real estate owned. Since the economy of the region continues to be troubled and there is evidence that certain sectors of the real estate market have not yet improved, additional loan loss provisions and provisions for losses on other real estate owned may become necessary. Loans currently nonperforming and OREO property may give rise to additional charge-offs and provisions. Residential Mortgage Lending. The Bank makes both conventional fixed and adjustable-rate loans on one-to-four family residential properties as well as second mortgages and home equity loans within its primary market area. The Bank retains the loans it originates for its own portfolio. Substantially all of the loans in the Bank's residential loan portfolio are secured by houses located in southeastern Massachusetts, Cape Cod, and eastern Rhode Island. The Bank makes residential construction loans primarily to homeowners. Construction loans are offered with fixed or variable rates for a term of fifteen to thirty years and become the homeowner's permanent mortgage. The ability and willingness of residential borrowers to honor their repayment commitments is generally dependent on the level of overall economic activity within the borrowers' geographic areas and real estate values. Commercial Lending. The Bank's commercial loan department originates construction and permanent mortgage loans on commercial real estate for its commercial loan portfolio which may include multi-family housing, strip shopping centers, office buildings, retail buildings, and industrial buildings. Commercial real estate loans are written primarily on a floating rate basis for terms of five years or less, although the amortization period may be longer. The Bank's commercial loan department also provides commercial services and corporate banking relationships with smaller and middle market companies with annual sales of $1 million to $50 million. The commercial loan department offers lines of credit, letters of credit, secured and unsecured loans, equipment loans, term loans for business expansion, commercial construction and project development loans. Aggregate extensions of credit to commercial borrowers are maintained at levels below statutory limits. Compared with residential mortgage lending on owner-occupied homes, commercial, commercial real estate and construction lending entail additional risks. These loans are affected, to a greater extent than residential mortgage loans, by adverse conditions in the economy generally and in the local real estate market. The repayment of loans secured by income-producing properties is often dependent on the successful completion and operation of the real estate project or development. Moreover, the cost of labor and material or the amount of time necessary to sell the project and carry the debt may vary from projections, or other contingencies may arise, that change the total amount of funds necessary to complete the project. Such lending also typically involves larger loan balances to single borrowers or groups of related borrowers. The ability and willingness of commercial real estate, and commercial and construction loan borrowers to honor their repayment commitments is generally dependent on the health of the real estate sector in the borrowers' geographic areas and the general economy. While non-performing assets have improved in 1993, charge-offs and provisions for OREO losses reflect the problems in the New England economy. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" in the Annual Report to Stockholders for the year ended December 31, 1993 attached as an exhibit hereto. Consumer Loans. The Bank originates both secured and unsecured consumer loans which include home improvement loans, automobile loans, boat loans, personal loans, and guaranteed educational loans. Consumer loans are generally offered at a fixed rate for terms not exceeding five years. Investment Activities The Bank invests in U. S. Government and Agency obligations, investment grade corporate securities, money instruments, corporate equities and other authorized investments. The Bank's investment portfolio is managed with the assistance of an independent investment advisor. The Board of Directors has adopted an investment policy to govern the Bank's investment activities. Management believes it is prudent to maintain an investment portfolio that provides income and a source of liquidity to meet lending demand and deposit flow. The investment policy of the Bank calls for staggered maturities while maintaining an average portfolio maturity of five years, depending on the outlook for interest rates. Effective December 31, 1993, the Bancorp adopted Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Dept and Equity Securities." Under SFAS No. 115, debt securities that the Bancorp has the positive intent and ability to hold to maturity are classified as held-to-maturity and reported at amortized cost; debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as trading and reported at fair value, with unrealized gains and losses included in earnings; and debt and equity securities not classified as either held-to-maturity or trading are classified as available-for-sale and reported at fair value, with unrealized gains and losses excluded from earnings and reported in a separate component of stockholders' equity. The Bancorp classifies its securities based on its intention at the time of purchase. The Bancorp has no securities held for trading. As a result of adoption, as of December 31, 1993, stockholders' equity was increased by approximately $6.8 million, representing the net unrealized gain on securities available-for-sale, less applicable income taxes. At December 31, 1993, $588.4 million of the Bancorp's securities were considered to be available-for-sale. Securities available-for-sale provide liquidity, facilitate interest rate sensitivity management, and enhance the Bank's ability to respond quickly to the needs of customers should economic conditions result in an increase in loan demand. Securities held-to-maturity totaled $399.5 million at December 31, 1993. Sources of Funds General. Deposit accounts of all types have historically constituted the primary source of funds for the Bank's lending and investment activities. Other sources of funds include interest payments on loans and securities, loan principal payments and sales and maturities of securities. The availability of funds is influenced by prevailing interest rates, competition, and other market conditions. Deposits. The Bank's deposits are primarily attracted from customers in the Bank's market area. It has been the Bank's practice not to solicit deposits outside of its market area, accept deposits from brokers, or use premiums to attract deposits. In recent years, the Bank has attracted substantial deposits into short-term certificates and money market accounts. These accounts may be more responsive to changes in market rates of interest than passbook accounts and longer maturity, fixed-rate, fixed-term certificates, which are also deposit products offered by the Bank. Borrowings. The Bank is a member of the Federal Home Loan Bank of Boston and has access to a pre-approved line of credit up to 2% of total assets and the capacity to borrow an amount up to 30% of total assets, less other borrowings. Subsidiaries/Other Activities The Bank has four wholly-owned subsidiary corporations: NBB Investment Corporation, NBIS Securities Corporation, NBIS Development Corp. and Knotty Walk, Inc. In addition, Fairhaven Development Corp. is a wholly-owned subsidiary of NBIS Development Corp. and Rope Walk Condominium, Inc. is a wholly-owned subsidiary of Knotty Walk, Inc. NBB Investment Corporation and NBIS Securities Corporation, established in December 1993 for the purpose of managing portions of the Bank's investment portfolio, had no assets at December 31, 1993. NBIS Development Corp. and Knotty Walk, Inc. own real estate which is leased to the Bank and nonrelated parties. Assets of NBIS Development Corp. and Knotty Walk, Inc. totaled $4.3 million and $4.1 million, respectively at December 31, 1993. Fairhaven Development Corp. and Rope Walk Condominium, Inc. were incorporated for the purpose of real estate development. Assets of Fairhaven Development Corp. and Rope Walk Condominium, Inc. totaled $143,000 and $1.6 million, at December 31, 1993, respectively. The consolidated financial statements of the Bancorp appearing in this Form 10-K include the accounts of the Bank and its subsidiaries described above. Savings Bank Life Insurance The Bank had been an issuing bank for Savings Bank Life Insurance (SBLI). On December 31, 1991, SBLI was demutualized by legislation enacted in December 1990. Based on an appraisal of the value of the new company, SBLI determined the value of the stock distributed to the Bank was $1.0 million. For purposes of conservatism, the stock received was recorded at $500,000 which increased net income by $290,000 after providing for income taxes. Competition The Bank faces strong competition in all aspects of its deposit and loan business. The Bank competes by providing a full range of deposit and loan products, offering competitive rates, providing quality service, and by supporting a strong network of conveniently located branches with extended banking hours. The Bank attracts deposits through its network of branch offices, primarily from the communities in which those offices are located. Competition for deposits has traditionally come from other thrift institutions, commercial banks, money market mutual funds and credit unions located in its market area. The Bank is recognized in its market area as a leading provider of mortgage funds but faces strong competition from savings banks, mortgage banking companies, credit unions, and commercial banks. Competition for consumer and commercial loans comes from commercial banks, savings banks, and other financial services companies. Employees Bancorp utilizes the support staff of the Bank from time to time without the payment of any fees. No separate compensation is being paid to the executive officers of the Bancorp, all of whom are executive officers of the Bank and receive compensation as such. As of December 31, 1993, the Bank had 524 full-time employees and 89 part-time employees. Full-time employees receive a comprehensive range of employee benefit programs. None of the Bank's employees is represented by a union or other labor organization, and management believes that its employee relations are good. NOTE: The headings and sub-headings on the following pages correspond to SEC --- Guide 3 - Statistical Disclosure by Bank Holding Companies - ---------------------------------------------------------- I. DISTRIBUTION OF ASSETS, LIABILITIES AND STOCKHOLDERS' EQUITY; ------------------------------------------------------------- INTEREST RATES AND INTEREST DIFFERENTIAL - ---------------------------------------- I.A. & I.B. Average Balance Sheets, and Analysis of Net Interest Earnings Reference is hereby made to Bancorp's Annual Report to Stockholders for the year ended December 31, 1993 attached as an exhibit hereto. The information required under I.A. (average balance sheets) and I.B.1. through I.B.5. (analysis of net interest earnings) is set forth on page 33 of such Annual Report and is incorporated herein by reference. I.C. Rate/Volume Analysis. Reference is hereby made to Bancorp's Annual Report to Stockholders for the year ended December 31, 1993 attached as an exhibit hereto. The information set forth on page 34 of such Annual Report entitled "Rate/Volume Analysis" is incorporated herein by reference. The following table sets forth maturity and repricing information relating to interest-sensitive assets and liabilities at December 31, 1993. Fixed-rate loans and pass-through certificates are shown in the table in the time periods corresponding to principal amortization which has been computed based on their respective weighted average maturities and weighted average rates. Adjustable-rate loans and securities are allocated to the period in which the rates would be next adjusted. The table does not reflect partial or full prepayment of loans and certain securities prior to final contractual maturity. Analysis of the Bank's non-certificate deposit accounts in 1993 shows that only a portion of savings, money market deposit and NOW accounts are rate-sensitive. Deposit balances have been distributed accordingly in the 0 to 5-year time bands. In accordance with the proposed Federal Reserve guidelines for risk-based capital standards which account for interest rate risk, no amounts related to such deposit accounts are placed beyond five years. A deficiency of rate-sensitive assets over rate-sensitive liabilities will generally result in increased net interest income during a period of falling interest rates and in decreased net interest income during a period of rising interest rates. II. INVESTMENT PORTFOLIO A. The following table shows the aggregate market value for 1993 and book value for 1992 and 1991 of the major categories of securities available-for-sale for the years indicated: (In Thousands) At December 31, 1993 1992 1991 - ------------------------------------------------------------------------------- Securities available-for-sale: U. S. Government obligations $438,079 $322,619 $146,647 U. S. Agency obligations 75,977 84,008 157,396 Mortgage-backed securities 41,220 - - Marketable equity securities 16,056 - - Other equity securities 12,031 8,970 7,723 Other debt securities 5,079 - ------------------------------------------------------------------------------- Total securities held-for-sale $588,442 $415,597 $311,766 - ------------------------------------------------------------------------------- The following table shows the book value of the major categories of securities held-to-maturity for the years indicated: (In Thousands) At December 31, 1993 1992 1991 - ------------------------------------------------------------------------------- Securities held-to-maturity: U. S. Government obligations - $47,198 - U. S. Agency obligations 2,575 - - Corporate debt securities 121,749 118,640 108,004 Other debt securities 249,993 213,386 126,780 Mortgage-backed securities 25,136 37,646 11,992 Marketable equity securities - 16,107 13,185 ----------------------------------------------------------------------------- Total securities held-to-maturity $399,453 $432,977 $259,961 ----------------------------------------------------------------------------- B. The following tables present the carrying value of debt securities available-for-sale and held-to-maturity at December 31, 1993 maturing within stated periods with the weighted average interest yield from securities falling within the range of maturities: Debt Securities Available-for-Sale ---------------------------------------------------------- U. S. U. S. Mortgage- Government Agency Backed Other Debt Obligations Obligations Securities Securities Total ---------------------------------------------------------- (Dollars in Thousands) Due in 1 year or less: Amount $24,195 $12,193 $9 $1,000 $37,397 Yield 5.4% 5.8% 8.9% 6.0% 5.5% Due from 1 to 5 years: Amount 403,539 47,725 1,682 3,005 455,951 Yield 5.6% 4.0% 8.8% 5.3% 5.5% Due from 5 to 10 years: Amount 10,345 16,059 4,236 1,000 31,640 Yield 5.0% 5.5% 8.0% 7.5% 5.7% Due after 10 years: Amount - - 35,293 74 35,367 Yield - - 6.9% 18.7% 6.9% - -------------------------------------------------------------------------------- TOTAL: Amount $438,079 $75,977 $41,220 $5,079 $560,355 Yield 5.6% 4.6% 7.1% 6.5% 5.6% - -------------------------------------------------------------------------------- Securities Held-to-Maturity --------------------------------------------- U. S. Mortgage- Agency Backed Other Debt Obligations Securities Securities Total -------------------------------------------- (Dollars in Thousands) Due in 1 year or less: Amount $ $ $100,642 $100,642 Yield - - 6.5% 6.5% Due from 1 to 5 years: Amount - - 266,489 266,489 Yield - - 6.4% 6.4% Due from 5 to 10 years: Amount 2,575 - 4,308 6,883 Yield 8.4% - 9.1% 8.8% Due after 10 years: Amount - 25,136 303 25,439 Yield - 6.5% 8.0% 6.5% - ------------------------------------------------------------------------------- TOTAL: Amount $2,575 $25,136 $371,742 $399,453 Yield 8.4% 6.5% 6.5% 6.5% - -------------------------------------------------------------------------------- Yields on securities shown above represent the annual coupon income, net of amortization and accretion, divided by the carrying value of securities. C. The book and market values of other bonds and obligations of a single issuer exceeding 10% of stockholders' equity at December 31, 1993 were as follows: Market Issuer Book Value Value - -------------------------------------------------------------------- Ford Motor Company $34,200 $35,896 Sears Roebuck & Co. 30,010 31,873 There were no other marketable securities from a single issuer, excluding the U. S. Government or its agencies, exceeding 10% of stockholders' equity. III. LOAN PORTFOLIO A. The following table shows Bancorp's amount of loans by category as of the end of the reported period for the past five years ended December 31: Second mortgage and home equity lines of credit were reclassified from residential loans to consumer for the years prior to 1993 to conform to current classifications. The increases in total loans from December 31, 1990 to December 31, 1991 and December 31, 1991 to December 31, 1992 were primarily attributable to loans acquired as part of the acquisition of Sentry Savings Bank, FSB in 1991 and Attleboro Pawtucket Savings Bank in 1992. B. The following table shows the maturity distribution and interest rate sensitivity of selected loan categories at December 31, 1993: Maturity/Scheduled Payments -------------------------------------------- Within One to After one year five years five years Total --------- ----------- ---------- ------- (In Thousands) Loan Category - ------------- Commercial/commercial real estate $60,879 $75,662 $99,212 $235,753 Real estate - construction 6,806 1,638 12,253 20,697 ------- ------- --------- -------- $67,685 $77,300 $111,465 $256,450 ------- -------- --------- -------- The following table shows the amounts, included in the table above, which are due after one year and which have fixed interest rates and adjustable rates: Total Due After One Year --------------------------------- Fixed Adjustable Rate Rate Total ----------- ---------- --------- (In Thousands) Loan Category - ------------- Commercial/commercial real estate $13,452 $161,422 $174,874 Real estate - construction 12,382 1,509 13,891 ------- -------- -------- $25,834 $162,931 $188,765 ------- -------- -------- C.1. Nonperforming assets. (Dollars in Thousands)December 31, 1993 1992 1991 1990 1989 - ----------------------------------------------------------------------------- Nonaccrual loans $15,470 $28,495 $26,376 $28,349 $8,771 Loans 90 days or more delinquent and still accruing - - - - - Troubled debt restructurings $6,182 $10,064 $11,343 $9,491 - Real estate acquired by foreclosure or substantively repossessed $20,236 $25,834 $21,166 $14,677 $1,020 Percentage of nonaccrual loans to total loans 1.2% 2.1% 2.6% 3.1% 0.9% Percentage of nonaccrual loans and real estate acquired by foreclosure or substantively repossessed to total assets 1.5% 2.3% 2.7% 3.5% 0.8% Nonaccrual and restructured loans at December 31, 1993 had gross interest income of $1,254,000 and $352,000, respectively, that would have been recorded in 1993 if the loans had been current in accordance with their original terms and had been outstanding throughout the period or since origination. The amount of interest income included in net income from nonaccrual and restructured loans at December 31, 1993 totaled $392,000 and $169,000, respectively, for the year then ended. In-substance foreclosures totaling $2.4 million, $12.5 million, $10.0 million and $3.6 million at December 31,1993, 1992, 1991 and 1990, respectively, are included in real estate acquired by foreclosure or substantively repossessed. There were no in-substance foreclosures at December 31, 1989. It is the Bank's general policy to place loans on nonaccrual status when either principal or interest has not been received within 90 days of the loan's contractual due date and, thereafter, to characterize such loans interchangeably as both "nonaccrual" and "nonperforming." Other loans are placed on nonaccrual when there exists serious doubt as to their collectibility. C.2. At December 31, 1993 no material loans were excluded from the nonperforming categories reflected above where serious doubts existed at the time as to the ability of borrowers to comply with contractual terms. Management is continuing to monitor developments in the Bank's market area and will provide for future loan losses as necessary. C.3. Bancorp does not have any loans outstanding to foreign countries. C.4. Bancorp did not have a concentration of loans at December 31, 1993 where concentration is defined as exceeding 10% of total loans, which are not otherwise disclosed as a category under Item III A. The Bank's lending activities are conducted principally in Massachusetts and Rhode Island. The Bank grants single-family residential loans, commercial real estate loans, commercial loans and a variety of consumer loans. In addition, the Bank grants loans for the construction of residential homes, multi-family properties, commercial real estate properties and for land development. Most loans granted by the Bank are collateralized by real estate. D. Segregated Assets. As discussed in the Business Section above under the title "Acquisitions", the insured deposits and certain assets of Attleboro Pawtucket Savings Bank were acquired in 1992 from the FDIC. A key element of the APSB acquisition is the loss-sharing agreement with the FDIC. Under the agreement, the FDIC will, for a three-year period, absorb 80% of the net losses on all loans other than consumer loans. Because of this agreement, nonperforming assets covered by the agreement are classified as segregated assets and are shown on the consolidated balance sheets, net of allocated allowance for loan losses. Further information on segregated assets is contained in footnote 7 on page 53 of Bancorp's Annual Report to Stockholders attached as Exhibit 13 hereto. There are no other interest-bearing assets that would require to be disclosed under Item III C.1. or C.2. as of December 31, 1993. IV. SUMMARY OF LOAN LOSS EXPERIENCE Reference is hereby made to Bancorp's Annual Report to Stockholders for the year ended December 31, 1993 annexed as an exhibit hereto. The information required under IV.A. (Analysis of the Allowance for Loan Losses) for the five-year period ended December 31, 1993 is set forth on page 39 of such Annual Report and is incorporated herein by reference. In determining the amount to provide for loan losses, the key factor is the adequacy of the allowance for loan losses. The allowance is established, in part, as a result of an analysis of the risk elements of the various parts of the portfolio. The Bancorp's methodology for determining the adequacy of the allowance for loan losses is based on recurring evaluations of a number of factors, including the composition of the portfolio, historic loan loss experience for categories of loans, current and anticipated economic conditions, nonperforming loan levels and trends, specific credit reviews, and the results of regulatory examinations, as well as subjective factors. The review of the adequacy of the allowance for loan losses includes the general allowance on all loans in the loan portfolio based on percentages established for each loan category. The review also includes allocations applicable to nonaccrual loans or loans classified as substandard when the risk of loss is considered possible and overall loan performance indicates that an allowance is prudent. Nonaccrual and substandard loans are reviewed individually in order to determine whether an increase in the allowance for loan losses is necessary. The provision for loan losses in 1993 was $3.3 million compared to $6.2 million for 1992. Net charge-offs in 1993 totaled $8.1 million. During 1993 the Bancorp experienced a substantial decrease in nonperforming loans. This, coupled with the overall decrease in the loan portfolio, allowed the Bancorp to reduce its provision for loan losses and still maintain asset-quality ratios that were strong. Nonperforming loans decreased from $28.5 million at December 31, 1992 to $15.5 million at December 31, 1993, a 46% decrease. The commercial real estate component of nonperforming loans was reduced to $9.1 million at December 31, 1993, a decrease of 54% or $10.6 million from the same date last year. Nonperforming residential loans, which tend to have smaller balances and somewhat lower risk, also decreased by $2.1 million or 25% since December 31, 1992 and totaled $6.3 million at December 31, 1993. The allowance for loan losses at December 31, 1993 represented 2.24% of total loans compared to 2.55% at the same date last year and 191% of nonaccrual loans compared to 121% for those same dates, respectively. An analysis of the allocation of the allowance for loan losses is set forth on page 39 of the Annual Report to Stockholders for the year ended December 31, 1993 and is incorporated herein by reference. In 1993 management changed the method of allocation in order to better differentiate between the allocated and the unallocated portion of the allowance. Prior to 1993 the Company assigned all of the allowance, including an unallocated portion, to specific loan categories. The provision for loan losses for 1992 totaled $6.2 million compared to $9.5 million for 1991. The provision in 1992 was necessary due to the increase in the level of nonperforming loans during 1992, which totaled $28.5 million at December 31, 1992 compared to $26.4 million at December 31, 1991, and net charge-offs of $4.9 million during 1992. The increase in nonperforming loans from December 31, 1991 to December 31, 1992 occurred in spite of additional foreclosures and transfers of loans to in-substance foreclosed status. Increases in nonperforming loans occurred in all major categories. Nonperforming commercial real estate loans, residential real estate and consumer loans increased by $1.1 million, $908,000 and $294,000, respectively, while nonperforming commercial business loans decreased by $139,000. A significant factor in these increases relates to loans acquired as part of the Sentry and APSB acquisitions which have since become nonperforming. Loans which were acquired as part of the Sentry acquisition which have become nonperforming totaled $1.6 million and consumer loans not covered by the loss-sharing agreement with the FDIC from the APSB acquisition totaled $317,000. Allowances established at the time of the acquisitions reflect the increase in credit risk perceived in the acquired portfolios. The allowance for loans losses at December 31, 1992 represented 2.55% of the total loan portfolio compared to 1.64% at December 31, 1991 and 121.4% of nonaccrual loans compared to 64.4% for those same dates. Due to the acquisition in 1992, $18.0 million was added to the allowance for loan losses as the initial allowance on the loans acquired. The provision for loan losses for 1991 totaled $9.5 million compared to $10.7 million for 1990. The provision in 1991 was necessary due to the level of nonperforming loans during 1991, which totaled $26.4 million at December 31, 1991 compared to $28.3 million at December 31, 1990, and net charge-offs of $6.1 million during 1991. The decrease in nonperforming loans from December 31, 1990 to December 31, 1991 was the net result of charge-offs and the transfer of certain nonperforming loans to in-substance foreclosed status offset by loans becoming nonperforming in 1991. Nonperforming commercial real estate loans and residential real estate loans increased by $2.9 million and $374,000, respectively, while nonperforming commercial construction loans decreased by $4.6 million. The allowance for loans losses at December 31, 1991 represented 1.64% of the total loan portfolio and 64.4% of nonaccrual loans. Due to the acquisition in 1991, $4.2 million was added to the allowance for loan losses as the initial allowance on the loans acquired. As a result of the increase in delinquent loans, nonperforming loans, and foreclosures that were experienced during 1990, the allowance was substantially increased during 1990. Nonperforming loans totaled $28.3 million at December 31, 1990 compared to $8.8 million at December 31, 1989. The largest increase in nonperforming loans occurred in the commercial real estate loan category due to the addition of $13.2 million of loans that were performing in accordance with contractual terms but were perceived to have a collateral weakness. Nonperforming residential real estate loans also increased to $7.1 million at December 31, 1990 from $3.7 million at December 31, 1989. Loans charged off during 1990 totaled $7.6 million compared to $265,000 during 1989. The provision for loan losses for 1990 and 1989 totaled $10.7 and $4.4 million, respectively. The allowance represented 1.01% of the total loan portfolio and 33.1% of nonaccrual loans at December 31, 1990. The allowance for loan losses was also substantially increased during 1989 due to the increase in nonperforming loans and foreclosures and in response to the recessionary economic conditions and depressed real estate markets. The allowance for loan losses of $6.3 million at December 31, 1989 represented .66% of the total loan portfolio and 71.4% of nonaccrual loans. Net loan charge-offs during the year ended December 31, 1989 were $261,000 or .03% of average loans outstanding during 1989. The percentage mix of outstanding loans to total loans for the five years ended December 31, follows: 1993 1992 1991 1990 1989 ---- ---- ---- ---- ---- Residential 74.1% 70.5% 78.5% 79.5% 77.2% Commercial real estate 16.6 17.2 13.5 10.3 11.2 Commercial 1.3 2.6 .3 .1 .1 Consumer 6.5 7.7 6.8 6.5 6.0 Commercial construction .5 1.2 .6 3.2 4.9 Residential construction 1.0 .8 .3 .4 .6 ----- ----- ----- ----- ----- 100.0% 100.0% 100.0% 100.0% 100.0% ----- ----- ----- ------ ----- V. DEPOSITS In the following table, the average amount of deposits and average rate is shown for each of the years indicated. 1993 1992 1991 ----------------- ------------------ ---------------- Average Average Average Average Average Average Balance Rate Balance Rate Balance Rate ----------------- ------------------ ---------------- (Dollars in Thousands) NOW and super NOW $160,738 2.2% $123,742 3.2% $73,785 5.2% Demand (non- interest-bearing) 72,261 - 37,976 - 29,046 - Money market 498,653 3.0 390,317 4.0 262,845 5.8 Regular and special notice 387,105 2.7 313,404 3.5 176,711 5.3 Certificates of deposit 1,027,617 4.4 856,824 5.4 709,197 7.0 --------- ---------- --------- $2,146,374 $1,722,263 $l,251,584 --------- ---------- ---------- Bancorp has no foreign offices and no material deposits from outside of the United States. As of December 31, 1993, Bancorp had no negotiable rate time certificates of deposit in amounts of $100,000. As of December 31, 1993, six month and other time certificates of deposit in amounts of $100,000 or more had the following maturities: Over Over 3 months 3 to 6 6 to 12 Over 12 or less months months months Total -------------------------------------------------- (In Thousands) $27,160 $19,924 $18,267 $22,757 $88,108 VI. RETURN ON EQUITY AND ASSETS The following table reflects the return on average assets, return on average equity, dividend payout ratio, and average equity to average assets ratio for each of the years in the three-year period ended December 31. 1993 1992 1991 ---- ---- ---- Return on average assets 1.17% 1.42% .88% Return on average equity 11.91 12.88 6.42 Dividend payout ratio 31.90 25.77 42.38 Average equity to average assets ratio 9.80 11.04 13.65 VII. SHORT-TERM BORROWINGS During the years ended December 31, 1993, 1992 and 1991, Bancorp had no short-term borrowings Item 2.		Item 2. Properties The headquarters for Bancorp, as well as the main office for the Bank, are located at 174 Union Street, New Bedford, Massachusetts. The building is owned by the Bank. As of December 31, 1993, there were 51 additional offices, 34 of which were owned and 17 were under lease agreements. The offices are located in significant portions of southeastern Massachusetts, Cape Cod, and eastern Rhode Island. The properties occupied by the Bancorp and the Bank are considered to be in good condition and adequate for the purposes for which they are used. Item 3.	Item 3. Legal Proceedings There are no material pending legal proceedings to which the Bancorp is a party or to which any of its properties is subject. Item 4.	Item 4. Submission of Matters to a Vote of Security Holders None. PART II Item 5.	Item 5. Market for Bancorp's Common Stock and Related Stockholder Matters Reference is hereby made to Bancorp's Annual Report to Stockholders for the year ended December 31, 1993, attached as an exhibit hereto. The information set forth on page 66 of such Annual Report entitled "Common Stock" is incorporated herein by reference. Item 6.	Item 6. Selected Financial Data Reference is hereby made to Bancorp's Annual Report to Stockholders for the year ended December 31, 1993, attached as an exhibit hereto. The information set forth on page 31 of such Annual Report entitled "Selected Consolidated Financial Data" is incorporated herein by reference. Item 7.	Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Reference is hereby made to Bancorp's Annual Report to Stockholders for the year ended December 31, 1993, attached as an exhibit hereto. The information set forth on pages 32 through 41 of such Annual Report entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations" is incorporated herein by reference. Item 8.	Item 8. Financial Statements and Supplementary Data Reference is hereby made to Bancorp's Annual Report to Stockholders for the year ended December 31, 1993 attached as an exhibit hereto. The consolidated balance sheets at December 31, 1993 and 1992, and the consolidated statements of income, changes in stockholders' equity and cash flows for each of the years in the three-year period ended December 31, 1993 and the related notes with the report thereon of KPMG Peat Marwick, independent auditors, as of and for the years ended December 31, 1993, 1992 and 1991, which appear on pages 42 through 65 of such Annual Report to Stockholders, are incorporated herein by reference. The unaudited quarterly financial data set forth on page 64 of such Annual Report is incorporated herein by reference. 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 required by this Item appears under the headings "ELECTION OF A CLASS OF DIRECTORS (Item 1 on Proxy)" on pages 3 and 4, and "Executive Officers of the Company and the Bank" on page 6 of Bancorp's Definitive Proxy Statement dated March 30, 1994, which information is incorporated herein by reference. Item 11.	Item 11. Executive Compensation The information required by this Item appears under the heading "Compensation Committee Report on Executive Compensation" on pages 6 through 13 of Bancorp's Definitive Proxy Statement dated March 30, 1994, which information is incorporated herein by reference. Item 12.	Item 12. Security Ownership of Certain Beneficial Owners and Management The information required by this Item appears under the heading "ELECTION OF A CLASS OF DIRECTORS (Item 1 on Proxy)" appearing on pages 4 and 5 of Bancorp's Definitive Proxy Statement dated March 30, 1994, which information is incorporated herein by reference. Item 13.	Item 13. Certain Relationships and Related Transactions The information required by this Item appears under the heading "Certain Relationships and Related Transactions" on pages 14 and 15 of Bancorp's Definitive Proxy Statement dated March 30, 1994, which information is incorporated herein by reference. PART IV Item 14.	Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) 1. Financial Statements -------------------- Included in Part II of this report, incorporated by reference from the Annual Report to Stockholders: Independent Auditors' Report Consolidated Balance Sheets at December 31, 1993 and 1992 Consolidated Statements of Income for each of the years in the three-year period ended December 31, 1993 Consolidated Statements of Stockholders' Equity for each of the years in the three-year period ended December 31, 1993 Consolidated Statements of Cash Flows for each of the years in the three-year period ended December 31, 1993 Notes to Consolidated Financial Statements 2. Financial Statement Schedules ----------------------------- Schedules are omitted as they are either not material or not applicable. 3. Exhibits -------- (3) Articles of Incorporation and By-laws: ------------------------------------- (i) The Certificate of Incorporation of Bancorp is incorporated by reference to Appendix C to Bancorp's Registration Statement, registration number 33-20219, filed with the Securities and Exchange Commission on February 19, 1988. (ii) The By-laws of Bancorp are incorporated by reference to Exhibit 3.2 to Bancorp's Registration Statement, registration number 33-20219, on Form S-4. (4) Instruments Defining the Rights of Security Holders --------------------------------------------------- (a) The Certificate of Incorporation of Bancorp is incorporated by reference to Appendix C to Bancorp's Registration Statement, registration number 33-20219, filed with the Securities and Exchange Commission on February 19, 1988. (b) The By-laws of Bancorp are incorporated by reference to Exhibit 3.2 to Bancorp's Registration Statement, registration number 33-20219, on Form S-4. (c) Plan of Reorganization and Acquisition dated February 17, 1988 between Bancorp and the Bank is incorporated by reference to Appendix A to Bancorp's Registration Statement, registration number 33-20219 on Form S-4. (d) Bancorp's specimen certificate for shares of Common Stock is incorporated by reference to Exhibit 4(d) to Bancorp's 1988 Annual Report on Form 10-K. (e) Shareholder Rights Plan dated November 14, 1989 is incorporated by reference to Report on Form 8-K filing dated November 22, 1989. (10) Material Contracts ------------------ (a) Bancorp's Stock Option Plan is incorporated by reference to Appendix B to Bancorp's Registration Statement, registration number 33-28482, on Form S-8. (b) Taunton Savings Bank 1986 Incentive and Nonqualified Stock Option Plan is incorporated by reference to Appendix C to Bancorp's Registration Statement, registration number 33-28482 on Form S-8. (c) Amendment dated April 17, 1991 to the Employment Agreement between the Bancorp, the Bank, and Robert McCarter dated September 20, 1989 is incorporated by reference to Exhibit 10(c) to Bancorp's 1991 Annual Report on Form 10-K. (d) Employment Agreement between the Bancorp, the Bank, and Irving J. Goss dated December 22, 1992 incorporated by reference to Exhibit 10(l) to Bancorp's 1992 Annual Report on Form 10-K. (e) Amendment dated April 17, 1991 to the Executive Supplemental Retirement Agreement between the Bank and Robert McCarter dated September 4, 1986 is incorporated by reference to Exhibit 10(e) to Bancorp's 1991 Annual Report on Form 10-K. (f) Special Termination Agreement between the Bancorp, the Bank, and Robert McCarter dated October 31, 1989 is incorporated by reference to Exhibit 10(f) to Bancorp's 1989 Annual Report on Form 10-K. (g) Special Termination Agreement between the the Bank and Frederick D. Healey dated October 31, 1993 is attached as Exhibit 10(n) to this Annual Report on Form 10-K. (h) Special Termination Agreement between the Bank and Paul A. Lamoureux dated October 31, 1989 is incorporated by reference to Exhibit 10(h) to Bancorp's 1989 Annual Report on Form 10-K. (i) Special Termination Agreement between Bancorp, the Bank, and George J. Charette III dated October 31, 1989 is incorporated by reference to Exhibit 10(i) to Bancorp's 1989 Annual Report on Form 10-K. (j) Special Termination Agreement between the Bank and Gayle A. Johnston dated October 31, 1989 is incorporated by reference to Exhibit 10(j) to Bancorp's 1989 Annual Report on Form 10-K. (k) Special Termination Agreement between the Bank and William A. Flaherty dated October 31, 1989 is incorporated by reference to Exhibit 10(k) to Bancorp's 1989 Annual Report on Form 10-K. (l) Special Termination Agreement between Bancorp, the Bank, and Irving J. Goss dated December 22, 1992 incorporated by reference to Exhibit 10(m) to Bancorp's 1992 Annual Report on Form 10-K. (m) Purchase and Assumption Agreement between the Resolution Trust Corporation and the Bank dated July 26, 1991 is incorporated by reference to Exhibit 2.1 to Bancorp's Current Report on Form 8-K dated August 9, 1991. (n) Purchase and Assumption Agreement between the Federal Deposit Insurance Corporation and the Bank dated August 21, 1992 is incorporated by reference to Exhibit 2.1 to Bancorp's Current Report on Form 8-K dated September 4, 1992. (o) Agreement and Plan of Merger dated November 23, 1987 between the Bank and Taunton Savings Bank is incorporated by reference to Exhibit 10.11 to Bancorp's Registration Statement, registration number 33-20219, on Form S-4. (p) Agreement for the Purchase and Sale of Assets and Assumption of Liabilities between the Bank and the First National Bank of Boston is incorporated by reference to Bancorp's Registration Statement, registration number 33-20219, on Form S-4. (q) Salary Incentive Plan: A written description thereof is incorporated by reference to the Section headed "Performance Cash Incentive Plan" on pages 7 and 8 of Bancorp's Definitive Proxy Statement dated March 30, 1994. (11) Computation of Per Share Earnings: Computation of ---------------------------------- primary and fully diluted earnings per share is attached hereto as Exhibit 11 to this Annual Report on Form 10-K. (12) Statement re Computation of Ratios: Not applicable, as ----------------------------------- Bancorp does not have any debt securities registered under Section 12 of the Securities Exchange Act of 1934. (13) Annual Report to Security Holders: The Bancorp's 1993 ---------------------------------- Annual Report to Stockholders is attached hereto as Exhibit 13 to this Annual Report on Form 10-K. (16) Letter re Change in Certifying Accountant: None. ------------------------------------------ (18) Letter re Change in Accounting Principles: Not ------------------------------------------ applicable. (19) Previously Unfiled Documents: None. ----------------------------- (21) Subsidiaries of Registrant: A list of the subsidiaries -------------------------- of the Registrant is attached hereto as Exhibit 21 to this Annual Report on Form 10-K. (23) Consents of Experts and Counsel: -------------------------------- (b) Consent of KPMG Peat Marwick. (b) Reports on Form 8-K: -------------------- None (c) Index to Exhibits ----------------- Upon request directed to: NBB Bancorp, Inc., Stockholder Relations, Post Office Box 5000, New Bedford, Massachusetts 02742-5000, copies of the individual exhibits to this Annual Report on Form 10-K will be furnished upon payment of a reasonable fee. Exhibit 10(n) Special Termination Agreement Exhibit 11 Computation of Per Share Earnings Exhibit 13 Annual Report to Security Holders Exhibit 21 Subsidiaries of Registrant Exhibit 23(b) Consent of KPMG Peat Marwick re registration SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. NBB BANCORP, INC. Date: March 16, 1994 /s/ Robert McCarter ----------------------------------- Robert McCarter, President, Chief Executive Office and Chairman of the Board Date: March 16, 1994 /s/ Irving J. Goss ----------------------------------- Irving J. Goss, Senior Vice President, CFO and Treasurer (Principal Financial and Accounting Officer) Date: March 16, 1994 /s/ Alan Ades ----------------------------------- Alan Ades, Director Date: March 16, 1994 /s/ Maurice F. Downey ----------------------------------- Maurice F. Downey, Director Date: March 16, 1994 /s/John K. Stanton ----------------------------------- John K. Stanton, Director Date: March 16, 1994 /s/Charles T.Toomey ----------------------------------- Charles T. Toomey, Director Date: March 16, 1994 /s/Clifford H. Tuttle, Jr. ----------------------------------- Clifford H. Tuttle, Jr., Director Exhibit 10(n) - ------------- SPECIAL TERMINATION AGREEMENT ----------------------------- AGREEMENT made as of the 31st day of October 1993 between and among NBB Bancorp, Inc., a Delaware corporation (the "Company") and its subsidiary, New Bedford Institution for Savings, a Massachusetts savings bank with its main office in New Bedford, Massachusetts (the "Bank") (the Bank and the Company shall be hereinafter collectively referred to as the "Employers") and Frederick D. Healey, an individual presently serving in the position of Senior Vice President of the Bank (the "Executive"). WHEREAS, the Employers wish to provide the Executive with certain severance benefits under certain conditions as set forth herein. NOW, THEREFORE, in consideration of services performed and to be performed in the future as well as of the mutual promises and covenants herein contained, it is agreed as follows: 1.Purpose. In order to allow the Executive to consider the prospect of ------- a Change in Control (as defined in Section 2) in an objective manner and in consideration of the services rendered and to be rendered by the Executive to the Employers and other good and valuable consideration, the receipt and sufficiency of which is hereby acknowledged by the Employers, the Employers are willing to provide, subject to the terms of this Agreement, certain severance benefits to protect the Executive from the consequences of a Terminating Event (as defined in Section 3) occurring subsequent to a Change in Control. 2.Change in Control. A "Change in Control" shall be deemed to have ----------------- occurred in any of the following events: (i) if there has occurred a change in control which the Company would be required to report in response to Item 6(e) of Schedule 14A of the Rules and Regulations of the Securities and Exchange Commission promulgated under the Securities Exchange Act of 1934, as amended (the "1934 Act"), or, if such regulation is no longer in effect, any regulations promulgated by the Securities and Exchange Commission pursuant to the 1934 Act which are intended to serve similar purposes; or (ii) when any "person" (as such term is used in Sections 13(d) and 14(d)(2) of the 1934 Act) becomes a "beneficial owner" (as such term is defined in Rule 13d-3 promulgated under the 1934 Act), directly or indirectly, of securities of the Company or the Bank representing twenty-five percent (25%) or more of the total number of votes that may be cast for the election of directors of the Company or the Bank (other than in the case of the Bank, the Company's ownership of the capital stock of the Bank); or (iii) during any period of thirty consecutive months (not including any period prior to the execution of this Agreement), individuals who at the beginning of such period constitute the Board of Directors of the Company, and any new director whose election by the Board or nomination for election by the Company's stockholders was approved by a vote of at least two-thirds (2/3) of the directors then still in office who either were directors at the beginning of the period or whose election or nomination for election was previously so approved, cease for any reason, including without limitation as a result of a tender offer, proxy contest, merger or similar transaction, to constitute at least a majority of the Board of Directors of the Company; or (iv) the stockholders of the Company approve a merger or consolidation of the Company with any other corporation, other than a merger or consolidation which would result in the voting securities of the Company outstanding immediately prior thereto continuing to represent (either by remaining outstanding or by being converted into voting securities of the surviving entity) more than 50% of the combined voting power of the voting securities of the Company or such surviving entity outstanding immediately after such merger or consolidation; or (v) the stockholders of the Company approve a plan of complete liquidation of the Company or an agreement for the sale or disposition by the Company of all or substantially all of the Company's assets. 3.Terminating Event. A "Terminating Event" shall mean ----------------- (a) termination by either of the Employers of the employment of the Executive with either of the Employers for any reason, other than (i) death, (ii) deliberate dishonesty of the Executive with respect to either of the Employers or any subsidiary or affiliate thereof, or (iii) conviction of the Executive of a crime involving moral turpitude, or (b) resignation of the Executive from the employ of either of the Employers, subsequent to the occurrence of any of the following events: (i) a significant change in the nature or scope of the Executive's responsibilities, authorities, powers, functions or duties from the responsibilities, authorities, powers, functions or duties exercised by the Executive immediately prior to the Change in Control; or (ii) a determination by the Executive that, as a result of a Change in Control, he is unable to exercise the responsibilities, authorities, powers, functions or duties exercised by the Executive immediately prior to such Change in Control; or (iii) a reduction in the Executive's annual base salary as in effect on the date hereof or as the same may be increased from time to time; or (iv) the relocation of either of the Employers' offices at which the Executive is principally employed immediately prior to the date of the Change in Control to a location more than 25 miles from New Bedford, Massachusetts, or either of the Employers' requiring the Executive to be based anywhere other than the Employers' offices at such location; or (v) the failure by either of the Employers to pay to the Executive any portion of his current compensation or to pay to the Executive any portion of an installment of deferred compensation under any deferred compensation program of either of the Employers within seven (7) days of the date such compensation is due; or (vi) the failure by either of the Employers to continue in effect any material compensation, incentive, bonus or benefit plan in which the Executive participates immediately prior to the Change in Control, unless an equitable arrangement (embodied in an ongoing substitute or alternative plan) has been made with respect to such plan, or the failure by either of the Employers to continue the Executive's participation therein (or in such substitute or alternative plan) on a basis not materially less favorable, both in terms of the amount of benefits provided and the level of the Executive's participation relative to other participants, as existed at the time of the Change in Control; or (vii) the failure by either of the Employers to continue to provide the Executive with benefits substantially similar to those available to the Executive under any of either of the Employers' life insurance, medical, health and accident, or disability plans or any other material benefit plans in which the Executive was participating at the time of the Change in Control, the taking of any action by either of the Employers which would directly or indirectly materially reduce any of such benefits, or the failure by either of the Employers to provide the Executive with the number of paid vacation days to which the Executive is entitled on the basis of years of service with either of the Employers in accordance with their normal vacation policy in effect at the time of the Change in Control; or (viii) the failure of the Employers to obtain a satisfactory agreement from any successor to assume and agree to perform this Agreement. 4. Severance Payment. Subject to the provisions of Section 5 below, ----------------- in the event a Terminating Event occurs within three (3) years after a Change in Control, the Employers shall pay to the Executive an aggregate amount equal to (x) three times the "base amount" (as defined in Section 280G(b)(3) of the Internal Revenue Code of 1986, as amended (the "Code")) applicable to the Executive, less (y) One Dollar ($1.00), payable in one lump-sum payment on the date of such termination or resignation. 5. Limitation on Benefits. ---------------------- (a) It is the intention of the Executive and of the Employers that no payments by the Employers to or for the benefit of the Executive under this Agreement when combined with any other payments under any other agreement or plan pursuant to which the Executive is entitled to receive payments or benefits shall be non-deductible to either Employer which is to pay such amount by reason of the operation of Section 280G of the Code or any successor provision relating to parachute payments. Accordingly, and notwithstanding any other provision of this Agreement or any such agreement or plan, if by reason of the operation of said Section 280G, any such payments exceed the amount which can be deducted by either Employer, the payments made pursuant to this Agreement shall be reduced to the maximum amount which can be deducted by the Employers. To the extent that payments exceeding such maximum deductible amount have been made pursuant to this Agreement to or for the benefit of the Executive, such excess payments shall be refunded to the Employers with interest thereon at the applicable Federal Rate determined under Section 1274(d) of the Code, compounded annually, or at such other rate as may be required in order that no such payments shall be non-deductible to the Employers by reason of the operation of said Section 280G. To the extent that there is more than one method of reducing the payments to bring them within the limitations of said Section 280G, the Executive shall determine which method shall be followed, provided that if the Executive fails to make such determination within forty-five days after the Employers have sent the Executive written notice of the need for such reduction, the Employers may determine the method of such reduction in its sole discretion. (b) If any dispute between the Employers and the Executive as to any of the amounts to be determined under this Section 5, or the method of calculating such amounts, cannot be resolved by the Employers and the Executive, either the Employers or the Executive after giving three days' written notice to the other, may refer the dispute to a partner in the Boston office of a firm of independent certified public accountants selected jointly by the Employers and the Executive. The determination of such partner as to the amount to be determined under Section 5(a) and the method of calculating such amounts shall be final and binding on both the Employers and the Executive. The Employers shall pay, as they are incurred, the costs of any such determination. 6. Employment Status. This Agreement is not an agreement for the ----------------- employment of the Executive and shall confer no rights on the Executive except as herein expressly provided. 7. Term. This Agreement shall take effect on the day first above ---- written, and shall terminate upon the earlier of (a) the termination by the Employers of the employment of the Executive because of death, deliberate dishonesty of the Executive with respect to either of the Employers or any subsidiary or affiliate thereof, or conviction of the Executive of a crime involving moral turpitude, (b) the resignation or termination of the Executive for any reason prior to a Change in Control, or (c) the resignation of the Executive after a Change in Control for any reason other than the occurrence of any of the events enumerated in Section 3(b)(i)-(viii) of this Agreement. 8. Withholding. All payments made by either of the Employers under ----------- this Agreement shall be net of any tax or other amounts required to be withheld by either of the Employers under applicable law. 9. Arbitration of Disputes. Any controversy or claim arising out of ----------------------- or relating to this Agreement or the breach thereof shall be settled by arbitration in accordance with the laws of the Commonwealth of Massachusetts by three arbitrators, one of whom shall be appointed by the Employers, one by the Executive and the third by the first two arbitrators. If the first two arbitrators cannot agree on the appointment of a third arbitrator, then the third arbitrator shall be appointed by the American Arbitration Association in the City of Boston. Such arbitration shall be conducted in the City of Boston in accordance with the rules of the American Arbitration Association, except with respect to the selection of arbitrators which shall be as provided in this Section 9. Judgment upon the award rendered by the arbitrators may be entered in any court having jurisdiction thereof. In the event that it shall be necessary or desirable for the Executive to retain legal counsel and/or incur other costs and expenses in connection with the enforcement of any or all of the Executive's rights under this Agreement, the Employers shall pay, as they are incurred, the Executive's reasonable attorneys' fees and other reasonable costs and expenses in connection with the enforcement of said rights (including the enforcement of any arbitration award in court) regardless of the final outcome, unless and to the extent the arbitrators shall determine that under the circumstances recovery by the Executive of all or a part of any such fees and costs and expenses would be unjust. This arbitration provision shall not be used for matters of the type referred to in Section 5(b), except to settle the selection of the accounting partner described in said Section in the event that the Employers and the Executive cannot agree on the selection. 10. Assignment. Neither the Employers nor the Executive may make any ---------- assignment of this Agreement or any interest herein, by operation of law or otherwise, without the prior written consent of the other party. This Agreement shall inure to the benefit of and be binding upon the Employers and the Executive, their respective successors, executors, administrators, heirs and permitted assigns. In the event of the Executive's death prior to the payment by the Employers of all payments due to the Executive under this Agreement, the Employers shall make such payments to the Executive's beneficiary designated in writing to the Employers prior to his death (or to his estate, if the Executive fails to make such designation). 11. Enforceability. If any portion or provision of this Agreement -------------- shall to any extent be declared illegal or unenforceable by a court of competent jurisdiction, then the remainder of this Agreement, or the application of such portion or provision in circumstances other than those as to which it is so declared illegal or unenforceable, shall not be affected thereby, and each portion and provision of this Agreement shall be valid and enforceable to the fullest extent permitted by law. 12. Waiver. No waiver of any provision hereof shall be effective ------ unless made in writing and signed by the waiving party. The failure of any party to require the performance of any term or obligation of this Agreement, or the waiver by any party of any breach of this Agreement, shall not prevent any subsequent enforcement of such term or obligation or be deemed a waiver of any subsequent breach. 13. Notices. Any notices, requests, demands and other communications ------- provided for by this Agreement shall be sufficient if in writing and delivered in person or sent by registered or certified mail, postage prepaid, to the Executive at the last address the Executive has filed in writing with the Employers or, in the case of the Bank, at its main office, attention of the Clerk or, in the case of the Company, at its main office, attention of the Secretary. 14. Election of Remedies. An election by the Executive to resign -------------------- after a Change in Control under the provisions of this Agreement shall not constitute a breach by the Executive of any employment agreement between the Employers and the Executive or a breach of any of the Executive's obligations as an employee of the Employers. Nothing in this Agreement shall be construed to limit the rights of the Executive under any employment agreement he may then have with the Employers. 15. Amendment. This Agreement may be amended or modified only by a --------- written instrument signed by the Executive and by a duly authorized representative of each of the Employers. 16. Allocation of Obligations Between Employers. The obligations of ------------------------------------------- the Employers under this Agreement are intended to be the joint and several obligations of the Bank and the Company and the Employers shall, as between themselves, allocate these obligations in a manner agreed upon by them. 17. Governing Law. This is a Massachusetts contract and shall be ------------- construed under and be governed in all respects by the laws of the Commonwealth of Massachusetts. 18. Special Provisions Relating to Regulatory Matters. -------------------------------------------------- Notwithstanding anything to the contrary elsewhere herein contained: (a) If the Executive is suspended and/or temporarily prohibited from participating in the conduct of the Bank's affairs by a notice served under Section 8(e)(3) of the Federal Deposit Insurance Act or Section 12A of Chapter 167 of the Massachusetts General Laws, the Employers' obligations under this Agreement shall be suspended as of the date of service, unless stayed by appropriate proceedings. If the charges in the notice are dismissed, the Bank may in its discretion (i) pay the Executive all or part of the compensation withheld while its contract obligations were suspended and (ii) reinstate (in whole or in part) any of its obligations which were suspended. (b) If the Executive is removed and/or permanently prohibited from participating in the conduct of the Bank's affairs by an order issued under Section 8(e)(1) or (2) of the Federal Deposit Insurance Act and/or Section 12 of Chapter 167 of the Massachusetts General Laws, all obligations of the Employers under this Agreement shall terminate as of the effective date of the order. (c) All obligations under this Agreement shall be terminated, (i) in the event that the Federal Deposit Insurance Corporation (the "FDIC") is appointed as a conservator or receiver of the Bank pursuant to the provisions of Section 11 of the Federal Deposit Insurance Act, as amended, or (ii) in the event that the Commissioner of Banks, Commonwealth of Massachusetts, takes possession of the Bank under the provisions of Section 22 of Massachusetts General Laws, Chapter 167. (d) No payments will be made under this Agreement if such payments are prohibited by the FDIC either by regulation or order. To the extent that the Bank is prohibited from paying the amounts but the Holding Company would be able to pay, the payments will be made by the Holding Company. IN WITNESS WHEREOF, this Agreement has been executed as a sealed instrument by the Employers, by their duly authorized officers, and by the Executive, as of the date first above written. ATTEST: NBB BANCORP, INC. /s/ CAROL E. CORREIA By: /s/ ROBERT McCARTER - --------------------------- ------------------------------- Carol E. Correia, Secretary Title:CHAIRMAN, PRESIDENT, AND CEO ---------------------------- ATTEST: NEW BEDFORD INSTITUTION FOR SAVINGS /s/ CAROL E. CORREIA By: /s/ ROBERT McCARTER - -------------------------- ------------------------------- Carol E. Correia, Clerk Title:CHAIRMAN, PRESIDENT, AND CEO ---------------------------- WITNESS: /s/ IRVING J. GOSS /s/ IRVING J. GOSS - -------------------------- ---------------------------------- Exhibit 11 - ---------- COMPUTATION OF PRIMARY AND FULLY DILUTED EARNINGS PER SHARE For the Year Ended December 31, 1993 (Dollars in thousands except per share amounts) The information below is presented to comply with Regulation S-K Item 601. The computation is not used or required in the consolidated statements of income as its dilutive effect on simple earnings per share is less than 3%. Primary EPS Fully Diluted EPS ----------- ----------------- Weighted average shares 8,615,399 8,615,399 Common Stock Equivalents (CSE) Stock options 142,753 142,753 ---------- ---------- Primary weighted average shares 8,758,152 8,758,152 ---------- Additional CSE 20,656 ---------- Fully diluted weighted average shares 8,778,808 ---------- Net Income $ 28,092 $ 28,092 ---------- ---------- Earnings Per Share $ 3.21 $ 3.20 ---------- ---------- Exhibit 21 Subsidiaries of Bancorp - ---------- ----------------------- Bancorp has one subsidiary, New Bedford Institution for Savings, which is incorporated in the Commonwealth of Massachusetts. New Bedford Institution for Savings is the name under which the subsidiary does business. Exhibit 23(b) - ------------- To the Board of Directors and Stockholders of NBB Bancorp, Inc.: We consent to the incorporation by reference in the registration statement (No. 33-28482) on Form S-8 of NBB Bancorp, Inc. of our report dated January 19, 1994, relating to the consolidated balance sheets of NBB Bancorp, Inc. and subsidiary as of December 31, 1993 and 1992, and the related consolidated statements of income, stockholders' equity and cash flows for each of the years in the three-year period ended December 31, 1993, which report is incorporated by reference in the December 31, 1993 annual report on Form 10-K of NBB Bancorp, Inc. KPMG PEAT MARWICK Providence, Rhode Island March 23, 1994 Exhibit 13 Selected Consolidated Financial Data The following consolidated financial information for Bancorp does not purport to be complete and is qualified in its entirety by the more detailed information contained elsewhere herein. Management's Discussion and Analysis of Financial Condition and Results of Operations OVERVIEW Income from operations in 1993 was $28.1 million, 23% greater than the $22.9 million earned in 1992. The significant increase in operating results was due primarily to the combination of a low interest rate environment, a reflection of the low inflation rate and the slow economic recovery, the reduction in nonperforming loans and overall improvement in asset quality. In the first quarter of 1992, the Company recognized a nonrecurring after- tax gain of $5.0 million from the implementation of Statement of Financial Accounting Standards (SFAS)No. 109 which resulted in net income of $27.9 million that year. Income from operations and net income were the same in 1993. The net interest margin in 1993 was 4.24%, a 21 basis point increase from 1992. At the same time, average earning assets increased $426 million, reflecting the full year impact of the acquisition of the Attleboro Pawtucket Savings Bank (APSB) in August of 1992. Provisions for loan losses were reduced from $6.2 million in 1992 to $3.3 million in 1993 due to improved asset quality, as evidenced by a 35% decrease in nonperforming assets during the year. Non-interest income, which also reflected the impact of the APSB acquisition for a full year, increased from $10.6 million to $11.3 million, despite a decrease of $1.5 million in securities gains. Operating expenses were significantly higher as a result of the larger branch network and certain nonrecurring expenses associated with the acquisition, such as branch consolidations and centralization of several services and functions. OREO expense increased by $3.7 million due to increased sales efforts to reduce the amount and number of properties held and the continuing weakness in the southeastern New England real estate market. During 1993, Data Management Systems, Inc. (DMS), a 45% owned subsidiary of NBIS, sold the item processing portion of its business, which resulted in an after-tax gain of $540 thousand in NBB's 1993 earnings. Attleboro Pawtucket Acquisition In August 1992, NBIS acquired the insured deposits and certain assets of APSB from the FDIC. The acquisition was a significant event for the corporation, both in terms of size and geographic expansion. Total assets grew by 35% and branch offices by 50%, including the first NBIS offices in Rhode Island. Because the former APSB was owned for less than five months in 1992, the acquisition will have a significant impact on comparisons between 1992 and 1993. A key element of the APSB acquisition is the loss-sharing agreement with the FDIC. Under the agreement, the FDIC will, for a three-year period, absorb 80% of the net losses on all loans other than consumer loans. Because of this agreement, nonperforming assets covered by the agreement are classified as segregated assets and are shown on the consolidated balance sheets, net of allocated allowance for loan losses. Further information on this acquisition is contained in footnote 7 on page 53. Sections below on Asset Quality and Segregated Assets provide further information on the risk elements of the acquired portfolio. Net Interest Income Net interest income is the difference between interest and fees earned on the Bank's loan and investment portfolios and the interest paid on deposits and borrowed funds. The following discussion, and all related data, is presented on a fully taxable equivalent basis (FTE), which presents interest income on tax-exempt loans and securities as if they were taxed at statutory rates. An increase of $21.9 million in net interest income, 29% above 1992's level, was due to an acquisition-related increase of $426 million in average earning assets and a net interest margin that was 21 basis points above the previous year. The increase in the margin was the result of greater spreads, as the Bank's large base of core deposits repriced more quickly in the falling rate environment of 1993 than did the fixed rate mortgages that are a substantial part of the Bank's portfolio. The Bank continued in 1993 to closely monitor its deposit pricing and aggressively reduce costs, consistent with the rate environment and the need to remain competitive. The Bank's strategy of retaining mortgage loans in its portfolio and its large base of core deposits result in an interest rate sensitivity GAP in which interest-sensitive liabilities exceed interest-sensitive assets by approximately 16% within a one-year time horizon. This resulted in a favorable impact on net interest income in the rate environment experienced in 1993, but contains some risk in a rising rate environment. A discussion of asset/liability management follows under the Financial Condition section. In analyzing the net interest margin, another important factor is the change in the balance sheet mix. The ratio of loans to total earning assets has been impacted by a number of circumstances in recent years, including the severity of the recession in southeastern New England which has hampered loan growth. However, NBIS' ratio has also been affected by acquisitions. In particular, the nature of the loss-sharing agreement with the FDIC is such that there is a natural attrition of loans, either to segregated assets in the case of nonperforming loans, or out of NBIS in the case of loans that mature and are not renewed for reasons of risk control or avoiding industry concentrations. As a result, the ratio of loans to earning assets averaged 58% in 1993 compared to 62% in 1992. While disappointing, the rate of decrease in the ratio of average loans had slowed since 1991 when the average was 71%. This change in the balance sheet mix, combined with the relatively short-term maturity and duration of the securities portfolio results in lower average yields on earning assets than would have been achieved if there had been a greater concentration of loans. The following table presents an analysis of average balances of interest-earning assets and interest-bearing liabilities, income and yields earned, and interest and rates paid: (1) Nonaccrual loans are included in the average loan balances. The variances due to rate in the table below include the effect of such loans because no interest or less than contractual rates are earned on such loans. (2) Includes mortgagors' escrow payments. (3) Represents the weighted average yield on all interest-earning assets during the period less the weighted average rate paid on all interest-bearing liabilities. (4) Determined by dividing net interest income by total interest-earning assets. Rate/Volume Analysis The following table shows the change in interest and dividend income, and interest expense, for each major category of interest-earning assets and interest-bearing liabilities. The amount of the change due to volume and rate has been allocated proportionately to volume and rate for the years indicated. Provision for Loan Losses The provision for loan losses in 1993 was $3.3 million, a $2.9 million decrease from the amount provided in 1992. In determining the amount to provide for loan losses, the key factor is the adequacy of the allowance for loan losses. In making the decision, management considers a number of factors, including prior experience relative to the loan portfolio mix, economic conditions, especially regional economic trends, internal analysis, and the results of examinations conducted by bank regulatory authorities. During 1993 the bank experienced a substantial decrease in nonperforming loans. This, coupled with the overall decrease in the loan portfolio, allowed the Company to reduce its provision for loan losses and still maintain asset-quality ratios that were strong, reflecting the risk inherent in a slow economic recovery. The fact that a relatively large portion of the portfolio had been acquired created an additional consideration in determining the allowance level. At December 31, 1993, the allowance for loan losses was $29.6 million or 2.24% of total loans compared to $34.6 million or 2.55% of total loans at December 31, 1992. Nonperforming loans at December 31st represented 1.17% and 2.10% of the portfolio in 1993 and 1992, respectively. Non-Interest Income An analysis of non-interest income is presented below: - -------------------------------------------------------------------------------- (In Thousands) .......................... 1993 1992 1991 Deposit related fees .................... $ 5,210 $ 3,445 $ 2,461 Mortgage-servicing ...................... 670 301 94 Gain on sales of securities ............. 3,859 5,377 9,647 Acquisition-related settlement items ..................... -- 428 860 Gain on sales of OREO ................... 468 5 2 Rental income from non-bank real estate ................. 312 188 186 Other ................................... 809 817 422 - -------------------------------------------------------------------------------- $11,328 $10,561 $13,672 ================================================================================ Excluding securities gains, non-interest income increased 44% from 1992 to 1993. A significant portion of this gain was due to the full-year impact of the APSB acquisition. However, an increase in deposits, as well as an increase in charges for certain services, contributed to the $1.8 million or 51% increase in deposit-related fees. Another factor in the increase from 1992 to 1993 was greater activity in the sale of OREO property, which resulted in a $463 thousand increase in non-interest income. Mortgage servicing revenue increased due to the fact that APSB had a significantly larger servicing portfolio than did NBIS. Securities gains were $1.5 million less in 1993 than they were in 1992, reflecting a somewhat more stable rate environment, as well as the fact that most of the repositioning required by the acquisitions had been accomplished prior to 1993. Operating Expenses An analysis of operating expenses is presented below: - ------------------------------------------------------------------------------ (Dollars In Thousand) Years ended December 31, 1993 1992 1991 Compensation: Salaries $16,387 $11,128 $ 8,466 Benefits 4,962 3,809 2,926 Temporary Help 523 1,635 137 - ------------------------------------------------------------------------------ Subtotal 21,872 16,572 11,529 - ------------------------------------------------------------------------------ Occupancy and equipment 5,717 4,357 3,259 Deposit insurance 4,879 3,505 2,241 Data processing 3,189 2,341 1,856 Amortization of goodwill and other intangibles 3,171 2,521 1,628 Office supplies, postage and telephone 2,212 1,294 1,047 Banking fees 1,652 1,088 717 Credit and collection fees 982 689 486 Other professional fees 811 793 448 Advertising and marketing 810 593 483 Legal and accounting fees 797 610 653 Insurance 791 617 456 Contributions 218 162 77 Other 1,861 1,078 621 - ------------------------------------------------------------------------------ Total $48,962 $36,220 $25,501 ============================================================================== Overhead/Average Assets 2.03% 1.84% 1.73% ============================================================================== Staff (full time equivalents) Regular 580 559 382 Temporary 8 47 35 - ------------------------------------------------------------------------------ Total 588 606 417 ============================================================================== Branches 52 56 39 ============================================================================== Operating expenses increased $12.7 million to $49.0 million. In addition to the anticipated impact of a full year of APSB operating expenses, 1993's expenses were affected by costs associated with several nonrecurring items, including the finalization of some outstanding issues with the FDIC relative to the APSB branch offices, closing of four branches, consolidation of NBIS' loan servicing functions at one site, and upgrading communications and loan processing systems. In total, these nonrecurring items account for approximately $750 thousand of expenses in 1993. In addition, some duplicative expenses were incurred until the consolidation of data processing systems was completed during the first quarter of 1993. As a result, the ratio of operating expenses to average assets increased from 1.84% to 2.03% for the year. However, excluding nonrecurring expenses, that ratio had been reduced to 1.94% for the fourth quarter of 1993, an indication that the Company was returning to more normal expense levels after absorbing the impact of growth through acquisitions in the last several years. Compensation, including temporary help, increased by $5.3 million, clearly the result of the APSB acquisition. Because former APSB employees were initially hired as temporary employees through a third party, a common occurrence in these transactions, this category must be combined with salaries and benefits in any analysis of overhead at NBB during this period. Thus, the decrease of $1.1 million in temporary help is offset by some additional compensation. However, as can be seen from the table above, total employee count, including temporary employees, has been reduced since 1992. In addition to compensation expense, increases in deposit insurance, data processing, amortization of intangibles, banking fees, credit and collection, legal and accounting, and advertising and marketing all reflect the increased size and complexity of the organization. Marketing expenses increased 37% as a result of both the expansion of the franchise geographically, as well as a recognition of the need to expand our marketing efforts in view of increased competition for both loans and deposits. NBIS' effort to control and reduce nonperforming assets resulted in an increase of $293 thousand in credit and collection expense. In addition, while the Company strongly believes that the loss-sharing process is one that benefits both the banks and the regulators, there are certain costs to administering these transactions, which is reflected to some extent in increased overhead, especially in compensation and professional fees. Other Expense OREO consists of properties acquired through foreclosure or substantively foreclosed, as well as an investment in a condominium project from a previous acquisition. OREO expense increased from $1.6 million in 1992 to $5.3 million in 1993. Of the $5.3 million in OREO expense, $3.7 million was due to provisions, while $1.6 million represented operating costs. The increase in OREO expense reflects both the continuing softness in the southeastern New England real estate market and the effort made by the Company to aggressively sell OREO properties. At December 31, 1993, the balance of OREO property was $21.2 million, a decrease of $7.1 million or 25% from the level at December 31, 1992. The Company owns 45% of DMS, a data processing company located in Hyannis, Massachusetts. During 1993, DMS sold a portion of its business, item processing, to another company. The after-tax gain from this sale was approximately $540 thousand which is included in the $519 thousand of equity in loss (income) of unconsolidated subsidiary. Income Tax Expense The fully taxable equivalent rate of 44.8% in 1993 was slightly above the 44.2% rate in 1992, reflecting changes in federal and state tax laws. The effect of the $5.0 million benefit that resulted from the adoption of SFAS No.109, "Accounting for Income Taxes," in 1992 is not reflected in the 1992 percentage. 1992 Results Compared to 1991 Income from operations in 1992 was $22.9 million, a 78% increase over the $12.9 million earned in 1991. In addition to the benefit derived from the regulatory assisted acquisitions of APSB in August 1992 and Sentry Savings Bank (Sentry) in July 1991, operating results were favorably impacted by a 50 basis point increase in the net interest margin, as the Bank's large base of core deposits repriced more quickly in the falling rate environment than did the fixed rate mortgage loans that make up a substantial part of the Bank's portfolio. Net income in 1992 was $27.9 million as a result of the previously mentioned implementation of SFAS No. 109. During 1992 the Bank benefited from having a full year of results from the Sentry acquisition, as well as more than four months of operations which included APSB. As a result, average earning assets increased $482 million compared to 1991. The Bank's loss-sharing agreement with the FDIC is an important element of the APSB acquisition and is discussed in greater detail in footnote 7 on page 53. The provision for loan losses at $6.2 million in 1992 was $3.3 million lower than in 1991 as significant improvement in asset quality ratios, due to acquisition-related allowances, and improved performance and stability in several major problem credits allowed the Bank to lower the provision while maintaining an adequate allowance. A 29% increase in other income, excluding securities gains, was due to the increased size and activity that resulted from the acquisitions. Increases in deposit-related fees ($1.0 million) and mortgage servicing income ($207 thousand) accounted for the gain. Operating expenses increased $10.7 million or 42% as a result of the expanded operation. Certain of the expenses were nonrecurring or duplicative in nature since systems conversions and resolution of issues with the FDIC on APSB were not finalized until 1993. OREO expense was lower in 1992 than 1991, $1.6 million compared to $4.7 million, as the real estate market began to stabilize. However, total OREO properties increased from $24.0 million to $28.3 million, as the effect of the recession continued to be felt in southeastern Massachusetts. Nonperforming loans also increased $2.1 million, due in part to the nature of the Sentry acquisition, where the Bank received a discount on loans acquired, but agreed to take the risk should they become nonperforming. Management feels that the results since that acquisition indicate that the combination of discount and the allowance established have allowed for adequate returns and protection for the risks. Financial Condition Total assets increased by $102 million to $2.5 billion, while deposits grew by $75 million to $2.2 billion as the Company continued to take advantage of the increase in size and geographic diversity that resulted from acquisitions made in 1991 and 1992. The lack of loan demand, the previously anticipated runoff of shared-loss assets from the APSB acquisition and the substantial improvement in nonperforming assets resulted in a very strong, highly liquid balance sheet as of December 31, 1993. An analysis of the components of earning assets as a percentage of total earning assets follows: (In Thousands) December 31, 1993 1992 1991 Federal funds sold and overnight deposits 0.5% 0.8% 1.2% Securities available-for-sale 25.4 18.7 18.7 Securities held-to-maturity 17.2 19.5 16.5 Loans, net 56.9 61.0 63.6 - ----------------------------------------------------------------------- Total 100.0% 100.0% 100.0% ======================================================================= Total securities increased $139 million and comprised 43% of earning assets at December 31, 1993 compared to 38% at December 31, 1992. The Company adopted SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," as of December 31, 1993. In conjunction with this, the Company reevaluated the classification of its securities with the result that securities available for sale now total $588 million or 60% of securities compared to $416 million or 49% of securities as of December 31, 1992. For additional discussion of SFAS No.115, see footnote 1 on page 46. Securities available for sale provide liquidity, facilitate interest rate sensitivity management, and enhance the Bank's ability to respond to customers' needs should loan demand increase and/or deposit growth slow. Securities held-to-maturity, which totaled $399 million or 40% of securities at December 31, 1993, are those securities which the Company has the positive intent and ability to hold to maturity. Except in a limited number of specific circumstances, SFASNo. 115 does not allow for the transfer or sale of securities classified as held-to-maturity. Additional information on securities can be found in footnote 2 on page 49. Loans Total loans, as well as loans as a percentage of earning assets, decreased during the year. This was due in large part to the dynamics of the APSB portfolio. Since the acquisition of APSB, there has been an inherent loss of loans outstanding which impacts the overall potential for loan growth at NBIS. Former APSB loans which become nonperforming are reclassified as segregated assets until they are resolved, thus immediately reducing the appropriate loan category. In addition, APSB was lending to certain lines of business which NBIS had chosen not to enter, or, in some cases, to reduce total exposure, which meant that certain segments of the portfolio were intentionally not being replaced. These circumstances, coupled with slow economic recovery, have resulted in a decrease in loans outstanding that was greater than might be expected under normal conditions. The change in the loan portfolio as a result of the APSB acquisition and the impact of the factors mentioned above can be most clearly seen in the schedule below which shows the composition of the portfolio at December 31st for the last three years. An analysis of the loan portfolio's composition as of December 31 follows: - -------------------------------------------------------------------------------- 1993 1992 1991 Residential loans 74.1% 70.5% 78.5% Commercial real estate loans 16.6 17.2 13.5 Consumer loans 6.5 7.7 6.8 Construction loans, net of unadvanced loan proceeds 1.5 2.0 .9 Commercial loans 1.3 2.6 .3 - -------------------------------------------------------------------------------- Total 100.0% 100.0% 100.0% ================================================================================ As seen above, the Company had a substantial increase in its commercial/commercial real estate and consumer loan portfolios as a result of the APSB acquisition in 1992. The commercial/commercial real estate portfolio, in particular, decreased during 1993 for the reasons mentioned above. That, along with the decrease in the consumer portfolio, was partially offset by a $26 million increase in residential lending. The Company remains committed to maintaining a commercial lending presence in our marketplace, but it will be difficult to show a net increase in that portfolio until the runoff of the higher risk elements in the APSB portfolio is absorbed. The increase in residential mortgages can be attributed to the continuation of the low interest rate environment, an aggressive marketing campaign, and NBIS' reputation as a high quality, local servicer of loans. Asset Quality As previously mentioned, an important aspect of the acquisition of APSB was the loss-sharing agreement between the FDIC and NBIS. Because of some of the unique elements of this agreement as it pertains to asset quality, there are two parts to the discussion of asset quality. The first pertains to NBIS and includes, where applicable, performing loans from that portfolio and related reserves. It excludes, however, any APSB nonperforming loans covered by the loss-sharing agreement. As a result of this, certain ratios related to nonperforming assets and loans have been favorably impacted. APSB nonperforming loans which fall under the loss-sharing agreement have been designated as Segregated Assets throughout the consolidated financial statements and are, along with associated allowances, charge-offs and recoveries, discussed separately under that caption. Because of the structure of the agreement, there have been very few APSB nonperforming assets that were not covered by the agreement ($38 thousand as of December 31, 1993), so for discussion purposes the term "shared-loss" will not be used when discussing APSB nonperforming loans or segregated assets. Under the terms of the loss-sharing agreement, the FDIC reimburses NBIS for 80% of any losses, net of recoveries, associated with any commercial, commercial real estate, residential mortgage and home equity loans that occur during the three years following the acquisition. Effectively, only consumer loans are excluded from the loss sharing. The agreement also provides for the reimbursement of carrying costs on nonperforming assets at a previously agreed upon rate of interest, as well as 80% of direct collection costs for nonperforming assets. During the fourth and fifth years following the acquisition, the Bank will pay to the FDIC an amount equal to 80% of the gross amount of recoveries during such period which pertain to amounts charged-off during the three years following the acquisition. If at the end of the five year period, total net charge-offs exceed $49 million, the FDIC will pay the Bank an amount equal to 15% of the difference between net charge-offs and $49 million. Through December 31, 1993, net charge-offs amounted to $7.9 million. Nonperforming Assets Nonperforming assets decreased 35% to $36.7 million, the lowest year-end level since December 31, 1989. While, as evident in the table below, all major categories achieved decreases, the reductions in commercial/commercial real estate and other real estate owned represent significant achievements for the Company. The softness of the regional economy and the slow recovery from the recession is apparent in the slower rate of improvement in nonperforming residential real estate loans. However, since these loans tend to be smaller individually and represent a broader diversification of risk, the fact that they account for a greater percentage of nonperforming loans at December 31, 1993 than the prior year is additional evidence of the improvement in asset quality. Included in nonperforming assets are assets acquired when NBIS purchased Sentry in 1991. In that transaction, the Bank received a significant discount on assets purchased as part of the transaction, but retained the credit risk. Former Sentry assets included in nonperforming assets were $3.1 million, $3.5 million and $1.2 million at December 31, 1993, 1992 and 1991, respectively. However, with more than two years having passed since the acquisition, management believes that the discount received was more than adequate to provide an acceptable return as well as protection for the risks associated with the assets. The following table shows the composition of nonperforming assets as of December 31: - -------------------------------------------------------------------------------- (In Thousands) 1993 1992 1991 Nonperforming Loans: Residential real estate $ 6,307 $ 8,365 $ 7,457 Commercial real estate 9,096 19,742 18,686 Commercial -- 11 150 Consumer 67 377 83 - -------------------------------------------------------------------------------- Total nonperforming loans 15,470 28,495 26,376 - -------------------------------------------------------------------------------- Other real estate owned: Real estate acquired by foreclosure 17,861 13,320 11,161 Real estate substantively foreclosed 2,375 12,514 10,005 Investment in condominium project 1,000 2,499 2,787 - -------------------------------------------------------------------------------- Total other real estate owned 21,236 28,333 23,953 - -------------------------------------------------------------------------------- Total nonperforming assets $36,706 $56,828 $50,329 ================================================================================ Total nonperforming assets as a percentage of total assets 1.5% 2.4% 2.9% Allowance for loan losses as a percentage of total nonperforming loans 191% 121% 64% Restructured loans that are performing and not included above $6,182 $10,064 $11,343 Of the $15.5 million in nonperforming loans as of December 31, 1993, $2.8 million are being paid in accordance with contractual terms and are included with nonperforming loans because of a perceived collateral weakness. These loans will be candidates to return to accrual status if this positive trend continues during 1994. One disappointment amidst the positive developments in 1993 was the continuation of high levels of OREO provisions and operating expenses. This was due in part to a concerted effort on the part of the Company to sell these properties, an effort which resulted in a decrease of $7.1 million in OREO balances during the year. It was also due to the depth of the economic recession in the region, which impacted both the commercial and residential real estate markets. While the economy of the region continues to be troubled, and there is evidence that certain sectors of the real estate market have not yet improved, management feels that the aggressive actions taken in 1993 have positioned the Company to withstand the negative trends and be well-positioned to take advantage of any improvement that might occur in 1994. Notwithstanding that, it is possible that additional provisions will be required in the future. Allowance for Loan Losses The Company's methodology for determining the adequacy of the allowance for loan losses is based on recurring evaluations of a number of factors, including the composition of the portfolio, historic loan loss experience for categories of loans, current and anticipated economic conditions, nonperforming loan levels and trends, specific credit reviews, and the results of regulatory examinations, as well as subjective factors. Since the allowance is established, in part, as a result of an analysis of the risk elements of the various parts of the portfolio, an allocation of the allowance to various loan categories results from the process. However, while that allocation represents management's best judgement as to risk, it should be understood that the allowance itself is available as a single unallocated allowance to address any problems that may occur in the portfolio. In 1993 management changed the method of allocation in order to better differentiate between the allocated and the unallocated portion of the allowance. Prior to 1993 the Company assigned all of the allowance, including an unallocated portion, to specific loan categories. The following tables show average loans, an analysis of the allowance for loan losses, including charge-offs and recoveries, and the allocation of the allowance for the past five years: Notwithstanding the foregoing allocations, the entire allowance for loan losses is available to absorb charge-offs in any category of loans. The decline in nonperforming loans, coupled with the decline in commercial loans as a percentage of the loan portfolio, allowed the Company to decrease the total allowance from $34.6 million to $29.6 million while maintaining strong asset quality ratios. The allowance totaled 2.24% of total loans at December 31, 1993 compared to 2.55% the prior year, while the allowance equaled 191% of nonperforming loans compared to 121% at the respective year ends. Net charge-offs as a percentage of loans increased from .42% of average loans outstanding in 1992 to .61% in 1993. Included in the net charge-offs was a $1.4 million charge-off related to the return to accrual of a large shared national credit. Excluding that amount, the net charge-off percentage would have been .50%, lower than 1990 and 1991, though higher than the 1992 percentage. Net charge-offs remained high in 1993, reflecting the continuing problems in the economy; however, the Company was able to reduce the provision for losses to the lowest level since 1988 as a result of the improvement in asset quality mentioned above. Segregated Assets Because of the loss-sharing agreement with the FDIC, nonperforming APSB assets that are covered by the loss- sharing agreement are disclosed separately on the consolidated balance sheets under the caption, "Segregated Assets." Included in this amount are nonperforming loans and OREO and in-substance foreclosures, net of an allowance for losses which is deemed adequate to cover NBIS' potential losses from the current balance in the category. An analysis of segregated assets follows: - -------------------------------------------------------------------------------- (In Thousands) December 31, 1993 1992 Nonperforming loans $ 5,954 $ 7,398 In-substance foreclosures 3,168 3,559 Acquired by foreclosure 1,132 -- Deferred income (340) -- - -------------------------------------------------------------------------------- 9,914 10,957 Allowance for losses (992) (1,096) - -------------------------------------------------------------------------------- Total $ 8,922 $ 9,861 ================================================================================ At December 31, 1993, $9.9 million of segregated assets represented an exposure to NBIS of $2.0 million. An allowance of $1.0 million or 50% of the exposure was considered adequate by management. During the year, $215 thousand of allowance was transferred to segregated assets and $319 thousand of charge-offs were taken, representing NBIS' 20% share of the losses. Since the acquisition of APSB in August 1992, $2.0 million of allowances have been transferred and $975 thousand of charge-offs taken. While management remains cautious because of the lack of historic experience with the APSB portfolio, credit loss experience to date has been satisfactory. The allowance established as part of the transaction appears to be adequate to cover both shared losses and NBIS' exposure after the agreement expires. Other Assets Decreases in goodwill, core deposits and other intangibles ($3.2 million) and deferred income taxes ($4.7 million) were partially offset by increases in premises and equipment as the Bank upgraded its telephone and mortgage processing systems during the year. The Bank established a $5.2 million core deposit intangible for the APSB acquisition which is being amortized over 10 years on an accelerated basis. See footnote 6 on page 53 for details on intangibles. Deposits Growth in average savings deposits ($220.2 million), certificates of deposit ($170.8 million) and demand deposits ($33.5 million) primarily represents the full-year impact of APSB. However, from December 31, 1992 to December 31, 1993, total deposits grew $74.6 million or 3.6%. While relatively low on an historic basis, this was a noteworthy achievement in the current environment in which many banks have been experiencing significant deposit outflows to nonbank competitors such as mutual funds. NBIS achieved this through a combination of competitive pricing, increased marketing, and the convenience and service offered to our very loyal customer base. Management has been especially pleased with the continued deposit growth experienced in Rhode Island since the APSB acquisition. Liquidity and Capital Resources Liquidity refers to a bank's ability to meet funding needs for operations, deposit outflows, loan growth and other commitments on a timely and cost effective basis. The Bank's principal sources of liquidity are deposits, loan payments and income, and investment maturities and sales. In addition, the Bank is a member of the Federal Home Loan Bank (FHLB), where it has access to a pre-approved line of credit, as well as additional borrowing capacity. The Bank has had no borrowings from the FHLB since 1990. The marketability of certain assets, such as loans, that can be sold or securitized provides another potential source of liquidity. During the last three years, through a combination of acquisitions, limited loan growth due to the recession, and run-off of higher risk loans that were acquired, the Bank has become increasingly liquid. At December 31, 1993, the ratio of loans to deposits was 61% compared to 65% a year earlier and 68% at December 31, 1991. The Bancorp's source of liquidity is dividends from the Bank. The cornerstone of NBIS' liquidity position is a large and stable base of core deposits. In addition, the relatively short maturity and duration of the Bank's securities portfolio, of which almost 60% is classified as available-for- sale, provides a significant liquidity reserve. While the current economic environment has created a situation where the Bank is very liquid, management of liquidity remains an important element of managing risk in the Bank. The Company and the Bank continued to maintain strong capital positions during 1993, far exceeding regulatory requirements. A strong capital position not only allows the organization to withstand adverse developments which may occur unexpectedly, but also provides a means of taking advantage of profitable investment opportunities that may arise. During 1993 stockholders' equity increased from $227.8 million to $254.9 million. While this was primarily the result of retained earnings, stockholders' equity in 1993 includes $6.8 million (after-tax) of unrealized gains on securities available-for-sale. The inclusion of these gains in stockholders' equity in 1993 is the result of the Company's adoption of SFASNo. 115. In recognition of the record net income and the strong capital position, the Board of Directors increased the dividend to stockholders twice during 1993 and four times between the fourth quarter of 1992 and first quarter of 1994. In 1993 dividends paid totaled $1.04 per share, 24% higher than the $.84 paid in 1992. The table below shows the regulatory capital ratios for both the Bancorp and the Bank. For regulatory capital purposes, the impact of SFASNo. 115 has not yet been authorized. - -------------------------------------------------------------------------------- Minimum Regulatory Bancorp Bank Requirement Tier 1 capital to risk-weighted assets 19.2% 19.2% 4.0% Total risk-based capital ratio 20.3% 20.2% 8.0% Leverage capital ratio 10.2% 10.0% 3.0 to 5.0% Asset/Liability Management A major source of earnings for the Bank is net interest income, the difference in interest received from interest- bearing assets and interest paid on interest bearing liabilities. Financial institutions are subject to interest rate risk when their interest-bearing liabilities mature or reprice more or less rapidly than their interest-earning assets. The objective of asset/liability management is to achieve an acceptable level of net interest income while prudently managing the risk inherent in the balance sheet. NBIS has an Asset/Liability Management Committee whose primary function is to monitor the Bank's interest sensitivity position or risk, and insure that the level of risk and options available to adjust the risk are communicated to management and the board. Among the factors that are considered in determining an acceptable level of risk are lending strategies, capital adequacy, the stability of the deposit base, the maturity and duration of the securities portfolio, particularly securities available-for-sale, and the economic outlook. At December 31, 1993, the Company had a one-year liability-sensitive gap of $397 million or 16.2%. This compares with a liability-sensitive gap of $1.2 billion or 50.0% at December 31, 1992. Analysis of the Bank's non-certificate deposit accounts in 1993 shows that only a portion of regular savings, money market deposit and NOW accounts are rate-sensitive. Deposit balances have been distributed accordingly in the 0 to 5-year time bands, which was not the case in 1992. In accordance with the proposed Federal Reserve guidelines for risk-based capital standards which account for interest rate risk, no amounts related to such deposit accounts are placed beyond five years. The Company does not try to manage to a zero GAP, believing that some interest rate risk is acceptable as part of the Bank's overall strategy for growth and profitability. One factor which affected the Bank's GAP position in 1993 was the fact that those APSB loans which matured, or were not renewed for risk considerations, were primarily adjustable rate commercial/commercial real estate loans, which represented lower interest rate risk, but which were, in the opinion of management, greater credit risks. Thus, in evaluating the interaction of the various risk elements of the consolidated balance sheets, this is a case where management sought to lower credit risk while retaining a little more interest rate risk than they might otherwise have. Recent Accounting Developments For further information on recent accounting developments, refer to footnotes 1, 2, 9, and 14 to the consolidated financial statements contained elsewhere herein. NBB Bancorp, Inc. and Subsidiary Consolidated Balance Sheets See accompanying notes to consolidated financial statements. NBB Bancorp, Inc. and Subsidiary Consolidated Statements of Income See accompanying notes to consolidated financial statements. NBB Bancorp, Inc. and Subsidiary Consolidated Statements of Stockholders' Equity See accompanying notes to consolidated financial statements. NBB Bancorp, Inc. and Subsidiary Consolidated Statements of Cash Flows See accompanying notes to consolidated financial statements. Notes to Consolidated Financial Statements Years Ended December 31, 1993, 1992 and 1991 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation and Consolidation The consolidated financial statements include the accounts of NBB Bancorp, Inc. (the Bancorp) and its wholly-owned subsidiary, New Bedford Institution for Savings (the Bank). The Bank has four wholly-owned subsidiaries; two engage in leasing and development of real estate and two were established in 1993 for the purpose of managing portions of the Bank's investment portfolio. All significant intercompany balances and transactions have been eliminated in consolidation. Certain prior year amounts have been reclassified so as to conform with the presentation for the current year. The accounting and reporting policies of the Bancorp conform to generally accepted accounting principles and prevailing practices within the banking industry. In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities at the consolidated balance sheet date and income and expense for the year. Actual results could differ from those estimates. The estimates that are particularly susceptible to change in the near-term relate to the allowance for loan losses and valuation of other real estate owned. Acquisitions Pursuant to a Purchase and Assumption Agreement between the Federal Deposit Insurance Corporation (FDIC) and the Bank, effective August 21, 1992, the Bank acquired from the FDIC selected assets and assumed all deposits of Attleboro Pawtucket Savings Bank (APSB). In addition, pursuant to a Deposit Insurance Transfer and Asset Purchase Agreement between the Resolution Trust Corporation (RTC) and the Bank, effective July 26, 1991, the Bank acquired from the RTC selected assets and assumed the federally insured deposits of Sentry Savings Bank, FSB (Sentry). The acquisitions have been accounted for under the purchase method of accounting, whereby the purchase price has been allocated to the underlying assets acquired and liabilities assumed based on their respective fair values at the date of acquisition. Premiums and discounts on loans acquired are amortized and accreted as adjustments to interest income over the estimated remaining lives of the related loans using the interest method. Premiums and discounts on deposits assumed are amortized and accreted as adjustments to interest expense over the remaining contractual terms of the related deposit accounts using the straight-line method, the results of which do not differ materially from those which would be recognized using the interest method. Securities Effective December 31, 1993, the Bank adopted Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities." Under SFAS No. 115, debt securities that the Bank has the positive intent and ability to hold to maturity are classified as held-to-maturity and reported at amortized cost; debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as trading and reported at fair value, with unrealized gains and losses included in earnings; and debt and equity securities not classified as either held-to-maturity or trading are classified as available-for-sale and reported at fair value, with unrealized gains and losses excluded from earnings and reported in a separate component of stockholders' equity. The Bank classifies its securities based on the Bank's intention at the time of purchase. The Bank has no securities held for trading. As a result of adoption, as of December 31, 1993, stockholders' equity was increased by approximately $6,772,000, representing the net unrealized gain on securities available-for-sale, less applicable income taxes. In 1992 and prior periods, debt securities intended to be held to maturity were carried at amortized cost; marketable equity securities were carried at the lower of aggregate cost or market value; and securities available-for-sale were carried at the lower of cost or market value. Premiums and discounts on debt securities are amortized or accreted to income by use of the level-yield method. If a decline in fair value below the amortized cost basis of a security is judged to be other than temporary, the cost basis of the investment is written down to fair value as a new cost basis and the amount of the write-down is included in earnings. Gains and losses on the sale of securities are recognized at the time of sale on a specific identification basis. Loans Loans are stated at the principal amount outstanding, net of deferred loan origination fees and unadvanced loan proceeds. Loan origination fees and related direct loan origination costs are offset and the resultant net amounts are amortized by the level-yield method. When loans are sold or paid off, the unamortized fees are transferred to income. Interest is not accrued on loans which are 90 days or more past due or on other loans which are identified as problem loans. Any interest that has been accrued on such loans is reversed against interest income and amortization of deferred loan fees is discontinued. Nonperforming loans are returned to performing status when there no longer exists concern over collectability and the borrower has demonstrated, over time, both the intent and ability to service the loan. Allowance for Loan Losses The adequacy of the allowance for loan losses is evaluated on a regular basis by management. Some of the factors considered are the composition of the loan portfolio, previous loss experience, current economic conditions, and realizable value of the collateral. The provision for loan losses is based upon management's judgement of the amount necessary to maintain the allowance at a level adequate to absorb loan losses. Loan losses are charged against the allowance when management believes the collectability of the principal is unlikely. While management uses available information to evaluate the allowance for loan losses, future additions to the allowance may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Bank's allowance for loan losses. Such agencies may require the Bank to recognize additions to the allowance based on their judgements of information available to them at the time of their examination. Banking Premises and Equipment Buildings, improvements and equipment are stated at cost, less accumulated depreciation, computed on the straight-line method over the estimated useful lives of the assets or the terms of the leases, if shorter. Land is carried at cost. Other Real Estate Owned Other real estate owned (OREO) includes real estate acquired by foreclosure and real estate substantively repossessed. Real estate acquired by foreclosure is comprised of properties acquired through foreclosure proceedings or acceptance of a deed in lieu of foreclosure. When there is indication that a borrower no longer has equity in the property collateralizing a loan and it is doubtful that equity will be rebuilt in the foreseeable future, the property is considered repossessed in substance. Both in-substance foreclosures and real estate formally acquired in settlement of loans are recorded at the lower of the carrying value of the loan or the market value of the property constructively or actually received, less estimated costs to sell the property following foreclosures. Loan losses arising from the acquisition of OREO properties are charged against the allowance for loan losses. After foreclosure, if the fair value of the property, less estimated costs to sell, is less than the cost of the asset, then this amount is recognized as a valuation allowance. If the fair value of the asset, less estimated costs to sell, subsequently increases, and this amount is more than the asset's current carrying value, then the valuation allowance is reversed. Operating expenses and any subsequent provisions to reduce the carrying value to fair market value less costs to sell in 1993, and to net realizable value prior to 1993, are charged to current period earnings. Gains upon disposition are reflected in earnings as realized. Realized losses are charged to the valuation allowance. Goodwill, Core Deposit and Other Intangibles Costs in excess of net assets acquired or goodwill, core deposit intangibles, and organization costs for the Bancorp are reported net of accumulated amortization. Goodwill is amortized on a straight-line basis over a period of up to 15 years. The excess of the purchase price over the fair value of the tangible net assets acquired from the FDIC and RTC has been allocated to core deposits and is amortized over a period of ten years using an accelerated method. Organization costs are amortized on a straight-line basis over a five-year period. Income Taxes Effective January 1, 1992, the Bancorp recognizes income taxes under the asset and liability method. Under this method, deferred tax assets and liabilities are established for the temporary differences between the accounting basis and the tax basis of the Bancorp's assets and liabilities at enacted tax rates expected to be in effect when the amounts related to such temporary differences are realized or settled. The adoption of this method as of January 1, 1992, resulted in the recognition of additional deferred income tax benefit of $5,000,000, which has been reported as the cumulative effect of an accounting change. Prior to January 1, 1992, the Bancorp recognized income taxes under the deferred method. Under this method, annual income tax expense was matched with pretax accounting income by providing deferred taxes at current tax rates for timing differences between income reported for accounting purposes and that reported for tax purposes. Pension Benefits The Bank provides pension benefits to its employees under a non-contributory defined benefit plan which is funded on a current basis in compliance with the requirements of the Employee Retirement Income Security Act of 1974. Earnings Per Share Per share calculations are based on the weighted average number of common and common equivalent shares outstanding. Stock options, when dilutive, are included as common stock equivalents using the treasury stock method. 2. Securities Available-for-Sale and Held-to-Maturity As discussed in Note 1, effective December 31, 1993, the Bancorp adopted SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." The amortized cost and estimated market values of securities available-for-sale and securities held-to-maturity are as follows: - ------------------------------------------------------------------------------- The amortized cost and estimated market value of debt securities at December 31, 1993, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because of prepayments on mortgage-backed securities and certain obligors have the right to call obligations without prepayment penalties. Proceeds from sales of securities available-for-sale during 1993, 1992 and 1991 were $248,572,000, $489,152,000 and $655,730,000, respectively. Gross gains of $2,857,000, $6,402,000 and $8,689,000 and gross losses of $40,000, $1,605,000 and $55,000 were realized on those sales. Proceeds from sales of debt securities held-to-maturity during 1992 and 1991 were $8,217,000 and $30,595,000, respectively. Gross gains of $59,000 and $382,000 and gross losses of $148,000 and $73,000 were realized on those sales. There were no sales of debt securities held-to-maturity in 1993. Proceeds from the sales of equity securities during 1993, 1992 and 1991 were $9,363,000, $11,347,000 and $17,934,000, respectively. Gross gains of $1,586,000, $1,268,000 and $2,282,000 and gross losses of $192,000, $599,000 and $853,000 were realized on those sales. Included in net realized gains for the years ended December 31, 1993 and 1991 are write-downs of $352,000 and $254,000, respectively, in certain equity securities and $471,000 in 1991 in certain debt securities, which represented other than temporary declines in value. As a member of the Federal Home Loan Bank of Boston (FHLB), the Bank is required to invest in $100 par value stock of the FHLB in an amount equal to 1% of its outstanding residential mortgage loans or 5% of the Bank's advances from the FHLB, whichever is higher. If redeemed, the Bank will receive an amount equal to the par value of the stock. The Bank's investment in FHLB stock is included in other equity securities. At December 31, 1993 and 1992, securities with a book value of $4,000,000 and $6,000,000, respectively, were pledged as collateral for the Bank's treasury tax and loan account at the Federal Reserve Bank of Boston. 3. Loans, Net A summary of the balances of loans follows: - ------------------------------------------------------------------------------- (In Thousands) December 31, 1993 1992 Residential: Residential real estate $ 983,483 $ 959,781 Residential construction to individuals 23,622 18,782 - ------------------------------------------------------------------------------ 1,007,105 978,563 Less: Unadvanced loan proceeds (9,557) (7,272) Deferred loan origination fees, net (5,598) (5,057) - ------------------------------------------------------------------------------ Total residential loans 991,950 966,234 - ------------------------------------------------------------------------------ Commercial: Real estate 218,901 232,953 Construction 9,284 19,048 - ------------------------------------------------------------------------------ 228,185 252,001 - ------------------------------------------------------------------------------ Commercial and industrial 16,852 35,169 - ------------------------------------------------------------------------------ 245,037 287,170 Less: Unadvanced loan proceeds (2,652) (2,836) Deferred loan origination fees, net (267) (274) - ------------------------------------------------------------------------------ Total commercial loans 242,118 284,060 - ------------------------------------------------------------------------------ Consumer: Home equity and second mortgages 61,086 71,832 Other consumer 24,133 32,912 - ------------------------------------------------------------------------------ Total consumer loans 85,219 104,744 - ------------------------------------------------------------------------------ Total loans 1,319,287 1,355,038 Less allowance for loan losses (29,596) (34,588) - ------------------------------------------------------------------------------ Loans, net $ 1,289,691 $ 1,320,450 ============================================================================== The Bank's lending activities are conducted principally in Massachusetts and Rhode Island. The Bank grants single-family and multi-family residential loans, commercial real estate loans, commercial loans and a variety of consumer loans. In addition, the Bank grants loans for the construction of residential homes, multi-family properties, commercial real estate properties and for land development. Most loans granted by the Bank are collateralized by real estate. The ability and willingness of the single-family residential and consumer borrowers to honor their repayment commitments is generally dependent on the level of overall economic activity within the borrowers' geographic areas and real estate values. The ability and willingness of commercial real estate, and commercial and construction loan borrowers to honor their repayment commitments is generally dependent on the health of the real estate sector in the borrowers' geographic areas and the general economy. Certain directors and executive officers of the Bank (including their immediate families), and companies in which they are principal owners, are borrowers of the Bank. Such loans are made in the ordinary course of business at the Bank's normal credit terms, including interest rates and collateralization. An analysis of aggregate loan activity to these related parties for the year ended December 31, 1993 follows: - ------------------------------------------------------------------------------- (In Thousands) Balance at beginning of year $ 1,549 New loans granted during the year 337 Repayments (335) - ------------------------------------------------------------------------------- Balance at end of year $ 1,551 =============================================================================== As of December 31, 1993, all loans to related parties were performing in accordance with their contractual terms. An analysis of the allowance for loan losses follows: - ----------------------------------------------------------------------------- (In Thousands) Years Ended December 31, 1993 1992 1991 Balance at beginning of year $ 34,588 $ 16,988 $ 9,391 Provision for loan losses 3,300 6,215 9,496 Allowance on acquired loans -- 18,000 4,186 Recoveries 1,275 142 177 - ----------------------------------------------------------------------------- 39,163 41,345 23,250 Transfers to segregated assets (215) (1,752) -- Charge-offs (9,352) (5,005) (6,262) - ----------------------------------------------------------------------------- Balance at end of year $ 29,596 $ 34,588 $ 16,988 ============================================================================= Nonaccrual loans at December 31, 1993 and 1992 totaled $15,470,000 and $28,495,000, respectively. Restructured loans at December 31, 1993 and 1992 totaled $6,182,000 and $10,064,000, respectively. An analysis of the reduction in interest income due to nonaccrual and restructured loans follows: - ----------------------------------------------------------------------------- (In Thousands) Years Ended December 31, 1993 1992 1991 Income in accordance with original loan terms $1,606 $4,553 $8,345 Income recognized 561 1,271 4,458 - ----------------------------------------------------------------------------- Reduction in interest income $1,045 $3,282 $3,887 ============================================================================= The Bank serviced loans for others totaling $120.8 million, $156.3 million and $28.5 million at December 31, 1993, 1992 and 1991, respectively. In May 1993 the FASB issued SFAS No. 114, "Accounting by Creditors for Impairment of a Loan," which is effective for the Bancorp on January 1, 1995. This statement provides guidance on identifying impaired loans and measuring the impairment of those loans. Generally, the quantification of the impairment of a loan under this statement requires the discounting of expected future cash flows at the loan's original effective rate as opposed to the utilization of a market rate. In addition, the criteria for classifying a loan as an in-substance foreclosure was modified so that such classification applies only when a creditor has possession of the loan collateral. The effect of adopting this statement has not been fully determined but is not expected to have a material adverse impact on the Bancorp's consolidated financial statements. 4. Banking Premises and Equipment, Net A summary of the cost and accumulated depreciation of banking premises and equipment, and their estimated useful lives follows: - ------------------------------------------------------------------------------ Estimated (In Thousands) December 31, 1993 1992 Useful Lives Land $ 3,828 $ 3,878 -- Buildings 19,413 14,597 10-50 years Furniture and equipment 8,499 7,646 3-20 years - ------------------------------------------------------------------------------ 31,740 26,121 Less accumulated depreciation (8,946) (7,751) - ------------------------------------------------------------------------------ Balance at end of year $ 22,794 $ 18,370 ============================================================================== Total depreciation expense for the years ended December 31, 1993, 1992, and 1991 amounted to $1,206,000, $1,075,000 and $875,000, respectively. 5. Other Real Estate Owned A summary of other real estate owned follows: - ------------------------------------------------------------------------------ (In Thousands) December 31, 1993 1992 Real estate acquired by foreclosure $17,861 $13,320 Real estate substantively repossessed 2,375 12,514 Investment in condominium project held for sale 1,000 2,499 - ------------------------------------------------------------------------------ Balance at end of year $21,236 $28,333 ============================================================================== The carrying value of other real estate owned was written down by a charge to earnings of $977,000 and $3,101,000 in 1992 and 1991, respectively. The condominium project was written down by $800,000 and $653,000, during 1993 and 1991, respectively. There was no write-down of this investment in 1992. During the years ended December 31, 1993, 1992, and 1991, proceeds from the sales of condominium units were applied to the carrying value of the project. An analysis of properties held in real estate acquired by foreclosure or substantively repossessed follows: - ------------------------------------------------------------------------------ (In Thousands) December 31, 1993 1992 Commercial buildings $ 8,469 $ 10,912 Land--residential 5,758 5,908 Residential property, primarily 1 to 4 family 4,173 5,247 Residential condominiums 1,248 2,196 Land--commercial 1,149 1,571 - ------------------------------------------------------------------------------ 20,797 25,834 Valuation allowance (561) -- - ------------------------------------------------------------------------------ Total $ 20,236 $ 25,834 ============================================================================== In 1993, a valuation allowance was established. Provisions are charged to expense as they are made. The provisions for 1993 totaled $2,885,000 while write-downs charged to the allowance totaled $2,324,000. An analysis of OREO expense follows: - ------------------------------------------------------------------------------ (In Thousands) Years Ended December 31, 1993 1992 1991 Provision for losses $2,885 $ -- $ -- OREOoperating expenses 1,614 619 955 Write-down of condominium project held for sale 800 -- 653 OREO write-downs -- 977 3,101 - ------------------------------------------------------------------------------ $5,299 $1,596 $4,709 ============================================================================== Included in other non-interest income for 1993, 1992 and 1991 are gains on sales of OREO of $468,000, $5,000 and $2,000, respectively. Rental income from OREOproperty included in other non-interest income for 1993 was $330,000. Rental income for OREO property in 1992 and 1991 was a component of OREO operating expenses and is considered to be immaterial. 6. Goodwill, Core Deposit and Other Intangibles A summary of the components of goodwill, core deposit and other intangibles with remaining amortization years follows: - ------------------------------------------------------------------------------ Years to (Dollars in Thousands) December 31, 1993 1992 Amortize Goodwill: Acquisition of Taunton Savings Bank $ 9,090 $ 10,039 10 Acquisition of branch offices 1,425 1,784 5 Other 21 28 3 Core deposit resulting from acquisition from FDIC 3,164 4,531 9 Core deposit resulting from acquisition from RTC 1,751 2,174 8 Organization costs -- 66 -- - ------------------------------------------------------------------------------ Total goodwill, core deposit and other intangibles $ 15,451 $ 18,622 ============================================================================== 7. Segregated Assets Segregated assets are those APSB loans acquired by the Bank that were or have become nonaccrual, a foreclosed property, or an in-substance foreclosure. All such loans and other real estate owned are subject to the loss-sharing provisions of the Purchase and Assumption Agreement. A summary of the balances of segregated assets follows: - ------------------------------------------------------------------------------ (In Thousands) December 31, 1993 1992 Non-performing loans $ 5,954 $ 7,398 Acquired by foreclosure 1,132 -- Substantively repossessed 3,168 3,559 - ------------------------------------------------------------------------------ 10,254 10,957 Less deferred income (340) -- - ------------------------------------------------------------------------------ Total segregated assets 9,914 10,957 Less allowance for losses (992) (1,096) - ------------------------------------------------------------------------------ Segregated assets, net $ 8,922 $ 9,861 ============================================================================== An analysis of the allowance for losses on segregated assets follows: - ------------------------------------------------------------------------------ (In Thousands) December 31, 1993 1992 Balance at beginning of year $ 1,096 $ -- Transfer from allowance for loan losses 215 1,752 Charge-offs (319) (656) - ------------------------------------------------------------------------------ Balance at end of year $ 992 $ 1,096 ============================================================================== Under the loss-sharing provisions of the Purchase and Assumption Agreement, the FDIC will pay to the Bank, on a quarterly basis, 80% of all net charge-offs on APSB-acquired commercial, mortgage and home equity loans during the three-year period commencing with August 21, 1992. Such charge-offs include losses on sales of assets and foreclosed properties and accrued interest for up to 90 days. In addition, the FDIC will reimburse the Bank for 80% of the aggregate amount of the actual direct expenses incurred with respect to collection and other costs related to shared-loss assets as defined in the Agreement. If, at the end of the five-year period, total net charge-offs exceed $49,034,000, the FDIC will pay the Bank an amount equal to 15% of the difference between total net charge-offs and $49,034,000. During the fourth and fifth years following the acquisition, the Bank will pay to the FDIC an amount equal to 80% of the gross amount of recoveries during such period on charge-offs of commercial, mortgage and home equity loans that occurred during the three years following the acquisition. During the five-year period following the acquisition, the Bank will pay to the FDIC an amount equal to 80% of any recoveries on charge-offs of consumer loans charged off prior to the acquisition. The Bank is required to administer assets entitled to loss-sharing protection in the same manner as assets for which no loss sharing exists. 8. Deposits The following table shows deposits at December 31, 1993 and 1992: - ------------------------------------------------------------------------------ (In Thousands) 1993 1992 Non-certificate deposits: Noninterest-bearing demand $ 82,253 $ 74,542 NOW 163,587 166,283 Money market 489,875 429,642 Regular and special notice 386,045 432,720 - ------------------------------------------------------------------------------ Total non-certificate deposits 1,121,760 1,103,187 - ------------------------------------------------------------------------------ Time certificates in denominations: Less than $100,000 957,929 914,544 $100,000 or more 88,108 74,231 - ------------------------------------------------------------------------------ Total time certificates 1,046,037 988,775 - ------------------------------------------------------------------------------ Discount on deposits 1,459 2,649 - ------------------------------------------------------------------------------ Total deposits $2,169,256 $2,094,611 ============================================================================== A summary of time certificates, by maturity, is as follows: - ------------------------------------------------------------------------------ (Dollars In Thousands) December 31, 1993 1992 Weighted Weighted Average Average Amount Rate Amount Rate Within 1 year $ 800,699 3.95% $786,076 4.56% Over 1 year to 2 years 124,940 5.05 114,662 6.09 Over 2 years to 3 years 113,056 4.97 68,585 5.74 Over 3 years 7,342 6.04 19,452 6.38 - ------------------------------------------------------------------------------ $1,046,037 4.21% $988,775 4.86% ============================================================================== Interest expense on deposits is summarized as follows: - ------------------------------------------------------------------------------ (In Thousands) Years Ended December 31, 1993 1992 1991 NOW $ 3,509 $ 3,979 $ 3,807 Money market 14,858 15,750 15,158 Regular and special notice 10,469 11,056 9,615 Time certificates 44,897 45,803 49,960 - ------------------------------------------------------------------------------ Total $73,733 $76,588 $78,540 ============================================================================== 9. Income Taxes As discussed in note 1, effective January 1, 1992, the Bank adopted SFAS No. 109, "Accounting for Income Taxes." The components of income tax expense (benefit) are as follows: - ------------------------------------------------------------------------------ (In Thousands) Years Ended December 31, 1993 1992 1991 Current: Federal $ 16,135 $ 12,634 $ 7,332 State 6,816 5,327 3,347 - ------------------------------------------------------------------------------ Total current income tax expense 22,951 17,961 10,679 - ------------------------------------------------------------------------------ Deferred: Federal (290) 157 (910) State 144 18 (354) - ------------------------------------------------------------------------------ Total deferred income tax expense (benefit) (146) 175 (1,264) - ------------------------------------------------------------------------------ Total provision $ 22,805 $ 18,136 $ 9,415 ============================================================================== The difference between the effective income tax rate computed by applying the statutory federal income tax rate of 35% (34% for 1992 and 1991) to income before income taxes and cumulative effect of a change in accounting principle and the actual effective income tax rate is summarized as follows: - ------------------------------------------------------------------------------- Years Ended December 31, 1993 1992 1991 Statutory rate 35.0% 34.0% 34.0% Increase (decrease) resulting from: State taxes, net of federal tax benefit 8.9 8.7 8.8 Bad debt deduction -- -- (.1) Goodwill amortization .9 2.0 2.4 Effect of change in tax law (.4) -- -- Other purchase accounting adjustments -- (.9) (2.4) Change in valuation reserve (.2) .3 -- Other, net .6 .1 (.5) - ------------------------------------------------------------------------------- Effective income tax rates 44.8% 44.2% 42.2% =============================================================================== Prior to January 1, 1992, deferred income taxes resulted from timing differences in the recognition of revenues and expenses for tax and financial statement purposes. The sources of these differences for the year ended December 31, 1991, and the tax effects of each were as follows: - ------------------------------------------------------------------------------- (In Thousands) Year Ended December 31, 1991 Cash basis accounting for tax purposes $ (506) Write-down of other real estate owned (275) Deferred loan revenue 410 Deferred loan income (245) Pension liability (724) Other, net 76 - ------------------------------------------------------------------------------- Total deferred income tax benefit (1,264) Deferred income tax benefit decrease not affecting operations: Net unrealized loss on marketable equity securities 388 - ------------------------------------------------------------------------------- Net change in deferred income taxes $ (876) =============================================================================== At December 31, 1993 and 1992, the Bank had gross deferred income tax assets and gross deferred income tax liabilities as follows: - ------------------------------------------------------------------------------ (In Thousands)December 31, 1993 1992 Deferred income tax asset: Allowance for loan losses $13,003 $ 16,111 Deferred loan revenue 2,657 2,624 Pension liability 1,343 940 Valuation adjustment of other real estate owned 1,554 666 Other 245 542 - ------------------------------------------------------------------------------ Gross deferred income tax asset 18,802 20,883 Valuation allowance (197) (320) - ------------------------------------------------------------------------------ Deferred income tax asset 18,605 20,563 - ------------------------------------------------------------------------------ Deferred income tax liability: Purchase accounting adjustments 8,273 10,473 Unrealized appreciation on securities available for sale 4,880 -- Depreciation 1,117 1,181 Other 420 288 - ------------------------------------------------------------------------------ Gross deferred income tax liability 14,690 11,942 - ------------------------------------------------------------------------------ Net deferred income tax asset $ 3,915 $ 8,621 =============================================================================== A valuation reserve is provided when it is more likely than not that some portion of the gross deferred tax asset will not be realized. Management has established a valuation reserve for the state tax effect of subsidiary losses. The change in the beginning of the year allowance was a reduction of $123,000. The gross deferred federal income tax asset ($13,686,000) is supported by the potential recovery of taxes previously paid by the Bancorp in the carryback period and the scheduled reversal of deferred tax liabilities. Since there is no carryback provision for state tax purposes, management believes the existing net deductible temporary differences which give rise to the gross deferred state income tax asset ($5,116,000) will reverse during periods in which the Bancorp generates taxable income. At October 31, 1993, the date as of which the Bancorp's most recent federal income tax return is to be filed, the total reserve for loan losses for federal income tax purposes amounted to $23,079,000. If any portion thereof is used for purposes other than to absorb the losses for which established, such amount must be included in gross income for federal income tax purposes in the fiscal year in which it is used. As the Bancorp does not intend to use the reserves for purposes other than to absorb loan losses, deferred income taxes of approximately $10,339,000 have not been provided on this amount. Additionally, under certain circumstances, most notably if qualifying assets (principally residential mortgage loans, U.S. Government securities, and cash) fall below 60% of total assets, cumulative excess bad debt deductions would be recaptured over a four-year period for income tax purposes. The full effect of this recapture would be recognized immediately in the consolidated financial statements. At December 31, 1993, the Bank's qualifying assets exceeded 60% of total assets. 10. Long-Term Debt Long-term debt is the outstanding balance of funds borrowed by the Employees' Stock Ownership Plan (ESOP) of the Bank amounting to $283,000 at December 31, 1992. Interest is payable monthly at a rate equal to 83% of the prime rate of the lending institution. The rate payable was 4.98% at December 31, 1992. The final principal payment of $283,000 was made in November 1993. 11. Commitments and Contingencies Reserve Requirements Cash and due from banks at December 31, 1993 and 1992 includes $20,200,000 and $13,000,000, respectively, which is subject to withdrawal and usage restrictions to satisfy the reserve requirements of the Federal Reserve Bank. Lease Commitments Pursuant to the terms of noncancelable operating lease agreements in effect at December 31, 1993, future minimum rent commitments are as follows: - -------------------------------------------------------------------------------- (In Thousands) 1994 1995 1996 1997 1998 Thereafter Total $557 $522 $479 $430 $396 $2,741 $5,125 Rent expense for the years ended December 31, 1993, 1992 and 1991, amounted to $889,000, $693,000, and $461,000, respectively. Certain subsidiaries of the Bank own and lease real property to unrelated parties. Future minimum rents receivable applicable to those properties for leases in effect at December 31, 1993, are as follows: - -------------------------------------------------------------------------------- (In Thousands) 1994 1995 1996 1997 1998 Thereafter Total $171 $140 $ 54 $41 $ 9 -- $415 Sublease income for the years ended December 31, 1993, 1992 and 1991, amounted to $312,000, $188,000 and $186,000, respectively. Certain leases contain options to extend for periods from two to ten years. Income and expense from these options is not included in the amounts under commitment. Employment and Special Termination Agreements The Bancorp has employment agreements with its Chairman and Chief Financial Officer which expire May 1994 and December 1994, respectively. The Chief Financial Officer's agreement will be automatically renewed for successive one-year terms at the expiration date unless written notice is given as defined in the agreement. These agreements provide for a specified minimum compensation and the continuation of benefits in accordance with the Bank and Bancorp's general policies. The Bank and Bancorp have also entered into special termination agreements with these senior executives and certain other officers which provide for certain lump-sum severance payments within a three-year period following a "change in control," as defined in the special termination agreements. Litigation In the ordinary course of business, the Bancorp is involved in routine litigation. Based on its review of such litigation, management does not foresee any material effect on the Bancorp's consolidated financial position. 12. Financial Instruments with Off-Balance-Sheet Risk The Bancorp is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. The financial instruments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheet. The amounts of those instruments reflect the extent of involvement the Bank has in particular classes of financial instruments. The Bancorp's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments.The contract amounts of financial instruments with off-balance sheet risk are as follows: - -------------------------------------------------------------------------------- (In Thousands) December 31, 1993 1992 Commitments to grant fixed rate loans $41,477 $39,703 Commitments to grant variable rate loans 5,792 12,329 Performance standby letters of credit 45 150 Financial standby letters of credit 71 368 Unused lines of credit-- Commercial 1,149 1,636 Unused lines of credit-- Home equity 28,055 34,484 Unadvanced funds on construction loans 12,209 10,108 Commitments to sell loans -- 217 Commitments to grant loans are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Some commitments are expected to expire without being drawn upon; therefore, the total commitment amounts do not necessarily represent future cash requirements. The Bank evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, upon extension of credit, is based on management's credit evaluation of the borrower. The collateral for commitments to grant fixed and variable rate loans, as well as unadvanced funds on home equity lines of credit, is primarily residential real estate. Certain commercial commitments included in commitments to grant loans, as well as commercial lines of credit, are collateralized by cash or other non-real estate assets. Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that for commitments to grant loans. Standby letters of credit are primarily collateralized by funds on deposit. 13. Stockholders' Equity In accordance with Massachusetts law, when the Bank converted to stock form in 1987, a liquidation account was established for the benefit of eligible account holders who continue to maintain their accounts in the Bank after the conversion. In the event of a complete liquidation, each eligible account holder would be entitled to receive a distribution in an amount equal to the current adjusted liquidation account balances to the extent that funds are available. According to the Bancorp's records, the balance of the liquidation account at December 31, 1993, was $10.8 million (unaudited). On November 14, 1989, the Board of Directors adopted a Shareholder Rights Plan and declared a dividend of one preferred stock purchase right for each outstanding share of common stock. Such rights only become exercisable, or transferable apart from the common stock, ten business days after a person or group (Acquiring Person) acquires beneficial ownership of, or commences a tender or exchange offer for, 20% or more of the Bancorp's common stock, or the declaration by the Board of Directors that any person is an Adverse Person. Each right then may be exercised to acquire one one-hundredth of a share of a newly authorized Series A Junior Participating Preferred Stock at an exercise price of $60, subject to adjustment. If the Bancorp is acquired in a merger or other business combination transaction, or 50% of the Bancorp's assets or earning power is sold, the rights entitle holders to acquire common stock of the Acquiring Person having a value twice the exercise price of the rights. The rights may be redeemed in whole by the Bancorp at $.02 per right at any time prior to (i) the declaration of a person as an Adverse Person, (ii) the tenth day following public announcement that a 20% position has been acquired, or (iii) the occurrence of a merger or other business combination transaction. The rights expire on November 14, 1999. Federal and state banking regulations place certain restrictions on dividends paid by the Bank to the Bancorp. In addition, if dividends from the Bank to the Bancorp exceed accumulated earnings and profits, an amount up to approximately one and one half times the amount actually used must be included in gross income for federal income tax purposes in the fiscal year in which it is used. At December 31, 1993, the unrestricted amount available for dividends totaled $132,621,000. The Bancorp and the Bank are subject to regulatory capital standards based on Tier 1 capital, total capital and on risk weighting of assets. The minimum Tier 1 capital ratio required is 4.00%. The Bancorp and the Bank must have a minimum total risk-based capital ratio of 8.00% (of which 4.00% must be Tier 1 capital consisting of stockholders' equity). Leverage capital standards (Tier 1 capital to adjusted total assets) require a minimum of 3.0% for the most highly rated banks. All others will need to meet a minimum leverage ratio that is at least 100 to 200 basis points above the minimum requirement. At December 31, 1993, the capital ratios of both the Bancorp and the Bank significantly exceeded minimum applicable regulatory requirements. These ratios at December 31, 1993, were as follows (unaudited): - -------------------------------------------------------------------------------- Bancorp Bank Tier 1 capital to risk-weighted assets 19.2% 19.2% Total risk-based capital ratio 20.3% 20.2% Leverage capital ratio 10.2% 10.0% 14. Pension Plan and Employee Benefit Plans The Bank has a noncontributory, qualified, defined pension plan covering eligible employees through the Savings Banks Employees Retirement Association (SBERA) Pension Plan. Each employee reaching the age of 21 and having completed 1,000 hours of service in a 12-month period beginning with such employee's date of employment automatically becomes a participant in the retirement plan. Participants become 100% vested when credited with five years of service. Net pension expense for the plan years ended October 31, 1993, 1992, and 1991 consisted of the following: - -------------------------------------------------------------------------------- (In Thousands) 1993 1992 1991 Service cost $ 751 $ 673 $ 528 Interest cost on projected benefits 602 514 481 Actual return on plan assets (965) (504) (1,078) Net amortization and deferral 485 122 678 - -------------------------------------------------------------------------------- $ 873 $ 805 $ 609 ================================================================================ Total pension expense for the years ended December 31, 1993, 1992, and 1991 amounted to $969,000, $847,000 and $652,000, respectively. A reconciliation of the funded status of the plan at October 31, 1993 and 1992, according to SBERA, follows: - -------------------------------------------------------------------------------- (In Thousands) 1993 1992 Plan assets at fair value $ 7,557 $ 6,700 Projected benefit obligation (9,814) (8,592) - -------------------------------------------------------------------------------- Projected benefit obligation in excess of plan assets (2,257) (1,892) Unrecognized net asset at adoption (470) (492) Unrecognized experience loss (gain) (237) 293 - -------------------------------------------------------------------------------- Accrued pension cost $(2,964) $(2,091) ================================================================================ Plan assets are primarily invested in bonds and equity securities. The unrecognized net asset and the unrecognized experience loss are being amortized over 21 and 25 years, respectively. The accumulated benefit obligation at October 31, 1993 and 1992 amounted to $5,461,000 and $5,022,000, respectively, of which $5,255,000 and $4,842,000, respectively, was vested. For the plan years ended October 31, 1993, 1992, and 1991, actuarial assumptions include an assumed discount rate on benefit obligations of 7.00%, 7.00% and 6.75%, respectively, and an expected long-term rate of return on plan assets of 7.00%, 6.75% and 7.75%, respectively. An annual salary increase of 6.00% was utilized for all years. The Bank has a salary incentive plan (Incentive Plan) for the purpose of rewarding the Bank's officers and employees for meeting or exceeding certain of the Bank's financial goals. All officers and employees with a full calendar year of service are eligible for participation in the Incentive Plan. Each officer and employee is eligible to receive an incentive award proportionate to his or her respective salary at the discretion of the Compensation Committee. The amounts expensed under the plan for the years ended December 31, 1993, 1992 and 1991 amounted to $990,000, $684,000 and $350,000, respectively. An executive supplemental retirement agreement formerly existed for the Chief Executive Officer which provided for an additional retirement benefit for his lifetime of $80,000 a year and a benefit for his surviving spouse for her lifetime of $40,000 a year. In 1992 the Chief Executive Officer elected to receive a lump sum payment of $815,000 in lieu of these lifetime payments. Total expense applicable to the agreement for the year ended December 31, 1991, amounted to $320,000. No expense for the plan was incurred in 1993 or 1992. In December 1990 the FASB issued SFASNo. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." Under SFASNo. 106, the cost of postretirement benefits other than pensions must be recognized on an accrual basis compared to the current method of a pay-as-you-go basis, as employees perform services to earn the benefits. The Bank adopted the provisions of SFASNo. 106 and its adoption on January 1, 1993, did not have a material impact on the Bank's consolidated financial statements. In November 1992 the FASB issued SFAS No. 112, "Employers' Accounting for Postemployment Benefits." This new accounting standard will be effective for the Bank on January 1, 1994, and requires accrual for postemployment benefits during either employees' service lives or at the time a liability is incurred. Postemployment benefits include salary continuation, supplemental unemployment benefits, severance benefits, disability-related benefits, job training and counseling, and continuation of benefits such as health care and life insurance. Management does not believe the provisions of SFAS No. 112 will have a material impact on the Bancorp's consolidated financial statements. 15. Stock Option Plan The Bancorp has a stock option plan for the benefit of directors and officers. Up to 820,000 shares of common stock have been reserved for issuance pursuant to options granted under the plan. Both incentive stock options and non-qualified stock options may be granted under the plan. The maximum option term is ten years. All stock options granted, as determined appropriate by the Board of Directors, have an exercise price equal to the fair market value of a share of common stock of the Bancorp on the date the option is granted. An analysis of shares under option follows: - -------------------------------------------------------------------------------- Years Ended December 31, 1993 1992 1991 Number Average Number Average Number Average of Option of Option of Option Shares Price Shares Price Shares Price Beginning of year 342,601 $17.25 299,000 $14.07 276,500 $14.24 Granted 100,100 36.88 74,000 28.53 22,500 11.88 Exercised 65,603 14.82 30,399 13.37 -- -- Expired 2,000 14.38 -- -- -- -- - -------------------------------------------------------------------------------- End of year 375,098 $22.93 342,601 $17.25 299,000 $14.07 ================================================================================ Allocated as follows: Non-qualified 153,117 120,420 141,920 Incentive 221,981 222,181 157,080 - -------------------------------------------------------------------------------- 375,098 342,601 299,000 ================================================================================ 16. Employees' Stock Ownership Plan The Bank has an Employees' Stock Ownership Plan (ESOP) in which all employees who have reached the age of 21 and who have completed 1,000 hours of service in a 12-month period beginning with such employee's date of employment may participate. An analysis of the Bank's contribution to the ESOP follows: - -------------------------------------------------------------------------------- (In Thousands) Years ended December 31, 1993 1992 1991 Compensation expense $254 $298 $294 Interest expense -- 7 28 - -------------------------------------------------------------------------------- Total expense $254 $305 $322 ================================================================================ 17. Acquisitions On August 21, 1992, the Bancorp, through the Bank, acquired all deposits and certain assets of Attleboro Pawtucket Savings Bank from the FDIC. The Bank received approximately $12.3 million for the acquisition. The FDIC paid approximately $44.6 million in cash to fund the difference between assets acquired and liabilities assumed, and the discount received by the Bank. On July 26, 1991, the Bancorp, through the Bank, acquired the federally insured deposits and certain assets of Sentry Savings Bank, FSB from the RTC. The Bank paid approximately $13.1 million for the acquisition. The RTC paid approximately $218.9 million in cash to fund the difference between the assets acquired and liabilities assumed, and the purchase price paid by the Bank. The fair value of assets acquired and liabilities assumed on August 21, 1992 and July 26, 1991, using the purchase method of accounting is as follows: 18. Disclosures about Fair Value of Financial Instruments The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value: Cash and Cash Equivalents, Accrued Interest Receivable and Payable For these short-term instruments, the carrying amount is a reasonable estimate of fair value. Securities Available - for - Sale and Securities Held - to - Maturity The fair values of securities available-for-sale and securities held-to-maturity are based on quoted market prices or dealer quotes. Loans For all categories of loans, fair value is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. Deposit Liabilities The fair value of demand deposits, NOW accounts, regular and special notice accounts, and money market deposits is the amount payable on demand at the reporting date. The fair value of fixed-maturity certificates of deposit is estimated by discounting the future cash flow using the rates currently offered for deposits of similar remaining maturities. Long -Term Debt Rates currently available to the Bancorp for debt with similar terms and remaining maturities are used to estimate fair value of existing debt. Commitments to Extend Credit and Letters of Credit The fair value of the Bancorp's commitments to originate loans of $47,269,000, unused lines of credit of $29,204,000 and standby letters of credit of $116,000 are estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties' credit standing. At December 31, 1993 and 1992, the Bank estimates the fair value of these financial investments to be immaterial. The estimated fair values of the Bancorp's financial instruments at December 31, 1993 and 1992, are as follows: Limitations Fair value estimates are made at a specific point in time, based on relevant market information and information about each financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Bancorp's entire holdings of a particular financial instrument. Because no market exists for some of the Bancorp's financial instruments, fair value estimates are based on judgements regarding future expected loss experience, cash flows, current economic conditions, risk characteristics, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgement and therefore cannot be determined with precision. Changes in assumptions and changes in the loan, debt and interest rate markets could significantly affect the estimates. Further, the income tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered. 19. Condensed Financial Information of Parent Company Parent company only financial information is as follows: The Statements of Changes in Stockholders' Equity for the Parent Company are identical to the Consolidated Statements of Changes in Stockholders' Equity and are, therefore, not presented here. 20. Quarterly Data (Unaudited) Summaries of consolidated operating results on a quarterly basis for the years ended December 31, 1993 and 1992, are as follows: Independent Auditors' Report To the Board of Directors and Stockholders of NBB Bancorp, Inc. We have audited the accompanying consolidated balance sheets of NBB Bancorp, Inc. and subsidiary as of December 31, 1993 and 1992, and the related consolidated statements of income, stockholders' equity and cash flows for each of the years in the three-year period ended December 31, 1993. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of NBB Bancorp, Inc. and subsidiary as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1993 in conformity with generally accepted accounting principles. As discussed in Notes 1 and 2 to the consolidated financial statements, the Company changed its method of accounting for securities in 1993. As discussed in Notes 1 and 9, the Company changed its method of accounting for income taxes in 1992. [KPMG Peat Marwick Signature] Providence, Rhode Island January 19, 1994 Stockholder Information Annual Meeting The Annual Meeting of the stockholders of NBB Bancorp, Inc. will be held at 10:00 a.m. on Wednesday, May 18, 1994, at the Hawthorne Country Club, 970 Tucker Road, North Dartmouth, Massachusetts. Stockholder Relations NBB Bancorp, Inc., Post Office Box 5000, New Bedford, MA 02742-5000. Toll-free within Massachusetts and Rhode Island (800) 338-3001 Transfer Agent First National Bank of Boston, Shareholder Services Division, Post Office Box 644, Mail Stop: 45-02-09, Boston, MA 02102-0644 (617) 575-2900 Independent Auditors KPMG Peat Marwick, 50 Kennedy Plaza, Providence, RI 02903 General Counsel Goodwin, Procter & Hoar, Exchange Place, Boston, MA 02109 Form 10-K Copies of this Annual Report, the Annual Report on Form 10-K, and quarterly reports on Form 10-Q are available without charge upon written request to: NBB Bancorp, Inc., Stockholder Relations, Post Office Box 5000, New Bedford, MA 02742-5000 Stock Listing The Bancorp's common stock is traded on the New York Stock Exchange under the symbol NBB. The stock is listed as NBB Bcp in the New York Stock Exchange section of The Wall Street Journal. There may be variations of this abbreviation in other newspapers in which the stock quotation appears. Common Stock The following table sets forth the high and low price per share and the dividends paid in the calendar quarters indicated for the Bancorp's common stock on the New York Stock Exchange: High Low Dividends 1st Quarter $19 1/8 $14 3/8 $.18 2nd Quarter 20 3/8 17 5/8 .21 3rd Quarter 21 5/8 18 1/4 .21 4th Quarter 29 1/2 19 1/2 .24 1st Quarter $31 3/4 $25 1/4 $.24 2nd Quarter 31 25 3/4 .26 3rd Quarter 38 5/8 28 7/8 .26 4th Quarter 41 1/4 33 1/2 .28 Dividends were paid to stockholders on February 11, 1994 at $.30 per share, an annual rate of $1.20. Additional Stock Information at February 24, 1994: Closing sale price: $37 5/8. Number of shares outstanding: 8,656,844. Approximate number of stockholders of record: 4,800.
807711_1993.txt	807711	1993	Item 1. Description of Business Amstar Corporation (the "Company" or "Amstar") is a privately held Delaware corporation which was formed in l986 for the purpose of effecting the merger (the "Merger") of its wholly owned indirect subsidiary ("Acquisition") with and into AHI, Inc., a Delaware corporation ("AHI"). On November 21, 1986, Acquisition merged with and into AHI and AHI became a wholly owned indirect subsidiary of the Company. AHI acquired the former Amstar Corporation in a leveraged buy-out in February 1984. On December 5, 1986, AHI adopted a plan of complete liquidation pursuant to Section 332 of the Internal Revenue Code of 1954, as amended, and, effective December 31, 1986, the assets of AHI were distributed to wholly owned subsidiaries of the Company which together owned all the outstanding shares of capital stock of AHI. On July 30, 1987, the Company sold its Spreckels sugar beet processing operations and its Industrial Products Group to a leveraged buy-out group including certain managers of those units. The purchase price was approximately $170 million, including the discharge of certain indebtedness, $15 million of preferred stock, and warrants to purchase common stock of the new corporation. On December 22, 1988, the Company sold the capital stock of Amstar Sugar Corporation and other subsidiaries engaged in the cane sugar refining and related packaging businesses to an affiliate of Tate & Lyle PLC, London, England for approximately $310 million. On March 28, 1991, the Company sold the capital stock of Milford Products Corporation, a subsidiary engaged in the manufacture and sale of saw blades and accessories, to a U.S. subsidiary of Sandvik AB of Sweden, for approximately $19.7 million in cash. (See "Sale of Milford" at page 23.) The Company had three subsidiaries engaged in the manufacture and sale of specialized electronic equipment. Those units, all of which have been sold, were Aiken Advanced Systems, Inc., California Instruments Corporation and Keltec Florida, Inc. Those units constituted the Amstar Electronics Group (the "Electronics Group"). (See note 3 to consolidated financial statements at page S-8 for a discussion of discontinued operations.) On June 30, 1989, the holders of all the then outstanding shares of common stock of Amstar exchanged (the "Amstar Exchange") such shares for shares of common stock of ESSTAR Holdings Inc., a Delaware corporation, now known as ESSTAR Incorporated ("Esstar"). Simultaneously with the Amstar Exchange, the holders of all the then outstanding shares of common stock of EI Holdings Corp., a Delaware corporation ("EI Holdings"), exchanged such shares for shares of Esstar common stock (together with the Amstar Exchange, the "Combination"). As a result of the Combination, Amstar and EI Holdings each became direct, wholly owned subsidiaries of Esstar. Affiliates of Merrill Lynch Capital Partners, Inc. ("ML Capital Partners"), a subsidiary of Merrill Lynch & Co., Inc., hold an aggregate of approximately 91.4% of the voting power of Esstar, and approximately 76.2% of the total common equity of Esstar including the shares of stock issuable upon exercise of outstanding employee stock options exercisable within 60 days, but not including shares issuable upon conversion of outstanding shares of preferred stock and non-voting common stock into voting common stock. The Company has an investment in certain securities of ESSEX Holdings, Inc., a subsidiary of EI Holdings. (See "Long-Term Investments" at page 18.) ESSEX Holdings, Inc., referred to herein as "Essex", changed its name from ESSEX Industries, Inc., effective January 23, 1992. In the Combination, Amstar issued (i) an aggregate of 413,362 shares of Amstar Common Stock to certain institutional investors for $40.00 per share or an aggregate purchase price of approximately $16.5 million in cash and (ii) an aggregate of 22,285 shares of Amstar Common Stock to certain other institutional investors for $40.00 per share or an aggregate purchase price of approximately $0.9 million in cash. In addition, certain institutional investors purchased (i) an aggregate of 404,050 shares of Amstar Common Stock held by Amstar management investors for $40.00 per share or an aggregate purchase price of approximately $16.2 million and (ii) an aggregate of 32,599 shares of Amstar Common Stock for $40.00 per share from an affiliate of ML Capital Partners for an aggregate purchase price of approximately $1.3 million. Certain institutional investors also purchased an aggregate of 435,750 shares of Amstar Common Stock held by certain Amstar management investors for $40.00 per Amstar share for an aggregate purchase price of approximately $17.4 million. In connection with the Combination, Amstar (i) repurchased 49,550 shares of Amstar Common Stock from two former members of Amstar management for $40.00 per share or an aggregate purchase price of approximately $2.0 million, (ii) repurchased 250,000 shares of Amstar Common Stock from affiliates of ML Capital Partners for $40.00 per share or an aggregate purchase price of approximately $10.0 million, (iii) made a supplemental payment aggregating approximately $0.5 million to two former Amstar management investors, (iv) canceled an aggregate of 422,325 options to purchase Amstar Common Stock held by certain members and former members of Amstar management for an aggregate payment of approximately $12.8 million and (v) paid a dividend of approximately $2.3 million to Esstar. Segment Information The Company's business consists of one industry segment: heavy-duty portable electric power tools. The power tools segment is composed of Milwaukee Electric Tool Corporation ("METCO"). Milford Products Corporation ("Milford"), formerly part of the power tools segment, was sold on March 28, 1991. (See "Sale of Milford" at page 23.) METCO is one of the three largest manufacturers and distributors in the United States of heavy-duty portable electric power tools and accessories sold to professional tradesmen and consumers. METCO'S products include over 300 models of heavy-duty portable electric tools and accessories, such as drills, grinders, saws, blades, routers and hammers, substantially all of which it manufactures. Major METCO products include the following: Diamond Drilling Equipment Saws Band saws Drills Chain saws Pistol drills Circular saws D-handle drills Jig saws Right angle drills Miter saws Compact drills Reciprocating saws Super hole-shooters (Sawzall ) Cordless drills Worm drive saws Screwdrivers Screw-shooters, nut runners Electromagnetic drill presses Adjustable clutch screwdrivers Grinders Drywall screwdrivers Bench grinders Self-drilling, self-tapping Right angle sander-grinders screwdrivers Straight and die grinders Cordless screwdrivers Hammers Power tool accessories Hammer drills Selfeed bits Rotary hammers Band saw blades Hole saw blades Reciprocating saw blades Polishers Sanders Belt sanders Circular sanders Orbital sanders Random orbit sanders Marketing and Distribution The METCO sales organization includes a U.S. sales group; a national accounts/home center sales group; a Canadian subsidiary located in Scarborough, Ontario; and an international sales operation located in Brookfield, Wisconsin. METCO has company-owned service centers in 21 major U.S. metropolitan areas and one in the Toronto, Canada, area. These branches repair and service METCO's products, sell parts and accessories, and handle order entry for the field sales force. METCO also has a network of 392 independently-owned authorized service stations to provide customers with post-sale warranty and repair service. METCO's products are sold throughout the U.S. and Canada to distributors reaching the industrial and construction markets and service trades. METCO also markets its tools and accessories through hardware chains and building supply home centers. All products are shipped from METCO's Distribution Center in Olive Branch, Mississippi. The markets in which METCO competes are highly competitive, as portable electric tools are manufactured by a number of other companies, both domestic and foreign. METCO competes primarily on quality and, to a lesser extent, on price. METCO's end users are primarily professional tradesmen. Patents The Company does not believe that any single patent is of material importance to its business. Research and Development The Company's research and development costs amounted to $4,531,000 for the year ended December 31, 1993, $3,986,000 for the year ended December 31, 1992, and $3,387,000 for the year ended December 31, 1991. Employees On March 1, 1994, the Company had approximately 1800 employees. The Company regards relations with its employees to be satisfactory. Environmental Matters The Company believes that it is in compliance in all material respects with applicable environmental laws and regulations. The Company expended approximately $0.6 million for environmental quality projects in the year ended December 31, 1993, and anticipates the expenditure of approximately $0.7 million for environmental quality projects in the year ending December 31, 1994. Item 2.		Item 2. Properties PROPERTIES OF THE COMPANY Amstar Corporation Executive Office New Haven, CT Milwaukee Electric Tool Corporation General Office Brookfield, WI Plants Blytheville, AR;Brookfield, WI; Pewaukee, WI; Jackson, MS Technical Center Brookfield, WI Distribution Center Olive Branch, MS Sales and service Anaheim, CA; Atlanta, GA; offices Boston, MA; Brookfield, WI; Chicago, IL; Cincinnati, OH; Cleveland, OH; Dallas, TX; Denver, CO; Detroit, MI; Houston, TX; Kansas City, MO; Miami, FL; Minneapolis, MN; New Orleans, LA; New York, NY; Philadelphia, PA; Phoenix, AZ; San Francisco, CA; Seattle, WA; St. Louis, MO Milwaukee Electric Tool (Canada) Ltd. Sales and service Scarborough, Ontario, Canada office METCO's general offices and plant in Brookfield, Wisconsin, are owned. METCO's plants in Jackson, Mississippi, Blytheville, Arkansas, and Pewaukee, Wisconsin, its distribution center in Olive Branch, Mississippi, and its technical center in Brookfield, Wisconsin, are leased under leases which give METCO options to purchase the properties. Manufacturing facilities have an aggregate of approximately 400,000 square feet of area and distribution facilities have an aggregate of approximately 150,000 square feet of area. In October 1990 METCO leased approximately 75,000 square feet of additional manufacturing space in Kosciusko, Mississippi. Commencement of manufacturing operations at that facility has been postponed indefinitely. Item 3.	Item 3. Legal Proceedings (a) The Company is involved in various matters of litigation incidental to the normal conduct of its business. In management's opinion the disposition of that litigation will not have a material adverse impact on the financial condition of the Company. (b) Not applicable. Item 4.	Item 4. Submission of Matters to a Vote of Security Holders Not applicable. PART II Item 5.	Item 5. Market for the Registrant's Common Stock and Related Security Holder Matters There is no established public trading market for the common stock. Item 6.	Item 6. Selected Financial Data See page 8. Item 7.	Item 7. Management's Discussion and Analysis of Results of Operations and Financial Condition The following Summary of Operations with respect to the Company's continuing operations for the years ended December 31, 1993, 1992, and 1991 is presented to accompany management's discussion of results of operations. The Company's continuing operations for the periods set forth above include METCO and its subsidiary for all periods presented, and Milford and its subsidiary through March 28, 1991 (the date on which the Company sold the stock of Milford). (See "Sale of Milford" at page 23.) During the last several years the Company has divested several operating units including the Spreckels Operations, the Industrial Products Group, Amstar Sugar Corporation and the Electronics Group. Historically, these operations have been reflected as Discontinued Operations in the Company's financial statements. On April 15, 1992, the Company sold Keltec Florida, Inc., the last of its operations which had been classified as Discontinued Operations in its historical financial statements. (See discussion at page 2.) The Summary of Operations should be read in conjunction with the Consolidated Financial Statements. AMSTAR CORPORATION SUMMARY OF OPERATIONS (dollars in millions) Year Ended December 31, 1993 1992 1991 Net sales $306.4 $266.4 $242.0 Costs of products sold 214.1 186.0 174.0 Gross profit 92.3 80.4 68.0 Selling, general and administrative expenses 58.1 49.3 50.6 Other expense 4.6 4.5 4.1 Operating income 29.6 26.6 13.3 Interest income 14.9 13.1 28.8 Interest expense (23.6) (23.6) (36.1) Other non-operating income - - 0.3 (8.7) (10.5) (7.0) Income before provision for income taxes, extraordinary gain and cumulative effect of changes in accounting principles 20.9 16.1 6.3 Income tax provision 10.7 6.9 5.0 Income before extraordinary item and cumulative effects of changes in accounting principles 10.2 9.2 1.3 Extraordinary gain on repurchase of 113/8 Senior Subordinated Notes, net of related income taxes - - 20.2 Income before cumulative effects of changes in accounting principles 10.2 9.2 21.5 Cumulative effects of changes in accounting principles (10.9) - - Net income (loss) $ (0.7) $ 9.2 $ 21.5 Year Ended December 31, 1993 Compared with Year Ended December 31, 1992 Sales Amstar's net sales were $306.4 million during the year ended December 31, 1993, an increase of $40.0 million or 15.0%, over the preceding year. The increase is due to a 12.4% increase in unit sales of tools and accessories, and a 2.3% increase in the average tool unit and accessory selling price. Income from Operations Income from operations was $29.6 million during the year ended December 31, 1993, compared with $26.6 million during the year ended December 31, 1992. The improvement was due primarily to greater sales volume during the 1993 period. Gross margin was 30.1% of net sales during the year ended December 31, 1993, as compared with 30.2% during the year ended December 31, 1992. Effective January 1, 1993, Amstar adopted Financial Accounting Standard No. 109, "Accounting for Income Taxes" ("FAS 109") (See note 9 to consolidated financial statements at page S-14). This accounting change resulted in additional depreciation included in costs of products sold of $0.6 million during 1993. Exclusive of this accounting change, gross margin was 30.3% of net sales, a slight increase over the prior year. Selling, general, and administrative expenses, including corporate expenses, increased 0.4% to 18.9% as a percentage of sales during the year ended December 31, 1993, as compared with the preceding year. Effective January 1, 1993, Amstar adopted Financial Accounting Standard No. 106, "Accounting for Postretirement Benefits Other Than Pensions" ("FAS 106") (See note 8 to consolidated financial statements at page S-13). This accounting change resulted in additional selling and administrative expense of $0.8 million during 1993. Exclusive of FAS 106 charges and corporate expenses, selling and administrative expenses increased by $8.6 million. This represents an increase of 0.6% as a percentage of sales, resulting from the expansion of sales and marketing programs. Other Items Interest expense, which primarily reflects interest on the 11-3/8% Senior Subordinated Notes (the "Notes"), remained unchanged from the preceding year at $23.6 million. Interest income, including $14.1 million of interest from loans and advances to related parties, increased by $1.8 million during the current year to $14.9 million. This increase is primarily the result of additional accretion of interest on the Senior Subordinated Discount Notes due in 1997 (the "Discount Notes"). Subsequent to December 31, 1993, Essex informed the Company that as of December 31, 1993, Essex wrote off the remaining balance of its goodwill of $82.3 million. (See "Goodwill Write-off" at page 29.) Based on this information, the Company determined that, as of December 31, 1993, the ultimate realization of a portion of the Discount Notes may be in doubt. Accordingly, the Company has classified the Discount Notes as an offset to stockholder's equity in the consolidated balance sheet and statement of changes in stockholder's equity as of December 31, 1993, and will reserve in full against the accretion of interest on the Discount Notes subsequent to December 31, 1993. (See "Exchange of Indebtedness" at page 15.) The effective consolidated federal income tax rate for continuing operations was 38.2% in 1993 compared with 30.9% in 1992, (See note 9 to the Consolidated Financial Statements starting at page S-14.) Results of Operations Year Ended December 31, 1992 Compared with Year Ended December 31, 1991 Sales Amstar's net sales were $266.4 million during the year ended December 31, 1992, an increase of $24.4 million or 10.1% over the year ended December 31, 1991. Milford, which was sold on March 28, 1991, accounted for $5.9 million of net sales during the year ended December 31, 1991. (See "Sale of Milford" at page 23.) Exclusive of Milford, net sales increased $30.3 million, or 12.8%, from the preceding year. The increase is due to a 10.0% increase in unit sales of tools and accessories, and a 2.5% increase in the average tool unit and accessory selling price. Income from Operations Income from operations was $26.6 million during the year ended December 31, 1992, compared with $13.3 million during the year ended December 31, 1991. The improvement was due to greater sales volume and improved gross margin. Gross margin improved to 30.2% of net sales during the year ended December 31, 1992, from 28.1% during the year ended December 31, 1991, primarily because of higher production levels in 1992 as compared to 1991. Higher production levels resulted in the spreading of fixed overhead costs over a larger number of units, thus reducing the per unit cost of products sold, and increasing gross margin during 1992 as compared to 1991. Additionally, manufacturing efficiencies were experienced during 1992 resulting from the Company's conversion to cellular manufacturing during 1990 and 1991. Selling, general, and administrative expenses, including corporate expenses, declined 2.4% as a percentage of sales during the year ended December 31, 1992, compared with 1991, due to several factors. Exclusive of Milford and corporate expenses, selling and administrative expenses increased by $1.5 million during the current year. This represents a decrease of 1.4% as a percentage of sales, however, because of the increase in sales volume. The remaining portion of the decline in selling and administrative expenses as a percentage of sales is the result of a decrease in corporate expenses of $1.4 million, and the sale of Milford, whose selling and administrative expenses, as a percentage of sales, had exceeded the Company's, as a whole. Other Items Interest expense, which primarily reflects interest on the Notes, decreased by $12.5 million during 1992, as compared with 1991. The decrease is primarily due to the repurchase of $30.0 million principal amount of the Notes on March 28, 1991, and the reduction of $86.6 million principal amount of the Notes on December 31, 1991, resulting from the exchange of debt. (See "Exchange of Indebtedness" at page 15.) Additionally, during the year ended December 31, 1991, the Company incurred interest expense in connection with tax payments related to prior years' tax returns. Interest income, primarily reflecting interest from loans and advances to related parties, decreased by $15.7 million during 1992 to $13.1 million, as compared to the prior year, primarily as a result of the exchange of indebtedness that occurred on December 31, 1991. During 1992, the Company recorded $12.2 million of interest income representing an increase of that amount in the accreted value of the Discount Notes. (See "Exchange of Indebtedness" at page 15.) The effective consolidated federal income tax rate for continuing operations was 30.9% in 1992 compared with 56.7% in 1991. (See note 9 to the Consolidated Financial Statements starting at page S-14.) Restructuring The following related transactions affecting the financial structure of Amstar and Essex occurred on December 31, 1991. Consummation of Tender Offer by Essex On December 31, 1991, Essex, pursuant to the Offer to Purchase dated November 12, 1991, and related letter of transmittal (as amended, supplemented and extended, the "Offer"), accepted for payment, and thereby purchased, $86.6 million principal amount of Amstar's Notes. The Notes purchased by Essex were purchased at a price of $750 per $1,000 principal amount, plus interest accrued thereon from August 15, 1991, to December 31, 1991, the date of acceptance for payment. The accrued interest payable on the Notes purchased in the Offer was reimbursed to Essex by Amstar. Exchange of Indebtedness Concurrent with the purchase of the Notes by Essex pursuant to the Offer, Amstar exchanged, pursuant to the Debt Exchange Agreement dated as of December 31, 1991, between Amstar and Essex (the "Debt Exchange Agreement"), (a)(i) $100.0 million principal amount of 14% Subordinated Debentures due 1997 of Essex (the "Debentures") held by Amstar, plus the right to accrued interest thereon and (ii) $25.0 million accreted value of Senior Subordinated Discount Notes due 1997 of Essex (the "Discount Notes") held by Amstar for (b) the $86.6 million principal amount of Notes purchased pursuant to the Offer (the "Debt Swap"). In connection with the consummation of the Debt Swap, the Board of Directors of Amstar received the opinion of a nationally recognized investment banking firm to the effect that the consideration received by Amstar in the Debt Swap was fair, from a financial point of view, to securities holders of Amstar. As of March 25, 1994, there was outstanding $195.3 million principal amount of Notes (excluding $3.5 million principal amount of Notes beneficially owned by the Company that are held pursuant to an escrow agreement to secure certain obligations of a subsidiary of the Company). As of December 31, 1993, Amstar held approximately $107.8 million accreted value of Discount Notes. Subsequent to December 31, 1993, Essex informed the Company that as of December 31, 1993, Essex wrote off the remaining balance of its goodwill of $82.3 million. (See "Goodwill Write-off" at page 29.) Based on this information, the Company determined that, as of December 31, 1993, the ultimate realization of a portion of the Discount Notes may be in doubt. Accordingly, the Company has classified the Discount Notes as an offset to stockholder's equity in the consolidated balance sheet and statement of changes in stockholder's equity as of December 31, 1993, and will reserve in full against the accretion of interest on the Discount Notes subsequent to December 31, 1993. Amendment of Discount Note Indenture In response to a condition imposed by the lenders under Essex's bank credit agreement (the "Essex Credit Agreement") with respect to consummation of the amendments to the Essex Credit Agreement described below, Amstar and Essex amended the terms of the indenture governing the Discount Notes (the "Discount Note Indenture") pursuant to the Second Supplemental Indenture dated as of December 31, 1991 (the "Second Supplemental Indenture"). The Second Supplemental Indenture amended the Discount Note Indenture to provide that, at the option of Essex, the date from and after which cash interest must be paid on the Discount Notes may be extended to the maturity of the Discount Notes, February 1, 1997. In addition, the Second Supplemental Indenture amended the Discount Note Indenture to (i) increase the amount of indebtedness permitted to be incurred by Essex under the revolving loan portion of the Essex Credit Agreement by an additional $3.0 million and (ii) permit ESSEX Industries, Inc., a newly formed wholly owned subsidiary of Essex, to guarantee, and to provide a pledge of its assets in connection with, indebtedness incurred under the Essex Credit Agreement, provided that the new subsidiary does not hold tangible assets material to the operations of Essex and its subsidiaries as a whole. The new subsidiary was incorporated under the name ESSEX Holdings, Inc. and changed its name to ESSEX Industries, Inc., effective January 23, 1992. (See reference at page 3 to the related name change by Essex.) Refinancing of Amstar Credit Agreement On December 31, 1991, METCO entered into a credit agreement (the "Credit Agreement") with Heller Financial, Inc. ("Heller"). The Credit Agreement provides for a primary letter of credit facility of $15.0 million, a primary revolving facility of $45.0 million (up to $15.0 million of which may be used for letters of credit) and, effective January 15, 1993, a secondary revolving loan facility of $10.0 million which was amended and increased to $15.0 million effective October 26, 1993 (collectively the "Credit Facility"). The Credit Agreement expires and all obligations outstanding thereunder become due and payable on December 31, 1995. All amounts outstanding under the Credit Facility are Senior Indebtedness for purposes of the Indenture, dated as of February 15, 1987, between Amstar and Chemical Bank, as Trustee (the "Indenture"). The Credit Facility replaced the revolving credit agreement (the "Revolving Credit Agreement") dated as of June 28, 1989 between Amstar, METCO and The Bank of New York ("BNY") and the letter of credit agreement (the "Letter of Credit Agreement") dated as of June 28, 1989, between Amstar, BNY, Amstar Technical Products Company, Inc., a Delaware corporation ("ATP"), and Akadvans Corporation (formerly called Aiken Advanced Systems, Inc.), a Delaware corporation ("Akadvans"). ATP is a wholly owned subsidiary of Amstar and Akadvans is a wholly owned subsidiary of ATP. Pursuant to a Release and Termination Agreement dated as of December 31, 1991, between Amstar, METCO and BNY, BNY released its interest in the collateral granted in connection with the Revolving Credit Agreement, and such agreement and the Letter of Credit Agreement were terminated. The loans made pursuant to the Credit Facility are secured by a first security interest in substantially all the real and personal property of METCO, the capital stock of METCO and 65% of the capital stock of METCO's sole subsidiary. Additionally, Amstar has guaranteed the indebtedness of METCO under the Credit Agreement pursuant to the terms of a secured guaranty, executed in connection with the Credit Facility, as amended on December 31, 1992 (the "Secured Guaranty"). METCO has granted a security interest in all of its intellectual property pursuant to a copyright assignment agreement, a patent assignment agreement, and a trademark assignment agreement. The obligations of Amstar under the Secured Guaranty are secured by a pledge of all the capital stock of METCO pursuant to a pledge agreement between Amstar and Heller. METCO's pledge of 65% of the capital stock of its sole subsidiary is evidenced by a subsidiary pledge agreement. Financial Condition Years Ended December 31, 1993, 1992, and 1991 Working Capital The working capital of the Company was $48.5 million on December 31, 1993, $44.3 million on December 31, 1992, and $50.0 million on December 31, 1991. The accounting change caused by the adoption of FAS 109 effective January 1, 1993, resulted in a $6.3 million increase in the carrying value of the inventory as compared to the balance at December 31, 1992. The accounting change also resulted in the reclassification of approximately $11.2 million of current tax liabilities to noncurrent liabilities, and the recording of a current deferred tax liability of $3.5 million. Additionally, during the year ended December 31, 1993, the Company transferred $4.0 million of noncurrent tax liabilities to Esstar, resulting in a reduction in the Company's Receivable from Esstar. All other working capital changes during 1993 were normal period-to-period variations. During the year ended December 31, 1992, the payment of the full amount of an income tax receivable of $15.75 million was received by the Company, and was used to reduce outstanding indebtedness under the Company's revolving credit facility. All other working capital changes were normal period-to-period variations during 1992. The current ratio was 2.0 to 1.0 at December 31, 1993, as compared to 1.9 to 1.0 at December 31, 1992, and 2.1 to 1.0 at December 31, 1991. The ratios changed due to the changes in working capital accounts described above. Under the terms of the tax sharing agreement with Esstar, the Company provides and pays income taxes as if it files its own consolidated return. During the year ended December 31, 1993, the Company paid Esstar $6.8 million of such taxes. During the year ended December 31, 1992 and 1991, $6.6 million and $16.5 million, respectively, of such taxes were paid. Receivable from Esstar represents advances made to Esstar, which primarily result from normal period-to-period cash management operations of the Company, and which are due and payable to the Company on demand. Additionally, during 1993, the Company transferred $4.0 million of noncurrent tax liabilities to Esstar, resulting in a reduction in the Company's receivable from Esstar. Beginning in 1991, the receivable bears interest at 10% per annum. Long-Term Investments Prior to October 31, 1989, the Company held a $15.0 million preferred stock investment and warrants to purchase six percent of the outstanding common stock of Spreckels Industries, Inc. ("Spreckels"). The stock and warrants were acquired in July 1987 as part of the sales price for Spreckels operations and the Industrial Products Group. On October 31, 1989, as permitted by the terms of the preferred stock, Spreckels exchanged the preferred stock, plus dividends accrued to that date, for a Junior Subordinated Note due July 31, 1995, in the principal amount on the exchange date of $16.8 million, and bearing interest at 13% per annum. On February 13, 1991, the Company sold the note and the warrants for an aggregate price of $15.0 million. The proceeds from the sale were used for working capital requirements of the Company, which included payment of accrued interest on the indebtedness of the Company. On June 30, 1989, in connection with the Combination, the Company made an intercompany loan to Essex (the "Intercompany Loan"). The Intercompany Loan was evidenced by $152.7 million aggregate principal amount of Discount Notes due 1997 (the "Discount Notes") and $100.0 million aggregate principal amount of 14% Subordinated Debentures due 1997 (the "Debentures"). Interest on the Debentures was payable semi-annually, on August 1 and February 1 of each year. Essex paid the Company $1.2 million, due on August 1, 1989, and $7.0 million each due on February 1, 1990, August 1, 1990, February 1, 1991 and August 1, 1991, of interest in cash on the Debentures, as required under the terms thereof. On December 31, 1991, the Discount Note Indenture was amended to provide that, among other things, at the option of Essex, the date from and after which cash interest must be paid on the Discount Notes may be extended to the maturity of the Discount Notes, February 1, 1997. Pursuant to a Debt Exchange Agreement dated as of December 31, 1991, between Amstar and Essex, Amstar exchanged $100.0 million aggregate principal amount of the Debentures, plus the right to receive accrued interest thereon, and $25.0 million accreted value of the Discount Notes, for $86.6 million of the Notes (the "Debt Swap"). (See "Exchange of Indebtedness" at page 15.) As of December 31, 1993, the Company held approximately $107.8 million accreted value of Discount Notes. As of the same date, Essex informed the Company that Essex was in compliance with the terms and conditions of the Discount Note Indenture. Subsequent to December 31, 1993, Essex informed the Company that as of December 31, 1993, Essex wrote off the remaining balance of its goodwill of $82.3 million. (See "Goodwill Write-off" at page 29.) Based on this information, the Company determined that, as of December 31, 1993, the ultimate realization of a portion of the Discount Notes may be in doubt. Accordingly, the Company has classified the Discount Notes as an offset to stockholder's equity in the consolidated balance sheet and statement of changes in stockholder's equity as of December 31, 1993, and will reserve in full against the accretion of interest on the Discount Notes subsequent to December 31, 1993. Financial data and a discussion of the results of operations and financial condition of Essex for the year ended December 31, 1993, are included in this report commencing at page 25. Effective at the close of business on December 31, 1989, the Company sold substantially all of the assets of Aiken Advanced Systems, Inc., a wholly-owned subsidiary in the Electronics Group, for a purchase price of approximately $7.2 million, which approximated the book value of those assets, and the assumption of specified liabilities. Of the $7.2 million, $0.25 million was in cash with the remainder payable under a promissory note bearing interest at 16% per annum and payable in four semi-annual installments beginning July 2, 1990. Approximately $2.6 million in cash was received by the Company during the year ended December 31, 1990, in partial payment of the principal of the promissory note. As of December 31, 1990, the obligor was not in compliance with certain terms and conditions of the promissory note. As a result of discussions the Company had with the purchaser to resolve a dispute regarding the original purchase price, the promissory note was amended to reduce the remaining principal balance of the indebtedness to $1.6 million, as of January 1, 1991, to provide that it would mature on December 31, 1992, and that it would bear interest at 12% per annum in 1991 and at 16% per annum in 1992. As of March 25, 1994, the obligor had not paid the quarterly interest installments due on June 30, September 30 and December 31, 1992. The promissory note matured on December 31, 1992, and was not paid at that time. The Company fully reserved for the value of this note during the year ended December 31, 1990. Leverage, Credit Availability and Liquidity As of December 31, 1993, the Company's debt included $195.3 million principal amount of the Notes (excluding $3.5 million principal amount of Notes beneficially owned by the Company that are held pursuant to an escrow agreement to secure certain obligations of a subsidiary of the Company). Subsequent to December 31, 1993, Essex informed the Company that Essex wrote off the remaining balance of its goodwill (See "Goodwill Write-off" at page 29.) Accordingly, as of December 31, 1993, the Company has classified the Discount Notes as an offset to stockholder's equity in the consolidated financial statements, resulting in a reduction in net equity of $107.8 million as of December 31, 1993. Exclusive of this reduction, the total debt to equity ratio was 2.3 to 1.0 on December 31, 1993, as compared to 2.1 to 1.0 on December 31, 1992, and 2.4 to 1.0 on December 31, 1991. The adoption of FAS 106 and FAS 109 had a cumulative effect of reducing equity by $11.0 million during the year ended December 31, 1993. Additionally, the Company declared a dividend of $7.5 million on May 10, 1993 (See "Dividend" at page 23.) On June 28, 1989, the Company entered into the Revolving Credit Agreement which provided for loans, secured by accounts receivable, of up to $30.0 million with interest payable at the prime rate, or the reserve adjusted Eurodollar rate plus 7/8%. On December 31, 1991, METCO entered into the Credit Agreement with Heller, which replaced the Revolving Credit Agreement. (See "Refinancing of Amstar Credit Agreement" at page 16.) The Credit Agreement provides for a primary revolving facility of $45.0 million (up to $15.0 million of which may be used for letters of credit) and, effective January 15, 1993, a secondary revolving loan facility of $10.0 million which was amended and increased to $15.0 million effective October 26, 1993 (collectively the "Credit Facility"). In addition, the Credit Agreement provides for a primary letter of credit facility of $15.0 million. Borrowings under the primary revolving facility are limited to 90% of eligible accounts receivable of METCO, as defined, 65% of eligible inventory, as defined, and the primary letter of credit borrowing base of $15.0 million, as defined. Borrowings under the Credit Facility bear interest at either the London Interbank Offered Rate (LIBOR) plus 3.0% to 3.75%, or the prime rate plus 1.75% to 2.5%, with borrowings under the secondary revolving loan facility bearing the higher interest rates. There is a 2.0% per annum fee on all outstanding letters of credit and a 0.5% per annum fee on the unused portion of the Credit Facility. In addition, if METCO's operating cash flow, as defined, does not meet certain minimum ratios for a specified period of time, these interest rates will increase by 1.0% on the Credit Facility borrowings and by 0.5% on the outstanding letters of credit. As of February 28, 1994, METCO's operating cash flow met those ratios. The loans made and letters of credit issued pursuant to the Credit Agreement are secured by substantially all the real and personal property of METCO, the capital stock of METCO and 65% of the capital stock of METCO's sole subsidiary. Additionally, the Company has guaranteed the indebtedness of METCO under the Credit Agreement. On December 31, 1993, there was $14.6 million outstanding under the primary revolving facility, including $8.1 million of letters of credit, and there were letters of credit of $15.0 million outstanding under the primary letter of credit facility. As of the same date, there was $45.4 million of available credit remaining under the terms of the Credit Agreement. (See "Refinancing of Amstar Credit Agreement" at page 16.) As of March 25, 1994, there was $25.9 million outstanding under the primary revolving facility, including $9.5 million of letters of credit, and there were $15.0 million of letters of credit outstanding under the primary letter of credit facility. There was $34.1 million of availability remaining under the terms of the primary revolving facility as of the same date. The Indenture for the Notes and the Credit Agreement contain various covenants that restrict the business activities of the Company. As of February 28, 1994, Amstar was in compliance with the covenants in those agreements. The Company anticipates that the Company and its subsidiaries will remain in compliance with all such covenants during the next twelve months. As a result of the Debt Swap on December 31, 1991, (see "Exchange of Indebtedness" at page 15), the Company incurred a capital loss which it carried back to a prior year in which the Company paid federal taxes on capital gains. The Company recorded an income tax receivable of $15.75 million on its balance sheet as of December 31, 1991, in connection with this transaction. Payment of the full amount of that receivable was received by the Company on March 23, 1992, and was used to reduce outstanding indebtedness under the Credit Facility. Management believes that funds generated by the operations of the Company combined with its credit availability are adequate to meet its working capital, capital expenditures and other funding requirements. Debt and preferred stock agreements of Esstar require that the Company apply the proceeds of certain asset sales to reduce the Company's indebtedness. These agreements may require Amstar to repurchase a portion of the outstanding Notes as well as repaying other borrowings which may be outstanding. The Company is in the process of reviewing various alternatives to its present capital structure, including the potential refinancing of indebtedness outstanding under the Notes. The Company has received, and is reviewing a preliminary proposal from Merrill Lynch & Co. in connection with such a potential refinancing. Such a refinancing, if pursued, would be subject to a number of factors, including market conditions, economic conditions and the Company's operating performance. While the Company believes that the positive trends reflected in its fiscal 1993 operating results have continued into the first quarter of fiscal 1994, there can be no assurance as to the Company's operating performance in 1994 or as to the other conditions necessary to consummate a refinancing. Therefore, there can be no assurance that a refinancing or other transaction, if pursued, would occur. Esstar has advised the Company that it is reviewing potential alternatives with respect to its consolidated financial and corporate structure. Repurchase of 11-3/8% Senior Subordinated Notes During the six month period ended December 31, 1989, the Company repurchased, in the open market, $12.1 million principal amount of the Notes. On May 1, 1990, the Company repurchased, in the open market, an additional $11.0 million principal amount of the Notes. As of December 31, 1990, $311.9 million principal amount of the Notes were outstanding. These transactions resulted in a gain of approximately $1.3 million at December 31, 1989, and $3.0 million at December 31, 1990, net of related costs and a provision for income taxes. On March 28, 1991, the Company used $16.5 million of the proceeds from the sale of Milford to repurchase $30.0 million principal amount of the Notes. (See "Sale of Milford" at page 23.) In addition, on December 31, 1991, in connection with the Debt Swap, Amstar cancelled $86.6 million of Notes received in the Debt Swap. (See "Exchange of Indebtedness" at page 15.) The gains resulting from these transactions of $20.2 million, net of related costs and a provision for income taxes during 1991, in addition to the gain resulting from the repurchase during 1990, have been reflected as extraordinary items in the Summary of Operations at page 10. At December 31, 1993, $195.3 million principal amount of the Notes was outstanding (excluding $3.5 million principal amount of the Notes beneficially owned by the Company that are held pursuant to an escrow agreement to secure certain obligations of a subsidiary of the Company). Cash Interest Expense During each of the years ended December 31, 1993 and 1992, the Company's cash interest expense related to the Notes was $22.2 million. During 1992 the Company's cash interest expense related to the Notes was $13.3 million less than 1991 as a result of the $116.6 million reduction in the principal amount of Notes outstanding that occurred during 1991 (see "Repurchase of 11-3/8% Senior Subordinated Notes"). In addition, as a result of the exchange and cancellation of the $100.0 million principal amount of the Debentures, the Company no longer receives $14.0 million annual interest income in cash from Essex. (See "Exchange of Indebtedness" at page 15.) Dividend On May 10, 1993, the Company declared, and subsequently paid on June 28, 1993, a dividend in the aggregate amount of $7.5 million on its issued and outstanding shares of capital stock, all of which are owned by Esstar. The Company did not declare any dividends during 1992 or 1991. Inflation Inflation has not had a significant effect on the Company's operations during the 1991 through 1993 fiscal periods. Capital Expenditures Capital expenditures for continuing operations were $8.3 million, $6.8 million, and $7.0 million during the years ended December 31, 1993, 1992 and 1991, respectively. Expenditures during 1993, 1992, and 1991 include a portion of a project to further increase the automation of motor manufacturing and other projects related to new product development and cost reduction. Sale of Milford On March 28, 1991, the Company sold the stock of Milford, and entered into a covenant not to compete, for an aggregate consideration of approximately $19.7 million in cash, which was in excess of Milford's net book value at December 31, 1990. Of the proceeds, $16.5 million was used to repurchase $30.0 million principal amount of the Notes. (See "Repurchase of 11-3/8% Senior Subordinated Notes" at page 22.) The net assets, revenues and operating income of Milford were not material to the consolidated net assets and operating results of the Company. In connection with the sale, Milford sold its equipment for the production of reciprocating saws and hole saws to METCO. The equipment was moved from Milford's Branford, Connecticut plant to METCO's main plant in Brookfield, Wisconsin. Also in connection with the sale, the Company entered into an agreement with the buyer under which it agreed to provide, through a wholly owned subsidiary, for the remediation of certain environmental conditions found on Milford's Branford, Connecticut plant site during an investigation carried out by the buyer prior to the sale. Based on the results of an investigation carried out by environmental consultants, it is presently estimated that the cost of remediation will not exceed $1.0 million. The Company's obligations are secured in part by the pledge by the Company of $3.5 million aggregate principal amount of the Notes. In addition, the Company agreed to assume the responsibility for all workers' compensation claims incurred by Milford through March 28, 1991, which are estimated to be $2.8 million, as of December 31, 1993. A wholly owned subsidiary of the Company has recorded a reserve for the estimated costs of the remediation and the Company has recorded a reserve for the workers' compensation liability. As of December 31, 1993, the Company had expended $0.3 million on the environmental remediation and $1.7 million in workers' compensation claims. Also, $1.1 million of Milford indebtedness associated with Milford's Branford, Connecticut plant remained with Milford in connection with the sale. Cuban Claim The Company holds a claim for compensation for operations of a predecessor corporation seized by Cuba in 1960. The amount of the claim, certified at approximately $81.0 million in 1969 by the Foreign Claims Settlement Commission of the United States, plus interest accrued in accordance with the terms of the certification, currently is up to approximately $587.0 million. There is no assurance that the Company will ever receive compensation in settlement of the claim, and no value is recorded on the Company's financial statements for this claim. The receipt of consideration in satisfaction of such claim will depend on a number of uncertainties, including economic and political conditions in Cuba and the policies of the United States government. ESSEX Holdings, Inc. In connection with the Combination, the Company made the Intercompany Loan to Essex which was evidenced by $252.7 million aggregate principal amount of securities, which consisted of the Discount Notes and the Debentures. As a result of the Debt Swap at December 31, 1991, the Debentures, together with accrued interest thereon as of that date, and $25.0 million of the Discount Notes, were redeemed and are no longer outstanding as indebtedness of Essex due to Amstar. (See "Exchange of Indebtedness" at page 15.) For a description of the securities held as an investment see the discussion at page 18 and note 5 to the Amstar Consolidated Financial Statements starting at page S-9. Essex, through its wholly owned subsidiaries, is engaged in the manufacture and distribution of architectural hardware and related products primarily for the non-residential building market. The subsidiaries and their businesses include the manufacture and distribution of locks, locksets, door closers and exit devices by Sargent Manufacturing Company and Sargent of Canada, Ltd., a Canadian corporation; metal doors and frames by Curries Company ("Curries"); wood doors by Graham Manufacturing Corporation ("Graham")and hinges and stainless steel washroom accessories by McKinney Products Company ("McKinney"). On November 7, 1991, Essex formed a new subsidiary which, on January 23, 1992, changed its name from ESSEX Holdings, Inc. to ESSEX Industries, Inc. (and, on January 23, 1992, Essex changed its name from ESSEX Industries, Inc. to ESSEX Holdings, Inc.). This subsidiary conducts sales and marketing activities for the domestic operating subsidiaries of Essex. On September 6, 1991, Essex sold the capital stock of Arrow Lock Manufacturing Company ("Arrow") to a subsidiary of Securitas AB of Sweden for an aggregate consideration of approximately $28.7 million (see "Sale of Arrow" at page 34). On May 22, 1990, a federal grand jury in St. Louis indicted McKinney, and three unrelated corporations, for allegedly violating the antitrust laws. McKinney entered a plea of nolo contendere and the court accepted the plea. Five present or former executives of three of the indicted corporations, including Robert A. Haversat, President and Chief Executive Officer of the Company and of Essex, and formerly President of McKinney and David B. Gibson, President of McKinney, also were indicted. Messrs. Haversat and Gibson entered pleas of nolo contendere and the court accepted such pleas. On March 31, 1993, in the United States District Court in St. Louis, Missouri, McKinney was fined $2.0 million, payable over a five year period. Essex has recorded the impact of this fine in the accompanying financial statements as of and for the year ended December 31, 1993. On March 31, 1993, and April 1, 1993, respectively, Mr. Gibson and Mr. Haversat were also fined in the United States District Court in St. Louis, each in the amount of $250,000. The United States Department of Justice filed notices of appeal with respect to the sentences imposed on McKinney and Messrs. Gibson and Haversat. McKinney and the individual defendants filed responsive notices of appeal to preserve its and their rights should the government proceed with an appeal. Subsequently, the United States and McKinney entered into a stipulation to terminate the appeals, thereby bringing to a conclusion the criminal action against McKinney. The appeals with respect to Messrs. Haversat and Gibson are proceeding. Six civil class actions on behalf of direct purchasers of architectural hinges were initiated against McKinney and the other indicated corporations. McKinney and two of the other corporate defendants entered into a settlement agreement of $4.0 million with respect to those actions. This settlement agreement was approved by the court, and payment was made in 1990. Three class actions on behalf of California indirect purchasers and a class action on behalf of Alabama indirect purchasers of architectural hinges were initiated against McKinney and the three other corporate defendants. McKinney and other corporate defendants entered into a settlement agreement with respect to two of the three California actions and with respect to the Alabama action. Those settlement agreements received court approval and payment was made as of December 31, 1992. It is presently expected that a satisfactory resolution of the third California class action will be obtained. The ESSEX Holdings, Inc. Summary of Operations, ESSEX Holdings, Inc. discussion of Results of Operations and Financial Condition, and the Audited Consolidated Financial Statements of ESSEX Holdings, Inc. set forth herein have been furnished to the Company by the management of Essex and are included herein to provide investors in the Company with information about Essex. Certain reclassifications have been made to the 1992 and 1991 income statement data provided in the Essex Summary of Operations in order for the presentation to be in conformity with the 1993 income statement data. The information reported reflects all adjustments (consisting only of normal recurring accruals and the cumulative effect of changes in accounting principles discussed in the Notes to Condensed Consolidated Financial Statements.) which are, in the opinion of Essex management, necessary to a fair statement of the results for the period presented. The ESSEX Summary of Operations should be read in conjunction with the financial statements of ESSEX Holdings, Inc. and notes thereto included in this report. ESSEX HOLDINGS, INC. SUMMARY OF OPERATIONS (dollars in millions) Year Ended December 31, 1993 1992 1991 Income Statement Data: Net sales $ 204.3 $188.2 $203.6 Costs of products sold 186.0 171.4 182.6 Gross profit 18.3 16.8 21.0 Selling, general and administrative expenses 33.6 27.6 34.9 Amortization of goodwill and other expense 10.1 6.9 6.5 Goodwill write-off 82.3 - - Loss from operations (107.7) (17.7) (20.4) Interest expense 23.3 23.1 43.4 Loss before benefit from income taxes, extraordinary gain and cumulative effects of changes in accounting principles (131.0) (40.8) (63.8) Income tax benefit (5.2) (1.7) (15.9) Loss before extraordinary item and cumulative effects of changes in accounting principles $(125.8) $(39.1) $(47.9) Depreciation and amortization included above: Cost of sales $ 37.2 $ 32.0 $ 34.1 Other expense 4.8 5.6 5.1 Balance Sheet Data: Working capital $ 12.4 $ 13.8 $ 23.3 Total assets 131.8 235.7 272.5 Capitalization: Long-term debt, including notes payable to Amstar 205.6 204.9 211.8 Common stockholder's equity (deficit) (156.5) (37.9) 1.2 Results of Operations Year Ended December 31, 1993 Compared with December 31, 1992 Sales Essex's net sales for the year ended December 31, 1993, were $204.3 million, an increase of $16.1 million, or 8.6% over the preceding year. The increase resulted from greater unit sales and, to a lesser extent, higher average selling prices of certain Essex products during 1993. Income from Operations Excluding the write-off of the December 31, 1993 goodwill balance of $82.3 million, Essex incurred a loss from operations of approximately $25.4 million during the year ended December 31, 1993, as compared to a loss from operations of $17.7 million during the 1992 period. The greater loss during 1993 is due to an increase in selling and administrative expenses of $6.0 million and an increase in other expenses of $3.2 million, which were partially offset by an increase in gross profit of $1.5 million. Gross margin, excluding depreciation and amortization expense, was 27.2% during 1993 as compared with 25.9% during the preceding year. Higher margins are the result of manufacturing efficiencies and higher production levels. Higher production levels resulted in the spreading of fixed production costs over a larger number of units, thus reducing the per unit cost of products sold, and increasing gross margin during 1993 as compared with 1992. Depreciation increased during the year ended December 31, 1993, as a result of Essex's adoption of FAS 109. This accounting change resulted in additional depreciation included in costs of products sold of $4.9 million during 1993. As a percentage of sales, selling and administrative expenses increased by 1.7% to 16.4% during 1993, as compared to the prior year. Effective January 1, 1993, Essex adopted FAS 106. This accounting change resulted in additional selling and administrative expense of $1.5 million during 1993. Exclusive of FAS 106 charges, selling and administrative expenses increased by $4.5 million, representing an increase of 1.0% as a percentage of net sales. The increase is primarily due to the introduction of new sales and marketing programs. Other expenses, which primarily reflects amortization of goodwill and other intangible assets, increased by $3.2 million during 1993 as compared with 1992. During 1993, a $2.0 million fine was imposed on McKinney relating to the antitrust suit (see discussion at page 25). Additionally, Essex recorded a $2.5 million reserve for costs associated with the Graham plant move (see "Graham Plant Move" at page 34) and other reorganization costs. Exclusive of these nonrecurring costs, other expense declined by $1.3 million during the year ended December 31, 1993 as compared to 1992. Goodwill Write-off Since the Combination in 1989, Essex has not achieved its sales or earnings projections established at that time due primarily to the general economic recession and its impact on certain markets served by Essex related to the nonresidential segment of the construction industry, combined with significantly increased competitive pressures. During December 1993, when Essex prepared its operating plans for 1994, it determined that it most likely would not be in compliance with certain financial ratio covenants during 1994 under the Essex Credit Agreement. Additionally, during this period, there was consolidation of certain Essex competitors, which led Essex to believe that there might be additional pressure on profit margins in the future. These events caused Essex to reevaluate its longer term operating projections and its ability to recover the remaining balance of its goodwill recorded on the Essex balance sheet. The methodology used by Essex to assess the recoverability of its goodwill involved the projection of its net income over the remaining 35 year amortization period of the goodwill. This projection indicated that Essex would incur a net loss of approximately $8.0 million during the remaining 35 year amortization period, including a net loss of over $100.0 million during the first 15 years without regard to goodwill amortization. Accordingly, Essex wrote off the remaining balance of its goodwill of $82.3 million, as of December 31, 1993. (See "Financial Condition" at page 32.) Other Items Interest expense of $23.3 million during 1993 increased by $0.2 million, in comparison with the prior year. During the current year, Essex recorded $14.1 million of interest expense, representing an increase of that amount in the accreted value of Discount Notes. Essex will continue to record interest expense under the terms of the Discount Notes through maturity. (See "Exchange of Indebtedness" at page 15.) Essex recorded an income tax benefit of $5.2 million dollars in 1993, as compared with an income tax benefit of $1.7 million in 1992. (See note 6 to the Consolidated Financial Statements starting at page 51.) Results of Operations Year Ended December 31, 1992 Compared with December 31, 1991 Sales Essex's net sales for the year ended December 31, 1992, of $188.2 million were $15.4 million, or 7.6%, below 1991 net sales. The decrease during 1992 resulted from the sale of Arrow, which accounted for sales of $17.3 million during the year ended December 31, 1991. (See "Sale of Arrow" at page 34.) Exclusive of Arrow, Essex's sales increased during 1992 by 1.0% over the prior year. Income from Operations Essex incurred a loss from operations of approximately $17.7 million during the year ended December 31, 1992, as compared to a loss from operations of $20.4 million during the 1991 period. The decline in loss is due to a reduction in selling and administrative expenses of $7.3 million, which was partially offset by a reduction in gross profit of $4.2 million during 1992. During the year ended December 31, 1991, Arrow accounted for $1.3 million of the operating loss. Gross margin, excluding depreciation and amortization expense, declined to 25.9% during the year ended December 31, 1992, as compared to 27.1% a year earlier. Lower margins in 1992 are due to the continued decline in the commercial segment of the construction industry. Arrow accounted for $1.6 million of gross profit during the year ended December 31, 1991. As a percentage of sales, selling and administrative expenses decreased by 2.4% to 14.7% during the 1992 period, as compared to the prior year period. The decline is due primarily to cost reductions gained through a continuing effort to improve marketing efficiencies and by consolidating various Essex marketing programs. Additionally, Essex incurred certain nonrecurring organization costs during 1991 associated with a restructuring of various Essex marketing programs. Arrow accounted for $2.8 million of selling and administrative expenses during the year ended December 31, 1991. Other Items Interest expense of $23.1 million during 1992 decreased by $20.3 million, in comparison with the prior year, primarily as a result of the exchange of indebtedness that occurred on December 31, 1991. During 1992, Essex recorded $12.2 million of interest expense, representing an increase of that amount in the accreted value of Discount Notes. (See "Exchange of Indebtedness" at page 15.) Essex recorded an income tax benefit of $1.7 million dollars in 1992, as compared with an income tax benefit of $15.9 million in 1991. (See note 6 to the Consolidated Financial Statements starting at page 51.) Financial Condition Years Ended December 31, 1993, 1992, and 1991 Leverage, Credit Availability and Liquidity At December 31, 1993, Essex had $226.9 million of debt outstanding of which $21.3 million was current. The debt consisted of $111.0 million of senior borrowings under the Essex Credit Agreement, $107.8 million accreted value of the Discount Notes held by Amstar and $8.1 million of non-acquisition related debt. The Essex Credit Agreement contains various covenants that restrict the business activities of Essex. On March 31 and June 30, 1991, Essex was not in compliance with certain of the covenants under the Essex Credit Agreement, which compliance was waived pursuant to the Essex Credit Agreement. In July 1991, the Essex Credit Agreement was amended to modify covenants related to quarterly measurements of minimum cash flows and leverage and interest coverage ratios through and including the quarter ended September 30, 1991. On December 31, 1991, the Essex Credit Agreement was again amended to, among other things, modify certain covenants related to quarterly and annual measurements of minimum cash flows and leverage and interest coverage ratios through the maturity of the Essex Credit Agreement. In addition, the December 31, 1991, amendment modified the principal amortization required under the Essex Credit Agreement to be $7.5 million in 1991; $10.0 million in 1992; $20.0 million in 1993; $21.0 million in 1994; $57.7 million upon the expiration of the term loan and long-term loan portions of the Essex Credit Agreement in 1995 and repayment of all borrowings outstanding upon the expiration of the revolving loan portion of the Essex Credit Agreement in 1996. On December 29, 1992, the Essex Credit Agreement was again amended to, among other things, modify certain covenants related to quarterly and annual measurements of minimum cash flows, and ratios related to working capital, leverage and interest coverage, through December 31, 1993. As of December 31, 1993, Essex was in compliance with the covenants under the Essex Credit Agreement. On March 28, 1994, the Essex Credit Agreement was again amended to, among other things, modify certain covenants related to quarterly and annual measurements of minimum cash flows and interest coverage, through December 31, 1994. Essex anticipates that Essex and its subsidiaries will remain in compliance with all such amended covenants. In addition, the March 28, 1994, amendment modified the principal amortization required under the Essex Credit Agreement, requiring $3.0 million of the $10.5 million due on June 30, 1994, and $2.0 million of the $10.5 million due on December 31, 1994, to be paid as of the effective date of the amendment. The aggregate principal amortization for 1994 of $21.0 million remains unchanged. Borrowings under the Essex Credit Agreement bear interest as follows, as of December 31, 1993: $103.9 million at the three month Adjusted Eurodollar Rate plus 3.5% (approximately 6.75%); and $7.1 million at the prime rate of Bankers Trust Company plus 1.5% (7.5%). Under the terms of the March 28, 1994 amendment to the Essex Credit Agreement, the interest rate on borrowings under the Essex Credit Agreement will increase by 0.5% on August 1, 1994, an additional 0.5% on October 1, 1994 and an additional 0.5% on January 1, 1995, in consideration of the covenant amendments referred to above. On September 6, 1991, upon consummation of the Arrow sale, the commitment under the revolving loan portion of the Essex Credit Agreement was reduced by $8.0 million to $42.0 million. On December 31, 1991, the commitment under the Essex Credit Agreement was increased by $3.0 million to $45.0 million of which up to $5.0 million may be used for the issuance of letters of credit. As of March 25, 1994, Essex had available but unused capacity of $4.3 million under the Essex Credit Agreement. During the year ended December 31, 1993, the working capital of Essex decreased by $1.4 million. The current portion of the Senior borrowings under the Essex Credit Agreement increased by $1.0 million to $21.0 million at December 31, 1993. The decrease in working capital of $10.8 million during the year ended December 31, 1992, as compared to the year ended December 31, 1991, is primarily due to the increase in the current maturity of long-term debt of $10.0 million as of December 31, 1992. The current portion of the senior borrowings under the Essex Credit Agreement increased by $10.0 million to $20.0 million at December 31, 1992. Capital expenditures of Essex, which relate primarily to new product development and cost reduction projects, were $4.7 million during the year ended December 31, 1993, as compared to $2.7 million for the year ended December 31, 1992, and $1.9 million in 1991. Additionally, during 1993, Curries expended $5.8 million related to the construction of a new manufacturing facility in Mason City, Iowa, which was funded through the issuance of General Obligation Urban Renewal Bonds by the City of Mason City, Iowa. (See note 3 beginning at page 44). On June 28, 1993, Essex received a $7.5 million capital contribution from Esstar. Under the terms of a tax sharing agreement with Esstar, Essex accounts for income taxes as if it filed its own consolidated tax return. Also, Esstar may give Essex the tax benefit of losses which are incurred by Essex and utilized by Esstar in filing the Esstar consolidated tax return. During the year ended December 31, 1993, $5.2 million of such benefit was transferred from Esstar to Essex. During the years ended December 31, 1992 and 1991, $1.7 million and $15.9 million, respectively, of such tax benefits were transferred. For the years ended December 31, 1993, 1992 and 1991, Essex incurred losses of $121.7 million, $39.1 million and $38.7 million, respectively, and has a stockholder's deficit of $156.5 million at December 31, 1993. Included in the loss for 1993 is a write-off of Essex's remaining goodwill balance of $82.3 million at December 31, 1993, based on the projection that Essex will be unable to recover this asset through future operations. (See note 2 to the Consolidated Financial Statements starting at page 42.) Additionally, Essex was required to amend certain financial covenants under the Essex Credit Agreement through December 31, 1994, and cannot, without the financial support of Esstar, generate sufficient cash flow from operations to meet its debt service requirements during 1994. In addition, the term loan portion under the Essex Credit Agreement matures between June 30, 1995 and December 31, 1995, and the revolving loan portion under the Essex Credit Agreement matures on December 31, 1996. Essex has informed the Company that it is reviewing various alternatives to its present financial structure, including refinancing its debt instruments and raising additional capital. There can be no assurance however, that such a refinancing or capital restructuring will take place. Essex's management believes that funds generated from the operations of Essex, including benefits it may receive under the tax sharing agreement with Esstar and capital contributions it may receive from Esstar, combined with its credit availability, will be adequate to meet its working capital, capital expenditure and other funding requirements during the next twelve months. Graham Plant Move On February 11, 1994, Essex announced that Graham's plant and corporate headquarters would be moved from Marshfield, Wisconsin to Mason City, Iowa, where its operations will be near those of Curries. A reserve for this reorganization has been recorded as of December 31, 1993. Sale of Arrow On September 6, 1991, Essex sold the stock of Arrow for approximately $28.7 million, resulting in a gain of approximately $2.0 million. The net assets, revenues and operating income of Arrow were not material to the consolidated net assets and operating results of Essex. In connection with the sale, Essex received $10.0 million in cash and received a promissory note for the balance of the selling price, which note was secured by an escrow deposit under a deposit security agreement with Bankers Trust Company. On December 31, 1991, Essex received $17.4 million of accreted value of this note and received the remaining amount, $1.8 million of accreted value, on June 30, 1992. The net proceeds from the sale were used to reduce the principal amount outstanding under the Essex Credit Agreement. Of the $10.0 million received on September 6, 1991, $8.35 million was used to reduce the borrowings outstanding under the revolving portion of the Essex Credit Agreement and $1.65 million was used to reduce the term portion of the borrowings under the Essex Credit Agreement. The December 31, 1991, proceeds of $17.4 million were used to reduce the revolving portion of the Essex Credit Agreement by $3.7 million and the term portion of the Essex Credit Agreement by $13.7 million. The remaining $1.8 million received on June 30, 1992, was used to reduce the principal amount outstanding under the term portion of the borrowings under the Essex Credit Agreement. ESSEX HOLDINGS, INC. AND SUBSIDIARIES Index to Consolidated Financial Statements Page Report of Independent Public Accountants 37 Statements: Essex Holdings, Inc. and Subsidiaries Consolidated 38 Balance Sheets as of December 31, 1993 and 1992. Essex Holdings, Inc. and Subsidiaries Consolidated 39 Statements of Operations for the years ended December 31, 1993, 1992 and 1991. Essex Holdings, Inc. and Subsidiaries Consolidated 40 Statements of Changes in Stockholder's Equity (Deficit) for the years ended December 31, 1993, 1992 and 1991. Essex Holdings, Inc. and Subsidiaries Consolidated 41 Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991. Notes to Consolidated Financial Statements 42 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors and Stockholder of ESSEX Holdings, Inc.: We have audited the accompanying consolidated balance sheets of ESSEX Holdings, Inc. (formerly ESSEX Industries, Inc., a Delaware corporation and a wholly-owned subsidiary of EI Holdings Corp.) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, changes in stockholder's equity (deficit) and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of ESSEX Holdings, Inc. and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. As discussed in notes 5 and 6 to the consolidated financial statements, effective January 1, 1993, the Company changed its methods of accounting for income taxes and postretirement benefits other than pensions. New Haven, Connecticut February 21, 1994 (except with respect to the matter discussed in Note 3, as to which the date is March 28, 1994) ESSEX HOLDINGS, INC. AND SUBSIDIARIES (formerly ESSEX Industries, Inc., and a wholly-owned subsidiary of EI Holdings Corp.) CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1993 AND 1992 (dollar amounts in thousands) ASSETS 1993 1992 CURRENT ASSETS: Cash and cash equivalents $ 1,419 $ 1,504 Accounts receivable, net of allowance for doubtful accounts of $1,519 and $1,787 26,058 23,125 Inventories 36,116 38,369 Other 2,002 843 Total current assets 65,595 63,841 PROPERTY, PLANT AND EQUIPMENT, at cost: Land 7,741 7,566 Buildings and leasehold improvements 25,937 25,494 Machinery and equipment 48,031 42,102 Building construction in progress 6,675 - 88,384 75,162 Less - accumulated depreciation and amortization 32,144 24,616 56,240 50,546 GOODWILL AND OTHER INTANGIBLES net of accumulated amortization of $144,786 and $122,727 6,555 118,714 OTHER 3,442 2,579 $131,832 $235,680 LIABILITIES AND STOCKHOLDER'S EQUITY (DEFICIT) 1993 1992 CURRENT LIABILITIES: Current maturities of long-term debt $ 21,295 $ 20,057 Accounts payable 15,781 13,381 Payable to ESSTAR Incorporated 4,163 6,137 Accrued payroll and employee benefits costs 4,166 3,589 Other accrued expenses 7,750 6,889 Total current liabilities 53,155 50,053 LONG-TERM DEBT, less current maturities 97,849 111,202 NOTES AND ACCRUED INTEREST PAYABLE TO RELATED PARTY 107,759 93,703 ACCRUED EMPLOYEE BENEFIT COSTS AND OTHER 29,524 18,620 COMMITMENTS AND CONTINGENCIES (Notes 4 and 7) STOCKHOLDER'S EQUITY (DEFICIT): Class A common stock, $.01 par value, 1,000 shares authorized, issued and outstanding - - Additional paid-in capital 160,778 153,278 Retained earnings (deficit) (312,905) (191,176) Excess of pension liability over unrecognized prior service cost (4,328) - Total stockholder's equity (deficit) (156,455) (37,898) $131,832 $235,680 The accompanying notes are an integral part of these consolidated financial statements. ESSEX HOLDINGS, INC. AND SUBSIDIARIES (formerly ESSEX Industries, Inc., and a wholly-owned subsidiary of EI Holdings Corp.) CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (amounts in thousands) 1993 1992 1991 Net sales $ 204,337 $188,195 $203,616 Costs of products sold 185,991 171,399 182,653 Gross profit 18,346 16,796 20,963 Selling, general and admini- strative expenses 33,613 27,627 34,831 Amortization of goodwill and other expense, net 10,098 6,832 6,532 Goodwill write-off 82,287 - - Operating loss (107,652) (17,663) (20,400) Interest expense 23,348 23,154 43,418 Loss before benefit from income taxes, extraordinary gain and cumulative effect of changes in accounting principles (131,000) (40,817) (63,818) Benefit from income taxes 5,167 1,670 15,889 Loss before extraordinary gain and cumulative effect of changes in accounting principles (125,833) (39,147) (47,929) Extraordinary gain on utilization of net operating loss carryforwards - - 9,200 Loss before cumulative effect of changes in accounting principles (125,833) (39,147) (38,729) Cumulative effect of changes in accounting principles 4,104 - - Net loss $(121,729) $(39,147) $(38,729) The accompanying notes are an integral part of these consolidated financial statements. ESSEX HOLDINGS, INC. AND SUBSIDIARIES (formerly ESSEX Industries, Inc., and a wholly-owned subsidiary of EI Holdings Corp.) CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDER'S EQUITY (DEFICIT) FOR THE YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 (dollar amounts in thousands) Excess of Pension Liability Over Additional Retained Unrecognized Common Stock Paid-In Earnings Prior Shares Amount Capital (Deficit) Service Cost Balance, January 1, 1991 1,000 $ - $ 43,025 $(113,300) $ - EI Holdings Corp. capital contribution - - 66,770 - - Gain on Debt Swap with related party, net of tax effect (note 3) - - 43,483 - - Net loss - - - (38,729) - Balance, December 31, 1991 1,000 - 153,278 (152,029) - Net loss - - - (39,147) - Balance, December 31, 1992 1,000 - 153,278 (191,176) - EI Holdings Corp. capital contribution - - 7,500 - - Net loss - - - (121,729) - Excess of pension liability over unrecognized prior service cost - - - - (4,328) Balance, December 31, 1993 1,000 $ - $160,778 $(312,905) $(4,328) ESSEX HOLDINGS, INC. AND SUBSIDIARIES (formerly ESSEX Industries, Inc., and a wholly-owned subsidiary of EI Holdings Corp.) CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (amounts in thousands) CASH FLOWS FROM OPERATING ACTIVITIES: 1993 1992 1991 Loss before extraordinary gain and cumulative effect of changes in accounting principles $(125,833) $(39,147) $(47,929) Adjustments to reconcile net loss to net cash provided by (used in) operating activities: Depreciation and amortization 41,688 37,558 39,204 Goodwill write-off 82,287 - - Accretion of non-cash interest 14,056 12,222 13,889 Gain on sale of Arrow Lock Manufacturing Company - - (2,049) Change in operating assets and liabilities, net of effects of company sold: Accounts receivable, net (2,431) 915 2,180 Inventories 2,253 2,019 2,506 Other current assets (1,159) (488) 283 Other assets 27 (420) (127) Accounts payable 2,400 599 (1,196) Payable to ESSTAR Incorporated (1,973) (70) 632 Accrued payroll and employee benefit costs 577 (104) (1,249) Other accrued expenses 860 (3,219) 4,116 Other noncurrent liabilities 3,207 2,113 4,187 Net cash provided by (used in) operating activities 15,959 11,978 14,447 CASH FLOWS FROM INVESTING ACTIVITIES: Purchases of property, plant and equipment, net (4,754) (2,733) (1,877) Proceeds from sale of Arrow Lock Manufacturing Company - - 28,747 Net cash provided by (used in) investing activities (4,754) (2,733) 26,870 CASH FLOWS FROM FINANCING ACTIVITIES: EI Holdings Corp. capital contribution 7,500 - 66,770 Proceeds from (payment of) bank revolving loan agreement and other debt, net 1,210 2,680 (8,580) Repayments of long-term bank borrowings (20,000) (11,857) (22,956) Repayments of debt related to Debt Swap, net of tax effect - - (78,152) Net cash used in financing activities (11,290) (9,177) (42,918) NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS (85) 68 (1,601) CASH AND CASH EQUIVALENTS, beginning of year 1,504 1,436 3,037 CASH AND CASH EQUIVALENTS, end of year $ 1,419 $ 1,504 $ 1,436 SUPPLEMENTAL DISCLOSURE: Cash paid during the year for: Interest $ 9,030 $ 8,739 $ 29,389 Income taxes $ 33 $ 190 $ 395 The accompanying notes are an integral part of these consolidated financial statements. ESSEX HOLDINGS, INC. AND SUBSIDIARIES (formerly ESSEX Industries, Inc., and a wholly-owned subsidiary of EI Holdings Corp.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 AND 1992 1. Organization and Operations: On June 30, 1989, the holders of all the outstanding shares of common stock of EI Holdings Corp. (the Parent) and Amstar Corporation (Amstar) exchanged (the Exchange) their respective shares for common stock of ESSTAR Incorporated (ESSTAR). As a result of the combination, the Parent and Amstar each became direct, wholly-owned subsidiaries of ESSTAR. The combination was treated as a pooling-of-interests. On January 23, 1992, ESSEX Industries, Inc. changed its name to ESSEX Holdings, Inc. (the Company). On November 7, 1991, the Company formed a new subsidiary which, on January 23, 1992, changed its name from ESSEX Holdings, Inc. to ESSEX Industries, Inc. For the years ended December 31, 1993, 1992 and 1991, the Company has incurred losses of $121,729,000, $39,147,000 and $38,729,000, respectively, and has a stockholder's deficit of $156,455,000 at December 31, 1993. Included in the loss for 1993 is a write-off of the Company's remaining goodwill balance of $82,287,000 at December 31, 1993, based on the projection that the Company will be unable to recover this asset through future operations (see Note 2). Additionally, the Company was required to amend certain financial covenants through December 31, 1994 under its Bank Credit Agreement (see Note 3), and cannot, without the financial support of ESSTAR, generate sufficient cash flow from operations to meet its debt service requirements during 1994. Management is reviewing various alternatives to the Company's overall financial structure, including refinancing its debt instruments and raising additional capital. There can be no assurance however, that such a refinancing or capital restructuring will take place. Management believes that funds generated from the operations of the Company, including benefits it may receive under the tax sharing arrangement with ESSTAR and capital contributions it may receive from ESSTAR, combined with its credit availability, will be adequate to meet its obligations during 1994. 2. Summary of Significant Accounting Policies: Principles of consolidation - The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries: Sargent Manufacturing Company; Sargent of Canada, Ltd.; McKinney Products Company (McKinney); Arrow Lock Manufacturing Company (through September 6, 1991); Curries Company (Curries); Graham Manufacturing Corporation and ESSEX Industries, Inc. (formerly ESSEX Holdings, Inc.) (collectively, the Subsidiaries). The Subsidiaries primarily manufacture locks, doors, hinges and related products. All significant intercompany transactions and accounts have been eliminated in consolidation. Effective September 6, 1991, the Company sold the stock of Arrow Lock Manufacturing Company for approximately $28,747,000, which resulted in a gain of approximately $2,049,000. This gain is included in amortization of goodwill and other expense, net in the accompanying 1991 consolidated statement of operations. Inventories - The Company values its inventories at the lower of cost, using the first-in, first-out (FIFO) method, or market and includes materials, labor and manufacturing overhead. Inventories at December 31, 1993 and 1992 consisted of the following (in thousands): 1993 1992 Raw materials and parts $ 7,048 $ 8,107 Work-in-process 19,987 21,091 Finished goods 9,081 9,171 $36,116 $38,369 Depreciation and amortization - Property, plant and equipment are depreciated or amortized using the straight-line method over the estimated useful lives of the assets ranging from 7 to 31.5 years. Leasehold improvements are amortized over the shorter of the lease term or their estimated useful lives. Goodwill and other intangible assets - Goodwill and other intangible assets includes $84,639,000 at December 31, 1992 of the excess of cost over the fair value of assets acquired and liabilities assumed related to the December 29, 1988 acquisition of the Company and its subsidiaries by its Parent, which was being amortized over 40 years, but was fully written off in 1993. Other intangible assets include $25,372,000 at December 31, 1992, of product technology, engineering drawings, service contracts and patents, which were being amortized over an average life of 5 years and became fully amortized at December 31, 1993. Also included are deferred financing and transaction fees of $6,555,000 and $8,703,000 at December 31, 1993 and 1992, respectively, which are being amortized over an average life of 8 years. Since the Exchange, the Company has not achieved its sales or earnings projections established at that time due primarily to the general economic recession and its impact on certain markets served by the Company related to the nonresidential segment of the construction industry, combined with significantly increased competitive pressures. During December 1993, when the Company prepared its operating plans for 1994, it determined that it most likely would not be in compliance with certain financial ratio covenants during 1994 under its Bank Credit Agreement (see Note 3). Additionally, during this period, there was a consolidation of certain of the Company's competitors, which led the Company to believe that there might be additional pressure on profit margins in the future. These events caused the Company to reevaluate its longer term operating projections and its ability to recover the remaining balance of its goodwill recorded on the Company's balance sheet. The methodology used by the Company to assess the recoverability of its goodwill involved the projection of its net income over the remaining 35 year amortization period of the goodwill. This projection indicated that the Company would incur a net loss of approximately $8,000,000 during the remaining 35 year amortization period, including a net loss of over $100,000,000 during the first 15 years, without regard to goodwill amortization. Accordingly, the Company wrote off the remaining balance of its goodwill of $82,287,000 in the fourth quarter of 1993. Workers' compensation - The Company is partially self-insured for workers' compensation claims. Included in the accompanying financial statements is a liability for workers' compensation claims based on an assessment of claims outstanding, as well as an estimate, based on experience, of incurred claims which have not yet been reported. Cash and cash equivalents - For purposes of the consolidated statements of cash flows, the Company considers all highly liquid debt instruments with an original maturity of three months or less to be cash equivalents. Reclassifications - Certain reclassifications have been made to the 1991 and 1992 financial statements in order for them to be presented in conformity with the 1993 financial statements. 3. Long-Term Debt: Long-term debt at December 31, 1993 and 1992 consisted of the following (in thousands): 1993 1992 Bank loans $111,044 $131,019 Notes and accrued interest payable to related party 107,759 93,703 Other 8,100 240 Total 226,903 224,962 Less - current maturities (21,295) (20,057) $205,608 $204,905 Bank loans - At December 31, 1993, the Company and its Subsidiaries had outstanding borrowings of $111,044,000 pursuant to a Bank Credit Agreement (the Agreement). The loans consist of a Term Loan to the Company for $57,819,000, and a Revolving Loan and Long-Term Loan (collectively, the Loans) for $34,125,000 and $19,100,000, respectively, to the Subsidiaries. Borrowings of up to $45,000,000 (including up to $5,000,000 for letters-of-credit) are available under the Revolving Loan, limited to 54% of eligible inventory plus 85% of eligible accounts receivable, as defined. At December 31, 1993, additional borrowings of $3,294,000 were available under the Revolving Loan. The Term Loan must be repaid in periodic principal amounts, as defined in the Agreement, with full payment on or before June 30, 1995. The Long-Term Loan is due and payable on or before December 31, 1995. The Revolving Loan commitment expires on December 31, 1996. The Loans bear interest, at the option of the Company, at either the prime lending rate (6.0% at December 31, 1993) plus 1.5%, or the Eurodollar rate (3.375% at December 31, 1993) plus 3.0% for Revolving Loans or 3.5% for Term and Long-Term Loans. Additionally, the Company is required to pay a commitment fee of 0.5% per annum of the daily unused portion of the commitments under the Loans. On March 28, 1994, the Agreement was amended, thereby increasing the interest rate on borrowings under the Agreement by 0.5% on July 1, 1994, an additional 0.5% on October 1, 1994 and an additional 0.5% on January 1, 1995. The Agreement contains various restrictive covenants including, but not limited to, maximum ratios of consolidated senior liabilities to consolidated net worth (1.35 to 1.00 at December 31, 1993, decreasing to 0.78 to 1.00 at December 31, 1996), minimum ratios of consolidated earnings before interest and taxes to consolidated cash interest expense, as defined (1.80 to 1.00 at December 31, 1993, increasing to 13.00 to 1.00 at December 31, 1996), minimum ratios of consolidated current assets to consolidated current liabilities (1.60 to 1.00 at December 31, 1993 and thereafter), minimum consolidated operating cash flow ($21,500,000 at December 31, 1993, increasing to $43,800,000 at December 31, 1996) and minimum consolidated cash flow ($7,800,000 at December 31, 1993, increasing to $36,500,000 at December 31, 1996). At December 31, 1993, the Company was in compliance with these financial covenants. Under the terms of the March 28, 1994 amendment, the Agreement was amended to, among other things, modify certain covenants related to quarterly and annual measurements of minimum cash flows and interest coverage through December 31, 1994. The Company anticipates that it will be in compliance with these amended covenants. The Agreement does not permit the declaration or payment of any dividends or other distributions on any shares of any class of stock of the Company's Parent, except for a dividend payable solely in shares of that class of stock and only to the holders of that class of stock. Under the terms of the Agreement, the Company and its subsidiaries entered into interest rate agreements with respect to a portion of their borrowings. The Company has entered into agreements which will effectively cap the Eurodollar base rate component at a rate of 7.0% through June 24, 1994 for $50,000,000 of principal borrowings and 5.0% through March 15, 1995 for $70,000,000 of principal borrowings. The Company would be exposed to a loss of this interest rate protection in the event of nonperformance by the other party to the interest rate agreement. However, the Company does not anticipate nonperformance by the other party. Borrowings under the Agreement are secured by substantially all of the assets of the Company and its subsidiaries. At December 31, 1993, there were $2,985,000 of outstanding letters-of-credit. Notes and accrued interest payable to related party - Concurrent with the Exchange, the Company issued, and Amstar purchased, $152,733,000 aggregate principal amount of Senior Subordinated Discount Notes due 1997 and $100,000,000 aggregate principal amount of 14% Subordinated Debentures due 1997 for an aggregate cash purchase price of $175,000,000. On December 31, 1991, the Company purchased $86,600,000 principal amount of Amstar's publicly held 11.375% Senior Subordinated Notes (the Notes), in the open market, for $64,950,000. The purchase was financed by the $65,000,000 of proceeds received from ESSTAR in the form of capital contributed to the Company. Concurrent with the purchase, the Company exchanged the Notes for outstanding indebtedness due Amstar of $100,000,000 of its Subordinated Debentures, $5,833,000 of accrued interest related to this debt and $25,000,000 of its Senior Subordinated Discount Notes (the Debt Swap). The resulting gain on the Debt Swap of $65,883,000 is reflected in the accompanying 1991 statement of changes in stockholder's equity (deficit), net of a federal tax provision of $22,400,000, as an increase to additional paid-in capital. As a result of the Debt Swap, the Company has no outstanding obligations related to the 14% Subordinated Debentures and has $107,759,000 and $93,703,000 at December 31, 1993 and 1992, respectively, of outstanding obligations related to the Senior Subordinated Discount Notes. Commencing August 1, 1994, the Senior Subordinated Discount Notes will bear interest at 15% per annum, payable semi-annually. At the option of the Company, the payment of interest in cash may be deferred until the February 1, 1997 maturity date of these notes. If the cash interest payments are deferred, the Company will settle its interest obligation through the issuance of additional securities in lieu of cash. These notes are subject to redemption after August 1, 1994, in whole or in part, at the election of the Company, at a redemption price equal to 104.29%, 102.14% and 100% of the outstanding principal balance as of the first day of August 1994, 1995, and 1996, respectively. The Company recognized $14,056,000, $12,222,000 and $27,889,000 for the years ended December 31, 1993, 1992 and 1991, respectively, of interest expense related to these notes payable to affiliate. Included in this interest expense is $14,056,000, $12,222,000 and $13,889,000 of interest accretion which was added to the carrying value of the Senior Subordinated Discount Notes during the years ended December 31, 1993, 1992 and 1991, respectively. These interest amounts are included in the accompanying consolidated statements of operations. Other - Included in other debt is a capital lease obligation which Curries entered into on April 29, 1993 with the City of Mason City, Iowa (the City), whereby the City agreed to construct a manufacturing facility (the Facility) for Curries and, upon completion, Curries agreed to lease the Facility from the City. To finance the construction, the City issued $7,000,000 of General Obligation Urban Renewal Bonds (the Bonds). Approximately $325,000 of the proceeds of these bonds have been retained by the City in a debt service reserve account. The bonds are dated June 1, 1993 and will mature on June 1, 2008. Interest on the Bonds is payable semiannually beginning December 1, 1993 at variable rates ranging from 6.1% to 7.1%. Principal is payable annually, beginning June 1, 1995, in installments ranging from $300,000 to $750,000. At December 31, 1993, proceeds of this offering that had not yet been used to fund construction costs totaled $874,000 and are included in other assets in the accompanying consolidated balance sheet. As stated above, upon completion of the Facility, Curries will enter into a capital lease with the City. Base rent payments will be equal to the amounts necessary to fund the scheduled bond principal and interest payments and will be payable at the beginning of each month. The lease is collateralized by the Facility and land on which it is being constructed. Aggregate maturities of all long-term debt for each of the succeeding five years subsequent to December 31, 1993, and thereafter, are as follows: Year Ending Amount December 31, (in thousands) 1994 $ 21,295 1995 56,537 1996 34,804 1997 108,376 1998 and thereafter 5,891 $226,903 Maturities of the debt instruments may be accelerated upon the occurrence of certain events as defined in the respective agreements including, but not limited to, failure to make principal and interest payments when due, breach of certain covenants in the agreements and sale of the stock of the Company. Additionally, certain of the debt instruments require payment of premiums upon early retirement of the debt. 4. Commitments and Related Matters: Leases - The Company and its subsidiaries lease certain property, plant and equipment under noncancellable operating leases. Operating lease rental expense amounted to approximately $1,375,000, $1,340,000 and $1,881,000 for the years ended December 31, 1993, 1992 and 1991, respectively. The minimum future rental commitments for each of the next five years subsequent to December 31, 1993, are as follows: Year Ending December 31, Amount (in thousands) 1994 $1,260 1995 878 1996 793 1997 714 1998 315 Environmental liabilities - The Company has incurred certain environmental obligations incidental to the normal conduct of its business. The estimated costs associated with such known obligations have been recognized in the accompanying consolidated financial statements. 5. Employee Retirement Plans: Profit sharing and 401(k) plans - Certain subsidiaries of the Company have profit sharing or 401(k) savings plans for substantially all of their employees. Expense for these plans amounted to $807,000, $744,000 and $840,000 for the years ended December 31, 1993, 1992 and 1991, respectively. Pension plans - Certain subsidiaries have union-sponsored, collectively bargained, pension plans. The Company contributed $34,000, $32,000 and $204,000 to these plans for the years ended December 31, 1993, 1992 and 1991, respectively. The 1991 contributions include those made on behalf of Arrow (Note 2). The contributions, which provide for pension as well as other benefits, are determined in accordance with the provisions of negotiated labor contracts and generally are based on the number of hours worked. Information from the plans' administrators is not available to determine vested benefits. Certain subsidiaries maintain defined benefit pension plans. These subsidiaries have recorded a pension liability which represents the excess of the subsidiaries' projected benefit pension obligation over the related pension plan assets. These liabilities will be funded over the average service lives of the pension plan participants. Pension expense of the Company-sponsored defined benefit plans for the years ended December 31, 1993, 1992 and 1991 included the following components (in thousands): 1993 1992 1991 Service cost $ 734 $ 727 $ 705 Interest cost on projected benefit obligations 2,791 2,624 2,317 Net amortization and deferral (77) (271) 791 Actual return on plan assets (1,481) (1,115) (2,215) Net pension expense $ 1,967 $ 1,965 $ 1,598 The net liability of the pension plans, as included in accrued employee benefit costs in the accompanying consolidated balance sheets, as of December 31, 1993 and 1992, is set forth in the table below (in thousands): 1993 1992 Actuarial present value of: Vested benefit obligation $ 33,267 $ 26,581 Accumulated benefit obligation $ 35,615 $ 29,578 Projected benefit obligation $ 39,162 $ 32,731 Plan assets at fair value (19,106) (18,416) Projected benefit obligation in excess of plan assets 20,056 14,315 Unrecognized gain (3,315) (1,619) Accrued pension costs $ 16,741 $ 12,696 The projected benefit obligation at December 31, 1993 and 1992 was determined using a weighted average discount rate of 7.25% and 8.5%, respectively, and assumed long-term rate of compensation increases of 5.0% and 6.5%, respectively. The assumed long-term rate of return on plan assets was 10%. Included in 1993 stockholder's equity (deficit) is a $4,328,000 charge reflecting the excess of pension liability over unrecognized prior service cost which resulted primarily from the 1993 change in actuarial assumptions. Postretirement benefits - Employees retiring from certain subsidiaries of the Company on or after attaining age 62 and meeting specified criteria are entitled to certain postretirement health care coverages and life insurance. These benefits are subject to certain limitations and the Company reserves the right to amend or change the plan at any time. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions (SFAS 106). SFAS 106 requires that the expected cost of postretirement benefits be recognized in the financial statements during the years that the employees render service. Commencing in 1993, the Company accrues an actuarially determined charge for postretirement benefits during the period in which active employees become eligible for such future benefits. The $1,569,000 cumulative effect of adopting this accounting change, after giving consideration to a pre-existing accrual at time of adoption, is reflected as a decrease to 1993 net income. Additionally, the effect of this change during the year ended December 31, 1993 was to reduce net income by $1,501,000. The following table reconciles the accrued postretirement benefit liability as reflected on the balance sheet as of December 31, 1993 (in thousands): Retirees $2,987 Other fully eligible participants 935 Other active participants 3,414 Accrued postretirement benefit liability $7,336 Net postretirement benefit expense for 1993 included the following components: Service cost $ 233 Interest cost on accumulated postretirement benefit obligation 471 Change in actuarial assumption 1,107 Net postretirement benefit expense $1,811 For measurement purposes, a 10% annual rate of increase in the per capita cost of covered health care claims was assumed for 1994; the rate was assumed to decrease gradually to 5% for 2004 and remain at that level thereafter. The health care cost trend rate assumption has a significant effect on the amounts reported. Increasing the assumed health care cost trend rates by one percentage point in each year would increase the accumulated postretirement benefit obligation as of December 31, 1993 by $512,000 and the aggregate of the service and interest cost components of net postretirement health care cost for the year then ended by $61,000. The weighted-average discount rate used in determining the accumulated postretirement benefit liability was 8.25% at time of adoption and 7.25% as of December 31, 1993. Prior to 1993, the Company had recognized postretirement health care costs on a modified cash basis. Postretirement healthcare costs charged to expense were $248,000 and $83,000 in 1992 and 1991, respectively. Prior year financial statements have not been restated to reflect this new method. 6. Income Taxes: Under the terms of the tax sharing arrangement with ESSTAR, the Company accounts for income taxes as if it filed its own consolidated return. Should the Company incur a loss, ESSTAR may contribute to the Company the tax benefit of the loss. The 1993, 1992 and 1991 income tax benefits, which are included in the accompanying consolidated statements of operations, reflect the amount of benefit which ESSTAR elected to contribute to the Company as a result of its losses. Effective January 1, 1993, the Company adopted the provisions of Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes (SFAS 109). SFAS 109 utilizes the liability method and deferred income taxes are determined based on the estimated future tax effects of differences between the financial statement and tax bases of assets and liabilities given the provisions of enacted tax laws. Prior to the adoption of SFAS 109, the Company accounted for income taxes using Accounting Principles Board Opinion No. 11. The cumulative effect of adopting this accounting change as of January 1, 1993, was to increase net income by $5,673,000. Prior year financial statements have not been restated to reflect this new method of accounting. The provisions (benefits) for income taxes for the years ended December 31, 1993, 1992 and 1991 were as follows (in thousands): 1993 1992 1991 Current: Federal $(5,167) $(1,077) $(16,500) State - (593) 611 (5,167) (1,670) (15,889) The tax effect of significant temporary differences giving rise to the Company's consolidated deferred tax assets and liabilities at December 31, 1993, are as follows (in thousands): Current Asset Long-term Asset (Liability) (Liability) Post retirement benefits $ - $ 2,773 Employee benefit accruals - 4,087 Intangibles - 12,079 Federal net operating losses - 26,792 State net operating losses - 3,400 Other, net 3,945 2,887 3,945 52,018 Valuation allowance (3,945) (52,018) Total deferred income taxes $ - $ - Gross deferred tax assets of $58,701,000, net of a valuation allowance of $55,863,000 and gross deferred tax liabilities of $2,838,000 are included in the deferred tax balances as of December 31, 1993. The difference between the Company's Federal effective tax rate for continuing operations and the statutory rate for the years ended December 31, 1993, 1992 and 1991 arises from the following: 1993 1992 1991 Federal statutory rate (35.0)% (34.0)% (34.0)% Increase (decrease) resulting from: Goodwill amortization not deductible 0.6 2.1 1.2 Goodwill write-off 22.2 - - Nondeductible expense 0.5 - - Benefit not recognized 8.0 29.3 6.9 Effective Federal tax rate (3.9)% (2.6)% (25.9)% At December 31, 1993, the Company had approximately $76,000,000 of federal net operating loss carryforwards which can be used, subject to certain limitations, to offset future federal taxable income, if any. The carryforwards expire beginning in the year 2003. As of December 31, 1993, the Company had approximately $30,000,000 of state net operating loss carryforwards which can be used, subject to certain limitations, to offset future state taxable income, if any. These carryforwards expire beginning in the year 1994. The future timing and ultimate realization of the tax benefits from these net operating loss carryforwards may be limited based upon the application of statutory regulations. For the year ended December 31, 1993, additional depreciation and amortization expense of $4,897,000 was recognized as a result of the adoption of SFAS 109. Included in the accompanying consolidated statement of operations for the year ended December 31, 1991, is $9,200,000 of extraordinary gain resulting from the utilization of federal net operating loss carryforwards. 7. Litigation: On May 22, 1990, a federal grand jury in St. Louis indicted McKinney and three unrelated corporations for allegedly violating the antitrust laws. McKinney has entered a plea of nolo contendere and the court has accepted the plea. Five present or former executives of three of the indicted corporations, including two officers of the Company, were also indicted. These two officers of the Company have entered pleas of nolo contendere and the court has accepted such pleas. On March 31, 1993, McKinney was fined $2,000,000, payable over a five year period. This amount is included in other expense in the accompanying consolidated statement of operations for the year ended December 31, 1993. In 1993, the two officers of the Company were each fined $250,000. The United States Department of Justice filed notices of appeal with respect to the sentences imposed on McKinney and the two officers. McKinney and the officers filed responsive notices of appeal to preserve its and their rights should the government proceed with an appeal. Subsequently, the United States and McKinney entered into a stipulation to terminate the appeals, thereby bringing to a conclusion the criminal action against McKinney. The appeals with respect to the two officers are proceeding. Six civil class actions on behalf of direct purchasers of architectural hinges were initiated against McKinney and the other indicted corporations. McKinney and two of the other corporate defendants entered into a settlement agreement providing for an aggregate payment of $4,000,000. This settlement agreement has been approved by the court, and payment was made in 1990. Three class actions on behalf of California indirect purchasers and a class action on behalf of Alabama indirect purchasers of architectural hinges have been initiated against McKinney and the three other corporate defendants. McKinney and other corporate defendants entered into a settlement agreement with plaintiffs' counsel with respect to two of the three California actions and with respect to the Alabama action. These settlement agreements have received court approval and payment was made as of December 31, 1992. It is presently expected that a satisfactory resolution of the third California class action will be obtained. No provision has been made in the Company's financial statements for any liability and related expense to be incurred in resolving the remaining indirect purchaser litigation as the amount is presently not determinable. The Company is involved in various other matters of litigation incidental to the normal conduct of its business. In management's opinion, the disposition of this litigation will not have a material adverse impact on the financial condition of the Company. 8. Related Party Transactions: The Company, Amstar and ESSTAR share facilities and personnel related to corporate and administrative activities. Charges of $2,149,000, $2,227,000 and $1,738,000 for these costs have been allocated to the Company for the years ended December 31, 1993, 1992 and 1991, respectively. Certain members of management of the Company are participants in the ESSTAR stock option plans. At December 31, 1993 and 1992, there were $4,163,000 and $6,137,000, respectively, of advances from ESSTAR which are due and payable on demand. The advances bear interest at 10% of the average outstanding monthly balance. In connection with the Debt Swap and related transactions at December 31, 1991, the Company incurred certain advisory, legal and financing fees. As a result, the Company incurred $2,270,000 in such fees, of which $750,000 were paid to an affiliate of a primary stockholder of ESSTAR. Of these fees, $1,770,000 were paid by ESSTAR in the form of contributed capital to the Company. At December 31, 1993 and 1992, $840,000 and $1,120,000, respectively, of such fees are included in goodwill and other intangible assets in the accompanying consolidated balance sheets and are being amortized over six years. 9. Disclosures about Fair Value of Financial Instruments: The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value: Cash and cash equivalents, accounts receivable and payable, and accrued current liabilities - For these short-term account balances, the carrying amount is a reasonable estimate of fair value. Bank loans - The carrying amount is a reasonable estimate of fair value as the debt is frequently repriced based on prime and Eurodollar rates, and there has been no significant change in credit risks since the financing was amended on December 31, 1991. Notes and accrued interest payable to related party - The notes and accrued interest payable to related party are obligations for which there is no public market and no quoted market price is available. The Company believes that since the date of the Exchange, any increase in the credit risk of these notes was offset by changes in interest rates on similar subordinated debt instruments during that same period and, therefore, the carrying amount of the debt is a reasonable estimate of its fair value. In addition, it is the Company's intent to repay the full principal amount outstanding by the maturity date of the debt. 10. Industry Segment Data: The Company's products are all included in one segment, the locks, doors and related products segment. The Company's principal plants and other facilities are located in the United States, with a small installation located in Canada. Item 8.	Item 8. Financial Statements and Supplementary Data (a) Financial Statements See Item 14(a)(1) for the reference made therein to the financial statements. (b) Supplementary Data Not applicable. Item 9.	Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. PART III Item 10.	Item 10. Directors1 and Executive Officers of the Registrant Name Age Position Howard B. Wentz, Jr. (64) Chairman of the Board and Director Robert A. Haversat (57) President, Chief Executive Officer and Director Roger D. Chesley (50) Vice President and General Counsel Jeffrey A. Mereschuk (41) Vice President, Treasurer and Chief Financial Officer James J. Burke, Jr. (42) Director A. J. Fitzgibbons, III (48) Director Alexis P. Michas (36) Director Jerry G. Rubenstein (63) Director __________________________ 1Each of the Directors of the Company is also a Director of Esstar. Directors of the Company do not receive any retainer or meeting fees from the Company. Mr. Rubenstein receives an annual retainer of $20,000 from Esstar, for his service as a director of Esstar. Mr. Wentz joined Duff-Norton Company, Inc. in 1969, the year after that former subsidiary was acquired by Amstar, as Vice President-Operations. He became President of Duff-Norton in 1970, and its Chief Executive Officer in 1972. Elected as Vice President of Amstar in 1972, Mr. Wentz has been a member of its Board of Directors since 1976. He served Amstar as Executive Vice President and Chief Operating Officer from January 1979 until January 1981, and President and Chief Operating Officer from January 1981 until July 1, 1982. He was named Chief Executive Officer of Amstar on July 1, 1982, and elected to the additional post of Chairman of the Board effective February 1, 1983. Mr. Wentz holds a B.S.E. degree from Princeton University and an M.B.A. from the Harvard Graduate School of Business Administration. He retired from Amstar on June 30, 1989, and relinquished his positions of Chairman of the Board, President and Chief Executive Officer. He continued as a director. On July 27, 1989, Mr. Wentz was elected Chairman of the Board of Amstar. Mr. Wentz is Chairman of the Board and a director of Esstar, and was elected to those positions in June 1989. He also is a director of Colgate-Palmolive Company, Crompton & Knowles Corporation and Tambrands, Inc. He was elected Chairman of the Board of Tambrands, Inc. in June 1993. Mr. Haversat was elected President and Chief Executive Officer and a Director of Amstar in July 1989. He is President and Chief Executive Officer of Esstar, and was elected to those positions in June 1989. Since January 1989 he also has been Chairman of the Board, President and Chief Executive Officer of Essex and EI Holdings. From August 1987 to January 1989, Mr. Haversat was President, Chief Executive Officer and a director of a predecessor of Essex. From September 1986 to August 1987, Mr. Haversat was Group Vice President of ESSEX Hardware, Inc. ("EHI"), formerly Foster Hardware and Bank Equipment Corporation, and a Vice President of four subsidiaries of EHI. Previously, he was President and Chief Executive Officer of McKinney Products Company and its predecessors since 1978. On May 22, 1990, Mr. Haversat was indicted by a federal grand jury for violations of the antitrust laws and on April 1, 1993, he was fined $250,000 following entry of a plea of nolo contendere. (See discussion at pages 25 and 26.) Mr. Haversat is a member of the Board of Trustees of Quinnipiac College and of Yale- New Haven Hospital. Mr. Chesley joined Amstar as a member of the Law Department in 1977. He was elected Assistant Secretary in 1978 and appointed General Attorney in 1981. He was elected Assistant General Counsel in 1982. In 1985, Mr. Chesley was elected Vice President and General Counsel. Mr. Chesley also is Vice President and General Counsel of Esstar. He was elected to those positions in June 1989. He is a member of the New York Bar and holds an LL.B from Harvard Law School. He received a B.S. in economics from the Wharton School of the University of Pennsylvania. Mr. Mereschuk was elected a Vice President of Amstar on July 27, 1989, and Chief Financial Officer on October 1, 1989, and Treasurer on June 30, 1993. He also is Vice President, Treasurer, Chief Financial Officer and Assistant Secretary of Esstar, having been elect those positions, except Treasurer, in June 1989. He was elected Treasurer on June 30, 1993. He also is Treasurer of METCO, having been elected to that position on December 31, 1991. Since January 1989, Mr. Mereschuk has been Vice President-Finance and Secretary of Essex and EI Holdings. Mr. Burke has been a Director of Amstar since 1986. Mr. Burke joined Merrill Lynch & Co. in 1979 and was an associate in the Mergers and Acquisitions Group until 1983, when he was elected a Vice President. In 1985, he was elected a Managing Director of Merrill Lynch & Co. and an Executive Vice President of ML Capital Partners, the leveraged buyout unit of Merrill Lynch. In January 1987, Mr. Burke was elected President and Chief Executive Officer of ML Capital Partners. Mr. Burke is a director of Esstar. He is also a director of Borg-Warner Security Corporation, Pathmark Stores, Inc., AnnTaylor Stores Corporation, London Fog Corporation, United Artists Theatre Circuit, Inc., World Color Press, Inc. and Wherehouse Entertainment, Inc. Mr. Burke holds a B.A. degree from Brown University and an M.B.A. degree from the Harvard Graduate School of Business Administration. Mr. Fitzgibbons has been a Director of Amstar since July 1989. Mr. Fitzgibbons has been a director since 1987, Executive Vice President since 1988 and a Senior Vice President from 1987 to 1988 of ML Capital Partners. He has been a Managing Director of Merrill Lynch & Co. since 1978. Mr. Fitzgibbons is a director of Essex, EI Holdings and Esstar. He is also a director of Eckerd Corporation, Borg-Warner Security Corporation, Borg-Warner Automotive, Inc. and United Artists Theatre Circuit, Inc. Mr. Fitzgibbons holds a B.A. degree from Boston College and an M.B.A. degree from the Columbia University Graduate School of Business. Mr. Michas has been a Director of Amstar since July 1989. Mr. Michas has been a director since 1988, Partner since 1993, Senior Vice President since 1989, Vice President from 1987 to 1989 and Assistant Vice President from 1985 to 1987 of ML Capital Partners. He has been a Managing Director since February 1991, a Director since 1989 and a Vice President since 1987 of Merrill Lynch & Co. Mr. Michas is a director of Essex, EI Holdings and Esstar. He is also a director of Eckerd Corporation, Borg-Warner Security Corporation, Borg-Warner Automotive, Inc. and Blue Bird Corporation. Mr. Michas holds a B. A. degree from Harvard College and an M.B.A. degree from the Harvard Graduate School of Business Administration. Mr. Rubenstein has been a Director of Amstar since 1986. Mr. Rubenstein was employed by IU International Corporation ("IU") from 1966 through 1975 and was elected President of such entity in 1973. Mr. Rubenstein left IU in 1975 and since that time has been the President, and has had the controlling interest in, Omni Management Associates, a private investment company, and its predecessor firms. Mr. Rubenstein is a director of Esstar and Supermarkets General Holdings Corporation. Mr. Rubenstein holds a B.B.A. from the City College of New York. 2. Amounts of bonus in the Bonus column are reported for the year for which they were earned. Bonus payments are made in March of the year following the year for which the bonus was earned. 3. All Other Compensation for Messrs. Ames and Schmidt, for each year shown, was the contribution by METCO to their respective participant accounts held by the trustee under METCO's Employees' Profit Sharing Retirement Plan (the "Retirement Plan"), a defined contribution plan that provides retirement benefits for salaried and hourly employees of METCO. Under the terms of the Retirement Plan, 25% of a participant's share of METCO's contribution under the Retirement Plan for a year is paid directly to the participant in cash, following the end of the year, rather than to the trustee for the Retirement Plan. The cash payments received by Messrs. Ames, Grove and Schmidt for the years 1993, 1992 and 1991 as a result of their participation in the Retirement Plan are included in the table above under Bonus and not under All Other Compensation. For Mr. Grove, All Other Compensation consists of the following amounts for 1993, 1992 and 1991, respectively: $26,531, $25,749 and $21,753 contributed to his account held by the trustee under the Retirement Plan; $71,577, $64,000 and $46,000 accrued for the benefit of his account under the Supplemental Retirement Benefit Program ("SERP"); $22,261, $22,000 and $45,000, which are the amounts of premiums paid by Esstar with respect to Mr. Grove under an executive split-dollar life insurance policy. Under the terms of the policy, a portion of those amounts will be recovered by Esstar upon Mr. Grove's termination of employment. For 1993, 1992 and 1991, the term-life insurance economic value of the split-dollar life insurance premium for Mr. Grove were the following respective amounts: $1,899, $1,712 and $1,597. Since the inception of the SERP in 1989, a total of $267,521 has been accrued for the benefit of Mr. Grove's account under the SERP. Of that total amount, a total of $226,577 was accrued in the years 1990 through 1993 and has been reported on Form 10-K as All Other Compensation for Mr. Grove for the year of accrual. In 1993, Mr. Grove received a distribution of $112,291 of the total of $267,521 that had been accrued for his benefit. That distribution is not included in All Other Compensation for 1993 because of the prior reporting of accruals. Effective on December 31, 1992, grants of options to purchase class A common stock of Esstar were made by the Board of Directors of Esstar under the Esstar Incorporated 1992 Management Investors Stock Option Plan to employees of Esstar and its subsidiaries. The total number of options granted to all employees consisted of grants of 134,544 Basic Options and 2,000,000 Additional Options. The option grants made to Messrs. Haversat, Ames, Grove, Schmidt and Wentz were as follows: Mr. Haversat, 34,789 Basic Options and 250,000 Additional Options; Mr. Ames, 16,500 Additional Options; Mr. Grove 170,000 Additional Options; Mr. Schmidt, 4,349 Basic Options and 35,000 Additional Options; and Mr. Wentz, 295,000 Additional Options. Basic Options were immediately exercisable. Additional Options are not exercisable until December 31, 1994. The options all expire on December 31, 2001. The option price for all option grants was $0.01 per share, which Esstar has stated was not materially different from the fair market value of the related stock at the date of grant. No amount has been recorded under All Other Compensation with respect to the option grants. Employment Agreement Mr. Grove entered into an employment agreement with Esstar, effective as of June 30, 1989, which agreement is to be adopted by METCO. Mr. Grove's employment agreement provides that upon his resignation during the initial term of the agreement under circumstances that make his resignation not wholly voluntary, he will be entitled to receive a lump-sum severance payment equal to his then annual base salary and the highest award received by him under the METCO Bonus Plan or a bonus plan of the Company or its predecessors, multiplied by the greater of (i) the number of years, including fractional portions thereof, remaining in the initial term, and (ii) one and one-half. The initial term of the agreement was from June 30, 1989 to June 30, 1992, and extends automatically for successive one year periods thereafter unless earlier terminated. In the event of Mr. Grove's disability or death during the initial term or an extended term he or his estate would be entitled to receive his salary and accrued benefits earned up to the last day of the month of his death and for six months thereafter and a bonus prorated for the portion of the year for which his salary is paid. Retirement Benefits (Defined Benefit) The Company's pension plan for salaried employees terminated on June 30, 1989. No service under the plan accrued after that date and benefits payable under the plan became fixed on that date. The plan provided non-contributory benefits based upon both years of service and the employee's highest consecutive 3-year average annual compensation during the last 10 years of service, including bonuses. Payment of benefits remaining to be paid under the plan has been funded through the purchase of annuities with assets held in the trust for the plan. Mr. Grove will be entitled to receive at age 60 monthly pension payments of $4,433, assuming he elects a single life basis of payment. Item 12.		Item 12. Security Ownership of Certain Beneficial Owners and Management Esstar owns 1,000 shares of common stock, par value $0.01 per share, of the Company, which constitutes all of the shares of capital stock of the Company which were outstanding as of March 25, 1994. Effective on July 23, 1992, the Company amended its restated certificate of incorporation to change its authorized capital to 1,000 shares of common stock, par value $0.01 per share, and simultaneously converted each of its issued and outstanding shares of common stock into .00016345 of a new share, resulting in the 6,118,097 shares of common stock then outstanding being converted into 1,000 issued and outstanding shares of common stock. No director or executive officer of the Company owns any shares of common stock of the Company. Item 13.	Item 13. Certain Relationships and Related Transactions All of the Directors of the Company are also Directors of Esstar. Three of the six members of the Board of Directors of both the Company and Esstar are employees of ML Capital Partners. In connection with the Combination, the Company entered into a tax sharing agreement with Esstar. Pursuant to the terms of such agreement, the Company accounts for income taxes as if it filed its own consolidated tax return. (See "Working Capital" at page 17.) Merrill Lynch & Co., an affiliate of ML Capital Partners, acted as exclusive dealer manager for Essex in connection with the solicitation of the holders of the Notes and the purchase by Essex on December 31, 1991, of $86.6 million principal amount of the Notes. (See "Consummation of Tender Offer by Essex" at page 15.) Essex paid Merrill Lynch & Co. a fee of $749,500 for its services as dealer manager. On December 31, 1991, affiliates of ML Capital Partners purchased 500,000 shares of convertible preferred stock of Esstar at a price per share of $100, or an aggregate purchase price of $50,000,000. The proceeds of the sale, along with the proceeds of the sale of 150,000 of such shares to certain other investors, were contributed by Esstar to Essex on December 31, 1991, for the purpose of providing Essex with the funds necessary to purchase $86,600,000 principal amount of the Notes on that date. (See "Consummation of Tender Offer by Essex" at page 15.) During 1993 METCO paid $110 thousand to a consultant for management development and leadership training programs conducted by the consultant for METCO employees. The consultant is a brother-in-law of Richard C. Grove, president of METCO. PART IV Item 14.	Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) Documents filed as part of this Form 10-K (1) Financial Statements The consolidated financial statements, together with the report thereon of Arthur Andersen & Co. dated February 21, 1994, filed with this report are listed in the accompanying Index to Consolidated Financial Statements and Schedules (S- 1). (2) Financial Statement Schedules The financial statement schedules filed with this Report are listed in the accompanying Index to Consolidated Financial Statements and Schedules (S- 1). (3) Exhibits The Exhibits filed with this report are listed in the Exhibit Index commencing at page 66. Each management contract or compensatory plan or arrangement required to be filed as an exhibit to this Report pursuant to Item 14(c) is identified in the Exhibit Index by the sign # immediately beneath the numerical listing of the filing in the Index. (b) Reports on Form 8-K None SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. AMSTAR CORPORATION By /s/ Jeffrey A. Mereschuk Jeffrey A. Mereschuk Vice President and Chief Financial Officer Dated: March 30, 1994 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. * President and Director Robert A. Haversat (Principal Executive Officer) /s/ Jeffrey A. Mereschuk Vice President and Chief Jeffrey A. Mereschuk Financial Officer (Principal Financial Officer) /s/ John D. Speridakos Controller John D. Speridakos (Principal Accounting Officer) Dated: March 30, 1994 Directors: * James J. Burke, Jr. * A. J. Fitzgibbons, III * Alexis P. Michas * J. G. Rubenstein * Howard B. Wentz, Jr. By /s/ Kenneth J. Jones Kenneth J. Jones Attorney-in-Fact March 30, 1994 EXHIBIT INDEX (2) - Agreement and Plan of Merger, dated as of November 14, 1986, by and among the Registrant, Acquisition and AHI. (3) (i)(1)* - Restated Certificate of Incorporation of the Registrant. (i)(2)* - Certificate of Amendment, effective December 9, 1986. (i)(3)* - Certificate of Amendment, effective December 31, 1986. (i)(4) - Certificate of Amendment, effective July 23, 1992. (Incorporated by reference to exhibit (3) to Form 10-Q of the Registrant for the quarter ended June 30, 1992) (ii)(1)* - By-Laws of the Registrant, as amended to January 28, 1987. (ii)(2) - Amendment to the By-Laws, effective July 27, 1989. (Incorporated by reference to the same numbered exhibit to Form 10-K of the Registrant for the year ended June 30, 1989.) (4)* - Indenture dated as of February 15, 1987, between the Company and Chemical Bank, as Trustee. (10) (ix)(8) - Milwaukee Electric Tool Corporation Bonus Plan. # (x)* - Supplementary Retirement Benefit Program for Certain # Key Executives of ESSTAR Incorporated and its Subsidiaries. _____________ * Incorporated by reference to the same numbered exhibit to Registration Statement of the Registrant on Form S-1 (File No. 33- 10740). Incorporated by reference to the same numbered exhibit to Form 10-K of the Registrant for the transition period from July 1, 1989, to December 31, 1989. * Incorporated by reference to the same numbered exhibit to Form 10-K of the Registrant for the year ended December 31, 1992. # Required to be filed as an exhibit pursuant to Item 14(c). (xiii)(3) - Indenture dated as of June 30, 1989, between ESSEX Industries, Inc. and ____________________, as Trustee, and acknowledged by Amstar Corporation, relating to Senior Subordinated Discount Notes due 1997. (Incorporated by reference to Exhibit 3 to Form 8-K of the Registrant, Date of Report: June 30, 1989.) (xiii)(4)* - First Supplemental Indenture dated as of June 30, 1989, between ESSEX Industries, Inc. and____________________, as Trustee, and acknowledged by Amstar Corporation, relating to Senior Subordinated Discount Notes due 1997. (xiii)(5) - Second Supplemental Indenture dated as of December 31, 1991, between ESSEX Industries, Inc. and ____________, as Trustee, and acknowledged by Amstar Corporation, relating to Senior Subordinated Discount Notes due 1997. (xiv) - Letter of Credit Agreement, dated as of June 28, 1989, among Amstar Corporation, Amstar Technical Products Company, Inc, Aiken Advanced Systems, Inc. and The Bank of New York. (Incorporated by reference to Exhibit 4 to Form 8-K of the Registrant, Date of Report: June 30, 1989). (xv) - Revolving Credit Agreement, dated as of June 28, 1989, among Milwaukee Electric Tool Corporation, Amstar Corporation and The Bank of New York. (Incorporated by reference to Exhibit 5 to Form 8-K of the Registrant, Date of Report: June 30, 1989.) (xvi) - The Credit Agreement, dated as of December 31, 1991, between Milwaukee Electric Tool Corporation, as borrower and Heller Financial, Inc., as agent and lender. (xvi)(1)*** - Waiver and First Amendment to Credit Agreement dated December 31,1992, between Milwaukee Electric Tool Corporation and Heller Financial, Inc., as agent and lender. (xvi)(2) - Second Amendment, dated October 26, 1993, to Credit Agreement dated as of December 31, 1991,between Milwaukee Electric Tool Corporation, as borrower and Heller Financial Inc., as agent and lender. (Incorporated by reference to Exhibit 10(i) to Form 10-Q of the Registrant for the quarter ended September 30, 1993.) _________________ * Incorporated by reference to the same numbered exhibit to Form 10-K of the Registrant for the year ended June 30, 1989. Incorporated by reference to the same numbered exhibit to Form 8-K of the Registrant, Date of Report: December 31, 1991. * Incorporated by reference to the same numbered exhibit to Form 10-K of the Registrant for the year ended December 31, 1992. (xvi)(3) - Reaffirmation, dated October 26, 1993, of Amstar Corporation, acknowledging the Second Amendment to Credit Agreement and reaffirming its obligations under the Secured Guaranty dated as of December 31, 1991, in favor of Heller Financial, Inc. (Incorporated by reference to Exhibit 10(ii) to Form 10-Q of the Registrant for the quarter ended September 30, 1993.) (xvii)** - The Secured Guaranty of Amstar Corporation, dated as of December 31, 1991, in favor of Heller Financial, Inc. as agent, and the lenders specified therein. (xvii)(1)* - Amended and Restated Secured Guaranty of Amstar Corporation dated as of December 31, 1992, in favor of Heller Financial, Inc. as agent, and the lenders specified therein. (xviii) - Assignment of Copyrights and Licenses, dated as of December 31, 1991, between Milwaukee Electric Tool Corporation and Heller Financial, Inc. as agent. (xix) - Assignment of Patents, dated as of December 31, 1991, between Milwaukee Electric Tool Corporation and Heller Financial, Inc as agent. (xx) - Assignment of Trademarks, dated as of December 31, 1991, between Milwaukee Electric Tool Corporation and Heller Financial, Inc. as agent. (xxi) - Pledge Agreement, dated as of December 31, 1991, between Amstar Corporation and Heller Financial, Inc. as agent. (xxii)** - Subsidiary Pledge Agreement, dated as of December 31, 1991, between Milwaukee Electric Tool Corporation and Heller Financial, Inc. as agent. ________________ * Incorporated by reference to the same numbered exhibit to Form 10-K of the Registrant for the year ended December 31, 1992. Incorporated by reference to the same numbered exhibit to Form 8-K of the Registrant, Date of Report: December 31, 1991. (xxiii) - Post-Closing Agreement, dated as of December 31, 1991, between Milwaukee Electric Tool Corporation and Heller Financial, Inc. as agent. (xxiv)** - Debt Exchange Agreement, dated as of December 31, 1991, between Amstar Corporation and ESSEX Industries, Inc. (22)* - List of subsidiaries of the Registrant. (25) - Power of attorney. (28)* - ESSTAR Incorporated 1992 Management Investors Stock # Option Plan (28)(viii)*** - Agreement entered into by ESSTAR Incorporated with Richard # C. Grove, as of June 30, 1989. ______________________ * Incorporated by reference to the same numbered exhibit to Form 10-K of the Registrant for the year ended December 31, 1992. Incorporated by reference to the same numbered exhibit to Form 8-K of the Registrant, Date of Report: December 31, 1991. * Incorporated by reference to the same numbered exhibit to Registration Statement of the Registrant on Form S-1 (Regis. No. 33-10740). # Required to be filed as an exhibit pursuant to Item 14(c). S-1 AMSTAR CORPORATION AND SUBSIDIARIES Index to Consolidated Financial Statements and Schedules Page Report of Independent Public Accountants S-2 Statements: Amstar Corporation and Subsidiaries Consolidated Balance Sheets as of December 31, 1993 and December 31, 1992. S-3 Amstar Corporation and Subsidiaries Consolidated Statements of Operations for the years ended December 31, 1993, 1992, and 1991. S-4 Amstar Corporation and Subsidiaries Consolidated Statements of Changes in Stockholder's Equity (Deficit) for the years ended December 31, 1993, 1992, and 1991. S-5 Amstar Corporation and Subsidiaries Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992, and 1991. S-6 Notes to Consolidated Financial Statements S-7 Schedules - For the Years Ended December 31, 1991, 1992, and 1993 IV Indebtedness of and to Related Parties - Not Current S-19 V Property, Plant and Equipment S-20 VI Accumulated Amortization and Depreciation of Property, Plant and Equipment S-21 VIII Valuation and Qualifying Accounts S-22 X Supplementary Income Statement Information S-23 Separate financial statements of the Registrant have been omitted because (i) the consolidated statements of the Registrant and its subsidiaries are filed, and (ii) the Registrant is primarily an operating company and all subsidiaries are wholly owned and are not indebted to any person other than the Registrant in an amount which is material in relation to the total consolidated assets, as of December 31, 1993, excepting indebtedness incurred in the ordinary course of business which is not overdue and which matures within one year from the date of its creation. Schedules other than those listed in the index are omitted because they are not required or are not applicable or because the required information is included in the financial statements or notes thereto. S-2 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors and Stockholder of Amstar Corporation: We have audited the accompanying consolidated balance sheets of Amstar Corporation (a Delaware corporation and wholly-owned subsidiary of ESSTAR Incorporated) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, changes in stockholder's equity and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Amstar Corporation and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. As discussed in Notes 8 and 9 to the consolidated financial statements, effective January 1, 1993, the Corporation changed its methods of accounting for income taxes and postretirement benefits other than pensions. New Haven, Connecticut February 21, 1994 S-3 AMSTAR CORPORATION AND SUBSIDIARIES (a wholly-owned subsidiary of ESSTAR Incorporated) CONSOLIDATED BALANCE SHEETS AS OF DECEMBER 31, 1993 AND 1992 (dollar amounts in thousands) ASSETS 1993 1992 CURRENT ASSETS: Cash and cash equivalents $ 2,554 $ 6,483 Accounts receivable, net of allowance for doubtful accounts of $788 and $725 54,943 43,542 Receivable from ESSTAR Incorporated 946 7,167 Inventories 38,671 36,643 Other 861 955 Total current assets 97,975 94,790 PROPERTY, PLANT AND EQUIPMENT, at cost: Land 1,578 1,490 Buildings and structures 9,627 9,036 Machinery and equipment 81,218 69,957 92,423 80,483 Less - accumulated depreciation and amortization 28,328 23,220 64,095 57,263 NOTES AND ACCRUED INTEREST RECEIVABLE FROM RELATED PARTY - 93,703 GOODWILL AND OTHER INTANGIBLES, net of accumulated amortization of $29,236 and $24,627 99,787 104,137 OTHER 1,024 865 $ 262,881 $350,758 LIABILITIES AND STOCKHOLDER'S EQUITY (DEFICIT) CURRENT LIABILITIES: Accounts payable $ 15,895 $ 15,028 Accrued interest 8,331 8,331 Accrued income taxes 1,179 10,258 Accrued payroll and employee benefit costs 11,223 9,024 Deferred income taxes 3,467 - Other accrued expenses 9,365 7,847 Total current liabilities 49,460 50,488 LONG-TERM DEBT 201,800 195,300 DEFERRED INCOME TAXES 9,851 3,388 OTHER NONCURRENT LIABILITIES 22,643 6,465 COMMITMENTS AND CONTINGENCIES (Notes 7 and 10) STOCKHOLDER'S EQUITY (DEFICIT): Common stock $.01 par value, 1,000 shares authorized, issued and outstanding - - Additional paid-in capital 64,814 64,814 Retained earnings 22,072 30,303 Notes and accrued interest receivable from related party (107,759) - Total stockholder's equity (deficit) (20,873) 95,117 $ 262,881 $350,758 The accompanying notes are an integral part of these consolidated financial statements. S-4 AMSTAR CORPORATION AND SUBSIDIARIES (a wholly-owned subsidiary of ESSTAR Incorporated) CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (amounts in thousands) 1993 1992 1991 Net sales $306,441 $266,405 $242,008 Costs of products sold 214,191 185,974 173,966 Gross profit 92,250 80,431 68,042 Selling, general and administrative expenses 58,023 49,272 50,687 Amortization of goodwill and other intangibles 4,609 4,520 4,088 Operating income 29,618 26,639 13,267 Interest income 14,869 13,109 28,806 Interest expense (23,591) (23,626) (36,076) Other income (expense) (21) (35) 311 Income before income taxes, extraordinary gain and cumulative effect of changes in accounting principles 20,875 16,087 6,308 Income taxes: Provision for state and local income taxes 2,679 1,963 1,380 Provision for Federal income taxes 7,970 4,971 3,579 10,649 6,934 4,959 Income before extraordinary gain and cumulative effect of changes in accounting principles 10,226 9,153 1,349 Extraordinary gain on retirement of Senior Subordinated Notes, net of related income taxes - - 20,182 Income before cumulative effect of changes in accounting principles 10,226 9,153 21,531 Cumulative effect changes in accounting principles (10,957) - - Net income (loss) $ (731) $ 9,153 $ 21,531 The accompanying notes are an integral part of these consolidated financial statements. S-7 AMSTAR CORPORATION AND SUBSIDIARIES (a wholly-owned subsidiary of ESSTAR Incorporated) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 AND 1992 1. Organization: On June 30, 1989, the holders of all the outstanding shares of common stock of Amstar Corporation (the Corporation) exchanged (the Amstar Exchange) such shares for shares of common stock of ESSTAR Incorporated (ESSTAR). Simultaneously with the Amstar Exchange, the holders of all the outstanding shares of common stock of EI Holdings Corp. (EIH) exchanged (the Essex Exchange and together with the Amstar Exchange, the Combination) such shares for shares of ESSTAR common stock. As a result of the Combination, the Corporation and EIH each became direct, wholly-owned subsidiaries of ESSTAR. The Combination was treated as a pooling-of-interests. 2. Summary of Significant Accounting Policies: Principles of consolidation - The accompanying consolidated financial statements include the accounts of Amstar Corporation and its wholly-owned subsidiaries Milwaukee Electric Tool Corporation (Metco), Milford Products Corporation (Milford)through March 28, 1991, and Milrem Corp. (Milrem). All significant intercompany transactions and accounts have been eliminated in consolidation. On March 28, 1991, the Corporation sold the stock of Milford, and entered into a covenant not to compete, for $19,662,000 in cash, which was in excess of Milford's net book value. Under the terms of the Stock Purchase Agreement, a subsidiary of the Corporation provided a letter-of-credit for $2,500,000 and placed in escrow $3,500,000 principal amount of the Corporation's 11.375% Senior Subordinated Notes as security for the performance of certain environmental remediation obligations of the Corporation to the purchaser. Such obligations are accrued and are currently estimated to cost substantially less than the security. Depreciation and amortization - Property, plant and equipment are depreciated or amortized, using the straight-line method, over the estimated useful lives of the assets ranging from 20 to 45 years for buildings and structures and 3 to 16 years for machinery and equipment. Leasehold improvements are amortized over the shorter of the lease term or the estimated useful lives. Expenditures for repairs and maintenance are charged against income as incurred. Renewals and betterments are capitalized. S-8 Goodwill and other intangibles - Goodwill and other intangibles represent the excess of cost over the fair value of assets acquired and liabilities assumed related to a previous acquisition of the Corporation and are being amortized, on a straight-line basis, over 40 years for goodwill and 7.5 to 10 years for other intangible assets. The unamortized balances of goodwill and other intangibles were $95,242,000 and $4,545,000, respectively, at December 31, 1993 and $98,148,000 and $5,989,000, respectively, at December 31, 1992. The Corporation continually evaluates whether events and circumstances have occurred which indicate that the remaining estimated useful life of goodwill may warrant revision or that the remaining balance of goodwill may not be recoverable. The Corporation uses an estimate of its related business segment's undiscounted net income over the remaining life of goodwill in measuring whether the goodwill is recoverable. Research and development - The Corporation's research and development costs are charged to expense as incurred and amounted to $4,531,000, $3,986,000 and $3,387,000 for the years ended December 31, 1993, 1992 and 1991, respectively. Product liability and workers' compensation - The Corporation is partially self-insured for product liability and workers' compensation claims. The Corporation accrues for its product liability and workers' compensation claims based on an assessment of claims outstanding, as well as an estimate, based on experience, of incurred workers' compensation claims which have not yet been reported. Stockholder's equity - Effective on July 23, 1992, through a reverse stock split, the Corporation converted the then issued and outstanding 6,118,097 shares of common stock to 1,000 shares of common stock. The number of shares as presented in the accompanying consolidated financial statements has been retroactively restated to reflect the reverse stock split. Cash and cash equivalents - For purposes of the consolidated statements of cash flows, the Corporation considers all highly liquid debt instruments with an original maturity of three months or less to be cash equivalents. 3. Discontinued Operations: On October 31, 1989, the Corporation converted preferred stock and related warrants, which represented the Corporation's continuing investment in a previously sold subsidiary, into a subordinated note receivable. This note, which bore interest at 13% per annum, was payable semi-annually on March 31 and September 30 of each year. During 1991, the Corporation sold the note receivable for an aggregate price of $15,000,000. S-9 Effective April 15, 1992, the Corporation sold substantially all of the assets of Keltec Florida, Inc. The proceeds received from the sale, net of related costs, approximated the book value of the assets. This company had previously been recorded as a discontinued operation. Net sales of all discontinued businesses approximated $8,122,000, and $30,792,000 for the years ended December 31, 1992 and 1991, respectively. 4. Inventories: Substantially all inventories are valued at the lower of cost, under the last-in, first-out method (LIFO), or market and include materials, labor and manufacturing overhead. As a result of the application of purchase accounting in 1986, the financial accounting basis of the inventories changed, while the basis for federal income tax reporting purposes did not. Accordingly, as of December 31, 1993 the LIFO inventories reflected in the accompanying consolidated balance sheets are stated at an amount $17,952,000 greater than the LIFO inventories reported for federal income tax purposes. At December 31, 1993 and 1992, the LIFO inventories reflected in the consolidated balance sheets are $5,721,000 and $11,140,000, respectively, less than current costs. The decrease in the LIFO reserve results primarily from the reclassification of deferred taxes related to the adoption of Statement of Financial Accounting Standards No. 109, accounting for Income Taxes (Note 9). During 1991, the Corporation liquidated certain LIFO inventories that were carried at lower costs prevailing in prior years. The effect of this liquidation was to increase operating income by approximately $1,900,000. Inventories at December 31, 1993 and 1992 consisted of the following: 1993 1992 (amounts in thousands) Raw materials and parts $14,859 $18,118 Work-in-process 1,167 853 Finished goods 22,645 17,672 $38,671 $36,643 5. Notes Receivable from Related Party: Concurrent with the Combination, ESSEX Holdings, Inc. (formerly ESSEX Industries, Inc.) (ESSEX) issued, and the Corporation purchased, $152,733,000 aggregate principal amount of Senior Subordinated Discount Notes due 1997 and $100,000,000 aggregate principal amount of 14% Subordinated Debentures due 1997, for an aggregate cash purchase price of $175,000,000. S-10 On December 31, 1991, EIH, through its wholly-owned subsidiary ESSEX, purchased in the open market $86,600,000 principal amount of the Corporation's 11.375% Senior Subordinated Notes for $64,950,000. Concurrent with the purchase, ESSEX exchanged the Senior Subordinated Notes for its outstanding indebtedness due the Corporation of $100,000,000 of Subordinated Debentures, $5,833,000 of related accrued interest and $25,000,000 of Senior Subordinated Discount Notes (the Debt Swap). The resulting loss on the Debt Swap of $65,883,000 is reflected in the accompanying consolidated statement of changes in stock- holder's equity for the year ended December 31, 1991, net of a federal tax benefit of $15,750,000, as a decrease in retained earnings. As of December 31, 1993 and 1992, $116,874,000 aggregate principal amount of Senior Subordinated Discount Notes remained outstanding which have accreted values of $107,759,000 and $93,703,000, respectively. The Senior Subordinated Discount Notes will bear interest, commencing August 1, 1994, at 15% per annum, payable semi- annually. At the option of ESSEX, the payment of interest in cash may be deferred until the February 1, 1997 maturity date of these notes. If the cash interest payments are deferred, the Corporation will receive additional securities in lieu of cash. These notes are subject to redemption after August 1, 1994, in whole or in part, at the election of ESSEX, at a redemption price equal to 104.29%, 102.14% and 100% of the outstanding principal balance as of the first day of August 1994, 1995 and 1996, respectively. For the years ended December 31, 1993, 1992 and 1991, the Corporation recognized $14,056,000, $12,222,000 and $27,889,000 of interest income, respectively, related to these notes receivable from affiliate. Included in this interest income is $14,056,000, $12,222,000 and $13,889,000 of debt discount amortization which was added to the carrying value of the Senior Subordinated Discount Notes during the years ended December 31, 1993, 1992 and 1991, respectively. Subsequent to year end, Essex informed the Corporation that as of December 31, 1993, ESSEX wrote off the remaining balance of its goodwill of $82,287,000 based on ESSEX's projections of future net income. Based on this information, the Corporation determined that, as of December 31, 1993, the ultimate realization of a portion of the Senior Subordinated Discount Notes may be in doubt. Accordingly, the Corporation has classified the Senior Subordinated Discount Notes as an offset to stockholder's equity in the accompanying consolidated balance sheet and statement of changes in stockholder's equity (deficit) as of December 31, 1993, and will reserve in full against the accretion of interest on the Senior Subordinated Discount Notes subsequent to December 31, 1993. 6. Long-Term Debt: Long-term debt at December 31, 1993 and 1992 consisted of the following: 1993 1992 (amounts in thousands) 11.375% Senior Subordinated Notes $195,300 $195,300 Bank debt 6,500 - $201,800 $195,300 S-11 Bank debt - On December 31, 1991, Metco entered into a credit agreement with a lending institution which provides for a primary letter of credit facility of $15,000,000, a primary revolving facility of $45,000,000 (of which up to $15,000,000 may be used for additional letters of credit) and, effective October 26, 1993, a secondary revolving loan facility of $15,000,000 (collectively the Credit Facility). Borrowings under the revolving facilities are limited to 90% of eligible accounts receivable, 65% of eligible inventory, and the primary letter of credit borrowing base of $15,000,000, as defined. At December 31, 1993, additional borrowings of $45,438,000 were available under the Credit Facility. The Credit Agreement expires and all obligations outstanding thereunder become due and payable on December 31, 1995. Interest on outstanding borrowings is payable at either the London Interbank Offered Rate (3.25-3.8125% at December 31, 1993) plus 3.0% to 3.75% or the prime rate (6.0% at December 31, 1993) plus 1.75% to 2.50%, depending upon the nature of the borrowing. If Metco's operating cash flow, as defined, does not meet certain minimum ratios for a specified period of time, then interest rates will be increased by 1.0%. Borrowings under the Credit Facility are secured by a first security interest on substantially all of the real and personal property of Metco, the capital stock of Metco, and 65% of the capital stock of Metco's sole subsidiary. Additionally, the Corporation has guaranteed the indebtedness of Metco. The Credit Facility contains certain restrictive provisions on both Metco and the Corporation. The Metco restrictive provisions include, among others, that Metco may not incur certain additional indebtedness, incur certain contingent liabilities, sell or dispose of certain assets, or make certain investments. Metco is also subject to financial covenants including maximum annual capital expenditures ($8,000,000 in 1993 increasing to $8,500,000 by 1995; provided that up to $2,000,000 not expended in any fiscal year may be carried over and expended in the next succeeding fiscal year), consolidated net income before interest, depreciation, amortization and taxes (EBIDAT), as defined, ($38,000,000 in 1993 increasing to $42,000,000 by 1995), EBIDAT as a ratio of interest expense, as defined (5.0 to 1.0 in 1993 and thereafter), and EBIDAT as a ratio of fixed charges, as defined (1.0 to 1.0 in 1993 and thereafter). The Corporation's restrictive provisions include, among others, that the Corporation may not incur certain additional indebtedness, incur certain contingent liabilities, or pay dividends or certain other payments to ESSTAR except as set forth in the Credit Facility. In addition, the Corporation is also subject to a financial covenant that the ratio of certain of its income divided by certain of its interest expense, as defined, must not be less than 1.0 to 1.0. At December 31, 1993, Metco and the Corporation were in compliance with the covenants in the Credit Facility. S-12 This Agreement provides for a 2.0% per annum fee on all outstanding letters of credit and a 0.5% per annum fee on the unused portion of the Credit Facility. The outstanding standby letters-of-credit at December 31, 1993 and 1992 were $22,992,000 and $24,250,000, respectively. In addition, the Corporation had $70,000 and $88,000 in documentary letters- of-credit outstanding at December 31, 1993 and 1992, respectively. In the event that the Corporation terminates the Credit Facility during 1994, the Corporation would pay a termination fee of $750,000. 11.375% Senior Subordinated Notes - The indenture agreement under which the 11.375% Senior Subordinated Notes (the Notes) were issued does not require sinking fund payments. Interest is payable semi-annually and the Notes are due on February 15, 1997. The Notes are redeemable at the option of the Corporation at a redemption price of 103.8% of the principal amount in 1993, declining thereafter to 100% of the principal amount by 1996. During the year ended December 31, 1991, the Corporation repurchased in the open market $30,000,000, at a cost of $16,500,000, of principal amount of its 11.375% Senior Subordinated Notes plus all accrued interest through the repurchase date. In addition, ESSEX purchased in the open market an additional $86,600,000 principal amount of the 11.375% Senior Subordinated Notes at a cost of $64,950,000 (Note 5). The gain of $20,182,000, net of related costs and after a provision for income taxes of $12,215,000, is reflected as an extraordinary gain in the accompanying consolidated statement of operations for the year ended December 31, 1991. The indenture agreement limits the amount of dividends which the Corporation can pay to ESSTAR to 50% of cumulative net income, as defined, as adjusted for certain equity transactions. As of December 31, 1993, approximately $5,030,000 was available for future distribution. Maturities under the debt instruments may be accelerated upon the occurrence of certain events as defined in the respective agreements including, but not limited to, failure to make principal and interest payments when due and breach of certain covenants in the agreements. 7. Commitments and Related Matters: Leases - The Corporation and its subsidiaries lease property, plant and equipment under a number of leases extending for varying periods of time. Operating lease rental expense amounted to approximately $2,866,000, $2,857,000 and $3,074,000 for the years ended December 31, 1993, 1992 and 1991, respectively. S-13 Minimum rental commitments as of December 31, 1993, under non-cancelable leases with terms of more than one year, are as follows: Year Ending Amount December 31, (in thousands) 1994 $2,541 1995 1,826 1996 1,045 1997 354 1998 181 Thereafter 207 $6,154 Environmental liabilities - The Corporation has incurred certain environmental obligations incidental to the normal conduct of its business. The estimated costs associated with such known obligations have been recognized in the accompanying consolidated financial statements. 8. Retirement Benefits: Profit sharing plans - Metco has a profit sharing plan for substantially all of its employees. Expense for this plan amounted to $8,221,000, $7,381,000 and $5,704,000, for the years ended December 31, 1993, 1992 and 1991, respectively. Other postretirement benefits - Employees retiring from the Corporation on or after attaining age 55 and meeting certain criteria are entitled to postretirement health care coverage and life insurance benefits. These benefits are subject to certain limitations and the Corporation reserves the right to change or terminate the benefits at any time. Effective January 1, 1993, the Corporation adopted Statement of Financial Accounting Standards No. 106, Employers' Accounting for Postretirement Benefits Other than Pensions (SFAS 106). SFAS 106 requires that the cost of postretirement benefits be recognized in the financial statements during the years employees render service. Commencing in 1993, the Corporation accrues an actuarially determined charge for postretirement benefits during the period in which active employees become eligible for such future benefits. The $8,324,000 cumulative effect of adopting this accounting change, net of a tax benefit of $2,911,000, is reflected as a decrease to 1993 net income. Additionally, the effect of this change during the year ended December 31, 1993 was to reduce net income by $776,000. S-14 The following table reconciles the accrued postretirement benefit liability as reflected on the accompanying consolidated balance sheet as of December 31, 1993 (in thousands): Retirees $6,314 Other fully eligible participants 1,074 Other active participants 2,418 Accrued postretirement benefit liability $9,806 Net postretirement benefit expense for 1993 included the following components: Service cost $ 152 Interest cost on accumulated postretirement benefit obligation 732 Change in actuarial assumptions (259) Net postretirement benefit expense $ 625 For measurement purposes, as of December 31, 1993 a 10% annual rate of increase in the per capita cost of covered health care claims was assumed for 1994, with the rate assumed to decrease gradually to 5% for 2004 and remain at that level thereafter. The health care cost trend rate assumption has a significant effect on the amounts reported. Increasing the assumed health care cost trend rates by one percentage point in each year would increase the accumulated postretirement benefit obligation as of December 31, 1993 by $819,000 and the aggregate of the service and interest cost components of net postretirement health care cost for the year then ended by $142,000. The weighted-average discount rate used in determining the accumulated postretirement benefit liability was 8.25% at time of adoption and 7.25% as of December 31, 1993. The $259,000 change in actuarial assumptions results from the decrease in the weighted- average discount rate, as well as a decrease in the Metco rate of increase in the per capita cost of health care claims. Prior to 1993, the Corporation recognized postretirement health care benefits on a modified cash basis. Post- retirement health care benefits charged to expense were $404,000 and $326,000 in 1992 and 1991, respectively. Prior year financial statements have not been restated to reflect this new method of accounting. 9. Income Taxes: Under the terms of the tax sharing agreement with ESSTAR, the Corporation provides income taxes as if it files its own consolidated return. S-15 Effective January 1, 1993, the Corporation adopted the provisions of Statement of Financial Accounting Standards 109, Accounting for Income Taxes (SFAS 109). SFAS 109 utilizes the liability method and deferred taxes are determined based on the estimated future tax effects of differences between the financial statements and tax bases of assets and liabilities given the provisions of enacted tax laws. Prior to the implementation of SFAS 109, the Corporation accounted for income taxes using Accounting Principles Board Opinion No. 11. The cumulative effect of adopting this accounting change as of January 1, 1993, was to reduce net income by $5,544,000. Prior year financial statements have not been restated to reflect this new method. The provisions for income taxes for the years ended December 31, 1993, 1992 and 1991 were as follows (in thousands): 1993 1992 1991 Current: Federal $ 7,736 $4,971 $3,579 State and local 2,720 1,963 1,380 10,456 6,934 4,959 Deferred: Federal 234 - - State and local (41) - - 193 - - Total provision $10,649 $6,934 $4,959 The tax effect of the primary temporary differences giving rise to the Corporation's consolidated deferred tax assets and liabilities at December 31, 1993 are as follows (in thousands): Current Asset Long-Term Asset (Liability) (Liability) Inventory related $(6,667) $ - Post-retirement benefits - 4,104 Depreciation and amortization - (15,472) State net operating losses - 1,150 Federal net operating losses - 1,050 Other, net 3,499 1,319 (3,168) (7,849) Valuation allowance (299) (2,002) Total deferred income taxes $(3,467) $(9,851) Gross deferred tax assets of $12,708,000, net of a valuation allowance of $2,301,000 and gross deferred tax liabilities of $23,725,000 are included in the deferred tax balances as of December 31, 1993. S-16 The difference between the Corporation's Federal effective tax rate for continuing operations and the statutory tax rate for the years ended December 31, 1993, 1992 and 1991 arises from the following: 1993 1992 1991 Federal statutory rate 35.0% 34.0% 34.0% Increase (decrease) resulting from: Goodwill amortization not deductible 4.9 6.1 14.2 State income taxes (4.5) (4.1) (7.4) Non-deductible depreciation - 2.1 5.3 Reduction of prior year tax liability - (2.7) - Deductible reserves - (4.5) - Statutory rate change 1.9 - - Other, net .9 - 10.6 Effective Federal tax rate 38.2% 30.9% 56.7% As a result of differences in the recognition of expenses for tax and financial statement purposes, the 1992 and 1991 provisions for Federal income taxes are more (less) than the amount currently payable due to the following (in thousands): 1992 1991 Accelerated depreciation $ (714) $(539) Employee benefit reserves (86) (114) Insurance reserves (275) (42) Disposition of assets 1,768 - Other 350 285 $1,043 $(410) At December 31, 1993, the Corporation had approximately $3,000,000 of Federal net operating loss carryforwards which can be used, subject to certain limitations, to offset future Federal taxable income, if any. The carryforwards expire beginning in the year 2007. As of December 31, 1993, the Corporation had approximately $10,000,000 of state net operating loss carryforwards which can be used, subject to certain limitations, to offset future state taxable income,if any. These carryforwards expire beginning in the year 1997. For the year ended December 31, 1993, additional depreciation and amortization expense of $614,000 was recognized as a result of the adoption of SFAS 109. At December 31, 1993, the Corporation had a $1,140,000 payable to its Parent, which is net against receivable from ESSTAR in the accompanying consolidated balance sheet related to Federal income taxes. S-17 10. Litigation: The Corporation is involved in various matters of litigation incidental to the normal conduct of its business. In management's opinion, the disposition of that litigation will not have a material adverse impact on the Corporation's financial condition or results of operations. 11. Related Party Transactions: In connection with the Combination, ESSTAR and its subsidiaries incurred certain advisory, legal and financing fees. As a result, the Corporation paid $1,572,000 in such fees, of which $975,000 were paid to an affiliate of a primary stockholder of ESSTAR. Of these fees, $382,000 and $492,000 are included in goodwill and other intangible assets in the accompanying consolidated balance sheets as of December 31, 1993 and 1992, respectively, and are being amortized over eight years, concurrent with the length of the respective debt. During the year ended December 31, 1993, the Corporation paid a dividend to its parent in the amount of $7,500,000. There were no dividends declared or paid in 1992 or 1991. The Corporation, ESSEX and ESSTAR share facilities and personnel related to corporate administrative activities. Charges of $3,960,000, $3,960,000, and $5,210,000 for these costs have been allocated to the Corporation for the years ended December 31, 1993, 1992 and 1991, respectively, and are based on time and expenses incurred by ESSTAR. Certain members of management of the Corporation participate in ESSTAR's stock option plans. Receivable from ESSTAR represents advances by the Corporation to ESSTAR. The advances bear interest at 10% of the average outstanding monthly balance. 12. Disclosures about Fair Value of Financial Instruments: The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value: Cash and cash equivalents, accounts receivable and payable, and accrued current obligations - For these short-term account balances, the carrying amount is a reasonable estimate of fair value. 11.375% Senior Subordinated Notes - The fair value of the Notes is estimated to be $200,000,000, based on the most recent traded price known at December 31, 1993. S-18 Bank loans - The carrying value is a reasonable estimate of fair value as the debt is frequently repriced based on prime and London Interbank Offered rates, and there has been no significant change in credit risks since the financing was obtained in 1991. 13. Industry Segment Data: The Corporation's products are all included in one segment, the power tool segment. The Corporation's principal plants and other facilities are located in the United States, with a small installation located in Canada.
37931_1993.txt	37931	1993	ITEM 1. BUSINESS: GENERAL Response to this item is incorporated by reference to the Registrant's Annual Report to shareholders for fiscal year ended December 31, 1993 on page 8. REVENUES Response to this item is incorporated by reference to the Registrant's Annual Report to shareholders for fiscal year ended December 31, 1993 on page 8. CLIENTS The Registrant and its subsidiaries (the Company) consider their relations with their clients to be satisfactory. Due to the nature of the business, however, any client could at some time in the future reduce its advertising budget, or transfer to another agency all or part of its advertising presently placed through the Company. Representation of a client does not necessarily mean that all advertising for such clients is handled by the Company exclusively. In many cases, the Company handles the advertising of only a portion of a client's products or services or only the advertising in particular geographic areas. COMPETITION The advertising agency business is highly competitive, with agencies of all sizes competing primarily on the basis of quality of service to attract and retain clients and personnel. Advertisers are able to move from one agency to another with relative ease, in part because accounts are terminable on short notice, usually90-180 days. Competition for clients by large agencies is limited somewhat because many advertisers prefer not to be represented by an agency which handles competing products or services for other advertisers. REGULATION Federal, state and local governments and governmental agencies in recent years have adopted statutes and regulations affecting the advertising activities of advertising agencies and their clients. For example, statutes and regulations have prohibited television advertising for certain products and have regulated the form and content of certain types of advertising for many consumer products. The Federal Trade Commission ("FTC") has also required proof of accuracy of advertising claims with respect to various products and, in its enforcement policies, is seeking to establish more stringent standards with respect to advertising practices. The FTC has the authority to investigate and to institute proceedings against advertisers and their advertising agencies for deceptive advertising. Proposals have also been made for the adoption of additional statutes and regulations which would further restrict the advertising activities of advertising agencies and their clients. The effect on the advertising business of future application of existing statutes or regulations, or the extent, nature or effect of future legislation or regulatory activity with respect to advertising, cannot be predicted. FINANCIAL INFORMATION ABOUT FOREIGN AND DOMESTIC OPERATIONS Response to this item is incorporated by reference to the Registrant's Annual Report to shareholders for the fiscal year ended December 31, 1993 on page 21. ITEM 2.		ITEM 2. PROPERTIES Virtually all of the Company's operations are conducted in leased premises. The Company's physical property consists primarily of leasehold improvements, furniture, fixtures and equipment. However, the Company does own office buildings in Puerto Rico and the Dominican Republic, neither of which are material to the Company's consolidated financial statements. Further information regarding the Company's leased premises, which it considers to be adequate for its current operations, is contained in note 12 of the Registrant's Annual Report to Shareholders (page 23). ITEM 3.	ITEM 3. PENDING LEGAL PROCEEDINGS Response to this item is incorporated by reference to the Registrant's Annual Report to shareholders for the fiscal year ended December 31, 1993 note 5 on page 19. ITEM 4.	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not Applicable. PART II ITEM 5.	ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK Response to this item is incorporated by reference to the Registrant's Annual Report to shareholders for the fiscal year ended December 31, 1993 on page 9. ITEM 6.	ITEM 6. SELECTED FINANCIAL DATA Response to this item is incorporated by reference to the Registrant's Annual Report to shareholders for the fiscal year ended December 31, 1993 on page 11. ITEM 7.	ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Response to this item is incorporated by reference to the Registrant's Annual Report to shareholders for the fiscal year ended December 31, 1993 on pages 10 and 11. ITEM 8.	ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA The following consolidated financial statements of the Registrant and its subsidiaries, included in the Registrant's Annual Report to shareholders for the fiscal year ended December 31, 1993 are incorporated by reference: Consolidated Balance Sheets--December 31, 1992 and 1993 Consolidated Statements of Income--Years ended December 31, 1991, 1992 and Consolidated Statements of Stockholders' Equity--Years ended December 31, 1991, 1992 and 1993 Consolidated Statements of Cash Flows--Years ended December 31, 1991, 1992 and 1993 Notes to Consolidated Financial Statements--December 31, 1993 Quarterly Financial Data--Years ended December 31, 1992 and 1993 ITEM 9.	ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10.	ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information with respect to the Directors of the Registrant is incorporated by reference to the Proxy Statement for the Annual Meeting of Stockholders filed with the Commission prior to April 1, 1994 pursuant to Regulation 14A. Information with respect to executive officers of the Registrant who are not also Directors or nominees to the Board of Directors is included below. JACK J. BOLAND (37) --Executive Vice President, North American Finance Director MARY A. CARRAGHER (34) --Vice President, General Counsel and Assistant Secretary MICHAEL S. DUFFEY (39) --Vice President, Treasurer and Assistant Secretary --Vice President, DALE F. PERONA (48) Controller and Secretary Mr. Duffey and Ms. Carragher joined the Company and became officers during 1992. Previous to that time, Mr. Duffey held various executive positions at Outboard Marine Corporation, and Ms. Carragher held various positions at Sidley & Austin. No officer of the Registrant is related to any other officer. All other officers have been officers of the Registrant or have held senior executive positions with the Company for the past five years, except as otherwise disclosed in Registrant's Proxy Statement. ITEMS 11. EXECUTIVE COMPENSATION The Registrant has filed with the Commission, prior to April 1, 1994, a definitive proxy statement pursuant to Regulation 14A. Information required under this item with respect to Directors and Officers is incorporated by reference to said Proxy Statement. ITEMS 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT (a) Persons or "groups" (as that term is used in Section 13(d)(3) of the Securities and Exchange Act of 1934) known by the Registrant to beneficially own more than five percent of any class of the Registrant's voting securities, included in the Proxy Statement for the Annual Meeting of Stockholders, is incorporated herein by reference. (b) Security ownership of management included in the Proxy Statement for the Annual Meeting of Stockholders is incorporated herein by reference. (c) There are no arrangements known to the Registrant the operation of which may at a subsequent date result in change in control of the Registrant. ITEM 13.			ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS For information with respect to certain transactions with directors of the Registrant, see the Proxy Statement for the Annual Meeting of Stockholders which is incorporated herein by reference. PART IV ITEM 14.	ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K FORM 10-K--ITEM 14(A) FOOTE, CONE & BELDING COMMUNICATIONS, INC. AND SUBSIDIARIES LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES The following consolidated financial statements of Foote, Cone & Belding Communications, Inc. and Subsidiaries, and the Independent Public Accountant's Report covering these financial statements, appearing in the Registrant's Annual Report to shareholders on pages 12 through 26 for the year ended December 31, 1993, are incorporated by reference in Item 8: Consolidated Balance Sheets--December 31, 1992 and 1993 Consolidated Statements of Income--Years ended December 31, 1991, 1992 and Consolidated Statements of Stockholders' Equity--Years ended December 31, 1991, 1992 and 1993 Consolidated Statements of Cash Flows--Years ended December 31, 1991, 1992 and 1993 Notes to Consolidated Financial Statements--December 31, 1993 The following consolidated financial statements (numbered in accordance with Regulation S-X) of Publicis Communication (a 26% owned unconsolidated affiliate of the Registrant) and Subsidiaries, and Auditors' Report with respect thereto, are included in this Report. Consolidated Income Statements--Years ended December 31, 1992 and 1993, page 10 of this Report. Consolidated Balance Sheet--December 31, 1992 and 1993, page 9 of this Report. Consolidated Statement of Change in Financial Position--Year ended December 31, 1992 and 1993, pages 11 and 12 of this Report. Notes to the Consolidated Financial Statements--December 31, 1993, pages 13 through 18 of this Report. Auditors' Report, page 19 of this Report. All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions, or are inapplicable, or the information called for therein is included elsewhere in the financial statements or related notes thereto contained in or incorporated by reference into this Report. Accordingly, such schedules have been omitted. Publicis Communication owns 51% of Publicis.FCB BV. Accordingly, the consolidated financial statements of Publicis Communication and Subsidiaries include the results of operations and financial position of Publicis.FCB BV. These financial statements have been prepared and audited based upon accounting and auditing standards and practices acceptable for external reporting purposes in France. These practices and standards can vary from U.S. accounting practices. Following is a reconciliation, prepared by Registrant, of reported net income to net income which would be reported under U.S. generally accepted accounting principles (amounts in thousands). - - - - - -------- Notes: (1) Net income as reported was computed using the average exchange rates for the year. (2) Goodwill is charged directly to retained earnings or income in the year it arises for French financial reporting purposes. The goodwill amortization expense adjustment was computed using forty years as the estimated useful life for each of the related goodwill components. All calculations have been made by Registrant based upon assumptions deemed appropriate by Registrant. PUBLICIS COMMUNICATION CONSOLIDATED FINANCIAL STATEMENTS 31/12/1993 PUBLICIS COMMUNICATION 31/12/1993 PAGE 9: Comparative Consolidated Balance Sheet : Comparative Consolidated Income Statement PAGES 11-12 : Consolidated Statement of Change in Financial Statements. PAGES 13-18 : Notes to the Consolidated Financial Statements PUBLICIS COMMUNICATION GROUP CONSOLIDATED BALANCE SHEET (IN THOUSANDS OF FRENCH FRANCS) PUBLICIS COMMUNICATION GROUP CONSOLIDATED INCOME STATEMENTS (IN THOUSANDS OF FRENCH FRANCS) PUBLICIS COMMUNICATION GROUP CONSOLIDATED STATEMENT OF CHANGE IN FINANCIAL POSITION (US GAAP--IN THOUSAND FRF) PUBLICIS COMMUNICATION GROUP CONSOLIDATED STATEMENT OF CHANGE IN FINANCIAL POSITION (US GAAP--IN THOUSAND FRF) PUBLICIS COMMUNICATION NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS AS OF 31/12/1993. I. CONSOLIDATED PRINCIPLES. PUBLICIS COMMUNICATION GROUP'S consolidated financial statements as at December 31, 1993 have been prepared in accordance with the French legislation and are in conformity with generally accepted international accounting principles. The consolidated financial statements include the accounts of the Company's wholly owned and majority owned domestic and international subsidiaries. The subsidiary companies with less than 50% ownership are consolidated on an equity basis. The company translates the financial statements of its international subsidiaries into French Francs using official exchange rates as of December 31. II. SUMMARY OF MAJOR ACCOUNTING POLICIES. Companies Consolidated: No material changes are noted in the scope of the consolidation as compared to last year. The FCA! Group accounts will only be consolidated within Publicis Communication as at January 1st 1994. General: The accounting policies used as at December 31, 1993 are identical to those used in preparing the consolidated financial statements of the Publicis Group. Tangible and Intangible Assets: Tangible assets are valued at cost and the depreciation is calculated according to the most suitable method in order to take into account the economical criteria. Listed below are the methods most currently used within the Publicis Communication Group: Building : 20 years straightline Leasehold property and improvements : 10 years straightline Furniture and Equipment : 5-10 years straightline Motor Vehicles : 4 years straightline Premiums paid to acquire marketable leasehold property and the cost of acquired goodwill are not amortized except in cases where the estimated market value is considered to be inferior to the acquisition cost. To comply with the regulation, goodwill generated through the legal reevaluation of 1976 have been fully written off against net equity 1993. Goodwill: The excess costs over the net book value of subsidiaries, after reallocating potential capital gains to the assets concerned, by their nature, are considered to be intangible assets, justified by elements such as: market shares, trade marks, clients' lists, brands . . . Usually they are not amortized. However, each year, a careful examination is made to determine their market value. If their market value is inferior to their acquisition cost, a provision for depreciation is made. The excess costs referring to unidentified elements are amortized over a maximum period of 40 years. In any case, all goodwill of small value are immediately depreciated at 100%. PUBLICIS COMMUNICATION NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) As at December 31, 1993, considering the economic background (pooling of interest) of FCA! Group, the goodwill has been exceptionally written off against net equity. Work in Progress: Work in progress is valued at the lower of cost and net realisable value. Billings: Since March 31, 1993, the Sapin law has been changing the accounting principles applicable to Media Buying activities. In order to be able to show comparable Billings with last year and to be in line with the principles applied by our foreign competitors, our consolidated Media Revenues raised in France have been capitalised using the international multiple of 6,67. Retirement Indemnities: French Subsidiaries: Potential and probable retirement indemnities including social security charges appear either on the Balance Sheet or are shown in the Contingent Liabilities. The criteria for choosing the treatment is the age of the employees concerned. The yearly movements in the provision for the retirement indemnities shown on the Balance Sheet are accounted for in the expenses of the year. Foreign Subsidiaries: Retirement indemnities are accrued for in accordance with the laws and regulations specific to each country. Statutory Profit Sharing: The Statutory Profit Sharing related to the 1993 fiscal year and payable to the employees is accounted for on a consistent basis with last year. Income Tax: All actual and deferred Income Taxes payable are accounted for. Deferred Income Tax assets or potential fiscal credits are not recognised with the exception of a latent fiscal credit of 33 1/3% calculated on the provision for the French statutory profit sharing. III. COMMENTS ON THE CONSOLIDATED ACCOUNTS. Foreign Subsidiaries' Contribution in Group Activities: Foreign subsidiaries account for 64% of the total billings and 62% of the total consolidated net income. Intangible Assets: In addition to lease rights and softwares, intangible assets include KF 21,379 of acquired goodwill and KF 468,409 related to the excess of cost over the underlying book value of subsidiaries. PUBLICIS COMMUNICATION NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONCLUDED) As of December 31, 1993 accumulated depreciation and amortization on Intangible Assets is KF 23,916 versus KF 24,666 as of December 31, 1992. Variation in Stockholders' Equity: The variation of the stockholders' equity between December 31, 1992 and December 31, 1993 is as follows: (in thousands of FF) NET EQUITY OF THE GROUP The Net Equity of the Group is as follows: (in thousands of FF) - - - - - -------- (1) After a deduction of the excess of cost over the underlying book value of subsidiaries amounting to KF 569 961 CONSOLIDATED CASH FLOW CONTINGENT LIABILITIES PRINCIPALES SOCIETES CONSOLIDEES AU 31 DECEMBRE 1993 A/ SOCIETES CONSOLIDEES PAR INTEGRATION GLOBALE CABINET ROBERT MAZARS We have examined the consolidated balance sheet of PUBLICIS COMMUNICATION and Subsidiaries as of December 31, 1993 and the related consolidated statements of income, stockholders' equity and changes in financial position for the year in the period ended December 31, 1993. These statements present a net equity (group share) of 369,647,000 FF and a net income (group share) of 131,659,000 FF. Our examination was made in accordance with generally accepted auditing standards and, accordingly, include such test of the accounting records and other auditing procedures that we considered necessary in the circumstances. In our opinion, the financial statements referred to above present fairly the financial position of PUBLICIS COMMUNICATION and Subsidiaries as of December 31, 1993, and the result of their operations and the changes in their financial position for the year in the period ended December 31, 1993, in conformity with generally accepted accounting principles applied on a consistent basis. Paris, 16th March 1994 Frederic ALLILAIRE Jose MARETTE (This page left blank intentionally) REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SUPPLEMENTAL NOTES We have audited in accordance with generally accepted auditing standards, the consolidated financial statements included in Foote, Cone & Belding Communications, Inc.'s Annual Report to Shareholders incorporated by reference in this Form 10-K, and have issued our report thereon dated February 15, 1994 (except with respect to the matter discussed in Note 10, as to which the date is March 16, 1994). Our report on the consolidated financial statements includes an explanatory paragraph with respect to the change in the method of accounting for income taxes, effective January 1, 1992, as discussed in Note 1 to the consolidated financial statements, and the change in the method of accounting for post-retirement benefits other than pensions, effective January 1, 1993, as discussed in Note 4 to the consolidated financial statements. Our audits were made for the purpose of forming an opinion on those financial statements taken as a whole. Supplemental Notes A through C are the responsibility of the Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic consolidated financial statements. The Supplemental Notes have been subjected to the auditing procedures applied in the audits of the basic consolidated financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic consolidated financial statements taken as a whole. Arthur Andersen & Co. Chicago, Illinois, February 15, 1994. FORM 10-K -- ITEM 14(A)(1) NOTE A--VALUATION ACCOUNTS FOR THE YEARS ENDED DECEMBER 31, 1991, 1992, AND 1993 - - - - - -------- NOTES: (1) Account consists of currency translation adjustment and adjustments made as a result of subsidiaries acquired and sold during the year. NOTE B--SHORT-TERM BORROWINGS FOR THE YEARS ENDED DECEMBER 31, 1991, 1992, AND 1993 - - - - - -------- NOTES: (1) The average amount outstanding during the period was computed by dividing the total of month-end outstanding principal balances by 12. (2) The weighted average interest rate during the period was computed by dividing the actual interest expense by average short-term debt outstanding. NOTE C--AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES - - - - - -------- (1) Note (represents relocation loan) due on demand. SIGNATURES PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934 AND TO THE POWER OF ATTORNEY FILED WITH THE SECURITIES AND EXCHANGE COMMISSION, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS (CONSTITUTING, AMONG OTHERS, A MAJORITY OF THE MEMBERS OF THE BOARD OF DIRECTORS OF THE REGISTRANT) ON BEHALF OF THE REGISTRANT. /s/ Bruce Mason By: _________________________________ Bruce Mason as Attorney-in-Fact /s/ Terry M. Ashwill By: _________________________________ Terry M. Ashwill as Attorney-in-Fact Date: March 29, 1994 PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED. Date: March 29, 1994 Foote, Cone & Belding Communications, Inc. /s/ Bruce Mason By: _________________________________ Bruce Mason Chairman of the Board of Directors and Chief Executive Officer (Principal Executive Officer) /s/ Terry M. Ashwill By: _________________________________ Terry M. Ashwill Executive Vice President, Chief Financial Officer and Director FORM 10-K--ITEM 14(a)(3) INDEX OF EXHIBITS EXHIBIT NO. DESCRIPTION Page - - - - - ----------- ----------- ---- 3(i) Amended Certificate of Incorporation. 28-35 11 Summary of Calculations of Earnings Per Share. 36 13 Portions of the Company's 1993 Annual Report to Shareholders Incorporated by Reference to this Form 10-K. 37-55 21 Parent and Significant Subsidiaries of Registrant. 56 23 Consent of Independent Public Accountants 57 24 Power of Attorney 58
311359_1993.txt	311359	1993				ITEM 3. LEGAL PROCEEDINGS None ITEM 4.	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDER Item 4 is omitted pursuant to General Instruction J of Form 10-K. PART II ITEM 5.	ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Item 5 is inapplicable. ITEM 6.	ITEM 6. SELECTED FINANCIAL DATA Item 6 is omitted pursuant to General Instruction J of Form 10-K. ITEM 7.	ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Item 7 is presented in the reduced disclosure format pursuant to General Instruction J of Form 10-K. RESULTS OF OPERATIONS Revenues of the Company for 1993 were $352.8 million compared to $331.1 million for 1992, an increase of $21.7 million (7%). Casino revenues for 1993 were $297.7 million compared to $278.0 million for 1992, an increased of $19.7 million (7%). Slot revenues, which include the discontinuation of certain progressive slot jackpots, increased $14.7 million (8%) due to an 11% increase in slot handle (volume) offset, in part, by a decline in the slot win percentage from 9.9% in 1992 to 9.6% in 1993. The Company added 112 slot machines (a 6% increase) during 1993. Slot revenue represented 69% of the Company's casino revenues in 1993 compared to 68% in 1992. Table games revenue, excluding poker, increased $2.4 million (3%) from 1992 primarily due to a 6% increase in the drop (amount wagered) offset, in part, by a decline in the hold percentage from 17.0% in 1992 to 16.5% in 1993. The Company's poker operations, which commenced in July 1993, contributed $2.6 million to its casino revenues. Rooms revenue increased $1.3 million (5%) due to an increase in rooms occupied in 1993 compared to 1992 offset, in part, by a reduction in the average room rate. Food and beverage revenue remained essentially unchanged. Interest income from affiliates declined $.9 million due to the elimination in 1992 of an intercompany loan. Atlantic City city-wide casino revenues for all operators in 1993, excluding poker and horse race simulcasting, increased approximately 2% from 1992, which was primarily attributable to a 5% increase in slot revenues offset, in part, by a 3% decrease in table game revenues. Atlantic City's 1993 results were negatively impacted by severe weather conditions that hampered attendance on several weekends in the first quarter. The number of slot machines in Atlantic City increased approximately 8% during 1993, while the number of Atlantic City table games, excluding poker tables, declined approximately 1%. Slot revenues in 1993 represented 67% of total gaming revenues in Atlantic City compared to 66% in 1992. Changes in gaming regulations, including modifications allowing more slot machines on existing casino floor space and permitting unrestricted 24-hour gaming effective July 1992, have aided Atlantic City slot revenue growth. In addition to the ongoing slot revenue trend, the introduction in the second quarter of 1993 of poker and horse race simulcasting has also improved the Atlantic City gaming climate. The Company's competitors in Atlantic City intensified their promotional slot marketing efforts during 1992 to expand their share of slot revenues and this trend continued through 1993. The Company believes it is well-positioned to compete for its share of casino revenues by continuing to offer promotional slot and table game programs and special events. Also, the Company plans a 13% expansion of its slot capacity and to introduce horse race simulcasting and keno, if approved by the CCC, in 1994. However, the Company believes that as a result of the aggressive competition for slot patrons, the slot win percentage will continue to be subject to competitive pressure and may further decline. Operating income of the Company for 1993 was $85.8 million compared to $62.7 million in 1992, an increase of $23.1 million (37%) due to the aforementioned increase in revenues and, to a lesser extent, a $1.4 million (1%) decrease in operating expenses. Casino expenses increased $.8 million (1%) due to an increase in salaries, benefits and other costs associated with expanded marketing and promotional efforts. Rooms expense increased $2.1 million (26%) mainly due to increased operating costs related to the higher room occupancy. Food and beverage expenses increased $1.2 million (7%) due to an increase in the cost of providing goods and services. Other operating expenses were essentially unchanged. Selling, general and administrative expenses decreased $4.1 million (10%) primarily due to a reduction in costs associated with a management restructuring, legal, insurance and other expenses. Depreciation and amortization expense were essentially unchanged. In addition, operating costs and expenses include charges for BMC's corporate overhead (including executive salaries and benefits, public company reporting costs and other corporate headquarters' costs) allocated to the Company of $4.1 million and $3.7 million for 1993 and 1992, respectively. Allocations for 1993 and 1992 were, and management expects allocations in subsequent years will be, based upon similar cost categories and allocation methods subject to changes in circumstances which may warrant modifications. Management of BMC has advised the Company that no significant changes are presently contemplated. Interest expense was $44.9 million for 1993 compared to $48.0 million for 1992. The decrease of $3.1 million (6%) reflects lower average line of credit and intercompany borrowings and, to a lesser extent, lower average interest rates charged on these borrowings. Effective rates of the income tax provision were 45% in 1993 and 46% in 1992. The 1993 and 1992 income tax rates differ from the U.S. statutory tax rates of 35% and 34%, respectively, due principally to state income taxes, net of the related federal income tax benefit. A reconciliation of the income tax provision with amounts determined by applying the U.S. statutory tax rate to income before income taxes and cumulative effect on prior years of change in accounting for income taxes is included in Notes to consolidated financial statements. Effective January 1, 1993, the Company changed its method of accounting for income taxes as required by Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes." SFAS No. 109 retains the requirement to record deferred income taxes for temporary differences that are reported in different years for financial reporting and for tax purposes; however, the methodology for calculating and recording deferred income taxes has changed. Under the liability method adopted by SFAS No. 109, deferred tax liabilities or assets are computed using the tax rates expected to be in effect when the temporary differences reverse. Also, requirements for recognition of deferred tax assets and operating loss and tax credit carryforwards were liberalized by requiring their recognition when and to the extent that their realization is deemed to be more likely than not. As permitted by SFAS No. 109, the Company elected to use the cumulative effect approach rather than to restate the consolidated financial statements of any prior years to apply the provisions of SFAS No. 109. The cumulative effect on prior years of this change in accounting for income taxes as of January 1, 1993 was a charge of $11.4 million. The effect of this change in accounting for income taxes on the provision for income taxes for 1993 was to increase the income tax provision by $.4 million as a result of applying the change in the U.S. statutory tax rate from 34% to 35% to deferred tax balances. ITEM 8.	ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEX Reference Report of independent auditors. . . . . . . . . . . . . . . . . . 11 Consolidated balance sheet. . . . . . . . . . . . . . . . . . . . 12 Consolidated statement of income. . . . . . . . . . . . . . . . . 14 Consolidated statement of stockholder's equity. . . . . . . . . . 15 Consolidated statement of cash flows. . . . . . . . . . . . . . . 16 Notes to consolidated financial statements. . . . . . . . . . . . 18 REPORT OF INDEPENDENT AUDITORS The Board of Directors and Stockholder BALLY'S PARK PLACE, INC. We have audited the accompanying consolidated balance sheet of Bally's Park Place, Inc. (an indirect wholly owned subsidiary of Bally Manufacturing Corporation) as of December 31, 1993 and 1992, and the related consolidated statements of income, stockholder's equity, and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Bally's Park Place, Inc. at December 31, 1993 and 1992, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in the "Summary of significant accounting policies -- Income taxes" note to the consolidated financial statements, in 1993 the Company changed its method of accounting for income taxes. ERNST & YOUNG Philadelphia, Pennsylvania February 25, 1994, except for the "Long-term debt" note, as to which the date is March 8, 1994 Income taxes Taxable income or loss of the Company is included in the consolidated federal income tax return of BMC. Under agreements between the Company, BMC and Casino Holdings, income taxes are allocated to the Company based on amounts the Company would pay or receive if it filed a separate consolidated federal income tax return, except that the Company receives credit from BMC for the tax benefit of the Company's net operating losses and tax credits, if any, that can be utilized in BMC's consolidated federal income tax return, regardless of whether these losses or credits could be utilized by the Company on a separate consolidated federal income tax return basis. Payments to BMC are due at such time and in such amounts as payments are required to be made for income tax purposes. Payments by BMC for such tax benefits are due at the time BMC files the applicable consolidated federal income tax return. Under the tax sharing agreement, the Company had income taxes payable to BMC of $5,562 and $3,697 at December 31, 1993 and 1992, respectively, which are classified as income taxes payable on the accompanying consolidated balance sheet. Effective January 1, 1993, the Company changed its method of accounting for income taxes as required by Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes." SFAS No. 109 retains the requirement to record deferred income taxes for temporary differences that are reported in different years for financial reporting and for tax purposes; however, the methodology for calculating and recording deferred income taxes has changed. Under the liability method adopted by SFAS No. 109, deferred tax liabilities or assets are computed using the tax rates expected to be in effect when the temporary differences reverse. Also, requirements for recognition of deferred tax assets and operating loss and tax credit carryforwards were liberalized by requiring their recognition when and to the extent that their realization is deemed to be more likely than not. As permitted by SFAS No. 109, the Company elected to use the cumulative effect approach rather than to restate the consolidated financial statements of any prior years to apply the provisions of SFAS No. 109. The cumulative effect on prior years of this change in accounting for income taxes as of January 1, 1993 was a charge of $11,377. The effect of this change in accounting for income taxes on the provision for income taxes for 1993 was to increase the income tax provision by $427 as a result of applying the change in the U.S. statutory tax rate from 34% to 35% to deferred tax balances. Fair value of financial instruments The fair value of the Company's financial instruments approximates their recorded book values at December 31, 1993 and 1992, excluding the 11 7/8% First Mortgage Notes due 1999 (the "11 7/8% Notes") whose fair market value, based on quoted market prices, was approximately $378,875 and $363,125 at December 31, 1993 and 1992, respectively. Casino licensing In September 1992, the New Jersey Casino Control Commission (the "CCC") granted a two-year renewal of the Company's casino license to operate Bally's Park Place. A New Jersey casino license is not transferable, is issued for a term of one or two years and must be renewed by filing an application. The CCC requires that dividends and other payments to BMC by the Company, other than specifically defined payments made in the ordinary course of business, receive prior notice. The Company is not aware of any reasons that the license would not be renewed during 1994 for an additional two years. Allocations from BMC and transactions with related parties BMC is a holding company without significant operations of its own. During 1992, BMC completed a major restructuring effort which began in late 1990 and which included the divestiture of several of its non-core businesses including the businesses operated directly by BMC. The businesses operated directly by BMC had previously supported BMC's overhead costs and made measurement of costs associated with oversight of subsidiary operations unnecessary. During 1991, BMC allocated costs to the Company consisting of the Company's allocable share of BMC's director's and officer's insurance and other BMC stockholder-related expenses primarily attributable to a restructuring. During 1992 and 1993, BMC allocated costs to the Company consisting of the Company's allocable share of BMC's corporate overhead including executive salaries and benefits, public company reporting costs and other corporate headquarters' costs. While the Company does not obtain a measurable direct benefit from these allocated costs, management believes that the Company receives an indirect benefit from BMC's oversight. BMC's method for allocating costs to its subsidiaries is designed to apportion its costs to its subsidiaries based upon many subjective factors including size of operations and extent of BMC's oversight requirements. Management of BMC and the Company believe that the methods used to allocate these costs are reasonable and expect similar allocations in future years. Because of BMC's controlling relationship with the Company and the allocation of certain BMC costs, the operating results of the Company could be significantly different from those that would have been obtained if the Company operated autonomously. Certain executive officers of the Company function in a similar capacity for GNAC, CORP. (a wholly owned subsidiary of BMC which owns and operates the casino resort in Atlantic City known as the "The Grand"), and exercise decision making and operational authority over both entities. No allocation of cost is made from the Company to The Grand for these executive officers as management deems the direct allocable cost to be immaterial. In addition, certain administrative and support operations of the Company and The Grand are consolidated, including legal services, purchasing, limousine services and certain aspects of human resources. Costs of these operations are allocated to or from the Company either directly or using various formulas based on utilization estimates of such services. On a net basis, allocations from the Company were $1,096, $2,568 and $2,486 in 1993, 1992 and 1991, respectively, which management believes were reasonable. The Company leases surface area parking lots to The Grand, and rental income was $696 in each of 1993, 1992 and 1991. In addition, the Company paid $869 and $2,557 to The Grand during 1992 and 1991, respectively, for New Jersey Casino Reinvestment Development Authority ("CRDA") credits which were used by the Company in satisfaction of a portion of its CRDA obligations. In April 1990, the Company advanced BMC $50,000, with interest earned at the prime rate of its agent bank. In October 1992, BMC petitioned the CCC to allow the Company to declare the receivable due from BMC as a dividend. The CCC approved this request in December 1992. No interest was paid to the Company subsequent to April 1, 1992. Intercompany interest earned on this advance was $808 and $4,243 in 1992 and 1991, respectively. In December 1990, the Company advanced The Grand $2,700. This advance was repaid in June 1992. The Company earned interest monthly on this advance (at the prime rate of its agent bank) which totalled $73 and $228 in 1992 and 1991, respectively. The Company and The Grand have a cash management arrangement whereby The Grand advances excess funds to the Company which the Company uses to reduce the outstanding balance under its revolving credit agreement. As of December 31, 1992, the Company owed The Grand $16,000 which was repaid during 1993. These advances are payable on demand. The Company pays interest monthly on these advances (at the prime rate of its agent bank) which totalled $432, $1,249 and $862 in 1993, 1992 and 1991, respectively. Discontinued motel operation In December 1991, the Company made a decision to close and demolish the motel operation of one of its subsidiaries. In connection with this decision, the Company recorded a $3,500 charge against operations in 1991 to write-off the remaining net book value of the property and equipment of this motel and to provide for the demolition cost and other related closing costs. The revenues and operating income of this motel operation were immaterial. Casino Reinvestment Development Authority investments The New Jersey Casino Control Act (the "Act") provides, among other things, for an assessment of licensees equal to 1 1/4% of their gross casino revenues. This assessment may be satisfied by the Company investing in qualified eligible direct investments, by depositing funds with the CRDA (which will be used to purchase bonds issued by the CRDA), by making qualified contributions or, under certain circumstances, donating funds on deposit with the CRDA in exchange for credits against future CRDA obligations. The Company's investment obligation for 1993 was met by purchasing CRDA bonds, donating funds on deposit with the CRDA, utilizing CRDA credits and depositing funds with the CRDA. CRDA bonds have terms up to fifty years and bear interest at below market rates. The Company records a charge to operations when it deposits funds with the CRDA to reflect the estimated realizable value of its CRDA investments. No gain or loss is recorded relating to the donation of the CRDA obligations as the book value of the Company's investment in CRDA obligations approximates the credits received. The Company charged to operations $2,059, $2,228 and $2,950 in 1993, 1992 and 1991 respectively, to reflect the estimated realizable value of its CRDA investments. In January 1991, the Company received an assessment from the New Jersey Department of the Treasury (the "Treasury") alleging, pursuant to the Act, that the Company in 1983 failed to have sufficient qualified investments in excess of casino revenues. The Act in effect in 1983 required in this situation that a casino pay an assessment to satisfy its investment obligation. In January 1992, the Company and the Treasury settled this dispute, and the Company agreed to invest an additional $2,250 with the CRDA as follows: $600 in 1992; $300 in 1993; $300 in 1994; $300 in 1995 and $750 in 1996, and to participate in certain CRDA approved low income mortgage guarantee programs. The Company charged $1,100 to operations in 1991 as a result of the settlement, representing the Company's estimated net cost of the settlement obligation. Long-term debt On March 8, 1994, the Company issued $425,000 principal amount of 9 1/4% First Mortgage Notes due 2004 (the "9 1/4% Notes"). The 9 1/4% Notes are not subject to any sinking fund requirement, but may be redeemed beginning March 1999, in whole or in part, with premiums ranging from 4.5% in 1999 to zero in 2002 and thereafter. In addition, on or before March 15, 1997, a portion of the 9 1/4% Notes may be redeemed at a premium of 9.25% out of the proceeds of one or more public equity offerings by the Company or Casino Holdings if such offerings were to occur, provided that at least $100,000 principal amount of the 9 1/4% Notes remains outstanding after the redemption. The 9 1/4% Notes are secured by a first mortgage on and security interest in substantially all property and equipment of the Company. The Company used the net proceeds from the sale of the 9 1/4% Notes to purchase and retire certain of its 11 7/8% Notes, defease the remaining 11 7/8% Notes at a price of 104.45% of their principal amount plus accrued interest through the redemption date, thereby satisfying all obligations thereunder, and pay a $30,000 dividend to Casino Holdings. The retirement and defeasance of the 11 7/8% Notes results in an extraordinary loss in the first quarter of 1994 of approximately $20,500, net of an income tax benefit of approximately $14,300. In connection with the sale of the 9 1/4% Notes, the Company terminated its existing credit facility and entered into an agreement for a new $50,000 revolving credit facility which expires on December 31, 1996, at which time all amounts outstanding become due. The new credit facility provides for interest on borrowings payable, at the Company's option, at the agent bank's prime rate or the LIBOR rate plus 2%, each of which increases as the balance outstanding increases. The rate of interest on borrowings was previously based upon the agent bank's prime rate or certain other short-term rates (6% at December 31, 1993). The Company pays a fee of 1/2% on the unused commitment. The new credit facility is secured by a pari passu lien on the collateral securing the 9 1/4% Notes. At December 31, 1993, $595 was available under the indenture for the 11 7/8% Notes to pay dividends, which was paid in February 1994. The indenture for the 9 1/4% Notes and the new credit facility imposes restrictions on the Company's ability to incur debt and issue preferred stock, make acquisitions and certain restricted payments, create liens, sell assets or enter into transactions with affiliates. The new credit facility is, in certain circumstances, more restrictive than the indenture for the 9 1/4 % Notes. In connection with the sale of the 9 1/4% Notes, the CCC requires, among other things, that dividends paid by the Company to Casino Holdings which are not paid pursuant to a net income test (generally limited to 50% of aggregate consolidated net income, as defined, earned since April 4, 1994) receive prior approval from the CCC. The indenture for the 9 1/4% Notes limits these dividends to $50,000 in aggregate. The Company has aggregate annual maturities of long-term debt (adjusted for the refinancing described above) for the five years after December 31, 1993 of $44, $46, $2,048, $50 and $52. Income taxes The provision for income taxes consists of the following: Deferred income taxes reflect the net tax effect of temporary differences between the carrying amounts of assets and liabilities for financial reporting and income tax purposes. Significant components of the Company's deferred tax assets and liabilities as of December 31, 1993 and January 1, 1993, along with their classification, are as follows: At December 31, 1993, the Company had net operating loss carryforwards for state income tax purposes of approximately $1,787. The loss carryforwards begin to expire in 1997 and fully expire in 1999. The deferred income tax provision (benefit) for 1992 and 1991 arises from the tax effect of timing differences as follows: Benefit plans The Company has a noncontributory supplemental executive retirement plan (the "SERP") for certain key executives. Normal retirement under the SERP is age 60 and participants receive benefits based on years of service and compensation. Pension costs of the SERP are unfunded. The net periodic pension cost for the Company's SERP for 1993, 1992 and 1991 consists of the following: The following sets forth the plan's obligation and funded status as of December 31 for the SERP. The discount rate was 6.0% in 1993 and 8.0% in 1992 and 1991, and the rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligations was 6.0% in 1993, 1992 and 1991. In 1991, the Company and one of its executives entered into an agreement to terminate the executive's participation in a noncontributory supplemental executive retirement plan sponsored by the Company. Pursuant to this agreement, the Company agreed to pay the executive $27,600 over five years. The Company recorded the settlement in an amount equal to the net present value of the required payments. No charge against operations in 1991 was required, as the Company had fully accrued in prior years the value of this settlement as part of its pension liability. The net present value of the remaining payments under this termination agreement was $16,042 at December 31, 1992. On January 8, 1993, the Company and BMC entered into a retirement and separation agreement with this executive which, among other things, reduced the remaining amount payable under the termination agreement to $13,500, which the Company paid on such date. In addition to the defined benefit pension plans described above, the Company has a defined contribution plan which covers certain non-union employees and which is considered part of the Company's overall retirement program. The plan is a 401(k) plan to which the Company contributes an amount allocable based on eligible participants' compensation and a percent of eligible employees' contributions. The expense for the Company's defined contribution plan was $3,129, $2,608 and $3,800 for 1993, 1992 and 1991, respectively. Certain employees of the Company are covered by union-sponsored, collectively bargained, multiemployer defined benefit pension plans. The contributions and charges to expense for these plans were $583, $562 and $567 in 1993, 1992 and 1991, respectively. In April 1991, an insurance company that issued guaranteed interest contracts ("GICs") that were purchased by both BMC's and the Company's qualified 401(k) plans was declared insolvent by the State of California's Insurance Commissioner (the "Commissioner"). Operations of this insurance company were assumed by the Commissioner. Approximately $7,400 of these GICs are held in a Master Trust for BMC's and its subsidiaries' employee benefit plans, of which approximately 42% is attributable to the Company's 401(k) plan. Although BMC and the Company had no legal obligation to fund any 401(k) plan losses, BMC's Board of Directors, in June 1991, authorized BMC, and therefore the Company, to ensure that participants in the Company's 401(k) plan not suffer any loss in principal, as determined on March 31, 1991, to their 401(k) account balances which might otherwise occur due to this insolvency. During 1991, the Company charged $900 to operations for its estimated cost of reimbursing any shortfall in the participants' 401(k) account balances, which was included in the $3,800 defined contribution plan expense. ITEM 9.	ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Item 9 is inapplicable. PART III Part III is omitted pursuant to General Instruction J of Form 10-K. PART IV ITEM 14.					ITEM 14. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES (a) 1. Index to Financial Statements. Reference Report of independent auditors . . . . . . . . . . . . . . . . . . 11 Consolidated balance sheet at December 31, 1993 and 1992 . . . . . 12 For each of the three years in the period ended December 31, 1993: Consolidated statement of income . . . . . . . . . . . . . . . . 14 Consolidated statement of stockholder's equity . . . . . . . . . 15 Consolidated statement of cash flows . . . . . . . . . . . . . . 16 Notes to consolidated financial statements . . . . . . . . . . . . 18 2. Index to Financial Statement Schedules. Schedule II Amounts Receivable from Related Parties and Underwriters, Promoters, and Employees Other Than Related Parties for each of the three years in the period ended December 31, 1993 . . . . . 33 Schedule V Property and Equipment for each of the three years in the period ended December 31, 1993 . . . . . 34 Schedule VI Accumulated Depreciation and Amortization of Property and Equipment for each of the three years in the period ended December 31, 1993 . . . . . 35 Schedule VIII Valuation and Qualifying Accounts for each of the three years in the period ended December 31, 1993. . . . . . . . . . . . . . . . . . . . . . . . . 36 Schedule X Supplementary Income Statement Information for each of the three years in the period ended December 31, 1993 . . . . . . . . . . . . . . . . . . 37 All other schedules specified under Regulation S-X are omitted because they are not applicable, not required under the instructions or all information required is set forth in the Notes to consolidated financial statements. 3. Index to Exhibits. 3.1 Restated Certificate of Incorporation of the Company. 3.2 Amended and Restated By-laws of the Company. 3.3 Certificate of Incorporation of Bally's Park Place Funding, Inc. 3.4 Amended and Restated By-laws of Bally's Park Place Funding, Inc. 3.5 Amended and Restated Certificate of Incorporation of Bally's Park Place-New Jersey. 3.6 Amended and Restated By-laws of Bally's Park Place-New Jersey. 4.1 Form of Indenture governing 11 7/8% First Mortgage Notes due 1999 of Bally's Park Place Funding, Inc. 4.1.1 Form of First Mortgage Note. 4.1.2 Form of Guaranty of the Company. 4.2 Form of Indenture governing 9 1/4% First Mortgage Notes due 2004 of Bally's Park Place Funding, Inc. 4.2.1 Form of Note (included as part of Article II of the Indenture). 4.2.2 Form of Guaranty of the Company of the Notes (included as part of Article II of the Indenture). 10(i).1 Intercorporate Agreement dated as of June 24, 1993 among Casino Holdings, Bally's Park Place-New Jersey and BMC. 10(i).2 Tax Sharing Agreement dated as of June 17, 1993 between BMC and Casino Holdings. 10(i).3 Tax Sharing Agreement dated as of June 17, 1993 between BMC and Bally's Park Place-New Jersey. 10(i).4 Amended and Restated Loan Agreement dated as of June 30, 1992 among Bally's Park Place-New Jersey, the Company, Bally's Park Place Realty Co. ("Realty Co."), and the Senior Lender, as agent and the other banks named therein governing the existing credit facility (filed as an exhibit to the Annual Report on Form 10-K for the Company for the year ended December 31, 1992). 10(i).5 Form of Mortgage and Security Agreement with Assignment of Rents among the Bally's Park Place-New Jersey, Realty Co., Bally's Park Place Funding, Inc. and First Bank. 10(i).6 Form of Assignment of Leases and Rents among Bally's Park Place- New Jersey, Realty Co. and First Bank. 10(i).7 Form of Note Pledge Agreement among the Bally's Park Place-New Jersey, Bally's Park Place Funding, Inc. and First Bank. 10(i).8 Form of Note. *10(i).9 Form of Intercreditor Agreement. 10(i).10 Mortgage and Security Agreement with Assignment of Rents dated August 31, 1989 among Bally's Park Place-New Jersey, Realty Co., the Issuer and First Fidelity Bank. 10(i).11 Assignment of Leases and Rents dated August 31, 1989 among Bally's Park Place-New Jersey, Realty Co. and First Fidelity Bank. 10(i).12 Note Pledge Agreement dated August 31, 1989 among Bally's Park Place-New Jersey, Realty Co. and First Fidelity Bank. 10(i).13 $350,000,000 Note dated August 31, 1989. 10(i).14 Loan and Guaranty Agreement dated March 8, 1994 among Bally's Park Place-New Jersey, Realty Co., Inc. and First Fidelity Bank, as agent and lender and Midlantic National Bank as lender. 10(i).15 Mortgage and Security Agreement with Assignment of Rents dated March 8, 1994 in connection with Exhibit 10(i).14. 10(ii).1 Lease Agreement dated June 8, 1977, between Bally's Park Place- New Jersey and the Palley Blatt Company respecting the Marlborough-Blenheim Hotel Property (filed as an exhibit to the Company's Registration Statement on Form S-1, Registration No. 2-65017). 10(ii).2 Letter dated April 27, 1979, from Bally's Park Place-New Jersey to Alexander K. Blatt and Norman Palley, as Trustees, agreeing to the Purchase and modification of the First Peoples National Bank of New Jersey's $4,000,000 mortgage loan to the Palley Blatt Company (filed as an exhibit to the Company's Registration Statement on Form S-1, Registration No. 2-65017). 10(iii).1 Retirement and Separation Agreement dated January 8, 1993 between BMC, Bally's Park Place-New Jersey and Richard Gillman (filed as an exhibit to the Company's Annual Report on Form 10K for the year ended December 31, 1992). 10(iii).2 Split-Dollar Life Insurance Agreements and Collateral Assignments by and among the Company's, Bally's Park Place-New Jersey, Richard Gillman and Scott Gillman dated February 1, 1985. 10(iii).3 Split-Dollar Life Insurance Agreements and Collateral Assignments by and among the Company's, Bally's Park Place-New Jersey, Richard Gillman and Marc Gillman dated February 1, 1985. 10(iii).4 Employee Incentive Stock Option Plan of Bally's Park Place-New Jersey (filed as an exhibit to the Company's Registration Statement on Form S-8, Registration No. 2-76757). 10(iii).5 Amendment to Employee Incentive Stock Option Plan of Bally's Park Place-New Jersey dated May 6, 1985. 10(iii).6 Amendments to Employee Incentive Stock Option Plan of Bally's Park Place-New Jersey dated January 24, 1986. 10(iii).7 Supplemental Executive Retirement Plan of Bally's Park Place-New Jersey effective as of January 1, 1987. 10(iii).8 Group Travel Accident Policy between Bally's Park Place-New Jersey and Hartford Insurance Group effective February 5, 1988. 10(iii).9 Profit Sharing Plan and Trust Agreement of Bally's Park Place- New Jersey. 10(iii).10 Amended and Restated Profit Sharing Plan and Trust Agreement of Bally's Park Place-New Jersey. 10(iii).11 Amended and Restated Profit Sharing Plan and Trust Agreement of Bally's Park Place-New Jersey dated as of January 1, 1987. 10(iv).1 Employment Agreement dated as of November 1, 1990, as amended, between BMC and Arthur Goldberg (filed as an exhibit to the Company's Annual Report on Form 10-K for the year ended December 31, 1991). 10(iv).1.1 First Amendment to Employment Agreement effective as of November 1, 1991 between BMC and Arthur Goldberg (filed as an exhibit to the Company's Annual Report on Form 10K for the year ended December 31, 1992). 10(iv).1.2 Second Amendment to Employment Agreement effective September 29, 1993 between BMC and Arthur Goldberg. 10(iv).2 Employment Agreement effective as of January 1, 1993 between BMC and Wallace R. Barr. 10(iv).3 Employment Agreement effective as of July 1, 1992 between BMC and Robert Conover. 10(iv).4 Severance Agreement effective as of March 1, 1993 between Bally's Park Place-New Jersey and C. Patrick McKoy. *10(iv).5 Settlement Agreement and Release dated July 30, 1993 between Bally's Park Place-New Jersey and Charles Tannenbaum. 22 Subsidiaries of Bally's Park Place-New Jersey. Incorporated herein by reference and filed as an exhibit to Bally Park Place Funding's, Inc. Registration Statement on Form S-1, Registration No. 33-26464, unless otherwise indicated. Incorporated herein by reference and filed as an exhibit to Bally's Park Place Funding's, Inc. Registration Statement on Form S-1, Registration No. 33- 51765. **Incorporated herein by reference and filed as an exhibit to Bally's Casino Holdings, Inc. Registration Statement on Form S-1, Registration No. 33-654438. BALLY'S PARK PLACE, INC. SCHEDULE X-SUPPLEMENTARY INCOME STATEMENT INFORMATION Years Ended December 31, 1993, 1992 and 1991 (In thousands) Charged to costs and expenses ----------------------------- Item 1993 1992 1991 ---- -------- -------- -------- Maintenance and repairs. . . . . . . . . . $ 17,308 $ 17,548 $ 16,536 ======== ======== ======== Amortization . . . . . . . . . . . . . . . $ 1,712 $ 2,602 $ 3,543 ======== ======== ======== Taxes other than payroll and income taxes: State gaming taxes . . . . . . . . . . . $ 23,923 $ 22,396 $ 21,248 Real estate and personal property taxes. 12,344 12,196 11,474 -------- -------- -------- $ 36,267 $ 34,592 $ 32,722 ======== ======== ======== Advertising. . . . . . . . . . . . . . . . $ 8,391 $ 9,032 $ 8,863 ======== ======== ======== /TABLE SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this Annual Report to be signed on its behalf by the undersigned thereunto duly authorized. Bally's Park Place, Inc. Dated: March 31, 1994 /s/ Joseph A. D'Amato --------------------------------- Joseph A. D'Amato Vice President and Treasurer (principal financial and accounting officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this Annual Report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. This Annual Report may be signed in multiple identical counterparts, all of which taken together, shall constitute a single document. Dated: March 31, 1994 /s/ Arthur M. Goldberg --------------------------------- Arthur M. Goldberg Chairman of the Board and Chief Executive Officer (principal executive officer) (sole director) Dated: March 31, 1994 /s/ Wallace R. Barr --------------------------------- Wallace R. Barr President, Chief Operating Officer Dated: March 31, 1994 /s/ Joseph A. D'Amato --------------------------------- Joseph A. D'Amato Vice President and Treasurer (principal financial and accounting officer) Dated: March 31, 1994 /s/ Lee S. Hillman --------------------------------- Lee S. Hillman Director Dated: March 31, 1994 /s/ J. Kenneth Looloian --------------------------------- J. Kenneth Looloian Director
18792_1993.txt	18792	1993	Item 1. Business Central Telephone Company (Central Telephone) was incorporated December 14, 1970, under the laws of Delaware and is the successor by merger on December 1, 1971, to a Delaware corporation of the same name incorporated May 25, 1944. Central Telephone and its subsidiaries (the Company) provide local exchange telephone service in portions of Nevada, North Carolina, Florida, Illinois and Virginia. In addition, intra-LATA toll service and access by other carriers to the Company's local exchange facilities are provided. Central Telephone is a subsidiary of Centel Corporation (Centel) which, in addition to its ownership of all the common stock of Central Telephone, has a subsidiary which provides local exchange telephone service in portions of Texas, subsidiaries which provide cellular communications services in various markets, and various other subsidiaries. On March 9, 1993, Centel became a wholly-owned subsidiary of Sprint Corporation (Sprint), a holding company with subsidiaries in a number of telecommunications markets. As of December 31, 1993, the Company served more than 1.5 million access lines. All of the access lines are served through central offices equipped with switching. Over 60 percent of the access lines served are located in the following seven communities: Access Community Lines Las Vegas, Nevada 528,590 Tallahassee, Florida 163,939 Des Plaines, Illinois 73,969 Charlottesville, Virginia 62,187 Park Ridge, Illinois 45,872 Fort Walton Beach, Florida 39,582 Hickory, North Carolina 38,874 953,013 The Company is providing and continuing to introduce new services made possible by the enhancement of its facilities to a more intelligent network. A new signaling system (SS7) routes calls more efficiently and makes possible Custom Local Area Signaling Services (CLASS) features such as automatic callback, automatic recall, calling line identification/block (Caller ID), and customer initiated trace. Revenues from communications services constituted 88 percent of operating revenues in 1993, with the remainder derived largely from directory operations, equipment sales and billing and collection services. The Company recovers its costs of providing telephone services, as well as a return on investment, through a combination of local rates and access charges. Access charge tariffs are the principal means by which the Company is reimbursed for services provided to interexchange carriers. American Telephone and Telegraph (AT&T), as the dominant long distance telephone company, is the Company's largest customer for access services. In 1993, 16 percent of the Company's operating revenues was derived from services provided to AT&T. While AT&T is a significant customer, the Company does not believe its revenues are dependent upon AT&T as customers' demand for inter- LATA long distance telephone service is not tied to any one long distance carrier. Historically, as the market share of AT&T's long distance competitors increases, the percent of revenues derived from network access services provided to AT&T decreases. The Company is subject to the jurisdiction of the Federal Communications Commission (FCC) and the utilities commissions of each of the states in which it operates. In each state in which the commission exercises authority to grant certificates of public convenience and necessity, the Company has been granted such certificates of indefinite duration to provide local exchange telephone service in its current service areas. In most instances, where required by law, the Company has valid local franchises sufficient to enable it to provide local exchange telephone service in the areas in which it is operating. The absence of any such franchises should have no material adverse effect upon the Company's operations. In the communities where the Company provides local exchange telephone service, no other local exchange carrier is currently authorized to provide such facilities based service. The potential for more direct competition is, however, increasing for the Company. Illinois law allows alternative telecommunications providers to obtain certificates of local exchange telephone service authority in direct competition with existing local exchange carriers if certain showings are made to the satisfaction of the Illinois Commerce Commission. In November 1993, MFS Intelenet of Illinois, Inc. submitted an application to the Illinois Commerce Commission to operate as an alternative local exchange carrier for business customers located in portions of the Chicago metropolitan area served by Illinois Bell Telephone Company and Central Telephone's Illinois subsidiary; the application is pending. Many states, including most of the states in which the Company offers local exchange telephone service, allow competitive entry into the intra-LATA long distance service market. Illinois permits the resale of local exchange telephone service, and North Carolina allows customers to participate in the sharing and resale of local exchange telephone service under shared tenant arrangements. At the interstate level, the FCC has revised its rules to permit connection of customer-owned coin telephones to the local network, exposing local exchange carriers (LECs) to direct coin telephone competition. Additionally, the FCC has assisted Competitive Access Providers (CAPs) in providing access to interexchange carriers and end users by mandating that all Tier 1 (over $100 million annual operating revenues) LECs allow collocation of CAP equipment in LEC central offices. The FCC's decision regarding collocation is under appeal to the U.S. Court of Appeals for the District of Columbia Circuit. Central Telephone's Illinois subsidiary had provided physical collocation prior to the FCC's mandate. New technology, as well as changes in state law and regulatory decisions, is permitting expansion of the types of services available through the local exchange and increasing the number of competitors. Other means of communication, such as private network, satellite, cellular and cable systems permit bypass of the local exchange. Although the extent to which bypass has occurred cannot be precisely determined, management believes it has not had a material adverse effect on the Company's operating revenues. The extent and ultimate impact of competition for the Company and other LECs will continue to depend, to a considerable degree, on FCC and state regulatory actions, court decisions and possible federal or state legislation. Legislation designed to stimulate local competition between local exchange service providers and cable programming service providers, in both markets, is presently pending in both houses of the U.S. Congress although it is uncertain if any of the bills will be enacted. Effective January 1, 1991, the FCC adopted a price caps regulatory format for the Bell Operating Companies (the LECs owned by AT&T prior to divestiture) and the LECs owned by GTE Corporation. Other LECs could volunteer to become subject to price caps regulation. Under price caps, prices for network access service must be adjusted annually to reflect industry average productivity gains (as specified by the FCC), inflation and certain allowed cost changes. The Company did not originally elect price caps, but as a result of Sprint's merger with Centel, adopted price caps effective July 1, 1993. Under the form of the plan adopted, the Company generally has an opportunity to earn up to a 14.25 percent rate of return on investment. Certain of the Company's operations have committed to produce higher than industry average productivity gains, and as a result have an opportunity to earn up to a 15.25 percent rate of return on investment. Prior to price caps, under rate of return regulation, the Company's authorized rate of return on investment was 11.25 percent, with the ability to earn 0.25 percent above the authorized return. The FCC is conducting a scheduled review of all aspects of the price caps plan; changes to the plan may be proposed by interested parties and the FCC may implement changes in 1995. Without further action by the FCC, the current price caps plan would expire in 1995 and would be replaced by rate of return regulation. In December 1992, the Florida Public Service Commission approved a stipulation giving Central Telephone's Florida subsidiary an annual revenue increase of approximately $3.5 million, effective January 1, 1993. From January 1, 1993 to June 30, 1994, any earnings in excess of an annual earned return on equity of 12.0 percent must be refunded. Also in December 1992, the Public Service Commission of Nevada authorized an annual revenue increase of approximately $6.1 million for Central Telephone's Nevada division, effective January 1, 1993. Central Telephone's Illinois subsidiary has applied for a rate increase of approximately $10.2 million from the Illinois Commerce Commission, and the final order is due in May 1994. In December 1993, the Virginia alternative regulatory plan was modified to lower the maximum rate of return on equity from 14 percent to 12.55 percent, and to include 25 percent of yellow page income in the determination of return on equity. Compliance with federal, state and local provisions relating to the protection of the environment has had no significant effect on the capital expenditures or earnings of the Company and future effects are not expected to be material. As of December 31, 1993, the Company had approximately 5,900 employees. During 1993, the Company had no material work stoppages caused by labor controversies. Item 2.		Item 2. Properties The properties of the Company consist principally of land, structures, facilities and equipment and are in good operating condition. All of the central office buildings are owned, except eight which are leased. Substantially all of the telephone property, plant and equipment is subject to the liens of the indentures securing indebtedness. As of December 31, 1993, cable and wire facilities represented 50 percent of total net property, plant and equipment; central office equipment, 37 percent; land and buildings, 6 percent; and other assets, 7 percent. The following table sets forth the gross property additions and retirements or sales during each of the five years in the period ended December 31, 1993 (in millions): Gross Property Year Additions Retirements or Sales 1993 $ 163.4 $ 60.1 1992 168.1 173.1 1991 162.2 254.8 [1] 1990 214.7 54.3 1989 175.3 72.8 [1] Includes $213 million related to the sale of the Company's operations in Iowa and Minnesota. Item 3.	Item 3. Legal Proceedings There are no material pending legal proceedings, and the Company is a party only to ordinary routine litigation incidental to its business. Item 4.	Item 4. Submission of Matters to a Vote of Security Holders No matter was submitted to a vote of security holders during the fourth quarter of 1993. Item 10. Executive Officers of the Registrant Officer Name Age President and Chief Executive Officer D. Wayne Peterson (1) 58 Vice President-Chief Financial Officer John P. Meyer (2) 43 Vice President-Controller Ralph J. Hodge (3) 41 Vice President-Treasurer M. Jeannine Strandjord (4) 48 Vice President Stephen M. Bailor (5) 50 Vice President Peter W. Chehayl (6) 46 Vice President-Assistant Secretary Don A. Jensen (7) 58 Vice President A. Allan Kurtze (8) 49 Secretary Marion W. O'Neill (9) 53 President-North Carolina William E. Division McDonald (10) 51 President-Nevada Division Dianne Ursick (11) 44 (1)Mr. Peterson has been President and Chief Executive Officer since September 1993. He has also served as President-Local Telecommunications Division of Sprint since August 1993. From 1980 to 1993, he served as President of Carolina Telephone and Telegraph Company, a subsidiary of Sprint. (2)Mr. Meyer has been Vice President-Chief Financial Officer since January 1993. Mr. Meyer has also served as Senior Vice President and Controller of Sprint since April 1993. He served as Vice President and Controller of Centel from 1989 to 1993 and as Controller of Centel from 1986 to 1989. (3)Mr. Hodge has been Vice President-Controller since December 1993. He has also served as Assistant Vice President and Assistant Controller of Sprint since April 1993. He was Director of Earnings Analysis and External Reporting for Sprint from 1992 to 1993. He served as Treasurer of the companies comprising the Midwest Group of local exchange companies of Sprint from 1991 to 1992 and Controller of the companies comprising the Midwest Group from 1988 to 1991. (4)Ms. Strandjord has been Vice President-Treasurer since September 1993. She has also served as Senior Vice President and Treasurer of Sprint since 1990. She served as Vice President and Controller of Sprint from 1986 to 1990. (5)Mr. Bailor has been Vice President since December 1993. Mr. Bailor served as Vice President and Controller of Central Telephone from 1989 to December 1993. He has also served as Vice President-Financial and Local Billing Services of Sprint's Finance Division since September 1993. (6)Mr. Chehayl has been Vice President since December 1993. He has also served as Vice President and Assistant Treasurer of Sprint since 1991. He was Vice President and Treasurer of Alert Holdings, Inc., a provider of security alarm monitoring services, during part of 1990, and from 1988 to 1990 he was Treasurer of Firestone Tire & Rubber Company (now known as Bridgestone/Firestone, Inc.) , a manufacturer and retailer of tires and a retailer of automotive services. (7)Mr. Jensen has been Vice President-Assistant Secretary since September 1993. He has also served as Vice President and Secretary of Sprint since 1975. (8)Mr. Kurtze has been Vice President since 1991. Mr. Kurtze has also served as Senior Vice President of Sprint/United Management Company, a subsidiary of Sprint, since July 1993. He served as Executive Vice President of Centel from 1991 to 1993 and as Senior Vice President-Planning and Technology of Centel from 1986 to 1991. (9)Ms. O'Neill has been Secretary since July 1993. She has been an attorney for Sprint for more than five years. (10)Mr. McDonald has been President of the North Carolina Division since September 1993. He has also served as President of the other four companies comprising the Mid- Atlantic Group of local exchange companies of Sprint since August 1993. From 1988 to 1993, he served as President of the two companies comprising the Eastern Group of local exchange companies of Sprint. (11)Ms. Ursick has been President of the Nevada Division since March 1993. From 1989 to 1993, she was General Regulatory Manager of the Nevada Division. Part II Item 5.	Item 5. Market for Registrant's Common Equity and Related Stockholder Matters All shares of common stock of Central Telephone, representing 97.4 percent of the aggregate outstanding capital stock of Central Telephone, are owned by Centel, a wholly-owned subsidiary of Sprint. There is no established public trading market for the common stock. One series of voting convertible junior preferred stock and four series of voting cumulative preferred stock of Central Telephone are outstanding. Since issuance, quarterly dividends have been paid on all series of the preferred stock at the respective prescribed rates. The junior preferred stock is publicly held and each share is convertible to 6.47325 shares of Sprint common stock. There were 35,528 shares outstanding as of December 31, 1993. During 1993, there were 7,290 shares converted. There is no established public trading market for this particular issue. There is no active market for shares of any of the series of cumulative preferred stock. Transfer Agent for all Conversion Agent for the Junior Preferred Stocks Preferred Stock First Chicago Trust Company of First Chicago Trust Company of New York, New York New York, New York Item 6.	Item 6. Selected Financial Data Selected consolidated financial data as of and for the years ended December 31 is as follows (in millions): 1993 1992 1991 1990 1989 Operating revenues $ 868.6 $ 786.6 $ 808.9 $ 831.7 $ 771.7 Income before extraordinary item and cumulative effect of changes in accounting principles [1], [2] 41.4 71.6 143.3 100.9 88.0 Total assets 1,704.8 1,724.1 1,665.9 1,743.8 1,637.2 Long-term debt and redeemable preferred stock (including current maturities) 472.6 522.0 530.3 549.1 424.7 [1] During 1993, nonrecurring charges of $77 million were recorded related to the Company's portion of the transaction costs associated with Sprint's merger with Centel and the expenses of integrating and restructuring the operations of the companies. Such charges reduced consolidated 1993 income before extraordinary item and cumulative effect of changes in accounting principles by $48 million. [2] During 1991, gains of $92 million were recognized related to the sale of the Company's Iowa and Minnesota operations, which increased consolidated 1991 income before extraordinary item and cumulative effect of changes in accounting principles by $64 million. Item 7.	Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Recent Development - Sprint/Centel Merger Effective March 9, 1993, Centel, the parent company of Central Telephone Company, and Sprint consummated a merger of the companies (see Note 2 of "Notes to Consolidated Financial Statements" for additional information). Sprint is a diversified telecommunications company with local exchange telephone operations in seventeen states prior to the merger, including Florida, North Carolina and Virginia. As a result of the merger, the operations of the merged companies continue to be integrated and restructured to achieve efficiencies which have begun to yield operational synergies and cost savings, particularly in the latter half of 1993. The transaction costs associated with the merger (consisting primarily of investment banking and legal fees) and the estimated expenses of integrating and restructuring the operations of the companies (consisting primarily of employee severance and relocation expenses and costs of eliminating duplicative facilities) resulted in a nonrecurring charge to Sprint during 1993. The portion of such charge attributable to the Company was $77 million, which reduced 1993 net income by approximately $48 million. Results of Operations As described in Note 8 of "Notes to Consolidated Financial Statements," the Company's local exchange telephone operations in Minnesota and Iowa were divested in 1991. The following comparisons and discussion exclude the effects of such divested operations. Net operating revenues increased 10 percent in 1993, following a 2 percent increase in 1992. Local service revenues, derived from providing local exchange telephone service, increased 11 percent and 9 percent in 1993 and 1992, respectively. These increases reflect continued growth in the number of access lines served, add-on services, such as custom calling, and increased Centrex revenues. Access lines grew 5.0 percent in 1993 versus 4.8 percent in 1992. Rate increases also contributed to increased local service revenue. The Florida Public Service Commission (FPSC) ordered an interim rate increase effective September 1992, which increased 1992 local service revenue by $1 million. In addition, permanent annual increases granted by the FPSC and the Public Service Commission of Nevada, effective January 1993, increased 1993 local service revenue by $10 million. Toll and access service revenues are derived from interexchange long distance carriers use of the local network to complete calls, and the provision of long distance services within specified geographical areas. These revenues increased $37 million in 1993 as a result of increased traffic volumes and the recognition of a portion of the merger, integration and restructuring costs for regulatory purposes in certain jurisdictions, partially offset by periodic reductions in network access rates charged. Toll and access service revenue decreased $3 million in 1992 principally due to reductions in network access rates charged. Other revenues increased $4 million in 1993 following a decrease of $10 million in 1992. The increase in 1993 is generally due to higher equipment sales and increased directory revenue. The decrease in other revenue in 1992 was caused by a decrease in certain billing services provided to American Telephone and Telegraph and by an inside wire maintenance settlement which resulted in refunds to the customers of the Company's Florida subsidiary. Operating expenses increased $45 million and $19 million in 1993 and 1992, respectively, primarily reflecting increases in the costs of providing services resulting from access line growth. The increases in 1993 also resulted from increases in systems development costs incurred to enhance the efficiency and capabilities of the billing processes and increases in the cost of equipment sales. The increase in operating expenses in 1992 also resulted from increases in pension costs due to a new union agreement. The increases in operating expenses in 1993 also reflect the impact of changes in accounting principles. As a result of the change in accounting for certain software costs, the Company recognized additional expense in 1993 of $7 million. In addition, increased postretirement benefits cost of approximately $7 million were recognized as a result of the adoption of Statement of Financial Accounting Standards (SFAS) No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" (see Notes 1 and 3 of "Notes to Consolidated Financial Statements" for additional information). Depreciation and amortization expense increased $7 million in 1993, following a $4 million decrease in 1992. The 1993 increase was generally due to plant additions. The decrease in 1992 depreciation expense was due to nonrecurring charges recorded in 1991, partially offset by plant additions. Interest expense was $44 million, $43 million and $45 million in 1993, 1992 and 1991, respectively. The increase in 1993 was generally related to increased advances from affiliates, whereas the decrease in 1992 was related to a decrease in average levels of debt outstanding and lower interest rates. The divestitures of the Company's Minnesota and Iowa operations in 1991 resulted in a gain of $92 million, which increased income from continuing operations by $64 million. The Company's income tax provisions for 1993, 1992 and 1991 resulted in effective tax rates of 25 percent, 29 percent and 30 percent, respectively. See Note 4 of "Notes to Consolidated Financial Statements" for information regarding the differences that cause the effective income tax rates to vary from the statutory federal income tax rates. Effective January 1, 1993, the Company conformed its accounting practices for certain software costs with the prevalent practice in the industry and with the accounting method used by Sprint's local communications services division. The Company now expenses these costs as incurred. The cumulative effect of this change in accounting principle reduced 1993 net income by $22 million, net of related income tax benefits of $13 million. Regulatory Activities In June 1993, the Company's Illinois subsidiary filed with the Illinois Commerce Commission a petition to adjust its rates and charges such that annual intrastate revenues would increase by approximately $10 million. This rate proceeding was required to provide revenue recovery for the added costs related to the adoption of SFAS No. 106 and to recognize the phases of the Federal Communications Commission mandated jurisdictional cost shifts from interstate to intrastate. A final order will be issued in May 1994. In addition, in December 1993, the Company's Virginia subsidiary's alternative regulatory plan was modified to lower the maximum rate of return on equity from 14 percent to 12.55 percent, and to include 25 percent of yellow page income in the determination of return on equity. Liquidity and Capital Resources Cash Flows-Operating Activities Cash flows from operating activities, which are the Company's primary source of liquidity, were $227 million, $211 million and $175 million in 1993, 1992 and 1991, respectively. The improvement in 1993 operating cash flows reflects better operating results, partially offset by expenditures of $26 million related to the merger, integration and restructuring actions. Cash Flows-Investing Activities Capital expenditures, which represent the Company's most significant investing activity, were $163 million, $168 million and $162 million in 1993, 1992 and 1991, respectively. Capital expenditures were made to accommodate access line growth and to expand the capabilities for providing enhanced telecommunications services. Investing activities in 1991 also include proceeds of $216 million from the sales of the Company's Iowa and Minnesota local telephone operations to Rochester Telephone Corporation (Rochester). In addition to cash of $116 million, the Company received shares of Rochester's common stock and ownership rights to investments in cellular franchises. The Company received $100 million in cash and $12 million in advances from Centel for the Rochester stock and cellular franchises. Cash Flows-Financing Activities The Company's financing activities used cash of $65 million, $45 million and $200 million in 1993, 1992 and 1991, respectively. Improved operating cash flows during each year, together with the proceeds from the divestitures in 1991, allowed the Company to fund capital expenditures internally and reduce total debt outstanding. In addition, the Company paid a special dividend in 1991 of $112 million to Centel with a portion of the proceeds received from the sales of the Iowa and Minnesota operations. During 1993 and 1992, a significant level of debt refinancing occurred in order to take advantage of lower interest rates. Accordingly, a majority of the proceeds from long-term borrowings in 1993 and 1992 were used to finance the redemption prior to scheduled maturities of $144 million and $148 million of debt, respectively. Financial Position, Liquidity and Capital Requirements As of December 31, 1993, the Company's total capitalization aggregated $1.09 billion, consisting of long-term debt (including current maturities), advances from affiliates, redeemable preferred stock, and common stock and other stockholder's equity. Long-term debt (including current maturities and advances from affiliates) comprised 43 percent of total capitalization as of December 31, 1993, adjusted on a proforma basis for the effects of changes in accounting principles, compared to 45 percent at year-end 1992. During 1994, the Company anticipates funding estimated capital expenditures of $190 million with cash flows from operating activities. The Company expects its external cash requirements for 1994 to be approximately $12 million which is generally required to pay scheduled long-term debt maturities. The method of financing the cash requirements will depend on prevailing market conditions during the year. The Company may also undertake additional debt refinancings during 1994 in order to take advantage of favorable interest rates. The Company, Sprint and Sprint Capital Corporation (a wholly- owned subsidiary of Sprint) have a $1.1 billion revolving credit agreement with a syndicate of domestic and international banks, under which the Company can borrow up to an aggregate of $200 million. As of December 31, 1993, the Company had no borrowings outstanding under this agreement. The revolving credit agreement expires in July 1996 and, subject to the approval of the lenders, may be extended for up to an additional two years. Recent Accounting Developments Effective January 1, 1994, the Company will adopt SFAS No. 112, "Employers' Accounting for Postemployment Benefits" (see Note 1 of "Notes to Consolidated Financial Statements" for additional information). Consistent with most local exchange carriers, the Company accounts for the economic effects of regulation pursuant to SFAS No. 71, "Accounting for the Effects of Certain Types of Regulation." The application of SFAS No. 71 requires the accounting recognition of the rate actions of regulators where appropriate, including the recognition of depreciation and amortization based on estimated useful lives prescribed by regulatory commissions rather than those which might be utilized by non-regulated enterprises. Management believes the Company's operations meet the criteria for the continued application of SFAS No. 71. With increasing competition and the changing nature of regulation in the telecommunications industry, the ongoing applicability of SFAS No. 71 must, however, be constantly monitored and evaluated. Should the Company no longer qualify for the application of the provisions of SFAS No. 71 at some future date, the accounting impact could result in the recognition of a material, extraordinary, noncash charge. Effects of Inflation The effects of inflation on the Company's operations were not significant during 1993, 1992 or 1991. Item 8.	Item 8. Financial Statements and Supplementary Data INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES Report of Independent Auditors - Ernst & Young Report of Independent Public Accountants - Arthur Andersen & Co. Consolidated Statements of Income and Retained Earnings for each of the three years ended December 31, 1993 Consolidated Balance Sheets as of December 31, 1993 and 1992 Consolidated Statements of Cash Flows for each of the three years ended December 31, 1993 Notes to Consolidated Financial Statements Financial Statement Schedules for each of the three years ended December 31, 1993: V - Consolidated Property, Plant and Equipment VI - Consolidated Accumulated Depreciation VIII-Consolidated Valuation and Qualifying Accounts IX - Consolidated Short-Term Borrowings X - Consolidated Supplementary Income Statement Information Certain financial statement schedules are omitted because the required information is not present, or because the information required is included in the consolidated financial statements and notes thereto. REPORT OF INDEPENDENT AUDITORS The Board of Directors and Stockholders Central Telephone Company We have audited the consolidated balance sheet of Central Telephone Company (a wholly-owned subsidiary of Sprint Corporation) as of December 31, 1993, and the related consolidated statements of income and retained earnings, and cash flows for the year then ended. Our audit also included the 1993 financial statement schedules listed in the Index to Financial Statements and Financial Statement Schedules. These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audit. The financial statements and schedules of Central Telephone Company for the years ended December 31, 1992 and 1991, were audited by other auditors whose report dated February 3, 1993, expressed an unqualified opinion on those statements prior to restatement. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the 1993 consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Central Telephone Company at December 31, 1993, and the consolidated results of its operations and its cash flows for the year then ended, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note 1 to the consolidated financial statements, in 1993 the Company changed its method of accounting for income taxes, software costs and postretirement benefits. We also audited the adjustments described in Note 1 that were applied to restate the 1992 consolidated financial statements for the change in the method of accounting for income taxes. In our opinion, such adjustments are appropriate and have been properly applied. ERNST & YOUNG Kansas City, Missouri January 21, 1994 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Shareowners of Central Telephone Company We have audited the consolidated balance sheet of CENTRAL TELEPHONE COMPANY (a Delaware corporation and wholly owned subsidiary of Centel Corporation) AND SUBSIDIARIES as of December 31, 1992, and the related consolidated statements of income, retained earnings and cash flows for each of the two years in the period ended December 31, 1992, prior to the restatement (and, therefore, are not presented herein) for the change in the Company's method of accounting for income taxes as described in Note 1 to the restated financial statements. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the consolidated financial statements (prior to restatement) based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements (prior to restatement) referred to above present fairly, in all material respects, the financial position of Central Telephone Company and Subsidiaries as of December 31, 1992, and the results of their operations and their cash flows for each of the two years in the period ended December 31, 1992, in conformity with generally accepted accounting principles. Our audits were made for the purpose of forming an opinion on the basic financial statements (prior to restatement) taken as a whole. In connection with our audits, certain auditing procedures were applied to the following schedules (prior to restatement) (and, therefore, are not presented herein) which are required for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements: Schedule V--Consolidated Property, Plant and Equipment Schedule VI--Consolidated Accumulated Depreciation Schedule VIII--Consolidated Valuation and Qualifying Accounts Schedule IX--Consolidated Short-Term Borrowings Schedule X--Consolidated Supplementary Income Statement Information In our opinion, the information contained in these schedules (prior to restatement) 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 & CO. Chicago, Illinois February 3, 1993 CENTRAL TELEPHONE COMPANY CONSOLIDATED STATEMENTS OF INCOME AND RETAINED EARNINGS Years ended December 31, 1993, 1992 and 1991 (In Millions) 1993 1992 1991 OPERATING REVENUES Local service $ 416.9 $ 375.4 $ 362.9 Toll and access service 345.8 309.1 328.4 Other 105.9 102.1 117.6 868.6 786.6 808.9 OPERATING EXPENSES Other operating expenses 558.9 514.4 511.8 Merger, integration and restructuring costs 77.2 Depreciation and amortization 134.3 127.8 138.5 770.4 642.2 650.3 OPERATING INCOME 98.2 144.4 158.6 Gain on divestiture of telephone properties 91.6 Interest expense (43.6) (43.1) (45.3) Other income (expense), net 0.5 (0.6) 0.7 Income before income taxes, extraordinary item and cumulative effect of changes in accounting principles 55.1 100.7 205.6 Income tax provision (13.7) (29.1) (62.3) Income before extraordinary item and cumulative effect of changes in accounting principles 41.4 71.6 143.3 Extraordinary losses on early extinguishments of debt, net (4.6) Cumulative effect of changes in accounting principles, net (21.6) (0.5) NET INCOME 15.2 71.1 143.3 RETAINED EARNINGS AT BEGINNING OF YEAR 257.3 216.7 259.4 Cash dividends Common stock (27.1) (30.0) (185.4) Preferred stock (0.5) (0.5) (0.6) RETAINED EARNINGS AT END OF YEAR $ 244.9 $ 257.3 $ 216.7 PRO FORMA AMOUNTS ASSUMING THE CHANGE IN ACCOUNTING FOR SOFTWARE COSTS WAS RETROACTIVELY APPLIED Income before extraordinary $ 41.4 $ 63.0 $ 138.1 item Net income $ 36.8 $ 62.5 $ 138.1 See accompanying notes to consolidated financial statements. CENTRAL TELEPHONE COMPANY CONSOLIDATED BALANCE SHEETS December 31, 1993 and 1992 (In Millions) 1993 1992 ASSETS CURRENT ASSETS Cash $ 9.5 $ 7.3 Receivables Customers and other, net of allowance for doubtful accounts of $0.6 million ($0.5 million in 1992) 84.0 82.9 Interexchange carriers 4.9 6.5 Affiliated companies 13.9 2.9 Advances to affiliates 3.3 7.0 Deferred income taxes 19.8 17.7 Prepaid expenses and other 13.2 13.5 Total current assets 148.6 137.8 PROPERTY, PLANT AND EQUIPMENT Land and buildings 116.4 113.0 Telephone network equipment and outside plant 2,150.1 2,037.0 Other 138.8 151.7 Construction in progress 13.9 28.3 2,419.2 2,330.0 Less accumulated depreciation (943.7) (871.2) 1,475.5 1,458.8 DEFERRED CHARGES AND OTHER ASSETS 80.7 127.5 $ 1,704.8 $ 1,724.1 CENTRAL TELEPHONE COMPANY CONSOLIDATED BALANCE SHEETS (continued) December 31, 1993 and 1992 (In Millions) 1993 1992 LIABILITIES AND STOCKHOLDER'S EQUITY CURRENT LIABILITIES Outstanding checks in excess of cash balances $ 17.5 $ 19.6 Current maturities of long-term debt 22.7 31.2 Advances from affiliates 14.4 Accounts payable Vendors and other 17.6 24.3 Interexchange carriers 13.4 30.1 Affiliated companies 32.2 5.8 Accrued merger, integration and restructuring costs 24.3 Accrued interest 17.2 13.1 Advance billings 16.2 13.0 Accrued vacation pay 15.2 16.4 Other 42.7 52.8 Total current liabilities 233.4 206.3 LONG-TERM DEBT 440.9 481.3 DEFERRED CREDITS AND OTHER LIABILITIES Deferred income taxes and investment tax credits 276.4 293.2 Postretirement benefits obligations 71.6 43.8 Regulatory liability 59.1 74.8 Other 15.1 3.5 422.2 415.3 REDEEMABLE PREFERRED STOCK 9.0 9.5 COMMON STOCK AND OTHER STOCKHOLDER'S EQUITY Common stock, no par value, authorized- 10.0 million shares, issued and outstanding-9.0 million shares 354.4 354.4 Retained earnings 244.9 257.3 599.3 611.7 $ 1,704.8 $ 1,724.1 See accompanying notes to consolidated financial statements. CENTRAL TELEPHONE COMPANY CONSOLIDATED STATEMENTS OF CASH FLOWS Years ended December 31, 1993, 1992 and 1991 (In Millions) 1993 1992 1991 OPERATING ACTIVITIES Net income $ 15.2 $ 71.1 $ 143.3 Adjustments to reconcile net income to net cash provided by operating activities Depreciation and amortization 134.3 127.8 138.5 Gain on divestiture of telephone properties (91.6) Extraordinary losses on early extinguishments of debt 7.6 Cumulative effect of changes in accounting principles 21.6 0.5 Deferred income taxes and investment tax credits (33.8) 2.1 (44.5) Changes in operating assets and liabilities Receivables, net (10.5) (2.5) 0.4 Other current assets 0.3 (2.4) 4.3 Accounts payable 0.9 12.3 (4.0) Accrued expenses and other current liabilities 32.9 (14.1) 24.1 Noncurrent assets and liabilities, net 55.6 16.2 4.5 Other, net 2.5 (0.4) (0.3) NET CASH PROVIDED BY OPERATING ACTIVITIES 226.6 210.6 174.7 INVESTING ACTIVITIES Capital expenditures (163.4) (168.1) (162.2) Proceeds from divestiture of telephone properties 215.8 (Increase) decrease in advances to affiliates 3.7 19.5 (23.7) Other, net 0.6 (17.6) (11.5) NET CASH PROVIDED (USED) BY INVESTING ACTIVITIES (159.1) (166.2) 18.4 FINANCING ACTIVITIES Proceeds from long-term debt 118.6 157.1 88.3 Retirements of long-term debt (147.5) (190.0) (39.1) Increase (decrease) in short-term borrowings (20.0) 20.0 (70.1) Increase (decrease) in advances from affiliates 14.4 (1.5) (1.9) Dividends paid (27.6) (30.5) (176.8) Other, net (3.2) (0.1) (0.3) NET CASH USED BY FINANCING ACTIVITIES (65.3) (45.0) (199.9) INCREASE (DECREASE) IN CASH 2.2 (0.6) (6.8) CASH AT BEGINNING OF YEAR 7.3 7.9 14.7 CASH AT END OF YEAR $ 9.5 $ 7.3 $ 7.9 See accompanying notes to consolidated financial statements. CENTRAL TELEPHONE COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. ACCOUNTING POLICIES Central Telephone Company is engaged in the business of providing communications services, principally local, network access and toll services in portions of Florida, Illinois, Nevada, North Carolina and Virginia. The principal industries in the Company's service area include retail and wholesale trade, transportation, agriculture, manufacturing, finance and service. Basis of Presentation The accompanying consolidated financial statements include the accounts of Central Telephone Company and its wholly-owned subsidiaries, Central Telephone Company of Florida, Central Telephone Company of Virginia and Central Telephone Company of Illinois (the Company). All significant intercompany transactions have been eliminated. The Company is a wholly-owned subsidiary of Centel Corporation (Centel); accordingly, earnings per share information has been omitted. Centel became a wholly- owned subsidiary of Sprint Corporation (Sprint) on March 9, 1993, in connection with the Sprint/Centel merger (see Note 2 for additional information). The Company accounts for the economic effects of regulation pursuant to Statement of Financial Accounting Standards (SFAS) No. 71, "Accounting for the Effects of Certain Types of Regulation," which requires the accounting recognition of the rate actions of regulators where appropriate. Such actions can provide reasonable assurance of the existence of an asset, reduce or eliminate the value of an asset, or impose a liability on a regulated enterprise. Certain amounts in the accompanying consolidated financial statements for 1992 and 1991 have been reclassified to conform to the presentation of amounts in the 1993 consolidated financial statements. These reclassifications had no effect on net income in either year. Property, Plant and Equipment Property, plant and equipment are recorded at cost. Retirements of depreciable property are charged against accumulated depreciation with no gain or loss recognized. Repairs and maintenance costs are expensed as incurred. Depreciation Depreciation expense is generally computed on a straight-line basis over the estimated useful lives as prescribed by regulatory commissions. Depreciation rate changes granted by a state commission resulted in additional depreciation expense in 1993 of $1 million. In addition, as ordered by the state commissions, the Company recorded nonrecurring charges to depreciation expense in 1991 of $5 million, which reduced net income by $1 million. Average annual composite depreciation rates, excluding the nonrecurring charges, were 5.5 percent for 1993, 5.3 percent for 1992 and 5.9 percent for 1991. Income Taxes Subsequent to the Sprint/Centel merger, operations of the Company are included in the consolidated federal income tax returns of Sprint. Prior to the merger, operations of the Company were included in the consolidated federal income tax returns of Centel. Federal income tax is calculated by the Company on the basis of its filing a separate return. In 1993, the Company retroactively changed its method of accounting for income taxes by adopting SFAS No. 109, "Accounting for Income Taxes," which requires an asset and liability approach to accounting for income taxes. The new standard was adopted retroactive to January 1, 1992; accordingly, the 1992 financial statements were restated to reflect the change in accounting for income taxes. Under the provisions of SFAS No. 109, the Company adjusted existing deferred income tax amounts, using current tax rates, for the estimated future tax effects attributable to temporary differences between the tax bases of the Company's assets and liabilities and their reported amounts in the financial statements. The Company's principal temporary difference results from using different depreciable lives and methods with respect to its property, plant and equipment for tax and financial statement purposes. The adoption of SFAS No. 109 resulted in a decrease in the deferred income tax liabilities as previous income tax accounting standards did not permit accumulated deferred income tax amounts to be adjusted for subsequent tax rate changes. However, because this decrease will accrue to the benefit of the Company's customers it has been reflected as a regulatory liability. Additionally, upon adoption of SFAS No. 109, the Company recognized deferred income tax liabilities for those temporary differences for which deferred income taxes had not previously been provided. Corresponding regulatory assets were also recorded by the Company to reflect the anticipated recovery of such taxes in future telephone rates. The adoption of SFAS No. 109 is reflected as a change in accounting principle in the 1992 consolidated statement of income. Adoption of this standard did not significantly impact the Company's 1993 results of operations. Investment tax credits (ITC) are deferred and amortized over the useful life of the related property. The Tax Reform Act of 1986 effectively eliminated ITC after December 31, 1985. Software Costs Effective January 1, 1993, the Company changed its method of accounting for certain software costs. The change was made to conform the Company's accounting to the predominant practice among local exchange carriers. Under the new method, such costs are being expensed when incurred. The resulting nonrecurring, noncash charge of $22 million, net of related income tax benefits of $13 million, is reflected as a change in accounting principle in the 1993 consolidated statement of income. As a result of the change in accounting, the Company recognized incremental expense of $7 million in 1993. Postretirement Benefits Effective January 1, 1993, the Company modified its accrual method of accounting for postretirement benefits (principally health care and life insurance benefits) provided to certain retirees by adopting SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." As permitted by SFAS No. 106, the Company elected to recognize its previously unrecognized obligation for postretirement benefits as of January 1, 1993 by amortizing such obligation on a straight-line basis generally over a period of 20 years, except in those jurisdictions where shorter amortization periods have been authorized for regulatory treatment. Postemployment Benefits Effective January 1, 1994, the Company will adopt SFAS No. 112, "Employers' Accounting for Postemployment Benefits." Under the new standard, the Company is required to recognize certain previously unrecorded obligations for benefits provided to former or inactive employees and their dependents, after employment but before retirement. Postemployment benefits offered by the Company include severance, workers compensation and disability benefits, including the continuation of other benefits such as health care and life insurance coverage. As required by the standard, the Company will recognize its obligations for postemployment benefits through a cumulative adjustment in the consolidated statement of income. The resulting nonrecurring, noncash charge will not significantly impact the Company's 1994 net income. Adoption of this standard is not expected to significantly impact future operating expenses. Interest Charged to Construction In accordance with the Uniform System of Accounts, as prescribed by the Federal Communications Commission (FCC), interest is capitalized on those telephone plant construction projects for which the estimated construction period exceeds one year. In addition, the Public Service Commission of Nevada has ordered that the Company's Nevada operations capitalize interest during construction on short-term projects. 2. MERGER, INTEGRATION AND RESTRUCTURING COSTS Effective March 9, 1993, Sprint consummated its merger with Centel. Pursuant to the Agreement and Plan of Merger dated May 27, 1992, Sprint issued 1.37 shares of its common stock in exchange for each outstanding share of Centel common stock. The operations of the merged companies are being integrated and restructured to achieve efficiencies which have begun to yield operational synergies and cost savings. The transaction costs associated with the merger (consisting primarily of investment banking and legal fees) and the estimated expenses of integrating and restructuring the operations of the companies (consisting primarily of employee severance and relocation expenses and costs of eliminating duplicative facilities) resulted in nonrecurring charges to Sprint during 1993. The portion of such charges attributable to the Company was $77 million, which reduced 1993 net income by approximately $48 million. 3. EMPLOYEE BENEFIT PLANS Defined Benefit Pension Plans Substantially all employees of the Company are covered by noncontributory defined benefit pension plans sponsored by Centel. Effective December 31, 1993, such plans were merged with the defined benefit pension plan sponsored by Sprint. For participants of the plans represented by collective bargaining agreements, benefits are based upon schedules of defined amounts as negotiated by the respective parties. For participants not covered by collective bargaining agreements, the plans provide pension benefits based upon years of service and participants' compensation. The Company's policy is to make contributions to the plans each year equal to an actuarially determined amount consistent with applicable federal tax regulations. The funding objective is to accumulate funds at a relatively stable rate over the participants' working lives so that benefits are fully funded at retirement. As of December 31, 1993, the plans' assets consisted principally of investments in corporate equity securities and U.S. government and corporate debt securities. The components of the net pension costs (credits) and related assumptions are as follows (in millions): 1993 1992 1991 Service cost -- benefits earned during $ 10.0 $ 8.8 $ 7.2 the period Interest cost on projected benefit 20.8 18.7 14.2 obligation Actual return on plan assets (29.7) (18.3) (43.7) Net amortization and deferral 5.8 (5.2) 16.7 Net pension cost (credit) $ 6.9 $ 4.0 $ (5.6) Discount rate 8.0% 8.8% 8.8% Expected long-term rate of return on plan assets 9.5% 10.0% 10.0% Anticipated composite rate of future increases in compensation 5.5% 7.0% 7.0% In addition, the Company recognized pension curtailment losses of $5 million during 1993 as a result of the integration and restructuring actions (see Note 2 for additional information). The funded status and amounts recognized in the consolidated balance sheets for the plans, as of December 31, are as follows (in millions): 1993 1992 Actuarial present value of pension benefit obligations Vested benefit obligation $ (262.8) $ (207.4) Accumulated benefit obligation $ (304.4) $ (241.3) Projected benefit obligation $ (317.4) $ (263.7) Plan assets at fair value 279.7 262.4 Projected benefit obligation in excess of plan assets (37.7) (1.3) Unrecognized net losses 39.4 23.3 Unrecognized prior service cost 59.5 55.3 Unamortized portion of transition asset (31.9) (36.0) Prepaid pension cost $ 29.3 $ 41.3 The projected benefit obligations as of December 31, 1993 and 1992 were determined using a discount rate of 7.5 percent for 1993 and 8.0 percent for 1992, and anticipated composite rates of future increases in compensation of 4.5 percent for 1993 and 5.5 percent for 1992. Defined Contribution Plans Substantially all employees of the Company are covered by defined contribution employee savings plans. Effective December 31, 1993, the plan covering participants not represented by collective bargaining agreements was merged with a defined contribution plan sponsored by Sprint. Eligible employees may contribute a portion of their compensation to the plans, and the Company makes matching contributions up to specified levels. The Company's contributions to the plans aggregated $10 million in 1993 and 1992, and $9 million in 1991. Postretirement Benefits The Company provides other postretirement benefits (principally health care and life insurance benefits) to certain retirees. Employees who retired from the Company before specified dates became eligible for these postretirement benefits at no cost to the retirees. Employees retiring after specified dates are eligible for these benefits on a shared cost basis. The Company funds the accrued costs as benefits are paid. For regulatory purposes, the FCC permits recognition of net postretirement benefits costs, including amortization of the transition obligation, in accordance with SFAS No. 106. The components of the 1993 net postretirement benefits cost are as follows (in millions): Service cost -- benefits earned during the period $ 4.5 Interest on accumulated postretirement benefits obligation 12.4 Amortization of transition obligation 5.9 Net postretirement benefits cost $ 22.8 For measurement purposes, an annual health care cost trend rate of 13 percent was assumed for 1993, gradually decreasing to 6 percent by 2000 and remaining constant thereafter. The effect of a one percent annual increase in the assumed health care cost trend rate would have increased the 1993 net postretirement benefits cost by approximately $4 million. The weighted average discount rate for 1993 was 8 percent. In addition, the Company recognized postretirement benefits curtailment losses of $10 million during 1993 as a result of the integration and restructuring actions (see Note 2 for additional information). The cost of providing health care and life insurance benefits to retirees was $11 million and $12 million in 1992 and 1991, respectively. Such costs were being accrued over the service periods of employees expected to receive the benefits, with past service costs amortized over 30 years except in those jurisdictions where shorter amortization periods had been authorized for regulatory purposes. The amount recognized in the consolidated balance sheet as of December 31, 1993 is as follows (in millions): Accumulated postretirement benefits obligation Retirees $ 79.0 Active plan participants -- fully eligible 34.3 Active plan participants -- other 64.2 177.5 Unrecognized net losses (14.9) Unrecognized transition obligation (91.0) Accrued postretirement benefits cost $ 71.6 The accumulated benefits obligation as of December 31, 1993 was determined using a discount rate of 7.5 percent. An annual health care cost trend rate of 12 percent was assumed for 1994, gradually decreasing to 6 percent by 2001 and remaining constant thereafter. The effect of a one percent annual increase in the assumed health care cost trend rate would have increased the accumulated benefits obligation as of December 31, 1993 by approximately $18 million. 4. INCOME TAXES The components of the federal and state income tax provision are as follows (in millions): 1993 1992 1991 Current income tax provision Federal $ 42.7 $ 23.0 $ 91.8 State 4.8 4.0 15.0 Amortization of deferred ITC (4.5) (5.5) (8.2) 43.0 21.5 98.6 Deferred income tax provision (benefit) Federal (26.8) 6.4 (32.0) State (2.5) 1.2 (4.3) (29.3) 7.6 (36.3) Total income tax provision $ 13.7 $ 29.1 $ 62.3 On August 10, 1993, the Revenue Reconciliation Act of 1993 was enacted which, among other changes, raised the federal income tax rate for corporations to 35 percent from 34 percent, retroactive to the beginning of the year. Pursuant to SFAS No. 71, the resulting adjustments to the Company's deferred income tax assets and liabilities to reflect the revised rate have generally been reflected as reductions to the related regulatory liabilities. The differences which cause the effective income tax rate to vary from the statutory federal income tax rate of 35 percent in 1993 and 34 percent in 1992 and 1991 are as follows (in millions): 1993 1992 1991 Federal income tax provision at the statutory rate $ 19.3 $ 34.2 $ 69.9 Less amortization of deferred ITC (4.5) (5.5) (8.2) Expected federal income tax provision after amortization of deferred ITC 14.8 28.7 61.7 Effect of Reversal of rate differentials (3.2) (2.9) (5.2) State income tax, net of federal income tax effect 1.5 3.4 7.0 Divestiture of telephone properties (4.7) Other, net 0.6 (0.1) 3.5 Income tax provision, including $ 13.7 $ 29.1 $ 62.3 ITC Effective income tax rate 25% 29% 30% The 1993 income tax benefits allocated to other items are as follows (in millions): Extraordinary losses on early extinguishments of debt $ 3.0 Cumulative effect of changes in accounting principles 12.5 During 1993 and 1992, in accordance with SFAS No. 109, deferred income taxes were provided for the temporary differences between the carrying amounts of the Company's assets and liabilities for financial statement purposes and their tax bases. The sources of the differences that give rise to the deferred income tax assets and liabilities as of December 31, along with the income tax effect of each, are as follows (in millions): 1993 Deferred 1992 Deferred Income Tax Income Tax Assets Liabilities Assets Liabilities Property, plant and equipment $ 272.1 $ 255.1 Postretirement and other benefits $ 23.7 $ 16.6 Expense accruals 10.8 17.7 Integration and restructuring costs 11.0 Other, net 11.0 31.3 $ 45.5 $ 283.1 $ 34.3 $ 286.4 During 1991, in accordance with APB No. 11, deferred income tax provisions resulted from the differences in the timing of recognizing certain revenues and expenses for financial statement and income tax purposes. The sources of the differences, along with the income tax effect of each, were as follows (in millions): Postretirement and other benefits $ (1.5) Expense accruals (5.0) Divestiture of telephone properties (26.7) Other, net (3.1) $ (36.3) 5. DEBT Long-term debt as of December 31 is as follows (in millions): 1993 1992 Weighted Average Interest Amount Rate Amount Central Telephone Company First mortgage bonds, due 1994 through 2021 $ 245.2 7.6% $ 298.1 Capital leases, due 1994 to 1996 0.2 8.5% 0.8 Short-term borrowings classified as long-term debt 20.0 Subsidiaries First mortgage bonds, due 1994 through 2021 115.5 7.9% 156.1 Notes, due 2002 through 2020 102.7 7.2% 37.5 463.6 512.5 Less current maturities 22.7 31.2 Total long-term debt, excluding current maturities $ 440.9 $ 481.3 Long-term debt maturities during each of the next five years are as follows (in millions): Amount 1994 $ 22.7 1995 3.9 1996 22.8 1997 23.8 1998 15.7 The first mortgage bonds are secured by substantially all of the Company's property, plant and equipment. Provisions in certain debt agreements and charters restrict the payment of dividends. Under the most restrictive of these provisions, at any time the ratio of equity to total capitalization falls below 50 percent, dividends are limited to a percentage, as defined, of net income for the prior twelve month period. As a result of this requirement, $115 million of retained earnings were restricted from payment of dividends as of December 31, 1993. In connection with dividend restrictions, $138 million of the related subsidiaries' $154 million of retained earnings is restricted as of December 31, 1993. Short-term borrowings of $20 million at December 31, 1992 with a weighted average interest rate of 7.3 percent are classified as long-term debt due to the Company's intent to refinance such borrowings on a long-term basis and its demonstrated ability to do so. The Company, Sprint and Sprint Capital Corporation (a wholly- owned subsidiary of Sprint) have a $1.1 billion revolving credit agreement with a syndicate of domestic and international banks, under which the Company can borrow up to an aggregate of $200 million. The revolving credit agreement expires in July 1996 and, subject to the approval of the lenders, may be extended for up to an additional two years. As of December 31, 1993, the Company did not have any borrowings outstanding under the agreement. During 1993, the Company redeemed, prior to scheduled maturities, $144 million of first mortgage bonds with interest rates ranging from 7.5 percent to 8.6 percent. During 1992, the Company redeemed, prior to scheduled maturities, $148 million of first mortgage bonds and debentures with interest rates ranging from 6.7 percent to 12.4 percent. Except for amounts deferred as allowed by the state commissions, the prepayment penalties incurred in connection with the early extinguishments of debt and the write-off of related debt issuance costs aggregated $5 million in 1993, net of related income tax benefits, and are reflected as extraordinary losses in the consolidated statement of income. Consistent with regulatory treatment, prepayment penalties incurred in 1992 are being amortized over the life of the applicable new issues. 6. COMMITMENTS AND CONTINGENCIES Minimum rental commitments as of December 31, 1993 for all non- cancelable operating leases, consisting principally of leases for data processing equipment and real estate, are as follows (in millions): Amount 1994 $ 5.3 1995 4.6 1996 3.7 1997 3.3 1998 0.9 Thereafter 1.0 Gross rental expense aggregated $22 million in 1993 and 1992, and $21 million in 1991. 7. RELATED PARTY TRANSACTIONS Under agreements with Sprint and Centel, the Company reimburses such affiliates for data processing services, other data related costs and certain management costs which are incurred for the Company's benefit. Total charges to the Company aggregated $49 million, $45 million and $43 million in 1993, 1992 and 1991, respectively. The Company enters into cash advance and borrowing transactions with such affiliates; generally, interest on such transactions is computed based on the rate at which the Company is able to obtain funds externally. Interest expense on advances from such affiliates was $1 million in 1993. Interest expense in 1992 and 1991 was not significant. Interest income on advances to such affiliates was $1 million in 1993 and 1992 and $2 million in 1991. The Company purchases telecommunications equipment, construction and maintenance equipment, materials and supplies from its affiliate, North Supply. Total purchases for 1993 were $13 million. The Company provides various services to Sprint's long distance communications services division, such as network access, billing and collection services, operator services and the lease of network facilities. The Company received $20 million in 1993 for these services The Company paid Sprint's long distance communications services division $1 million in 1993 for interexchange telecommunications services. The CenDon partnership (CenDon), a general partnership between Centel Directory Company, an affiliate, and The Reuben H. Donnelley Corporation, pays the Company a fee for the right to publish telephone directories in the Company's operating territories, a listing fee and a fee for billing and collections services performed for CenDon by the Company. CenDon paid the Company $50 million in 1993 and 1992 and $46 million in 1991. 8. ADDITIONAL FINANCIAL INFORMATION Divestiture of Telephone Properties During 1991, the sale of the Company's local telephone operations in Minnesota and Iowa were completed, pursuant to a definitive agreement reached in November 1990. Proceeds from the sales included $116 million in cash, 2,885,000 shares of Rochester Telephone Corporation (Rochester) common stock and ownership rights in various cellular partnerships. Gains of $64 million, net of related income taxes, were realized on the sale. The Company received $112 million in cash and advances from Centel for the Rochester common stock and the cellular franchises and paid a dividend in cash and advances for the same amount to Centel. Financial Instruments Information The Company's financial instruments consist of long-term debt including current maturities with carrying amounts as of December 31, 1993 and 1992, of $464 million and $513 million, respectively, and an estimated fair values of $511 million and $526 million, respectively. The fair values are estimated based on the present value of estimated future cash flows using a discount rate commensurate with the risks involved. Supplemental Cash Flows Information The supplemental disclosures required for the consolidated statements of cash flows for the years ended December 31, are as follows (in millions): 1993 1992 1991 Cash paid for Interest, net of amounts capitalized $ 39.4 $ 40.5 $ 41.5 Income taxes 38.5 39.1 89.6 Major Customer Information Operating revenues from American Telephone & Telegraph resulting primarily from network access, billing and collection services and the lease of network facilities aggregated approximately $137 million, $150 million and $154 million for 1993, 1992 and 1991, respectively. 9. SUPPLEMENTAL QUARTERLY INFORMATION - UNAUDITED 1993 Quarters Ended March 31 June 30 September 30 December 31 (in millions) Operating revenues $ 204.9 $ 215.4 $ 218.8 $ 229.5 Operating income (loss)[1] (38.0) 48.0 47.3 40.9 Income (loss) before extraordinary item and cumulative effect of changes in accounting principles (28.9) 25.0 24.7 20.6 Net income (loss) (50.6) 25.0 20.9 19.9 1992 Quarters Ended March 31 June 30 September 30 December 31 (in millions) Operating revenues $ 194.2 $ 198.2 $ 198.5 $ 195.7 Operating income 36.0 39.5 33.7 35.2 Income before extraordinary item and cumulative effect of changes in accounting principles 17.8 20.0 16.3 17.5 Net income 17.3 20.0 16.3 17.5 [1] During the first, third and fourth quarters 1993, the Company recognized nonrecurring charges of $68 million, $5 million and $4 million, respectively. Such charges reduced income before extraordinary item and cumulative effect of changes in accounting principles by $44 million, $2 million and $2 million, respectively. (See Note 2 for additional information.) CENTRAL TELEPHONE COMPANY SCHEDULE V -- CONSOLIDATED PROPERTY, PLANT AND EQUIPMENT Year Ended December 31, 1993 (In Millions) Balance Balance beginning Additions, Other end of of year at cost Retirements changes year Land and buildings $113.0 $ 5.3 $2.1 $ 0.2 $116.4 Other general support assets 151.7 14.8 26.9 (0.8) 138.8 Cable and wire facility assets 1,067.7 73.9 9.8 (1.2) 1,130.6 Central office assets 869.4 73.6 17.3 (12.3) 913.4 Information origination/ termination assets 99.9 10.2 4.0 106.1 Telephone plant under construction 28.3 (14.4) 13.9 $2,330.0 $ 163.4 $60.1 $ (14.1) [1] $2,419.2 [1] Primarily represents the write-off of certain software costs to conform the Company's accounting with the predominant practice in the industry and with the accounting method used by Sprint's local communications services division. CENTRAL TELEPHONE COMPANY SCHEDULE V -- CONSOLIDATED PROPERTY, PLANT AND EQUIPMENT Year Ended December 31, 1992 (In Millions) Balance Balance beginning Additions, Other end of of year at cost Retirements changes year Land and buildings $107.2 $ 6.7 $1.1 $ 0.2 $113.0 Other general support assets 140.5 22.2 11.1 0.1 151.7 Cable and wire facility assets 1,017.6 60.7 10.6 1,067.7 Central office assets 825.8 60.9 17.0 (0.3) 869.4 Information origination/ termination assets 225.5 7.8 133.3 (0.1) 99.9 Telephone plant under construction 18.4 9.8 0.1 28.3 $2,335.0 $ 168.1 $173.1 $2,330.0 CENTRAL TELEPHONE COMPANY SCHEDULE V -- CONSOLIDATED PROPERTY, PLANT AND EQUIPMENT Year Ended December 31, 1991 (In Millions) Balance Balance beginning Additions, Other end of of year at cost Retirements changes year Land and buildings $114.3 $ 4.6 $11.1 $ (0.6) $107.2 Other general support assets 143.0 16.2 22.9 4.2 140.5 Cable and wire facility assets 1,049.7 67.0 99.0 (0.1) 1,017.6 Central office assets 851.7 73.8 96.7 (3.0) 825.8 Information origination/ termination assets 242.0 8.1 25.1 0.5 225.5 Telephone plant under construction 26.9 (7.5) (1.0) 18.4 $2,427.6 $162.2 $254.8 [1] $2,335.0 [1] Retirements include approximately $213 million related to the divestiture of the Company's operations in Minnesota and Iowa. CENTRAL TELEPHONE COMPANY SCHEDULE VI -- CONSOLIDATED ACCUMULATED DEPRECIATION Year Ended December 31, 1993 (In Millions) Balance Additions Balance beginning charged Other end of of year to income Retirements changes year Buildings $ 23.4 $3.2 $ 2.1 $(0.6) $ 23.9 Other general support assets 80.9 16.1 26.9 3.3 73.4 Cable and wire facility assets 356.7 47.4 9.8 (3.0) 391.3 Central office assets 325.9 59.6 17.3 (1.0) 367.2 Information origination/ termination assets 84.3 7.0 4.0 0.6 87.9 $ 871.2 $133.3 [1] $ 60.1 $(0.7) $ 943.7 [1] Reconciliation of additions charged to income to amount disclosed in the consolidated statement of income: Amount charged to income $ 133.3 Amortization of intangibles 1.0 Depreciation and amortization included in consolidated statement of income $ 134.3 CENTRAL TELEPHONE COMPANY SCHEDULE VI -- CONSOLIDATED ACCUMULATED DEPRECIATION Year Ended December 31, 1992 (In Millions) Balance Additions Balance beginning charged Other end of of year to income Retirements changes year Buildings $ 21.6 $3.3 $ 1.1 $(0.4) $ 23.4 Other general support assets 80.5 10.5 11.1 1.0 80.9 Cable and wire 326.2 44.4 10.5 (3.4) 356.7 facility assets Central office 282.8 60.0 17.1 0.2 325.9 assets Information origination/ 208.4 8.9 133.3 0.3 84.3 termination assets $ 919.5 $127.1 [1] $ 173.1 $(2.3) $ 871.2 [1] Reconciliation of additions charged to income to amount disclosed in the consolidated statement of income: Amount charged to income $ 127.1 Amortization of intangibles 0.7 Depreciation and amortization included in consolidated statement of income $ 127.8 CENTRAL TELEPHONE COMPANY SCHEDULE VI -- CONSOLIDATED ACCUMULATED DEPRECIATION Year Ended December 31, 1991 (In Millions) Balance Additions Balance beginning charged Other end of of year to income Retirements changes year Buildings $ 23.6 $3.0 $ 4.6 $(0.4) $ 21.6 Other general 74.6 19.5 15.6 2.0 80.5 support assets Cable and wire 324.2 43.0 38.2 (2.8) 326.2 facility assets Central office 274.5 58.4 50.3 0.2 282.8 assets Information origination/ 217.0 13.9 23.4 0.9 208.4 termination assets $ 913.9 $137.8 [1] $ 132.1 [2] $(0.1) $ 919.5 [1] Reconciliation of additions charged to income to amount disclosed in the consolidated statement of income: Amount charged to income $ 137.8 Amortization of intangibles 0.7 Depreciation and amortization included in consolidated statement of income $ 138.5 [2] Reconciliation of retirements included in Schedule V -- Consolidated Property, Plant and Equipment: Amount charged to reserve $ 132.1 Net book value of property sold in divestiture of local companies 122.7 Total Schedule V retirements $ 254.8 CENTRAL TELEPHONE COMPANY SCHEDULE VIII -- CONSOLIDATED VALUATION AND QUALIFYING ACCOUNTS Years Ended December 31, 1993, 1992 and 1991 (In Millions) Additions Balance Charged Charged Other Balance beginning to to other additions end of of year income accounts (deductions) year Allowance for doubtful accounts $0.5 $ 4.5 $ (4.4) [1] $0.6 Allowance for doubtful accounts $0.6 $ 2.8 $ (2.9) [1] $0.5 Allowance for doubtful accounts $0.6 $ 2.4 $ (2.4) [1] $0.6 [1] Accounts charged off, net of collections. CENTRAL TELEPHONE COMPANY SCHEDULE IX -- CONSOLIDATED SHORT-TERM BORROWINGS Years Ended December 31, 1993, 1992 and 1991 (In Millions) 1993 1992 [1] 1991 Balance at end of period $ 20.0 Weighted average interest rate 3.73% Average amount outstanding during the year $28.1 $ 28.2 $25.3 Maximum amount outstanding during the year $67.0 $ 45.7 $58.1 Weighted average interest rate during the year (computed by dividing the annual interest expense by the average debt outstanding during the year) 3.17% 3.96% 6.81% [1] As of December 31, 1992, short-term borrowings were classified as long-term debt in the consolidated balance sheet due to the Company's intent to refinance such borrowings on a long-term basis. CENTRAL TELEPHONE COMPANY SCHEDULE X -- CONSOLIDATED SUPPLEMENTARY INCOME STATEMENT INFORMATION Years Ended December 31, 1993, 1992 and 1991 (In Millions) 1993 1992 1991 Maintenance and repairs [1] $ 288.4 $ 262.7 $ 259.3 Taxes, other than payroll and income taxes: Property taxes $ 14.9 $ 15.5 $ 15.5 Gross receipts and other 11.1 9.8 8.9 $ 26.0 $ 25.3 $ 24.4 [1] Amounts represent plant operations expense as maintenance and repairs is the primary component of this total. Item 9.	Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure As reported in Central Telephone's Current Report on Form 8-K dated April 28, 1993, following consummation of the Sprint/Centel merger, Arthur Andersen & Co. was replaced with Ernst & Young as auditors of the Company, effective April 23, 1993. Part III Item 10.	Item 10. Directors and Executive Officers of the Registrant Pursuant to Instruction G(3) to Form 10-K, the information relating to Directors of Central Telephone required by Item 10 is incorporated by reference from Central Telephone's definitive proxy statement or information statement which is anticipated to be filed within 120 days after the end of Central Telephone's fiscal year ended December 31, 1993. For information pertaining to Executive Officers of Central Telephone, as required by Instruction 3 of Paragraph (b) of Item 401 of Regulation S-K, refer to the "Executive Officers of the Registrant" section of Part I of this report. Pursuant to Instruction G(3) to Form 10-K, the information relating to compliance with Section 16(a) required by Item 10 is incorporated by reference from Central Telephone's definitive proxy statement or information statement which is anticipated to be filed within 120 days after the end of Central Telephone's fiscal year ended December 31, 1993. Item 11.	Item 11. Executive Compensation Pursuant to Instruction G(3) to Form 10-K, the information required by Item 11 is incorporated by reference from Central Telephone's definitive proxy statement or information statement which is anticipated to be filed within 120 days after the end of Central Telephone's fiscal year ended December 31, 1993. Item 12.	Item 12. Security Ownership of Certain Beneficial Owners and Management Pursuant to Instruction G(3) to Form 10-K, the information required by Item 12 is incorporated by reference from Central Telephone's definitive proxy statement or information statement which is anticipated to be filed within 120 days after the end of Central Telephone's fiscal year ended December 31, 1993. Item 13.	Item 13. Certain Relationships and Related Transactions Pursuant to Instruction G(3) to Form 10-K, the information required by Item 13 is incorporated by reference from Central Telephone's definitive proxy statement or information statement which is anticipated to be filed within 120 days after the end of Central Telephone's fiscal year ended December 31, 1993. Part IV Item 14.	Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) 1. The consolidated financial statements of the Company and supplementary financial information are listed in the Index to Financial Statements and Financial Statement Schedules included at Item 8 of this report. 2. The consolidated financial statement schedules of the Company are listed in the Index to Financial Statements and Financial Statement Schedules included at Item 8 of this report. 3. The following exhibits are filed as part of this report. 3(a) Certificate of Incorporation of Central Telephone, as amended. 3(b) Bylaws of Central Telephone, as amended. 4(a) Indenture dated June 1, 1944, between Central Telephone and The First National Bank of Chicago and Robert L. Grinnell, as Trustees (under which J. G. Finley is successor to Robert L. Grinnell), as amended and supplemented by indentures supplemental thereto through and including a Thirty-third Supplemental Indenture dated as of August 15, 1982 (Incorporated by reference to Exhibit No. 4A to Central Telephone's Registration Statement No. 33-10475 filed December 1, 1986). 4(b) Thirty-fourth Supplemental Indenture, dated as of December 15, 1986 (Incorporated by reference to Exhibit No. 4B to Central Telephone's Registration Statement No. 33-35411 filed June 14, 1990). 4(c) Thirty-fifth Supplemental Indenture, dated as of October 15, 1990 (Incorporated by reference to Central Telephone's Current Report on Form 8-K dated October 26, 1990). 4(d) Thirty-sixth Supplemental Indenture, dated as of March 15, 1991 (Incorporated by reference to Central Telephone's Current Report on Form 8-K dated June 14, 1991). 4(e) Thirty-seventh Supplemental Indenture dated as of August 15, 1992. 12 Ratio of Earnings to Fixed Charges 21 Subsidiaries of the Registrant. 23(a) Consent of Ernst & Young. 23(b) Consent of Arthur Andersen & Co. Central Telephone will furnish to the Securities and Exchange Commission, upon request, a copy of the instruments, other than the indentures listed as Exhibits 4(a), (b), (c), (d) and (e), defining the rights of holders of its long-term debt and the long-term debt of its subsidiaries. The total amount of securities authorized under any of said other instruments does not exceed 10 percent of the total assets of Central Telephone and its subsidiaries on a consolidated basis. (b) Reports on Form 8-K No reports on Form 8-K were filed during the fourth quarter of 1993. (c) Exhibits are listed in Item 14(a). SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. CENTRAL TELEPHONE COMPANY (Registrant) By /s/ D. Wayne Peterson D. Wayne Peterson President and Chief Executive Officer Date: March 31, 1994 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 indicated on the 31st day of March, 1994. /s/ D. Wayne Peterson D. Wayne Peterson President and Chief Executive Officer /s/ John P. Meyer John P. Meyer Vice President - Chief Financial Officer /s/ Ralph J. Hodge Ralph J. Hodge Vice President - Controller SIGNATURES CENTRAL TELEPHONE COMPANY (Registrant) 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 indicated on the 31st day of March, 1994. /s/ Stephen M. Bailor Stephen M. Bailor, Director /s/ Don A. Jensen Don A. Jensen, Director /s/ William E. McDonald William E. McDonald, Director /s/ D. Wayne Peterson D. Wayne Peterson, Director /s/ Alan J. Sykes Alan J. Sykes, Director /s/ M. Jeannine Strandjord M. Jeannine Strandjord, Director /s/ Dianne Ursick Dianne Ursick, Director
862923_1993.txt	862923	1993	Item 1. Business. The Registrant is an indirect wholly-owned subsidiary of Merrill Lynch & Co., Inc., a corporation whose common stock is traded on the New York Stock Exchange. The information set forth under the caption "A. History and Business" in the preliminary prospectus contained in Registrant's registration statement filed March 31, 1994, pursuant to the Securities Act of 1933, File No. 33-60288 (the "Prospectus"), is incorporated herein by reference. Item 2.		Item 2. Properties. The information set forth under the caption "J. Properties" in the Prospectus is incorporated herein by reference. Item 3.	Item 3. Legal Proceedings. The information set forth under the caption "Legal Proceedings" in the Prospectus is incorporated herein by reference. Item 4.	Item 4. Submission of Matters to a Vote of Security Holders. Information called for by this item is omitted pursuant to General Instruction J. of Form 10-K. PART II Item 5.	Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. The Registrant is a wholly-owned subsidiary of Merrill Lynch Insurance Group, Inc., which is the sole record holder of Registrant's shares. Therefore, there is no public trading market for Registrant's common stock. The Registrant has declared no cash dividends on its common stock at any time during the two most recent fiscal years. Under laws applicable to insurance companies domiciled in the State of New York, the Registrant's ability to pay dividends on its common stock is restricted. See Note 5 to the Registrant's financial statements. Item 6.	Item 6. Selected Financial Data. Information called for by this item is omitted pursuant to General Instruction J. of Form 10-K. Item 7.	Item 7. Management's Narrative Analysis of Results of Operations. The information set forth under the caption "C. Management's Discussion and Analysis of Financial Condition and Results of Operations" in the Prospectus is incorporated herein by reference. Item 8.	Item 8. Financial Statements and Supplementary Data. The financial statements of Registrant are set forth in Part IV hereof and are incorporated herein by reference. Item 9.	Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure. Not applicable. PART III Information called for by items 10 through 13 of this part is omitted pursuant to General Instruction J. of Form 10-K. PART IV Item 14.					Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) Financial Statements and Exhibits. (1) The following financial statements of the Registrant are filed as part of this report: a. Independent Auditors' Report dated February 28, 1994. b. Balance Sheets at December 31, 1993 and 1992. c. Statements of Earnings for the Years Ended December 31, 1993, 1992 and 1991. d. Statements of Stockholder's Equity for the Years Ended December 31, 1993, 1992 and 1991. e. Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991. f. Notes to Financial Statements for the Years Ended December 31, 1993, 1992 and 1991. (2) The following exhibits are filed as part of this report as indicated below: 3.1 Certificate of Amendment and Restatement of Charter of Royal Tandem Life Insurance Company. (In- - 3 - corporated by reference to Exhibit 3(a) to the Registrant's registration statement on Form S-1, File No. 33-34562, filed April 26, 1990.) 3.2 By-Laws of Royal Tandem Life Insurance Company. (Incorporated by reference to Exhibit 3(b) to the Registrant's registration statement on Form S-1, File No. 33-34562, filed April 26, 1990.) 3.3 Certificate of Amendment of the Charter of ML Life Insurance Company of New York. (Incorporated by reference to Exhibit 3(c) to Post-Effective Amendment No. 3 to the Registrant's registration statement on Form S-1, File No. 33-34562, filed March 30, 1992.) 3.4 By-Laws of ML Life Insurance Company of New York. (Incorporated by reference to Exhibit 3(d) to Post- Effective Amendment No. 3 to the Registrant's registration statement on Form S-1, File No. 33-34562, filed March 30, 1992.) 4.1 Modified Guaranteed Annuity Contract. (Incorporated by reference to Exhibit 4(a) to Pre-Effective Amendment No. 1 to the Registrant's registration statement on Form S-1, File No. 33-34562, filed October 16, 1990.) 4.2 Modified Guaranteed Annuity Contract Application. (Incorporated by reference to Exhibit 4(b) to Pre- Effective Amendment No. 1 to the Registrant's registration statement on Form S-1, File No. 33-34562, filed October 16, 1990.) 4.3 Qualified Retirement Plan Endorsement. (Incorporated by reference to Exhibit 4(c) to Pre-Effective Amendment No. 1 to the Registrant's registration statement on Form S-1, File No. 33-34562, filed October 16, 1990.) 4.4 IRA Endorsement. (Incorporated by reference to Exhibit 4(d) to Pre-Effective Amendment No. 1 to the Registrant's registration statement on Form S-1, File No. 33-34562, filed October 16, 1990.) 4.5 Company Name Change Endorsement. (Incorporated by reference to Exhibit 4(e) to Post-Effective Amendment No. 3 to the Registrant's registration statement on Form S-1, File No. 33-34562, filed March 30, 1992.) - 4 - 4.6 IRA Endorsement, MLNY009 (Incorporated by reference to Exhibit 4(d)(2) to Post-Effective Amendment No. 1 to the Registrant's registration statement on Form S-1, File No. 33-60288, filed March 31, 1994). 10.1 General Agency Agreement between Royal Tandem Life Insurance Company and Merrill Lynch Life Agency Inc. (Incorporated by reference to Exhibit 10(a) to Pre-Effective Amendment No. 1 to the Registrant's registration statement on Form S-1, File No. 33-34562, filed October 16, 1990.) 10.2 Investment Management Agreement by and between Royal Tandem Life Insurance Company and Equitable Capital Management Corporation. (Incorporated by reference to Exhibit 10(b) to Pre-Effective Amendment No. 1 to the Registrant's registration statement on Form S-1, File No. 33-34562, filed October 16, 1990.) 10.3 Shareholders' Agreement by and among The Equitable Life Assurance Society of the United States and Merrill Lynch & Co., Inc. and Tandem Financial Group, Inc. (Incorporated by reference to Exhibit 10(c) to Pre- Effective Amendment No. 1 to the Registrant's registration statement on Form S-1, File No. 33-34562, filed October 16, 1990.) 10.4 Service Agreement by and between Royal Tandem Life Insurance Company and Tandem Financial Group, Inc. (Incorporated by reference to Exhibit 10(d) to Pre-Effective Amendment No. 1 to the Registrant's registration statement on Form S-1, File No. 33-34562, filed October 16, 1990.) 10.5 Service Agreement by and between Tandem Financial Group, Inc. and Merrill Lynch & Co., Inc. (Incorporated by reference to Exhibit 10(e) to Pre-Effective Amendment No. 1 to the Registrant's registration statement on Form S-1, File No. 33-34562, filed October 16, 1990.) 10.6 Form of Investment Management Agreement by and between Royal Tandem Life Insurance Company and Merrill Lynch Asset Management, Inc. (Incorporated by reference to Exhibit 10(f) to Post-Effective Amendment No. 1 to the Registrant's registration statement on Form S-1, File No. 33-34562, filed March 7, 1991.) - 5 - 10.7 Assumption Reinsurance Agreement between Merrill Lynch Life Insurance Company, Tandem Insurance Group, Inc. and Royal Tandem Life Insurance Company and Family Life Insurance Company. (Incorporated by reference to Exhibit 10(g) to Post-Effective Amendment No. 3 to the Registrant's registration statement on Form S-1, File No. 33-34562, filed March 30, 1992.) 10.8 Indemnity Agreement between ML Life Insurance Company of New York and Merrill Lynch Life Agency, Inc. (Incorporated by reference to Exhibit 10(h) to Post-Effective Amendment No. 3 to the Registrant's registration statement on Form S-1, File No. 33-34562, filed March 30, 1992.) 10.9 Amended General Agency Agreement between ML Life Insurance Company of New York and Merrill Lynch Life Agency, Inc. (Incorporated by reference to Exhibit 10(i) to Post-Effective Amendment No. 3 to the Registrant's registration statement on Form S-1, File No. 33-34562, filed March 30, 1992.) 10.10 Amended Management Agreement between ML Life Insurance Company of New York and Merrill Lynch Asset Management, Inc. (Incorporated by reference to Exhibit 10(j) to the Registrant's registration statement on Form S-1, File No. 33-60288, filed March 30, 1993.) 25.1 Power of attorney of Frederick J.C. Butler. (Incorporated by reference to Exhibit 25(a) to Post-Effective Amendment No. 1 to the Registrant's registration statement on Form S-1, File No. 33-60288, filed March 31, 1994.) 25.2 Power of attorney of Michael P. Cogswell. (Incorporated by reference to Exhibit 25(b) to Post-Effective Amendment No. 1 to the Registrant's registration statement on Form S-1, File No. 33-60288, filed March 31, 1994.) 25.3 Power of attorney of Sandra K. Cox. (Incorporated by reference to Exhibit 25(c) to Post-Effective Amendment No. 1 to the Registrant's registration statement on Form S-1, File No. 33-60288, filed March 31, 1994.) 25.4 Power of attorney of Joseph E. Crowne. (Incorporated by reference to Exhibit 25(d) to Post-Effective Amendment No. 1 to the Registrant's - 6 - registration statement on Form S-1, File No. 33-60288, filed March 31, 1994.) 25.5 Power of attorney of David M. Dunford. (Incorporated by reference to Exhibit 25(e) to Post-Effective Amendment No. 1 to the Registrant's registration statement on Form S-1, File No. 33-60288, filed March 31, 1994.) 25.6 Power of attorney of John C.R. Hele. (Incorporated by reference to Exhibit 25(f) to Post-Effective Amendment No. 1 to the Registrant's registration statement on Form S-1, File No. 33-60288, filed March 31, 1994.) 25.7 Power of attorney of Robert L. Israeloff. (Incorporated by reference to Exhibit 25(g) to Post-Effective Amendment No. 1 to the Registrant's registration statement on Form S-1, File No. 33-60288, filed March 31, 1994.) 25.8 Power of attorney of Allen N. Jones. (Incorporated by reference to Exhibit 25(h) to Post Effective Amendment No. 1 to the Registrant's registration statement on Form S-1, File No. 33-60288, filed March 31, 1994.) 25.9 Power of attorney of Cynthia L. Kahn. (Incorporated by reference to Exhibit 25(i) to Post-Effective Amendment No. 1 to the Registrant's registration statement on Form S-1, File No. 33-60288, filed March 31, 1994.) 25.10 Power of attorney of Robert A. King. (Incorporated by reference to Exhibit 25(j) to Post-Effective Amendment No. 1 to the Registrant's registration statement on Form S-1, File No. 33-60288, filed March 31, 1994.) 25.11 Power of attorney of Irving M. Pollack. (Incorporated by reference to Exhibit 25(k) to Post-Effective Amendment No. 1 to the Registrant's registration statement on Form S-1, File No. 33-60288, filed March 31, 1994.) 25.12 Power of attorney of Barry G. Skolnick. (Incorporated by reference to Exhibit 25(l) to Post-Effective Amendment No. 1 to the Registrant's registration statement on Form S-1, File No. 33-60288, filed March 31, 1994.) - 7 - 25.13 Power of attorney of William A. Wilde. (Incorporated by reference to Exhibit 25(m) to Post-Effective Amendment No. 1 to the Registrant's registration statement on Form S-1, File No. 33-60288, filed March 31, 1994.) 25.14 Power of attorney of Anthony J. Vespa. (Incorporated by reference to Exhibit 25(n) to Post-Effective Amendment No. 1 to the Registrant's registration statement on Form S-1, File No. 33-60288, filed March 31, 1994.) 28.1 Preliminary prospectus contained in Post-Effective Amendment No. 1 to the Registrant's registration statement, filed on March 31, 1994, pursuant to the Securities Act of 1933, File No. 33-60288. (3) Not applicable. (b) Reports on Form 8-K. No reports on Form 8-K have been filed during the last quarter of the fiscal year ended December 31, 1993. - 8 - Independent Auditors' Report . . . . . . . . . . . . . . . . . . . . . . . . . Balance Sheets at December 31, 1993 and 1992 . . . . . . . . . . . . . . . . . Statements of Earnings for the Years Ended December 31, 1993, 1992 and 1991 . . . . . . . . . . . . . . . . . . . . . . . . . . . . Statements of Stockholder's Equity for the Years Ended December 31, 1993, 1992 and 1991 . . . . . . . . . . . . . . . . . . . . . . Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Notes to Financial Statements for the Years Ended December 31, 1993, 1992 and 1991 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . SIGNATURES Pursuant to the requirements of Section 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. 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. *Signing in his own capacity and as Attorney-in-Fact. SUPPLEMENTAL INFORMATION TO BE FURNISHED WITH REPORTS FILED PURSUANT TO SECTION 15(D) OF THE ACT BY REGISTRANTS WHICH HAVE NOT REGISTERED SECURITIES PURSUANT TO SECTION 12 OF THE ACT. No annual report covering the Registrant's last fiscal year or proxy material has been or will be sent to Registrant's security holder. EXHIBIT INDEX - E-1 - - E-2 - - E-3 - - E-4 - - E-5 - - E-6 - - E-7 -
736157_1993.txt	736157	1993	ITEM 1. BUSINESS Time Warner Inc. (the "Company") was incorporated in the State of Delaware in August 1983 and is the successor to a New York corporation originally organized in 1922. The Company changed its name from Time Incorporated following its acquisition of 59.3% of the common stock of Warner Communications Inc. ("WCI") in July 1989. WCI became a wholly owned subsidiary of the Company in January 1990 upon the completion of the merger of WCI and a subsidiary of the Company (the "Merger"). As used in this report, the terms "Registrant," the "Company" and "Time Warner" refer to Time Warner Inc. and its subsidiaries and divisions, and includes Time Warner Entertainment Company, L.P. ("TWE"), which conducts substantially all of the Entertainment businesses of the Company, unless the context otherwise requires. The Company is the largest media and entertainment company in the world. Its businesses are carried on in three principal groups: Publishing, Music and Entertainment. The Publishing group consists principally of the publication and distribution of magazines and books; the Music group consists principally of the production and distribution of recorded music and the ownership and administration of music copyrights; and the Entertainment group consists principally of the production and distribution of motion pictures and television programming, the distribution of videocassettes, the ownership and operation of retail stores and theme parks, the production and distribution of pay television and cable programming, and the operation of cable television systems. These businesses are conducted throughout the world through numerous wholly owned, and in certain cases less than wholly owned, subsidiaries and affiliates. TWE was formed as a Delaware limited partnership in February 1992 pursuant to an Agreement of Limited Partnership, dated as of October 29, 1991, as amended (the "TWE Partnership Agreement"), and has, since its capitalization on June 30, 1992 (the "TWE Capitalization"), owned and operated substantially all of the Entertainment group businesses, and certain other businesses, previously owned and operated by the Company. Upon the TWE Capitalization, certain wholly owned subsidiaries of the Company (the "TW Partners" or the "General Partners"), contributed such businesses, or assigned the net cash flow derived therefrom (or an amount equal to the net cash flow derived therefrom), to TWE and became general partners of TWE. Also upon the TWE Capitalization, wholly owned subsidiaries of ITOCHU Corporation (formerly C. Itoh & Co., Ltd.), a corporation organized under the laws of Japan ("ITOCHU"), and Toshiba Corporation, a corporation organized under the laws of Japan ("Toshiba"), collectively contributed $1 billion to TWE and became limited partners of TWE. On September 15, 1993, TWE consummated the transactions contemplated by the Admission Agreement, dated as of May 16, 1993, as amended (the "Admission Agreement"), between TWE and U S WEST, Inc., a Colorado corporation ("USW"). Pursuant to the Admission Agreement, a wholly owned subsidiary of USW made a capital contribution of $2.553 billion and became a limited partner of TWE (the "USW Transaction"). As a result of the USW Transaction, the TW Partners collectively own 63.27% pro rata priority capital and residual equity interests in TWE and wholly owned subsidiaries of ITOCHU, Toshiba and USW (the "Class A Partners" or the "Limited Partners") own pro rata priority capital and residual equity interests in TWE of 5.61%, 5.61% and 25.51%, respectively. Each of ITOCHU and Toshiba has the right to maintain its original 6.25% pro rata priority capital and residual equity interests by acquiring additional partnership interests. In addition, the TW Partners own priority capital interests senior and junior to the pro rata priority capital interests. The Admission Agreement provides that TWE will use its best efforts to upgrade a substantial portion of its cable systems to "Full Service Network(TM)" capacity over the next five years. As systems are designated for such upgrade and after any required approvals are obtained, USW and TWE will share joint control of those systems through a 50-50 management committee. The "Full Service Network" business is expected to include substantially all of TWE's cable systems, subject to obtaining necessary regulatory consents and approvals. See "Entertainment--Description of Certain Provisions of the TWE Partnership Agreement." I-1 For financial information about the Company's industry segments and operations in different geographical areas with respect to each of the years in the three-year period ended December 31, 1993, see Note 10, "Segment Information," to the Company's consolidated financial statements at pages through herein. The Company's Entertainment Group, consisting of the Company's interests in certain entertainment companies, principally TWE, was deconsolidated effective January 1, 1993 as a result of the USW Transaction. The TWE Partnership Agreement and the TWE credit agreement impose restrictions on the ability of TWE to make distributions to the Company and the TW Partners. See Note 1, "Summary of Significant Accounting Policies," and Note 2, "Entertainment Group," to the Company's consolidated financial statements at pages through herein. PUBLISHING The Company's wholly owned publishing division, Time Inc., publishes magazines and books and develops products for the multimedia and television markets. It conducts these activities through wholly owned subsidiaries, joint ventures, equity investments and partnerships. MAGAZINES General Time Inc. publishes TIME, PEOPLE, SPORTS ILLUSTRATED, FORTUNE, MONEY, LIFE, SPORTS ILLUSTRATED FOR KIDS and ENTERTAINMENT WEEKLY. In March 1994, Time Inc. announced the launch of IN STYLE, a monthly celebrity life style publication, which will have an initial rate base of 500,000. Time Publishing Ventures, Inc. ("TPV"), a subsidiary of Time Inc. Ventures ("TIV") and an indirect subsidiary of Time Inc., is responsible for international, regional and special interest publishing and development activities, including Southern Progress Corporation ("Southern Progress"), Sunset Publishing Corporation ("Sunset Publishing"), PARENTING, BABY TALK, HEALTH, HIPPOCRATES, MARTHA STEWART LIVING and WHO WEEKLY magazines and various joint ventures. In September 1993, a joint venture between a subsidiary of TPV and affiliates of Quincy Jones Entertainment Company began publication of VIBE, a magazine that covers rap, rhythm and blues, reggae and dance music, as well as politics and fashion. Southern Progress publishes SOUTHERN LIVING, PROGRESSIVE FARMER, SOUTHERN ACCENTS, COOKING LIGHT and TRAVEL GUIDE magazines. Time Inc., either directly or through subsidiaries, has equity interests in ASIAWEEK, ELLE JAPON, PRESIDENT, American Family Publishers, Time Distribution Services and Publishers Express. In 1993, Time Inc. sold its interest in WORKING WOMAN and WORKING MOTHER, and in March 1994, it sold its interest in the magazine, YAZHOU ZHOUKAN, but retained the right to reacquire 25% of the magazine in the future. TIV has management responsibility for most of the American Express Publishing Corporation's operations, including TRAVEL & LEISURE and FOOD & WINE magazines. TIV also operates an in-store advertising and demonstration business, Time Inc. In-Store Marketing. Each magazine published by the Company has an editorial staff under the general supervision of a managing editor and a business staff under the management of a president or publisher. Magazine manufacturing and distribution activities are generally managed by centralized staffs at Time Inc. Fulfillment activities for Time Inc.'s magazines are generally administered from a centralized facility in Tampa, Florida. I-2 PARENTING, SUNSET, BABY TALK, HEALTH, HIPPOCRATES, MARTHA STEWART LIVING and Time Inc.'s overseas operations employ independent fulfillment services and undertake their own manufacturing and distribution. Magazine publishing follows a seasonal pattern with revenues being generally higher in the second and fourth quarters and lower in the first and third quarters. The individual magazines of the Company are summarized below: TIME, a weekly magazine, summarizes the news and brings original interpretation and insight to the week's events. The domestic advertising rate base of TIME as of January 1994 was 4,000,000, which is unchanged from January 1993. TIME Asia, TIME Atlantic, TIME Canada, TIME Latin America and TIME South Pacific are weekly English-language editions of TIME which circulate outside the United States. These editions had an aggregate worldwide advertising rate base of 1,480,000 as of January 1994, compared to 1,510,000 in January 1993. SPORTS ILLUSTRATED is a weekly magazine which covers the activities of, and is designed to appeal to, spectators and participants in virtually all forms of recreation and competitive sports. In 1993, Time Canada Ltd. tested a Canadian version of the magazine which provides expanded coverage of Canada's teams and athletes. The advertising rate base as of January 1994 was 3,150,000, the same as in January 1993. SPORTS ILLUSTRATED FOR KIDS is a monthly sports-oriented magazine geared to children ages eight through 14. Its advertising rate base as of January 1994 was 900,000, compared to 800,000 in January 1993, including 250,000 copies distributed free to over 1,400 schools. PEOPLE, a weekly magazine, focuses on celebrities and other notable personalities. The advertising rate base as of January 1994 was 3,150,000, the same as in January 1993. ENTERTAINMENT WEEKLY is a weekly magazine which includes reviews and reports on television, movies, video, music and books. The advertising rate base as of January 1994 was 1,075,000, compared to 800,000 in January 1993 and 1,000,000 in February 1993. FORTUNE, a biweekly magazine, reports on worldwide economic and business developments. FORTUNE International, an overseas English-language edition, contains most of the articles in the domestic edition. The combined worldwide advertising rate base was 870,000 as of January 1994, which is unchanged from January 1993. MONEY is a monthly magazine which reports on personal finance. The advertising rate base as of January 1994 was 1,900,000, the same as in January 1993. LIFE is a monthly magazine which features photographic essays. The advertising rate base as of January 1994 was 1,500,000 as compared to 1,700,000 in January 1993. The rate base was reduced in May 1993 as the magazine sought to redefine its publishing niche for the 1990's. SOUTHERN LIVING is a monthly regional home, garden, food and travel magazine focused on the South with an advertising rate base of 2,300,000 as of January 1994, which is the same as in January 1993. PROGRESSIVE FARMER is a monthly regional farming magazine with an advertising rate base of 415,000 as of January 1994, compared to 425,000 in January 1993. SOUTHERN ACCENTS, published six times a year, features architecture, fine homes and gardens, arts and travel and is targeted to affluent Southerners. Its advertising rate base as of January 1994 was 250,000, which is unchanged from January 1993. I-3 COOKING LIGHT is published seven times a year and features health and fitness through active lifestyles and good nutrition. The advertising rate base as of January 1994 was 1,100,000, compared to 1,000,000 in January 1993. TRAVEL GUIDE, formerly TRAVEL SOUTH, is a seasonal, regional travel magazine focused on the South with an average circulation of 200,000 as of January 1994, the same as in January 1993. PARENTING is published ten times per year and is aimed at parents of children under the age of ten. The advertising rate base increased as of January 1994 to 925,000, compared to 875,000 in January 1993. SUNSET, The Magazine of Western Living, is a monthly regional magazine focused on lifestyles in the West. The advertising rate base increased to 1,400,000 in January 1994 compared to 1,375,000 in January 1993. HEALTH is a consumer health magazine published seven times a year, and HIPPOCRATES is published ten times a year. Although similar in editorial content, HEALTH is targeted at the consumer market, while HIPPOCRATES is a trade magazine targeted at physicians and carries primarily trade advertising. HEALTH had an advertising rate base of 900,000 in January 1994, the same as in January 1993. HIPPOCRATES had a controlled circulation of 125,000 primary care physicians in January 1994, the same as in January 1993. MARTHA STEWART LIVING presents Martha Stewart's personal perspective on entertaining, cooking, decorating and gardening. Published bimonthly in 1993, it will expand to eight issues in 1994. Its advertising rate base as of January 1994 was 725,000, compared to 575,000 in January 1993. In 1993, a TIV subsidiary developed a weekly one-half hour syndicated television show featuring Martha Stewart which began airing on broadcast television to a nationwide audience in September 1993. BABY TALK is a monthly magazine targeted at expectant and new mothers. Its rate base as of January 1994 was 1,125,000, the same as in January 1993. BABY TALK's ancillary publications are BABY ON THE WAY (published semi-annually) and BABY ON THE WAY BASICS (published annually). WHO WEEKLY is an Australian version of PEOPLE which focuses on celebrities and other notable personalities. The advertising rate base as of January 1994 was 200,000, compared to 180,000 in January 1993. VIBE was launched in September 1993 and covers rap, rhythm and blues, reggae and dance music, as well as politics and fashion. Four issues of VIBE were published in 1993 and it is expected that 10 issues will be published in 1994. The advertising rate base as of January 1994 was 200,000. Circulation The Company's publications are sold primarily by subscription. Subscription copies are delivered to subscribers through the mail. Subscriptions are sold by direct-mail solicitation, subscription sales agencies, television and telephone solicitation and insert cards in the Company's magazines and other publications. Single copies of magazines are sold through retail news dealers who are supplied in turn by regional wholesalers. Advertising Advertising carried in the Company's magazines is predominantly consumer advertising. Eleven of the Company's magazines have numerous regional and demographic editions which contain the same basic editorial material but permit advertisers to concentrate their advertising in specific markets. Through the use of selective binding and ink-jet technology, the Company creates special custom editions targeted towards specific groups. This allows the Company to deliver advertisers a more highly targeted audience by I-4 segmenting subscriber lists to identify those subscribers advertisers desire most, as well as providing the opportunity to personalize advertising messages. Paper and Printing Lightweight coated paper, which for certain magazines is recycled, constitutes a significant component of physical costs in the production of magazines. Time Inc. has contractual commitments to ensure an adequate supply of paper, but periodic shortages may occur in the event of strikes or other unexpected disruptions in the paper industry. During 1993, a year in which paper prices generally increased, Time Inc. purchased paper principally from four independent manufacturers, in each case under contracts that, for the most part, are either fixed-term or open-ended at prices determined on a market price or formula price basis. Printing and binding for the Company's magazines are accomplished primarily by major domestic and international printing concerns in 21 locations. Magazine printing contracts are either fixed-term or open-ended at fixed prices with, in some cases, adjustments based on certain criteria. BOOKS General The Company's book operations include Time Life Inc.; Book-of-the-Month Club Inc.; Time Warner Trade Publishing which operates Warner Books, Warner Publisher Services and Little, Brown and Company, each of which is a wholly owned subsidiary of Time Inc.; and the Oxmoor House and Sunset Books divisions of Southern Progress and Sunset Publishing, respectively. In 1993, the book operations distributed, in aggregate, approximately 142 million gross units. Time Life Inc. Time Life Inc. is composed of five divisions: Books, Music, Video and Television, Education, and International. Time Life Inc. is one of the nation's largest direct marketers of books, music and videos. The products are sold by direct response, including mail order, television and telephone, through retail, institutional and license channels, and by door-to-door independent distributors in some foreign markets. Editions of the books are currently sold in 22 languages worldwide and approximately 42% of Time Life Inc.'s revenues are generated outside the United States. In 1993, Time Life Inc. created Time Life Education, a division designed to enter the school and library market. Editorial material is created by in-house staffs as well as through outside book packagers. The most significant new product launched in 1993 was Time Life Music's new series "The Rolling Stone Collection: 25 Years of Essential Rock." Other 1993 best sellers included the series "Barney & Friends" at Time Life Video and Television. In 1993, Time Life began the development of two ten-hour television documentary series, "Lost Civilizations" and "The History of Rock 'n' Roll," each of which draw on Time Life's existing editorial resources. First-run television rights to "Lost Civilizations" have been pre-sold to one of the three major networks, and "The History of Rock 'n' Roll" is being co- produced with TWE's Telepictures Productions. Manufacturing for Time Life Books is done by several independent companies. Manufacturing contracts are entered into on a series rather than a single title basis and are fixed-price with provisions for cost of labor, material and specification adjustments. These contracts, subject to certain limitations, may be terminated by Time Life Inc. or the manufacturer. Time Life Inc.'s fulfillment activities, excluding international operations, are conducted from a centralized facility in Richmond, Virginia. Book-of-the-Month Club Book-of-the-Month Club operates seven book clubs and two continuity businesses with combined membership in excess of 3.1 million. Two of the clubs, Book-of-the-Month Club and Quality Paperback Book I-5 Club, are general interest clubs and the remaining clubs specialize in history, cooking and crafts, business, children's books and the books of a particular author. In addition, audio and video products are offered through the clubs. In 1993, Book-of-the-Month Club launched its businesses internationally in over 20 countries primarily in Europe and Asia. Book-of-the-Month Club buys the rights from publishers to manufacture and distribute books and then has them printed by independent printing concerns. Book-of-the-Month Club runs its own fulfillment and warehousing operations in Mechanicsburg, Pennsylvania. Time Warner Trade Publishing Warner Books Warner Books publishes hardcover, mass market and trade paperback books. Among the best selling hardcover books published in 1993 were Robert James Waller's "Slow Waltz in Cedar Bend," and Sandra Brown's "Where There's Smoke." Robert James Waller's "The Bridges of Madison County," published in 1992, was the number one selling hardcover title of 1993. Mass market paperback books published in 1993 included "The General's Daughter" by Nelson DeMille, "The Star Shines Down" by Sidney Sheldon, "Decked: A Regan Reilly Mystery" by Carol Higgins Clark, "Along Came a Spider" by James Patterson, "French Silk" by Sandra Brown, and "Double Cross" by Sam and Chuck Giancana. The major trade paperback book published by Warner Books in 1993 was: "Bottoms Up!" by Joyce L. Vedral, Ph.D. Little, Brown Little, Brown publishes general and children's trade books, legal and medical reference books and textbooks. Through its subsidiary, Little, Brown (U.K.), it also publishes general hardcover and mass market paperback books in the United Kingdom. Among the trade hardcover books published by Little, Brown in 1993 were "The Hope" by Herman Wouk and "The Best Cat Ever" by Cleveland Amory. The major trade paperback book published by Little, Brown in 1993 was "Revolution From Within" by Gloria Steinem. Little, Brown handles book distribution for itself and Warner Books. The marketing of trade books is primarily to retail stores and wholesalers throughout the United States, Canada and the United Kingdom. Law and medical textbooks are sold primarily to university retail stores. Professional reference books are sold to practitioners through retail stores and direct marketing. Through their combined U.S. and U.K. operations, Little, Brown and Warner Books have the ability to acquire English-language publishing rights for the distribution of hard and softcover books throughout the world. In July 1993, the trade publishing group and Warner Music Group's Atlantic Records formed a joint venture, Time Warner AudioBooks, to develop and market audio versions of books and other materials published by Warner Books, Little, Brown and other outside publishers. Oxmoor House and Leisure Arts Oxmoor House, the book publishing division of Southern Progress, markets how- to books on a wide variety of topics including food and crafts, as well as illustrated volumes on art and other subjects. Acquired in 1992 and integrated into Oxmoor House, Leisure Arts is a well-established publisher and distributor of instructional leaflets, continuity books series and magazines for the needlework and craft market. Sunset Books Sunset Books, the book publishing division of Sunset Publishing, markets books on topics such as building and decorating, cooking, gardening and landscaping, and travel. Sunset Books' unique marketing formula includes an extensive network of home repair and garden centers. I-6 OTHER PUBLISHING OPERATIONS Multimedia and Other Television Development Time Inc. is actively developing products for emerging technologies such as on-line computer networks, the Full Service Network, and the CD ROM market. These efforts include alliances with leading worldwide consumer on-line computer services to provide interactive entertainment and information to the home computer market, the development of an interactive news-on-demand service for the Full Service Network, as well as the creation of CD ROM versions of original and existing Time Inc. editorial products. Time Inc. has also undertaken development efforts in various television ventures, both in combination with other divisions of the Company and independently. The most significant of these activities is an entertainment news show, "Entertainment News Television," produced in conjunction with the Telepictures division of TWE, which will be a six-day-a-week program utilizing the editorial resources of Time Inc. to break exclusive stories. The first episode of this show is planned for the autumn of 1994. Time Inc. In-Store Marketing In June 1993, Time Inc. formed, as part of TIV, Time Inc. In-store Marketing, an umbrella organization to operate all of the company's in-store advertising and demonstration businesses, including Media One, Inc. ("Media One") and SmartDemo Inc. ("SmartDemo"). Media One's primary product is a two-sided backlit advertising display unit that is installed in supermarket checkout lanes. SmartDemo, an in-store demonstration, couponing, sampling and merchandising business, was acquired by TIV in June 1993. American Express Publishing In March 1993, Time Inc., through its TIV subsidiary, entered into an agreement to assume management responsibility for most of American Express Publishing Corporation's operations, including its core lifestyle magazines, TRAVEL & LEISURE and FOOD & WINE. Under the terms of the agreement, TIV receives a fee for managing these properties, as well as incentives for improving profitability. American Family Publishers Time Inc. is a 50% partner in American Family Publishers ("AFP"), a direct mail magazine subscription sales agency. AFP sells magazine subscriptions for approximately 200 major magazines in the United States, including many of the Company's publications. AFP sells primarily through two heavily promoted nationwide sweepstakes mailings conducted each year. Time Distribution Services Time Inc. owns approximately a 63% interest in Time Distribution Services ("TDS"), a joint venture with the New York Times Company. TDS markets and distributes magazines published by both companies, and also certain other publishers in the United States and Canada, through wholesalers to retail outlets such as newsstands and directly to supermarkets and drugstore chains. Warner Publisher Services Warner Publisher Services ("WPS") is a major distributor of magazines and paperback books sold through wholesalers in the United States and Canada. WPS is the sole national distributor for MAD magazine, the publications of DC Comics and certain publications owned by other publishers, including TEEN, VOGUE, WOMAN'S DAY, and the Dell Puzzle Books. WPS also distributes the paperback books published by Warner Books as well as the full paperback lines of the Berkley Group and St. Martin's Press/Tor Books. WPS is wholly owned by the Company. I-7 Publishers Express Time Inc. owns 25% of Publishers Express Inc., a corporation whose shareholders consist of eleven other publishers, printers, paper companies and direct mailers established to deliver second- and third-class mail and advertising material in competition with the U.S. Postal Service. As of January 1994, the corporation was delivering in 30 cities throughout the United States. POSTAL RATES Postal costs represent a significant operating expense for the Company's publishing activities. There were no general postal rate increases in 1993 and none will occur in 1994. A general increase of approximately 10% has been proposed for 1995 by the Postal Service. Some relatively small savings will be realized by the Company through the adoption by the Postal Board of Governors of a special discount for certain types of barcoded postal material. Publishing operations continue to minimize postal expense through the use of certain cost-saving measures, including the utilization of contract carriers to transport books and magazines to central postal centers. It has been the Company's practice in selling books and other products by mail to include a charge for postage and handling, which is adjusted from time to time to partially offset any increased postage or handling costs. COMPETITION The Company's magazine operations compete for sales with numerous other publishers and retailers, as well as other media. The general circulation magazine industry is highly competitive both within itself and with other advertising media which compete with the Company's magazines for audience and advertising revenue. The Company's book publishing operations compete for sales with numerous other publishers and retailers as well as other media. In addition, the acquisition of publication rights to important book titles is highly competitive, and Warner Books and Little, Brown compete with numerous other book publishers. WPS and TDS meet with direct competition from other distributors operating throughout the United States and Canada in the distribution of magazines and paperback books. MUSIC GENERAL The Company's music business, conducted under the umbrella name Warner Music Group ("WMG"), consists of a vertically integrated worldwide recorded music business and a worldwide music publishing business. The Company's domestic recorded music business is conducted principally through WCI's wholly owned subsidiaries Warner Bros. Records Inc. ("WBR"), Atlantic Recording Corporation ("Atlantic"), WEA Manufacturing Inc. ("WEA Mfg.") and Warner-Elektra-Atlantic Corporation ("WEA"), and a division of WCI, Elektra Entertainment ("Elektra"). Outside of the United States, the recorded music business is conducted in 72 countries through WEA International Inc. and a division of WCI, Warner Music International, and their subsidiaries and affiliates ("WMI"), as well as through non-affiliated licensees. The Company's music publishing business is conducted principally through wholly owned subsidiaries of WCI (collectively, "Warner/Chappell"). In 1993, approximately 52% of WMG's revenues were derived from sources outside of the United States. I-8 RECORDED MUSIC WMI, WBR, Atlantic and Elektra produce, sell and license compact discs, cassette tapes and music videos (in both videocassette and video laserdisc configurations) of the performances of recording artists under contract to them or for whose recordings they have acquired rights. WMG's recorded music and video product is marketed under various labels, including the proprietary labels "Warner Bros.," "Reprise," "Sire," "Tommy Boy," "Warner Nashville," "Elektra," "Asylum," "Nonesuch," "Atlantic," "A*Vision," "EastWest America," "Big Beat," "Atlantic Nashville," "WEA," "EastWest," "Teldec," "CGD," "Carrere," "Erato," "MMG," "DRO," "Telegram," "D-Day" and "Muser." In addition, WMG has entered into joint venture agreements pursuant to which WMG companies manufacture, distribute and market (both domestically and, in most cases, internationally) recordings owned by such joint ventures. The terms of such agreements vary widely, but each agreement typically provides the WMG record company with an equity interest and a profit participation in the venture, with financing furnished either solely by WMG or by both parties. Included among these arrangements are the labels "American Recordings," "Giant," "Interscope," "Maverick," "Quest" and "Rhino." WMG's record companies also acquire rights pursuant to agreements to manufacture and distribute certain recordings that are marketed under the licensor's proprietary label. Included among the labels distributed under such arrangements are "Slash," which is distributed by WBR; "Hollywood" and "Mute," which are distributed by Elektra; and "Beggars Banquet," "Delicious Vinyl" and "Matador," which are distributed by Atlantic. Recording artists are engaged under arrangements that generally provide that the artist is to receive a percentage of the suggested retail selling price of compact discs, cassette tapes and music videos sold. Most artists receive non- returnable advance payments against future royalties. Among the artists whose albums resulted in significant record sales for WMG's record companies during 1993 were: Eric Clapton, Rod Stewart, the artist formerly known as Prince, Neil Young, Silk, Metallica, 10,000 Maniacs, Stone Temple Pilots, 4 Non Blondes, John Michael Montgomery, Tracy Lawrence, Luis Miguel, Noriyuki Mikihara, Leandro e Leonardo and Mana. In 1994, WMG's record companies expect to release albums by the following artists: Madonna, R.E.M., Travis Tritt, Philip Glass, Motley Crue, Keith Sweat, Tori Amos, Stevie Nicks, Confederate Railroad, Clawfinger, Enya, Gilberto Gil and Inner Circle, among others. WEA Mfg. is engaged in the domestic manufacturing of audio and ROM compact discs, cassette tapes, vinyl records and videocassettes. WEA Mfg. conducts its operations from facilities situated in Olyphant, Pennsylvania and in the greater Los Angeles area. WMI also operates two plants in Germany that manufacture compact discs, cassette tapes and vinyl records for WMI's European affiliates and licensees and for WMI companies outside Europe, as well as for unrelated parties. Ivy Hill Corporation ("Ivy Hill") is engaged in the offset lithography and packaging business through facilities situated in four states. Ivy Hill is a major supplier of packaging to the recorded music industry (including WMG's record companies) and also supplies packaging for a wide variety of other consumer products. Warner Special Products produces, primarily for telemarketers, compilations of music for which it has obtained rights from WMG's recorded music companies as well as third parties. WMG's recorded music product is marketed and distributed in the continental United States by WEA, which supplies, directly or indirectly through sub- distributors and wholesalers, thousands of record stores, department stores, discount centers and other retail outlets across the country. Alternative Distribution Alliance, a music distribution company specializing in alternative rock music, with a focus on new artists, was formed in 1993 as a joint venture of Warner Music Group, its labels, Restless Records and Sub-Pop. I-9 In foreign markets, WMI produces, distributes, promotes and sells recordings of local artists and, in most cases, distributes the recordings of those artists for whom WMG's domestic recording companies have international rights. In certain countries, WMI licenses to non-affiliated parties rights to distribute recordings of WMG's labels. Warner Music Enterprises, a direct marketing company, entered into an agreement in 1993 with the BBC to launch the BBC Music Service, a subscription program specializing in classical music, announced the launch of New Country Music Service, another subscription service, in the first quarter of 1994 and announced the addition of a new rock music magazine to the existing Rock Video Monthly Service for the third quarter of 1994. Through partnerships with Sony Music Entertainment Inc., Time Warner owns a 50% interest in the music and video clubs of The Columbia House Company. The Columbia House Company, consisting of a U.S. partnership and a Canadian partnership, is the leading direct marketer of compact discs, cassette tapes and videocassettes in the United States and Canada. WCI owns a minority portion of Time Warner's 50% interest in the U.S. partnership and all of Time Warner's 50% interest in the Canadian partnership. WMG and Sony Music Entertainment are also partners in Music Sound Exchange, a direct marketing catalog launched in 1993 that is primarily geared to selling music and related product to consumers age 35 and over. A 1993 joint venture between WMG and Sony Software Corporation became an equity partner with TWE's Time Warner Cable in Music Choice, an audio programming service that delivers multiple channels of CD-quality stereo music via cable television. In Europe, where the service is known as Music Choice Europe, it is delivered via cable television and direct-to-home satellite. In December 1993, a joint venture among WMG, Sony, PolyGram, EMI and Hamburg radio executive Frank Otto, launched VIVA, a 24-hour German language music video channel carried on cable television in Germany. In January 1994, WMG, EMI, PolyGram, Sony and Ticketmaster announced plans to form a partnership that will operate an advertiser-supported, 24-hour music video channel to be offered as a basic cable television service in the United States and Puerto Rico. MUSIC PUBLISHING Time Warner's music publishing companies own or control the rights to over 900,000 standard and contemporary compositions, including numerous popular hits, folk songs and music from the stage and motion pictures. Certain works of the following artists, authors and composers are included in Warner/Chappell's catalogues: John Bettis, Michael Bolton, The Black Crowes, Phil Collins, Comden & Green, Dubin & Warren, Genesis, George and Ira Gershwin, Gin Blossoms, Victor Herbert, Michael Jackson, Elton John, Leiber & Stoller, Lerner & Lowe, Madonna, Henry Mancini, Johnny Mercer, George Michael, Midnight Oil, Cole Porter, the artist formerly known as Prince, R.E.M., Rodgers & Hart, Soul Asylum, Jule Styne, Bernie Taupin, Van Halen, John Williams and the foreign administration of the works of Irving Berlin. Warner/Chappell also administers the film music of Lucasfilm, Ltd., Viacom Enterprises, Samuel Goldwyn Productions, Famous Music (the music publishing division of Paramount Communications Inc.) outside the United States and Japan, and several other television and motion picture companies. Warner/Chappell's printed music division markets publications throughout the world containing the works of Alabama, Phil Collins, Bon Jovi, The Eagles, The Grateful Dead, Michael Jackson, Led Zeppelin, Madonna, John Mellencamp, the artist formerly known as Prince, Rush, Bob Seger and many others. Principal sources of revenues to Warner/Chappell are license fees for use of its music copyrights on radio and television, in motion pictures and in other public performances; royalties for use of its music copyrights on compact discs, cassette tapes, vinyl records, music videos and in commercials; and sales of published sheet I-10 music and song books for the home musician as well as the professional and school markets, including methods for teaching musical instruments. LEGISLATION The Audio Home Recording Act, enacted in 1992, establishes the right of individuals to copy pre-recorded music for private non-commercial use and grants to copyright owners, including music publishers and record companies, a royalty in connection with the sale of new digital audio recording equipment and blank digital audio recording media. The statute also requires manufacturers of digital audio recording equipment to utilize technology that would prevent subsequent copying from copied audio recordings. In 1993, Congress began considering bills to provide royalties to performers and producers of digitized music. The legislation is prompted by the improved reception and the potential for recording that digitization of broadcast, cable and other means of music distribution is expected to provide. Passage of this legislation could be favorable to WMG's interests. COMPETITION The recorded music business is highly competitive. The revenues and income of a company in the recording industry depend upon the public acceptance of the company's recording artists and the recordings released in a particular year. Although WMG is one of the largest recorded music companies in the world, its competitive position is dependent upon its continuing ability to attract and develop talent that can achieve a high degree of public acceptance. The recorded music business continues to be adversely affected by counterfeiting, piracy, parallel imports and, in particular, the home taping of recorded music. In addition, the recorded music business also meets with competition from other forms of entertainment, such as television, pre-recorded videocassettes and video games. Competition in the music publishing business is intense. Although WMG's music publishing business is the largest on a worldwide basis, it competes with every other music publishing company in acquiring musical compositions and in having them recorded and performed. ENTERTAINMENT The Company's Entertainment Group consists of TWE's Filmed Entertainment, Programming--HBO and Cable businesses, and also the Company's interests in certain other businesses. Each of the three principal businesses is operated as a separate division of TWE and, except as described below, in the same manner as it was operated by the Company at the time of the TWE Capitalization. See "--Description of Certain Provisions of the TWE Partnership Agreement-- Management and Operations of TWE." In order to ensure compliance with the Modification of Final Judgment entered on August 24, 1982 by the United States District Court for the District of Columbia applicable to USW and its affiliated enterprises, which may include TWE (the "Modification of Final Judgment"), prior to USW's investment in TWE, TWE distributed to the TW Partners certain assets, including the satellite receiving dishes and broadcast antennae used by TWE's cable division, the transponders and other transmission equipment used by TWE's cable television programming and filmed entertainment divisions and equity interests in certain programming entities (collectively, the "TW Service Partnership Assets"). Such partners then contributed such assets to newly formed sister partnerships in which the TW Partners and subsidiaries of ITOCHU and Toshiba are the partners (the "Time Warner Service Partnerships"). Upon the distribution of the TW Service Partnership Assets to the TW Partners, the TW Partners' junior priority capital interests were reduced by approximately $300 million. See "--Other Entertainment Group Assets--Time Warner Service Partnerships." Generally, the Modification of Final Judgment prohibits the seven Regional Bell Operating Companies ("RBOCs") including USW, and any of their "affiliated enterprises," which, as a result of the USW I-11 Transaction, may include TWE, from among other things, (i) providing long distance telecommunications services, which may include operating or providing long distance services using TVROs or satellites, or coaxial cable, fiber or microwave facilities, (ii) manufacturing or providing telecommunications equipment and (iii) manufacturing "customer premises equipment," which may include cable television converter or multimedia boxes. In addition, the Modification of Final Judgment may prohibit the RBOCs and their "affiliated enterprises" from holding certain financial interests in ventures that engage in the foregoing activities. Several bills that would alleviate many of the restrictions contained in the Modification of Final Judgment are under active consideration in the Congress. See "--Other Entertainment Group Assets--Time Warner Service Partnerships." FILMED ENTERTAINMENT DIVISION General TWE's principal operations in the fields of motion pictures and television are conducted by its Warner Bros. division ("WB"). The filmed entertainment business includes the production, financing and distribution of feature motion pictures, television series, made-for-television movies, mini-series for television, first-run syndication programming, and animated programming for theatrical and television exhibition; and the distribution of pre-recorded videocassettes and videodiscs. TWE also is engaged in product licensing and the ownership and operation of retail stores, movie theaters and theme parks. Feature motion pictures and television programs are produced at various locations throughout the world, including The Warner Bros. Studio in Burbank, California and The Warner Hollywood Studio in West Hollywood, California. For additional information, see Item 2		ITEM 2. PROPERTIES PUBLISHING, MUSIC AND CORPORATE The following table sets forth certain information as of December 31, 1993 with respect to the Company's principal properties (over 250,000 square feet in area) that are used primarily by its publishing and music divisions or occupied for corporate offices, all of which the Company considers adequate for its present needs, and all of which were substantially used by the Company or were leased to outside tenants: I-37 ENTERTAINMENT The following table sets forth certain information as of December 31, 1993 with respect to TWE's principal properties (over 125,000 square feet in area), all of which TWE considers adequate for its present needs, and all of which were substantially used by TWE or were leased to outside tenants. I-38 - -------- (a) Ten acres consist of various parcels adjoining The Warner Bros. Studio, with mixed commercial, office and residential uses. (b) 1,640 acres of which are undeveloped land available for expansion. (c) Excludes 8,817,000 sq. ft. of owned and 2,024,000 sq. ft. of leased properties used by the Cable division for headend, hub, and tower sites. (d) Includes 108,000 sq. ft. of office space occupied by Time Warner corporate staff who provide services to TWE pursuant to arrangements set forth in the TWE Partnership Agreement. ITEM 3.	ITEM 3. LEGAL PROCEEDINGS The Company and its subsidiaries are parties, in the ordinary course of business, to litigations involving property, personal injury and contract claims. The amounts that the Company believes may be recoverable in these matters are either covered by insurance or are not material. In June 1989, a stockholder class action was filed in the Court of Chancery for the State of Delaware, in and for New Castle County ("Delaware Chancery Court"), entitled In re Time Incorporated Shareholder Litigation, Consol. Civ. Action No. 10670 (the "Time Warner Stockholder Litigation"), against the Company, its Board of Directors, WCI and the Company's financial advisors, Wasserstein Perella & Co., Inc. ("Wasserstein Perella") and Shearson Lehman Hutton Inc. ("Shearson Lehman"), in which plaintiffs seek, among other things, judgment declaring that the defendant directors breached their fiduciary duties by entering into the Share Exchange Agreement dated as of March 3, 1989, as amended, between the Company and WCI (the "Share Exchange Agreement") and the Agreement and Plan of Merger (as amended, the "Merger Agreement") among the Company, TW Sub Inc., then a wholly owned subsidiary of the Company, and WCI, as in effect on March 3, 1989, and that WCI, Shearson Lehman and Wasserstein Perella aided and I-39 abetted those breaches; an order requiring redemption of the Rights issued pursuant to the Company's Stockholder Rights Plan; and judgment rescinding consummation of the Share Exchange Agreement and enjoining the Company's acquisition of WCI pursuant to the tender offer (the "Tender Offer") pursuant to which the Company purchased 100 million shares of WCI common stock for $70 per share on July 24, 1989 and the Merger Agreement. Plaintiffs' motion preliminarily to enjoin the Tender Offer was denied in July 1989 and that decision was affirmed on appeal. In July 1993, the action was dismissed without prejudice and without the payment of any compensation to the plaintiffs by the defendants. Two other purported stockholder class actions, Greenberg v. Time, et al., and Northern Laminating, Inc. Retirement Fund v. Munro, et al., Index No. 12653-89, were filed in June 1989 in the Supreme Court of the State of New York, County of New York ("New York Supreme Court") and make substantially similar allegations against most of the same defendants, plus an alleged violation of New York antitrust law. Defendants have not yet been required to respond to the amended complaint in the Northern Laminating case. The Greenberg action had been consolidated with the Time Warner Stockholder Litigation, which was dismissed in July 1993. Also pending in the Delaware Chancery Court is another consolidated stockholder litigation, In re Warner Communications Inc. Shareholders Litigation, Consol. Civ. Action No. 10671 (the "Warner Stockholder Litigation"), commenced in 1989 against WCI, its Board of Directors and the Company, alleging that WCI's Board of Directors breached their fiduciary duties to WCI's stockholders, and the Company aided and abetted such alleged breach, by not ensuring that the securities distributed to WCI stockholders in the Merger contained certain protective covenants and redemption provisions. The amended complaint seeks, among other things, to enjoin the consummation of the Tender Offer and the Merger, or to rescind the Tender Offer and the Merger. The defendants have not yet been required to respond to the amended complaint. The action has been stayed pending resolution of the Berger action described below. Another 1989 purported stockholder class action, Berger, et al. v. Warner Communications Inc., et al., Index No. 91-3735, filed in the New York Supreme Court against WCI, certain of WCI's directors, the Company, Wasserstein Perella, Shearson Lehman and Lazard Freres & Co. ("Lazard") alleges, among other things, that WCI's directors and the Company breached their fiduciary duties to WCI's stockholders by structuring the Merger as a freezeout of WCI's minority stockholders, and by failing to ensure that the securities to be distributed to stockholders in the Merger would in fact trade at the value imputed to those securities, and that Wasserstein Perella, Shearson Lehman and Lazard aided and abetted those breaches of fiduciary duty. The complaint seeks, among other things, a declaratory judgment that defendants have breached their fiduciary duties, compensatory damages and a judgment declaring the Merger a nullity. On April 9, 1991, a court order effected defendants' stipulation to the certification of a plaintiff class consisting of those persons who held shares of WCI common stock on August 23, 1989 and before the effective date of the Merger, except defendants in this litigation and any person or entity related to or affiliated with any defendants. Argument on both sides' motions for partial summary judgment on plaintiffs' contract claim for additional interest of approximately $20 million in connection with the consideration paid in the merger transaction was heard on February 22, 1994. Another purported stockholder class action, Silverstein v. Warner Communications Inc., et al., Civ. Action No. 11285, was filed in 1989 in the Delaware Chancery Court against WCI, members of its Board of Directors and the Company. The complaint alleges, among other things, violations of fiduciary duties to WCI stockholders by allegedly "forcing out" WCI's stockholders upon consummation of the Merger at an unfair price without according them a meaningful vote or the right to an appraisal proceeding. The complaint seeks rescission or rescissory and other damages in an unspecified amount. In August 1991, the court signed a stipulation of the parties staying the Silverstein action and the Warner Stockholder Litigation pending resolution of the Berger action. The parties have agreed to dismiss this action without prejudice and without compensation to the plaintiffs or their attorneys. An order effectuating that agreement was approved by the court on March 28, 1994. I-40 Two class actions consolidated under the caption In re Time Warner Inc. Securities Litigation, Master Case No. 91 Civ. 4081, brought purportedly on behalf of holders of the Company's Common Stock, were filed in June 1991 in the United States District Court for the Southern District of New York against the Company and several of its directors. Plaintiffs allege that defendants issued materially false and misleading statements regarding possible strategic alliances and failed to disclose the Company's intention to make the Rights Offering Proposal of June 5, 1991, whereby each holder of the Company's Common Stock was granted a specific number of transferable subscription rights to purchase additional shares of the Company's Common Stock that could be exercised or sold under certain specified terms and conditions, in violation of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder and the state common law of fraud and negligent misrepresentation. Plaintiffs in both actions seek unspecified monetary damages. On May 29, 1992, the defendants' motion to dismiss these actions with prejudice was granted. On November 30, 1993, a panel of the United States Court of Appeals for the Second Circuit, with one judge dissenting, reversed the dismissal and remanded the case to the District Court for further proceedings. On January 24, 1994, defendants filed a petition for a writ of certiorari in the U.S. Supreme Court. Plaintiffs filed briefs in opposition to the petition and in support of a conditional cross-petition on or about February 23, 1994, and defendants have filed reply papers. On March 3, 1994, defendants also filed a motion for summary judgment in the District Court. The District Court has stayed all proceedings pending a determination by the Supreme Court on the certiorari petitions. Two identical lawsuits under the name of Ferne Glanzrock, Bernice Berger, Charles Elder and Arthur Schecter v. Steven J. Ross et al., that were filed in March 1992, in the New York Supreme Court and in the Delaware Chancery Court against the Company's Board of Directors relating to certain payments to the Company's former President and Co-Chief Executive Officer N.J. Nicholas Jr. in connection with his termination of employment were dismissed without prejudice by Court order on January 26, 1994 pursuant to a stipulation of the parties. On January 24, 1994, a purported class action entitled Dr. Arun Shingala v. Gerald M. Levin, et al., Civil Action No. 13356, was filed against the Company and its directors in the Court of Chancery of the State of Delaware, New Castle County, on behalf of all stockholders of the Company, other than defendants and their related or affiliated entities. The complaint alleges that the defendant directors acting on behalf of the Company have adopted a plan ("rights plan") to thwart any attempt to take over control of the Company which the defendants find unfavorable to their personal interests. Plaintiff contends that defendants' actions are in violation of their fiduciary duties and seeks a judgment rescinding the adoption of the rights plan and ordering the director defendants jointly and severally to account for all damages which reasonably flow from the actions and transactions alleged. In November 1992, TWE filed a federal lawsuit seeking to overturn major provisions of the 1992 Cable Act primarily on First Amendment grounds. The complaint, filed in the U.S. District Court for the District of Columbia against the FCC and the United States of America, challenges the provisions of the 1992 Cable Act relating to rate regulation, must carry, retransmission consent, terms of dealing by vertically integrated programmers, uniform pricing and operation of cable systems by municipal authorities, the number of subscribers that a cable operator could serve nationwide, free previews of certain premium channels and educational channel set-aside requirements for direct broadcast satellite service. In addition, the complaint seeks to overturn several parts of the 1984 Cable Act relating to public, educational and government access requirements and commercial leased channels. The complaint seeks injunctions against the enforcement or implementation of these provisions. Several other parties have also filed similar lawsuits and these actions have been at least partially consolidated with the action filed by TWE. Hearings on the plaintiffs' motions for summary judgment and the defendants' motions to dismiss or for summary judgment were held in March 1993. On April 8, 1993, in a 2-1 decision, the District Court upheld the constitutionality of the must carry provisions of the 1992 Cable Act. On May 3, 1993, TWE filed an appeal from this decision directly to the U.S. Supreme Court. The U.S. Supreme Court heard argument on that appeal in January 1994. On September 16, 1993, a one-judge District Court upheld the constitutionality on First Amendment grounds of all the other challenged provisions except restrictions on the number of subscribers that a cable operator could serve I-41 nationwide, free pay TV previews and direct broadcast channel usage. TWE appealed this decision to the U.S. Court of Appeals for the D.C. Circuit on November 12, 1993. For a description of the 1984 Cable Act and the 1992 Cable Act, see Item 1 "Business--Cable Division--Regulation and Legislation." By letters dated July 15, 1993 and September 21, 1993 (the "Access Letters"), the Dallas Regional Office of the Federal Trade Commission (the "FTC") informed WEA that it is conducting a preliminary investigation to determine whether WEA is "unreasonably restricting the resale of previously-owned compact discs" and "unreasonably restricting the sale of new compact discs." The Access Letters allege that WEA's conduct may violate Section 5 of the Federal Trade Commission Act, but also say that neither the Access Letters nor the existence of the investigation "should be viewed as an accusation by the FTC or its staff of any wrongdoing by [WEA]." The Access Letters request that WEA voluntarily submit the documents and information requested therein. The FTC investigation also includes other major distributors of recorded music. WEA is cooperating with the investigation. On July 19, 1993, Wherehouse Entertainment, Inc., a California corporation engaged in the retail sale of music cassettes and compact discs ("CDs"), filed an action in the United States District Court for the Central District of California entitled Wherehouse Entertainment, Inc. v. CEMA Distribution, Sony Music Distribution, UNI Distribution Corporation and Warner Elektra Atlantic Corporation, No. 93-4253 SVW, alleging that, by implementing policies restricting the advertising allowances of customers that sell used CDs, the defendants have violated Section 1 of the Sherman Act, Sections 2(d) and 2(e) of the Robinson-Patman Act and Section 17200 of the California Business & Professions Code. Plaintiff sought injunctive relief, treble damages pursuant to Section 4 of the Clayton Act, attorneys' fees and costs of suit. On October 20, 1993, plaintiff and WEA settled this case on terms not material to the business of either WEA or WCI. Also in July 1993, two purported class actions against the same defendants in the Wherehouse litigation were filed in the United States District Court for the Northern District of Ohio and in the United States District Court for the Central District of California, containing substantially the same allegations and seeking substantially the same relief as the complaint in the Wherehouse case. Both class action suits have been settled by agreements that are currently before the courts for approval. In October 1993, a purported class action was filed in the United States District Court for the Northern District of Georgia entitled Samuel B. Moore, et al. v. American Federation of Television and Radio Artists, et al., No. 93- CV-2358. The action was brought by fifteen named music performers or representatives of deceased performers on behalf of an alleged class of performers who participated in the creation or production of phonograph recordings for one or more of the defendant recording companies. The named defendants include the American Federation of Television and Radio Artists ("AFTRA"), the AFTRA Health and Retirement Fund ("Fund"), each present trustee of the Fund and fifty named recording companies, including four WCI subsidiaries. The named defendant recording companies comprise substantially all of the domestic recording industry and the complaint seeks to establish a defendant class for purposes of the litigation. The complaint seeks recovery against the recording companies for, among other things, breach of contract, breach of fiduciary duty, fraud, embezzlement and RICO violations, all growing out of alleged failure by the recording companies to make proper contributions to the Fund pursuant to the Phono Code, which is negotiated by AFTRA and most of the domestic recording companies, and other alleged failures to meet the terms of the Phono Code and individual contracts. Plaintiffs seek from the defendant record companies substantial monetary damages, treble damages, attorneys' fees and costs and the imposition of a constructive trust over the master recordings created from recorded performances of the plaintiffs. In March 1994, plaintiffs filed an amended complaint. Plaintiffs also have filed a motion for a preliminary injunction against AFTRA and the Fund's trustees seeking, among other things, to enjoin the completion of audits of the amount of contributions to be made to the Fund and ongoing collective bargaining negotiations between AFTRA and the record companies, as well as the removal of the Fund's present trustees. The defendant record companies, along with AFTRA and the Fund, have filed papers in opposition to the motion for a preliminary injunction. The time for the record companies to respond to plaintiffs' amended complaint has not yet expired. I-42 The Company and its subsidiaries are also subject to industry investigations by certain government agencies and/or proceedings under the antitrust laws that have been filed by private parties in which, in some cases, other companies in the same or related industries are also defendants. The Company and its subsidiaries have denied or will deny liability in all of these actions. In all but a few similar past actions, the damages, if any, recovered from the Company or the amounts, if any, for which the actions were settled were small or nominal in relation to the damages sought; and it is the opinion of the management of the Company that any settlements or adverse judgments in the similar actions currently pending will not involve the payment of amounts or have other results that would have a material adverse effect on the financial condition of the Company. In addition, WCI and certain of its current and former directors are parties to lawsuits previously disclosed in WCI's annual reports or other filings which, among other things, challenge as excessive certain executive compensation arrangements between WCI and, among others, Steven J. Ross, formerly Chairman of the Board of WCI. The parties have executed a stipulation of settlement of these actions and on March 15, 1994 the New York Supreme Court approved a Notice of Proposed Settlement to be sent to shareholders and set May 13, 1994 as the date for the settlement hearing. ITEM 4.	ITEM 4. Submission of Matters to a Vote of Security Holders Not Applicable. I-43 EXECUTIVE OFFICERS OF THE COMPANY Pursuant to General Instruction G (3), the information regarding the Company's executive officers required by Item 401(b) of Regulation S-K is hereby included in Part I of this report. The following table sets forth the name of each executive officer of the Company, the office held by such officer and the age, as of February 28, 1994, of such officer: Set forth below are the positions held by each of the executive officers named above since March 1, 1989: Mr. Levin.................. Chairman of the Board of Directors, President and Chief Executive Officer since January 21, 1993. Prior to that he served as President and Co-Chief Executive Officer from February 20, 1992; Vice Chairman and Chief Operating Officer from May 1991; and Vice Chairman of the Board prior to that. Mr. Munro.................. Chairman of the Executive/Finance Committee of the Board of Directors since January 1993 (at which time the functions of the Executive Committee and the Finance Committee were merged), having served as Chairman of the Executive Committee since May 8, 1990. Prior to that, he was Co-Chairman of the Board and Co-Chief Executive Officer from July 1989 and he served as Chairman and Chief Executive Officer prior to that. Mr. Wasserman.............. Executive Vice President and Chief Financial Officer since January 10, 1990. Prior to that, he was a member of the Office of the President and Chief Financial Officer of WCI. Mr. Haje................... Executive Vice President and General Counsel since October 1, 1990. Prior to that, he was a member of the law firm of Paul, Weiss, Rifkind, Wharton & Garrison. Mr. Boggs.................. Senior Vice President, Public Policy since November 19, 1992. Prior to that he served as Vice President of Public Affairs from January 1990 and Vice President of Public Affairs of WCI prior to that. Mr. Haas................... Senior Vice President and Controller since January 18, 1990. Prior to that, he served as Senior Vice President and Controller of WCI. Mr. Holmes................. Senior Vice President, Technology since January 21, 1993. Prior to that, he served as Senior Vice President from January 10, 1990 and as Senior Vice President of WCI prior to that. I-44 Mr. Hullin................. Senior Vice President, Communications and Public Affairs since February 7, 1991. Prior to that, he served as Senior Vice President, Corporate Affairs of SmithKline Beecham (diversified health care company) from July 1989 and as Vice President, Communications and Public Affairs prior to that. Mr. Lochner................ Senior Vice President since July 18, 1991. Prior to that, he was a Commissioner of the Securities and Exchange Commission from March 1990 to June 1991. Prior to his tenure with the SEC, Mr. Lochner served as Deputy General Counsel and Senior Vice President of Time Warner from January to March 1990 and General Counsel, Senior Vice President and Secretary prior to that. I-45 PART II ITEM 5.	ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The principal market for the Company's Common Stock is the New York Stock Exchange. The Common Stock is also listed on the Pacific Stock Exchange and the London Stock Exchange. For quarterly price information with respect to the Company's Common Stock for the two years ended December 31, 1993, see "Quarterly Financial Information" at page herein, which information is incorporated herein by reference. The approximate number of holders of record of the Company's Common Stock as of March 1, 1994 was 23,000. For information on the frequency and amount of dividends paid with respect to the Company's Common Stock during the two years ended December 31, 1993, see "Quarterly Financial Information" at page herein, which information is incorporated herein by reference. ITEM 6.	ITEM 6. SELECTED FINANCIAL DATA The selected financial information of the Company for the five years ended December 31, 1993 is set forth at pages and herein and is incorporated herein by reference. ITEM 7.	ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information set forth under the caption "Management's Discussion and Analysis" at pages through herein is incorporated herein by reference. ITEM 8.	ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The consolidated financial statements and supplementary data of the Company and the report of independent auditors thereon set forth at pages through and herein are incorporated herein by reference. Quarterly Financial Information set forth at page herein is incorporated herein by reference. ITEM 9.	ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not Applicable. II-1 PART III ITEMS 10, 11, 12 AND 13. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT; EXECUTIVE COMPENSATION; SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT; CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information called for by PART III (Items 10, 11, 12 and 13) is incorporated by reference from the Company's definitive Proxy Statement to be filed in connection with its 1994 Annual Meeting of Stockholders pursuant to Regulation 14A, except that the information regarding the Company's executive officers called for by Item 401(b) of Regulation S-K has been included in PART I of this report and the information called for by Items 402(k) and 402(l) of Regulation S-K is not incorporated by reference. III-1 PART IV ITEM 14.					ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) (1)-(2) Financial Statements and Schedules: (i) The list of consolidated financial statements and schedules set forth in the accompanying Index to Consolidated Financial Statements and Other Financial Information at page herein is incorporated herein by reference. Such consolidated financial statements and schedules are filed as part of this report. (ii) The financial statements and financial statement schedules of Paragon Communications and the report of independent accountants thereon, set forth at pages through in the 1993 Annual Report on Form 10-K of Time Warner Entertainment Company, L.P. (Reg. No. 33-53742) are incorporated herein by reference and are filed as an exhibit to this report. (3) Exhibits: The exhibits listed on the accompanying Exhibit Index are filed or incorporated by reference as part of this report and such Exhibit Index is incorporated herein by reference. Exhibits 10.1 through 10.20 listed on the accompanying Exhibit Index identify management contracts or compensatory plans or arrangements required to be filed as exhibits to this report, and such listing is incorporated herein by reference. (b) No reports on Form 8-K were filed by Time Warner during the quarter ended December 31, 1993. IV-1 SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED. Time Warner Inc. /s/ Bert W. Wasserman By ................................... BERT W. WASSERMAN EXECUTIVE VICE PRESIDENT AND CHIEF FINANCIAL OFFICER Date: March 30, 1994 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/ Gerald M. Levin Director, Chairman of the March 30, 1994 ............................ Board, President and Chief (GERALD M. LEVIN) Executive Officer /s/ Bert W. Wasserman Executive Vice President and March 30, 1994 ............................ Chief Financial Officer (BERT W. WASSERMAN) (principal financial officer) /s/ David R. Haas Senior Vice President and March 30, 1994 ............................ Controller (principal (DAVID R. HAAS) accounting officer) * Director March 30, 1994 ............................ (MERV ADELSON) * Director March 30, 1994 ............................ (LAWRENCE B. BUTTENWIESER) * Director March 30, 1994 ............................ (HUGH F. CULVERHOUSE) * Director March 30, 1994 ............................ (EDWARD S. FINKELSTEIN) * ............................ Director March 30, 1994 (BEVERLY SILLS GREENOUGH) IV-2 SIGNATURE TITLE DATE --------- ----- ---- * ............................. Director March 30, 1994 (CARLA A. HILLS) * ............................. Director March 30, 1994 (DAVID T. KEARNS) * ............................. Director March 30, 1994 (HENRY LUCE III) * ............................. Director March 30, 1994 (REUBEN MARK) * ............................. Director March 30, 1994 (J. RICHARD MUNRO) * ............................. Director March 30, 1994 (RICHARD D. PARSONS) * ............................. Director March 30, 1994 (DONALD S. PERKINS) * ............................. Director March 30, 1994 (RAYMOND S. TROUBH) * ............................. Director March 30, 1994 (FRANCIS T. VINCENT, JR.) /s/ David R. Haas By: ........................ ATTORNEY-IN-FACT IV-3 TIME WARNER INC. AND TIME WARNER ENTERTAINMENT COMPANY, L.P. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND OTHER FINANCIAL INFORMATION All other financial statements and schedules are omitted because the required information is not present, or is not present in amounts sufficient to require submission of the financial statements or schedules, or because the information required is included in the consolidated financial statements and notes thereto. TIME WARNER INC. CONSOLIDATED BALANCE SHEET DECEMBER 31, (MILLIONS, EXCEPT PER SHARE AMOUNTS) - -------- (a)The 1993 financial statements reflect the deconsolidation of the Entertainment Group, principally TWE, effective January 1, 1993. The historical financial statements for periods prior to such date have not been changed; however, financial statements for the year ended December 31, 1992 retroactively reflecting the deconsolidation are presented as supplementary information under the column heading "restated" to facilitate comparative analysis (Note 1). (b)Time Warner issued $6.1 billion of long-term debt and used $.5 billion of cash and equivalents in 1993 in exchange for or to redeem preferred stock having an aggregate liquidation preference of $6.4 billion (Notes 5 and 7). See accompanying notes. TIME WARNER INC. CONSOLIDATED STATEMENT OF OPERATIONS YEARS ENDED DECEMBER 31, (MILLIONS, EXCEPT PER SHARE AMOUNTS) (d)Includes $70 million unusual charge for increase in deferred income tax liability as a result of new tax law. (e)Time Warner issued $6.1 billion of long-term debt and used $.5 billion of available cash and equivalents in 1993 in exchange for or to redeem preferred stock having an aggregate liquidation preference of $6.4 billion (Notes 5 and 7). See accompanying notes. TIME WARNER INC. CONSOLIDATED STATEMENT OF CASH FLOWS YEARS ENDED DECEMBER 31, (MILLIONS) - -------- (a)The 1993 financial statements reflect the deconsolidation of the Entertainment Group, principally TWE, effective January 1, 1993. The historical financial statements for periods prior to such date have not been changed; however, financial statements for the year ended December 31, 1992 retroactively reflecting the deconsolidation are presented as supplementary information under the column heading "restated" to facilitate comparative analysis (Note 1). (b)Includes $70 million increase in deferred income tax liability as a result of new tax law and $57 million extraordinary loss on the retirement of debt. See accompanying notes. TIME WARNER INC. CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY (MILLIONS, EXCEPT PER SHARE AMOUNTS) See accompanying notes. TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1.SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF CONSOLIDATION AND ACCOUNTING FOR INVESTMENTS IN AFFILIATED COMPANIES The consolidated financial statements include the accounts of Time Warner Inc. and its subsidiaries ("Time Warner"). Significant intercompany accounts and transactions are eliminated. Interests in consolidated subsidiaries not owned by Time Warner are eliminated from operating results and reflected in the balance sheet as minority interests. Investments in companies in which Time Warner has significant influence but less than controlling financial interest are stated at cost plus equity in the affiliates' undistributed earnings. The excess of cost over the underlying net equity of investments in affiliated companies is attributed to the underlying net assets based on their respective fair values and amortized over their respective economic lives. Time Warner Entertainment Group ("Entertainment Group"), consisting of Time Warner's interests in certain entertainment companies, principally Time Warner Entertainment Company, L.P. ("TWE"), was deconsolidated effective January 1, 1993 as a result of an agreement between TWE and U S WEST, Inc. ("USW") to co- manage TWE Cable's Full Service Networks(TM), subject to franchise and regulatory approvals, and certain other changes to the partnership agreement relating to the general governance of TWE (Note 2). The historical financial statements of Time Warner for periods prior to January 1, 1993 have not been changed; accordingly, they include TWE and other Entertainment Group interests on a consolidated basis. However, financial statements for the year ended December 31, 1992 retroactively reflecting the deconsolidation of the Entertainment Group also are presented under the caption "restated" to facilitate comparative analysis. The effect of changes in Time Warner's ownership interests resulting from the issuance of equity capital to third parties by consolidated subsidiaries or affiliates accounted for on the equity basis is included in income. Time Warner's $14 billion cost to acquire Warner Communications Inc. ("WCI") was allocated to the net assets acquired as of December 31, 1989 in accordance with the purchase method of accounting for business combinations. The acquisition was financed principally by $8.3 billion of long-term debt and $5.6 billion of Series C and Series D preferred stock, which was redeemed or exchanged for debt in 1993 (Notes 5 and 7). The effect of the four-for-one common stock split on September 10, 1992 has been reflected retroactively. REVENUES AND COSTS The unearned portion of paid subscriptions is deferred until magazines are delivered to subscribers. Upon each delivery, a proportionate share of the gross subscription price is included in revenues. Inventories of magazines, books, cassettes and compact discs are stated at the lower of cost or estimated realizable value. Cost is determined using first-in, first-out; last-in, first-out; and average cost methods. In accordance with industry practice, certain products are sold to customers with the right to return unsold items. Revenues from such sales represent gross sales less a provision for future returns. Returned goods included in inventory are valued at estimated realizable value but not in excess of cost. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment are stated at cost. Depreciation is provided generally on the straight-line method over useful lives ranging up to twenty- five years for buildings and improvements and up to fifteen years for furniture, fixtures and equipment. TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) INTANGIBLE ASSETS Intangible assets are amortized over periods up to forty years using the straight-line method. Amortization of the excess of cost over net assets acquired amounted to $148 million, $257 million ($142 million on a restated basis) and $246 million in 1993, 1992 and 1991, respectively, and amortization of music copyrights, artists' contracts and record catalogues amounted to $113 million in all years. Amortization of cable television franchises in 1992 and 1991, years in which the Entertainment Group was consolidated, amounted to $194 million and $171 million, respectively. Accumulated amortization of intangible assets at December 31, 1993 and 1992 amounted to $1.245 billion and $2.021 billion ($943 million on a restated basis), respectively. FOREIGN CURRENCY TRANSLATION The financial position and operating results of substantially all foreign operations are consolidated using the local currency as the functional currency. Local currency assets and liabilities are translated at the rates of exchange on the balance sheet date, and local currency revenues and expenses are translated at average rates of exchange during the period. Resulting translation gains or losses, which have not been material, are included in retained earnings (accumulated deficit). Foreign currency transaction gains and losses, which have not been material, are included in operating results. INCOME TAXES Income taxes are provided in 1993 and 1992 using the liability method prescribed by Financial Accounting Standards Board ("FASB") Statement No. 109, "Accounting for Income Taxes," which Time Warner adopted as of January 1, 1992. Income taxes provided in 1991 using the liability method prescribed by FASB Statement No. 96 were not restated. The effect of the change in accounting method was not material. Under the liability method, deferred income taxes reflect tax carryforwards and the net tax effects of temporary differences between the carrying amount of assets and liabilities for financial statement and income tax purposes, as determined under enacted tax laws and rates. The financial effect of changes in tax laws or rates is accounted for in the period of enactment. Realization of the net operating loss and investment tax credit carryforwards, which were acquired in acquisitions, are accounted for as a reduction of the excess of cost over net assets acquired. The principal operations of the Entertainment Group are conducted by partnerships. Income tax expense includes all income taxes related to Time Warner's allocable share of partnership income and its equity in the income tax expense of corporate subsidiaries of the partnerships. FINANCIAL INSTRUMENTS Investments in unrestricted marketable equity securities not accounted for on the equity basis are stated at fair value. Unrealized appreciation is reported net-of-tax in a separate component of shareholders' equity in accordance with FASB Statement No. 115, "Accounting for Certain Investments in Debt and Equity Securities," which Time Warner adopted as of December 31, 1993. Foreign exchange contracts are used to reduce exchange rate exposure on future cash flows and earnings denominated in foreign currencies. Contract gains and losses generally are included in income. Time Warner had contracts for the sale of $573 million of foreign currencies at fixed rates at December 31, 1993, primarily Japanese yen, German marks, Canadian dollars and French francs. The fair value of foreign exchange contracts approximates carrying value. Time Warner reimburses or is reimbursed by TWE for contract gains or losses related to TWE's exposure. TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Interest rate swap agreements are used to reduce exposure to interest rate changes and to lower the overall costs of borrowing. The net amounts paid and received under open contracts are included in interest expense. At December 31, 1993, Time Warner had contracts to pay floating rates of interest (average rate of 3.7%) and receive fixed rates of interest (average rate of 5.4%) on $2.1 billion notional amount of indebtedness over an average remaining term of 4 years. The fair value of the Company's debt and related interest rate swap agreements will fluctuate with changes in the credit markets, including changes in the level of interest rates. At December 31, 1993, the fair value of Time Warner's long-term debt was estimated to exceed its carrying value by $530 million. The fair value of the related interest rate swap agreements was not material. Fair value is generally determined by reference to market values resulting from trading on a national securities exchange or in an over-the-counter market. LOSS PER COMMON SHARE Loss per common share is based upon the net loss applicable to common shares after preferred dividend requirements and upon the weighted average of common shares outstanding during the period. The conversion of securities convertible into common stock and the exercise of stock options were not assumed in the calculations of loss per common share because the effect would have been antidilutive. 2.ENTERTAINMENT GROUP Time Warner's investment in and amounts due to and from the Entertainment Group at December 31, 1993 consists of the following (millions): TWE is a Delaware limited partnership that was capitalized on June 30, 1992 to own and operate substantially all of the Filmed Entertainment, Programming- HBO and Cable businesses previously owned by subsidiaries of Time Warner. At December 31, 1993, the Time Warner subsidiaries ("General Partners") held a 63.27% pro rata priority capital partnership interest in TWE in the initial capital amount of $3.5 billion, plus partnership income allocated thereto; a partnership capital interest senior to the pro rata priority capital interests ("General Partners' Senior Capital"), in the initial capital amount of $1.4 billion, plus partnership income allocated thereto; a partnership capital interest junior to pro rata priority capital interests ("General Partners' Junior Capital") in the initial capital amount of $2.7 billion, plus partnership income allocated thereto; and a 63.27% residual equity partnership interest. The limited partners, subsidiaries of USW, ITOCHU Corporation ("ITOCHU") and Toshiba Corporation ("Toshiba"), held 25.51%, 5.61% and 5.61% pro rata priority capital partnership interests, respectively, in the initial capital amounts of $1.4 billion, $313 million and $313 million, respectively, plus partnership income allocated thereto; and residual equity partnership interests of 25.51%, 5.61% and 5.61%, respectively. General Partners' Senior Capital is required to be distributed no later than in three annual installments beginning July 1, 1997; earlier distributions may be made under certain circumstances. General Partners' Junior Capital may be increased if certain performance targets are achieved between 1992 and 2001. Prior to the admission of USW on September 15, 1993, the General Partners held 87.5% pro rata priority capital and residual equity partnership interests in TWE, and the General Partners' Junior Capital interest; and ITOCHU and Toshiba each held 6.25% pro rata priority capital and residual equity partnership interests. TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) At the initial capitalization of TWE, the General Partners contributed the assets and liabilities or the rights to the cash flow of substantially all of Time Warner's Filmed Entertainment, Programming-HBO and Cable businesses, and ITOCHU and Toshiba each contributed $500 million of cash. On September 15, 1993, USW contributed $1.532 billion of cash and a $1.021 billion 4.4% note ("USW Note") for its interests. USW has an option to increase its pro rata priority capital and residual equity interests to as much as 31.84%, depending on cable operating performance. The option is exercisable between January 1, 1999 and on or about May 31, 2005 at a maximum exercise price of $1.25 billion to $1.8 billion, depending on the year of exercise. Either USW or TWE may elect that the exercise price be paid with partnership interests rather than cash. Each of ITOCHU and Toshiba have options to increase their interests to as much as 6.25% in certain circumstances, payable in cash. Each General Partner has guaranteed a pro rata portion of $7 billion of TWE's debt and accrued interest at December 31, 1993, based on the relative fair value of the net assets each General Partner contributed to TWE. Such indebtedness is recourse to each General Partner only to the extent of its guarantee. In addition to their interests in TWE and the other Entertainment Group companies, the assets of the General Partners include the equivalent of 29.6 million common shares of Turner Broadcasting System, Inc., 12.1 million common shares of Hasbro, Inc., 43.7 million common shares of Time Warner, and substantially all the assets of Time Warner's music business. There are no restrictions on the ability of the General Partner guarantors to transfer assets, other than TWE assets, to parties that are not guarantors. The summarized financial information for the Entertainment Group set forth below reflects the consolidation of Six Flags Entertainment Corporation ("Six Flags") as of January 1, 1993 as a result of the increase in TWE's ownership from 50% to 100% in September 1993. The historical financial information for periods prior to such date has not been changed; however, financial information for the year ended December 31, 1992 retroactively reflecting the consolidation is presented as supplementary information under the column heading "restated" to facilitate comparative analysis. TIME WARNER ENTERTAINMENT GROUP TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Pursuant to the TWE partnership agreement, partnership income, to the extent earned, is first allocated to the partners so that the economic burden of the income tax consequences of partnership operations is borne as though the partnership were taxed as a corporation ("special tax allocations"), then to the priority capital interests, in order of priority, at rates of return ranging from 8% to 13.25% per annum, and finally to the residual equity interests. For the purpose of the foregoing allocations, partnership income is based on the fair value of assets contributed to the partnership, and differs from net income of TWE, which is based on the historical cost of contributed assets. Partnership losses generally are allocated first to eliminate prior allocations of partnership income to, and then to reduce the initial capital amounts of, the residual equity, General Partners' Junior Capital and pro rata priority capital interests, in that order, then to reduce General Partners' Senior Capital, including partnership income allocated thereto, and finally to reduce any special tax allocations. TWE reported net income of $198 million and $160 million in 1993 and 1992, respectively, no portion of which was allocated to the limited partners. Time Warner did not recognize a gain when TWE was capitalized. The excess of the General Partners' interest in the net assets of TWE over the net book value of their investment in TWE is being amortized to income over a twenty year period at the rate of $17 million per year prior to the admission of USW, and $72 million per year thereafter. The assets and cash flows of TWE are restricted by the TWE partnership and credit agreements and are unavailable for use by the partners except through the payment of certain fees, reimbursements, cash distributions and loans, which are subject to limitations. At December 31, 1993, the General Partners had recorded $276 million of tax related distributions due from TWE, $108 million of which is receivable on or after July 1, 1994, and $271 million of stock option related distributions due from TWE, based on a closing price of $44.25, receivable when the options are exercised. In addition to the tax, stock option and General Partners' Senior Capital distributions, TWE may make other distributions, generally depending on excess cash and credit agreement limitations. The General Partners' full share of such distributions may be deferred if the limited partners do not receive certain threshold amounts by certain dates. TWE may loan Time Warner up to $1.1 billion, increasing up to $1.5 billion on July 1, 1995. Generally, TWE must be in compliance with its credit agreement at the time distributions and loans are made. In the normal course of conducting their businesses, Time Warner and its subsidiaries and affiliates have had various transactions with TWE and other Entertainment Group companies, generally on terms resulting from a negotiation between the affected units that in management's view results in reasonable allocations. Time Warner provides TWE with certain corporate support services for which it receives an annual fee of $60 million. Inventories of TWE at December 31, 1993 and 1992 include $821 million and $879 million, respectively, of unamortized cost of the WCI acquisition allocated to the film library, which is amortized on a straight-line basis over twenty years, $1.085 billion and $982 million, respectively, of the unamortized cost of completed films, more than 90% of which is expected to be amortized within three years after release under the TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) individual film-forecast method prescribed by FASB Statement No. 53, "Financial Reporting by Producers and Distributors of Motion Picture Films," $347 million and $285 million, respectively, of theatrical films and television programs in process, and $405 million and $457 million, respectively, of unamortized programming acquired or produced for pay cable television exhibition, which is allocated to availability periods and amortized as the programming is exhibited. On June 26, 1992, Time Warner acquired the 18.7% minority interest in American Television and Communications Corporation ("ATC") by issuing redeemable reset notes due August 15, 2002 (Note 5), valued at such date at $1.3 billion. The acquisition was accounted for by the purchase method of accounting. ATC subsequently contributed its cable assets to TWE. The Entertainment Group would have reported net income of $142 million and Time Warner would have reported net income of $47 million (a loss of $1.57 per common share after preferred dividends) in 1992 if the acquisition of the ATC minority interest had occurred at the beginning of that year. 3. OTHER INVESTMENTS Time Warner's other investments consist of: - -------- (1) Upon adoption of FASB Statement No. 115 at December 31, 1993, unrestricted marketable equity securities not accounted for on the equity basis are stated at fair value. The 1993 amount includes the market value of 12.058 million shares of common stock of Hasbro, Inc., which can be used, at Time Warner's option, to satisfy its obligations with respect to the zero coupon exchangeable notes due 2012 (Note 5). Investments in unrestricted marketable equity securities not accounted for on the equity basis were carried at a cost of $297 million and had a market value of $481 million at December 31, 1992. Companies accounted for on the equity basis other than TWE and its equity affiliates include Turner Broadcasting System, Inc. ("TBS") (19.4% owned); Cinamerica Theatres, L.P. (50% owned) and The Columbia House Company partnerships (50% owned) and other music joint ventures (generally 50% owned). Equity affiliates of TWE include Paragon Communications (50% owned), certain other cable system joint ventures (generally 50% owned) and Comedy Partners (50% owned). A summary of financial information of equity affiliates (100% basis) is set forth below. TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The market value and cost of Time Warner's investment in TBS at December 31, 1993 was $1.484 billion and $493 million, respectively. The sale, transfer or other disposition of substantially all of the shares of TBS capital stock is restricted pursuant to shareholder agreements. The TBS securities also may be considered restricted securities under the Securities Act of 1933 and, if so, could only be sold pursuant to an effective registration statement or in a transaction exempt from the registration requirements of the Securities Act of 1933. 4.INVENTORIES Time Warner's current inventories consist of: 5.LONG-TERM DEBT Long-term debt consists of: - -------- (1) Classified as long-term because of the intent and ability to refinance under a long-term financing arrangement with TWE. Time Warner issued $6.126 billion of long-term debt and used $494 million of cash and equivalents in 1993 in connection with the redemption and exchange of preferred stock having an aggregate liquidation value of $6.368 billion (Note 7). TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The redeemable reset notes due August 15, 2002 do not pay interest prior to August 15, 1995, the first redemption date, at which time an interest rate will be set. The interest rate will be reset on August 15, 1998, the second redemption date. The notes are redeemable at par on each redemption date, payable in any combination of cash and debt securities, if Time Warner elects to redeem the notes, or in any combination of cash or equity or debt securities of Time Warner or any other entity, if the holders elect to have the notes redeemed. Unamortized discount was $229 million and $358 million at December 31, 1993 and 1992, respectively. The zero coupon notes do not pay interest until maturity. The zero coupon exchangeable notes due December 17, 2012 are exchangeable at any time by the holder into 7.301 shares of common stock of Hasbro, Inc. ("Hasbro shares") per $1,000 principal amount, subject to Time Warner's right to pay in whole or in part with cash instead of Hasbro shares. Time Warner can elect to redeem the notes any time after December 17, 1997, and holders can elect to have the notes redeemed prior thereto in the event of a change of control, at the issue price plus accrued interest. Holders also can elect to have the notes redeemed at the issue price plus accrued interest on December 17, 1997, 2002 and 2007, subject to Time Warner's right to pay in whole or in part with Hasbro shares instead of cash. Unamortized discount was $1.137 billion and $1.168 billion at December 31, 1993 and 1992, respectively. The zero coupon convertible notes due June 22, 2013 are convertible at any time by the holder into 7.759 shares of Time Warner common stock. Time Warner can elect to redeem the notes any time after June 22, 1998, and holders can elect to have the notes redeemed prior thereto in the event of a change in control, at the issue price plus accrued interest. Holders also can elect to have the notes redeemed at the issue price plus accrued interest on June 22, 1998, 2003 and 2008, subject to Time Warner's right to pay in whole or in part with Time Warner common stock instead of cash. Unamortized discount was $1.492 billion at December 31, 1993. $3.125 billion of 8.75% convertible subordinated debentures due January 10, 2015 were issued in exchange for Series C convertible preferred stock in April 1993 (Note 7). $900 million of such debentures were redeemed in July 1993. The $2.225 billion of 8.75% convertible subordinated debentures outstanding at December 31, 1993 are convertible into 46.6 million shares of Time Warner common stock at the rate of $47.73 principal amount of indebtedness per common share and are redeemable at any time, in whole or in part, at Time Warner's option, at 105.25% of par until January 9, 1995, decreasing ratably each year thereafter to 100% of par on January 10, 2000. An after-tax cost of $57 million was incurred in connection with the redemption of debt in 1993, principally the redemption of $900 million of 8.75% convertible subordinated debentures and $529 million of WCI senior and subordinated debentures. Each General Partner has guaranteed a pro rata portion of $7 billion of TWE's debt and accrued interest at December 31, 1993, as more fully described in Note 2. When TWE was consolidated with Time Warner at December 31, 1992, TWE's debt consisted of $5.507 billion borrowed under its credit agreement (4.5% interest rate), $447 million of commercial paper (4.3% interest rate), $600 million of 9.625% senior notes due 2002, $350 million of 8.875% senior notes due 2012 and $250 million of 10.15% senior notes due 2012. TWE's credit agreement contains certain restrictive covenants relating to, among other things, additional indebtedness; cash flow coverage and leverage ratios; and loans, advances, distributions or other cash payments or transfers of assets to Time Warner and its subsidiaries. Interest expense amounted to $698 million in 1993, $729 million ($287 million on a restated basis) in 1992 and $912 million in 1991. TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Annual repayments of long-term debt for the five years subsequent to December 31, 1993 are: 1994-$375 million; 1995-$300 million; and 1998-$500 million. Such amounts exclude the aggregate repurchase or redemption prices of $1.801 billion in 1995, $656 million in 1997 and $1.151 billion in 1998 relating to the redeemable reset notes, zero coupon exchangeable notes and zero coupon convertible notes, respectively, in the years in which the holders of such debt may first exercise their redemption options. 6.INCOME TAXES Domestic and foreign pretax income (loss) are as follows: Current and deferred income taxes (tax benefits) provided are as follows: - -------- (1) Includes utilization of tax carryforwards of $136 million in 1993, $15 million in 1992 and $120 million in 1991. Excludes $14 million of current tax benefits resulting from the exercise of stock options in 1993, which were credited directly to paid-in-capital, and $6 million of current tax benefits resulting from the retirement of debt, which reduced the extraordinary loss. (2) Includes $70 million unusual charge in 1993 to increase deferred tax liability for increase in tax rate. (3) Includes foreign withholding taxes of $79 million in 1993, $57 million in 1992 and $43 million in 1991. TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The differences between income taxes expected at the U.S. federal statutory income tax rate and income taxes provided are as set forth below. The relationship between income before income taxes and income tax expense is most affected by the amortization of excess cost over net assets acquired and certain other financial statement expenses that are not deductible for income tax purposes and by a $70 million unusual charge ($.19 per common share) in 1993 to adjust the deferred income tax liability for the increase in the U.S. federal statutory rate from 34% to 35% enacted into law during the year. U.S. income and foreign withholding taxes have not been recorded on permanently reinvested earnings of foreign subsidiaries aggregating approximately $575 million at December 31, 1993. Determination of the amount of unrecognized deferred U.S. income tax liability with respect to such earnings is not practicable. If such earnings are repatriated, additional U.S. income and foreign withholding taxes are expected to be offset by the accompanying foreign tax credits. U.S. federal tax carryforwards at December 31, 1993 consisted of $52 million of net operating losses that expire from 1997 to 2003, $267 million of investment tax credits that expire from 1996 to 2004, and $27 million of alternative minimum tax credits that have no expiration dates. The utilization of certain carryforwards is subject to limitations under U.S. federal income tax laws. Significant components of Time Warner's net deferred tax liabilities are as follows: TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 7. CAPITAL STOCK In 1993, Time Warner redeemed its Series D convertible preferred stock for cash and exchanged its Series C convertible preferred stock for 8.75% convertible subordinated debentures due January 10, 2015. The Series D redemption was financed principally by the proceeds from the issuance of long- term notes and debentures (Note 5). Pursuant to a shareholder rights plan adopted in January 1994, Time Warner distributed one right per common share which becomes exercisable in certain events involving the acquisition of 15% or more of Time Warner common stock. Upon the occurrence of such an event, each right entitles its holder to purchase for $150 the economic equivalent of common stock of Time Warner, or in certain circumstances, of the acquiror, worth twice as much. In connection with the plan, 4 million shares of preferred stock were reserved. The rights expire on January 20, 2004. Time Warner issued 137.9 million shares of common stock at $20 per share at the completion of its rights offering on August 5, 1991. Net proceeds of $2.558 billion, after expenses and a $70 million loan to the Time Warner Employee Stock Ownership Plan, were used to reduce credit agreement debt. If the rights offering had been completed on January 1, 1991, net loss for the year ended December 31, 1991 would have been reduced to $33 million, or $1.70 per common share after preferred dividends. At December 31, 1993, Time Warner had reserved 66.2 million shares of common stock for the conversion of the 8.75% convertible subordinated debentures, zero coupon convertible notes and other convertible securities, and 73 million shares for the exercise of outstanding options to purchase shares of common stock. There were 45.2 million shares of common stock in treasury at December 31, 1993, of which 43.7 million were held by subsidiaries who are the General Partners of TWE. At January 31, 1994, there were approximately 23,000 holders of record of Time Warner common stock. 8. STOCK OPTION PLANS Options to purchase Time Warner common stock under various stock option plans have been granted to employees of Time Warner and TWE, generally at fair market value at the date of grant. Generally, the options become exercisable over a three-year vesting period and expire ten years from the date of grant. A summary of stock option activity under all plans is as follows: For options granted to employees of TWE, Time Warner is reimbursed for the amount by which the market value of Time Warner common stock on the exercise date exceeds the exercise price, or the greater of the exercise price or $27.75 for options granted prior to the TWE capitalization. There were 26.8 million options held by employees of TWE at December 31, 1993, 18.5 million of which were exercisable (Note 2). There were 933,000 options exercised in 1992 at prices ranging from $8-$28 per share, 512,000 options exercised in 1991 at prices ranging from $6-$29 per share, and 50.1 million options exercisable and 5.1 million options available for grant at December 31, 1992. TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 9. BENEFIT PLANS Time Warner and its subsidiaries have defined benefit pension plans covering substantially all domestic employees. Pension benefits are based on formulas that reflect the employees' years of service and compensation levels during their employment period. Qualifying plans are funded in accordance with government pension and income tax regulations. Plan assets are invested in equity and fixed income securities. Pension expense included the following: The status of funded pension plans is as follows: Employees of Time Warner's operations in foreign countries participate to varying degrees in local pension plans, which in the aggregate are not significant. Time Warner also has an employee stock ownership plan, 401(k) savings plans and profit sharing plans as to which the expense amounted to $46 million in 1993, $57 million ($41 million on a restated basis) in 1992 and $53 million in 1991. Contributions to the 401(k) plans are based upon a percentage of the employees' elected contributions. Contributions to the employee stock ownership plan are determined by management and approved by the Board of Directors. TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 10.SEGMENT INFORMATION Information as to the operations of Time Warner and the Entertainment Group in different business segments is set forth below: - -------- (1) Includes a $60 million restructuring charge ($36 million after taxes). TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) - -------- (1) Depreciation and amortization includes all amortization relating to the acquisition of WCI in 1989, the acquisition of the ATC minority interest in 1992 and other business combinations accounted for by the purchase method. Information as to the assets and capital expenditures of Time Warner and its Entertainment Group is as follows: - -------- (1) At December 31, 1993 and December 31, 1992 on a restated basis, Entertainment Group assets represent Time Warner's investment in and amounts due to and from Entertainment Group. At December 31, 1992 and 1991 on an historical basis, Entertainment Group assets represent total assets of the Entertainment Group, less certain assets related to transactions with other Time Warner companies. (2) Consists principally of cash and investments. TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Information as to Time Warner's operations in different geographical areas is as follows: - -------- (/1/) Includes Filmed Entertainment export revenues of $1.379 billion and $1.133 billion in 1992 and 1991, respectively. TIME WARNER INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 11.COMMITMENTS AND CONTINGENCIES Total rent expense amounted to $163 million in 1993, $258 million ($159 million on a restated basis) in 1992 and $236 million in 1991. The minimum rental commitments under noncancellable long-term operating leases are: 1994- $138 million; 1995-$125 million; 1996-$113 million; 1997-$104 million; 1998- $102 million and after 1998-$954 million. Minimum commitments and guarantees under certain licensing, artists and other agreements aggregated approximately $1.5 billion at December 31, 1993, which are payable principally over a seven-year period. Such amounts do not include the General Partner guarantees of approximately $7 billion of TWE debt. Pending legal proceedings are substantially limited to litigation incidental to the businesses of Time Warner and alleged damages in connection with class action lawsuits. In the opinion of counsel and management, the ultimate resolution of these matters will not have a material effect on the financial statements of Time Warner. 12.SUPPLEMENTAL INFORMATION Supplemental information with respect to cash flows is as follows: The noncash effects of the deconsolidation of the Entertainment Group are reflected in the differences between the historical and restated balance sheet amounts at December 31, 1992. Time Warner issued $3.125 billion of debentures in a noncash exchange for Series C preferred stock on April 1, 1993 (Note 5 and 7). The principal noncash effects of the acquisition of the ATC minority interest in 1992 were to increase investments by $156 million, cable television franchise costs by $865 million, excess of cost over net assets acquired by $410 million, deferred income taxes by $299 million and long-term debt by $1.312 billion, and to eliminate the ATC minority interest of $180 million. On a restated basis, the investments in and amounts due to and from Entertainment Group were increased $1.431 billion. Investment proceeds in 1992 on a restated basis include $875 million from the collection of a note receivable from TWE. Cash equivalents consist of commercial paper and other investments that are readily convertible into cash, and have original maturities of three months or less. Other current liabilities consist of: REPORT OF MANAGEMENT The accompanying consolidated financial statements have been prepared by management in conformity with generally accepted accounting principles, and necessarily include some amounts that are based on management's best estimates and judgments. Time Warner maintains a system of internal accounting controls designed to provide management with reasonable assurance that assets are safeguarded against loss from unauthorized use or disposition, and that transactions are executed in accordance with management's authorization and recorded properly. The concept of reasonable assurance is based on the recognition that the cost of a system of internal control should not exceed the benefits derived and that the evaluation of those factors requires estimates and judgments by management. Further, because of inherent limitations in any system of internal accounting control, errors or irregularities may occur and not be detected. Nevertheless, management believes that a high level of internal control is maintained by Time Warner through the selection and training of qualified personnel, the establishment and communication of accounting and business policies, and its internal audit program. The Audit Committee of the Board of Directors, composed solely of directors who are not employees of Time Warner, meets periodically with management and with Time Warner's internal auditors and independent auditors to review matters relating to the quality of financial reporting and internal accounting control, and the nature, extent and results of their audits. Time Warner's internal auditors and independent auditors have free access to the Audit Committee. Gerald M. Levin Bert W. Wasserman Chairman and Executive Vice President and Chief Executive Officer Chief Financial Officer REPORT OF INDEPENDENT AUDITORS THE BOARD OF DIRECTORS AND SHAREHOLDERS TIME WARNER INC. We have audited the accompanying consolidated balance sheet of Time Warner Inc. ("Time Warner") as of December 31, 1993 and 1992, and the related consolidated statements of operations, cash flows and shareholders' equity for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of Time Warner's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Time Warner at December 31, 1993 and 1992, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. ERNST & YOUNG New York, New York February 4, 1994 TIME WARNER INC. SELECTED FINANCIAL INFORMATION The selected financial information for each of the five years in the period ended December 31, 1993 set forth below has been derived from and should be read in conjunction with the financial statements and other financial information presented elsewhere herein. The selected historical financial information for 1993 reflects the deconsolidation of the Entertainment Group, principally TWE, effective January 1, 1993. The selected historical financial information for periods prior to such date have not been changed; however, selected financial information for 1992 retroactively reflecting the deconsolidation is presented as supplementary information under the column heading "restated" to facilitate comparative analysis. The selected historical financial information for 1993 reflects the issuance of $6.1 billion of long-term debt and the use of $.5 billion of cash and equivalents in 1993 for the exchange or redemption of preferred stock having an aggregate liquidation preference of $6.4 billion. The selected historical financial information for 1992 reflects the capitalization of TWE on June 30, 1992 and associated refinancings, and the acquisition of the 18.7% minority interest in American Television and Communications Corporation as of June 30, 1992, using the purchase method of accounting for business combinations. The selected historical financial information for 1989 reflects the acquisition of a 59.3% common stock interest in Warner Communications Inc. ("WCI") as of July 31, 1989, and the acquisition on January 10, 1990 of the remaining capital stock of WCI as of December 31, 1989, using the purchase method of accounting for business combinations. Per common share amounts and average common shares have been restated to give effect to the four-for-one common stock split that occurred on September 10, 1992. - -------- (a) The net loss for the year ended December 31, 1993 includes an extraordinary loss on the retirement of debt of $57 million ($.15 per common share) and an unusual charge of $70 million ($.19 per common share) from the effect of the new income tax law on Time Warner's deferred income tax liability. (b) The net loss for the year ended December 31, 1991 includes a $36 million after-tax charge ($.12 per common share) relating to the restructuring of the Publishing division. The net loss in 1989 includes an after-tax gain of $42 million ($.18 per common share) resulting primarily from the sale of 3.125 million shares of Columbia Pictures Entertainment, Inc. common stock and an after-tax loss of $120 million ($.51 per common share) from the sale of Scott, Foresman and Company. (c) In August 1991, Time Warner completed the sale of 137.9 million shares of common stock pursuant to a rights offering. Net proceeds of $2.558 billion from the rights offering were used to reduce indebtedness under Time Warner's bank credit agreement. If the rights offering had been completed at the beginning of 1991, net loss for the year would have been reduced to $33 million, or $1.70 per common share, and there would have been 369.3 million shares of common stock outstanding during the year. (d) After preferred dividend requirements. TIME WARNER INC. SELECTED FINANCIAL INFORMATION--(CONTINUED) TIME WARNER INC. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) - -------- (a) The 1993 financial statements reflect the deconsolidation of the Entertainment Group, principally TWE, effective January 1, 1993. The historical financial statements for periods prior to such date have not been changed; however, financial statements for the year ended December 31, 1992 retroactively reflecting the deconsolidation are presented as supplementary information under the heading "restated" to facilitate comparative analysis. (b) The net loss for the second quarter of 1993 includes an extraordinary loss on the retirement of debt of $35 million ($.09 per common share). The net loss for the third quarter of 1993 includes an extraordinary loss on the retirement of debt of $22 million ($.06 per common share) and an unusual charge of $70 million ($.19 per common share) due to the effect of the new income tax law on Time Warner's deferred income tax liability. (c) After preferred dividend requirements. TIME WARNER INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION TRANSACTIONS AFFECTING COMPARABILITY OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION There have been a series of transactions during 1993 and 1992 resulting from the restructuring of Time Warner's balance sheet that have affected the comparability of the financial statements, including the following (collectively, the "Time Warner Transactions"): . The USW Transaction: The admission of a subsidiary of USW as an additional limited partner of TWE on September 15, 1993, which resulted in the deconsolidation of the Entertainment Group effective as of January 1, 1993. The historical financial statements of Time Warner for periods prior to 1993 have not been changed; however, financial statements retroactively reflecting the deconsolidation for 1992 also have been presented as supplementary information under the column heading "restated" in order to facilitate comparative analysis. . The Series C Exchange and Series D Redemption: The issuance of $3 billion of publicly held long-term debt early in 1993 and $.5 billion late in 1992 in connection with the redemption of $3.3 billion aggregate liquidation value of Series D preferred stock and the exchange of $3.1 billion aggregate liquidation value of Series C preferred stock for $3.1 billion aggregate principal amount of 8-3/4% convertible subordinated debentures. . The 8-3/4% Partial Redemption: The issuance of zero coupon convertible notes in 1993 at an aggregate issue price of $900 million and the use of the proceeds therefrom and available cash and equivalents to redeem $900 million aggregate principal amount of 8-3/4% convertible subordinated debentures. . The 1993 WCI Refinancings: The repurchase or redemption of all of WCI's outstanding senior and subordinated debentures in the aggregate principal amount of $570 million. The following transactions have affected the comparability of the financial statements of both the Entertainment Group and Time Warner (collectively, and together with the USW Transaction, the "Entertainment Group Transactions"): . The 1993 Six Flags Acquisition and Refinancing: The increase in TWE's ownership of Six Flags from 50% to 100% on September 17, 1993 and the retirement of outstanding debt and preferred stock of Six Flags and its subsidiaries, using Six Flags cash flow and $550 million of funds provided by TWE, which resulted in the consolidation of Six Flags effective as of January 1, 1993. The historical summarized financial information of the Entertainment Group for periods prior to January 1, 1993 has not been changed; however, summarized financial information retroactively reflecting the consolidation for 1992 also has been presented as supplementary information under the column heading "restated" in order to facilitate comparative analysis. . The 1993 TWE Refinancings: The issuance of $2.6 billion of TWE debentures in 1993 to reduce indebtedness under the TWE credit agreement. . The TWE Capitalization and Refinancing: The initial capitalization of TWE on June 30, 1992 and associated refinancings, including the repayment of the Time Warner and ATC credit agreements with $5.9 billion borrowed under a new TWE credit agreement and $1 billion of capital contributions; and the issuance of $1.2 billion of senior notes to reduce bank debt. TIME WARNER INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION--(CONTINUED) . The ATC Merger: The acquisition of the ATC minority interest on June 26, 1992, in exchange for Time Warner notes then valued at $1.3 billion. . The 1992 Six Flags Recapitalization: The issuance of $192 million aggregate principal amount of zero coupon notes by Six Flags in December 1992 to redeem or repurchase shares of common stock of Six Flags and its principal subsidiary. The impact of these transactions on the financial statements of Time Warner and the Entertainment Group is reflected on a pro forma basis in the discussion and analysis set forth below. RESULTS OF OPERATIONS 1993 VS. 1992 Time Warner had 1993 revenues of $6.581 billion, a loss of $94 million ($.56 per common share) before a one-time tax charge and an extraordinary loss, and a net loss of $221 million ($.90 per common share), compared to 1992 revenues of $13.070 billion ($6.309 billion on a restated basis) and net income of $86 million (a loss of $1.46 per common share after preferred dividends). The one- time tax charge of $70 million ($.19 per common share) resulted from the effect on the company's deferred income tax liability of the increase in the corporate income tax rate enacted in August 1993; the extraordinary loss of $57 million ($.15 per common share) resulted from the retirement of debt in 1993. The improvement in per share results in 1993 includes the after-tax benefits of replacing preferred stock with debt in the first quarter. Preferred dividends were $118 million in 1993, compared to $628 million in 1992. Only Series B preferred stock is outstanding at December 31, 1993, as to which the annual dividends on a financial statement basis are $13 million. On a pro forma basis, giving effect to the Time Warner Transactions and the Entertainment Group Transactions as if they had occurred at the beginning of the years, Time Warner would have reported a net loss of $160 million ($.46 per common share) in 1993 and $247 million ($.70 per common share) in 1992. The relationship between income before income taxes and income tax expense of Time Warner is principally affected by the amortization of excess cost over net assets acquired and certain other financial statement expenses that are not deductible for income tax purposes, and by the unusual tax charge in 1993. Time Warner's income tax expense includes all income taxes related to its equity in the pretax income of the Entertainment Group, including its equity in the income tax expense of TWE. The Entertainment Group had revenues of $7.963 billion, income of $217 million before a $10 million extraordinary loss on the retirement of debt, and net income of $207 million in 1993, compared to revenues of $6.761 billion ($7.251 billion on a restated basis) and net income of $173 million in 1992. On a pro forma basis, giving effect to the Entertainment Group Transactions as if they had occurred at the beginning of the year, the Entertainment Group would have reported net income of $207 million in 1993 compared to $23 million in 1992. Other factors affecting comparative operating results are discussed below on a business segment basis. That discussion includes, among other factors, an analysis of changes in the operating income of the business segments before depreciation and amortization ("EBITDA") in order to eliminate the effect on the operating performance of the music, filmed entertainment and cable businesses of significant amounts of purchase price amortization from the $14 billion acquisition of WCI in 1989, the $1.3 billion acquisition of the ATC minority interest in 1992 and other business combinations accounted for by the purchase method. TIME WARNER INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION--(CONTINUED) EBITDA for Time Warner and the Entertainment Group in 1993 and 1992 was as follows: While many financial analysts consider EBITDA to be an important measure of comparative operating performance for the businesses of Time Warner and the Entertainment Group, it should be considered in addition to, but not as a substitute for, or superior to, operating income, net income, cash flow and other measures of financial performance reported in accordance with generally accepted accounting principles. TIME WARNER Publishing. Revenues increased to $3.270 billion compared to $3.123 billion in 1992. Operating income increased to $295 million from $254 million. Depreciation and amortization amounted to $77 million in 1993 and $74 million in 1992. EBITDA increased to $372 million from $328 million. Revenues benefited from increased magazine circulation revenues, higher book publishing revenues and the full year impact of the 1992 Leisure Arts acquisition. Magazine circulation revenues reflected higher overall subscription and newsstand sales, led by People, Time and Entertainment Weekly, as well as increases at American Family Publishers, the subscription agency. Despite a difficult market, advertising revenues were nearly flat. EBITDA increased as a result of the revenue gains and improved operating margins achieved through continued cost savings. Music. Revenues increased to $3.334 billion compared to $3.214 billion in 1992. Operating income increased to $296 million from $275 million. Depreciation and amortization, including amortization related to the purchase of WCI, amounted to $347 million in 1993 and $310 million in 1992. EBITDA increased to $643 million from $585 million. The revenue gains primarily reflected an increase in domestic recorded music sales and Warner/Chappell Music Publishing revenues. An increase in unit volume was achieved internationally, principally because of an increase in Pacific Rim sales. International dollar-denominated revenues did not increase, however, because of exchange rate fluctuations. Overall, revenues benefited from a broad range of popular releases from both new and established artists, increased unit sales of compact discs and higher average unit selling prices. The increase in EBITDA reflects the revenue gains and improved margins, offset in part by start-up costs for new business ventures. Interest and Other, Net. Interest and other, net, decreased to $718 million in 1993 compared to $882 million ($351 million on a restated basis) in 1992. Interest expense decreased to $698 million compared to $729 million ($287 million on a restated basis) in 1992. The decrease in interest and other, net, on an historical basis resulted primarily from the exclusion in 1993 of the expenses of the Entertainment Group, which was TIME WARNER INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION--(CONTINUED) deconsolidated in 1993, offset in part by an increase in interest expense from higher debt levels associated with the Series D Redemption and Series C Exchange. Other expenses, net, in 1993 included reductions in the carrying value of certain investments offset by investment-related income. Other expenses, net, in 1992 included an expense in connection with the settlement of senior management employment contracts, ATC minority interest expense and litigation-related costs. ENTERTAINMENT GROUP Filmed Entertainment. Revenues increased to $4.565 billion compared to $3.455 billion ($3.945 billion on a restated basis) in 1992. Operating income increased to $286 million from $213 million ($254 million on a restated basis). Depreciation and amortization, including amortization related to the purchase of WCI, amounted to $263 million in 1993 and $197 million ($266 million on a restated basis) in 1992. EBITDA increased to $549 million from $410 million ($520 million on a restated basis). The increase in revenues, operating income and EBITDA on an historical basis resulted primarily from the inclusion in 1993 of the operating results of Six Flags, which previously had been accounted for using the equity method. Revenues at Warner Bros. increased during the period primarily due to increases in international theatrical, international syndication and domestic home video revenues, as well as increased revenues from retail operations. Record international revenues of $1.650 billion would have been greater but for unfavorable exchange rate fluctuations. Warner Bros. ranked number one at both the domestic and international box office in 1993, led by the success of The Fugitive and The Bodyguard. Revenues at Six Flags increased, benefiting from higher revenues per visitor. EBITDA benefited from the revenue gains. Programming--HBO. Revenues decreased to $1.441 billion compared to $1.444 billion in 1992. Operating income increased to $213 million from $201 million. Depreciation and amortization amounted to $17 million in 1993 and $14 million in 1992. EBITDA increased to $230 million from $215 million. The decrease in revenues reflects lower HBO Video sales, which in 1992 were favorably affected by a children's sell-thru title, offset in part by higher subscriber revenues, principally as a result of higher pay-TV rates at HBO and an increase in subscribers. EBITDA benefited primarily from improved results from new businesses, including Time Warner Sports and the Comedy Central joint venture. Cable. Revenues increased to $2.208 billion compared to $2.091 billion in 1992. Operating income increased to $406 million from $400 million. Depreciation and amortization, including amortization related to the purchase of WCI and the ATC Merger, amounted to $629 million in 1993 and $577 million in 1992. EBITDA increased to $1.035 billion from $977 million. Revenues increased principally as a result of growth in the number of cable subscribers and increases in advertising sales and pay-per-view. The increase in subscribers accounted for approximately three quarters of the revenue increase. EBITDA benefited from the revenue gains and increased income from cable joint ventures, but was negatively affected in the fourth quarter by cable rate regulation which went into effect on September 1, 1993. The negative effect of rate regulation is expected to continue into 1994 (see "Financial Condition and Liquidity" elsewhere herein). Interest and Other, Net. Interest and other, net, increased to $564 million in 1993 compared to $531 million ($569 million on a restated basis) in 1992. Interest expense increased to $580 million compared to $442 million ($491 million on a restated basis) in 1992. The increase in interest expense resulted primarily from the higher average debt levels attributable to the TWE capitalization, the higher interest cost of the TWE notes and debentures issued to refinance TWE bank debt, and the consolidation of Six Flags' interest expense in 1993. Other income, net, in 1993 included gains on the sale of certain assets partially offset by losses from and reductions in the carrying value of certain investments. Other expenses, net, on a restated basis in 1992 is principally attributable to losses on certain investments and litigation- related costs. TIME WARNER INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION--(CONTINUED) 1992 VS. 1991 Time Warner had revenues of $13.070 billion, net income of $86 million and a $1.46 net loss per common share after preferred dividends in 1992, compared to revenues of $12.021 billion, a net loss of $99 million and a net loss of $2.40 per common share in 1991. The 1991 results include a $60 million restructuring charge in the Publishing division ($36 million after tax, or $.12 per common share). Per common share amounts for 1991 have been restated to give effect to the four-for-one common stock split that occurred on September 10, 1992. EBITDA for 1992 and 1991 on a historical consolidated basis was as follows: Publishing. Revenues increased to $3.123 billion compared to $3.021 billion in 1991. Operating income increased to $254 million from $174 million in 1991, which included the $60 million restructuring charge. Depreciation and amortization amounted to $74 million in 1992 and $72 million in 1991. EBITDA increased to $328 million from $246 million in 1991. Magazine revenues benefited from increases in both circulation and advertising revenues and the inclusion in 1992 of the revenues of Leisure Arts, a crafts publisher acquired in the third quarter of 1992. Circulation revenues reflected higher overall subscription and newsstand sales. The revenue growth was led by People, Entertainment Weekly and the regional and lifestyle magazines. Book revenues benefited from higher direct marketing sales at Time Life Inc. Excluding the restructuring charge in 1991, EBITDA improved in 1992 as a result of cost savings and the revenue gains. Music. Revenues increased to $3.214 billion compared to $2.960 billion in 1991. Operating income increased to $275 million from $256 million. Depreciation and amortization, including amortization related to the purchase of WCI, amounted to $310 million in 1992 and $304 million in 1991. EBITDA increased to $585 million from $560 million in 1991. Revenues benefited from increases in both international and domestic recorded music sales. The strong international revenue growth reflected Warner Music International's continued success with local artist development and the continued popularity of the domestic labels' artists outside the U.S. Overall, revenues benefited from a broad range of popular releases, increased unit sales of compact discs and higher average unit selling prices. Warner/Chappell Music Publishing revenues increased, reflecting the continued popularity of its large worldwide catalogue of music copyrights. The revenue gains and increased income from the Columbia House partnerships contributed to the increase in EBITDA. Filmed Entertainment. Revenues increased to $3.455 billion compared to $3.065 billion in 1991, and operating income increased to $213 million from $207 million. Depreciation and amortization, including amortization related to the purchase of WCI, amounted to $197 million in 1992 and $183 million in 1991. EBITDA increased to $410 million from $390 million in 1991. The revenue growth resulted primarily from increased worldwide theatrical revenues, which benefited from a number of very successful releases. Warner Bros. ranked number one in domestic box office. Revenues from international home video and syndication, sales to network television and retail operations also increased, while revenue from pay-television sales declined. The increase in EBITDA reflects the higher revenues, offset in part by lower margins. TIME WARNER INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION--(CONTINUED) Programming--HBO. Revenues increased to $1.444 billion from $1.366 billion in 1991, while operating income rose to $201 million from $183 million. Depreciation and amortization amounted to $14 million in 1992 and $12 million in 1991. EBITDA increased to $215 million from $195 million in 1991. The revenue growth resulted from higher subscriber revenues and increased revenues from ancillary businesses, particularly from television production. The increase in subscriber revenues resulted from higher pay-TV rates at HBO and a slight increase in the number of subscribers. EBITDA benefited from the revenue gains, improved operating margins and a smaller loss from the Comedy Central joint venture, offset in part by expenses associated with the start-up of international pay-TV ventures. Cable. Revenues increased to $2.091 billion, compared to $1.935 billion in 1991, and operating income increased to $400 million from $334 million. Depreciation and amortization, including amortization related to the purchase of WCI, amounted to $577 million in 1992 and $538 million in 1991. EBITDA increased to $977 million from $872 million in 1991. Revenues increased as a result of growth in the number of cable customers and an increase in per subscriber revenue. The increase in subscribers accounted for approximately 40% of the revenue increase. EBITDA benefited from the revenue gains, continued cost containment and increased income from domestic cable joint ventures, partially offset by higher cable programming costs and expenses associated with the start-up of international cable ventures. Operating income also was affected by amortization related to the ATC Merger. Interest and Other, Net. Interest and other, net, decreased to $882 million in 1992 from $966 million in 1991. Interest expense decreased to $729 million in 1992 compared with $912 million in 1991. The decrease in interest expense, which is attributable to lower interest rates and lower average debt levels, was offset in part by increases in litigation-related costs and other expenses, including expenses in connection with the settlement of senior management employment contracts, and a decline in investment-related income. In August 1992, Time Warner and TWE settled the litigation brought by Viacom International, Inc. in 1989 against Time Warner, ATC and HBO. The settlement terminated with prejudice all claims and counterclaims raised in the litigation. The effects of the settlement were not material to Time Warner or TWE. FINANCIAL CONDITION AND LIQUIDITY DECEMBER 31, 1993 TIME WARNER Aided by favorable conditions in the credit markets, Time Warner continued to restructure its balance sheet and reduce its after-tax financing cost. The Series C Exchange, Series D Redemption and 8-3/4% Partial Redemption replaced $6.4 billion of Series C and Series D preferred stock having an average after- tax cost of 9.9% with $6.6 billion of long-term debt having an average after- tax cost of 5%, resulting in annual savings of $300 million. In addition, the new debt includes $1.4 billion of zero coupon exchangeable or convertible notes that require no periodic payments of interest, resulting in annual deferrals of $75 million. The deconsolidation of the Entertainment Group also had a significant effect on the balance sheet by eliminating nearly $16 billion of assets and over $7 billion of debt. Principally as a result of these factors, Time Warner had $9.4 billion of debt and $1.4 billion of equity at December 31, 1993, compared to $10.2 billion of debt and $8.2 billion of equity at December 31, 1992. Cash and equivalents were $200 million at December 31, 1993, compared to $942 million at December 31, 1992, resulting in debt-net-of-cash amounts of $9.2 billion and $9.3 billion at such dates. Substantially all of Time Warner's debt at December 31, 1993 consisted of long-term fixed-rate or zero coupon obligations, approximately $2 billion of which was effectively converted to a floating rate basis through the use of interest-rate swap agreements. TIME WARNER INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION--(CONTINUED) Cash provided by Time Warner's operations amounted to $257 million in 1993, after $330 million of interest payments, $182 million of income taxes and working capital requirements. Cash flows used in investing activities in 1993, excluding investment proceeds, were $373 million. Of this amount, $198 million was for capital expenditures, principally in the Music division. Cash dividends of $125 million were paid on common and Series B preferred stock during 1993. On a pro forma basis, giving retroactive effect to the beginning of the year to the 1993 Time Warner Transactions, cash flow from operations would have been $183 million, after $402 million of interest payments, $179 million of income taxes and working capital requirements. Time Warner has no claim on the assets and cash flows of TWE except through the payment of certain fees and reimbursements, such as the $60 million annual charge for corporate services, and cash distributions to the General Partners, which are limited by the TWE partnership and credit agreements. Distributions from TWE of $20 million in 1993 are expected to increase to approximately $125 million in 1994, primarily because of tax-related distributions. TWE is permitted under its partnership and credit agreements to loan Time Warner up to $1.1 billion, increasing up to $1.5 billion on July 1, 1995. Time Warner has $375 million of debt maturing in 1994 that will be refinanced by borrowings from TWE under a long-term arrangement. Management believes that 1994 operating cash flow, cash and marketable securities and additional borrowing capacity are sufficient to meet Time Warner's liquidity needs without distributions and loans from TWE above those permitted by existing agreements. ENTERTAINMENT GROUP TWE continued its strategy of significantly lengthening debt maturities at attractive fixed rates. Over the past two years, TWE reduced variable rate debt by $3.8 billion with proceeds from the issuance of long-term notes and debentures having an after-tax cost to Time Warner of 5.1%. An additional $2.5 billion of capital was raised by the USW Transaction, $1 billion of which, presently in the form of the USW Note, has been earmarked for building cable Full Service Networks(TM) ("FSN"). The Six Flags acquisition culminated a series of transactions over a two-year period that resulted in it becoming a wholly-owned subsidiary of TWE. Six Flags was consolidated by TWE effective as of January 1, 1993. Primarily as a result of these transactions, the Entertainment Group had $7.1 billion of long-term debt at December 31, 1993, $1.5 billion of TWE General Partners' Senior Capital and $6 billion of TWE partners' capital (net of the $1 billion uncollected amount of the USW Note), compared to $7.2 billion of long-term debt ($7.7 billion restated for the Six Flags consolidation) and $6.4 billion of TWE partners' capital at December 31, 1992. Cash and equivalents were $1.3 billion at December 31, 1993, reducing the debt-net-of-cash amount to $5.8 billion. Cash and equivalents at December 31, 1992 were $47 million. Cash provided by the operations of the Entertainment Group in 1993 amounted to $1.276 billion, after $450 million of interest payments, $70 million of income taxes and working capital requirements. On a pro forma basis, giving retroactive effect to the beginning of 1993 to the Entertainment Group Transactions, cash flow from operations would have been $1.284 billion, after $473 million of interest payments, $70 million of income taxes and working capital requirements. Cash used in investing activities in 1993, excluding investment proceeds, amounted to $981 million. Of this amount, $613 million was spent on capital projects, including $352 million to upgrade cable systems and $244 million to expand international theaters and Warner Bros. Studio Stores, upgrade facilities at the Warner Bros. Studio and introduce new rides at Six Flags. The Entertainment Group continues to expand its core businesses through selective acquisitions and investments, which in 1993 resulted in payments of $368 million, including $136 million for the purchase of common and preferred stocks of Six Flags. The Milwaukee, Wisconsin cluster of cable systems was TIME WARNER INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION--(CONTINUED) augmented by the purchase of a cable system from Viacom Inc. Several other cable systems that did not fit into a cluster were disposed of in 1993 for approximately $100 million. Capital spending is expected to increase significantly in 1994, principally because of the plan to upgrade a significant percentage of cable systems to FSN capacity over the next five years at an estimated cost of $5 billion, which is about three times cable capital expenditures for the last five years. $1 billion of FSN capital expenditures will be funded by collections on the USW Note. TWE is permitted under its partnership and credit agreements to loan up to $1.1 billion to Time Warner. An additional $400 million of such loans are permitted beginning July 1, 1995. There was $1.3 billion of cash and equivalents and $2 billion of available credit under the TWE credit agreement at December 31, 1993. In early 1994, TWE filed a shelf registration statement with the Securities and Exchange Commission covering the issuance of up to $2 billion of debt securities. These securities may be issued from time to time on terms determined at the time of sale. Management believes that 1994 operating cash flow, cash and equivalents, the USW Note, and additional borrowing capacity are sufficient to meet the capital and liquidity needs of TWE, and to fund anticipated loans to Time Warner. On October 5, 1992, Congress enacted the 1992 Cable Act, which among other things reimposed rate regulation on most cable systems. The Federal Communications Commission ("FCC") froze rates in April 1993 for regulated cable services and associated equipment, other than for systems in which local franchising authorities regulate rates. The current expiration date of the freeze is May 15, 1994. On May 3, 1993, the FCC released rules implementing rate regulation, which required that rates for certain equipment be established based on a cost-of-service standard and rates for regulated cable services be established based on either a per-channel benchmark or a cost-of-service standard, at the election of the cable operator. TWE Cable elected to establish rates based on the per-channel benchmarks, which the FCC had set at 10% below the average level of rates prevailing nationwide in September of 1992. On February 22, 1994, the FCC announced the adoption of revised rules lowering the per-channel benchmarks from 10% to 17% below the average level of rates prevailing in September of 1992 and changing the factors cable operators must use to calculate the benchmarks applicable to their systems. The text of the new rules is expected to be released in late March, with an effective date of May 15. Under the May 1993 rules, revenues from sales of regulated equipment and services had been expected to decline by $90 to $100 million per year. That decline was expected to be partially offset by increases in revenues from other activities, including optional services, advertising sales and subscriber growth, which could not be quantified. It is not yet possible to estimate the effect of the new rules adopted in February 1994, although it is expected to be more adverse than the effect of the earlier rules. On November 5, 1992, TWE filed a lawsuit seeking to overturn major provisions of the 1992 Cable Act, primarily on First Amendment grounds. On April 8, 1993, a three-judge District Court upheld the constitutionality of the "must carry" provisions of the 1992 Cable Act. TWE's appeal from this decision was heard by the U.S. Supreme Court in January 1994. On September 16, 1993, a one-judge District Court upheld the constitutionality of a majority of the other challenged provisions of the 1992 Cable Act. The Company and the federal defendants have appealed this decision to the U.S. Court of Appeals for the D.C. Circuit. Warner Bros.' backlog, representing the amount of future revenue not yet recorded from cash contracts for the licensing of films for pay and basic cable, network and syndicated television exhibition amounted to $724 million at December 31, 1993 compared to $674 million at December 31, 1992 (including amounts relating to HBO of $178 million at December 31, 1993 and $161 million at December 31, 1992). The backlog excludes advertising barter contracts. The net impact of inflation on operations has not been significant in the past three years. TIME WARNER INC. SCHEDULE II--AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 - -------- (a) The 1993 financial statements reflect the deconsolidation of the Entertainment Group, principally TWE, effective January 1, 1993. TIME WARNER INC. SCHEDULE II--AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 NOTES TO SCHEDULE II (1) Note pursuant to an employment agreement bearing interest at 6% per annum, payable quarterly, due December 31, 1994. Secured by a mortgage on real estate. (2) Note pursuant to an employment agreement bearing interest at 8% per annum, payable quarterly, until end of employment term at which time principal and interest are payable in 48 monthly installments, beginning on August 1, 1996. Secured by a mortgage on real estate. (3) Note in the amount of $950,000 bearing interest at 6% per annum payable on December 31, 1996. Note in the amount of $431,746 bearing interest at 7% per annum due on demand. (4) Note bearing interest at 10% per annum due December 31, 1994. (5) Non-interest bearing notes pursuant to an employment agreement due on demand. TIME WARNER INC. SCHEDULE VIII--VALUATION AND QUALIFYING ACCOUNTS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 - -------- (a) The 1993 financial statements reflect the deconsolidation of the Entertainment Group, principally TWE, effective January 1, 1993. The historical financial statements for periods prior to such date have not been changed; however, financial information for the year ended December 31, 1992 retroactively reflecting the deconsolidation is presented as supplementary information under the column heading "restated" to facilitate comparative analysis. (b) Represents uncollectible receivables charged against reserve. (c) Represents returns or allowances applied against reserve. (d) The distribution of magazines not owned by Time Warner results in a receivable recorded at the sales price and a corresponding liability to the publisher recorded at the sales price less the distribution commission recognized by Time Warner as revenue. Therefore, it would be misleading to compare magazine revenues to the provision charged to the reserve for magazine returns that is deducted from accounts receivable without also considering the related offsetting activity in the reserve for magazine returns that is deducted from the liability due to the publishers. TIME WARNER INC. SCHEDULE X--SUPPLEMENTARY OPERATING STATEMENT INFORMATION YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 - -------- (a) The 1993 financial statements reflect the deconsolidation of the Entertainment Group, principally TWE, effective January 1, 1993. The historical financial statements for periods prior to such date have not been changed; however, financial information for the year ended December 31, 1992 retroactively reflecting the deconsolidation is presented as supplementary information under the column heading "restated" to facilitate comparative analysis. TIME WARNER ENTERTAINMENT COMPANY, L.P. CONSOLIDATED BALANCE SHEET DECEMBER 31, (MILLIONS) - -------- (a) The 1993 financial statements reflect the consolidation of Six Flags effective January 1, 1993 as a result of the 1993 Six Flags acquisition. The historical financial statements for periods prior to such date have not been changed; however, financial statements for the year ended December 31, 1992 retroactively reflecting the consolidation are presented as supplementary information under the column heading "restated" to facilitate comparative analysis (Notes 1 and 2). See accompanying notes. TIME WARNER ENTERTAINMENT COMPANY, L.P. CONSOLIDATED STATEMENT OF OPERATIONS YEARS ENDED DECEMBER 31, (MILLIONS) See accompanying notes. TIME WARNER ENTERTAINMENT COMPANY, L.P. CONSOLIDATED STATEMENT OF CASH FLOWS YEARS ENDED DECEMBER 31, (MILLIONS) - -------- (a) The 1993 financial statements reflect the consolidation of Six Flags effective January 1, 1993 as a result of the 1993 Six Flags acquisition. The historical financial statements for periods prior to such date have not been changed; however, financial statements for the year ended December 31, 1992 retroactively reflecting the consolidation are presented as supplementary information under the column heading "restated" to facilitate comparative analysis (Notes 1 and 2). See accompanying notes. TIME WARNER ENTERTAINMENT COMPANY, L.P. CONSOLIDATED STATEMENT OF PARTNERSHIP CAPITAL (MILLIONS) - -------- (a) Distributions in 1993 and 1992 included $252 million and $24 million, respectively, of tax-related distributions, $274 million and $17 million, respectively, of stock option distributions and in 1993 $13 million of distributions to the Time Warner Service Partnerships. In addition, General Partners' Junior Capital was reduced $95 million in 1993 for the distribution of the Time Warner Service Partnership Assets. A $12 million contribution was made by the General Partners in 1992 after the TWE Capitalization pursuant to the net worth adjustment provision of the partnership agreement. (Note 6.) See accompanying notes. TIME WARNER ENTERTAINMENT COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION Time Warner Entertainment Company, L.P., a Delaware limited partnership ("TWE"), was capitalized on June 30, 1992 (the "TWE Capitalization") to own and operate substantially all of the Filmed Entertainment, Programming-HBO and Cable businesses previously owned by subsidiaries of Time Warner Inc. ("Time Warner"). At December 31, 1993, the general partners of TWE, subsidiaries of Time Warner ("General Partners"), collectively held 63.27% pro rata priority capital and residual equity partnership interests in TWE, and certain priority capital interests senior and junior to the pro rata priority capital interests, which they received for the net assets, or the rights to cash flows, they contributed to the partnership at the TWE Capitalization; and the limited partners, subsidiaries of U S WEST, Inc. ("USW"), ITOCHU Corporation ("ITOCHU") and Toshiba Corporation ("Toshiba"), held 25.51%, 5.61% and 5.61% pro rata priority capital and residual equity partnership interests, respectively. ITOCHU and Toshiba each contributed $500 million of cash at the TWE Capitalization for their limited partnership interests. USW contributed $1.532 billion of cash and a $1.021 billion 4.4% note ("USW Note") on September 15, 1993 for its limited partnership interests. Prior to the admission of USW, the General Partners held 87.5% pro rata priority capital and residual equity partnership interests, and a priority capital interest junior to the pro rata priority capital interests, and ITOCHU and Toshiba each held 6.25% pro rata priority capital and residual equity partnership interests (Note 6). In lieu of contributing certain assets (the "Beneficial Assets"), the General Partners assigned to TWE the net cash flow generated by such assets or agreed to pay an amount equal to the net cash flow generated by such assets. TWE has the right to receive from the General Partners, at the limited partners' option, an amount equal to the fair value of Beneficial Assets, net of associated liabilities, that have not been contributed to TWE by June 30, 1996, rather than continuing to receive the net cash flow, or an amount equal to the net cash flow, generated by the Beneficial Assets. The consolidated financial statements include the assets and liabilities of the businesses contributed by the General Partners, including the Beneficial Assets and associated liabilities, all at Time Warner's historical cost basis of accounting. Time Warner's $14 billion acquisition of Warner Communications Inc. ("WCI") as of December 31, 1989, and $1.3 billion acquisition of the minority interest in American Television and Communications Corporation ("ATC") on June 26, 1992 were accounted for by the purchase method of accounting. WCI subsequently contributed filmed entertainment and cable assets to TWE, and ATC subsequently contributed its cable assets. The financial statements of TWE reflect an allocable portion of Time Warner's cost to acquire WCI and the ATC minority interest in accordance with the pushdown method of accounting. BASIS OF CONSOLIDATION AND ACCOUNTING FOR INVESTMENTS IN AFFILIATED COMPANIES The consolidated financial statements include the accounts of TWE and its subsidiaries. Significant intercompany accounts and transactions are eliminated. Significant accounts and transactions between TWE and its partners and affiliates are disclosed as related party transactions (Note 11). Investments in companies in which TWE has significant influence but less than controlling financial interest are stated at cost plus equity in the affiliates' undistributed earnings. The excess of cost over the underlying net equity of investments in affiliated companies is attributed to the underlying net assets based on their respective fair values and amortized over their respective economic lives. Six Flags Entertainment Corporation ("Six Flags") was consolidated effective January 1, 1993 as a result of the increase of TWE's ownership in Six Flags from 50% to 100% on September 17, 1993 (Note 2). The historical financial statements for periods prior to such date have not been changed; however, financial TIME WARNER ENTERTAINMENT COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) statements for the year ended December 31, 1992 retroactively reflecting the consolidation of Six Flags are presented as supplementary information under the column heading "restated" in order to facilitate comparative analysis. Certain other prior year amounts have been reclassified to conform to the 1993 presentation. REVENUES AND COSTS Feature films are produced or acquired for initial exhibition in theaters followed by distribution in the home video, pay cable, basic cable, broadcast network and syndicated television markets. Generally, distribution to the theatrical, home video and pay cable markets (the primary markets) is completed within eighteen months of initial release. Theatrical revenues are recognized as the films are exhibited. Home video revenues, less a provision for returns, are recognized when the home videos are sold. Revenues from cable and broadcast television distribution are recognized when the films are available to telecast. Television films and series are initially produced for the networks or first-run television syndication (the primary markets) and may be subsequently licensed to foreign or other domestic television markets. Revenues from television license agreements are recognized when the films or series are available to telecast, except for barter agreements where the recognition of revenue is deferred until the related advertisements are telecast. Inventories of theatrical and television product are stated at the lower of amortized cost or net realizable value. Cost includes direct production and acquisition costs, production overhead and capitalized interest. A portion of the cost to acquire WCI was allocated to its theatrical and television product as of December 31, 1989, including an allocation to product that had been exhibited at least once in all markets ("Library"). Individual films and series are amortized, and the related participations and residuals are accrued, based on the proportion that current revenues from the film or series bear to an estimate of total revenues anticipated from all markets. These estimates are revised periodically and losses, if any, are provided in full. WCI acquisition cost allocated to the Library is amortized on a straight-line basis over twenty years. Current film inventories include the unamortized cost of completed feature films allocated to the primary markets, television films and series in production pursuant to a contract of sale, film rights acquired for the home video market and advances pursuant to agreements to distribute third-party films in the primary markets. Noncurrent film inventories include the unamortized cost of completed theatrical and television films allocated to the secondary markets, theatrical films in production and WCI acquisition cost allocated to the Library. A significant portion of cable system and cable programming revenues are derived from subscriber fees, which are recorded as revenue in the period the service is provided. The right to exhibit feature films and other programming on pay cable services during one or more availability periods ("programming costs") generally is recorded when the programming is initially available for exhibition, and is allocated to the appropriate availability periods and amortized as the programming is exhibited. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment are stated at cost. Additions to cable property, plant and equipment generally include material, labor, overhead, interest and certain start-up costs incurred in developing new franchises. Depreciation is provided generally on the straight-line method over useful lives ranging up to twenty-five years for buildings and improvements and up to fifteen years for furniture, fixtures and cable television and other equipment. INTANGIBLE ASSETS Intangible assets are amortized over periods up to forty years using the straight-line method. Amortization of the excess of cost over net assets acquired amounted to $132 million in 1993, $115 million TIME WARNER ENTERTAINMENT COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) ($124 million on a restated basis) in 1992 and $110 million in 1991, and amortization of cable television franchises amounted to $222 million, $194 million, and $171 million, respectively. Accumulated amortization of intangible assets at December 31, 1993 and 1992 amounted to $1.438 billion and $1.078 billion ($1.108 billion on a restated basis), respectively. FOREIGN CURRENCY TRANSLATION The financial position and operating results of substantially all of the foreign operations of TWE are consolidated using the local currency as the functional currency. Accordingly, local currency assets and liabilities are translated at the rates of exchange on the balance sheet date, and local currency revenues and expenses are translated at average rates of exchange during the period. Resulting translation gains or losses, which have not been material, are included in partners' capital. Foreign currency transaction gains and losses, which have not been material, are included in operating results. INCOME TAXES As a Delaware limited partnership, TWE is not subject to U.S. federal and state income taxation. However, certain of TWE's operations are conducted by subsidiary corporations that are subject to domestic or foreign taxation. Income taxes are provided on the income of such corporations using the liability method of accounting for income taxes prescribed by Financial Accounting Standards Board ("FASB") Statement No. 109, "Accounting for Income Taxes." The consolidated financial statements for periods prior to the TWE Capitalization include, for comparative purposes, the income and withholding tax consequences of those TWE operations subject to domestic or foreign taxation, as determined on a stand-alone basis consistent with the liability method of accounting for income taxes. FINANCIAL INSTRUMENTS Foreign exchange contracts are used to reduce exchange rate exposure on future cash flows and earnings denominated in foreign currencies. Contract gains and losses are included in income. TWE is reimbursed by or reimburses Time Warner for Time Warner contract gains and losses related to TWE's exposure. At December 31, 1993, Time Warner had contracts for the sale of $226 million of foreign currencies at fixed rates related to TWE's exposure, primarily Japanese yen, German marks, Canadian dollars and French francs. The fair value of foreign exchange contracts approximates carrying value. TWE has used interest rate swap agreements to reduce its exposure to interest rate changes; however, there were no material amounts of contracts outstanding at December 31, 1993. The net amounts paid and received under the contracts are included in interest expense. The fair value of TWE's debt will fluctuate with changes in the credit markets, including changes in the level of interest rates. At December 31, 1993, the fair value of TWE's publicly-held long-term debt was estimated to exceed its carrying value by approximately $290 million. Fair value is generally determined by reference to market values resulting from trading on a national securities exchange or in an over-the-counter market. 2.INVESTMENTS Investments accounted for on the equity basis include Paragon Communications (50% owned), certain other cable system joint ventures (generally 50% owned), Comedy Partners (50% owned), Six Flags (50% owned until 1993 when consolidated) and E! Entertainment Corporation (50% owned until distributed in 1993). These investments were carried at cost plus undistributed equity in the affiliates' earnings of $517 TIME WARNER ENTERTAINMENT COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) million at December 31, 1993 and $594 million ($562 million on a restated basis) at December 31, 1992. A summary of financial information of equity affiliates (100% basis) is set forth below: In September 1993, TWE provided Six Flags with $136 million to repurchase the 50% common stock interest held by other stockholders and preferred stock of certain subsidiaries. TWE also provided $414 million to finance the repurchase or retirement of all indebtedness of Six Flags and its subsidiaries, except for the zero coupon notes due 1999. As a result, TWE has consolidated Six Flags effective January 1, 1993. Certain investments included in the balance sheet at December 31, 1992 were among the Time Warner Service Partnership Assets distributed to the General Partners in 1993 (Note 6), including common and common equivalent stock of QVC Inc., which was carried at a cost of $28 million and had a market value of $142 million at December 31, 1992, and common and common equivalent stock of E! Entertainment Corporation, an equity affiliate. The remainder of TWE's investments, none of which are individually significant, were carried at cost. 3.INVENTORIES TWE's inventories consist of: Excluding the Library, the unamortized cost of completed films at December 31, 1993 amounted to $1.085 billion, more than 90% of which is expected to be amortized within three years after release. Excluding the effects of accounting for the acquisition of WCI, the total cost incurred in the production of theatrical and television films amounted to $1.784 billion in 1993, $1.652 billion in 1992 and $1.476 billion in 1991; and the total cost amortized amounted to $1.619 billion, $1.535 billion and $1.494 billion, respectively. TIME WARNER ENTERTAINMENT COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 4. LONG-TERM DEBT Long-term debt consists of: Each General Partner has guaranteed a pro rata portion of substantially all of TWE's debt and accrued interest thereon based on the relative fair value of the net assets each General Partner contributed to TWE (the "General Partner Guarantees"). Such indebtedness is recourse to each General Partner only to the extent of its guarantee. The indenture pursuant to which TWE's notes and debentures have been issued (the "Indenture") requires the unanimous consent of the holders of the notes and debentures to terminate the General Partner Guarantees prior to June 30, 1997, and the consent of a majority of such holders to effect a termination thereafter. There are no restrictions on the ability of the General Partner guarantors to transfer material assets, other than TWE assets, to parties who are not guarantors. As of December 31, 1993, the TWE credit agreement provided for up to $5.2 billion of borrowings and consisted of a $4.2 billion revolving credit facility with available credit reducing at June 30, 1995 and thereafter by $200 million per quarter through June 30, 1996, by $125 million per quarter from September 30, 1996 through September 30, 1999, and by $1.575 billion at final maturity on December 31, 1999; and a $986 million term loan with repayments of $66 million on June 30, 1995, $98 million per quarter beginning September 30, 1995 through March 31, 1996, $27 million per quarter beginning June 30, 1996 through June 30, 1999, $20 million on September 30, 1999 and a final repayment of $255 million on December 31, 1999. Unused credit is available for general business purposes and to support commercial paper borrowings. Outstanding borrowings under the credit agreement generally bear interest at LIBOR plus 7/8% per annum. The credit agreement contains covenants relating to, among other things, additional indebtedness; liens on assets; acquisitions and investments; cash flow coverage and leverage ratios; and loans, advances, distributions or other cash payments or transfers of assets to its partners or their affiliates. TWE is permitted under the credit agreement to loan Time Warner up to $1.1 billion, increasing to up to $1.5 billion at July 1, 1995 (Note 6). In connection with and immediately prior to the TWE Capitalization, indebtedness under the Time Warner and ATC credit agreements was assigned to and assumed by the General Partners. Immediately TIME WARNER ENTERTAINMENT COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) thereafter and concurrently with the TWE Capitalization, such indebtedness was assigned to and assumed by TWE. Proceeds from a $5.9 billion initial borrowing under the TWE credit agreement, $1 billion of capital contributed to the partnership by ITOCHU and Toshiba and $250 million of other loan proceeds were used, directly or indirectly, to repay and terminate the credit agreements of Time Warner and ATC and to pay certain transaction costs. In addition, $850 million of 9 5/8% and 10.15% long-term notes issued by Time Warner in April 1992 were assigned to and assumed by TWE. An after-tax cost of $10 million was incurred by Six Flags in 1993 in connection with the retirement of its debt (Note 2). The Six Flags zero coupon senior notes due 1999 are guaranteed by TWE. Interest expense was $573 million in 1993, $436 million ($486 million on a restated basis) in 1992 and $479 million in 1991. Interest expense for all periods prior to the TWE Capitalization includes interest expense related to Time Warner's credit and interest rate swap agreements on a pushdown basis and interest expense on $875 million of loans due to WCI, which were repaid at the TWE Capitalization. Annual repayments of long-term debt for the five years subsequent to December 31, 1993 are: 1994-$0 million; 1995-$262 million; 1996-$179 million; 1997-$108 million and 1998-$372 million. 5. INCOME TAXES Domestic and foreign pretax income are as follows: As a partnership, TWE is not subject to U.S. federal, state or local income taxation (Note 1). Income taxes (benefits) of TWE and subsidiary corporations are as set forth below: - -------- (1) Includes utilization of $75 million of Six Flags tax carryforwards in 1993. (2) Includes foreign withholding taxes of $59 million in 1993, $34 million in 1992 and $19 million 1991. TIME WARNER ENTERTAINMENT COMPANY, L.P. NOTES TO FINANCIAL STATEMENTS--(CONTINUED) The financial statement basis of TWE's assets exceeds the corresponding tax basis by $10 billion at December 31, 1993, principally as a result of differences in accounting for depreciable and amortizable assets for financial statement and income tax purposes. At December 31, 1993, Six Flags had $100 million of net operating loss carryforwards that expire from 2004 to 2007, which are subject to limitations. 6. TWE PARTNERS' CAPITAL The TWE partnership agreement provides for special allocations of income, loss and distributions of partnership capital, including priority distributions in the event of liquidation. Pursuant to the partnership agreement as amended for the admission of USW on September 15, 1993, and assuming that no additional partnership interests are issued to new partners, the relative priority of initial partnership capital amounts and of partnership income and loss related thereto is as follows, from most to least senior: (1) partnership income, to the extent earned, allocated to the partners so that the economic burden of the income tax consequences of partnership operations is borne as though the partnership was taxed as a corporation, reduced by prior distributions and allocations of partnership agreement losses ("special tax allocations"), (2) a senior capital interest in the initial capital amount of $1.4 billion, plus allocations of partnership income, to the extent earned, of up to 8% per annum, compounded quarterly, of the initial capital amount, reduced by prior distributions and allocations of partnership losses, allocated to the General Partners ("General Partners' Senior Capital"), (3) pro rata priority capital interests in the initial capital amounts of $3.5 billion allocated to the General Partners, $1.4 billion allocated to USW and $313 million allocated to each of ITOCHU and Toshiba, plus allocations of partnership income, to the extent earned, of up to 13% per annum (11% to the extent concurrently distributed), compounded quarterly, of the initial capital amounts, reduced by prior distributions and allocations of partnership losses, allocated to all the partners according to their residual equity partnership interests, (4) a junior capital interest in the initial capital amount of $2.7 billion, plus allocations of partnership income, to the extent earned, of up to 13.25% per annum (11.25% to the extent concurrently distributed), compounded quarterly, of the initial capital amount, reduced by prior distributions and allocations of partnership losses, allocated to the General Partners ("General Partners' Junior Capital") and (5) residual equity capital, plus allocations of partnership income, to the extent earned, reduced by prior distributions and allocations of partnership losses, allocated to all partners according to their residual partnership interests. To the extent partnership income is insufficient to satisfy all special allocations in a particular accounting period, the unearned portion is carried over until satisfied out of future partnership income. Partnership losses are allocated first to eliminate prior allocations of partnership income to, and then to reduce the initial capital amounts of, the residual equity, General Partners' Junior Capital and pro rata priority capital interests, in that order, then to reduce General Partners' Senior Capital, including partnership income allocated thereto, and finally to reduce special tax allocations. Partnership income first earned following a period of partnership losses will be allocated in reverse order so as to eliminate prior allocations of loss. For the purpose of the foregoing allocations, partnership income or loss is based on the fair value of the assets contributed to the partnership, and differs from net income of TWE, which is based on the historical cost of the contributed assets. General Partners' Senior Capital is required to be distributed no later than in three annual installments beginning July 1, 1997; earlier distributions may be made under certain circumstances ("Senior Capital Distributions"). General Partners' Junior Capital is subject to retroactive adjustment, based on TWE's operating performance over five-and ten-year periods, so as to result in an additional initial capital amount of up to $4 billion, plus allocations of partnership income, to the extent earned, of up to 13% per annum (11% per annum to the extent concurrently distributed), compounded quarterly, reduced by prior distributions and allocations of partnership losses. USW has an option to increase its pro rata priority capital and residual equity interests to as much as 31.84%, depending on cable operating performance. The option is exercisable between January 1, 1999 and on or about May 31, 2005 at a maximum exercise price ranging from $1.25 billion to $1.8 billion, depending TIME WARNER ENTERTAINMENT COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) on the year of exercise. USW or TWE may elect that the exercise price be paid with partnership interests rather than cash. Prior to the exercise of the USW option, each of ITOCHU and Toshiba has the right to maintain its original 6.25% pro rata priority capital and residual equity interests by acquiring additional partnership interests at fair market value; thereafter, each would have the right to maintain the percentage of the pro rata priority capital and residual equity interests it held immediately prior to USW's exercise. Distributions and loans to the partners are subject to partnership and credit agreement limitations. Generally, TWE must be in compliance with the cash flow coverage and leverage ratios, restricted payment limitations and other credit agreement covenants in order to make such distributions or loans. Certain assets of TWE (the "Time Warner Service Partnership Assets") were distributed to the General Partners prior to the admission of USW in order to ensure compliance with the Modification of Final Judgment entered on August 24, 1982 by the United States District Court for the District of Columbia applicable to USW and its affiliated companies, which may include TWE. The distribution was recorded based on the $95 million historical cost of the Time Warner Service Partnership Assets. For purposes of the partnership agreement, the initial capital amount of General Partners' Junior Capital of $3 billion was reduced by approximately $300 million to give effect to such distributions. The General Partners contributed the Time Warner Service Partnership Assets to newly formed partnerships (the "Time Warner Service Partnerships") in which the General Partners and subsidiaries of ITOCHU and Toshiba are the partners. The Time Warner Service Partnerships have entered into service agreements that make certain Time Warner Service Partnership Assets and related services available to TWE (Note 11). TWE is required to make quarterly distributions of $12.5 million with respect to General Partners' Junior Capital through September 30, 1998 ("TWSP Distributions"). The General Partners are required to contribute such amounts to the Time Warner Service Partnerships. TWE reimburses Time Warner for the amount by which the market price on the exercise date of Time Warner common stock options or options to purchase Time Warner redeemable reset notes due 2002 granted to employees of TWE exceeds the exercise price or, with respect to options granted prior to the TWE Capitalization, the greater of the exercise price or the market price of such securities at the TWE Capitalization ("Stock Option Distributions"). TWE paid $20 million of Stock Option Distributions in 1993 for exercised options and had a liability of $271 million and $17 million at December 31, 1993 and 1992, respectively, for future Stock Option Distributions based on the unexercised options and the market prices at such dates of $44.25 and $29.25, respectively, per Time Warner common share and $908.75 and $807.50, respectively, per $1,000 principal amount of Time Warner redeemable reset note. Cash distributions are required to be made to the partners to permit them to pay income taxes at statutory rates based on their allocable taxable income from TWE ("Tax Distributions"), including any taxable income generated by the Beneficial Assets, subject to limitations referred to herein. The aggregate amount of such Tax Distributions is computed generally by reference to the taxes that TWE would have been required to pay if it were a corporation. Tax Distributions in the amount of $276 million and $24 million were payable to the General Partners at December 31, 1993 and 1992, respectively. Other than the Stock Option Distributions and TWSP Distributions, under the most restrictive limitations, no other cash distributions to partners are permitted prior to July 1, 1994, at which time the payment of a Tax Distribution, limited in amount, is permitted. Accordingly, a $108 million Tax Distribution is classified as a current liability at December 31, 1993. Additional Tax Distributions are permitted beginning July 1, 1995. In addition to Stock Option Distributions, Tax Distributions, Senior Capital Distributions and TWSP Distributions, quarterly cash distributions may be made to the partners to the extent of excess cash, as defined ("Excess Cash Distribution"). Assuming that no additional partnership interests are issued to new partners and that certain cash distribution thresholds are met, cash distributions other than Stock Option TIME WARNER ENTERTAINMENT COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Distributions, Tax Distributions, Senior Capital Distributions and TWSP distributions will in the aggregate be made 63.27% to the General Partners and 36.73% to the limited partners prior to June 30, 1998; thereafter, the General Partners also will be entitled to additional distributions of General Partners' Junior Capital. If aggregate distributions made to the limited partners, generally from all sources, have not reached approximately $800 million by June 30, 1997, cash distributions to the General Partners with respect to the General Partners' pro rata priority and residual equity capital, other than Stock Option Distributions and Tax Distributions, will be deferred until such threshold is met. Similarly, if such aggregate distributions to the limited partners have not reached approximately $1.6 billion by June 30, 1998, cash distributions with respect to General Partners' Junior Capital, other than TWSP Distributions, will be deferred until such threshold is met. If any such deferral occurs, a portion of the corresponding partnership income allocations with respect to such deferred amounts will be made at a rate higher than otherwise would have been the case. If a division of TWE or a substantial portion thereof is sold, the net proceeds of such sale, less expenses and proceeds used to repay outstanding debt, will be required to be distributed with respect to the partners' partnership interests. Similar distributions are required to be made in the event of a financing or refinancing of debt. Subject to any limitations on the incurrence of additional debt contained in the TWE partnership and credit agreements, and the Indenture, TWE may borrow funds to make distributions. 7. STOCK OPTION PLANS Options to purchase Time Warner common stock under various stock option plans have been granted to employees of TWE, generally at fair market value at the date of grant. Generally, the options are exercisable over a three-year vesting period and expire ten years from the date of grant. A summary of stock option activity with respect to employees of TWE is as follows: TWE reimburses Time Warner for the use of Time Warner stock options on the basis described in Note 6. There were 129,000 options exercised by employees of TWE in 1992 at prices ranging from $8-$24 per share. TIME WARNER ENTERTAINMENT COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 8. BENEFIT PLANS TWE and its divisions have defined benefit pension plans covering substantially all domestic employees. Pension benefits are based on formulas that reflect the employees' years of service and compensation levels during their employment period. Qualifying plans are funded in accordance with government pension and income tax regulations. Plan assets are invested in equity and fixed income securities. Pension expense included the following: Certain domestic employees of TWE participate in defined contribution multiemployer pension plans as to which the expense amounted to $19 million in 1993, $20 million in 1992 and $21 million in 1991. Employees in foreign countries participate to varying degrees in local pension plans, which in the aggregate are not significant. Certain domestic employees also participate in Time Warner's 401(k) savings plans and profit sharing plans as to which the expense amounted to $20 million in 1993, $16 million in 1992 and $18 million in 1991. Contributions to the 401(k) plans are based upon a percentage of the employees' elected contributions. TIME WARNER ENTERTAINMENT COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 9. SEGMENT INFORMATION Information as to the operations of TWE in different business segments is as set forth below: - -------- (1) Depreciation and amortization includes amortization relating to the acquisitions of WCI in 1989 and the ATC minority interest in 1992 and to other business combinations accounted for by the purchase method. - -------- (1)Consists principally of cash, cash equivalents and other investments. TIME WARNER ENTERTAINMENT COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Information as to the capital expenditures of TWE is as follows: Substantially all operations outside of the United States support the export of domestic products. Approximately 60% of export revenues are from sales to European customers. 10. COMMITMENTS AND CONTINGENCIES Total rent expense amounted to $119 million in 1993, $99 million ($107 million on a restated basis) in 1992 and $83 million in 1991. The minimum rental commitments under noncancellable long-term operating leases are: 1994-- $100 million; 1995--$97 million; 1996--$90 million; 1997--$76 million; 1998-- $71 million and after 1998--$453 million. Minimum commitments and guarantees under certain programming, licensing, franchise and other agreements at December 31, 1993 aggregated approximately $3 billion, which are payable principally over a five-year period. Pending legal proceedings are substantially limited to litigation incidental to the businesses of TWE. In the opinion of counsel and management, the ultimate resolution of these matters will not have a material effect on the consolidated financial statements. 11. RELATED PARTY TRANSACTIONS In the normal course of conducting their businesses, TWE units have had various transactions with Time Warner units, generally on terms resulting from a negotiation among the affected parties that in management's view results in reasonable allocations. Employees of TWE participate in various Time Warner medical, stock option (Note 7) and other benefit plans (Note 8) for which TWE is charged its allocable share of plan expenses, including administrative costs. Time Warner's corporate group provides various other services to TWE. The Music division of WCI provides home videocassette distribution services to certain TWE operations, and certain TWE units have placed advertising in magazines published by Time Warner's Publishing division. TWE is required to pay a $130 million advisory fee to USW over a five-year period ending September 15, 1997 for USW's expertise in telecommunications, telephony and information technology, and its participation in the management and upgrade of the cable systems to Full Service Network(TM) capacity. Time Warner provides TWE with certain corporate support services for which Time Warner is paid $60 million per year, subject to adjustment for inflation beginning in 1995. The corporate services agreement runs through June 30, 1997, and may be extended by agreement of both parties. Management believes that the corporate services fee is representative of the cost of corporate services that would be necessary for the stand-alone operations of TWE. TIME WARNER ENTERTAINMENT COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) TWE has entered into service agreements with the Time Warner Service Partnerships for program signal delivery and transmission services, and TWE provides billing, collection and marketing services to the Time Warner Service Partnerships. TWE also has distribution and merchandising agreements with Time Warner Entertainment Japan Inc., a company owned by partners of TWE to conduct TWE's businesses in Japan. In addition to transactions with its partners, TWE has had transactions with Paragon Communications, L.P., Comedy Partners, L.P. and its other equity affiliates, and with Turner Broadcasting System, Inc., The Columbia House Company partnerships, Cinamerica Theatres, L.P. and other equity affiliates of Time Warner, generally with respect to sales of product in the ordinary course of business. Long-term debt and interest expense prior to the TWE Capitalization include the effects of the pushdown of a portion of the Time Warner credit agreement debt that was related to the WCI acquisition, based on the proportion that the fair value of the WCI contributed businesses acquired bore to the fair value of all of the WCI net assets acquired. Interest expense prior to the TWE Capitalization also reflects interest on $875 million of loans due to WCI, which were repaid at the TWE Capitalization, at a rate approximating the rate applicable to borrowings under the Time Warner credit agreement. 12. SUPPLEMENTAL INFORMATION Supplemental information with respect to cash flows is as follows: The noncash effects of the consolidation of Six Flags are reflected in the difference between the historical and restated balance sheet amounts at December 31, 1992. The noncash effect of the acquisition of the ATC minority interest was to increase investments--$156 million; cable television franchises--$865 million; excess of cost over net assets acquired--$410 million; and partners' capital--$1.431 billion. A noncash effect of the TWE Capitalization was the assumption by TWE of $2.545 billion of Time Warner debt in excess of the amount reflected as a liability prior to the TWE Capitalization. Cash equivalents consist of commercial paper and other investments that are readily convertible into cash, and have original maturities of three months or less. TIME WARNER ENTERTAINMENT COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Other current liabilities consist of: REPORT OF INDEPENDENT AUDITORS TO THE PARTNERS OF TIME WARNER ENTERTAINMENT COMPANY, L.P. We have audited the accompanying consolidated balance sheet of Time Warner Entertainment Company, L.P. ("TWE") as of December 31, 1993 and 1992, and the related consolidated statements of operations, cash flows and partnership capital for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of TWE's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of TWE at December 31, 1993 and 1992, and the consolidated results of its operations and cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. ERNST & YOUNG New York, New York February 4, 1994 TIME WARNER ENTERTAINMENT COMPANY, L.P. SELECTED FINANCIAL INFORMATION The selected financial information for each of the five years in the period ended December 31, 1993 set forth below has been derived from and should be read in conjunction with the consolidated financial statements and other financial information presented elsewhere herein. Capitalized terms are as defined and described in such consolidated financial statements, or elsewhere herein. The selected historical financial information for 1993 gives effect to the consolidation of Six Flags effective as of January 1, 1993, as a result of the 1993 Six Flags acquisition. The selected historical financial information for periods prior to such date has not been changed; however, selected financial information for 1992 retroactively reflecting the consolidation is presented as supplementary information under the column heading "restated" to facilitate comparative analysis. The selected historical financial information for 1993 gives effect to the USW Transaction as of September 15, 1993 and the 1993 TWE Refinancings, and for 1992 gives effect to the TWE Capitalization and Refinancing as of the dates such transactions were consummated and the ATC Merger as of June 30, 1992, using the purchase method of accounting and reflected in the consolidated financial statements of TWE under the pushdown method of accounting. The selected historical financial information for 1989 gives effect to the purchase by Time Warner of 59.3% of the WCI contributed businesses (as part of Time Warner's acquisition of 59.3% of WCI) as of July 31, 1989, and to the purchase by Time Warner of the 40.7% minority interest in the WCI contributed businesses (as part of Time Warner's acquisition on January 10, 1990 of the remaining capital stock of WCI) as of December 31, 1989, using the purchase method of accounting for business combinations and reflected in the consolidated financial statements of TWE under the pushdown method of accounting. TIME WARNER ENTERTAINMENT COMPANY, L.P. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) - -------- (a) The 1993 financial statements reflect the consolidation of Six Flags effective January 1, 1993 as a result of the 1993 Six Flags acquisition. The historical financial statements for periods prior to such date have not been changed; however, financial statements for the year ended December 31, 1992 retroactively reflecting the consolidation are presented as supplementary information under the heading "restated" to facilitate comparative analysis. (b) Net income for each of the second and third quarters of 1993 includes an extraordinary loss on the retirement of debt of $2 million and $8 million, respectively. TIME WARNER ENTERTAINMENT COMPANY, L.P. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION TRANSACTIONS AFFECTING COMPARABILITY OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION The following transactions that occurred in 1993 and 1992 have affected the comparability of the financial statements of TWE (collectively, the "TWE Transactions"): . The 1993 Six Flags Acquisition and Refinancing: The increase in TWE's ownership of Six Flags from 50% to 100% on September 17, 1993 and the retirement of outstanding debt and preferred stock of Six Flags and its subsidiaries, using Six Flags cash flow and $550 million of funds provided by TWE, which resulted in the consolidation of Six Flags effective as of January 1, 1993. The historical financial information prior to 1993 has not been changed; however, financial statements retroactively reflecting the consolidation of Six Flags for 1992 also have been presented as supplementary information under the column heading "restated" in order to facilitate comparative analysis. . The USW Transaction: The admission of a subsidiary of USW as an additional limited partner of TWE on September 15, 1993 for a capital contribution of $2.553 billion, consisting of $1.532 billion in cash and the $1.021 billion USW Note, in exchange for 25.51% pro rata priority capital and residual equity interests. . The 1993 TWE Refinancings: The issuance of $2.6 billion of TWE debentures in 1993 to reduce indebtedness under the TWE credit agreement. . The TWE Capitalization and Refinancing: The initial capitalization of TWE on June 30, 1992 and associated refinancings, including the repayment of the Time Warner and ATC credit agreements with $5.9 billion borrowed under a new TWE credit agreement and $1 billion of capital contributions; and the issuance of $1.2 billion of senior notes to reduce bank debt. . The ATC Merger: Time Warner's acquisition of the ATC minority interest on June 26, 1992, in exchange for Time Warner notes then valued at $1.3 billion. . The 1992 Six Flags Recapitalization: The issuance of $192 million aggregate principal amount of zero coupon notes by Six Flags in December 1992 to redeem or repurchase shares of common stock of Six Flags and its principal subsidiary. The impact of these transactions on the financial statements of TWE is reflected on a pro forma basis in the discussion and analysis set forth below. RESULTS OF OPERATIONS 1993 VS. 1992 TWE had 1993 revenues of $7.946 billion, income of $208 million before an extraordinary loss of $10 million on the retirement of debt and net income of $198 million, compared to 1992 revenues of $6.761 billion ($7.251 billion on a restated basis) and net income of $160 million. On a pro forma basis, giving effect to the TWE Transactions as if such transactions had occurred at the beginning of the year, TWE would have reported net income of $198 million in 1993, compared to $208 million on an historical basis. On the same pro forma basis, TWE would have reported net income of $10 million in 1992, compared to net income of $160 million on an historical basis. TIME WARNER ENTERTAINMENT COMPANY, L.P. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION--(CONTINUED) As a U.S. partnership, TWE is not subject to U.S. federal and state income taxation. Income and withholding taxes of $64 million and $50 million ($53 million on a restated basis) in the years ended December 31, 1993 and 1992, respectively, have been provided in respect of the operations of TWE's domestic and foreign subsidiary corporations, including Six Flags in 1993. Other factors affecting comparative operating results are discussed below on a business segment basis. That discussion includes, among other factors, an analysis of changes in the operating income of the business segments before depreciation and amortization ("EBITDA"), because the operating income of certain businesses has been affected by significant amounts of purchase price amortization from Time Warner's $14 billion acquisition of WCI in 1989, the $1.3 billion acquisition of the ATC minority interest in 1992 and other business combinations accounted-for by the purchase method. EBITDA for 1993 and 1992 was as follows: While many financial analysts consider EBITDA to be an important measure of comparative operating performance for the businesses of TWE, it should be considered in addition to, but not as a substitute for, or superior to, operating income, net income, cash flow and other measures of financial performance reported in accordance with generally accepted accounting principles. Filmed Entertainment. Revenues increased to $4.557 billion compared to $3.455 billion ($3.945 billion on a restated basis) in 1992. Operating income increased to $263 million from $194 million ($235 million on a restated basis). Depreciation and amortization, including amortization related to the purchase of WCI, amounted to $258 million in 1993 and $191 million ($260 million on a restated basis) in 1992. EBITDA increased to $521 million from $385 million ($495 million on a restated basis). The increase in revenues, operating income and EBITDA on an historical basis resulted primarily from the inclusion in 1993 of the operating results of Six Flags, which previously had been accounted for using the equity method. Revenues at Warner Bros. increased during the period primarily due to increases in international theatrical, international syndication and domestic home video revenues, as well as increased revenues from retail operations. Record international revenues of $1.650 billion would have been greater but for unfavorable exchange rate fluctuations. Warner Bros. ranked number one at both the domestic and international box office in 1993, led by the success of The Fugitive and The Bodyguard. Revenues at Six Flags increased, benefiting from higher revenues per visitor. EBITDA benefited from the above gains. Programming--HBO. Revenues decreased to $1.435 billion compared to $1.444 billion in 1992. Operating income increased to $213 million from $201 million. Depreciation and amortization amounted to $17 million in 1993 and $14 million in 1992. EBITDA increased to $230 million from $215 million. The decrease in revenues reflects lower HBO Video sales, which in 1992 were favorably affected by a children's sell-thru title, offset in part by higher subscriber revenues, principally as a result of higher pay-TV rates at TIME WARNER ENTERTAINMENT COMPANY, L.P. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION--(CONTINUED) HBO and an increase in subscribers. EBITDA benefited primarily from improved results from new businesses, including Time Warner Sports and the Comedy Central joint venture. Cable. Revenues increased to $2.205 billion compared to $2.091 billion in 1992. Operating income increased to $407 million from $400 million. Depreciation and amortization, including amortization related to the purchase of WCI and the ATC Merger, amounted to $627 million in 1993 and $577 million in 1992. EBITDA increased to $1.034 billion from $977 million. Revenues increased principally as a result of growth in the number of cable subscribers and increases in advertising sales and pay-per-view. The increase in subscribers accounted for approximately three quarters of the revenue increase. EBITDA benefited from the revenue gains and increased income from cable joint ventures, but was negatively affected in the fourth quarter by cable rate regulation which went into effect on September 1, 1993. The negative effect of rate regulation is expected to continue into 1994 (see "Financial Condition and Liquidity" elsewhere herein). Interest and Other, Net. Interest and other, net, increased to $551 million in 1993 from $525 million ($563 million on a restated basis) in 1992. Interest expense increased to $573 million compared with $436 million ($486 million on a restated basis) in 1992. The increase in interest expense resulted primarily from the higher average debt levels attributable to the TWE Capitalization, the higher interest cost of the TWE notes and debentures issued to refinance TWE bank debt, and the consolidation of Six Flags' interest expense in 1993. Other income, net, in 1993 included gains on the sale of certain assets partially offset by reductions in the carrying value of certain investments. Other expenses, net, on a restated basis in 1992 is principally attributable to losses on certain investments and litigation-related costs. 1992 VS. 1991 TWE had revenues of $6.761 billion and net income of $160 million in 1992, compared to revenues of $6.068 billion and net income of $97 million in 1991. EBITDA for 1992 and 1991 on a historical basis was as follows: Filmed Entertainment. Revenues increased to $3.455 billion compared to $3.065 billion in 1991, and operating income decreased to $194 million from $195 million. Depreciation and amortization, including amortization related to Time Warner's purchase of WCI, amounted to $191 million in 1992 and $183 million in 1991. EBITDA increased to $385 million from $378 million in 1991. The revenue growth resulted primarily from increased worldwide theatrical revenues, which benefited from a number of very successful releases. Warner Bros. ranked number one in domestic box office. Revenues from international home video and syndication, sales to network television and retail operations also increased, while revenue from pay-television sales declined. The increase in EBITDA reflects the higher revenues, offset in part by lower margins. Programming--HBO. Revenues increased to $1.444 billion from $1.366 billion in 1991, while operating income rose to $201 million from $183 million. Depreciation and amortization amounted to $14 million in 1992 and $12 million in 1991. EBITDA increased to $215 million from $195 million in 1991. The revenue TIME WARNER ENTERTAINMENT COMPANY, L.P. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION--(CONTINUED) growth resulted from higher subscriber revenues and increased revenues from ancillary businesses, particularly from television production. The increase in subscriber revenues resulted from higher pay-TV rates at HBO and a slight increase in the number of subscribers. EBITDA benefited from the revenue gains, improved operating margins and a smaller loss from the division's 50% investment in Comedy Central, offset in part by expenses associated with the start-up of international pay-TV ventures. Cable. Revenues increased to $2.091 billion, compared to $1.935 billion in 1991, and operating income increased to $400 million from $334 million. Depreciation and amortization, including amortization related to the purchase of WCI, amounted to $577 million in 1992 and $538 million in 1991. EBITDA increased to $977 million from $872 million in 1991. Revenues increased as a result of growth in the number of cable customers and an increase in per subscriber revenue. The increase in subscribers accounted for approximately 40% of the revenue increase. EBITDA benefited from the revenue gains, continued cost containment and increased income from domestic cable joint ventures, partially offset by higher cable programming costs and expenses associated with the start-up of international cable ventures. Operating income also was affected by amortization related to the ATC merger. Interest and Other, Net. Interest and other, net increased to $525 million in 1992 from $520 million in 1991. Interest expense decreased to $436 million in 1992 compared with $479 million in 1991. The decrease in interest expense, which is attributable to lower interest rates and lower average debt levels, was offset in part by increases in litigation-related costs and a decline in investment-related income. In August 1992, Time Warner and TWE settled the litigation brought by Viacom International, Inc. in 1989 against Time Warner, ATC and HBO. The settlement terminated with prejudice all claims and counterclaims raised in the litigation. The effects of the settlement were not material to TWE. FINANCIAL CONDITION AND LIQUIDITY DECEMBER 31, 1993 Aided by favorable conditions in the credit markets, TWE continued its strategy of significantly lengthening debt maturities at attractive fixed rates. Over the past two years, TWE reduced variable rate debt by $3.8 billion with proceeds from the issuance of long-term notes and debentures having an average fixed interest rate of 8.6%. An additional $2.5 billion of capital was raised by the USW Transaction, $1 billion of which, presently in the form of the USW Note, has been earmarked for building the Cable division's Full Service Networks(TM) ("FSN"). The Six Flags acquisition culminated a series of transactions over a two-year period that resulted in it becoming a wholly-owned subsidiary of TWE. Six Flags was consolidated effective as of January 1, 1993. Primarily as a result of these transactions, TWE had $7.1 billion of long-term debt at December 31, 1993, and $1.5 billion of General Partners' Senior Capital and $6 billion of partners' capital (net of the $1 billion uncollected portion of the USW Note), compared to $7.2 billion of long-term debt ($7.7 billion on a restated basis) and $6.4 billion of partners' capital at December 31, 1992. Cash and equivalents were $1.3 billion at December 31, 1993, reducing the debt- net-of-cash amount to $5.8 billion at such date. Cash and equivalents at December 31, 1992 were $47 million on a restated basis. Cash provided by the operations of TWE in 1993 amounted to $1.271 billion, after interest payments of $450 million, income taxes of $70 million and working capital requirements. On a pro forma basis, giving retroactive effect to the beginning of the year to the 1993 TWE Refinancings, the USW Transaction and the 1993 Six Flags Acquisition and Refinancings, cash flow from operations would have been $1.279 billion, after interest payments of $473 million, income taxes of $70 million and working capital requirements. Cash used in investing activities in 1993, excluding proceeds from investments, amounted to $960 million. Of this amount, $613 million was spent on capital projects, including $352 million by the Cable division to upgrade its cable systems and $244 million by the Filmed Entertainment division, principally to continue the expansion of international theaters and Warner Bros. Studio Stores, to upgrade facilities at the Warner Bros. Studio, and to introduce new rides at Six Flags. TIME WARNER ENTERTAINMENT COMPANY, L.P. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION--(CONTINUED) TWE continues to expand its core businesses through selective acquisitions and investments, which in 1993 resulted in payments of $347 million, including $136 million for the purchase of common and preferred stocks of Six Flags in connection with the 1993 Six Flags Acquisition and Refinancing. The Milwaukee, Wisconsin cluster of cable systems was augmented by the purchase of a cable system from Viacom Inc. Several other cable systems that did not fit into a cluster were disposed of in 1993 for approximately $100 million. Capital spending is expected to increase significantly in 1994, principally because of the plan to upgrade a significant percentage of cable systems to FSN capacity over the next five years at an estimated cost of $5 billion, which is about three times cable capital expenditures for the last five years. $1 billion of FSN capital expenditures will be funded by collections on the USW Note. TWE is permitted under its partnership and credit agreements to loan up to $1.1 billion to Time Warner. An additional $400 million of such loans are permitted beginning July 1, 1995. There was $1.3 billion of cash and equivalents and $2 billion of available credit under the TWE credit agreement at December 31, 1993. In early 1994, TWE filed a shelf registration statement with the Securities and Exchange Commission covering the issuance of up to $2 billion of debt securities. These securities may be issued from time to time on terms determined at the time of sale. Management believes that 1994 operating cash flow, cash and equivalents, the USW Note, and additional borrowing capacity are sufficient to meet the capital and liquidity needs of TWE, and to fund anticipated loans to Time Warner. On October 5, 1992, Congress enacted the 1992 Cable Act, which among other things reimposed rate regulation on most cable systems. The Federal Communications Commission ("FCC") froze rates in April 1993 for regulated cable services and associated equipment, other than for systems in which local franchising authorities regulate rates. The current expiration date of the freeze is May 15, 1994. On May 3, 1993, the FCC released rules implementing rate regulation, which required that rates for certain equipment be established based on a cost-of-service standard and rates for regulated cable services be established based on either a per-channel benchmark or a cost-of-service standard, at the election of the cable operator. The Cable division elected to establish rates based on the per-channel benchmarks, which the FCC had set at 10% below the average level of rates prevailing nationwide in September of 1992. On February 22, 1994, the FCC announced the adoption of revised rules setting the benchmarks at an average of 17% below the level of rates prevailing in September of 1992, compared with an average 10% rollback under the earlier rules published in May 1993. The text of the new rules is expected to be released in late March, with an effective date of May 15. Under the earlier rules, revenues from sales of regulated equipment and services were expected to decline $90 to $100 million per year. That decline was expected to be partially offset by increases in revenues from other activities, including optional services, advertising sales and subscriber growth that could not be quantified. It is not yet possible to estimate the effect of the new rules although it is expected to be more adverse than the effect of the earlier rules. On November 5, 1992, TWE filed a lawsuit seeking to overturn major provisions of the 1992 Cable Act, primarily on First Amendment grounds. On April 8, 1993, a three-judge District Court upheld the constitutionality of the "must carry" provisions of the 1992 Cable Act. TWE's appeal from this decision was heard by the U.S. Supreme Court in January 1994. On September 16, 1993, a one-judge District Court upheld the constitutionality of a majority of the other challenged provisions of the 1992 Cable Act. The Company and the federal defendants have appealed this decision to the U.S. Court of Appeals for the D.C. Circuit. Warner Bros.' backlog, representing the amount of future revenue not yet recorded from cash contracts for the licensing of films for pay and basic cable, network and syndicated television exhibition amounted to $724 million at December 31, 1993 compared to $674 million at December 31, 1992 (including amounts TIME WARNER ENTERTAINMENT COMPANY, L.P. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION--(CONTINUED) relating to HBO of $178 million at December 31, 1993 and $161 million at December 31, 1992). The backlog excludes advertising barter contracts. The net impact of inflation on operations has not been significant in the past three years. TIME WARNER ENTERTAINMENT COMPANY, L.P. SUPPLEMENTARY INFORMATION SUMMARIZED FINANCIAL INFORMATION OF SIX FLAGS Six Flags was formed by a group of companies, including a subsidiary of Time Warner ("Enterprises") which owned 50% of Six Flags common stock, to effect the acquisition on December 29, 1991 of Six Flags Theme Parks Inc. ("1991 SF Acquisition"). Enterprises' interest in Six Flags was contributed to TWE at the TWE capitalization. In December 1992, Six Flags redeemed certain of its equity with $102 million of proceeds from the issuance of zero coupon senior notes due 1999 and $12 million of proceeds from the issuance of additional shares of Six Flags common stock ("1992 SF Recapitalization"). TWE continued to own 50% of the common stock of Six Flags following the 1992 SF Recapitalization, until September 17, 1993, when it provided Six Flags with $136 million to repurchase all the common stock held by the other stockholders and preferred stock of certain subsidiaries. TWE also provided $414 million to finance the repurchase or retirement of all the indebtedness of Six Flags and its subsidiaries, except for the zero coupon senior notes due 1999 ("1993 SF Acquisition and Refinancing"). As a result of the 1993 SF Acquisition and Refinancing, TWE has consolidated Six Flags effective January 1, 1993. Set forth below is summarized financial information of Six Flags for 1993 and 1992, and of the predecessor to Six Flags ("Predecessor Company") for 1991, the year preceding the 1991 SF Acquisition. SIX FLAGS ENTERTAINMENT CORPORATION - -------- (a)The 1993 SF Acquisition and Refinancing, certain transactions with respect to the 1992 SF Recapitalization, and the 1991 SF Acquisition were accounted for using the purchase method of accounting for business combinations. If the 1993 SF Acquisition and Refinancing had occurred at the beginning of the year, the 1993 income before extraordinary item would have been $7 million; if the 1992 SF Recapitalization had occurred at the beginning of the year, the 1992 net loss would have been $18 million; and if the 1991 SF Acquisition had occurred at the beginning of the year, the 1991 net loss would have been $17 million. (b)Six Flags entered into a sale and leaseback transaction with TWE with respect to certain of its wholly-owned theme parks. Sale proceeds of $301 million were used to repay indebtedness to TWE incurred in connection with the 1993 SF Acquisition and Refinancing. The 15-year leases have been accounted for as capital leases. TIME WARNER ENTERTAINMENT COMPANY, L.P. SCHEDULE II--AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 - -------- (1)Non-interest bearing note pursuant to an employment agreement for $1,000,000 due on demand. Additional loan pursuant to the agreement of $1,000,000 due December 31, 1994, bearing interest at 6%, payable quarterly. (2)Note pursuant to an employment agreement due on demand bearing interest at 6% per annum, payable annually. (3)Payment of $50,000 received in February 1994. Remaining balance of note due on January 1, 1995, bearing interest at 10% per annum. TIME WARNER ENTERTAINMENT COMPANY, L.P. SCHEDULE VIII--VALUATION AND QUALIFYING ACCOUNTS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 - -------- (a) Represents uncollectible receivables charged against the reserve. (b) Represents returns or allowances applied against the reserve. TIME WARNER ENTERTAINMENT COMPANY, L.P. SCHEDULE X--SUPPLEMENTARY OPERATING STATEMENT INFORMATION YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 - -------- (a)The 1993 financial statements reflect the consolidation of Six Flags effective January 1, 1993 as a result of the 1993 Six Flags acquisition. The historical financial statements for periods prior to such date have not been changed; however, financial information for the year ended December 31, 1992 retroactively reflecting the consolidation is presented as supplementary information under the column heading "restated" to facilitate comparative analysis. APPENDIX FOR GRAPHIC AND IMAGE MATERIAL DESCRIPTION OF OMITTED LOCATION OF GRAPHIC GRAPHIC OR IMAGE OR IMAGE IN TEXT - --------------------- ------------------- An organizational chart showing the Registrant's major business groups and its ownership interests therein. IFC - 1 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ---------------- EXHIBITS FILED WITH FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF FOR THE FISCAL YEAR ENDED DECEMBER 31, 1993 COMMISSION FILE NUMBER 1-8637 TIME WARNER INC. (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- EXHIBIT INDEX i ii iii - -------- Incorporated by reference. The Registrant hereby agrees to furnish to the Securities and Exchange Commission at its request copies of long-term debt instruments defining the rights of holders of the Registrant's outstanding long-term debt that are not required to be filed herewith. iv
104918_1993.txt	104918	1993	ITEM 1. BUSINESS COMPANY OVERVIEW Incorporated in 1889 under the laws of the State of Washington, The Washington Water Power Company (WWP, the Company) is an investor-owned company primarily engaged as a combination electric and natural gas utility serving a 26,000 square mile area known as the Inland Northwest in eastern Washington and northern Idaho with a population estimated to be in excess of 750,000. Also, WP Natural Gas (WPNG), an operating division, provides natural gas service in northeast and southwest Oregon and the South Lake Tahoe region in California with a population estimated to be in excess of 450,000. The Company's utility operations include the generation, purchase, transmission, distribution and sale of electric energy on both a retail and wholesale basis plus the purchase, transportation, distribution and sale of natural gas. In addition to its utility operations, the Company owns Pentzer Corporation, parent company to the majority of the Company's non-utility businesses. Pentzer's portfolio of investments includes companies involved in advertising display manufacturing, electronic technology, energy services, financial services, real estate development and telecommunications. At December 31, 1993, the Company employed 1,696 people with 1,438 in its utility operations and 258 in its majority-owned non-utility operations. The Company headquarters are in Spokane, Washington, which with a population of about 480,000 in the Greater Spokane Area, serves as the Inland Northwest's center for business, transportation, health care, education, communication and agricultural interests. For the twelve months ended December 31, 1993 and 1992, respectively, the Company derived operating revenues and income from operations in the following proportions: UTILITY OVERVIEW The Company owns and operates nine hydroelectric projects, a wood-waste fueled generating station and a natural gas combustion turbine. The Company also retains a 15% ownership in two coal-fired generating facilities, one in southwestern Washington and one in southeastern Montana. In addition the Company is in the process of constructing a natural gas combustion turbine peaking unit in northern Idaho. Four natural gas pipelines provide the Company access to both domestic and Canadian natural gas supplies. With this diverse resource portfolio, the Company remains one of the nation's lowest-cost producers and sellers of energy services. At December 31, 1993, electric service was supplied to approximately 267,000 customers in eastern Washington and northern Idaho. The Company's average hourly load for 1993 was 900 aMW. The Company's annual peak load, including firm contractual obligations, was 2,126 MW. This peak occurred on January 13, 1993, at which time the maximum capacity available from the Company's generating facilities, contracts and non-firm purchases was 2,335 MW. At December 31, 1993, the Company's natural gas operations served approximately 196,000 customers in four states. The Company's natural gas business has more than doubled since 1990 due primarily to the acquisition of the natural gas distribution properties of CP National in Oregon and South Lake Tahoe, California in September, 1991. The peak load in 1993 occurred on February 16, 1993 when 2.7 million therms were required. During that peak 3.5 million therms were available under firm transportation and storage contracts. NON-UTILITY OVERVIEW The Company's principal subsidiary, Pentzer, is the parent company of all the Company's non-utility subsidiaries except for three non-operating subsidiaries. Wholly-owned Pentzer is a company with approximately $130 million in total assets and about $86 million in shareholder equity. Pentzer's business strategy is to acquire controlling interests in a broad range of middle market companies, to help these companies grow through internal development and strategic acquisitions, and to sell the portfolio investments either to the public or to strategic buyers when it becomes most advantageous in meeting Pentzer's return on invested capital objectives. THE WASHINGTON WATER POWER COMPANY ELECTRIC SERVICE ELECTRIC COMPETITION AND BUSINESS OVERVIEW The electric utility business is undergoing numerous changes and is becoming increasingly competitive as a result of economic, regulatory, and technological changes. The Company believes that it is well positioned to meet the challenges described below due to its low production costs, close proximity to major transmission lines, experience in the wholesale market and its commitment to high levels of customer satisfaction, cost reduction and continuous improvement of work processes. The Company currently competes for new retail electric customers with various rural electric cooperatives and public utility districts. Challenges facing the electric retail business include changing technologies which reduce energy consumption, self- generation and fuel switching by industrial and other large retail customers, the potential for retail wheeling (described below) and the costs of increasingly stringent environmental laws. Cogeneration has had only a minor impact on the Company to date. See "Purchases, Exchanges and Sales" for additional detail on cogeneration purchases and sales. In addition, if electric utility companies are eventually required to provide retail wheeling service, which is the transmission by an electric utility of electric power from another supplier to a customer located within such utility's service area, the Company believes it will be in a position to benefit since it is committed to remaining one of the country's lowest-cost providers of electric energy. The Company also competes in the wholesale electric market with other western utilities, including the BPA. Challenges facing the electric wholesale business include new entrants in the wholesale market and competition from lower cost generation being developed by independent power producers. The National Energy Policy Act (NEPA) enacted in 1992 addresses a wide range of issues affecting the wholesale electric business. NEPA gives the FERC expanded authority to order electric utilities (a) to transmit electric power to or for wholesale purchasers and sellers if the result would not unreasonably impair the continuing reliability of the affected electric systems and (b) to increase transmission capacity to provide access for wholesale purchasers and sellers of electric power at prices that permit the recovery by the utility of all costs incurred in connection with the transmission services. NEPA also created Exempt Wholesale Generators (EWG's), a new class of independent power plant owners who are able to sell generation only at the wholesale level. The Company believes NEPA provides future transmission, energy production and sales opportunities to the Company and complements the Company's commitment to the wholesale electric business. The Company's wholesale electric business remains an important part of the Company's overall business. Since 1987 the Company has entered into a number of long-term firm power sales contracts that have increased its wholesale electric business and the Company intends to continue active pursuit of wholesale business opportunities. In 1993, 31% of total KWH sales were to wholesale customers with 55% of these sales under firm contracts. ELECTRIC SYSTEM The Company owns and operates nine hydroelectric projects, a wood-waste fueled generating station and a natural gas combustion turbine in addition to retaining a 15% ownership in two coal-fired generating facilities. Hydroelectric Resources Hydroelectric generation is the Company's lowest cost source of electricity and the availability of hydroelectric generation has a significant effect on the Company's total power costs. The Company expects to meet about 49% of its total system requirements with its own hydroelectric generation and long-term hydro contracts in normal water years. The streamflows in the Company's drainage systems were 86%, 64% and 116% of normal in 1993, 1992 and 1991, respectively. For the years 1993, 1992 and 1991, respectively, the Company's own hydroelectric generation facilities provided 33%, 28% and 38%, while long-term hydro contracts provided approximately 10%, 12% and 14% of the Company's total system requirements. Thermal Resources The Company has a 15% interest in two coal-fired facilities - - the Centralia Power Plant (Centralia) in southwestern Washington and Units 3 and 4 of the Colstrip Generating Project (Colstrip) in southeastern Montana. In addition, the Company owns a woodwaste-fired facility known as the Kettle Falls Generating Station (Kettle Falls) in northeastern Washington and a natural gas-fired combustion turbine (CT) in Spokane. The CT is primarily used for peaking needs. In a normal water year about 32% of the Company's total system requirements are met by thermal sources. Company-owned thermal facilities provided 25%, 31% and 26% of the Company's total electricity requirements for the years 1993, 1992 and 1991, respectively. THE WASHINGTON WATER POWER COMPANY Centralia, which is operated by PacifiCorp, is supplied with coal under a fuel supply agreement in effect through December 31, 2020. In 1993, 1992 and 1991 Centralia provided approximately 46%, 40% and 40%, respectively, of the Company's thermal generation. Colstrip is supplied with fuel under coal supply and transportation agreements in effect through December 2019, from adjacent coal reserves owned and controlled by Entech, Inc. (Entech). Entech is a wholly-owned subsidiary of The Montana Power Company, which is also the operator of Colstrip. In 1993, 1992 and 1991 Colstrip provided approximately 43%, 51%, and 51% of the Company's thermal generation, respectively. Kettle Falls' primary fuel is waste wood generated as a by-product of forest product processing facilities such as sawmills within an approximate one hundred mile radius of the plant. Natural gas may be used as an alternate fuel. The cost of waste wood fuel is heavily influenced by operations of the forest products industry as well as transportation costs and, therefore, is subject to significant price variations. Current fuel supplies are adequate through the remainder of 1994. A combination of long term contracts already in place plus spot purchases allow the Company the flexibility to meet all expected future fuel requirements for the plant. In 1993, 1992 and 1991 Kettle Falls provided approximately 11%, 9% and 9% of the Company's thermal generation, respectively. Purchases, Exchanges and Sales In addition to the Company-owned hydro, long-term hydro contracts and thermal generating resources discussed above, total system requirements are met with other long-term purchases and exchanges of power. Other power purchases and exchanges for the years 1993, 1992 and 1991 provided approximately 32%, 29% and 22%, respectively, of the Company's total system requirements. The following table summarizes the Company's major long-term wholesale power agreements as of December 31, 1993 (1): (1) Available capacity may vary pursuant to the provisions of the specific contracts. See Notes 11 and 13 to Financial Statements for additional information Under PURPA, the Company is required to purchase generation from qualifying facilities, including small hydro and cogeneration projects, at avoided cost rates adopted by the WUTC and IPUC. The Company purchased approximately 623 million KWH, or about 6% of the Company's total energy requirements, from these sources at a cost of approximately $26 million in 1993. The largest such contract is a ten-year power purchase contract between the Company and Potlatch, one of the Company's major industrial customers, which became effective on January 1, 1992. Under the terms of the agreement, the Company purchases 50-55 aMW of Potlatch's electric generation and makes available approximately 95 aMW of firm energy for sale. In addition, the Company makes available 25 aMW of interruptible energy and Potlatch must provide an equivalent amount of reserve generation capacity in case of interruption. ELECTRIC REGULATORY ISSUES The Company, as a public utility, is currently subject to regulation by state utility commissions with respect to rates, accounting, the issuance of securities and other matters. The electric retail operations are subject to the jurisdiction of the WUTC and IPUC. The Company is also subject to the jurisdiction of the FERC for its accounting procedures and its wholesale transmission rates. In each regulatory jurisdiction, the prices the Company may charge for utility services (other than certain wholesale sales and specially negotiated retail rates for industrial or large commercial customers) are determined on a "cost of service" basis and are designed to provide, after recovery of allowable operating expenses, an opportunity to earn a reasonable return on "rate base" or assets employed in the business. "Rate base" is generally determined by reference to the original cost (net of accumulated depreciation) of utility plant in service, subject to various adjustments for deferred taxes and other items. Over time, rate base is increased by additions to utility plant in service and reduced by depreciation and retirements of utility plant from service. The Company is a licensee under the Federal Power Act and its licensed projects are subject to the provisions of Part I of that Act. See "Properties - Electric Properties" for additional information. These provisions include payment for headwater THE WASHINGTON WATER POWER COMPANY benefits, condemnation of licensed projects upon payment of just compensation and take-over of such projects after the expiration of the license upon payment of the lesser of "net investment" or "fair value" of the project, in either case plus severance damages. General Rate Cases The Company does not currently plan to file for any general electric rate increases in 1994. The following table summarizes information for the Company's most recent general electric rate cases: (1) Anticipated annual revenue effect. (2) Through June 30, 1994, the IPUC has approved a power cost adjustment (PCA) mechanism Integrated Resource Planning (IRP) IRP is a process required by both the WUTC and IPUC and represents the Company's responsibility to meet customer demand for reliable energy services at the lowest total cost to both the Company and its customers. The process entails (1) the forecasting of future energy needs, (2) the assessment of energy supplies, conservation options, customer costs, and social and environmental impacts and (3) the development of action plans which support a least cost resource strategy. The Company's need for future electric resources to serve retail loads is very minimal. The electric integrated resource plan accepted by both the IPUC and the WUTC in 1993 showed that, through the year 1998, the Company's additional electric load requirements will be met for the most part by a combination of demand side management, including conversions to natural gas, and the redevelopment of existing hydro generating plants. The cost of these resources is generally competitive with the costs of resources being developed by independent power producers. Demand Side Management (DSM) Energy efficiency programs, which include residential space and water heat conversion programs, are material components of the Company's long-term resource strategy. In 1992 the Company filed a request with both the WUTC and IPUC for approval of new electric DSM tariffs which would provide for the implementation of new and revised energy efficiency programs including the "Energy Exchanger" program, which offers incentives to the Company's electric space and/or hot water heating customers to convert to natural gas. In conjunction with the request for tariff approval, DSM accounting treatment was requested which would allow the Company to defer the costs in new program investments until the next general rate case. With only minor modifications, the applications were approved and the effective dates for implementation were May 1 and July 17, 1992 in Washington and Idaho, respectively. Reductions in the DSM incentives were approved by both the IPUC and WUTC in 1993. Justification will be required for continuation of the programs beyond December 31, 1994. Approximately 18 aMW were saved in 1993 under these programs and over 23 aMW have been saved since the program's inception. Power Cost Adjustment (PCA) The Company's PCA surcharge of $2.3 million in Idaho expired on November 1, 1993. The current balance in the account has not yet triggered either a surcharge or a refund. In June 1993 the IPUC approved an extension of the PCA to June 30, 1994. See Note 1 to Financial Statements for additional details. THE WASHINGTON WATER POWER COMPANY ELECTRIC OPERATING STATISTICS (1) Includes firm contract obligations of 485 MW, 462 MW and 323 MW and 120 MW, 63 MW and 247 MW of non-firm sales in 1993, 1992 and 1991, respectively. (2) Includes firm contract obligations of 610 MW, 468 MW and 474 MW in 1993, 1992 and 1991, respectively; 1991 results do not include 150 MW for non-firm sales. There were no non-firm sales in 1993 or 1992 during the summer system peak period. THE WASHINGTON WATER POWER COMPANY NATURAL GAS SERVICE NATURAL GAS COMPETITION AND BUSINESS OVERVIEW Natural gas is priced competitively compared to other alternative fuel sources for both residential and commercial customers. The Company provides programs that encourage electric customers to convert to natural gas. Significant growth has occurred in the Company's natural gas business in recent years due to these conversions. The Company also makes sales or provides transportation service directly to large natural gas customers. Challenges facing the Company's natural gas business include the potential for customers to by-pass the Company and securing competitively priced natural gas supplies for the future. Since 1988 one of the Company's large industrial customers has built its own pipeline interconnection. However, this customer still purchases some natural gas services from the Company. The Company prices its natural gas services, including transportation contracts, competitively and has varying degrees of flexibility to price its transportation and delivery rates by means of special contracts to assist in retaining potential by-pass customers. The Company has signed long-term transportation contracts with two of its largest industrial customers which minimizes the chances of these customers by-passing the Company's system. Order 636B adopted by FERC in 1992 provides the Company more flexibility in optimizing its natural gas transportation and supply portfolios. While rate design changes have increased the costs of firm transportation to low load factor pipeline customers such as the Company, flexible receipt and delivery points and capacity releases allow temporarily under-utilized transportation to be released to others when not needed to serve the Company's customers. NATURAL GAS SYSTEM The Company's natural gas operations are operated as separate divisions, with the WWP service territory including the Washington and Idaho properties and the WPNG service territory including Oregon and California properties. Natural Gas Supply The Company has access to four natural gas pipelines, Northwest Pipeline Company (NWP), Pacific Gas Transmission (PGT), Paiute Pipeline (Paiute) and Alberta Natural Gas Co. Ltd. (ANG), which provide the Company access to both domestic and Canadian natural gas supplies. Due to this resource portfolio, the Company remains one of the nation's lowest-cost local distribution companies. Both WWP and WPNG contract with (1) NWP for three types of firm service: transportation, liquefied natural gas storage and underground storage and (2) PGT and ANG for firm transportation. WPNG also contracts with Paiute for firm transportation and liquefied natural gas storage to deliver natural gas to its California customers. Firm winter natural gas supplies are purchased by the Company through negotiated agreements having terms ranging between one month and eleven years with a variety of natural gas suppliers. As a result of FERC Order 636B, WWP has completed the process of converting its NWP natural gas sales to firm transportation and assuming its share of NWP's natural gas supply contracts. In January 1993, the Company contracted with ANG, PGT, NWP and Paiute for additional transportation capacity to be available by November 1995 for service in the Oregon and California service territory of WPNG. The Company has also contracted with PGT and ANG for additional capacity for service beginning in 1995 for its Washington and Idaho properties. Jackson Prairie Natural Gas Storage Project (Storage Project) The Company retains a one-third ownership interest in the Storage Project, which is an underground natural gas storage field located near Chehalis, Washington. Under FERC's open access policy the role of the Storage Project in providing flexible natural gas supplies is increasingly important to the Company's natural gas operations. The Storage Project enables the Company to place natural gas into storage when prices are low or to meet minimum natural gas purchasing requirements, as well as to withdraw natural gas from storage when spot prices are high or as needed to meet high demand periods. The Company has released some of its Storage Project capacity to two other utilities until 1995 and 1996 with a provision under one of the releases to partially recall the released capacity if the Company determines additional natural gas is required for its own system supply. Natural Gas Transportation Services The Company provides transportation service to customers who obtain their own natural gas supplies. Transportation service continued to be a significant component of the Company's total system deliveries in 1993. The competitive nature of the spot natural gas market results in savings in the cost of purchased natural gas, which encourages large customers with fuel-switching capabilities to continue to utilize natural gas for their energy needs. The total volume transported on behalf of transportation customers was approximately 197.5 million therms in 1993. This total volume represented approximately 40% of the Company's total system deliveries in 1993. THE WASHINGTON WATER POWER COMPANY NATURAL GAS REGULATORY ISSUES The Company, as a public utility, is currently subject to regulation by several state utility commissions with respect to rates, accounting, the issuance of securities and other matters. The natural gas operations are subject to the jurisdiction of the WUTC, IPUC, OPUC and CPUC in addition to the FERC with respect to natural gas rates charged for the release of capacity from the Storage Project. Refer to Electric Regulatory Issues for additional details regarding the rate setting process. General Rate Cases The Company has no current plans to file for any natural gas general rate cases in 1994. The following table summarizes information for the Company's most recent general natural gas rate cases (1): (1) In addition, the Company from time to time, upon request, receives regulatory approval from the WUTC, the IPUC, the OPUC and the CPUC to adjust rates to reflect changes in the cost of purchased natural gas between general rate cases. (2) Anticipated annual revenue effect. In September 1991, the Company commenced operations in both California and Oregon upon the acquisition of the natural gas properties of CP National. The conditions of the CPUC order approving the acquisition included an exemption from filing a general rate case until January 1, 1994 and a rate "freeze" until January 1, 1995. On October 20, 1993, the CPUC granted a one year extension to January 1, 1995 before the Company is required to file a general rate case. As a result, the existing rate "freeze" will continue until at least January 1, 1996. The OPUC also authorized a general rate "freeze" which extends to December 31, 1995. Purchased natural gas costs will continue to be tracked through to customers in both jurisdictions during the rate "freeze" period. Integrated Resource Planning (IRP) In 1993 biannual natural gas IRP reports were accepted by both the WUTC and OPUC. Refer to Electric Regulatory Issues for a description of the IRP process. Demand Side Management (DSM) Included with the WUTC and IPUC electric DSM applications discussed above under Electric Regulatory Issues, the Company requested approval of new natural gas tariffs which would provide for the implementation of new and revised energy efficiency programs for the Company's residential, commercial and industrial natural gas customers. In conjunction with the request for tariff approval, the Company requested approval of associated natural gas DSM accounting treatment. With only minor modifications, the applications were approved. The effective dates for implementation were May 1 and July 17, 1992 in Washington and Idaho, respectively, with revisions made in July 1993 and future justification required for continuance of programs beyond December 31, 1994. On December 21, 1993, the OPUC authorized the Company to defer revenue requirement amounts associated with its WPNG DSM investments, and established an annual rate adjustment mechanism to reflect the deferred costs on a timely basis. Under this authorization, each December 1 the Company will file a rate adjustment to recover DSM program costs and margin losses. This filing will be concurrent with the Company's annual natural gas tracker filing. The effective date for both the deferrals and the rate adjustment mechanism was January 1, 1994. Natural Gas Trackers In the second quarter of 1993, the Company filed special natural gas trackers with the WUTC, IPUC, OPUC and CPUC due primarily to the increased costs from the pipelines related to the implementation of FERC Order 636B. The increases range from 3% to 25% but will result in no additional net income to the Company. The trackers were approved by all four state commissions. In a separate proceeding, the annual Oregon natural gas tracker became effective on December 1, 1993. The tracker will increase overall revenue by about $3.1 million or 8.74% in Oregon but will result in no additional net income to the Company as it is only a passthrough of changes in the cost of purchased natural gas and amortization rates pursuant to the Company's natural gas tracker. The filing also included the acquisition of additional capacity over the PGT system. THE WASHINGTON WATER POWER COMPANY NATURAL GAS OPERATING STATISTICS (1) Includes WPNG results from September 30 to December 31 except where otherwise noted; includes a three-month average of WPNG customers and a twelve-month average of WWP customers. THE WASHINGTON WATER POWER COMPANY ENVIRONMENTAL MATTERS The Company is subject to environmental regulation by federal, state and local authorities. The generation, transmission, distribution, service and storage facilities in which the Company has an ownership interest have been designed to comply with all environmental laws presently applicable. The Company was named a potentially responsible party under the Comprehensive Environmental Response, Compensation, and Liability Act of 1980 ("CERCLA" or "Superfund") at the Coal Creek site in Chehalis, Washington. The estimated cost of clean-up is $12,000,000, which is being shared by over 90 utilities. The Company is responsible for approximately $800,000 of this cost, the majority of which was spent in 1993. In 1993 the EPA referred a matter to the U.S. Justice Department requesting the Company and other potentially responsible parties to enter into negotiations for the recovery of costs incurred by EPA and for initiation of action in connection with the clean-up at the Spokane Junk Yard Site located in Spokane, Washington. If an action is commenced, the claim is expected to be for $2.4 million in site stabilization costs plus additional costs including attorneys' fees and site rehabilitation costs. The Company has no records showing that any Company equipment was ever deposited at the Spokane Junk Yard Site or that PCB contaminated equipment was delivered to any company which disposed of materials at the site. Therefore, the Company has disclaimed any liability with respect to the Spokane Junk Yard Site. If an action is commenced, the Company will vigorously defend against such claim. Refer to both Note 11 to Financial Statements: Commitments and Contingencies and Significant Trends in Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations for additional information. NON-UTILITY BUSINESS As of December 31, 1993, the Company had an investment of approximately $93 million in non-utility operations, of which about $86 million was invested in Pentzer. The remainder was invested in three non-operating subsidiaries, the largest of which is WIDCo, which maintains a small investment portfolio. Substantially all of the non-utility operations are controlled by Pentzer, a wholly owned subsidiary of the Company. As of December 31, 1993, Pentzer had approximately $130 million in total assets, or about 7% of the Company's consolidated assets. Pentzer's portfolio of investments includes companies involved in advertising display manufacturing, electronic technology, energy services, financial services, real estate development and telecommunications. Pentzer's current investment profile focuses on manufacturers and distributors of industrial and consumer products as well as service businesses. The Company seeks businesses with above average records of earnings growth in industries that are not cyclical or dependent upon high levels of research and development. Emphasis is placed on leading companies with strong market franchises, dominant or proprietary product lines or other significant competitive advantages. Pentzer is particularly interested in companies serving niche markets. Total investment in any one company is generally limited to $15 million, and control of the acquired company's board of directors is generally required. Pentzer's business strategy is to acquire controlling interests in a broad range of middle market companies, to help these companies grow through internal development and strategic acquisitions, and to sell the portfolio investments either to the public or to strategic buyers when it becomes most advantageous in meeting Pentzer's return on invested capital objectives. Pentzer's goal is to produce financial returns for the Company's shareholders that, over the long term, should be higher than that of the utility operations. From time to time, a significant portion of Pentzer's earnings contributions may be the result of transactional gains. Accordingly, although the income stream is expected to be positive, it may be uneven from year to year. THE WASHINGTON WATER POWER COMPANY ITEM 2.		ITEM 2. PROPERTIES ELECTRIC PROPERTIES The Company's electric properties, located in the States of Washington, Idaho and Montana, include the following: Generating Plant N/A Not applicable. (1) Nameplate Rating, also referred to as "installed capacity", is the manufacturer's assigned rating under specified conditions. (2) Capability is the maximum generation of the plant without exceeding approved limits of temperature, stress and environmental conditions. (3) Due to the redevelopment project which was started during 1993, the actual plant capability at year end declined from 18 MW; upon completion of this project in mid-1994, the plant capability is expected to rise to 29 MW. (4) Reduced from 13 MW due to possible penstock enlargement; if completed, the plant capability is expected to return to 13 MW. (5) Due to the upgrade project started during 1993 on unit no. 1, the actual plant capability at year end declined from 230 MW; upon completion of this project in mid-1994, the plant capability is expected to rise to 240 MW. (6) Jointly-owned. Data above refers to Company's respective 15% interests. (7) Used primarily for peaking needs. Distribution and Transmission Plant The Company operates approximately 11,250 miles of distribution lines in its electric system. The Company's transmission system consists of approximately 550 miles of 230 KV line and 1,500 miles of 115 KV line. The Company also owns a 10% interest in 495 miles of a 500 KV line from Colstrip, Montana and a 15% interest in 3 miles of a 500 KV line from Centralia, Washington to the nearest BPA interconnections. The 230 KV lines are used primarily to transmit power from the Company's Noxon Rapids and Cabinet Gorge hydro generating stations to major load centers in the Company's service area. The 230 KV lines also transmit to points of interconnection with adjoining electric transmission systems for bulk power transfers. These lines interconnect with BPA THE WASHINGTON WATER POWER COMPANY at five locations and at one location each with PacifiCorp, Montana Power and Idaho Power Company. The BPA interconnections serve as points of delivery for power from the Colstrip and Centralia generating stations as well as for the interchange of power with the Southwest. The interconnection with PacifiCorp is the point of delivery for power purchased by the Company from Mid-Columbia projects' hydro generating stations. The 115 KV lines provide for transmission of energy as well as providing for the integration of the Spokane River hydro and Kettle Falls wood-waste generating stations with service area load centers. These lines interconnect with BPA at nine locations, Grant County PUD at three locations, Seattle City Light and Tacoma City Light at two locations and one each with Chelan County PUD, PacifiCorp, and Montana Power. Electric Projects Under Construction Rathdrum Combustion Turbine On October 5, 1993, the IPUC issued an order approving the combustion turbine project consisting of two 88 MW units. Construction has begun on the project, which is designed to meet the Company's peaking needs for both its retail and wholesale obligations. The air quality permit that has been issued, which allows for the operation of the project as scheduled, has been challenged and is currently under administrative review. Natural gas will be used as both the primary and back-up fuel. The Company has obtained separate construction and long-term lease financing for this project. The project is currently expected to be completed by early 1995 at an expected cost of $66 million, of which $29 million had been spent as of December 31, 1993. Company Hydro The Company continues to study its hydroelectric facilities on both the Spokane and Clark Fork Rivers to identify additional economic hydroelectric generating potential. Turbine efficiency improvements are underway at the Nine Mile project that would increase generating capacity by 12 MW to a total of 29 MW by mid-1994 at an expected cost of $20 million. Similar improvements are underway at the Cabinet Gorge powerhouse that would increase capacity by approximately 10 MW to a total of 240 MW at an expected cost of $12 million; it is expected back on-line by the end of the first quarter 1994. Feasibility studies for upgrading the Company's other hydroelectric facilities are continuing. Proposed Acquisition On February 15, 1994, the Company announced it had reached agreement to acquire the northern Idaho electric properties of Pacific Power and Light Company, an operating division of PacifiCorp. The cash purchase price will be $26 million, subject to closing adjustments, and includes a premium above the book value of the net assets acquired. Pacific Power's northern Idaho electric system currently serves approximately 9,300 residential, commercial and industrial customers. The purchase is subject to regulatory approval by the IPUC and the FERC. Closing of the transaction is expected to occur during the summer of 1994. See Note 14 to Financial Statements for additional information related to this acquisition. NATURAL GAS PROPERTIES The WWP and WPNG service territories' natural gas properties have natural gas distribution mains of approximately 2,912 miles and 1,410 miles, respectively. The Company, NWP and Washington Natural Gas Company each own a one-third undivided interest in the Storage Project. The Storage Project has a total peak day deliverability of 4.6 million therms, with a total working natural gas inventory of 155.2 million therms. ITEM 3.	ITEM 3. LEGAL PROCEEDINGS Refer to Note 11 to Financial Statements: Commitments and Contingencies. ITEM 4.	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not Applicable. THE WASHINGTON WATER POWER COMPANY PART II ITEM 5.	ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Outstanding shares of Common Stock are listed on the New York and Pacific Stock Exchanges. As of February 25, 1994, there were approximately 36,000 registered shareholders of the Company's no par value Common Stock. It is the intention of the Board of Directors to continue to pay dividends quarterly on the Common Stock, but the amount of such dividends is dependent on future earnings, the financial position of the Company and other factors. For further information, see Notes 8 and 15 to Financial Statements. THE WASHINGTON WATER POWER COMPANY ITEM 6.	ITEM 6. SELECTED FINANCIAL DATA On November 9, 1993, the Company distributed, to shareholders of record on October 25, 1993, shares of its common stock, without par value, under a two-for-one stock split effected in the form of a 100% stock dividend. All references to number of shares and per share information have been adjusted to reflect the common stock split on a retroactive basis. In 1992, Pentzer's common stock ownership in ITRON was reduced from approximately 60% to approximately 40% as a result of the issuance of common stock by ITRON in an acquisition. Accordingly, beginning in 1992, Pentzer's share of ITRON's earnings is accounted for by the equity method and is included in Other Income-Net and its investment in ITRON is reflected on the balance sheet under Other Property and Investments. ITRON's initial public offering in November 1993 and Pentzer's sale of a portion of its ITRON stock resulted in a reduction in Pentzer's ownership interest in ITRON to approximately 25%. The Company purchased natural gas distribution properties in Oregon and California from CP National Corporation on September 30, 1991. The 1991 financial information reflects three months of operations of these properties. On July 31, 1990, WIDCo sold its 50% interest in its coal mining properties. The consolidated financial statements, notes and selected financial data have been reclassified to reflect the continuing operations of the Company. The revenues, expenses, assets and liabilities of the discontinued operations have been reclassified from those categories and netted into single line items in the income statements and balance sheets. (Thousands of Dollars except Per Share Data and Ratios) THE WASHINGTON WATER POWER COMPANY ITEM 7.	ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The Company is primarily engaged as a utility in the generation, purchase, transmission, distribution and sale of electric energy and the purchase, transportation, distribution and sale of natural gas. Natural gas operations are affected to a significant degree by weather conditions and customer growth. The Company's electric operations are highly dependent upon hydroelectric generation for its power supply. As a result, the electric operations of the Company are significantly affected by weather and streamflow conditions and, to a lesser degree, by customer growth. Revenues from the sale of surplus energy to other utilities and the cost of power purchases vary from year to year depending on streamflow conditions and the wholesale power market. The wholesale power market in the Northwest region is affected by several factors, including the availability of water for hydroelectric generation, the availability of base load plants in the region and the demand for power from the Southwest region. Usage by retail customers varies from year to year primarily as a result of weather conditions, the economy in the Company's service area, customer growth and conservation. The Company will continue to emphasize the efficient use of energy by its customers, increase efforts to grow its customer base, especially natural gas, and continue to manage its operating costs, increase revenues and improve margins. The Company will also pursue resource opportunities through demand side management, system upgrades, purchases and other options that will result in obtaining electric power and natural gas supplies at the lowest possible cost. The Company purchased natural gas distribution properties in Oregon and California from CP National Corporation on September 30, 1991. The 1991 financial statements reflect three months of operations of these properties. See Note 14 to Financial Statements for further information. On November 9, 1993, the Company distributed, to shareholders of record on October 25, 1993, shares of its common stock, without par value, under a two-for-one stock split effected in the form of a 100% stock dividend. All references to number of shares and per share information have been adjusted to reflect the common stock split on a retroactive basis. RESULTS OF OPERATIONS OVERALL OPERATIONS Overall earnings per share for 1993 were $1.44, compared to $1.37 in 1992 and $1.34 in 1991. The 1993 results include transactional gains totaling $12.8 million recorded by Pentzer Corporation (Pentzer) as a result of the sale of several investments in its portfolio and the sale of stock in the initial public offering by ITRON, Inc. (ITRON) in November 1993. The 1992 results include an after-tax gain of $4.4 million, or $0.09 per share, due to the issuance of common stock by ITRON in an acquisition and a transactional gain of $1.2 million due to the sale of Pentzer's interest in a company involved in power plant maintenance. Discontinued coal mining operations contributed $2.4 million to net income, or $0.05 per share, in 1992 and $1.6 million, or $0.03 per share, in 1991. Earnings per share from continuing operations were $1.44 for 1993, $1.32 for 1992 and $1.31 for 1991. Utility income available for common stock increased $4.0 million, or 7.0%, in 1993 after decreasing $2.8 million, or 4.6%, in 1992. Utility income available for common stock contributed $1.19 to earnings per share in 1993, compared to $1.15 in 1992 and $1.28 in 1991. Non-utility income available for common stock from continuing operations increased $5.0 million in 1993 and $6.9 million in 1992 and contributed $0.25 to earnings per share in 1993, compared to $0.17 in 1992 and $0.03 in 1991. Slightly colder-than-normal weather during 1993 impacted both electric and natural gas operations as compared to 1992. Income from electric operations decreased $1.8 million in 1993, as compared to 1992, primarily as a result of increases in purchased power costs due to thermal plant outages, a large sale of wholesale energy and lower hydroelectric generation due to below normal streamflows, and increases in other operating and maintenance expenses. Income from natural gas operations increased $9.3 million in 1993 over 1992 due primarily to increased customer usage from the colder weather and customer growth. Warmer-than-normal weather throughout most of 1992 significantly impacted both electric and natural gas operations during the year. Increased purchased power and fuel costs, due to low hydroelectric generation and reduced streamflows, combined with decreased customer usage, were responsible for a decrease of $10.2 million in 1992 income from electric operations as compared to 1991. Income from natural gas operations decreased $2.3 million in 1992, as compared to 1991, due primarily to reduced revenues as a result of the warmer-than-normal temperatures. THE WASHINGTON WATER POWER COMPANY Electric revenues and expenses were both impacted by a ten-year power purchase contract, effective January 1992, with Potlatch Corporation (Potlatch), one of the Company's major industrial customers. Under terms of the agreement, the Company purchases 50-55 average MW of Potlatch's electric generation and makes available up to approximately 95 average MW of firm energy for sale. In addition, the Company makes available 25 average MW of interruptible energy and Potlatch must provide an equivalent amount of reserve generation capacity in case of interruption. The increased KWH sales to Potlatch result in increased industrial revenues to the Company, while the purchase of Potlatch's generating output increases purchased power expense. Non-recurring adjustments were made in 1991 to establish reserves for potential write-offs related to the recovery of costs associated with the Creston Project, a proposed 2,000 MW coal-fired generating station located near Creston, Washington, and related transmission. The reserves were calculated assuming regulators would allow the Company to recover its investment, but would not allow the Company to earn a return on the investment during a recovery period. Through December 31, 1993, the Company had invested $11.0 million in the Creston Project. These adjustments decreased Other Income net of taxes in 1991 by $3.2 million. A non-recurring adjustment was also made during 1991 to adjust previous accruals of deferred federal income tax related to electric operations. This adjustment decreased income taxes by $4.0 million in 1991. Interest expense decreased $3.4 million in 1993 and $1.0 million in 1992. From 1991 through 1993, $69 million of long-term debt matured and $344 million of higher-cost debt was redeemed and refinanced at lower interest rates. Preferred stock dividend requirements increased $1.5 million, or 22.3%, in 1993 due to the issuance of preferred stock in late 1992. Preferred stock dividend requirements decreased $2.5 million, or 26.6%, in 1992. The redemption of preferred stock in early 1992, combined with an issuance later in the year at a lower dividend rate and lower rates on variable rate preferred stock were the primary reasons for the 1992 decrease. UTILITY OPERATIONS Electric Operating Income Summary (1) Does not include interest expense or other income. Electric revenues increased in all classes for 1993, as compared to 1992, as a result of customer growth, increased wholesale sales and a slight increase in customer usage due to colder than normal weather. As the Company's Demand Side Management programs grow, the electric load is becoming less weather-sensitive as a result of the shifting of a greater portion of the heat load to natural gas. Residential and commercial revenues increased by $12.8 million, primarily as a result of a 3% growth in customers in 1993. Industrial sales during 1993 increased by $6.2 million, or 12%, primarily due to increased KWH sales under the Potlatch agreement discussed earlier. Wholesale revenues increased by $16.8 million, or 18%, due primarily to a large sale of wholesale energy over a six-week period in the first quarter of 1993. THE WASHINGTON WATER POWER COMPANY Electric revenues increased by 3% in 1992, compared to 1991, due to a combination of increased industrial sales and customer growth, which offset the decrease in residential usage due to warm weather. The Company's electric customer base grew by 2% in 1992, in both the residential and commercial sectors, which helped to reduce the weather-related impact on revenues. Industrial sales increased by $11.5 million, or 29%, primarily due to increased KWH sales under the Potlatch agreement discussed earlier. Commercial sales increased $4.7 million, or 4%, in 1992, as compared to 1991, due to customer growth. Residential revenues decreased by $3.1 million, despite a 2% increase in customers, due to warm weather throughout most of 1992. Wholesale KWH sales were down 23% in 1992, reflecting low streamflow conditions during the year. However, increased prices in the secondary market resulted in decreased wholesale revenues of only $0.6 million, or 1%, in 1992 from 1991. Electric Revenues, KWH Sales, and Customers by Service Class Below-normal streamflow conditions and thermal plant outages significantly affected 1993 electric operating results. Hydroelectric generation was 11% below normal, caused by streamflows which were 86% of normal. Purchased power increased by $27.1 million, or 30%, in 1993 primarily due to reduced hydroelectric generation early in the year, a large sale of wholesale energy in the first quarter and to replace lost thermal generation due to plant outages. In October 1989, the Idaho Public Utilities Commission (IPUC) approved the Company's filing for a Power Cost Adjustment (PCA) designed to allow the Company to change rates to recover or rebate a portion of the difference between actual and allowed net power supply costs. Net PCA adjustments accounted for $4.6 million of the increase in other operating and maintenance expenses from 1992. Higher levels of purchased power resulted in higher transmission costs which also contributed to the increase in other operating and maintenance expenses in 1993 over 1992. Shutdowns at thermal generation plants and improved streamflows in the latter part of 1993 were the primary reasons for the $2.9 million decrease in fuel costs, and repairs at the plants resulted in an increase of nearly $2.0 million in other operating and maintenance expenses. Warmer-than-normal weather and below-normal streamflow conditions significantly affected 1992 electric operating results. Hydroelectric generation was 22% below normal, caused by streamflows which were 64% of normal in 1992. In 1991, streamflows were 116% of normal. Fuel costs and purchased power costs in 1992 were a combined $27.6 million, or 27%, over levels incurred during 1991, due to low hydroelectric generation and the Potlatch agreement previously discussed. Transmission and distribution costs, which decreased $2.2 million and $1.5 million, respectively, contributed to the $7.9 million, or 12%, decrease in other operating and maintenance expenses. Transmission expenses decreased in 1992 over 1991 due to decreased wholesale KWH sales. Distribution expense was lower in 1992, compared to 1991, due to mild weather and fewer storm-related damages. Net PCA adjustments, resulting from low hydroelectric conditions and prices of secondary energy, accounted for $3.3 million of the decrease in other operating and maintenance expenses from 1991. THE WASHINGTON WATER POWER COMPANY NATURAL GAS OPERATIONS Natural Gas Operating Income Summary (1) Does not include interest expense or other income. On September 30, 1991, the Company purchased the Oregon and South Lake Tahoe, California, natural gas distribution assets of CP National Corporation. The Company's natural gas operations are operated as separate divisions, with the WWP service territory including the Washington and Idaho properties and the WP Natural Gas (WPNG) service territory including the Oregon and California properties. As of December 31, 1993, there were approximately 73,300 WPNG natural gas customers and 122,500 WWP natural gas customers. The Company's natural gas business experienced weather-related impacts on operating results in both 1993 and 1992. In 1993, weather in the Washington and Idaho service territory was 5% colder than normal, compared to 11% warmer than normal in 1992. The Oregon service territory experienced temperatures only 8% warmer than normal in 1993, compared to 24% warmer in 1992. Substantial customer growth of 9% in 1993, along with colder weather, contributed to increased revenues. The 7% growth in customers in 1992 helped offset the impact of the weather. Total natural gas operating revenues increased $37.0 million, or 37%, in 1993. WPNG revenues accounted for an increase of $10.1 million, while WWP revenues increased $26.9 million. Total therm sales increased by 18% in 1993 due to customer growth in all service classes except transportation and higher customer usage due to colder weather in 1993 as compared to 1992. Approximately 40% of the customer growth in the WWP service area during 1993 was the result of the Company's emphasis on conversion from electric space and water heating to natural gas through Demand Side Management programs. Total natural gas revenues increased in all customer classes in 1992 from 1991 due to the WPNG acquisition. WPNG revenues accounted for an increase of $24.5 million in overall natural gas operating revenues, as compared to 1991. In 1992, natural gas revenues from WWP residential and commercial customers rose by $2.0 million and $0.5 million, respectively, due to growth in the number of customers, as usage per customer decreased as a result of warm temperatures. THE WASHINGTON WATER POWER COMPANY Natural Gas Revenues, Therm Sales, and Customers by Service Class Natural gas purchased expense increased $23.7 million, or 49%, in 1993 as compared to 1992, primarily as a result of an increase in therm sales of 76.3 million, or 18%, across all customer classes due to customer growth and colder weather. Taxes other than income and income taxes also increased substantially in 1993 due to increased revenues and income. Natural gas purchased expense and other operating and maintenance expenses increased $17.4 million and $5.1 million, respectively, in 1992 from 1991. All other expenses also increased substantially over 1991, primarily as a result of the operation of the WPNG properties, combined with the Company's continued emphasis on conversions from electric energy to natural gas. NON-UTILITY OPERATIONS Non-Utility Operations Summary Non-utility operations include the results of Pentzer and three non-operating subsidiary companies. Pentzer's business strategy is to acquire controlling interests in a broad range of middle-market companies, to help these companies grow through internal development and strategic acquisitions, and to sell the portfolio investments to the public or to strategic buyers when it becomes most advantageous in meeting Pentzer's return on invested capital objectives. Pentzer's goal is to produce financial returns for the Company's shareholders that, over the long term, should be higher than that of the utility operations. From time to time, a significant portion of Pentzer's earnings contributions may be the result of transactional gains. Accordingly, although the income stream is expected to be positive, it may be uneven from year to year. THE WASHINGTON WATER POWER COMPANY For the year ended December 31, 1993, Pentzer had consolidated earnings of $19.7 million before provision for possible losses. At the end of the year, Pentzer established a $7.0 million provision for possible write-off of a portion of its investment portfolio. The provision was recorded based on the determination that future cashflows may be lower than expected, impairing the value of certain investments. After deducting this provision, Pentzer reported consolidated earnings of $12.7 million, which represents a 50% increase over Pentzer's 1992 earnings of $8.5 million. Pentzer's return on invested capital increased from 12% in 1992 to 17% in 1993 due, in part, to transactional gains. Pentzer earnings for 1993 were significantly impacted by transactional gains of $7.1 million as a result of the sale of companies involved in telecommunications, technology and energy and by a transactional gain of $5.7 million resulting from the successful completion by ITRON, a company in which Pentzer is the largest shareholder, of an initial public offering which also resulted in the sale of a portion of the ITRON shares owned by Pentzer. This transaction reduced Pentzer's investment in ITRON from approximately 40% to approximately 25%. Included in other income, total 1993 transactional gains of $12.8 million compares with transactional gains of $5.6 million in 1992. In addition to the transactional gains from ITRON in 1993, Pentzer also recorded a $3.0 million increase in net income as a result of improved earnings at ITRON. Pentzer's earnings increase from 1991 to 1992 was primarily attributable to the 1992 transactional gains of $5.6 million relating to ITRON's issuance of common stock in an acquisition and the sale of Pentzer's interest in a company involved in power plant maintenance. This issuance of common stock reduced Pentzer's ownership from approximately 60% to approximately 40%. Accordingly, Pentzer's investment in ITRON after 1991 is accounted for by the equity method. The 1991 results presented include ITRON on a fully consolidated basis. The decrease in revenues and expenses from 1991 to 1992 was primarily due to the change to the equity method of accounting for ITRON. THE WASHINGTON WATER POWER COMPANY LIQUIDITY AND CAPITAL RESOURCES UTILITY Capital expenditures, excluding Allowance for Funds Used During Construction (AFUDC) and Allowance for Funds Used to Conserve Energy (AFUCE, a carrying charge similar to AFUDC for conservation-related capital expenditures), were $378 million for the 1991-1993 period. In addition, $69 million of long-term debt matured and $344 million of higher-cost debt and preferred stock was redeemed and refinanced at lower cost during the 1991-1993 period. Capital expenditures are funded with internally-generated cash and external financing. The level of cash generated internally and the amount that is available for capital expenditures fluctuates from year to year. During 1993, $274 million of long-term debt, with an average interest rate of 8.67% and 13.6 years remaining to maturity, was redeemed or matured and $250 million of long-term debt was issued at an average interest rate of 6.59% and with 16.1 years remaining to maturity. In January 1994, authorization was received for $250 million of Secured Medium Term Notes, Series B, which brings the total authorized but unissued Secured Medium Term Notes to $275 million as of February 28, 1994. Capital expenditures are financed on an interim basis with short-term debt. The Company has $160 million in committed lines of credit, a portion of which backs up a $50 million commercial paper facility. In addition, the Company may borrow up to $60 million through other borrowing arrangements with banks. As of December 31, 1993, $20 million in commercial paper was outstanding, $4 million was outstanding under the committed lines of credit and $44 million was outstanding under other short-term borrowing arrangements. The Company's total common equity increased by $47 million to $634 million at the end of 1993. The 1993 increase was primarily due to the issuance of approximately 1,900,000 shares of common stock through the Periodic Offering Program, the Dividend Reinvestment Plan and the Investment and Employee Stock Ownership Plan for proceeds of $36 million. The utility capital structure at December 31, 1993, was 49% debt, 10% preferred stock and 41% common equity as compared to 48% debt, 11% preferred stock and 41% common equity at year-end 1992. The Company is restricted under various agreements as to the additional securities it can issue. Under the most restrictive test of the Company's Mortgage, an additional $431 million of First Mortgage Bonds could be issued as of December 31, 1993. As of December 31, 1993, under its Restated Articles of Incorporation, approximately $670 million of additional preferred stock could be issued at an assumed dividend rate of 7.00%. During the 1994-1996 period, capital expenditures are expected to be $334 million, and $90 million will be required for long-term debt maturities and preferred stock sinking fund requirements. During this three-year period, the Company expects that internally- generated funds will provide approximately 50% of the funds for its capital expenditures. External financing will be required to fund maturing long-term debt, preferred stock sinking fund requirements and the remaining portion of capital expenditures. See Notes 4 through 8 to Financial Statements, inclusive, for additional details related to financing activities. NON-UTILITY Capital expenditures for the non-utility operations were $15 million for the 1991-1993 period. These capital expenditure requirements were financed primarily with internally-generated funds. In addition, $2 million of debt either matured or was redeemed during that same period. The non-utility operations have $26 million in borrowing arrangements ($20 million outstanding as of December 31, 1993) to fund capital expenditures and other corporate requirements on an interim basis. At December 31, 1993, the non-utility operations had $32 million in cash and marketable securities. The 1994-1996 non-utility capital expenditures are expected to be $8 million, and $1 million in debt maturities will also occur. During the next three years, internally-generated cash and other debt obligations are expected to provide the majority of the funds for the non-utility capital expenditure requirements. THE WASHINGTON WATER POWER COMPANY TOTAL COMPANY CASH REQUIREMENTS (Millions of Dollars) (1) Excludes $66 million for the combustion turbine project under construction in Rathdrum, Idaho; the Company has obtained separate construction and long-term lease financing for this project. Also excludes $26 million for the proposed acquisition of the northern Idaho electric properties of Pacific Power and Light, an operating division of PacifiCorp; see Note 14 to Financial Statements for additional information related to this proposed acquisition. (2) Excludes AFUDC and AFUCE. (3) Demand Side Management programs. (4) Includes $68 million for the acquisition of the CP National Corporation's natural gas distribution properties in Oregon and California. SIGNIFICANT TRENDS Competition The electric and natural gas utility businesses are undergoing numerous changes and are becoming increasingly competitive as a result of economic, regulatory and technological changes. The Company believes that it is well positioned to meet future challenges due to its low production costs, close proximity to major transmission lines and natural gas pipelines, experience in the wholesale electric market and its commitment to high levels of customer satisfaction, cost reduction and continuous improvement of work processes. The Company currently competes for new retail electric customers with various rural electric cooperatives and public utility districts. Challenges facing the electric retail business include changing technologies which reduce energy consumption, self-generation and fuel switching by industrial and other large retail customers, the potential for retail wheeling and the costs of increasingly stringent environmental laws. In addition, if electric utility companies are eventually required to provide retail wheeling service, which is the transmission by an electric utility of electric power from another supplier to a customer located within such utility's service area, the Company believes it will be in a position to benefit since it is committed to remaining one of the country's lowest-cost providers of electric energy. The Company also competes in the wholesale electric market with other Western utilities, including the Bonneville Power Administration. Challenges facing the electric wholesale business include new entrants in the wholesale market and competition from lower cost generation being developed by independent power producers. The National Energy Policy Act (NEPA) enacted in 1992 addresses a wide range of issues affecting the wholesale electric business. The Company believes NEPA provides future transmission, energy production and sales opportunities to the Company and complements the Company's commitment to the wholesale electric business. Natural gas is priced competitively compared to other alternative fuel sources for both residential and commercial customers. Challenges facing the Company's natural gas business include the potential for customers to by-pass the Company and securing competitively priced natural gas supplies for the future. Since 1988 one of the Company's large industrial customers has built its own pipeline interconnection. However, this customer still purchases some THE WASHINGTON WATER POWER COMPANY natural gas services from the Company. The Company prices its natural gas services, including transportation contracts, competitively and has varying degrees of flexibility to price its transportation and delivery rates by means of special contracts to assist in retaining potential by-pass customers. The Company has signed long-term transportation contracts with two of its largest industrial customers which minimizes the risks of these customers by-passing the Company's system. Order 636B adopted by FERC in 1992 provides the Company more flexibility in optimizing its natural gas transportation and supply portfolios. While rate design changes have increased the costs of firm transportation to low load factor pipeline customers such as the Company, flexible receipt and delivery points and capacity releases allow temporarily under-utilized transportation to be released to others when not needed to serve the Company's customers. Least cost planning for both the electric and natural gas businesses has been integrated so that the Company's customers are provided the most efficient and cost-effective products possible for all their energy requirements. The Company's need for future electric resources to serve retail loads is very minimal. The electric integrated resource plan accepted by both the IPUC and the Washington Utility and Transportation Commission (WUTC) in 1993 showed that, through the year 1998, the Company's additional electric load requirements will be met for the most part by a combination of demand side management, including conversions to natural gas, and the redevelopment of existing hydro generating plants. The cost of these resources is generally less than costs of resources being developed by independent power producers and other exempt wholesale generators. The Company's natural gas integrated resource plan was accepted by both the WUTC and Public Utility Commission of Oregon (OPUC) in 1993 and insures adequate supplies of natural gas are available at the least possible cost. The switching of electric heating customers to natural gas requires increased efforts on the Company's part in negotiating and securing competitively-priced natural gas supplies for the future. Economic and Load Growth The Company expects economic growth to continue in its eastern Washington and northern Idaho service area, although at a slower pace than seen in the past couple of years. The Company, along with others in the service area, continues its efforts to expand existing businesses and attract new businesses to the Inland Northwest. In the past, agriculture, mining and lumber have been the primary industries. However, health care, electronic and other manufacturing, tourism and the service sectors have become increasingly important industries that operate in the Company's service area. In addition, the Company also expects economic growth to continue in its Oregon and California service areas. The Company anticipates electric retail load growth to average approximately 0.4% annually for the next five years. Although the number of electric customers is expected to increase, the average annual usage by residential customers is expected to continue to decline on a weather-adjusted basis due to newer technologies, construction and appliance efficiency standards and continued conversions to natural gas where available. The Company anticipates natural gas load growth, including transportation volumes, in its Washington and Idaho service area to average approximately 2.7% annually for the next five years. The Oregon and South Lake Tahoe, California service area is anticipated to realize 2.6% growth annually during that same period. Environmental Matters The Company continues to assess both the potential and actual impact of the 1990 Clean Air Act Amendments (CAAA) on its thermal generating plants. The Centralia Power Plant (Centralia), which is operated by PacifiCorp, is classified as a "Phase II" coal-fired plant under the CAAA and as such, will be required to reduce sulfur dioxide (SO2) emissions by approximately 40% by the year 2000. Several methods to meet CAAA compliance by reducing SO2 are being evaluated and a plan is expected to be completed by early 1995. The alternatives most likely to be used in meeting the compliance standards will be some combination of lower sulfur coal, SO2 reduction through clean coal technology and SO2 allowances either purchased or pooled, if available, among the Centralia owners. The Colstrip Generating Project (Colstrip), which is also a "Phase II" coal-fired plant operated by Montana Power, is not expected to be required to implement any additional SO2 mitigation in the foreseeable future in order to continue operations. Reduction in nitrogen oxides (NOX) will be required at both Centralia and Colstrip prior to the year 2000. The anticipated costs for NOX compliance will have a minor economic impact on the Company. THE WASHINGTON WATER POWER COMPANY Since December 1991, a number of species of fish, including the Snake River sockeye salmon and chinook salmon, the Kootenai River white sturgeon and the bull trout have either been added to the endangered species list under the Federal Endangered Species Act (ESA), listed as "threatened" under the ESA or been petitioned for listing under the ESA. Thus far, measures which have been adopted and implemented to save both the Snake River sockeye and chinook salmon have not directly impacted generation levels at any of the Company's hydroelectric dams. The Company does, however, purchase power from four projects on the Columbia River that are being directly impacted by this operation. The reduction in generation is relatively small resulting in minimal economic impact on the Company. Future actions to save the Snake River salmon, Kootenai River white sturgeon and bull trout could further impact the Company's hydroelectric resources. However, it is unknown at this time what impact, if any, will occur from the processes discussed above on the Company's operations. See Note 11 to Financial Statements for discussion of additional environmental matters. ITEM 8.	ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Independent Auditor's Report and Financial Statements begin on page 24. ITEM 9.	ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. INDEPENDENT AUDITORS' REPORT The Washington Water Power Company Spokane, Washington We have audited the accompanying consolidated balance sheets and statements of capitalization of The Washington Water Power Company and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income and retained earnings, cash flows, and the schedules of information by business segments for each of the three years in the period ended December 31, 1993. These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements and schedules are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements and schedules. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement and schedule presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements and schedules present fairly, in all material respects, the financial position of the Company and its subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. In addition, the schedules referred to above present fairly in all material respects, the segment information of the Company and its subsidiaries in accordance with generally accepted accounting principles. As discussed in Notes 2 and 3 to the financial statements, the Company changed its methods of accounting for other post-employment benefits and income taxes effective January 1, 1993, to conform with Statements of Financial Accounting Standards No. 106 and 109. Deloitte & Touche Seattle, Washington January 28, 1994 (February 15, 1994 as to Note 14) CONSOLIDATED STATEMENTS OF INCOME AND RETAINED EARNINGS The Washington Water Power Company For the Years Ended December 31 Thousands of Dollars The Accompanying Notes are an Integral Part of These Statements. CONSOLIDATED BALANCE SHEETS The Washington Water Power Company At December 31 Thousands of Dollars The Accompanying Notes are an Integral Part of These Statements. CONSOLIDATED STATEMENTS OF CAPITALIZATION The Washington Water Power Company At December 31 Thousands of Dollars The Accompanying Notes are an Integral Part of These Statements. CONSOLIDATED STATEMENTS OF CASH FLOWS Increase (Decrease) in Cash and Cash Equivalents The Washington Water Power Company For the Years Ended December 31 Thousands of Dollars The Accompanying Notes are an Integral Part of These Statements. SCHEDULE OF INFORMATION BY BUSINESS SEGMENTS The Washington Water Power Company For the Years Ended December 31 Thousands of Dollars The Accompanying Notes are an Integral Part of These Statements. THE WASHINGTON WATER POWER COMPANY NOTES TO FINANCIAL STATEMENTS NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES SYSTEM OF ACCOUNTS The accounting records of The Washington Water Power Company (Company) utility operations are maintained in accordance with the uniform system of accounts prescribed by the Federal Energy Regulatory Commission (FERC) and adopted by the appropriate state regulatory commissions. BASIS OF REPORTING The accompanying financial statements include the Company's proportionate share of utility plant and related operations resulting from its interests in jointly owned plants (See Note 12). The financial statements are presented on a consolidated basis and, as such, include the assets, liabilities, revenues and expenses of the Company and its wholly owned subsidiaries, Pentzer Corporation (Pentzer), Washington Irrigation and Development Company (WIDCo), The Limestone Company and WP Finance Company. All material intercompany transactions that are not allowed recovery under regulation have been eliminated in the consolidation. On July 31, 1990, WIDCo sold its 50% interest in the Centralia coal mining properties for $40.8 million. As discussed in Note 14, operating results for ITRON are no longer consolidated and are accounted for on the equity method. The financial activity of each of the Company's segments is reported in the "Schedule of Information by Business Segments." Such information is an integral part of these financial statements. UTILITY PLANT The cost of additions to utility plant, including internally developed information systems, an allowance for funds used during construction and replacements of units of property and betterments, is capitalized. Maintenance and repairs of property and replacements determined to be less than units of property are charged to operating expenses. Costs of depreciable units of property retired plus costs of removal less salvage are charged to accumulated depreciation. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION The Allowance for Funds Used During Construction (AFUDC) represents the cost of both the debt (Interest Capitalized) and equity funds used to finance utility plant additions during the construction period. In accordance with the uniform system of accounts prescribed by regulatory authorities, AFUDC is capitalized as a part of the cost of utility plant and is credited currently as a noncash item to Other Income and Interest Capitalized (see Other Income below). The Company generally is permitted, under established regulatory rate practices, to recover the capitalized AFUDC and a fair return thereon through its inclusion in rate base and the provision for depreciation after the related utility plant has been placed in service. Cash inflow related to AFUDC does not occur until the related utility plant is placed in service. The effective AFUDC rate was 10.67% in 1993, 1992 and 1991. The Company's AFUDC rates do not exceed the maximum allowable rates as determined in accordance with the requirements of regulatory authorities. ALLOWANCE FOR FUNDS USED TO CONSERVE ENERGY The Allowance for Funds Used to Conserve Energy (AFUCE) rate recovers carrying costs associated with Demand Side Management (DSM) program expenditures until such investment is included in rate base. AFUCE is capitalized as a part of the cost of the DSM investment and is credited currently as a noncash item to Other Income and Interest Capitalized. The AFUCE rate in effect is the last authorized, or otherwise stipulated, rate of return from the Company's proceeding for natural gas or electric operations. The rate for Washington is adjusted for the tax effect of interest. Cash inflow related to AFUCE does not occur until the related DSM investment is placed in service. DEPRECIATION For utility operations, depreciation provisions are computed by a method of depreciation accounting utilizing unit rates for hydroelectric plants and composite rates for other properties. Such rates are designed to provide for retirements of properties at the expiration of their service lives. The rates for hydroelectric plants include annuity and interest components, in which the interest component is 6%. For utility operations, the ratio of depreciation provisions to average depreciable property was 2.68% in 1993, 2.37% in 1992 and 2.44% in 1991. THE WASHINGTON WATER POWER COMPANY AMORTIZATION Deferred charges include regulatory assets which are amortized primarily over periods allowed by regulators. Also included in Deferred Charges, Other are debt issuance and redemption costs which are amortized over the terms of the respective debt issues. POWER AND NATURAL GAS COST ADJUSTMENT PROVISIONS In 1989, the Idaho Public Utilities Commission (IPUC) approved the Company's filing for a power cost adjustment mechanism (PCA). The PCA is designed to allow the Company to change electric rates to recover or rebate a portion of the difference between actual and allowed net power supply costs. In 1993 and 1991, the Company deferred $4.6 million and $1.8 million, respectively, of net power supply cost savings, which resulted in like increases in electric operating expenses. In 1992, the Company deferred $3.3 million of net power supply costs, which resulted in like decreases in electric operating expenses. Rate changes are triggered when the deferred balance reaches $2.2 million. A rate increase was implemented in November 1992 to pass through accumulated costs. A rate reduction was implemented in May 1991 to pass through accumulated cost savings. As of December 31, 1993, $0.6 million of costs not yet subject to a rate increase had accumulated in the PCA deferral account. The PCA is currently scheduled to end on June 30, 1994. Under established regulatory practices, the Company is also allowed to adjust its natural gas rates from time to time to reflect increases or decreases in the cost of natural gas purchased. Differences between actual natural gas costs and the natural gas costs allowed in rates are deferred and charged or credited to expense when regulators approve inclusion of the cost changes in rates. OPERATING REVENUES The Company accrues estimated unbilled revenues for services provided through month-end. INCOME TAXES Provisions for income taxes are based generally on income and expense as reported for financial statement purposes adjusted principally for the excess of tax depreciation over book depreciation. Beginning with 1981 property additions, deferred income taxes are provided for the tax effect of Accelerated Cost Recovery System (ACRS) depreciation over straight-line depreciation. Investment tax credits (ITC) are amortized over the period established by regulators. The Company and its eligible subsidiaries file consolidated federal income tax returns. Subsidiaries are charged or credited with the tax effects of their operations on a stand alone basis. The Company's federal income tax returns have been examined with all issues resolved, and all payments made, through the 1990 return. EARNINGS PER COMMON SHARE Earnings per common share have been computed based on the weighted average number of common shares outstanding during the period. On November 9, 1993, the Company distributed, to shareholders of record on October 25, 1993, shares of its common stock, without par value, under a two-for-one stock split effected in the form of a 100% stock dividend. All references to number of shares and per share information have been adjusted to reflect the common stock split on a retroactive basis. CASH For the purposes of the Consolidated Statements of Cash Flows, the Company considers all temporary investments with an initial maturity of three months or less to be cash equivalents. THE WASHINGTON WATER POWER COMPANY OTHER INCOME--NET Other income-net is composed of the following items: Non-recurring adjustments were made in 1991 to establish reserves for a potential write-off related to the recovery of costs associated with the Creston Project and related transmission. The reserves were calculated assuming regulators would not allow the Company to earn a return during a recovery period. These adjustments decreased other income by $4.8 million before income taxes and decreased income net of taxes by $3.2 million. The Company's costs of $10,990,000 less a reserve for a potential write-off of $3,967,000 related to this project as of December 31, 1993, are included in Other Deferred Charges on the Balance Sheet. NEW ACCOUNTING STANDARDS FAS No. 112, entitled "Employers' Accounting for Postemployment Benefits," was issued by the Financial Accounting Standards Board in November 1992 and is effective for fiscal years beginning after December 15, 1993. This Statement requires the accrual of the expected cost of providing benefits to former or inactive employees after employment but before retirement. It has been determined that the liabilities related to the Company's Long-Term Disability and Workers' Compensation programs are affected by this Statement. The Company does not expect FAS No. 112 to have a material effect on the Company's financial position or results of operations. NOTE 2. RETIREMENT PLANS AND OTHER POSTRETIREMENT BENEFITS Effective January 1, 1993, the Company adopted FAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." FAS No. 106 requires the Company to accrue the estimated cost of postretirement benefit payments during the years the employee provides services. The Company previously expensed the cost of these benefits, which are principally health care, as claims were incurred. FAS No. 106 allows recognition of the unrecognized transition obligation in the year of adoption or the amortization of such obligation over a period of up to twenty years. The Company has elected to amortize this obligation of approximately $39,600,000 over a period of twenty years. Income from continuing operations during 1993 was not changed by the implementation of this Statement. The Company has received accounting orders from the Washington Utilities and Transportation Commission (WUTC) and the IPUC allowing the current deferral of expense accruals under this Statement as a regulatory asset for future recovery. At such time that rate recovery is requested and allowed, cumulative deferrals will be amortized over the remainder of the twenty-year amortization period. The Company expects to be able to recover the amortized amounts. Therefore, the Company's cash flows are not affected by implementation of this Statement. The Company provides certain health care and life insurance benefits for substantially all of its retired employees. In 1993, 1992 and 1991, the Company recognized $1,250,000, $1,290,000 and $1,233,000, respectively, as an expense for postretirement health care and life insurance benefits. The following table sets forth the health care plan's funded status at December 31, 1993. THE WASHINGTON WATER POWER COMPANY Accumulated postretirement benefit obligation: Net postretirement benefit cost for 1993 consisted of the following components: The currently assumed health care cost trend rate used in measuring the accumulated postretirement benefit obligation is 12.0% for 1993, decreasing linearly each successive year until it reaches 6.0% in 1997. A one-percentage-point increase in the assumed health care cost trend rate for each year would increase the accumulated postretirement benefit obligation as of December 31, 1993 and net postretirement health care cost by approximately $3,079,000. The assumed discount rate used in determining the accumulated postretirement benefit obligation was 7.5%. The Company has a pension plan covering substantially all of its regular full-time employees. Some of the Company's subsidiaries also participate in this plan. Individual benefits under this plan are based upon years of service and the employee's average compensation as specified in the Plan. The Company's funding policy is to contribute annually an amount equal to the net periodic pension cost, provided that such contributions are not less than the minimum amounts required to be funded under the Employee Retirement Income Security Act, nor more than the maximum amounts which are currently deductible for tax purposes. Pension fund assets are invested primarily in marketable debt and equity securities. Net pension credit for 1993, 1992 and 1991 is summarized as follows: (1) The Company has received accounting orders from regulatory authorities requiring the Company to defer the difference between pension cost as determined under FAS 87 and that determined for ratemaking purposes. THE WASHINGTON WATER POWER COMPANY The funded status of the Plan and the pension liability at December 31, 1993, 1992 and 1991, are as follows: NOTE 3. ACCOUNTING FOR INCOME TAXES The Company adopted Statement of Financial Accounting Standards (FAS) No. 109, "Accounting for Income Taxes," effective January 1, 1993, which supersedes Accounting Principles Board Opinion 11 previously adopted by the Company. FAS No. 109 establishes revised financial accounting and reporting standards for the effects of income taxes. As of January 1, 1993, the Company accrued net regulatory assets of $171,365,000 related to the probable recovery of FAS No. 109 deferred tax liabilities from customers through future rates. In the third quarter, the balance was adjusted to account for the 35% federal income tax rate, which brought the accrued net regulatory assets balance to $182,196,000. As such, the Company's adoption of FAS No. 109 has no effect on income for 1993. The regulatory assets and deferred tax liabilities are being amortized over the estimated remaining life of the associated assets. Deferred income taxes reflect the net tax effects of (a) temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes, and (b) tax credit carryforwards. The tax effects of significant items comprising the Company's net deferred tax liability as of January 1, 1993, restated to reflect the 35% federal income tax rate, are as follows: THE WASHINGTON WATER POWER COMPANY The provision for income tax expense for 1993 was $42,503,000, of which $35,443,000 and $7,060,000 is current and deferred tax expense, respectively. The provision for income tax expense for 1992 was $41,330,000, of which $24,148,000 and $17,182,000 was current and deferred tax expense, respectively. The provision for income tax expense for 1991 was $38,086,000, of which $31,853,000 and $6,233,000 was current and deferred tax expense, respectively. The current and deferred effective tax rates are approximately the same during all periods. NOTE 4. LONG-TERM DEBT The annual sinking fund requirements and maturities for the next five years for First Mortgage Bonds and Medium-Term Notes outstanding at December 31, 1993 are as follows: The sinking fund requirements may be met by certification of property additions at the rate of 167% of requirements. All of the utility plant is subject to the lien of the Mortgage and Deed of Trust securing outstanding First Mortgage Bonds. In 1993, 1992 and 1991, $25,000,000, $113,000,000 and $37,000,000, respectively, of unsecured Medium-Term Notes, Series A and B (Notes) were issued. At December 31, 1993, the Company had outstanding $250,000,000 of the Notes with maturities between 1 and 29 years and with interest rates varying between 5.50% and 9.58%. As of December 31, 1993, the Company had authorization to issue up to $25,000,000 of the $250,000,000 originally authorized in aggregate principal amount of new First Mortgage Bonds issued in the form of Secured Medium-Term Notes, Series A (Secured MTNs). The Secured MTNs may be issued from time to time and may vary in term from 9 months to 30 years. At December 31, 1993, the Company had outstanding $225,000,000 of the Secured MTNs with maturities between 2 and 30 years and with interest rates varying between 4.72% and 7.54%. In January 1994, authorization was received for an additional $250,000,000 of Secured Medium-Term Notes, Series B, which may vary in term from 9 months to 40 years. At December 31, 1993, the Company had $68,000,749 outstanding under borrowing arrangements which will be refinanced in 1994. See Note 5 for details of credit agreements. Included in other long-term debt are the following items related to non-utility operations: In accordance with FAS No. 107 "Disclosures About Fair Value of Financial Instruments," the fair value of the Company's long-term debt at December 31, 1993 and 1992 is estimated to be $690.0 million, or 107% of the carrying value, and $612.1 million, or 103% of the carrying value, respectively. These estimates are based on available market information and appropriate valuation methodologies. THE WASHINGTON WATER POWER COMPANY NOTE 5. BANK BORROWINGS AND COMMERCIAL PAPER At December 31, 1993, the Company maintained total lines of credit with various banks under two separate credit agreements amounting to $160,000,000. The Company has a revolving line of credit expiring December 9, 1995, which provides a total credit commitment of $70,000,000. The second revolving credit agreement is composed of two tranches totaling $90,000,000. The one-year tranche is renewable each year through 1995 and provides for up to $50,000,000 of notes to be outstanding at any one time. The three-year tranche expires September 30, 1995, and provides for up to $40,000,000 of notes to be outstanding at any one time. The Company pays commitment fees of up to 1/5% per annum on the average daily unused portion of each credit agreement. In addition, under various agreements with banks, the Company can have up to $60,000,000 in loans outstanding at any one time, with the loans available at the banks' discretion. These arrangements provide, if funds are made available, for fixed-term loans for up to 180 days at a fixed rate of interest. Balances and interest rates of bank borrowings under these arrangements were as follows: Non-utility operations have $26 million of credit arrangements available. At December 31, 1993, 1992 and 1991, $19.7 million, $7.8 million and $9.3 million, respectively, were outstanding. NOTE 6. ACCOUNTS RECEIVABLE SALE The Company has entered into an agreement whereby it can sell, on a revolving basis, up to $40,000,000 of interests in certain accounts receivable, both billed and unbilled. The Company is obligated to pay fees which approximate the purchaser's cost of issuing commercial paper equal in value to the interests in receivables sold. The amount of such fees is included in operating expenses. At both December 31, 1993 and 1992, $40,000,000 in receivables had been sold pursuant to the agreement. THE WASHINGTON WATER POWER COMPANY NOTE 7. PREFERRED STOCK CUMULATIVE PREFERRED STOCK NOT SUBJECT TO MANDATORY REDEMPTION: The dividend rate on Flexible Auction Preferred Stock, Series J is reset every 49 days based on an auction. During 1993, the dividend rate varied from 3.00% to 3.27% and at December 31, 1993, was 3.14%. Series J is subject to redemption at the Company's option at a redemption price of 100% per share plus accrued dividends. CUMULATIVE PREFERRED STOCK SUBJECT TO MANDATORY REDEMPTION: Redemption requirements: $8.625, Series I - On June 15, 1996, 1997, 1998, 1999 and 2000, the Company must redeem 100,000 shares at $100 per share plus accumulated dividends. The Company may, at its option, redeem up to 100,000 shares in addition to the required redemption on any redemption date. $6.95, Series K - On September 15, 2002, 2003, 2004, 2005 and 2006, the Company must redeem 17,500 shares at $100 per share plus accumulated dividends through a mandatory sinking fund. Remaining shares must be redeemed on September 15, 2007. The Company has the right to redeem an additional 17,500 shares on each September 15 redemption date. There are $30 million in mandatory redemption requirements during the 1994-1998 period. In accordance with FAS No. 107 "Disclosures About Fair Value of Financial Instruments," the fair value of the Company's preferred stock at December 31, 1993 and 1992 is estimated to be $93.8 million, or 110% of the carrying value, and $89.4 million, or 105% of the carrying value, respectively. These estimates are based on available market information and appropriate valuation methodologies. NOTE 8. COMMON STOCK On November 9, 1993, the Company distributed, to shareholders of record on October 25, 1993, shares of its common stock, without par value, under a two-for-one stock split effected in the form of a 100% stock dividend. All references to number of shares and per share information have been adjusted to reflect the common stock split on a retroactive basis. In April 1990, the Company sold 1,000,000 shares of its common stock to the Trustee of the Investment and Employee Stock Ownership Plan for Employees of the Company (Plan) for the benefit of the participants and beneficiaries of the Plan. In payment for the shares of Common Stock, the Trustee issued a promissory note payable to the Company in the amount of $14,125,000. Dividends paid on the stock held by the Trustee, plus Company contributions to the Plan, if any, are used by the Trustee to make interest and principal payments on the promissory note. The balance of the promissory note receivable from the Trustee ($12,755,500 at December 31, 1993) is reflected as a reduction to common equity. The shares of Common Stock are allocated to the accounts of participants in the Plan as the note is repaid. During 1993, the cost recorded for the Plan was $2,216,000. This included the cost for an additional 165,335 shares which were issued for ongoing employee and Company contributions to the Plan. Interest on the note payable, cash and stock contributions to the Plan and dividends on the shares held by the Trustee were $1,238,000, $1,776,000 and $1,231,000, respectively. In February 1990, the Company adopted a shareholder rights plan pursuant to which holders of Common Stock outstanding on March 2, 1990, or issued thereafter, have been granted one preferred share purchase right ("Right") on each outstanding share of Common Stock. Each Right, initially evidenced by and traded with the shares of Common Stock, entitles the registered holder to purchase one one-hundredth of a share of Preferred Stock of the Company, without par value, at an exercise price of $40, subject to certain adjustments, regulatory approval and other specified conditions. The Rights will be exercisable only if a person or group acquires 10% or more of the Common Stock or announces a tender offer, the consummation of which would result in the beneficial ownership by a person or group of 10% or more of the Common Stock. The Rights may be redeemed, at a redemption price of $0.01 per Right, by the Board of Directors of the Company at any time until any person or group has acquired 10% or more of the Common Stock. The Rights will expire on February 16, 2000. THE WASHINGTON WATER POWER COMPANY In November 1991, the Company received authorization to issue from time to time 1,500,000 shares of Common Stock under a Periodic Offering Program (POP). During 1992, the remaining 1,107,600 shares of the first POP were issued under this program for net proceeds of $18.0 million. In the second half of 1992, the Company received authorization to issue a second 1,500,000 shares of common stock under the POP. Through December 31, 1993, 927,600 shares of the second POP were issued for net proceeds of $17.3 million. The Company has a Dividend Reinvestment and Stock Purchase Plan under which the Company's stockholders may automatically reinvest their dividends and make optional cash payments for the purchase of the Company's Common Stock. Sales of Common Stock for 1993, 1992 and 1991, are summarized below (dollar amounts in thousands): THE WASHINGTON WATER POWER COMPANY NOTE 9. FEDERAL INCOME TAXES A reconciliation of federal income taxes derived from statutory tax rates applied to income from continuing operations for accounting purposes and such taxes charged to expense for the consolidated Company is as follows: NOTE 10. DISCONTINUED COAL MINING OPERATIONS Washington Irrigation & Development Company (WIDCo) owned an undivided one-half interest in coal mining properties near Centralia, Washington, which it operated and which supplied coal to the Centralia Steam Electric Generating Plant owned 15% by the Company. On July 31, 1990, WIDCo sold its 50% interest in the Centralia coal mining properties for $40.8 million. A tax adjustment of $1.6 million related to the sale was recorded in 1991. Net income of $2.4 million in 1992 resulted from accounting adjustments and a refund of federal income taxes for years prior to the sale. The consolidated financial statements have been reclassified to reflect the continuing operations of the Company. The revenues, expenses, assets and liabilities of the discontinued operations have been reclassified from those categories and netted into single line items for discontinued operations in the Balance Sheets and Income Statements. THE WASHINGTON WATER POWER COMPANY NOTE 11. COMMITMENTS AND CONTINGENCIES SUPPLY SYSTEM PROJECT 3 In 1985, the Company and the Bonneville Power Administration (BPA) reached a settlement surrounding litigation related to the suspension of construction of Washington Public Power Supply System (Supply System) Project 3. Project 3 is a partially constructed 1,240 MW nuclear generating plant in which the Company has a 5% interest. Under the settlement agreement, the Company receives power deliveries from BPA from 1987 to 2017 in proportion to the Company's investment in Project 3. The settlement with BPA and other parties does not affect the Company's obligations under the Ownership Agreement among the owners of Project 3. In connection with its 1993 rate proceedings, BPA has proposed termination of Project 1 and 3. Termination of Project 3 will require proposal of a termination budget and approval by BPA and the Project 3 Owners under the Ownership Agreement. The Company would be reimbursed for the cost of termination under the settlement with BPA. The only material claim against the Company arising out of the Company's involvement in Project 3, which is still pending in the United States District Court for the Western District of Washington (District Court), is the claim of Chemical Bank, as bond fund trustee for Supply System Projects 4 and 5, against all owners of Projects 1, 2 and 3 for unjust enrichment in the allocation of certain costs of common services and facilities among the Supply System's five nuclear projects. Projects 4 and 5 were being constructed adjacent to Projects 1 and 3, respectively, under a plan to share certain costs. Chemical Bank is seeking a reallocation of $495 million in costs (plus interest since commencement of construction in 1976) originally allocated to Projects 4 and 5. On October 7, 1992, the District Court issued an order ruling in favor of the defendants, including the Company, that the "proportional" allocation methodology actually employed by the Supply System was permitted by the Projects 4 and 5 bond resolution. This ruling does not resolve all cost reallocation claims pending in the District Court, including whether the Supply System correctly followed its methodology. Chemical Bank has indicated its intent to assert claims for cost reallocations based upon other theories which have not been litigated. The case is now in the discovery phase on those claims, as settlement talks were not successful. The Company cannot predict whether Chemical Bank will ultimately be successful in its claim for reallocation of any of the costs of Supply System projects, nor can the Company predict any amounts which might be reallocated to Project 3 or to the Company due to its 5% ownership interest therein. The Company also has claims pending against the Supply System and Chemical Bank with respect to a subordinated loan made by the Company to Projects 4 and 5 in 1981, in the amount of approximately $11 million including interest. The District Court has deferred ruling on the Company's motion to set-off the amount due on the loan, including interest, against any recovery by Chemical Bank on its cost reallocation claims. The Company intends to continue to defend this suit vigorously. Since the discovery is not yet complete, the Company is unable to assess the likelihood of an adverse outcome in this litigation, or estimate an amount or range of potential loss in the event of an adverse outcome. NEZ PERCE TRIBE On December 6, 1991, the Nez Perce Tribe filed an action against the Company in U. S. District Court for the District of Idaho alleging, among other things, that two dams formerly operated by the Company, the Lewiston Dam on the Clearwater River and the Grangeville Dam on the South Fork of the Clearwater River, provided inadequate passage to migrating anadromous fish in violation of rights under treaties between the Tribe and the United States made in 1855 and 1863. The Lewiston and Grangeville Dams, which had been owned and operated by other utilities under hydroelectric licenses from the Federal Power Commission (the "FPC", predecessor of the FERC) prior to acquisition by the Company, were acquired by the Company in 1937 with the approval of the FPC, but were dismantled and removed in 1973 and 1963, respectively. The Tribe initially indicated through expert opinion disclosures that they were seeking actual and punitive damages of $208 million. However, supplemental disclosures reflect allegations of actual loss under different assumptions of between $425 million and $650 million. Discovery in this case has been stayed pending a decision by the Court on a case involving some similar issues between Idaho Power Company and the Nez Perce Tribe. The case is not yet set for trial. The Company intends to vigorously defend against the Tribe's claims. Since the discovery is not yet complete, the Company is unable to assess the likelihood of an adverse outcome in this litigation, or estimate an amount or range of potential loss in the event of an adverse outcome. THE WASHINGTON WATER POWER COMPANY LITTLE FALLS PROJECT Pending before the U. S. District Court in the Eastern District of Washington is the case of Spokane Tribe of Indians v. WWP. This matter involves a claim of the Spokane Tribe of Indians for damages arising out of the Company's Little Falls Hydroelectric Development that was constructed on the Spokane River pursuant to a 1905 Act of Congress. The Tribe is claiming the Company's dam interfered with Indian fishing rights. The Tribe is also seeking a declaratory judgment and quiet title to part of the property comprising the Little Falls Hydroelectric Development. Discovery conducted by the Company revealed that the Tribe may seek damages in the range of $100 million to $1.4 billion, to compensate them for the alleged loss of fishing rights, alleged lost opportunity to develop the properties, and alleged damage to the Tribe's cultural heritage. The trial of these matters is currently scheduled for April 1994 in the United States District Court for the Eastern District of Washington, in Spokane, Washington. On the merits, the Company claims that it has all of the right, title and interest necessary for the construction, operation and maintenance of the Little Falls Development, which rights, title and interest were duly acquired from the United States pursuant to a 1905 Act of Congress. The Company intends to vigorously defend against the Tribe's claims. The Company is unable to assess the likelihood of an adverse outcome in this litigation, or estimate an amount or range of potential loss in the event of an adverse outcome. STEAM HEAT PLANT The Company recently completed an updated investigation of an oil spill that occurred several years ago in downtown Spokane at the site of the Company's steam heat plant. The Company purchased the plant in 1916 and operated it as a non-regulated plant until it was deactivated in 1986 in a business decision unrelated to the leak. After the Bunker C fuel oil spill, initial studies suggested that the oil was being adequately contained by both geological features and man-made structures. The Washington State Department of Ecology (DOE) concurred with these findings. However, more recent tests confirm that the oil has migrated beyond the steam plant property. On December 6, 1993, the Company asked the DOE to approve a voluntary proposal to begin extracting the underground oil. The extraction process is intended to remove quantities of the oil and relieve any pressure on the deposit which might cause it to move. In December 1993, the Company established a reserve of $2.0 million, which is the current best estimate of mitigation costs. FIRESTORM On October 16, 1991, gale-force winds struck a five-county area in eastern Washington and a seven-county area in northern Idaho. These winds were responsible for causing 92 separate wildland fires, resulting in two deaths and the loss of 114 homes and other structures, some of which were located in the Company's service territory. On October 13, 1993, three separate class action lawsuits were filed by private individuals in the Superior Court of Spokane County in connection with fires occurring in the Midway, Nine Mile and Chattaroy regions of eastern Washington. Service of these suits, together with a fourth suit, occurred on January 7, 1994. Complainants allege various theories of tortious conduct, including negligence, creation of a public nuisance, strict liability and trespass. The lawsuits seek recovery for property damage, emotional and mental distress, lost income and punitive damages, but do not specify the amount of damages being sought. The Superior Court has yet to certify these lawsuits as class actions. The Company intends to vigorously defend against all such pending claims. Since the discovery is not yet complete, the Company is unable to assess the likelihood of an adverse outcome in this litigation, or estimate an amount or range of potential loss in the event of an adverse outcome. OTHER CONTINGENCIES The Company has long-term contracts related to the purchase of fuel for thermal generation, natural gas and hydroelectric power. Terms of the natural gas purchase contracts range from one month to five years and the majority provide for minimum purchases at the then effective market rate. The Company also has various agreements for the purchase, sale or exchange of power with other utilities, cogenerators, small power producers and government agencies. For information relating to certain long-term purchased power contracts, see Note 13. THE WASHINGTON WATER POWER COMPANY NOTE 12. JOINTLY-OWNED ELECTRIC FACILITIES The Company is involved in several jointly owned generating plants. Financing for the Company's ownership in the projects is provided by the Company. The Company's share of related operating and maintenance expenses for plants in service is included in corresponding accounts in the Consolidated Statements of Income. The following table indicates the Company's percentage ownership and the extent of the Company's investment in such plants at December 31, 1993: NOTE 13. LONG-TERM PURCHASED POWER CONTRACTS WITH REQUIRED MINIMUM PAYMENTS Under fixed contracts with Public Utility Districts, the Company has agreed to purchase portions of the output of certain generating facilities. Although the Company has no investment in such facilities, these contracts provide that the Company pay certain minimum amounts (which are based at least in part on the debt service requirements of the supplier) whether or not the facility is operating. The cost of power obtained under the contracts, including payments made when a facility is not operating, is included in operations and maintenance expense in the Consolidated Statements of Income. Information as of December 31, 1993, pertaining to these contracts is summarized in the following table: (1) The Company purchases 100% of the Lake Chelan Project output and sells back to the PUD about 40% of the output to supply local service area requirements. (2) The annual costs will change in proportion to the percentage of output allocated to the Company in a particular year. Amounts represent the operating costs for the year 1993. (3) Included in annual costs. Actual expenses for payments made under the above contracts for the years 1993, 1992 and 1991, were $8,721,000, $8,433,000 and $7,589,000, respectively. The estimated aggregate amounts of required minimum payments (the Company's share of debt service costs) under the above contracts for the next five years are $4,338,000 in 1994, $4,775,000 in 1995, $3,830,000 in 1996, $4,300,000 in 1997 and $4,684,000 in 1998 (minimum payments thereafter are dependent on then market conditions). In addition, the Company will be required to pay its proportionate share of the variable operating expenses of these projects. THE WASHINGTON WATER POWER COMPANY NOTE 14. ACQUISITIONS AND DISPOSITIONS During 1993, Pentzer acquired three companies, two involved in financial services and one in point-of-purchase display manufacturing. Sales of companies involved in telecommunications, technology and energy services resulted in transactional gains of $7.1 million. At December 31, 1993, Pentzer had approximately $130 million in assets compared to $103 million at the end of 1992. In 1992, Pentzer's common stock ownership in ITRON was reduced from approximately 60% to approximately 40% as a result of the issuance of common stock by ITRON in an acquisition. Accordingly, beginning in 1992, Pentzer's share of ITRON's earnings is accounted for by the equity method and is included in Other Income-Net and its investment in ITRON is reflected on the balance sheet under Other Property and Investments. As a result of ITRON's initial public offering in November 1993 and Pentzer's sale of a portion of its ITRON stock, Pentzer's ownership interest in ITRON was reduced to approximately 25%. In December 1992, the Company completed the purchase of the northern Idaho electric distribution assets of Citizens Utilities. The cash purchase price of $1.2 million included a premium above the book value of the net assets acquired. The premium will be amortized over a 19-month period. The purchase provided approximately 2,100 additional electric customers. The Company believes that this acquisition will not have a material impact on its revenues or its operations. On September 30, 1991, the Company completed the purchase of the Oregon and South Lake Tahoe, California, natural gas assets of CP National Corporation, a subsidiary of ALLTEL Corporation, for approximately $67.9 million. The cash purchase included a premium of approximately $24.9 million above the book value of the net assets acquired. The premium and other costs associated with acquiring the properties will be amortized under a straight-line method over 20 years and the amortization may be accelerated depending upon earnings. The California and Oregon Commissions have agreed to a general rate "freeze" which extends to January 1, 1996, in California and to December 31, 1995, in Oregon. Purchased natural gas costs will continue to be tracked through to customers during the rate "freeze" period. On February 15, 1994, the Company announced it had reached agreement to acquire the northern Idaho electric properties of Pacific Power & Light Company, an operating division of PacifiCorp. The cash purchase price will be $26 million, subject to adjustments upon closing. The approximate book value of the assets is $19 million. The purchase agreement is subject to approval by the IPUC and FERC. It is anticipated the acquisition will be completed mid-year 1994. Pacific Power's northern Idaho electric system currently serves approximately 9,300 customers. The Company believes this acquisition will not have a material impact on its revenues or its operations. THE WASHINGTON WATER POWER COMPANY NOTE 15. SELECTED QUARTERLY INFORMATION (UNAUDITED) The Company's electric and natural gas operations are significantly affected by weather conditions. Consequently, there can be large variances in revenues, expenses and net income between quarters based on seasonal factors such as temperatures and streamflow conditions. A summary of quarterly operations (in thousands of dollars except for per share amounts) for 1993 and 1992 follows. All references to number of shares and per share information have been adjusted to reflect the common stock split on a retroactive basis. THE WASHINGTON WATER POWER COMPANY PART III ITEM 10.	ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information regarding the directors of the Registrant has been omitted pursuant to General Instruction G to Form 10-K. Reference is made to the Registrant's Proxy Statement to be filed with the Securities and Exchange Commission in connection with the Registrant's annual meeting of shareholders to be held on May 12, 1994. Executive Officers of the Registrant All of the Company's executive officers, with the exception of Messrs. Harvey, Bryan, Ely, Fukai and Buergel and Ms. Racicot, were officers or directors of one or more of the Company's subsidiaries in 1993. Executive officers are elected annually by the Board of Directors. THE WASHINGTON WATER POWER COMPANY ITEM 11.	ITEM 11. EXECUTIVE COMPENSATION Information regarding executive compensation has been omitted pursuant to General Instruction G to Form 10-K. Reference is made to the Registrant's Proxy Statement to be filed with the Securities and Exchange Commission in connection with the Registrant's annual meeting of shareholders to be held on May 12, 1994. ITEM 12.	ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT (a) Security ownership of certain beneficial owners (owning 5% or more of Registrant's voting securities): None. (b) Security ownership of management: Information regarding security ownership of management has been omitted pursuant to General Instruction G to Form 10-K. Reference is made to the Registrant's Proxy Statement to be filed with the Securities and Exchange Commission in connection with the Registrant's annual meeting of shareholders to be held on May 12, 1994. (c) Changes in control: None. ITEM 13.	ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information regarding certain relationships and related transactions has been omitted pursuant to General Instruction G to Form 10-K. Reference is made to the Registrant's Proxy Statement to be filed with the Securities and Exchange Commission in connection with the Registrant's annual meeting of shareholders to be held on May 12, 1994. THE WASHINGTON WATER POWER COMPANY PART IV ITEM 14.	ITEM 14. FINANCIAL STATEMENTS, FINANCIAL STATEMENT SCHEDULES, EXHIBITS AND REPORTS ON FORM 8-K (a) 1. Financial Statements (Included in Part II of this report): Independent Auditors' Report Consolidated Statements of Income and Retained Earnings for the Years Ended December 31, 1993, 1992 and 1991 Consolidated Balance Sheets, December 31, 1993 and 1992 Consolidated Statements of Capitalization, December 31, 1993 and Consolidated Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 Schedule of Information by Business Segments for the Years Ended December 31, 1993, 1992 and 1991 Notes to Financial Statements (a) 2. Financial Statement Schedules (Included in Part IV of this report): Independent Auditors' Report (Relating to Supplemental Schedules) Supplemental Schedules for the Years Ended December 31, 1993, 1992 and 1991: Schedule V(a), (b), (c) - Property, Plant and Equipment Schedule VI(a),(b), (c) - Accumulated Depreciation and Amortization of Property, Plant and Equipment Schedule X - Supplementary Income Statement Information Other schedules are omitted because of the absence of conditions under which they are required or because the required information is given in the financial statements or notes thereto. (a) 3. Exhibits: Reference is made to the Exhibit Index commencing on page 58. The Exhibits include the management contracts and compensatory plans or arrangements required to be filed as exhibits to this Form 10-K by Item 601(10)(iii) of Regulation S-K. (b) Reports on Form 8-K: Dated November 9, 1993 regarding the two-for-one stock split in the form of a 100% stock dividend. INDEPENDENT AUDITORS' REPORT The Washington Water Power Company Spokane, Washington We have audited the consolidated financial statement of The Washington Water Power Company and subsidiaries as of December 31, 1993 and 1992, and for each of the three years in the period ended December 31, 1993, and have issued our report thereon dated January 28, 1994 (February 15, 1994 as to Note 14); such financial statement and report are included in Part II of this Annual Report on Form 10-K. Our audits also comprehended the financial statement schedules of The Washington Water Power Company, listed in Item 14(a)2. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects, the information shown therein. Deloitte & Touche Seattle, Washington January 28, 1994 (February 15, 1994 as to Note 14) SCHEDULE V(a) THE WASHINGTON WATER POWER COMPANY Property, Plant and Equipment For the Year Ended December 31, 1993 (Thousands of Dollars) The cost of additions includes completed projects transferred from CWIP. The Company's 1993 construction program was financed with internally-generated funds, bank borrowings and commercial paper, and proceeds from the sales of preferred and common stock and long-term debt. (1) Represents balance of Citizen Utility acquisition adjustment. (2) Amortization of reserve for nonrecovery of a portion of the Kettle Falls project in accordance with FAS 90. (3) Represents the redistribution of Citizen Utility Electric Plant to appropriate category. (4) Represents $110,796,000 spent on construction less $88,344,000 closed to plant in service from CWIP. SCHEDULE V(b) THE WASHINGTON WATER POWER COMPANY Property, Plant and Equipment For the Year Ended December 31, 1992 (Thousands of Dollars) The cost of additions includes completed projects transferred from CWIP. The Company's 1992 construction program was financed with internally-generated funds, bank borrowings and commercial paper, and proceeds from the sales of preferred and common stock and long-term debt. (1) Amortization of reserve for nonrecovery of a portion of the Kettle Falls project in accordance with FAS 90. (2) Represents the purchase of Citizen Utility Electric Plant. (3) Acquisition adjustment related to purchase of natural gas assets from CP National Corporation. (4) Represents $89,748,000 spent on construction less $96,829,000 closed to plant in service from CWIP. (5) Deconsolidation of ITRON, Inc. SCHEDULE V(c) THE WASHINGTON WATER POWER COMPANY Property, Plant and Equipment For the Year Ended December 31, 1991 (Thousands of Dollars) NOTE: All balances have been restated to exclude the assets of the Company's discontinued coal mining operations. These properties were sold in 1990. The amount of WP Natural Gas assets in Column F is $73,828,000. The cost of additions includes completed projects transferred from CWIP. The Company's 1991 construction program was financed with internally-generated funds, bank borrowings and commercial paper, and proceeds from the sales of preferred and common stock and long-term debt. (1) Amortization of reserve for non-recovery of a portion of the Kettle Falls project in accordance with FAS 90. (2) Amortization of adjustment related to City of Worley acquisition. (3) Acquisition adjustment related to purchase of natural gas assets from CP National Corporation. (4) Reclassification of software development costs. (5) Includes $234,237 of computer software transferred from general plant to intangible plant. (6) Represents $143,915,000 spent on construction less $123,869,000 closed to plant in service from CWIP. SCHEDULE VI(a) THE WASHINGTON WATER POWER COMPANY Accumulated Depreciation and Amortization of Property, Plant and Equipment for the Year Ended December 31, 1993 (Thousands of Dollars) (1) Retirements are reported net of cost of removal and salvage. (2) Reference is made to Note 1 to Financial Statements for depreciation method. (3) Pertains to adjustment resulting from sale of equipment, transfers to non-utility, acquisition premium for Citizens Utility of ($340,298) and $838,911 accumulated depreciation acquired at the time of the purchase of Citizens Utility. (4) Represents a transfer relating to the accrued liability for Steam Heat Environmental clean-up. SCHEDULE VI(b) THE WASHINGTON WATER POWER COMPANY Accumulated Depreciation and Amortization of Property, Plant and Equipment for the Year Ended December 31, 1992 (Thousands of Dollars) NOTE: All balances have been restated to exclude the accumulated depreciation and amortization on the Company's discontinued coal mining operations. These properties were sold in 1990. The amount in Column F related to WP Natural Gas is $31,460. (1) Retirements are reported net of cost of removal and salvage. (2) Reference is made to Note 1 to Financial Statements for depreciation method. (3) Pertains to adjustment resulting from sale of equipment. (4) Deconsolidation of ITRON. SCHEDULE VI(c) THE WASHINGTON WATER POWER COMPANY Accumulated Depreciation and Amortization of Property, Plant and Equipment for the Year Ended December 31, 1991 (Thousands of Dollars) - --------- NOTE: All balances have been restated to exclude the accumulated depreciation and amortization on the Company's discontinued coal mining operations. These properties were sold in 1990. The amount in Column F related to WP Natural Gas is $29,404. (1) Retirements are reported net of cost of removal and salvage. (2) Reference is made to Note 1 to Financial Statements for depreciation method. (3) Represents balance of accumulated depreciation & amortization for WP Natural Gas at time of purchase. (4) Reclassification related to intangibles and software development costs. SCHEDULE X THE WASHINGTON WATER POWER COMPANY Supplementary Income Statement Information for the Years Ended December 31, 1993, 1992 and 1991 (Thousands of Dollars) Amounts of maintenance and repairs, and depreciation, other than as set out separately in the Consolidated Statements of Income and Retained Earnings, are not material. Amounts of advertising costs are not material. THE WASHINGTON WATER POWER COMPANY SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. THE WASHINGTON WATER POWER COMPANY 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. THE WASHINGTON WATER POWER COMPANY INDEPENDENT AUDITORS' CONSENT We consent to the incorporation by reference in Registration Statement No. 2-81697 on Form S-8, in Registration Statement No. 2-94816 on Form S-8, in Registration Statement No. 33-10040 on Form S-3, in Registration Statement No. 33-32148 on Form S-8, in Registration Statement No. 33-40333 on Form S-3, in Registration Statement No. 33-49662 on Form S-3, in Registration Statement No. 33-60136 on Form S-3, and in Registration Statement No. 33-51669 on Form S-3 of our report dated January 28, 1994 (February 15, 1994 as to Note 14), appearing in this Annual Report on Form 10-K of The Washington Water Power Company for the year ended December 31, 1993. Deloitte & Touche Seattle, Washington March 4, 1994 THE WASHINGTON WATER POWER COMPANY EXHIBIT INDEX Incorporated herein by reference. Filed herewith. THE WASHINGTON WATER POWER COMPANY EXHIBIT INDEX (continued) Incorporated herein by reference. *Filed herewith. THE WASHINGTON WATER POWER COMPANY EXHIBIT INDEX (continued) Incorporated herein by reference. ** Filed herewith. THE WASHINGTON WATER POWER COMPANY EXHIBIT INDEX (continued) * Incorporated herein by reference. ** Filed herewith. THE WASHINGTON WATER POWER COMPANY EXHIBIT INDEX (continued) * Incorporated herein by reference. ** Filed herewith. THE WASHINGTON WATER POWER COMPANY EXHIBIT INDEX (continued) * Incorporated herein by reference. ** Filed herewith. THE WASHINGTON WATER POWER COMPANY EXHIBIT INDEX (continued) * Incorporated herein by reference. Filed herewith. * Management contracts or compensatory plans filed as exhibits by reference per Item 601(10)(iii) of Regulation S-K. THE WASHINGTON WATER POWER COMPANY EXHIBIT INDEX (continued) * Incorporated herein by reference. Filed herewith. * Management contracts or compensatory plans filed as exhibits by reference per Item 601(10)(iii) of Regulation S-K.
350847_1993.txt	350847	1993	ITEM 1. BUSINESS Riggs National Corporation Riggs National Corporation (the "Corporation") is a multi-bank holding company registered under the Bank Holding Company Act of 1956, as amended (the "BHCA"), and incorporated in the State of Delaware. The Corporation engages in a variety of banking-related activities, either directly or through subsidiaries. The Corporation currently has banking subsidiaries in Washington, D.C.; Virginia; Maryland; Miami, Florida; London, England; Paris, France; and Nassau, Bahamas. Additionally, the Corporation provides investment advisory services domestically through a subsidiary registered under the Investment Advisers Act of 1940 and internationally through a subsidiary in Geneva, Switzerland. Subsidiaries of the Corporation located in Gibraltar provide trust and corporate services. The Corporation provides a wide range of financial services to a broad customer base. These include traditional retail banking, corporate and commercial banking, and trust and investment advisory services. The Corporation's trust group provides fiduciary and administrative services, including financial management and tax planning for individuals, investment and accounting services for corporate and nonprofit organizations, estate planning and trust administration, as well as bond trusteeship for state and local governments and public companies. --------------------------------------------------- The Riggs National Bank of Washington, D.C. The Corporation's principal subsidiary is The Riggs National Bank of Washington, D.C. ("Riggs-Washington"), a national banking association founded in 1836 and incorporated under the national banking laws of the United States in 1896. Riggs-Washington had assets of $4.21 billion, deposits of $3.29 billion, and stockholder's equity of $270 million at December 31, 1993. Riggs-Washington operates 34 branches and an investment advisory subsidiary in Washington, D.C., commercial banks in London, England and Paris, France, an Edge Act subsidiary in Miami, Florida, branch offices in London, England and Nassau, Bahamas, an investment advisory subsidiary in Geneva, Switzerland, and a Bahamian bank and trust company. At December 31, 1993, Riggs-Washington and its subsidiaries had 1,494 full-time equivalent employees. As a commercial bank, Riggs-Washington provides a wide array of financial services to customers in the Washington metropolitan area, throughout the United States and internationally. Riggs-Washington's Corporate and Commercial Banking Groups provide services to customers ranging from small regional businesses to major multinational companies. These services include lines of credit, secured and unsecured term loans, letters of credit, credit support facilities, foreign currency transactions and cash management. Riggs-Washington's Trust and Financial Services Group provides fiduciary and administrative services, including financial management and tax planning for individuals, investment and accounting services for corporate and non-profit organizations, estate planning and trust administration, as well as bond trusteeship for state and local governments and public companies. Riggs-Washington provides investment advisory services through Riggs Investment Management Corporation ("RIMCO"), a wholly owned subsidiary incorporated under the laws of Delaware and registered under the Investment Advisers Act of 1940. Riggs-Washington's Retail Banking Group provides a variety of services including checking, NOW, savings and money market accounts, loans and personal lines of credit, certificates of deposit and individual retirement accounts. Additionally, the Retail Banking Group provides 24-hour banking services through a network of Riggs's automated teller machines ("ATMs") and through national and regional ATM networks. Riggs-Washington's International Banking Group furnishes a variety of financial services including issuing letters of credit in connection with trade and other transactions, taking deposits, foreign exchange, private banking and cash management. Customers include embassies and foreign missions in Washington, D.C., foreign governments, central banks, and over 200 correspondent banks around the world. These services are provided through both domestic and international offices. Riggs-Washington owns majority interests in an investment advisory firm, Riggs Valmet, S.A., headquartered in Geneva, Switzerland, and a trust and corporate service company, Riggs Valmet Holdings Limited, headquartered in Gibraltar. Riggs Valmet, S.A. provides portfolio management services and Riggs Valmet Holdings Limited forms and administers trusts and private companies in many jurisdictions for a wide variety of purposes including estate planning and personal and corporate tax planning. The Riggs Bank and Trust Company (Bahamas) Limited, in Nassau, provides trust services for international private banking customers. Riggs-Washington operates a branch in the U.S. Embassy in London which services the Embassy, its employees and official visitors. In 1991, Riggs-Washington opened a banking subsidiary under the laws of France. A full service commercial bank, The Riggs National Bank (Europe) S.A. ("Riggs-Europe") has one branch located in the U.S. Embassy in Paris. In addition to serving the Embassy, its employees and official visitors, the Riggs-Europe office also assists the U.S. Government with disbursement activities for the Department of Defense and Department of State for all their facilities in Europe. Riggs AP Bank Limited Riggs AP Bank Limited ("Riggs AP"), a merchant bank located in London, England is a wholly owned subsidiary of Riggs-Washington. Riggs AP provides traditional corporate banking services, commercial property financing, investment banking services and trade finance. At December 31, 1993, Riggs AP had total assets of $173 million representing 3.6% of the Corporation's total assets and loans of $93 million or 36.4% of the Corporation's total foreign loans and 3.7% of total loans. --------------------------------------------------- The Riggs National Bank of Virginia The Riggs National Bank of Virginia ("Riggs-Virginia") is a nationally chartered full-service commercial bank. At December 31, 1993, Riggs-Virginia had assets of $344 million, deposits of $311 million and stockholder's equity of $31 million. Riggs-Virginia's 17 branches are located in Northern Virginia. At December 31, 1993, Riggs-Virginia had 102 full-time equivalent employees. --------------------------------------------------- The Riggs National Bank of Maryland The Riggs National Bank of Maryland ("Riggs-Maryland") is a nationally chartered full-service commercial bank. At December 31, 1993, Riggs-Maryland had assets of $196 million, deposits of $182 million, and stockholder's equity of $13 million. Riggs-Maryland's 11 branches are all located in Montgomery and Prince Georges counties, Maryland. At December 31, 1993, Riggs-Maryland had 68 full- time equivalent employees. --------------------------------------------------- Supervision and Regulation The Corporation and certain of its subsidiaries are subject to the supervision of and regulation by the Board of Governors of the Federal Reserve System (the "Federal Reserve Board"). The Corporation's national banking subsidiaries and certain of their subsidiaries are subject to the supervision of and regulation by the Office of the Comptroller of the Currency (the "OCC"). Other federal, state and foreign laws govern many aspects of the businesses of the Corporation and its subsidiaries. Under the BHCA, bank holding companies may not directly or indirectly acquire the ownership or control of five percent or more of the voting shares or substantially all of the assets of any company, including a bank, without the prior approval of the Federal Reserve Board. The BHCA also restricts the types of businesses and activities in which a bank holding company and its subsidiaries may engage. Generally, activities are limited to banking and activities found by the Federal Reserve Board to be so closely related to banking as to be a proper incident thereto. In addition, the BHCA generally prohibits the Federal Reserve Board from approving an application from a bank holding company to acquire a bank or bank holding companies unless such an acquisition is specifically authorized by statute of the state in which the bank whose shares to be acquired is located. A majority of states have adopted statutes permitting out-of-state bank holding companies to acquire in-state banks and bank holding companies, but usually only if the state in which the acquiring company is located permits reciprocal acquisitions of its banks and bank holding companies. The District of Columbia has authorized banks outside a thirteen-state region to acquire District banks provided they make substantial financial commitments to the District of Columbia. Congress is currently considering legislation that would provide for nationwide interstate banking, subject to certain limitations, including the ability of states to opt out of coverage. However, the Corporation is unable to predict whether or not any such legislation will be adopted and, if so, what the final form of the legislation will be. The Corporation is required to maintain minimum levels of qualifying capital under Federal Reserve Board risk-based capital guidelines. For full discussion of these guidelines, see Pages 22 and 23 and Note 11, Page 51. Pursuant to the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"), in September 1992, the FDIC issued regulations to implement a risk- based deposit insurance assessment system under which the assessment rate for an insured depository institution varies according to the level of risk incurred in its activities. An institution's risk category is based partly upon whether the institution is assigned to one of the following "supervisory subgroups": "healthy"; "supervisory concern"; or "substantial supervisory concern." Based on its capital category and supervisory subgroup, each insured institution is assigned an annual FDIC assessment rate, which currently varies between $.23 and $.31 per $100 of deposits. The new rates were effective for the semi-annual assessment period beginning January 1, 1993. The Corporation experienced an increase in its insurance premiums for its three insured banking subsidiaries of approximately $1.5 million during 1993 as a result of the new assessment schedule. FDICIA contains numerous other provisions. Among other things, FDICIA requires the federal banking agencies to take "prompt corrective action" in respect of depository institutions that do not meet minimum capital requirements. FDICIA required each Federal banking agency, including the OCC, to specify within nine months after the date of enactment of the statute, by regulation, the levels at which an insured institution would be considered "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized," and "critically undercapitalized." In October 1992, each of the federal banking agencies including the OCC, issued uniform final regulations defining such capital levels. Under these regulations, a bank is considered "well capitalized" if it has (i) a total risk-based capital ratio of 10 percent or greater, (ii) a Tier 1 risk-based capital ratio of 6 percent or greater, (iii) a leverage ratio of 5 percent or greater and (iv) is not subject to any order or written directive to meet and maintain a specific capital level. An "adequately capitalized" bank is defined as one that has (i) a total risk-based capital ratio of 8 percent or greater, (ii) a Tier 1 risk-based capital ratio of 4 percent or greater and (iii) a leverage ratio of 4 percent or greater (or 3 percent or greater in the case of a bank with the highest composite regulatory examination rating). A bank is considered (A) "undercapitalized" if it has (i) a total risk-based capital ratio of less than 8 percent, (ii) a Tier 1 risk-based capital ratio of less than 4 percent or (iii) a leverage ratio of less than 4 percent (or 3 percent in the case of a bank with the highest composite regulatory examination rating); (B) "significantly undercapitalized" if the bank has (i) a total risk- based capital ratio of less than 6 percent, (ii) a Tier 1 risk-based capital ratio of less than 3 percent or (iii) a leverage ratio of less than 3 percent; and (C) "critically undercapitalized" if the bank has a ratio of tangible equity to total assets of equal to or less than 2 percent. Each of the bank subsidiaries of the Corporation exceeds current minimum regulatory capital requirements, and qualifies, at a minimum, as "adequately capitalized." The applicable federal bank regulator for a depository institution may, under certain circumstances, reclassify a "well capitalized" institution as "adequately capitalized" or require an "adequately capitalized" or "undercapitalized" institution to comply with supervisory actions as if it were in the next lower category. Such a reclassification may be made if the regulatory agency determines that the institution is in an unsafe or unsound condition (which could include unsatisfactory examination ratings). A summary of applicable regulatory capital ratios and the minimums required by the OCC under its capital guidelines for Riggs-Washington, Riggs-Virginia and Riggs- Maryland on a historical basis are shown in Note 11, "Reserve Balances, Funds Restrictions, Regulatory Matters and Capital Requirements." FDICIA generally prohibits a depository institution from making any capital distribution (including payment of a dividend) or paying any management fee to its holding company if the depository institution would thereafter be undercapitalized. Undercapitalized depository institutions are subject to increased regulatory monitoring and growth limitations and are required to submit capital restoration plans. A depository institution's holding company must guarantee that capital plan in order for it to be accepted by the regulators, up to an amount equal to the lesser of 5% of the depository institution's assets at the time it becomes undercapitalized or the amount needed to comply with the plan. The federal banking agencies may not accept a capital plan without determining, among other things, that the plan is based on realistic assumptions and is likely to succeed in restoring the depository institution's capital. If a depository institution fails to submit an acceptable plan, it is treated as if it is significantly undercapitalized. Significantly or critically undercapitalized institutions and undercapitalized institutions that do not submit and comply with capital restoration plan acceptable to the applicable Federal banking agency will be subject to one or more of the following sanctions: (i) forced sale of shares to raise capital or, where grounds exist for the appointment of a receiver or conservator, or forced merger; (ii) restrictions on transactions with affiliates; (iii) limitations on interest rates paid on deposits; (iv) further restrictions on growth or required shrinkage; (v) replacement of directors or senior executive officers, subject to certain grandfather provisions for those elected prior to enactment of FDICIA; (vi) prohibitions on the receipt of correspondent deposit; (vii) restriction on capital distributions by the holding companies of such institutions; (viii) required divestiture of subsidiaries by the institution; or (ix) other restrictions, as determined by the regulator. In addition, the compensation of executive officers would be frozen at the level in effect when the institition failed to meet the capital standards. A forced sale of shares or merger, restrictions on affiliate transactions and restrictions on rates paid on deposits would be required to be imposed by the primary federal regulator unless that regulator determined that they would not further capital improvement. FDICIA generally requires the appointment of a conservator or receiver within 90 days after a depository institution becomes critically undercapitalized, unless the FDIC and the institution's primary federal regulator jointly determine that another course of action would better protect the federal deposit insurance fund. FDICIA also provides that the board of directors of an insured depository institution would not be liable to the institution's shareholders or creditors for consenting in good faith to the appointment of a receiver or conservator for the institution or to an acquisition or merger of the institution required by the regulators. Under the FDIC's final regulations governing the receipt of brokered deposits, a bank cannot accept brokered deposits unless it is (i) "well capitalized" or (ii) it is "adequately capitalized" and receives a waiver from the FDIC. In addition, a bank that is not well capitalized may not offer rates of interest on deposits that are more than 75 basis points above prevailing rates. Also, "pass through" deposit insurance is not available for deposits of certain employee benefit plans in banks that do not meet all minimum capital requirements. As mentioned above, under the current regulations, each of the bank subsidiaries of the Corporation exceeds current minimum regulatory capital requirements and qualifies, at a minimum, as "adequately capitalized." Riggs-Washington does not solicit brokered deposits and, accordingly, the Corporation does not believe that the regulations will have an adverse effect on its operations. However, Riggs-Washington has received a waiver from the FDIC to provide pass-through deposit insurance to employee benefit plans held in the Trust Department. Among FDICIA's numerous other provisions are new reporting requirements, termination of the "too big to fail" doctrine except in special cases, limitations on the FDIC's ability to pay deposits at foreign branches and provisions requiring the federal banking agencies to promulgate regulations and specify standards in numerous areas of bank operations, including interest rate exposure, asset growth, internal controls, credit underwriting, executive officer and director compensation, real estate construction financing, additional review of capital standards, interbank liabilities and other operational and managerial standards as the agencies determine appropriate. These regulations have increased and may continue to increase the cost of and the regulatory burden associated with the banking business. There are legal restrictions on the extent to which the Corporation and its non-bank subsidiaries may borrow or otherwise obtain credit from Riggs- Washington, Riggs-Virginia, and Riggs-Maryland. Subject to certain limited exceptions, a bank subsidiary may not extend credit to the Corporation or to any other affiliate (as defined) in an amount which exceeds 10% of its capital stock and surplus and may not extend credit in the aggregate to such affiliates in an amount which exceeds 20% of its capital stock and surplus. Further, there are legal requirements as to the type, amount and quality of collateral which must secure such extensions of credit by each bank subsidiary to the Corporation or to other affiliates. Finally, extensions of credit and other transactions between a bank subsidiary and the Corporation or other affiliates must be on terms and under circumstances, including credit standards, that are substantially the same or at least as favorable to such a bank subsidiary as those prevailing at the time for comparable transactions with non-affiliated companies. Under Federal Reserve Board policy, bank holding companies are expected to act as a source of financial strength to their subsidiary banks and to commit resources to support such banks in circumstances where a bank holding company might not do so absent such policy. In addition, any capital loans by a bank holding company to any of its subsidiary banks are subordinate in right of payment to deposits and to certain other indebtedness of such subsidiary bank. In the event of a bank holding company's bankruptcy, any commitment by the bank holding company to a federal bank regulatory agency to maintain the capital of a subsidiary bank will be assumed by the bankruptcy trustee and entitled to a priority of payment. --------------------------------------------------- ITEM 2.		ITEM 2. PROPERTIES The Corporation owns properties located in Washington, D.C. which house its executive offices, twelve of its branches and certain operational units of Riggs-Washington. The Corporation also owns an office building and a residential property in London, England, and leases various properties in Washington, D.C.; London, England; Miami, Florida; Northern Virginia; Maryland; Paris, France; Geneva and Lugano, Switzerland; and Gibraltar. ITEM 3.	ITEM 3. LEGAL PROCEEDINGS In the normal course of business, the Corporation is involved in various types of litigation, including litigation with borrowers who are in default under their loan agreements. In certain instances, borrowers have asserted or threatened counterclaims and defenses based on various "lender liability" theories. In the opinion of management, based on its assesssment and consultation with outside counsel, litigation which is currently pending against the Corporation will not have a material impact on the financial condition or future operations of the Corporation as a whole. The Corporation is contesting in Tax court the disallowance of Brazilian Foreign Tax Credits by the Internal Revenue Service. The net tax benefit of these tax credits have not been recognized for financial reporting purposes, therefore, there will be no adverse impact on earnings if the Internal Revenue Service were to prevail. ITEM 4.	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to security holders for vote during the fourth quarter of 1993. PART II ITEM 5.	ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS The common stock of Riggs National Corporation is traded in the Over-the-Counter Market, NASDAQ National Market System. The NASDAQ symbol for the common stock is "RIGS." A history of the Corporation's stock prices and dividends can be found under Quarterly Stock Information on Page 67 of this Form 10-K. As of December 31, 1993, there were 4,488 stockholders of record. Other information required by this item is set forth in Notes 11 and 15 on Pages 51 and 57, respectively, of this Form 10-K. ITEM 6.	ITEM 6. FINANCIAL REVIEW * A cash dividend of $.15 per share applicable to the fourth quarter of 1990 was declared on January 22, 1991, and paid on February 15, 1991. ITEM 7.	ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Earnings Summary The Corporation achieved a profitable second half of 1993, earning $6.0 million, compared with a loss of $18.8 million for the same period in 1992. In addition, nonperforming assets decreased by $98.5 million during this period to their lowest level in over three years. The financial results also reflect the impact of a significant cost reduction and revenue enhancing strategy ("BankStart '93"), which was initiated in the first quarter of 1993, and financial restructurings of both domestic and London operations during the second quarter of 1993. In addition, the Corporation's performance during the last half of 1993 was positively affected by economic improvements in the Washington, D.C., and London areas, the Corporation's primary markets. For the year 1993, the Corporation reported a loss of $94.2 million, compared with a loss of $21.1 million for 1992. The major factors contributing to the 1993 loss were provisions for loan losses of $69.3 million, other real estate owned expenses of $13.5 million, and restructuring expenses of $34.6 million, which were only partially offset by securities gains of $24.1 million. The 1992 loss resulted from provisions for loan losses of $52.1 million and other real estate owned expenses of $15.7 million, and was partially offset by securities gains of $34.2 million, as well as $5.9 million of nonrecurring interest income related to a tax receivable. --------------------------------------------------- Restructuring and Positioning Riggs for the Future During 1993 the Corporation undertook and accomplished a significant self- evaluation and redefinition of its goals and market position. These initiatives included BankStart '93, financial restructurings (both domestically and in the London operations), hiring a new Chief Executive Officer for The Riggs National Bank of Washington, D.C. ("Riggs-Washington") and significantly strengthening the management team, adopting a supercommunity bank focus for the future and raising $132 million in new equity capital. BankStart '93. In January 1993, the Corporation initiated BankStart '93, a comprehensive, corporation-wide project designed to make it more cost efficient and operationally effective. Each line of business was reexamined in order to identify opportunities to improve efficiencies and reduce costs. The goal of the project was to identify revenue enhancements, productivity advances, expense reductions and product line modifications needed to facilitate the Corporation's return to consistent profitability. A significant portion of the expense reduction came from reduced staffing. When the program began, the authorized number of full-time positions for the Corporation's domestic subsidiaries was 2,060. By December 31, 1993, the authorized number of full-time equivalent domestic employees had been reduced to approximately 1,700. Subsequent to BankStart '93, the Corporation identified market opportunities available and has decided to pursue a "supercommunity bank" strategy (discussed later in this section). This strategy will result in staff additions, although such additions, when netted against the remaining BankStart '93 and other reductions, will leave the staffing complement at approximately the year-end 1993 level. In the first quarter of 1993, the Corporation took a restructuring charge of $13.8 million, representing management's estimate of the cost of implementing BankStart '93. At December 31, 1993, $4.6 million of these expenses remained in the accrual and are expected to be paid over the remaining implementation period. BankStart '93 is expected to be substantially implemented by mid-year 1994. This estimate of the implementation costs is evaluated by management on an ongoing basis and, as adjustments are known, will be revised accordingly. Financial Restructurings. At the end of the second quarter of 1993, the Corporation announced a financial restructuring designed to facilitate its return to profitability. The steps taken included charging off the doubtful portions of all loans, exiting unprofitable lines of business in the United Kingdom, reducing its investments in certain foreign subsidiaries and increasing reserves against problem assets in order to facilitate their disposition. These actions led to second-quarter provisions for loan losses of $49.2 million, restructuring charges of $20.8 million, and expenses for other real estate owned of $16.9 million. Of the $49.2 million in provisions for loan losses, $24.7 million related to commercial real estate in the Washington, D.C., area, and $24.5 million related to commercial property loans and corporate loans in the United Kingdom. As a part of the financial restructuring, the Corporation adopted a plan for its London operations (the combination of the London branch of Riggs-Washington and the subsidiary, Riggs AP Bank). This plan addresses the potential risk in the loan and other real estate owned portfolios in its London operations, and is designed to facilitate the disposition of certain troubled assets and to exit unprofitable lines of business. The London operations have been reorganized on a basis consistent with the Corporation's domestic strategy to segregate ongoing banking business from the management of problem assets. In June 1993, Riggs AP Bank transferred all $152.8 million of its nonperforming and classified loans to Riggs-Washington. These assets were transferred at book value, net of related reserves, and continue to be serviced by Riggs AP Bank. Ongoing business lines are now centered on financing income-producing commercial real estate properties in the United Kingdom, as well as financing international trade transactions, primarily for mid-sized corporations based in the United Kingdom. The Corporation has substantially completed its withdrawal from certain business activities in the United Kingdom, including commercial leasing, corporate finance and trading activity in foreign exchange and money market instruments. New Management Team. In June 1993, Paul M. Homan was appointed President and Chief Executive Officer of Riggs-Washington and Vice Chairman of the Corporation. Prior to joining the Corporation and Riggs-Washington, Mr. Homan was President and Chief Executive Officer of First Florida Banks, Inc. of Tampa, Florida. Prior to his tenure with First Florida, Mr. Homan held executive positions with several other large financial institutions as well as with the Office of the Comptroller of the Currency. In addition to the appointment of Mr. Homan, the Corporation has significantly strengthened its senior management team since early 1993 with the appointment of a new Chief Financial Officer, a new head of its General Banking Group and new heads of its Retail, Corporate and Commercial Lending, Commercial Real Estate Lending, Loan Review, Audit and Appraisal Services Divisions and its newly created Risk Management Division. Each of the new division heads has extensive banking experience. Supercommunity Bank Strategy. As the largest commercial bank holding company headquartered in the nation's capital, the Corporation is uniquely positioned in the center of an affluent market that combines significant public- and private- sector customers. The Corporation attained this position by steadily growing and prospering in the Washington, D.C., area for 157 years, and being the only Washington, D.C.-based bank of size to survive the economic and industry travails of the late 1980s and early 1990s. This departure of banks leaves the Corporation competing with a host of community banks and the "super regionals." In order to differentiate itself from the competition, the Corporation will offer its customers a breadth of financial products typical of a regional bank with the personalized service and local decision-making of a community bank. The Corporation believes that its size will allow it to offer a broader product line than its smaller competitors, while its personalized service and local decision-making will give the Corporation a distinct advantage over its larger regional competitors. Local decision-making and a commitment to the community will be the key to retaining its existing customers and building new relationships. October Equity Sale. On October 21, 1993, as part of the financial restructuring plan announced by the Corporation at the end of the second quarter of 1993, the Corporation issued and sold 4,000,000 shares of Series B Preferred Stock and 5,000,000 shares of Common Stock to certain investors in transactions exempt from the registration requirements of the Securities Act. The shares of Series B Preferred Stock and Common Stock were sold for $25 per share and $7.75 per share, respectively. The net proceeds to the Corporation from the October equity sale (after deducting placement agent fees and related estimated expenses) were approximately $132 million. All of the Series B Preferred Stock and 2,924,000 shares of the Common Stock sold in the October equity sale have been registered for resale by the investors referred to above pursuant to a shelf registration statement, which is to be maintained in effect for three years. The Corporation will not receive the proceeds from any such resales. --------------------------------------------------- Regulatory Developments On May 14, 1993, the Corporation entered into a Memorandum of Understanding with the Federal Reserve Bank of Richmond ("Reserve Bank") and Riggs-Washington entered into a Written Agreement with the Office of the Comptroller of the Currency (the "OCC"). The Memorandum of Understanding and the Written Agreement were the result of regulatory concern over financial and operational weaknesses and continued losses related primarily to the Corporation's domestic and United Kingdom commercial real estate exposure. Under the terms of the Memorandum of Understanding, the Corporation will notify the Reserve Bank in advance of dividend declarations, the issuance and/or redemption of long-term debt and use of cash assets in certain circumstances. The Corporation is also required to submit plans and reports to the Reserve Bank relating to capital, asset quality, loan loss reserves and operations, including contingency measures if projected operational results do not occur. In addition, the Audit Committee of the Corporation's Board of Directors has reviewed and submitted a report to the Reserve Bank on the adequacy of data submitted to it and the Board, and the Corporation has appointed a compliance committee of Directors to monitor performance under the Memorandum of Understanding. In accordance with the terms of the Written Agreement, Riggs-Washington has appointed a committee of its Board of Directors to monitor and coordinate compliance with the agreement, implement recommendations previously made by an independent management consultant, and continue to implement the action plan and work plan previously adopted by Riggs-Washington. Riggs-Washington has met a number of the requirements of the Written Agreement, including filing amended call reports; adopting policies and procedures relating to the preparation of call reports; adopting a capital plan that has been approved by the OCC (that requires, among other things, a minimum total risk-based capital ratio of 10.00%, a minimum Tier I risk-based capital ratio of 6.00% and a minimum leverage ratio of 5.00%); submitting for review by the OCC the results of BankStart '93; and appointing a new president and chief executive officer. EARNING ASSETS Money Market Assets Short-term instruments such as time deposits with other banks, federal funds sold and resale agreements represent alternatives for the Corporation for the deployment of excess short-term liquidity. These investments are lower-yielding and are highly interest-rate sensitive. Funds available for short-term investments generally are a function of daily movements in the Corporation's deposit and loan portfolios, combined with the Corporation's overall interest- rate risk and asset/liability strategy. In 1993, total money market assets declined by $857.8 million, or 67.9%, as the Corporation shifted to higher- yielding, longer-term assets, with increases in securities available for sale and loans during the year. The total average of time deposits with other banks, federal funds sold and resale agreements fell from $1.12 billion in 1992 to $862.8 million in 1993. Securities Available for Sale Securities available for sale totaled $708.1 million at December 31, 1993, compared with $159.6 million at year-end 1992. In the first quarter of 1993, in view of management's intention to use certain securities as part of its asset/liability strategy and the possibility that securities could be sold in response to changes in interest rates or for liquidity purposes, $983 million of securities were classified as held for sale. In the second quarter of 1993, $696 million in securities held for sale were sold for a pretax gain of $25.9 million. Proceeds from this sale were used to purchase shorter-duration and variable-rate securities classified as held for sale, in addition to money market assets. In May 1993, Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" (SFAS No. 115) was issued, effective for fiscal years beginning after December 15, 1993. This pronouncement requires, among other items, the determination at the acquisition date of a security whether such security is purchased with the intent and ability to hold to maturity, whether it is purchased with the intent to trade, or whether the security is available for sale. Under prior accounting policy, securities were classified as held for investment if the Corporation had the ability to hold securities to maturity and the intent to hold such securities for the foreseeable future, with all other securities classified as held for sale or trading. The Corporation adopted SFAS No. 115 on December 31, 1993, which included a review of the securities portfolio based on management's intent for the securities at that time. This review resulted in the net transfer of $168.7 million in securities at December 31, 1993, from the available for sale portfolio to the held-to-maturity portfolio. All unrealized gains and losses from securities available for sale are excluded from earnings, with unrealized gains and losses included, net, in stockholders' equity until realized. After taking into affect the $168.7 million net transfer on December 31, 1993, the new accounting treatment for the securities available for sale portfolio under SFAS No. 115 resulted in a $1.28 million net unrealized gain in stockholders' equity. Securities available for sale pledged to secure deposits and certain borrowings amounted to $372.8 million at December 31, 1993, and $14.0 million at December 31, 1992. Securities Available for Sale Total Securities Available for Sale Securities Held-to-Maturity Securities held-to-maturity totaled $660.1 million at December 31, 1993, down $135.3 million, or 17.0%, from the level at December 31, 1992. The average balance in securities held-to-maturity was $709.8 million for 1993, compared with $686.1 million for 1992. At December 31, 1993, securities held-to-maturity had gross unrealized gains of $729 thousand and gross unrealized losses of $18 thousand. The decrease in this portfolio was due to the transfer in the first quarter of 1993 of $983 million in investment securities to the held for sale portfolio -- see "Securities Available for Sale" discussion on prior page. At December 31, 1993, this portfolio consisted primarily of U.S. Treasury Securities with 97.6% of the portfolio maturing in one year or less. Other securities consist primarily of floating-rate notes, preference shares of United Kingdom companies and Federal Reserve stock. A portion of the securities held- to-maturity portfolio is pledged to secure certain borrowings and deposits, with total securities pledged of $271.2 million at December 31, 1993, and $320.0 million at year-end 1992. As discussed in "Securities Available for Sale," the Corporation has specific policies in place, in compliance with SFAS No. 115, that require the determination at the acquisition date whether a security should be included in the securities held-to-maturity portfolio; a security is included if it was purchased with the intent and the ability to hold the security to maturity and the Corporation does not anticipate disposing of it for liquidity purposes or for the recognition of unrealized gains and losses. The Corporation has policies that require, on an ongoing basis, that a determination be made whether a security should continue to be in the held-to-maturity portfolio or be transferred to the securities available for sale portfolio. The table below details the securities held-to-maturity portfolio at December 31, 1993, 1992 and 1991. Book Value of Securities Held-to-Maturity * Investment Securities for 1992 and 1991 are presented in the Securities Held-to-Maturity category. See Note 1 - "Summary of Significant Accounting Policies." - - -------------------------------------------------------------------------------- Loans As of December 31, 1993, loans, net of premiums, discounts and unearned fees, were $2.53 billion, an increase of $347.1 million (15.9%) from the year-end 1992 loan balance. This increase was due to the purchase of $435.9 million in residential mortgage loans during 1993, which was part of an overall asset/liability strategy to shift certain shorter-term assets to longer-term maturities. Substantially all of these loans were recently originated, fixed- rate residential mortgages with original maturities of 15 or 30 years, have an average bond equivalent yield of 6.47% and are secured by properties located in various regions throughout the United States. The purchases combined with local area originations in 1993 were partially offset by loan curtailments and payoffs, particularly with respect to residential mortgage loans, as the result of the high level of mortgage loans refinanced during 1993 and, to a lesser extent, transfers of loans to other real estate owned. Domestic commercial and financial loans were $412.0 million at December 31, 1993, an increase of $42.1 million, or 11.4%, when compared with $369.9 million at December 31, 1992. This increase was attributable to new commercial loan originations in the fourth quarter of 1993. Domestic real estate commercial/construction loans were $388.4 million at December 31, 1993, a decrease of $145.2 million from year-end 1992. This decrease was the result of loan curtailments and payoffs, transfers to other real estate owned and limited new lending by the Corporation in this sector. Domestic real estate commercial/construction loans were 15.4% of total loans and 8.1% of total assets at year-end 1993, compared with 24.4% and 10.5%, respectively, for year-end 1992. Permanent domestic mortgage loans, which are primarily to finance owner-occupied commercial buildings, represented one-third of real estate commercial/construction loans. The remainder of the portfolio comprised residential and commercial development properties, including office buildings, warehouses, shopping centers and hotels. The domestic real estate-commercial/construction portfolio is secured by properties concentrated in the Washington, D.C., metropolitan area. Residential mortgage loans totaled $1.15 billion at December 31, 1993, an increase of $620.0 million (117.1%) from the year-earlier level. This increase is the result of the local area originations and purchases in the open market during 1993. The purchase and origination activity during 1993 was partially offset by high levels of principal curtailments and payoffs, the result of increased mortgage loan refinance activity as consumers took advantage of the lowest mortgage loan interest rate environment since the late 1960s. Residential mortgage loans represented 45.6% of the Corporation's loan portfolio at year-end 1993 and generally provide for a higher credit quality than other loans. The historically lower charge-off levels over the last five years attest to the quality of this portfolio ( see the "Reserve for Loan Losses and Summary of Charge-offs and Recoveries" section). Home equity loans, which are primarily floating-rate loans secured by first or second trusts on single-family residential properties, decreased $39.5 million to $234.1 million at December 31, 1993. This decrease was caused largely by refinancing resulting from the lower interest-rate environment. Consumer loans were $82.8 million at year-end 1993, decreasing $24.6 million from $107.4 million at December 31, 1992, as a result of limited originations of installment loans and student loans in the domestic markets. Foreign loans totaled $255.4 million at December 31, 1993, a decrease of $116.1 million from the year-end 1992 total of $371.5 million. Foreign loans in the Corporation's London operations were $199.8 million at December 31, 1993, and constituted 78.2% of the Corporation's total foreign loans. Approximately 59.7% of the decline in the foreign loan portfolio was due to repayments, with 4.0% due to exchange rate fluctuation, 9.3% related to transfers to other real estate owned and 27.0% due to charge-offs during the year. Riggs AP Bank's lending activities have been significantly reduced because of the weak economic conditions in the United Kingdom and the previously discussed financial restructuring. At December 31, 1993, 72.0% of the Riggs AP Bank's loan portfolio was secured by commercial-leased properties, with the remainder in corporate loans. Year-End Loans Year-End Maturities and Rate Sensitivity ------------------------------------------------------- Real Estate-Commercial/Construction Geographic Distribution by Type December 31, 1993 ------------------------------------------------------- LOANS TO LESSER DEVELOPED COUNTRIES The Corporation's exposure to lesser developed countries ("LDC") was $16 million at December 31, 1993, down $5 million from the $21 million of LDC exposure reported at year-end 1992. This exposure includes all short, medium and long-term outstandings less amounts previously charged-off. The Corporation provides reserves for LDC exposure based upon its assessment of the private sector and sovereign risk inherent in the portfolio. Foreign reserves available to absorb future losses related to the Corporation's LDC exposures were $364 thousand at December 31, 1993 or approximately 2% of such exposures. This compares to reserves at December 31, 1992 of $4 million or approximately 17% of such exposure. The ratio of reserves to LDC exposure reflects management's conclusion that a lower overall level of reserves for LDC exposure was adequate based on an assessment of individual country economic reports, status of debt negotiations, sovereign refinancing plans, changes in the composition of the portfolio, transfer risk reserve considerations, and to a lesser extent, secondary market quotes for third world debt obligations. In the opinion of management, the reserve for LDC exposure was adequate at December 31, 1993. CROSS-BORDER OUTSTANDINGS The Corporation extends credit to borrowers domiciled outside of the United States. These assets may be impacted by changing economic conditions in their respective countries. Management routinely reviews these credits and continuously monitors the international economic climate and assesses the impact of these changes on its current and proposed foreign-domiciled borrowers. Cross-border outstandings include loans, acceptances, interest-bearing deposits with other banks, investments, accrued interest and other monetary assets, which are denominated in dollars or other non-local currencies. In addition, cross-border outstandings include legally enforceable guarantees issued on behalf of non-local third parties and local currency outstandings to the extent they are not funded by local currency borrowings. Cross-border outstandings are then reduced by tangible liquid collateral and any legally enforceable guarantees issued by non-local third parties on behalf of the respective country. At December 31, 1993, the Corporation had no cross-border outstandings exceeding 1% of its total assets to countries experiencing difficulties in repaying their external debt. At December 31, 1993, the United Kingdom was the only country with cross- border outstandings in excess of 1% of the Corporation's total assets which had loans in either a nonperforming or past due status. Nonaccrual loans in the United Kingdom totaled $37.7 million at December 31, 1993 as compared to $27.7 million at December 31, 1992. In light of current economic conditions in the United Kingdom, it is possible that nonperforming assets in the United Kingdom will be higher at year-end 1994. There were $4 thousand in past due loans in the United Kingdom at December 31, 1993 and no past due loans at year-end 1992. At December 31, 1993, the Corporation had identified approximately $8.9 million in potential problem loans in the United Kingdom. These loans, which are primarily commercial property and corporate loans, were performing at December 31 and therefore not included as nonaccrual or past due at December 31. Cross-Border Outstandings which Exceed 1% of Total Assets Cross-Border Outstandings in Excess of 1% of Total Assets with Nonperforming or Past Due Loans Cross-Border Outstandings .75% and 1% of Total Assets ASSET QUALITY Nonperforming Asset Summary Nonperforming assets, which include nonaccrual loans, renegotiated loans, and other real estate owned (net of reserves), totaled $213.3 million at year-end 1993, a $93.3 million (30.4%) decrease from the year-end 1992 total of $306.6 million. This significant decrease in nonperforming assets during 1993 was attributable to sales of $140.0 million, net charge-offs/writedowns of $90.5 million, combined with exchange rate fluctuations and other reductions of $3.4 million that were partially offset by net additions in 1993 of $140.6 million. Nonaccrual, Renegotiated and Past Due Loans At December 31, 1993, nonaccrual loans, including both domestic and foreign loans, were $130.2 million, or 5.15% of total loans, compared with $205.4 million, or 9.42% of total loans, at December 31, 1992. Loans (other than consumer) are placed on nonaccrual status when, in management's opinion, there is doubt as to the ability to collect either interest or principal, or when interest or principal is 90 days or more past due and the loan is not well- secured and in the process of collection. Consumer loans are generally charged off when they become 120 days past due. The decrease in nonaccrual loans during 1993 was due primarily to a decrease in domestic nonaccrual loans from $152.8 million at year-end 1992 to $85.1 million at year-end 1993. This decrease was attributable to sales, repayments and other reductions of $77.1 million, charge- offs/writedowns of $39.8 million and transfers of nonaccrual loans to other real estate owned of $26.7 million. These decreases more than offset net additions to nonaccrual loans of $75.9 million during the period. Nonaccrual foreign loans decreased $7.5 million during 1993, to $45.1 million at December 31, 1993. Of the $45.1 million of foreign nonaccrual loans at December 31, 1993, $38.9 million were attributable to nonaccrual real estate- commercial mortgage loans in the United Kingdom. This decrease was the result of sales, repayments, transfers to other real estate owned, writedowns/charge- offs and other reductions of $68.2 million, exceeding net additions of $60.7 million during 1993. With 86.4% of foreign nonaccrual loans residing in the United Kingdom, the foreign nonaccrual loan portfolio continues to be adversely affected by the United Kingdom economy. Renegotiated loans totaled $30.3 million at December 31, 1993, compared with $11.8 million at year-end 1992. The domestic renegotiated loans ($29.5 million) generally consisted of commercial real estate loans that were renegotiated to provide a reduction or deferral of interest or principal as a result of a deterioration in the financial position of the borrower. Past due loans consist predominantly of residential real estate and consumer loans that are well-secured and in the process of collection and, on which the Corporation is accruing interest. Past due loans increased $1.9 million in 1993, to $3.3 million. At December 31, 1993, the Corporation had identified approximately $14.3 million in potential problem loans that are currently performing but that management believes have certain attributes that may lead to nonaccrual or past due status in the foreseeable future. These loans consisted of $2.7 million in domestic loans (principally real estate-commercial loans) and $11.6 million of commercial property and corporate loans originated in the United Kingdom. INTEREST INCOME ON NONACCRUAL AND RENEGOTIATED LOANS Nonperforming Assets and Past Due Loans /1/ Loans (other than consumer) that are in default in either principal or interest for 90 days or more that are not well-secured and in the process of collection. /2/ Loans for which terms are being renegotiated to provide a reduction of interest or principal as a result of a deterioration in the financial position of the borrower in accordance with Statement of Financial Accounting Standards No. 15. /3/ Loans contractually past due 90 days or more in principal or interest that are well-secured and in the process of collection. ------------------------------------------------- Nonaccrual and Renegotiated Real Estate-Commercial/Construction Loans - Geographic Distribution by Type as of December 31, 1993 Implementation of Interagency Guidance on Reporting of In-Substance Foreclosures At December 31, 1993, the Corporation implemented the narrower definition of In- Substance Foreclosure required by the March 10, 1993, Interagency Policy Statement on Credit Availability and the June 10, 1993, Interagency Guidance on Reporting of In-Substance Foreclosures. Under previous financial accounting guidelines, a nonaccrual loan was transferred from loans to other real estate owned when foreclosure was probable or the loan was considered in-substance foreclosed, which by definition in the Securities and Exchange Commission's Financial Reporting Release No. 28 meant that the borrower had little or no equity in the property, proceeds for repayment of the loan could be expected to come only from the operation or sale of the collateral, and the debtor had either abandoned control of the collateral or it was doubtful that the debtor would be able to rebuild equity in the collateral or otherwise repay the loan in the foreseeable future. Loans considered in-substance foreclosed must be recorded at the lower of cost or fair value. Under the revised regulatory accounting guidelines, a loan is recognized as an in-substance foreclosure when the Corporation has possession of the underlying collateral. This change in treatment impacts only the classification of accounts in the financial statements and does not result in a change in the accounting policy related to the determination of the assets' carrying value. The impact of this change in definition of in-substance foreclosures on certain categories in the Corporation's financial statements for the indicated periods is presented in the following table. The Consolidated Statements of Condition, Income and Cash Flows and the Notes to Consolidated Financial Statements, as well as the disclosures within this report, reflect these reclassifications. Adjustments to Implement New Definition of In-Substance Foreclosures Provision and Reserve For Loan Losses The provision for loan losses totaled $69.3 million for 1993, compared with a provision of $52.1 million for the prior year. Approximately $29.7 million of the provision for 1993 related to loans originated in the United Kingdom, with the remainder relating to primarily domestic real estate commercial loans. The United Kingdom provisions reflect the continued deterioration throughout much of 1993 of economic conditions in the United Kingdom. The Corporation's banking subsidiaries maintain reserves for loan losses that are available to absorb potential losses in the current loan portfolio. The reserve for loan losses is increased by loan loss provisions and recoveries of previously charged-off loans and is reduced by loan charge-offs. The Corporation's reserve for loan losses is based on management's assessment of existing conditions and reflects potential losses determined to be probable and subject to reasonable estimation. The Corporation determines the appropriate balance of the reserve for loan losses based upon an analysis of risk factors affecting the entire loan portfolio and specific reviews of individual loans. The analysis includes the primary source of repayment on individual loans and groups of similar loans, the liquidity and financial condition of the borrowers and guarantors, historical charge-offs/writedowns within loan categories and the general economic conditions and other factors existing at the determination date. On a quarterly basis, the Loan Loss Reserve Committee evaluates the adequacy of the reserve for loan losses. The Audit Committee of the Board of Directors reviews management's determination of the adequacy of the reserve for loan losses. The loan portfolios are continually monitored by management to identify loans requiring particular attention. Net charge-offs for 1993 totaled $66.4 million, down slightly from 1992's $68.4 million. Total net charge-offs for 1993 include domestic commercial real estate loan net charge-offs of $34.5 million (51.9%) and $26.7 million (40.2%) from foreign loans. Total domestic commercial real estate and foreign net charge-off totals compare with $28.4 million (41.5%) and $35.3 million (51.6%), respectively, for 1992. These totals reflect the continued deterioration of domestic and foreign commercial real estate portfolios during the past two years (see the "Nonaccrual, Renegotiated and Past Due Loans" section). The reserve for loan losses was $86.5 million, or 3.42% of total loans, at December 31, 1993, compared with $84.2 million, or 3.86% of total loans, at December 31, 1992. The Corporation's coverage ratio was 53.9% at year-end 1993 and 38.7% at year-end 1992. The coverage ratio is derived by dividing the reserve for loan losses by the sum of nonaccrual and renegotiated loans. Several factors should be considered when reviewing the Corporation's coverage ratio, such as: 54.9% of the Corporation's loan portfolio consisted of residential mortgage and home equity loans at December 31, 1993. These loans generally require minimal reserves based upon their favorable historical loss experience. Further, the Corporation has no credit card loans in its portfolio, which normally carry high levels of reserves and charge-off activity. Finally, the coverage ratio does not account for the existence of collateral on nonaccrual and renegotiated loans, which limits the risk of principal loss on these assets. At December 31, 1993, 78.3% of the Corporation's nonaccrual and renegotiated loans were partially or fully secured by real estate, and 56.2% were contractually current based on their respective loan agreements. Reserve for Loan Losses and Summary of Charge-Offs and Recoveries Allocation of the Reserve for Loan Losses Distribution of Year-End Loans Other Real Estate Owned, Net Other real estate owned declined to $52.8 million at December 31, 1993, from $89.4 million at December 31, 1992. The reduction resulted from sales and repayments of $52.2 million and $18.6 million in charge-offs/writedowns, offset by net additions of $34.2 million, during the period. Loans are transferred to other real estate owned when acquired or deemed to be acquired through foreclosure. At December 31, 1993, residential and commercial land composed 68.1% of other real estate owned with office, industrial, retail, and other types of properties accounting for 31.9%. Approximately 85% of the other real estate owned properties were located in the Washington, D. C., metropolitan area at year-end 1993, with the remainder located in the United Kingdom. Loans are transferred to other real estate owned at the lower of cost or fair value at the date of foreclosure or possession. Other real estate owned is recorded at the lower of cost or fair value less selling expenses. Any related charge-offs at acquisition of other real estate owned are charged to the reserve for loan losses. Subsequent charge-offs and selling expenses are charged to operations in the period they become known. Other Real Estate Owned - Geographic Distribution by Type December 31, 1993 (In thousands) DEPOSITS Total deposits at December 31, 1993, were $3.77 billion, as compared with $4.44 billion at year-end 1992, a decrease of $663.8 million, or 15.0%. Foreign deposits decreased $350.7 million, to $262.7 million, as a result of the Corporation's decision to phase out the deposit gathering business within its London operations. Average domestic deposits were $3.74 billion for 1993, down from $3.91 billion in 1992. The reductions in year-end and average domestic deposits were due to reductions in demand for certificates of deposit and other deposit products, the result of the continued lower interest-rate environment. Average core deposits (total deposits in domestic offices, excluding negotiable certificates of deposit) were $3.72 billion, down $175.5 million, or 4.5%, from 1992's $3.89 billion. SHORT-TERM BORROWINGS Average short-term borrowings, comprising federal funds purchased and repurchase agreements, U.S. Treasury demand notes and other borrowed funds, totaled $232.6 million during 1993, an increase of $105.1 million from 1992's average balance. The overall increase in short-term borrowings was attributable to the Corporation's replacing a portion of the decrease in total deposits during the year with short-term borrowings. Short-term borrowings are discussed more fully in Note 9 of "Notes to the Consolidated Financial Statements." Average Deposits and Short-Term Borrowings * The majority of interest-bearing deposits in foreign offices are denominated in amounts of $100 thousand or more. LONG-TERM DEBT Long-term debt totaled $213.3 million at December 31, 1993, unchanged from its balance at December 31, 1992. Long-term debt includes two series of floating- rate subordinated notes maturing in 1996, which totaled $146.8 million at year- end 1993. These subordinated notes had an aggregate weighted-average interest rate of 5.25% at December 31, 1993. Long-term debt also includes subordinated debentures due in 2009, bearing a fixed rate of interest of 9.65% per annum. The Corporation's long-term debt is discussed more fully in Note 9 of "Notes to the Consolidated Financial Statements." On February 2, 1994, the Corporation issued and sold $125 million of 8.5% Subordinated Notes, due February 1, 2006. The notes were priced at par and are not callable for five years. The notes were sold under a shelf registration statement declared effective on January 13, 1994. The Corporation intends to use the net proceeds from the offering, approximately $120.7 million, to redeem equal amounts of the subordinated notes due in 1996. The proceeds were placed in short-term investments prior to the redemption of the floating-rate notes. ----------------------------------------- CAPITAL RESOURCES Under the Federal Reserve Board's risk-based capital guidelines, bank holding companies are required to meet a minimum ratio of qualifying total capital (combined Tier I and Tier II) to risk-weighted assets of 8.00%, at least half of which must be composed of core (Tier I) capital elements. The Corporation's total and core capital ratios were 16.81% and 10.76%, respectively, at December 31, 1993. The Federal Reserve Board has established an additional capital adequacy guideline referred to as the leverage ratio, which measures the ratio of Tier I capital to average quarterly assets. The most highly rated bank holding companies that are not contemplating or experiencing significant growth are required to maintain a minimum leverage ratio of 3.00%. However, most bank holding companies, including the Corporation, are expected to maintain an additional cushion of at least 100 to 200 basis points above the 3.00% minimum. The actual required ratio for individual bank holding companies is based on the Federal Reserve Board's assessment of a corporation's asset quality, earnings performance, interest-rate risk and liquidity. The Federal Reserve Board has not advised the Corporation of a specific minimum leverage ratio requirement. The Corporation's leverage ratio was 6.03% at December 31, 1993. The Corporation's policy is to ensure that its bank subsidiaries are capitalized in accordance with regulatory guidelines. The three national bank subsidiaries of the Corporation are subject to minimum capital ratios prescribed by the OCC, which are the same as those for the Federal Reserve Board. Pursuant to the Written Agreement, Riggs-Washington has committed to the OCC to maintain a leverage ratio of 5.00%, a Tier I to risk-weighted assets ratio of 6.00% and a total capital to risk-weighted assets ratio of 10.00%. Riggs-Washington's ratios were 6.13%, 10.69% and 11.97%, respectively, at December 31, 1993. The following table summarizes the actual and required capital ratios for the Corporation and each of its banking subsidiaries. CAPITAL RATIOS * Most bank holding companies and national banks, including the Corporation and the Corporation's national bank subsidiaries, are expected to maintain an add- itional cushion of at least 100 to 200 basis points above the 3.00% minimum. ---------------------------------------------------------- INTEREST-RATE RISK MANAGEMENT The Corporation manages its risk related to movements in interest rates through the use of simulation and gap analysis. Interest-rate risk arises from the potential mismatch in the repricing of assets and liabilities within a given period. Gap analysis presents a period-end analysis of repricing assets as compared with repricing liabilities, while simulation analysis incorporates the Corporation's current gap position in addition to future forecasted changes to the Corporation's portfolios and compositions, as well as anticipated interest- rate spreads under varying interest-rate scenarios. Gap analysis provides a general indicator of the potential effect that changing interest rates and repricing trends may have on the Corporation's net interest income. Thus, the Corporation utilizes simulation, gap analysis and other techniques to manage the sensitivity of net interest income to potential changes in interest rates in order to maximize the Corporation's net interest income while maintaining acceptable levels of risk. Gap analysis is performed using contractual maturities, repricing frequency and management judgment for items with no stated maturity or for items with expected lives significantly different from their contractual maturity. The two most significant assumptions made by the Corporation in the gap analysis relate to securities available for sale and core deposits. Securities available for sale are considered interest-sensitive due to management's ability to sell them in response to changes in interest rates and the Corporation's intent to manage interest-rate risk. Core deposits (savings and NOW accounts) that have no stated maturity are distributed based on the Corporation's historical experience and independent studies regarding retention of such deposits. At December 31, 1993, the Corporation had earning assets subject to repricing in less than one year in excess of its interest-bearing liabilities subject to repricing within the same period. This asset-sensitive position was $201.4 million, or 4.21% of total assets, as compared with an asset-sensitive position of $195.3 million, or 3.80% of assets, at December 31, 1992. Based on the Corporation's asset-sensitive position at December 31, 1993, downward movements in interest rates would tend to moderately decrease net interest income, while upward movements would tend to moderately increase net interest income. YEAR-END RATE SENSITIVITY /1/ Securities available for sale are presented in maturity categories that differ from their respective contractual maturities. Securities available for sale are considered interest-sensitive due to management's ability to sell them in response to changes in interest rates and the Corporation's intent to manage interest rate risk. /2/ Differences between the presentation of securities held-to-maturity based upon rate sensitivity and presentation based upon contractual maturity exist as a result of $3.0 million of floating rate securities of Riggs AP Bank. /3/ Differences between the presentation of loans based upon rate sensitivity and presentation based upon contractual maturity exist as a result of certain floating rate loans. /4/ Savings and NOW accounts have been adjusted for rate sensitivity purposes based upon the Corporation's historical experience and an independent study regarding deposit retention over a representative period covering January through March 1990. It is assumed that historical deposit longevity patterns are predictive of existing accounts. Although such accounts are subject to immediate withdrawal, the Corporation's experience indicates that they provide a stable source of funds. NET INTEREST INCOME Net interest income on a tax-equivalent basis (net interest income plus an amount equal to the tax savings on tax-exempt interest) totaled $139.5 million for 1993, down $4.9 million, or 3.4%, from the $144.4 million earned in 1992. The positive impact on earnings of a $309.1 million decline in average interest- bearing liabilities during 1993 with the added benefit of a 139-average-basis- point reduction in the interest rate incurred for the year, was partially offset by a $299.2 million decrease in average earning assets and a 117-average-basis- point reduction in the rate earned for 1993. Loans were 50.5% of average earning assets during 1993, compared with 55.6% for 1992. The net interest margin (net interest income on a tax-equivalent basis divided by average earning assets) was 3.23% during 1993, an increase of 10 basis points from the 3.13% net interest margin for 1992, because of the aforementioned changes in earning assets and interest-bearing liabilities. Net interest spread (the difference between the average tax-equivalent rate earned and the average rate incurred on interest-bearing liabilities) for 1993 was 2.88%, a 22-basis-point improvement from 1992's spread of 2.66%. Interest lost on nonaccrual loans totaled $12.6 million for 1993, which had the effect of reducing the net interest margin by approximately 29 basis points for 1993. In 1992, interest lost totaled $13.3 million and had the effect of reducing the net interest margin in that year by approximately 28 basis points. The Corporation established the goal in 1993 of increasing its loan-to-deposit ratio above 70% in 1994. The Corporation moved toward this goal in the latter part of 1993 by purchasing in the open market $435.9 million of residential mortgages. Subsequent to year-end, the Corporation purchased an additional $90 million of mortgage loans. The Corporation's loan-to-deposit ratio stood at 67.0% at December 31, 1993. The Corporation believes this strategy will have a significant positive impact on net interest income. Net Interest Income Changes* * The dollar amount of changes in interest income and interest expense attributable to changes in rate/volume (change in rate multiplied by change in volume) has been allocated between rate and volume variances based on the percentage relationship of such variances to each other. Income and rates are computed as a tax-equivalent basis using a Federal income tax rate of 34% and local tax rates as appliable. THREE-YEAR AVERAGE CONSOLIDATED STATEMENTS OF CONDITION AND RATES* * Income and rates are computed on a tax-equivalent basis using a Federal income tax rate of 34% and local tax rates as applicable. Loan amounts include nonaccrual and renegotiated loans. Average foreign assets, excluding net pool funds provided, details of which can be found on page 68 of this report, were 14.6%, 21.5% and 23.4% of average total assets for the periods presented, respectively. Average foreign liabilities were 18.1%, 23.9% and 29.8% of average total liabilities for the periods presented, respectively. NONINTEREST INCOME Noninterest income for 1993 was $112.7 million, down $17.8 million, or 13.6%, from 1992. Excluding securities gains of $24.1 million and $34.2 million for 1993 and 1992, respectively, and $5.9 million of nonrecurring interest income related to a tax receivable recognized in 1992, noninterest income decreased $1.8 million, or 2.0%. Trust income of $28.9 million was up $1.3 million, or 4.8%, as increases in fees on trust and investment services more than offset decreases in corporate custodial accounts. Decreases in corporate custodial accounts should not have a material impact on future trust income as they provided marginal profitability. Total assets under management by the Financial Services Group at December 31, 1993, were approximately $4.3 billion, down slightly from $4.4 billion at year-end 1992. The market value of trust and custodial assets of the Corporation's Financial Services Group decreased $10.6 billion, or 55.8%, to $8.4 billion at December 31, 1993, due to the Corporation's exit from the corporate custodial business. Service charges for 1993 of $39.3 million increased $.9 million, or 2.4%, primarily because of an increase in advisory fee income. Foreign exchange income decreased $2.2 million or 43.9% in 1993, primarily due to the previously discussed restructuring of Riggs AP Bank and the exiting of foreign exchange trading-related activities. Other noninterest income of $8.1 million was down $1.8 million as letter-of- credit fees decreased $1.1 million during 1993. Noninterest Income ----------------------------------------------- NONINTEREST EXPENSE Noninterest expense for the year ended December 31, 1993, was $266.8 million, compared with $238.4 million for 1992. Noninterest expense for 1993 included restructuring expense of $34.6 million, of which $20.8 million related to Riggs AP Bank. The Riggs AP Bank charge consisted of $1.6 million in severance- related expenses, $11.5 million from the write-off of a foreign currency translation account associated with Riggs-Washington's investment in Riggs AP Bank, and $7.7 million of other restructuring expense. The $20.8 million of restructuring expense related to Riggs AP Bank included $14.2 million of noncash expenses, which included the aforementioned $11.5 million write-off of the foreign currency translation account, the write-off of $2.2 million of fixed assets and a $.5 million write-off of goodwill. The remaining $6.6 million was accrued to offset expenses related to severance and excess space and equipment leases that will be charged against the accrual when paid. Also included in the $34.6 million in restructuring expense was $13.8 million in expenses related to the implementation of BankStart '93. The restructuring expenses related to BankStart '93 consisted of $7.0 million in consulting fees, $4.0 million in severance-related costs, $1.0 million in occupancy-related costs and $1.8 million in other costs. Implementation of BankStart '93 began in April 1993 and is expected to continue through mid-1994. During 1993, $9.2 million of the accrued expenses were paid, with the remainder expected to be paid in 1994. The estimate of the implementation costs is evaluated by management on an ongoing basis and, as adjustments become known, may be revised accordingly. Other real estate owned expense, net of revenues, was $13.5 million, down 13.9% from $15.7 million incurred in 1992. For the first half of 1992, writedowns and disposition-related losses and expenses from the Corporation's asset-disposition program totaling $35.2 million were charged to the program- related reserves rather than other real estate owned expense. Had these amounts been charged to noninterest expense, other real estate owned expense for 1993 would have decreased $37.4 million from the adjusted 1992 level. This decrease is attributed to the overall decrease in other real estate owned, which totaled $89.4 million at December 31, 1992, and decreased $36.6 million (40.9%) during 1993. Excluding restructuring and other real estate owned expense, noninterest expense for 1993 was down $4.0 million, or 1.8%, from the total of $222.7 million for 1992. Salaries and related benefits were $88.0 million for 1993, a decrease of $1.3 million, as a reduction in salaries and wages was offset by an increase in medical and life insurance premiums, pension expenses and relocation expenses. Net occupancy expense of $25.8 million was down $2.6 million, or 9.1%, due to decreases in rent expense of $1.2 million, real estate taxes of $916 thousand and repairs of $815 thousand. Furniture and equipment expense of $11.2 million decreased $1.6 million, or 12.8%, due to decreases in depreciation and rental expense of $1.2 million. FDIC insurance expense of $10.3 million increased $1.5 million in 1993 as an increase in the assessment rate more than offset a reduction in the deposit base during the period. Data processing expense of $16.6 million was down $1.1 million for the year, attributable to savings obtained from outsourcing agreements implemented in 1992 and 1991. Other noninterest expense totaled $56.9 million, up $2.3 million, or 4.2%, from the $54.5 million for 1992. Accounting for the increase was $3.6 million of write-offs related to mortgage indemnity insurance claims on other real estate owned in the United Kingdom. NONINTEREST EXPENSE ------------------------------------------------ INCOME TAXES The Corporation's provision for income taxes includes both federal and state income taxes. The rise in the provision for income taxes to $5.6 million for 1993 from the benefit of $1.1 million for 1992 is primarily attributable to the Corporation's inability to utilize the tax benefits of the provision for loan losses and other real estate owned. The provision for income taxes for 1993 is more than the amount determined by application of the Federal statutory income tax rate principally because of tax preference items and the Corporation's inability to carryback the full potential of the net operating losses. The Corporation adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS No. 109"), required for fiscal years beginning after December 15, 1992, which requires the Corporation to implement new accounting and disclosure rules for income taxes. The adoption of SFAS No. 109 did not result in a cumulative adjustment since it was not apparent at implementation of SFAS No. 109 that future income or the establishment of certain tax planning strategies would be sufficient to realize deferred tax assets in future periods in excess of the Corporation's carryback potential. Further tax discussion and a reconciliation of the effective tax rate to the 1993 federal statutory rate of 34% can be found in Note 14 of "Notes to Consolidated Financial Statements." FOURTH QUARTER 1993 VS. FOURTH QUARTER 1992 For the fourth quarter of 1993, the Corporation reported net income of $3.1 million, or $.09 per share, compared with a net loss of $24.1 million, or $.97 per share, for the fourth quarter of 1992. Results for the fourth quarter of 1993 reflected provisions for loan losses of $2.1 million, which were significantly lower than the $27.3 million recognized in the fourth quarter of 1992. The decrease in provisions for loan losses is indicative of the continued improvement in asset quality. Nonperforming assets totaled $213.3 million at December 31, 1993, a decrease of $60.3 million for the fourth quarter of 1993 and a decrease of $93.3 million from $306.6 million at December 31, 1992. The 1992 provision included additional reserves for loans to domestic residential real estate developers and foreign corporate and property loans. The larger provisions a year earlier reflected overall declines in collateral values and deteriorating borrower liquidity, combined with weak economic conditions in the foreign and domestic commercial/construction markets. Net interest income on a tax-equivalent basis for the fourth quarter of 1993 was $36.1 million, an increase of $2.6 million, or 7.61%, year to year, reflecting the positive impact of the October 1993 equity sale, combined with an approximate $60 million decrease in average nonperforming assets between the periods. The net interest margin was 3.43% during the fourth quarter of 1993, up 46 basis points from the fourth quarter of 1992. Interest lost on nonaccrual loans had the effect of reducing the net interest margin by approximately 16 basis points during the fourth quarter of 1993. The net interest spread was 3.00% for the quarter ended December 31, 1993, up 43 basis points from the same period in the prior year. Net recoveries in the fourth quarter of 1993 totaled $1.5 million, an improvement of $17.5 million when compared with $16.0 million in net charge-offs for the fourth quarter of 1992. Charge-offs in the fourth quarter of 1993 totaled $9.1 million and were more than offset by $10.6 million in recoveries during the period. The 1992 charge-offs were primarily related to domestic real estate loans, principally residential developments, as sluggish residential sales activity created liquidity problems for some borrowers. Noninterest income for the fourth quarter of 1993 was $21.2 million, a decrease of $6.3 million, or 22.7%, when compared with the same period in 1992. Trust income of $7.2 million was up $409 thousand as an increase in trust and investment service fees more than offsetting a decline in corporate custodial account fees. Service charges of $11.5 million were down $638 thousand due to the decline in the volume of deposit-related services during the period. Investment advisory fees were down $361 thousand. Partially offsetting these decreases was an increase in securities gains of $801 thousand. Other noninterest income of $2.3 million for the fourth quarter of 1993 declined $6.8 million due to the recognition in 1992 of nonrecurring interest income totaling $5.9 million from an outstanding tax receivable. Noninterest expense for the fourth quarter of 1993 totaled $51.1 million, compared with $57.4 million a year earlier, an improvement of $6.2 million, or 10.9%. Salaries and related benefits of $20.7 million were down $2.0 million as a result of reduced staff levels. Net occupancy expense was down $885 thousand, to $5.8 million, in the fourth quarter of 1993 because of decreases in property rent expense, utilities and repairs. Furniture and equipment expense decreased $695 thousand due to reductions in depreciation, maintenance and repairs, and equipment rentals. Legal expenses totaled $849 thousand in the fourth quarter of 1993, down $1.0 million from the prior year's period. Other real estate owned expense, net of revenues, was $1.3 million, an increase of $1.2 million when compared with 1992's fourth quarter other real estate owned expense. Other noninterest expense totaled $12.0 million for the fourth quarter of 1993, a decrease of $3.0 million, as a result of decreases in consulting fees and interest cost on hedge transactions. 1992 VS. 1991 The Corporation reported a net loss of $21.1 million, or $.87 per share, for 1992, compared with a net loss of $63.5 million, or $4.61 per share, for 1991. The 1992 results included provisions for loan losses of $52.1 million, other real estate owned expenses of $15.7 million, securities gains of $34.2 million and the recognition of $5.9 million of nonrecurring interest income related to a tax receivable. The 1991 results included provisions for loan losses of $43.7 million, other real estate owned expenses of $14.2 million, provisions for accelerated dispositions of $49.8 million, securities gains of $13.7 million and an extraordinary gain of $2.5 million (net of applicable income tax) related to the repurchase of subordinated debt at a discount. During the third quarter of 1991, the Corporation initiated a strategy to accelerate the disposition of its domestic problem commercial real estate assets, including both loans and other real estate owned. At the inception, the Corporation took a charge to earnings of $49.8 million and segregated $191.0 million of program assets. During the program, which ended in June 1992, these assets were reduced by $146.3 million through sales, the return of a loan to performing status and writedowns. The remaining $44.3 million of program assets were transferred to loans and other real estate owned at fair value at the end of the second quarter of 1992. Average earning assets during 1992 decreased $746.5 million, or 13.9%, to $4.62 billion. This decline reflected both weak loan demand due to unfavorable economic conditions and management's desire to improve asset quality and further reduce the size of the Corporation to enhance capital ratios. During 1992, the loan portfolio declined primarily due to loan payments. Average loans were $2.57 billion during 1992, down $854.4 million, or 25.0%, from the average for 1991. Money market assets, which consist of time deposits with other banks and federal funds sold and resale agreements, ended 1992 at $1.26 billion, up slightly from the $1.14 billion a year earlier. These assets averaged $1.12 billion and $1.13 billion, respectively, for 1992 and 1991 and reflect the Corporation's commitment to maintaining adequate liquidity. At December 31, 1991, the Corporation had total securities held for sale of $101.2 million, which included only U. S. Treasury securities with a weighted- average yield of 7.67% and an average maturity of approximately four years at year-end 1991. This portfolio was established at year-end 1991 in view of the possible sale of these securities for liquidity purposes. During the first quarter of 1992, these securities were sold, resulting in a pre-tax gain of $4.2 million, with the proceeds from the sale being reinvested in mortgage-backed securities. Investment securities at year-end 1992 totaled $795.4 million, up $311.7 million, or 64.4%, from year-end 1991. The increase was the result of the reinvestment of a portion of the proceeds from loan curtailments, payoffs, and the sale of problem assets in 1992. U. S. Treasury securities were $579.6 million at year-end 1992, an increase of $222.9 million during the year. The weighted-average yield on these securities was 5.93% at year-end 1992, with an average maturity of approximately two years, compared with a weighted-average yield of 6.40% and an average maturity of two and one-half years for year-end 1991. Mortgage-backed securities were $173.8 million at year-end 1992, compared with $51.0 million at year-end 1991. The weighted-average yields were 6.12% and 8.31% at year-end 1992 and 1991, respectively, with average maturities of approximately seven years and 22 years, respectively. Other investment securities were $40.0 million at year-end 1992, a decrease of $33.9 million. This decrease was due to a transfer of $16 million of United Kingdom government securities to the held for sale category in addition to the sale of $13 million of other United Kingdom securities. Total loans at December 31, 1992, were $2.19 billion, down from the $3.02 billion reported at the previous year-end. The decrease in loans was the result of loan repayments, limited opportunities for quality loan growth, transfer of loans to other real estate owned, charge-offs, exchange rate fluctuations and management's desire to reduce the total assets of the Corporation during the period. During 1992, commercial and financial loans were down $162.3 million (30.5%), due primarily to loan curtailments. Domestic real estate- commercial/construction loans were $533.7 million, a decrease of $85.6 million (13.8%), when compared with year-end 1991, because of transfers to other real estate owned, charge-offs and curtailments/payoffs. Residential mortgage loans totaled $529.4 million, a decline of $196.0 million (27.0%), due to the high volume of prepayment/refinance activity during the declining interest-rate environment in 1992. Foreign loans decreased $289.7 million for 1992, to $371.5 million at year-end. This significant decrease included repayments (39%), exchange-rate fluctuations (26%), transfers to other real estate owned (24%) and charge-offs (11%) during the year. Home equity and consumer loans decreased $100.0 million from 1991, impacted by the high level of prepayments/refinance activity discussed above. Nonperforming assets at December 31, 1992, were $306.6 million, compared with $331.1 million at December 31, 1991. Nonaccrual loans decreased by $24.5 million and real estate assets subject to accelerated disposition decreased by $89.4 million, but were partially offset by the increase in renegotiated loans ($11.8 million) and other real estate owned ($77.6 million), as problem commercial real estate credits continued to work their way through the nonperforming asset categories. The previously mentioned accelerated disposition program was completed in the second quarter of 1992 and accounted for approximately one-half of the increase in other real estate owned. In addition to the assets discussed above, the Corporation identified $41.6 million of potential problem credits at December 31, 1992, that were performing and not reported as either nonperforming or past due. Provisions for loan losses totaled $52.1 million for 1992, as compared with provisions of $43.7 million for 1991. Net charge-offs were $68.4 million, or 2.66% of average loans, during 1992 compared with $48.9 million, or 1.43% of average loans, during 1991. The reserve for loan losses was $84.2 million, or 3.86% of loans, at December 31, 1992, compared with $103.7 million, or 3.45% of loans at December 31, 1991. The ratio of loan loss reserves to nonaccrual loans was 41.0% at December 31, 1992, compared with 45.1% a year earlier. At December 31, 1992, total deposits were $4.44 billion, compared with $4.91 billion at December 31, 1991. Decreases in time deposits of $616 million and demand deposits of $127 million were partially offset by increases in savings and NOW accounts of $159 million and money market deposits of $109 million. On an average basis, total deposits decreased $653 million, to $4.64 billion, from $5.30 billion. This decrease was due to declines of $648 million in time deposits, $51 million in money market deposits and $50 million in demand deposits, partially offset by an increase of $96 million in savings and NOW accounts. The decreases in time deposits were a result of the Corporation's plan to shrink the balance sheet in response to pressure on the capital adequacy ratios. These wholesale funding sources were repaid with the liquid assets of the Corporation. Long-term debt of the Corporation was $213.3 million at December 31, 1992, compared with $232.1 million at December 31, 1991. The decrease of $18.8 million in long-term debt was due to the issuance of 764,537 shares of Series A 7.5% Cumulative Convertible Preferred Stock in exchange for the Sterling Denominated Fixed-Rate Capital Note due 2004 of Riggs AP Bank. Stockholders' equity increased to $245 million at December 31, 1992, from $205 million at December 31, 1991. This increase was due to the issuance of $19 million of Series A 7.5% Cumulative Convertible Preferred Stock as discussed above and $49 million of common stock (in a rights offering), partially offset by the $21 million loss for the year and foreign exchange translation losses of $6 million. Net interest income on a tax-equivalent basis totaled $144.4 million during 1992, down $17.8 million, or 11.0%, from the $162.2 million earned in 1991, as the positive impact of an improved net interest spread was more than offset by the effect of a $746 million decrease in average earning assets and, to a lesser extent, the reduced benefit of noninterest-bearing funds in a declining rate environment. The net interest margin was 3.13% during 1992, up from 3.02% in 1991. Net interest spread for 1992 was 2.66%, an increase of 30 basis points, year to year. Net interest income continued to be affected by the level of nonperforming assets. Interest lost on nonaccrual loans totaled $13.3 million for 1992, compared with $32.0 million for 1991. The 1992 net interest margin and net interest spread were both negatively impacted by nonaccrual loans by approximately 36 basis points. Noninterest income during 1992 increased $23.8 million, or 22.3%, to $130.4 million. The 1992 results included securities gains of $34.2 million and interest on a tax receivable of $5.9 million, while the 1991 results included securities gains of $13.7 million. Excluding these items, noninterest income for 1992 was down $2.7 million, or 2.9%. This decrease was due primarily to lower foreign exchange income from lower volumes and a narrower spread and lower service charges on deposits. Partially offsetting these negative factors were increased international fee-based services and increased miscellaneous fees. Noninterest expense for 1992 was $238.4 million, $51.8 million, or 17.8%, below the 1991 level, primarily due to the $49.8 million 1991 charge related to the establishment of the reserve for accelerated disposition of certain of the Corporation's domestic problem commercial real estate assets. Total staff expenses were $3.5 million less in 1992 than 1991 because of a decrease in full- time-equivalent staff, from 2,187 to 2,147, partially offset by increases in benefits expenses. Occupancy expense for 1992 totaled $28.4 million, down $1.8 million (6.0%) because of a decrease in property rentals, repairs and services. Furniture and equipment expense of $12.8 million for 1992 decreased $1.5 million (10.5%) as a result of the sale of equipment combined with the transfer of certain equipment and lease agreements to IBM under an outsourcing agreement for certain computer operations. Data processing expense increased $.3 million due to increased expenses related to the same IBM outsourcing agreement. The net decreases summarized above were partially offset during 1992 by an increase in other noninterest expense of $3.8 million (7.5%), the result of increases in interest cost of hedges, consulting fees and losses on disposal of equipment. The income tax benefit for 1992 was $1.1 million, compared with a benefit of $6.1 million for 1991. The decrease in the benefit during 1992 is the result of several factors, the most significant being the overall decline in net operating losses during 1992. The effective tax rate was 4.8% in 1992, compared with 6.5% in 1991. The benefits for 1992 and 1991 are less than the amount determined by application of the Federal statutory income tax rate, due principally to tax preference items and the Corporation's inability to carryback the full potential of the net operating losses. Consolidated Statements of Income NET INTEREST INCOME CHANGES* * The dollar amount of changes in interest income and interest expense attributable to changes in rate/volume (change in rate multiplied by change in volume) has been allocated between rate and volume variances based on the percentage relationship of such variances to each other. Income and rates are computed on a tax-equivalent basis using a Federal tax rate of 34% for 1993 and 1992 and local tax rates. Item 8.	Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA Consolidated Statements of Income The accompanying notes are an integral part of these statements. Consolidated Statements of Condition The accompanying notes are an integral part of these statements. Consolidated Statements of Changes in Stockholders' Equity * A cash dividend of $.15 per share applicable to the fourth quarter of 1990 was declared on January 22, 1991, and paid on February 15, 1991. The accompanying notes are an integral part of these statements. Consolidated Statements of Cash Flows Increase (Decrease) in Cash and Cash Equivalents The accompanying notes are an integral part of these statements. Notes to Consolidated Financial Statements (Dollar amounts in thousands, except per share amounts and as indicated) Note 1. Summary of Significant Accounting Policies - - -------------------------------------------------------------------------------- The following summary of significant accounting policies of Riggs National Corporation ("the Corporation"), including its principal subsidiaries, The Riggs National Bank of Washington, D.C. ("Riggs-Washington") and Riggs AP Bank Limited ("Riggs AP") and other subsidiaries, The Riggs National Bank of Virginia ("Riggs-Virginia"), and The Riggs National Bank of Maryland ("Riggs-Maryland"), is presented to assist the reader in understanding the financial, statistical and other data presented in this report. References to Riggs-Washington include The Riggs National Bank of Washington, D.C., and its subsidiaries, including Riggs-AP. General Accounting Policies The accounting and reporting policies of the Corporation are in accordance with generally accepted accounting principles and conform to general practice within the banking industry. For purposes of reporting cash flows, cash equivalents include cash on hand, amounts due from banks and federal funds sold and resale agreements. Generally, federal funds are purchased and sold for one-day periods. Certain reclassifications have been made to the 1991 and 1992 balances to conform with the 1993 classifications. Consolidation Policy The consolidated financial statements include the accounts of the Corporation and its subsidiaries, after elimination of all intercompany transactions. Securities Held-to-Maturity and Securities Available for Sale Effective December 31, 1993, the Corporation adopted Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS No. 115"). This pronouncement is effective for fiscal years beginning after December 15, 1993 (with early adoption encouraged), and may not be applied retroactively to prior years' financial statements. SFAS No. 115 requires, among other items, the determination at the acquisition date of a security whether such security is purchased with the intent and ability to hold to maturity, whether it is purchased with the intent to trade, or whether the security is available for sale. Under prior accounting policy, securities were classified as held for investment if the Corporation had the ability to hold securities to maturity and the intent to hold such securities for the foreseeable future, with all other securities classified as held for sale. Under SFAS No. 115, securities available for sale are carried at fair value, with unrealized gains and losses, net of tax, included as a separate component of stockholders' equity. This is contrary to prior accounting policy, in which the Corporation carried these securities at the lower of cost or market with any adjustments included in earnings. Management has established policies which require the periodic review of the securities portfolio. This review includes the Corporation's current asset/liability strategy and the possibility that the Corporation could sell securities in response to changes in interest rates or for liquidity purposes, to determine if certain securities held-to-maturity should be transferred to the available for sale portfolio. (See Note 2, "Securities.") Securities Held for Sale in 1992 and prior years are presented in the Securities Available for Sale category and Investment Securities are presented in the Securities Held-to-Maturity category in the Corporation's financial statements and in the accompanying notes. Loans Loans are carried at the principal amount outstanding net of unearned discounts, unamortized premiums and deferred fees and costs. Interest on loans and amortization of unearned discounts/premiums and deferred fees and costs are computed by methods which generally result in level rates of return on principal amounts outstanding. Loan origination fees and certain direct loan origination costs are deferred and the net amount is amortized as an adjustment of the related loan's yield. The Corporation generally amortizes these amounts in a manner that approximates a level yield over the estimated life of the loans. The Corporation discontinues the accrual of interest on loans based on delinquency status, an evaluation of the related collateral and the financial strength of the borrower. Generally, loans are placed on nonaccrual status when the loans are in default in either principal or interest for 90 days or more and the loans are not well-secured and in the process of collection. Income recognition on consumer loans is discontinued and the loans are charged off after a delinquency period of 120 days. At that point, any accrued interest which has not actually been collected is reversed. At December 31, 1993, the Corporation implemented a narrower definition of In-Substance Foreclosure as required by regulatory agencies. This definition is also consistent with Statement of Financial Accounting Standards No. 114, "Accounting by Creditors for Impairment of a Loan." This definition is discussed in detail below, and loan related disclosures have been adjusted to reflect this new definition. Implementation of Interagency Guidance on Reporting of In-Substance Foreclosures At December 31, 1993, the Corporation implemented the narrower definition of In-Substance Foreclosure required by the March 10, 1993 Interagency Policy Statement on Credit Availability and the June 10, 1993 Interagency Guidance on Reporting of In-Substance Foreclosures. Under previous financial accounting guidelines, a nonaccrual loan was transferred from loans to other real estate owned when foreclosure was probable or the loan was considered in-substance foreclosed, which by definition in the Securities and Exchange Commission's Financial Reporting Release No. 28 meant that the borrower had little or no equity in the property, proceeds for repayment of the loan could be expected to come only from the operation or sale of the collateral, and the debtor had either abandoned control of the collateral or it was doubtful that the debtor would be able to rebuild equity in the collateral or otherwise repay the loan in the foreseeable future. Loans considered in-substance foreclosed must be recorded at the lower of cost or fair value. Under the revised regulatory accounting guidelines, a loan is recognized as an in-substance foreclosure when the Corporation has possession of an asset prior to obtaining legal title. This definition is consistent with the Statement of Financial Accounting Standards No. 114, "Accounting by Creditors for Impairment of a Loan," which will be required for fiscal years beginning after December 15, 1994. This change in treatment impacts only the classification of accounts in the financial statements and does not result in a change in the accounting policy related to the determination of the assets' carrying value. The impact of this change in definition of in-substance foreclosures on certain categories in the Corporation's financial statements is presented in the following table. The Consolidated Statements of Condition, Income and Cash Flows and the Notes to Consolidated Financial Statements reflect these reclassifications. Adjustments to Implement New Definition of In-Substance Foreclosures Other Real Estate Owned Other real estate owned is property acquired or deemed to have been acquired through foreclosure. See the "Implementation of Interagency Guidance on Reporting of In-Substance Foreclosures" section, discussed in detail above. Other real estate owned is recorded at the lower of fair value less estimated costs to sell, or cost. Initial writedowns of other real estate owned are charged to the reserve for loan losses. Revenues and expenses incurred in connection with ownership of the properties, and subsequent writedowns and gains and losses upon sale are included, net, in other real estate owned expense. Real Estate Assets Subject to Accelerated Disposition Real estate assets subject to accelerated disposition include specific foreclosed and in-substance foreclosed properties and nonperforming loans secured by commercial real estate. In 1991, the Corporation adopted a strategy to accelerate the disposition of these assets by pricing the properties at a discount to fair value. As a result, the Corporation established a reserve to cover potential losses due to the pricing strategy as well as estimated costs associated with the disposition efforts, including legal expenses and selling costs. At June 30, 1992, the program was discontinued. Premises and Equipment Premises, leasehold improvements and furniture and equipment are stated at cost less accumulated depreciation and amortization. Depreciation and amortization on premises, leasehold improvements, and furniture and equipment are computed using the straight-line method. Ranges of useful lives for computing depreciation and amortization are as follows: Major improvements and alterations to premises and leaseholds are capitalized. Leasehold improvements are amortized over the shorter of the terms of the respective leases or the estimated useful lives of the improvements. Other Assets Included in other assets are intangible assets, such as goodwill, which is the excess of cost over net assets of acquired entities, and core-deposit intangibles. Goodwill is amortized on the straight-line method over 25 years. The Corporation had unamortized goodwill of $7.3 million at December 31, 1993, and amortization expense of $565 thousand; $716 thousand, and $668 thousand for 1993, 1992, and 1991, respectively. Core-deposit intangibles represent the net present value of the future income streams related to deposits acquired through mergers or acquisitions and are amortized on an accelerated basis over 10 years. The unamortized core-deposit intangibles recorded on the Corporation's books at December 31, 1993, were $21.4 million, and amortization expense of $3.5 million, $3.7 million, and $3.6 million was recorded for 1993, 1992, and 1991, respectively. Income Taxes Effective January 1, 1993, the Corporation adopted Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes," which mandates the asset and liability method of accounting for deferred income taxes. The Corporation had previously accounted for deferred taxes under the deferral method required by Accounting Principles Board ("APB") Opinion No. 11. Earnings Per Share Earnings per share is calculated by dividing net earnings after deduction of preferred stock dividends by the weighted-average number of shares of common stock and common stock equivalents outstanding during each period. Stock options are considered common stock equivalents, unless determined to be anti- dilutive. Earnings per share also reflects provisions for dividend requirements on all outstanding shares of preferred stock. The weighted-average shares outstanding were 26,208,315 for 1993, 24,534,063 for 1992 and 13,777,014 for 1991. Fully diluted earnings per share was not presented because outstanding preferred shares, when converted to Common Stock, as well as the assumed exercise of outstanding stock options, were anti-dilutive. Foreign Currency Translation The functional currency amounts of assets and liabilities of foreign entities are translated into U.S. dollars at year-end exchange rates. Income and expense items are translated using appropriately weighted-average exchange rates for the period. Functional currency to U.S. dollars translation gains and losses, net of related hedge transactions, are credited or charged directly to the stockholders' equity account, "Foreign Exchange Translation Adjustments." Foreign Exchange Income Foreign currency trading and exchange positions, including spot and forward exchange contracts, are valued monthly and the resulting profits and losses are recorded in foreign exchange trading income. The amounts of net foreign exchange trading gains included in the accompanying consolidated statements of income under other noninterest income were $2.8 million for 1993, $5.0 million for 1992 and $8.2 million for 1991. Interest-Rate Futures and Forward Contracts Gains and losses on futures and forward contracts and interest-rate agreements used to hedge certain interest-sensitive assets and liabilities are deferred and are either recognized as income at the time of disposition of the assets or liabilities being hedged, or are amortized over the life of the hedged transaction as an adjustment to yield. Gains and losses on futures and forward contracts with trading account activities are recognized currently in trading income. Interest-Rate Swap Agreements Interest-rate swaps are entered into as hedges against fluctuations in the interest rate of specifically identified assets or liabilities. There is no effect on total assets or liabilities of the Corporation. Net receivables or payables under agreements designated as hedges are recorded as adjustments to interest income or interest expense related to the hedge asset or liability. Related fees are deferred and amortized over the life of the swap agreements. New Financial Accounting Standards On January 1, 1993, the Corporation adopted SFAS No. 109, "Accounting for Income Taxes." SFAS No. 109 established financial accounting and reporting standards for the effects of income taxes that result from the Corporation's activities during the current and preceding years. It requires an asset and liability approach in accounting for income taxes versus the deferred method previously used under Accounting Principles Board Opinion No. 11 ("APB No. 11"). Under SFAS No. 109, deferred income taxes are recorded using enacted tax laws and rates for the years in which the taxes are expected to be paid. In addition, SFAS No. 109 provides for the recognition of deferred tax assets based on tax loss and tax credit carryforwards, to the extent that realization of such assets is more likely than not. Under APB No. 11, deferred tax assets were generally recognized only to the extent such assets were reasonably assured of realization, primarily through tax loss and tax credit carryback potential. Income tax provisions for 1992 were determined under APB No. 11 and have not been restated to reflect adoption of SFAS No. 109. The effect of the adoption of SFAS No. 109 was not material. (See Note 14, "Income Taxes.") In May 1993, SFAS No. 114, "Accounting by Creditors for Impairment of a Loan" was issued which specifies how allowances for credit losses related to impaired loans, as defined in the Statement, should be determined. Upon implementation of the Statement, the Corporation will be required to identify and measure impaired loans in its loan portfolio. For the most part measurement will be based on the present value of expected future cash flows discounted at the loan's effective interest rate or, for collateral-dependent loans, on the fair value of the collateral. If the valuation of the impaired loan is less than the recorded investment in the loan, the Corporation will recognize an impairment by creating a valuation allowance with a corresponding charge to provision for loan losses or by adjusting an existing valuation allowance for the impaired loan with the corresponding amount reflected in earnings. This Statement is effective for financial statements for fiscal years beginning after December 15, 1994. The Corporation is evaluating the impact that the adoption of this Statement will have on future financial statements. At December 31, 1993, the Corporation implemented a narrower definition of In-Substance Foreclosure as required by regulatory agencies. This definition is consistent with SFAS No. 114; see "Implementation of Interagency Guidance on Reporting of In-Substance Foreclosures," detailed above. Effective December 31, 1993, the Corporation adopted SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities" (SFAS No. 115). This pronouncement is effective for fiscal years beginning after December 15, 1993. In addition, SFAS No. 115 may not be applied retroactively to prior years' financial statements. (See "Securities Held-to-Maturity and Securities Available for Sale" above.) NOTE 2. SECURITIES - - -------------------------------------------------------------------------------- Effective December 31, 1993, the Corporation adopted Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS No. 115"). This pronouncement is discussed in detail in Note 1, "Summary of Significant Accounting Policies." Implementation of SFAS No. 115 included a review of the securities portfolio based on management's intent for those securities at that time, which resulted in the net transfer of $168.7 million in securities available for sale to the held-to-maturity portfolio. SFAS No. 115 requires that all unrealized gains and losses from the securities available for sale portfolio be included, net, in stockholders' equity until realized. This treatment is contrary to previous accounting policy, which require such securities to be carried at the lower of cost or market with any unrealized gains and losses included in earnings. After giving effect to the $168.7 million net transfer on December 31, 1993, the new accounting treatment for securities available for sale resulted in a $1.28 million net unrealized gain in stockholders' equity and an immaterial adjustment to earnings. Securities Available for Sale A comparison of book and market value for securities available for sale at year- end follows: Proceeds from the sale of securities available for sale totaled $736 million during 1993, as compared with $1.10 billion during 1992. During 1993, gross gains from the sale of securities available for sale totaled $27.0 million, with no gross losses during the year. The weighted-average yield to maturity of these securities was 4.43% at year-end 1993. The average maturity on these securities was 6 years and 5 months. The "Other Securities" category consists of $1.9 million of foreign debt securities. Securities available for sale pledged to secure deposits and other borrowings amounted to $372.8 million at December 31, 1993, and $14.0 million at December 31, 1992. Securities Held-to-Maturity A comparison of book and market value for the securities held-to-maturity category at year-end follows: There were no sales of securities held-to-maturity during 1993, compared with $33 million in 1992. Gross gains and losses on the sale of these securities were $108 thousand and $595 thousand, respectively, in 1992. The maturity distribution of securities held-to-maturity at year-end follows: * Weighted-average yield to maturity at December 31, 1993. Obligations of states and political subdivisions are not reported on a tax-equivalent basis. The "Other Securities" category consists primarily of floating-rate notes, and preference shares of United Kingdom companies. Also included under this category are investments for which there is no readily available market value quotation, such as Federal Reserve Bank stock. These securities, which amounted to $8.9 million at December 31, 1993, and $12.3 million at December 31, 1992, have their year-end book values included as an approximation of their market values in the table above. U.S. Treasury securities and mortgage-backed securities pledged to secure deposits and other borrowings amounted to $271.2 million on December 31, 1993, and $320.0 million on December 31, 1992. NOTE 3. LOANS - - -------------------------------------------------------------------------------- The following schedule reflects loans by type at year-end: A summary of nonperforming and renegotiated loans, loans contractually past due 90 days or more and potential problem loans at year-end follows: At December 31, 1993, the Corporation implemented a narrower definition of In-Substance Foreclosure as required by regulatory agencies, see Note 1, "Summary of Significant Accounting Policies." NOTE 4. RESERVE FOR LOAN LOSSES - - -------------------------------------------------------------------------------- An analysis of the changes in the reserve for loan losses follows: * At December 31, 1993, the Corporation implemented a narrower definition of In-Substance Foreclosure as required by regulatory agencies, see Note 1, "Summary of Significant Accounting Policies." The level of the reserve for loan losses as of December 31, 1993, is based on management's estimates of the amount required to reflect the collection risks in the loan portfolio based on circumstances and conditions known at the time. Current economic conditions in the United States and the United Kingdom, along with the state of the local commercial real estate market, will continue to affect the Corporation's loan portfolio. This may result in additional provisions and writedowns related to problem loans. The performance of these assets will depend on future economic conditions of these markets and the impact of such conditions on the Corporation's borrowers. However, in the opinion of management, the reserve for loan losses was adequate at December 31, 1993. NOTE 5. OTHER REAL ESTATE OWNED - - -------------------------------------------------------------------------------- Other real estate owned at December 31, 1993, and 1992 is summarized as follows: At December 31, 1993, the Corporation implemented a narrower definition of In- Substance Foreclosure as required by regulatory agencies. See Note 1, "Summary of Significant Accounting Policies." Total net other real estate owned expense and provision for losses on accelerated disposition of real estate assets totaled $13.5 million and $15.7 million for the years ended December 31, 1993 and 1992, respectively. Provisions for other real estate owned and accelerated disposition losses totaled $11.3 million and $11.9 million for the same periods. The remaining other real estate owned expense was comprised of operating and selling expenses, combined with losses on sale of other real estate owned, partially offset by operating revenues and gains on sale of other real estate owned. Real Estate Assets Subject to Accelerated Disposition and Other Real Estate Owned During the third quarter of 1991, the Corporation initiated a strategy to accelerate the disposition of domestic problem commercial real estate assets. At its inception, the program included approximately $191.0 million of assets, consisting of properties securing problem commercial real estate loans, properties to which the Corporation already had title and in-substance foreclosed properties. From inception of the program through June 30, 1992, the Corporation reduced program assets $146.3 million, or 76.6%, through sales, the return of a loan to performing status and writedowns. At the end of the second quarter of 1992, the Corporation discontinued the asset disposition program and transferred the remaining $44.3 million of assets to loans receivable and other real estate owned at fair value. Reserve for Other Real Estate Owned An analysis of the changes in the reserves for other real estate owned, including the reserve for losses on real estate assets subject to accelerated disposition, follows: NOTE 6. TRANSACTION WITH RELATED PARTIES - - -------------------------------------------------------------------------------- The Corporation and its banking subsidiaries have had and expect to have transactions in the ordinary course of business with many of the Corporation's directors, executive officers, their associates and family members. During 1993, Allbritton Communications Company ("ACC"), a company indirectly wholly owned by Mr. Allbritton (Chairman of the Board and CEO of the Corporation), paid Riggs-Washington $259 thousand to lease space in two office buildings owned by Riggs-Washington. In early 1992, ACC exercised its option to extend one of the leases through 1996. The second lease expired in December 1993 and is being renewed pursuant to a three-year renewal option. ACC also reimbursed Riggs-Washington $1 thousand for use of its dining room during 1993. Perpetual Corporation, also indirectly owned by Mr. Allbritton, reimbursed Riggs-Washington $2 thousand for use of its fitness facility during 1993. Riggs-Washington, through advertising agencies, purchases advertising time from various Washington metropolitan area television stations, including WJLA-TV, an affiliate of a major network, and NewsChannel 8, a cable television program service. WJLA-TV is a division of ACC and NewsChannel 8 is a division of ALLNEWSCO, Inc., both of which are indirectly wholly owned by Mr. Allbritton. During 1993, Riggs-Washington through advertising agencies, purchased $266 thousand in advertising time from WJLA-TV and $19 thousand in advertising time from NewsChannel 8. The amounts that Riggs-Washington, through advertising agencies, paid to WJLA-TV and NewsChannel 8 represent an immaterial portion of its gross revenues for 1993. Riggs-Washington has in the past sold participations in commercial real estate loans to University State Bank ("University"), a Texas bank that is indirectly wholly owned by Mr. Allbritton. The participations sold to University were in loans bearing floating rates of interest. The purchase price of each of the participations was equal to the outstanding principal amount of the portion of the loan purchased. Riggs-Washington receives a servicing fee of 0.25% on each of the loans in which participations were sold to University and, in some transactions, shared a portion of the loan fees with University. No loan participations were sold to University during 1993. On December 31, 1993, there were $17 million in loan participations outstanding to University. As of that date, University's total assets were $217.1 million and its total loans outstanding were $96.5 million. The table below reflects information concerning loans by banking subsidiaries of the Corporation to directors and executive officers of the Corporation, their associates and family members, and directors of Riggs-Washington and Riggs AP, their associates and family members. In addition to the amounts set forth in the table, the Corporation's banking subsidiaries had $7.7 million of letters of credit outstanding at December 31, 1993. There were no loans included in the table below that were nonaccrual, past due, restructured or potential problems at December 31, 1993. In the opinion of management, these credit transactions did not, at the time they were entered into, involve more than the normal risk of collectibility or present other unfavorable features. NOTE 7. PREMISES AND EQUIPMENT - - -------------------------------------------------------------------------------- Investments in premises and equipment at year-end were as follows: Depreciation and amortization expense amounted to $12.9 million in 1993, $14.0 million in 1992 and $14.3 million in 1991. The Corporation is committed to the following future minimum lease payments under non-cancelable operating lease agreements covering equipment and premises. These commitments expire intermittently through 2009 in varying amounts. The total minimum lease payments under these commitments at December 31, 1993, were as follows: Total minimum operating lease payments included in the preceding table have not been reduced by future minimum payments from sublease rental agreements that expire intermittently through 1999. Minimum sublease rental income for 1994 totals approximately $3.4 million. Rental expense for all operating leases (cancelable and non-cancelable) consisted of the following: NOTE 8. TIME DEPOSITS, $100 THOUSAND OR MORE - - -------------------------------------------------------------------------------- The following table reflects the year-end balances and maturities for the Corporation's time deposits in domestic offices of $100 thousand or more: Average time deposits of $100 thousand or more in domestic offices were $317 million in 1993, 5.9% below the $337 million for 1992. Interest expense related to time deposits of $100 thousand or more in domestic offices amounted to $5.5 million in 1993, $10.3 million in 1992 and $21.9 million in 1991. The majority of time deposits in foreign offices were in denominations of $100 thousand or more. Note 9. Borrowings - - -------------------------------------------------------------------------------- Short-Term Borrowings Short-term borrowings outstanding at year-end and other related information follow: * Average amounts are based on daily balances. Average rates are computed on actual interest expense divided by average amounts outstanding. Federal funds purchased consist of borrowings from other financial institutions that have maturities ranging from one to 180 days. Repurchase agreements are transactions with customers and brokers secured by either securities or resale agreements, which generally mature within 30 days. U.S. Treasury demand notes consist of treasury tax and loan account funds transferred to interest-bearing demand notes with no fixed maturity subject to call by the Federal Reserve. Other short-term borrowings are borrowings from other financial institutions. Long-Term Debt Long-term debt outstanding at year-end and other related information follow: * Minimum rate in effect according to indentures. Floating-Rate Subordinated Notes Due 1996 The Floating-Rate Subordinated Notes due 1996 (the "Subordinated Notes") were issued in the Euromarket on September 18, 1984, carry interest at rates determined quarterly by a formula based upon the London Interbank Offered Rate ("LIBOR") and are subject to a minimum rate of 5.25%. During 1991, the Corporation purchased, on the open market and at a discount, $8.5 million of the Subordinated Notes, resulting in pretax gains of $2.5 million. Floating-Rate Subordinated Capital Notes Due 1996 The Floating-Rate Subordinated Capital Notes due 1996 (the "Subordinated Capital Notes") were originally issued in the Euromarket on December 18, 1985, carry interest at rates determined quarterly by a formula based upon LIBOR and are subject to a minimum rate of 5.25%. Under the indenture related to the Subordinated Capital Notes, the Corporation was required to issue common stock or perpetual preferred stock totaling $95.3 million before the maturity date of the notes. This requirement was fulfilled during 1993. During 1991, the Corporation purchased, on the open market and at a discount, $4.7 million of the Subordinated Capital Notes, resulting in pretax gains of $1.7 million. Fixed-Rate Subordinated Debentures Due 2009 On June 6, 1989, the Corporation issued $100 million of 9.65% Subordinated Debentures due June 15, 2009. The debentures may not be redeemed prior to maturity and are unsecured subordinated obligations of the Corporation. In April 1990, the Corporation purchased, on the open market and at a discount, $33.5 million of the Subordinated Debentures, resulting in pretax gains of $7.7 million. Offering of Fixed-Rate Subordinated Notes Due 2006 Subsequent to year-end, the Corporation sold $125 million of 8.5% Subordinated Notes, due 2006. The notes were priced at par and are not callable for five years. A shelf registration statement relating to the Fixed-Rate Subordinated Notes was declared effective on January 13, 1994. The Corporation intends to use the net proceeds from the offering, approximately $120.7 million, to redeem equal amounts of the Subordinated Notes and Subordinated Capital Notes due in 1996, which are discussed above. NOTE 10. COMMITMENTS AND CONTINGENCIES - - -------------------------------------------------------------------------------- Off-Balance-Sheet Risk In the normal course of business, the Corporation enters into various transactions that, in accordance with generally accepted accounting principles, are not included on the consolidated statements of condition. These transactions are referred to as "off-balance-sheet commitments" and differ from the Corporation's balance sheet activities in that they do not give rise to funded assets or liabilities. The Corporation offers such products to enable its customers to meet their financing objectives, as well as to manage their interest and currency rate risk. Offering these products provides the Corporation with fee income. The Corporation also enters into these activities to manage its own risks arising from movements in interest and currency rates and as a part of its trading activities. These transactions involve varying degrees of credit, interest-rate or liquidity risk in excess of amounts recognized on the consolidated statements of condition. The Corporation seeks to minimize its exposure to loss under these commitments by subjecting them to credit approval and monitoring procedures, as well as by entering into offsetting or matching positions to hedge interest-rate and currency-rate risk. Outstanding commitments and contingent liabilities that do not appear in the consolidated financial statements at December 31, 1993, are as follows: Commitments to Extend Credit The Corporation enters into contractual commitments to extend credit, normally with fixed expiration dates or termination clauses, at specified rates and for specific purposes. Customers use credit commitments to ensure that funds will be available for working capital purposes, for capital expenditures and to ensure access on funds at specified terms and conditions. Substantially all of the Corporation's commitments to extend credit are contingent upon customers' meeting and satisfying other conditions at the time of loan funding. The contractual amount of commitments to extend credit for which the Corporation has received a commitment fee, or which were otherwise legally binding, was $714 million at December 31, 1993; approximately 73% of these commitments were scheduled to expire within one year. Since many of the commitments are expected to expire without being drawn upon, the total contractual amounts do not necessarily represent future funding requirements. Letters of Credit and Foreign Guarantees There are two major types of letters of credit: commercial and standby letters of credit. A commercial letter of credit is normally a short-term instrument used to finance a commercial contract for the shipment of goods from seller to buyer. This type of letter of credit ensures prompt payment to the seller in accordance with its terms. Although the commercial letter of credit is contingent upon the satisfaction of specified conditions, it represents a current exposure if the customer defaults on the underlying transaction. Commercial letters of credit issued by the Corporation totaled $57 million at December 31, 1993. A standby letter of credit can be either financial or performance based. Financial standby letters of credit obligate the Corporation to disburse funds to a third party if the Corporation's customer fails to repay an outstanding loan or debt instrument under the terms of the agreement with the beneficiary. Performance standby letters of credit obligate the Corporation to disburse funds if the customer fails to perform some contractual or non-financial obligation under the terms of the agreement with the beneficiary. The Corporation's policies generally require that all standby letter of credit arrangements contain security and debt covenants similar to those contained in loan agreements. At December 31, 1993, financial standby letters of credit and performance standby letters of credit totaled $35 million and $49 million, respectively. Capital Markets Capital markets products include commitments to purchase and sell foreign exchange, futures, forward and option contracts, and interest-rate agreements. The Corporation utilizes these products to manage its exposure to movements in interest and currency rates, and to generate revenue by assisting customers in managing their own exposure to such rate movements. There are several types of risk associated with these products: credit or performance risk, currency-rate risk, and interest-rate risk. Performance risk relates to the ability of a counterparty to meet its obligations under the contract. Performance risk is limited to the cost of replacing the contract at current rates -- not the security, foreign currency to be exchanged, or the notional principal, which is the amount upon which interest rates are applied to determine the payment streams under interest-rate agreements. Currency-rate risk and interest-rate risk arise from changes in the market value of positions stemming from movements in currency and interest rates. The Corporation limits its exposure to market value changes by entering into offsetting or matching positions. The Corporation establishes and monitors limits of exposure on unmatched positions. Commitments to purchase and sell foreign exchange facilitate the management of currency-rate risk by ensuring that at some future date a customer will have a specific currency at a specified rate. The Corporation enters into these contracts to serve its customers, to hedge its own risk positions associated with its asset and liability management, and as part of its trading activities. In addition to entering into offsetting or matching positions to offset foreign currency-rate risk, the Corporation has established limits on the aggregate amount of open positions, forward trading gaps and total volume of contracts outstanding, as well as counterparty and country limits. At December 31, 1993, commitments to purchase and sell foreign exchange were $34 million and $204 million, respectively. The difference between these positions is effectively hedged through the Corporation's Sterling equity investment in Riggs AP. Interest-rate agreements, which include interest-rate swaps, forward-rate agreements, and other interest-rate products, obligate two parties to exchange, or contingently exchange, interest payment flows calculated with reference to one or more interest-rate indices. Interest-rate agreements enable the Corporation to manage the interest-rate sensitivities of underlying assets or liabilities. There were no forward-rate agreements outstanding at December 31, 1993. Interest-rate swaps obligate two parties to exchange periodic payments based upon the difference between two designated or formula rates of interest applied to the same notional principal amount. Similar to other off-balance- sheet products, the notional amounts should not be taken as a measure of exposure because the replacement cost of the contract generally is much smaller than the face value or notional amount of the contract. The Corporation's notional principal of interest-rate swaps at December 31, 1993, totaled $274 million. Concentration of Credit Risk The Corporation regularly assesses the quality of its commercial credit exposures and assigns risk ratings to substantially all extensions of credit in its commercial, real estate and international portfolios. The Corporation seeks to identify as early as possible problems that may result from economic downturns or deteriorating conditions in certain markets or with respect to specific credits. Lending officers have the primary responsibility for monitoring credit quality, identifying problem credits and recommending changes in risk ratings. When signs of credit deterioration are detected, credit or other specialists may become involved to minimize the Corporation's exposure to future credit losses. The Loan Review Department provides an independent assessment of credit ratings, credit quality and the credit management process. This is achieved through regular reviews of loan documentation, collateral, risk ratings and problem loan classifications. Credit risk is reduced by maintaining a loan portfolio that is diverse in terms of type of loan, industry concentration, geographic distribution, and borrower concentration, thus minimizing the adverse impact of any single event or set of occurrences. Geographically, the Corporation's loans are concentrated in the Baltimore- Washington, D.C.-Richmond corridor and the United Kingdom. All categories of loans in the domestic portfolio are predominantly to borrowers located in the Washington metropolitan area. Loans originated by the Corporation's United Kingdom subsidiary represent 77% of foreign loans, and are predominantly to borrowers located in the United Kingdom. At December 31, 1993, approximately $538 million or 21% of the Corporation's loan portfolio consisted of loans secured by real estate (excluding single- family residential loans), approximately 70% and 30% of which were secured by properties located in the Washington, D. C. area and in the United Kingdom, respectively. In addition, the Corporation had $52.8 million in other real estate owned at December 31, 1993. These commercial and real estate markets have been experiencing problems, including declining occupancy and rental rates and property values, which have resulted in increases in the delinquency and default rates on the Corporation's commercial real estate loan portfolio and as such have caused significant losses. Additional provisions and writedowns will depend on future economic conditions in the United States and United Kingdom, as well as changes in the local real estate market and the impact of these events on the Corporation's borrowers. Domestic real estate-commercial loans represent the only industry in which the Corporation has a concentration of credit risk in excess of 10% of year-end loans. These loans totaled $388.4 million and represented 15.4% of the total loan portfolio at December 31, 1993. Approximately half of the Corporation's real estate-commercial portfolio is for the development of residential properties. The remainder of the portfolio is for the development of commercial properties, including office buildings, warehouses, shopping centers and hotels. Approximately 54.9% of the Corporation's loan portfolio is secured by the primary residence of the borrower. At December 31, 1993, residential mortgage loans were $1.15 billion and home equity loans were $234.0 million. Other Commitments During the first quarter of 1991, the Corporation entered into a ten-year outsourcing agreement with Integrated Systems Solutions Corp. ("ISSC"), a subsidiary of IBM, pursuant to which ISSC is managing the operations directly associated with computer and telecommunications functions of the Corporation. Payments for the remaining seven years of the contract are approximately $116 million. The base payment for 1993 was $14.8 million. Total expense under this contract for 1993 was $13.9 million, compared with total expenses of $14.1 million and $13.5 million for 1992 and 1991, respectively. Litigation In the normal course of business, the Corporation is involved in various types of litigation, including litigation with borrowers who are in default under their loan agreements. In certain instances, borrowers have asserted or threatened counterclaims and defenses based on various "lender liability" theories. In the opinion of management, based on its assessment and consultation with outside counsel, litigation that is currently pending against the Corporation will not have a material impact on the financial condition or future operations of the Corporation, as a whole. NOTE 11. RESERVE BALANCES, FUNDS RESTRICTIONS, REGULATORY MATTERS AND CAPITAL REQUIREMENTS - - -------------------------------------------------------------------------------- Reserve Balances Riggs-Washington, Riggs-Virginia and Riggs-Maryland must maintain reserves against deposits and Eurocurrency liabilities in accordance with Regulation D of the Federal Reserve Act. The total average reserve balances amounted to $102.2 million in 1993 and $82.8 million in 1992. Funds Restrictions The Federal Reserve Act ("The Act") imposes restrictions upon the amount of loans or advances that banks, such as Riggs-Washington, Riggs-Virginia and Riggs-Maryland, may extend to the Corporation and its non-bank subsidiaries ("affiliates"). Loans by any bank to any one affiliate are limited to 10% of the bank's capital stock and surplus. Further, aggregate loans by any one bank to all of its affiliates may not exceed 20% of its capital stock and surplus. In addition, the Act requires that borrowings by affiliates be secured by designated amounts of collateral. The National Bank Act limits dividends payable by national banks without approval of the Comptroller of the Currency to net profits (as defined) retained in the current and preceding two calendar years. Riggs-Washington had combined net losses (as defined) of approximately $91 million, for 1993 and 1992. Thus, Riggs-Washington's ability to pay dividends to the Corporation in 1994 will depend on whether its earnings exceed such losses. Riggs-Virginia and Riggs- Maryland had combined net income (as defined) of approximately $6 million and $600 thousand, for 1993 and 1992, respectively. The payment of dividends by the Corporation's national bank subsidiaries may also be affected by other factors, such as requirements for the maintenance of adequate capital. In addition, the Comptroller of the Currency is authorized to determine, under certain circumstances relating to the financial condition of a national bank, whether the payment of dividends would be an unsafe or unsound banking practice and to prohibit payment thereof. During 1991, Riggs-Virginia did not pay a dividend to the Corporation. During 1992 and 1993, Riggs-Virginia made dividend payments to the Corporation totaling $836 thousand and $1.2 million, respectively. Riggs-Washington and Riggs-Maryland made no dividend payments to the Corporation in 1993, 1992 or 1991. Regulatory Matters On May 14, 1993, the Corporation entered into a Memorandum of Understanding with the Federal Reserve Bank of Richmond ("Reserve Bank") and Riggs-Washington entered into a Written Agreement with the Office of the Comptroller of the Currency (the "OCC"). The Memorandum of Understanding and the Written Agreement were the result of regulatory concern over financial and operational weaknesses and continued losses related primarily to the Corporation's domestic and United Kingdom commercial real estate exposure. Under the terms of the Memorandum of Understanding, the Corporation will notify the Reserve Bank in advance of dividend declarations, the issuance and/or redemption of long-term debt and use of cash assets in certain circumstances. The Corporation is also required to submit plans and reports to the Reserve Bank relating to capital, asset quality, loan loss reserves and operations, including contingency measures if projected operational results do not occur. In addition, the Audit Committee of the Corporation's Board of Directors will review and submit a report to the Reserve Bank on the adequacy of data submitted to it and the Board, and the Corporation has appointed a compliance committee of Directors to monitor performance under the Memorandum of Understanding. In accordance with the terms of the Written Agreement, Riggs-Washington has appointed a committee of its Board of Directors to monitor and coordinate compliance with the agreement, implement recommendations previously made by an independent management consultant, and continue to implement the action plan and work plan previously adopted by Riggs-Washington. Riggs-Washington has met a number of the requirements of the agreement, including filing amended call reports; adopting policies and procedures relating to the preparation of call reports; adopting a capital plan that has been approved by the OCC (that requires, among other things, a minimum total risk-based capital ratio of 10.00%, a minimum Tier I risk-based capital ratio of 6.00% and a minimum leverage ratio of 5.00%); submitting for review by the OCC the results of BankStart '93; and appointing a new president and chief executive officer. Capital Requirements Under the Federal Reserve Board's risk-based capital guidelines, bank holding companies are required to meet a minimum ratio of qualifying total (combined Tier I and Tier II) capital to risk-weighted assets of 8.00%, at least half of which must be composed of core (Tier I) capital elements. The Corporation's total and core capital ratios were 16.81% and 10.76%, respectively, at December 31, 1993, as compared with 14.70% and 8.31% at December 31, 1992. The Federal Reserve Board has established an additional capital adequacy guideline referred to as the leverage ratio, which measures Tier I capital to quarterly average assets. The most highly rated bank holding companies are required to maintain a minimum leverage ratio of 3.00%. However, most bank holding companies, including the Corporation, are expected to maintain an additional cushion of at least 100 to 200 basis points above the 3.00% minimum. The actual required ratio for individual bank holding companies is based on the Federal Reserve Board's assessment of the company's asset quality, earnings performance, interest-rate risk and liquidity. The Federal Reserve Board has not advised the Corporation of a specific leverage ratio requirement. The Corporation's leverage ratio was 6.03% at December 31, 1993. As a result of enactment of the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"), the Federal Reserve Board and the other federal bank regulatory agencies have placed a greater emphasis on capital ratios of banking organizations. FDICIA expressly conditions the ability of a banking organization to engage in certain activities on the maintenance of capital levels equal to or in excess of minimum guidelines and imposes restrictions on banking organizations that fail to meet minimum guidelines. In addition, the Federal Reserve Board has shown an increased emphasis on the leverage ratio as a regulatory tool. The Corporation's policy is to ensure that its operating subsidiaries are capitalized within the appropriate regulatory guidelines. During 1993, the Corporation contributed $38 million to Riggs-Washington to ensure its capitalization would be in excess of the regulatory guidelines. The Corporation has no current plans to make any substantial capital contributions to its subsidiary banks. The three national bank subsidiaries of the Corporation are subject to minimum capital ratios prescribed by the Office of the Comptroller of the Currency that are the same as those of the Federal Reserve Board. In the event that the Corporation is unable to meet the projections in its capital plan, or any of its banking subsidiaries falls below the minimum capital requirements, additional regulatory action may be taken. With respect to the banking subsidiaries, the OCC can take action under the "prompt corrective action" provision of FDICIA. The classification from strongest to weakest include "well capitalized," "adequately capitalized," "under capitalized," "significantly undercapitalized" and "critically undercapitalized." Such actions can vary depending on the severity of the capital position, and may include the refiling of a capital plan, restrictions on growth, and other actions the regulators may deem to be appropriate in order to achieve compliance with capital requirements. Each of the bank subsidiaries of the Corporation exceeds current minimum regulatory capital requirements, and qualifies, at a minimum, as "adequately capitalized" under the FDICIA regulations. In addition, under Federal Reserve Board policy, bank holding companies are expected to act as a source of financial strength to their subsidiary banks and to commit resources to support such banks. The Corporation's ability to provide financial strength to its subsidiaries will depend on, among other things, its liquidity position and Federal Reserve approval. At December 31, 1993, the Corporation adopted SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." This pronouncement requires, among other items, the reporting of unrealized gains and losses in securities available for sale in stockholders' equity, contrary to previous accounting policy, which reported such unrealized gains and losses in earnings. At December 31, 1993, the Corporation reported net unrealized gains of $1.28 million in stockholders' equity. The year-end net unrealized gains were excluded from Tier I and Tier II capital for regulatory reporting purposes per current regulatory agency guidance. The regulatory agencies are reviewing the current reporting guidelines in relationship to SFAS No. 115, and may amend the applicable regulatory capital rules to include SFAS No. 115-related adjustments in equity. Thus, the capital ratios disclosed at December 31, 1993, do not include the $1.28 million in net unrealized gains from the implementation of SFAS No. 115. The following table reflects the actual and required minimum ratios for the Corporation and its national banking subsidiaries: * Most bank holding companies and national banks, including the Corporation and the Corporation's national bank subsidiaries, are expected to maintain an additional cushion of at least 100 to 200 basis points above the 3.00% minimum. NOTE 12. DISCLOSURE ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS - - -------------------------------------------------------------------------------- The following methods and assumptions were used to estimate the fair value of each class of financial instrument for which it is practicable to estimate that value: Cash and Money Market Assets For short-term investments that reprice or mature in 90 days or less, the carrying amount is a reasonable estimate of fair value. Securities Held-to-Maturity and Securities Available for Sale For U.S. Treasury securities, municipal securities and mortgage-backed securities, fair values are based on quoted market prices or dealer quotes. For "Other Securities," fair value equals quoted market prices, if available. If a quoted market price is not readily available, as is the case for $8.9 million of Federal Reserve Bank stock at December 31, 1993, management believes that the assets carrying value approximates fair value. Loans The fair value of loans is estimated by discounting the expected future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. For short- term loans, defined as those maturing or repricing in 90 days or less, management believes the carrying amount is a reasonable estimate of fair value. Criticized loans are predominantly collateral-dependent; therefore, their carrying value net of related reserves is a reasonable estimate of fair value. Deposit Liabilities The fair value of demand deposit, savings and NOW accounts, and money market deposit accounts is the amount payable on demand at the reporting date. The fair value of investment and negotiable certificates of deposit, and foreign time deposits with a repricing or maturity date extending beyond 90 days is estimated using a discounted cash flow at the rates currently offered for deposits of similar remaining maturities. The value attributable to the Corporation's core deposits representing the relatively low-cost funding afforded by core depositor relationships has not been considered in the calculation of fair value of deposit liabilities. Short-Term Borrowings For those short-term liabilities defined as those repricing or maturing in 90 days or less, the carrying amount is a reasonable estimate of fair value. Long-Term Debt For the Corporation's long-term debt, fair values are based on dealer quotes. Commitments to Extend Credit, and Standby and Commercial Letters of Credit The fair value of loan commitments and letters of credit, both standby and commercial, is assumed to equal the carrying value, which is immaterial. Extensions of credit under these commitments, if exercised, would result in loans priced at market terms. Foreign Exchange Contracts The fair value of foreign exchange contracts represents the net asset or liability already recorded by the Corporation, since these contracts are revalued on a daily basis. Interest-Rate Agreements The fair value of interest-rate agreements is equal to the replacement value of the agreement. The replacement value is defined as the amount the Corporation would receive or pay to terminate the agreement at the reporting date, taking into account the current market rate of interest and the current creditworthiness of the swap counterparties. The estimated fair values of the Corporation's financial instruments are as follows: Changes in interest rates, assumptions or estimation methodologies may have a material effect on these estimated fair values. As a result, the Corporation's ability to actually realize these derived values cannot be assured. Management is concerned that reasonable comparability between financial institutions may not be likely because of the wide range of permitted valuation techniques and numerous estimates that must be made, given the absence of active secondary markets for many of the financial instruments. This lack of uniform valuation methodologies introduces a greater degree of subjectivity to these estimated fair values. In addition, the estimated fair values exclude non-financial assets, such as premises and equipment, and certain intangibles, such as core deposit premiums and customer relationships. Thus, the aggregate fair values presented do not represent the underlying value of the Corporation. NOTE 13. NONINTEREST INCOME AND EXPENSE - - -------------------------------------------------------------------------------- Noninterest Income Noninterest income in the consolidated statement of income includes the following components: Noninterest Expense Noninterest expense in the consolidated statements of income includes the following components: Noninterest expense for 1993 included restructuring expense of $34.6 million, of which $20.8 million related to Riggs AP. The Riggs AP charge consists of severance of $1.6 million, the writeoff of the foreign currency translation account associated with Riggs-Washington's investment in Riggs AP of $11.5 million and $7.7 million of other restructuring expenses. The $13.8 million of restructuring expense related to BankStart '93 consisted of $7.0 million in consulting fees, $4.0 million in severance related costs, $1.0 million of occupancy-related costs and $1.8 million of other costs. These costs represent management's best estimate of the total costs of the restructurings and were accrued during 1993. These estimates are evaluated by management on an ongoing basis and, as adjustments become known, will be revised accordingly. NOTE 14. INCOME TAXES - - -------------------------------------------------------------------------------- In February 1992, SFAS No. 109, "Accounting for Income Taxes" was issued. SFAS No. 109 establishes financial accounting and reporting standards for the effects of income taxes that result from the Corporation's activities during the current and preceding years. It requires an asset and liability approach in accounting for income taxes versus the deferred method previously used under Accounting Principles Board No. 11 ("APB No. 11"). Under SFAS No. 109, deferred income taxes are recorded using enacted tax laws and rates for the years in which taxes are expected to be paid. In addition, SFAS No. 109 provides for the recognition of deferred tax assets based on tax loss and tax credit carryforwards, to the extent that realization of such assets is more likely than not. Under APB No. 11 deferred tax assets were generally recognized only to the extent realization of such assets was assured beyond a reasonable doubt, which was generally demonstrated by the Corporation's ability to carry back tax losses or tax credits to recover taxes previously paid. The Corporation's net realizable deferred tax asset at December 31, 1992, under APB No. 11 was $10.1 million. The Corporation adopted SFAS No. 109 on January 1, 1993, and the effect of adoption was not material. Income tax provisions for 1992 and 1991 were determined under APB No. 11 and have not been restated to reflect adoption of SFAS No. 109. Income (loss) before income taxes relating to the operations of domestic offices (on shore) and foreign offices (off shore) was as follows: The current and deferred portions of the income tax provision (benefit), were as follows: * Restated to reflect reclassification of current and deferred taxes based upon actual timing differences determined upon filing of tax returns. Reconciliation of Statutory Tax Rates to Effective Tax Rates: The components of income tax liabilities (assets) that result from temporary differences in the recognition of revenue and expenses for income tax and financial reporting purposes at December 31, 1993, follow: Sources of Temporary Differences Resulting in Deferred Tax Liabilities (Assets): At December 31,1992, and 1993, the Corporation maintained a valuation allowance of approximately $42.2 million and $74.7 million, respectively, to reduce the net deferred tax asset to $10.1 million and $4.5 million, respectively. The net change in the valuation allowance for deferred tax assets during 1993 was an increase of $32.5 million. The change related to an additional $14.9 million of loss carryforwards generated in 1993, $12.0 million of additional unbenefited regular deferred assets, and a $5.6 million reduction in existing deferred tax assets resulting from changes in financial forecasts and a tax refund from a loss carryback. The deferred tax assets include, among other items, investment tax credit carryforwards for Federal income tax purposes of $0.8 million that are available to reduce future Federal income tax through 2004, $0.1 million in foreign tax credit carryforwards that are available to reduce future income tax through 1997, and alternative minimum tax credit carryforwards of $5.1 million that are available to reduce future Federal regular income taxes over an indefinite period. In addition, the deferred tax assets include the benefit of tax loss carryforwards for $22.5 million, detailed as follows: NOTE 15. COMMON AND PREFERRED STOCK - - -------------------------------------------------------------------------------- The Corporation is authorized to issue 50 million shares of Common Stock, par value $2.50 (the "Common Stock"). At December 31, 1993, the Corporation had 30,222,014 shares issued and outstanding. On October 21, 1993, the Corporation issued and sold 5,000,000 shares of Common Stock, at a price of $7.75 per share, in transactions exempt from the registration requirements of the Securities Act of 1933. The net proceeds from the sale of the Common Stock totaled approximately $37.0 million and will be used for general purposes, which may include the payment of debt service, the payment of dividends on preferred stock, investments in or extensions of credit to its subsidiaries, and for other working capital purposes. Pursuant to a rights offering that commenced on December 12, 1991, and expired on January 23, 1992, the Corporation sold 11,445,000 shares of Common Stock, representing all of the shares offered, at a subscription price of $4.375 per share. Net proceeds from the offering were $49.1 million. The Corporation is authorized to issue 25 million shares of Preferred Stock, the conditions of which will be set at the time of issuance. As of December 31, 1993, 4,764,537 shares of Preferred Stock were issued and outstanding. On October 21, 1993, the Corporation issued 4,000,000 shares of 10.75% Noncumulative Perpetual Preferred Stock, Series B ("Series B Preferred"), in transactions exempt from the registration requirements of the Securities Act of 1933. The Series B Preferred shares have a liquidation preference of $25 per share, no preemptive rights, no public market and are non-voting (subject to certain limited exceptions). The Series B Preferred is not redeemable prior to October 1, 1998, at which time, at the Corporation's option, it may redeem in whole or in part the Series B Preferred at prices ranging from $27.25 in October 1998 to $25.00 in October 2008 and thereafter, plus accrued but unpaid dividends. There is no mandatory redemption or sinking fund obligation associated with the Series B Preferred. Dividends are payable on February 1, May 1, August 1 and November 1 of each year and are noncumulative. The Board of Directors of the Corporation declared a dividend of $0.746528 per share, payable on February 1, 1994, to shareholders of record on January 17, 1994, which covers the initial dividend period commencing October 21, 1993, and ending January 31, 1994. The proceeds from the Series B Preferred, net of expenses, was $95.3 million. During the second quarter of 1992, the Corporation issued 764,537 shares of 7.5% Cumulative Convertible Preferred Stock, Series A ("Series A Preferred"), to Norwich Union Insurance Group, a major insurance company headquartered in Norwich, England. The Series A Preferred was issued in exchange for debt of Riggs AP Bank Ltd., the Corporation's indirectly owned United Kingdom banking subsidiary. The Series A Preferred have no preemptive rights and are non- voting, subject to certain limited exceptions. The Series A Preferred shares have a liquidation preference of $25 per share and are convertible at the holder's option into 2,002,141 shares of common stock, at $9.5465 per share. The Series A Preferred Shares are redeemable, in whole or in part, at the Corporation's option, beginning July 1, 1996, at $26.125 per share and declining to $25.00 per share after July 1, 2002, plus any accrued but unpaid dividends. There is no mandatory redemption or sinking fund obligation associated with the Series A Preferred. Dividends are payable on February 1, May 1, August 1, and November 1 of each year and are cumulative. There is currently no public market for the Series A Preferred. All dividends related to the Series A Preferred have been paid. NOTE 16. BENEFIT PLANS - - -------------------------------------------------------------------------------- PENSION PLANS Riggs National Corporation Under the Corporation's noncontributory defined benefit pension plan, benefits are normally based on years of service and the average of the highest base annual salary for a consecutive five-year period prior to retirement. Reconciliation of Funded Status and Prepaid Pension Cost The Corporation's funding policy is to contribute an amount at least equal to the minimum required contribution under the Employee Retirement Income Security Act. The assets of the Corporation's pension plan consist of an Immediate Participation Guarantee contract with a life insurance company and funds held in trust by the Corporation. The monies held in trust are invested primarily in fixed-income and equity pooled funds. Net Periodic Pension Cost Riggs AP Bank The Riggs AP pension plan provides monthly pension payments upon normal retirement at age 60 or upon later retirement to substantially all employees. Reduced pensions are available for early retirement or disability. The plan has a final-pay benefit formula that takes into account years of service. Reconciliation of Funded Status and Prepaid Pension Cost Riggs AP's annual pension costs are determined based on the Projected Unit Credit Cost Method with specific amortization schedules for the various categories of plan liabilities. Actuarial assumptions are selected based on guidelines established by the Financial Accounting Standards Board. Net Periodic Pension Cost Supplemental Executive Retirement Plan. Effective January 1, 1993, the Corporation adopted a Supplemental Executive Retirement plan to provide supplemental retirement income and preretirement death benefits to certain key employees of the Corporation and its subsidiaries at the level of senior vice president and above. The Compensation Committee of the Board of Directors has the authority to determine the amount of benefits to be paid upon the participant's retirement, termination of employment or death and the vesting schedule under which such benefits will be paid. Under parameters adopted by the Compensation Committee, the amount of benefits is based on the participant's corporate title, functional responsibility and service as a member of the Board of Directors. Upon the later of a participant's termination of employment or attainment of age 62, the participant will receive the vested portion of the supplemental retirement benefit, payable for life of the participant, but for no more than 15 years. In the case of the death of a participant while employed, the participant's beneficiary will receive the supplemental benefit for 15 years. --------------------------------------------- POSTRETIREMENT BENEFITS In addition to providing pension benefits, the Corporation and its subsidiaries provide certain health care and life insurance benefits for retired employees. Substantially all active employees may become eligible for benefits if they reach normal retirement age or if they retire earlier with at least ten years' service. Similar benefits for active employees are provided through an insurance company and several health maintenance organizations. The Corporation recognizes the cost of providing those benefits by expensing the annual insurance premiums, which were $6.6 million in 1993, $6.4 million in 1992 and $5.6 million in 1991. In December 1990, the Financial Accounting Standards Board issued SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." The Statement requires a significant change in the Corporation's historical practice of accounting for postretirement benefits on a pay-as-you-go (cash) basis by requiring accrual of the expected cost of benefits during the years that the employee renders the necessary service. The Statement is generally effective for fiscal years beginning after December 15, 1992, except that its application to plans outside the United States (such as Riggs AP Bank Ltd.'s plan) was delayed to fiscal years beginning after December 15, 1994. The Corporation implemented SFAS No. 106 on January 1, 1993, resulting in an accumulated transition obligation of $13.0 million, which the Corporation elected to recognize on a delayed basis over a 20-year period. The Corporation experienced an increase of approximately $1.5 million in 1993 for postretirement health and life insurance expenses due to the implementation of SFAS No. 106, which included $652 thousand relating to the amortization of the transition obligation. Three benefit plans are provided by the Corporation to retired employees: Medical and Hospitalization Insurance, Dental Insurance and Life Insurance. Medical and Hospitalization Insurance. Retirees are eligible for postretirement benefits if they have been employed by the Corporation for at least 10 years at the time of their retirement. Participants pay a portion of their premium. Participants are in two general categories of benefits. Retirees over the age of 65 participate in a "coordination of benefits"- style plan in which Medicare is their primary insurer and the plan pays the remainder of medical and hospitalization insurance up to prescribed coverage limits. Retirees under 65 are in one of two plans. They may continue to participate in HMO's if they participated in the HMO as an active employee. The majority of retirees participate in a "point-of-service" plan that offers participants health care through a network of affiliated providers at pre-negotiated prices to the plan and low HMO-style co-payments to the participants. The plan also allows participants to use a non-network-affiliated provider, but the participants must pay a deductible and receive only a partial reimbursement of their expenses. Dental Insurance. Retirees become eligible for dental insurance on the same schedule as medical and hospitalization. Participants pay a portion of their premium. There are two plan options from which participants may choose. The first option is an indemnity plan that offers partial reimbursement up to an annual limit. The second plan offers services through a network of affiliated providers; the participant is liable only for a small co-payment when using a network-affiliated provider. Life Insurance. Retirees receive a life insurance benefit equal to one-half of their last annual salary with the Corporation. The net periodic cost for postretirement health and life insurance benefits during 1993 included the following: The funding status of the postretirement plans and the amounts recognized in the Corporation's Statements of Financial Condition at December 31, 1993, follow: The assumed health care cost trend rate ranged from 8% to 12% for 1993, gradually decreasing to 6% by the year 2003 and remaining constant thereafter. A discount rate of 7.5% was used to determine the accumulated postretirement benefit obligation. Increasing the assumed health care cost trend rate by one percentage point would increase the accumulated postretirement benefit obligation at December 31, 1993, by $1.0 million, and increase the net periodic postretirement benefit cost for 1993 by $100 thousand. ---------------------------------------------------------------------------- 1993 STOCK OPTION PLAN On March 10, 1993, the Board of Directors of the Corporation adopted the "1993 Stock Option Plan" (the "Plan"), which was approved at the May 14, 1993, Annual Meeting of Shareholders. The Plan provides for the issuance of options to purchase shares of Common Stock of the Corporation. Key employees of the Corporation and certain subsidiaries may be granted either incentive or nonqualified stock options. Generally, the exercise price cannot be less than the fair market value of the Common Stock at the date of the grant. The aggregate number of shares of Common Stock reserved for issuance upon exercise of options granted under the Plan is 1,250,000. Unless previously terminated by the Board of Directors, the Plan will terminate on March 10, 2003. A summary of the stock option activity for 1993 follows: NOTE 17. FOREIGN ACTIVITIES - - -------------------------------------------------------------------------------- Foreign activities are those conducted with customers domiciled outside the United States, regardless of the location of the banking office. Foreign business activity is substantially integrated within the Corporation. As a result, it is not possible to definitively classify the business of most operating activities as entirely domestic or foreign. The Foreign Consolidated Statements of Condition shown below reflect the portion of the Corporation's consolidated statements of condition derived from transactions with customers who are domiciled outside the United States. /1/ Pool Funds Provided. Net are amounts contributed by foreign activities to fund domestic activities. /2/ Total foreign deposits in domestic offices totaled $395.4 million, $480.0 million and $520.4 million at December 31, 1993, 1992 and 1991, respectively. /3/ The majority of time deposits are in amounts of $100 thousand or more. The table to the right reflects changes in the reserve for loan losses on loans to customers domiciled outside the United States. Although this reserve is allocated to foreign operations, it is available to the entire loan portfolio. Allocations of the provision for loan losses are based upon actual charge-off experience and additional amounts deemed necessary in relation to risks inherent in the foreign loan portfolio. The table below reflects foreign assets by geographical location for the last three years and selected categories of the Consolidated Statements of Income. Loans made to, or deposits placed with, a branch of a foreign bank located outside the foreign bank's home country are considered as loans to, or deposits with, the foreign bank. To measure profitability of foreign activity, the Corporation has established a funds pricing system for units that are users or providers of funds. Noninterest income and expense allocations are based on earning assets and interest-bearing liabilities identified with each geographical area. Foreign Reserve for Loan Losses Geographical Performance * Total foreign assets at December 31, 1993, 1992 and 1991, exclude net pool funds contributed by foreign activities to fund domestic activities. NOTE 18. PARENT CORPORATION FINANCIAL STATEMENTS - - -------------------------------------------------------------------------------- Statements of Income * Applicable income taxes are provided for based on parent corporation income only and do not reflect the tax expense or benefit of the subsidiaries' operations. Statements of Condition Statements of Cash Flows Report of Independent Public Accountants To Riggs National Corporation: We have audited the accompanying consolidated statements of condition of RIGGS NATIONAL CORPORATION (a Delaware corporation) and its subsidiaries as of December 31, 1993, and 1992, and the related consolidated statements of income, changes in stockholders' equity and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of Riggs National Corporation's management. Our responsibility is to express an opinion on these financial statements based on our audits. We did not audit the financial statements of Riggs AP Bank Limited (an indirect, wholly owned subsidiary), which statements reflect total assets of 10.3% and 17.4%, and total interest income of 20.7% and 24.5% of the related consolidated totals for 1992 and 1991, respectively. Those statements were audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to the amounts included for Riggs AP Bank Limited, is based solely on the report of the other auditors. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform an audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits and the report of other auditors provide a reasonable basis for our opinion. In our opinion, based on our audits and the report of other auditors, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Riggs National Corporation and its subsidiaries as of December 31, 1993, and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. /s/ Arthur Andersen & Co. Washington, D.C., January 31, 1994 Supplemental Financial Data QUARTERLY FINANCIAL INFORMATION CONSOLIDATED FINANCIAL RATIOS AND OTHER INFORMATION QUARTERLY STOCK INFORMATION * * The high and low information listed above represents high and low sales prices as reported on the NASDAQ National Market System. THREE-YEAR FOREIGN AVERAGE CONSOLIDATED STATEMENTS OF CONDITION AND RATES * Pool Funds Provided, Net are amounts contributed by foreign activities to fund domestic activities. Foreign Net Interest Income Changes* * The dollar amount of changes in interest income and interest expense attributable to changes in rate/volume (change in rate multiplied by change in volume) has been allocated between rate and volume variances based on the percentage relationship of such variances to each other. 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 required by this Item pertaining to directors of the Corporation is included in the Corporation's proxy statement for its 1994 Annual Meeting of Stockholders. The information required by this Item pertaining to executive officers of the Corporation is as follows: * Executive officers of Riggs National Corporation, including certain executive officers of Riggs-Washington, as of March 9, 1994. Experience of Management Joe L. Allbritton has been Chairman of the Board and Chief Executive Officer of the Corporation since 1981. He has served as Chairman of the Board of Riggs- Washington since 1983 and was the Chief Executive Officer of Riggs-Washington from 1982 to June 1993. Mr. Allbritton was the beneficial owner of approximately 33% of the Common Stock of the Corporation as of March 31, 1994. He also serves as Chairman of the Board of, and is the owner of, Perpetual Corporation, Westfield News Advertiser, Inc. and University Bancshares. Paul M. Homan was appointed President and Chief Executive Officer of Riggs- Washington and Vice Chairman of the Corporation in June 1993. Mr. Homan served as president and chief execuive officer of First Florida Banks, Inc. of Tampa from August 1991 through December 1992 before returning to serve as principal of Homan & Associates, a bank consulting firm which he founded in 1987. Mr. Homan served as senior adviser to the Comptroller of the Currency in 1990 and 1991, as executive vice president of Continental Bank Corporation from 1985 to 1987 and as chairman and chief executive officer of Nevada National Bank from 1983 to 1985. Mr. Homan also worked at the OCC from 1966 to 1983, rising to the position of senior deputy controller for bank supervision, the OCC's top career position. Timothy C. Coughlin has served as President of the Corporation since 1992. He served as President and Chief Operating Officer of the Riggs-Washington from 1983 to 1992. He has been a Director of the Corporation since 1988 and a Director of Riggs-Washington since 1983. John L. Davis joined the Corporation in June 1993 and is Chief Financial Officer of the Corporation and Senior Vice President and Chief Financial Officer of Riggs-Washington. Mr. Davis served as Senior Vice President and Controller of First Florida Bank, N.A. from 1990 to 1992 and as Senior Vice President and Chief Financial Officer of First Union National Bank of Georgia from 1987 to 1990. David Lesser has served as General Counsel of the Corporation and Executive Vice President and General Counsel of Riggs-Washington since 1987. Alexander C. Baker has served as Secretary of the Corporation and as Secretary of Riggs-Washington since 1992 and as Senior Vice President and Trust Officer of Riggs-Washington since 1987. Randall R. Reeves has served as Senior Executive Vice President and Chief Credit Officer of Riggs-Washington since 1991. Mr. Reeves was President and Chief Executive Officer of University Bancshares, Inc. from 1985 to 1992. Joseph W. Barr joined Riggs-Washington as Executive Vice President in charge of Retail Banking in June 1993. He served as Executive Vice President in charge of Retail Banking at First American Metro Corp. from 1992 to June 1993 and as Executive Vice President in charge of Community Banking at Perpetual Savings Bank, F.S.B. from 1989 to 1992. Fred L. Bollerer joined Riggs-Washington as Executive Vice President in charge of the General Banking Group in October 1993. During 1988 and 1989, Mr. Bollerer was the President and Chief Operating Officer of First American, N.A. of Washington, D.C. From 1989 to 1993, Mr. Bollerer was the Chairman and Chief Executive Officer of First American Metro Corp. Paul Cushman, III has served as Executive Vice President of Riggs-Washington in charge of the International Banking Group since 1992. He was Senior Vice President of Riggs-Washington from 1989 to 1992 and Vice President of Riggs- Washington from 1987 to 1989. George W. Grosz has served as Executive Vice President of Riggs-Washington in charge of Financial Services Group, which includes the Trust and Investment Department and the Private Banking Division, since 1987. He was a Director of Riggs-Washington from 1989 to 1993. Gloria A. Lembo has served as Executive Vice President in charge of Technology Services Group of Riggs-Washington since August 1993. She has been a Senior Vice President since 1988 with various responsibilities for Deposit Operations, Corporate Operations, Commercial Real Estate Operations and Loan Operations. S. Dean Lesiak joined the Corporation in July 1993 as Executive Vice President of Riggs-Washington in charge of Risk Management. He served as Chief Compliance Officer of First Florida Banks, Inc. from 1992 to 1993 and also as Senior Vice President--Senior Credit Policy Officer of First Florida Banks, Inc. from 1988 to 1991. Mr. Lesiak also served as a National Bank Examiner at the OCC for over ten years. ITEM 11.	ITEM 11. EXECUTIVE COMPENSATION The information required by this Item is included in Riggs National Corporation's definitive Proxy Statement to Stockholders, which is incorporated by reference, except for Items 402 (k) and (l) of Regulation S-K. ITEM 12.	ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this Item is included in Riggs National Corporation's definitive Proxy Statement to Stockholders, which is incorporated by reference, except for Items 402 (k) and (l) of Regulation S-K. ITEM 13.	ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this Item is included in Note 6 to the Financial Statements of this Form 10-K and in Riggs National Corporation's definitive Proxy Statement to Stockholders, which is incorporated by reference, except for Items 402 (k) and (l) of Regulation S-K. PART IV ITEM 14.	ITEM 14. EXHIBITS, FINANICAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K 14(b) Reports on Form 8-K On October 27, 1993, the Corporation filed a Form 8-K related to the sale of Series B Preferred and Common Stock completed on October 21, 1993. On December 21, 1993, the Corporation filed a Form 8-K related to the effective date of a previously filed shelf registration statement covering the sale of Series B Preferred and Common Stock. 14(c) Exhibits The exhibits listed on the Index to Exhibits on Pages 74 through 75 hereof are incorporated by reference or filed herewith in response to this item. Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. RIGGS NATIONAL CORPORATION /s/ JOE L. ALLBRITTON - - ------------------------------- Joe L. Allbritton, Chairman of the Board and Chief Executive Officer March 31, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. /s/ PAUL M. HOMAN Vice Chairman of the Board - - ------------------------------- Paul M. Homan /s/ TIMOTHY C. COUGHLIN President - - ------------------------------- Timothy C. Coughlin /s/ JOHN L. DAVIS Chief Financial Officer - - ------------------------------- (Principal Financial John L. Davis and Accounting Officer) /s/ BARBARA B. ALLBRITTON* Director - - ------------------------------- (Barbara B. Allbritton) Director - - ------------------------------- (Norman R. Augustine) /s/ CALVIN CAFRITZ* Director - - ------------------------------- (Calvin Cafritz) /s/ CHARLES A. CAMALIER, III* Director - - ------------------------------- (Charles A. Camalier, III) /s/ RONALD E. CUNEO* Director - - ------------------------------- (Ronald E. Cuneo) /s/ FLOYD E. DAVIS, III* Director - - ------------------------------- (Floyd E. Davis, III) /s/ JACQUELINE C. DUCHANGE* Director - - ------------------------------- (Jacqueline C. Duchange) /s/ MICHELA A. ENGLISH* Director - - ------------------------------- (Michela A. English) /s/ DR. JAMES E. FITZGERALD* Director - - ------------------------------- (Dr. James E. Fitzgerald) Director - - ------------------------------- (David J. Gladstone) /s/ LAWRENCE I. HEBERT* Director - - ------------------------------- (Lawrence I. Hebert) /s/ MICHAEL J. JACKSON* Director - - ------------------------------- (Michael J. Jackson) /s/ LEO J. O'DONOVAN, S.J.* Director - - ------------------------------- (Leo J. O'Donovan, S.J.) /s/ STEPHEN B. PFEIFFER* Director - - ------------------------------- (Stephen B. Pfeiffer) Director - - ------------------------------- (John A. Sargent) /s/ JAMES R. SCHLESINGER* Director - - ------------------------------- (James R. Schlesinger) /s/ ROBERT L. SLOAN* Director - - ------------------------------- (Robert L. Sloan) /s/ JAMES W. SYMINGTON* Director - - ------------------------------- (James W. Symington) Director - - ------------------------------- (Jack Valenti) /s/ EDDIE N. WILLIAMS* Director - - ------------------------------- (Eddie N. Williams) *By: /s/ ALEXANDER C. BAKER - - ------------------------------- Alexander C. Baker, Attorney-in-fact MARCH 31,1994 INDEX TO EXHIBITS Portions of Riggs National Corporation's definitive Proxy Statement to Stockholders, except for Items 402(k) and (l) of Regulations S-K are incorporated by reference in Parts I and III of this Annual Report.
3673_1993.txt	3673	1993	ITEM 1. BUSINESS Allegheny Power System, Inc. (APS), incorporated in Maryland in 1925, is an electric utility holding company that derives substantially all of its income from the electric utility operations of its direct and indirect subsidiaries (Subsidiaries), Monongahela Power Company (Monongahela), The Potomac Edison Company (Potomac Edison), West Penn Power Company (West Penn), and Allegheny Generating Company (AGC). The properties of the Subsidiaries are located in Maryland, Ohio, Pennsylvania, Virginia, and West Virginia, are interconnected, and are operated as a single integrated electric utility system (System), which is interconnected with all neighboring utility systems. The three electric utility operating Subsidiaries are Monongahela, Potomac Edison, and West Penn (Operating Subsidiaries). Monongahela, incorporated in Ohio in 1924, operates in northern West Virginia and an adjacent portion of Ohio. It also owns generating capacity in Pennsylvania. Monongahela serves about 340,700 customers in a service area of about 11,900 square miles with a population of about 710,000. The seven largest communities served have populations ranging from 10,900 to 33,900. On December 31, 1993, Monongahela had 1,962 employees. Its service area has navigable waterways and substantial deposits of bituminous coal, glass sand, natural gas, rock salt, and other natural resources. Its service area's principal industries produce coal, chemicals, iron and steel, fabricated products, wood products, and glass. There are two municipal electric distribution systems and two rural electric cooperative associations in its service area. Except for one of the cooperatives, they purchase all of their power from Monongahela. Potomac Edison, incorporated in Maryland in 1923 and in Virginia in 1974, operates in portions of Maryland, Virginia, and West Virginia. It also owns generating capacity in Pennsylvania. Potomac Edison serves about 354,300 customers in a service area of about 7,300 square miles with a population of about 782,000. The six largest communities served have populations ranging from 11,900 to 40,100. On December 31, 1993, Potomac Edison had 1,152 employees. Its service area is generally rural. Its service area's principal industries produce aluminum, cement, fabricated products, rubber products, sand, stone, and gravel. There are four municipal electric distribution systems in its service area, all of which purchase power from Potomac Edison, and six rural electric cooperatives, one of which purchases power from Potomac Edison. There are also several large federal government installations served by Potomac Edison. - 2 - West Penn, incorporated in Pennsylvania in 1916, operates in southwestern and north and south central Pennsylvania. It also owns generating capacity in West Virginia. West Penn serves about 646,700 customers in a service area of about 9,900 square miles with a population of about 1,399,000. The 10 largest communities served have populations ranging from 11,200 to 38,900. On December 31, 1993, West Penn had 2,043 employees. Its service area has navigable waterways and substantial deposits of bituminous coal, limestone, and other natural resources. Its service area's principal industries produce steel, coal, fabricated products, and glass. There are two municipal electric distribution systems in its service area, which purchase their power requirements from West Penn, and five rural electric cooperative associations, located partly within the area, which purchase virtually all of their power through a pool supplied by West Penn and other nonaffiliated utilities. AGC, organized in 1981 under the laws of Virginia, is jointly owned by the Operating Subsidiaries as follows: Monongahela, 27%; Potomac Edison, 28%; and West Penn, 45%. AGC has no employees, and its only operating assets are a 40% undivided interest in the Bath County (Virginia) pumped- storage hydroelectric station, which was placed in commercial operation in December 1985, and its connecting transmission facilities. AGC's 840-megawatt (MW) share of capacity of the station is sold to its three parents. The remaining 60% interest in the Bath County Station is owned by Virginia Electric and Power Company (Virginia Power). APS has no employees. Its officers are employed by Allegheny Power Service Corporation (APSC), a wholly-owned subsidiary of APS. On December 31, 1993, the Subsidiaries and APSC had 6,025 employees. The Subsidiaries in the past have experienced and in the future may experience some of the more significant problems common to electric utilities in general. These include increases in operating and other expenses, difficulties in obtaining adequate and timely rate relief, restrictions on construction and operation of facilities due to regulatory requirements and environmental and health considerations, including the requirements of the Clean Air Act Amendments of 1990 (CAAA), which among other things, require a substantial annual reduction in utility emissions of sulfur dioxides and nitrogen oxides. Additional concerns include proposals to restructure and, to some extent, deregulate portions of the industry and increase competition, particularly as a result of the National Energy Policy Act of 1992 (EPACT). EPACT may increase competition by allowing the formation of Exempt Wholesale Generators (EWGs), with the approval of the FERC, and providing mandatory access to the interconnected electric grid for wholesale transactions. It further provides for expansion of the grid where constraints are determined to exist - at the expense of the requestor of such transmission service and provided necessary authority to construct such facilities can be obtained. EPACT permits utility generation facilities to qualify as EWGs and allows sales to nonaffiliated and to affiliated utilities provided state commissions approve such transactions. (See ITEM 1. SALES, ELECTRIC FACILITIES and REGULATION for a further discussion of the impact of EPACT.) - 3 - In an effort to meet the challenges of the new competitive environment in the industry, APS is considering forming a new nonutility subsidiary, subject to regulatory approval, to pursue new business opportunities which have a meaningful relationship to the core utility business. APS would also consider establishing or acquiring its own EWGs, if that is feasible, particularly in view of the possible constraints imposed by regulations under the Public Utility Holding Company Act of 1935 (PUHCA) on nonexempt public utility holding companies such as APS and its Subsidiaries. Further concerns of the industry include possible restrictions on carbon dioxide emissions, uncertainties in demand due to economic conditions, energy conservation, market competition, weather, and interruptions in fuel supply because of weather and strikes. (See ITEM 1. CONSTRUCTION AND FINANCING, RATE MATTERS, and ENVIRONMENTAL MATTERS for information concerning the effect on the Subsidiaries of the CAAA.) SALES In 1993, consolidated kilowatthour (kWh) sales to the Operating Subsidiaries' retail customers increased 3.3% from those of 1992, as a result of increases of 6.5%, 5.2% and 0.3% in residential, commercial and industrial sales, respectively. The increased Kwh sales in 1993 reflect both growth in number of customers and higher use. Consolidated revenues from residential, commercial, and industrial sales increased 11.4%, 9.8%, and 5.6%, respectively, primarily because of several rate increases effective in 1993 as described in ITEM 1. RATE MATTERS, increases in fuel and energy cost adjustment clause revenues, and increased kWh sales. Consolidated kWh sales to and revenues from nonaffiliated utilities decreased 30.2% and 25.5%, respectively, due to increased native load, decreased demand, and price competition. The System's all-time peak load of 7,153 MW occurred on January 18, 1994. The peak loads in 1993 and 1992 were 6,678 MW and 6,530 MW, respectively. The increased 1994 peak was due in part to record cold temperatures throughout the Operating Subsidiaries' service areas and would have been higher except for voluntary curtailments. The average System load (Yearly Net Power Supply divided by number of hours in the year) was 4,674 megawatthours (MWh) and 4,526 MWh in 1993 and 1992, respectively. More information concerning sales may be found in the statistical sections and ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Consolidated electric operating revenues for 1993 were derived as follows: Pennsylvania, 44.8%; West Virginia, 28.4%; Maryland, 20.2%; Virginia, 5.0%; Ohio, 1.6% (residential, 35.1%; commercial, 18.4%; industrial, 28.9%; nonaffiliated utilities, 14.9%; and other, 2.7%). The following percentages of such revenues were derived from these industries: iron and steel, 6.0%; chemicals, 3.3%; fabricated products, 3.3%; aluminum and other nonferrous metals, 3.2%; coal mines, 3.1%; cement, 1.8%; and all other industries, 8.2%. The coal mine percentage decreased in 1993 principally due to the coal strike. More information concerning the coal strike may be found in ITEM 1. FUEL SUPPLY. Revenues from each of 16 industrial customers exceeded $5 million, including one coal customer of both Monongahela and West Penn with total revenues exceeding $15 million, three steel customers with revenues exceeding $26 million each, and one aluminum customer with revenues exceeding $63 million. - 4 - During 1993, Monongahela's kWh sales to retail customers increased 0.3% as a result of increases of 6.4% and 4.7% in residential and commercial sales, respectively, and a decrease of 4.4% in industrial sales, primarily due to the coal strike and lower sales to one iron and steel customer because of increased use of its own generation. Revenues from such customers increased 9.2%, 7.8% and 0.7%, respectively, and revenues from kWh sales to affiliated and nonaffiliated utilities decreased 7.8%. Monongahela's all- time peak load of 1,667 MW occurred on December 21, 1989. (For a discussion of the coal strike, See ITEM 1. FUEL SUPPLY.) Monongahela's electric operating revenues were derived as follows: West Virginia, 94.0% and Ohio, 6.0% (residential, 28.8%; commercial, 17.3%; industrial, 29.2%; nonaffiliated utilities, 13.4 %; and other, 11.3%). Revenues from each of five industrial customers exceeded $8 million, including one coal customer with revenues exceeding $13 million and one steel customer with revenues exceeding $26 million. The decreases in the revenues of these customers from 1992 levels were primarily due to the coal strike. During 1993, Potomac Edison's kWh sales to retail customers increased 6.3% as a result of increases of 8.4%, 7.1%, and 4.3% in residential, commercial, and industrial sales, respectively. Revenues from such customers increased 12.7%, 11.8%, and 11.8%, respectively, and revenues from kWh sales to affiliated and nonaffiliated utilities decreased 23.1%. Potomac Edison's all-time peak load of 2,595 MW occurred on January 19, 1994. Potomac Edison's electric operating revenues were derived as follows: Maryland, 66.6%; West Virginia, 16.8%; and Virginia 16.6% (residential, 38.5%; commercial, 17.5%; industrial, 24.7%; nonaffiliated utilities, 15.2%; and other, 4.1%). Revenues from one industrial customer, the Eastalco aluminum reduction plant near Frederick, Maryland, amounted to $63.4 million (8.9% of total electric operating revenues). Minimum annual charges to Eastalco under an electric service agreement which continues through March 31, 2000, with automatic extensions thereafter unless terminated on notice by either party, were $19.3 million in 1993. Said agreement may be canceled before the year 2000 upon 90 days notice of a governmental decision resulting in a material modification of the agreement. During 1993, West Penn's kWh sales to retail customers increased 3.1% as a result of increases of 5.2%, 4.4% and 0.8% in residential, commercial, and industrial sales, respectively. Revenues from residential, commercial, and industrial customers increased 11.5%, 9.6%, and 5.4%, respectively, and revenues from kWh sales to affiliated and nonaffiliated utilities decreased 24.3%. West Penn's all- time peak load of 3,068 MW occurred on January 18, 1994. - 5 - West Penn's electric operating revenues were derived as follows: Pennsylvania, 100% (residential, 33.1%; commercial, 18.0%; industrial, 28.5%; nonaffiliated utilities, 14.1%; and other, 6.3%). Revenues from each of three steel customers exceeded $10 million, including two with revenues exceeding $31 million each. On average, the Operating Subsidiaries are the lowest or among the lowest cost producers of electricity in their regions and therefore the Operating Subsidiaries' delivered power prices should compete favorably with those of potential alternate suppliers who use cost-based pricing. However, the Operating Subsidiaries are experiencing cost increases due to compliance with the CAAA and purchases from Public Utility Regulatory Policies Act of 1978 (PURPA) projects. (See page 7 for a discussion of PURPA projects, and ITEM 3. LEGAL PROCEEDINGS for a description of litigation and regulatory proceedings concerning PURPA capacity.) In 1993, the Operating Subsidiaries provided approximately 13.3 billion kWh of energy to nonaffiliated utility companies, of which 1.5 billion kWh were generated by the Subsidiaries and the rest were transmitted from electric systems located primarily to the west. These sales included a long-term transaction under which the Operating Subsidiaries purchased 450 MW of firm capacity and its associated energy from Ohio Edison Company for resale to Potomac Electric Power Company, both nonaffiliated utilities. The transaction began in mid-1987 and will continue through 2005, unless terminated earlier. Sales to nonaffiliated utility companies vary with the needs of those companies for imported power; the availability of System generating facilities, fuel, and regional transmission facilities; and the availability and price of competitive sources of power. System sales decreased in 1993 relative to 1992 primarily because of continued decreased demand, increased Operating Subsidiaries' native load, coal conservation because of the coal strike, and increased willingness of other suppliers to make sales at lower prices. Further decreases in kWh sales to nonaffiliated utilities are expected in 1994 and beyond. Substantially all of the revenues from kWh sales to nonaffiliated utilities are passed on to retail customers and as a result have little effect on net income. The Operating Subsidiaries reactivated a peak diversity exchange arrangement with Virginia Power effective June 1993 which continues indefinitely. The Operating Subsidiaries will annually supply Virginia Power with 200 MW during each June, July, and August, in return for which Virginia Power will supply the Operating Subsidiaries with 200 MW during each December, January, and February, at least through February 1997. Thereafter, specific amounts of annual diversity exchanges beyond those currently established are to be mutually determined no less than 34 months prior to each year for which an exchange is to take place. The total number of MWh to be delivered by each to the other over the term of the arrangement is expected to be equal. - 6 - The Operating Subsidiaries and Duquesne Light Company (Duquesne Light) in 1991 entered into an exchange arrangement under which the Operating Subsidiaries will supply Duquesne Light with up to 200 MW for a specified number of weeks, generally during each March, April, May, September, October, and November. In return, Duquesne Light will supply the Operating Subsidiaries with up to 100 MW, generally during each December, January, and February. The total number of MWh delivered by each utility to the other over the term of the arrangement is expected to be the same. West Penn supplies power to the Borough of Tarentum (Tarentum) using in part leased distribution facilities from Tarentum under a 30 year lease agreement terminating in 1996. In June 1993, Tarentum, which in that year had a load of 6.5 MW and revenues of $1.8 million, notified West Penn of its intention to exercise its option to end the lease agreement. The termination of the lease agreement and resulting transfer and sale of electric facilities will result in Tarentum becoming a municipal customer which will purchase electricity on a wholesale basis from West Penn or another supplier. The sale of electric facilities will require Pennsylvania Public Utility Commission approval. The System provides wholesale transmission services to applicants under its Federal Energy Regulatory Commission (FERC) approved Standard Transmission Service tariff. The tariff provides that such service is subordinate in priority to native load and reliability requirements of interconnected systems to avoid adverse effects on regional reliability in general and on the reliability of the Operating Subsidiaries' service to their retail and full- requirements wholesale customers in particular. (See ITEM 1. ELECTRIC FACILITIES for a discussion of stress on the System's transmission system.) Transmission services requiring special arrangements or long-term commitments have been and continue to be negotiated through mutually acceptable bilateral agreements. Substantially all of the revenues from transmission service sales are passed on to retail customers and as a result have little effect on net income. EPACT permits wholesale generators, utility-owned and otherwise, and wholesale consumers to request from System and other owners of bulk power transmission facilities a commitment to supply transmission services. Generators include nonaffiliated utilities and nonutility generators (NUG) of electricity (including classifications of generators known as Independent Power Producers (IPP) and EWGs). Consumers of wholesale power include qualifying nonaffiliated utilities or groups of utilities including the many small electric systems owned by municipalities and rural electric cooperative associations in the service areas of the Operating Subsidiaries. Many of these small systems currently purchase substantially all of their power from the Operating Subsidiaries. Under EPACT, these small systems may now seek an order from the FERC to force the Operating Subsidiaries to wheel power over the System to them from sources outside the System service area. All of the small electric wholesale customers in the Operating Subsidiaries' service areas which might avail themselves of this opportunity produced $42 million of total revenues in 1993. - 7 - Under PURPA, certain municipalities and private developers have installed, are installing or are proposing to install hydroelectric and other generating facilities at various locations in or near the Operating Subsidiaries' service areas with the intent of selling some or all of the electric capacity and energy to the Operating Subsidiaries at rates provided under PURPA and approved by appropriate state commissions. The System's total generation capacity includes 292 MW of on-line PURPA capacity. Payments for PURPA capacity and energy in 1993 totaled approximately $105 million at an average cost to the System of 5.04 cents per kWh. The System projects an additional 180 MW of PURPA capacity to come on-line in future years. In addition, lapsed purchase agreements totaling 203 MW and other PURPA complaints totaling 520 MW (none of which are included in the System's integrated resource plan as of August 20, 1993), are the subject of pending litigation. (See ITEM 3. LEGAL PROCEEDINGS for a description of litigation and regulatory proceedings in Pennsylvania, Maryland, and West Virginia affecting PURPA capacity.) In the future, ratings of the Operating Subsidiaries' first mortgage bonds and preferred stock may be affected by increased concern of rating agencies that purchased power contracts are a risk factor deserving consideration in assessing the credit- worthiness of electric utilities. ELECTRIC FACILITIES The following table shows the System's December 31, 1993, generating capacity, based on the maximum monthly normal seasonal operating capacity of each unit. The System-owned capacity totaled 7,991 MW, of which 7,089 MW (88.7%) are coal-fired, 840 MW (10.5%) are pumped-storage, and 62 MW (0.8%) are hydroelectric. The term "pumped-storage" refers to the Bath County station which stores energy for use principally during peak load hours by pumping water from a lower to an upper reservoir, using the most economic available electricity, generally during off-peak hours. During the generating cycle, power is produced by water falling from the upper to the lower reservoir through turbine generators. The average age of the System-owned coal-fired stations shown below, based on generating capacity at December 31, 1993, was about 23.6 years. In 1993, their average heat rate was 10,020 Btu's/kWh, and their availability factor was 87.0%. - 8 - - 9 - (a) Excludes 361 MW of West Penn oil-fired capacity, which was placed on cold reserve status as of June 1, 1983. Current plans call for the reactivation of these units within the next five years. (b) Where more than one year is listed as a commencement date for a particular source, the dates refer to the years in which operations commenced for the different units at that source. (c) The installation of flue-gas desulfurization equipment (See ITEM 1. ENVIRONMENTAL MATTERS) is expected to reduce the net generating capacity of each unit by about 3%. (d) Capacity entitlement through percentage ownership of AGC. (e) The FERC issued an annual license to West Penn for Lake Lynn for 1994. A relicensing application has been filed with the FERC for Lake Lynn and a license with a 30 to 50 year term is expected to be issued in late 1994. Potomac Edison's license for hydroelectric facilities, Dam #4 and Dam #5 will expire in 2003. Potomac Edison has received 30 year licenses, effective January 1994, for the Shenandoah, Warren, Luray and Newport projects. (f) Nonutility generating capacity available through contractual arrangements pursuant to PURPA. - 10 - SYSTEM MAP The Allegheny Power System Map (System Map), which has been omitted, provides a broad illustration of the names and approximate locations of the System's major generation and transmission facilities, both existing and under construction, in a five state region which includes portions of Pennsylvania, Ohio, West Virginia, Maryland and Virginia. Additionally, Extra High Voltage substations are displayed. By use of shading, the System Map also provides a general representation of the service areas of Monongahela (portions of West Virginia and Ohio), Potomac Edison (portions of Maryland, Virginia and West Virginia), and West Penn (portions of Pennsylvania). Power Stations shown on the System Map which appear within the Monongahela service area are Willow Island, Pleasants, Harrison, Rivesville, Albright, and Fort Martin. The single Power Station appearing within the Potomac Edison service area is R. Paul Smith. The Bath County Power Station appears on the map just south of the westernmost portion of Potomac Edison's service area formed by the borders of Virginia and West Virginia. Power Stations appearing within the West Penn service area are Armstrong, Mitchell, Hatfield's Ferry, Springdale and Lake Lynn. The System Map also depicts transmission facilities which are (i) owned solely by the Operating Subsidiaries; (ii) owned by the Operating Subsidiaries in conjunction with other utilities; or (iii) owned solely by other utilities. The transmission facilities portrayed range in capacity from 138kV to 765kV. Additionally, interconnections with other utilities are displayed. - 11 - The following table sets forth the existing miles of tower and pole transmission and distribution lines and the number of substations of the Subsidiaries as of December 31, 1993: (a) The System has a total of 5,203 miles of underground distribution lines. (b) The substations have an aggregate transformer capacity of 37,512,771 kilovoltamperes. (c) Total Bath County transmission lines, of which AGC owns an undivided 40% interest and Virginia Power owns the remainder. The System has 11 extra-high-voltage (345 kV and above) (EHV) and 29 lower-voltage interconnections with neighboring utility systems. The interregional EHV transmission system, including System facilities, continues to experience periods of heavy loading in a west-to-east direction. Increases in customer load, power transfers by the Subsidiaries and by nonaffiliated entities, and parallel flows caused by transactions to which the Operating Subsidiaries are not a party, all contribute to the heavy west-to-east power flows. In late 1992 and early 1993, a substantial amount of reactive power sources (shunt capacitors) were added to neighboring eastern utilities' EHV systems. These capacitors complement the capacitors added in 1991 and 1992 on the System and together they serve to increase transfer capability by improving voltage on the transmission system during heavy loading periods. While the additional capacitors installed by the Subsidiaries' eastern neighbors have enhanced transfer capability, the interregional transmission facilities are still expected periodically to operate up to their reliability limits; therefore, restrictions on transfers may still be necessary at times as was the case in recent years. Under certain provisions of EPACT, wholesale generators, utility-owned or otherwise, may seek from System and other owners of bulk power transmission facilities a commitment to supply power transmission services, so long as the FERC finds reliability and native load and existing contractual customers are not adversely affected (See discussion under ITEM 1. SALES and REGULATION). Such demand on the System for transmission service may add periodically to heavy power flows on the System's facilities. - 12 - The Operating Subsidiaries have, to date, provided managed contractual access to the System's transmission facilities via the provisions of their Standard Transmission Service tariff, or the terms and conditions of bilateral contracts with purchasers of transmission service. As a result of EPACT, the FERC is investigating the continued desirability of traditional methods of pricing and providing transmission service. The FERC may choose to maintain existing methods, implement new methodologies which the Operating Subsidiaries and their ratepayers may or may not find to be beneficial, or a combination thereof. The Operating Subsidiaries are participating fully in the FERC proceedings with the principal intent of safeguarding the reliability of the System's transmission facilities, and the rights and interests of its native load customers. The outcome of those deliberations cannot be predicted. RESEARCH AND DEVELOPMENT The Operating Subsidiaries spent $4.6 million, $2.7 million, and $2.8 million in 1993, 1992, and 1991, respectively, for research programs. Of these amounts, $3.2 million and $0.6 million were for Electric Power Research Institute (EPRI) dues in 1993 and 1992, respectively. The Operating Subsidiaries plan to spend approximately $7.5 million for research in 1994, with EPRI dues representing $5.9 million of that total. The Operating Subsidiaries joined EPRI, an industry- sponsored research and development institution, effective October 1, 1992, contingent upon the approval by state commissions of recovery of the dues in rates, which approval was subsequently received in all jurisdictions except Ohio and West Virginia, where the matter is pending. Ongoing participation in EPRI depends upon continued approval by state commissions of recovery of dues in rates. Dues are based on a three-year, new-member ramping formula. Independent research conducted by the Operating Subsidiaries in 1993, which will be completed or continued in 1994, concentrated on environmental protection, generating unit performance, future generating technologies, delivery systems, and customer-related research. Two U.S. Department of Energy Clean Coal Technology nitrogen oxide control projects, which the Operating Subsidiaries cofounded, have recently been completed. Based upon the results of one of the projects, retrofitting of low nitrogen oxide cell burners at the Hatfield's Ferry Power Station units has been undertaken at much lower costs than would otherwise have been required. - 13 - Research is also being directed to help address major issues facing the Operating Subsidiaries including electric and magnetic field (EMF) risk, waste disposal, greenhouse gas, client-server information system prospects, renewable resources, fuel cells, new combustion turbines and other cogeneration technologies. In addition, evaluation of technical proposals for business opportunities is also ongoing. EMF research includes monitoring work done by EPRI, Department of Energy (DOE), the Environmental Protection Agency (EPA) and other government researchers. It also includes monitoring literature, law and litigation, and standards as developed. This research enables the Operating Subsidiaries to evaluate any potential health risks to employees and customers which may exist. Research activities related to alleged global climate change include monitoring government activity, studying possible joint implementation activities in connection with the Clinton Climate Change Action Plan, and studying demand- side management, electro- technologies and possible joint implementation plans. The Operating Subsidiaries also made research grants to regional colleges and universities to encourage the development of technical resources related to current and future utility problems. CONSTRUCTION AND FINANCING Construction expenditures by the Subsidiaries in 1993 amounted to $574 million and for 1994 and 1995 are expected to aggregate $500 million and $400 million, respectively. In 1993, these expenditures included $240 million for compliance with the CAAA. The 1994 and 1995 estimated expenditures include $161 million and $53 million, respectively, to cover the costs of compliance with the CAAA. (See ITEM 1. ENVIRONMENTAL MATTERS.) Allowance for funds used during construction (AFUDC) (shown below) has been reduced for carrying charges on CAAA expenditures that are being collected through currently approved surcharges or in base rates. - 14 - * Includes allowance for funds used during construction for 1993, 1994 and 1995 of: Monongahela $5.8, $4.1 and $1.9; Potomac Edison $7.1, $5.7 and $2.7; and West Penn $8.6, $12.7 and $6.2. These construction expenditures include major capital projects at existing generating stations, including the construction of flue-gas desulfurization equipment (scrubbers) at the Harrison Power Station, upgrading distribution lines and substations, and the strengthening of the transmission and subtransmission systems. It is anticipated that the Harrison scrubber project will be completed on schedule and that the final costs will be approximately 24% below the original budget. Primary factors contributing to the reduced cost are: a) the absence of any major construction problems to date; b) financing and material and equipment costs lower than expected; and c) favorable rulings of state commissions allowing the inclusion of carrying costs of construction in rates in lieu of AFUDC. In order to avoid unnecessary and uneconomic additional outages, power station construction and long-range maintenance schedules and the expenditures associated therewith will have to be coordinated over the next several years with outages to meet the in-service dates of the new emission control facilities. - 15 - On a System basis, total expenditures for 1993, 1994, and 1995 include $270 million, $191 million, and $93 million, respectively, for construction of environmental control technology. The Operating Subsidiaries continue to study ways to reduce or meet future increases in customer demand, including aggressive demand- side management programs, new and efficient electric technologies, construction of various types and sizes of generating units and increasing the efficiency and availability of System generating facilities, reducing company electrical use and transmission and distribution losses, and where feasible and economical, acquisition of reliable long- term capacity from other electric systems and from nonutility developers. The Operating Subsidiaries are implementing demand-side management activities. Potomac Edison and West Penn are engaged in state commission supported or ordered evaluations of demand-side management programs (See ITEM 1. REGULATION for a further discussion of these programs). Several jurisdictions have adopted mechanisms which provide for recovery of the costs of such activities, some return on the related investment, the associated revenue reductions and a performance incentive, either on a current basis or through deferral to a base rate case. Current forecasts, which reflect demand-side management efforts and other considerations and assume normal weather conditions, project average annual winter and summer peak load growth rates of 1.47% and 1.28%, respectively, in the period 1994-2004. After giving effect to the reactivation of West Penn capacity in cold reserve (see page 9), peak diversity exchange arrangements described in ITEM 1. SALES above, demand- side management and conservation programs, and the capacity of an anticipated new PURPA plant, the System's integrated resource plan indicates that new System-owned generating capacity will not be required until the year 2000 or beyond. If future customer demand materially exceeds that forecast or anticipated supply-side resources do not become available or demand-side management efforts do not succeed, or under extremely adverse weather conditions, the Operating Subsidiaries may be unable at times to meet all of their customers' requirements for electric service. In connection with their construction and demand- side management programs, the Operating Subsidiaries must make estimates of the availability and cost of capital as well as the future demands of their customers that are necessarily subject to regional, national, and international developments, changing business conditions, and other factors. The construction of facilities and their cost are affected by laws and regulations, lead times in manufacturing, availability of labor, materials and supplies, inflation, interest rates, and licensing, rate, environmental, and other proceedings before regulatory authorities. As a result, future plans of the Operating Subsidiaries, as well as their projected ownership of future generating stations, are subject to continuing review and substantial change. - 16 - The Subsidiaries have financed their construction programs through internally generated funds, first mortgage bond, debenture, medium-term note and preferred stock issues, pollution control and solid waste disposal notes, instalment loans, long-term lease arrangements, equity investments by APS (or, in the case of AGC, by the Operating Subsidiaries), and, where necessary, interim short-term debt. Effective January 1994, the Operating Subsidiaries also have available a $300 million multi-year credit facility. The future ability of the Subsidiaries to finance their construction programs by these means depends on many factors, including rate levels sufficient to provide internally generated funds and adequate revenues to produce a satisfactory return on the common equity portion of the Subsidiaries' capital structures and to support their issuance of senior and other securities. APS obtains most of the funds for equity investments in the Operating Subsidiaries through the issuance and sale of its common stock publicly and through its Dividend Reinvestment and Stock Purchase Plan and its Employee Stock Ownership and Savings Plan. In May 1993, Monongahela, Potomac Edison, and West Penn issued $10.68 million, $13.99 million, and $18.04 million, respectively, in solid waste disposal notes to Harrison County, West Virginia. Harrison County in turn issued $24.67 million of 6-1/4% and $18.04 million of 6.3% tax-exempt 30-year solid waste disposal revenue bonds. The Operating Subsidiaries are using the proceeds from the issuance to finance certain solid waste disposal facilities which comprise a portion of the scrubbers located at the Harrison Power Station. On November 3, 1993, the holders of more than two-thirds of the shares of APS common stock voted to split the common stock by amending the charter to reclassify each share of common stock, par value $2.50, issued or unissued, into two shares of common stock, par value $1.25 each. The stock split became effective on November 4, 1993. All references to APS common stock herein reflect the two-for-one stock split. On October 14, 1993, APS issued and sold 2,400,000 shares of its common stock in an underwritten offering with net proceeds to APS of $64.1 million, and in 1993 sold 1,364,846 shares of its common stock for $36.1 million through its Dividend Reinvestment and Stock Purchase Plan and its Employee Stock Ownership and Savings Plan. In October 1993, Potomac Edison and West Penn issued and sold to APS 2,500,000 and 5,000,000 additional shares of each of their common stock, respectively, at a price of $20 per share. During 1993, the rate for West Penn's 400,000 shares of market auction preferred stock, par value $100 per share, reset approximately every 90 days at 2.62%, 2.55%, 2.595% and 2.7%. The rate set at auction on January 14, 1994, was 2.52%. In August 1993, Potomac Edison redeemed the remaining $404,600 of 4.70% Series B Preferred Stock outstanding. - 17 - In 1993, the Subsidiaries issued $651.9 million of securities having interest rates between 4.95% and 7.75%, to refund outstanding debt with rates of 7.0% to 9.75%, with an annual after-tax savings in interest cost of almost $9 million. In February 1993, Potomac Edison issued $45 million of 7-3/4%, 30-year first mortgage bonds to refund $25 million, 8-5/8% series due 2007 and $15 million, 8-5/8% series due 2003. In March 1993, West Penn issued $61.5 million of 10-year, 4.95% Pollution Control Revenue Notes to refund $30 million, 9-3/4% series due 2003 and $31.5 million, 9-1/2% series due 2003. In March 1993, AGC issued $50 million of 5- 3/4% medium-term notes due in 1998 to refund $50 million, 8% debentures due in 1997. In March 1993, Potomac Edison issued $75 million of 5-7/8% first mortgage bonds due 2000 to refund $72 million of four series due 1998-2002 with rates ranging from 7% to 8- 3/8%. In April 1993, Monongahela, Potomac Edison and West Penn issued $7.05 million, $8.6 million, and $7.75 million, respectively, in 20-year Pollution Control Revenue Notes to Monongalia County, West Virginia. Monongalia County, in turn issued $23.4 million of 5.95%, 20-year Pollution Control Revenue Bonds to refund $23.4 million of three series due in 2013 with rates ranging from 9.375% to 9.5%. In April 1993, Monongahela issued $65 million of 5-5/8% first mortgage bonds due in 2000 to refund $60 million of three series due 1998-2002 with rates ranging from 7.5% to 8.125%. In June 1993, West Penn issued $102 million of 5-1/2% first mortgage bonds due in 1998 to refund $102 million of three series due 1997-1999 with rates ranging from 7% to 7-7/8%. Also in June 1993, West Penn issued $80 million of 6-3/8% first mortgage bonds due 2003 to refund $75 million of two series due 2001-2002 with rates of 7-5/8% and 8-1/8%. In September 1993, AGC issued $50 million of 5-5/8% debentures due 2003 and $100 million of 6-7/8% debentures due 2023 to refund $50 million, 8-3/4% debentures due 2017 and $100 million, 9-1/8% debentures due 2016. At December 31, 1993, APS had $67.5 million and Monongahela had $63.1 million outstanding in short-term debt, and AGC had $50.87 million outstanding in commercial paper and notes payable to affiliates, while Potomac Edison and West Penn had short-term investments of $4.6 million and $24.9 million, respectively. The Subsidiaries' ratios of earnings to fixed charges for the year ended December 31, 1993, were as follows: Monongahela, 3.49; Potomac Edison, 3.34; West Penn, 3.49; and AGC, 2.88. APS and the Subsidiaries' consolidated capitalization ratios as of December 31, 1993, were: common equity, 46.1%; preferred stock, 6.5%; and long- term debt, 47.4%. APS and the Subsidiaries' long-term objective is to maintain the common equity portion above 45%, reduce the long-term debt portion toward 45%, and maintain the preferred stock ratio for the balance of the capital structure. In January 1994, the Operating Subsidiaries jointly entered into an aggregate $300 million multi- year credit agreement with eighteen lenders. Each Operating Subsidiary's borrowings under the agreement are limited to its pro rata share of the stock of AGC, which stock was pledged to secure the credit agreement. The Operating Subsidiaries' percentage ownership of AGC and resulting borrowing limitations are: Monongahela 27%, $81,000,000; Potomac Edison 28%, $84,000,000; and West Penn 45%, $135,000,000. The agreement may be used as a supplement to or in lieu of public financings and short-term debt programs. - 18 - During 1994, Monongahela, Potomac Edison and West Penn plan to issue up to $50 million, $75 million, and $105 million, respectively, of new securities, consisting of both debt and preferred and common equity, for general corporate purposes, including their construction programs. In addition, the Operating Subsidiaries may engage in tax-exempt solid waste disposal financings to the extent funds are available to Harrison County from the West Virginia cap allocation. APS plans to fund Operating Subsidiaries' sales of common stock to it through the issuance of short-term debt and the sale of APS' common stock through its Dividend Reinvestment and Stock Purchase Plan and Employee Stock Ownership and Savings Plan. The Operating Subsidiaries, if economic and market conditions make it desirable, may refund during 1994 up to $550 million of first mortgage bonds, up to $100 million of preferred stock, and up to $78 million of pollution control revenue notes through tender offers or optional redemptions. FUEL SUPPLY System-operated stations burned approximately 15.7 million tons of coal in 1993. Of that amount, 67% was cleaned (6.7 million tons) or used in stations equipped with scrubbers (3.9 million tons). Use of desulfurization equipment and cleaning and blending of coal make burning local higher-sulfur coal practical, and in 1993 about 96% of the coal received at System stations came from mines in West Virginia, Pennsylvania, Maryland, and Ohio. The Operating Subsidiaries do not mine or clean any coal. All raw, clean or washed coal is purchased from various suppliers as necessary to meet station requirements. Long-term arrangements, subject to price change, are in effect and will provide for approximately 12 million tons of coal in 1994. The System depends on short-term arrangements and spot purchases for its remaining requirements. Through the year 1999, the total coal requirements of present System-operated stations are expected to be met with coal acquired under existing contracts or from known suppliers. The Operating Subsidiaries will meet the requirements of Phase I of the CAAA by installing scrubbers at Harrison Power Station. This will allow the continued use of local, high-sulfur coal there. A long-term contract for the supply of lime for use in the scrubber operation and for fixation of the scrubber byproduct has been negotiated and is expected to be signed in early 1994. It is expected that the use of lime will increase the costs of operating the station. For each of the years 1989 through 1992, the average cost per ton of coal burned was, respectively, $34.64, $35.97, $36.74 and $36.31. For the year 1993, the cost per ton decreased to $36.19, and in December 1993 the cost per ton was $36.45. - 19 - The labor agreement between the United Mine Workers of America (UMWA) and the Bituminous Coal Operators' Association (BCOA) expired on February 1, 1993. As a result, the UMWA initiated selective strikes against BCOA member companies on February 2, 1993. In late May and early June, numerous mines which serve the Operating Subsidiaries' power stations were closed down to various degrees. The UMWA and BCOA agreed to a new five year contract on December 14, 1993, and mining operations resumed at most mines during the week of December 20, 1993. The Operating Subsidiaries continued to meet customer needs during this approximately seven-month period through the use of existing low cost inventories, additional spot and substitute contract coal purchases, and some conservation measures, primarily at the Harrison Power Station. The Operating Subsidiaries own coal reserves estimated to contain about 125 million tons of high- sulfur coal recoverable by deep mining. There are no present plans to mine these reserves and, in view of economic conditions now prevailing in the coal market, the Operating Subsidiaries plan to hold the reserves as a long-term resource. RATE MATTERS Rate case decisions in Pennsylvania and Maryland were issued for West Penn and Potomac Edison in May and February, 1993. West Penn On May 14, 1993, the Pennsylvania Public Utility Commission (PUC) issued an order in West Penn's base rate case effective May 18, 1993, authorizing an increase in revenues of $61.6 million, of which $26.1 million was for recovery of carrying charges (return on investment and taxes) associated with West Penn's CAAA compliance plan through June 30, 1993. West Penn had originally filed for a base rate increase designed to produce $101.4 million. West Penn received all maintenance expenses that it had requested, and a return on equity (ROE) of 11.5%. West Penn filed a petition on January 12, 1994 with the PUC requesting authorization to accrue post in-service carrying charges on the Harrison scrubbers and to defer related depreciation and operating and maintenance expenses until they are recognized in rates. West Penn cannot predict the outcome of this proceeding. West Penn plans to file an application with the PUC on or about March 31, 1994, for a base rate increase to recover the remaining carrying charges on investment, depreciation and all operating costs required to comply with Phase I of the CAAA, and other increasing levels of expense. It is expected that the new rates will become effective on or about December 31, 1994. West Penn cannot predict the precise amount to be requested or the outcome of this proceeding. On February 20, 1992, the Commonwealth Court of Pennsylvania affirmed the PUC's December 13, 1990, decision relating to West Penn's challenge to the PUC's methodology for calculation of ROE. Three industrial customers also appealed to the Commonwealth Court that part of the PUC order which failed to allocate capacity costs of PURPA projects on a demand basis in West Penn's Energy Cost Rate. On June 25, 1992, the Commonwealth Court reversed the PUC's decision on this issue and remanded the case to the PUC for further proceedings. West Penn and other parties have negotiated a settlement on capacity costs of PURPA projects and other demand-related costs in West Penn's Energy Cost Rate, which settlement does not affect West Penn's revenues. The settlement agreement was approved by the PUC and was implemented in 1993. - 20 - Monongahela On January 18, 1994, Monongahela filed an application with the West Virginia Public Service Commission (West Virginia PSC) for a base rate increase designed to produce $61.3 million in additional annual revenues which includes recovery of the remaining carrying charges on investment, depreciation, and all operating costs required to comply with Phase I of the CAAA, and other increasing levels of expense. It is expected that a decision will be rendered about November 15, 1994, with increases to be effective immediately. Monongahela cannot predict the outcome of this proceeding. Monongahela filed a petition on January 11, 1994, with the Public Utilities Commission of Ohio (PUCO) requesting authorization to accrue post-in-service carrying charges on the Harrison scrubbers until its investment in such scrubbers is recognized in rates. The petition also requested authorization for Monongahela to defer depreciation, and operating and maintenance expenses, including property taxes (but not including fuel costs) with respect to the scrubbers until the recovery of the deferrals can be addressed in Monongahela's next base rate case or otherwise, as the PUCO may deem appropriate. Monongahela is currently awaiting a decision on this petition. If the petition is approved, Monongahela will file its Ohio base rate case in early 1995. Potomac Edison The Maryland Public Service Commission (Maryland PSC) issued a final order in Potomac Edison's base rate case on February 24, 1993, authorizing an annual increase of $11.3 million, effective February 25, 1993, which included CAAA carrying charges through February 28, 1993. The original filing in July of 1992 was designed to produce approximately $23.0 million in additional annual revenues. Subsequent adjustments reduced this request to $17.6 million. Potomac Edison received most of the maintenance expenses that it had requested and a ROE of 11.9%. On April 30, 1993, Potomac Edison filed with the Virginia State Corporation Commission (SCC) for a rate increase designed to produce $10.0 million in additional annual revenues. The new rates went into effect on September 28, 1993, subject to refund. Hearings have been held and a final SCC decision is expected by April 1994. Potomac Edison cannot predict the outcome of this proceeding. - 21 - On January 14, 1994, Potomac Edison filed an application with the West Virginia PSC for a base rate increase designed to produce $12.2 million in additional annual revenues which includes recovery of the remaining carrying charges on investment, depreciation, and all operating costs required to comply with Phase I of the CAAA, and other increasing levels of expense. It is expected that a decision will be rendered about November 15, 1994, with increases to be effective immediately. Potomac Edison cannot predict the outcome of this proceeding. On or about April 15, 1994, and June 30, 1994, Potomac Edison plans to file new rate cases in Maryland and Virginia, respectively. The amounts of the requested increases have not yet been determined, but they will include recovery of the remaining carrying charges on investment, depreciation, and all operating costs required to comply with Phase I of the CAAA, and other increasing levels of expense. It is expected that the Maryland decision will be rendered in late 1994, and the Virginia decision in mid-1995. However, in both jurisdictions, it is expected that increases will be effective in late 1994. Monongahela and Potomac Edison Pursuant to its order of December 12, 1991, approving Monongahela and Potomac Edison's plan for compliance with Phase I of the CAAA, the West Virginia PSC authorized recovery by Monongahela and Potomac Edison of $5.6 million and $1.4 million, respectively, of carrying charges on Phase I CAAA compliance costs through March 31, 1993, effective July 1, 1993. This brings the annual Phase I CAAA recovery for Monongahela and Potomac Edison to $8.7 million and $2.2 million, respectively. Pursuant to the order, Monongahela and Potomac Edison will submit requests for recovery of carrying charges through March 31, 1994, on Phase I CAAA compliance costs in the annual energy cost review proceedings with any increase to be effective July 1, 1994. The annual values of all CAAA revenues authorized in these proceedings will be removed from this collection process effective when full Phase I CAAA costs are included in base rates as a result of the 1994 rate case filings. AGC Through February 29, 1992, AGC's ROE was adjusted annually pursuant to a settlement agreement approved by the FERC. In December 1991, AGC filed for a continuation of the existing ROE of 11.53% and other parties filed to reduce the ROE to 10%. Hearings were completed in June 1992, and a recommendation has been issued by an Administrative Law Judge (ALJ) on December 21, 1993, for an ROE of 10.83%, which the other parties argue should be further adjusted to reflect changes in capital market conditions since the hearings. Exceptions to this recommendation have been filed by all parties for consideration by the full Commission. On January 28, 1994, the Consumer Advocate Division of the West Virginia PSC, Maryland People's Counsel, and Pennsylvania Office of Consumer Advocate filed a joint complaint with the FERC against AGC claiming that both the existing ROE of 11.53% and the ROE recommended by the ALJ of 10.83% are unjust and unreasonable. This new complaint requests an ROE of 8.53% with rates subject to refund beginning April 1, 1994. AGC cannot predict the outcome of these proceedings. - 22 - FERC West Penn, Potomac Edison, and Monongahela implemented settlement agreements in 1993 covering wholesale rates in effect for their municipal, co-op, and borderline agreement customers subject to the jurisdiction of the FERC. Each included carrying charges for work in progress on the scrubbers at the Harrison Power Station, additional expenses for postretirement benefits other than pensions (see below), and future automatic rate changes resulting from changes to taxes or tax rates (federal, state and local for Monongahela and West Penn, and federal for Potomac Edison). The amounts of the increases and the effective dates for West Penn, Potomac Edison, and Monongahela were $1.6 million on June 15, 1993; $1.5 million on September 15, 1993; and $0.6 million on December 1, 1993, respectively. It is anticipated that additional filings to include recovery of the remaining carrying charges on investment, depreciation, as well as all operating costs required to comply with Phase I of the CAAA, and other increasing levels of expense for each Operating Subsidiary will be made in 1994 with increases to be effective around the end of 1994. Postretirement Benefits Other Than Pensions (SFAS No. 106) The Operating Subsidiaries and APSC adopted SFAS No. 106 as of January 1, 1993. This requires all companies to accrue for the cost of postretirement benefits other than pensions (principally health care and life insurance) for the employee and covered dependents during the years that the employee renders the necessary service to receive such benefits. Prior to 1993, medical expenses and life insurance premiums paid by the Operating Subsidiaries and APSC for retired employees and their dependents were recovered in rates on a pay-as-you-go basis. Recovery of SFAS No. 106 costs has been authorized for retail customers in Maryland effective in February 1993, in Pennsylvania effective in May 1993, and for FERC wholesale customers effective on the rate case effective date described above under ITEM 1. RATE MATTERS, FERC. Regulatory actions have been taken by the PUCO and Virginia PSC, which indicate that substantial recovery is probable. The West Virginia PSC considers recovery of SFAS No. 106 costs on a case- by-case basis and therefore Monongahela and Potomac Edison cannot predict the outcome of such proceedings. Recovery has been requested in rate cases filed in Virginia and West Virginia for which final commission decisions are expected in 1994. Recovery of these costs in Ohio will be requested in the next base rate case which is expected to be filed in early 1995. The Operating Subsidiaries are currently recovering approximately 85% of SFAS No. 106 expenses in rates. This reflects for West Virginia and Ohio only the recovery of the previously authorized pay-as-you-go component. The Operating Subsidiaries have recorded regulatory assets relating to those regulatory jurisdictions where full recovery of SFAS No. 106 level of expenses has not yet been granted recovery in rates. The Operating Subsidiaries do not anticipate that SFAS No. 106 will have a substantial effect on consolidated net income. - 23 - ENVIRONMENTAL MATTERS The operations of the Subsidiaries are subject to regulation as to air and water quality, hazardous and solid waste disposal, and other environmental matters by various federal, state, and local authorities. Meeting known environmental standards is estimated to cost the Subsidiaries about $361 million in capital expenditures over the next three years, including $254 million for compliance with Phase I of the CAAA, described below, and initial cost for anticipated compliance with Phase II. The full costs of compliance with Phase II cannot be estimated at this time, but may be substantial. Additional legislation or regulatory control requirements, if enacted, may well require modifying, supplementing, or replacing equipment at existing stations at substantial additional cost. Air Standards The Operating Subsidiaries meet applicable standards as to particulates and opacity at major stations with high-efficiency electrostatic precipitators, cleaned coal, flue-gas conditioning, and, at times, reduction of output. From time to time minor excursions of opacity normal to fossil fuel operations are experienced and are accommodated by the regulatory process. In February 1994, three notices of violation were received by the Operating Subsidiaries from the West Virginia Division of Environmental Protection (WVDEP) regarding opacity excursions for three power stations in West Virginia. The Operating Subsidiaries are working with the WVDEP to resolve the alleged violations. It is not anticipated that the alleged violations will result in substantial penalties. At the major stations (other than Mitchell Unit No. 3 and Pleasants, which have scrubbers), the Operating Subsidiaries meet current emission standards as to sulfur dioxide by using low-sulfur coal, by purchasing cleaned coal to lower the sulfur content, or by blending low-sulfur with higher sulfur coal. The CAAA, among other things, require an annual reduction in total utility emissions within the United States of 10 million tons of sulfur dioxide and two million tons of nitrogen oxides from 1980 emission levels, to be completed in two phases, Phase I and Phase II. Five coal-fired System plants are affected in Phase I and the remaining five coal-fired plants and any coal-fired plants or units reactivated in the future will be affected in Phase II. Installation of scrubbers at the Harrison Power Station is the strategy undertaken by the Operating Subsidiaries to meet the required sulfur dioxide emission reductions for Phase I (1995). Continuing studies will determine the compliance strategy for Phase II (2000). It is expected that burner modifications at all power stations will satisfy the nitrogen oxide emission reduction requirements for the acid rain (Title IV) provisions of the CAAA. Additional post-combustion controls may be mandated in Maryland and Pennsylvania for ozone nonattainment (Title I) reasons. Continuous emission monitoring equipment has been installed on all Phase I units and is being installed on Phase II units. Studies to evaluate cost effective options to comply with Phase II of the CAAA, including those which may be available from the use of Operating Subsidiaries' banked emission allowances and from the emission allowance trading market, are continuing. - 24 - In an effort to introduce market forces into pollution control, the CAAA created sulfur dioxide emission allowances. An allowance is defined as an authorization for an owner to emit one ton of sulfur dioxide into the atmosphere during or following a specified calendar year. Subject to regulatory limitations, allowances (including bonus and extension allowances) not used by an owner for its own compliance may be sold or "banked" for future use or sale. Through an industry allowance pooling agreement, the Operating Subsidiaries will receive a total of approximately 570,000 bonus and extension allowances during Phase I. These allowances are in addition to the Table A allowances of approximately 356,000 per year. As a result of EPA's 1993 auctioning of a number of Table A allowances retained from each utility's annual allotment, approximately 16,000 allowances were sold for the Operating Subsidiaries. Such auctions will be held every year for the foreseeable future and allowances sold thereby will result in a prorational allocation of revenues back to the Operating Subsidiaries. If some allowances offered at auction remain unsold, the balance will also be prorationally rebated to the utilities which contributed them. The proceeds from these auctions are expected to be relatively minimal and the Operating Subsidiaries plan to credit these proceeds against the capital cost of emission compliance activities, subject to regulatory approval. Other allowance trading activities may be undertaken by the Operating Subsidiaries once certain tax questions are answered and once studies to determine Phase II compliance strategy are completed. In 1989, the West Virginia Air Pollution Control Commission approved the construction of a cogeneration facility in the vicinity of Rivesville, West Virginia. Emissions impact modeling for that facility raised concerns about the compliance status of Monongahela's Rivesville Station with the National Ambient Air Quality Standards (NAAQS) for sulfur dioxide. Pursuant to a consent order, Monongahela agreed to collect on- site meteorological data and conduct additional dispersion modeling in order to demonstrate compliance. The modeling study and a compliance strategy recommending construction of a new "good engineering practices" (GEP) stack was submitted to the WVDEP in June 1993. Costs associated with the GEP stack are approximately $7 million. Monongahela is awaiting action by the WVDEP. - 25 - Under an EPA-approved consent order with Pennsylvania, West Penn completed construction of a GEP stack at the Armstrong Station in 1982 at a cost of over $13 million with the expectation that EPA's reclassification of Armstrong County to "attainment status" under NAAQS for sulfur dioxide would follow. As a result of the 1985 revision of its stack height rules, EPA refused to reclassify the area to attainment status. West Penn appealed the EPA's decision. In 1988, the U. S. Court of Appeals for the Third Circuit dismissed West Penn's appeal for lack of jurisdiction, stating that West Penn's request for reconsideration before EPA made EPA's denial a non-final agency action. West Penn's request for reconsideration before EPA remains pending. West Penn cannot predict the outcome of this proceeding. Water Standards Under the National Pollutant Discharge Elimination System (NPDES) permitting procedures, permits for all System-owned stations are in place. However, in proposed NPDES renewal permits for some stations which are currently being sought, some conditions are being appealed through the regulatory process since the Operating Subsidiaries believe the effluent limitations being applied are overly stringent. The Operating Subsidiaries continue to work with the appropriate state agencies to resolve these issues. In the meantime, the existing permits remain in effect during the appeal process. The EPA and states are now implementing stormwater runoff regulations for controlling discharges from industrial and municipal sources as well as construction sites. Stormwater discharges have been identified and included in NPDES renewals, but controls have not yet been required. Since the current round of permit renewals began in 1993, monitoring requirements have been imposed, with pollution reduction plans and additional control of some discharges anticipated. Pursuant to the National Groundwater Protection Strategy, which supplements existing West Virginia groundwater protection policy, West Virginia has adopted a Groundwater Protection Act. This law establishes a statewide antidegradation policy which could require the Operating Subsidiaries to undertake reconstruction of existing landfills and surface impoundments as well as groundwater remediation, and may affect herbicide use for right-of-way maintenance in West Virginia. Groundwater protection standards were approved and implemented in 1993 (based on EPA drinking water criteria) which established compliance limits which cannot be exceeded. The Operating Subsidiaries anticipate that some facilities will not be able to meet the new compliance limits. Variance requests and requests for stays of implementation have been made for all affected facilities. However, variance rules have not yet been promulgated and action on the requests has not been taken. Therefore, it is not possible to predict the difficulty and costs associated with obtaining variances. If variances are not granted, costs may be incurred by the Operating Subsidiaries for groundwater remediation. Such costs, if any, cannot be predicted at this time. - 26 - The Pennsylvania Department of Environmental Resources (PADER) developed a Groundwater Quality Protection Strategy which established a goal of nondegradation of groundwater quality. However, the strategy recognizes that there are technical and economic limitations to immediately achieving the goal and further recognizes that some groundwaters need greater protection than others. The PADER is beginning to implement the strategy by promulgating changes to the existing rules that heretofore did not consider the nondegradation goal. The full extent of the impact of the strategy on the Operating Subsidiaries cannot be anticipated at this time. In 1993, two notices of violation were received by the Operating Subsidiaries from the WVDEP regarding excursions above limits contained in NPDES permits for discharge of leachate from fly ash landfills in West Virginia. One violation notice was withdrawn by the state agency and the other was resolved without payment of substantial penalty. On January 27, 1994 and February 9, 1994, the Operating Subsidiaries received two separate notices of violation from PADER regarding excursions above limits contained in the NPDES permit for discharge of leachate from Hatfield's Ferry Power Station fly ash landfill. One violation notice was resolved without payment of substantial penalty. The Operating Subsidiaries are working with the PADER to resolve the other alleged violation. It is not anticipated that the alleged violation will result in substantial penalties. Hazardous and Solid Wastes Pursuant to the Resource Conservation and Recovery Act of 1976 and the Hazardous and Solid Waste Management Amendments of 1984 (RCRA), EPA regulates the disposal of hazardous and solid waste materials. Pennsylvania, West Virginia, Maryland, Ohio, and Virginia have also enacted hazardous and solid waste management legislation. With the installation of the scrubbers at the Harrison Power Station, approximately 2.8 million tons per year of scrubber sludge, consisting principally of limestone and ash, will be generated and disposed of in a disposal facility owned and operated by the Operating Subsidiaries. The expected capacity of the site is 30 years. Pleasants Power Station processes its scrubber sludge using a wet-fixation and slurry system, with the treated sludge disposed of in a properly permitted sludge pond. Mitchell and Harrison Power Stations process their scrubber sludge by a dry-fixation process with the stabilized sludge disposed of in a properly permitted landfill. Coal combustion byproducts from all other facilities are either sold for beneficial reuse or landfilled in properly permitted and currently adequate disposal facilities owned and operated by the Operating Subsidiaries. The Operating Subsidiaries are in the process of permitting additional capacity to meet future disposal needs. - 27 - Costs are being incurred as the Operating Subsidiaries progress with implementation of both West Virginia's and Pennsylvania's 1992 solid waste regulatory changes. A predominant portion of the costs are attributable to two major factors: 1) liner systems for new disposal sites and the expansion portion of existing disposal sites, and 2) the assessment of groundwater impacts via monitoring wells. Because past operating practices, while in compliance with then existing regulations, may not meet the current criteria, as measured by new standards, it is possible that groundwater remediation may be required at some of the Operating Subsidiaries' facilities. In addition, under West Virginia's Solid Waste Rules, it is possible that certain active disposal sites may have to be retrofitted with liner systems to address potential groundwater degradation. The draft permit renewal from WVDEP for the currently active disposal site at Albright Power Station requires, on a portion of the site, retrofitting with a new liner system with possible removal of already placed coal combustion byproducts. The Operating Subsidiaries are working to have this proposed permit condition removed; however if it is not, it is anticipated that this condition will be appealed. EPA regulations on the burning of hazardous waste in utility boilers are expected to be amended in 1994 making the practice cost prohibitive for the Operating Subsidiaries. Until such time as the regulations are amended, the Operating Subsidiaries will continue to minimize their hazardous waste and to burn small quantities of hazardous waste generated in accordance with EPA boiler and industrial furnace disposal rules. Once such regulations are amended, the low volume wastes will be disposed of in incinerators or landfills which are owned by third parties. None of the Operating Subsidiaries are required to obtain hazardous waste treatment, storage or disposal permits under RCRA. With a continued effort to reduce hazardous waste, disposal costs and potential environmental liability should be minimized. Potomac Edison has received a notice from the Maryland Department of the Environment (MDE) regarding a remediation ordered under Maryland law at a facility previously owned by Potomac Edison. The MDE has identified Potomac Edison as a potentially responsible party under Maryland law. Remediation is currently being implemented by the current owner of the facility in Frederick, Maryland. It is not anticipated that Potomac Edison's share of remediation costs, if any, will be substantial. Emerging Environmental Issues Title I of the CAAA establishes an ozone transport region consisting of 11 northeast states including Maryland and Pennsylvania. Sources within the region will be required to reduce nitrogen oxide emissions, a precursor of ozone, to a level conducive to attainment of the ambient ozone standard. The first step for Title I compliance will result in the installation of low nitrogen oxide burners and potentially overfire air at all Pennsylvania and Maryland stations by 1995. This is compatible with Title IV nitrogen oxide reduction requirements. Modeling studies being conducted by the states will determine if a second step of reductions will be necessary which could require installation of post- combustion control technologies. - 28 - Title III of the CAAA requires EPA to conduct studies of toxic air pollutants from utility plants to determine if emission controls are necessary. EPA's reports are expected to be submitted to Congress in late 1995. The impact of Titles I and III on the Operating Subsidiaries is unknown at this time. Both the CWA and the RCRA are expected to be reauthorized in 1994. It is anticipated that coal combustion byproducts will continue to be regulated as nonhazardous waste, minimizing the Operating Subsidiaries' disposal costs. An additional issue which could impact the Operating Subsidiaries and which is undergoing intense study, is the effect, if any, of electric and magnetic fields. The financial impact of this issue on the Operating Subsidiaries, if any, cannot be assessed at this time. In connection with President Clinton's Climate Change Action Plan concerning greenhouse gases, the Operating Subsidiaries expressed by letter to the DOE in August 1993, their willingness to work with the DOE on implementing voluntary, cost-effective courses of action that reduce or avoid emission of greenhouse gases. Such courses of action must take into account the unique circumstances of each participating company, such as growth requirements, fuel mix and other circumstances. Furthermore, they must be consistent with the Operating Subsidiaries' integrated resource planning process and must not have an adverse effect on competitive position in terms of costs and rates or be unacceptable to their regulators. Some 63 other utility systems submitted similar letters. REGULATION APS and the Subsidiaries are subject to the broad jurisdiction of the Securities and Exchange Commission (SEC) under the Public Utility Holding Company Act of 1935 (PUHCA). APS is also subject to the jurisdiction of the Maryland PSC as to certain of its activities. The Subsidiaries are regulated as to substantially all of their operations by regulatory commissions in the states in which they operate and also by the DOE and the FERC. In addition, they are subject to numerous other city, county, state, and federal laws, regulations, and rules. EPACT became law on October 24, 1992. This broad legislation, among other things, amends PUHCA to permit utilities subject to PUHCA to compete in the wholesale generation business with other wholesale generators which it exempts from PUHCA; to ease restrictions on financing for that purpose; and to permit investment in foreign utilities. EPACT also amends the Federal Power Act to permit the FERC to order, under specified circumstances, access to transmission systems (including those of the System) so long as it would not unreasonably impair reliability nor adversely affect its existing wholesale, retail and transmission customers. It also amends PURPA to encourage states to study and regulate various matters, including the capital structures of EWGs, integrated resource planning, and the amount of purchased power that electric utilities should have in their generation mix. EPACT also sets forth waste disposal standards, new nuclear licensing procedures, and contains provisions promoting alternate transportation fuels, research on environmental issues, and increased energy from renewables (See discussion of EPACT in ITEM 1. BUSINESS, SALES and ELECTRIC FACILITIES). - 29 - Pursuant to the requirements of Section 712 of EPACT, the Maryland, Ohio, Pennsylvania, Virginia, and West Virginia commissions issued orders regarding four broad economic and regulatory policy issues related to the purchase of wholesale power. All of the commissions decided to evaluate these issues on a case- by-case basis or within their existing regulatory framework, instead of establishing generic standards. On January 24, 1994, the Maryland PSC issued an order which instituted a proceeding for the purpose of determining whether to implement standards which, under EPACT, a state commission must consider in order to encourage integrated resource planning and investments in conservation and energy efficiency by electric utilities. The order provides for the filing of initial and reply comments and for a hearing on May 3, 1994. Potomac Edison intervened and will be submitting comments in this proceeding. Under EPACT, the FERC has initiated several proceedings, one of the most significant being the request for comments on transmission pricing, including pricing as it may apply to parallel power flows. The Operating Subsidiaries have developed and submitted a pricing philosophy intended to meet certain goals, including reliable operation of the transmission system and protection of native load customers, while promoting accurate price signals and offering third- party transmission service at the lowest reasonable rates. Other FERC initiatives included the issuance of guidelines governing open access transmission requests and rules governing the establishment of Regional Transmission Groups. The Operating Subsidiaries founded and continue to participate in, along with other utilities, an organization whose primary purpose is to develop a mutually acceptable method of resolving the inequities imposed on transmission network owners by parallel power flows. The SEC has also issued regulations and proposed regulations to implement EPACT, including the integration of EPACT with PUCHA and the effect of EPACT on nonexempt PUCHA companies such as APS and its Subsidiaries. In July 1993, the PUC directed the Bureau of Conservation, Economics and Energy Planning to develop competitive bidding regulations to replace, at least in part, the existing state PURPA regulations. In November 1993, West Penn filed a petition with the PUC requesting an Order that, pending the revision and replacement of the existing state PURPA regulations, any proceedings or orders regarding purchase by West Penn of capacity from a qualifying facility under PURPA shall be based on competitive bidding. The Office of Consumer Advocate, the Office of Small Business Advocate, the West Penn Power Industrial Intervenors, and West Penn's two largest industrial customers have intervened in support of West Penn's position. Several PURPA developers and a group purporting to represent PURPA interests have filed in opposition to certain parts of the petition. West Penn cannot predict the outcome of this proceeding. - 30 - On October 8, 1993, the West Virginia PSC issued proposed regulations concerning bidding procedures for capacity additions for electric utilities and invited comment by December 7, 1993. A number of interested parties, including Monongahela and Potomac Edison, filed comments. The West Virginia PSC has taken no further action since the filing of comments. On December 17, 1992, the PUCO issued proposed rules concerning competitive bidding for supply-side resources, transmission access for winning bidders and incentives for the recovery of the cost of purchased power. The PUCO invited comments by March 3, 1993 and reply comments by March 24, 1993. A number of interested parties, including Monongahela, submitted comments. The PUCO has taken no further action following the filing of comments. Maryland and Virginia have not mandated compulsory competitive bidding at this date. The Omnibus Budget Reconciliation Act of 1993 increased the marginal corporate income tax rate from 34% to 35%, retroactive to January 1, 1993. As a result, the Operating Subsidiaries' income tax expense for 1993 increased by about $3 million. On June 13, 1990, the Maryland PSC began an investigation to determine whether Potomac Edison's methodology for calculating avoided costs under PURPA is appropriate. On October 11, 1991, the Maryland PSC incorporated this review of avoided costs into a collaborative process already formed between its Staff, the Maryland Department of Natural Resources, Potomac Edison, Eastalco Aluminum, the Maryland Energy Administration, and the Office of People's Counsel. Although the group's primary mission was to avoid litigation by working cooperatively to develop demand- side management programs, the issue of avoided costs was addressed because avoided costs are needed for determining the cost-effectiveness of programs. These negotiations culminated in a Settlement Agreement which was signed by the six parties and filed with the Maryland PSC on October 14, 1993. The Hearing Examiner issued a proposed order accepting the Settlement Agreement on November 17, 1993. The proposed order became final on December 17, 1993, thereby concluding this proceeding. In October 1990, the PUC ordered Pennsylvania's major electric utilities, including West Penn, to file programs for demand-side management designed to reduce customer demand for electricity and to reduce the need for additional generating capacity. The PUC's order proposed that the affected utilities receive full recovery of the costs of approved programs, as well as financial incentives for implementing such programs, including recovery of lost revenues. West Penn filed its proposed programs with the PUC. On December 13, 1993, the PUC entered an order which provides for the recovery of program costs either through a surcharge or deferral to a base rate case; the recovery of revenues lost due to the implementation of demand-side management programs through a base rate case; and the award of incentives for good program performance or the assessment of penalties for poor performance. Two parties to this proceeding have petitioned the PUC for reconsideration and clarification and the Pennsylvania Industrial Energy Coalition has filed an appeal with the Commonwealth Court of Pennsylvania. West Penn cannot predict the final outcome of this proceeding. - 31 - During 1993, Potomac Edison continued its participation in the Collaborative Process for demand- side management in Maryland with the Maryland PSC Staff, Office of People's Counsel, the Department of Natural Resources, Maryland Energy Administration, and Potomac Edison's largest industrial customer. Potomac Edison received the Maryland PSC's approval to implement a Commercial and Industrial Lighting Rebate Program as of July 1, 1993. Through December 31, 1993 Potomac Edison had received applications for $7.5 million in rebates related to the commercial lighting program. Program costs, including rebates and lost revenues, are deferred and are to be recovered through an energy conservation surcharge over a five-year period. ITEM 2.		ITEM 2. PROPERTIES Substantially all of the properties of the Operating Subsidiaries are held subject to the lien securing each company's first mortgage bonds and, in many cases, subject to certain reservations, minor encumbrances, and title defects which do not materially interfere with their use. Some properties are also subject to a second lien securing certain solid waste disposal and pollution control notes. The indenture under which AGC's unsecured debentures and medium-term notes are issued, prohibits AGC, with certain limited exceptions, from incurring or permitting liens to exist on any of its properties or assets unless the debentures and medium-term notes are contemporaneously secured equally and ratably with all other indebtedness secured by such lien. Transmission and distribution lines, in substantial part, some substations and switching stations, and some ancillary facilities at power stations are on lands of others, in some cases by sufferance, but in most instances pursuant to leases, easements, permits or other arrangements, many of which have not been recorded and some of which are not evidenced by formal grants. In some cases no examination of titles has been made as to lands on which transmission and distribution lines and substations are located. Each of the Operating Subsidiaries possesses the power of eminent domain with respect to its public utility operations. (See also ITEM 1. BUSINESS and SYSTEM MAP.) - 32 - ITEM 3.	ITEM 3. LEGAL PROCEEDINGS In 1979, National Steel Corporation (National Steel) filed suit against certain Subsidiaries in the Circuit Court of Hancock County, West Virginia, alleging damages of approximately $7.9 million as a result of an order issued by the West Virginia PSC requiring curtailment of the plaintiff's use of electric power during the United Mine Workers' strike of 1977-8. A jury verdict in favor of the defendants was rendered in June 1991. National Steel has filed a motion for a new trial, which is still pending before the Circuit Court of Hancock County. The Subsidiaries believe the motion is without merit; however, they cannot predict the outcome of this case. In 1987, West Penn entered into separate agreements with developers of four PURPA projects: Milesburg (43 MW), Burgettstown (80 MW), Shannopin (80 MW) and Point Marion (2 MW). The agreements provided for the purchase of each project's power over 30 years or more at rates generally approximating West Penn's avoided costs at the time the agreements were negotiated, as defined by PURPA. Yearly capacity payments under the four agreements would total in excess of $50 million. Each agreement was subject to prior PUC approval of the pass-through to West Penn's customers of the total cost incurred under each agreement, on a current basis. In 1987 and 1988, West Penn filed a separate petition with the PUC for each agreement requesting an appropriate PUC order, and various parties intervened. Since that time, all four agreements have been, in varying degrees, the subject of complex and continuing regulatory and judicial proceedings. During 1993, West Penn entered into a settlement agreement with Point Marion and that project has been terminated. On November 24, 1993, the Pennsylvania Supreme Court issued a per curiam opinion regarding the Milesburg project which upheld the decision of the Commonwealth Court concerning the time frame for the calculation of avoided cost and upheld the decision that the PUC had the authority under PURPA to revise and reinstate a lapsed power purchase contract. West Penn is considering its options as a result of this ruling, including a petition for certiorari to the United States Supreme Court. On December 30, 1993, the Pennsylvania Supreme Court issued a per curiam opinion regarding the Shannopin project which upheld the decision of the Commonwealth Court affirming the PUC's authority under PURPA to revise voluntarily negotiated power purchase contracts. West Penn is considering its options as a result of this ruling, including a petition for certiorari to the United States Supreme Court. As of December 31, 1993, petitions for allowance of an appeal of the decision of the Pennsylvania Commonwealth Court on the Burgettstown project were pending before the Pennsylvania Supreme Court. West Penn cannot predict the outcome of these proceedings. On October 28, 1993, South River Power Partners, L.P. ("South River") filed a complaint against West Penn with the PUC. The complaint seeks to require West Penn to purchase 240 MW from a proposed coal-fired PURPA project which South River proposes to build in Fayette County, Pennsylvania. South River's proposed initial price for this power would be over $0.09 per kWh. West Penn is opposing this complaint as the power is not needed and the price is in excess of avoided cost. The Pennsylvania Consumer Advocate, the Small Business Advocate, the PUC Trial Staff and various industrial customers have also intervened in opposition to the complaint. West Penn cannot predict the outcome of this proceeding. - 33 - Two previously reported complaints had been filed with the West Virginia PSC by developers of cogeneration projects in Marshall and Barbour Counties, West Virginia to require Monongahela and Potomac Edison to purchase capacity from the projects. These two cases were consolidated. The West Virginia PSC on March 5, 1993, found that: Monongahela had no need for additional capacity; Potomac Edison will need new combustion turbine generating capacity beginning in 1996; and Potomac Edison's avoided cost estimate, which is substantially below the costs sought by the developers of the projects, is reasonable. The developers have asked the West Virginia PSC to consider issues not resolved in the March 5, 1993 order. On June 25, 1993 the West Virginia PSC found that Potomac Edison had a PURPA obligation to purchase power from qualifying facilities properly interconnected to the System in Monongahela's service territory and ordered negotiations by Monongahela and Potomac Edison with the two PURPA developers. On August 9, 1993, the West Virginia PSC deconsolidated the two cases. Following the West Virginia Supreme Court's denial of a petition for review of this order, both developers requested the start of negotiations. Monongahela and Potomac Edison cannot predict the outcome of these proceedings. On November 16, 1992, Potomac Edison and the developer of a proposed cogeneration project located in Cumberland, Maryland, requested that the Maryland PSC approve an amendment to a previously approved agreement for the sale of 180 MW of capacity and associated energy from the project to Potomac Edison. The amendment provides for the relocation of the proposed project within the Cumberland area; a delay of one year in the project's earliest in-service date to October 1, 1996, without increase in the initial capacity rate (which otherwise escalates annually at one-half the rate of actual inflation); and other changes consistent with the site and in-service date modifications. The Maryland PSC commenced an investigation of the amendment in December 1992. After hearings, the parties reached a settlement which was approved by the Maryland PSC on March 17, 1993. The settlement agreement resulted in a further delay of the project's in-service date to October 1, 1999, modified the initial capacity rate with only a slight escalation, and provided that Potomac Edison would pay, and recover from customers by a surcharge, a portion of the project's costs resulting from the delay. On December 22, 1993, the Maryland PSC approved the surcharge and these costs are being recovered from customers effective January 1, 1994. As previously reported, effective March 1, 1989, West Virginia enacted a new method for calculating the Business and Occupation Tax (B & O Tax) on electricity generated in that state, which disproportionately increased the B & O Tax on shipments of electricity to other states. In 1989, West Penn, the Pennsylvania Consumer Advocate, and several West Penn industrial customers filed a joint complaint in the Circuit Court of Kanawha County, West Virginia seeking to have the B & O Tax declared illegal and unconstitutional on the grounds that it violates the Interstate Commerce Clause and the Equal Protection Clause of the federal Constitution and certain provisions of federal law that bar the states from imposing or assessing taxes on the generation or transmission of electricity that discriminate against out-of-state entities. In 1991, West Penn amended the complaint to include a 1990 increase in the rate of the B & O Tax. The trial was held in July 1993 and briefs have been filed. West Penn cannot predict the outcome of this litigation. - 34 - As of January 1994, Monongahela has been named as a defendant along with multiple other defendants in 1,429 pending asbestos cases involving multiple plaintiffs and Monongahela, Potomac Edison and West Penn have been named as defendants along with multiple defendants in an additional 626 cases by multiple plaintiffs. Because these cases are filed by "shot- gun" complaints naming many plaintiffs and many defendants, it is presently impossible to determine the actual number of claims against the Operating Subsidiaries. However, based on past experience and data available to date, it is estimated that less than 600 cases actually involve claims against any or all of the Operating Subsidiaries. All complaints allege that the plaintiffs sustained unspecified injuries resulting from claimed exposure to asbestos in various generating plants and other industrial facilities operated by the various defendants, although all plaintiffs do not claim exposure at facilities operated by all defendants. All plaintiffs claiming exposure at Subsidiary-operated stations were employed by third- party contractors, with the exception of three who claim to have been employees of Monongahela. Each plaintiff generally seeks compensatory and punitive damages against all defendants in amounts of up to $1 million and $3 million, respectively; in those cases that include a spousal claim for loss of consortium, damages are generally sought against all defendants in an amount of up to $1 million for the loss of consortium claim. Therefore, because of the multiple defendants, the Operating Subsidiaries believe potential liability of the Operating Subsidiaries is a very small percentage of the total amount of the damages sought. A total of 94 cases have been previously settled by Monongahela for an amount substantially less than the anticipated cost of defense. While the Operating Subsidiaries believe that all of these cases are without merit, they cannot predict the outcome of these cases or whether other cases will be filed. On March 4, 1994, the Operating Subsidiaries received notice that the EPA had identified them as potentially responsible parties ("PRPs") under the Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended ("CERCLA"), with respect to the Jack's Creek/Sitkin Smelting Superfund Site ("Site"). The Operating Subsidiaries are among some 880 PRPs that have been identified at the Site. EPA is planning to issue a Proposed Plan and Record of Decision in September 1994 delineating the remedy selected for the Site. At this time it is not possible to determine what liability, if any, the Operating Subsidiaries may have regarding the Site. - 35 - In 1970, the Operating Subsidiaries filed with the Federal Power Commission (FPC) an application for a license to build a 1,000-MW energy-storage facility near Davis, West Virginia. In 1977, FPC issued a license for the project, but various parties, including the State of West Virginia and the U.S. Department of Interior, filed appeals, which are now pending before the U.S. Court of Appeals for the District of Columbia. The U.S. Army Corps of Engineers (Corps) denied a dredge and fill permit for the project, which decision was appealed. The U.S. District Court for the District of Columbia decided that the Corps had no jurisdiction in the matter. The Corps filed an appeal with the U.S. Court of Appeals for the District of Columbia. In 1987, the appellate Court decided that the Corps did have jurisdiction and remanded the case to the U.S. District Court for further consideration of the Corps' denial of the permit. The U. S. Supreme Court refused to review that decision. In 1988, the U.S. District Court reversed the Corps' denial of the dredge and fill permit. The District Court's decision, which has now been appealed, found, among other things, that the Operating Subsidiaries were denied an opportunity to review and comment upon written materials and other communications used by the Corps in making its decision, and as a result the Court remanded the matter to the Corps for further proceedings. Negotiations are ongoing to settle this matter. The Operating Subsidiaries cannot predict the outcome of these proceedings. ITEM 4.	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS The holders of 46,537,924 shares of common stock of APS voted at a special meeting held on November 3, 1993 to amend APS' charter to reclassify each share of common stock, par value $2.50 per share, issued or unissued, into two shares of common stock, par value $1.25 each. The holder of 259,451 shares voted against the proposal and the holders of 296,598 shares abstained. The charter amendment became effective at the close of business on November 4, 1993. The amount of APS' stated capital was not changed as a result of the amendment. The holder of the common stock of Monongahela on December 13, 1993, waived the holding of a meeting and consented in writing to the amendment of its Charter to reflect the redemption of 50,000 shares of $9.64 series cumulative preferred stock. No other company submitted matters to a vote of shareholders during the fourth quarter. - 36 - Executive Officers of the Registrants The names of the executive officers of each company, their ages, the positions they hold and their business experience during the past five years appears below: (a) All officers and directors are elected annually. - 37 - (a) All officers and directors are elected annually. - 48 - (a) All officers and directors are elected annually. - 39 - PART II ITEM 5.	ITEM 5. MARKET FOR THE REGISTRANTS' COMMON EQUITY AND RELATED STOCKHOLDER MATTERS APS. AYP is the trading symbol of the common stock of APS on the New York, Chicago, and Pacific Stock Exchanges. The stock is also traded on the Amsterdam (Netherlands) and other stock exchanges. As of December 31, 1993, there were 63,396 holders of record of APS' common stock. The tables below show the dividends paid and the high and low sale prices of the common stock for the periods indicated: The high and low prices in 1994 were 26-1/2 and 24-1/8 through February 3. The last reported sale on that date was at 25. Monongahela, Potomac Edison, and West Penn. The information required by this Item is not applicable as all the common stock of these Subsidiaries is held by APS. AGC. The information required by this Item is not applicable as all the common stock of AGC is held by Monongahela, Potomac Edison, and West Penn. - 40 - ITEM 6.	ITEM 6. SELECTED FINANCIAL DATA Page No. APS D-1 Monongahela D-3 Potomac D-5 West Penn D-7 AGC D-9 D-1 D-2 (a) Reflects a two-for-one common stock split effective November 4, 1993. (b) Capability available through contractual arrangements with nonutility generators. (c) Preliminary. D-3 D-3 (a) Capability available through contractual arrangements with nonutility generators. D-5 D-6 D-7 D-8 (a) Capability available through contractual arrangements with nonutility generators. D-9 - 41 - ITEM 7.	ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Page No. APS M-1 Monongahela M-9 Potomac M-18 West Penn M-27 AGC M-36 M-1 APS MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS CONSOLIDATED NET INCOME Earnings per share were $1.88 in 1993 and were $1.83 and $1.80 in 1992 and 1991. Consolidated net income was $215.8 million, $203.5 million, and $194.0 million. The increase in consolidated net income in 1993 resulted primarily from kWh sales and retail rate increases. The increase in 1992 resulted primarily from retail rate increases. These revenue increases, in both years, were offset in part by higher expenses. All per share amounts have been adjusted to reflect the November 4, 1993, two-for-one stock split (See Note F to the consolidated financial statements). SALES AND REVENUES KWh sales to and revenues from residential, commercial, and industrial customers are shown on page D-2. Such kWh sales increased 3.3% and 1.5% in 1993 and 1992, respectively. The increases in revenues from sales to residential, commercial, and industrial customers resulted from the following: Increase from Prior Year 1993 1992 (Millions of Dollars) Increased kWh sales $ 46.6 $ 9.1 Fuel and energy cost adjustment clauses (a) 57.0 37.9 Rate increases (b): Pennsylvania 25.2 5.8 Maryland 12.7 11.7 West Virginia 5.3 12.4 Virginia 2.5 1.8 Ohio 2.1 1.7 47.8 33.4 Other 6.2 .1 $157.6 $80.5 (a) Changes in revenues from fuel and energy cost adjustment clauses have little effect on consolidated net income. (b) See ITEM 1. RATE MATTERS for further information on rate changes. The increased kWh sales to residential and commercial customers in 1993 reflect both growth in number of customers and higher use. While 1993 heating degree days showed only a slight increase over 1992, and were approximately normal, cooling degree days increased 69% over 1992 and were 25% over normal, contributing to the 1993 kWh sales increases. The subsidiaries experienced a mild winter in the first quarter of 1992 followed by a much cooler than normal summer and early fall. As a result, weather had a negative impact on 1992 sales to retail customers. M -2 KWh sales to industrial customers increased .3% in 1993 and 2.9% in 1992. The relatively flat industrial sales growth in 1993 followed record industrial sales in 1992 which occurred in almost all industrial groups. One particular group, coal mines staffed by union personnel, recorded reduced usage because of selective work stoppages by the United Mine Workers of America (UMWA) for most of the year prior to the settling of the dispute in December 1993. KWh sales to and revenues from nonaffiliated utilities are comprised of the following items: 1993 1992 1991 KWh sales (in billions): From subsidiaries' generation 1.2 3.2 5.8 From purchased power 11.2 14.6 12.4 12.4 17.8 18.2 Revenues (in millions): From subsidiaries' generation $ 28.5 $ 91.7 $158.5 From sales of purchased power 318.2 373.8 366.5 $346.7 $465.5 $525.0 Decreased sales to nonaffiliated utilities resulted primarily from decreased demand and continuing price competition. Sales supplied by subsidiaries' generation in 1993 decreased to less than 15% of 1988 levels because of continuing growth of kWh sales to retail customers, which reduces the amount available for sale, and because other suppliers were willing or able to make the sales at lower prices. A significant factor affecting the subsidiaries' ability to compete in the market for sales to nonaffiliated utilities has been the approximate 290% increase (from about 67 cents per MWh to $2.60 per MWh) in taxes on generation in West Virginia since March 1989--a significant cost not experienced by utilities not generating in West Virginia. Further decreases in these sales are anticipated in 1994 before leveling off. About 95% of the aggregate benefits from sales to nonaffiliated utilities is passed on to retail customers and has little effect on consolidated net income. The decrease in other revenues in 1993 resulted from an agreement with the Federal Energy Regulatory Commission to record in 1993 about $14 million of revenues as sales to nonaffiliated utilities. Similar transactions were recorded as other revenues in prior years. M -3 OPERATING EXPENSES Fuel expenses decreased 4% in 1993 and 6% in 1992. Both decreases were primarily due to decreases in kWh generated. The 1992 decrease also included a 1% decrease in average coal prices. Fuel expenses are primarily subject to deferred power cost accounting procedures, as described in Note A to the consolidated financial statements, with the result that changes in fuel expenses have little effect on consolidated net income. "Purchased power and exchanges, net" represents power purchases from and exchanges with other utilities and qualified facilities under the Public Utility Regulatory Policies Act of 1978 (PURPA) and is comprised of the following items: 1993 1992 1991 (Millions of Dollars) Purchased power: For resale to other utilities $280.9 $344.0 $332.7 From PURPA generation 105.2 94.0 68.9 Other 33.8 12.7 29.0 Total power purchased 419.9 450.7 430.6 Power exchanges, net (2.5) .7 (1.4) $417.4 $451.4 $429.2 The amount of power purchased from other utilities for use by subsidiaries and for resale to other utilities depends upon the availability of the subsidiaries' generating equipment, transmission capacity, and fuel, and their cost of generation and the cost of operations of other utilities from which such purchases are made. The primary reason for the fluctuations in purchases for resale to other utilities is described under SALES AND REVENUES above. The cost of power purchased for use by the subsidiaries, including power from PURPA generation, is mostly recovered from customers currently through the regular fuel and energy cost recovery procedures followed by the subsidiaries' regulatory commissions and is primarily subject to deferred power cost procedures with the result that changes in such costs have little effect on consolidated net income. The increases in purchases from PURPA generation reflect additional generation from new PURPA projects. The 1993 increase in other purchased power reflects efforts to conserve coal during the UMWA dispute. The increase in other operation expense for 1993 and 1992 resulted primarily from increases in employee benefit costs and salaries and wages. The Financial Accounting Standards Board's (FASB) standard, SFAS No. 106, increased 1993 postretirement benefit expense by approximately $5 million. The subsidiaries are currently recovering approximately 85% of SFAS No. 106 expenses in rates and will be requesting recovery of substantially all of the remainder in 1994 rate cases. During 1992, the subsidiaries implemented significant changes to their benefits plans, including cost caps, in an effort to both control and reduce employee benefits costs. The cost caps provide for future postretirement medical benefit costs to be capped at two times 1993 levels. Because 1993 medical costs were more than actuarially projected, SFAS No. 106 costs for 1994 are expected to be approximately 20% greater than 1993 amounts. M-4 Another FASB standard, SFAS No. 112, "Employers' Accounting for Postemployment Benefits", effective in 1994, requires companies to accrue for other postemployment benefits such as disability benefits, health care benefits for disabled employees, severance pay, and workers' compensation claims. The subsidiaries currently accrue for workers' compensation claims and the estimated liability for the other benefits is not expected to be material. Maintenance expenses represent costs incurred to maintain the power stations, the transmission and distribution (T&D) system, and general plant, and reflect routine maintenance of equipment and rights-of-way as well as planned major repairs and unplanned expenditures, primarily from forced outages at the power stations and periodic storm damage on the T&D system. Maintenance expense in 1993 includes the effects of an ice storm and blizzard in March 1993. The subsidiaries are also experiencing, and expect to continue to experience, increased expenditures due to the aging of their power stations. Variations in maintenance expense result primarily from unplanned events and planned major projects, which vary in timing and magnitude depending upon the length of time equipment has been in service without a major overhaul, the amount of work found necessary when the equipment is dismantled, and outage requirements to comply with the Clean Air Act Amendments of 1990 (CAAA). Depreciation expense increases resulted primarily from additions to electric plant. Because of the increased levels of capital expenditures as a result of the CAAA (see Note I to the consolidated financial statements) and the replacement of aging equipment at the subsidiaries' power stations, depreciation expense is expected to increase significantly over the next few years. Taxes other than income increased $4 million in 1993 primarily due to increases in gross receipts taxes resulting from higher revenues from retail customers ($5 million) and increased property taxes ($2 million). These increases were offset by decreased West Virginia Business and Occupation taxes (B&O taxes) due to decreased generation in that state. The 1992 increase resulted from increased property taxes ($4 million), increases in gross receipts taxes ($3 million), and increased capital stock taxes ($2 million), offset by decreased B&O taxes ($2 million). The net increase of $13 million in federal and state income taxes in 1993 resulted primarily from an increase in income before taxes ($9 million), and an increase in the tax rate due to the Revenue Reconciliation Act of 1993 ($3 million). The net decrease in 1992 of $4 million resulted primarily from plant removal and certain bond refinancing cost tax deductions for which deferred taxes were not provided. Note B to the consolidated financial statements provides a further analysis of income tax expenses. M-5 The combined increase of $4 million in allowances for funds used during construction (AFUDC) in 1993 reflects increased construction expenditures including those associated with the CAAA, net of CAAA amounts included in rate base and earning a cash return. Future levels of AFUDC can be expected to increase slightly with increasing levels of CAAA expenditures until late 1994 upon substantial completion of Phase I of the CAAA compliance program. Fluctuations in other income, net, were individually insignificant. Other interest expense reflects changes in the levels of short-term debt maintained by the companies. The decrease in dividends on preferred stock of subsidiaries reflects the 1992 redemption of three series totaling $25 million with dividend rates of 9.4% to 9.64% and the 1993 redemption of an additional $2 million of 4.7% to $7.16 series, offset by the 1992 sale of $40 million of market auction preferred stock with an average dividend rate of 2.6%. LIQUIDITY AND CAPITAL RESOURCES SEC regulations define "liquidity" as "the ability of an enterprise to generate adequate amounts of cash to meet the enterprise's need for cash". System companies need cash for operating expenses, the payment of interest and dividends, retirement of debt and certain preferred stocks, and for their construction programs. To meet these needs, the companies have used internally generated funds and external financings, such as the sale of common and preferred stock, debt instruments, instalment loans, and lease arrangements. The timing and amount of external financings depend primarily upon economic and financial market conditions, the companies' cash needs, and capitalization ratio objectives. The availability and cost of external financing depend upon the financial health of the companies seeking those funds. CAPITAL REQUIREMENTS Construction expenditures for 1993 were $574 million and for 1994 and 1995 are estimated at $500 million and $400 million, respectively. These estimates include $161 million and $53 million, respectively, for substantial completion of the program of complying with Phase I of the CAAA discussed under ITEM 1. ENVIRONMENTAL MATTERS. It is anticipated that the Harrison Scrubber Project will be completed on schedule (late 1994) and that the final cost will be approximately 24% below the original budget. Primary factors contributing to the reduced cost include: 1) the absence of any major construction problems to date; 2) financing and material and equipment costs lower than expected; and 3) favorable rulings of state commissions allowing the inclusion of carrying costs of construction in rates in lieu of AFUDC. Construction expenditures through the year 2000 may include substantial amounts for M-6 compliance with both Phase I and Phase II of the CAAA. The subsidiaries are estimating amounts of approximately $1.4 billion, which includes $482 million expended through 1993, depending upon the strategy eventually selected for complying with Phase II. The mere possibility of new legislation which restricts or discourages carbon dioxide emissions, either through taxation or caps, further complicates the CAAA Phase II planning process. The remaining amount of this CAAA construction estimate, together with normal construction activity assures that continuing external financings will be required. In addition, the subsidiaries have additional capital requirements of an annual preferred stock sinking fund ($1.2 million) and debt maturities (see Note G to the consolidated financial statements). INTERNAL CASH FLOWS Internal generation of cash, consisting of cash flows from operations reduced by dividends, increased to $270 million in 1993. Regulatory commission orders received in Maryland, Pennsylvania, Virginia, and West Virginia provide for current cash recovery of the carrying costs of CAAA expenditures in rates, albeit with various amounts of lag. Based upon the authorizations received and requested and new rate cases planned in 1994, internal generation of cash can be expected to increase. The increase in other investments reflects the 1993 cash surrender values for secured benefit plans and a related prepayment. Materials and supplies, primarily fuel, constituted a significant source of cash in 1993 ($54 million). The five-year National Bituminous Coal Wage Agreement terminated on February 1, 1993. Coal inventories (fuel) as of December 31, 1992, were increased over 1991 amounts to provide an increased coal supply in the event of a strike. The union chose a strategy of selective shutdowns including mines that accounted for approximately 60% of the subsidiaries' regular coal supply. The union signed a new five-year contract in December 1993. System coal inventory, which declined during the dispute, and which is somewhat lower than the seasonal norm, is considered adequate. FINANCINGS In October 1993, the Company issued 2,400,000 shares of its common stock for $64.1 million. Also during 1993, the Company issued 1,364,846 shares of common stock under its Dividend Reinvestment and Stock Purchase Plan (DRISP), and Employee Stock Ownership and Savings Plan (ESOP) for $36.1 million. During 1993 the subsidiaries issued $43 million of 6.25% to 6.3% tax-exempt solid waste disposal notes to Harrison County, West Virginia, and refunded an aggregate of $634 million of debt securities having interest rates of 7% to 9.75% through the issuance of $652 million of securities having interest rates of 4.95% to 7.75%. The costs M-7 associated with the debt redemptions are being amortized over the life of the new bonds. Due to the significant number of refinancings which have occurred over the past two years, this balance is now about $44 million. Reduced future interest expense will more than offset these expenses. Short-term debt is used to meet temporary cash needs until the timing is considered appropriate to issue long-term securities. Short-term debt increased from $11.2 million in 1992 to $130.6 million in 1993. The subsidiaries canceled or postponed approximately $152 million of debt and equity financings in 1993 due to favorable short-term alternatives. In 1992, the Company and its subsidiaries established an internal money pool whereby surplus funds of the Company and certain subsidiaries may be borrowed on a short-term basis by the Company's subsidiaries. This has contributed to the decrease in the 1993 temporary cash investment amounts. Allegheny Generating Company in 1992 replaced its $65.7 million of commercial paper with $50.9 million of money pool borrowings and $2.4 million of four-year, 6.05%-6.10% medium-term notes. Allegheny Generating Company has available an established program to replace money pool borrowings with medium-term notes or commercial paper. At December 31, 1993, unused lines of credit with banks were $149 million. In addition, a multi-year credit program was established in January 1994, which provides that the subsidiaries may borrow on a standby revolving credit basis up to $300 million. After the initial three-year term, the program agreement provides that the maturity date may be extended in one-year increments. The borrowings have the support of a long-term credit facility. During 1994, the subsidiaries plan to issue about $230 million of new securities, consisting of both debt and equity issues and, if economic and market conditions make it desirable, may refinance up to $728 million of first mortgage bonds, preferred stock, and pollution control revenue notes. The subsidiaries may also engage in additional Harrison County tax-exempt solid waste disposal financings to the extent that funds are available. The Company plans to fund the subsidiaries' sale of common stock through the issuance of short-term debt and DRISP/ESOP common stock sales. The subsidiaries anticipate that they will be able to meet their future cash needs through internal cash generation and external financings as they have in the past and possibly through alternative financing procedures. M-8 ENVIRONMENTAL MATTERS AND OTHER CONTINGENCIES In the normal course of business, the subsidiaries are subject to various contingencies and uncertainties relating to their operations and construction programs, including cost recovery in the regulatory process, laws, regulations and uncertainties related to environmental matters, and legal actions. Contingencies and uncertainties related to the CAAA are discussed above and under Note I to the consolidated financial statements. All of the state jurisdictions in which the subsidiaries operate have enacted hazardous and solid waste management legislation. While the subsidiaries do not have significant hazardous waste concerns, solid wastes, such as fly ash and other coal by-products generated from power stations, must be disposed in accordance with the state requirements. The subsidiaries are incurring various costs, which are recoverable in rates, to comply with these and other environmental matters. The level of future expenditures for environmental matters is impossible to determine with any degree of certainty. It is management's opinion that the ultimate costs will not have a material effect on the financial position of the subsidiaries. As of January 1994, Monongahela has been named as a defendant along with multiple other defendants in 1,429 pending asbestos cases involving multiple plaintiffs and Monongahela, Potomac Edison, and West Penn have been named as defendants along with multiple defendants in an additional 626 cases by multiple plaintiffs. Because these cases are filed by "shotgun" complaints naming many plaintiffs and many defendants, it is presently impossible to determine the actual number of claims against the subsidiaries. However, based on past experience and data available to date, it is estimated that less than 600 cases actually involve claims against any or all of the subsidiaries. All complaints allege that the plaintiffs sustained unspecified injuries resulting from claimed exposure to asbestos in various generating plants and other industrial facilities operated by the various defendants, although all plaintiffs do not claim exposure at facilities operated by all defendants. All plaintiffs claiming exposure at subsidiary-operated stations were employed by third-party contractors, with the exception of three who claim to have been employees of Monongahela. Each plaintiff generally seeks compensatory and punitive damages against all defendants in amounts of up to $1 million and $3 million, respectively; in those cases that include a spousal claim for loss of consortium, damages are generally sought against all defendants in an amount of up to $1 million for the loss of consortium claim. Therefore, because of the multiple defendants, the subsidiaries believe potential liability of the subsidiaries is a very small percentage of the total amount of the damages sought. A total of 94 cases have been previously settled by Monongahela for an amount substantially less than the anticipated cost of defense. While the subsidiaries believe that all of these cases are without merit, they cannot predict the outcome of these cases or whether other cases will be filed. M-9 Monongahela MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Net Income Net income was $61.7 million, $58.3 million, and $54.1 million in 1993, 1992, and 1991, respectively. The increase in net income in 1993 resulted primarily from kWh sales and retail rate increases. The increase in 1992 resulted primarily from retail rate increases. These revenue increases, in both years, were offset in part by higher expenses. Sales and Revenues KWh sales to and revenues from residential, commercial, and industrial customers are shown on pages D-3 and D-4 Such kWh sales increased .3% in 1993 and decreased 1.0% in 1992. The increases in revenues from sales to residential, commercial, and industrial customers resulted from the following: Increase (Decrease) from Prior Year 1993 1992 (Millions of Dollars) Increased (decreased) kWh sales $ 6.6 $(5.3) Fuel and energy cost adjustment clauses (a) 11.8 12.3 Rate increases (b): West Virginia 4.1 12.1 Ohio 2.1 1.6 6.2 13.7 Other .2 (1.3) $24.8 $19.4 (a) Changes in revenues from fuel and energy cost adjustment clauses have little effect on net income. (b) Reflects a surcharge in West Virginia for recovery of carrying charges on expenditures to comply with the Clean Air Act Amendments of 1990 (CAAA), designed to produce $3.1 million on an annual basis effective on July 1, 1992, which was increased to $8.7 million on an annual basis effective on July 1, 1993, and a rate increase in Ohio, designed to produce $3.3 million on an annual basis, which became effective on July 21, 1992. The increased kWh sales to residential and commercial customers in 1993 reflect both growth in number of customers and higher use. While 1993 heating degree days showed only a slight increase over 1992, and were only 6% above normal, cooling degree days increased 54% over 1992, contributing to the 1993 kWh sales increases. The Company experienced a mild winter in the first quarter of 1992 followed by a much cooler than normal summer and early fall. As a result, weather had a negative impact on 1992 sales to retail customers. M-10 KWh sales to industrial customers decreased 4.4% in 1993 and .7% in 1992. The 1993 decrease was primarily due to continuing declines in sales to coal and primary metals customers. Coal mines staffed by union personnel, recorded reduced usage because of selective work stoppages by the United Mine Workers of America (UMWA) for most of the year prior to the settling of the dispute in December 1993. Lower sales to primary metals customers was due in part to one iron and steel customer's increased use of its own generation. KWh sales to and revenues from nonaffiliated utilities are comprised of the following items: 1993 1992 1991 KWh sales (in billions): From Company generation .3 1.0 1.8 From purchased power 2.8 3.6 3.1 3.1 4.6 4.9 Revenues (in millions): From Company generation $ 8.4 $ 26.7 $ 48.5 From sales of purchased power 77.6 92.9 91.5 $86.0 $119.6 $140.0 Decreased sales to nonaffiliated utilities resulted primarily from decreased demand and continuing price competition. Sales supplied by the Company's generation in 1993 decreased to less than 15% of 1988 levels because of growth of kWh sales to retail customers, which reduces the amount available for sale, and because other suppliers were willing or able to make the sales at lower prices. A significant factor affecting the Company's ability to compete in the market for sales to nonaffiliated utilities has been the approximate 290% increase (from about 67 cents per MWh to $2.60 per MWH) in taxes on generation in West Virginia since March 1989 - a significant cost not experienced by utilities not generating in West Virginia. Further decreases in these sales are anticipated in 1994 before leveling off. The increase in other revenues in 1993 and 1992 resulted from continued increases in sales of capacity, energy, and spinning reserve to other affiliated companies because of additional capacity and energy available from new PURPA projects in both years. This increase was offset in part in 1993 by an agreement with the Federal Energy Regulatory Commission to record in 1993 about $3 million of revenues as sales to nonaffiliated utilities. Similar transactions were recorded as other revenues in prior years. About 90% of the aggregate benefits from sales to affiliated and nonaffiliated utilities is passed on to retail customers and has little effect on net income. M-11 Operating Expenses Fuel expenses decreased 3% in 1993 and 9% in 1992. Both decreases were primarily due to decreases in kWh generated. Fuel expenses are primarily subject to deferred power cost accounting procedures, as described in Note A to the financial statements, with the result that changes in fuel expenses have little effect on net income. "Purchased power and exchanges, net" represents power purchases from and exchanges with nonaffiliated utilities and qualified facilities under the Public Utility Regulatory Policies Act of 1978 (PURPA), capacity charges paid to AGC, and other transactions with affiliates made pursuant to a power supply agreement whereby each company uses the most economical generation available in the System at any given time, and is comprised of the following items: 1993 1992 1991 (Millions of Dollars) Nonaffiliated transactions: Purchased power: For resale to other utilities $ 68.6 $ 85.5 $ 83.0 From PURPA generation 55.7 37.4 13.2 Other 8.1 3.1 7.2 Power exchanges, net (.6) .3 (.5) Affiliated transactions: AGC capacity charges 23.3 24.2 25.1 Energy and spinning reserve charges .5 2.8 5.3 $155.6 $153.3 $133.3 The amount of power purchased from nonaffiliated utilities for use by the Company and for resale to nonaffiliated utilities depends upon the availability of the Company's generating equipment, transmission capacity, and fuel, and its cost of generation and the cost of operations of nonaffiliated utilities from which such purchases are made. The primary reason for the fluctuations in purchases for resale to nonaffiliated utilities is described under Sales and Revenues above. The cost of power and capacity purchased for use by the Company, including power from PURPA generation and affiliated transactions, is mostly recovered from customers currently through the regular fuel and energy cost recovery procedures followed by the Company's regulatory commissions and is primarily subject to deferred power cost procedures with the result that changes in such costs have little effect on net income. The increases in purchases from PURPA generation reflects additional generation from new PURPA projects. The 1993 increase in other purchased power reflects efforts to conserve coal during the UMWA dispute. Energy and spinning reserve charges decreased in 1993 and 1992 primarily because of additional generation available from new PURPA projects. M-12 The increase in other operation expense for 1993 and 1992 resulted primarily from increases in salaries and wages and employee benefit costs. The Financial Accounting Standards Board's (FASB) standard, SFAS No. 106, will increase future employee benefit costs for postretirement benefit expenses. The Company is currently recovering approximately 50% of SFAS No. 106 expenses in rates and will be requesting recovery of the remainder in 1994 and early 1995 rate cases. This reflects for West Virginia and Ohio only the recovery of the previously authorized pay-as-you-go component. During 1992, the Company implemented significant changes to its benefits plans, including cost caps, in an effort to both control and reduce employee benefits costs. The cost caps provide for future postretirement medical benefit costs to be capped at two times 1993 levels. Because 1993 medical costs were more than actuarially projected, SFAS No. 106 costs for 1994 are expected to be approximately 25% greater than 1993 amounts. Another FASB standard, SFAS No. 112, "Employers' Accounting for Postemployment Benefits", effective in 1994, requires companies to accrue for other post- employment benefits such as disability benefits, health care benefits for disabled employees, severance pay, and workers' compensation claims. The Company currently accrues for workers' compensation claims and the estimated liability for the other benefits is not expected to be material. Maintenance expenses represent costs incurred to maintain the power stations, the transmission and distribution (T&D) system, and general plant, and reflect routine maintenance of equipment and rights-of-way as well as planned major repairs and unplanned expenditures, primarily from forced outages at the power stations and periodic storm damage on the T&D system. The Company is also experiencing, and expects to continue to experience, increased expenditures due to the aging of its power stations. Variations in maintenance expense result primarily from unplanned events and planned major projects, which vary in timing and magnitude depending upon the length of time equipment has been in service without a major overhaul, the amount of work found necessary when the equipment is dismantled, and outage requirements to comply with the CAAA. M-13 Depreciation expense increases resulted primarily from additions to electric plant. Because of the increased levels of capital expenditures as a result of the CAAA (see Note J to the financial statements) and the replacement of aging equipment at the Company's power stations, depreciation expense is expected to increase significantly over the next few years. Taxes other than income increased $1 million in 1993 primarily due to increases in gross receipts taxes resulting from higher revenues from retail customers ($1 million) and increased property taxes ($1 million), offset by decreased West Virginia Business and Occupation taxes (B&O taxes) ($1 million) due to decreased generation in that state. The 1992 decrease resulted from decreased B&O taxes ($2 million) and prior period B&O tax adjustments ($2 million), offset somewhat by increases in gross receipts and property taxes ($2 million). The net increase of $6 million in federal and state income taxes in 1993 resulted primarily from an increase in income before taxes ($4 million), and an increase in the tax rate due to the Revenue Reconciliation Act of 1993 ($1 million). The net decrease in 1992 of $3 million resulted primarily from plant removal and certain bond refinancing cost tax deductions for which deferred taxes were not provided. Note B to the financial statements provides a further analysis of income tax expenses. The combined increase of $2 million in allowances for funds used during construction (AFUDC) in 1993 reflects increased construction expenditures primarily associated with the CAAA, net of CAAA amounts included in rate base and earning a cash return. Future levels of AFUDC can be expected to decrease as the Company completes its Phase I compliance program. The decrease in other income, net, in 1993 resulted primarily from the Company's share of decreases in the earnings of AGC (see Note D to the financial statements). Other fluctuations in other income, net, were individually insignificant. Other interest expense reflects changes in the level of short-term debt maintained by the Company. Liquidity and Capital Resources SEC regulations define "liquidity" as "the ability of an enterprise to generate adequate amounts of cash to meet the enterprise's need for cash". The Company needs cash for operating expenses, the payment of interest and dividends, retirement of debt, and for its construction program. To meet these needs, the Company has used M-14 internally generated funds and external financings, such as the sale of common and preferred stock, debt instruments, instalment loans, and lease arrangements. The timing and amount of external financings depend primarily upon economic and financial market conditions, the Company's cash needs, and capitalization ratio objectives. The availability and cost of external financing depend upon the financial health of the companies seeking those funds. Capital Requirements Construction expenditures for 1993 were $141 million and for 1994 and 1995 are estimated at $103 million and $83 million, respectively. These estimates include $39 million and $10 million, respectively, for substantial completion of the program of complying with Phase I of the CAAA. It is anticipated that the Harrison Scrubber Project will be completed on schedule (late 1994) and that the final cost will be approximately 24% below the original budget. Primary factors contributing to the reduced cost include: 1) the absence of any major construction problems to date; 2) financing and material and equipment costs lower than expected; and 3) favorable rulings of state commissions allowing the inclusion of carrying costs of construction in rates in lieu of AFUDC. Construction expenditures through the year 2000 may include substantial amounts for compliance with both Phase I and Phase II of the CAAA. The Company is estimating amounts of approximately $400 million, which includes $122 million expended through 1993, depending upon the strategy eventually selected for complying with Phase II. The mere possibility of new legislation which restricts or discourages carbon dioxide emissions, either through taxation or caps, further complicates the CAAA Phase II planning process. The remaining amount of this CAAA construction estimate, together with normal construction activity assures that continuing external financings will be required. In addition, the Company has additional capital requirements of debt maturities (see Note H to the financial statements). Internal Cash Flows Internal generation of cash, consisting of cash flows from operations reduced by dividends, was about $69 million for 1993. A regulatory commission order has been received in West Virginia authorizing procedures to provide for current cash recovery of the carrying costs of CAAA expenditures in rates, albeit with a certain amount of lag. Based upon the authorization received and new rate cases planned in 1994 and early 1995, internal generation of cash can be expected to increase. M-15 Materials and supplies, primarily fuel, constituted a significant source of cash in 1993 ($13 million). The five- year National Bituminous Coal Wage Agreement terminated on February 1, 1993. Coal inventories (fuel) as of December 31, 1992, were increased over 1991 amounts to provide an increased coal supply in the event of a strike. The union chose a strategy of selective shutdowns including mines that accounted for approximately 60% of the System's regular coal supply. The union signed a new five-year contract in December 1993. System coal inventory, which declined during the dispute, and which is somewhat lower than the seasonal norm, is considered adequate. Financings During 1993 the Company issued $10.68 million of 6.25% tax-exempt solid waste disposal notes to Harrison County, West Virginia, and refunded an aggregate of $67 million of debt securities having interest rates of 7.5% to 9.5% through the issuance of $72 million of securities having interest rates of 5.625% to 5.95%. The costs associated with the debt redemptions are being amortized over the life of the new bonds. Due to the significant number of refinancings which have occurred over the past two years, this balance is now about $12 million. Reduced future interest expense will more than offset these expenses. Short-term debt is used to meet temporary cash needs until the timing is considered appropriate to issue long- term securities. Short-term debt, including notes payable to affiliates under the money pool, increased from $8.0 million in 1992 to $63.1 million in 1993. The Company canceled or postponed approximately $69 million of debt and equity financings in 1993 due to favorable short-term alternatives. In 1992, the Company and its affiliates established an internal money pool as a facility to accommodate intercompany short-term borrowing needs, to the extent that certain of the companies have funds available. At December 31, 1993, the Company had SEC authorization to issue up to $100 million of short-term debt. In addition, a multi-year credit program was established in January 1994, which provides that the Company may borrow on a standby revolving credit basis up to $81 million. After the initial three-year term, the program agreement provides that the maturity date may be extended in one-year increments. The borrowings have the support of a long-term credit facility. During 1994, the Company plans to issue about $50 million of new equity securities and, if economic and market conditions make it desirable, may refinance up to $285 million of first M-16 mortgage bonds, preferred stock, and pollution control revenue notes. The Company may also engage in additional Harrison County tax-exempt solid waste disposal financings to the extent that funds are available. The Company anticipates that it will be able to meet its future cash needs through internal cash generation and external financings as it has in the past and possibly through alternative financing procedures. Environmental Matters and Other Contingencies In the normal course of business, the Company is subject to various contingencies and uncertainties relating to its operations and construction programs, including cost recovery in the regulatory process, laws, regulations and uncertainties related to environmental matters, and legal actions. Contingencies and uncertainties related to the CAAA are discussed above and under Note J to the financial statements. All of the state jurisdictions in which the Company operates have enacted hazardous and solid waste management legislation. While the Company does not have significant hazardous waste concerns, solid wastes, such as fly ash and other coal by-products generated from power stations, must be disposed in accordance with the state requirements. The Company is incurring various costs, which are recoverable in rates, to comply with these and other environmental matters. The level of future expenditures for environmental matters is impossible to determine with any degree of certainty. It is management's opinion that the ultimate costs will not have a material effect on the financial position of the Company. As of January 1994, the Company has been named as a defendant along with multiple other defendants in 1,429 pending asbestos cases involving multiple plaintiffs and the Company and its affiliates have been named as defendants along with multiple defendants in an additional 626 cases by multiple plaintiffs. Because these cases are filed by "shotgun" complaints naming many plaintiffs and many defendants, it is presently impossible to determine the actual number of claims against the Company and its affiliates. However, based on past experience and data available to date, it is estimated that less than 600 cases actually involve claims against the M-17 Company or its affiliates. All complaints allege that the plaintiffs sustained unspecified injuries resulting from claimed exposure to asbestos in various generating plants and other industrial facilities operated by the various defendants, although all plaintiffs do not claim exposure at facilities operated by all defendants. All plaintiffs claiming exposure at System-operated stations were employed by third-party contractors, with the exception of three who claim to have been employees of the Company. Each plaintiff generally seeks compensatory and punitive damages against all defendants in amounts of up to $1 million and $3 million, respectively; in those cases that include a spousal claim for loss of consortium, damages are generally sought against all defendants in an amount of up to $1 million for the loss of consortium claim. Therefore, because of the multiple defendants, the Company believes its potential liability is a very small percentage of the total amount of the damages sought. A total of 94 cases have been previously settled by the Company for an amount substantially less than the anticipated cost of defense. While the Company believes that all of these cases are without merit, it cannot predict the outcome of these cases or whether other cases will be filed. M-18 Potomac MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Net Income Net income was $73.5 million, $67.5 million, and $58.2 million in 1993, 1992, and 1991, respectively. The increase in net income in 1993 resulted primarily from kWh sales and retail rate increases. The increase in 1992 resulted primarily from retail rate increases. These revenue increases, in both years, were offset in part by higher expenses. Sales and Revenues KWh sales to and revenues from residential, commercial, and industrial customers are shown on pages D-5 and D-6. Such kWh sales increased 6.3% and 2.0% in 1993 and 1992, respectively. The increases in revenues from sales to residential, commercial, and industrial customers resulted from the following: Increase from Prior Year 1993 1992 (Millions of Dollars) Increased kWh sales $24.4 $ 7.7 Fuel and energy cost adjustment clauses (a) 19.1 10.4 Rate increases (b): Maryland 12.7 11.7 Virginia 2.5 1.8 West Virginia 1.1 .3 16.3 13.8 Other 2.9 .2 $62.7 $32.1 (a) Changes in revenues from fuel and energy cost adjustment clauses have little effect on net income. (b) Reflects a rate increase in Maryland, designed to produce $11.3 million on an annual basis, which became effective on February 25, 1993, and a rate increase in Virginia, designed to produce $10.0 million on an annual basis, which became effective on September 28, 1993, subject to refund. The Maryland surcharge for recovery of carrying charges on Clean Air Act Amendments of 1990 (CAAA) compliance investment of $1.7 million effective on June 4, 1992, which was increased to $3.9 million effective on December 3, 1992, was rolled into base rates effective with the February 1993 increase. Rate increases also include a CAAA surcharge in West Virginia designed to produce $.8 million on an annual basis effective July 1, 1992, which was increased to $2.2 million on an annual basis effective July 1, 1993. The increased kWh sales to residential and commercial customers in 1993 reflect both higher use and growth in number of customers. While 1993 heating degree days showed only a slight increase over 1992, and were only 7% M-19 above normal, cooling degree days increased 82% over 1992 and were 12% over normal, contributing to the 1993 kWh sales increases. The Company experienced a normal winter in the first quarter of 1992 followed by a much cooler than normal summer and early fall. As a result, weather had a negative impact on 1992 sales to retail customers. KWh sales to industrial customers increased 4.3% in 1993 and 2.0% in 1992. The increase in both years occurred in almost all industrial groups, the most significant of which in 1993 was from sales to cement customers. KWh sales to and revenues from nonaffiliated utilities are comprised of the following items: 1993 1992 1991 KWh sales (in billions): From Company generation .4 1.0 1.8 From purchased power 3.5 4.4 3.8 3.9 5.4 5.6 Revenues (in millions): From Company generation $8.6 $27.5 $47.4 From sales of purchased power 99.5 113.6 114.3 $108.1 $141.1 $161.7 Decreased sales to nonaffiliated utilities resulted primarily from decreased demand and continuing price competition. Sales supplied by the Company's generation in 1993 decreased to less than 15% of 1988 levels because of continuing growth of kWh sales to retail customers, which reduces the amount available for sale, and because other suppliers were willing or able to make the sales at lower prices. A significant factor affecting the Company's ability to compete in the market for sales to nonaffiliated utilities has been the approximate 290% increase (from about 67cents per MWh to $2.60 per MWh) in taxes on generation in West Virginia since March 1989 - a significant cost not experienced by utilities not generating in West Virginia. Further decreases in these sales are anticipated in 1994 before leveling off. About 95% of the aggregate benefits from sales to nonaffiliated utilities is passed on to retail customers and has little effect on net income. The decrease in other revenues in 1993 resulted from an agreement with the Federal Energy Regulatory Commission to record in 1993 about $4 million of revenues as sales to nonaffiliated utilities. Similar transactions were recorded as other revenues in prior years. M-20 Operating Expenses Fuel expenses decreased 4% in 1993 and 6% in 1992. Both decreases were primarily due to decreases in kWh generated. The 1992 decrease also included a 1% decrease in average coal prices. Fuel expenses are primarily subject to deferred power cost accounting procedures, as described in Note A to the financial statements, with the result that changes in fuel expenses have little effect on net income. "Purchased power and exchanges, net" represents power purchases from and exchanges with nonaffiliated utilities, capacity charges paid to AGC, and other transactions with affiliates made pursuant to a power supply agreement whereby each company uses the most economical generation available in the System at any given time, and is comprised of the following items: 1993 1992 1991 (Millions of Dollars) Nonaffiliated transactions: Purchased power: For resale to other utilities $87.9 $104.6 $103.7 Other 10.5 3.7 8.9 Power exchanges, net (.8) .2 (.4) Affiliated transactions: AGC capacity charges 28.0 29.6 31.3 Other affiliated capacity charges 28.4 21.9 23.4 Energy and spinning reserve charges 51.1 41.2 37.6 $205.1 $201.2 $204.5 The amount of power purchased from nonaffiliated utilities for use by the Company and for resale to nonaffiliated utilities depends upon the availability of the Company's generating equipment, transmission capacity, and fuel, and its cost of generation and the cost of operations of nonaffiliated utilities from which such purchases are made. The primary reason for the fluctuations in purchases for resale to nonaffiliated utilities is described under Sales and Revenues above. The cost of power purchased from nonaffiliates for use by the Company and affiliated energy and spinning reserve charges are mostly recovered from customers currently through the regular fuel and energy cost recovery procedures followed by the Company's regulatory commissions and is primarily subject to deferred power cost procedures with the result that changes in such costs have little effect on net income. The 1993 increase in other purchased power reflects efforts to conserve coal because of selective work stoppages by the United Mine Workers of America for most of the year. M-21 While the Company does not currently purchase generation from qualified facilities under the Public Utility Regulatory Policies Act of 1978 (PURPA), several projects have been proposed, and an agreement has been reached with one facility to commence purchasing generation in 1999. This project and others may significantly increase the cost of power purchases passed on to customers. The increase in affiliated capacity and energy and spinning reserve charges in 1993 was due to growth of kWh sales to retail customers and an increase in affiliated energy available because of energy purchased by an affiliate from new PURPA projects in 1992 and 1993. The increase in other operation expense for 1993 and 1992 resulted primarily from increases in employee benefit costs and salaries and wages. The Financial Accounting Standards Board's (FASB) standard, SFAS No. 106, increased 1993 postretirement benefit expense by approximately $1.5 million. The Company is currently recovering approximately 90% of SFAS No. 106 expenses in rates and will be requesting recovery of the remainder in 1994 rate cases. During 1992, the Company implemented significant changes to its benefits plans, including cost caps, in an effort to both control and reduce employee benefits costs. The cost caps provide for future postretirement medical benefit costs to be capped at two times 1993 levels. Because 1993 medical costs were more than actuarially projected, SFAS No. 106 costs for 1994 are expected to be approximately 25% greater than 1993 amounts. Another FASB standard, SFAS No. 112, "Employers' Accounting for Postemployment Benefits", effective in 1994, requires companies to accrue for other post- employment benefits such as disability benefits, health care benefits for disabled employees, severance pay, and workers' compensation claims. The Company currently accrues for workers' compensation claims and the estimated liability for the other benefits is not expected to be material. Maintenance expenses represent costs incurred to maintain the power stations, the transmission and distribution (T&D) system, and general plant, and reflect routine maintenance of equipment and rights-of-way as well as planned major repairs and unplanned expenditures, primarily from forced outages at the power stations and periodic storm damage on the T&D system. M-22 The Company is also experiencing, and expects to continue to experience, increased expenditures due to the aging of its power stations. Variations in maintenance expense result primarily from unplanned events and planned major projects, which vary in timing and magnitude depending upon the length of time equipment has been in service without a major overhaul, the amount of work found necessary when the equipment is dismantled, and outage requirements to comply with the CAAA. Depreciation expense increases resulted primarily from additions to electric plant. Because of the increased levels of capital expenditures as a result of the CAAA (see Note J to the financial statements) and the replacement of aging equipment at the Company's power stations, depreciation expense is expected to increase significantly over the next few years. Taxes other than income increased $1 million in 1993 due to increases in gross receipts taxes resulting from higher revenues from retail customers ($1 million) and increased property taxes ($1 million), offset by decreased West Virginia Business and Occupation taxes due to decreased generation in that state ($1 million). The 1992 increase was due to increased property ($1 million) and gross receipts ($1 million) taxes. The net increase of $2 million in federal and state income taxes in 1993 resulted primarily from an increase in income before taxes ($3 million) and an increase in the tax rate due to the Revenue Reconciliation Act of 1993 ($1 million), offset by plant removal tax deductions for which deferred taxes were not provided ($1 million). The net increase in 1992 was primarily due to an increase in income before taxes. Note B to the financial statements provides a further analysis of income tax expenses. The combined increase of $2 million in allowances for funds used during construction (AFUDC) in 1993 reflects increased construction expenditures including those associated with the CAAA, net of CAAA amounts included in rate base and earning a cash return. Future levels of AFUDC can be expected to increase slightly with increasing levels of CAAA expenditures until late 1994 upon substantial completion of Phase I of the CAAA compliance program. The decrease in other income, net in 1993 resulted primarily from the Company's share of decreases in the earnings of AGC (see Note D to the financial statements). Other fluctuations in other income, net, were individually insignificant. Other interest expense reflects changes in the level of short-term debt maintained by the Company. Liquidity and Capital Resources SEC regulations define "liquidity" as "the ability of an enterprise to generate adequate amounts of cash to meet the enterprise's need for cash". The Company needs cash for operating expenses, the payment of interest and dividends, retirement of debt and certain preferred stock, M-23 and for its construction program. To meet these needs, the Company has used internally generated funds and external financings, such as the sale of common and preferred stock, debt instruments, instalment loans, and lease arrangements. The timing and amount of external financings depend primarily upon economic and financial market conditions, the Company's cash needs, and capitalization ratio objectives. The availability and cost of external financing depend upon the financial health of the companies seeking those funds. During 1993, the Company continued its participation in the Collaborative Process for Demand-Side Management in Maryland with the Maryland PSC Staff, Office of People's Counsel, the Department of Natural Resources, Maryland Energy Administration, and the Company's largest industrial customer. The Company received the Maryland PSC's approval to implement a Commercial and Industrial Lighting Rebate Program as of July 1, 1993. Through December 31, 1993, the Company had received applications for $7.5 million in rebates related to the commercial lighting program. Program costs, including rebates and lost revenues, are deferred and are to be recovered through an energy conservation surcharge over a five-year period. Capital Requirements Construction expenditures for 1993 were $179 million and for 1994 and 1995 are estimated at $136 million and $106 million, respectively. These estimates include $40 million and $10 million, respectively, for substantial completion of the program of complying with Phase I of the CAAA. It is anticipated that the Harrison Scrubber Project will be completed on schedule (late 1994) and that the final cost will be approximately 24% below the original budget. Primary factors contributing to the reduced cost include: 1) the absence of any major construction problems to date; 2) financing and material and equipment costs lower than expected; and 3) favorable rulings of state commissions allowing the inclusion of carrying costs of construction in rates in lieu of AFUDC. Construction expenditures through the year 2000 may include substantial amounts for compliance with both Phase I and Phase II of the CAAA. The Company is estimating amounts of approximately $350 million, which includes $153 million expended through 1993, depending upon the strategy eventually selected for complying with Phase II. The mere possibility of new legislation which restricts or discourages carbon dioxide emissions, either through taxation or caps, further complicates the CAAA Phase II planning process. The remaining amount of this CAAA construction estimate, together with normal construction activity assures that continuing external financings will be required. In addition, the Company has M-24 additional annual capital requirements of an annual preferred stock sinking fund ($1.2 million) and debt maturities (see Note H to the financial statements). Internal Cash Flows Internal generation of cash, consisting of cash flows from operations reduced by dividends, increased to $75 million in 1993. Regulatory commission orders received in all of the state jurisdictions and the FERC provide for current cash recovery of the carrying costs of CAAA expenditures in rates, albeit with various amounts of lag. Based upon the authorizations received and new rate cases planned in 1994, internal generation of cash can be expected to increase. Materials and supplies, primarily fuel, constituted a significant source of cash in 1993 ($14 million). The five-year National Bituminous Coal Wage Agreement terminated on February 1, 1993. Coal inventories (fuel) as of December 31, 1992, were increased over 1991 amounts to provide an increased coal supply in the event of a strike. The union chose a strategy of selective shutdowns including mines that accounted for approximately 60% of the System's regular coal supply. The union signed a new five-year contract in December 1993. System coal inventory, which declined during the dispute, and which is somewhat lower than the seasonal norm, is considered adequate. Financings During 1993 the Company issued $13.99 million of 6.25% tax-exempt solid waste disposal notes to Harrison County, West Virginia, and refunded an aggregate of $121 million of debt securities having interest rates of 7% to 9.5% through the issuance of $129 million of securities having interest rates of 5.875% to 7.75%. The costs associated with the debt redemptions are being amortized over the life of the new bonds. Due to the significant number of refinancings which have occurred over the past two years, this balance is now about $9 million. Reduced future interest expense will more than offset these expenses. Short-term debt is used to meet temporary cash needs until the timing is considered appropriate to issue long- term securities. The Company canceled or postponed approximately $36 million of debt financings in 1993 due to favorable short-term alternatives. In 1992, the Company and its affiliates established an internal money pool as a facility to accommodate intercompany short- term borrowing needs, to the extent that certain of the companies have funds available. M-25 At December 31, 1993, the Company had SEC authorization to issue up to $115 million of short-term debt. In addition, a multi-year credit program was established in January 1994, which provides that the Company may borrow on a standby revolving credit basis up to $84 million. After the initial three-year term, the program agreement provides that the maturity date may be extended in one-year increments. The borrowings have the support of a long-term credit facility. During 1994, the Company plans to issue about $75 million of new debt securities and, if economic and market conditions make it desirable, may refinance up to $231 million of first mortgage bonds, preferred stock, and pollution control revenue notes. The Company may also engage in additional Harrison County tax-exempt solid waste disposal financings to the extent that funds are available. The Company anticipates that it will be able to meet its future cash needs through internal cash generation and external financings as it has in the past and possibly through alternative financing procedures. Environmental Matters and Other Contingencies In the normal course of business, the Company is subject to various contingencies and uncertainties relating to its operations and construction programs, including cost recovery in the regulatory process, laws, regulations and uncertainties related to environmental matters, and legal actions. Contingencies and uncertainties related to the CAAA are discussed above and under Note J to the financial statements. All of the state jurisdictions in which the Company operates have enacted hazardous and solid waste management legislation. While the Company does not have significant hazardous waste concerns, solid wastes, such as fly ash and other coal by-products generated from power stations, must be disposed in accordance with the state requirements. The Company is incurring various costs, which are recoverable in rates, to comply with these and other environmental matters. The level of future expenditures for environmental matters is impossible to determine with any degree of certainty. It is management's opinion that the ultimate costs will not have a material effect on the financial position of the Company. M-26 As of January 1994, Monongahela Power Company (MP), an affiliated company, has been named as a defendant along with multiple other defendants in 1,429 pending asbestos cases involving multiple plaintiffs and the Company and its affiliates have been named as defendants along with multiple defendants in an additional 626 cases by multiple plaintiffs. Because these cases are filed by "shotgun" complaints naming many plaintiffs and many defendants, it is presently impossible to determine the actual number of claims against the Company and its affiliates. However, based on past experience and data available to date, it is estimated that less than 600 cases actually involve claims against the Company or its affiliates. All complaints allege that the plaintiffs sustained unspecified injuries resulting from claimed exposure to asbestos in various generating plants and other industrial facilities operated by the various defendants, although all plaintiffs do not claim exposure at facilities operated by all defendants. All plaintiffs claiming exposure at System-operated stations were employed by third-party contractors, with the exception of three who claim to have been employees of MP. The Company is joint owner with MP in five generating plants, including four operated by MP in West Virginia. Each plaintiff generally seeks compensatory and punitive damages against all defendants in amounts of up to $1 million and $3 million, respectively; in those cases that include a spousal claim for loss of consortium, damages are generally sought against all defendants in an amount of up to $1 million for the loss of consortium claim. Therefore, because of the multiple defendants, the Company believes its potential liability is a very small percentage of the total amount of the damages sought. A total of 94 cases have been previously settled by MP for an amount substantially less than the anticipated cost of defense. While the Company believes that all of these cases are without merit, it cannot predict the outcome of these cases or whether other cases will be filed. M-27 West Penn MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Consolidated Net Income Consolidated net income was $102.1 million, $98.2 million, and $101.2 million in 1993, 1992, and 1991, respectively. The increase in consolidated net income in 1993 resulted primarily from kWh sales and retail rate increases, offset in part by higher expenses. Higher retail revenues in 1992 from a surcharge to recover increases in various state taxes and greater kWh sales were more than offset by higher expenses. Sales and Revenues KWh sales to and revenues from residential, commercial, and industrial customers are shown on pages D-7 and D-8. Such kWh sales increased 3.1% and 2.7% in 1993 and 1992, respectively. The increases in revenues from sales to residential, commercial, and industrial customers resulted from the following: Increase from Prior Year 1993 1992 (Millions of Dollars) Increased kWh sales $15.5 $ 6.7 Fuel and energy cost adjustment clauses (a) 26.2 15.2 Rate increases (b) 25.2 5.8 Other 3.1 1.3 $70.0 $29.0 (a) Changes in revenues from fuel and energy cost adjustment clauses have little effect on consolidated net income. (b) Reflects a base rate increase on an annual basis of about $61.6 million in Pennsylvania effective May 18, 1993, including $26.1 million for recovery of carrying charges on Clean Air Act Amendments of 1990 (CAAA) compliance costs, and in 1992 also reflects a surcharge effective August 24, 1991, to recover Pennsylvania tax increases. The increased kWh sales to residential and commercial customers in 1993 reflect both growth in number of customers and higher use. While 1993 heating degree days remained about the same as 1992, and were only 6% below normal, cooling degree days increased 70% over 1992 and were 46% over normal, contributing to the 1993 kWh sales increases. The Company experienced a mild winter in the first quarter of 1992 followed by a much cooler than normal summer and early fall. As a result, weather had a negative impact on 1992 sales to retail customers. M-28 KWh sales to industrial customers increased .8% in 1993 and 6.3% in 1992. The relatively flat industrial sales growth in 1993 followed increases in industrial sales in 1992 which occurred in almost all industrial groups. One particular group, coal mines staffed by union personnel, recorded reduced usage because of selective work stoppages by the United Mine Workers of America (UMWA) for most of the year prior to the settling of the dispute in December 1993. KWh sales to and revenues from nonaffiliated utilities are comprised of the following items: 1993 1992 1991 KWh sales (in billions): From Company generation .4 1.3 2.3 From purchased power 5.0 6.5 5.4 5.4 7.8 7.7 Revenues (in millions): From Company generation $11.5 $37.5 $62.5 From sales of purchased power 141.0 167.2 160.7 $152.5 $204.7 $223.2 Decreased sales to nonaffiliated utilities resulted primarily from decreased demand and continuing price competition. Sales supplied by the Company's generation in 1993 decreased to less than 15% of 1988 levels because of continuing growth of kWh sales to retail customers, which reduces the amount available for sale, and because other suppliers were willing or able to make the sales at lower prices. A significant factor affecting the Company's ability to compete in the market for sales to nonaffiliated utilities has been the approximate 290% increase (from about 67 cents per MWh to $2.60 per MWh) in taxes on generation in West Virginia since March 1989 - a significant cost not experienced by utilities not generating in West Virginia. Further decreases in these sales are anticipated in 1994 before leveling off. The decrease in other revenues in 1993 and 1992 resulted from continued decreases in sales of energy and spinning reserve to an affiliated company because of additional energy available to it from new PURPA projects commencing in both years. The 1993 decrease was also due in part to an agreement with the Federal Energy Regulatory Commission to record in 1993 about $6 million of revenues as sales to nonaffiliated utilities. Similar transactions were recorded as other revenues in prior years. Most of the aggregate benefits from sales to affiliated and nonaffiliated utilities is passed on to retail customers and has little effect on consolidated net income. M-29 Operating Expenses Fuel expenses decreased 4% in each of the years of 1993 and 1992 primarily due to decreases in kWh generated. Fuel expenses are primarily subject to deferred power cost accounting procedures, as described in Note A to the consolidated financial statements, with the result that changes in fuel expenses have little effect on consolidated net income. "Purchased power and exchanges, net" represents power purchases from and exchanges with nonaffiliated utilities and qualified facilities under the Public Utility Regulatory Policies Act of 1978 (PURPA), capacity charges paid to AGC, and other transactions with affiliates made pursuant to a power supply agreement whereby each company uses the most economical generation available in the System at any given time, and is comprised of the following items: 1993 1992 1991 (Millions of Dollars) Nonaffiliated transactions: Purchased power: For resale to other utilities $124.5 $153.9 $146.0 From PURPA generation 49.6 56.5 55.6 Other 15.2 5.9 12.9 Power exchanges, net (1.2) .3 (.5) Affiliated transactions: AGC capacity charges 42.3 43.5 44.1 Energy and spinning reserve charges 4.7 3.5 3.8 Other affiliated capacity charges .7 .6 .6 $235.8 $264.2 $262.5 The amount of power purchased from nonaffiliated utilities for use by the Company and for resale to nonaffiliated utilities depends upon the availability of the Company's generating equipment, transmission capacity, and fuel, and its cost of generation and the cost of operations of nonaffiliated utilities from which such purchases are made. The primary reason for the fluctuations in purchases for resale to nonaffiliated utilities is described under Sales and Revenues above. The cost of power and capacity purchased for use by the Company, including power from PURPA generation and affiliated transactions, is mostly recovered from customers currently through the regular fuel and energy cost recovery procedures followed by the Company's regulatory commissions and is primarily subject to deferred power cost procedures with the result that changes in such costs have little effect on consolidated net M-30 income. The decrease in purchases from PURPA generation in 1993 was due to a planned generating outage at one PURPA project. The 1993 increase in other purchased power reflects efforts to conserve coal during the UMWA dispute. The increase in other operation expense for 1993 and 1992 resulted primarily from increases in salaries and wages and in 1993 also from employee benefit costs. The Financial Accounting Standards Board's (FASB) standard, SFAS No. 106, increased 1993 postretirement benefit expense by approximately $3.1 million. The Company is currently recovering all of SFAS No. 106 expenses in rates. During 1992, the Company implemented significant changes to its benefits plans, including cost caps, in an effort to both control and reduce employee benefits costs. The cost caps provide for future postretirement medical benefit costs to be capped at two times 1993 levels. Because 1993 medical costs were more than actuarially projected, SFAS No. 106 costs for 1994 are expected to be approximately 5% greater than 1993 amounts. Another FASB standard, SFAS No. 112, "Employers' Accounting for Postemployment Benefits", effective in 1994, requires companies to accrue for other post- employment benefits such as disability benefits, health care benefits for disabled employees, severance pay, and workers' compensation claims. The Company currently accrues for workers' compensation claims and the estimated liability for the other benefits is not expected to be material. Maintenance expenses represent costs incurred to maintain the power stations, the transmission and distribution (T&D) system, and general plant, and reflect routine maintenance of equipment and rights-of-way as well as planned major repairs and unplanned expenditures, primarily from forced outages at the power stations and periodic storm damage on the T&D system. Maintenance expense in 1993 includes the effects of an ice storm and blizzard in March 1993. The Company is also experiencing, and expects to continue to experience, increased expenditures due to the aging of its power stations. Variations in maintenance expense result primarily from unplanned events and planned major projects, which vary in timing and magnitude depending upon the length of time equipment has been in service without a major overhaul, the amount of work found necessary when the equipment is dismantled, and outage requirements to comply with the CAAA. M-31 Depreciation expense increases resulted primarily from additions to electric plant and in 1993 also from a change in depreciation rates and net salvage amortization as a result of the May 1993 rate order. Because of the increased levels of capital expenditures as a result of the CAAA (see Note J to the consolidated financial statements) and the replacement of aging equipment at the Company's power stations, depreciation expense is expected to increase significantly over the next few years. Taxes other than income increased $2 million in 1993 primarily due to increases in gross receipts taxes resulting from higher revenues from retail customers ($3 million) offset in part by decreased West Virginia Business and Occupation taxes (B&O taxes) ($2 million) due to decreased generation in that state. The 1992 increase resulted from increased property and capital stock taxes ($4 million), increased B&O taxes ($1 million), and increases in gross receipts taxes ($1 million). The net increase of $7 million in federal and state income taxes in 1993 resulted primarily from an increase in income before taxes ($6 million), and an increase in the tax rate due to the Revenue Reconciliation Act of 1993 ($1 million). The net decrease in 1992 of $4 million resulted primarily from a decrease in income before taxes. Note B to the consolidated financial statements provides a further analysis of income tax expenses. The combined increase of $.3 million in allowances for funds used during construction (AFUDC) in 1993 reflects increased construction expenditures including those associated with the CAAA, net of CAAA amounts included in rate base and earning a cash return. Future levels of AFUDC can be expected to increase slightly with increasing levels of CAAA expenditures until late 1994 upon substantial completion of Phase I of the CAAA compliance program. The decrease in other income, net, in 1993 resulted primarily from the Company's share of decreases in the earnings of AGC (see Note D to the consolidated financial statements). Other fluctuations in other income, net, were individually insignificant. Other interest expense reflects changes in the level of short-term debt maintained by the Company. Liquidity and Capital Resources SEC regulations define "liquidity" as "the ability of an enterprise to generate adequate amounts of cash to meet the enterprise's need for cash". The Company needs cash for operating expenses, the payment of interest and dividends, retirement of debt, and for its construction program. To meet these needs, the Company has used internally generated funds and external financings, such M-32 as the sale of common and preferred stock, debt instruments, instalment loans, and lease arrangements. The timing and amount of external financings depend primarily upon economic and financial market conditions, the Company's cash needs, and capitalization ratio objectives. The availability and cost of external financing depend upon the financial health of the companies seeking those funds. Capital Requirements Construction expenditures for 1993 were $251 million and for 1994 and 1995 are estimated at $258 million and $208 million, respectively. These estimates include $82 million and $33 million, respectively, for substantial completion of the program of complying with Phase I of the CAAA. It is anticipated that the Harrison Scrubber Project will be completed on schedule (late 1994) and that the final cost will be approximately 24% below the original budget. Primary factors contributing to the reduced cost include: 1) the absence of any major construction problems to date; 2) financing and material and equipment costs lower than expected; and 3) favorable ruling of the Pennsylvania PUC allowing the inclusion of carrying costs of construction in rates in lieu of AFUDC. Construction expenditures through the year 2000 may include substantial amounts for compliance with both Phase I and Phase II of the CAAA. The Company is estimating amounts of approximately $700 million, which includes $207 million expended through 1993, depending upon the strategy eventually selected for complying with Phase II. The mere possibility of new legislation which restricts or discourages carbon dioxide emissions, either through taxation or caps, further complicates the CAAA Phase II planning process. The remaining amount of this CAAA construction estimate, together with normal construction activity assures that continuing external financings will be required. In addition, the Company has additional capital requirements of debt maturities (see Note H to the consolidated financial statements). Internal Cash Flows Internal generation of cash, consisting of cash flows from operations reduced by dividends, increased to $119 million in 1993. A regulatory commission order has been received from the PUC which provides for current cash recovery of the carrying costs of CAAA expenditures in rates, albeit with a certain amount of lag. Based upon the authorization received and a new rate case planned in 1994, internal generation of cash can be expected to increase. M-33 Materials and supplies, primarily fuel, constituted a significant source of cash in 1993 ($27 million). The five-year National Bituminous Coal Wage Agreement terminated on February 1, 1993. Coal inventories (fuel) as of December 31, 1992, were increased over 1991 amounts to provide an increased coal supply in the event of a strike. The union chose a strategy of selective shutdowns including mines that accounted for approximately 60% of the System's regular coal supply. The union signed a new five-year contract in December 1993. System coal inventory, which declined during the dispute, and which is somewhat lower than the seasonal norm, is considered adequate. Financings During 1993 the Company issued $18.04 million of 6.30% tax-exempt solid waste disposal notes to Harrison County, West Virginia, and refunded an aggregate of $246 million of debt securities having interest rates of 7% to 9.75% through the issuance of $251 million of securities having interest rates of 4.95% to 6.375%. The costs associated with the debt redemptions are being amortized over the life of the new bonds. Due to the significant number of refinancings which have occurred over the past two years, this balance is now about $12 million. Reduced future interest expense will more than offset these expenses. Short-term debt is used to meet temporary cash needs until the timing is considered appropriate to issue long- term securities. The Company canceled or postponed approximately $47 million of debt financings in 1993 due to favorable short-term alternatives. In 1992, the Company and its affiliates established an internal money pool as a facility to accommodate intercompany short-term borrowing needs, to the extent that certain of the companies have funds available. At December 31, 1993, the Company had SEC authorization to issue up to $170 million of short-term debt. In addition, a multi-year credit program was established in January 1994, which provides that the Company may borrow on a standby revolving credit basis up to $135 million. After the initial three-year term, the program agreement provides that the maturity date may be extended in one-year increments. The borrowings have the support of a long-term credit facility. During 1994, the Company plans to issue about $105 million of new securities, consisting of both debt and equity issues and, if economic and market conditions make it desirable, may refinance up to $212 million of first mortgage bonds, preferred stock, and pollution control revenue notes. The Company may also engage in additional Harrison County tax-exempt solid waste disposal financings to the extent that funds are available. The Company anticipates that it will be able to meet its future cash needs through internal cash generation and external financings as it has in the past and possibly through alternative financing procedures. Environmental Matters and Other Contingencies In the normal course of business, the Company is subject to various contingencies and uncertainties relating to its operations and construction program, including cost recovery in the regulatory process, laws, regulations and uncertainties related to environmental matters, and legal actions. Contingencies and uncertainties related to the CAAA are discussed above and under Note J to the consolidated financial statements. Pennsylvania has enacted hazardous and solid waste management legislation. While the Company does not have significant hazardous waste concerns, solid wastes, such as fly ash and other coal by-products generated from power stations, must be disposed in accordance with the state requirements. The Company is incurring various costs, which are recoverable in rates, to comply with these and other environmental matters. The level of future expenditures for environmental matters is impossible to determine with any degree of certainty. It is management's opinion that the ultimate costs will not have a material effect on the financial position of the Company. M-35 As of January 1994, Monongahela Power Company (MP), an affiliated company, has been named as a defendant along with multiple other defendants in 1,429 pending asbestos cases involving multiple plaintiffs and the Company and its affiliates have been named as defendants along with multiple defendants in an additional 626 cases by multiple plaintiffs. Because these cases are filed by "shotgun" complaints naming many plaintiffs and many defendants, it is presently impossible to determine the actual number of claims against the Company and its affiliates. However, based on past experience and data available to date, it is estimated that less than 600 cases actually involve claims against the Company or its affiliates. All complaints allege that the plaintiffs sustained unspecified injuries resulting from claimed exposure to asbestos in various generating plants and other industrial facilities operated by the various defendants, although all plaintiffs do not claim exposure at facilities operated by all defendants. All plaintiffs claiming exposure at System- operated stations were employed by third-party contractors, with the exception of three who claim to have been employees of MP. The Company is joint owner with MP in four generating plants, including three operated by MP in West Virginia. Each plaintiff generally seeks compensatory and punitive damages against all defendants in amounts of up to $1 million and $3 million, respectively; in those cases that include a spousal claim for loss of consortium, damages are generally sought against all defendants in an amount of up to $1 million for the loss of consortium claim. Therefore, because of the multiple defendants, the Company believes its potential liability is a very small percentage of the total amount of the damages sought. A total of 94 cases have been previously settled by MP for an amount substantially less than the anticipated cost of defense. While the Company believes that all of these cases are without merit, it cannot predict the outcome of these cases or whether other cases will be filed. M-36 AGC MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations As described under Liquidity and Capital Resources, revenues are determined under a cost of service formula rate schedule. Therefore, if all other factors remain equal, revenues are expected to decrease each year due to a normal continuing reduction in the Company's net investment in the Bath County station and its connecting transmission facilities upon which the return on investment is determined. Revenues for 1993 and 1992 decreased due to a reduction in interest charges and net investment, and reduced operating expenses which are described below. Additionally, revenues for 1993 and 1992 were reduced by the recording of estimated liabilities for possible refunds pending final Federal Energy Regulatory Commission (FERC) decisions in rate case proceedings (see Liquidity and Capital Resources). The net investment (primarily net plant less deferred income taxes) decreases to the extent that provisions for depreciation and deferred income taxes exceed net plant additions. The decrease in operating expenses in 1993 resulted from a decrease in federal income taxes due to a decrease in income before taxes ($1.9 million) offset by an increase in the tax rate due to the Revenue Reconciliation Act of 1993 ($.5 million), partially offset by an increase in operation and maintenance expense. The decrease in operating expenses in 1992 resulted primarily from reduced federal income taxes because of a decrease in income before taxes, partially offset by increases in taxes other than income. The increase in taxes other than income in 1992 was due to increased property taxes. The decreases in interest on long-term debt in 1993 and 1992 were the combined result of decreases in the average amount of and interest rates on long-term debt outstanding. Liquidity and Capital Resources SEC regulations define "liquidity" as "the ability of an enterprise to generate adequate amounts of cash to meet the enterprise's need for cash". The Company's only operating assets are an undivided 40% interest in the Bath County (Virginia) pumped-storage hydroelectric station and its connecting transmission facilities. The Company has no present plans for construction of any other major facilities. M-37 Pursuant to an agreement, the Parents buy all of the Company's capacity in the station priced under a "cost of service formula" wholesale rate schedule approved by the FERC. Under this arrangement, the Company recovers in revenues all of its operation and maintenance expenses, depreciation, taxes, and a return on its investment. Through February 29, 1992, the Company's return on equity (ROE) was adjusted annually pursuant to a settlement agreement approved by the FERC. On March 1, 1990, the ROE decreased from 12% to 11.25%, and on March 1, 1991, it was increased to 11.53%. In December 1991, the Company filed for a continuation of the existing ROE of 11.53% and other parties (the Consumer Advocate Division of the Public Service Commission of West Virginia, Maryland People's Counsel, and Pennsylvania Office of Consumer Advocate, collectively referred to as the joint consumer advocates or JCA) filed to reduce the ROE, with any resultant rate decreases subject to refund from March 1, 1992 through May 31, 1993. Hearings were completed in June 1992, and a recommendation was issued by an Administrative Law Judge (ALJ) on December 21, 1993, for an ROE of 10.83%, which the JCA argues should be further adjusted to reflect changes in capital market conditions since the hearings. Exceptions to this recommendation have been filed by all parties for consideration by the full Commission. On January 28, 1994, the JCA filed a joint complaint claiming that both the existing ROE of 11.53% and the ALJ's recommended ROE of 10.83% are unjust and unreasonable. This new complaint requests an ROE of 8.53%, with rates subject to refund beginning April 1, 1994. In 1993, the Company issued $50 million of 5.75% medium-term notes due 1998, $50 million of 5.625% debentures due 2003, and $100 million of 6.875% debentures due 2023 to refund $50 million 8% debentures due 1997, $50 million 8.75% debentures due 2017, and $100 million 9.125% debentures due 2016. The Company and its affiliates in 1992 established an internal money pool as a facility to accommodate intercompany short- term borrowing needs, to the extent that certain of the companies have funds available. - 42 - ITEM 8.	ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Financial Statements Financial Statement Schedules - All other schedules are omitted because they are not applicable or the required information is shown in the Financial Statements or Notes thereto. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors of Allegheny Power System, Inc. In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Allegheny Power System, Inc. and its subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. As discussed in Notes A, B and E to the consolidated financial statements, the Company changed its method of accounting for income taxes and postretirement benefits other than pensions in 1993. PRICE WATERHOUSE PRICE WATERHOUSE New York, New York February 3, 1994 APS NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (These notes are an integral part of the consolidated financial statements.) NOTE A--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: The Company and its subsidiaries (companies) are subject to regulation by the Securities and Exchange Commission. The subsidiaries are subject to regulation by various state bodies having jurisdiction and by the Federal Energy Regulatory Commission (FERC). Significant accounting policies of the Company and its subsidiaries are summarized below. CONSOLIDATION: The Company owns all of the outstanding common stock of its subsidiaries. The consolidated financial statements include the accounts of the Company and all subsidiary companies after elimination of intercompany transactions. REVENUES: Customers are billed on a cycle basis, and revenues, including amounts resulting from the application of fuel and energy cost adjustment clauses, are generally recorded when billed. In accordance with ratemaking procedures followed by Monongahela Power Company in West Virginia, revenues include service rendered but unbilled at year end. Certain increases in rates being collected by subsidiaries are subject to final commission approvals, and possible refunds, for which estimated liabilities have been recorded. DEFERRED POWER COSTS, NET: The costs of fuel, purchased power, and certain other costs, and revenues from sales and transmission services to other utilities, are deferred until they are either recovered from or credited to customers under fuel and energy cost recovery procedures. PROPERTY, PLANT, AND EQUIPMENT: Property, plant, and equipment are stated at original cost, less contributions in aid of construction, except for capital leases which are recorded at present value. Cost includes direct labor and material, allowance for funds used during construction (AFUDC) on property for which construction work in progress is not included in rate base, and such indirect costs as administration, maintenance, and depreciation of transportation and construction equipment, and pensions, taxes, and other fringe benefits related to employees engaged in construction. The cost of depreciable property units retired, plus removal costs less salvage, are charged to accumulated depreciation. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION: AFUDC, an item that does not represent current cash income, is defined in applicable regulatory systems of accounts as including "the net cost for the period of construction of borrowed funds used for construction purposes and a reasonable rate on other funds when so used". AFUDC is recognized as a cost of property, plant, and equipment with offsetting credits to other income and interest charges. Rates used by the subsidiaries for computing AFUDC in 1993, 1992, and 1991 averaged 9.37%, 9.19%, and 8.84%, respectively. DEPRECIATION AND MAINTENANCE: Provisions for depreciation are determined generally on a straight-line method based on estimated service lives of depreciable properties and amounted to approximately 3.4% of average depreciable property in 1993 and 3.3% in each of the years 1992 and 1991. The cost of maintenance and of certain replacements of property, plant, and equipment is charged principally to operating expenses. INVESTMENTS: The investment in subsidiaries consolidated represents the excess of acquisition cost over book equity (goodwill) prior to 1966. Goodwill is not being amortized because, in management's opinion, there has been no reduction in its value. Other investments primarily represent the cash surrender values and prepayments of purchased life insurance contracts on certain qualifying management employees under an executive life insurance plan and a supplemental executive retirement plan (Secured Benefit Plan). Payment of future premiums will fully fund these benefits. INCOME TAXES: Financial accounting income before income taxes differs from taxable income principally because certain income and deductions for tax purposes are recorded in the financial income statement in another period. Differences between income tax that would be paid if taxes were computed on the basis of financial accounting income instead of taxable income are accounted for substantially in accordance with the accounting procedures followed for ratemaking purposes. Provisions for federal income tax were reduced in previous years by investment credits, and amounts equivalent to such credits were charged to income with concurrent credits to a deferred account, balances in which are being amortized over estimated service lives of the related properties. POSTRETIREMENT BENEFITS: The subsidiaries have a noncontributory, defined benefit pension plan covering substantially all employees, including officers. Benefits are based on the employee's years of service and compensation. The funding policy is to contribute annually at least the minimum amount required under the Employee Retirement Income Security Act and not more than can be deducted for federal income tax purposes. The subsidiaries also provide partially contributory medical and life insurance plans for eligible retirees and dependents. Medical benefits, which comprise the largest component of the plans, are based upon an age and years-of-service vesting schedule and other plan provisions. The funding plan for these costs is to contribute to Voluntary Employee Beneficiary Association (VEBA) trust funds an amount equal to the annual cost as determined by Statement of Financial Accounting Standards (SFAS) No. 106 (described below). Medical benefits are self-insured; the life insurance plan is paid through insurance premiums. The Financial Accounting Standards Board (FASB) has prescribed the determination of annual pension and other postretirement benefits expenses in SFAS No. 87, "Employers' Accounting for Pensions", and SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", respectively. Pursuant to SFAS No. 71, "Accounting for the Effects of Certain Types of Regulation", regulatory deferrals of these benefit expenses are recorded for those jurisdictions which reflect as net expense the funding of pensions and cash payment of other benefits in the ratemaking process. TEMPORARY CASH INVESTMENTS: For purposes of the Consolidated Statement of Cash Flows, temporary cash investments with original maturities of three months or less, generally in the form of commercial paper, certificates of deposit, and repurchase agreements, are considered to be the equivalent of cash. The carrying amount of temporary cash investments approximates the fair value because of the short-term maturity of those instruments. ACCOUNTING CHANGES: Effective January 1, 1993, the subsidiaries adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions". This statement requires the costs of providing postretirement benefits, such as medical and life insurance, to be accrued over the applicable employees' service periods. Prior to 1993, medical expenses and life insurance premiums paid for retired employees and their dependents were recorded as expense in the period they were paid. Also effective January 1, 1993, the subsidiaries adopted SFAS No. 109, "Accounting for Income Taxes". This standard mandated a change from the previous income-based deferral approach to a balance sheet-based liability approach for computing deferred income taxes as further described in Note B. The total provision for income taxes is different than the amount produced by applying the federal income statutory tax rate to financial accounting income before preferred dividends and income taxes, as set forth below: Federal income tax returns through 1989 have been examined and substantially settled. In adopting SFAS No. 109, the subsidiaries recognized a significant increase in both deferred tax assets and liabilities. At December 31, 1993, the deferred tax assets and liabilities were comprised of the following: (Thousands of Dollars) Deferred tax assets: Unamortized investment tax credit $ 105 289 Unbilled revenue 38 363 Tax interest capitalized 22 236 Contributions in aid of construction 17 176 State tax loss carryback/carryforward 14 560 Other 21 658 219 282 Deferred tax liabilities: Book vs. tax plant basis differences, net 1 051 500 Other 42 122 1 093 622 Total net deferred tax liabilities 874 340 Less portion above included in current liabilities 645 Total long-term net deferred tax liabilities $ 873 695 It is expected that regulatory commissions will allow recovery of the deferred tax liabilities in future years as they are paid, and accordingly, the subsidiaries have recorded regulatory assets for an amount equal to the $562 million increase in deferred tax liabilities. Regulatory liabilities were recorded in an amount equal to the $108 million increase in deferred tax assets to reflect the subsidiaries' obligation to pass such tax benefits on to their customers as the benefits are realized in cash in future years. Based on the provisions in the standard for recording these regulatory assets and liabilities on the balance sheet, there was no effect on consolidated net income resulting from adoption of the standard. NOTE C--DIVIDEND RESTRICTION: Supplemental indentures relating to most outstanding bonds of subsidiaries contain dividend restrictions under the most restrictive of which $461,539,000 of consolidated retained earnings at December 31, 1993, is not available for cash dividends on their common stocks, except that a portion thereof may be paid as cash dividends where concurrently an equivalent amount of cash is received by a subsidiary as a capital contribution or as the proceeds of the issue and sale of shares of such subsidiary's common stock. The benefits earned to date and funded status at December 31 using a measurement date of September 30 were as follows: In determining the actuarial present value of the projected benefit obligation at December 31, 1993, 1992, and 1991, the discount rates used were 7.25%, 7.75%, and 8%, and the rates of increase in future compensation levels were 4.75%, 5.25%, and 5.5%, respectively. The expected long-term rate of return on assets was 9% in each of the years 1993, 1992, and 1991. NOTE E--POSTRETIREMENT BENEFITS OTHER THAN PENSIONS: The subsidiaries adopted SFAS No. 106 as of January 1, 1993, which requires accrual of postretirement benefits other than pensions (principally health care and life insurance) for the employee and covered dependents during the years the employee renders the necessary service to receive such benefits. Prior to 1993, medical expenses and life insurance premiums paid by the subsidiaries for retired employees and their dependents were recorded in expense in the period in which they were paid and were $6,553,000 and $5,691,000 in 1992 and 1991, respectively. SFAS No. 106 postretirement cost in 1993, a portion of which (about 30%) was charged to plant construction, included the following components: (Thousands of Dollars) Service cost--benefits earned $ 2 000 Interest cost on accumulated postretirement benefit obligation 11 300 Actual return on plan assets (24) Amortization of unrecognized transition obligation 7 300 Other net amortization and deferral 24 SFAS No. 106 postretirement cost 20 600 Regulatory deferral (4 790) Net postretirement cost $15 810 The benefits earned to date and funded status at December 31, 1993, using a measurement date of September 30 were as follows: (Thousands of Dollars) Accumulated postretirement benefit obligation: Retirees $115 019 Fully eligible employees 24 135 Other employees 55 255 Total obligation 194 409 Plan assets at market value in short-term investment fund 4 646 Accumulated postretirement benefit obligation in excess of plan assets 189 763 Less: Unrecognized cumulative net loss from past experience different from that assumed 41 450 Unrecognized transition obligation, being amortized over 20 years beginning January 1, 1993 138 200 Postretirement benefit liability at September 30, 1993 10 113 Fourth quarter 1993 contributions and benefit payments 4 549 Postretirement benefit liability at December 31, 1993 $ 5 564 The unfunded accumulated postretirement benefit obligation (APBO) at January 1, 1993, of $145,500,000 (transition obligation) is being amortized prospectively over 20 years as permitted by the standard. In determining the APBO at January 1 and December 31, 1993, the discount rates used were 8% and 7.25%, the rates of increase in future compensation levels were 5.5% and 4.75%, respectively. For measurement purposes, a health care trend rate of 14% for 1993, declining 1% each year thereafter to 7% in the year 2000 and beyond, and plan provisions which limit future medical and life insurance benefits were assumed. Increasing the assumed health care trend rate by 1% in each year would increase the APBO at December 31, 1993, by $13.4 million and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for 1993 by $1.0 million. Recovery of SFAS No. 106 costs has been authorized for retail customers in Maryland effective in February 1993, in Pennsylvania effective in May 1993, and for the FERC wholesale customers effective in mid-to-late 1993. Regulatory actions have been taken by the Virginia and Ohio regulatory commissions which provide support that substantial recovery is probable. Recovery has been requested in rate cases filed in Virginia and West Virginia for which final commission decisions are expected in 1994. The subsidiaries have recorded regulatory assets at December 31, 1993, of $4.8 million relating to those regulatory jurisdictions where full recovery of SFAS No. 106 level of expenses has not yet been granted recovery in rates, with the result that adoption of SFAS No. 106 has had no effect on consolidated net income. NOTE F--STOCKHOLDERS' EQUITY: COMMON STOCK: In November 1993, the common shareholders approved a two-for-one split of the Company's common stock which was effective November 4, 1993. The stock split reduced the par value of the common stock from $2.50 per share to $1.25 per share and increased the number of authorized shares of common stock from 130,000,000 to 260,000,000. The number of common stock shares outstanding and per share information for all periods reflect the two-for-one split. PREFERRED STOCK: All of the preferred stock is entitled on voluntary liquidation to its then current call price and on involuntary liquidation to $100 a share. The holders of West Penn Power Company's auction preferred stock are entitled to dividends at a rate determined by an auction held the business day preceding each quarterly dividend payment date. MANDATORILY REDEEMABLE PREFERRED STOCK: The Potomac Edison Company's $7.16 preferred stock is entitled to a cumulative sinking fund sufficient to retire 12,000 shares each year, commencing in 1992, at $100 a share plus accrued dividends. That subsidiary has the noncumulative option in each year to retire up to an additional 12,000 shares at the same price. The estimated fair value of this series of preferred stock at December 31, 1993 and 1992, was $28,566,000 and $28,944,000, respectively, based on quoted market prices. The call price declines in future years. In August 1993, The Potomac Edison Company redeemed the remaining 4,046 outstanding shares of Series B, 4.70% preferred stock. NOTE G--LONG-TERM DEBT: Maturities for long-term debt for the next five years are: 1994, $26,000,000; 1995, $28,000,000; 1996, $43,575,000; 1997, $48,262,000; and 1998, $185,400,000. Substantially all of the properties of the subsidiaries are held subject to the lien securing each subsidiary's first mortgage bonds. Some properties are also subject to a second lien securing certain pollution control and solid waste disposal notes. Commercial paper borrowings issuable by Allegheny Generating Company are backed by a revolving credit agreement with a group of seven banks which provides for loans of up to $75 million at any one time outstanding through 1997. Each bank has the option to discontinue its loans after 1997 upon three years' prior written notice. Without such notice, the loans are automatically extended for one year. However, to the extent that funds are available from the companies, Allegheny Generating Company borrowings are made through an internal money pool as described in Note H. The estimated fair value of long-term debt at December 31, 1993 and 1992, was $2,129,923,000 and $2,033,103,000, respectively, based on actual market prices or market prices of similar issues. NOTE H--SHORT-TERM DEBT: To provide interim financing and support for outstanding commercial paper, lines of credit have been established with several banks. The companies have fee arrangements on all of their lines of credit and no compensating balance requirements. At December 31, 1993, unused lines of credit with banks were $149,175,000. In addition to bank lines of credit, in 1992 the companies established an internal money pool as a facility to accommodate intercompany short-term borrowing needs, to the extent that certain of the companies have funds available. In January 1994, a multi-year credit program was established which provides that the subsidiaries may borrow up to $300 million on a standby revolving credit basis. Short-term debt outstanding at the end of 1993 consisted of notes payable to banks ($75,825,000) and commercial paper ($54,811,000) and at the end of 1992 consisted of a note payable to a bank ($11,205,000). The carrying amount of short-term debt approximates the fair value because of the short-term maturity of those instruments. NOTE I--COMMITMENTS AND CONTINGENCIES: CONSTRUCTION PROGRAM: The subsidiaries have entered into commitments for their construction programs, for which expenditures are estimated to be $500 million for 1994 and $400 million for 1995. These estimates include expenditures for the program of complying with the Clean Air Act Amendments of 1990 (CAAA) as discussed below. ENVIRONMENTAL MATTERS: The companies are subject to laws, regulations, and uncertainties as to environmental matters discussed under ITEM 1. ENVIRONMENTAL MATTERS. Compliance may require them to incur substantial additional costs to modify or replace existing and proposed equipment and facilities and may affect adversely the lead time, size, and siting of future generating stations, increase the complexity and cost of pollution control equipment, and otherwise add to the cost of future operations. Construction expenditures through the year 2000 will include substantial amounts for compliance with Phase I and Phase II of the CAAA. The subsidiaries are estimating expenditures of approximately $1.4 billion, which includes $482 million expended through 1993, depending on the strategy eventually selected for complying with Phase II. Construction estimates for 1994 and 1995 include $161 million and $53 million, respectively, for the program of complying with the CAAA. In complying with the CAAA, the subsidiaries will face uncertainties, including regulatory administrative interpretations and contingencies, such as potential cost overruns, equipment performance, and cost recovery in rates. LITIGATION: In the normal course of business, the companies become involved in various legal proceedings. The companies do not believe that the ultimate outcome of these proceedings will have a material effect on their financial position. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors of Monongahela Power Company In our opinion, the financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Monongahela Power Company (a subsidiary of Allegheny Power System, Inc.) at December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. As discussed in Notes A, B and F to the financial statements, the Company changed its method of accounting for income taxes and postretirement benefits other than pensions in 1993. PRICE WATERHOUSE PRICE WATERHOUSE New York, New York February 3, 1994 Preferred Stock (not subject to mandatory redemption): Cumulative preferred stock - par value $100 per share, authorized 1,500,000 shares, outstanding as follows (Note G): Monongahela NOTES TO FINANCIAL STATEMENTS (These notes are an integral part of the financial statements.) Note A - Summary of Significant Accounting Policies: The Company is a wholly-owned subsidiary of Allegheny Power System, Inc. and is a part of the Allegheny Power integrated electric utility system (the System). The Company is subject to regulation by the Securities and Exchange Commission (SEC), by various state bodies having jurisdiction, and by the Federal Energy Regulatory Commission (FERC). Significant accounting policies of the Company are summarized below. REVENUES: Customers are billed on a cycle basis, and revenues, including amounts resulting from the application of fuel and energy cost adjustment clauses, are generally recorded when billed. In accordance with ratemaking procedures in West Virginia, revenues include service rendered but unbilled at year end. DEFERRED POWER COSTS, NET: The costs of fuel, purchased power, and certain other costs, and revenues from sales and transmission services to other utilities, are deferred until they are either recovered from or credited to customers under fuel and energy cost recovery procedures. PROPERTY, PLANT, AND EQUIPMENT: Property, plant, and equipment, including facilities owned with affiliates in the System, are stated at original cost, less contributions in aid of construction, except for capital leases which are recorded at present value. Cost includes direct labor and material, allowance for funds used during construction (AFUDC) on property for which construction work in progress is not included in rate base, and such indirect costs as administration, maintenance, and depreciation of transportation and construction equipment, and pensions, taxes, and other fringe benefits related to employees engaged in construction. The cost of depreciable property units retired, plus removal costs less salvage, are charged to accumulated depreciation. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION: AFUDC, an item that does not represent current cash income, is defined in applicable regulatory systems of accounts as including "the net cost for the period of construction of borrowed funds used for construction purposes and a reasonable rate on other funds when so used". AFUDC is recognized as a cost of property, plant, and equipment with offsetting credits to other income and interest charges. Rates used for computing AFUDC in 1993, 1992, and 1991 were 8.69%, 8.23%, and 6.17%, respectively. In accordance with FERC guidelines, the 1991 rate was based solely on borrowed funds because the Company's average outstanding short-term debt was greater than the average construction work in progress balance. DEPRECIATION AND MAINTENANCE: Provisions for depreciation are determined generally on a straight-line method based on estimated service lives of depreciable properties and amounted to approximately 3.8% of average depreciable property in each of the years 1993, 1992, and 1991. The cost of maintenance and of certain replacements of property, plant, and equipment is charged principally to operating expenses. INCOME TAXES: The Company joins with its parent and affiliates in filing a consolidated federal income tax return. The consolidated tax liability is allocated among the participants generally in proportion to the taxable income of each participant, except that no subsidiary pays tax in excess of its separate return tax liability. Financial accounting income before income taxes differs from taxable income principally because certain income and deductions for tax purposes are recorded in the financial income statement in another period. Differences between income tax that would be paid if taxes were computed on the basis of financial accounting income instead of taxable income are accounted for substantially in accordance with the accounting procedures followed for ratemaking purposes. Provisions for federal income tax were reduced in previous years by investment credits, and amounts equivalent to such credits were charged to income with concurrent credits to a deferred account, balances in which are being amortized over estimated service lives of the related properties. POSTRETIREMENT BENEFITS: The Company participates with affiliated companies in the System in a noncontributory, defined benefit pension plan covering substantially all employees, including officers. Benefits are based on the employee's years of service and compensation. The funding policy is to contribute annually at least the minimum amount required under the Employee Retirement Income Security Act and not more than can be deducted for federal income tax purposes. The Company also provides partially contributory medical and life insurance plans for eligible retirees and dependents. Medical benefits, which comprise the largest component of the plans, are based upon an age and years-of-service vesting schedule and other plan provisions. The funding plan for these costs is to contribute to Voluntary Employee Beneficiary Association (VEBA) trust funds an amount equal to the annual cost as determined by Statement of Financial Accounting Standards (SFAS) No. 106 (described below). Medical benefits are self-insured; the life insurance plan is paid through insurance premiums. The Financial Accounting Standards Board (FASB) has prescribed the determination of annual pension and other postretirement benefits expenses in SFAS No. 87, "Employers' Accounting for Pensions", and SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", respectively. Pursuant to SFAS No. 71, "Accounting for the Effects of Certain Types of Regulation", regulatory deferrals of these benefit expenses are recorded for those jurisdictions which reflect as net expense the funding of pensions and cash payment of other benefits in the ratemaking process. TEMPORARY CASH INVESTMENTS: For purposes of the Statement of Cash Flows, temporary cash investments with original maturities of three months or less, generally in the form of commercial paper, certificates of deposit, and repurchase agreements, are considered to be the equivalent of cash. ACCOUNTING CHANGES: Effective January 1, 1993, the Company adopted SFAS No. 106, "Employers' Accounting for Post- retirement Benefits Other Than Pensions". This statement requires the costs of providing postretirement benefits, such as medical and life insurance, to be accrued over the applicable employees' service periods. Prior to 1993, medical expenses and life insurance premiums paid for retired employees and their dependents were recorded as expense in the period they were paid. Also effective January 1, 1993, the Company adopted SFAS No. 109, "Accounting for Income Taxes". This standard mandated a change from the previous income-based deferral approach to a balance sheet-based liability approach for computing deferred income taxes as further described in Note B. The total provision for income taxes is different than the amount produced by applying the federal income statutory tax rate to financial accounting income before income taxes, as set forth below: Federal income tax returns through 1989 have been examined and substantially settled. In adopting SFAS No. 109, the Company recognized a significant increase in both deferred tax assets and liabilities. At December 31, 1993, the deferred tax assets and liabilities were comprised of the following: (Thousands of Dollars) Deferred tax assets: Unamortized investment tax credit $18 043 Unbilled revenue 4 181 Tax interest capitalized 2 430 Contributions in aid of construction 2 058 Vacation pay 1 958 Advances for construction 1 601 Other 4 455 34 726 Deferred tax liabilities: Book vs. tax plant basis differences, net 205 829 Other 23 411 229 240 Total net deferred tax liabilities 194 514 Less portion above included in current liabilities 2 048 Total long-term net deferred tax liabilities $192 466 It is expected that regulatory commissions will allow recovery of the deferred tax liabilities in future years as they are paid, and accordingly, the Company has recorded regulatory assets for an amount equal to the $158 million increase in deferred tax liabilities. Regulatory liabilities were recorded in an amount equal to the $19 million increase in deferred tax assets to reflect the Company's obligation to pass such tax benefits on to its customers as the benefits are realized in cash in future years. Based on the provisions in the standard for recording these regulatory assets and liabilities on the balance sheet, there was no effect on net income resulting from adoption of the standard. Note C - Dividend Restriction: Supplemental indentures relating to most outstanding bonds of the Company contain dividend restrictions under the most restrictive of which $103,482,000 of retained earnings at December 31, 1993, is not available for cash dividends on common stock, except that a portion thereof may be paid as cash dividends where concurrently an equivalent amount of cash is received by the Company as a capital contribution or as the proceeds of the issue and sale of shares of its common stock. Note D - Allegheny Generating Company: The Company owns 27% of the common stock of Allegheny Generating Company (AGC), and affiliates of the Company own the remainder. AGC owns an undivided 40% interest, 840 MW, in the 2,100-MW pumped-storage hydroelectric station in Bath County, Virginia operated by the 60% owner, Virginia Power Company, an unaffiliated utility. AGC recovers from the Company and its affiliates all of its operation and maintenance expenses, depreciation, taxes, and a return on its investment under a wholesale rate schedule approved by the FERC. Through February 29, 1992, AGC's return on equity (ROE) was adjusted annually pursuant to a settlement agreement approved by the FERC. In December 1991, AGC filed for a continuation of the existing ROE of 11.53% and other parties (the Consumer Advocate Division of the West Virginia PSC, Maryland People's Counsel, and Pennsylvania Office of Consumer Advocate, collectively referred to as the joint consumer advocates or JCA) filed to reduce the ROE, with any resultant rate decreases subject to refund from March 1, 1992 through May 31, 1993. Hearings were completed in June 1992, and a recommendation was issued by an Administrative Law Judge (ALJ) on December 21, 1993, for an ROE of 10.83%, which the JCA argues should be further adjusted to reflect changes in capital market conditions since the hearings. Exceptions to this recommendation have been filed by all parties for consideration by the full Commission. On January 28, 1994, the JCA filed a joint complaint claiming that both the existing ROE of 11.53% and the ALJ's recommended ROE of 10.83% are unjust and unreasonable. This new complaint requests an ROE of 8.53%, with rates subject to refund beginning April 1, 1994. Following is a summary of financial information for AGC: The Company's share of the equity in earnings above was $7.3 million, $8.3 million, and $8.9 million for 1993, 1992, and 1991, respectively, and was included in other income, net, on the Statement of Income. Note E - Pension Benefits: The Company's share of net pension costs under the System's pension plan, a portion of which (about 30%) was charged to plant construction, included the following components: The benefits earned to date and funded status of the Company's share of the System plan at December 31 using a measurement date of September 30 were as follows: The foregoing includes the Company's portion of amounts applicable to employees at power stations which are owned jointly with affiliates. In determining the actuarial present value of the projected benefit obligation at December 31, 1993, 1992, and 1991, the discount rates used were 7.25%, 7.75%, and 8%, and the rates of increase in future compensation levels were 4.75%, 5.25%, and 5.5%, respectively. The expected long-term rate of return on assets was 9% in each of the years 1993, 1992, and 1991. Note F - Postretirement Benefits Other Than Pensions: The Company adopted SFAS No. 106 as of January 1, 1993, which requires accrual of postretirement benefits other than pensions (principally health care and life insurance) for the employee and covered dependents during the years the employee renders the necessary service to receive such benefits. Prior to 1993, medical expenses and life insurance premiums paid by the Company for retired employees and their dependents were recorded in expense in the period in which they were paid and were $2,390,000 and $2,029,000 in 1992 and 1991, respectively. SFAS No. 106 postretirement cost in 1993, a portion of which (about 30%) was charged to plant construction, included the following components: (Thousands of Dollars) Service cost - benefits earned $ 478 Interest cost on accumulated postretirement benefit obligation 2 819 Actual return on plan assets (5) Amortization of unrecognized transition obligation 1 772 Other net amortization and deferral 5 SFAS No. 106 postretirement cost 5 069 Regulatory deferral (1 981) Net postretirement cost $3 088 The benefits earned to date and funded status of the Company's share of the System plan at December 31, 1993, using a measurement date of September 30 were as follows: (Thousands of Dollars) Accumulated postretirement benefit obligation: Retirees $32 469 Fully eligible employees 4 348 Other employees 14 664 Total obligation 51 481 Plan assets at market value in short-term investment fund 1 230 Accumulated postretirement benefit obligation in excess of plan assets 50 251 Less: Unrecognized cumulative net loss from past experience different from that assumed 14 161 Unrecognized transition obligation, being amortized over 20 years beginning January 1, 1993 34 059 Postretirement benefit liability at September 30, 1993 2 031 Fourth quarter 1993 contributions and benefit payments 997 Postretirement benefit liability at December 31, 1993 $ 1 034 The unfunded accumulated postretirement benefit obligation (APBO) at January 1, 1993, of $35,800,000 (transition obligation), is being amortized prospectively over 20 years as permitted by the standard. In determining the APBO at January 1 and December 31, 1993, the discount rates used were 8% and 7.25%, and the rates of increase in future compensation levels were 5.5% and 4.75%, respectively. For measurement purposes, a health care trend rate of 14% for 1993, declining 1% each year thereafter to 7% in the year 2000 and beyond, and plan provisions which limit future medical and life insurance benefits were assumed. Increasing the assumed health care trend rate by 1% in each year would increase the APBO at December 31, 1993, by $3.5 million and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for 1993 by $.2 million. Recovery of SFAS No. 106 costs has been authorized for FERC wholesale customers effective in December 1993. Recovery has been requested in a rate case filed in West Virginia for which a final commission decision is expected in 1994. Regulatory action has been taken by the Ohio regulatory commission which provides support that substantial recovery is probable. The Company has recorded regulatory assets at December 31, 1993, of $2.0 million for West Virginia and Ohio where full recovery of SFAS No. 106 level of expenses has not yet been granted recovery in rates, with the result that adoption of SFAS No. 106 has had no effect on net income. Note G - Stockholders' Equity: COMMON STOCK AND OTHER PAID-IN CAPITAL: In September 1992, the Company issued and sold to its parent, 800,000 shares of its common stock at $50 per share. Other paid-in capital decreased $4,000 in 1992 as a result of a preferred stock redemption. PREFERRED STOCK: All of the preferred stock is entitled on voluntary liquidation to its then current call price and on involuntary liquidation to $100 a share. Note H - Long-Term Debt: Maturities for long-term debt for the next five years are: 1994 and 1995, none; 1996, $18,500,000; 1997, $15,500,000; and 1998, $20,100,000. Substantially all of the properties of the Company are held subject to the lien securing its first mortgage bonds. Some properties are also subject to a second lien securing certain pollution control and solid waste disposal notes. Certain first mortgage bond series are not redeemable by certain refunding until dates established in the respective supplemental indentures. In 1993, the Company sold $65 million of 5-5/8% 7-year first mortgage bonds to refund a $10 million 8-1/8% issue due in 1999, a $30 million 7-7/8% issue due in 2002, and a $20 million 7-1/2% issue due in 1998. The Company also issued $7.05 million of 5.95% 20-year Pollution Control Revenue Notes to Monongalia County, West Virginia to refund a $7.05 million 9.5% issue due in 2013. The estimated fair value of long-term debt at December 31, 1993 and 1992, was $485,713,000 and $461,663,000, respectively, based on actual market prices or market prices of similar issues. Note I - Short-Term Debt: To provide interim financing and support for outstanding commercial paper, the System companies have established lines of credit with several banks. The Company has SEC authorization for total short-term borrowings of $100 million including money pool borrowings described below. The Company has fee arrangements on all of its lines of credit and no compensating balance requirements. In addition to bank lines of credit, in 1992 the Company and its affiliates established an internal money pool as a facility to accommodate intercompany short-term borrowing needs, to the extent that certain of the companies have funds available. In January 1994, the Company and its affiliates jointly established an aggregate $300 million multi-year credit program which provides that the Company may borrow up to $81 million on a standby revolving credit basis. Short-term debt outstanding at the end of 1993 consisted of $63.1 million of notes payable to banks and at the end of 1992 consisted of money pool borrowings from affiliates of $8.03 million. The carrying amount of short-term debt approximates the fair value because of the short-term maturity of those instruments. Note J - Commitments and Contingencies: CONSTRUCTION PROGRAM: The Company has entered into commitments for its construction program, for which expenditures are estimated to be $103 million for 1994 and $83 million for 1995. These estimates include expenditures for the program of complying with the Clean Air Act Amendments of 1990 (CAAA) as discussed below. ENVIRONMENTAL MATTERS: System companies are subject to laws, regulations, and uncertainties with respect to air and water quality, land use, and other environmental matters. Compliance may require them to incur substantial additional costs to modify or replace existing and proposed equipment and facilities and may affect adversely the lead time, size, and siting of future generating stations, increase the complexity and cost of pollution control equipment, and otherwise add to the cost of future operations. Construction expenditures through the year 2000 will include substantial amounts for compliance with Phase I and Phase II of the CAAA. The Company is estimating expenditures of approximately $400 million, which includes $122 million expended through 1993, depending on the strategy eventually selected for complying with Phase II. Construction estimates for 1994 and 1995 include $39 million and $10 million, respectively, for the program of complying with the CAAA. In complying with the CAAA, the Company will face uncertainties, including regulatory administrative interpretations and contingencies, such as potential cost overruns, equipment performance, and cost recovery in rates. LITIGATION AND OTHER: In the normal course of business, the Company becomes involved in various legal proceedings. The Company does not believe that the ultimate outcome of these proceedings will have a material effect on its financial position. The Company is guarantor as to 27% of a $75 million revolving credit agreement of AGC, which in 1993 was used by AGC solely as support for its indebtedness for commercial paper outstanding. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors of The Potomac Edison Company In our opinion, the financial statements listed in the accompanying index present fairly, in all material respects, the financial position of The Potomac Edison Company (a subsidiary of Allegheny Power System, Inc.) at December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. As discussed in Notes A, B and F to the financial statements, the Company changed its method of accounting for income taxes and postretirement benefits other than pensions in 1993. PRICE WATERHOUSE PRICE WATERHOUSE New York, New York February 3, 1994 Potomac NOTES TO FINANCIAL STATEMENTS (These notes are an integral part of the financial statements.) Note A - Summary of Significant Accounting Policies: The Company is a wholly-owned subsidiary of Allegheny Power System, Inc. and is a part of the Allegheny Power integrated electric utility system (the System). The Company is subject to regulation by the Securities and Exchange Commission (SEC), by various state bodies having jurisdiction, and by the Federal Energy Regulatory Commission (FERC). Significant accounting policies of the Company are summarized below. REVENUES: Customers are billed on a cycle basis, and revenues, including amounts resulting from the application of fuel and energy cost adjustment clauses, are recorded when billed. Revenues of $63.4 million from one industrial customer, Eastalco Aluminum Company, were 8.9% of total electric operating revenues in 1993. Certain increases in rates being collected by the Company in Virginia are subject to final commission approval, and possible refunds, for which estimated liabilities have been recorded. DEFERRED POWER COSTS, NET: The costs of fuel, purchased power, and certain other costs, and revenues from sales and transmission services to other utilities, are deferred until they are either recovered from or credited to customers under fuel and energy cost recovery procedures. PROPERTY, PLANT, AND EQUIPMENT: Property, plant, and equipment, including facilities owned with affiliates in the System, are stated at original cost, less contributions in aid of construction. Cost includes direct labor and material, allowance for funds used during construction (AFUDC) on property for which construction work in progress is not included in rate base, and such indirect costs as administration, maintenance, and depreciation of transportation and construction equipment, and pensions, taxes, and other fringe benefits related to employees engaged in construction. The cost of depreciable property units retired, plus removal costs less salvage, are charged to accumulated depreciation. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION: AFUDC, an item that does not represent current cash income, is defined in applicable regulatory systems of accounts as including "the net cost for the period of construction of borrowed funds used for construction purposes and a reasonable rate on other funds when so used". AFUDC is recognized as a cost of property, plant, and equipment with offsetting credits to other income and interest charges. Rates used for computing AFUDC in 1993, 1992, and 1991 were 9.97%, 9.92%, and 9.93%, respectively. AFUDC is not recorded for construction applicable to the state of Virginia, where construction work in progress is included in rate base. DEPRECIATION AND MAINTENANCE: Provisions for depreciation are determined generally on a straight-line method based on estimated service lives of depreciable properties and amounted to approximately 3.6% of average depreciable property in each of the years 1993, 1992, and 1991. The cost of maintenance and of certain replacements of property, plant, and equipment is charged principally to operating expenses. INCOME TAXES: The Company joins with its parent and affiliates in filing a consolidated federal income tax return. The consolidated tax liability is allocated among the participants generally in proportion to the taxable income of each participant, except that no subsidiary pays tax in excess of its separate return tax liability. Financial accounting income before income taxes differs from taxable income principally because certain income and deductions for tax purposes are recorded in the financial income statement in another period. Differences between income tax that would be paid if taxes were computed on the basis of financial accounting income instead of taxable income are accounted for substantially in accordance with the accounting procedures followed for ratemaking purposes. Provisions for federal income tax were reduced in previous years by investment credits, and amounts equivalent to such credits were charged to income with concurrent credits to a deferred account, balances in which are being amortized over estimated service lives of the related properties. POSTRETIREMENT BENEFITS: The Company participates with affiliated companies in the System in a noncontributory, defined benefit pension plan covering substantially all employees, including officers. Benefits are based on the employee's years of service and compensation. The funding policy is to contribute annually at least the minimum amount required under the Employee Retirement Income Security Act and not more than can be deducted for federal income tax purposes. The Company also provides partially contributory medical and life insurance plans for eligible retirees and dependents. Medical benefits, which comprise the largest component of the plans, are based upon an age and years-of-service vesting schedule and other plan provisions. The funding plan for these costs is to contribute to Voluntary Employee Beneficiary Association (VEBA) trust funds an amount equal to the annual cost as determined by Statement of Financial Accounting Standards (SFAS) No. 106 (described below). Medical benefits are self-insured; the life insurance plan is paid through insurance premiums. The Financial Accounting Standards Board (FASB) has prescribed the determination of annual pension and other postretirement benefits expenses in SFAS No. 87, "Employers' Accounting for Pensions", and SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", respectively. Pursuant to SFAS No. 71, "Accounting for the Effects of Certain Types of Regulation", regulatory deferrals of these benefit expenses are recorded for those jurisdictions which reflect as net expense the funding of pensions and cash payment of other benefits in the ratemaking process. TEMPORARY CASH INVESTMENTS: For purposes of the Statement of Cash Flows, temporary cash investments with original maturities of three months or less, generally in the form of commercial paper, certificates of deposit, and repurchase agreements, are considered to be the equivalent of cash. ACCOUNTING CHANGES: Effective January 1, 1993, the Company adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions". This statement requires the costs of providing postretirement benefits, such as medical and life insurance, to be accrued over the applicable employees' service periods. Prior to 1993, medical expenses and life insurance premiums paid for retired employees and their dependents were recorded as expense in the period they were paid. Also effective January 1, 1993, the Company adopted SFAS No. 109, "Accounting for Income Taxes". This standard mandated a change from the previous income-based deferral approach to a balance sheet-based liability approach for computing deferred income taxes as further described in Note B. The total provision for income taxes is less than the amount produced by applying the federal income statutory tax rate to financial accounting income before income taxes, as set forth below: Federal income tax returns through 1989 have been examined and substantially settled. In adopting SFAS No. 109, the Company recognized a significant increase in both deferred tax assets and liabilities. At December 31, 1993, the deferred tax assets and liabilities were comprised of the following: (Thousands of Dollars) Deferred tax assets: Unamortized investment tax credit $17 922 Unbilled revenue 12 556 Contributions in aid of construction 10 530 Tax interest capitalized 9 056 State tax loss carryback/carryforward 5 770 Advances for construction 1 303 Other 3 279 60 416 Deferred tax liabilities: Book vs. tax plant basis differences, net 183 892 Other 10 122 194 014 Total net deferred tax liabilities 133 598 Less portion above included in current liabilities 571 Total long-term net deferred tax liabilities $133 027 It is expected that regulatory commissions will allow recovery of the deferred tax liabilities in future years as they are paid, and accordingly, the Company has recorded regulatory assets for an amount equal to the $74 million increase in deferred tax liabilities. Regulatory liabilities were recorded in an amount equal to the $19 million increase in deferred tax assets to reflect the Company's obligation to pass such tax benefits on to its customers as the benefits are realized in cash in future years. Based on the provisions in the standard for recording these regulatory assets and liabilities on the balance sheet, there was no effect on net income resulting from adoption of the standard. Note C - Dividend Restriction: Supplemental indentures relating to most outstanding bonds of the Company contain dividend restrictions under the most restrictive of which $103,730,000 of retained earnings at December 31, 1993, is not available for cash dividends on common stock, except that a portion thereof may be paid as cash dividends where concurrently an equivalent amount of cash is received by the Company as a capital contribution or as the proceeds of the issue and sale of shares of its common stock. Note D - Allegheny Generating Company: The Company owns 28% of the common stock of Allegheny Generating Company (AGC), and affiliates of the Company own the remainder. AGC owns an undivided 40% interest, 840 MW, in the 2,100-MW pumped-storage hydroelectric station in Bath County, Virginia operated by the 60% owner, Virginia Power Company, an unaffiliated utility. AGC recovers from the Company and its affiliates all of its operation and maintenance expenses, depreciation, taxes, and a return on its investment under a wholesale rate schedule approved by the FERC. Through February 29, 1992, AGC's return on equity (ROE) was adjusted annually pursuant to a settlement agreement approved by the FERC. In December 1991, AGC filed for a continuation of the existing ROE of 11.53% and other parties (the Consumer Advocate Division of the West Virginia PSC, Maryland People's Counsel, and Pennsylvania Office of Consumer Advocate, collectively referred to as the joint consumer advocates or JCA) filed to reduce the ROE, with any resultant rate decreases subject to refund from March 1, 1992 through May 31, 1993. Hearings were completed in June 1992, and a recommendation was issued by an Administrative Law Judge (ALJ) on December 21, 1993, for an ROE of 10.83%, which the JCA argues should be further adjusted to reflect changes in capital market conditions since the hearings. Exceptions to this recommendation have been filed by all parties for consideration by the full Commission. On January 28, 1994, the JCA filed a joint complaint claiming that both the existing ROE of 11.53% and the ALJ's recommended ROE of 10.83% are unjust and unreasonable. This new complaint requests an ROE of 8.53%, with rates subject to refund beginning April 1, 1994. Following is a summary of financial information for AGC: The Company's share of the equity in earnings above was $7.6 million, $8.6 million, and $9.2 million for 1993, 1992, and 1991, respectively, and was included in other income, net, on the Statement of Income. Note E - Pension Benefits: The Company's share of net pension costs under the System's pension plan, a portion of which (about 35%) was charged to plant construction, included the following components: The benefits earned to date and funded status of the Company's share of the System plan at December 31 using a measurement date of September 30 were as follows: The foregoing includes the Company's portion of amounts applicable to employees at power stations which are owned jointly with affiliates. In determining the actuarial present value of the projected benefit obligation at December 31, 1993, 1992, and 1991, the discount rates used were 7.25%, 7.75%, and 8%, and the rates of increase in future compensation levels were 4.75%, 5.25%, and 5.5%, respectively. The expected long- term rate of return on assets was 9% in each of the years 1993, 1992, and 1991. Note F - Postretirement Benefits Other Than Pensions: The Company adopted SFAS No. 106 as of January 1, 1993, which requires accrual of postretirement benefits other than pensions (principally health care and life insurance) for the employee and covered dependents during the years the employee renders the necessary service to receive such benefits. Prior to 1993, medical expenses and life insurance premiums paid by the Company for retired employees and their dependents were recorded in expense in the period in which they were paid and were $1,790,000 and $1,564,000 in 1992 and 1991, respectively. SFAS No. 106 postretirement cost in 1993, a portion of which (about 35%) was charged to plant construction, included the following components: (Thousands of Dollars) Service cost - benefits earned $ 383 Interest cost on accumulated postretirement benefit obligation 3 042 Actual return on plan assets (7) Amortization of unrecognized transition obligation 1 986 Other net amortization and deferral 7 SFAS No. 106 postretirement cost 5 411 Regulatory deferral (846) Net postretirement cost $4 565 The benefits earned to date and funded status of the Company's share of the System plan at December 31, 1993, using a measurement date of September 30 were as follows: (Thousands of Dollars) Accumulated postretirement benefit obligation: Retirees $35 189 Fully eligible employees 7 741 Other employees 14 635 Total obligation 57 565 Plan assets at market value in short-term investment fund 1 375 Accumulated postretirement benefit obligation in excess of plan assets 56 190 Less: Unrecognized cumulative net loss from past experience different from that assumed 15 695 Unrecognized transition obligation, being amortized over 20 years beginning January 1, 1993 37 995 Postretirement benefit liability at September 30, 1993 2 500 Fourth quarter 1993 contributions and benefit payments 1 132 Postretirement benefit liability at December 31, 1993 $1 368 The unfunded accumulated postretirement benefit obligation (APBO) at January 1, 1993, of $40,000,000 (transition obligation) is being amortized prospectively over 20 years as permitted by the standard. In determining the APBO at January 1 and December 31, 1993, the discount rates used were 8% and 7.25%, the rates of increase in future compensation levels were 5.5% and 4.75%, respectively. For measurement purposes, a health care trend rate of 14% for 1993, declining 1% each year thereafter to 7% in the year 2000 and beyond, and plan provisions which limit future medical and life insurance benefits were assumed. Increasing the assumed health care trend rate by 1% in each year would increase the APBO at December 31, 1993, by $4.0 million and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for 1993 by $.3 million. Recovery of SFAS No. 106 costs has been authorized for retail customers in Maryland effective in February 1993 and for the FERC wholesale customers effective in September 1993. Regulatory action has been taken by the Virginia regulatory commission which provides support that substantial recovery is probable. Recovery has been requested in rate cases filed in Virginia and West Virginia for which final commission decisions are expected in 1994. The Company has recorded regulatory assets at December 31, 1993, of $.8 million relating to those regulatory jurisdictions where full recovery of SFAS No. 106 level of expenses has not yet been granted recovery in rates, with the result that adoption of SFAS No. 106 has had no effect on net income. Note G - Stockholders' Equity: COMMON STOCK AND OTHER PAID-IN CAPITAL The Company issued and sold common stock to its parent, at $20 per share, 2,500,000 shares in October 1993, 4,000,000 shares in September 1992, and 1,250,000 shares in September 1991. Other paid-in capital decreased $2,000 in 1992 as a result of preferred stock transactions. PREFERRED STOCK: All of the preferred stock is entitled on voluntary liquidation to its then current call price and on involuntary liquidation to $100 a share. MANDATORILY REDEEMABLE PREFERRED STOCK: The Company's $7.16 preferred stock is entitled to a cumulative sinking fund sufficient to retire 12,000 shares each year, commencing in 1992, at $100 a share plus accrued dividends. The Company has the noncumulative option in each year to retire up to an additional 12,000 shares at the same price. The estimated fair value of this series of preferred stock at December 31, 1993 and 1992, was $28,566,000 and $28,944,000, respectively, based on quoted market prices. The call price declines in future years. In August 1993, the Company redeemed the remaining 4,046 outstanding shares of Series B, 4.70% preferred stock. Note H - Long-Term Debt: Maturities for long-term debt for the next five years are: 1994, $16,000,000; 1995, none; 1996, $18,700,000; 1997, $800,000; and 1998, $1,800,000. Substantially all of the properties of the Company are held subject to the lien securing its first mortgage bonds. Some properties are also subject to a second lien securing certain pollution control and solid waste disposal notes. Certain first mortgage bond series are not redeemable by certain refunding until dates established in the respective supplemental indentures. In 1993, the Company sold $45 million of 7-3/4% 30-year first mortgage bonds and $75 million of 5-7/8% 7-year first mortgage bonds to refund a $25 million 8-5/8% issue due in 2007, a $15 million 8-5/8% issue due in 2003, a $20 million 8-3/8% issue due in 2001, a $15 million 7-5/8% issue due in 1999, a $12 million 7-1/2% issue due in 2002, and a $25 million 7% issue due in 1998. The Company also issued $8.6 million of 5.95% 20-year Pollution Control Revenue Notes to Monongalia County, West Virginia to refund an $8.6 million 9.5% issue due in 2013. The estimated fair value of long-term debt at December 31, 1993 and 1992, was $566,070,000 and $538,211,000, respectively, based on actual market prices or market prices of similar issues. Note I - Short-Term Financing: To provide interim financing and support for outstanding commercial paper, the System companies have established lines of credit with several banks. The Company has SEC authorization for total short-term borrowings of $115 million, including money pool borrowings described below. The Company has fee arrangements on all of its lines of credit and no compensating balance requirements. In addition to bank lines of credit, in 1992 the Company and its affiliates established an internal money pool as a facility to accommodate intercompany short-term borrowing needs, to the extent that certain of the companies have funds available. In January 1994, the Company and its affiliates jointly established an aggregate $300 million multi-year credit program which provides that the Company may borrow up to $84 million on a standby revolving credit basis. There was no short-term debt outstanding at the end of 1993 or 1992. The Company had outstanding at the end of 1993 and 1992, $4.6 million and $38 million, respectively, of notes receivable from affiliates in the money pool. Note J - Commitments and Contingencies: CONSTRUCTION PROGRAM: The Company has entered into commitments for its construction program, for which expenditures are estimated to be $136 million for 1994 and $106 million for 1995. These estimates include expenditures for the program of complying with the Clean Air Act Amendments of 1990 (CAAA) as discussed below. ENVIRONMENTAL MATTERS: System companies are subject to laws, regulations, and uncertainties with respect to air and water quality, land use, and other environmental matters. Compliance may require them to incur substantial additional costs to modify or replace existing and proposed equipment and facilities and may affect adversely the lead time, size, and siting of future generating stations, increase the complexity and cost of pollution control equipment, and otherwise add to the cost of future operations. Construction expenditures through the year 2000 will include substantial amounts for compliance with Phase I and Phase II of the CAAA. The Company is estimating expenditures of approximately $350 million, which includes $153 million expended through 1993, depending on the strategy eventually selected for complying with Phase II. Construction estimates for 1994 and 1995 include $40 million and $10 million, respectively, for the program of complying with the CAAA. In complying with the CAAA, the Company will face uncertainties, including regulatory administrative interpretations and contingencies, such as potential cost overruns, equipment performance, and cost recovery in rates. LITIGATION AND OTHER: In the normal course of business, the Company becomes involved in various legal proceedings. The Company does not believe that the ultimate outcome of these proceedings will have a material effect on its financial position. The Company is guarantor as to 28% of a $75 million revolving credit agreement of AGC, which in 1993 was used by AGC solely as support for its indebtedness for commercial paper outstanding. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors of West Penn Power Company In our opinion, the financial statements listed in the accompanying index present fairly, in all material respects, the financial position of West Penn Power Company (a subsidiary of Allegheny Power System, Inc.) at December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. As discussed in Notes A, B and F to the financial statements, the Company changed its method of accounting for income taxes and postretirement benefits other than pensions in 1993. PRICE WATERHOUSE PRICE WATERHOUSE New York, New York February 3, 1994 Preferred Stock of the Company (not subject to mandatory redemption): Cumulative preferred stock - par value $100 per share, authorized 3,097,077 shares, outstanding as follows (Note G): West Penn NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (These notes are an integral part of the consolidated financial statements.) Note A - Summary of Significant Accounting Policies: The Company is a wholly-owned subsidiary of Allegheny Power System, Inc. and is a part of the Allegheny Power integrated electric utility system (the System). The Company is subject to regulation by the Securities and Exchange Commission (SEC), by various state bodies having jurisdiction, and by the Federal Energy Regulatory Commission (FERC). Significant accounting policies of the Company are summarized below. CONSOLIDATION: The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries (the companies). REVENUES: Customers are billed on a cycle basis, and revenues, including amounts resulting from the application of fuel and energy cost adjustment clauses, are recorded when billed. DEFERRED POWER COSTS, NET: The costs of fuel, purchased power, and certain other costs, and revenues from sales and transmission services to other utilities, are deferred until they are either recovered from or credited to customers under fuel and energy cost recovery procedures. PROPERTY, PLANT, AND EQUIPMENT: Property, plant, and equipment, including facilities owned with affiliates in the System, are stated at original cost, less contributions in aid of construction, except for capital leases which are recorded at present value. Cost includes direct labor and material, allowance for funds used during construction (AFUDC) on property for which construction work in progress is not included in rate base, and such indirect costs as administration, maintenance, and depreciation of transportation and construction equipment, and pensions, taxes, and other fringe benefits related to employees engaged in construction. The cost of depreciable property units retired, plus removal costs less salvage, are charged to accumulated depreciation. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION: AFUDC, an item that does not represent current cash income, is defined in applicable regulatory systems of accounts as including "the net cost for the period of construction of borrowed funds used for construction purposes and a reasonable rate on other funds when so used". AFUDC is recognized as a cost of property, plant, and equipment with offsetting credits to other income and interest charges. Rates used for computing AFUDC in 1993, 1992, and 1991 were 9.40%, 9.25%, and 9.46%, respectively. DEPRECIATION AND MAINTENANCE: Provisions for depreciation are determined generally on a straight-line method based on estimated service lives of depreciable properties and amounted to approximately 3.4%, 3.3%, and 3.2% of average depreciable property in 1993, 1992, and 1991, respectively. The cost of maintenance and of certain replacements of property, plant, and equipment is charged principally to operating expenses. INCOME TAXES: The companies join with the parent and affiliates in filing a consolidated federal income tax return. The consolidated tax liability is allocated among the participants generally in proportion to the taxable income of each participant, except that no subsidiary pays tax in excess of its separate return tax liability. Financial accounting income before income taxes differs from taxable income principally because certain income and deductions for tax purposes are recorded in the financial income statement in another period. Differences between income tax that would be paid if taxes were computed on the basis of financial accounting income instead of taxable income are accounted for substantially in accordance with the accounting procedures followed for ratemaking purposes. Provisions for federal income tax were reduced in previous years by investment credits, and amounts equivalent to such credits were charged to income with concurrent credits to a deferred account, balances in which are being amortized over estimated service lives of the related properties. POSTRETIREMENT BENEFITS: The Company participates with affiliated companies in the System in a noncontributory, defined benefit pension plan covering substantially all employees, including officers. Benefits are based on the employee's years of service and compensation. The funding policy is to contribute annually at least the minimum amount required under the Employee Retirement Income Security Act and not more than can be deducted for federal income tax purposes. The Company also provides partially contributory medical and life insurance plans for eligible retirees and dependents. Medical benefits, which comprise the largest component of the plans, are based upon an age and years-of-service vesting schedule and other plan provisions. The funding plan for these costs is to contribute to Voluntary Employee Beneficiary Association (VEBA) trust funds an amount equal to the annual cost as determined by Statement of Financial Accounting Standards (SFAS) No. 106 (described below). Medical benefits are self-insured; the life insurance plan is paid through insurance premiums. The Financial Accounting Standards Board (FASB) has prescribed the determination of annual pension and other postretirement benefits expenses in SFAS No. 87, "Employers' Accounting for Pensions", and SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", respectively. Pursuant to SFAS No. 71, "Accounting for the Effects of Certain Types of Regulation", regulatory deferrals of these benefit expenses are recorded for those jurisdictions which reflect as net expense the funding of pensions and cash payment of other benefits in the ratemaking process. TEMPORARY CASH INVESTMENTS: For purposes of the Consolidated Statement of Cash Flows, temporary cash investments with original maturities of three months or less, generally in the form of commercial paper, certificates of deposit, and repurchase agreements, are considered to be the equivalent of cash. The carrying amount of temporary cash investments approximates the fair value because of the short-term maturity of those instruments. ACCOUNTING CHANGES: Effective January 1, 1993, the Company adopted SFAS No. 106, "Employers' Accounting for Post- retirement Benefits Other Than Pensions". This statement requires the costs of providing postretirement benefits, such as medical and life insurance, to be accrued over the applicable employees' service periods. Prior to 1993, medical expenses and life insurance premiums paid for retired employees and their dependents were recorded as expense in the period they were paid. Also effective January 1, 1993, the Company adopted SFAS No. 109, "Accounting for Income Taxes". This standard mandated a change from the previous income-based deferral approach to a balance sheet-based liability approach for computing deferred income taxes as further described in Note B. The total provision for income taxes is less than the amount produced by applying the federal income statutory tax rate to financial accounting income before income taxes, as set forth below: Federal income tax returns through 1989 have been examined and substantially settled. In adopting SFAS No. 109, the Company recognized a significant increase in both deferred tax assets and liabilities. At December 31, 1993, the deferred tax assets and liabilities were comprised of the following: (Thousands of Dollars) Deferred tax assets: Unamortized investment tax credit $40 455 Unbilled revenue 21 626 Tax interest capitalized 10 750 State tax loss carryback/carryforward 8 790 Contributions in aid of construction 4 588 Other 7 416 93 625 Deferred tax liabilities: Book vs. tax plant basis differences, net 507 214 Other 8 437 515 651 Total net deferred tax liabilities 422 026 Add portion above included in current assets 1 974 Total long-term net deferred tax liabilities $424 000 It is expected that regulatory commissions will allow recovery of the deferred tax liabilities in future years as they are paid, and accordingly, the Company has recorded regulatory assets for an amount equal to the $326 million increase in deferred tax liabilities. Regulatory liabilities were recorded in an amount equal to the $41 million increase in deferred tax assets to reflect the Company's obligation to pass such tax benefits on to its customers as the benefits are realized in cash in future years. Based on the provisions in the standard for recording these regulatory assets and liabilities on the balance sheet, there was no effect on consolidated net income resulting from adoption of the standard. Note C - Dividend Restriction: Supplemental indentures relating to most outstanding bonds of the Company contain dividend restrictions under the most restrictive of which $285,914,000 of consolidated retained earnings at December 31, 1993, is not available for cash dividends on common stock, except that a portion thereof may be paid as cash dividends where concurrently an equivalent amount of cash is received by the Company as a capital contribution or as the proceeds of the issue and sale of shares of its common stock. Note D - Allegheny Generating Company: The Company owns 45% of the common stock of Allegheny Generating Company (AGC), and affiliates of the Company own the remainder. AGC owns an undivided 40% interest, 840 MW, in the 2,100-MW pumped-storage hydroelectric station in Bath County, Virginia operated by the 60% owner, Virginia Power Company, an unaffiliated utility. AGC recovers from the Company and its affiliates all of its operation and maintenance expenses, depreciation, taxes, and a return on its investment under a wholesale rate schedule approved by the FERC. Through February 29, 1992, AGC's return on equity (ROE) was adjusted annually pursuant to a settlement agreement approved by the FERC. In December 1991, AGC filed for a continuation of the existing ROE of 11.53% and other parties (the Consumer Advocate Division of the Public Service Commission of West Virginia, Maryland People's Counsel, and Pennsylvania Office of Consumer Advocate, collectively referred to as the joint consumer advocates or JCA) filed to reduce the ROE, with any resultant rate decreases subject to refund from March 1, 1992 through May 31, 1993. Hearings were completed in June 1992, and a recommendation was issued by an Administrative Law Judge (ALJ) on December 21, 1993, for an ROE of 10.83%, which the JCA argues should be further adjusted to reflect changes in capital market conditions since the hearings. Exceptions to this recommendation have been filed by all parties for consideration by the full Commission. On January 28, 1994, the JCA filed a joint complaint claiming that both the existing ROE of 11.53% and the ALJ's recommended ROE of 10.83% are unjust and unreasonable. This new complaint requests an ROE of 8.53%, with rates subject to refund beginning April 1, 1994. Following is a summary of financial information for AGC: The Company's share of the equity in earnings above was $12.2 million, $13.8 million, and $14.8 million for 1993, 1992, and 1991, respectively, and was included in other income, net, on the Consolidated Statement of Income. Note E - Pension Benefits: The Company's share of net pension costs under the System's pension plan, a portion of which (about 25%) was charged to plant construction, included the following components: The benefits earned to date and funded status of the Company's share of the System plan at December 31 using a measurement date of September 30 were as follows: The foregoing includes the Company's portion of amounts applicable to employees at power stations which are owned jointly with affiliates. In determining the actuarial present value of the projected benefit obligation at December 31, 1993, 1992, and 1991, the discount rates used were 7.25%, 7.75%, and 8%, and the rates of increase in future compensation levels were 4.75%, 5.25%, and 5.5%, respectively. The expected long-term rate of return on assets was 9% in each of the years 1993, 1992, and 1991. Note F - Postretirement Benefits Other Than Pensions: The Company adopted SFAS No. 106 as of January 1, 1993, which requires accrual of postretirement benefits other than pensions (principally health care and life insurance) for the employee and covered dependents during the years the employee renders the necessary service to receive such benefits. Prior to 1993, medical expenses and life insurance premiums paid by the Company for retired employees and their dependents were recorded in expense in the period in which they were paid and were $1,907,000 and $1,721,000 in 1992 and 1991, respectively. SFAS No. 106 postretirement cost in 1993, a portion of which (about 25%) was charged to plant construction, included the following components: (Thousands of Dollars) Service cost - benefits earned $ 939 Interest cost on accumulated postretirement benefit obligation 4 389 Actual return on plan assets (9) Amortization of unrecognized transition obligation 2 817 Other net amortization and deferral 9 SFAS No. 106 postretirement cost 8 145 Regulatory deferral (1 963) Net postretirement cost $6 182 The benefits earned to date and funded status of the Company's share of the System plan at December 31, 1993, using a measurement date of September 30 were as follows: (Thousands of Dollars) Accumulated postretirement benefit obligation: Retirees $35 748 Fully eligible employees 9 030 Other employees 18 378 Total obligation 63 156 Plan assets at market value in short-term investment fund 1 510 Accumulated postretirement benefit obligation in excess of plan assets 61 646 Less: Unrecognized cumulative net loss from past experience different from that assumed 3 362 Unrecognized transition obligation, being amortized over 20 years beginning January 1, 1993 53 746 Postretirement benefit liability at September 30, 1993 4 538 Fourth quarter 1993 contributions and benefit payments 1 960 Postretirement benefit liability at December 31, 1993 $2 578 The unfunded accumulated postretirement benefit obligation (APBO) at January 1, 1993, of $56,600,000 (transition obligation) is being amortized prospectively over 20 years as permitted by the standard. In determining the APBO at January 1 and December 31, 1993, the discount rates used were 8% and 7.25%, and the rates of increase in future compensation levels were 5.5% and 4.75%, respectively. For measurement purposes, a health care trend rate of 14% for 1993, declining 1% each year thereafter to 7% in the year 2000 and beyond, and plan provisions which limit future medical and life insurance benefits were assumed. Increasing the assumed health care trend rate by 1% in each year would increase the APBO at December 31, 1993, by $4.3 million and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for 1993 by $.4 million. Recovery of SFAS No. 106 costs has been authorized for retail customers in Pennsylvania effective in May 1993 and for the FERC wholesale customers effective in June 1993. The Company has recorded regulatory assets at December 31, 1993, of $2.0 million relating to SFAS No. 106 costs in Pennsylvania incurred prior to the May rate order, with the result that adoption of SFAS No. 106 has had no effect on consolidated net income. The Company will seek to recover these costs in its next base rate case. Note G - Stockholders' Equity: COMMON STOCK AND OTHER PAID-IN CAPITAL: The Company issued and sold common stock to its parent, at $20 per share, 5,000,000 shares in October 1993, and 1,750,000 shares in December 1991. Other paid-in capital decreased $145,000 in 1993 and $550,000 in 1992 as a result of the underwriting fees and commissions and miscellaneous expenses associated with the Company's sale of $40 million of preferred stock in 1992. PREFERRED STOCK: All of the preferred stock is entitled on voluntary liquidation to its then current call price and on involuntary liquidation to $100 per share. The holders of the Company's market auction preferred stock are entitled to dividends at a rate determined by an auction held the business day preceding each quarterly dividend payment date. Note H - Long-Term Debt: Maturities for long-term debt for the next five years are: 1994, none; 1995, $27,000,000; 1996 and 1997, none; and 1998, $103,500,000. Substantially all of the properties of the Company are held subject to the lien securing its first mortgage bonds. Some properties are also subject to a second lien securing certain pollution control and solid waste disposal notes. Certain first mortgage bond series are not redeemable by certain refunding until dates established in the respective supplemental indentures. In 1993, the Company sold $102 million of 5-1/2% 5-year first mortgage bonds to refund a $25 million 7% issue due in 1997, a $25 million 7-7/8% issue due in 1999, and a $52 million 7-1/8% issue due in 1998, and sold $80 million of 6-3/8% 10-year first mortgage bonds to refund a $35 million 7-5/8% issue due in 2002 and a $40 million 8-1/8% issue due in 2001. The Company also issued $7.75 million of 5.95% 20-year Pollution Control Revenue Notes to refund a $7.75 million 9-3/8% issue due in 2013, and issued $61.5 million of 10-year 4.95% Pollution Control Revenue Notes to refund a $30 million 9-3/4% series and a $31.5 million 9-1/2% series due in 2003. The estimated fair value of long-term debt at December 31, 1993 and 1992, was $823,333,000 and $783,379,000, respectively, based on actual market prices or market prices of similar issues. Note I - Short-Term Financing: To provide interim financing and support for outstanding commercial paper, the System companies have established lines of credit with several banks. The Company has SEC authorization for total short-term borrowings of $170 million, including money pool borrowings described below. The Company has fee arrangements on all of its lines of credit and no compensating balance requirements. In addition to bank lines of credit, in 1992 the Company and its affiliates established an internal money pool as a facility to accommodate intercompany short-term borrowing needs, to the extent that certain of the companies have funds available. In January 1994, the Company and its affiliates jointly established an aggregate $300 million multi-year credit program which provides that the Company may borrow up to $135 million on a standby revolving credit basis. There was no short-term debt outstanding at the end of 1993 or 1992. The Company had outstanding at the end of 1993 and 1992, $24.9 million and $20.9 million, respectively, of notes receivable from affiliates in the money pool. Note J - Commitments and Contingencies: CONSTRUCTION PROGRAM: The Company has entered into commitments for its construction program, for which expenditures are estimated to be $258 million for 1994 and $208 million for 1995. These estimates include expenditures for the program of complying with the Clean Air Act Amendments of 1990 (CAAA) as discussed below. ENVIRONMENTAL MATTERS: System companies are subject to laws, regulations, and uncertainties with respect to air and water quality, land use, and other environmental matters. Compliance may require them to incur substantial additional costs to modify or replace existing and proposed equipment and facilities and may affect adversely the lead time, size, and siting of future generating stations, increase the complexity and cost of pollution control equipment, and otherwise add to the cost of future operations. Construction expenditures through the year 2000 will include substantial amounts for compliance with Phase I and Phase II of the CAAA. The Company is estimating expenditures of approximately $700 million, which includes $207 million expended through 1993, depending on the strategy eventually selected for complying with Phase II. Construction estimates for 1994 and 1995 include $82 million and $33 million, respectively, for the program of complying with the CAAA. In complying with the CAAA, the Company will face uncertainties, including regulatory administrative interpretations and contingencies, such as potential cost overruns, equipment performance, and cost recovery in rates. LITIGATION AND OTHER: In the normal course of business, the Company becomes involved in various legal proceedings. The Company does not believe that the ultimate outcome of these proceedings will have a material effect on its financial position. The Company is guarantor as to 45% of a $75 million revolving credit agreement of AGC, which in 1993 was used by AGC solely as support for its indebtedness for commercial paper outstanding. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors of Allegheny Generating Company In our opinion, the financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Allegheny Generating Company (an Allegheny Power System, Inc. affiliate) at December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. As discussed in Notes A and B to the financial statements, the Company changed its method of accounting for income taxes in 1993. PRICE WATERHOUSE PRICE WATERHOUSE New York, New York February 3, 1994 AGC NOTES TO FINANCIAL STATEMENTS (These notes are an integral part of the financial statements.) Note A - Summary of Significant Accounting Policies: The Company was incorporated in Virginia in 1981. Its common stock is owned by Monongahela Power Company - 27%, The Potomac Edison Company - 28%, and West Penn Power Company - 45% (the Parents). The Parents are wholly-owned subsidiaries of Allegheny Power System, Inc. and are a part of the Allegheny Power integrated electric utility system. The Company is subject to regulation by the Securities and Exchange Commission (SEC) and by the Federal Energy Regulatory Commission (FERC). Significant accounting policies of the Company are summarized below. PROPERTY, PLANT, AND EQUIPMENT: Property, plant, and equipment are stated at original cost, and consist of a 40% undivided interest in the Bath County pumped-storage hydroelectric station and its connecting transmission facilities. The cost of depreciable property units retired plus removal costs less salvage are charged to accumulated depreciation. DEPRECIATION AND MAINTENANCE: Provisions for depreciation are determined on a straight-line method based on estimated service lives of depreciable properties and amounted to approximately 2.1% of average depreciable property in each of the years 1993, 1992, and 1991. The cost of maintenance and of certain replacements of property, plant, and equipment is charged to operating expenses. INCOME TAXES: The Company joins with its parents and affiliates in filing a consolidated federal income tax return. The consolidated tax liability is allocated among the participants generally in proportion to the taxable income of each participant, except that no subsidiary pays tax in excess of its separate return tax liability. Financial accounting income before income taxes differs from taxable income principally because certain income and deductions for tax purposes are recorded in the financial income statement in another period. Differences between income tax that would be paid if taxes were computed on the basis of financial accounting income instead of taxable income are deferred. Prior to 1987, provisions for federal income tax were reduced by investment credits, and amounts equivalent to such credits were charged to income with concurrent credits to a deferred account, balances in which are being amortized over estimated service lives of the related properties. ACCOUNTING CHANGE: Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes". This standard mandated a change from the previous income-based deferral approach to a balance sheet-based liability approach for computing deferred income taxes. Note B - Income Taxes: Details of federal income tax provisions are: In 1993, the total provision for income taxes ($13,262,000) was less than the amount produced by applying the federal income tax statutory rate to financial accounting income before income taxes ($14,155,000), due primarily to amortization of deferred investment credit ($1,316,000). Federal income tax returns through 1989 have been examined and substantially settled. The Company adopted SFAS No. 109 as of January 1, 1993, and in doing so recognized a significant increase in both deferred tax assets and liabilities. At December 31, 1993, the deferred tax assets and liabilities were comprised of the following: (Thousands of Dollars) Deferred tax assets Unamortized investment tax credit $ 28 869 Deferred tax liabilities Book vs. tax plant basis differences, net 154 565 Other 152 154 717 Total net deferred tax liabilities $125 848 It is expected the FERC will allow recovery of the deferred tax liabilities in future years as they are paid, and accordingly, the Company has recorded regulatory assets for an amount equal to the $4 million increase in deferred tax liabilities. Regulatory liabilities were recorded in an amount equal to the $29 million increase in deferred tax assets to reflect the Company's obligation to pass such tax benefits on to its customers as the benefits are realized in cash in future years. Based on the provisions in the standard for recording these regulatory assets and liabilities on the balance sheet, there was no effect on net income resulting from adoption of the standard. Note C - Long-Term Debt: The Company had long-term debt outstanding as follows: The Company has a revolving credit agreement with a group of seven banks which provides for loans of up to $75 million at any one time outstanding through 1997. Each bank has the option to discontinue its loans after 1997 upon three years' prior written notice. Without such notice, the loans are automatically extended for one year. Amounts borrowed are guaranteed by the Parents in proportion to their equity interest. Interest rates are determined at the time of each borrowing. The revolving credit agreement serves as support for the Company's commercial paper. In addition to bank lines of credit, the Company and its affiliates in 1992 established an internal money pool as a facility to accommodate intercompany short-term borrowing needs, to the extent that certain of the companies have funds available. At the end of 1993, the Company had outstanding $29,500,000 of money pool borrowings from affiliates. Maturities for long-term debt for the next five years are: 1994, 10,000,000; 1995, $1,000,000; 1996, $6,375,000; 1997, $61,462,000; and 1998, $60,000,000. The estimated fair value of debentures and medium- term notes at December 31, 1993 and 1992, was $233,445,000 and $249,850,000 respectively, based on actual market prices or market prices of similar issues. The carrying amount of commercial paper and notes payable to affiliates approximates their fair value because of the short maturity of those instruments. (A) The maximum amount outstanding at any month end during the year. (B) Computed by multiplying the principal amounts of short-term debt by the days outstanding, and dividing the sum of the products by the number of days in the year. (C) Computed by dividing total interest accrued for the year by the average principal amount outstanding for the year. (D) Unsecured promissory notes issued under informal credit arrangements with various banks with terms of 270 days or less. (E) Unsecured bearer promissory notes sold to dealers at a discount with a term of 270 days or less. (F) Classified as long-term debt by Allegheny Generating Company (AGC). Charges for maintenance and depreciation other than amounts shown in the consolidated statement of income were not material. Charges for maintenance and depreciation other than amounts shown in the statement of income were not material. (A) The maximum amount outstanding at any month end during the year. (B) Computed by multiplying the principal amounts of short-term debt by the days outstanding, and dividing the sum of the products by the number of days in the year. (C) Computed by dividing total interest accrued for the year by the average principal amount outstanding for the year. (D) Unsecured promissory notes issued under informal credit arrangements with various banks with terms of 270 days or less. (E) Unsecured bearer promissory notes sold to dealers at a discount with a term of 270 days or less. (F) Internal arrangement for borrowing funds on a short-term basis. - 43 - - 44 - ITEM 9.	ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE For APS and the Subsidiaries, none. - 45 - PART III ITEM 10.	ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANTS APS, Monongahela, Potomac Edison, West Penn, and AGC. Reference is made to the Executive Officers of the Registrants in Part I of this report. The names, ages, and the business experience during the past five years of the directors of the System companies are set forth below: (1) See Executive Officers of the Registrants in Part I of this report for further details. (a) Eleanor Baum. Dean of the Albert Nerken School of Engineering of The Cooper Union for the Advancement of Science and Art. Director of United States Trust Company, Commissioner of the Engineering Manpower Commission, and a fellow of the Institute of Electrical and Electronic Engineers and the Society of Women Engineers. Ms. Baum filed one late report on Form 4 concerning one purchase transaction in 1993. (b) William L. Bennett. Co-Chairman, Director and Chief Executive Officer of Noel Group, Inc. Formerly, General partner, Discovery Funds, a venture capital affiliate of Rockefeller & Company, Inc. Chairman of the Board of TDX Corporation. Director of Forschner Group, Inc., Global Natural Resources Inc., Lincoln Snacks Company, Simmons Outdoor Corporation and VISX, Inc. (c) Phillip E. Lint. Retired. Formerly, partner, Price Waterhouse. (d) Edward H. Malone. Retired. Formerly, Vice President of General Electric Company and Chairman, General Electric Investment Corporation. Director of Fidelity Group of Mutual Funds, General Re Corporation, Mattel, Inc., and Corporate Property Investors, a real estate investment trust. (e) Frank A. Metz, Jr. Retired. Formerly, Senior Vice President, Finance and Planning, and Director, International Business Machines Corporation. Director of Monsanto Company and Norrell Corporation. (f) Clarence F. Michalis. Chairman of the Board of Directors of Josiah Macy, Jr. Foundation, a tax-exempt foundation for medical research and education. Director of Schroder Capital Funds Inc. (g) Steven H. Rice. Business consultant and attorney-at-law. Formerly, President and Chief Operating Officer and Director of The Seamen's Bank for Savings. Director and member of the Investment and Audit Committees of Royal Group, Inc. (The Royal Insurance Companies). Director and Vice Chairman of the Board of The Stamford (CT) Federal Savings Bank. (h) Gunnar E. Sarsten. President and Chief Operating Officer of Morrison Knudsen Corporation. Formerly, President and Chief Executive Officer of United Engineers & Constructors International, Inc., a subsidiary of the Raytheon Company, and Deputy Chairman of the Third District Federal Reserve Bank in Philadelphia. (i) Peter L. Shea. Managing director of Hydrocarbon Energy, Inc., a privately owned oil and gas development drilling and production company. - 46 - ITEM 11.	ITEM 11. EXECUTIVE COMPENSATION During 1993, and for 1992 and 1991, the annual compensation paid by each of the System companies, APS, APSC, Monongahela, Potomac Edison, West Penn, and AGC directly or indirectly for services in all capacities to such companies to their Chief Executive Officer and each of the four most highly paid executive officers of each such company whose cash compensation exceeded $100,000 was as follows: (a) APS has no paid employees. All salaries and bonuses are paid by APSC. (b) Bonus amounts are determined and paid in April of the year in which the figure appears and are based upon performance in the prior year. (c) Amounts constituting less than 10% of the total annual salary and bonus are not disclosed. All officers did receive miscellaneous other items amounting to less than 10% of total annual salary and bonus. (d) Effective January 1, 1992, the basic group life insurance provided employees was reduced from two times salary during employment, which reduced to one times salary after 5 years in retirement, to a new plan which provides one times salary until retirement and $25,000 thereafter. Executive officers and other senior managers remain under the prior plan. In order to pay for this insurance for these executives, during 1992 insurance was purchased on the lives of each of them. Effective January 1, 1993, APS started to provide funds to pay for the future benefits due under the supplemental retirement plan (Secured Benefit Plan) as described in note (a) on p. 53. To do this, APS purchased, during 1993, life insurance on the lives of the covered executives. The premium costs of both the 1992 and 1993 policies plus a factor for the use of the money are returned to APS at the earlier of (a) death of the insured or (b) the later of age 65 or 10 years from the date of the policy's inception. The figures in this column include the present value of the executives' cash value at retirement attributable to the current year's premium payment for both the Executive Life Insurance and Secured Benefit Plans (based upon the premium, future valued to retirement, using the policy internal rate of return minus the corporation's premium payment), as well as the premium paid for the basic Group Life Insurance program plan and the contribution for the 401(k) plan. For 1993, the figure shown includes amounts representing (a) the aggregate of life insurance premiums and dollar value of the benefit to the executive officer of the remainder of the premium paid on the Group Life Insurance program and the Executive Life Insurance and Secured Benefit Plans and (b) 401(k) contributions as follows: Mr. Bergman $42,392 and $4,497; Mr. Garnett $19,509 and $4,497; Mr. Skrgic $14,181 and $4,497; Ms. Gormley $11,152 and $4,294; and Mr. Jones $8,382 and $4,497, respectively. (e) These amounts as previously reported did not include the following amounts representing the dollar value of the benefit to the executive officer of the remainder of the premium paid on the Executive Life Insurance Plan: Mr. Bergman $786; Mr. Garnett $210; Mr. Skrgic $218; Ms. Gormley $232; and Mr. Jones $519. (f) See Executive Officers of the Registrants for other positions held. (g) Although less than 10% of total annual salary and bonus, Mr. Skrgic received a $15,000 housing allowance in 1993, 1992 and 1991. (h) The incentive plan was not in effect for these officers in 1991. (i) Includes $15,000 housing allowance for both 1993 and 1992 and miscellaneous other items totaling $2,423 and $2,457 for 1993 and 1992, respectively. - 47 - - 48 - - 49 - - 50 - Summary Compensation Tables AGC Annual Compensation (a) Name All Other and Compen- Principal sation Position Year Salary($) Bonus($) ($) (a) AGC has no paid employees. - 51 - DEFINED BENEFIT OR ACTUARIAL PLAN DISCLOSURE Estimated Name and Capacities Annual Benefits Company in Which Served on Retirement (a) APS (b) Klaus Bergman, President* $235,270 and Chief Executive Officer (c) Stanley I. Garnett, II, 112,320 Vice President, Finance (c) Peter J. Skrgic, 126,000 Vice President (c) Kenneth M. Jones, 90,004 Vice President and Comptroller (c) Nancy H. Gormley, 78,404 Vice President (c) Monongahela Klaus Bergman, $ Chief Executive Officer (c)(d) Benjamin H. Hayes, 113,364 President Thomas A. Barlow, 70,788 Vice President Robert R. Winter, 67,896 Vice President Richard E. Myers, 67,200 Comptroller * Elected Chairman of the Board effective January 1, 1994. - 52 - Estimated Name and Capacities Annual Benefits Company in Which Served on Retirement (a) Potomac Edison Klaus Bergman, $ Chief Executive Officer (c)(d) Alan J. Noia, 133,200 President Robert B. Murdock, 80,677 Vice President James D. Latimer, 75,298 Vice President Thomas J. Kloc, 68,591 Comptroller West Penn Klaus Bergman, $ Chief Executive Officer (c)(d) Jay S. Pifer, 111,463 President Thomas K. Henderson, 73,127 Vice President Charles S. Ault, 71,100 Vice President Charles V. Burkley, 66,442 Comptroller Allegheny Generating Company No paid employees. - 53 - (a) Assumes present insured benefit plan and salary continue and retirement at age 65 with single life annuity. Under plan provisions, the annual rate of benefits payable at the normal retirement age of 65 are computed by adding (i) 1% of final average pay up to covered compensation times years of service up to 35 years, plus (ii) 1.5% of final average pay in excess of covered compensation times years of service up to 35 years, plus (iii) 1.3% of final average pay times years of service in excess of 35 years. Covered compensation is the average of the maximum taxable Social Security wage bases during the 35 years preceding the member's retirement, except that years before 1959 are not taken into account for purposes of this average. The final average pay benefit is based on the member's average total earnings during the highest-paid 60 consecutive calendar months or, if smaller, the member's highest rate of pay as of any July 1st. Effective July 1, 1993 the maximum amount of any employee's compensation that may be used in these computations is $235,840. The maximum amount will be reduced to $150,000 effective July 1, 1994 as a result of The Omnibus Budget Reconciliation Act of 1993. Benefits for employees retiring between 55 and 62 differ from the foregoing. Pursuant to a supplemental plan (Secured Benefit Plan), senior executives of Allegheny Power System companies who retire at age 60 or over with 40 or more years of service are entitled to a supplemental retirement benefit in an amount that, together with the benefits under the basic plan and from other employment, will equal 60% of the executive's highest average monthly earnings for any 36 consecutive months. The supplemental benefit is reduced for less than 40 years service and for retirement age from 60 to 55. It is included in the amounts shown where applicable. In order to provide funds to pay such benefits, effective January 1, 1993 the Company purchased insurance on the lives of the plan participants. The Secured Benefit Plan has been designed that if the assumptions made as to mortality experience, policy dividends, and other factors are realized, the Company will recover all premium payments, plus a factor for the use of the Company's money. All executive officers are participants in the Secured Benefit Plan. This does not include benefits from an Employee Stock Ownership and Savings Plan (ESOSP) established as a non-contributory stock ownership plan for all eligible employees effective January 1, 1976, and amended in 1984 to include a savings program. Under the ESOSP for 1993, all eligible employees may elect to have from 2% to 7% of their compensation contributed to the Plan as pre-tax contributions and an additional 1% to 6% as post-tax contributions. Employees direct the investment of these contributions into one or more of five available funds. Each System company matches 50% of the pre-tax contributions up to 6% of compensation with common stock of Allegheny Power System, Inc. Effective January 1, 1993 the maximum amount of any employee's compensation that may be used in these computations is $235,840. Effective January 1, 1994, the amount was reduced to $150,000 as a result of The Omnibus Budget Reconciliation Act of 1993. Employees' interests in the ESOSP vest immediately. Their pre-tax contributions may be withdrawn only upon meeting certain financial hardship requirements or upon termination of employment. (b) APS has no paid employees. These executives are employees of APSC. (c) See Executive Officers of the Registrants for other positions held. (d) The total estimated annual benefits on retirement payable to Mr. Bergman for services in all capacities to APS, APSC and the Subsidiaries is set forth in the table for APS. Compensation of Directors In 1993, APS directors who were not officers or employees of System companies received for all services to System companies (a) $16,000 in retainer fees, (b) $800 for each committee meeting attended, except Executive Committee meetings which are $200, and (c) $250 for each Board meeting of each company attended. Under an unfunded deferred compensation plan, a director may elect to defer receipt of all or part of his or her director's fees for succeeding calendar years to be payable with accumulated interest when the director ceases to be such, in equal annual installments, or, upon authorization by the Board of Directors, in a lump sum. - 55 - ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS For APS and the Subsidiaries, none. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a)(1)(2) The financial statements and financial statement schedules filed as part of this Report are set forth under ITEM 8. and reference is made to the index on page 42. (b) APS filed a report on Form 8-K on November 5, 1993 concerning the two-for-one stock split. No other reports on Form 8-K were filed by System companies during the quarter ended December 31, 1993. (c) Exhibits for APS, Monongahela, Potomac Edison, West Penn, and AGC are listed in the Exhibit Index beginning on page E-1 and are incorporated herein by reference. Graphics Appendix Page System Map . . . . . . . . . . . . . . . . . . . . . . . 10 - 56 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. ALLEGHENY POWER SYSTEM, INC. By: KLAUS BERGMAN (Klaus Bergman, President and Chief Executive Officer) Date: February 3, 1994 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 (i) Principal Executive Officer: Chairman of 2/3/94 of the Board, KLAUS BERGMAN President, Chief (Klaus Bergman) Executive Officer, and Director (ii) Principal Financial Officer: STANLEY I. GARNETT, II Vice President, 2/3/94 (Stanley I. Garnett, II) Finance (iii) Principal Accounting Officer: KENNETH M. JONES Vice President 2/3/94 (Kenneth M. Jones) and Comptroller (iv) A Majority of the Directors: Eleanor Baum Frank A. Metz, Jr. William L. Bennett Clarence F. Michalis Klaus Bergman Steven H. Rice Phillip E. Lint Gunnar E. Sarsten Edward H. Malone Peter L. Shea By: NANCY H. GORMLEY 2/3/94 (Nancy H. Gormley) - 57 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. MONONGAHELA POWER COMPANY By: BENJAMIN H. HAYES (Benjamin H. Hayes, President) Date: February 3, 1994 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. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date (i) Principal Executive Officer: Chairman of 2/3/94 of the Board, KLAUS BERGMAN President, Chief (Klaus Bergman) Executive Officer, and Director (ii) Principal Financial Officer: CHARLES S. MULLETT Secretary and 2/3/94 (Charles S. Mullett) Treasurer (iii) Principal Accounting Officer: RICHARD E. MYERS Comptroller 2/3/94 (Richard E. Myers) (iv) A Majority of the Directors: Eleanor Baum Edward H. Malone William L. Bennett Frank A. Metz, Jr. Klaus Bergman Clarence F. Michalis Stanley I. Garnett, II Steven H. Rice Benjamin H. Hayes Gunnar E. Sarsten Phillip E. Lint Peter L. Shea Peter J. Skrgic By: NANCY H. GORMLEY 2/3/94 (Nancy H. Gormley) - 58 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. THE POTOMAC EDISON COMPANY By: ALAN J. NOIA (Alan J. Noia, President) Date: February 3, 1994 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. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date (i) Principal Executive Officer: Chairman of 2/3/94 of the Board, KLAUS BERGMAN President, Chief (Klaus Bergman) Executive Officer, and Director (ii) Principal Financial Officer: DALE F. ZIMMERMAN Secretary and 2/3/94 (Dale F. Zimmerman) Treasurer (iii) Principal Accounting Officer: THOMAS J. KLOC Comptroller 2/3/94 (THOMAS J. KLOC) (iv) A Majority of the Directors: Eleanor Baum Frank A. Metz, Jr. William L. Bennett Clarence F. Michalis Klaus Bergman Alan J. Noia Stanley I. Garnett, II Steven H. Rice Phillip E. Lint Gunnar E. Sarsten Edward H. Malone Peter L. Shea Peter J. Skrgic By: NANCY H. GORMLEY 2/3/94 (Nancy H. Gormley) - 59 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. WEST PENN POWER COMPANY By: JAY S. PIFER (Jay S. Pifer, President) Date: February 3, 1994 Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. Signature Title Date (i) Principal Executive Officer: Chairman of 2/3/94 of the Board, KLAUS BERGMAN President, Chief (Klaus Bergman) Executive Officer, and Director (ii) Principal Financial Officer: KENNETH D. MOWL Secretary and 2/3/94 (Kenneth D. Mowl) Treasurer (iii) Principal Accounting Officer: CHARLES V. BURKLEY Comptroller 2/3/94 (Charles V. Burkley) (iv) A Majority of the Directors: Eleanor Baum Frank A. Metz, Jr. William L. Bennett Clarence F. Michalis Klaus Bergman Jay S. Pifer Stanley I. Garnett, II Steven H. Rice Phillip E. Lint Gunnar E. Sarsten Edward H. Malone Peter L. Shea Peter J. Skrgic By: NANCY H. GORMLEY 2/3/94 (Nancy H. Gormley) - 60 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. ALLEGHENY GENERATING COMPANY By: KLAUS BERGMAN (Klaus Bergman, President and Chief Executive Officer) Date: February 3, 1994 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. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date (i) Principal Executive Officer: Chairman of 2/3/94 of the Board, KLAUS BERGMAN President, Chief (Klaus Bergman) Executive Officer, and Director (ii) Principal Financial Officer: NANCY L. CAMPBELL Treasurer and 2/3/94 (Nancy L. Campbell Assistant Secretary (iii) Principal Accounting Officer: THOMAS J. KLOC Comptroller 2/3/94 (Thomas J. Kloc) (iv) A Majority of the Directors: Klaus Bergman Kenneth M. Jones Stanley I. Garnett, II Peter J. Skrgic By: NANCY H. GORMLEY 2/3/94 (Nancy H. Gormley) - 61 - CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Prospectus constituting part of Allegheny Power System, Inc.'s Registration Statement on Form S-3 (No. 33-36716) relating to the Dividend Reinvestment and Stock Purchase Plan of Allegheny Power System, Inc.; in the Prospectus constituting part of Allegheny Power System, Inc.'s Registration Statement on Form S-3 (No. 33-49791) relating to the common stock shelf registration; in the Prospectus constituting part of Monongahela Power Company's Registration Statement on Form S-3 (No. 33-51301); in the Prospectus constituting part of The Potomac Edison Company's Registration Statement on Form S-3 (No. 33-51305); and in the Prospectus constituting part of West Penn Power Company's Registration Statement on Form S-3 (No. 33-51303); of our reports dated February 3, 1994 included in ITEM 8 of this Form 10-K. We also consent to the references to us under the heading "Experts" in such Prospectuses. PRICE WATERHOUSE PRICE WATERHOUSE New York, New York March 11, 1994 - 62 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned directors of Allegheny Power System, Inc., a Maryland corporation, Monongahela Power Company, an Ohio corporation, The Potomac Edison Company, a Maryland and Virginia corporation, and West Penn Power Company, a Pennsylvania corporation, do hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to Annual Reports on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Companies, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 ELEANOR BAUM FRANK A. METZ, JR. (Eleanor Baum) (Frank A. Metz, Jr.) WILLIAM L. BENNETT CLARENCE F. MICHALIS (William L. Bennett) (Clarence F. Michalis) KLAUS BERGMAN STEVEN H. RICE (Klaus Bergman) (Steven H. Rice) PHILLIP E. LINT GUNNAR E. SARSTEN (Phillip E. Lint) (Gunnar E. Sarsten) EDWARD H. MALONE PETER L. SHEA (Edward H. Malone) (Peter L. Shea) - 63 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned director of The Potomac Edison Company, a Maryland and Virginia corporation, does hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to the Annual Report on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Company, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 ALAN J. NOIA (Alan J. Noia) - 64 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned director of West Penn Power Company, a Pennsylvania corporation, does hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to the Annual Report on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Company, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 JAY S. PIFER (Jay S. Pifer) - 65 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned director of Monongahela Power Company, an Ohio corporation, does hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to the Annual Report on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Company, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 BENJAMIN H. HAYES (Benjamin H. Hayes) - 66 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned directors of Allegheny Generating Company, a Virginia corporation, do hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to the Annual Report on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Company, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 KLAUS BERGMAN (Klaus Bergman) KENNETH M. JONES (Kenneth M. Jones) PETER J. SKRGIC (Peter J. Skrgic) - 67 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned director of Monongahela Power Company, an Ohio corporation, The Potomac Edison Company, a Maryland and Virginia corporation, and West Penn Power Company, a Pennsylvania corporation, does hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to the Annual Report on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Companies, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 PETER J. SKRGIC (Peter J. Skrgic) E-1 EXHIBIT INDEX (Rule 601(a)) Allegheny Power System, Inc. Incorporation Documents by Reference 3.1 Charter of the Company, Form 10-Q of the Company as amended (1-267), September 1993, exh. (a)(3) 3.2 By-laws of the Company, Form 10-Q of the Company as amended (1-267), June 1990, exh. (a)(3) 4 Subsidiaries' Indentures described below. 10.1 Directors' Deferred Compensation Plan 10.2 Executive Compensation Plan 10.3 Allegheny Power System Incentive Compensation Plan 10.4 Allegheny Power System Supplemental Executive Retirement Plan 10.5 Executive Life Insurance Program and Collateral Assignment Agreement 10.6 Secured Benefit Plan and Collateral Assignment Agreement 11 Statement re computation of per share earnings: Clearly determinable from the financial statements contained in Item 8. 21 Subsidiaries of APS: Name of Company State of Organization Allegheny Generating Company (a) Virginia Allegheny Power Service Corporation Maryland Monongahela Power Company Ohio The Potomac Edison Company Maryland and Virginia West Penn Power Company Pennsylvania (a) Owned directly by Monongahela, Potomac Edison, and West Penn. 23 Consent of Independent Accountants See page 61 herein. 24 Powers of Attorney See pages 62-67 herein. Exhibit 10.1 Election to Defer Receipt of Directors Fees Under the Directors Elective Deferred Fees Plan of Allegheny Power System Pursuant to Section 4 of the captioned Plan, I hereby elect to defer receipt of ________% of all retainer and attendance fees payable to me on and after January 1, 19__. I elect to have my deferred account, with accumulated interest, paid as follows, commencing with the 2nd day of January following the termination of my service as a member of the Board of Directors of Allegheny: In a single lump sum, to be paid within 60 days after such January 2. In annual installment payments of equal amounts (adjusted for interest credits) over _______ years (at least 3) with such installment payments to be made on January 2 of each year. In annual installments of equal amounts (adjusted for interest credits) on January 2 of each year, such annual payments to be equal in number to the number of years of service. In the event of my death prior to receipt of all amounts I have deferred under this Plan, including interest credits, the balance of such deferred funds shall be paid in a lump sum to the following designees who survive me or to my estate in proportion to the percentage shares indicated, and, if I have indicated no designees or if all indicated designees predecease me, entirely to my estate. Designee Address Percentage Share Dated: Signature Exhibit 10.2 CONFIDENTIAL EXECUTIVE COMPENSATION PLAN OBJECTIVES To attract, hold, and motivate executive personnel. Prior approval of the chief executive officer is required for inclusion in the Plan. QUALIFICATIONS An employee becomes eligible for inclusion when 1. the employee has held a position with a salary grade of 28 or above for at least one year, is assuming the full responsibility of the position, is achieving satisfactory results and has a salary which exceeds the mid point between the minimum and standard amounts of salary grade 28, or 2. the employee has held the position of operating division manager with a salary grade of 18 or above for at least one year, is assuming the full responsibility of the position, is achieving satis- factory results and has a salary which exceeds the mid point between the minimum and standard amounts of salary grade 28. COMPENSATION 1. Life insurance 2. Dependent medical insurance 3. Dependent dental insurance 4. Annual physical examination during employment 5. Five weeks vacation, unless length of service would warrant more.* Participants in the Plan are not entitled to pay for accrued vacation (or to vacation in lieu of such pay) in excess of what they would receive if they were not par- ticipants. Language clarified. Exhibit 10.2 (Cont'd) 6. Sick pay allowance of one year at full pay and one year at half pay, regardless of length of service. PROCEDURE 1. The president of each of the operating companies, the Executive Director, Central Services and the APS, Inc. vice presidents shall submit to the chief executive officer the names of all eligible employees or reasons why an employee, otherwise eligible, should not be included, not less than 30 days prior to the employee's eligibility date. 2. The Vice President, Employee and Consumer Relations maintains an official list of employees included in the Executive Compensation Plan for all companies. January 1, 1987 Exhibit 10.3 ALLEGHENY POWER SYSTEM, INC. 1993 ANNUAL INCENTIVE PLAN I. PURPOSE OF THE INCENTIVE PLAN To attract and retain first quality managers in a com- petitive job market and to reward superior performance. II. ELIGIBILITY The annual incentive plan is designed to reward participating executives for achieving key goals for the System and for the units for which they are responsible. A prerequisite for participation in the plan shall be an understanding of and commitment to -- The System Management Plan and Policies -- The System's expectation that employees will observe the highest ethical standards in their conduct of System business and stewardship of its property. Eligibility will be determined by the Management Review Committee upon the recommendation of the CEO from among executives whose responsibilities can affect System performance. III. AWARDS Awards will reflect the importance of the participants to the System and the units for which they are responsible. Awards will be paid for the achievement of specific measurable goals set for the System, including goals set the individual and the units for which he or she is responsible. The plan's goals will be: -- Determined and communicated annually -- A reasonable number for each participant The types of goals which the Board will set with the help of the Management Review Committee include: -- Financial performance (return on equity, earnings, dividends) -- Customer satisfaction (cost, quality, and reliability of service) -- Cost and environmental consciousness (productivity, efficiency, availability and utilization of equipment) and conservation of resources -- Safety -- Development of personnel for management positions, including women and minorities IV. OVERALL LIMITATIONS ON AWARDS The Board of Directors shall not authorize any incentivepayment if, in the Board's opinion, the System's financial performance is less than satisfactory from the perspective of its stockholders. V. PERFORMANCE MEASURES Each year measures to evaluate participants' performance will be determined. They may vary among participants according to whether their principal responsibilities are to: -- The System as a whole -- An Operating Company -- Bulk Power Supply or Central Services. Each category of performance measure will carry appropriate weightings as shown on 1993 Participant Performance Schedule. Examples of possible measures include: For System as a whole -- Quantity and quality of earnings: return on equity, measured against previous year, authorized return on equity and as appropriate peer companies; financial ratings; capital structure, dividend payout ratios and total return -- Productivity, cost control, efficient use of equipment, natural resources, and other environmental considerations -- Quality and reliability of customer service -- Safety -- Attainment of reasonable rates and maintenance of competitive position For Operating Companies -- Balance for common stock: return on equity -- Safety -- Productivity and efficiency: revenues from regular customers, and administrative, operating, and maintenance expenditures - Per employee, customer, and kwh - Measured against previous year and peer companies -- Customer satisfaction (quality of service): outage rates, speedy restoration of service, customer complaints, employee courtesy, conservation and demand- side management programs -- Cost of service: rate per kwh measured against past period, economic indices, and peer companies -- Community relations and relations with state and local governments and their agencies -- Completion of construction projects on time and within budget -- Adequacy of management development programs For Bulk Power Supply and Central Services -- Adequacy of planning and accuracy of forecasts -- Completion of assignments and projects on time and within budget -- Availability, efficiency, and reliability of generating units and transmission systems -- Safety -- Cost consciousness (avoidance of excessive staffing and waste of work space and receptivity to cost saving techniques) -- Minimizing adverse effects in the environment -- User satisfaction -- Adherence to System Purchasing Policy and success in buying material, equipment, and supplies at the best possible price. For Individual Performance -- Initiative -- Resourcefulness -- Responsiveness -- Identifiable results -- Other VI. CALCULATION OF AWARDS Target Incentive Awards and Total Estimated Cost -- No awards will be paid for any year unless the Board of Directors finds that the System's financial performance is satisfactory from the perspective of its stockholders -- 100% of a target incentive award will be paid to a participant only if System, Responsibility Unit, and Individual target performance measures are fully achieved Performance Schedules -- The Performance Schedule describes ratings and weightings for each performance measure at all levels of performance -- As soon as practicable each year, Participant Performance Schedules for that year will be issued Performance Ratings -- Target performance represents the full and complete attainment of expectations in the performance area; it is rated 1.0 -- Performance that is acceptable but does not fully meet expectations can earn a rating but, of course, less than 1.0 -- Exceeding expectations can result in a performance rating as high as 1.25 -- Unacceptable individual performance will result in no award regardless of System or Unit Performance. Weightings -- Weightings will be established each year for System, Unit and Individual performance measures. Calculation of Award -- A participant's award, if any, will be determined by multiplying the participant's assigned incentive percentage times his/her rounded total performance rating times his/her salary at the close of the year prior to the year for which the award is to be made. The Management Review Committee or the Board of Directors,at its discretion, may supplement or decrease any partici-pant's calculated award to reflect extraordinary circumstances provided that it records its reason for doing so. VII. FORM AND TIMING OF PAYOUT Calculation of awards will be made as soon as practicable after the close of books for the year measured, but no award will be paid until it has been approved by the Management Review Committee or the Board of Directors, as appropriate. Payment will be in current cash unless the Management Review Committee or the Board at its discretion provides for deferral. VIII. TERMINATION AND TRANSFER PROVISIONS Termination Provisions -- Awards may at the discretion of the Management Review Committee or the Board be calculated on the basis of a full year's performance and prorated to the number of whole months actually served, except in the case of voluntary termination (other than retirement after the second quarter of the year) or termination by the company (with or without cause), in which case no award is made for year of termination. Designation of "Unit" in cases of transfer among Operating Companies, Central Services, Bulk Power Supply, and New York -- Weighting will be based on the number of months participant was in each unit. IX. PLAN ADMINISTRATION Administration of the plan is the responsibility of the Management Review Committee of the Board of Directors. -- The Committee is responsible for review and administration of all Systemwide goals and has final approval over these and other matters involving the plan, including eligibility. Exhibit 10.4 ALLEGHENY POWER SYSTEM SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN (Effective July 1, 1990) ALLEGHENY POWER SYSTEM SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN 1. Purpose of the Plan: The purpose of the Plan, the "Allegheny Power System Supplemental Executive Retirement Plan" (hereinafter referred to as the "Plan") is to provide for the payment of supplemental retirement benefits to or in respect of senior executives of Allegheny Power System companies (hereinafter sometimes referred to as a "Company" or the "Companies") as part of an integrated executive compensation program which is intended to assist the Companies in attracting, motivating and retaining executives of superior ability, industry, and loyalty. 2. Eligibility to Participate in the Plan: Each employee of a Company who was a participant in the Predecessor Plan or who on or after the Effective Date is assigned 1990 salary grade 28 or higher shall be a participant in the Plan. 3. Definitions: A. Average Compensation - shall mean 12 times the highest average monthly earnings (including overtime and other salary payments actually earned, whether or not payment thereof is deferred) for any 36 consecutive months. B. Committee - shall mean the Finance Committee of the Board of Directors of Allegheny Power System, Inc. C. Effective Date - shall mean July 1, 1990. D. Participant - shall mean an employee who meets the eligibility requirements of Section 2. Retired Participant shall mean a Participant who has retired from service after at least 10 years of service with one or more Companies and on or after his/her 55th birthday. E. Plan Year - shall mean the 12-month period on which the fiscal records of the Plan are kept, which is now the period from July 1st to June 30th. F. Predecessor Plan - shall mean the Allegheny Power System Supplemental Executive Retirement Plans effective July 1, 1982 and July 1, 1988. G. Supplemental Retirement Benefit Reduction - shall mean the retirement benefit payable to the Participant under the Allegheny Power System Retirement Plan excluding any increases in this benefit which become effective after the Participant has retired. H. Years of Service - shall mean the Participant's Years of Service, and fractional parts thereof, as computed under the terms of the Allegheny Power System Retirement Plan. 4. Supplemental Retirement Benefits: A. Eligibility for Benefits - A Participant shall be eligible for a benefit from this Plan only (a) if he/she has at least 10 Years of Service with one or more of the Companies and (b) on or after his/her 55th birthday: provided that, if a Participant is discharged from employment for cause or terminates employment with the Companies prior to retirement under the Allegheny Power System Retirement Plan for any reason whatsoever, other than death, such eligibility will terminate and no benefit shall be payable to such Participant from this Plan. A Participant who dies in active employment on or after his/her 55th birthday shall be deemed to have retired one day before his/her death. B. Amount of Benefits - (1) Subject to paragraph (2) of this Subsection, an eligible Participant will be entitled to receive a supplemental retirement benefit under this Plan equal to his/her Average Compensation multiplied by the sum of: (a) 2% times his/her number of Years of Service up to 25 years, (b) 1% times his/her number of Years of Service from 25 to 30 years, and (c) 1/2% times his/her number of Years of Service from 30 to 40 years less (x) such Participant's Supplemental Retirement Benefit Reduction and (y) 2% per year for each year that a Participant retires prior to his/her 60th birthday. (2) The supplemental retirement benefits contemplated by paragraph (1) of this Subsection shall be payable only to the extent such benefits, together with (i) all retirement benefits payable to the Participant by reason of employment with another employer (other than a benefit payable under the Federal Social Security Act) converted to the same form as the benefit paid under this Plan by using the actuarial equivalence factors of the Allegheny Power System Retirement Plan and (ii) the retirement benefit payable to the Participant under the Allegheny Power System Retirement Plan excluding any increases in this benefit which become effective after the Participant has retired do not exceed sixty percent (60%) of his/her Average Compensation, less 2% per year for each year the Participant retires prior to his/her 60th birthday. C. Form and Time of Payment - A benefit payable under this Plan shall be paid in such form as the Participant shall elect from those available, and at the same time as the retirement benefit payable to the Retired Participant, under the Allegheny Power System Retirement Plan. If the Benefit payable under this Plan is paid other than as a life annuity, the amount of the benefit when paid in such other form shall be determined by using the actuarial equivalence factors of the Allegheny Power System Retirement Plan. 5. Vesting: A Participant shall have no vested interest in the Plan until he/she becomes eligible to receive benefits under Section 4A. In the event such eligible Participant is discharged from employment for cause or terminates employment, other than by death or retirement under the Allegheny Power System Retirement Plan, any such interest which may have vested shall be discontinued and forfeited. 6. Funding: The Plan shall be unfunded. Benefits of a Participant shall be paid from the general assets of the Company employing the Participant at the time of his/her retirement and a Participant shall have no interest in any such assets under the terms of this Plan until he/she becomes a Retired Participant. An eligible Participant shall be an unsecured creditor of the Company as to the payment of any benefit under this plan. 7. Administration and Governing Law: This Plan will be administered by and under the direction of the Committee. The Committee shall adopt, and may from time to time modify or amend, such rules and guidelines consistent herewith as it may deem necessary or appropriate for carrying out the provisions and purposes of the Plan, which, upon their adoption and so long as in effect, shall be deemed a part hereof to the same extent as if set forth in the Plan (hereinafter referred to as the "Rules and Guidelines"). Any interpretation and construction by the Committee of any provision of, and the determination of any question arising under, the Plan or the Rules and Guidelines shall be final, conclusive, and binding upon the Participant, his/her surviving spouse and all other persons. The provisions of the Plan shall be construed, administered, and enforced according to and governed by the laws of the United States and the State of New York. 8. Entire Agreement: This Plan shall not be deemed to constitute a contract between any Company and any employee or other person in the employ of any Company, nor shall anything herein contained be deemed to give any employee or other person in the employ of any Company any right to be retained in the employ of any Company or to interfere with the right of any Company to discharge any employee or such other person at any time and to treat an employee without regard to the effect which such treatment might have upon such employee as a Participant in the Plan. 9. Non-Assignability: Neither a Participant, nor his beneficiary or any other person, shall have any right to commute, sell, assign, transfer, or otherwise convey the right to receive any payments hereunder; which payments and the right thereto are expressly declared to be nonassignable and nontransferable. In the event of any attempted assignment or transfer, the Companies shall have no further liability hereunder. Nor shall any payments be subject to attachment, garnishment, or execution, or be transferable by operation of law in the event of bankruptcy or insolvency, except to the extent otherwise provided by applicable law. 10. Termination or Amendment: This Plan may be terminated as to any Company at any time and amended from time to time by the Board of Directors of that Company; provided that neither termination nor amendment of the Plan may reduce or terminate any benefit to or in respect of a Participant eligible to receive benefits under Section 4A. Exhibit 10.5 AGREEMENT EXECUTIVE LIFE INSURANCE PROGRAM AND COLLATERAL ASSIGNMENT THIS AGREEMENT is entered into this day of , 19 , by and between Allegheny Power System, Inc., (hereinafter called "the Employer" in Part I or "Assignee" in Part II), and (hereinafter called "the Employee"). WHEREAS the Employee is currently a valued employee and Executive of Employer; Whereas the Employer wishes to assist the Employee with his (or her) personal life insurance program and the Employee desires to accept such assistance; and WHEREAS in consideration of the Assignee agreeing to pay all of the premiums, the Owner agrees to grant the Assignee a security for the recovery of the Assignee's premium outlay. NOW, THEREFORE for value received, the Employer and the Employee agree as follows: PART I - Individual Life Insurance Agreement A. Description of Policy - Policy Ownership In furtherance of the purposes of the Agreement, The Employee will purchase and own a certain policy of life insurance on his own life, being Policy No. issued by Security Life of Denver Insurance Company. Said policy is hereinafter called "the Policy" and said life insurance company is hereinafter called "the Insurer". The Employee's ownership of the Policy shall be subject to all the terms and conditions set forth in this Agreement. B. Payment of Premiums The Employer shall pay the entire annual premium for the Policy directly to the Insurer. C. Collateral Assignment and Possession of Policy To secure repayment of premiums paid by the Employer provided for in Section B, above, Part II of this Agreement includes an assignment of the policy or the Employee's interest therein (hereinafter called "Collateral Assignment") and provides for the transfer of possession of the Policy to the Employer during the term specified in Part II of this Agreement. Except as provided in or as otherwise consistent with the provisions of this Agreement, the Employer covenants that it will not exercise its rights under the Collateral Assignment provisions of this Agreement in such a manner as to defeat the rights of the Employee or the policy beneficiary under this Agreement. Specifically, the Employer covenants that it will not surrender the Policy unless Part I of the Agreement has terminated as provided in Section F and there has been a default in Employee's obligation under Section G of this Part I. The Employer shall have possession of the Policy during the period that the Employer makes premium payments and until all such payments are repaid. The Employer shall make the Policy available to the Insurer in order to make any change desired by the Employee as to the designation of beneficiary or the selection of a settlement option, subject, however, to the Collateral Assignment provisions hereof. D. Beneficiary Designation and Payment of Policy Proceeds The Employee shall be entitled to a death benefit from the Policy equal to one (1) times his base salary, excluding bonuses, until his retirement. At retirement, his death benefit shall increase to two (2) times salary for the next 12 months, then shall decrease by 20% of final salary each year until the earlier of the fifth anniversary of retirement or age 70, at which time it will be one (1) times salary. The Employee shall have the right to name the Policy beneficiary. However, in the event of the Employee's death, the Employer shall have an interest in the Policy proceeds equal to the total Policy proceeds in excess of the amount due to the Employee pursuant to this Section above. E. Procedure at Employee's Death Upon the death of the Employee while the policy and this Agreement are in force and subject to the provisions of Parts I and II hereof, the Employer shall promptly take all necessary steps, including rendering of such assistance as may reasonably be required by the Employee's beneficiary, to obtain payment from the Insurer of the amounts payable under the Policy to the respective parties, as provided under Section D, above. F. Termination of Agreement Part I of this Agreement shall terminate when the first of any of the following events occur: 1. Termination of the Employee's employment with the Employer prior to retirement; 2. The later of the Employee's actual retirement or ten years from the date of issuance of the Policy; 3. Performance of the Agreement's terms following the death of the Employee; 4. Failure by the Employer, for any reason, to make the premium contributions required under Section B of this Agreement; G. Disposition of Policy Upon Termination of Agreement Upon the termination of Part I of this Agreement for any reason other than Section above, the Employee shall have a thirty (30) day option to satisfy the Collateral Assignment regarding the policy held by the Employer in accordance with the terms of this Paragraph G. The amount necessary to satisfy such Collateral Assignment shall be an amount equal to the total premium payments made, from time to time, greater than the amount of cash value under the Policy and, at the option of the Employee, either shall be paid directly by the Employee or through the Employer's collection from the cash value under the policy. If the Policy shall then be encumbered by assignment, policy loan, or other means which have been the result of the Employer's actions, the Employer shall either remove such encumbrance, or reduce the amount necessary to satisfy the Collateral Assignment by the total amount of indebtedness outstanding against the Policy. If the Employee exercises his option to satisfy the Collateral Assignment, the Employer shall execute all necessary documents required by the Insurer to remove and satisfy the Collateral Assignment outstanding on the Policy. If the Employee does not exercise his option to satisfy the Collateral Assignment outstanding on the Policy, the Employee shall execute all documents necessary to transfer ownership of the Policy to the Employer. Such Transfer shall constitute satisfaction of any obligation the Employee has to the Employer with respect to this Agreement. The Employer shall then pay to the Employee the amount, if any, by which the cash surrender value of the Policy exceeds the amount necessary to satisfy the Collateral Assignment. H. Employee's Right to Assign His/Her Interest The Employee shall have the right to transfer his/her entire interest in the Policy (other than rights assigned to the Employer pursuant to this Agreement and subject to the obligations of any outstanding Collateral Assignment). If the Employee makes such a transfer, all his/her rights shall be vested in the Transferee and the Employee shall have no further interest in the Policy and Agreement. Any assignee shall be subject to all obligations of the Employee under both Parts I and II of this Agreement. I. Insurer's Obligations The Insurer is not party to this Agreement. It is understood by the parties hereto that in issuing such Policy of insurance, the Insurer shall have no liability except as set forth in the Policy and except as set forth in any assignment of the Policy filed at its Home Office and in Section J of this Agreement. Except as set forth in Section J, the Insurer shall not be bound to inquire into, or take notice of, any of the covenants herein contained as to the Policy of insurance or as to application of proceeds of such Policy. Upon the death of the Insured and payment of the proceeds in accordance with Section J of this Agreement, the insurer shall be discharged of all liability. J. Claims Procedure The following claims procedure shall apply to the Policy and the Executive Life Insurance Program: 1. Filing of a claim for benefits. The Employee or the beneficiary of the Policy shall make a claim for the benefits provided under the Policy in the manner provided in the Policy. 2. Claim denial. With respect to a claim for benefits under said Policy, the Insurer shall be the entity which reviews and makes decisions on claim denials according to the terms of the Policy. 3. Notification to claimant of decision. If a claim is wholly or partially denied, notice of the decision, meeting the requirements of Section J4, following shall be furnished to the claimant within a reasonable period of time after a claim has been filed. 4. Content of notice. The Insurer shall provide, to any claimant who is denied a claim for benefits, written notice setting forth in a manner calculated to be understood by the claimant, the following: a. The specific reason or reasons for the denial; b. Specific reference to pertinent Policy provisions or provisions of this Agreement on which the denial is based; c. A description of any additional material or information necessary for the claimant to perfect the claim and an explanation of which such material or information is necessary; and d. An explanation of this Agreement's claim review procedure, as set forth in Sections J5 and J6. 5. Review procedure. The purpose of the review procedure set forth in this subsection and subsection 6, following, is to provide a method by which a claimant under the Policy may have a reasonable opportunity to appeal a denial of claim for a full and fair review. To accomplish that purpose, the claimant or his/her duly authorized representative: a. May request a review upon written application to the Insurer; b. May review the Policy; and c. May submit issues and comments in writing. A claimant, (or his/her duly authorized representative), shall request a review by filing a written application of review at any time within sixty (60) days after receipt by the claimant of written notice of the denial of the claim. 6. Decision on review. A decision on review of a denial of a claim shall be made in the following matter; a. The decision on review shall be made by the Insurer which may, at its discretion, hold a hearing on the denied claim. The Insurer shall make its decision promptly, unless special circumstances (such as the need to hold a hearing) require an extension of time for processing, in which case a decision shall be rendered as soon as possible, but not later than on hundred twenty (120) days after receipt of the request for review. b. The decision on review shall be in writing and shall include specific reasons for the decision, written in a manner calculated to be understood by the claimant, and specific references to the pertinent Policy provision or provision of this Agreement on which the decision is based. Notwithstanding any provision of the Agreement or the Policy, no Employee, assignee or beneficiary may commence any action in any court regarding the Policy prior to pursuing all rights of an Employee under this Section J. PART II - Assignment of Life Insurance Policy as Collateral A. For value received and in specific consideration of the premium payments made by the Employer as set forth in Section B of Part I hereof, the Employee hereby assigns, transfers and sets over to the Employer (herein in this Part II called the "Assignee"), its successors and assigns, the Policy issued by the Insurer upon the life of Employee and all claims, options, privileges, rights, titles and interest therein and thereunder (except as provided in Paragraph C hereof), subject to all terms and conditions of the Policy and to all superior liens, if any, which the Insurer may have against the Policy. The Employee by this instrument agrees and the Assignee by the acceptance of this assignment agrees to the conditions and provisions herein set forth. B. It is expressly agreed that, without detracting from the generality of the foregoing, the following specific rights are included in this Agreement and Collateral Assignment and inure to the Assignee by virtue hereof: 1. The sole right to collect from the Insurer the net proceeds of the Policy in excess of the proceeds due the Employee under Part I, Section D when it becomes a claim by death or maturity; 2. The sole right to surrender the Policy and receive the surrender value thereof at any time provided by the terms of the Policy and at such other times as the Insurer may allow; 3. The sole right to obtain one or more loans or advances on the policy, either from the Insurer or, at any time, from other persons, and to pledge or assign the Policy as security for such loans or advances; 4. The sole right to collect and receive all distributions or share of surplus, dividend deposits or additions to he Policy now or hereafter made or apportioned thereto, and to exercise any and all options contained in the Policy with respect thereto; provided, that unless and until the Assignee shall notify the Insurer in writing to the contrary, the distributions or share of surplus, dividend deposits and additions shall continue on the Policy in force at the time of this assignment; and 5. The sole right to exercise all nonforfeiture rights permitted by the terms of the Policy or allowed by the Insurer and to receive all benefits and advantages derived therefrom. C. It is expressly agreed that the following specific rights, so long as the Policy has not been surrendered, are reserved and excluded from this Agreement and Collateral Assignment and do not pass by virtue hereof: 1. The right to designate and change the beneficiary; 2. The right to elect any optional mode of settlement permitted by the Policy or allowed by the Insurer; provided, however, that the reservation of these rights shall in no way impair the right of the Assignee to surrender the Policy completely with all its incidents or impair any other right of the Assignee hereunder, and any designation or change of beneficiary or election of a mode of settlement shall be made subject to this Agreement and Collateral Assignment and to the rights of the Assignee hereunder. D. This Collateral Assignment is made and the Policy is to be held as collateral security for any and all liabilities of the Employee to the Assignee arising under this Agreement (all of which liabilities secured to or to become secured are herein called "Liabilities"). It is expressly agreed that all sums received by the Assignee hereunder either in event of death of the Insured, the maturity or surrender of the Policy, the obtaining of a loan or advance on the Policy, or otherwise, shall first be applied to the payment of the liability for premiums paid by the Assignee on the Policy. E. The Assignee covenants and agrees with the Employee as follows: 1. That any balance of sums, if any, received hereunder from the Insurer remaining after payment of the existing Liabilities, matured or unmatured, shall be paid by the Assignee to the persons entitled thereto under the terms of the policy had this Collateral Assignment not been executed: 2. That the Assignee will not exercise either the right to surrender the Policy or the right to obtain policy loans from the Insurer, until there has been either default in any of the Liabilities pursuant to this Agreement or termination of Part I of said Agreement as therein provided; and 3. That the Assignee will, upon request, forward without reasonable delay to the Insurer the Policy for endorsement of any designation or change of beneficiary or any election of an optional mode of settlement. F. The Employee declares that no proceedings in bankruptcy are pending against him/her and that his/her property is not subject to any assignment for the benefit of creditors. PART III - Provisions Applicable to Parts I an II A. Amendments Amendments may be added to this Agreement by a written agreement signed by each of the parties and attached hereto. B. Choice of Law This agreement shall be subject to, and construed according to, the laws of the State of . C. A Binding Agreement This Agreement shall bind the Employer and the Employer's successors and assigns, the Employee and his/her heirs, executors, administrators, and assigns, and any Policy beneficiary. D. Provision The Employer and the Employee agree that if any provision of this Agreement is determined to be invalid or unenforceable, in whole or part, then all remaining provisions of this Agreement and, to the extent valid or enforceable, the provision in question shall remain valid, binding and fully enforceable as if the invalid or unenforceable provisions, to the extent necessary, was not a part of this Agreement. IN WITNESS WHEREOF, parties hereto have executed this Agreement, including the provisions regarding Collateral Assignment, on the day and year first above written. Witness Employee Address Employer (Title) Exhibit 10.6 AGREEMENT SECURED BENEFIT PLAN AND COLLATERAL ASSIGNMENT THIS AGREEMENT is entered into this _____ day of __________, 1992 by and between Allegheny Power Service Corporation (hereinafter called the "Employer" in Part I or "Assignee" in Part II), and ___________________________ (hereinafter called the "Employee"). WHEREAS the Employee is currently a valued employee and Executive of Employer; WHEREAS the Employer wishes to assist the Employee with his (or her) personal future financial program and the Employee desires to accept such assistance; and WHEREAS in consideration of the Employer agreeing to pay all of the premiums, the Employee agrees to grant the Employer security for the recovery of the Employer's premium outlay and the excess, if any, over the amounts due the Employee under Part I of this Agreement. NOW, THEREFORE, for value received, the Employer and the Employee agree as follows: Part I - Individual Life Insurance Agreement A. Description of Policy - Policy Ownership In furtherance of the purposes of the Agreement, the Employee will purchase and own a certain policy of life insurance on his own life, being Policy No. _____, issued by Pacific Mutual Life Insurance Co. Said policy is hereinafter called the "Policy" and said life insurance company is hereinafter called the "Insurer". The Employee's ownership of the Policy shall be subject to all the terms and conditions set forth in this Agreement. B. Payment of Premiums The Employer shall pay the entire annual premium for the Policy directly to the Insurer. C. Collateral Assignment and Possession of Policy To secure repayment of premiums paid by and amounts due to the Employer provided for in Section B, above, and Sections D and E, below, Part II of this Agreement includes an assignment of the policy or the Employee's interest therein (hereinafter called "Collateral Assignment") and provides for the transfer of possession of the policy, and the right to receive from the carrier and possess billings and policy statements, to the Employer during the term specified in Part II of this Agreement. Except as provided in or as otherwise consistent with the provisions of this Agreement, the Employer covenants that it will not exercise its rights under the Collateral Assignment provisions of this Agreement in such a manner as to defeat the rights of the Employee or the policy beneficiary under this Agreement. Specifically, the Employer covenants that it will not surrender the Policy unless Part I of the Agreement has terminated as provided in Section G and there has been a default in Employee's obligation under Section H of this Part I. The Employer shall have possession of the Policy during the period that the Employer makes premium payments and until all amounts due the Employer are repaid. The Employer shall make the Policy available to the Insurer in order to make any change desired by the Employee as to the designation of beneficiary or the selection of a settlement option, subject, however, to the provisions of this Agreement and the Collateral Assignment. D. Beneficiary Designation and Payment of Policy Proceeds The Employee shall be entitled to a death benefit from the Policy in the amount required to provide an annuity equal to (under then current annuity settlement rates from the Insurer) the supplemental retirement benefit that would be provided under Sections 4A and 4B of the Allegheny Power System Supplemental Executive Retirement Plan effective July 1, 1990, attached hereto as Appendix I, excluding the provision in Section 4A that states, "...provided that, if a Participant is discharged from employment for cause or terminates employment with the Companies prior to retirement under the Allegheny Power System Retirement Plan for any reason whatsoever, other than death, such eligibility will terminate and no benefit shall be payable to such Participant from this Plan." The Employer shall be the sole beneficiary of the policy until such time as the Employee has at least 10 years of service and is at least 55 years old. After that time and while this Agreement is in force, the following shall occur: 1. the beneficiary of the Employee's death benefit shall be the employee's spouse; 2. in the event of the Employee's death, the Employer shall be entitled to Policy proceeds equal to the total Policy proceeds in excess of the amount due to the Employee pursuant to this Section, above; and 3. if the employee is not married, he/she is entitled to no death benefit while this agreement is in force. E. Policy Cash Values The Employee shall be entitled to cash values of the Policy in excess of the premiums paid by the Employer pursuant to Section B, Above, but not to exceed the death benefits to which he/she is entitled under Section D, above. If the Employee is not married, he/she shall be entitled to cash values determined as if he/she were married. The Employer shall be entitled to Policy cash values in excess of the amount due to the Employee under this Section, above. F. Procedure at Employee's Death Upon the death of the Employee while the Policy and this Agreement are in force and subject to the provisions of Parts I and II hereof, the Employer shall promptly take all necessary steps, including rendering of such assistance as may reasonably be required, to obtain payment from the Insurer of the amounts payable under the Policy to the respective parties, as provided under Section D, above. G. Termination of Agreement Part I of this Agreement shall terminate when the first of any of the following events occur: 1. Termination of the Employee's employment with the Employer prior to retirement; 2. The later of the Employee's actual retirement or ten years from the date of issuance of the policy; 3. Performance of the Agreement's terms following the death of the Employee; 4. Failure by the Employer, for any reason, to make the premium contributions required under Section B of this Agreement. H. Disposition of Policy Upon Termination of Agreement Upon the termination of Part I of this Agreement for any reason other than Section G3 above, the Employee shall have a thirty (30) day option to satisfy the Collateral Assignment regarding the policy held by the Employer in accordance with the terms of this Paragraph H. The amount necessary to satisfy such Collateral Assignment shall be an amount equal to the total premium payments made by the Employer, plus any excess amounts as determined in Section E, above, but no greater than the amount of cash value under the Policy and, at the option of the Employee, either shall be paid directly by the Employee or through the Employer's collection from the cash value of the Policy. If the Policy shall then be encumbered by assignment, policy loan, or other means which have been the result of the Employer's actions, the Employer shall either remove such encumbrance, or reduce the amount necessary to satisfy the Collateral Assignment by the total amount of indebtedness outstanding against the Policy. If the Employee exercises his option to satisfy the Collateral Assignment, the Employer shall execute all necessary documents required by the Insurer to remove and satisfy the Collateral Assignment outstanding on the Policy. If the Employee does not exercise his option to satisfy the Collateral Assignment outstanding on the Policy, the Employee shall execute all documents necessary to transfer ownership of the Policy to the Employer. Such transfer shall constitute satisfaction of any obligation the Employee has to the Employer with respect to this Agreement. The Employer shall then pay to the Employee the amount, if any, by which the cash surrender value of the Policy exceeds the amount necessary to satisfy the Collateral Assignment. I. Employee's Right to Assign His/Her Interest Employee agrees not to sell, assign, surrender or otherwise terminate the policy while this Agreement is in effect without the consent of the Employer. J. Insurer's Obligations The Insurer is not a party to this Agreement. It is understood by the parties hereto that in issuing such Policy of insurance, the Insurer shall have no liability except as set forth in the Policy and except as set forth in any assignment of the Policy filed at it Home Office and in Section K of this Agreement. Except as set forth in Section K, the Insurer shall not be bound to inquire into, or take notice of, any of the covenants herein contained as to the Policy of insurance or as to application of proceeds of such policy. Upon the death of the Insured and payment of the proceeds in accordance with Section K of this Agreement, the Insurer shall be discharged of all liability. K. Claims Procedure The following claims procedure shall apply to the Policy and the Secured Benefit Plan: 1. Filing of a claim for benefits. The Employee or the Beneficiary shall make a claim for the benefits provided under the policy in the manner provided in the Policy. 2. Claim denial. With respect to a claim for benefits under said Policy, the Insurer shall be the entity which reviews and makes decisions on claim denials according to the terms of the Policy. 3. Notification to claimant of decision. If a claim is wholly or partially denied, notice of the decision, meeting the requirements of Section K4, following, shall be furnished to the claimant within a reasonable period of time after a claim has been filed. 4. Content of notice. The insurer shall provide, to any claimant who is denied a claim for benefits, written notice setting forth in a manner calculated to be understood by the claimant, the following: a. The specific reason or reasons for the denial; b. Specific reference to pertinent Policy provisions or provisions of this Agreement on which the denial is based; c. A description of any additional material or information necessary for the claimant to perfect the claim and an explanation of why such material or information is necessary; and d. An explanation of this Agreement's claim review procedure, as set forth in Sections K5 and K6. 5. Review procedure. The purpose of the review procedure set forth in this subsection and subsection 6, following, is to provide a method by which a claimant under the Policy may have a reasonable opportunity to appeal a denial of claim for a full and fair review. To accomplish that purpose, the claimant or his/her duly authorized representative: a. May request a review upon written application to the Insurer; b. May review the Policy; and c. May submit issues and comments in writing. A claimant, (or his/her duly authorized representative), shall request a review by filing a written application of review at any time within sixty (60) days after receipt by the claimant of written notice of the denial of the claim. 6. Decision on review. A decision on review of a denial of a claim shall be made in the following matter: a. The decision on review shall be made by the Insurer which may, at its discretion, hold a hearing on the denied claim. The Insurer shall make its decision promptly, unless special circumstances (such as the need to hold a hearing) require an extension of time for processing, in which case a decision shall be rendered as soon as possible, but not later than one hundred twenty (120) days after receipt of the request for review. b. The decision on review shall be in writing and shall include specific reasons for the decision, written in a manner calculated to be understood by the claimant, and specific references to the pertinent Policy provision or provision of this Agreement on which the decision is based. Notwithstanding any provision of the Agreement or the Policy, no Employee, assignee or beneficiary may commence any action in any court regarding the Policy prior to pursuing all rights of an Employee under this Section K. END OF PART I Part II - Assignment of Life Insurance Policy as Collateral A. For value received and in specific consideration of the premium payments made by the Employer as set forth in Section B of Part I hereof, the Employee hereby assigns, transfers and sets over to the Employer (herein this Part II called the "Assignee"), its successors and assigns, the Policy issued by the Insurer upon the life of Employee and all claims, options, privileges, rights, titles and interest therein and thereunder (except as provided in Paragraph C hereof), subject to all terms and conditions of the Policy and to all superior liens, if any, which the Insurer may have against the Policy. The Employee by this instrument agrees and the Assignee by the acceptance of this Assignment agrees to the conditions and provisions herein set forth. B. It is expressly agreed that, without detracting from the generality of the foregoing, the following specific rights are included in this Agreement and Collateral Assignment and inure to the Assignee by virtue hereof: 1. The sole right to collect from the Insurer the net proceeds of the Policy in excess of the proceeds due the Employee under Part I, Section D, when it becomes a claim by death or maturity; 2. The sole right to surrender the Policy and receive the surrender value thereof at any time provided by the terms of the Policy and at such other times as the Insurer may allow; 3. The sole right to obtain one or more loans or advances on the policy, either from the Insurer or, at any time, from other persons, and to pledge or assign the Policy as security for such loans or advances; 4. The sole right to exercise all nonforfeiture rights permitted by the terms of the Policy or allowed by the Insurer and to receive all benefits and advantages derived therefrom; 5. The sole right to direct investment of cash values as provided under the insurance contract, and to make changes and transfers in such fund allocations. C. It is expressly agreed that the following specific rights, so long as the Policy has not been surrendered, are reserved and excluded from this Collateral Assignment and do not pass by virtue hereof: 1. The right to designate and change the beneficiary; 2. The right to elect any optional mode of settlement permitted by the Policy or allowed by the Insurer; provided, however, that the reservation of these rights shall in no way impair the right of the Assignee to surrender the Policy completely with all its incidents or impair any other right of the Assignee hereunder, and any designation or change of beneficiary or election of a mode of settlement shall be made subject to this Agreement and Collateral Assignment and to the rights of the Assignee hereunder. D. This Collateral Assignment is made, and the Policy is to be held as collateral security for, any and all liabilities of the Employee to the Assignee arising under this Agreement (all of which liabilities secured or to become secured are herein called "Liabilities"). It is expressly agreed that all sums received by the Assignee hereunder either in the event of death of the Insured, the maturity or surrender of the Policy, the obtaining of a loan or advance on the Policy, or otherwise, shall first be applied to the payment of the liability for premiums paid by the Assignee on the Policy and other amounts due to Assignee under Part I of this Agreement. E. The Assignee covenants and agrees with the Employee as follows: 1. That any balance of sums, if any, received hereunder from the Insurer remaining after payment of the existing Liabilities, matured or unmatured, shall be paid by the Assignee to the persons entitled thereto under the terms of the policy had this Collateral Assignment not be executed; 2. That the Assignee will not exercise either the right to surrender the Policy or the right to obtain policy loans from the Insurer, until there has been either default in any of the Liabilities pursuant to this Agreement or termination of part I of said Agreement as therein provided; and 3. That the Assignee will, upon request, forward without unreasonable delay to the Insurer the Policy for endorsement of any designation or change of beneficiary or any election of an optional mode of settlement. F. The Employee declares that no proceedings in bankruptcy are pending against, him/her and that his/her property is not subject to any assignment for the benefit of creditors. Part III - Provisions Applicable to Parts I and II A. Amendments Amendments may be added to this Agreement by a written agreement signed by each of the parties and attached hereto. B. Choice of Law This Agreement shall be subject to, and construed according to, the laws of the State of Maryland. C. Binding Agreement This Agreement shall bind the Employer and the Employer's successors and assigns, the Employee and his/her heirs, executors, administrators, and assigns, and any Policy beneficiary. D. Validity of Provisions The Employer and the Employee agree that if any provision of this Agreement is determined to be invalid or unenforceable, in whole or part, then all remaining provisions of the Agreement and, to the extent valid or enforceable, the provision in question shall remain valid, binding and fully enforceable as if the invalid or unenforceable provisions, to the extent necessary, was not a part of this Agreement. IN WITNESS WHEREOF, parties hereto have executed this Agreement, including the provisions regarding Collateral Assignment, on the day and year first above written. ________________________ __________________________ Witness Employee ____________________________ _____________________________ Address Allegheny Power Service Corporation By: ____________________________ Richard J. Gagliardi Vice President E-2 Monongahela Power Company Incorporation Documents by Reference 3.1 Charter of the Company, as amended Form S-3, 33-51301, exh. 4(a) 3.2 Code of Regulations, Form 10-Q of the Company as amended (1-268-2), September 1993, exh. (a)(3) 4 Indenture, dated as S 2-5819, exh. 7(f) of August 1, 1945, S 2-8782, exh. 7(f) (1) and certain S 2-8881, exh. 7(b) Supplemental S 2-9355, exh.4(h) (1) Indentures of the S 2-9979, exh. 4(h)(1) Company defining S 2-10548, exh. 4(b) rights of security S 2-14763, exh. 2(b) (i) holders. S 2-24404, exh. 2(c); S 2-26806, exh. 4(d); Forms 8-K of the Company (1-268-2) dated August 8, 1989, November 21, 1991, June 4, 1992, July 15, 1992, September 1, 1992 and April 29, 1993 * There are omitted the Supplemental Indentures which do no more than subject property to the lien of the above Indentures since they are not considered constituent instruments defining the rights of the holders of the securities. The Company agrees to furnish the Commission on its request with copies of such Supplemental Indentures. 12 Computation of ratio of earnings to fixed charges 21 Subsidiaries: Monongahela Power Company has a 27% equity ownership in Allegheny Generating Company, incorporated in Virginia; and a 25% equity ownership in Allegheny Pittsburgh Coal Company, incorporated in Pennsylvania. 23 Consent of Independent Accountants See page 61 herein. 24 Powers of Attorney See pages 62-67 herein. E-3 The Potomac Edison Company Incorporation Documents by Reference 3.1 Charter of the Company, Form 10-Q of the Company as amended (1-3376-2), September 1993, exh. (a)3 3.2 By-laws of the Company, Form 10-Q of the Company as amended (1-3376-2), June 1990, exh. (a)3 4 Indenture, dated as of S 2-5473, exh. 7(b); Form October 1, 1944, and S-3, 33-51305, exh. 4(d) certain Supplemental Forms 8-K of the Company (1- Indentures of the 33-76-2) dated June 14, 1989, Company defining rights June 25, 1990, August 21, Company defining rights 1991, December 11, 1991, of security holders* December 15, 1992, February 17, 1993 and March 30, 1993 * There are omitted the Supplemental Indentures which do no more than subject property to the lien of the above Indentures since they are not considered constituent instruments defining the rights of the holders of the securities. The Company agrees to furnish the Commission on its request with copies of such Supplemental Indentures. 12 Computation of ratio of earnings to fixed charges 21 Subsidiaries: The Potomac Edison Company has a 28% equity ownership in Allegheny Generating Company, incorporated in Virginia and a 25% equity ownership in Allegheny Pittsburgh Coal Company, incorporated in Pennsylvania. 23 Consent of Independent See page 61 herein. Accountants 24 Powers of Attorney See pages 62-67 herein. E-4 West Penn Power Company Incorporation Documents by Reference 3.1 Charter of the Company, Form S-3, 33-51303, exh. 4(a) as amended 3.2 By-laws of the Company, Form 8-K of the Company as amended (1-255-2), dated June 9, 1993, exh. (a)(3) 4 Indenture, dated as of S-3, 33-51303, exh. 4(d) March 1, 1916, and certain S 2-1835, exh. B(1), B(6) Supplemental Indentures of S 2-4099, exh. B(6), B(7) the Company defining rights S 2-4322, exh. B(5) of security holders.* S 2-5362, exh. B(2), B(5) S 2-7422, exh. 7(c), 7(i) S 2-7840, exh. 7(d), 7(k) S 2-8782, exh. 7(e) (1) S 2-9477, exh. 4(c), 4(d) S 2-10802, exh. 4(b), 4(c) S 2-13400, exh. 2(c), 2(d) Form 10-Q of the Company (1-255-2), June 1980, exh. D Forms 8-K of the Company (1-255-2) dated June 1989, February 1991, December 1991, August 13, 1993, September 15, 1992, June 9, 1993 and June * There are omitted the Supplemental Indentures which do no more than subject property to the lien of the above Indentures since they are not considered constituent instruments defining the rights of the holders of the securities. The Company agrees to furnish the Commission on its request with copies of such Supplemental Indentures. 12 Computation of ratio of earnings to fixed charges 21 Subsidiaries: West Penn Power Company has a 45% equity ownership in Allegheny Generating Company, incorporated in Virginia; a 50% equity ownership in Allegheny Pittsburgh Coal Company, incorporated in Pennsylvania; and a 100% equity ownership in West Virginia Power and Transmission Company, incorporated in West Virginia, which owns a 100% equity ownership in West Penn West Virginia Water Power Company, incorporated in Pennsylvania. 23 Consent of Independent See page 61 herein. Accountants 24 Powers of Attorney See pages 62-67 herein. E-5 Allegheny Generating Company Documents 3.1(a) Charter of the Company, as amended* 3.1(b) Certificate of Amendment to Charter, effective July 14, 1989.** 3.2 By-laws of the Company, as amended* 4 Indenture, dated as of December 1, 1986, and Supplemental Indenture, dated as of December 15, 1988, of the Company defining rights of security holders.*** 10.1 APS Power Agreement-Bath County Pumped Storage Project, as amended, dated as of August 14, 1981, among Monongahela Power Company, West Penn Power Company, and The Potomac Edison Company and Allegheny Generating Company.* 10.2 Operating Agreement, dated as of June 17, 1981, among Virginia Electric and Power Company, Allegheny Generating Company, Monongahela Power Company, West Penn Power Company and The Potomac Edison Company.* 10.3 Equity Agreement, dated June 17, 1981, between and among Allegheny Generating Company, Monongahela Power Company, West Penn Power Company and The Potomac Edison Company.* 10.4 United States of America Before The Federal Energy Regulatory Commission, Allegheny Generating Company, Docket No. ER84-504-000, Settlement Agreement effective October 1, 1985.* 12 Computation of ratio of earnings to fixed charges 23 Consent of Independent See page 61 herein. Accountants 24 Powers of Attorney See pages 62-67 herein. * Incorporated by reference to the designated exhibit to AGC's registration statement on Form 10, File No. 0-14688. Incorporated by reference to Form 10-Q of the Company (0-14688) for June 1989, exh. (a). * Incorporated by reference to Forms 8-K of the Company (0-14688) for December 1986, exh. 4(A), and December 1988, exh. 4.1.		ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS For APS and the Subsidiaries, none. PART IV ITEM 14.	ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a)(1)(2) The financial statements and financial statement schedules filed as part of this Report are set forth under ITEM 8. and reference is made to the index on page 42. (b) APS filed a report on Form 8-K on November 5, 1993 concerning the two-for-one stock split. No other reports on Form 8-K were filed by System companies during the quarter ended December 31, 1993. (c) Exhibits for APS, Monongahela, Potomac Edison, West Penn, and AGC are listed in the Exhibit Index beginning on page E-1 and are incorporated herein by reference. Graphics Appendix Page System Map . . . . . . . . . . . . . . . . . . . . . . . 10 - 56 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. ALLEGHENY POWER SYSTEM, INC. By: KLAUS BERGMAN (Klaus Bergman, President and Chief Executive Officer) Date: February 3, 1994 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 (i) Principal Executive Officer: Chairman of 2/3/94 of the Board, KLAUS BERGMAN President, Chief (Klaus Bergman) Executive Officer, and Director (ii) Principal Financial Officer: STANLEY I. GARNETT, II Vice President, 2/3/94 (Stanley I. Garnett, II) Finance (iii) Principal Accounting Officer: KENNETH M. JONES Vice President 2/3/94 (Kenneth M. Jones) and Comptroller (iv) A Majority of the Directors: Eleanor Baum Frank A. Metz, Jr. William L. Bennett Clarence F. Michalis Klaus Bergman Steven H. Rice Phillip E. Lint Gunnar E. Sarsten Edward H. Malone Peter L. Shea By: NANCY H. GORMLEY 2/3/94 (Nancy H. Gormley) - 57 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. MONONGAHELA POWER COMPANY By: BENJAMIN H. HAYES (Benjamin H. Hayes, President) Date: February 3, 1994 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. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date (i) Principal Executive Officer: Chairman of 2/3/94 of the Board, KLAUS BERGMAN President, Chief (Klaus Bergman) Executive Officer, and Director (ii) Principal Financial Officer: CHARLES S. MULLETT Secretary and 2/3/94 (Charles S. Mullett) Treasurer (iii) Principal Accounting Officer: RICHARD E. MYERS Comptroller 2/3/94 (Richard E. Myers) (iv) A Majority of the Directors: Eleanor Baum Edward H. Malone William L. Bennett Frank A. Metz, Jr. Klaus Bergman Clarence F. Michalis Stanley I. Garnett, II Steven H. Rice Benjamin H. Hayes Gunnar E. Sarsten Phillip E. Lint Peter L. Shea Peter J. Skrgic By: NANCY H. GORMLEY 2/3/94 (Nancy H. Gormley) - 58 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. THE POTOMAC EDISON COMPANY By: ALAN J. NOIA (Alan J. Noia, President) Date: February 3, 1994 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. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date (i) Principal Executive Officer: Chairman of 2/3/94 of the Board, KLAUS BERGMAN President, Chief (Klaus Bergman) Executive Officer, and Director (ii) Principal Financial Officer: DALE F. ZIMMERMAN Secretary and 2/3/94 (Dale F. Zimmerman) Treasurer (iii) Principal Accounting Officer: THOMAS J. KLOC Comptroller 2/3/94 (THOMAS J. KLOC) (iv) A Majority of the Directors: Eleanor Baum Frank A. Metz, Jr. William L. Bennett Clarence F. Michalis Klaus Bergman Alan J. Noia Stanley I. Garnett, II Steven H. Rice Phillip E. Lint Gunnar E. Sarsten Edward H. Malone Peter L. Shea Peter J. Skrgic By: NANCY H. GORMLEY 2/3/94 (Nancy H. Gormley) - 59 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. WEST PENN POWER COMPANY By: JAY S. PIFER (Jay S. Pifer, President) Date: February 3, 1994 Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. Signature Title Date (i) Principal Executive Officer: Chairman of 2/3/94 of the Board, KLAUS BERGMAN President, Chief (Klaus Bergman) Executive Officer, and Director (ii) Principal Financial Officer: KENNETH D. MOWL Secretary and 2/3/94 (Kenneth D. Mowl) Treasurer (iii) Principal Accounting Officer: CHARLES V. BURKLEY Comptroller 2/3/94 (Charles V. Burkley) (iv) A Majority of the Directors: Eleanor Baum Frank A. Metz, Jr. William L. Bennett Clarence F. Michalis Klaus Bergman Jay S. Pifer Stanley I. Garnett, II Steven H. Rice Phillip E. Lint Gunnar E. Sarsten Edward H. Malone Peter L. Shea Peter J. Skrgic By: NANCY H. GORMLEY 2/3/94 (Nancy H. Gormley) - 60 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. ALLEGHENY GENERATING COMPANY By: KLAUS BERGMAN (Klaus Bergman, President and Chief Executive Officer) Date: February 3, 1994 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. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date (i) Principal Executive Officer: Chairman of 2/3/94 of the Board, KLAUS BERGMAN President, Chief (Klaus Bergman) Executive Officer, and Director (ii) Principal Financial Officer: NANCY L. CAMPBELL Treasurer and 2/3/94 (Nancy L. Campbell Assistant Secretary (iii) Principal Accounting Officer: THOMAS J. KLOC Comptroller 2/3/94 (Thomas J. Kloc) (iv) A Majority of the Directors: Klaus Bergman Kenneth M. Jones Stanley I. Garnett, II Peter J. Skrgic By: NANCY H. GORMLEY 2/3/94 (Nancy H. Gormley) - 61 - CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Prospectus constituting part of Allegheny Power System, Inc.'s Registration Statement on Form S-3 (No. 33-36716) relating to the Dividend Reinvestment and Stock Purchase Plan of Allegheny Power System, Inc.; in the Prospectus constituting part of Allegheny Power System, Inc.'s Registration Statement on Form S-3 (No. 33-49791) relating to the common stock shelf registration; in the Prospectus constituting part of Monongahela Power Company's Registration Statement on Form S-3 (No. 33-51301); in the Prospectus constituting part of The Potomac Edison Company's Registration Statement on Form S-3 (No. 33-51305); and in the Prospectus constituting part of West Penn Power Company's Registration Statement on Form S-3 (No. 33-51303); of our reports dated February 3, 1994 included in ITEM 8 of this Form 10-K. We also consent to the references to us under the heading "Experts" in such Prospectuses. PRICE WATERHOUSE PRICE WATERHOUSE New York, New York March 11, 1994 - 62 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned directors of Allegheny Power System, Inc., a Maryland corporation, Monongahela Power Company, an Ohio corporation, The Potomac Edison Company, a Maryland and Virginia corporation, and West Penn Power Company, a Pennsylvania corporation, do hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to Annual Reports on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Companies, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 ELEANOR BAUM FRANK A. METZ, JR. (Eleanor Baum) (Frank A. Metz, Jr.) WILLIAM L. BENNETT CLARENCE F. MICHALIS (William L. Bennett) (Clarence F. Michalis) KLAUS BERGMAN STEVEN H. RICE (Klaus Bergman) (Steven H. Rice) PHILLIP E. LINT GUNNAR E. SARSTEN (Phillip E. Lint) (Gunnar E. Sarsten) EDWARD H. MALONE PETER L. SHEA (Edward H. Malone) (Peter L. Shea) - 63 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned director of The Potomac Edison Company, a Maryland and Virginia corporation, does hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to the Annual Report on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Company, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 ALAN J. NOIA (Alan J. Noia) - 64 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned director of West Penn Power Company, a Pennsylvania corporation, does hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to the Annual Report on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Company, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 JAY S. PIFER (Jay S. Pifer) - 65 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned director of Monongahela Power Company, an Ohio corporation, does hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to the Annual Report on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Company, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 BENJAMIN H. HAYES (Benjamin H. Hayes) - 66 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned directors of Allegheny Generating Company, a Virginia corporation, do hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to the Annual Report on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Company, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 KLAUS BERGMAN (Klaus Bergman) KENNETH M. JONES (Kenneth M. Jones) PETER J. SKRGIC (Peter J. Skrgic) - 67 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned director of Monongahela Power Company, an Ohio corporation, The Potomac Edison Company, a Maryland and Virginia corporation, and West Penn Power Company, a Pennsylvania corporation, does hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to the Annual Report on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Companies, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 PETER J. SKRGIC (Peter J. Skrgic) E-1 EXHIBIT INDEX (Rule 601(a)) Allegheny Power System, Inc. Incorporation Documents by Reference 3.1 Charter of the Company, Form 10-Q of the Company as amended (1-267), September 1993, exh. (a)(3) 3.2 By-laws of the Company, Form 10-Q of the Company as amended (1-267), June 1990, exh. (a)(3) 4 Subsidiaries' Indentures described below. 10.1 Directors' Deferred Compensation Plan 10.2 Executive Compensation Plan 10.3 Allegheny Power System Incentive Compensation Plan 10.4 Allegheny Power System Supplemental Executive Retirement Plan 10.5 Executive Life Insurance Program and Collateral Assignment Agreement 10.6 Secured Benefit Plan and Collateral Assignment Agreement 11 Statement re computation of per share earnings: Clearly determinable from the financial statements contained in Item 8. 21 Subsidiaries of APS: Name of Company State of Organization Allegheny Generating Company (a) Virginia Allegheny Power Service Corporation Maryland Monongahela Power Company Ohio The Potomac Edison Company Maryland and Virginia West Penn Power Company Pennsylvania (a) Owned directly by Monongahela, Potomac Edison, and West Penn. 23 Consent of Independent Accountants See page 61 herein. 24 Powers of Attorney See pages 62-67 herein. Exhibit 10.1 Election to Defer Receipt of Directors Fees Under the Directors Elective Deferred Fees Plan of Allegheny Power System Pursuant to Section 4 of the captioned Plan, I hereby elect to defer receipt of ________% of all retainer and attendance fees payable to me on and after January 1, 19__. I elect to have my deferred account, with accumulated interest, paid as follows, commencing with the 2nd day of January following the termination of my service as a member of the Board of Directors of Allegheny: In a single lump sum, to be paid within 60 days after such January 2. In annual installment payments of equal amounts (adjusted for interest credits) over _______ years (at least 3) with such installment payments to be made on January 2 of each year. In annual installments of equal amounts (adjusted for interest credits) on January 2 of each year, such annual payments to be equal in number to the number of years of service. In the event of my death prior to receipt of all amounts I have deferred under this Plan, including interest credits, the balance of such deferred funds shall be paid in a lump sum to the following designees who survive me or to my estate in proportion to the percentage shares indicated, and, if I have indicated no designees or if all indicated designees predecease me, entirely to my estate. Designee Address Percentage Share Dated: Signature Exhibit 10.2 CONFIDENTIAL EXECUTIVE COMPENSATION PLAN OBJECTIVES To attract, hold, and motivate executive personnel. Prior approval of the chief executive officer is required for inclusion in the Plan. QUALIFICATIONS An employee becomes eligible for inclusion when 1. the employee has held a position with a salary grade of 28 or above for at least one year, is assuming the full responsibility of the position, is achieving satisfactory results and has a salary which exceeds the mid point between the minimum and standard amounts of salary grade 28, or 2. the employee has held the position of operating division manager with a salary grade of 18 or above for at least one year, is assuming the full responsibility of the position, is achieving satis- factory results and has a salary which exceeds the mid point between the minimum and standard amounts of salary grade 28. COMPENSATION 1. Life insurance 2. Dependent medical insurance 3. Dependent dental insurance 4. Annual physical examination during employment 5. Five weeks vacation, unless length of service would warrant more.* Participants in the Plan are not entitled to pay for accrued vacation (or to vacation in lieu of such pay) in excess of what they would receive if they were not par- ticipants. Language clarified. Exhibit 10.2 (Cont'd) 6. Sick pay allowance of one year at full pay and one year at half pay, regardless of length of service. PROCEDURE 1. The president of each of the operating companies, the Executive Director, Central Services and the APS, Inc. vice presidents shall submit to the chief executive officer the names of all eligible employees or reasons why an employee, otherwise eligible, should not be included, not less than 30 days prior to the employee's eligibility date. 2. The Vice President, Employee and Consumer Relations maintains an official list of employees included in the Executive Compensation Plan for all companies. January 1, 1987 Exhibit 10.3 ALLEGHENY POWER SYSTEM, INC. 1993 ANNUAL INCENTIVE PLAN I. PURPOSE OF THE INCENTIVE PLAN To attract and retain first quality managers in a com- petitive job market and to reward superior performance. II. ELIGIBILITY The annual incentive plan is designed to reward participating executives for achieving key goals for the System and for the units for which they are responsible. A prerequisite for participation in the plan shall be an understanding of and commitment to -- The System Management Plan and Policies -- The System's expectation that employees will observe the highest ethical standards in their conduct of System business and stewardship of its property. Eligibility will be determined by the Management Review Committee upon the recommendation of the CEO from among executives whose responsibilities can affect System performance. III. AWARDS Awards will reflect the importance of the participants to the System and the units for which they are responsible. Awards will be paid for the achievement of specific measurable goals set for the System, including goals set the individual and the units for which he or she is responsible. The plan's goals will be: -- Determined and communicated annually -- A reasonable number for each participant The types of goals which the Board will set with the help of the Management Review Committee include: -- Financial performance (return on equity, earnings, dividends) -- Customer satisfaction (cost, quality, and reliability of service) -- Cost and environmental consciousness (productivity, efficiency, availability and utilization of equipment) and conservation of resources -- Safety -- Development of personnel for management positions, including women and minorities IV. OVERALL LIMITATIONS ON AWARDS The Board of Directors shall not authorize any incentivepayment if, in the Board's opinion, the System's financial performance is less than satisfactory from the perspective of its stockholders. V. PERFORMANCE MEASURES Each year measures to evaluate participants' performance will be determined. They may vary among participants according to whether their principal responsibilities are to: -- The System as a whole -- An Operating Company -- Bulk Power Supply or Central Services. Each category of performance measure will carry appropriate weightings as shown on 1993 Participant Performance Schedule. Examples of possible measures include: For System as a whole -- Quantity and quality of earnings: return on equity, measured against previous year, authorized return on equity and as appropriate peer companies; financial ratings; capital structure, dividend payout ratios and total return -- Productivity, cost control, efficient use of equipment, natural resources, and other environmental considerations -- Quality and reliability of customer service -- Safety -- Attainment of reasonable rates and maintenance of competitive position For Operating Companies -- Balance for common stock: return on equity -- Safety -- Productivity and efficiency: revenues from regular customers, and administrative, operating, and maintenance expenditures - Per employee, customer, and kwh - Measured against previous year and peer companies -- Customer satisfaction (quality of service): outage rates, speedy restoration of service, customer complaints, employee courtesy, conservation and demand- side management programs -- Cost of service: rate per kwh measured against past period, economic indices, and peer companies -- Community relations and relations with state and local governments and their agencies -- Completion of construction projects on time and within budget -- Adequacy of management development programs For Bulk Power Supply and Central Services -- Adequacy of planning and accuracy of forecasts -- Completion of assignments and projects on time and within budget -- Availability, efficiency, and reliability of generating units and transmission systems -- Safety -- Cost consciousness (avoidance of excessive staffing and waste of work space and receptivity to cost saving techniques) -- Minimizing adverse effects in the environment -- User satisfaction -- Adherence to System Purchasing Policy and success in buying material, equipment, and supplies at the best possible price. For Individual Performance -- Initiative -- Resourcefulness -- Responsiveness -- Identifiable results -- Other VI. CALCULATION OF AWARDS Target Incentive Awards and Total Estimated Cost -- No awards will be paid for any year unless the Board of Directors finds that the System's financial performance is satisfactory from the perspective of its stockholders -- 100% of a target incentive award will be paid to a participant only if System, Responsibility Unit, and Individual target performance measures are fully achieved Performance Schedules -- The Performance Schedule describes ratings and weightings for each performance measure at all levels of performance -- As soon as practicable each year, Participant Performance Schedules for that year will be issued Performance Ratings -- Target performance represents the full and complete attainment of expectations in the performance area; it is rated 1.0 -- Performance that is acceptable but does not fully meet expectations can earn a rating but, of course, less than 1.0 -- Exceeding expectations can result in a performance rating as high as 1.25 -- Unacceptable individual performance will result in no award regardless of System or Unit Performance. Weightings -- Weightings will be established each year for System, Unit and Individual performance measures. Calculation of Award -- A participant's award, if any, will be determined by multiplying the participant's assigned incentive percentage times his/her rounded total performance rating times his/her salary at the close of the year prior to the year for which the award is to be made. The Management Review Committee or the Board of Directors,at its discretion, may supplement or decrease any partici-pant's calculated award to reflect extraordinary circumstances provided that it records its reason for doing so. VII. FORM AND TIMING OF PAYOUT Calculation of awards will be made as soon as practicable after the close of books for the year measured, but no award will be paid until it has been approved by the Management Review Committee or the Board of Directors, as appropriate. Payment will be in current cash unless the Management Review Committee or the Board at its discretion provides for deferral. VIII. TERMINATION AND TRANSFER PROVISIONS Termination Provisions -- Awards may at the discretion of the Management Review Committee or the Board be calculated on the basis of a full year's performance and prorated to the number of whole months actually served, except in the case of voluntary termination (other than retirement after the second quarter of the year) or termination by the company (with or without cause), in which case no award is made for year of termination. Designation of "Unit" in cases of transfer among Operating Companies, Central Services, Bulk Power Supply, and New York -- Weighting will be based on the number of months participant was in each unit. IX. PLAN ADMINISTRATION Administration of the plan is the responsibility of the Management Review Committee of the Board of Directors. -- The Committee is responsible for review and administration of all Systemwide goals and has final approval over these and other matters involving the plan, including eligibility. Exhibit 10.4 ALLEGHENY POWER SYSTEM SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN (Effective July 1, 1990) ALLEGHENY POWER SYSTEM SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN 1. Purpose of the Plan: The purpose of the Plan, the "Allegheny Power System Supplemental Executive Retirement Plan" (hereinafter referred to as the "Plan") is to provide for the payment of supplemental retirement benefits to or in respect of senior executives of Allegheny Power System companies (hereinafter sometimes referred to as a "Company" or the "Companies") as part of an integrated executive compensation program which is intended to assist the Companies in attracting, motivating and retaining executives of superior ability, industry, and loyalty. 2. Eligibility to Participate in the Plan: Each employee of a Company who was a participant in the Predecessor Plan or who on or after the Effective Date is assigned 1990 salary grade 28 or higher shall be a participant in the Plan. 3. Definitions: A. Average Compensation - shall mean 12 times the highest average monthly earnings (including overtime and other salary payments actually earned, whether or not payment thereof is deferred) for any 36 consecutive months. B. Committee - shall mean the Finance Committee of the Board of Directors of Allegheny Power System, Inc. C. Effective Date - shall mean July 1, 1990. D. Participant - shall mean an employee who meets the eligibility requirements of Section 2. Retired Participant shall mean a Participant who has retired from service after at least 10 years of service with one or more Companies and on or after his/her 55th birthday. E. Plan Year - shall mean the 12-month period on which the fiscal records of the Plan are kept, which is now the period from July 1st to June 30th. F. Predecessor Plan - shall mean the Allegheny Power System Supplemental Executive Retirement Plans effective July 1, 1982 and July 1, 1988. G. Supplemental Retirement Benefit Reduction - shall mean the retirement benefit payable to the Participant under the Allegheny Power System Retirement Plan excluding any increases in this benefit which become effective after the Participant has retired. H. Years of Service - shall mean the Participant's Years of Service, and fractional parts thereof, as computed under the terms of the Allegheny Power System Retirement Plan. 4. Supplemental Retirement Benefits: A. Eligibility for Benefits - A Participant shall be eligible for a benefit from this Plan only (a) if he/she has at least 10 Years of Service with one or more of the Companies and (b) on or after his/her 55th birthday: provided that, if a Participant is discharged from employment for cause or terminates employment with the Companies prior to retirement under the Allegheny Power System Retirement Plan for any reason whatsoever, other than death, such eligibility will terminate and no benefit shall be payable to such Participant from this Plan. A Participant who dies in active employment on or after his/her 55th birthday shall be deemed to have retired one day before his/her death. B. Amount of Benefits - (1) Subject to paragraph (2) of this Subsection, an eligible Participant will be entitled to receive a supplemental retirement benefit under this Plan equal to his/her Average Compensation multiplied by the sum of: (a) 2% times his/her number of Years of Service up to 25 years, (b) 1% times his/her number of Years of Service from 25 to 30 years, and (c) 1/2% times his/her number of Years of Service from 30 to 40 years less (x) such Participant's Supplemental Retirement Benefit Reduction and (y) 2% per year for each year that a Participant retires prior to his/her 60th birthday. (2) The supplemental retirement benefits contemplated by paragraph (1) of this Subsection shall be payable only to the extent such benefits, together with (i) all retirement benefits payable to the Participant by reason of employment with another employer (other than a benefit payable under the Federal Social Security Act) converted to the same form as the benefit paid under this Plan by using the actuarial equivalence factors of the Allegheny Power System Retirement Plan and (ii) the retirement benefit payable to the Participant under the Allegheny Power System Retirement Plan excluding any increases in this benefit which become effective after the Participant has retired do not exceed sixty percent (60%) of his/her Average Compensation, less 2% per year for each year the Participant retires prior to his/her 60th birthday. C. Form and Time of Payment - A benefit payable under this Plan shall be paid in such form as the Participant shall elect from those available, and at the same time as the retirement benefit payable to the Retired Participant, under the Allegheny Power System Retirement Plan. If the Benefit payable under this Plan is paid other than as a life annuity, the amount of the benefit when paid in such other form shall be determined by using the actuarial equivalence factors of the Allegheny Power System Retirement Plan. 5. Vesting: A Participant shall have no vested interest in the Plan until he/she becomes eligible to receive benefits under Section 4A. In the event such eligible Participant is discharged from employment for cause or terminates employment, other than by death or retirement under the Allegheny Power System Retirement Plan, any such interest which may have vested shall be discontinued and forfeited. 6. Funding: The Plan shall be unfunded. Benefits of a Participant shall be paid from the general assets of the Company employing the Participant at the time of his/her retirement and a Participant shall have no interest in any such assets under the terms of this Plan until he/she becomes a Retired Participant. An eligible Participant shall be an unsecured creditor of the Company as to the payment of any benefit under this plan. 7. Administration and Governing Law: This Plan will be administered by and under the direction of the Committee. The Committee shall adopt, and may from time to time modify or amend, such rules and guidelines consistent herewith as it may deem necessary or appropriate for carrying out the provisions and purposes of the Plan, which, upon their adoption and so long as in effect, shall be deemed a part hereof to the same extent as if set forth in the Plan (hereinafter referred to as the "Rules and Guidelines"). Any interpretation and construction by the Committee of any provision of, and the determination of any question arising under, the Plan or the Rules and Guidelines shall be final, conclusive, and binding upon the Participant, his/her surviving spouse and all other persons. The provisions of the Plan shall be construed, administered, and enforced according to and governed by the laws of the United States and the State of New York. 8. Entire Agreement: This Plan shall not be deemed to constitute a contract between any Company and any employee or other person in the employ of any Company, nor shall anything herein contained be deemed to give any employee or other person in the employ of any Company any right to be retained in the employ of any Company or to interfere with the right of any Company to discharge any employee or such other person at any time and to treat an employee without regard to the effect which such treatment might have upon such employee as a Participant in the Plan. 9. Non-Assignability: Neither a Participant, nor his beneficiary or any other person, shall have any right to commute, sell, assign, transfer, or otherwise convey the right to receive any payments hereunder; which payments and the right thereto are expressly declared to be nonassignable and nontransferable. In the event of any attempted assignment or transfer, the Companies shall have no further liability hereunder. Nor shall any payments be subject to attachment, garnishment, or execution, or be transferable by operation of law in the event of bankruptcy or insolvency, except to the extent otherwise provided by applicable law. 10. Termination or Amendment: This Plan may be terminated as to any Company at any time and amended from time to time by the Board of Directors of that Company; provided that neither termination nor amendment of the Plan may reduce or terminate any benefit to or in respect of a Participant eligible to receive benefits under Section 4A. Exhibit 10.5 AGREEMENT EXECUTIVE LIFE INSURANCE PROGRAM AND COLLATERAL ASSIGNMENT THIS AGREEMENT is entered into this day of , 19 , by and between Allegheny Power System, Inc., (hereinafter called "the Employer" in Part I or "Assignee" in Part II), and (hereinafter called "the Employee"). WHEREAS the Employee is currently a valued employee and Executive of Employer; Whereas the Employer wishes to assist the Employee with his (or her) personal life insurance program and the Employee desires to accept such assistance; and WHEREAS in consideration of the Assignee agreeing to pay all of the premiums, the Owner agrees to grant the Assignee a security for the recovery of the Assignee's premium outlay. NOW, THEREFORE for value received, the Employer and the Employee agree as follows: PART I - Individual Life Insurance Agreement A. Description of Policy - Policy Ownership In furtherance of the purposes of the Agreement, The Employee will purchase and own a certain policy of life insurance on his own life, being Policy No. issued by Security Life of Denver Insurance Company. Said policy is hereinafter called "the Policy" and said life insurance company is hereinafter called "the Insurer". The Employee's ownership of the Policy shall be subject to all the terms and conditions set forth in this Agreement. B. Payment of Premiums The Employer shall pay the entire annual premium for the Policy directly to the Insurer. C. Collateral Assignment and Possession of Policy To secure repayment of premiums paid by the Employer provided for in Section B, above, Part II of this Agreement includes an assignment of the policy or the Employee's interest therein (hereinafter called "Collateral Assignment") and provides for the transfer of possession of the Policy to the Employer during the term specified in Part II of this Agreement. Except as provided in or as otherwise consistent with the provisions of this Agreement, the Employer covenants that it will not exercise its rights under the Collateral Assignment provisions of this Agreement in such a manner as to defeat the rights of the Employee or the policy beneficiary under this Agreement. Specifically, the Employer covenants that it will not surrender the Policy unless Part I of the Agreement has terminated as provided in Section F and there has been a default in Employee's obligation under Section G of this Part I. The Employer shall have possession of the Policy during the period that the Employer makes premium payments and until all such payments are repaid. The Employer shall make the Policy available to the Insurer in order to make any change desired by the Employee as to the designation of beneficiary or the selection of a settlement option, subject, however, to the Collateral Assignment provisions hereof. D. Beneficiary Designation and Payment of Policy Proceeds The Employee shall be entitled to a death benefit from the Policy equal to one (1) times his base salary, excluding bonuses, until his retirement. At retirement, his death benefit shall increase to two (2) times salary for the next 12 months, then shall decrease by 20% of final salary each year until the earlier of the fifth anniversary of retirement or age 70, at which time it will be one (1) times salary. The Employee shall have the right to name the Policy beneficiary. However, in the event of the Employee's death, the Employer shall have an interest in the Policy proceeds equal to the total Policy proceeds in excess of the amount due to the Employee pursuant to this Section above. E. Procedure at Employee's Death Upon the death of the Employee while the policy and this Agreement are in force and subject to the provisions of Parts I and II hereof, the Employer shall promptly take all necessary steps, including rendering of such assistance as may reasonably be required by the Employee's beneficiary, to obtain payment from the Insurer of the amounts payable under the Policy to the respective parties, as provided under Section D, above. F. Termination of Agreement Part I of this Agreement shall terminate when the first of any of the following events occur: 1. Termination of the Employee's employment with the Employer prior to retirement; 2. The later of the Employee's actual retirement or ten years from the date of issuance of the Policy; 3. Performance of the Agreement's terms following the death of the Employee; 4. Failure by the Employer, for any reason, to make the premium contributions required under Section B of this Agreement; G. Disposition of Policy Upon Termination of Agreement Upon the termination of Part I of this Agreement for any reason other than Section above, the Employee shall have a thirty (30) day option to satisfy the Collateral Assignment regarding the policy held by the Employer in accordance with the terms of this Paragraph G. The amount necessary to satisfy such Collateral Assignment shall be an amount equal to the total premium payments made, from time to time, greater than the amount of cash value under the Policy and, at the option of the Employee, either shall be paid directly by the Employee or through the Employer's collection from the cash value under the policy. If the Policy shall then be encumbered by assignment, policy loan, or other means which have been the result of the Employer's actions, the Employer shall either remove such encumbrance, or reduce the amount necessary to satisfy the Collateral Assignment by the total amount of indebtedness outstanding against the Policy. If the Employee exercises his option to satisfy the Collateral Assignment, the Employer shall execute all necessary documents required by the Insurer to remove and satisfy the Collateral Assignment outstanding on the Policy. If the Employee does not exercise his option to satisfy the Collateral Assignment outstanding on the Policy, the Employee shall execute all documents necessary to transfer ownership of the Policy to the Employer. Such Transfer shall constitute satisfaction of any obligation the Employee has to the Employer with respect to this Agreement. The Employer shall then pay to the Employee the amount, if any, by which the cash surrender value of the Policy exceeds the amount necessary to satisfy the Collateral Assignment. H. Employee's Right to Assign His/Her Interest The Employee shall have the right to transfer his/her entire interest in the Policy (other than rights assigned to the Employer pursuant to this Agreement and subject to the obligations of any outstanding Collateral Assignment). If the Employee makes such a transfer, all his/her rights shall be vested in the Transferee and the Employee shall have no further interest in the Policy and Agreement. Any assignee shall be subject to all obligations of the Employee under both Parts I and II of this Agreement. I. Insurer's Obligations The Insurer is not party to this Agreement. It is understood by the parties hereto that in issuing such Policy of insurance, the Insurer shall have no liability except as set forth in the Policy and except as set forth in any assignment of the Policy filed at its Home Office and in Section J of this Agreement. Except as set forth in Section J, the Insurer shall not be bound to inquire into, or take notice of, any of the covenants herein contained as to the Policy of insurance or as to application of proceeds of such Policy. Upon the death of the Insured and payment of the proceeds in accordance with Section J of this Agreement, the insurer shall be discharged of all liability. J. Claims Procedure The following claims procedure shall apply to the Policy and the Executive Life Insurance Program: 1. Filing of a claim for benefits. The Employee or the beneficiary of the Policy shall make a claim for the benefits provided under the Policy in the manner provided in the Policy. 2. Claim denial. With respect to a claim for benefits under said Policy, the Insurer shall be the entity which reviews and makes decisions on claim denials according to the terms of the Policy. 3. Notification to claimant of decision. If a claim is wholly or partially denied, notice of the decision, meeting the requirements of Section J4, following shall be furnished to the claimant within a reasonable period of time after a claim has been filed. 4. Content of notice. The Insurer shall provide, to any claimant who is denied a claim for benefits, written notice setting forth in a manner calculated to be understood by the claimant, the following: a. The specific reason or reasons for the denial; b. Specific reference to pertinent Policy provisions or provisions of this Agreement on which the denial is based; c. A description of any additional material or information necessary for the claimant to perfect the claim and an explanation of which such material or information is necessary; and d. An explanation of this Agreement's claim review procedure, as set forth in Sections J5 and J6. 5. Review procedure. The purpose of the review procedure set forth in this subsection and subsection 6, following, is to provide a method by which a claimant under the Policy may have a reasonable opportunity to appeal a denial of claim for a full and fair review. To accomplish that purpose, the claimant or his/her duly authorized representative: a. May request a review upon written application to the Insurer; b. May review the Policy; and c. May submit issues and comments in writing. A claimant, (or his/her duly authorized representative), shall request a review by filing a written application of review at any time within sixty (60) days after receipt by the claimant of written notice of the denial of the claim. 6. Decision on review. A decision on review of a denial of a claim shall be made in the following matter; a. The decision on review shall be made by the Insurer which may, at its discretion, hold a hearing on the denied claim. The Insurer shall make its decision promptly, unless special circumstances (such as the need to hold a hearing) require an extension of time for processing, in which case a decision shall be rendered as soon as possible, but not later than on hundred twenty (120) days after receipt of the request for review. b. The decision on review shall be in writing and shall include specific reasons for the decision, written in a manner calculated to be understood by the claimant, and specific references to the pertinent Policy provision or provision of this Agreement on which the decision is based. Notwithstanding any provision of the Agreement or the Policy, no Employee, assignee or beneficiary may commence any action in any court regarding the Policy prior to pursuing all rights of an Employee under this Section J. PART II - Assignment of Life Insurance Policy as Collateral A. For value received and in specific consideration of the premium payments made by the Employer as set forth in Section B of Part I hereof, the Employee hereby assigns, transfers and sets over to the Employer (herein in this Part II called the "Assignee"), its successors and assigns, the Policy issued by the Insurer upon the life of Employee and all claims, options, privileges, rights, titles and interest therein and thereunder (except as provided in Paragraph C hereof), subject to all terms and conditions of the Policy and to all superior liens, if any, which the Insurer may have against the Policy. The Employee by this instrument agrees and the Assignee by the acceptance of this assignment agrees to the conditions and provisions herein set forth. B. It is expressly agreed that, without detracting from the generality of the foregoing, the following specific rights are included in this Agreement and Collateral Assignment and inure to the Assignee by virtue hereof: 1. The sole right to collect from the Insurer the net proceeds of the Policy in excess of the proceeds due the Employee under Part I, Section D when it becomes a claim by death or maturity; 2. The sole right to surrender the Policy and receive the surrender value thereof at any time provided by the terms of the Policy and at such other times as the Insurer may allow; 3. The sole right to obtain one or more loans or advances on the policy, either from the Insurer or, at any time, from other persons, and to pledge or assign the Policy as security for such loans or advances; 4. The sole right to collect and receive all distributions or share of surplus, dividend deposits or additions to he Policy now or hereafter made or apportioned thereto, and to exercise any and all options contained in the Policy with respect thereto; provided, that unless and until the Assignee shall notify the Insurer in writing to the contrary, the distributions or share of surplus, dividend deposits and additions shall continue on the Policy in force at the time of this assignment; and 5. The sole right to exercise all nonforfeiture rights permitted by the terms of the Policy or allowed by the Insurer and to receive all benefits and advantages derived therefrom. C. It is expressly agreed that the following specific rights, so long as the Policy has not been surrendered, are reserved and excluded from this Agreement and Collateral Assignment and do not pass by virtue hereof: 1. The right to designate and change the beneficiary; 2. The right to elect any optional mode of settlement permitted by the Policy or allowed by the Insurer; provided, however, that the reservation of these rights shall in no way impair the right of the Assignee to surrender the Policy completely with all its incidents or impair any other right of the Assignee hereunder, and any designation or change of beneficiary or election of a mode of settlement shall be made subject to this Agreement and Collateral Assignment and to the rights of the Assignee hereunder. D. This Collateral Assignment is made and the Policy is to be held as collateral security for any and all liabilities of the Employee to the Assignee arising under this Agreement (all of which liabilities secured to or to become secured are herein called "Liabilities"). It is expressly agreed that all sums received by the Assignee hereunder either in event of death of the Insured, the maturity or surrender of the Policy, the obtaining of a loan or advance on the Policy, or otherwise, shall first be applied to the payment of the liability for premiums paid by the Assignee on the Policy. E. The Assignee covenants and agrees with the Employee as follows: 1. That any balance of sums, if any, received hereunder from the Insurer remaining after payment of the existing Liabilities, matured or unmatured, shall be paid by the Assignee to the persons entitled thereto under the terms of the policy had this Collateral Assignment not been executed: 2. That the Assignee will not exercise either the right to surrender the Policy or the right to obtain policy loans from the Insurer, until there has been either default in any of the Liabilities pursuant to this Agreement or termination of Part I of said Agreement as therein provided; and 3. That the Assignee will, upon request, forward without reasonable delay to the Insurer the Policy for endorsement of any designation or change of beneficiary or any election of an optional mode of settlement. F. The Employee declares that no proceedings in bankruptcy are pending against him/her and that his/her property is not subject to any assignment for the benefit of creditors. PART III - Provisions Applicable to Parts I an II A. Amendments Amendments may be added to this Agreement by a written agreement signed by each of the parties and attached hereto. B. Choice of Law This agreement shall be subject to, and construed according to, the laws of the State of . C. A Binding Agreement This Agreement shall bind the Employer and the Employer's successors and assigns, the Employee and his/her heirs, executors, administrators, and assigns, and any Policy beneficiary. D. Provision The Employer and the Employee agree that if any provision of this Agreement is determined to be invalid or unenforceable, in whole or part, then all remaining provisions of this Agreement and, to the extent valid or enforceable, the provision in question shall remain valid, binding and fully enforceable as if the invalid or unenforceable provisions, to the extent necessary, was not a part of this Agreement. IN WITNESS WHEREOF, parties hereto have executed this Agreement, including the provisions regarding Collateral Assignment, on the day and year first above written. Witness Employee Address Employer (Title) Exhibit 10.6 AGREEMENT SECURED BENEFIT PLAN AND COLLATERAL ASSIGNMENT THIS AGREEMENT is entered into this _____ day of __________, 1992 by and between Allegheny Power Service Corporation (hereinafter called the "Employer" in Part I or "Assignee" in Part II), and ___________________________ (hereinafter called the "Employee"). WHEREAS the Employee is currently a valued employee and Executive of Employer; WHEREAS the Employer wishes to assist the Employee with his (or her) personal future financial program and the Employee desires to accept such assistance; and WHEREAS in consideration of the Employer agreeing to pay all of the premiums, the Employee agrees to grant the Employer security for the recovery of the Employer's premium outlay and the excess, if any, over the amounts due the Employee under Part I of this Agreement. NOW, THEREFORE, for value received, the Employer and the Employee agree as follows: Part I - Individual Life Insurance Agreement A. Description of Policy - Policy Ownership In furtherance of the purposes of the Agreement, the Employee will purchase and own a certain policy of life insurance on his own life, being Policy No. _____, issued by Pacific Mutual Life Insurance Co. Said policy is hereinafter called the "Policy" and said life insurance company is hereinafter called the "Insurer". The Employee's ownership of the Policy shall be subject to all the terms and conditions set forth in this Agreement. B. Payment of Premiums The Employer shall pay the entire annual premium for the Policy directly to the Insurer. C. Collateral Assignment and Possession of Policy To secure repayment of premiums paid by and amounts due to the Employer provided for in Section B, above, and Sections D and E, below, Part II of this Agreement includes an assignment of the policy or the Employee's interest therein (hereinafter called "Collateral Assignment") and provides for the transfer of possession of the policy, and the right to receive from the carrier and possess billings and policy statements, to the Employer during the term specified in Part II of this Agreement. Except as provided in or as otherwise consistent with the provisions of this Agreement, the Employer covenants that it will not exercise its rights under the Collateral Assignment provisions of this Agreement in such a manner as to defeat the rights of the Employee or the policy beneficiary under this Agreement. Specifically, the Employer covenants that it will not surrender the Policy unless Part I of the Agreement has terminated as provided in Section G and there has been a default in Employee's obligation under Section H of this Part I. The Employer shall have possession of the Policy during the period that the Employer makes premium payments and until all amounts due the Employer are repaid. The Employer shall make the Policy available to the Insurer in order to make any change desired by the Employee as to the designation of beneficiary or the selection of a settlement option, subject, however, to the provisions of this Agreement and the Collateral Assignment. D. Beneficiary Designation and Payment of Policy Proceeds The Employee shall be entitled to a death benefit from the Policy in the amount required to provide an annuity equal to (under then current annuity settlement rates from the Insurer) the supplemental retirement benefit that would be provided under Sections 4A and 4B of the Allegheny Power System Supplemental Executive Retirement Plan effective July 1, 1990, attached hereto as Appendix I, excluding the provision in Section 4A that states, "...provided that, if a Participant is discharged from employment for cause or terminates employment with the Companies prior to retirement under the Allegheny Power System Retirement Plan for any reason whatsoever, other than death, such eligibility will terminate and no benefit shall be payable to such Participant from this Plan." The Employer shall be the sole beneficiary of the policy until such time as the Employee has at least 10 years of service and is at least 55 years old. After that time and while this Agreement is in force, the following shall occur: 1. the beneficiary of the Employee's death benefit shall be the employee's spouse; 2. in the event of the Employee's death, the Employer shall be entitled to Policy proceeds equal to the total Policy proceeds in excess of the amount due to the Employee pursuant to this Section, above; and 3. if the employee is not married, he/she is entitled to no death benefit while this agreement is in force. E. Policy Cash Values The Employee shall be entitled to cash values of the Policy in excess of the premiums paid by the Employer pursuant to Section B, Above, but not to exceed the death benefits to which he/she is entitled under Section D, above. If the Employee is not married, he/she shall be entitled to cash values determined as if he/she were married. The Employer shall be entitled to Policy cash values in excess of the amount due to the Employee under this Section, above. F. Procedure at Employee's Death Upon the death of the Employee while the Policy and this Agreement are in force and subject to the provisions of Parts I and II hereof, the Employer shall promptly take all necessary steps, including rendering of such assistance as may reasonably be required, to obtain payment from the Insurer of the amounts payable under the Policy to the respective parties, as provided under Section D, above. G. Termination of Agreement Part I of this Agreement shall terminate when the first of any of the following events occur: 1. Termination of the Employee's employment with the Employer prior to retirement; 2. The later of the Employee's actual retirement or ten years from the date of issuance of the policy; 3. Performance of the Agreement's terms following the death of the Employee; 4. Failure by the Employer, for any reason, to make the premium contributions required under Section B of this Agreement. H. Disposition of Policy Upon Termination of Agreement Upon the termination of Part I of this Agreement for any reason other than Section G3 above, the Employee shall have a thirty (30) day option to satisfy the Collateral Assignment regarding the policy held by the Employer in accordance with the terms of this Paragraph H. The amount necessary to satisfy such Collateral Assignment shall be an amount equal to the total premium payments made by the Employer, plus any excess amounts as determined in Section E, above, but no greater than the amount of cash value under the Policy and, at the option of the Employee, either shall be paid directly by the Employee or through the Employer's collection from the cash value of the Policy. If the Policy shall then be encumbered by assignment, policy loan, or other means which have been the result of the Employer's actions, the Employer shall either remove such encumbrance, or reduce the amount necessary to satisfy the Collateral Assignment by the total amount of indebtedness outstanding against the Policy. If the Employee exercises his option to satisfy the Collateral Assignment, the Employer shall execute all necessary documents required by the Insurer to remove and satisfy the Collateral Assignment outstanding on the Policy. If the Employee does not exercise his option to satisfy the Collateral Assignment outstanding on the Policy, the Employee shall execute all documents necessary to transfer ownership of the Policy to the Employer. Such transfer shall constitute satisfaction of any obligation the Employee has to the Employer with respect to this Agreement. The Employer shall then pay to the Employee the amount, if any, by which the cash surrender value of the Policy exceeds the amount necessary to satisfy the Collateral Assignment. I. Employee's Right to Assign His/Her Interest Employee agrees not to sell, assign, surrender or otherwise terminate the policy while this Agreement is in effect without the consent of the Employer. J. Insurer's Obligations The Insurer is not a party to this Agreement. It is understood by the parties hereto that in issuing such Policy of insurance, the Insurer shall have no liability except as set forth in the Policy and except as set forth in any assignment of the Policy filed at it Home Office and in Section K of this Agreement. Except as set forth in Section K, the Insurer shall not be bound to inquire into, or take notice of, any of the covenants herein contained as to the Policy of insurance or as to application of proceeds of such policy. Upon the death of the Insured and payment of the proceeds in accordance with Section K of this Agreement, the Insurer shall be discharged of all liability. K. Claims Procedure The following claims procedure shall apply to the Policy and the Secured Benefit Plan: 1. Filing of a claim for benefits. The Employee or the Beneficiary shall make a claim for the benefits provided under the policy in the manner provided in the Policy. 2. Claim denial. With respect to a claim for benefits under said Policy, the Insurer shall be the entity which reviews and makes decisions on claim denials according to the terms of the Policy. 3. Notification to claimant of decision. If a claim is wholly or partially denied, notice of the decision, meeting the requirements of Section K4, following, shall be furnished to the claimant within a reasonable period of time after a claim has been filed. 4. Content of notice. The insurer shall provide, to any claimant who is denied a claim for benefits, written notice setting forth in a manner calculated to be understood by the claimant, the following: a. The specific reason or reasons for the denial; b. Specific reference to pertinent Policy provisions or provisions of this Agreement on which the denial is based; c. A description of any additional material or information necessary for the claimant to perfect the claim and an explanation of why such material or information is necessary; and d. An explanation of this Agreement's claim review procedure, as set forth in Sections K5 and K6. 5. Review procedure. The purpose of the review procedure set forth in this subsection and subsection 6, following, is to provide a method by which a claimant under the Policy may have a reasonable opportunity to appeal a denial of claim for a full and fair review. To accomplish that purpose, the claimant or his/her duly authorized representative: a. May request a review upon written application to the Insurer; b. May review the Policy; and c. May submit issues and comments in writing. A claimant, (or his/her duly authorized representative), shall request a review by filing a written application of review at any time within sixty (60) days after receipt by the claimant of written notice of the denial of the claim. 6. Decision on review. A decision on review of a denial of a claim shall be made in the following matter: a. The decision on review shall be made by the Insurer which may, at its discretion, hold a hearing on the denied claim. The Insurer shall make its decision promptly, unless special circumstances (such as the need to hold a hearing) require an extension of time for processing, in which case a decision shall be rendered as soon as possible, but not later than one hundred twenty (120) days after receipt of the request for review. b. The decision on review shall be in writing and shall include specific reasons for the decision, written in a manner calculated to be understood by the claimant, and specific references to the pertinent Policy provision or provision of this Agreement on which the decision is based. Notwithstanding any provision of the Agreement or the Policy, no Employee, assignee or beneficiary may commence any action in any court regarding the Policy prior to pursuing all rights of an Employee under this Section K. END OF PART I Part II - Assignment of Life Insurance Policy as Collateral A. For value received and in specific consideration of the premium payments made by the Employer as set forth in Section B of Part I hereof, the Employee hereby assigns, transfers and sets over to the Employer (herein this Part II called the "Assignee"), its successors and assigns, the Policy issued by the Insurer upon the life of Employee and all claims, options, privileges, rights, titles and interest therein and thereunder (except as provided in Paragraph C hereof), subject to all terms and conditions of the Policy and to all superior liens, if any, which the Insurer may have against the Policy. The Employee by this instrument agrees and the Assignee by the acceptance of this Assignment agrees to the conditions and provisions herein set forth. B. It is expressly agreed that, without detracting from the generality of the foregoing, the following specific rights are included in this Agreement and Collateral Assignment and inure to the Assignee by virtue hereof: 1. The sole right to collect from the Insurer the net proceeds of the Policy in excess of the proceeds due the Employee under Part I, Section D, when it becomes a claim by death or maturity; 2. The sole right to surrender the Policy and receive the surrender value thereof at any time provided by the terms of the Policy and at such other times as the Insurer may allow; 3. The sole right to obtain one or more loans or advances on the policy, either from the Insurer or, at any time, from other persons, and to pledge or assign the Policy as security for such loans or advances; 4. The sole right to exercise all nonforfeiture rights permitted by the terms of the Policy or allowed by the Insurer and to receive all benefits and advantages derived therefrom; 5. The sole right to direct investment of cash values as provided under the insurance contract, and to make changes and transfers in such fund allocations. C. It is expressly agreed that the following specific rights, so long as the Policy has not been surrendered, are reserved and excluded from this Collateral Assignment and do not pass by virtue hereof: 1. The right to designate and change the beneficiary; 2. The right to elect any optional mode of settlement permitted by the Policy or allowed by the Insurer; provided, however, that the reservation of these rights shall in no way impair the right of the Assignee to surrender the Policy completely with all its incidents or impair any other right of the Assignee hereunder, and any designation or change of beneficiary or election of a mode of settlement shall be made subject to this Agreement and Collateral Assignment and to the rights of the Assignee hereunder. D. This Collateral Assignment is made, and the Policy is to be held as collateral security for, any and all liabilities of the Employee to the Assignee arising under this Agreement (all of which liabilities secured or to become secured are herein called "Liabilities"). It is expressly agreed that all sums received by the Assignee hereunder either in the event of death of the Insured, the maturity or surrender of the Policy, the obtaining of a loan or advance on the Policy, or otherwise, shall first be applied to the payment of the liability for premiums paid by the Assignee on the Policy and other amounts due to Assignee under Part I of this Agreement. E. The Assignee covenants and agrees with the Employee as follows: 1. That any balance of sums, if any, received hereunder from the Insurer remaining after payment of the existing Liabilities, matured or unmatured, shall be paid by the Assignee to the persons entitled thereto under the terms of the policy had this Collateral Assignment not be executed; 2. That the Assignee will not exercise either the right to surrender the Policy or the right to obtain policy loans from the Insurer, until there has been either default in any of the Liabilities pursuant to this Agreement or termination of part I of said Agreement as therein provided; and 3. That the Assignee will, upon request, forward without unreasonable delay to the Insurer the Policy for endorsement of any designation or change of beneficiary or any election of an optional mode of settlement. F. The Employee declares that no proceedings in bankruptcy are pending against, him/her and that his/her property is not subject to any assignment for the benefit of creditors. Part III - Provisions Applicable to Parts I and II A. Amendments Amendments may be added to this Agreement by a written agreement signed by each of the parties and attached hereto. B. Choice of Law This Agreement shall be subject to, and construed according to, the laws of the State of Maryland. C. Binding Agreement This Agreement shall bind the Employer and the Employer's successors and assigns, the Employee and his/her heirs, executors, administrators, and assigns, and any Policy beneficiary. D. Validity of Provisions The Employer and the Employee agree that if any provision of this Agreement is determined to be invalid or unenforceable, in whole or part, then all remaining provisions of the Agreement and, to the extent valid or enforceable, the provision in question shall remain valid, binding and fully enforceable as if the invalid or unenforceable provisions, to the extent necessary, was not a part of this Agreement. IN WITNESS WHEREOF, parties hereto have executed this Agreement, including the provisions regarding Collateral Assignment, on the day and year first above written. ________________________ __________________________ Witness Employee ____________________________ _____________________________ Address Allegheny Power Service Corporation By: ____________________________ Richard J. Gagliardi Vice President E-2 Monongahela Power Company Incorporation Documents by Reference 3.1 Charter of the Company, as amended Form S-3, 33-51301, exh. 4(a) 3.2 Code of Regulations, Form 10-Q of the Company as amended (1-268-2), September 1993, exh. (a)(3) 4 Indenture, dated as S 2-5819, exh. 7(f) of August 1, 1945, S 2-8782, exh. 7(f) (1) and certain S 2-8881, exh. 7(b) Supplemental S 2-9355, exh.4(h) (1) Indentures of the S 2-9979, exh. 4(h)(1) Company defining S 2-10548, exh. 4(b) rights of security S 2-14763, exh. 2(b) (i) holders. S 2-24404, exh. 2(c); S 2-26806, exh. 4(d); Forms 8-K of the Company (1-268-2) dated August 8, 1989, November 21, 1991, June 4, 1992, July 15, 1992, September 1, 1992 and April 29, 1993 * There are omitted the Supplemental Indentures which do no more than subject property to the lien of the above Indentures since they are not considered constituent instruments defining the rights of the holders of the securities. The Company agrees to furnish the Commission on its request with copies of such Supplemental Indentures. 12 Computation of ratio of earnings to fixed charges 21 Subsidiaries: Monongahela Power Company has a 27% equity ownership in Allegheny Generating Company, incorporated in Virginia; and a 25% equity ownership in Allegheny Pittsburgh Coal Company, incorporated in Pennsylvania. 23 Consent of Independent Accountants See page 61 herein. 24 Powers of Attorney See pages 62-67 herein. E-3 The Potomac Edison Company Incorporation Documents by Reference 3.1 Charter of the Company, Form 10-Q of the Company as amended (1-3376-2), September 1993, exh. (a)3 3.2 By-laws of the Company, Form 10-Q of the Company as amended (1-3376-2), June 1990, exh. (a)3 4 Indenture, dated as of S 2-5473, exh. 7(b); Form October 1, 1944, and S-3, 33-51305, exh. 4(d) certain Supplemental Forms 8-K of the Company (1- Indentures of the 33-76-2) dated June 14, 1989, Company defining rights June 25, 1990, August 21, Company defining rights 1991, December 11, 1991, of security holders* December 15, 1992, February 17, 1993 and March 30, 1993 * There are omitted the Supplemental Indentures which do no more than subject property to the lien of the above Indentures since they are not considered constituent instruments defining the rights of the holders of the securities. The Company agrees to furnish the Commission on its request with copies of such Supplemental Indentures. 12 Computation of ratio of earnings to fixed charges 21 Subsidiaries: The Potomac Edison Company has a 28% equity ownership in Allegheny Generating Company, incorporated in Virginia and a 25% equity ownership in Allegheny Pittsburgh Coal Company, incorporated in Pennsylvania. 23 Consent of Independent See page 61 herein. Accountants 24 Powers of Attorney See pages 62-67 herein. E-4 West Penn Power Company Incorporation Documents by Reference 3.1 Charter of the Company, Form S-3, 33-51303, exh. 4(a) as amended 3.2 By-laws of the Company, Form 8-K of the Company as amended (1-255-2), dated June 9, 1993, exh. (a)(3) 4 Indenture, dated as of S-3, 33-51303, exh. 4(d) March 1, 1916, and certain S 2-1835, exh. B(1), B(6) Supplemental Indentures of S 2-4099, exh. B(6), B(7) the Company defining rights S 2-4322, exh. B(5) of security holders.* S 2-5362, exh. B(2), B(5) S 2-7422, exh. 7(c), 7(i) S 2-7840, exh. 7(d), 7(k) S 2-8782, exh. 7(e) (1) S 2-9477, exh. 4(c), 4(d) S 2-10802, exh. 4(b), 4(c) S 2-13400, exh. 2(c), 2(d) Form 10-Q of the Company (1-255-2), June 1980, exh. D Forms 8-K of the Company (1-255-2) dated June 1989, February 1991, December 1991, August 13, 1993, September 15, 1992, June 9, 1993 and June * There are omitted the Supplemental Indentures which do no more than subject property to the lien of the above Indentures since they are not considered constituent instruments defining the rights of the holders of the securities. The Company agrees to furnish the Commission on its request with copies of such Supplemental Indentures. 12 Computation of ratio of earnings to fixed charges 21 Subsidiaries: West Penn Power Company has a 45% equity ownership in Allegheny Generating Company, incorporated in Virginia; a 50% equity ownership in Allegheny Pittsburgh Coal Company, incorporated in Pennsylvania; and a 100% equity ownership in West Virginia Power and Transmission Company, incorporated in West Virginia, which owns a 100% equity ownership in West Penn West Virginia Water Power Company, incorporated in Pennsylvania. 23 Consent of Independent See page 61 herein. Accountants 24 Powers of Attorney See pages 62-67 herein. E-5 Allegheny Generating Company Documents 3.1(a) Charter of the Company, as amended* 3.1(b) Certificate of Amendment to Charter, effective July 14, 1989.** 3.2 By-laws of the Company, as amended* 4 Indenture, dated as of December 1, 1986, and Supplemental Indenture, dated as of December 15, 1988, of the Company defining rights of security holders.*** 10.1 APS Power Agreement-Bath County Pumped Storage Project, as amended, dated as of August 14, 1981, among Monongahela Power Company, West Penn Power Company, and The Potomac Edison Company and Allegheny Generating Company.* 10.2 Operating Agreement, dated as of June 17, 1981, among Virginia Electric and Power Company, Allegheny Generating Company, Monongahela Power Company, West Penn Power Company and The Potomac Edison Company.* 10.3 Equity Agreement, dated June 17, 1981, between and among Allegheny Generating Company, Monongahela Power Company, West Penn Power Company and The Potomac Edison Company.* 10.4 United States of America Before The Federal Energy Regulatory Commission, Allegheny Generating Company, Docket No. ER84-504-000, Settlement Agreement effective October 1, 1985.* 12 Computation of ratio of earnings to fixed charges 23 Consent of Independent See page 61 herein. Accountants 24 Powers of Attorney See pages 62-67 herein. * Incorporated by reference to the designated exhibit to AGC's registration statement on Form 10, File No. 0-14688. Incorporated by reference to Form 10-Q of the Company (0-14688) for June 1989, exh. (a). * Incorporated by reference to Forms 8-K of the Company (0-14688) for December 1986, exh. 4(A), and December 1988, exh. 4.1.
275177_1993.txt	275177	1993	Item 1. Business - -------- Carolina Telephone and Telegraph Company (the Company), a wholly-owned subsidiary of Sprint Corporation (Sprint), was incorporated under the laws of the State of North Carolina in 1968, and in 1969 acquired all of the public utility assets of the predecessor company of the same name pursuant to a plan of merger. The Company's principal offices are located at 14111 Capital Boulevard, Wake Forest, North Carolina 27587-5900 and its telephone number is (919) 554-7900. The term Company herein refers to the present Company and, as the context requires, its predecessor of the same name which was incorporated in the State of North Carolina in 1900. The Company is engaged in the business of furnishing communication services, mainly local and long-distance services and network access, in 145 exchange areas serving all or part of 50 counties in the eastern part of North Carolina. As of December 31, 1993, the Company had an investment in property, plant and equipment of $1,595,266,000. Operating revenues for the year 1993 amounted to $638,541,000. No other company furnishes local telephone service in any exchange area served by the Company. The principal industries in the Company's service area are agriculture, textiles, pulp and paper manufacturing, chemicals, fertilizer, and tourism. Military installations, including Fort Bragg, Camp Lejeune, Cherry Point Marine Corps Air Station, the U. S. Coast Guard Base at Elizabeth City and Pope Air Force Base contribute significantly to the economy of the area. Digital switching equipment and fiber optics cable represent a substantial portion of the Company's expansion of long-distance facilities. At December 31, 1993, the Company served 905,534 access lines, distributed among 145 exchange areas as follows: Fayetteville, 14.7 percent; Greenville, 5.5 percent; Rocky Mount, 4.6 percent; Jacksonville, 4.2 percent; Wilson, 3.1 percent; and all other areas less than 3.0 percent each. In addition to furnishing local service, the Company's central offices and toll lines are connected with other telephone companies and with the nationwide toll networks of interexchange carriers. Toll calls may thus be made from any telephone in the Company's service area to anywhere in the United States and most other countries. Other telecommunications services, for the most part furnished in conjunction with other telephone companies, include facilities for private line service, data transmission, radio and television program transmission, mobile radio telephone, cellular and wide area telecommunications service. Revenues from communication services, principally telephone service, constitute about 85.9 percent of the total 1993 operating revenues of the Company. The Company has one wholly-owned subsidiary, Carolina Telephone Long Distance, Inc. (CTLD) which offers zero-plus and one-plus interlata long-distance service. A significant portion of the Company's network access revenues are derived from access charge billings to American Telephone & Telegraph Company (AT&T). Other revenues are derived in large part from the sale of telephone directory listings, the sale of telecommunications equipment, the lease of network facilities, providing operator services and processing customer toll billings for interexchange carriers, primarily AT&T. Carolina Telephone & Telegraph Company Form 10-K Part I Item 1. Business (continued) - -------- The following tables show certain information regarding access lines in service and toll messages handled at the dates or for the periods indicated. Access Lines --------------------------------------------------------------- Change Number at End of Period During Period ---------------------------- ------------------- Period Residence Business Total Number % Change ------ --------- -------- ------- ------ -------- 1993 710,977 194,557 905,534 42,693 4.9 1992 681,167 181,674 862,841 36,343 4.4 1991 655,375 171,123 826,498 36,532 4.6 1990 627,778 162,188 789,966 18,514 2.4 1989 616,808 154,644 771,452 24,516 3.3 Toll Messages --------------------------------------------------------------- Total For Year Average Messages Per Day ---------------------- ------------------------ Period Number % Change Number % Change ------ ----------- -------- --------- -------- 1993 455,139,205 7.3 1,246,957 7.6 1992 424,096,621 8.8 1,158,734 8.5 1991 389,952,486 16.5 1,068,363 16.5 1990 334,783,858 7.4 917,216 7.4 1989 311,673,465 12.4 853,900 12.7 On December 31, 1993, the Company had 4,308 employees, of which 2,117 or 49.1 percent were represented by the Communications Workers of America, and 107 or 2.5 percent were represented by the International Brotherhood of Electrical Workers for collective bargaining purposes. Compliance with federal, state and local provisions relating to the protection of the environment has had no significant effect upon capital expenditures or earnings of the Company, and future effects are not expected to be material. Effective January 1, 1991, the Federal Communications Commission (FCC) adopted a price caps regulatory format for the Regional Bell Operating Companies and the GTE local exchange companies. Other local exchange companies (LECs) could volunteer to become subject to the price caps regulation. Under price caps, prices for access service must be adjusted annually to reflect industry average productivity gains (as specified by the FCC), inflation and certain allowed cost changes. The Company elected to be subject to price caps regulation, and under the form of the plan adopted, the Company has an opportunity to earn up to a 14.25 percent rate of return on investment. Carolina Telephone & Telegraph Company Form 10-K Part I Item 1. Business (continued) - ------- Areas of competition have emerged in the intralata and local market- place. On January 1, 1986, the intralata toll market in North Carolina was opened to non-facilities based carriers (resellers), and on January 1, 1987, facilities-based carriers were authorized to resell intralata toll. In February 1994, the North Carolina Utilities Commission approved an order authorizing long-distance companies to provide intralata toll service on a limited basis. This order, which is effective July 1, 1994, will offer customers choices in deciding which long-distance companies they want to use by dialing 1-0 and a designated 3 digit prefix code indicating the carrier of their choice. In addition, the potential for more direct competition is increasing in the local service market. In May 1988, the Commission issued an order which allows customers to participate in the sharing and resale of local exchange services under shared tenant arrangements. At the interstate level, the FCC has revised its rules to permit connection of customer-owned coin telephones to the local network, exposing LECs to direct coin telephone competition. Additionally, the FCC has assisted Competitive Access Providers (CAPs) in providing access to interexchange carriers and end users by mandating that all Tier I (over $100 million annual operating revenues) LECs allow collocation of CAP equipment in LEC central offices. The FCC's decision regarding collocation is under appeal to the U.S. Court of Appeals for the D.C. Circuit. In October 1992, the FCC adopted a new rate structure and new pricing rules for LEC-provided switched transport. LECs filed new access transport tariffs with the FCC in September 1993, which contain rates that will purportedly reduce the costs of the largest interexchange carrier by less than 1 percent and increase the costs of the smallest carriers by less than 2 percent. The new rates, which went into effect on December 30, 1993, are not expected to have any significant impact to the LECs. The extent and ultimate impact of competition for local exchange carriers will continue to depend, to a considerable degree, on FCC and Commission actions, court decisions and possible federal or state legislation. Legislation designed to stimulate local competition between local exchange service providers and cable programming service providers, in both markets, is presently pending in both houses of the U.S. Congress. Carolina Telephone & Telegraph Company Form 10-K Part I Item 2.		Item 2. Properties - ------- The properties of the Company consist principally of land, structures, facilities and equipment. Substantially all of the Company's property, plant and equipment is restricted for use under the terms of long-term debt indentures. Central office equipment represents approximately 38.1 percent of the Company's investment in telephone plant in service; land and buildings (occupied principally by central office equipment) represent 8.2 percent; telephone instruments and related wiring and equipment including private branch exchanges (PBX) (substantially all of which are located on the premises of subscribers) represent 2.9 percent; connecting lines not on subscribers' premises (the majority of which are on or under public highways and streets and the remainder on or under private property) represent 45.9 percent; and other telephone plant represents 4.9 percent. In 141 exchanges serving approximately 84.4 percent of the Company's access lines, central offices are located on land owned by the Company; in 3 exchanges serving 0.9 percent of the Company's access lines, central offices are located in leased quarters. In one exchange (Fayetteville), central offices serving an aggregate of 14.7 percent of the Company's access lines are located in quarters, some of which are owned and some of which are leased. Standard practices prevailing in the telephone industry are followed by the Company in the construction and maintenance of its plant and facilities; and the Company considers that its plant and facilities are, as a whole, in sound physical and operating condition. The following table shows gross additions to and retirements of properties of the Company during the five years ended December 31, 1993 (in thousands): Gross Additions Retirements --------- ----------- 1993 $146,543 $51,020 1992 143,057 89,179 1991 130,332 49,766 1990 122,760 68,754 1989 118,824 67,136 Carolina Telephone & Telegraph Company Form 10-K Part II Item 3.	Item 3. Legal Proceedings - ------- No material legal proceedings are pending to which the Company or its subsidiary is a party or of which any of their property is the subject. Item 4.	Item 4. Submission of Matters to a Vote of Security Holders - ------- No matter was submitted to a vote of security holders during the fourth quarter of 1993. Item 5.	Item 5. Market for the Registrant's Common Stock and Related Stockholder - ------- Matters The Registrant is a wholly-owned subsidiary of Sprint and consequently its common stock is not traded. Item 6.	Item 6. Selected Financial Data (in thousands) - ------- December 31, ---------------------------------------------------- 1993 1992 1991 1990 1989 ---------- ---------- -------- -------- -------- Operating revenues $ 638,541 $ 590,440 $552,986 $509,724 $496,841 Net income 47,168 72,800 77,420 76,649 70,659 Total assets 1,078,910 1,025,295 968,806 920,489 892,575 Long-term debt (excluding current maturities) and redeemable preferred stock 269,087 240,535 224,398 226,881 229,759 During 1993, nonrecurring charges of $46,382,000 were recorded representing the portion of the costs attributable to the Company associated with the merger of Sprint and Centel Corporation. Such charges reduced 1993 net income by $27,765,000. In addition, extraordinary losses on early extinguishments of debt were recorded in 1993, which reduced net income by $2,318,000. Earnings and dividends per share information have been omitted because the Company is a wholly-owned subsidiary of Sprint. Carolina Telephone & Telegraph Company Form 10-K Part II Item 7.	Item 7. Management's Discussion and Analysis of Financial Condition and - ------- Results of Operations Recent Development - ------------------ Effective March 9, 1993, Sprint consummated its merger with Centel Corporation, a telecommunications company with local exchange and cellular/wireless communications services operations (see Note 2 of "Notes to Consolidated Financial Statements" for additional information). The transaction costs associated with the merger (consisting primarily of investment banking and legal fees) and the estimated expenses of integrating and restructuring the operations of the two companies (consisting primarily of employee severance and relocation expenses and costs of eliminating duplicative facilities) resulted in a nonrecurring charge to Sprint during 1993. The portion of such charge attributable to the Company was $46,382,000, which reduced 1993 net income by $27,765,000. Liquidity and Capital Resources - ------------------------------- Cash flows from operating activities are the Company's primary source of liquidity. Net cash provided by operating activities increased by $30,230,000 during the year ended December 31, 1993. The increase was primarily attributable to reduced payments of amounts associated with accounts payable as well as improved operating results excluding the effects of the merger and integration costs and non-cash expenses. These increases in cash flows were partially offset by payments made related to the integration of Sprint and Centel. In order to meet customer demands, the Company must continually replace and construct new facilities. The Company's planned construction expenditures for 1994 are $143,131,000 which includes expenditures of $74,307,000 for central office equipment, $46,477,000 for cable facilities, $11,765,000 for general support assets and $10,582,000 for other expenditures. The Company anticipates that the funds for these expenditures will be supplied primarily by operating activities. The primary source of financing for the Company has been long-term debt. In addition, the Company periodically receives cash advances from Sprint and issues commercial paper and notes payable to banks. Net cash used by financing activities increased $30,841,000 during the year ended December 31, 1993, compared to the same period in 1992. During 1993, the Company issued $150,000,000 in long-term debt. The proceeds of this debt were primarily used to reduce short-term debt and to retire existing higher cost long-term debt prior to scheduled maturities. The prepayment penalties incurred in connection with these early extinguishments of debt and the write-off of related debt issuance costs and unamortized premiums and discounts were $3,836,000, which reduced net income by $2,318,000. The increase in cash used related to debt activity was partially offset by reduced dividend payments during 1993. Carolina Telephone & Telegraph Company Form 10-K Part II Item 7. Management's Discussion and Analysis of Financial Condition and - ------- Results of Operations (continued) Liquidity and Capital Resources (continued) - ------------------------------------------- As of December 31, 1993, the Company had a total of $60,000,000 in one-year bank commitments. The bank lines provide for short-term borrowings at market rates of interest and require annual commitment fees based on the unused portion. Such lines of credit, which support commercial paper, may be withdrawn by the banks if there is a material adverse change in the financial condition of Sprint or the Company. As of December 31, 1993, no amounts were borrowed against this credit facility; however, $41,100,000 of the bank line supports the commercial paper outstanding at year end. The Company is also authorized to issue and sell an additional $75,000,000 in debentures. The debentures must be due within thirty years of the date of issue and cannot exceed an interest rate of 7.25 percent. The new debentures, which may be issued and sold in future offerings, are available to refinance existing debt at lower interest rates, if appropriate. The Company's ratio of common equity to total capital was 59.2 percent in 1993, 59.1 percent in 1992, and 61.1 percent in 1991. The Company's ratio of long-term debt to total capital was 35.4 percent in 1993, 33.2 percent in 1992, and 33.2 percent in 1991. The Company's ratio of short-term debt to total capital was 5.4 percent in 1993, 7.7 percent in 1992, and 5.7 percent in 1991. Operating Results - ----------------- Operating revenues are classified as local service, network access, long-distance network and miscellaneous. Local service revenues come from providing local telephone exchange services and leasing equipment. Network access revenues are derived from billing other carriers and telephone customers for their use of the local network to complete long- distance calls in those instances where the long-distance service is not provided by the Company. Long-distance revenues are derived principally from providing long-distance services within designated areas. Miscellaneous revenues primarily relate to directory advertising, billing and collection services for interexchange long-distance carriers, operator services, network facilities leases and sales of telecommunications equipment. Operating revenues increased by $48,101,000 or 8.1 percent during the year ended December 31, 1993 as compared to 1992. All categories of operating revenues increased during the year. Local service revenues increased $20,502,000 or 8.7 percent during 1993 as compared to 1992. Basic area service revenues contributed $10,713,000 to this increase, primarily attributable to a 4.9 percent growth in access lines during 1993. Basic area service revenues have also been impacted by the implementation of regional calling plans which have resulted in a transfer of long distance revenues to the local revenue category. Custom calling and touch tone features also added to the local service revenues as a result of access line gains and increased marketing promotions. Carolina Telephone & Telegraph Company Form 10-K Part II Item 7. Management's Discussion and Analysis of Financial Condition and - ------- Results of Operations (continued) Operating Results (continued) - ----------------------------- Network access revenues increased $19,460,000 or 11.4 percent during the year ended December 31, 1993 as compared to 1992 due primarily to an 8.0 percent growth in access minutes of use during 1993. Miscellaneous revenues increased $6,518,000 or 7.8 percent during the year ended December 31, 1993 as compared to 1992. Additional telephone equipment sales and installation revenue of $6,358,000 is largely responsible for the increase during 1993. The equipment sales revenues related principally to PBX, data and key systems. North Carolina Utility Services (NCUS), a non-regulated business venture specializing in locating underground utility lines, contributed $4,703,000, due to the expansion of the service area and an increase of the customer base in existing service areas. These increases were partially offset by decreased revenues related to billing and collection services provided to interexchange carriers as well as lowered revenues associated with the lease and provision of transmission facilities to interexchange carriers. Customer operations expenses increased $13,379,000 or 18.0 percent during 1993 as compared to 1992. Sales expense increased significantly during 1993, as the Company continues to intensify its efforts to achieve an increased market share and gain knowledge of its customer expectations. The results of these efforts are demonstrated in the current year increase in telephone equipment sales. As a result of continued expansions of its customer base, NCUS experienced increases in cost of goods and services during 1993. Billing services also contributed to the increase in customer operations expense, primarily due to expenses incurred during the first part of 1993 related to the development and implementation of new billing systems. Business office operations also experienced increased expenses during 1993, principally due to increased staffing requirements and expenses related to the administration and service center charges for 800 portability services. As previously discussed, nonrecurring merger and integration costs totaling $46,382,000 were recognized during 1993. Other operating expenses increased $2,836,000 or 17.3 percent during 1993 as compared to 1992. This fluctuation was primarily due to a $4,636,000 increase in cost of equipment sales, generally corresponding with the overall trend in equipment sales. This increase was partially offset by a reduction in the losses associated with nonregulated activities during 1993. In addition to the increases discussed above, plant expense, customer operations expense, corporate operations expense and other operating expense also increased as a result of higher postretirement benefits costs due to the adoption of Statement of Financial Accounting Standards (SFAS) No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions." The incremental cost associated with this change in accounting principle was approximately $15,159,000. Carolina Telephone & Telegraph Company Form 10-K Part II Item 7. Management's Discussion and Analysis of Financial Condition and - ------- Results of Operations (continued) Effects of Inflation - -------------------- The effects of inflation on the operations of the Company were not significant during 1993, 1992 or 1991. Recent Accounting Developments - ------------------------------ Effective January 1, 1994, the Company will adopt Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" (see Note 1 of "Notes to Consolidated Financial Statements" for additional information). Consistent with most local exchange carriers, the Company accounts for the economic effects of regulation pursuant to SFAS No. 71, "Accounting for the Effects of Certain Types of Regulation." The application of SFAS No. 71 requires the accounting recognition of the rate actions of regulators where appropriate, including the recognition of depreciation based on estimated useful lives prescribed by regulatory commissions rather than those which might be utilized by non-regulated enterprises. The Company's management believes that the Company's operations meet the criteria for the continued application of the provisions of SFAS No. 71. With increasing competition and the changing nature of regulation in the telecommunications industry, the ongoing applicability of SFAS No. 71 must, however, be constantly monitored and evaluated. Should the Company no longer qualify for the application of the provisions of SFAS No. 71 at some future date, the accounting impact could result in the recognition of a material, extraordinary, non-cash charge. Carolina Telephone & Telegraph Company Form 10-K Part II Item 8.	Item 8. Financial Statements and Supplementary Data - ------- CAROLINA TELEPHONE AND TELEGRAPH COMPANY INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Page Reference -------------- Report of Independent Auditors Page 11 Consolidated Balance Sheets as of December 31, 1993 and 1992 Pages 12 - 13 Consolidated Statements of Income for each of the three years ended December 31, 1993 Page 14 Consolidated Statements of Retained Earnings for each of the three years ended December 31, 1993 Page 15 Consolidated Statements of Cash Flows for each of the three years ended December 31, 1993 Pages 16 - 17 Notes to Consolidated Financial Statements Pages 18 - 30 Carolina Telephone & Telegraph Company Form 10-K Part II REPORT OF INDEPENDENT AUDITORS The Board of Directors Carolina Telephone and Telegraph Company We have audited the accompanying consolidated balance sheets of Carolina Telephone and Telegraph Company, a wholly-owned subsidiary of Sprint Corporation, as of December 31, 1993 and 1992, and the related consolidated statements of income, retained earnings, and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements and related schedules are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Carolina Telephone and Telegraph Company at December 31, 1993 and 1992, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note 1 to the consolidated financial statements, Carolina Telephone and Telegraph Company changed its method of accounting for postretirement benefits in 1993. ERNST & YOUNG Kansas City, Missouri January 21, 1994 Carolina Telephone & Telegraph Company Form 10-K Part II CAROLINA TELEPHONE AND TELEGRAPH COMPANY CONSOLIDATED BALANCE SHEETS December 31, 1993 and 1992 (In Thousands) 1993 1992 ---------- ---------- ASSETS - ------ CURRENT ASSETS Cash $ 1 $ 1 Receivables Customers and other, net of allowance for doubtful accounts of $1,895 ($1,415 in 1992) 63,090 60,957 Interexchange carriers 20,238 17,713 Affiliated companies 4,699 2,256 Inventories 9,807 7,861 Prepayments and other 870 1,573 ---------- ---------- 98,705 90,361 PROPERTY, PLANT AND EQUIPMENT Land and buildings 128,635 120,560 Telephone network equipment and outside plant 1,370,948 1,296,144 Other 78,455 71,366 Construction in progress 17,228 11,673 ---------- ---------- 1,595,266 1,499,743 Less accumulated depreciation 673,839 610,603 ---------- ---------- 921,427 889,140 DEFERRED CHARGES AND OTHER ASSETS 58,778 45,794 ---------- ---------- $1,078,910 $1,025,295 ========== ========== (Continued) Carolina Telephone & Telegraph Company Form 10-K Part II CAROLINA TELEPHONE AND TELEGRAPH COMPANY CONSOLIDATED BALANCE SHEETS (CONTINUED) December 31, 1993 and 1992 (In Thousands) 1993 1992 ---------- ---------- LIABILITIES AND STOCKHOLDER'S EQUITY - ------------------------------------ CURRENT LIABILITIES Outstanding checks in excess of cash balances $ 9,303 $ 8,169 Short-term borrowings Commercial paper 41,100 55,500 Advances from parent company - 1,703 Current maturities of long-term debt 568 7,717 Accounts payable: Vendors and other 20,742 14,846 Interexchange carriers 22,950 22,270 Affiliated companies 10,866 5,272 Accrued merger and integration costs 17,035 - Accrued taxes 13,298 13,897 Advance billings 11,653 11,262 Accrued vacation pay 10,550 10,493 Other 20,484 19,056 ---------- ---------- 178,549 170,185 LONG-TERM DEBT 269,087 240,535 DEFERRED CREDITS AND OTHER LIABILITIES Deferred income taxes 113,399 118,540 Deferred investment tax credits 6,790 10,830 Regulatory liability 26,338 32,903 Postretirement benefits obligation 22,542 3,750 Other 11,919 6,847 ---------- ---------- 180,988 172,870 COMMITMENTS COMMON STOCK AND OTHER STOCKHOLDER'S EQUITY Common stock, authorized 5,000,000 shares, par value $20 per share, issued and outstanding 3,626,510 shares 72,530 72,530 Capital in excess of par value 71,991 71,991 Retained earnings 305,765 297,184 ---------- ---------- 450,286 441,705 ---------- ---------- $1,078,910 $1,025,295 ========== ========== See Notes to Consolidated Financial Statements. Carolina Telephone & Telegraph Company Form 10-K Part II CAROLINA TELEPHONE AND TELEGRAPH COMPANY CONSOLIDATED STATEMENTS OF INCOME Years ended December 31, 1993, 1992, and 1991 (In Thousands) 1993 1992 1991 -------- -------- -------- OPERATING REVENUES Local service $257,050 $236,548 $219,194 Network access 189,747 170,287 165,725 Long-distance network 101,581 99,960 97,474 Miscellaneous 90,163 83,645 70,593 -------- -------- -------- 638,541 590,440 552,986 OPERATING EXPENSES Plant expense 192,297 181,658 169,209 Depreciation 114,765 109,865 94,288 Customer operations 87,668 74,289 63,374 Corporate operations 64,400 58,300 59,932 Merger and integration costs 46,382 - - Other operating expenses 19,247 16,411 12,951 Taxes: Federal income: Current 33,786 34,218 37,826 Deferred (9,064) 1,797 1,154 Deferred investment tax credit (4,040) (4,925) (5,369) State, local and miscellaneous 22,352 25,094 25,629 -------- -------- -------- 567,793 496,707 458,994 -------- -------- -------- OPERATING INCOME 70,748 93,733 93,992 INTEREST CHARGES Interest on long-term debt 19,232 18,735 18,783 Other interest 2,728 3,432 1,259 -------- -------- -------- 21,960 22,167 20,042 OTHER INCOME Interest charged to construction 54 632 87 Other, net 644 602 3,383 -------- -------- -------- 698 1,234 3,470 -------- -------- -------- INCOME BEFORE EXTRAORDINARY ITEM 49,486 72,800 77,420 EXTRAORDINARY LOSSES ON EARLY EXTINGUISHMENTS OF DEBT, NET 2,318 - - -------- -------- -------- NET INCOME $ 47,168 $ 72,800 $ 77,420 ======== ======== ======== See Notes to Consolidated Financial Statements. Carolina Telephone & Telegraph Company Form 10-K Part II CAROLINA TELEPHONE AND TELEGRAPH COMPANY CONSOLIDATED STATEMENTS OF RETAINED EARNINGS Years ended December 31, 1993, 1992, and 1991 (In Thousands) 1993 1992 1991 -------- -------- -------- BALANCE AT BEGINNING OF YEAR $297,184 $272,262 $249,445 Net Income 47,168 72,800 77,420 Cash dividends Common stock (38,587) (47,869) (54,578) Preferred stock - (9) (25) -------- -------- -------- BALANCE AT END OF YEAR $305,765 $297,184 $272,262 ======== ======== ======== See Notes to Consolidated Financial Statements. Carolina Telephone & Telegraph Company Form 10-K Part II CAROLINA TELEPHONE AND TELEGRAPH COMPANY CONSOLIDATED STATEMENTS OF CASH FLOWS Years ended December 31, 1993, 1992, and 1991 (In Thousands) 1993 1992 1991 -------- -------- ------- OPERATING ACTIVITIES Net Income $ 47,168 $ 72,800 $ 77,420 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation 114,765 109,865 94,288 Deferred income taxes and investment tax credits (14,695) (2,030) (3,240) Extraordinary losses on early extinguishments of debt 3,836 - - Changes in operating assets and liabilities: Receivables, net (7,101) (3,714) (5,489) Inventories (1,946) 264 1,682 Other current assets 703 19 (487) Accounts payable 12,170 (10,371) (2,154) Other current liabilities 19,231 (2,153) 12,735 Noncurrent assets and liabilities, net 23,597 1,000 2,750 Other, net (7,540) (5,722) (4,409) ------- ------- ------- NET CASH PROVIDED BY OPERATING ACTIVITIES 190,188 159,958 173,096 INVESTING ACTIVITIES Additions to property, plant and equipment (146,543) (143,057) (130,332) Net cost to retire plant and equipment (509) (599) (478) Additions to investments (4,865) (8,872) (2,979) -------- -------- -------- NET CASH USED BY INVESTING ACTIVITIES (151,917) (152,528) (133,789) (Continued) Carolina Telephone & Telegraph Company Form 10-K Part II CAROLINA TELEPHONE AND TELEGRAPH COMPANY CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED) Years ended December 31, 1993, 1992, and 1991 (In Thousands) 1993 1992 1991 ------- ------- ------- FINANCING ACTIVITIES Proceeds from long-term borrowings $148,638 $ 49,382 $ - Retirements of long-term debt (127,521) (27,537) (2,954) Increase (decrease) in commercial paper (14,400) 25,500 9,900 Increase (decrease) in advances from parent company (1,703) (6,797) 8,500 Redemption of preferred stock - (100) (150) Dividends paid (38,587) (47,878) (54,603) Other (4,698) - - -------- -------- ------- NET CASH USED BY FINANCING ACTIVITIES (38,271) (7,430) (39,307) CHANGE IN CASH - - - CASH AT BEGINNING OF YEAR 1 1 1 -------- -------- -------- CASH AT END OF YEAR $ 1 $ 1 $ 1 ======== ======== ======== See Notes to Consolidated Financial Statements. Carolina Telephone & Telegraph Company Form 10-K Part II CAROLINA TELEPHONE AND TELEGRAPH COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 1. ACCOUNTING POLICIES Carolina Telephone and Telegraph Company is engaged in the business of providing communications services, principally local, network access and long distance services in North Carolina. The principal industries in its service area include agriculture, textiles, pulp and paper manufacturing, chemicals, and tourism. Basis of Presentation - --------------------- The accompanying consolidated financial statements include the accounts of Carolina Telephone & Telegraph Company and its wholly-owned subsidiary, Carolina Telephone Long Distance, Inc. (CTLD), collectively referred to as the "Company". All significant intercompany transactions have been eliminated. The Company is a wholly-owned subsidiary of Sprint Corporation (Sprint); accordingly, earnings per share information has been omitted. The Company accounts for the economic effects of regulation pursuant to Statement of Financial Accounting Standards (SFAS) No. 71, "Accounting for the Effects of Certain Types of Regulation", which requires the accounting recognition of the rate actions of regulators where appropriate. Such actions can provide reasonable assurance of the existence of an asset, reduce or eliminate the value of an asset, or impose a liability on a regulated enterprise. Certain amounts in the accompanying consolidated financial statements for 1992 and 1991 have been reclassified to conform to the presentation of amounts in the 1993 consolidated financial statements. These reclassifications had no effect on net income in either year. Inventories - ----------- Inventories consist of materials and supplies, stated at average cost, and equipment held for resale, stated at the lower of average cost or market. The sales inventory balances were $2,604,000 and $2,156,000 at December 31, 1993 and 1992, respectively. Property, Plant and Equipment - ----------------------------- Property, plant and equipment are recorded at cost. Retirements of depreciable property are charged against accumulated depreciation with no gain or loss recognized. Repairs and maintenance costs are expensed as incurred. Carolina Telephone & Telegraph Company Form 10-K Part II CAROLINA TELEPHONE AND TELEGRAPH COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 1. ACCOUNTING POLICIES (continued) Depreciation - ------------ Depreciation expense is generally computed on a straight-line basis over estimated useful lives as prescribed by regulatory commissions. Depreciation rate changes granted by the North Carolina Utilities Commission (Commission) resulted in additional depreciation expense in 1992 of $19,365,000 which reduced net income by $11,245,000 after considering the partial offset from the related revenue settlement and income tax effects. There were no depreciation rate changes during 1993 or 1991. In addition, as ordered by the Commission, the Company recorded nonrecurring charges to depreciation expense in 1991 of $9,000,000 which reduced net income by $5,016,000. Average annual composite depreciation rates, excluding the nonrecurring charges, were 7.5 percent for 1993, 7.6 percent for 1992 and 6.2 percent for 1991. Income Taxes - ------------ Operations of the Company are included in the consolidated federal income tax returns of Sprint. Federal income tax is calculated by the Company on the basis of its filing a separate return. Effective January 1, 1992, the Company changed its method of accounting for income taxes by adopting SFAS No. 109, "Accounting for Income Taxes", which requires an asset and liability approach to accounting for income taxes. Under the provisions of SFAS No. 109, the Company adjusted existing deferred income tax amounts, using current tax rates, for the estimated future tax effects attributable to temporary differences between the tax bases of the Company's assets and liabilities and their reported amounts in the financial statements. The Company's principal temporary difference results from using different depreciable lives and methods with respect to its property, plant and equipment for tax and financial reporting purposes. As a result of corporate income tax rate reductions in prior years and the previous income tax accounting standards which did not permit accumulated deferred income tax amounts to be adjusted for subsequent tax rate changes, adoption of SFAS No. 109 resulted in a decrease in the amount of deferred income tax liabilities recorded. However, because this decrease will accrue to the benefit of the Company's customers through future telephone rates established by the Company's regulators, this decrease in deferred income tax liabilities has been reflected as a regulatory liability in the Company's financial statements. Accordingly, the adoption of SFAS No. 109 had no significant effect upon the Company's 1992 net income. As allowed by SFAS No. 109, prior years' consolidated financial statements were not restated. Carolina Telephone & Telegraph Company Form 10-K Part II CAROLINA TELEPHONE AND TELEGRAPH COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 1. ACCOUNTING POLICIES (continued) Income Taxes (continued) - ------------------------ During 1991, in accordance with Accounting Principles Board Opinion No. 11, deferred income taxes were provided for all differences in timing of reporting income and expenses for financial statement and income tax purposes, except for items that were not allowable by the Federal Communications Commission (FCC) or the Commission as an expense for rate- making purposes. Investment tax credits (ITC) are deferred and amortized over the useful life of the related property. The Tax Reform Act of 1986 effectively eliminated ITC after December 31, 1985. Postretirement Benefits - ----------------------- Effective January 1, 1993, the Company changed its method of accounting for postretirement benefits (principally health care benefits) provided to certain retirees by adopting SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." SFAS No. 106 requires accrual of the expected cost of providing postretirement benefits to employees and their dependents or beneficiaries during the years employees earn the benefits. As permitted by SFAS No. 106, the Company elected to recognize the obligation for postretirement benefits already earned by its current retirees and active work force as of January 1, 1993 by amortizing such obligation on a straight-line basis over a period of twenty years. During 1992 and 1991, the Company expensed postretirement benefits as such costs were paid. Postemployment Benefits - ----------------------- Effective January 1, 1994, the Company will adopt SFAS No. 112, "Employers' Accounting for Postemployment Benefits." Under the new standard, the Company is required to recognize certain previously unrecorded obligations for benefits provided to former or inactive employees and their dependents, after employment but before retirement. Postemployment benefits offered by the Company include severance, workers' compensation and disability benefits, including the continuation of other benefits such as health care and life insurance coverage. As required by the standard, the Company will recognize its obligations for postemployment benefits through a cumulative adjustment in the consolidated income statement. The resulting nonrecurring, non-cash charge will not significantly impact the Company's 1994 net income. Adoption of this standard is not expected to significantly impact future operating expenses. Carolina Telephone & Telegraph Company Form 10-K Part II CAROLINA TELEPHONE AND TELEGRAPH COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 1. ACCOUNTING POLICIES (continued) Interest Charged to Construction - -------------------------------- In accordance with the Uniform System of Accounts, as prescribed by the FCC, interest is capitalized only on those telephone plant construction projects for which the estimated construction period exceeds one year. 2. MERGER AND INTEGRATION COSTS Effective March 9, 1993, Sprint consummated its merger with Centel Corporation (Centel), a telecommunications company with local exchange and cellular/wireless communications services operations. Centel's local exchange telephone businesses operate in six states: Florida, North Carolina, Virginia, Illinois, Texas and Nevada. Pursuant to the Agreement and Plan of Merger dated May 27, 1992, Sprint issued 1.37 shares of its common stock in exchange for each outstanding share of Centel common stock. The operations of the merged companies are being integrated and restructured to achieve efficiencies which are expected to yield significant operational synergies and cost savings. The transaction costs associated with the merger and the estimated expenses of integrating and restructuring the operations of the two companies resulted in nonrecurring charges to Sprint during 1993. The portion of such charges attributable to the Company was $46,382,000, which reduced 1993 net income by approximately $27,765,000. 3. EMPLOYEE BENEFIT PLANS Defined Benefit Pension Plan - ---------------------------- Substantially all employees of the Company are covered by a noncontributory defined benefit pension plan. For participants of the plan represented by collective bargaining units, benefits are based upon schedules of defined amounts as negotiated by the respective parties. For participants not covered by collective bargaining agreements, the plan provides pension benefits based upon years of service and participants' compensation. The Company's policy is to make contributions to the plan each year equal to an actuarially determined amount consistent with applicable federal tax regulations. The funding objective is to accumulate funds at a relatively stable rate over the participants' working lives so that benefits are fully funded at retirement. As of December 31, 1993, the plan's assets consisted principally of investments in corporate equity securities and U.S. government and corporate debt securities. Carolina Telephone & Telegraph Company Form 10-K Part II CAROLINA TELEPHONE AND TELEGRAPH COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 3. EMPLOYEE BENEFIT PLANS (continued) Defined Benefit Pension Plan (continued) - ---------------------------------------- The components of the net pension credits and related assumptions are as follows (in thousands): 1993 1992 1991 -------- -------- -------- Service cost -- benefits earned during the period $ 5,505 $ 4,739 $ 4,622 Interest cost on projected benefit obligation 15,654 14,745 14,047 Actual return on plan assets (41,636) (15,461) (65,761) Net amortization and deferral 11,403 (9,789) 42,132 -------- -------- -------- Net pension credit $ (9,074) $ (5,766) $ (4,960) ======== ======== ======== Discount rate 8.00% 8.50% 8.50% Expected long-term rate of return on plan assets 9.50% 8.25% 8.25% Anticipated composite rate of future increases in compensation 5.50% 6.33% 7.02% In addition, the Company recognized pension curtailment gains of $98,000 during 1993 as a result of the integration actions as discussed in Note 2. The funded status and amounts recognized in the consolidated balance sheets for the plan, as of December 31, are as follows (in thousands): 1993 1992 --------- --------- Actuarial present value of pension benefit obligations Vested benefit obligation $(207,186) $(166,022) ========= ========= Accumulated benefit obligation $(231,695) $(182,369) ========= ========= Projected benefit obligation $(241,000) $(198,533) Plan assets at fair value 344,187 311,202 --------- --------- Plan assets in excess of the projected benefit obligation 103,187 112,669 Unrecognized net gains (35,769) (40,377) Unrecognized prior service cost (benefit) 5,464 (4,112) Unamortized portion of transition asset (40,236) (44,706) --------- --------- Prepaid pension cost $ 32,646 $ 23,474 ========= ========= Carolina Telephone & Telegraph Company Form 10-K Part II CAROLINA TELEPHONE AND TELEGRAPH COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 3. EMPLOYEE BENEFIT PLANS (continued) Defined Benefit Pension Plan (continued) - ---------------------------------------- The projected benefit obligations as of December 31, 1993 and 1992 were determined using a discount rate of 7.50 percent for 1993 and 8.00 percent for 1992, and anticipated composite rates of future increases in compensation of 4.50 percent for 1993 and 5.50 percent for 1992. Defined Contribution Plans - -------------------------- Sprint sponsors two defined contribution employee savings plans covering substantially all employees of the Company. Participants may contribute portions of their compensation to the plans. Contributions of participants represented by collective bargaining units are matched by the Company based upon defined amounts as negotiated by the respective parties. Contributions of participants not covered by collective bargaining agreements are also matched by the Company. For these participants, the Company provides matching contributions equal to 50 percent of participants' contributions up to 6 percent of their base compensation and may, at the discretion of Sprint's Board of Directors, provide additional matching contributions based upon the performance of Sprint's common stock price in comparison to other telecommunications companies. The Company's contributions to the plans aggregated $3,278,000, $2,195,000 and $2,300,000 in 1993, 1992 and 1991, respectively. Postretirement Benefits - ----------------------- The Company provides other postretirement benefits (principally health care benefits) to certain retirees. Substantially all employees who retired from the Company before January 1, 1991 became eligible for these postretirement benefits at reduced cost to the retirees. Employees retiring after such date, who meet specified age and years of service requirements, are eligible for these benefits on a shared cost basis, with the Company's portion of the cost determined by the retirees' years of credited service at retirement. The Company funds the accrued costs as benefits are paid. For regulatory purposes, the FCC permits recognition of net postretirement benefits costs, including amortization of the transition obligation, in accordance with SFAS No. 106. The Company is also recording postretirement benefits costs in accordance with SFAS No. 106 for state regulatory purposes, pending direction from the Commission in future rate- making procedures. Carolina Telephone & Telegraph Company Form 10-K Part II CAROLINA TELEPHONE AND TELEGRAPH COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 3. EMPLOYEE BENEFIT PLANS (continued) Postretirement Benefits (continued) - ----------------------------------- The components of the 1993 net postretirement benefits cost are as follows (in thousands): Service cost-benefits earned during the period $ 2,514 Interest on accumulated postretirement benefits obligation 9,599 Amortization of transition obligation 5,912 --------- Net postretirement benefits cost $ 18,025 ========= For measurement purposes, an annual health care cost trend rate of 13 percent was assumed for 1993, gradually decreasing to 6 percent by 2001 and remaining constant thereafter. The effect of a one percent increase in the assumed trend rate would have increased the 1993 net postretirement benefits cost by approximately $328,000. The discount rate for 1993 was 8 percent. In addition, the Company recognized postretirement benefits curtailment losses of $2,963,000 during 1993 as a result of the integration actions as discussed in Note 2. The cost of providing health care benefits to retirees was $2,383,000 and $2,382,000 in 1992 and 1991, respectively. The amount recognized in the consolidated balance sheet as of December 31, 1993 is as follows (in thousands): Accumulated postretirement benefits obligation Retirees $ 52,590 Active plan participants - fully eligible 32,830 Active plan participants - other 45,727 --------- 131,147 Unrecognized net gains 3,387 Unrecognized transition obligation (111,992) --------- Accrued postretirement benefits cost $ 22,542 ========= The accumulated benefits obligation as of December 31, 1993 was determined using a discount rate of 7.5 percent. An annual health care cost trend rate of 12 percent was assumed for 1994, gradually decreasing to 6 percent by 2001 and remaining constant thereafter. The effect of a one percent annual increase in the assumed health care cost trend rate would have increased the accumulated benefits obligations as of December 31, 1993 by approximately $32,830,000. Carolina Telephone & Telegraph Company Form 10-K Part II CAROLINA TELEPHONE AND TELEGRAPH COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 4. INCOME TAXES The components of federal and state income tax expense are as follows (in thousands): 1993 1992 1991 -------- -------- -------- Federal income taxes Current $ 33,786 $ 34,218 $ 37,826 Deferred (9,064) 1,797 1,154 Amortization of deferred ITC (4,040) (4,925) (5,369) -------- -------- -------- 20,682 31,090 33,611 State income taxes Current 7,746 8,242 9,162 Deferred (1,591) 1,098 975 -------- -------- -------- 6,155 9,340 10,137 -------- -------- -------- Total income tax expense $ 26,837 $ 40,430 $ 43,748 ======== ======== ======== In 1993 income tax benefits of $1,518,000 associated with the extraordinary losses incurred related to the early extinguishments of debt were reflected as reductions of such losses in the consolidated statements of income. The differences which cause the effective income tax rate to vary from the statutory federal income tax rate of 35 percent in 1993 and 34 percent in 1992 and 1991 are as follows (in thousands): 1993 1992 1991 -------- -------- -------- Federal income tax at the statutory rate $ 26,713 $ 38,498 $ 41,197 Less amortization of deferred ITC 4,040 4,883 5,200 -------- -------- -------- Expected federal income tax provision after amortization of deferred ITC 22,673 33,615 35,997 Effect of Differences required to be flowed through by regulatory commissions 543 673 290 Reversal of rate differentials (1,096) (1,496) (1,821) State income tax, net of federal income tax effect 4,001 6,164 6,690 Other, net 716 1,474 2,592 -------- -------- -------- Income tax expense, including ITC $ 26,837 $ 40,430 $ 43,748 ======== ======== ======== Effective income tax rate 35.2% 35.7% 36.1% ======== ======== ======== Carolina Telephone & Telegraph Company Form 10-K Part II CAROLINA TELEPHONE AND TELEGRAPH COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 4. INCOME TAXES (continued) During 1993 and 1992, in accordance with SFAS No. 109, deferred income taxes were provided for the temporary differences between the carrying amounts of the Company's assets and liabilities for financial statement purposes and their tax bases. The sources of the differences that give rise to the deferred income tax assets and liabilities as of December 31, along with the income tax effect of each, are as follows (in thousands): 1993 1992 --------------------- --------------------- Deferred Income Tax Deferred Income Tax --------------------- --------------------- Assets Liabilities Assets Liabilities -------- ----------- -------- ----------- Property, plant and equipment $ - $122,697 $ - $114,888 Allowance for doubtful accounts 373 - 426 - Expense accruals 2,795 - - 3,235 Deferred ITC - 6,790 - 10,830 Other, net 5,726 - 265 1,296 -------- -------- -------- -------- $ 8,894 $129,487 $ 691 $130,249 ======== ======== ======== ======== On August 10, 1993, the Revenue Reconciliation Act of 1993 (the Act) was enacted which, among other changes, raised the federal income tax rate for corporations to 35 percent from 34 percent, retroactive to the beginning of the year. Pursuant to SFAS No. 71, the resulting adjustments to the Company's deferred income tax assets and liabilities to reflect the revised rate have generally been reflected as reductions to the related regulatory liabilities. During 1991, in accordance with APB No. 11, deferred income tax provisions resulted from the differences in the timing of recognizing certain revenues and expenses for financial statement and income tax purposes. The sources of the differences, along with the income tax effect of each, were as follows (in thousands): Property, plant and equipment $ 6,331 Pension costs 1,869 Revenue accruals 1,098 Expense accruals (6,647) Other, net (522) ------- $ 2,129 ======= Carolina Telephone & Telegraph Company Form 10-K Part II CAROLINA TELEPHONE AND TELEGRAPH COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 5. LONG-TERM DEBT AND EXTRAORDINARY LOSSES ON EXTINGUISHMENTS Long-term debt as of December 31, excluding current maturities, is as follows (in thousands): 1993 1992 --------------------------- -------- Weighted Average Amount Interest Rate Amount -------- ---------------- -------- Debentures, maturities 1995 - 2016 $271,878 6.81% $242,052 Other notes, maturities 1995 - 1998 219 9.51% 345 Unamortized debt discount (3,010) (1,862) -------- -------- $269,087 $240,535 ======== ======== Long-term debt maturities during each of the next five years are as follows (in thousands): Year Amount ---- ------- 1994 $ 568 1995 8,575 1996 12,663 1997 841 1998 6 The first mortgage bonds and notes are secured by substantially all of the Company's property, plant and equipment. As of December 31, 1993, the Company had lines of credit with banks totaling $60,000,000. No amounts were borrowed against these lines of credit at year end. The bank lines, which are renewable in April 1994, provide for short-term borrowings at market rates of interest and require annual commitment fees based on the unused portion. Lines of credit, which support both outstanding commercial paper and notes payable to banks, may be withdrawn by the banks if there is a material adverse change in the financial condition of the Company. During 1993, the Company redeemed prior to scheduled maturities $120,209,000 of first mortgage bonds and debentures with interest rates ranging from 7.75 percent to 11.75 percent. Prepayment penalties incurred in connection with the early extinguishments of debt and the write-off of related debt issuance costs and unamortized debt discounts and premiums, net of the related income tax benefits, are reflected as extraordinary losses in the 1993 consolidated statement of income. Carolina Telephone & Telegraph Company Form 10-K Part II CAROLINA TELEPHONE AND TELEGRAPH COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 6. COMMITMENTS Gross rental expense aggregated $6,959,000 in 1993, $6,145,000 in 1992 and $6,967,000 in 1991. The Company's planned capital expenditures for the year ending December 31, 1994 are approximately $143,131,000. Normal purchase commitments have been or will be made for these planned expenditures. 7. RELATED PARTY TRANSACTIONS The Company purchases telecommunications equipment, construction and maintenance equipment, and materials and supplies from its affiliate, North Supply Company. Total purchases for 1993, 1992, and 1991 were $47,401,000, $45,272,000 and $36,421,000, respectively. Under an agreement with Sprint, the Company reimburses Sprint for data processing services, other data related costs and certain management costs which are incurred for the Company's benefit. A credit resulting from deferred income taxes on intercompany profits is also allocated by Sprint to affiliated companies. Total charges to the Company aggregated $55,885,000, $43,481,000 and $36,590,000 in 1993, 1992 and 1991, respectively, and the credit relating to deferred income taxes was $852,500, $714,000 and $824,000 in 1993, 1992 and 1991, respectively. The Company enters into cash advance and borrowing transactions with Sprint; generally, interest on such transactions is computed based on the prior month's thirty-day average commercial paper index, as published in the Federal Reserve Statistical Release H.15, plus 45 basis points. Interest expense on such advances from Sprint was $19,800, $402,000 and $101,000 in 1993, 1992 and 1991, respectively. Interest income on such advances to Sprint was $51,000, $9,100 and $21,500 in 1993, 1992 and 1991, respectively. Sprint Publishing & Advertising, an affiliate, pays the Company a fee for the right to publish telephone directories in the Company's operating territory, a listing fee, and a fee for billing and collection services performed for Sprint Publishing & Advertising by the Company. For 1993, 1992 and 1991, Sprint Publishing & Advertising paid the Company a total of $21,759,000, $21,526,000 and $20,109,000, respectively. The Company paid Sprint Publishing & Advertising $1,543,000, $1,515,000 and $1,174,000 in 1993, 1992 and 1991, respectively, for its costs of publishing the white page portion of the directories. Carolina Telephone & Telegraph Company Form 10-K Part II CAROLINA TELEPHONE AND TELEGRAPH COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 7. RELATED PARTY TRANSACTIONS (continued) The Company provides various services to Sprint's long distance communications services division, such as network access, operator and billing and collection services, and the lease of network facilities. The Company recognized income of $18,017,000, $16,698,000 and $15,694,000 in 1993, 1992 and 1991, respectively, for these services. The Company paid Sprint's long distance communications services division $25,000,000, $22,811,000 and $21,797,000 in 1993, 1992 and 1991, respectively, for interexchange telecommunications services. The Company provides services such as operator assistance, directory assistance, end user trouble report processing and payment processing for United Telephone-Southeast, Inc. (an affiliate) and United Telephone Company of the Carolinas, (an affiliate). The Company recognized income of $3,324,000, $2,525,000, and $1,025,000 during 1993, 1992 and 1991, respectively, for these services. Certain directors and officers of the Company are also directors or officers of banks at which the Company conducts borrowings and related transactions. The terms are comparable with other banks at which the Company has similar transactions. 8. ADDITIONAL FINANCIAL INFORMATION Financial Instruments Information - --------------------------------- The Company's financial instruments consist of long-term debt, including current maturities, with carrying amounts as of December 31, 1993 and 1992 of $269,655,000 and $248,252,000, respectively, and estimated fair values of $288,871,000 and $257,624,000, respectively. The fair values are estimated based on quoted market prices for publicly-traded issues, and based on the present value of estimated future cash flows using a discount rate commensurate with the risks involved for all other issues. The carrying values of the Company's other financial instruments (principally short-term borrowings) approximate fair value as of December 31, 1993 and 1992. Carolina Telephone & Telegraph Company Form 10-K Part II CAROLINA TELEPHONE AND TELEGRAPH COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 8. ADDITIONAL FINANCIAL INFORMATION (continued) Supplemental Cash Flows Information - ----------------------------------- The supplemental disclosures required for the consolidated statements of cash flows for the years ended December 31, are as follows (in thousands): 1993 1992 1991 ------- ------- ------- Cash paid for Interest, net of amounts capitalized $20,395 $22,884 $21,564 Income taxes 41,391 44,884 42,030 Major Customer Information - -------------------------- Operating revenues from American Telephone & Telegraph resulting primarily from network access, billing and collection services, and the lease of network facilities aggregated approximately $105,225,000, $101,418,000 and $97,679,000 for 1993, 1992 and 1991, respectively. 9. SUPPLEMENTAL QUARTERLY INFORMATION - UNAUDITED (in thousands) 1993 Quarters Ended ------------------------------------------------ March 31 June 30 September 30 December 31 -------- -------- ------------ ----------- Operating revenues $152,282 $159,756 $163,536 $162,967 Operating income (loss) (1,869) 23,895 28,038 20,684 Income (loss) before extraordinary item (7,464) 18,436 23,147 15,367 Net income (loss) (7,464) 17,070 22,195 15,367 1992 Quarters Ended ------------------------------------------------ March 31 June 30 September 30 December 31 -------- -------- ------------ ----------- Operating revenues $137,608 $146,034 $149,770 $157,028 Operating income 25,058 28,027 25,785 14,863 Net income 19,749 22,905 20,782 9,364 Nonrecurring charges associated with the transaction costs of the Sprint/Centel merger and the estimated expenses of integrating and restructuring the operations of the two companies were recorded during 1993. The portion of such charges attributable to the Company was $41,700,000 and $4,682,000 in the first and fourth quarters of 1993, respectively, which reduced net income by approximately $25,346,000 and $2,419,000, respectively. The Company recorded additional depreciation expense of approximately $19,365,000 during the fourth quarter of 1992 as the result of depreciation rate changes granted by the Commission. The effect of this adjustment on 1992 fourth quarter net income was $11,245,000. Carolina Telephone & Telegraph Company Form 10-K Part II/III/IV Item 9.	Item 9. Changes in and Disagreements with Accountants on Accounting and - ------- Financial Disclosure None Item 10.	Item 10. Directors and Executive Officers of the Registrant - -------- Omitted under the provisions of General Instruction J. Item 11.	Item 11. Executive Compensation - -------- Omitted under the provisions of General Instruction J. Item 12.	Item 12. Security Ownership of Certain Beneficial Owners and Management - -------- Omitted under the provisions of General Instruction J. Item 13.	Item 13. Certain Relationships and Related Transactions - -------- Omitted under the provisions of General Instruction J. Item 14.	Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K - -------- (a) 1. The consolidated financial statements of the Company filed as part of this report are listed in the Index to Consolidated Financial Statements on page 10. 2. The consolidated financial statement schedules of the Company filed as part of this report are listed in the Index to Consolidated Financial Statement Schedules on page 32. (b) The Registrant was not required to file a report on Form 8-K during the last quarter of 1993. (c) The exhibits filed as part of this report are listed in the Index to Exhibits on pages 42 - 44. Carolina Telephone & Telegraph Company Form 10-K Part IV CAROLINA TELEPHONE AND TELEGRAPH COMPANY INDEX TO CONSOLIDATED FINANCIAL STATEMENT SCHEDULES (ITEM 14(a)2.) Page For each of the three years in the period ended December 31, 1993: Reference - ------------------------------------------------------------------ --------- Schedule V - Property, Plant and Equipment - Consolidated Pages 33-35 Schedule VI - Accumulated Depreciation on Property, Plant and Equipment - Consolidated Pages 36-38 Schedule VIII - Valuation and Qualifying Accounts - Consolidated Page 39 Schedule IX - Short-Term Borrowings - Consolidated Page 40 Schedule X - Supplementary Income Statement Information - Consolidated Page 41 All other schedules have been omitted since the required information is not present or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements, including the notes thereto. Carolina Telephone and Telegraph Company Form 10-K Part IV SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT - CONSOLIDATED Year Ended December 31, 1993 (In Thousands) Balance Retirements Balance beginning Additions or end of year at cost sales of year ---------- ----------- ----------- ---------- Land and buildings $ 120,560 $ 8,619 $ 544 $ 128,635 Other general support assets 65,424 12,853 5,897 72,380 Central office assets 562,672 67,120 28,746 601,046 Information origination/ termination assets 44,301 7,727 5,749 46,279 Cable and wire facilities assets 689,171 44,314 9,862 723,623 Amortizable assets 4,431 355 222 4,564 Property held for future use 310 - - 310 Telephone plant under construction 11,673 5,555 - 17,228 Telephone plant acquisition adjustment 342 - - 342 Nonoperating plant 859 - - 859 ---------- -------- -------- ---------- $1,499,743 $146,543 $51,020 $1,595,266 ========== ======== ======== ========== Depreciation expense is computed on a straight-line basis. The average annual composite depreciation rate in 1993 was 7.5%. Carolina Telephone and Telegraph Company Form 10-K Part IV SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT - CONSOLIDATED Year Ended December 31, 1992 (In Thousands) Balance Retirements Balance beginning Additions or end of year at cost sales of year ---------- ---------- ---------- ---------- Land and buildings $ 92,700 $ 28,394 $ 534 $ 120,560 Other general support assets 59,841 10,911 5,328 65,424 Central office assets 524,038 67,512 28,878 562,672 Information origination/ termination assets 84,180 5,265 45,144 44,301 Cable and wire facilities assets 655,864 42,176 8,869 689,171 Amortizable assets 4,696 161 426 4,431 Property held for future use 376 (66) - 310 Telephone plant under construction 22,969 (11,296) - 11,673 Telephone plant acquisition adjustment 342 - - 342 Nonoperating plant 859 - - 859 ---------- -------- ------- ---------- $1,445,865 $143,057 $89,179 $1,499,743 ========== ======== ======= ========== Depreciation expense is computed on a straight-line basis. The average annual composite depreciation rate in 1992 was 7.6%. Carolina Telephone and Telegraph Company Form 10-K Part IV SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT - CONSOLIDATED Year Ended December 31, 1991 (In Thousands) Balance Retirements Balance beginning Additions or end of year at cost sales of year ---------- ------------ ----------- ----------- Land and buildings $ 86,427 $ 7,078 $ 805 $ 92,700 Other general support assets 55,839 8,831 4,829 59,841 Central office assets 493,218 60,232 29,412 524,038 Information origination/ termination assets 83,571 5,287 4,678 84,180 Cable and wire facilities assets 628,570 37,097 9,803 655,864 Amortizable assets 4,845 90 239 4,696 Property held for future use 1,396 (1,020) - 376 Telephone plant under construction 9,994 12,975 - 22,969 Telephone plant acquisition adjustment 520 (178) - 342 Nonoperating plant 919 (60) - 859 ---------- -------- ------- ---------- $1,365,299 $130,332 $49,766 $1,445,865 ========== ======== ======= ========== Depreciation expense is computed on a straight-line basis. The average annual composite depreciation rate in 1991 was 6.2%. Carolina Telephone and Telegraph Company Form 10-K Part IV SCHEDULE VI - ACCUMULATED DEPRECIATION ON PROPERTY, PLANT AND EQUIPMENT - CONSOLIDATED Year Ended December 31, 1993 (In Thousands) Balance Charged to Retirements Balance beginning depreciation Net or end of year expense salvage sales of year --------- ---------- --------- ----------- -------- Buildings $ 27,126 $ 4,154 $ (263) $ 517 $ 30,500 Other general support assets 26,930 8,027 693 5,968 29,682 Central office assets 174,863 54,081 29 28,746 200,227 Information origination/ termination assets 31,000 3,701 637 5,686 29,652 Cable and wire facilities assets 348,091 44,449 (1,600) 9,803 381,137 Amortizable assets 1,422 310 (5) 300 1,427 Property held for future use 25 10 - - 35 Telephone plant acquisition adjustment 487 33 - - 520 Nonoperating plant 659 - - - 659 -------- -------- -------- ------- -------- $610,603 $114,765 $ (509) $51,020 $673,839 ======== ======== ======== ======= ======== Carolina Telephone and Telegraph Company Form 10-K Part IV SCHEDULE VI - ACCUMULATED DEPRECIATION ON PROPERTY, PLANT AND EQUIPMENT - CONSOLIDATED Year Ended December 31, 1992 (In Thousands) Balance Charged to Retirements Balance beginning depreciation Net or end of year expense salvage sales of year -------- ------------ -------- --------- -------- Buildings $ 24,632 $ 3,232 $ (204) $ 534 $ 27,126 Other general support assets 24,366 7,347 544 5,327 26,930 Central office assets 151,089 53,136 (483) 28,879 174,863 Information origination/ termination assets 72,007 3,489 648 45,144 31,000 Cable and wire facilities assets 315,768 42,363 (1,171) 8,869 348,091 Amortizable assets 1,526 255 67 426 1,422 Property held for future use 15 10 - - 25 Telephone plant acquisition adjustment 454 33 - - 487 Nonoperating plant 659 - - - 659 -------- -------- -------- ------- -------- $590,516 $109,865 $ (599) $89,179 $610,603 ======== ======== ======== ======= ======== Carolina Telephone and Telegraph Company Form 10-K Part IV SCHEDULE VI - ACCUMULATED DEPRECIATION ON PROPERTY, PLANT AND EQUIPMENT - CONSOLIDATED Year Ended December 31, 1991 (In Thousands) Balance Charged to Retirements Balance beginning depreciation Net or end of year expense salvage sales of year -------- ------------ ------- ----------- ------- Buildings $ 23,384 $ 2,107 $ (99) $ 760 $ 24,632 Other general support assets 23,494 5,426 275 4,829 24,366 Central office assets 140,203 40,979 (912) 29,181 151,089 Information origination/ termination assets 73,119 2,663 1,180 4,955 72,007 Cable and wire facilities assets 283,716 42,820 (965) 9,803 315,768 Amortizable assets 1,476 250 38 238 1,526 Property held for future use - 10 5 - 15 Telephone plant acquisition adjustment 421 33 - - 454 Nonoperating plant 659 - - - 659 -------- ------- ------- ------- -------- $546,472 $94,288 $ (478) $49,766 $590,516 ======== ======= ======= ======= ======== Carolina Telephone and Telegraph Company Form 10-K Part IV SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS - CONSOLIDATED Years Ended December 31, 1993, 1992 and 1991 (In Thousands) Deductions ----------- Additions Accounts Balance at ---------- charged off Balance beginning Charged to net of at end of year expense collections of year ---------- ---------- ----------- ------- Year ended December 31, 1993 - ---------------------------- Deducted from assets: Allowance for uncollectible accounts $1,415 $1,965 $1,485 $1,895 ====== ====== ====== ====== Year ended December 31, 1992 - ---------------------------- Deducted from assets: Allowance for uncollectible accounts $1,319 $1,613 $1,517 $1,415 ====== ====== ====== ====== Year ended December 31, 1991 - ---------------------------- Deducted from assets: Allowance for uncollectible accounts $1,478 $1,816 $1,975 $1,319 ====== ====== ====== ====== Carolina Telephone and Telegraph Company Form 10-K Part IV SCHEDULE IX - SHORT-TERM BORROWINGS - CONSOLIDATED Years Ended December 31, 1993, 1992 and 1991 (In Thousands) 1993 1992 1991 Commercial Commercial Commercial Paper Paper Paper ---------- ---------- ---------- Amount outstanding at end of year $41,100 $55,500 $30,000 ======= ======= ======= Maximum amount outstanding at any month end $59,900 $55,500 $30,000 ======= ======= ======= Approximate average amount outstanding during the year $46,764 $30,129 $24,930 ======= ======= ======= Approximate weighted average interest rate for the year (computed by dividing the annual interest expense by the average debt outstanding during the year) 3.24% 4.17% 6.06% ======= ======= ======= Average interest rate at end of year 3.37% 4.12% 5.31% ======= ======= ======= Commercial paper is generally carried for periods ranging from 15 days to 30 days. Carolina Telephone and Telegraph Company Form 10-K Part IV SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION - CONSOLIDATED Years Ended December 31, 1993, 1992 and 1991 (In Thousands) Year ended December 31, --------------------------- 1993 1992 1991 ------- ------- ------- Taxes other than payroll and income taxes: Gross receipts taxes $ 7,009 $ 6,562 $ 6,031 Property taxes 8,484 8,054 8,080 Other state and local taxes 704 1,138 1,381 ------- ------- ------- $16,197 $15,754 $15,492 ======= ======= ======= Maintenance expense is the primary component of plant expense which is shown separately in the Consolidated Statement of Income. The Company had no significant advertising expense and paid no royalties during 1993, 1992 and 1991. Carolina Telephone and Telegraph Company Form 10-K Part IV INDEX TO EXHIBITS ITEM 14(c) Exhibit No. 3 Articles of incorporation and by-laws (filed as Exhibit 3 to 1980 Annual Report Form 10-K and incorporated herein by reference). 4 Instruments defining the rights of security holders, including indentures, contained in documents previously filed with the Commission are incorporated herein by reference. 4(A) Indenture dated as of February 1, 1963, from the Company to Bankers Trust Company, Trustee (See Current Report Form 8-K for February 1963, Exhibit 4-F). 4(B) Indenture dated as of March 1, 1965, from the Company to Bankers Trust Company, Trustee (See Current Report Form 8-K for March 1965, Exhibit A). 4(C) Indenture dated as of March 1, 1966, from the Company to Bankers Trust Company, Trustee (See Current Report Form 8-K for March 1966, Exhibit A). 4(D) Indenture dated as of January 15, 1968, from the Company to North Carolina National Bank as Trustee (See Registration No. 2-27816, Exhibit 4-J). 4(E) Indenture dated as of October 1, 1970, from the Company to Bankers Trust Company, as Trustee (See Registration NO. 2- 38292, Exhibit 4-J). 4(F) Supplemental Indenture from the Company to Bankers Trust Company dated as of March 28, 1969 supplementing Indenture dated as of July 1, 1948 (See Registration No. 2-34018, Exhibit 4-K). 4(G) Supplemental Indenture from the Company to Bankers Trust Company dated as of March 28, 1969 supplementing Indenture dated as of August 1, 1952 (See Registration No. 2-34018, Exhibit 4-L). 4(H) Supplemental Indenture from the Company to Bankers Trust Company dated as of March 28, 1969 supplementing Indenture dated as of August 1, 1957 (See Registration No. 2-34018, Exhibit 4-M). Carolina Telephone & Telegraph Company Form 10-K Part IV INDEX TO EXHIBITS (CONTINUED) ITEM 14(c) Exhibit No. 4(I) Supplemental Indenture from the Company to Bankers Trust Company dated as of March 28, 1969 supplementing Indenture dated as of February 1, 1963 (See Registration No. 2- 34018, Exhibit 4-N). 4(J) Supplemental Indenture from the Company to Bankers Trust Company dated as of March 28, 1969 supplementing Indenture dated as of March 1, 1965 (See Registration No. 2-34018, Exhibit 4-O). 4(K) Supplemental Indenture from the Company to Bankers Trust Company dated as of March 28, 1969 supplementing Indenture dated as of March 1, 1966 (See Registration No. 2-34018, Exhibit 4-P). 4(L) Supplemental Indenture from the Company to North Carolina National Bank dated as of March 28, 1969 supplementing Indenture dated as of January 15, 1968 (See Registration No. 2-34018, Exhibit 4-Q). 4(M) Indenture dated as of August 1, 1969 from the Company to Bankers Trust Company (See Registration No. 2-34018, Exhibit 4-A). 4(N) Indenture dated as of October 1, 1971 from the Company to Bankers Trust Company (See Registration No. 2-41721, Exhibit 2-A). 4(O) Indenture dated as of November 1, 1973 from the Company to Bankers Trust Company (See Registration No. 2-49251, Exhibit 2-A). 4(P) Indenture dated as of May 1, 1978 from the Company to Bankers Trust Company (See Registration No. 2-61151, Exhibit 2-A). 4(Q) Indenture dated as of October 26, 1978 from the Company to Bankers Trust Company (See Administrative Proceeding File No. 3-5541, Exhibit 5). 4(R) Indenture dated as of December 27, 1979 from the Company to Bankers Trust Company (See the Company's Application, File Nos. 2-34018, 2-38292, 2-41721, 2-49251 and 2-61151, Exhibit 5). Carolina Telephone & Telegraph Company Form 10-K Part IV INDEX TO EXHIBITS (CONTINUED) ITEM 14(c) Exhibit No. 4(S) Indenture dated as of May 15, 1986 from the Company to Bankers Trust Company (See Amendment No. 1 to Registration No. 33-5350 Exhibit 4-A). 4(T) Indenture dated as of December 1, 1992 from the Company to Bankers Trust Company. (See Registration No. 33-54936, Exhibit 4). 4(U) Indenture dated as of August 15, 1993 from the Company to Bankers Trust Company. (See Registration No. 33-64476, Exhibit 4). 10 Incentive Compensation Plan (filed as Exhibit 10(c) (vi) to United Telecommunications, Inc., Registration Statement No. 2-72988 and incorporated herein by reference). 12 Computation of Ratio of Earnings to Fixed Charges. 23 Consent of Ernst & Young. Carolina Telephone & Telegraph Company Form 10-K Part IV SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. CAROLINA TELEPHONE AND TELEGRAPH COMPANY Date: March 9, 1994 By s/ F. E. Westmeyer --------------- ----------------------------------------- F. E. Westmeyer, Vice President-Finance 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. Date Signature and Title ---- ------------------- March 9, 1994 s/ W. E. McDonald - -------------- -------------------------------------------- W. E. McDonald, President, Director and Chief Executive Officer March 9, 1994 s/ F. E. Westmeyer - -------------- -------------------------------------------- F. E. Westmeyer, Vice President-Finance March 9, 1994 s/ T. J. Geller - -------------- -------------------------------------------- T. J. Geller, Controller March 9, 1994 s/ F. J. Boling - -------------- -------------------------------------------- F. J. Boling, Jr, Director March 9, 1994 s/ T. G. Crewe - -------------- -------------------------------------------- T. G. Crewe, Jr, Director March 9, 1994 s/ E. I. Davis - -------------- -------------------------------------------- E. I. Davis, Director March 9, 1994 s/ N. B. DeFriece - -------------- -------------------------------------------- N. B. DeFriece, Director March 9, 1994 s/ C. D. Evans - -------------- -------------------------------------------- C. D. Evans, Director Carolina Telephone & Telegraph Company Form 10-K Part IV SIGNATURES (CONTINUED) Date Signature and Title ---- ------------------- March 9, 1994 s/ J. A. Hackney, III - -------------- -------------------------------------------- J. A. Hackney, III, Director March 9, 1994 s/ W. P. Hendricks - -------------- -------------------------------------------- W. P. Hendricks, Director March 9, 1994 s/ J. W. Jones, Jr - -------------- -------------------------------------------- J. W. Jones, Jr, Director March 9, 1994 s/ J. A. Laughery - -------------- -------------------------------------------- J. A. Laughery, Director March 9, 1994 s/ G. W. Little - -------------- -------------------------------------------- G. W. Little, Director March 9, 1994 s/ B. R. McCain - -------------- -------------------------------------------- B. R. McCain, Director March 9, 1994 s/ J. M. Mead - -------------- -------------------------------------------- J. M. Mead, Director - -------------- -------------------------------------------- M. K. Norris, Director March 9, 1994 s/ D. W. Peterson - -------------- -------------------------------------------- D. W. Peterson, Director - -------------- -------------------------------------------- J. J. Powell, Director March 9, 1994 - -------------- -------------------------------------------- D. L. Ward, Jr, Director
36340_1993.txt	36340	1993	Item 1. Business Premier Financial Services, Inc. (the "Company") is a registered bank holding company organized in 1976 under Delaware law. The operations of the Company and its subsidiaries consist primarily of those financial activities, including trust and investment services, common to the commercial banking industry. Unless the context otherwise requires, the term "Company" as used herein includes the Company and its subsidiaries on a consolidated basis. Substantially all of the operating revenue and net income of the Company is attributable to its subsidiary banks. The primary function of the Company is to coordinate the banking policies and operations of its subsidiaries in order to improve and expand their services and effect economies in their operations by joint efforts in certain areas such as auditing, training, marketing, and business development. The Company also provides operational and data processing services for its subsidiaries. All services and counsel to subsidiaries are provided on a fee basis, with fees based upon fair market value. The Company's banking subsidiaries include First Bank North ("FBN"), First Bank South ("FBS"), First National Bank of Northbrook ("FNBN") and First Security Bank of Cary Grove ("FSBCG"). Although chartered as commercial banks, the offices of the banks serve as general sales offices providing a full array of financial services and products to individuals, businesses, local governmental units and institutional customers throughout northern Illinois. Banking services include those generally associated with the commercial banking industry such as demand, savings and time deposits, loans to commercial, agricultural and individual customers, cash management, electronic funds transfers and other services tailored for the client. The Company has banking offices located in Freeport, Stockton, Warren, Mt. Carroll, Dixon, Rockford, Polo, Sterling, Northbrook, Riverwoods and Cary, Illinois. Premier Trust Services, Inc., ("PTS") a wholly owned subsidiary of FBN, provides a full line of fiduciary and investment services throughout the Company's general market area. Premier Insurance Services, Inc., also a wholly owned subsidiary of FBN, is a full line casualty and life insurance agency. Premier Operating Systems, Inc., ("POS") a direct subsidiary of the Company, provides data processing and operational services to the Company and its subsidiaries. Competition Active competition exists in all principal areas where the Company and its subsidiaries are engaged, not only with commercial banking organizations, but also with savings and loan associations, finance companies, mortgage companies, credit unions, brokerage houses and other providers of financial services. The Company has seen the level of competition and number of competitors in its markets increase in recent years and expects a continuation of these aggressively competitive market conditions. To gain a competitive market advantage, the Company relies on a strategic marketing plan that is employed throughout the Company, reaching every level of its sales force. The marketing plan includes the identification of target markets and customers so that the Company's resources, both financial and manpower, can be utilized where the greatest opportunities for gaining market share exist. The differentiation between the Company's approach to providing products and services to its customers and that of the competition is in the individualized attention that the Company devotes to the needs of its customers. This focus on fulfilling customer's financial needs generally results in long-term customer relationships. Banking deposits are well balanced, with a large customer base and no dominant accounts in any category. The Company's loan portfolio is also characterized by a large customer base, balanced between loans to individuals, commercial and agricultural customers, with no dominant relationships. There is no readily available source of information which delineates the market for financial services, including services offered by non-bank competitors, in the company's market area. Regulation and Supervision Bank holding companies and banks are extensively regulated under both federal and state law. To the extent that the following information describes statutory and regulatory provisions, it is qualified in its entirety by references to the particular statutes and regulations. Any significant change in applicable law or regulation may have an effect on the business and prospects of the Company and its subsidiaries. The Company is registered under and is subject to the provisions of the Bank Holding Company Act, and is regulated by the Federal Reserve Board. Under the Bank Holding Company Act the Company is required to file annual reports and such additional information as the Federal Reserve Board may require and is subject to examination by the Federal Reserve Board. The Federal Reserve Board has jurisdiction to regulate all aspects of the Company's business. The Bank Holding Company Act requires every bank holding company to obtain the prior approval of the Federal Reserve Board before merging with or consolidating into another bank holding company, acquiring substantially all the assets of any bank or acquiring direct or indirect ownership or control of more than 5% of the voting shares of any bank. Bank holding companies are also prohibited from acquiring shares of any bank located outside the state in which the operations of the holding company's banking subsidiaries are principally conducted unless such an acquisition is specifically authorized by statute of the state of the bank whose shares are to be acquired. The Bank Holding Company Act also prohibits a bank holding company, with certain exceptions, from acquiring direct or indirect ownership or control of more than 5% of the voting shares of any company which is not a bank and from engaging in any business other than that of banking, managing and controlling banks, or services to banks and their subsidiaries. The Company, however, may engage in certain businesses determined by the Federal Reserve Board to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. The Bank Holding Company Act does not place territorial restrictions on the activities of bank holding companies or their nonbank subsidiaries. The Company is also subject to the Illinois Bank Holding Company Act of 1957, as amended (the "Illinois Act"). Effective December 1, 1990, certain provisions of the Illinois Act were amended to permit Illinois banks and bank holding companies to acquire or be acquired by banks and bank holding companies located in any state having a reciprocal law. The approval of the Commissioner of Banks and Trusts Companies of Illinois is required to complete such an interstate acquisition in Illinois. The Illinois Act also permits intrastate acquisition throughout Illinois by Illinois bank holding companies. The passage of the Financial Institutions Reform, Recovery and Enforcement Act of 1989 ("FIRREA") resulted in significant changes in the enforcement powers of federal banking agencies, and more significantly, the manner in which the thrift industry is regulated. While FIRREA's primary purpose is to address public concern over the financial crisis of the thrift industry through the imposition of strict reforms on that industry, FIRREA grants bank holding companies more expansive rights of entry into "the savings institution" market through the acquisition of both healthy and failed savings institutions. Under the provisions of FIRREA, a banking holding company can expand its geographic market or increase its concentration in an existing market by acquiring a savings institution, but the bank holding company cannot expand its product market by acquiring a savings institution. FIRREA authorizes the Federal Reserve Board to approve applications under Section 4(c)(8) of the Act for bank holding companies to acquire savings associations, under certain conditions, regardless of the associations' financial condition. Previously, under the provisions of the Garn-St. Germain Depository Institutions Act of 1983 and subsequent Federal Reserve Board interpretations, bank holding companies could generally acquire only failing thrifts. Under FIRREA, they realize a significant expansion of authority. Furthermore, bank holding companies may acquire thrifts without regard to certain restrictions on interstate banking, as long as the thrift is operated as a separate subsidiary. FIRREA also allows a bank holding company to merge an acquired savings association with the bank holding company's subsidiary bank, if the bank continues to pay insurance assessments to the Savings Association Insurance Fund for the deposits acquired from the savings association and if, among other conditions, the merger complies with current state law. On September 5, 1989, the Federal Reserve Board promulgated a final rule amending Regulation Y to allow bank holding companies to acquire savings associations. On December 19, 1991, The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") was enacted into law. In addition to providing for the recapitalization of the Bank Insurance Fund (the"BIF"), FDICIA contains, among other things: (i) truth-in savings legislation that requires financial institutions to disclose terms, conditions, fees and yields on deposit accounts in a uniform manner; (ii) provisions that impose strict audit requirements and expand the role of the independent auditors of financial institutions; (iii) provisions that require regulatory agencies to examine financial institutions more frequently than was required in the past; (iv) provisions that limit the powers of state-chartered banks to those of national banks unless the state-chartered bank meets minimum capital requirements and the FDIC finds that the activity to be engaged in by the state-chartered banks poses no significant risk to the BIF; (v) provisions that require the expedited resolution of problem financial institutions; (vi) provisions that require regulatory agencies to develop a method for financial institutions to provide information concerning the estimated fair market value of assets and liabilities as supplemental disclosures to the financial statements filed with the regulatory agencies; (vii)provisions that require regulators to consider adopting capital requirements that account for interest rate risk; and (viii) provisions that require the regulatory agencies to adopt regulations that facilitate cross-industry transactions, and (ix) provide for the acquisition of banks by thrift institutions. While regulations implementing many of the provisions of FDICIA have been issued by the federal banking agencies, regulations implementing certain significant FDICIA requirements (including requirements for establishment of operational and managerial standards to promote bank safety and soundness and modification of regulatory capital standards to account for interest rate risk) have not yet been issued in final form. Consequently, it is not possible at this time to determine the full impact FDICIA will have on the Company and its operations. It is expected, however, that FDICIA is likely to result in, among other things, increased regulatory compliance costs and a greater emphasis on capital. The Company's Subsidiaries FBN and FBS are State chartered, Federal Reserve member banks. They are, therefore, subject to regulation and an annual examination by the Illinois Commissioner of Banks and Trust Companies and by the Board of Governors of the Federal Reserve Bank. FNBN is a nationally chartered bank and is under the supervision of and subject to the examination by the Comptroller of the Currency. All national banks are members of the Federal Reserve System and subject to applicable provisions of the Federal Reserve Act and to regular examination by the Federal Reserve Bank of their district. FSBCG is a State chartered non-member bank and is subject to regulation and an annual examination by the Illinois Commissioner of Banks and Trust Companies and by the Federal Deposit Insurance Corporation. All of the Company's banks are insured by the Federal Deposit Insurance Corporation and each bank is consequently subject to the provisions of the Federal Deposit Insurance Act. The examinations by the various regulatory authorities are designed for the protection of bank depositors and not for bank or holding company stockholders. The federal and state laws and regulations generally applicable to banks regulate, among other things, the scope of their business, their investments, their reserves against deposits, the nature and amount of and collateral for loans, minimum capital requirements and the number of banking offices and activities which may be performed at such offices. Subsidiary banks of a bank holding company are subject to certain restrictions under the Federal Reserve Act and the Federal Deposit Insurance Act on loans and extensions of credit to the bank holding company or to its other subsidiaries, investments in the stock or other securities of the bank holding company or its other subsidiaries, or advances to any borrower collateralized by such stock or other securities. All banks located in Illinois have traditionally been restricted as to the number and geographic location of branches which they may establish. Illinois law was amended in June, 1993, to eliminate all such branching restrictions. Accordingly, banks located in Illinois are now permitted to establish branches anywhere in Illinois without regard to the location of other banks' main offices or the number of branches previously maintained by the bank establishing the branch. Capital Requirements In December 1992, the Federal Reserve Board's final rules for risk- based capital guidelines became effective. These guidelines establish risk-based capital ratios based upon the allocation of assets and specified off-balance sheet commitments into four risk-weighted categories. The guidelines require all bank holding companies and banks to maintain a Tier 1 capital to risk weighted asset ratio of 4% and a total capital to risk weighted asset ratio of 8.00%. In addition to the risk-based capital guidelines, the Federal Reserve Board has adopted the use of a leverage ratio as an additional tool to evaluate the capital adequacy of banks and bank holding companies. The leverage ratio is defined to be a company's "Tier 1" capital divided by its adjusted total assets. The Company and its banking subsidiaries meet or exceed these guidelines as currently defined. Monetary Policy and Economic Conditions The earnings of commercial banks and bank holding companies are affected not only by general economic conditions, but also by the policies of various governmental regulatory authorities. In particular, the Federal Reserve Board influences conditions in the money and capital markets, which affect interest rates and growth in bank credit and deposits. Federal Reserve Board monetary policies have had a significant effect on the operating results of commercial banks in the past and are expected to in the future. Also, assessments from the Bank Insurance Fund, which insures commercial bank deposits, will continue to impact future earnings of the company. Employees As of December 31, 1993, the Company and its subsidiaries had a total of 253 full-time and 65 part-time employees. Item 2.		Item 2. Properties The Company owns a two story office building at 27 West Main Street, Freeport, Illinois which has a total of 13,900 square feet and approximately 5.5 acres of land located at the northeast corner of Lake-Cook Road and Corporate Drive in Riverwoods, Illinois. The land in Riverwoods, Illinois was acquired in 1992 for possible future use as a branch site or denovo bank location. FBN conducts its operations from its offices located in Freeport, Stockton, Rockford, Warren and Mount Carroll, Illinois. Its main office is located at 101 West Stephenson Street, Freeport, Illinois and includes approximately 26,400 square feet. In addition, two other office buildings are attached to the bank's main office by a parking deck. One is occupied by the Commercial Division. The other serves as a drive in facility and operations center. All three buildings including the underlying land, are owned by the Bank. FBN also operates a remote banking facility located approximately 1.5 miles southwest of the Bank's main office in a shopping center. The underlying land is leased by FBN from an unaffiliated party through 1995, and the Bank has an option to renew through 2000. The annual rental payment for the remaining two years is $6,000. FBN conducts its operations in Mount Carroll from its quarters located at 102 E. Market Street, Mount Carroll, Illinois and its drive-in facility located at 315 N. Clay Street (Highway 78), Mount Carroll, Illinois. The main bank building, containing approximately 12,000 square feet, is owned by the bank as is the underlying land. FBN occupies the main floor and most of the basement, with total square footage of approximately 9,000 square feet. The second floor, containing approximately 3,400 square feet, is rented to various professional organizations. The drive-in facility is located approximately one block east of the main office. It houses the drive- in and walk-up facilities as well as a small lobby in a building containing approximately 1,200 square feet. The drive-in facility as well as the underlying land is owned by FBN. FBN conducts its operations in Stockton from its quarters located at 133 W. Front Street, Stockton, Illinois. The office at Stockton includes drive-in facilities and is approximately 8,000 square feet. The building, underlying land and an adjoining 9,000 square foot parking lot are owned by FBN. FBN's office in Warren is located at 135 Main Street, Warren, Illinois. The building, which contains approximately 9,000 square feet is owned and occupied by the bank. The building also houses its wholly owned insurance subsidiary, Premier Insurance Services, Inc. FBN's office in Rockford is located at 2470 Eastrock Drive, Rockford, Illinois. Both the building which contains approximately 2660 square feet and underlying land are leased from an unaffiliated party through June 1994, with an option to renew annually. The Company has not exercised its option to renew in 1994 and is exploring alternatives for relocating its office. FBS conducts its operations from its offices located in Dixon, Polo, and Sterling, Illinois. Its main office is located at 102 Galena Avenue, Dixon, Illinois. The building, which contains approximately 15,000 square feet, is owned and occupied by the bank. The land underlying the building, as well as an adjoining parking lot, are also owned by the bank. FBS conducts its operations in Polo from its quarters located at 101 W. Mason St., Polo, Illinois. Drive-In and Walk-up facilities are part of the building. The building contains approximately 17,000 square feet, and is owned by the bank as is the underlying land. FBS occupies the first floor and the majority of the basement, with total square footage of about 10,000 square feet. The remainder of the basement and the second floor, which contain the remaining 7,000 square feet, are rented to various professional and/or retail organizations. FBS conducts its operations in Sterling from its quarters located at 3014 E. Lincolnway, Sterling, Illinois. Drive-in and Walk-up facilities are part of the building. The building contains approximately 6,800 square feet. Both the building, which is occupied solely by the bank, and the underlying land are owned by FBS. FNBN owns the land and building on which its main office and adjacent drive-through facility are located at 1300 Meadow Road, Northbrook, Illinois. The two story, colonial building and drive- through facility are located on 30,318 square feet of land. The main building consists of 8,035 square feet. This property also includes a satellite parking area with 29 parking spaces. FNBN also owns the land and building located at 2755 West Dundee Road, Northbrook, Illinois, which houses a full-service branch facility. The building consists of 4,913 square feet and is located on 22,500 square feet of land. FNBN leases 16,739 square feet for its Riverwoods branch at Milwaukee and Deerfield Road. FNBN also operates a private banking office located in the corporate headquarters of the Sears Consumer Financial Corporation in Riverwoods, Illinois. The Company is in the process of closing the office. FSBCG conducts its business in Cary from its main office located at Route 45 Highway 14. The main bank building containing approximately 3,500 square feet is owned by the bank as well as the 4 lane drive-through and the underlying land. In addition, there is a parking lot which contains 26,000 square feet of land. FSBCG owns a second banking center located at 3114 Northwest Highway, Cary, Illinois. The building consists of 1,856 square feet, three drive-through lanes and is located on 145,953 square feet. FSBCG is also committed to lease office space at 740-A Industrial Drive, Cary, Illinois through October 31, 1994. The Company does not plan to renew the lease. The Bank had planned to use the space for its operations functions prior to consolidating their back office areas with FNBN. Premier Operating Systems, Inc. conducts the majority of it operations from a two story office building at 110 West Stephenson Street, Freeport, Illinois which has a total of 13,000 square feet. The building and underlying land is owned by Premier Operating Systems, Inc. Item 3.	Item 3. Legal Proceedings Neither the Company nor its subsidiaries are a party to any material legal proceedings, other than routine litigation incidental to the business of the banks as of December 31, 1993. Item 4.	Item 4. Submission of Matters to a Vote of Security Holders No matters, through the solicitation of proxies or otherwise, have been submitted to a vote of security holders for the quarter ended December 31, 1993. PART II Item 5.	Item 5. Market for the Registrant's Common Stock and Related Stockholder Matters The approximate number of Holders of Common Stock as of 12/31/93 was as follows: Title of Class No. of Record Holders Common Stock 658 ($5 Par Value) Other information required by this item is incorporated herein by reference to the Registrant's Annual Report to its shareholders for the year ended December 31, 1993, which is included as an exhibit to this report. Item 6.	Item 6. Selected Financial Data Incorporated herein by reference to the Registrant's Annual Report to its shareholders for the year ended December 31, 1993, which is included as an exhibit to this report. On July 16, 1993, the Company acquired 100% of the common stock of First Northbrook Bancorp, Inc. The acquisition was accounted for as a purchase transaction; accordingly, the assets and liabilities of First Northbrook Bancorp, Inc. were recorded at fair market value on the acquisition date and the results of operations have been included in the consolidated statements of earnings since July 16, 1993. The business combination materially affected the comparability of the information shown on page 26, "Five Year Summary of Selected Data" of the Registrant's Annual Report to its shareholders for the year ended December 31, 1993. For a discussion regarding the business combination see footnote #12 on pages 16 and 17 of Registrant's Annual Report. Item 7.	Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Incorporated by reference to the Registrant's Annual Report to its shareholders for the year ended December 31, 1993, which is included as an exhibit to this report. Submitted herewith is the following supplementary financial information of the registrant for each of the last five years (Unless otherwise stated): Distribution of Assets, Liabilities and Stockholders' Equity Interest Rates and Interest Differential Changes in Interest Margin for each of the last two years Investment Portfolio Maturities of Investments, December 31, 1993 Loan Portfolio Loan Maturities and Sensitivity to Changes in Interest Rates, December 31, 1993 Risk Elements in the Loan Portfolio Summary of Loan Loss Experience Deposits Time Certificates and Other Time Deposits of $100,000 or more as of December 31, 1993 Return on Equity and Assets Short Term Borrowings Item 8.	Item 8. Financial Statements and Supplementary Data The following consolidated financial statements of the Company, which are included in the annual report of the registrant to its stockholders for the year ended December 31, 1993, are submitted herewith as an exhibit, and are incorporated by reference: 1. Consolidated Balance Sheets, December 31, 1993 and 1992 2. Consolidated Statements of Earnings, for the three years ended December 31, 1993 3. Consolidated Statements of Changes in Stockholders' Equity for the three years ended December 31, 1993 4. Consolidated Statements of Cash Flows for the three years ended December 31, 1993 5. Notes to Consolidated Financial Statements 6. Independent Auditors' Report Item 9.	Item 9. Disagreement on Accounting and Financial Disclosure Not Applicable DISTRIBUTION OF ASSETS, LIABILITIES AND STOCKHOLDERS' EQUITY PREMIER FINANCIAL SERVICES, INC. The following table sets forth the registrant's consolidated average daily condensed balance sheet for each of the last five years (dollar figures in thousands): Year Ended December 31 1989 1990 1991 1992 1993 ASSETS: Cash & Non-interest bearing deposits $ 14,026 $ 16,457 $ 15,129 $ 17,162 $30,003 Interest Bearing Deposits 4,684 1,701 1,114 880 1,677 Taxable Investment Securities 119,229 119,804 114,281 95,691 102,323 Non-Taxable Investment Securities 8,087 20,102 26,200 24,374 37,038 Total Investment Securities 127,316 139,906 140,481 120,065 139,361 Trading Account Assets --- 386 773 2,017 --- Federal Funds Sold 13,095 9,390 1,704 656 4,706 Loans (Net) 162,537 169,711 182,975 219,684 273,951 All Other Assets 17,100 17,827 16,755 17,450 32,101 TOTAL ASSETS $338,758 $355,378 $358,931 $377,914 $481,799 LIABILITIES & STOCKHOLDERS EQUITY: Non-Interest Bearing Deposits $ 39,197 $ 36,437 $ 36,118 $ 38,402 $ 66,895 Interest Bearing Deposits 259,978 275,436 244,253 259,271 335,510 Total Deposits 299,175 311,873 280,371 297,673 402,405 Short Term Borrowings 12,713 12,469 49,544 47,556 24,014 Long Term Debt 1,119 4,532 826 --- --- All Other Liabilities & Reserves 4,312 3,500 2,861 2,844 10,785 Stockholders' Equity 21,439 23,004 25,329 29,841 44,595 TOTAL LIABILITIES & EQUITY $338,758 $355,378 $358,931 $377,914 $481,799 INTEREST RATES AND INTEREST DIFFERENTIAL PREMIER FINANCIAL SERVICES, INC. The following table sets forth the registrant's interest earned or paid, as well as the average yield or average rate paid on each of the major interest earning assets and interest bearing liabilities for each of the last five years (dollar figures are in thousands): Year Ended December 31 1989 1990 1991 1992 1993 Interest Earned: Interest Bearing Deposits Interest Earned $ 398 $ 144 $ 94 $ 68 $ 104 Average Yield 8.50% 8.47% 8.43% 7.73% 6.20% Taxable Investment Securities Interest Earned 9,928 10,234 9,387 6,691 6,077 Average Yield 8.33% 8.54% 8.21% 6.99% 5.94% Non-Taxable Investment Securities (taxable equivalent) (1) Interest Earned 792 1,961 2,593 2,418 3,080 Average Yield 9.79% 9.76% 9.89% 9.92% 8.32% Trading Account Assets Interest Earned --- 31 58 151 --- Average Yield --- 8.03% 7.50% 7.49% --- Federal Funds Sold Interest Earned 1,193 768 88 25 133 Average Yield 9.11% 8.18% 5.16% 3.81% 2.83% Loans (Excluding Unearned Discount & Non Accrual Loans) (taxable equivalent) (1) Interest & Fees Earned (2) 18,517 19,226 19,357 19,860 22,262 Average Yield (3) 11.34% 11.21% 10.56% 9.06% 8.13% Interest Paid: Interest Bearing Deposits Interest Paid 17,636 18,464 14,358 11,559 11,461 Average Effective Rate Paid 6.78% 6.70% 5.87% 4.46% 3.42% Borrowed Funds Interest Paid 1,359 968 2,921 1,800 1,289 Average Effective Rate Paid 10.69% 7.76% 5.89% 3.79% 5.37% Long Term Debt Interest Paid 118 465 88 --- --- Average Effective Rate Paid 10.50% 10.26% 10.65% --- --- Margin Between Rates Earned and Rates Paid: All Interest Earnings Assets (taxable equivalent) Interest & Fees Earned 30,828 32,364 31,577 29,213 31,656 Average Yield 10.00% 10.02% 9.65% 8.52% 7.55% All Interest Bearing Liabilities Interest Paid 19,113 19,898 17,367 13,359 12,750 Average Effective Rate Paid 6.98% 6.80% 5.89% 4.35% 3.55% Net Interest Earned 11,715 12,466 14,210 15,854 18,906 Net Yield 3.77% 3.86% 4.34% 4.62% 4.43% (1) Yields on tax exempt securities and loans are full tax equivalent yields at 34%. (2) Includes fees of $247, $255, $548, $568 and $718 for 1989 through 1993 respectively. (3) There were no material out-of-period adjustments or foreign activities for any reportable period. CHANGES IN INTEREST MARGIN PREMIER FINANCIAL SERVICES, INC. The following table sets forth the registrant's dollar amount of change in interest earned on each major interest earning assets and the dollar amount of change in interest paid on each major interest bearing liabilities, as well as the portion of such changes attributable to changes in rate and changes in volume for each of the last two years (Dollar figures in thousands): Increase (Decrease) 1992 over 1991 1993 over 1992 Rate Volume Rate Volume Changes in Interest Earned: Interest Bearing Deposits $ (8) $ (18) (16) 52 Taxable Investment Securities (1,287) (1,409) (1,055) 441 Non-taxable Investment Securities (taxable equivalent) 8 (183) (438) 1,100 Trading Account Assets --- 93 --- (151) Fed Funds Sold (19) (44) (8) 116 Loans (net) (2,982) 3,485 (2,185) 4,587 Total $(4,288) $1,924 $ (3,702) 6,145 Changes in Interest Paid: Interest Bearing Deposits $(3,633) $ 834 (3,051) 2,953 Short Term Borrowings (1,008) (113) 581 (1,092) Long Term Debt --- (88) --- --- Total $(4,641) 633 (2,470) 1,861 Changes in Interest Margin $ 353 $1,291 $ (1,232) $4,284 Changes attributable to rate/volume, i.e., changes in the interest margin which occurred because of a combination rate/volume change and cannot be attributed solely to a rate change or a volume change, are apportioned between rate and volume as follows: 1. Percentage rate increases (decreases) in rate and in volume were calculated for each major interest earning asset and interest bearing liability based upon their year-to-year change. 2. The percentage rate changes in rate and in volume were then allocated proportionately in relationship to 100%. 3. The proportionate allocations were applied to the total rate/volume change. INVESTMENT PORTFOLIO PREMIER FINANCIAL SERVICES, INC. The following table sets forth the registrant's book values of investments in obligations of the U.S. Treasury Government Agencies and Corporations, State and Political Subdivisions (U.S.), and other securities for each of the last five years (dollar figures in thousands): 1989 1990 1991 1992 1993 U.S. Treasury and U.S. Agency Securities $104,252 $114,485 $ 89,825 $ 77,897 $140,725 Obligations of States and Political Subdivisions 16,151 26,145 25,258 24,358 36,693 Other Securities 16,308 16,425 10,308 3,580 3,068 Total $136,711 $157,055 $125,391 $105,835 $180,486 The following table sets forth the registrant's book values of investments in obligations of the U.S. Treasury, U.S. Government Agencies and Corporations, State and Political Subdivisions (U.S.), and other securities as of December 31, 1993 by maturity and also sets forth the weighted average yield for each range of maturities. Obligations of U.S. Treasury States and Weighted and U.S. Agency Political Other Average Book Value: Securities Subdivision Securities Yield One Year or Less $ 26,650 $ 5,543 $ 274 4.87% After One Year to Five Years 94,916 23,967 284 6.55% After Five Years to Ten Years 5,671 6,238 --- 9.20% Over Ten Years 13,488 945 2,510 10.17% Total $ 140,725 $ 36,693 $ 3,068 6.76% (1) Weighted Average Yields were calculated as follows: 1. The weighted average yield for each category in the portfolio was calculated based upon the maturity distribution shown in the table above. 2. The yields determined in step 1 were weighted in relation to the total investments in each maturity range shown in the table above. (2) Yields on tax exempt securities are full tax equivalent yields at a 34% rate. (3) At December 31, 1993 the Company did not own any Obligation of a State or Political Subdivision or Other Security which was greater than 10% of its total equity capital. LOAN PORTFOLIO PREMIER FINANCIAL SERVICES, INC. The following table sets forth the registrant's Loan Portfolio by major category for each of the last five years (dollar figures in thousands): Year Ended December 31 1989 1990 1991 1992 1993 Commercial & Financial Loans $ 56,773 $ 56,043 $ 83,777 $ 88,341 $121,514 Agricultural Loans 25,308 38,738 32,428 45,924 40,972 Real Estate - Residential Mortgage Loans 54,112 56,980 66,256 54,728 103,234 Real Estate - Other 12,551 10,130 18,289 16,904 35,832 Loans to Individuals 16,004 16,185 13,364 13,268 29,728 Other Loans 30 1,857 859 980 625 164,778 179,933 214,973 220,145 331,905 Less: Unearned Discount 200 223 231 182 518 Allowance for Possible Loan Losses 3,477 3,160 3,202 2,713 4,369 Net Loans $161,101 $176,550 $211,540 $217,250 $327,018 The following tables set forth the registrant's loan maturity distribution for certain major categories of loans as of December 31, 1993 (dollar figures in thousands). AMOUNT DUE IN 1 Year or Less 1-5 Years After 5 Years Commercial & Financial Loans $ 66,089 $ 51,875 $ 3,550 Agricultural Loans 18,176 17,583 5,213 Real Estate - Other Loans 15,964 16,973 2,895 Total $ 100,229 $ 86,431 $ 11,658 As of December 31, 1993 loans totaling $67,715,000, which are due after one year have predetermined interest rates, while $30,374,000 of loans due after one year have floating interest rates. RISK ELEMENTS IN THE LOAN PORTFOLIO PREMIER FINANCIAL SERVICES, INC. The Company's financial statements are prepared on the accrual basis of accounting, and substantially all of the loans currently accruing interest are accruing at the rate contractually agreed upon when the loan was negotiated. When in the judgement of management the timely receipt of interest payments on a loan is doubtful, it is the Company's policy to cease the accrual of interest thereon and to recognize income on a cash basis when payments are received, unless there is adequate collateral or other substantial basis for continued accrual of interest. An exception is made in the case of consumer installment and charge card loans; such loans are not placed on a cash basis and all interest accrued thereon is charged against income at the time a loan is charged off. At the time a loan is placed in non-accrual status all interest accrued in the current year but not yet collected is reversed against current interest income. Troubled debt restructurings (renegotiated loans) are loans on which interest is being accrued at less than the original contractual rate of interest because of the inability of the borrower to service the obligation under the original terms of the agreement. Income is accrued at the renegotiated rate so long as the borrower is current under the revised terms and conditions of the agreement. Other Real Estate is real estate, sales contracts, and other assets acquired because of the inability of the borrower to serve the obligation of a previous loan collateralized by such assets. The following table sets forth the registrant's non-accrual, past due, and renegotiated loans, and other Real Estate for each of the last five years (dollar figures in thousands): Year Ended December 31 1989 1990 1991 1992 1993 Non-accrual Loans $ 1,908 $ 156 $ 3,683 $ 2,915 $ 5,791 Loans Past Due 90 days or More 1,074 946 501 152 5,151 Renegotiated Loans 1,115 372 314 288 523 Other Real Estate 350 210 48 153 1,749 Total $ 4,447 $ 1,684 $ 4,546 $ 3,508 $13,214 In addition to the non-performing loans shown above the registrant from time-to-time has certain loans which although not currently non-performing are potential problem loans. Potential problem loans are those for which there are serious doubts as to the ability of the borrowers to comply with present loan repayment terms. As of December 31, 1993 loans considered potential problem loans were not material. The registrant had no foreign loans outstanding in any of the reported periods. The following table sets forth interest information for certain non- performing loans for the year ended December 31, 1993 (dollar figures in thousands): Non-Accrual Loans Renegotiated Loans Balance December 31, 1993 $ 5,791 $ 523 Gross interest income that would have been recorded if the loans had been current in accordance with their original terms 471 57 Amount of interest included in net earnings. 55 47 SUMMARY OF LOAN LOSS EXPERIENCE PREMIER FINANCIAL SERVICES, INC. The Company and its subsidiary banks have historically evaluated the adequacy of their Allowance for Possible Loan Losses on an overall basis, and the resulting provision charged to expense has similarly been determined in relation to management's evaluation of the entire loan portfolio. In determining the adequacy of its Allowance for Possible Loan Losses, management considers such factors as the size, composition and quality of the loan portfolio, historical loss experience, current loan losses, current potential risks, economic conditions, and other risks inherent in the loan portfolio. Because the Company has historically evaluated its Allowance for Loan Losses on an overall basis, the Allowance has not been allocated by category. The allocation shown in the table below, encompassing the major segments of the loan portfolio judged most informative by management, represents only an estimate for each category of loans based upon historical loss experience and management's judgement of amounts deemed reasonable to provide for the possibility of losses being incurred within each category. Approximately 24% remain unallocated as a general valuation reserve for the entire portfolio to cover unexpected variations from historical experience in individual categories. The following table sets forth the registrant's loan loss experience for each of the last five years (dollar figures in thousands): Commercial & Real Loans to Agricultural Estate Individuals Other Unallocated Total Year Ended 12/31/93: Loans-year End (Gross) $162,486 $139,066 $29,728 $ 625 --- $331,905 Average Loans (Gross) 148,376 107,254 21,498 800 --- 277,928 Allowance for Loan Losses (Beginning of Year) 1,062 853 77 21 700 2,713 Allowance from Acquired Entities 750 750 500 --- 351 2,351 Loans Charged Off 1,845 546 129 --- --- 2,520 Recoveries - Loans Previously Charged Off 138 --- 67 --- --- 205 Net Loan Losses (Recoveries) 1,707 546 62 --- --- 2,315 Operating Expense Provision 1,000 550 70 --- --- 1,620 Allowance For Loan Losses (Year End) 1,105 1,607 585 21 1,051 4,369 Ratios: Loans in Category to Total Loans 48.96% 41.90% 8.96% .18% --- 100% Net Loan Losses (Recoveries) to Average Loans 1.15% .51% .29% --- --- .83% Commercial & Real Loans to Agricultural Estate Individuals Other Unallocated Total Year Ended 12/31/92: Loans-year End (Gross) $ 134,265 $ 71,632 $ 13,268 $ 980 $ --- $220,145 Average Loans (Gross) 129,764 77,851 13,976 1,041 --- 222,632 Allowance for Loan Losses (Beginning of Year) 1,553 832 97 21 700 3,203 Loans Charged Off 925 9 124 --- --- 1,058 Recoveries - Loans Previously Charged Off 159 30 54 --- --- 243 Net Loan Losses (Recoveries) 766 (21) 70 --- --- 815 Operating Expense Provision 275 --- 50 --- --- 325 Allowance For Loan Losses (Year End) 1,062 853 77 21 700 2,713 Ratios: Loans in Category to Total Loans 60.99% 32.54% 6.03% .44% --- 100% Net Loan Losses (Recoveries) to Average Loans .59% (.03%) .50% --- --- .37% Commercial & Real Loans to Agricultural Estate Individuals Other Unallocated Total Year Ended 12/31/91: Loans-year End (Gross) $ 116,205 $ 84,545 $ 13,364 $ 859 $ --- $214,973 Average Loans (Gross) 101,545 69,453 13,873 1,500 --- 186,371 Allowance for Loan Losses (Beginning of Year) 1,394 837 208 21 700 3,160 Loans Charged Off 337 36 165 --- --- 538 Recoveries - Loans Previously Charged Off 496 31 54 --- --- 581 Net Loan Losses (Recoveries) (159) 5 111 --- --- (43) Operating Expense Provision --- --- --- --- --- --- Allowance For Loan Losses (Year End) 1,553 832 97 21 700 3,203 Ratios: Loans in Category to Total Loans 54.06% 39.32% 6.22% .40% --- 100% Net Loan Losses (Recoveries) to Average Loans (.16%) .01% .80% --- --- (.02%) Commercial & Real Loans to Agricultural Estate Individuals Other Unallocated Total Year Ended 12/31/90: Loans-year End (Gross) $ 94,781 $ 67,110 $ 16,185 $ 1,857 $ --- $179,933 Average Loans (Gross) 88,431 66,887 15,789 2,204 --- 173,311 Allowance for Loan Losses (Beginning of Year) 1,647 824 285 21 700 3,477 Loans Charged Off 712 58 120 --- --- 890 Recoveries - Loans Previously Charged Off 459 71 43 --- --- 573 Net Loan Losses (Recoveries) 253 (13) 77 --- --- 317 Operating Expense Provision --- --- --- --- --- --- Allowance For Loan Losses (Year End) 1,394 837 208 21 700 3,160 Ratios: Loans in Category to Total Loans 52.68% 37.30% 9.00% 1.02% --- 100% Net Loan Losses (Recoveries) to Average Loans .29% (.02%) .49% --- --- .18% Commercial & Real Loans to Agricultural Estate Individuals Other Unallocated Total Year Ended 12/31/89: Loans-year End (Gross) $ 82,081 $ 66,663 $ 16,004 $ 30 $ --- $164,778 Average Loans (Gross) 81,908 66,273 20,184 2,311 --- 166,054 Allowance for Loan Losses (Beginning of Year) 1,181 830 301 21 700 3,033 Loans Charged Off 95 124 80 --- --- 299 Recoveries - Loans Previously Charged Off 561 118 64 --- --- 743 Net Loan Losses (Recoveries) (466) 6 16 --- --- (444) Operating Expense Provision --- --- --- --- --- --- Allowance For Loan Losses (Year End) 1,647 824 285 21 700 3,477 Ratios: Loans in Category to Total Loans 49.81% 40.46% 9.71% .02% --- 100% Net Loan Losses (Recoveries) to Average Loans (.57%) .01% .08% --- --- (0.27%) DEPOSITS PREMIER FINANCIAL SERVICES, INC. The following table sets forth the registrant's average daily deposits for each of the last five years (dollar figures in thousands): Year Ended December 31 1989 1990 1991 1992 1993 Demand Deposits (Non- Interest Bearing) $ 39,197 $ 36,437 $ 36,119 $ 38,402 $66,895 Demand Deposits (Interest Bearing) 34,977 32,948 38,194 44,772 57,937 Savings Deposits 75,155 71,821 67,456 73,684 95,351 Time Deposits 149,846 170,667 138,603 140,815 182,222 Deposits in Foreign Bank Offices None None None None None TOTAL DEPOSITS $299,175 $311,873 $280,372 $297,673 $402,405 The following table sets forth the average rate paid on interest bearing deposits by major category for each of the last five years (dollar figures in thousands): Year Ended December 31 1989 1990 1991 1992 1993 Demand Deposits (Interest Bearing) 5.00% 5.26% 4.83% 3.67% 2.41% Savings Deposits 6.26% 5.45% 4.89% 3.52% 2.74% Time Deposits 7.47% 7.50% 6.65% 5.20% 4.09% TIME CERTIFICATE OF DEPOSIT/TIME DEPOSITS OF $100,000 OR MORE PREMIER FINANCIAL SERVICES, INC. The following table sets for the registrant's maturity distribution for all time deposits of $100,000 or more as of December 31, 1993 (in thousands): Maturity Amount Outstanding 3 months or less $ 9,583 3 through 6 months 9,936 6 through 12 months 4,970 Over 12 months 6,353 TOTAL $ 30,842 RETURN ON EQUITY AND ASSETS PREMIER FINANCIAL SERVICES, INC. The following table sets forth the registrant's return on average assets, return on average equity, dividend payout ratio, and average equity to average asset ratio for each of the last five years: Year Ended December 31 1989 1990 1991 1992 1993 Return on Average Assets .69% .81% 1.01% 1.15% .83% Return of Average Common Equity 10.92% 12.53% 14.29% 14.58% 10.80% Return on Average Equity 10.92% 12.53% 14.29% 14.58% 8.99% Dividend Payout Ratio 17.09% 16.32% 16.75% 19.73% 29.27% Average Equity to Average Asset Ratio 6.33% 6.47% 7.06% 7.90% 9.26% SHORT TERM BORROWINGS PREMIER FINANCIAL SERVICES, INC. The following table sets forth a summary of the registrant's short- term borrowings for each of the last five years (dollar figures in thousands): Year Ended December 31 1989 1990 1991 1992 1993 Balance at End of Period: Federal Funds Purchased $ 1,562 $ 4,272 $ 14,241 $ 4,272 $ --- Securities Sold Under Repurchase Agreements 2,757 50,534 43,688 14,854 20,571 Notes Payable to Banks 3,300 1,030 260 1,880 12,410 Other 2,500 2,000 --- --- --- TOTAL $ 10,119 $ 57,836 $ 58,189 $21,006 $32,981 Weighted Average Interest Rate at the end of Period: Federal Funds Purchased 8.26% 7.68% 4.75% 3.53% --- Securities Sold Under Repurchase Agreements 7.15% 7.19% 4.53% 3.79% 2.76% Notes Payable to Banks 10.00% 10.00% 6.50% 6.00% 6.00% Other 7.00% 6.50% --- --- --- Highest Amount Outstanding at Any Month-End: Federal Funds Purchased $ 3,368 $ 7,072 $ 14,241 $16,614 $18,535 Securities Sold Under Repurchase Agreements 3,082 50,534 47,033 45,557 23,952 Notes Payable to Banks 8,550 3,300 1,115 1,880 17,500 Other 2,500 2,380 2,000 --- --- Average Outstanding During the Year: Federal Funds Purchased $ 1,759 $ 2,737 $ 6,305 $10,715 8,534 Securities Sold Under Repurchase Agreements 2,221 8,187 42,320 36,073 15,480 Notes Payable to Banks 8,476 1,370 760 768 7,362 Other 103 176 160 --- --- Weighted Average Interest Rate During the Year: Federal Funds Purchased 9.11% 8.00% 5.78% 3.93% 3.30% Securities Sold Under Repurchase Agreements 7.38% 7.31% 5.87% 3.74% 3.58% Notes Payable to Banks 11.18% 10.17% 8.63% 6.12% 6.14% Other 7.00% 6.75% 6.40% --- --- PART III Item 10.	Item 10. Directors and Executive Officers of the Registrant Incorporated herein by reference to the Registrant's Proxy Statement dated March 25, 1994 in connection with its annual meeting to be held on April 28, 1994. Item 405 of Regulation S-K calls for disclosure of any known late filing or failure by an insider to file a report required by Section 16 of the Exchange Act. This disclosure is contained in the Registrant's Proxy Statement dated March 25, 1994 on page 20 under the Section "Compliance with Section 16 (a) of the Exchange Act" and is incorporated herein by reference in this Annual Report on Form 10-K. Item 11.	Item 11. Executive Compensation Incorporated herein by reference to the Registrant's Proxy Statement dated March 25, 1994, in connection with its annual meeting to be held on April 28, 1994. Item 12.	Item 12. Security Ownership of Certain Beneficial Owners and Management Incorporated herein by reference to the Registrant's Proxy Statement dated March 25, 1994, in connection with its annual meeting to be held on April 28, 1994. Item 13.	Item 13. Certain Relationships and Related Transactions Incorporated herein by reference to the Registrant's Proxy Statement dated March 25, 1994 in connection with its annual meeting to be held on April 28, 1994. PART IV Item 14.	Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K 1. The following documents are filed as a part of this report: A. Consolidated Financial Statements of the Company which are included in the annual report of the registrant to its stock- holders for the year ended December 31, 1993 as follows: 1. Consolidated Balance Sheets, December 31, 1993 and 1992 2. Consolidated Statements of Earnings, for the three years ended December 31, 1993. 3. Consolidated Statements of Cash Flows, for the three years ended December 31, 1993. 4. Consolidated Statements of Changes in Stockholders' Equity, for the three years ended December 31, 1993. 5. Independent Auditors' Report 6. Notes to Consolidated Financial Statements B. Financial Statement Schedules as follows: Schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission have been omitted because they are not required under the related instructions or the required information as set forth in the financial statements and related notes. C. Exhibits as follows: 13. Premier Financial Services, Inc. Annual Report for 1993. 21. Subsidiaries of the Registrant. 22. Published report regarding matters submitted to vote of security holders. See previous filing submitted on March 21, 1994. 23. Consents of Experts and Counsel. 99. Premier Financial Services, Inc. Stock and Savings Plan Form 11-K Annual Report for the Fiscal Year ended December 31, 1993. 2. Reports on Form 8-K The registrant has not filed a report on Form 8-K, during the quarter ended December 31, 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Premier Financial Services, Inc. Richard L. Geach By: Richard L. Geach, President Chief Executive Officer and Director Date: March 24, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated. D. L. Murray Donald E. Bitz By: D. L. Murray, Executive Vice President Chief Financial Officer and Director Date: March 24, 1994 Date: March 24, 1994 R. Gerald Fox Charles M. Luecke Date: March 24, 1994 Date: March 24, 1994 Joseph C. Piland H. Barry Musgrove Date: March 24, 1994 Date: March 24, 1994 H. L. Fenton E. G. Maris Date: March 24, 1994 Date: March 24, 1994
19722_1993.txt	19722	1993	ITEM 1. BUSINESS GENERAL Bell Atlantic - Maryland, Inc. (formerly The Chesapeake and Potomac Telephone Company of Maryland) (the "Company") is incorporated under the laws of the State of Maryland and has its principal offices at 1 East Pratt Street, Baltimore, Maryland 21202 (telephone number 410-539-9900). The Company is a wholly owned subsidiary of Bell Atlantic Corporation ("Bell Atlantic"), which is one of the seven regional holding companies ("RHCs") formed in connection with the court- approved divestiture (the "Divestiture"), effective January 1, 1984, of those assets of the American Telephone and Telegraph Company ("AT&T") related to exchange telecommunications, exchange access functions, printed directories and cellular mobile communications. The Company presently serves a territory consisting of two complete and parts of two other Local Access and Transport Areas ("LATAs"). These LATAs are generally centered on a city or based on some other identifiable common geography and, with certain limited exceptions, each LATA marks the boundary within which the Company may provide telephone service. The Company provides two basic types of telecommunications services. First, the Company transports telecommunications traffic between subscribers located within the same LATA ("intraLATA service"), including both local and toll services. Local service includes the provision of local exchange ("dial tone"), local private line and public telephone services (including dial tone service for pay telephones owned by the Company and other pay telephone providers). Among other local services provided are Centrex (telephone company central office-based switched telephone service enabling the subscriber to make both intercom and outside calls) and a variety of special and custom calling services. Toll service includes message toll service (calling service beyond the local calling area) within LATA boundaries, and intraLATA Wide Area Toll Service (WATS)/800 services (volume discount offerings for customers with highly concentrated demand). Second, the Company provides exchange access service, which links a subscriber's telephone or other equipment to the transmission facilities of interexchange carriers which, in turn, provide telecommunications service between LATAs ("interLATA service") to their customers. See "Line of Business Restrictions". The Company also provides exchange access service to interexchange carriers which provide intrastate intraLATA long distance telecommunications service. See "Competition - IntraLATA Toll Competition". The communications industry is currently undergoing fundamental changes driven by the accelerated pace of technological innovation, the convergence of the telecommunications, cable television, information services and entertainment businesses, and a regulatory environment in which many traditional regulatory barriers are being lowered and competition permitted or encouraged. Although no definitive prediction can be made of the market opportunities these changes will present or whether Bell Atlantic and its subsidiaries, including the Company, will be able successfully to take advantage of these opportunities, Bell Atlantic is positioning itself to be a leading communications, information services and entertainment company. OPERATIONS During 1993, Bell Atlantic reorganized certain functions formerly performed by each of the seven Bell System operating companies ("BOCs") transferred to it pursuant to the Divestiture, including the Company (collectively, the "Network Services Companies"), into nine lines of business ("LOBs") organized across the Network Services Companies around specific market segments. The Network Services Companies, however, remain responsible within their respective service areas for the provision of telephone services, for financial performance and for regulatory matters. The nine LOBs are: BELL ATLANTIC - MARYLAND, INC. The Consumer Services LOB markets communications services to residential ----------------- customers within the service territories of the Network Services Companies, including the service territory of the Company, and plans in the future to market information services and entertainment programming. The Carrier Services LOB markets (i) switched and special access to the ---------------- Company's local exchange network, and (ii) billing and collection services, including recording, rating, bill processing and bill rendering. The principal customers of this LOB are interexchange carriers; AT&T is the largest single customer. Other customers include business customers and government agencies with their own special access network connections, wireless customers and other local exchange carriers ("LECs") which resell network connections to their own customers. The Small Business Services LOB markets communications and information ----------------------- services to small businesses (customers having up to 20 access lines or 100 Centrex lines). The Large Business Services LOB markets communications and information ----------------------- services to large businesses (customers having more than 20 access lines or more than 100 Centrex lines). These services include voice switching/processing services (e.g., dedicated private lines, custom Centrex, call management and voice messaging), end-user networking (e.g., credit and debit card transactions, and personal computer-based conferencing, including data and video), internetworking (establishing links between the geographically disparate networks of two or more companies or within the same company), network integration (integrating multiple geographically disparate networks into one system), network optimization (disaster avoidance, 911, intelligent vehicle highway systems), video services (distance learning, telemedicine, surveillance, videoconferencing) and integrated multi-media applications services. The Directory Services LOB manages the provision of (i) advertising and ------------------ marketing services to advertisers, and (ii) listing information (e.g., White Pages and Yellow Pages). These services are currently provided primarily through print media, but the Company expects that use of electronic formats will increase in the future. In addition, the Directory Services LOB manages the provision of photocomposition, database management and other related products and services to publishers. The Public and Operator Services LOB markets pay telephone and operator ---------------------------- services in the service territories of the Network Services Companies to meet consumer needs for accessing public networks, locating and identifying network subscribers, providing calling assistance and arranging billing alternatives (e.g., calling card, collect and third party calls). The Federal Systems LOB markets communications and information technology and --------------- services to departments, agencies and offices of the executive, judicial and legislative branches of the federal government. The Information Services LOB has been established to provide programming -------------------- services, including on-demand entertainment, transactions and interactive multimedia applications within the Territory and in selected other markets. See "FCC Regulation and Interstate Rates - Telephone Company Provision of Video Dial Tone and Video Programming". The Network LOB manages the technologies, services and systems platforms ------- required by the other eight LOBs and the Network Services Companies, including the Company, to meet the needs of their respective customers, including, without limitation, switching, feature development and on-premises installation and maintenance services. The Company has been making and expects to continue to make significant capital expenditures on its networks to meet the demand for communications services and to further improve such services. Capital expenditures of the Company were approximately $398 million in 1991, $369 million in 1992, and $349 million in 1993. Total investment of the Company in plant, property and equipment decreased from approximately $5.04 billion at December 31, 1991 to approximately $4.90 billion at December 31, 1992, and increased to approximately $5.10 billion at December 31, 1993, in each case after giving effect to retirements, but before deducting accumulated depreciation at such date. BELL ATLANTIC - MARYLAND, INC. The Company is projecting construction expenditures for 1994 at approximately $408 million. However, subject to regulatory approvals, the Network Services Companies, including the Company, plan to allocate capital resources to the deployment of broadband network platforms (technologies ultimately capable of providing a switched facility for access to and transport of, high-speed data services, video-on-demand, and image and interactive multimedia applications). Most of the funds for these expenditures are expected to be generated internally. Some additional external financing may be necessary or desirable. LINE OF BUSINESS RESTRICTIONS The consent decree entitled "Modification of Final Judgment" ("MFJ") approved by the United States District Court for the District of Columbia (the "D.C. District Court") which, together with the Plan of Reorganization ("Plan") approved by the D.C. District Court set forth the terms of Divestiture also established certain restrictions on the post-Divestiture activities of the RHCs, including Bell Atlantic. The MFJ's principal restrictions on post-Divestiture RHC activities included prohibitions on (i) providing interexchange telecommunications, (ii) providing information services, (iii) engaging in the manufacture of telecommunications equipment and customer premises equipment ("CPE"), and (iv) entering into any non-telecommunications businesses, in each case without the approval of the D.C. District Court. Since Divestiture, the D.C. District Court has retained jurisdiction over the construction, modification, implementation and enforcement of the MFJ. In September 1987, the D.C. District Court rendered a decision which eliminated the need for the RHCs to obtain its approval prior to entering into non-telecommunications businesses. However, the D.C. District Court refused to eliminate the restrictions relating to equipment manufacturing or providing interexchange services. With respect to information services, the Court issued a ruling in March 1988 which permitted the RHCs to engage in a number of information transport functions as well as voice storage and retrieval services, including voice messaging, electronic mail and certain information gateway services. However, the RHCs were generally prohibited from providing the content of the data they transmitted. As the result of an appeal of the D.C. District Court's September 1987 and March 1988 decisions by the RHCs and other parties, the United States Court of Appeals for the District of Columbia Circuit ordered the D.C. District Court to reconsider the RHCs' request to provide information content and determine whether removal of the restrictions thereon would be in the public interest. In July 1991, the D.C. District Court removed the remaining restrictions on RHC participation in information services, but imposed a stay pending appeal of that decision. In October 1991, the United States Court of Appeals for the District of Columbia Circuit vacated the stay, thereby permitting the RHCs to provide information services, and in May 1993 affirmed the D.C. District Court's July 1991 decision. The United States Supreme Court denied certiorari in November 1993. Several bills have been introduced in the current session of Congress pursuant to which the line of business restrictions established by the MFJ could be eliminated or modified. No definitive prediction can be made as to whether or when any such legislation will be enacted, the provisions thereof or their impact on the business or financial condition of the Company. FCC REGULATION AND INTERSTATE RATES The Company is subject to the jurisdiction of the Federal Communications Commission ("FCC") with respect to interstate services and certain related matters. The FCC prescribes a uniform system of accounts for telephone companies, interstate depreciation rates and the principles and standard procedures used to separate plant investment, expenses, taxes and reserves between those applicable to interstate services under the jurisdiction of the FCC and those applicable to intrastate services under the jurisdiction of the respective state regulatory authorities ("separations procedures"). The FCC also prescribes procedures for allocating costs and revenues between regulated and unregulated activities. BELL ATLANTIC - MARYLAND, INC. Interstate Access Charges The Company provides intraLATA service and does not participate in the provision of interLATA service except through offerings of exchange access service. The FCC has prescribed structures for exchange access tariffs to specify the charges ("Access Charges") for use and availability of the Company's facilities for the origination and termination of interstate interLATA service. Access Charges are intended to recover the related costs of the Company which have been allocated to the interstate jurisdiction ("Interstate Costs") under the FCC's separations procedures. In general, the tariff structures prescribed by the FCC provide that Interstate Costs of the Company which do not vary based on usage ("non-traffic sensitive costs") are recovered from subscribers through flat monthly charges ("Subscriber Line Charges"), and from interexchange carriers through usage- sensitive Carrier Common Line ("CCL") charges. See "FCC Regulation and Interstate Rates - FCC Access Charge Pooling Arrangements". Traffic-sensitive Interstate Costs are recovered from carriers through variable access charges based on several factors, primarily usage. In May 1984, the FCC authorized the implementation of Access Charge tariffs for "switched access service" (access to the local exchange network) and of Subscriber Line Charges for multiple line business customers (up to $6.00 per month per line). In 1985, the FCC authorized Subscriber Line Charges for residential and single-line business customers at the rate of $1.00 per month per line, which increased in installments to $3.50 effective April 1, 1989. As a result of the phasing in of Subscriber Line Charges, a substantial portion of non-traffic sensitive Interstate Costs is now recovered directly from subscribers, thereby reducing the per-minute CCL charges to interexchange carriers. This significant reduction in CCL charges has tended to reduce the incentive for interexchange carriers and their high-volume customers to bypass the Company's switched network via special access lines or alternative communications systems. However, competition for this access business has increased in recent years. See "Competition - Alternative Access and Local Services". FCC Access Charge Pooling Arrangements The FCC previously required that all LECs, including the Company, pool revenues from CCL and Subscriber Line Charges that cover the non-traffic sensitive costs of the local exchange network, that is, the Interstate Costs associated with the lines from subscribers' premises to telephone company central offices. To administer such pooling arrangements, the FCC mandated the formation of the National Exchange Carrier Association, Inc. Some LECs received more revenue from the pool than they billed their interexchange carrier customers using the nationwide average CCL rate. Other companies, including the Company, received substantially less from the pool than the amount billed to their interexchange carrier customers. By an order adopted in 1987, the FCC changed its mandatory pooling requirements. These changes, which became effective April 1, 1989, permitted all of the Network Services Companies as a group to withdraw from the pool and to charge CCL rates which more closely reflect their non-traffic sensitive costs. The Network Services Companies, including the Company, are still obligated to make contributions of CCL revenues to companies who choose to continue to pool non-traffic sensitive costs so that the pooling companies can charge a CCL rate no greater than the nationwide average CCL rate. In addition to this continuing obligation, the Network Services Companies, including the Company, have a transitional support obligation to high cost companies who left the pool in 1989 and 1990. This transitional support obligation phases out over five years. These long-term and transitional support requirements will be recovered in the Network Services Companies' (including the Company's) CCL rates. BELL ATLANTIC - MARYLAND, INC. Depreciation Depreciation rates provide for the recovery of the Company's investment in telephone plant and equipment, and are revised periodically to reflect more current estimates of remaining service lives and future net salvage values. In October 1993, the FCC issued an order simplifying the depreciation filing process by reducing the information required for certain categories of plant and equipment whose remaining service life, salvage estimates and depreciation ratio fall within an approved range. Petitions for reconsideration of that order were filed in December 1993. In November 1993, the FCC issued a further order inviting comments on proposed ranges for an initial group of categories of plant and equipment. Price Caps In September 1990, the FCC adopted "price cap" regulation to replace the traditional rate of return regulation of LECs. LEC price cap regulation became effective on January 1, 1991. The price cap system places a cap on overall prices for interstate services and requires that the cap decrease annually, in inflation-adjusted terms, by a fixed percentage which is intended to reflect expected increases in productivity. The price cap level can also be adjusted to reflect "exogenous" changes, such as changes in FCC separations procedures or accounting rules. LECs subject to price caps have somewhat increased flexibility to change the prices of existing services within certain groupings of interstate services, known as "baskets". Under the price cap regulation, the FCC set an authorized rate of return of 11.25% for the years 1991 and beyond. To the extent that a company is able to earn a higher rate of return through improved efficiency, the FCC's price cap rules permit them to retain the full amount of this higher return up to 100 basis points above the authorized rate of return (currently, up to a 12.25% rate of return). If a company's rate of return is between 100 and 500 basis points above the authorized rate of return (that is, currently, between 12.25% and 16.25%), the company must share 50% of the earnings above the 100-basis-point level with customers by reducing rates prospectively. All earnings above the 500-basis-point level must be returned to customers in the form of prospective rate decreases. If, on the other hand, a company's rate of return is more than 100 basis points below the authorized rate of return (that is, currently, below 10.25%), the company is permitted to increase rates prospectively to make up the deficiency. Under FCC-approved tariffs, the Network Services Companies are charging uniform rates for interstate access services (with the exception of Subscriber Line Charges) throughout their service areas and are regarded as a single unit by the FCC for rate of return measurement. On February 16, 1994, the FCC initiated a rulemaking proceeding to determine the effectiveness of LEC price cap rules and decide what changes, if any, should be made to those rules. This rulemaking is expected to be concluded by the end of 1994. In January 1993, the FCC denied the Company exogenous treatment of the increased expense for postretirement benefits required under Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", which the Company adopted effective January 1, 1991. The Company has appealed this decision. The appeal is likely to be decided during the second half of 1994. Computer Inquiry III In August 1985, the FCC initiated Computer Inquiry III to re-examine its regulations requiring that "enhanced services" (e.g., voice messaging services, electronic mail, videotext gateway, protocol conversion) be offered only through a structurally separated subsidiary. In 1986, the FCC eliminated this requirement, permitting the Company to offer enhanced services, subject to compliance with a series of nonstructural safeguards designed to promote an effectively competitive market. These safeguards include detailed cost accounting, protection of customer information and certain reporting requirements. BELL ATLANTIC - MARYLAND, INC. In June 1990, the United States Court of Appeals for the Ninth Circuit vacated and remanded the Computer Inquiry III decisions to the FCC, finding that the FCC had not fully justified those decisions. In December 1991, the FCC adopted an order which reinstated relief from the separate subsidiary requirement upon a company's compliance with the FCC's Computer III Open Network Architecture ("ONA") requirements and strengthened some of the nonstructural safeguards. In the interim, the Network Services Companies, including the Company, had filed interstate tariffs implementing the ONA requirements. Those tariffs became effective in February 1992, subject to further investigation. That investigation was completed on December 15, 1993, when an order was released making minor changes to the Network Services Companies' ONA rates. In March 1992, the Company certified to the FCC that it had complied with all initial ONA obligations and therefore should be granted structural relief for enhanced services. The FCC granted the Company structural relief in June 1992. Other parties have appealed this decision, which remains in effect pending the outcome of the appeal. A decision on the appeal is likely by the end of 1994. The FCC's December 1991 order has been appealed to the United States Court of Appeals for the Ninth Circuit by several parties. Pending decision on those appeals, the FCC's decision remains in effect. If a court again reverses the FCC, the Company's right to offer enhanced services could be impaired. FCC Cost Allocation and Affiliate Transaction Rules In 1987, the FCC adopted rules governing (i) the allocation of costs between the regulated and unregulated activities of a communications common carrier and (ii) transactions between the regulated and unregulated affiliates of a communications common carrier. The cost allocation rules apply to certain unregulated activities: activities that have never been regulated as communications common carrier offerings and activities that have been preemptively deregulated by the FCC. The costs of these activities are removed prior to the separations procedures process and are allocated to unregulated activities in the aggregate, not to specific services for pricing purposes. Other activities must be accounted for as regulated activities, and their costs are subject to separations procedures. These activities include (i) those which have been deregulated by the FCC without preempting state regulation, (ii) those which have been deregulated by a state but not the FCC and (iii) "incidental activities," which cannot, in the aggregate, generate more than 1% of a company's revenues. Since the Network Services Companies engage in both these types of activities, the Network Services Companies, including the Company, pursuant to the FCC's cost allocation rules, filed a cost allocation manual, which has been approved by the FCC. The affiliate transaction rules govern the pricing of assets transferred to and services provided by affiliates. These rules generally require that assets be transferred between affiliates at "market price," if such price can be established through a tariff or a prevailing price actually charged to third parties. In the absence of a tariff or prevailing price, "market price" cannot be established, in which case (i) asset transfers from a regulated to an unregulated affiliate must be valued at the higher of cost or fair market value, and (ii) asset transfers from an unregulated to a regulated affiliate must be valued at the lower of cost or fair market value. The affiliate transaction rules require that a service provided by one affiliate to another affiliate, which service is also provided to unaffiliated entities, must be valued at tariff rates or market prices. If the affiliate does not also provide the service to unaffiliated entities, the price must be determined in accordance with the FCC's cost allocation principles. In October 1993, the FCC proposed new affiliate transaction rules which would essentially eliminate the different rules for the provision of services and apply the asset transfer rules to all affiliate transactions. The Network Services Companies, including the Company, have filed comments opposing the proposed rules. The FCC has not attempted to make its cost allocation or affiliate transaction rules preemptive. State regulatory authorities are free to use different cost allocation methods and affiliate transaction rules for intrastate ratemaking and to require carriers to keep separate allocation records. BELL ATLANTIC - MARYLAND, INC. Telephone Company Provision of Video Dial Tone and Video Programming In 1987, the FCC initiated an inquiry into whether developments in the cable and telephone industries warranted changes in the rules prohibiting telephone companies such as the Company from providing video programming in their respective service territories directly or indirectly through an affiliate. In November 1991, the FCC released a Further Notice of Proposed Rulemaking in these proceedings. In August 1992, the FCC issued an order permitting telephone companies such as the Company to provide "video dial tone" service. Video dial tone permits telephone companies to provide video transport to multiple programmers on a non-discriminatory common carrier basis. The FCC has also ruled that neither telephone companies that provide video dial tone service, nor video programmers that use these services, are required to obtain local cable franchises. Other parties have appealed these orders, which remain in effect pending the outcome of the appeal. In December 1992, two Bell Atlantic Companies, Bell Atlantic - Virginia, Inc. and Bell Atlantic Video Services Company, filed a lawsuit against the federal government in the United States District Court for the Eastern District of Virginia seeking to overturn the prohibition in the Cable Communications Policy Act of 1984 against LECs providing video programming in their respective service areas. In a decision rendered in August 1993 and clarified in October 1993, the court struck down this prohibition as a violation of the First Amendment's freedom of speech protections and enjoined its enforcement against Bell Atlantic, the Network Services Companies, including the Company, and Bell Atlantic Video Services Company. This decision has been appealed to the United States Court of Appeals for the Fourth Circuit. In early 1993, the FCC granted Bell Atlantic authority to test a new technology known as Asynchronous Digital Subscriber Line ("ADSL") for use in delivering video entertainment and information over existing copper telephone lines. Beginning in March 1993, Bell Atlantic began a one-year technical trial of ADSL serving up to 400 Bell Atlantic employees in northern Virginia. In the Fall of 1993, Bell Atlantic petitioned the FCC for authorization to expand and convert this technical trial upon its completion into a six month market trial serving up to 2,000 customers. Bell Atlantic also requested authority to offer a commercial video dial tone service to customers served by 25 central offices in parts of northern Virginia and southern Maryland upon completion of the six month market trial. These applications are pending at the FCC. Interconnection and Collocation In October 1992, the FCC issued an order allowing third parties to collocate their equipment in telephone company offices to provide special access (private line) services to the public. The FCC's stated purpose was to encourage greater competition in the provision of interstate special access services. The order permits collocating parties to pay LECs an interconnection charge that is lower than the existing tariffed rates for similar non-collocated services; it allows LECs limited additional pricing flexibility for their own special access services when collocated interconnection is operational. In February 1993, Bell Atlantic's seven telephone subsidiaries, including the Company, filed an interstate tariff to allow collocation for special access services. This tariff is currently effective. Bell Atlantic and certain other parties have appealed the FCC's special access collocation order. Bell Atlantic expects the appeal to be decided in 1994. On September 2, 1993, the FCC extended collocation to switched access services. The terms and conditions for switched access collocation are similar to those for special access collocation. On November 18, 1993, Bell Atlantic's seven telephone subsidiaries, including the Company, filed an interstate tariff to allow collocation for switched access services. This tariff became effective on February 16, 1994. Bell Atlantic and certain other parties have appealed the FCC's switched access collocation order. Appeals of this order have been stayed pending a decision on the appeals of the special access collocation order. BELL ATLANTIC - MARYLAND, INC. Increased competition through collocation will adversely affect the revenues of the Company, although some of the lost revenues could be offset by increased demand of the Company's own special access services as a result of the slightly increased pricing flexibility that the FCC has permitted the Company. The Company does not expect the net revenue impact of special access collocation to be material. Revenue losses from switched access collocation, however, may be larger than from special access collocation. Intelligent Networks In December 1991, the FCC issued a Notice of Inquiry into the plans of the BOCs, including the Company, to deploy new "modular" network architectures, such as Advanced Intelligent Network ("AIN") technology. The Notice of Inquiry asks what, if any, regulatory action the FCC should take to assure that such architectures are deployed in a manner that is "open, responsive, and procompetitive". On August 31, 1993, the FCC issued a Notice of Proposed Rulemaking proposing a schedule for AIN deployment. The proposals in that Notice of Proposed Rulemaking generally follow those that Bell Atlantic proposed in its response to the Notice of Inquiry. The Company cannot estimate when the FCC will conclude this proceeding. The results of this proposed rulemaking could include a requirement that the Company offer individual components of its services, such as switching and transport, to competitors who will provide the remainder of such services through their own facilities. Such increased competition could divert revenues from the Company. However, deployment of AIN technology may also enable the Company to respond more quickly and efficiently to customer requests for new services. This could result in increased revenues from new services that could at least partially offset losses resulting from increased competition. STATE REGULATION AND INTRASTATE RATES The communications services of the Company are subject to regulation by the Public Service Commission of Maryland (the "PSC") with respect to intrastate rates and services and other matters. As the result of a process initiated by a joint petition of the Company, the Office of People's Counsel of the Maryland state government, and the PSC Staff, the PSC in 1990 approved an agreement which instituted a regulatory reform plan (the "Reform Plan") for regulation of intrastate services provided by the Company. The Reform Plan provides for sharing of earnings on other-than- competitive services (e.g., basic business and residential dial tone line and usage, pay telephone services and intraLATA toll services) within a prescribed rate-of-return range (12.7% to 14.5% return on equity), for the direct refund to ratepayers of all earnings above that range and for no sharing of earnings if earnings fall below that range. Earnings on competitive services (e.g., Centrex intercom and high capacity, special access and private line services) are not subject to a rate of return limitation. In connection with its approval of the Reform Plan, the PSC required the Company to initiate a rate proceeding to examine the Company's financial and operating results under the Reform Plan and to serve as a rate case for determining rates and rate structure on a going- forward basis for services that the PSC has determined are other-than- competitive. On January 22, 1993, at the conclusion of this rate proceeding, the PSC issued an order directing the Company to reduce rates prospectively in the aggregate amount of $28.6 million annually. Tariffs reducing rates by that amount became effective on January 23, 1993. The Company's application for a modification or rehearing of the order was denied in part and granted in part on March 30, 1993. Under the terms of the revised order, the Company's rate reduction was upheld, but it was permitted to accelerate the amortization of certain postemployment benefit obligations, eliminating any refund requirement for prior periods. The decision in this case is now final. On July 26, 1993, MFS-Intelenet of Maryland, Inc. ("MFS-Maryland"), a subsidiary of MFS Communications Company, Inc. ("MFS"), filed an application with the PSC for authority to provide and resell local exchange and interexchange telecommunications services to business customers in areas served by the Company and for an order establishing policies and requirements for interconnection of competing local exchange networks. Hearings have been held and a final decision is expected in April 1994. BELL ATLANTIC - MARYLAND, INC. On November 9, 1993, the PSC instituted an investigation into legal and policy matters relevant to the regulation of firms, including current telecommunications providers and cable television firms, which may provide local exchange and exchange access services in Maryland in the future. A procedural schedule has been established and a final decision is expected this year. NEW PRODUCTS AND SERVICES Data Services The Company introduced two Integrated Service Digital Network ("ISDN") services in 1993, which provide digital local loops to customers over copper facilities and three fast packet services (Fiber Distributed Data Interfact Network, Switched Redirect and Frame Relay Service), all of which are used to interconnect customers' Local Area Networks. Educational Services The Company introduced its School/Parent Communication Service which provides a low cost alternative to normal business service used to deliver messages between schools and students' homes. Bell Atlantic - Maryland also offers Distance Learning Service to public high schools, public community colleges and public four-year colleges and universities. This service provides switched network capability to connect video equipped classrooms for educational purposes to allow two-way fully interactive audio and video. Other Business Services Centrex Extend service uses the public switched network to provide capabilities and features typically offered by a private network: it permits multi-location Centrex intercom service for a closed end user group of a single Centrex customer. COMPETITION Regulatory proceedings, as well as new technology, are continuing to expand the types of available communications services and equipment and the number of competitors offering such services. An increasing amount of this competition is from large companies which have substantial capital, technological and marketing resources, many of which do not face the same regulatory constraints as the Company. Alternative Access and Local Services A substantial portion of the Company's revenues from business and government customers is derived from a relatively small number of large, multiple-line subscribers. The Company faces competition from alternative communications systems, constructed by large end users, interexchange carriers, and alternative access vendors, which are capable of originating and/or terminating calls without the use of the local telephone company's plant. MFS has an optical fiber network, which currently competes with the Company in the Baltimore metropolitan area. In the Maryland suburbs of Washington, D.C., Institutional Communications Company, in which MFS has acquired a controlling interest, has deployed fiber network to compete with the Company in the provision of switched and special access services and local services. The ability of such alternative access providers to compete with the Company has been enhanced by the FCC's orders requiring the Company to offer collocated interconnection for special and switched access services. Other potential sources of competition are cable television systems, shared tenant services and other non-carrier systems which are capable of bypassing the Company's local plant, either partially or completely, through substitution of special access for switched access or through concentration of telecommunications traffic on fewer of the Company's lines. BELL ATLANTIC - MARYLAND, INC. Well-financed competitors are seeking authority, or are likely soon to seek authority, to offer competing local exchange services, such as dial tone and local usage, in some of the most lucrative of the Company's local telephone service areas. Southwestern Bell Corporation ("Southwestern Bell") acquired existing cable television systems in Montgomery County, Maryland. Southwestern could use these systems to compete with the Company's telephone services in this area. Southwestern Bell also provides cellular service in the Maryland suburbs of Washington, D.C. On July 26, 1993, MFS-Maryland filed an application with the PSC for authority to provide and resell local exchange and interexchange telecommunications services to business customers in areas served by the Company and for an order establishing policies and requirements for interconnection of competing local exchange networks. Hearings have been held and a final decision is expected in April 1994. On November 9, 1993, the PSC instituted an investigation into legal and policy matters relevant to the regulation of firms, including current telecommunications providers and cable television firms, which may provide local exchange and exchange access services in Maryland in the future. A procedural schedule has been established and a final decision is expected this year. The two largest long-distance carriers are also positioning themselves to begin to offer services that will compete with the Company's local exchange services. In November 1992, AT&T announced its intention to acquire a controlling interest in McCaw Cellular Communications Inc. ("McCaw"), the largest cellular company in the United States, and to integrate McCaw's wireless local service network with AT&T's long distance network. In December 1993, MCI announced its intention to invest $2 billion to begin building competing local exchange and access networks in twenty major markets in the United States, some of which are likely to be in the Company's service territory. In March 1994, MCI also announced its intention to acquire a substantial interest in Nextel Communications Inc. (formerly Fleet Call Inc.), and to integrate Nextel's wireless local service network with MCI's long distance network in at least 10 major markets, one or more of which might be in the Company's service territory. The entry of these and other local exchange service competitors will almost certainly reduce the local exchange service revenues of the Company, at least in the market segments and geographical areas in which the competitors operate. Depending on such competitors' success in marketing their services, and the conditions of interconnection established by the regulatory commissions, these reductions could be significant. These revenue reductions may be offset to some extent by revenues from interconnection charges to be paid to the Company by these competitors. The Company seeks to meet such competition by establishing and/or maintaining competitive cost-based prices for local exchange services (to the extent the FCC and state regulatory authorities permit the Company's prices to move toward costs), by keeping service quality high and by effectively implementing advances in technology. See "FCC Regulation and Interstate Rates - Interstate Access Charges" and "- FCC Access Charge Pooling Arrangements". Personal Communications Services Radio-based personal communications services ("PCS") also constitute potential sources of competition to the Company. PCS consists of wireless portable telephone services which would allow customers to make and receive telephone calls from any location using small handsets, and which could also be used for data transmission. The FCC has authorized trials of such services, using a variety of technologies, by numerous companies. In September 1993, the FCC issued a report and order allocating radio spectrum to be licensed for use in providing PCS. Under the order, seven separate bandwidths of spectrum, ranging in size from 10 MHz to 30 MHz, would be auctioned to potential PCS providers in each geographic area of the United States; five of the spectrum blocks would be auctioned by "basic trading area" and the remaining two would be auctioned by larger "major trading area" (as such trading areas are defined by Rand McNally). LECs and companies with LEC subsidiaries, such as Bell Atlantic, are eligible to bid for PCS licenses, except that cellular carriers, such as Bell Atlantic, are limited to obtaining only 10 MHz of PCS bandwidth in areas where they provide BELL ATLANTIC - MARYLAND, INC. cellular service. Bidders other than cellular providers may obtain multiple licenses aggregating up to 40 MHz of bandwidth in any area. Bell Atlantic has stated that it intends to pursue PCS licenses in the auctions, which are expected to be held in 1994 or in early 1995. In December 1993, the FCC awarded pioneer's preference PCS licenses to, among other entities, American Personal Communications ("APC"), which is owned in part by The Washington Post Company. APC's license authorizes it to provide PCS service in competition with the local exchange services of the Network Services Companies in all or large portions of Pennsylvania, the District of Columbia, Maryland and West Virginia. APC has announced its intention to build out an operational systems by the first quarter of 1995. If implemented, PCS and other similar services would compete with services currently offered by the Company, and could result in losses of revenues. Centrex The Company offers Centrex service, which is a telephone company central office-based communications system for business, government and other institutional customers consisting of a variety of integrated software-based features located in a centralized switch or switches and extended to the customer's premises primarily via local distribution facilities. In the provision of Centrex, the Company is subject to significant competition from the providers of CPE systems, such as private branch exchanges ("PBXs"), which perform similar functions with less use of the Company's switching facilities. Users of Centrex systems generally require more subscriber lines than users of PBX systems of similar capacity. The FCC increased the maximum Subscriber Line Charge on embedded Centrex lines to $6.00 per month per line effective April 1, 1989. Increases in Subscriber Line Charges result in Centrex users incurring higher charges than users of comparable PBX systems. The PSC has approved the Company's Centrex tariff methodology and rates, which are designed to offset the effects of such higher Subscriber Line Charges. The PSC established a proceeding to consider the tariff for Centrex Extend service (multi-location Centrex intercom service for a closed end user group of a single Centrex customer), which the Company began offering in August 1993. A decision on the appropriateness of this tariff is expected this year. IntraLATA Toll Competition The ability of interexchange carriers to engage in the provision of intrastate intraLATA toll service in competition with the Company is subject to state regulation. Such competition is permitted in Maryland. Directories The Company continues to face significant competition from other providers of directories as well as competition from other advertising media. In particular, the former sales representative of several of the Network Services Companies, including the Company, publishes directories in competition with those published by the Company in its service territory. Public Telephone Services The Company faces increasing competition in the provision of pay telephone services from other pay telephone service providers. In addition, the growth of wireless communications negatively impacts usage of public telephones. BELL ATLANTIC - MARYLAND, INC. Operator Services Alternative operator services providers have entered into competition with the Company's operator services product line. CERTAIN CONTRACTS AND RELATIONSHIPS Certain planning, marketing, procurement, financial, legal, accounting, technical support and other management services are provided on behalf of the Company on a centralized basis by Bell Atlantic's wholly owned subsidiary, Bell Atlantic Network Services, Inc. ("NSI"). Bell Atlantic Network Funding Corporation provides short-term financing and cash management services to the Company. The seven RHCs each own (directly or through subsidiaries) a one-seventh interest in Bell Communications Research, Inc. ("Bellcore"). Pursuant to the Plan, Bellcore furnishes the RHCs and their BOC subsidiaries with technical assistance such as network planning, engineering and software development, as well as various other consulting services that can be provided more effectively on a centralized basis. Bellcore is the central point of contact for coordinating the efforts of the RHCs in meeting the national security and emergency preparedness requirements of the federal government. It also helps to mobilize the combined resources of the RHCs in times of natural disasters. EMPLOYEE RELATIONS As of December 31, 1993, the Company employed approximately 9,200 persons, including employees of the centralized staff at NSI. This represents approximately a 2% increase from the number of employees at December 31, 1992. The Company's workforce is augmented by members of the centralized staff of NSI, who perform services for the Company on a contract basis. Approximately 88% of the employees of the Company are represented by the Communications Workers of America, which is affiliated with the American Federation of Labor - Congress of Industrial Organizations. Under the terms of the three-year contracts ratified in October 1992 by unions representing associate employees of the Network Services Companies, including the Company, and NSI, represented associates received a base wage increase of 3.74% in August 1993. Under the same contracts, associates received a Corporate Profit Sharing payment of $495 per person in 1994 based upon Bell Atlantic's 1993 financial performance. BELL ATLANTIC - MARYLAND, INC. ITEM 2.		ITEM 2. PROPERTIES The principal properties of the Company do not lend themselves to simple description by character and location. At December 31, 1993, the Company's investment in plant, property and equipment consisted of the following: "Connecting lines" consists primarily of aerial cable, underground cable, poles, conduit and wiring. "Central office equipment" consists of switching equipment, transmission equipment and related facilities. "Land and buildings" consists of land owned in fee and improvements thereto, principally central office buildings. "Telephone instruments and related equipment" consists primarily of public telephone terminal equipment and other terminal equipment. "Other" property consists primarily of furniture, office equipment, vehicles and other work equipment, capital leases, leasehold improvements and plant under construction. The Company's central offices are served by various types of switching equipment. At December 31, 1993 and 1992, the number of local exchanges and the percent of subscriber lines served by each type of equipment were as follows: BELL ATLANTIC - MARYLAND, INC. ITEM 3.	ITEM 3. LEGAL PROCEEDINGS PRE-DIVESTITURE CONTINGENT LIABILITIES AND LITIGATION The Plan provides for the recognition and payment by AT&T and the former BOCs (including the Company) of liabilities that are attributable to pre-Divestiture events but do not become certain until after Divestiture. These contingent liabilities relate principally to litigation and other claims with respect to the former Bell System's rates, taxes, contracts and torts (including business torts, such as alleged violations of the antitrust laws). Except to the extent that affected parties otherwise agree, contingent liabilities that are attributable to pre-Divestiture events are shared by AT&T and the BOCs in accordance with formulas prescribed by the Plan, whether or not an entity was a party to the proceeding and regardless of whether an entity was dismissed from the proceeding by virtue of settlement or otherwise. Each company's allocable share of liability under these formulas depends on several factors, including the type of contingent liability involved and each company's relative net investment as of the effective date of Divestiture. Under the formula generally applicable to most of the categories of these contingent liabilities, the Company's aggregate allocable share of liability is approximately 1.5%. AT&T and various of its subsidiaries and the BOCs (including, in some cases, the Company) have been and are parties to various types of litigation relating to pre-Divestiture events, including actions and proceedings involving environmental claims and allegations of violations of equal employment laws. Damages, if any, ultimately awarded in the remaining actions relating to pre- Divestiture events could have a financial impact on the Company whether or not the Company is a defendant since such damages will be treated as contingent liabilities and allocated in accordance with the allocation rules established by the Plan. While complete assurance cannot be given as to the outcome of any contingent liabilities or litigation, in the opinion of the Company's management, any monetary liability or financial impact to which the Company would be subject after final adjudication of all of the remaining potential or actual pre- Divestiture claims would not be material in amount to the financial position of the Company. BELL ATLANTIC - MARYLAND, INC. PART I ITEM 4.	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS (Omitted pursuant to General Instruction J(2).) PART II ITEM 5.	ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS (Inapplicable.) ITEM 6.	ITEM 6. SELECTED FINANCIAL DATA (Omitted pursuant to General Instruction J(2).) BELL ATLANTIC - MARYLAND, INC. ITEM 7.	ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS (Abbreviated pursuant to General Instruction J(2).) This discussion should be read in conjunction with the Financial Statements and Notes to Financial Statements as listed in the index set forth on page. RESULTS OF OPERATIONS Net income for 1993 decreased $28,496,000 or 11.4% from the same period last year. Results for 1993 reflect an after-tax charge of $14,271,000 for the adoption of Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits," (Statement No. 112) and a $19,921,000 extraordinary charge, net of tax, for the early extinguishment of debt. OPERATING REVENUES Operating revenues increased $34,743,000 or 1.9% in 1993. The increase in total operating revenues was comprised of the following: Local service revenues are earned by the Company from the provision of local exchange, local private line, and public telephone services. Local service revenues increased $23,489,000 or 2.4% in 1993. The increase was principally due to growth in network access lines in service and higher demand for value- added central office services such as Custom Calling and Caller ID. The growth in access lines in service was 86,600 or 2.9% in 1993. These increases were partly offset by Maryland Public Service Commission (PSC) ordered rate reductions which were effective in January 1993. Network access revenues are received from interexchange carriers (IXCs) for their use of the Company's local exchange facilities in providing long-distance services to IXCs' customers and from end-user subscribers. Switched access revenues are derived from usage-based charges paid by IXCs for access to the Company's network. Special access revenues arise from access charges paid by subscribers who have private lines, and end-user revenues are earned from local exchange carrier customers who pay for access to the network. Network access revenues increased $16,388,000 or 3.4% in 1993 primarily due to lower support payments to the National Exchange Carrier Association (NECA) interstate common line pool and growth of 7.9% in access minutes of use. Also contributing to this increase was higher end-user revenues principally due to the growth in business access lines. These revenue increases were partially offset by the effect of interstate rate reductions filed by the Company with the Federal Communications Commission (FCC), which became effective on July 2, 1993 and July 1, 1992 and by related estimated price cap sharing liabilities. Toll service revenues are earned from interexchange usage services such as Message Telecommunication Service (MTS) and Unidirectional Services (Wide Area Toll Services (WATS) and 800 Services). Toll service revenues decreased $8,653,000 or 7.1% in 1993, principally as a result of the previously mentioned PSC-ordered rate reductions in intrastate daytime rates and volume discounts. This revenue decrease was partially offset by a 6.4% growth in total message volumes in 1993. BELL ATLANTIC - MARYLAND, INC. Directory advertising, billing services and other revenues include revenues from the sale of advertising in the Company's telephone directories, billing and collection services provided to IXCs and others, premises services such as inside wire installation and maintenance services, rent of Company facilities by affiliates and non-affiliates, and certain nonregulated enhanced network services. Directory advertising, billing services and other revenues increased $12,211,000 or 4.3% in 1993 due primarily to the effect of increased revenue from government contracts, revenue growth from Answer Call, a nonregulated enhanced network service and increased premises service revenues attributable to growth in inside wire installations. Directory advertising revenues increased slightly, but revenue growth was adversely impacted by decreasing sales volume attributable primarily to competition. These increases were offset in part by decreased billing and collection revenues resulting from reductions in services provided under long-term contracts with certain IXCs. The provision for uncollectibles, expressed as a percentage of total operating revenues was 1.3% in 1993 and .9% in 1992 due primarily to unfavorable collection experience. OPERATING EXPENSES Operating expenses increased $13,713,000 or 1.0% in 1993. The increase in total operating expenses was comprised of the following: Employee costs consist primarily of salaries, wages and other employee compensation, employee benefits, and payroll taxes paid directly by the Company. Similar costs incurred by employees of Bell Atlantic Network Services, Inc. (NSI), are allocated to the Company and are included in other operating expenses. Employee costs increased $2,631,000 or .6% in 1993. Higher employee costs from salary and wage increases and overtime were offset in part by savings resulting from workforce reduction programs implemented in 1992. The Company continues to evaluate ways to streamline and restructure its operations and reduce its workforce requirements in an effort to improve its cost structure. Depreciation and amortization expense increased $1,194,000 or .3% in 1993 primarily due to the growth in depreciable plant. This increase was substantially offset by the completion, in June 1992, of the FCC-ordered Reserve Deficiency Amortization. Taxes other than income increased $6,755,000 or 6.5% in 1993 due to higher property assessments which resulted in an increase in the property and capital stock tax. Other operating expenses consist primarily of contracted services, including centralized service expenses allocated from NSI, rents, network software costs, and other general and administrative expenses. Other expenses increased $3,133,000 or .6% in 1993, primarily reflecting higher costs for contracted services as a result of higher employee costs and taxes allocated from NSI and increased network software costs associated with enhancing the Company's network. BELL ATLANTIC - MARYLAND, INC. OPERATING INCOME TAXES Operating income taxes increased $19,819,000 or 17.4% in 1993. The Company's effective income tax rate was 34.2% in 1993 compared to 31.1% for 1992. The increase in the effective tax rate was principally the result of federal tax legislation enacted in 1993, which increased the federal corporate tax rate from 34% to 35%, and the effect of recording in 1992 an adjustment to deferred taxes associated with the retirement of certain plant investment. A reconciliation of the statutory federal income tax rate to the effective rate for each period is included in Note 5 of Notes to Financial Statements. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (Statement No. 109). In connection with the adoption of Statement No. 109, the Company recorded a charge to income of $193,000 in the first quarter of 1993 (see Note 5 of Notes to Financial Statements). OTHER INCOME AND EXPENSE Other income, net of expense, decreased $7,503,000 in 1993, primarily due to the effect of interest income recognized in 1992 in connection with the settlement of various federal income tax matters related to prior periods. Also contributing to this decrease was the termination of the accrual of interest income on short-term plant under construction, as approved by the PSC in its January 1993 rate order. INTEREST EXPENSE Interest expense decreased $11,988,000 or 13.2% in 1993, primarily due to the effects of lower short-term interest rates and long-term debt refinancings. EXTRAORDINARY ITEM The Company called $470,000,000 in 1993 of long-term debentures which were refinanced at more favorable rates. As a result of these early retirements, the Company incurred after-tax charges of $19,921,000 in 1993. These debt refinancings will reduce annual interest costs on the refinanced debt by approximately $9,800,000. CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE In connection with the adoption of Statement No. 112, effective January 1, 1993, the Company recorded a one-time, cumulative effect after-tax charge of $14,271,000 in 1993 (see Note 4 of Notes to Financial Statements). The adoption of Statement No. 112 did not have a significant effect on the Company's ongoing level of expense in 1993 and is not expected to have a significant effect in future periods. COMPETITION AND REGULATORY ENVIRONMENT The telecommunications industry is currently undergoing fundamental changes which may have a significant impact on future financial performance of all telecommunications companies. These changes are driven by a number of factors, including the accelerated pace of technology change, customer requirements, a changing industry structure characterized by strategic alliances and the convergence of telecommunications and cable television, and a changing regulatory environment in which traditional regulatory barriers are being lowered and competition encouraged. The convergence of cable television, computer technology, and telecommunications can be expected to dramatically increase competition in the future. The Company is already subject to competition from numerous sources, including competitive access providers for network access services, competing cellular telephone companies and others. BELL ATLANTIC - MARYLAND, INC. During 1993, a number of business alliances were announced that have the potential to significantly increase competition both within the industry and within the areas currently served by Bell Atlantic. Over the past several years, Bell Atlantic has taken a number of actions in anticipation of the increasingly competitive environment. Cost reductions have been achieved, giving greater pricing flexibility for services exposed to competition. A new lines of business organization structure was adopted. Subject to regulatory approval, the Company plans to allocate capital resources to the deployment of broadband network platforms. On the regulatory front, alternative regulation plans have been approved by the Public Service Commission of Maryland (PSC). The Company conducts ongoing evaluations of its accounting practices, many of which have been prescribed by regulators. These evaluations include the assessment of whether costs that have been deferred as a result of actions of regulators and the cost of the Company's telephone plant will be recoverable in the future. In the event recoverability of costs becomes unlikely due to decisions by the Company to accelerate deployment of new technology, in response to specific regulatory actions or increasing levels of competition, the Company may no longer apply the provisions of Statement of Financial Accounting Standards No. 71, "Accounting for the Effects of Certain Types of Regulation" (Statement No. 71). The discontinued application of Statement No. 71 would require the Company to write off its regulatory assets and liabilities and may require the Company to adjust the carrying amount of its telephone plant should it determine that such amount is not recoverable. The Company believes that it continues to meet the criteria for continued financial reporting under Statement No. 71. A determination in the future that such criteria are no longer met may result in a significant one-time, non-cash, extraordinary charge, if the Company determines that a substantial portion of the carrying value of its telephone plant may not be recoverable. In September 1993, the FCC issued a report and order allocating radio spectrum to be licensed for use in providing personal communications services (PCS). Under the order, seven separate bandwidths of spectrum, ranging in size from 10 MHz to 30 MHz, would be auctioned to potential PCS providers in each geographic area of the United States. The geographical units by which the licenses would be allocated will be "basic trading areas" or larger "major trading areas." Five of the spectrum blocks are to be auctioned on a basic trading area basis, and the remaining two are to be auctioned by major trading area. Local exchange carriers such as the Company are eligible to bid for PCS licenses, except that cellular carriers are limited to obtaining 10 MHz of PCS bandwidth in areas where they provide cellular service. Bidders other than cellular providers may obtain multiple licenses aggregating up to 40 MHz of bandwidth in any area. Bell Atlantic has stated that it intends to pursue PCS licenses in the auctions, which are expected to be held in 1994. In August 1993, the United States District Court for the Eastern District of Virginia ruled unconstitutional the 1984 Cable Act's limitation on in territory provision of programming by local exchange carriers such as the Company. The Cable Act currently prohibits local exchange carriers from owning more than 5% of any company that provides cable programming in their local service area. In a case originally brought by two Bell Atlantic subsidiaries, the court ruled that this prohibition violates the First Amendment's freedom of speech protections, and enjoined enforcement of the prohibition against Bell Atlantic and its telephone subsidiaries. The ruling has been appealed. STATE REGULATORY ENVIRONMENT The communications services of the Company are subject to regulation by the PSC with respect to intrastate rates and services and other matters. BELL ATLANTIC - MARYLAND, INC. As the result of a process initiated by a joint petition of the Company, the Office of People's Counsel of the Maryland state government, and the PSC Staff, the PSC in 1990 approved an agreement which instituted a regulatory reform plan (Reform Plan) for regulation of intrastate services provided by the Company. The Reform Plan provides for sharing of earnings on other-than-competitive services (e.g., basic business and residential dial tone line and usage, pay telephone services and intraLATA toll services) within a prescribed rate-of-return range (12.7% to 14.5% return on equity), for the direct refund to ratepayers of all earnings above that range and for no sharing of earnings if earnings fall below that range. Earnings on competitive services (e.g., Centrex intercom and high capacity, special access and private line services) are not subject to a rate of return limitation. In connection with its approval of the Reform Plan, the PSC required the Company to initiate a rate proceeding to examine the Company's financial and operating results under the Reform Plan and to serve as a rate case for determining rates and rate structure on a going-forward basis for services that the PSC has determined are other-than-competitive. On January 22, 1993, at the conclusion of this rate proceeding, the PSC issued an order directing the Company to reduce rates prospectively in the aggregate amount of $28.6 million annually. Tariffs reducing rates by that amount became effective on January 23, 1993. The Company's application for a modification or rehearing of the order was denied in part and granted in part on March 30, 1993. Under the terms of the revised order, the Company's rate reduction was upheld, but it was permitted to accelerate the amortization of certain postemployment benefit obligations, eliminating any refund requirement for prior periods. The decision in this case is now final. On July 26, 1993, MFS Intelenet of Maryland, Inc., a subsidiary of MFS Communications Company, Inc., filed an application with the PSC for authority to provide and resell local exchange and interexchange telecommunications services to business customers in areas served by the Company and for an order establishing policies and requirements for interconnection of competing local exchange networks. Hearings have been held and a final decision is expected in April 1994. On November 9, 1993, the PSC instituted an investigation into legal and policy matters relevant to the regulation of firms, including current telecommunications providers and cable television firms, which may provide local exchange and exchange access services in Maryland in the future. A procedural schedule has been established and a final decision is expected this year. FINANCIAL CONDITION Management believes that the Company has adequate internal and external resources available to meet ongoing requirements including network expansion and modernization, and payment of dividends. Management expects that presently foreseeable capital requirements will be financed primarily through internally generated funds, although additional long-term debt may be needed fund development activities and to maintain the Company's capital structure within management's guidelines. During 1993, the Company's primary source of funds continued to be cash generated from operations. Revenue growth, cost containment measures and savings on interests contributed to cash provided from operations of $663,201,000 for the year ended December 31, 1993. The primary use of capital resources continued to be capital expenditures. The Company invested $349,103,000 in 1993 in the network. This level of investment is expected to continue in 1994. The Company plans to allocate capital resources to the deployment of broadband network platforms, subject to regulatory approval. The Company's debt ratio was 44.4% at December 31, 1993 compared to 46.6% at December 31, 1992. BELL ATLANTIC - MARYLAND, INC. On May 4, 1993, the Company sold $200,000,000 of Ten Year 6% Debentures through a public offering. The debentures are not redeemable prior to maturity. On May 5, 1993, the Company sold $250,000,000 of Thirty Year 7.15% Debentures through a public offering. The debentures are not redeemable prior to May 1, 2013. The net proceeds from both debentures were used to redeem $245,000,000 of Forty Year 9 1/8% Debentures, $125,000,000 of Forty Year 9% Debentures and $100,000,000 of Thirty-five Year 8 7/8% Debentures. These debt refinancings will reduce annual interest costs on the refinanced debt by approximately $9,800,000. As of December 31, 1993, the Company had $50,000,000 outstanding under a shelf registration statement filed with the Securities and Exchange Commission. BELL ATLANTIC - MARYLAND, INC. PART II ITEM 8.	ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required by this Item is set forth on pages through . 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 (Omitted pursuant to General Instruction J(2).) ITEM 11.	ITEM 11. EXECUTIVE COMPENSATION (Omitted pursuant to General Instruction J(2).) ITEM 12.	ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT (Omitted pursuant to General Instruction J(2).) ITEM 13.	ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS (Omitted pursuant to General Instruction J(2).) BELL ATLANTIC - MARYLAND, INC. PART IV ITEM 14.	ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The following documents are filed as part of this report: (1) Financial Statements See Index to Financial Statements and Financial Statement Schedules appearing on page. (2) Financial Statement Schedules See Index to Financial Statements and Financial Statement Schedules appearing on page. (3) Exhibits Exhibits identified in parentheses below, on file with the Securities and Exchange Commission (SEC), are incorporated herein by reference as exhibits hereto. Exhibit Number (Referenced to Item 601 of Regulation S-K) --------------------------------------------------------- 3a Articles of Restatement of registrant filed July 30, 1990. (Exhibit 3a to the registrant's Annual Report on Form 10-K for 1990, File No. 1-6875.) 3a(i) Articles of Amendment to registrant's Certificate of Incorporation dated January 11, 1994 and filed January 13, 1994. 3b By-Laws of the registrant, as amended January 1, 1990. (Exhibit 3b to the registrant's Annual Report on Form 10-K for 1989, File No. 1-6875.) 3b(i) Resolution dated August 31, 1992 amending Article V, Section 5-a regarding: Indemnification of Directors. (Exhibit 3b to the registrant's Annual Report on Form 10-K for 1992, File No. 1-6075.) 4 No instrument which defines the rights of holders of long-term debt of the registrant is filed herewith pursuant to Regulation S-K, Item 601(b)(4)(iii)(A). Pursuant to this regulation, the registrant hereby agrees to furnish a copy of any such instrument to the SEC upon request. 10a Agreement Concerning Contingent Liabilities, Tax Matters and Termination of Certain Agreements among AT&T, Bell Atlantic Corporation, the Bell Atlantic Corporation telephone subsidiaries, and certain other parties, dated as of November 1, 1983. (Exhibit 10a to Bell Atlantic Corporation Annual Report on Form 10-K for the year ended December 31, 1993, File No. 1-8606). 10b Agreement among Bell Atlantic Network Services, Inc. and the Bell Atlantic Corporation telephone subsidiaries, dated November 7, 1983. (Exhibit 10b to Bell Atlantic Corporation Annual Report on Form 10-K for the year ended December 31, 1993, File No. 1-8606). 23 Consent of Coopers & Lybrand. 24 Powers of attorney. (b) Reports on Form 8-K: There were no Current Reports on Form 8-K filed during the quarter ended December 31, 1993. BELL ATLANTIC - MARYLAND, INC. SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED. Bell Atlantic - Maryland, Inc. By /s/ W. M. English -------------------------- W. M. English Controller March 29, 1994 PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BY THE FOLLOWING PERSONS ON BEHALF OF THIS REGISTRANT AND IN THE CAPACITIES AND ON THE DATE INDICATED. ____ Principal Executive Officer: ) Frederick D. D'Alessio President and ) Chief Executive ) Officer ) ) Principal Financial Officer: ) William M. English Controller ) ) ) ) Directors: ) By /s/ W. M. English George L. Bunting, Jr. ) ----------------------- Frederick D. D'Alessio ) W. M. English Dr. Rhoda M. Dorsey ) (individually and as F. Barton Harvey, Jr. ) attorney-in-fact) James H. McLean ) March 29, 1994 J. William Sarver ) John W. Seazholtz ) J. Blacklock Wills ____) (constituting a majority of the registrant's Board of Directors) BELL ATLANTIC - MARYLAND, INC. INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES Financial statement schedules other than those listed above have been omitted either because the required information is contained in the financial statements and the notes thereto, or because such schedules are not required or applicable. BELL ATLANTIC - MARYLAND, INC. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareowner of Bell Atlantic - Maryland, Inc. We have audited the financial statements and the financial statement schedules of Bell Atlantic - Maryland, Inc. as listed in the index on page of this Form 10-K. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Bell Atlantic - Maryland, Inc. as of December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. As discussed in Notes 1, 4 and 5 to financial statements, the Company changed its method of accounting for income taxes and postemployment benefits in 1993 and postretirement benefits other than pensions in 1991. /s/ COOPERS & LYBRAND 2400 Eleven Penn Center Philadelphia, Pennsylvania February 7, 1994 BELL ATLANTIC - MARYLAND, INC. STATEMENTS OF INCOME AND REINVESTED EARNINGS FOR THE YEARS ENDED DECEMBER 31 (DOLLARS IN THOUSANDS) The accompanying notes are an integral part of these financial statements. BELL ATLANTIC - MARYLAND, INC. BALANCE SHEETS (DOLLARS IN THOUSANDS) The accompanying notes are an integral part of these financial statements. BELL ATLANTIC - MARYLAND, INC. BALANCE SHEETS (DOLLARS IN THOUSANDS) The accompanying notes are an integral part of these financial statements. BELL ATLANTIC - MARYLAND, INC. STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31 (DOLLARS IN THOUSANDS) The accompanying notes are an integral part of these financial statements. BELL ATLANTIC - MARYLAND, INC. NOTES TO FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION Bell Atlantic - Maryland, Inc. (formerly The Chesapeake and Potomac Telephone Company of Maryland) (the Company), a wholly owned subsidiary of Bell Atlantic Corporation (Bell Atlantic), maintains its accounts in accordance with the Uniform System of Accounts (USOA) prescribed by the Federal Communications Commission (FCC) and makes certain adjustments necessary to present the accompanying financial statements in accordance with generally accepted accounting principles applicable to regulated entities. Such principles differ in certain respects from those used by unregulated entities, but are required to appropriately reflect the financial and economic impacts of regulation and the ratemaking process. Significant differences resulting from the application of these principles are disclosed elsewhere in these Notes to Financial Statements where appropriate. REVENUE RECOGNITION Revenues are recognized as earned on the accrual basis which is generally when services are rendered based on the usage of the Company's local exchange network and facilities. CASH AND CASH EQUIVALENTS The Company considers all highly liquid investments with a maturity of 90 days or less when purchased to be cash equivalents. Cash equivalents are stated at cost, which approximates market value. MATERIAL AND SUPPLIES New and reusable materials are carried in inventory, principally at average original cost, except that specific costs are used in the case of large individual items. Nonreusable material is carried at estimated salvage value. PREPAID DIRECTORY Costs of directory production and advertising sales are deferred until the directory is published. Such costs are amortized to expense and the related advertising revenues are recognized over the average life of the directory, which is generally 12 months. PLANT AND DEPRECIATION The Company's provision for depreciation is based principally on the remaining life method of depreciation and straight-line composite rates. The provision for depreciation is based on the following estimated remaining service lives: buildings, 25 to 35 years; central office equipment, 1 to 11 years; telephone instruments and related equipment, 4 to 6 years; poles, 19 years; cable and wiring, 12 to 17 years; conduit, 45 years; office equipment and furniture, 5 to 12 years; vehicles and other work equipment, 4 to 11 years. This method provides for the recovery of the remaining net investment in telephone plant, less anticipated net salvage value, over the remaining service lives authorized by regulatory commissions. Depreciation expense also includes amortization of certain classes of telephone plant (and certain identified depreciation reserve deficiencies) over periods authorized by regulatory commissions. BELL ATLANTIC - MARYLAND, INC. When depreciable plant is replaced or retired, the amounts at which such plant has been carried in plant, property and equipment are removed from the respective accounts and charged to accumulated depreciation, and any gains or losses on disposition are amortized over the remaining service lives of the remaining net investment in telephone plant. MAINTENANCE AND REPAIRS The cost of maintenance and repairs of plant, including the cost of replacing minor items not constituting substantial betterments, is charged to operating expenses. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION Regulatory commissions allow the Company to record an allowance for funds used during construction, which includes both interest and equity return components, as a cost of plant and as an item of other income. Such income is not recovered in cash currently, but will be recoverable over the service life of the plant through higher depreciation expense recognized for regulatory purposes. EMPLOYEE BENEFITS Pension Plans Substantially all employees of the Company are covered under multi-employer noncontributory defined benefit pension plans sponsored by Bell Atlantic and its subsidiaries, including the Company. The Company uses the projected unit credit actuarial cost actuarial method for determining pension cost for financial reporting purposes. Amounts contributed to the Company's pension plans are actuarially determined principally under the aggregate cost actuarial method, and are subject to applicable federal income tax regulations. Postretirement Benefits Other Than Pensions Substantially all employees of the Company are covered under postretirement health and life insurance benefit plans. Effective January 1, 1991, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," which requires accrual accounting for all postretirement benefits other than pensions. Under the prescribed accrual method, the Company's obligation for these postretirement benefits is to be fully accrued by the date employees attain full eligibility for such benefits. A portion of the postretirement accrued benefit obligation is contributed to 501(c)(9) trusts and 40lh accounts under applicable federal income tax regulations. The amounts contributed to these trusts and accounts are actuarially determined, principally under the aggregate cost actuarial method. Postemployment Benefits The Company provides employees with postemployment benefits such as disability benefits, workers' compensation, and severance pay. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits," which requires accrual accounting for the estimated cost of benefits provided to former or inactive employees after employment but before retirement. Prior to 1993, the cost of these benefits was charged to expense as the benefits were paid. BELL ATLANTIC - MARYLAND, INC. INCOME TAXES Bell Atlantic and its domestic subsidiaries, including the Company, file a consolidated federal income tax return. Effective January 1, 1993, the Company adopted Statement of Financial Standard No. 109, "Accounting for Income Taxes" (Statement No. 109), which requires the determination of deferred taxes using the liability method. Under the liability method, deferred taxes are provided on book and tax basis differences and deferred tax balances are adjusted to reflect enacted changes in income tax rates. The consolidated amount of current and deferred tax expense is allocated by applying the provisions of Statement No. 109 to each subsidiary as if it were a separate taxpayer. Prior to 1993, the Company accounted for income taxes based on the provisions of Accounting Principles Board Opinion No. 11, "Accounting for Income Taxes" (APB No. 11). Under APB No. 11, deferred taxes were generally provided to reflect the effect of timing differences on the recognition of revenue and expense determined for financial and income tax reporting purposes. The Tax Reform Act of 1986 repealed the investment tax credit (ITC) as of January 1, 1986, subject to certain transitional rules. ITCs were deferred and are being amortized as a reduction to income tax expense over the estimated service lives of the related assets. RECLASSIFICATIONS Certain reclassifications of prior years' data have been made to conform to 1993 classifications. 2. DEBT LONG-TERM Long-term debt consists principally of debentures issued by the Company. Interest rates and maturities of the amounts outstanding at December 31 are as follows: BELL ATLANTIC - MARYLAND, INC. Long-term debt outstanding at December 31, 1993 includes $260,000,000 that is callable by the Company. The call prices range from 102.6% to 100.0% of face value, depending upon the remaining term to maturity of the issue. In addition, long-term debt includes $100,000,000 and $50,000,000 that will become redeemable only on August 1, 1996 and October 15, 1996, respectively, at the option of the holders. The redemption prices will be 100.0% of face value, plus accrued interest. On May 4, 1993, the Company sold $200,000,000 of Ten Year 6% Debentures through a public offering. The debentures are not redeemable by the Company prior to maturity. On May 5, 1993, the Company sold $250,000,000 of Thirty Year 7.15% Debentures through a public offering. The debentures are not redeemable by the Company prior to May 1, 2013. The net proceeds from both debentures were used to redeem $245,000,000 of Forty Year 9 1/8% Debentures at a call price equal to 106.9% of the face value of the issue, $125,000,000 of Forty Year 9% Debentures at a call price equal to 105.6% of the face value of the issue and $100,000,000 of Thirty-five Year 8 7/8% Debentures at a call price equal to 103.2% of the face value of the issue. As a result of the early extinguishment of these debentures, which were called on April 21 and 22, 1993, the Company recorded a charge of $31,020,000, before an income tax benefit of $11,099,000. In 1992, the Company recorded a charge associated with the early extinguishment of debentures called by the Company. The financial impact of the early extinguishment of debt was not material. At December 31, 1993, the Company had $50,000,000 outstanding under a shelf registration statement filed with the Securities and Exchange Commission. The fair value of long-term debt is estimated based on quoted market prices for the same or similar issues. At December 31, 1993 and 1992, the fair value of the Company's long-term debt, excluding unamortized discount and premium and capital lease obligations, is estimated at $993,200,000 and $988,900,000, respectively. The fair value of interest rate swap agreements is the estimated amount that the Company would receive upon termination of the swap agreement at year end, taking into account current interest rates and the creditworthiness of the swap counterparties. At December 31, 1993, the Company had no interest rate swap agreements. At December 31, 1992, the Company would have received $167,000 to terminate its interest rate swap agreement. MATURING WITHIN ONE YEAR Debt maturing within one year consists of the following at December 31: * Amounts represent average daily face amount of the note. ** Weighted average interest rates are computed by dividing the average daily face amount of the note into the aggregate related interest expense. BELL ATLANTIC - MARYLAND, INC. At December 31, 1993, the Company had an unused line of credit balance of $222,200,000 with an affiliate, Bell Atlantic Network Funding Corporation (BANFC) (Note 7). At December 31, 1993 and 1992, the carrying amount of debt maturing within one year, excluding capital lease obligations, approximates fair value. 3. LEASES The Company has entered into both capital and operating leases for facilities and equipment used in operations. Plant, property and equipment included capital leases of $47,954,000 and $47,974,000 and related accumulated amortization of $19,352,000 and $16,258,000 at December 31, 1993 and 1992, respectively. The Company incurred no initial capital lease obligations in 1993, as compared to $11,192,000 in 1992, and $2,607,000 in 1991. Total rent expense amounted to $45,441,000 in 1993, $47,824,000 in 1992, and $53,977,000 in 1991. Of these amounts, the Company incurred rent expense of $32,925,000, $32,786,000, and $36,010,000 in 1993, 1992, and 1991, respectively, from affiliated companies. At December 31, 1993, the aggregate minimum rental commitments under noncancelable leases for the periods shown are as follows: 4. EMPLOYEE BENEFITS PENSION PLANS Substantially all of the Company's management and associate employees are covered under multi-employer noncontributory defined benefit pension plans sponsored by Bell Atlantic and certain of its subsidiaries, including the Company. The pension benefit formula is based on a flat dollar amount per year of service according to job classification under the associate plan and a stated percentage of adjusted career average earnings under the plans for management employees. The Company's objective in funding the plans is to accumulate funds at a relatively stable level over participants' working lives so that benefits are fully funded at retirement. Plan assets consist principally of investments in domestic and foreign corporate equity securities, U.S. and foreign Government and corporate debt securities, and real estate. BELL ATLANTIC - MARYLAND, INC. Aggregate pension cost for the plans is as follows: The decrease in pension cost in 1993 is due to the net effect of the elimination of one-time charges associated with special termination benefits that were recognized in the preceding years, favorable investment experience, and changes in plan demographics due to retirement and severance programs. In 1992, the Company recognized $5,958,000 of special termination benefit costs related to the early retirement of associate employees. The special termination benefit costs and the net effect of changes in plan provisions, certain actuarial assumptions, and the amortization of actuarial gains and losses related to demographic and investment experience increased pension cost in 1992. A change in the expected long-term rate of return on plan assets resulted in a $8,932,000 reduction in pension cost (which reduced operating expenses by $7,661,000 after capitalization of amounts related to the construction program) and substantially offset the 1992 cost increase. Statement of Financial Accounting Standards No. 87, "Employers' Accounting for Pensions" (Statement No. 87) requires a comparison of the actuarial present value of projected benefit obligations with the fair value of plan assets, the disclosure of the components of net periodic pension costs and a reconciliation of the funded status of the plans with amounts recorded on the balance sheets. The Company participates in multi-employer plans and therefore, such disclosures are not presented for the Company because the structure of the plans does not allow for the determination of this information on an individual participating company basis. Significant actuarial assumptions are as follows: The Company has in the past entered into collective bargaining agreements with unions representing certain employees and expects to do so in the future. Pension benefits have been included in these agreements and improvements in benefits have been made from time to time. Additionally, the Company has amended the benefit formula under pension plans maintained for its management employees. Expectations with respect to future amendments to the Company's pension plans have been reflected in determining the Company's pension cost under Statement No. 87. POSTRETIREMENT BENEFITS OTHER THAN PENSIONS Effective January 1, 1991, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," (Statement No. 106). Statement No. 106 requires accrual accounting for all postretirement benefits other than pensions. Under the prescribed accrual method, the Company's obligation for these postretirement benefits is to be fully accrued by the date employees attain full eligibility for such benefits. BELL ATLANTIC - MARYLAND, INC. In conjunction with the adoption of Statement No. 106, the Company elected, for financial reporting purposes, to recognize immediately the accumulated postretirement benefit obligation for current and future retirees, net of the fair value of plan assets and recognized accrued postretirement benefit cost (transition obligation), in the amount of $257,874,000, net of a deferred income tax benefit of $143,604,000. For purposes of measuring the interstate rate of return achieved by the Company, the Federal Communications Commission (FCC) permits recognition of postretirement benefit costs, including amortization of the transition obligation, in accordance with the prescribed accrual method included in Statement No. 106. In January 1993, the FCC denied adjustments to the interstate price cap formula which would have permitted tariff increases to reflect the incremental postretirement benefit cost resulting from the adoption of Statement No. 106. For intrastate ratemaking purposes, the Maryland Public Service Commission issued an order as part of a general rate proceeding permitting recognition of accrued postretirement benefit costs, including flexible amortization of the transition obligation, for rate of return measurement purposes. Pursuant to Statement of Financial Accounting Standards No. 71, "Accounting for the Effects of Certain Types of Regulation" (Statement No. 71), a regulatory asset associated with the recognition of the transition obligation was not recorded because of uncertainties as to the timing and extent of recovery given the Company's assessment of its long-term competitive environment. Substantially all of the Company's management and associate employees are covered under postretirement health and life insurance benefit plans sponsored by Bell Atlantic and certain of its subsidiaries, including the Company. The determination of benefit cost for postretirement health benefit plans is based on comprehensive hospital, medical, surgical and dental benefit plan provisions. The postretirement life insurance benefit formula used in the determination of postretirement benefit cost is primarily based on annual basic pay at retirement. The Company funds the postretirement health and life insurance benefits of current and future retirees. Plan assets consist principally of investments in domestic and foreign corporate equity securities, and U.S. Government and corporate debt securities. The aggregate postretirement benefit cost for the years ended December 31, 1993, 1992, and 1991 was $38,653,000, $33,431,000, and $31,812,000, respectively. As a result of 1992 collective bargaining agreements, Bell Atlantic amended the postretirement medical benefit plan for associate employees and certain associate retirees of the Company. The increases in the postretirement benefit cost between 1993 and 1991 were primarily due to the change in benefit levels and claims experience. Also contributing to these increases were changes in actuarial assumptions and demographic experience. Statement No. 106 requires a comparison of the actuarial present value of projected benefit obligations with the fair value of plan assets, the disclosure of the components of net periodic postretirement benefit costs, and a reconciliation of the funded status of the plan with amounts recorded on the balance sheets. The Company participates in multi-employer plans and therefore, such disclosures are not presented for the Company because the structure of the plans does not provide for the determination of this information on an individual participating company basis. The assumed discount rate used to measure the accumulated postretirement benefit obligation was 7.25% at December 31, 1993 and 7.75% at December 31, 1992. The assumed rate of future increases in compensation levels was 5.25% at December 31, 1993 and 1992. The expected long-term rate of return on plan assets was 8.25% for 1993 and 1992 and 7.5% for 1991. The medical cost trend rate in 1993 was approximately 13.0%, grading down to an ultimate rate in 2003 of approximately 5.0%. The dental cost trend rate in 1993 and thereafter is approximately 4.0%. BELL ATLANTIC - MARYLAND, INC. Postretirement benefits other than pensions have been included in collective bargaining agreements and have been modified from time to time. The Company has periodically modified benefits under plans maintained for its management employees. Expectations with respect to future amendments to the Company's postretirement plans have been reflected in determining the Company's postretirement benefit cost under Statement No. 106. POSTEMPLOYMENT BENEFITS Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" (Statement No. 112). Statement No. 112 requires accrual accounting for the estimated cost of benefits provided to former or inactive employees after employment but before retirement. This change principally affects the Company's accounting for disability and workers' compensation benefits, which previously were charged to expense as the benefits were paid. The cumulative effect at January 1, 1993 of adopting Statement No. 112 reduced net income by $14,271,000, net of a deferred tax benefit of $7,881,000. The adoption of Statement No. 112 did not have a significant effect on the Company's ongoing level of operating expense in 1993. 5. INCOME TAXES Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (Statement No. 109). Statement No. 109 requires the determination of deferred taxes using the liability method. Under the liability method, deferred taxes are provided on book and tax basis differences and deferred tax balances are adjusted to reflect enacted changes in income tax rates. Prior to 1993, the Company accounted for income taxes based on the provisions of Accounting Principles Board Opinion No. 11. Statement No. 109 has been adopted on a prospective basis and amounts presented for prior years have not been restated. As of January 1, 1993, the Company recorded a charge to income of $193,000, representing the cumulative effect of adopting Statement No. 109, which has been reflected in Operating Income Taxes in the Statement of Income and Reinvested Earnings. Upon adoption of Statement No. 109, the effects of required adjustments to deferred tax balances were primarily deferred on the balance sheet as regulatory assets and liabilities in accordance with Statement of Financial Accounting Standards No. 71, "Accounting for the Effects of Certain Types of Regulation" (Statement No. 71). At January 1, 1993, the Company recorded income tax-related regulatory assets totaling $108,518,000 in Other Assets. These regulatory assets represent the anticipated future regulatory recognition of the Statement No. 109 adjustments to recognize (i) temporary differences for which deferred taxes had not been provided and (ii) the increase in the deferred state tax liability which resulted from increases in state income tax rates subsequent to the dates the deferred taxes were recorded. In addition, income tax-related regulatory liabilities totaling $127,475,000 were recorded in Deferred Credits and Other Liabilities - Other. These regulatory liabilities represent the anticipated future regulatory recognition of the Statement No. 109 adjustments to recognize (i) a reduced deferred tax liability resulting from decreases in federal income tax rates subsequent to the dates the deferred taxes were recorded and (ii) a deferred tax benefit required to recognize the effects of the temporary differences attributable to the Company's policy of accounting for investment tax credits using the deferred method. These deferred taxes and regulatory assets and liabilities have been increased for the tax effect of future revenue requirements. These regulatory assets and liabilities are amortized at the time the related deferred taxes are recognized in the ratemaking process. BELL ATLANTIC - MARYLAND, INC. Prior to the adoption of Statement No. 109, the Company had income tax timing differences for which deferred taxes had not been provided pursuant to the ratemaking process of $142,762,000 and $118,686,000 at December 31, 1992 and 1991, respectively. These timing differences principally related to the allowance for funds used during construction and certain taxes and payroll- related construction costs capitalized for financial statement purposes, but deducted currently for income tax purposes, net of applicable depreciation. The Omnibus Budget Reconciliation Act of 1993, which was enacted in August 1993, increased the federal corporate income tax rate from 34% to 35%, effective January 1, 1993. In the third quarter of 1993, the Company recorded a net benefit to the tax provision of $293,000, which included a $2,836,000 charge for the nine month effect of the 1% rate increase, more than offset by a one- time net benefit of approximately $3,129,000 related to adjustments to deferred tax assets associated with the postretirement benefit obligation of the Company. Pursuant to Statement No. 71, the effect of the income tax rate increase on the deferred tax balances was primarily deferred through the establishment of regulatory assets of $4,345,000 and the reduction of regulatory liabilities of $16,727,000. The Company did not recognize regulatory assets and liabilities related to the postretirement benefit obligation or the associated deferred income tax asset. The components of operating income tax expense are as follows: Income tax benefits which relate to non-operating income and expense and is included in Miscellaneous-net were $116,000, $566,000, and $371,000 in 1993, 1992, and 1991, respectively. For the years ended December 31, 1992 and 1991, deferred income tax expense resulted from timing differences in the recognition of revenue and expense for financial and income tax accounting purposes. The sources of these timing differences and the tax effects of each were as follows: BELL ATLANTIC - MARYLAND, INC. The provision for income taxes varies from the amount computed by applying the statutory federal income tax rate to income before provision for income taxes. The difference is attributable to the following factors: At December 31, 1993, the significant components of deferred tax assets and liabilities were as follows: Total deferred tax assets include approximately $160,000,000 related to postretirement benefit costs recognized in accordance with Statement No. 106. This deferred tax asset will gradually be realized over the estimated lives of current retirees and employees. 6. SUPPLEMENTAL CASH FLOW AND ADDITIONAL FINANCIAL INFORMATION For the years ended December 31, 1993, 1992, and 1991, revenues generated from services provided to AT&T, principally network access, billing and collection, and sharing of network facilities, were $209,971,000, $235,732,000, and $238,778,000, respectively. At December 31, 1993 and 1992, Accounts receivable, net, included $15,148,000 and $17,696,000, respectively, from AT&T. BELL ATLANTIC - MARYLAND, INC. Financial instruments that potentially subject the Company to concentrations of credit risk consist of trade receivables with AT&T, as noted above. Credit risk with respect to other trade receivables is limited due to the large number of customers included in the Company's customer base. At December 31, 1992, $16,053,000 of negative cash was classified as Accounts payable. 7. TRANSACTIONS WITH AFFILIATES The Company has contractual arrangements with an affiliated company, Bell Atlantic Network Services, Inc. (NSI), for the provision of various centralized corporate, administrative, planning, financial and other services. These arrangements serve to fulfill the common needs of Bell Atlantic's telephone subsidiaries on a centralized basis. In connection with these services, the Company recognized $299,150,000, $295,317,000, and $290,717,000 in operating expenses for the years ended December 31, 1993, 1992, and 1991, respectively. Included in these expenses were $23,446,000 in 1993, $31,691,000 in 1992, and $25,684,000 in 1991 billed to NSI and allocated to the Company by Bell Communications Research, Inc., another affiliated company owned jointly by the seven regional holding companies. In 1991, these charges included $7,580,000 associated with NSI's adoption of Statement No. 106. In addition, in 1991, the Company recognized a charge of $76,651,000 representing the Company's proportionate share of NSI's accrued transition obligation under Statement No. 106. In connection with the adoption of Statement No. 112 in 1993, the cumulative effect included $1,478,000, net of a deferred income tax benefit of $816,000, representing the Company's proportionate share of NSI's accrued cost of postemployment benefits at January 1, 1993. The Company has a contractual agreement with an affiliated company, BANFC, for the provision of short-term financing and cash management services. BANFC issues commercial paper and secures bank loans to fund the working capital requirements of the telephone subsidiaries and NSI and invests funds in temporary investments on their behalf. In connection with this arrangement, the Company recognized interest expense of $2,042,000, $3,252,000, and $9,806,000 in 1993, 1992, and 1991, respectively, and $498,000 and $43,000 in interest income in 1993 and 1992, respectively. In 1993, the Company received $40,828,000 in revenue from affiliates, principally related to rent received for the use of Company facilities and equipment, and paid $36,902,000 in other operating expenses to affiliated companies. These amounts were $36,988,000 and $32,786,000, respectively, in 1992 and $37,811,000 and $36,010,000, respectively, in 1991. On February 1, 1994, the Company declared and paid a dividend in the amount of $54,911,000 to Bell Atlantic. BELL ATLANTIC - MARYLAND, INC. 8. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) Net income for the first quarter of 1993 has been restated to include a charge of $14,271,000, net of a deferred income tax benefit of $7,881,000, related to the adoption of Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" (Note 4). BELL ATLANTIC - MARYLAND, INC. SCHEDULE V - PLANT, PROPERTY AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1993 (DOLLARS IN THOUSANDS) The notes on page are an integral part of this schedule. BELL ATLANTIC - MARYLAND, INC. SCHEDULE V - PLANT, PROPERTY AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1992 (DOLLARS IN THOUSANDS) The notes on page are an integral part of this schedule. BELL ATLANTIC - MARYLAND, INC. SCHEDULE V - PLANT, PROPERTY AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1991 (DOLLARS IN THOUSANDS) The notes on page are an integral part of this schedule. BELL ATLANTIC - MARYLAND, INC. NOTES TO SCHEDULE V - PLANT, PROPERTY AND EQUIPMENT - -------------- (a) These additions include (1) the original cost (estimated if not specifically determinable) of reused material, which is concurrently credited to material and supplies, and (2) allowance for funds used during construction. Transfers between Plant in Service, Plant Under Construction and Other are also included in Additions at Cost. (b) Items of plant, property and equipment are deducted from the property accounts when retired or sold at the amounts at which they are included therein, estimated if not specifically determinable. (c) The Company's provision for depreciation is principally based on the remaining life method and straight-line composite rates prescribed by regulatory authorities. The remaining life method provides for the full recovery of the remaining net investment in plant, property and equipment. In 1992, the Company implemented changes in depreciation rates approved by the FCC and state regulators. These changes reflect decreases in estimated service lives of the Company's plant, property and equipment in service. This ruling will allow a more rapid recovery of the Company's investment in plant, property and equipment through closer alignment with current estimates of its remaining economic useful life. For the years 1993, 1992, and 1991, depreciation expressed as a percentage of average depreciable plant was 7.3%, 7.3%, and 6.3% respectively. (d) See Note 1 of Notes to Financial Statements for the Company's depreciation policies. BELL ATLANTIC - MARYLAND, INC. SCHEDULE VI - ACCUMULATED DEPRECIATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 (DOLLARS IN THOUSANDS) - ---------------------------------------- (a) Includes any gains or losses on disposition of plant, property and equipment. These gains and losses are amortized to depreciation expense over the remaining service lives of remaining net investment in plant, property and equipment. BELL ATLANTIC - MARYLAND, INC. SCHEDULE VIII - VALUATION OF QUALIFYING ACCOUNTS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 (DOLLARS IN THOUSANDS) - ------------------------------------------- (a) (i) Amounts previously written off which were credited directly to this account when recovered; and (ii) accruals charged to accounts payable for anticipated uncollectible charges on purchases of accounts receivable from others which were billed by the Company. (b) Amounts written off as uncollectible. BELL ATLANTIC - MARYLAND, INC. SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 (DOLLARS IN THOUSANDS) Advertising costs for 1993 and 1991 are not presented, as such amounts are less than 1 percent of total operating revenues. Amounts reported for 1992 and 1991 for maintenance and repairs have been revised to include certain additional costs. EXHIBITS FILED WITH ANNUAL REPORT FORM 10-K UNDER THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 1993 COMMISSION FILE NUMBER 1-6875 Form 10-K for 1993 File No. 1-6875 Page 1 of 1 EXHIBIT INDEX Exhibits identified in parentheses below, on file with the Securities and Exchange Commission (SEC), are incorporated herein by reference as exhibits hereto. EXHIBIT NUMBER (REFERENCED TO ITEM 601 OF REGULATION S-K) --------------------------------------------------------- 3a Articles of Restatement of registrant filed July 30, 1990. (Exhibit 3a to the registrant's Annual Report on Form 10-K for 1990, File No. 1-6875.) 3a(i) Articles of Amendment to registrant's Certificate of Incorporation dated January 11, 1994 and filed January 13, 1994. 3b By-Laws of the registrant, as amended January 1, 1990. (Exhibit 3b to the registrant's Annual Report on Form 10-K for 1989, File No. 1-6875.) 3b(i) Resolution dated August 31, 1992 amending Article V, Section 5-a regarding: Indemnification of Directors. (Exhibit 3b to the registrant's Annual Report on Form 10-K for 1992, File No. 1-6075.) 4 No instrument which defines the rights of holders of long-term debt of the registrant is filed herewith pursuant to Regulation S-K, Item 601(b)(4)(iii)(A). Pursuant to this regulation, the registrant hereby agrees to furnish a copy of any such instrument to the SEC upon request. 10a Agreement Concerning Contingent Liabilities, Tax Matters and Termination of Certain Agreements among AT&T, Bell Atlantic Corporation, the Bell Atlantic Corporation telephone subsidiaries, and certain other parties, dated as of November 1, 1983. (Exhibit 10a to Bell Atlantic Corporation Annual Report on Form 10-K for the year ended December 31, 1993, File No. 1-8606). 10b Agreement among Bell Atlantic Network Services, Inc. and the Bell Atlantic Corporation telephone subsidiaries, dated November 7, 1983. (Exhibit 10b to Bell Atlantic Corporation Annual Report on Form 10-K for the year ended December 31, 1993, File No. 1-8606). 23 Consent of Coopers & Lybrand. 24 Powers of attorney.
19150_1993.txt	19150	1993	ITEM 1. BUSINESS GENERAL Champion International Corporation was incorporated under the laws of the State of New York on April 28, 1937. References to the "Company" include Champion International Corporation and its subsidiaries at December 31, 1993, unless the context otherwise requires. The Company is one of the leading domestic manufacturers of paper for business communications, commercial printing, publications and newspapers. In addition, the Company has significant plywood and lumber manufacturing operations and owns or controls approximately 5,072,000 acres of timberlands in the United States. The Company's Canadian and Brazilian subsidiaries also own or control significant timber resources supporting their operations. The Company's business segments are paper and wood products. See Note 13 of Notes to Financial Statements on pages 37 and 38 of the Company's Annual Report to Shareholders for the fiscal year ended December 31, 1993 (the "Company's 1993 Annual Report"), which Note is incorporated by reference herein, for information concerning the Company's business segments and operations in different geographic areas for 1991, 1992 and 1993. PAPER See the Net Sales table on page 18 of the Company's 1993 Annual Report, which table is incorporated by reference herein, for information concerning the net sales to unaffiliated customers of the various products of the paper business for 1991, 1992 and 1993. PRINTING AND WRITING PAPERS The printing and writing papers business manufactures and sells printing and writing papers, bleached paperboard and pulp. The principal domestic manufacturing properties of this operation consist of integrated pulp and paper mills at Courtland, Alabama; Canton, North Carolina; and Pensacola, Florida; and a paper mill at Hamilton, Ohio. As of December 31, 1993, these mills had an annual capacity of approximately 1,846,000 tons of pulp and 2,066,000 tons of printing and writing papers and bleached paperboard. Most of the pulp produced by the printing and writing papers business is used in its own paper mills; approximately 14%, produced at the Pensacola and Courtland mills, was sold in the open market in 1993. A portion of the fiber requirements of this business also is supplied by other Company pulp mills, and approximately 4% of its fiber requirements in 1993 were purchased from third- party suppliers. Uncoated papers produced by the printing and writing papers business are used for computer forms, copier paper and envelope papers. Coated papers are used in catalogs, magazines, brochures, labels and annual reports. In 1993, 63% of this operation's bleached paperboard production was used by the Company's DairyPak unit, which converts polyethylene-coated paperboard into milk and juice cartons and ovenable packaging. The balance either was sold to independent purchasers, primarily for conversion to cups, or was exported. The Company leases substantial portions of the Courtland mill under 10 long- term net leases which expire between 1997 and 2029. Each of these leases provides for rental payments over its term sufficient to pay interest on and to retire the industrial development or pollution control revenue bonds issued in connection with the financing of the property subject to such lease. The Company is required to purchase, or has the option to purchase, the property subject to each such lease for a nominal sum at the time the related bonds are retired. The domestic printing and writing papers business and the publication papers business jointly maintain 11 sales offices in various parts of the United States, as well as an order services office in Hamilton, Ohio, for the sale of their products to direct purchasers and through paper merchants. Certain of these sales offices are shared with the newsprint and kraft operations. Champion Papel e Celulose Ltda., a 99%-owned subsidiary ("Champion Papel"), is a major integrated manufacturer of pulp and printing and writing papers in Brazil with net sales to unaffiliated customers of (U.S.) $272,498,000 in 1993. As of December 31, 1993, this mill had an annual capacity of approximately 334,000 tons of pulp and 373,000 tons of paper. In addition to being a leading supplier of printing and writing papers in Brazil, Champion Papel exports a substantial portion of its paper production. PUBLICATION PAPERS The publication papers business manufactures and sells coated and uncoated publication papers and pulp. The manufacturing properties of this operation consist of integrated pulp and paper mills at Bucksport, Maine; Deferiet, New York; Quinnesec, Michigan; and Sartell, Minnesota. As of December 31, 1993, these mills had an annual capacity of approximately 810,000 tons of pulp and 1,250,000 tons of publication papers. A significant portion of the fiber requirements of the publication papers business is supplied by its own mills. In addition, a portion of its fiber requirements is supplied by other Company pulp mills, and approximately 26% of its fiber requirements in 1993 were purchased from third-party suppliers. The Company manufactures pulp for sale in the open market at the Quinnesec mill. In 1993, approximately 60% of the pulp production of this mill, or 215,000 tons, was sold in the open market through the Company's headquarters in Stamford, Connecticut, as well as a sales office in Appleton, Wisconsin. The balance was used in the production of paper at the Quinnesec mill and at the Company's printing and writing papers mills. The Company's publication papers are used primarily for consumer magazines, direct mail catalogs, directories, textbooks and coupons. Sales are made to direct purchasers and through paper merchants and brokers from the 11 sales offices jointly maintained by the publication papers operation and the printing and writing papers operation, and from the Hamilton, Ohio order services office. The Company leases the building which houses one of the paper machines at the Sartell mill until 2008. Thereafter, the Company has options to renew the lease for five terms of five years each. The Company also has the option to purchase the building at its then-current market value at the end of the initial term in 2008 or at the end of each five-year renewal term. The Company leases certain water pollution control facilities at the Deferiet mill until November 30, 1994. The lease provides for rental payments over its term sufficient to pay interest on and to retire the tax-exempt bonds (in the original principal amount of $7 million) issued to finance the acquisition of those facilities. The Company has the option to purchase the facilities for a nominal sum at the time the bonds are retired. NEWSPRINT The newsprint business manufactures pulp and manufactures and sells newsprint, directory paper and groundwood specialties. The manufacturing properties of this operation consist of integrated pulp and paper mills at Lufkin and Sheldon, Texas. As of December 31, 1993, these mills had an annual capacity of approximately 1,191,000 tons of pulp (which includes 150,000 tons of recycled pulp) and 952,000 tons of newsprint, directory paper and groundwood specialties. Virtually all of the newsprint operation's pulp production is used in its own paper mills; approximately 2% was sold in the open market in 1993. Most of the newsprint produced by the Company is sold in the Southwest, Southeast and Midwest. In general, sales are made directly to publishers and printers through four sales offices, three of which are shared with the printing and writing papers and publication papers operations, and one order services office. PULP For information concerning market pulp produced at the Pensacola and Courtland mills, see the section captioned Printing and Writing Papers above, and for information concerning market pulp produced at the Quinnesec mill, see the section captioned Publication Papers above. Weldwood of Canada Limited, a Canadian subsidiary in which the Company has approximately 85% ownership ("Weldwood"), manufactures bleached softwood kraft pulp at its mill in Hinton, Alberta, Canada. As of December 31, 1993, this mill had an annual capacity of approximately 424,000 tons. In 1993, approximately 29% of the mill's pulp production was used in the Company's own publication papers and printing and writing papers mills. The balance was sold in the open market through the Company's headquarters in Stamford, Connecticut, a Company sales office in Appleton, Wisconsin and a Weldwood sales office in Bad Homburg, Germany. Cariboo Pulp & Paper Company, a joint venture owned equally by Weldwood and Daishowa-Marubeni International Limited, operates a bleached softwood kraft pulp mill in Quesnel, British Columbia, Canada. As of December 31, 1993, this mill had an annual capacity of approximately 340,000 tons. In 1993, approximately 13% of Weldwood's 50% share of the mill's pulp production was used in the Company's own publication papers and printing and writing papers mills. The balance of Weldwood's share was sold in the open market through the Company's headquarters in Stamford, Connecticut, a Company sales office in Appleton, Wisconsin and a Weldwood sales office in Bad Homburg, Germany. While certain of the Company's mills purchase pulp in the open market, the Company and Weldwood overall are net sellers of pulp. In 1993, the Company and Weldwood in the aggregate produced approximately 855,000 tons of pulp for sale to unaffiliated purchasers, while the Company used approximately 314,000 tons of pulp purchased from third-party suppliers, resulting in net market pulp of approximately 541,000 tons. KRAFT The Company produces pulp, unbleached linerboard and kraft paper for multiwall and grocery bags at its mill in Roanoke Rapids, North Carolina. As of December 31, 1993, this mill had an annual capacity to produce approximately 489,000 tons of pulp, 402,000 tons of linerboard and 105,000 tons of kraft paper. All of this mill's pulp production is used at the mill. In addition, approximately 7% of its fiber requirements in 1993 were purchased from third- party suppliers. The linerboard and kraft paper produced at the Roanoke Rapids mill are sold to converters through three sales offices, two of which are shared with the printing and writing papers and publication papers operations, and one order services office. PAPER DISTRIBUTION OPERATION Nationwide Papers is the Company's wholly owned distributor of paper and paper products. Its marketing operations are carried out through 28 wholesale warehouse facilities in 18 states. In addition, Nationwide Papers operates a facility which converts rolls of bleached paperboard into sheets for sale to textile, furniture and tobacco producers. In 1993, approximately 75% of its sales were attributable to merchandise purchased from numerous manufacturers other than the Company. However, Nationwide Papers is not dependent on any single supplier for such merchandise. WOOD PRODUCTS The Company is a major producer of plywood and lumber. The Company's wood products business is conducted through its domestic wood products operations and through the wood products operations of Weldwood. The principal wood products manufacturing facilities operated by the Company and by Weldwood are summarized under Item 2		ITEM 2. PROPERTIES In 1993, the overall operating rate for the Company's domestic and foreign manufacturing facilities exceeded 98% of capacity in the paper segment, 80% of capacity for lumber and studs, and 97% of capacity for panelboard (plywood and waferboard). Production curtailments in the Company's paper segment were attributable primarily to scheduled maintenance. Production curtailments in the wood products segment were attributable primarily to log supply shortages resulting from the scarcity of timber, as well as the process of disposing of several mills. Reference is made to Item 1 of this Report for information concerning the general character, adequacy and capacity of the principal plants, timber properties and other materially important physical properties of the Company. The following lists show the location, nature and ownership of the Company's principal plants. Except as indicated, none of these plants is subject to a mortgage and all are owned in fee. PAPER PRINTING AND WRITING PAPERS (a) Integrated pulp and printing and writing papers mills: (i) Courtland, Alabama/1/; (ii) Canton, North Carolina; (iii) Pensacola, Florida; and (iv) Mogi Guacu, Brazil. (b) The Company operates a printing and writing papers mill in Hamilton, Ohio. (c) The Company operates a plant in Waynesville, North Carolina which applies polyethylene coating to bleached paperboard and which also converts roll stock into cut-size paper. (d) The Company operates five plants which convert polyethylene-coated paperboard into milk and juice cartons and one plant which converts polyethylene-coated paperboard into ovenable packaging. All of these plants are located in the United States. PUBLICATION PAPERS (e) Integrated pulp and publication papers mills: (i) Bucksport, Maine; (ii) Deferiet, New York/2/; (iii) Quinnesec, Michigan; and (iv) Sartell, Minnesota/2/. - ---------- /1/For Courtland, Alabama mill lease information, see Item 1 - Paper of this Report. /2/For Deferiet, New York and Sartell, Minnesota mill lease information, see Item 1 - Paper of this Report. NEWSPRINT (f) Integrated pulp and newsprint mills: (i) Lufkin, Texas; and (ii) Sheldon, Texas. PULP (g) The Company's printing and writing papers mills in Pensacola, Florida and Courtland, Alabama and publication papers mill in Quinnesec, Michigan also produce market pulp. (h) Weldwood operates a pulp mill in Hinton, Alberta, Canada and owns 50% of a joint venture which operates a pulp mill in Quesnel, British Columbia, Canada. KRAFT (i) The Company operates an integrated pulp, unbleached linerboard and kraft paper mill in Roanoke Rapids, North Carolina. WOOD PRODUCTS (a) The Company operates three softwood plywood plants in the United States. (b) Weldwood operates two softwood plywood plants and one specialty hardwood plywood plant in Canada. One of these plants is located on leased land. (c) The Company operates seven softwood lumber mills in the United States. (d) Weldwood operates five softwood lumber mills in Canada. One of these mills is located on leased land. (e) Each of Babine Forest Products Company and Houston Forest Products Company, joint ventures in which Weldwood has an interest, operates a mill for the production of softwood lumber in Canada. Both mills are located on leased land. (f) Weldwood operates one waferboard plant in Canada. ITEM 3.	ITEM 3. LEGAL PROCEEDINGS On January 4, 1991, a class action was brought against the Company in state court in Tennessee. The class consisted of all Tennessee residents who own or lease land around Douglas Lake or along the Pigeon River. Subsequently, the case was transferred to the United States District Court for the Eastern District of Tennessee. While the original complaint sought $5 billion in compensatory and punitive damages, immediately prior to trial the plaintiffs reduced their demand to $367.9 million. The plaintiffs originally claimed damages for both personal injury and property damage, but the personal injury claims were dismissed. The case proceeded to trial on plaintiffs' theory that discharges of hazardous materials, including dioxin, from the Company's Canton, North Carolina mill had decreased property values along the river and the lake. On October 16, 1992, a mistrial was declared when the jury was unable to reach a unanimous verdict. On May 3, 1993, the court approved a settlement of the action providing for a payment of $6.5 million by the Company. On June 1, 1993, the court's approval of the settlement was appealed. On September 18, 1992, an action was brought in the District Court of Brazoria County, Texas by 26 individuals engaged in seafood-related businesses against the Company, Simpson Pasadena Paper Company, the Gulf Coast Waste Disposal Authority and eight other corporations and individuals. The action sought unspecified damages for lost business profits, diminution in property value and mental anguish allegedly resulting from the purported discharge of dioxin into the Brazos River, Galveston Bay, the Neches River and their adjacent waters, from the Company's Sheldon and Lufkin, Texas mills, Simpson's Pasadena, Texas mill and the other defendants' mills and plants. The Company sold the Pasadena mill to Simpson in 1987 but may be liable for damages, if any, arising from wastewater discharges which occurred prior to the sale. On September 2, 1993, at the plaintiffs' request, the action was dismissed with respect to the Company's Lufkin mill. In December 1993, the action was settled for an immaterial amount. On September 18, 1992, an action was brought in the District Court of Harris County, Texas by 71 individuals primarily engaged in seafood-related businesses against the Company, Simpson Pasadena Paper Company, the Gulf Coast Waste Disposal Authority and eight other corporations and individuals. The action sought unspecified damages for lost business profits, diminution in property value and mental anguish allegedly resulting from the purported discharge of dioxin into the Brazos River, Galveston Bay, the Neches River and their adjacent waters, from the Company's Sheldon and Lufkin, Texas mills, Simpson's Pasadena, Texas mill and the other corporate defendants' mills and plants. The Company sold the Pasadena mill to Simpson in 1987 but may be liable for damages, if any, arising from wastewater discharges which occurred prior to the sale. On September 2, 1993, at the plaintiffs' request, the action was dismissed with respect to the Company's Lufkin mill. In December 1993, the action was settled for an immaterial amount. On November 9, 1992, an action was brought against the Company in the Circuit Court for Baldwin County, Alabama purportedly on behalf of a class consisting of all persons who own land along Perdido Bay in Florida and Alabama. The action originally sought $500 million in compensatory and punitive damages for personal injury, intentional infliction of emotional distress and diminution in property value allegedly resulting from the purported discharge of hazardous substances, including dioxin, from the Company's Pensacola, Florida mill into Eleven Mile Creek, which flows into Perdido Bay. However, in February 1994, the plaintiffs reduced their demand to not more than $50,000 for each class member. It is anticipated that the class, if certified, will consist of approximately 1,000 members. The parties currently are engaged in discovery. The Company and many other corporations, municipalities and individuals are defendants in three separate actions filed in the District Court of Galveston County, Texas by numerous individuals on March 8, 1993, April 20, 1993 and May 13, 1993, respectively. Each of these actions seeks compensatory and punitive damages in excess of $5 billion for personal injury and property damage allegedly resulting from the purported disposal of waste materials, including hazardous substances, into the McGinnis Waste Disposal Site located at Hall's Bayou Ranch. On July 17, 1991, an action was brought in the United States District Court for the District of Colorado against Weldwood and 14 other Canadian forest products companies purportedly on behalf of a class of United States purchasers of Canadian lumber. The action, seeking injunctive relief and unspecified treble damages, alleged a conspiracy by the defendants and others to fix freight charges for, and to sell on a delivered price basis, Western Canadian softwood lumber, thereby allegedly artificially raising, fixing, maintaining or stabilizing prices in violation of United States antitrust laws. On January 8, 1993, the action was dismissed, upon the motion of the defendants, for reasons of comity. On January 20, 1993, the plaintiff filed a notice of appeal. In February 1994, the action was settled for an immaterial amount. The Company is vigorously defending each of the pending actions described above. The Company also is involved in other legal and administrative proceedings and claims of various types. While any litigation contains an element of uncertainty, management, based upon the opinion of the Company's General Counsel, presently believes that the outcome of each such proceeding or claim which is pending or known to be threatened (including the actions described above), or all of them combined, will not have a material adverse effect on the Company. ITEM 4.	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. EXECUTIVE OFFICERS OF THE REGISTRANT/1/ John A. Ball (age 65) is a Senior Vice President of the Company, a position which he has held since March 1983. He has responsibility for corporate and marketing communications, governmental affairs, public affairs and facilities services. L. Scott Barnard (age 51) is an Executive Vice President of the Company, a position which he has held since August 1992. He has responsibility for sales and marketing for the printing and writing papers and publication papers businesses. From February 1989 to August 1992, he was Vice President-Sales and Marketing for the printing and writing papers and publication papers businesses. Gerald J. Beiser (age 63) is Senior Vice President-Finance of the Company, a position which he has held since 1975. William H. Burchfield (age 58) is an Executive Vice President of the Company, a position which he has held since November 1982. He has responsibility for the domestic printing and writing papers business. Mark V. Childers (age 41) is Senior Vice President-Organizational Development and Human Resources of the Company, a position which he has held since August 1992. From June 1991 to August 1992, he was Vice President-Organizational Development Project of the Company. From August 1988 to June 1991, he was Manager-Organizational Development at the Lufkin, Texas mill. Richard J. Diforio, Jr. (age 58) is a Senior Vice President of the Company, a position which he has held since November 1992. He has responsibility for environmental, health and safety affairs. From September 1990 to November 1992, he was Vice President-Environment, Health and Safety of the Company. From September 1986 to September 1990, he was Vice President-Environmental Affairs of the Company. Joe K. Donald (age 51) is an Executive Vice President of the Company, a position which he has held since August 1989. He heads the publication papers business. From December 1987 to August 1989, he was Vice President- Manufacturing of the printing and writing papers business. Mark A. Fuller, Jr. (age 61) is an Executive Vice President of the Company, a position which he has held since August 1980. He has responsibility for the Company's overall marketing program as well as for Nationwide Papers, Champion Export, pulp sales and sales of wood chemicals and by-products. From July 1986 to August 1989, he headed the publication papers business. Marvin H. Ginsky (age 63) is Senior Vice President and General Counsel of the Company. He was elected a Senior Vice President in May 1981. He has been the General Counsel since 1973. L.C. Heist (age 62) is President and Chief Operating Officer and a director of the Company, positions which he has held since December 1987. Burton G. MacArthur, Jr. (age 47) is an Executive Vice President of the Company, a position which he has held since January 1990. He has responsibility for the newsprint and kraft operations. From March 1989 to January 1990, he was Vice President-Management Information Services of the Company. _______________________________ /1/The term of office for each executive officer expires at the Annual Meeting of the Board of Directors of the Company scheduled to be held on May 19, 1994. Kenwood C. Nichols (age 54) is Vice Chairman and a director of the Company, positions which he has held since August 1989. He has been the principal accounting officer of the Company since July 1983. He also has responsibility for internal audit, corporate analysis, tax affairs, management information services, mineral resources, corporate security and the Company's real estate subsidiaries. From July 1983 to August 1989, he was a Senior Vice President of the Company. Richard E. Olson (age 56) is an Executive Vice President of the Company, a position which he has held since December 1987. He has responsibility for engineering, technology, manufacturing support and major projects. From December 1987 to January 1990, he had responsibility for the newsprint, domestic pulp and kraft operations. Richard L. Porterfield (age 47) is an Executive Vice President of the Company, a position which he has held since August 1992. He heads the forest products unit, which consists of domestic timberlands operations and the domestic wood products business. From January 1990 to August 1992, he was Senior Vice President- Organizational Development and Human Resources of the Company. From August 1989 to January 1990, he was Vice President-Organizational Development Project of the Company. From June 1988 to August 1989, he was Director-Participative Management and Administration of the forest products unit. Andrew C. Sigler (age 62) is Chairman of the Board of Directors and Chief Executive Officer of the Company. He was elected Chairman of the Board effective January 1, 1979. He has served as Chief Executive Officer since 1974 and has been a director since 1973. PART II ITEM 5.	ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company had 23,394 record holders of its Common Stock as of February 28, 1994. The Company's Common Stock is traded on the New York Stock Exchange. Restrictions on the ability of the Company to pay cash dividends are included in several of the Company's debt instruments and the Company's Restated Certificate of Incorporation. At December 31, 1993, the most restrictive of these limitations required the Company to maintain tangible net worth (as defined below) of at least $2.770 billion. As a result of this requirement, such amount is unavailable for the payment of dividends. Approximately $454 million of tangible net worth at December 31, 1993 was free of such restrictions. Tangible net worth is defined as shareholders' equity plus the Company's $92.50 Cumulative Convertible Preference Stock minus goodwill, unamortized debt discount and other like intangibles, all determined on a consolidated basis for the Company. For information concerning the high and low sales prices of the Company's Common Stock for each quarterly period during the last two years and the amount of dividends paid on the Company's Common Stock in each quarterly period during the last two years, see the section on the inside back cover of the Company's 1993 Annual Report captioned Common Stock Prices and Dividends Paid. Said section is incorporated by reference herein. ITEM 6.	ITEM 6. SELECTED FINANCIAL DATA There is incorporated by reference herein the table on pages 50 and 51 of the Company's 1993 Annual Report captioned Eleven-Year Selected Financial Data. ITEM 7.	ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS There is incorporated by reference herein the section on pages 43 to 49 of the Company's 1993 Annual Report captioned Management's Discussion and Analysis of Financial Condition and Results of Operations. ITEM 8.	ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA There is incorporated by reference herein the sections of the Company's 1993 Annual Report captioned Consolidated Income, Consolidated Retained Earnings, Consolidated Balance Sheet, Consolidated Cash Flows, Notes to Financial Statements and Report of Independent Public Accountants, which sections are located on pages 22, 23, 24, 25, 26 to 40, and 41, respectively, of the Company's 1993 Annual Report. ITEM 9.	ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10.	ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT See the section captioned Executive Officers of the Registrant under Part I of this Report for information concerning the Company's executive officers. For information concerning the directors of the Company, see the sections captioned The Board of Directors -The Nominees, Information on the Nominees and Directors, and Committees in the Company's definitive Proxy Statement for the Annual Meeting of Shareholders scheduled to be held on May 19, 1994. Said sections are incorporated by reference herein. ITEM 11.	ITEM 11. EXECUTIVE COMPENSATION There is incorporated by reference herein from the Company's definitive Proxy Statement for the Annual Meeting of Shareholders scheduled to be held on May 19, 1994 the sections therein captioned The Board of Directors - Directors' Compensation; and Executive Compensation - Summary Compensation Table, Option/SAR Grant Table, Option/SAR Exercise and Year-End Values Table, Pension Plan Table, and Employment and Severance Agreements. ITEM 12.	ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT There is incorporated by reference herein from the Company's definitive Proxy Statement for the Annual Meeting of Shareholders scheduled to be held on May 19, 1994 the sections therein captioned Principal Shareholders and Stock Ownership by Nominees, Directors and Named Executive Officers. ITEM 13.	ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS There is incorporated by reference herein from the Company's definitive Proxy Statement for the Annual Meeting of Shareholders scheduled to be held on May 19, 1994 the section therein captioned Transactions. PART IV ITEM 14.	ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) FINANCIAL STATEMENTS. The following Consolidated Financial Statements of Champion International Corporation and Subsidiaries, Notes to Financial Statements, and Report of Independent Public Accountants are incorporated by reference herein from the Company's 1993 Annual Report: (b) FINANCIAL STATEMENT SCHEDULES. The following Financial Statement Schedules and Report of Independent Public Accountants on Schedules are filed with this Annual Report on Form 10-K on the pages indicated: All other schedules have been omitted since the information is not applicable, is not required or is included in the Consolidated Financial Statements or Notes to Financial Statements listed under section (a) of this Item 14. (c) EXHIBITS. Each Exhibit is listed according to the number assigned to it in the Exhibit Table of Item 601 of Regulation S-K. The Exhibit numbers preceded by an asterisk () indicate Exhibits physically filed with this Annual Report on Form 10-K. All other Exhibit numbers indicate Exhibits filed by incorporation by reference herein. Exhibit numbers 10.1 through 10.29, which are preceded by a plus sign (+), are management contracts or compensatory plans or arrangements. EXHIBIT NUMBER DESCRIPTION - ------ ------------ 3.1 Restated Certificate of Incorporation of the Company, filed in the State of New York on October 20, 1986 (filed by incorporation by reference to Exhibit 3.1 to the Company's Form 10-K for the fiscal year ended December 31, 1986, Commission File No. 1-3053). 3.2 Certificate of Amendment of Restated Certificate of Incorporation of the Company, filed in the State of New York on July 18, 1988 (filed by incorporation by reference to Exhibit 4.1 to the Company's Form 10-Q for the quarter ended June 30, 1988, Commission File No. 1-3053). 3.3 Certificate of Amendment of Restated Certificate of Incorporation of the Company, filed in the State of New York on December 6, 1989 (filed by incorporation by reference to EXHIBIT NUMBER DESCRIPTION - ------ ------------ Exhibit 4.1 to the Company's Form 8-K dated December 14, 1989, Commission File No. 1-3053). 3.4 Certificate of Amendment of Restated Certificate of Incorporation of the Company, filed in the State of New York on December 21, 1989 (filed by incorporation by reference to Exhibit 3.4 to the Company's Form 10-K for the fiscal year ended December 31, 1989, Commission File No. 1-3053). 3.5 By-Laws of the Company (filed by incorporation by reference to Exhibit 3(ii).1 to the Company's Form 10-Q for the quarter ended March 31, 1993, Commission File No. 1-3053). 4.1 Letter agreement dated March 29, 1991 of the Company to furnish to the Commission upon request copies of certain instruments with respect to long-term debt (filed by incorporation by reference to Exhibit 4 to the Company's Form 10-K for the fiscal year ended December 31, 1990, Commission File No. 1-3053). 4.2 Agreement dated February 2, 1994 between the Company and Loews Corporation (filed by incorporation by reference to Exhibit 4.7 to the Company's Registration Statement on Form S-3, Commission Registration No. 33-52123). +10.1 Champion International Corporation 1986 Management Incentive Program, consisting of the 1986 Stock Option Plan and the 1986 Contingent Compensation Plan (filed by incorporation by reference to Exhibit 19.1 to the Company's Form 10-Q for the quarter ended June 30, 1986, Commission File No. 1-3053). +10.2 Amendment to Champion International Corporation 1986 Management Incentive Program (filed by incorporation by reference to Exhibit 10.1 to the Company's Form 10-Q for the quarter ended March 31, 1993, Commission File No. 1-3053). +10.3 Champion International Corporation Restricted Share Performance Plan, as amended (filed by incorporation by reference to Exhibit 10.2 to the Company's Form 10-K for the fiscal year ended December 31, 1989, Commission File No. 1-3053). +10.4 Champion International Corporation Management Incentive Program, as amended, consisting of the Amended 1976 Incentive Stock Option Plan and the Contingent Compensation Plan (filed by incorporation by reference to Exhibit 4.3 to the Company's Registration Statement on Form S-8, Commission Registration No. 2-77129). +10.5 Resolutions of the Board of Directors of the Company adopted on August 16, 1984 amending the Amended 1976 Incentive Stock Option Plan (filed by incorporation by reference to Exhibit 10(b) to the Company's Registration Statement on Form S-14, Commission Registration No. 2-94030). +10.6 Champion International Corporation Supplemental Retirement Income Plan (filed by incorporation by reference to Exhibit 10.7 to the Company's Form 10-K for the fiscal year ended December 31, 1989, Commission File No. 1-3053). +10.7 Supplemental Retirement and Death Payments Agreement dated as of August 1, 1964, as amended by letter agreement dated January 9, 1965, between the Company and Mr. Sigler (filed by incorporation by reference to Exhibit 10.8 to the Company's Form 10-K for the fiscal year ended December 31, 1990, Commission File No. 1-3053). EXHIBIT NUMBER DESCRIPTION - ------ ------------ +10.8 Restated Agreement between the Company and Mr. Sigler, as amended as of February 19, 1987, providing certain employment, severance and retirement arrangements (filed by incorporation by reference to Exhibit 19.1 to the Company's Form 10-Q for the quarter ended June 30, 1987, Commission File No. 1-3053). +10.9 Agreement Relating to Legal Expenses dated February 19, 1987 between the Company and Mr. Sigler providing reimbursement of certain legal expenses following a change in control of the Company (filed by incorporation by reference to Exhibit 19.2 to the Company's Form 10-Q for the quarter ended June 30, 1987, Commission File No. 1-3053). +10.10 Amendment dated as of April 21, 1988 to Restated Agreement between the Company and Mr. Sigler as amended as of February 19, 1987 (filed by incorporation by reference to Exhibit 19.1 to the Company's Form 10-Q for the quarter ended June 30, 1988, Commission File No. 1-3053). +10.11 Amendment dated as of August 18, 1988 to Restated Agreement between the Company and Mr. Sigler as amended as of February 19, 1987 (filed by incorporation by reference to Exhibit 10.10 to the Company's Form 10-K for the fiscal year ended December 31, 1988, Commission File No. 1-3053). +10.12 Amendment dated as of August 18, 1988 to Agreement Relating to Legal Expenses dated February 19, 1987 between the Company and Mr. Sigler (filed by incorporation by reference to Exhibit 10.11 to the Company's Form 10-K for the fiscal year ended December 31, 1988, Commission File No. 1-3053). +10.13 Amendment dated as of September 19, 1991 to Restated Agreement between the Company and Mr. Sigler as amended as of February 19, 1987 (filed by incorporation by reference to Exhibit 10.12 to the Company's Form 10-K for the fiscal year ended December 31, 1991, Commission File No. 1-3053). +10.14 Agreement dated as of August 18, 1988 between the Company and Mr. Heist providing certain employment, severance and retirement arrangements (filed by incorporation by reference to Exhibit 10.17 to the Company's Form 10-K for the fiscal year ended December 31, 1988, Commission File No. 1-3053). +10.15 Agreement Relating to Legal Expenses dated August 18, 1988 between the Company and Mr. Heist providing reimbursement of certain legal expenses following a change in control of the Company (filed by incorporation by reference to Exhibit 10.18 to the Company's Form 10-K for the fiscal year ended December 31, 1988, Commission File No. 1-3053). +10.16 Amendment dated as of September 19, 1991 to Agreement dated as of August 18, 1988 between the Company and Mr. Heist (filed by incorporation by reference to Exhibit 10.15 to the Company's Form 10-K for the fiscal year ended December 31, 1991, Commission File No. 1-3053). +10.17 Agreement dated as of October 18, 1990 between the Company and Mr. Nichols providing certain employment, severance and retirement arrangements (filed by incorporation by reference to Exhibit 10.16 to the Company's Form 10-K for the fiscal year ended December 31, 1990, Commission File No. 1-3053). +10.18 Agreement Relating to Legal Expenses dated October 18, 1990 between the Company and Mr. Nichols providing reimbursement of certain legal expenses following a change in EXHIBIT NUMBER DESCRIPTION - ------ ------------ control of the Company (filed by incorporation by reference to Exhibit 10.17 to the Company's Form 10-K for the fiscal year ended December 31, 1990, Commission File No. 1-3053). +10.19 Amendment dated as of September 19, 1991 to Agreement dated as of October 18, 1990 between the Company and Mr. Nichols (filed by incorporation by reference to Exhibit 10.18 to the Company's Form 10-K for the fiscal year ended December 31, 1991, Commission File No. 1-3053). +10.20 Agreement dated as of February 19, 1987 between the Company and Mr. Burchfield providing certain severance arrangements (filed by incorporation by reference to Exhibit 10.15 to the Company's Form 10-K for the fiscal year ended December 31, 1987, Commission File No. 1-3053). +10.21 Agreement Relating to Legal Expenses dated February 19, 1987 between the Company and Mr. Burchfield providing reimbursement of certain legal expenses following a change in control of the Company (filed by incorporation by reference to Exhibit 10.16 to the Company's Form 10-K for the fiscal year ended December 31, 1987, Commission File No. 1-3053). +10.22 Amendment dated as of April 21, 1988 to Agreement dated as of February 19, 1987 between the Company and Mr. Burchfield (filed by incorporation by reference to Exhibit 19.5 to the Company's Form 10-Q for the quarter ended June 30, 1988, Commission File No. 1-3053). +10.23 Amendment dated as of September 19, 1991 to Agreement dated as of February 19, 1987 between the Company and Mr. Burchfield (filed by incorporation by reference to Exhibit 10.22 to the Company's Form 10-K for the fiscal year ended December 31, 1991, Commission File No. 1-3053). +10.24 Agreement dated as of August 18, 1988 between the Company and Mr. Olson providing certain severance arrangements (filed by incorporation by reference to Exhibit 10.23 to the Company's Form 10-K for the fiscal year ended December 31, 1990, Commission File No. 1-3053). +10.25 Agreement Relating to Legal Expenses dated August 18, 1988 between the Company and Mr. Olson providing reimbursement of certain legal expenses following a change in control of the Company (filed by incorporation by reference to Exhibit 10.24 to the Company's Form 10-K for the fiscal year ended December 31, 1990, Commission File No. 1-3053). +10.26 Amendment dated as of September 19, 1991 to Agreement dated as of August 18, 1988 between the Company and Mr. Olson (filed by incorporation by reference to Exhibit 10.28 to the Company's Form 10-K for the fiscal year ended December 31, 1991, Commission File No. 1-3053). +10.27 Trust Agreement dated as of February 19, 1987 between the Company and Connecticut National Bank securing certain payments under the contracts listed as Exhibit Numbers 10.8 through 10.26, among others, following a change in control of the Company (filed by incorporation by reference to Exhibit 19.11 to the Company's Form 10-Q for the quarter ended June 30, 1987, Commission File No. 1- 3053). EXHIBIT NUMBER DESCRIPTION - ------ ------------ +10.28 Amendment dated as of August 18, 1988 to Trust Agreement dated as of February 19, 1987 between the Company and Connecticut National Bank (filed by incorporation by reference to Exhibit 10.29 to the Company's Form 10-K for the fiscal year ended December 31, 1988, Commission File No. 1-3053). +10.29 Champion International Corporation Executive Life Insurance Plan (filed by incorporation by reference to Exhibit 10.27 to the Company's Form 10-K for the fiscal year ended December 31, 1990, Commission File No. 1-3053). 10.30 Extract from the minutes of the meeting of the Board of Directors of the Company held on October 18, 1979 relating to the $50,000 of group term life insurance provided by the Company for non- employee directors (filed by incorporation by reference to Exhibit 10.28 to the Company's Form 10-K for the fiscal year ended December 31, 1990, Commission File No. 1-3053). 10.31 Resolutions of the Board of Directors of the Company adopted on September 19, 1991 relating to the compensation of directors (filed by incorporation by reference to Exhibit 19 to the Company's Form 10-Q for the quarter ended September 30, 1991, Commission File No. 1-3053). 10.32 Retirement Plan for Outside Directors (filed by incorporation by reference to Exhibit 19 to the Company's Form 10-Q for the quarter ended September 30, 1992, Commission File No. 1-3053). 11 Schedule showing calculation of primary earnings per common share and fully diluted earnings per common share. 13 Portions of the Annual Report to Shareholders of Champion International Corporation for the fiscal year ended December 31, 1993, which are incorporated herein by reference. 21 List of significant subsidiaries of the Company. 23.1 Opinion and Consent of the Senior Vice President and General Counsel of the Company. 23.2 Consent of Arthur Andersen & Co. 24 Power of Attorney relating to the execution and filing of this Annual Report on Form 10-K and all amendments hereto. (d) REPORTS ON FORM 8-K. No Reports on Form 8-K were filed during the last quarter of the period covered by this Report. SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED, ON THE 30TH DAY OF MARCH, 1994. CHAMPION INTERNATIONAL CORPORATION (Registrant) By Lawrence A. Fox ----------------------------------- (LAWRENCE A. FOX) VICE PRESIDENT AND SECRETARY PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATE INDICATED. A POWER OF ATTORNEY AUTHORIZING LAWRENCE A. FOX, MARVIN H. GINSKY AND ANDREW C. SIGLER AND EACH OF THEM TO SIGN THIS REPORT AND ALL AMENDMENTS HERETO AS ATTORNEYS-IN-FACT FOR OFFICERS AND DIRECTORS OF THE REGISTRANT IS FILED AS EXHIBIT 24 HERETO. SCHEDULE V CHAMPION INTERNATIONAL CORPORATION AND SUBSIDIARIES PROPERTY, PLANT AND EQUIPMENT For the Years Ended December 31, 1993, 1992 and 1991 (in thousands of dollars) - ----------------- Notes: (1) Property, plant and equipment is carried at cost. (2) Effect of foreign currency translation. (3) Reclassifications and transfers to and from other accounts. (4) Cost of timber harvested charged to costs and expenses. (5) As the result of adopting, as of January 1, 1992, Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," assets formerly acquired in purchase business combinations were revalued to reflect gross values. Prior to adoption of this standard, these assets were valued net of related tax effects. S-1 SCHEDULE VI CHAMPION INTERNATIONAL CORPORATION AND SUBSIDIARIES ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT For the Years Ended December 31, 1993, 1992 and 1991 (in thousands of dollars) Notes: (1) Reclassifications and transfers to and from other accounts. (2) Effect of foreign currency translation. (3) As the result of adopting, as of January 1, 1992, Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," assets formerly acquired in purchase business combinations were revalued to reflect gross values. Prior to adoption of this standard, these assets were valued net of related tax effects. S-2 (4) Reference is made to Note 1 of Notes to Financial Statements in the Company's Annual Report to Shareholders for the fiscal year ended December 31, 1993, which Note is incorporated by reference herein, for the Company's policies in providing for depreciation, cost of timber harvested and amortization. The reconciliations of depreciation, cost of timber harvested and amortization, as shown above and on Schedule V, with the amounts in the statement of income follow: (5) For financial reporting purposes, property, plant and equipment are depreciated on the straight-line method over the estimated service lives of the individual assets as follows: Land improvements 2 to 20% Buildings 2 to 20% Machinery and equipment 3 to 33% Leasehold improvements are amortized over the shorter of the leases or estimated service lives. S-3 SCHEDULE VIII CHAMPION INTERNATIONAL CORPORATION AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS For the Years Ended December 31, 1993 and 1992 (in thousands of dollars) - ----------------------- Note: (1) The deferred income tax valuation allowance primarily relates to general business credit carryforwards. S-4 SCHEDULE IX CHAMPION INTERNATIONAL CORPORATION AND SUBSIDIARIES SHORT-TERM BORROWINGS For the Years Ended December 31, 1993, 1992 and 1991 (in thousands of dollars) - ----------------------------------- Notes: (1) Variations in weighted average interest rates and in outstanding balances for 1993, 1992 and 1991 are attributable to book cash overdrafts. (2) Average amount of short-term borrowings is determined by utilizing the average month-end balances. (3) Weighted average interest rate for the year is determined by dividing average interest expense for the year by the average of month-end short-term borrowings for the year. S-5 SCHEDULE X CHAMPION INTERNATIONAL CORPORATION AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION For the Years Ended December 31, 1993, 1992 and 1991 (in thousands of dollars) Royalties, advertising costs, and amortization of intangible assets and pre- operating costs were not material. S-6 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SCHEDULES To Champion International Corporation: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements included in Champion International Corporation's 1993 Annual Report to Shareholders incorporated by reference in this Form 10-K, and have issued our report thereon dated January 17, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed in Item 14(b) are the responsibility of the Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state 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 & CO. New York, N.Y. January 17, 1994 S-7 EXHIBIT INDEX Each Exhibit is listed according to the number assigned to it in the Exhibit Table of Item 601 of Regulation S-K. The Exhibit numbers preceded by an asterisk () indicate Exhibits physically filed with this Annual Report on Form 10-K. All other Exhibit numbers indicate Exhibits filed by incorporation by reference herein. Exhibit numbers 10.1 through 10.29, which are preceded by a plus sign (+), are management contracts or compensatory plans or arrangements. EXHIBIT NUMBER DESCRIPTION - -------------- ----------- 3.1 Restated Certificate of Incorporation of the Company, filed in the State of New York on October 20, 1986 (filed by incorporation by reference to Exhibit 3.1 to the Company's Form 10-K for the fiscal year ended December 31, 1986, Commission File No. 1-3053). 3.2 Certificate of Amendment of Restated Certificate of Incorporation of the Company, filed in the State of New York on July 18, 1988 (filed by incorporation by reference to Exhibit 4.1 to the Company's Form 10-Q for the quarter ended June 30, 1988, Commission File No. 1-3053). 3.3 Certificate of Amendment of Restated Certificate of Incorporation of the Company, filed in the State of New York on December 6, 1989 (filed by incorporation by reference to Exhibit 4.1 to the Company's Form 8-K dated December 14, 1989, Commission File No. 1-3053). 3.4 Certificate of Amendment of Restated Certificate of Incorporation of the Company, filed in the State of New York on December 21, 1989 (filed by incorporation by reference to Exhibit 3.4 to the Company's Form 10-K for the fiscal year ended December 31, 1989, Commission File No. 1-3053). 3.5 By-Laws of the Company (filed by incorporation by reference to Exhibit 3(ii).1 to the Company's Form 10-Q for the quarter ended March 31, 1993, Commission File No. 1-3053). 4.1 Letter agreement dated March 29, 1991 of the Company to furnish to the Commission upon request copies of certain instruments with respect to long-term debt (filed by incorporation by reference to Exhibit 4 to the Company's Form 10-K for the fiscal year ended December 31, 1990, Commission File No. 1-3053). 4.2 Agreement dated February 2, 1994 between the Company and Loews Corporation (filed by incorporation by reference to Exhibit 4.7 to the Company's Registration Statement on Form S-3, Commission Registration No. 33-52123). +10.1 Champion International Corporation 1986 Management Incentive Program, consisting of the 1986 Stock Option Plan and the 1986 Contingent Compensation Plan (filed by incorporation by reference to Exhibit 19.1 to the Company's Form 10-Q for the quarter ended June 30, 1986, Commission File No. 1-3053). +10.2 Amendment to Champion International Corporation 1986 Management Incentive Program (filed by incorporation by reference to Exhibit 10.1 to the Company's Form 10-Q for the quarter ended March 31, 1993, Commission File No. 1-3053). EXHIBIT NUMBER DESCRIPTION - -------------- ----------- +10.3 Champion International Corporation Restricted Share Performance Plan, as amended (filed by incorporation by reference to Exhibit 10.2 to the Company's Form 10-K for the fiscal year ended December 31, 1989, Commission File No.1-3053). +10.4 Champion International Corporation Management Incentive Program, as amended, consisting of the Amended 1976 Incentive Stock Option Plan and the Contingent Compensation Plan (filed by incorporation by reference to Exhibit 4.3 to the Company's Registration Statement on Form S-8, Commission Registration No. 2-77129). +10.5 Resolutions of the Board of Directors of the Company adopted on August 16, 1984 amending the Amended 1976 Incentive Stock Option Plan (filed by incorporation by reference to Exhibit 10(b) to the Company's Registration Statement on Form S-14, Commission Registration No. 2-94030). +10.6 Champion International Corporation Supplemental Retirement Income Plan (filed by incorporation by reference to Exhibit 10.7 to the Company's Form 10-K for the fiscal year ended December 31, 1989, Commission File No. 1-3053). +10.7 Supplemental Retirement and Death Payments Agreement dated as of August 1, 1964, as amended by letter agreement dated January 9, 1965, between the Company and Mr. Sigler (filed by incorporation by reference to Exhibit 10.8 to the Company's Form 10-K for the fiscal year ended December 31, 1990, Commission File No. 1-3053). +10.8 Restated Agreement between the Company and Mr. Sigler, as amended as of February 19, 1987, providing certain employment, severance and retirement arrangements (filed by incorporation by reference to Exhibit 19.1 to the Company's Form 10-Q for the quarter ended June 30, 1987, Commission File No. 1-3053). +10.9 Agreement Relating to Legal Expenses dated February 19, 1987 between the Company and Mr. Sigler providing reimbursement of certain legal expenses following a change in control of the Company (filed by incorporation by reference to Exhibit 19.2 to the Company's Form 10-Q for the quarter ended June 30, 1987, Commission File No. 1-3053). +10.10 Amendment dated as of April 21, 1988 to Restated Agreement between the Company and Mr. Sigler as amended as of February 19, 1987 (filed by incorporation by reference to Exhibit 19.1 to the Company's Form 10-Q for the quarter ended June 30, 1988, Commission File No. 1-3053). +10.11 Amendment dated as of August 18, 1988 to Restated Agreement between the Company and Mr. Sigler as amended as of February 19, 1987 (filed by incorporation by reference to Exhibit 10.10 to the Company's Form 10-K for the fiscal year ended December 31, 1988, Commission File No. 1-3053). +10.12 Amendment dated as of August 18, 1988 to Agreement Relating to Legal Expenses dated February 19, 1987 between the Company and Mr. Sigler (filed by incorporation by reference to Exhibit 10.11 to the Company's Form 10-K for the fiscal year ended December 31, 1988, Commission File No. 1-3053). EXHIBIT NUMBER DESCRIPTION - -------------- ----------- +10.13 Amendment dated as of September 19, 1991 to Restated Agreement between the Company and Mr. Sigler as amended as of February 19, 1987 (filed by incorporation by reference to Exhibit 10.12 to the Company's Form 10-K for the fiscal year ended December 31, 1991, Commission File No. 1-3053). +10.14 Agreement dated as of August 18, 1988 between the Company and Mr. Heist providing certain employment, severance and retirement arrangements (filed by incorporation by reference to Exhibit 10.17 to the Company's Form 10-K for the fiscal year ended December 31, 1988, Commission File No. 1-3053). +10.15 Agreement Relating to Legal Expenses dated August 18, 1988 between the Company and Mr. Heist providing reimbursement of certain legal expenses following a change in control of the Company (filed by incorporation by reference to Exhibit 10.18 to the Company's Form 10-K for the fiscal year ended December 31, 1988, Commission File No. 1-3053). +10.16 Amendment dated as of September 19, 1991 to Agreement dated as of August 18, 1988 between the Company and Mr. Heist (filed by incorporation by reference to Exhibit 10.15 to the Company's Form 10-K for the fiscal year ended December 31, 1991, Commission File No. 1-3053). +10.17 Agreement dated as of October 18, 1990 between the Company and Mr. Nichols providing certain employment, severance and retirement arrangements (filed by incorporation by reference to Exhibit 10.16 to the Company's Form 10-K for the fiscal year ended December 31, 1990, Commission File No. 1-3053). +10.18 Agreement Relating to Legal Expenses dated October 18, 1990 between the Company and Mr. Nichols providing reimbursement of certain legal expenses following a change in control of the Company (filed by incorporation by reference to Exhibit 10.17 to the Company's Form 10-K for the fiscal year ended December 31, 1990, Commission File No. 1-3053). +10.19 Amendment dated as of September 19, 1991 to Agreement dated as of October 18, 1990 between the Company and Mr. Nichols (filed by incorporation by reference to Exhibit 10.18 to the Company's Form 10-K for the fiscal year ended December 31, 1991, Commission File No. 1-3053). +10.20 Agreement dated as of February 19, 1987 between the Company and Mr. Burchfield providing certain severance arrangements (filed by incorporation by reference to Exhibit 10.15 to the Company's Form 10-K for the fiscal year ended December 31, 1987, Commission File No. 1-3053). +10.21 Agreement Relating to Legal Expenses dated February 19, 1987 between the Company and Mr. Burchfield providing reimbursement of certain legal expenses following a change in control of the Company (filed by incorporation by reference to Exhibit 10.16 to the Company's Form 10-K for the fiscal year ended December 31, 1987, Commission File No. 1-3053). +10.22 Amendment dated as of April 21, 1988 to Agreement dated as of February 19, 1987 between the Company and Mr. Burchfield (filed by incorporation by reference to Exhibit 19.5 to the Company's Form 10-Q for the quarter ended June 30, 1988, Commission File No. 1-3053). EXHIBIT NUMBER DESCRIPTION - -------------- ----------- +10.23 Amendment dated as of September 19, 1991 to Agreement dated as of February 19, 1987 between the Company and Mr. Burchfield (filed by incorporation by reference to Exhibit 10.22 to the Company's Form 10-K for the fiscal year ended December 31, 1991, Commission File No. 1-3053). +10.24 Agreement dated as of August 18, 1988 between the Company and Mr. Olson providing certain severance arrangements (filed by incorporation by reference to Exhibit 10.23 to the Company's Form 10-K for the fiscal year ended December 31, 1990, Commission File No. 1-3053). +10.25 Agreement Relating to Legal Expenses dated August 18, 1988 between the Company and Mr. Olson providing reimbursement of certain legal expenses following a change in control of the Company (filed by incorporation by reference to Exhibit 10.24 to the Company's Form 10-K for the fiscal year ended December 31, 1990, Commission File No. 1-3053). +10.26 Amendment dated as of September 19, 1991 to Agreement dated as of August 18, 1988 between the Company and Mr. Olson (filed by incorporation by reference to Exhibit 10.28 to the Company's Form 10-K for the fiscal year ended December 31, 1991, Commission File No. 1-3053). +10.27 Trust Agreement dated as of February 19, 1987 between the Company and Connecticut National Bank securing certain payments under the contracts listed as Exhibit Numbers 10.8 through 10.26, among others, following a change in control of the Company (filed by incorporation by reference to Exhibit 19.11 to the Company's Form 10-Q for the quarter ended June 30, 1987, Commission File No. 1-3053). +10.28 Amendment dated as of August 18, 1988 to Trust Agreement dated as of February 19, 1987 between the Company and Connecticut National Bank (filed by incorporation by reference to Exhibit 10.29 to the Company's Form 10-K for the fiscal year ended December 31, 1988, Commission File No. 1-3053). +10.29 Champion International Corporation Executive Life Insurance Plan (filed by incorporation by reference to Exhibit 10.27 to the Company's Form 10-K for the fiscal year ended December 31, 1990, Commission File No. 1-3053). 10.30 Extract from the minutes of the meeting of the Board of Directors of the Company held on October 18, 1979 relating to the $50,000 of group term life insurance provided by the Company for non-employee directors (filed by incorporation by reference to Exhibit 10.28 to the Company's Form 10-K for the fiscal year ended December 31, 1990, Commission File No. 1-3053). 10.31 Resolutions of the Board of Directors of the Company adopted on September 19, 1991 relating to the compensation of directors (filed by incorporation by reference to Exhibit 19 to the Company's Form 10-Q for the quarter ended September 30, 1991, Commission File No. 1-3053). 10.32 Retirement Plan for Outside Directors (filed by incorporation by reference to Exhibit 19 to the Company's Form 10-Q for the quarter ended September 30, 1992, Commission File No. 1-3053). EXHIBIT NUMBER DESCRIPTION - -------------- ----------- 11 Schedule showing calculation of primary earnings per common share and fully diluted earnings per common share. 13 Portions of the Annual Report to Shareholders of Champion International Corporation for the fiscal year ended December 31, 1993 which are incorporated herein by reference. 21 List of significant subsidiaries of the Company. 23.1 Opinion and Consent of the Senior Vice President and General Counsel of the Company. 23.2 Consent of Arthur Andersen & Co. 24 Power of Attorney relating to the execution and filing of this Annual Report on Form 10-K and all amendments hereto. 28:exhibt93.10k
55642_1993.txt	55642	1993	ITEM 1. BUSINESS. Keystone International, Inc. ("Keystone" or the "Company") designs, manufactures and markets, on a worldwide basis, valves and other specialized industrial products that control the flow of liquids, gases and fibrous and slurry materials for use in various industries, including chemical, power, food and beverage, marine and government, petroleum production and refining, water, commercial construction, oil and gas pipeline, mining and metals, and pulp and paper. Keystone, incorporated in Texas in 1947, is one of the leading manufacturers of flow control products in the world. The Company's operations are conducted in a single industry segment. For information concerning geographic segments, see Note 12 to the Consolidated Financial Statements in Item 8 of this Report. Substantially all of the products sold outside the United States are manufactured and assembled at facilities in Canada, The Netherlands, Japan, the United Kingdom, France, Italy, Germany, Korea, Singapore, the People's Republic of China, Mexico, Brazil, Australia, New Zealand, and India. Most of Keystone's employees engaged in operations outside the United States, including plant managers and other executive personnel, are citizens of the nations in which they work. The various aspects of Keystone's operations outside the United States take into account local conditions and customs, but basic business methods are similar in all areas. Sales and operations outside the United States are subject to the inherent risk of fluctuations in currency rates. As with other United States companies engaged in business outside the United States, Keystone is subject to political and economic uncertainties, the risk of expropriation and embargo, foreign exchange restrictions and political disruptions. Keystone purchases virtually all castings and certain finished or semi-finished components used in its products. Machining of components and assembling are done primarily by the Company, although a limited amount of machining and assembling is done under contract by outside parties. Keystone does not believe that compliance with federal, state or local environmental laws adversely affects its business, earnings or competitive position. Management believes that the Company's present level of product liability coverage is adequate, and will make adjustments in such coverage in the future as it believes appropriate after considering the cost and availability of such insurance and any legal developments in the product liability area. While Keystone has a number of patents and patent applications relating to or covering certain features of its products, its patents are not of a scope to exclude competition in any significant way or preclude competitors from successfully marketing substitute products. Competition is on the basis of quality, service, delivery and price. There was no single customer which accounted for more than 10% of sales during 1993. Although the Company does not necessarily know the intended use or ultimate customer for all of its products, particularly those sold through distributors, its business is not dependent on a single customer or a few customers. Sales in diverse geographic areas and to a large number of customers and industries lessen exposure to adverse conditions in a single industry or area. These factors, however, do not afford protection against a general economic downturn. Keystone extends 30-day credit to most customers except in certain foreign markets where local trade practices differ. Credit losses have not been material. Keystone carries some inventory of all its products, and it generally satisfies its working capital requirements out of internally generated funds. Reference is made to Note 5 of the Consolidated Financial Statements in Item 8 of this Report for information about lines of credit that are available to finance working capital. In the fourth quarter of 1991, the Company recognized a pretax charge to income of $22,372,000 for restructuring and merger expenses. For information concerning these charges, see Note 3 to the Consolidated Financial Statements in Item 8 of this Report. At December 31, 1993, the Company's backlog of unshipped orders was $100,268,000 compared with $107,853,000 at December 31, 1992. Orders in backlog at year-end are usually shipped during the following year. In the past, the effect of changes or cancellations of orders has been minimal. At December 31, 1993, Keystone had approximately 4,200 employees worldwide. ITEM 2.		ITEM 2. PROPERTIES. Keystone's domestic manufacturing operations are located in Houston and Harlingen, Texas; Blue Bell, Pennsylvania; Andrews and Fort Wayne, Indiana; Black Mountain, North Carolina; Penns Grove, New Jersey and Pelham, Alabama. These facilities, including the corporate offices located in Houston, contain approximately 309,000 square feet of office space and 810,000 square feet of manufacturing space on 165 acres of land owned by the Company. Keystone's other manufacturing and assembly facilities are in most cases owned by the Company and are located in 16 other countries. The Company also leases warehouse and office space in which it maintains its sales offices. Aggregate rentals for leased premises totalled $3,015,000 during 1993. ITEM 3.	ITEM 3. LEGAL PROCEEDINGS. The Company is a party to routine litigation incidental to its business, none of which in the opinion of management will have a material adverse impact on the consolidated financial position or future results of operations of the Company. ITEM 4.	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. No matters were submitted to a vote of security holders during the fourth quarter of 1993. PART II ITEM 5.	ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The common stock of Keystone is traded on the New York Stock Exchange under the symbol KII. The following table shows the high and low sales prices as reported by the New York Stock Exchange Composite Tape and cash dividends declared per share. The approximate number of security holders of the Company's common stock was 3,081 as of February 22, 1994. This number does not include the number of security holders for whom shares are held in a "nominee" or "street" name. ITEM 6.	ITEM 6. SELECTED FINANCIAL DATA. - --------------- (1) After considering the estimated tax benefits of $5,235, the effect of restructuring and merger expenses was to reduce income from continuing operations by $17,137, or $.50 per share. See Note 3 to the Consolidated Financial Statements in Item 8 of this Report. (2) The 8.75% Notes totalling $43,000 were due November 1, 1993 and as of December 31, 1992 were classified as current portion of long-term debt. These 8.75% notes were refinanced on November 1, 1993 with $45,000 6.34% Senior Notes due November 1, 2000. See Note 5 to the Consolidated Financial Statements in Item 8 of this Report. (3) In 1991, the cumulative effect of the change in accounting principle represents a charge relating to the adoption of the accounting standard for postretirements benefits other than pensions. See Note 9 to the Consolidated Financial Statements in Item 8 of this Report. The 1993 cumulative effect of change in accounting principle represents a credit relating to the adoption of the new accounting standard for income taxes. See Note 6 to the Consolidated Financial Statements in Item 8 of this Report. Reference is made to the Notes to Consolidated Financial Statements in Item 8 of this Report for a summary of accounting policies and additional information. ITEM 7.	ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. SUMMARY The following table sets forth for the periods indicated (i) percentages which certain items reflected in the accompanying Consolidated Statements of Income bear to net sales of the Company and (ii) the percentage increase or decrease of amounts of such items as compared to the indicated prior period: - --------------- * Percentage not meaningful. RESULTS OF OPERATIONS (DOLLAR AMOUNTS IN THOUSANDS) Net Sales Net sales decreased 2% in 1993 compared with a 2% increase in 1992. Shown below is an analysis of net sales. The translation effect of weakening foreign currencies had a significant impact in 1993 on the results of international operations. - --------------- * Percentage not meaningful. The Company's sales and results of operations outside the United States are subject to the inherent risk of fluctuations in currency rates. During 1993, a basket of European currencies weakened in relation to the U.S. dollar by approximately 12%, which impacted the U.S. dollar results of the Company's European operations. Further weakening may occur in 1994. Keystone's European operations represent about 29% of the Company's consolidated sales. Costs and Expenses Cost of sales as a percentage of sales were 57.4%, 56.7% and 57.4% in 1993, 1992 and 1991, respectively. The decrease in gross profit as a percentage of sales in 1993 compared to 1992 was due to lower margins earned in Europe where the Company is experiencing increased price competition. In 1992, the improvement in gross profit as a percentage of sales compared to 1991 was primarily due to improvements in gross margins at the two Italian companies acquired in 1989 and a decrease in lower margin project-oriented business, reflective of more selective sales order activity. Selling, general and administrative expenses increased by 1% and 2% in 1993 and 1992, respectively. The increases are primarily attributable to costs related to increased sales volume primarily in the Asia-Pacific region, partially offset by the translation effect of weakening foreign currencies. The Company's ongoing program to maintain tight controls over selling, general and administrative expenses has resulted in maintaining the amount as a percentage of sales in the 28% range. As a percentage of net sales, selling, general and administrative expenses were 28.9%, 28.1% and 27.9% in 1993, 1992 and 1991, respectively. Restructuring and merger expenses in 1991 of $22,372 represent $19,993 accrued for operational restructuring primarily in the United States and Europe as well as $2,379 of expenses associated with the merger and rationalization of operations of Kunkle Industries, Inc. The Company's restructuring actions focus on strengthening its capabilities as a low-cost provider of quality flow control products and systems worldwide. During 1993, the majority of the remaining restructuring and merger provision was utilized. Major restructuring and merger activities during 1993 related to the completion of the Houston, Texas-based product rationalization and relocation in which a facility was acquired in Guadalajara, Mexico and refurbished to accommodate the Company's manufacturing requirements. As part of this relocation, several small product lines were moved from Houston to this lower-cost facility. Other activities during the year included the consolidation of certain facilities primarily in European locations. The Company believes the remaining restructuring reserves, which are expected to be utilized during 1994, are sufficient to cover the restructuring projects which are still in process. Other expense includes amortization of intangible assets and debt costs as well as exchange gains and losses on transactions denominated in foreign currencies. In 1992, other expense also included a reserve of $2,000 for management's estimate of potential environmental exposure at one of the Company's inoperative facilities. Management still believes this reserve is adequate and potential exposure will not have a material impact on the Company's consolidated financial position or future results of operations. The Company's effective income tax rate was 37%, 39% and 47% in 1993, 1992 and 1991, respectively. The Company records taxes on all unremitted foreign earnings at a rate not less than the U.S. statutory rate. The primary components of the difference between the domestic statutory tax rate and the actual effective tax rate is caused by net operating losses of certain foreign entities not currently realizable for tax purposes and foreign taxes in excess of the U.S. statutory rate. The effective tax rate in 1993 includes the remeasurement of deferred tax assets at the current U.S. statutory rate in accordance with the new accounting standard for income taxes. See Note 6 to the Consolidated Financial Statements in Item 8	ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The response to this item is submitted as a separate section of this Report on page 9. ITEM 9.	ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III Part III (Items 10 through 13) is omitted since the Registrant expects to file with the Securities and Exchange Commission within 120 days after the close of the fiscal year ended December 31, 1993, a definitive proxy statement pursuant to Regulation 14A under the Securities Exchange Act of 1934 which involves the election of directors. If for any reason such a statement is not filed within such a period, this Report will be appropriately amended. PART IV ITEM 14.					ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a)(1) and (2): The response to this portion of Item 14 is submitted as a separate section of this Report on page 9. (a)(3) Exhibits: (b) Reports on Form 8-K. The Company filed no reports on Form 8-K for the quarter ended December 31, 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 9th day of March, 1994. KEYSTONE INTERNATIONAL, INC. By: RAYMOND A. LEBLANC (Raymond A. LeBlanc) Chairman of the Board 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 in the capacities indicated on the 9th day of March, 1994. KEYSTONE INTERNATIONAL, INC. AND SUBSIDIARIES FORM 10-K ITEMS 8 AND 14(A)(1) AND (2) INDEX OF FINANCIAL STATEMENTS AND SCHEDULES The following financial statements of the Registrant and its subsidiaries required to be included in Items 8 and 14(a)(1) are listed below: The following financial statement schedules of the Registrant and its subsidiaries are included in Item 14(a)(2): Consolidated Financial Statement Schedules for the years ended December 31, 1993, 1992 and 1991: --------------------------- Schedules other than those listed above are omitted because the conditions requiring their filing do not exist or because the required information is given in the financial statements, including the notes thereto. KEYSTONE INTERNATIONAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA) The accompanying notes are an integral part of these financial statements. KEYSTONE INTERNATIONAL, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1993 AND 1992 (AMOUNTS IN THOUSANDS) The accompanying notes are an integral part of these financial statements. KEYSTONE INTERNATIONAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (AMOUNTS IN THOUSANDS) The accompanying notes are an integral part of these financial statements. KEYSTONE INTERNATIONAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' INVESTMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA) The accompanying notes are an integral part of these financial statements. KEYSTONE INTERNATIONAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA) (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Consolidation -- The consolidated financial statements include the accounts of Keystone International, Inc. and its subsidiaries ("Keystone" or the "Company"). All significant intercompany accounts and transactions have been eliminated. Foreign Currency Translation -- Assets and liabilities of most foreign subsidiaries are translated at current exchange rates, and related revenues and expenses are translated at average exchange rates for the year. Since the functional currencies of these subsidiaries are not the U.S. dollar, the resulting translation adjustments are recorded as a separate component of shareholders' investment. Translation gains and losses relating to the Company's Brazilian subsidiary, which operates in a highly inflationary economy, are charged against income. Cash Equivalents -- The Company considers all highly liquid investments with an original maturity of three months or less to be cash equivalents. Depreciation and Amortization -- Keystone provides depreciation for financial reporting purposes primarily on a straight-line method over the estimated useful lives of the assets. Goodwill is included in other assets and is being amortized over periods ranging from ten to forty years. Other intangible assets, which primarily include engineering drawings, patents and tradenames, are being amortized over periods ranging from three to twenty years. (2) ACQUISITIONS During November 1991, the Company acquired Kunkle Industries, Inc. and an associated company ("Kunkle") in a transaction accounted for as a pooling-of-interests. As the effect of this acquisition was not significant to the results of operations of the Company, prior year financial statements were not restated. Also, the Company has made other small acquisitions during 1993, 1992 and 1991. The total effect of these acquisitions was not material to the consolidated results of Keystone. (3) RESTRUCTURING AND MERGER EXPENSES Restructuring and merger expenses in 1991 of $22,372 represent $19,993 accrued for operational restructuring primarily in the United States and Europe as well as $2,379 of expenses associated with the merger and rationalization of operations of Kunkle. The Company's restructuring actions focus on strengthening its capabilities as a low-cost provider of quality flow control products and systems worldwide. During 1993, the majority of the remaining restructuring and merger provision was utilized. Major restructuring and merger activities during 1993 related to the completion of the Houston, Texas-based product rationalization and relocation in which a facility was acquired in Guadalajara, Mexico and refurbished to accommodate the Company's manufacturing requirements. As part of this relocation, several small product lines were moved from Houston to this lower-cost facility. Other activities during the year included the consolidation of certain facilities primarily in European locations. The Company believes the remaining restructuring reserves, which are expected to be utilized during 1994, are sufficient to cover the restructuring projects which are still in process. (4) INVENTORIES Inventories are stated at cost which is not in excess of market. Keystone uses the last-in, first-out (LIFO) method of determining inventory cost for most of its domestic inventories. Inventories valued at LIFO cost comprised approximately 40% of consolidated inventories at December 31, 1993. The remainder of Keystone's inventories are costed using the first-in, first-out (FIFO) method. KEYSTONE INTERNATIONAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Inventories, which include material, labor and manufacturing overhead costs, consisted of the following at December 31, 1993 and 1992: (5) LONG-TERM DEBT AND SHORT-TERM BANK BORROWINGS In November 1993, the Company refinanced its 8.75% notes totalling $43,000 with $45,000 6.34% Senior Notes due November 1, 2000. Other long-term notes payable at December 31, 1993 consists primarily of debt related to the construction of new manufacturing facilities in Japan and debt assumed in two 1989 Italian acquisitions which bear interest at weighted average interest rates of approximately 7% and 12%, respectively. Annual maturities of all long-term debt for the next five years are as follows: 1994 -- $2,216; 1995 -- $6,718; 1996 -- $2,495; 1997 -- $1,905; 1998 -- $1,477; 1999 and thereafter -- $49,705. Short-term bank borrowings of $6,944 at December 31, 1993 primarily represent borrowings under various committed and uncommitted lines of credit aggregating $61,000. Interest rates on these borrowings vary according to the country in which the funds are borrowed, but generally approximate the market rate of interest. The Company made cash interest payments of $5,654, $6,849, and $7,853 during 1993, 1992 and 1991, respectively. (6) INCOME TAXES Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 109 -- "Accounting for Income Taxes." This statement provides, among other things, for the recognition and presentation of deferred tax assets and liabilities for the future consequences of temporary differences between the financial statement basis and the tax basis of assets and liabilities using the tax rates in effect during the period when taxes are actually paid or recovered. Accordingly, income tax provisions will increase or decrease in the same period in which a change in tax rates is enacted. The adoption of this accounting method resulted in a credit to income of $1,879 which is reflected in the Consolidated Statements of Income as a cumulative effect of change in accounting principle. The cumulative effect results primarily from calculating temporary differences using currently enacted tax rates as required. Prior year financial statements were not restated for SFAS No. 109. KEYSTONE INTERNATIONAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The provisions (benefits) for income taxes are summarized as follows: The tax effects of the significant temporary differences which comprise the net deferred tax asset as of December 31, 1993 are as follows: A valuation allowance is provided when it is more likely than not that some portion of the deferred tax asset will not be realized. Keystone has recorded no deferred tax assets for which a valuation reserve is required. The major components in 1993 of the deferred tax provision include amounts related to temporary differences between financial and tax reporting methods for inventories of $1,387, reserves and accruals of $(1,859) and restructuring and merger expenses of $3,210. In 1992, the primary components of the deferred tax provision include amounts related to temporary differences between financial and tax reporting methods for inventories of $1,401, depreciation and amortization expense of $1,202 and restructuring and merger expenses of $2,256. In 1991, the primary components of the deferred tax benefit include amounts related to temporary differences between financial and tax reporting methods for inventories of $(1,378), reserves and accruals of $(2,992), unremitted foreign earnings of $(922), and restructuring and merger expenses of $(5,235). KEYSTONE INTERNATIONAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) A reconciliation between the actual provision for income taxes and income taxes computed by applying the federal statutory rate follows: The Company made cash tax payments, net of refunds, of approximately $20,651, $26,854 and $25,974 during 1993, 1992 and 1991, respectively. Income from continuing operations before income taxes of foreign subsidiaries was $36,215 in 1993, $43,982 in 1992, and $33,989, including $8,235 in restructuring expenses, in 1991. The Internal Revenue Service (IRS) has completed its examination of the Company's federal income tax returns for the years 1986 through 1988 and the Company has received an assessment of additional tax. Most issues have been resolved for these years, and the Company is vigorously pursuing administrative remedies for the remaining issues. In addition, the IRS is currently examining the federal income tax returns filed by the Company for the years 1989 and 1990. Management believes that any adjustment that may result from these examinations will not have a material adverse impact on the Company's consolidated financial position or future results of operations. (7) SHAREHOLDERS' INVESTMENT Incentive Stock Plans -- Keystone has a number of restricted stock grant and stock option plans which are incentive stock plans administered by a committee of outside directors for the benefit of the Company's key employees. As of December 31, 1993, 1,434 shares were available for award under these plans. Shares issued under the stock grant plans are owned by the employees at the time of grant, subject to certain restrictions, principally continued employment with Keystone for a period to be set by the committee, typically five years. The deferred compensation expense related to the stock grants is being amortized to expense on a straight-line basis over the period of time the stock is restricted, and the unamortized portion is classified as a reduction of shareholders' investment in the accompanying Consolidated Balance Sheets. As of December 31, 1993, there were 309 shares as to which restrictions had not lapsed under the stock grant plans. KEYSTONE INTERNATIONAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Stock options are issued at exercise prices which are not less than the fair market value at the date of grant. Information about Keystone's stock option plans for the three years ended December 31, 1993 is set forth below: Shareholder Rights Plan -- In June 1990, the Company adopted a Shareholder Rights Plan and declared a dividend of one Depositary Preferred Share purchase right ("Right") for each share of Common Stock outstanding at the close of business on July 2, 1990. Each Right entitles the shareholder to buy from the Company 1/1000 of a share of a new series of preferred stock at an exercise price of $80 per Right. The Board of Directors has authorized 900 preferred shares, designated as Preferred Shares -- Junior Participating Series A, for issuance upon exercise of such Rights. The Rights will not be exercisable unless a party acquires, or announces a tender offer for, beneficial ownership of 20% or more of the Company's Common Stock. The Rights may be redeemed by the Company at a price of $.001 per Right at any time prior to their expiration on March 31, 2000 or any earlier distribution of Rights certificates in accordance with the terms of the plan. If a party acquires a 20% or more position in the Company, each Right, except those held by the acquiring party, will entitle its holder to purchase, at the exercise price, Depositary Preferred Shares having a value of two times the $80 exercise price, with each Depositary Preferred Share valued at the market price of a share of Common Stock. In the event the Company is acquired in a merger or other business combination transaction, each Right will entitle its holder to purchase, at the exercise price, that number of the acquiring company's common shares having a value of two times the exercise price of the Right. (8) EARNINGS PER SHARE Earnings per share is computed by dividing net income by the weighted average number of common and common equivalent shares outstanding. The weighted average number of common shares and common equivalent shares used in computing earnings per share was 35,085, 34,902 and 34,676 in 1993, 1992 and 1991, respectively. There is no significant difference between earnings per share on a primary and a fully diluted basis. (9) EMPLOYEE BENEFIT PLANS Defined Contribution and Benefit Plans -- Keystone has qualified and nonqualified profit sharing and stock bonus plans for employees of its domestic operations. Contributions to these plans, which may be in the form of cash or shares of the Company's stock, are based on a discretionary percentage (as approved by the Board of Directors) of pretax income before profit sharing and stock bonus contributions. Certain foreign subsidiaries and one domestic subsidiary also maintain retirement benefit plans for their employees. KEYSTONE INTERNATIONAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Keystone's expenses related to these profit sharing, stock bonus and retirement benefit plans were $5,183 in 1993, $5,322 in 1992 and $5,010 in 1991. Bonus Plan -- Keystone has incentive bonus plans for certain key employees. The amounts of such bonuses, which are included in selling, general and administrative expenses, were $5,851, $5,689, and $6,669 for 1993, 1992 and 1991, respectively. Postretirement Benefit Plans -- Effective January 1, 1991, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" on the immediate recognition basis. The standard requires that the cost of these benefits, primarily health care benefits, be recognized in the financial statements during the employee's service period. The Company controls its obligation for retiree health care by maintaining an unfunded, defined contribution plan for those domestic retirees with at least 25 years of service. Postretirement benefit expenses charged to operating income were $991, $899, and $832 for 1993, 1992, and 1991, respectively. Other long-term liabilities included $9,678 and $8,885 at December 31, 1993 and 1992, respectively, related to the long-term obligation for postretirement benefits. Accrued liabilities included $175 at both December 31, 1993 and 1992 related to the current obligation for postretirement benefits. (10) COMMITMENTS AND CONTINGENCIES Litigation -- Keystone and its subsidiaries are engaged in various claims and litigation arising from their operations. In the opinion of management, uninsured losses, if any, resulting from these matters will not have a material adverse impact on the consolidated financial position or future results of operations of the Company. Rental Expense -- Rental expense was $6,322, $6,348, and $6,114 for 1993, 1992 and 1991, respectively. The Company has entered into various leases, including an insignificant amount of capital leases, which provide for future minimum lease payments as follows: 1994 -- $5,429; 1995 -- $3,129; 1996 -- $1,351; 1997 -- $749; 1998 -- $329; 1999 and thereafter $2,755. Letters of Credit -- At December 31, 1993 and 1992, the Company had outstanding letters of credit of $4,949 and $5,288, respectively. (11) QUARTERLY RESULTS OF OPERATIONS (UNAUDITED) The following is a tabulation of the unaudited quarterly results of operations for each of the two years ended December 31, 1993: KEYSTONE INTERNATIONAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (12) INDUSTRY AND GEOGRAPHIC AREA INFORMATION Industry Segments -- Keystone operates in one dominant industry segment which involves the design, manufacture and marketing of flow control products. Geographic Segments -- Keystone's export sales, other than those intercompany sales reported below as sales between geographic areas, are not significant. Sales between geographic areas consist of sales of finished products, raw materials and unfinished products which are sold at adjusted market prices. Keystone does not derive more than 10% of its revenue from any single customer. Corporate assets consist primarily of cash, certificates of deposit and other assets. Keystone's geographic area data for each of the three years ended December 31, 1993 are as follows: (Table continued on following page) KEYSTONE INTERNATIONAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (13) OTHER ASSETS The following presents details of other assets, including certain prior year reclassifications which have been made to conform with current year presentation, at December 31, 1993 and 1992: (14) ACCRUED LIABILITIES The following presents details of accrued liabilities at December 31, 1993 and 1992: KEYSTONE INTERNATIONAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (15) SUPPLEMENTARY INCOME STATEMENT INFORMATION The following presents selected income statement information for the years ended: SCHEDULE V KEYSTONE INTERNATIONAL, INC. AND SUBSIDIARIES PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (AMOUNTS IN THOUSANDS) - --------------- (1) Includes the change in asset cost due to application of Statement No. 52 of the Financial Accounting Standards Board regarding foreign currency translation. Also, 1991 includes assets acquired in pooling transactions of $18,090. (2) Includes assets acquired in purchase transactions of $2,076, $1,294 and $799 in 1993, 1992 and 1991, respectively. The notes to consolidated financial statements are an integral part of this schedule. SCHEDULE VI KEYSTONE INTERNATIONAL, INC. AND SUBSIDIARIES ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (AMOUNTS IN THOUSANDS) - --------------- (1) The annual straight-line depreciation rates generally in use are as follows: (2) Represents primarily the change in accumulated depreciation due to application of Statement No. 52 of the Financial Accounting Standards Board regarding foreign currency translation. Also, 1991 includes $11,751 in accumulated depreciation of assets acquired in pooling transactions. The notes to consolidated financial statements are an integral part of this schedule. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Shareholders and Board of Directors, Keystone International, Inc.: We have audited the accompanying consolidated balance sheets of Keystone International, Inc. (a Texas corporation) and subsidiaries as of December 31, 1993 and 1992, 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, 1993. These consolidated financial statements and the schedules referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Keystone International, Inc. and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As explained in Note 6 to the consolidated financial statements, effective January 1, 1993, the Company changed its method of accounting for income taxes. As explained in Note 9 to the consolidated financial statements, effective January 1, 1991, the Company changed its method of accounting for postretirement benefit obligations. Our audits were made for the purpose of forming an opinion on the basic consolidated financial statements taken as a whole. The schedules listed in the index of financial statements and schedules are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic consolidated financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic consolidated financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic consolidated financial statements taken as a whole. ARTHUR ANDERSEN & CO. February 4, 1994 Houston, Texas
354647_1993.txt	354647	1993	ITEM 1. BUSINESS CVB Financial Corp. CVB Financial Corp. (referred to herein on an unconsolidated basis as "CVB" and on a consolidated basis as the "Company") is a bank holding company incorporated in California on April 27, 1981 and registered under the Bank Holding Company Act of 1956, as amended. The Company commenced business on December 30, 1981 when, pursuant to a reorganization, it acquired all of the voting stock of Chino Valley Bank (the "Bank"), which is the Company's principal asset. The Company has two other subsidiaries, Community Trust Deed Services ("Community") and Premier Results, Inc. ("Premier"). The Company's principal business is to serve as a holding company for the Bank and Community and for other banking or banking related subsidiaries which the Company may establish or acquire. Although Premier offered item and other processing services, all of its assets were sold to Electronic Data Systems Corporation on December 31, 1992. See "Item 1. BUSINESS - - Premier Results, Inc." The Company has not engaged in any other activities to date. As a legal entity separate and distinct from its subsidiaries, CVB's principal source of funds is and will continue to be dividends paid by and other funds advanced from primarily the Bank. Legal limitations are imposed on the amount of dividends that may be paid and loans that may be made by the Bank to CVB. See "Item 1. BUSINESS - Supervision and Regulation - Restrictions on Transfers of Funds to CVB by the Bank." At December 31, 1993, the Company had $687.4 million in total consolidated assets, $442.1 million in total consolidated net loans and $596.0 million in total consolidated deposits. The principal executive offices of the Company and the Bank are located at 701 North Haven Avenue, Suite 350, Ontario, California. Chino Valley Bank The Bank was incorporated under the laws of the State of California on December 26, 1973, was licensed by the California State Banking Department and commenced operations as a California state chartered bank on August 9, 1974. The Bank's deposit accounts are insured under the Federal Deposit Insurance Act up to applicable limits. Like many other state chartered banks in California, the Bank is not a member of the Federal Reserve System. At December 31, 1993, the Bank had $686.7 million in assets, $442.1 million in net loans and $596.5 million in deposits. The Bank currently has 16 banking offices located in San Bernardino County, Riverside County and the eastern portion of Los Angeles County in Southern California. Of the 16 offices, the Bank opened seven as de novo branches and acquired the other nine in acquisition transactions. Since 1990, the Bank has added four offices, two in 1990 and two in 1993. On March 5, 1993, the Company completed its acquisition of Fontana First National Bank, a one-branch bank located in Fontana, California ("Fontana"), for an aggregate cash purchase price of $5.0 million. As of December 31, 1992, Fontana had total assets of $26.3 million, net loans of $18.5 million, deposits of $22.8 million and shareholders' equity of $3.4 million. For the year ended December 31, 1992, Fontana reported net income of $74,000. On October 21, 1993, the Bank entered into an agreement with the Federal Deposit Insurance Corporation for the purchase of certain assets and the assumption of deposits and other liabilities of the failed Mid City Bank. The agreement provided the Bank with the ability to re-price the deposits assumed within specific time frames, regardless of the original terms of the deposit. Net of the deposits that were re-priced and allowed to withdraw, the Bank assumed approximately $20.0 million in deposits, $2.0 million in investments, and $18.0 million in loans. Through its network of banking offices, the Bank emphasizes personalized service combined with offering a full range of banking services to businesses, professionals and individuals located in the service areas of its offices. Although the Bank focuses the marketing of its services to small- and medium-sized businesses, a full range of retail banking services are made available to the local consumer market. The Bank offers a wide range of deposit instruments. These include checking, savings, money market and time certificates of deposit for both business and personal accounts. The Bank also serves as a federal tax depository for its business customers. The Bank also provides a full complement of lending products, including commercial, installment and real estate loans. Commercial products include lines of credit and other working capital financing, accounts receivable lending and letters of credit. Financing products for individuals include automobile financing, lines of credit and home improvement and home equity lines of credit. Real estate loans include mortgage and construction loans. The Bank also offers a wide range of specialized services designed for the needs of its commercial accounts. These services include cash management systems for monitoring cash flow, a credit card program for merchants, courier pick-up and delivery, payroll services and electronic funds transfers by way of domestic and international wires and automated clearing house. The Bank also makes available investment products to customers, including a full array of fixed income vehicles and a program pursuant to which it places its customers' funds in federally insured time certificates of deposit of other institutions. The Bank does not operate a trust department; however, it makes arrangements with a correspondent institution to offer trust services to its customers on request. Community Trust Deed Services The Company owns 100% of the voting stock of Community, which has one office. Community's services, which are provided to the Bank and non-affiliated persons, include preparing and filing notices of default, reconveyances and related documents and acting as a trustee under deeds of trust. At present, the assets, revenues and earnings of Community are not material in amount as compared to the Bank. Premier Results, Inc. The Company owns 100% of the voting stock of Premier. Through Premier, the Company offered item processing services to the Bank and other financial institutions, in addition to statement reconcilement, bookkeeping, check filing, lock box, microfilm development and on-site printing. On December 31, 1992, the Company sold all of the assets of Premier to Electronic Data Systems Corporation. The assets, revenues and earnings of Premier were not material in amount as compared to the Bank. Economic Environment in the Bank's Market Area The Bank concentrates on marketing to, and serving the needs of, businesses, professionals and individuals in San Bernardino, Riverside, northern Orange and eastern Los Angeles counties. The general economy in Southern California, including the Bank's market area, and particularly the real estate market, is suffering from the effects of a prolonged recession that has negatively impacted upon the ability of certain borrowers to perform their obligations to their lending institutions, including the Bank. According to The UCLA Business Forecast For California, December 1993 Report (the "UCLA Report"), the current recession in California is expected to continue until at least the second half of 1994, despite the presence of a moderate national economic recovery. The UCLA Report attributes the length and depth of the California recession, which began in 1990, to a number of negative economic factors, including permanent cutbacks in the California defense industries and military base closings, a cyclical downturn in California residential real estate construction, lower rates on international trade growth as a result of the worldwide recession and the effects on employment of an increased global emphasis on cost controls and downsizing. The statewide unemployment rate in November 1993 was 8.6%, compared with the national average of 6.4%. The UCLA Report notes that while statewide unemployment figures have improved recently, this was due to a decline in the size of the labor force and that total CalifoRnia employment has declined. Nevertheless, the UCLA Report expects a weak job recovery to begin in California during the second half of 1994, approaching a normal growth rate over the next four years. Based on its assessment of recent economic reports and the current economic environment in the Company's market areas, management believes that the California recession may continue beyond 1994. The overall general economic conditions and the real estate market in Southern California have had and may continue to have an adverse impact on certain of the Bank's borrowing customers and their debt service capacities. The Bank's nonperforming assets increased from $19.0 million at year end 1992 to $23.0 million at year end 1993. While management believes that the allowance for credit losses at December 31, 1993 was adequate to absorb the then known or inherent losses in the loan portfolio, declining real estate values in Southern California have reduced the value of the real estate collateral that secures certain of the Bank's loans and increased the loan-to-value ratio of those credits. As of December 31, 1993, the Bank had approximately $322.9 million in loans secured by real estate located in Southern California. For a further discussion of the Bank's nonperforming assets and allowance for possible credit losses, see "Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS." Competition The Bank faces substantial competition for deposits and loans throughout its market areas. The primary factors in competing for deposits are interest rates, personalized services, the quality and range of financial services, convenience of office locations and office hours. Competition for deposits comes primarily from other commercial banks, savings institutions, credit unions, money market and mutual funds and other investment alternatives. The primary factors in competing for loans are interest rates, loan origination fees, the quality and range of lending services and personalized services. Competition for loans comes primarily from other commercial banks, savings institutions, mortgage banking firms and other financial intermediaries. The Bank faces competition for deposits and loans throughout its market areas not only from local institutions but also from out-of-state financial intermediaries which have opened loan production offices or which solicit deposits in the Bank's market areas. Many of the financial intermediaries operating in the Bank's market areas offer certain services, such as trust, investment and international banking services, which the Bank does not offer directly. Additionally, banks with larger capitalization and financial intermediaries not subject to bank regulatory restrictions have larger lending limits and are thereby able to serve the needs of larger customers. The Bank has 16 offices located in San Bernardino, Riverside, northern Orange and eastern Los Angeles counties. Neither the deposits nor loans of any office of the Bank exceed 1% of the aggregate loans or deposits of all financial intermediaries located in the counties in which such offices are located. Employees At December 31, 1993, CVB, the Bank, Community and Premier employed 311 persons, 200 on a full-time and 111 on a part-time basis. The Company believes that its employee relations are satisfactory. Effect of Governmental Policies and Recent Legislation Banking is a business that depends on rate differentials. In general, the difference between the interest rate paid by the Bank on its deposits and its other borrowings and the interest rate received by the Bank on loans extended to its customers and securities held in the Bank's portfolio comprise the major portion of the Company's earnings. These rates are highly sensitive to many factors that are beyond the control of the Bank. Accordingly, the earnings and growth of the Company are subject to the influence of local, domestic and foreign economic conditions, including recession, unemployment and inflation. The commercial banking business is not only affected by general economic conditions but is also influenced by the monetary and fiscal policies of the federal government and the policies of regulatory agencies, particularly the Federal Reserve Board. The Federal Reserve Board implements national monetary policies (with objectives such as curbing inflation and combating recession) by its open-market operations in United States Government securities, by adjusting the required level of reserves for financial intermediaries subject to its reserve requirements and by varying the discount rates applicable to borrowings by depository institutions. The actions of the Federal Reserve Board in these areas influence the growth of bank loans, investments and deposits and also affect interest rates charged on loans and paid on deposits. The nature and impact of any future changes in monetary policies cannot be predicted. From time to time, legislation is enacted which has the effect of increasing the cost of doing business, limiting or expanding permissible activities or affecting the competitive balance between banks and other financial intermediaries. Proposals to change the laws and regulations governing the operations and taxation of banks, bank holding companies and other financial intermediaries are frequently made in Congress, in the California legislature and before various bank regulatory and other professional agencies. The likelihood of any major changes and the impact such changes might have on the Company are impossible to predict. Certain of the potentially significant changes which have been enacted and proposals which have been made recently are discussed below. Federal Deposit Insurance Corporation Improvement Act of 1991 On December 19, 1991, the Federal Deposit Insurance Corporation Improvement Act of 1991 (the "FDIC Improvement Act") was enacted into law. Set forth below is a brief discussion of certain portions of this law and implementing regulations that have been adopted or proposed by the Federal Reserve Board, the Comptroller of the Currency, the Office of Thrift Supervision and the FDIC (collectively, the "federal banking agencies"). BIF Recapitalization. The FDIC Improvement Act provides the FDIC with three additional sources of funds to protect deposits insured by the Bank Insurance Fund (the "BIF") administered by the FDIC. The FDIC is authorized to borrow up to $30 billion from the U.S. Treasury; borrow from the Federal Financing Bank up to 90% of the fair market value of assets of institutions acquired by the FDIC as receiver; and borrow from financial intermediaries that are members of the BIF. Any borrowings not repaid by asset sales are to be repaid through insurance premiums assessed to member institutions. Such premiums must be sufficient to repay any borrowed funds within 15 years and provide insurance fund reserves of $1.25 for each $100 of insured deposits. Improved Examinations. All insured depository institutions, except certain small, well managed and, well capitalized institutions, must undergo a full-scope, on-site examination by their appropriate federal banking agency at least once every 12 months. The cost of examinations of insured depository institutions and any affiliates may be assessed by the appropriate federal banking agency against each institution or affiliate as it deems necessary or appropriate. Standards for Safety and Soundness. Pursuant to the FDIC Improvement Act, the federal banking agencies have issued proposed safety and soundness standards on matters such as loan underwriting and documentation, asset quality, earnings, internal controls and audit systems, interest rate risk exposure and compensation and other employee benefits. The proposals establish, among other things, the maximum ratio of classified assets to total capital plus ineligible allowance at 1.0 and the minimum level of earnings sufficient to absorb losses without impairing capital. The proposals provide that a bank's earnings are sufficient to absorb losses without impairing capital if the bank is in compliance with minimum capital requirements and the bank would, if its net income or loss over the last four quarters continued over the next four quarters, remain in compliance with minimum capital requirements. Any institution which fails to comply with these standards must submit a compliance plan. Failure to submit an acceptable plan or to comply with an approved plan will subject the institution to further enforcement action. No assurance can be given as to the final form of the proposed regulations or, if adopted, the impact of such regulations on the Company and the Bank. In December 1992, the federal banking agencies issued final regulations prescribing uniform guidelines for real estate lending. The regulations, which became effective on March 19, 1993, require insured depository institutions to adopt written policies establishing standards, consistent with such guidelines, for extensions of credit secured by real estate. The policies must address loan portfolio management, underwriting standards and loan-to-value limits that do not exceed the supervisory limits prescribed by the regulations. Prompt Corrective Regulatory Action. The FDIC Improvement Act requires each federal banking agency to take prompt corrective action to resolve the problems of insured depository institutions that fall below one or more prescribed minimum capital ratios. The purpose of this law is to resolve the problems of insured depository institutions at the least possible long-term cost to the appropriate deposit insurance fund. The law required each federal banking agency to promulgate regulations defining the following five categories in which an insured depository institution will be placed, based on the level of its capital ratios: well capitalized (significantly exceeding the required minimum capital requirements), adequately capitalized (meeting the required capital requirements), undercapitalized (failing to meet any one of the capital requirements), significantly undercapitalized (significantly below any one capital requirement) and critically undercapitalized (failing to meet all capital requirements). In September 1992, the federal banking agencies issued uniform final regulations implementing the prompt corrective action provisions of the FDIC Improvement Act. Under the regulations, an insured depository institution will be deemed to be: o "well capitalized" if it (i) has a total risk-based capital ratio of 10% or greater, a Tier 1 risk-based capital ratio of 6% or greater and a leverage ratio of 5% or greater and (ii) is not subject to an order, written agreement, capital directive or prompt corrective action directive to meet and maintain a specific capital level for any capital measure; o "adequately capitalized" if it has a total risk- based capital ratio of 8% or greater, a Tier 1 risk- based capital ratio of 4% or greater and a leverage ratio of 4% or greater (or a leverage ratio of 3% or greater if the institution is rated composite 1 under the applicable regulatory rating system in its most recent report of examination); o "undercapitalized" if it has a total risk-based capital ratio that is less than 8%, a Tier 1 risk- based capital ratio that is less than 4% or a leverage ratio that is less than 4% (or a leverage ratio that is less than 3% if the institution is rated composite 1 under the applicable regulatory rating system in its most recent report of examination); o "significantly undercapitalized" if it has a total risk-based capital ratio that is less than 6%, a Tier 1 risk-based capital ratio that is less than 3% or a leverage ratio that is less than 3%; and o "critically undercapitalized" if it has a ratio of tangible equity to total assets that is equal to or less than 2%. An institution that, based upon its capital levels, is classified as well capitalized, adequately capitalized or undercapitalized may be reclassified to the next lower capital category if the appropriate federal banking agency, after notice and opportunity for hearing, (i) determines that the institution is in an unsafe or unsound condition or (ii) deems the institution to be engaging in an unsafe or unsound practice and not to have corrected the deficiency. At each successive lower capital category, an insured depository institution is subject to more restrictions and federal banking agencies are given less flexibility in deciding how to deal with it. The law prohibits insured depository institutions from paying management fees to any controlling persons or, with certain limited exceptions, making capital distributions if after such transaction the institution would be undercapitalized. If an insured depository institution is undercapitalized, it will be closely monitored by the appropriate federal banking agency, subject to asset growth restrictions and required to obtain prior regulatory approval for acquisitions, branching and engaging in new lines of business. Any undercapitalized depository institution must submit an acceptable capital restoration plan to the appropriate federal banking agency 45 days after becoming undercapitalized. The appropriate federal banking agency cannot accept a capital plan unless, among other things, it determines that the plan (i) specifies the steps the institution will take to become adequately capitalized, (ii) is based on realistic assumptions and (iii) is likely to succeed in restoring the depository institution's capital. In addition, each company controlling an undercapitalized depository institution must guarantee that the institution will comply with the capital plan until the depository institution has been adequately capitalized on an average basis during each of four consecutive calendar quarters and must otherwise provide adequate assurances of performance. The aggregate liability of such guarantee is limited to the lesser of (a) an amount equal to 5% of the depository institution's total assets at the time the institution became undercapitalized or (b) the amount which is necessary to bring the institution into compliance with all capital standards applicable to such institution as of the time the institution fails to comply with its capital restoration plan. Finally, the appropriate federal banking agency may impose any of the additional restrictions or sanctions that it may impose on significantly undercapitalized institutions if it determines that such action will further the purpose of the prompt corrective action provisions. An insured depository institution that is significantly undercapitalized, or is undercapitalized and fails to submit, or in a material respect to implement, an acceptable capital restoration plan, is subject to additional restrictions and sanctions. These include, among other things: (i) a forced sale of voting shares to raise capital or, if grounds exist for appointment of a receiver or conservator, a forced merger; (ii) restrictions on transactions with affiliates; (iii) further limitations on interest rates paid on deposits; (iv) further restrictions on growth or required shrinkage of assets; (v) modification or termination of specified activities; (vi) replacement of directors or senior executive officers, subject to certain grandfather provisions for those elected prior to enactment of the FDIC Improvement Act; (vii) prohibitions on the receipt of deposits from correspondent institutions; (viii) restrictions on capital distributions by the holding companies of such institutions; (ix) required divestiture of subsidiaries by the institution; or (x) other restrictions as determined by the appropriate federal banking agency. Although the appropriate federal banking agency has discretion to determine which of the foregoing restrictions or sanctions it will seek to impose, it is required to force a sale of voting shares or merger, impose restrictions on affiliate transactions and impose restrictions on rates paid on deposits unless it determines that such actions would not further the purpose of the prompt corrective action provisions. In addition, without the prior written approval of the appropriate federal banking agency, a significantly undercapitalized institution may not pay any bonus to its senior executive officers or provide compensation to any of them at a rate that exceeds such officers' average rate of base compensation during the 12 calendar months preceding the month in which the institution became undercapitalized. Further restrictions and sanctions are required to be imposed on insured depository institutions that are critically undercapitalized. For example, a critically undercapitalized institution generally would be prohibited from engaging in any material transaction other than in the ordinary course of business without prior regulatory approval and could not, with certain exceptions, make any payment of principal or interest on its subordinated debt beginning 60 days after becoming critically undercapitalized. Most importantly, however, except under limited circumstances, the appropriate federal banking agency, not later than 90 days after an insured depository institution becomes critically undercapitalized, is required to appoint a conservator or receiver for the institution. The board of directors of an insured depository institution would not be liable to the institution's shareholders or creditors for consenting in good faith to the appointment of a receiver or conservator or to an acquisition or merger as required by the regulator. As of December 31, 1993, the Bank had a total risk-based capital ratio of 13.0%, a Tier 1 risk-based ratio of 11.7% and a leverage ratio of 8.3%. Other Items. The FDIC Improvement Act also, among other things, (i) limits the percentage of interest paid on brokered deposits and limits the unrestricted use of such deposits to only those institutions that are well capitalized; (ii) requires the FDIC to charge insurance premiums based on the risk profile of each institution; (iii) eliminates "pass through" deposit insurance for certain employee benefit accounts unless the depository institution is well capitalized or, under certain circumstances, adequately capitalized; (iv) prohibits insured state chartered banks from engaging as principal in any type of activity that is not permissible for a national bank unless the FDIC permits such activity and the bank meets all of its regulatory capital requirements; (v) directs the appropriate federal banking agency to determine the amount of readily marketable purchased mortgage servicing rights that may be included in calculating such institution's tangible, core and risk-based capital; and (vi) provides that, subject to certain limitations, any federal savings association may acquire or be acquired by any insured depository institution. The FDIC has adopted final regulations implementing the risk-based premium system mandated by the FDIC Improvement Act. Under the transitional regulations, which cover the assessment periods commencing on and after January 1, 1994, insured depository institutions are required to pay insurance premiums within a range of 23 cents per $100 of deposits to 31 cents per $100 of deposits depending on their risk classification. To determine the risk-based assessment for each institution, the FDIC will categorize an institution as well capitalized, adequately capitalized or undercapitalized based on its capital ratios. A well capitalized institution is one that has at least a 10% total risk-based capital ratio, a 6% Tier 1 risk-based capital ratio and a 5% Tier 1 leverage capital ratio. An adequately capitalized institution will have at least an 8% total risk-based capital ratio, a 4% Tier 1 risk-based capital ratio and a 4% Tier 1 leverage capital ratio. An undercapitalized institution will be one that does not meet either of the above definitions. The FDIC will also assign each institution to one of three supervisory subgroups based upon reviews by the institution's primary federal or state regulator, statistical analyses of financial statements and other information relevant to evaluating the risk posed by the institution. As a result, the assessment rates within each of three capital categories will be as follows (expressed as cents per $100 of deposits): Supervisory Subgroup A B C Well capitalized 23 26 29 Adequately capitalized 26 29 30 Undercapitalized 29 30 31 In addition, the FDIC has issued final regulations implementing provisions of the FDIC Improvement Act relating to powers of insured state banks. The regulations prohibit, subject to certain specified exceptions, insured state banks from making equity investments of a type, or in an amount, that are not permissible for national banks. In general, equity investments include equity securities, partnership interests and equity interests in real estate. Under the final regulations, non-permissible investments must be divested by no later than December 19, 1996. The FDIC has also issued final regulations which prohibit insured state banks from engaging as principal in any activity not permissible for a national bank, without FDIC approval. The regulations also provide that, subject to certain specified exceptions, subsidiaries of insured state banks may not engage as principal in any activity that is not permissible for a subsidiary of a national bank, without FDIC approval. The impact of the FDIC Improvement Act on the Company and the Bank is uncertain, especially since many of the regulations promulgated thereunder have been only recently adopted and certain of the law's provisions still need to be defined through future regulatory action. Certain provisions, such as the recently adopted real estate lending standards and the limitations on investments and powers of state banks and the rules to be adopted governing compensation, fees and other operating policies, may affect the way in which the Bank conducts its business, and other provisions, such as those relating to the establishment of the risk-based premium system, may adversely affect the Bank's results of operations. Capital Adequacy Guidelines The Federal Reserve Board and the FDIC have issued guidelines to implement risk-based capital requirements. The guidelines are intended to establish a systematic analytical framework that makes regulatory capital requirements more sensitive to differences in risk profiles among banking organizations, takes off-balance-sheet financial instruments into account in assessing capital adequacy and minimizes disincentives to holding liquid, low-risk assets. Under these guidelines, assets and credit equivalent amounts of off-balance-sheet financial instruments, such as letters of credit and long-term outstanding loan commitments, are assigned to one of several risk categories, which range from 0% for credit risk-free assets, such as cash and certain U.S. government securities, to 100% for relatively high-risk assets, such as loans and investments in fixed assets, premises and other real estate owned. The aggregated dollar amount of each category is then multiplied by the risk-weight associated with that category. The resulting weighted values from each of the risk categories are then added together to determine the total risk-weighted assets. Beginning on December 31, 1992, the guidelines require a minimum ratio of qualifying total capital to risk-weighted assets of 8%, of which at least 4% must consist of Tier 1 capital. Higher risk-based ratios are required to be considered well capitalized under the prompt corrective action provisions of the FDIC Improvement Act. See "Item 1. BUSINESS - Effect of Governmental Policies and Recent Legislation - Federal Deposit Insurance Improvement Act of 1991 - Prompt Corrective Regulatory Action." A banking organization's qualifying total capital consists of two components: Tier 1 capital (core capital) and Tier 2 capital (supplementary capital). Tier 1 capital consists primarily of common stock, related surplus and retained earnings, qualifying noncumulative perpetual preferred stock (plus, for bank holding companies, qualifying cumulative perpetual preferred stock in an amount up to 25% of Tier 1 capital) and minority interests in the equity accounts of consolidated subsidiaries. Intangibles, such as goodwill, are generally deducted from Tier 1 capital; however, purchased mortgage servicing rights and purchase credit card relationships may be included, subject to certain limitations. At least 50% of the banking organization's total regulatory capital must consist of Tier 1 capital. Tier 2 capital may consist of (i) the allowance for possible loan and lease losses in an amount up to 1.25% of risk-weighted assets; (ii) cumulative perpetual preferred stock and long-term preferred stock (which for bank holding companies must have an original maturity of 20 years or more) and related surplus; (iii) hybrid capital instruments (instruments with characteristics of both debt and equity), perpetual debt and mandatory convertible debt securities; and (iv) eligible term subordinated debt and intermediate-term preferred stock with an original maturity of five years or more, including related surplus, in an amount up to 50% of Tier 1 capital. The inclusion of the foregoing elements of Tier 2 capital are subject to certain requirements and limitations of the federal banking agencies. The Federal Reserve Board and the FDIC have also adopted a minimum leverage ratio of Tier 1 capital to average total assets of 3% for the highest rated banks. This leverage ratio is only a minimum. Institutions experiencing or anticipating significant growth or those with other than minimum risk profiles are expected to maintain capital well above the minimum level. Furthermore, higher leverage ratios are required to be considered well capitalized or adequately capitalized under the prompt corrective action provisions of the FDIC Improvement Act. See "Item 1. BUSINESS - Effect of Governmental Policies and Recent Legislation - Federal Deposit Insurance Corporation Improvement Act of 1991 -Prompt Corrective Regulatory Action." As of December 31, 1993, the Company and the Bank had total risk-based capital ratios of 13.1% and 13.0%, Tier 1 risk-based capital ratios of 11.8% and 11.7% and leverage ratios of 8.4% and 8.3%, respectively. In addition, the federal banking agencies have issued proposed rules, in accordance with the FDIC Improvement Act, seeking public comment on methods for measuring interest rate risk, and two alternative methods for determining what amount of additional capital, if any, a bank may be required to have for interest rate risk. The Company cannot yet determine whether such proposals will be adopted or the impact of such regulations, if adopted, on the Company and the Bank. The federal banking agencies issued a statement advising that, for regulatory purposes, federally supervised banks and savings associations should report deferred tax assets in accordance with Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes," beginning in 1993. See "Item 1. BUSINESS -Effect of Governmental Policies and Recent Legislation - Accounting Changes." However, the federal banking agencies have advised that they will place a limit on the amount of deferred tax assets that is allowable in computing an institution's regulatory capital. Deferred tax assets that can be realized from taxes paid in prior carryback years and from the future reversal of temporary differences would generally not be limited. Deferred tax assets that can only be realized through future taxable earnings, including the implementation of a tax planning strategy, would be limited for regulatory capital purposes to the lesser of (i) the amount that can be realized within one year of the quarter-end report date or (ii) 10% of Tier 1 capital. The amount of deferred taxes in excess of this limit, if any, would be deducted from Tier 1 capital and total assets in regulatory capital calculations. The federal banking agencies have notified institutions that their capital rules will be amended to reflect this change. Management does not expect implementation of this proposal to have a material impact on the Bank's regulatory capital levels. The federal banking agencies issued a proposal in January 1994 seeking public comment on whether to amend their capital definitions of leverage and risk based capital to conform such definitions to the recently issued SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," which requires an institution to recognize as a separate component of stockholders' equity the amount of unrealized gains and losses on securities that are deemed to be "available for sale." See "Business -- Effect of Government Policies and Recent Legislation -- Accounting Changes." Accounting Changes In February 1992, the Financial Accounting Standards Board ("FASB") issued SFAS No. 109, which supersedes SFAS No. 96. SFAS No. 109 is effective for fiscal years beginning after December 31, 1992, or earlier at the Company's option. SFAS No. 109 employs an asset and liability approach in accounting for income taxes payable or refundable at the date of the financial statements as a result of all events that have been recognized in the financial statements and as measured by the provisions of enacted tax laws. The Company adopted SFAS No. 109 in 1992, elected not to restate prior years and has determined that the cumulative effect of the implementation was immaterial. In May 1993, the FASB issued SFAS No. 114, "Accounting by Creditors for Impairment of a Loan" ("SFAS No. 114"). Under the provisions of SFAS No. 114, a loan is considered impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. SFAS No. 114 requires creditors to measure impairment of a loan based on the present value of expected future cash flows discounted at the loan's effective interest rate, market prices (when available) or the fair market value of collateral for a collateral-dependent loan. If the measure of the impaired loan is less than the recorded investment in the loan, a creditor shall recognize an impairment by recreating a valuation allowance with a corresponding charge to bad debt expense. This statement also applies to restructured loans and changes the definition of in-substance foreclosures to apply only to the loans where the creditor has taken physical possession of the borrower's assets. SFAS No. 114 applies to financial statements for fiscal years beginning after December 15, 1994. Earlier implementation is permitted. The Company is currently evaluating the impact of the statement on its results of operations and financial position but is unlikely to implement the statement early. In December 1990, the FASB issued SFAS No. 106, "Employers' Accounting for Post-Retirement Benefits Other Than Pensions" ("SFAS No. 106"), effective for fiscal years beginning after December 15, 1992. In November 1992, the FASB issued SFAS No. 112, "Employers' Accounting for Post- Employment Benefits" ("SFAS No. 112") effective for fiscal years beginning after December 15, 1993. SFAS No. 106 and SFAS No. 112 focus primarily on post-retirement health care benefits. The Company does not provide post- retirement benefits and SFAS No. 106 and SFAS No. 112 will have no impact on net income in 1994. In May 1993, the FASB issued SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," addressing the accounting and reporting for investments in equity securities that have readily determinable fair values and for all investments in debt securities. Those investments would be classified in three categories and accounted for as follows: (i) debt and equity securities that the entity has the positive intent and ability to hold to maturity would be classified as "held to maturity" and reported at amortized cost; (ii) debt and equity securities that are held for current resale would be classified as trading securities and reported at fair value, with unrealized gains and losses included in operations; and (iii) debt and equity securities not classified as either securities held to maturity or trading securities would be classified as securities available for sale, and reported at fair value, with unrealized gains and losses excluded from operations and reported as a separate component of shareholders' equity. The Compnay adopted SFAS No. 115 effective as of January 1, 1994, and as of that date the Bank had both investment securities classified at "held to maturity" and investment securities classified as "available for sale." Securities classified as available for sale will be reported at their fair value at the end of each fiscal quarter. The value of such securities fluctuates based on changes in interest rates. Generally, an increase in interest rates would result in a decline in the value of investment securities held for sale, while a decline in interest rates would result in an increase in the value of such securities. Therefore, the value of investment securities available for sale and the Bank's shareholders' equity could be subject to fluctuation, based on changes in interest rates. As a consequence, the Bank's capital levels for regulatory purposes could change based solely on fluctuations in interest rates and fluctuations in the value of investment securities available for sale. Such change could result in additional regulatory restrictions under the prompt corrective actions provisions of the FDIC Improvement Act of 1991 and various other laws and regulations that are based, in part, on a institution's capital levels, including those dealing with the risk related insurance premium system and brokered deposit restrictions. See "Item 1, Business -- Effect of Governmental Policies and Recent Legislation -- Federal Deposit Insurance Corporation Improvement Act of 1991." Omnibus Budget Reconciliation Act of 1993 On August 10, 1993, President Clinton signed the Omnibus Budget Reconciliation Act of 1993 (the "Reconciliation Act"). Some of the provisions in the Reconciliation Act that may have an effect on the Company include the following: (i) the corporate income tax rate was increased from 34.04% to 35.0% for taxable income in excess of $10.0 million; (ii) mark-to-market rules for tax purposes with regard to securities held for sale by the Company; (iii) beginning in 1994 the amount of business meals and entertainment expenses that will be disallowed will be increased from the current 20.0% disallowance to 50.0% disallowance; (iv) club dues and lobbying expenses will no longer be deductible; and (v) certain intangible assets, including goodwill, will be amortized over a period of 15 years. Considering the Company's current tax situation, the Company does not expect the provisions of the Reconciliation Act to have a material effect on the Company. Supervision and Regulation Bank holding companies and banks are extensively regulated under both federal and state law. The Company The Company, as a registered bank holding company, is subject to regulation under the Bank Holding Company Act of 1956, as amended (the "Act"). The Company is required to file with the Federal Reserve Board quarterly and annual reports and such additional information as the Federal Reserve Board may require pursuant to the Act. The Federal Reserve Board may conduct examinations of the Company and its subsidiaries. The Federal Reserve Board may require that the Company terminate an activity or terminate control of or liquidate or divest certain subsidiaries or affiliates when the Federal Reserve Board believes the activity or the control of the subsidiary or affiliate constitutes a significant risk to the financial safety, soundness or stability of any of its banking subsidiaries. The Federal Reserve Board also has the authority to regulate provisions of certain bank holding company debt, including authority to impose interest ceilings and reserve requirements on such debt. Under certain circumstances, the Company must file written notice and obtain approval from the Federal Reserve Board prior to purchasing or redeeming its equity securities. Under the Act and regulations adopted by the Federal Reserve Board, a bank holding company and its nonbanking subsidiaries are prohibited from requiring certain tie-in arrangements in connection with any extension of credit, lease or sale of property or furnishing of services. Further, the Company is required by the Federal Reserve Board to maintain certain levels of capital. See "Item 1. BUSINESS - Effect of Governmental Policies and Recent Legislation - Capital Adequacy Guidelines." The Company is required to obtain the prior approval of the Federal Reserve Board for the acquisition of more than 5% of the outstanding shares of any class of voting securities or substantially all of the assets of any bank or bank holding company. Prior approval of the Federal Reserve Board is also required for the merger or consolidation of the Company and another bank holding company. The Company is prohibited by the Act, except in certain statutorily prescribed instances, from acquiring direct or indirect ownership or control of more than 5% of the outstanding voting shares of any company that is not a bank or bank holding company and from engaging directly or indirectly in activities other than those of banking, managing or controlling banks or furnishing services to its subsidiaries. However, the Company may, subject to the prior approval of the Federal Reserve Board, engage in , or acquire shares of companies engaged in, any activities that are deemed by the Federal Reserve Board to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. In making any such determination, the Federal Reserve Board is required to consider whether the performance of such activities by the Company or an affiliate can reasonably be expected to produce benefits to the public, such as greater convenience, increased competition or gains in efficiency, that outweigh possible adverse effects, such as undue concentration of resources, decreased or unfair competition, conflicts of interest or unsound banking practices. The Federal Reserve Board is also empowered to differentiate between activities commenced de novo and activities commenced by acquisition, in whole or in part, of a going concern and is generally prohibited from approving an application by a bank holding company to acquire voting shares of any commercial bank in another state unless such acquisition is specifically authorized by the laws of such other state. Under Federal Reserve Board regulations, a bank holding company is required to serve as a source of financial and managerial strength to its subsidiary banks and may not conduct its operations in an unsafe or unsound manner. In addition, it is the Federal Reserve Board's policy that, in serving as a source of strength to its subsidiary banks, a bank holding company should stand ready to use available resources to provide adequate capital funds to its subsidiary banks during periods of financial stress or adversity and should maintain the financial flexibility and capital-raising capacity to obtain additional resources for assisting its subsidiary banks. A bank holding company's failure to meet its obligations to serve as a source of strength to its subsidiary banks will generally be considered by the Federal Reserve Board to be an unsafe and unsound banking practice or a violation of the Federal Reserve Board's regulations or both. This doctrine has become known as the "source of strength" doctrine. Although the United States Court of Appeals for the Fifth Circuit found the Federal Reserve Board's source of strength doctrine invalid in 1990, stating that the Federal Reserve Board had no authority to assert the doctrine under the Act, the decision, which is not binding on federal courts outside the Fifth Circuit, was recently reversed by the United States Supreme Court on procedural grounds. The validity of the source of strength doctrine is likely to continue to be the subject of litigation until definitively resolved by the courts or by Congress. The Company is also a bank holding company within the meaning of Section 3700 of the California Financial Code. As such, the Company and its subsidiaries are subject to examination by, and may be required to file reports with, the California State Banking Department. Finally, the Company is subject to the periodic reporting requirements of the Securities Exchange Act of 1934, as amended, including, but not limited to, filing annual, quarterly and other current reports with the Securities and Exchange Commission. The Bank The Bank, as a California state chartered bank, is subject to primary supervision, periodic examination and regulation by the California Superintendent of Banks ("Superintendent") and the FDIC. The Bank is insured by the FDIC, which currently insures deposits of each member bank to a maximum of $100,000 per depositor. For this protection, the Bank, as is the case with all insured banks, pays a semiannual statutory assessment and is subject to the rules and regulations of the FDIC. See "Item 1. BUSINESS - Effect of Governmental Policies and Recent Legislation." Although the Bank is not a member of the Federal Reserve System, it is nevertheless subject to certain regulations of the Federal Reserve Board. Various requirements and restrictions under the laws of the State of California and the United States affect the operations of the Bank. State and federal statutes and regulations relate to many aspects of the Bank's operations, including reserves against deposits, interest rates payable on deposits, loans, investments, mergers and acquisitions, borrowings, dividends and locations of branch offices. Further, the Bank is required to maintain certain levels of capital. See "Item 1. BUSINESS - Effect of Governmental Policies and Recent Legislation - Capital Adequacy Guidelines." Restrictions on Transfers of Funds to CVB by the Bank CVB is a legal entity separate and distinct from the Bank and its subsidiaries. There are statutory and regulatory limitations on the amount of dividends which may be paid to CVB by the Bank. California law restricts the amount available for cash dividends by state chartered banks to the lesser of retained earnings or the bank's net income for its last three fiscal years (less any distributions to shareholders made during such period). In the event a bank has no retained earnings or net income for its last three fiscal years, cash dividends may be paid in an amount not exceeding the greater of the retained earnings of the bank, the net income for such bank's last preceding fiscal year, or the net income of the bank for its current fiscal year only after obtaining the prior approval of the Superintendent. The FDIC also has authority to prohibit the Bank from engaging in what, in the FDIC's opinion, constitutes an unsafe or unsound practice in conducting its business. It is possible, depending upon the financial condition of the bank in question and other factors, that the FDIC could assert that the payment of dividends or other payments might, under some circumstances, be such an unsafe or unsound practice. Further, the FDIC and the Federal Reserve Board have established guidelines with respect to the maintenance of appropriate levels of capital by banks or bank holding companies under their jurisdiction. Compliance with the standards set forth in such guidelines and the restrictions that are or may be imposed under the prompt corrective action provisions of the FDIC Improvement Act could limit the amount of dividends which the Bank or the Company may pay. See "Item 1. BUSINESS - Federal Deposit Insurance Corporation Improvement Act of 1991 - Prompt Corrective Regulatory Action and - Capital Adequacy Guidelines" for a discussion of these additional restrictions on capital distributions. At present, substantially all of CVB's revenues, including funds available for the payment of dividends and other operating expenses, are, and will continue to be, primarily dividends paid by the Bank. At December 31, 1993, the Bank had approximately $18.0 million available for the payment of cash dividends. The Bank is subject to certain restrictions imposed by federal law on any extensions of credit to, or the issuance of a guarantee or letter of credit on behalf of, CVB or other affiliates, the purchase of or investments in stock or other securities thereof, the taking of such securities as collateral for loans and the purchase of assets of CVB or other affiliates. Such restrictions prevent CVB and such other affiliates from borrowing from the Bank unless the loans are secured by marketable obligations of designated amounts. Further, such secured loans and investments by the Bank to or in CVB or to or in any other affiliate are limited to 10% of the Bank's capital and surplus (as defined by federal regulations) and such secured loans and investments are limited, in the aggregate, to 20% of the Bank's capital and surplus (as defined by federal regulations). California law also imposes certain restrictions with respect to transactions involving CVB and other controlling persons of the Bank. Additional restrictions on transactions with affiliates may be imposed on the Bank under the prompt corrective action provisions of the FDIC Improvement Act. See "Item 1. BUSINESS - Effect of Governmental Policies and Recent Legislation - - Federal Deposit Insurance Corporation Improvement Act of 1991 - Prompt Corrective Regulatory Action." Potential Enforcement Actions Commercial banking organizations, such as the Bank, and their institution-affiliated parties, which include the Company, may be subject to potential enforcement actions by the Federal Reserve Board, the FDIC and the Superintendent for unsafe or unsound practices in conducting their businesses or for violations of any law, rule, regulation or any condition imposed in writing by the agency or any written agreement with the agency. Enforcement actions may include the imposition of a conservator or receiver, the issuance of a cease-and-desist order that can be judicially enforced, the termination of insurance of deposits (in the case of the Bank), the imposition of civil money penalties, the issuance of directives to increase capital, the issuance of formal and informal agreements, the issuance of removal and prohibition orders against institution-affiliated parties and the imposition of restrictions and sanctions under the prompt corrective action provisions of the FDIC Improvement Act. Additionally, a holding company's inability to serve as a source of strength to its subsidiary banking organizations could serve as an additional basis for a regulatory action against the holding company. Neither the Company nor the Bank have been subject to any such enforcement actions. ITEM 2.		ITEM 2. Properties The principal executive offices of the Company and the Bank are located at 701 N. Haven Avenue, Suite 350, Ontario, California. The office of Community is located at 125 East "H" Street, Colton, California. The Bank occupies the premises for ten of its offices under leases expiring at various dates from 1994 through 2014. The Bank owns the premises for its six other offices. The Company's total occupancy expense, exclusive of furniture and equipment expense, for the year ended December 31, 1993, was $2.2 million. Management believes that its existing facilities are adequate for its present purposes. However, management currently intends to increase the Bank's assets over the next several years and anticipates that a substantial portion of this growth will be accomplished through acquisition or de novo opening of additional banking offices. For additional information concerning properties, see Notes 6 and 9 to the Company's financial statements included in this report. See "Item 8, FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA." ITEM 3.	ITEM 3. Legal Proceedings From time to time the Company and the Bank are party to claims and legal proceedings arising in the ordinary course of business. After taking into consideration information furnished by counsel to the Company and the Bank management believes that the ultimate aggregate liability represented thereby, if any, will not have a material adverse effect on the Company's consolidated financial position or results of operations. ITEM 4.	ITEM 4.Submission of Matters to a Vote of Security Holders No matters were submitted to shareholders during the fourth quarter of 1993. ITEM 4(A). EXECUTIVE OFFICERS OF THE REGISTRANT As of March 15, 1994, the principal executive officers of the Company and Chino are: Name Position Age George A. Borba Chairman of the Board of 61 the Company and the Bank D. Linn Wiley President and Chief Executive 55 Officer of the Company and the Bank Daniel L. Thomas Executive Vice President/Manager 53 of the Chino office Vincent T. Breitenberger Executive Vice President/Senior 60 Loan Officer of the Bank Jay W. Coleman Executive Vice President of the Bank 51 Robert J. Schurheck Chief Financial Officer of 61 the Company and Executive Vice President and Chief Financial Officer of the Bank Other than George A. Borba, who is the brother of John A. Borba, a director of the Company and the Bank, there is no family relationship among any of the above-named officers or any of the Company's directors. Mr. Borba has served as Chairman of the Board of the Company since its organization in April 1981 and Chairman of the Board of the Bank since its organization in December 1973. In addition, Mr. Borba is the owner of George Borba Dairy. Mr. Wiley has served as President and Chief Executive Officer of the Company since October 4, 1991. Mr. Wiley joined the Company and Bank as a director and as President and Chief Executive Officer designate on August 21, 1991. Prior to that, Mr. Wiley served as an Executive Vice President of Wells Fargo Bank from April 1, 1990 to August 20, 1991. From 1988 to April 1, 1990 Mr. Wiley served as the President and Chief Administrative Officer of Central Pacific Corporation, and from 1983 to 1990 he was the President and Chief Executive Officer of American National Bank. Mr. Thomas assumed the position of Executive Vice President/Manager of the Chino office effective November 1, 1988. Prior to that time he was Executive Vice President from February 25, 1985 to October 31, 1988. Prior to that, he served as Senior Vice President of Loan Administration at Bank of Newport. Mr. Breitenberger has served as Executive Vice President of the Bank since April 1982, and prior to that time was Senior Vice President of the Bank from November 1980 to March 1982. He has been the Senior Loan Officer of the Bank since November 1980. Mr. Coleman assumed the position of Executive Vice President of the Bank on December 5, 1988. Prior to that he served as President and Chief Executive Officer of Southland Bank, N.A. from March 1983 to April 1988. Mr. Schurheck assumed the position of Chief Financial Officer of the Company and Executive Vice President/Chief Financial Officer of the Bank on March 1, 1990. He served as Senior Vice President of the Bank from September 11, 1989 to February 28, 1990. Prior to that he served as Senior Vice President of General Bank from June 1988 to September 1989. From July 1987 to June 1988 Mr. Schurheck was a self-employed consultant; from December 1973 to June 1987 he was Senior Vice President of Operations and Finance of State Bank in Lake Havasu City, Arizona. PART II ITEM 5.	ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS. Shares of CVB Financial Corp. common stock price increased from an average price of $10.129 for the first quarter of 1993, to an average price of $12.538 for the fourth quarter of 1993. Fears regarding the recession, weak California real estate prices, and bank capital levels continued to dominate investors' perceptions of bank stocks, regardless of the performance of CVB Financial Corp. The average price of CVB common stock for the fourth quarter of 1993 was $12.538, and this represented a multiple of book value of approximately 1.52. The following table presents the high and low sales prices for the Company's common stock during each quarter for the past three years. The share prices and cash dividend per share amounts presented for all periods in the table below have been restated to give retroactive effect to the ten percent stock dividends declared on December 15, 1993. There were approximately 1,039 shareholders as of December 31, 1993. Three Year Summary of Common Stock Prices Quarter Ended High Low Dividends 3/31/91 11.57 8.58 $.058 Cash Dividend 6/30/91 10.85 9.61 $.058 Cash Dividend 9/30/91 10.13 8.26 $.058 Cash Dividend 12/31/91 9.50 6.82 $.066 Cash Dividend 3/31/92 10.02 7.34 $.066 Cash Dividend 6/30/92 8.88 8.16 $.066 Cash Dividend 9/30/92 8.36 7.65 $.066 Cash Dividend 12/31/92 8.47 6.82 $.066 Cash Dividend 10% Stock Dividend 3/31/93 12.27 8.52 $.073 Cash Dividend 6/30/93 11.42 10.00 $.073 Cash Dividend 9/30/93 13.41 10.91 $.073 Cash Dividend 12/31/93 13.52 11.70 $.073 Cash Dividend 10% Stock Dividend The Company lists its common stock on the American Stock Exchange under the symbol "CVB." ITEM. 6. SELECTED FINANCIAL DATA ITEM 7.		ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management's discussion and analysis is written to provide greater insight into the results of operations and the financial condition of CVB Financial Corp. and its subsidiaries. This analysis should be read in conjunction with the audited financial statements contained within this report including the notes thereto. CVB Financial Corp., (CVB) is a bank holding company. Its primary subsidiary, Chino Valley Bank, (the Bank) is a state chartered bank with 16 branch offices located in San Bernardino, Riverside, east Los Angeles, and north Orange Counties. Community Trust Deed Services (CTD) is a nonbank subsidiary providing services to the Bank as well as nonaffiliated persons. For purposes of this analysis, the consolidated entities are referred to as the "Company". The results of operations, and the financial condition of the Company were affected in 1993 by two separate bank acquisitions. On March 8, 1993, the Company acquired Fontana First National Bank through merger with the "Capital B Bank" as the continuing entity. On the date of acquisition Fontana First National Bank had approximately $23.7 million in deposits and acquiring approximately $18.5 million in loans. Fontana First National Bank was purchased for $5.04 million, which resulted in $2.0 million in goodwill. On October 21, 1993, the Bank assumed the deposits and purchased certain assets of the failed Mid City Bank, N.A. from the Federal Deposit Insurance Corporation (the FDIC). The acquisition was structured under a written agreement between the FDIC and the Bank that allowed the Bank certain rights in regard to repricing deposits and purchasing additional assets as well as providing the Bank with indemnification from prior activities of the failed bank. After exercising its right to re-price specific deposits, the Bank assumed approximately $20.0 million in deposits, and purchased $2.0 million in investments and $18.0 million in loans. ANALYSIS OF THE RESULTS OF OPERATIONS The Company reported net earnings of $9.5 million for the year ended December 31, 1993. This represented an increase of $507,000 or 5.60%, over net earnings of $9.0 million for the year ended December 31, 1992. For the year ended December 31, 1991, net earnings totaled $7.9 million. Earnings per share have increased from $1.10, to $1.23, to $1.27, for the years ended December 31, 1991, 1992, and 1993, respectively. The return on average assets increased from 1.54% for the year ended December 31, 1991, to 1.62% for the year ended December 31, 1992, then decreased to 1.52% for the year ended December 31, 1993. Return on average shareholders' equity decreased from 19.45%, to 18.72%, to 17.46%, for the years ended December 31, 1991, 1992, and 1993, respectively. The capital to asset ratio (the leverage ratio) increased from 8.28% at December 31, 1991, to 8.37% at December 31, 1993. The increase in net earnings for 1993 and 1992 was primarily the result of increases in net interest income. Contributing to the increase in net interest income was a significant increase in assets and a lower cost of total deposits resulting from increased noninterest bearing demand deposits as a percent of total deposits. Significant growth in other operating income for 1993 also contributed to increased net earnings. This was the result of gains realized on securities sold during the year. Increases in the provision for loan losses for 1992 and 1993, and a $2.8 million provision for potential losses on other real estate owned for 1993, offset a portion of the increase in net interest income for 1992 and 1993. Growth in assets exceeded increases in earnings for 1993, resulting in a decrease in return on assets. NET INTEREST INCOME AND THE NET INTEREST MARGIN Table 1 provides average balances of assets, liabilities, and shareholders' equity, for the years ended December 31, 1993, 1992, and 1991. Interest income and interest expense and the corresponding yields and costs are included for applicable interest earning assets and interest bearing liabilities for each year ended. Rates for tax preferenced investments are provided on a taxable equivalent basis using a marginal tax rate of 34.25%. Net interest income is equal to the difference between the interest the Company receives on interest earning assets and the interest it pays for interest bearing liabilities. Net interest income totaled $35.9 million for the year ended December 31, 1993, representing an increase of $3.9 million, or 12.1%, over net interest income of $32.0 million for the year ended December 31, 1992. For the year ended December 31, 1991, the Company generated net interest income of $29.5 million. The net interest margin is the net return on average interest earning assets, or net interest income measured as a percent of average interest earning assets. The net interest margin totaled 6.56%, 6.49%, and 6.36%, for the years ended December 31, 1993, 1992, and 1991, respectively. The increases in net interest income and net interest margin for both 1993 and 1992 were the result of continued improvement in the net interest spread. A general decline in the rate paid for interest bearing liabilities, coupled with increases in noninterest bearing demand deposits as a percent of total deposits, resulted in a decrease in the cost of funds. The net interest spread is the difference between the yield on interest earning assets and the cost of interest bearing liabilities. The yield on interest earning assets decreased from 10.51%, to 8.95%, to 8.37%, for the years ended December 31, 1991, 1992, and 1993, respectively. During the same period, the cost of interest bearing liabilities decreased from 5.44% for 1991, to 3.34% for 1992, to 2.55% for 1993. The decreases in the yields on interest earning assets as well as the cost of interest bearing liabilities both reflect decreases in interest rates in general during the three year period. As the decreases in the cost of interest bearing liabilities was greater than the decreases in the yield on interest earning assets, the net interest spread increased from 5.07% for 1991, to 5.61% for 1992, to 5.82% for 1993. Increases in net interest income and the net interest margin for 1992 and 1993 were also affected by a less costly deposit mix. The Company's assets are primarily funded by deposits, including non-interest bearing demand deposits. Noninterest bearing demand deposits have increased from $131.5 million, to $157.4 million, to $221.6 million at December 31, 1991, 1992 and 1993, respectively. This represented increases of $64.1 million, or 40.70% for 1993, and $25.9 million, or 19.75% for 1992. As a percent of average total deposits, average noninterest bearing demand deposits have increased from 24.70%, to 27.96%, to 31.99%, for the years ended December 31, 1991, 1992, and 1993, respectively. As average noninterest bearing deposits have increased as a percent of average total deposits, the cost of average total deposits has decreased from 4.09%, to 2.40%, to 1.73%, for the years ended December 31, 1991, 1992 and 1993, respectively. Table 2 provides a summary of the changes in interest income and interest expense resulting from changes in the volume of interest earning assets and interest bearing liabilities, and the changes resulting from changes in interest rates for the years ended December 31, 1993, 1992, and 1991. The changes in interest income or expense attributable to volume changes are calculated by multiplying the change in volume by the initial average rate. The changes in interest income attributable to changes in interest rates are calculated by multiplying the change in rate by the initial volume. The changes attributable to rate and volume changes are calculated by multiplying the change in rate times the change in volume. The Company's primary source of revenue is the interest income it receives on loans. In general, the Company stops accruing interest on a nonperforming loan after its principal or interest becomes 90 days or more past due. Interest that has already accrued on a nonperforming loan is reversed from income when the loan is placed in a nonperforming status. Interest income for the year ended December 31, 1992, and 1991, respectively, included interest of $115,900, and $89,500 that was accrued and not reversed on nonperforming loans. There was no interest income that was accrued and not reversed on any nonperforming loan at December 31, 1993. For 1991 and 1992, the amount of interest accrued on nonperforming loans was deemed collectable primarily based on the value of collateral in which the Bank held a security interest. Had nonperforming loans for which interest was no longer accruing complied with the original terms and conditions of the notes, interest income would have increased by $1,186,000, $698,600, and $1,037,200 for the years ended December 31, 1993, 1992, and 1991 respectively. Accordingly, yields on loans would have increased by 0.28%, 0.19%, and 0.29%, respectively. Included in Other Real Estate Owned at December 31, 1993 is a loan totaling $977,000 which, although performing according to its original terms, is accounted for as real estate held for sale as required under SFAS 66. As principal and interest payments on this loan were current at December 31, 1993, for analysis purposes, the average balance of the loan was included in total loans, and the yield on loans was adjusted accordingly. Loan fees and the direct costs associated with the origination of loans are deferred and netted against the outstanding loan balance. The deferred net loan fees and costs are recognized as interest income net of cost over the term of the loan in a manner that approximates the level-yield method. (See Note 1 of the Financial Statements). Fees collected on loans are an integral part of the loan pricing decision. For the year ended December 31, 1993, the Company recognized $2.7 million in loan origination fees, representing an increase of $373,000, or 16.1%, from fee income of $2.3 million recognized in 1992. Fee income recognized for 1991 totaled $2.4 million. Table 3 summarizes loan fee activity for the Bank for the three year period. During periods of changing interest rates, the ability to reprice interest earning assets and interest bearing liabilities can influence net interest income, the net interest margin, and consequently, the Company's earnings. The Bank's Management actively monitors interest rate "sensitivity" to potential changes in interest rates using a maturity/repricing gap analysis. This analysis measures, for specific time intervals, the differences between interest earning assets and interest bearing liabilities for which re-pricing opportunities will occur. A positive difference, or gap, indicates that interest earning assets will reprice faster than interest bearing liabilities. This will generally produce a greater net interest margin during periods of rising interest rates, and a lower net interest margin during periods of decreasing interest rates. Conversely, a negative gap will generally produce lower net interest margin during periods of rising interest rates and a greater net interest margin during periods of decreasing interest rates. Table 4 provides the Bank's maturity/repricing gap analysis at December 31, 1993 and 1992. The Bank had a positive one year cumulative gap of $22.1 million at December 31, 1993, compared to a negative one year cumulative gap of $33.5 million at December 31, 1992. The change from a negative gap position to a positive gap position is primarily the result of an increase in loans that reprice within one year. The interest rates paid on deposit accounts do not always move in unison with the rates charged on loans. Specifically, changes in the prime lending rate do not always result in an immediate change in the rate paid on money market and savings accounts. In addition, the magnitude of changes in the rate charged for loans is not necessarily proportionate to the magnitude of changes in the rate paid for deposits. Consequently, changes in interest rates do not necessarily result in increases or decreases in the net interest margin solely as a result of the differences between re-pricing opportunities of interest earning assets or interest bearing liabilities. The fact that the Bank reported a nominal positive gap at December 31, 1993 does not necessarily indicate that the Bank's net interest margin will increase if rates increase in 1994, or decrease if interest rates decrease. The analysis does provide a measure for the Bank's Management to determine the relative level of interest rate risk at any point in time. SUMMARY OF CREDIT LOSS EXPOSURE Implicit in lending activities is the risk that losses will be experienced and the amount of such losses will vary over time. Consequently, the Company maintains an allowance for credit losses by charging to earnings a provision for potential credit losses. Loans determined to be a loss are charged to the allowance. The Company's allowance for credit losses is maintained at a level considered by the Bank's Management to be adequate to provide for estimated losses inherent in the existing portfolio, including commitments under commercial and standby letters of credit. In evaluating the adequacy of the allowance for credit losses, the Bank's Management estimates the amount of potential loss for each loan that has been identified as having greater than standard credit risk, including loans identified as nonperforming. Loss estimates also consider the borrowers' financial data and the current valuation of collateral when appropriate. In addition to the allowance for specific potential problem credits, an allowance is further allocated for all loans in the portfolio based on the risk characteristics of particular categories of loans including historical loss experience in the portfolio. Additional allowance is allocated on the basis of credit risk concentrations in the portfolio and contingent obligations under off-balance sheet commercial and standby letters of credit. At December 31, 1993, the allowance for credit losses was $8.8 million, representing an increase of $2.4 million or 36.96%, over the allowance for credit losses of $6.5 million at December 31, 1992. As a percent of gross loans, the allowance for credit losses increased from 1.70% at December 31, 1992, to 1.96% at December 31, 1993. The increase in the allowance for credit losses at December 31, 1993 resulted as the provision for credit losses of $1.7 million, plus acquired reserves of $1.6 million, exceeded the net amount of loans charged to the reserve of $919,000 for the year. Acquired reserves represent the allowance for credit losses acquired from Fontana First National Bank, and the discount from face value of specific loans purchased from the FDIC relating to the Mid City Bank acquisition. Net loans charged to the allowance for credit losses totaled $433,000, $574,000, and $919,000 for the years ended December 31, 1991, 1992, and 1993, respectively. The increase in the amount charged to reserves each year reflects the increases in loans outstanding and the continued economic downturn in the Southern California economy. The provision for credit losses totaled $604,000, $1,772,000, and $3,307,000, for the years ended December 31, 1991, 1992 and 1993. The increased provision primarily reflects the increase in loans charged to the allowance for credit losses for each period. Net loans charged to the reserve, as a percent of average loans totaled 0.12%, 0.16%, and 0.22% for the years ended December 31, 1991, 1992, and 1993. The increase in the allowance for credit losses reflects the prolonged regional economic downturn and the Bank's recognition of the possibility that the downturn may continue and the uncertain impact it may have on the Company's loan portfolio. The increase in the allowance for credit losses has been made to support the growth in the loan portfolio and to provide an additional measure of protection in a recessionary economic environment. The Bank recognizes that the current recessionary conditions may continue, and the potential impact this may have on the loan portfolio is uncertain. Nonperforming loans increased from $10.2 million, or 2.68% of gross loans, at December 31, 1992, to $12.5 million, or 2.77% of gross loans, at December 31, 1993. While the Bank's Management believes that the allowance was adequate to provide for both recognized potential losses and estimated inherent losses in the portfolio, no assurance can be given that economic conditions that may adversely affect the Company's service area or other circumstances will not result in increased provisions for credit losses in the future. Table 5 provides the comparative statistics on net credit losses, the provisions for credit losses, and the allowance for credit losses. Loan losses are fully, or partially charged against the allowance for credit losses when, in the Bank's Management's judgment, the full collectability of the loan's principal is in doubt. However, there is not a precise method of predicting specific losses which ultimately may be charged against the allowance for credit losses, and as such, Management is unable to reasonably estimate the full amount of loans to be charged to the reserve in future periods. Table 6 provides a summary of the allocation of the allowance for credit losses for specific loan categories for the five year period ended December 31, 1993. The allocations presented should not be interpreted as an indication that loans charged to the allowance for credit losses will occur in these amounts or proportions, or that the portion of the allowance allocated to each loan category represents the total amount available for future losses that may occur within such categories, since there is a large unallocated portion of the allowance for credit losses and the total allowance is applicable to the entire loan portfolio. OTHER OPERATING INCOME Other operating income for the Company includes service charges on deposit accounts, gain on sale of securities, gross revenue from CTD, and other revenues not derived from interest on earning assets. Other operating income increased from $7.9 million for the year ended December 31, 1992, to $10.7 million for the year ended December 31, 1993. This represented an increase of $2.8 million, or 36.05%. For 1992, other operating income increased $858,899, or 12.2%, from $7.0 million for the year ended December 31, 1991. The increase in other operating income for 1993 was the result of gains on securities sold. Gains on sales of securities totaled $3.7 million for the year ended December 31, 1993, compared to gains of $261,531 for 1992, and $716,608 for 1991. The gains in 1993 were a result of restructuring the portfolio in anticipation of adopting SFAS 115. (See discussion of Investment Securities for explanation of SFAS 115). Service charges on deposit accounts increased from $5.0 million to $5.2 million for the years ended December 31, 1992 and 1993, respectively. Service charges totaled $4.5 million for the year ended December 31, 1991. Other operating income for 1991 and 1992 included gross revenue from a subsidiary called Premier Results (Premier). Premier began operation in 1990 and provided item processing services for other financial institutions. Premier had total revenues of $870,000 in 1992, and $638,000 for 1991. In December of 1992, Premier was sold to Electronic Data Systems, Inc. as it was determined that the nature of the business was not compatible with the Company's long term strategic plans. Net earnings from Premier for 1992 totaled $125,000. Consequently, the divestiture did not have a significant impact on 1993's earnings. Other income also includes total revenue from CTD, a subsidiary of the Company. Total revenue from CTD was approximately $238,000, $337,000, and $271,000 for the years ended December 31, 1991, 1992, and 1993, respectively. NONINTEREST EXPENSES Noninterest expenses totaled $29.4 million for the year ended December 31, 1993. This represented an increase of $5.9 million, or 25.34%, from total noninterest expenses of $23.4 million for the year ended December 31, 1992. Total noninterest expenses for the year ended December 31, 1991 were $22.7 million. As a percent of average assets, total noninterest expenses decreased from 4.39% for 1991, to 4.20% for 1992, then increased to 4.68% for 1993. This increase was entirely related to expenses associated with collection and foreclosure costs on troubled credits. A $2.8 million provision for potential losses on the sale of other real estate owned contributed substantially to the increase in noninterest expense for 1993. Other real estate owned is property acquired by the Bank through foreclosure (See Loans). Primarily as a result of the current economic climate in Southern California, real estate values have decreased significantly over the last two years. In anticipation of a continuation of this trend in both commercial and residential real estate values, the Bank's Management has provided an allowance for potential losses on specific properties currently held by the Bank. The allowance primarily protects against further decreases in real estate values. Without the provision for potential losses on other real estate owned for 1993, and the cost of carrying that real estate, total noninterest expense, as a percent of average assets, would have decreased for 1993 compared to 1992. Salaries and related expenses totaled $14.4 million for the year ended December 31, 1993. This represented an increase of $962,073, or 7.14%, over total salaries and related expenses of $13.5 million for the year ended December 31, 1992. Total salaries and related expenses were $13.7 million for the year ended December 31, 1991. As a percent of average assets, total salaries and related expenses have decreased from 2.64%, to 2.42%, to 2.30%, for the years ended December 31, 1991, 1992, and 1993, respectively. Full time equivalent employees decreased from 296 for 1991, to 243 for 1992, then increased to 302 for 1993. This increase in salaries for 1993 was primarily related to the acquisitions of Fontana First National Bank and Mid City Bank. As both acquisitions resulted in increased assets, the additional salaries did not impact salary expense as a percent of average assets. INCOME TAXES The Company's effective tax rate for 1993 was 39.2%, compared to a rate of 38.8% for 1992, and a rate of 39.5% for 1991. These rates are below the nominal combined Federal and State tax rates as a result of tax preferenced income for each period. The increase in the effective tax rate for 1993 reflects the retroactive Federal tax increase for revenues in excess of $10.0 million, and the increase in the State tax rate for 1993. ANALYSIS OF FINANCIAL CONDITION Total assets increased from $592.1 million at December 31, 1992, to $687.4 million at December 31, 1993. This represented an increase of $95.3 million, or 16.10%. Net loans increased $67.4 million, or 18.00%, from $374.7 million for the year ended December 31, 1992, to $442.1 million for the year ended December 31, 1993. As in previous years, asset growth was primarily funded by increased deposit growth. Total deposits increased from $526.9 million at December 31, 1992, to $596.0 million at December 31, 1993, an increase of $69.0 million, or 13.10%. The acquisitions of Fontana First National Bank and Mid City Bank accounted for approximately $43.0 million, or 45.0% of the $95.3 million increase in the Company's assets for 1993. INVESTMENT SECURITIES The Company maintains a portfolio of investment securities to provide income and serve as a source of liquidity for its ongoing operations. Note 2 of the financial statements sets forth the distribution of the investment portfolio at December 31, 1993 and 1992. In 1993, the Financial Accounting Standards Board introduced new mark to market accounting rules for investment securities (SFAS 115). Under the new accounting method, when adopted, securities held as "available for sale" will be reported at current market value for financial reporting purposes. Increases or decreases in market value when compared to cost will be adjusted directly to the Company's capital accounts. While the Company has demonstrated the ability and the intent to hold investment securities until maturity, changes in liquidity needs as well as changes in interest rates have resulted in the sale of investment securities in the past. The introduction of SFAS 115 has changed the methodology used in determining the type of securities purchased for the portfolio and the timing of sales of securities within the portfolio. The Bank's Management now reviews the portfolio from a total return perspective. Current yields, in addition to current and projected changes in market values, are now considered for both purchases and sales of investment securities. Primarily as a result of the adoption of this methodology in 1993, significant changes were made to both the structure and maturities of the investment portfolio. This restructure resulted in significant gains from the sales of securities in 1993. (See Other Operating Income) The Bank's Management has elected to adopt SFAS 115 effective for 1994. At December 31, 1993, the market value of the investment portfolio was approximately $150.9 million, representing an unrealized gain of approximately $1.4 million over "book value" of $149.5 million. Had SFAS 115 been adopted, stockholders' equity would have been increased by the amount of the unrealized gain at December 31, 1993, net of the tax effect. The variance between market value and the cost value reported at December 31, 1993, is not material in relation to the Company's total capital. In preparing for the implementation of SFAS 115 in 1994, the Bank's investment portfolio is divided into two primary categories. These included the "held for sale" portfolio and the "held to maturity" portfolio. At December 31, 1993, the held for sale portion of the portfolio comprised approximately 93.9% of the investment portfolio. The balance was allocated to securities to be held to maturity. If securities are sold prior to maturity to provide for liquidity needs or to take advantage of changes in interest rates, securities from the held for sale portion of the portfolio will be sold. LOANS Table 7 sets forth the distribution of the Company's loan portfolio for each of the last five years. Net loans increased $67.4 million, or 18.00%, from $374.7 million at December 31, 1992, to $442.1 million at December 31, 1993. Approximately $32.9 million, or 48.8% of the $67.4 million increase in net loans for 1993 resulted from the acquisitions of Fontana First National Bank and Mid City Bank. Net of acquired loans, loans increased approximately $34.5 million, or 9.2%, for 1993. The increase in loans, net of acquired loans, represents a significant increase over the increase for 1992 when net loans increased only $9.1 million, or 2.49%. The relatively slow real growth in loans (net of loans acquired) for both 1992 and 1993, reflects the prolonged economic downturn in the Southern California economy, and the resulting decrease in loan demand. Approximately $192.1 million, or 42.5% of the loan portfolio matures within one year. Of this total, approximately $169.3 million, or 88.1%, have variable rates that are tied to the Bank's prime lending rate. Loans that mature within one year assist with the liquidity needs of the Bank as well as providing greater repricing opportunities. Variable rate loans tied to the Bank's prime lending rate provide immediate re-pricing opportunities when interest rates change. Table 8 provides the maturity distribution for commercial and industrial loans as well as real estate construction loans as of December 31, 1993. Amounts are also classified according to repricing opportunities or rate sensitivity. As a normal practice in extending credit for commercial and industrial purposes, the Bank may accept trust deeds on real property as collateral. In some cases, when the primary source of repayment for the loan is anticipated to come from cash flow from normal operations of the borrower, the requirement of real property as collateral is an abundance of caution. In these cases, the real property is considered a secondary source of repayment for the loan. Since the Bank lends primarily in Southern California, its real estate loan collateral is concentrated in this region. At December 31, 1993, approximately 97.0% of the Bank's loans secured by real estate were collateralized by properties located in Southern California. This concentration is considered when determining the adequacy of the Company's allowance for credit losses. In January of 1994, the greater Los Angeles area was affected by a major earthquake and a series of aftershocks that were centered in the San Fernando Valley. The Company is not located in the San Fernando Valley nor is the San Fernando Valley part of the Company's service area. It is not yet possible to assess the effect of the earthquake on the Company's borrowers' primary or secondary repayment sources, or its overall effect on the local economy in general. The Company's facilities and other real estate owned suffered no damage, and management is not aware of any effects from the earthquake that would materially impact its financial condition. At December 31, 1993, nonperforming assets totaled $22.1 million. This represented an increase of $4.1 million, or 21.6%, from total nonperforming assets of $19.0 million at December 31, 1992. Nonperforming assets include loans for which interest is no longer accruing, loans 90 or more days past due, restructured loans, other real estate owned, and in substance foreclosures. Although the Bank's Management believes that nonperforming loans are generally well secured and that potential losses are provided for in the Company's allowance for credit losses, there can be no assurance that continued deterioration in economic conditions or collateral values will not result in future credit losses. Table 9 provides information on nonperforming loans and other real estate owned for the periods indicated. At December 31, 1993, loans for which interest was no longer accruing totaled $12.5 million. All loans on a nonaccrual status were secured by real property which has a current appraisal that is less than one year old. The estimated ratio of the outstanding loan balances to the fair values of the related collateral for nonaccrual loans at December 31, 1993, ranged between approximately 21% to 92% of the loan value. The Bank has allocated specific reserves included in the allowance for credit losses for potential losses on these loans. Except for nonperforming loans as set forth in Table 9, the Bank's Management is not aware of any loans as of December 31, 1993 for which known credit problems of the borrower would cause the Company to have serious doubts as to the ability of such borrowers to comply with their present loan repayment terms or any known events that would result in the loan being designated as nonperforming at some future date. The Bank's Management cannot, however, predict the extent to which the current economic environment may persist or worsen or the full impact this environment may have on the Company's loan portfolio. At December 31, 1993, the book value of other real estate owned totaled $9.8 million. This included 9 separate parcels of property acquired through foreclosure, and one loan secured by real estate that is performing but is classified as real estate held for sale. The Bank is actively marketing these properties. The Bank's Management cannot predict when these properties will be sold or the terms of those sales when they occur. While Management recognizes that the Southern California real estate market continues to remain weak, the Bank has recent appraisals on each property that support the carrying costs of those properties at December 31, 1993. No assurance can be given that if Southern California real estate values continue to decrease, and the Bank cannot dispose of the properties held promptly, further charges to earnings may not occur. DEPOSITS Total deposits increased $69.0 million, or 13.10%, from $526.9 million at December 31, 1992, to $596.0 million at December 31, 1993. The acquisitions of Fontana First National Bank and Mid City Bank accounted for approximately $43.0 million, or 62.0%, of the $69.0 million increase in the Company's deposits for 1993. Non-interest bearing demand deposits represented the largest growth, increasing $64.1 million, or 40.73%, from $157.4 million at December 31, 1992, to $221.6 million at December 31, 1993. As a result of the increase, average non-interest bearing demand deposits represented 32.0% of average deposits for the year ended December 31, 1993. This compared with 27.96% of average deposits for 1992. Table 1 provides the average balances for each general deposit category, including the associated costs for the years ended December 31, 1991, 1992, and 1993. As average non-interest bearing demand deposits have increased as a percent of total average deposits for 1992 and 1993, average savings and time deposits have decreased as a percent of total average deposits. Average savings deposits, as a percent of average total deposits, have decreased from 58.30% in 1991, to 55.56% for 1992, to 51.44% for 1993. Average time deposits, as a percent of average total deposits, have decreased from 17.00% in 1991, to 16.48% in 1992, to 16.57%, for 1993. The change in the deposit mix has resulted in a lower cost of average total deposits in 1992 and 1993. Despite the changes in the deposit mix, the majority of funds provided from customer deposits are derived from savings deposits. Savings deposits include money market accounts as well as traditional savings accounts. Table 10 provides the remaining maturities of large denomination ($100,000 or more) time deposits, including public funds as of December 31, 1993. TABLE 10 - Maturity Distribution of Large Denomination Time Deposits (amounts in thousands) December 31, 1993 3 months or less $27,242 Over 3 months through 6 months 7,732 Over 6 months through 12 months 6,716 Over 12 months 4,172 Total $45,862 LIQUIDITY Liquidity is actively managed to ensure sufficient funds are available to meet the ongoing needs of both the Bank and CVB. This includes projections of future sources and uses of funds, in addition to the maintenance of sufficient liquid reserves to provide for unanticipated events. For the Bank, sources of funds normally include interest and principal payments on loans and investments, proceeds from maturing or sold investments, and growth in deposits. Uses of funds include withdrawal of deposits, interest paid on deposits, advances or funding of new loans, purchases and operating expenses. The Bank maintains funds as overnight federal funds sold and other short term investment securities to provide for short term liquidity needs. In addition, the Bank maintains short term unsecured lines of credit of $50.0 million with correspondent banks to provide for contingent liquidity needs. At December 31, 1993, the Bank reported liquid assets, including cash, federal funds sold, and unpledged investment securities of $156.0 million. Liquid assets represented 22.7% of total assets at December 31, 1993. Since the primary sources and uses of funds for the Bank are loans and deposits, the relationship between gross loans and total deposits provides a useful measure of the Bank's liquidity. Typically, the closer the ratio of loans to deposits is to 100%, the more reliant the Bank is on its loan portfolio to provide for short term liquidity needs. Since repayment of loans tends to be less predictable than investments and other liquid resources, the higher the loan to deposit ratio the less liquid the Bank. For the year ended December 31, 1993, the Bank's loan to deposit ratio averaged 74.7%, compared to an average ratio of 73.9% for 1992. The liquidity ratio provides another measure of the Bank's liquidity. This ratio is calculated by dividing the difference between short term liquid assets from short term volatile liabilities by the sum of loans and long term investments. This ratio measures the percent of illiquid long term assets that are being funded by short term volatile liabilities. As of December 31, 1993, this ratio was 2.72%, compared to a negative 1.7%, at December 31, 1992. CVB is a company separate and apart from the Bank that must provide for its own liquidity. Substantially all of CVB's revenues are obtained from dividends declared and paid by the Bank. There are statutory and regulatory provisions that could limit the ability of the Bank to pay dividends to CVB. At December 31, 1993, approximately $20.0 million of the Bank's equity was unrestricted and available to be paid as dividends to CVB. Management of CVB believes that such restrictions will not have a significant impact on the ability of CVB to meet its ongoing cash obligations. As of December 31, 1993, neither the Bank nor CVB had any material commitments for capital expenditures. On November 16, 1993, the Company entered into a definitive agreement and plan of reorganization (the Agreement) for the Company to acquire, through merger, Western Industrial National Bank (WIN). Chino Valley Bank will be the continuing operation. The Company will provide to the shareholders of WIN $13.5 million, plus accrued earnings from December 31, 1993. WIN currently has two branch offices located in South El Monte. WIN reported total assets of $45.3 million, total deposits of $36.3 million, and gross loans of $37.5 million at December 31, 1993. It is not anticipated that the acquisition will have a significant effect on the Company's liquidity or its capital ratios. CAPITAL RESOURCES Historically, the primary source of capital for the Company has been the retention of operating earnings. The Company conducts an ongoing assessment of projected sources and uses of capital in conjunction with projected increases and anticipated mixes of assets in order to maintain adequate levels of capital. Total adjusted capital, shareholder equity plus allowance for credit losses, was $68.8 million at December 31, 1993, representing an increase of $10.3 million, or 17.6%, over total adjusted capital of $58.5 million at December 31, 1992. Bank regulators have established minimum capital adequacy guidelines requiring that qualifying capital be at least 8.0% of risk-based assets, of which at least 4.0% must be Tier 1 capital (primarily stockholders' equity). These ratios represent minimum capital standards. Under Prompt Corrective Action rules, certain levels of capital adequacy have been established for financial institutions. Depending on an institution's capital ratios, the established levels can result in restrictions or limits on permissible activities. The highest level for capital adequacy under Prompt Corrective Action is "Well Capitalized". To qualify for this level of capital adequacy an institution must maintain a total risk-based capital ratio of at least 10.0%, a Tier 1 risk-based capital ratio of at least 6.0%, and a leverage ratio of at least 5.0%. At December 31, 1993, the Company exceeded all of the minimum capital ratios required to be considered well capitalized. At December 31, 1993, the Company's total risk-based capital ratio was 13.1% compared to 13.7% on December 31, 1992. The ratio of Tier I capital to risk weighted assets was 11.8% at December 31, 1993, compared to a ratio of 13.3% for December 31, 1992. The decrease in the risk-based capital ratios during 1993 reflects increases in risk weighted assets greater than increases in both Tier I and total adjusted capital. The Company's risk- based capital ratio was also affected by $2.0 million in goodwill that resulted from the acquisition of Fontana First National Bank. In addition to the aforementioned requirement, the Company and Bank must also meet minimum leverage ratio standards. The leverage ratio is calculated as Tier 1 capital divided by the most recent quarterly period's average total assets. As of December 31, 1993, the Company's leverage ratio was 8.4%, down from a ratio of 9.2% at December 31, 1992. The Bank's leverage ratio was 8.3% at the 1993 year end, down from 8.9% at December 31, 1992. Banking regulators have established 3.0% as the minimum leverage ratio. However, institutions experiencing or anticipating significant growth or those with other than minimum risk profiles are expected to maintain a leverage ratio in excess of the minimum. During 1992, the Board of Directors of the Company declared quarterly cash dividends that totaled 32 cents per share for the full year (29 cents per share after retroactive adjustment for the ten percent stock dividend declared on December 15, 1993). After retroactive adjustment, cash dividends declared during 1993 was equal to dividends paid for 1992. Management does not believe that the continued payment of cash dividends will impact the ability of the Company to exceed the current minimum capital standards. ITEM 8.	ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA CVB Financial Corp. Index to consolidated Financial Statements and Financial Statement Schedules Consolidated Financial Statements Page Consolidated Balance Sheets -- 51 December 31, 1993 and 1992 Consolidated Statements of Earnings Year Ended December 31, 1993, 1992 and 1991 52 Consolidated Statements of Stockholders' Equity Year Ended December 31, 1993, 1992 and 1991 53 Consolidated Statements of Cash Flows for the Year Ended December 31, 1993, 1992 and 1991 54 Notes to Consolidated Financial Statements 57 Independent Auditors' Report 79 All schedules are omitted because they are not applicable, not material or because the information is included in the financial statements or the notes thereto. CONSOLIDATED BALANCE SHEETS - DECEMBER 31, 1993 AND 1992 CONSOLIDATED STATEMENTS OF EARNINGS THREE YEARS ENDED DECEMBER 31, 1993 See accompanying notes to the consolidated financial statements. CONSOLIDATED STATEMENTS OF CASH FLOWS - CONTINUED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS THREE-YEAR PERIOD ENDED DECEMBER 31, 1993 1.SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The accounting and reporting policies of CVB Financial Corp. and subsidiaries are in accordance with generally accepted accounting principles and conform to practices within the banking industry. A summary of the significant accounting policies consistently applied in the preparation of the accompanying consolidated financial statements follows: Principles of Consolidation - The consolidated financial statements include the accounts of CVB Financial Corp. (the "Company") and its wholly owned subsidiaries, Chino Valley Bank (the "Bank"), Community Trust Deed Services and Premier Results, Inc., after elimination of all material intercompany transactions and balances. Investment Securities Held for Sale - The Bank has identified those investment securities which may be sold prior to maturity. These assets have been classified as held for sale on the accompanying consolidated balance sheet and are recorded at the lower of amortized cost or market value on an aggregate basis by type of asset. Investment Securities Held for Investment - Investment securities, excluding those held for sale, are carried at amortized cost, adjusted for amortization of premiums and accretion of discounts over the estimated terms of the assets using the interest method. Such amortization and accretion are included in interest income. Sales of certain of these assets could occur if unforeseen circumstances arise, and any gain or loss on sale would be calculated based on the specific identification method. The carrying value of these assets is not adjusted for temporary declines in market value because the Bank intends and has the ability to hold them to maturity. Equity securities are accounted for at the lower of aggregate cost or market. Loans and Lease Finance Receivables - Loans and lease finance receivables are reported at the principal amount outstanding, less deferred net loan origination fees and the allowance for credit losses. Interest on loans and lease finance receivables is credited to income based on the principal amount outstanding. Interest income is not recognized on loans and lease finance receivables when collection of interest is deemed by management to be doubtful. The Bank receives collateral to support loans, lease finance receivables and commitments to extend credit for which collateral is deemed necessary. The most significant category of collateral is real estate, principally commercial and industrial income-producing properties. Nonrefundable fees and direct costs associated with the origination or purchase of loans are deferred and netted against outstanding loan balances. The deferred net loan fees and costs are recognized in interest income over the loan term in a manner that approximates the level-yield method. Provision and Allowance for Credit Losses - The determination of the balance in the allowance for credit losses is based on an analysis of the loan and lease finance receivables portfolio and reflects an amount that, in management's judgment, is adequate to provide for potential credit losses after giving consideration to the character of the loan portfolio, current economic conditions, past credit loss experience and such other factors as deserve current recognition in estimating credit losses. The provision for credit losses is charged to expense. Premises and Equipment - Premises and equipment are stated at cost less accumulated depreciation, which is computed principally on the straight-line method over the estimated useful lives of the assets. Property under capital lease and leasehold improvements are amortized over the shorter of their economic lives or the initial term of the lease. Other Real Estate Owned - Other real estate owned, shown net of an allowance for losses of $1,650,903 and $100,000 at December 31, 1993 and 1992, respectively, represents real estate acquired through foreclosure in satisfaction of commercial and real estate loans and is stated at the lower of the fair value minus estimated costs to sell or cost (fair value at time of foreclosure). Loan balances in excess of fair value of the real estate acquired at the date of acquisition are charged against the allowance for credit losses. Any subsequent operating expenses or income, reduction in estimated values, and gains or losses on disposition of such properties are charged to current operations. Goodwill - Goodwill of $2.1 million, net of amortization of $116,000 resulting from the acquisition of Fontana First National Bank during March 1993, and the excess purchase premium of $50,000 paid on assuming the deposits of Mid City Bank, N.A. in October 1993, are included in other assets. Goodwill is amortized on a straight-line basis over 15 years. Income Taxes - In the fourth quarter of 1992, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes." Under SFAS No. 109, deferred income taxes are recognized for the tax consequences in future years of differences between the tax basis of assets and liabilities and their financial reporting amounts at each year-end based on enacted tax laws and statutory tax rates applicable to the periods in which the differences are expected to affect taxable income. Prior years' financial statements have not been restated for the accounting change. Earnings per Common Share - Earnings per common share are computed on the basis of the weighted average number of common shares outstanding during the year plus shares issuable upon the assumed exercise of outstanding common stock options (common stock equivalents). The weighted average number of common shares outstanding and common stock equivalents was 7,511,884 (1993), 7,357,187 (1992) and 7,220,967 (1991). Earnings per common share and stock option amounts have been retroactively restated to give effect to all stock splits and dividends. Statement of Cash Flows- Cash and cash equivalents as reported in the statement of cash flows include cash and due from banks and federal funds sold. Recent Accounting Pronouncements - In May 1993, the Financial Accounting Standards Board ("FASB") issued SFAS No. 114, "Accounting by Creditors for Impairment of a Loan." This statement prescribes that a loan is impaired when it is probable that a creditor will be unable to collect all amounts due (principal and interest) according to the contractual terms of the loan agreement. Measurement of the impairment can be based on the expected future cash flows of an impaired loan, which are to be discounted at the loan's effective interest rate, or impairment can be measured by reference to an observable market price, if one exists, or the fair value of the collateral. Collateral-dependent loans for which foreclosure is probable must be measured at the fair value of the collateral. Additionally, the statement prescribes measuring impairment of a restructured loan by discounting the total expected future cash flows at the loan's effective rate of interest in the original loan agreement. Finally, the impact of initially applying the statement is reported as a part of the provision for credit losses. The Company must adopt this standard by 1995. The Company has not yet determined the impact of the adoption of this statement or when the Company will adopt this statement. In May 1993, the FASB also issued SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." This statement addresses the accounting and reporting for investments in equity securities that have readily determinable fair values, and all investments in debt securities. Under this statement, securities will be classified into three categories as follows: Held-to-Maturity Securities - Debt securities that the Company has the positive intent and ability to hold to maturity. These securities are to be reported at amortized cost. Trading Securities - Debt and equity securities that are bought and held principally for the purpose of selling them in the near term. These securities are to be reported at fair value with unrealized gains and losses included in earnings. Available-for-Sale Securities - Debt and equity securities not classified as either held-to-maturity or trading securities. These securities are to be reported at fair value, with unrealized gains and losses excluded from earnings and reported as a separate component of stockholders' equity (net of tax effects). The Company has elected to adopt SFAS No. 115 as of January 1, 1994. If the Company had adopted SFAS No. 115 as of December 31, 1993, stockholders' equity would have been increased by approximately $620,000, net of $394,000 of applicable income taxes. Reclassifications - Certain reclassifications were made to prior years' presentations to conform them to the current-year presentation. These reclassifications are of a normal recurring nature. 2.INVESTMENT SECURITIES The amortized cost and estimated market value of investment securities held for investment and investment securities held for sale are shown below. All securities held are publicly traded, and estimated market value was obtained from an independent pricing service. The CMO/REMIC securities noted above represent collateralized mortgage obligations and real estate mortgage investment conduits. All are issues of U.S. government agencies that guarantee payment of principal and interest of the underlying mortgages. All CMO/REMIC securities in the Bank's investment portfolio have met or surpassed the Federal Financial Institutions Examination Council's three-part test. At December 31, 1993 and 1992, investment securities having an amortized cost of approximately $38,780,000 and $42,553,000, respectively, were pledged to secure public deposits and for other purposes as required or permitted by law. The amortized cost and market value of debt securities at December 31, 1993, by contractual maturity, are shown below. Although mortgage-backed securities/CMO/REMIC have contractual maturities through 2019, expected maturities will differ from contractual maturities because borrowers may have the right to prepay such obligations without penalty. 3.LOANS AND LEASE FINANCE RECEIVABLES The Bank grants loans to its customers throughout its primary market in the San Gabriel Valley and Inland Empire areas of Southern California, which has recently experienced adverse economic conditions, including declining real estate values. These factors have adversely affected certain borrowers' ability to repay loans. Although management believes the level of allowances for loan losses is adequate to absorb losses inherent in the loan portfolio, additional declines in the local economy may result in increasing loan losses that cannot be reasonably predicted at December 31, 1993. The Bank makes loans to borrowers in a number of different industries. No industry had aggregate loan balances exceeding 10% of the December 31, 1993 or 1992 loan and lease finance receivables balance. At December 31, 1993 the Bank's loan portfolio included approximately $322.9 million of loans secured by commercial and residential real estate properties. The following is a summary of the components of loan and lease finance receivables: The following is a summary of nonperforming loans at December 31, 1993 and 1992: Interest foregone on nonperforming loans outstanding during the years ended December 31, 1993, 1992 and 1991 amounted to approximately $1,186,000, $698,600, and $1,037,200, respectively. 4.TRANSACTIONS INVOLVING DIRECTORS AND SHAREHOLDERS In the ordinary course of business, the Bank has granted loans to certain directors, executive officers and the businesses with which they are associated. All such loans and commitments to lend were made under terms that are consistent with the Bank's normal lending policies. The following is an analysis of the activity of all such loans: 5.ALLOWANCE FOR CREDIT AND OTHER REAL ESTATE OWNED LOSSES Activity in the allowance for credit losses was as follows: Activity in the allowance for other real estate owned losses was as follows: The Company incurred expenses of $1,004,015 (1993), $205,768 (1992) and $103,651 (1991) related to the holding and disposition of other real estate owned. 6.PREMISES AND EQUIPMENT Premises and equipment consist of: 7.INCOME TAXES In 1992, the Company adopted SFAS No. 109, "Accounting for Income Taxes." Under the provisions of SFAS No. 109, the Company elected not to restate prior year financial statements, and has determined that the cumulative effect of implementation was immaterial. Income tax expense (benefit) comprised the following: Income tax liability (asset) comprised the following: The components of the net deferred tax asset are as follows: No valuation allowance under SFAS No. 109 was required. Deferred tax assets would be fully realized as an offset against reversing temporary differences, which create net future tax liabilities, or through loss carrybacks. Therefore, even if no future income was expected, deferred tax assets would still be fully realized. A reconciliation of the statutory income tax rate to the consolidated effective income tax rate follows: 8.DEPOSITS Time certificates of deposit with balances of $100,000 or more amounted to approximately $45,862,000 and $43,887,000 at December 31, 1993 and 1992, respectively. Interest expense on such deposits amounted to approximately $1,804,000 (1993), $2,044,000 (1992) and $2,856,000 (1991). 9.COMMITMENTS AND CONTINGENCIES The Bank leases land and buildings under operating leases for varying periods extending to 2014, at which time the Bank can exercise options that could extend the leases to 2027. The future minimum annual rental payments required, which have initial or remaining noncancelable lease terms in excess of one year as of December 31, 1993, excluding property taxes and insurance, are approximately as follows: 1994 $ 1,548,000 1995 1,498,000 1996 1,458,000 1997 1,444,000 1998 1,461,000 Succeeding years 6,475,000 Total minimum payments required $13,884,000 Total rental expense was approximately $1,449,000 (1993), $1,460,000 (1992) and $1,223,000 (1991). At December 31, 1993, the Bank had commitments to extend credit of approximately $61,543,000 and obligations under letters of credit of $7,182,000. Commitments to extend credit are agreements to lend to customers provided there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Commitments are generally variable rate, and many of these commitments are expected to expire without being drawn upon. As such, the total commitment amounts do not necessarily represent future cash requirements. The Company uses the same credit underwriting policies in granting or accepting such commitments or contingent obligations as it does for on-balance-sheet instruments, evaluating customers' creditworthiness individually. Standby letters of credit written are conditional commitments issued by the Company to guarantee the financial performance of a customer to a third party. Those guarantees are primarily issued to support private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. When deemed necessary, the Company holds appropriate collateral supporting those commitments. Management does not anticipate any material losses as a result of these transactions. In the ordinary course of business, the Company becomes involved in litigation. In the opinion of management and based upon discussions with legal counsel, the disposition of such litigation will not have a material effect on the Company's consolidated financial position. During 1993 the Company executed a definitive agreement that provides for its acquisition of Western Industrial National Bank ("WIN") through a merger of WIN and the Bank. At December 31, 1993, WIN had deposits, loans and shareholders' equity of $36.3 million, $36.6 million and $8.4 million, respectively. Management currently expects the acquisition to be consummated during the second quarter of 1994. 10.EMPLOYEE PROFIT SHARING PLAN The Bank sponsors a noncontributory profit-sharing plan for the benefit of its employees. Employees are eligible to participate in the plan after 12 months of consecutive service provided they have completed 1,000 service hours in the plan year. Contributions to the plan are determined by the Board of Directors. Contributions are limited to 15% of the compensation of eligible participants. The Bank contributed approximately $680,000 (1993), $639,000 (1992) and $760,000 (1991). 11.STOCK OPTION PLANS The Company has a plan under which options to purchase shares of the Company's common stock have been and may be granted to certain officers and directors. The plan authorizes the issuance of up to 1,028,500 shares. Option prices under the plan are to be at the fair market value of such shares on the date of grant, and options are exercisable in such installments as determined by the Board of Directors. Each option shall expire no later than ten years from the grant date. Additional options have been granted to certain officers and directors under a plan that expired during 1991. Although no more options can be granted under the expired plan, the options granted thereunder will remain outstanding until they are exercised or canceled pursuant to their terms. At December 31, 1993, options for the purchase of 482,555 shares of the Company's common stock were outstanding, of which options to purchase 119,143 shares were exercisable at prices ranging from $2.66 to $14.50; 573,271 shares of common stock were available for the granting of future options. Status of all optioned shares is as follows: Shares Price Range Outstanding at January 1, 1991 641,570 $ 2.66 - $16.14 Granted 348,810 $ 11.71 - $12.62 Exercised (88,312) $ 2.66 - $ 3.97 Canceled (285,718) $ 3.99 - $16.14 Outstanding at December 31, 1991 616,350 $ 2.66 - $12.62 Granted 348,398 $ 7.50 - $10.45 Exercised (159,645) $ 2.66 - $ 7.50 Canceled (350,460) $ 2.66 - $10.68 Outstanding at December 31, 1992 454,643 $ 2.66 - $12.62 Granted 55,745 $ 10.88 - $14.50 Exercised (13,753) $ 7.50 - $11.70 Canceled (14,080) $ 7.50 - $11.71 Outstanding at December 31, 1993 482,555 $ 2.66 - $14.50 In 1993 and 1992, the Company granted to a key executive 22,000 and 10,000 shares, respectively, of the Company's common stock in accordance with his compensation agreement. The agreement also provides for the granting of an additional 60,500 shares through 1996 for which the executive is entitled to receive stock and cash dividends. 12.REGULATORY MATTERS Section 23A of the Federal Reserve Act restricts the Bank from making loans or advances to the Company and other affiliates in excess of 20% of the Bank's capital stock and surplus. In addition, California Banking Law limits the amount of dividends that a bank can pay without obtaining prior approval from bank regulators. Under this law, the Bank could, as of December 31, 1993, declare and pay dividends of approximately $18,025,000 to the Company. The remaining amount of Bank equity of approximately $41,265,000 is restricted with respect to dividends and represents 70% of consolidated stockholders' equity. As of December 31, 1993, the Company and the Bank were required to meet the risk-based capital standard set by the respective regulatory authorities. The risk-based capital standards require the achievement of a minimum ratio of total capital to risk-weighted assets of 8.0% (of which at least 4.0% must be Tier 1 capital, which consists primarily of common stock and retained earnings, less goodwill). Additionally, the regulatory authorities require the highest rated institutions to maintain a minimum leverage ratio of 3% as of December 31, 1993. The leverage ratio basically consists of Tier 1 capital divided by average total assets. Institutions experiencing or anticipating significant growth or those with high or inordinate levels of risk are expected to maintain a leverage ratio well above the minimum level, e.g., 4% or 5%. The leverage ratio will operate in conjunction with the risk-based capital guidelines. The capital ratios of the Company and Bank at December 31, 1993 and 1992 are as follows: Company Bank Minimum Risk-Based Capital Ratio: Tier 1 11.8% 11.7% 4.00% Total 13.1% 13.0% 8.00% Leverage Ratio 8.4% 8.3% 3.00% Risk-Based Capital Ratio: Tier 1 12.4% 12.1% 4.00% Total 13.7% 13.3% 8.00% Leverage Ratio 9.2% 8.9% 3.00% Banking regulations require that all banks maintain a percentage of their deposits as reserves at the Federal Reserve Bank. During the year ended December 31, 1993, required reserve balances averaged approximately $11,099,000. 13.CONDENSED FINANCIAL INFORMATION OF PARENT COMPANY BALANCE SHEETS (In thousands) December 31, 1993 1992 Assets: Investment in Chino Valley Bank $59,290 $50,410 Other assets, net 782 1,628 Total assets $60,072 $52,038 Liabilities $ 114 Stockholders' equity 59,958 $52,038 Total liabilities and stockholders' equity $60,072 $52,038 STATEMENTS OF EARNINGS (In thousands, except per-share amounts) Year Ended December 31, 1993 1992 1991 Equity in earnings of Chino Valley Bank $9,935 $8,941 $8,075 Other (expense) income, net (413) 74 (106) Net earnings $9,522 $9,015 $7,969 Dividends received from Chino Valley Bank $6,098 $ 956 $1,872 14.QUARTERLY FINANCIAL DATA (UNAUDITED) Summarized quarterly financial data follows: 15.FAIR VALUE INFORMATION The following disclosure of the estimated fair value of financial instruments is made in accordance with the requirements of SFAS No. 107, "Disclosures about Fair Value of Financial Instruments." The estimated fair value amounts have been determined by the Company using available market information and appropriate valuation methodologies. However, considerable judgment is required to develop the estimates of fair value. Accordingly, the estimates presented below are not necessarily indicative of the amounts the Company could have realized in a current market exchange as of December 31, 1993 and 1992. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. The methods and assumptions used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value are explained below: For federal funds sold and cash and due from banks, the carrying amount is considered to be a reasonable estimate of fair value. For investment securities, fair values are based on quoted market prices, dealer quotes and prices obtained from an independent pricing service (see also Notes 1 and 2). The carrying amount of loans and lease financing receivables is their contractual amounts outstanding reduced by deferred net loan origination fees and the allocable portion of the allowance for credit losses (see also Notes 1 and 3). Variable rate loans are composed primarily of loans whose interest rates float with changes in the prime interest rate. The carrying amount of variable rate loans (other than such loans in nonaccrual status) is considered to be their estimated fair value. The fair value of fixed rate loans (other than such loans in nonaccrual status) was estimated by discounting the remaining contractual cash flows using the estimated current rate at which similar loans would be made to borrowers with similar credit risk characteristics and for the same remaining maturities, reduced by deferred net loan origination fees and the allocable portion of the allowance for credit losses. Accordingly, in determining the estimated current rate for discounting purposes, no adjustment has been made for any change in borrowers' credit risks since the origination of such loans. Rather, the allocable portion of the allowance for credit losses is considered to provide for such changes in estimating fair value. The fair value of loans on nonaccrual status (see Note 3) has not been specifically estimated because it is not practicable to reasonably assess the credit risk adjustment that would be applied in the market place for such loans. As such, the estimated fair value of total loans at December 31, 1993 and 1992 includes the carrying amount of nonaccrual loans at each respective date. The amounts payable to depositors for demand, savings, and money market accounts are considered to be stated at fair value. The fair value of fixed-maturity certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities. The fair value estimates presented herein are based on pertinent information available to management as of December 31, 1993 and 1992. Although management is not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been comprehensively revalued for purposes of these financial statements since that date, and, therefore, current estimates of fair value may differ significantly from the amounts presented above. 16.ACQUISITION OF BRANCH AND PURCHASE OF ASSETS AND LIABILITIES On March 8, 1993, the Company purchased Fontana First National Bank, assuming approximately $23.7 million in deposits and acquiring approximately $18.3 million in loans. Fontana First National Bank was purchased by the Company for $5.0 million, which resulted in the recording of $1.9 million in goodwill. The assets and liabilities were contributed to the Bank by the Company. On October 21, 1993, the Bank assumed the deposits and purchased certain assets of the failed Mid City Bank, N.A. from the Federal Deposit Insurance Corporation (the "FDIC"). The acquisition was structured under a written agreement between the FDIC and the Bank that allowed the Bank certain rights in regard to repricing deposits and purchasing additional assets, as well as providing the Bank with indemnification from prior activities of the failed bank. The Bank assumed approximately $79.3 million in deposits and purchased $4.6 million in investments and $20.8 million in loans. 17.SUBSEQUENT EVENT In January 1994, the greater Los Angeles area was affected by a major earthquake and series of aftershocks which were centered in the San Fernando Valley. The Company is not located in the San Fernando Valley, nor is the San Fernando Valley part of the Company's service area. However, it is not yet possible to assess the effect of the earthquake on the Company's borrowers' primary or secondary repayment sources, or its overall effect on the local economy in general. The Company's facilities and other real estate owned suffered no significant damage, and management is not aware of any effects from the earthquake which would materially impact its financial condition. INDEPENDENT AUDITORS' REPORT To the Board of Directors and Stockholders of CVB Financial Corp. Ontario, California We have audited the accompanying consolidated balance sheets of CVB Financial Corp. and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of earnings, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of CVB Financial Corp.'s management. Our responsibility is to express an opinion on these financial statements based on our audits. We have 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 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, such consolidated financial statements present fairly, in all material respects, the financial position of CVB Financial Corp. and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. /s/ Deloitte & Touche Delloite & Touche Los Angeles, California January 27, 1994 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 Except as hereinafter noted, the information concerning directors and executive officers of the Company is incorporated by reference from the section entitled "DIRECTORS AND EXECUTIVE OFFICERS - Election of Directors" and "COMPLIANCE WITH SECTION 16(A) OF THE SECURITIES EXCHANGE ACT OF 1934" of the Company's definitive Proxy Statement to be filed pursuant to Regulation 14A within 120 days after the end of the last fiscal year. For information concerning executive officers of the Company, see "Item 4(A). EXECUTIVE OFFICERS OF THE REGISTRANT" above. ITEM 11.	ITEM 11. EXECUTIVE COMPENSATION Information concerning management remuneration and transactions is incorporated by reference from the section entitled "DIRECTORS AND EXECUTIVE OFFICERS -Compensation of Executive Officers and Directors - Executive Compensation, - Employment Agreements and Termination of Employment Arrangements, - Stock Options, - Option Exercises and Holdings and - Compensation Committee Interlocks and Insider Participation" of the Company's definitive Proxy Statement to be filed pursuant to Regulation 14A within 120 days after the end of the last fiscal year. ITEM 12.	ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information concerning security ownership of certain beneficial owners and management is incorporated by reference from the sections entitled "INTRODUCTION -Principal Shareholders" and "DIRECTORS AND EXECUTIVE OFFICERS - Election of Directors" of the Company's definitive Proxy Statement to be filed pursuant to Regulation 14A within 120 days after the end of the last fiscal year. ITEM 13.	ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information concerning certain relationships and related transactions with management and others is incorporated by reference from the section entitled "DIRECTORS AND EXECUTIVE OFFICERS--Certain Transactions" of the Company's definitive Proxy Statement to be filed pursuant to Regulation 14A within 120 days after the end of the last fiscal year. PART IV ITEM 14.	ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K Financial Statements Reference is made to the index to Financial Statements at page 50 for a list of financial statements filed as part of this Report. Exhibits See Index to Exhibits at Page 85 of this Form 10-K. Executive Compensation Plans and Arrangements The following compensation plans and arrangements are filed as exhibits to this Form 10-K: 1981 Stock Option Plan, Exhibit 10.1; Agreement by and among D. Linn Wiley, CVB Financial Corp. and Chino Valley Bank dated August 8, 1991, Exhibit 10.2; Chino Valley Bank Profit Sharing Plan, Exhibit 10.3; 1991 Stock Option Plan, Exhibit 10.17; Severance Agreement between John Cavallucci, Chino Valley Bank and CVB Financial Corp. dated March 26, 1991 and Waiver Agreement dated October 4, 1991, Exhibit 10.18; Key Employee Stock Grant Plan, Exhibit 10.19. See Index to Exhibits at Page 85 to this Form 10-K. Reports on Form 8-K The Company filed a Report on Form 8-K, on November 4, 1993 reporting under Item 5. Undertaking for Registration Statement on Form S-8 For the purpose of complying with the amendments to the rules governing Form S-8 (effective July 13, 1990) under the Securities Act of 1933, the undersigned registrant hereby undertakes as follows, which undertaking shall be incorporated by reference into registrant's Registration Statement on Form S-8 No. 2-76121 (filed February 18, 1982): Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers and controlling persons of the registrant pursuant to the foregoing provisions, or otherwise, the registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Securities Act of 1933 and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the registrant of expenses incurred or paid by a director, officer or controlling person of the registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 16th day of March, 1994. CVB FINANCIAL CORP. (Registrant) By /s/ D. Linn Wiley D. LINN WILEY 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 in the capacities and on the dates indicated. Signature Title Date /s/ George A. Borba Chairman of the Board March 28, 1994 George A. Borba /s/ John A. Borba Director March 28, 1994 John A. Borba /s/ Ronald O. Kruse Director March 28, 1994 Ronald O. Kruse /s/ John J. LoPorto Director March 28, 1994 John J. LoPorto /s/ Charles M. Magistro Director March 28, 1994 Charles M. Magistro /s/ John Vander Schaaf Director March 28, 1994 John Vander Schaaf /s/ Robert J. Schurheck Chief Financial Officer March 28, 1994 Robert J. Schurheck (Principal Financial and Accounting Officer) /s/ D. Linn Wiley Director, President and March 28, 1994 D. Linn Wiley Chief Executive Officer (Principal Executive Officer) INDEX TO EXHIBITS Exhibit No. Page 3.1 Articles of Company, as amended.(1) * 3.2 Bylaws of Company, as amended.(2) * 10.1 1981 Stock Option Plan, as amended.(1) * 10.2 Agreement by and among D. Linn Wiley, CVB Financial Corp. and Chino Valley Bank dated August 8, 1991.(2) * 10.3 Chino Valley Bank Profit Sharing Plan, as amended.(3) * 10.4 Definitive Agreement by and between CVB Financial Corp. and Huntington Bank dated January 6, 1987.(4) * 10.5 Transam One Shopping Center Lease dated May 20, 1986, by and between Transam One and Chino Valley Bank for the East Chino Office.(4) * 10.6 Sublease dated November 1, 1986, by and between Eldorado Bank and Chino Valley Bank for the East Highland Office.(4) * 10.7 Lease Assignment, Acceptance and Assumption and Consent dated December 23, 1986, executed by the FDIC, Receiver of Independent National Bank, Covina, California, as Assignor, Chino Valley Bank, as Assignee, and INB Bancorp, as Landlord under that certain Ground Lease dated September 30, 1983 by and between INB Bancorp and Independent National Bank for the Covina Office.(4) * 10.8 Lease Assignment dated May 15, 1987 and Consent of Lessor dated April 21, 1987 executed by Huntington Bank, as Assignor, Chino Valley Bank as Assignee and Gerald G. Myers and Lynn H. Myers as Lessors under that certain lease dated March 1, 1979 between Lessors and Huntington Bank for the Arcadia Office.(5) * 10.9 Lease Assignment dated May 15, 1987 and Consent of Lessor dated March 18, 1987 executed by Huntington Bank, as Assignor, Chino Valley Bank as Assignee and George R. Meeker as Lessor under that certain Memorandum of Lease dated May 1, 1982 between Lessor and Huntington Bank for the South Arcadia Office.(5) * 10.10 Lease Assignment dated May 15, 1987 and Consent of Lessor dated March 17, 1987 executed by Huntington Bank, as Assignor, Chino Valley Bank as Assignee and William R. Hayden and Marie Virginia Hayden as Lessor under that Certain Lease and Sublease, dated March 1, 1983, as amended, between Lessors and Huntington Bank for the San Gabriel Office.(5) * 10.11 Lease Assignment dated May 15, 1987 executed by Huntington Bank as Assignor and Chino Valley Bank as Assignee under that certain Shopping Center Lease dated June 1, 1982, between Anita Associates, a limited partnership and Huntington Bank for the Santa Anita ATM Branch.(5) * 10.12 Office Building Lease between Havenpointe Partners Ltd. and CVB Financial Corp. dated April 14, 1987 for the Ontario Airport Office.(6) * 10.13 Form of Indemnification Agreement.(7) * 10.14 Office Building Lease between Chicago Financial Association I, a California Limited Partnership and CVB Financial Corp. dated October 17, 1989, as amended, for the Riverside Branch.(1) * 10.15 Office Building Lease between Lobel Financial Corporation and Chino Valley Bank dated June 12, 1990, for the Premier Results data processing center.(3) * 10.16 Office Space Lease between Rancon Realty Fund IV and Chino Valley Bank dated September 6, 1990, for the Tri-City Business Center Branch.(3) * 10.17 1991 Stock Option Plan.(6) * 10.18 Severance Agreement between John Cavallucci, Chino Valley Bank and CVB Financial Corp. dated March 26, 1991 and Waiver Agreement dated October 4, 1991.(2) * 10.19 Key Employee Stock Grant Plan.(8) * 10.20 Lease by and between Allan G. Millew and William F. Kragness and Chino Valley Bank dated March 5, 1993 for the Fontana Office. (9) * 10.21 Office Lease by and between Mulberry Properties and Chino Valley Bank dated October 12, 1992. (9) * 10.22 First Amended and Restated Agreement and Plan of Reorganization by and between CVB Financial Corp., Chino Valley Bank and Fontana First National Bank, dated October 8, 1992 88 10.23 Purchase and Assumption Agreement among FDIC receiver of Mid City Bank, National Association, FDIC and Chino Valley Bank, dated October 21, 1993 (10) * 10.24 Agreement and Plan of Reorganization by and between CVB Financial Corp., Chino Valley Bank and Western Industrial National Bank, dated November 16, 1993 181 10.25 Lease by and between Bank of America and Chino Valley Bank dated October 15, 1993, for the West Arcadia Office 230 10.26 Lease be and between RCI Loring and CVB Financial Corp dated March 11, 1993, for the Riverside Office. 250 22 Subsidiaries of Company. (9) * 23 Consent of Independent Certified Public Accountants. 283 __________________________ *Not applicable. (1) Filed as Exhibits 3.1, 10.1 and 10.14 to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1989, Commission file number 0-10140, which are incorporated herein by this reference. (2) Filed as Exhibits 3.2, 10.2 and 10.18 to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1991, Commission file number 0-10140, which are incorporated herein by this reference. (3) Filed as Exhibits 10.3, 10.15 and 10.16 to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1990, Commission file number 0-10140, which are incorporated herein by this reference. (4) Filed as Exhibits 10.4, 10.5, 10.6 and 10.7 to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1986, Commission file number 0-10140, which are incorporated herein by this reference. (5) Filed as Exhibits 10.8, 10.9, 10.10, 10.11 and 10.12 to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1987, Commission file number 0- 10140, which are incorporated herein by this reference. (6) Filed as Exhibit 4.1 to Registrant's Registration Statement on Form S-8 (33-41318) filed with the Commission on June 21, 1991, which is incorporated herein by this reference. (7) Filed as Exhibit 10.13 to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1988, Commission file number 0-10140, which is incorporated herein by this reference. (8) Filed as Exhibit 4.1 to Registrant's Registration Statement on Form S-8 (33-50442) filed with the Commission on August 1, 1992, which is incorporated herein by this reference. (9) Filed as Exhibit 10.20, 10.21 and 22 to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1992, Commission file number 0-10140, which are incorporated herein by this reference. (10) Filed as Exhibit 99 to the Registrant's Current Report on Form 8-K filed with the Commission on November 4, 1993, which is incorporated herein by this reference.
791269_1993.txt	791269	1993	Item 1. BUSINESS CHRYSLER CORPORATION GENERAL Chrysler Corporation was incorporated under the laws of the State of Delaware on March 4, 1986, and is the continuing corporation of mergers into itself of a number of its operating subsidiaries, including Chrysler Motors Corporation, which was originally incorporated in 1925. Chrysler Corporation and its consolidated subsidiaries ("Chrysler") operates in two principal industry segments: automotive operations and financial services. Automotive operations include the research, design, manufacture, assembly and sale of cars, trucks and related parts and accessories. Financial services include the operations of Chrysler Financial Corporation and its consolidated subsidiaries ("CFC"), which is engaged in wholesale and retail vehicle financing, servicing nonautomotive leases and loans, and property, casualty and other insurance. Chrysler also participates in short-term vehicle rental activities through its subsidiaries (the "Car Rental Operations") and manufactures electronics products and systems through its Chrysler Technologies Corporation subsidiary. Chrysler's principal executive offices are located at Chrysler Center, 12000 Chrysler Drive, Highland Park, Michigan 48288-0001. The telephone number of those offices is (313) 956-5741. AUTOMOTIVE OPERATIONS Chrysler and its subsidiaries manufacture, assemble and sell cars and trucks under the brand names Chrysler, Dodge, Plymouth, Eagle and Jeep, and related automotive parts and accessories, primarily in the United States, Canada and Mexico. Passenger cars are offered in various size classes and models. Chrysler produces trucks in light-duty, sport-utility and van/wagon models, which constitute the largest segments of the truck market. Chrysler also purchases and distributes under the Dodge, Plymouth and Eagle brand names certain passenger cars and trucks manufactured in Japan by Mitsubishi Motors Corporation ("MMC"), as well as cars manufactured in the United States by MMC's subsidiary, Diamond-Star Motors Corporation ("Diamond-Star"). Although Chrysler currently sells most of its vehicles in the United States, Canada and Mexico, Chrysler also participates in other international markets through its wholly-owned subsidiary, Chrysler Motors de Venezuela, S.A., and indirectly through its minority investments in Beijing Jeep Corporation, Ltd. and Arab American Vehicles Company. In addition, Chrysler distributes in Europe and other world markets vehicles produced in North America and by Eurostar Automobilwerk Ges.m.b.H & Co. KG ("Eurostar"), a joint venture between Chrysler and Steyr-Daimler-Puch Fahrzeugtechnik of Graz, Austria. Eurostar began producing and distributing Chrysler minivans in March 1992. During 1993, Chrysler also entered into an agreement with Steyr-Daimler-Puch Fahrzeugtechnik to assemble up to 47,000 right and left-hand drive Jeep Grand Cherokees per year in Austria beginning in late 1994. Chrysler's automotive operations, including product design and development efforts, manufacturing operations and sales, are conducted mainly in North America. Chrysler's principal domestic competitors in the United States are General Motors Corporation and Ford Motor Company. In addition, a number of Japanese automotive companies own and operate manufacturing and/or assembly facilities in the United States ("transplants") and there are a number of other foreign manufacturers that distribute automobiles and light-duty trucks in the United States. Chrysler's plan is to focus on its core automotive business. As part of this plan, Chrysler has sold certain assets and businesses which are not related to its core automotive business, and may sell other such assets in the future. The automotive industry in North America is highly competitive with respect to a number of factors, including product quality, price, appearance, size, special options, distribution organization, warranties, reliability, fuel economy, dealer service and financing terms. As a result, Chrysler's ability to increase vehicle prices and the effectiveness of its use of special sales incentives to improve sales are significantly affected by the pricing actions and special sales programs of its principal competitors. Moreover, the introduction of new products by other manufacturers may adversely affect the market shares of competing products made by Chrysler. Also, many of Chrysler's competitors have larger worldwide sales volumes and greater financial resources, which may place Chrysler at a competitive disadvantage in responding to substantial changes in consumer preferences or governmental regulations that require major additional capital expenditures. Adverse economic conditions in North America may also be more readily absorbed by Chrysler's larger and more diversified competitors. Item 1. BUSINESS - Continued Part I - Continued Automotive Operations - Continued Chrysler's long-term profitability depends upon its ability to introduce and market its new products successfully. The success of Chrysler's new products will depend on a number of factors, including the economy, competition, consumer acceptance, Chrysler's ability to fund its new product development and facility modernization programs, the effect of governmental regulation and the strength of Chrysler's marketing and dealer networks. As both Chrysler and its competitors plan to introduce new products, Chrysler cannot predict the market shares its new products will achieve. Moreover, Chrysler is substantially committed to the types of vehicles contemplated by its product plans and would be adversely affected by developments requiring a major shift in product design. The Automotive Industry in the United States The tables below set forth (a) comparative market share data for domestic retail sales of cars and trucks for the major domestic manufacturers (including cars and trucks imported by them) and for foreign-based manufacturers and (b) unit sales of passenger cars and trucks (including imports to the United States) by Chrysler. ____________________________________ (1) All U.S. retail sales data are based on publicly available information on manufacturers from the American Automobile Manufacturers Association and data on foreign company imports from Ward's Automotive Reports, a trade publication. (2) "Foreign-Based Manufacturers" include imports and vehicles assembled and sold in the United States by foreign companies. (3) U.S. truck retail market share includes minivans. Item 1. BUSINESS - Continued Part I - Continued Automotive Operations - Continued The Automotive Industry in the United States - Continued Competition from foreign car and truck manufacturers, particularly Japanese manufacturers, in the form of both exports to the United States and sales by transplants, has been significant in recent years. The market share for foreign passenger cars sold in the United States (including transplants) increased from 32.1 percent in 1989 to 35.7 percent in 1991 but decreased to 34.0 percent during 1993. The market share for foreign trucks sold in the United States (including transplants) increased from 16.0 percent in 1989 to 17.8 percent in 1991, but decreased to 14.8 percent during 1993. The Japanese transplants enjoy several competitive advantages over domestic producers, such as more flexible work rules, a younger, lower-cost work force and the absence of significant numbers of retired workers and their attendant costs. Sales of vehicles assembled in the United States by Japanese manufacturers have increased to approximately 14.8 percent of the U.S. passenger car market and 5.4 percent of the U.S. truck market in 1993 from 14.1 percent and 5.3 percent, respectively, in 1992. Japanese manufacturers' exports to the United States are currently subject to voluntary restraints limiting exports of new passenger cars (excluding station wagons) from Japan to the United States. These restraints have been in effect since 1981 and will continue in effect through March 1994 by a unilateral decision of the Japanese Government. For the 12 months ended March 31, 1993, the Japanese export limit was 1.65 million cars while actual exports during that period were 1.56 million cars. For the 12 months ending March 31, 1994, Japanese exports are still limited to 1.65 million cars. Estimated exports during the nine month period ended December 31, 1993 were approximately 912,000 cars. There are no assurances as to what the restraints on exports from Japan to the United States, if any, will be after March 31, 1994. A significant increase in the number of vehicles manufactured in Japan and exported to the United States could adversely affect Chrysler's sales levels and profitability. Chrysler Canada Ltd. Chrysler's consolidated subsidiary, Chrysler Canada Ltd. ("Chrysler Canada"), operates manufacturing and assembly facilities and sales and distribution networks in Canada. Chrysler Canada, whose operations are substantially integrated with Chrysler's U.S. operations, manufactures components and assembles front-wheel-drive minivan/wagons, front-wheel-drive mid-size and large sedans, and rear-wheel-drive van/wagons. Chrysler Canada began production of the mid-size and large sedans at its Bramalea, Ontario facility in mid-1992 and early 1993, respectively. The Brampton, Ontario facility was closed in 1992 when production of the Jeep Wrangler sport-utility vehicle was transferred to Toledo, Ohio. In 1993, Chrysler Canada produced 643,371 vehicles, of which 566,388 were sold outside of Canada. In 1992, Chrysler Canada produced 464,565 vehicles, of which 416,204 were sold outside of Canada. Chrysler Canada's retail sales totaled 226,819 vehicles in 1993 and 205,071 vehicles in 1992, of which 158,373 and 156,244, respectively, were produced outside of Canada. In 1993, Chrysler Canada's factory unit sales to Canadian dealerships accounted for approximately 9.1 percent of Chrysler's total car and truck sales, compared with 8.9 percent in 1992. Chrysler Canada's retail unit sales of cars accounted for 14.7 percent and 12.3 percent of the Canadian car market in 1993 and 1992, respectively. In 1993, retail unit sales of trucks accounted for 26.3 percent of the Canadian truck market compared with 25.1 percent in 1992. In 1993, Chrysler Canada ranked third in the Canadian industry in retail unit sales of both cars and trucks. Chrysler de Mexico Chrysler's consolidated subsidiary, Chrysler de Mexico S.A. ("Chrysler Mexico"), operates assembly and manufacturing facilities in Mexico, producing vehicles and components for both Mexican and export markets. Chrysler Mexico also distributes in the Mexican market finished vehicles imported from Chrysler's U.S. and Canadian operations. Chrysler Mexico's vehicle sales accounted for 16.0 percent of the wholesale car market and 17.2 percent of the wholesale truck market in 1993, compared with 19.7 percent and 19.6 percent, respectively, in 1992. Within the Mexican industry, Chrysler Mexico's wholesale unit sales ranked third in cars and trucks in both 1993 and 1992. In 1993, overall wholesale industry sales in Mexico were 585,200 units, compared with 710,623 units in 1992, a decrease of 17.6 percent. Item 1. BUSINESS - Continued Part I - Continued Automotive Operations - Continued Chrysler de Mexico - Continued In 1993, Chrysler Mexico exported 104,712 automobiles, consisting of Plymouth Acclaims, Dodge Spirits, Dodge Shadow coupes and convertibles, Plymouth Sundances and Chrysler LeBaron sedans, compared with 70,395 units in 1992. In 1993, Chrysler Mexico also exported 36,660 trucks, consisting of Dodge Ramchargers, Dodge Club Cab pickups, and selected models of the all-new full-size Dodge Ram pickup trucks, compared with 30,331 units in 1992. In addition, Chrysler Mexico provides certain major automobile components to Chrysler, including engines and air conditioner condensers. North American Free Trade Agreement The North American Free Trade Agreement ("NAFTA") unites Mexico, Canada and the United States into the world's largest trading region, a market with more than 360 million consumers. NAFTA provides for the phase-out of trade regulations which restricted vehicle imports and exports between Mexico and the U.S. and Canada. Mexico represents a growing economy, and Chrysler ranks third among worldwide manufacturers in wholesale unit sales in the Mexican car and truck market. While Chrysler's management believes that NAFTA may result in overall improvements in the North American automobile industry in the future, the immediate impact of the agreement cannot be determined. International Operations Chrysler's automotive operations outside North America consist primarily of Eurostar's manufacturing operations in Austria and the export of finished vehicles and component kits produced in North America to independent foreign distributors and local manufacturers. Chrysler has equity interests in companies with manufacturing and assembly facilities in China, Venezuela, and Egypt, and has established joint ventures with certain other foreign manufacturers. Chrysler's European shipments were 60,566 in 1993, consisting primarily of 33,109 minivans and 21,895 Jeep vehicles, an increase of 11 percent from 1992. In addition, Chrysler sold 46,354 units in other world markets, primarily in the Middle East, Taiwan and to U.S. military personnel. Chrysler continues to export its newly designed Jeep Grand Cherokee, mid-size sedans and right-hand drive Jeep Cherokees. In addition, Chrysler plans to export the new Neon and Stratus passenger cars that will be introduced during 1994. Chrysler also exported 19,946 kits to worldwide affiliates for overseas assembly of Jeep vehicles. Most of the kits were shipped to Beijing Jeep Corporation Ltd. in China and Chrysler's wholly-owned subsidiary in Venezuela. Eurostar began production and distribution of Chrysler minivans in March 1992 for the European market. Eurostar sold 33,738 minivans in 1993, compared to 15,100 in 1992. The Eurostar facility launched a second shift during 1993 and has a capacity of 55,000 vehicles per year. During 1993, Chrysler entered into an agreement with Steyr-Daimler-Puch Fahrzeugtechnik to assemble up to 47,000 right and left-hand drive Jeep Grand Cherokees annually in Austria for the European and other world markets beginning in late 1994. Mitsubishi Motors Corporation Chrysler imports and distributes in the United States and Canada selected models of passenger cars and light-duty trucks manufactured by MMC in Japan and by its affiliates overseas. In 1993, Chrysler sold 69,646 MMC-manufactured vehicles in the United States (of which 67,988 were passenger cars) representing 3.4 percent of Chrysler's U.S. retail vehicle sales during 1993. In 1992, Chrysler sold 67,474 MMC-manufactured vehicles in the United States (of which 62,174 were passenger cars), representing 3.9 percent of Chrysler's U.S. retail vehicle sales. In addition to passenger cars and light- duty trucks, Chrysler purchases 3.0-liter V-6 engines for use in the production of the Dodge Caravan and Plymouth Voyager minivans and other vehicles, and intends to buy approximately 428,000 of these engines from MMC during the 1994 model year. Item 1. BUSINESS - Continued Part I - Continued Automotive Operations - Continued Mitsubishi Motors Corporation - Continued Diamond-Star produces small sporty cars in the United States for Chrysler and Mitsubishi Motor Sales of America ("MMSA"). The Plymouth Laser and Eagle Talon (marketed in the United States and Canada) and the Mitsubishi Eclipse (marketed in the United States, Europe and Japan) are produced by Diamond-Star. Chrysler sold its 50 percent interest in Diamond-Star to MMC, its partner in the joint venture, in October 1991. Pursuant to a distribution agreement that terminates in July 1999, Chrysler retains the right to purchase a portion of Diamond-Star's production capacity. As long as Chrysler purchases at least 60,000 units per year, Chrysler will also have co-exclusive rights for the Eagle Talon replacement vehicle and exclusive rights for a replacement for the Dodge Daytona and Chrysler LeBaron Coupe, both of which are planned for the 1994-95 period. In addition, Chrysler will provide engines and transmissions for use in a portion of Diamond-Star's FJ-platform vehicles. During 1993, Diamond-Star produced 135,610 units, of which 38,432 were for Chrysler and 97,178 were for MMSA. In 1992, Diamond-Star produced 140,156 units, of which 57,261 were for Chrysler and 82,895 were for MMSA. Chrysler's sales of Diamond-Star cars in 1993 and 1992 represented 2.1 and 3.6 percent, respectively, of Chrysler's U.S. retail vehicle sales volume in each period. Under the terms of the United States Distribution Agreement ("USDA") in effect between Chrysler and MMC, which terminates in March 1998, Chrysler and MMSA share co-exclusive rights to distribute various MMC passenger car and light-duty truck models which are available for sale in the United States. In practice, Chrysler and MMSA share the distribution of certain models and exclusively distribute other models. In connection with Chrysler's sale of its 50 percent interest in Diamond-Star to MMC in October 1991, the USDA was amended to reassign a portion of MMC's total voluntary restraint agreement quota from Chrysler to MMSA and to designate three vehicles as exclusive models for MMSA. Agreements similar to the USDA are in effect covering the Canadian market. In practice, Chrysler Canada acts as sole distributor of MMC products. The Japanese Government does not presently limit exports from Japan to the Canadian vehicle market. Chrysler Canada distributes a two-door and four-door subcompact Dodge and Plymouth Colt 100 and the Eagle Vista car imported from MMC Sittipol Motors of Thailand (a MMC joint venture). In 1992 and 1993, Chrysler sold 93.9 million shares of its equity interest in MMC for approximately $544 million in cash, net of related expenses, ending its equity interest in MMC. Segment Information Industry segment and geographic area data for 1993, 1992 and 1991 are summarized in Part II, Item 8, Notes to Consolidated Financial Statements, Note 18. Seasonal Nature of Business Reflecting retail sales fluctuations of a seasonal nature, production varies from month to month in the automotive business. In addition, the changeover period related to new model introductions has traditionally occurred in the third quarter of each year. Accordingly, third quarter operating results are generally less favorable than those in the other quarters of the year. Automotive Product Plans In the late 1970's and early 1980's, Chrysler concentrated on the development of fuel efficient, front-wheel drive cars. Chrysler created a new market segment with the introduction of the first minivan in 1983. The Dodge Caravan, Plymouth Voyager, and Chrysler Town and Country were redesigned for the 1991 model year, freshened slightly for the 1994 model year and have captured 46.7 percent of the U.S. minivan market segment for the 1993 calendar year versus 50.5 percent in 1992 despite new competitive entries in the segment. The 1987 acquisition of American Motors Corporation ("AMC") provided Chrysler with the highly regarded Jeep nameplate and four-wheel-drive technology. In the spring of 1992, the Jeep division introduced the all new Grand Cherokee as an upscale companion to the existing Jeep lineup. The Jeep Grand Cherokee and the Jeep Cherokee have collectively attained 32.5% of the small sport-utility segment in calendar year 1993, up from 24.7% in 1992. Item 1. BUSINESS - Continued Part I - Continued Automotive Operations - Continued Automotive Product Plans - Continued In 1989, Chrysler initiated a strategic plan to replace all of its passenger car platforms and its full-size pickup truck by 1995. Chrysler's objective is to maintain and improve its positions in the minivan, small sport-utility, and full-size pickup markets, while strengthening its passenger car offerings. To accomplish this goal, Chrysler changed the organizational structure of its automotive design and development efforts by establishing cross-functional product development groups called "platform teams." There are four Platform teams: Small Car, Large Car, Minivan, and Jeep and Truck. Each team includes designers, engineers, purchasing agents, manufacturing personnel, financial analysts, sales and marketing personnel and supplier representatives. Chrysler's platform team system is designed to (a) improve communications and enhance collaborative problem solving as early as possible in the design and development process; (b) reduce the cycle time required to design and develop new vehicles, enhancing Chrysler's ability to respond to market changes more quickly; (c) improve the quality of its new products through the identification of potential problems early in the development process; and (d) reduce the costs of developing new vehicle lines. In the fall of 1992, Chrysler introduced the first of its all-new passenger car platforms resulting from the new platform team concept. The Chrysler Concorde, Dodge Intrepid, and Eagle Vision compete primarily in the important upper-middle segment. These cars employ a "cab-forward" design, with the windshield steeply raked forward over the front axle. This design creates more interior passenger space without significantly increasing vehicle size or weight. The early success of these vehicles resulted in expanding production to a second facility. Chrysler's share of the basic middle segment was 9.7 percent for 1993, compared to 5.3 percent for 1992. In early 1993, a new Chrysler New Yorker and a touring derivative called the LHS were introduced based on this platform. In 1993, Dodge introduced the first truck designed under this platform team system, a new full-size Ram pickup. This new pickup also marks the first full-scale production use of a new "big gas" V-10 engine which was also used as a basis for the design of the Dodge Viper V-10 engine. The Small Car platform team introduced the subcompact Dodge and Plymouth Neon in January 1994. The Neon introduces an all new family of 16-valve 4-cylinder engines, provides both driver and passenger airbags, and also applies the "cab-forward" design used by the successful upper-middle segment vehicles. The Large Car platform team is expected to introduce, in the third quarter of 1994, an all new compact car marketed as the Chrysler Cirrus and Dodge Stratus. The Cirrus and Stratus will introduce two new engines, a 2.4-liter 16-valve double overhead cam 4-cylinder engine and a 2.5-liter 24-valve single overhead cam V-6 engine, provide driver and passenger airbags, dynamic side impact protection, and also apply the "cab-forward" design used by the successful upper-middle segment vehicles. Automotive Marketing New passenger cars and trucks are sold at retail principally by dealers who have sales and service agreements with the manufacturer. The dealers purchase cars, trucks, parts and accessories from the manufacturer for sale to retail customers. In the United States, Chrysler had 4,726 dealers at December 31, 1993 compared with 4,779 at December 31, 1992. The U.S. dealers sold an average of 433 vehicles per dealer in 1993 compared with an average of 358 in 1992. Chrysler Canada had 601 dealers at December 31, 1993 compared with 606 dealers at December 31, 1992. The Canadian dealers sold an average of 377 and 338 vehicles per dealer in 1993 and 1992, respectively. Chrysler's ability to maintain, expand and improve the quality of its dealer organization will have an important impact on future sales. Chrysler maintains programs to provide dealership operating capital by equity investments where sufficient private capital is not available. The programs anticipate that the dealer receiving such assistance will eventually purchase Chrysler's equity investment from the dealer's share of the dealership profits. Chrysler's equity interest in U.S. and Canadian dealerships totaled $37 million in 91 dealerships as of December 31, 1993, compared with $40 million in 116 dealerships as of December 31, 1992. Chrysler continues to focus on improving customer satisfaction throughout the corporation. Chrysler has improved their Owner Relations capabilities as they relocated the group to modern facilities with the latest technology and added 49 representatives to assist owners requesting information or assistance. Item 1. BUSINESS - Continued Part I - Continued Automotive Operations - Continued Manufactured and Purchased Components and Materials Chrysler manufactures most of its requirements for eight-cylinder, 8.0-liter V-10, 3.5-liter V-6, 3.9-liter V-6, 3.8-liter V-6, 3.3-liter V-6, in-line six-cylinder, four-cylinder, and derivative gasoline engines for cars and trucks, gray iron casting for cylinder blocks for such engines, stampings for passenger car and truck bodies, transmissions for cars and trucks, automatic and manual transaxles, engine controllers, alternators, voltage regulators, distributors, instrument clusters, radios and automotive air conditioners, and processes about two-thirds of its requirements for fabricated glass parts. In the second quarter of 1993, Chrysler sold the plastics operations of its Acustar division for $132 million, net of related expenses. Chrysler uses approximately 16,600 suppliers for services, materials, parts and components, and purchases from one or more of such firms substantially all of its requirements for 3.0-liter V-6 engines and 5.9-liter diesel engines, constant velocity joints, batteries, bearings, axles, bumpers, carpets, cloth for trim and seat covers, vinyl trim and seat cushion back covers, cylinder heads for four, six, and eight cylinder gasoline engines, decorative die castings, fuel management systems, malleable iron, nuts, bolts and other fasteners, radiators, raw glass, seat belts, steel, tires, wheels and certain other items. Chrysler purchases a larger portion of its materials, parts and other components from unaffiliated suppliers than do its principal domestic competitors. Chrysler expects to continue purchasing its requirements for these items rather than manufacturing them. Government Regulation Vehicle Regulation Fuel economy, safety and emissions regulations and standards applicable to motor vehicles have been issued from time to time under a number of federal statutes, including the National Traffic and Motor Vehicle Safety Act of 1966 (the "Safety Act"), the Clean Air Act, Titles I and V of the Motor Vehicle Information and Cost Savings Act and the Noise Control Act of 1972. In addition, the State of California has promulgated exhaust emission standards, some of which are more stringent than the federal standards. Other states may, under the Clean Air Act, adopt vehicle emission standards identical to those adopted by the State of California. The States of New York and Massachusetts have adopted such standards and several other states are considering similar action. The American Automobile Manufacturers Association and the Association of International Automobile Manufacturers have challenged the legality of portions of both states' action on behalf of a number of vehicle manufacturers, including Chrysler. Vehicle Emissions Standards - Under the Clean Air Act, auto manufacturers are required, among other things, to reduce significantly tailpipe emissions of polluting gases from automobiles and light trucks and to increase the length of time vehicles are subject to recall for failure to meet emission standards to ten years or 100,000 miles, whichever occurs first. This Act imposes standards for model years through 2003 that require further significant reductions in motor vehicle emissions. This Act also may require production of certain vehicles capable of operating on fuels other than gasoline or diesel fuel (alternative fuels) under a pilot test program to be conducted principally in California beginning in the 1996 model year. Chrysler is actively pursuing the development of flexible fuel vehicles capable of operating on both gasoline and M-85 methanol blend fuels as well as development of vehicles capable of operating on compressed natural gas. The California Air Resources Board has received federal approval, pursuant to the Clean Air Act, for a series of passenger car and light truck emission standards, effective through the 2003 model year, that are more stringent than those prescribed by the Clean Air Act for the corresponding periods of time. These California standards are intended to promote the development of various classes of low emission vehicles. California also requires that a specified percentage of each manufacturer's California sales volume, beginning at two percent in 1998 and increasing to ten percent in 2003, must be zero-emission vehicles ("ZEVs") that produce no emissions of regulated pollutants. A number of states located in the Northeast have indicated that they will petition the United States Environmental Protection Agency ("EPA") to impose a regional vehicle emissions program similar to the California program. Chrysler has entered into a consortium of vehicle manufacturers, electric utilities and the Department of Energy to develop new battery technology for use in electric vehicles which would qualify as ZEVs and has built a limited number of experimental prototype electric vehicles using existing advanced battery technology. Item 1. BUSINESS - Continued Part I - Continued Automotive Operations - Continued Government Regulation - Continued Vehicle Regulation - Continued CAFE - The Motor Vehicle Information and Cost Savings Act, as amended by the Energy Policy and Conservation Act, requires vehicle manufacturers to provide vehicles that comply with federally mandated fuel economy standards. Under this Act, a manufacturer earns credits for exceeding the applicable fuel economy standards; however, fuel economy credits earned on cars may not be used for trucks. Failure to meet the average fleet fuel economy standards can result in the imposition of penalties unless a manufacturer has sufficient fuel economy credits from the preceding three years or projects that it will generate sufficient credits over the succeeding three years. Chrysler is in substantial compliance with existing CAFE requirements and anticipates continued compliance with such requirements. In addition, the Energy Tax Act of 1978 imposes a graduated "Gas Guzzler" tax on automobiles with a fuel economy rating below specified levels. There have been recent legislative initiatives in Congress that would increase corporate average fuel economy standards from their current levels. A significant increase in those requirements could be costly to Chrysler and could result in significant restrictions on the products Chrysler offers. Vehicle Safety - Under the Safety Act, the National Highway Traffic Safety Administration ("NHTSA") is required to establish appropriate federal motor vehicle safety standards that are practicable, meet the need for motor vehicle safety and are stated in objective terms. NHTSA has announced its intention to establish additional standards in the near future, which Chrysler supports in principle. Chrysler expects to be able to comply with those standards. Vehicle Recalls - The Safety Act and the Clean Air Act require product recalls under certain circumstances. Recalls vary as to cause; some involve problems that are relatively serious in nature, while others are much less significant. In addition, since it is often unknown which vehicles may contain a defect, large numbers of vehicles must be recalled to find, in many cases, a very low percentage of vehicles with defects. The number of vehicles recalled and the cost of such recalls vary widely from year to year. While Chrysler has not had significant recalls in recent years, it cannot assure that there will not be such recalls in the future. Stationary Source Regulation Chrysler's assembly, manufacturing and other operations are subject to substantial environmental regulation under the Clean Air Act, the Clean Water Act, the Resource Conservation and Recovery Act, the Pollution Prevention Act of 1990 and the Toxic Substances Control Act, as well as a substantial volume of state legislation paralleling and, in some cases, imposing more stringent obligations than the federal requirements. These regulations impose severe restrictions on air and water-born discharges of pollution from Chrysler facilities, the handling of hazardous materials at Chrysler facilities and the disposal of wastes from Chrysler operations. Chrysler is faced with many similar requirements in its operations in Canada and is facing increased governmental regulation and environmental enforcement in Mexico. Clean Air Act - Pursuant to the Clean Air Act, the states are required to amend their implementation plans to require more stringent limitations and other controls on the quantity of pollutants which may be emitted into the atmosphere to achieve national ambient air quality standards established by the EPA. In addition, the Clean Air Act requires reduced emissions of substances that are classified as hazardous, toxic or that contribute to acid deposition, imposes comprehensive permit requirements for manufacturing facilities in addition to those required by various states, and expands federal authority to impose severe penalties and criminal sanctions. The Clean Air Act also allows states to adopt standards more stringent than those required by the Clean Air Act. Most recent reports filed with the EPA pursuant to the Superfund Amendments and Reauthorization Act of 1986 indicate that for calendar year 1992 releases and emissions of chemicals and toxics by Chrysler were reduced by more than 70 percent from comparable 1987 levels. Chrysler is unable to predict the exact level of expenditures that will be required by the Clean Air Act but believes that the cost of complying with the legislation will be substantial. While Chrysler is unable to predict the exact level of expenditures that will be required to develop and implement new technology in its North American facilities, since federal and state requirements are not fully defined, it expects that in excess of $1.0 billion will be spent during the period 1994 through 1998, including the impact of annual emissions fees. Of this total, Chrysler estimates that $190 million will be spent in 1994 and $200 million will be spent in 1995. In addition, the extensive federal-state permit program established by the Clean Air Act may reduce operational flexibility and cause delays in upgrading of Chrysler's production facilities in the United States. Item 1. BUSINESS - Continued Part I - Continued Automotive Operations - Continued Government Regulation - Continued Stationary Source Regulation - Continued Environmental Liabilities - The EPA and various state agencies have notified Chrysler that it may be a potentially responsible party ("PRP") for the cost of cleaning up hazardous waste storage or disposal facilities pursuant to the Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA") and other federal and state environmental laws. Chrysler is also a party to a number of lawsuits in various jurisdictions which allege conduct by Chrysler in violation of CERCLA or other environmental laws which seek to recover costs associated with remedial action. In virtually all instances, Chrysler is only one of a number of PRPs who may be found to be jointly and severally liable for remediation costs at the 116 sites involved in the foregoing matters at December 31, 1993. Chrysler may also incur remediation costs at an additional 45 of its active or deactivated facilities. In particular, the Ohio Environmental Protection Agency notified Chrysler on October 12, 1993 of its intention to institute a proceeding concerning a Chrysler facility in Dayton, and the Indiana Department of Environmental Management initiated an administrative proceeding in August 1985 concerning a Chrysler facility in Indianapolis. Each proceeding alleges improper disposal of waste, and each may result in the imposition of civil penalties in excess of $100,000. The Indiana proceeding also seeks to require Chrysler to conduct a site assessment and undertake remedial action. Estimates of future costs of pending environmental matters are necessarily imprecise due to numerous uncertainties, including the enactment of new laws and regulations, the development and application of new technologies, and the apportionment and collectibility of remediation costs among responsible parties. Chrysler may ultimately incur significant expenditures over an extended period of time in connection with the foregoing environmental matters, and therefore has established reserves totalling $287 million for the estimated costs associated with all of its environmental remediation efforts. Chrysler believes that these reserves will be sufficient to resolve these matters. After giving effect to these reserves, management believes, based on currently known facts and circumstances and existing laws and regulations, that the disposition of these matters will not have a material adverse effect on Chrysler's consolidated financial position. Future developments could cause Chrysler to change its estimate of the total costs associated with these matters, and such changes could be material to Chrysler's consolidated results of operations for the period in which such developments occur. FINANCIAL SERVICES Chrysler's principal subsidiary, CFC, is a financial services organization engaged in wholesale and retail vehicle financing, servicing nonautomotive leases and loans, property, casualty and other insurance, and automotive dealership facility development and management. All of CFC's common stock is owned by Chrysler. CFC, a Michigan corporation, is the continuing corporation resulting from a merger on June 1, 1967 of a financial services subsidiary of Chrysler into a newly acquired, previously unaffiliated finance company incorporated in 1926. CFC's primary objective is to provide financing for automotive dealers and retail purchasers of Chrysler's products. CFC sells significant amounts of automotive receivables acquired in transactions subject to limited recourse provisions. CFC remains as servicer for which it is paid a servicing fee. At the end of 1993, CFC had nearly 3,100 employees and its portfolio of receivables managed totaled $28.3 billion. CFC's financial condition and liquidity improved during 1993 as it regained full access to the investment grade markets, continued to sell significant amounts of automotive receivables and repaid all borrowings under its revolving credit facilities. In addition, CFC realized aggregate cash proceeds of $2.4 billion from the sales of certain nonautomotive assets during 1993. The sales of nonautomotive assets over the last two years have made CFC more dependent upon Chrysler. Thus, lower levels of production and sales of Chrysler products could result in a reduction in the level of finance operations of CFC. CFC's portfolio of finance receivables managed includes receivables owned and receivables serviced for others. Receivables serviced for others primarily represent sold receivables which CFC services for a fee. At December 31, 1993, receivables serviced for others accounted for 69 percent of CFC's portfolio of receivables managed. Total finance receivables managed at the end of each of the five most recent years were as follows: Item 1. BUSINESS - Continued Part I - Continued Financial Services - Continued Automotive Financing - CFC conducts its automotive finance business principally through its subsidiaries Chrysler Credit Corporation ("Chrysler Credit"), Chrysler Credit Canada Ltd., and, in Mexico, Chrysler Comercial S.A. de C.V. Chrysler Credit is the major source of automobile and light-duty truck wholesale (also referred to as "floor plan") and retail financing for Chrysler dealers and their customers throughout North America. At December 31, 1993, Chrysler Credit was providing financing to approximately 2,600 Chrysler dealers who exclusively sell Chrysler products. Chrysler Credit also finances approximately 1,400 dealers who sell non-Chrysler products (either exclusively or together with Chrysler products). Chrysler Credit also offers its floor plan dealers working capital loans, real estate and equipment financing, and financing plans for fleet buyers, including daily rental car companies independent of, and affiliated with, Chrysler. The automotive financing operations of Chrysler Credit and such other subsidiaries are conducted through 100 branches in the United States, Canada, Mexico and Puerto Rico. During 1993, CFC financed or leased approximately 766,000 vehicles at retail in the United States, including approximately 516,000 new Chrysler passenger cars and light-duty trucks, representing 25 percent of Chrysler's U.S. retail and fleet deliveries. In 1993, the average monthly payment for new vehicle retail installment sale contracts acquired in the United States was $341. The average percentage of dealer cost financed was 91 percent and the average original term was 55 months. CFC also financed at wholesale approximately 1,510,000 new Chrysler passenger cars and light-duty trucks representing 75 percent of Chrysler's U.S. factory shipments in 1993. Wholesale vehicle financing accounted for 74 percent of the total automotive financing volume of CFC in 1993 and represented 16 percent of automotive finance receivables outstanding at December 31, 1993. Nonautomotive Financing - CFC has downsized its nonautomotive operations through sales and liquidations over the last several years. During 1993, CFC realized $2.4 billion of aggregate cash proceeds from the sale of substantially all of the consumer and inventory financing businesses of Chrysler First Inc. ("Chrysler First") and the sale of certain assets of Chrysler Capital Corporation ("Chrysler Capital"). Chrysler Capital manages nonautomotive leases and loans to clients in over 30 industries through 16 offices throughout the United States. At December 31, 1993, Chrysler Capital managed $2.7 billion of nonautomotive finance receivables compared to $3.2 billion at December 31, 1992. In addition, CFC managed a portfolio of secured small business loans totalling $0.6 billion at December 31, 1993. Insurance - Chrysler Insurance Company and its subsidiaries ("Chrysler Insurance") provide specialized insurance coverages to automotive dealers and their customers in the United States and Canada. The property and casualty segment of Chrysler Insurance's business includes physical damage, garage liability, workers' compensation and property and contents coverage provided directly to automotive dealers. During 1993, the inventories of approximately 2,800 automotive dealerships that were financed by Chrysler Credit were insured by Chrysler Insurance. During 1993, 1,875 Chrysler and non-Chrysler automotive dealerships were insured by CFC's multi-line property and casualty insurance program known as the Pentastar Protection program. Chrysler Insurance also provides collateral protection and single interest insurance to retail automobile customers and their financing sources. Real Estate Management - Chrysler Realty Corporation ("Chrysler Realty"), which is engaged in the ownership, development and management of Chrysler automotive dealership properties in the United States, typically purchases, leases or options dealership facilities and then leases or subleases these facilities to Chrysler dealers. At December 31, 1993, Chrysler Realty controlled 923 sites (of which 297 were owned by Chrysler Realty). Funding - CFC's primary objective is to provide financing for automotive dealers and retail purchasers of Chrysler's products. CFC's liquidity improved during 1993. Proceeds from nonautomotive asset sales and CFC's improved access to the capital markets enabled it to issue $2.3 billion of term debt and increase the level of short-term notes outstanding (primarily commercial paper) to $2.8 billion and repay all borrowings outstanding under revolving credit facilities. Receivable sales continued to be a significant source of funding during 1993, as CFC realized $7.8 billion of net proceeds from the sale of automotive retail receivables compared to $5.8 billion of net proceeds from the sale of automotive and nonautomotive receivables in 1992. Item 1. BUSINESS - Continued Part I - Continued Financial Services - Continued CFC's outstanding debt at December 31, of each of the five most recent years was as follows: CAR RENTAL OPERATIONS Through its Pentastar Transportation Group, Inc. ("Pentastar") subsidiary, Chrysler owns Thrifty Rent-A-Car System, Inc. ("Thrifty"), Snappy Car Rental, Inc. ("Snappy") and Dollar Rent A Car System, Inc. ("Dollar"). Both Thrifty and Dollar are engaged in leasing vehicles to independent businesses they have licensed to use their trade names, systems and technologies in the daily rental of cars for business, personal and leisure use. They also maintain and operate a number of their own locations. Snappy, through corporate-owned locations, is engaged in renting automobiles on a short-term basis, primarily to customers whose insurance coverage entitles them to a replacement vehicle if their own cars are damaged, stolen or require major repairs. In September 1992, Chrysler announced a realignment of a part of the Car Rental Operations under Pentastar and the consolidation and phase out of certain of those operations. As part of that realignment, Chrysler subsequently transferred to Dollar ownership of General Rent-A-Car, which also rents cars for business, leisure and personal use, exclusively through corporate owned locations. The consolidation process will be completed in 1994. RESEARCH AND DEVELOPMENT For the years ended December 31, 1993, 1992 and 1991, Chrysler spent $1.2 billion, $1.1 billion, and $955 million, respectively, for company-sponsored research and development activities. These activities relate to the development of new products and services and the improvement of existing products and services, as well as compliance with standards that have been and are being promulgated by the government. EMPLOYEES At December 31, 1993, Chrysler and its consolidated subsidiaries had a total of approximately 128,000 employees worldwide, approximately 91,000 of which were employed in the United States. In the United States and Canada, approximately 93 percent of Chrysler's hourly employees and 21 percent of its salaried employees are represented by unions. Of these represented employees, 98 percent of hourly and 90 percent of salaried employees are represented by the United Automotive, Aerospace, and Agricultural Implement Workers of America ("UAW") or the National Automobile, Aerospace and Agricultural Implement Workers of Canada ("CAW"). In 1993, Chrysler negotiated three-year national agreements with the UAW and CAW in the United States and Canada, respectively, without an interruption of production. The UAW contract patterns the prior 1990 agreement in that it provides moderate wage and pension benefit improvements, and retains the job and income security protection program and health care coverage. The job and income security benefit caps were negotiated at the previous contract amount of $660 million with new Supplemental Unemployment Benefits Contingency Accounts of $106 million. The contract also adopted provisions expected to abate future increases in labor costs including Cost of Living Allowance diversions, lower wage rates for new hires, and a broadened approach to managed health care. Item 1. BUSINESS - Continued Part I - Continued Employees - Continued Chrysler estimates that, when the UAW contract expires September 14, 1996, its total hourly labor costs, including employee and retiree benefits, will have increased approximately 14 percent over the estimated $44 per hour in effect when the prior UAW contract expired September 14, 1993. Chrysler projects its labor cost at the end of the contract to be competitive compared to the domestic automobile manufacturers' average. Chrysler's pension plans, group life, and health care benefits for active, inactive, and retired employees generally follow the structure of benefits common to the automotive industry. See Part II, Item 8, Notes to Consolidated Financial Statements, Notes 1, 11 and 12 for further information on postemployment benefits, pension plans, and postretirement benefits. INTELLECTUAL PROPERTY Chrysler has intellectual property rights which include patents, proprietary technology, trademarks, service marks, copyrights, and licenses under such rights of others, relating to its businesses, products, and manufacturing equipment and processes. Chrysler grants licenses to others under its intellectual property rights and receives fees and royalties under some of these licenses. While Chrysler does not consider any particular intellectual property right to be essential, it does consider the aggregate of such rights important to the overall conduct of its businesses. Item 2.		Item 2. PROPERTIES AUTOMOTIVE OPERATIONS The statements concerning ownership of Chrysler's properties are made without regard to taxes or assessment liens, rights of way, contracts, easements or like encumbrances or questions of survey and are based on the records of Chrysler. Chrysler knows of no material defects in title to, or adverse claims against, any of such properties, nor any existing material liens or encumbrances against Chrysler or its properties, except the mortgage loan on Chrysler's Sterling Heights Assembly Plant (Sterling Heights, Michigan), and a mortgage granted to a state industrial development authority and various banks on the vehicle paint facility at its Toledo Assembly Plant (Toledo, Ohio). Chrysler's credit agreement with its commercial banks enables the banks to obtain a security interest, to be shared equally and ratably with holders of other senior indebtedness and guarantees of Chrysler, in Chrysler's principal domestic plants and related machinery, equipment and tooling under certain circumstances, including when borrowings under the amended agreement exceed $500 million, and if Chrysler's senior debt does not have investment grade credit ratings. None of the commitment was drawn upon at December 31, 1993. Chrysler's manufacturing plants include a foundry, machining plants, metal stamping plants, engine plants, transmission plants, trim plants, electronic parts plants, an air conditioning equipment plant, a glass fabricating plant and other component parts plants. In addition to Michigan, other manufacturing plants in the United States are located in Alabama, Illinois, Indiana, New York, Ohio, Texas and Wisconsin. Chrysler's U.S. passenger car assembly plants are located in Sterling Heights and Detroit, Michigan; Belvidere, Illinois and Newark, Delaware. The U.S. truck assembly plants are located in Warren and Detroit, Michigan; Fenton, Missouri; and Toledo, Ohio. An assembly facility located in Fenton, Missouri was idled in 1991. The parts depots, warehouses and sales offices are situated in various sections of the United States, while Chrysler's principal engineering and research facilities and its general offices are located in Michigan. Automotive properties outside the U.S. are owned or leased principally by Chrysler Canada and Chrysler Mexico. Other manufacturing and assembly plants of subsidiaries outside the U.S. are located in Venezuela and Austria. In 1991, Chrysler dedicated its new technology center in Auburn Hills, Michigan and began the relocation of employees into the facility. By the end of 1993, Chrysler had moved 99.6 percent of the employees expected to occupy the technology center. The initial project is in the final stages of completion and will be completed in the first half of 1994. The center includes design, vehicle engineering, manufacturing engineering and pilot build facilities associated with the development of new Chrysler cars and trucks, and has total floor space of 3.3 million square feet. In the third quarter of 1992, the Board of Directors approved a subsequent project to build an administrative building which is currently under construction. In the opinion of management, Chrysler's properties include facilities which are suitable and adequate for the conduct of its present assembly and component plant requirements. Item 2. PROPERTIES - Continued Part I - Continued FINANCIAL SERVICES At December 31, 1993, the following facilities were utilized by CFC in conducting its business: (a) executive offices of CFC, Chrysler Credit, Chrysler Insurance and certain other domestic subsidiaries of CFC in Southfield, Michigan; (b) a total of 86 branches of Chrysler Credit located throughout the United States; (c) headquarters of remaining Chrysler First operations in Allentown, Pennsylvania, and a total of 3 offices of such corporation in the United States; (d) headquarters of Chrysler Capital in Stamford, Connecticut and a total of 16 offices of such corporation located throughout the United States; (e) headquarters of Chrysler Realty in Troy, Michigan; and (f) a total of 15 offices used as headquarters and branch offices in Canada, Mexico and Puerto Rico. All of the facilities described above were leased by CFC. At December 31, 1993, a total of 297 automobile dealership properties generally consisting of land and improvements were owned by Chrysler Realty for lease to dealers franchised by Chrysler. Item 3.	Item 3. LEGAL PROCEEDINGS Chrysler and its subsidiaries are parties to various legal proceedings, including some purporting to be class actions, and some which demand large monetary damages or other relief that would require significant expenditures. Chrysler believes that each of the product and environmental proceedings described below constitutes ordinary routine litigation incidental to the business conducted by Chrysler and its subsidiaries. See also Note 8 of Notes To Consolidated Financial Statements. Product Matters Many of the legal proceedings seek damages for personal injuries claimed to have resulted from alleged defects in the design or manufacture of products distributed by Chrysler. The complaints filed in such matters specify approximately $930 million in compensatory and $965 million in punitive damages in the aggregate as of December 31, 1993. These amounts represent damages sought by plaintiffs and, therefore, do not necessarily constitute an accurate measure of Chrysler's ultimate cost to resolve such matters. Further, many complaints do not specify a dollar amount of damages or specify only the jurisdictional minimum. These amounts may vary significantly from one period to the next depending on the number of new complaints filed or pending cases resolved in a given period. Numerous complaints seek damages for personal injuries sustained in accidents involving alleged rollovers of Jeep CJ vehicles. These complaints represent approximately $335 million of the compensatory and $763 million of the punitive damages specified above. Pursuant to an indemnification agreement with Chrysler, Renault has agreed to indemnify Chrysler against a portion of certain costs arising from accidents involving alleged Jeep CJ vehicle rollovers occurring between April 1, 1985 and March 31, 1994. Many of the remaining complaints seek compensatory and punitive damages for personal injuries sustained in accidents involving alleged defects in occupant restraint systems, seats, heater cores, or various other components in several different vehicle models. Some complaints seek repair of the vehicles or compensation for the alleged reduction in vehicle value. Chrysler may ultimately incur significant expenditures over an extended period of time in connection with the foregoing matters, and therefore has established reserves which it believes will be sufficient to resolve such matters. After giving effect to these reserves, management believes, based on currently known facts and circumstances, that the disposition of these matters will not have a material adverse effect on Chrysler's consolidated financial condition. Future developments could cause Chrysler to change its estimate of the ultimate cost of resolving these matters, and such changes could be material to Chrysler's consolidated results of operations for the period in which such developments occur. Item 3. LEGAL PROCEEDINGS -Continued Part I - Continued Environmental Matters The United States Environmental Protection Agency and various state agencies have notified Chrysler that it may be a potentially responsible party ("PRP") for the cost of cleaning up hazardous waste storage or disposal facilities pursuant to the Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA") and other federal and state environmental laws. Chrysler is also a party to a number of lawsuits in various jurisdictions which allege conduct by Chrysler in violation of CERCLA or other environmental laws which seek to recover costs associated with remedial action. In virtually all instances, Chrysler is only one of a number of PRPs who may be found to be jointly and severally liable for remediation costs at the 116 sites involved in the foregoing matters at December 31, 1993. Chrysler may also incur remediation costs at an additional 45 of its active or deactivated facilities. In particular, the Ohio Environmental Protection Agency notified Chrysler on October 12, 1993 of its intention to institute a proceeding concerning a Chrysler facility in Dayton, and the Indiana Department of Environmental Management initiated an administrative proceeding in August 1985 concerning a Chrysler facility in Indianapolis. Each proceeding alleges improper disposal of waste, and each may result in the imposition of civil penalties in excess of $100,000. The Indiana proceeding also seeks to require Chrysler to conduct a site assessment and undertake remedial action. Estimates of future costs of pending environmental matters are necessarily imprecise due to numerous uncertainties, including the enactment of new laws and regulations, the development and application of new technologies, and the apportionment and collectibility of remediation costs among responsible parties. Chrysler may ultimately incur significant expenditures over an extended period of time in connection with the foregoing environmental matters, and therefore has established reserves totalling $287 million for the estimated costs associated with all of its environmental remediation efforts. Chrysler believes that these reserves will be sufficient to resolve these matters. After giving effect to these reserves, management believes, based on currently known facts and circumstances and existing laws and regulations, that the disposition of these matters will not have a material adverse effect on Chrysler's consolidated financial position. Future developments could cause Chrysler to change its estimate of the total costs associated with these matters, and such changes could be material to Chrysler's consolidated results of operations for the period in which such developments occur. Other Matters In December 1990 and January 1991, eight class action lawsuits were commenced by separate plaintiffs against Chrysler and certain of its directors in the Court of Chancery of the State of Delaware for New Castle County, Delaware. The Complaints in these suits are very similar and allege that the directors breached their fiduciary duties to stockholders by amending Chrysler's Share Purchase Rights Plan in a manner designed to entrench themselves in office and to impair the right of stockholders to avail themselves of offers to purchase their shares by an acquiror not favored by management. The Complaints ask for (a) certification of the class, (b) rescission of and an injunction against implementation of the Rights Plan amendments, (c) an order that Chrysler cooperate with Kirk Kerkorian, the holder of 9.8% of Chrysler's common stock at the time the complaints were filed, and take steps to enhance its attractiveness as a merger/acquisition candidate, and (d) damages and costs. On January 9, 1991, the eight suits were consolidated into one. On January 28, 1991, Chrysler filed an Answer and Affirmative Defenses in the consolidated case. On March 7, 1991, the parties agreed to allow an Amended Complaint to be filed which purports to assert a derivative claim brought on behalf of Chrysler, in addition to class action claims as originally filed. In this regard, the Amended Complaint alleges injury to Chrysler as a direct result of violations of fiduciary duties by the individual defendants. On July 25, 1991, Chrysler filed a motion to dismiss the consolidated lawsuit. On July 27, 1992, the Court entered a memorandum opinion dismissing the complaint as to all claims for relief other than rescission. Chrysler later filed a Motion for Reargument which was denied on August 11, 1992. The Corporation and the named directors are continuing with the defense of this matter. Item 4.	Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None during the fourth quarter ended December 31, 1993. EXECUTIVE OFFICERS OF THE REGISTRANT (AS OF FEBRUARY 4, 1994) __________________________ * The "Officer Since" date shown is the date from which the named individual has served continuously as an officer of either Chrysler Corporation or the former Chrysler Motors Corporation which, effective December 31, 1989, was merged with and into Chrysler Corporation. ** Also a member of the Board of Directors. There are no family relationships, as defined for reporting purposes, between any of the executive officers named above and there is no arrangement or understanding between any of the executive officers named above and any other person pursuant to which he was selected as an officer. All of the executive officers named above, except Messrs. Eaton and Pawley, have been in the employ of Chrysler Corporation or its subsidiaries for more than five years. During the last five years, and immediately preceding employment by Chrysler Corporation, Mr. Eaton was a high-level executive at General Motors Corporation and Mr. Pawley was employed as a high-level manufacturing executive by the Otis Group, United Technologies Corporation and prior to that time as an executive for the Mazda Motor Corporation. PART II Item 5.	Item 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Chrysler's common stock is listed on the stock exchanges specified on pages 1 and 2 of this Form 10-K under the trading symbol (C). The approximate number of shareholders of Chrysler's common stock at December 31, 1993 was 145,000. The following table sets forth the high and low sale prices of Chrysler's common stock as reported on the composite tape and the quarterly dividends declared for the last two years. On December 2, 1993, Chrysler's Board of Directors increased the quarterly dividend on Chrysler's common stock to $0.20 per share. The quarterly dividend had been $0.15 per common share since the first quarter of 1991. Dividends on the common stock are payable at the discretion of the Chrysler's Board of Directors out of funds legally available therefor. Chrysler's ability to pay dividends in the future will depend upon its financial results, liquidity and financial condition and its ability to meet its new product development and facility modernization spending programs. Chrysler's ability to pay dividends is also affected by the provision in its credit agreement that it must maintain net worth (as defined) at the end of each quarter at certain specified levels. Item 6.	Item 6. SELECTED FINANCIAL DATA Part II - Continued The table below summarizes recent financial information for Chrysler. For further information, refer to Chrysler's consolidated financial statements and notes thereto presented under Item 8 of this Form 10-K. ___________________________ (1) Results for the year ended December 31, 1993 include a pre-tax gain of $205 million ($128 million after applicable income taxes) on the sale of Chrysler's remaining 50.3 million shares of MMC stock, a pre-tax gain of $60 million ($39 million after applicable income taxes) on the sale of the plastics operations of Chrysler's Acustar division, a $4.68 billion after-tax charge for the adoption of Statement of Financial Accounting Standards ("SFAS") No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," and a $283 million after-tax charge for the adoption of SFAS No. 112, "Employers' Accounting for Postemployment Benefits." (2) Earnings for the year ended December 31, 1992 include a pre-tax gain of $142 million ($88 million after applicable income taxes) on the sale of 43.6 million shares of MMC stock, a $218 million favorable effect of a change in accounting principle relating to the adoption of SFAS No. 109, "Accounting for Income Taxes," a $101 million pre-tax charge ($79 million after applicable income taxes) relating to the restructuring of Chrysler's short- term vehicle rental subsidiaries, and a $110 million pre-tax charge ($69 million after applicable income taxes) relating to investment losses experienced by Chrysler Canada. (3) Results for the year ended December 31, 1991 include a pre-tax gain of $205 million ($127 million after applicable income taxes) on the sale of Chrysler's 50 percent equity interest in Diamond-Star, the favorable effect of a $391 million ($242 million after applicable income taxes) noncash, nonrecurring credit provision relating to a plant capacity adjustment and a $257 million after-tax charge for the cumulative effect of a change in accounting principle related to the timing of the recognition of the costs of special sales incentive programs. (4) Earnings for the year ended December 31, 1990 include a pre-tax return to income of $101 million ($63 million after applicable income taxes) resulting from a reduction in the estimated costs recognized in 1989 in connection with the restructuring of Chrysler's automotive operations. (5) Earnings for the year ended December 31, 1989 include a pre-tax charge of $931 million ($577 million after applicable income taxes) for costs associated with a restructuring of Chrysler's automotive operations and a pre-tax gain of $503 million ($309 million after applicable income taxes) on the sale of 75 million shares of MMC stock. Item 7.	Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL Part II - Continued CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis should be read in conjunction with the consolidated financial statements and notes thereto. FINANCIAL REVIEW Chrysler reported earnings before income taxes and the cumulative effect of changes in accounting principles of $3.8 billion in 1993, compared with $934 million in 1992. The earnings in 1993 included a gain on sales of automotive assets and investments of $265 million. Earnings in 1992 included a gain on the sale of an automotive investment of $142 million, a $110 million charge for reducing investments of Chrysler Canada, and certain of its employee benefit plans in a real estate investment concern to their estimated net realizable value, and a $101 million restructuring charge related to the realignment of the Car Rental Operations. Excluding the effect of these items, Chrysler's pre-tax earnings for 1993 and 1992 were $3.6 billion and $1.0 billion, respectively. The improvement in 1993 over 1992 was primarily the result of a substantial increase in unit sales volume, pricing actions, including significantly lower per unit sales incentives, and an improved mix of higher-margin products, partially offset by increased labor and benefit costs. Chrysler's worldwide factory car and truck sales increased 14 percent during 1993 to 2,475,738 units. U.S. and Canadian dealers' days supply of vehicle inventory decreased to 63 days at December 31, 1993 from 72 days at December 31, 1992. Including the provision for income taxes and the cumulative effect of changes in accounting principles, Chrysler reported a net loss for 1993 of $2.6 billion, or $7.62 per common share, compared with net earnings of $723 million, or $2.21 per common share, for 1992. The net loss for 1993 resulted from a charge of $4.68 billion, or $13.57 per common share, for the cumulative effect of a change in accounting principle related to the adoption of SFAS No. 106, "Employers'Accounting for Postretirement Benefits Other Than Pensions." Also included in the 1993 results was a charge of $283 million, or $0.82 per common share, for the cumulative effect of a change in accounting principle relating to the adoption of SFAS No. 112, "Employers' Accounting for Postemployment Benefits." Net earnings for 1992 included a $218 million, or $0.74 per common share, favorable cumulative effect of a change in accounting principle relating to the adoption of SFAS No. 109, "Accounting for Income Taxes." During 1993, North American vehicle industry retail sales were 15.4 million cars and trucks, an increase of 7.7 percent from the 14.3 million units sold in 1992. In addition to the improvements in the overall automotive industry, Chrysler's U.S. and Canada combined retail car and truck market share increased 1.4 percentage points in 1993, as shown below: ________________________________ (1) All market share data include fleet sales. The increase in U.S. retail car market share during 1993 resulted from the fall 1992 introduction and subsequent market success of Chrysler's upper-middle segment sedans, the Dodge Intrepid, Eagle Vision and Chrysler Concorde. The increase in U.S. truck market share in 1993 is the result of increased sales in the small sport-utility vehicle segment, primarily the result of the spring 1992 introduction and subsequent market success of the Jeep Grand Cherokee, partially offset by reduced sales in the small pickup segment, as a portion of the Dodge Dakota production was relocated among Chrysler's assembly facilities. In addition to these 1992 new product introductions, Chrysler launched the Chrysler New Yorker and Chrysler LHS, which compete in the large car segment, in the first quarter of 1993. During the fourth quarter of 1993, Chrysler introduced its all new full-size Dodge Ram pickup truck. New product introductions which will occur in 1994 include a new subcompact, the Dodge and Plymouth Neon, in January 1994 and an all new compact car platform in the third quarter of 1994, which will be marketed as the Chrysler Cirrus and Dodge Stratus. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL Part II - Continued CONDITION AND RESULTS OF OPERATIONS - Continued FINANCIAL REVIEW - Continued The earnings of CFC before income taxes and the cumulative effect of changes in accounting principles were $267 million in 1993, compared to $295 million in 1992. The decline in 1993 was primarily due to increased borrowing costs incurred under CFC's revolving credit agreements. CFC reported net earnings of $129 million and $231 million for 1993 and 1992, respectively. CFC's net earnings for 1993 included charges totaling $30 million for the adoptions of SFAS No. 106 and SFAS No. 112. Net earnings for 1992 included a $51 million favorable adjustment for the adoption of SFAS No. 109. During 1992 and 1993, Chrysler took various actions to strengthen its financial condition, improve liquidity and add to its equity base in order to ensure its ability to carry out its new product development and facility modernization programs without significant interruption. In the second and third quarters of 1993, Chrysler sold its remaining 50.3 million shares of MMC stock for net proceeds of $329 million and sold the plastics operations of its Acustar division for net proceeds of $132 million. In February 1993, Chrysler issued 52 million shares of common stock for net proceeds of $1.95 billion. In 1992, Chrysler sold 43.6 million shares of MMC stock for net proceeds of $215 million and issued 1.7 million shares of convertible preferred stock for net proceeds of $836 million. Both Chrysler and CFC regained investment grade credit ratings in 1993. The improved credit ratings reflect Chrysler's improved operating results, the significant improvements in Chrysler's balance sheet (including reductions in its outstanding debt and unfunded pension obligation), and CFC's improved liquidity. Chrysler's operating results have improved during 1992 and 1993, despite the slower than normal economic and automobile industry recoveries in the U.S. and declining automobile industry sales in Canada, Mexico and most European countries. The consensus of major economic forecasters suggests that automobile industry sales will continue to increase in the U.S. in 1994, and will begin to recover in Canada, Mexico and Europe. Chrysler's new products may enable it to benefit from these market improvements. However, due to Chrysler's dependence on the North American market, a deterioration in North American economic conditions would adversely affect Chrysler's operating results. COMPARISON OF SELECTED ELEMENTS OF REVENUE AND COSTS Chrysler's total sales and revenues were as follows: The increase in sales of manufactured products in 1993 primarily reflects the 14 percent increase in factory unit sales to 2,475,738 units in 1993. The 1992 increase is largely due to a 17 percent increase in factory unit sales from the 1,866,101 units in 1991. Average revenue per unit, net of sales incentives, was $16,461, $15,086 and $14,109 in 1993, 1992 and 1991, respectively. The increases in average revenue per unit in 1993 and 1992 were principally due to an improved mix of higher-priced products (primarily small sport-utility vehicles and upper-middle segment cars in 1993 and small sport-utility vehicles and minivans in 1992), lower per unit sales incentives and pricing actions. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL Part II - Continued CONDITION AND RESULTS OF OPERATIONS - Continued COMPARISON OF SELECTED ELEMENTS OF REVENUE AND COSTS - Continued The decreases in finance and insurance income in 1993 and 1992 were primarily attributable to lower levels of earning assets and declining interest rates. Total automotive financing volume in 1993, 1992 and 1991 was $59.8 billion, $46.6 billion and $41.5 billion, respectively. The increase in automotive financing volume over the last two years was largely due to higher amounts of wholesale financing provided to automotive dealers. Financing support provided in the United States by CFC for new Chrysler vehicle retail deliveries (including fleet) and wholesale vehicle sales to dealers and the number of vehicles financed during the last three years were as follows: Other income, which was relatively consistent between 1993 and 1992, primarily represents revenues generated by the Car Rental Operations. The increase in 1992 over 1991 was due to the acquisition of General Rent-A-Car in March 1991. Total costs and expenses were as follows: Costs, other than items below increased in 1993 primarily due to the 14 percent increase in factory unit sales volume and an increased proportion of sales of higher-priced products, primarily small sport-utility vehicles and upper-middle segment sedans. The increase in costs, other than items below in 1992 compared to 1991 was due to the 17 percent increase in factory unit sales volume and new-product-related pre-production and launch costs in 1992. Included in costs, other than items below in 1992 is a $110 million investment loss for reducing investments of Chrysler Canada and certain of its employee benefit plans in a real estate concern to their estimated net realizable value. Included in costs, other than items below in 1991 was a $391 million credit provision which resulted from a reduction in planned capacity adjustments related to facilities acquired in connection with Chrysler's acquisition of AMC in 1987. Excluding the 1992 investment loss and the 1991 plant capacity credit provision, costs, other than items below as a percent of net sales of manufactured products were 79 percent, 84 percent, and 91 percent in 1993, 1992 and 1991, respectively. These improvements were primarily due to increased capacity utilization and an increased mix of higher-margin products. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL Part II - Continued CONDITION AND RESULTS OF OPERATIONS - Continued COMPARISON OF SELECTED ELEMENTS OF REVENUE AND COSTS - Continued Depreciation of property and equipment for 1993 remained consistent with 1992, as increases resulting from Chrysler's capital spending program were offset by reductions at CFC resulting from the sales and downsizing of its nonautomotive financing operations. The increase in depreciation of property and equipment in 1992 compared to 1991 was principally the result of Chrysler's capital spending program, coupled with higher obsolescence costs at renovated facilities. Amortization of special tooling has remained relatively constant over the three years, as tooling amortization associated with new vehicles has approximated prior year write-offs of tooling related to discontinued models. Selling and administrative expenses in 1993 remained consistent with 1992, as increased employee costs were offset by reduced costs at CFC due to the downsizing of its nonautomotive financing operations. The increase in selling and administrative expenses in 1992 over 1991 was primarily due to increased employee costs and increased advertising expenses related to Chrysler's new products. Pension expense decreased in 1993 as compared to 1992 due to improved funding of the plans. Nonpension postretirement benefit expense increased significantly in 1993 due to the adoption of SFAS No. 106, which requires that the costs of health and life insurance benefits for retirees be accrued as expense in the period in which employees provide services. The decline in interest expense over the three years was primarily due to CFC's lower average borrowings. The reduced average borrowings in 1993 as compared to 1992 resulted from CFC's sales and downsizing of its nonautomotive financing operations, the proceeds from which were used to reduce outstanding indebtedness. The reduction in average borrowings in 1992 from 1991 was principally due to CFC's increased reliance on receivable sales as a funding source. CFC's average effective cost of borrowings was 8.6 percent, 7.8 percent and 8.7 percent in 1993, 1992 and 1991, respectively. Despite improved credit ratings and lower market interest rates, CFC's average effective cost of borrowings increased in 1993, primarily as a result of the amortization of up-front fees and costs associated with CFC's U.S. and Canadian revolving credit agreements commencing in August 1992 and January 1993, respectively. The decrease in the 1992 average effective cost of borrowings from 1991 was the result of lower market interest rates. The results of operations for 1992 included a restructuring charge of $101 million relating to the realignment of the Car Rental Operations under Pentastar Transportation Group and the consolidation and phase-out of certain of these operations. This restructuring charge included the write-down of goodwill, lease termination costs, losses associated with the disposal of tangible assets, and other related charges. Operating results for 1993, 1992 and 1991 included gains on sales of automotive assets and investments of $265 million, $142 million and $205 million, respectively. The 1993 gain was comprised of the $205 million pre-tax gain on the sales of an aggregate of 50.3 million shares of MMC stock and a $60 million pre-tax gain on the sale of the plastics operations of Chrysler's Acustar division. The 1992 gain represented the pre-tax gain on the sale of 43.6 million shares of MMC stock. The 1991 gain resulted from Chrysler's sale of its 50 percent equity interest in Diamond-Star to MMC, its partner in the joint venture. Chrysler's effective tax rate was 37.1 percent in 1993, compared with 45.9 percent in 1992 and 33.5 percent in 1991. The decrease in the effective tax rate in 1993 was largely due to the favorable adjustment of Chrysler's deferred tax assets and liabilities to the new 35 percent U.S. income tax rate, partially offset by the increase in the 1993 income tax provision to reflect this one percent increase in the U.S. income tax rate. Nondeductible expenses, primarily goodwill amortization were higher in 1992 as compared to 1993 and 1991. LIQUIDITY AND CAPITAL RESOURCES Chrysler's combined cash, cash equivalents and marketable securities totaled $5.1 billion at December 31, 1993 (including $613 million held by CFC), an increase of $1.4 billion from December 31, 1992. The increase in 1993 was the result of cash generated by operating activities, the issuance of 52 million shares of new common stock and the sale of assets and investments, partially offset by debt repayments, pension contributions and capital expenditures. During 1992, Chrysler increased its consolidated cash, cash equivalents and marketable securities by $614 million, as cash generated by operating activities, the issuance of 1.7 million shares of convertible preferred stock and the sale of automotive assets exceeded capital expenditures and debt repayments. Chrysler believes that cash from operations and its cash position will provide sufficient liquidity to meet its funding requirements. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL Part II - Continued CONDITION AND RESULTS OF OPERATIONS - Continued LIQUIDITY AND CAPITAL RESOURCES - Continued Both Chrysler and CFC regained investment grade credit ratings in 1993. The improved credit ratings reflect Chrysler's improved operating results, the significant improvements in Chrysler's balance sheet (including reductions in its outstanding debt and unfunded pension obligation), and CFC's improved liquidity. Chrysler's long-term profitability will depend on its ability to introduce and market its products successfully. Chrysler expects to spend approximately $20 billion over the next five years for new product development and the acquisition of productive assets. At December 31, 1993, Chrysler had commitments for capital expenditures, including commitments for assets currently under construction, totaling $1.1 billion. Chrysler's projected pension benefit obligation in excess of pension plan assets was $2.2 billion at December 31, 1993, as compared to $3.9 billion at December 31, 1992. This reduction in the unfunded pension obligation during 1993 resulted from Chrysler's contributions of $3.5 billion to the pension fund, which exceeded the significant increases in the projected pension benefit obligation caused by a reduction in the discount rate used to measure such obligations and pension benefit increases which were included in Chrysler's new national labor agreements with its principal collective bargaining units. Chrysler's objective is to fully fund its remaining unfunded pension obligation by the end of 1995. At December 31, 1993, Chrysler (excluding CFC) had debt maturities of $500 million in 1994, $412 million in 1995 and $42 million in 1996. Chrysler (excluding CFC) redeemed early $769 million of its outstanding debt during the fourth quarter of 1993. On June 30, 1993, Chrysler entered into an agreement with its bank lenders which extended the maturity of its $1.5 billion bank facility to June 30, 1996. At Chrysler's option, up to 50 percent of the total commitment under the amended agreement may be used by CFC. The agreement enables the banks to obtain a security interest, to be shared equally and ratably with holders of other senior indebtedness and guarantees of Chrysler, in Chrysler's principal domestic plants and related machinery, equipment and tooling, Chrysler's equity interest in CFC and certain other assets under certain circumstances, including when borrowings under the agreement exceed $500 million, and if Chrysler's senior debt does not have investment grade credit ratings. Under the agreement, Chrysler is subject to, and has complied with, financial covenants relating to minimum net worth and the ratio of liabilities and guarantees to net worth. None of the commitment was drawn upon during 1993. Chrysler's ability to market its products successfully depends significantly on the availability of inventory financing for its dealers and, to a lesser extent, the availability of financing for retail and fleet customers, both of which CFC provides. CFC's liquidity improved during 1993 following the sales and downsizing of its nonautomotive financing operations and the achievement of investment grade credit ratings. CFC's improved access to the credit markets enabled it to issue $2.3 billion of term debt and increase the level of its short-term notes (primarily commercial paper) outstanding to $2.8 billion. Receivable sales continued to be a significant source of funding, as CFC realized $7.8 billion of net proceeds from the sale of automotive retail receivables during 1993, as compared to $5.8 billion of net proceeds from the sale of automotive and nonautomotive retail receivables during 1992. In addition, CFC's revolving wholesale receivable sale arrangements provided funding which aggregated $4.6 billion and $4.3 billion at December 31, 1993 and 1992, respectively. During 1993, $2.4 billion in aggregate cash proceeds were received from the sale of substantially all of the net assets of the consumer and inventory financing businesses of Chrysler First and the sale of certain assets of Chrysler Capital. Proceeds from these sales were used to reduce outstanding indebtedness. At December 31, 1993, CFC had U.S. and Canadian credit facilities aggregating $5.2 billion, consisting of contractually committed U.S. credit lines of $4.7 billion expiring in August 1995 and $489 million of Canadian credit lines expiring in December 1995. CFC also has receivable sale agreements totaling $2.9 billion, consisting of a $2.5 billion U.S. automotive receivable sale agreement (which will be reduced to $1.25 billion in September 1994) which expires in September 1996, and a $414 million Canadian receivable sale agreement which expires in December 1995. At December 31, 1993, none of CFC's U.S. and Canadian credit facilities or receivable sale agreements were utilized. At December 31, 1993, CFC had debt maturities of $4.1 billion in 1994 (including $2.8 billion of short-term notes), $626 million in 1995, and $1.0 billion in 1996. CFC believes that cash provided by operations, receivable sales, issuance of term debt, and issuance of commercial paper backed by unused revolving credit facilities will provide sufficient liquidity. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL Part II - Continued CONDITION AND RESULTS OF OPERATIONS - Continued NEW ACCOUNTING STANDARDS In May 1993, the Financial Accounting Standards Board ("FASB") issued SFAS No. 114, "Accounting by Creditors for Impairment of a Loan," effective for fiscal years beginning after December 15, 1994. This new accounting standard requires creditors to evaluate the collectibility of both contractual interest and principal of receivables when evaluating the need for a loss accrual. Chrysler has not determined the impact that the adoption of this accounting standard will have on its consolidated operating results or financial position. Chrysler plans to adopt this standard on or before January 1, 1995, as required. In May 1993, the FASB issued SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," effective for fiscal years beginning after December 15, 1993. This accounting standard specifies the accounting and reporting requirements for changes in the fair values of investments in certain debt and equity securities. Based upon its initial assessment, Chrysler believes that the implementation of this new accounting standard will not have a material impact on its consolidated operating results and financial position. Chrysler plans to adopt this standard effective January 1, 1994, as required. Item 8.	Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY Part II - Continued DATA CHRYSLER CORPORATION AND CONSOLIDATED SUBSIDIARIES CONSOLIDATED STATEMENT OF EARNINGS (in millions of dollars) ____________________ Amounts for the prior periods have been reclassified to conform with current period classifications. See notes to consolidated financial statements. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY Part II - Continued DATA - Continued CHRYSLER CORPORATION AND CONSOLIDATED SUBSIDIARIES CONSOLIDATED BALANCE SHEET (in millions of dollars) _______________________ Amounts for the prior period have been reclassified to conform with current period classifications. See notes to consolidated financial statements. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY Part II - Continued DATA - Continued CHRYSLER CORPORATION AND CONSOLIDATED SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS (in millions of dollars) ______________________ Amounts for the prior periods have been reclassified to conform with current period classifications. See notes to consolidated financial statements. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY Part II - Continued DATA - Continued CHRYSLER CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1. Summary of Significant Accounting Policies Consolidation and Financial Statement Presentation The consolidated financial statements of Chrysler Corporation and its consolidated subsidiaries ("Chrysler") include the accounts of all significant majority-owned subsidiaries and entities. Intercompany accounts and transactions have been eliminated in consolidation. Revenue Recognition Vehicle and parts sales are generally recorded when such products are shipped to dealers. Provisions for normal dealer sales allowances are made at the time of sale and treated as sales reductions. Prior to 1991, the cost of special sales incentive programs was recognized when a retail sale was made. Due to the increased frequency and significance of special sales incentive programs, Chrysler changed its method of accounting, effective January 1, 1991, to recognize the cost of such programs as sales reductions at the time a vehicle is sold to a dealer. The cumulative effect of this change in accounting principle resulted in an after-tax charge of $257 million, or $1.06 per common share. Interest income from owned finance receivables is recognized using the interest method. Lending fees and certain direct loan origination costs are deferred and amortized to interest income using the interest method over the contractual terms of the finance receivables. Recognition of interest income is generally suspended when a loan becomes contractually delinquent for periods ranging from 60 to 90 days. Income recognition is resumed when the loan becomes contractually current, at which time all past due interest income is recognized. Chrysler Financial Corporation ("CFC"), a wholly-owned subsidiary of Chrysler, sells significant amounts of automotive receivables subject to limited recourse provisions. CFC generally sells its receivables to a trust, and remains as servicer, for which it is paid a servicing fee. In a subordinated capacity, CFC retains excess servicing cash flows, a limited interest in the principal balances of the sold receivables and certain cash deposits provided as credit enhancements for investors. Gains or losses from the sale of retail receivables are recognized in the period that such sale occurs. In determining the gain or loss for each qualifying sale, the investment in the sold receivable pool is allocated between the portion sold and the portion retained based on their relative fair values on the date of sale. Gains on sales of wholesale receivables are not material. The portion of the receivables sold is removed from the balance sheet. Depreciation and Tool Amortization Property and equipment are stated at cost less accumulated depreciation. Depreciation is generally provided on a straight-line basis. At December 31, 1993, the weighted-average service lives of assets were 32 years for buildings (including improvements and building equipment), 11 years for machinery and equipment and 12 years for furniture and fixtures. Special tooling costs are amortized over the years that a model using that tooling is expected to be produced, and within each year based on the units produced. Amortization is deducted directly from the asset account. During any given model year, special tools will contain tooling with varying useful lives. Product-Related Costs Expenditures for advertising, sales promotion and other product-related costs are expensed as incurred. Estimated costs of product warranty are accrued at the time of sale. Research and development costs are expensed as incurred and were $1.2 billion, $1.1 billion, and $955 million in 1993, 1992, and 1991, respectively. Cash and Cash Equivalents Highly liquid investments with an original maturity of three months or less from the date of purchase are classified as cash equivalents. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY Part II - Continued DATA - Continued Note 1. Summary of Significant Accounting Policies - Continued Marketable Securities Marketable equity securities are carried at cost, which approximates market. Debt securities are carried at cost adjusted for amortized premium or discount and accrued interest. Allowance for Credit Losses An allowance for credit losses is generally established during the period in which finance receivables are acquired. The allowance for credit losses is maintained at a level deemed appropriate based on loss experience and other factors. Retail automotive receivables not supported by a dealer guaranty are charged to the allowance for credit losses net of the estimated value of repossessed collateral at the time of repossession. Nonautomotive finance receivables are reduced to the estimated fair value of the collateral when determined to be uncollectible. Inventories Inventories are valued at the lower of cost or market. The cost of approximately 42 percent and 44 percent of inventories at December 31, 1993 and 1992, respectively, was determined on a Last-In, First-Out ("LIFO") basis. The balance of inventory cost was determined on a First-In, First-Out ("FIFO") basis. Intangible Assets The purchase price of companies in excess of the value of net tangible assets acquired is amortized on a straight-line basis over periods of up to 40 years. The amount is reported net of accumulated amortization of $643 million and $558 million at December 31, 1993 and 1992, respectively. As a result of the adoption of Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes," previously unrecognized net operating loss ("NOL") and tax credit carryforwards totaling $188 million, which were purchased as part of acquisitions, have been recorded as a reduction to goodwill. As part of Chrysler's purchase in 1987 of the interest of Regie Nationale des Usines Renault ("Renault") in American Motors Corporation ("AMC"), Chrysler made a $211 million payment in 1992 to Renault, which was recorded as an adjustment to intangible assets, based on the volume of sales of certain Jeep vehicles manufactured from 1987 through 1991. Intangible assets also included an intangible pension asset of $2.1 billion and $2.3 billion at December 31, 1993 and 1992, respectively. Postemployment Benefits Effective January 1, 1993, Chrysler adopted SFAS No. 112, "Employers' Accounting for Postemployment Benefits." This new accounting standard requires the accrual of benefits provided to former or inactive employees after employment but prior to retirement. Prior to 1993, Chrysler accrued for certain of these benefits at the time an employee's active service ended and expensed certain other benefits on the basis of cash expenditures. Adoption of this accounting standard resulted in the recognition of an after-tax charge of $283 million, or $0.82 per common share, for the cumulative effect of this change in accounting principle. Adoption of SFAS No. 112 resulted in a nominal increase in the annual expense recognized for these benefits and no cash impact. Off-Balance-Sheet Financial Instruments Chrysler enters into various interest rate and foreign currency exchange agreements to reduce its exposure to fluctuations in interest rates and foreign currency exchange rates. Net interest differentials to be paid or received relating to interest rate exchange agreements are accrued and included as interest expense. Debt obligations denominated in foreign currencies and subject to foreign currency swap agreements are included in the consolidated balance sheet at the contractual rate of exchange in the respective foreign currency swap agreement. Gains and losses on forward contracts and purchased options, designated as hedges of known or anticipated contractual obligations and export sales revenues, are deferred and included in the settlement of the related transaction. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY Part II - Continued DATA - Continued Note 2. Inventories and Cost of Sales Inventories, summarized by major classification, were as follows: Inventories valued on the LIFO basis would have been $259 million and $238 million higher than reported had they been valued on the FIFO basis at December 31, 1993 and 1992, respectively. Total manufacturing cost of sales aggregated $33.5 billion, $28.6 billion and $24.9 billion for 1993, 1992, and 1991, respectively. Note 3. Finance Receivables, Retained Interests in Sold Receivables and Other Related Amounts and Allowance for Credit Losses Finance receivables outstanding were as follows: Contractual maturities of total finance receivables outstanding as of December 31, 1993, were (in millions of dollars): 1994 - $1,863; 1995 - $1,421; 1996 - $743; 1997 - $513; 1998 - $376; thereafter - $1,767. Actual cash flow experience will vary from contractual cash flow due to future sales of finance receivables and prepayments. CFC's retained interests in sold receivables and other related amounts are generally restricted and subject to limited recourse provisions. Retained interests in sold receivables and other related amounts were comprised as follows: item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY Part II - Continued DATA - Continued Note 3. Finance Receivables, Retained Interests in Sold Receivables and Other Related Amounts and Allowance for Credit Losses - Continued Changes in the allowance for credit losses including receivables sold subject to limited recourse and amounts included as assets held for sale were as follows: Nonearning finance receivables, including receivables sold subject to limited recourse, totaled $333 million and $735 million at December 31, 1993 and 1992, respectively, which represented 1.21 percent and 2.49 percent of such receivables outstanding, respectively. In May 1993, the Financial Accounting Standards Board ("FASB") issued SFAS No. 114, "Accounting by Creditors for Impairment of a Loan," effective for fiscal years beginning after December 15, 1994. This new accounting standard requires creditors to evaluate the collectibility of both contractual interest and principal of receivables when evaluating the need for a loss accrual. Chrysler has not determined the impact that the adoption of this accounting standard will have on its consolidated operating results or financial position. Chrysler plans to adopt this standard on or before January 1, 1995, as required. Note 4. Property and Equipment Property and equipment, summarized by major classification, were as follows: Note 5. Accrued Liabilities and Expenses Accrued liabilities and expenses consisted of the following: Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY Part II - Continued DATA - Continued Note 6. Long-term Debt Long-term debt consisted of the following: The weighted average interest rates include the effects of interest rate exchange agreements and have been calculated on the basis of rates in effect at December 31, 1993. Interest rate exchange agreements have been entered into with major financial institutions, which are expected to fully perform under the terms of the agreements. These agreements are generally used as hedges and are matched with specific financial instruments. At December 31, 1993, the notional amount of Chrysler's portfolio of interest rate exchange agreements totaled $1.8 billion. While the notional amount is used to measure the volume of these agreements, it does not represent exposure to credit loss. CFC has entered into foreign currency swap arrangements which provide for payment of foreign currency principal and interest obligations in U.S. or Canadian dollars based on the contractual exchange rate in the respective agreement. As a result, the underlying debt obligations are recorded at the contractual rate totaling $535 million at December 31, 1993. If the debt obligations had been translated at the various exchange rates in effect at December 31, 1993, the recorded amount would have been $121 million higher. On June 30, 1993, Chrysler entered into an agreement with its bank lenders which extended the maturity of its $1.5 billion bank facility to June 30, 1996. At Chrysler's option, up to 50 percent of the total commitment under the amended agreement may be used by CFC. The agreement enables the banks to obtain a security interest, to be shared equally and ratably with holders of other senior indebtedness and guarantees of Chrysler, in Chrysler's principal domestic plants and related machinery, equipment and tooling, Chrysler's equity interest in CFC and certain other assets under certain circumstances, including when borrowings under the agreement exceed $500 million, and if Chrysler's senior debt does not have investment grade credit ratings. Under the agreement, Chrysler is subject to, and has complied with, financial covenants relating to minimum net worth and the ratio of liabilities and guarantees to net worth. None of the commitment was drawn upon at December 31, 1993. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY Part II - Continued DATA - Continued Note 6. Long-term Debt - Continued At December 31, 1993, CFC had contractually committed credit lines of $5.2 billion and receivable sale agreements of $2.9 billion. At December 31, 1993, CFC had no borrowings outstanding under any of its credit lines or receivable sale arrangements. At December 31, 1993, aggregate annual maturities of consolidated debt, including principal payments on capital leases, were as follows (in millions of dollars): 1994 - $4,580; 1995 - $1,038; 1996 - $1,103; 1997 - $516; 1998 - $737. Note 7. Income Taxes Effective January 1, 1992, Chrysler adopted SFAS No. 109, "Accounting for Income Taxes," which requires the liability method of accounting for deferred income taxes and the recognition of net deferred tax assets subject to an ongoing assessment of realizability. The principal difference between the liability method and the method previously used is that under the liability method, deferred tax assets and liabilities are adjusted to reflect changes in statutory tax rates, as income adjustments, in the period changes are enacted. At January 1, 1992, the adjustment of deferred tax assets and liabilities resulted in a favorable cumulative effect of the change in accounting principle of $218 million, or $0.74 per common share. Also during 1992, adjustments to deferred tax assets and liabilities recognized in retained earnings resulted in an increase of $37 million in shareholders' equity. Earnings (loss) before income taxes and cumulative effect of changes in accounting principles was attributable to the following sources: The provision (credit) for income taxes on earnings (loss) before income taxes and cumulative effect of changes in accounting principles in the consolidated statement of earnings included the following: Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY Part II - Continued DATA - Continued Note 7. Income Taxes - Continued Chrysler does not provide U.S. income tax or foreign withholding taxes on the undistributed earnings of foreign subsidiaries as such earnings of $1.6 billion are intended to be permanently reinvested in those operations. It is not practicable to estimate the amount of unrecognized deferred tax liability for the undistributed foreign earnings. A reconciliation of income taxes determined using the statutory U.S. rate (35 percent for 1993; 34 percent for 1992 and 1991) to actual income taxes provided was as follows: The tax-effected temporary differences and carryforwards which comprised deferred tax assets and liabilities were as follows: The valuation allowance was principally related to net operating loss carryforwards of certain domestic and foreign subsidiaries of $389 million at December 31, 1993, which may be used through the year 2008. At December 31, 1993, Chrysler had tax credit carryforwards of $342 million, which expire at various dates through the year 2008, and alternative minimum tax credit carryforwards of $825 million, which have no expiration date. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY Part II - Continued DATA - Continued Note 8. Commitments and Contingent Liabilities Litigation Various claims and legal proceedings have been asserted or instituted against Chrysler, including some purporting to be class actions, and some which demand large monetary damages or other relief which would require significant expenditures. Although the ultimate cost of resolving these matters cannot be precisely determined at December 31, 1993, Chrysler has established reserves which it believes will be sufficient to resolve these matters. After giving effect to these reserves, management believes, based on currently known facts and circumstances, that the disposition of these matters will not have a material adverse effect on Chrysler's consolidated financial position. Future developments could cause Chrysler to change its estimate of the ultimate cost of resolving these matters, and such changes could be material to Chrysler's consolidated results of operations for the period in which such developments occur. Environmental Matters The United States Environmental Protection Agency and various state agencies have notified Chrysler that it may be a potentially responsible party ("PRP") for the cost of cleaning up hazardous waste storage or disposal facilities pursuant to the Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA") and other federal and state environmental laws. Chrysler is also a party to a number of lawsuits filed in various jurisdictions alleging CERCLA or other environmental claims. In virtually all cases, Chrysler is only one of a number of PRPs who may be found to be jointly and severally liable. In addition, Chrysler has identified additional active or deactivated facilities at which it may be responsible for closure activities or cleaning up hazardous waste. Estimates of future costs of such environmental matters are necessarily imprecise due to numerous uncertainties, including the enactment of new laws and regulations, the development and application of new technologies, the identification of new sites for which Chrysler may have remediation responsibility and the apportionment and collectibility of remediation costs among responsible parties. Chrysler may ultimately incur significant expenditures over an extended period of time in connection with the foregoing environmental matters, and therefore has established reserves for the estimated costs associated with all of its environmental remediation efforts, including CERCLA and related matters, expected closure activities and voluntary environmental cleanup efforts. Chrysler believes that these reserves will be sufficient to resolve these matters. After giving effect to these reserves, management believes, based on currently known facts and circumstances and existing laws and regulations, that the disposition of these matters will not have a material adverse effect on Chrysler's consolidated financial position. Future developments could cause Chrysler to change its estimate of the total costs associated with these matters, and such changes could be material to Chrysler's consolidated results of operations for the period in which such developments occur. Other Matters The majority of Chrysler's lease payments are for operating leases. At December 31, 1993, Chrysler had the following minimum rental commitments under noncancelable operating leases (in millions of dollars): Future minimum lease commitments have not been reduced by minimum sublease rentals of $325 million due in the future under noncancelable subleases. Rental expense for operating leases, with original expiration dates beyond one year, was $410 million, $383 million and $343 million in 1993, 1992 and 1991, respectively. Sublease rentals of $61 million, $60 million, and $61 million were received in 1993, 1992, and 1991, respectively. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY Part II - Continued DATA - Continued Note 8. Commitments and Contingent Liabilities - Continued Other Matters - Continued Chrysler had commitments for capital expenditures, including commitments for facilities currently under construction, totaling $1.1 billion at December 31, 1993. At December 31, 1993, Chrysler had guaranteed obligations of others in the amount of $115 million, none of which are secured by collateral. Note 9. Stock Options and Performance-Based Compensation The Chrysler Corporation 1991 Stock Compensation Plan (the "1991 Plan") provides that Chrysler may grant stock options to officers, key employees and nonemployee directors and also may grant reload stock options (which are options granted when outstanding options are exercised by payment in stock), stock appreciation rights (payable in cash or stock, at the sole discretion of the Stock Option Committee) and limited stock appreciation rights (payable in cash in the event of a change in control). The 1991 Plan also provides for awarding restricted stock units and performance stock units, which reward service for specified periods or attainment of performance objectives. The Chrysler Corporation Stock Option Plan (the "Plan"), initially adopted in 1972 and readopted in 1982, was amended to incorporate certain features of the 1991 Plan. Under the Plan and the 1991 Plan, outstanding options, consisting of ten-year nonqualified stock options, have exercise prices of not less than 100 percent of the market value of Chrysler common stock at date of grant. Options generally become exercisable on up to 40 percent of the shares after one year from the date of grant, 70 percent after two years and 100 percent after three years. Information with respect to options granted under the Plan and the 1991 Plan was as follows: ________________________ * Includes conversion of AMC options outstanding at date of acquisition. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY Part II - Continued DATA - Continued Note 9. Stock Options and Performance-Based Compensation - Continued Shares available for granting options at the end of 1993, 1992, and 1991 were 1.5 million, 4.4 million, and 8.1 million, respectively. At December 31, 1993, 5.5 million options with prices ranging from $11.75 to $56.44 were not yet exercisable under the terms of the Plan and the 1991 Plan. In addition to the Plan and the 1991 Plan, Chrysler has programs under which additional compensation is paid to hourly and salaried employees based upon various measures of Chrysler's performance. Such performance-based compensation programs include incentive compensation and profit sharing paid to certain hourly and salaried employees. Note 10. Shareholders' Equity Information with respect to shareholders' equity was as follows (shares in millions): Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY Part II - Continued DATA - Continued Note 10. Shareholders' Equity - Continued The annual dividend on the Series A Convertible Preferred Stock (the "Convertible Preferred Stock") is $46.25 per share. The Convertible Preferred Stock is convertible unless previously redeemed, at a rate (subject to adjustment in certain events) of 27.78 shares of common stock for each share of Convertible Preferred Stock. The Convertible Preferred Stock is not redeemable prior to January 22, 1997. Thereafter, Chrysler may redeem the Convertible Preferred Stock, in whole or in part, at $523.13 per share of Convertible Preferred Stock for the period ending December 31, 1997, and thereafter declining ratably annually to $500.00 per share after December 31, 2001, plus accrued and unpaid dividends. In February 1988, the Board of Directors declared and distributed a dividend of one Preferred Share Purchase Right (a "Right") for each then outstanding share of Chrysler's common stock and authorized the distribution of one right with respect to each subsequently issued share of common stock. Each Right, as amended, entitles a shareholder to purchase one one-hundredth of a share of Junior Participating Cumulative Preferred Stock of Chrysler at a price of $120. The Rights are attached to the common stock and are not represented by separate certificates or exercisable until the earliest to occur of (i) 10 days after a person or group of persons acquires or obtains the right to acquire 10 percent or more of Chrysler's outstanding common stock, and (ii) 10 business days after a person or group announces or commences a tender offer that would result, if successful, in the bidder owning 10 percent or more of Chrysler's outstanding common stock. If the acquiring person or group acquires more than 10 percent of the common stock (except pursuant to a tender offer made for all of Chrysler's common stock, and determined by Chrysler's independent directors to be fair and in the best interests of Chrysler and its shareholders) each Right (other than those held by the acquiror) will entitle its holder to buy, for $120, a number of shares of Chrysler's common stock having a market value of $240. Similarly, if after the Rights become exercisable, Chrysler is acquired in a merger or other business combination and is not the surviving corporation, or 50 percent or more of its assets, cash flow or earning power is sold, each Right (other than those held by the surviving or acquiring company) will entitle its holder to purchase, for $120, shares of the surviving or acquiring company having a market value of $240. Chrysler's directors may redeem the Rights at $0.05 per Right, and may amend the Rights or extend the time during which the Rights may be redeemed until 10 business days following the date the Rights first become exercisable. Additionally, at any time after a person acquires 10 percent or more, but less than 50 percent, of Chrysler's common stock, Chrysler's directors may exchange the Rights (other than those held by the acquiror), in whole or in part, at an exchange ratio of one share of common stock per right. The Rights will expire on February 22, 1998. Of the 500 million shares of authorized common stock at December 31, 1993, 7.9 million shares were reserved for the Chrysler Salaried Employees' Savings Plan, 11.0 million shares were reserved for the 1991 Plan, 13.2 million shares were reserved for the Plan and 47.9 million shares were reserved for issuance on conversion of the Convertible Preferred Stock. CFC did not pay cash dividends to Chrysler in 1993, 1992 or 1991. Under CFC's credit facility, CFC is effectively prohibited from paying cash dividends. Earnings (loss) per common share amounts were computed by dividing earnings (loss) after deduction of preferred stock dividends by the average number of common and dilutive equivalent shares outstanding. Fully diluted per common share amounts assume conversion of the Convertible Preferred Stock, the elimination of the related preferred stock dividend requirement, and the issuance of common stock for all other potentially dilutive equivalents outstanding. Fully diluted per common share amounts are not applicable for loss periods. Note 11. Pension Plans Chrysler's pension plans provide noncontributory and contributory benefits. The noncontributory pension plans cover substantially all of the hourly and salaried employees of Chrysler and certain of its consolidated subsidiaries. Benefits are based on a fixed rate for each year of service. Additionally, contributory benefits and supplemental noncontributory benefits are provided to substantially all salaried employees of Chrysler and certain of its consolidated subsidiaries under the Salaried Employees' Retirement Plan. This plan provides contributory benefits based on the employee's cumulative contributions and a supplemental noncontributory benefit based on years of service during which employee contributions were made, and the employee's average salary during the consecutive five years in which salary was highest in the 15 years preceding retirement. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY Part II - Continued DATA - Continued Note 11. Pension Plans - Continued Annual contributions to the pension trust fund for U.S. plans are in compliance with the Employee Retirement Income Security Act of 1974, as amended. All pension trust fund assets and income accruing thereon are used solely to administer the plans and pay pension benefits. Chrysler made pension fund contributions totaling $3.5 billion in 1993, $816 million in 1992, and $327 million in 1991. The components of pension expense were as follows: Pension expense is determined using assumptions at the beginning of the year. The PBO is determined using the assumptions at the end of the year. Assumptions used to determine pension expense and the PBO were: The reduction in the discount rate for U.S. Plans from 8.38 percent as of December 31, 1992 to 7.38 percent as of December 31, 1993 resulted in a $1.0 billion increase in the PBO at December 31, 1993, and is expected to result in a $89 million increase in the 1994 expense. Scheduled increases in benefits under the 1993 U. S. collective bargaining agreements resulted in a $642 million increase in the PBO in 1993, and is expected to result in a $112 million increase in the 1994 expense. These increases in 1994 expense are expected to be more than offset by reductions in 1994 expense resulting from the increased fair value of U.S. plan assets at December 31, 1993, which is largely the result of Chrysler's contributions to the pension fund and higher than expected returns on plan assets in 1993. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY Part II - Continued DATA - Continued Note 11. Pension Plans - Continued The following table presents a reconciliation of the funded status of the plans with amounts recognized in the consolidated balance sheet: Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY Part II - Continued DATA - Continued Note 11. Pension Plans - Continued At December 31, 1993, plan assets were invested in a diversified portfolio that consisted primarily of debt and equity securities, including 19.2 million shares of Chrysler common stock. During 1993, 1992, and 1991, Chrysler offered voluntary early retirement opportunities to certain salaried and hourly employees. The cost of early retirement programs offered in 1993, 1992, and 1991 was $40 million, $48 million, and $158 million, respectively. Note 12. Postretirement Benefits Other Than Pensions Chrysler provides health insurance and life insurance benefits to substantially all of its hourly and salaried employees and those of certain of its consolidated subsidiaries. Upon retirement from Chrysler, employees may become eligible for continuation of these benefits. However, benefits and eligibility rules may be modified periodically. Prior to 1993, the expense recognized for these benefits was based primarily on cash expenditures for the period. Effective January 1, 1993, Chrysler adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("OPEB"), which requires the accrual of such benefits during the years the employees provide services. The adoption of this accounting standard resulted in an after-tax charge of $4.68 billion, or $13.57 per common share, in 1993. This one-time charge represented the immediate recognition of the OPEB transition obligation of $7.44 billion, partially offset by $2.76 billion of estimated tax benefits. The OPEB transition obligation is the aggregate amount that would have been accrued in the years prior to the adoption of SFAS No. 106, had this standard been in effect for those years. Implementation of SFAS No. 106 did not increase Chrysler's cash expenditures for postretirement benefits. Components of nonpension postretirement benefit expense were as follows for the year ended December 31, 1993 (in millions of dollars): The following table summarizes the components of the postretirement benefit obligation recognized in the consolidated balance sheet at December 31, 1993, and upon implementation of this standard on January 1, 1993: Note 12. Postretirement Benefits Other Than Pensions - Continued Nonpension postretirement benefit expense is determined using assumptions at the beginning of the year. The APBO is determined using the assumptions at the end of the year. Assumptions at December 31, 1993 were: The APBO at January 1, 1993 was determined using a discount rate of 8.6 percent. The reduction in the discount rate from 8.6 percent to 7.5 percent as of December 31, 1993 resulted in a $1.1 billion increase in the APBO in 1993, and is expected to result in a $53 million increase in nonpension postretirement benefit expense in 1994. A one percentage point increase in the assumed health care inflation rates in each year would increase the APBO by $1.1 billion and would increase the aggregate of the service and interest cost components of nonpension postretirement benefit expense in 1994 by $99 million. Note 13. Gain on Sales of Automotive Assets and Investments In 1993, Chrysler sold the plastics operations of its Acustar division for net proceeds of $132 million. The sale resulted in a pre-tax gain of $60 million ($39 million after applicable income taxes). Also during 1993, Chrysler sold its remaining 50.3 million shares of Mitsubishi Motors Corporation ("MMC") stock for net proceeds of $329 million, which resulted in a pre-tax gain of $205 million ($128 million after applicable income taxes). In 1992, Chrysler sold 43.6 million shares of MMC stock for net proceeds of $215 million. This sale resulted in a pre-tax gain of $142 million ($88 million after applicable income taxes). In 1991, Chrysler sold its 50 percent equity interest in Diamond-Star Motors Corporation ("DSM") to MMC, its partner in the joint venture, for $100 million. The sale resulted in a pre-tax gain of $205 million ($127 million after applicable income taxes). Chrysler was released from its guarantees of DSM's financial obligations. Note 14. Restructuring Charge The results of operations for the year ended December 31, 1992 included a $101 million pre-tax restructuring charge ($79 million after applicable income taxes) relating to the realignment of a part of Chrysler's short-term vehicle rental subsidiaries (the "Car Rental Operations") under Pentastar Transportation Group, Inc. and to provide for the consolidation and phase out of certain of those operations. This restructuring charge included the write-down of goodwill, lease termination costs, losses associated with the disposal of tangible assets and other related charges. Note 15. Investment and Plant Capacity Adjustments The results of operations for the year ended December 31, 1992 included a pre-tax charge of $110 million ($69 million after applicable income taxes) as a result of a reduction to the estimated net realizable value of investments of Chrysler Canada Ltd. and certain of its employee benefit plans in a real estate investment concern, which filed reorganization proceedings in February 1992 and was subsequently placed in bankruptcy, and in certain of its affiliated companies. In 1991, the results of operations included a noncash, nonrecurring pre-tax credit provision of $391 million ($242 million after applicable income taxes) which was the result of a reduction in planned capacity adjustments related to facilities which were acquired by Chrysler in connection with its purchase of AMC in 1987. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY Part II - Continued DATA - Continued Note 16. Supplemental Cash Flow Information Supplemental disclosures to the consolidated statement of cash flows were as follows: Note 17. Financial Instruments The following disclosure of the estimated fair value of financial instruments is made in accordance with the requirements of SFAS No. 107, "Disclosures About Fair Value of Financial Instruments." The estimated fair value amounts have been determined by Chrysler using available market information and the valuation methodologies described below. However, considerable judgment is required in interpreting market data to develop the estimates of fair value. Accordingly, the estimates presented herein may not be indicative of the amounts that Chrysler could realize in a current market exchange. The use of different assumptions or valuation methodologies may have a material effect on the estimated fair value amounts. The carrying amounts and estimated fair values of Chrysler's financial instruments were as follows: ________________________________ (1) The carrying value of finance receivables excludes $2.0 billion and $2.3 billion of direct finance and leveraged leases classified as finance receivables in Chrysler's Consolidated Balance Sheet at December 31, 1993 and 1992, respectively. (2) The carrying value of debt excludes $22 million and $30 million of obligations under capital leases classified as debt in Chrysler's Consolidated Balance Sheet at December 31, 1993 and 1992, respectively. The carrying values of cash and cash equivalents, accounts receivable and accounts payable approximated fair values due to the short-term maturities of these instruments. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY Part II - Continued DATA - Continued Note 17. Financial Instruments - Continued The methods and assumptions used to estimate the fair values of other financial instruments are summarized as follows: Marketable securities and noncurrent equity and debt investments The fair values of marketable securities and noncurrent equity and debt investments were estimated using quoted market prices. Finance receivables, retained interests in sold receivables and other related amounts - net The carrying value of variable-rate finance receivables was assumed to approximate fair value since they are priced at current market rates. The fair value of fixed-rate finance receivables was estimated by discounting expected cash flows using the current rates at which loans of similar credit quality and maturity would be made as of the date of the consolidated balance sheet. The fair values of excess servicing cash flows and other subordinated amounts due CFC arising from receivable sale transactions were estimated by discounting expected cash flows using current market rates. Debt The fair value of public debt was estimated using quoted market prices. The fair value of other long-term debt was estimated by discounting future cash flows using rates currently available for debt of similar terms and remaining maturities. The carrying value of borrowings under revolving credit facilities was assumed to approximate fair value due to their short maturities. Interest rate swaps and interest rate caps The fair values of interest rate swaps and interest rate caps were estimated by discounting expected cash flows using quoted market interest rates. Foreign currency forward contracts The fair value of foreign currency forward contracts was estimated based on quoted market prices for contracts of similar terms. Foreign currency swaps The fair value of foreign currency swap agreements was estimated by discounting expected cash flows using market exchange rates and relative market interest rates over the remaining term of the swap. The fair value estimates presented herein were based on information available as of the date of the consolidated balance sheet. Although management is not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been revalued since the date of the consolidated balance sheet and, therefore, current estimates of fair value may differ significantly from the amounts presented herein. Note 18. Industry Segment and Geographic Area Data Industry Segment Data Chrysler operates in two principal industry segments, Car and Truck and Financial Services. The Car and Truck segment is composed of the automotive operations of Chrysler, which includes the research, design, manufacture, assembly and sale of cars, trucks and related parts and accessories. The Car Rental Operations and Chrysler's defense electronics business, Chrysler Technologies Corporation, each represents less than 10 percent of consolidated revenues, operating profits and identifiable assets, and have been included in the Car and Truck segment. The Financial Services segment is composed of CFC, which is engaged in wholesale and retail vehicle financing, property and casualty insurance, and servicing nonautomotive loans and leases. Information concerning operations by industry segment was as follows: Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY Part II - Continued DATA - Continued Note 18. Industry Segment and Geographic Area Data - Continued Industry Segment Data - Continued Interest expense of the Financial Services segment has been netted against operating earnings, which is consistent with industry practice. The individual segments do not add to the consolidated amounts due to the elimination of intersegment transactions and adjustments for the minority interest in CFC. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY Part II - Continued DATA - Continued Note 18. Industry Segment and Geographic Area Data - Continued Geographic Area Data Information concerning operations by principal geographic area was as follows: Transfers between geographic areas are based on prices negotiated between the buying and selling locations. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY Part II - Continued DATA - Continued CONFORMED INDEPENDENT AUDITORS' REPORT Shareholders and Board of Directors Chrysler Corporation Highland Park, Michigan We have audited the accompanying consolidated balance sheet of Chrysler Corporation and consolidated subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of earnings and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a)2. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such financial statements present fairly, in all material respects, the financial position of Chrysler Corporation and consolidated subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in the notes to the financial statements, the Company has adopted recently issued Statements of Financial Accounting Standards and, accordingly, changed its methods of accounting for postretirement benefits other than pensions and postemployment benefits in 1993, and its method of accounting for income taxes in 1992. In addition, the Company changed its method of accounting for the cost of special sales incentive programs in 1991. DELOITTE & TOUCHE Detroit, Michigan January 18, 1994 Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY Part II - Continued DATA - Continued Conformed MANAGEMENT REPORT ON RESPONSIBILITY FOR FINANCIAL REPORTING Chrysler's management is responsible for preparing the financial statements and other financial information in this Annual Report. This responsibility includes maintaining the integrity and objectivity of financial data and the presentation of Chrysler's results of operations and financial position in accordance with generally accepted accounting principles. The financial statements include amounts that are based on management's best estimates and judgments. Chrysler's financial statements have been audited by Deloitte & Touche, independent auditors. Their audits were conducted in accordance with generally accepted auditing standards and included consideration of the internal control system and tests of transactions as part of planning and performing their audits. Chrysler maintains a system of internal controls that provides reasonable assurance that its records reflect its transactions in all material respects and that significant misuse or loss of assets will be prevented. Management believes the system of internal controls is adequate to accomplish these objectives on a continuous basis. Chrysler maintains a strong internal auditing program that independently assesses the effectiveness of the internal controls and recommends possible improvements. Management considers the General Auditor's and Deloitte & Touche's recommendations concerning the system of internal controls and takes appropriate actions to respond to these recommendations. The Board of Directors, acting through its Audit Committee composed solely of nonemployee directors, is responsible for determining that management fulfills its responsibilities in the preparation of financial statements and the maintenance of internal controls. In fulfilling its responsibility, the Audit Committee recommends independent auditors to the Board of Directors for appointment by the shareholders. The Committee also reviews the consolidated financial statements and adequacy of internal controls. The Audit Committee meets regularly with management, the General Auditor and the independent auditors. Both the independent auditors and the General Auditor have full and free access to the Audit Committee, without management representatives present, to discuss the scope and results of their audits and their views on the adequacy of internal controls and the quality of financial reporting. It is the business philosophy of Chrysler Corporation and its subsidiaries to obey the law and to require that its employees conduct their activities according to the highest standards of business ethics. Management reinforces this philosophy by numerous actions, including issuing a Code of Ethical Behavior and maintaining a Business Practices Committee and a Business Practices Office to support compliance with the Corporation's policies. R. J. Eaton G. C. Valade - --------- ---------- R. J. EATON G. C. VALADE Chairman of the Board and Executive Vice President and Chief Executive Officer Chief Financial Officer Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY Part II - Continued DATA - Continued SUPPLEMENTAL INFORMATION CHRYSLER CORPORATION AND CONSOLIDATED SUBSIDIARIES SELECTED QUARTERLY FINANCIAL DATA (unaudited) _________________________________ (1) Results for the first quarter of 1993 included the unfavorable effects of changes in accounting principles of $4.68 billion related to the adoption of SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," and $283 million related to the adoption of SFAS No. 112, "Employers' Accounting for Postemployment Benefits." Previously reported results for the first quarter of 1993 have been restated to reflect the adoption of SFAS No. 112 effective January 1, 1993. (2) Earnings for the second quarter of 1993 included a gain of $60 million ($39 million after applicable income taxes) related to the sale of the plastics operations of Chrysler's Acustar division, and a gain of $111 million ($70 million after applicable income taxes) related to the sale of 27 million shares of Mitsubishi Motors Corporation ("MMC") stock. (3) Earnings for the third quarter of 1993 included a gain of $94 million ($58 million after applicable income taxes) related to the sale of Chrysler's remaining 23.3 million shares of MMC stock. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY Part II - Continued DATA - Continued SUPPLEMENTAL INFORMATION CHRYSLER CORPORATION AND CONSOLIDATED SUBSIDIARIES SELECTED QUARTERLY FINANCIAL DATA (unaudited) _______________________________ (1) Results for the first quarter of 1992 included a gain of $142 million ($88 million after applicable income taxes) related to the sale of 43.6 million shares of MMC stock, the favorable effect of a change in accounting principle of $218 million related to the adoption of SFAS No. 109, "Accounting for Income Taxes," and a $98 million charge ($63 million after applicable income taxes) related to an investment loss experienced by Chrysler Canada Ltd. (2) Earnings for the third quarter of 1992 included a charge of $101 million ($79 million after applicable income taxes) related to the restructuring of Chrysler's short-term vehicle rental subsidiaries. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY Part II - Continued DATA - Continued SUPPLEMENTAL INFORMATION CHRYSLER (WITH CFC AND CAR RENTAL OPERATIONS ON AN EQUITY BASIS) STATEMENT OF EARNINGS (unaudited) (in millions of dollars) This Supplemental Information, "Chrysler (with CFC and Car Rental Operations on an Equity Basis)", reflects the results of operations of Chrysler with its investments in Chrysler Financial Corporation ("CFC") and its investments in short-term vehicle rental subsidiaries ("Car Rental Operations") accounted for on an equity basis rather than as consolidated subsidiaries. This Supplemental Information does not purport to present results of operations in accordance with generally accepted accounting principles because it does not comply with Statement of Financial Accounting Standards ("SFAS") No. 94, "Consolidation of All Majority-Owned Subsidiaries." The financial covenants contained in certain of Chrysler's credit facilities are based on this Supplemental Information. In addition, because the operations of CFC and the Car Rental Operations are different in nature than Chrysler's manufacturing operations, management believes that this disaggregated financial data enhances an understanding of the consolidated financial statements. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY Part II - Continued DATA - Continued SUPPLEMENTAL INFORMATION CHRYSLER (WITH CFC AND CAR RENTAL OPERATIONS ON AN EQUITY BASIS) BALANCE SHEET (unaudited) (in millions of dollars) This Supplemental Information, "Chrysler (with CFC and Car Rental Operations on an Equity Basis)", reflects the financial position of Chrysler with its investments in CFC and the Car Rental Operations accounted for on an equity basis rather than as consolidated subsidiaries. This Supplemental Information does not purport to present financial position in accordance with generally accepted accounting principles because it does not comply with Statement of Financial Accounting Standards ("SFAS") No. 94, "Consolidation of All Majority-Owned Subsidiaries." The financial covenants contained in certain of Chrysler's credit facilities are based on this Supplemental Information. In addition, because the operations of CFC and the Car Rental Operations are different in nature than Chrysler's manufacturing operations, management believes that this disaggregated financial data enhances an understanding of the consolidated financial statements. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY Part II - Continued DATA - Continued SUPPLEMENTAL INFORMATION CHRYSLER (WITH CFC AND CAR RENTAL OPERATIONS ON AN EQUITY BASIS) STATEMENT OF CASH FLOWS (unaudited) (in millions of dollars) This Supplemental Information, "Chrysler (with CFC and Car Rental Operations on an Equity Basis)", reflects the cash flows of Chrysler with its investments in CFC and the Car Rental Operations accounted for on an equity basis rather than as consolidated subsidiaries. This Supplemental Information does not purport to present cash flows in accordance with generally accepted accounting principles because it does not comply with Statement of Financial Accounting Standards ("SFAS") No. 94, "Consolidation of All Majority-Owned Subsidiaries." The financial covenants contained in certain of Chrysler's credit facilities are based on this Supplemental Information. In addition, because the operations of CFC and the Car Rental Operations are different in nature than Chrysler's manufacturing operations, management believes that this disaggregated financial data enhances an understanding of the consolidated financial statements. Item 9.	Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS Part II - Continued ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III Items 10, 11, 12, and 13 Information required by Part III (Items 10, 11, 12, and 13) of this Form 10-K is incorporated by reference from Chrysler Corporation's definitive Proxy Statement for its 1994 Annual Meeting of Stockholders, which will be filed with the Securities and Exchange Commission, pursuant to Regulation 14A, not later than 120 days after the end of the fiscal year, all of which information is hereby incorporated by reference in, and made part of, this Form 10-K, except that the information required by Item 10					Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The following documents are filed as part of this report: 1. Financial Statements Financial statements filed as part of this Form 10-K are listed under Part II, Item 8 of this Form 10-K. Part IV - Continued Item 14. EXHIBITS, FINANCIAL STATEMENTS SCHEDULES, AND REPORTS ON FORM 8-K 3. Exhibits: 3-A Copy of Certificate of Incorporation of Chrysler Corporation, as amended and restated and in effect on May 21, 1987. Filed as Exhibit 3-A to Registration Statement No. 33-15544 on Form S-4 of Chrysler Corporation, and incorporated herein by reference. 3-B Copy of By-Laws of Chrysler Corporation, as amended as of June 10, 1993. Filed as Exhibit 3-B to Chrysler Corporation Quarterly Report on Form 10-Q for the quarterly period ended June 30, 1993, and incorporated herein by reference. 3-C Copy of Certificate of Designation for Chrysler Corporation Junior Participating Cumulative Preferred Stock. Filed as Exhibit 3-D to Chrysler Corporation Annual Report on Form 10-K for the year ended December 31, 1987, and incorporated herein by reference. 3-D Copy of Certificate of Designation, Preferences and Rights of Series A Convertible Preferred Stock. Filed as Exhibit 3- D to Chrysler Corporation Quarterly Report on Form 10-Q for the quarterly period ended March 31, 1992 and incorporated herein by reference. 4-A Certificate of Incorporation and By-Laws of Chrysler Corporation. See Exhibits 3-A through 3-D above. 4-B-1 Copy of Certificate of Ownership and Merger merging Chrysler Motors Corporation into Chrysler Corporation, effective on December 31, 1989. Filed as Exhibit 4-B-1 to Chrysler Corporation Annual Report on Form 10-K for the year ended December 31, 1989, and incorporated herein by reference. 4-B-2 Copy of Agreement of Merger and Plan of Reorganization, dated as of March 6, 1986, among Chrysler Corporation, Chrysler Holding Corporation (now Chrysler Corporation) and New Chrysler, Inc., annexed as Exhibit A to Registration Statement No. 33-4537 on Form S-4 of Chrysler Holding Corporation (now Chrysler Corporation), and incorporated herein by reference. 4-C Copy of Rights Agreement, dated as of February 4, 1988, and amended and restated as of December 14, 1990, between Chrysler Corporation and First Chicago Trust Company of New York (formerly Morgan Shareholder Services Trust Company), as Rights Agent, relating to Rights to purchase Chrysler Corporation Junior Participating Cumulative Preferred Stock. Filed as Exhibit 1 to Chrysler Corporation Current Report on Form 8-K, dated December 14, 1990, and incorporated herein by reference. 4-D-1 Conformed copy of Indenture, dated as of July 15, 1987, between Chrysler Corporation and Manufacturers Hanover Trust Company, as Trustee, relating to Debt Securities, Appendix B thereto relating to 9.60% Notes Due 1994, Appendix B thereto relating to 10.95% Debentures Due 2017 and Appendix C thereto relating to 10.40% Notes Due 1999. Filed as Exhibit 4-D-1 to Chrysler Corporation Annual Report on Form 10-K for the year ended December 31, 1987, and incorporated herein by reference. 4-D-2 Conformed copy of Indenture, dated as of March 1, 1985, between Chrysler Corporation and Manufacturers Hanover Trust Company, as Trustee, relating to Debt Securities and Appendix B thereto relating to 13% Debentures Due 1997. Filed as Exhibit 4-B to Chrysler Corporation Annual Report on Form 10-K for the year ended December 31, 1985, and incorporated herein by reference. 4-D-3 Form of Supplemental Indenture, dated as of May 30, 1986, between Chrysler Holding Corporation (now Chrysler Corporation), Chrysler Corporation and Manufacturers Hanover Trust Company, as Trustee, relating to Debt Securities. Filed as Exhibit 4-E-2 to the Post-Effective Amendment No. 1 to Registration Statement No. 33-4537 on Form S-4 of Chrysler Holding Corporation (now Chrysler Corporation), and incorporated herein by reference. 4-D-4 Copy of Supplemental Indenture, dated as of December 31, 1989, between Chrysler Corporation and Manufacturers Hanover Trust Company, as Trustee, relating to Debt Securities. Filed as Exhibit 4-D-4 to Chrysler Corporation Annual Report on Form 10-K for the year ended December 31, 1989, and incorporated herein by reference. Part IV - Continued Item 14. EXHIBITS, FINANCIAL STATEMENTS SCHEDULES, AND REPORTS ON FORM 8-K - Continued 4-D-5 Conformed copy of Third Supplemental Indenture, dated as of May 1, 1990, between Chrysler Corporation and Manufacturers Hanover Trust Company, as Trustee, relating to Debt Securities and Appendix D to Indenture dated as of March 1, 1985 between Chrysler Corporation and Manufacturers Hanover Trust Company relating to Debentures Due 2020. Filed as Exhibit 4-D-5 to Chrysler Corporation Annual Report on Form 10-K for the year ended December 31, 1990, and incorporated herein by reference. 4-D-6 Conformed copy of Trust Agreement, dated as of May 1, 1990, between Chrysler Corporation and Manufacturers Hanover Bank (Delaware), Trustee, relating to the Auburn Hills Trust. Filed as Exhibit 4-D-6 to Chrysler Corporation Annual Report on Form 10-K for the year ended December 31, 1990, and incorporated herein by reference. 4-E-1 Conformed copy of $2,640,000,000 Amended and Restated Revolving Credit Agreement, dated as of December 31, 1989, among Chrysler Corporation, the several Banks parties to the Agreement and Manufacturers Hanover Trust Company, as agent for such Banks. Filed as Exhibit 4-E to Chrysler Corporation Annual Report on Form 10-K for the year ended December 31, 1989, and incorporated herein by reference. 4-E-2 Form of $1,750,000,000 Second Amendment and Waiver, dated as of March 22, 1991, amending the $2,640,000,000 Amended and Restated Revolving Credit Agreement, dated as of December 31, 1989, among Chrysler Corporation, the several Banks parties to the Agreement and Manufacturers Hanover Trust Company, as agent for such Banks. Filed as Exhibit 4-E-2 to Chrysler Corporation Annual Report on Form 10-K for the year ended December 31, 1990 and incorporated herein by reference. 4-E-3 Copy of Third Amendment, dated as of April 30, 1991, amending the $2,640,000,000 Amended and Restated Revolving Credit Agreement, dated as of December 31, 1989, as amended by the $1,750,000,000 Second Amendment and Waiver, dated as of March 22, 1991, among Chrysler Corporation, the several Banks parties to the Agreement and Manufacturers Hanover Trust Company, as agent for such Banks. Filed as Exhibit 4-D-3 to Chrysler Corporation Quarterly Report on Form 10-Q for the quarter ended June 30, 1991, and incorporated herein by reference. 4-E-4 Conformed copy of $1,500,000,000 Amended and Restated Revolving Credit Agreement, dated as of June 30, 1993, among Chrysler Corporation, the several Banks parties to the Agreement and Chemical Bank, as Agent for the Banks. Filed as Exhibit 4-E to the Chrysler Corporation Quarterly Report on Form 10-Q for the quarter ended June 30, 1993, and incorporated herein by reference. 4-F-1 Copy of Indenture, dated as of June 1, 1985, between Chrysler Financial Corporation and Manufacturers Hanover Trust Company, Trustee, United States Trust Company of New York, as successor Trustee, related to Chrysler Financial Corporation Senior Debt Securities. Filed as Exhibit 4-A to the Quarterly Report of Chrysler Financial Corporation on Form 10-Q for the quarter ended June 30, 1985, and incorporated herein by reference. 4-F-2 Copy of First Supplemental Indenture, dated as of June 1, 1986, between Chrysler Financial Corporation and Manufacturers Hanover Trust Company, Trustee, United States Trust Company of New York, as Successor Trustee, to the Indenture dated as of June 1, 1985 between such parties, related to Chrysler Financial Corporation Senior Debt Securities. Filed as Exhibit 4-B to the Quarterly Report of Chrysler Financial Corporation on Form 10-Q for the quarter ended September 30, 1986, and incorporated herein by reference. 4-F-3 Copy of Indenture, dated as of September 15, 1986, between Chrysler Financial Corporation and Manufacturers Hanover Trust Company, Trustee, United States Trust Company of New York, as Successor Trustee, related to Chrysler Financial Corporation Senior Debt Securities. Filed as Exhibit 4-E to the Quarterly Report of Chrysler Financial Corporation on Form 10-Q for the quarter ended September 30, 1986, and incorporated herein by reference. 4-F-4 Copy of Amended and Restated Indenture, dated as of September 15, 1986, between Chrysler Financial Corporation and Manufacturers Hanover Trust Company, Trustee, United States Trust Company of New York, as Successor Trustee, related to Chrysler Financial Corporation Senior Debt Securities. Filed as Exhibit 4-H to the Quarterly Report of Chrysler Financial Corporation on Form 10-Q for the quarter ended June 30, 1987, and incorporated herein by reference. Part IV - Continued Item 14. EXHIBITS, FINANCIAL STATEMENTS SCHEDULES, AND REPORTS ON FORM 8-K - Continued 4-F-5 Copy of Indenture, dated as of February 15, 1988, between Chrysler Financial Corporation and Manufacturers Hanover Trust Company, Trustee, United States Trust Company of New York, as Successor Trustee, related to Chrysler Financial Corporation Senior Debt Securities. Filed as Exhibit 4-A to Registration No. 33-23479 of Chrysler Financial Corporation, and incorporated herein by reference. 4-F-6 Copy of First Supplemental Indenture, dated as of March 1, 1988, between Chrysler Financial Corporation and Manufacturers Hanover Trust Company, Trustee, United States Trust Company of New York, as successor Trustee, to the Indenture, dated as of February 15, 1988, between such parties, related to Chrysler Financial Corporation Senior Debt Securities. Filed as Exhibit 4-L to the Quarterly Report of Chrysler Financial Corporation on Form 10-Q for the quarter ended December 31, 1987, and incorporated herein by reference. 4-F-7 Copy of the Second Supplemental Indenture, dated as of September 7, 1990, between Chrysler Financial Corporation and Manufacturers Hanover Trust Company, Trustee, United States Trust Company of New York, as Successor Trustee, to the Indenture, dated as of February 15, 1988, between such parties, related to Chrysler Financial Corporation Senior Debt Securities. Filed as Exhibit 4-M to the Quarterly Report of Chrysler Financial Corporation on Form 10-Q for the quarter ended September 30, 1990, and incorporated herein by reference. 4-F-8 Copy of Third Supplemental Indenture, dated as of May 4, 1992, between Chrysler Financial Corporation and United States Trust Company of New York, as Successor Trustee, to the Indenture, dated as of February 15, 1988 between such parties, relating to Chrysler Financial Corporation Senior Debt Securities. Filed as Exhibit 4-N to the Quarterly report of Chrysler Financial Corporation on Form 10-Q for the quarter ended June 30, 1992, and incorporated herein by reference. 4-G-1 Copy of Indenture, dated as of June 1, 1985, between Chrysler Financial Corporation and Irving Trust Company, Trustee, related to Chrysler Financial Corporation Junior Subordinated Debt Securities. Filed as Exhibit 4-B to the Quarterly Report of Chrysler Financial Corporation on Form 10-Q for the quarter ended June 30, 1985, and incorporated herein by reference. 4-G-2 Copy of Indenture, dated as of September 15, 1986, between Chrysler Financial Corporation and Irving Trust Company, Trustee, related to Chrysler Financial Corporation Junior Subordinated Debt Securities. Filed as Exhibit 4-G to the Quarterly Report of Chrysler Financial Corporation on Form 10-Q for the quarter ended September 30, 1986, and incorporated herein by reference. 4-G-3 Copy of Amended and Restated Indenture, dated as of September 15, 1986, between Chrysler Financial Corporation and Irving Trust Company, Trustee, related to Chrysler Financial Corporation Junior Subordinated Debt Securities. Filed as Exhibit 4-J to the Quarterly Report of Chrysler Financial Corporation on Form 10-Q for the quarter ended June 30, 1987, and incorporated herein by reference. 4-G-4 Copy of Indenture, dated as of February 15, 1988, between Chrysler Financial Corporation and IBJ Schroder Bank & Trust Company, Trustee, related to Chrysler Financial Corporation Subordinated Debt Securities. Filed as Exhibit 4-B to Registration No. 33-23479 of Chrysler Financial Corporation, and incorporated herein by reference. 4-G-5 Copy of First Supplemental Indenture, dated as of September 1, 1989, between Chrysler Financial Corporation and IBJ Schroder Bank & Trust Company, Trustee, to the Indenture, dated as of February 15, 1988, between such parties, related to Chrysler Financial Corporation Subordinated Debt Securities. Filed as Exhibit 4-N to the Current Report of Chrysler Financial Corporation on Form 8-K dated September 1, 1989 and filed September 13, 1989, and incorporated herein by reference. 4-H-1 Copy of Indenture, dated as of July 15, 1985, between Chrysler Financial Corporation and Bankers Trust Company, Trustee, related to Chrysler Financial Corporation Subordinated Debt Securities, J. Henry Schroder Bank and Trust Company having subsequently succeeded Banker's Trust Company as Trustee. Filed as Exhibit 4-C to the Quarterly Report of Chrysler Financial Corporation on Form 10-Q for the quarter ended June 30, 1985, and incorporated herein by reference. Part IV - Continued Item 14. EXHIBITS, FINANCIAL STATEMENTS SCHEDULES, AND REPORTS ON FORM 8-K - Continued 4-H-2 Copy of Indenture, dated as of September 15, 1986, between Chrysler Financial Corporation and J. Henry Schroder Bank & Trust Company, Trustee, related to Chrysler Financial Corporation Subordinated Debt Securities. Filed as Exhibit 4-F to the Quarterly Report of Chrysler Financial Corporation on Form 10-Q for the quarter ended September 30, 1986, and incorporated herein by reference. 4-H-3 Copy of Amended and Restated Indenture, dated as of September 15, 1986, between Chrysler Financial Corporation and IBJ Schroder Bank & Trust Company, Trustee, related to Chrysler Financial Corporation Subordinated Debt Securities. Filed as Exhibit 4-I to the Quarterly Report of Chrysler Financial Corporation on Form 10-Q for the quarter ended June 30, 1987, and incorporated herein by reference. 4-H-4 Copy of Indenture, dated as of February 15, 1988, between Chrysler Financial Corporation and Irving Trust Company, Trustee, related to Chrysler Financial Corporation Junior Subordinated Debt Securities. Filed as Exhibit 4-C to Registration No. 33-23479 of Chrysler Financial Corporation, and incorporated herein by reference. 4-H-5 Copy of First Supplemental Indenture dated as of September 1, 1989, between Chrysler Financial Corporation and Irving Trust Company, Trustee, to the Indenture, dated as of February 15, 1988, between such parties, related to Chrysler Financial Corporation Junior Subordinated Debt Securities. Filed as Exhibit 4-O to the Current Report of Chrysler Financial Corporation on Form 8-K dated September 1, 1989 and filed on September 13, 1989, and incorporated herein by reference. 10-A-1 Copy of Chrysler Corporation Stock Option Plan, as amended and in effect on and after December 8, 1983 and before May 14, 1986, assumed by Chrysler Corporation (formerly Chrysler Holding Corporation). Filed as Exhibit 10-D-8 to Chrysler Corporation Annual Report on Form 10-K for the year ended December 31, 1983, and incorporated herein by reference. 10-A-2 Copy of Chrysler Corporation Stock Option Plan, as amended and in effect on and after May 14, 1986 and before November 5, 1987, assumed by Chrysler Corporation (formerly Chrysler Holding Corporation). Filed as Exhibit 10-A-8 to Chrysler Corporation Annual Report on Form 10-K for the year ended December 31, 1986, and incorporated herein by reference. 10-A-3 Copy of Chrysler Corporation Stock Option Plan, as amended and in effect on and after November 5, 1987 and before February 4, 1988. Filed as Exhibit 10-A-8 to Chrysler Corporation Annual Report on Form 10-K for the year ended December 31, 1987, and incorporated herein by reference. 10-A-4 Copy of Chrysler Corporation Stock Option Plan, as amended and in effect on and after February 4, 1988 and before June 7, 1990. Filed as Exhibit 10-A-9 to Chrysler Corporation Annual Report on Form 10-K for the year ended December 31, 1987, and incorporated herein by reference. 10-A-5 Copy of Chrysler Corporation Stock Option Plan, as amended and in effect on and after June 7, 1990 and before May 16, 1992. Filed as Exhibit 10-A-10 to Chrysler Corporation Annual Report on Form 10-K for the year ended December 31, 1990 and incorporated herein by reference. 10-A-6 Copy of Chrysler Corporation Stock Option Plan, as amended through December 2, 1993. 10-A-7 Copy of American Motors Corporation 1980 Stock Option Plan as in effect on August 5, 1987. Filed as Exhibit 28-B to Post-Effective Amendment No. 1 on Form S-8 to Registration Statement No. 33-15544 on Form S-4 of Chrysler Corporation, and incorporated herein by reference. 10-A-8 Copy of Chrysler Corporation 1991 Stock Compensation Plan as in effect on and after May 16, 1991 and before December 2, 1993. Filed as Exhibit 10-A-32 to the Chrysler Corporation Annual Report on Form 10-K for the year ended December 31, 1991, and incorporated herein by reference. 10-A-9 Copy of Chrysler Corporation 1991 Stock Compensation Plan, as amended and in effect on and after December 2, 1993. _______________ Filed herewith Part IV - Continued Item 14. EXHIBITS, FINANCIAL STATEMENTS SCHEDULES, AND REPORTS ON FORM 8-K - Continued 10-B-1 Copy of Chrysler Corporation Incentive Compensation Plan, as amended through June 7, 1990 and currently in effect. Filed as Exhibit 10-B-1 to Chrysler Corporation Annual Report on Form 10-K for the year ended December 31, 1990 and incorporated herein by reference. 10-B-2 Copy of Chrysler Corporation Long-Term Performance Plan, as amended and in effect on and after December 2, 1993. 10-B-3 Copy of Chrysler Supplemental Executive Retirement Plan, as amended through December 20, 1993. 10-C-1 Copy of agreement, dated July 12, 1990, between Chrysler Corporation and Lee A. Iacocca. Filed as Exhibit 10-C-5 to Chrysler Corporation Annual Report on Form 10-K for the year ended December 31, 1990 and incorporated herein by reference. 10-C-2 Copy of agreement, dated June 22, 1992 between Chrysler Corporation and Lee A. Iacocca, amending agreement dated July 12, 1990, between Chrysler Corporation and Lee A. Iacocca. Filed as Exhibit 10-C-6 to the Chrysler Corporation Annual Report on Form 10-K for the year ended December 31, 1992 and incorporated herein by reference. 10-C-3 Copy of agreement, dated June 11, 1992, between Chrysler Corporation and Lee A. Iacocca. Filed as Exhibit 10-C-7 to the Chrysler Corporation Annual Report on Form 10-K for the year ended December 31, 1992 and incorporated herein by reference. 10-C-4 Copy of agreement, dated March 14, 1992, between Chrysler Corporation and Robert J. Eaton. Filed as Exhibit 10-C-8 to the Chrysler Corporation Annual Report on Form 10-K for the year ended December 31, 1992 and incorporated herein by reference. 10-D Conformed copy of Participation Agreement for Sale and Leaseback Financing of Chrysler Technology Center Facilities among Chrysler Corporation, Manufacturers Hanover Bank (Delaware), as Trustee, and AH Service Corporation, dated as of May 1, 1990. Filed as Exhibit 10-E-11 to Chrysler Corporation Annual Report on Form 10-K for the year ended December 31, 1990 and incorporated herein by reference. 10-E-1 Copy of Income Maintenance Agreement made December 20, 1968 among Chrysler Financial Corporation, Chrysler Corporation and Chrysler Motors Corporation (now dissolved). Filed as Exhibit 13-D to Registration Statement No. 2-32037 of Chrysler Financial Corporation, and incorporated herein by reference. 10-E-2 Copy of Agreement made April 19, 1971 among Chrysler Financial Corporation, Chrysler Corporation and Chrysler Motors Corporation (now dissolved), amending the Income Maintenance Agreement among such parties. Filed as Exhibit 13-B to Registration Statement No. 2-40110 of Chrysler Financial Corporation and Chrysler Corporation, and incorporated herein by reference. 10-E-3 Copy of Agreement made May 29, 1973 among Chrysler Financial Corporation, Chrysler Corporation and Chrysler Motors Corporation (now dissolved), further amending the Income Maintenance Agreement among such parties. Filed as Exhibit 5-C to Registration Statement No. 2-49615 of Chrysler Financial Corporation, and incorporated herein by reference. 10-E-4 Copy of Agreement made as of July 1, 1975 among Chrysler Financial Corporation, Chrysler Corporation and Chrysler Motors Corporation (now dissolved), further amending the Income Maintenance Agreement among such parties. Filed as Exhibit D to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1975, and incorporated herein by reference. 10-E-5 Copy of Agreement made June 4, 1976 between Chrysler Financial Corporation and Chrysler Corporation further amending the Income Maintenance Agreement between such parties. Filed as Exhibit 5-H to Registration Statement No. 2-56398 of Chrysler Financial Corporation, and incorporated herein by reference. _______________________ Filed herewith Part IV - Continued Item 14. EXHIBITS, FINANCIAL STATEMENTS SCHEDULES, AND REPORTS ON FORM 8-K - Continued 10-E-6 Copy of Agreement made March 27, 1986 between Chrysler Financial Corporation, Chrysler Holding Corporation (now Chrysler Corporation) and Chrysler Corporation further amending the Income Maintenance Agreement among such parties. Filed as Exhibit 10-F to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1986, and incorporated herein by reference. 10-G-1 Copy of Amended and Restated Revolving Term Credit Facility, dated as of January 17, 1993, among Chrysler Credit Canada Ltd., as the Borrower, Chrysler Financial Corporation, as the Guarantor, the several financial institutions parties thereto, and Royal Bank of Canada, as Agent Bank. Filed as Exhibit 10-G to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. 10-G-2 Copy of Standby Receivables Purchase Agreement, dated as of January 17, 1993 among Chrysler Credit Canada, Ltd., Chrysler Financial Corporation, Royal Bank of Canada and the several other financial institutions parties thereto dated as of January 15, 1993. Filed as Exhibit 10-H to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. 10-G-3 Copy of Retail Purchase and Servicing Agreement, dated as of January 17, 1993 among Royal Bank of Canada, Chrysler Credit Canada Ltd., Chrysler Financial Corporation and the several other financial institutions parties thereto. Filed as Exhibit 10-I to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992 and incorporated herein by reference. 10-G-4 Copy of Bank Series Supplement, dated as of January 17, 1993, among Chrysler Credit Canada Ltd., Royal Bank of Canada, the several bank parties thereto and The Royal Trust Company, to the Master Custodial and Servicing Agreement, dated as of September 1, 1992. Filed as Exhibit 10-J to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992 and incorporated herein by reference. 10-H-1 Copy of Amendment dated as of December 1, 1992, to the Series 1992-1 Supplement dated as of February 1, 1992, among U.S. Auto Receivables Company, as Seller, Chrysler Credit Corporation, as Servicer, and Security Pacific National Trust Company (New York), as Trustee, with respect to DRAC Auto Loan Master Trust. Filed as Exhibit 10-DDDD to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1991, and incorporated herein by reference. 10-H-2 Copy of Series 1992-1 Supplement dated as of February 1, 1992, among U.S. Auto Receivables Company, as Seller, Chrysler Credit Corporation, as Servicer, and Security Pacific National Trust Company (New York), as Trustee, with respect to DRAC Auto Loan Master Trust. Filed as Exhibit 10-YYYY to the Registration Statement on Form S-2 of Chrysler Financial Corporation (Registration Statement No. 33-51302) on November 24, 1992, and incorporated herein by reference. 10-H-3 Copy of Series 1992-2 Supplement dated as of December 1, 1992 among U.S. Auto Receivables Company, as Seller, Chrysler Credit Corporation, as Servicer, and Security Pacific National Bank (New York), as Trustee, with respect to DRAC Auto Loan Master Trust. Filed as Exhibit 10-FFFF to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1991, and incorporated herein by reference. 10-I Copy of Pooling and Servicing Agreement, dated as of January 1, 1992, among Chrysler Auto Receivables Company, as Seller, Chrysler Credit Corporation, as Servicer, and LaSalle National Bank, as Trustee, with respect to CFC-16 Grantor Trust. Filed as Exhibit 10-QQQQ to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1991, and incorporated herein by reference. 10-J Copy of Standard Terms and Conditions of Agreement, dated as of January 1, 1992, between Chrysler Auto Receivables Company, as Seller, and Chrysler Credit Corporation, as Servicer, with respect to CFC-16 Grantor Trust. Filed as Exhibit 10-RRRR to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1991, and incorporated herein by reference. 10-K Copy of Purchase Agreement, dated as of January 1, 1992, between Chrysler Financial Corporation and Chrysler Auto Receivables Company with respect to CFC-16 Grantor Trust. Filed as Exhibit 10-SSSS to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1991, and incorporated herein by reference. Part IV - Continued Item 14. EXHIBITS, FINANCIAL STATEMENTS SCHEDULES, AND REPORTS ON FORM 8-K - Continued 10-L-1 Copy of Sale and Servicing Agreement, dated as of January 1, 1992, among Premier Auto Trust 1992-1, as Issuer, U.S. Auto Receivables Company, as Seller and Chrysler Credit Corporation, as Servicer, with respect to Premier Auto Trust 1992-1. Filed as Exhibit 10-QQQQ to the Registration Statement of Chrysler Financial Corporation on Form S-2 (Registration Statement No. 33-51302) on November 24, 1992 and incorporated herein by reference. 10-L-2 Copy of Trust Agreement, dated as of January 1, 1992, between U.S. Auto Receivables Company and Chemical Bank Delaware, as Owner Trustee, with respect to Premier Auto Trust 1992-1. Filed as Exhibit 10-RRRR to the Registration Statement of Chrysler Financial Corporation on Form S-2 (Registration Statement No. 33-51302) on November 24, 1992 and incorporated herein by reference. 10-L-3 Copy of Purchase Agreement, dated as of January 1, 1992, between Chrysler Financial Corporation, as Seller, and U.S. Auto Receivables Company, as Purchaser, with respect to Premier Auto Trust 1992-1. Filed as Exhibit 10-SSSS to the Registration Statement of Chrysler Financial Corporation on Form S-2 (Registration Statement No. 33-51302) on November 24, 1992 and incorporated herein by reference. 10-M Copy of Pooling and Servicing Agreement, dated as of January 1, 1992, among Chrysler Financial Corporation, as Master Servicer, Chrysler First Business Credit Corporation, as Seller, and Security Pacific National Bank, as Trustee, with respect to U.S. Business Equity Loan Trust 1992-1. Filed as Exhibit 4-A to the Quarterly Report on Form 10-Q of U.S. Business Equity Loan Trust 1992-1 for the quarter ended March 31, 1992, and incorporated herein by reference. 10-N-1 Copy of Series B Supplement, dated as of March 1, 1992, among U.S. Auto Receivables Company, as Seller, Chrysler Credit Corporation, as Servicer, and Manufacturers and Traders Trust Company, as Trustee, with respect to CARCO Auto Loan Master Trust. Filed as Exhibit 4-H to the Quarterly Report on Form 10-Q of CARCO Auto Loan Master Trust for the quarter ended March 31, 1992, and incorporated herein by reference. 10-N-2 Copy of Series C Supplement, dated as of May 1, 1992, among U.S. Auto Receivables Company, as Seller, Chrysler Credit Corporation, as Servicer, and Manufacturers and Traders Trust Company, as Trustee, with respect to CARCO Auto Loan Master Trust. Filed as Exhibit 4-J to the Quarterly Report on Form 10-Q of CARCO Auto Loan Master Trust for the quarter ended June 30, 1992, and incorporated herein by reference. 10-O-1 Copy of Series 1992-1 Supplement, dated as of February 1, 1992, among U.S. Auto Receivables Company, as Seller, Chrysler Credit Corporation, as Servicer, and Security Pacific National Trust Company (New York), as Trustee, with respect to DRAC Auto Loan Master Trust. Filed as Exhibit 10-YYYY to the Quarterly Report on Form 10-Q of CARCO Auto Loan Master Trust for the quarter ended June 30, 1992, and incorporated herein by reference. 10-P-1 Copy of Indenture, dated as of March 1, 1992, between Premier Auto Trust 1992-2 and Bankers Trust Company, with respect to Premier Auto Trust 1992-2 Asset Backed Notes. Filed as Exhibit 4-A to the Quarterly Report on Form 10-Q of Premier Auto Trust 1992-2 for the quarter ended March 31, 1992, and incorporated herein by reference. 10-P-2 Copy of a 6-3/8% Asset Backed Note with respect to Premier Auto Trust 1992-2 Asset Backed Notes. Filed as Exhibit 4-B to the Quarterly Report on Form 10-Q of Premier Auto Trust 1992-2 for the quarter ended March 31, 1992, and incorporated herein by reference. 10-P-3 Copy of Trust Agreement, dated as of March 1, 1992, between U.S. Auto Receivables Company and Manufacturers Hanover Bank (Delaware) with respect to Premier Auto Trust 1992-2 Asset Backed Certificates. Filed as Exhibit 4-C to the Quarterly Report on Form 10-Q of Premier Auto Trust 1992-2 for the quarter ended March 31, 1992, and incorporated herein by reference. 10-Q-1 Copy of Pooling and Servicing Agreement, dated as of March 1, 1992 among Chrysler Financial Corporation, as Master Servicer, Financial Acceptance Corporation, as Seller, and The First National Bank of Chicago, as Trustee, with respect to CFC-17 Grantor Trust. Filed as Exhibit 4-A to the Quarterly report on Form 10-Q of CFC-17 Grantor Trust for the quarter ended June 30, 1992, and incorporated herein by reference. Part IV - Continued Item 14. EXHIBITS, FINANCIAL STATEMENTS SCHEDULES, AND REPORTS ON FORM 8-K - Continued 10-Q-2 Copy of Standard Terms and Conditions of Agreement, dated as of March 1, 1992, among Chrysler Financial Corporation, as Master Servicer, Financial Acceptance Corporation, as Seller, and The First National Bank of Chicago, as Trustee, with respect to CFC-17 Grantor Trust. Filed as Exhibit 4-B to the Quarterly Report on Form 10-Q of CFC-17 Grantor Trust for the quarter ended June 30, 1992, and incorporated herein by reference. 10-Q-3 Copy of Purchase Agreement, dated as of March 1, 1992, between Chrysler First Inc. and Financial Acceptance Corporation with respect to CFC-17 Grantor Trust. Filed as Exhibit 4-C to the Quarterly Report on Form 10-Q of CFC-17 Grantor Trust for the quarter ended June 30, 1992, and incorporated herein by reference. 10-R-1 Copy of Indenture, dated as of May 1, 1992, between Premier Auto Trust 1992-3 and Bankers Trust Company with respect to Premier Auto Trust 1992-3. Filed as Exhibit 4-N to the Quarterly Report on Form 10-Q of Premier Auto Trust 1992-3 for the quarter ended June 30, 1992, and incorporated herein by reference. 10-R-2 Copy of a 5.90% Asset Backed Note with respect to Premier Auto Trust 1992-3. Filed as Exhibit 4-B to the Quarterly Report on Form 10-Q of Premier Auto Trust 1992-3 for the quarter ended June 30, 1992, and incorporated herein by reference. 10-R-3 Copy of Trust Agreement, dated as of April 1, 1992, as amended and restated as of May 1, 1992, between Premier Auto Receivables Company and Manufacturers Hanover Bank (Delaware) with respect to Premier Auto Trust 1992-3. Filed as Exhibit 4-C to the Quarterly Report on Form 10-Q of Premier Auto Trust 1992-3 for the quarter ended June 30, 1992, and incorporated herein by reference. 10-R-4 Copy of Receivables Purchase Agreement, dated as of April 15, 1992, between Chrysler Credit Canada Ltd., Chrysler Financial Corporation and Associated Assets Acquisition Inc. with respect to Canadian Auto Receivables Securitization 1992-1. Filed as Exhibit 10-IIIII to the Registration Statement on Form S-2 of Chrysler Financial Corporation (Registration Statement No. 33-51302) on November 24, 1992, and incorporated herein by reference. 10-S-1 Copy of Combined and Restated Revolving Credit Agreement, dated as of July 29, 1992, among Chrysler Financial Corporation, as Borrower, Chemical Bank, as Agent and Arranger, and Swiss Bank Corporation, New York Branch, as Managing Co-Agent and Co-Arranger including as Exhibit G thereto forms of the Trust Agreement and related security documents executed and delivered concurrently therewith. Filed as Exhibit 10-A to the Current Report on Form 8-K of Chrysler Financial Corporation dated August 17, 1992 and filed August 19, 1992, and incorporated herein by reference. 10-S-2 Copy of Second Amended and Restated Commitment Transfer Agreement, dated as of July 29, 1992, between Chrysler Financial Corporation, as Borrower, and Chemical Bank, as Agent. Filed as Exhibit 10-B to the Current Report on Form 8-K of Chrysler Financial Corporation, dated August 17, 1992 and filed August 19, 1992 and incorporated herein by reference. 10-S-3 Copy of Amended and Restated Standby Receivables Purchase Agreement, dated as of September 15, 1993, among Chrysler Financial Corporation, Chrysler Credit Corporation, U.S. Auto Receivables Company, American Auto Receivables Company, Chemical Bank, as Agent, and Chemical Bank Agency Services Corporation, as Administrative Agent. Filed as Exhibit 10-YY to the Quarterly Report on Form 10-Q of Chrysler Financial Corporation for the quarter ended September 30, 1993, and incorporated herein by reference. 10-S-4 Copy of Participation and Servicing Agreement, dated as of July 29, 1992, among American Auto Receivables Company, Chrysler Credit Corporation, the Purchasers named therein, Chemical Bank, as Agent, and Chemical Bank Agency Services Corporation, as Administrative Agent, with respect to the Standby Receivable Purchase Agreement. Filed as Exhibit 10-D to the Current Report on Form 8-K of Chrysler Financial Corporation dated August 17, 1992 and filed August 19, 1992, and incorporated herein by reference. 10-S-5 Copy of Bank Supplement, dated as of July 29, 1992, to the Pooling and Servicing Agreement, dated as of May 31, 1992, among U.S. Auto Receivables Company, as Seller, Chrysler Credit Corporation, as Servicer, and Manufacturers and Traders Trust Company, as Trustee, with respect to the Standby Receivables Purchase Agreement. Filed as Exhibit 10-E to the Current Report on Form 8-K of Chrysler Financial Corporation dated August 17, 1992 and filed on August 19, 1992, and incorporated herein by reference. Part IV - Continued Item 14. EXHIBITS, FINANCIAL STATEMENTS SCHEDULES, AND REPORTS ON FORM 8-K - Continued 10-S-6 Copy of Short Term Standby Receivables Purchase Agreement, dated as of September 15, 1993, among Chrysler Financial Corporation, Chrysler Credit Corporation, U.S. Auto Receivables Company, American Auto Receivables Company, Chemical Bank, as Agent, and Chemical Bank Agency Services Corporation, as Administrative Agent. Filed as Exhibit 10-BBB to the Quarterly Report on Form 10-Q of Chrysler Financial Corporation for the quarter ended September 30, 1993, and incorporated herein by reference. 10-S-7 Copy of Participation and Servicing Agreement, dated as of September 15, 1993, among American Auto Receivables Company, Chrysler Credit Corporation, the Purchasers named therein, Chemical Bank, as Agent, and Chemical Bank Agency Services Corporation, as Administrative Agent. Filed as Exhibit 10-CCC to the Quarterly Report on Form 10-Q of Chrysler Financial Corporation for the quarter ended September 30, 1993, and incorporated herein by reference. 10-S-8 Copy of Short Term Bank Supplement, dated as of September 15, 1993, to the Pooling and Servicing Agreement, dated as of May 31, 1991, among U.S. Auto Receivables Company, as Seller, Chrysler Credit Corporation, as Servicer, and Manufacturers and Traders Trust Company, as Trustee, with respect to Short Term Standby Receivables Purchase Agreement. Filed as Exhibit 10-DDD to the Quarterly Report on Form 10-Q of Chrysler Financial Corporation for the quarter ended September 30, 1993, and incorporated herein by reference. 10-S-9 Copy of Receivables Purchase Agreement, dated as of August 18, 1992, between Chrysler Credit Canada Ltd., Chrysler Financial Corporation and Associated Assets Acquisition Inc. with respect to Canadian Auto Receivables Securitization 1992-2. Filed as Exhibit 10-OOOOO to the Registration Statement on Form S-2 of Chrysler Financial Corporation (Registration Statement No. 33-51302) on November 24, 1992, and incorporated herein by reference. 10-T-1 Copy of Indenture, dated as of September 1, 1992, between Premier Auto Trust 1992-5 and Bankers Trust Company with respect to Premier Auto Trust 1992-5. Filed as Exhibit 4-A to the Quarterly Report on Form 10-Q of Premier Auto Trust 1992-5 for the quarter ended September 30, 1992, and incorporated herein by reference. 10-T-2 Copy of a 4.55% Asset Backed Note with respect to Premier Auto Trust 1992-5. Filed as Exhibit 4-B to the Quarterly Report on Form 10-Q of Premier Auto Trust 1992-5 for the quarter ended September 30, 1992, and incorporated herein by reference. 10-T-3 Copy of Trust Agreement, dated as of September 1, 1992, between Premier Auto Receivables Company and Manufacturers Hanover Bank (Delaware) with respect to Premier Auto Trust 1992-5. Filed as Exhibit 4-C to the Quarterly Report on Form 10-Q of Premier Auto Trust 1992-5 for the quarter ended September 30, 1992, and incorporated herein by reference. 10-U Copy of Series 1992-2 Supplement to the Pooling and Servicing Agreement, dated as of October 1, 1992, among U.S. Auto Receivables Company, as Seller, Chrysler Credit Corporation, as Servicer, and Manufacturers and Traders Trust Company, as Trustee, with respect to CARCO Auto Loan Master Trust, Series 1992-2. Filed as Exhibit 3 to Form 8-K of CARCO Auto Loan Master Trust on October 30, 1992, and incorporated herein by reference. 10-V-1 Copy of Master Custodial and Servicing Agreement, dated as of September 1, 1992 between Chrysler Credit Canada Ltd. and The Royal Trust Company, as Custodian. Filed as Exhibit 10-TTTTT to the Registration Statement on Form S-2 of Chrysler Financial Corporation (Registration Statement No. 33-51302) on November 24, 1992, and incorporated herein by reference. 10-V-2 Copy of Trust Indenture, dated as of September 1, 1992, among Canadian Dealer Receivables Corporation and Montreal Trust Company of Canada, as Trustee. Filed as Exhibit 10-UUUUU to the Registration Statement on Form S-2 of Chrysler Financial Corporation (Registration statement No. 33-51302) on November 24, 1992, and incorporated herein by reference. Part IV - Continued Item 14. EXHIBITS, FINANCIAL STATEMENTS SCHEDULES, AND REPORTS ON FORM 8-K - Continued 10-W-1 Copy of Loan Asset Purchase Agreement by and between NationsBank of Texas, N.A. and Chrysler First Inc., and the Subsidiaries of Chrysler First Inc. named therein, dated as of November 17, 1992, with respect to the sale of certain loan assets of Chrysler First Inc. and its subsidiaries. Filed as Exhibit 10-VVVVV to the Registration Statement on Form S-2 of Chrysler Financial Corporation (Registration Statement No. 33-51302) on November 24, 1992, and incorporated herein by reference. 10-W-2 Copy of Business Asset Purchase Agreement by and among NationsBank Financial Services Corporation and the Purchasers named therein and Chrysler First Inc. and the Sellers named therein, dated as of November 17, 1992, with respect to the sale of certain business assets of Chrysler First Inc. and its subsidiaries. Filed as Exhibit 10-WWWWW to the Registration Statement on Form S-2 of Chrysler Financial Corporation (Registration Statement No. 33-51302) on November 24, 1992, and incorporated herein by reference. 10-X-1 Copy of Securitization Closing Agreement, dated as of February 1, 1993, among Chrysler Financial Corporation, certain Sellers, certain Purchasers, and certain Purchaser Parties. Filed as Exhibit 2-E to the Current Report of Chrysler Financial Corporation on Form 8-K dated February 1, 1993, and incorporated herein by reference. 10-X-2 Copy of First Amendment to Loan Asset Purchase Agreement, dated December 30, 1992, among NationsBank of Texas, N.A. and Chrysler Financial Corporation, for and on behalf of Chrysler First Inc. and the Asset Sellers parties thereto. Filed as Exhibit 2-B to the Current Report of Chrysler Financial Corporation on Form 8-K dated February 1, 1993, and incorporated herein by reference. 10-X-3 Copy of First Amendment to Business Asset Purchase Agreement dated as of January 29, 1993, among NationsBank Financial Services Corporation, the other Purchasers parties thereto and the Sellers parties thereto and Chrysler Financial Corporation. Filed as Exhibit 2-D to the Current Report of Chrysler Financial Corporation on Form 8-K dated February 1, 1993, and incorporated herein by reference. 10-Y-1 Copy of Asset Purchase Agreement, dated as of May 15, 1992, between Chrysler Capital Public Finance Corporation and Koch Financial Corporation. Filed as Exhibit 10-DDDDDD to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. 10-Y-2 Copy of Asset Purchase Agreement, dated as of June 1, 1992, among General Electric Capital Corporation, Chrysler Financial Corporation, Chrysler Capital Corporation, Chrysler Asset Management Corporation and Chrysler Credit Corporation. Filed as Exhibit 10-EEEEEE to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. 10-Y-3 Copy of Purchase Agreement, dated as of August 1, 1992, among General Electric Capital Corporation, Chrysler Financial Corporation, Chrysler Capital Corporation and Chrysler Asset Management Corporation. Filed as Exhibit 10-FFFFFF to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. 10-Z-1 Copy of Asset Purchase Agreement, dated as of September 30, 1992, between Chrysler Rail Transportation Corporation and United States Rail Services, a division of United States Leasing International, Inc. Filed as Exhibit 10-GGGGGG to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. 10-Z-2 Copy of Asset Purchase Agreement, dated as of December 18, 1992, among Chrysler Rail Transportation Corporation, Greenbrier Transportation Limited Partnership and Greenbrier Capital Corporation. Filed as Exhibit 10-HHHHHH to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. 10-Z-3 Copy of Asset Purchase Agreement, dated as of February 1, 1993, among Chrysler Rail Transportation Corporation, Chrysler Capital Transportation Services, Inc. and United States Rail Services, a division of United States Leasing International, Inc. Filed as Exhibit 10-IIIIII to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. Part IV - Continued Item 14. EXHIBITS, FINANCIAL STATEMENTS SCHEDULES, AND REPORTS ON FORM 8-K - Continued 10-AA-1 Copy of Asset Purchase Agreement between Chrysler Leaserve, Inc. (a subsidiary of General Electric Capital Auto Lease, Inc.), Chrysler Financial Corporation and Chrysler Credit Corporation, dated as of October 20, 1992, with respect to the sale of Gold Key Leases. Filed as Exhibit 10-XXXXX to the Registration Statement on Form S-2 of Chrysler Financial Corporation (Registration Statement No. 33-51302) on November 24, 1992, and incorporated herein by reference. 10-AA-2 Copy of Servicing Agreement, dated as of October 20, 1992, between Chrysler Leaserve, Inc. (a subsidiary of General Electric Capital Auto Lease, Inc.) and Chrysler Credit Corporation, with respect to the sale of Gold Key Leases. Filed as Exhibit 10-YYYYY to the Registration Statement on Form S-2 of Chrysler Financial Corporation (Registration Statement No. 33-51302) on November 24, 1992, and incorporated herein by reference. 10-BB-1 Copy of First Amendment dated as of August 24, 1992 to the Series 1991-1 Supplement dated as of May 31, 1991, among U.S. Auto Receivables Company ("USA"), as seller (the "Seller"), Chrysler Credit Corporation, as servicer (the "Servicer") and Manufacturers and traders Trust Company, as Trustee (the "Trustee"), to the Pooling and Servicing Agreement dated as of May 31, 1991, as assigned by Chrysler Auto Receivables Company to USA on August 8, 1991, as amended by the First Amendment dated as of August 6, 1992, among the Seller, the Servicer and the Trustee, with respect to CARCO Auto Loan Master Trust. Filed as Exhibit 4-M to the Quarterly Report on Form 10-Q of CARCO Auto Loan Master Trust for the quarter ended September 30, 1992, and incorporated herein by reference. 10-BB-2 Copy of Second Amendment dated as of August 24, 1992 to the Series 1991-2 Supplement dated as of June 30, 1991, among U.S. Auto Receivables Company ("USA"), as seller (the "Seller"), Chrysler Credit Corporation, as servicer (the "Servicer") and Manufacturers and Traders Trust Company, as Trustee (the "Trustee"), to the Pooling and Servicing Agreement dated as of May 31, 1991, as assigned by Chrysler Auto Receivables Company to USA on August 8, 1991, as amended by the First Amendment dated as of August 6, 1992, among the Seller, the Servicer and the Trustee, with respect to CARCO Auto Loan Master Trust. Filed as Exhibit 4-N to the Quarterly Report on Form 10-Q of CARCO Auto Loan Master Trust for the quarter ended September 30, 1992, and incorporated herein by reference. 10-BB-3 Copy of Second Amendment dated as of August 24, 1992 to the Series 1991-3 Supplement dated as of June 30, 1991, among U.S. Auto Receivables Company ("USA"), as seller (the "Seller"), Chrysler Credit Corporation, as servicer (the "Servicer") and Manufacturers and Traders Trust Company, as Trustee (the "Trustee"), to the Pooling and Servicing Agreement dated as of May 31, 1991, as assigned by Chrysler Auto Receivables Company to USA on August 8, 1991, as amended by the First Amendment dated as of August 6, 1992, among the Seller, the Servicer and the Trustee, with respect to CARCO Auto Loan Master Trust. Filed as Exhibit 4-O to the Quarterly Report on Form 10-Q of CARCO Auto Loan Master trust for the quarter ended September 30, 1992, and incorporated herein by reference. 10-BB-4 Copy of First Amendment dated as of August 24, 1992 to the Series 1991-4 Supplement dated as of September 30, 1991, among U.S. Auto Receivables Company ("USA"), as seller (the "Seller"), Chrysler Credit Corporation, as servicer (the "Servicer") and Manufacturers and Traders Trust Company, as Trustee (the "Trustee"), to the Pooling and Servicing Agreement dated as of May 31, 1991, as assigned by Chrysler Auto Receivables Company to USA on August 8, 1991, as amended by the First Amendment dated as of August 6, 1992, among the Seller, the Servicer and the Trustee, with respect to CARCO Auto Loan Master Trust. Filed as Exhibit 4-P to the Quarterly Report on Form 10-Q of CARCO Auto Loan Master Trust for the quarter ended September 30, 1992, and incorporated herein by reference. 10-CC-1 Copy of Sale and Servicing Agreement, dated as of November 1, 1992, among Premier Auto Receivables Company, as Seller, Chrysler Credit Corporation, as Servicer, and Premier Auto Trust 1992-6, as Purchaser, with respect to Premier Auto Trust 1992-6. Filed as Exhibit 10-PPPPPP to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. 10-CC-2 Copy of Trust Agreement, dated as of November 1, 1992, among ML Asset Backed Corporation, Premier Auto Receivables Company and Chemical Bank Delaware as Owner Trustee, with respect to Premier Auto Trust 1992-6. Filed as Exhibit 10-QQQQQQ to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. Part IV - Continued Item 14. EXHIBITS, FINANCIAL STATEMENTS SCHEDULES, AND REPORTS ON FORM 8-K - Continued 10-CC-3 Copy of Sale and Servicing Agreement, dated as of January 1, 1993, among Premier Auto Receivables Company, as Seller, Chrysler Credit Corporation, as Servicer, and Premier Auto Trust 1993-1, as Purchaser, with respect to Premier Auto Trust 1993-1. Filed as Exhibit 10-RRRRRR to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. 10-CC-4 Copy of Trust Agreement, dated as of January 1, 1993, among ML Asset Backed Corporation, Premier Auto Receivables Company and Chemical Bank Delaware, as Owner Trustee, with respect to Premier Auto Trust 1992-6. Filed as Exhibit 10- SSSSSS to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. 10-CC-5 Copy of Receivables Purchase Agreement, dated as of November 25, 1992, between Chrysler Credit Canada Ltd., Chrysler Financial Corporation and Associated Assets Acquisitions Inc. with respect to Canadian Auto Receivables Securitization 1992-3. Filed as Exhibit 10-TTTTTT to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. 10-CC-6 Copy of Purchase Agreement, dated as of January 25, 1993, among Chrysler Credit Canada Ltd., Chrysler Canada Ltd., Auto 1 Limited Partnership and Chrysler Financial Corporation, with respect to Auto 1 Trust. Filed as Exhibit 10-UUUUUU to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. 10-CC-7 Copy of Master Lease Agreement, dated as of January 25, 1993, among Chrysler Credit Canada Ltd., Chrysler Canada Ltd. and Auto 1 Limited Partnership, with respect to Auto 1 Trust. Filed as Exhibit 10-VVVVVV to the Annual Report of Chrysler Financial Corporation on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. 10-DD Copy of Amended and Restated Trust Agreement, dated as of April 1, 1993, among Premier Auto Receivables Company, Chrysler Financial Corporation and Chemical Bank Delaware, as Owner Trustee, with respect to Premier Auto Trust 1993-2. Filed as Exhibit 4.1 to the Quarterly Report of Premier Auto Trust 1993-2 on Form 10-Q for the quarter ended June 30, 1993, and incorporated herein by reference. 10-EE Copy of Indenture, dated as of April 1, 1993, between Premier Auto Trust 1993-2 and Bankers Trust Company, as Indenture Trustee, with respect to Premier Auto Trust 1993-2. Filed as Exhibit 4.2 of the Quarterly Report of Premier Auto Trust 1993-2 on Form 10-Q for the quarter ended June 30, 1993, and incorporated herein by reference. 10-FF Copy of Amended and Restated Trust Agreement, dated as of June 1, 1993, among Premier Auto Receivables Company, Chrysler Financial Corporation and Chemical Bank Delaware, as Owner Trustee, with respect to Premier Auto Trust 1993-3. Filed as Exhibit 4.1 to the Quarterly Report of Premier Auto Trust 1993-3 on Form 10-Q for the quarter ended June 30, 1993, and incorporated herein by reference. 10-GG Copy of Indenture, dated as of June 1, 1993, between Premier Auto Trust 1993-3 and Bankers Trust Company, as Indenture Trustee. Filed as Exhibit 4.2 to the Quarterly Report of Premier Auto Trust 1993-3 on Form 10-Q for the quarter ended June 30, 1993, and incorporated herein by reference. 10-HH Copy of Series 1993-1 Supplement, dated as of February 1, 1993, among U.S. Auto Receivables Company, as Seller, Chrysler Credit Corporation, as Servicer, and Manufacturers Hanover Trust Company, as Trustee, with respect to CARCO Auto Loan Master Trust. Filed as Exhibit 3 to the Trust's Registration Statement on Form 8-A dated March 15, 1993, and incorporated herein by reference. 10-II Copy of Receivables Purchase Agreement, made as of April 7, 1993, among Chrysler Credit Canada Ltd., Chrysler Financial Corporation and Association Assets Acquisition Inc., with respect to CARS 1993-1. Filed as Exhibit 10-OOOO to the Quarterly Report on Form 10-Q of Chrysler Financial Corporation for the quarter ended September 30, 1993, and incorporated herein by reference. 10-JJ Copy of Receivables Purchase Agreement, made as of June 29, 1993, among Chrysler Credit Canada Ltd., Chrysler Financial Corporation and Associated Assets Acquisition Inc., with respect to CARS 1993-2. Filed as Exhibit 10-PPPP to the Quarterly Report on Form 10-Q of Chrysler Financial Corporation for the quarter ended September 30, 1993, and incorporated herein by reference. Part IV - Continued Item 14. EXHIBITS, FINANCIAL STATEMENTS SCHEDULES, AND REPORTS ON FORM 8-K - Continued 10-KK Copy of Pooling and Servicing Agreement, dated as of August 1, 1993, among Auto Receivables Corporation, Chrysler Credit Canada Ltd., Montreal Trust Company of Canada and Chrysler Financial Corporation, with respect to CARCO 1993-1. Filed as Exhibit 10-QQQQ to the Quarterly Report on Form 10-Q of Chrysler Financial Corporation for the quarter ended September 30, 1993, and incorporated herein by reference. 10-LL Copy of Standard Terms and Conditions of Agreement, dated as of August 1, 1993, among Auto Receivables Corporation, Chrysler Credit Canada Ltd. and Chrysler Financial Corporation, with respect to CARCO 1993-1. Filed as Exhibit 10-RRRR to the Quarterly Report on Form 10-Q of Chrysler Financial Corporation for the quarter ended September 30, 1993, and incorporated herein by reference. 10-MM Copy of Purchase Agreement, dated as of August 1, 1993, between Chrysler Credit Canada Ltd., and Auto Receivables Corporation, with respect to CARCO 1993-1. Filed as Exhibit 10-SSSS to the Quarterly Report on Form 10-Q of Chrysler Financial Corporation for the quarter ended September 30, 1993, and incorporated herein by reference. 10-NN Copy of Lease Receivables Purchase Agreement, dated as of December 23, 1992, among Chrysler Systems Leasing Inc., Chrysler Financial Corporation and Sanwa Business Credit Corporation. Filed as Exhibit 10-TTTT to the Quarterly Report on Form 10-Q of Chrysler Financial Corporation for the quarter ended September 30, 1993, and incorporated herein by reference. 10-OO Copy of Lease Receivables Purchase Agreement, dated September 3, 1993, among CXC Incorporated, Chrysler Systems Inc., and Chrysler Financial Corporation. Filed as Exhibit 10-UUUU to the Quarterly Report on Form 10-Q of Chrysler Financial Corporation for the quarter ended September 30, 1993, and incorporated herein by reference. 10-PP Copy of Lease Receivables Purchase Agreement, dated September 22, 1993, among the CIT Group/Equipment Financing, Inc., Chrysler Systems Inc., and Chrysler Financial Corporation. Filed as Exhibit 10-VVVV to the Quarterly Report on Form 10-Q of Chrysler Financial Corporation for the quarter ended September 30, 1993, and incorporated herein by reference. 10-QQ Copy of Asset Purchase Agreement, dated as of July 31, 1993, between Chrysler Rail Transportation Corporation and General Electric Railcar Leasing Services Corporation. Filed as Exhibit 10-WWWW to the Quarterly Report on Form 10-Q of Chrysler Financial Corporation for the quarter ended September 30, 1993, and incorporated herein by reference. 10-RR Copy of Amended and Restated Loan Agreement, dated as of June 1, 1993, between Chrysler Realty Corporation and Chrysler Credit Corporation. Filed as Exhibit 10-XXXX to the Quarterly Report on Form 10-Q of Chrysler Financial Corporation for the quarter ended September 30, 1993, and incorporated herein by reference. 10-SS Copy of Loan Agreement, dated as of March 31, 1993, between Manatee Leasing, Inc. and Chrysler Credit Corporation. Filed as Exhibit 10-YYYY to the Quarterly Report on Form 10-Q of Chrysler Financial Corporation for the quarter ended September 30, 1993, and incorporated herein by reference. 10-TT Copy of Origination and Servicing Agreement, dated as of June 4, 1993, among Chrysler Leaserve, Inc., General Electric Capital Auto Lease, Inc., Chrysler Credit Corporation and Chrysler Financial Corporation. Filed as Exhibit 10-ZZZZ to the Quarterly Report on Form 10-Q of Chrysler Financial Corporation for the quarter ended September 30, 1993, and incorporated herein by reference. 10-UU Copy of Amended and Restated Trust Agreement, dated as of September 1, 1993, among Premier Auto Receivables Company, Chrysler Financial Corporation and Chemical Bank Delaware, as Trustee, with respect to Premier Auto Trust 1993-5. Filed as Exhibit 4.1 to the Quarterly Report of Premier Auto Trust 1993-5 on Form 10-Q for the quarter ended September 30, 1993, and incorporated herein by reference. 10-VV Copy of Indenture, dated as of September 1, 1993, between Premier Auto Trust 1993-5 and Bankers Trust Company, as Indenture Trustee, with respect to Premier Auto Trust 1993-5. Filed as Exhibit 4.2 to the Quarterly Report of Premier Auto Trust 1993-5 on Form 10-Q for the quarter ended September 30, 1993, and incorporated herein by reference. Part IV - Continued Item 14. EXHIBITS, FINANCIAL STATEMENTS SCHEDULES, AND REPORTS ON FORM 8-K - Continued 10-WW Copy of Asset Purchase Agreement, dated as of October 29, 1993, between Marine Asset Management Corporation and Trico Marine Assets, Inc. Filed as Exhibit 10-CCCCC to the Quarterly Report on Form 10-Q of Chrysler Financial Corporation for the quarter ended September 30, 1993, and incorporated herein by reference. 10-XX Copy of Asset Purchase Agreement, dated as of December 3, 1993, between Chrysler Rail Transportation Corporation and Allied Railcar Company. Filed as Exhibit 10-OOOO to the Annual Report on Form 10-K of Chrysler Financial Corporation and incorporated herein by reference. 10-YY Copy of Secured Loan Purchase Agreement, dated as of December 15, 1993, among Chrysler Credit Canada Ltd., Leaf Trust and Chrysler Financial Corporation. Filed as Exhibit 10-PPPP to the Annual Report on Form 10-K of Chrysler Financial Corporation and incorporated herein by reference. 11 Statement regarding computation of earnings per common share. 12 Statement regarding computation of ratios of earnings to fixed charges and preferred stock dividends. 21 Subsidiaries of the Registrant. 23 Consent of Deloitte & Touche, independent auditors for Chrysler Corporation. 24 Powers of Attorney executed by officers and directors who signed this Annual Report on Form 10-K by an attorney-in-fact. In lieu of filing certain instruments with respect to the long-term debt of the type described in Item 601 (b)(4) of Regulation S-K with respect to the long-term debt of Chrysler Corporation and its consolidated subsidiaries, Chrysler Corporation agrees to furnish a copy of such instruments to the Securities and Exchange Commission on request. (b) Reports on Form 8-K: No reports on Form 8-K were filed during the three months ended December 31, 1993. __________________ Filed herewith CONFORMED 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. Pursuant to the requirements of the Securities and 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. CONFORMED SIGNATURES CONFORMED SIGNATURES CHRYSLER CORPORATION AND CONSOLIDATED SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT Year ended December 31, 1993 (in millions of dollars) _______________________ (a) Reclassifications. (b) Amortization charged to cost of products sold. (c) Includes the sale of the plastics operations of Chrysler's Acustar division. CHRYSLER CORPORATION AND CONSOLIDATED SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT Year ended December 31, 1992 (in millions of dollars) _______________________ (a) Includes consolidation of New Venture Gear, Inc. (b) Reclassifications. (c) Amortization charged to cost of products sold. CHRYSLER CORPORATION AND CONSOLIDATED SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT Year ended December 31, 1991 (in millions of dollars) __________________________ (a) Includes fixed assets of General Rent-A-Car. (b) Reclassifications. (c) Amortization charged to cost of products sold. CHRYSLER CORPORATION AND CONSOLIDATED SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT Years ended December 31, 1993, 1992 and 1991 (in millions of dollars) _____________________ (a) Reclassifications. (b) Includes consolidation of New Venture Gear, Inc. (c) Includes fixed assets of General Rent-A-Car. (d) Includes the sale of the plastics operations of Chrysler's Acustar division. CHRYSLER CORPORATION AND CONSOLIDATED SUBSIDIARIES SCHEDULE VII - GUARANTEES OF SECURITIES OF OTHER ISSUERS December 31, 1993 (in millions of dollars) CHRYSLER CORPORATION AND CONSOLIDATED SUBSIDIARIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS Years ended December 31, 1993, 1992 and 1991 (in millions of dollars) _______________________ (a) Losses charged to reserve. (b) Chrysler adopted SFAS No. 109, "Accounting for Income Taxes," effective January 1, 1992. (c) Acquisition of General Rent-A-Car in March 1991. (d) Principally utilization of foreign net operating loss carryforwards. CHRYSLER CORPORATION AND CONSOLIDATED SUBSIDIARIES SCHEDULE IX - SHORT-TERM BORROWINGS Years ended December 31, 1993, 1992 and 1991 (in millions of dollars) _______________________ (a) Based on month-end averages. (b) Computed by dividing total daily outstanding principal balances by 365 or 366 days, as applicable. (c) Computed by dividing actual short-term interest expense by the average short-term debt outstanding after adjustments for compensating balances and fees applicable to such borrowings. (d) Weighted average interest rates are inflated due to high interest rates on Peso borrowings in Mexico. CHRYSLER CORPORATION AND CONSOLIDATED SUBSIDIARIES SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION Years ended December 31, 1993, 1992 and 1991 (in millions of dollars) Note: Amounts denoted by "*" are not presented because they are less than 1% of total sales and revenues.
54045_1993.txt	54045	1993	Item 1. BUSINESS 1(a) GENERAL DEVELOPMENT OF BUSINESS Joslyn Corporation, an Illinois corporation (together with its subsidiaries, the "Registrant") is a holding company formed in 1988 in connection with a share exchange with its principal operating subsidiary, Joslyn Manufacturing Co. Joslyn Manufacturing Co., founded by Marcellus L. Joslyn, was incorporated in Illinois on December 6, 1902 as the Independent Arm and Pin Co. The Registrant is a holding company for a number of subsidiaries which are engaged primarily in the manufacturing and supplying of electrical hardware, apparatus, protective equipment, air pressurization and dehydration products and services used in the construction and maintenance of transmission and distribution facilities to electric power and telephone companies. The Registrant's subsidiaries also manufacture and supply vacuum switchgear and electrical controls to commercial and industrial markets as well as protective equipment, connector backshells, and air and gas dehydration systems to aerospace and defense companies. The Registrant has eleven wholly owned operating subsidiaries: * JOSLYN MANUFACTURING CO., a Delaware corporation, manufactures and supplies electrical hardware, apparatus, and protective equipment used in the construction and maintenance of electric power transmission and distribution facilities and telephone and cable television communication lines. * JOSLYN CLARK CONTROLS, INC., a Delaware corporation, manufactures electrical controls, fire pump controllers, general purpose contactors and starters for industrial and commercial markets. * JOSLYN CANADA INC., organized under the laws of the Province of Ontario, Canada, supplies electrical apparatus and protective equipment, high-voltage vacuum and sulfur hexaflouride (SF-6) switching equipment for commercial, heavy industrial and electrical utility markets within Canada. * JOSLYN HI-VOLTAGE CORPORATION, a Delaware corporation, manufactures and supplies high-voltage vacuum and air switching equipment for commercial, heavy industrial and electrical utility markets. * JOSLYN ELECTRONIC SYSTEMS CORPORATION, a Delaware corporation, manufactures and supplies electric power equipment, electronic protection equipment, and field test equipment designed and produced primarily for the telecommunications, industrial, aerospace and defense industries. * JOSLYN POWER PRODUCTS CORPORATION, a Delaware corporation, manufactures and supplies sulfur hexaflouride (SF-6) fuses and medium voltage switchgear for commercial, industrial and electrical utility markets. * JOSLYN JENNINGS CORPORATION, a Delaware corporation, manufacturers and supplies vacuum capacitors for aerospace and defense markets and vacuum interrupters for industrial, commercial and electrical utility markets. * JOSLYN RESEARCH AND DEVELOPMENT CORPORATION, a Delaware corporation, conducts research and product development jointly with other Joslyn subsidiaries. * ADK PRESSURE EQUIPMENT CORPORATION, a Delaware corporation, manufactures and distributes air dehydrators and associated equipment to provide and monitor pressurized dry air. Most products are used to prevent moisture intrusion in telephone cables, antenna lines and wave guides and are sold to telephone markets worldwide. * The SUNBANK FAMILY OF COMPANIES,INC., a California holding corporation, and its two subsidiaries, SUNBANK ELECTRONICS,INC., and AIR-DRY CORPORATION OF AMERICA, Delaware corporations, supply custom designed electrical connector accessories and flexible conduits, multi-conductor cable and air and gas dehydration systems for aerospace and defense markets. * JOSLYN FOREIGN SALES CORPORATION, organized under the laws of the Virgin Islands of the United States, exports the Registrant's products throughout the world. 1(b) FINANCIAL INFORMATION ABOUT BUSINESS SEGMENTS Note 12, Segment of Business Reporting, on page 22 of the Annual Report is incorporated herein by reference. 1(c) NARRATIVE DESCRIPTION OF BUSINESS The Registrant's business is composed of two business segments: Utility Systems and Electrical Technologies. The products and services of Registrant's subsidiaries have been grouped as business segments based upon and in a manner consistent with the types of markets existing for the products and services. UTILITY SYSTEMS SEGMENT (a) PRINCIPAL PRODUCTS AND SERVICES The Registrant designs and manufactures construction, maintenance materials and electric power protection equipment principally for electric power distribution and overhead telephone and cable television communication lines. These products are manufactured from metal, rubber and porcelain and include pole line hardware, earth anchors, power surge arresters, power distribution cut-outs, cable termination devices and other products. Sales of these materials and products by Registrant's subsidiaries are made directly to ultimate users, distributors for resale to ultimate users, contractors, and to original equipment manufacturers by a direct sales force of approximately twenty people. Distribution is made directly from manufacturing plants or through a network of distribution centers operated by Registrant's subsidiaries. (b) RAW MATERIALS Materials used in the manufacture of the products of this segment are basic commodities, primarily various types of steel, rubber, porcelain, zinc, zinc oxide powder and components which are readily available and are purchased by Registrant's subsidiaries from numerous sources, none of which is material to the business of this segment as a whole. (c) PATENTS, LICENSES AND TRADEMARKS The Registrant does not consider that the business of the Utility Systems segment is dependent to a material extent upon patent and trademark protection, although certain features of the products of this segment are protected by patents and trademarks. Licensing of these products to others plays no material role in the Registrant's earnings. (d) SEASONAL ASPECTS OF BUSINESS Although the level of business of the Utility Systems segment varies modestly throughout the year, the business of this segment is not seasonal. (e) CUSTOMERS The business of this segment is not dependent upon any single customer or a few customers, the loss of which would have a material adverse effect on this segment as a whole. (f) BACKLOG ORDERS The Registrant does not believe information related to backlog orders to be material to the understanding of the business of this segment. (g) RENEGOTIATION OF PROFITS The business of the Utility Systems segment is not subject to renegotiation of profits or termination of contracts or subcontracts at the election of the Government. (h) COMPETITION There are several competitors in every product line of this segment resulting in strong competition. Because of the range of products manufactured by Registrant's subsidiaries, it is difficult to determine accurately its overall competitive position in these lines. The Registrant believes, however, that it is one of the principal suppliers of transmission, distribution and communication hardware, electric power surge arresters, electric power distribution cutouts and terminating devices in the United States and Canada. Some of the products manufactured by this segment, however, are commodity products with respect to which the Registrant experiences competition with directly competing products. The Registrant competes on the basis of its service, product quality, marketing technique and price and believes that its ability in these areas permits it to compete effectively. ELECTRICAL TECHNOLOGIES SEGMENT (a) PRINCIPAL PRODUCTS AND SERVICES Electric power and electronic protection equipment and switchgear are designed and produced primarily for use by the telecommunications, industrial, aerospace, defense, electric utility and petrochemical industries. These products include communication transient voltage suppression devices, communication test equipment, vacuum interrupters for power switching, starters and contactors, air dryers, and sulfur hexaflouride switches. The Registrant's defense products include electrical flexible conduits, vacuum capacitors, air and gas dehydration systems, electromagnetic pulse protection applications, and specialty products. Such products are primarily sold by Registrant's subsidiaries own sales force or through sales representatives directly to end users or to original equipment manufacturers, although some sales are made to distributors for resale. (b) RAW MATERIALS Materials used in the manufacture of the products of the Electrical Technologies segment are basic commodities and components which are readily available and are purchased by Registrant's subsidiaries from numerous sources, none of which is material to the business of this segment as a whole. (c) PATENTS, LICENSES AND TRADEMARKS The Registrant does not consider that the business of the Electrical Technologies segment is dependent to a material extent upon patent and trademark protection, although certain features of the products of the segment are protected by patents and trademarks. Licensing of these products to others is not material to the Registrant's earnings. The Registrant has obtained licenses to utilize various patents in some of the lines of business of this segment. However, no product manufactured by the Electrical Technologies segment under licenses from others makes a material contribution to sales or earnings. (d) SEASONAL ASPECTS OF BUSINESS Although the level of the business of the Electrical Technologies segment varies modestly throughout the year, the business of this segment is not seasonal. (e) CUSTOMER The business of this segment is not dependent upon any single customer or a few customers, the loss of which would have a material adverse effect on the segment as a whole. (f) BACKLOG ORDERS The Registrant does not believe information related to backlog orders to be material to the understanding of the business of this segment. (g) RENEGOTIATION OF PROFITS The business of the Electrical Technologies segment is not subject to renegotiation of profits or termination of contracts or subcontracts at the election of the Government. (h) COMPETITION There are several competitors in most product lines of this segment resulting in competition. Because of the range of products manufactured by the Registrant's subsidiaries, it is difficult to determine accurately its overall competitive position in these lines. The Registrant believes, however, that it is one of the principal U.S. suppliers of electrical power switching systems using vacuum and SF-6 technologies. Some of the electrical products manufactured by this segment are high technology products with respect to which Registrant's subsidiaries experience competition with products utilizing competing technology. The Registrant competes on the basis of its advanced technology, services, product quality, marketing technique and price and believes that its ability in these areas permits it to compete effectively. EFFECT OF ENVIRONMENTAL PROTECTION Compliance with federal, state and local provisions which have been enacted or adopted regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment, has had no material adverse impact upon capital expenditures, earnings and the competitive position of the Registrant and its subsidiaries, except to the extent as described in Item 3, "Legal Proceedings." The Registrant regularly makes provision in its budgeted capital expenditures for environmental control facilities; however, for the current fiscal year ending December 31, 1993, and for future periods, the Registrant has not planned any capital expenditures for environmental control facilities which are expected to be material to current operations. See also Item 3, "Legal Proceedings." NUMBER OF EMPLOYEES As of March 1, 1994, the Registrant had approximately 2,025 employees. 1(d) FINANCIAL INFORMATION ABOUT FOREIGN AND DOMESTIC OPERATIONS AND EXPORT SALES Note 12, Segment of Business Reporting, on page 22 of the Annual Report is incorporated herein by reference. Item 2.		Item 2. PROPERTIES EXPIRATION OF TERM PLANT OR FACILITY AND LOCATION GENERAL CHARACTER IF LEASED ______________________________ _________________ __________ (a) CORPORATE HEADQUARTERS Allen County, Indiana Undeveloped Property Bonner County, Idaho Undeveloped Property Chicago, Illinois Office 4/30/05 Goleta, California Undeveloped Property Santa Maria, California Undeveloped Property (b) UTILITY SYSTEMS Birmingham, Alabama Distribution Center and Undeveloped Property Brooklyn Center, Minnesota Undeveloped Property Chicago, Illinois Manufacturing Plant and Distribution Center Chicago, Illinois Manufacturing Plant Franklin Park, Illinois Office, Manufacturing Plant Franklin Park, Illinois Undeveloped Property Richmond, Virginia Distribution Center and 9/1/96 Sales Office Vernon, California Distribution Center 10/30/94 (c) ELECTRICAL TECHNOLOGIES Alsip, Illinois Manufacturing Plant Cleveland, Ohio (116th Street) Manufacturing Plant Cleveland, Ohio (Harvard Avenue) Manufacturing Plant Goleta, California Manufacturing Plant Lachine, Quebec Manufacturing Plant and Office 12/31/96 Lancaster, South Carolina Manufacturing Plant Maui, Hawaii Investment Property Moorpark, California Manufacturing Plant 1/31/98 Paso Robles, California Manufacturing Plant 1/31/98 San Dimas, California Service Center Month to Month San Jose, California Manufacturing Plant Spokane, Washington Manufacturing Plant 9/30/94 Somerset, New Jersey Distribution Center and Sales Office Month to Month Woodstock, Illinois Office, Manufacturing Plant and Test Facility The Registrant believes that its properties are in good condition and are adequate to meet its current and reasonably anticipated needs. Item 3.	Item 3. LEGAL PROCEEDINGS Registrant's subsidiary, Joslyn Manufacturing Co. (the "Company") previously operated wood treating facilities that chemically preserved utility poles, pilings and railroad ties. An environmental reserve for estimated additional, future remedial actions and clean-up costs for known sites currently under investigation pursuant to environmental laws and regulations has been made. Note 6, Environmental Matters, on page 19 of the Annual Report is incorporated herein by reference. Joslyn Manufacturing Co. executed a Consent Order effective May 30, 1985, with the Minnesota Pollution Control Agency pertaining to a former wood treating facility owned by the Company located in Brooklyn Center, Minnesota. The Consent Order requires the Company to undertake soil and groundwater investigation and clean-up of the site. The Company is currently performing its obligations under the Consent Order and is continuing the clean-up of the site. Registrant has completed a significant portion of the clean-up at the site. The Louisiana Department of Environmental Quality issued administrative orders against potentially responsible parties, including Joslyn Manufacturing Co., to perform a clean-up at a former wood treating facility located in Bossier City, Louisiana. The Company is complying with the administrative order and has unilaterally implemented a remedial action plan for remediating the site. Additional offsite soil remediation may be required. The Company has begun preliminary investigation of offsite areas. The site has recently been proposed for listing on the National Priorities List by the U.S. Environmental Protection Agency. The Company is opposing the proposed listing. The Company is currently appealing adverse decisions against other potentially responsible parties as well as its insurance carrier for allocation, contribution and indemnification for remediation efforts which have been or will be performed by the Company. The Company is a defendant in a purported class action lawsuit entitled, JOHNSON ET AL. V. LINCOLN CREOSOTE CO., INC., filed with the 26th Judicial Court for Bossier Parish, Louisiana, No. 70481 on February 23, 1987, . Plaintiffs are seeking damages allegedly sustained from the disposal of materials on the former wood treating site previously owned and operated by the Company prior to 1970 and located in Bossier City, Louisiana. The damages sought are unspecified. The Court held a hearing for the purpose of determining class certification but no decision has yet been made by the judge. The Company has tendered the defense of the suit to its insurance carrier. On November 20, 1986, the Illinois Environmental Protection Agency issued an Immediate Removal Order for the Company's former wood treating facility in Franklin Park, Illinois. In compliance with that Order, Registrant has completed a significant portion of the clean-up at the site. In 1990, the Company entered into a Consent Order with the current property owner and the Oregon Department of Environmental Quality pertaining to a former wood treating facility located in Portland, Oregon. The Consent Order requires an investigation of the site which is continuing. It is anticipated that a feasibility study for remediating the site will be completed in 1994. The Company has been named as a third party defendant in a suit filed on September 11, 1992 entitled UNITED STATES OF AMERICA, ET AL. VS. SCA SERVICES OF INDIANA V. OMNISOURCE CORP.,-29, U.S. District Court Northern District Indiana (Ft. Wayne Division). The suit seeks contribution for the remediation of the Ft. Wayne Reduction Superfund Site. The Company is one of over 65 potentially responsible parties. The Company is defending the suit. Item 4.	Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. EXECUTIVE OFFICERS OF THE REGISTRANT Listed below are the names, titles, offices, positions and ages of all executive officers of the Registrant. There are no family relationships between them. The officers' terms in office expire on April 27, 1994, the date of the meeting of the Board of Directors, which is held immediately before the 1994 Annual Meeting of Shareholders. DONALD B. HAMISTER Chairman of the Board - Age 73 Experience 1992 Retired as Chief Executive Officer 1991 Re-elected Chief Executive Officer 1987 Retired as Chief Executive Officer RAYMOND E. MICHELETTI President, Chief Executive Officer and a Director - Age 68 Experience 1992 Elected President, Chief Executive Officer and Director 1991 Elected President, Chief Operating Officer and Director 1988 Elected Senior Vice President; Elected President, Joslyn Hi-Voltage Corporation LAWRENCE G. WOLSKI Director, Executive Vice President, Chief Financial Officer, and Utility Systems Group Director - Age 49 Experience 1993 Elected Executive Vice President 1987 Elected Senior Vice President GEORGE W. DIEHL Vice President, Power Switching and Controls Group Director and a Director - Age 54 Experience 1991 Appointed Vice President; Elected President and Chief Operating Officer, Joslyn Hi-Voltage Corporation 1988 General Manager, Joslyn Hi-Voltage Corporation DANIEL DUMONT Vice President - Age 46 Experience 1990 Appointed Vice President; Elected President and Chief Operating Officer, Joslyn Canada Inc. 1987 General Manager, Joslyn Canada Inc. WAYNE M. KOPROWSKI Vice President, General Counsel and Secretary - Age 47 Experience 1990 Elected Vice President 1986 Elected General Counsel and Secretary, Joslyn Corporation STEVEN L. THUNANDER Vice President - Age 43 Experience 1988 Appointed Vice President; Elected President and Chief Operating Officer, Joslyn Manufacturing Co. PART II Item 5.	Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Information regarding the price of Registrant's common stock, dividend payments and numbers of shareholders is included in Common Stock Prices and Dividends on page 10 of the Annual Report which is incorporated herein by reference. Item 6.	Item 6. SELECTED FINANCIAL DATA Selected financial data, which is included in the Five-Year Comparative Financial Data on page 10 of the Annual Report, is incorporated herein by reference. Item 7.	Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION Management's Discussion and Analysis of Financial Condition and Results of Operations on pages 4 through 9 of the Annual Report is incorporated herein by reference. Item 8.	Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The following consolidated financial statements of the Registrant and its subsidiaries, included in the Annual Report, are incorporated herein by reference: ANNUAL REPORT PAGE NO. _____________ Consolidated Statement of Income for the Years Ended December 31, 1993, 1992 and 1991 11 Consolidated Balance Sheet -- December 31, 1993 and 1992 12 Consolidated Statement of Shareholders' Equity for the Years Ended December 31, 1993, 1992 and 1991 13 Consolidated Statement of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 14 Notes to Consolidated Financial Statements 15-23 Report of Independent Public Accountants 23 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 (a) Information regarding directors of the Registrant required by this Item 10 is contained under the caption "Nominees For Election As Director" on pages 2 and 3 of the Proxy Statement, and is incorporated herein by reference. (b) Information regarding executive officers of the Registrant required by this Item 10 is included on pages 10 and 11 in Part I of this Report pursuant to General Instruction G of Form 10-K. Item 11.	Item 11. EXECUTIVE COMPENSATION Information concerning executive compensation required by this Item 11 is contained under the following captions in the Proxy Statement, and is incorporated herein by reference: PROXY Statement Page No. _________ Compensation of Directors 5 Summary Compensation Table 6 Stock Option/SAR Grants in 1993 7 Defined Benefit Pension Plan 7 Employment Agreements 8 Item 12.	Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this Item 12 is contained in the Proxy Statement under the captions "Principal Holders of Voting Securities" on page 4 and "Security Ownership of Management on March 3, 1994" on page 3 and is incorporated herein by reference. PART IV Item 13.	Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS None. Item 14.	Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a)1. Financial Statements Included in Part II of this report: Consolidated Statement of Income for the years ended December 31, 1993, 1992 and 1991 Consolidated Balance Sheet as of December 31, 1993 and 1992 Consolidated Statement of Shareholders' Equity for the years ended December 31, 1993, 1992 and 1991 Consolidated Statement of Cash Flows for the years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements 2. Financial Statement Schedules Included in Part IV of this Report: PAGE Report of Independent Public Accountants on Consolidated Financial Statement Schedules 16 Schedule II - Amounts Receivable From Related Parties And Underwriters, Promoters and Employees 17 Schedule V - Property, Plant and Equipment 18 Schedule VI - Accumulated Depreciation of Property, Plant and Equipment 19 Other schedules are omitted because of the absence of conditions under which they are required or because the required information is given in the financial statements or notes thereto. 3. Exhibits The exhibits filed in response to Item 601 of Regulation S-K and Item 14(c) of Form 10-K are listed in the Exhibit Index on page 20. Management contracts or compensatory plans or arrangements are identified in the Exhibit Index by a "+". (b) Reports on Form 8-K No reports on Form 8-K were filed during the fourth quarter of the period ended December 31, 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. March 30, 1994 JOSLYN CORPORATION By:/s/ Raymond E. Micheletti ________________________________ Raymond E. Micheletti 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/Donald B. Hamister Chairman of the Board March 30, 1994 ________________________ Donald B. Hamister /s/Raymond E. Micheletti President, Chief Executive ________________________ Officer, Director March 30, 1994 Raymond E. Micheletti /s/Lawrence G. Wolski Executive Vice President, March 30, 1994 ________________________ Chief Financial Officer, Chief Lawrence G. Wolski Accounting Officer, Director /s/William E. Bendix Director March 30, 1994 ________________________ William E. Bendix /s/John H. Deininger Director March 30, 1994 ________________________ John H. Deininger /s/Richard C. Osborne Director March 30, 1994 ________________________ Richard C. Osborne /s/Walter W. Schoenholz Director March 30, 1994 ________________________ Walter W. Schoenholz REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON CONSOLIDATED FINANCIAL STATEMENT SCHEDULES ___________________________________________ We have audited, in accordance with generally accepted auditing standards, the consolidated financial statements included in Joslyn Corporation's annual report incorporated by reference in this Form 10-K, and have issued our report thereon dated February 9, 1994. Our audit was made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed in Item 14(a)(2) are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic consolidated financial statements. These schedules have been subjected to the auditing procedures applied in the audit of the basic consolidated financial statements and, in our opinion, fairly state in all material respects the consolidated financial data required to be set forth therein in relation to the basic consolidated financial statements taken as a whole. ARTHUR ANDERSEN & CO. Chicago, Illinois February 9, 1994. SCHEDULE II AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES _________________________________________ Balance at End of Period _____________ Balance at Name of Beginning Amounts Amounts Not Debtor of Period Additions Collected Written Off Current Current ______________________________________________________________________________ Year Ended December 31, 1993 A.R. Gray(1)$175,000 $0 $5,000 $0 $0 $170,000 Year Ended December 31, 1992 A. R. Gray $185,000 $0 $10,000 $0 $0 $175,000 Year Ended December 31, 1991 A. R. Gray $195,000 $0 $10,000 $0 $0 $185,000 ____________________________ (1) Mr. Gray is Vice President and a Director of Joslyn Electronic Systems Corporation. The above debt relates to his relocation to California from Spokane, Washington, and is a second mortgage on his primary residence of 0% interest, payable in annual installments of the lesser of $10,000 or his annual bonus. The Balance at the end of the period for the current portion is not determinable until annual bonus payments are granted. A balloon payment equal to the unpaid balance of the loan is due March 1, 1997. (a) 1993 includes the transfer of $438 of long-term assets, previously held for resale, to land and buildings, $280 of a tax agents reclassification within fixed asset categories and $193 of equipment to the acquisition for cash of the EEV vacuum capacitor product line. (b) 1992 includes $8,018 of property, plant and equipment relating to the acquisition for cash of Lear Siegler Jennings Corp. Depreciation is computed using the straight-line method for financial statement purposes. Generally the rates of depreciation range from 2.5% to 4% for buildings and 6.67% to 20% for machinery and equipment. EXHIBIT INDEX Page 3(i) Articles of Incorporation (Exhibit D to Registrant's Form S-4 Registration Statement filed March 17, 1988)* 3(ii) By-Laws (Exhibit D to Registrant's Form S-4 Registration Statement filed March 17, 1988)* 4 Rights Agreement with the First National Bank of Chicago dated February 10, 1988 (Exhibit 4 to Registrant's 1987 Form 10-K)* 10 (a) Form of Employment Agreement with Mr. Micheletti (Exhibit 10(c) to Registrant's 1991 Form 10-K)+ (b) Form of Employment Agreement with Mr. Wolski (Exhibit 10(c) to Registrant's 1991 Form 10-K)+ (c) Joslyn Corporation Long Term Incentive Compensation Plan (Exhibit 10(c) to Registrant's 1989 Form 10-K)+ (d) Joslyn Corporation Parity Compensation Plan (Exhibit 10(c) to Registrant's 1989 Form 10-K)+ (e) Joslyn Mfg. and Supply Co. Employee Stock Benefit Plan, as amended (Exhibit A to Registrant's Proxy Statement dated March 25, 1983)+ (f) Joslyn Corporation Stock Option Plan (Exhibit A to Registrant's Proxy Statement dated March 28, 1989)+ 13 Portions of the Annual Report for the year ended December 31, 1993 incorporated by reference 21 21 Subsidiaries of the Registrant 41 23 Consent of Independent Public Accountants 42 99 Proxy Statement dated March 25, 1994 43 * Incorporated by reference. + Management contract or compensatory plan or arrangement. EXHIBIT 13 PORTIONS OF THE ANNUAL REPORT FOR THE YEAR ENDED DECEMBER 31, 1993 INCORPORATED BY REFERENCE Management's Discussion and Analysis of Financial Condition and Results of Operations LIQUIDITY AND CAPITAL RESOURCES The financial condition of the Corporation remains strong with a working capital ratio of 2.8 to 1 at December 31, 1993 compared to a restated 2.5 to 1 at December 31, 1992. Net deferred tax assets and retained earnings were reduced and restated by $3.1 million due to the adoption of Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes", as discussed in Note 4 of the Notes to Consolidated Financial Statements. Joslyn Corporation has no long-term debt. The $41.1 million of cash and cash equivalents, together with internally generated funds and unused lines of credit with a bank, should provide adequate liquidity and financial flexibility for 1994 and beyond to fund planned operations, environmental remedial expenditures, normal capital expansion and acquisitions. The sources and uses of cash flows are summarized in the Consolidated Statement of Cash Flows. The Balance Sheet was comparable from December 31, 1992 to December 31, 1993. Inventories increased $3.7 million or 11.5% from the prior year end, reflecting increased inventory levels at several subsidiaries to provide more Page 21 4 responsiveness to customer demand and because of new products. Despite the higher year-end inventory levels, the average monthly inventory turnover during 1993 improved compared to 1992. Also, Accounts Payable increased $1.2 million, or 10.8%, due to the timing of payments while Accrued Liabilities decreased $3.0 million, or 10.4%, due to 1) a decreased current accrual for environmental matters, 2) payments made for the relocation or discontinuance of product lines and 3) a reduction in advance payments. Environmental accruals are discussed more fully in Note 6 of the Notes to Consolidated Financial Statements. Expenditures for environmental clean-up activities were $2.7 million in 1993 compared to $15.0 million in 1992. The 1992 expenditures were partially offset by cash recoveries from an insurance carrier and other third parties which resulted in approximately $9.6 million being credited to the environmental accruals. The Corporation anticipates that it may spend up to approximately $2.0 million in 1994. The expenditures are expected to continue to decrease in the future years. Although inflation has not been a significant factor in the last several years, the Corporation continually seeks to minimize its effects by controlling costs and improving productivity. Costs are passed on by increasing selling prices when competitive conditions permit. Page 22 5 RESULTS OF OPERATIONS 1993 Net income of $14.9 million was 4% higher than in 1992 and was $2.10 per share, a new Joslyn record. In 1993, sales of $217.7 million and income from business segments of $27.8 million were flat compared to 1992. Increases in the Electrical Technologies segment of business offset decreases in the Utility Systems segment. The Electrical Technologies business segment sales of $142.7 million were $6.5 million or 4.7% greater than in 1992 and operating income of $22.8 million was $1.5 million or 7.1% greater than in 1992. Joslyn Jennings, acquired during the second quarter of 1992, made a significant contribution not only because it was included for the entire year in 1993, but also because its operating results improved. Joslyn Electronic Systems had an excellent year by increasing sales more than 14% and improving profit margins. New products helped these increases. Joslyn Hi-Voltage, Joslyn Clark Controls and Joslyn Sunbank had increased sales and earnings. Joslyn Power Products' sales and earnings were lower due to changes in product mix, decreased volume related to significant competition and because of delays in obtaining new orders. The integration of the Air-Dry and ADK Pressure Equipment operations resulted in lower combined sales and earnings because of distractions associated with this merger, as well as continued softness in defense and some areas of the telecommunications markets. The Utility Systems business segment had a difficult year with sales down $6.6 million from $81.7 million in 1992 and operating income down $1.7 million from $6.7 million in the prior Page 23 6 year. The segment's markets were weak, which led to reduced sales and increased competition. In addition, operating inefficiencies and start-up problems were encountered due to closing the Birmingham, Alabama hardware plant and relocating the production to the Chicago, Illinois hardware plant. The gross profit margin improved to 27.3% in 1993 from 26.3% in 1992 by selling higher margin products and reducing certain production costs. Selling, distribution and administrative expense of $29.5 million increased $2.8 million over 1992 primarily because of the inclusion of Joslyn Jennings and Sierra for the entire year in 1993 versus a partial year in 1992 and increased research and development expense. Other expense, net in 1993 includes charges related to plant consolidations and certain postemployment costs, as well as other miscellaneous charges of a non-operating nature. In the third quarter of 1993, Congress enacted the Revenue Reconciliation Act of 1993 (RRA) which, among other things, increased the federal statutory tax rate to 35% retroactive to January 1, 1993. Statement of Financial Accounting Standards No. 109 requires companies to recompute their tax assets if there are changes in tax laws or tax rates and to record the effects of the change in net income. In the third quarter of 1993, the Corporation recorded the effects of the RRA which increased net income and earnings per share by approximately two cents ($.02) per share because the Corporation has significant net deferred tax assets. The related tax benefit contributed to a portion of the improvement in the Corporation's effective income tax rate from 36.2% in 1992 to 34.7% in 1993. Page 24 7 RESULTS OF OPERATIONS 1992 Sales of $217.9 million were $14.2 million or 7.0% greater and income from business segments of $28.0 million was $3.1 million or 12.3% greater in 1992 than in 1991. The Electrical Technologies business segment sales of $136.2 million in 1992 increased 13.8% over 1991. The 1992 sales include approximately $14 million by Joslyn Jennings Corporation since its acquisition in April 1992. All business units within this segment had increased sales except for the defense businesses which decreased 3%. Increased sales of the SF-6 Switch products and ADK Pressure Equipment's dryers and Adam-720 monitor system were particularly strong. Operating income from this segment of $21.3 million in 1992 increased 10.6% compared to 1991. Increased income from the SF-6 Switches, Joslyn Clark Controls and ADK Pressure Equipment, along with continued strong performance by Joslyn Hi- Voltage Corporation and contributions from Joslyn Jennings, more than offset decreased income from Joslyn Electronic Systems and the defense businesses. The Utility Systems business segment sales of $81.7 million in 1992 decreased 2.8% from 1991, but operating income of $6.7 million in Page 25 8 1992 was 17.9% higher than in 1991. Operating income improved due to product mix, including the divestiture of a marginally profitable product line, and reduced operating costs related to actions taken in the last half of 1991. The Utility Systems segment had inventory reductions that also contributed to improved earnings performance. The gross profit margins improved to 26.3% for 1992 from 25.6% in 1991 due to changes in product mix, cost reductions and new products, combined with the ongoing process of reviewing and pruning marginal product lines. Selling, distribution and administrative expense of $26.7 million increased $1.6 million or 6.2% in 1992 compared to 1991 primarily because 1) the inclusion of Joslyn Jennings expenses, 2) increased direct costs related to higher sales and 3) greater spending for research and development, more than offset other expense reductions. Investment income of $1.2 million decreased 7.2% compared to 1991 because lower interest rates more than offset the increased average amount of funds invested. Other expense, net in 1992 includes primarily charges for plant consolidations, as well as miscellaneous other non-operating expenses and gains. Page 26 9 FIVE-YEAR COMPARATIVE DATA Joslyn Corporation and Subsidiaries The Corporation adopted SFAS No. 109, "Accounting for Income Taxes", (See Note 4) in 1993 and elected to apply it retroactively to 1990. Accordingly, income and per share amounts in 1990 and certain balance sheet amounts for 1990, 1991 and 1992 were restated. Relates to accounting change for postretirement medical benefits in 1991. See Note 7. Includes non-recurring charges of $23.5 million before taxes and $21.5 million after taxes primarily related to a write-down of goodwill and other intangibles. *Includes non-operating items that net to $8.0 million pretax income. COMMON STOCK PRICES AND DIVIDENDS Shares Traded on the NASDAQ National Market System The bid market price quotations were obtained from the NASDAQ National Market System. The bid prices represent prices between broker-dealers, do not include retail markups and markdowns or any commission to the broker-dealers and may not reflect prices in actual transactions. The approximate number of holders of the Corporation's common stock at March 1, 1994 was 3,200 (including employee shareholders under the Employees' Savings and Profit Sharing Plan, but excluding the number of shareholders of record whose shares are held in "nominee" or "street" name). Page 27 10 CONSOLIDATED STATEMENT OF INCOME Joslyn Corporation and Subsidiaries The accompanying Notes to Consolidated Financial Statements are an integral part of this statement. Page 28 11 CONSOLIDATED BALANCE SHEET Joslyn Corporation and Subsidiaries Restated to reflect Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes". See Note 4 in the Notes to Consolidated Financial Statements. The accompanying Notes to Consolidated Financial Statements are an integral part of this balance sheet. Page 29 12 CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY Joslyn Corporation and Subsidiaries The accompanying Notes to Consolidated Financial Statements are an integral part of this statement. Page 30 13 CONSOLIDATED STATEMENT OF CASH FLOWS Joslyn Corporation and Subsidiaries The accompanying Notes to Consolidated Financial Statements are an integral part of this statement. Page 31 14 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Joslyn Corporation and Subsidiaries 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: Principles of Consolidation: The Consolidated Financial Statements include the accounts of the Corporation and all subsidiaries, after elimination of intercompany accounts and transactions. Cash and Cash Equivalents: Cash and cash equivalents of $41,102,000 and $38,228,000 at December 31, 1993 and 1992, respectively, include cash equivalents which are highly liquid investments with original maturities or put dates of three months or less. They are recorded at cost which approximates market. Also included in this balance sheet caption are equity securities having an aggregate cost of $4,089,000 and $4,199,000 on December 31, 1993 and 1992 and an aggregate market value of $4,704,000 and $4,671,000, respectively. At December 31, 1993, gross unrealized gains were $633,000 and there were immaterial gross unrealized losses. At December 31, 1992, gross unrealized gains were $504,000 and there were immaterial unrealized losses. There were $124,000 net realized gains on the sale of equity securities in 1993, immaterial net realized gains on the sale of equity securities in 1992 and no realized gains or losses on equity securities in 1991. At December 31, 1993, cash and cash equivalents also included $608,000 of restricted funds used to guarantee a self-insurance program with an insurance company. Inventories: At December 31, 1993 and 1992, inventories of $18,424,000 and $17,646,000, respectively, are valued using the last-in, first-out (LIFO) method. The remaining inventories are valued at the lower of first-in, first-out (FIFO) cost or market. If FIFO inventory methods had been used for all inventories, the December 31, 1993 and 1992 inventories would have been $9,069,000 and $9,068,000 higher, respectively. During 1993, 1992 and 1991, certain inventories were reduced, which resulted in a liquidation of some LIFO inventories valued at lower costs prevailing in prior years. These liquidations resulted in increasing income before taxes by an immaterial amount in 1993, $875,000 in 1992 and $903,000 in 1991. Property, Plant and Equipment: Property, plant and equipment are stated at cost. Depreciation is computed using the straight-line method for financial statement purposes and accelerated methods for income tax purposes. When properties are retired or otherwise disposed of, the related cost and accumulated depreciation are removed from the respective accounts and any gain or loss from disposition is recognized. Maintenance and repair costs are expensed when incurred and were $4,261,000, $3,650,000 and $3,403,000 in 1993, 1992 and 1991, respectively. Research and Development: Costs related to research and development activities are charged against income as incurred. These costs were approximately $6,200,000 in 1993, $5,000,000 in 1992 and $4,100,000 in 1991. Cash Flow Information: Cash paid for interest was $135,000 in 1993, $212,000 in 1992 and $199,000 in 1991. Cash paid for income taxes was $7,999,000 in 1993, $5,737,000 in 1992 and $6,626,000 in 1991. Equity Adjustments: Included in Equity Adjustments are Cumulative Currency Translation Adjustments with debit balances of $260,000 and $131,000 at December 31,1993 and 1992, respectively, and Pension Liability Adjustments with debit balances of $509,000 and $445,000 at December 31, 1993 and 1992, respectively. Net Income Per Share: Net income per share of common stock was computed based on weighted average shares of 7,086,000 in 1993, 7,045,000 in 1992 and 7,047,000 in 1991. 2. FINANCING ARRANGEMENTS: At December 31, 1993, 1992 and 1991, the Corporation had unused lines of credit established with banks of $15.0 million, $17.5 million and $24.0 million, respectively, that may be drawn as needed. The lines of credit were not used during 1993, 1992 or 1991. In connection with the line of credit agreements, the Corporation was not required to maintain compensating cash balances in 1993. In 1992 and 1991, the Corporation maintained cash balances of 5% on certain unused credit lines and paid fees on certain other unused credit lines. At December 31, 1992, cash in the consolidated balance sheet included $125,000 used for compensating cash balances. The Corporation has complied with the compensating cash balance requirements of all credit agreements with banks. Page 32 15 3. PROFIT SHARING AND PENSION BENEFITS: Most domestic subsidiaries of Joslyn participate in one of two Profit Sharing Plans. The plans distribute Unit Contributions primarily in relationship to covered compensation and years of service. For both plans, Company Unit Contributions are at the discretion of the Board of Directors of each participating Corporation and are related to profit sharing income, as defined, for each Company Unit. Company Unit Contributions are made partly in cash and partly in common stock of Joslyn Corporation. The plans have similar provisions requiring one year of service for eligibility and five years of service for vesting. Each member of the Profit Sharing Plans is entitled to vote the number of Joslyn Corporation shares allocated to that member's account. Additionally, a 401(k) savings feature is part of the plans which provides proportionate, fully-vested, Company matching contributions. Profit Sharing Expense for both plans was $2,191,000 in 1993, $2,596,000 in 1992 and $2,023,000 in 1991. Additional retirement benefits are provided through a frozen non-contributory, defined benefit pension plan for eligible domestic, salaried employees of participating units. Benefits are based on years of service and an average of the five highest consecutive years of defined compensation, both before the plan freeze date. Effective December 31, 1988, this plan was frozen and no employees may qualify for participation in the plan thereafter. No amounts were contributed in 1993, 1992 and 1991 because of the full funding limitation in the 1974 Employee Retirement Income Security Act (ERISA). If a qualified defined benefit pension plan is terminated and all accrued liabilities to employees and their beneficiaries are satisfied, in general, all remaining assets in the plan's trust may revert to the employer as income, subject to significant excise and income taxes. Joslyn Clark Controls, Inc. and Joslyn Jennings Corporation each also has a non-contributory, defined benefit pension plan for eligible hourly employees. The benefits are based on negotiated amounts per year of service. The Corporation's funding policy is to make the contribution required by ERISA. The three pension plans include provisions limiting benefits in accordance with the Internal Revenue Code and ERISA. The assets of the three pension plans consist primarily of stocks and bonds in a Master Trust account which is managed by an independent investment manager. Following is a schedule reconciling the aggregate funded status of the pension plans with the amounts included in the applicable consolidated balance sheet: Actuarial present values Page 33 16 The discount rate used in determining the actuarial present value of the projected benefit obligation as of October 1, 1993 and 1992 was 6.25% and, as of October 1, 1991 was 7.25%. The expected long-term rate of return on assets for 1993, 1992 and 1991 was 8.0%. The components of net pension income (cost) in 1993, 1992 and 1991 are as follows: (in thousands) - ----------------------------------------------------------------- 1993 1992 1991 - ----------------------------------------------------------------- Service Costs-Benefits Earned During the Period $ (218) $ (314) $ (124) Interest Cost on Projected Benefit Obligation (2,231) (2,187) (1,736) Actual Return on Plan Assets 3,004 4,189 4,918 Net Amortization and Deferrals (549) (1,664) (3,081) - ----------------------------------------------------------------- Net Pension Income (Cost) $ 6 $ 24 $ (23) ================================================================= 4. INCOME TAXES: The Corporation adopted Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes", in the first quarter of 1993 and elected to apply the provisions retroactively to the calendar year ended December 31, 1990. SFAS No. 109 requires the adjustment of deferred taxes for changes in tax rates and tax laws using the liability method. The adoption of SFAS No. 109 resulted in a $3.1 million, or $.43 per share, "Cumulative Effect of Change in Accounting" charge against 1990 net income and 1990 retained earnings. Net deferred tax assets also were reduced by $3.1 million. There was no effect on income or earnings per share for 1991, 1992 or for the first two quarters of 1993. In the third quarter of 1993, Congress enacted the Revenue Reconciliation Act of 1993 (RRA) which, among other things, increased the federal statutory rate from 34% to 35% retroactively to January 1, 1993. In the third quarter, the Corporation recorded the tax effects of the RRA which increased net income and earnings per share by approximately two cents ($.02) per share. The increase reflects the benefits related to the Corporation's significant net deferred tax assets. Income before income taxes consists of the following: (in thousands) - --------------------------------------------------------------- 1993 1992 1991 - --------------------------------------------------------------- Domestic $20,409 $20,467 $19,540 Foreign 2,361 1,941 940 - --------------------------------------------------------------- $22,770 $22,408 $20,480 =============================================================== The provision for income taxes consists of the following: (in thousands) - --------------------------------------------------------------- 1993 1992 1991 - --------------------------------------------------------------- Current: U.S. Federal $ 5,801 $ 5,318 $ 5,918 Foreign 787 594 322 State and Local 1,305 1,143 1,393 - --------------------------------------------------------------- $ 7,893 $ 7,055 $ 7,633 - --------------------------------------------------------------- Deferred: U.S. Federal $ (6) $ 822 $ (283) Foreign 15 46 (12) State and Local (2) 177 (63) - --------------------------------------------------------------- $ 7 $ 1,045 $ (358) - --------------------------------------------------------------- Total Income Tax Provision $ 7,900 $ 8,100 $ 7,275 =============================================================== Page 34 17 A reconciliation of the statutory U.S. federal income tax rates to the Corporation's effective income tax rates is as follows: - ----------------------------------------------------------------- 1993 1992 1991 - ----------------------------------------------------------------- Expected Tax Rates 35.0% 34.0% 34.0% State Income Taxes, Net of Federal Income Tax 3.9 4.1 4.3 Tax Reductions Related to: Foreign Sales Corporation (1.5) (1.4) (1.4) U.S. Tax-exempt Interest (1.2) (1.2) (1.4) Research and Development Credit (0.5) (0.4) (0.7) U.S. Taxes on Foreign Operations 0.2 0.1 0.2 All Other, Net (1.2) 1.0 0.5 - ---------------------------------------------------------------- Effective Tax Rates 34.7% 36.2% 35.5% ================================================================ Deferred tax assets and liabilities arise from the tax effects of timing differences in the recognition of income and expenses for financial statement and tax purposes. Significant deferred tax assets and liabilities as of December 31, 1993 and 1992 are as follows: (in thousands) - ---------------------------------------------------------------- 1993 1992 - ---------------------------------------------------------------- Assets: Postretirement Medical $ 5,077 $ 4,650 Environmental Matters 3,705 4,034 Other Employee Benefits 1,868 1,604 Warranties 1,421 1,545 All Other 4,063 4,008 - ---------------------------------------------------------------- Gross Deferred Tax Assets $16,134 $15,841 Valuation Allowance (200) (200) - ---------------------------------------------------------------- $15,934 $15,641 ================================================================ Liabilities: Depreciation $ 4,552 $ 4,476 Pension 1,246 1,113 Other - 43 - ---------------------------------------------------------------- Gross Deferred Tax Liabilities $ 5,798 $ 5,632 ================================================================ The Corporation's policy is to provide deferred U.S. federal income taxes on the undistributed cumulative income of its foreign operating subsidiaries, to the extent that foreign tax credits are not available. The Corporation's tax credit carry-forwards are not significant. In 1991, the Corporation recorded a pretax charge of $10.2 million for the cumulative effect to January 1, 1991 of a change in accounting for postretirement medical benefits. This charge resulted in related deferred federal and state income taxes of $3.2 million and $0.7 million, respectively. 5. STOCK OPTIONS: The shareholders have approved two stock option plans for key employees which include Incentive Stock Options (ISOs), non- qualified stock options and non-qualified stock options with tandem stock appreciation rights. Stock options granted after 1991 and ISOs do not have tandem stock appreciation rights. These plans provided for a maximum of 2,081,250 shares that could be delivered upon exercise of stock options and stock appreciation rights (SARs). Stock options and SARs are granted at the market value of the Corporation's stock on the date of grant. Options granted prior to 1990 are exercisable not less than six months nor more than ten years after the date of the grant. Options granted subsequent to 1989 are exercisable not less than six months nor more than five years after the date of the grant. An SAR entitles an option holder to elect to receive, in lieu of the exercise of an option and without payment to the Corporation, an amount equal to the difference between the option price and the market value of the common stock on the date the right is exercised. This amount may be paid in cash, in common shares, or in a combination thereof, subject to approval of a committee of non-participants. An immaterial expense in 1993 and expenses of $282,000 in 1992, $208,000 in 1991 are included in Other Expense, Net with respect to SARs. The Corporation made payments or issued stock related to the exercise of SARs as follows: - ------------------------------------------------------------------ Year Number of Rights Option Price - ------------------------------------------------------------------ 1993 12,435 $15.29 to 21.17 1992 45,764 14.92 to 21.17 1991 28,748 15.29 to 18.25 ================================================================== Page 35 18 A summary of activity in the plans is presented below: 6. ENVIRONMENTAL AND LEGAL MATTERS: The Corporation previously operated wood treating facilities that chemically preserved utility poles, pilings and railroad ties. All such treating operations were discontinued or sold prior to 1982. These facilities used wood preservatives that included creosote, pentachlorophenol and chromium-arsenic-copper. While preservatives were handled in accordance with all appropriate procedures called for at the time, subsequent changes in environmental laws now require the generators of these spent preservatives to be responsible for the cost of remedial actions at the sites where spent preservatives have been deposited. The Corporation has environmental accruals of approximately $10 million as of December 31, 1993. It is anticipated that approximately $2 million may be spent in 1994 on clean-up and related activities. Consequently, approximately $2 million is classified as a current liability and the remaining $8 million of the reserve is classified as a long-term liability at December 31, 1993. Net expenditures of $2.7 million, $5.4 million and $2.9 million were made during 1993, 1992 and 1991, respectively, on environmental clean-up and related activities, of former wood treating sites. The expenditures for 1992 are net of $9.6 million proceeds received from an insurance settlement and from other parties. No charges to expense were recorded in 1993, 1992 and 1991 related to the environmental accruals. While it is difficult to estimate the timing or amount of expenditures, the Corporation believes that this reserve is adequate for clean-up of known sites currently under investigation by various state and federal environmental agencies. The reserve is based on facts known at the current time; however, changes in EPA standards, possible future listing on the National Priorities List, improvements in clean-up technology and discovery of additional information concerning these sites and other sites could affect the estimated costs in the future. The Corporation has notified its insurance carrier of the sites being investigated and has submitted claims against it for the cost of clean-up at several sites. Recoveries, if any, from the carrier are uncertain at this time. Additionally, there are other potentially responsible parties who also operated certain of the sites. The reserve reflects an estimate of the allocation of remediation costs between the various parties. Page 36 19 Joslyn Manufacturing Co., a subsidiary of the Corporation, is a defendant in a purported class action tort suit. The suit alleges exposure to chemicals and property devaluation resulting from wood treating operations previously conducted at a Louisiana site. Both the size of the class and the damages are unspecified. The Corporation has tendered the defense of the suit to its insurance carrier. The Corporation believes that it may have adequate insurance coverage for the litigation, however, because of the above uncertainties, the Corporation is unable to determine at this time the potential liability, if any. The Corporation is involved in various other claims, legal actions and complaints arising in the normal course of business. It is the opinion of Management that such actions and claims will not have a material adverse effect on the results of operations or financial condition of the Corporation. 7. POSTRETIREMENT MEDICAL BENEFITS: The Corporation and its participating domestic subsidiaries provide optional health care benefits for retired employees under a frozen contributory plan. Employees may become eligible for these benefits if they were employed by the Corporation at the defined retirement age, were employed at least ten years and were hired prior to January 1, 1989. The benefits are subject to deductibles, co-payment provisions and other limitations, which are amended periodically. Also, the Corporation assumed a frozen retiree medical coverage plan as a result of its acquisition of the Jennings business in 1992. The following data is for these coverages in aggregate. These benefits are discretionary and are not a commitment to long-term benefit payments. The plans are funded as claims are paid. In 1991, Joslyn Corporation adopted Statement of Financial Accounting Standards (SFAS) No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", on the immediate recognition basis. As a result of the adoption of SFAS No. 106, the Corporation recorded charges of $10,963,000 for optional postretirement medical benefits. The after-tax charge of $6,763,000, or $.95 per share, had two components: $6,268,000, or $.89 per share, was a one-time cumulative non-operating adjustment to January 1, 1991 and $495,000, or $.06 per share, was a charge for 1991, in addition to normal claims paid. The net periodic postretirement medical benefit cost for 1993, 1992 and 1991 was as follows: (in thousands) - ---------------------------------------------------------------- 1993 1992 1991 - ---------------------------------------------------------------- Service Cost $ 434 $ 486 $ 514 Interest Cost 762 889 868 Other (93) (25) - - ---------------------------------------------------------------- Net Medical Benefit Cost $1,103 $ 1,350 $ 1,382 ================================================================ The accumulated postretirement medical benefit obligation at December 31, 1993 and 1992 was as follows: (in thousands) - ---------------------------------------------------------------- 1993 1992 - ---------------------------------------------------------------- Retirees $ 4,129 $ 3,651 Fully Eligible Active Plan Participants 1,138 1,308 Other Active Plan Participants 6,049 7,103 - ---------------------------------------------------------------- Total Accumulated Medical Obligation $11,316 $12,062 Unrecognized Net Gain 2,816 1,334 - ---------------------------------------------------------------- Accrued Medical Benefit Cost $14,132 $13,396 ================================================================ The assumed health care cost trend rate used in the calculation for measuring the accumulated postretirement medical benefit obligation was 15.4% in 1993 and 17.7% in 1992. This rate was assumed to decrease by 2.3% per year to 8.5% in 1996 and remain at that level thereafter. The effect on the accumulated medical benefit obligation at January 1, 1993 of a one-percentage-point increase for each year in the health care cost trend rate used would result in an increase of $2,114,000 in the total obligation and a $211,000 increase in the aggregate service and interest cost components of the 1993 expense. The weighted average discount rates used to determine the accumulated postretirement medical benefit obligation as of December 31, 1993 and 1992 were 7% and 8%, respectively. Page 37 20 8. ACQUISITIONS: In the second quarter of 1993, Joslyn Jennings Corporation purchased a vacuum capacitor product line from EEV Limited in Chelmsford, England. The product line was relocated to Joslyn Jennings' facility in San Jose, California. The purchase price was not material. In April 1992, Joslyn Corporation purchased, for cash, the stock of Lear Siegler Jennings Corp., a San Jose, California based manufacturer of high-voltage vacuum products and telecommunications test instrumentation. A wholly-owned subsidiary of Joslyn Corporation also purchased certain real estate, some of which is being used in the business and some of which was sold in 1993. The Corporation paid $9.9 million for this acquisition, which was accounted for by the purchase method. The operating results of this acquisition are included in the Corporation's consolidated financial statements from the date of acquisition. In March 1991, Joslyn Clark Controls, Inc. acquired a product line of photoelectric sensing and control devices that was relocated to Joslyn Clark Controls' plant in Lancaster, South Carolina. The purchase price was not material. 9. SHAREHOLDERS' RIGHTS: The Corporation has a Shareholders' Right attached to each share of common stock. Each Right entitles the holder to buy from the Corporation one newly issued share of common stock at an exercise price of $60. The Rights become exercisable upon the acquisition of a certain percentage of Corporation stock or a tender offer or exchange offer for Corporation stock by a person or group. The Corporation is entitled to redeem the Rights at $.05 per Right at any time prior to fifteen days after a public announcement that a person or group has acquired a certain percentage of the Corporation's common stock. Depending on the occurrence of certain specific events, each exercisable Right, other than Rights held by the acquiring party, either entitles the holder to purchase the Corporation's common stock at an adjusted per-share price equal to 20% of the then market price or entitles the holder to purchase a share of the acquiring company common stock at a 50% discount. The Rights will expire on March 3, 1998. 10. OTHER EXPENSE, NET: Other Expense, Net in 1993, 1992 and 1991 includes primarily charges related to plant consolidations and to actions to eliminate marginal products as part of Management's continuing effort to simplify the organization, reduce costs and improve efficiencies. Also included are certain post-employment benefit expenses and other miscellaneous non-operating items. In 1992 and 1991, respectively, the expenses were partially offset by a gain on the sale of certain property and a $4 million gain from the settlement of a patent infringement lawsuit. 11. DETAILS OF CONSOLIDATED BALANCE SHEET: (in thousands) - ------------------------------------------------------------ 1993 1992 - ------------------------------------------------------------ Inventories: Finished Goods $ 6,788 $ 6,826 Work in Process 11,407 9,685 Raw Materials 18,165 16,113 - ------------------------------------------------------------ $36,360 $32,624 ============================================================ Prepaid Income Taxes and Other Current Assets: Prepaid Income Taxes $ 8,693 $ 8,308 Other 2,267 2,337 - ------------------------------------------------------------ $10,960 $10,645 ============================================================ Net Property, Plant and Equipment: Land $ 7,525 $ 6,920 Buildings 24,510 24,317 Machinery and Equipment 47,768 45,566 Construction in Progress 486 635 - ------------------------------------------------------------ $80,289 $77,438 Less Accumulated Depreciation 40,305 35,888 - ------------------------------------------------------------ $39,984 $41,550 ============================================================ Accrued Liabilities: Reserve for Environmental Matters $ 1,889 $ 2,560 Accrued Wages, Bonuses and Vacation Expenses 3,616 3,486 Accrued Taxes, Other than Income Taxes 1,543 1,425 Accrued Warranties and Workers' Compensation 6,088 5,694 Advance Payments 2,279 3,065 Reserve for Relocation or Discontinuance of Product Lines 1,007 2,488 Other Accrued Liabilities 9,032 9,702 - ------------------------------------------------------------ $25,454 $28,420 ============================================================ * Restated. See Note 4. Page 38 21 12. SEGMENT OF BUSINESS REPORTING: The operations of the Corporation are divided into the following business segments for financial reporting purposes: Electrical Technologies: Electronic protection equipment, high voltage vacuum products, connector accessories and switchgear are designed and produced for use by the telecommunications, industrial, aerospace, defense, electric utility and petrochemical industries. These products include communication electronic transient suppression devices, telecommunications test instrumentation, electric switching and interrupting systems, capacitors, relays, starters, contactors, fire pump controllers, sulfur hexafluoride switches and air pressurization and dehydration products for insulated cables, antenna lines and waveguides and similar systems. Utility Systems: Construction and maintenance materials and electric power protection equipment are designed and produced principally for electric power distribution and for overhead telephone communication lines. These products are manufactured and assembled from metal, rubber and porcelain and include hardware, earth anchors, power surge arresters, cable accessories, electrical terminating devices and other products. In addition, the Corporation sells complementary goods produced by other manufacturers. Inter-segment sales are not material. Foreign operations of the Corporation, which are not material, are located in Canada and primarily serve markets in that country. No single customer accounts for 10% or more of the Corporation's sales. General Corporate assets are principally cash and cash equivalents, prepaid expenses and land. Export sales from the Corporation's United States operations to unaffiliated customers were as follows: Page 39 22 13. QUARTERLY FINACIAL INFORMATION (Unaudited): The following table sets forth certain unaudited quarterly financial information for 1993 and 1992: REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Shareholders and Board of Directors of Joslyn Corporation: We have audited the accompanying consolidated balance sheets of Joslyn Corporation (an Illinois corporation) and Subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, shareholders' equity and cash flows for each of the three fiscal years in the period ended December 31, 1993. These financial statements are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the 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 financial statements referred to above present fairly, in all material respects, the financial position of Joslyn Corporation and Subsidiaries as of December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three fiscal years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As explained in Note 7 to the consolidated financial statements, effective January 1, 1991, the Corporation changed its method of accounting for postretirement benefits other than pensions. As explained in Note 4 to the consolidated financial statements, the Corporation has given retroactive effect to the change in accounting for the method of calculating the provision for income taxes. Chicago, Illinois ARTHUR ANDERSEN & CO. February 9, 1994 Page 40 23 EXHIBIT 21 Subsidiaries of the Registrant * JOSLYN MANUFACTURING CO., a Delaware corporation * JOSLYN CLARK CONTROLS, INC., a Delaware corporation * JOSLYN CANADA, INC., organized under the laws of the Province of Ontario, Canada * JOSLYN HI-VOLTAGE CORPORATION, a Delaware corporation * JOSLYN ELECTRONIC SYSTEMS CORPORATION, a Delaware corporation * JOSLYN JENNINGS CORPORATION, a Delaware corporation * JOSLYN RESEARCH AND DEVELOPMENT CORPORATION, a Delaware corporation * THE SUNBANK FAMILY OF COMPANIES, INC., a California holding corporation, and its two subsidiaries, SUNBANK ELECTRONICS, INC., and AIR-DRY CORPORATION OF AMERICA, Delaware corporations * JOSLYN FOREIGN SALES CORPORATION, organized under the laws of the Virgin Islands of the United States. EXHIBIT 23 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS _________________________________________ As independent public accountants, we hereby consent to the incorporation by reference in Registration Statement File No. 33-50686 of our report dated February 9, 1994, included or incorporated by reference in the Joslyn Corporation and subsidiaries Form 10-K and to all references to our firm included in that Registration Statement. ARTHUR ANDERSEN & CO. Chicago, Illinois March 23, 1994. EXHIBIT 99 PROXY STATEMENT DATED MARCH 25, 1994 JOSLYN Joslyn Corporation CORPORATION 30 South Wacker Drive Chicago, Illinois 60606 Telephone: (312) 454-2900 Telecopier: (312) 454-2930 Notice of Annual Meeting of Shareholders To Be Held April 27, 1994 ______________________________________________________________________________ The Secretary of Joslyn Corporation hereby gives notice that the Annual Meeting of Shareholders of Joslyn Corporation will be held in the Assembly Room, 6th Floor, The Northern Trust Company Building, 50 South LaSalle Street, Chicago, Illinois 60675 on Wednesday, April 27, 1994, at 10:00 o'clock a.m., for the following purposes: (1) the election of six Directors; (2) the ratification of the appointment of Arthur Andersen & Co. as independent public accountants for the year 1994; (3) the amendment of the Joslyn Corporation Articles of Incorporation to limit the personal liability of the Corporation's directors; and (4) the transaction of such other business as may properly come before the meeting or any adjournment thereof. Only Shareholders of record at the close of business on March 1, 1994 will be entitled to vote at the meeting. The Annual Report of the Corporation for the year 1993, including financial statements, accompanies this Proxy Statement. Each Shareholder, whether or not he or she expects to be present at the meeting, is requested to sign, date and return the enclosed Proxy in the envelope which is supplied with this Notice. By order of the Board of Directors, Joslyn Corporation Wayne M. Koprowski Secretary ______________________________________________________________________________ JOSLYN CORPORATION 30 South Wacker Drive Chicago, Illinois 60606 PROXY STATEMENT This Proxy Statement is furnished in connection with the solicitation of proxies on behalf of the Board of Directors of Joslyn Corporation (the "Corporation") for the Annual Meeting of Shareholders to be held in the Assembly Room, 6th Floor, The Northern Trust Company Building, 50 South LaSalle Street, Chicago, Illinois 60675 on Wednesday, April 27, 1994, at 10:00 o'clock a.m., or any adjournment thereof. On or before March 25, 1994, this Proxy Statement and the enclosed Proxy were first sent or given to the Corporation's Shareholders. The 1993 Annual Report to Shareholders, including financial statements for the fiscal year ended December 31, 1993, accompanies this Proxy Statement. The executive offices of the Corporation are located at 30 South Wacker Drive, Chicago, Illinois 60606. The only voting securities of the Corporation are its Common Shares, of which there were 7,108,141 shares outstanding on March 1, 1994, the record date. A majority of such shares will constitute a quorum for the transaction of business at the Annual Meeting. Shareholders are entitled to one vote for each Common Share of the Corporation held. The Board of Directors is soliciting discretionary authority to accumulate votes. In the election of the Board of Directors, shareholders have the right to vote the number of shares owned by them for each of the six nominees, or they may cumulate their votes and give six votes to one nominee for each share owned, or they may distribute their votes on the same principle among as many nominees as they choose. No act need be done or notice given prior to the exercise of such cumulative voting rights. An affirmative vote of the shareholders of at least two-thirds of the outstanding shares entitled to vote is required to approve the amendment to the Articles of Incorporation. For the purpose of counting votes, abstentions, broker non-votes and other shares not voted have the same effect as a vote against the proposal. Each proxy received by the Board of Directors of the Corporation will be voted as specified by the Shareholder thereon. Any Shareholder may revoke their proxy at any time prior to the voting thereof by (1) giving written notice of such revocation to the Secretary of the Corporation, (2) properly submitting to the Corporation a duly executed proxy bearing a later date or (3) appearing in person at the 1994 Annual Meeting and voting in person. The cost of preparation of proxy solicitation materials and solicitation of proxies will be paid by the Corporation. In addition to use of the mails, proxies may be solicited by any Director, Officer, or employee of the Corporation either personally or by such other means as he may choose, and any such solicitation shall be made without additional compensation. The Corporation may reimburse brokers and others for their expenses in forwarding proxy solicitation materials to beneficial owners. The Corporation has retained Morrow & Co., Inc. to assist in the solicitation of proxies at an estimated fee of less than $10,000, plus reasonable expenses. Page 44 1 NOMINEES FOR ELECTION AS DIRECTOR The Board of Directors has designated the six persons hereinafter listed to be nominees for election as Directors of the Corporation at the Annual Meeting. Proxies solicited by the Board of Directors will be voted as directed therein with respect to the election of Directors; but if no choice is specified in any proxy, then such proxies will be voted for such nominees. The entire Board of Directors is elected annually and each Director is elected to serve until his successor is duly elected and qualified unless the Directorship is eliminated, in which case the Directorship will expire at the next Annual Meeting. Each of the nominees has consented to serve as a Director if he is elected. If for any reason any such nominee for election should become unavailable for election, a circumstance the Board of Directors does not anticipate, discretionary authority may be exercised for a substitute nominee. The persons named in proxies hereby solicited reserve the right, exercisable in their sole discretion, to vote proxies cumulatively so as to elect all or as many as possible of such nominees depending upon circumstances at the meeting. NOMINEES FOR REELECTION AS DIRECTOR: William E. Bendix Mr. Bendix is President, Chief Executive Officer and a Director of Mark Controls Corporation, a NASDAQ listed company, and has held this position since 1987. Mark Controls Corporation is a manufacturer of industrial valves, liquid temperature control devices and electronic controllers. Prior to that, Mr. Bendix was Group Vice President and a Director and was responsible for five of the company's business units. Mr. Bendix joined Mark Controls as Vice President of Manufacturing in 1969, was subsequently named Vice President of Operations and was elected a Director in 1973. Prior to joining Mark Controls, Mr. Bendix was a principal at Theodore Barry and Associates, a management consulting firm with a practice emphasizing operations management. Mr. Bendix is a Director of DEP Corporation, the former Chairman of the Valve Manufacturers Association of America, and a former Director of Sargent-Welch Scientific Company. Mr. Bendix is 59 years of age. John H. Deininger Mr. Deininger is Chief Executive Officer and President of Union City Body Company, L.P., a manufacturer of truck bodies. He is a retired Executive Vice President of Illinois Tool Works, Inc., a manufacturer of engineered components and industrial systems. He was formerly President, Chief Operating Officer and a Director of Signode Industries, Inc., now a wholly-owned subsidiary of Illinois Tool Works, Inc. Mr. Deininger is currently a Director of Eljer Industries, a New York Stock Exchange listed company which manufactures and markets plumbing and heating ventilation products. Mr. Deininger is also a Director of Life Fitness, Inc., a maker of exercise and fitness equipment and a Director of Wayn-Tex, Inc., a manufacturer of plastic woven for the carpet and food packaging industries. He formerly was a Director for Allied Tube & Conduit, a manufacturer of metal tubing for plumbing and electrical use. He is also a part-time consultant on industrial business operations. Mr. Deininger is 62 years of age. Page 45 2 Donald B. Hamister Mr. Hamister is Chairman of Joslyn Corporation's Board of Directors. Mr. Hamister joined Joslyn in 1939. He became an Operating Manager of the Corporation in 1958 and was elected a Vice President and Director of the Corporation in 1973. He was elected President and Chief Executive Officer in 1978 and Chairman of the Board in 1979. He retired as President and Chief Executive Officer of the Corporation in 1985, was reelected to the position of Chief Executive Officer in 1986, and held that position until 1987. He was reelected as Chief Executive Officer in 1991 and held that position through December, 1992. Mr. Hamister served in the United States Navy from 1942 to 1946 attaining the rank of lieutenant. He is a member of the Institute of Electrical and Electronics Engineers and the Airline Avionics Institute. He served as Chairman of the Airline Avionics Institute from 1972 to 1974. Mr. Hamister is 73 years of age. Raymond E. Micheletti Mr. Micheletti is President and Chief Executive Officer of Joslyn Corporation. He joined Joslyn in 1966, became General Manager of the Joslyn Hi-Voltage Equipment Division in 1972, was named Vice President of the Corporation in 1976, and assumed the additional responsibility of Joslyn's Wood Products Group. In 1984, he led the acquisition of a new business unit, Joslyn Clark Controls, Inc. He was named a Senior Vice President of the Corporation in 1988 with responsibility for the Industrial Controls business segment. In 1991, Mr. Micheletti was elected President and a Director of the Corporation. He led the acquisition of a new business unit, Joslyn Jennings Corporation, in 1992 and later that year was elected to his current position with the Company. He is a graduate electrical engineer and a member of the Institute of Electrical and Electronics Engineers. Mr. Micheletti is 68 years of age. Richard C. Osborne Mr. Osborne is President, Chief Executive Officer and Chairman of the Board of Scotsman Industries, Inc., a New York Stock Exchange listed company. Scotsman is a leading manufacturer of refrigeration products primarily serving the foodservice, hospitality, beverage, bakery and healthcare industries, with a secondary focus on luxury appliances for the consumer market. Mr. Osborne previously held the position of Executive Vice President of Household Manufacturing, Inc. from 1982 to 1989, and from 1979 to 1982 was President of Structo and Halsey Taylor, a division of Household Manufacturing, Inc. Mr. Osborne was the Director of Manufacturing of Pillsbury Company from 1967 to 1979, and began his career as an Engineer with the Chevrolet Division of General Motors. Mr. Osborne is 50 years of age. Lawrence G. Wolski Mr. Wolski is Executive Vice President, Chief Financial Officer, and Director of the Utility Systems Group. He joined Joslyn in 1974 as Controller, having been employed previously by Arthur Andersen & Co. for eight years, his last position being that of Audit Manager. In 1976, he was elected Vice President, Finance, of the Corporation. He was elected Chief Financial Officer of the Corporation in 1980, Senior Vice President in 1987, and Executive Vice President in 1993. Mr. Wolski was elected a Director of the Corporation in 1981. Mr. Wolski is 49 years of age. SECURITY OWNERSHIP OF MANAGEMENT ON MARCH 3, 1994 The following table sets forth information about the beneficial ownership of Common Stock for each Director and nominees for Director, each Executive Officer named in the Summary Compensation Table in this Proxy Statement, and all Directors and Executive Officers of the Corporation as a group as of March 3, 1994. Page 46 3 Directors and Number Nominees of Shares(a) ______________ _____________ William E. Bendix . . . . . . . . . . . . . . . . . . 2,000 John H. Deininger . . . . . . . . . . . . . . . . . . 900 Donald B. Hamister . . . . . . . . . . . . . . . . . 12,000 Raymond E. Micheletti . . . . . . . . . . . . . . . . 25,937 Richard C. Osborne . . . . . . . . . . . . . . . . . 750 Lawrence G. Wolski . . . . . . . . . . . . . . . . . 36,664 Certain Executive Officers _________________ Wayne M. Koprowski . . . . . . . . . . . . . . . . . 20,044 Steven L. Thunander . . . . . . . . . . . . . . . . . 21,645 A. Russell Gray . . . . . . . . . . . . . . . . . . 11,541 Directors and Officers as a Group . . . . . . . . . . 155,897 ____________ (a) Includes shares Executive Officers have the right to acquire pursuant to the Corporation's Employee Stock Benefit and Stock Option Plans. The number of shares which each of the above individuals have the right to acquire are: Mr. Micheletti 12,253 shares; Mr. Wolski 22,664 shares; Mr. Koprowski 15,044 shares; Mr. Thunander 18,356 shares; and Mr. Gray 6,136 shares. In addition to the shares shown as owned by the nominees in the preceding table, the following approximate number of shares are held by the Profit Sharing Plan in which the individuals named have shared voting power as to those shares: Mr. Micheletti 1,698 shares; Mr. Wolski 1,451 shares; Mr. Koprowski 800 shares; Mr. Thunander 1,125 shares; and Mr. Gray 539 shares. None of the Director nominees or Executive Officers hold 1.0% or more of the outstanding shares of the Corporation. PRINCIPAL HOLDERS OF VOTING SECURITIES The following table sets forth certain information regarding the beneficial ownership of the Corporation's Common Shares on December 31, 1993, by each person known by management to be the beneficial owner of more than 5% of the outstanding shares of the Corporation: Name and Address of Amount and Nature of Percent Beneficial Owner Beneficial Ownership of Class ____________________ ____________________ _________ Robert D. MacDonald, James H. Ingersoll & . . . . . 659,438(a) 9.3% David L. Everhart, Trustees 150 N. Michigan Avenue, Suite 2500 Chicago, Illinois 60601 Joslyn Retirement Plans' Company Stock Trust . . . . 454,472(b) 6.4% 30 South Wacker Drive Chicago, Illinois 60606 Pioneering Management Corporation . . . . . . . . . 430,337(c) 6.1% 60 State Street Boston, Massachusetts 02109 Page 47 4 ___________________ (a) Includes 515,645 shares held by Messrs. MacDonald, Ingersoll and Everhart as co-trustees of the Alice Newell Joslyn Trust and the Marcellus Lindsey Joslyn Trust. These trusts have sole voting and dispositive power with respect to the shares in each trust. In addition to the 515,645 shares held with co-trustees Messrs. Ingersoll and Everhart, Mr. MacDonald holds 143,793 shares as a trustee of four other trusts. (b) Joslyn Retirement Plans' Company Stock Trust ("Trust") has sole voting and investment power for 43,173 of such shares and shared voting and investment power for 411,299 of such shares. The Trust beneficially owns certain of the above shares for the Corporation's Employees' Savings and Profit Sharing Plan ("Profit Sharing Plan") and the Trustee has power to dispose of such shares; provided, however, that in the event of a tender or exchange offer, the participants generally have the right to direct the Trustee on how to respond to the tender or exchange offer. (c) Pioneering Management Corporation has reported in its Form 13G that it has sole voting power as to 430,337 shares and shared dispositive power as to 430,337 shares. BOARD OF DIRECTORS AND COMMITTEES The Board of Directors has standing Audit, Compensation and Nominating Committees. Messrs. William E. Bendix, Donald B. Hamister, Richard C. Osborne and Walter W. Schoenholz were the members of the Audit Committee during 1993. Messrs. John H. Deininger, Hamister, Osborne and Schoenholz were members of the Compensation Committee during 1993. Messrs. Raymond E. Micheletti, Bendix, Deininger, and Hamister were members of the Nominating Committee during 1993. In addition, the Board of Directors formed an ad hoc Succession Committee for the purpose of identifying candidates for the position of President and Chief Executive Officer to succeed Mr. Micheletti upon his retirement. Messrs. Bendix, Deininger, Hamister, Osborne and Schoenholz were members of the Succession Committee in 1993. Among other responsibilities, the Audit Committee recommends the selection of the independent public accountants, reviews the scope and procedures of the planned audit activities and reviews the results of the audits. The Audit Committee considers and approves in advance non-audit services performed by the independent public accountants to determine that such services do not compromise their independence. The Compensation Committee recommends the compensation to be paid for the services of the Directors and Executive Officers of the Corporation. The Nominating Committee develops criteria for Directors, evaluates the qualifications of and interviews prospective candidates for the Board of Directors of the Corporation and makes recommendations to the Directors of nominees for election to the Board of Directors of the Corporation. During 1993, there were two meetings for each of the Audit and Compensation Committees and one meeting of the Succession Committee. There were five meetings of the Board of Directors in 1993. All members of the Board attended all of the meetings of the Board, and all members of the Committees attended all meetings of the Committees of the Board. COMPENSATION OF DIRECTORS Directors of the Corporation who are employees serve without additional compensation. Directors of the Corporation who are not employees of the Corporation each receive an annual compensation payment of $19,000. These Directors also receive $700 for each meeting of the Board of Directors or a Committee thereof attended and $700 for each day or fraction thereof spent in the conduct of the Corporation's business other than Board or Board Committee meetings. The Chairman of the Board of Directors receives an additional $10,000 per year to serve in that capacity. Page 48 5 Directors who are not employees may elect to become participants in the Deferred Compensation Plan in order to defer all or a portion of their fees. Deferred fees otherwise payable are credited to a participant's Deferred Fee Account bearing an annual interest rate. Upon termination of their services, payment from the Deferred Fee Account will be paid to the former Directors in installments. SUMMARY COMPENSATION TABLE The following table sets forth the compensation paid or to be paid for the fiscal year 1993 to the Chief Executive Officer and to the four most highly compensated Executive Officers of the Corporation. A more detailed explanation follows the table. Name and Principal Fiscal All Other Position Year Salary(1) Bonus Compensation(2) ____________________ _______ _________ _______ _______________ Raymond E. Micheletti 1993 $299,224 $91,125 $15,485 President and Chief 1992 250,557 107,800 16,078 Executive Officer 1991 219,657 76,223 14,812 Lawrence G. Wolski 1993 $237,548 $73,552 $15,485 Exec. Vice President, 1992 233,001 82,854 16,078 Chief Financial Officer 1991 220,534 71,320 14,812 Wayne M. Koprowski 1993 $148,610 $32,400 $10,716 Vice President 1992 145,157 40,625 13,845 1991 136,718 36,963 9,849 Steven L. Thunander 1993 $164,882 $25,000 $5,839 Vice President 1992 163,800 28,529 7,997 1991 163,132 10,000 4,796 A. Russell Gray 1993 $134,000 $25,746 $10,727 Dir., Communications 1992 130,000 7,450 8,536 & Defense Group 1991 125,000 18,237 10,751 ______________________ 1) Salary includes base compensation and contributions made under the Joslyn Corporation Retirement Parity Compensation Plan ("Parity Plan"). Certain Executive Officers of Joslyn Corporation are participants in the Parity Plan. The Parity Plan provides annual payments to eligible employees who may elect to deposit their payments in an individual trust. Each trust provides for distribution upon: (1) retirement after attaining age 60, (2) disability or death, (3) attaining age 65, or (4) termination of employment prior to age 60. The 1993 Parity Plan amount for eligible individuals listed in the Summary Compensation Table were: Mr. Micheletti $29,224; Mr. Wolski $23,548; Mr. Koprowski $13,610; and Mr. Thunander $14,882. 2) "All Other Compensation" is comprised of contributions on behalf of the Executive Officers to the Corporation's Profit Sharing Plan, a defined plan, except that it also includes a $1,000 director fee for Messrs. Gray and Thunander for being subsidiary company board members. Page 49 6 STOCK OPTION/SAR GRANTS IN 1993 The following tables show, as to the Chief Executive Officer and the four most highly compensated Executive Officers of the Corporation, information with respect to grants of non-qualified stock options and stock exercises for the period January 1, 1993 to December 31, 1993. Non-Qualified Option grants awarded December 31, 1993 _______________________ (1) All options were granted on December 31, 1993, and first become exercisable on June 29, 1994. (2) The Base Price equals the average of the last reported high and low transactions of Common Shares on the NASDAQ National Market System on the date of the grant of options. Aggregated Option/SAR Exercises in 1993 and Fiscal Year-end Option/SAR Values This table provides the number of shares acquired by stock option exercise during 1993. The value realized is the difference between the market price on the date of exercise and the base price multiplied by the number of shares exercised. The table also provides the year-end value of all stock options and Stock Appreciation Rights ("SARs") granted to but not yet exercised by each executive. The value represents the difference of the market price on December 31, 1993 and the base price multiplied by the number of outstanding options. This value may go up or down as the stock price fluctuates and is not realized until exercised. DEFINED BENEFIT PENSION PLAN Salaried employees participated in the Employees' Supplemental Retirement Plan of Joslyn Corporation ("Pension Plan") until December 31, 1988 when the Pension Plan was frozen. Therefore, no additional benefit accruals for either additional employment service or compensation increases will be incurred. The estimated annual benefits payable upon retirement at age 65 for each of the individuals named in the Summary Compensation Table are as follows: Mr. Micheletti $40,158; Mr.Wolski $76,068; Mr. Koprowski $13,687; Mr. Thunander $34,976 and Mr. Gray $0. Page 50 7 EMPLOYMENT AGREEMENTS The Corporation has entered into separate employment agreements with the following individuals: Messrs. Raymond E. Micheletti (President, Chief Executive Officer and a Director) and Lawrence G. Wolski (Executive Vice President, Chief Financial Officer and a Director). Each agreement provides for an annual salary to be paid to the employee at least equal to that being received at the date of the agreement. The agreements expire on March 31, 1994 as to Mr. Micheletti, and on December 31, 1996 as to Mr. Wolski. These agreements may be earlier terminated by Joslyn upon 180 days written notice. Messrs. Micheletti and Wolski each are entitled to receive salary at the rate in effect at the date of notice for a period of 18 months following termination of employment conditioned upon their rendition of consulting services to Joslyn for the remaining term of their Agreement. However, Joslyn may terminate an agreement within such period if the employee accepts other employment prior to the expiration of the period, and Joslyn reasonably determines the new employment to be in conflict or competition with Joslyn. Upon the death of any such employee, his legal representative is entitled to receive his salary payable to the end of the month following the month in which death occurs, plus incentive compensation for the fiscal year extended to the last day of the month following date of death, plus an amount equal to the monthly base salary in effect at the time of death multiplied by three. Mr. Micheletti has announced his intention to retire at the end of 1994 from his position of President and Chief Executive Officer and therefore his agreement will not be extended. JOSLYN CORPORATION STOCK PERFORMANCE GRAPH The graph provided below compares Joslyn Corporation's cumulative shareholder total return with that of the NASDAQ Composite Index and the Dow Jones Electrical Equipment Group. The comparison is made by calculating the difference in share price from December 31, 1988, and December 31, 1993 and including the cumulative amount of dividends, assuming reinvestment, during this five year period. An initial investment of $100.00 has been used as a common point of reference. Comparative Five Year Cumulative Total Return - GRAPH - Page 51 8 For ease of comparison, the table below provides the data utilized in the graph. The table assumes an investment of $100.00 on December 31, 1988 and indicates the appreciation or depreciation of each investment over a five year period. REPORT OF THE COMPENSATION COMMITTEE ON EXECUTIVE COMPENSATION The Compensation Committee of the Board of Directors is responsible for reviewing and approving to the Board compensation for the Executive Officers of the Corporation, including the Chief Executive Officer and the four most highly compensated Executive Officers. The Committee reviews base salaries and corporate and individual bonus goals of the Chief Executive Officer and of the Executive Officers as recommended by the Chief Executive Officer. The Committee also approves all grants of stock options under the Corporation's Stock Option Plan. All Committee members are non-employee, outside directors of the Corporation. Compensation Philosophy The Corporation seeks to link Executive Officer compensation to profitability resulting in enhanced shareholder value. The compensation philosophy has the following objectives: - to attract and retain quality management - to encourage and reward performance on an individual, business unit and corporate basis - to reward both short term and long term performance - to tie executive compensation to long term growth of shareholder value The Corporation's executive compensation program is comprised of a base salary, an annual incentive bonus program and a long term incentive compensation plan in the form of stock options. In addition, Executive Officers are eligible to participate in various benefit plans, including medical insurance coverage and profit sharing, which are available to all employees. Base Salary Base salaries for Executive Officers are determined in consideration of each Executive Officer's position, responsibilities, experience and performance. In setting compensation, the Committee takes into account the national marketplace for a group of companies consisting of Page 52 9 electrical and electronics manufacturing companies of similar size (annual sales between $100 and $600 million) in the Corporation's labor market ("Labor Market Group"). The Committee decided against using the companies in the industry peer group as reflected in the Performance Graph because the Committee believes that the comparatively large size of many of the peer group companies distorts compensation levels for similar positions. Each Executive Officer's base salary is initially set at the median for similar positions within the Labor Market Group. The Committee annually reviews and may adjust individual salaries of all Executive Officers including the Chief Executive Officer and the four highest compensated Executive Officers taking into account compensation guidelines (utilizing executive compensation surveys, outside compensation specialists, or both), business performance and individual performance. Business performance is evaluated in reference to both actual corporate earnings results and comparative results of the companies in the Corporation's industry peer group as reflected in the Performance Graph. The factors impacting base salary are not independently assigned specific weights. Rather, the Committee reviews all the factors and makes salary recommendations which reflect the Committee's analysis of the aggregate impact of these factors. Mr. Micheletti's 1992 base salary of $220,000 was increased to $270,000 in 1993 in recognition of his promotion to Chief Executive Officer, the additional responsibilities that would be imposed on him in that capacity, and the Corporation's record earnings performance in 1992. The Committee used market comparisons obtained from compensation surveys for comparably sized manufacturing companies in setting his 1993 base salary. Mr. Micheletti's base salary places him about 20% below the median for chief executive officers in the Labor Market Group. Annual Incentive Bonus Program In addition to base salary, each Executive Officer is eligible for an annual incentive cash bonus award under the Executive Management Incentive Plan. The Compensation Committee believes that the plan provides an additional short term incentive to those executives who have a greater potential impact on business performance by having a larger portion of their total compensation in variable bonus opportunities. Annual cash bonuses are paid based on formulas which take into consideration attainment of corporate and business unit earnings goals and individual goals designed to improve the Corporation's overall performance. Individual performance goals are taylored to each Executive Officer's position and vary from person to person. For Executive Officers, excluding the Chief Executive Officer, potential bonus payments range from 0% to a maximum of 50% of base salary depending on the Executive Officer's position with half of the bonus potential based upon corporate or business unit earnings performance and the other half based upon individual performance. However, since actual payouts are dependent on achieving pre-determined performance goals, failure to attain those goals could result in no bonus. During 1993, the Corporation achieved its business plan earnings goals for the year and the Executive Officers, including the Chief Executive Officer and the four highest compensated Executive Officers, received cash bonuses for achieving the business plan earnings goal. For 1993, Mr. Micheletti's potential bonus ranges from 0% to 70% of base salary with a target payment of 35% of base salary. Over 70% of his annual potential bonus was based upon the attainment targeted net income goals for the plan year, with the remaining bonus based upon the achievement of individual goals. For 1993, Mr. Micheletti was awarded a bonus of $91,125, which is 33.8% of base salary based in part upon the Committee's achievement of its 1993 business plan earnings goal. Page 53 10 Long Term Incentive Compensation Plan (Stock Option Plan) The Compensation Committee believes that by providing key employees, including the Chief Executive Officer and the four highest compensated Executive Officers, who have substantial responsibility over the management and growth of the Corporation, with an opportunity to increase their ownership of the Corporation's stock, the interests of the shareholders and key employees, including Executive Officers, will be more closely aligned. The Stock Option Plan meets this objective by permitting the Corporation through the Compensation Committee to make annual grants of non-qualified stock options to key employees, including the Chief Executive Officer and the four highest paid Executive Officers. Stock options are granted with an exercise price equal to the fair market value of the Corporation's common stock on the date of grant and typically may be exercised over a period of five years. This approach is intended to motivate the key employees to contribute to the creation and growth of shareholder value over the long term. Value to the optionee is dependent upon an increase in the stock price above the exercise price. The size of each person's stock option grant is based upon a formula, originally recommended by an outside compensation consultant, which provides a range of possible grants utilizing a multiple of the optionee's base salary. The formula for determining the number of stock option grants is the base salary times a multiplier (ranging from 0.3 to 1.0), divided by the then market price of the Corporation's stock. Currently, the stock option grants awarded by the Committee place optionees approximately 66% below the median compared to optionees in the Labor Market Group. The Compensation Committee also considers previous options granted but unexercised as well as actual ownership in the Corporation's stock in making additional grants of options. In 1993, Mr. Micheletti was granted 9,273 options at an exercise price of $24.75. The option grant was below the median compared to grants typically made to chief executive officers in the Labor Market Group. Richard C. Osborne, Chairman John H. Deininger Donald B. Hamister Walter W. Schoenholz PROPOSAL TO AMEND THE ARTICLES OF INCORPORATION TO LIMIT DIRECTOR LIABILITY The proposed amendment would limit the personal liability of the Directors to the Corporation or its shareholders for monetary damages arising from breach of fiduciary duty. The proposed amendment is authorized by a change to the Illinois Business Corporation Act of 1983 that became effective January 1, 1994 and will assist the Corporation in attracting and retaining qualified individuals to serve as Directors of the Corporation. Background Until the amendment of the Illinois Business Corporation Act in July 1993, Illinois was one of the few states that had not taken action to protect corporate directors who acted in good faith but were nevertheless threatened with substantial liability from negligence claims. As a result of the change in the law, an Illinois corporation is now able to provide its directors with liability protection similar to that available to companies incorporated in a vast majority of other states, including Delaware. Liability is not limited under Illinois law if the acts or omissions of directors are in bad faith, involve intentional wrongdoing, violate certain statutory provisions, or result in profit or other advantage to which the director is not legally entitled. Page 54 11 Text of Proposed Amendment The text of the proposed amendment to be added to the Corporation's Articles of Incorporation as Article Nine is as follows: The Directors of the Corporation shall not be liable to the Corporation or to its shareholders for monetary damages for breach of fiduciary duties as a Director, provided that this provision shall not eliminate or limit the liability of a Director (i) for any breach of the Director's duty of loyalty to the Corporation or its shareholders, (ii) for acts or omissions not in good faith or that involve intentional misconduct or a knowing violation of the law, (iii) under Section 8.65 of the Illinois Business Corporation Act or (iv) for any transaction from which the Director derived an improper personal benefit. Reasons for the Proposed Amendment Directors of Illinois corporations are required, under Illinois law, to perform their duties in good faith and with that degree of care that an ordinarily prudent person in a like position would use under similar circumstances. A director may rely upon information, opinions and reports prepared by certain officers or employees, professional advisors, or committees of the Board. Decisions made on that basis are protected by the "business judgment rule" and should not be questioned by a court in the event of a lawsuit challenging such decisions. However, the expense of defending such lawsuits and the inevitable uncertainties of applying the business judgment rule to particular facts and circumstances mean, as a practical matter, that directors are not relieved of the threat of monetary damage awards. The Board of Directors of the Corporation, therefore, believes that the proposed amendment should be adopted in order to ensure that the Corporation will continue to be able to attract and retain competent, qualified and talented persons to serve as directors. Effect of the Proposed Amendment The proposed amendment would protect the Corporation's Directors against personal liability to the Corporation or its shareholders for any breach of duty unless a judgment or other final adjudication adverse to them establishes (i) a breach of the duty of loyalty to the Corporation, (ii) acts or omissions in bad faith or involving intentional misconduct or a knowing violation of the law, (iii) acts violating the prohibitions contained in Section 8.65 of the Illinois Business Corporation Act against certain improper distributions of assets, or (iv) an improper personal benefit to a Director to which he or she was not legally entitled. No claim of the type which would be affected by the proposed amendment is presently pending or, to the knowledge of management of the Corporation, threatened. The amendment as proposed would not reduce the fiduciary duty of a Director, it merely limits monetary damage awards to the Corporation and its shareholders arising from certain breaches of that duty. It does not affect the availability of equitable remedies, such as the right to enjoin or rescind a transaction, based upon a Director's breach of fiduciary duty. The amendment also does not affect a Director's liability for acts taken or omitted prior to the time it becomes effective (after shareholder approval and upon filing with the Illinois Secretary of State). The limitation of liability afforded by the proposed amendment affects only actions brought by the Corporation or its shareholders, and does not preclude or limit recovery of damages by third parties. With respect to this proposal, shareholders may direct that their votes be cast for or against such proposal, or may abstain, by marking the proper box on the Proxy. THE BOARD OF DIRECTORS RECOMMENDS A VOTE "FOR" THE PROPOSED AMENDMENT. Proxies solicited by management will be so voted unless shareholders specify a contrary choice in their proxies. For approval, the proposed requires the affirmative vote of at least two-thirds of the outstanding shares of Common Stock of the Corporation. Abstentions and broker non-votes will have the effect of a vote against the proposal. Page 55 12 RATIFICATION OF INDEPENDENT PUBLIC ACCOUNTANTS Shareholders will be asked to ratify the appointment by the Board of Directors of Arthur Andersen & Co. as independent public accountants for the Corporation and its subsidiary companies for the year 1994. Arthur Andersen & Co. served in this capacity in 1993, and has been retained by the Corporation in this capacity since 1933. THE BOARD OF DIRECTORS RECOMMENDS THAT YOU VOTE "FOR" THE RATIFICATION OF THE APPOINTMENT BY THE BOARD OF DIRECTORS OF ARTHUR ANDERSEN & CO. AS INDEPENDENT ACCOUNTANTS FOR THE YEAR 1994. Representatives of Arthur Andersen & Co. are expected to be present at the Annual Meeting. They will have an opportunity to make a statement if they wish and will be available to respond to any questions at the Annual Meeting. The Chairman of the Meeting will refer appropriate questions from Shareholders to the representatives of Arthur Andersen & Co. for response. SHAREHOLDER PROPOSAL FOR 1995 ANNUAL MEETING The 1995 Annual Meeting of the Shareholders of the Corporation is expected to be held on April 26, 1995. If any Shareholder wishes a proposal to be considered for presentation at the 1995 Annual Meeting, such proposal must be received by the Corporation at its offices at 30 South Wacker Drive, Chicago, Illinois 60606 not later than November 29, 1994. OTHER MATTERS The Board of Directors does not know of any matters to be presented at the meeting other than those mentioned in the Notice of Annual Meeting of Shareholders. However, if other matters come before the meeting, it is the intention of each person named in the accompanying Proxy to vote said Proxy in accordance with his judgment of such matters. The Notice of Annual Meeting of Shareholders and Proxy Statement are hereby sent by order of the Board of Directors. Chicago, Illinois March 25, 1994 Page 56 13
824430_1993.txt	824430	1993	ITEM 1. DESCRIPTION OF BUSINESS. (1) The Company. Xanthic Enterprises, Inc. was incorporated in Colorado on October 27, 1986 and has not yet commenced operations. The primary activity of the Company will involve seeking merger or acquisition candidates. (2) Plan of Operations. The Company plans to seek merger or acquisition candidates. (3) Employees. At the present time the Company has no employees other than its officers. The officers devote as much time as they deem appropriate to the Company's business. The officers are not paid salary or expenses. (4) Administrative Offices. The Company maintains its executive offices at 9028 Sunset Blvd., Penthouse Suite, Los Angeles, CA 90069 pursuant to an oral lease agreement with David G. Lilly, a shareholder of the Company on a month to month basis. No rent is paid for this office at this time. ITEM 2.		ITEM 2. PROPERTIES. The Company owns no properties, plans or other real estate, and has no Letters of Intent to purchase or acquire any property. ITEM 3.	ITEM 3. LEGAL PROCEEDINGS. On November 2, 1991 the State of Oregon issued a cease and desist order ordering the Company to cease and desist issuing unregistered securities in the State of Oregon. The proceeding was based on the distribution of shares and warrants to Oregon shareholders (registered by way of a S-18 registration statement) pursuant to the agreement for such distribution between the Company and Automated Services, Inc. On April 2, 1992 the State of Oregon issued a final order to cease and desist violating any provision of Oregon Securities Law. Xanthic was denied the use of any statutory exemption provided in ORS 59.022 and ORS 59.035. Xanthic, Mark Lilly and Glenn DeCicco were assessed civil penalties of $ 750.00 each for violating ORS 59.055 and ORS 59.132(2). Directors Mark Lilly and Glenn DeCicco were ordered to cease and desist violating any provision of ORS Chapter 59. Neither the Company nor the Directors appealed. The Company has been advised that the effect of the Oregon ruling was to invalidate the issuance and distribution of the registered shares and warrants to residents of Oregon until such time as said securities are registered pursuant to the provisions of the Oregon Securities Law. The number of shares affected by the ruling is estimated to be 188,000 shares owned by approximately 650 residents of Oregon. The 188,000 shares represent approximately 3.4% of the issued and outstanding shares of Xanthic. ITEM 4.	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. No matters were submitted to the shareholders during the year 1993. PART II ITEM 5.	ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS. There is no established public trading market for the common shares of the Company. ITEM 6.	ITEM 6. SELECTED FINANCIAL DATA. This information is omitted as allowed by General Instruction 1 of Form 10-K as the information is adequately reflected in the certified financial statements as set forth in Item 8. ITEM 7.	ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. (1) LIQUIDITY. The Company has no cash assets and no liquidity. (2) CAPITAL RESOURCES. The Company has no capital resources. (3) RESULTS OF OPERATIONS. The Company has not operated during the past fiscal year and there are no results of operations. ITEM 8.	ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Attached are audited financial statements for the Company as of December 31, 1993. XANTHIC ENTERPRISES, INC. (A DEVELOPMENT STAGE COMPANY) FINANCIAL STATEMENTS DECEMBER 31, 1993 AND 1992 CONTENTS PAGE AUDITOR'S REVIEW REPORT.................................................... 6 FINANCIAL STATEMENTS: BALANCE SHEET............................................................ 7 STATEMENTS OF OPERATION.................................................. 8 STATEMENT OF STOCKHOLDERS' EQUITY........................................ 9 STATEMENTS OF CASH FLOWS................................................. 10 NOTES TO FINANCIAL STATEMENTS............................................11-12 TO THE BOARD OF DIRECTORS AND STOCKHOLDERS OF XANTHIC ENTERPRISES, INC.: We have audited the accompanying balance sheets of Xanthic Enterprises, Inc. (a development stage company) as of December 31, 1993 and 1992, and the related statements of operations, stockholders' equity (deficit), and cash flows for the years then ended and for the period from October 27, 1986 (inception), to December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Xanthic Enterprises, Inc. as of December 31, 1993, and 1992, and the results of its operations and cash flows for the years then ended and from October 27, 1986 (inception), to December 31, 1993 in conformity with generally accepted accounting principles. Harlan & Boettger, CPA's San Diego, California February 17, 1997 XANTHIC ENTERPRISES, INC. (A DEVELOPMENT STAGE COMPANY) BALANCE SHEETS The accompanying notes are an integral part of these financial statements. XANTHIC ENTERPRISES, INC. (A DEVELOPMENT STAGE COMPANY) STATEMENT OF OPERATIONS The accompanying notes are an integral part of these financial statements. XANTHIC ENTERPRISES, INC. (A DEVELOPMENT STAGE COMPANY) STATEMENT OF STOCKHOLDERS' EQUITY (DEFICIT) The accompanying notes are an integral part of these financial statements. XANTHIC ENTERPRISES, INC. (A DEVELOPMENT STAGE COMPANY) STATEMENT OF CASH FLOWS The accompanying notes are an integral part of these financial statements. XANTHIC ENTERPRISES, INC. (A DEVELOPMENT STAGE COMPANY) NOTES TO FINANCIAL STATEMENTS DECEMBER 31, 1993 A. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: ORGANIZATION Xanthic Enterprises, Inc., a Colorado corporation, was incorporated October 27, 1986, and since its inception, the Company has been in the development stage. The Company's primary intended activity is to engage in all aspects of review and evaluation of private companies, partnerships, or sole proprietorships for the purpose of completing mergers or acquisitions with the Company, and to engage in mergers acquisitions with any or all varieties of private entities. The Company has had no operations since its inception except for expenses related to maintaining the corporate status. BASIS OF ACCOUNTING The Company's policy is to use the accrual method of accounting and to prepare and present financial statements which conform to generally accepted accounting principles. 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 reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates. B. ACCOUNTS PAYABLE: Accounts payable at December 31, 1993 represents amounts due the Company's stock transfer agency, AST. C. CAPITAL STOCK The Company is authorized to issue 50,000,000 shares of common stock, with a par value of $.0001 per share. In May, 1989 the Company became obligated to distribute shares and warrants to the shareholders of ASI pursuant to the S-18 registration statement. The Company distributed 313,826 shares of stock and 627,652 warrants pursuant to the agreement with ASI. The shares and warrants were delivered at various dates between May of 1989 and February of 1990. This distribution included 313,826 shares of common stock and one (1) Class A Warrant and one (1) Class B Warrant with each share of stock distributed. Each warrant allowed the holder to acquire an additional share of common stock as follows: The Class A Warrant had an exercise price of $0.75 per share and an expiration date of April 30, 1990. The Class B Warrant had an exercise price of $1.50 per share and an expiration date of April 30, 1992. No warrants were exercised. XANTHIC ENTERPRISES, INC. (A DEVELOPMENT STAGE COMPANY) NOTES TO FINANCIAL STATEMENTS DECEMBER 31, 1993 (CONTINUED) D. LITIGATION: On November 2, 1991 the State of Oregon issued a cease and desist order ordering the Company to cease and desist issuing unregistered securities in the State of Oregon. The proceedings was based on the distribution of shares and warrants to Oregon shareholders (registered by way of an S-18 registration statement) pursuant to the agreements for such distribution between the Company and Automated Services, Inc. On April 2, 1992 the State or Oregon issued a final order to cease and desist violating any provision of Oregon Securities Law. Xanthic was denied the use of any statutory exemption provided in ORS 59.022 and ORS 59.035. Xanthic, Mark Lilly and Glenn DeCicco were assessed civil penalties of $750.00 each for violating ORS 59.055 and ORS 59.132(2). Directors Mark Lilly and Glenn DeCicco were ordered to cease and desist violating any provision of ORS Chapter 59. Neither the Company nor the Directors appealed. The Company has been advised that the effect of the Oregon ruling was to invalidate the issuance and distribution of the registered shares and warrants to residents of Oregon until such time as said securities are registered pursuant to the provisions of the Oregon Securities Law. The number of shares affected by the ruling is estimated to be 188,000 shares owned by approximately 650 residents at Oregon. The 188,000 shares represent approximately 3.4% of the issued and outstanding shares of the Company. ITEM 9.	ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES There is no disagreement with any prior accountant. PART III ITEM 10.	ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. Mark A. Lilly, President and a Director. Mr. Lilly, age 30, has been President of Xanthic since inception. During 1988 he was President of NinHao Enterprises, Inc., a Colorado corporation. NinHo Enterprises is no longer active. Mr. Lilly was an Assistant Health Planner for the Alameda Health Consortium from February 1987 to May, 1988. Since May, 1988 Mr. Lilly has been self employed as a free lance computer programer. Glenn DeCicco, Vice-President, Secretary and a Director. Mr. DeCicco, age 33, was a Senior Vice President of Nin Hao Enterprises during 1988 and was Presient of Land and Water Real Estate Company, an inactive development stage real estate consultation company formed in 1987. Land and Water Real Estate Company has no assets, income or employees. John D. Lilly, Vice-President and Director. Mr. Lilly, age 27, is a freelance software consultant and technical writer. John Lilly and Mark Lilly are brothers. ITEM 11.	ITEM 11. EXECUTIVE COMPENSATION. During the past year the Company did not compensate any officer or director. The Company has no plans to compensate any officer or director at the present time. ITEM 12.	ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. *The total number of shares owned by officers and directors is 2,534,500. ITEM 13.	ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Not Applicable. ITEM 14.	ITEM 14. EXHIBITS, FINANCIAL STATEMENTS AND SCHEDULES. The Company incorporates by reference the exhibits filed with its registration statement and the amendments thereto. There have been no 8-K filings during the past year. Attached under Item 8 are audited financial statements for the Company as of December 31, 1993. SIGNATURE In accordance with Section 12 of the Securities Exchange Act of 1934, this registrant caused this registration statement to be signed on its behalf by the undersigned, thereunto duly authorized. XANTHIC ENTERPRISES, INC. Dated: 4/2/97 ---------------------------- By: /s/ Mark A. Lilly ------------------------------------------------------------------ Mark A. Lilly, President, Director and Chief Financial Officer Dated: 4/2/97 ---------------------------- By: /s/ Glenn DeCicco ------------------------------------------------------------------ Glenn DeCicco, Vice-President and Director
94610_1993.txt	94610	1993	ITEM 1. BUSINESS (A) GENERAL DEVELOPMENT OF BUSINESS The information relating to the general development of the Registrant's business for the year ended December 31, 1993, is incorporated herein by reference to Item 7 - -Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") included in this report, under the sections entitled "Financial Condition and Liquidity," pages 15-22, and to the Financial Statements, included in this report, under Notes to the Consolidated Financial Statements, "Note 2--Subsequent Events," page 39, "Note 3--Acquisitions/Mergers/Dispositions," pages 39-40, "Note 4--Public Offering of Subsidiary Stock," page 40, "Note 16--Related Party Transactions," pages 58-59, and "Note 19--Segment Information," pages 62-64. Except where the context clearly indicates otherwise, the terms "Registrant" and "Company" as hereinafter used refer to Stone Container Corporation together with its consolidated subsidiaries. (B) FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS Financial information relating to the Registrant's industry segments, for the year ended December 31, 1993, is incorporated herein by reference to the MD&A, included in this report, under the section entitled "Results of Operations," pages 11-15, and to the Financial Statements, included in this report, under Notes to the Consolidated Financial Statements, "Note 19--Segment Information," pages 62-64. (C) NARRATIVE DESCRIPTION OF BUSINESS Descriptive information relating to the Registrant's principal products, markets and industry ranking is outlined in the table entitled "Profile" on page 2 of this report and is also incorporated herein by reference to the MD&A, included in this report, under the sections entitled "General," page 11, "Results of Operations," pages 11-15, "Investing Activities," page 21, and "Environmental Issues," pages 21-22, and to the Financial Statements, included in this report, under Notes to the Consolidated Financial Statements, "Note 3--Acquisitions/Mergers/Dispositions," pages 39-40, "Note 4--Public Offering of Subsidiary Stock," page 40, and "Note 19--Segment Information," pages 62-64. PROFILE A) PAPERBOARD AND PAPER PACKAGING: 1) CONTAINERBOARD AND CORRUGATED CONTAINERS: MARKETS: A board range of manufacturers of consumable and durable goods and other manufacturers of corrugated containers. INDUSTRY POSITION: Industry leader MANUFACTURING FACILITIES: Production at 17 mills Converting at 120 plants 1993 PRODUCTION & SHIPMENTS: 4.388 million short tons of containerboard produced 52.5 billion square feet of corrugated containers shipped 2) KRAFT PAPER AND BAGS AND SACKS: MARKETS: Supermarket chains and other retailers of consumable products. Industrial and consumer bags sold to the food, agricultural, chemical and cement industries, among others. INDUSTRY POSITION: Industry leader MANUFACTURING FACILITIES: Production at 5 mills Converting at 18 plants 1993 PRODUCTION & SHIPMENTS: 500 thousand short tons of kraft paper produced 613 thousand short tons of paper bags and sacks shipped 3) BOXBOARD, FOLDING CARTONS AND OTHER: MARKETS: Manufacturers of consumable goods, especially food, beverage and tobacco products, and other box manufacturers. INDUSTRY POSITION: A major position in Europe; a nominal position in North America MANUFACTURING FACILITIES: Production at 2 mills Converting at 10 plants 1993 PRODUCTION & SHIPMENTS: 81 thousand short tons of boxboard and other paperboard produced 92 thousand short tons of folding cartons and partitions shipped B) WHITE PAPER AND PULP: 1) NEWSPRINT MARKETS: Newspaper publishers and commercial printers. INDUSTRY POSITION: A major position MANUFACTURING FACILITIES: Production at 5 mills 1993 PRODUCTION & SHIPMENTS: 1.312 million short tons produced 2) UNCOATED GROUNDWOOD PAPER MARKETS: Producers of advertising materials, magazines, directories and computer papers. INDUSTRY POSITION: A major position MANUFACTURING FACILITIES: Production at 2 mills 1993 PRODUCTION & SHIPMENTS: 461 thousand short tons produced 3) MARKET PULP MARKETS: Manufacturers of paper products, including fine papers, photographic papers, tissue and newsprint. INDUSTRY POSITION: A major position MANUFACTURING FACILITIES: Production at 6 mills 1993 PRODUCTION & SHIPMENTS: 733 thousand short tons produced C) WOOD PRODUCTS: 1) LUMBER, PLYWOOD AND VENEER: MARKETS: Construction and furniture industries. INDUSTRY POSITION: A moderate position in North America MANUFACTURING FACILITIES: Production at 17 mills 1993 PRODUCTION & SHIPMENTS: 581 million board feet of lumber produced 425 million square feet of plywood and veneer produced Wood fiber and waste paper constitute the basic raw materials from which the Company's principal products are made. The Company's wood procurement operations provide wood fiber for the Company's mills. Wood fiber resources are generally available within economic proximity of the Registrant's mills and the Registrant has not experienced any significant difficulty in obtaining such resources, although the supply of timber in the United States continues to decrease due to environmental concerns in the Pacific Northwest. At December 31, 1993, the Company owned approximately 11 thousand and 339 thousand acres of private fee timberland in the United States and Canada, respectively. The Registrant's business is not dependent upon a single customer or upon a small number of major customers. The loss of any one customer would not have a material adverse effect on the Registrant. The Registrant's business is affected by cyclical industry conditions and economic factors affecting its products. These conditions and factors affect the prices which the Registrant is able to charge for its products. Export sales may be affected by fluctuations in foreign exchange rates. Backlogs are not a significant factor in the industry in which the Registrant operates; most orders placed with the Registrant are for delivery within 60 days or less. The major markets in which the Registrant sells its principal products are highly competitive. Its products compete with similar products produced by others and, in some instances, with products produced from other materials. Areas of competition include price, innovation, quality and service. The Registrant owns patents, licenses, trademarks and tradenames on products. The loss of any patent, license, trademark and tradename would not have a material adverse effect on the Registrant's operations. As of December 31, 1993, the Registrant had approximately 29,000 employees, of whom approximately 21,100 were employees of U.S. operations and the remainder were employees of foreign operations. Of those in the United States, approximately 12,300 are union employees. (D) FINANCIAL INFORMATION ABOUT FOREIGN AND DOMESTIC OPERATIONS AND EXPORT SALES Financial information relating to the Registrant's foreign and domestic operations and export sales for the year ended December 31, 1993, is incorporated herein by reference to the Financial Statements, included in this report, under Notes to the Consolidated Financial Statements, "Note 19--Segment Information," pages 62-64. The Company's results are affected by economic conditions in certain foreign countries and fluctuations in foreign exchange rates, particularly in the white paper and pulp segment, where the majority of such operations of the Company are conducted in Canada and the United Kingdom. ITEM 2.		ITEM 2. PROPERTIES The Registrant, including its subsidiaries and affiliates, maintains manufacturing facilities and sales offices throughout North America, Continental Europe and the United Kingdom, as well as sales offices in Japan and China. A listing of such worldwide facilities as of December 31, 1993 is provided on pages 5-6 of this report. The approximate annual production capacity of the Company's mills is summarized in the following table: All mills and converting facilities are owned, or partially owned through investments in other companies, by the Registrant, except for 45 converting plants in the United States, which are leased. The Registrant owns certain properties that have been mortgaged or otherwise encumbered. These properties include 12 paper mills, 9 bag plants and 45 corrugated container plants, including those subject to a leasehold mortgage. The Registrant's properties and facilities are properly equipped with machinery suitable for their use. Such facilities and related equipment are well maintained and adequate for the Registrant's current operations. Additional information relating to the Registrant's properties for the year ended December 31, 1993 is incorporated herein by reference to the Financial Statements, included in this report, under the Notes to the Consolidated Financial Statements, "Note 3--Acquisitions/Mergers/Dispositions," pages 39-40, "Note 4--Public Offering of Subsidiary Stock," page 40, "Note 10--Long-term Debt," pages 47-53, and "Note 13--Long-term Leases," pages 54-55. WORLDWIDE FACILITIES UNITED STATES: ALABAMA -Birmingham (corrugated container) ARIZONA -Eagar (forest products) -Glendale (corrugated container) -Phoenix (bag) -Snowflake (paperboard/paper/pulp) -Snowflake (paperboard/paper/pulp) The Apache Railway Company ARKANSAS -Jacksonville (bag) (Little Rock) -Little Rock (corrugated container) -Rogers (corrugated container) CALIFORNIA -City of Industry (corrugated container) (Los Angeles) -Fullerton (corrugated container) -Happy Camp (forest products) -Los Angeles (bag) -Salinas (corrugated container) -San Jose (corrugated container) -Santa Fe Springs (corrugated container, 2) COLORADO -Denver (corrugated container) -South Fork (forest products) CONNECTICUT -Portland (corrugated container) -Torrington (corrugated container) -Uncasville (paperboard/paper/pulp) FLORIDA -Cantonment (bag) (Pensacola) -Graceville (forest products) -Jacksonville (paperboard/paper/pulp) -Panama City (paperboard/paper/pulp) -Yulee (bag) -Orlando (corrugated container) Packaging Systems -Jacksonville (corrugated container) Preprint GEORGIA -Atlanta (corrugated container, 3) -Port Wentworth (paperboard/paper/pulp) -Atlanta (paperboard/paper/pulp) Technology and Engineering Center ILLINOIS -Bedford Park (corrugated container) (Chicago) -Bloomington (corrugated container) -Cameo (corrugated container) (Chicago) -Danville (corrugated container) -Herrin (affiliate); (corrugated container) -Joliet (corrugated container) -Naperville (corrugated container) (Chicago) -North Chicago (corrugated container) -Plainfield (bag) -Quincy (bag) -Zion (affiliate); (corrugated container) -Burr Ridge (paperboard/paper/pulp) Techonolgy and Engineering Center -Oak Brook (corrugated container) Marketing and Technical Center INDIANA -Columbus (corrugated container) -Indianapolis (corrugated container) -Mishawaka (corrugated container) -South Bend (corrugated container) IOWA -Des Moines (corrugated container), (bag) -Keokuk (corrugated container) -Sioux City (corrugated container) KANSAS -Kansas City (corrugated container) KENTUCKY -Louisville (corrugated container), (bag) LOUISIANA -Arcadia (bag) -Hodge (bag), (paperboard/paper/pulp) -New Orleans (corrugated container) MARYLAND -Savage (bag) (Baltimore) MASSACHUSETTS -Mansfield (corrugated container) -Westfield (corrugated container) MICHIGAN -Detroit (corrugated container) -Grand Rapids (bag) -Ontonagon (paperboard/paper/pulp) -Melvindale (corrugated container) (Detroit) MINNESOTA -Minneapolis (corrugated container) -Rochester (corrugated container) -St. Cloud (corrugated container) -St. Paul (corrugated container), (bag) -Minneapolis (corrugated container) Preprint MISSISSIPPI -Jackson (corrugated container) -Tupelo (corrugated container, 2) MISSOURI -Blue Springs (corrugated container) -Kansas City (bag) -Liberty (corrugated container) (Kansas City) -Springfield (corrugated container) -St. Joseph (corrugated container) -St. Louis (corrugated container) MONTANA -Missoula (paperboard/paper/pulp) NEBRASKA -Omaha (corrugated container) NEW JERSEY -Elizabeth (bag) -Teterboro (corrugated container) NEW MEXICO -Reserve (forest products) NEW YORK -Buffalo (corrugated container) NORTH CAROLINA -Charlotte (corrugated container) -Lexington (corrugated container) -Raleigh (corrugated container) NORTH DAKOTA -Fargo (corrugated container) -Grand Forks (bag) OHIO -Cincinnati (corrugated container) -Coshocton (paperboard/paper/pulp) -Jefferson (corrugated container) -Mansfield (corrugated container) -Marietta (corrugated container) -New Philadelphia (bag) OKLAHOMA -Oklahoma City (corrugated container) -Sand Springs (corrugated container) (Tulsa) OREGON -Albany (forest products) -Grants Pass (forest products) -Medford (forest products) -Springfield (forest products) -White City (forest products) PENNSYLVANIA -Philadelphia (corrugated container, 2) -Williamsport (corrugated container) -York (paperboard/paper/pulp) SOUTH CAROLINA -Columbia (corrugated container), (forest products) -Florence (paperboard/paper/pulp) -Fountain Inn (corrugated container) -Orangeburg (forest products) SOUTH DAKOTA -Sioux Falls (corrugated container) TENNESSEE -Chattanooga (corrugated container) -Collierville (corrugated contaier) (Memphis) -Nashville (corrugated container) TEXAS -Dallas (corrugated container) -El Paso (corrugated container, 2), (folding carton) -Grand Prairie (corrugated container) (Dallas) -Houston (corrugated container) -Temple (corrugated container) -Tyler (corrugated container) UTAH -Salt Lake City (bag) -Salt Lake City (bag) Bag Packaging systems VIRGINIA -Hopewell (paperboard/paper/pulp) -Martinsville (corrugated container) -Richmond (corrugated container,2), (bag) WEST VIRGINIA -Wellsburg (bag) WISCONSIN -Beloit (corrugated container) -Germantown (corrugated container) (Milwaukee) -Neenah (corrugated container) CANADA: ALBERTA -Calgary (affiliate); (corrugated container) -Edmonton (affiliate); (corrugated container) BRITISH COLUMBIA -Castlegar (affiliate); (paperboard/paper/pulp) -New Westminster (affiliate); (corrugated container) MANITOBA -Winnepeg (affiliate); (corrugated container) NEW BRUNSWICK -Bathurst (paperboard/paper/pulp); (forest products) -Saint John (affiliate); (corrugated container) NOVA SCOTIA *Dartmouth (corrugated container) ONTARIO -Etobicoke (affiliate); (corrugated container) -Guelph (affiliate); (corrugated container) -Pembroke (affiliate); (corrugated container) -Rexdale (affiliate); (corrugated container) -Whitby (affiliate); (corrugated container) QUEBEC -Chibougamau (forest products) -Grand-Mere (paperboard/paper/pulp) -LaBaie (paperboard/paper/pulp) -New Richmond (paperboard/paper/pulp) -Portage-du-Fort (paperboard/paper/pulp) -Roberval (forest products) -Saint-Fulgence (forest products) -Saint-Laurent (affiliate); (corrugaed container) -Shawinigan (paperboard/paper/pulp) -Trois-Rivieres (paperboard/paper/pulp) -Ville Mont-Royal (affiliate); (corrugated container) -Grand-Mere (paperboard/paper/pulp) Research Center SASKATCHEWAN -Regina (affiliate); (corrugated container) GERMANY: -Augsburg (affiliate); (folding carton) -Bremen (affiliate); (folding carton) -Dusseldorf (corrugated container) -Frankfurt (affiliate); (folding carton) -Germersheim (corrugated container) -Hamburg (corrugated container) -Heppenheim (affiliate) (folding carton) -Hoya (paperboard/paper/pulp) -Julich (corrugated container) -Lauenburg (corrugated container) -Lubbecke (corrugated container) -Neuburg (corrugated container) -Platting (corrugated container) -Viersen (paperboard/paper/pulp) -Waren (corrugated container) -Hamburg Institute for Package and Corporate Design UNITED KINGDOM: -Ellesmere Port (paperboard/paper/pulp) NETHERLANDS: -Sneek (affiliate); (folding carton) BELGIUM: -Ghlin (corrugated container) -Grand-Bigard (corrugated container) FRANCE: -Bordeaux (affiliate); (folding carton) -Cholet (affiliate); (folding carton) -Molieres-Sur-Ceze (corrugated container) -Nimes (corrugated container) -Soissons (affiliate); (folding carton) -Strasbourg (affiliate); (folding carton) COSTA RICA: -Palmar Norte (forest products) -San Jose (forest products) Administrative Office VENEZUELA -Puerto Ordaz (forest products) Administrative Office CORPORATE HEADQUARTERS: -Chicago, Illinois FAR EAST OFFICES: -Beijing, China TOKYO, JAPAN Stone Container Japan Company, Ltd. ITEM 3.	ITEM 3. LEGAL PROCEEDINGS In November 1988, the Legal Environmental Assistance Foundation ("LEAF") filed a citizens suit in the U.S. District Court for the Northern District of Florida against the Board of County Commissioners of Bay County, Florida (the "County") pursuant to Section 505 of the Clean Water Act. The Registrant's Panama City, Florida mill is one of the parties which contracts to utilize the County's wastewater treatment facility. The suit sought declaratory and injunctive relief in connection with alleged violations by the County of its wastewater treatment facility's National Pollutant Discharge Elimination Standards ("NPDES") discharge permit conditions. In September 1990, LEAF amended its complaint to include a request for an unspecified amount of penalties as provided by statute. If any penalties are ultimately assessed or agreed to by the County in this matter, the Registrant anticipates that the County would claim an undetermined portion of such penalties as the liability of the Registrant pursuant to the warranty and indemnification language contained in a March 20, 1979 Water Treatment and Disposal Service agreement between the County and Southwest Forest Industries, Inc., the Registrant's predecessor in interest. On March 9, 1993, the Court issued its Order granting the County's Motion For Summary Judgment. In its Order, the Court concluded that the suit was moot because LEAF's amended complaint requesting civil penalties was filed after the County had brought its facilities into compliance with the applicable permit limits. On February 14, 1994, the district court's decision was affirmed by the U.S. Court of Appeals for the Eleventh Circuit. On October 27, 1992, the Florida Department of Environmental Regulation ("DER") filed a civil complaint in the Fourteenth Judicial Circuit Court of Bay County, Florida against the Company seeking injunctive relief, an unspecified amount of fines and civil penalties, and other relief based on alleged groundwater contamination at the Company's Panama City, Florida pulp and paper mill site. In addition, the complaint alleges operation of a solid waste facility without a permit and discrepancies in hazardous waste shipping manifests. Because of uncertainties in the interpretation and application for DER's rules, it is premature to assess the Company's potential liability, if any, in the event of an adverse ruling. At the parties' request, the case has been placed in abeyance pending the conclusion of a related administrative proceeding petitioned by the Company following DER's proposal to deny the Company a permit renewal to continue operating its wastewater pretreatment facility at the mill site. The administrative proceeding has been referred to a hearing officer for an evidentiary hearing on the consolidated issues of compliance with a prior consent order, denial of the permit renewal, completion of a contamination assessment and denial of a sodium exemption. All issues were deferred until May 16, 1994 in order to allow additional studies to be performed. The Company intends to vigorously assert its entitlement to the permit renewal and to defend against the groundwater contamination and unpermitted facility allegations. In November 1990, the U.S. Environmental Protection Agency ("EPA") announced its decision to list two bodies of water in Arizona, Dry Lake and Twin Lakes, as "waters of the United States" impacted by toxic pollutant discharges under Section 304(l) of the federal Clean Water Act. These bodies of water have been used by the Company's Snowflake, Arizona pulp and paper mill for the evaporation of its process wastewater. EPA is preparing a draft consent decree to resolve the alleged past unpermitted discharges which will include EPA's proposal that the Company pay civil penalties in the amount of $900,000. The Company has vigorously disputed the application of the Clean Water Act to these two privately owned evaporation ponds. The Company has proposed to EPA a plan to convert its Snowflake, Arizona mill's wastewater management system to a tree farm irrigation system. EPA has indicated an interest in this proposal and discussions are ongoing. It is premature to predict either the outcome of the negotiations with EPA or the amount of penalties which will eventually be assessed. By letter dated January 4, 1994, the Company was advised by the Water Management Division of the U.S. Environmental Protection Agency, Region 9 (EPA) that EPA was seeking penalties in the amount of $125,000 for violations of discharge limits and monitoring requirements of the applicable NPDES permit at the Company's Flagstaff, Arizona Sawmill during the period from January 1990 through December 1992. The Company is investigating the matter and intends to negotiate with EPA a reduced penalty amount. EPA has advised that if a prompt settlement cannot be reached it will refer the matter to the Department of Justice for the filing of a civil suit. The Registrant is involved in contractual disputes, administrative and legal proceedings and investigations of various types. Although any litigation, proceeding or investigation has an element of uncertainty, the Registrant believes that the outcome of any proceeding, lawsuit or claim which is pending or threatened, or all of them combined, would not have a material adverse effect on its consolidated financial position or results of operations. ITEM 4.	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. PART II ITEM 5.	ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS (A) PRINCIPAL MARKET, STOCK PRICE AND DIVIDEND INFORMATION Information relating to the principal market, stock price and dividend information for the Registrant's Common and Preferred Stock and related stockholder matters, for the year ended December 31, 1993, is incorporated herein by reference to the MD&A, included in this report, under the sections entitled "Common and Series E Cumulative Preferred Stock--Cash Dividends, Market and Price Range," page 22 and "Financial Condition and Liquidity," pages 15-22, and to the Financial Statements, included in this report, under Notes to the Consolidated Financial Statements, "Note 10--Long-term Debt," pages 47-53, "Note 14--Preferred Stock," pages 55-56, "Note 15--Common Stock," pages 56-58 and "Note 20--Summary of Quarterly Data (unaudited)," page 65. (B) APPROXIMATE NUMBER OF HOLDERS OF COMMON STOCK There were approximately 6,822 holders of record of the Registrant's common stock, as of March 1, 1994. ITEM 6.	ITEM 6. SELECTED FINANCIAL DATA In addition to the table set forth on pages 9-10 of this report, selected financial data of the Registrant is incorporated herein by reference to the Financial Statements, included in this report, under Notes to the Consolidated Financial Statements, "Note 1--Summary of Significant Accounting Policies," pages 37-39, and "Note 3--Acquisitions/Mergers/Dispositions," pages 39-40. SELECTED FINANCIAL DATA - --------- NOTES TO SELECTED FINANCIAL DATA (a) Amounts per average common share and average common shares outstanding have been adjusted to reflect the 2 percent stock dividend in 1992, the 3-for-2 stock split in 1988 and the 2-for-1 stock split in 1987. The price range of common shares outstanding has been adjusted only to reflect the previously mentioned stock splits. (b) The Company made major acquisitions in 1989, 1987, 1986 and 1983. (c) For 1986, calculation assumes conversion of convertible preferred stock and convertible subordinated debentures which were converted/redeemed in 1987. (d) Includes non-consolidated affiliates. (e) In accordance with Statement of Financial Accounting Standards No. 95, "Statements of Cash Flows," the Company now discloses "Net cash provided by (used in) operating activities." For years prior to 1986, "Net funds provided by operations" are presented in this summary. (f) Represents the percentage of long-term debt to the sum of long-term debt, stockholders' equity, redeemable preferred stock, minority interest and deferred taxes. (g) 1993 and 1992 return on beginning common stockholders' equity calculated using the loss before cumulative effects of accounting changes. (h) For 1993, includes the Company's 25.4 percent minority interest liability in the common shares of Stone-Consolidated. ITEM 7.	ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS GENERAL The Company's major products are containerboard and corrugated containers, newsprint and market pulp. The markets for these products are highly competitive and sensitive to changes in industry capacity and cyclical changes in the economy that can significantly impact selling prices and the Company's profitability. In recent years, price changes have had a greater impact on the Company's sales and profitability than changes in sales volume. Although the Company had experienced declining product pricing in all of its product lines over the last several years, the Company believes that current market conditions may permit the Company to realize improved product pricing for most of its product lines during 1994. However, there is no assurance any such price increases will be achieved. (See "Financial Condition and Liquidity--Outlook.") As a result of the low average selling prices for the Company's products and interest costs as a result of its highly leveraged capital structure, the Company has incurred net losses in each of the last three years and will incur a net loss for the first quarter of 1994. Such net losses have significantly impaired the Company's liquidity and will continue to adversely affect the Company until significant product price improvement is achieved. In 1993, Management adopted a financial plan designed to enhance the Company's liquidity and increase its financial flexibility by satisfying amortization requirements under certain bank credit agreements of the Company and Stone Container (Canada) Inc. ("Stone Canada"). The Company completed portions of this financial plan during 1993 and in February of 1994. (See "Financial Condition and Liquidity" for further details.) RESULTS OF OPERATIONS COMPARATIVE RESULTS OF OPERATIONS 1993 COMPARED WITH 1992 Net sales for 1993 were $5.1 billion, a decrease of 8.4 percent over 1992 net sales of $5.5 billion. Net sales decreased as a result of both reduced sales volume and lower average selling prices for most of the Company's products. In 1993, the Company incurred a loss before the cumulative effect of a change in the accounting for postretirement benefits other than pensions of $319 million, or $4.59 per common share. The Company adopted Statement of Financial Accounting Standards No. 106, "Accounting for Postretirement Benefits Other than Pensions" ("SFAS 106"), effective January 1, 1993, and recorded a one-time, non-cash cumulative effect charge of $39.5 million net of income taxes or $.56 per common share, resulting in a net loss of $359 million or $5.15 per common share. In 1992, the Company incurred a loss before the cumulative effect of a change in the accounting for income taxes of $170 million, or $2.49 per common share. The adoption of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS 109"), effective January 1, 1992, required a one-time, non-cash cumulative effect charge of $99.5 million, or $1.40 per common share, resulting in a net loss of $269 million or $3.89 per common share. The increase in the loss before the cumulative effects of accounting changes primarily resulted from lower average selling prices for most of the Company's products. The 1993 results included a $35.4 million pretax gain from the sale of the Company's 49 percent equity interest in Empaques de Carton Titan, S.A., ("Titan") and the favorable effect of a reduction in an accrual relating to a change in the Company's vacation pay policy. The earnings impact of these non-recurring items was partially offset by the writedown of the carrying values of certain Company assets. The 1993 results also reflect both an increase in interest expense, primarily associated with a reduction in capitalized interest caused by completion of capital projects, and foreign currency transaction losses of $11.8 million. The 1992 results included foreign currency transaction losses of $15.0 million and an $8.8 million pretax charge relating to the writedown of investments. The Company recorded an income tax benefit of $147.7 million in 1993 as compared with an income tax benefit of $59.4 million in 1992. The increase in the income tax benefit primarily reflects the tax effect associated with the increased pretax loss for 1993 over 1992. Additionally, deferred income taxes were provided for the retroactive increase in the U.S. federal income tax rate, which was more than offset by the effects of an enacted decrease in German and Canadian income tax rates. The Company's effective income tax rates for both years reflect the impact of non-deductible depreciation and amortization. SEGMENT DATA SEGMENT AND PRODUCT LINE SALES DATA See Note 19 of the consolidated financial statements included in this report for additional segment information. PAPERBOARD AND PAPER PACKAGING: The 1993 net sales for the paperboard and paper packaging segment decreased 9.0 percent compared to 1992. This decrease was due in part to the exclusion of sales for the Company's European folding carton operations which in the early part of 1993 were merged into a joint venture and accordingly are now accounted for under the equity method of accounting. Sales from these operations were approximately $178 million in 1992. Sales for 1993 were approximately $60 million prior to the merger in May. Excluding the effect of the folding carton operations, 1993 net sales for the paperboard and paper packaging segment decreased 6.4 percent. Net sales of corrugated containers decreased 3.5 percent from 1992 primarily due to lower average selling prices in 1993 which more than offset a slight increase in sales volume. Net sales of paperboard decreased 11.9 percent from 1992 as a result of significantly lower average selling prices and declines in sales volume. Net sales of kraft paper decreased 28.0 percent from 1992 primarily due to reduced sales volume. Net sales for paper bags and sacks decreased from 1992 primarily due to lower sales volume and a decrease in average selling prices for retail paper bags which more than offset a modest increase in average selling prices for industrial paper bags. Operating income for the paperboard and paper packaging segment for 1993 decreased 35.9 percent from 1992 due to significantly lower operating margins, primarily resulting from the lower average selling prices for corrugated containers and containerboard. Operating income for this segment includes the previously mentioned $35.4 million pretax gain from the sale of Titan and a favorable effect of a reduction in an accrual resulting from a change in the Company's vacation policy. The earnings impact from these non-recurring items was partially offset by the writedowns of the carrying values of certain Company assets. WHITE PAPER AND PULP: The 1993 net sales for the white paper and pulp segment decreased 10.5 percent, as significant sales declines for market pulp more than offset a sales increase for groundwood paper. The sales declines for market pulp were primarily attributable to significantly lower average selling prices which deteriorated further in 1993 from the low average selling prices of 1992. Reduced sales volume in 1993 also contributed to the lower market pulp sales. Newsprint sales declined slightly in 1993 compared to 1992, primarily as a result of unfavorable foreign exchange translation effects attributable to the stronger U.S. dollar, which more than offset the benefits of higher average selling prices and a slight volume increase. Net sales for groundwood paper increased 11 percent, primarily as a result of significant volume increases which more than offset the effects of slightly lower average selling prices. The operating loss for the white paper and pulp segment for 1993 increased significantly over 1992 due to reduced operating margins primarily resulting from the significantly lower average selling prices for market pulp. Slightly lower average selling prices for groundwood paper also contributed to the reduced earnings, although to a much lesser extent. While average selling prices for newsprint in 1993 improved over the depressed levels of 1992, (although such prices declined in the fourth quarter of 1993 and in the first quarter of 1994), and certain cost reductions have been implemented, the margins associated with such improvements have only partially offset the effects of the lower average selling prices for market pulp and groundwood paper. OTHER: Net sales and operating income for the other segment increased over 1992 mainly due to improved demand and a reduced supply of timber available to the U.S. building industry. This resulted in increased sales volume and the realization of higher average selling prices for certain of the Company's lumber and wood products. However, shortages of timber available to be harvested due to environmental concerns in the Pacific Northwest continue to keep raw material costs high. 1992 COMPARED WITH 1991 Net sales for 1992 were $5.5 billion, an increase of 2.5 percent over 1991 net sales of $5.4 billion. Net sales rose primarily as a result of increased sales volume, most of which was offset by reduced average selling prices for certain of the Company's products. In 1992, the Company incurred a loss before the cumulative effect of change in accounting for income taxes of $170 million, or $2.49 per common share, compared to a loss of $49 million, or $.78 per common share in 1991. The Company adopted SFAS 109, effective January 1, 1992, and recorded a one-time, non-cash cumulative effect charge of $99.5 million or $1.40 per common share. All per share amounts have been adjusted to reflect a 2 percent common stock dividend issued September 15, 1992. The increase in the loss before the cumulative effect of a change in accounting for income taxes primarily resulted from lower average selling prices for newsprint and groundwood paper in 1992 as compared with 1991. Additionally, continued low average selling prices for the majority of the Company's other products contributed to the net loss for 1992. The 1992 results include foreign currency transaction losses of $15.0 million and an $8.8 million pretax charge relating to the writedown of investments. The 1991 results included non-recurring pretax gains of $59.3 million and foreign currency transaction gains of $4.9 million. The Company recorded an income tax benefit of $59.4 million in 1992 as compared with a $31.1 million income tax expense in 1991. This change primarily reflects the tax effect associated with the increased pretax loss for 1992 over 1991. The Company's effective income tax rates for both years reflect the impact of non-deductible depreciation and amortization, together with taxes payable by certain foreign subsidiaries at rates in excess of the U.S. statutory rate. PAPERBOARD AND PAPER PACKAGING: The 1992 net sales for the paperboard and paper packaging segment increased 3.7 percent as sales increases for corrugated containers, paperboard and folding cartons more than offset sales declines for kraft paper and paper bags and sacks. Net sales of corrugated containers increased 6.7 percent over 1991, primarily as a result of increased sales volume. Additionally, slightly higher average selling prices in 1992 contributed to this increase. However, such selling prices continued to remain at unsatisfactory levels. Net sales of paperboard increased over 1991 mainly as a result of modestly higher average selling prices. Such 1992 average paperboard selling prices were still, however, at unsatisfactory levels. Slight volume increases also contributed to the improved paperboard sales for 1992. Net sales of kraft paper decreased 9.3 percent from 1991, primarily due to reduced sales volume. Net sales of paper bags and sacks decreased from 1991 primarily due to lower sales volume and a decrease in average selling prices for retail paper bags. Operating income for the paperboard and paper packaging segment for 1992 decreased 9.5 percent, primarily as a result of the inclusion, in 1991, of a non-recurring pretax gain of $17.5 million from an involuntary conversion relating to a boiler explosion at the Company's Missoula, Montana linerboard mill. Excluding this 1991 non-recurring item, 1992 operating income for this segment would have decreased by 4.8 percent. This decrease is mainly attributable to reduced operating margins resulting from continued low average selling prices for the Company's paperboard and paper packaging products. WHITE PAPER AND PULP: The 1992 net sales for the white paper and pulp segment decreased 3.4 percent, as significant sales decreases for newsprint more than offset a significant sales increase for market pulp. The significant decrease in newsprint sales resulted primarily from lower average selling prices. Additionally, reduced volume associated with market-related downtime contributed to the lower sales of newsprint. Net sales for groundwood paper decreased slightly as lower average selling prices more than offset volume increases for this product. The increase in 1992 market pulp sales mainly resulted from volume increases associated with sales generated from the Stone Savannah River mill, which commenced market pulp operations in the fourth quarter of 1991. Furthermore, while market pulp selling prices declined significantly in the fourth quarter of 1992, the Company realized modestly higher average selling prices for this product in 1992, as compared with the even more depressed average selling prices of 1991. Operating income for the white paper and pulp segment for 1992 decreased significantly from 1991, primarily due to reduced operating margins resulting from the significantly lower average selling prices for newsprint and groundwood paper. The 1991 results included a non-recurring pretax gain of $41.8 million resulting from the settlement and termination of a Canadian supply contract. OTHER: Net sales and operating income for the other segment increased over 1991 mainly due to improved demand and a tighter supply of timber available to the U.S. building industry. This resulted in increased sales volume and the realization of higher average selling prices for certain of the Company's lumber and wood products. However, shortages of timber due to environmental concerns in the Pacific Northwest continued to keep raw material costs high. FINANCIAL CONDITION AND LIQUIDITY The Company's working capital ratio was 1.9 to 1 at December 31, 1993 and 1.8 to 1 at December 31, 1992. The Company's long-term debt to total capitalization ratio was 75.9 percent at December 31, 1993 and 69.2 percent at December 31, 1992. Capitalization, for purposes of this ratio, includes long-term debt (which includes debt of certain consolidated affiliates which is non-recourse to the Company), deferred income taxes, redeemable preferred stock, minority interest and stockholders' equity. The Company and Stone-Canada, a wholly-owned subsidiary, have entered into bank credit agreements (collectively, the "Credit Agreements") consisting of (i) two term-loan facilities with outstanding borrowings in the aggregate of $877.7 million as of December 31, 1993, (ii) an additional term loan (the "Additional Term Loan") with outstanding borrowings of $292.9 million at December 31, 1993 and (iii) two revolving credit facilities with aggregate commitments of $315.8 million and total outstanding borrowings of $263.8 million at December 31, 1993. The Company is the borrower under one of the term loans, the Additional Term Loan and one of the revolving credit facilities (collectively, the "U.S. Credit Agreement") and Stone-Canada is the borrower under the other term loan and revolving credit facility. Proceeds of the Additional Term Loan borrowings were used solely to repay regularly scheduled amortization of term loans under the U.S. Credit Agreement. At December 31, 1993, the Company had unused borrowing availability of $52.0 million under the revolving credit facilities. On February 3, 1994, under the Company's $1 billion shelf registration, the Company sold $710 million principal amount of 9- 7/8 percent Senior Notes due February 1, 2001 and 16.5 million shares of common stock for an additional $251.6 million at $15.25 per common share. On February 17, 1993, the underwriters elected to exercise their option to sell an additional 2.47 million shares of common stock for an additional $37.7 million, also at $15.25 per common share (collectively, with the February 3, 1994 offering, the "Offerings"). The net proceeds from the Offerings of approximately $962 million were used to (i) prepay approximately $652 million of 1995, 1996 and 1997 required amortization under the Company's Credit Agreements, including the ratable amortization payment under the revolving credit facilities which had the effect of reducing the total commitments thereunder to approximately $168 million; (ii) redeem the Company's 13- 5/8 percent Subordinated Notes due 1995 at a price equal to par, approximately $98 million principal amount, plus accrued interest to the redemption date; (iii) repay approximately $136 million of the outstanding borrowings under the Company's revolving credit facilities without reducing the commitments thereunder; and (iv) provide liquidity in the form of cash. At March 14, 1994, the Company had borrowings outstanding under its term loans and Additional Term Loan of $467.5 million and $191.9 million, respectively. The Company had no outstanding borrowings under its revolving credit facilities at March 14, 1994 and had borrowing availability under its revolving credit facilities of $168.2 million at such date. The term loans (other than the Additional Term Loan) and the revolving credit facilities had weighted average interest rates during 1993 of 8.3 percent and 5.7 percent, respectively. The weighted average interest rate on the Additional Term Loan was 6.3 percent for the year ended 1993. The weighted average interest rates for certain borrowings under the Credit Agreements reflect the impact of interest rate swap and interest rate collar contracts which had the effect in 1993 of increasing the effective borrowing rates over the contractual rates provided for such facilities. These weighted average rates do not include the effects of the amortization of deferred debt issuance costs. At December 31, 1993, the Company was a party to an interest rate swap contract related to $150 million of U.S. term loan borrowings which had the effect of fixing the interest rate at approximately 12.9 percent. This swap expired on March 22, 1994. Refer to Note 10 of the consolidated financial statements, included in this report, for information relating to the Company's repayment obligations with respect to its borrowings outstanding under the Credit Agreements. See also "Outlook" included in this section. The Credit Agreements contain covenants that include, among other things, requirements to maintain certain financial tests and ratios (including a minimum current ratio, an indebtedness ratio, a minimum earnings before interest, taxes, depreciation and amortization test ("EBITDA") and a tangible net worth test) and certain restrictions and limitations, including those on capital expenditures, changes in control, payment of dividends, sales of assets, lease payments, investments, additional borrowings, mergers and purchases of stock and assets. The Credit Agreements also contain cross-default provisions relating to the non-recourse debt of its consolidated affiliate, Stone-Consolidated Corporation, and cross-acceleration provisions relating to the non-recourse debt of the consolidated affiliates, including Seminole Kraft Corporation ("Seminole") and Stone Savannah River Pulp & Paper Corporation ("Stone Savannah River"). Additionally, the Credit Agreements provide for mandatory prepayments from sales of certain assets, debt and equity financings and excess cash flows. These prepayments along with voluntary prepayments are to be applied ratably to reduce loan commitments under the Credit Agreements. The indebtedness under the Credit Agreements is secured by a substantial portion of the assets of the Company. See Note 10 of the consolidated financial statements for additional information regarding the Credit Agreements. The Credit Agreements limit in certain specific circumstances any further investments by the Company in Stone-Consolidated Corporation, Seminole and Stone Savannah River. Stone Savannah River and Seminole have incurred substantial indebtedness in connection with project financings and are significantly leveraged. As of December 31, 1993, Stone Savannah River had $402.6 million in outstanding indebtedness (including $268.9 million in secured indebtedness owed to bank lenders) and Seminole had $161.0 million in outstanding indebtedness (including $120.6 million in secured indebtedness owed to bank lenders). Emerging Issues Task Force Issue No. 86-30, "Classification of Obligations when a Violation is Waived by the Creditor," requires a company to reclassify long-term debt as current when a covenant violation has occurred at the balance sheet date or would have occurred absent a loan modification and it is probable that the borrower will not be able to comply with the same covenant at measurement dates that are within the next twelve months. In November 1993, Stone Savannah River received a waiver of its fixed-charges-coverage covenant requirement as of December 31, 1993 and March 31, 1994. Management has prepared projections that indicate that upon the expiration of the waiver Stone Savannah River will not be in compliance with this covenant as of June 30, September 30, and December 31, 1994. Consequently, approximately $237.9 million of Stone Savannah River debt that otherwise would have been classified as long-term, has been classified as current in the December 31, 1993 consolidated balance sheet. Stone Savannah River intends to seek, prior to June 10, 1994, appropriate financial covenant waivers or amendments from its bank group, although no assurance can be given that such waivers or amendments will be obtained. Any such failure to obtain covenant relief would result in a default under Stone Savannah River's credit agreement and other indebtedness and, if any such indebtedness were accelerated by the holders thereof, the lenders to the Company under the Credit Agreements and various other of the Company's debt instruments will be entitled to accelerate the indebtedness owed by the Company. The Company has entered into separate output purchase agreements with each of these subsidiaries which require the Company to purchase Seminole's linerboard production at fixed prices until no later than September 1, 1994 and Stone Savannah River's linerboard and market pulp production at fixed prices until December 1994 and November 1995, respectively. After such dates, the Company is required to purchase the respective production at market prices for the remaining terms of these agreements. While the fixed prices in effect at December 31, 1993 were higher than market prices at such date, the price differentials have not had, nor are they expected to have, a significant impact on the Company's results of operations or financial position. However, at the time that the fixed price provisions of the output purchase agreements terminate, such subsidiaries may need to undertake additional measures to meet their debt service requirements, including obtaining additional sources of funds, postponing or restructuring of debt service payments or refinancing the indebtedness. In the event that such measures are required and are not successful, and such indebtedness is accelerated by the respective lenders to Stone Savannah River or Seminole, the lenders to the Company under the Credit Agreements and various other of its debt instruments would be entitled to accelerate the indebtedness owed by the Company. The Company and its bank group have amended the Company's Credit Agreements several times during the past three years. Such amendments provided among other things, greater financial flexibility and/or relief from certain financial covenants. In some instances, certain restrictions and limitations applicable to the Credit Agreements were tightened. The most recent amendment, which was executed in February of 1994 and became effective upon the completion of the Offerings, provided, among other things, for the following: (i) Permitted the Company to apply up to $200 million of net proceeds from the Offerings, which increased liquidity, as repayment of borrowings under the revolving credit facilities of the Credit Agreements without reducing the commitments thereunder and to the extent no balance was outstanding under the revolving credit facilities, permitted the Company to retain the balance of such $200 million of proceeds in cash. (ii) Permitted the Company to redeem the Company's 13- 5/8 percent Subordinated Notes maturing on June 1, 1995, from the proceeds received from the Offerings at a price equal to par, approximately $98 million principal amount, plus accrued interest to the redemption date. (iii) Amended the required levels of EBITDA, (as defined in the Credit Agreements), for certain specified periods to the following: The required level of EBITDA is scheduled to increase for each rolling four quarter period thereafter until December 31, 1996, when the EBITDA for the twelve months ended December 31, 1996 is required to be $822 million. (iv) Reset to zero as of January 1, 1994, the dividend pool under the Credit Agreements which permits payment of dividends on the Company's capital stock and modifies the components used in calculating the ongoing balance in the dividend pool. Effective January 1, 1994, dividend payments on the Company's common stock and on certain preferred stock issues cannot exceed the sum of (i) 75 percent of the consolidated net income, (as defined in the Credit Agreements), of the Company from January 1, 1994 to the date of payment of such dividends minus (ii) 100 percent of the consolidated net loss, (as defined in the Credit Agreements), of the Company from January 1, 1994 to the date of payment of such dividends, plus (iii) 100 percent of any net cash proceeds from sales of common stock or certain preferred stock of the Company from January 1, 1994 to any date of payment of such dividends (excluding the proceeds from the Offerings for which no dividend credit was received by the Company). Additionally, restrictions with respect to dividends on the Series E Cumulative Preferred Stock now mirror the dividend restrictions in the Company's Senior Subordinated Indenture dated as of March 15, 1992. (v) Replaced the existing cross-default provisions relating to obligations of $10 million or more of the Company's separately financed subsidiaries, Seminole and Stone Savannah River, with cross-acceleration provisions. (vi) Replaced the current prohibition of investments in Stone Venepal Consolidated Pulp Inc. with restrictions substantially similar to the restrictions applicable to the Company's subsidiaries, Stone Savannah River and Seminole. (vii) Maintains the monthly indebtedness ratio requirement, as defined in the Credit Agreements, to be no higher than: 81.5 percent as of the end of each month from December 31, 1993 and ending prior to March 31, 1995 and 81 percent as of the end of each month from March 31, 1995 and ending prior to June 30, 1995. The indebtedness ratio requirement is scheduled to periodically decrease thereafter (from 80 percent on June 30, 1995) until February 28, 1997, when the ratio limitation is required to be 68 percent. (viii) Maintains the Consolidated Tangible Net Worth (CTNW), (as defined in the Credit Agreements), to be equal to or greater than 50 percent of the highest CTNW for any quarter since the inception of the Credit Agreements. Additionally, at various times during the year, the Company amended and restated its Credit Agreements which provided, among other things, to (i) extend the maturity of the revolving credit facilities from March 1, 1994 to March 1, 1997 and reduce over a three-year period the revolving loan commitments; (ii) revise various financial covenants to provide greater financial flexibility to the Company; (iii) permit the Company to retain 25 percent of the net proceeds from future sales of equity securities (which could be used to reduce revolving credit borrowings without reducing the commitments thereunder); and (iv) permit the Company to retain 50 percent (maximum $100 million in the aggregate) of the net proceeds from any sale or disposition of its investment in certain joint ventures or unconsolidated subsidiaries (which could be used to reduce revolving credit borrowings without reducing the commitments thereunder). As part of these amendments, the Company agreed (i) to pay certain fees and higher interest rate margins and (ii) to mortgage or pledge additional collateral including a pledge of the Stone-Consolidated common stock owned by the Company. There can be no assurance that the Company will be able to achieve and maintain compliance with the prescribed financial ratio tests or other requirements of its Credit Agreements. Failure to achieve or maintain compliance with such financial ratio tests or other requirements under the Credit Agreements, in the absence of a waiver or amendment, would result in an event of default and could lead to the acceleration of the obligations under the Credit Agreements. The Company has successfully sought and received waivers and amendments to its Credit Agreements on various occasions since entering into the Credit Agreements. If further waivers or amendments are requested by the Company, there can be no assurance that the Company's bank lenders will again grant such requests. The failure to obtain any such waivers or amendments would reduce the Company's flexibility to respond to adverse industry conditions and could have a material adverse effect on the Company. OUTLOOK: Due to industry conditions during the past few years and interest costs as a result of the Company's highly leveraged capital structure, the Company has incurred net losses in each of the last three years and the Company will incur a net loss for the first quarter of 1994. Such net losses have significantly impaired the Company's liquidity and available sources of liquidity and will continue to adversely affect the Company until significant product price improvement is achieved. The Company's containerboard and corrugated container product lines, which represent a substantial portion of the Company's net sales, have generally experienced pricing pressures during the past three years. Recently, however, the Company has implemented a $25 per ton price increase for containerboard, which had been announced for the fourth quarter of 1993. This increase did not, however, restore prices for containerboard to the levels at the beginning of 1993. As a result of a further strengthening in demand, the Company announced and began implementing another price increase of $30 per ton for containerboard effective March 1, 1994. While the Company currently believes that it will implement this most recent price increase during the first half of 1994, there can be no assurance it will occur. In addition, price increases for corrugated containers were effected during the fourth quarter of 1993 and the first quarter of 1994. These recent price increases achieved in corrugated containers represent restoration of prices to prior levels realized during 1993. While there can be no assurance that prices will continue to increase or even be maintained at present levels, the Company believes that the supply/demand characteristics for containerboard and corrugated containers are improving which could allow for further price restorations for these product lines. Pricing conditions for newsprint, groundwood paper and market pulp have been volatile in recent years. Additions to industry-wide capacity and declines in demand for such products during the past three years led to supply/ demand imbalances that have contributed to depressed prices for these products. While the Company at certain times in 1993 realized modest price improvements for newsprint, average selling prices declined in the fourth quarter of 1993 and in the first quarter of 1994 and continue to remain low. In 1993, the Company attempted to balance supply and demand by taking downtime at selected production facilities. Independently, other industry participants also took downtime at their various facilities. Such downtime helped to reduce industry inventory levels and the Company recently announced a $47.95 per metric ton price increase for newsprint effective March 1, 1994. There can be no assurance that this price increase will be achieved. Other major North American producers have announced similar price increases. Also as a result of improvements in industry supply/demand characteristics, the Company announced price increases for its various grades of market pulp effective January 1, 1994 and March 1, 1994 which increased the transaction price of market pulp by a least $90 per metric ton. While other producers have announced similar price increases for market pulp, due to significant worldwide competition in this product line, there can be no assurance that such price increases will be achieved as scheduled. The Company improved its liquidity and financial flexibility through the completion of the Offerings in February of 1994. At March 14, 1994, the Company had borrowing availability of $168.2 million under its revolving credit facilities. Notwithstanding these improvements in the Company's liquidity and financial flexibility, unless the Company achieves substantial price increases beyond year-end levels, the Company will continue to incur net losses and negative cash flows from operating activities. Without such sustained substantial price increases, the Company may exhaust all or substantially all of its cash resources and borrowing availability under the revolving credit facilities. In such event, the Company would be required to pursue other alternatives to improve liquidity, including further cost reductions, sales of assets, the deferral of certain capital expenditures, obtaining additional sources of funds or pursuing the possible restructuring of its indebtedness. There can be no assurance that such measures, if required, would generate the liquidity required by the Company to operate its business and service its indebtedness. As currently scheduled, beginning in 1996 and continuing thereafter, the Company will be required to make significant amortization payments on its indebtedness which will require the Company to raise sufficient funds from operations or other sources or refinance or restructure maturing indebtedness. No assurance can be given that the Company will be able to generate or raise such funds. The Company, as part of its financial plan, had intended to sell an energy supply agreement related to its Florence, South Carolina mill. Even though a sale is still being investigated by the Company, the Company is no longer pursuing the original transaction; however, the Company is currently investigating alternative transactions. CASH FLOWS FROM OPERATIONS: The following table shows, for the last three years, the net cash provided by (used in) operating activities: The results of operations for 1991 through 1993 have had a significant adverse impact on the Company's cash flow. Borrowings in 1991, 1992 and 1993 have increased to meet cash flow needs. During 1993, the Company entered into various financing and investing activities designed to provide liquidity and enhance financial flexibility. See "Financing activities" and "Investing activities." The 1993 decrease in accounts and notes receivable reflects the timing of receivable collections, lower average selling prices for a majority of the Company's products and the writedown of certain receivables to net realizable value. The increase in accounts and notes receivable for 1992 reflect an increase in sales volume for certain of the Company's products during the latter part of 1992 over 1991 and the timing of receivable collections resulting from the continued slow recovery of the economy. Inventories decreased in 1993 due primarily to a reduction in certain paperstock and newsprint levels, partially attributable to market related downtime. The decrease in inventories for 1992 resulted mainly from reductions in certain paperstock levels due to increased sales volume during the latter part of 1992 and market-related downtime. The 1992 decrease in other current assets resulted mainly from the collection of $43 million of cash related to the 1991 settlement and termination of a Canadian supply contract. The decreases in accounts payable and other current liabilities for 1993 and 1992 were due primarily to the timing of payments. FINANCING ACTIVITIES: The following summarizes the Company's significant financing activities in 1993: - During 1993, outstanding borrowings under the Company's revolving credit facilities increased approximately $6.8 million. The net increase takes into account the financial transactions discussed below and those transactions discussed in the "Investing activities" section following. Borrowings and payments made on debt as presented in the Statement of Cash Flows does not take into account certain repayments and subsequent reborrowings under the revolving credit facilities which occurred as a result of these transactions. - In December 1993, Stone-Consolidated Corporation ("Stone-Consolidated"), a newly created Canadian subsidiary, acquired the newsprint and uncoated groundwood papers business of Stone Container (Canada) Inc. ("Stone-Canada") (formerly Stone-Consolidated Inc.) and sold $346.5 million of units in an initial public offering comprised of both common stock and convertible subordinated debentures (the "Units Offering"). Each unit was priced at $2,100 and consisted of 100 shares of common stock at $10.50 per share and $1,050 principal amount of convertible subordinated debentures. The convertible subordinated debentures mature December 31, 2003, bear interest at an annual rate of 8 percent and are convertible beginning June 30, 1994, into 6.211 shares of common stock for each Canadian $100 principal amount, representing a conversion price of $12.08 per share. Concurrent with the initial public offering, Stone-Consolidated sold $225 million of senior secured notes in a public offering in the United States. The senior secured notes mature December 15, 2000 and bear interest at an annual rate of 10.25 percent. As a result of the Units Offering, 16.5 million shares of common stock, representing 25.4 percent of the total shares outstanding of Stone-Consolidated, were sold to the public, resulting in the recording in the Company's Consolidated Balance Sheet of a minority interest liability of $236.7 million. The Company used approximately $373 million of the net proceeds from the sale of the Stone-Consolidated securities for repayment of commitments under its Credit Agreements and the remainder for general corporate purposes. As a result of the Units Offering, the Company recorded a charge of $74.4 million to common stock related to the excess carrying value per common share over the offering price per common share associated with the shares issued. - In December 1993, the Company sold two of its short-line railroads in a transaction in which the Company has guaranteed to contract minimum railroad services which will provide freight revenues to the railroads over a 10 year period. The transaction has been accounted for as a financing and accordingly, had no impact on the Company's 1993 net loss. The Company received proceeds of approximately $28 million, of which approximately $19 million was used to repay commitments under the Credit Agreements. - In the fourth quarter of 1993, the Company sold, prior to their expiration date, certain of the U.S. dollar denominated interest rate and cross currency swaps associated with the Credit Agreement borrowings of Stone-Canada. The net proceeds totaled approximately $34.9 million, the substantial portion of which was used to repay borrowings under the revolving credit facilities of the Credit Agreements, thereby restoring borrowing availability thereunder. The sale of the swaps resulted in a deferred loss which will be amortized over the remaining life of the underlying obligation. - In July 1993, the Company sold $150 million principal amount of 12- 5/8 percent Senior Notes due July 15, 1998 and, in a private transaction, sold $250 million principal amount of 8- 7/8 percent Convertible Senior Subordinated Notes due July 15, 2000. The Company filed a shelf registration statement declared effective August 13, 1993 registering the 8- 7/8 percent Convertible Senior Subordinated Notes for resale by the holders thereof. The net proceeds of approximately $386 million received from the sales of these notes were used by the Company to repay borrowings without reducing commitments under the revolving credit facilities of its Credit Agreements, thereby restoring borrowing availability thereunder. INVESTING ACTIVITIES: The following summarizes the Company's significant 1993 investing activities: - The Company sold its 49 percent equity interest in Titan. The net proceeds were used to repay commitments under the Credit Agreements and for repayment of borrowings under its revolving credit facilities without reducing commitments, thereunder. - During 1993, the Company increased its ownership in the common stock of Stone Savannah River from 90.2 percent to 92.8 percent through the purchase of an additional 6,152 common shares and through the receipt of Series D Preferred Stock as a dividend in kind on Stone Savannah River's Series B Preferred Stock and the election of its right to convert the Series D Preferred Stock into 198,438 common shares. - On May 6, 1993, the Company's wholly-owned German subsidiary, Europa Carton A.G., ("Europa Carton"), completed a joint venture with Financiere Carton Papier (FCP), a French company, to merge the folding carton operations of Europa Carton with those of FCP ("FCP Group"). Under the joint venture, FCP Group is owned equally by Europa Carton and the shareholders of FCP immediately prior to the merger. The Company's investment in the joint venture is being accounted for under the equity method of accounting. - Capital expenditures for 1993 totaled approximately $150 million (including capitalized interest of approximately $9 million), of which approximately $15 million was funded from existing project financings. The Company's capital expenditures for 1994 are budgeted at approximately $190 million. ENVIRONMENTAL ISSUES: The Company's operations are subject to extensive environmental regulation by federal, state and local authorities in the United States and regulatory authorities with jurisdiction over its foreign operations. The Company has in the past made significant capital expenditures to comply with water, air and solid and hazardous waste regulations and expects to make significant expenditures in the future. Capital expenditures for environmental control equipment and facilities were approximately $28 million in 1993 and the Company anticipates that 1994 and 1995 environmental capital expenditures will approximate $71 million and $96 million, respectively. Included in these amounts are capital expenditures for Stone-Consolidated which were approximately $5 million in 1993 and are anticipated to approximate $36 million in 1994 and $64 million in 1995. Although capital expenditures for environmental control equipment and facilities and compliance costs in future years will depend on legislative and technological developments which cannot be predicted at this time, the Company anticipates that these costs are likely to increase as environmental regulations become more stringent. Environmental control expenditures include projects which, in addition to meeting environmental concerns, yield certain benefits to the Company in the form of increased capacity and production cost savings. In addition to capital expenditures for environmental control equipment and facilities, other expenditures incurred to maintain environmental regulatory compliance (including any remediation) represent ongoing costs to the Company. On December 17, 1993, the Environmental Protection Agency proposed regulations under the Clean Air Act and the Clean Water Act for the pulp and paper industry which, if and when implemented, would affect directly a number of the Company's facilities. Since the regulations have only recently been proposed, the Company is currently unable to estimate the nature or level of future expenditures that may be required to comply with such regulations if the proposed regulations become final in some form. In addition, the Company is from time to time subject to litigation and governmental proceedings regarding environmental matters in which injunctive and/or monetary relief is sought. The Company has been named as a potentially responsible party ("PRP") at a number of sites which are the subject of remedial activity under the Comprehensive Environmental Response, Compensation and Liability Act of 1980 ("CERCLA" or "Superfund") or comparable state laws. Although the Company is subject to joint and several liability imposed under Superfund, at most of the multi-PRP sites there are organized groups of PRPs and costs are being shared among PRPs. Future environmental regulations, including the December 17, 1993 regulations, may have an unpredictable adverse effect on the Company's operations and earnings, but they are not expected to adversely affect the Company's competitive position. COMMON AND SERIES E CUMULATIVE PREFERRED STOCK--CASH DIVIDENDS, MARKET AND PRICE RANGE Due to limitations and restrictions imposed upon the Company under the Credit Agreements, the Company did not declare or pay a cash dividend on its shares of common stock during 1993 or in the third and fourth quarter of 1992. Cash dividends paid per common share were $.35 for 1992 and $.71 for 1991. Cash dividends paid per share on the Series E Cumulative Convertible Exchangeable Preferred Stock (the "Series E Cumulative Preferred Stock") were $.875 for 1993 and $1.28 for 1992. Due to a restrictive provision in the Senior Subordinated Indenture dated March 15, 1992 (the "Senior Subordinated Indenture") relating to the Company's 10- 3/4 percent Senior Subordinated Notes due June 15, 1997, its 11 percent Senior Subordinated Notes due August 15, 1999 and its 10- 3/4 percent Senior Subordinated Debentures due April 1, 2002, the Board of Directors did not declare the scheduled August 15, 1993 or November 15, 1993 quarterly dividend of $.4375 per share on the Series E Cumulative Preferred Stock, nor was it permitted to declare or pay future dividends on the Series E Cumulative Preferred Stock until the Company generated income, or effected certain sales of capital stock, to replenish the dividend "pool" under various of its debt instruments. As of December 31, 1993, accumulated dividends on the Series E Cumulative Preferred Stock amounted to $4.0 million. As a result of the Offerings, the dividend pool under the Senior Subordinated Indenture was replenished from the sale of the common shares. Pursuant to the most recent amendment to the Company's Credit Agreements, the Company will be able, to the extent declared by the Board of Directors, to pay dividends on the Series E Cumulative Preferred Stock to the extent permitted under the Senior Subordinated Indenture. In the event the Company does not pay a dividend on the Series E Cumulative Preferred Stock for six quarters, the holders of the Series E Cumulative Preferred Stock would have the right to elect two members to the Company's Board of Directors until the accumulated dividends on such Series E Cumulative Preferred Stock have been declared and paid or set apart for payment. The Company's Common Stock and Series E Cumulative Preferred Stock are traded on the New York Stock Exchange under the symbols "STO" and "STOPRE", respectively. The quarterly and annual price ranges for the Company's Common Stock and the Company's Series E Cumulative Preferred Stock were: The 1992 amounts set forth in the table above have not been restated to reflect the 2 percent common stock dividend paid by the Company on September 15, 1992. There were approximately 7,032 common stockholders and 535 preferred stockholders of record at December 31, 1993. ACCOUNTING STANDARDS CHANGES In November 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" ("SFAS 112"), which requires accrual accounting for the estimated costs of providing certain benefits to former or inactive employees and the employees' beneficiaries and dependents after employment but before retirement. The Company intends to adopt SFAS 112 by recognizing the catch-up obligation for its worldwide operations as a cumulative effect of an accounting change effective January 1, 1994 in the 1994 first quarter Statement of Operations. The one-time, non-cash charge will be approximately $14 million, net of income taxes. ITEM 8.	ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Registrant's financial statements required by Item 8, together with the report thereon of the Independent Accountants dated March 23, 1994 are set forth on pages 32-65 of this report. The financial statement schedules listed under Item 14(a)2, together with the report thereon of the Independent Accountants dated March 23, 1994 are set forth on pages 66-71 of this report and should be read in conjunction with the financial statements. 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 Information relating to the Registrant's Directors and Executive Officers is incorporated herein by reference to the Proxy Statement, to be filed on or before April 30, 1994, for the Annual Meeting of Stockholders scheduled May 10, 1994, under the captions, "Directors -- Nominees for Directors," "Directors -- Information as to Directors and Executive Officers" and "Directors -- Certain Transactions." ITEM 11.	ITEM 11. EXECUTIVE COMPENSATION Information relating to the Registrant's executive compensation is incorporated herein by reference to the Proxy Statement, to be filed on or before April 30, 1994, for the Annual Meeting of Stockholders scheduled May 10, 1994, under the caption "Compensation," excluding the section thereunder entitled "Compensation Committee Report." ITEM 12.	ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT (A) SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS Information relating to certain beneficial ownership of the Registrant's common stock is incorporated herein by reference to the Proxy Statement, to be filed on or before April 30, 1994, for the Annual Meeting of Stockholders scheduled May 10, 1994, under the captions "Directors -- Nominees for Directors" and "Security Ownership by Certain Beneficial Owners and Management--Security Ownership by Certain Beneficial Owners." (B) SECURITY OWNERSHIP OF MANAGEMENT Information relating to ownership of the Registrant's equity securities by Directors and Executive Officers is incorporated herein by reference to the Proxy Statement, to be filed on or before April 30, 1994, for the Annual Meeting of Stockholders scheduled May 10, 1994, under the captions "Directors -- Nominees for Directors" and "Security Ownership by Certain Beneficial Owners and Management--Security Ownership by Management." (C) CHANGES IN CONTROL The Registrant knows of no contractual arrangements which may, at a subsequent date, result in a change in control of the Registrant. ITEM 13.	ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information related to certain relationships and related transactions is incorporated herein by reference to the Proxy Statement, to be filed on or before April 30, 1994, for the Annual Meeting of Stockholders scheduled May 10, 1994, under the caption "Directors -- Certain Transactions." PART IV ITEM 14.	ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (A) DOCUMENTS FILED AS PART OF THIS REPORT 1. FINANCIAL STATEMENTS. The Registrant's financial statements, for the year ended December 31, 1993, together with the Report of Independent Accountants are set forth on pages 32-65 of this report. The supplemental financial information listed and appearing hereafter should be read in conjunction with the Financial Statements included in this report. Separate financial statements of 50 percent or less owned persons accounted for by the equity method have been omitted because they would not constitute a significant subsidiary. 2. SUPPLEMENTAL FINANCIAL INFORMATION. The following are included in Part IV of this report for each of the years ended December 31, 1993, 1992 and 1991 as applicable: Financial statement schedules not included in this report have been omitted, either because they are not applicable or because the required information is shown in the financial statements or notes thereto, included in this report. At December 31, 1993, the Company had outstanding loans receivable of $275,000 and $250,000, respectively, to James Doughan, Executive Vice President of the Company and President and Chief Executive Officer of Stone-Consolidated, and to James B. Heider, Senior Vice President and General Manager, Containerboard and Paper Division. Such loans bear no interest and are repayable on demand pursuant to request by the Company. 3. EXHIBITS. The exhibits required to be filed by Item 601 of Regulation S-K are listed under the caption "Exhibits" in Item 14(c). (B) REPORTS ON FORM 8-K A Report on Form 8-K dated October 15, 1993 was filed reporting under Item 5 - -Other Events, that the Company amended its Credit Agreement as of September 15, 1993, which amendment was filed as an exhibit to the Report on Form 8-K. A Report on Form 8-K dated January 3, 1994 was filed reporting (i) under Item 2 - -Acquisition or Disposition of Assets, that Stone-Consolidated Corporation, an indirect Canadian subsidiary of the Company, sold in Canada in an initial public offering both common stock and convertible subordinated debentures and concurrently sold in the United States senior secured notes and; (ii) under Item 5 - -Other Events, that the Company and its bank group entered into an Amended and Restated Credit Agreement effective December 17, 1993 (the "Third Restated Credit Agreement"). A Report on Form 8-K dated January 5, 1994 was filed reporting under Item 5 - -Other Events, with respect to certain amendments to the Credit Agreements and disclosure relating to the Offerings, and other recent developments. A Report on Form 8-K dated January 24, 1994 was filed reporting under Item 5 - -Other Events, that (i) the Company issued a press release on February 3, 1994 announcing its financial results for the fourth quarter of 1993 and for the year ended December 31, 1993 and the recent developments concerning the Company's issuance of common stock and senior unsecured notes and (ii) the Company amended and received a waiver to its Credit Agreements as of January 24, 1994. (C) EXHIBITS - --------- * Management contract or compensatory plan or arrangement SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. SIGNATURES--(CONTINUED) 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. INDEX TO FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Report of Independent Accountants To the Board of Directors and Stockholders of Stone Container Corporation In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, of cash flows and of stockholders' equity present fairly, in all material respects, the financial position of Stone Container Corporation and its subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. As discussed in Note 11 to the consolidated financial statements, the Company's liquidity has been adversely affected by the net losses incurred in the past three years. Recent financings and other transactions have improved liquidity; however, improvements in cash flows from operations eventually will be necessary. In addition, as discussed in Note 18, two of the Company's subsidiaries may need to undertake additional measures to meet their separate debt service requirements. As discussed in Note 1 to the consolidated financial statements, the Company changed its methods of accounting for income taxes and for postretirement benefits other than pensions effective January 1, 1992 and 1993, respectively. PRICE WATERHOUSE Chicago, Illinois March 23, 1994 STONE CONTAINER CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (in millions except per share) The accompanying notes are an integral part of these statements. STONE CONTAINER CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (in millions) The accompanying notes are an integral part of these statements. STONE CONTAINER CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (in millions) The accompanying notes are an integral part of these statements. STONE CONTAINER CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (in millions except per share) The accompanying notes are an integral part of these statements. STONE CONTAINER CORPORATION AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS NOTE 1--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION: The consolidated financial statements include the accounts of the Company and all subsidiaries that are more than 50 percent owned. The Company's subsidiary Cartomills, S.A. ("Cartomills") was also accounted for as a consolidated subsidiary beginning October 31, 1990 upon the Company's acquisition of 30 percent of the outstanding common stock of Cartomills. In 1992, the Company purchased the remaining 70 percent of the common stock of Cartomills. All significant intercompany accounts and transactions have been eliminated. Investments in non-consolidated affiliated companies are primarily accounted for by the equity method. PER SHARE DATA: Net loss per common share is computed by dividing net loss applicable to common shares by the weighted average number of common shares outstanding during each year. The weighted average number of common shares outstanding was 71,162,646 in 1993, 70,986,564 in 1992 and 63,206,529 in 1991. Common stock equivalent shares, issuable upon exercise of outstanding stock options, are included in these calculations when they would have a dilutive effect on the per share amounts. All amounts per common share and the weighted average number of common shares outstanding have been adjusted for the 2 percent common stock dividend issued September 15, 1992. Fully diluted earnings per share is not disclosed because of the anti-dilutive effect of the Company's convertible securities. RECLASSIFICATIONS: Certain prior year amounts have been restated to conform with the current year presentation in the Consolidated Statements of Operations, the Consolidated Balance Sheets and the Consolidated Statements of Cash Flows. CASH AND CASH EQUIVALENTS: The Company considers all highly liquid short-term investments with original maturities of three months or less to be cash equivalents and, therefore, includes such investments as cash and cash equivalents in its financial statements. INVENTORIES: Inventories are stated at the lower of cost or market. The primary methods used to determine inventory costs are the first-in-first-out ("FIFO") method, the last-in-first-out ("LIFO") method and the average cost method. PROPERTY, PLANT, EQUIPMENT AND DEPRECIATION: Property, plant and equipment is stated at cost. Expenditures for maintenance and repairs are charged to income as incurred. Additions, improvements and major replacements are capitalized. The cost and accumulated depreciation related to assets sold or retired are removed from the accounts and any gain or loss is credited or charged to income. For financial reporting purposes, depreciation and amortization is primarily provided on the straight-line method over the estimated useful lives of depreciable assets, or over the duration of the leases for capitalized leases, based on the following annual rates: TIMBERLANDS: Timberlands are stated at cost less accumulated cost of timber harvested. The Company amortizes its private fee timber costs over the estimated total fiber that will be available during the estimated growth cycle. Cost of non-fee timber harvested is determined on the basis of timber removal rates and the estimated volume of recoverable timber. The Company capitalizes interest costs related to pre-merchantable timber. INCOME TAXES: Effective January 1, 1992, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS 109"), which required a change from the deferred method to the liability method of STONE CONTAINER CORPORATION AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 1--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) accounting for income taxes. In connection with the adoption of SFAS 109, the Company recorded a one-time, non-cash after-tax charge to its first quarter 1992 earnings of $99.5 million or $1.40 per share of common stock. This adjustment is reported as a cumulative effect of a change in accounting principles in the Company's Statements of Operations. Under the liability method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between financial statement carrying amounts of existing assets and liabilities and their respective tax bases. SFAS 109 requires that assets and liabilities acquired in a business combination accounted for under the purchase method of accounting be recorded at their gross fair values, with a separate deferred tax balance recorded for the related tax effects. Accordingly, effective with the adoption of SFAS 109, the Company's property, plant and equipment increased by $331 million, resulting in increased annual depreciation expense of approximately $28 million which is offset by comparable reductions in deferred income tax expense as the related taxable temporary differences reverse. The impact of the adoption of SFAS 109 on the deferred income tax accounts as of January 1, 1992 was an increase in the deferred tax liability of approximately $500 million and an increase in the current deferred tax asset of approximately $18 million. Financial statements for years prior to 1992 have not been restated. GOODWILL AND OTHER ASSETS: Goodwill is amortized on a straight-line basis over 40 years, and is recorded net of accumulated amortization of approximately $129 million and $107 million at December 31, 1993 and 1992, respectively. The Company assesses at each balance sheet date whether there has been a permanent impairment in the value of goodwill. This is accomplished by determining whether projected undiscounted future cash flows from operations exceed the net book value of goodwill as of the assessment date. Such projections reflect price, volume and cost assumptions. Additional factors considered by management in the preparation of the projections and in assessing the value of goodwill include the effects of obsolescence, demand, competition and other pertinent economic factors and trends and prospects that may have an impact on the value or remaining useful life of goodwill. Deferred debt issuance costs are amortized over the expected life of the related debt using the interest method. Start-up costs on major projects were capitalized and amortized over a ten-year period prior to October 1, 1993. Effective October 1, 1993, the Company changed its estimate of the useful life of deferred start-up costs to a five-year period. The effect of this change in estimate was to increase depreciation and amortization expense by approximately $3.1 million and decrease net income by $2.0 million or $.02 per common share. Other long-term assets include $80 million and $73 million of unamortized deferred start-up costs at December 31, 1993 and 1992, respectively. PUBLIC OFFERING OF SUBSIDIARY STOCK: When the sale of subsidiary stock takes the form of a direct sale of its unissued shares, the Company records the difference relating to the carrying amount per share and the offering price per share as an adjustment to common stock in those instances in which the Company has determined that the difference does not represent a permanent impairment. FOREIGN CURRENCY TRANSLATION: The functional currency for the Company's foreign operations is the applicable local currency. Accordingly, assets and liabilities are translated at the exchange rate in effect at the balance sheet date and income and expenses are translated at average exchange rates prevailing during the year. Translation gains or losses are accumulated as a separate component of stockholders' equity entitled Foreign Currency Translation Adjustment. Foreign currency transaction gains or losses are credited or charged to income. These transaction gains or losses arise primarily from the translation of monetary assets and liabilities that are denominated in a currency other than the local currency. FOREIGN CURRENCY AND INTEREST RATE HEDGES: The Company utilizes various financial instruments to hedge its foreign currency and interest rate exposures. Premiums received and fees paid on the financial instruments are deferred and amortized over the period of the agreements. Gains and losses on the instruments are used to offset the effects of foreign exchange and interest rate fluctuations in the Statements of Operations. STONE CONTAINER CORPORATION AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 1--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) POSTRETIREMENT BENEFITS OTHER THAN PENSIONS: Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions" ("SFAS 106"), which required the Company to change from the pay-as-you-go (cash) method to the accrual method of accounting for such postretirement benefits (primarily health care and life insurance). Upon adoption of SFAS 106, the Company recorded its catch-up accumulated postretirement benefit obligation (approximately $62.8 million) by recognizing a one-time, non-cash charge of $39.5 million, net of income taxes, as a cumulative effect of an accounting change in its 1993 first quarter Statement of Operations. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS: In November 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" ("SFAS 112"), which requires accrual accounting for the estimated costs of providing certain benefits to former or inactive employees and the employees' beneficiaries and dependents after employment but before retirement. The Company intends to adopt SFAS 112 by recognizing the catch-up obligation for its worldwide operations as a cumulative effect of an accounting change effective January 1, 1994 in the 1994 first quarter Statement of Operations. The one-time, non-cash charge will be approximately $14 million, net of income taxes. NOTE 2--SUBSEQUENT EVENTS On February 3, 1994, under the Company's $1 billion shelf registration, the Company sold $710 million principal amount of 9- 7/8 percent Senior Notes due February 1, 2001 and 16.5 million shares of common stock for an additional $251.6 million at $15.25 per common share. On February 17, 1993, the underwriters elected to exercise their option to sell an additional 2.47 million shares of common stock for an additional $37.7 million, also at $15.25 per common share (collectively, with the February 3, 1994 offering, the "Offerings"). The net proceeds from the Offerings of approximately $962 million were used to (i) prepay approximately $652 million of the 1995, 1996 and 1997 required amortization under the Company's bank credit agreements which includes two term loan facilities, two revolving credit facilities and an additional term loan (the "Credit Agreements") including the ratable amortization payment under the revolving credit facilities which had the effect of reducing the total commitments thereunder to approximately $168 million; (ii) redeem the Company's 13- 5/8 percent Subordinated Notes due 1995 at a price equal to par, approximately $98 million principal amount, plus accrued interest to the redemption date; (iii) repay approximately $136 million of the outstanding borrowings under the Company's revolving credit facilities without reducing the commitments thereunder; and (iv) provide liquidity in the form of cash. Had the issuance of the common shares occurred on January 1, 1993, the Company's weighted average number of common shares outstanding would have been 84,270,232 and the net loss per common share would have been $4.35 for the year ended December 31, 1993. NOTE 3--ACQUISITIONS/MERGERS/DISPOSITIONS In December 1993, the Company sold two of its short-line railroads in a transaction in which the Company has guaranteed to contract minimum railroad services which will provide freight revenues to the railroads over a 10 year period. The transaction has been accounted for as a financing and accordingly, had no impact on the Company's 1993 net loss. The Company received proceeds of approximately $28 million, of which approximately $19 million was used to repay commitments under the Credit Agreements. Also in December 1993, the Company sold its 49 percent equity interest in Empaques de Carton Titan, S.A. ("Titan"). The net proceeds were used to repay commitments under the Credit Agreements and for repayment of borrowings under its revolving credit facilities without reducing commitments thereunder. The sale resulted in a pre-tax gain of approximately $35.4 million. On May 6, 1993, the Company's wholly-owned German subsidiary, Europa Carton A.G., ("Europa Carton"), completed a joint venture with Financiere Carton Papier (FCP), a French company, to merge the folding carton operations of Europa Carton with those of FCP ("FCP Group"). Under the joint venture, FCP Group is owned equally by Europa Carton and the shareholders of FCP immediately prior to the merger. The Company's investment in the joint venture is being accounted for under the equity method of accounting. STONE CONTAINER CORPORATION AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 3--ACQUISITIONS/MERGERS/DISPOSITIONS (CONTINUED) During 1993, the Company increased its ownership in the common stock of Stone Savannah River Pulp & Paper Corporation ("Stone Savannah River") from 90.2 percent to 92.8 percent through the purchase of an additional 6,152 common shares and through the receipt of Series D Preferred Stock as a dividend in kind on Stone Savannah River's Series B Preferred Stock and the election of its right to convert the Series D Preferred Stock into 198,438 common shares. The Company had previously increased its ownership in the common stock of Stone Savannah River from 50.0 percent to 90.2 percent by acquiring 321,502 shares during 1992 and 1991. Stone Savannah River operates a linerboard and market pulp mill in Port Wentworth, Georgia. In October and November 1992, the Company purchased the remaining 70.0 percent of the common stock (12,600 shares) of Cartomills, a Belgian company that operates two corrugated container plants. In June 1992, the Company acquired an additional 45,666 shares of Seminole Kraft Corporation ("Seminole") common stock, thereby increasing its ownership in the common stock of Seminole from 94.4 percent to 99.0 percent. The Company had previously increased its ownership in the common stock of Seminole from 85.4 percent to 94.4 percent by purchasing 90,000 shares during 1991. Seminole operates an unbleached recycled linerboard and kraft paper mill in Jacksonville, Florida. The Company also made a minor acquisition and a divestiture during the years for which financial statements are presented which did not have a significant impact on the Company's results of operations or financial condition. NOTE 4--PUBLIC OFFERING OF SUBSIDIARY STOCK In December 1993, Stone-Consolidated Corporation ("Stone-Consolidated"), a newly created Canadian subsidiary, acquired the newsprint and uncoated groundwood papers business of Stone Container (Canada) Inc. ("Stone-Canada") (formerly Stone-Consolidated, Inc.) and sold $346.5 million of units in an initial public offering comprised of both common stock and convertible subordinated debentures (the "Units Offering"). Each unit was priced at $2,100 and consisted of 100 shares of common stock at $10.50 per share and $1,050 principal amount of convertible debentures. The convertible subordinated debentures mature December 31, 2003, bear interest at an annual rate of 8 percent and are convertible beginning June 30, 1994, into 6.211 shares of common stock for each Canadian $100 principal amount, representing a conversion price of $12.08 per share. Concurrent with the initial public offering, Stone-Consolidated sold $225 million of senior secured notes in a public offering in the United States. The senior secured notes mature December 15, 2000 and bear interest at an annual rate of 10.25 percent. As a result of the Units Offering, 16.5 million shares of common stock, representing 25.4 percent of the total shares outstanding of Stone-Consolidated, were sold to the public, resulting in the recording in the Company's Consolidated Balance Sheet of a minority interest liability of $236.7 million. The Company used approximately $373 million of the net proceeds from the sale of the Stone-Consolidated securities for repayment of commitments under its Credit Agreements and the remainder for general corporate purposes. As a result of the Units Offering, the Company recorded a charge of $74.4 million to common stock relating to the excess carrying value per common share over the offering price per common share associated with the shares issued. STONE CONTAINER CORPORATION AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 5--ADDITIONAL CASH FLOW STATEMENT INFORMATION The Company's non-cash investing and financing activities and cash payments (receipts) for interest and income taxes were as follows: In 1993, the other-net component of net cash used in operating activities included debt issuance costs of $84 million and an adjustment to remove the effect of a $35 million gain from the sale of the Company's 49 percent equity interest in Titan, partially offset by adjustments to remove the effects of amortization of deferred debt issuance costs and a non-cash charge of $19 million pertaining to the writedown of certain decommissioned assets. In 1992, the other-net component of net cash provided by operating activities included $54 million of cash received from the sale of an energy contract in October 1992. NOTE 6--INVENTORIES Inventories are summarized as follows: At December 31, 1993 and 1992, the percentages of total inventories costed by the LIFO, FIFO and average cost methods were as follows: STONE CONTAINER CORPORATION AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 7--PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment is summarized as follows: Property, plant and equipment includes capitalized leases of $70.3 million and $71.8 million and related accumulated amortization of $24.2 million and $19.8 million at December 31, 1993 and 1992, respectively. NOTE 8--INCOME TAXES Effective January 1, 1992, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS 109"), which required a change from the deferred method to the liability method of accounting for income taxes. In connection with the adoption of SFAS 109, the Company recorded a one-time, non-cash after-tax charge to its first quarter 1992 earnings of $99.5 million or $1.40 per share of common stock. This adjustment is reported as a cumulative effect of a change in accounting principles in the Company's Statements of Operations. Under the liability method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between financial statement carrying amounts of existing assets and liabilities and their respective tax bases. SFAS 109 requires that assets and liabilities acquired in a business combination accounted for under the purchase method of accounting be recorded at their gross fair values, with a separate deferred tax balance recorded for the related tax effects. The provision (credit) for income taxes consists of the following: STONE CONTAINER CORPORATION AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 8--INCOME TAXES (CONTINUED) The income tax (credit) at the federal statutory rate is reconciled to the provision (credit) for income taxes as follows: The components of the net deferred tax liability as of December 31, 1993 and 1992 were as follows: STONE CONTAINER CORPORATION AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 8--INCOME TAXES (CONTINUED) During 1991, deferred taxes were provided for significant timing differences between revenue and expenses for tax and financial statement purposes. Following is a summary of the significant components of the deferred tax provision: The components of the loss before income taxes and cumulative effects of accounting changes are: As a result of certain acquisitions, the Company had, at December 31, 1993, approximately $27 million of pre-acquisition net operating loss carryforwards and approximately $5 million of investment tax credit carryforwards for federal income tax purposes. To the extent not utilized, the carryforwards will expire in the period commencing in the year 1996 and ending in the year 2004. At December 31, 1993, Bridgewater Paper Company Ltd., which was acquired in the 1989 Stone-Canada acquisition, had approximately $92 million of net operating loss carryforwards for United Kingdom income tax purposes. These losses are available indefinitely. At December 31, 1993, the Company had approximately $252 million of net operating loss carryforwards for U.S. tax purposes and, additionally, approximately $236 million of net operating loss carryforwards for Canadian tax purposes. To the extent not utilized, the U.S. net operating losses will expire in 2007 and 2008 and the Canadian net operating losses will expire in 1998, 1999 and 2000. The Company also had approximately $11 million of alternative minimum tax credit carryforwards for U.S. tax purposes which are available indefinitely. NOTE 9--PENSION PLANS AND OTHER POSTRETIREMENT BENEFITS The Company has contributory and noncontributory pension plans for the benefit of most salaried and certain hourly employees. The funding policy for the plans, with the exception of the Company's salaried supplemental unfunded plans and the Company's German subsidiary's unfunded plan, is to annually contribute the statutory required minimum. The salaried pension plans provide benefits based on a formula which takes into account each participant's estimated final average earnings. The hourly pension plans provide benefits under a flat benefit formula. The salaried and hourly plans provide reduced benefits for early retirement. The salaried plans take into account offsets for governmental benefits. STONE CONTAINER CORPORATION AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 9--PENSION PLANS AND OTHER POSTRETIREMENT BENEFITS (CONTINUED) Net pension expense for the combined pension plans includes the following components: The following table sets forth the funded status of the Company's pension plans and the amounts recorded in the Consolidated Balance Sheets: In accordance with Statement of Financial Accounting Standards No. 87, "Employer's Accounting for Pensions," the Company has recorded an additional minimum liability for underfunded plans representing the excess of the unfunded accumulated benefit obligation over previously recorded liabilities. The additional minimum liability at December 31, 1993 of $92.4 million is recorded as a long-term liability with an offsetting intangible asset of $29.4 million and a charge to stockholders' equity of $39.6 million, net of a tax benefit of $23.4 million. Of this additional minimum liability, $19.6 million was recorded as a long-term liability at December 31, 1992 with an offsetting intangible asset of $6.7 million and a charge to stockholders' equity of $7.9 million, net of a tax benefit of $5.0 million. The weighted average discount rate and the rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligations was 7.5 percent for all U.S. and German operations and 8.0 percent for Canadian and United Kingdom operations and 4.0 percent, respectively, for 1993 and 9.0 percent and 4.5 to 5.0 percent, respectively, for 1992. The expected long-term rate of return on assets was 11 percent for 1993 and 1992. The change in the weighted average discount rates during 1993 had the effect of increasing the total projected benefit obligation at December 31, 1993 by $108.8 million and the change in the rate of increase in future compensation levels in 1993 had the effect of decreasing the projected benefit obligation by $19.3 million. STONE CONTAINER CORPORATION AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 9--PENSION PLANS AND OTHER POSTRETIREMENT BENEFITS (CONTINUED) Certain domestic operations of the Company participate in various multi-employer union-administered defined benefit pension plans that principally cover production workers. Pension expense under these plans was $5.1 million for 1993 and 1992 and $4.7 million for 1991. In addition to providing pension benefits, the Company provides certain retiree health care and life insurance benefits covering substantially all U.S. salaried and hourly employees and certain Canadian employees. Employees become eligible for such benefits if they are fully vested in one of the Company's pension plans when they retire from the Company and they begin to draw retirement benefits upon termination of service. Such retiree health care costs were expensed as the claims were paid through December 31, 1992. However, as discussed in Note 1--"Summary of Significant Accounting Policies," effective January 1, 1993, the Company adopted SFAS 106, which required the Company to accrue for its obligation to pay such postretirement health care costs during the employees' years of service, as opposed to when such costs are actually paid. The effect of SFAS 106 on income from operations is not material. In conjunction with the adoption, the Company, effective January 1, 1993, implemented cost saving provisions designed to reduce certain postretirement health care and life insurance costs. Among other things, these provisions provide for a cap on the Company's share of certain health care costs. Such provisions do not apply to current retirees and those active employees age 55 and over who were eligible to retire as of December 31, 1992. Accordingly, the Company is generally responsible for 50 percent of the claims of such individuals. Net worldwide periodic postretirement benefit cost for 1993 included the following components: Worldwide postretirement benefits costs for retired employees approximated $4.7 million for 1992. Prior to 1992, the cost of providing such benefits for retired employees was not readily separable from the cost of providing benefits for active employees. On a combined basis, worldwide health care and life insurance benefit cost for both active and retired employees approximated $76 million in 1991. The following table sets forth the components of the Company's accumulated postretirement benefit obligation and the amount recorded in the Consolidated Balance Sheet at December 31, 1993: The Company has not currently funded any of its accumulated postretirement benefit obligation. The discount rate used in determining the accumulated postretirement benefit cost was 7.5 percent for U.S. and German operations and 8.0 percent for Canadian and United Kingdom operations. The assumed health care cost trend rates for substantially all employees used in measuring the accumulated postretirement benefit obligation range from 7 percent to 15 percent decreasing to ultimate rates of 5.5 percent to 8 percent. If the health care cost trend rate assumptions were increased by 1 percent, the accumulated postretirement benefit obligation at December 31, 1993 and the net periodic postretirement benefit cost for the year ended December 31, 1993 would have increased by $6.5 million and $0.6 million, respectively. STONE CONTAINER CORPORATION AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 9--PENSION PLANS AND OTHER POSTRETIREMENT BENEFITS (CONTINUED) At December 31, 1993, the Company had approximately 8,300 retirees and 29,000 active employees of which approximately 3,000 and 21,100, respectively, were employees of U.S. operations. NOTE 10--LONG-TERM DEBT Long-term debt consists of the following: STONE CONTAINER CORPORATION AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 10--LONG-TERM DEBT (CONTINUED) The Credit Agreements provided for a $400 million multiple-draw facility (the "MDF") to supplement the revolving credit facility thereunder. The MDF had substantially the same terms and conditions, including covenants, as the STONE CONTAINER CORPORATION AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 10--LONG-TERM DEBT (CONTINUED) Credit Agreements. Proceeds of MDF borrowings (approximately $371 million) were required to be used solely to repay regularly scheduled amortization of term loans under the Credit Agreements. The Company cancelled the remaining commitment under the MDF in 1991. On October 1, 1992, the $371 million outstanding under the MDF was converted to an Additional Term Loan (the "ATL"). Borrowings under the ATL are collateralized by an equal and ratable lien on the existing collateral under the Credit Agreements. The Credit Agreements permit the Company to choose among various interest rate options, to specify the portion of the borrowings to be covered by specific interest rate options and to specify the interest rate period to which the interest rate options are to apply, subject to certain parameters. As a result of the February 1994 amendment, interest rate options available to the Company under term loans, ATL and revolving credit borrowings under the Credit Agreements are (i) U.S. or Canadian prime rate plus a borrowing margin of 2 percent, (ii) CD rate plus a borrowing margin of 3 1/8 percent, (iii) Eurodollar rate plus a borrowing margin of 3 percent and (iv) bankers' acceptance rate plus a borrowing margin of 3 percent. Upon achievement of specified indebtedness ratios and interest coverage ratios, the borrowing margins will be reduced. Additionally, the Company pays a 3/8 percent commitment fee on the unused portions of the revolving credit facilities. The weighted average rates as reflected in the table do not include the effects of the amortization of deferred debt issuance costs. The Credit Agreements require that the Company hedge a portion of the U.S. dollar-based borrowings to protect against increases in market interest rates. Pursuant to that requirement, at December 31, 1993, the Company was a party to an interest rate swap contract which had the effect of fixing the interest rate at approximately 12.9 percent on $150 million of U.S. term loan borrowings. The interest rate swap is scheduled to expire on March 22, 1994. During 1993, the Company sold prior to their expiration date, certain of its U.S. dollar denominated interest rate swaps and cross currency swaps associated with the Credit Agreement borrowings of Stone-Canada. The net proceeds totaled approximately $34.9 million, the substantial portion of which was used to repay borrowings under the Company's revolving credit facilities. At December 31, 1993, the $1.45 billion of borrowings and accrued interest outstanding under the Credit Agreements and the ATL were secured by property, plant and equipment with a net book value of $518.4 million and by common stock of various subsidiaries of the Company representing net assets of approximately $3.4 billion (including collateralized property, plant and equipment with a net book value of $349.4 million) and by a lien on the Company's inventories. Additionally, other loan agreements aggregating $646.0 million were collateralized by approximately $1.56 billion of property, plant and equipment-net. Emerging Issues Task Force Issue No. 86-30, "Classification of Obligations When a Violation is Waived by the Creditor," requires a company to reclassify long-term debt as current when a covenant violation has occurred at the balance sheet date or would have occurred absent a loan modification and it is probable that the borrower will not be able to comply with the same covenant at measurement dates that are within the next twelve months. In November 1993, Stone Savannah River received a waiver of its fixed-charges-coverage covenant requirement as of December 31, 1993 and March 31, 1994. Management has prepared projections that indicate that upon the expiration of the waiver Stone Savannah River will not be in compliance with this covenant as of June 30, September 30, and December 31, 1994. Consequently, approximately $237.9 million of Stone Savannah River debt that otherwise would have been classified as long-term has been classified as current in the December 31, 1993 consolidated balance sheet. Stone Savannah River intends to seek, prior to June 10, 1994, appropriate financial covenant waivers or amendments from its bank group, although no assurance can be given that such waivers or amendments will be obtained. Any such failure to obtain covenant relief would result in a default under Stone Savannah River's credit agreement and other indebtedness and, if any such indebtedness was accelerated by the holders thereof, the lenders to the Company under the Credit Agreements and various other of the Company's debt instruments will be entitled to accelerate the indebtedness owed by the Company. On July 6, 1993, the Company sold $150 million principal amount of 12- 5/8 percent Senior Notes due July 15, 1998 (the "12- 5/8 percent Senior Notes"). The 12- 5/8 percent Senior Notes are not redeemable by the Company prior to maturity. Interest is payable semi-annually on January 15 and July 15, commencing January 15, 1994. Also on July 6, 1993, the Company sold, in a private transaction, $250 million principal amount of 8- 7/8 percent Convertible Senior Subordinated Notes due July 15, 2000 (the "8- 7/8 percent Convertible Senior Subordinated STONE CONTAINER CORPORATION AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 10--LONG-TERM DEBT (CONTINUED) Notes"). The Company filed a shelf registration statement registering the 8- 7/8 percent Convertible Senior Subordinated Notes for resale by the holders thereof, which was declared effective August 13, 1993. The 8- 7/8 percent Convertible Senior Subordinated Notes are convertible, at the option of the holder, sixty days following the date of original issuance and prior to maturity, into shares of the Company's common stock at a conversion price of $11.55 per share of common stock, subject to adjustment in certain events. Additionally, the 8- 7/8 percent Convertible Senior Subordinated Notes are redeemable, at the option of the Company, in whole or in part, on and after July 15, 1998. Interest is payable semi-annually on January 15 and July 15, commencing January 15, 1994. The net proceeds of approximately $386 million received from the sales of the 12- 5/8 percent Senior Notes and the 8- 7/8 percent Convertible Senior Subordinated Notes were used by the Company to repay borrowings, without a reduction of commitments under the revolving credit facilities of its Credit Agreements, thereby restoring borrowing availability thereunder. In December 1993, Stone-Consolidated sold $173.3 million of 8 percent convertible subordinated debentures as part of the Units Offering. Concurrent with the Units Offering, Stone-Consolidated sold $225 million of 10- 1/4 percent Senior Secured Notes maturing on December 15, 2000 in a public offering in the United States. See Note 4--"Public Offering of Subsidiary Stock," for further details. On February 20, 1992, the Company sold $115 million principal amount of 6- 3/4 percent Convertible Subordinated Debentures due February 15, 2007 (the "6- 3/4 percent Subordinated Debentures"). The 6- 3/4 percent Subordinated Debentures are convertible, at the option of the holder, at any time prior to maturity, into shares of the Company's common stock at a conversion price of $33.94 per share of common stock (adjusted for the 2 percent common stock dividend issued September 15, 1992), subject to adjustment in certain events. Additionally, the 6- 3/4 percent Subordinated Debentures are redeemable at the option of the Company, in whole or from time to time in part, on and after February 16, 1996. Interest is payable semi-annually on February 15 and August 15, commencing August 15, 1992. The net proceeds from the sale of the 6- 3/4 percent Subordinated Debentures were used to fully prepay the $59.5 million sinking fund obligation due June 1, 1992, including accrued interest due thereon, and to prepay $47.5 million of the $59.5 million sinking fund obligation due June 1, 1993, including accrued interest due thereon, on the Company's 13- 5/8 percent Subordinated Notes. On March 18, 1992, the Company sold $200 million principal amount of 10- 3/4 percent Senior Subordinated Debentures due April 1, 2002 (the "10- 3/4 percent Senior Subordinated Debentures"). The 10- 3/4 percent Senior Subordinated Debentures are redeemable at the option of the Company, in whole or from time to time in part, on and after April 1, 1997. Interest is payable semi-annually on April 1 and October 1, commencing October 1, 1992. The net proceeds from these debentures were used to fund future capital expenditures by the Company. On June 25, 1992, the Company sold $150 million principal amount of 10- 3/4 percent Senior Subordinated Notes due June 15, 1997 (the "10- 3/4 percent Senior Subordinated Notes"). The 10- 3/4 percent Senior Subordinated Notes are redeemable at the option of the Company, in whole or from time to time in part, on and after June 15, 1995. Interest is payable semi-annually on June 15 and December 15, commencing December 15, 1992. The net proceeds of approximately $147 million from the issuance of these notes were used to fund a partial redemption of the Company's 13- 5/8 percent Subordinated Notes including accrued interest due thereon. On August 11, 1992, the Company sold $125 million principal amount of 11 percent Senior Subordinated Notes due August 15, 1999 (the "11 percent Senior Subordinated Notes"). The 11 percent Senior Subordinated Notes are redeemable at the option of the Company, in whole or from time to time in part, on and after August 15, 1997. Interest is payable semi-annually on February 15 and August 15, commencing February 15, 1993. The Company entered into a three-year interest rate swap arrangement that has the effect of converting, for the first three years, the fixed rate of interest on $100 million of the 11 percent Senior Subordinated Notes into a floating interest rate. As a result of this swap arrangement, the effective rate of interest for 1993 was 9.95 percent. While the Company is exposed to credit loss on its interest rate swaps in the event of nonperformance by the counterparties to such swaps, management believes that such nonperformance is unlikely to occur. The Company used the net proceeds from the issuance of the 11 percent Senior Subordinated Notes to partially repay approximately $102 million and $20 million, respectively, under its revolving credit facility and the March 1993 term loan amortization of its Credit Agreement. STONE CONTAINER CORPORATION AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 10--LONG-TERM DEBT (CONTINUED) In 1992, Stone Financial Corporation ("Stone Fin") extended the maturity date of the $185 million three-year revolving credit facility used to purchase the accounts receivable for the first tranche of the Company's accounts receivable securitization program to September 15, 1995 from September 15, 1994. Stone Fin has the option, subject to bank consent, to extend the maturity date of its credit facility beyond September 15, 1995. Various interest rate options (LIBOR plus 1- 1/4 percent or Prime) are available to Stone Fin under its credit facility. In accordance with the provisions of this program, Stone Fin purchases (on an ongoing basis) certain of the accounts receivable of Stone Delaware, Inc., Stone Corrugated, Inc., and Stone Southwest, Inc., each of which is a wholly-owned subsidiary of the Company. Such purchased accounts receivable are solely the assets of Stone Fin, a wholly-owned but separate corporate entity of the Company, with its own separate creditors. In the event of a liquidation of Stone Fin such creditors would be entitled to satisfy their claims from Stone Fin's assets prior to any distribution to the Company. At December 31, 1993 and 1992, the Company's Consolidated Balance Sheets included $175.6 million and $160.3 million, respectively of Stone Fin accounts receivable and $150.5 million and $146.3 million, respectively, of borrowings under the program. On August 20, 1992, the Company completed the second tranche of its accounts receivable securitization program through the sale of certain of its accounts receivable to a newly formed wholly-owned subsidiary, Stone Fin II Receivables Corporation ("Stone Fin II"). Stone Fin II purchased the accounts receivable with proceeds from borrowings under a $180 million, three-year revolving credit facility (due September 15, 1995) provided by South Shore Funding Corporation, an unaffiliated financial organization. Stone Fin II has the option, subject to bank consent, to extend the maturity date of its credit facility beyond September 15, 1995. Two interest rate options (LIBOR plus 1- 1/4 percent or Prime) are available to Stone Fin II under its credit facility. In accordance with the provisions of this program, Stone Fin II purchases (on an ongoing basis) certain of the accounts receivable of Stone Consolidated Newsprint, Inc., Stone Packaging Corporation, Stone Southwest, Inc. and Stone Bag Corporation, each of which is a wholly-owned subsidiary of the Company. Such purchased accounts receivable are solely the assets of Stone Fin II, a wholly-owned but separate corporate entity of the Company, with its own separate creditors. In the event of a liquidation of Stone Fin II, such creditors would be entitled to satisfy their claims from Stone Fin II's assets prior to any distribution to the Company. The initial net proceeds of approximately $100 million from this transaction were used by the Company to complete the prepayment of its March 31, 1993 term loan installment and partially prepay approximately $57 million of its $175 million term loan installment due September 30, 1993. Subsequent proceeds from this securitization program were used for general corporate purposes. At December 31, 1993 and 1992, the Company's Consolidated Balance Sheets included $124.4 million and $152.6 million, respectively, of Stone Fin II accounts receivable and $81.9 million and $115.5 million, respectively, of borrowings under the program. In August and October 1992, the Company refinanced, in two separate issues, $30 million and $35 million of tax-exempt revenue bonds, respectively. The $30 million bonds bear interest at a rate of 7- 7/8 percent and are due August 1, 2013. The $35 million bonds bear interest at a rate of 8- 1/4 percent and are due June 1, 2016. The following table provides, as of December 31, 1993, the actual and pro forma amounts of long-term debt maturing during the next five years. The maturities on a pro forma basis reflect the impact of the Offerings discussed in Note 2 and the application of the net proceeds received therefrom, as if such transaction had occurred as of December 31, 1993. STONE CONTAINER CORPORATION AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 10--LONG-TERM DEBT (CONTINUED) The 1995 maturities include $232.4 million outstanding under Stone Fin's and Stone Fin II's revolving credit facilities. Stone Fin and Stone Fin II have the option, subject to bank consents, to extend or refinance such obligations beyond 1995. Amounts payable under capitalized lease agreements are excluded from the above tabulation. See Note 13 for capitalized lease maturities. The Credit Agreements contain covenants that include, among other things, requirements to maintain certain financial tests and ratios (including a minimum current ratio, an indebtedness ratio, a minimum earnings before interest, taxes, depreciation and amortization test ("EBITDA") and a tangible net worth test) and certain restrictions and limitations, including those on capital expenditures, changes in control, payment of dividends, sales of assets, lease payments, investments, additional borrowings, mergers and purchases of stock and assets. The Credit Agreements also contain cross-default provisions relating to the non-recourse debt of its consolidated affiliate, Stone-Consolidated Corporation, and cross-acceleration provisions relating to the non-recourse debt of the consolidated affiliates, including Seminole and Stone Savannah River (see Note 18). Additionally, the Company's Credit Agreements provide for mandatory prepayments from sales of certain assets, debt and equity financings and excess cash flows. These prepayments along with voluntary prepayments are to be applied ratably to reduce loan commitments under the Credit Agreements. The indebtedness under the Credit Agreements is secured by a substantial portion of the assets of the Company. The Company and its bank group have amended the Company's Credit Agreements several times during the past three years. Such amendments provided among other things, greater financial flexibility and/or relief from certain financial covenants. In some instances, certain restrictions and limitations applicable to the Credit Agreements were tightened. There can be no assurance that future covenant relief will not be required or, if such relief is requested by the Company, that it will be obtained from the banks' lenders. The most recent amendment, which was executed in February of 1994 and became effective upon the completion of the Offerings, as discussed in Note 2--"Subsequent Events," provided, among other things, for the following: (i) Permitted the Company to apply up to $200 million of net proceeds from the Offerings, which increased liquidity, as repayment of borrowings under the revolving credit facilities of the Credit Agreements without reducing the commitments thereunder and to the extent no balance was outstanding under the revolving credit facilities, permitted the Company to retain the balance of such $200 million of proceeds in cash. (ii) Permitted the Company to redeem the Company's 13- 5/8 percent Subordinated Notes maturing on June 1, 1995 from the proceeds received from the Offerings at a price equal to par, approximately $98 million principal amount, plus accrued interest to the redemption date. (iii) Amended the required levels of EBITDA, (as defined in the Credit Agreements), for certain specified periods to the following: The required level of EBITDA is scheduled to increase for each rolling four quarter period thereafter until December 31, 1996, when the EBITDA for the twelve months ended December 31, 1996 is required to be $822 million. (iv) Reset to zero as of January 1, 1994 the dividend pool under the Credit Agreements which permits payment of dividends on the Company's capital stock and modifies the components used in calculating the ongoing balance in the dividend pool. Effective January 1, 1994, dividend payments on the Company's common stock and on certain preferred stock issues cannot exceed the sum of (i) 75 percent of the consolidated net STONE CONTAINER CORPORATION AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 10--LONG-TERM DEBT (CONTINUED) income, (as defined in the Credit Agreements), of the Company from January 1, 1994 to the date of payment of such dividends, minus (ii) 100 percent of the consolidated net loss, (as defined in the Credit Agreements), of the Company from January 1, 1994 to the date of payment of such dividends, plus (iii) 100 percent of any net cash proceeds from sales of common stock or certain preferred stock of the Company from January 1, 1994 to any date of payment of such dividends (excluding the proceeds from the Offerings for which no dividend credit was received by the Company). Additionally, the restriction with respect to dividends on Series E Cumulative Convertible Exchangeable Preferred Stock (the "Series E Cumulative Preferred Stock") now mirror the dividend restriction in the Company's Senior Subordinated Indenture dated as of March 15, 1992. (v) Replaced the existing cross-default provisions relating to obligations of $10 million or more of the Company's separately financed subsidiaries, Seminole and Stone Savannah River, with cross-acceleration provisions. (vi) Replaced the current prohibition of investments in Stone Venepal Consolidated Pulp Inc. with restrictions substantially similar to the restrictions applicable to the Company's subsidiaries, Stone Savannah River and Seminole. (vii) Maintains the monthly indebtedness ratio requirement, as defined in the Credit Agreements, to be no higher than: 81.5 percent as of the end of each month from December 31, 1993 and ending prior to March 31, 1995 and 81 percent as of the end of each month from March 31, 1995 and ending prior to June 30, 1995. The indebtedness ratio requirement is scheduled to periodically decrease thereafter (from 80 percent on June 30, 1995) until February 28, 1997, when the ratio limitation is required to be 68 percent. (viii) Maintains the Consolidated Tangible Net Worth requirement (CTNW), (as defined in the Credit Agreements), to be equal to or greater than 50 percent of the highest CTNW for any quarter since the inception of the Credit Agreements. Additionally, at various times during the year, the Company amended and restated its Credit Agreements which provided, among other things to, (i) extend the maturity of the revolving credit facilities from March 1, 1994 to March 1, 1997 and reduce over a three-year period the revolving loan commitments; (ii) revise various financial covenants to provide greater financial flexibility to the Company; (iii) permit the Company to retain 25 percent of the net proceeds from future sales of equity securities (which could be used to reduce revolving credit borrowings without reducing the commitments thereunder); and (iv) permit the Company to retain 50 percent (maximum $100 million in the aggregate) of the net proceeds from any sale or disposition of its investment in certain joint ventures or unconsolidated subsidiaries (which could be used to reduce revolving credit borrowings without reducing the commitments thereunder). As part of these amendments, the Company agreed (i) to pay certain fees and higher interest rate margins and (ii) mortgage or pledge additional collateral including a pledge of the Stone-Consolidated common stock owned by the Company. There can be no assurance that the Company will be able to achieve and maintain compliance with the prescribed financial ratio tests or other requirements of its Credit Agreements. Failure to achieve or maintain compliance with such financial ratio tests or other requirements under the Credit Agreements, in the absence of a waiver or amendment, would result in an event of default and could lead to the acceleration of the obligations under the Credit Agreements. The Company has successfully sought and received waivers and amendments to its Credit Agreements on various occasions since entering into the Credit Agreements. If further waivers or amendments are requested by the Company, there can be no assurance that the Company's bank lenders will again grant such requests. The failure to obtain any such waivers or amendments would reduce the Company's flexibility to respond to adverse industry conditions and could have a material adverse effect on the Company. NOTE 11--LIQUIDITY MATTERS The Company's liquidity and financial flexibility is adversely affected by the net losses incurred during the past three years. Recently, the Company has improved its liquidity and financial flexibility through the completion of the Offerings in February of 1994 as discussed in Note 2--"Subsequent Events." At March 14, 1994 the Company had borrowing availability of $168.2 million under its revolving credit facilities. Notwithstanding these improvements in the Company's liquidity and financial flexibility, unless the Company achieves substantial price increases beyond year- STONE CONTAINER CORPORATION AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 11--LIQUIDITY MATTERS (CONTINUED) end levels, the Company will continue to incur net losses and negative cash flows from operating activities. Without such sustained substantial price increases, the Company may exhaust all or substantially all of its cash resources and borrowing availability under the revolving credit facilities. In such event, the Company would be required to pursue other alternatives to improve liquidity, including further cost reductions, sales of assets, the deferral of certain capital expenditures, obtaining additional sources of funds or pursuing the possible restructuring of its indebtedness. There can be no assurance that such measures, if required, would generate the liquidity required by the Company to operate its business and service its indebtedness. As currently scheduled, beginning in 1996 and continuing thereafter, the Company will be required to make significant amortization payments on its indebtedness which will require the Company to raise sufficient cash from operations or other sources or refinance or restructure maturing indebtedness. No assurance can be given that the Company will be able to generate or raise such funds. The Company, as part of its financial plan, had intended to sell an energy supply agreement related to its Florence, South Carolina mill. Even though a sale is still being investigated by the Company, the Company is no longer pursuing the original transaction; however, the Company is currently investigating alternative transactions. NOTE 12--DISCLOSURE ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS At December 31, 1993 and 1992, the carrying values of the Company's financial instruments approximate their fair values, except as noted below: The fair values of notes receivable and certain investments are based on discounted future cash flows or the applicable quoted market price. The fair value of the Company's debt is estimated based on the quoted market prices for the same or similar issues. The fair value of letters of credit represent the face amount of the letters of credit adjusted for current rates. The fair value of interest rate swap agreements are obtained from dealer quotes. These values represent the estimated amount the Company would pay to terminate agreements, taking into consideration the current interest rate and market conditions. NOTE 13--LONG-TERM LEASES The Company leases certain of its facilities and equipment under leases expiring through the year 2023. STONE CONTAINER CORPORATION AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 13--LONG-TERM LEASES (CONTINUED) Future minimum lease payments under capitalized leases and their present value at December 31, 1993, and future minimum rental commitments (net of sublease rental income and exclusive of real estate taxes and other expenses) under operating leases having initial or remaining non-cancellable terms in excess of one year, are reflected below: Approximately $2.8 million of the total present value of future minimum capital lease payments relates to a Stone-Consolidated newsprint mill. Minimum lease payments for capitalized leases have not been reduced by minimum sublease rental income of $1.6 million due in the future under a non-cancellable lease. Rent expense for operating leases, including leases having a duration of less than one year, was approximately $83 million in 1993, $84 million in 1992 and $81 million in 1991. NOTE 14--PREFERRED STOCK The Company has authorized 10,000,000 shares of preferred stock, $.01 par value, of which 4,600,000 shares are outstanding at December 31, 1993. Shares of preferred stock can be issued in series with varying terms as determined by the Board of Directors. On February 20, 1992, the Company issued 4,600,000 shares of $1.75 Series E Cumulative Preferred Stock at $25.00 per share. Dividends on the Series E Cumulative Preferred Stock are payable quarterly when, as and if declared by the Company's Board of Directors. The Series E Cumulative Preferred Stock is convertible, at the option of the holder at any time, into shares of the Company's common stock at a conversion price of $33.94 per share of common stock (adjusted for the 2 percent common stock dividend issued September 15, 1992), subject to adjustment under certain conditions. The Series E Cumulative Preferred Stock may alternatively be exchanged, at the option of the Company, on any dividend payment date commencing February 15, 1994, for the Company's 7 percent Convertible Subordinated Exchange Debentures due February 15, 2007 (the "Exchange Debentures") in a principal amount equal to $25.00 per share of Series E Cumulative Preferred Stock so exchanged. The Exchange Debentures would be virtually identical to the 6- 3/4 percent Subordinated Debentures, except that the Exchange Debentures would bear interest at the rate of 7 percent per annum and the interest payment dates would differ. Additionally, the Series E Cumulative Preferred Stock is redeemable at the option of the Company, in whole or from time to time in part, on and after February 16, 1996. The net proceeds of $111 million from the sale of the Series E Cumulative Preferred Stock were used to partially prepay the $175 million March 31, 1993 semi-annual term loan amortization under the Credit Agreements. The Company paid cash dividends during the first two quarters of 1993 on its Series E Cumulative Preferred Stock. However, due to a restrictive provision in the Senior Subordinated Indenture dated March 15, 1992 (the "Senior Subordinated Indenture") relating to the Company's 10- 3/4 percent Senior Subordinated Notes, its 11 percent Senior Subordinated Notes and its 10- 3/4 percent Senior Subordinated Debentures, the Board of Directors did not declare the scheduled August 15, 1993 or the November 15, 1993 quarterly dividend of $.4375 per share on the Series E Cumulative Preferred Stock nor was it permitted to declare or pay future dividends on the Series E Cumulative Preferred Stock until the Company generated income, or effected certain sales of capital stock, to replenish the dividend "pool" under various of its debt instruments. As of December 31, 1993, accumulated dividends on the STONE CONTAINER CORPORATION AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 14--PREFERRED STOCK (CONTINUED) Series E Cumulative Preferred Stock amounted to $4.0 million. As a result of the Offerings, the dividend pool under the Senior Subordinated Indenture was replenished from the sale of the common shares. Pursuant to the most recent amendment to the Company's Credit Agreements, the Company will be able, to the extent declared by the Board of Directors, to pay dividends on the Series E Cumulative Preferred Stock to the extent permitted under the Senior Subordinated Indenture. In the event the Company does not pay a dividend on the Series E Cumulative Preferred Stock for six quarters, the holders of the Series E Cumulative Preferred Stock would have the right to elect two members to the Company's Board of Directors until the accumulated dividends on such Series E Cumulative Preferred Stock have been declared and paid or set apart for payment. REDEEMABLE PREFERRED STOCK OF A CONSOLIDATED AFFILIATE: The Company's Consolidated Balance Sheets include the Redeemable Series A Preferred Stock (the "Series A Preferred Stock") of Stone Savannah River. Stone Savannah River has authorized 650,000 shares of Series A Preferred Stock, of which 637,900 shares and 548,500 shares, having a total liquidation preference of $63.8 million and $54.9 million, were outstanding at December 31, 1993 and 1992, respectively. The Company owns one-third of the Series A Preferred Stock and has eliminated such investment in consolidation. The Series A Preferred Stock, $.01 par value, liquidation preference $100 per share, is cumulative with dividends of $15.375 per annum payable quarterly when, as and if declared by Stone Savannah River's Board of Directors. On or prior to December 15, 1993, dividends are payable through the issuance of additional shares of Series A Preferred Stock; thereafter, such dividends are payable in cash. Stock dividends of approximately $6.0 million in 1993, $5.1 million in 1992 and $4.4 million in 1991, representing approximately 60,000 shares, 51,000 shares and 44,000 shares, respectively, have been distributed to shareholders other than the Company. Commencing December 15, 2001, Stone Savannah River is required to redeem the Series A Preferred Stock at its liquidation preference in no less than three annual installments. Additionally, upon the occurrence of certain events, Stone Savannah River may be required to redeem all of the Series A Preferred Stock at prices declining annually to 100 percent of the liquidation preference by December 15, 2001. The Series A Preferred Stock is solely the obligation of Stone Savannah River and is without recourse to the parent company. SERIES F PREFERRED STOCK: As a result of the agreement discussed in Note 18 between the Company and Venezolana de Pulpa y Papel ("Venepal"), a Venezuelan pulp and paper company, the Company has authorized 400,000 shares of 7 percent Series F Cumulative Convertible Exchangeable Preferred Stock (the "Series F Preferred Stock"). The Series F Preferred Stock, $.01 par value, liquidation preference $100 per share, is cumulative with dividends of $7 per annum payable quarterly when, as and if declared by the Company's Board of Directors and is convertible into shares of the Company's common stock at a conversion price of $18.422, subject to adjustment under certain conditions. The terms of the Series F Preferred Stock are virtually identical to the Series E Preferred Stock, except for the liquidation preference and the conversion rate. No shares of Series F Preferred Stock have been issued to date. NOTE 15--COMMON STOCK The Company has authorized 200,000,000 shares of common stock, $.01 par value, of which 71,174,587 shares were outstanding at December 31, 1993. On September 15, 1992, the Company issued a 2 percent stock dividend to common stockholders of record August 25, 1992. The stock dividend was effected by the issuance of one share of common stock for every 50 shares of common stock held. Accordingly, all amounts per common share and weighted average number of common shares for all periods included in the consolidated financial statements have been retroactively adjusted to reflect this stock dividend. STOCK RIGHTS: Each outstanding share of the Company's common stock carries a stock purchase right ("Right"). Each Right entitles the holder to purchase from the Company one one-hundredth of a share of Series D Junior Participating Preferred Stock, par value $.01 per share, at a purchase price of $130 subject to adjustment under certain circumstances. The Rights expire August 8, 1998 unless extended or earlier redeemed by the Company. STONE CONTAINER CORPORATION AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 15--COMMON STOCK (CONTINUED) The Rights will be exercisable only if a person or group, subject to certain exceptions, acquires 15 percent or more of the Company's common stock or announces a tender offer, the consummation of which would result in ownership by such person or group of 15 percent or more of the Company's common stock. The Company can redeem the Rights at the rate of $.01 per Right at any time before the tenth business day (subject to extension) after a 15 percent position is acquired. If the Company is acquired in a merger or other business combination transaction, each Right will entitle its holder (other than the acquiring person or group) to purchase, at the Right's then-current exercise price, a number of the acquiring company's shares of common stock having a market value at that time of twice the Right's then-current exercise price. In addition, in the event that a 15 percent or greater stockholder acquires the Company by means of a reverse merger in which the Company and its common stock survive, or engages in self-dealing transactions with the Company, each holder of a Right (other than the acquiring person or group) will be entitled to purchase the number of shares of the Company's common stock having a market value of twice the then-current exercise price of the Right. STOCK OWNERSHIP AND OPTION PLANS: In 1982, the Company adopted an Incentive Stock Option Plan under which options are granted to key employees who are not participants in the Company's Long-Term Incentive Program described below. This plan expired on March 21, 1992 and upon its expiration, the Board of Directors adopted a 1993 Plan, effective January 1, 1993. The provisions under the 1993 Plan are similar to the 1982 Plan, with 1,530,000 shares of common stock authorized except that under the new plan the Company may issue either incentive stock options or non-qualified stock options. Options under these plans provide for the purchase of common shares at prices not less than 100 percent of the market value of such shares on the date of grant. The options are exercisable, in whole or in part, after one year but no later than ten years from the date of the respective grant. No accounting recognition is given to stock options until they are exercised, at which time the option price received is credited to common stock. STONE CONTAINER CORPORATION AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 15--COMMON STOCK (CONTINUED) Transactions under the stock option plans are summarized as follows: Additionally, the Company's Long-Term Incentive Program provides for contingent awards of restricted shares of common stock and cash to certain key employees. The payment of the cash portion of the awards granted will depend on the extent to which the Company has met certain long-term performance goals as established by a committee of outside directors. The compensation related to this program is amortized over the related five-year restricted periods. The charge (credit) to compensation expense under this plan was $(1.2) million, $3.6 million and $4.7 million in 1993, 1992 and 1991, respectively. In 1993, prior cash awards that were accrued have been deemed to be not payable due to the financial results of the Company. Under this plan, 1,800,000 shares have been reserved for issuance, of which 186,253, 120,834 and 238,546 shares were granted in 1993, 1992 and 1991, respectively. At December 31, 1993, there were 951,761 shares available for grant. NOTE 16--RELATED PARTY TRANSACTIONS The Company sells linerboard and corrugating medium to MacMillan Bathurst, a 50 percent owned non-consolidated affiliate and to Titan, a 49 percent owned non-consolidated affiliate. As discussed in Note 3, the Company sold its 49 percent interest in Titan in December 1993. Additionally, the Company purchases market pulp from Stone Venepal Consolidated Pulp Inc. ("Stone Venepal Consolidated"), a 50 percent owned non-consolidated affiliate of the Company. Stone Venepal Consolidated owns 50 percent of the Celgar Pulp Company, which operates a market pulp mill in British Columbia. The Company also sells boxboard to FCP, a 50 percent owned non-consolidated affiliate. Transactions under all of these agreements are primarily at market prices. STONE CONTAINER CORPORATION AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 16--RELATED PARTY TRANSACTIONS (CONTINUED) The following table summarizes the transactions between the Company and its non-consolidated affiliates and the payable and receivable balances outstanding at the end of each year. NOTE 17--ADDITIONAL INFORMATION RELATING TO THE CONSOLIDATED FINANCIAL STATEMENTS OTHER NET OPERATING (INCOME) EXPENSE: The major components of other net operating (income) expense are as follows: INTEREST EXPENSE: PROVISION FOR DOUBTFUL ACCOUNTS AND NOTES RECEIVABLE: Selling, general and administrative expenses include provisions for doubtful accounts and notes receivable of $12.2 million for 1993, $8.3 million for 1992 and $7.1 million for 1991. STONE CONTAINER CORPORATION AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 17--ADDITIONAL INFORMATION RELATING TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) OTHER, NET: The major components of other, net are as follows: INVESTMENTS IN NON-CONSOLIDATED AFFILIATES: The Company had investments in non-consolidated affiliates of $107.2 million and $131.9 million at December 31, 1993 and 1992, respectively. These amounts are included in other long-term assets in the Company's Consolidated Balance Sheets. See Note 16 for discussion of the transactions between the Company and its major non-consolidated affiliates. ACCRUED AND OTHER CURRENT LIABILITIES: The major components of accrued and other current liabilities are as follows: OTHER LONG-TERM LIABILITIES: Included in other long-term liabilities at December 31, 1993 and 1992 is approximately $52.3 million and $57.8 million, respectively, of deferred income relating to the October 1992 sale of an energy contract at the Company's Hopewell mill. This amount is being amortized over a 12 year period. NOTE 18--COMMITMENTS AND CONTINGENCIES At December 31, 1993, the Company, excluding Stone Savannah River and Seminole, had commitments outstanding for capital expenditures under purchase orders and contracts of approximately $20.3 million of which $8.3 million relates to Stone-Consolidated. Stone Savannah River and Seminole had, at December 31, 1993, commitments outstanding for capital expenditures of approximately $4.9 million in the aggregate. The Company has a 50 percent equity interest in Stone Venepal Consolidated Pulp Inc. ("Stone Venepal Consolidated"), which in turn has a 50 percent undivided interest in the assets and liabilities of a joint venture which owns the Celgar pulp mill located at Castlegar, British Columbia. Venepal owns the other 50 percent equity interest in Stone Venepal Consolidated. On February 12, 1991, Stone Venepal Consolidated entered into a $350 million (Canadian) bank credit agreement for the purpose of financing its 50 percent share of a major improvement and expansion project at the Castlegar mill. Additionally, the Company entered into a Completion Financing Agreement for the purpose of funding part of the project costs that were incurred in excess of the primary borrowing facility, up to a maximum of $50 million (Canadian) in the aggregate. At December 31, 1993, the Company has paid $37.5 million (Canadian) under the Completion Financing Agreement which is the maximum amount the Company has determined it will be required to contribute. On October 30, 1992, the Company and Venepal entered into an agreement whereby Venepal's investment in the Celgar pulp mill, represented by Venepal's ownership of 50 percent of the outstanding common stock of Stone STONE CONTAINER CORPORATION AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 18--COMMITMENTS AND CONTINGENCIES (CONTINUED) Venepal Consolidated can be exchanged for the Company's Series F Preferred Stock (see Note 14). The exchange would occur at Venepal's option as a result of certain specific conditions relating to the operations of the Celgar pulp mill. None of these conditions as of December 31, 1993 have occurred that would trigger the exchange. The Company may, at its option, elect to honor the contingent exchange obligation with a cash payment to Venepal. Based upon Venepal's initial investment in Stone Venepal Consolidated, 212,903 shares of Series F Preferred Stock, liquidation preference $100 per share, would be issued in the event Venepal elected its exchange option. Further, if the Series F Preferred shares were converted to the Company's common stock at the conversion price of $18.422, an additional 1,155,703 shares of common stock would be issued. Venepal's interest in Stone Venepal Consolidated replaces the equity ownership formerly held by Power Corporation of Canada. The Credit Agreements limit in certain specific circumstances any further investments by the Company in Stone-Consolidated Corporation, Seminole and Stone Savannah River. Stone Savannah River and Seminole have incurred substantial indebtedness in connection with project financings and are significantly leveraged. As of December 31, 1993, Stone Savannah River had $402.6 million in outstanding indebtedness (including $268.9 million in secured indebtedness owed to bank lenders) and Seminole had $161.0 million in outstanding indebtedness (including $120.6 million in secured indebtedness owed to bank lenders). The Company has entered into separate output purchase agreements with each of these subsidiaries which require the Company to purchase Seminole's linerboard production at fixed prices until no later than September 1, 1994 and Stone Savannah River's linerboard and market pulp production at fixed prices until December 1994 and November 1995, respectively. After such dates, the Company is required to purchase the respective production at market prices for the remaining terms of these agreements. While the fixed prices in effect at December 31, 1993 were higher than market prices at such date, the price differentials have not had, nor are they expected to have, a significant impact on the Company's results of operations or financial position. However, at the time that the fixed price provisions of the output purchase agreements terminate, such subsidiaries may need to undertake additional measures to meet their debt service requirements, including obtaining additional sources of funds, postponing or restructuring of debt service payments or refinancing the indebtedness. In the event that such measures are required and are not successful, and such indebtedness is accelerated by the respective lenders to Stone Savannah River or Seminole, the lenders to the Company under the Credit Agreements and various other of its debt instruments would be entitled to accelerate the indebtedness owed by the Company. Under certain timber contracts, title passes as the timber is cut. These are considered to be commitments and are not recorded until the timber is removed. At December 31, 1993 commitments on such contracts, which run through 1997, were approximately $16.8 million. The Company's operations are subject to extensive environmental regulation by federal, state and local authorities in the United States and regulatory authorities with jurisdiction over its foreign operations. The Company has in the past made significant capital expenditures to comply with water, air and solid and hazardous waste regulations and expects to make significant expenditures in the future. Capital expenditures for environmental control equipment and facilities were approximately $28 million in 1993 and the Company anticipates that 1994 and 1995 environmental capital expenditures will approximate $71 million and $96 million, respectively. Included in these amounts are capital expenditures for Stone-Consolidated which were approximately $5 million in 1993 and are anticipated to approximate $36 million in 1994 and $64 million in 1995. Although capital expenditures for environmental control equipment and facilities and compliance costs in future years will depend on legislative and technological developments which cannot be predicted at this time, the Company anticipates that these costs are likely to increase as environmental regulations become more stringent. Environmental control expenditures include projects which, in addition to meeting environmental concerns, yield certain benefits to the Company in the form of increased capacity and production cost savings. In addition to capital expenditures for environmental control equipment and facilities, other expenditures incurred to maintain environmental regulatory compliance (including any remediation) represent ongoing costs to the Company. On December 17, 1993, the Environmental Protection Agency proposed regulations under the Clean Air Act and the Clean Water Act for the pulp and paper industry, which if and when implemented, would affect directly a number of the Company's facilities. Since the regulations have only recently been proposed, the Company is currently unable to estimate the nature or level of future expenditures that STONE CONTAINER CORPORATION AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 18--COMMITMENTS AND CONTINGENCIES (CONTINUED) may be required to comply with such regulations if the proposed regulations become final in some form. In addition, the Company is from time to time subject to litigation and governmental proceedings regarding environmental matters in which injunctive and/or monetary relief is sought. The Company has been named as a potentially responsible party ("PRP") at a number of sites which are the subject of remedial activity under the Comprehensive Environmental Response, Compensation and Liability Act of 1980 ("CERCLA" or "Superfund") or comparable state laws. Although the Company is subject to joint and several liability imposed under Superfund, at most of the multi-PRP sites there are organized groups of PRPs and costs are being shared among PRPs. Future environmental regulations, including the December 17, 1993 regulations, may have an unpredictable adverse effect on the Company's operations and earnings, but they are not expected to adversely affect the Company's competitive position. The Company has entered into a purchase agreement with a certain party in which the Company has agreed to purchase annually 90,000 tons of linerboard at specified prices over a ten year period. Commencement of this agreement is contingent upon the completion of a manufacturing facility by the other party. Refer to Notes 10 and 13 for further discussion of the Company's debt, hedging and lease commitments. Additionally, the Company is involved in certain litigation primarily arising in the normal course of business. In the opinion of management, the Company's liability under any pending litigation would not materially affect its financial condition or results of operations. NOTE 19--SEGMENT INFORMATION BUSINESS SEGMENTS: The Company operates principally in two business segments. The paperboard and paper packaging segment is comprised primarily of facilities that produce containerboard, kraft paper, boxboard, corrugated containers and paper bags and sacks. The white paper and pulp segment consists of facilities that manufacture and sell newsprint, groundwood paper and market pulp. The Company has other operations, primarily consisting of wood products operations, flexible packaging operations and railroad operations. Intersegment sales are accounted for at transfer prices which approximate market prices. Operating profit includes all costs and expenses directly related to the segment involved. The corporate portion of operating profit includes corporate general and administrative expenses and equity income (loss) of non-consolidated affiliates. Assets are assigned to segments based on use. Corporate assets primarily consist of cash and cash equivalents, fixed assets, certain deferred charges and investments in non-consolidated affiliates. STONE CONTAINER CORPORATION AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 19--SEGMENT INFORMATION (CONTINUED) Financial information by business segment is summarized as follows: STONE CONTAINER CORPORATION AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 19--SEGMENT INFORMATION (CONTINUED) GEOGRAPHIC SEGMENTS: The chart below provides financial information for the Company's operations based on the region in which the operations are located. The Company's export sales from the United States were $341 million, $428 million and $330 million for 1993, 1992 and 1991, respectively. STONE CONTAINER CORPORATION AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 20--SUMMARY OF QUARTERLY DATA (UNAUDITED) The following table summarizes quarterly financial data for 1993 and 1992: Report of Independent Accountants on _Supplemental Financial Information_ To the Board of Directors of Stone Container Corporation Our audits of the consolidated financial statements referred to in our report dated March 23, 1994 appearing on page 32 of this Annual Report on Form 10-K (such report contains explanatory paragraphs referring to (i) certain liquidity matters discussed in Notes 11 and 18 to the Company's consolidated financial statements; and (ii) the change in accounting methods discussed in Note 1 to the Company's consolidated financial statements) also included an audit of the Supplemental Financial Information listed and appearing in Item 14(a)2 of this Form 10-K. In our opinion, this Supplemental Financial Information presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. PRICE WATERHOUSE Chicago, Illinois March 23, 1994 Consent of Independent Accountants We hereby consent to the incorporation by reference in the Prospectus constituting part of the Registration Statement on Form S-3 (No. 33-66086) and in the Registration Statements on Form S-8 (Nos. 2-79221, 33-33784, 33-38295 and 33-66132) of Stone Container Corporation of our report dated March 23, 1994 appearing on page 32 of this Annual Report on Form 10-K. We also consent to the incorporation by reference of our report on the Supplemental Financial Information, which appears on page 66 of this Form 10-K. PRICE WATERHOUSE Chicago, Illinois March 23, 1994 STONE CONTAINER CORPORATION AND SUBSIDIARIES SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT (A) (IN MILLIONS) STONE CONTAINER CORPORATION AND SUBSIDIARIES SCHEDULE VI--ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (IN MILLIONS) STONE CONTAINER CORPORATION AND SUBSIDIARIES SCHEDULE VIII--VALUATION AND QUALIFYING ACCOUNTS AND RESERVES (IN MILLIONS) SCHEDULE IX--SHORT-TERM BORROWINGS (IN MILLIONS) SCHEDULE X--SUPPLEMENTARY INCOME STATEMENT INFORMATION (IN MILLIONS) STONE CONTAINER CORPORATION AND SUBSIDIARIES SUMMARIZED FINANCIAL INFORMATION--STONE SOUTHWEST, INC. Shown below is consolidated, summarized financial information for Stone Southwest, Inc. (formerly known as Southwest Forest Industries, Inc.). The summarized financial information for Stone Southwest, Inc. ("Stone Southwest") does not include purchase accounting adjustments or the impact of the debt incurred to finance the acquisition of Stone Southwest:
872552_1993.txt	872552	1993	ITEM 1. BUSINESS Each of the Grantor Trusts, (the "Trusts"), listed below, was formed by GMAC Auto Receivables Corporation (the "Seller") by selling and assigning the receivables and the security interests in the vehicles financed thereby to The First National Bank of Chicago, as Trustee, in exchange for Class A certificates representing an undivided ownership interest that ranges between approximately 91% and 94.5% in each Trust, which were remarketed to the public, and Class B certificates representing an undivided ownership interest that ranges between approximately 5.5% and 9% in each Trust, which were not offered to the public and initially were held by the Seller. The right of the Class B certificateholders to receive distribution of the receivables is subordinated to the rights of the Class A certificateholders. GRANTOR TRUST ------------- GMAC 1990-A GMAC 1991-A GMAC 1991-B GMAC 1991-C GMAC 1992-A GMAC 1992-C GMAC 1992-D GMAC 1992-E GMAC 1992-F GMAC 1992-G GMAC 1993-A GMAC 1993-B _____________________ PART II ITEM 7.							ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Each of the Grantor Trusts, listed in the table as shown below, was formed by GMAC Auto Receivables Corporation (the "Seller") pursuant to a Pooling and Servicing Agreement between the Seller and The First National Bank of Chicago, as trustee. Each Trust acquired retail finance receivables from the Seller in the aggregate amount as shown below in exchange for certificates representing undivided ownership interests in each Trust. Each Trust's property includes a pool of retail instalment sale contracts secured by new, and in some Trust's used, automobiles and light trucks, certain monies due thereunder and security interests in the vehicles financed thereby. The certificates for each of the following Trusts consist of two classes, entitled Asset Backed certificates, Class A and Asset Backed certificates, Class B. The Class A certificates represent in the aggregate an undivided ownership interest that ranges between approximately 91% and 94.5% of the Trusts and the Class B certificates represent in the aggregate an undivided ownership interest that ranges between approximately 5.5% and 9% of the Trusts. Only the Class A certificates have been remarketed to the public. The Class B certificates have not been offered to the public and initially are being held by the Seller. The rights of the Class B certificateholder to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. Original Aggregate Amount ----------------------------------- Date of Pooling Retail Asset Backed Certificates Grantor and Servicing Finance ------------------------- Trust Agreement Receivables Class A Class B - ------- ----------------- --------- -------- ------- (In millions of dollars) GMAC 1990-A December 20, 1990 $1,162.6 $1,057.9 $104.7 GMAC 1991-A March 14, 1991 891.7 811.4 80.3 GMAC 1991-B September 17, 1991 1,007.4 916.7 90.7 GMAC 1991-C December 16, 1991 1,326.4 1,207.0 119.4 GMAC 1992-A January 30, 1992 2,001.4 1,851.3 150.1 GMAC 1992-C March 26, 1992 1,100.3 1,012.3 88.0 GMAC 1992-D June 4, 1992 1,647.6 1,499.3 148.3 GMAC 1992-E August 20, 1992 1,578.0 1,436.0 142.0 GMAC 1992-F September 29, 1992 1,644.6 1,496.6 148.0 GMAC 1992-G November 19, 1992 1,379.4 1,303.5 75.9 GMAC 1993-A March 24, 1993 1,403.0 1,297.8 105.2 GMAC 1993-B September 16, 1993 1,450.6 1,341.8 108.8 II-1 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (concluded) General Motors Acceptance Corporation, the originator of the retail receivables, continues to service the receivables for each of the aforementioned Grantor Trusts and receives compensation and fees for such services. Investors receive monthly payments of the pro rata portion of principal and interest for each Trust as the receivables are liquidated. ------------------------ II-2 ITEM 8.	ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. CROSS REFERENCE SHEET Caption Page - --------------------------------------------------- ------ GMAC 1990-A Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-4 Data for the Year Ended December 31, 1993. GMAC 1991-A Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-9 Data for the Year Ended December 31, 1993. GMAC 1991-B Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-14 Data for the Year Ended December 31, 1993. GMAC 1991-C Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-19 Data for the Year Ended December 31, 1993. GMAC 1992-A Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-24 Data for the Year Ended December 31, 1993. GMAC 1992-C Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-29 Data for the Year Ended December 31, 1993. GMAC 1992-D Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-34 Data for the Year Ended December 31, 1993. GMAC 1992-E Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-39 Data for the Year Ended December 31, 1993. GMAC 1992-F Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-44 Data for the Year Ended December 31, 1993. GMAC 1992-G Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-49 Data for Year Ended from December 31, 1993. GMAC 1993-A Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-54 Data for the period from March 24, 1993 to December 31, 1993. GMAC 1993-B Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-59 Data for period from September 16, 1993 to December 31, 1993. II-3 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1990-A Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago, Trustee: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1990-A Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1990-A Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for each of the three years in the period ended December 31, 1993, on the basis of accounting described in Note 1. s\ DELOITTE & TOUCHE - ---------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-4 GMAC 1990-A GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) ................... 207.1 459.8 ------- ------- TOTAL ASSETS ........................... 207.1 459.8 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ...................... 207.1 459.8 ------- ------- TOTAL LIABILITIES ...................... 207.1 459.8 ======= ======= Reference should be made to the Notes to Financial Statements. II-5 GMAC 1990-A GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the years ended December 31, 1993, 1992 and 1991 (in millions of dollars) 1993 1992 1991 ----- ----- ----- Distributable Income $ $ $ Allocable to Principal ............... 252.7 344.1 358.7 Allocable to Interest ............... 27.7 52.9 82.6 ----- ----- ----- Distributable Income ................... 280.4 397.0 441.3 ===== ===== ===== Income Distributed ..................... 280.4 397.0 441.3 ===== ===== ===== Reference should be made to the Notes to Financial Statements. II-6 GMAC 1990-A GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1990-A Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On December 20, 1990, GMAC 1990-A Grantor Trust acquired retail finance receivables aggregating approximately $1,162.6 million from the Seller in exchange for certificates representing undivided ownership interests of 91% for the Class A certificates and 9% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new automobiles and light trucks, certain monies due thereunder, and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing January 15, 1991. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 8.25% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-7 GMAC 1990-A GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 70.0 9.0 79.0 Second quarter ..................... 69.0 7.5 76.5 Third quarter ...................... 61.8 6.2 68.0 Fourth quarter ..................... 51.9 5.0 56.9 --------- -------- ----- Total ......................... 252.7 27.7 280.4 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 90.4 16.0 106.4 Second quarter ..................... 90.0 14.1 104.1 Third quarter ...................... 86.1 12.3 98.4 Fourth quarter ..................... 77.6 10.5 88.1 --------- -------- ----- Total ......................... 344.1 52.9 397.0 ========= ======== ===== 1991 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 86.6 23.4 110.0 Second quarter ..................... 93.2 21.7 114.9 Third quarter ...................... 90.8 19.7 110.5 Fourth quarter ..................... 88.1 17.8 105.9 --------- -------- ----- Total ......................... 358.7 82.6 441.3 ========= ======== ===== II-8 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1991-A Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago, Trustee: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1991-A Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the two years in the period ended December 31, 1993 and the period March 14, 1991 (inception) through December 31, 1991. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1991-A Grantor Trust at December 31, 1993 and 1992 and its distributable income and distributions for the two years in the period ended December 31, 1993 and the period March 14, 1991 (inception) through December 31, 1991, on the basis of accounting described in Note 1. s/ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-9 GMAC 1991-A GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) ................... 162.0 370.4 ------- ------- TOTAL ASSETS ........................... 162.0 370.4 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ...................... 162.0 370.4 ------- ------- TOTAL LIABILITIES ...................... 162.0 370.4 ======= ======= Reference should be made to the Notes to Financial Statements. II-10 GMAC 1991-A GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the years ended December 31, 1993, 1992 and the period March 14, 1991 (inception) through December 31, 1991 (in millions of dollars) 1993 1992 1991 ----- ----- ----- $ $ $ Distributable Income Allocable to Principal ................ 208.3 290.7 230.6 Allocable to Interest ................ 21.2 41.2 46.7 ----- ----- ----- Distributable Income .................... 229.5 331.9 277.3 ===== ===== ===== Income Distributed ...................... 229.5 331.9 277.3 ===== ===== ===== Reference should be made to the Notes to Financial Statements. II-11 GMAC 1991-A GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1991-A Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On March 14, 1991, GMAC 1991-A Grantor Trust acquired retail finance receivables aggregating approximately $891.7 million from the Seller in exchange for certificates representing undivided ownership interests of 91% for the Class A certificates and 9% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new automobiles and light trucks, certain monies due thereunder, and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing April 15, 1991. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 7.90% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-12 GMAC 1991-A GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 58.0 6.9 64.9 Second quarter ..................... 55.5 5.8 61.3 Third quarter ...................... 50.6 4.7 55.3 Fourth quarter ..................... 44.2 3.8 48.0 --------- -------- ----- Total ......................... 208.3 21.2 229.5 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 78.5 12.5 91.0 Second quarter ..................... 75.1 11.0 86.1 Third quarter ...................... 71.9 9.5 81.4 Fourth quarter ..................... 65.2 8.2 73.4 --------- -------- ----- Total ......................... 290.7 41.2 331.9 ========= ======== ===== 1991 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Second quarter ..................... 78.6 17.1 95.7 Third quarter ...................... 76.7 15.6 92.3 Fourth quarter ..................... 75.3 14.0 89.3 --------- -------- ----- Total ......................... 230.6 46.7 277.3 ========= ======== ===== II-13 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1991-B Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago, Trustee: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1991-B Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the two years in the period ended December 31, 1993 and the period September 17, 1991 (inception) through December 31, 1991. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1991-B Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for the two years in the period ended December 31, 1993 and the period September 17, 1991 (inception) through December 31, 1991, on the basis of accounting described in Note 1. s\ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-14 GMAC 1991-B GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) ................... 306.4 582.8 ------- ------- TOTAL ASSETS ........................... 306.4 582.8 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ...................... 306.4 582.8 ------- ------- TOTAL LIABILITIES ...................... 306.4 582.8 ======= ======= Reference should be made to the Notes to Financial Statements. II-15 GMAC 1991-B GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the years ended December 31, 1993, 1992 and the period September 17, 1991 (inception) through December 31, 1991 (in millions of dollars) 1993 1992 1991 ------ ------ ------ $ $ $ Distributable Income Allocable to Principal ............... 276.3 340.7 83.9 Allocable to Interest ............... 30.4 51.5 16.5 ------ ------ ------ Distributable Income ................... 306.7 392.2 100.4 ====== ====== ====== Income Distributed ..................... 306.7 392.2 100.4 ====== ====== ====== Reference should be made to the Notes to Financial Statements. II-16 GMAC 1991-B GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1991-B Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On September 17, 1991, GMAC 1991-B Grantor Trust acquired retail finance receivables aggregating approximately $1,007.4 million from the Seller in exchange for certificates representing undivided ownership interests of 91% for the Class A certificates and 9% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new automobiles and light trucks, certain monies due thereunder and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing October 15, 1991. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 6.75% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-17 GMAC 1991-B GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 72.7 9.4 82.1 Second quarter ..................... 74.8 8.2 83.0 Third quarter ...................... 68.3 7.0 75.3 Fourth quarter ..................... 60.5 5.8 66.3 --------- -------- ----- Total ......................... 276.3 30.4 306.7 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 87.1 15.1 102.2 Second quarter ..................... 89.5 13.6 103.1 Third quarter ...................... 84.9 12.1 97.0 Fourth quarter ..................... 79.2 10.7 89.9 --------- -------- ----- Total ......................... 340.7 51.5 392.2 ========= ======== ===== 1991 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Fourth quarter ..................... 83.9 16.5 100.4 ========= ======== ===== II-18 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1991-C Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago, Trustee: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1991-C Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the years then ended. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1991-C Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for the years then ended, on the basis of accounting described in Note 1. s\ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-19 GMAC 1991-C GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) ................... 496.0 874.6 ------- ------- TOTAL ASSETS ........................... 496.0 874.6 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ...................... 496.0 874.6 ------- ------- TOTAL LIABILITIES ...................... 496.0 874.6 ======= ======= Reference should be made to the Notes to Financial Statements. II-20 GMAC 1991-C GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the years ended December 31, 1993 and 1992 (in millions of dollars) 1993 1992 -------- -------- $ $ Distributable Income Allocable to Principal ...................... 378.5 451.8 Allocable to Interest ...................... 39.7 63.3 -------- -------- Distributable Income .......................... 418.2 515.1 ======== ======== Income Distributed ............................ 418.2 515.1 ======== ======== Reference should be made to the Notes to Financial Statements. II-21 GMAC 1991-C GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1991-C Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On December 16, 1991, GMAC 1991-C Grantor Trust acquired retail finance receivables aggregating approximately $1,326.4 million from the Seller in exchange for certificates representing undivided ownership interests of 91% for the Class A certificates and 9% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new automobiles and light trucks, certain monies due thereunder, and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing January 15, 1992. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 5.70% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-22 GMAC 1991-C GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 96.7 12.0 108.7 Second quarter ..................... 101.1 10.6 111.7 Third quarter ...................... 95.2 9.2 104.4 Fourth quarter ..................... 85.5 7.9 93.4 --------- -------- ----- Total ......................... 378.5 39.7 418.2 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 120.6 18.3 138.9 Second quarter ..................... 115.3 16.6 131.9 Third quarter ...................... 109.9 15.0 124.9 Fourth quarter ..................... 106.0 13.4 119.4 --------- -------- ----- Total ......................... 451.8 63.3 515.1 ========= ======== ===== II-23 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1992-A Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1992-A Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the year ended December 31, 1993 and the period January 30, 1992 (inception) through December 31, 1992. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1992-A Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for the year ended December 31, 1993 and the period January 30, 1992 (inception) through December 31, 1992, on the basis of accounting described in Note 1. s\ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-24 GMAC 1992-A GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) .............................. 370.7 1,052.5 ------- ------- TOTAL ASSETS ...................................... 370.7 1,052.5 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ................................. 370.7 1,052.5 ------- ------- TOTAL LIABILITIES ................................. 370.7 1,052.5 ======= ======= Reference should be made to the Notes to Financial Statements. II-25 GMAC 1992-A GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the year ended December 31, 1993 and the period January 30, 1992 (inception) through December 31, 1992 (in millions of dollars) 1993 1992 ------- ------- $ $ Distributable Income Allocable to Principal ...................... 681.7 948.9 Allocable to Interest ...................... 35.4 72.0 ------- ------- Distributable Income .......................... 717.1 1,020.9 ======= ======= Income Distributed ............................ 717.1 1,020.9 ======= ======= Reference should be made to the Notes to Financial Statements. II-26 GMAC 1992-A GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1992-A Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On January 30, 1992, GMAC 1992-A Grantor Trust acquired retail finance receivables aggregating approximately $2,001.4 million from the Seller in exchange for certificates representing undivided ownership interests of 92.5% for the Class A certificates and 7.5% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new automobiles and light trucks, certain monies due thereunder and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing February 18, 1992. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 5.05% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-27 GMAC 1992-A GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 206.9 12.4 219.3 Second quarter ..................... 192.5 9.8 202.3 Third quarter ...................... 157.7 7.5 165.2 Fourth quarter ..................... 124.6 5.7 130.3 --------- -------- ----- Total ......................... 681.7 35.4 717.1 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 171.8 16.5 188.3 Second quarter ..................... 278.3 21.9 300.2 Third quarter ...................... 263.6 18.4 282.0 Fourth quarter ..................... 235.2 15.2 250.4 --------- -------- ------- Total ......................... 948.9 72.0 1,020.9 ========= ======== ======= II-28 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1992-C Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1992-C Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the year ended December 31, 1993 and the period March 26, 1992 (inception) through December 31, 1992. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1992-C Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for the year ended December 31, 1993 and the period March 26, 1992 (inception) through December 31, 1992, on the basis of accounting described in Note 1. s\ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-29 GMAC 1992-C GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) .............................. 311.3 716.3 ------- ------- TOTAL ASSETS ...................................... 311.3 716.3 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) .................................. 311.3 716.3 ------- ------- TOTAL LIABILITIES ................................. 311.3 716.3 ======= ======= Reference should be made to the Notes to Financial Statements. II-30 GMAC 1992-C GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the year ended December 31, 1993 and the period March 26, 1992 (inception) through December 31, 1992 (in millions of dollars) 1993 1992 ------- ------- $ $ Distributable Income Allocable to Principal ...................... 405.0 384.0 Allocable to Interest ...................... 31.0 41.2 ------- ------- Distributable Income .......................... 436.0 425.2 ======= ======= Income Distributed ............................ 436.0 425.2 ======= ======= Reference should be made to the Notes to Financial Statements. II-31 GMAC 1992-C GRANTOR TRUST (continued)) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1992-C Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On March 26, 1992, GMAC 1992-C Grantor Trust acquired retail finance receivables aggregating approximately $1,100.3 million from the Seller in exchange for certificates representing undivided ownership interests of 92% for the Class A certificates and 8% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new automobiles and light trucks, certain monies due thereunder and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing April 15, 1992. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 5.95% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-32 GMAC 1992-C GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 109.2 10.1 119.3 Second quarter ..................... 109.3 8.5 117.8 Third quarter ...................... 99.7 6.9 106.6 Fourth quarter ..................... 86.8 5.5 92.3 --------- -------- ----- Total ......................... 405.0 31.0 436.0 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Second quarter ..................... 133.1 15.7 148.8 Third quarter ...................... 129.8 13.7 143.5 Fourth quarter ..................... 121.1 11.8 132.9 --------- -------- ----- Total ......................... 384.0 41.2 425.2 ========= ======== ===== II-33 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1992-D Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1992-D Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the year ended December 31, 1993 and the period June 4, 1992 (inception) through December 31, 1992. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1992-D Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for the year ended December 31, 1993 and the period June 4, 1992 (inception) through December 31, 1992, on the basis of accounting described in Note 1. s/ DELOITTE & TOUCHE - ---------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-34 GMAC 1992-D GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) .............................. 702.0 1,270.4 ------- ------- TOTAL ASSETS ...................................... 702.0 1,270.4 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ................................. 702.0 1,270.4 ------- ------- TOTAL LIABILITIES ................................. 702.0 1,270.4 ======= ======= Reference should be made to the Notes to Financial Statements. II-35 GMAC 1992-D GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the year ended December 31, 1993 and the period June 4,1992 (inception) through December 31, 1992 (in millions of dollars) 1993 1992 ------ ------ $ $ Distributable Income Allocable to Principal ...................... 568.4 377.2 Allocable to Interest ...................... 55.4 48.0 ------ ------ Distributable Income .......................... 623.8 425.2 ====== ====== Income Distributed ............................ 623.8 425.2 ====== ====== Reference should be made to the Notes to Financial Statements. II-36 GMAC 1992-D GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1992-D Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On June 4, 1992, GMAC 1992-D Grantor Trust acquired retail finance receivables aggregating approximately $1,647.6 million from the Seller in exchange for certificates representing undivided ownership interests of 91% for the Class A certificates and 9% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new and used automobiles and light trucks, certain monies due thereunder and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing June 15, 1992. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 5.55% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-37 GMAC 1992-D GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 148.6 16.9 165.5 Second quarter ..................... 153.3 14.8 168.1 Third quarter ...................... 140.7 12.8 153.5 Fourth quarter ..................... 125.8 10.9 136.7 --------- -------- ----- Total ......................... 568.4 55.4 623.8 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Second quarter ..................... 50.7 7.6 58.3 Third quarter ...................... 166.9 21.4 188.3 Fourth quarter ..................... 159.6 19.0 178.6 --------- -------- ----- Total ......................... 377.2 48.0 425.2 ========= ======== ===== II-38 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1992-E Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1992-E Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the year ended December 31, 1993 and the period August 20, 1992 (inception) through December 31, 1992. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1992-E Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for the year ended December 31, 1993 and the period August 20, 1992 (inception) through December 31, 1992, on the basis of accounting described in Note 1. s\ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-39 GMAC 1992-E GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) .............................. 885.4 1,398.0 ------- ------- TOTAL ASSETS ...................................... 885.4 1,398.0 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ................................. 885.4 1,398.0 ------- ------- TOTAL LIABILITIES ................................. 885.4 1,398.0 ======= ======= Reference should be made to the Notes to Financial Statements. II-40 GMAC 1992-E GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the year ended December 31, 1993 and the period August 20, 1992 (inception) through December 31, 1992 (in millions of dollars) 1993 1992 ------- ------- $ $ Distributable Income Allocable to Principal ...................... 512.6 180.0 Allocable to Interest ...................... 55.1 23.9 ------- ------- Distributable Income .......................... 567.7 203.9 ======= ======= Income Distributed ............................ 567.7 203.9 ======= ======= Reference should be made to the Notes to Financial Statements. II-41 GMAC 1992-E GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1992-E Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On August 20, 1992, GMAC 1992-E Grantor Trust acquired retail finance receivables aggregating approximately $1,578.0 million from the Seller in exchange for certificates representing undivided ownership interests of 91% for the Class A certificates and 9% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new and used automobiles and light trucks, certain monies due thereunder and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing September 15, 1992. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 4.75% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-42 GMAC 1992-E GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 128.3 16.1 144.4 Second quarter ..................... 134.8 14.5 149.3 Third quarter ...................... 129.0 13.0 142.0 Fourth quarter ..................... 120.5 11.5 132.0 --------- -------- ----- Total ......................... 512.6 55.1 567.7 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Third quarter ...................... 46.1 6.2 52.3 Fourth quarter ..................... 133.9 17.7 151.6 --------- -------- ----- Total ......................... 180.0 23.9 203.9 ========= ======== ===== II-43 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1992-F Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1992-F Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the year ended December 31, 1993 and the period September 29, 1992 (inception) through December 31, 1992. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1992-F Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for the year ended December 31, 1993 and the period September 29, 1992 (inception) through December 31, 1992, on the basis of accounting described in Note 1. s\ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-44 GMAC 1992-F GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) .............................. 908.7 1,492.8 ------- ------- TOTAL ASSETS ...................................... 908.7 1,492.8 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ................................. 908.7 1,492.8 ------- ------- TOTAL LIABILITIES ................................. 908.7 1,492.8 ======= ======= Reference should be made to the Notes to Financial Statements. II-45 GMAC 1992-F GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the year ended December 31, 1993 and the period September 29, 1992 (inception) through December 31, 1992 (in millions of dollars) 1993 1992 ------ ------ $ $ Distributable Income Allocable to Principal ...................... 584.1 151.8 Allocable to Interest ...................... 55.0 17.9 ------ ------ Distributable Income .......................... 639.1 169.7 ====== ====== Income Distributed ............................ 639.1 169.7 ====== ====== Reference should be made to the Notes to Financial Statements. II-46 GMAC 1992-F GRANTOR TRUST (continued)) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1992-F Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On September 29, 1992, GMAC 1992-F Grantor Trust acquired retail finance receivables aggregating approximately $1,644.6 million from the Seller in exchange for certificates representing undivided ownership interests of 91% for the Class A certificates and 9% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new and used automobiles and light trucks, certain monies due thereunder, and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing October 15, 1992. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 4.50% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-47 GMAC 1992-F GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 146.9 16.2 163.1 Second quarter ..................... 151.2 14.6 165.8 Third quarter ...................... 147.3 12.9 160.2 Fourth quarter ..................... 138.7 11.3 150.0 --------- -------- ----- Total ......................... 584.1 55.0 639.1 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Fourth quarter ..................... 151.8 17.9 169.7 ========= ======== ===== II-48 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1992-G Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1992-G Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the year ended December 31, 1993 and the period November 19, 1992 (inception) through December 31, 1992. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1992-G Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for the year ended December 31, 1993 and the period November 19, 1992 (inception) through December 31, 1992, on the basis of accounting described in Note 1. s/ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-49 GMAC 1992-G GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) .............................. 335.3 1,288.5 ------- ------- TOTAL ASSETS ...................................... 335.3 1,288.5 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ................................. 335.3 1,288.5 ------- ------- TOTAL LIABILITIES ................................. 335.3 1,288.5 ======= ======= Reference should be made to the Notes to Financial Statements. II-50 GMAC 1992-G GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the year ended December 31, 1993 and the period November 19, 1992 (inception) through December 31, 1992 (in millions of dollars) 1993 1992 ------ ------ $ $ Distributable Income Allocable to Principal ...................... 953.1 91.0 Allocable to Interest ...................... 35.2 4.9 ------ ------ Distributable Income .......................... 988.3 95.9 ====== ====== Income Distributed ............................ 988.3 95.9 ====== ====== Reference should be made to the Notes to Financial Statements. II-51 GMAC 1992-G GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1992-G Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On November 19, 1992, GMAC 1992-G Grantor Trust acquired retail finance receivables aggregating approximately $1,379.4 million from the Seller in exchange for certificates representing undivided ownership interests of 94.5% for the Class A certificates and 5.5% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new and used automobiles and light trucks, certain monies due thereunder, and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing December 15, 1992. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 4.30% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-52 GMAC 1992-G GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 268.1 12.9 281.0 Second quarter ..................... 258.3 10.0 268.3 Third quarter ...................... 230.4 7.3 237.7 Fourth quarter ..................... 196.3 5.0 201.3 --------- -------- ----- Total ......................... 953.1 35.2 988.3 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Fourth quarter ..................... 91.0 4.9 95.9 ========= ======== ===== II-53 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1993-A Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1993-A Grantor Trust as of December 31, 1993 and the related Statement of Distributable Income for the period March 24, 1993 (inception) through December 31, 1993. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1993-A Grantor Trust at December 31, 1993 and its distributable income and distributions for the period March 24, 1993 (inception) through December 31, 1993, on the basis of accounting described in Note 1. s\ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-54 GMAC 1993-A GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 ------- ASSETS $ Receivables (Note 2) .............................. 845.9 ------- TOTAL ASSETS ...................................... 845.9 ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ................................. 845.9 ------- TOTAL LIABILITIES ................................. 845.9 ======= Reference should be made to the Notes to Financial Statements. II-55 GMAC 1993-A GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the period March 24, 1992 (inception) through December 31, 1993 (in millions of dollars) ----- $ Distributable Income Allocable to Principal .................... 557.0 Allocable to Interest .................... 35.6 ----- Distributable Income ......................... 592.6 ===== Income Distributed ........................... 592.6 ===== Reference should be made to the Notes to Financial Statements. II-56 GMAC 1993-A GRANTOR TRUST (continued)) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1993-A Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On March 24, 1993, GMAC 1993-A Grantor Trust acquired retail finance receivables aggregating approximately $1,403.0 million from the Seller in exchange for certificates representing undivided ownership interests of 92.5% for the Class A certificates and 7.5% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new and used automobiles and light trucks, certain monies due thereunder, and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing April 15, 1993. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 4.15% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-57 GMAC 1993-A GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Second quarter ..................... 196.7 13.9 210.6 Third quarter ...................... 194.4 11.8 206.2 Fourth quarter ..................... 165.9 9.9 175.8 --------- -------- ----- Total ......................... 557.0 35.6 592.6 ========= ======== ===== II-58 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1993-B Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1993-B Grantor Trust as of December 31, 1993 and the related Statement of Distributable Income for the period September 16, 1993 (inception) through December 31, 1993. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1993-B Grantor Trust at December 31, 1993 and its distributable income and distributions for the period September 16, 1993 (inception) through December 31, 1993, on the basis of accounting described in Note 1. s/ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-59 GMAC 1993-B GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 ------- ASSETS $ Receivables (Note 2) .............................. 1,269.0 ------- TOTAL ASSETS ...................................... 1,269.0 ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ................................. 1,269.0 ------- TOTAL LIABILITIES ................................. 1,269.0 ======= Reference should be made to the Notes to Financial Statements. II-60 GMAC 1993-B GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the period September 16, 1993 (inception) through December 31, 1993 (in millions of dollars) ----- $ Distributable Income Allocable to Principal .................... 181.6 Allocable to Interest .................... 13.9 ----- Distributable Income ......................... 195.5 ===== Income Distributed ........................... 195.5 ===== Reference should be made to the Notes to Financial Statements. II-61 GMAC 1993-B GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1993-B Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On September 16, 1993, GMAC 1993-B Grantor Trust acquired retail finance receivables aggregating approximately $1,450.6 million from the Seller in exchange for certificates representing undivided ownership interests of 92.5% for the Class A certificates and 7.5% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new and used automobiles and light trucks, certain monies due thereunder, and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing October 15, 1993. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 4.00% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-62 GMAC 1993-B GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Fourth quarter ..................... 181.6 13.9 195.5 ========= ======== ===== II-63 PART IV ITEM 14.						ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) (1) FINANCIAL STATEMENTS. Included in Part II, Item 8, of Form 10-K. (a) (2) FINANCIAL STATEMENT SCHEDULES. All schedules have been omitted because they are inapplicable or because the information called for is shown in the financial statements or notes thereto. (a) (3) EXHIBITS (Included in Part II of this report). -- GMAC 1990-A Grantor Trust Financial Statements for the Year Ended December 31, 1993. -- GMAC 1991-A Grantor Trust Financial Statement for the Year Ended December 31, 1993. -- GMAC 1991-B Grantor Trust Financial Statements for the Year Ended December 31, 1993. -- GMAC 1991-C Grantor Trust Financial Statements for the Year Ended December 31, 1993. -- GMAC 1992-A Grantor Trust Financial Statements for the Year Ended December 31, 1993. -- GMAC 1992-C Grantor Trust Financial Statement for the Year Ended December 31, 1993. -- GMAC 1992-D Grantor Trust Financial Statements for the Year Ended December 31, 1993. -- GMAC 1992-E Grantor Trust Financial Statements for the Year Ended December 31, 1993. -- GMAC 1992-F Grantor Trust Financial Statements for the Year Ended December 31, 1993. -- GMAC 1992-G Grantor Trust Financial Statement for the Year Ended December 31, 1993. -- GMAC 1993-A Grantor Trust Financial Statements for the period March 24, 1993 through December 31, 1993. -- GMAC 1993-B Grantor Trust Financial Statements for the period September 16, 1993 through December 31, 1993. (b) REPORTS ON FORM 8-K. No current reports on Form 8-K have been filed by any of the above-mentioned Grantor Trusts during the fourth quarter ended December 31, 1993 ITEMS 2, 3, 4, 5, 6, 9, 10, 11, 12 and 13 are inapplicable and have been omitted. IV-1 SIGNATURE Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the Trustee has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. GMAC 1990-A GRANTOR TRUST GMAC 1991-A GRANTOR TRUST GMAC 1991-B GRANTOR TRUST GMAC 1991-C GRANTOR TRUST GMAC 1992-A GRANTOR TRUST GMAC 1992-C GRANTOR TRUST GMAC 1992-D GRANTOR TRUST GMAC 1992-E GRANTOR TRUST GMAC 1992-F GRANTOR TRUST GMAC 1992-G GRANTOR TRUST GMAC 1993-A GRANTOR TRUST GMAC 1993-B GRANTOR TRUST The First National Bank of Chicago (Trustee) s\ Steven M. Wagner ---------------------------------- (Steven M. Wagner, Vice President) Date: March 30, 1994 -------------- IV-2
91142_1993.txt	91142	1993	ITEM 1 - BUSINESS A. O. Smith Corporation, a Delaware corporation organized in 1916, its subsidiaries and its affiliates (hereafter collectively called the "Corporation" unless the context otherwise requires) are engaged in four business segments. These segments are Original Equipment Manufacturer ("OEM") Products, Water Products, Agricultural Products, and Other Products. The Corporation's principal OEM Products business is the Automotive Products Company, a supplier of truck and automobile structural components and assemblies. OEM Products also includes the Electrical Products Company which produces fractional horsepower and hermetic electric motors. Included in Water Products is the Water Products Company, a leading manufacturer of residential and commercial gas, oil, and electric water heating systems. Agricultural Products consists of two units. A. O. Smith Harvestore Products, Inc. (Harvestore) is a manufacturer of agricultural feed storage and handling systems, for which AgriStor Credit Corporation (AgriStor) provides financing, and industrial and municipal water and bulk storage systems. The Corporation intends to sell Harvestore and is in the process of liquidating Agristor. Other Products consist of Smith Fiberglass Products Inc. which manufactures reinforced thermosetting resin piping. Information regarding industry segments is provided in Note 13 to the Consolidated Financial Statements which appear elsewhere herein. The following table summarizes revenues by segment for the Corporation's operations. This segment summary and all other information presented in this section should be read in conjunction with the Consolidated Financial Statements and the Notes thereto which appear elsewhere herein. OEM PRODUCTS Automotive Products Automotive sales in 1993 of $606.3 million, or 51 percent of total Corporation revenues, increased almost 15 percent from previous year sales due to continued strength in both the light and heavy truck segments plus added volume in the passenger car segment. As a result of increased volume, Automotive Products showed improved operating profits over 1992. The largest product group within Automotive Products continues to be truck frames and components which accounted for slightly more than 80 percent of Automotive Products' sales and 41 percent of the Corporation's revenues. The company continues to hold its lead position in truck frame manufacturing in the United States and Canada, supplying more than 30 percent of the 1993 market. Automotive Products had two product launches during 1993. The company began to ship full frame assemblies for a Mazda pick-up truck in the spring. During the third quarter, the company began production of a new full frame assembly in Milwaukee, Wisconsin, for Chrysler's Dodge Ram pick-up truck. In 1994, the Granite City, Illinois, plant will begin shipping engine cradles for a new Ford Windstar mini-van and Lincoln Continental, and for the new Ford Contour and Mercury Mystique. The Milan, Tennessee, plant will build trailing axles for the Ford mini-van and will manufacture a new structural assembly for Toyota U.S.A. The company expects capital expenditures to increase in 1994 to support these and additional new product launches. Automotive Products has contracts, some of which are subject to economic price adjustments, to supply frame assemblies and components to Ford, General Motors and Chrysler in the light truck class. The company is also a supplier of truck frames to most domestic producers of medium and heavy-duty trucks, such as Ford, Navistar International, General Motors, Freightliner and Paccar. The company believes the North American market will grow in 1994. Longer term, the products now under development, combined with continuing strength in the economy could result in Automotive's sales surpassing $800 million by 1996. The company's products are sold in highly competitive markets with its principal competitors including Dana Corporation and vertically integrated units of Ford, General Motors, and Chrysler. The following table summarizes sales to the company's three largest automotive customers: Years Ended December 31 (Dollars in Millions) 1993 1992 1991 1990 1989 Ford Sales $266.9 $219.3 $177.5 $179.8 $171.3 Percentage of total Corporation revenues 22.4% 21.0% 19.4% 18.4% 16.9% General Motors Sales $132.0 $148.1 $115.6 $136.3 $169.6 Percentage of total Corporation revenues 11.1% 14.2% 12.6% 13.9% 16.7% Chrysler Sales $118.2 $ 96.7 $ 75.8 $ 96.8 $106.2 Percentage of total Corporation revenues 9.9% 9.2% 8.3% 9.9% 10.5% Total 43.4% 44.4% 40.3% 42.2% 44.1% Electrical Products The Corporation's sales of electric motors which are included in the OEM Product segment totalled $242.5 million, or 20 percent of total Corporation revenues in 1993. This represents a 7 percent increase over the previous year's sales of $225.6 million. Although Electrical Products' sales increased in 1993, profits declined from 1992 levels due in part to the costs and lower initial productivity associated with transferring the hermetic motor production from Mt. Sterling, Kentucky to Mebane, North Carolina location. Product lines include jet pump motors sold to manufacturers of home water systems, swimming pools, hot tubs and spas plus fan motors used in furnaces, air conditioners and ceiling fans as well as fractional horsepower motors used in other consumer products. Hermetic motors are sold to almost every U.S. manufacturer of compressors and are used in air conditioning and refrigeration systems. In addition to selling its products directly to OEMs, Electrical Products also markets its products through a distributor network which sells to both OEMs and the related after-market. The company has maintained a reduced break-even point, which remains more than 20 percent lower than in 1989. This improved cost structure has roughly coincided with a competitive period in the motor industry and has accounted for the company's ability to remain profitable during this time. Electrical Products has reduced costs through increased productivity and higher output from its Mexican facilities and reduced manufacturing conversion costs throughout the organization. An improved economy should have a positive effect on Electrical Products' 1994 sales and earnings. Motor efficiency and environmental concerns are two areas influencing product development. Electrical Products is working with new materials and variable speed designs that can improve the efficiency of both hermetic and fractional horsepower motors. Work continues on new motors and motor insulation materials that are compatible with refrigerants that do not deplete the ozone layer. The company's principal products are sold in highly competitive markets with its major competitors being Emerson Electric, General Electric, Magnetek, Inc., Fasco and vertically integrated customers. WATER PRODUCTS Sales in 1993 were a record $248.1 million which represented 21 percent of total Corporation revenues. Sales were up over 15 percent compared to 1992 sales of $215.2 million, as the company gained market share in residential water heaters and increased unit volume in higher margin commercial heaters. Operating profits also set new highs increasing 33% percent over the prior year, which is the result of increased volume and improved pricing. Water Products believes it is the most consistently profitable water heater supplier in the extremely competitive U. S. market. Water Products markets residential gas and electric water heaters through a diverse network of plumbing wholesalers. About 80 percent of Water Products' sales is in the less cyclical replacement market although the new housing market is an important segment as well. The company's residential plants were able to adjust easily to 1993's increase in volume without significantly increasing costs. The residential water heater market remains highly competitive with Water Products and three other manufacturers supplying over 90 percent of market requirements. Water Products markets commercial water heating systems through a diverse network of plumbing wholesalers and manufacturers' representatives. Commercial water heating systems are used in a wide range of applications including schools, nursing homes, hospitals, prisons, hotels, motels, laundries, restaurants, stadiums, amusement parks, car washes, and other large users of hot water. The commercial market is characterized by a much broader range of competitors than the residential market. The company expects both sales and profits will increase in 1994 due primarily to new product introductions and an improving economy. In addition, Water Products intends to grow through the selective addition of quality distribution, possible acquisitions and further expansion of its international presence. The principal competitors in the Water Products segment are Rheem-Rudd, State Industries, Bradford-White and SABH, Inc. Water Products believes it continues to be the largest manufacturer of commercial water heaters and the fourth largest manufacturer of residential water heaters in the United States. AGRICULTURAL PRODUCTS Agricultural Products includes Harvestore and AgriStor. Harvestore sales in 1993 were $33.3 million, which were about 20 percent higher than 1992 sales of $27.7 million. The increase was attributable to demand for water and agricultural waste storage systems. Harvestore's operating profits were much improved over 1992. AgriStor revenues in 1993 were $4.8 million, down 25 percent from $6.4 million in 1992. The lower revenues resulted from a decline in the size of Agristor's lending portfolio and represents management's continued progress toward its goal of phasing out of the agricultural finance business. Agricultural Products sustained a net loss of $4.8 million between Harvestore and Agristor operations which include additional reserve provisions taken during the year. Harvestore manufactures and markets agricultural feed storage and handling systems, and industrial and municipal water and bulk storage systems. Harvestore products are distributed through a network of independent dealers. AgriStor assists farm customers in the financing of Harvestore[R] equipment out of offices in Milwaukee, Wisconsin; Columbus, Ohio; and Memphis, Tennessee. A good backlog of Slurrystore[R] systems orders combined with the recovery in industrial capital spending will benefit Harvestore in 1994. Harvestore expects sales and earnings to increase in 1994. Stable interest rates and adequate milk prices also will have a positive impact on Agristor's operations. The Corporation expects its agricultural operations loss in 1994 to be less than it was in 1993. Harvestore's principal competitor in the municipal and industrial segment is U.S. Filter. OTHER PRODUCTS Other Products consists essentially of Smith Fiberglass Products Inc. Sales of Smith Fiberglass Products Inc. totaled $58.9 million in 1993; up 34 percent from 1992 sales of $43.9 million. Strong recoveries in the service station and petroleum production markets were largely responsible for the increase in sales. The company doubled its profits compared to 1992 due primarily to this resurgence in sales. Smith Fiberglass manufactures reinforced thermosetting resin piping used to carry corrosive materials. Typical applications include chemical and industrial plant piping, oil field piping, and underground distribution at gasoline service stations. Smith Fiberglass also manufactures high pressure fiberglass piping systems used in the petroleum production industry. Its products are sold through a network of distributors. Smith Fiberglass should have another good year in 1994. The company expects to increase its presence in international markets, expand participation in the petroleum marketing segment and aggressively pursue the chemical and industrial markets. Smith Fiberglass has two principal competitors which are Ameron Corporation and Fibercast Company. Raw Material Raw materials for the Corporation's operations, which consist primarily of steel, copper and aluminum, are generally available from several sources in adequate quantities. Seasonality The Corporation's third quarter revenues and earnings have traditionally been lower than the other quarters due to Automotive Products' model year changeovers and customer plant shutdowns. Research and Development, Patents and Trademarks The Corporation conducts new product and process development at its Corporate Technology Center in Milwaukee, Wisconsin, and at its operating unit locations. The objective of this activity is to increase the competitiveness of A. O. Smith and generate new products to fit the Corporation's market knowledge. Total expenditures for research and development in 1993, 1992 and 1991 were approximately $7.6 million, $6.5 million, and $6.1 million, respectively. The Corporation owns and uses in its businesses various trademarks, trade names, patents, trade secrets and licenses. While a number of these are important to the Corporation, it does not consider a material part of its business to be dependent on any one of them. Employees The Corporation and its subsidiaries employed approximately 10,800 persons in its operations as of December 31, 1993. Backlog Normally none of the Corporation's operations sustain significant backlogs. Environmental Laws Compliance with federal, state and local laws regulating the discharge of materials into the environment or otherwise relating to the protection of the environment has not had a material effect and is not expected to have a material effect upon the capital expenditures, earnings or competitive position of the Corporation. See ITEM 3. Foreign Sales Total export sales from the U.S. were $71 million, $48 million, and $49 million in 1993, 1992, and 1991, respectively. The increase in export sales from 1992 to 1993 was largely attributable to increased Automotive Products Company exports to Canada. The amount of revenue and operating profit derived from, or the assets attributable to, sales outside the North American geographic area are not a substantial portion of total Corporation operations. ITEM 2		ITEM 2 - PROPERTIES The Corporation manufactures its products in 35 locations worldwide. These facilities have an aggregate floor space of approximately 8,927,000 square feet and are owned by the Corporation with the exception of the following leased facilities: four Automotive Products plants, two of which are approximately 124,000 square feet each, located in Corydon, Indiana and Rockford, Illinois, a plant of approximately 39,000 square feet in Bowling Green, Kentucky and a fourth plant of approximately 41,000 square feet located in Barrie, Ontario, Canada; a Water Products Company plant with floor space of approximately 84,000 square feet located in Seattle, Washington and a second plant of approximately 100,000 square feet in El Paso, Texas; and a Smith Fiberglass plant in Little Rock, Arkansas, with floor space of approximately 45,000 square feet. A 258,000 square foot facility for the Electrical Products Company in Mt. Sterling, Kentucky, a 533,000 square foot facility for the Automotive Products Company in Milan, Tennessee, and a 237,000 square foot facility for the Smith Fiberglass plant in Little Rock, Arkansas are being acquired on a lease-purchase basis and have been capitalized for accounting purposes. Included in the above totals are approximately 478,000 square feet of domestic floor space in DeKalb, Illinois, occupied by the Corporation's agricultural operations and which is being held for sale. Of the Corporation's facilities, thirteen are foreign plants with approximately 1,142,000 square feet of space, including approximately 442,000 square feet which are leased. The manufacturing plants presently operated by the Corporation are listed below by industry segment. This data excludes six plants operated by a Mexican affiliate. The principal equipment at the Corporation's facilities consist of presses, welding, machining, slitting and other metal fabricating equipment, winding machines, and furnace and painting equipment. The Corporation regards its plant and equipment as well-maintained and adequate for its needs. Multishift operations are used where necessary. ITEM 3	ITEM 3 - LEGAL PROCEEDINGS As of December 31, 1993, the Corporation and Harvestore were defendants in 26 cases alleging damages for economic losses claimed to have arisen out of alleged defects in Harvestore animal feed storage equipment. Some plaintiffs are seeking punitive as well as compensatory damages. The Corporation believes that a significant number of these claims were related to the deteriorated general farm economy at the time suit was commenced, including those filed in 1993. The Corporation and Harvestore continue to vigorously defend these cases. In 1993, nine new cases were filed and 38 cases were concluded. One of the cases filed during 1993 is a New York state court action and contains class action allegations, and names the Corporation, Harvestore and two of its dealers as defendants. Among the many motions the defendants have filed in this action is one to stay the action pending the ruling on class action certification requested by the plaintiffs in a lawsuit pending in the Federal District Court for the Southern District of Ohio. Based on the facts currently available to management and its prior experience with lawsuits alleging damages for economic loss resulting from use of the Harvestore animal feed storage equipment, management is confident that the motion for class certification in the Ohio lawsuit can be defeated and that the lawsuit does not represent a material threat to the Corporation. The Corporation believes that any damages, including any punitive damages, arising out of the pending cases are adequately covered by insurance and recorded reserves. The Corporation reevaluates its exposure periodically and makes adjustment of its reserves as appropriate. A lawsuit for damages and declaratory judgments in the Circuit Court of Milwaukee County, State of Wisconsin, in which the Corporation and Harvestore are plaintiffs, is pending against three insurance companies for failure to pay in accordance with liability insurance policies issued to the Corporation. The insurers have failed to pay, in full or in part, certain judgments, settlements and defense costs incurred in connection with pending and closed lawsuits alleging damages for economic losses claimed to have arisen out of alleged defects in Harvestore animal feed storage equipment. While the Corporation has, in part, assumed applicability of this coverage, an adverse judgment should not be material to its financial condition. As part of its routine business operations, the Corporation disposes of and recycles or reclaims certain industrial waste materials, chemicals and solvents at disposal and recycling facilities which are licensed by appropriate federal, state and local agencies. In some instances, when those facilities are operated such that hazardous substances contaminate the soil and groundwater, the United States Environmental Protection Agency ("EPA") will designate the contaminated sites as Superfund sites, and will designate those parties which are believed to have contributed hazardous materials to the sites as potentially responsible parties ("PRPs"). Under the Comprehensive Environmental Response, Compensation, and Liability Act ("CERCLA" or the "Superfund" law) and similar state laws, each PRP that contributes hazardous substances to a Superfund site is jointly and severally liable for the costs associated with cleaning up the site. Typically, PRPs negotiate with the EPA and those state environmental agencies that are involved in the matter regarding the selection and implementation of a plan to clean up the Superfund site and the terms and conditions under which the PRPs will be involved in process. PRPs also negotiate with each other regarding allocation of each PRP's share of the clean up costs. The Corporation is currently involved as a PRP in judicial and administrative proceedings initiated on behalf of the EPA seeking to clean up the environment at fifteen Superfund sites and to recover costs it has or will incur as a result of the clean up. Certain state environmental agencies have also asserted claims to recover their clean up costs in some of these actions. The sites are as follows: Two separate sites in Kentucky involving related storage and disposal facilities. Proceedings were commenced on behalf of the EPA in the United States District Court for the District of Kentucky, Louisville Division in March, 1988 with respect to these sites. A consent decree allocating liability among the PRPs for costs of remediation at the sites and the response costs of the EPA and the Commonwealth of Kentucky was executed by the Corporation in September, 1993. It is anticipated that the consent decree will be entered by the Court in 1994. A site in Indiana used for storage, treatment, recycling and disposal of waste chemicals. In January, 1984, the Company and several other PRPs became parties to an action that had been pending in the United States District Court for the District of Indiana since January, 1980 regarding this site. In July, 1988, the Corporation executed a consent decree allocating liability among the PRPs for costs of remediation at the site and the EPA's response costs. Remediation is well underway at the site. A municipal landfill in Michigan is the subject of a proceeding that was filed on behalf of the EPA in the United States District Court for the Western District of Michigan in this case in April, 1991. The final remedy has been selected and a consent decree has been executed by the PRPs and the EPA. The consent decree was entered by the Court in 1991. The bulk of the work on the remedy is expected to begin in 1995. A county owned incinerator, ash disposal lagoon and landfill in Ohio. A proceeding was commenced on behalf of the EPA in the United States District Court for the Southern District of Ohio, Western Division regarding this site in December, 1989. The final remedy has been selected and the consent decree, which was executed by the PRPs and the EPA, was entered by the Court in March, 1993. Work on the remedy began shortly after the consent decree was entered and has been progressing. An industrial and municipal waste landfill in Wisconsin. Separate proceedings were commenced on behalf of the EPA and the State of Wisconsin in the United States District Court for the Eastern District of Wisconsin in November, 1991 relative to this site. The two actions which were consolidated into a single matter in 1992. The consent decree entered into by the PRPs, the EPA and the State of Wisconsin divides the site into two operable units, the first of which deals with soil remediation and an interim groundwater remedy and the second of which is anticipated to deal with the long term groundwater remedy. Work on the design of the remedy for the first operable unit is underway. At this time, the extent to which remedial action will be required with respect to the second operable unit has not been determined. A drum disposal site in Wisconsin. In September, 1992, the Corporation joined a group of PRPs that attempted to negotiate with other PRPs and the EPA to come to agreement as to the respective liabilities of the PRPs involved at the site, the implementation of a plan to clean up the site, and the terms and conditions under which the PRPs would be involved in the process. In May, 1993, after those negotiations stalled, the EPA issued an order to 17 of the PRPs, one of which was the Corporation, under Section 106 of CERCLA requiring them to take certain measures to clean up the site. Since then negotiations resumed and settlement was reached among the PRPs with respect to some, but not all of the issues related to liability under the Section 106 order. The clean up has proceeded as directed by the EPA. A former mining site in Colorado. The Corporation held the majority of stock of a Colorado mining operation for a period of time beginning in 1936 and ending in 1942. Because of that stock ownership, the Corporation was notified by the EPA in March, 1993 that it is a PRP at the site. Estimates of clean up costs at this site have been as high as $100,000,000. The Corporation believes that a large majority of those costs relate to contamination caused by a corporation that worked the mine in the 1980s, and the EPA has indicated that it does not believe the Corporation is responsible to remediate the damage caused by those operations. The EPA is not bound by that initial determination and may seek to impose joint and several liability upon the PRPs at the site. However, the Corporation believes that it has valid defenses to any liability at this site. It is impossible at this time to reasonably estimate the Corporation's liability at this site, if any. A manufacturing facility in Indiana. In January, 1994 the Corporation received a general notice of potential liability from the EPA concerning a plant site the Corporation operated in Indiana for a brief period of time in the mid-1980s. Based upon a preliminary investigation into this matter, the Corporation believes that a viable business has a valid obligation to the Corporation to investigate and remediate contamination at this site at the cost and expense of the other business. A drum recycling facility. In 1992, the EPA commenced an action against a small group of PRPs in the United States District Court for the Western District of Michigan to recover its response costs and require the PRPs to clean up a Superfund site in Michigan. Those PRPs believe they have valid defenses to any liability at this site and have filed a motion for summary judgment in this matter. Those PRPs had previously commenced a third party contribution action against approximately eighty other parties which were involved at the subject site but were not named as defendants in the EPA's action. The Corporation became a third party defendant to that action in January, 1994. CERCLA provides that the EPA has authority to enter into de minimis settlement agreements with those PRPs that are believed to have contributed relatively small ("de minimis") amounts of materials to a Superfund site as compared to major contributors at the site. The Corporation has settled its liability at sites in Indiana and Arkansas as a de minimis party. Under those settlement agreements, the Corporation may have additional liability to participate in cleaning up the affected site under certain circumstances, such as: changes in the scope of remedial action are required to the extent that costs to clean up the site are substantially increased, or new information is discovered that indicates that the Corporation contributed more or different materials to the site than was previously believed. There is no information at this time which would indicate that the Corporation will incur any material additional liability at either site. Further, the Corporation has joined with similarly situated PRPs to negotiate settlements as de minimis parties at three sites in Indiana and Illinois. Based upon information compiled by the Corporation, the estimate of known and estimated cleanup costs for all parties at all sites involving claims filed by the EPA where the Corporation has been designated a PRP is approximately $232 million. The Corporation's estimate of the portion of the total for which the Corporation is or may be responsible is approximately $5.0 million, of which $3.6 million has been contributed towards the cleanup costs by the Corporation and its insurance companies. The balance of the identified potential cleanup costs is covered by insurance and established reserves set by the Corporation which are believed to be adequate to cover the Corporation's obligations with respect to the unpaid balance of the claims. To the best of the Corporation's knowledge, the insurers have the financial ability to pay any such covered claims. The Corporation reevaluates its exposure periodically and makes adjustment of its reserves as appropriate. The above cost estimates are not complete. It is impossible at this time to estimate the total cost of remediation for all of the sites, or the Corporation's ultimate share of those costs, for a variety of reasons. Many of the reasons are related to the fact that the sites are in various stages of the remediation process. For example, the investigation of the extent of remediation has not been completed at all sites; at several sites the final remedy has not been selected; negotiations concerning the Corporation's liability relative to the liability of the other PRPs continue at some sites; and for others, even though the remedy has been selected, final cost estimates have not been determined. Other uncertainties are based upon the current status of the law. Key issues that have not been resolved include the extent to which costs associated with the sites are recoverable from insurers, the extent to which joint and several liability can be imposed upon PRPs at the various sites, and the viability of defenses asserted by the PRPs. It is impossible to determine at this time how the courts will resolve those issues. With the exception of the former mining site in Colorado discussed above, the amount allocated to the Corporation at any specific site, or in the aggregate for all sites, is not expected to be material. Concerning the former mining site, a judgment as to materiality is premature given the early stage of the investigation, the uncertainty regarding appropriate remediation and its costs, and the potential liability of governmental agencies in this case. Over the past several years, the Corporation has self-insured a portion of its product liability loss exposure and other business risks. The Corporation has established reserves which it believes are adequate to cover incurred claims. For the year ended December 31, 1993, the Corporation had $60 million of third-party product liability insurance for individual losses in excess of $1.5 million and for aggregate losses in excess of $10 million. In March 1992, a subsidiary of the Corporation, Smith Fiberglass Products Inc. (Smith Fiberglass), won a patent infringement suit filed against a competitor. A judgment was entered in favor of Smith Fiberglass. The judgment was appealed by the defendant. However, the Court of Appeals affirmed the award in 1993 and Smith Fiberglass recognized the judgment which amounted to $1.9 million after recognition of legal fees as other income in the second quarter of 1993. A lawsuit initiated by the Corporation in connection with previously concluded antitrust action involving a former subsidiary was terminated in the second quarter of 1993 with a favorable settlement of $2.8 million which was included as other income. Reference also Note 12 in the Notes to the Consolidated Financial Statements. ITEM 4	ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of the security holders during the fourth quarter of 1993. The voting results from the Annual Meeting of Stockholders held on April 7, 1993 were previously reported in the Corporation's quarterly report on Form 10-Q for the quarter ended June 30, 1993. EXECUTIVE OFFICERS OF THE CORPORATION ROBERT J. O'TOOLE Chairman of the Board of Directors, President, and Chief Executive Officer Mr. O'Toole, 53, became chairman of the board of directors on March 31, 1992. He is a member of the Investment Policy Committee of the board. He was elected chief executive officer in March 1989. From November 1990 to May 1992, he served as head of the A. O. Smith Automotive Products Company, a division of the Corporation. He was elected president, chief operating officer and a director in 1986. He is a director of Firstar Bank Milwaukee, N.A. Mr. O'Toole joined the Corporation in 1963. GLEN R. BOMBERGER Executive Vice President, Chief Financial Officer and Director Mr. Bomberger, 56, has been a director and executive vice president and chief financial officer of the Corporation since 1986. He is a member of the Investment Policy Committee of the board of directors. He is currently a director and vice president-finance of Smith Investment Company. He is a director of Portico Funds, Inc. Mr. Bomberger joined the Corporation in 1960. DONALD L. DUNAWAY Executive Vice President Mr. Dunaway, 56, became executive vice president in 1986. He is a trustee of the Kemper Mutual Funds. Mr. Dunaway joined the Corporation in 1963. He will retire effective April 30, 1994. RODNEY A. LEMENSE Executive Vice President Mr. LeMense, 56, became executive vice president in 1986. Since July 1990, he has also been the president of A. O. Smith Water Products Company, a division of the Corporation. He is a director of The Oilgear Company. He joined the Corporation in 1957. Mr. LeMense will retire effective March 31, 1994. JOHN A. BERTRAND President ~ A. O. Smith Electrical Products Company Mr. Bertrand, 55, has been president of A. O. Smith Electrical Products Company, a division of the Corporation, since 1986. Mr. Bertrand joined the Corporation in 1960. CHARLES J. BISHOP Vice President ~ Corporate Technology Dr. Bishop, 52, has been vice president-corporate technology since 1985. Dr. Bishop joined the Corporation in 1981. DONALD M. HEINRICH Vice President ~ Business Development Mr. Heinrich, 41, was elected vice president-business development in October 1992. Previously, from 1990 to 1992, he was president of DM Heinrich & Co., a financial advisory firm. From 1983 to 1990, he was senior vice president of Shearson Lehman Brothers, an investment banking firm. SAMUEL LICAVOLI President ~ A. O. Smith Automotive Products Company Mr. Licavoli, 52, was appointed president of A. O. Smith Automotive Products Company, a division of the Corporation, in May 1992. Previously, from 1988 to 1992, he was senior vice president, and from 1984 to 1988, vice president of operations for Walker Manufacturing Company's OEM division, an automotive products company. EDWARD J. O'CONNOR Vice President ~ Human Resources and Public Affairs Mr. O'Connor, 53, has been vice president-human resources and public affairs for the Corporation since 1986. He joined the Corporation in 1970. W. DAVID ROMOSER Vice President, General Counsel and Secretary Mr. Romoser, 50, was elected vice president, general counsel and secretary on March 1, 1992. Prior thereto, he was vice president, general counsel and secretary from 1988 to 1992 and general counsel and secretary from 1982 to 1988 of Amsted Industries Incorporated, a manufacturer of railroad, building and construction and industrial products. THOMAS W. RYAN Vice President, Treasurer and Controller Mr. Ryan, 47, was elected controller in February 1990, and was elected treasurer of the Corporation in 1987. He joined the Corporation in 1985 as vice president and assistant controller. JAMES C. SCHAAP President ~ A. O. Smith Harvestore Products, Inc. Mr. Schaap, 52, has been president of A. O. Smith Harvestore Products, Inc., a subsidiary of the Corporation, since 1988. He joined the Corporation in 1977. WILLIAM V. WATERS President ~ Smith Fiberglass Products Inc. Mr. Waters, 59, has been president of Smith Fiberglass Products Inc., a subsidiary of the Corporation, since 1988. Previously, he served as vice president and controller for Smith Fiberglass Products since 1984. Mr. Waters joined the Corporation in 1960. MICHAEL W. WATT President ~ A. O. Smith Water Products Company Mr. Watt, 49, was named president of A. O. Smith Water Products Company, a division of the Corporation, on January 1, 1994. Previously, he was executive general manager from June 1988 to June 1991 and president from June 1991 to September 1993 of SABH International Group, a manufacturer of water heaters. PART II ITEM 5	ITEM 5 - MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS (a) Market Information. Both classes of A. O. Smith Corporation stock are listed on the American Stock Exchange. The symbols for these classes of the Corporation's stock are: SMCA for the Class A Common Stock and SMC for the Common Stock. Firstar Trust Company, P. O. Box 2077, Milwaukee, Wisconsin 53201 serves as the registrar, stock transfer agent and the dividend reinvestment agent for both classes of the Corporation's stock. Quarterly Common Stock Price Range (split adjusted dollars per share) 1993 1st Qtr. 2nd Qtr. 3rd Qtr. 4th Qtr. Class A Common High 22-7/16 26-1/2 30 35-7/8 Low 17-7/16 19-1/16 23-1/4 26-3/4 Common Stock High 22-5/8 26-7/8 30 35-3/4 Low 17-3/8 18-1/2 23-1/8 26-1/2 1992 1st Qtr. 2nd Qtr. 3rd Qtr. 4th Qtr. Class A Common High 13-1/8 17-3/4 18-3/16 18-15/16 Low 9-11/16 13 13-1/2 12 Common Stock High 13 17-5/8 18-1/8 19-1/8 Low 8-15/16 12-7/8 13-1/2 11-15/16 (b) Holders. As of January 31, 1994, the approximate number of holders of Class A Common Stock and Common Stock were 700 and 1300, respectively. (c) Dividends. Dividends paid on the preferred (which was redeemed in 1992) and common stock are shown in Note 14 to the Consolidated Financial Statements appearing elsewhere herein. The Corporation's credit agreements contain certain conditions and provisions which restrict the Corporation's payment of dividends. Under the most restrictive of these provisions, retained earnings of $72.1 million were unrestricted as of December 31, 1993. ITEM 6	ITEM 6 - SELECTED FINANCIAL DATA (Dollars in Thousands, except per share amounts) As discussed in Notes 10 and 11 to the Consolidated Financial Statements, the Corporation changed its method of accounting for postretirement benefits other than pensions and income taxes effective January 1, 1992. ITEM 7	ITEM 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Financial Review A. O. Smith Corporation achieved record earnings of $42.7 million or $2.08 per share in 1993 versus $28 million or $1.41 per share before a one-time charge for postretirement benefits in 1992. Three units, Automotive Products, Water Products and the Smith Fiberglass Products subsidiary, established new sales records in 1993 while increasing their profits over the prior year. Sales for the Electrical Products Company also increased over 1992, but profits of this company were adversely affected by costs associated with production transfer. Additional details of individual unit performance will be discussed later in this section. The Corporation's record operating results and improving prospects have favorably impacted the performance of its common stock over the last three years. Since the end of 1991 the market value of outstanding stock has quadrupled, increasing from $180 million to $740 million at December 31, 1993. Working capital at December 31, 1993 was $80.7 million compared to $62.6 million and $36.7 million at December 31, 1992 and 1991, respectively. Higher sales in 1993 resulted in increased working capital requirements, particularly for accounts receivable and inventories, which were partially offset by related increases in trade payables and accrued wages and benefits. In 1992, the Corporation's adoption of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" resulted in an increase in working capital versus 1991 due to the classification of $20.5 million of deferred taxes as a current asset. Capital expenditures were $54.7 million in 1993 compared to $46.9 million in 1992 and $59.3 million in 1991. In addition, production equipment acquired under a master operating lease agreement totalled $10.9 million in 1993, $8.1 million in 1992 and $19.2 million in 1991. Capital spending in 1993 was up from 1992 levels due to new Automotive Products Company programs including a full frame assembly for the new Chrysler light truck; structural components for the Ford Contour and Windstar and the Mercury Mystique; and a suspension assembly for Toyota, U.S.A. Capital acquisitions in 1992 were down from 1991 levels primarily because the Automotive Products Company's regional assembly plants had been substantially completed. The Corporation projects that it will use approximately $73 million of internally generated funds and $13 million of operating lease financing to support 1994 planned capital acquisitions of $86 million. The majority of this money will be spent by Automotive Products Company to support new product programs including full frames for a new General Motors truck and the Ford Explorer; structural components for a Nissan light truck; and engine cradles for the Ford Taurus, Mercury Sable and Lincoln Continental. Long-term debt, excluding debt of the finance subsidiary, decreased from $174.3 million in 1992 to $148.9 million at the end of 1993. The long- term debt of the finance subsidiary has been reduced, as the planned liquidation of AgriStor Credit Corporation continued, from $62.3 million in 1992 to $41.7 million at December 31, 1993. As a result of these reduced debt levels and 1993 earnings, the debt-to-equity ratio, excluding the finance subsidiary, decreased from 71.2% at December 31, 1992 to 55.2% at the end of 1993. The Corporation anticipates that, given a continued economic rebound, debt and debt-to-equity levels will decline further during 1994. The Corporation drew a total of $30 million against facilities totalling $65 million with two insurance companies. These notes have 10-year terms and carry an average interest rate of approximately 6.8 percent. During the third quarter the Corporation redeemed, at a modest premium, $10 million in Granite City Industrial Revenue Bonds. The bonds, which had a coupon rate of 11.5%, were to mature on August 1, 2003. At a special meeting on January 26, 1993, shareholders approved charter amendments to change the name of the Corporation's Class B Common Stock to "Common Stock"; permit the holders of Class A Common Stock at any time, at their option, to convert to Common Stock on a share-for-share basis; and increase the number of authorized shares. These changes have increased the Corporation's financial flexibility and enhanced the liquidity of the Common Stock. On February 1, 1993, the Board of Directors declared a special, one-time dividend of $.25 per share, (split-adjusted), which was paid only to Common Stockholders (formerly Class B) of record as of March 8, 1993. Subsequent to the declaration of the special dividend on the Common Stock, split-adjusted shares totaling 4,019,366 of Class A Common Stock including 1,133,584 shares held in Treasury were converted by the holders into Common Stock. At its June 8, 1993 meeting, A. O. Smith Corporation's Board of Directors approved a 2-for-1 split of the Corporation's Class A and Common Stock effected in the form of a 100 percent stock dividend to shareholders on August 16, 1993. In addition, the Board of Directors increased the regular quarterly dividend by 10 percent to a split-adjusted $.11 per share on its common stocks (Class A and Common) for the last two quarterly dividend payments of 1993, resulting in a total of $.42 per share being paid versus $.40 per share in 1992. A. O. Smith Corporation has paid dividends on its common stock for 54 consecutive years. Results of Operations Revenues in 1993 were $1.19 billion establishing a record and surpassing 1992 revenues of $1.05 billion by 14 percent and 1991 revenues of $915.8 million by 30 percent. All of the Corporation's product operations reported double digit percentage increases in sales in 1993 with the exception of the Electrical Products Company where sales increased 7.5 percent over 1992. For the second consecutive year the Automotive Products Company provided the majority of the Corporation's year-to-year sales increase as the recovery in the domestic automotive industry which commenced in 1992 gained momentum in 1993. The Corporation's gross profit margin was 14.9 percent in 1993, representing a significant improvement from 13.6 percent and 11.1 percent gross margins in 1992 and 1991, respectively. The impact of increased volume was evident in the favorable trend in the gross margin. The Automotive Products Company achieved record sales of $606.3 million in 1993, reflecting a 14.9 percent increase from 1992 sales of $527.6 million and a 42.3 percent increase from 1991 sales of $426.1 million. The record sales were a result of several factors. Light trucks continued to be the vehicle of choice within the marketplace, as evidenced by the second straight year in which this market has demonstrated 11 percent growth. Automotive benefitted from the preference for this vehicle type over the past two years, since it is a supplier for such popular vehicles as the Ford Ranger, Econoline, and Explorer, General Motors GMT-400 and Suburban, and the recently introduced redesigned Dodge Ram pick-up. The successful launch of Chrysler's three new mid-sized LH model passenger cars also had a major impact on Automotive's sales growth in 1993. The excellent acceptance of these Chrysler vehicles resulted in additional production of engine cradles and rear suspension modules and resulted in a new line being placed in Automotive's plant in Belcamp, Maryland. Sales of heavy- truck related products also bolstered Automotive's sales as the number of heavy trucks sold during the year was the highest in the last five years. Operating profits at Automotive increased over 1992 which in turn reflected a significant improvement over the loss incurred in 1991. The favorable trend in earnings was a direct result of Automotive's position as a supplier of vehicles experiencing strong demand. The prognosis for 1994 is encouraging. In addition to the core of successful products for which Automotive is the supplier, several new launches will occur during the year. Shipment of engine cradles and rear trailing axles for the new Ford Windstar mini van will begin in the first quarter as will production of rear suspension assemblies for Toyota U.S.A. During the second quarter Automotive will commence manufacturing of engine cradles for the new Ford Contour/Mercury Mystique. Later in the year Automotive will begin producing cradles for the redesigned Lincoln Continental. Additional programs are being developed for subsequent years and with a new automotive products office in Yokohama, Japan, a very good opportunity exists for early involvement in future new products to be manufactured by the Japanese. Equity in the earnings of the Corporation's 40-percent owned Mexican affiliate, Metalsa S.A., was $2.3 million in 1993 compared to $3.5 million and $1.5 million in 1992 and 1991, respectively. In 1993, Metalsa's sales decreased approximately 10% due to a decline in automotive industry sales in Mexico. Earnings were lower than the prior year due to the lower sales, product mix, and certain restructuring costs. In 1992, Metalsa's sales increased about 8 percent over 1991 due to the improved Mexican economy and, in particular, strength in the automotive sector. This increase, combined with higher gross margins, lower administrative and interest costs, and a low effective tax rate due to the benefit of tax loss carryforwards, resulted in a significant increase in profits compared to 1991. Sales at the Electrical Products Company increased 7.5 percent in 1993 to $242.5 million from $225.6 million in 1992. Sales in 1991 were $205 million. The company has shown a steady growth in sales over the past two years despite weak market conditions and competitive pressures. In 1993 the market for pools, spas and room air conditioners was adversely impacted by poor spring weather while in 1992 the same market was affected by a cautious attitude on the part of consumers toward discretionary spending. Although sales increased in 1993, earnings declined from the 1992 level and were sightly better than in 1991. The favorable impact of increased 1993 volume and productivity improvements resulting from the initiation of a continuous improvement program throughout the organization were more than offset by the costs associated with transferring the hermetic motor production from the Mt. Sterling, Kentucky plant to the lower-cost Mebane, North Carolina location. Costs associated with the transfer of production, which was substantially completed in 1993, amounted to several million dollars. Sales for the Water Products Company established a record for the second straight year in 1993, increasing more than 15 percent to $248.1 million from the previous record of $215.2 million in 1992. 1991 sales were $194.6 million. The domestic residential water heater market as a whole increased by nearly seven percent in 1993 with Water Products benefitting from this expanded market by capturing more than a pro rata share of the increase. The company's most notable market penetration occurred in the western United States where additional product distribution was established. The introduction of the power vent line of water heaters also had a favorable impact on residential volume. The commercial segment of the business experienced mixed results. While the sales of replacement commercial heaters was strong in 1993, a weakness in commercial construction caused a decline in sales of specialty commercial units. Plans to increase the activity in the international export market, introduction of redesigned commercial products and an expected increase in housing starts in 1994 should continue the trend of improved sales. Earnings for the Water Products Company increased significantly in 1993 when compared to 1992 and 1991 as a result of higher revenues and the ability to minimize incremental manufacturing costs associated with the additional volume. Sales for Smith Fiberglass Products, Inc. increased 34 percent in 1993 to $58.9 million from $43.9 million in 1992 and exceeded the previous record of $53.9 million in 1991. Strong recoveries in the service station and petroleum production markets contributed significantly to the increase in sales over both 1992 and 1991. 1993 volumes were particularly strong in the service station market as customers increased their fiberglass pipe installation to meet environmental regulations including the requirements of the Federal Clean Air Act Amendments. The shipment of a large overseas oil field order provided a major share of the increase in petroleum production volume in 1993. The chemical and industrial segment of the business experienced a relatively flat year in 1993. Continued penetration of the overseas markets coupled with domestic service station demand resulting from state programs to comply with federal vapor recovery regulations bode well for 1994 sales activity. Earnings for Fiberglass Products in 1993 more than doubled 1992 earnings and were improved over 1991. The increased earnings were a direct result of the resurgence of demand in the service station and petroleum production market. Revenues for agricultural products were $38.1 million in 1993, an increase of $4.1 million and $2.0 million over 1992 and 1991, respectively. Much of the increase in sales was attributable to the water storage segment of A. O. Smith Harvestore Products, Inc. (Harvestore) where new markets for this product line have developed as a result of recent Environmental Protection Agency regulations regarding the handling and disposal of waste water. Harvestore's 1993 earnings were much improved over both 1992 and 1991 as a result of higher volume. Revenues for AgriStor Credit Corporation were $7.7 million, $6.4 million and $4.8 million in 1991, 1992, and 1993, respectively. This trend of decreasing revenues is consistent with management's objective of expeditiously liquidating this finance subsidiary. As the liquidation proceeds, the losses of AgriStor continue to decline as a result of reduced operating expenses. Despite operating earnings improvement for Harvestore and AgriStor the overall loss within the agricultural segment has been relatively consistent over the period of 1991 to 1993 reflecting the impact of maintaining adequate bad debt and liability reserves. Selling, general and administrative expense in 1993 was $96.3 million compared to $85.6 million in 1992 and $77.9 million in 1991. The increases over this time period were caused in part by higher employee incentive and profit sharing accruals associated with the improved earnings. Higher commissions and other expenses in support of the increased sales volumes also contributed to the upward trend. Interest expense in 1993 was $13.4 million and compares favorably to interest of $17.9 million in 1992 and $20.9 million in 1991. The trend of declining interest expense is a function of the continuation of lower interest rates in conjunction with a steady reduction in debt levels throughout the three year period. During 1993, other income and expense for the Corporation reflected several non-recurring items which had a minimal aggregate impact on net earnings. A total of $4.7 million of income was recognized as a result of favorable resolution of litigation which was offset by the impairment or write off of certain fixed assets and receivables. The Corporation's overall effective income tax rate increased from 1992 to 1993 due to the one percent federal rate increase and increased state franchise taxes. For purposes of determining net periodic pension expenses, the discount rate was reduced to 8.5 percent. A further reduction in the discount rate to 7.75 percent was made as of year-end to determine the benefit obligations. At discount rates below 7.75 percent, management estimates each 25 basis points of incremental lower discount rate would reduce earnings by about two cents per share and would increase the pension liability adjustment charged to stockholders' equity by about $3.5 million. The assumed rate of return on plan assets was reduced to 10.25 percent in 1993. While this return assumption has been exceeded meaningfully and consistently, including 1993 when the return was 14.8 percent, management deemed it prudent to reduce the rate to reflect current market conditions. The changes made resulted in an increase of approximately $2.0 million in pension expense for 1993 compared to 1992. As to other postretirement benefits, a reduction in discount rate assumption to 7.75 percent was also made. Due to recent coverage policy changes and current demographics, the discount rate change is anticipated to have only a minimal impact on future expense. A. O. Smith Corporation achieved record net earnings in 1993 of $42.7 million or $2.08 per share. In 1992 the Corporation earned $28 million or $1.41 per fully diluted share before recognition of a one-time charge for postretirement benefits as required by Financial Accounting Standard No. 106 "Employers' Accounting for Postretirement Benefits Other Than Pensions". The Corporation recorded an after tax charge of $46.1 million, or $2.25 per share to record the cumulative effect of the accounting change. 1992's earnings were also impacted by a $1.6 million favorable cumulative effect as a result of the Corporation being able to recognize tax credits. This tax adjustment was required due to the adoption of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" in the first quarter of 1992. As a result of adopting FAS Nos. 106 and 109 in 1992, the Corporation reported a net loss applicable to common shareholders of $18.2 million or $.84 per fully diluted share. 1991 was essentially a break-even year. The Corporation achieved its expectation of establishing new sales and earnings records in 1993. Considering domestic light vehicle sales are projected to increase in 1994, the process of transferring electric motor production is complete, and interest rates appear stable at historically attractive rates, it appears that similar expectations may be achieved in 1994. ITEM 8	ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Index to Financial Statements: Form 10-K Page Number Report of Independent Auditors . . . . . . . . . . . . . 23 Consolidated Balance Sheet at December 31, 1993 and 1992 24 For each of the three years in the period ended December 31, 1993: - Consolidated Statement of Operations and Retained Earnings . . . . . . . . . . . . . . . 25 - Consolidated Statement of Cash Flows . . . . . . . 26 Notes to Consolidated Financial Statements . . . . . 27-46 REPORT OF ERNST & YOUNG, INDEPENDENT AUDITORS The Board of Directors and Stockholders A. O. Smith Corporation We have audited the accompanying consolidated balance sheet of A. O. Smith Corporation as of December 31, 1993 and 1992 and the related consolidated statements of operations and retained earnings and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index in Item 14(a). These financial statements and schedules are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of A. O. Smith Corporation at December 31, 1993 and 1992, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Notes 10 and 11 to the financial statements, the Corporation changed its method of accounting for postretirement benefits other than pensions and income taxes effective January 1, 1992. ERNST & YOUNG Milwaukee, Wisconsin January 19, 1994 CONSOLIDATED BALANCE SHEET December 31 (Dollars in Thousands) Assets 1993 1992 Current Assets Cash and cash equivalents $ 11,902 $ 6,025 Trade receivables 126,949 102,172 Finance subsidiary receivables and leases 19,151 19,680 Customer tooling 15,471 5,651 Inventories 89,804 72,750 Deferred income taxes 27,614 20,487 Other current assets 12,987 7,432 ------- ------- Total Current Assets 303,878 234,197 Investments in and advances to affiliated companies 23,669 22,919 Deferred model change 22,095 34,652 Finance subsidiary receivables and leases 53,481 67,098 Other assets 44,962 46,015 Net property, plant and equipment 375,014 364,106 -------- -------- Total Assets $823,099 $768,987 ======== ======== Liabilities Current Liabilities Trade payables $ 99,320 $ 62,106 Accrued payroll and pension 38,347 29,803 Postretirement benefit obligation 8,950 8,332 Accrued liabilities 59,448 57,752 Income taxes 2,707 840 Long-term debt due within one year 8,819 6,406 Finance subsidiary long-term debt due within one year 5,598 6,401 -------- ------- Total Current Liabilities 223,189 171,640 Long-term debt 148,851 174,284 Finance subsidiary long-term debt 41,723 62,337 Postretirement benefit obligation 69,773 71,198 Product warranty 12,981 10,917 Deferred income taxes 41,281 28,148 Other liabilities 15,671 5,807 -------- ------- Total Liabilities 553,469 524,331 Commitments and contingencies (notes 7 and 12) Stockholders' Equity Preferred Stock -- -- Class A Common Stock (shares issued 6,084,845 and 5,039,498) 30,424 25,197 Common Stock (shares issued 15,614,805 and 5,766,927) 15,615 5,767 Capital in excess of par value 65,950 78,009 Retained earnings 177,543 147,065 Cumulative foreign currency translation adjustments (841) 656 Pension liability adjustment (9,141) (1,120) Treasury stock at cost (9,920) (10,918) -------- -------- Total Stockholders' Equity 269,630 244,656 -------- -------- Total Liabilities and Stockholders' Equity $823,099 $768,987 ======== ======== See accompanying notes which are an integral part of these statements. CONSOLIDATED STATEMENT OF OPERATIONS AND RETAINED EARNINGS Years ended December 31 (Dollars in Thousands, except per share amounts) Operations 1993 1992 1991 Net revenues $1,193,870 $1,046,345 $915,833 Cost of products sold 1,015,397 903,615 813,960 --------- --------- ------- Gross profit 178,473 142,730 101,873 Selling, general and administrative expenses 96,345 85,578 77,866 Interest expense 13,431 17,897 20,874 Other expense--net 179 448 669 -------- -------- ------- 68,518 38,807 2,464 Provision for income taxes 28,124 15,122 560 -------- -------- ------- Earnings before equity in earnings of affiliated companies 40,394 23,685 1,904 Equity in earnings of affiliated companies 2,284 3,521 1,546 -------- -------- ------- Earnings Before Cumulative Effect of Changes in Accounting Principles 42,678 27,206 3,450 Tax credits realizable under FAS No. 109 resulting from reclassification of agricultural businesses -- 1,600 -- -------- -------- ------- Earnings before effect of postretirement benefits 42,678 28,806 3,450 Change in method of accounting for postretirement benefits, net of tax benefit of $28,873 -- (46,122) -- -------- -------- ------- Net Earnings (Loss) 42,678 (17,316) 3,450 Preferred dividends (per share-- $.00, $.531 and $2.125, respectively) -- (856) (3,425) -------- -------- ------- Net Earnings (Loss) Applicable to Common Stock 42,678 (18,172) 25 Retained Earnings Balance at beginning of year 147,065 172,869 179,176 Cash dividends on common stock (12,200) (7,632) (6,332) -------- -------- ------- Balance at End of Year $ 177,543 $ 147,065 $172,869 ======== ======== ======= Primary Earnings (Loss) Per Share of Common Stock Earnings before cumulative effect of accounting changes $2.08 $1.40 $ .00 Realization of tax credits of agricultural businesses -- .08 -- -------- ------- ------- Earnings before effect of postretirement benefits 2.08 1.48 .00 Change in postretirement benefits, net of taxes -- (2.44) -- -------- ------- ------- Net earnings (loss) $2.08 $(.96) $ .00 ======= ======= ======= Fully Diluted Earnings (Loss) Per Share of Common Stock Earnings before cumulative effect of accounting changes $2.08 $1.33 $ .00 Realization of tax credits of agricultural businesses -- .08 -- ------ ------ ------ Earnings before effect of postretirement benefits 2.08 1.41 .00 Change in postretirement benefits, net of taxes -- (2.25) -- ------ ------ ------ Net earnings (loss) $2.08 $(.84) $ .00 ====== ====== ====== See accompanying notes which are an integral part of these statements. See accompanying notes which are an integral part of these statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Summary of Significant Accounting Policies Consolidation and Basis of Presentation. The consolidated financial statements include the accounts of the Corporation and its wholly-owned subsidiaries including the Corporation's agricultural businesses which are being held for sale or liquidation. Foreign Currency Translation. Financial statements for the Corporation's subsidiaries outside of the United States are translated into U.S. dollars at year-end exchange rates for assets and liabilities and weighted average exchange rates for revenues and expenses. The resulting translation adjustments are recorded as a component of stockholders' equity. Inventory Valuation. Domestic inventories are carried at lower of cost or market determined on the last-in, first-out (LIFO) method. Inventories of foreign subsidiaries and supplies are determined using the first-in, first-out (FIFO) method. Futures Contracts. The Corporation enters into futures contracts to hedge certain raw material purchases, principally copper and aluminum, with the objective of minimizing cost risk due to market fluctuations. Any gains or losses from hedging transactions are included as part of the inventory cost. The Corporation also enters into forward foreign exchange contracts to hedge foreign currency transactions on a continuing basis for periods consistent with its committed exposures. The Corporation does not engage in speculation. The Corporation's foreign exchange contracts do not subject the Corporation to risk due to exchange rate movements because gains and losses on these contracts offset gains and losses on the assets, liabilities, and transactions being hedged. Gains and losses are recognized in the same period in which gains or losses from the transactions being hedged are recognized. As of December 31, 1993, the Corporation and its foreign subsidiaries had contracts to purchase or sell the U.S. dollar equivalent of $36.2 million in foreign currencies (Canadian dollars, Irish punts, British pounds, Dutch guilders and French francs) at varying maturities, most of which occur during 1994. Deferred Model Change. Tool costs not reimbursed by customers and expenses associated with significant model changes are amortized over the estimated model life which ranges from four to ten years, with the shorter periods associated with automobile structural components and the longer periods associated with structural components for trucks. Property, Plant and Equipment. Property, plant and equipment are stated at cost. Depreciation is computed primarily by the straight-line method. Finance Subsidiary. Finance charges for retail contracts receivable are recognized as income as installments become due using the interest method. For direct finance leases, income is recognized based upon a constant rate of return on the unrecovered lease investment over the term of the related lease. Income Taxes. The Corporation accounts for income taxes using the liability method prescribed by FAS No. 109 in 1993 and 1992 and FAS No. 96 in 1991. Research and Development. Research and development costs are charged to expense as incurred and amounted to approximately $7.6, $6.5 and $6.1 million during 1993, 1992 and 1991, respectively. Common Stock Dividend. On January 26, 1993, the stockholders authorized certain increases in the authorized capital stock as follows: increase of 1,000,000 shares of Class A Common Stock for a total of 7,000,000 shares and 12,000,000 shares of Common Stock (formerly Class B Common Stock) for a total of 24,000,000 shares. In addition, the stockholders authorized the conversion of the Class A Common Stock into Common Stock on a share- for-share basis, at any time, at the option of the holder. On June 8, 1993, the Board of Directors declared a two-for-one stock split in the form of a 100 percent stock dividend to stockholders of record on July 30, 1993 and payable on August 16, 1993. All references in the financial statements to average number of shares outstanding, price per share, per share amounts and stock option plan data have been restated to reflect the split. Earnings (Loss) Per Share of Common Stock. Primary per share amounts are determined by dividing earnings (loss) applicable to common shareholders by the weighted average number of shares of common stock and materially dilutive common stock equivalents (stock options) outstanding. Fully diluted per share amounts include the dilutive effect, if any, of the assumed conversion in 1991 and 1992 of the outstanding preferred stock into common stock with appropriate adjustments being made to earnings (loss) applicable to common stock for dividends on the preferred stock. For 1992, fully diluted net loss per share amounts are anti-dilutive because of the preferred stock conversion. If the redemption of the Series I Preferred Stock discussed in Note 8 had taken place at the beginning of 1992, primary loss per share for 1992 would not have been significantly impacted. Reclassifications. Certain prior year amounts have been reclassified to conform to the 1993 presentation. 2. Statement of Cash Flows For purposes of the consolidated statement of cash flows, cash and cash equivalents include investments with original maturities of three months or less. Supplemental cash flow information is as follows: Years ended December 31 (Dollars in Thousands) The finance subsidiary provided cash before financing activities of $21.4, $13.7 and $11.7 million in 1993, 1992 and 1991, respectively. 3. Agricultural Businesses The Corporation's strategic plan is to concentrate the Corporation's resources in nonagricultural businesses and withdraw from the agricultural market. The strategy includes plans to sell A. O. Smith Harvestore Products, Inc. (Harvestore), a wholly-owned manufacturing subsidiary, and to phase out AgriStor Credit Corporation (AgriStor), a wholly-owned finance subsidiary. Due to the uncertainties which continue to impact the farm sector, it is not possible to predict when the sale of Harvestore will occur. The Corporation is continuing to phase out AgriStor's operations in an orderly manner. The agricultural businesses are classified as continuing operations in accordance with SEC Staff Accounting Bulletin No. 93. The Corporation's consolidated balance sheet includes AgriStor. A condensed consolidated balance sheet of AgriStor is presented below: December 31 (Dollars in Thousands) 1993 1992 Assets Cash and cash equivalents $ 3,680 $ 4,688 Retail contracts receivable 29,049 33,856 Net investment in leases 32,023 37,685 Residual value of equipment 11,560 15,237 Due from parent 13,660 19,908 Other assets 2,941 4,161 ------- -------- Total Assets $92,913 $115,535 ======= ======== Liabilities and stockholder's equity Long-term debt due within one year $ 5,598 $ 6,401 Other liabilities 21,838 21,410 Long-term debt 41,723 62,337 Subordinated debt due parent -- 1,900 Stockholder's equity 23,754 23,487 ------- -------- Total Liabilities and Stockholder's Equity $92,913 $115,535 ======= ======= The receivables and net investment in leases are net of bad debt reserves totalling $14.6 and $20.6 million at December 31, 1993 and 1992, respectively. AgriStor is the lessor in the direct finance leasing of Harvestore equipment. The equipment has an estimated economic life of 15 years and is leased under agreements with original terms of 5 to 12 years. Following is a summary of the components of net retail contracts receivable and net investment in leases, which are included in the consolidated balance sheet as finance subsidiary receivables and leases. December 31 (Dollars in Thousands) 1993 1992 Installment contracts and loans (net of allowance for credit losses) $32,362 $ 39,044 Less unearned finance charges (3,313) (5,188) ------ ------ Net installment contracts and loans 29,049 33,856 Gross rentals receivable (net of allowance for credit losses) 17,789 21,252 Less unearned and deferred income (5,653) (8,033) Estimated residual value 11,560 15,237 Equipment held for resale 19,887 24,466 ------- ------ 43,583 52,922 ------- ------ Total $72,632 $ 86,778 ======= ======== Current $19,151 $ 19,680 Non-current 53,481 67,098 ------- -------- Total $72,632 $ 86,778 ======= ======== There is no quoted market price available for the retail contracts and leases. Management believes fair value approximates book value. While some maturities extend beyond the year 2000, the portfolio is predominantly of two to three year duration carrying an average interest rate of 8.2%. As a liquidating business, it is possible certain instruments could be sold before maturity and gains or losses recognized at time of sale. Given the maturities involved, it is not expected that such gains or losses would be material to the financial condition of the Corporation. Finance subsidiary long-term debt was comprised of the following: December 31 (Dollars in Thousands) 1993 1992 Bank credit lines, average year-end interest rate of 3.8% for 1993 and 6.0% for 1992 $ 4,969 $ 4,640 Commercial paper, average year-end interest rate of 3.5% for 1993 and 3.9% for 1992 32,159 50,110 Other notes, expiring through 1998, average year-end interest rate of 8.1% for 1993 and 8.1% for 1992 10,193 13,988 ------- ------- 47,321 68,738 Less amount due within one year 5,598 6,401 ------- ------- $41,723 $62,337 ======= ======= AgriStor has $36.5 million in committed bank credit facilities at December 31, 1993. The total consists of a $35 million multi-year revolving credit facility from a group of eleven banks which expires January 2, 1997 and $1.5 million from a revolver bank under a separate revolving credit facility to provide additional liquidity for up to one year. In addition, AgriStor Credit Corporation-Canada (AgriStor Canada) has a $7.6 million credit facility to meet its borrowing needs. Included in AgriStor's other notes are a $5.0 million term loan with a final maturity in 1995 and a $5.2 million note with a final maturity in 1998 for AgriStor-Canada which require a combined annual principal payment of $3.5 million in 1994. It has been AgriStor's practice to renew or replace its credit agreements to maintain 100% coverage of its borrowing needs in the commercial paper market as well as its direct borrowing under the credit facilities. AgriStor has entered into interest rate swap agreements to minimize the impact of changes in interest rates on its line of credit and commercial paper borrowings. At December 31, 1993, AgriStor had outstanding three interest rate swap agreements and four interest rate cap agreements with commercial banks, having a total notional principal of $40 million. The fixed rates under the swap agreements range from 7.46% to 7.84% and expire August 6, 1994. The interest rate cap agreements expire February 21, 1995. Long-term, debt maturing within each of the five years subsequent to December 31, 1993, is as follows: 1994--$5.6, 1995--$3.5, 1996--$1.0, 1997--$1.0, 1998--$1.0 million. A condensed consolidated statement of operations of AgriStor is presented below. The following does not include certain bad debt reserves provided by the Corporation totalling $1.8, $1.4 and $1.0 million in 1993, 1992 and 1991, respectively: Years Ended December 31 (Dollars in Thousands) 1993 1992 1991 Revenues $ 4,783 $ 6,354 $ 7,713 Interest expensed and paid 3,794 5,984 7,937 General and administrative expenses 2,951 3,250 4,553 ------- ------- ------- Total expenses 6,745 9,234 12,490 ------- ------- ------- Loss before income taxes $(1,962) $(2,880) $(4,777) ======= ======= ======= 4. Inventories December 31 (Dollars in Thousands) 1993 1992 Finished products $ 53,337 $ 41,951 Work in process 37,215 31,901 Raw materials 36,371 31,043 Supplies 5,228 6,054 -------- -------- 132,151 110,949 Allowance to state inventories at LIFO cost 42,347 38,199 -------- -------- $ 89,804 $ 72,750 ======== ======== During 1992 and 1991, inventory reductions in certain operations resulted in liquidations of certain LIFO inventory quantities acquired at lower costs in prior years as compared with 1992 and 1991 costs, the effect of which reduced the 1992 net loss by $2.8 million and increased the 1991 net earnings by $.6 million. The inventory amounts exclude $19.9 and $24.5 million, respectively, of equipment held for resale by AgriStor. 5. Investments in and Advances to Affiliated Companies Investments in affiliates in which ownership is 50 percent or less are accounted for under the equity method. During 1993, 1992 and 1991, the Corporation received dividends of $2.8, $1.3 and $.8 million, respectively, from such affiliates. The Corporation's equity in the undistributed earnings of such affiliates at December 31, 1993, amounted to approximately $22.5 million. In 1993, the Corporation advanced $1.2 million to its Mexican affiliate with repayment due in 1996 and interest at 5% due quarterly. 6. Property, Plant and Equipment December 31 (Dollars in Thousands) 1993 1992 Land $ 7,538 $ 7,539 Buildings 183,485 175,883 Equipment 632,763 600,692 -------- -------- 823,786 784,114 Less accumulated depreciation 448,772 420,008 -------- -------- $375,014 $364,106 ======== ======== Interest on borrowed funds during construction of $1.1, $.8 and $3.0 million was capitalized in 1993, 1992 and 1991, respectively. As of December 31, 1993, the Corporation has pledged $4.1 million of net property, plant and equipment under long-term debt obligations. 7. Long-Term Debt and Lease Commitments December 31 (Dollars in Thousands) 1993 1992 Bank credit lines, average year-end interest rate of 3.8% for 1993 and 4.6% for 1992 $ 12,413 $ 14,340 Commercial paper, average year-end interest rate of 3.5% for 1993 and 3.9% for 1992 60,838 94,508 8.75% notes, payable annually through 1997 14,275 17,850 8.9% term loan, payable semi-annually, through April 1996 12,500 15,000 Long-term notes, expiring through 2003, average year-end interest rate of 6.8% for 1993 30,000 -- Other notes, expiring through 2012, average year-end interest rate of 5.8% for 1993 and 8.3% for 1992 27,644 38,992 ------- -------- 157,670 180,690 Less amount due within one year 8,819 6,406 ------- -------- $148,851 $174,284 ======== ======== The Corporation has a $115 million multi-year revolving credit facility from a group of eleven banks which expires April 3, 1996. At its option, the Corporation maintains either cash balances or pays fees for bank credit and services. In 1993, the Corporation entered into two loan facilities with insurance companies totalling $65 million. Through December 31, 1993, the Corporation had drawn down, under ten year terms, $30 million under these facilities. The Corporation used a portion of these proceeds to redeem a $1.2 million bank note with an interest rate of 9.5% due December 1, 2001 and, at a modest premium, a $10 million Industrial Revenue Bond with an interest rate of 11.5% due August 1, 2003 saving several million dollars in interest costs over the remaining term of the retired instruments. The Corporation's credit agreement and term loans contain certain conditions and provisions which restrict the Corporation's payment of dividends. Under the most restrictive of these provisions, retained earnings of $72.1 million were unrestricted as of December 31, 1993. Borrowings under the bank credit lines and in the commercial paper market are supported by the revolving credit agreements and have been classified as long-term. It has been the Corporation's practice to renew or replace the credit agreements so as to maintain the availability of debt on a long-term basis and to provide 100% backup for its borrowings in the commercial paper market. Long-term debt, exclusive of AgriStor, maturing within each of the five years subsequent to December 31, 1993, is as follows: 1994--$8.8; 1995--$8.9; 1996--$6.6; 1997--$7.9; 1998--$5.0 million. The Corporation sold, without recourse and at market rates, certain automotive related receivables totalling $16.0 million at December 31, 1993, compared to $14.0 million at December 31, 1992. The receivables sale program is scheduled to expire on April 30, 1994, unless mutually extended. Future minimum payments under noncancelable operating leases total $105.4 million and are due as follows: 1994--$20.7; 1995--$18.1; 1996--$14.6; 1997--$13.1; 1998--$12.7; thereafter--$26.2 million. Rent expense, including payments under operating leases, was $28.2, $27.5 and $23.9 million in 1993, 1992 and 1991, respectively. Interest paid by the Corporation, excluding AgriStor, was $10.2, $12.4 and $12.5 million in 1993, 1992 and 1991, respectively. 8. Stockholders' Equity As of December 31, 1993, there were 7,000,000 shares of Class A Common Stock $5 par value, 24,000,000 shares of Common Stock $1 par value and 3,000,000 shares of preferred stock $1 par value authorized. The Common Stock has equal dividend rights with Class A Common Stock and is entitled as a class to elect 25 percent of the board of directors and has 1/10th vote per share on all other matters. On February 1, 1993 the Board of Directors declared a special $.25 per share dividend payable on March 22 to Common Stockholders of record March 8. No special dividend was declared on the Class A Common Stock. During 1993, 2,009,683 shares of Class A Common Stock including 623,362 shares held in Treasury were converted by the holders into Common Stock. Regular dividends paid on the Class A Common and Common Stock amounted to $.42, $.40 and $.40 per share in 1993, 1992 and 1991, respectively. The Corporation issued 1,725,000 shares of Series I Preferred Stock in 1985. The preferred stock was convertible at the option of the holder at any time into approximately 1.1905 shares of Common Stock. The Corporation called for redemption of all of its $2.125 Convertible Exchangeable Preferred Stock on April 23, 1992. The Corporation issued 1,901,458 shares of Common Stock as a result of the conversion of 1,597,313 shares of its preferred stock prior to the redemption date with cash of $377,659 paid in lieu of 14,387 shares of preferred stock which otherwise would have been converted into fractional shares of Common Stock. On January 26, 1993, the stockholders authorized a restatement of the Certificate of Incorporation deleting the designation relating to Series I Preferred Stock. Changes in certain components of stockholders' equity are as follows: In 1993, 5,930 shares of treasury stock were acquired under a purchase offer made to holders of less than 100 shares of Class A Common Stock and Common Stock. At December 31, 1993, 3,460 and 1,009,324 shares of Class A Common Stock and Common Stock, respectively, were held as treasury stock. 9. Stock Options During 1990, the Corporation adopted a Long-Term Executive Incentive Compensation Plan (1990 Plan). The 1990 Plan initially reserved 1,000,000 shares of common stock for granting of nonqualified and incentive stock options. The Corporation will submit a proposal to stockholders in 1994 for approval to reserve an additional 1,000,000 shares of Common Stock. Each option entitles the holder upon exercise to obtain one share of Common Stock. In addition, the Corporation has a Long-Term Executive Incentive Compensation Plan (1980 Plan) which has terminated except as to outstanding options. Options under both plans become exercisable one year from date of grant and, for active employees, expire ten years after date of grant. The number of shares available for granting of options at December 31, 1993 and 1992 was 25,400. Options as to 188,400 shares granted in 1993 are subject to approval by the stockholders. Changes in option shares (all Common Stock) were as follows: Years ended December 31 1993 1992 1991 Outstanding at beginning of year 1,184,200 1,627,200 1,469,400 Granted 1993--$27.50 per share 188,400 1992--$11.125 to $15.188 per share 232,200 1991--$8.438 and $9.563 per share 262,400 Exercised 1993--$6.375 to $15.188 per share (362,800) 1992--$6.375 to $9.563 per share (666,200) 1991--$6.375 to $8.688 per share (104,600) Canceled or expired -- (9,000) -- ------- -------- -------- Outstanding at End of Year (1993--$7.00 to $27.50 per share) 1,009,800 1,184,200 1,627,200 ========= ========= ========= Exercisable at December 31, 1993 821,400 ======= 10. Retirement Plans The Corporation and its domestic subsidiaries have noncontributory defined benefit pension plans covering all employees. Plans covering salaried employees provide benefits that are based on an employee's years of service and compensation. Plans covering hourly employees provide benefits of stated amounts for each year of service. The Corporation's funding policy is to contribute amounts which are actuarially determined to provide the plans with sufficient assets to meet future benefit payment requirements consistent with the funding requirements of federal laws and regulations. Plan assets consist primarily of marketable equities and debt securities. The Corporation also has several foreign pension plans, none of which are material. The following tables present the components of pension expense, the funded status and the major assumptions used to determine these amounts for domestic pension plans: 1993 1992 Minimum liability adjustment $39,598 $28,213 Intangible asset 24,539 26,392 ------- ------- 15,059 1,821 Tax benefit 5,918 701 ------- ------- Pension liability adjustment to stockholders' equity $ 9,141 $ 1,120 ======= ======= Major assumptions at year-end: 1993 1992 1991 Discount rate 7.75% 8.75% 8.75% Rate of increase in compensation level 4.00% 5.50% 5.50% Expected long-term rate of return on assets 10.25% 10.50% 10.50% Net periodic pension cost is determined using the assumptions as of the beginning of the year. The funded status is determined using the assumptions as of the end of the year. The Corporation has a defined contribution profit sharing and retirement plan covering salaried nonunion employees which provides for annual corporate contributions of 35 percent to 140 percent of qualifying contributions made by participating employees. The amount of the Corporation's contribution in excess of 35 percent is dependent upon the Corporation's profitability. The amount of the contribution was $4.0, $2.3 and $1.2 million for 1993, 1992 and 1991, respectively. The Corporation has several unfunded defined benefit postretirement plans covering certain hourly and salaried employees which provide medical and life insurance benefits from retirement to age 65. Salaried employees retiring after January 1, 1995 will be covered by an unfunded defined contribution plan with benefits based on years of service. Certain hourly employees retiring after January 1, 1996 will be subject to a maximum annual benefit limit. Salaried employees hired in the future are not eligible for postretirement medical benefits. Effective January 1, 1992, the Corporation adopted FAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." The Corporation recorded a charge of $46.1 million ($75.0 million before tax) or $2.25 per share to record the cumulative effect of the accounting change which represents the transition obligation as of January 1, 1992. Net periodic postretirement benefit cost included the following components: Years ended December 31 (Dollars in Thousands) 1993 1992 Service cost--benefits attributed to employee service during the years $1,841 $1,672 Interest cost on accumulated postretirement benefit obligation 6,959 6,931 ------ ------ Net periodic postretirement benefit cost $8,800 $8,603 ====== ====== The following table sets forth the plans' status as reflected in the consolidated balance sheet: December 31 (Dollars in Thousands) 1993 1992 Accumulated postretirement benefit obligation: Retirees $39,269 $36,227 Fully eligible active plan participants 11,880 10,958 Other active plan participants 35,062 32,345 ------- ------- 86,211 79,530 Unrecognized net loss (7,488) -- ------- ------- Accrued postretirement benefit cost $78,723 $79,530 ======= ======= The assumed health care cost trend rate used in measuring the accumulated postretirement benefit obligation (APBO) was 10% in 1992, declining by 1% per year to 6% in 1996. The weighted average discount rate used in determining the APBO was 7.75% and 8.75% at December 31, 1993 and 1992, respectively. If the health care cost trend rate was increased by 1%, the APBO at December 31, 1993 would increase by $4.1 million and net periodic postretirement benefit cost for 1993 would increase by $.5 million. Prior to 1992, the cost of continuing life and health insurance for eligible retirees was accounted for on a pay-as-you-go basis and totalled $8.5 million in 1991. 11. Income Taxes Effective January 1, 1992, the Corporation adopted FAS No. 109, "Accounting for Income Taxes." The adoption of FAS No. 109 had a $1.6 million favorable effect as of January 1, 1992 as a result of the realization of tax credits. The components of the provision for income taxes consisted of the following: Years ended December 31 (Dollars in Thousands) 1993 1992 1991 Current: Federal $11,208 $ 4,916 $ 931 State 1,955 1,449 725 Foreign 3,109 1,466 1,462 Cumulative effect of rate change 836 -- -- Deferred 11,297 7,879 (1,715) Business tax credits (281) (588) (843) ------- ------- ------ Provision for income taxes $28,124 $15,122 $ 560 ======= ======= ====== The tax provision differs from the statutory U.S. federal rate due to the following items: Years ended December 31 (Dollars in Thousands) 1993 1992 1991 Provision at federal statutory rate $23,981 $13,195 $ 838 Cumulative effect of rate change 836 -- -- Foreign income taxes 637 286 539 State income and franchise taxes 3,056 1,864 73 Business and foreign tax credits (631) (588) (1,143) Non-deductible items 287 325 265 Other (42) 40 (12) ------- ------- ------ Provision for income taxes $28,124 $15,122 $ 560 ======= ======= ====== On August 10, 1993, the Revenue Reconciliation Act of 1993 was signed into law. The Act increased the corporate federal income tax rate from 34 percent to 35 percent. In the third quarter, the Corporation adjusted its deferred income tax accounts by $.8 million and increased its provision for current income taxes for the first half of 1993 by $.4 million. The domestic and foreign components of income (loss) from operations before income taxes were as follows: Years ended December 31 (Dollars in Thousands) 1993 1992 1991 Domestic $60,407 $34,776 $ (926) Foreign 8,111 4,031 3,390 ------ ------ ------- $68,518 $38,807 $ 2,464 ====== ====== ====== Taxes paid amounted to $12.2, $5.4 and $4.6 million in 1993, 1992 and 1991, respectively. The Corporation has the following carryforwards for federal income tax purposes: - Tax credits of $14.4 million which expire from 1996 through 2007. - Alternative Minimum Tax credits of $6.1 million which do not expire. No provision for U.S. income taxes has been made on the undistributed earnings of foreign subsidiaries as such earnings are considered to be permanently invested. At December 31, 1993, the undistributed earnings amounted to $16.7 million. It is not practical to determine the income tax liability that would result had such earnings been repatriated. The amount of withholding taxes that would be payable upon such repatriation is estimated to be $.7 million. No provision for U.S. income taxes has been made on undistributed earnings of equity investees attributable to cumulative net translation gains and other items. Since the investees do not have the capability to remit such gains in the foreseeable future, such gains are considered permanently invested. At December 31, 1993, the amount of unrecognized U.S. tax liability for the net translation gains and other items of $17.7 million amounted to $6.2 million. The approximate tax effects of temporary differences between income tax and financial reporting at December 31, 1993 and 1992, respectively, are as follows: These deferred tax assets and liabilities are classified in the balance sheet as current or long-term based on the balance sheet classification of the related assets and liabilities. The balances are as follows: Current deferred income tax assets $ 27,614 $20,487 Long-term deferred income tax liabilities (41,281) (28,148) -------- ------- Net liability $(13,667) $(7,661) ======== ======= 12. Litigation and Insurance Matters As of December 31, 1993, the Corporation and Harvestore were defendants in 26 cases alleging damages for economic losses claimed to have arisen out of alleged defects in Harvestore animal feed storage equipment. Some plaintiffs are seeking punitive as well as compensatory damages. The Corporation believes that a significant number of these claims were related to the deteriorated general farm economy at the time suit was commenced, including those filed in 1993. The Corporation and Harvestore continue to vigorously defend these cases. In 1993, nine new cases were filed and 38 cases were concluded. One of the cases filed during 1993 is a New York state court action and contains class action allegations, and names the Corporation, Harvestore and two of its dealers as defendants. Among the many motions the defendants have filed in this action is one to stay the action pending the ruling on class action certification requested by the plaintiffs in a lawsuit pending in the Federal District Court for the Southern District of Ohio. Based on the facts currently available to management and its prior experience with lawsuits alleging damages for economic loss resulting from use of the Harvestore animal feed storage equipment, management is confident that the motion for class certification in the Ohio lawsuit can be defeated and that the lawsuit does not represent a material threat to the Corporation. The Corporation believes that any damages, including any punitive damages, arising out of the pending cases are adequately covered by insurance and recorded reserves. The Corporation reevaluates its exposure periodically and makes adjustment of its reserves as appropriate. A lawsuit for damages and declaratory judgments in the Circuit Court of Milwaukee County, State of Wisconsin, in which the Corporation and Harvestore are plaintiffs, is pending against three insurance companies for failure to pay in accordance with liability insurance policies issued to the Corporation. The insurers have failed to pay, in full or in part, certain judgments, settlements and defense costs incurred in connection with pending and closed lawsuits alleging damages for economic losses claimed to have arisen out of alleged defects in Harvestore animal feed storage equipment. While the Corporation has, in part, assumed applicability of this coverage, an adverse judgment should not be material to its financial condition. The Corporation is involved in other litigation and claims which arise in the ordinary course of its business including governmental proceedings regarding the disposal of hazardous waste at sites which are in various stages of the remediation process. For some of the sites, total costs for remediation are not available because the final remedy has not been selected or for other reasons. Further, the ultimate liability of the Corporation, if any, has not been determined at all of the sites. As a result, it is impossible at this time to estimate the total cost of remediation for all of the sites. The total estimated cleanup costs identified at this time for all parties at all sites involving claims filed by the Environmental Protection Agency or similar state agencies where the Corporation has been designated a potentially responsible party is approximately $232 million. The estimated portion of the total for which the Corporation is or may be responsible is approximately $5.0 million, of which $3.6 million has been contributed towards the cleanup costs by the Corporation and its insurance companies. The balance of the identified potential cleanup costs is covered by insurance and established reserves set by the Corporation which are believed to be adequate to cover the Corporation's obligations with respect to the unpaid balance of the claims. To the best of the Corporation's knowledge, the insurers have the financial ability to pay any such covered claims. The Corporation reevaluates its exposure periodically and makes adjustment of its reserves as appropriate. In March 1992, a subsidiary of the Corporation, Smith Fiberglass Products Inc. (Smith Fiberglass), won a patent infringement suit filed against a competitor. A judgment was entered in favor of Smith Fiberglass. The judgment was appealed by the defendant. However, the Court of Appeals affirmed the award and Smith Fiberglass recognized the judgment which amounted to $1.9 million after recognition of legal fees as other income in the second quarter of 1993. A legal action against a supplier of certain automotive equipment alleging breach of warranty was settled in December 1992. The Corporation recorded the settlement, net of expenses, of $1.1 million as other income in 1992. A lawsuit initiated by the Corporation in connection with previously concluded antitrust action involving a former subsidiary was terminated in the second quarter of 1993 with a favorable settlement of $2.8 million which is included as other income. Over the past several years, the Corporation has self-insured a portion of its product liability loss exposure and other business risks. The Corporation has established reserves which it believes are adequate to cover incurred claims. For the year ended December 31, 1993, the Corporation had $60 million of third-party product liability insurance for individual losses in excess of $1.5 million and for aggregate losses in excess of $10 million. 13. Operations by Segment Further discussion of the segment results, including Automotive Products and Electrical Products which comprise the OEM segment, can be found under "Management's Discussion and Analysis--Results of Operations." 14. Quarterly Results of Operations (Unaudited) Net earnings (loss) per share is computed separately for each period and, therefore, the sum of such quarterly per share amounts may differ from the total for the year. See note 7 for restrictions on the payment of dividends. The cumulative effect of the accounting changes in the first quarter of 1992 includes a credit of $1.6 million ($.10 and $.08 per primary and fully diluted shares, respectively) for a change in accounting for income taxes and a charge of $46.1 million [($2.89) and ($2.26) per primary and fully diluted shares, respectively] for a change in accounting for postretirement benefits. The fourth quarter of 1993 includes, on an after-tax basis, approximately $2.3 million of charges for additions to product liability and bad debt reserves and writedown of certain assets partially offset by inventory adjustments. The fourth quarter of 1992 includes, on an after-tax basis, approximately $3.0 million of charges for additions to product liability and bad debt reserves partially offset by net proceeds of a lawsuit settlement. 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 included under the heading "Election of Directors" in the Corporation's definitive Proxy Statement dated March 3, 1994 for the Annual Meeting of Stockholders to be held April 13, 1994 is incorporated herein by reference. The information required regarding Executive Officers of the Corporation is included in Part I of this Form 10-K under the caption "Executive Officers of the Corporation." The information included under the heading "Compliance with Section 16(a) of the Securities Exchange Act" in the Corporation's definitive Proxy Statement dated March 3, 1994 for the Annual Meeting of Stockholders to be held on April 13, 1994 is incorporated herein by reference. ITEM 11	ITEM 11 - EXECUTIVE COMPENSATION The information included under the heading "Executive Compensation" in the Corporation's definitive Proxy Statement dated March 3, 1994 for the April 13, 1994 Annual Meeting of Stockholders is incorporated herein by reference, except for the information required by paragraphs (i), (k) and (l) of Item 402(a)(8) of Regulation S-K. ITEM 12	ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information included under the headings "Principal Stockholders" and "Security Ownership of Directors and Management" in the Corporation's Proxy Statement dated March 3, 1994 for the April 13, 1994 Annual Meeting of Stockholders is incorporated hereby by reference. ITEM 13	ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information included under the headings "Relationships and Related Transactions" and "Compensation Committee Interlocks and Insider Participation" in the Corporation's Proxy Statement dated March 3, 1994 for the April 13, 1994 Annual Meeting of Stockholders is incorporated herein by reference. PART IV ITEM 14	ITEM 14 - EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) Financial Statements and Financial Statement Schedules Form 10-K Page Number The following consolidated financial statements of A. O. Smith Corporation are included in Item 8: Consolidated Balance Sheet at December 31, 1993 and 1992 . . . . . . For each of the three years in the period ended December 31, 1993: - Consolidated Statement of Operations and Retained Earnings . . . . . . . . . . . . . . . . . . . . . . - Consolidated Statement of Cash Flows . . . . . . . . . . . . . . Notes to Consolidated Financial Statements . . . . . . . . . . . . . The following consolidated financial statement schedules of A. O. Smith Corporation are included in Item 14(d): Schedule V - Consolidated Property, Plant and Equipment . . . . . . Schedule VI - Consolidated Accumulated Depreciation of Property, Plant and Equipment . . . . . . . . . . Schedule VIII - Valuation and Qualifying Accounts . . . . . . . . . Schedule IX - Consolidated Short-Term Borrowings . . . . . . . . . . Schedule X - Consolidated Supplementary Income Statement Information . . . . . . . . . . . . . . . All other schedules are omitted since the required information is not present or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements or the notes thereto. Financial statements of Metalsa S.A., an affiliate in which the Corporation has a 40 percent investment, are omitted since it does not meet the significant subsidiary test of Rule 3-09 of Regulation S-X. (b) Reports on Form 8-K No reports on Form 8-K were filed during the last quarter of 1993. A current report on Form 8-K was voluntarily filed by the Corporation on February 9, 1993. The Form 8-K reported on the approval of three charter amendments by the stockholders of the Corporation at a special meeting held on January 26, 1993 and included as an exhibit the Corporation's Amended and Restated Certificate of Incorporation. The Form 8-K also contained a copy of a press release issued by the Corporation relating to the declaration of a special dividend payable only to holders of Common Stock of record on March 8, 1993. (c) Exhibits Pursuant to the requirements of Rule 14a-3(b)(10) of the Securities Exchange Act of 1934, as amended, the Corporation will, upon request and upon payment of a reasonable fee not to exceed the rate at which such copies are available from the Securities and Exchange Commission, furnish copies of any of the following exhibits to its security holders. Management contracts and compensatory plans and arrangements required to be filed as exhibits pursuant to Item 14(c) of Form 10-K are listed below as Exhibits 10(a) through 10(h). Form 10-K Page Number (3i) Restated Certificate of Incorporation of the Corporation as amended and restated January 26, 1993 incorporated by reference to the Form 8-K report dated February 8, 1993 filed by the Corporation . . . . . . N/A (3ii) By-laws of the Corporation as amended February 5, 1990 incorporated by reference to the Annual Report on Form 10-K for the year ended December 31, 1989 . . . . . . . . . . . . . . . . . . . . . N/A (4) (a) Certain long-term debt is described in Note 7 to the Consolidated Financial Statements. The Corporation agrees to furnish to the Commission, upon request, copies of any instruments defining rights of holders of long-term debt described in Note 7 . . . . . . . N/A (b) Amended and Restated $115 Million Credit Agreement incorporated by reference to the Annual Report on Form 10-K for the fiscal year ended December 31, 1992 . . . . . . . . . . . . . . . . . . . . . N/A (c) A. O. Smith Corporation agreement dated July 6, 1987 regarding a Credit Agreement on the same date between AgriStor Credit Corporation and various banks incorporated by reference to Amendment No. 1 to the quarterly report on Form 10-Q for the quarter ended September 30, 1987 . . . . . . . . . . . . . . . . . N/A (d) AgriStor Credit Corporation Credit Agreement dated June 25, 1990 extending its revolving credit agreement with its lending banks to June 30, 1994. The Agreement is incorporated by reference to the quarterly report on Form 10-Q for the quarter ended June 30, 1990 . . . . . . . . . . . . . . . . . . . . . . . N/A (e) A. O. Smith Corporation Restated Certificate of Incorporation dated January 26, 1993 (incorporated by reference to Exhibit (3)(i) hereto) . . . . . . . . . . . . N/A (f) Note Purchase and Medium-Term Note Agreement, dated July 23, 1993 between A. O. Smith Corporation and Metropolitan Life Insurance Company, incorporated by reference to the Quarterly Report on Form 10-Q for the quarter ended June 30, 1993 . . . . . . . . . . . . . . . . N/A (g) Note and Agreement dated May 14, 1993 between A. O. Smith Corporation and The Prudential Insurance Company of America, incorporated by reference to the Quarterly Report on Form 10-Q for the quarter ended June 30, 1993 . . . . . . . . . . . . . . . . . . . . . . . N/A (10) Material Contracts (a) 1990 Long-Term Executive Compensation Plan incorporated by reference to the Corporation's Proxy Statement dated March 3, 1994 for an April 13, 1994 Annual Meeting of Shareholders . . . . . . . . . . . . . . . N/A (b) 1980 Long-Term Executive Incentive Compensation Plan incorporated by reference to the Corporation's Proxy Statement dated March 1, 1988 for an April 6, 1988 Annual Meeting of Shareholders . . . . . . . . . . . . N/A (c) Executive Incentive Compensation Plan, as amended, incorporated by reference to the Annual Report on Form 10-K for the fiscal year ended December 31, 1992 . . . . . . N/A (d) Letter Agreement dated December 15, 1979, as amended by the Letter Agreement dated November 9, 1981, between the Corporation and Thomas I. Dolan incorporated by reference to Amendment No. 2 to the Annual Report on Form 10-K for the year ended December 31, 1984 . . . . . . . . . . . . N/A (e) Supplemental Benefit Plan, as amended, incorporated by reference to the Annual Report on Form 10-K for the fiscal year ended December 31, 1992 . . . . . . . . . . . . . . . . N/A (f) Executive Life Insurance Plan, incorporated by reference to the Annual Report on Form 10-K for the fiscal year ended December 31, 1992 . . . . . . . . . . . . . . . . . . . . . N/A (g) Corporate Directors' Deferred Compensation Plan, as amended, incorporated by reference to the Annual Report on Form 10-K for the fiscal year ended December 31, 1992 . . . N/A (h) Non-employee Directors' Retirement Plan incorporated by reference to the quarterly report on Form 10-Q for the quarter ended June 30, 1991 . . . . . . . N/A (11) Computation of Earnings Per Common Share . . . . . . . . . . . . (21) Subsidiaries . . . . . . . . . . . . . . . . . . . . . . . . . . (23) Consent of Independent Auditors . . . . . . . . . . . . . . . . (24) (a) Power of Attorney - Thomas F. Russell Arthur O. Smith incorporated by reference to the Annual Report on Form 10-K for the year ended December 31, 1980 . . . . . . . . . . . . . . . . . . N/A (b) Power of Attorney - Tom H. Barrett incorporated by reference to the Annual Report on Form 10-K for the year ended December 31, 1981 . . . . . N/A (c) Power of Attorney - Russell G. Cleary incorporated by reference to the Annual Report on Form 10-K for the year ended December 31, 1984 . . . . . N/A (d) Power of Attorney - Lee W. Jennings incorporated by reference to the Annual Report on Form 10-K for the year ended December 31, 1986 . . . . . N/A (e) Power of Attorney - Donald J. Schuenke incorporated by reference to the Annual Report on Form 10-K for the year ended December 31, 1988 . . . . . N/A (f) Power of Attorney - Dr. Agnar Pytte incorporated by reference to the Annual Report on Form 10-K for the year ended December 31, 1990 . . . . . N/A (g) Power of Attorney - Thomas I. Dolan incorporated by reference to the Annual Report on Form 10-K for the year ended December 31, 1992 . . . . . N/A N/A = Not Applicable SCHEDULE X - CONSOLIDATED SUPPLEMENTARY INCOME STATEMENT INFORMATION (000 Omitted) Years ended December 31, 1993, 1992 and 1991 Item Charged to Costs and Expenses 1993 1992 1991 Maintenance and Repairs $40,609 $34,743 $30,339 ======= ======= ======= Depreciation and amortization of intangible assets, pre-operating costs and similar deferrals; taxes, other than payroll and income taxes; royalties; and advertising costs are each less than 1 percent of consolidated net sales. For the purposes of complying with the amendments to the rules governing Form S-8 (effective July 13, 1990) under the Securities Act of 1933, the undersigned registrant hereby undertakes as follows, which undertaking shall be incorporated by reference into registrant's Registration Statements on Form S-8 Nos. 2-72542 filed on May 26, 1981, Post-Effective Amendment No. 1, filed on May 12, 1983, Post-Effective Amendment No. 2, filed on December 22, 1983, Post-Effective Amendment No. 3, filed on March 30, 1987; 33-19015 filed on December 11, 1987; 33-21356 filed on April 21, 1988; and Form S-8 No. 33-37878 filed November 16, 1990: Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers and controlling persons of the registrant pursuant to the foregoing provisions, or otherwise, the registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Securities Act of 1933 and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the registrant of expenses incurred or paid by a director, officer or controlling person of the registrant in the successful defense of any action, suit or proceedings) is asserted by such director, officer or controlling person in connection with the securities being registered, the registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue. 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 behalf of the undersigned, thereunto duly authorized. A. O. SMITH CORPORATION Date By: ROBERT J. O'TOOLE March 22, 1994 Robert J. O'Toole 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. EXHIBIT INDEX Exhibit No. Description (11) Computation of Earnings Per Common Share (21) Subsidiaries (23) Consent of Independent Auditors
84557_1993.txt	84557	1993	ITEM 1. BUSINESS The following are discussed under the general heading of "Business". Reference is made to the various other Items as applicable. GENERAL Incorporated in 1904 in the State of New York, the Company supplies electric and gas service wholly within that State. It produces and distributes electricity and distributes gas in parts of nine counties centering about the City of Rochester. At December 31, 1993 the Company had 2,536 employees. The Company's service area has a population of approximately one million and is well diversified among residential, commercial and industrial consumers. In addition to the City of Rochester, which is the third largest city and a major industrial center in New York State, it includes a substantial suburban area with commercial growth and a large and prosperous farming area. A majority of the industrial firms in the Company's service area manufacture consumer goods. Many of the Company's industrial customers are nationally known, such as Xerox Corporation, Eastman Kodak Company, General Motors Corporation, Mobil Corporation and Bausch & Lomb Incorporated. Energyline Corporation, a wholly owned subsidiary, was formed by the Company as a gas pipeline corporation to fund the Company's investment in the Empire State Pipeline. The Company has invested a net amount of approximately $10 million in Energyline as of December 31, 1993. The business of the Company is seasonal. With respect to electricity, winter peak loads are attained due to spaceheating sales and shorter daylight hours and summer peak loads are reached due to the use of air-conditioning and other cooling equipment. With respect to gas, the greatest sales occur in the winter months due to spaceheating usage. In each of the communities in which it renders service, the - 2 - Company, with minor exceptions, holds the necessary municipal franchises, none of which contains burdensome restrictions. The franchises are non-exclusive, and are either unlimited as to time or run for terms of years. The Company anticipates renewing franchises as they expire on a basis substantially the same as at present. Information concerning revenues, operating profits and identifiable assets for significant industry segments is set forth in Note 4 of the Notes to the Company's financial statements under Item 8. Information relating to the principal classes of service from which electric and gas revenues are derived and other operating data are included herein under "Operating Statistics". A discussion of the causes of significant changes in revenues is presented in Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations. Percentages of the Company's operating revenues derived from electric and gas operations for each of the last three years are as follows: FINANCING AND CAPITAL REQUIREMENTS PROGRAM A discussion of the Company's capital requirements and the resources available to meet such requirements may be found in Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations. In addition to those issues discussed in Item 7, the sale of additional securities depends on regulatory approval and the Company's ability to meet certain requirements contained in its mortgage and Restated Certificate of Incorporation. Under the New York State Public Service Law, the Company is required to secure authorization from the Public Service Commission of the State of New York (PSC) prior to issuance of any stock or any debt having a maturity of more than one year. The Company's First Mortgage Bonds are issued under a General Mortgage dated September 1, 1918, between the Company and Bankers Trust Company, as Trustee, which has been amended and supplemented by thirty-nine supplemental indentures. Before additional First Mortgage Bonds are issued, the following financial requirements must be satisfied: (a) The First Mortgage prohibits the issuance of additional First Mortgage Bonds unless earnings (as defined) for a period of twelve months ending not earlier than sixty days prior to the issue date of the additional bonds are at least 2.00 times the annual interest charges on First Mortgage Bonds, both those outstanding and those proposed to be outstanding. The ratio under this test for the twelve months ended December 31, 1993 was 4.52. - 3 - (b) The First Mortgage also provides that, if additional First Mortgage Bonds are being issued on the basis of property additions (as defined), the principal amount of the bonds may not exceed 60% of available property additions. As of December 31, 1993 the amount of additional First Mortgage Bonds which could be issued on that basis was approximately $332,408,000. In addition to issuance on the basis of property additions, First Mortgage Bonds may be issued on the basis of 100% of the principal amount of other First Mortgage Bonds which have been redeemed, paid at maturity, or otherwise reacquired by the Company. As of December 31, 1993, the Company could issue $160,584,000 of Bonds against Bonds that have matured or been redeemed. The Company's Restated Certificate of Incorporation (Charter) provides that, without consent by two-thirds of the votes entitled to be cast by the preferred stockholders, the Company may not issue additional preferred stock unless in a 12-month period within the preceding 15 months: (a) net earnings applicable to payment of dividends on preferred stock, after taxes, have been at least 2.00 times the annual dividend requirements on preferred stock, including the shares both outstanding and proposed to be issued, and (b) net earnings available for interest on indebtedness, after taxes, have been at least 1.50 times the annual interest requirements on indebtedness and annual dividend requirements on preferred stock, including the shares both outstanding and proposed to be issued. For the twelve months ended December 31, 1993, the coverage ratio under (b) above (the more restrictive provision) was 2.23. The Company's Charter also provides that, without consent by a majority of the votes entitled to be cast by the preferred stockholders, the Company may not issue or assume any unsecured indebtedness in excess of 15% of the total of its outstanding bonds and any other secured indebtedness plus its capital and surplus. At December 31, 1993, including the $51.3 million of unsecured indebtedness already outstanding, the Company was able to issue $70.5 million of unsecured debt under this provision. The Company also has unsecured short-term credit facilities totaling $70 million. Interim financing is available through short-term borrowings under a $90 million revolving credit agreement which expires December 31, 1996. In order to be able to use its revolving credit agreement, the Company created a subordinate mortgage which secures borrowings under its revolving credit agreement that might otherwise be restricted by this provision of the Company's Charter. The subordinate mortgage provides that the aggregate principal amount of bonds outstanding under the First Mortgage together with all borrowings under the revolving credit agreement will not exceed 70% of available property additions. At December 31, 1993, this provision would not restrict borrowings under the revolving credit agreement. In addition, the Company has a loan and security agreement with a domestic bank providing for up to $20 million of short-term debt. Borrowings under this agreement, which extends to December 31, 1994, are secured by the Company's accounts receivable. At December 31, 1993, the Company had $68 million of short-term debt outstanding consisting of $51 million unsecured short- term debt and $17 million of secured short-term debt. The Company's Charter does not contain any financial tests for the - 4 - issuance of preference or common stock. REGULATORY MATTERS The Company is subject to regulation by the PSC under New York statutes, by the Federal Energy Regulatory Commission (FERC) as a licensee and public utility under the Federal Power Act and by the Nuclear Regulatory Commission (NRC) as a licensee of nuclear facilities. The National Energy Policy Act (Energy Act), signed into law in 1992 is the most comprehensive energy bill in more than a decade and impacts virtually every sector of the U.S. energy industry. Major provisions of the Energy Act, as they relate to the Company, include energy efficiency, promoting competition in the electric power industry at the wholesale level, streamlining of federal licensing of nuclear power plants, encouraging development and production of coal resources and ensuring that a new class of independent power producers established under the bill as well as qualified facilities and other electric utilities can achieve access to utility-owned transmission lines upon payment of appropriate prices. Under the Energy Act, FERC may order utilities to provide wholesale transmission services for others only if, among other things, the order meets certain requirements as to cost recovery and fairness of rates. This law prohibits FERC from ordering retail wheeling, which is power to be transmitted directly to a customer from a supplier other than the customer's local utility. The law, however, does not prevent state regulatory commissions from allowing or ordering intrastate retail wheeling; and, New York State is currently considering the issue of retail wheeling through various studies and hearings. The Company believes this Act could lead to enhanced competition among the Company and other service providers in the electric industry. In April 1992 FERC issued Order No. 636 with the intention of fostering competition in the gas supply industry and improving access of customers to gas supply sources. In essence, FERC Order No. 636 requires interstate natural gas companies to offer customers "unbundled", or separate, sales and transportation services. FERC Order 636 offers an opportunity for the Company and other gas utilities to negotiate directly with gas producers for supplies of natural gas. With the unbundling of services, primary responsibility for reliable natural gas supply has shifted from interstate pipeline companies to local distribution companies, such as the Company. Since 1988 the Company has endeavored to diversify both its natural gas supply sources and the pipelines on which that supply is delivered to the Company's distribution system. With the unbundling of services as required under FERC Order 636 and the commencement of Empire State Pipeline operation, the Company has successfully achieved those goals, which should enhance its competitive position. In 1988 the PSC ordered New York utilities to submit proposals to implement a competitive bidding procedure for new electric generation. In response to this requirement, the Company filed with the PSC (and thereafter amended such filings as required by the PSC) its proposed request for proposals (RFP) for the bidding of capacity additions and certain demand side management (DSM) measures. On September 11, 1990, - 5 - the Company issued an RFP to purchase 70,000 kilowatts (Kw) of capacity or capacity savings. Of this total resource block, 20,000 Kw was set aside for DSM projects implemented within the Company's service territory while the remaining 50,000 Kw could be filled either by some form of generation directly interconnected to the electric system within or outside the Company's service territory or by additional DSM projects. The Company expressed a strong preference for peaking capacity in the RFP. The Company announced the successful bids in October 1991. Contract negotiations have been completed with three successful bidders of DSM projects resulting in contracts to supply 20.6 MW of capacity savings to be phased-in over the 1993-1996 period. Contract negotiations continue with one successful bidder for .125 MW of capacity savings. One successful bidder decided not to go forward with a proposal for 3 MW of capacity savings. A joint New York State utility analysis completed in late August 1991 concluded that capacity reserves on a statewide basis would exceed required levels until after the long-range planning period, or through and beyond the year 2007. Based on this analysis, the Company determined that its remaining needs could be more economically met through spot market purchases of capacity more closely tailored to its year-to-year requirements than by a long-term supply commitment. As a result, no contracts were offered to sponsors of supply-side proposals. On September 1, 1993 the Company issued an RFP for 3 MW of summer peak capacity savings at one of its facilities. Four proposals were received on October 20, 1993. A contract was executed on December 1, 1993. This project is expected to be completed in 1996. In June 1992, the Company filed with the PSC an Integrated Resource Plan (IRP), which is a long-range plan used to examine future options with regard to generating resources and alternative methods of meeting electric capacity requirements. The plan covers a 15-year period, beginning in 1992, and provides current strategies and alternatives for meeting the Company's customers' energy requirements in a changing business and technological environment. The IRP takes into account anticipated capacity requirements and available resource options, as well as factors such as reliability, price of product, public acceptance, financial integrity, environmental issues, the competitive marketplace, demand side management and potential new technologies. One result of the IRP was the decision made by the Company in December 1992 to replace the two steam generators at the Ginna nuclear plant in 1996. Like similar plants, the Ginna nuclear plant has experienced degradation in some of the tubes that make up each steam generator. About 30 percent of these tubes have required repair. In addition, a chemical buildup in some of the tubes has reduced their heat transfer capability. Both conditions would continue to erode the plant's performance if the existing steam generators were left in place. Installation of new steam generators was determined by the Company to be the most cost-effective, reliable and environmentally compatible option for the plant. The new steam generators should result in reduced maintenance costs and help sustain a high level of plant availability. Cost of replacement is estimated at $115 million, and preparation to replace these generators began during the plant's routine 1993 fuel outage. As a part of the on-going IRP process, the Company in mid-1993 made - 6 - a decision to place Unit 1 at Russell Station (47 MW) on cold standby, while modifying Units 2, 3 and 4 to meet Federal Environmental Protection Agency standards. Unit 1 is expected to be in cold standby in early 1994. Modification of Units 3 and 4 is expected to be completed by March 1995 at a cost of approximately $4.6 million. In addition, Unit 12 at Beebee Station and Unit 2 at Russell Station will be adjusted to produce fewer nitrogen oxides (NOx) by converting a third of the burners in each to achieve overfire air capability at a cost of approximately $1.2 million. These actions will allow the Company to comply with Phase I -Title I, NOx controls requirements of the Federal Clean Air Act, to meet projected load demands in its service territory, and to maintain a mix of fuel generation while remaining competitive and retaining wholesale opportunities. Outlined below are other results of the IRP process to date: - The plan calls for evaluating the possibility of using either alternative generation or current generating equipment in partnership with certain large industrial customers. - The Company will continue to use demand side management programs to reduce the need for generating capacity. - The Company will consider phasing out the coal-fired Beebee Station by the year 2000, unless it is converted to natural gas and operated under a partnership arrangement with a large customer. The Company is subject to regulation of rates, service, and sale of securities, among other matters, by the PSC. On August 24, 1993 the PSC issued an order approving a settlement agreement (1993 Rate Agreement) among the Company, PSC Staff and other interested parties. This agreement resolves the Company's rate case proceedings initiated in July 1992. Retroactive application of new rates to July 1, 1993 was authorized by the PSC. The 1993 Rate Agreement will determine the Company's rates through June 30, 1996 and includes certain incentive arrangements providing for both rewards and penalties. The 1993 Rate Agreement is discussed below. A summary of recent PSC rate decisions is presented in the table below. The 1993 Rate Agreement amounts are based on an allowed return on common equity of 11.50% through June 30, 1996. Earnings between 8.50% and 14.50% will be absorbed/retained by the Company. Earnings above 14.50% will be refunded to the customers. If, but not unless, earnings fall below 8.50%, or if cash interest coverage falls below 2.2 times, the Company can seek relief by petitioning the PSC for a review of the 1993 Rate Agreement terms. - 7 - * See below for additional details. The following measures were incorporated into the 1993 Rate Agreement: - Incentive mechanisms that have the potential to either increase or reduce earnings from 5 to 70 basis points each, depending on the Company's ability to meet a variety of prescribed targets in the areas of electric fuel costs, demand side management, service quality and integrated resource management (relative electric production efficiency). During the rate year ending July 30, 1994, these incentives have the potential to affect earnings by approximately $12 million. - Mechanisms for sharing costs between customers and shareholders for operation and maintenance expenses. In general, non-fuel operation and maintenance expense variations are treated in three different ways depending upon the amount of control the Company can exert over them. Those costs that are directly manageable (approximately $172 million in the first rate year) have no sharing and are absorbed by the Company, those costs that are not significantly affected by management action in the short run (approximately $34 million in the first rate year) are trued up 100% and variances resulting from all other such costs (approximately $110 million in the first rate year) are shared 50% by customers and 50% by the Company. - Mechanisms for sharing 50% of overspending variances between forecasted and actual electric capital expenditures related to production and transmission facilities. The Company will retain the savings for cost of money and depreciation on underspending variances. The settlement also provides for a sharing mechanism regarding the replacement of the Ginna nuclear station steam generators. A graduated sharing percentage is applied for up to $15 million of variances, plus or minus, from the forecasted cost of $115 million. Variances above $130 million or below $100 million are absorbed by the Company. - An Electric Revenue Adjustment Mechanism designed to stabilize electric revenues by eliminating the impact of variations in electric sales. A gas weather normalization clause previously in place was retained. - 8 - To the extent incentive and sharing mechanisms apply, the negotiated revenue increase shown in the table above may be adjusted up or down in the second and third year of the agreement. As shown in the table below negotiated electric rate increases could be reduced to zero or increased up to an additional 1.5% in year two, 1.6% in year three and 1.8% in the following year. Negotiated gas rate increases could also be reduced to zero or increased up to an additional 0.8% in year two, 0.9% in year three and 1.1% in the following year, exclusive of the impact of the Empire State Pipeline going into service. In July 1993 the Company requested approval from the PSC for a new flexible pricing tariff for major industrial and commercial electric customers. A settlement in this matter was filed with the PSC on November 19, 1993 and a decision on whether or not to approve the settlement is expected early in 1994. Such a tariff would allow the Company to negotiate competitive electric rates at discount prices to compete with alternative power sources, such as customer-owned generation facilities. Under the terms of the settlement, the Company would absorb 30 percent of any net revenues lost as a result of such discounts through June 1996, while the remainder would be recovered from other customers. The portion recoverable after June 1996 is expected to be determined in a generic proceeding currently being conducted by the PSC. In September 1993 the PSC instituted a formal proceeding to investigate what the Company believes are undercharges to gas customers for certain gas purchases for the period August 1990 to August 1992. The Company's estimate of these undercharges is approximately $7.5 million, of which $2.3 million had been previously expensed and $5.2 million had been deferred on the Company's balance sheet. The Company wrote off the $2.0 million balance of the undercharges as of December 31, 1993. See Item 7 - Management's Discussion and Analysis of Financial Condition and Results of operations under the subheading "New York State Public Service Commission" and Item 8, Note 10 - Commitments and Other Matters under the subheading "Gas Purchase Undercharges" for a further discussion. COMPETITION The Company is operating in an increasingly competitive environment. In its electric business, this environment includes a federal trend toward deregulation and a state trend toward incentive regulation. In addition, excess capacity in the region, new technology and cost pressures on major customers have created incentives for major - 9 - customers to investigate different electric supply options. Initially, those options will include various forms of self generation, but may eventually include customer access to the transmission system in order to purchase electricity from suppliers other than the Company. As discussed under the Regulatory Matters section, the passage of the National Energy Policy Act of 1992 has accelerated these competitive challenges. The Company accepts these challenges and is working to anticipate the impact of the increased competition. Its Business Plan, both in detail for one year and in summary for five years, focuses on improving service while reducing expenses. The Company is engaged in a continuous process improvement program to find opportunities for improved service and efficiency and has implemented an early retirement program in which 173 people, representing approximately seven percent of its workforce, have retired early and will not be replaced. In addition, the Company has agreed to a three-year rate settlement which includes caps on rate increases that approximate or are less than projected inflation, contains incentive programs that tie performance to earnings and stabilizes revenue through revenue adjustment mechanisms. An agreement has been reached with the PSC Staff and others on the terms of a competitive rate tariff that would allow negotiated rates with larger industrial and commercial customers that have competitive electric supply options. These regulatory changes are discussed in more detail in the Regulatory Matters section. Competition in the Company's gas business has existed for some time, as the larger customers have had the option of obtaining their own gas supply and transporting it through the Company's distribution system. This process has been accelerated with FERC Order 636, discussed in more detail in the Regulatory Matters section above. In addition, the Company has responded to the changes in the gas business by positioning itself to obtain greater access to both US and Canadian natural gas supplies and storage, so that it can take advantage of the unbundling of services that results from FERC Order 636. A major element of this strategy went into place in 1993 with the start-up of the Empire State Pipeline. The Company is engaged in various aspects of capacity release and is investigating other options available to it to mitigate its cost and increase its revenue in the new gas regulatory environment. Beyond the Company's efforts to remain competitive in its core business, it is conducting a broad review of its general business strategy to identify opportunities that will exist in this changed environment. This may result in expansion of various elements of the core business or engaging in new, but related, business activity. ELECTRIC OPERATIONS The total net generating capacity of the Company's electric system is 1,237,000 Kw. In addition the Company purchases 120,000 Kw of firm power under contract and 35,000 Kw of non-contractual peaking power from the Power Authority, 150,000 Kw of a 1,000,000 Kw pumped storage plant owned by the Power Authority in Schoharie County, New York, 22,000 Kw of firm power from the Power Authority's 821,000 Kw FitzPatrick Nuclear Power Plant near Oswego, New York and 20,000 Kw of firm power from Hydro- - 10 - Quebec purchased through the Power Authority. The Company's net peak load of 1,333,000 Kw occurred on July 8, 1993. The percentages of electricity generated and purchased for the years 1989-1993 are as follows: The Company, six other New York utilities and the Power Authority are members of the New York Power Pool. The primary purposes of the Power Pool are to coordinate inter-utility sales of bulk power, long range planning of generation and transmission facilities, and inter- utility operating and emergency procedures in order to better assure reliable, adequate and economic electric service throughout the State. By agreement with the other members of the New York Power Pool, the Company is required to maintain a reserve generating capacity equal to at least 18% of its forecasted peak load. The Company expects to have reserve margins, which include purchased energy under long term firm contractual arrangements, of 25%, 26% and 30%, for the years 1994, 1995 and 1996, respectively. The Company's five major generating facilities are two nuclear units, the Ginna Nuclear Plant and the Company's 14% share of Nine Mile Point Nuclear Plant Unit No. 2 (Nine Mile Two), and three fossil fuel generating stations, the Russell and Beebee Stations and the Company's 24% share of Oswego Unit Six. These comprise 38%, 12%, 21%, 6% and 16%, respectively, of the Company's current electric system generating capacity. Nine Mile Two, a nuclear generating unit in Oswego County, New York with a capability of 1,080 megawatts (Mw), was completed and entered commercial service in Spring 1988. Niagara Mohawk Power Corporation (Niagara) is operating the Unit on behalf of all owners pursuant to a full power operating license which the NRC issued on July 2, 1987 for a 40-year term beginning October 31, 1986. Under arrangements dating from September 1975, ownership, output and cost of the project are shared by the Company (14%), Niagara (41%) Long Island Lighting Company (18%), New York State Electric & Gas Corporation (18%) and Central Hudson Gas & Electric Corporation (9%). Under the operating Agreement, Niagara serves as operator of Nine Mile Two, but all five cotenant owners shared certain policy, budget and managerial oversight functions. The base term of the Operating Agreement is 24 months from its effective date, with automatic extension, unless terminated by written notice of one or more of the cotenant owners to the other cotenant owners; such termination becomes effective six months from the receipt of any such notice of termination by all the cotenant owners receiving such notice. The owners petitioned the PSC in March 1993 for approval of the Operating Agreement and - 11 - understand that action by the PSC will be taken thereon early in 1994. The Company has four licensed hydroelectric generating stations with an aggregate capability of 49 megawatts. Although applications for renewal of those licenses were timely made in 1991, the FERC was unable to complete processing of many such applications by the December 31, 1993 license expiration. The Company and many other hydro project owners are thus operating under FERC annual licenses that essentially extend the terms of the old licenses year-to year until processing of new ones can be completed. The Company understands that renewal licenses for three of its four stations are scheduled to be issued by the second quarter of 1994, but a license for the fourth -- the smallest -- may be delayed or even denied depending on what environmental conditions are determined to apply to its continued operation. That determination, as well as decisions on what environmental conditions FERC will impose in new licenses for the other three stations, depends in part on the content of state water quality certifications issued by the New York State Department of Environmental Conservation (NYSDEC). Certifications NYSDEC issued for the Company's projects in late 1992 are in the process of revisions, owing to a November 1993 decision by the State of New York's highest court which, in a case brought by another utility licensee, held in effect that NYSDEC certifications exceeded the authority of the agency under applicable law. Draft revisions purporting to comply with that decision are currently under review in a NYSDEC administrative proceeding initially brought by the Company to challenge the 1992 certifications. Overly stringent environmental conditions or other governmental requirements could nullify or greatly impair the economic viability of one or more of the Company's hydro stations and could even compel it to abandon efforts to relicense the affected station or stations. If, however, conditions in the renewal licenses for these stations can be limited to those proposed by FERC Staff in its evaluation, the Company believes that it can continue to operate them economically. The Company's Ginna Nuclear Plant, which has been in commercial operation since July 1, 1970, provides 470 Mw of the Company's electric generating capacity. In August 1991 the NRC approved the Company's application for amendment to extend the Ginna Nuclear Plant facility operating license expiration date from April 25, 2006 to September 18, 2009. In December 1992, the Company announced that it will replace the two steam generators in the Ginna Nuclear Plant in 1996. Cost of the replacement is estimated at $115 million. The units themselves cost about $40 million, and installation will cost about $60 million. The remainder of the cost is for engineering, radiation protection, site support, interest charges and other services. During 1993, fixed price contracts were issued for both the steam generators and for the installation. Preparation for the replacement began in 1993 and will continue until the replacement in 1996. Steam generator fabrication is well underway and detailed engineering will begin in 1994. The existing steam generators, once removed, will become low-level radioactive waste. They will be placed in a protective structure which will be built on site, pending as yet undetermined permanent disposal. - 12 - Like similar plants, Ginna has experienced degradation in some of the 3,260 tubes that make up each steam generator. About 30 percent of the tubes have required repair. In addition, a chemical buildup on some of the tubes has reduced their ability to transfer heat, causing a loss in plant output of about 3 percent, or 15 megawatts. Both conditions would continue to erode the plant's performance if the existing steam generators were left in place. A number of design improvements have been incorporated into the new steam generators. These improvements combined with continued aggressive maintenance should result in a higher level of plant availability. The decision regarding Ginna is one part of the Integrated Resource Plan (IRP) previously discussed. Installation of new steam generators was determined to be the most cost-effective, reliable and environmentally compatible option for the plant. The gross and net book cost of the Ginna Plant as of December 31, 1993 are $470 million and $263 million, respectively. From time to time the NRC issues directives requiring all or a certain group of reactor licensees to perform analyses as to their ability to meet specified criteria, guidelines or operating objectives and where necessary to modify facilities, systems or procedures to conform thereto. Typically, these directives are premised on the NRC's obligation to protect the public health and safety. The Company is reviewing several such directives and is in the process of implementing a variety of modifications based on these directives and resulting analyses. Additional analyses and modifications can be expected. Expenditures, including AFUDC, at the Ginna Plant (including the cost of these modifications and $17.1 million in 1994, $30.6 million in 1995, and $51.4 million in 1996 for steam generator replacement as discussed above) are estimated to be $43.2 million, $57.0 million and $71.9 million for the years 1994, 1995 and 1996, respectively, and are included in the capital expenditure amounts presented under Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations. See Item 8, Note 10 - Commitments and Other Matters, "Nuclear- Related Matters", for a discussion relating to nuclear insurance including information on coverages and maximum assessments. GAS OPERATIONS The total daily capacity of the Company's gas system, reflecting the maximum demand which the transmission system can accept without a deficiency, is 4,485,000 Therms (one Therm is equivalent to 1,000,000 British Thermal Units). On January 19, 1994, the Company experienced its maximum daily send out of approximately 4,740,000 Therms. If a deficiency exists, the Company is able to manually bypass the regulators in the system to meet a demand of up to 10% in excess of capacity. As a result of the implementation of FERC Order 636, and the commencement of operation of the Empire State Pipeline (Empire), the Company now purchases all of its required gas supply from numerous producers and marketers under contracts containing varying terms and conditions. The Company anticipates no problem with obtaining reliable, - 13 - competitively priced natural gas in the future. See Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations under the captions "Energy Costs and Supply - Gas" and "FERC Order 636" for a discussion of those topics and "Capital Requirements and Gas Operations" for a discussion of Empire. The Company continues to provide new and additional gas service. Of 231,937 residential gas spaceheating customers at December 31, 1993, 3,841 were added during 1993, and 37% of those were conversions from other fuels. Approximately 23% of the gas delivered to customers by the Company during 1993 was purchased directly by commercial, industrial and municipal customers from brokers, producers and pipelines. The Company provided the transportation of gas on its system to these customers' premises. FUEL SUPPLY NUCLEAR Generally, the nuclear fuel cycle consists of the following: (1) the procurement of uranium concentrate (yellowcake), (2) the conversion of uranium concentrate to uranium hexaflouride, (3) the enrichment of the uranium hexaflouride, (4) the fabrication of fuel assemblies, (5) the utilization of the nuclear fuel in generating station reactors and (6) the appropriate storage or disposition of spent fuel and radioactive wastes. Arrangements for nuclear fuel materials and services for the Ginna Plant and Nine Mile Two have been made to permit operation of the units through the years indicated: (1) Information was supplied by Niagara Mohawk Power Corporation. (2) Arrangements have been made for procuring the majority of the uranium and conversion requirements through 2000, leaving the remaining portion of the requirements uncommitted. (3) Seventy percent of the conversion requirements have been procured through 1997. (4) Thirty years from 1984 or life of reactor, whichever is less. See the following discussion. The Company has a contract with United States Enrichment Corporation (USEC) formerly with the federal Department of Energy (DOE) - 14 - for nuclear fuel enrichment services which assures provision of 70% of the Ginna Plant's requirements throughout its service life or 30 years, whichever is less. No payment obligation accrues unless such enrichment services are needed. Annually, the Company is permitted to decline USEC-furnished enrichment for a future year upon giving ten years' notice. Consistent with that provision, the Company has terminated its commitment to USEC for the years 2000, 2001 and 2002. The USEC waived, for an interim period, the obligation to give ten years notice for 2003. The Company has secured the remaining 30% of its Ginna requirements for the reload years 1994 through 1995 under different arrangements with USEC. The Company plans to meet its enrichment requirements for years beyond those already committed by making further arrangements with USEC or by contracting with third parties. The cost of USEC enrichment services utilized for the next seven reload years (priced at the most current rate) range from $4 million to $7 million per year. The Company is pursuing arrangements for the supply of uranium requirements and related services beyond those years for which arrangements have been made as shown above. The prices and terms of any such arrangements cannot be predicted at this time. The average annual cost of nuclear fuel per million BTU used for electric generation for the last five years is as follows: There are presently no facilities in operation in the United States available for the reprocessing of spent nuclear fuel from utility companies. In the Company's determination of nuclear fuel costs it has taken into account that nuclear fuel would not be reprocessed and has provided for disposal costs in accordance with the Nuclear Waste Policy Act discussed below. The Company currently has adequate interim storage capability at the Ginna Plant, including full core discharge capability through the year 1999 based on anticipated fuel usage. The cost of nuclear fuel and estimated permanent storage costs of spent nuclear fuel are charged to operating expense on the basis of the thermal output of the reactor. These costs are charged to customers through the fuel cost adjustment clause and base rates. The Nuclear Waste Policy Act (Act) of 1982, as amended, requires the DOE to establish a nuclear waste disposal site and to take title to nuclear waste. A permanent DOE high level nuclear waste repository is not expected to be operational before the year 2010. The DOE is pursuing efforts to establish a monitored retrievable interim storage facility which may allow it to take title to and possession of nuclear waste prior to the establishment of a permanent repository. The Act provides for a determination of the fees collectible by the DOE for the disposal of nuclear fuel irradiated prior to April 7, 1983 and for three payment options. The option of a single payment to be made at any time prior to the first delivery of fuel to the DOE was selected in June 1985. The Company estimates the fees, including accrued interest, owed to the DOE - 15 - to be $68.1 million at December 31, 1993. The Company is allowed by the PSC to recover in rates these costs. The estimated fees are classified as a long term liability and interest is accrued at the three-month Treasury bill rate, adjusted quarterly. The Act also requires the DOE to provide for the disposal of nuclear fuel irradiated after April 6, 1983, for a charge of one mill ($.001) per Kwh of nuclear energy generated and sold. This charge is currently being collected from customers and paid to the DOE pursuant to PSC authorization. The Company expects to utilize on-site storage for all spent or retired fuel assemblies until an interim or permanent nuclear disposal facility is operational. Decommissioning costs (costs to take the plant out of service in the future) for the Ginna Plant are estimated to be approximately $150.7 million, and those for the Company's 14% share of Nine Mile Two are estimated to be approximately $34.3 million (January 1993 dollars). Through December 31, 1993, the Company has accrued and recovered in rates $61.2 million for this purpose and is currently accruing for decommissioning costs at a rate of approximately $8.9 million per year based on the use of a combination of internal and external sinking funds. See Notes 1 and 10 of the Notes to Financial Statements under Item 8 for additional information regarding nuclear plant decommissioning and DOE uranium enrichment facility decontamination and decommissioning. COAL The Company's present annual coal requirement is approximately 570,000 tons. In 1993 approximately 5% of its requirements were purchased under contract and the balance on the open market. The Company is meeting its requirements during early 1994 through contract purchases. Normally, the Company maintains a reserve supply of coal ranging from a 30 to a 60 day supply at maximum burn rates. The sulfur content of the coal utilized in the Company's existing coal-fired facilities ranges from 1.4 to 1.9 pounds per million BTU. Under existing New York State regulations, the Company's coal-fired facilities may not burn coal which exceeds 2.5 pounds per million BTU, which averages more than 1.9 pounds per million BTU over a three-month period or which averages more than 1.7 pounds per million BTU over a 12-month period. The average annual delivered cost of coal used for electric generation was as follows: OIL The Company's present annual requirement at Company-operated facilities is estimated at 800,000 gallons of #2 fuel oil. The Company currently intends to meet this requirement through competitively bid - 16 - contracts. ENVIRONMENTAL QUALITY CONTROL Operations at the Company's facilities are subject to various Federal, state and local environmental standards. To assure the Company's compliance with these requirements, the Company expended approximately $1.0 million on a variety of projects and facility additions during 1993. The most significant environmental control measures affecting Company operations involve the regulation of the quality of fuel burned in utility boilers, the evaluation to determine ambient air quality standards, the imposition of emission limitations on discharges into the air and effluent limitations and pretreatment standards on liquid discharges, the evaluation to determine water quality objectives for water bodies into which Company facilities discharge, the regulation of toxic substances and the disposal of solid wastes. The Company is monitoring a public concern tending to associate health effects with electromagnetic fields from power lines. Together with other New York utilities, the Company funded some of the earliest governmentally-directed research on the question and it continues, with other electric utilities nationwide, to underwrite a broad program of industry-sponsored research in this area. The Company also participated with other New York utilities in compiling information on the state's existing high voltage lines in an initiative which served as a basis for PSC adoption of field limits applicable to the construction of new high voltage lines. The Company has no definitive plans to construct new high voltage lines for its system, but, in connection with Clean Air Act compliance and planning of generation resources, it is considering possible transmission reinforcements; at least one option could require such construction. On request, the Company performs surveys of electromagnetic fields on customer premises. None of its lines have been found to exceed the State field limits applicable to new construction. The Federal Low Level Radioactive Waste Policy Act (Act), as amended in 1985, provides for states to join compacts or individually develop their own low level radioactive waste disposal sites. The portion of the Act that requires a state which fails to provide access to a licensed disposal site by 1996 to take title to such waste was declared unconstitutional by the United States Supreme Court on June 19, 1992, but the court upheld other provisions of the Act enabling sited states to increase charges on shipments from non-sited states and ultimately to refuse such shipments altogether. New York has entered into a contract with the State of South Carolina for the disposal of all low level radioactive waste through June 1994. The Company can provide no assurance as to what disposal arrangements, if any, New York will have in place after that date. The State has not passed legislation that would designate a site for the disposal of low level radioactive waste. In 1990, Governor Cuomo certified a plan that requires all nuclear power plants in New York State to store their low level radioactive waste on site from January 1, 1993, until the end of 1995. The Company has interim storage capacity at the Ginna Plant through December 31, 1995 and - 17 - efforts are being pursued to extend storage capacity to mid-1999, if necessary, at this plant. A low level radioactive waste management and contingency plan is currently ongoing to provide assurance that Nine Mile Two will be properly prepared to handle interim storage of low level radioactive waste for the next ten years. The Company has wastewater discharge permits from NYSDEC for its Beebee, Russell and Ginna Stations. The Russell Station permit is currently in the renewal process. The Beebee and Ginna Station permits were renewed in December 1993 and July 1992, respectively. While no significant changes are anticipated, modifications to the wastewater treatment systems may be necessary. The Company believes that any costs associated with such modifications would be fully recoverable in rates. The Company believes that additional expenditures and costs made necessary by environmental regulations will be fully allowable for ratemaking purposes. Expenditures for meeting various Federal, State and local environmental standards are estimated to be $6.7 million for the year 1994, $4.8 million for the year 1995 and $3.9 million for the year 1996. These expenditures are included under Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations, in the table entitled "Capital Requirements". See Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations and Item 8, Note 10 - Commitments and Other Matters, with respect to other environmental matters. RESEARCH AND DEVELOPMENT The Company's research activities are designed to improve existing energy technologies and to develop new technologies for the production, distribution, utilization and conservation of energy while preserving environmental quality. Research and development expenditures in 1993, 1992 and 1991 were $8,329,278, $7,416,945, and $6,404,766, respectively. These expenditures represent the Company's contribution to research administered by Electric Power Research Institute and Empire State Electric Energy Research Corporation, the Company's share of research related to Nine Mile Two, an assessment for state government sponsored research by the New York State Energy Research and Development Authority, as well as internal research projects. - 18 - Electric Department Statistics - 19 - *Method for determining daily capacity, based on current network analysis, reflects the maximum demand which the transmission systems can accept without a deficiency. - 20 - ITEM 2.		ITEM 2. PROPERTIES ELECTRIC PROPERTIES The net capability of the Company's electric generating plants in operation as of December 31, 1993, the net generation of each plant for the year ended December 31, 1993, and the year each plant was placed in service are as set forth below: (1) Represents 24% share of jointly-owned facility. (2) Represents 14% share of jointly-owned facility. (3) Owned and operated by the Power Authority. The Company owns 146 distribution substations having an aggregate rated transformer capacity of approximately 2,058,579 Kva, of which 137, having an aggregate rated capacity of 1,879,413 Kva, were - 21 - located on lands owned in fee, and 9 of which, having an aggregate rated capacity of 179,166 Kva, were located on land under easements, leases or license agreements. The Company also has 73,950 line transformers with a capacity of 2,894,753 Kva. The Company also owns 24 transmission substations having an aggregate rated capacity of approximately 2,996,017 Kva of which 23, having an aggregate rated capacity of approximately 2,921,350 Kva, were located on land owned in fee and 1, having a rated capacity of 74,667 Kva, was located on land under easements. The Company's transmission system consists of approximately 702 wire miles of overhead lines and 396 wire miles of underground lines. The distribution system consists of approximately 15,987 wire miles of overhead lines, approximately 3,427 wire miles of underground lines and 340,546 installed meters. The electric transmission and distribution system is entirely interconnected and, in the central portion of the City of Rochester, is underground. The electric system of the Company is directly interconnected with other electric utility systems in New York and indirectly interconnected with most of the electric utility systems in the United States and Canada. (See Item 1 - Business, "Electric Operations".) GAS PROPERTIES The gas distribution systems consists of 4,175 miles of gas mains and 278,850 installed meters. (See Item 1 - Business, "Gas Operations".) OTHER PROPERTIES The Company owns a ten-story office building centrally located in Rochester, an Operations Center south of Rochester, and other structures and property. The Company has good title in fee, with minor exceptions, to its principal plants and important units, except rights of way and flowage rights, subject to restrictions, reservations, rights of way, leases, easements, covenants, contracts, similar encumbrances and minor defects of a character common to properties of the size and nature of those of the Company. The electric and gas transmission and distribution lines and mains are located in part in or upon public streets and highways and in part on private property, either pursuant to easements granted by the apparent owner containing in some instances removal and relocation provisions and time limitations, or without easements but without objection of the owners. The First Mortgage securing the Company's outstanding bonds is a first lien on substantially all the property owned by the Company (except cash and accounts receivable). A mortgage securing the Company's revolving credit agreement is also a lien on substantially all the property owned by the Company (except cash and accounts receivable) subject and subordinate to the lien of the First Mortgage. The Company has a credit agreement with a domestic bank under which short term borrowings are secured by the Company's accounts receivable. ITEM 3.	ITEM 3. LEGAL PROCEEDINGS See Item 8, Note 10 - Commitments and Other Matters. - 22 - ITEM 4.	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted to a vote of security holders during the fourth quarter of the fiscal year ended December 31, 1993. ITEM 4 - A. EXECUTIVE OFFICERS OF THE REGISTRANT - 23 - The term of office of each officer extends to the meeting of the Board of Directors following the next annual meeting of shareholders and until his or her successor is elected and qualifies. - 24 - PART II ITEM 5	ITEM 5 MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS COMMON STOCK AND DIVIDENDS Tax Status of Cash Dividends Cash dividends paid in 1993, 1992 and 1991 were 100 percent taxable for Federal income tax purposes. Dividend Policy The Company has paid cash dividends quarterly on its Common Stock without interruption since it became publicly held in 1949. The level of future cash dividend payments will be dependent upon the Company's future earnings, its financial requirements and other factors. The Company's Certificate of Incorporation provides for the payment of dividends on Common Stock out of the surplus net profits (retained earnings) of the Company. Quarterly dividends on Common Stock are generally paid on the twenty-fifth day of January, April, July and October. In January 1994, the Company paid a cash dividend of $.44 per share on its Common Stock, up $.01 from the prior quarterly dividend payment of $.43. The January 1994 dividend payment is equivalent to $1.76 on an annual basis. Common Stock Trading Shares of the Company's Common Stock are traded on the New York Stock Exchange under the symbol "RGS". - 25- Item 6.	Item 6. Selected Financial Data - 26 - - 27 - (a) Includes Company's long term liability to the Department of Energy (DOE) for nuclear waste disposal. Excludes DOE long term liability for uranium enrichment decommissioning and amounts due or redeemable within one year. (b) Excludes disallowed Nine Mile Two plant costs written off in 1989. (c) The recognition by the Company in 1991 of a fuel procurement audit approved by the New York State Public Service Commission (PSC) has been excluded from 1991 coverages. Likewise, recognition by the Company in 1992 of disallowed ice storm costs as approved by the PSC has been excluded from 1992 coverages. Coverages for 1993 exclude the effects of retirement enhancement programs recognized by the Company during the year and certain gas purchase undercharges written off in December 1993. - 28 - ITEM 7.	ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following is Management's assessment of significant factors which affect the Company's financial condition and operating results. Liquidity and Capital Resources During 1993 cash flow from operations, together with proceeds from external financing activity (see Consolidated Statement of Cash Flows), provided the funds for construction expenditures and the retirement and refinancing of long-term debt and preferred stock. Capital requirements during 1994, including debt maturity and sinking fund obligations, are anticipated to be satisfied primarily from the use of internally generated funds. Some external financing, mainly in the form of short-term debt, is expected to be incurred. Any refinancing activity would require additional external financing. Projected Capital and Other Requirements The Company's capital requirements relate primarily to expenditures for electric generation, transmission and distribution facilities and gas mains and services as well as the repayment of existing debt. Construction programs of the Company focus on the need to serve new customers, to provide for the replacement of obsolete or inefficient utility property and to modify facilities consistent with the most current environmental and safety regulations. The Company has no current plans to install additional baseload generation. The Company either has contracts or is continuing negotiations for the realization of approximately 24 megawatts of capacity savings being phased- in over the 1993-1996 period under its demand side management program and, beginning in late 1994 or early 1995, expects approximately 55 megawatts of capacity to be supplied by a cogenerator under contract with the Company. The Company has no other obligations with non-utility generating companies at this time. In June 1992 the Company filed with the New York State Public Service Commission (PSC) an Integrated Resource Plan (IRP) - 29 - which is a long-range plan examining options for the future with regard to generating resources and alternative methods of meeting electric capacity requirements. The plan covers a 15-year period, beginning in 1992, and provides current strategies and alternatives for meeting customer energy requirements in a changing business and technological environment. The IRP takes into account anticipated capacity requirements and available resource options, as well as factors such as reliability, price of product, public acceptance, financial integrity, environmental issues, the competitive marketplace, demand side management and potential new technologies. One result of the IRP was the decision made by the Company in December 1992 to replace the two steam generators at the Ginna nuclear plant in 1996. Like similar plants, the Ginna nuclear plant has experienced degradation in some of the tubes that make up each steam generator. About 30 percent of these tubes have required repair. In addition, a chemical buildup in some of the tubes has reduced their heat transfer capability. Both conditions would continue to erode the plant's performance if the existing steam generators were left in place. Installation of new steam generators was determined by the Company to be the most cost-effective, reliable and environmentally compatible option for the plant. The new steam generators should result in reduced maintenance costs and help sustain a high level of plant availability. Cost of replacement is estimated at $115 million, and preparation to replace these generators began during the plant's routine 1993 fuel outage. As a part of the on-going IRP process, the Company in mid-1993 made a decision to place Unit 1 at Russell Station (47 MW) on cold standby, while modifying Units 2, 3 and 4 with new burners to meet Federal Environmental Protection Agency standards. Unit 1 is expected to be in cold standby by early 1994. Modification of Units 3 and 4 is expected to be completed by March 1995 at a cost of approximately $4.6 million. In addition, Unit 12 at Beebee Station and Unit 2 at Russell Station will be adjusted to produce fewer nitrogen oxides (NOx) by converting a third of the burners in each to achieve overfire air capability at a cost of approximately $1.2 million. These actions will allow the Company to comply with Phase I - Title I, NOx controls requirements of the Federal Clean Air Act, to meet projected load demands in its service territory, and to maintain a mix of fuel generation while remaining competitive and retaining wholesale sales opportunities. Outlined below are other results of the IRP process to date: - The plan calls for evaluating the possibility of using either alternative generation or current generating equipment in partnership with certain large industrial customers. - 30 - - The Company will continue to use demand side management programs to reduce the need for generating capacity. - The Company will consider phasing out its coal-fired Beebee Station by the year 2000, unless it is converted to natural gas and operated under a partnership arrangement with a large customer. The Company's capital expenditures program is under continuous review and will be revised depending upon the progress of construction projects, customer demand for energy, rate relief, government mandates and other factors. In addition to its projected construction requirements, the Company may consider, as conditions warrant, the redemption or refinancing of certain long- term securities. Capital Requirements and Electric Operations Electric production plant expenditures in 1993 included $42 million of expenditures made at the Company's Ginna nuclear plant, of which $15 million was incurred for preparation to replace the steam generators. In addition, nuclear fuel expenditures of $11 million were incurred at Ginna during 1993. A refueling outage at Ginna normally occurs annually for a period of approximately 40 to 50 days. Exclusive of fuel costs, the Company's 14 percent share of electric production plant expenditures at the Nine Mile Two nuclear facility totaled $6 million in 1993. Expenditures of $5 million during 1993 were made for the Company's share of nuclear fuel at Nine Mile Two. On October 2, 1993 Nine Mile Two was taken out of service for a scheduled refueling outage. Refueling was completed and Nine Mile Two resumed full operation on December 3, 1993. The prior refueling outage occurred in 1992 from early March to early July. The next refueling outage for Nine Mile Two is anticipated to begin in May 1995. Electric transmission and distribution expenditures, as presented in the Capital Requirements table, totaled $29 million in 1993, of which $24 million was for the upgrading of electric distribution facilities to meet the energy requirements of new and existing customers. Capital Requirements and Gas Operations Construction began in June 1993 on the Empire State Pipeline (Empire), an intrastate natural gas pipeline subject to PSC regulation between Grand Island and Syracuse, New York. The Company received its first gas deliveries through the pipeline in early November 1993. This pipeline will provide capacity for up to 50 percent of the Company's gas requirements by its second - 31 - year of operation. The Company is participating as an equity owner of Empire, along with subsidiaries of Coastal Corporation and Westcoast Energy Inc. In June 1991 the PSC authorized the Company to invest up to $20 million in Empire subject to certain conditions, notably that the investment not be included in rate base. In 1992 the Company formed a wholly owned subsidiary, Energyline Corporation, to acquire its ownership interest in Empire. The Company's share of ownership in Empire will be dependent upon final project costs and the timing and method of financing selected by the Company. In June 1993 Empire secured a $150 million credit agreement, the proceeds of which are to finance approximately 75 percent of the total construction cost. At December 31, 1993 the Company had invested a net amount of $10.2 million in Energyline ($9.9 million in 1992 and $0.3 million in 1993) and was committed for $9.7 million of the borrowings under the credit agreement. In December 1993 the Company's investment in Energyline was consolidated for accounting and reporting purposes into the accounts of the Company. Such consolidation resulted in a $0.5 million charge to Other Income during 1993. In addition to the Empire project discussed above, construction expenditures in the Gas Department totaled $20 million and were principally for the replacement of older cast iron mains with longer-lasting and less expensive plastic and coated steel pipe, the relocation of gas mains for highway improvement, and the installation of gas services for new load. Environmental Issues The production and delivery of energy are necessarily accompanied by the release of by-products subject to environmental controls. In recognition of the Company's responsibility to preserve the quality of the air, water, and land it shares with the community it serves, the Company has taken a variety of measures (e.g., self-auditing, recycling and waste minimization, training of employees in hazardous waste management) to reduce the potential for adverse environmental effects from its energy operations and, specifically, to manage and appropriately dispose of wastes currently being generated. The Company, nevertheless, has been contacted, along with numerous others, concerning wastes shipped off-site to licensed treatment, storage and disposal sites where authorities have later questioned the handling of such wastes. In such instances, the Company typically seeks to cooperate with those authorities and with other site users to develop cleanup programs and to fairly allocate the associated costs. As a part of its commitment to environmental excellence, the Company is conducting proactive Site Investigation and Remediation (SIR) efforts at Company-owned sites where past waste handling and disposal may have occurred. - 32 - The Company currently estimates the total costs it could incur for SIR activities at Company-owned sites to be about $20 million. This estimate will vary as better site information is available. The Company anticipates spending $10 million over the next 5 years on SIR initiatives. Approximately $4.5 million has been provided for in rates through June 1996 for recovery of SIR costs. To the extent actual expenditures differ from this amount, they will be deferred for future disposition and recovery as authorized by the PSC. Additional environmental issues are discussed in Note 10 of the Notes to Financial Statements. The Company is developing strategies responsive to the Federal Clean Air Act Amendments of 1990 (Amendments). The Amendments primarily affect air emissions from the Company's fossil-fueled electric generating facilities (see Note 10 of the Notes to Financial Statements). The Company is in the process of identifying the optimum mix of control measures that will allow the fossil fuel based portion of the generation system to fully comply with applicable regulatory requirements. Although work is continuing, not all compliance control measures have been determined. The Company has adopted control measures for NOx emissions which must be in effect by the federally mandated compliance date of May 31, 1995. These control measures are discussed under Projected Capital and Other Requirements. Capital costs for NOx controls and the installation of continuous emission monitoring systems are not expected to exceed $6.8 million and will be incurred during 1994 and 1995. A range of capital costs between $20 million and $30 million (1993 dollars) has been estimated for the implementation of several potential scenarios which would enable the Company to meet the foreseeable future NOx and sulphur dioxide requirements of the Amendments. These capital costs would be incurred between 1996 and 2000. The Company currently estimates that it could also incur up to $2 million (1993 dollars) of additional annual operating expenses, excluding fuel, to comply with the Amendments. The use of scrubbing equipment is not presently being considered. Likewise, the purchase or sale of "emission allowances", as allowed by the Amendments, is not currently being considered. The Company anticipates that the costs incurred to comply with the Amendments will be recoverable through rates based on previous rate recovery of environmental costs required by governmental authorities. Competition The Company is operating in an increasingly competitive environment. In its electric business, this environment includes a federal trend toward deregulation and a state trend toward incentive regulation. In addition, excess capacity in the region, new technology and cost pressures on major customers have created incentives for major customers to investigate different electric supply options. Initially, those options will include various forms of self generation, but may eventually include - 33 - customer access to the transmission system in order to purchase electricity from suppliers other than the Company. As discussed under the Regulatory Matters section, the passage of the National Energy Policy Act of 1992 has accelerated these competitive challenges. The Company accepts these challenges and is working to anticipate the impact of the increased competition. Its Business Plan, both in detail for one year and in summary for five years, focuses on improving service while reducing expenses. The Company is engaged in a continuous process improvement program to find opportunities for improved service and efficiency and has implemented an early retirement program in which 173 people, representing approximately seven percent of its workforce, have retired early and will not be replaced. In addition, the Company has agreed to a three-year rate settlement which includes caps on rate increases that approximate or are less than projected inflation, contains incentive programs that tie performance to earnings and stabilizes revenue through revenue adjustment mechanisms. An agreement has been reached with the PSC Staff and others on the terms of a competitive rate tariff that would allow negotiated rates with larger industrial and commercial customers that have competitive electric supply options. These regulatory changes are discussed in more detail in the Regulatory Matters section. Competition in the Company's gas business has existed for some time, as the larger customers have had the option of obtaining their own gas supply and transporting it through the Company's distribution system. This process has been accelerated with FERC Order 636, discussed in more detail in the Regulatory Matters section. In addition to the matters discussed above, the Company has responded to the changes in the gas business by positioning itself to obtain greater access to both U.S. and Canadian natural gas supplies and storage, so that it can take advantage of the unbundling of services that results from FERC Order 636. A major element of this strategy went into place in 1993 with the start-up of the Empire State Pipeline. The Company is engaged in various aspects of capacity release and is investigating other options available to it to mitigate its cost and increase its revenue in the new gas regulatory environment. Beyond the Company's efforts to remain competitive in its core business, it is conducting a broad review of its general business strategy to identify opportunities that will exist in this changed environment. This may result in expansion of various elements of the core business or engaging in new, but related, business activity. - 34 - Redemption of Securities Discretionary first mortgage bond redemptions totaled $120 million during 1993. A $75 million first mortgage bond maturity and $17 million of sinking fund obligations were also a part of the Company's capital requirements in 1993. Capital requirements in 1992 included a $75 million first mortgage bond maturity, and discretionary first mortgage bond redemptions of $79.5 million. Capital Requirements - Summary The Company's capital program is designed to maintain reliable and safe electric and natural gas service, to improve the Company's competitive position, and to meet future customer service requirements. Capital requirements for the three-year period 1991 to 1993 and the current estimate of capital requirements through 1996 are summarized in the Capital Requirements table. Excludes prospective refinancings. - 35 - For the period 1994 through 1996, the Company anticipates construction requirements to total approximately $493 million. Replacement of the steam generators at the Ginna nuclear plant is scheduled to be completed in 1996. Electric production plant expenditures over the period include $16 million in 1994, $29 million in 1995, and $50 million in 1996 for that replacement. In addition to its construction expenditures, the Company has security maturities and sinking fund obligations totaling $63 million over the three-year period 1994 through 1996. Excluded from the Capital Requirements table are expenditures associated with the Company's obligations to the United States Department of Energy for nuclear waste disposal and the Department of Energy's uranium enrichment facility decommissioning (see Notes 1 and 10 of the Notes to Financial Statements). Financing and Capital Structure Capital requirements in 1993 were satisfied by a combination of long- term debt and equity issues, internally generated funds, and short-term borrowings. Common shareholders equity increased during 1993 as the result of a public issue of one and one-half million shares of Common Stock in September. Favorable market conditions allowed the Company to refinance $120 million of its higher-cost long-term debt in 1993. In addition, the Company was able to refinance at a lower interest rate $75 million of its First Mortgage, 8.60% Bonds, Series LL, which matured on August 1. Such refinancing activity over the past three years has helped to reduce the annual cost of long-term debt by approximately $8.8 million and contributed to a drop in the Company's embedded cost of long-term debt from 8.6% at year-end 1990 to 7.4% at the end of 1993. The Company believes that an average of approximately 85 percent to 90 percent of the funds required per year for its 1994 through 1996 construction program will be generated internally and the balance will be obtained through the issue of securities and short-term borrowings. The Company is utilizing its credit agreements to meet any interim external financing needs prior to issuing any long-term securities. As financial market conditions warrant, the Company may, from time to time, issue securities to permit the early redemption of higher-cost senior securities. The Company's financing program is under continuous review and may be revised depending upon the level of construction, financial market conditions, rate relief, cost of capital and other factors. - Financing Interim financing is available from certain domestic banks in the form of short-term borrowings under a $90 million revolving credit agreement which continues until December 31, - 36 - 1996 and may be extended annually. Borrowings under this agreement are secured by a subordinate mortgage on substantially all of the Company's property except cash and accounts receivable. In addition, the Company entered into a Loan and Security Agreement with a domestic bank until December 31, 1994 providing for up to $20 million of short-term debt. Borrowings under this agreement, which can be renewed annually, are secured by the Company's accounts receivable. The Company also has unsecured short-term credit facilities totaling $70 million. At December 31, 1993 the Company had short-term borrowings outstanding of $68.1 million, consisting of $51.3 million of unsecured short-term debt and $16.8 million of secured short-term debt. Under provisions of the Company's Certificate of Incorporation (Charter), the Company may not issue unsecured debt if immediately after such issuance the total amount of unsecured debt outstanding would exceed 15 percent of the Company's total secured indebtedness, capital, and surplus without the approval of at least a majority of the holders of outstanding Preferred Stock. Under this restriction, the Company as of December 31, 1993 was able to issue $19.2 million of additional unsecured debt. Additional interim financing capability remains available with secured borrowings under the Company's credit agreements, as discussed above. During 1993 the Company sold several issues of First Mortgage Bonds, Designated Secured Medium-Term Notes, Series A aggregating $200 million principal amount. Proceeds from the sale of the medium-term notes were used to redeem prior to maturity, at lower interest rates, $120 million principal amount of first mortgage bonds, to pay at maturity $75 million principal amount of first mortgage bonds and to repay short-term debt of $5 million. In July 1993 the Company filed a shelf registration on Form S-3 providing for the offering of $250 million of new securities. The Company may use the shelf registration to offer, from time to time, its first mortgage bonds in one or more series, its Preferred Stock in one or more series and/or its Common Stock depending on market conditions and Company requirements. This Registration Statement became effective August 1993 and allows the Company financing flexibility regarding the timing of new issues. The net proceeds from the sale of the securities will be used to finance a portion of the Company's capital requirements, to discharge or refund certain outstanding indebtedness or preferred stock of the Company, to satisfy certain sinking fund obligations, or for general corporate purposes. In September 1993 the Company sold 1,500,000 shares of new Common Stock in a public offering under the shelf - 37 - registration discussed above. The offering raised $43.1 million in net proceeds, which were used to retire short-term debt incurred in the Company's construction program. During 1993 approximately 515,000 new shares of Common Stock were sold through the Company's Automatic Dividend Reinvestment and Stock Purchase Plan (ADR Plan), providing approximately $14.1 million to help finance its capital expenditures program. New shares issued in 1992 and 1993 through the ADR Plan were purchased from the Company at a market price above the book value per share at the time of purchase. - Capital Structure The public sale of Common Stock in 1992 and 1993 strengthened the Company's common equity. The Company's retained earnings at December 31, 1993 were $75.1 million, an increase of approximately $8.1 million compared with a year earlier. Common equity (including retained earnings) comprised 44.0 percent of the Company's capitalization at December 31, 1993, with the balance being comprised of 6.6 percent preferred equity and 49.4 percent long-term debt. At December 31, 1993 the Company had $21.3 million of long-term debt due within one year and $6.0 million of preferred stock redeemable within one year which, if included in capitalization, would increase the long-term debt component of capitalization at 1993 year-end to 49.8 percent, raise the preferred equity to 6.9 percent and reduce common equity to 43.3 percent of capitalization. As presented, these percentages are based on the Company's capitalization inclusive of its long-term liability to the United States Department of Energy (DOE) for nuclear waste disposal as explained in Note 1 of the Notes to Financial Statements. It is the Company's long-term objective to move to a less leveraged capital structure and to increase the common equity percentage of capitalization toward the 45 percent range. To improve its capital structure, the Company anticipates the issuance of new shares of common stock, primarily through the Company's ADR Plan, and will consider the redemption of higher-cost senior securities. Regulatory Matters - New York State Public Service Commission (PSC) The Company is subject to regulation of rates, service, and sale of securities, among other matters, by the PSC. On August 24, 1993 the PSC issued an order approving a settlement agreement (1993 Rate Agreement) among the Company, PSC Staff and other interested parties. This agreement resolves the Company's rate case proceedings initiated in July 1992. Retroactive application of new rates to July 1, 1993 was authorized by the PSC. The 1993 Rate Agreement will determine the Company's rates through June 30, 1996 and includes certain incentive arrangements - 38 - providing for both rewards and penalties. A summary of recent PSC rate decisions is presented in the table titled "Rate Increases". The 1993 Rate Agreement amounts are based on an allowed return on common equity of 11.50% through June 30, 1996. Earnings between 8.50% and 14.50% will be absorbed/retained by the Company. Earnings above 14.50% will be refunded to the customers. If, but not unless, earnings fall below 8.50%, or cash interest coverage falls below 2.2 times, the Company can seek relief by petitioning the PSC for a review of the 1993 Rate Agreement terms. See under heading Regulatory Matters for additional details The following measures were incorporated into the 1993 Rate Agreement: - Incentive mechanisms that have the potential to either increase or reduce earnings from 5 to 70 basis points each, depending on the Company's ability to meet a variety of prescribed targets in the areas of electric fuel costs, demand side management, service quality, and integrated resource management (relative electric production efficiency). During the rate year ending June 30, 1994, these incentives have the potential to affect earnings by approximately $12 million. - Mechanisms for sharing costs between customers and shareholders for operation and maintenance expenses. In general, non-fuel operation and maintenance - 39 - expense variations are treated in three different ways depending upon the amount of control the Company can exert over them. Those costs that are directly manageable (approximately $172 million in the first rate year) have no sharing and are absorbed by the Company, those costs that are not significantly affected by management action in the short run (approximately $34 million in the first rate year) are trued up 100% and variances resulting from all other such costs (approximately $110 million in the first rate year) are shared 50% by customers and 50% by the Company. - Mechanisms for sharing 50% of overspending variances between forecasted and actual electric capital expenditures related to production and transmission facilities. The Company will retain the savings for cost of money and depreciation on underspending variances. The settlement also provides for a sharing mechanism regarding the replacement of the Ginna nuclear station steam generators. A graduated sharing percentage is applied for up to $15 million of variances, plus or minus, from the forecasted cost of $115 million. Variances above $130 million or below $100 million are absorbed by the Company. - An Electric Revenue Adjustment Mechanism (ERAM) designed to stabilize electric revenues by eliminating the impact of variations in electric sales. A gas weather normalization clause previously in place was retained. To the extent incentive and sharing mechanisms apply, the negotiated rate increases shown in the table titled "Rate Increases" may be adjusted up or down in the second and third year of the agreement. Negotiated electric rate increases could be reduced to zero or increased up to an additional 1.5% in year two, 1.6% in year three and 1.8% in the subsequent year. Negotiated gas rate increases could also be reduced to zero or increased up to an additional 0.8% in year two, 0.9% in year three, and 1.1% in the subsequent year, exclusive of the impact of the Empire State Pipeline going into service. In July 1993 the Company requested approval from the PSC for a new flexible pricing tariff for major industrial and commercial electric customers. A settlement in this matter was filed with the PSC on November 19, 1993 and a decision on whether or not to approve the settlement is expected early in 1994. Such a tariff would allow the Company to negotiate competitive electric rates at discount prices to compete with alternative power sources, such as customer- owned generation facilities. Under the terms of the settlement, the Company would absorb 30 - 40 - percent of any net revenues lost as a result of such discounts through June 1996, while the remainder would be recovered from other customers. The portion recoverable after June 1996 is expected to be determined in a generic proceeding currently being conducted by the PSC. In September 1993 the PSC instituted a formal proceeding to investigate what the Company believes are under-charges to gas customers for certain gas purchases for the period August 1990 to August 1992. The Company's estimate of these undercharges is approximately $7.5 million, of which $2.3 million had been previously expensed and $5.2 million had been deferred on the Company's balance sheet. The PSC has made the Company's current gas rates under the 1993 Rate Agreement temporary solely to consider the impact of these undercharges. On December 30, 1993, a proposed settlement among the Company, PSC Staff and another party was filed with the PSC. It provides for the recovery in rates of $3.2 million over three years, subject to audit and to limitations on rate adjustments established in the August 24 Order. The Company wrote off the $2.0 million balance of the undercharges as of December 31, 1993. That write-off amounts to a reduction in 1993 earnings of approximately $.04 per share, net of tax. Although no party, to the Company's knowledge, opposes the proposed settlement, the Company is unable to predict whether the PSC will approve it. A PSC decision on whether to approve this settlement is not expected before March 1994. In its June 1992 rate decision, the PSC allowed the Company to defer and recover through rates over a period of ten years approximately $21.3 million of non-capital incremental storm-damage repair costs which the Company had incurred as a result of a March 1991 ice storm. The PSC has permitted the unamortized balance of these allowed costs to be included in rate base. Rate recovery of an additional $8.2 million of non-capital storm-damage costs incurred by the Company was denied by the PSC and the Company accordingly recorded in the second quarter of 1992 a charge to earnings in the amount of $8.2 million, equivalent to approximately $.15 per share, net of tax, after issuance of the two million shares of stock in August 1992. Pursuant to a November 1991 Order approving a settlement agreement between the PSC Staff and the Company relating to the Staff's audit of the Company's fuel procurement practices, the Company refunded $10 million to its electric customers through adjustments to their energy bills over a twelve-month period beginning in January 1992. The Company recorded a $6.6 million net-of- tax reduction to net income, thereby reducing earnings per share by approximately $.21 for the fourth quarter of 1991. - 41 - - National Energy Policy Act of 1992 The National Energy Policy Act (Energy Act) was signed into law in 1992. Major provisions of the Energy Act, as they relate to the Company, include energy efficiency, promoting competition in the electric power industry at the wholesale level, streamlining of federal licensing of nuclear power plants, encouraging development and production of coal resources, and ensuring that a new class of independent power producers established under the bill, as well as qualified facilities and other electric utilities, can achieve access to utility-owned transmission facilities upon payment of appropriate prices. Under the Energy Act, FERC may order utilities to provide wholesale transmission services for others only if, among other things, the order meets certain requirements as to cost recovery and fairness of rates. FERC is prohibited, however, from ordering retail wheeling, i.e. transmitting power directly to a customer from a supplier other than the customer's local utility. The law, however, does not prevent state regulatory commissions from allowing or ordering intrastate retail wheeling; and, New York State is currently considering the issue of retail wheeling through various studies and hearings. The Company believes this Act could lead to enhanced competition among the Company and other service providers in the electric industry. - FERC Order 636 In April 1992 FERC issued Order No. 636 with the intention of fostering competition and improving access of customers to gas supply sources. In essence, FERC Order No. 636 requires interstate natural gas companies to offer customers "unbundled", or separate, sales and transportation services. FERC Order 636 enables the Company and other gas utilities to contract directly with gas producers for supplies of natural gas. With the unbundling of services, primary responsibility for reliable natural gas supply has shifted from interstate pipeline companies to local distribution companies, such as the Company. Since 1988 the Company has endeavored to diversify both its natural gas supply sources and the pipelines on which that supply is delivered to the Company's distribution system. The unbundling of services as required under FERC Order 636 and the commencement of Empire State Pipeline operation have enabled the Company to achieve those goals, which should enhance its competitive position. As a result of FERC Order 636, the Company does face certain restructuring transition costs as explained under the heading Energy Costs and Supply-Gas. Results of Operations The following financial review identifies the causes of - 42 - significant changes in the amounts of revenues and expenses, comparing 1993 to 1992 and 1992 to 1991. The Notes to Financial Statements contain additional information. Operating Revenues and Sales Compared with a year earlier, operating revenues rose six percent in 1993 following a five percent increase in 1992. Gains in retail customer electric and gas revenues offset a decline in electric revenues from the sale of electric energy to other utilities. Customer revenue increases in 1993 resulted primarily from rate relief and the impact of warmer weather on air conditioning usage. Details of the revenue changes are presented in the Operating Revenues table. As presented in this table, the base cost of fuel has been excluded from customer consumption and is included under fuel costs, revenue taxes are included as a part of other revenues, and unbilled revenues are included in each caption as appropriate. Unbilled revenues are the estimated revenues attributable to energy which has been delivered to customers but for which the metered amount has not been read and recorded on the Company's books. Such revenues do not enhance the Company's cash position. The Company records monthly accruals for unbilled revenues. The Company's Statement of Income reflects net unbilled revenues of $18.7 million in 1993, $(0.8) million in 1992, and $2.6 million in 1991. Primarily as a result of the seasonal nature of gas revenues, unbilled revenues can fluctuate from month to month and will normally be near their maximum around January and at their minimum near the end of June. Under the ERAM provisions of the 1993 Rate Agreement, as discussed under Regulatory Matters, the Company is comparing, on a monthly basis, actual results to forecast electric gross - 43 - margins as defined (basically, revenues less incremental cost of fuel) and utilized in establishing rates. Variations between these target margins and the Company's actual margins may be deferred and either recovered from or returned to customers. As discussed earlier, the 1993 Rate Agreement "caps", that is limits, the amount of revenue increases that can be obtained each rate year. At the end of each rate year (i.e. June 30) any balance for ERAM will be taken into consideration along with other balances eligible for passback or surcharge to customers (primarily incentive and expense sharing provisions) to determine the final disposition of the balance. As of December 31, 1993 no provisions to accrue or defer revenues associated with any of the ERAM incentive or sharing provisions under the 1993 Rate Agreement had been made, except for fuel adjustment clause revenues. Changes in fuel and purchased power cost revenues are normally earnings neutral. The Company, however, does have fuel clause provisions which currently provide that customers and shareholders will share, generally on a 50%/50% basis subject to certain incentive limits, the benefits and detriments realized from actual electric fuel costs, generation mix, sales of gas to dual- fuel customers and sales of electricity to other utilities compared with PSC- approved forecast, or base rate, amounts. As a result of these sharing arrangements, discussed further in Note 1 of the Notes to Financial Statements, pretax earnings were increased by $4.4 million in 1992 and in 1993, primarily reflecting actual experience in both electric fuel costs and generation mix compared with rate assumptions. Fuel clause revenues also include the recovery of incremental margins that vary from those provided for in base rates for the implementation of the Company's energy efficiency programs (discussed below in this section). Beginning in October 1993, the Company also began the recovery through its fuel adjustment clause of deferred costs associated with the DOE's assessment for future uranium enrichment decontamination. For the 1992 comparison period, fuel clause revenues were reduced due to a refund to electric customers resulting from a PSC fuel audit settlement as described in the last paragraph under the heading New York State Public Service Commission. The effect of weather variations on operating revenues is most measurable in the Gas Department, where revenues from space heating customers comprise about 85 to 90 percent of total gas operating revenues. Variation in weather conditions can also have a meaningful impact on the volume of gas delivered and the revenues derived from the transportation of customer-owned gas since a substantial portion of these gas deliveries is ultimately used for space heating. After experiencing unseasonably mild weather during the 1991 heating season, weather in the Company's service area during 1992 and 1993 was colder than normal. Gas sales were enhanced as a result of this cooler weather, while - 44 - unseasonably warm summer weather during 1993 boosted electric energy sales to meet the demand for air conditioning usage, compared with the cool, wet 1992 summer weather conditions. The decoupling, or separation, of sales level fluctuations from revenue through the ERAM provisions, discussed under Regulatory Matters, and a gas normalization weather clause (see following paragraph) may mitigate the effect of abnormal weather conditions on earnings. As part of the June 1992 rate decision, retail customers who use gas for spaceheating became subject to a weather normalization adjustment to reflect the impact of variations from normal weather on a billing cycle month basis for the months of October through May, inclusive. The weather normalization adjustment for a billing cycle will apply only if the actual heating degree days are lower than 97.5 percent or higher than 102.5 percent of the normal heating degree days. Weather normalization adjustments lowered gas revenues in 1993 by approximately $1.2 million and in 1992 by approximately $1.8 million. The potential for such adjustments continues through June 1996 under the terms of the 1993 Rate Agreement. Compared with the prior year, kilowatt-hour sales of energy to retail customers in 1993 climbed about one percent after being nearly flat in 1992. Electric demand for air conditioning usage had a significant impact on such sales in 1993 and 1992. During 1993, an increase in sales to both residential and commercial customers more than offset a decline in sales to industrial customers. Kilowatt-hour sales of energy in 1993 reflect the impact of approximately 2,200 new electric customers, which follows the addition of nearly 2,400 customers a year earlier. Like many other electric utilities, the Company is encouraging energy efficiency through demand side management (DSM) programs. Objectives of the DSM programs include increasing the efficiency with which electricity is used and shifting electric load from peak to non-peak times, thus helping to save energy and delay the need to add new generating capacity. DSM programs include rebates for energy-efficient equipment, audits which focus on potential techniques for saving energy, consumer information and outreach, and design assistance to encourage energy-efficient new construction. In general, the Company is being allowed to amortize major DSM program expenditures over a five-year period. An incentive allowance (award) of approximately $0.6 million was provided for in the Company's rates based on the Company's DSM performance during 1992. Lost margins resulting from DSM activities are estimated and recovered in base rates. Variances between actual results and such estimates are recovered through fuel clause revenue adjustments, subject to certain incentive limitations. - 45 - Fluctuations in revenues from electric sales to other utilities are generally related to the Company's customer energy requirements, New York Power Pool energy market and transmission conditions and the availability of electric generation from Company facilities. Such revenues in 1992 and 1993 reflect the sale of energy at a lower average rate per megawatt hour, a result, in part, of competition and greater availability of energy. With more open access to transmission services as provided for under the Energy Act, the Company is examining alternative markets and procedures to meet what it believes will be increased competition for the sale of electric energy to other utilities. The transportation of gas for large-volume customers who are able to purchase natural gas from sources other than the Company remains an important component of the Company's marketing mix. Company facilities are used to transport this gas, which amounted to 12.4 million dekatherms in 1993 and 12.6 million dekatherms in 1992. These purchases have caused decreases in customer revenues, with offsetting decreases in purchased gas expenses, but do not adversely affect earnings because transportation customers are billed at rates which, except for the cost of gas, approximate the rates charged the Company's other gas service customers. Gas supplies transported in this manner are not included in Company therm sales, depressing reported gas sales to non- residential customers. Therms of gas sold and transported, including unbilled sales, were nearly flat in 1993, following an 11.8 percent increase in 1992. These changes reflect, primarily, the effect of weather variations on therm sales to customers with space heating. If adjusted for normal weather conditions, residential gas sales would have decreased about 0.3 percent in 1993 over 1992, while nonresidential sales, including gas transported, would have decreased approximately 2.1 percent in 1993. The average use per residential gas customer, when adjusted for normal weather conditions was slightly down in 1993, following a modest increase in 1992. Total therms of gas transported increased in 1992 primarily as a result of higher sales to certain large industrial and municipal transportation customers. Sales to these customers in 1993 were down compared with 1992 sales. Fluctuations in "Other" customer revenues shown in the Operating Revenues table for both comparison periods are largely the result of revenue taxes, deferred fuel costs, and miscellaneous revenues. Operating Expenses Compared with the prior year, operating expenses were up $40.2 million in 1993 after increasing $33.1 million in 1992. Approximately two-thirds of the increase in 1993 operating - 46 - expenses resulted from higher gas purchased for resale costs. The increase in operating expenses for the 1993 comparison period was mitigated by the Company's continuing efforts to curtail increases in other operation expenses. Operating expenses are summarized in the table titled "Operating Expenses". - Energy Costs - Electric An electric generation mix favoring less expensive nuclear fuel, compared with the cost of coal or oil, resulted in fuel expenses not increasing at the same rate as electric generation for the 1993 comparison period. For the 1992 comparison period, fuel expense for electric generation was lower by $16.7 million due, in part, to a refund to electric customers as described in the last paragraph under the heading New York State Public Service Commission. For both comparison periods, the average cost of coal declined. Average rates for purchased electricity declined in 1993, after increasing in 1992. Such average rates partially offset an increase in kilowatt-hours purchased in 1993. For the 1992 comparison period, the increase in purchased electricity expense was caused by higher average rates during the year. - Energy Costs and Supply - Gas As a result of the implementation of FERC Order 636, and the commencement of operation of the Empire State Pipeline, the Company now purchases all of its required gas supply directly - 47 - from numerous producers and marketers under contracts containing varying terms and conditions. The Company holds firm transportation capacity on nine major pipelines, giving the Company access to the major gas-producing regions of North America. In addition to firm pipeline capacity, the Company also has obtained contracts for firm storage capacity on the CNG Transmission Corporation (CNG) system (10.4 billion cubic feet) and on the ANR Pipeline system (6.4 billion cubic feet) which are used to help satisfy its customers' winter demand requirements. With the commencement of operation of the Empire State Pipeline, the Company placed into operation its new Mendon gate station which is capable of supplying up to one-half of the Company's gas supply needs while also maintaining the various gate station interconnections with the CNG system that, prior to Empire, had supplied all of the Company's needs. The transportation service to be provided by Empire was scheduled to phase in over 12 months, at which point the combined CNG and Empire transportation capacity would have exceeded the Company's current requirements. Therefore, the Company recently entered into a marketing agreement with CNG, pursuant to which CNG will assist the Company in obtaining permanent replacement customers for the transportation capacity the Company will not require. It may renegotiate its arrangements with CNG and/or Empire or it may negotiate assignment, on a permanent or temporary basis, of the transportation capacity that exceeds the requirements of its customers. In addition, under FERC rules, the Company may sell its excess transportation capacity in the market. While CNG has already secured letters of intent for a substantial portion of such capacity, whether and to what extent CNG and/or the Company can successfully negotiate the assignment or sale of the excess capacity, or at what price, cannot be determined at the present time. The retention of some or all of this excess transportation capacity may cause an increase in the Company's gas supply costs. This would be in addition to any increase caused by other aspects of the gas transportation restructuring. As a result of the restructuring of the gas transportation industry by the FERC, there will be a number of changes in this aspect of the Company's business over the next several years. These changes, which will apply throughout the industry, will affect different companies differently and may result, at least initially, in increases in the gas transportation costs of the Company. The Company will also be required to pay a share of certain transition costs incurred by the pipelines as a result of the FERC restructuring. These include costs related to restructuring existing gas supply contracts, unrecovered gas costs that would otherwise have been billable to pipeline customers under previous regulation and other related costs deemed reasonable by the FERC. Although the final amounts of such transition costs are subject to continuing - 48 - negotiations with several pipelines and ongoing pipeline filings requiring FERC approval, the Company expects such costs to range between $43.5 and $52.0 million. A substantial portion of such costs will be on the CNG system of which approximately $27 million was billed to the Company on December 3, 1993 payable over the following three years. The Company recorded a regulatory asset on its Balance Sheet and concurrently recognized a liability totaling approximately $43.5 million for estimated restructuring transition costs under FERC Order 636. The Company expects these transition costs to be recoverable in its rates. The volume of gas purchased increased in both comparison periods primarily due to higher combined residential and commercial space heating sales, reflecting colder weather. The effect of higher-volume purchases was partially offset by lower average rates in 1992. In contrast to 1992, however, it was primarily an increase in these rates that pushed up the cost of gas purchased for resale in 1993. These higher rates reflect, in part, increased demand charges and, to a lesser extent, newly assessable gas service restructuring charges as a result of FERC Order 636. - Operating Expenses, Excluding Fuel Other operation expenses rose over both comparison periods as shown by the table titled "Operating Expenses". The recording of certain postretirement benefits other than pensions, as required by Statement of Financial Accounting Standards No. 106 (SFAS-106) and discussed in the following paragraph, increased other operation expenses in 1992 by $4.9 million. Compared with a year earlier, other operation expenses in 1992 also reflect an increase of $3.0 million for transmission wheeling charges, $1.9 million due to increased amortization of costs associated with the Company's demand side management programs, and additional expenses of about $1.6 million associated with the Company's share of Nine Mile Two operation expenses. As stated earlier, the growth in other operation expenses was significantly less over the 1993 comparison period, a direct result, in part, of enhanced cost control efforts by the Company's employees. Compared with 1992, operating expenses associated with fire and liability insurance, transportation, materials and supplies, legal expenses, and the Company's share of Nine Mile Two operation expenses declined in 1993. The change in other operation expenses for the 1993 comparison period reflects primarily increased payroll costs and demand side management expenses. During the first quarter of 1992, the Company adopted the Financial Accounting Standards Board's (FASB) SFAS-106 for financial accounting purposes. Among other things, SFAS-106 requires accrual accounting for postretirement benefits other than pensions. Based on accrual accounting required by SFAS-106, - 49 - the Company's net periodic cost for postretirement benefits other than pension was $7.5 million in 1993 and $7.8 million in 1992. The PSC has allowed the Company revenues in rates based on SFAS-106. In September 1993, the PSC issued a "Statement of Policy Concerning the Accounting and Ratemaking Treatment for Pensions and Postretirement Benefits Other Than Pensions." The Statement's provisions require, among other things, ten-year amortization of actuarial gains and losses and deferral of differences between actual costs and rate allowances. The Company adopted the Statement in 1993 for regulatory accounting purposes. In November 1992, the FASB issued SFAS-112 entitled "Employees' Accounting for Postemployment Benefits" which is effective for fiscal years beginning after December 15, 1993. This Statement requires the Company to recognize the obligation to provide postemployment benefits to former or inactive employees after employment but before retirement. Employers must accrue an obligation if the benefits are attributable to service already rendered, the benefits accumulate or vest, payment is probable, and the amounts can be reasonably estimated. The Company must adopt SFAS-112 not later than the first quarter of 1994. The Company is currently evaluating the impact of SFAS- 112; however, based on studies the Company has performed to date, the adoption of SFAS-112 is not expected to have a material effect on the Company's financial condition or results of operations. Reduced maintenance expense in both comparison periods was largely due to lower maintenance expenses incurred at nuclear production facilities and the effect of increased activity in 1991 associated with electric distribution facilities. Despite an increase in depreciable plant in both comparison periods, depreciation and amortization of other plant fluctuated only moderately due mainly to a decrease in the depreciation and accrued decommissioning expenses related to the Ginna nuclear plant because of a three-year extension of its operating license and the completion in July 1992 of amortization of the Sterling property previously abandoned. - Taxes Charged to Operating Expenses The increase in local, state and other taxes in both comparison periods resulted primarily from an increase in revenues combined with an increase in the revenue tax rate, and increased property tax rates and higher property assessments. The 1993 increase in local, state and other taxes was mitigated by the effect of the relative magnitude of these factors compared with 1992. The increase in these taxes for the 1992 comparison period reflects an adjustment for a one-half percent increase in the New York State gross revenue tax rate accounted for beginning - 50 - in October 1991 retroactive to January 1, 1991. During the first quarter of 1993, the Company adopted SFAS-109 entitled "Accounting for Income Taxes" issued by the FASB in February 1992. Among other things, SFAS-109 requires that a deferred tax liability be recognized on the balance sheet for tax differences previously flowed through to customers. The Company's adoption of SFAS-109 in the first quarter of 1993 did not have a material effect on the Company's results of operations although since then, reflection of a deferred tax liability, together with a corresponding regulatory asset, caused total assets and liabilities to increase significantly. See Note 2 of the Notes to Financial Statements for further discussion of SFAS- 109 and an analysis of Federal income taxes. In August 1993, the Revenue Reconciliation Act of 1993 (1993 Tax Act) was signed into law. Among other provisions, the 1993 Tax Act provides for a Federal corporate income tax rate of 35% (previously 34%) retroactive to January 1, 1993. The Company has adjusted its tax reserve balances to reflect this new rate. There was no earnings impact since the effects of the tax change have been deferred. The Company petitioned the PSC in late 1993 for recognition and recovery of this incremental tax liability which was not reflected in the provisions of its 1993 Rate Agreement. The Company's ability to recover this cost is dependent upon the PSC issuing a generic ruling on the treatment of the 1993 Tax Act. Other Statement of Income Items AFUDC variances are generally related to the amount of utility plant under construction and not included in rate base. AFUDC levels also reflect decreases in the gross rate to 3.90 percent effective September 1, 1993 from earlier rates of 4.50 percent, 5.50 percent, and 7.10 percent. Variations in non-operating Federal income tax reflect mainly accounting adjustments related to retirement enhancement programs (see following paragraph), regulatory disallowances, and an employee performance incentive program (discussed below in this section). Recorded under the caption Other Income and Deductions is the recognition of retirement enhancement programs designed to reduce overall labor costs which were implemented by the Company during the third and fourth quarters of 1993. A total of 173 employees elected to participate under these programs. The Company does not plan to replace any of those employees. Total estimated pretax costs of $8.2 million associated with these programs were recognized by the Company in its 1993 Statement of Income, thereby reducing after-tax earnings by approximately $.15 - 51 - per share for the year. The Company estimates that the net pre-tax savings through 1997 resulting from these programs will amount to about $8.9 million. Recorded under the caption Regulatory Disallowances is the recognition of the 1991 PSC order associated with the Company's fuel procurement practices, the 1992 PSC order related to the March 1991 ice storm, and the 1993 settlement with the PSC regarding certain alleged gas purchase undercharges, each discussed under the heading New York State Public Service Commission. Other Income in 1992 includes $3.5 million of proceeds received in settlement of lawsuits filed against certain contractors involved in the construction of the Nine Mile Two nuclear plant. Non-cash earnings associated with the amortization of customer prepaid Nine Mile Two financing costs of $4.8 million in 1991, $2.5 million in 1992, and $1.2 million in 1993 are also included in Other Income. The decline in Other-Net Income and Deductions for the 1993 comparison period results mainly from the recognition of an employee performance incentive program for 1993. This program recognizes employees' achievements in meeting corporate goals and reducing expenses. Compared with a year earlier, Other-Net Income and Deductions also reflects lower miscellaneous interest revenues in 1993 and the recognition of Energyline earnings (losses) upon consolidation with the accounts of the Company as discussed under Capital Requirements and Gas Operations. Both mandatory and optional redemptions of certain higher-cost first mortgage bonds have helped to reduce long-term debt interest expense over the three-year period 1991-1993, despite the issuance of additional long-term debt in 1991 and 1992. In 1992, the effect of lower interest rates on debt expense was partially offset by increased short-term borrowings. The level of short- term debt borrowings decreased in 1993. EARNINGS/SUMMARY Presented below is a table which summarizes the Company's Common Stock earnings on a per-share basis. Certain non-recurring items and their effect on earnings per share have been identified in this table. Compared with a year earlier, earnings per share were up in 1993 and 1992 despite the effect of a public issuance of Common Stock in each year. Future earnings will be affected, in part, by the Company's success in achieving demand side management and other incentive goals, as well as controlling operating and capital costs, within levels provided for in rates under the terms of the 1993 Rate Agreement. In December 1992 the Company announced a quarterly - 52 - dividend increase from $.42 to $.43 per share of Common Stock payable in January 1993. Subsequently, in December 1993 the Company announced a new quarterly dividend rate of $.44 per share payable in January 1994. The Company's Charter provides for the payment of dividends on Common Stock out of the surplus net profits (retained earnings) of the Company. Accordingly, dividend payments are dependent on future earnings, in addition to financial requirements and other factors. - 53 - ITEM 8.	ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA A. Financial Statements Report of Independent Accountants Consolidated Statements of Income and Retained Earnings for each of the three years ended December 31, 1993. Consolidated Balance sheets at December 31, 1993 and 1992. Consolidated Statement of Cash Flows for each of the three years ended December 31, 1993. Notes to Consolidated Financial Statements. Financial Statement Schedules - The following Financial Statement Schedules are submitted as part of Item 14, Exhibits, Financial Statement Schedules and Reports on Form 8-K, of this Report. (All other Financial Statement Schedules are omitted because they are not applicable, or the required information appears in the Financial Statements or the Notes thereto.) Schedule V - Property, Plant and Equipment (Utility Plant) Schedule VI - Accumulated Depreciation and Amortization (Utility Plant) Schedule VIII - Valuation and Qualifying Accounts Schedule IX - Short-term Borrowings Schedule X - Supplementary Income Statement Information B. Supplementary Data Interim Financial Data. - 54 - REPORT OF INDEPENDENT ACCOUNTANTS To the Shareholders and Board of Directors of Rochester Gas and Electric Corporation In our opinion, the consolidated financial statements listed under Item 8A in the index appearing on the preceding page present fairly, in all material respects, the financial position of Rochester Gas and Electric Corporation and its subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. As discussed in Note 1 to the financial statements, the Company adopted the provisions of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" in 1993. PRICE WATERHOUSE Rochester, New York January 14, 1994 - 55 - Consolidated Statement of Income Consolidated Statement of Retained Earnings The accompanying notes are an integral part of the financial statements. - 56 - The accompanying notes are an integral part of the financial statements. The accompanying notes are an integral part of the financial statements. - 58 - NOTES TO FINANCIAL STATEMENTS NOTE 1. SUMMARY OF ACCOUNTING PRINCIPLES General. The Company is subject to regulation by the Public Service Commission of the State of New York (PSC) under New York statutes and by the Federal Energy Regulatory Commission (FERC) as a licensee and public utility under the Federal Power Act. The Company's accounting policies conform to generally accepted accounting principles as applied to New York State public utilities giving effect to the rate-making and accounting practices and policies of the PSC. In June 1988, the Board of Directors authorized the creation of Utilicom, Inc. as a wholly owned subsidiary. Utilicom develops and markets computer software to assist customers in complying with state and federal environmental and safety regulations. On August 31, 1993, the Company sold the assets of Utilicom and liquidated the subsidiary. The subsidiary activity prior to and including disposition was insignificant to the Company's financial position and results of operation. In April 1990, the Board of Directors authorized the creation of Energyline Corporation, a wholly owned subsidiary, which was incorporated in July 1992. Energyline was formed as a gas pipeline corporation to fund the Company's investment in the Empire State Pipeline project. On November 1, 1993 Empire commenced service to the Company's gas distribution facilities. The Company has authority to invest up to $20 million in Empire. In June 1993 Empire secured a $150 million credit agreement, the proceeds of which are to finance approximately 75 percent of the total construction cost and initial operating expenses. Energyline is obligated to pay up to 20% of the balance outstanding subject to a commitment of $9.7 million under the credit agreement. Excluding the loan commitment, at December 31, 1993 the Company had invested a net amount of $10.2 million in Energyline. A description of the Company's principal accounting policies follows. Rates and Revenue. Revenue is recorded on the basis of meters read. In addition, the Company records an estimate of unbilled revenue for service rendered subsequent to the meter-read date through the end of the accounting period. Tariffs for electric and gas service include fuel cost adjustment clauses which adjust the rates monthly to reflect changes in the actual average cost of fuels. The electric fuel adjustment provides that ratepayers and the Company will share the effects of any variation from forecast monthly unit fuel costs on a 50%/50% basis up to a $5.6 million cumulative annual gain or loss to the Company. Thereafter, 100 percent of additional fuel clause adjustment amounts are assigned to customers. The electric fuel cost adjustment also provides that any variation from forecast margins below $7.1 million or above $8.5 million on sales to electric utilities be shared with retail customers on a 50%/50% basis. - 59 - In addition, there is a similar 50%/50% sharing process of variances from forecasted margins derived from sales and the transportation of privately owned gas to large customers that can use alternate fuels. Under the Company's Electric Revenue Assurance Mechanism (ERAM), which was established in the 1993 multi-year rate settlement, any variations between actual margins and the established targets may be recovered from or returned to customers. Other performance incentives or penalties were established in the settlement and under some circumstances could be recognized periodically. However, through December 31, 1993, no amount was recognized as recoverable or payable to customers. Retail customers who use gas for spaceheating are subject to a weather normalization adjustment to reflect the impact of variations from normal weather on a billing month basis for the months of October through May, inclusive. The weather normalization adjustment for a billing cycle will apply only if the actual heating degree days are lower than 97.5 percent or higher than 102.5 percent of the normal heating degree days. Weather normalization adjustments lowered gas revenues in 1993 and 1992 by approximately $1.2 million and $1.8 million respectively. These adjustments will continue through June 1996 in accordance with the 1993 multi-year rate settlement agreement. Deferred Fuel Costs. The Company practices fuel cost deferral accounting as described above. A reconciliation of recoverable gas costs with gas revenues is done annually as of August 31, and the excess or deficiency is refunded to or recovered from the customers during a subsequent twelve-month period beginning in December. These deferred fuel costs are included as a component of unbilled revenues. Utility Plant, Depreciation and Amortization. The cost of additions to utility plant and replacement of retirement units of property is capitalized. Cost includes labor, material, and similar items, as well as indirect charges such as engineering and supervision, and is recorded at original cost. The Company capitalizes an allowance for funds used during construction approximately equivalent to the cost of capital devoted to plant under construction that is not included in its rate base. Replacement of minor items of property is included in maintenance expenses. Costs of depreciable units of plant retired are eliminated from utility plant accounts, and such costs, plus removal expenses, less salvage, are charged to the accumulated depreciation reserve. Depreciation in the financial statements is provided on a straight- line basis at rates based on the estimated useful lives of property, which have resulted in provisions of 2.9%, 2.9% and 3.3% per annum of average depreciable property in 1993, 1992 and 1991, respectively. The decrease in depreciation provision percentages from 1991 to 1992 is principally the result of a 3 1/2 year extension of the Ginna Nuclear Plant license term and lengthening estimated useful lives at other property. Nuclear Fuel Disposal Costs. The Nuclear Waste Policy Act (Act) of 1982, as amended, requires the United States Department of Energy (DOE) - 60 - to establish a nuclear waste disposal site and to take title to nuclear waste. A permanent DOE high-level nuclear waste repository is not expected to be operational before the year 2010. The DOE is pursuing efforts to establish a monitored retrievable interim storage facility which may allow it to take title to and possession of nuclear waste prior to the establishment of a permanent repository. The Act provides for a determination of the fees collectible by the DOE for the disposal of nuclear fuel irradiated prior to April 7, 1983 and for three payment options. The option of a single payment to be made at any time prior to the first delivery of fuel to the DOE was selected by the Company in June 1985. The Company estimates the fees, including accrued interest, owed to the DOE to be $68.1 million at December 31, 1993. The Company is allowed by the PSC to recover these costs in rates. The estimated fees are classified as a long-term liability and interest is accrued at the current three-month Treasury bill rate, adjusted quarterly. The Act also requires the DOE to provide for the disposal of nuclear fuel irradiated after April 6, 1983, for a charge of one mill ($.001) per KWH of nuclear energy generated and sold. This charge is currently being collected from customers and paid to the DOE pursuant to PSC authorization. The Company expects to utilize on-site storage for all spent or retired nuclear fuel assemblies until an interim or permanent nuclear disposal facility is operational. Nuclear Decommissioning Costs. Decommissioning costs (costs to take the plant out of service in the future) for the Company's Ginna Nuclear Plant are estimated to be approximately $150.7 million, and those for the Company's 14% share of Nine Mile Two's decommissioning costs are estimated to be approximately $34.3 million (January 1993 dollars). Through December 31, 1993, the Company has accrued and recovered in rates $61.2 million for this purpose and is currently accruing and recovering decommissioning costs at a rate of approximately $8.9 million per year based on the use of a combination of internal and external sinking funds. (See Note 10.) The decommissioning costs, which form the basis for current accruals, were derived from the record of the Company's prior rate proceeding (PSC Opinion 93-19, issued August 1993) and were estimated principally by reference to a formula prescribed by the NRC for the purpose of providing for adequate funding at the time of the decommissioning. Uranium Enrichment Decontamination and Decommissioning Fund. As part of the National Energy Act (Act) issued in October 1992, utilities with nuclear generating facilities are assessed an annual fee payable over 15 years to pay for the decommissioning of Federally owned uranium enrichment facilities. The assessments for Ginna and Nine Mile Two are estimated to total $24.1 million, excluding inflation and interest. The first installment of $1.6 million was paid in 1993 and recovered through the fuel adjustment clause. A liability has been recognized on the financial statements along with a corresponding regulatory asset. The Company believes that the full amount of the assessment will be recoverable in rates as described in the Act. FERC Order 636. Under this order, gas supply and pipeline companies are allowed to pass restructuring and transition costs associated with the - 61 - implementation of the order on to their customers. The Company, as a customer, has estimated a total of $43.5 million which will be paid to its suppliers. A regulatory asset and related deferred credit have been established on the balance sheet to account for these estimated costs. Approximately $2.2 million of these costs were paid during 1993 to various suppliers, and have been included in purchased gas costs (see Note 10). Allowance for Funds Used During Construction. The Company capitalizes an Allowance for Funds Used During Construction (AFUDC) based upon the cost of borrowed funds for construction purposes, and a reasonable rate upon the Company's other funds when so used. AFUDC is segregated into two components and classified in the Statement of Income as Allowance for Borrowed Funds Used During Construction, an offset to Interest Charges, and Allowance for Other Funds used During Construction, a part of Other Income. The rates approved by the PSC for purposes of computing AFUDC were: 3.9% from September 1, 1993 through December 31, 1993; 4.5% from September 1, 1992 through August 31, 1993; 5.5% from April 1, 1992 through August 31, 1992; 7.1% from July 1, 1991 through March 31, 1992; 8.6% from February 1, 1991 through June 30, 1991; 9.6% from January 1, 1991 through January 31, 1991. In 1984, the Company discontinued accruing AFUDC on a portion of its investment in Nine Mile Two for which a cash return was allowed. Amounts were accumulated in deferred debit and credit accounts equal to the amount of AFUDC which was no longer accrued. The balance in the deferred credit account was intended to reduce future cash revenue requirements over a period substantially shorter than the life of Nine Mile Two, and the balance in the deferred debit account would then be collected from customers over a longer period of time. The current balances of $19.2 million are expected to remain on the Company's books for future application by the PSC as a rate moderator. Federal Income Tax. For income tax purposes, depreciation is generally computed using the most liberal methods permitted. The resulting tax reductions are offset by provisions for deferred income taxes only to the extent ordered or permitted by regulatory authorities. Statement of Financial Accounting Standards (SFAS) 109, Accounting for Income Taxes, was adopted by the Company during the first quarter of 1993. SFAS-109 requires that a deferred tax liability must be recognized on the balance sheet for tax differences previously flowed through to customers. Substantially all of these flow-through adjustments relate to property plant and equipment and related investment tax credits and will be amortized consistent with the depreciation of these accounts. The net amount of the additional liability at December 31, 1993 was $241 million. In conjunction with the recognition of this liability, a corresponding regulatory asset was also recognized. SFAS-109 also requires that a deferred tax liability or asset be adjusted in the period of enactment for the effect of changes in tax laws or rates. During the year the statutory income tax rate was - 62 - increased one percent to 35%. This resulted in increases of $.6 million and $1.3 million for current and deferred tax liabilities, respectively. There was no earnings impact since the effects of the tax change have been deferred for future recovery. The Company uses the separate-period approach in calculating the interim quarterly tax provision. Retirement Health Care and Life Insurance Benefits. The Company provides certain health care and life insurance benefits for retired employees and health care coverage for surviving spouses of retirees. Substantially all of the Company's employees may become eligible for these benefits if they reach retirement age while working for the Company. These and similar benefits for active employees are provided through insurance policies whose premiums are based upon the experience of benefits actually paid. In December 1990, the FASB issued SFAS-106 entitled "Accounting for Postretirement Benefits Other than Pensions" effective for fiscal years beginning after December 15, 1992. Among other things, SFAS-106 requires accrual accounting by employers for postretirement benefits other than pensions reflecting currently earned benefits. The Company adopted this accounting practice in 1992. In September 1993, the PSC issued a "Statement of Policy Concerning the Accounting and Ratemaking Treatment for Pensions and Postretirement Benefits Other Than Pensions". The Statement's provisions require, among other things, ten-year amortization of actuarial gains and losses and deferral of differences between actual costs and rate allowances. The effects of applying the ten year amortization of actuarial gains were deferred. Postemployment Benefits. In November 1992, the FASB issued SFAS-112 entitled "Employees' Accounting for Postemployment Benefits" which is effective for fiscal years beginning after December 15, 1993. This Statement requires the Company to recognize the obligation to provide post-employment benefits to former or inactive employees after employment but before retirement. The Company must adopt SFAS-112 not later than the first quarter of 1994. The Company is currently evaluating the impact of SFAS-112; however, based on studies the Company has performed to date, the adoption of SFAS-112 is not expected to have a material effect on the Company's financial condition or results of operations. Earnings Per Share. Earnings applicable to each share of common stock are based on the weighted average number of shares outstanding during the respective years. - 63 - Note 2. Federal Income Taxes The provision for Federal income taxes is distributed between operating expense and other income based upon the treatment of the various components of the provision in the rate-making process. The following is a summary of income tax expense for the three most recent years. The following is a reconciliation of the difference between the amount of Federal income tax expense reported in the Statement of Income and the amount computed by multiplying the income by the statutory tax rate. A summary of the components of the net deferred tax liability is as follows: In 1993, the regulatory asset recognized by the Company as a result of adopting SFAS No. 109 is attributed to $222 million in depreciation, $18 million to property taxes, $18 million of deferred finance charges - Nine Mile Two and $4 million of Miscellaneous items offset by $21 million attributed to investment tax credits. - 64 - Note 3. Pension Plan and Other Retirement Benefits The Company has a defined benefit pension plan covering substantially all of its employees. The benefits are based on years of service and the employee's compensation during the last three years of employment. The Company's funding policy is to contribute annually an amount consistent with the requirements of the Employee Retirement Income Security Act and the Internal Revenue Code. These contributions are intended to provide for benefits attributed to service to date and for those expected to be earned in the future. The plan's funded status and amounts recognized on the Company's balance sheet are as follows: * Actuarial present value ** Includes $9.2 million pension plan curtailment charge. - 65 - The projected benefit obligation at December 31, 1993 and 1992 assumed discount rates of 7 1/4 percent and 7 3/4 percent, respectively and long-term rate of increase in future compensation levels of 6 percent and 6 1/2 percent, respectively. The assumed long-term rate of return on plan assets for 1993 and 1992 was 8 1/2 percent. The unrecognized net obligation is being amortized over 15 years beginning January 1986. In September 1993, the PSC issued a "Statement of Policy Concerning the Accounting and Ratemaking Treatment for Pensions and Postretirement Benefits Other than Pensions" (Statement). The 1993 pension cost reflects adoption of the Statement's provisions which, among other things, requires ten-year amortization of actuarial gains and losses and deferral of differences between actual costs and rate allowances. In addition to providing pension benefits, the Company provides certain health care and life insurance benefits to retired employees and health care coverage for surviving spouses of retirees. Substantially all of the Company's employees are eligible provided that they retire as employees of the Company. In 1993, the health care benefit consisted of a contribution of up to $175 per month towards the cost of a group health policy provided by the Company. The life insurance benefit consists of a Basic Group Life benefit, covering substantially all employees, providing a death benefit equal to one-half of the retiree's final pay. In addition, certain employees and retirees, employed by the Company at December 31, 1982, are entitled to a Special Group Life benefit providing a death benefit equal to the employee's December 31, 1982 pay. The Company adopted SFAS-106, "Accounting for Postretirement Benefits Other than Pensions" as of January 1, 1992 for financial accounting purposes. Subsequently, with the issuance of the Statement referenced above, the Company's application of SFAS-106 will extend to ratemaking purposes as well. The Company has elected to amortize the unrecognized, unfunded Accumulated Postretirement Benefit Obligation at January 1, 1992 over twenty years as provided by SFAS-106. The Company intends to continue funding these benefits on a pay-as-you-go basis. - 66 - The plans' funded status reconciled with the Company's balance sheet is as follows: The Accumulated Postretirement Benefit Obligation at December 31, 1993 and 1992 assumed discount rates of 7 1/4 percent and 7 3/4 percent, respectively and long-term rate of increase in future compensation levels of 6 percent and 6 1/2 percent, respectively. - 67 - Note 4. Departmental Financial Information The Company's records are maintained by operating departments, in accordance with PSC accounting policies, giving effect to the rate- making process. The following is the operating data for each of the Company's departments, and no interdepartmental adjustments are required to arrive at the operating data included in the Statement of Income. (a) Excludes cash, unamortized debt expense and other common items. - 68 - NOTE 5. JOINTLY-OWNED FACILITIES The following table sets forth the jointly-owned electric generating facilities in which the Company is participating. Both Oswego Unit No. 6 and Nine Mile Point Nuclear Plant Unit No. 2 have been constructed and are operated by Niagara Mohawk Power Corporation. Each participant must provide its own financing for any additions to the facilities. The Company's share of direct expenses associated with these two units is included in the appropriate operating expenses in the Statement of Income. Various modifications will be made throughout the lives of these plants to increase operating efficiency or reliability, and to satisfy changing environmental and safety regulations. The Plant in Service and Accumulated Provision for Depreciation balances for Nine Mile Point Nuclear Unit No. 2 shown above have been increased by the disallowed costs of $374.3 million. Such costs, net of income tax effects, were previously written off in 1987 and 1989. - 69 - (a) The Series EE, Series OO, Series RR and Series SS First Mortgage Bonds equal the principal amount of and provide for all payments of principal, premium and interest corresponding to the Pollution Control Revenue Bonds, Series A, Series C, and Pollution Control Refunding Revenue Bonds, Series 1992 A, Series 1992 B (Rochester Gas and Electric Corporation Projects), respectively, issued by the New York State Energy Research and Development Authority through a participation agreement with the Company. Payment of the principal of, and interest on the Series 1992 A and Series 1992 B Bonds are guaranteed under a Bond Insurance Policy by Municipal Bond Investors Assurance Corporation. The Series EE Bonds are subject to a mandatory sinking fund beginning August 1, 2000 and each August 1 thereafter. Nine annual deposits aggregating $3.2 million will be made to the sinking fund, with the balance of $6.8 million principal amount of the bonds becoming due August 1, 2009. (b) The Series QQ First Mortgage Bonds and 7%, 7.15%, 7.13% and 6.375% medium- term notes described below are generally not redeemable prior to maturity. (c) In 1993 the Company issued $200 million under a medium-term note program - 70 - entitled "First Mortgage Bonds, Designated Secured Medium-Term Notes, Series A" with maturities that range from seven years to thirty years. The First Mortgage provides security for the bonds through a first lien on substantially all the property owned by the Company (except cash and accounts receivable). Sinking and improvement fund requirements aggregate $333,540 per annum under the First Mortgage, excluding mandatory sinking funds of individual series. Such requirements may be met by certification of additional property or by depositing cash with the Trustee. The 1992 and 1993 requirements were met by certification of additional property. Sinking fund requirements and bond maturities for the next five years are: (d) The Series FF First Mortgage Bonds are subject to a mandatory sinking fund of $2.75 million annually each February 15. (e) The Series JJ First Mortgage Bonds are subject to a mandatory sinking fund of $2.5 million annually each June 15. Promissory Notes (f) The $51.7 million Promissory Note was issued in connection with NYSERDA's Floating Rate Monthly Demand Pollution Control Revenue Bonds (Rochester Gas and Electric Corporation Project), Series 1984. This obligation is supported by an irrevocable Letter of Credit expiring October 15, 1994. The interest rate on this note for each monthly interest payment period will be based on the evaluation of the yields of short term tax-exempt securities at par having the same credit rating as said Series 1984 Bonds. The average interest rate was 2.19% for 1993, 2.74% for 1992 and 4.32% for 1991. The interest rate will be adjusted monthly unless converted to a fixed rate. - 71 - (g) The $40.2 million Promissory Note was issued in connection with NYSERDA's Adjustable Rate Pollution Control Revenue Bonds (Rochester Gas and Electric Corporation Project), Series 1985. This obligation is supported by an irrevocable Letter of Credit expiring November 30, 1996. The annual interest rate was adjusted to 4.50% effective November 15, 1991, to 3.10% effective November 15, 1992 and to 2.75% effective November 15, 1993. The interest rate will be adjusted annually unless converted to a fixed rate. The Company is obligated to make payments of principal, premium and interest on each Promissory Note which correspond to the payments of principal, premium, if any, and interest on certain Pollution Control Revenue Bonds issued by the New York State Energy Research and Development Authority (NYSERDA) as described above. These obligations are supported by certain Bank Letters of Credit discussed above. Any amounts advanced under such Letters of Credit must be repaid, with interest, by the Company. Based on an estimated borrowing rate at year-end 1993 of 6.68% for long term debt with similar terms and average maturities (14 years), the fair value of the Company's long term debt outstanding (including Promissory Notes as described above) is approximately $816 million at December 31, 1993. - 72 - Note 7. Preferred and Preference Stock See below for mandatory redemption requirements No shares of preferred or preference stock are reserved for employees, or for options, warrants, conversions, or other rights. A. Preferred Stock, not subject to mandatory redemption: #May be redeemed at any time at the option of the Company on 30 days minimum notice, plus accrued dividends in all cases B. Preferred Stock, subject to mandatory redemption: +Thereafter at $100.00 Excludes $ six million optional redemption effective March 1, 1993 Mandatory Redemption Provisions. - ------------------------------- In the event the Company should be in arrears in the sinking fund requirement, the Company may not redeem or pay dividends on any stock subordinate to the Preferred Stock. Series R. Mandatory redemption of 60,000 shares per year at $100 per share - -------- commenced on March 1, 1993 for Series R and on each March 1 thereafter, so long as any shares remain outstanding. In addition, the Company has the non- cumulative right to redeem up to an additional 60,000 shares on the same terms and dates applicable to the mandatory sinking fund redemptions. The Company redeemed 120,000 shares on March 1, 1993 and the Company has the right to redeem up to the remaining 180,000 shares on March 1, 1994. - 73 - Series S, Series T, Series U. All of the shares are subject to redemption - ---------------------------- pursuant to mandatory sinking funds on September 1, 1997 in the case of Series S, September 1, 1998 in the case of Series T and September 1, 1999 in the case of Series U; in each case at $100 per share. Based on an estimated dividend rate at year-end 1993 of 5.25% for Preferred Stock, subject to mandatory redemption, with similar terms and average maturities (3.25 years), the fair value of the Company's Preferred Stock, subject to mandatory redemption, is approximately $53 million at December 31, 1993. - 74 - Note 8. Common Stock At December 31, 1993, there were 50,000,000 shares of $5 par value Common Stock authorized, of which 36,911,265 were outstanding. No shares of Common Stock are reserved for options, warrants, conversions, or other rights. There were 1,193,613 shares of Common Stock reserved and unissued for shareholders under the Automatic Dividend Reinvestment and Stock Purchase Plan and 253,090 shares reserved and unissued for employees under the RG&E Savings Plus Plan. Common Stock - 75 - Note 9. Short Term Debt At December 31, 1993 and December 31, 1992, the Company had short term debt outstanding of $68.1 million and $50.8 million, respectively. The weighted average interest rate on short term debt outstanding at year end 1993 was 3.46% and was 3.48% for borrowings during the year. For 1992, the weighted average interest rate on short term debt outstanding at year end was 3.99% and was 4.28% for borrowings during the year. On December 1, 1988 the Company renewed its $90 million revolving credit facility for a period of three years and this agreement has been regularly extended. In November of 1993 the Company was granted a one-year extension of the commitment termination date to December 31, 1996. Commitment fees related to this facility amounted to $169,000 in 1993, $169,000 in 1992 and $149,000 in 1991. The Company's Charter provides that unsecured debt may not exceed 15 percent of the Company's total capitalization (excluding unsecured debt). As of December 31, 1993, the Company would be able to incur $19.2 million of additional unsecured debt under this provision. In order to be able to use its revolving credit agreement, the Company has created a subordinate mortgage which secures borrowings under its revolving credit agreement that might otherwise be restricted by this provision of the Company's Charter. Since June 1990 the Company has had a credit agreement with a domestic bank providing for up to $20 million of short term debt. Borrowings under this agreement, which has been extended to December 31, 1994, are secured by the Company's accounts receivable. Also, additional unsecured short term borrowing capacity of up to $70 million is available from domestic banks, at their discretion. - 76 - Note 10. Commitments and Other Matters CAPITAL EXPENDITURES. The Company's 1994 construction expenditures program is currently estimated at $138 million, including $16 million related to replacement of the steam generators at the Ginna Nuclear Plant and $2 million of Allowance for Funds Used During Construction. The Company has entered into certain commitments for purchase of materials and equipment in connection with that program. NUCLEAR-RELATED MATTERS. DECOMMISSIONING TRUST. Under accounting procedures approved by the PSC, the Company has been collecting in its electric rates amounts for the eventual decommissioning of its Ginna Plant and for its 14% share of the decommissioning of Nine Mile Two. The operating licenses for these plants expire in 2009 and 2026 respectively. The Company has collected approximately $61.2 million through December 31, 1993. The Nuclear Regulatory Commission (NRC) requires reactor licensees to submit funding plans that establish minimum external funding levels for reactor decommissioning. The Company's plan consists principally of an external decommissioning trust fund covering both its Ginna Plant and its Nine Mile Two share. Since 1990, the Company has contributed some $36.9 million to this fund. In addition, the Company maintains an internal reserve to fund the removal of non-radioactive structures, a feature not covered by the NRC minimum funding. In connection with the Company's rate settlement completed in August 1993, the PSC approved the collection during the rate year ending June 30, 1994 of an aggregate $8.9 million for decommissioning, covering both nuclear units. The amount allowed in rates is based on estimated ultimate decommissioning costs of $150.7 million for Ginna and $34.3 million for the Company's 14% share of Nine Mile Two (January 1993 dollars). This estimate is based principally on the application of a NRC formula to determine minimum funding. Site specific studies of the anticipated costs of actual decommissioning are required to be submitted to the NRC at least five years prior to the expiration of the license. The Company intends to fund the external decommissioning trust in the amount of the NRC minimum funding requirement. The difference between the amount to be collected and the NRC minimum will be held in an internal reserve. The Company is aware of recent NRC activities related to upward revisions to the required minimum funding levels. These activities, primarily focused on disposition of low level radioactive waste, may require the Company to increase funding. The Company continues to monitor these activities but cannot predict what regulatory actions the NRC may ultimately take. URANIUM ENRICHMENT DECONTAMINATION AND DECOMMISSIONING FUND. Nuclear reactor licensees in the U.S. are assessed annually for the decontamination and decommissioning of Department of Energy (DOE) enrichment facilities. The Company made the first of 15 annual payments for this purpose in September 1993, remitting approximately $1.6 million ($1.5 million for the Ginna Plant and $0.1 million for its share of the Nine Mile Two plant). For the two facilities the Company recognized liabilities at December 31, 1993 of $23.4 million ($21.7 million as a - 77 - long-term liability and $1.7 million as a current liability). In October 1993, the Company began recovery of this deferral through its fuel adjustment clause. INSURANCE PROGRAM. The Price-Anderson Act establishes a federal program, providing indemnification and insurance against public liability, applicable in the event of a nuclear accident at a licensed U.S. reactor. As a result of amendments to the Act in 1988, the limit of liability has increased to approximately $9.4 billion. Also in 1988 coverage was expanded to include precautionary evacuations and the Act was extended until the year 2002. Under the program, claims would first be met by insurance which licensees are required to carry in the maximum amount available (currently $200 million). If claims exceed that amount, licensees are subject to a retrospective assessment up to $75.5 million per licensed facility for each nuclear incident, payable at a rate not to exceed $10 million per year. Those assessments are subject to periodic inflation-indexing and to a 5% surcharge if funds prove insufficient to pay claims. In addition, the retrospective assessments would be subject to a three percent charge for premium tax. The Company's interests in two nuclear units could thus expose it to a potential liability for each accident of $86.1 million through retrospective assessments of $11.4 million per year in the event of a sufficiently serious nuclear accident at its own or another U.S. commercial nuclear reactor. Beginning in 1988, coverage for claims alleging radiation-induced injuries to some workers at nuclear reactor sites was removed from the nuclear liability insurance policies purchased by the Company. Coverage for workers first engaged in nuclear-related employment at a nuclear site prior to 1988 continues to be provided under then-existing nuclear liability insurance policies. Those workers first employed at a nuclear facility in 1988 or later are covered under a separate, industry-wide insurance program. That program contains a retrospective premium assessment feature whereby participants in the program can be assessed to pay incurred losses that exceed the program's reserves. Under the plan as currently established, the Company could be assessed a maximum of $3.1 million over the life of the insurance coverage. The Company is a member of Nuclear Electric Insurance Limited, which provides insurance coverage for the cost of replacement power during certain prolonged accidental outages of nuclear generating units and coverage for property losses in excess of $500 million at nuclear generating units. As of December 31, 1993, the Company is purchasing a weekly indemnity limit of $3.5 million in the NEIL I replacement power expense program and full policy limits of $1.4 billion in the NEIL II Property Insurance Program for the Ginna Nuclear Power Plant. Coverage under the Property Insurance Program includes the shortfall in the NRC required external trust fund resulting from the premature decommissioning of a nuclear power plant following an accident with property damage in excess of $500 million. The Company currently has designated $166 million as a sublimit for this coverage at the Ginna Nuclear Power Plant. For its share in the generation of Nine Mile Two the Company purchases a weekly indemnity limit of $.5 million in the NEIL I replacement power expense program. The owners at Nine Mile Two purchase the full policy limit of $1.4 billion in the NEIL II Property Insurance Program and the Company pays its proportionate share of those premiums. The owners at Nine Mile Two have selected the maximum available sublimit of $250 million for premature decommissioning. If an insuring program's losses exceeded its other resources available to pay - 78 - claims, the Company could be subject to maximum assessments in any one policy year of approximately $4.9 million and $14.9 million in the event of losses under the replacement power and property damage coverages, respectively. ENVIRONMENTAL MATTERS. The production and delivery of energy are necessarily accompanied by the release of by-products subject to environmental controls. In recognition of the Company's responsibility to preserve the quality of the air, water, and land it shares with the community it serves, the Company has taken a variety of measures (e.g., self-auditing, recycling and waste minimization, training of employees in hazardous waste management) to reduce the potential for adverse environmental effects from its energy operations and, specifically, to manage and appropriately dispose of wastes currently being generated. The Company, nevertheless, has been contacted, along with numerous others, concerning wastes shipped off-site to licensed treatment, storage and disposal sites where authorities have later questioned the handling of such wastes. In such instances, the Company typically seeks to cooperate with those authorities and with other site users to develop cleanup programs and to fairly allocate the associated costs. As part of its commitment to environmental excellence, the Company is conducting proactive Site Investigation and Remediation (SIR) efforts at Company-owned sites where past waste handling and disposal may have occurred. The Company currently estimates the total costs it could incur for SIR activities at Company-owned sites to be about $20 million. This estimate will vary as better site information is available. The Company anticipates spending $10 million over the next 5 years on SIR initiatives. Approximately $4.5 million has been provided for in rates through June 1996 for recovery of SIR costs. To the extent actual expenditures differ from this amount, they will be deferred for future disposition and recovery as authorized by the PSC. In 1985, the New York State Department of Environmental Conservation (NYSDEC) identified property in the vicinity of the Lower Falls of the Genesee River (the Lower Falls) in Rochester as an inactive hazardous waste disposal site. The Company owns, and was the prior owner or operator of, a number of locations within the Lower Falls. In mid-1991, NYSDEC advised the Company that it had delisted the Lower Falls site, i.e., removed it from its Registry of Inactive Hazardous Waste Disposal Sites. The effect of delisting is to terminate the Company's status as a potentially responsible party for the Lower Falls site, to discontinue the pending NYSDEC review of a joint Company/City of Rochester proposal for a limited further investigation of the Lower Falls, to defer the prospect of remedial action and perhaps to end any Company sharing of the cost thereof. However, NYSDEC also stated its intention to consider listing individual coal gasification sites within the larger, original site once the State of New York adopts new federal hazardous waste criteria. There is at least some material at one of the individual coal gasification sites that could trigger relisting. The Company is unable to predict what further listing action NYSDEC may take, but regards the delisting as a positive development. The Company and its predecessors formerly owned and operated coal gasification facilities within the Lower Falls. In September 1991 the Company initiated a study of subsurface conditions in the vicinity of retired facilities at its West Station property and has since commenced the removal of soils containing hazardous substances in order - 79 - to minimize any potential long-term exposure risks. Cleanup efforts have been temporarily suspended while the Company investigates more cost effective remedial technologies. Activities are expected to resume within a year. On a portion of the Company's property in the Lower Falls, and elsewhere in the general area, the County of Monroe has installed and operates sewer lines. During sewer installation, the County constructed over Company property, pursuant to an easement which the Company granted the County, certain retention ponds which reportedly received from the sewer construction area certain fossil-fuel-based materials ("the materials") found there. In July 1989 the Company received a letter from the County asserting that activities of the Company left the County unable to effect a regulatorily-approved closure of the retention pond area. The County's letter takes the position that it intends to seek reimbursement for its additional costs incurred with respect to the materials once the NYSDEC identifies the generator thereof and that any further cleanup action which the NYSDEC may require at the retention pond site is the Company's responsibility. In the course of discussions over this matter, the County has claimed, without offering any evidence, that the Company was the original generator of the materials. It asserts that it will hold the Company liable for all County costs --presently estimated at $1.5 million -- associated both with the materials' excavation, treatment and disposal and with effecting a regulatorily-approved closure of the retention pond area. The Company could incur costs as yet undetermined if it were to be found liable for such closure and materials handling, although provisions of the easement afford the Company rights which may serve to offset all or a portion of any such County claim. To date, the Company has agreed to pay a 20% share of the County's investigation of this area, which commenced in September 1993 and which is estimated to cost no more than $150,000, but no commitment has been made toward any remedial measures which may be recommended by the investigation. In the letter announcing the delisting of the Lower Falls site, NYSDEC indicated an intention to pursue appropriate closure of the County's former retention pond area, suggesting that it will be evaluated separately to determine whether it meets the criteria of a hazardous waste site. The Company is unable to assess what implications the NYSDEC letter may have for the County's claim against it. At another location along the River where the Company owns property, a boring taken in Fall 1988 for a sewer system project showed a layer containing a black viscous material. The Company undertook an investigation to determine the extent of the layer. The study found that some of the soil and ground water on- site had been adversely impacted by the hazardous substance constituents of the black viscous material, but evidence was inadequate to determine whether the material or its constituents had migrated off-site. The matter was reported to the NYSDEC and, in September 1990, the Company also provided the agency with a risk assessment for its review. That assessment concluded that the findings warranted no agency action and that site conditions posed no significant threat to the environment. Although NYSDEC could require the Company to undertake further investigation and/or remediation, the agency has taken no action in the nearly three and one-half years since the report's submittal. In August 1990 the Company was notified of the existence of a federal Superfund site located in Syracuse, NY, known as the Quanta Resources Site. The federal Environmental Protection Agency (EPA) has included the Company in its list of approximately 25 potentially - 80 - responsible parties (PRPs) at the site, but no data has been produced showing that any of its wastes were delivered to the site. In return for its release from liability for that phase, the Company has joined other PRPs in agreeing to divide among them, utilizing a two-tier structure, EPA's cost of a contractor- performed removal action intended to stabilize the site. The Company, in the lower tier of PRPs, paid its $27,500 share of such cost. The NYSDEC has not yet made an assessment for certain response and investigation costs it has incurred at the site, nor is there as yet any information on which to base an estimate of the cost to design and conduct at the site any remedial measures which federal or state authorities may require. On May 21, 1993, the Company was notified by NYSDEC that it was considered a potentially responsible party (PRP) for the Frontier Chemical Pendleton Superfund Site located in Pendleton, NY. The Company has signed a PRP Agreement with approximately 15 parties and is participating in negotiations for an Administrative Order on Consent with NYSDEC. The PRPs have negotiated a workplan for site remediation and have retained a consulting firm to implement the workplan. Preliminary estimates indicate site remediation will be between $6 and $8 million. The Company is participating with the group to allocate costs among the PRPs. An allocation scheme has yet to be developed. Monitoring wells installed at another Company facility in 1989 revealed that an undetermined amount of leaded gasoline had reached the groundwater. The Company has continued to monitor free product levels in the wells, and has begun a modest free product recovery project, reports on both of which are routinely furnished to the NYSDEC. Free product levels in the wells have declined, but authorities may require further remediation once most of the free product has been recovered. The Company is developing strategies responsive to the Federal Clean Air Act Amendments of 1990 (Amendments). The Amendments will primarily affect air emissions from the Company's fossil-fueled electric generating facilities. The Company is in the process of identifying the optimum mix of control measures that will allow the fossil fuel based portion of the generation system to fully comply with applicable regulatory requirements. Although work is continuing, not all compliance control measures have been determined. The Company has adopted control measures for nitrogen oxides (NOx) emissions which must be in effect by the federally mandated compliance date of May 31, 1995. The chosen NOx control measures consist of the installation of low NOx burners on some units, the derating of unit generation by taking burners out of service on other units and placing one unit on cold standby with the redistribution of load to the remaining more efficient units. Capital costs for NOx controls and the installation of continuous emission monitoring systems are not expected to exceed $6.8 million and will be incurred during 1994 and 1995. A range of capital costs between $20 million and $30 million (1993 dollars) has been estimated for the implementation of several potential scenarios which would enable the Company to meet the foreseeable future NOx and sulphur dioxide requirements of the Amendments. These capital costs would be incurred between 1996 and 2000. The Company currently estimates that it could also incur up to $2 million (1993 dollars) of additional annual operating expenses, excluding fuel, to comply with the Amendments. The use of scrubbing equipment is not presently being considered. Likewise, the purchase or sale of "emission allowances," as allowed by the Amendments, is not currently being considered. The Company anticipates that the costs incurred to comply with the Amendments will be recoverable through rates based on previous rate recovery of - 81 - environmental costs required by governmental authorities. GAS COST RECOVERY. Many interstate gas pipeline companies entered into contracts with gas producers which required the pipeline companies to pay for a minimum amount of gas whether or not the gas is actually taken from the producer (take-or-pay costs). Pursuant to FERC authorization, the Company's gas suppliers have included certain amounts of their take-or-pay costs in the rates charged to the Company. The PSC instituted a proceeding in October 1988 to determine the extent to which the gas distribution companies in New York State would be permitted to recover in rates the take-or-pay costs imposed upon them. Through a series of subsequent settlements between the Staff of the PSC and the Company, the Company was permitted to recover in rates 87.5% of the first $12 million of the pipeline take-or-pay costs imposed upon it and all such costs in excess thereof except for a maximum of $562,500. As of December 31, 1993 the Company had been billed for $17.6 million of take-or-pay costs and has thus far recovered $16.4 million from its customers. The Company expects only insignificant amounts of take-or-pay costs remain to be billed to the Company. As a result of the restructuring of the gas transportation industry by the FERC, there will be a number of changes in this aspect of the Company's business over the next several years. These changes, which will apply throughout the industry, will affect different companies differently and may result, at least initially, in increases in the gas transportation costs of the Company. The Company will also be required to pay a share of certain transition costs incurred by the pipelines as a result of the FERC restructuring. Although the final amounts of such transition costs are subject to continuing negotiations with several pipelines and ongoing pipeline filings requiring FERC approval, the Company expects such costs to range between $43.5 and $52.0 million. A substantial portion of such costs will be on the CNG Transmission Corporation (CNG) system of which approximately $27 million was billed to the Company on December 3, 1993 payable over the following three years. The Company expects these transition costs to be recoverable in its rates. In a related matter, in connection with the development of the Empire State Pipeline ("Empire"), the Company is committed as of November 1993, to transportation capacity from Empire, to upstream pipeline transportation and storage service and to the purchase of natural gas in quantities corresponding to these transportation and storage arrangements. The Company also has certain contractual obligations with CNG whereby the Company is subject to demand charges for transportation capacity for a period of eight years. In October 1993, the effective date of implementation of pipeline restructuring pursuant to FERC Order No. 636 and CNG's individual restructuring in Docket No. RS92-14, CNG's transportation rights on upstream pipelines were assigned to its customers, including the Company. The Company has concluded the corresponding contracts with those upstream pipelines. The transportation service to be provided by Empire was scheduled to phase in over 12 months, at which point the combined CNG and Empire transportation capacity would have exceeded the Company's current requirements. Therefore, the Company recently entered into a marketing agreement with CNG, pursuant to which CNG will assist the Company in obtaining permanent replacement customers for the - 82 - transportation capacity the Company will not require. It may renegotiate its arrangements with CNG and/or Empire or it may negotiate assignment, on a permanent or temporary basis, of the transportation capacity that exceeds the requirements of its customers. In addition, under FERC rules, the Company may sell its excess transportation capacity in the market. While CNG has already secured letters of intent for a substantial portion of such capacity, whether and to what extent CNG and/or the Company can successfully negotiate the assignment or sale of the excess capacity, or at what price, cannot be determined at the present time. The retention of some or all of this excess transportation capacity may cause an increase in the Company's gas supply costs. This would be in addition to any increase caused by other aspects of the gas transportation restructuring. GAS PURCHASE UNDERCHARGES. The Company became aware during 1993 that it did not account properly for certain gas purchases for the period August 1990 - August 1992 resulting in undercharges to gas customers of approximately $7.5 million. The Company had previously estimated the effect to approximate as much as $10 million; however, further review determined that the magnitude of the error on previously reported operations was substantially less. The undercharges arose from the increased complexity arising from the federal deregulation of the gas industry and the Company's transition from a full requirements customer of one gas supplier to the purchase of gas transportation service and natural gas on the open market. Problems of this type are routinely corrected through the Gas Adjustment Clause process and appropriate amounts are collected from or refunded to customers. Of the total undercharges, $2.3 million has previously been expensed and $5.2 million had been deferred on the Company's balance sheet. The Company advised the PSC and all parties to the Company's most recent rate proceeding of the undercharges. In its August 24, 1993 Order approving the Company's three-year rate settlement the PSC made the Company's current gas rates temporary solely to consider the impacts of the erroneous gas accounting, and in a September 13, 1993 Order the PSC instituted a proceeding to investigate the resulting undercollections and the recoverability of such amounts from customers. In its September 13 Order the PSC directed the Company to demonstrate fully the existence and amount of the undercharges, to explain the reasons for the errors, and to address possible general and specific legal limitations on the Company's right to recover portions of the undercharges. The Company filed evidence and analysis responsive to that Order on October 27, 1993. On December 30, 1993, a proposed settlement among the Company, PSC Staff and another party was filed with the PSC. It provides for the recovery in rates of $3.2 million over three years, subject to audit and to limitations on rate adjustments established in the August 24 Order. The Company wrote off the $2.0 million balance of the undercharges as of December 31, 1993. That write- off amounts to a reduction in 1993 earnings of four cents per share, net of tax. Although no party, to the Company's knowledge, opposes the proposed settlement, the Company is unable to predict whether the PSC will approve it. - 83 - OTHER MATTERS. REGULATORY DISALLOWANCES. In June 1992 the Company recorded a charge to earnings of $8.2 million in connection with ice storm restoration costs disallowed by the PSC. In December 1991, the Company recorded a non-cash charge against earnings of $10 million for refunds to be made to customers in connection with a PSC fuel procurement audit. NUCLEAR FUEL ENRICHMENT SERVICES. The Company has a contract with the United States Enrichment Corporation (USEC), formerly with the DOE, for nuclear fuel enrichment services which assures provision of 70% of the Ginna Nuclear Plant's requirements throughout its service life or 30 years, whichever is less. No payment obligation accrues unless such enrichment services are needed. Annually, the Company is permitted to decline USEC-furnished enrichment for a future year upon giving ten years' notice. Consistent with that provision, the Company has terminated its commitment to USEC for the years 2000, 2001 and 2002. The USEC waived, for an interim period, the obligation to give ten years' notice for 2003. The Company has secured the remaining 30% of its Ginna requirements for the reload years 1994 through 1995 under different arrangements with USEC. The Company plans to meet its enrichment requirements for years beyond those already committed by making further arrangements with USEC or by contracting with third parties. The cost of USEC enrichment services utilized for the next seven reload years (priced at the most current rate) ranges from $4 million to $7 million per year. ASSERTION OF TAX LIABILITY. The Company's federal income tax returns for 1987 and 1988 have been examined by the Internal Revenue Service (IRS) which has proposed adjustments of approximately $29 million. The adjustments at issue generally pertain to the characterization and treatment of events and relationships at the Nine Mile Two project and to the appropriate tax treatment of investments made and expenses incurred at the project by the Company and the other co-tenants. A principal issue appears to be the year in which the plant was placed in service. The Company has filed a protest of the IRS adjustments to its 1987-88 tax liability and has had an initial hearing before the appeals officers. The Company believes it has sound bases for its protest, but cannot predict the outcome thereof. Generally, the Company would expect to receive rate relief to the extent it was unsuccessful in its protest except for that part of the IRS assessment stemming from the Nine Mile Two disallowed costs, although no such assurance can be given. - 84 - Interim Financial Data In the opinion of the Company, the following quarterly information includes all adjustments, consisting of normal recurring adjustments, necessary for a fair statement of the results of operations for such periods. The variations in operations reported on a quarterly basis are a result of the seasonal nature of the Company's business and the availability of surplus electricity. Includes recognition of $1.9 million net-of-tax pension plan curtailment Includes recognition of $3.4 million net-of-tax pension plan curtailment * Includes recognition of $5.4 million net-of-tax ice storm disallowance **** Includes recognition of $6.6 million net-of-tax fuels audit disallowance Item 9.	Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. None. - 85 - PART III ITEM 10.	ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by Item 10 of Form 10-K relating to directors who are nominees for election as directors at the Company's Annual Meeting of Shareholders to be held on April 20, 1994, will be set forth under the heading "Election of Directors" in the Company's Definitive Proxy Statement for such Annual Meeting of Shareholders. The information required by Item 10 of Form 10-K with respect to executive officers is, pursuant to instruction 3 of paragraph (b) of Item 401 of Regulation S-K, set forth in Part I as Item 4 - A of this Form 10-K under the heading "Executive Officers of the Registrant". ITEM 11.	ITEM 11. EXECUTIVE COMPENSATION The information required by Item 11 of Form 10-K will be set forth under the headings "Report of the Committee on Management on Executive Compensation", "Executive Compensation" and "Pension Plan Table" in the Company's Definitive Proxy Statement for the Annual Meeting of Shareholders. ITEM 12.	ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by Item 12 of Form 10-K will be set forth under the headings "General" and "Security Ownership of Management" in the Company's Definitive Proxy Statement for the Annual Meeting of Shareholders. ITEM 13.	ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by Item 13 of Form 10-K will be set forth under the heading "Election of Directors" in the Company's Definitive Proxy Statement for the Annual Meeting of Shareholders. Pursuant to General Instruction G(3) to Form 10-K, Items 10 through 13 have not been answered because, within 120 days after the close of its fiscal year, the Registrant will file with the Commission a definitive proxy statement pursuant to Regulation 14A which involves the election of directors. Regis- trant's definitive proxy statement dated March 7, 1994 will be filed with the Securities and Exchange Commission prior to April 30, 1994. The information required in Items 10 through 13 under the headings set forth above is incorpo- rated by reference herein by this reference thereto. Except as specifically referenced herein the proxy statement in connection with the annual meeting of shareholders to be held April 20, 1994 is not deemed to be filed as part of this Report. - 86 - Part IV ------- Item 14.	Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) 1. The financial statements listed below are shown under Item 8 of this Report. Report of Independent Accountants Consolidated Statements of Income and Retained Earnings for each of the three years ended December 31, 1993 Consolidated Balance Sheets at December 31, 1993 and 1992 Consolidated Statement of Cash Flows for each of the three years ended December 31, 1993 Notes to Consolidated Financial Statements (a) 2. Financial Statement Schedules - Included in Item 14 herein: For each of the three years ended December 31, 1993 Schedule V - Property, Plant and Equipment (Utility Plant) Schedule VI - Accumulated Depreciation and Amortization (Utility Plant) Schedule VIII - Valuation and Qualifying Accounts Schedule IX - Short-term Borrowings Schedule X - Supplementary Income Statement Information (a) 3. Exhibits - 87 - - 88 - The Company agrees to furnish to the Commission, upon request, a copy of all agreements or instruments defining the rights of holders of debt which do not exceed 10% of the total assets with respect to each issue, including the Supplemental Indentures under the General Mortgage and credit agreements in connection with promissory notes as set forth in Note 6 of the Notes to Financial Statements. (b) Reports on Form 8-K - None - 89 - Parentheses denote negative amounts (a) Includes $375,929 addition to nuclear plant due to Nine Mile Two Settlement recognized in March, 1991. Rochester Gas and Electric Corporation SCHEDULE V - UTILITY PLANT For the Year Ended December 31, 1992 (Thousands of Dollars) Parentheses denote negative amounts Rochester Gas and Electric Corporation SCHEDULE V - UTILITY PLANT For the Year Ended December 31, 1993 (Thousands of Dollars) Parentheses denote negative amounts - 92 - Rochester Gas and Electric Corporation SCHEDULE VI - ACCUMULATED DEPRECIATION AND AMORTIZATION OF UTILITY PLANT For the Year Ended December 31, 1991 (Thousands of Dollars) Parentheses denote negative amounts NOTES: a. Represents mainly adjustments to accumulated depreciation due to Nine Mile Two Plant Settlement Agreement recognized in March 1991. b. Represents reclassification as a long term liability for disposal of nuclear fuel. - 93 - Rochester Gas and Electric Corporation SCHEDULE VI - ACCUMULATED DEPRECIATION AND AMORTIZATION OF UTILITY PLANT For the Year Ended December 31, 1992 (Thousands of Dollars) Parentheses denote negative amounts NOTES: a. Represents miscellaneous adjustments of $1,003 and interdepartmental transfers of $(15). b. Represents reclassification as a long term liability for disposal of nuclear fuel. c. Represents interdepartmental transfers. - 94 - Rochester Gas and Electric Corporation SCHEDULE VI - ACCUMULATED DEPRECIATION AND AMORTIZATION OF UTILITY PLANT For the Year Ended December 31, 1993 (Thousands of Dollars) Parentheses denote negative amounts NOTES: a. Represents miscellaneous adjustments of $544 and interdepartmental transfers of $23. b. Represents reclassification as a long term liability for disposal of nuclear fuel. c. Represents interdepartmental transfers. - 95 - ROCHESTER GAS AND ELECTRIC CORPORATION SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS (Thousands of Dollars) FOR THE YEAR ENDED DECEMBER 31, 1991 FOR THE YEAR ENDED DECEMBER 31, 1992/(b)/ FOR THE YEAR ENDED DECEMBER 31, 1993/(b)/ /(a)/ Accounts written off, less recoveries. /(b)/ Beginning in 1992 the Company no longer charges uncollectible expenses through the uncollectible reserve. The total amount written off directly to expense in 1992 was $5,116 and in 1993 was $6,241. - 96 - ROCHESTER GAS AND ELECTRIC CORPORATION SCHEDULE IX - SHORT TERM BORROWINGS(1) (Thousands of Dollars) NOTES: 1. Borrowings under a Revolving Credit Loan Agreement are at Prime, C.D. or Libor rates plus a fraction thereof. Notes issued have various terms of maturity but do not exceed six months. The Company also issues commercial paper at various discount rates, usually maturing within 30-45 days. 2. Average amount outstanding is the simple average of the daily amount outstanding during the period. 3. Weighted average interest rate is computed by dividing the total interest accrued during the period by the daily average amount outstanding. - 97 - ROCHESTER GAS AND ELECTRIC CORPORATION SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION (Thousands of Dollars) The amounts of maintenance and provisions for depreciation and amortization are as set forth in the Statements of Income and of Cash Flows. During the years 1991, 1992, and 1993 and the amounts for royalties or advertising costs did not exceed 1% of total revenues as reported in the Statement of Income. Taxes, other than Federal income tax, which exceed 1% of total revenues were classified as follows: - 98 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. ROCHESTER GAS AND ELECTRIC CORPORATION By ROGER W. KOBER ------------------------------------- (Roger W. Kober) (Chairman of the Board, President and Chief Executive Officer) Date: February 15, 1994 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 in the capacities and on the dates indicated. Signature Title Date Principal Executive Officer: ROGER W. KOBER Chairman of the Board, February 15, 1994 - ------------------------------ (Roger W. Kober) President and Chief Executive Officer Principal Financial Officer and Principal Accounting Officer: THOMAS S. RICHARDS Senior Vice President, February 15, 1994 - ------------------------------ (Thomas S. Richards) Finance and General Counsel - 99 - Signature Title Date Directors: WILLIAM BALDERSTON III Director February 15, 1994 - ---------------------------------- (William Balderston III) ANGELO J. CHIARELLA Director February 15, 1994 - ---------------------------------- (Angelo J. Chiarella) ALLAN E. DUGAN Director February 15, 1994 - ---------------------------------- (Allan E. Dugan) WILLIAM F. FOWBLE Director February 15, 1994 - ---------------------------------- (William F. Fowble) JAY T. HOLMES Director February 15, 1994 - ---------------------------------- (Jay T. Holmes) ROGER W. KOBER Director February 15, 1994 - ---------------------------------- (Roger W. Kober) THEODORE L. LEVINSON Director February 15, 1994 - ---------------------------------- (Theodore L. Levinson) CONSTANCE M. MITCHELL Director February 15, 1994 - ---------------------------------- (Constance M. Mitchell) CORNELIUS J. MURPHY Director February 15, 1994 - ---------------------------------- (Cornelius J. Murphy) ARTHUR M. RICHARDSON Director February 15, 1994 - ---------------------------------- (Arthur M. Richardson) M. RICHARD ROSE Director February 15, 1994 - ---------------------------------- (M. Richard Rose) Director February , 1994 - ---------------------------------- (Harry G. Saddock)
21271_1993.txt	21271	1993	ITEM 1. BUSINESS Valero Energy Corporation was incorporated under the laws of the State of Delaware in 1955 and became a publicly held corporation in 1979. Its principal executive offices are located at 530 McCullough Avenue, San Antonio, Texas 78215 (telephone number 210/246-2000). Unless otherwise required by the context, the term "Energy" as used herein refers to Valero Energy Corporation, and the term "Company" refers to Energy and its consolidated subsidiaries individually and collectively. The Company's principal business is petroleum refining and marketing. Valero Refining Company ("VRC"), a wholly owned subsidiary of Valero Refining and Marketing Company ("VRMC"), owns a specialized petroleum refinery in Corpus Christi, Texas (the "Refinery") and engages in petroleum refining and marketing operations. VRMC is a wholly owned subsidiary of Energy. VRMC and VRC are collectively referred to herein as "Refining." The Company also owns an approximate 49% effective equity interest in Valero Natural Gas Partners, L.P. and its subsidiaries, which own and operate natural gas pipeline systems serving Texas intrastate and certain interstate markets. Valero Natural Gas Partners, L.P. and its subsidiaries also process natural gas for the extraction of natural gas liquids ("NGL"). See "Valero Natural Gas Partners, L.P." Unless otherwise required by the context, the term "VNGP, L.P." as used herein refers to Valero Natural Gas Partners, L.P. and the term "Partnership" refers to VNGP, L.P. and its consolidated subsidiaries individually and collectively. The Company's investment in and equity in earnings of the Partnership are shown separately in the accompanying consolidated financial statements. In addition to its interest in the Partnership, the Company owns a natural gas processing plant, a natural gas pipeline and certain natural gas liquids fractionation facilities that the Company leases to the Partnership. The Company also owns two additional natural gas processing plants, related gathering lines and a natural gas liquids line that the Partnership operates for a fee. See "Other Natural Gas Operations." For additional financial and statistical information regarding the Company's operations, see "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Note 10 of Notes to Consolidated Financial Statements. For information regarding cash flows provided by and used in the Company's operations, see "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources." RECENT DEVELOPMENTS Proposal to Acquire the Partnership Effective December 20, 1993, Energy, VNGP, L.P. and Valero Natural Gas Company ("VNGC"), the general partner of VNGP, L.P., entered into an agreement of merger (the "Merger Agreement") providing for the merger of VNGP, L.P. with a wholly owned subsidiary of Energy (the "Merger"). In the Merger, the 9.7 million issued and outstanding common units of limited partner interests ("Common Units") in VNGP, L.P. held by persons other than the Company (the "Public Unitholders") will be converted into a right to receive cash in the amount of $12.10 per Common Unit, and VNGP, L.P. will become a wholly owned subsidiary of Energy. A special committee of outside directors (the "Special Committee") of VNGC, appointed to consider the fairness of the transaction to the Public Unitholders, has received an opinion from its independent financial advisor that the consideration to be received by the Public Unitholders in the transaction is fair from a financial point of view. The Special Committee has determined that such transaction is fair to, and in the best interest of, the Public Unitholders. The Board of Directors of VNGC has unanimously recommended that the Public Unitholders vote in favor of the Merger. The transaction is subject, among other things, to: (i) approval by the holders of a majority of the issued and outstanding Common Units; (ii) approval by the holders of a majority of the Common Units held by the Public Unitholders and voted at a special meeting to be called for the purpose of considering the Merger; (iii) receipt of satisfactory waivers, consents or amendments to certain of the Company's financial agreements; and (iv) completion of an underwritten public offering of preferred stock by Energy. See "Recent Developments - Convertible Preferred Stock Offering." A proposal to approve the Merger will be submitted to the holders of Common Units at the special meeting of Unitholders tentatively scheduled to be held during the second quarter of 1994. The Company owns approximately 47.5% of the outstanding Common Units and intends to vote its Common Units in favor of the Merger. There can be no assurance, however, that the Merger will be completed. The foregoing discussion of the Merger omits certain information contained in the Merger Agreement. Statements in this Report concerning the Merger Agreement are not necessarily complete, and are qualified by and are made subject to the Merger Agreement filed as an exhibit to this Report. The Company believes that the natural gas and NGL industries are undergoing a period of restructuring and consolidation that may create opportunities for expansions, acquisitions or strategic alliances which, if the Partnership could take advantage of them, could enable the Partnership to compete more effectively in the competitive natural gas environment. Because of Federal Energy Regulatory Commission ("FERC") Order No. 636 ("Order 636") which requires interstate pipeline companies to offer services on an unbundled, nondiscriminatory basis, the Company believes that intrastate pipelines such as the Partnership may enjoy increased opportunities to compete for interstate business. In addition, an emerging trend of west-to-east movement of gas may provide beneficial transportation opportunities for the Partnership if the Partnership were able to make the necessary capital expenditures for added west-to-east capacity on its pipeline system. However, the Partnership's competitive position could be eroded if the Partnership is unable to respond effectively to the changing dynamics of the industry. The Merger was proposed because the Company believes that the Partnership has insufficient financial flexibility to participate fully in opportunities that may arise in the natural gas and NGL industries. The Company believes that the ability of the Partnership to compete effectively in these businesses will be enhanced through the Merger. The Company also believes that potential conflicts of interest between the Partnership and the Company can be eliminated through the Merger. Convertible Preferred Stock Offering During the fourth quarter of 1993, Energy filed a registration statement on Form S-3 (as amended, the "Registration Statement"), registering for issuance and sale in an underwritten public offering (the "Public Offering") $150 million (up to $172.5 million with underwriters' over-allotments) of a series of Energy's authorized but unissued Preferred Stock. Energy intends to offer for sale up to 3,000,000 shares (3,450,000 shares with underwriters' over-allotments) of convertible preferred stock in the Public Offering (the "New Preferred Stock"). Energy intends to use a portion of the proceeds from the Public Offering to fund the cash payment to the Public Unitholders contemplated by the Merger. See "Recent Developments - Proposal to Acquire the Partnership." Any remaining proceeds will be used to pay expenses of the Merger and for general corporate purposes, including the reduction of existing indebtedness under the Company's bank credit agreements. If the Merger is not consummated, the proceeds from the Public Offering will be added to the Company's funds and used for general corporate purposes, including repayment of indebtedness, financing of capital projects and additions to working capital. Offers to sell or the solicitation of offers to buy shares of the New Preferred Stock will be made exclusively by means of a prospectus complying in all respects with the Securities Act of 1933, as amended. The description of the New Preferred Stock herein is not and shall not be construed as an offer to sell or the solicitation of an offer to buy any shares of the New Preferred Stock. Decline of Crude Oil and Refined Product Prices Beginning in November 1993, crude oil prices fell significantly and have not recovered to prior levels. During the November 1993 meeting of the Organization of Petroleum Exporting Countries ("OPEC"), the member countries declined to adopt any cuts in crude oil production. This decision, combined with increased production from non-OPEC regions, continued uncertainty regarding Iraq's possible re-entry into world oil markets and weakened global demand for energy, caused a precipitous drop in crude oil prices to their lowest levels in five years. Refined product and NGL prices fell in conjunction with the decline in crude oil prices. Moreover, refined product and NGL prices were further depressed due to continued high refinery-capacity utilization rates and unusually high gasoline and NGL inventories. These conditions caused a substantial decline in refining margins and required the Company to write down the carrying value of its refinery inventories as of December 31, 1993. See Note 1 of Notes to Consolidated Financial Statements. The conditions causing the recent decline in crude oil, refined product and NGL prices have continued in 1994. Although refined product prices and refining margins have increased modestly since late December 1993, the Company's operating income and net income in the first quarter of 1994 are expected to be in the same range as operating income and net income for the fourth quarter of 1993, excluding the effect of the write-down in the carrying value of the Company's refinery inventories. Refinery Facilities Additions During 1993, the Company added certain facilities at the Refinery to enable the Company to produce reformulated gasolines containing the levels of oxygenates required by the Clean Air Act Amendments of 1990 (the "Clean Air Act"). A facility to produce methyl tertiary butyl ether ("MTBE") from butane feedstock (the "Butane Upgrade Facility") was placed in service during the second quarter of 1993. MTBE is a high-octane blendstock used to manufacture oxygenated and reformulated gasolines. The Butane Upgrade Facility can produce 15,000 barrels per day of MTBE. The Company can blend the MTBE produced at the Refinery into the Company's own gasoline cargos or sell the MTBE separately as a gasoline blendstock. All the butane feedstocks required to operate the Butane Upgrade Facility are available to the Company through the Refinery's and the Partnership's operations. In November 1993, the Company placed in service an MTBE/TAME complex (the "MTBE/TAME Complex"). The MTBE/TAME Complex converts streams currently produced at the Refinery's heavy oil cracker into about 2,500 barrels per day of MTBE and 3,000 barrels per day of tertiary amyl methyl ether ("TAME"). TAME, like MTBE, is a high-octane, oxygen-rich gasoline blendstock. The Butane Upgrade Facility and MTBE/TAME Complex enable the Company to produce approximately 20,000 barrels per day of oxygenates for gasoline blending. During the fourth quarter of 1993, the Company also placed in service a 25,000 barrel per day reformate splitter (the "Reformate Splitter"). The Reformate Splitter extracts a benzene concentrate stream from reformate produced at the Refinery's naphtha reformer unit. The benzene concentrate stream may be shipped to other refineries that can recover and purchase the benzene at market prices and then return the balance of the concentrate stream to the Company for gasoline blending or for sale as a petrochemical feedstock. The 1993 facilities additions enable the Company to produce all of its gasoline as reformulated gasoline and represent investments totalling approximately $300 million. MTBE Plant in Mexico Productos Ecologicos, S.A. de C.V., a Mexican corporation ("Proesa"), has executed a Memorandum of Understanding with Petroleos Mexicanos, the Mexican state-owned oil company ("PEMEX"), to construct a MTBE plant in Mexico, and has proposed a butane supply contract and MTBE sales contract with PEMEX. Proesa is owned 35% by the Company; 10% by Dragados y Construcciones, the largest construction company in Spain; and 55% by a corporation formed by Banamex, Mexico's largest bank, and Groupo Infomin, a privately held Mexican company. Proesa has also executed an option agreement for a plant site near the Bay of Campeche. The proposed Mexican MTBE plant is expected to have a capacity of approximately 15,000 barrels per day and to be similar to the Refinery's Butane Upgrade Facility. The project is expected to cost approximately $440 million and is subject to, among other things, the arrangement of satisfactory financing. Proesa has been advised by lenders with whom it is negotiating for project financing that certain provisions will be required in the proposed PEMEX contracts in order to secure satisfactory financing for the project. Proesa has entered into negotiations with PEMEX regarding such provisions. As a result of delays incurred in completing financing, Proesa has determined that the commencement of plant construction will be delayed. If satisfactory financing is obtained, construction of the MTBE plant could not begin before late 1994, with approximately two years required for completion. As of February 1994, no material amounts have been invested in the project. The amount of the Company's equity contribution will depend upon the level of debt financing obtained by Proesa and the ultimate equity interest of each partner. Under the proposed commercial contracts, PEMEX will purchase approximately 75% of the MTBE plant's production, one-half at a formula price and one-half at market-related prices, with the remainder of the plant's production being sold to the Company at a formula price. In addition, the butane feedstocks required by the plant will be purchased from PEMEX at market-related prices. A subsidiary of Energy has agreed to provide technical advice and assistance to Proesa in connection with the design, engineering, construction and operation of the MTBE plant. There can be no assurance that financing for the project can be obtained or that the plant will be constructed. PETROLEUM REFINING AND MARKETING Refining Operations The Refinery is designed to process primarily high- sulfur atmospheric tower bottoms, a type of residual fuel oil ("resid"), into a product slate of higher value products, principally unleaded gasoline and middle distillates. The Refinery also processes crude oil, butanes and other feedstocks. The Refinery can produce approximately 140,000 barrels per day of refined products, with gasoline and gasoline-related products comprising approximately 85% of the Refinery's throughput. The remaining product slate from the Refinery is primarily middle distillates. The Refinery has substantial flexibility to vary its mix of gasoline products to meet changing market conditions. Refining owns feedstock and product storage facilities with a capacity of approximately 6.4 million barrels. Approximately 4.1 million barrels of storage capacity are heated tanks for heavy feedstocks. During 1994, the Company anticipates having approximately 850,000 barrels of fuel oil storage available under lease in Malta. The Malta storage site will allow the Company to accumulate small parcels of high-sulfur resid for shipment to the Refinery. Refining also owns dock facilities that can simultaneously unload two 150,000 dead weight ton capacity ships and can dock larger crude carriers after partial unloading. One of the Refinery's principal operating units is a hydrodesulfurization unit ("HDS Unit"), which removes sulfur and metals from resid, thereby improving its subsequent cracking characteristics. The HDS Unit has a capacity of approximately 64,000 barrels per day. The Refinery's other principal unit is a heavy oil cracking complex ("HOC"), which processes feedstock primarily from the HDS Unit. The capacity of the HOC is approximately 66,000 barrels per day. The Refinery also has a hydrocracker with a capacity of approximately 34,000 barrels per day (the "Hydrocracker"), a continuous catalyst regeneration reformer with a capacity of approximately 31,000 barrels per day (the "Reformer"), and a reformer feed hydrotreater, hydrogen purification unit and related equipment (collectively, the "H/R Units"). The Hydrocracker processes gas oil and distillate streams from the Refinery to produce reformer feed naphtha. The Hydrocracker naphtha and other naphtha streams produced at the Refinery provide feed for the Reformer to produce reformate, a high-octane, low vapor pressure gasoline blendstock, and other products. The Refinery's other refining units include a 30,000 barrel per day crude unit and a 24,000 barrel per day vacuum unit. In 1993, the Company added the Butane Upgrade Facility, MTBE/TAME Complex and Reformate Splitter. See "Recent Developments - Refinery Facilities Additions" for a discussion of these facilities. The HDS Unit was down 15 days for a scheduled maintenance and catalyst change completed in December 1993. The Refinery's principal refining units operated during 1991, 1992 and 1993 with no significant unscheduled downtime. The HOC is scheduled for a turnaround in late 1994. For additional information with respect to Refining's operating results for the three years ended December 31, 1993, see "Management's Discussion and Analysis of Financial Condition and Results of Operations." Feedstock Supply The principal feedstock for the Refinery is resid produced at refineries outside the United States. Most of the large refineries in the United States are complex, sophisticated facilities able to convert internally produced resid into higher value products. Many overseas refineries are less sophisticated, process smaller portions of resid internally and, therefore, produce larger volumes of resid for sale. As a result, Refining acquires and expects to acquire most of its resid in international markets. A substantial portion of Refining's feedstock supplies are obtained from Middle Eastern sources. These supplies are loaded aboard chartered vessels at ports in the Arabian Gulf and are subject to the usual maritime hazards. Refining maintains insurance on its feedstock cargos. Under a feedstock supply agreement with the Company, Saudi Aramco (successor to the Saudi Arabian Marketing and Refining Company "SAMAREC") has agreed to provide an average of 55,000 barrels per day of resid to the Company at market-related prices. Deliveries under the agreement will continue through 1994 and provide approximately 75% of Refining's resid requirements. During 1993, Refining also purchased approximately 11,000 barrels per day of South Korean resid at market-related prices under an agreement which expires in the first quarter of 1994. The Company is negotiating to renew the agreement for South Korean resid on pricing terms more favorable to the Company than the existing contract. The Company also renewed a contract for approximately 22,000 barrels of crude produced in the People's Republic of China. Although the volume for this contract has been committed to the Company, the price must be renegotiated each quarter. The remainder of the Refinery's feedstocks are purchased at market-based prices under short-term contracts. The Company believes that if any of Refining's existing feedstock arrangements were interrupted, adequate supplies of feedstock could be obtained from other sources or on the open market. Resid generally sells at a discount to crude oil. In recent years, however, developments in the market have reduced this discount. The Company generally expects the long-term trend in the relationship between the supply of and demand for resid to be favorable, and expects resid to continue to sell at a discount to crude oil. In the short term, other factors, including price volatility and political developments, are likely to play an important role in refining industry economics. See "Recent Developments - Decline in Crude Oil and Refined Product Prices." Sales Set forth below is a summary of Refining's throughput volumes per day, average throughput margin per barrel and sales volumes per day for the three years ended December 31, 1993. Average throughput margin per barrel is computed by subtracting total direct product cost of sales from product sales revenues and dividing the result by throughput. Refining sells refined products principally on a spot and truck rack basis. A truck rack sale is a sale to a customer that provides trucks to take delivery at loading facilities. In 1993, spot and truck rack sales volumes accounted for 79% and 21%, respectively, of combined gasoline and distillate sales. Spot sales of Refining's products are made principally to larger oil companies and gasoline distributors. The principal purchasers of Refining's products from truck racks have been wholesalers and jobbers in the southeastern and midwestern United States. Refining's products are transported through common-carrier pipelines, barges and tankers. Interconnects with common-carrier pipelines give Refining the flexibility to sell products to the midwestern or southeastern United States. Factors Affecting Operating Results Refining's results of operations are determined principally by the relationship between refined product prices and resid prices, which in turn are largely determined by market forces. In recent years, the crude oil and refined product markets have experienced periods of extreme price volatility. During such periods, disproportionate changes in the prices of refined products and resid usually occur. Such changes have sometimes reduced margins, and, in some cases, such as in August 1990 at the beginning of the Arabian Gulf crisis, margins have expanded significantly. During the fourth quarter of 1993, however, refined product prices fell sharply, significantly reducing margins and requiring a writedown of the carrying value of the Company's Refinery inventories. See "Recent Developments - Decline of Crude Oil and Refined Product Prices" and Note 1 of Notes to Consolidated Financial Statements. The potential impact of changing crude oil and refined product prices on Refining's results of operations is further affected by the fact that, on average, Refining buys its resid feedstock approximately 40 days prior to processing it in the Refinery. The Company believes that resid will continue to sell at a discount to crude oil, and expects to continue to generate higher margins in its refining operations than conventional refiners that use crude oil as a principal feedstock. The future price of resid will depend on the relationship between the growth in crude oil demand (which generates more resid when processed) and worldwide additions to resid conversion capacity (which has the effect of reducing the available supply of resid). The Company believes that industry-wide additions to resid conversion capacity are not likely to exceed the expected increase in resid availability caused by increasing crude runs, decreasing environmentally permissible uses for resid and other factors. Refined product prices are influenced principally by factors of supply and demand. The Company expects that global demand for light products, including gasoline, will continue to increase in relation to the level of general economic activity, while fuel oil demand will increase more slowly. Most of the demand growth is expected to occur outside of the United States, particularly in Asia. The supply of gasoline and other light products is influenced by a variety of factors. Factors that may reduce available supplies include refinery shutdowns, vapor pressure reduction programs (which effectively remove butanes from the gasoline supply pool), lead phase-out programs and requirements for reformulated gasoline (which effectively remove benzene and other aromatics from the gasoline supply pool). Factors tending to increase supplies include imports, additions of conversion capacity and requirements for oxygenated gasoline under the Clean Air Act (which effectively adds oxygenates such as MTBE and ethanol to the gasoline pool). Predictions of future supply and demand are necessarily uncertain. However, the Company believes that prior to 1995, conversion capacity additions and projects to produce MTBE and other oxygenates are likely to cause gasoline supplies to increase more rapidly than demand. Thereafter, possible refinery closings and the more prevalent use of reformulated gasolines may reduce gasoline supplies and improve refining margins. The anticipated growth in demand for MTBE may be adversely affected by recent oxygenate proposals promulgated by the EPA under the Clean Air Act. On December 15, 1993, the EPA issued proposed reformulated gasoline regulations requiring that at least 30% of the oxygenates used in reformulated gasolines come from renewable sources such as corn, grain, wood, and organic waste products. Ethanol and ether producers capable of manufacturing ethanol-based ethyl tertiary butyl ether ("ETBE") stand to benefit the most if the proposed oxygenate rules are adopted due to the resulting, immediate increase in demand for ethanol and ETBE likely to occur. The proposed mandate for renewable oxygenates is generally disfavored by the fossil fuel- based oxygenate industry, including producers of methanol and manufacturers of MTBE. The EPA is expected to issue a final rule on renewable oxygenates by June 1994. Domestic gasoline production is supplemented with foreign imports. However, the Company believes that the availability of foreign gasoline supplies may decline because of the implementation of lead phasedown programs in some countries and a gradual increase in other environmental restrictions. The Company also believes that beginning in 1995, United States gasoline production capacity may become limited because of the prohibitive costs of new refinery construction and the expense of compliance for many older refineries with environmental regulations, including the Clean Air Act. Under provisions of the Clean Air Act, U.S. refineries must apply for new federal operating permits in 1995. Because the Refinery was completed in 1984, the Company expects to be able to comply with present and future environmental legislation more easily than older, conventional refineries. See "Environmental Matters" for a further discussion of the Clean Air Act and its impact on the refining industry. Other Projects Through its wholly owned subsidiary, the Company is a 20% general partner in Javelina Company ("Javelina"), which completed construction in 1991 of a plant in Corpus Christi (the "Javelina Plant") to process waste gases from the Refinery and other refineries in the Corpus Christi area and to extract hydrogen, ethylene, propylene and NGLs from the gas stream. The Company has made capital contributions and advances to Javelina of approximately $19.3 million through December 31, 1993, for the Company's proportionate share of capital expenditures and operating expenses. Javelina maintains a term loan agreement and a working capital and letter of credit facility which mature on January 31, 1996. The Company's guarantees of these bank credit agreements were approximately $19.6 million at December 31, 1993. VALERO NATURAL GAS PARTNERS, L.P. The Company holds an approximate 49% effective equity interest in the Partnership, and various subsidiaries of Energy serve as general partners of VNGP, L.P. and its subsidiary partnerships. For information with respect to the Company's investment in the Common Units of Limited Partner Interest ("Common Units") in VNGP, L.P., see Note 2 of Notes to Consolidated Financial Statements. Natural Gas Operations The Partnership owns and operates natural gas pipeline systems principally serving Texas intrastate markets. The Partnership's principal natural gas pipeline system is the intrastate gas system ("Transmission System") operated by Valero Transmission, L.P. ("Transmission") in the State of Texas. The Partnership also owns a 3.5-mile, 24-inch pipeline that connects the Partnership's pipeline near Penitas in South Texas to PEMEX's 42-inch pipeline outside of Reynosa, Mexico. The Partnership's wholly owned, jointly owned and leased natural gas pipeline systems include approximately 7,200 miles of mainlines, lateral lines and gathering lines. The Partnership leases and operates several natural gas pipelines, including approximately 240 miles of 24-inch pipeline extending from near Dallas to near Houston which the Partnership leases from a third party, and approximately 105 miles of pipeline in East Texas extending to Carthage, near the Louisiana border, which the Partnership leases from the Company. These integrated systems include 39 mainline compressor stations with a total of approximately 162,000 horsepower, together with gas processing plants, dehydration and gas treating plants and numerous measuring and regulating stations. The Partnership's gas sales, including gas sales by those subsidiaries operating the Partnership's special marketing programs ("SMPs"), transportation volumes in million cubic feet ("MMcf") per day, average gas sales prices and average gas transportation fees for the three years ended December 31, 1993, are as follows: The Partnership's natural gas operating results have improved in 1993 as natural gas supply and demand have become more balanced. Although increased industry competition will continue to affect the Partnership's operating results from natural gas operations, in 1993 the Partnership's natural gas throughput benefitted from increased business opportunities arising under FERC Order 636, a west-to-east shift in natural gas supply patterns and the temporary shutdown of a nuclear power plan in the Partnership's service area. See "Governmental Regulations - Federal Regulation" and "Management's Discussion and Analysis of Financial Condition and Results of Operations." Natural Gas Liquids Operations The Partnership's NGL operations include the processing of natural gas to extract a mixed stream of NGLs comprised of ethane, propane, butanes and natural gasoline, the separation ("fractionation") of mixed NGLs into component products and the transportation and marketing of NGLs. Extracted NGLs are transported to downstream fractionation facilities and end-use markets through NGL pipelines owned or leased by the Partnership and certain common carrier NGL pipelines. The Partnership owns or operates for its own account nine gas processing plants including a plant near Thompsonville in South Texas, which is leased by the Partnership from the Company. The Partnership's owned and leased gas processing plants are located in the western and southern regions of Texas and process approximately 1.3 billion cubic feet of gas per day. The Partnership's NGL production is sold primarily in the Corpus Christi and Mont Belvieu (Houston) markets. A substantial portion of the Partnership's butane production is sold to the Company as a feedstock for the Refinery's Butane Upgrade Facility. Volumes of NGLs produced at the Partnership's owned and leased plants (in thousands of barrels per day) and the average market price per gallon for the three years ended December 31, 1993, are as follows: The Partnership also owns or leases approximately 375 miles of NGL pipelines and fractionation facilities at three locations. In 1993, the Partnership fractionated an average of 70,000 barrels per day, compared to 68,000 barrels per day in 1992 and 51,000 barrels per day in 1991. In addition, the Partnership operates for a fee two NGL processing plants, approximately 59 miles of NGL pipeline and 450 miles of gathering lines owned by a subsidiary of Energy. See "Other Natural Gas Operations." Additional information regarding the Partnership is set forth in the Partnership's Annual Report on Form 10-K (Commission File No. 1-9433), which is separately filed with the Securities and Exchange Commission (the "Commission"). Items 1 through 3 of the Partnership's Annual Report on Form 10-K for the year ended December 31, 1993, as filed with the Commission on March 1, 1994, are filed as an Exhibit to this Report. OTHER NATURAL GAS OPERATIONS In addition to the natural gas and NGL operations conducted through the Partnership, the Company, through its wholly owned subsidiary Valero NGL Investments Company, owns certain South Texas NGL assets including two natural gas processing plants in Starr and Dimmit Counties, 450 miles of associated natural gas gathering lines, a 59-mile NGL pipeline and a 17.5% interest in a third gas processing plant in Nueces County. The Partnership operates these facilities for a fee under operating agreements with the Company. During 1993, these plants produced a daily average of approximately 9,500 barrels per day of NGLs. Prices realized from the sale of plant products were comparable to those obtained by the Partnership for its own production. See "Valero Natural Gas Partners, L.P. - Natural Gas Liquids." The Company leases certain assets to the Partnership under capital leases. The leased assets include (i) a gas processing plant near Thompsonville in South Texas and 48 miles of NGL product pipeline (the "Thompsonville Project"), (ii) an interest in approximately 105 miles of pipeline in East Texas (the "East Texas pipeline"), and (iii) certain fractionation facilities in Corpus Christi. The Thompsonville Project lease commenced December 1, 1992, and has a term of 15 years. The East Texas pipeline lease commenced February 1, 1991, and has a term of 25 years. The lease for the fractionation facilities commenced December 1, 1991, and has a term of 15 years. The rate of return available to the Company from the leases is limited to the lease payments specified in the respective leases plus any related tax benefits. The Partnership has the right to purchase all or any portion of the leased assets, subject to certain restrictions, under purchase option provisions of the respective lease agreements. Effective September 30, 1993, the Company sold its stock of Rio Grande Valley Gas Company ("RGV"), a wholly owned subsidiary of Energy whose operations are included in "Other Operations" of the Company, for cash in the amount of approximately $31 million. The disposition of RGV resulted in an after-tax gain, net of other nonoperating charges, of approximately $5 million. RGV owns approximately 1,552 miles of retail distribution lines, sells gas to approximately 75,000 retail customers in a number of communities in the Lower Rio Grande Valley of Texas and transports gas for approximately 60 transportation customers. Pursuant to contracts with the Partnership, RGV will continue to acquire all of its gas supply from the Partnership through the year 2000. RGV had aggregate gas sales and transportation volumes averaging approximately 14 MMcf per day in each of 1992 and 1991, and 15 MMcf per day for the first nine months of 1993. Val Gas Company ("Val Gas"), a wholly owned subsidiary of VNGC, owns and operates several small gathering systems in Texas that are subject to regulation by the FERC. See "Governmental Regulations - Federal Regulation." Until December 31, 1993, Valero Interstate Transmission Company ("Vitco"), an indirect wholly owned subsidiary of Energy, operated a small interstate pipeline system in South Texas comprised of approximately 240 miles of transmission and gathering lines. Effective January 1, 1994, the FERC authorized Vitco's abandonment of its pipeline system which is no longer subject to FERC rate regulation. GOVERNMENTAL REGULATIONS Certain of the Company's subsidiaries are subject to regulations issued by the Railroad Commission under the Cox Act, the Gas Utilities Regulatory Act ("GURA") and the Natural Resources Code, all of which are Texas statutes, and the federal Natural Gas Policy Act ("NGPA"). In addition, certain activities of Val Gas Company are subject to the regulations of the FERC under the NGPA, the Department of Energy Organization Act of 1977 (the "DOE Act"), and the federal Natural Gas Act. The Company's activities are also subject to various state and federal environmental statutes and regulations. See "Environmental Matters." Texas Regulation The Railroad Commission regulates the intrastate transportation, sale, delivery and pricing of natural gas in Texas by intrastate pipeline and distribution systems, including those of the Partnership. During 1992, the Railroad Commission revised its rules governing the production and purchase of natural gas. As part of such revision, the Railroad Commission adopted the gas proration rule (the "gas proration rule") to prevent the production of gas in excess of market demand. The gas proration rule requires producers to tender and deliver, and gas purchasers, including pipelines and purchasers offering SMPs, to take, only volumes of gas equal to their market demand. The gas proration rule further requires purchasers to take gas by priority categories, ratably among producers without undue discrimination, and with high-priority gas (defined as casinghead gas, or gas from wells primarily producing oil, and certain special allowable gas that are the last to be shut in during periods of reduced market demand) having higher priority than gas well gas (defined as gas from wells primarily producing gas), notwithstanding any contractual commitments. The revised rules are intended to simplify the previous system of nominations and to bring production allowables in line with estimated market demand. Federal Regulation In 1992, the FERC issued Order 636 related to restructuring of the interstate natural gas pipeline industry. Order 636 requires pipelines subject to FERC jurisdiction to provide unbundled marketing, transportation, storage and load balancing services on a nondiscriminatory basis to producers and end users instead of offering only combined packages of services, thus increasing competition in the natural gas industry. No Company subsidiary or Partnership subsidiary operating partnership is directly subject to Order 636. However, Order 636 is expected to create new supply, marketing and transportation opportunities for the Partnership. See "Recent Developments - Proposal to Acquire the Partnership." The Natural Gas Act and DOE Act grant to the FERC the authority to regulate rates and charges for natural gas transported in interstate commerce or sold by natural gas companies in interstate commerce for resale. Interstate natural gas sales for resale are made at rates subject to FERC regulation. Val Gas Company is subject to regulation as a "natural gas company" under the Natural Gas Act. ENVIRONMENTAL MATTERS The Company's Refinery operations and natural gas and NGL operations are subject to environmental regulation by federal and state authorities, including the EPA, the Texas Natural Resources Conservation Commission ("TNRCC"), the Texas General Land Office and the Railroad Commission. Compliance with regulations promulgated by these authorities increases the cost of designing, installing and operating such facilities. The regulatory requirements relate to water and storm water discharges, waste management and air pollution control measures. In 1993, Refining's capital expenditures attributable to compliance with environmental regulations (exclusive of expenditures for the Butane Upgrade Facility, MTBE/TAME Complex and Reformate Splitter, for which the amount of expenditures attributable to environmental regulation is not determinable) were approximately $8 million and are currently estimated to be approximately $6 million for 1994. Under the Clean Air Act, U.S. refineries must apply for new federal operating permits in 1995. Compliance with this and other environmental requirements may prove difficult and expensive for many older refineries. As a result, many refineries during the next few years likely will focus their capital expenditures on bringing their facilities into compliance with environmental requirements, rather than adding to capacity. Because of the Clean Air Act and other environmental regulations, various U.S. refiners have announced their intention to sell or close those refineries where capital expenditures needed to ensure compliance are not economically feasible. Because the Refinery was completed in 1984, it was built under more stringent environmental requirements than most existing U.S. refineries. Accordingly, the Company expects to be able to comply with the Clean Air Act and future environmental legislation more easily than older, conventional refineries. The Company expects that the demand for oxygenates such as MTBE will increase. (But see "Factors Affecting Operating Results" for a discussion of recent regulations proposed by the EPA that require the use of renewable oxygenates such as ethanol and ETBE.) The increase in demand for oxygenates is expected not only because of the mandates of the Clean Air Act for the use of clean burning fuels, but also because of the expected election by many areas to use reformulated gasolines even though not formally required by the Clean Air Act. The Clean Air Act requires the 39 areas that have failed to attain carbon monoxide air quality standards to use oxygenated gasolines during winter months. Beginning in 1995, the Clean Air Act also requires the nine areas that have the worst ozone air quality to use reformulated gasoline throughout the year to decrease their emissions of hydrocarbons and toxic pollutants. Also beginning in 1995, another 87 areas that have failed to attain certain ozone air-quality standards may elect to use reformulated gasolines throughout the year to decrease their emissions of hydrocarbons and toxic pollutants. Already, 43 of the 87 areas have notified the EPA of their election to use reformulated gasolines. Recent additions to the Refinery's facilities enable the Company to produce all of its gasoline as reformulated gasoline. See "Recent Developments - Refinery Facilities Additions." During 1991, environmental legislation was passed in Texas which conformed Texas law with the Clean Air Act to allow Texas to administer the federal programs. The Company and the Partnership have been and will continue to be affected by provisions of these laws concerning control requirements for air toxins and new operating permit requirements. The Company and the Partnership also have been affected by the increasing regulation of wastes by the Railroad Commission and the TNRCC and the promulgation of EPA permitting requirements for storm water discharges associated with industrial activities. Although these new laws and requirements may increase operating costs, they are not expected to have a material adverse effect on the Company's or the Partnership's operations or financial condition. The Oil Pollution Act of 1990 requires newly constructed tank vessels carrying crude oil to U.S. ports to be equipped with double hulls or double containment systems, and provides for a phaseout of existing vessels without double hulls beginning in 1995. Although these requirements are expected to increase the cost of transporting feedstocks to the Refinery, the staggered phaseout of existing vessels is expected to give existing vessel operators sufficient time to replace their fleets to provide adequate shipping capability. COMPETITION The refining industry is highly competitive with respect to both supply and markets. Refining competes with numerous other companies for available supplies of resid and other feedstocks and for outlets for its refined products. Prices of feedstocks and refined products are established principally by market conditions. Many of the companies with which Refining competes obtain a significant portion of their feedstocks from company-owned production and are able to dispose of refined products at their own retail outlets. Competitors that have their own production or retail outlets may be able to offset losses from refining operations with profits from producing or retailing operations and may be better positioned than the Company to withstand periods of depressed refining margins. See "Environmental Matters" for a discussion of the effects of environmental regulations on refining competition. The natural gas industry is and is expected to remain highly competitive with respect to both gas supply and markets, with no company or small group of companies being dominant. Order 636 provides a mechanism for producers and marketers to sell gas directly to end users, resulting in increased competition for gas sales. See "Governmental Regulations - Federal Regulation." EMPLOYEES As of December 31, 1993, the Company had approximately 1,740 employees. EXECUTIVE OFFICERS OF THE REGISTRANT The following table sets forth certain information as of December 31, 1993 regarding the present executive officers of Energy. Each officer named in the following table has been elected to serve until his successor is duly appointed and elected or his earlier removal or resignation from office. No family relationship exists among any of the executive officers, directors or nominees for director of Energy. Similarly, there is no arrangement or understanding between any executive officer and any other person pursuant to which he was or is to be selected as an officer. Mr. Greehey has served as Chief Executive Officer and as a director of Energy since 1979 and as Chairman of the Board since 1983. Mr. Greehey is also a director of Weatherford International Incorporated and Santa Fe Resources, Inc., neither of which are affiliated with the Company or the Partnership. Mr. Benninger has served as a director of Energy since 1990. He was elected Executive Vice President in 1989 and served as Chief Financial Officer from 1986 to 1992. In 1992, he was elected Executive Vice President and Chief Operating Officer of Valero Natural Gas Company. Mr. McLelland was elected Executive Vice President and General Counsel in 1989 and had served as Senior Vice President and General Counsel of Energy since 1981. Mr. Heep was elected Senior Vice President and Chief Financial Officer of Energy in 1994, prior to which he served as Vice President Finance since 1990. He has been employed by the Company in various capacities since 1977. Mr. Fry was elected Vice President Administration of Energy in 1989 and served as Secretary of Energy from 1980 to 1992. Mr. Zanotti has served as Executive Vice President of VRMC since 1988 and as President and Chief Operating Officer of VRC since 1990, and has served in other positions with the Company since 1983. Mr. Manning has served as Senior Vice President of VRMC since 1986 and of VRC since 1987. ITEM 2.		ITEM 2. PROPERTIES The Company's properties include a petroleum refinery and related facilities, three natural gas processing plants, and various natural gas and NGL pipelines, gathering lines and related facilities, all located in Texas. The Company also operates natural gas pipeline systems and NGL facilities, processing plants, compressor stations, treating plants, measuring and regulating stations, fractionation facilities, underground natural gas storage caverns and other properties owned or used by the Partnership, all of which are located in Texas. Substantially all of Refining's fixed assets are pledged as security under deeds of trust securing industrial revenue bonds issued on behalf of Refining, while its inventories and receivables are pledged as security under a bank credit agreement providing working capital to Refining. See Note 4 of Notes to Consolidated Financial Statements. The Partnership has pledged substantially all of its gas systems and processing facilities, except for certain pipeline, processing and fractionation assets leased from the Company, as collateral for its First Mortgage Notes. Reference is made to "Item 1. Business," which includes detailed information regarding properties of the Company. Management believes that the Company's facilities are generally adequate for their respective operations, and that the facilities of the Company are maintained in a good state of repair. The Company and the Partnership are lessees under a number of cancelable and noncancelable leases for certain real properties. See Note 14 of Notes to Consolidated Financial Statements. ITEM 3.	ITEM 3. LEGAL PROCEEDINGS The Company is party to the following proceedings: Coastal Oil and Gas Corporation v. TransAmerican Natural Gas Corporation ("TANG"), 49th State District Court, Webb County, Texas (filed October 30, 1991) (reported in the Company's Form 10-K for the year ended December 31, 1992 as Transamerican Natural Gas Corporation v. The Coastal Corporation et al). In March 1993, Valero Transmission Company and Valero Industrial Gas Company were served as third party defendants in this lawsuit. In August 1993, Energy, VNGP, L.P. and certain of their respective subsidiaries were named as additional third-party defendants (collectively, including the original defendant subsidiaries, the "Valero Defendants"). In TANG's counterclaims against Coastal and third-party claims against the Valero Defendants, TANG alleges that it contracted to sell natural gas to Coastal at the posted field price of Valero Industrial Gas Company and that the Valero Defendants and Coastal conspired to set such price at an artificially low level. TANG also alleges that the Valero Defendants and Coastal conspired to cause TANG to deliver unprocessed or "wet" gas thus precluding TANG from extracting NGLs from its gas prior to delivery. TANG seeks actual damages of approximately $50 million, trebling of damages under antitrust claims, punitive damages of $300 million, and attorneys' fees. The Valero Defendants' motion for summary judgment on TANG's antitrust claim was argued on January 24, 1994. The court has not ruled on such motion. The current trial setting for this case is March 14, 1994. Toni Denman v. Valero Natural Gas Partners, L.P., Valero Natural Gas Company, Valero Energy Corporation, et al., (filed October 15, 1993); Howard J. Vogel v. Valero Natural Gas Partners, L.P., Valero Natural Gas Company, Valero Energy Corporation, et al., (filed October 15, 1993); 7547 Partners v. Valero Natural Gas Partners, L.P., Valero Natural Gas Company, Valero Energy Corporation, et al., (filed October 19, 1993); Robert Endler Trust v. Valero Natural Gas Partners, L.P., Valero Natural Gas Company, Valero Energy Corporation, et al., (filed October 27, 1993); Dorothy Real v. Valero Energy Corporation, Valero Natural Gas Company and Valero Natural Gas Partners, L.P., (filed November 4, 1993); Malcolm Rosenwald v. Valero Natural Gas Partners, L.P., Valero Natural Gas Company, Valero Energy Corporation, et al., (filed November 9, 1993); Norman Batwin v. Valero Natural Gas Partners, L.P., Valero Natural Gas Company, Valero Energy Corporation, et al., (filed November 15, 1993) Court of Chancery, New Castle County, Delaware. Each of the foregoing suits was filed in response to the announcement of Energy's proposal to acquire the publicly traded Common Units of VNGP, L.P. pursuant to a proposed merger of VNGP, L.P. with a wholly owned subsidiary of Energy. The suits were consolidated by the Court of Chancery on November 23, 1993. The plaintiffs sought to enjoin or rescind the proposed merger, alleging that the corporate defendants and the individual defendants, as officers or directors of the corporate defendants, engaged in actions in breach of the defendants' fiduciary duties to the holders of the Common Units by proposing the merger. The plaintiffs alternatively sought an increase in the proposed merger consideration, compensatory damages and attorneys' fees. In December 1993, the parties reached a tentative settlement of the consolidated lawsuit. The terms of the settlement will not require a material payment by the Company or the Partnership. Garcia, et al. v. Coastal Chemical Company, Inc., Valero Refining Company, Javelina Company, et al., 347th Judicial District Court, Nueces County, Texas (filed August 31, 1993). This action was brought by certain residents of the Oak Park Triangle area of Corpus Christi, Texas, against several defendants including Valero Refining Company. All named defendants are either refiners or gas processors having facilities located at or near Up River Road in Corpus Christi. Plaintiffs allege in general terms damages resulting from ground water contamination and air pollution allegedly caused by the operations of the defendants. Plaintiffs seek unspecified actual and punitive damages. The Long Trusts v. Tejas Gas Corporation, 123rd Judicial District Court, Panola County, Texas (filed March 1, 1989). Valero Transmission Company (an indirect wholly owned subsidiary of Energy, "VTC"), as buyer, and Tejas Gas Corporation ("Tejas"), as seller, are parties to various gas purchase contracts assigned to and assumed by Valero Transmission, L.P. upon formation of the Partnership in 1987. Tejas is also a party to a series of gas purchase contracts between Tejas, as buyer, and certain trusts ("The Long Trusts"), as seller, which are in litigation ("The Long Trusts Litigation"). Neither the Partnership nor VTC is a party to The Long Trusts Litigation or the Tejas/Long Trusts contracts. However, because of the relationship between the Transmission/Tejas contracts and the Tejas/Long Trusts contracts, and in order to resolve existing and potential disputes, Tejas, VTC and Valero Transmission, L.P. have agreed that Tejas, VTC and Valero Transmission, L.P. will cooperate in the conduct of The Long Trusts Litigation, and that VTC and Valero Transmission, L.P. will bear a substantial portion of the costs of any appeal and any nonappealable final judgment rendered against Tejas. In The Long Trusts Litigation, The Long Trusts allege that Tejas has breached various minimum take, take-or-pay and other contractual provisions of the Tejas/Long Trusts contracts, and assert a statutory non-ratability claim. The Long Trusts seek alleged actual damages of approximately $30 million including interest and an unspecified amount of punitive damages. The District Court ruled on the plaintiff's motion for summary judgment, finding that as a matter of law the three gas purchase contracts at issue were fully binding and enforceable, that Tejas breached the minimum take obligations under one of the contracts, that Tejas is not entitled to claimed offsets for gas purchased by third parties and that the "availability" of gas for take-or-pay purposes is established solely by the delivery capacity testing procedures in the contracts. Damages, if any, have not been determined. Because of existing contractual obligations of Valero Transmission, L.P. to Tejas, the lawsuit may ultimately involve a contingent liability for Valero Transmission, L.P. The Court recently granted Tejas's Motion for Continuance in connection with the former January 10, 1994 trial date. The Long Trusts Litigation is not currently set for trial. NationsBank of Texas, N.A., Trustee of The Charles Gilpin Hunter Trust, et al. v. Coastal Oil & Gas Corporation, Valero Transmission Company, et al., 160th State District Court, Dallas County, Texas (filed February 2, 1993) (formerly reported as "Williamson, et al. v. Coastal Oil & Gas Corporation, Valero Transmission Company, et al., 68th State District Court, Dallas County, Texas (filed June 30, 1988)" in Energy's Form 10-K for the fiscal year ended December 31, 1992). In a lawsuit filed in 1988, certain plaintiffs alleged that defendants Coastal Oil & Gas Corporation ("Coastal") and Energy, VTC, VNGP, L.P., the Management Partnership and Valero Transmission, L.P. (the "Valero Defendants") were liable for failure to take minimum quantities of gas, failure to make take-or-pay payments and other breach of contract and breach of fiduciary duty claims. The plaintiffs sought declaratory relief, actual damages in excess of $37 million and unquantified punitive damages. The lawsuit was settled on terms immaterial to the Valero Defendants, and the parties agreed to a dismissal of the lawsuit. On November 16, 1992, prior to entry of an order of dismissal, NationsBank of Texas, N.A., as trustee for certain trusts (the "Intervenors"), filed a plea in intervention to intervene in the lawsuit. The Intervenors asserted that they held a nonparticipating mineral interest in the lands subject to the litigation and that their rights were not protected by the plaintiffs in the settlement. On February 4, 1993, the Court struck the Intervenors' plea in intervention. However, on February 2, 1993, the Intervenors had filed a separate suit in the 160th State District Court, Dallas County, Texas, against all prior defendants and an additional defendant, substantially adopting the allegations and claims of the original litigation. In February 1994, the parties reached a tentative settlement of the lawsuit on terms immaterial to the Company or the Partnership. Valero Energy Corporation, et al. v. M.W. Kellogg Company, et al., 117th Judicial District Court, Nueces County, Texas (filed July 11, 1986). The Company claims that the defendants are liable for breach of warranty, breach of contract, negligence, gross negligence, breach of implied warranty of good and workmanlike performance, breach of the Texas Deceptive Trade Practices - Consumer Protection Act, breach of implied warranty of fitness for ordinary purposes and strict liability in tort in connection with services performed at the Refinery. The Company claims actual damages in excess of $165 million plus exemplary damages, statutory penalties, attorney's fees and costs of court. In September 1991, the court considered motions for summary judgment filed by the Company, Kellogg and Ingersoll-Rand, another primary defendant. On October 25, 1991, the court entered judgment which granted the motions of Kellogg and Ingersoll-Rand for summary judgment in their entirety, denied the motion for summary judgment filed by the Company and entered a take nothing judgment dismissing all of the Company's claims with prejudice. The Company appealed the trial court's decision to the Thirteenth Court of Appeals, Corpus Christi, Texas. On June 30, 1993, the Court of Appeals affirmed the trial court's decision. The Company has appealed the decision to the Texas Supreme Court. White, et al. v. Coastal Javelina, Inc., Valero Energy Corporation, et al., 94th State District Court, Nueces County, Texas (filed November 27, 1991). Plaintiffs, as owners of real property situated near the Javelina Plant, have alleged that the operation and maintenance of the Javelina Plant have (i) interfered with their use and enjoyment of their property, (ii) caused depreciation in the value of their property, (iii) caused physical and mental injuries, (iv) damaged persons and property, and (v) caused a nuisance. Plaintiffs seek unspecified actual damages, punitive damages, prejudgment and postjudgment interest, costs of the lawsuit and equitable relief. Javelina Company Litigation. Valero Javelina Company, a wholly owned subsidiary of Energy, is a general partner of Javelina Company, a general partnership. See "Petroleum Refining and Marketing - Other Projects" and Note 5 of Notes to Consolidated Financial Statements. In addition to White and Garcia (reported above), Javelina Company has been named as a defendant in five other lawsuits filed since 1992 in state district courts in Nueces County, Texas. Garcia and three other suits include as defendants several other companies that own refineries or other industrial facilities in Nueces County. These suits were brought by a number of plaintiffs who reside in neighborhoods near the facilities. The plaintiffs claim injuries relating to alleged exposure to toxic chemicals, and generally claim that the defendants were negligent, grossly negligent and committed trespass. The plaintiffs claim personal injury and property damages resulting from soil and ground water contamination and air pollution allegedly caused by the operations of the defendants. One of the suits seeks certification of the litigation as a class action. The plaintiffs seek an unspecified amount of actual and punitive damages. White and two other suits were brought by plaintiffs who either live or have businesses near the Javelina Company plant. The suits allege claims similar to those described above. These plaintiffs also fail to specify an amount of damages claimed. City of Houston Claim. In a letter dated September 1, 1993 from the City of Houston (the "City") to Valero Transmission Company ("VTC"), the City stated its intent to bring suit against VTC for certain claims asserted by the City under the franchise agreement between the City and VTC. VTC is the general partner of Valero Transmission, L.P. The franchise agreement was assigned to and assumed by Valero Transmission, L.P. upon formation of the Partnership in 1987. In the letter, the City declared a conditional forfeiture of the franchise rights based on the City's claims. In a letter dated October 27, 1993, the City claimed that VTC owes to the City franchise fees and accrued interest thereon aggregating approximately $13.5 million. In a letter dated November 9, 1993, the City claimed an additional $18 million in damages related to the City's allegations that VTC engaged in unauthorized activities under the franchise agreement by transmitting gas for resale and by transporting gas for third parties on the franchised premises. Any liability of VTC with respect to the City's claims has been assumed by the Partnership. The City has not filed a lawsuit. Take-or-Pay and Related Claims. As a result of past market conditions and contracting practices in the natural gas industry, numerous producers and other suppliers brought claims against Transmission and Vitco asserting breach of contractual provisions requiring that they take, or pay for if not taken, certain volumes of natural gas. The Company and the Partnership have settled substantially all of the significant take-or-pay claims, pricing differences and contractual disputes heretofore brought against them. In 1987, Transmission and a producer from whom Transmission has purchased natural gas entered into an agreement resolving certain take-or-pay issues between the parties in which Transmission agreed to pay one-half of certain excess royalty claims arising after the date of the agreement. The royalty owners of the producer recently completed an audit of the producer and have presented to the producer a claim for additional royalty payments in the amount of approximately $17.3 million, and accrued interest thereon of approximately $19.8 million. Approximately $8 million of the royalty owners' claim accrued after the effective date of the agreement between the producer and Transmission. The producer and Transmission are reviewing the royalty owners' claims. No lawsuit has been filed by the royalty owners. The Company believes that various defenses under the agreement may reduce any liability of Transmission to the producer in this matter. Although additional claims may arise under older contracts until their expiration or renegotiation, the Company believes that the Partnership and the Company have resolved substantially all of the significant take-or-pay claims that are likely to be made. The Company believes any remaining take-or-pay claims can be resolved on terms satisfactory to the Partnership and the Company. Any liability of Energy, VNGC or VNGC's wholly owned subsidiaries with respect to take-or-pay claims involving Transmission's intrastate pipeline operations has been assumed by the Partnership. If the Partnership were unable or otherwise failed to discharge any liability which it assumed, the Company would remain ultimately liable for such liability. Conclusion. The Company is also a party to additional claims and legal proceedings arising in the ordinary course of business. The Company believes it is unlikely that the final outcome of any of the claims or proceedings to which the Company is a party including the claims and proceedings described above would have a material adverse effect on the Company's financial position or results of operations; however, due to the inherent uncertainty of litigation, the range of possible loss, if any, cannot be estimated with a reasonable degree of precision and there can be no assurance that the resolution of any particular claim or proceeding would not have an adverse effect on the Company's results of operations for the fiscal period in which such resolution occurred. As described above, the Partnership has assumed the obligations and liabilities of the Company with respect to certain claims. If the Partnership were unable or otherwise failed to discharge any such obligation or liability, the Company could remain ultimately liable for the same. ITEM 4.	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the fourth quarter of 1993. PART II ITEM 5.	ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Energy's Common Stock is listed on the New York Stock Exchange, which is the principal trading market for this security. As of February 14, 1994, there were 8,095 holders of record and an estimated 20,000 beneficial owners of Energy's Common Stock. The range of the high and low sales prices of the Common Stock as quoted in The Wall Street Journal, New York Stock Exchange-Composite Transactions listing, and the amount of per- share dividends for each quarter in the preceding two years, are set forth in the tables shown below: The Energy Board of Directors declared a quarterly dividend of $.13 per share of Common Stock at its January 20, 1994 meeting. Dividends are considered quarterly by the Energy Board of Directors and are limited by, among other things, the Company's financing agreements. See Note 4 of Notes to Consolidated Financial Statements. ITEM 6.	ITEM 6. SELECTED FINANCIAL DATA The selected financial data set forth below for the year ended December 31, 1993 is derived from the Company's Consolidated Financial Statements contained elsewhere herein. The selected financial data for the years ended prior to December 31, 1993 is derived from the selected financial data contained in the Company's Annual Report on Form 10-K for the year ended December 31, 1992. The following summaries are in thousands of dollars except for per share amounts: ITEM 7.	ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS The following are the Company's financial and operating highlights for each of the three years in the period ended December 31, 1993. The Partnership operating income amounts presented below represent 100% of the Partnership's operating income by segment. The amounts in the following table are in thousands of dollars, unless otherwise noted: GENERAL The Company reported net income of $36.4 million or $.82 per share for the year ended December 31, 1993, compared to $83.9 million or $1.94 per share, respectively, for 1992. Operating income was $75.5 million in 1993 compared to $134 million in 1992. For the fourth quarter of 1993, the Company reported a net loss of $15.2 million or $.36 per share compared to net income of $8.2 million or $.18 per share for the same period in 1992. Operating loss was $17.7 million for the fourth quarter of 1993 compared to operating income of $15.9 million for the same period in 1992. The 1993 results were reduced by a $27.6 million, or $17.9 million after-tax, write-down in the carrying value of the Company's refinery inventories during the fourth quarter of 1993 to reflect existing market prices. Also affecting 1993 results compared to 1992 were depressed refining margins and the operation of the butane upgrade facility and other new refinery units discussed below. Crude oil, refined product prices and refining margins were weak throughout 1993. During the November meeting of the Organization of Petroleum Exporting Countries ("OPEC"), the member countries decided to forego any cuts in production. This decision, combined with increased production from the North Sea region, continued uncertainty regarding Iraq's possible re-entry into world oil markets and weak global demand for energy caused a precipitous drop in crude oil prices to their lowest levels in five years. Refined product prices decreased faster and further than crude oil prices due to continuing high refinery capacity utilization rates and high gasoline inventories. These conditions resulted in a substantial decline in refining margins and the write-down in the carrying value of the Company's refinery inventories. Refined product prices and refining margins have increased modestly since late December. The Company's operating income and net income for the first quarter of 1994, however, are expected to be in the same range as operating income and net income for the fourth quarter of 1993, excluding the effect of the write-down in the carrying value of the Company's refinery inventories. The following is a discussion of the Company's results of operations first comparing 1993 to 1992 results and then comparing 1992 to 1991 results: 1993 COMPARED TO 1992 Refining Operations During 1993, the Company's specialized petroleum refinery (the "Refinery") began operation of a butane upgrade facility which converts butane into MTBE, a MTBE/TAME complex and a reformate splitter. See Note 5 of Notes to Consolidated Financial Statements. These projects have increased the Refinery's production capacity to approximately 140,000 barrels per day of refined products. Refining's operating revenues were $1,044.7 million for the year ended December 31, 1993 compared to $1,056.9 million for 1992. Operating revenues remained level as an 8% decrease in the average sales price per barrel offset an 8% increase in sales volumes. Increased production capacity resulting from operation of the butane upgrade facility contributed to the increase in sales and throughput volumes. Refining's cost of sales increased $42.9 million to $910.2 million in 1993 compared to 1992. Cost of sales increased due to the increase in throughput volumes and the inventory write-down discussed above. Partially offsetting the increase in cost of sales was a decrease in the average feedstock cost per barrel. The average throughput margin per barrel, before operating costs, for 1993 was $5.99 ($5.44, including the effect of the inventory write-down) compared to $7.00 for 1992. Both Refinery operating costs, which are included in cost of sales, and depreciation expense increased for 1993 compared to 1992 due primarily to costs associated with operation of the butane upgrade facility and other new Refinery units. As a result of the above factors, Refining's operating income decreased 45% to $75.4 million. The Refinery's hydrodesulfurization unit (the "HDS Unit") and heavy oil cracking unit (the "HOC Unit"), collectively the HDS/HOC complex, process high-sulfur atmospheric tower bottoms, a type of residual fuel oil ("resid") which normally sells at a significant discount to crude oil, the conventional feedstock for refineries. The remainder of the Refinery units process crude oil, butanes, and other feedstocks. The Company does not have retailing or crude oil producing operations. Refining's operations and throughput margins continue to benefit from the discount at which resid sells to crude oil. This discount per barrel has averaged $4.43, $4.73 and $4.87 for the years ended December 31, 1993, 1992, and 1991, respectively. The discount at which resid sells to crude oil generally decreases with decreases in crude oil prices due to price competition for resid from natural gas and other markets. However, resid is expected to continue to sell at a discount to crude. The Company believes that the Refinery's ability to process resid, combined with a product slate consisting primarily of unleaded gasoline and related higher value products, positions the Company to effectively compete in the emerging clean fuels marketplace. Under a feedstock supply agreement with the Company, Saudi Aramco (successor to the Saudi Arabian Marketing and Refining Company "SAMAREC"), has agreed to provide an average of 55,000 barrels per day of resid to the Company at market-related prices. Deliveries under the agreement will continue through 1994 and provide approximately 75% of Refining's resid requirements. During 1993, Refining also purchased approximately 11,000 barrels per day of South Korean resid at market-related prices under an agreement which expires in the first quarter of 1994. The Company is negotiating to renew this agreement for South Korean resid on pricing terms more favorable to the Company than the existing contract. The Company also renewed a contract for approximately 22,000 barrels of crude produced in the People's Republic of China. Although the volume for this contract has been committed to the Company, the price must be renegotiated quarterly. The remainder of the Refinery's feedstocks are purchased at market-related prices under short- term contracts. The Company believes that if any of Refining's existing feedstock arrangements were interrupted, adequate supplies of feedstock could be obtained from other sources or on the open market. Scheduled maintenance and catalyst changes of the HDS Unit were completed in April 1991, October 1992 and December 1993, and a turnaround of the HOC was completed in November 1991. The HOC is scheduled for a turnaround in late 1994. Other Operations The Company's other operations consist of certain minor natural gas pipeline and natural gas distribution operations not transferred to Valero Natural Gas Partners, L.P. ("VNGP, L.P." or the "Partnership") and the natural gas liquids assets ("NGL Assets") acquired from Oryx Energy in May 1992. Also included in other operations are the Company's activities as the General Partner of the Partnership and other miscellaneous revenues. The Company receives a management fee, which is included in operating revenues, equal to the direct and indirect costs incurred by it on behalf of the Partnership. Operating income from other operations for 1993 increased $3.3 million from the same period in 1992 primarily due to an increase in operating income associated with the NGL Assets attributable to the full period effect of those operations in 1993 and decreased corporate expenses borne by the Company. On September 30, 1993, the Company sold Rio Grande Valley Gas Company ("RGV"), its natural gas distribution subsidiary, for approximately $31 million. The disposition of RGV resulted in an after-tax gain, net of other nonoperating charges, of approximately $5 million. Partnership Operations Effective December 20, 1993, Energy, Valero Natural Gas Company and Valero Natural Gas Partners, L.P. entered into an agreement of merger. In the merger, VNGP, L.P. will become a wholly owned subsidiary of Energy, with the public holders of common units receiving cash consideration of $12.10 per common unit, or a total of approximately $117.5 million. Energy has filed a registration statement with the Securities and Exchange Commission (the "Commission") for the issuance of $150 million (up to $172.5 million with underwriters' over-allotments) of convertible preferred stock to finance the merger and to use for general corporate purposes, including the reduction of existing indebtedness under the Company's bank credit agreements. The transaction is subject to approval by the holders of a majority of the issued and outstanding common units, approval by the holders of a majority of the common units held by the public unitholders and voted at a special meeting to be called to consider the merger, receipt of satisfactory waivers, consents or amendments to certain of the Company's financial agreements and completion of the offering of convertible preferred stock discussed above. These financial agreements, which include a new bank credit agreement as well as amendments to other financial agreements, are in the process of being negotiated to provide for the proposed merger. In the event that the proposed merger of VNGP, L.P. with the Company is not ultimately consummated, the proceeds from the offering would be added to the Company's funds and used for general corporate purposes, including the repayment of existing indebtedness, financing of capital projects and additions to working capital. There can be no assurance, however, that the merger can be completed. The Company believes that the natural gas and natural gas liquids industries are undergoing a period of restructuring and consolidation that may create opportunities for expansions, acquisitions or strategic alliances which, if the Partnership could take advantage of them, could enable the Partnership to compete more effectively in the competitive natural gas environment. Because of the Federal Energy Regulatory Commission's Order No. 636 which requires interstate pipeline companies to offer various services on an unbundled, nondiscriminatory basis, the Company believes that intrastate pipelines such as the Partnership may enjoy increased opportunities to compete for interstate business. In addition, an emerging trend of west-to-east movement of gas across the United States may provide beneficial transportation opportunities for the Partnership if the Partnership were able to make the necessary capital expenditures for added west-to-east capacity on its pipeline system. However, the Partnership's competitive position could be eroded if the Partnership is unable to respond effectively to the changing dynamics of the industry. The merger was proposed because the Company believes that the Partnership has insufficient financial flexibility to participate fully in opportunities that may arise in the natural gas and natural gas liquids ("NGL") industries. The Company believes that the ability of the Partnership to compete effectively in these businesses will be enhanced through the merger. The Company also believes that potential conflicts of interest between the Partnership and the Company can be eliminated through the merger. For additional information regarding the proposed acquisition and pro forma consolidated financial data, see Note 2 of Notes to Consolidated Financial Statements. During 1993, 1992 and 1991, the Company's equity in earnings of the Partnership contributed $6.8 million, $10.5 million and $15 million, respectively, to the Company's net income. The Company's equity in earnings of the Partnership decreased in 1993 due primarily to a decrease in operating income from the Partnership's NGL operations, partially offset by an increase in operating income from the Partnership's natural gas operations. The profitability of the Partnership's NGL operations depends principally on the margin between NGL sales prices and the cost of the natural gas from which such liquids are extracted ("shrinkage cost"). Operating income from the Partnership's NGL operations decreased $31.3 million, or 55%, in 1993 compared to 1992 due primarily to a decrease in NGL prices in the last six months of 1993 resulting from continuing high levels of NGL inventories and the significant decline in refined product prices discussed above, combined with an increase in fuel and shrinkage costs resulting from a 22% increase in the cost of natural gas. The decline in NGL prices resulted in a $1.4 million operating loss from NGL operations for the fourth quarter of 1993 compared to operating income of $12.9 million for the fourth quarter of 1992. Also reducing fourth quarter 1993 operating results was an increase in depreciation expense resulting from the recognition in the 1992 period of a change in the estimated useful lives of the majority of the Partnership's NGL facilities from 14 to 20 years retroactive to January 1, 1992. Operating income from the Partnership's natural gas operations increased $21 million, or 65%, for 1993 compared to 1992 due to a 10% increase in daily natural gas sales volumes and a 12% increase in transportation revenues resulting from continued strong demand for natural gas, certain favorable measurement, fuel usage and customer billing adjustments and an increase in income generated by the Partnership's Market Center Services Program. The Market Center Services Program was established in 1992 to provide price risk management services to gas producers and end users through the use of forward contracts and other tools which have traditionally been used in financial risk management. The Partnership recognized gas cost reductions and other benefits from this program of $18.7 million in 1993, which represents an increase of $5.8 million from 1992. Partially offsetting these increases in natural gas operating income was a decrease in the recovery of Valero Transmission, L.P.'s ("VT, L.P.", a subsidiary operating partnership) fixed costs resulting from the settlement of a customer audit of VT, L.P.'s weighted average cost of gas. For the fourth quarter of 1993, natural gas operating income increased $9.8 million to $15.8 million compared to $6 million in the fourth quarter of 1992 due to the factors noted above. During the first quarter of 1994, NGL prices have increased modestly since late December 1993, but remain below first quarter 1993 levels. Concurrently, natural gas prices and resulting shrinkage costs have increased during the first quarter of 1994 compared to the same period in 1993. As a result, Partnership operating income and the Company's equity in earnings of the Partnership are expected to be substantially lower in the first quarter of 1994 compared to the fourth quarter of 1993. Other Interest and debt expense, net of capitalized interest, increased due to the issuance of medium-term notes in 1992 (see Note 4 of Notes to Consolidated Financial Statements) and decreased capitalized interest primarily due to the placing in service of the butane upgrade facility during the second quarter of 1993. Income tax expense decreased primarily due to a decrease in pre-tax income. Partially offsetting this was the effect of a federal tax rate increase due to the enactment of the Omnibus Budget Reconciliation Act of 1993, which provides for an increase in the corporate tax rate from 34% to 35%, retroactive to January 1, 1993. As a result of this legislation, the Company recorded a onetime, noncash charge to 1993 third quarter earnings of $8.2 million related to deferred taxes as of the end of 1992. 1992 COMPARED TO 1991 Refining Operations Refining's operating revenues were $1,056.9 million for the year ended December 31, 1992, which represented a 19% increase over the same period in 1991. The increase in operating revenues was due to a 27% increase in sales volumes as a result of the commencement of operations of the hydrocracker/reformer units (the "H/R Units") during the early part of 1992, partially offset by the effect of a 7% decrease in Refining's average sales price per barrel in 1992. For 1992, Refining's operating income was $137.2 million, which represented a 3% increase over 1991. The average throughput margin for 1992 was $7.00 per barrel compared to $7.31 per barrel for 1991, calculated using total throughput volumes, or $8.84 per barrel for 1991, using only HDS/HOC complex volumes. The decrease in average throughput margin per barrel in 1992 compared to 1991 is primarily due to a decrease in refined product sales prices. Operating income in 1991 also benefitted significantly from a forward sale in 1991 of a significant portion of refined products at the higher prices which prevailed prior to the Arabian Gulf crisis in January 1991. Other Operations Operating income from other operations for 1992 increased $11.2 million primarily due to the inclusion of $9.3 million of operating income associated with the NGL Assets. Partnership Operations The Company's equity in earnings of the Partnership decreased in 1992 due to a decrease in operating income in both the Partnership's natural gas and NGL operations and a decrease in interest and other income. Operating income from the Partnership's NGL operations decreased $5.4 million, or 9%, during 1992 compared to 1991 due to a decrease in the average NGL market price, higher shrinkage costs and higher operating expenses. This was partially offset by an increase in production, transportation and fractionation volumes and a decrease in depreciation expense. Operating income from the Partnership's natural gas operations decreased $4.6 million, or 12%, to $32.5 million during 1992 compared to 1991 due to a decrease in natural gas sales volumes, lower average transportation fees and higher operating expenses, primarily due to higher pipeline transportation expense and the charge from the Company for the Partnership's allocable cost of the Company's early retirement program. The decrease in operating income as a result of these factors was partially offset by gas cost reductions and other benefits of $12.9 million from its Market Center Services Program. Other The Company's other income, net, decreased during 1992 due to decreased interest income caused by decreased average investments resulting from the gradual utilization of proceeds from the issuance of Energy's 10.58% Senior Notes in December 1990 and January 1991 and lower interest rates. Interest and debt expense, net of capitalized interest, increased due to an increase in interest incurred from substantially higher borrowings outstanding to finance a portion of the Company's capital expenditure program and decreased capitalized interest primarily due to the completion of a major part of the Company's capital expenditure program, the H/R Units, in early 1992, partially offset by interest capitalized on the butane upgrade facility and the Thompsonville gas processing plant (see Notes 2 and 5 of Notes to Consolidated Financial Statements). Income tax expense was relatively unchanged primarily due to Texas franchise taxes, which are based on income, offsetting the effect of reduced income taxes attributable to lower pre-tax income. The reporting of a portion of Texas franchise taxes as part of income tax expense commenced in 1992 as a result of new state legislation enacted during 1991. Preferred stock dividend requirements decreased in 1992 due to the redemption of one-half of the outstanding $68.80 Cumulative Preferred Stock, Series B ("Series B Preferred Stock") in September of 1991 and the remainder in January of 1992. See Note 8 of Notes to Consolidated Financial Statements. LIQUIDITY AND CAPITAL RESOURCES During 1993, net cash provided by the Company's operating activities totalled $141.3 million compared to $152.5 million during 1992. Net cash provided by operating activities includes a $39 million favorable effect in 1993 and a $15.1 million unfavorable effect in 1992 from cyclical changes in current assets and liabilities. These changes for 1993 include a decrease in inventories compared to 1992, attributable to the inventory write-down discussed above. The Company utilized the cash provided by its operating activities, as well as bank borrowings and proceeds from the disposition of RGV (described above), to fund capital expenditures, deferred turnaround and catalyst costs and investments in joint ventures, to pay dividends and to repay principal on outstanding debt. As described in Note 4 of Notes to Consolidated Financial Statements, during February 1992, Energy filed with the Commission a shelf registration statement to offer up to $150 million principal amount of medium-term notes (the "Medium-Term Notes"), $116 million of which had been issued through January 1994 with a weighted average life of 8.5 years and a weighted average interest rate of 8.56%. During March 1992, the Company issued 2,610,000 shares of Energy common stock ("Common Stock") at a price to the public of $30 per share which generated net proceeds of approximately $75 million. Refining currently maintains a $160 million revolving credit and letter of credit facility that is available for working capital purposes and matures September 30, 1996. Energy has an unsecured $30 million revolving credit and letter of credit facility which matures February 29, 1996. As of December 31, 1993, Refining and Energy had approximately $52 million and $29 million, respectively, available under their committed bank credit facilities for additional borrowings and letters of credit. Energy also currently has $60 million of unsecured short-term credit lines which are unrestricted as to use, of which no amounts were outstanding at December 31, 1993. Total borrowings under Energy's bank credit facility and short-term lines are limited to $50 million. Certain of the Company's financing agreements contain various financial ratio requirements, including fixed charge coverage and debt-to-capitalization and require each of the Company and Refining to maintain a minimum consolidated net worth and positive working capital (see Note 4 of Notes to Consolidated Financial Statements). Certain of these financial ratio requirements were amended, effective as of the fourth quarter of 1993, to improve the financial flexibility of the Company. Under the most restrictive of the debt-to-capitalization tests, the Company's indebtedness for borrowed money may not exceed 40% of its capitalization. At December 31, 1993, this ratio, as calculated under the most restrictive of the Company's financing agreements, was 38% and would permit additional borrowings or guarantees of $47 million. Increases or decreases in the Company's stockholders' equity, such as those resulting from incremental earnings or losses, cash dividends, stock issuances, or stock redemptions or repurchases, will disproportionately increase or decrease the amount of additional permitted borrowings or guarantees. As described in Note 4 of Notes to Consolidated Financial Statements, at December 31, 1993, the Company had the ability to pay $47.6 million in Common Stock dividends and other restricted payments under its principal bank credit agreements, which were the most restrictive of its provisions concerning restricted payments. In September 1991 Energy redeemed one-half, and in November 1991 called for redemption the other one-half, of its Series B Preferred Stock for a total of $42.4 million. In June 1992, the Energy Board of Directors approved a stock repurchase program of up to one million shares of Common Stock. Through December 31, 1993, Energy had repurchased 455,000 shares at an average price of $23.75 per share. During 1993, the Company incurred $166 million for capital expenditures, deferred turnaround and catalyst costs, investments and related expenditures. Expenditures for 1993 included $149 million for Refinery expenditures, such as the butane upgrade facility, the MTBE/TAME complex, the reformate splitter and the scheduled maintenance and catalyst change for the Refinery's HDS Unit completed in December 1993. Such amounts include $37 million for capital expenditures incurred in 1993, but not payable until 1994. For 1994, the Company currently expects to incur approximately $80 million for capital expenditures, deferred turnaround and catalyst costs, investments and related expenditures. In addition, the Company expects to pay approximately $117.5 million for an effective equity interest of 51% in VNGP, L.P. as discussed above. The Partnership currently expects to incur approximately $40 million in capital expenditures in 1994, much of which would be incurred after the expected merger date. The Company believes it has sufficient funds from operations, the convertible preferred stock offering discussed above, and to the extent necessary, from the public markets and private capital markets, to fund its current and ongoing operating requirements. The Energy Board of Directors increased the quarterly dividend on its Common Stock from $.11 per share to $.13 per share at its September 1993 meeting, effective in the fourth quarter of 1993. Dividends are considered quarterly by the Energy Board of Directors, and may be paid only when approved by the Board. The Company knows of no reason why Common Stock dividends at the current levels could not be continued. The Company's refining operations have a concentration of customers in the spot and retail gasoline markets. These concentrations of customers may impact the Company's overall exposure to credit risk, either positively or negatively, in that the customers may be similarly affected by changes in economic or other conditions. However, the Company believes that its portfolio of accounts receivable is sufficiently diversified to the extent necessary to minimize any potential credit risk. Historically, the Company has not had any significant problems collecting its accounts receivable. The accounts receivable and inventories of Refining are pledged as collateral under Refining's bank credit agreement. The Company is subject to environmental regulation at both the federal and state level. The Company's expenditures for environmental control and protection for its refining operations are expected to be approximately $6 million in 1994 and totalled approximately $8 million in 1993. These amounts are exclusive of any amounts related to recently constructed facilities for which the portion of expenditures relating to environmental requirements is not determinable. The Refinery was completed in 1984 under more stringent environmental requirements than most existing United States refineries, which are older and were built before such environmental regulations were enacted. As a result, the Company is able to more easily comply with present and future environmental legislation. Under provisions of the Clean Air Act Amendments of 1990 (the "Clean Air Act"), all U.S. refineries must obtain new operating permits by 1995. However, the Clean Air Act is not expected to have any significant adverse impact on the Refinery's operations and the Company does not anticipate that it will be necessary to expend any material amounts in addition to those mentioned herein to comply with such legislation. The Clean Air Act also has requirements for oxygenated gasolines, which add oxygenates such as MTBE and ethanol to the gasoline pool. Such requirements are expected to increase the demand for MTBE. However, recent renewable oxygenate rules proposed under the Clear Air Act may adversely affect the anticipated growth in demand for MTBE. The Company is not aware of any material environmental remediation costs related to its operations. Accordingly, no amount has been accrued for any contingent environmental liability. ITEM 8.	ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors and Stockholders of Valero Energy Corporation: We have audited the accompanying consolidated balance sheets of Valero Energy Corporation (a Delaware corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, common stock and other stockholders' equity and cash flows for each of the three years in the period ended December 31, 1993. These financial statements and the schedules referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Valero Energy Corporation and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The supplemental schedules V, VI and IX are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state 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 & CO. San Antonio, Texas February 17, 1994 VALERO ENERGY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation and Basis of Presentation The accompanying consolidated financial statements include the accounts of Valero Energy Corporation ("Energy") and subsidiaries (collectively referred to herein as the "Company"). All significant intercompany transactions have been eliminated in consolidation. Energy conducts its refining operations through its wholly owned subsidiary, Valero Refining and Marketing Company ("VRMC"), and VRMC's principal operating subsidiary, Valero Refining Company ("VRC") (collectively referred to herein as "Refining"). Certain prior period amounts have been reclassified for comparative purposes. The Company accounts for its investment in Valero Natural Gas Partners, L.P. ("VNGP, L.P.") and VNGP, L.P.'s consolidated subsidiaries, including Valero Management Partnership, L.P. (the "Management Partnership") and various subsidiary operating partnerships ("Subsidiary Operating Partnerships" or "SOPs") (collectively referred to herein as the "Partnership") on the equity method of accounting. The Partnership acquired substantially all of the Company's natural gas and natural gas liquids operations in March 1987 in exchange for cash and an effective equity interest in the Partnership of approximately 49%. See Note 2 for a further discussion of the Partnership. Income taxes on the Company's equity in earnings of the Partnership are included in the provision for income taxes. Statements of Cash Flows In order to determine net cash provided by operating activities, net income has been adjusted by, among other things, changes in current assets and current liabilities, excluding changes in cash and temporary cash investments, current maturities of long-term debt and notes payable. Those changes are shown in the following table as an (increase) decrease in current assets and an increase (decrease) in current liabilities. The Company's temporary cash investments are highly liquid low- risk debt instruments which have a maturity of three months or less when acquired and whose carrying amounts approximate fair value. (Dollars in thousands.) The following provides information related to cash interest and income taxes paid by the Company for the periods indicated (in thousands): Noncash investing and financing activities for the years ended December 31, 1993, 1992 and 1991 include reductions of $1.3 million, $1.2 million and $1.1 million, respectively, of the recorded guarantee by Energy of a $15 million long-term borrowing by the Valero Employees' Stock Ownership Plan ("VESOP") to purchase Common Stock. Such reductions were a result of debt service by the VESOP. See Notes 4 and 12. Noncash investing and financing activities for 1993 also include the reclassification to property, plant and equipment of $5 million previously included in deferred charges and other assets on the Consolidated Balance Sheet. Noncash investing activities between Energy and the Partnership include the East Texas pipeline and fractionation facilities leases in 1991 and the Thompsonville Project lease in 1992 (see Note 2). Noncash financing activities for 1991 include a benefit of $.9 million credited to stockholders' equity for stock option exercises and represents the tax effect of the difference between market value at date of grant and market value at date of exercise for all options exercised during the period. Inventories Inventories are carried at the lower of cost or market with cost determined primarily under the last-in, first-out ("LIFO") method of inventory costing. Inventories as of December 31, 1993 and December 31, 1992 were as follows (in thousands): During the fourth quarter of 1993, Refining incurred a charge to earnings of $27.6 million to write down the carrying value of its inventories to reflect existing market prices. As a result of the inventory write-down, the replacement cost of Refining's inventories was approximately equal to its LIFO value at December 31, 1993. Property, Plant and Equipment Property additions and betterments include capitalized interest, and acquisition and administrative costs allocable to construction and property purchases. The costs of minor property units (or components thereof), net of salvage, retired or abandoned are charged or credited to accumulated depreciation. Gains or losses on sales or other dispositions of major units of property are credited or charged to income. Provision for depreciation of property, plant and equipment is made primarily on a straight-line basis over the estimated useful lives of the depreciable facilities. The rates for depreciation are as follows: Income Taxes Effective January 1, 1992, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes." SFAS No. 109 superseded SFAS No. 96 which the Company had adopted in 1987. These statements established financial accounting and reporting standards for deferred income tax liabilities that arise as a result of differences between the reported amounts of assets and liabilities for financial reporting and income tax purposes. Deferred Charges Catalyst and Refinery Turnaround Costs Catalyst cost is deferred when incurred and amortized over the estimated useful life of that catalyst, normally one to three years. Refinery turnaround costs are deferred when incurred and amortized over that period of time estimated to lapse until the next turnaround occurs. Other Deferred Charges Other deferred charges consist of technological royalties and licenses, debt issuance costs, and certain other costs. Technological royalties and licenses are amortized over the estimated useful life of each particular related asset. Debt issuance costs are amortized by the effective interest method over the estimated life of each instrument or facility. Transactions with Affiliates Transactions with affiliates primarily represent those conducted with the Partnership. See Note 2. Price Risk Management Activities The Company periodically enters into exchange-traded futures and options contracts and forward contracts to hedge against a portion of the price risk associated with price fluctuations from holding inventories of feedstocks and refined products. Changes in the market value of such contracts are accounted for as additions to or reductions in inventory. Gains and losses resulting from changes in the market value of such contracts are recognized when the related inventory is sold. The Company also enters into futures and options contracts that are not specific hedges and gains or losses resulting from changes in the market value of these contracts are recognized in income currently. As of December 31, 1993 and 1992, the Company had outstanding contracts for quantities totalling 2,700 thousand barrels ("Mbbls") and 2,260 Mbbls, respectively, for which the Company is the fixed price payor and 2,615 Mbbls and 1,613 Mbbls, respectively, for which the Company is the fixed price receiver. Such contracts run for a period of approximately two to five months. A portion of such contracts represented hedges of inventory volumes which totalled approximately 8,082 Mbbls and 8,693 Mbbls at December 31, 1993 and 1992, respectively. See "Inventories" above. The Company's activities in both hedging and nonhedging futures and options contracts were not material to the Company's results of operations for the years ended December 31, 1993, 1992 and 1991. Earnings Per Share Earnings per share of common stock were computed, after recognition of the preferred stock dividend requirements, based on the weighted average number of common shares outstanding during each year. Potentially dilutive common stock equivalents and other potentially dilutive securities were not material and therefore were not included in the computation. The weighted average number of common shares outstanding for the years ended December 31, 1993, 1992 and 1991 was 43,098,808, 42,577,368, and 40,570,798, respectively. Accounting Change Effective January 1, 1993, the Company adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." See Note 12. Accrued Expenses Accrued expenses for the periods indicated are as follows (in thousands): 2. VALERO NATURAL GAS PARTNERS, L.P. The Company holds an effective equity interest of approximately 49% in the Partnership at December 31, 1993, consisting of general partner interests and common units of limited partner interests (the "Common Units"). The remaining equity interest in the Partnership consisting of publicly traded common units of limited partner interests are referred to herein as "Public Units" and holders of such units are referred to as "Public Unitholders." Components of the line items Investment in and Leases Receivable from Valero Natural Gas Partners, L.P. in the accompanying Consolidated Balance Sheets and Equity in Earnings of and Income from Valero Natural Gas Partners, L.P. in the accompanying Consolidated Statements of Income, are as follows (in thousands): Summarized financial information for the Partnership for each of the three years in the period ended December 31, 1993 is as follows (in thousands, except per Unit amounts): The Partnership is required to make quarterly cash distributions with respect to all units in an amount equal to "Distributable Cash Flow" as defined in the Second Amended and Restated Agreement of Limited Partnership of VNGP, L.P. Beginning with the second quarter of 1992, the quarterly cash distributions were reduced from a rate of $.625 per unit to a rate of $.125 per unit. On January 25, 1994, the Board of Directors of VNGC declared a cash distribution of $.125 per unit for the fourth quarter of 1993 that is payable March 1, 1994. Net income is allocated to partners based on their effective ownership interest in the Partnership, except that additional depreciation expense pertaining to the excess of the Partnership's acquisition cost over the Company's historical cost basis in net property, plant and equipment and certain other assets in which the Public Unitholders currently have an ownership interest is allocated solely to the Public Unitholders as a noncash charge to net income. The allocation of additional depreciation expense to the Public Unitholders does not affect the cash distributions with respect to the Public Units or to the Company as holder of the Common Units. The Company enters into transactions with the Partnership commensurate with its status as the General Partner. The Company charges the Partnership a management fee equal to the direct and indirect costs incurred by it on behalf of the Partnership that are associated with managing the Partnership's operations. In addition, Refining purchases natural gas and NGLs from the Partnership and sells NGLs to the Partnership. The Company pays the Partnership a fee for operating the Company's NGL Assets. In connection with the NGL Assets, the Company also pays the Partnership a fee to process natural gas, buys natural gas from and sells natural gas and NGLs to the Partnership. The Company's retail natural gas distribution system operated by Rio Grande Valley Gas Company, a wholly owned subsidiary of Energy until its sale on September 30, 1993, purchases natural gas from the Partnership. Also, the Company and the Partnership enter into other operating transactions, including certain leasing transactions which are described below. As of December 31, 1993 and 1992, the Company had recorded approximately $31.8 million and $13.5 million, respectively, of accounts receivables, net of accounts payables, due from the Partnership. The following table summarizes transactions between the Company and the Partnership for each of the three years in the period ended December 31, 1993 (in thousands): During 1992, the Partnership entered into a capital lease with Energy to lease a 200-million cubic foot per day turboexpander gas processing plant near Thompsonville in South Texas and 48 miles of NGL product pipeline (the "Thompsonville Project") which were constructed by Energy. The Thompsonville Project lease commenced December 1, 1992 and has a term of 15 years. During 1991, the Company leased its interests in a newly constructed 105-mile pipeline in East Texas (the "East Texas Pipeline") and certain fractionation facilities in Corpus Christi, Texas, to the Partnership under capital leases. The fractionation facility lease, which commenced December 1, 1991, has a term of 15 years. The East Texas Pipeline lease, which commenced February 1, 1991, has a term of 25 years. Future minimum lease payments to be received from the Partnership for the years 1994 through 1998 are $12.9 million, $12.9 million, $13.9 million, $15.1 million and $15.4 million, respectively. Components of the Company's net investment in these capital leases at December 31, 1993, which is included in Investment in and Leases Receivable from Valero Natural Gas Partners, L.P. in the accompanying Consolidated Balance Sheet, are as follows (in thousands): Effective December 20, 1993, Energy, Valero Natural Gas Company ("VNGC", a wholly owned subsidiary of Energy and general partner of VNGP, L.P.,) and VNGP, L.P. entered into an agreement of merger. In the merger, the 9.7 million issued and outstanding Public Units will be converted into a right to receive cash consideration of $12.10 per Common Unit, and VNGP, L.P. will become a wholly owned subsidiary of Energy. A special committee of outside directors (the "Special Committee") of VNGC, appointed to consider the fairness of the transaction to the Public Unitholders, has received an opinion from its independent financial advisor that the consideration to be received by the Public Unitholders in the transaction is fair from a financial point of view. The Special Committee has determined that such transaction is fair to, and in the best interest of, the Public Unitholders. The Board of Directors of VNGC has unanimously recommended that the Public Unitholders vote in favor of the merger. The transaction is subject, among other things, to: (i) approval by the holders of a majority of the issued and outstanding Common Units, (ii) approval by the holders of a majority of the Common Units held by the Public Unitholders and voted at a special meeting to be called for the purpose of considering such merger; (iii) receipt of satisfactory waivers, consents or amendments to certain of the Company's financial agreements; and (iv) completion of the offering of convertible preferred stock (see Note 7 of Notes to Consolidated Financial Statements). These financial agreements, which include a new bank credit agreement as well as amendments to other financial agreements, are in the process of being negotiated to provide for the proposed merger. While Energy believes that it will obtain satisfactory new agreements and amendments, there can be no assurance in this regard. The Company currently owns approximately 47.5% of the Common Units and intends to vote such Common Units in favor of the transaction. A proposal to approve the merger agreement will be submitted to the holders of Common Units at a special meeting of unitholders tentatively scheduled to be held during the second quarter of 1994. There can be no assurance, however, that the merger can be completed. The accompanying unaudited pro forma condensed consolidated financial statements of Valero Energy Corporation and subsidiaries give effect to the sale of $150 million of convertible preferred stock and the utilization of approximately $117.5 million of the net proceeds therefrom to fund the acquisition by the Company of the Public Units. The remaining net proceeds, estimated to be approximately $28.4 million, are used to pay expenses of the proposed acquisition and reduce outstanding indebtedness under bank credit lines. The acquisition is accounted for as a purchase. The pro forma condensed consolidated financial statements are based on the historical consolidated financial statements of Valero Energy Corporation and Valero Natural Gas Partners, L.P. after certain adjustments as described below. The pro forma condensed consolidated balance sheet assumes that the above described transactions occurred on December 31, 1993. The pro forma consolidated statement of income assumes that the above described transactions occurred on January 1, 1993. Following these pro forma financial statements are accompanying explanatory notes. Such pro forma condensed consolidated financial statements are not necessarily indicative of the results of future operations. [FN] (a) Reflects the elimination of transactions between the Company and VNGP, L.P., including product sales and purchases, management fees billed by the Company to the Partnership for direct and indirect costs, and accrued interest receivable and payable on leases. (b) Adjustment to fair value of the portion of VNGP, L.P.'s assets acquired and liabilities assumed not currently held by the Company and the related income statement effects. Also included is the elimination of the noncurrent receivable and payable between the Company and VNGP, L.P. for postretirement benefits other than pensions. (c) Reflects the elimination of the Company's investment in and leases receivable from VNGP, L.P. and related equity in earnings and interest income. The corresponding VNGP, L.P. partners' capital and current and long-term portions of VNGP, L.P.'s capital lease obligations to the Company and related interest expense are also eliminated. (d) Represents the repayment of $21.7 million of indebtedness under bank credit lines with the excess of the net proceeds of the offering over the acquisition cost of the limited partner interests in VNGP, L.P. not currently held by the Company and the expenses of the acquisition, which causes a decrease in interest expense. (e) Represents the net proceeds from the sale of $150 million of assumed 6.5% convertible preferred stock and the related increase in preferred stock dividends. The preferred stock is assumed to be convertible into Common Stock at a premium of 25% above a Common Stock market price of $22 per share at the date of issuance of the preferred stock. Conversion of the convertible preferred stock into Common Stock is antidilutive to earnings per share of common stock for the year ended December 31, 1993. (f) Reflects the tax effects of the consolidation of VNGP, L.P. into the Company, primarily the taxability of VNGP, L.P.'s net income after its merger into the Company. 3. SHORT-TERM BANK LINES At December 31, 1993, Energy maintained five separate short-term bank lines of credit totalling $60 million, of which no amounts were outstanding. One of these lines is payable on demand, and the others mature at various times in 1994. These short-term lines bear interest at each respective bank's quoted money market rate, have no commitment or other fees or compensating balance requirements and are unsecured and unrestricted as to use. Total borrowings under these short-term lines and Energy's bank credit facility described in Note 4 are limited to $50 million. 4. LONG-TERM DEBT AND BANK CREDIT FACILITIES Long-term debt balances were as follows (in thousands): The Company's bank credit agreements include a $160 million revolving credit and letter of credit facility for Refining and a separate unsecured $30 million revolving credit and letter of credit facility for Energy. Borrowings under Refining's agreement bear interest, at Refining's option, at either (i) the agent bank's prime rate, (ii) certain reference banks' adjusted Eurodollar rate plus 3/4 of 1% or (iii) certain reference banks' average CD rate plus 7/8 of 1%. Borrowings under Energy's agreement bear interest, at its option, at either (i) the agent bank's prime rate plus 1/4 of 1%, (ii) certain reference banks' adjusted Eurodollar rate plus 1 3/8% or (iii) certain reference banks' average CD rate plus 1 1/2%. The Company is charged various fees in connection with the bank credit agreements, including commitment fees based on the unused portion of the commitments and various letter of credit and facility fees. As of December 31, 1993, Energy and Refining had approximately $29 million and $52 million, respectively, available under their bank credit facilities for additional borrowings and letters of credit. Energy filed with the Commission a shelf registration statement that became effective on February 28, 1992, and is being used to offer up to $150 million principal amount of Medium-Term Notes. Through January 1994, the Company has issued, in ten separate series, $116 million principal amount of Medium- Term Notes with a weighted average life of approximately 8.5 years and a weighted average interest rate of approximately 8.56%. Certain of the Company's financing agreements contain various financial ratio requirements including fixed charge coverage and debt-to-capitalization and require each of the Company and Refining to maintain a minimum consolidated net worth and positive working capital. Certain of these financial ratio requirements were amended, effective as of the fourth quarter of 1993, to improve the financial flexibility of the Company. Under the fixed charge coverage ratio tests in the Company's principal bank credit agreements, the ratio of the Company's earnings to its fixed charges must be at least 2:1 during the most recent four consecutive quarters; however, any fiscal quarter in which one of the Refinery's major units is shut down for scheduled or periodic maintenance for more than 14 days (a "turnaround quarter") is excluded from such fixed charge coverage ratio tests, provided that only one such quarter in each five quarter period may be excluded. In addition, the Company's unsecured $30 million revolving credit and letter of credit facility requires that the Company's ratio of earnings to fixed charges be at least 1.5:1 for each quarter (excluding a turnaround quarter). Under the most restrictive of the debt-to-capitalization tests, the Company's indebtedness for borrowed money may not exceed 40% of its capitalization. At December 31, 1993, this ratio, as calculated under the most restrictive of the Company's financing agreements, was 38%, and would permit additional borrowings or guarantees of $47 million. Increases or decreases in the Company's stockholders' equity, such as those resulting from incremental earnings or losses, cash dividends, stock issuances, or stock redemptions or repurchases, will disproportionately increase or decrease the amount of additional permitted borrowings or guarantees. The Company's principal bank credit agreements and certain other financing agreements contain covenants limiting Energy's ability to make certain "restricted payments," including dividend payments on and redemptions or repurchases of its capital stock and certain investments. Under its principal bank credit agreements, which currently contain the most restrictive of these covenants, Energy had the ability to pay $47.6 million in Common Stock dividends and other restricted payments at December 31, 1993. Under the Company's bank credit agreements, the amount available for such payments is increased by an amount equal to the Company's earnings, the net cash proceeds from any issuance of capital stock and funded indebtedness, and by an amount equal to the Company's depreciation and amortization expense (including amortization of deferred turnaround and catalyst costs), and is decreased by the amount of capital expenditures, turnaround and catalyst costs, previous dividends, investments (including advances to or assets leased to the Partnership), and repayments of funded indebtedness (other than under the Company's bank credit agreements). Certain of the Company's financing agreements also contain various other covenants, including capital expenditure limitations, limitations on creating liens or guaranteeing the obligations of others, limitations on additional debt and on certain transfers of assets, limitations on entering into new leases, restrictions on mergers or the acquisition of new subsidiaries or the capital stock or assets of other companies, customary default provisions and certain limitations on the businesses of the Company. Under the bank credit agreements, Energy and VRMC have guaranteed the obligations of Refining. The obligations of Refining are secured by a pledge of all inventories and receivables of Refining. The Company and Refining were in compliance with all required covenants as of December 31, 1993. Based on long-term debt outstanding at December 31, 1993, maturities of long-term debt, including sinking fund requirements and excluding borrowings under bank credit facilities, for the years ending December 31, 1995 through 1998 are approximately $31.9 million, $36.8 million, $37 million and $37.2 million, respectively. Maturities of long-term debt under bank credit facilities for the year ended December 31, 1996 are $75 million, however it is expected that at such time these bank credit facilities will be replaced with new bank credit facilities on similar terms and conditions. Based on the borrowing rates currently available to the Company for long-term debt with similar terms and average maturities, the fair value of the Company's long-term debt, including current maturities, was $584 million at December 31, 1993. The fair value of the Company's long-term debt was essentially equal to its carrying value at December 31, 1992. 5. INVESTMENTS AND CAPITAL EXPENDITURES Refinery Projects During the second quarter of 1993, the Refinery began operation of a butane upgrade facility which converts butane into MTBE, a high-octane blendstock used to manufacture oxygenated and reformulated gasolines. Also, during the fourth quarter of 1993, the Refinery placed in service a MTBE/TAME complex and a reformate splitter. The MTBE/TAME complex converts streams currently produced at the Refinery's heavy oil cracker into MTBE and TAME. TAME, like MTBE, is a high-octane, oxygen-rich gasoline blendstock. The reformate splitter extracts a benzene concentrate stream from the reformate produced at the Refinery's naphtha reformer unit. These projects, which represent investments totalling approximately $300 million, have increased the Refinery's production capacity to approximately 140,000 barrels per day of refined products. Proesa The Company holds a 35% interest in a Mexican corporation, Productos Ecologicos, S.A. de C.V. ("Proesa"). Proesa has executed a Memorandum of Understanding with Petroleos Mexicanos ("PEMEX") to construct a MTBE plant in Mexico, and has proposed a butane supply contract and MTBE sales contract with PEMEX. Proesa has also executed an option agreement for a plant site near the Bay of Campeche. The proposed Mexican MTBE plant is expected to have a capacity of approximately 15,000 barrels per day and to be similar to the Refinery's butane upgrade facility. The project is expected to cost approximately $440 million and is subject to, among other things, the arrangement of satisfactory financing. Proesa has been advised by lenders with whom it is negotiating for project financing that certain provisions will be required in the proposed PEMEX contracts in order to secure satisfactory financing for the project. Proesa has entered into negotiations with PEMEX regarding such provisions. However, as a result of delays incurred in completing financing, Proesa has determined that the commencement of plant construction will be delayed. If satisfactory financing is obtained, construction of the MTBE plant could not begin before late 1994, with approximately two years required for completion. As of February 1994, no material amounts have been invested in the project. The amount of the Company's equity contribution will depend upon the level of debt financing obtained by Proesa and the ultimate equity interest of each partner. Under the proposed commercial contracts, PEMEX will purchase approximately 75% of the MTBE plant's production, one- half at a formula price and one-half at market-related prices, with the remainder of the plant's production being sold to the Company at a formula price. In addition, the butane feedstocks required by the plant will be purchased from PEMEX at market- related prices. A subsidiary of Energy has agreed to provide technical advice and assistance to Proesa in connection with the design, engineering, construction and operation of the MTBE plant. There can be no assurance that financing for the project can be obtained or that the plant will be constructed. Javelina Partnership Valero Javelina Company, a wholly owned subsidiary of Energy, owns a 20% interest in Javelina Company ("Javelina"), a general partnership. Javelina maintains a term loan agreement and a working capital and letter of credit facility which mature on January 31, 1996. Because the Company accounts for its interest in Javelina on the equity method of accounting, its share of the borrowings outstanding under such bank credit agreements is not recorded on its Consolidated Balance Sheets. The Company's guarantees of these bank credit agreements were approximately $19.6 million at December 31, 1993. At December 31, 1993, the Company's investment in Javelina included its equity contributions and advances to Javelina of approximately $19.3 million to cover its proportionate share of expenditures in excess of the proceeds available under Javelina's bank credit agreements, and capitalized interest and overhead. 6. REDEEMABLE PREFERRED STOCK Energy is required to redeem and, commencing in 1986, has redeemed in December of each year its Cumulative Preferred Stock, $8.50 Series A ("Series A Preferred Stock"), at $100 per share at the rate of 11,500 shares annually ($1,150,000 per year). The redemption requirement for the Series A Preferred Stock for each of the five years following December 31, 1993 is also $1,150,000 per year. Energy also has the option to redeem shares of the Series A Preferred Stock at any time at $105.50 per share until November 30, 1994, with such amount being reduced by $.50 per share each year thereafter to $100 per share. In the event of an involuntary liquidation, the holders of the outstanding Series A Preferred Stock would be entitled, after the payment of all debts, to $100 per share, plus any accrued and unpaid dividends. In the event of a voluntary liquidation, the holders of the outstanding Series A Preferred Stock would be entitled to $100 per share, any applicable premium Energy would have had to pay if it had elected to redeem the Series A Preferred Stock at that time and any accrued and unpaid dividends. In the event dividends on the Series A Preferred Stock are six or more quarters in arrears, holders may vote to elect two directors. No arrearages currently exist. 7. CONVERTIBLE PREFERRED STOCK On October 18, 1993, Energy filed a registration statement with the Commission covering the offering of 2,500,000 shares of convertible preference stock. Energy intends to file an amended registration statement covering the offering of 3,000,000 shares (up to 3,450,000 shares with underwriters' over- allotments) of convertible preferred stock in March 1994. The proceeds from the offering would be utilized to fund the proposed acquisition of the Partnership (see Note 2). 8. REDEMPTION OF SERIES B PREFERRED STOCK On September 1, 1991, Energy redeemed one-half of its 1.6 million Depositary Preferred Shares ("Depositary Shares"), each of which represented one-twentieth share of Energy's $68.80 Cumulative Preferred Stock, Series B, at a price of $26.475 per Depositary Share representing a total expenditure of approximately $21.2 million. On November 21, 1991, Energy called the remaining half of the Depositary Shares for redemption on January 15, 1992, also at a price of $26.475 per Depositary Share. 9. PREFERENCE SHARE PURCHASE RIGHTS On November 15, 1985, Energy's Board of Directors declared a dividend distribution of one Preference Share Purchase Right ("Right") for each outstanding share of Energy's Common Stock. Until exercisable, the Rights are not transferable apart from Energy's Common Stock. Each Right will entitle shareholders to buy one-hundredth (1/100) of a share of a newly issued series of Junior Participating Serial Preference Stock, Series II, at an exercise price of $35 per Right. 10. INDUSTRY SEGMENT INFORMATION The Company is primarily engaged in the refining and marketing of petroleum products. The Company's primary refining activities involve the operation of its Refinery. Refining sells refined products principally on a spot and truck rack basis. Spot sales of Refining's products are made principally to larger oil companies and gasoline distributors. The principal purchasers of Refining's products from truck racks have been wholesalers and jobbers in the southeastern and midwestern United States. The Company has no foreign operations other than storage facilities and no single customer accounts for more than 10% of its operating revenues. 11. INCOME TAXES Components of income tax expense attributable to continuing operations are as follows (in thousands): The Company has credited the tax benefit associated with expenses for certain employee benefits recognized differently for financial reporting and income tax purposes directly to stockholders' equity. Such amounts (in thousands) were $903, $1,758 and $915 for 1993, 1992 and 1991, respectively. Total income tax expense differs from the amount computed by applying the statutory federal income tax rate to income before income taxes. The reasons for these differences are as follows (in thousands): The tax effects of significant temporary differences representing deferred income tax assets and liabilities are as follows (in thousands): At December 31, 1993, the Company had federal net operating loss carryforwards of approximately $7 million, which are available to reduce future federal taxable income and will expire in 1997 if not utilized. In addition, the Company had investment tax credit ("ITC"), Employee Stock Ownership Plan ("ESOP") tax credit and alternative minimum tax credit ("AMT") carryforwards of approximately $71 million which are available to reduce future federal income tax liabilities. The ITC and ESOP tax credits of approximately $55 million expire between 1995 and 2001 if not utilized and the AMT credit of approximately $16 million has no expiration date. The Company did not record any valuation allowances against deferred income tax assets at December 31, 1993. The Company's federal income tax returns have been examined by the IRS for all taxable years through 1989. All issues were resolved with the exception of one in which the Company has petitioned the Tax Court. A decision from the Tax Court is expected during 1994 . The Company believes that adequate provisions for income taxes have been reflected in its consolidated financial statements. 12. EMPLOYEE BENEFIT PLANS Pension and Other Employee Benefit Plans The following table sets forth for the pension plans of the Company, the funded status and amounts recognized in the Company's consolidated financial statements at December 31, 1993 and 1992 (in thousands): Net periodic pension cost for the years ended December 31, 1993, 1992 and 1991 included the following components (in thousands): A participant in the Company's pension plan vests in plan benefits after 5 years of vesting service or upon reaching normal retirement date. The pension plan provides a monthly pension payable upon normal retirement of an amount equal to a set formula which is based on the participant's 60 consecutive highest months of compensation during credited service under the plan. The weighted-average discount rate used in determining the actuarial present value of the projected benefit obligation was 7.2% and 8.3%, respectively, as of December 31, 1993 and 1992. The rate of increase in future compensation levels used in determining the projected benefit obligation as of December 31, 1993 was 4% for nonexempt personnel and 2% for exempt personnel, while the 1992 projected benefit obligation was based on an assumed overall 6.3% rate of compensation increase. The expected long-term rate of return on plan assets was 9% and 10% as of December 31, 1993 and 1992, respectively. Contributions, when permitted, are actuarially determined in an amount sufficient to fund the currently accruing benefits and amortize any prior service cost over the expected life of the then current work force. The Company also maintains a nonqualified Supplemental Executive Retirement Plan ("SERP") which provides additional pension benefits to the executive officers and certain other employees of the Company. The Company's contributions to the pension plan and SERP in 1993, 1992 and 1991 were approximately $7.5 million, $7.5 million and $8 million, respectively, and are currently estimated to be $5.9 million in 1994. The tables at the beginning of this note include amounts related to the SERP. The Company is the sponsor of the Valero Energy Corporation Thrift Plan ("Thrift Plan") which is an employee profit sharing plan. Participation in the Thrift Plan is voluntary and is open to employees of the Company who become eligible to participate following the completion of three months of continuous employment. Participating employees may make a base contribution from 2% up to 8% of their annual base salary, depending upon months of contributions by a participant. Prior to the establishment of the VESOP, 100% of these contributions were matched by the Company. Subsequent to the establishment of the VESOP, the Company has made contributions to the Thrift Plan only to the extent employees' base contributions have exceeded the amount of the Company's contribution to the VESOP for debt service. In 1994, the Thrift Plan was amended to provide for a total Company match in both the Thrift Plan and the VESOP aggregating either 75% or 100% of employee base contributions, subject to certain conditions. Participants may also make a supplemental contribution to the Thrift Plan of up to an additional 10% of their annual base salary which is not matched by the Company. Company contributions to the Thrift Plan during 1993, 1992 and 1991 were approximately $660,000, $348,000 and $1,027,000, respectively. In February 1989, the Company established the VESOP which is a leveraged employee stock ownership plan. Pursuant to a private placement in March 1989, the VESOP issued notes in the principal amount of $15 million, maturing February 15, 1999 (the "VESOP Notes"). The net proceeds from this private placement were used by the VESOP trustee to fund the purchase of Common Stock. The Company makes semi-annual contributions of approximately $1.16 million to the VESOP until maturity to fund the debt service on the VESOP Notes, and, as explained above, the Company's annual contribution to the Thrift Plan during such period is reduced accordingly. During the third quarter of 1991, the Company made an additional loan of $8 million to the VESOP which was also used by the Trustee to purchase Common Stock. This new VESOP loan matures on August 15, 2001. During 1993, the Company contributed $3,596,000 to the VESOP, incurred $947,000 of interest on the VESOP Notes and recognized $2,173,000 of compensation expense. During 1992, the Company contributed $3,596,000 to the VESOP, incurred $1,065,000 of interest on the VESOP Notes and recognized $2,055,000 of compensation expense. Such amounts for 1991 were $2,320,000, $1,172,000 and $1,448,000, respectively. Dividends paid on Common Stock during 1993, 1992 and 1991 have not been used to reduce the VESOP obligation. In addition to the above plans, the Company also sponsors other employee benefit plans, including the Valero Energy Corporation Employee's Stock Ownership Plan. During the third quarter of 1991, the Company contributed $2.3 million to the ESOP for investment tax credits claimed on Refining's separate 1982 federal income tax return which had not been utilized. The Company also sponsors the Executive Deferred Compensation Plan, the Key Employee Deferred Compensation Plan and the Excess Thrift Plan. At December 31, 1993 and 1992, the amount recorded as deferred compensation on the consolidated balance sheets under these plans was $4.9 million and $4.8 million, respectively. The Company also provides certain health care and life insurance benefits for retired employees, referred to herein as "postretirement benefits other than pensions." Substantially all of the Company's employees may become eligible for those benefits if, while still working for the Company, they either reach normal retirement age or take early retirement. Health care benefits are provided by the Company through a self-insured plan while life insurance benefits are provided through an insurance company. Effective January 1, 1993, the Company adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", which requires a change in the Company's accounting for postretirement benefits other than pensions from a pay-as-you-go basis to an accrual basis of accounting. The Company is amortizing the transition obligation over 20 years, which is greater than the average remaining service period until eligibility of active plan participants. The Company continues to fund its postretirement benefits other than pensions on a pay- as-you-go basis. The adoption of this standard resulted in a decrease to net income in 1993 of $1.7 million, or $.04 per share, after allocation to the Partnership of its pro rata portion of such costs. The following table sets forth for the Company's postretirement benefits other than pensions, the funded status and amounts recognized in the Company's consolidated financial statements at December 31, 1993 (in thousands): Net periodic postretirement benefit cost for the year ended December 31, 1993 included the following components (in thousands): For measurement purposes, the health care cost trend rate was 10% in 1993, decreasing gradually to 5.5% in 1998 and remaining level thereafter. The health care cost trend rate assumption has a significant effect on the amount of the obligation and periodic cost reported. An increase in the assumed health care cost trend rate by 1% in each year would increase the accumulated postretirement benefit obligation as of December 31, 1993 by $4.7 million and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for the year then ended by $.6 million. The weighted-average discount rate used in determining the accumulated postretirement benefit obligation as of December 31, 1993 was 7.2%. Prior to 1993, the cost of providing health care and life insurance benefits to retired employees was recognized as expense as health care claims and life insurance premiums were paid. These costs totaled approximately $675,000 and $700,000 for 1992 and 1991, respectively. Stock Option and Bonus Plans Energy has three non-qualified stock option plans, Stock Option Plan No. 5, Stock Option Plan No. 4, and Stock Option Plan No. 3, collectively referred to herein as the "Stock Option Plans." The Stock Option Plans provide for the granting of options to purchase shares of Energy's Common Stock. Such options are granted to key officers, employees and prospective employees of the Company. Under the terms of the Stock Option Plans, the exercise price of the options granted will generally not be less than 75% of the fair market value of Common Stock at the date of grant. All stock options granted since 1990 contain exercise prices equal to the market value at the date of grant. Stock options become exercisable pursuant to the individual written agreements between Energy and the participants in the Stock Option Plans, which provide for options becoming exercisable in three equal annual installments beginning one year after the date of grant, with unexercised options expiring ten years from the date of grant. The aggregate difference between the market value of Common Stock at date of grant and the option price is recorded as compensation expense during the exercise period. At December 31, 1993, 1,261,624 options were outstanding, at a weighted-average exercise price of $23.69 per share, of which 357,258 options were exercisable at a weighted- average exercise price of $20.88 per share. During 1993, 597,050 options were granted at a weighted-average exercise price of $23.19, 140,588 options were exercised at a weighted-average exercise price of $10.46 and 53,433 options were terminated and/or forfeited. At December 31, 1993, there were 194,375 shares available for grant under these Stock Option Plans, including shares transferred from previously terminated stock option plans of the Company. For each share of stock that can be purchased thereunder pursuant to a stock option, Stock Option Plans No. 3 and 4 provide that a stock appreciation right ("SAR") may also be granted. A SAR is a right to receive a cash payment equal to the difference between the fair market value of Energy's Common Stock on the exercise date and the option price of the stock to which the SAR is related. SARs are exercisable only upon the exercise of the related stock options. At the end of each reporting period within the exercise period, Energy records an adjustment to deferred compensation expense based on the difference between the fair market value of Energy's Common Stock at the end of each reporting period and the option price of the stock to which the SAR is related. At December 31, 1993, 139,315 SARs were outstanding, at a weighted-average exercise price of $14.52 per share, of which 138,940 SARs were exercisable at a weighted- average exercise price of $14.52 per share. During 1993, 113,999 SARs were exercised at a weighted-average exercise price of $10.32 per share, and 1,466 SARs were terminated and/or forfeited. Compensation expense recognized during 1993 in connection with the grant of options and SARs under the Company's Stock Option Plans was $110,000. The Company maintains a Restricted Stock Bonus and Incentive Stock Plan ("Bonus Plan") for certain key executives of the Company. Under the Bonus Plan, 750,000 shares of Common Stock were reserved for issuance. At December 31, 1993, there were 18,927 shares available for award and 77,750 shares awarded under this plan during 1993. The amount of Bonus Stock and terms governing the removal of applicable restrictions, and the amount of Incentive Stock and terms establishing predefined performance objectives and periods, are established pursuant to individual written agreements between Energy and each participant in the Bonus Plan. Compensation expense recognized in connection with the Bonus Plan for 1993 was $570,000. The Company also maintains an executive incentive bonus plan (the "Incentive Plan") for the purpose of providing bonus compensation to key executive and managerial employees. During 1993, bonuses were paid in cash and Common Stock. Compensation expense recognized during 1993 in connection with the Incentive Plan was approximately $2.4 million. 13. DEFERRED CREDITS AND OTHER LIABILITIES Deferred credits and other liabilities are as follows (in thousands): Deferred management fees were recorded upon the formation of the Partnership in March 1987 and are being amortized over the ten-year period during which VNGC agreed not to withdraw as General Partner of the Partnership. 14. LEASE AND OTHER COMMITMENTS The Company has two major operating lease commitments in connection with a gas storage facility leased to the Partnership and its corporate headquarters office complex. The remaining primary lease term for the gas storage facility is six years, while the corporate headquarters lease has a primary term remaining of three years with eight optional renewal periods of five years each. The Company has the right to purchase the office complex at any time after the end of the third renewal period at the then determined fair market value. The Company also has other noncancelable operating leases with remaining terms ranging from one year to 7 years. The related future minimum lease payments as of December 31, 1993 are as follows (in thousands): The future minimum lease payments listed above under the caption "Other" exclude certain operating lease commitments which are cancelable by the Company upon notice of one year or less. Consolidated rent expense amounted to $12,948,000, $12,643,000, and $11,740,000 for 1993, 1992 and 1991, respectively, and includes various month-to-month and other short-term rentals in addition to rents paid and accrued under long-term lease commitments. A portion of these amounts was charged to and reimbursed by the Partnership for its proportionate use of the Company's corporate headquarters office complex and for the use of certain other properties managed by the Company. The obligations of Valero Gas Storage Company ("Gas Storage"), a wholly owned subsidiary of VNGC, under the gas storage facility lease include its obligation to make scheduled lease payments and, in the event of a declaration of default and acceleration of the lease obligation, to make certain lump sum payments based on a stipulated loss value for the gas storage facility less the fair market sales price or fair market rental value of the gas storage facility. Under certain circumstances, a default by Energy or a subsidiary of Energy under its bank credit facilities could result in a cross default under the gas storage facility lease. The Company believes that it is unlikely that a default by Energy or a subsidiary of Energy would result in actual acceleration of the gas storage facility lease, and further believes that such event, if it occurred, would not have a material adverse effect on the Company or the Partnership. The obligation of the Company to make certain payments to Gas Storage equal to the amount of Gas Storage's required payments under the gas storage facility lease has been assumed by the Partnership. 15. LITIGATION AND CONTINGENCIES Partnership Related Claims In 1987, VT, L.P. and a producer from whom VT, L.P. has purchased natural gas entered into an agreement resolving certain take-or-pay issues between the parties in which VT, L.P. agreed to pay one-half of certain excess royalty claims arising after the date of the agreement. The royalty owners of the producer recently completed an audit of the producer and have presented to the producer a claim for additional royalty payments in the amount of approximately $17.3 million, and accrued interest thereon of approximately $19.8 million. Approximately $8 million of the royalty owners' claim accrued after the effective date of the agreement between the producer and VT, L.P.. The producer and VT, L.P. are reviewing the royalty owners' claims. No lawsuit has been filed by the royalty owners. The Company believes that various defenses under the agreement may reduce any liability of VT, L.P. to the producer in this matter. Seven lawsuits were filed in Chancery Court in Delaware against VNGP, L.P., VNGC and Energy and certain officers and directors of VNGC and/or Energy in response to the announcement by Energy on October 14, 1993 of its proposal to acquire the publicly traded Common Units of VNGP, L.P. pursuant to a proposed merger of VNGP, L.P. with a wholly owned subsidiary of Energy. See Note 2. The suits were consolidated into a single proceeding by the Chancery Court on November 23, 1993. The plaintiffs sought to enjoin or rescind the proposed merger, alleging that the corporate defendants and the individual defendants, as officers or directors of the corporate defendants, engaged in actions in breach of the defendants' fiduciary duties to the Public Unitholders by proposing the merger. The plaintiffs alternatively sought an increase in the proposed merger consideration, unspecified compensatory damages and attorneys' fees. In December 1993, the parties reached a tentative settlement of the consolidated lawsuit. The terms of the settlement will not require a material payment by the Company or the Partnership. However, there can be no assurance that the settlement will be completed, or that it will be approved by the Chancery Court. In a letter dated September 1, 1993 from the City of Houston (the "City") to Valero Transmission Company ("VTC"), an indirect wholly owned subsidiary of Energy, the City stated its intent to bring suit against VTC for certain claims asserted by the City under the franchise agreement between the City and VTC. VTC is the general partner of VT, L.P., an indirect subsidiary partnership of VNGP, L.P. The franchise agreement was assigned to and assumed by VT, L.P. upon formation of the Partnership in 1987. In the letter, the City also declared a conditional forfeiture of the franchise rights based on the City's claims. In a letter dated October 27, 1993, the City claimed that VTC owes to the City franchise fees and accrued interest thereon aggregating approximately $13.5 million. In a letter dated November 9, 1993, the City claimed an additional $18 million in damages relating to the City's allegations that VTC engaged in unauthorized activities under the franchise agreement by transmitting gas for resale and by transporting gas for third parties on the franchised premises. The City has not filed a lawsuit. While any liability of VTC with respect to the City's claims has been assumed by the Partnership, if the proposed merger with VNGP, L.P. is consummated, the Company's financial position would necessarily reflect the full amount of any Partnership liability. Additionally, in the event that the Partnership failed to pay any such liability, the Company could remain ultimately responsible. The Company believes that the City's claims are significantly overstated, and that VTC has a number of meritorious defenses to the claims. VTC and one of its gas suppliers are parties to various gas purchase contracts assigned to and assumed by VT, L.P. upon formation of the Partnership in 1987. The supplier is also a party to a series of gas purchase contracts between the supplier, as buyer, and certain trusts, as seller, which are in litigation. Neither the Partnership nor VTC is a party to this litigation or the contracts between the supplier and the trusts. However, because of the relationship between VTC's contracts with the supplier and the supplier's contracts with the trusts, and in order to resolve existing and potential disputes, the supplier, VTC and VT, L.P. have agreed that they will cooperate in the conduct of this litigation, and that VTC and VT, L.P. will bear a substantial portion of the costs of any appeal and any nonappealable final judgment rendered against the supplier. In the litigation, the trusts allege that the supplier has breached various minimum take, take-or-pay and other contractual provisions and assert a statutory nonratability claim. The trusts seek alleged actual damages, including interest, of approximately $30 million and an unspecified amount of punitive damages. The District Court ruled on the plaintiff's motion for summary judgment, finding, among other things, that as a matter of law the three gas purchase contracts at issue were fully binding and enforceable, the supplier breached the minimum take obligations under one of the contracts, the supplier is not entitled to claimed offsets for gas purchased by third parties and the "availability" of gas for take-or-pay purposes is established solely by the delivery capacity testing procedures in the contracts. Damages, if any, have not been determined. Because of existing contractual obligations of the Partnership to its supplier, the lawsuit may ultimately involve a contingent liability for the Partnership. The Company believes that the claims brought against the supplier have been significantly overstated, and that the supplier has a number of meritorious defenses to the claims, including various regulatory, statutory, contractual and common law defenses. The Court recently granted the supplier's Motion for Continuance of the former January 10, 1994 trial date. This litigation is not currently set for trial. In March 1993, two indirect wholly owned subsidiaries of Energy serving as general partners of two of the Partnership's principal subsidiary operating partnerships were served as third- party defendants in a lawsuit originally filed in 1991 by a subsidiary of the Coastal Corporation ("Coastal") against TransAmerican Natural Gas Corporation ("TANG"). In August 1993, Energy, VNGP, L.P. and certain of their respective subsidiaries were named as additional third-party defendants (collectively, including the original defendant subsidiaries, the "Valero Defendants") in this lawsuit. In its counterclaims against Coastal and third-party claims against the Valero Defendants, TANG alleges that it contracted to sell natural gas to Coastal at the posted field price of one of the Valero Defendants and that the Valero Defendants and Coastal conspired to set such price at an artificially low level. TANG also alleges that the Valero Defendants and Coastal conspired to cause TANG to deliver unprocessed or "wet" gas thus precluding TANG from extracting NGLs from its gas prior to delivery. TANG seeks actual damages of approximately $50 million, trebling of damages under antitrust claims, punitive damages of $300 million, and attorneys' fees. The Company believes that the plaintiff's claims have been exaggerated, and that it has meritorious defenses to such claims. In the event of an adverse determination involving the Company, the Company likely would seek indemnification from the Partnership under terms of the partnership agreements and other applicable agreements between VNGP, L.P., its subsidiary partnerships and their respective general partners. The Valero Defendants' motion for summary judgment on TANG's antitrust claims was argued on January 24, 1994. The court has not ruled on such motion. The current trial setting for this case is March 14, 1994. The Company was a party to a lawsuit originally filed in 1988 in which Energy, VTC, VNGP, L.P. and subsidiaries of VNGP, L.P. (the "Valero Defendants") and a subsidiary of Coastal were alleged to be liable for failure to take minimum quantities of gas, failure to make take-or-pay payments and other breach of contract and breach of fiduciary duty claims. The plaintiffs sought declaratory relief, actual damages in excess of $37 million and unspecified punitive damages. During the third quarter of 1992, the plaintiffs, Coastal and the Valero Defendants settled this lawsuit on terms which were not material to the Valero Defendants and on July 19, 1993, this lawsuit was dismissed. On November 16, 1992, prior to entry of the order of dismissal, NationsBank of Texas, N.A., as trustee for certain trusts (the "Intervenors"), filed a plea in intervention to intervene in the lawsuit. The Intervenors asserted that they held a non-participating mineral interest in the lands subject to the litigation and that their rights were not protected by the plaintiffs in the settlement. On February 4, 1993, the Court struck the Intervenors' plea in intervention. However, on February 2, 1993, the Intervenors had filed a separate suit in the 160th State District Court, Dallas County, Texas, against all prior defendants and an additional defendant, substantially adopting in form and substance the allegations and claims in the original litigation. In February 1994, the parties reached a tentative settlement of the lawsuit on terms immaterial to the Company or the Partnership. The Partnership has settled substantially all of the significant take-or-pay claims, pricing differences and contractual disputes heretofore brought against it. Although additional take-or-pay claims may continue to be brought against the Partnership, the Company believes that the Partnership has resolved substantially all of the significant take-or-pay claims that are likely to be made. Any liability of the Company with respect to these claims has been assumed by the Partnership. No provision has been made with respect to these claims because the Company believes that the Partnership has valid defenses with respect to such claims and because the Company believes that the Partnership will fulfill its obligation to pay any such liability as may ultimately be determined to exist. The Company and the Partnership believe it is unlikely that the final outcome of any of the claims or proceedings described above would have a material adverse effect on either the Company's or the Partnership's financial position or results of operations; however, due to the inherent uncertainty of litigation, the range of possible loss, if any, cannot be estimated with a reasonable degree of precision and there can be no assurance that the resolution of any of these claims or proceedings would not have an adverse effect on either the Company's or the Partnership's results of operations for the fiscal period in which the resolution occurred. Other Litigation On August 31, 1993, suit was brought by certain residents of the Oak Park Triangle area of Corpus Christi, Texas, against several defendants including Valero Refining Company. All named defendants are either refiners or gas processors having facilities located at or near Up River Road in Corpus Christi. Plaintiffs allege in general terms damages resulting from ground water contamination and air pollution allegedly caused by the operations of the defendants. Plaintiffs seek unspecified actual and punitive damages. No provision has been made with respect to the claims of the plaintiffs because the Company believes that Valero Refining Company has meritorious defenses to the claims. Valero Javelina Company, a wholly owned subsidiary of Energy, owns a 20% general partner interest in Javelina Company, a general partnership. See Note 5 of Notes to Consolidated Financial Statements. Javelina Company has been named as a defendant in seven lawsuits filed since 1992 in state district courts in Nueces County, Texas. Four of the suits include as defendants other companies that own refineries or other industrial facilities in Nueces County. These suits were brought by a number of plaintiffs who reside in neighborhoods near the facilities. The plaintiffs claim injuries relating to an alleged exposure to toxic chemicals, and generally claim that the defendants were negligent, grossly negligent and committed trespass. The plaintiffs claim personal injury and property damages resulting from soil and ground water contamination and air pollution allegedly caused by the operations of the defendants. One of the suits seeks certification of the litigation as a class action. The plaintiffs seek unspecified actual and punitive damages. The other three suits were brought by plaintiffs who either live or have businesses near the Javelina Plant. The suits allege claims similar to those described above. These plaintiffs also fail to specify an amount of damages claimed. The Company is also a party to additional claims and legal proceedings arising in the ordinary course of business. The Company believes it is unlikely that the final outcome of any of the claims or proceedings to which the Company is a party, including those described above, would have a material adverse effect on the Company's financial position or results of operations; however, due to the inherent uncertainty of litigation, the range of possible loss, if any, cannot be estimated with a reasonable degree of precision and there can be no assurance that the resolution of any particular claim or proceeding would not have an adverse effect on the Company's results of operations for the fiscal period in which such resolution occurred. As is described above, the Partnership has assumed the obligations and liabilities of the Company with respect to claims relating to the business or properties transferred by the Company to the Partnership in 1987. If the Partnership were unable or otherwise failed to discharge any such liability of the Company which it assumed, the Company could remain ultimately liable for such liability. 16. QUARTERLY RESULTS OF OPERATIONS (Unaudited) The results of operations by quarter for the years ended December 31, 1993 and 1992 were as follows (in thousands of dollars, except per share amounts): For the fourth quarter of 1993, results of operations were affected by a $27.6 million or $17.9 million after-tax ($.42 per share) write-down in the carrying value of the Company's refinery inventories to reflect existing market prices. This was due to a significant decline in feedstock and refined product prices, which were weak throughout 1993. Also affecting the decrease in the Company's fourth quarter operating and net income compared to the first three quarters of 1993 is the effect of seasonal market conditions on the Company's refining operations. The Company's refinery processes a type of residual fuel oil as a feedstock to produce a product slate consisting primarily of unleaded gasoline. The national demand for and price of gasoline is typically lower in the fourth quarter compared to other quarters due to the lower level of driving during the winter season. Gasoline prices are typically higher during the second and third quarters due to the increased demand related to the summer driving season. In addition, demand for and the price of fuel oils are typically higher in the fourth quarter because of the approaching heating season; these factors tend to adversely affect feedstock costs in the fourth quarter. A typical combination of lower gasoline sales prices and higher feedstock costs decreases refining throughput margins in the fourth quarter. Quarterly results for 1992 were also affected by seasonal market conditions. 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), ITEM 11.	ITEM 11. (EXECUTIVE COMPENSATION), ITEM 12.			ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) 1. Financial Statements- The following Consolidated Financial Statements of Valero Energy Corporation and its subsidiaries are included in Part II, Item 8 of this Form 10-K: Page Report of independent public accountants . . . . . . . . . Consolidated balance sheets as of December 31, 1993 and 1992 . . . . . . . . . . . . . . . . . . . . . . . . Consolidated statements of income for the years ended December 31, 1993, 1992 and 1991 . . . . . . . . . . . . Consolidated statements of common stock and other stockholders' equity for the years ended December 31, 1993, 1992 and 1991 . . . . . . . . . . . . Consolidated statements of cash flows for the years ended December 31, 1993, 1992 and 1991 . . . . . . . . . Notes to consolidated financial statements . . . . . . . . 2. Financial Statement Schedules and Other Financial Information- (A) Schedules required to be furnished for the years ended December 31, 1993, 1992 and Schedule V-Property, plant and equipment. . . . . . . . . . . . . . . Schedule VI-Accumulated depreciation, depletion and amortization of property, plant and equipment. . . . . Schedule IX-Short-term borrowings. . . . All other schedules are not submitted because they are not applicable or because the required information is included in the financial statements or notes thereto. 3. Exhibits Filed as part of this Form 10-K are the following exhibits: 2.1 - Agreement of Merger, dated December 20, 1993, among Valero Energy Corporation, Valero Natural Gas Partners, L.P., Valero Natural Gas Company and Valero Merger Partnership, L.P.-- incorporated by reference from Exhibit 2.1 to Amendment No. 2 to the Valero Energy Corporation Registration Statement on Form S-3 (Commission File No. 33-70454, filed December 29, 1993). 3.1 -- Restated Certificate of Incorporation of Valero Energy Corporation--incorporated by reference from Exhibit 4.1 to the Valero Energy Corporation Registration Statement on Form S-8 (Commission File No. 33-53796, filed October 27, 1992). 3.2 -- By-Laws of Valero Energy Corporation, as amended and restated October 17, 1991--incorporated by reference from Exhibit 4.2 to the Valero Energy Corporation Registration Statement on Form S-3 (Commission File No. 33-45456, filed February 4, 1992). 3.3 -- Amendment to By-Laws of Valero Energy Corporation, as adopted February 25, 1993-- incorporated by reference from Exhibit 3.3 to the Valero Energy Corporation Annual Report on Form 10-K (Commission File No. 1-4718, filed February 26, 1993). 4.1 -- Amended and Restated Rights Agreement, dated as of October 17, 1991, between Valero Energy Corporation and Ameritrust Texas, N.A., successor to Mbank Alamo, N.A., as Rights Agent --incorporated by reference from Exhibit 1 to the Valero Energy Corporation Current Report on Form 8-K (Commission File No. 1- 4718, filed October 18, 1991). 4.2 -- $200,000,000 Senior Notes Purchase Agreement dated as of December 19, 1990--incorporated by reference from Exhibit 4.2 to the Valero Energy Corporation Annual Report on Form 10-K (Commission File No. 1-4718, filed February 21, 1992). 4.3 -- $160,000,000 Amended and Restated Credit Agreement, dated as of December 4, 1992, among Valero Refining Company, Bankers Trust Company, as Agent and certain other banks party thereto--incorporated by reference from Exhibit 4.3 to the Valero Energy Corporation Form 10-K (Commission File No. 1-4718, filed February 26, 1993). 4.4 -- First Amendment to Amended and Restated Credit Agreement, dated as of August 25, 1993-- incorporated by reference from Exhibit 4.5 to the Valero Energy Corporation Registration Statement on Form S-3 (Commission File No. 33-70454, filed October 18, 1993). 4.5 -- Second Amendment to Amended and Restated Credit Agreement, dated as of December 31, 1993. +10.1 -- Valero Energy Corporation Executive Deferred Compensation Plan, amended and restated as of October 21, 1986--incorporated by reference from Exhibit 10.16 to the Valero Energy Corporation Annual Report on Form 10-K (Commission File No. 1-4718, filed February 26, 1988). +10.2 -- Valero Energy Corporation Key Employee Deferred Compensation Plan, amended and restated as of October 21, 1986--incorporated by reference from Exhibit 10.17 to the Valero Energy Corporation Annual Report on Form 10-K (Commission File No. 1-4718, filed February 26, 1988). +10.3 -- Valero Energy Corporation Amended and Restated Restricted Stock Bonus and Incentive Stock Plan dated as of January 24, 1984 (as amended through January 1, 1988)--incorporated by reference from Exhibit 10.19 to the Valero Energy Corporation Annual Report on Form 10-K (Commission File No. 1-4718, filed February 26, 1988). +10.4 -- Valero Energy Corporation Stock Option Plan No. 3, as amended and restated November 28, 1993--incorporated by reference from Exhibit 10.5 to the Valero Natural Gas Partners, L.P. Annual Report on Form 10-K (Commission File No. 1-9433, filed March 1, 1994). +10.5 -- Valero Energy Corporation Stock Option Plan No. 4, as amended and restated effective November 28, 1993--incorporated by reference from Exhibit 10.6 to the Valero Natural Gas Partners, L.P. Annual Report on Form 10-K (Commission File No. 1-9433, filed March 1, 1994). +10.6 -- Valero Energy Corporation 1990 Restricted Stock Plan for Non-Employee Directors, dated effective as of November 14, 1990--incorporated by reference from Exhibit 10.23 to the Valero Energy Corporation Annual Report on Form 10-K (Commission File No. 1- 4718, filed February 26, 1991). +10.7 -- Valero Energy Corporation Supplemental Executive Retirement Plan as amended and restated effective January 1, 1990--incorporated by reference from Exhibit 10.24 to the Valero Energy Corporation Annual Report on Form 10-K (Commission File No. 1- 4718, filed February 26, 1991). +10.8 -- Valero Energy Corporation Executive Incentive Bonus Plan--incorporated by reference from Exhibit 10.9 to the Valero Natural Gas Partners, L.P. Annual Report on Form 10-K (Commission File No. 1-4718, filed February 20, 1992). +10.9 -- Executive Severance Agreement between Valero Energy Corporation and William E. Greehey, dated December 15, 1982--incorporated by reference from Exhibit 10.11 to the Valero Natural Gas Partners, L.P. Annual Report on Form 10-K (Commission File No. 1-9433, filed February 25, 1993). +10.10 -- Schedule of Executive Severance Agreements-- incorporated by reference from Exhibit 10.12 to the Valero Energy Corporation Annual Report on Form 10-K (Commission File No. 1-4718, filed February 26, 1993). +10.11 -- Employment Agreement between Valero Energy Corporation and William E. Greehey, dated May 16, 1990--incorporated by reference from Exhibit 10.1 to the Valero Energy Corporation Quarterly Report on Form 10-Q (Commission File No. 1-4718, filed November 14, 1990). +10.12 -- Indemnity Agreement, dated as of February 24, 1987, between Valero Energy Corporation and William E. Greehey--incorporated by reference from Exhibit 10.16 to the Valero Energy Corporation Annual Report on Form 10-K (Commission File No. 1-4718, filed February 26, 1993). +10.13 -- Schedule of Indemnity Agreements--incorporated by reference from Exhibit 10.17 to the Valero Energy Corporation Annual Report on Form 10-K (Commission File No. 1-4718, filed February 26, 1993). 11 -- Computation of Earnings Per Share. 21.1 -- Valero Energy Corporation subsidiaries, including state or other jurisdiction of incorporation or organization. 23.1 -- Consent of Arthur Andersen & Co., dated March 1, 1994. 24.1 -- Power of Attorney, dated March 1, 1994--set forth at the signatures page of this Form 10-K. 99.1 -- Items 1 through 3 of the Valero Natural Gas Partners, L.P. Annual Report on Form 10-K for the year ended December 31, 1993 (Commission File No. 1-9433, filed March 1, 1994). ______________ * Filed herewith + Identifies management contracts or compensatory plans or arrangements required to be filed as an exhibit hereto pursuant to Item 14(c) of Form 10-K. Copies of exhibits filed as a part of this Form 10-K may be obtained by stockholders of record at a charge of $.15 per page, minimum $5.00 each request. Direct inquiries to Rand C. Schmidt, Corporate Secretary, Valero Energy Corporation, P.O. Box 500, San Antonio, Texas 78292. Pursuant to paragraph 601(b)(4)(iii)(A) of Regulation S- K, the registrant has omitted from the foregoing listing of exhibits, and hereby agrees to furnish to the Commission upon its request, copies of certain instruments, each relating to long- term debt not exceeding 10% of the total assets of the registrant and its subsidiaries on a consolidated basis. (b) No reports on Form 8-K were filed during the three- month period ended December 31, 1993. For the purposes of complying with the rules governing Form S-8 under the Securities Act of 1933, the undersigned registrant hereby undertakes as follows, which undertaking shall be incorporated by reference into registrant's Registration Statements on Form S-8 No. 2-66297 (filed December 21, 1979), No. 2-82001 (filed February 23, 1983), No. 2-97043 (filed April 15, 1985), No. 33-23103 (filed July 15, 1988), No. 33-14455 (filed May 21, 1987), No. 33-38405 (filed December 3, 1990) and No. 33-53796 (filed October 27, 1992). Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers and controlling persons of the registrant pursuant to the foregoing provisions, or otherwise, the registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Securities Act of 1933 and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the registrant of expenses incurred or paid by a director, officer or controlling person of the registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question of whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors of Valero Natural Gas Company as General Partner of Valero Natural Gas Partners, L.P. and to the Common Unitholders: We have audited the accompanying consolidated balance sheets of Valero Natural Gas Partners, L.P. (a Delaware limited partnership) as of December 31, 1993 and 1992, and the related consolidated statements of income, partners' capital and cash flows for each of the three years in the period ended December 31, 1993. These financial statements and the schedules referred to below are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Valero Natural Gas Partners, L.P. as of December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The supplemental schedules V, VI and IX are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state 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 & CO. San Antonio, Texas February 17, 1994 VALERO NATURAL GAS PARTNERS, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Organization and Control Valero Natural Gas Partners, L.P. ("VNGP, L.P."), Valero Management Partnership, L.P. (the "Management Partnership") and various subsidiary operating partnerships (the "Subsidiary Operating Partnerships"), all Delaware limited partnerships, are the successors to substantially all of the natural gas and natural gas liquids businesses, assets and liabilities of substantially all of the subsidiaries of Valero Natural Gas Company ("VNGC") and the transmission division of Rio Grande Valley Gas Company ("Rio"). VNGC is, and Rio at the time of such succession was, a wholly owned subsidiary of Valero Energy Corporation (unless otherwise required by the context, the term "Energy" as used herein refers to Valero Energy Corporation and its consolidated subsidiaries, both individually and collectively). VNGC is the general partner of VNGP, L.P. and the Management Partnership (in such capacity, the "General Partner"), while subsidiaries of VNGC are general partners (the "Subsidiary General Partners") of the respective Subsidiary Operating Partnerships. In March 1987, VNGP, L.P. sold in an underwritten public offering 9.5 million preference units of limited partner interests (the "Preference Units"), representing a 52% limited partner interest in VNGP, L.P. VNGP, L.P. concurrently issued approximately 8.6 million common units of limited partner interests (the "Common Units"), representing a 47% limited partner interest, to subsidiaries of Energy, and issued a 1% general partner interest in VNGP, L.P. to VNGC. Subsequent to March 1987, VNGP, L.P. issued .4 million additional Common Units to a subsidiary of Energy. In addition, approximately .2 million Common Units held by a subsidiary of Energy were transferred to employees of Energy and converted into Preference Units in connection with an employee benefit plan adopted by Energy. During 1992, all outstanding Preference Units were automatically converted into Common Units (see "Allocation of Net Income and Cash Distributions"). The original Common Units and former Preference Units converted into Common Units are collectively referred to herein as the "Units." Holders of the Units are referred to herein as the "Unitholders." Under the partnership structure, VNGP, L.P. holds a 99% limited partner interest and VNGC holds a 1% general partner interest in the Management Partnership. The Management Partnership in turn holds a 99% limited partner interest and various wholly owned subsidiaries of VNGC each hold a 1% general partner interest in the various Subsidiary Operating Partnerships to which the acquired businesses, assets and liabilities were transferred. Valero Transmission, L.P. ("Transmission"), one of the Subsidiary Operating Partnerships, owns and operates the principal pipeline system of the Partnership. (References to Transmission prior to March 25, 1987 refer to Valero Transmission Company, a wholly owned subsidiary of VNGC, and after that date to its successor in interest, Valero Transmission, L.P.) Transmission is principally a transporter of natural gas as it transports gas for affiliates and third parties. Transmission also sells natural gas to intrastate customers under long-term contracts; however, most of the Partnership's gas sales are made through other Subsidiary Operating Partnerships which operate special marketing programs ("SMPs"). Subsequent to March 1987, VNGP, L.P. acquired a wholly owned subsidiary that makes certain intrastate gas sales, and formed certain subsidiary partnerships, one of which leases certain assets from Energy under capital leases as described in Note 5. Also, during 1992, an additional Subsidiary Operating Partnership was formed to make certain intrastate gas sales. VNGP, L.P., the Management Partnership, the original Subsidiary Operating Partnerships and the additional entities acquired or formed subsequent to March 1987 are collectively referred to herein as the "Partnership." As of December 31, 1993, Energy's total effective equity interest in the Partnership was approximately 49%. In October 1993, Energy publicly announced its proposal to acquire the 9.7 million issued and outstanding Common Units in VNGP, L.P. held by persons other than Energy (the "Public Unitholders") pursuant to a merger of VNGP, L.P. with a wholly owned subsidiary of Energy. The Board of Directors of VNGC appointed a special committee of outside directors (the "Special Committee") to consider the merger and to determine the fairness of the transaction to the Public Unitholders. The Special Committee thereafter retained independent financial and legal advisors to assist the Special Committee. Upon the recommendation of the Special Committee, the Board of Directors of VNGC unanimously approved the merger. Effective December 20, 1993, Energy, VNGP, L.P. and VNGC entered into an agreement of merger (the "Merger Agreement") providing for the merger. In the merger, the Common Units held by the Public Unitholders will be converted into the right to receive cash in the amount of $12.10 per Common Unit. As a result of the merger, VNGP, L.P. would become a wholly owned subsidiary of Energy. Consummation of the merger is subject to, among other things, (i) approval of the Merger Agreement by the holders of a majority of the issued and outstanding Common Units; (ii) approval by the holders of a majority of the Common Units held by the Public Unitholders and voted at a special meeting of holders of Common Units to be called to consider the Merger Agreement; (iii) receipt of satisfactory waivers, consents or amendments to certain of Energy's financial agreements; and (iv) completion of an underwritten public offering of convertible preferred stock by Energy. Energy currently owns approximately 47.5% of the outstanding Common Units and intends to vote its Common Units in favor of the merger. Basis of Presentation The accompanying consolidated financial statements have been prepared in accordance with generally accepted accounting principles and are not the basis for reporting taxable income to Unitholders. The consolidated financial statements include the accounts of VNGP, L.P. and its consolidated subsidiaries. All significant interpartnership transactions have been eliminated in consolidation. Statements of Cash Flows In order to determine net cash provided by operating activities, net income has been adjusted by, among other things, changes in current assets and current liabilities, excluding changes in cash and temporary cash investments, cash held in debt service escrow for principal (see Note 3), and current maturities of long-term debt and capital lease obligations. Those changes, shown as an (increase)/decrease in current assets and an increase/ (decrease) in current liabilities, are provided in the following table. Temporary cash investments are highly liquid low-risk debt instruments which have a maturity of three months or less when acquired and whose carrying amount approximates fair value. (Dollars in thousands.) Cash interest paid by the Partnership (net of amounts capitalized) for the years ended December 31, 1993, 1992 and 1991 was $62.7 million, $66.4 million and $62.5 million, respectively. No cash payments for federal income taxes were made during these periods as the Partnership is not subject to federal income taxes (see "Income Taxes" below). Cash payments for state income taxes made during these periods were insignificant. Noncash investing and financing activities for the years ended December 31, 1992 and 1991 included $26 million and $75 million, respectively, of various natural gas and natural gas liquids facilities acquired by the Partnership through capital lease transactions entered into with Energy. See Note 5. Transactions with Energy The Partnership enters into various types of transactions with Energy in the normal course of business on market-related terms and conditions. The Partnership is charged a management fee for the direct and indirect costs incurred by Energy on behalf of the Partnership that are associated with managing its operations. The Partnership sells natural gas and natural gas liquids ("NGLs") to, and purchases NGLs from, Energy's refining subsidiary. The Partnership sold natural gas to Energy's retail natural gas distribution business operated by Rio until September 30, 1993, when Rio was sold by Energy. The Partnership operates for a fee two natural gas processing plants and related facilities for Energy and sells natural gas to, purchases natural gas and NGLs from, and processes natural gas owned by Energy in connection with these NGL operations. The Partnership also enters into other operating transactions with Energy, including certain leasing transactions discussed in Note 5. As of December 31, 1993 and 1992, the Partnership had recorded approximately $31.8 million and $13.5 million, respectively, of accounts payable and accrued expenses, net of accounts receivable, due to Energy. During the fourth quarter of 1992, the Partnership recognized a charge to earnings through the management fee billed by Energy of approximately $4.4 million, or $.23 per limited partner unit, representing the Partnership's allocable portion of the cost of a voluntary early retirement program implemented by Energy. The following table summarizes transactions between the Partnership and Energy for the years ended December 31, 1993, 1992 and 1991 (in thousands): The direct and indirect costs incurred by the General Partner on behalf of the Partnership that are charged to the Partnership through the management fee include, among other things, salaries and wages and other employee-related costs. Effective January 1, 1993, Energy adopted the Financial Accounting Standards Board's Statement of Financial Accounting Standards ("SFAS") No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." This statement requires a change in Energy's accounting for postretirement benefits other than pensions from a pay-as-you-go basis to an accrual basis of accounting. Energy is amortizing the transition obligation over 20 years, which is greater than the average remaining service period until eligibility of active plan participants. As a result of Energy's adoption of this statement, the Partnership's proportionate share of other postretirement employee benefits included in the management fee in 1993 increased by approximately $1.5 million and the Partnership's proportionate share of the total accumulated postretirement benefit obligation at December 31, 1993 was approximately $15 million. The adoption of this statement by Energy did not affect the Partnership's cash flows in 1993, nor is it expected to affect the Partnership's future cash flows, as Energy expects to continue to fund its postretirement benefits other than pensions, and require reimbursement from the Partnership for the Partnership's proportionate share of such funding, on a pay-as-you-go basis. Gas Sales and Transportation In the course of making gas sales and providing transportation services to customers, Transmission experiences measurement and other volumetric differences related to the amounts of gas received and delivered. Transmission has in the past experienced overall net volume gains due to such differences and its Rate Order allows such volumes to be sold to its customers. Transmission historically has derived a substantial benefit from such sales. The amount included in operating income in 1993 was substantially the same as in 1992. However, the implementation of more precise gas measurement equipment and standards and the reduction in Transmission's total sales volumes, discussed in Note 6 - "Customer Audit of Transmission", is expected to reduce operating income from such sales in future periods. Inventories Inventories are carried principally at weighted average cost not in excess of market. Inventories as of December 31, 1993 and 1992 were as follows (in thousands): In addition to the above noted natural gas storage inventories, which are located at the Wilson Storage Facility in Wharton County, Texas (see Note 5), the Partnership also had natural gas in third-party storage facilities, available under exchange agreements, totalling $10.8 million and $1.2 million at December 31, 1993 and 1992, respectively. Such amounts are included in receivables in the accompanying consolidated balance sheets. Property, Plant and Equipment Property, plant and equipment at date of inception of the Partnership was increased by the excess of the acquisition cost of the holders of the Preference Units over VNGC's historical net cost basis. Accordingly, approximately 51% of property, plant and equipment was recorded at fair value reflecting the value attributable to the holders of the Preference Units while the remaining 49% was recorded at historical net book cost to reflect the value attributable to the General Partner and the holders of the original Common Units. Property additions and betterments include capitalized interest and acquisition and administrative costs allocable to construction and property purchases. Assets under capital leases are included in property, plant and equipment and are recorded at the lesser of the fair value of the leased property at the inception of the lease or the present value of the related future minimum lease payments. The costs of minor property units (or components thereof), net of salvage, retired or abandoned are charged or credited to accumulated depreciation. Gains or losses on sales or other dispositions of major units of property are credited or charged to income. Provision for depreciation of property, plant and equipment is made primarily on a straight-line basis over the estimated useful lives of the depreciable facilities. Assets under capital leases are depreciated on a straight-line basis over the lease term. The rates for depreciation are as follows: During the fourth quarter of 1992, the Partnership extended the estimated useful lives of the majority of its natural gas liquids facilities from 14 to 20 years to better reflect the estimated periods during which such assets are expected to remain in service. The effect of this change in accounting estimate, which was made retroactive to January 1, 1992, was to decrease depreciation expense and increase net income for 1992 by approximately $5.6 million, or $.29 per limited partner unit. Other Assets Payments made or agreed to be made in connection with the settlement of certain disputed contractual issues with gas suppliers of Transmission are initially deferred. The balance of such payments is subsequently reduced as recoveries are made through Transmission's rates. The balance of deferred gas costs of $67 million and $72 million at December 31, 1993 and 1992, respectively, is included in noncurrent other assets and is expected to be recovered over future periods. See Note 6 - "Customer Audit of Transmission." Debt issuance costs are included in deferred charges and other assets and are amortized by the effective interest method over the term of each respective issue of the Management Partnership's First Mortgage Notes ("First Mortgage Notes"). See Note 3. Income Taxes Income and deductions of the Partnership for federal income tax purposes are includable in the tax returns of the individual partners. Accordingly, no recognition has been given to federal income taxes in the accompanying consolidated financial statements of the Partnership. At December 31, 1993 and 1992, the net difference between the tax bases and the reported amounts of assets and liabilities in the accompanying Consolidated Balance Sheets was $314 million and $322 million, respectively. Under the Revenue Act of 1987, certain publicly traded limited partnerships will be taxed as corporations after December 31, 1997 unless specifically exempted. This Act exempted natural resource partnerships including those dealing with natural gas transportation and processing of natural gas liquids, such as the Partnership, from its taxation provision. Price Risk Management Activities The Partnership, through its Market Center Services Program established in 1992, enters into exchange-traded futures and options contracts, forward contracts, swaps and other financial instruments with third parties to hedge natural gas inventories and certain anticipated natural gas purchase requirements in order to minimize the risk of market fluctuations. The Partnership also utilizes such price risk management techniques to provide services to gas producers and end users. Changes in the market value of these contracts are deferred until the gain or loss is recognized on the hedged transaction. As of December 31, 1993 and 1992, the Partnership had outstanding contracts for natural gas totalling approximately 15.0 billion cubic feet ("Bcf") and 4.8 Bcf, respectively, for which the Partnership is the fixed price payor and 27.1 Bcf and 10.0 Bcf, respectively, for which the Partnership is the fixed price receiver. Such contracts run for a period of one to twelve months. A portion of such contracts represented hedges of natural gas volumes in underground storage and in third-party storage facilities which totalled approximately 10.3 Bcf and 7.4 Bcf at December 31, 1993 and 1992, respectively. See "Inventories" above. In 1993 and 1992, the Partnership recognized $18.7 million and $12.9 million, respectively, in gas cost reductions and other benefits from this program. An additional $5.1 million and $3.6 million in other reductions of cost of gas was generated by transactions entered into in 1993 and 1992, respectively, which is recognized in income in the subsequent year as the related gas is sold. Allocation of Net Income and Cash Distributions Net income is allocated to partners based on their effective ownership interest in the operating results of the Partnership, except that additional depreciation expense pertaining to the excess of the Partnership's acquisition cost over the historical cost basis in net property, plant and equipment and certain other assets in which the former holders of Preference Units have an ownership interest is allocated solely to such holders as a noncash charge to net income. The allocation of additional depreciation expense to the former holders of Preference Units does not affect the cash distributions with respect to the Units. Under the Partnership structure, the income of the Subsidiary Operating Partnerships is allocated to the Subsidiary General Partners, which hold a 1% general partner interest, and to the Management Partnership, which holds a 99% limited partner interest. As a result, net income allocable to the Subsidiary General Partners is not reduced by interest expense associated with the Management Partnership's First Mortgage Notes. The Partnership is required to make quarterly cash distributions with respect to all Units in an amount equal to "Distributable Cash Flow" as defined in the Second Amended and Restated Agreement of Limited Partnership of VNGP, L.P. (the "Partnership Agreement") and as determined by the General Partner. With the payment on May 30, 1992 of the cash distribution of $.625 per Unit for the first quarter of 1992, the Partnership completed the payment of cumulative cash distributions of $12.50 per Preference Unit resulting in the termination of the period (the "Preference Period") during which the holders of Preference Units were entitled to a preferential distribution amount. As a result of the termination of the Preference Period, all outstanding Preference Units were automatically converted into Common Units in accordance with the terms of the Partnership Agreement. The Partnership subsequently reduced cash distributions to $.125 per Unit for the remaining quarters of 1992 and the first three quarters of 1993. On January 25, 1994, the VNGC Board of Directors declared a cash distribution of $.125 per Unit for the fourth quarter of 1993 that is payable March 1, 1994 to holders of record as of February 7, 1994. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" for a discussion of factors that have reduced the amount of cash available for distribution to Unitholders. If the proposed merger with Energy described above under "Organization and Control" occurs after March 9, 1994, the General Partner intends and expects to declare and pay a pro rata distribution to holders of record of the Common Units on the effective date of the merger based upon the number of days elapsed between February 7, 1994 and such effective date. 2. SHORT-TERM BANK LINES The Partnership, through the Management Partnership, currently maintains five separate short-term bank lines of credit totalling $80 million. In accordance with the terms of the indenture of mortgage and deed of trust pursuant to which the Management Partnership's First Mortgage Notes were issued (the "Mortgage Note Indenture"), at least $20 million of revolving credit agreements must be maintained at all times; however, no more than $50 million of borrowings are permitted to be outstanding at any time. See Note 3. The Partnership had borrowings of as much as $39.9 million under its short-term bank lines during 1993. No borrowings were outstanding under these lines at December 31, 1993 or 1992. The lines of credit mature at various times during 1994, bear interest at each respective bank's prime, quoted money market or Eurodollar rate and require commitment fees based on the unused amount of the credit. If the proposed merger with Energy does not occur, the General Partner believes that these short-term bank lines could be renewed or replaced with other short-term lines during 1994 on terms and conditions similar to those currently existing. If the proposed merger with Energy is completed, the General Partner anticipates that new bank credit agreements will be negotiated and that the Partnership's existing short-term bank lines will be cancelled. 3. LONG-TERM DEBT Long-term debt balances were as follows (in thousands): The First Mortgage Notes, which are currently comprised of eight remaining series due serially from 1994 through 2009, are secured by mortgages on and security interests in substantially all of the currently existing and after-acquired property, plant and equipment of the Management Partnership and each Subsidiary Operating Partnership and by the Management Partnership's limited partner interest in each Subsidiary Operating Partnership (the "Mortgaged Property"). As of December 31, 1993, the First Mortgage Notes have a remaining weighted average life of approximately 7.3 years and a weighted average interest rate of 10.12% per annum. Interest on the First Mortgage Notes is payable semiannually, but one-half of each interest payment and one-fourth of each annual principal payment are escrowed quarterly in advance. At December 31, 1993 and 1992, $34.2 million and $32.9 million, respectively, had been deposited with the Mortgage Note Indenture trustee ("Trustee") in an escrow account. The amount on deposit is classified as a current asset (cash held in debt service escrow) and the liability to be paid off when the cash is released by the Trustee from escrow is classified as a current liability. The Mortgage Note Indenture contains covenants prohibiting the Management Partnership and the Subsidiary Operating Partnerships (collectively referred to herein as the "Operating Partnerships") from incurring additional indebtedness, including any additional First Mortgage Notes, other than (i) up to $50 million of indebtedness to be incurred for working capital purposes (provided that for a period of 45 consecutive days during each 16 consecutive calendar month period no such indebtedness will be permitted to be outstanding) and (ii) up to the amount of any future capital improvements financed through the issuance of debt or equity by VNGP, L.P. and the contribution of such amounts as additional equity to the Management Partnership. The Mortgage Note Indenture also prohibits the Operating Partnerships from (a) creating new indebtedness unless certain cash flow to debt service requirements are met; (b) creating certain liens; or (c) making cash distributions in any quarter in excess of the cash generated in the prior quarter, less (i) capital expenditures during such prior quarter (other than capital expenditures financed with certain permitted indebtedness), (ii) an amount equal to one-half of the interest to be paid on the First Mortgage Notes on the interest payment date occurring in or next following such prior quarter and (iii) an amount equal to one-quarter of the principal required to be paid on the First Mortgage Notes on the principal payment date occurring in or next following such prior quarter, plus cash which could have been distributed in any prior quarter but which was not distributed. The Operating Partnerships are further prohibited from purchasing or owning any securities of any person or making loans or capital contributions to any person other than investments in the Subsidiary Operating Partnerships, advances and contributions of up to $20 million per year and $100 million in the aggregate to entities engaged in substantially similar business activities as the Operating Partnerships, temporary investments in certain marketable securities and certain other exceptions. The Mortgage Note Indenture also prohibits the Operating Partnerships from consolidating with or conveying, selling, leasing or otherwise disposing of all or any material portion of their property, assets or business as an entirety to any other person unless the surviving entity meets certain net worth requirements and certain other conditions are met, or from selling or otherwise disposing of any part of the Mortgaged Property, subject to certain exceptions. The Mortgage Note Indenture also provides that it will be an event of default if VNGC withdraws as General Partner of the Management Partnership prior to 1997, if VNGC is removed as General Partner but the Subsidiary General Partners are not also removed, or if the General Partner or any Subsidiary General Partner withdraws or is removed and is not replaced within 30 days. Maturities of long-term debt for the years ending December 31, 1995 through 1998 are $30.3 million, $32.9 million, $35.3 million and $37.9 million, respectively. Based on the borrowing rates currently available to the Partnership for long-term debt with similar terms and average maturities, the fair value of the Partnership's First Mortgage Notes, including current maturities, at December 31, 1993 was approximately $562 million. At December 31, 1992, the fair value of the First Mortgage Notes was essentially equal to their carrying value. 4. INDUSTRY SEGMENT INFORMATION The Partnership operates in the natural gas and natural gas liquids industry segments. The natural gas operations consist of purchasing, gathering, transporting and selling natural gas, principally to gas distribution companies, electric utilities, pipeline companies and industrial customers. The Partnership also transports gas for a fee for sales customers, other pipelines and end users and provides price risk management services to gas producers and end users through its Market Center Services Program. The natural gas liquids operations include the extraction of natural gas liquids, principally from natural gas throughput of the natural gas operations, and the fractionation and transportation of natural gas liquids. The primary markets for sales of natural gas liquids are petrochemical plants, refineries and domestic fuel distributors. Intersegment revenue eliminations relate primarily to transportation provided by the natural gas segment for the natural gas liquids segment. During 1993, natural gas sales and transportation revenues from San Antonio City Public Service accounted for approximately 11% of the Partnership's total consolidated operating revenues. No single unaffiliated customer accounted for more than 10% of the Partnership's total consolidated operating revenues during 1992 or 1991. Energy and its consolidated subsidiaries accounted for approximately 12%, 12% and 11% of the Partnership's total consolidated operating revenues during 1993, 1992 and 1991, respectively. The Partnership's natural gas segment has a concentration of customers in the natural gas transmission and distribution industries while its natural gas liquids segment has a concentration of customers in the refining and petrochemical industries. These concentrations of customers may impact the Partnership's overall exposure to credit risk, either positively or negatively, in that the customers may be similarly affected by changes in economic or other conditions. However, the General Partner believes that the Partnership's portfolio of accounts receivable is sufficiently diversified to the extent necessary to minimize any potential credit risk. Historically, the Partnership has not had any significant problems in collecting its accounts receivable. The Partnership's accounts receivable are generally not collateralized. 5. LEASE AND OTHER COMMITMENTS Valero Gas Storage Company ("Gas Storage"), a wholly owned subsidiary of VNGC, is the lessee under an operating lease for a gas storage facility (the "Wilson Storage Facility"). Gas Storage and Valero Transmission Company had previously entered into a gas storage agreement ("Gas Storage Agreement") which required Valero Transmission Company to pay to Gas Storage amounts essentially equivalent to the lease payments and operating costs in connection with Valero Transmission Company's use of the Wilson Storage Facility. Upon formation of the Partnership, Valero Transmission Company assigned the Gas Storage Agreement to Valero Transmission, L.P., and Valero Transmission, L.P. assumed Valero Transmission Company's obligation to make such payments to Gas Storage. The remaining primary lease term for the Wilson Storage Facility is six years with options to renew at varying terms. The future minimum lease payments related to this lease are included in the table below. The Partnership has other noncancelable operating leases with remaining terms ranging generally from one year to 13 years. During 1992, the Partnership entered into a capital lease with Energy to lease a gas processing plant near Thompsonville in South Texas and 48 miles of NGL product pipeline (the "Thompsonville Project"). The Thompsonville Project lease commenced December 1, 1992 and has a term of 15 years. During 1991, the Partnership entered into capital leases with Energy to lease an interest in an approximate 105-mile pipeline in East Texas (the "East Texas pipeline") and certain fractionation facilities in Corpus Christi, Texas. The East Texas pipeline lease commenced February 1, 1991 and has a term of 25 years while the lease for the fractionation facilities commenced December 1, 1991 and has a term of 15 years. As a result of the settlement and dismissal in 1992 of certain claims asserted in litigation filed against Energy and certain of its affiliates, officers and directors, Energy agreed to adjust the payments and certain other terms under these capital leases. Such adjusted payments are reflected in the table of future minimum lease payments shown below. The assets and associated obligations related to the capital leases with Energy described above are not subject to the Mortgage Note Indenture. The Partnership has the right to purchase all or any portion of these assets, subject to certain restrictions, under purchase option provisions of the respective lease agreements. The total cost of these leased facilities, which is included in the accompanying consolidated balance sheets under property, plant and equipment, was approximately $101 million. Amortization of these capital leases, which is included in depreciation expense in the accompanying consolidated income statements, was $5.3 million, $3.5 million and $2.2 million for 1993, 1992 and 1991, respectively. The related future minimum lease payments under the Partnership's capital leases and noncancelable operating leases as of December 31, 1993 are as follows (in thousands): The future minimum lease payments listed above under the caption "Partnership Lease Commitments" exclude certain operating lease commitments which are cancelable by the Partnership upon notice of one year or less. Consolidated rent expense was approximately $698,000, $833,000 and $746,000 for the years ended December 31, 1993, 1992 and 1991, respectively, and excludes amounts billed by Energy to the Partnership for its proportionate use of Energy's corporate headquarters office complex and related charges which are included in the management fee charged to the Partnership. See Note 1 - "Transactions with Energy." Rentals paid of $10,438,000 per year for 1993, 1992 and 1991 in connection with the Wilson Storage Facility were included in the computation of Transmission's weighted average cost of gas. The obligations of Gas Storage under the gas storage facility lease include its obligation to make scheduled lease payments and, in the event of a declaration of default and acceleration of the lease obligation, to make certain lump sum payments based on a stipulated loss value for the gas storage facility less the fair market sales price or fair market rental value of the gas storage facility. Under certain circumstances, a default by Energy or a subsidiary of Energy, including VNGC, with respect to its own indebtedness could result in a cross default under the gas storage facility lease. The General Partner believes that it is unlikely that a default by Energy or a subsidiary of Energy would result in acceleration of the gas storage facility lease, and further believes that such event, if it occurred, would not have a material adverse effect on the Partnership. 6. LITIGATION AND CONTINGENCIES Take-or-Pay and Related Claims As a result of past market conditions and contracting practices in the natural gas industry, numerous producers and other suppliers brought claims against Transmission asserting that it was in breach of contractual provisions requiring that it take, or pay for if not taken, certain specified volumes of natural gas. The Partnership has settled substantially all of the significant take-or-pay claims, pricing differences and contractual disputes heretofore brought against it. Although additional claims may arise under older contracts until their expiration or renegotiation, the General Partner believes that the Partnership has resolved substantially all of the significant take-or-pay claims that are likely to be made. As described below, Energy and/or the Partnership have agreed to bear a portion of certain potential liabilities that may be incurred by certain Partnership suppliers. Although the General Partner is currently unable to predict the total amount Transmission or the Partnership ultimately may pay or be required to pay in connection with the resolution of existing and potential take-or- pay claims, the General Partner believes that any remaining claims can be resolved on terms satisfactory to the Partnership and that the resolution of such claims and any potential claims has not had and will not have a material adverse effect on the Partnership's financial position or results of operations. In 1987, Transmission and a producer from whom Transmission has purchased natural gas entered into an agreement resolving certain take-or-pay issues between the parties in which Transmission agreed to pay one-half of certain excess royalty claims arising after the date of the agreement. The royalty owners of the producer recently completed an audit of the producer and have presented to the producer a claim for additional royalty payments in the amount of approximately $17.3 million, and accrued interest thereon of approximately $19.8 million. Approximately $8 million of the royalty owners' claim accrued after the effective date of the agreement between the producer and Transmission. The producer and Transmission are reviewing the royalty owners' claims. No lawsuit has been filed by the royalty owners. The General Partner believes that various defenses under the agreement may reduce any liability of Transmission to the producer in this matter. Valero Transmission Company and one of its gas suppliers are parties to various gas purchase contracts assigned to and assumed by Valero Transmission, L.P. upon formation of the Partnership in 1987. The supplier is also a party to a series of gas purchase contracts between the supplier, as buyer, and certain trusts, as seller, which are in litigation. Neither the Partnership nor Valero Transmission Company is a party to this litigation or the contracts between Transmission's supplier and the trusts. However, because of the relationship between Transmission's contracts with the supplier and the supplier's contracts with the trusts, and in order to resolve existing and potential disputes, the supplier, Valero Transmission Company and Valero Transmission, L.P. have agreed that they will cooperate in the conduct of this litigation, and that Valero Transmission Company and Valero Transmission, L.P. will bear a substantial portion of the costs of any appeal and any nonappealable final judgment rendered against the supplier. In the litigation, the trusts allege that Transmission's supplier has breached various minimum take, take-or-pay and other contractual provisions, and assert a statutory nonratability claim. The trusts seek alleged actual damages, including interest, of approximately $30 million and an unspecified amount of punitive damages. The District Court ruled on the plaintiff's motion for summary judgment, finding, among other things, that as a matter of law the three gas purchase contracts at issue were fully binding and enforceable, the supplier breached the minimum take obligations under one of the contracts, the supplier is not entitled to claimed offsets for gas purchased by third parties and the "availability" of gas for take-or-pay purposes is established solely by the delivery capacity testing procedures in the contracts. Damages, if any, have not been determined. Because of existing contractual obligations of Valero Transmission, L.P. to its supplier, the lawsuit may ultimately involve a contingent liability for Valero Transmission, L.P. The General Partner believes that the claims brought against the supplier have been significantly overstated, and that the supplier has a number of meritorious defenses to the claims including various regulatory, statutory, contractual and common law defenses. The Court recently granted the supplier's Motion for Continuance of the former January 10, 1994 trial date. This litigation is not currently set for trial. Payments that Transmission has made or agreed to make in connection with settlements to date are included in its deferred gas costs. The General Partner believes that the rate order under which Transmission currently operates (the "Rate Order"), issued in 1979 by the Railroad Commission of Texas (the "Railroad Commission," which regulates the sale and transportation of natural gas by intrastate pipeline systems in Texas), allows for the recovery of such costs. See Note 1 - "Other Assets" and "Customer Audit of Transmission" below. Certain take-or-pay and other claims have been resolved through the Partnership agreeing to provide discounted transportation services. These agreements do not involve a cash outlay by the Partnership but in certain cases have the effect of reducing transportation margins over an extended period of time. Any liability of Energy with respect to take-or-pay claims involving Transmission's intrastate pipeline operations has been assumed by the Partnership. Based upon the General Partner's beliefs and rate considerations discussed above, no liabilities have been recorded for any unresolved take-or-pay claims. Other Litigation Seven lawsuits were filed in Chancery Court in Delaware against VNGP, L.P., VNGC and Energy and certain officers and directors of VNGC and/or Energy in response to the announcement by Energy on October 14, 1993 of its proposal to acquire the publicly traded Common Units of VNGP, L.P. pursuant to a proposed merger of VNGP, L.P. with a wholly owned subsidiary of Energy. See Note 1 - "Organization and Control." The suits were consolidated into a single proceeding by the Chancery Court on November 23, 1993. The plaintiffs sought to enjoin or rescind the proposed merger, alleging that the corporate defendants and the individual defendants, as officers or directors of the corporate defendants, engaged in actions in breach of the defendants' fiduciary duties to the Public Unitholders by proposing the merger. The plaintiffs alternatively sought an increase in the proposed merger consideration, unspecified compensatory damages and attorneys' fees. In December 1993, the parties reached a tentative settlement of the consolidated lawsuit. The terms of the settlement will not require a material payment by Energy or the Partnership. However, there can be no assurance that the settlement will be completed, or that it will be approved by the Chancery Court. In March 1993, two indirect wholly owned subsidiaries of Energy serving as general partners of two of VNGP, L.P.'s principal Subsidiary Operating Partnerships were served as third- party defendants in a lawsuit originally filed in 1991 by a subsidiary of The Coastal Corporation ("Coastal") against TransAmerican Natural Gas Corporation ("TANG"). In August 1993, Energy, VNGP, L.P. and certain of their respective subsidiaries were named as additional third-party defendants (collectively, including the original defendant subsidiaries, the "Valero Defendants") in this lawsuit. In its counterclaims against Coastal and third-party claims against the Valero Defendants, TANG alleges that it contracted to sell natural gas to Coastal at the posted field price of one of the Valero Defendants and that the Valero Defendants and Coastal conspired to set the posted field price at an artificially low level. TANG also alleges that the Valero Defendants and Coastal conspired to cause TANG to deliver unprocessed or "wet" gas, thus precluding TANG from extracting NGLs from its gas prior to delivery. TANG seeks actual damages of approximately $50 million, trebling of damages under antitrust claims, punitive damages of $300 million, and attorneys' fees. The General Partner believes that the plaintiff's claims have been exaggerated, and that Energy and the Partnership have meritorious defenses to such claims. In the event of an adverse determination involving Energy, Energy likely would seek indemnification from the Partnership under terms of the partnership agreements and other applicable agreements between VNGP, L.P., its subsidiary partnerships and their respective general partners. The Valero Defendants' motion for summary judgment on TANG's antitrust claims was argued on January 24, 1994. The court has not ruled on such motion. The current trial setting for this case is March 14, 1994. In September 1991, a lawsuit was filed by Valero Transmission, L.P. alleging breach of contract against a producer. On January 11, 1993, the defendant filed a cross- action against Valero Transmission, L.P., Valero Industrial Gas, L.P. and Reata Industrial Gas, L.P. The defendant asserted claims for actual damages for failure to pay for goods and services delivered. Additionally, the defendant asserted various other cross-claims, including conversion, breach of contract, breach of an alleged duty to market gas in good faith, tortious breach of a duty imposed by law and tortious negligence. The defendant sought actual damages aggregating not less than $1 million, injunctive relief, attorneys fees and costs, and exemplary damages in the amount of not less than $20 million. In January 1994, the parties reached a tentative settlement of the lawsuit on terms immaterial to the Partnership. The Partnership was a party to a lawsuit originally filed in 1988 in which Energy, Valero Transmission Company, VNGP, L.P., the Management Partnership and Valero Transmission, L.P. (the "Valero Defendants") and a subsidiary of Coastal were alleged to be liable for failure to take minimum quantities of gas, failure to make take-or-pay payments and other breach of contract and breach of fiduciary duty claims. The plaintiffs sought declaratory relief, actual damages in excess of $37 million and unspecified punitive damages. During the third quarter of 1992, the plaintiffs, Coastal and the Valero Defendants settled this lawsuit on terms which were not material to the Valero Defendants and on July 19, 1993, this lawsuit was dismissed. On November 16, 1992, prior to entry of the order of dismissal, NationsBank of Texas, N.A., as trustee for certain trusts (the "Intervenors"), filed a plea in intervention to intervene in the lawsuit. The Intervenors asserted that they held a non-participating mineral interest in the lands subject to the litigation and that their rights were not protected by the plaintiffs in the settlement. On February 4, 1993, the Court struck the Intervenors' plea in intervention. However, on February 2, 1993, the Intervenors had filed a separate suit in the 160th State District Court, Dallas County, Texas, against all prior defendants and an additional defendant, substantially adopting in form and substance the allegations and claims in the original litigation. In February 1994, the parties reached a tentative settlement of the lawsuit on terms immaterial to the Partnership. City of Houston Franchise Fee Audit In a letter dated September 1, 1993 from the City of Houston (the "City") to Valero Transmission Company ("VTC"), the City stated its intent to bring suit against VTC for certain claims asserted by the City under the franchise agreement between the City and VTC. VTC is the general partner of Valero Transmission, L.P. The franchise agreement was assigned to and assumed by Valero Transmission, L.P. upon formation of the Partnership in 1987. In the letter, the City declared a conditional forfeiture of the franchise rights based on the City's claims. In a letter dated October 27, 1993, the City claimed that VTC owes to the City franchise fees and accrued interest thereon aggregating approximately $13.5 million. In a letter dated November 9, 1993, the City claimed an additional $18 million in damages related to the City's allegations that VTC engaged in unauthorized activities under the franchise agreement by transmitting gas for resale and by transporting gas for third parties on the franchised premises. The City has not filed a lawsuit. The General Partner believes that the City's claims are significantly overstated and that VTC has a number of meritorious defenses to the claims. Any liability of VTC with respect to the City's claims has been assumed by the Partnership. Customer Audit of Transmission Transmission's Rate Order provides for Transmission to sell gas at its weighted average cost of gas, as defined ("WACOG"), plus a margin of $.15 per Mcf. In addition to the cost of gas purchases, Transmission's WACOG has included storage, gathering and other fixed costs totalling approximately $19 million per year, and amortization of deferred gas costs related to the settlement of take-or-pay and related claims (see Note 1 - "Other Assets" and "Take-or-Pay and Related Claims" above). Transmission's gas purchases include high-cost casinghead gas and certain special allowable gas that Transmission is required to purchase contractually and under the Railroad Commission's priority rules. Transmission's sales volumes have been decreasing with the expiration of its sales contracts including the July 1992 expiration of a contract representing approximately 37% of Transmission's sales volumes for the first six months of 1992. As a result of each of these factors, Transmission's WACOG and gas sales price are substantially in excess of market clearing levels. Transmission's WACOG has been periodically audited by certain of its customers, as allowed under the Rate Order. One such customer (the "Customer") questioned the application of certain of Transmission's current rate policies to future periods in light of the decreases that have occurred in Transmission's throughput, and the Customer has recently completed its audit of Transmission's WACOG with respect thereto. For 1993, the Customer represented approximately 70% of Transmission's sales volumes and such percentage is expected to increase as other sales contracts expire and are not renewed. As a result of the Customer's audit, Transmission and the Customer entered into a settlement agreement which excludes certain of the fixed costs described above from Transmission's WACOG, effective with July 1993 sales, resulting in a reduction of the Partnership's annual net income by approximately $6 million. Upon the termination of Transmission's gas sales contract with the Customer in 1998, Transmission's fixed costs, including storage (see Note 5), would be charged to income instead of recovered through its gas sales rates. Transmission expects to recover its deferred gas costs over a period of approximately eight years. The recovery of any additional payments made in connection with any future settlements would be limited. The Partnership is also a party to additional claims and legal proceedings arising in the ordinary course of business. The General Partner believes it is unlikely that the final outcome of any of the claims or proceedings to which the Partnership is a party, including those described above, would have a material adverse effect on the Partnership's financial position or results of operations; however, due to the inherent uncertainties of litigation, the range of possible loss, if any, cannot be estimated with a reasonable degree of precision and there can be no assurance that the resolution of any particular claim or proceeding would not have an adverse effect on the Partnership's results of operations for the fiscal period in which such resolution occurred. 7. QUARTERLY RESULTS OF OPERATIONS (Unaudited) The results of operations by quarter for the years ended December 31, 1993 and 1992 were as follows (in thousands of dollars, except per Unit amounts): SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. VALERO ENERGY CORPORATION (Registrant) By /s/ William E. Greehey (William E. Greehey) Chairman of the Board and Chief Executive Officer Date: March 1, 1994 POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears below hereby constitutes and appoints William E. Greehey, Stan L. McLelland and Rand C. Schmidt, or any of them, each with power to act without the other, his true and lawful attorney-in-fact and agent, with full power of substitution and resubstitution, for him and in his name, place and stead, in any and all capacities, to sign any or all subsequent amendments and supplements to this Annual Report on Form 10-K, and to file the same, or cause to be filed the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto each said attorney-in-fact and agent full power to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby qualifying and confirming all that said attorney-in-fact and agent or his substitute or substitutes may lawfully do or cause to be done by virtue hereof. 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 Director, Chairman of the Board and Chief Executive Officer (Principal /s/ William E. Greehey Executive Officer) March 1, 1994 (William E. Greehey) Senior Vice President and Chief Financial Officer (Principal Financial /s/ Don M. Heep and Accounting Officer) March 1, 1994 (Don M. Heep) /s/ Edward C. Benninger Director March 1, 1994 (Edward C. Benninger) /s/ Robert G. Dettmer Director March 1, 1994 (Robert G. Dettmer) /s/ A. Ray Dudley Director March 1, 1994 (A. Ray Dudley) /s/ James L. Johnson Director March 1, 1994 (James L. Johnson) /s/ Lowell H. Lebermann Director March 1, 1994 (Lowell H. Lebermann) /s/ Sally A. Shelton Director March 1, 1994 (Sally A. Shelton) Director (Philip K. Verleger, Jr.)
833053_1993.txt	833053	1993				ITEM 3. LEGAL PROCEEDINGS ASBESTOS-RELATED PERSONAL INJURY CLAIMS At December 31, 1993, Fibreboard was a defendant in approximately 57,800 personal injury claims. Approximately 14,600 of these claims were filed on or after August 27, 1993 and will be covered by the Global Settlement discussed below, if approved. Additional claims are anticipated in the future. These claims typically allege injury or death from asbestos exposure. Fibreboard is typically only one of several defendants. These claims seek compensatory, and in many cases, punitive damages in varying amounts depending on injury severity. Claims are pending in federal and state courts throughout the United States. During 1993 Fibreboard reached settlement agreements (the Global Settlement and Insurance Settlement) with its insurers and plaintiff representatives which, if approved by the courts, should resolve Fibreboard's existing and future asbestos-related personal injury liabilities within insurance resources and existing corporate reserves. These settlements require court approval (Gerald Ahearn, James Dennis and Charles W. Jeep, on Behalf of Themselves and Others Similarly Situated, Plaintiffs, v. Fibreboard Corporation, Defendant, Continental Casualty Company and Pacific Indemnity Company, Intervenors, Civil Action No. 6:93cv526, U.S. District Court for the Eastern District of Texas, Tyler Division). Additional information concerning personal injury claims can be found in Note 16 to Fibreboard's consolidated financial statements, "Asbestos-Related Litigation," which begins on page 40. ASBESTOS-IN-BUILDINGS CLAIMS At December 31, 1993, Fibreboard was a defendant in 21 asbestos-in-buildings claims pending in federal and state courts throughout the United States. Fibreboard is typically only one of several defendants. These claims involve many thousands of buildings and seek hundreds of millions of dollars in compensatory damages for expenses incurred for locating, testing and monitoring or removing asbestos-containing materials. Many claims also seek punitive damages. Additional information concerning Fibreboard's asbestos-in-buildings claims can be found in Note 16 to Fibreboard's consolidated financial statements, "Asbestos-Related Litigation," which begins on page 40. INSURANCE COVERAGE FOR PERSONAL INJURY CLAIMS Fibreboard is litigating with two insurers, Continental Casualty Company and Pacific Indemnity Company, to determine the amount of insurance available to Fibreboard under policies issued by these companies (In Re Asbestos Insurance Coverage Cases, Judicial Council Coordination Proceeding No. 107). The litigation has been completed at the trial court level, with judgments favoring Fibreboard on all issues. These judgments were appealed to the California Court of Appeal by the insurers. In November 1993, the Court of Appeal issued its ruling on the trigger and scope of coverage issues which upheld the favorable trial court judgments in these areas, except the court held the period for coverage would begin at the time of exposure to Fibreboard's asbestos products rather than at the time of exposure to any company's asbestos product, with the presumption that those periods are the same. The insurers have filed petitions for review with the California Supreme Court, which has granted review but not yet scheduled any further activity. At the request of Fibreboard, Continental and Pacific Indemnity, the Court of Appeal withheld its ruling on certain issues which were unique between Fibreboard and its insurers while the parties seek approval of the Global and Insurance Settlements. If the Global and/or Insurance Settlements are ultimately approved, Fibreboard and its insurers will seek to dismiss the insurance coverage litigation. Further information concerning this litigation can be found in Note 16 to Fibreboard's consolidated financial statements, "Asbestos-Related Litigation," which begins on page 40. INSURANCE COVERAGE FOR ASBESTOS-IN-BUILDINGS CLAIMS Fibreboard believes the total limits of insurance policies in effect from 1932 to 1985 which may provide coverage for the asbestos-in-buildings claims aggregate approximately $420 million, which is in addition to the bodily injury insurance coverage and does not include additional policies which contain no aggregate limit. A portion of this coverage was confirmed through settlements with certain insurers during 1993. As the remaining insurers dispute coverage, Fibreboard is pursuing an insurance coverage suit (Fibreboard vs. Continental Casualty, et al; Superior Court of the State of California for the City and County of San Francisco). Trial in this action has been continued. During the continuance, Fibreboard and its insurers are attempting to settle their disputes. Additional information concerning this litigation can be found in Note 16 to Fibreboard's consolidated financial statements, "Asbestos-Related Litigation," which begins on page 40. OTHER LITIGATION Fibreboard has been named as a potentially responsible party in two California landfill clean ups, the Operating Industries Inc. site in Monterey Park and the GBF landfill in Pittsburg and has been named as a defendant in a private lawsuit related to the Acme landfill in Martinez, CA. Additional information concerning Fibreboard's involvement can be found in Note 17 to Fibreboard's consolidated financial statements, "Other Litigation and Contingencies," on page 48. In March 1994, two purported class action lawsuits were filed in Delaware Chancery Court naming the Company and its directors as defendants (Sonem Partners Ltd., et al. v. Roach, et al., Civil Action No. 13411; Vogel v. Roach, et al., Civil Action No. 13421). Both lawsuits allege substantially similar causes of actions for breach of fiduciary duty relating to the recent amendment of Fibreboard's stockholder rights plan and Fibreboard's rejection of a March 1994 unsolicited proposal from Carl Pohlad of a merger with or an acquisition of Fibreboard. Both lawsuits seek injunctive relief and unspecified monetary damages. Fibreboard believes the purported class action suits are without merit and intends to defend them vigorously. Fibreboard is involved in a number of additional disputes arising from its operations. Fibreboard believes resolution of these disputes will not have a material adverse impact on its financial condition or results of operations. ITEM 4.	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not Applicable. EXECUTIVE OFFICERS OF THE REGISTRANT Information with respect to executive officers of Fibreboard follows: Officers serve at the discretion of the board of directors. Mr. Roach was elected Chairman, President and Chief Executive Officer of Fibreboard on July 2, 1991. Prior to his election, Mr. Roach was Executive Vice President of Manville Corporation, where he served as President of its Mining and Minerals Group and President of Celite Corporation, a wholly-owned Manville subsidiary. In addition, Mr. Roach served as President of Manville Sales Corporation and the Fiberglass and Specialty Products Groups from 1988 to 1989, and as Chief Financial Officer of Manville Corporation from 1987 to 1988. Prior to Manville, Mr. Roach was a strategy consultant and Vice Chairman of Braxton Associates; Vice President and Managing Director of the Strategic Management Practice for Booz, Allen, Hamilton; and Vice President and Director of The Boston Consulting Group. Previous experience at Northrop Corporation included Director of Strategic Planning, economic analysis, accounting, management information systems and co-manager of a venture capital subsidiary. Mr. Roach is a director of Magma Power Company. Mr. Donohue was elected Senior Vice President, Finance and Administration and Chief Financial Officer in October 1991. Prior to joining Fibreboard, he was an Executive Vice President of Continental Bank in Chicago where he held a wide variety of senior management positions during his 25 years with the bank. Mr. Douglas became General Counsel to Fibreboard in September 1987 and was elected Secretary in November 1990. He was named a Vice President in August 1991 and Senior Vice President in October 1993. From March 1986 to September 1987 he was employed by the Asbestos Claims Facility, of which Fibreboard was a member, as Senior Legal Counsel and then as Director of Law--West Coast Region. From 1982 to 1986 he was an attorney in the asbestos litigation group of Jim Walter Corporation. Mr. Costello has been Vice President, Wood Products Operations since December 1988. He previously was employed by Snider Lumber Products Co., Inc. from December 1983 until December 1988. Prior to December 1983, he was employed by Fibreboard for 14 years. Mr. Costello rejoined Fibreboard with the acquisition of Snider in October 1988, at which time he was president of Snider. Mr. Costello is First Vice Chairman of Western Wood Products Association, an industry group. Mr. DeMaria joined Fibreboard in May 1989 as Director--Corporate Communications and Investor Relations and was elected Vice President, Corporate Relations in August 1991. Prior to joining Fibreboard, he was Executive Vice President of the California Forest Protective Association, an industry trade association representing the interests of industrial timberland owners before the California legislature and regulatory agencies. Mr. Elliott was appointed General Manager of Pabco in October 1991 and was elected Vice President, Industrial Insulation Products in February 1992. Prior to joining Fibreboard, Mr. Elliott was a partner in Management Resource Partners, a professional management firm advising corporations on financial and operating matters and functioned as CEO, CFO or a director of companies with sales from $5-$50 million. Mr. Elliott has been CFO of Consolidated Fibers and Itel Corporation, Vice President Corporate Development of Alexander and Baldwin and a consultant for A.T. Kearney. Mr. Jensen joined Fibreboard in October 1991 as General Manager of Northstar-at-Tahoe and was elected Vice President in June 1993. From 1989 to 1992, Mr Jensen was Vice President of Marketing and Sales for Sunday River Ski Resort in Bethel, Maine. From 1986 to 1989, Mr Jensen was Vice President, Tracked Vehicles for Kassbohrer of North America, a manufacturer of ski resort snow grooming vehicles and equipment. Mr. Swan has been Controller of Fibreboard since October 1988, and was elected a Vice President in October, 1991. He previously was an Audit and Financial Consulting Manager in the Portland, Oregon office of Arthur Andersen & Co. PART II ITEM 5.	ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS As of March 21, 1994, there were 12,373 holders of record of Fibreboard common stock. Fibreboard's common stock is traded on the American Stock Exchange under the symbol FBD. Information with respect to the quarterly high and low market sales prices for Fibreboard's common stock for 1993 and 1992, based upon sales transactions reported by the American Stock Exchange, is provided below. Market Prices of Fibreboard Common Stock The closing price of Fibreboard's common stock on March 21, 1994 was $38 7/8. Since its spin-off from Louisiana-Pacific Corporation on June 6, 1988, Fibreboard has not paid cash dividends. Fibreboard's Structured Settlement Program contains restrictions on the amount of dividends or distributions to shareholders. At December 31, 1993, no amounts were available for the payment of dividends or other distributions. ITEM 6.	ITEM 6. SELECTED FINANCIAL DATA ITEM 7.	ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 1993 VS. 1992 Net sales increased 11%, reflecting increased wood products sales and resort operations revenues while sales of industrial insulation products were flat. Income from continuing operations was $11.7 million compared to $9.4 million in 1992. Operating profit increased in wood products and resort operations, but declined slightly in insulation products. WOOD PRODUCTS Wood products sales increased 12%, due principally to increased selling prices in all three major product lines while shipment volumes declined in lumber and plywood. Mill closures and manufacturing operations consolidations accounted for the majority of the lumber volume decline while softer demand impacted plywood shipments. Selling prices for many products reached record highs during the second quarter, before falling during the third quarter. Prices strengthened during the fourth quarter and have steadied during the first quarter of 1994. Wood products operating income increased from $17.3 million to $18.5 million. This improvement was due to price increases and manufacturing improvements offset by increased log costs and volume decreases. Price increases during the year were largely in response to timber and finished product shortage concerns, as timber supply continued to be more restricted and additional industry production capacity reductions were made during the year. Fibreboard believes it has adequate raw material on hand or under contract to operate its primary converting facilities at scheduled production levels through 1994 and into 1995. At year end 1993, Fibreboard had record log inventories which represent nearly 70% of anticipated log needs for 1994. However, these inventories were acquired when prices were relatively high. While Fibreboard expects solid operating performance during 1994, the higher costs of these inventories could keep margins from equaling the record levels attained in 1993. Future timber supply remains a strategic concern. Competition for the reduced timber available from the USFS has resulted in higher prices for those contracts where Fibreboard has been the successful bidder. Harvest rules announced in early 1993 for USFS timber in California, designed to provide protection to the California spotted owl for two years while further study is performed, are likely to further reduce the quantity of timber available for harvest. Fibreboard has responded to these concerns by pursuing non-traditional sources of raw materials. Examples include imported logs from New Zealand and Chile, cottonwood peeler logs from the Pacific Northwest and the acquisition of timber cutting rights on 4,800 acres in northern New Mexico. Fibreboard expects to continue pursuing alternative timber sources in the future, as well as evaluating various operating configurations available to respond most profitably to raw material constraints. In the past, timber supply concerns have resulted in increased sales prices for Fibreboard's wood products. While there can be no assurance, Fibreboard believes sales prices for its products will continue to increase should timber supply be further constrained. Continuing supply constraints should also enhance the value of Fibreboard's fee-owned timberlands. INDUSTRIAL INSULATION PRODUCTS Industrial insulation products sales were nearly unchanged between years. A lack of significant construction and maintenance activity in the petrochemical and power generation industries was offset by a modest increase in export sales activity. This low demand level is expected to continue into 1994. Operating income decreased to $5.4 million from $6.1 million in 1992. The decrease was caused by reduced average sales prices for molded insulation products, which were partially offset by continuing manufacturing improvements and tighter margins on sales of metal products. RESORT OPERATIONS Resort revenues increased from $20.4 million to $25.5 million on a 16% increase in skier visits. The increase in skier visits was a result of improved snowfall in the Sierra during the first quarter of 1993 compared to 1992. Northstar set records during 1993 in a number of areas, including skier days, meals served and lodging room nights. Operating income improved from $1.6 million to $2.3 million. This increase understates the significant improvements achieved at Northstar-at-Tahoe during the year, as the business unit operating income includes anticipated start-up and operating expenses at Sierra since its acquisition at the beginning of the second quarter in excess of revenues of approximately $1 million. Sierra is expected to contribute operating profits in future years. The Northstar improvement was due to the increase in skier visits, lower snowmaking costs due to increased snowfall, aggressive marketing and cost controls. Fibreboard believes Northstar's marketing campaign has resulted in increased market share among North Lake Tahoe ski resorts. GENERAL CORPORATE EXPENSES Unallocated costs declined from $11.9 million to $8.3 million, reflecting improvements resulting from the organizational restructuring completed during 1992 and reversal of certain contingency accruals no longer considered necessary, offset by higher incentive compensation tied to stock performance. In addition, 1992 costs include $1.0 million to increase the reserve for future landfill cleanup costs. ASBESTOS-RELATED COSTS The 1993 and 1992 results of operations do not include any asbestos-related costs. During 1993, $1.8 million of unreimbursed costs related to the asbestos litigation were incurred and charged against the reserve established in prior years. As more fully discussed in Note 16 to the consolidated financial statements, at December 31, 1991, Fibreboard estimated its potential liability for asbestos-related personal injury claims to be received through the end of the decade at $1,610 million and that it would ultimately receive insurance proceeds of $1,584 million related to those claims. Although Fibreboard, its insurers and plaintiffs' representatives entered into the Insurance and Global Settlements discussed elsewhere, Fibreboard does not believe these settlements impact its estimate of liability through the end of the decade, and no additional events have transpired which indicate these estimates should be changed. Consequently, no adjustment has been made to the estimated liability for personal injury claims through the end of the decade or anticipated insurance proceeds. Fibreboard will periodically evaluate its estimates and make adjustments as circumstances and future developments dictate. OTHER ITEMS Interest expense declined from $4.2 million to $3.6 million, due to lower rates on variable rate debt and lower aggregate borrowings. Interest and other income decreased from $7.7 million to $5.6 million. Other income included $2.4 million in 1992 resulting from the freezing of a defined benefit pension plan and gains from the sales of surplus real estate of $3.0 million in 1992 and $3.8 million in 1993. Interest income declined as lower amounts were available for investment at lower rates than in prior years. On July 1, 1993, Fibreboard adjusted the depreciable lives of its assets to more closely approximate their economic useful lives, resulting in a reduction of depreciation expense of $1.4 million during 1993. This expense reduction is included in the segment results discussed above. Fibreboard's effective tax rate was 41% in 1993 and 44% in 1992. Fibreboard adopted Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes (SFAS 109) on January 1, 1993. SFAS 109 requires an asset and liability approach for financial accounting and reporting for income taxes, and requires the recognition of the tax impact of certain items for which no income tax impact would have been provided in the past. Fibreboard recorded no adjustment of its tax accounts as a result of adopting SFAS 109. LIQUIDITY AND CAPITAL RESOURCES During 1993, Fibreboard generated cash flows from operations before working capital changes of $23.3 million, compared to $24.1 million in 1992. Non-cash working capital increased $30.6 million in 1993 versus $7.3 million in 1992, reflecting a significant buildup in inventories, primarily logs. Fibreboard believes it will continue to generate substantial cash flows from operations in the future, including the effect of a significant reduction of inventories during 1994. Fibreboard has a $40 million operating line of credit that can be used to support its operating cash needs and which expires in August 1994. Borrowings are limited to specified percentages of pledged eligible receivables and inventories. At December 31, 1993, borrowings were $17.7 million and $16.6 million remained available. Borrowings are limited in purpose to support business operations, prosecute the insurance coverage litigation and pay in-house asbestos claims management costs, but may not be used to pay defense or indemnity costs of asbestos-related claims. In addition, Fibreboard's resort operations have two revolving credit facilities, a $5 million operating credit line which expires May 31, 1995 and a $10 million reducing revolving line which expires May 31, 1998 and under which maximum availability is reduced by $1.4 million in April of each year. Fibreboard believes these facilities, combined with cash generated from on-going operations, will be adequate to fund existing operating cash needs. In anticipation of the expiration of its $40 million operating line of credit, Fibreboard has initiated discussions with a number of banks regarding a replacement facility. Fibreboard believes it will be able to secure a replacement facility which will have higher aggregate availability and lower borrowing costs. Fibreboard expects to finalize such a facility prior to the expiration of its current facility. In addition to working capital needs, Fibreboard anticipates primarily discretionary capital expenditures of approximately $6 million to $7 million during 1994. The planned capital expenditures are primarily for replacements and improvements of machinery and equipment and additional ski area amenities. Capital expenditures will be funded from operating cash flow and borrowings under Fibreboard's credit facilities as needed. Fibreboard has scheduled principal reductions of long-term debt due in 1994 of $4.8 million. Of this amount, Fibreboard will receive $1.0 million from notes receivable which have interest and payment terms identical to a like amount of Fibreboard's revenue bonds. In addition to cash needs related to continuing operations, Fibreboard must fund its on-going asbestos-related costs. To date, substantially all such costs, other than the cost of litigating insurance coverage issues, have been funded from insurance resources. At December 31, 1993, Fibreboard had $0.8 million in cash on hand restricted for asbestos-related uses. Fibreboard and Continental have entered into an interim agreement under which Continental agreed to make certain funds available for defense and indemnity costs associated with asbestos-related personal injury claims during the period pending final approval of the Global and/or Insurance Settlements discussed below, or if neither are approved, through the final conclusion of the insurance coverage litigation, however long that may take. Fibreboard believes the amounts to be paid by Continental under this interim agreement and amounts available under prior settlements with asbestos-in-buildings insurers will be adequate to satisfy its asbestos-related cash requirements as they come due. During 1993, Fibreboard and its insurers entered into the Insurance Settlement Agreement, and Fibreboard, its insurers and plaintiffs representatives entered into the Global Settlement Agreement. These agreements are interrelated. Final court approval of these agreements is required. Fibreboard believes trial court approval could occur during 1994, but if appealed, it may be 1995 or later before final court approval could be obtained. If both the Global and Insurance Settlement Agreements are approved, Fibreboard believes its existing and future personal injury asbestos liabilities will be resolved through insurance resources and existing corporate reserves. If the Insurance Settlement is approved but the Global Settlement is not approved, the insurers will provide Fibreboard with up to $2 billion to resolve claims pending as of August 27, 1993 and all future claims, and will pay claims settled but not yet paid as of August 27, 1993. In November 1993, the California Court of Appeal issued its rulings on the trigger and scope of coverage issues before it, confirming the trial court judgments, except the court held the period for coverage would begin at the time of exposure to Fibreboard's asbestos products rather than at the time of exposure to any company's asbestos product, with the presumption that those periods are the same. The court withheld ruling on the unique issues between Fibreboard and its insurers at the request of the parties. The insurers have filed petitions for review of the Court of Appeal rulings with the California Supreme Court, which has granted review, but not yet scheduled any further activity. In the event the Global and/or Insurance Settlements are approved by the court, Fibreboard and its insurers will seek to dismiss their insurance coverage disputes. Fibreboard believes it is probable its insurance coverage for personal injury claims will ultimately be confirmed on appeal or the settlements discussed above will be approved by the court. However, if neither the Global Settlement nor Insurance Settlement is approved and if the trial court decisions in the insurance coverage litigation are subsequently overturned or substantially modified on appeal, Fibreboard would not have adequate resources to fund its asbestos personal injury liabilities. 1992 VS. 1991 Net sales increased 2%, primarily from increased wood products sales as increased resort operations revenues were nearly offset by a decline in industrial insulation products sales. Income from continuing operations was $9.4 million compared to a loss of $29.3 million in 1991. Operating profit increased in each of the business segments. Further, there were no unusual charges in 1992, whereas unusual items and asbestos-related pre-tax charges of $33.9 million were recorded in 1991. WOOD PRODUCTS Wood products sales increased 3%, due principally to increased selling prices for lumber and millwork products, countered by reduced shipments of all products except hardwood plywood. Mill closures and manufactur-ing operations consolidations accounted for the majority of the volume declines. Selling prices for many products reached record highs during the second quarter, before falling during the third quarter. Prices strengthened during the fourth quarter. Wood products operating income increased from $11.5 million to $17.3 million. This improvement was due to price increases and manufacturing improvements resulting from an operational restructuring begun in 1991 and completed in 1992. Price increases during the year were largely in response to timber shortage concerns, as demand was less than robust. Raw material costs increased during the second half of 1992 following finished product price increases, and were further increased by competitive pressures caused by timber supply concerns. INDUSTRIAL INSULATION PRODUCTS Industrial insulation products sales declined 5% from 1991 levels, primarily due to reduced shipment volumes and slightly lower sales prices for molded insulation products. Reduced sales activity reflects a lack of significant construction and maintenance activity in the petrochemical and power generation industries. Despite reduced sales, operating income increased to $6.1 million from $4.5 million in 1991. This improvement reflects operating efficiencies gained in the molded insulation operations, tight cost controls in the metals operations and production improvements in the manufacture of industrial fireproofing board. RESORT OPERATIONS Resort revenues increased from $16.7 million to $20.4 million on a 22% increase in skier visits. The increase in skier visits was a result of improved snowfall in the Sierra during the first quarter of 1992 compared to 1991. In addition, a new record for golf rounds was set during the summer. Operating income improved from $0.1 million to $1.6 million. The improvement was due to the increase in skier visits and summer activity, aggressive marketing and cost controls. GENERAL CORPORATE EXPENSES Unallocated costs declined from $12.2 million to $11.9 million. However, on a comparative basis, the reduction was more significant as 1992 costs include $1.0 million to increase the reserve for future landfill cleanup costs and increased incentive compensation costs of $1.7 million when compared to 1991. ASBESTOS-RELATED COSTS During 1992, $4.7 million of unreimbursed costs related to the asbestos litigation were incurred and charged against the reserve established in prior years. The 1992 results of operations do not include any amounts for asbestos-related costs. As more fully discussed in Note 16 to the consolidated financial statements, at December 31, 1991, Fibreboard estimated its potential liability for asbestos-related personal injury claims to be received through the end of the decade at $1,610 million and that it would ultimately receive insurance proceeds of $1,584 million related to those claims. As a result, a $20 million increase in an existing reserve for unreimbursed asbestos costs was recorded. During 1992, no events transpired which indicated these estimates should be changed. Consequently, no adjustment was made to the estimated liability for personal injury claims through the end of the decade or anticipated insurance proceeds. OTHER ITEMS Interest expense declined from $5.3 million to $4.2 million, due to lower rates on variable rate debt and lower aggregate borrowings. Interest and other income increased from $3.2 million to $7.7 million. Other income included $2.4 million resulting from the freezing of a defined benefit pension plan and $3.0 million of gain from the sales of surplus real estate. Interest income declined as lower amounts were available for investment at lower rates than in prior years. Fibreboard's effective tax rate for continuing operations was 44% in 1992 and 15% in 1991. The low effective tax rate in 1991 was due to the non-deductible nature of a sizeable portion of the restructuring charges recorded during the year as well as resolution of a tax dispute with Fibreboard's former parent. IMPACT OF INFLATION Inflation has not had any significant impact on Fibreboard's operations during the three years ended December 31, 1993. ITEM 8.	ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEX TO FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA FIBREBOARD CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME SEE ATTACHED NOTES TO FINANCIAL STATEMENTS FIBREBOARD CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS SEE ATTACHED NOTES TO FINANCIAL STATEMENTS FIBREBOARD CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS SEE ATTACHED NOTES TO FINANCIAL STATEMENTS FIBREBOARD CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED) FIBREBOARD CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS CONTINUED SEE ATTACHED NOTES TO FINANCIAL STATEMENTS FIBREBOARD CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY SEE ATTACHED NOTES TO FINANCIAL STATEMENTS FIBREBOARD CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLAR AMOUNTS IN THOUSANDS) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF PRESENTATION The consolidated financial statements include the accounts of Fibreboard Corporation, a Delaware Corporation, and all its wholly-owned subsidiaries (collectively Fibreboard) after elimination of intercompany balances and transactions. EARNINGS PER SHARE Net earnings per common and common equivalent share are calculated using the weighted average number of common shares outstanding during the year plus the net additional number of shares which would be issuable upon the exercise of stock options, assuming Fibreboard used the proceeds received to purchase additional shares at market value. The effect of common stock equivalents was not material in 1992 and 1991. CASH AND CASH EQUIVALENTS Fibreboard utilizes a centralized cash management system to minimize the amount of cash on deposit with banks and maximize interest income from amounts not required for immediate disbursement. Cash includes cash on hand or in banks available for immediate disbursal. Cash equivalents are short-term investments that have an original maturity date of less than 90 days. INVENTORY VALUATION Inventories are valued at the lower of cost (first-in, first-out) or market. Inventory costs include material, labor and operating overhead. Operating supplies are priced at average cost. Inventories are valued as follows: TIMBER Fibreboard follows an overall policy on fee timber that amortizes timber costs over the total fiber available during the estimated growth cycle. Timber carrying costs are expensed as incurred. PROPERTY, PLANT AND EQUIPMENT Fibreboard uses the units of production method of depreciation for most machinery and equipment which amortizes the cost of equipment over the estimated number of units that the equipment will be able to produce during its useful life. Provisions for depreciation of buildings and the remaining machinery and equipment have been computed using straight-line rates based upon the estimated service lives (5-30 years) of the various units of property. FIBREBOARD CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLAR AMOUNTS IN THOUSANDS) Fibreboard capitalizes interest on borrowed funds incurred during construction periods. Capitalized interest is amortized over the lives of the related assets. Interest capitalized in 1993, 1992 and 1991 was $183, $142 and $0. Fibreboard capitalizes logging road construction costs as part of "Land and Improvements." These costs are amortized as the timber volume adjacent to the road system is harvested. On July 1, 1993, Fibreboard adjusted the depreciable lives of its assets to more closely approximate their useful lives, resulting in a reduction of depreciation expense of $1,437. INCOME TAX POLICIES The income tax provision (benefit) includes the following: Income taxes are allocated to the components of income as follows: The following table summarizes the differences between the statutory federal and effective tax rate: In 1993, the Omnibus Budget Reconciliation Act of 1993 was signed into law increasing the federal tax rate from 34% to 35%. Effective January 1, 1993, the Company implemented the provisions of Statement of Accounting Standards No. 109, Accounting for Income Taxes (SFAS 109). SFAS 109 utilizes the liability method and FIBREBOARD CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLAR AMOUNTS IN THOUSANDS) deferred taxes are determined based on the estimated future tax effects of differences between the financial statements and tax bases of assets and liabilities given the provisions of the enacted tax laws. The adoption of SFAS 109 had no effect on reported net income in the Consolidated Statements of Income. Prior to the implementation of SFAS 109, the Company accounted for income taxes using Accounting Principles Board Opinion No. 11, Accounting for Income Taxes (APB 11). The following table summarizes the major components of the provision (benefit) for deferred taxes under APB 11 which resulted from timing differences in the recognition of income and expense for financial reporting and tax purposes: The tax effect of significant temporary differences representing deferred tax assets and liabilities are as follows: FIBREBOARD CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLAR AMOUNTS IN THOUSANDS) 2. RECEIVABLES 3. ACCOUNTS PAYABLE AND ACCRUED LIABILITIES Fibreboard is self-insured for the majority of its workers' compensation benefits. Workers' compensation expense was $1,074, $1,836 and $2,384 in 1993, 1992 and 1991 based on actual and estimated claims incurred. 4. NOTES PAYABLE At December 31, 1993, Fibreboard has a $40,000 operating line of credit facility. This facility is secured by a substantial majority of Fibreboard's receivables, inventories and machinery and equipment. The facility expires in August 1994. Maximum borrowings are limited to a calculated availability based upon levels of eligible receivables and inventories. At December 31, 1993, borrowings were $17,657 with an additional $16,576 available, net of $5,599 in standby letters of credit. Borrowings under the facility carry interest at the prime rate plus 2 1/2% (8 1/2% at December 31, 1993). The agreement requires that Fibreboard maintain certain financial ratios and other covenants and prohibits the use of borrowings to pay defense and indemnity costs of asbestos-related claims. At December 31, 1993, Fibreboard was in compliance with the requirements of this credit facility. During 1993, Fibreboard secured a $5,000 operating line of credit dedicated for the seasonal cash needs of its resort operations. Borrowings under the facility carry interest at the prime rate plus 1/4% (6 1/4% at December 31, 1993). The facility expires May 31, 1995. At December 31, 1993, no amounts were outstanding. FIBREBOARD CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLAR AMOUNTS IN THOUSANDS) 5. LONG-TERM DEBT Fibreboard's long-term debt not associated with asbestos consists of the following: Required repayment of long-term debt is as follows: FIBREBOARD CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLAR AMOUNTS IN THOUSANDS) Fibreboard has notes receivable with terms and payment dates which are substantially identical to $6,875 of revenue bonds included in the above table. Payments under these notes are as follows: Fibreboard's loan agreements contain various financial covenants. At December 31, 1993, these covenants were met. Fibreboard's asbestos related long-term debt consists of the following and is due upon conclusion of the asbestos bodily injury insurance coverage litigation. In the event Fibreboard prevails in the insurance coverage litigation, the amounts will be repaid from insurance proceeds. 6. FAIR VALUE OF FINANCIAL INSTRUMENTS The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value: CASH AND SHORT-TERM INVESTMENTS Carrying amount approximates fair value because of the short maturity of these investments. NOTES RECEIVABLE Fair value of notes receivable is estimated by discounting future cash flows using current rates at which similar loans would be made. NOTES PAYABLE TO BANKS Carrying amount approximates fair value based on current rates offered to the corporation for similar debt. LONG-TERM DEBT Fair market value is estimated by discounting the future cash flows using the current rates at which similar debt could be placed. FIBREBOARD CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLAR AMOUNTS IN THOUSANDS) The estimated fair values of financial instruments are as follows: Fibreboard's consolidated balance sheets include financial instruments resulting from the asbestos-related litigation, asbestos costs to be reimbursed, asbestos claims settlement obligations and asbestos-related long-term debt. These are unique financial instruments. Consequently, these instruments are not traded nor is it likely a willing buyer could be found for them. Therefore, it is not practicable to estimate a market value. The balance sheets as of December 31, 1993 and 1992 reflects asbestos costs to be reimbursed of $968,309 and $820,085, asbestos claims settlements of $952,928 and $798,724 and asbestos-related long-term debt of $21,361 and $20,572. 7. PENSION PLANS Fibreboard has pension plans covering substantially all employees. Contributions to a frozen defined benefit plan are based on actuarial calculations of amounts necessary to cover current cost and amortization of prior service cost over periods ranging from 10 to 20 years. All benefits accrued under this plan are fully vested. Contributions to defined contribution plans are nondiscretionary and based on varying percentages of eligible compensation for the year. The status of Fibreboard's frozen defined benefit pension plan at December 31, 1993 and 1992 is as follows: FIBREBOARD CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLAR AMOUNTS IN THOUSANDS) The actuarial assumptions used to determine accrued pension expense and the funded status of the plans for 1993 were: 7.5% discount rate on benefit obligations and a 8% expected long-term rate of return on plan assets. The assets of the plan at December 31, 1993 and 1992 consist of bonds, both corporate and government, stocks, cash and cash equivalents. As required by Statement of Accounting Standards No. 87, Employers' Accounting for Pensions, Fibreboard has recognized a minimum pension liability associated with its frozen defined benefit plan. As a result, Fibreboard recorded an after tax reduction in equity of $2,427 at December 31, 1993 and $1,439 at December 31, 1992. Pension expense for 1993, 1992 and 1991 included the following components: On December 31, 1992, a defined benefit pension plan with assets in excess of obligations was frozen, resulting in a curtailment gain of $2,353. The assets of the plan were merged with Fibreboard's other defined benefit pension plan. The curtailment gain is reflected as a component of interest and other income in the Consolidated Statements of Income. Beginning January 1, 1993, active employees are covered by a defined contribution pension plan. 8. NON-PENSION POST-RETIREMENT BENEFITS Through 1992, Fibreboard provided post-employment benefits to employees who met certain requirements until they reached age 65. The benefits provided were mainly health care and dental. This benefit was discontinued for employees who retired after December 31, 1992. However, post-employment benefits are available to certain collective bargaining units of facilities which have been sold. On January 1, 1991, Fibreboard adopted Statement of Financial Accounting Standards No. 106, Employers' Accounting for Post Retirement Benefits Other than Pensions, and recorded the full transition obligation. Fibreboard does not hold any assets to fund the obligation. FIBREBOARD CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLAR AMOUNTS IN THOUSANDS) The status of Fibreboard's non-pension post retirement benefits at December 31, 1993 and 1992 are as follows: A 16% annual rate of increase in the per capita cost of covered health care benefits was assumed for 1993. The cost trend rate was assumed to decrease slightly until 2003 at which time the rate was assumed to stabilize at 7%. Increasing the assumed health care cost trend rates by 1% in each year would increase the accumulated post retirement benefit obligation as of December 31, 1993 by $185 and the aggregate of the service and interest cost components of net periodic post retirement cost for the year then ended by $60. The weighted average discount rate used in determining the accumulated post retirement benefits was 7.5%. 9. STOCK OPTION AND STOCK PURCHASE PLANS Fibreboard has a stock option and rights plan for certain officers, directors and key employees. The plan provides for the granting of stock options, stock appreciation rights, limited stock appreciation rights and restricted stock awards. Awards under the plan are determined by the compensation committee of the Board of Directors. The maximum number of shares available for award under the plan is 800,000. Option prices are set by the committee. Option prices for grants must be at least 85% of the fair market value on the date of grant. The time limit within which options may be exercised and other exercise terms are fixed by the committee. When stock options are exercised, the proceeds (including any tax benefits to Fibreboard resulting from the exercise) are credited to the appropriate common stock and additional paid-in capital accounts. Compensation related to restricted stock awards and certain option grants (measured at the grant date) is recognized as expense over the term of the related award. At December 31, 1993, options to purchase 499,400 shares at prices from $2.83 to $14.25 were outstanding. Options exercised in 1993 were 59,120. At December 31, 1993, options to purchase 486,650 shares were immediately exercisable. Options becoming exercisable in 1994 are 12,750. Option awards for 42,000 shares include limited stock appreciation rights for a like number of shares. Each limited stock FIBREBOARD CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLAR AMOUNTS IN THOUSANDS) appreciation right entitles the holder, in certain limited circumstances, to surrender the underlying option in exchange for cash equal to the difference between fair market value at the date of surrender and the option price for such shares. At December 31, 1993, restricted stock awards of 45,000 shares were outstanding. The shares awarded will be issued 23,000 shares in 1994, 7,000 shares in 1995 and 15,000 in 1996 provided the grantee is employed continuously through the issue date. In addition, Fibreboard has an employee stock purchase plan. The plan allows employees to purchase Fibreboard stock with an aggregate purchase price of up to 15% of the employee's base salary at the beginning of each purchase period. The purchase price shall be the lesser of 85% of fair market value at the beginning of each purchase period or 85% of fair market value at the actual purchase date. The maximum number of shares issuable under the plan is 250,000. During 1993, 1992 and 1991, 0, 17,360 and 61,497 shares of Fibreboard stock were sold to employees under this plan. In 1993, Fibreboard adopted a long-term equity incentive plan, which provides for awards of phantom stock units. Each phantom stock unit entitles the grantee to a cash payment equal to the fair market value of one share of Fibreboard common stock at the maturity date less the fair market value on the grant date. At December 31, 1993, 126,400 phantom stock units had been awarded, which mature 47,400 units in 1995 and 79,000 units in 1996. Compensation expense recognized for these plans was $1,039, $517 and $308 in 1993, 1992 and 1991. 10. PREFERRED STOCK PURCHASE RIGHTS In 1988, Fibreboard implemented a stockholder rights plan and distributed to stockholders one preferred share purchase right for each share of Fibreboard common stock then outstanding. Under the rights plan, as amended in 1994, each right entitles the registered holder to purchase from Fibreboard 1/100th of a share of Series A Junior Participating Preferred Stock at an exercise price of $106 per 1/100th share, subject to adjustment. The rights will not be exercisable until a party acquires beneficial ownership of 15% or more of Fibreboard's then outstanding common shares. The rights, which do not have voting rights, expire in February 2004 and may be redeemed in whole by Fibreboard, at its option, at a price of $.01 per right prior to the expiration or exercise of the rights. In the event Fibreboard is acquired in an unsolicited merger or other business combination transaction, each right will entitle the holder to receive, upon exercise of the right, common stock of the acquiring company having a market value of two times the then current exercise price of the right. In the event a party acquires 15% or more of Fibreboard's outstanding common shares, each right will entitle the holder to receive upon exercise Fibreboard common shares having a market value of two times the exercise price of the right. FIBREBOARD CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLAR AMOUNTS IN THOUSANDS) 11. COMMITMENTS Fibreboard is obligated to purchase timber under cutting contracts, primarily with the U.S. Forest Service, which extend to 1996. The table below presents Fibreboard's best estimate of its commitment under timber cutting contracts by year of contract expiration: Fibreboard leases certain office space and machinery and equipment under operating leases which expire within five years and for which minimum lease payments are as follows: In addition, the Company leases property from the U.S. Forest Service for one of its resort operations. Lease payment terms are based on a percentage of revenues. Total rent expense for all operating leases amounted to $2,194, $1,753 and $1,812 in 1993, 1992 and 1991. FIBREBOARD CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLAR AMOUNTS IN THOUSANDS) 12. INDUSTRY SEGMENT INFORMATION Information about Fibreboard's industry segments is set forth below. FIBREBOARD CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLAR AMOUNTS IN THOUSANDS) 13. UNUSUAL ITEMS Fibreboard's results of operations include the following unusual items: During 1991, Fibreboard recognized an anticipated $3,925 loss related to the closure and disposition of its manufacturing facilities located in Turlock and Wallace, CA. The Turlock facility was closed to complete a realignment of the wood products operating facilities while the Wallace facility was closed in response to timber supply constraints. Fibreboard previously recorded goodwill associated with acquisitions made in 1988 and 1989. Based upon historical operating results, Fibreboard concluded in 1991 that there was no future value to the goodwill associated with these transactions. Accordingly, the remaining unamortized balance of goodwill was written off. 14. DISCONTINUED OPERATIONS During 1991, Fibreboard terminated operations of its Roxboro, NC engineered lumber manufacturing facility. The net loss through closing of $3,792 has been reflected as discontinued. In addition, the assets of the facility were written-down to net realizable value and a reserve established for ongoing costs which resulted in an additional net loss of $10,851. Sales and losses before taxes for discontinued operations in 1991 were $3,589 and ($23,244). During 1993, this facility with net assets of $2,193 was sold at a gain of $665, which is reflected as a component of "Interest and other income" in the Consolidated Statements of Income. 15. ACQUISITIONS AND DISPOSITIONS In July 1993, Fibreboard acquired the net assets of Sierra Ski Ranch, a ski facility located in California, for $13,054. The acquisition was accounted for as a purchase of assets. The ski area was subsequently renamed Sierra-at-Tahoe. Subsequent to December 31, 1993, Fibreboard sold its agricultural container manufacturing facilities located in Fresno, CA in order to concentrate its resources on the primary wood products and remanufacturing businesses. FIBREBOARD CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLAR AMOUNTS IN THOUSANDS) 16. ASBESTOS-RELATED LITIGATION CONTINGENT LIABILITY FOR ASBESTOS-RELATED CLAIMS OVERVIEW: Fibreboard's ability to continue operations outside of bankruptcy protection has been dependent upon its ongoing capability to fund asbestos-related defense and indemnity costs. Prior to 1972, Fibreboard manufactured insulation products containing asbestos. Fibreboard has since been named as a defendant in many thousands of personal injury claims for injuries allegedly caused by asbestos exposure and in asbestos-in-buildings actions involving many thousands of buildings. Fibreboard believes it has unique insurance coverage for personal injury claims, as the trial court has held (with the issue on appeal) that claims with initial exposure to asbestos prior to 1959 are covered by two no-aggregate-limit policies. During 1993, Fibreboard and its insurers entered into the Insurance Settlement Agreement, and Fibreboard, its insurers and plaintiffs representatives entered into the Global Settlement Agreement. These agreements are interrelated. Final court approval of these agreements is required. Fibreboard believes trial court approval could occur during 1994, but if appealed, it may be 1995 or later before final court approval could be obtained. If both the Global and Insurance Settlement Agreements are approved, Fibreboard believes its existing and future personal injury asbestos liabilities will be resolved through insurance resources and existing corporate reserves. If the Insurance Settlement is approved but the Global Settlement is not approved, the insurers will provide Fibreboard with up to $2,000,000 to resolve claims pending as of August 27, 1993 and all future claims, and will pay claims settled but not yet paid as of August 27, 1993. CLAIMS ACTIVITY: Fibreboard has already resolved 132,200 personal injury claims for approximately $1,521,100, not including legal defense costs. Substantially all of the settlements have been achieved through 1) payments by Fibreboard's insurers; 2) assignments of Fibreboard's rights to insurance payments; or 3) deferring payments pending resolution of the personal injury insurance coverage litigation discussed below. An additional 23,900 claims have been disposed of at no cost to Fibreboard other than legal defense costs. At December 31, 1993, Fibreboard estimates that approximately 57,800 claims have been filed against it which remain unresolved. Approximately 14,600 of these claims were initially filed against Fibreboard on or after August 27, 1993 and will be covered by the Global Settlement, if approved. Fibreboard is unable to determine the exact number of claims that may be filed in the future, although the number is expected to be substantial. Fibreboard has achieved excellent results in resolving asbestos-in-buildings actions. At December 31, 1993, of the 151 actions served against it, Fibreboard has been dismissed from 126 (31 of which joined the National Schools class action), settled or agreed to settle five for $2,020, tried one to a defense verdict and remains a defendant in 21 actions. In one of the remaining actions, Fibreboard won a defense verdict on product identification and cost of abatement issues, although further proceedings are scheduled. FIBREBOARD CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLAR AMOUNTS IN THOUSANDS) The following tables illustrate asbestos-related claims activity for the last three years: FIBREBOARD CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLAR AMOUNTS IN THOUSANDS) INSURANCE COVERAGE FOR PERSONAL INJURY CLAIMS: During 1993, Fibreboard entered into a settlement agreement with Continental Casualty Company (Continental) and Pacific Indemnity Company (Pacific) (the Insurance Settlement). In addition, Fibreboard, Continental, Pacific and plaintiffs' representatives entered into a settlement agreement (the Global Settlement). These agreements are interrelated. Final court approval of the agreements is required. Fibreboard believes trial court approval could occur during 1994, but if appealed, it may be 1995 or later before final court approval could be obtained. If both the Global Settlement and Insurance Settlement are approved, Fibreboard believes its existing and future personal injury asbestos liabilities will be resolved through insurance resources and existing corporate reserves. Fibreboard will contribute $10,000 toward a $1,535,000 settlement trust, which it will obtain from other remaining insurance sources and existing reserves. The remainder of the trust will be funded by Continental and Pacific (at December 31, 1993, the insurers had placed $1,525,000 in an escrow account pending court approval of the settlements). The trust will be used to compensate "future" plaintiffs, defined as those plaintiffs who had not filed a claim against Fibreboard before August 27, 1993. Such future plaintiffs only source of compensation will be the trust, as an injunction will be entered prohibiting future claims against Fibreboard or the insurers. If the Global Settlement is not approved, but the Insurance Settlement is approved, the insurers will instead provide Fibreboard with up to $2,000,000 to resolve pending and future claims and will pay the deferred payment portion of existing settled claims. While Fibreboard is optimistic, there is no assurance final court approval of either the Global Settlement or the Insurance Settlement can be obtained. If neither the Global Settlement nor the Insurance Settlement is approved, the parties will be bound by the outcome of the insurance coverage litigation, unless other settlements are reached. All insurance proceeds due from other insurers under previous settlements have been received with the exception of approximately $10,000 from Home Insurance (Home). Fibreboard intends to draw these funds for substantially all of its contribution to the Global Settlement if approved. In the event the settlements discussed above are not approved, Fibreboard believes it has substantial insurance coverage for asbestos-related defense and indemnity costs. Fibreboard's disputes with Continental and Pacific have been the subject of litigation which began in 1979. Trial court judgments rendered in 1990 give Fibreboard virtually unlimited insurance coverage for asbestos-related personal injury claims where the initial exposure to asbestos occurred prior to March 1959. Under the judgments, these insurers can be required to pay up to $500 for each occurrence (defined as each individual claim) with no limitation on the aggregate number of occurrences. The insurers appealed to the California Court of Appeal. Among other issues, Continental disputed the definition of an occurrence under its policy as well as the trigger and scope of coverage as determined by the trial court, while Pacific argued that its policy contained an aggregate limit as well as disputing the trigger and scope of coverage issues. In November 1993, the Court of Appeal issued its ruling on the trigger and scope of coverage issues, confirming the favorable trial court judgments, except the court held the period for coverage would begin at the time of exposure to Fibreboard's asbestos products rather than at the time of exposure to FIBREBOARD CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLAR AMOUNTS IN THOUSANDS) any company's asbestos product, with the presumption that these periods are the same. The insurers have filed petitions for review with the California Supreme Court, which has granted review but not yet scheduled any further activity. At the request of Fibreboard, Continental and Pacific, the Court of Appeal withheld its ruling on the remaining issues while the parties seek approval of the Global and Insurance Settlements. If the Global and/or Insurance Settlements are ultimately approved, Fibreboard and its insurers will seek to dismiss the insurance coverage litigation. Fibreboard has entered into an interim agreement with Continental under which Continental agreed to provide a full defense to Fibreboard on pre-1959 claims and make certain funds available as needed to pay currently due Structured Settlement Obligations and other personal injury defense costs for which Fibreboard does not otherwise have insurance available during the period pending final approval of the Global and/or Insurance Settlement, or if neither is approved, through the ultimate conclusion of the insurance coverage appeal, however long that may take. In exchange for the benefits provided under this agreement, Fibreboard agreed not to settle additional pre-1959 personal injury claims without Continental's consent. If neither the Global Settlement nor the Insurance Settlement are approved and Fibreboard prevails in the appeal of the insurance coverage litigation, Continental has agreed to provide Fibreboard with $315,000 to $425,000 to resolve personal injury claims alleging first exposure to asbestos after March 1959, less any amounts Fibreboard recovers from the Pacific settlement described below. Continental would also continue to have responsibility for all pre-1959 personal injury claims against Fibreboard up to $500 per claim. In March 1992, Fibreboard and Pacific entered into a settlement agreement (the Pacific Agreement). If the Global Settlement or Insurance Settlement is approved, the Pacific Agreement will be of no effect. If neither of the settlements is approved, the Pacific Agreement establishes amounts payable to Fibreboard if the trial court judgments are upheld. Fibreboard received $10,000 upon signing the agreement and received an additional $10,000 during 1993. In addition, if the judgments are affirmed on appeal, Fibreboard will receive from $80,000 to $105,000 to be used for claims costs for which it does not otherwise have insurance. In the event the trigger and scope of coverage judgments are reversed on appeal, Pacific will owe Fibreboard nothing and will have a right to repayment of interim funds previously advanced. Fibreboard believes amounts available under the settlements discussed above will be adequate to fund defense and indemnity costs until the insurance coverage appeal is concluded, whether as a result of the final approval of the Global and/or Insurance Settlements or the final resolution of the insurance coverage litigation. LIABILITY QUANTIFICATION: At the end of 1991, Fibreboard attempted to quantify its liability for asbestos-related personal injury claims then pending as well as anticipated to be received through the end of the decade. There are many opportunities for error in such an exercise. Assumptions concerning the number of claims to be received, the disease mix of pending and future claims and projections of defense and indemnity costs may or may not prove correct. Fibreboard's assumptions are based on its historical experience, modified as appropriate for anticipated demographic changes or changes in the litigation environment. FIBREBOARD CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLAR AMOUNTS IN THOUSANDS) Notwithstanding the inherent risk of significant error in such a calculation, Fibreboard estimated that the amount necessary to defend and dispose of asbestos-related personal injury claims pending at December 31, 1991 and anticipated through the end of the decade plus the costs of prosecuting its insurance coverage litigation would aggregate $1,610,000. Because of the dynamic nature of this litigation, it is more difficult to estimate how many personal injury claims will be received after 1999 as well as the costs of defending and disposing of those future claims. Consequently, Fibreboard's estimated liability contains no amounts for personal injury claims received after the end of the decade, although it is likely additional claims will be received thereafter. Fibreboard believes it is probable that it will ultimately receive insurance proceeds of $1,584,000 for the defense and disposition of the claims quantified above. Fibreboard's opinion is based on its understanding of the disputed issues, the financial strength of the insurers and the opinion of outside legal counsel regarding the outcome of the litigation. As a result, Fibreboard recorded a liability, net of anticipated insurance proceeds, of $26,000 at December 31, 1991, representing its best estimate of the unreimbursed cost of resolving personal injury claims then pending and anticipated through the remainder of the decade as well as the costs of prosecuting the insurance coverage litigation. Although there likely will be claims filed beyond the end of the decade, these have not been estimated. During 1993 and 1992, unreimbursed costs of $1,802 and $4,729 were charged against this reserve. Although Fibreboard, its insurers and plaintiffs' representatives entered into the Insurance and Global Settlements discussed above, Fibreboard does not believe these settlements impact its estimate of liability through the end of the decade, and no additional events have transpired which indicate the potential liability and insurance proceeds estimates should be changed. Consequently, no adjustment has been made to the estimated liability for personal injury claims through the end of the decade or anticipated insurance proceeds. Fibreboard will continue to reevaluate its estimates and will make adjustments to the effect dictated by changes in the personal injury litigation. ASBESTOS-IN-BUILDINGS LIABILITIES: Fibreboard does not believe it is presently possible to reasonably estimate potential liabilities for asbestos-in-buildings claims, if any. Fibreboard believes that its asbestos-containing products, properly used, cause no damage to buildings. Further, Fibreboard can frequently identify its asbestos-containing products and aggressively pursues dismissals of claims where its products are not identified. To date, Fibreboard has been very successful in obtaining dismissals, and has won the only trial which went to verdict and won a defense verdict on product identification and cost of abatement issues in another trial in which further proceedings are scheduled. Fibreboard has only paid nominal amounts for settlement of two asbestos-in-buildings claims in prior years, although it did settle three claims during 1993, including settlement agreements in the National Schools class action and another class action, for $2,010. The class action settlements are subject to court approval. Further, although personal injury claims have similar characteristics, the same cannot be said for asbestos-in-buildings claims. Each claim can involve from one to several thousand buildings, each of which may vary as to age, ability to identify various producers products contained in the building as well as the FIBREBOARD CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLAR AMOUNTS IN THOUSANDS) extent of a producer's product present, building use, difficulty of abatement (if required) and so on. Thus, while extrapolation of personal injury claims disposition experience may provide useful information for estimating future personal injury liability, such an analysis cannot be applied to asbestos-in-buildings claims. Trials in a number of the pending asbestos-in-buildings claims are scheduled over the next few years. To date Fibreboard has successfully defended these claims, or settled the claims for nominal amounts compared to the damages sought. Based on its experience to date, Fibreboard is optimistic asbestos-in-buildings claims can be resolved within available insurance resources. INSURANCE FOR ASBESTOS-IN-BUILDINGS CLAIMS: Fibreboard has reached final settlements with three of its primary insurers and one of its excess level insurers. In addition, a settlement subject to court approval has been reached with a fourth primary insurer. The final settlements confirm more than $175,000 of insurance as needed to defend and dispose of asbestos-in-buildings claims, of which $4,269 has been used through December 31, 1993. Fibreboard is also litigating with its remaining insurance carriers and believes the total limits of insurance policies in effect from 1932 to 1985 which may provide coverage for asbestos-in-buildings claims aggregate approximately $420 million (including the $175,000 referred to in the prior paragraph), which is in addition to the personal injury insurance coverage and does not include additional policies which contain no aggregate limit. The insurers dispute coverage, although to date substantially all of Fibreboard's costs of defending asbestos-in-buildings claims have been paid by primary carriers. Fibreboard is seeking a declaration that the underlying asbestos-in-building claims are covered under various insurance policies. While Fibreboard does not expect that this trial will take as many years to complete as the personal injury insurance coverage trial, it will likely extend through 1994 and perhaps into 1995. Barring settlement, final resolution of the insurance available for asbestos-in-buildings claims may not be known for some time as an appeal of the trial court decision is likely. The trial commenced in May 1991 and is continuing in phases. In June 1991 the Superior Court entered a judgment which was affirmed on appeal declaring that a $10,000 excess liability insurance policy issued to Fibreboard's former parent, Louisiana-Pacific Corporation, for the period April 1, 1979 to April 1, 1980 is void because of fraud, misrepresentation and concealment in the policy application due to the insurer not being informed of the existing asbestos-related claims against Fibreboard at the time. The effect of this judgment is not expected to be significant unless Fibreboard is first forced to exhaust the primary and underlying excess insurance to defend and dispose of asbestos-in-buildings claims. The trial has been continued. No date has been set for the trial to recommence. Fibreboard is continuing settlement discussions with the remaining insurers. While optimistic, Fibreboard cannot predict whether such discussions will result in settlements. EVENTS IMPACTING ASBESTOS-RELATED LIABILITIES A number of events could impact Fibreboard's ability to continue to manage its asbestos-related liabilities within available resources. The potential impact of the personal injury issues which follow are largely dependent on whether the Global and/or Insurance Settlements are approved. FIBREBOARD CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLAR AMOUNTS IN THOUSANDS) INSURANCE ASSIGNMENT PROGRAM: During 1991, Fibreboard introduced its Insurance Assignment Program as a settlement vehicle for large groups of claims. Under this program, the plaintiffs accept an assignment of Fibreboard's right to insurance monies from Continental as complete settlement of their claims against Fibreboard. Consequently, these settlements involve no cash payments by Fibreboard. This contrasts with settlements under Fibreboard's Structured Settlement Program, in existence since 1988, wherein partial payments are made by Fibreboard using insurance funds with the remainder of the settlement deferred pending resolution of insurance coverage. The settlement agreements entered into to date under the Insurance Assignment Program do not require Fibreboard to pay cash unless insurance proceeds are ultimately not available. Additional provisions of certain settlement agreements provide that Fibreboard and the plaintiffs return to the "status quo" existing prior to settlement if certain specified court actions are not obtained. The plaintiffs have a right to return to the status quo should Continental declare bankruptcy prior to the final resolution of the personal injury insurance coverage litigation. During 1992, Fibreboard obtained widespread acceptance of this program to resolve large numbers of pending and not yet filed claims. Fibreboard also obtained a judicial determination in California state court supporting the right of Fibreboard to settle claims via the Insurance Assignment Program. This judgment is being appealed by Continental to the California Court of Appeal. Insurance Assignment Program settlements are recorded as a liability when the settlement is executed. A corresponding asset for anticipated insurance proceeds is also recorded. This accounting treatment differs from the handling of unresolved claims, where no gross liability is recorded until such time as the claim is settled. This program was initially used during 1991 to settle the Cimino consolidated group of claims for $185,000. During 1992, Continental entered into a separate settlement agreement with the Cimino plaintiffs. The terms of the agreement, which have been approved by the Court, include a release of Fibreboard from any obligation to the Cimino plaintiffs, regardless of the outcome of the insurance coverage litigation. As a result, Fibreboard removed the $185,000 liability and the related asset from its balance sheet. Under the interim agreement with Continental, Fibreboard agreed not to use this settlement vehicle without Continental's prior consent. Fibreboard and Continental have been converting prior Insurance Assignment Program settlements to three-party settlements among Fibreboard, Continental, and the plaintiffs, rather than between Fibreboard and plaintiffs alone. STRUCTURED SETTLEMENT PROGRAM: Beginning in 1988, Fibreboard has used its Structured Settlement Program (SSP) to settle personal injury claims. Under the SSP, Fibreboard and the plaintiff agree to a settlement amount. Fibreboard agrees to pay 40% of the settlement amount of pre-1959 claims in cash, and the remainder is deferred until September 1, 1996. Settlements of post-1959 claims result in deferring 100% of the settlement amount. As a consequence of the insurance settlements with Continental and Pacific in 1993, the SSP now has been superseded by three-party agreements among Continental, Fibreboard and the plaintiffs, whereby Continental or Fibreboard agrees to pay certain amounts depending upon the resolution of the insurance coverage case or the final approval or disapproval of the Global and Insurance Settlements. These three-party agreements typically provide a partial cash payment from Continental on pre-1959 claims. FIBREBOARD CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLAR AMOUNTS IN THOUSANDS) OTHER ISSUES (PERSONAL INJURY CLAIMS): During 1991, the Judicial Panel on Multi-District Litigation issued a ruling which requires consolidation of all personal injury cases pending in the federal court system for pre-trial handling and scheduling purposes. Claims pending in state courts are not impacted by this ruling. Fibreboard is unable to determine what effect, if any, this consolidation will have on personal injury litigation. There has been a continuation in the trend to consolidate or combine large numbers of personal injury claims for trial. Fibreboard has had reasonable success to date settling large group cases. OTHER ISSUES (ASBESTOS-IN-BUILDINGS CLAIMS): Many asbestos-in-buildings claims allege a conspiracy and/or concert of action theory which assert, among other things, that the asbestos producers withheld information regarding the potential danger of asbestos. If this theory prevails at trial, it could eliminate the requirement that the plaintiff positively identify Fibreboard's products as present in buildings in trials where the conspiracy theory is alleged. The conspiracy theory has not yet been tested in trial against Fibreboard, although Fibreboard believes it has meritorious defenses. OTHER ISSUES (PUNITIVE DAMAGE CLAIMS): Most of the personal injury claims and many of the asbestos-in-buildings actions also seek punitive damages. Fibreboard has not paid any punitive damages judgments except when funded by insurance. It is uncertain whether punitive damages would be covered by insurance as the law in this area varies from state to state. During 1991, Fibreboard received a ruling by the 9th Circuit Court of Appeal that punitive damages awarded by the Cimino jury in Texas and by a West Virginia jury in a consolidated trial similar to Cimino were covered by insurance. However, this ruling may have limited applicability in view of the varying state rules regarding punitive damage awards. RESOURCES AVAILABLE FOR ASBESTOS-RELATED COSTS Under the terms of the interim agreement, Continental will provide a full defense to Fibreboard on pre-1959 claims and make certain funds available as needed to pay currently due Structured Settlement obligations and other personal injury defense costs for which Fibreboard does not have insurance available during the period pending final approval of the Global and/or Insurance Settlement, or if neither is approved, through the ultimate conclusion of the insurance coverage appeal, however long that may take. At December 31, 1993, Fibreboard had approximately $821 in cash on hand restricted for asbestos-in-buildings-related expenditures. Fibreboard's operating line of credit contains prohibitions on using operating cash flow or borrowed funds to pay for asbestos-related costs, other than the costs of pursuing the insurance coverage litigation and internally generated case management expenses. At December 31, 1993, $11,048 was due in 1994 to asbestos claimants who had accepted Structured Settlement Program obligations. Fibreboard believes restricted cash on hand, amounts available under the interim agreement with Continental and amounts available under settlement agreements with Fibreboard's asbestos-in-buildings insurers will be adequate to fund defense and indemnity costs of personal injury and asbestos-in-buildings claims plus any amounts due under current and future Structured Settlement Program settlements. FIBREBOARD CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLAR AMOUNTS IN THOUSANDS) 17. OTHER LITIGATION AND CONTINGENCIES Fibreboard has been named as a potentially responsible party in two separate landfill clean-ups in the state of California, the Operating Industries, Inc. landfill in Monterey Park and the GBF landfill in Pittsburg. In addition, Fibreboard has been named a defendant in a private party lawsuit seeking to recover costs of clean-up and remediation of the Acme landfill in Martinez, California. In all cases, Fibreboard's former container products division was responsible for materials deposited at the landfills. Fibreboard is working with the steering committees of each site to determine Fibreboard's allocable share of investigation and remediation costs. Fibreboard has established a reserve against which the costs of study and cleanup, as well as ongoing legal and steering committee administrative costs, will be charged. The amount of the reserve was increased by $986 in 1992 to account for the addition of the Acme landfill contingency and to reflect more current remediation cost estimates for the GBF landfill. As of December 31, 1993, the reserve had a remaining balance of $1,814. Fibreboard believes the reserve will be adequate to cover its remaining costs associated with these landfill sites. Fibreboard is involved in a number of additional disputes arising from its operations. Fibreboard believes resolution of these disputes will not have a material adverse impact on its financial condition or results of operations. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Stockholders of Fibreboard Corporation: We have audited the accompanying consolidated balance sheets of Fibreboard Corporation (a Delaware corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Fibreboard Corporation and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in more detail in Note 16 to the accompanying financial statements, Fibreboard has been subject to significant asbestos-related litigation and claims allegedly caused by products that the Company manufactured prior to 1972. The amounts involved are substantial. During 1993, Fibreboard, its insurance carriers, and counsel for personal injury claimants entered into agreements which, if finally approved by the court, would resolve the Company's asbestos-related personal injury liabilities within available insurance and existing reserves. However, if these agreements are not approved by the court, the ultimate resolution of these claims and litigation could be materially adverse to Fibreboard causing a substantial doubt about the Company's ability to continue as a going concern. The accompanying financial statements have been prepared assuming that Fibreboard will continue as a going concern and do not include any adjustments that might result from the final resolution of these asbestos-related uncertainties. Arthur Andersen & Co. San Francisco, California, February 11, 1994. REPORT OF MANAGEMENT The objectivity and integrity of the consolidated financial statements are the responsibility of Fibreboard Corporation management. To discharge this responsibility, management maintains a system of internal controls designed to provide reasonable assurance that assets are safeguarded and that accounting records are reliable. Management supports an internal audit program to provide assurance that the system of internal controls is operating effectively. The consolidated financial statements and notes thereto and other financial information included in this annual financial report have been prepared by management in accordance with generally accepted accounting principles, and by necessity include some items determined using management's best judgment, tempered by materiality. The Board of Directors discharges its responsibility for reported financial information through its Audit Committee. This Committee, composed of all outside directors, meets periodically with management, the internal audit department and Arthur Andersen & Co. to review the activities of each. FIBREBOARD CORPORATION AND SUBSIDIARIES SELECTED QUARTERLY FINANCIAL DATA ITEM 9.	ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10.	ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information with respect to the Directors of Fibreboard is incorporated herein by reference from "Election of Directors" and "Directors Not Standing for Election" of Fibreboard Corporation's Proxy Statement to be filed pursuant to Regulation 14A not later than April 30, 1994. See also "Executive Officers of the Registrant" in Part I of this Form 10-K. ITEM 11.	ITEM 11. EXECUTIVE COMPENSATION Information with respect to Executive Compensation is incorporated herein by reference from "Compensation of Directors" and "Executive Compensation" of Fibreboard's Proxy Statement to be filed pursuant to Regulation 14A not later than April 30, 1994. FIBREBOARD CORPORATION AND SUBSIDIARIES ITEM 12.	ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information with respect to Security Ownership of Certain Beneficial Owners and Management is incorporated herein by reference from "Security Ownership of Management and Principal Stockholders" of Fibreboard's Proxy Statement to be filed pursuant to Regulation 14A not later than April 30, 1994. ITEM 13.	ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Not applicable. PART IV ITEM 14.	ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES AND REPORTS ON FORM 8-K (a) Financial Statements, financial statement schedules and exhibits filed in this report. 1. Index to Financial Statements and Supplementary Data. See page 20. 2. Index to Financial Statement Schedules. See page 56. 3. The following exhibits are filed as part of this Form 10-K: FIBREBOARD CORPORATION AND SUBSIDIARIES FIBREBOARD CORPORATION AND SUBSIDIARIES FIBREBOARD CORPORATION AND SUBSIDIARIES FIBREBOARD CORPORATION AND SUBSIDIARIES (b) Reports on Form 8-K The following Current Reports on Form 8-K were filed during the period October 1, 1993 to December 31, 1993: INDEX TO FINANCIAL STATEMENT SCHEDULES TO FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 1993 FIBREBOARD CORPORATION AND SUBSIDIARIES SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS ENDED DECEMBER (000'S OMITTED) FIBREBOARD CORPORATION AND SUBSIDIARIES SCHEDULE IX -- SHORT TERM BORROWINGS FOR THE YEARS ENDED DECEMBER 31 (000'S OMITTED) SCHEDULE X -- SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31 (000'S OMITTED) REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Stockholders of Fibreboard Corporation: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements of Fibreboard Corporation included in this Form 10-K, and have issued our report thereon dated February 11, 1994. Our report on the consolidated financial statements includes an explanatory paragraph with respect to the significant uncertainty surrounding the asbestos claims that have been filed against the Company as discussed in Note 16 to the financial statements. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed in the index of financial statement schedules on page 56 are the responsibility of the Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly state 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 & Co. San Francisco, California February 11, 1994. SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED THEREUNTO DULY AUTHORIZED. FIBREBOARD CORPORATION (Registrant) Dated: March 25, 1994 By: /s/ JOHN D. ROACH ------------------------------------ JOHN D. ROACH 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 IN THE CAPACITIES AND ON THE DATES INDICATED: FIBREBOARD CORPORATION EXHIBIT INDEX TO FORM 10-K FOR YEAR ENDED DECEMBER 31, 1993 * INCORPORATED HEREIN BY REFERENCE. * INCORPORATED HEREIN BY REFERENCE. * INCORPORATED HEREIN BY REFERENCE. * INCORPORATED HEREIN BY REFERENCE.
12400_1993.txt	12400	1993	ITEM 1. BUSINESS GENERAL The Company was incorporated under the laws of South Dakota in 1941 under the name Black Hills Power and Light Company. In 1986 the Company changed its name to Black Hills Corporation and now operates its investor-owned electric public utility operations under the assumed name of Black Hills Power and Light Company. In addition the Company has diversified into coal mining through Wyodak Resources and into oil and gas production through Western Production. Black Hills Power is engaged in the generation, purchase, transmission, distribution and sale of electric power and energy to approximately 53,330 customers in 11 counties in western South Dakota, northeastern Wyoming and southeastern Montana. The territory served by Black Hills Power includes 20 incorporated communities and various unincorporated and rural areas with a population estimated at 165,000. The largest community served is Rapid City, South Dakota, with a population, including environs, estimated at 75,000. Rapid City is the major retail, wholesale and health care center for a 250-mile radius. Principal industries in the territory served are tourism (including small stake casino gambling at Deadwood), cattle and sheep raising, farming, milling, meat packing, lumbering, the production of cement, the mining of bentonite, stone, gravel, silica sand, gold, silver, coal and other minerals, the manufacture of electronic products, wood products and gold jewelry, and the production and refining of oil. Black Hills Power serves a substantial portion of the electric needs of the Black Hills tourist region which includes the National Shrine of Democracy, Mount Rushmore National Memorial and the Crazy Horse Memorial, a large granite mountain carving under construction as a memorial to native Americans and one of their leaders. Tourism has been and is expected to continue to be enhanced significantly by the establishment of small stakes casino gambling at Deadwood, South Dakota, which is a part of Black Hills Power's service territory. Although only a small portion of EAFB is served by Black Hills Power, EAFB forms a significant economic base for the territory served. Wyodak Resources, incorporated under the laws of Delaware in 1956, is engaged in the mining and sale of sub-bituminous coal. The coal mining operation is located approximately five miles east of Gillette, Wyoming. In 1986, Wyodak Resources acquired all of the outstanding capital stock of Western Production, an oil and gas exploration, producing and operating company incorporated under the laws of Wyoming. Western Production is an oil producing and operating company with interests located in the Rocky Mountain Region and Texas. Western Production also has a partial interest in a natural gas processing plant. Information as to the continuing lines of business of the Company for the calendar years 1991-1993 is as follows: Reference is made to the Consolidated Statements of Income and Note 11 of "Notes to Consolidated Financial Statements" appended hereto. ELECTRIC POWER SALES AND SERVICE TERRITORY ELECTRIC POWER SALES--RETAIL. Even though Black Hills' service area again experienced milder than normal summer weather, Black Hills Power's firm kilowatt hour sales increased in 1993 by 3.5 percent over 1992. The increase in energy sales is largely due to an increase in the number of customers and their use of electricity. Firm energy sales are forecast to increase over the next ten years at an annual compound growth rate of approximately 2.5 percent. During the next ten years the peak system demand is forecast to increase at an annual compound growth rate of 2.6 percent. These forecasts are from studies conducted by Black Hills Power with the help of outside consultants whereby the service territory of Black Hills Power is carefully examined and analyzed to estimate changes in the needs for electrical energy and demand over a 20-year period. These forecasts are only estimates, and the actual changes in electric sales may be substantially different. In the past Black Hills Power's forecasts have tracked actual sales within a band of reasonable performance. Electric sales are materially affected by weather. Like 1992, Black Hills Power's electric service territory again experienced a cool summer in 1993, resulting in degree days that were 59 percent lower than normal for the 1993 summer months. Consequently, energy sales and peak demand were substantially less during the cooling season than they would have been in a normal weather year. RETAIL ELECTRIC SERVICE TERRITORY. Black Hills Power's service territory is currently protected by assigned service area and franchises that generally grant to Black Hills Power the exclusive right to sell all electric power consumed therein, subject to providing adequate service. See--COMPETITION IN ELECTRIC UTILITY BUSINESS--COMPETITION IN SERVICE AT RETAIL under this Item 1. At the end of 1993, Black Hills served electric energy to 53,330 customers in a population island that includes the major population centers of the Black Hills area in western South Dakota and northeastern Wyoming and a small oil field in southeastern Montana. (See--GENERAL under this Item 1 for a general description of the service territory.) Black Hills Power's electric service territory is experiencing modest business and population growth. In 1993 the value of commercial building permits in Rapid City increased by 91 percent, and residential building permits increased 10.5 percent. South Dakota's unemployment rate in 1993 averaged 3.4 percent. Personal income in South Dakota increased 7.3 percent in 1993 and visitor spending in South Dakota increased by 14 percent. The Company believes that this growth in its electric service territory will continue; however, the Company can give no assurances. One of the major employers in the Rapid City area is the United States Defense Department's EAFB. EAFB is a military air force base near Rapid City, South Dakota. Its current mission is to serve as the training, operation and maintenance base for the Air Force's B-1 bombers. There are now stationed at EAFB 30 B-1 bombers, out of the Defense Department's total of 96 B-1s, of which 80 are operational. Black Hills Power does not provide electric service to EAFB. However, currently EAFB employs approximately 5,200 military and 600 civilian personnel. In addition to these direct employees, additional nongovernmental employees residing in Rapid City and the surrounding area depend upon the continual operation of EAFB. Many of the persons with these jobs reside in the service territory of Black Hills Power. Many businesses in Black Hills Power's service territory are at least partially dependent upon the operations at EAFB. The exact economic impact from a closing of EAFB on Black Hills Power's electric sales cannot be estimated. While the impact would be felt, there are other businesses that would not be affected and are experiencing growth for other reasons in Black Hills Power's electric service territory. While the future of EAFB is not certain, management believes that the mission of EAFB assures that the base will continue. Emphasis on reducing the budget deficit and the deemphasis of military spending are expected to result in additional military base closings. The independent commission that recommends base closings is expected to make its recommendations in 1995 for the next base closings. If the United States Congress or the Administration does not interfere with those recommendations, those bases as recommended for closing are expected to be subsequently closed. There are many criteria used by the independent commission in making its decision, but three of the most important considerations are the strategic importance of the mission of the base, civilian encroachments interfering with the safe operation of the base, and the amount and timing of the savings or payback to the government resulting from such closings. EAFB personnel have been complaining about certain civilian business and housing encroachments to the flight line of the base. The City of Box Elder and the State of South Dakota are expected to take corrective action to satisfy those complaints, but no assurances can be given that the encroachments will be eliminated. Box Elder has already placed a moratorium on new buildings in the encroachment zone. Because of the large number of employees at EAFB and the cost of maintaining EAFB, a large savings would result to the Department of Defense from the closing. The Company believes, however, that the strategic mission of the base (the training, maintenance and operation of the B-1 bombers) and the open, low-populated area in western South Dakota and eastern Wyoming that is available for practicing bombing runs along with strong community support of the base should result in no EAFB closing. This may depend, however, upon the continual support by the Department of Defense and Congress of the B-1 bomber program. Due to cost overruns and failures of some tactical ancillary equipment along with debates on the need for long-range bombing capability in light of the end of the cold war have caused the B-1 bomber program to be somewhat controversial. This controversy has led to a decision to run the B-1 through extensive tests during 1994. EAFB has announced that those tests will be conducted at EAFB. Currently the Clinton Administration's budget provides for the Air Force to maintain an active, operational B-1 bomber fleet of 50. A fleet of 50 is believed to require the B-1s to be operated from two bases. The current Air Force plan is to base its operational B-1s only at EAFB and Dyess Air Force Base, Texas. The EAFB receives strong support from the Black Hills communities and the State of South Dakota and is the only major military establishment of the Department of Defense located in South Dakota. For all of these reasons, the Company believes that the EAFB will survive the next round of base closings, but the Company can give no assurances. Two other major industries in Black Hills' service territory suffering some stress are the lumbering industry and gold mining industry. The lumbering industry has already suffered substantial cutbacks due to government cutbacks in timber harvesting. Some impact has already occurred. The gold mining industry, including Homestake Mining Company (representing 11.8 percent of Black Hills' total firm KWH sales in 1993 and 8.2 percent of firm electric sales revenue) depends largely upon the price of gold and continuing to find economically minable ore reserves. Homestake has gradually over the years reduced the number of employees, and this impact has substantially occurred. Homestake recently abandoned a deep exploration program 6,000 feet underground to a location north of its present mine to locate another ore body that would have economically justified the construction of another shaft and the extension of the underground mine for several years. However, Homestake did recently report the discovery of some additional deep reserves at its present underground mining location below the 7,000-foot level. Unless a substantial reduction in the current price of gold occurs, the Company believes that the gold mining industry will be stable in the Black Hills area for at least the next ten years; however, the life of mines cannot be predicted, and no assurances can be given. The new industry of low stakes casino gambling at Deadwood (located in Black Hills Power's service territory) continues to experience modest growth despite the South Dakota voters' rejection of raising the $5 betting limit to $100. The Black Hills area continues to attract new small businesses and retirees who are attracted by a quality place to live. ELECTRIC SALES--WHOLESALE. At this time the only firm wholesale customer of Black Hills Power is the municipal electric system at Gillette, Wyoming. Service is rendered under a long- term contract expiring July 1, 2012 wherein Black Hills Power undertakes the obligation to serve the City of Gillette 60 percent of its highest demand and that associated energy as if the demand served by Black Hills Power was always Gillette's first demand. The agreement also allows Gillette to obtain the benefits of a 4,000 kilowatt average firm power purchase agreement from WAPA. Gillette's highest demand to date is 38.78 megawatts, making Black Hills' current base load obligation to serve 23 megawatts. The most recent average yearly capacity factor of this 23 megawatt demand has been approximately 80 percent. Revenue from sales to Gillette represented 8 percent of revenue from total sales in 1993. Black Hills Power is further obligated to serve the next increment of 10 megawatts of Gillette's demand above 33 megawatts if Gillette is unable to obtain other sources. Subject to certain emergency conditions, once Black Hills Power serves a full increment of another 10 megawatts, that increment is added to Black Hills Power's firm obligation to serve. When Gillette serves 10 megawatts, that increment is added to Gillette's firm obligation to serve. At this time Gillette has obtained resources to serve its load above the 60 percent of base load obligation of Black Hills Power. However, Gillette's resources come from short-term contracts, so Black Hills Power is required to stand by to serve a 10 megawatt increment of capacity to Gillette. Other than this firm sale to the City of Gillette, Black Hills Power has made only minimal energy sales to other utilities. FUTURE WHOLESALE OPPORTUNITIES. Black Hills Power has not had sufficient surplus resources in the past to effectively engage in the wholesale electric market. Therefore, to date Black Hills Power has not developed any wholesale markets other than the Gillette sale. If utility retail sales do not increase as expected, the addition of Neil Simpson Unit #2 may result in surplus power and energy. In that event, Black Hills Power would explore all possible avenues to sell that surplus power. Due to the inability to serve firm power to the east of Black Hills Power's service territory without high-cost AC-DC-AC converter stations because of the incompatibility of the east and west transmission systems, Black Hills Power's opportunities for wholesale sales are restricted to the western system. Black Hills Power maintains two firm interconnections to the western system, one with WAPA's western transmission system at Stegall, Nebraska and one with Pacific Power's transmission system at the Wyodak Plant. These two interconnections give Black Hills Power the potential ability to sell power wholesale to any utility entity in the western part of the United States if transmission charges are paid. See--COMPETITION IN ELECTRIC UTILITY BUSINESS - --TRANSMISSION ACCESS under this Item 1. Whether physical transmission limitations exist that would restrict such sales by Black Hills Power is unknown for any particular sale, but Black Hills Power believes that the western transmission system is adequate at this time to accommodate the relatively small sale of wholesale power required for Black Hills Power to sell any surplus resulting from Neil Simpson Unit #2. The revenue received from such a sale would depend on transmission costs, the type of sale Black Hills Power would make (i.e., firm long-term or short-term, capacity sale with minimum energy or base load sale with maximum energy, unit power from Neil Simpson Unit #2 only or system power with reserves), and the competitive market at the time such sale is made. The needs of Black Hills to serve its present retail and wholesale commitments and the regulatory treatment of Neil Simpson Unit #2 will govern the type of power and energy sale Black Hills Power would be able to make. All of these conditions are unknown at this time, but Black Hills Power will be carefully studying these conditions as the operating date for Neil Simpson Unit #2 approaches. ELECTRIC POWER SUPPLY GENERAL. In 1993 Black Hills Power retired three 5 megawatt low-pressure units at the Kirk Station. Obsolescence and high costs of operation made these units no longer economical to operate and maintain. Black Hills Power owns generation with a nameplate rating totalling 283.21 megawatts. See--UTILITY PROPERTIES under Item 2.		ITEM 2. PROPERTIES UTILITY PROPERTIES The following table provides information on the generating plants of Black Hills Power. During 1993, 99 percent of the fuel used in electric generation, measured in Btus (British thermal units), was coal. Black Hills Power owns transmission lines and distribution systems in and adjoining the communities served consisting of 445 miles of 230 kV, 4 miles of 115 kV, 532 miles of 69 kV, 8 miles of 47 kV and numerous distribution lines of less voltage. Black Hills Power owns a service center in Rapid City, several district office buildings at various locations within its service area, and an eight-story home office building at Rapid City, South Dakota housing its home office on four floors, with the balance of the building rented to three tenants. MINING PROPERTIES Wyodak Resources is engaged in mining and processing sub- bituminous coal near Gillette in Campbell County, Wyoming. The coal averages 8,000 Btus per pound. Mining rights to the coal are based upon coal owned and five federal leases. The estimated tons of recoverable coal from each source as of December 31, 1993 are set forth in the following table: ESTIMATED TONS OF RECOVERABLE COAL (IN THOUSANDS) Fee coal 1,381 Federal lease dated May 1, 1959 19,763 Federal lease dated April 1, 1961 7,703 Federal lease dated October 1, 1965 117,534 Federal lease dated September 28, 1983 20,355 Federal lease dated March 1, 1983 22,604 189,340 Coal reserves are estimated at 189,340,000 tons of which approximately 32,250,000 tons are committed to be sold to the Wyodak Plant, approximately 10,000,000 tons to Black Hills Power's other plants, and 20,000,000 tons for Neil Simpson Unit #2. Purchase options are granted on 52,000,000 tons of which options for 50,000,000 tons can be exercised only if Wyodak Resources has not committed the coal reserves to other buyers prior to such exercise. Because the coal purchase price that will be paid if the options are exercised would be substantially higher than prices being paid under new coal contracts, it is unlikely that the options will be exercised. In 1989 an oil and gas developer established two oil- producing wells on the north portion of the lease dated October 1, 1965. The oil was leased to the developer by the owner of the oil rights, the State of Wyoming, and the coal is leased by Wyodak Resources from the owner of the coal rights, the federal government through its BLM. The oil is produced from a formation at a depth of approximately 9,000 feet while the coal is mined by the open pit method at a depth of 200 to 300 feet. Therefore, it is impossible to mine coal in the vicinity of the oil wells and maintain and operate the oil wells at the same time. The law is uncertain as to who would have priority under these circumstances. To date this conflict would affect approximately 15,000,000 tons of coal. At this time Wyodak Resources does not plan any mining operations at the site of the oil wells for at least 15 years, but the life of oil wells may extend for many years beyond 15. To mitigate its potential damages, Wyodak Resources has negotiated an option to purchase the oil wells at fair market value if a mining conflict should occur. Each federal lease grants Wyodak Resources the right to mine all of the coal in the land described therein, but the government has the right at the end of 20 years from the date of the lease to readjust royalty payments and other terms and conditions. All of the federal leases provide for a royalty of 12.5 percent of the selling price of the coal. Each federal lease requires diligent development to produce at least one percent of all recoverable reserves within either 10 years from the respective dates of the 1983 leases or 10 years from the date of adjustment of the other leases. Each lease further requires a continuing obligation to mine, thereafter, at an average annual rate of at least one percent of the recoverable reserves. All of the federal leases and its remaining fee coal constitute one logical mining unit and is treated as one lease for the purpose of determining diligent development and continuing operation requirements. All coal is to be mined within 40 years from 1992, the date of the logical mining unit. Even if federal coal leases are not mined out in 40 years, the federal coal is likely to be available for further lease after the 40 years. Wyodak Resources' current coal agreements require production which should be sufficient to satisfy the diligent development and continual operation requirements of present law. Wyodak Resources will require additional coal sales in order to mine all of its federal coal within the 40 year requirement. The law, which requires that an owner of land that is primarily devoted to agriculture must approve a reclamation plan before the state will approve a permit for open pit mining, affects approximately 3,100,000 tons of the recoverable coal included in the federal lease dated October 1, 1965. Wyodak Resources has excluded these tons of coal from its mine plan and will not mine such coal until a surface consent has been negotiated or the right to mine has been settled by litigation. Approximately 32,250,000 tons of the Federal Coal Lease dated October 1, 1965, has been mortgaged as security for the performance of its obligations under the coal supply agreement for the Wyodak Plant. In 1992, Pacific Power, the Company and Wyodak Resources entered into an agreement providing for the construction of new coal handling facilities. The new coal handling facilities consist of an in-pit system (consisting of in-pit movable crushers and a conveyor to a secondary crusher transfer point), an out-of-pit system (consisting of the secondary crusher), new truck load-out facilities, a conveyor to deliver coal to Neil Simpson Unit #1 and a conveyor to deliver coal to the Wyodak Plant and eventually to Neil Simpson Unit #2. The total construction costs of these facilities is expected to be $24,500,000, of which Pacific Power will pay $19,000,000 and Wyodak Resources $5,500,000. The reason for the large amount being paid by Pacific Power is that under the PacifiCorp Settlement, Pacific Power was obligated to pay up to $15,000,000, plus an amount to adjust for inflation since 1987, for new coal handling facilities which were required to extend the mining of coal to another pit, the Peerless area, situated west of the Wyodak Plant. Under the agreement among PacifiCorp, the Company and Wyodak Resources, Wyodak Resources will operate the in-pit system, the conveyor to Neil Simpson Unit #1 and the truck load-out system, and PacifiCorp will operate the secondary crusher transfer building and the conveyor to the Wyodak Plant. The agreement provides for the use of the new coal handling facilities to deliver coal to the Wyodak Plant, Neil Simpson Unit #1, Neil Simpson Unit #2, the truck load-out and, if there is sufficient capacity, to additional power plants to be constructed at the site. The agreement provided for Black Hills Power to own certain undivided interests of these facilities, but Black Hills Power and Wyodak Resources have entered into an agreement providing for the transfer of all interests of Black Hills Power in these facilities to Wyodak Resources. This transfer is consistent with the agreement of Wyodak Resources to deliver Black Hills Power completely processed coal. OIL AND GAS PROPERTIES Western Production operates 347 wells as of December 31, 1993. The vast majority of these wells are in the Finn Shurley Field, located in Weston and Niobrara Counties, Wyoming. Twelve of the wells Western Production operates are located in Adams and Weld Counties, Colorado, two are located in Washakie County, Wyoming and two are located in Fall River County, South Dakota. Western Production does not operate but owns a working interest in 39 producing properties located in Wyoming, Kansas, Colorado, Montana, North Dakota and Texas. The majority of wells operated by Western Production were drilled between 1977 and 1984, prior to its acquisition by Wyodak Resources. They were drilled under drilling programs wherein working interests were sold to various investors. Approximately 232 investors own working interests in wells operated by Western Production. Western Production owns a 44.7 percent interest in a natural gas processing plant also located at the Finn Shurley Field. The gas plant is operated by Western Gas Resources, Inc. of Denver, Colorado, which owns a 50 percent interest therein and processes all the gas produced from the Finn Shurley Field and the Boggy Creek Field. The following table summarizes Western Production's estimated quantities of proved developed and undeveloped oil and natural gas reserves at December 31, 1993 and 1992, and a reconciliation of the changes between these dates using constant product prices for the respective years. These estimates are based on reserve reports by Ralph E. Davis Associates, Inc. (an independent engineering company selected by the Company). Such reserve estimates are based upon a number of variable factors and assumptions which may cause these estimates to differ from actual results. Western Production has approximately 99,000 gross and 65,000 net acres of oil and gas leases, out of which 25,000 gross and 15,000 net acres are producing and 74,000 gross and 50,000 net acres are undeveloped. Approximately 23 percent of the undeveloped acres are held by production thereby not requiring annual delay rental payments. No representations are made that reserves can be attributed to any undeveloped oil and gas leases. Undeveloped leasehold that are not held by production have varying provisions but generally terminate if oil and gas is not produced within the primary term of the lease. ITEM 3.	ITEM 3. LEGAL PROCEEDINGS The Company and its subsidiaries are involved in minor routine administrative proceedings and litigation incidental to the businesses, none of which, in the opinion of management, will have a material effect on the consolidated financial statements of the Company. ITEM 4.	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matter was submitted to a vote of security holders during the fourth quarter of 1993. EXECUTIVE OFFICERS OF THE COMPANY The following is a list of all executive officers of the Company. There are no family relationships among them. Officers are normally elected annually. Daniel P. Landguth, born May 9, 1946, Chairman, President, and Chief Executive Officer of Black Hills Corporation Mr. Landguth was elected to his present position in January 1991. He had served as President of Black Hills Corporation since October 1989, President and Chief Operating Officer of Black Hills Power since June 1987, and Senior Vice President and Chief Operating Officer since 1985. Dale E. Clement, born August 1, 1933, Senior Vice President - Finance Mr. Clement was elected to his present position in September 1989. He had served on the Board of Directors since 1979. Prior to joining the Company he was Dean and Professor of Finance at the University of South Dakota, School of Business. Joseph E. Rovere, born July 7, 1929, Vice President - Public Affairs/District Administration Mr. Rovere was elected to his present position in October 1982. Roxann R. Basham, born August 6, 1961, Secretary and Treasurer Mrs. Basham was elected to her present position January 1, 1993. She had served as Assistant Secretary/Treasurer since May 1991 and as Financial Analyst since February 1985. Gary R. Fish, born August 1, 1958, Controller Mr. Fish was elected to his present position in August 1988. Everett E. Hoyt, born August 8, 1939, President and Chief Operating Officer of Black Hills Power Mr. Hoyt was elected to his present position in October 1989. Prior to joining the Company he was Senior Vice President - Legal, Corporate Secretary, and Assistant Treasurer of Northwestern Public Service Company. PART II ITEM 5.	ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The information required by Item 5 is provided in the Annual Report to Shareholders of the Company for the year ended December 31, 1993, on page 32 appended hereto and market price information is shown in Note 13 of "Notes to Consolidated Financial Statements" on page 29 of the Annual Report to Shareholders of the Company for the year ended December 31, 1993, appended hereto. ITEM 6.	ITEM 6. SELECTED FINANCIAL DATA The information required by Item 6 is provided under an identical caption in the Annual Report to Shareholders of the Company for the year ended December 31, 1993, on page 29 appended hereto. ITEM 7.	ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION The information required by Item 7 is provided under a similar caption in the Annual Report to Shareholders of the Company for the year ended December 31, 1993, on pages 12 through 18 appended hereto. ITEM 8.	ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required by Item 8 is provided under proper captions in the Annual Report to Shareholders of the Company for the year ended December 31, 1993, on pages 20 through 29 appended hereto. Selected quarterly financial data is shown in Note 13 of "Notes to Consolidated Financial Statements" on page 29 of the Annual Report to Shareholders of the Company for the year ended December 31, 1993, appended hereto. ITEM 9.	ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE No change of accountants or disagreements on any matter of accounting principles or practices or financial statement disclosure have occurred. PART III ITEM 10.	ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information regarding the directors of the Company is incorporated herein by reference to the Proxy Statement for the Annual Shareholders' Meeting to be held May 24, 1994. For information regarding the executive officers of the Company refer to Part I, Item 4. ITEM 11.	ITEM 11. EXECUTIVE COMPENSATION Information regarding management remuneration and transactions is incorporated herein by reference to the Proxy Statement for the Annual Shareholders' Meeting to be held May 24, 1994. ITEM 12.	ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information regarding the security ownership of certain beneficial owners and management is incorporated herein by reference to the Proxy Statement for the Annual Shareholders' Meeting to be held May 24, 1994. ITEM 13.	ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information regarding certain relationships and related transactions is incorporated herein by reference to the Proxy Statement for the Annual Shareholders' Meeting to be held May 24, 1994. PART IV ITEM 14.	ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) 1. Index to Consolidated Financial Statements Page Reference* Report of Independent Public Accountants. . . . .19 Consolidated Statements of Income and Retained Earnings for the three years ended December 31, 1993. . . . . . . . . . . . .20 Consolidated Statements of Cash Flows for the three years ended December 31, 1993. . . . .21 Consolidated Balance Sheets at December 31, 1993 and 1992 . . . . . . . . . . . . . . . . . . . .22 Consolidated Statements of Capitalization at December 31, 1993 and 1992 . . . . . . . . . . .23 Notes to Consolidated Financial Statements. . 24-29 2. Schedules ** V Property, Plant, and Equipment for the three years ended December 31, 1993 VI Accumulated Depreciation and Depletion of Property, Plant, and Equipment for the three years ended December 31, 1993 IX Short-Term Borrowings for the three years ended December 31, 1993 * Page References are to the incorporated portion of the Annual Report to Shareholders of the Company for the year ended December 31, 1993. ** All other schedules have been omitted because of the absence of the conditions under which they are required or because the required information is included elsewhere in the financial statements incorporated by reference in the Form 10-K. 3. Exhibits 3(a) Bylaws dated December 10, 1991 (Exhibit 3(a) to Form 10-K for 1991). 3(b) Restated Articles of Incorporation dated July 28, 1986 (Exhibit 3(b) to Form 10-K for 1986). Articles of Amendment to Restated Articles of Incorporation dated May 21, 1987, (Exhibit 3(b) to Form 8-K for May 1987, File No. 0-0164). Articles of Amendment to Restated Articles of Incorporation dated May 16, 1989 (Exhibit 3(b) to Form 10-K for 1989). Articles of Amendment to Restated Articles of Incorporation dated May 28, 1992 (Exhibit 3(b) to Form 10-K for 1992). Articles of Correction to Amendment to Restated Articles of Incorporation, dated September 13, 1993 (Exhibit 4.03 to Form S-3 dated September 22, 1993, Registration No. 33- 69234). 4(a) Reference is made to Article Fourth (7) of the Restated Articles of Incorporation of the Company and the Articles of Amendment to Restated Articles of Incorporation (Exhibit 3(b) hereto). 4(b) Indemnification Agreement and Company and Directors' and Officers' indemnification insurance (Exhibit 4(b) to Form 10-K for 1987). 4(c) Indenture of Mortgage and Deed of Trust, dated September 1, 1941, and as amended by supplemental indentures (Exhibit B to Form 8-K, File No. 2-4832); (Exhibit 7-B, File No. 2-6576); (Exhibit 7-C, File No. 2-7695); (Exhibit 7-D, File No. 2-8157); (Exhibit A to Form 10-K for fiscal year 1950, File No. 2-4832); (Exhibit 4-I, File No. 2-9433); (Exhibit 4-H, File No. 2-13140); (Exhibit 4-I, File No. 2-14829); (Exhibits 4-J and 4-K, File No. 2-16756); (Exhibits 4-L, 4-M, and 4-N, File No. 2-21024); (Exhibits 2(q), 2(r), 2(s), 2(t), 2(u), and 2(v) to Form S-7, File No. 2-57661); (Exhibit (b) to Form 8-K for February 1977, File No. 2-4832); (Exhibit II-1 to Form 10-Q for quarter ended April 30, 1977, File No. 2-21024); (Exhibit II-1 to Form 10-Q for quarter ended July 31, 1977, File No. 2-21024); (Exhibit 4(b) to Form S-3, File No. 2-81643); (Exhibit II-6a to Form 10-Q for quarter ended September 30, 1986, File No. 0-0164); (Exhibit II-6a to Form 10-Q for quarter ended September 30, 1987, File No. 0-0164); (Exhibit II-6a to Form 10-Q for quarter ended September 30, 1988, File No. 0-0164); and (Exhibit 4(d) and 4(e) to Post- Effective Amendment No. 1 to Form S-8, File No. 33-15868). 10(a) Coal Supply Agreement dated May 12, 1975, between Wyodak Resources Development Corp. and the South Dakota Cement Commission (Exhibit 5(d) to Form S-7, File No. 2-57661). Extension of Coal Supply Agreement dated June 2, 1980, and First Supplement dated February 8, 1983 (Exhibit 10(c) to Form 10-K for 1983). Second Supplement to Extension of Coal Supply Agreement dated June 1, 1985 (Exhibit 10(c) to Form 10-K for 1985). Third Supplement to Extension of Coal Supply Agreement dated July 14, 1986 (Exhibit 10(c) to Form 10-K for 1986). Fourth Supplement to Extension of Coal Supply Agreement dated December 1, 1987 (Exhibit 10(c) to Form 10-K for 1987). Fifth Supplement to Extension of Coal Supply Agreement dated March 12, 1992 (Exhibit 10(a) to Form 10-K for 1992). 10(b) Agreement for Transmission Service and The Common Use of Transmission Systems dated January 1, 1986, among the Company, Basin Electric Power Cooperative, Rushmore Electric Power Cooperative, Inc., Tri-County Electric Association, Inc., Black Hills Electric Cooperative, Inc., and Butte Electric Cooperative, Inc. (Exhibit 10(d) to Form 10-K for 1987). 10(c) Restated and Amended Coal Supply Agreement for Neil Simpson Unit #2 dated February 12, 1993 (Exhibit 10(c) to Form 10-K for 1992). 10(d) Coal Supply Agreement and First Amendment dated September 1, 1977, between the Company and Wyodak Resources Development Corp. (Exhibit 5(g) to Form S-7, File No. 2-60755). Second Amendment to Coal Supply Agreement dated November 2, 1987 (Exhibit 10(f) to Form 10-K for 1987). 10(e) Coal Lease dated May 1, 1959, between Wyodak Resources Development Corp. and the Federal Government (Exhibit 5(i) to Form S-7, File No. 2-60755). Modified coal lease dated January 22, 1990, between Wyodak Resources Development Corp. and the Federal Government (Exhibit 10(h) to Form 10-K for 1989). 10(f) Coal Lease dated April 1, 1961, between Wyodak Resources Development Corp. and the Federal Government (Exhibit 5(j) to Form S-7, File No. 2-60755). Modified coal lease dated January 22, 1990, between Wyodak Resources Development Corp. and the Federal Government (Exhibit 10(i) to Form 10-K for 1989). 10(g) Coal Lease dated October 1, 1965, between Wyodak Resources Development Corp. and the Federal Government, as amended (Exhibit 5(k) to Form S-7, File No. 2-60755). Modified coal lease dated January 22, 1990, between Wyodak Resources Development Corp. and the Federal Government (Exhibit 10(j) to Form 10-K for 1989). 10(h) Participation Agreement dated May 16, 1978, and various related agreements dated June 8, 1978, including, without limitation, Lease Agreement, Amended and Restated Coal Supply Agreement, Coal Supply System Agreement and Security Agreement, and Real Estate Mortgage (all relating to the lease financing of the Wyodak Plant and the dedication by Wyodak Resources Development Corp. of coal deposits with respect thereto) filed pursuant to item 6(b) of Amendment No. 1 to Registrant's Current Report on Form 8-K for June 1978 and located in Commission File No. 2-4832. Further Restated and Amended Coal Supply Agreement dated May 5, 1987 (Exhibit 10(k) to Form 10-K for 1987). 10(i) Coal Supply Agreement dated August 24, 1978, between Wyodak Resources Development Corp. and the City of Grand Island, Nebraska (Exhibit 5(l) to Form S-7, File No. 2-64014). Restated and Amended Coal Supply Agreement dated March 4, 1983 (Exhibit 10(l) to Form 10-K for 1983). First Amendment to Restated and Amended Coal Supply Agreement dated October 29, 1987 (Exhibit 10(l) to Form 10-K for 1987). 10(j) Power Sales Agreement dated December 31, 1983, between Pacific Power & Light Company and the Company (Exhibit 7(b) to Form 8-K for January 1984, File No. 0-0164). 10(k) Coal Supply Agreement for Wyodak Unit #2 dated February 3, 1983, and Ancillary Agreement dated February 3, 1982, between Wyodak Resources Development Corp. and Pacific Power & Light Company and the Company (Exhibit 10(o) to Form 10-K for 1983). Amendment to greement for Coal Supply for Wyodak #2 dated May 5, 1987 (Exhibit 10(o) to Form 10-K for 1987). 10(l) Coal lease dated February 16, 1983, between Wyodak Resources Development Corp. and the Federal Government (Exhibit 10(p) to Form 10-K for 1983). 10(m) Coal lease dated September 28, 1983, between Wyodak Resources Development Corp. and the Federal Government (Exhibit 10(q) to Form 10-K for 1983). 10(n) Indenture of Trust dated as of August 1, 1984, City of Gillette, Campbell County, Wyoming, to Norwest Bank Minneapolis, N.A. as Trustee (Black Hills Power and Light Company Project) (Exhibit 10(r) to Form 10-K for 1984). Indenture of Trust dated as of June 1, 1992, City of Gillette, Campbell County, Wyoming, to Norwest Bank Minnesota, National Association, as Trustee (Black Hills Power and Light Company Project) (Exhibit 10(n) to Form 10-K for 1992). 10(o) Loan Agreement dated as of August 1, 1984, by and between City of Gillette, Campbell County, Wyoming, and the Company (Exhibit 10(s) to Form 10-K for 1984). Loan Agreement dated as of June 1, 1992, by and between City of Gillette, Campbell County, Wyoming, and the Company (Exhibit 10(o) to Form 10-K for 1992). 10(p) Loan Agreement dated as of June 1, 1992, by and between Lawrence County, South Dakota and the Company (Exhibit 10(p) to Form 10-K for 1992). 10(q) Indenture of Trust dated as of June 1, 1992, Lawrence County, South Dakota, to Norwest Bank Minnesota, National Association, as Trustee (Black Hills Power and Light Company Project) (Exhibit 10(q) to Form 10-K for 1992). 10(r) Loan Agreement dated as of June 1, 1992, by and between Pennington County, South Dakota and the Company (Exhibit 10(r) to form 10-K for 1992). 10(s) Indenture of Trust dated as of June 1, 1992, Pennington County, South Dakota, to Norwest Bank Minnesota, National Association, as Trustee (Black Hills Power and Light Company Project) (Exhibit 10(s) to Form 10K for 1992). 10(t) Loan Agreement dated as of June 1, 1992, by and between Weston County, South Dakota and the Company (Exhibit 10(t) to Form 10-K for 1992). 10(u) Indenture of Trust dated as of June 1, 1992, Weston County, Wyoming, to Norwest Bank Minnesota, National Association, as Trustee (Black Hills Power and Light Company Project) (Exhibit 10(u) to Form 10-K for 1992). 10(v) Loan Agreement dated as of June 1, 1992, by and between Campbell County, South Dakota and the Company (Exhibit 10(v) to Form 10-K for 1992). 10(w) Indenture of Trust dated as of June 1, 1992, Campbell County, Wyoming, to Norwest Bank Minnesota, National Association, as Trustee (Black Hills Power and Light Company Project) (Exhibit 10(w) to Form 10-K for 1992). 10(x) Restated Electric Power and Energy Supply and Transmission Agreement and Restated Seasonal Non-Firm Power Sale Agreement both dated December 21, 1987, both by and between the Company and the City of Gillette, Wyoming (Exhibit 10(t) to Form 10-K for 1987). 10(y) Reserve Capacity Integration Agreement dated May 5, 1987, between Pacific Power & Light Company and the Company (Exhibit 10(u) to Form 10-K for 1987). 10(z) Firm Capacity and Energy Purchase Agreement between Tri-State Generation and Transmission Association, Inc. and the Company dated May 11, 1992 (Exhibit 10(aa) to Form 10-K for 1992). 10(aa) Firm Capacity and Energy Purchase Agreement between Sunflower Electric Power Cooperative and the Company dated October 11, 1993. 10(bb) Compensation Plan for Outside Directors (Exhibit 10(bb) to Form 10-K for 1992). 10(cc) Retirement Plan for Outside Directors dated January 1, 1993 (Exhibit 10(cc) to Form 10-K for 1992). 10(dd) Pension Equalization Plan of Black Hills Corporation dated January 1, 1990 (Exhibit 10(dd) to Form 10-K for 1992). 10(dd) Amendment #1 to Pension Equalization Plan of Black Hills Corporation dated April 27, 1993. 10(ee) Black Hills Corporation 1994 Executive Gainsharing Program. 10(ff) Black Hills Corporation 1994 Results Compensation Program. 10(gg) Pension Plan of Black Hills Corporation as amended and restated effective October 1, 1989. First amendment to the Pension Plan of Black Hills Corporation dated September 25, 1992. Amendment to the Pension Plan of Black Hills Corporation dated December 4, 1992. Amendment to the Pension Plan of Black Hills Corporation dated February 5, 1993 (Exhibit 10(ff) to form 10-K for 1992). 10(hh) Agreement for Supplemental Pension Benefit for Everett E. Hoyt dated January 20, 1992 (Exhibit 10(gg) to Form 10-K for 1992). 10(ii) Agreement for Supplemental Pension Benefit for Dale E. Clement dated December 19, 1991 (Exhibit 10(hh) to Form 10-K for 1992). 13 Annual Report to Shareholders of the Registrant for the year ended December 31, 1993. 22 Subsidiaries of the Registrant. 23 Consent of Independent Public Accountants. _________________________ Exhibits incorporated by reference. (b) No reports on Form 8-K have been filed in the quarter ended December 31, 1993. (c) See (a) 3. above. (d) See (a) 2. above. _________________________________________________________________ REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS We have audited in accordance with generally accepted auditing standards, the consolidated financial statements included in Black Hills Corporation's 1993 Annual Report to Shareholders incorporated by reference in this Form 10-K, and have issued our report thereon dated January 28, 1994. Our audit was made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed as a part of Item 14.(a)2. in this Form 10-K are the responsibility of the Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly state 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 & CO. Minneapolis, Minnesota, January 28, 1994 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. BLACK HILLS CORPORATION By DANIEL P. LANDGUTH Daniel P. Landguth, Chairman, President, and Chief Executive Dated: March 11, 1994 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. DANIEL P. LANDGUTH Director and Principal March 11, 1994 Daniel P. Landguth (Chairman, Executive Officer President, and Chief Executive) DALE E. CLEMENT Director and Principal March 11, 1994 Dale E. Clement (Senior Vice Financial Officer President - Finance) GARY R. FISH Principal Accounting March 11, 1994 Gary R. Fish (Controller) Officer GLENN C. BARBER Director March 11, 1994 Glenn C. Barber BRUCE B. BRUNDAGE Director March 11, 1994 Bruce B. Brundage MICHAEL B. ENZI Director March 11, 1994 Michael B. Enzi JOHN R. HOWARD Director March 11, 1994 John R. Howard EVERETT E. HOYT Director and Officer March 11, 1994 Everett E. Hoyt (President and Chief Operating Officer of Black Hills Power) KAY S. JORGENSEN Director March 11, 1994 Kay S. Jorgensen CHARLES T. UNDLIN Director March 11, 1994 Charles T. Undlin ___________________________________________________________________________ The Company's short-term borrowings consist solely of notes payable to banks. See Note 4 in the consolidated financial statements for additional discussion on notes payable to banks. The average amount of short-term borrowings outstanding during the year represents an average of daily balances. The weighted average interest rate during the year was based on a weighting of interest rates associated with these balances. ___________________________________________________________________________ APPENDIX BLACK HILLS CORPORATION The following items, appended hereto, are incorporated into the Form 10-K from the 1993 Annual Report to Shareholders: PART II Pages Item 5 Market for Registrant's Common Equity and Related Stockholder Matters . . . . . . . . . 32 Item 6 Selected Financial Data. . . . . . . . . . . . 29 Item 7 Management's Discussion and Analysis of Financial Condition and Results of Operation. . . . .12-18 Item 8 Financial Statements and Supplementary Data. . . . . . . . . . . . . . . . . . . .20-29 EXHIBIT INDEX EX-10.aa Firm Capacity and Energy Purchase Agreement between Sunflower Electric Power Cooperative and the Company dated October 11, 1993. EX-10.dd Amendment #1 to Pension Equalization Plan of Black Hills Corporation dated April 27, 1993. EX-10.ee Black Hills Corporation 1994 Executive Gainsharing Program. EX-10.ff Black Hills Corporation 1994 Results Compensation Program. EX-13 Annual Report to Shareholders of the Registrant for the year ended December 31, 1993. EX-22 Subsidiaries of the Registrant. EX-23 Consent of Independent Public Accountants.
806027_1993.txt	806027	1993	Item 1. Business DESCRIPTION OF THE BUSINESS Business Groups ServiceMaster is functionally divided into four operating groups: Management Services, Consumer Services, Diversified Health Services and International and New Business Development. Management Services and Consumer Services are the two principal business groups. Reference is made to the information under the caption "Business Unit Reporting" on page 31 of the ServiceMaster Annual Report to Shareholders for 1993 (the "1993 Annual Report") for detailed financial information on these two groups. The Company's trademarks and service marks are important for all elements of the Company's business, although such marks are particularly important in the advertising and franchising activities conducted by the operating subsidiaries of ServiceMaster Consumer Services L.P. Such marks are registered and are renewed at each registration expiration date. Within ServiceMaster Consumer Services, franchises are important for the ServiceMaster Residential/Commercial business, the Merry Maids business, the Terminix business and the TruGreen- ChemLawn business. Nevertheless, revenues and profits derived from franchise-related activities constitute less than 10% of the revenue and profits of the consolidated ServiceMaster enterprise. Franchise agreements made in the course of these businesses are generally for a term of five years. ServiceMaster's renewal history is that the majority of franchise agreements which expire in any given year are renewed. As discussed in further detail below, the Terminix and TruGreen-ChemLawn businesses are seasonal in nature. Management Services ServiceMaster pioneered the providing of supportive management services to health care facilities by instituting housekeeping management services in 1962. Since then, ServiceMaster has expanded its management services business such that it now provides a variety of supportive management services to health care, education and commercial customers (including the management of housekeeping, plant operations and maintenance, laundry and linen, grounds and landscaping, clinical equipment maintenance, energy management services and food service). ServiceMaster's general programs and systems free the customer to focus on its core business activity with confidence that the support services are being managed and performed in an efficient manner. As of December 31, 1993, ServiceMaster was providing supportive management services to approximately 2,300 health care, educational and commercial facilities. These services were being provided in all 50 states and the District of Columbia and in 15 foreign countries. Outside of the United States, ServiceMaster was providing management services through subsidiaries in the United Kingdom and Japan, through affiliated companies in Canada, Japan and Italy, and through licensees in Mexico, Korea, Australia, New Zealand, Singapore, Taiwan, Hong Kong, Czechoslovakia, Japan and throughout the Middle East. International and New Business Development is responsible for overseeing the services provided in foreign markets. Consumer Services ServiceMaster Consumer Services provides specialty services to homeowners and commercial facilities through five companies: The Terminix International Company L.P. ("Terminix"); TruGreen- ChemLawn L.P. ("TruGreen-ChemLawn"); Merry Maids L.P. ("Merry Maids"); American Home Shield Corporation ("American Home Shield" or "AHS"); and ServiceMaster Residential/Commercial Services L.P. ("Res/Com"). The services provided by these companies include termite and pest control and radon testing services under the "Terminix" service mark; lawn care, tree and shrub services under the "TruGreen" and "ChemLawn" service marks; domestic housekeeping services under the "Merry Maids" service mark; home systems and appliance warranty contracts under the "American Home Shield" service mark; and residential and commercial cleaning and disaster restoration services under the "ServiceMaster" service mark. The services provided by the five Consumer Services companies are part of the ServiceMaster "Quality Service Network" and are accessed by calling a single toll-free telephone number: 1-800-WE SERVE. ServiceMaster focuses on establishing relationships to provide one or more of these services on a repetitive basis to customers. Since 1986, the number of customers served by ServiceMaster Consumer Services has increased from fewer than one million customers to more than 5.9 million customers (including International operations). Terminix. Terminix is a wholly owned subsidiary of ServiceMaster Consumer Services L.P. Terminix, both directly and through franchisees, is the leading provider of termite, pest control and radon testing services to approximately 1.9 million residential and commercial customers in the United States. As of December 1993, Terminix was providing these services through 315 company-owned branches in 39 states and Mexico and through 218 franchised branches in 21 states and Mexico. Terminix also provides termite and pest control services in Japan, Taiwan, Lebanon, Saudi Arabia, Oman and the United Kingdom through licensing arrangements with local partners. TruGreen-ChemLawn. TruGreen-ChemLawn is an 85% owned subsidiary of ServiceMaster Consumer Services Limited Partnership (with senior management of TruGreen-ChemLawn holding the remaining 15% interest) and is the entity through which ServiceMaster provides lawn care services. TruGreen-ChemLawn is the leading provider of lawn care services to over 2.2 million residential and commercial customers in the United States. As of December 31, 1993, TruGreen-ChemLawn had 172 company-owned branches and 71 franchised branches. Merry Maids. Merry Maids is a wholly owned subsidiary of ServiceMaster Consumer Services Limited Partnership. (A minority interest held by senior management of Merry Maids at the end of 1993 will be acquired by Merry Maids in 1994). Merry Maids is the organization through which ServiceMaster provides domestic house cleaning services, of which it is one of the country's leading providers. As of December 31, 1993, these services were provided to about 170,000 customers through one company-owned branch and through 689 licensees operating in 49 states. Merry Maids also provides domestic housecleaning services in Japan, the United Kingdom, Canada, Saudi Arabia and Australia through licensing arrangements with local service providers. American Home Shield. AHS is a wholly owned subsidiary of SVM Holding Corp., a holding company in which ServiceMaster Consumer Services L.P. owns 100% of the equity. (An 8% interest held by senior management of AHS at the end of 1993 will be acquired by SVM Holding Corp. in 1994). AHS is a leading provider of home service warranty contracts in the United States, providing homeowners with contracts covering the repair or replacement of built-in appliances, hot water heaters and the electrical, plumbing, central heating, and central air conditioning systems which malfunction by reason of normal use. Service contracts are presently sold principally through participating real estate brokerage offices in conjunction with resales of single-family residences to homeowners. AHS also sells service warranty contracts directly to non-moving homeowners through various other distribution channels which are currently being expanded. As of December 31, 1993, AHS was providing services to approximately 268,000 homes through approximately 6,000 independent repair maintenance contractors in 48 states and the District of Columbia, with operations in California, Texas and Arizona accounting for 32%, 20% and 9%, respectively, of AHS' gross contracts written. AHS also provides home service warranty contracts in Japan and Saudi Arabia through licensing arrangements with local service providers. Res/Com. Res/Com is a wholly owned subsidiary of ServiceMaster Consumer Services L.P. ServiceMaster, through Res/Com, is one of the leading franchisors in the residential and commercial cleaning field. Res/Com provides, through franchisees, carpet and upholstery cleaning and janitorial services, disaster restoration services and window cleaning services to over 1.2 million residential and commercial customers worldwide through a worldwide network of over 4,260 independent franchisees. Diversified Health Services The Diversified Health Services Group was organized in 1993. It consists of ServiceMaster Home Health Care Services and ServiceMaster Diversified Health Services. The latter company was acquired by ServiceMaster in August 1993, at which time the company was known as VHA Long Term Care. ServiceMaster Diversified Health Services. ServiceMaster Diversified Health Services, Inc., ServiceMaster Diversified Health Services L.P. and their respective subsidiaries (collectively, the "ServiceMaster Diversified Health Services Companies") form a comprehensive health services organization which provides: management services to freestanding, hospital based, and government owned nursing homes and assisted living facilities; design, development, refurbishing and construction consulting services to long-term care facilities; hospice services; and various medical supplies. The companies are the exclusive licensee to promote the provision of long-term care services to the hospitals in the Voluntary Hospitals of America alliance. As of December 31, 1993, the ServiceMaster Diversified Health Services Companies were providing management services to approximately 14,000 beds in 26 states in a total of 93 facilities. Home Health Care Services. ServiceMaster Home Health Care Services Inc. provides management services to hospital-based home health care agencies and operates freestanding home health care agencies. As of December 31, 1993, this organization was serving 46 hospital-affiliated home health care agencies and was serving four freestanding agencies. International and New Business Development. The International and New Business Development Group oversees the performance of supportive management services and consumer services in international markets in each case through the arrangements described above. The International and New Business Development Group also operates employer or developer sponsored child care centers under the "GreenTree" service mark. As of December 31, 1993, GreenTree had 14 child care centers in operation, all of which were in the greater Chicago area and in Milwaukee, Wisconsin. Other Activities Supporting Departments. ServiceMaster has various departments responsible for technical, engineering, management information, planning and market services, and product and process development activities. Various administrative support departments provide personnel, public relations, administrative, education, accounting, financial and legal services. Manufacturing Division. ServiceMaster has a manufacturing division which manufactures and distributes supplies, products and equipment that are used internally in providing management services to customers and which are sold to licensees for use in the operation of their businesses. ServiceMaster has an insignificant share of the market for the manufacture and distribution of cleaning equipment, chemicals and supplies. Industry Position, Competition and Customers The following information is based solely upon estimates made by the management of ServiceMaster and cannot be verified. In considering ServiceMaster's industry and competitive positions, it should be recognized that ServiceMaster competes with many other companies in the sale of its services, franchises and products and that some of these competitors are larger or have greater financial and marketing strength than ServiceMaster. The principal methods of competition employed by ServiceMaster in the Management Services, etc. business are price, quality of service and history of providing management services. The principal methods of competition employed by ServiceMaster in the Consumer Services business are name recognition, assurance of customer satisfaction and history of providing quality services to homeowners. The principal methods of competition employed by ServiceMaster in the Diversified Health Services business are name recognition, price, quality of services and history of providing management services. Management Services: Health Care Market. Within the market consisting of general health care facilities having 50 or more beds, ServiceMaster is the leading supplier of plant operations and maintenance, housekeeping, clinical equipment maintenance, and laundry and linen management services. As of December 31, 1993, ServiceMaster was serving in approximately 1,300 health care facilities. The majority of health care facilities within this market not currently served by ServiceMaster assume direct responsibility for managing their own non-medical support functions. ServiceMaster believes that its management services for health care facilities may expand by the addition of facilities not presently served, by initiating additional services at facilities which use only a portion of the services now offered, by the development of new services and by growth in the size of facilities served. At the same time, changes in use and methods of health care delivery and payment for services continue to affect the health care environment. Management Services: Education Market. ServiceMaster is a leading provider of maintenance, custodial, grounds and food management services to the education market. The facilities which comprise the education market served by ServiceMaster include primary schools, secondary schools and school districts, private specialty schools and colleges and universities. ServiceMaster continues to experience steady growth in this market. As of December 31, 1993, ServiceMaster was serving in approximately 500 educational facilities. ServiceMaster believes there is significant potential for expansion in the education market due to its current relatively low penetration of that market and the trend of educational facilities to consider outsourcing more of their service requirements. However, a majority of the educational facilities continue to assume direct responsibility for managing their support functions. Management Services: Industrial and Commercial Market. ServiceMaster believes it is a leading provider of plant operations and maintenance, custodial and grounds management services to industrial and commercial customers. During the period 1991 - 1993, this market has been adversely affected by generally weak economic conditions and corporate downsizing, but ServiceMaster continues to believe that there is potential for expansion in the industrial and commercial market due to ServiceMaster's low current penetration of that market and the trend of industrial and commercial enterprises to consider outsourcing more of their service requirements. Consumer Services. Consumer Services franchisees provide a variety of residential and commercial services under their respective names on the basis of their and ServiceMaster's reputation, the strength of their service mark, their size and financial capability, training and technical support services. The market for termite, pest control and radon testing services to commercial and residential customers includes several large competitors and many small competitors. Terminix is the leading national termite and pest control company within this market and has a significant share of the market. Competition within the termite and pest control market is strong, coming mainly from regional and local, independently owned firms throughout the United States and from one other company which operates on a national basis. Termite and pest control services are regulated by law in most of the states in which Terminix provides such services. These laws require licensing which is conditional on a showing of technical competence and adequate bonding and insurance. The extermination industry is regulated at the federal level under the Federal Insecticide, Fungicide and Rodenticide Act, and pesticide applicators (such as Terminix) are regulated under the Federal Environmental Pesticide Control Act of 1972. Such laws, together with a variety of state and local laws and regulations, may limit or prohibit the use of certain pesticides, and such restrictions may adversely affect the business of Terminix. TruGreen-ChemLawn, both directly and through ChemLawn franchisees, provides lawn care services to residential and commercial customers. Competition within the lawn care market is strong, coming mainly from regional and local, independently owned firms and from homeowners who elect to care for their lawns through their own personal efforts. TruGreen-ChemLawn is the leading national lawn care company within this market. The market for domestic house cleaning services is highly competitive. In urban areas the market involves numerous local companies and a few national companies. ServiceMaster believes that its share of the total potential market for such services is small and that there is a significant potential for further expansion of its housecleaning business through continued internal expansion and greater penetration of the housecleaning market. Through its franchisees, ServiceMaster has a small share of the market for the cleaning of residential and commercial buildings. The market for home systems and appliance warranty contracts is relatively new. ServiceMaster believes that AHS maintains a favorable position in its industry due to the system developed and used by AHS for accepting, dispatching and fulfilling service calls from homeowners through a nationwide network of approximately 6,000 independent contractors. AHS also has a computerized information system developed and owned by AHS, and an electronic digital voice communication system through which AHS handled more than 5.3 million calls in 1993. Diversified Health Services. The ServiceMaster Diversified Health Services Companies constitute the nation's ninth largest long term care company based on the number of beds served and the largest company that is primarily a management services company (as distinguished from a real estate operator). It is also a major provider of planning and design services for long term care facilities and for acute care hospitals. ServiceMaster Home Health Care Services is a leading provider of management services to hospital-affiliated home health care agencies. The number of free-standing home health care agencies operated by ServiceMaster Home Health Care Services represents a very small proportion of home health care agencies in the United States. New Business Development. ServiceMaster Child Care Services, Inc. is the sixth largest manager of employer-based child care facilities in the United States. ServiceMaster believes that there is a significant potential for expansion of its child care services, including particularly in the market consisting of employer-based child care. Major Customers. ServiceMaster has no single customer which accounts for more than 10% of its total revenues. No part of the Company's business is dependent on a single customer or a few customers the loss of which would have a material adverse effect on that part. Revenues from governmental sources are not material. Employees On December 31, 1993, ServiceMaster had a total of approximately 31,000 employees. ServiceMaster provides its employees with annual vacation, medical, hospital and life insurance benefits and the right to participate in additional benefit plans which are described in the Notes to Financial Statements included in the 1993 Annual Report. [CHART] STRUCTURE OF SERVICEMASTER DESCRIPTION OF THE PARTNERSHIP STRUCTURE Organization and Structure of the Parent Companies Until December 30, 1986, the ServiceMaster business was conducted by ServiceMaster Industries Inc. On December 30, 1986, ServiceMaster was reorganized into a limited partnership with the following results, among others: (i) ServiceMaster Limited Partnership became the new parent unit in the ServiceMaster enterprise with one limited partnership share in ServiceMaster Limited Partnership being issued to replace every then outstanding share of common stock issued by ServiceMaster Industries Inc.; (ii) The ServiceMaster Company Limited Partnership was established as the principal operating subsidiary of ServiceMaster Limited Partnership, with the parent entity receiving the entire limited partnership interest in The ServiceMaster Company (representing not less than 99% of the entire ownership interest); and (iii) substantially all of the assets and liabilities associated with the ServiceMaster business were conveyed to The ServiceMaster Company. Until January 31, 1992, the general partners in ServiceMaster Limited Partnership and The ServiceMaster Company were ServiceMaster Management Corporation, which served as the managing general partner, and three individual general partners. On January 31, 1992, the three individual general partners withdrew and became stockholders of ServiceMaster Management Corporation, leaving ServiceMaster Management Corporation as the sole general partner having management authority in the two principal partnerships and, as further discussed below, the sole general partner having an interest in the 1% carried interest reserved to the general partners of the two partnerships. Since January 1, 1987, the general partners have collectively held a 1% interest in all profits and losses of ServiceMaster Limited Partnership and of The ServiceMaster Company, in each case limited to profits and losses generated since the reorganization. Following the withdrawal of the individual general partners on January 31, 1992, the entire 1% interest in the profits and losses of each of ServiceMaster Limited Partnership and The ServiceMaster Company has been held by ServiceMaster Management Corporation. These separate interests constitute an aggregate interest of approximately 2% of the consolidated income and losses of the ServiceMaster business (determined after allowing for minority interests in subsidiaries, where applicable). The Board of Directors of ServiceMaster Management Corporation has the ultimate power to govern the ServiceMaster business. A majority of the positions on the Board are reserved for independent directors. Although the stock of ServiceMaster Management Corporation is owned by members of ServiceMaster management, the stockholders have entered into voting trust arrangements under which the incumbent members of the Board have the right to determine the persons who will be elected to the Board each year. These arrangements were not altered by the 1992 Reorganization. Although the owners of the outstanding limited partner shares issued by ServiceMaster Limited Partnership do not have the right to vote directly for the directors of ServiceMaster Management Corporation, they do have the right to replace ServiceMaster Management Corporation as the managing general partner by voting the percentages of their shares prescribed in the Partnership Agreement in favor of such replacement (provided, however, that certain opinions of counsel are obtained). The holders of the outstanding shares of ServiceMaster Limited Partnership accordingly retain the ultimate right to select the ServiceMaster management. The 1992 Reorganization (ServiceMaster Corporation) Reference is made to the Preface on page 1 for the background of the 1992 Reorganization. As a result of the approval of the Reorganization Package on January 13, 1992, ServiceMaster Corporation was admitted as a Special General Partner of the Registrant on January 31, 1992. As of March 21, 1994, no shares of stock of ServiceMaster Corporation had been issued and the corporation remained in a formative stage. Organization and Structure of Management Services ServiceMaster Management Services Limited Partnership ("SMMS") provides a separate identity for the Management Services business. This business is primarily carried out through several divisions of SMMS, with a small amount of specialized business conducted through a wholly owned subsidiary. SMMS has two general partners, ServiceMaster Management Services, Inc. and The ServiceMaster Company and 44 limited partners in two classes: Class A and Class B. The general partners together hold a 1% interest in SMMS. The Class A limited partners, all of whom are senior members of SMMS management, collectively own 10% of the equity of SMMS (with equity determined for this purpose after allowing for $505.6 million of intercompany debt to The ServiceMaster Company). The Class B limited partner is The ServiceMaster Company, which holds the remaining equity interest in SMMS. The board of directors of ServiceMaster Management Services, Inc. establishes policy for all elements of the Management Services unit of the ServiceMaster enterprise, subject to the overriding authority of the board of directors of ServiceMaster Management Corporation. Organization and Structure of Consumer Services ServiceMaster Consumer Services Limited Partnership ("SMCS") provides a separate identity for the Consumer Services business. SMCS is a holding company for all of the operating units which comprise such business. SMCS holds all of the Company's interests in the following organizations: ServiceMaster Residential/Commercial Services L.P. and its managing general partner; The Terminix International Company L. P. and its managing general partner; TruGreen L.P. and its managing general partner; Merry Maids L. P. and its managing general partner; and SVM Holding Corp. (the parent company of American Home Shield Corporation). SMCS has two general partners, ServiceMaster Consumer Services, Inc., and The ServiceMaster Company, and two limited partners, The ServiceMaster Company and a subsidiary of WMX Technologies, Inc. (which holds a 27.8% interest). The controlling interest in ServiceMaster Consumer Services, Inc., is held by ServiceMaster Management Corporation. The board of directors of ServiceMaster Consumer Services, Inc. is the governance body for SMCS and establishes policy for all elements of the Consumer Services unit of the ServiceMaster enterprise, subject to the overriding authority of the board of directors of ServiceMaster Management Corporation. Organization and Structure of Diversified Health Services The ServiceMaster Company holds the controlling interests in the following organizations which, together, comprise the ServiceMaster Diversified Health Services Group: the ServiceMaster Diversified Health Services Companies and ServiceMaster Home Health Care Services Inc. The ServiceMaster Diversified Health Services Companies consist of a limited partnership and its general partner and their respective subsidiaries. The ServiceMaster Company owns 89% of the equity of the ServiceMaster Diversified Health Services Companies, with members of senior management owning the remaining 11% of such equity. ServiceMaster Home Health Care Services Inc. is wholly owned by The ServiceMaster Company. Organization and Structure of International and New Business Development International operations of the Company are carried out through licensing or joint venture arrangements all of which are coordinated and supervised by International and New Business Development. This unit of the Company also owns all of the equity in ServiceMaster Child Care Services, Inc. Notes to Organizational Structure Chart The following Notes are intended to be read in conjunction with the organizational structure chart on page 13. Note A--Public Investors The public investors in the Registrant collectively hold a 99% interest in the profits, losses and distributions of the Registrant through their ownership of the limited partner interests in the Registrant ("Partnership Shares"). (If ServiceMaster Corporation were to issue any shares of its common stock, this 99% interest would be divided among the owners of the Partnership Shares and the owners of the corporate shares in accordance with their respective interests). The Partnership Shares are listed on the New York Stock Exchange under the symbol "SVM". For the reasons indicated in Note D below, the public investors' 99% interest in the Registrant entitles the public investors to an approximately 98% interest in the consolidated profits, losses and distributions of ServiceMaster. On June 7, 1993 the Registrant effected a 3-for-2 split of its outstanding Partnership Shares. Note B--ServiceMaster Limited Partnership The Registrant (ServiceMaster Limited Partnership) serves as the holding company for the ServiceMaster business. It does not conduct any significant business operations or own any significant property except for its 99% common equity interest in the profits, losses and distributions of The ServiceMaster Company Limited Partnership. ServiceMaster Corporation became a special general partner of the Registrant following the approval of and in accordance with the 1992 Reorganization. Reference is made to the Proxy Statement/Prospectus of ServiceMaster Limited Partnership dated December 11, 1991 for a complete discussion of the background and arrangements regarding ServiceMaster Corporation. Note C--The ServiceMaster Company Limited Partnership The ServiceMaster Company Limited Partnership conducts all of the operations of the International and New Business Development Group and serves as a holding company for the Management Services, Consumer Services, and Diversified Health Services Groups. All of its common limited partner interests are held by the Registrant. An individual holds a preferred limited partner interest in The ServiceMaster Company which will be redeemed by The ServiceMaster Company on March 31, 1994 with payment to be made on May 31, 1994 - see Note R. On January 1, 1993, the ServiceMaster SGP Trust became a special general partner of The ServiceMaster Company - see Note S. Note D--ServiceMaster Management Corporation (Managing General Partner) ServiceMaster Management Corporation is the managing general partner of ServiceMaster Limited Partnership and The ServiceMaster Company Limited Partnership (collectively referred to in this Note D as the "Partnerships"). ServiceMaster Management Corporation has the ultimate authority to control each entity in the ServiceMaster enterprise. The certificate of incorporation of ServiceMaster Management Corporation requires that a majority of the positions on its board of directors must be comprised of independent directors. The certificate of incorporation further provides that this requirement may not be amended without the consent of the holders of a majority of the outstanding shares of ServiceMaster Limited Partnership. The stock of ServiceMaster Management Corporation is owned by persons who were or are senior members of the ServiceMaster management. The stockholders of this corporation have deposited their stock in a voting trust of which the directors themselves are trustees with discretionary power to vote the stock. These arrangements enable the incumbent members of the Board of Directors to choose the persons elected to the Board each year. On January 31, 1992, as contemplated by the 1992 Reorganization, all individuals who were then serving as general partners of the Partnership withdrew as general partners and became stockholders of ServiceMaster Management Corporation with stock interests therein which indirectly represented their former general partner carried interests. Their general partner carried interests were transferred to ServiceMaster Management Corporation as part of these adjustments. ServiceMaster Management Corporation does not employ any significant number of persons or own any office space or other equipment used to conduct the day-to-day management of ServiceMaster; rather, the employees and assets necessary to manage the ServiceMaster business are based within the operating entities. The applicable partnership agreements as adopted in 1986 and as amended since then provide that the general partners of the Partnerships are entitled to a 1% interest in each of the two Partnerships. As noted above, since January 31, 1992, the sole holder of the 1% interest in each of the two Partnerships has been ServiceMaster Management Corporation. These interests are "carried interests" which means that ServiceMaster Management Corporation is not required to contribute to the capital of the Partnerships except as may be necessary to pay liabilities for which provision cannot otherwise be made. These carried interests will remain at a constant 1% in each of the two Partnerships at all times regardless of the extent to which additional investments in the Partnerships are made by others and regardless of the extent to which the Partnerships redeem other interests. These 1% interests provide ServiceMaster Management Corporation with approximately 1.99% of the profits and losses of the entire ServiceMaster enterprise, that is, ServiceMaster Management Corporation is entitled to 1% of the profits of The ServiceMaster Company Limited Partnership and, because that partnership is 99% owned by ServiceMaster Limited Partnership, it is entitled to an additional 1% of the 99% of The ServiceMaster Company Limited Partnership's profits which are allocated to ServiceMaster Limited Partnership. For the year 1993, each of the Partnerships made cash distributions equal to 1% of its net income to ServiceMaster Management Corporation. The total of the distributions made with respect to 1993 was $2,547,618. From that amount the corporation paid state corporate taxes and, on behalf of its stockholders, the letter of credit fees charged with respect to the promissory notes described in the next paragraph. The balance, $2,339,310, was distributed by ServiceMaster Management Corporation to those past and present officers of ServiceMaster who constituted the stockholders of ServiceMaster Management Corporation. Such persons include Messrs. Pollard, Stair, Cantu, Erickson and Oxley, whose indirect allocations of the total 1.99% carried interest at the end of 1993 were 15.46%, 11.34%, 11.34%, 11.34% and 5.02%, respectively. At December 31, 1993, the stock of ServiceMaster Management Corporation was owned by 33 ServiceMaster executives, each of whom had signed a promissory note payable to the corporation in the amount of the purchase price of his or her stock. Such notes amounted to approximately $15,000,000 in the aggregate and are payable upon demand. The payment of each such note is secured by a letter of credit from the Continental Bank N.A. The fees for such letters of credit are borne entirely by the makers of the notes and not by ServiceMaster. Note E--ServiceMaster Consumer Services Limited Partnership and ServiceMaster Consumer Services,Inc. ServiceMaster Consumer Services Limited Partnership ("SMCS") is the holding company and governance entity for the Consumer Services business. The governance function is carried out through ServiceMaster Consumer Services, Inc., one of the two general partners of SMCS. The second general partner is The ServiceMaster Company. The general partners collectively hold a 1% interest in SMCS. The ServiceMaster Company, one of two limited partners, holds a 72.2% equity interest in SMCS. The other limited partner is WMI Urban Services, Inc. ("WMUS"), a wholly owned subsidiary of WMX Technologies, Inc., which owned 27.8% of the common equity of SMCS at the end of 1993. In June 1992, WMUS and ServiceMaster amended the SMCS limited partnership agreement for the purpose of eliminating the right which WMUS theretofore held to withdraw from SMCS and to receive $160 million in redemption of its equity ownership interest. This withdrawal right was replaced by a right held by WMUS to increase its equity ownership interest in SMCS to 27.8% upon a payment to SMCS of $68 million. On June 8, 1993, WMUS exercised such right, with the result that SMCS received $68 million and WMUS' limited partner interest in SMCS increased from 22% to 27.8%. The board of directors of ServiceMaster Consumer Services, Inc., consists of twelve persons in the following categories: ServiceMaster directors and officers: C. William Pollard, Carlos H. Cantu, Charles W. Stair; persons who are also members of the Board of Directors of ServiceMaster Management Corporation or Senior Management Advisors but who are not ServiceMaster officers: Henry O. Boswell, Herbert P. Hess, Vincent C. Nelson, Kay A. Orr, Phillip B. Rooney and Dallen W. Peterson; persons who are ServiceMaster officers but not directors of ServiceMaster Management Corporation or a Senior Management Adviser: Robert F. Keith; and persons not affiliated with ServiceMaster except as a director of ServiceMaster Consumer Services, Inc.: Donald G. Soderquist (Vice Chairman of the Board and Chief Operating Officer of Wal Mart Stores, Inc.). ServiceMaster Management Corporation has the power to elect and remove the directors of ServiceMaster Consumer Services, Inc. The following persons have been appointed as Senior Management Advisers to the Board of Directors of ServiceMaster Consumer Services, Inc.: Paul A. Bert and Thomas W. Scherer (both of whom are officers of Consumer Services). A Senior Management Adviser, Consumer Services, attends Consumer Services board meetings but does not vote. This position carries no compensation. Note F--ServiceMaster Management Services Limited Partnership and ServiceMaster Management Services, Inc. ServiceMaster Management Services Limited Partnership ("SMMS") is the holding company and governance entity for the Management Services business. The governance function is carried out through ServiceMaster Management Services, Inc., one of the two general partners of SMMS. The second general partner is The ServiceMaster Company. The general partners collectively hold a 1% interest in SMMS, and The ServiceMaster Company, as the Class B limited partner, and members of senior management of Management Services, as Class A limited partners, hold the remaining 99% interest. The board of directors of ServiceMaster Management Services, Inc. consists of nine persons in the following categories: ServiceMaster directors and officers: C. William Pollard, Carlos H. Cantu, Charles W. Stair and Robert D. Erickson; persons who are also members of the Board of Directors of ServiceMaster Management Corporation but who are not ServiceMaster officers: Herbert P. Hess, Gunther H. Knoedler and David K. Wessner; persons who are Senior Management Advisers and officers: Brian D. Oxley; persons who are ServiceMaster officers but not members of the Board of Directors of ServiceMaster Management Corporation or a Senior Management Adviser: Jerry D. Mooney (President, ServiceMaster Diversified Health Services); and persons not affiliated with ServiceMaster except as a director of ServiceMaster Management Services, Inc.: Paul W. Berezny, Jr. (real estate investor). ServiceMaster Management Corporation has the power to elect and remove the directors of ServiceMaster Management Services, Inc. Members of senior SMMS management purchased a 10% interest in SMMS as Class A limited partners. The equity of SMMS is determined, for purposes of such 10% interest, after allowing for intercompany debt to The ServiceMaster Company. Such intercompany debt is offset and eliminated in preparing the consolidated financial statements of the Registrant. SMMS has the right (the "call right") to purchase this minority interest and each Class A limited partner has the right (the "put right") to require SMMS to purchase his or her interest at any time during the period beginning on January 1, 1999 and ending on January 31, 2003. Each Class A limited partner can accelerate his or her put right to the end of 1997 in order to receive shares of the Registrant instead of cash. The purchase price for all transactions involving the purchase of a Class A limited partner interest is the then current fair market value of the interest as confirmed by an independent appraisal. Note G--ServiceMaster Diversified Health Services ServiceMaster Diversified Health Services is comprised of the ServiceMaster Diversified Health Services Companies and ServiceMaster Home Health Care Services. The former is 89% owned by The ServiceMaster Company while the latter is 100% owned by The ServiceMaster Company. The ServiceMaster Diversified Health Services Companies include a parent limited partnership and its general partner, and a number of subsidiary companies. The governance body for the ServiceMaster Diversified Health Services Companies is the board of directors of ServiceMaster Diversified Health Services, Inc. This board consists of eight persons in the following categories: ServiceMaster directors and officers: Carlos H. Cantu, Charles W. Stair, Jerry D. Mooney, Joseph K. Piper, Robert D. Erickson and David K. Wessner; and persons not affiliated with ServiceMaster except as a director of ServiceMaster Diversified Health Services, Inc.: Richard D. Thomas and Curt W. Nomomaque. The following persons have been appointed as Senior Management Advisers, ServiceMaster Diversified Health Services: Bradley T. Barker, James J. Goodrich, Steven R. Martin and Judith A. Ullery. A Senior Management Adviser attends ServiceMaster Diversified Health Services board meetings but does not vote. This position carries no compensation. Note H--The Terminix International Company Limited Partnership The Terminix International Company Limited Partnership ("Terminix") has two general partners: Terminix International, Inc., the managing general partner, and TSSGP Limited Partnership ("TSSGP"). Terminix is a wholly owned subsidiary of SMCS. Note I--TruGreen Limited Partnership TruGreen Limited Partnership ("TruGreen") has two general partners: TruGreen, Inc., which is the managing general partner, and TSSGP. Members of TruGreen management own a 15% minority interest in TruGreen. TruGreen has the right (the "call right") to purchase this 15% minority interest, and each person who holds a part of the minority interest has the right (the "put right") to require TruGreen to purchase his or her minority interest in TruGreen. The call right and the put right may be exercised at any time during the period beginning on January 1, 1997, and ending on January 31, 2002. The purchase price for all transactions involving a minority interest purchase is the then current fair market value as confirmed by an independent appraisal. Note J--Res/Com ServiceMaster Residential/Commercial Services Limited Partnership ("Res/Com") has two general partners: ServiceMaster Residential/Commercial Services Management Corporation, which is the managing general partner, and TSSGP. Res/Com is a wholly owned subsidiary of SMCS. Note K--Merry Maids Merry Maids Limited Partnership ("Merry Maids") has two general partners: Merry Maids, Inc., which is the managing general partner, and TSSGP. Merry Maids is a wholly owned subsidiary of SMCS. (The minority interest in Merry Maids held by members of senior management of Merry Maids at the end of 1993 will be acquired by Merry Maids in 1994). Note L--American Home Shield American Home Shield Corporation ("AHS") is a wholly-owned subsidiary of SVM Holding Corp. ("Holding"). Holding is a wholly owned subsidiary of SMCS. (The 8% interest in Holding held by members of senior management of AHS at the end of 1993 was acquired by Holding in 1994). Note M--ServiceMaster Diversified Health Services Companies The ServiceMaster Diversified Health Services Companies (formerly VHA Long Term Care) are wholly owned subsidiaries of LTCS Investment, L.P. The latter partnership is 89% owned by The ServiceMaster Company and 11% by members of senior management of the ServiceMaster Diversified Health Services Companies. LTCS L.P. has the right (the "call right") to purchase this 11% minority interest, and each person who holds a part of the minority interest has the right (the "put right") to require LTCS L.P. to purchase his or her minority interest in LTCS L.P. The call right and the put right may be exercised at any time during the period beginning on January 1, 1999, and ending on January 31, 2004. The purchase price for all transactions involving a minority interest purchase is the then current fair market value as confirmed by an independent appraisal. Note N--Home Health Care Services ServiceMaster Home Health Care Services Inc. is a wholly owned subsidiary of The ServiceMaster Company and is a part of the ServiceMaster Diversified Health Services Group. Note O--International and New Business Development International and New Business Development is a division of The ServiceMaster Company. Its operations have been described above (page 8). Note P--Child Care Services ServiceMaster Child Care Services, Inc., is a wholly owned subsidiary of The ServiceMaster Company and is a part of the International and New Business Development Group. Its operations have been described above (page 8). Note Q--Other Subsidiaries Other subsidiaries include CMI Group, Inc., a subsidiary of ServiceMaster Management Services L.P.; miscellaneous operating and name protection entities; and ServiceMaster Operations, AG, a Swiss corporation which, in turn, operates through separate subsidiaries organized in the United Kingdom and Germany. Reference is made to Exhibit 22 for a complete list of the subsidiaries of the Registrant. Note R--Norrell Corporation On February 11, 1994, ServiceMaster sold to Norrell Corporation ("Norrell") all of the common equity interest in Norrell held by ServiceMaster for $29.3 million, an amount which exceeded its carrying value. On March 31, 1994, ServiceMaster will redeem the preferred interest in The ServiceMaster Company which was issued in 1991 to, and thereafter held by, Norrell's principal stockholder. Payment of the redemption price will be made on May 31, 1994 in the form of cash in the amount of $14.6 million and 372,950 shares of the Registrant. Note S--ServiceMaster SGP Trust On January 1, 1993, the limited partnership agreement of The ServiceMaster Company was amended to admit a trust as a special general partner of The ServiceMaster Company (the "SGP Trust"). The beneficiaries of the ServiceMaster SGP Trust are the limited partners of the Registrant as constituted from time to time and ServiceMaster Corporation (but the latter is a beneficiary only if shares of its common stock are outstanding, which is not now the case). SGP Trust will receive each year an allocation of taxable income equal to the amount by which the aggregate taxable income of The ServiceMaster Company exceeds the cash distributions made by the Registrant directly to its limited partners and to ServiceMaster Corporation. As a result of this allocation of taxable income, the cash distributions made by the Registrant directly to its limited partners and to ServiceMaster Corporation will be exactly equal to the taxable income of the Registrant which is directly allocated to its limited partners and to ServiceMaster Corporation. The ServiceMaster Company will annually make a cash distribution to SGP Trust in the amount required by the trust for the payment of its federal and state income tax liabilities. This arrangement solves the "crossover problem" described in earlier annual reports and in the Registrant's Proxy Statement dated December 11, 1991. Item 2.		Item 2. Properties The headquarters facility of ServiceMaster, which also serves as headquarters for the ServiceMaster Management Services and International and New Business Development Groups, is owned by The ServiceMaster Company and is located on a ten-acre tract at One ServiceMaster Way, Downers Grove, Illinois. The initial structure was built in 1963, and two additions were completed in 1968 and 1976. In early 1988, ServiceMaster completed construction of a two-story 15,000 square foot addition for office space, food service demonstrations and dining facilities. The building contains approximately 118,900 square feet of air conditioned office space and 2,100 square feet of laboratory space. In the Spring of 1992, ServiceMaster completed the conversion of approximately 30,000 square feet of space formerly used as a warehouse to offices for Management Services and for The Kenneth and Norma Wessner Training Center. ServiceMaster owns a seven acre, improved tract at 2500 Warrenville Road, Downers Grove, Illinois, which is adjacent to its headquarters facility. In 1993, ServiceMaster substantially remodeled the building and thereafter leased approximately half the space (50,000 square feet) to a commercial tenant. The balance of the space will continue to be utilized by ServiceMaster personnel. ServiceMaster leases a 50,000 square foot facility near Aurora, Illinois which is used by ServiceMaster as a warehouse/distribution center. ServiceMaster believes that the facilities described in the preceding three paragraphs will satisfy the Company's needs for administrative and warehouse space in the Chicago area for the immediate future. ServiceMaster owns four properties in Cairo, Illinois, consisting of a 36,000 square foot, three-story building used for manufacturing and warehousing equipment, supplies and products used in the business; a warehouse and package facility comprising 30,000 square feet; a three-story warehouse and manufacturing building consisting of 43,000 square feet; and a 2,500 square foot building used for a machine shop. ServiceMaster leases a 44,000 square foot manufacturing facility in Lancaster, Pennsylvania, which is used to provide products and equipment primarily to customers of Management Services in the eastern part of the United States. Management believes that the foregoing manufacturing and warehouse facilities are adequate to support the current needs of ServiceMaster. The headquarters for ServiceMaster Consumer Services L.P. are located in leased premises at 855 Ridge Lake Boulevard, Memphis, Tennessee. This facility also serves as the headquarters for Terminix, Res/Com and TruGreen-ChemLawn. The headquarters facility for Merry Maids is located in leased premises at 11117 Mill Valley Road, Omaha, Nebraska. The headquarters facility for American Home Shield is presently located in leased premises at 90 South E Street, Santa Rosa, California, but later in 1994 this facility will be closed and the American Home Shield headquarters will be relocated to Memphis, Tennessee. American Home Shield's service and data processing departments are located in premises owned by the company in Carroll, Iowa. This facility consists of a 43,000 square foot building on a seven-acre site. American Home Shield owns approximately 98 acres of land in Santa Rosa, California. This land is held for investment purposes and has been and will continue to be offered for sale, with the timing of sales being affected by, among other things, market demand, zoning regulations, and the availability of financing to purchasers. Terminix owns 16 buildings which are used as branch sites. These properties are all one-story buildings that contain both office and storage space. These properties are located in New Jersey (2 properties), California (2 properties), Florida (8 properties), and Texas (4 properties). TruGreen-ChemLawn owns several buildings which are used as branch sites for lawn care services. These facilities are located in various parts of the United States. In July 1992, TruGreen leased the former ChemLawn headquarters facility in Columbus, Ohio. In 1993, this facility was sold by its owner and the lease with TruGreen was terminated. The headquarters for the ServiceMaster Diversified Health Services Companies ("DHS") is located in leased premises at 5050 Poplar Avenue, Memphis, Tennessee. DHS leases other administrative facilities in Plymouth Meeting, Pennsylvania; Dallas, Texas; and Atlanta, Georgia. DHS has an ownership interest in three nursing home facilities through joint venture arrangements in which DHS has a 50% interest. Item 3.	Item 3. Legal Proceedings In the ordinary course of conducting its business activities, ServiceMaster becomes involved in judicial and administrative proceedings which involve both private parties and governmental authorities. As of March 21, 1994, these proceedings included a number of general liability actions and a very small number of environmental proceedings. General Liability Matters. Terminix is a party to litigation in Tennessee involving an alleged misapplication of the chemical Aldrin. This matter has been settled as to the compensatory element of the case for an amount within Terminix's insurance coverage. The punitive damages element of the case will be the subject of a new trial. Terminix expects that punitive damages, if any, will not be material in amount. Environmental Matters. Terminix is one of several defendants named in a suit filed by the United States Environmental Protection Agency (the "EPA") on November 3, 1986 in the United States District Court for the Western District of Tennessee, to recover the costs of remediation at two sites in Tennessee which have been designated by the EPA as "Superfund sites" under the Comprehensive Environmental Response Compensation and Liability Act ("CERCLA"). Terminix has agreed, on an interim basis, to a ten percent cost share with respect to one site and has not entered a cost sharing agreement with respect to the other. Terminix has also been notified by a letter from the EPA, along with many other parties, as a "potentially responsible party" under CERCLA at a site in Wichita, Kansas. Terminix was named in a Superfund site in Michigan but Terminix's connection to this matter is through an acquisition in which the seller retained responsibility for environmental matters; Terminix considers its exposure in this case to be not material. Terminix's actual participation in the total volume of hazardous waste at these sites is less than five percent. The CERCLA law is written to impose joint and several liability for the cleanup costs at any particular site on every contributor to that site, and accordingly every contributor's potential liability at every site is large. Based on practical experience with prior CERCLA situations and the circumstances of the cases in which it is now involved, Terminix expects that its actual liability at these sites will not be material. ServiceMaster believes the outcome of the proceedings referred to above will not be, individually or in the aggregate, material to its business, financial condition or results of operations. Item 4.	Item 4. Submission of Matters to a Vote of Security Holders Not Applicable PART II Item 5.	Item 5. Market for Registrant's Partnership Shares and Related Shareholder Matters Except for the information set forth in the second and third sentences of this Item 5, the portions of the ServiceMaster Annual Report to Shareholders for 1993 under the captions "Shareholders' Equity" (pages 34 - 35) and "Cash Distributions Per Share" and "Price Per Share" in the Quarterly Operating Results table (page 36) supply the information required by this item and such portions are hereby incorporated herein by reference. The Registrant's shares are listed and traded on the New York Stock Exchange. At March 21, 1994, the Registrant's shares were held of record by approximately 65,000 persons. Item 6.	Item 6. Selected Financial Data The portion of the ServiceMaster Annual Report to Shareholders for 1993 in the Financial Statements and Management Discussion section ("FSMD Section") under the caption "Eleven Year Financial Summary" (pages 24 - 25) supplies the information required by this item and such portion is hereby incorporated herein by reference. Item 7.	Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Management's Discussion and Analysis of Financial Condition and Results of Operations for the three years ended December 31, 1993, is contained in the FSMD Section of the ServiceMaster Annual Report to Shareholders for 1993 on pages 19 - 23 and is hereby incorporated herein by reference. Item 8.	Item 8. Financial Statements and Supplementary Data The consolidated statements of financial position of ServiceMaster as of December 31, 1993 and 1992, and the consolidated statements of income, cash flows and shareholders' equity for the years ended December 31, 1993, 1992 and 1991 and notes to the consolidated financial statements are contained in the FSMD Section of the ServiceMaster Annual Report to Shareholders for 1993 on pages 27 - 36 and are incorporated herein by reference. The report of Arthur Andersen & Co. thereon dated January 25, 1994, and the summary of significant accounting policies are contained in the FSMD Section of the ServiceMaster Annual Report to Shareholders for 1993 on page 26 and are hereby incorporated herein by reference. Item 9.	Item 9. Disagreements on Accounting and Financial Disclosure Inapplicable. PART III Item 10.	Item 10. Directors and Executive Officers of the Corporate General Partner of Registrant and The ServiceMaster Company The following section of this Item 10 shows: (i) the names and ages (as of March 18, 1994) of the present directors of ServiceMaster Management Corporation (the corporate general partner of ServiceMaster Limited Partnership and The ServiceMaster Company); (ii) all positions and offices with ServiceMaster held by each such director; and (iii) the term of each such person as a director and all period(s) during which each director has served. There are no arrangements or understandings between any director and any other person pursuant to which the director was or is to be selected as a director or nominee. 1994 Class Carlos H. Cantu, age 60, has been a director since 1988. On January 1, 1994, Mr. Cantu became the President and Chief Executive Officer of ServiceMaster. He is the President and Chief Executive Officer of ServiceMaster Consumer Services, a director and the Chairman of ServiceMaster Consumer Services, Inc., a director and the Chairman of ServiceMaster Management Services, Inc. and a director of ServiceMaster Diversified Health Services, Inc. He served as Executive Vice President and Chief Operating Officer, Consumer Services, from October 1988 to May 1990 and as President and Chief Operating Officer of ServiceMaster Consumer Services from June 1, 1990 to May 1991. Mr. Cantu also serves as Vice Chairman of American Home Shield Corporation. He served as President and Chief Executive Officer of The Terminix International Company Limited Partnership from December 18, 1986 to December 31, 1992. He is a director of Terminix International, Inc., the corporate general partner of The Terminix International Company Limited Partnership. He has been a director of NationsBank/Memphis in Memphis, Tennessee, since August 1988; of NationsBank/Tennessee in Nashville, Tennessee, since January 1990; and of Midland Financial Group, Inc., an insurance company in Memphis, Tennessee, since September 1992. Lord Brian Griffiths of Fforestfach, age 52, has been a director since August 1992. He is a member of the Executive Committee of the Board of Directors. He is an international advisor to Goldman, Sachs & Co. concerned with strategic issues related to their United Kingdom and European operations and business development activities worldwide. During the period 1985 to 1990, he served at No. 10 Downing Street as Head of the Prime Minister's Policy Unit. He was made a life peer at the conclusion of his service to the Prime Minister. Lord Griffiths is a director of THORN EMI plc, Times Newspapers Holding Ltd., Herman Miller, Inc., Zeeland, Michigan, and HTV (Harlech Television). Gunther H. Knoedler, age 64, has been a director since 1979. He is a member of the Executive Committee, the Chairman of the Audit Committee and a member of the Share Option Committees of the Board of Directors and he is a director of ServiceMaster Management Services, Inc. Mr. Knoedler is Executive Vice President and Director Emeritus of Bell Federal Savings & Loan Association, Chicago, Illinois. He is the Chairman of the Board of Trustees of Wheaton College, Wheaton, Illinois, and a member of the Board of Directors of Tyndale House Publishers, Inc. Vincent C. Nelson, age 52, has been a director since 1978. Mr. Nelson is a member of the Executive Committee and the Audit, Employee Share Purchase Plan, and Share Option Committees of the Board of Directors. He is also a director of ServiceMaster Consumer Services, Inc. Mr. Nelson is a business investor and is a trustee of Westmont College, Santa Barbara, California. Mr. Nelson is the foster son of Kenneth N. Hansen, Director Emeritus and Adviser. C. William Pollard, age 55, has been a director since December 1977. Since May 1990, he has been the Chairman of the Board and Chairman of the Executive Committee. From May 1983 to December 31, 1993, Mr. Pollard served as the Chief Executive Officer of ServiceMaster. He served as President of ServiceMaster from 1981 to May 1990 and has been the Chief Executive Officer of the Company since May 1983. He is a director and the Vice Chairman of ServiceMaster Consumer Services, Inc., a director and the Vice Chairman of ServiceMaster Management Services, Inc. and a director and the Chairman of American Home Shield Corporation. Mr. Pollard joined ServiceMaster as Senior Vice President in December 1977. He served as Executive Vice President and Chief Operating Officer from November 1980 until his election as Chief Executive Officer in May 1983. Mr. Pollard is a director of Herman Miller, Inc., Zeeland, Michigan; a director of Provident Life and Casualty Insurance Company, Chattanooga, Tennessee; and an advisory director of Trammell Crow Company, Dallas, Texas. 1995 Class Henry O. Boswell, age 64, has been a director since 1985. He is a member of the Executive Committee of the Board of Directors and he is a director of ServiceMaster Consumer Services, Inc. From 1983 until his retirement in October 1987, Mr. Boswell was President of Amoco Production Company. During the same time period, he was Chairman of the Board of Amoco Canada and a director of Amoco Corporation. He has served in various positions with affiliates of Amoco Corporation since 1953. Mr. Boswell is a director of Rowan Companies, Inc., Houston, Texas, and Cabot Oil & Gas Corp. in Houston, Texas. James D. McLennan, age 57, has been a director since May 1986. He is a member of the Audit Committee. Mr. McLennan joined McLennan Company, a real estate service company, in 1958. He was named partner in 1968 and became President in 1981. He is a member of the Board of Directors of Lutheran General Medical Health Systems, Park Ridge, Illinois and the Chairman of the Board of the Lutheran General Foundation. Mr. McLennan is also a director of NBD Bank of Park Ridge, Park Ridge, Illinois, a director of Potomac Corporation in Wheeling, Illinois, a laminator of paper products and a director of The Loewen Group Inc., a provider of funeral services, Burnaby, B.C., Canada. Burton E. Sorensen, age 64, has been a director since May 1984. He is a member of the Executive Committee of the Board of Directors. He is the Chairman and Chief Executive Officer of Lord Securities Corporation. He served as President and Chief Executive Officer of the corporation from December 1984 to December 1992. He joined Goldman, Sachs & Co., an investment banking and brokerage firm, in 1972 as Vice President, Investment Banking Division, and became a general partner in 1977. Mr. Sorensen is also a director of Provident Life and Casualty Insurance Company, Chattanooga, Tennessee. Charles W. Stair, age 53, has been a director since December 1986. He previously served as a director from 1976 to 1983. He has been the President and Chief Executive Officer of ServiceMaster Management Services since May 1991, he is a director of ServiceMaster Management Services, Inc. and he is a director and the Chairman of ServiceMaster Diversified Health Services, Inc. Mr. Stair served as President and Chief Operating Officer, Management Services, from June 1990 to April 1991 and as Executive Vice President and Chief Operating Officer, Management Services, from October 1, 1988 to May 1990. He served as Executive Vice President, Management Services from December 31, 1987 to September 30, 1988. Mr. Stair is a member of the Profit Sharing, Savings and Retirement Plan Administrative Committee. He is a director of Tyndale House Publishers, Inc., Wheaton, Illinois. David K. Wessner, age 42, has been a director since March 1987. He is a member of the Executive Committee and is a director of ServiceMaster Management Services, Inc. and ServiceMaster Diversified Health Services, Inc. Mr. Wessner has been Senior Vice President, Programs and Process Improvement, Geisinger Health Systems, since January 1, 1994. He served as Executive Vice President, Programs and Process Improvement, Geisinger Health Systems from November 1992 to December 31, 1993 and as Senior Vice President and Administrative Director from 1982 to November 1992. Mr. Wessner is a director of Commonwealth Bank, a division of Meridian Bank, Reading, Pennsylvania, and a director of Geisinger Health Plan, Danville, Pennsylvania. He is the son of Kenneth T. Wessner, who is a Director Emeritus. 1996 Class Herbert P. Hess, age 57, has been a director since 1981. He is a member of the Executive Committee and a director of ServiceMaster Consumer Services, Inc. Mr. Hess is a Managing Director of Berents & Hess Capital Management, Inc., an investment management firm. He is the past President and Chief Executive Officer of State Street Research & Management Company, an investment management firm. Mr. Hess was Chairman of MetLife-State Street Investment Services, Inc. from 1988 to April 1, 1990. Kay A. Orr, age 55, has been a director since January 1, 1994. She is also a director of ServiceMaster Consumer Services, Inc. Mrs. Orr was Governor of Nebraska from 1987 to 1991 and served as the State Treasurer of Nebraska from 1981 to 1986. From 1979 to 1981, she served as Chief of Staff to the Governor of Nebraska. Mrs. Orr is a director of The Williams Companies, Tulsa, Oklahoma, a trustee of Hastings (Nebraska) College, and a trustee of the Peoples City Mission Foundation. Philip B. Rooney, age 49, has been a director since January 1, 1994. He is a member of the Executive Committee of the Board of Directors. He is also a director of ServiceMaster Consumer Services, Inc. Mr. Rooney is a director and the President and Chief Operating Officer of WMX Technologies, Inc., Oak Brook, Illinois, the Chairman of the Board and Chief Executive Officer of Wheelabrator Technologies, Inc., Hampton, New Hampshire, Chairman of the Board of Rust International, Inc., Oak Brook, Illinois, a director of Chemical Waste Management, Inc., Oak Brook, Illinois, and a director of Waste Management International, Inc., Oak Brook, Illinois. He is also a director of Illinois Tool Works, Inc., Caremark International, Inc. and Urban Shopping Centers, Inc. Directors Emeritus Kenneth N. Hansen, age 75, served as a director from 1947 until 1987. Mr. Hansen has been Director Emeritus and Adviser to ServiceMaster since April 1987. He served as Vice Chairman from 1981 until 1987. He served as Chairman of the Executive Committee from 1975 to 1981, as Chairman of the Board of Directors from 1973 to 1981, as Chief Executive Officer from 1957 through 1975 and as President from 1957 to 1973. He is an ex- officio member of all committees of the Board. Mr. Hansen is the foster parent of Vincent C. Nelson, a director of ServiceMaster Management Corporation. Kenneth T. Wessner, age 71, served as a director from 1965 to December 12, 1992. Since that date he has been Director Emeritus. Mr. Wessner was Chairman of the Board and Chairman of the Executive Committee of ServiceMaster from 1981 to May 1990. He was Chief Executive Officer from 1975 until June 1, 1983 and President from 1973 until June 1, 1981. Mr. Wessner established the Health Care Division in 1962 and served as its President. He is a director of Bell Federal Savings & Loan Association, Chicago, Illinois. Mr. Wessner is a member of the Nominating Committee. He is the father of David K. Wessner who is a ServiceMaster director. Senior Management Advisers The Bylaws of ServiceMaster Management Corporation provide that the Board of Directors may appoint officers of ServiceMaster and other persons having a special relationship to ServiceMaster to serve as Senior Management Advisers. Senior Management Advisers attend the meetings of the Board and advise the Board but do not have the power to vote. The Board has determined that providing a greater number of officers the opportunity to advise and interact with the Board is in the best interest of ServiceMaster as well as the individual officers. The Senior Management Advisers receive no special compensation for their services in this capacity. The Board of Directors has appointed the persons listed below as Senior Management Advisers effective as of the 1993 annual meeting of shareholders to serve in such capacity until the annual meeting of shareholders in 1994 or until otherwise determined by the Board of Directors. Robert D. Erickson, age 50, was a director from May 1987 to May 1993. He previously served as a director from May 1981 through May 1984. He is a director of ServiceMaster Management Services, Inc. He is presently President, International and New Business Development. He served as Executive Vice President and Chief Operating Officer of this division from November 1992 to December 31, 1993. He served as Executive Vice President and Chief Operating Officer, People Services, from January 1990 to October 1992 and as Executive Vice President and Chief Financial Officer of ServiceMaster from January 1986 through December 1989. Mr. Erickson is a director of Moody Bible Institute, Chicago, Illinois; and VanCom Incorporated, South Holland, Illinois, a transportation company. Mr. Erickson is a member of the Profit Sharing, Savings and Retirement Plan Administrative Committee, the Employee Share Purchase Plan Administrative Committee, and the Employee Benefits Plan Committee. Brian D. Oxley, age 43, is Executive Vice President and Chief Operating Officer of ServiceMaster Management Services. He is a director of ServiceMaster Management Services, Inc. From November 1992 to December 31, 1993, he served as the President and Chief Executive Officer of the International and New Business Development Group. He served as Executive Vice President, New Business Development from January 1991 to November 11, 1992 and as President of International Services from January 1, 1988 to November 11, 1992. He served as President of the Residential/Commercial and International divisions of ServiceMaster from 1987 through 1989. Mr. Oxley is a director of Kawakita Hospital, Tokyo, Japan. Dallen W. Peterson, age 57, served as the Chairman of Merry Maids, Inc. until the acquisition of that company's assets by Merry Maids Limited Partnership in July 1988. He is presently the Chairman of Merry Maids Limited Partnership. Donald K. Karnes, age 43, is President of TruGreen- ChemLawn. He has served as President and Chief Operating Officer of TruGreen-ChemLawn since January 1, 1992; from January 1, 1990 to December 31, 1991, he was Senior Vice President, TruGreen Limited Partnership. During the year 1989, Mr. Karnes was a Regional Vice President for Waste Management Urban Services, Inc. Executive Officers of ServiceMaster The following table shows: (i) the names and ages (as of March 18, 1994) of the present executive officers of the Registrant, The ServiceMaster Company and ServiceMaster Management Corporation; (ii) all positions presently held by each officer; and (iii) the year each person became an officer. Each person named has served as an officer of the Registrant continuously since the year shown. There are no arrangements or understandings between any executive officer and any other person pursuant to which the officer was or is to be selected as an officer. Messrs. Pollard, Stair and Cantu are also Directors of ServiceMaster Management Corporation. Messrs. Erickson and Oxley are Senior Management Advisers. See pages 31, 32, and 33 for biographical information with respect to these executive officers. Vernon T. Squires, age 59, was elected Senior Vice President and General Counsel effective January 1, 1988. He served as Vice President and General Counsel from April 1, 1987 until December 31, 1987. He served as an associate and partner with the law firm of Wilson & McIlvaine in Chicago, specializing in corporate and tax law, from 1960 to April 1, 1987. He is presently Of Counsel to that firm. He is a director of the Suburban Bus Division of the Regional Transportation Authority. Ernest J. Mrozek, age 40, was elected Vice President, Treasurer and Chief Financial Officer effective November 1, 1992. He served as Vice President and Chief Accounting Officer, from January 1, 1990 to October 31, 1992 and as Vice President, Accounting, from December 1987 to December 1989. He practiced public accounting as a manager with Arthur Andersen and Co. from 1981 to December 1987. Compliance With Section 16(a) of The Exchange Act of 1934 Section 16(a) of the Securities Exchange Act of 1934 requires ServiceMaster's officers and directors, and persons who own more than ten percent of ServiceMaster's shares, to file reports of ownership and changes in ownership with the Securities and Exchange Commission (the "Commission") and the New York Stock Exchange. The Commission's regulations require certain officers, directors and greater-than-ten-percent shareholders to furnish to ServiceMaster copies of all Section 16(a) forms that they file. During 1993, ServiceMaster received Section 16(a) forms from such officers and directors; ServiceMaster has no shareholders with an interest greater than ten percent. Based solely on a review of the copies of Section 16(a) forms received by ServiceMaster or on written representations from certain reporting persons that no Forms 5 were required for those persons, ServiceMaster believes that during 1993, its officers and directors complied with applicable filing requirements except that five reports, covering an aggregate of six transactions, were filed late by Messrs. Karnes, Oxley, Rooney and Mrs. Orr. (Two of such late reports were amendments of earlier reports which were timely filed). Item 11.	Item 11. Executive Compensation The following table sets forth all compensation awarded to, earned by, or paid to the Chief Executive Officer of ServiceMaster and ServiceMaster's four most highly compensated executive officers other than the Chief Executive Officer of ServiceMaster during or in respect of the year 1993. Each of the listed persons was holding the office indicated in the table on the last day of December 1993. Notes: (A) President and Chief Executive Officer, ServiceMaster Consumer Services. (B) President and Chief Executive Officer, ServiceMaster Management Services. (C) Executive Vice President and Chief Operating Officer, Management Services. (D) President, International and New Business Development. (E) The table does not include the cash distributions made to ServiceMaster Management Corporation, as the managing general partner of the Registrant and The ServiceMaster Company, and the redistribution of such amounts to the stockholders of ServiceMaster Management Corporation (who include the persons listed in the above table). See "Description of the Partnership Structure" Note D, page 18. The foregoing amounts represent the stockholders' share of profits in return for their equity risk. The table also does not include the value of shares of the Registrant issued to C. William Pollard pursuant to certain agreements made in 1986 and concluded in 1993 (see Item 13: "Miscellaneous Transactions", page 58). (F) With respect to the year 1993, see Note (A) to the Option/SAR Grants Table. The figures shown for earlier years are the number of the underlying shares for grants of options under the ServiceMaster 10 Plus Option Plan. The number of options shown for Mr. Oxley for the year 1991 has been adjusted to reflect the Registrant's 3-for-2 share split in June 1993. The following table summarizes the number and terms of the stock options (if any) granted during the year 1993 to the named executive officers. Notes: (A) ServiceMaster 10 Plus Option grants were approved for C. William Pollard, Brian D. Oxley and Robert D. Erickson in October 1992. In the case of each of the foregoing grantees, acceptance of the option and payment by the grantee of the price for the option itself ($1.00 per option share on a post-split basis) was not required and did not occur until early 1993. These grants were not shown in the Option/SAR Grants Table in ServiceMaster's Form 10-K for 1992 but are reported in the above table. Column (A) reflects the 3-for-2 share split effected by the Registrant in June 1993. (B) ServiceMaster 10 Plus Option grants were approved for C. William Pollard, Carlos H. Cantu, and Robert D. Erickson in October 1993. In the case of each of the foregoing grantees, acceptance of the option and payment by the grantee of the price for the option itself ($1.50 per option share) was not required until early 1994. These grants will be shown in the Option/SAR Grants Table in ServiceMaster's Form 10-K for 1994. (C) The fair market value of the Registrant's shares at the time when the grants of the option were made (October 1992) was $26.00. Each grantee was required to pay $1.50 per option share as a condition to the actual grant of the option (which sum was, in each case, paid in February 1993). Column (d) combines the exercise price and the option price. In June 1993, the Registrant split its shares 3-for-2 and the exercise price for the options shown in the table has therefore been adjusted to $18.33 per share, which includes the option price as adjusted to $1.00 per option share. The following table summarizes the exercises of stock options during the year 1993 by the named executive officers and the number of, and the spread on, unexercised options held by such officers at December 31, 1993. As shown in the following table, no long-term incentive awards were granted to any of the named executive officers during the year 1993. Compensation of Directors Directors of ServiceMaster Management Corporation who are not officers receive $3,000 for each meeting of the Board of Directors and each meeting of the Executive Committee which they attend. In addition, directors who are not officers and who are not members of the Executive Committee receive an annual stipend of $5,000; directors who are not officers and who are members of the Executive Committee receive an annual stipend of $10,000. Directors who are members of the Audit Committee (which committee does not include any officers) receive an annual stipend of $8,000, except that the annual stipend for the Chairman of the Audit Committee is $10,000. A director of a subsidiary company who is not an officer of that company or any ServiceMaster company which is a parent of the subsidiary receives $3,000 for each meeting of the subsidiary board of directors which he or she attends. If such a person is not a director of ServiceMaster Management Corporation, he or she also receives an annual stipend of $5,000. Each director of ServiceMaster Management Corporation or of a subsidiary board of directors may enter into a deferred fee agreement with the company on whose board he or she is serving whereby part or all of the fees payable to him or her as a director are deferred and will either earn interest based on the five-year borrowing rate for ServiceMaster or be used to purchase shares of ServiceMaster Limited Partnership in a number determined by the fair market value of such shares on the date of purchase. Upon termination of a director's services as a director or attainment of age 70, whichever occurs first, a director will receive the amount for his or her deferred fee account in a lump sum or in installments or in shares of ServiceMaster Limited Partnership, depending on which deferral plan the director has elected. Directors of ServiceMaster Corporation do not receive any compensation for their services in that capacity. Employment Contracts and Termination of Employment ServiceMaster enters into employment contracts with each of its executive officers in December of each year to cover the officer's employment during the subsequent calendar year. Each contract provides for the amount of such officer's base salary for the calendar year covered by the contract. Either party may cancel the contract on two week's notice to the other party. If an executive's employment terminates, the executive is prohibited from entering into certain activities which are competitive with any of the ServiceMaster businesses. These contracts do not provide for any bonuses or other form of compensation beyond the base salary stated in the contract. The amounts paid under the employment contracts with each of the persons listed in the Summary Compensation Table are included in Column (c) of the table. Change-in-Control Arrangements The ServiceMaster Plan for Continuity of Employment (the "Plan") was adopted by the Board of Directors of ServiceMaster Industries Inc. on July 19, 1986 and assumed by ServiceMaster Limited Partnership and its subsidiaries at the time the ServiceMaster reorganization became effective on December 30, 1986. The purpose of the Plan is to provide protection to a broad range of ServiceMaster employees from damage to their careers which could result if ServiceMaster were taken over by another organization. The Plan provides that if during the period following a takeover to which the Plan applies any covered employee is fired or leaves after being demoted, then ServiceMaster will be obligated to pay that employee an amount equal to either (i) the amount of the employee's relevant annual compensation (if the employee has between two and five years of credited service with ServiceMaster) or (ii) 2.5 times the employee's relevant annual compensation (if the employee has more than five years of credited service). The amount of an employee's relevant annual compensation will be the amount of the cash compensation received by the employee during the calendar years preceding the year in which the Plan becomes activated with respect to the takeover involved, provided that in no event will an employee be entitled to receive under the Plan more than twice the amount of the compensation (including both cash compensation and benefits with a monetary value received in a form other than cash) received by the employee during the calendar year preceding the termination of his or her employment. The Plan is not limited to management employees but rather covers every ServiceMaster employee who has at least two years of credited service at the time his employment terminates. The Plan provides that a takeover will be deemed to have occurred for purposes of the Plan when (i) any organization or group (other than ServiceMaster employees or plans established for the benefit of ServiceMaster employees) acquires ownership of at least 20% of ServiceMaster outstanding shares, or (ii) a majority of the positions on the ServiceMaster Board come to be occupied by "Takeover Directors" (as defined in the Plan). The Plan provides that it will automatically become activated with respect to any particular takeover ten days after the ServiceMaster Chief Executive Officer becomes aware that the takeover has occurred except that the ServiceMaster Board has the right to accelerate or postpone the date upon which the Plan will become activated with respect to any particular takeover. The Board has the right at any time before the Plan becomes activated to modify the terms of the Plan and to exempt any particular takeover from operation of the Plan or to terminate the Plan, but no such notification exemption or termination can be made after activation. Employees are entitled to compensation under the Plan in connection with any takeover to which the Plan applies only if their employment terminates within the "Shakeout Period" beginning at the time such takeover occurs and ending on the second anniversary of the date on which the Plan is activated with respect to that particular takeover. The Plan is expressly intended to be a severance pay plan for purposes of the Employee Retirement Income Security Act of 1974 ("ERISA") and ServiceMaster employees are expressly entitled to the protection afforded by ERISA to participants in a severance pay plan. The Plan is designed to put any organization which may at any time consider taking over ServiceMaster on notice in advance that it may be required to compensate individuals who have made significant career investments in ServiceMaster if those individuals are disadvantaged by the takeover. At the same time, the Plan is intended to serve the best interests of those who invest in ServiceMaster for the long term by (i) improving the ability of the ServiceMaster enterprise to recruit and retain employees, (ii) increasing the willingness of employees to risk working for long-term rewards rather than seeking to maximize their immediate salary, and (iii) providing insurance to employees against any unfavorable outcome, and thereby encouraging employees to remain with ServiceMaster while the outcome of a takeover attempt is in doubt. Compensation Committee Interlocks and Insider Participation The persons who served as members of the compensation committee of the Registrant's board of directors during 1993 are listed in the next section. The compensation committee consists solely of independent members of the board of directors. There are no interlocking arrangements involving service by any executive officer of the Registrant on the compensation committee of another entity and an executive officer of such other entity serving on the ServiceMaster compensation committee. Board Compensation Committee Report on Executive Compensation The following report of the Compensation Committee of the Board of Directors of ServiceMaster Management Corporation was delivered to the Board of Directors on March 18, 1994. The Compensation Committee consists of the members of the Executive Committee other than the Chairman of the Company. (The Executive Committee consists of independent directors and the Chairman. As used in the report, the term "salary year" means the calendar year. "REPORT OF THE COMPENSATION COMMITTEE To: The Board of Directors: The Executive Committee as constituted in December 1993, in its capacity as the Compensation Committee for the year 1993, hereby submits its report to the Board of Directors for the year 1993. In December of each year, the Compensation Committee reviews the compensation levels of senior members of management, evaluates the performance of management and recommends a base salary for each member of senior management for the next salary year. This review and recommendation process includes a review of additional compensation (if any) payable under the Company's Incentive Reward Compensation Plan. At the end of each salary year, the Compensation Committee determines whether adjustments should be made in the compensation of an executive as established by his base salary and the Incentive Reward Compensation Plan. The Compensation Committee does not constitute the administering committee under any of the Company's stock option plans, but the Compensation Committee does take option grants to senior members of management into account in the reviews and recommendations described above. Summary of Compensation Policies. The compensation policies applicable to all executive officers are as follows: (1) a base level of compensation is established by reference to the standards described below; (2) bonuses are paid in accordance with the Company's Incentive Reward Compensation Plan, under which bonuses are determined by the extent to which the actual performance of the Company (or the relevant division thereof) achieved budget objectives; and (3) such year-end adjustments as the Compensation Committee may consider to be warranted. The standards for determining the base compensation in any given year for the Chief Executive Officer (and for all other officers whose salaries are subject to Compensation Committee approval) are: performance by the officer in the discharge of his or her responsibilities, financial performance of the Company for the immediately preceding year, and the base salary levels of comparable officers in comparable companies. Five Highest Paid Officers. The base compensation of each of the highest paid officers for 1993 (including the Chief Executive Officer) was in the amount recommended by the Compensation Committee in December 1992 and approved by the Board of Directors in the same month. This base compensation was further reviewed at the end of 1993. The Compensation Committee unanimously agrees that these base levels were reasonable at the time established and reasonable in the context of the performance of the Company in 1993 and the contribution of such persons to the Company's performance. Chief Executive Officer. The base compensation of C. William Pollard, Chairman and Chief Executive Officer of ServiceMaster, for the year 1993 was set at $300,000 at the commencement of the year. This amount did not reflect any increase in his base compensation for the year 1992. No increases in his base compensation were made during the year 1993. An increase in the base compensation for the Chief Executive Officer for the year 1993 would have been warranted in the light of both the Company's and his performance in the year 1993. (Reference is made to the Management Discussion and Analysis section of the Company's 1993 Annual Report to Shareholders (the "Annual Report") for a summary of the Company's growth in 1993 relative to 1992). The Committee approved a modification of the formula in the Company's Incentive Reward Compensation Plan so that the Chief Executive Officer was awarded incentive compensation in the amount of 150% of his base compensation. That award included $60,000 beyond what the Incentive Reward Compensation Plan would have called for without modification. (Reference is made to the Annual Report for a discussion of the Company's performance in 1993). The Compensation Committee notes that the Chief Executive Officer was granted an option for 75,000 shares in October 1993, subject to acceptance by him and payment of the price for the option itself of $1.50 per option share. This grant was accepted and the required payment was made in March 1994. No member of the Compensation Committee is a former or current officer or employee of the Company or any of its subsidiaries. However, for a short period of time Mr. Nelson was Vice Chairman of American Home Shield Corporation. Dated: March 18, 1994 Respectfully submitted, H. O. Boswell Lord Brian Griffiths H. P. Hess G. H. Knoedler V. C. Nelson D. K. Wessner (Compensation Committee)" Performance Graph The following graph compares the five-year cumulative total return to shareholders of the Registrant with the five year cumulative return as determined under the Standard & Poor's 500 Index and under the Standard & Poor's Commercial Services Group. [Performance Graph] Item 12.	Item 12. Security Ownership of Certain Beneficial Owners and Management The following table sets forth as of March 18, 1994, the beneficial ownership of the Partnership Shares with respect to the ServiceMaster directors and senior management advisers and directors and officers as a group. ServiceMaster does not know of any person who is the beneficial owner of more than five percent of the Partnership Shares. Notes: (1) The shares owned by each person and by all directors and officers as a group, and the shares included in the total number of shares, have been adjusted, and the percentage ownership figures have been computed, in accordance with Rule 13d-3(d)(1)(i). (2) Shares in column (3) include shares held by spouse and/or other family members. (3) Shares in column (2) include shares which may be acquired within sixty days under the ServiceMaster Executive Debenture Plan, options granted under the ServiceMaster Share Option Plan, and/or options granted under the ServiceMaster 10-Plus Plan. (4) Shares in column (3) include shares held in one or more investment partnerships in which the listed person is a partner with shared voting power and investment power. (5) Shares in column (2) include shares held in trust for the benefit of self and/or family members. (6) Shares in column (3) include shares held in trust for the benefit of self and/or family members. (7) Shares in column (3) include 28,792 shares owned by spouse or held in trust for the benefit of family members as to which beneficial ownership is disclaimed. (8) The 1,378,996 shares in column (3) are in trust for the benefit of family members as to which beneficial ownership is disclaimed. (9) Shares in column (3) include 4,204 shares in trust for the benefit of family members as to which beneficial ownership is disclaimed. (10) Shares in column (2) include 17,445 shares in trust for the benefit of family members as to which beneficial ownership is disclaimed. (11) Shares in column (2) include 450,000 shares held in trust for the benefit of the parents of David K. Wessner and for charitable interests. Mr. Wessner is a trustee of this trust and has sole voting and investment power over such shares but he disclaims beneficial ownership of such shares. (12) Shares in column (3) includes 206,110 shares held by an investment company of which David K. Wessner is a shareholder and one of four directors. (13) Shares in column (2) include 20,815 shares owned by a charitable foundation of which C. William Pollard is a director. Mr. Pollard disclaims beneficial ownership of such shares. (14) Shares in column (2) includes 292,408 shares held in trust for the benefit of spouse as to which beneficial ownership is disclaimed. (15) Includes 2,150,464 shares which certain officers of ServiceMaster, through the exercise of their respective rights, may acquire within 60 days under share purchase agreements, the ServiceMaster Executive Debenture Plan, options granted under the ServiceMaster Share Option Plan and options granted under the ServiceMaster 10-Plus Option Plan. This figure includes shares purchasable by the persons identified in Item 11 as follows: Mr. Pollard - 112,500 shares; Mr. Oxley - 30,000 shares; Mr. Erickson - 30,000 shares; and all executive officers as a group - 292,500 shares. Item 13.	Item 13. Certain Relationships and Related Miscellaneous Transactions ServiceMaster Limited Partnership and The ServiceMaster Company distributed an aggregate of $2,547,618 to ServiceMaster Management Corporation with respect to the year 1993, the managing general partner of each of these partnerships, with respect to its aggregate 1.99% carried interest in the profits and losses of these two partnerships. (See Note D, pages 18 -20). On January 17, 1993, ServiceMaster Limited Partnership, as the successor to ServiceMaster Industries Inc., distributed 18,708 partnership shares to C. William Pollard pursuant to the Exchange Agreement between Mr. Pollard and ServiceMaster Industries Inc. dated December 24, 1986. (This agreement related to the acquisition by ServiceMaster of Jubilee Investment Company in December 1986). On March 19, 1993, the Executive Committee of the Board of Directors of ServiceMaster Management Corporation, acting on the basis of a recommendation from a special committee of three independent directors, approved the issuance of 37,806 shares of ServiceMaster Limited Partnership to C. William Pollard as a payment in final settlement of the above-mentioned Exchange Agreement of December 24, 1986. On September 30, 1993, The ServiceMaster Company loaned Carlos H. Cantu the sum of $282,143, with interest at the rate of 3.5% per annum, as a bridge loan in connection with his purchase of a personal residence in Illinois. This purchase was made in connection with Mr. Cantu's assumption of the responsibilities as the Chief Executive Officer of ServiceMaster on January 1, 1994. This loan was paid in full in December, 1993. Indebtedness of Management The following executive officers were indebted to The ServiceMaster Company in excess of $60,000 at some point during the year 1993. Except for the indebtedness referred to in the last sentence of this paragraph, in each case, the indebtedness was incurred by reason of one or more share grants made to the person before 1993 under the ServiceMaster Share Grant Award Plan. As provided in the Share Grant Award Plan, The ServiceMaster Company advances to a share grant recipient the amount of federal and state income taxes incurred by the recipient as a result of the receipt of the share grant. The figure set opposite the person's name below is the largest amount of indebtedness outstanding during the year 1993; the figure in parentheses is the amount of indebtedness outstanding on March 21, 1994: Brian D. Oxley - $142,914 ($118,373); Ernest J. Mrozek - $117,582 ($103,355); and Vernon T. Squires $139,260 ($119,322). Interest on each of the foregoing loans is charged to the borrower at a rate between 7.75% and 9.29% per annum. Interest and principal payments on all of such loans are made quarterly. On September 30, 1993 The ServiceMaster Company made the loan to Carlos H. Cantu which is described under "Miscellaneous Transactions"; such loan was paid in full prior to the end of 1993. PART IV Item 14.	Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) Financial Statements, Schedules and Exhibits 1. Financial Statements The documents shown below are contained in the Financial Statements and Management Discussion section of the ServiceMaster Annual Report to Shareholders for 1993, on pages 19 - 36 and are incorporated herein by reference: Summary of Significant Accounting Policies Report of Independent Public Accountants Consolidated Statements of Income for the three years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Financial Position as of December 31, 1993 and 1992 Consolidated Statements of Cash Flows for the three years ended December 31, 1993, 1992 and Consolidated Statements of Shareholders' Equity for the three years ended December 31, 1993, 1992 and 1991 Notes to the Consolidated Financial Statements 2. Financial Statements Schedules Schedule IV--Amounts Receivable from Related Parties and Underwriters, Promoters, and Employees other than Related Parties. The items required by this Schedule are incorporated into the information relating to Share Grants on page 35. Included in Part IV of this Report: Schedule VIII--Valuation and Qualifying Accounts Schedule X--Supplementary Income Statement Information Report of Independent Public Accountants on Schedules Exhibit 11 -- Exhibit Regarding Detail of Income Per Share Computation Exhibit 24 -- Consent of Independent Public Accountants Other schedules are omitted because of the absence of conditions under which they are required or because the required information is given in the financial statements or notes thereto. Separate financial statements and supplemental schedules of ServiceMaster are omitted because prior to 1987 the Registrant was primarily an operating company. Its subsidiaries, included in the consolidated financial statements being filed, did not have a minority equity interest or indebtedness to any person other than the Registrant in an amount in excess of five percent of the total assets as shown by the consolidated financial statements as filed herein. 3. Exhibits The exhibits filed with this report are listed on pages 63-67 herein (the "Exhibits Index"). The following entries in the Exhibits Index are management contracts or compensatory plans in which a director or any of the named executive officers of the Registrant does or may participate. Reference is made to the Exhibits Index for the filing with the Commission which contains such contract or plan. Exhibit Contract or Plan 10.1 1987 ServiceMaster Option Plan. 10.3 Deferred Compensation and Salary Continuation Agreement for Officers. 10.4 Deferred Directors Fee Agreement. 10.5 ServiceMaster Executive Share Subscription Program. 10.6 Incentive Reward Compensation Plan. 10.9 ServiceMaster Profit Sharing, Savings & Retirement Plan as amended and restated effective January 1, 1987. 10.11 Share Grant Award Plan. 10.13 Executive Debenture Equity Program 9% Convertible Subordinated Debenture due April 1, 1995. 10.14 The Terminix International Company L.P. Profit Sharing and Retirement Plan. See note below. 10.15 ServiceMaster 10-Plus Plan. See also Item 10.21. 10.17 Directors Deferred Fees Plan (ServiceMaster Shares Alternative). 10.20 ServiceMaster 10-Plus Plan as amended September 3, 1991. Notes: The Terminix International Company L.P. Profit Sharing and Retirement Plan (Item 10.14) was integrated into the ServiceMaster Consumer Services Limited Partnership Profit Sharing Plan in February 1993. The ServiceMaster Consumer Services Limited Partnership Profit Sharing Plan is available to officers and employees generally. (b) Reports on Form 8-K None in the last quarter of the period covered by this Report on Form 10-K. Certain Undertakings With Respect To Registration Statements on Form S-8 For the purposes of complying with the amendments to the rules governing Form S-8 (effective July 13, 1990) under the Securities Act of 1933, the Registrant hereby undertakes as follows which undertaking shall be incorporated by reference into each of the Registrant's Registration Statements on Form S-8, including No. 33-19763 and No. 2-75851: Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers and controlling persons of the Registrant pursuant to the foregoing provisions, or otherwise, the Registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Securities Act of 1933 and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the Registrant of expenses incurred or paid by a director, officer or controlling person of the Registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the Registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue. FEDERAL INCOME TAX CONSIDERATIONS The following discussion of Federal income tax matters describes the material consequences to the non-corporate U.S. shareholders of ServiceMaster Limited Partnership (the "Public Partnership") and to the Public Partnership as sole common limited partner of The ServiceMaster Company Limited Partnership (the "Principal Subsidiary Partnership"). This discussion does not consider state, local and foreign tax issues, nor does it separately describe (except where noted) the consequences to shareholders who received their shares as a form of compensation (or in exchange for ServiceMaster stock issued in prior years as compensation), or which are corporations, tax-exempt entities, or non-resident alien individuals. THIS DISCUSSION MAY NOT BE DIRECTLY APPLICABLE TO ANY PARTICULAR SHAREHOLDER, DEPENDING ON THAT SHAREHOLDER'S UNIQUE CIRCUMSTANCES. SHAREHOLDERS ARE URGED TO CONSULT THEIR OWN TAX ADVISORS TO DETERMINE THE FEDERAL INCOME TAX TREATMENT IN THEIR SPECIFIC TAX SITUATIONS, INCLUDING THE APPLICATION AND EFFECT OF THE STATE, LOCAL AND FOREIGN LAWS WHICH MIGHT APPLY TO A SPECIFIC SHAREHOLDER. The following discussion is based on provisions of the Internal Revenue Code of 1986 (the "Code"), as amended, existing and proposed regulations promulgated thereunder, judicial deci- sions, legislative history, and current administrative rulings and practices. For a number of Code sections the Internal Revenue Service (the "IRS") has been directed or authorized by statute to issue regulations that may materially affect the tax consequences of holding an interest in ServiceMaster. As of the date hereof, certain of these regulations have not yet been promulgated. Moreover, any of the statutes, regulations, rulings, practices, or judicial precedents upon which this discussion is based could be changed, perhaps retroactively, with adverse tax consequences. The Federal income tax treatment of shareholders, as described below, depends in some instances on interpretation by ServiceMaster Management Corporation (hereinafter referred to as the "Managing General Partner") of complex provisions of the Federal income tax law for which no clear precedent or authority may be available. In determining basis adjustments, allocations, asset valuations and taxable income of the Principal Partnerships, the Managing General Partner must make determinations that will affect a shareholder in various ways depending on such factors as the date a shareholder purchased shares of the Principal Partnerships and subsidiary partnerships. Possible Legislative Changes. Congress is considering the possible enactment of proposals to revise in certain respects the federal income taxation of widely held partnerships (such as the Public Partnership). These proposals would, among other changes, simplify the rules under which the partners report their share of partnership income or loss and change the rules relating to the auditing of, and the collection of deficiencies with respect to, such partnerships. Tax Status of the Partnerships Significance of "Partnership" Status. Except as otherwise provided by Code Section 7704, a partnership incurs no Federal income tax liability unless the partnership is classified as an association taxable as a corporation. Instead, each partner in a partnership is required to take into account in computing his or her Federal income tax liability his or her allocable share of the income, gains, losses, deductions and credits of the partnership. The Federal income tax treatment contemplated for shareholders will be available only if the Principal Partnerships are not classified as associations taxable as corporations. If either of the Principal Partnerships were classified as an association taxable as a corporation in any year, such partnership's income, gains, losses, deductions and credits would be reflected on its own tax return, rather than being passed through to shareholders, and its net income would be taxed at corporate rates (with the maximum rate for regular tax currently equal to 35%, and the rate for alternative minimum tax equal to 20%). In addition, distributions made to shareholders would be treated as (a) taxable dividend income (to the extent of such partnership's current and accumulated earnings and profits) or, to the extent distributions exceed the partnership's earnings and profits, (b) a non-taxable return of capital (to the extent of a shareholder's basis for his or her shares) or (c) taxable capital gain. In sum, classification of either of the Principal Partner- ships as an association taxable as a corporation would result in a material reduction in the anticipated cash flow and after-tax return to shareholders from holding Public Partnership shares. Classification of the Principal Partnerships. The Principal Partnerships received an opinion of counsel that, as of their formation in December, 1986, the Principal Partnerships would be classified as partnerships for Federal income tax purposes. Counsel's opinion regarding the Federal income tax classification of the Principal Partnerships is based upon, among other things, the Managing General Partner's representations that: (a) ServiceMaster Management Corporation has acted as a general partner in each of the Principal Partnerships and will maintain a net worth, on a fair market value basis, of at least $15.0 million (apart from direct or indirect interests in either of the Principal Partnerships or in any subsidiaries of the Principal Partnerships) in the form of (i) cash or cash equivalents; (ii) marketable obligations issued or guaranteed by the United States government or any agency or political subdivision thereof or issued by any state of the United States or any agency or political subdivision thereof; (iii) commercial paper; (iv) certificates of deposit; (v) bankers' acceptances; (vi) securities regularly traded on an established market; and/or (vii) notes receivable secured by bank letters of credit; (b) Each of the Principal Partnerships has operated at all times in accordance with applicable provisions of the Delaware Revised Uniform Limited Partnership Act, the terms and conditions of their respective partnership agreements, and the statements and representations made in ServiceMaster's December 11, 1991, proxy statement/prospectus; (c) Except as required by Section 704(c) of the Code or as the result of a temporary allocation required under Section 704(b) of the Code (for example, a qualified income offset or a minimum gain chargeback), the aggregate interest of the general partners of the Principal Partnerships in each material item of gain, loss, deduction or credit of each of the Principal Partnerships has been equal to at least 1% of each such item; (d) The partnership agreement governing each of the Principal Partnerships has provided, and continues to provide, in accordance with IRS Revenue Procedure 89-12, that upon dissolution of the respective partnership the general partners of that partnership will contribute to the partnership an amount equal to the deficit balance, if any, in their capital accounts; and (e) The general partners of each of the Principal Partnerships have held their interests in each of the Principal Partnerships for their own account and, in managing each of the Principal Partnerships, have not acted under the direction of or as agents for the limited partners of the Public Partnership. If the Managing General Partner were to withdraw as a partner at a time when there is no successor Managing General Partner, or if the successor Managing General Partner could not satisfy the applicable net worth requirement and other restric-tions, then the IRS might attempt to classify one or both of the Principal Partnerships as associations taxable as corporations. The general partners and the Principal Partnerships intend to contest any material adverse determination by the IRS classifying either of the Principal Partnerships as an associ-ation taxable as a corporation. Shareholders should be aware that the Principal Partnerships, and hence indirectly the shareholders, may incur substantial legal expenses in the event of such a contest, and there can be no assurance that such a contest would be successful. Publicly Traded Partnerships Treated as Corporations. Pursuant to Code Section 7704, a publicly traded partnership (i.e., any partnership if interests in the partnership are traded on an established securities market or are readily tradeable on a secondary market or the substantial equivalent thereof) will generally be treated as a corporation for Federal income tax purposes with respect to taxable years beginning after 1987. However, a partnership which was a publicly traded partnership on December 17, 1987 will not be treated as a corporation under Sec- tion 7704 until the partnership's first taxable year beginning after 1997. This "grandfather status" is lost, however, if the partnership adds a substantial new line of business after December 17, 1987; in that event, the partnership may be treated as a corporation as of the day after the date on which such substantial new line of business is added. The Public Partnership is a publicly traded partnership for purposes of Section 7704 but ServiceMaster currently intends to operate its businesses in a manner so as to qualify under this exception to the general rule of Section 7704 and to thereby retain its partnership tax status for Federal income tax purposes for tax years beginning before 1998. If the Public Partnership were treated as a corporation under Code Section 7704, shareholders of the Public Partnership would be deemed to exchange their shares in the Public Partner-ship ("Partnership Shares") for stock in a corporation. Such deemed exchange is currently anticipated to be generally tax-free; however, the exchange could result in tax liability for a shareholder of the Public Partnership (i) if the shareholder's tax basis for his or her partnership Shares is less than his or her share of the Principal Partnerships' liabilities (as determined for purposes of Code Section 752); (ii) if the deemed exchange triggers any tax benefit recapture; or (iii) if ServiceMaster's liabilities exceed the tax basis of its assets. For most shareholders, it is unlikely that Federal income taxes would have to be paid on the deemed exchange. After such deemed exchange, shareholders would not be taxable on their allocable shares of the taxable income of the Public Partnership. Instead, distributions from the Public Part-nership would generally be taxable to the shareholders to the same extent as dividends from a corporation. Thus, distributions would be taxable to the shareholders as ordinary income to the extent of the Public Partnership's earnings and profits, and distributions in excess of the Public Partnership's earnings and profits would first reduce the shareholder's basis in his or her shares and would, to the extent in excess of such basis, be taxed as capital gain. If the Public Partnership were treated as a corporation under Code Section 7704, the Public Partnership's income, gains, losses, deductions and credits would be reflected on its own tax return and its net income would be taxed at corporate rates (with the top average rate for regular tax currently equal to 35% and the rate for alternative minimum tax equal to 20%). The treatment of the Public Partnership as a corporation pursuant to Section 7704 could result in a reduction in the anticipated cash flows and after-tax return to shareholders holding Partnership Shares and could have a negative impact on the value of the Shares. In accordance with shareholder approval granted on January 13, 1992, ServiceMaster currently intends to engage in a reincorporating merger on December 31, 1997, immediately prior to the time when Code Section 7704 would otherwise automatically treat the Public Partnership as a corporation for Federal income tax purposes. The reincorporating merger should provide certain benefits which might not be available if ServiceMaster remained in partnership form subject to the application of Code Section 7704. As discussed more fully in ServiceMaster's December 11, 1991 proxy statement/prospectus, no Federal income tax will be imposed on shareholders in the Public Partnership by reason of the reincorporating merger, assuming that Federal income tax laws remain as now constituted and also based on certain factual assumptions The board of directors of the Managing General Partner may accelerate the effective date of the reincorporating merger to a date earlier than December 31, 1997 if either changes in tax laws or other developments cause more than 51% of ServiceMaster's income to be subject to corporate income tax prior to 1998 or the board of directors, in its sole discretion, determines that the advantages of such acceleration to ServiceMaster and the holders of a majority of its outstanding shares outweigh the disadvantages. It is possible that acceleration of the effective date of the reincorporating merger could adversely impact some shareholders in the Public Partnership. THE DISCUSSION THAT FOLLOWS IS BASED ON THE ASSUMPTION THAT THE PRINCIPAL PARTNERSHIPS ARE NOT CLASSIFIED FOR FEDERAL INCOME TAX PURPOSES AS ASSOCIATIONS TAXABLE AS CORPORATIONS, AND THAT THE PUBLIC PARTNERSHIP IS NOT TREATED AS A CORPORATION PURSUANT TO CODE SECTION 7704. Tax Consequences of Partnership Share Ownership General. The Public Partnership is not subject to Federal income tax as an entity. Rather, subject to the limitations prescribed in Code Section 469, each partner is required to report on his or her Federal and state income tax returns his or her allocable share of the income, gains, losses, deductions and credits (and, for alternative minimum tax purposes, tax preference items) of the Public Partnership for the taxable year of the Public Partnership ending with or within his or her taxable year and will be taxable directly on his or her allocable share of the Public Partnership's taxable income. The Public Partnership's taxable income includes its allocable share of the income, gains, losses, deductions and credits (and, for alternative minimum tax purposes, tax preference items) of the Principal Subsidiary Partnership which, in turn, includes its allocable share of such items of subsidiary partnerships. The beneficial owners of Partnership Shares are treated as partners of the Public Partnership for Federal income tax purposes. Thus, if Partnership Shares are held by a nominee, the beneficial owner of the Partnership Shares will be taxed on income and loss of the Public Partnership. Subject to the discussion set forth in the next five paragraphs, because shareholders are required to include Public Partnership income in their income for tax purposes without regard to whether they receive cash distributions of that income, shareholders may be liable for Federal income taxes with respect to Public Partnership income even though they have not received cash distributions from the Public Partnership sufficient to pay such taxes. However, throughout the period from January 1, 1987 to December 31, 1993, the Public Partnership's cash distributions to its shareholders have been substantially in excess of the taxes payable in respect of the taxable income allocated to such shareholders. The Public Partnership has no reason to expect that this situation will not continue through the end of the year 1997. ServiceMaster SGP Trust. In recognition of the fact that in 1993 (for the first time in the Public Partnership's history) taxable income was likely to exceed cash distributions to many shareholders of the Public Partnership, the Principal Subsidiary Partnership admitted the ServiceMaster T Trust as a special general partner of the Principal Subsidiary Partnership effective January 1, 1993. On September 30, 1993, the ServiceMaster T Trust was replaced by the ServiceMaster A Trust. Each of these trusts is hereinafter referred to as the "SGP Trust". The interest held by the SGP Trust is denominated in the Principal Subsidiary Partnership's partnership agreement as a Class T Partnership Interest. (See Note S, page 16). As stated in such Note, the beneficiaries of the SGP Trust are the limited partners of the Public Partnership as constituted from time to time. On the date on which ServiceMaster converts back to corporate form pursuant to the Reincorporating Merger approved on January 16, 1992, the SGP Trust will be assimilated into ServiceMaster Incorporated of Delaware, the successor corporate holding company for the ServiceMaster enterprise. The beneficial interests held by the beneficiaries of the SGP Trust are not assignable or transferable separately, but only by and in connection with the transfer of shares in the Public Partnership Every assignment, sale or transfer of any interest in shares in the Public Partnership prior to the date on which the SGP Trust terminates will include a proportional undivided beneficial interest in the SGP Trust. The SGP Trust will receive each year, beginning with the year 1993, an allocation of the amount of the taxable income of the Principal Subsidiary Partnership which exceeds the aggregate cash distributions made by the Public Partnership to its limited partners. The effect of this arrangement is that the cash distributions made by the Principal Partnership to its limited partners will be exactly equal to the taxable income of the Principal Partnership which is directly allocated to its limited partners. The Principal Subsidiary Partnership will make cash distributions to the SGP Trust in the amounts required by the SGP Trust to discharge its federal and state income tax liabilities. The SGP Trust will not receive any other allocations of income or cash distributions. The formation of the SGP Trust was not a taxable event to the Principal Partnerships or the shareholders, and the creation of the Class T Partnership Interest was not a taxable event to either the SGP Trust or the Principal Subsidiary Partnership or to the Principal Partnership. The distribution of funds to the SGP Trust by the Principal Subsidiary Partnership will not be a taxable event to either party. The SGP Trust will include in its taxable income its allocable share of the income of the Principal Subsidiary Partnership. If the SGP Trust were to distribute its income to its beneficiaries, such distributions would be taxable to the beneficiaries. However, because it is not anticipated that the SGP Trust will make any distributions to its beneficiaries, the shareholders of the Principal Partnership will not recognize any taxable income on account of the establishment of, and allocations to, the SGP Trust. Accounting Method and Tax Information. The Public Partnership uses the accrual method of accounting in reporting income and computes income on the basis of a taxable year ending on December 31. The Public Partnership will prepare and furnish to each shareholder of record during any taxable year the information necessary for the preparation of the shareholder's Federal, state and other tax returns required as a result of the operations of the Public Partnership for that year. Tax Basis of Partnership Shares. The tax basis of a share- holder in his or her Partnership Shares is significant because (i) basis is used in measuring the gain or loss recognized for tax purposes either upon the receipt of cash distributions from the Public Partnership or upon a partial or complete disposition of Partnership Shares by the shareholder and (ii) a shareholder may deduct his or her allocable share of Public Partnership losses only to the extent of his or her tax basis in his or her shares. See "Tax Consequences of Partnership Share Ownership --Taxation of Partners on Public Partnership Distributions" and "Sale or Other Disposition of Shares." Generally, the initial tax basis of any shareholder in his shares received upon the 1986 reorganization of ServiceMaster (the "1986 Reorganization") was equal to the fair market value of the shares on the date of the 1986 Reorganization and the initial tax basis of any shareholder who purchases Partnership Shares is equal to the amount paid. In either case, a shareholder's tax basis is increased by his or her share (as determined for purposes of Code Section 752) of the Principal Partnerships' liabilities. Any reduction of his or her share of liabilities would reduce a shareholder's basis. Adjustments to a shareholder's tax basis are made to reflect distributions and the shareholder's allocable share of Public Partnership income and loss. Taxation of Partners on Public Partnership Distributions. If the cash distributions to a shareholder by the Public Partner-ship in any year exceed his or her allocable share of the Public Partnership's taxable income for that year, the excess will constitute a return of capital to the shareholder to the extent of the shareholder's basis in his or her Partnership Shares. This situation is expected to occur for shareholders whose taxable income is determined by reference to the Section 754 election (see "Section 754 Election", page 51). A return of capital will not be reportable as taxable income by a shareholder for Federal income tax purposes, but will reduce the tax basis of his or her Partnership Shares. If a shareholder's tax basis were reduced to zero, then any further cash distribution to the shareholder for any year in excess of his or her allocable share of the Public Partnership's taxable income for that year would be taxable to him or her as though it were gain on the sale or exchange of his or her Partnership Shares. All or a portion of such excess cash distribution could be treated as ordinary income as the result of the application of the recapture provisions of the Code. See "Sale or Other Disposition of Shares." A decrease in the shareholder's percentage interest in the Public Partnership due, for example, to a new Public Partnership offering of shares, will give rise to a deemed cash distribution to the extent the shareholder's share of liabilities (as determined for purposes of Code Section 752) decreases. Such deemed distribution would result in ordinary income pursuant to Code 751(b) to a shareholder (whether or not such deemed distribution exceeds the adjusted basis of the shareholder's Partnership Shares) to the extent that such deemed distribution is treated as an exchange of "unrealized receivables" (including recapture amounts) and "substantially appreciated inventory" (as defined in Code Sections 751(b) and 751(d)) for money. However, when additional shares are issued by the Public Partnership, certain items of income, gain, loss or deduction will be reallocated to reflect the fair market value of the Principal Partnerships' property and such reallocation should minimize or eliminate the recognition of such ordinary income pursuant to Code Section 751(b). Nevertheless, the IRS may contend that such ordinary income must be recognized by shareholders whose percentage interests have decreased due to an offering of addi-tional shares by the Public Partnership. Limitation on Losses. No investor should invest in the Public Partnership with the expectation that an investment in the Public Partnership will result in tax losses that may be applied to offset an investor's income from other sources. To the extent that the Principal Partnerships' operations result in losses for tax purposes in any calendar year, a shareholder generally will be entitled to use his or her allocable share of such losses to the extent of his or her tax basis in his or her Partnership Shares at the end of the year, subject to the limitations prescribed in Code Section 469. Code Section 469 limits a taxpayer's ability to use losses or credits generated by limited partnerships and other business activities in which such taxpayer does not materially participate ("passive activities"). In general, losses from passive activities will not offset earned income (salary and bonus) or portfolio income (interest, dividends and royalties). Such losses will generally only offset income from other passive activities. Similarly, tax credits from passive activities will only reduce income tax attributable to income from passive activities. Losses and credits from a passive activity which cannot be used in a given year are generally carried forward. These deferred losses and credits, if not usable sooner, will generally be allowed in full when the taxpayer disposes of his or her entire interest in the activity. Section 469 applies separately to each publicly traded partnership. Thus, passive activity losses and credits attribut- able to a limited partner's interest in a publicly traded partnership (such as the Public Partnership) cannot be applied against the limited partner's other income, even if such income is treated as passive under Section 469. Such losses and credits are suspended and carried forward for applications against income from the publicly traded partnership in future years. Upon a complete disposition of the limited partner's interest in the publicly traded partnership in a fully taxable transaction, any of the limited partner's remaining suspended losses generally may be applied against other income. Income attributable to a limited partner's interest in a publicly traded partnership (such as the Public Partnership) cannot be offset by losses or credits from the limited partner's other passive activities. Substantially all of any losses or credits generated by the Public Partnership will likely be subject to the limitations prescribed in Section 469. The limitations prescribed in Section 469 generally apply to individuals, estates, trusts, personal service corporations and, with certain modifications, closely-held corporations. Under current law, a partner who is subject to the "at-risk" limitations of Code Section 465 may not deduct his or her allocable share of partnership losses for a taxable year to the extent they exceed the aggregate amount for which he or she is considered to be "at-risk" with respect to the partnership activities giving rise to those losses as of the end of its taxable year in which the losses occur. Because it is not anticipated that the Principal Partnerships will incur losses that exceed either the shareholders' aggregate basis in their Partnership Shares or amounts "at-risk" with respect to the Principal Partnerships' activities, the "at- risk" limitations under current law should generally not affect shareholders adversely. Federal Income Tax Allocations General. In general, items of Principal Partnership income, gain, loss, deduction and credit are allocated for both accounting and Federal income tax purposes in accordance with the percentage interests of the general and limited partners. However, as discussed in greater detail below, the Managing General Partner is empowered by the limited partnership agreements for the Principal Partnerships (the "Principal Partnership Agreements") to specially allocate various Principal Partnership tax items other than in accordance with percentage interests when, in the judgment of the Managing General Partner, such special allocations are necessary to comply with applicable provisions of the Code and the regulations or, to the extent permissible under the Code and the regulations, to preserve the uniformity of the shares in the Public Partnership, i.e., to ensure that all Partnership Shares will have identical attributes. These allocation provisions will be recognized for Federal income tax purposes if they are considered to have "substantial economic effect" within the meaning of Code Section 704(b). If any allocation fails to satisfy the "substantial economic effect" requirement, the allocated items will be reallocated among the shareholders based on their respective "interests in the partnership," determined on the basis of all of the relevant facts and circumstances. Pursuant to regulations issued under Section 704(b), a partnership allocation will be considered to have "substantial economic effect" if it is determined that the allocation has "economic effect" and the economic effect is "substantial." An allocation to partners (other than an allocation of loss, deduction or certain other items attributable to nonrecourse liabilities ("nonrecourse deductions")) will be considered to have "economic effect" if (i) the partnership maintains capital accounts in accordance with specific rules set forth in the regulations and the allocation is reflected through an increase or decrease in the partners' capital accounts, (ii) liquidating distributions are required to be made in accordance with the partners' respective positive capital account balances by the end of the taxable year (or, if later, within 90 days after the date of liquidation), and (iii) any partner with a deficit in his or her capital account following the distribution of liquidation proceeds would be unconditionally required to restore the amount of such deficit to the partnership. If the first two of these requirements are met but the partner to whom an allocation is made is not obligated to restore the full amount of any deficit balance in his or her capital account, the allocation still will be considered to have "economic effect" to the extent the allocation does not cause or increase a deficit balance in the partner's capital account (determined after reducing that account for certain "expected" adjustments, allocations, and distributions specified by the regulations) if the partnership agreement contains a "qualified income offset" provision. A qualified income offset requires that in the event of any unex-pected distribution (or specified adjustments or allocations) to a partner that results in a deficit balance in such partner's capital account, there must be an allocation of income or gain to the distributee that eliminates the resulting capital account deficit as quickly as possible. In order for the "economic effect" of an allocation to be considered "substantial," the regulations require that the allocation must have a "reasonable possibility" of "substantially" affecting the dollar amounts to be received by the partners, independent of tax consequences. The regulations provide that the "economic effect" of an allocation will be presumed to be insubstantial if it merely shifts tax consequences within a partnership taxable year or is transitory, i.e., likely to be offset by other allocations in subsequent taxable years. The regulations state, however, that adjustments to the tax basis in property will be presumed to be matched by corresponding changes in the fair market value of the property. Thus, the regulations conclude that there will not be a strong likelihood that an allocation of deductions attributable to depreciation will be transitory due to a provision for a subsequent corresponding allocation of gain attributable to the disposition of that property. In addition to the regulations described above, the Treasury has issued regulations which address the effect of nonrecourse liabilities upon partnership allocations. Under the regulations, if (i) the partnership maintains capital accounts in accordance with specific rules set forth in the regulations and allocations are reflected through an increase or decrease in partners'capital accounts and (ii) liquidating distributions are required to be made in accordance with partners' respective positive capital account balances by the end of the taxable year (or, if later, within 90 days after the date of liquidation), then a partner may be allocated nonrecourse deductions that cause his or her capital account to fall below zero, provided (among other requirements) that the deficit produced by the allocation is not in excess of the minimum gain that would be allocated to the partner in the event the partnership property securing the nonrecourse liability were disposed of in a taxable transaction in full satisfaction of such liability. The regulations further provide that in the event there is a decrease in such partnership's minimum gain for a partnership taxable year, the partners must be allocated items of partnership income and gain for such year (and, if necessary, for subsequent years) in proportion to, and to the extent of, an amount equal to such partner's share of the net decrease in partnership minimum gain during such year. The Principal Partnership Agreements provide that a capital account is to be maintained for each partner, that the capital accounts are to be maintained in accordance with applicable prin- ciples set forth in the regulations, and that all allocations to a partner are to be reflected in the partner's capital account. In addition, distributions upon liquidation of the Principal Partnerships are to be made in accordance with respective capital account balances. The Principal Partnership Agreements do not require the limited partners to restore any deficit balance in their capital accounts upon liquidation of the Principal Partnerships. However, the Principal Partnership Agreements contain a "minimum gain" allocation for nonrecourse deductions and a "qualified income offset" provision. Pursuant to the Principal Partnership Agreements, tax income and gain will be allocated in a manner consistent with the book income and gain allocations associated with the minimum gain and qualified income offset provisions. The manner of allocation of items of income, gain, loss, deduction and credit for both book and Federal income tax purposes is set forth in the Principal Partnership Agreements. In general, the Principal Partnerships' income, gains, losses, deductions and credits are allocated pursuant to the Principal Partnership Agreements among the partners pro rata in accordance with their percentage interests, except that the allocation of taxable income of the Principal Subsidiary Partnership to the ServiceMaster SGP Trust is determined in the manner described above and in Note S, page 25. The Principal Partnership Agreements contain special allocations of book income and gain for the qualified income offset and minimum gain provisions (discussed above) and special allocations of income and deduction to preserve the uniformity of shares. The Principal Partnership Agreements further provide exceptions to the pro rata allocations for Federal income tax purposes of (i) income, gain, loss and deductions attributable to properties contributed to the Principal Partnerships in exchange for shares ("Contributed Property"), (ii) income, gain, loss and deductions attributable to the Principal Partnerships' properties where the Principal Partnerships have adjusted the book value of such properties upon the Public Partnership's issuance of additional shares to reflect unrealized appreciation or depreciation in value from the later of the Principal Partnerships' acquisition date for such properties or the latest date of a prior issuance of shares ("Adjusted Property"), (iii) curative allocations of gross income and deductions to preserve the uniformity of shares issued or sold from time to time, (iv) recapture income resulting from the sale or disposition of Principal Subsidiary Partnership assets ("Recapture Income"), (v) income and gain in a manner consistent with the allocation of book income and gain pursuant to a qualified income offset, and (vi) income and gain attributable to nonrecourse debt in a manner consistent with the allocation of book income and gain under a minimum gain provision. With respect to property contributed by a shareholder to the Principal Partnerships, the Principal Partnership Agreements provide that, for Federal income tax purposes, partnership income, gain, loss and deductions shall first be allocated among the partners in a manner consistent with Code Section 704(c). In addition, the Principal Partnership Agreements provide that partnership income, gain, loss and deductions attributable to Adjusted Property shall be allocated for Federal income tax purposes in accordance with Section 704(c) principles. Pursuant to Section 704(c), items of partnership income, gain, loss and deduction with respect to Contributed Property are to be shared among the partners pursuant to regulations not yet adopted so as to take account of the differences between the Principal Subsidiary Partnership's basis for the property and the fair market value of the property at the time of the contribution (i.e., a Book-Tax Disparity). The IRS has issued proposed regulations under Section 704(c) which provide that these allocations of partnership income, gain, loss and deduction to account for the Book-Tax Disparity can be made by any reasonable method. The proposed regulations set forth three non-exclusive allocation methods which are generally considered to be reasonable. Because regulations have not been issued in final form under Section 704(c), it is not clear whether allocations made pursuant to the Principal Partnership Agreements will be respected for Federal income tax purposes. As discussed below, the Code Section 754 election permits an adjustment in the basis in the assets of the Principal Subsidiary Partnerships and subsidiary partnerships pursuant to Code Section 743(b) to reflect the price at which Partnership Shares are purchased from a shareholder as if such purchaser had acquired a direct interest in such assets. See "Section 754 Election." Such Section 743(b) adjustment is attributed solely to such purchaser of shares and is not added to the bases of the assets of the Principal Subsidiary Partnership and subsidiary partnerships associated with all of the shareholders ("common bases"). With respect to Section 743(b) adjustments, proposed regulations relating to ACRS depreciation appear to require the acquiring partner to use a depreciation method and useful life for the increase in basis which is different from the method and useful life generally used to depreciate the Public Partnership's common bases in the assets of the Principal Subsidiary Partnerships and subsidiary partnerships. The Managing General Partner has the authority under the Principal Partnership Agreements to specially allocate items of income and deductions in a manner that will preserve the uniformity among all shares, so long as such allocations are consistent with and supportable under the principles of Code Section 704. The Managing General Partner may use a "depreciation convention method" or any other convention to preserve the uniformity of shares. If no allowable or workable convention is available to preserve the uniformity of Partnership Shares or the Managing General Partner in its discretion so elects, the Partnership Shares may be separately identified as distinct classes to reflect differences in tax consequences. The Managing General Partner has adopted conventions and allocations to achieve uniformity among all Partnership Shares. The Principal Partnership Agreements also require that gain from the sale of Principal Subsidiary Partnership properties, to the extent characterized as Recapture Income, be allocated (to the extent such allocation does not alter the allocation of gain otherwise provided for in the Principal Partnership Agreements) among the partners (or their successors) in the same manner in which such partners were allocated the deductions giving rise to such Recapture Income. The Section 704(b) regulations and Sections 1.1245-1(e) and 1.1250-1(f) of the regulations tend to support a special allocation of Recapture Income. However, such regulations do not specifically address a special allocation based on the allocation of the deductions giving rise to such Recapture Income as stated in the Principal Partnership Agreements. Therefore, it is not clear that the allocation of Recapture Income will be given effect for Federal income tax purposes. If it is not, such Recapture Income will be allocated to all shareholders and the general partners. Transferor/Transferee Allocations. The Principal Part- nerships will allocate their taxable income and losses among the shareholders of record in proportion to the number of Partnership Shares owned by them based on the number of months during the year for which each shareholder was record owner of the shares. The Principal Partnerships' taxable income and loss allocable to each month will be determined by allocating such income or loss pro rata to each month in the year. With respect to any Partnership Share that is transferred during any calendar month, the Principal Partnerships will treat a shareholder who becomes the record owner of such share on or before the close of business on the fifteenth day of the month as having been the owner of such share for the entire month if he or she holds such share for the remainder of such month. Conversely, a shareholder who becomes the record owner of a Partnership Share during such month but after the fifteenth day of a calendar month will be allocated the taxable income and losses attributable to the second half of such month if he or she holds such share for the remainder of such month. Code Section 706 generally requires that items of partnership income and deduction be allocated among transferors and transferees of partnership interests (as well as among partners whose interests otherwise vary during a taxable period) on a daily basis among the partners who own interests on the end of each such day. The Principal Partnerships' proposed allocation method will not literally comply with this requirement. However, the legislative history indicates that monthly and semi-monthly conventions may be permitted in normal situations. This issue may be clarified by regulations. The floor debates in connection with the enactment of the Deficit Reduction Act of 1984 (the "1984 Act") reflect that Congress intended that any regulations limiting the use of conventions under the 1984 Act provisions would apply only on a prospective basis. If the "mid-month" convention to be used by the Principal Partnerships were not permitted by the regulations ultimately adopted, then the IRS might contend that taxable income (or losses) of the Principal Partnerships must be allocated among the shareholders in a manner different from that presently contemplated (for example, on a daily basis). In that event, the respective tax liabilities of the shareholders might be adjusted, and some shareholders might be allocated additional income. The Principal Partnership Agreements authorize the Managing General Partner to revise the Principal Partnerships' method of allocating income and loss between transferor and transferee, as well as among shareholders whose interests otherwise vary during a taxable period, in order to comply with any regulations or rulings ultimately adopted. Depreciation; Amortization; Recapture General. The Principal Partnerships claim depreciation, cost recovery and amortization deductions with respect to the purchase price (or other tax basis) of the various properties of the Principal Partnerships and subsidiary partnerships and related improvements to the extent permitted by the applicable Code provisions. Land is not subject to depreciation, cost recovery or amortization deductions. As a general rule, if an intangible asset has a determinable useful life, then the cost of the asset may be amortized over that useful life using a straight-line method. If, however, the useful life of an intangible asset is not determinable, then the cost of the intangible asset may not be amortized or deducted. Various components of the Principal Partnerships' properties fall into each of the categories discussed in the preceding paragraphs. A portion of the cost of certain Principal Partnership properties is allocable to (i) nondepreciable, nonamortizable land, (ii) tangible property, some of which is real property (i.e., buildings and structural components) or tangible personal property that may qualify for depreciation deductions, and (iii) intangible property that may or may not qualify for amortization. As part of the Revenue Reconciliation Act of 1993, Congress enacted Code Section 197. This section allows for the amortization of certain intangibles over a 15-year period. This 15-year amortization period must be used even if the intangible asset has a useful life of less than 15 years. The types of intangible assets covered by Code Section 197 include goodwill, going concern value, work force in place, licenses, permits, covenants not to compete, franchises, trademarks, trade names, customer-based intangible assets (e.g., favorable sale contracts ) and supplier-based intangible assets (e.g., favorable supply contracts). Interests in partnerships are specifically excluded from Code Section 197, among other types of intangible assets. Code Section 197 applies to intangible assets acquired after August 10, 1993 unless an election is made to apply Code Section 197 retroactively starting after July 25, 1991. The Principal Partnerships will elect to have the provisions of Code Section 197 apply retroactively to an increase in basis for property acquired by the Principal Partnerships after that date. This election can be expected to increase the amount of intangible amortization of the Principal Partnerships. For shareholders who purchased shares in the Public Partnership after July 25, 1991, the amortization on the intangible assets acquired by the Principal Partnerships before July 26, 1991 allowed by Section 197 will apply only to the increase in basis resulting from the Code Section 754 election. In other words, no amortization under Code Section 197 will be allowed on the Principal Partnerships' original basis in intangible assets, unless those assets were acquired by the Principal Partnerships after July 25, 1991. With respect to bases adjustments for partners resulting from the Section 754 election, in March 1994, the IRS issued proposed and temporary regulations which, among other things, provided a procedure by which a taxpayer who purchased shares of a partnership during the period July 25, 1991 to August 10, 1993 and in respect of which a Section 754 election was in effect (which is true for the Public Partnership's shares) may elect to apply retroactively the provisions of Code Section 197. However, the regulations as initially issued may effectively prevent shareholders of publicly traded partnerships (such as the Parent Partnership) from making the election. Whether such regulations will become final as initially written, and whether such regulations are entirely valid in the form originally issued, were matters which were not clear as of the date of this Form 10-K. Deductions for depreciation, cost recovery and amortization claimed by the Principal Partnerships with respect to assets of the Principal Partnerships and subsidiary partnerships reduce the partnerships' adjusted basis for the properties, thereby increasing the potential gain (or decreasing the potential loss) to the Principal Partnerships upon the ultimate disposition of the properties. These deductions also have the effect of reducing the shareholders' adjusted basis for their Partnership Shares (by reducing taxable income or increasing tax losses), thereby affecting the potential gain or loss to be realized upon a subsequent sale of the shares. See "Sale or Other Disposition of Shares." Sale or Other Disposition of Shares General. In the event of a sale or disposition of Part- nership Shares, a shareholder will recognize gain or loss, as the case may be, on the disposition in an amount equal to the differ- ence between the amount realized by the shareholder on the dispo- sition and his adjusted tax basis for his Partnership Shares. See "Tax Consequences of Partnership Share Ownership" -- "Tax Basis of Partnership Shares." For these purposes, a shareholder's share (as determined for purposes of Code Section 752) of any Principal Partnership indebtedness attributable to the transferred Part- nership Shares will be included in the amount realized on the disposition. Generally, under current law, gain recognized by a share- holder on the sale or exchange of shares that have been held for more than twelve months will be taxable as long-term capital gain, taxable at a maximum rate of 28% in the case of taxpayers other than corporations. However, that portion of the gain attributable to "substantially appreciated inventory items" and "unrealized receivables" of the Principal Partnerships, as those terms are defined in the Code, will be treated as ordinary income. Ordinary income attributable to unrealized receivables and inventory items may exceed the net taxable gain realized upon the sale and may be recognized even if there is a net tax loss realized upon the sale. "Unrealized receivables" include, among other things, the shareholder's proportionate share of the amounts that would be recaptured as ordinary income if the Principal Partnerships were to have sold their assets at fair market value at the time the shareholder transferred his shares. See "Depreciation; ACRS; Amortization; Recapture" -- "Recapture." Any loss recognized upon the sale of shares generally will be treated as a capital loss. A shareholder will not ordinarily recognize any gain or loss upon making a gift of Partnership Shares. However, a shareholder making a gift of Partnership Shares more likely than not will include as an amount realized the share (as determined for purposes of Code Section 752) of any of the Partnerships' indebt- edness allocable to the transferred Partnership Shares. See "Tax Consequences of Partnership Share Ownership" -- "Tax Basis of Partnership Shares," such shareholder would therefore recognize gain (but not loss) on making a gift of Partnership Shares if the shareholder's basis had declined so that it were less than such amount deemed realized. In the case of a deductible gift to a charitable organization the donor's basis is apportioned between the value deemed contributed and the deemed sale price. Any gain recognized more likely than not would be subject to the same rules (described above) which apply to gain recognized on a sale of a Partnership Share, so that some portion could be treated as ordinary income. The IRS has ruled that a partner must maintain an aggregate adjusted tax basis in his entire partnership interest (consisting of all interests in a given partnership acquired in separate transactions). Upon the sale of a portion of such aggregate interest, such partner would be required to allocate his aggregate tax basis between the portion of the interest sold and the portion of the interest retained according to some equitable apportionment method. (The IRS ruling requires that the apportionment be based on the relative fair market values of such interests on the date of sale.) This requirement, if applicable to the Public Partnership, effectively would preclude a shareholder owning shares that were purchased at different prices on different dates from controlling the timing of the recognition of the inherent gain or loss in his shares by selecting the specific shares that he will sell. However, the application of this ruling in the context of a publicly traded limited partnership such as the Public Partnership is not clear. The ruling does not address whether this aggregation requirement, if applicable, results in the tacking of the holding period of older shares onto the holding period of more recently acquired shares. Transferor/Transferee Allocations. The manner in which the Principal Partnerships intend to allocate their taxable income and losses between transferors and transferees of shares is described above under "Federal Income Tax Allocations" -- "Transferor/Transferee Allocations." Shareholders contemplating a transfer of shares should note that cash distributions to which they are entitled may not correspond to the Principal Partnerships' taxable income and loss which shall be allocated between the transferor and transferee of such shares. Information Return Filing Requirements. Any shareholder who sells or exchanges a share at a time when the Principal Part- nerships have unrealized receivables (including certain recapture items) or substantially appreciated inventory generally will be required to notify the Public Partnership of such transaction within 30 days of the transaction (or if earlier by January 5 of the calendar year following the calendar year in which the trans- action occurs). The notification is required to include (i) the name and address of the transferor shareholder and the transferee; (ii) the taxpayer identification number of the transferor shareholder and, if known, of the transferee; and (iii) the date of the sale or exchange. Any transferor of a share who fails so to notify the Public Partnership may be subject to a $50 penalty for each such failure. In addition, the Public Partnership is required to notify the IRS of any sale or exchange (of which the Public Partnership has notice) of a share and to report to the IRS the name, address, and taxpayer identification number of the transferee and the transferor who were parties to such transaction and of the Public Partnership, the date of the transaction and any additional information required by the applicable information return or its instructions. The Public Partnership also must provide this information to the transferor and the transferee. If the Public Partnership fails to furnish the required information to the IRS, the Public Partnership may be subject to a penalty of up to $50 per failure, up to an annual maximum penalty of $250,000, unless the failure is due to an intentional disregard of the requirement, in which ease a penalty of $100 per failure or if greater, 5% of the amount required to be reported, would apply, without limit. Penalties could also be asserted against the Public Partnership if it fails to furnish the required information to the transferor and the transferee. Any person who directly or indirectly holds an interest in the Public Partnership as a nominee on behalf of another person during a Public Partnership taxable year must furnish the Public Partnership with a written statement for such taxable year iden- tifying the name, address and taxpayer identification number of the nominee and such other person and providing information regarding acquisitions and transfers of Partnership Shares (including information regarding acquisition cost and net sale proceeds) made by the nominee on behalf of such other person during such taxable year. Section 754 Election Effect of the Election. The Principal Partnerships have made and expect to continue to make the election permitted by Section 754 of the Code which allows adjustments to the basis of partnership property under Section 743 of the Code upon certain transfers of a partnership interest. Such election, once made, is irrevocable absent the consent of the IRS. The general effect of such an election upon a transfer of shares is to permit the purchaser of such shares to adjust the basis of the Principal Partnerships' properties for purposes of his tax return to reflect the price at which his shares are purchased, as if such purchaser had acquired a direct interest in the Principal Partnerships' assets. Effect of the Interplay Between the Section 754 Election, Section 197 and the SGP Trust. As discussed on pages 69 - 70, the existence of the SGP Trust means that the taxable income of ServiceMaster Limited Partnership as allocated to each of its shareholders will not be greater than the cash distributions made to that shareholder. For many shareholders, however, taxable income will be less than their cash distributions due to the effect of the Section 754 election. The principal effect of the Section 754 election is to cause the calculation of a partner's share of taxable income to reflect amortization and depreciation deductions which are determined by using a higher basis (reflecting the partner's purchase price) in the underlying assets than the partnership's own internal, historical basis for those assets. In this connection, the provision in the Revenue Reconciliation Act of 1993 which permits the amortization of intangible assets over a 15- year period has important consequences to those persons who purchased ServiceMaster shares on July 25, 1991 or thereafter. If their purchase price for such shares is at least $22 per share ($33 per share before the June 7, 1993 3-for-2 share split), their proportionate interest in the assets of ServiceMaster, including goodwill and other intangible assets on which amortization is now being taken over a 15-year period, will cause the calculation of their share of ServiceMaster's taxable income to include deductions which are expected to leave such persons with an allocation of no taxable income on such ServiceMaster shares or with negative taxable income on those shares. (If a limited partner is allocated negative taxable income on his or her ServiceMaster shares, it can be used to offset a like amount of positive taxable income on other ServiceMaster shares or gain upon the sale of ServiceMaster shares; however, it can not be used to offset taxable income from other sources). Under these circumstances, cash distributions on such shares will decrease the tax basis of those shares by the amount of cash distributed and without an offset increase in basis attributable to the allocation of taxable income to those shares. Accordingly, the amount of gain realized upon a taxable disposition of the shares will be greater than would be the case if the Section 754 election had not been made. Tax exempt organization such as pension plans, profit sharing plans, IRAs, Keoghs, private foundations and other charitable organizations will benefit from the interplay among the Section 754 election, the SGP Trust and the amortization of intangibles in another way. Such entities are subject to the unrelated business income tax on their share of the taxable income of a publicly traded partnership (such as ServiceMaster). However, since their ServiceMaster taxable income is expected to be zero or less (for the reasons discussed above), such entities should not be subject to any unrelated business income tax liability. Other Section 754-Related Matters. If a shareholder's adjusted basis in his or her Partnership Shares is less than his or her proportionate share of adjusted basis of the Principal Partnerships' property at the time of acquisition of such Partnership Shares, such shareholder's share of adjusted basis of the Principal Partnerships' property must be reduced to equal his or her basis in the Partnership Shares, resulting in adverse con- sequences to such shareholder. A proper allocation of the adjustment among the various assets deemed purchased for purposes of Section 743(b) requires a determination of the relative value of the Principal Partnerships' assets at such time. The IRS may challenge any such allocations. The Public Partnership calculates the basis adjustments for purchasers of its shares. For basis adjustments relating to new Code section 197 (see Depreciation; Amortization; Recapture) the Public Partnership will not provide amended K-1s to its shareholders but will provide the necessary information to the shareholders upon request. The rules governing basis adjustments under Section 743(b) and 754 of the Code are very complex and are made more complex by the interaction of various tax rules governing the allocation of the Public Partnership's items of income, gain, loss and deduction. Interpretation and application of the rules in some cases is uncertain because of the lack of precedents. Reference is made to the discussion under "Depreciation; Amortization; Recapture" for information on the ability of partners of the Public Partnership to apply Section 157 retroactively to purchases of shares during the period July 25, 1991 to August 10, 1993. Should the IRS require a different basis adjustment to be made, and should, in the Corporate General Partner's opinion, the expense of compliance exceed the benefit of the election, the Corporate General Partner may seek permission from the IRS to revoke the Section 754 elections for the Principal Partnerships. If such permission is granted, a purchaser of Partnership Shares probably will incur increased tax liability. Termination of the Principal Partnerships for Tax Purposes Code Section 708 provides that if 50% or more of the capital and profits interests in a partnership are sold or exchanged within a single 12-month period, the partnership will be considered to have terminated for tax purposes. Because of the structure of the Principal Partnerships, it is likely that a Code Section 708 termination of the Public Partnership would result in a Code Section 708 termination of the Principal Subsidiary Part- nership as well. In view of the fact that Partnership Shares will be publicly traded, it is possible that shares representing 50% or more of the Public Partnership's capital and profits interests might be sold or exchanged within a single 12-month period. However, a share that changes hands several times during a 12-month period would only be counted once for purposes of determining whether a termination has occurred. If the Principal Partnerships should terminate for tax purposes, they would be deemed to have distributed their assets to their partners, who would then be deemed to have contributed the assets to new partnerships. The Principal Partnerships would have a new basis in their non-cash assets equal to the aggregate basis of the shareholders in their Partnership Shares prior to the termination plus any gain recognized by the shareholders in the termination, less any cash deemed distributed to the shareholders in connection with the termination. Accordingly, if the basis of the shareholders in their Partnership Shares is more or less than the Principal Partnerships' aggregate basis in their assets immediately prior to the termination, the Principal Partnerships' basis in their non- cash assets following the termination might have to be reallocated among those assets to reflect the relative fair market values of those assets at the time of termination. Such a reallocation may be favorable or unfavorable, depending on the circumstances. Generally, a shareholder would not recognize any taxable gain or loss as a result of the deemed pro rata distribution of Principal Partnership assets incident to a termination of the Principal Partnerships. A shareholder, however, would recognize gain to the extent, if any, that the shareholder's pro rata share of the Principal Partnerships' cash (and the reduction, if any in the shareholder's share of the Principal Partnerships' indebtedness as determined for purposes of Code Section 752) at the date of termination exceeded the adjusted tax basis of his Partnership Shares. Also, the Principal Partnerships' taxable years would terminate. If the shareholder's taxable year were other than the calendar year, the inclusion of more than one year of the Principal Partnerships' income in a single taxable year of the shareholder could result. Also, new tax elections would be required to be made by the reconstituted partnerships. Finally a termination of the Principal Partnerships may cause the Principal Partnerships or their assets to become subject to unfavorable statutory or regulatory changes enacted prior to the termination but previously not applicable to the Principal Partnerships or their assets because of protective "transitional" rules. However, a constructive termination under Code Section 708 should not cause the Partnership to lose the benefits of the up-to-10-year grace period during which the application of new Code Section 7704 is postponed. See "Tax Status of the Partnerships"- "Publicly Traded Partnerships Treated as Corporations." In order to preserve maximum liquidity for the Partnership Shares, the Public Partnership has not adopted procedures designed to prevent a deemed termination of the Principal Partnerships from occurring. An actual dissolution of the Principal Partnerships will result in the distribution to the shareholders of record of any assets remaining after payment of, or provision for, the Principal Partnerships' debts and liabilities. To the extent that a shareholder is deemed to receive money (including any reduction in his share of Principal Partnership liabilities as determined for purposes of Code Section 752) in excess of the basis of his Partnership Shares, such excess generally will be taxed as a capital gain, except to the extent of any unrealized receivables or substantially appreciated inventory items, as described above. See "Sale or Other Disposition of Shares." A shareholder will recognize a loss upon dissolution only if the liquidating distribution consists solely of cash, or of cash and unrealized receivables and appreciated inventory items, and then only to the extent that the adjusted basis of his Partnership Shares exceeds the amount of money received and his basis in such unrealized receivables and inventory items. Minimum Tax on Tax Preference Items For noncorporate taxpayers, the alternative minimum tax is imposed on the excess of alternative minimum taxable income ("AMTI") over the exemption amount. If this excess is less than or equal to $175,000, the alternative minimum tax is imposed at a rate of 26% if such excess is greater than $175,000. The exemption amount is reduced (though not below zero) by 25% of the amount by which AMTI exceeds $150,000 for married taxpayers filing jointly, $112,500 for single taxpayers, and $75,000 for estates, trusts, and married taxpayers filing separately. For corporate taxpayers, the alternative minimum tax is imposed at the rate of 20% on the excess of the corporation's AMTI over the $40,000 exemption amount. The exemption amount is reduced (but not below zero) by 25% of the amount by which AMTI exceeds $150,000. As in the case of noncorporate taxpayers, corporations are liable for alternative minimum tax only to the extent the tax exceeds regular Federal income tax liability (with certain adjustments) for the taxable year. Both corporate and noncorporate shareholders must take into account in determining AMTI their respective shares of tax preference items generated by the Principal Partnerships' opera- tions including: (i) for most tangible property that the Principal Partnerships place in service after 1986, both corporate and noncorporate shareholders must essentially treat as a preference item their respective shares of the excess of any accelerated depreciation deductions taken by the Principal Partnerships over the deductions that would have been allowed under a new alternative depreciation system; (ii) if the Principal Partnerships sell inventory or similar dealer property, all shareholders will be prohibited from using the installment method in computing their allocable shares of gain on the sale for AMTI purposes; (iii) to the extent the Principal Partnerships receive tax-exempt interest income from certain sources, all shareholders must treat such income as a preference item; and (iv) for a shareholder that is an individual, estate, trust, closely- held C corporation, or personal service corporation, net losses generated by the Principal Partnerships in any taxable year might not be deductible for minimum tax (or regular tax) purposes unless the shareholder materially participates in the activities of the Principal Partnerships. Although these rules are applicable to the shareholders of the Public Partnership, in fact the Public Partnership has had no preference items since inception and does not anticipate generating any preference items in the future. Investment Interest Each individual shareholder's distributive share of the Public Partnership's portfolio income (i.e., income from interest, dividends, annuities and royalties not derived in the ordinary course of a trade or business) will be treated as investment income under Code Section 163(d) and may be offset by the shareholder's investment interest expense. Code section 163(d) has been amended to exclude capital gains on the disposition of investment property from the computation of investment income unless a shareholder elects to include such gains in his or her taxable income at ordinary rates. A portion of the interest incurred by a shareholder to finance the acquisition of Partnership Shares will generally be treated as investment interest expense if the Principal Partnerships hold investment property. The IRS has announced that forthcoming Regulations will also treat an individual shareholder's net passive income from a publicly traded partnership (such as the Public Partnership) as investment income under Code Section 163(d). Accordingly, the amount of an individual shareholder's net passive income if any from the Public Partnership will be treated as investment income for purposes of Code Section 163(d). For this purpose, the computation of the amount of a shareholder's net passive income from the Public Partnership will take into account any passive activity deductions attributable to expenses of the shareholder that are incurred outside the Public Partnership and are properly allocable to the interest in passive activities that the share- holder holds through Partnership Shares. Thus, the amount of a shareholder's net passive income, if any, from the Public Part- nership generally will be reduced on account of a portion of any interest incurred by the shareholder to finance the acquisition of Partnership Shares. Noncorporate shareholders are urged to consult their tax advisors with regard to the specific effect that limitations on the deduction of investment interest would have on their investment in the Public Partnership. Tax-Exempt Entities, Individual Retirement Accounts and Regulated Investment Companies Unrelated Business Taxable Income. Tax-exempt entities (including IRAs and trusts that hold assets of employee benefit or retirement plans) are subject to tax on certain income derived from a business regularly carried on by the entity that is unre-lated to its exempt activities (i.e., "unrelated business taxable income" ("UBTI")). It is anticipated that nearly all of any tax-exempt entity's share (whether or not distributed) of the Principal Partnerships' gross income will be treated as gross income from an unrelated business, and the tax-exempt entity's share of nearly all of the Principal Partnerships' deductions will be allowed in computing the tax-exempt entity's UBTI. Tax-exempt shareholders other than those who benefit from the interplay between the Section 754 Election, Section 197 and the SGP Trust as described on pages 51 and 52 would be subject to tax on any UBTI to the extent that the sum of such UBTI (i.e., gross income net of deductions), if any, from their Partnership Shares and from other sources were to exceed $1,000 in any particular year. Moreover, even if their UBTI does not exceed $1,000 so that tax-exempt shareholders do not incur a Federal income tax liability, they nevertheless will be required to file income tax returns if their gross income included in computing such UBTI is $1,000 or more for any tax year. Investment Company Income. For purposes of determining whether a shareholder is a regulated investment company (within the meaning of Code Section 851), the shareholder's income derived from the Principal Partnerships will be treated as income from dividends, interest and gains from the sale or other disposition of securities only to the extent the shareholder's income is attributable to such dividends, interest and gains realized by the Principal Partnerships. Administrative Matters Information to Shareholders and Assignees. In addition to the required Schedule K1 to be furnished by the Public Part-nership to holders of Partnership Shares during a particular taxable year, the Public Partnership intends to furnish detailed instructions and explanations advising recipients of the Schedule K1 as to how to fill out their own income tax returns. The information will be provided within 90 days after the end of the Public Partnership's taxable year. Partnership Tax Returns and Possible Audit. Although a partnership is not required to pay any Federal income tax, tax audits are conducted, and the tax treatment of partnership income, loss, deduction and credit is determined, at the partnership level in a unified proceeding. In audits of partnerships, the IRS ordinarily will provide notice of the commencement of administrative proceedings and final adjustment only to each partner with an interest in profits of 1% or more. The Corporate General Partner is designated the "tax matters partner" ("TMP") to receive notice on behalf of and to provide notice to those shareholders with interests of less than 1% in the Public Partnership ("non-notice shareholders"). The TMP may extend the statutory period of limitations for assessment of adjustments attributable to "partnership items" for all shareholders and may enter into a binding settlement on behalf of non-notice shareholders, except for any group of such shareholders with an aggregate interest of 5% or more in Public Partnership profits that elects to form a separate notice group or shareholders who otherwise properly notify the IRS that the TMP is not authorized to act on their behalf. If the IRS and the TMP fail to settle an audit proceeding, then the TMP may choose to litigate the matter. In that event, the TMP would select the court in which such litigation would occur (including, perhaps, a court where prepayment of the tax may be required). All shareholders would have the right to participate in such litigation and, regardless of participation, would be bound by the outcome of the litigation. Because shareholders will be affected by the outcome of any administrative or court proceedings with respect to both the Public Partnership and the Principal Subsidiary Partnership, the Corporate General Partner intends to provide shareholders with appropriate notices of Federal income tax proceedings with respect to both Principal Partnerships. Shareholders will be required to treat Public Partnership items on their individual returns in a manner consistent with the treatment of those items on the Public Partnership's return, unless the shareholders file with the IRS a statement identifying the inconsistency. Examination of the Principal Partnerships' tax returns could result in an adjustment to the tax liability of a shareholder without any examination of the shareholder's tax return. In addition, any such audit could result in an audit of a shareholder's entire tax return and in adjustments to non- partnership related items on that return. Tax Shelter Registration. The Code requires a tax shelter organizer to register a "tax shelter" with the IRS by the first date on which interests in the tax shelter are offered for sale. Such registration does not indicate approval by the IRS and could result in an audit. The registration provisions require the tax shelter organizer to maintain a list containing information on each investor, would require the shareholders to report the Public Partnership's tax registration number on their separate Federal income tax returns, and would require the Public Partnership to maintain a list of each person to whom it transfers an interest in a "tax shelter." Penalties may be imposed if registration is required and not made. A "tax shelter" for purposes of the registration requirement is one in which a person could reasonably infer, from the representations made in connection with any offer for sale of any interest in the investment, that the "tax shelter ratio" for any investor may be greater than two to one as of the close of any of the first five years ending after the date on which the investment is offered for sale. The term "tax shelter ratio" is the ratio that the aggregate amount of gross deductions plus 350% of the credits that are potentially allowable to an investor bears to the partner's investment base for the year. The Public Partnership has not been registered as a "tax shelter" because it expects that no shareholder's tax shelter ratio will exceed two to one. Accuracy-Related Penalties. The Code provides for a penalty to be assessed in the event of a tax underpayment attributable to a substantial overstatement of the value or adjusted basis of property claimed on a tax return. This penalty will apply if (i) the claimed value or adjusted basis of the property equals or exceeds 200% of the correct value or adjusted basis, and (ii) the amount of the tax underpayment for the taxable year attributable to substantial valuation overstatements exceeds $5,000 ($10,000 in the case of a corporation other than an S corporation or a personal holding company). The amount of the penalty generally is 20% of the tax underpayment attributable to substantial valuation overstatements where the claimed value or adjusted basis is less than 400% of the correct value of adjusted basis, and 40% of the tax underpayment attributable to substantial valuation overstatements where the claimed value or adjusted basis equals or exceeds 400% of the correct value or adjusted basis. The penalty will likely be potentially applicable to partners in cases where the partnership has made a substantial valuation overstatement. The penalty generally will not apply with respect to any portion of a tax underpayment attributable to a substantial valuation overstatement (with respect to property other than charitable deduction property) if it is shown that there was a reasonable cause for such portion and that the taxpayer acted in good faith with respect to such portion. The IRS might contend that the portion of the Principal Partnerships' basis allocated to certain customer contracts of the properties exceeds the correct fair market value of those elements and therefore that the adjusted basis used by the Principal Partnerships for calculating deductions with respect to those elements of the properties constitutes substantial valuation overstatement for purposes of this penalty. Although the Corporate General Partner's allocation of the basis among the various properties and elements comprising the properties has been determined by an independent appraisal of the individual assets, there can be no assurance that the IRS will not contend that the allocation resulted in an overvaluation of certain assets. The Code provides for a penalty in the amount of 20% of any underpayment of tax attributable to a "substantial understatement of income tax." A "substantial understatement of income tax" is the amount of the understatement of tax on a taxpayer's return for a particular taxable year that exceeds the greater of $5,000 ($10,000 if the taxpayer is a corporation other than an S corporation or a personal holding company) or 10% of the tax required to be shown on the return for the year. As a general rule, the penalty will not be imposed with respect to underpayments attributable to items for which (i) there is or was substantial authority for the tax treatment afforded such items by the taxpayer, or (ii) the relevant facts affecting the treatment of such items are adequately disclosed in the taxpayer's return or in a statement attached to the return and there was a reasonable basis for the position. The penalty will not apply with respect to any portion of a tax underpayment attributable to a substantial understatement of income tax if it is shown that there was a reasonable cause for such portion and that the taxpayer acted in good faith with respect to such portion. There can be no assurance that a shareholder will not have a substantial understatement of income tax as a result of the treatment of items of income, gain, loss, deduction and credit resulting from his investment in the Public Partnership or that the IRS will not contend that there is not substantial authority for the treatment on the shareholder's return of certain items of income, gain, loss, deduction and credit. If the IRS should challenge the treatment by the Principal Partner-ships for tax purposes of the various items of income, gain, loss, deduction and credit, and if a shareholder should fail to meet the substantial authority and adequate disclosure tests, a shareholder could incur a penalty for a substantial underpayment of taxes resulting from his investment in the Public Partnership. Interest on Deficiencies. The Code provides that interest accrues on all tax deficiencies at a rate based on the Federal short-term rate plus 3 percentage points (5 percentage points in certain cases involving underpayment by a C corporation of tax amounting to more than $100,000) and compounded daily. This interest applies to penalties as well as tax deficiencies. Backup Withholding. Distributions to shareholders whose Partnership Shares are held on their behalf by a broker may con- stitute reportable payments subject to backup withholding. Backup withholding, however, would apply only if the shareholder (i) failed to furnish his Social Security number or other taxpayer identification number to the person subject to the backup withholding requirement (e.g., the broker) or (ii) furnished an incorrect Social Security number or taxpayer identification number. If backup withholding were applicable to a shareholder, the person subject to the backup withholding requirement would be required to withhold 31% of each distribution to such shareholder and to pay such amount to the IRS on behalf of such shareholder. Amounts withheld under the backup withholding provisions are allowable as a refundable credit against a taxpayer's Federal income tax. Tax Considerations for Foreign Investors General. A nonresident alien or foreign corporation, trust or estate ("foreign person") which is a partner in a partnership which is engaged in a business in the United States will be considered to be engaged in such business, even though the foreign person is only a limited partner. The activities of the Principal Partnerships will constitute a United States business for this purpose, and such activities likely will be deemed to be conducted through a permanent establishment within the meaning of the Code and applicable tax treaties. Therefore, a foreign person who becomes a shareholder in the Public Partnership will be required to file a United States tax return on which he must report his distributive share of the Principal Partnerships' items of income, gain, loss, deduction and credit, and to pay United States taxes at regular United States rates on his share of any of the Principal Partnerships' net income, whether ordinary income or capital gains. Code Section 1446 generally requires partnerships which have taxable income effectively connected with a trade or business in the United States to withhold tax with respect to the portion of such income allocable to foreign partners. This withholding tax generally is imposed at the rate of 39.6% with respect to effectively connected income (as computed for purposes of Section 1446) allocable to foreign individuals, and 35% with respect to effectively connected income (as computed for purposes of Section 1446) allocable to foreign corporations and withholding may be required under Section 1446 even if no actual distribution has been made to partners. However, pursuant to an IRS Revenue Procedure, in the case of a publicly traded partnership (such as the Public Partnership) the Code Section 1446 withholding tax will be imposed in an alternative manner unless the publicly traded partnership elects not to have such alternative treatment apply. Under this alternative approach, the Code Section 1446 withholding tax is imposed on distributions made to individual or corporate foreign partners. The Treasury is authorized to issue such regulations applying Section 1446 to publicly traded partnerships as may be necessary to carry out the purposes of Section 1446, but such regulations have not yet been issued. Although foreign shareholders would be entitled to a United States tax credit for amounts withheld by Principal Partnerships under Section 1446, either Section 1446 or the regulations (not yet issued) applying Section 1446 to publicly traded partnerships could under some circumstances adversely affect the Principal Partnerships and the foreign shareholders, e.g., by destroying the uniformity of Partnership Shares. Branch Profits Tax. Code Section 884 imposes a branch profits tax at the rate of 30 percent (or lower to the extent provided by any applicable income tax treaty) on the earnings and profits (after certain adjustments) of a U.S. branch of a foreign corporation, if such earnings and profits are attributable to income effectively connected with a U.S. trade or business. The legislative history of Code Section 884 indicates that the branch prose tax is intended to apply to foreign corporations that are partners in partnerships which have a U.S. trade or business. Thus, foreign corporations which own shares in the Public Part- nership may be subject to the branch profits tax on earnings and profits attributable to the Principal Partnerships' income as well as federal income tax on their share of Partnership income. The earnings and profits (which are subject to branch profits tax) attributable to Partnership Shares held by a foreign corporation will, of course, reflect a reduction for Federal income taxes paid by the foreign corporate shareholder on its share of Partnership income. FIRPTA. The Foreign Investment in Real Property Tax Act of 1980 ("FIRPTA"), as amended by subsequent legislation, provides that gain or loss on the disposition of a United States Real Property Interest ("USRPI") is taxable in the United States as if effectively connected with a U.S. business and imposes withholding requirements on such sales and on distributions of USRPIs by partnerships to foreign persons. USRPIs include (i) United States real estate and (ii) interest in certain entities (including publicly traded partnerships) holding United States real estate. The shares will not be USRPIs unless the value of the Principal Partnerships' United States real estate equals or exceeds 50% of the value of all its business assets. Furthermore, the FIRPTA rules generally do not apply to any foreign person which owns 5% or less of the publicly traded Partnership Shares. FIPPTA also imposes certain withholding obligations with respect to dispositions of USRPIs by a partnership that are includable in a foreign person's share of partnership income. Foreign Taxes. A foreign person may be subject to tax on his share of the Principal Partnerships' income and gain in his country of nationality or residence, or elsewhere. The method of taxation in such jurisdictions, if any, may differ considerably from the United States tax system described previously, and may be affected by the United States characterization of the Principal Partnerships and their income. Prospective investors who are foreign persons should consult their own tax advisors with respect to the potential tax effects of these and other items related to an investment in the Public Partnership. State and Local Income Taxes In addition to the Federal income tax consequences described above, prospective investors should consider state and local tax consequences of an investment in the Public Partnership. A shareholder's share of the taxable income or loss of the Principal Partnerships generally will be required to be included in determining his reportable income for state or local tax purposes. If the Public Partnership is treated as a corporation under Code Section 7704, as described above under "Tax Status of the Partnerships" -- "Publicly Traded Partnerships Treated as Corporations," the Public Partnership may also be treated as a corporation for state tax purposes in those states which base state income taxes on Federal income tax laws. Management has been successful in filing a composite return on behalf of its individual shareholders in all states where the Principal Partnerships do business. The Public Partnership will provide information each year to the shareholders as to the share of income and taxes paid on their behalf in each state. For those entities not included in the composite state return (corpo-rations, partnerships and certain other entities), the Public Partnership will provide the applicable state information. Certain tax benefits which are available to shareholders for Federal income tax purposes may not be available to shareholders for state or local tax purposes and, in this regard, investors are urged to consult their own tax advisors. The Public Partnership intends to supply shareholders with information regarding their income, if any, derived from various jurisdictions in which the Principal Subsidiary Partnership operates. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Shareholders of ServiceMaster Limited Partnership: We have audited in accordance with generally accepted auditing standards, the financial statements included in ServiceMaster Limited Partnership's annual report to shareholders incorporated by reference in this Form 10-K, and have issued our report thereon dated January 25, 1994. Our audit was made for the purpose of forming an opinion on those statements taken as a whole. The schedules included in Part IV in the Form 10-K are the responsibility of the Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These supporting schedules have been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly state 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 & CO. /s/ Arthur Andersen & Co. Chicago, Illinois January 25, 1994 Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. SERVICEMASTER LIMITED PARTNERSHIP Registrant By: ServiceMaster Management Corporation (General Partner) Date: March 18, 1994 By: /s/ C. WILLIAM POLLARD C. William Pollard Chairman 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 their capacities and on the date indicated. EXHIBIT 22 SUBSIDIARIES OF THE REGISTRANT As of March 21, 1994, ServiceMaster had the following subsidiaries: State or Country of Subsidiary or Organization Incorporation The ServiceMaster Company Limited Partnership Delaware ServiceMaster Consumer Services Limited Partnership Delaware ServiceMaster Consumer Services, Inc Delaware ServiceMasterResidential/Commercial Services Limited Partnership Delaware ServiceMaster Residential/Commercial Services Management Corporation Delaware The Terminix International Company Limited Partnership Delaware Terminix International, Inc. Delaware Merry Maids Limited Partnership Delaware Merry Maids, Inc. Delaware TruGreen Limited Partnership Delaware TruGreen, Inc. Delaware SVM Holding Corp. Delaware American Home Shield Corporation Delaware ServiceMaster Direct Distributor Company Limited Partnership Delaware ServiceMaster DDC, Inc. Delaware ServiceMaster Management Services Limited Partnership Delaware ServiceMaster Management Services, Inc. Delaware CMI Group, Inc. Wisconsin ServiceMaster Home Health Care Services Inc. Delaware ServiceMaster Child Care Services, Inc. Delaware The ServiceMaster Acceptance Company Limited Partnership Delaware ServiceMaster AM Limited Partnership Delaware ServiceMaster Acceptance Corporation Delaware Azimuth Advertising Limited Partnership Delaware Azimuth Management Corporation Delaware AFM Beveraging, Inc. Missouri FCIC Inc. Illinois ServiceMaster Employment Corporation Delaware ServiceMaster International Limited Partnership Delaware ServiceMaster International Management Corporation Delaware ServiceMaster Operations, AG Switzerland ServiceMaster Limited United Kingdom ServiceMaster Operations Germany GmbH Germany ServiceMaster Japan, Inc. Japan LTCS Investment Limited Partnership Delaware ServiceMaster Diversified Health Services, Inc. Delaware ServiceMaster Diversified Health Services, L.P. Tennessee We Serve America, Inc. Delaware TSSGP Limited Partnership Delaware TSSGP, Inc. Delaware EXHIBIT 24 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation by reference in this Form 10-K of our report dated January 25, 1994, included in the ServiceMaster Limited Partnership Annual Report to Shareholders for the year ended December 31, 1993. ARTHUR ANDERSEN & CO. /s/ Arthur Andersen & Co. Chicago, Illinois March 21, 1994 Graphics Appendix This appendix describes the graphics which could not be put into electronic format and which have been filed with the Securities and Exchange Commission as a paper filing. A diagram captioned "Structure of ServiceMaster" is set forth on page 8. This diagram shows the principal holding and operating units within the ServiceMaster enterprise. The Registrant is shown at the top of the diagram and The ServiceMaster Company appears directly below the Registrant. The four principal segments of ServiceMaster are set forth below. The principal operating units within each segment are then depicted. Reference is made to the "Notes to Organizational Structure Chart" on page 11 for a further explanation of the diagram. A Performance Graph is set forth on page 31 which consists of a line graph which compares the yearly percentage change in ServiceMaster's cumulative total shareholder return on its limited partner shares (computed in accordance with the Item 302(d) of Reg. S-K) with the cumulative return on the stocks of the companies within the S&P 500 Index and with the S&P Commercial Services Index over the five year period from January 1, 1988 to December 31, 1993. The chart shows that ServiceMaster underperformed both indices in 1988; ServiceMaster outperformed the Commercial Services Index in 1989 but slightly underperformed the S&P 500 Index in 1989; and outperformed both indices in 1991, 1992 and 1993 in increasingly wide margins over this three-year period.
71344_1993.txt	71344	1993	Item 1. BUSINESS General New England Telephone and Telegraph Company (the "Company") was incorporated in 1883 under the laws of the State of New York, has its principal executive offices at 125 High Street, Boston, Massachusetts 02110 (telephone number 617-743-9800) and is engaged primarily in providing telecommunications services in Maine, Massachusetts, New Hampshire, Rhode Island and Vermont. The Company is a wholly-owned subsidiary of NYNEX Corporation ("NYNEX"). Telecommunications Services The Company is engaged primarily in providing two types of telecommunications services, exchange telecommunications and exchange access, in Maine, Massachusetts, New Hampshire, Rhode Island and Vermont. Exchange telecommunications service is the transmission of telecommunications among customers located within geographical areas (local access and transport areas or "LATAs"). These LATAs are generally centered on a city or other identifiable community of interest and, subject to certain exceptions, each LATA marks an area within which a former Bell System local exchange company ("LEC") operating within such territory may provide telecommunications services (see "Operations Under the Modification of Final Judgment" below). Exchange telecommunications service may include long distance service as well as local service within LATAs. Examples of exchange telecommunications services include switched local residential and business services, long distance service, private line voice and data services, Wide Area Telecommunications Service ("WATS") and Centrex services. Exchange access service refers to the link provided by LECs between a customer's premises and the transmission facilities of other telecommunications carriers, generally interLATA carriers. Examples of exchange access services include switched access and special access services. Certain billing and collection services are performed by the Company for other carriers, primarily American Telephone and Telegraph Company ("AT&T"), and certain information providers that elect to subscribe to these services rather than perform such services themselves. Effective January 1, 1987, such billing and collection services were detariffed on an interstate basis and are offered to interexchange carriers under contract. In 1993, approximately 1% of operating revenues were derived from such billing and collection services. In 1990, the Company and AT&T signed a six-year contract extending the Company's role as an AT&T long distance billing and collection agent. The agreement allows AT&T the flexibility of gradually assuming certain administrative and billing functions performed by the Company. The contract expires on December 31, 1995. There are six LATAs that comprise the area served by the Company and they are referred to as follows: Eastern Massachusetts, Western Massachusetts, Maine, New Hampshire, Rhode Island and Vermont. The following table sets forth for the Company the approximate number of network access lines in service at the end of each year: Sizeable areas and many localities within the territories served by the Company are served by nonaffiliated telephone companies that had approximately 212,000 network access lines in service in those territories on December 31, 1993. The Company does not furnish local service in the areas and localities served by such companies. For the year ending December 31, 1993, approximately 93% of the total operating revenues of the Company were derived from telecommunications services. In 1993, one customer, AT&T, accounted for approximately 15% of such revenues, primarily in network access and other revenues. The remaining approximate 7% of total operating revenues was from other sources, primarily licensing fees for telephone directories. Telesector Resources Group, Inc. Telesector Resources Group, Inc. ("Telesector Resources") is a wholly-owned subsidiary of the Company and New York Telephone Company ("New York Telephone"), also a wholly-owned subsidiary of NYNEX. In 1990, NYNEX Materiel Enterprises Company was transferred from NYNEX to the Company and to New York Telephone (collectively, the "Telephone Companies") and then merged into another jointly owned subsidiary, NYNEX Service Company, which was renamed Telesector Resources. The Company has a 33 1/3% ownership in Telesector Resources and shares voting rights equally with the other owner, New York Telephone. The Telephone Companies have consolidated all or part of many regional service and support functions into Telesector Resources. Regional service functions are interstate access services, operator services, public communications, sales, market area services, corporate services, information services, labor relations, engineering/construction and business planning. Support functions are quality and process re-engineering, marketing, technology and planning, public relations, legal and human resources. In addition, Telesector Resources provides various procurement, procurement support and materials management services to the Telephone Companies, on a nonexclusive basis. These services include product evaluation, contracting, purchasing, materials management and disposition, warehousing, transportation, and equipment repair management. Under a reciprocal services agreement, the Company provides certain administrative and other services for Telesector Resources. Each of the seven regional holding companies ("RHCs") formed in connection with the AT&T divestiture owns an equal interest in Bell Communications Research, Inc. ("Bellcore") (see "Operations Under the Modification of Final Judgment" below). Bellcore furnishes to the LECs, including the Company, and certain of their subsidiaries technical and support services (that include research and development) relating to exchange telecommunications and exchange access services that can be provided more efficiently on a centralized basis. Bellcore serves as a central point of contact for coordinating the efforts of NYNEX and the other RHCs in meeting the national security and emergency preparedness requirements of the federal government. Certain Affiliated Business Operations NYNEX Information Resources Company The Company has agreements with NYNEX Information Resources Company ("Information Resources"), a wholly-owned subsidiary of NYNEX, pursuant to which Information Resources pays a fee to the Company for the right to produce, publish and distribute alphabetical (White Pages) and classified (Yellow Pages) directories for the Company. Business Restructuring In the fourth quarter of 1993, the Company recorded charges of approximately $619 million for business restructuring. These charges resulted from a comprehensive analysis of operations and work processes, resulting in a strategy to redesign them to improve efficiency and customer service, to implement work force reductions, and to produce cost savings necessary for the Company to operate in an increasingly competitive environment. Capital Expenditures The Company meets the expanding needs for telecommunications services by making capital expenditures to upgrade and extend the existing telecommunications network, including new construction, optical fiber and modernization. Capital expenditures (excluding the equity component of allowance for funds used during construction and additions under capital leases) for 1989 through 1993 are set forth below: Operations Under the Modification of Final Judgment The operations of NYNEX and its subsidiaries in all industry segments are subject to the requirements of a consent decree known as the "Modification of Final Judgment" ("MFJ"). The MFJ arose out of an antitrust action brought by the United States Department of Justice ("DOJ") against AT&T. On August 24, 1982, the United States District Court for the District of Columbia (the "MFJ Court") approved the MFJ as in the public interest. On February 28, 1983, the United States Supreme Court affirmed the MFJ Court's action. Pursuant to the MFJ, AT&T divested its 22 wholly-owned LECs, including the Telephone Companies, distributed them to the RHCs, and distributed the stock of the RHCs to AT&T's stockholders on January 1, 1984. As initially approved, the MFJ restricted the RHCs, including NYNEX and its subsidiaries, including the Company, to the provision of exchange telecommunications service, exchange access and information access services, the provision (but not manufacture) of customer premises equipment ("CPE") and the publishing of printed directory advertising. Although some restrictions placed on RHC operations have been removed or modified since entry of the MFJ, the RHCs are still required to seek MFJ Court approval in order to provide interLATA telecommunications services, to manufacture or provide telecommunications products and to manufacture CPE. Also, the Company is still required to offer to all interexchange carriers and information service providers exchange access and information access, at certain locations, which are equal in quality, type and price to that provided to AT&T and its affiliates ("Equal Access"). Included in capital expenditures for the period 1989 through 1993 are costs in connection with the requirement to provide Equal Access (see "Capital Expenditures" above). MFJ Court approval to engage in any of the prohibited activities is normally predicated upon a showing to the MFJ Court that there is no substantial possibility that an RHC could use its monopoly power to impede competition in the market it seeks to enter. The MFJ Court has established procedures for dealing with requests by an RHC to enter new businesses. Such requests must first be submitted to the DOJ for its review. After DOJ review, the RHC seeks approval directly from the MFJ Court. The MFJ Court will consider the recommendation of the DOJ in deciding whether a specific request should be granted. On July 25, 1991, the MFJ Court lifted the MFJ restriction on the provision of the content of information services by the RHCs and LECs, including NYNEX and the Telephone Companies. On May 28, 1993, the United States Court of Appeals for the District of Columbia affirmed that decision. The Court of Appeals decision allows the RHCs and LECs, including NYNEX and the Telephone Companies, to create and own the content of the information they transmit over the telephone lines and to provide data processing services to customers. On November 15, 1993, the United States Supreme Court declined to review the Court of Appeals decision. Regulated Services Intrastate communications services offered by the Company are under the jurisdiction of state public utility commissions (see "State Regulatory Matters" below). Interstate communications services offered by the Company are regulated by the Federal Communications Commission ("FCC") (see "Federal Regulatory Matters" below). In addition, state and federal regulators review various transactions between the Company and the other subsidiaries of NYNEX. State Regulatory Matters Set forth below is a description of certain intrastate regulatory proceedings with respect to changes in rates and revenues1/. The net annual intrastate revenue reduction ordered for the Company, comprised of both reductions in rates and one-time credits to customers, was approximately $6.2 million, $9.0 million and $4.4 million for 1993, 1992, and 1991, respectively. Maine On May 1, 1992, the Maine Public Utilities Commission ("MPUC") issued a Notice of Proceeding to commence a comprehensive investigation regarding the Company's cost of service and rate design. The Company filed its comprehensive rate design proposal with the MPUC on July 6, 1992. Although the Company did not seek to increase the overall revenues it receives, the rate design proposal would affect the rates charged for various services. The rate design proposal seeks a reduction in rates for message telecommunications and related toll services, a corresponding decrease in access rates and an increase in residence basic exchange service rates. At a March 11, 1994 deliberative session, the MPUC voted to reject the Company's rate design proposal. The MPUC found that the Company had not adequately supported its proposal. Because the Company's proposal was designed to be revenue neutral, there will be no immediate earnings impact from the MPUC's decision. The final order is expected to be released by the end of March. The MPUC expressed an interest in exploring how the rate realignment proposed by the Company might be accomplished through an alternative form of regulation, in lieu of traditional rate of return regulation. The MPUC announced its intention to commence such an investigation upon release of its final order. 1/ The term "rates" is synonymous with prices. When changes in rates are referred to in the aggregate, the reference is to the aggregate effect of individual price changes multiplied by the volumes of services, assuming no change in volume as a result of the price changes. The term "revenues", on the other hand, refers to the aggregate effect of prices multiplied by volumes of service, with effect given to the change in volume as a result of any price changes. New Hampshire On March 16, 1993, the Company, the New Hampshire Public Utilities Commission ("NHPUC") staff, the NHPUC Office of Consumer Advocate, various interexchange and local exchange carriers and an association of business customers filed a stipulation for approval by the NHPUC to resolve all matters in the current phase of the generic intraLATA competition docket. On June 10, 1993, the NHPUC issued an order approving in part and modifying in part the stipulation, subject to the acceptance of the parties, to provide that (1) the NHPUC will not initiate a show cause proceeding, for effect prior to October 1, 1995, as to the Company's earnings or cost of capital; (2) the Company will not initiate, prior to April 1, 1995, a request for an increase in basic exchange rates, for effect prior to October 1, 1995, except to reflect changes in exogenous costs; (3) switched access rates for non-800 access service decreased from 20 cents to 16 cents in 1993, which resulted in an annual reduction of approximately $3.1 million effective October 1, 1993, and will decrease 12 cents the following year, 8 cents in the third year, and in the fourth year would be equal to the interstate rate in effect at that time; (4) the Company will have pricing flexibility with respect to its long distance services; and (5) the settlements process between the Company and independent carriers will be replaced by access arrangements. On July 29, 1993, the parties resubmitted the stipulation with the NHPUC, as modified by the NHPUC and the Company. On August 2, 1993, the NHPUC approved the stipulation as resubmitted. Rhode Island Pursuant to an order of the Rhode Island Public Utilities Commission, the Company, with respect to 1993 earnings, must apply a one-time credit to customers' bills of 50% of any earnings between 13.25% and 19.25% return on equity and 100% of any return in excess of 19.25%. Vermont The Company filed a petition for a price regulation plan with the Vermont Public Service Board ("VPSB") on October 5, 1993. This proposal provides that (1) the Company would be allowed to adjust its rates annually based on an increase in the Gross Domestic Product Price Index, adjusted for productivity and exogenous factors; (2) the Company would enhance its current quality commitments; (3) the Company would retain the ability to offer new products and services on 15 days' notice, and the ability to offer customer specific contracts, without prior VPSB approval; and (4) the Company's earnings would not be restricted. In a related proceeding, on December 1, 1993, the Vermont Department of Public Service filed a petition seeking to examine the Company's rates and to ensure that rates are at appropriate levels prior to the initiation of a price regulation plan. The petition asserts that the Company may be over-earning and asks the VPSB to direct that any rate reduction be returned to the ratepayers of Vermont in the form of a rebate retroactive to December 1993. A decision in both the incentive regulation and rate dockets is due from the VPSB by August 24, 1994. On February 18, 1994, the VPSB opened an investigation into open network architecture ("ONA"), unbundling and interconnection issues. This is a major competition docket that is expected to continue into 1995. See also discussion of State Regulatory Matters in Part II, Management's Discussion and Analysis of Results of Operations, which is incorporated herein by reference. Federal Regulatory Matters Interstate Access Charges Interstate access charges are tariff charges filed with the FCC that compensate LECs, including the Company, for services that allow carriers and other customers to originate and terminate interstate telecommunications traffic on the LECs' local distribution networks. Such charges recover the LECs' access-related costs allocated to the interstate jurisdiction ("Interstate Costs") under the FCC's jurisdictional cost allocation rules. With respect to the provision of access to the switched network, separate charges are applied to end users ("End User Common Line Charges") and to interexchange carriers ("switched access"). End User Common Line Charges recover, through a fixed charge, a portion of the Interstate Costs of the line connecting an end user's premises with the LEC's central office. The LECs recover their remaining Interstate Costs through mileage and usage sensitive charges to the interexchange carriers. Special access refers to the provision of nonswitched access for private line services. Between January 1, 1984 and April 1985, the Company charged AT&T for special access pursuant to contracts and charged other interexchange carriers pursuant to pre-existing tariffs. In November 1984, pursuant to permission granted by the FCC, the Company increased by approximately 20 percent the special access rates to the other interexchange carriers. In April 1985, special access tariffs applicable to all interexchange carriers, including AT&T, became effective. Upon review, the United States Court of Appeals for the District of Columbia Circuit found that the rate increases permitted prior to June 3, 1985 were instituted without the requisite period of notice and, therefore, remanded the case to the FCC for a determination of the appropriate refunds. On July 12, 1993, the FCC issued an order requiring the Company to calculate refunds for certain interexchange carriers. Pursuant to that order, which is subject to a pending petition for reconsideration by one of the interexchange carriers, the Company provided a refund totalling approximately $135,000 on November 29, 1993. Effective January 1, 1991, the FCC adopted a new system for regulating the interstate rates of the LECs, including the Company, and established so called "price caps" that set maximum limits on the prices the Company can charge. The limits will be adjusted each year to reflect inflation, a productivity factor and certain other cost changes. Price cap regulation does not guarantee that any LEC will earn its authorized rate of return. If the Company's earnings in any year fall below 10.25%, the Company is permitted to increase its rates in the following year to reflect the difference between its earnings and what earnings would have been at a 10.25% rate of return. On November 1, 1990, the Company filed tariffs to comply with the FCC's new price cap rate regulation policy. Effective January 1, 1991, the FCC lowered the interstate access authorized rate of return from 12% to 11.25%. The tariffs, which became effective on January 1, 1991, were based upon the authorized rate of return on overall investment of 11.25%. Under the FCC price cap regulations, each LEC may earn a rate of return above the authorized rate of return, up to 12.25%, which equates to a return on equity of slightly over 15.0% for the Company. Above that level, earnings are divided equally between the LEC and customers, until they reach an effective cap on interstate return on equity of approximately 18.7%. Also, if the Company chooses to set its tariffs in any one year based on a more stringent (4.3% as opposed to 3.3%) productivity standard, the Company may earn in that year a rate of return on overall investment of up to 13.25% before earnings are shared with customers, which equates to a correspondingly higher return on equity. On April 2, 1991, the Company filed its first annual access tariff revisions under the new price cap rules. These revisions incorporated a 3.3% productivity factor, as well as inflation factor adjustments and other cost changes. The revised tariffs became effective on July 1, 1991 and reduced annual interstate access rates approximately $22 million. In addition, on January 13, 1992, the FCC permitted the Telephone Companies to implement the first step of a transition plan to unify their interstate access rates. The Telephone Companies implemented the second step transition rates on July 2, 1993 and the third and final step on November 24, 1992. On July 1, 1992, the Company implemented the second annual update to the price cap rates. These tariff changes, which included the second step transition rates, resulted in an increase in the Company's annual interstate access rates of approximately $55 million during the tariff period from July 1, 1992 to July 1, 1993. On July 2, 1993, the Company implemented the third annual update to the price cap rates. These tariffs will result in a net reduction in the Company's annual interstate access rates of approximately $35 million during the tariff period from July 2, 1993 to June 30, 1994. While the unified rate structure is designed to have no impact on the Telephone Companies' aggregate interstate revenues, the Company experienced an interstate rate increase and New York Telephone experienced an offsetting interstate rate decrease. In order to avoid sudden changes in each of the Telephone Company's earnings, the Telephone Companies implemented a transition plan to phase-in the earnings effect of the unified rate structure on each Telephone Company. With unification of interstate rates, the Telephone Companies report one unified interstate rate of return to the FCC, which will be the basis for determining any possible refund obligations due to over-earnings as well as any need to increase interstate rates due to under-earnings under the price cap plan. Previously, each individual Telephone Company's rate of return was used for such purposes. Other Federal Matters On January 27, 1993, NYNEX, together with two other RHCs, requested that the FCC initiate an immediate investigation of the competitive impact on the public interest of the proposed acquisition by AT&T of a 33 percent interest in McCaw Cellular Communications Inc. ("McCaw"), and in particular, on the FCC's policies governing competition in wireless services. The petition urged that the FCC require AT&T and McCaw to disclose fully the terms of their agreement so that the FCC can determine whether control of McCaw is passing to AT&T and whether the proposed transaction is in the public interest. The FCC requested and received comments from interested parties. Subsequently, after AT&T announced its intent to acquire all of McCaw immediately, the FCC commenced a proceeding to examine the proposed transaction. NYNEX and a number of other parties filed petitions in that proceeding on November 1, 1993. NYNEX asked that the FCC impose conditions on any approval of the transaction it might grant, in order to preserve and promote competition in the cellular marketplace. This matter is pending. In September 1992, the FCC adopted rules requiring certain LECs, including the Company, to offer physical collocation to interexchange carriers for the provision of special access services under terms and conditions similiar to the intrastate collocation arrangement already in existence in Massachusetts. The Company filed Special Access Expanded Interconnection tariffs on February 16, 1993. The FCC issued an order on September 2, 1993 requiring certain LECs, including the Company, to file Switched Transport Expanded Interconnection tariffs. The Company filed its tariff on November 18, 1993. Although the FCC rejected requests by the LECs to impose contribution charges, the FCC granted the LECs additional pricing flexibility to be effective after expanded interconnection arrangements become available. In August 1992, the FCC determined that the LECs may provide video dialtone service, a common carrier platform for transporting and switching video programming from programmers to subscribers, and that neither the LEC providing video dialtone nor its programmer-customers require a local cable franchise. The Company filed tariffs for its ONA services with the FCC on November 1, 1991. The Company requested a waiver of the filing requirement for nine enhanced telecommunications services. On January 1, 1992, the FCC issued orders allowing the tariffs to take effect on February 2, 1992, subject to an investigation of the costs and rates, and granting the requested waivers as to seven services. On December 15, 1993, the FCC issued an order requiring certain revisions in the Telephone Company's ONA tariffs. The required revisions became effective March 12, 1994. On December 5, 1993, the Telephone Companies filed a petition with the FCC for a waiver to implement the Universal Service Preservation Plan ("USPP") in order to compete more effectively with alternative providers of local telephone service. The USPP would reduce the Switched Access rate for multiline business users in zones of high traffic density by approximately 40 percent, and would shift most of the revenues lost from this rate reduction to flat, per-line charges applicable to all access lines. Overall annual access revenues for the Telephone Companies would be reduced by $25 million. See also discussion of Federal Regulatory Matters in Part II, Management's Discussion and Analysis of Results of Operations, which is incorporated herein by reference. The outcome of all refund matters, including those described above under "Regulated Services", as well as the time frame within which each will be resolved, is not presently determinable. As of December 31, 1993, the aggregate amount of revenues that was estimated to be subject to possible refund from all regulatory proceedings was approximately $8.2 million, plus related interest. Competition Advances in technology, as well as regulatory and court decisions, have expanded the types of communications products and services available in the market, as well as the number of alternatives to the telecommunications services provided by the Company. Various business alliances and other undertakings were announced in the telecommunications industry in 1993 that indicate an intensifying level of competion. Alternative service providers operate in Boston and are expanding into the greater Boston metropolitan area as well as other markets in the Company's region. Moreover, the Company has tariffs approved by the MDPU to allow these competitors to place their transmission equipment in selected central offices under an arrangement known as collocation. The Company also faces increasing competition in Centrex services, long distance, WATS, billing and collection services, pay telephones and various other services. The ultimate impact of competition on the provision of telecommunications services and equipment will depend, to a considerable degree, on future government policy on telecommunications. The Congress is considering proposals regarding various restrictions imposed on the RHCs, including cable television restrictions and MFJ restrictions (see "Operations Under the Modification of Final Judgment" above). The Company cannot predict whether these proposals will be adopted, or the effect of competition on future revenues, expenses, rates of return, profit or growth. Employee Relations The Company had approximately 22,000 employees at December 31, 1993. Approximately 14,300 employees are represented by unions. Of those so represented, approximately 99% are represented by the International Brotherhood of Electrical Workers ("IBEW") and approximately 1% by the Communications Workers of America ("CWA"), both of which are affiliated with the AFL-CIO. In August 1993, pursuant to labor agreements that expire in August 1995, employees represented by the CWA and IBEW at the Company received wage increases of up to 4.25%. In August 1994, these employees will receive an additional wage increase of up to 4.0%. There may also be a cost-of-living adjustment in August 1994. A tentative agreement has been reached with the CWA on a new contract extending the existing contract to August 1998. The tentative agreement is subject to the completion of local bargaining and ratification by the union membership. Talks began on March 21, 1994 in attempts to reach similar agreements with the locals of the IBEW. Item 2.		Item 2. PROPERTIES The properties of the Company do not lend themselves to simple description by character and location of principal units. At December 31, 1993, the gross book value of telephone plant was $11.6 billion, consisting principally of telephone plant and equipment (91%). Other classifications include: land, land improvements and buildings (7%); furniture and other equipment (1%); and plant under construction and other (1%). Substantially all of the Company's central office equipment is located in buildings owned by the Company situated on land that it owns. Many administrative offices, garages and business offices are in rented quarters. Included in the Company's 1993 restructuring associated with re-engineering the way service is delivered to customers (see "Business Restructuring" above), the Company intends to consolidate work centers by the end of 1996 to build larger work teams in fewer locations. Item 3.	Item 3. LEGAL PROCEEDINGS Contingent Liabilities Agreement The Plan of Reorganization, which was approved by the MFJ Court in August 1983 in connection with the AT&T divestiture, provides for the recognition and payment of liabilities that are attributable to predivestiture events (including transactions to implement divestiture), but that do not become certain until after divestiture. These contingent liabilities relate principally to predivestiture litigation and other claims against AT&T, its affiliates and the LECs with respect to the environment, rates, taxes, contracts and torts (including business torts, such as alleged violations of the antitrust laws). With respect to such liabilities, AT&T and the LECs will share the costs of any judgment or other determination of liability entered by a court or administrative agency against any of them, whether or not a given entity is a party to the proceeding and regardless of whether an entity is dismissed from the proceeding by virtue of settlement or otherwise. Other costs to be shared would include the costs of defending the claim (including attorneys' fees and court costs) and the cost of interest or penalties with respect to any such judgment or determination. With certain exceptions, responsibility for such contingent liabilities will generally be divided among AT&T and the LECs on the basis of their relative net investment as of the effective date of divestiture. Under this general rule of allocation, the Company pays approximately 3.5% of any judgment or determination of liability. Litigation On January 25, 1990, Wegoland Ltd. and Howard Weiner filed an action in the United States District Court for the Southern District of New York on behalf of the telephone ratepayers of the Telephone Companies alleging violations of the Racketeer Influenced and Corrupt Organizations Act and various state laws. A substantially identical case was filed by Donna Roazen on March 12, 1990. The defendants in these cases are NYNEX, certain of its subsidiaries, including the Company, and certain present and former officers of those companies. Plaintiffs allege that the Telephone Companies have been charged inflated prices in transactions with their affiliates and that those prices are unlawfully reflected in the Telephone Companies' regulated rates. On November 13, 1992, the District Court granted defendants' motions to dismiss these actions with prejudice. Plaintiffs' appeal is pending before the United States Court of Appeals for the Second Circuit. While counsel cannot give assurance as to the outcome of any of these matters, in the opinion of Management based upon the advice of counsel, the ultimate resolution of these matters in future periods is not expected to have a material effect on the Company's financial position or annual operating results but could have a material effect on quarterly operating results. On November 15, 1993, NYNEX and the Company filed suit in the United States District Court for the District of Maine seeking an order declaring that section 533(b) of the Cable Communications Policy Act of 1984 is unconstitutional and permanently enjoining the United States from enforcing section 533(b) against NYNEX. Section 533(b) prohibits NYNEX from providing video programming to subscribers in areas where the Telephone Companies provide service. PART II The results for 1993 reflect the effects of pretax charges of $619 million ($376 million after-tax) for business restructuring, primarily related to efforts to redesign operations and incremental costs associated with work force reductions (see Management's Discussion and Analysis of Results of Operations). The results for 1991 reflect the effects of pretax charges of $193 million ($122 million after-tax) for operational restructuring related to force reduction programs. The 1989 results reflect the effects of pretax charges of $130 million ($80 million after-tax) primarily relating to operational restructuring, asset write-downs, a work stoppage, benefit plan changes and other items. + Excludes additions under capital lease obligations and the equity component of allowance for funds used during construction. ++ For the purpose of this ratio: (i) earnings have been calculated by adding Interest expense and the estimated interest portion of rentals to Earnings before Income taxes and cumulative effect of change in accounting principle; and (ii) fixed charges are comprised of Interest expense and the estimated interest portion of rentals. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS The following Management's Narrative Analysis of Results of Operations is provided pursuant to General Instruction J(2) to Form 10-K. Business Restructuring The 1993 results include pretax charges of approximately $619 million ($376 million after-tax) for business restructuring. These charges resulted from a comprehensive analysis of operations and work processes, resulting in a strategy to redesign them to improve efficiency and customer service, to implement work force reductions, and to produce cost savings necessary for New England Telephone and Telegraph Company (the "Company") to operate in an increasingly competitive environment. The charges taken in 1993 were not related to the restructure charges recorded in 1991. Approximately $395 million of the charges ($240 million after-tax) is for severance and postretirement medical costs for employees leaving the Company through 1996; approximately $201 million is for employee severance payments, and $194 million is the medical curtailment loss recognized as a result of the planned decrease in the work force. The Company expects to reduce its work force by approximately 6,300 employees by the end of 1996, consisting of 1,300 management employees and 5,000 employees covered under existing union agreements. A pension enhancement to the NYNEX management pension plan was announced in February 1994 in order to accomplish a portion of the management work force reduction. Any additional costs related to the pension enhancement will be recorded as employees choose to leave under the plan through 1996. Approximately $83 million of the charges ($51 million after-tax) consists of costs associated with re-engineering the way service is delivered to customers, including operating the Company and New York Telephone Company ("New York Telephone") (collectively the "Telephone Companies") as a single enterprise under the "NYNEX" brand. The Telephone Companies will decentralize the provision of residence and business customer service throughout the region, create regional businesses to focus on unique markets, and centralize numerous operations and support functions. Included in this amount are: (1) $13 million of systems re-engineering costs for redesign of systems, processes and procedures to realize operational efficiencies and enable the Company to reduce work force levels; (2) $14 million primarily for consolidation of work centers by the end of 1996, lease terminations, and other incremental costs required to build larger work teams in fewer locations in order to take advantage of lower force levels and system efficiencies; (3) $19 million to develop and market a single "NYNEX" brand identity associated with the restructured business operations; (4) $15 million for employee relocations as a result of work center consolidations; (5) $21 million for training employees on newly-designed, cross-functional job positions and re-engineered systems; and (6) $1 million in incremental costs to implement the various re-engineering initiatives. Approximately $141 million of restructuring charges ($86 million after-tax) was allocated to the Company from Telesector Resources Group, Inc. ("Telesector Resources"), primarily related to its force reduction and re-engineering programs; approximately $27 million is for severance payments, $19 million is the medical curtailment loss recognized as a result of the planned decrease in its work force, and $95 million consists of Telesector Resources' costs associated with re-engineering the way service is delivered to customers. Collective Bargaining Agreements In October 1991, the Communications Workers of America and the International Brotherhood of Electrical Workers ratified agreements with the Company to extend until August 5, 1995 the collective bargaining agreements that were to have expired on August 8, 1992. State Regulatory Matters Massachusetts In June 1990, the Massachusetts Department of Public Utilities ("MDPU") issued an order in Phase III of a proceeding that culminated a five-year investigation into the Company's rates, costs and revenues. The order calls for the gradual restructuring of local and long distance rates within the state, with the objective of moving prices for services closer to the costs of providing them. This is accomplished through an annual transitional filing of new rates by the Company. At the time the rates are established, revenue neutrality is maintained. The Company's first and second transitional filings became effective on November 15, 1991 and January 15, 1993, respectively (see Operating Revenues below). On January 13, 1994, the MDPU approved the third transitional filing with minor modifications to become effective April 14, 1994. Rhode Island In August 1992, the Rhode Island Public Utilities Commission approved a Price Regulation Trial ("PRT") that provides the Company with significantly increased pricing and earnings freedom through 1995 and calls for specific investment and service-quality commitments by the Company. As a part of the PRT, the Company makes an annual filing, with overall price increases capped by a formula indexing Rhode Island prices to the Gross National Product Price Index, adjusted for productivity and exogenous factors. The PRT allows the Company to continue moving the prices of its services closer to the costs of providing them. The Company's most recent annual filing became effective January 15, 1994. The filing calls for an overall revenue reduction of approximately $3.2 million for 1994, resulting from decreases in long distance revenues partially offset by increases in local service revenues. Federal Regulatory Matters Effective January 1, 1991, the Federal Communications Commission ("FCC") adopted incentive regulation in the form of price caps with respect to interstate services provided by the Company. Price caps focus on local exchange carriers' ("LECs") prices rather than costs and set maximum limits on prices LECs can charge for their services. These limits are subject to adjustment each year to reflect inflation, a productivity factor and certain other cost changes. Under FCC price cap regulation, the Company may earn a return on equity up to approximately 15%. Above that level, earnings are subject to equal sharing with ratepayers until they reach an effective cap on interstate return on equity of approximately 18.7%. In 1992, the Company and New York Telephone implemented a three-step transition plan to unify their interstate access rates, with tariffs that became effective in January, July and November 1992. These tariffs, including the effect of the Company's annual price cap tariff filings, resulted in a decrease in the Company's interstate access revenues of approximately $4 million during the tariff period ending June 30, 1992, an increase of approximately $88 million during the tariff period ending July 1, 1993 and will result in a decrease of approximately $25 million during the tariff period ending June 30, 1994. As a result of these filings, a net increase in access revenues of $33 million was recorded in 1993. The Telephone Companies implemented a phase-in payment plan in order to avoid sudden changes in each of the Telephone Company's earnings resulting from the unified rate structure. A substantial portion of the increase in the Company's access revenues during those tariff periods was offset by the payment plan, which provided for transition payments to New York Telephone in the amounts of $18 million in 1992 and $55 million in 1993 (see Other Income (Expense) - - Net). In September 1992, the FCC adopted rules requiring certain LECs, including the Company, to offer physical collocation to interexchange carriers for the provision of special access services under terms and conditions similar to the intrastate collocation arrangement already in existence in Massachusetts. The Company filed Special Access Expanded Interconnection tariffs on February 16, 1993. The FCC issued an order on September 2, 1993, requiring certain LECs, including the Company, to file Switched Transport Expanded Interconnection tariffs. The Company filed its tariff on November 18, 1993. Although the FCC rejected requests by the LECs to impose contribution charges, the FCC granted the LECs additional pricing flexibility to be effective after expanded interconnection arrangements become available. Local service revenues are earned from the provision of local exchange, local private line and local public network services. Local service revenues increased $90.4 million due principally to net increases of approximately $52 million in local service rates resulting from the implementation of the second transitional filing of a restructuring of Massachusetts rates on January 15, 1993 (see State Regulatory Matters above) and increased customer demand evidenced by growth in access lines. Long distance revenues are earned from the provision of services beyond the local service area, but within the local access and transport area ("LATA"), and include public and private network switching. Long distance revenues decreased $25.0 million due principally to decreases of approximately $51 million in long distance rates resulting from the second transitional filing of a restructuring of Massachusetts rates on January 15, 1993 (see State Regulatory Matters above) and decreases in long distance private line revenues and wide area telecommunications service revenues due primarily to increased competition and customer shifts to lower priced services offered by the Company. These decreases were partially offset by increased toll usage. Network access revenues, which are earned from the provision of exchange access services primarily to interexchange carriers, increased $71.1 million due principally to an increase in switched access revenues. Switched access revenues increased approximately $83 million due primarily to a $49 million increase resulting from increased network demand and a net increase of $31 million resulting primarily from interstate rate changes. Special access revenues decreased approximately $12 million due primarily to a $9 million decrease resulting from decreased demand and a net $4 million decrease resulting from interstate rate reductions. (See Federal Regulatory Matters above.) Other revenues are earned from the provision of products and services other than Local service, Long distance and Network access. Other revenues increased $11.8 million due principally to an increase in rent revenues from Telesector Resources for space in training centers owned and leased by the Company (see Operating Expenses below). Business restructuring charges recorded in the fourth quarter of 1993 consisted of incremental costs associated with work force reductions, re-engineering, and costs related to consolidation of work locations (see Business Restructuring above). Employee related costs, which consist primarily of wages, payroll taxes and employee benefits, increased $72.2 million. The increase was principally due to a $40 million increase in wages and payroll taxes, due principally to increases in salaries and wage rates, including a 4.25% wage increase for nonmanagement employees pursuant to the 1991 collective bargaining agreements, and to additional labor costs in 1993 primarily attributable to severe winter weather and marketing initiatives. In addition, there was a $32 million increase in employee benefit costs for active and retired employees due primarily to increased medical costs and a $10 million accrual for a supplemental executive retirement plan. These increases were partially offset by decreases in the Company's work force of 541 management employees due to force reduction plans in 1992 and transfers of approximately 250 management employees to Telesector Resources in 1993 (see Other operating expenses below). Other operating expenses, which consist primarily of contracted and centralized services, rent and other general and administrative costs, increased $45.8 million. The increase was principally due to: a $42 million increase in charges from affiliated companies primarily attributable to the transfer of the training functions previously performed by the Company to Telesector Resources (see Operating Revenues and Employee related costs above); an $8 million increase resulting from increased maintenance, repairs and utilities costs; a $6 million increase in advertising and sales commission expenses due to increased promotion of new products; and a $5 million increase due to the Company's contractual share of a predivestiture American Telephone and Telegraph Company ("AT&T") liability. These increases were partially offset by a $17 million decrease in right-to-use fees resulting from a decrease in software purchases and a $13 million decrease resulting from capitalization in 1993 of certain 1993 and 1992 engineering charges. Taxes other than income taxes, which include gross receipts taxes, property taxes and other non-income based taxes, increased $21.7 million principally due to a $19 million increase in property taxes primarily attributable to increased tax rates and municipal assessments. Depreciation and amortization increased $4.8 million due principally to: a $26 million increase associated with increased plant investment; a $25 million increase due to represcribed interstate depreciation rates; and a $41 million increase due to revised intrastate depreciation rates in Massachusetts, Rhode Island and New Hampshire. These increases were partially offset by: a $62 million decrease due primarily to completion in 1992 of intrastate amortization of electro-mechanical switching equipment in Massachusetts; a $4 million decrease due to recognition in 1992 of expenses that were previously deferred in accordance with a prior regulatory agreement in New Hampshire; a $6 million decrease due to completion in 1992 of interstate amortization of the reserve deficiency; an $11 million decrease in the amortization of the reserve deficiency for analog electronic switching systems offices in Rhode Island; and a $3 million decrease due to the completion in 1992 of amortization of customer premises wiring. Other Income (Expense) - Net Other income (expense) - net decreased $59.5 million from the same period last year principally due to $37 million resulting from higher payments made during 1993 to New York Telephone pursuant to the transition plan to phase-in the earnings impact of the unified tariff access rate structure (see Federal Regulatory Matters above), and $20 million for the interstate portion of call premiums and other charges associated with the refinancing of long-term debt in 1993. Interest Expense Interest expense decreased $14.7 million from the same period last year primarily due to a decrease in average interest rates resulting from long-term debt refinancings in 1993 and a decrease in the average level of external debt. Income Taxes Income taxes decreased $280.0 million from the same period last year principally due to lower pretax income. The decrease includes $23 million from a one-time benefit representing adjustments of prior year estimates of depreciation on capitalized overheads and of the reversal of excess deferred taxes, using the average rate assumption method, which had been deferred at a rate higher than the current statutory rate. These decreases were partially offset by the enactment of the Revenue Reconciliation Act of 1993, which increased the statutory corporate federal income tax rate from 34 percent to 35 percent, retroactive to January 1, 1993. Adoption of Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" The Company adopted Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" ("Statement No. 112"), in the fourth quarter of 1993, retroactive to January 1, 1993. Statement No. 112 applies to postemployment benefits, including workers' compensation, disability plans and disability pensions, provided to former or inactive employees, their beneficiaries, and covered dependents after employment but before retirement. Statement No. 112 changed the Company's method of accounting from recognizing costs as benefits are paid to accruing the expected costs of providing these benefits. The initial effect of adopting Statement No. 112 was reported as a cumulative effect of a change in accounting principle and resulted in a one-time, non-cash charge of $39.1 million ($25.0 million after-tax). In subsequent years, the effect of Statement No. 112 is not expected to result in periodic expense materially different from the expense recognized under the prior method. The rate recovery of these costs in the intrastate jurisdictions has not been determined. Financing In 1993, the Company took advantage of favorable interest rates and refinanced a substantial amount of long-term debt. During 1993, the Company issued $425 million of Notes and $250 million of Debentures and used $666 million of the proceeds from these issuances and short-term borrowings from NYNEX to redeem $895 million of Debentures. On October 15, 1993, the Company filed a registration statement with the Securities and Exchange Commission ("SEC") for the issuance of up to $450 million in unsecured debt securities, which became effective on October 22, 1993. The Company has $500 million of unissued, unsecured debt securities registered with the SEC. ITEM 8. FINANCIAL STATEMENTS Report of Management Management of New England Telephone and Telegraph Company (the "Company") has the responsibility for preparing the accompanying financial statements and for their integrity and objectivity. The financial statements were prepared in accordance with generally accepted accounting principles and, in management's opinion, are fairly presented. The financial statements include amounts that are based on management's best estimates and judgments. Management also prepared the other information in this report and is responsible for its accuracy and consistency with the financial statements. The financial statements have been audited by Coopers & Lybrand, independent accountants, whose appointment was approved by the Company's Board of Directors. Management has made available to Coopers & Lybrand all of the Company's financial records and related data, as well as the minutes of share owner's and directors' meetings. Furthermore, management believes that all representations made to Coopers & Lybrand during its audit were valid and appropriate. Management of the Company has established and maintains an internal control structure that is designed to provide reasonable assurance as to the integrity and reliability of the financial statements, the protection of assets from unauthorized use or disposition, and the prevention and detection of fraudulent financial reporting. The concept of reasonable assurance recognizes that the cost of the internal control structure should not exceed the benefits to be derived. The internal control structure provides for appropriate division of responsibility and is documented by written policies and procedures that are communicated to employees with significant roles in the financial reporting process. Management monitors the internal control structure for compliance, considers recommendations for improvement from both the internal auditors and Coopers & Lybrand and updates such policies and procedures as necessary. Monitoring includes an internal auditing function to independently assess the effectiveness of the internal controls and recommend possible improvements thereto. Management believes that the internal control structure of the Company is adequate to accomplish the objectives discussed herein. The Audit Committee of the Board of Directors, which is comprised of directors who are not employees, meets periodically with management, the internal auditors and Coopers & Lybrand to review the manner in which they are performing their responsibilities and to discuss matters relating to auditing, internal controls and financial reporting. Both the internal auditors and Coopers & Lybrand periodically meet privately with the Audit Committee and have access to the Audit Committee at any time. Management also recognizes its responsibility for conducting Company activities under the highest standards of personal and corporate conduct. This responsibility is accomplished by fostering a strong ethical climate as characterized in the NYNEX Code of Business Conduct, which is publicized throughout the Company. The Code of Conduct addresses, among other things, standards of personal conduct, potential conflicts of interest, compliance with all domestic and foreign laws, accountability for Company property and the confidentiality of proprietary information. Donald B. Reed President and Chief Executive Officer Gail Deegan Vice President and Chief Financial Officer REPORT OF INDEPENDENT ACCOUNTANTS To the Share Owner and Board of Directors of New England Telephone and Telegraph Company: We have audited the financial statements and financial statement schedules of New England Telephone and Telegraph Company listed in Item 14(a) (1) and (2) of this Form 10-K. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of New England Telephone and Telegraph Company as of December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. As discussed in Notes A and D to the financial statements, the Company changed its methods of accounting for income taxes, postretirement benefits other than pensions, and postemployment benefits in 1993. Coopers & Lybrand Boston, Massachusetts February 9, 1994 NOTES TO FINANCIAL STATEMENTS (A) Accounting Policies Basis of Presentation New England Telephone and Telegraph Company (the "Company") is a wholly-owned subsidiary of NYNEX Corporation ("NYNEX") and primarily provides exchange telecommunications and exchange access services. The financial statements for 1992 and 1991 have been reclassified to conform to the current year's format. The financial statements have been prepared in conformity with generally accepted accounting principles applicable to regulated entities. Such accounting principles are consistent in all material respects with accounting rules prescribed by the Federal Communications Commission ("FCC"), except for certain intrastate items accorded a different accounting treatment by state regulatory commissions. The Company has a 33 1/3% ownership interest in Telesector Resources Group, Inc. ("Telesector Resources") and shares voting rights equally with the other owner, New York Telephone Company ("New York Telephone"). The Company uses the equity method of accounting for its investment in Telesector Resources. Cash The Company's cash management policy is to make funds available in banks when checks are presented. At December 31, 1993 and 1992, the Company had recorded in Accounts payable checks outstanding but not yet presented for payment of $49.7 and $100.5 million, respectively. Inventory Inventory, consisting of materials and supplies, is carried principally at average cost. Telephone Plant Telephone plant is stated at its original cost. When depreciable plant is disposed of, the carrying amount, salvage, and the cost to remove such plant are charged to accumulated depreciation. Depreciation rates are prescribed by the FCC for interstate operations and by the respective state commissions for intrastate operations. All rates are calculated on a straight-line basis using the concept of "remaining life." In 1993, revised interstate depreciation rates were approved by the FCC. Revised intrastate depreciation rates were effective November 1, 1992 for Rhode Island, January 1, 1993 for New Hampshire and July 1, 1993 for Massachusetts. The application of the interstate and intrastate rates resulted in average effective composite rates of 7.3%, 7.4% and 7.2% for 1993, 1992 and 1991, respectively. Regulatory authorities in Maine, Massachusetts, New Hampshire and Rhode Island allow the Company to capitalize interest, including an allowance on share owner's equity, as a cost of constructing certain telephone plant and as income, included in Other income (expense) - net. Such income will be realized over the service life of the plant as the resulting higher depreciation expense is recovered through the rate-making process. In Vermont, telephone plant under construction is included in the rate base, thereby eliminating the need for any interest accrual mechanism. The FCC requires the same method as Vermont for short-term telephone plant under construction, while long-term plant under construction accrues interest under FCC procedures. Refinancing Charges The Company defers the intrastate portion of call premiums and other charges associated with the redemption of long-term debt and expenses the interstate portion of these charges, as required by the state commissions and the FCC, respectively. The deferred amounts are amortized over periods stipulated by the state commissions. Prior to January 1, 1988, these charges were deferred and amortized for both intrastate and interstate purposes. The deferred amounts included in the accompanying balance sheets are $78.0 and $14.7 million at December 31, 1993 and 1992, respectively. Income Taxes NYNEX and its subsidiaries, including the Company, file a consolidated Federal income tax return. The Company's provision for federal income taxes currently payable is allocated in accordance with its contribution to the consolidated group's taxable income and tax credits. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("Statement No. 109"), which superseded Statement of Financial Accounting Standards No. 96, "Accounting for Income Taxes." The effect of implementing Statement No. 109 on the Company's financial position and results of operations was not significant. Statement No. 109 requires that deferred tax assets and liabilities be measured based on the enacted tax rates that will be in effect in the years in which temporary differences are expected to reverse. However, for the Company, the treatment of excess deferred taxes resulting from the reduction of federal tax rates prior to 1993 is subject to federal income tax and regulatory rules. Deferred income tax provisions of the Company are based on amounts recognized for rate-making purposes. The Company recognizes a deferred tax liability and establishes a corresponding regulatory asset for tax benefits on temporary differences previously flowed through to ratepayers. The major temporary difference that gave rise to the net deferred tax liability is depreciation, which for income tax purposes is determined based on accelerated methods and shorter lives. Statement of Financial Accounting Standards No. 71, "Accounting for the Effects of Certain Types of Regulation", requires the Company to reflect the additional deferred income taxes as regulatory assets to the extent that they will be recovered in the rate-making process. In accordance with the normalization provisions under federal tax law, the Company reverses excess deferred taxes relating to depreciation of regulated assets over the regulatory lives of those assets. For other excess deferred taxes, the regulatory agencies generally allow amortization of excess deferred taxes over the reversal period of the temporary difference giving rise to the deferred taxes. On August 10, 1993, the Revenue Reconciliation Act of 1993 was signed into law, and the statutory corporate federal income tax rate increased to 35% from 34%, retroactive to January 1, 1993. In accordance with Statement No. 109, the Company adjusted its current and deferred income tax balances to reflect the tax rate change. The Company reflected the additional deferred income taxes arising from the tax rate increase primarily as increases to the regulatory asset and decreases to the regulatory liability. The Tax Reform Act of 1986 repealed the investment tax credit ("ITC"), effective January 1, 1986. As required by tax law, ITC for the Company was deferred and is amortized as a reduction to tax expense over the estimated service lives of the related assets giving rise to the credits. (B) Receivables - Affiliates At December 31, 1992, the Company had advances to NYNEX of $82.0 million included in Receivables-Affiliates which was principally due to the investment by NYNEX of a portion of the proceeds from the long-term debt issued by the Company on December 9, 1992. On January 19, 1993, these proceeds were used for the redemption of $175 million of the Company's Thirty-Nine Year 8 5/8% Debentures, due September 1, 2009 (see Note (G)). * Does not include the deferred tax benefit of $14.1 million associated with the Cumulative effect of change in accounting for postemployment benefits. In 1993, the total tax benefit includes $23.1 million representing a one-time benefit from adjustments of prior year estimates of depreciation on capitalized overheads and of the reversal of excess deferred taxes. The total deferred tax benefit includes $187.7 million due to the Company's restructuring. Additional 1993 decreases resulted from the adoption of a new accounting standard related to postretirement benefits (see Note D). The increase in 1992 deferred tax expense was due principally to the partial reversal of temporary differences associated with the Company's 1991 restructuring. Temporary differences for which deferred income taxes have not been provided by the Company are represented principally by "c" above. Only taxes currently payable on these temporary differences are recognized in the rate-making process. At December 31, 1993 and 1992 the Company recorded approximately $223.4 and $223.7 million, respectively, in deferred taxes primarily representing the cumulative amount of income taxes on temporary differences that were previously flowed through to ratepayers. The Company recorded a corresponding regulatory asset in deferred charges for these items, representing amounts that will be recovered through the rate-making process. These deferrals have been increased for the tax effect of future revenue requirements and will be amortized over the lives of the related depreciable assets concurrently with their recovery in rates. The Company recorded a regulatory liability at December 31, 1993 and 1992 of approximately $246.3 and $354.8 million, respectively, primarily representing previously recorded excess deferred federal income taxes resulting from the reduction of the statutory federal income tax rate and unamortized ITC, which is recorded in Other long-term liabilities and deferred credits and Accounts payable - Trade and other (see Note A). These liabilities have been increased for the tax effect of future revenue requirements. (D) Employee Benefits Pensions Substantially all of the Company's employees are covered by one of two NYNEX noncontributory defined benefit pension plans (the "Plans"). Benefits for management employees are based on a modified career average pay plan, while benefits for nonmanagement employees are based on a nonpay-related plan. Contributions are made, to the extent deductible under the provisions of the Internal Revenue Code, to an irrevocable trust for the sole benefit of pension plan participants. Total Company pension (benefit)/cost for 1993, 1992 and 1991 was $(51.0), $2.2 and $(3.9) million, respectively, of which $1.5 and $(2.7) million were deferred in 1992 and 1991, respectively, as a result of state regulatory decisions that required pension expense to be equivalent to amounts contributed to the Plans. Deferral of pension cost was discontinued in 1993, and the Company has implemented a plan to recover deferred pension costs through the rate-making process (see Postretirement Benefits Other Than Pensions below). At December 31, 1993 and 1992, the Company had recorded $276.7 and $327.6 million, respectively, in Other long-term liabilities and deferred credits representing the Company's pension liability. The assumptions used to determine the projected benefit obligation at December 31, 1993 and 1992 include a discount rate of 7.5% and 8.5%, respectively, and an increase in future compensation levels of 4.5% in both years for management employees and 4.0% in both years for nonmanagement employees. The expected long-term rate of return on pension plan assets used to calculate pension expense was 8.9% in 1993 and 1992 and 8.5% in 1991. Periodically, the Plans have been amended to increase the level of plan benefits. The actuarial projections included herein anticipate plan improvements in the future. In 1992 and 1993, management employees who left the Company under the Force Management Plan could elect to receive their pension benefit in a lump sum distribution, or as a monthly annuity beginning when they left the Company. The 1992 reduction in the number of management employees and the lump sum option were accounted for as a curtailment and a settlement, respectively, and reduced pension costs by $13.0 million in 1992, of which $3.8 million was recognized as a reduction to expense and $9.2 million was deferred. There was no reduction in the number of management employees under the Force Management Plan in 1993. In October 1991, NYNEX amended its nonmanagement pension plan to provide an early retirement incentive, which increased the projected benefit obligation by $113.4 million, of which $34.2 million was expensed and $79.2 million was deferred. The expense associated with the nonmanagement early retirement incentive was included in the charges for force reduction programs in the fourth quarter of 1991. Postretirement Benefits Other Than Pensions The Company provides certain health care and life insurance benefits for retired employees and their families. Substantially all of the Company's employees may become eligible for these benefits if they reach pension eligibility while working for the Company. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("Statement No. 106"). Statement No. 106 changed the practice of accounting for postretirement benefits from recognizing costs as benefits are paid to accruing the expected cost of providing these benefits during an employee's working life. The Company is recognizing the transition obligation for retired employees and the earned portion for active employees over a 20-year period. The cost of health care benefits and group life insurance was determined using the unit credit cost actuarial method. The net postretirement benefit cost for 1993 for the Company was $143.0 million. As a result of planned work force reductions, the Company recorded an additional $193.9 million of postretirement benefit cost in 1993 accounted for as a curtailment. Total costs of providing benefits for retired employees and their families were $63.7 and $50.8 million in 1992 and 1991, respectively. The Company participates in the NYNEX benefit plans, and the structure of the plans is such that certain disclosures required by Statement No. 106 cannot be presented for the Company on an individual basis. A comparison of the actuarial present value of the accumulated postretirement benefit obligation with the fair value of plan assets, the components of the net postretirement benefit cost, and the reconciliation of the funded status of the plans with the amount recorded on the balance sheet are provided on a consolidated basis in the Proxy Statement and Consolidated Financial Statements for the year ended December 31, 1993 filed by NYNEX. The actuarial assumptions used to determine the 1993 obligation for postretirement benefit plans under Statement No. 106 include the following: discount rate of 7.5%; weighted average expected long-term rate of return on plan assets of 8.4%; weighted average salary growth rate of 4.2%; medical cost trend rate of 14.3% grading down to 4.5% in 2008; and dental cost trend rate of 5.0% grading down to 3.0% in 2002. With respect to interstate treatment, the FCC released an order in January 1993 stating that costs recognized under Statement No. 106 are not exogenous costs and, therefore, did not warrant an upward rate adjustment under price caps at that time. In the April 2, 1993 filing of interstate access tariffs under the FCC's price cap rules, the Company and New York Telephone (collectively, the "Telephone Companies") sought an exogenous cost increase of $12 million to reflect the transition obligation for current retirees under Statement No. 106. On June 23, 1993, the FCC's Common Carrier Bureau (the "Bureau") issued an order allowing the proposed rates to go into effect July 2, 1993, subject to an investigation and an accounting order. In its order, the Bureau designated several issues for investigation, including the accounting treatment of postretirement health care costs. Commencing July 2, 1993, the Company began collecting these revenues, subject to possible refund pending resolution of the Bureau's investigation. With respect to intrastate treatment, the Company implemented an accounting plan as previously discussed with the regulatory commissions in each of the states in which it operates for regulatory accounting and rate-making treatment. The plan provided for: (1) immediate adoption of both Statement No. 106 and Statement of Financial Accounting Standards No. 87, "Employers' Accounting for Pensions" ("Statement No. 87") on a revenue requirement neutral basis, (2) amortization of existing deferred pension costs within a ten-year period and (3) discontinuance of additional deferrals of Statement No. 106 and Statement No. 87 costs. Approval of the plan is still pending in the State of Rhode Island. In 1991, NYNEX established two separate Voluntary Employees' Beneficiary Association Trusts ("VEBA Trusts"), one for management and the other for nonmanagement, to begin prefunding postretirement health care benefits. The assets in the VEBA Trusts consist primarily of equity securities and fixed income securities. In 1991 and 1992, NYNEX transferred a portion of excess pensions assets, totalling $486 million, to health care benefit accounts, within the pension plans and then contributed those assets to to the VEBA Trusts. Additional contributions to the VEBA Trusts are evaluated and determined by NYNEX management. Postemployment Benefits The Company adopted Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" ("Statement No. 112") in the fourth quarter of 1993, retroactive to January 1, 1993. Statement No. 112 applies to postemployment benefits, including workers' compensation, disability plans and disability pensions, provided to former or inactive employees, their beneficiaries, and covered dependents after employment but before retirement. Statement No. 112 changed the Company's method of accounting from recognizing costs as benefits are paid to accruing the expected costs of providing these benefits. The initial effect of adopting Statement No. 112 was reported as a cumulative effect of a change in accounting principle and resulted in a one-time, non-cash charge of $39.1 million ($25.0 million after-tax). In subsequent years, the effect of Statement No. 112 is not expected to result in periodic expense materially different from the expense recognized under the prior method. The rate recovery of these costs in the intrastate jurisdictions has not been determined. In 1997 and 1998, $175 and $100 million, respectively, of the Notes will mature. The Company's Debentures, except for its Forty Year 7 7/8% Debentures, due November 15, 2029, and its Forty Year 9% Debentures, due August 1, 2031, are callable five years after the issue date, upon thirty days' notice, at the option of the Company. The Company's Forty Year 7 7/8% Debentures, due November 15, 2029, are repayable on November 15, 1996, in whole or in part, at the option of the holder, and its Forty Year 9% Debentures, due August 1, 2031, are callable ten years after issue date upon thirty days' notice by the Company. At December 3l, l993, the Company had $500.0 million of unissued, unsecured debt securities registered with the Securities and Exchange Commission. On December 9, 1992, the Company issued $175 million of its Five Year 6 1/4% Notes, due December 15, 1997. On January 19, 1993, the net proceeds of this issue were used for the redemption of the Company's Thirty-Nine Year 8 5/8% Debentures, due September 1, 2009, outstanding in the principal amount of $175 million, and classified as Short-term debt at December 31, 1992. Interest expense on advances from NYNEX was $4.2, $0.9 and $11.5 million in 1993, 1992 and 1991, respectively. (I) Transactions with American Telephone and Telegraph Company In 1993, 1992 and 1991, American Telephone and Telegraph Company ("AT&T") provided approximately 15%, 15% and 14%, respectively, of the Company's total operating revenues, primarily Network access revenues and Other revenues from billing and collection services performed under contract by the Company for AT&T. In connection with such services, the Company purchases the related receivables with recourse, up to a contractual limit. (J) Transactions with Affiliates The Company receives corporate governance and ownership services such as securities administration, investor relations, certain tax support and human resources planning services from NYNEX. For 1993, 1992 and 1991, the Company recorded charges of $51.9, $48.5 and $63.2 million, respectively, in connection with these services. Telesector Resources performs data processing and related services and materials management services on a centralized basis on behalf of the Telephone Companies. In 1993, 1992 and 1991, the Company recorded charges from Telesector Resources of $670.3, $590.3 and $619.9 million, respectively, for data processing services and materials related charges, including both materials management services (such as procurement support, warehousing and transportation costs) and the Company's purchase of materials (including items charged to plant accounts). The total materials related charges to the Company in 1993, 1992 and 1991 were approximately $255.4, $240.3 and $221.1 million, respectively. In addition, in 1993, approximately $140.8 million of restructuring charges ($85.5 million after-tax) was allocated to the Company from Telesector Resources, primarily related to its force reduction and re-engineering programs. Effective in July 1991, arrangements were made for Telesector Resources to act as a purchasing agent for the Company for directly shipped materials and supplies. During 1993, 1992 and 1991, total agency purchases by Telesector Resources amounted to $123.6, $120.6 and $32.4 million, respectively. Telesector Resources owns a one-seventh interest in Bell Communications Research, Inc. ("Bellcore"). Bellcore furnishes technical and support services relating to exchange telecommunications and exchange access services, a portion of which is research and development. For 1993, 1992 and 1991, the Company recorded charges of $42.1, $42.7 and $41.8 million, respectively, for services provided by Bellcore. In 1992, the FCC permitted the Telephone Companies to unify their interstate access rates. As a result of the unified rate structure, the Company experienced an interstate rate increase and New York Telephone experienced an offsetting interstate rate decrease. The Telephone Companies implemented a phase-in payment plan in order to avoid sudden changes in each of the Telephone Company's earnings resulting from the unified rate structure. In 1993 and 1992, the Company made transition payments of $55 million and $18 million, respectively, to New York Telephone. The Company has an agreement with NYNEX Information Resources Company ("Information Resources") pursuant to which Information Resources pays a fee to the Company for the use of the Company's name in soliciting directory advertising and in publishing and distributing directories. For the years ended December 31, 1993, 1992 and 1991, licensing fees, included in Other revenues, amounted to $156.7, $159.0 and $165.5 million, respectively. (M) Revenues Subject to Possible Refund Several state and federal regulatory matters may possibly require the refund of a portion of the revenues collected in the current and prior periods. As of December 31, 1993, the aggregate amount of such revenues that was estimated to be subject to possible refund was approximately $8.2 million, plus related interest. The outcome of each pending matter, as well as the time frame within which each will be resolved, is not presently determinable. (N) Litigation and Other Contingencies Various other legal actions and regulatory proceedings are pending that may affect the Company, including matters involving Racketeer Influenced and Corrupt Organizations Act, antitrust, tort, contract and tax deficiency claims. While counsel cannot give assurance as to the outcome of any of these matters, in the opinion of management based upon the advice of counsel, the ultimate resolution of these matters in future periods is not expected to have a material effect on the Company's financial position or annual operating results but could have a material effect on quarterly operating results. (O) Business Restructuring In the fourth quarter of 1993, approximately $619 million of pretax business restructuring charges was recorded, primarily related to efforts to redesign operations and work force reductions. These charges included: $395 million for severance and postretirement medical costs for employees leaving the Company through 1996; $83 million for re-engineering service delivery; and $141 million of restructuring charges allocated to the Company from Telesector Resources. The restructuring charges were included in the Income Statements as follows: Maintenance and support - $78 million; Marketing and customer services - $77 million; and Other expense - $464 million. In the fourth quarter of 1991, approximately $193 million of pretax organizational restructuring charges was recorded related to force reduction programs. The restructuring charges were included in the Income Statements as follows: Other revenues - $4 million; Maintenance and support - $94 million; Marketing and customer services - $19 million; Other expense - $75 million; and Other income (expense)-net - $1 million. Results for the first quarter of 1993 include the adoption of Statement No. 112 (see Note (D) "Employee Benefits" for further discussion). Results for the third quarter of 1993 reflect the effect of the increase in the statutory corporate federal income tax rate (see Note (A) "Accounting Policies - Income Taxes" for further discussion). Results for the fourth quarter of 1993 reflect the effects of $619 million of pretax charges for business restructuring, including re-engineering operations and force reductions, which were recorded in operating expenses. The after-tax effect of these charges was a reduction in net income of approximately $376 million. (See the section entitled "Business Restructuring" included in Management's Discussion and Analysis of Results of Operations for further discussion of these charges.) ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. During 1993 and 1992, the Company did not change its auditors, and there was no disagreement on any matter of accounting principles or practices or financial statement disclosure that would have required the filing of a Current Report on Form 8-K. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) Documents filed as part of this Annual Report on Form 10-K. Pages in This Annual Report On Form 10-K (1) Financial Statements filed as part of this report are listed in the Table of Contents on page 2 and contained in Item 8 herein. (2) Financial Statement Schedules. The following financial statement schedules of the Registrant are included herein in response to Item 14: V - Telephone Plant............................ 49-52 VI - Accumulated Depreciation, Depletion, and Amortization of Telephone Plant............ 53 VIII - Valuation and Qualifying Accounts.......... 54 Financial statement schedules other than those listed above have been omitted because the required information is contained in the financial statements and notes thereto or because such schedules are not required or applicable. (3) Exhibits. Exhibits identified in parentheses below, on file with the Securities and Exchange Commission ("SEC"), are incorporated herein by reference as exhibits hereto. Exhibit Number (3)a Restated Certificate of Incorporation of the Company dated August 19, 1988 (Exhibit No. (19)ii to the Registrant's filing on Form SE dated May 2, 1989, File No. 1-1150). (3)b By-Laws of the Company as amended April 18, 1989 (Exhibit No. (3)b to the Registrant's filing on Form SE, dated May 2, 1989, File No. 1-1150). (4) No instrument which defines the rights of holders of long-term debt of the Company is filed herewith pursuant to Regulation S-K, Item 601(b)(4)(iii)(A). Pursuant to this regulation, the Company hereby agrees to furnish a copy of any such instrument to the SEC upon request. (10)(i)1 Reorganization and Divestiture Agreement among American Telephone and Telegraph Company, NYNEX Corporation and Affiliates dated as of November 1, 1983 (Exhibit No. (10)(i)1 to Form 10-K of NYNEX Corporation for 1983, File No. 1-8608). (10)(i)2 Shared Network Facilities Agreement among American Telephone and Telegraph Company, AT&T Communications of New England, Inc. and New England Telephone and Telegraph Company dated as of November 1, 1983 (Exhibit No. (10)(i)21 to Form 10-K of NYNEX Corporation for 1983, File No. 1-8608). (10)(i)3 Agreement Concerning Contingent Liabilities, Tax Matters and Termination of Certain Agreements among American Telephone and Telegraph Company, Bell System Operating Companies, Regional Holding Companies and Affiliates dated as of November 1, 1983 (Exhibit No. (10)(i)8 to Form 10-K of NYNEX Corporation for 1983, File No. 1-8608). (10)(i)4 Post-Divestiture Shared Services Force Transfer Agreement between American Telephone and Telegraph Company and New England Telephone and Telegraph Company dated as of January 1, 1984 (Exhibit No. (10)(i)39 to Form 10-K of NYNEX Corporation for 1983, File No. 1-8608). (10)(i)5 Agreement Concerning the Sharing of Contingent Liabilities dated as of January 28, 1985 (Exhibit No. (19)(i)1 to Form 10-K of NYNEX Corporation for 1984, File No. 1-8608). (10)(ii)(B)1 Directory License Agreement between New England Telephone and Telegraph Company and NYNEX Information Resources Company dated as of January 1, 1991 (Exhibit No. (10)(ii)(B)4 to the Registrant's filing on Form SE, dated March 26, 1991, File No. 1-1150). 10)(ii)(B)2 Service Agreement concerning provision by Telesector Resources Group, Inc. to New England Telephone and Telegraph Company of numerous services, including (i) purchasing, materials handling, inspection, distribution, storage and similar services and (ii) technical, regulatory, government relations, marketing operational support and similar services, dated March 31, 1992 (Exhibit No. (19)(i)1 to the Registrant's filing on Form SE, dated March 23, 1993, File No. 1-1150. (12) Computation of Ratio of Earnings to Fixed Charges. (23) Consent of Independent Accountants. (24) Powers of attorney. (b) Reports on Form 8-K. The Company's Current Report on Form 8-K, date of report November 15, 1993 and filed November 19, 1993, reporting on Item 5.		Item 5. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. New England Telephone and Telegraph Company By Gail Deegan Gail Deegan, Vice President and Chief Financial Officer March 25, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. Principal Executive Officer: Donald B. Reed* President and Chief Executive Officer Principal Financial and Accounting Officer: Gail Deegan Vice President and Chief Financial Officer A Majority of Directors: Kenneth M. Curtis* Gerhard M. Freche* Thomas F. Gilbane, Jr.* L. F. Hackett* Ronald A. Homer* Anna Faith Jones* Jane E. Newman* By Gail Deegan Paul C. O'Brien (Gail Deegan, as attorney-in-fact, Donald B. Reed* and on her own behalf as Principal Ivan Seidenberg* Financial and Accounting Officer) Ira Stepanian* Kimon S. Zachos* March 25, 1994
51303_1993.txt	51303	1993	ITEM 1. BUSINESS The registrant, Navistar Financial Corporation ("NFC"), was incorporated in Delaware in 1949 and is a wholly-owned subsidiary of Navistar International Transportation Corp. ("Transportation"), which is wholly-owned by Navistar International Corporation ("Navistar"). As used herein, the "Corporation" refers to Navistar Financial Corporation and its wholly-owned subsidiaries unless the context otherwise requires. The Corporation provides wholesale, retail, and to a lesser extent, lease financing in the United States for sales of new and used trucks sold by Transportation and Transportation's dealers. The Corporation also finances wholesale accounts and selected retail accounts receivable of Transportation. To a minor extent, sales of new products (including trailers) of other manufacturers are also financed regardless of whether designed or customarily sold for use with Transportation truck products. Harco National Insurance Company, NFC's wholly-owned insurance subsidiary, provides commercial physical damage and liability insurance coverage to Transportation's dealers and retail customers, and to the general public through the independent insurance agency system. ITEM 2.		ITEM 2. PROPERTIES The Corporation uses leased facilities to carry out most of the administrative and finance sales activities. ITEM 3.	ITEM 3. LEGAL PROCEEDINGS In July 1992, Navistar announced its decision to change its retiree health care benefit plans, including those of the Corporation. Navistar concurrently filed a declaratory judgment class action lawsuit to confirm its right to change these benefits in the U.S. District Court for the Northern District of Illinois ("Illinois Court"). A countersuit was subsequently filed against Navistar by its unions in the U.S. District Court for the Southern District of Ohio. On October 16, 1992, Navistar withdrew its declaratory judgment action in the Illinois Court and began negotiations with the United Automobile, Aerospace and Agricultural Implement Workers of America ("UAW") to resolve issues affecting both retirees and employees. On December 17, 1992, Navistar announced that a tentative agreement had been reached with the UAW on restructuring retiree health care and life insurance benefits ("the Settlement Agreement"). During the third quarter of 1993, all court, regulatory agency and shareowner approvals required to implement the Settlement Agreement concerning retiree health care benefit plans were obtained. The Settlement Agreement became effective and the restructured retiree health care and life insurance plan was implemented on July 1, 1993. In May 1993, a jury issued a verdict in favor of Vernon Klein Truck & Equipment, Inc. and against Transportation and the Corporation in the amount of $10.8 million in compensatory damages and $15 million in punitive damages. The amount of any potential liability is uncertain and Transportation and the Corporation believe that there are meritorious arguments for overturning or diminishing the verdict on appeal. ITEM 4.	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Intentionally omitted. See the index page of this Report for explanation. PART II The information required by Items 5, 7 and 8 is incorporated by reference from the 1993 Annual Report to Shareowner on the pages indicated: ---------------- ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None PART III ITEMS 10, 11, 12 AND 13 Intentionally omitted. See the index page of this Report for explanation. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K Financial Statements See Index to Financial Statements in Item 8.
745276_1993.txt	745276	1993	ITEM 1. BUSINESS - ---------------- Description of Business ----------------------- CoBancorp Inc. (the "Corporation"), headquartered in Elyria, Ohio, is a one-bank holding company registered with the Federal Reserve System whose principal asset is the common stock of its wholly owned commercial bank subsidiary, PremierBank & Trust (the "Bank"). The Corporation was organized under Ohio law in November 1983 and remained inactive until September 8, 1984. On that date, the Bank's shareholders became Corporation shareholders in a tax-free and regulatory reorganization. This transaction was accounted for as a pooling of interests. As a bank holding company, the Corporation is exclusively engaged and intends to continue to engage in the management of the Bank. The Bank was chartered by the State of Ohio in 1926 and is a member bank of the Federal Reserve System. The Bank operates twenty-three (23) banking offices throughout its market area of Lorain County and portions of Cuyahoga, Erie, Richland, Huron, Delaware and Crawford Counties. The Bank also operates a consumer loan office in Elyria and a loan production office in Franklin County. The Bank has 27 automated teller machines ("ATMs") and is a member of the MAC, Money Station and Plus ATM networks. As a member bank of the Federal Reserve System, the Bank's deposits are insured by the Federal Deposit Insurance Corporation (the "FDIC") to the extent permitted by law. The Bank is subject to primary regulation by the Federal Reserve and the Ohio Department of Commerce, Division of Banking. The Bank is also subject to regulation by the FDIC. The Corporation's activities as a bank holding company are regulated by the Federal Reserve, and the Corporation's corporate governance is determined by Ohio law. The Bank provides commercial and retail banking services to individual, business, institutional and governmental customers. These services include personal and commercial checking accounts, savings and time deposit accounts, personal and business loans, a credit card system and safe deposit facilities. The Trust Department of the Bank performs complete trust administrative functions and offers agency and trust services to individuals, partnerships, corporations, institutions and municipalities. As of December 31, 1993, in the opinion of management, the Corporation did not have any concentration of loans to similarly situated borrowers exceeding 10% of total loans. There were no foreseeable losses relating to other interest-earning nonloan assets. The Bank is not significantly affected by seasonal activity or large deposits of individual customers. The Bank is not engaged in operations in any foreign country. On December 31, 1993, the Corporation and its subsidiary employed approximately 277 full-time and 92 part-time employees. None of the employees is represented by a union or collective bargaining group. Management considers its relations with employees to be satisfactory. Employee benefit programs are considered by management to be competitive with benefits provided by other financial institutions and major employers within the normal operating area. Competition ----------- The Bank actively competes with other financial institutions in its market area. Competition for savings comes principally from other commercial banks, savings and loan associations, credit unions and brokerage house "money market funds" located in its primary market area. The primary factors in competing for savings are interest rates paid on deposits and convenience of office hours and locations. During periods when money market rates are relatively high, obligations offered by governments, government agencies and other entities seeking funds add significantly to competition for savings. The Bank's principal competition for loans is provided by other commercial banks, savings and loan associations, mortgage companies and credit unions. The primary factors in loan competition are interest rates, extent and time interval of interest rate adjustments, origination charges and convenience of office location for applications, closing and servicing. Regulation ---------- The Corporation is subject to regulation under the Bank Holding Company Act of 1956, as amended (the "Act"). The Act requires the prior approval of the Federal Reserve Board for a bank holding company to acquire or hold more than a 5 percent voting interest in any bank, and restricts interstate banking activities. The Act restricts the Corporation's non-banking activities to those which are closely related to banking. The Federal Reserve Board has determined by regulation that the following activities are permissible for bank holding companies and their subsidiaries. Some of these activities include the following: making, acquiring or servicing loans or other extensions of credit; trust company functions; leasing personal or real property; courier services; management and consulting for other depository institutions; and real estate appraising. The Corporation presently has no non-banking activities, but may in the future engage in one or more of the non-banking activities identified above. The Corporation's cash revenues are derived from dividends paid by the Bank, its subsidiary. These dividends are subject to various legal and regulatory restrictions as summarized in Note I on page 18 of the Registrant's 1993 Annual Report to Shareholders, which is incorporated herein by reference. Under the Act and regulations of the Federal Reserve Board pursuant thereto, a bank holding company and its subsidiaries are prohibited from engaging in certain tie-in arrangements in connection with the extension of credit. The Bank is a stock-form commercial bank organized under the laws of the State of Ohio, and its deposits are insured by the FDIC. The Bank derives its lending, investment and other powers from the applicable provisions of Ohio law and the regulations of the Ohio Department of Banking (the "Banking Department"), subject to limitation or other modification under applicable federal laws and regulations of such agencies as the FDIC and the Federal Reserve Board. The Bank is subject to periodic examination and supervision by the Federal Reserve Board and the Banking Department. The Banking Department regulates the Bank's internal organization as well as its deposit, lending and investment activities. The Superintendent of the Banking Department must approve changes to the Bank's Certificate of Incorporation, establishing or relocating branch offices, mergers and the issuance of additional stock. Many of the areas regulated by the Banking Department are subject to similar regulation by the Federal Reserve Board. The Federal Deposit Insurance Corporation Improvement Act of 1991 (the "FDIC Improvement Act") covers a wide expanse of banking regulatory issues. The FDIC Improvement Act deals with the recapitalization of the Bank Insurance Fund, with deposit insurance reform, including requiring the FDIC to establish a risk-based premium assessment system, and with a number of other regulatory and supervisory matters. The effective dates for the provisions of the FDIC Improvement Act are staggered, some having already taken effect and others taking effect at various times in the future. Regulations have been proposed to implement this Act, but the full effects of the FDIC Improvement Act generally on the financial services industry, and specifically on the Corporation, cannot now be measured. Examination and Supervision --------------------------- Both the Banking Department and the Federal Reserve Board issue regulations and require the filing of reports describing the activities and financial condition of banks under their jurisdiction. Each regulatory body conducts periodic examinations to test compliance with various regulatory requirements and generally supervises the operations of such banks. This supervision and regulation is intended primarily for the protection of depositors. The Federal Reserve Board may sanction any insured bank that does not operate in accordance with Federal Reserve Board regulations, policies and directives. Proceedings may be instituted against any insured bank, or any trustee, director, officer or employee of the bank, that engages in unsafe and unsound practices, including the violation of applicable laws and regulations. The Federal Reserve Board may revalue assets of an institution, based upon appraisals, and may require the establishment of specific reserves in amounts equal to the difference between such revaluation and the book value of the assets. In addition, the FDIC has the authority to terminate insurance of accounts, after notice and hearing, upon a finding by the FDIC that the insured institution is or has engaged in any unsafe or unsound practice that has not been corrected, or is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, rule or order of or condition imposed by the FDIC. Under Ohio law, the Superintendent of the Banking Department may also issue an order to an Ohio-chartered banking institution to appear and explain an apparent violation of law, to discontinue unsound or unsafe practices, and to keep books and accounts as prescribed. Upon a finding by the Banking Department that any director, trustee or officer of any banking organization has violated any law or duly enacted regulation, or has continued unauthorized or unsafe practices in conducting the business of the banking organization after having been notified by the Superintendent to discontinue such practices, such director, trustee or officer may be removed from office after notice and an opportunity to be heard. Effective January 1, 1991, the Federal Reserve Board adopted core capital requirements to be applicable to state member banks and bank holding companies, which require a 3 percent core capital requirement for any institution in the highest regulatory rating ("CAMEL rating") category. All other banking organizations would be required to maintain levels 100 to 200 basis points higher, based on their particular circumstances. As of December 31, 1993, the Corporation and the Bank, respectively, had tier one leverage ratios of 7.90% and 8.10%, which placed each in compliance with applicable core capital requirements. Failure to meet the capital requirements would mean that the insured member bank would be treated as having inadequate capital, and such an insured member bank would have to develop and file a plan with the Federal Reserve Board describing the means and a schedule for achieving the minimum capital requirements. In addition, such an insured member bank would not receive the Federal Reserve Board's approval of any application that required the consideration of capital adequacy, for instance, a branch application, unless the Federal Reserve Board found that the bank had a reasonable plan to meet the capital requirement within a reasonable period of time. In March 1989, the Federal Reserve Board adopted a risk-based capital rule which will apply to all BIF-insured state-chartered banks that are members of the Federal Reserve System ("state member banks"), such as the Bank. The rule requires state member banks to maintain minimum capital levels based upon a weighting of the assets according to risk. Under the new rule, qualifying total risk-based capital equals the sum of Tier I and Tier II capital. Among other items, Tier I capital is generally comprised of common stockholders' equity, non-cumulative perpetual preferred stock and minority interests in the equity account of consolidated subsidiaries, while Tier II capital generally consists of allowances for loan and lease losses (limited to a percentage of risk-weighted assets) and maturing capital instruments such as cumulative perpetual preferred stock, convertible debt securities and subordinated debt. At least 50 percent of the qualifying total risk-based capital must consist of Tier I capital. Tier I capital is defined as the sum of Tier I capital elements minus all intangible assets other than mortgage servicing rights. Once risk-based capital is calculated, the rule then assigns each balance sheet asset held by state member banks to one of four risk categories (0%, 20%, 50% and 100%) based on the amount of credit risk associated with that particular class of assets. For example, cash and U.S. Government securities backed by the full faith and credit of the U.S. Government are assigned a 0% risk weight while qualifying first mortgages on one- to four-family residential loans are assigned a 50% risk weight. Assets not within a specific risk-based category are assigned to the 100% risk-weight category. Indirect holding of pools of assets, for example mutual funds, are assigned the highest risk category appropriate to the highest risk-weighted asset that the fund is permitted to hold. Off-balance sheet items are included in risk-weighted assets pursuant to a conversion formula. Assets not included for purposes of calculating capital are not included in calculating risk-weighted assets. The book value of assets in each category is multiplied by the weighing factor (from 0% to 100%) assigned to that category. The resulting weighted value from each of the four risk categories are added together and this sum is the risk-weighted assets total that, as adjusted, comprises the denominator of the risk-based capital ratio. The state member bank's risk-based capital ratio is then calculated by dividing its qualifying total risk-based capital base by its risk-weighted assets. The rule for calculating risk-based capital ratios took effect in 1989. At the end of 1992, state member banks are required to maintain qualifying total capital equal to 8 percent of their risk-weighted assets and off-balance sheet items. Banks that fail to meet the risk-based capital requirements are required to file a capital plan with the Federal Reserve Board describing the means and a schedule for achieving the minimum capital requirements. In addition, any application that requires the consideration of capital adequacy, such as a branch application, may not be approved by the Federal Reserve Board unless the Federal Reserve Board finds that the bank has a plan to meet the capital requirements within a reasonable period of time. At December 31, 1993, the Bank's total capital-to-risk weighted assets ratio calculated under the risk-based capital requirement was 14.93 percent, while the Bank's actual risk-based capital was in excess of that required by $20,132,000. Federal Reserve System ---------------------- Under Federal Reserve Board regulations, the Bank is required to maintain reserves against its transaction accounts (primarily checking and NOW accounts), non-personal money market deposit accounts, and non-personal time deposits. Effective April 2, 1992, the Federal Reserve Board cut the reserve requirement on transaction accounts from 12 percent to 10 percent. Effective December 31, 1990, in addition, no reserves (subject to adjustment by the Federal Reserve Board up to 9 percent) must be maintained on time deposits, which include borrowings with original maturities of less than one and one-half years. These amounts and percentages are subject to adjustment by the Federal Reserve Board. Money market deposit accounts are subject to the reserve requirement applicable to time deposits when held by an entity other than a natural person. Insurance of Deposits --------------------- Deposits in the Bank are insured by the Federal Deposit Insurance Corporation (the "FDIC"), to the legal maximum. Under FIRREA, the deposits of commercial banks continue to be insured to a maximum of $100,000 for each insured depositor. Community Reinvestment Act -------------------------- Ratings of depository institutions under the Community Reinvestment Act of 1977 ("CRA") must be disclosed. The disclosure will include both a four-unit descriptive rating for all CRA examinations at banks and thrifts after July 1, 1990, using terms such as satisfactory and unsatisfactory, and a written evaluation of each institution's performance. At its most recent CRA performance evaluation, the Bank received a satisfactory evaluation of its CRA performance. Each of the above executive officers of the Corporation has been an officer of the Registrant or its subsidiary, PremierBank & Trust, during the past five years, except as follows. Mr. Kreighbaum joined the Corporation and the Bank as President in January 1991. Mr. Kreighbaum most recently was the President and Chief Executive Officer of The Delaware County Bank, Delaware, Ohio, from 1986 through 1990. Mrs. Barnes joined the Corporation and the Bank as Vice President in August 1991, and became Senior Vice President/Branch Administration in June 1993. Prior to that, Mrs. Barnes was Vice President at Delaware County Bank from 1987 to July 1991. Mr. Miller joined the Corporation and the Bank in October 1992 as Vice President. In June 1993 he was made Senior Vice President/Operations. Prior to joining CoBancorp Inc. and PremierBank & Trust, Mr. Miller was Senior Vice President/Chief Auditor at First Security Corporation of Kentucky from 1988 to October 1992. Mr. Scott joined the Corporation and the Bank in March 1993. Prior to that, he was at Mid-State Bank and Trust Company, Altoona, Pennsylvania since 1983. Mr. Stevens joined the Corporation and the Bank in June 1992 as Vice President/Commercial Loan Officer, and became Vice President/Director, Commercial Lending in May 1993. Prior to joining CoBancorp Inc. and PremierBank & Trust, Mr. Stevens was Senior Vice President, Loan Administration at a local commercial bank from 1974 to 1992. There are no family relationships between any of the above executive officers of the Corporation. Supplemental Financial Data --------------------------- Numeric disclosure regarding the Corporation's business and supplemental financial data concerning the Corporation and the Bank as described below is incorporated herein by reference to the pages of this report set forth opposite each specific caption: ITEM 2.		ITEM 2. PROPERTIES - ------------------ The principal office of CoBancorp Inc. and PremierBank & Trust is located at 124 Middle Avenue, Elyria, Ohio. At December 31, 1993, the Bank owned 19 of its banking facilities and leased the other 12 facilities. All but seven of the offices are located in Lorain County, Ohio. Through the Bank, the Corporation owns and operates 27 ATMs at various branch offices and at six remote locations and is a member of the MAC and Money Station ATM Networks, which provide their members with regional ATM access, and the Plus System ATM network, which provides its members with international access. The following table sets forth certain information regarding the properties of the Corporation and the Bank. Continued ITEM 3.	ITEM 3. LEGAL PROCEEDINGS - ------------------------- There is no pending litigation of a material nature in which the Corporation or the Bank is involved and no such legal proceeding was terminated during the fourth quarter of 1993. Furthermore, there is no material proceeding in which any director, officer, or affiliate of the Registrant, or any associate of any such director or officer, is a party, or has a material interest, adverse to the Corporation or the Bank. As a part of its ordinary course of business, the Corporation and the Bank are each a party to lawsuits (such as garnishment proceedings) involving claims to the ownership of funds in particular accounts and involving the collection of delinquent accounts. All such litigation is incidental to the business of the Bank and the Corporation. ITEM 4.	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - ----------------------------------------------------------- None. PART II ------- ITEM 5.	ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER - ------------------------------------------------------------------------ MATTERS ------- Reference is made to the "Market and Dividend Information" on page 25 of the Registrant's 1993 Annual Report to Shareholders, which is incorporated herein by reference, for information concerning the principal market for Registrant's Common Stock, market prices, number of shareholders and dividends, which is incorporated herein by reference. The high and low bid prices quoted from the newspaper (prior to the Corporation's listing on the Nasdaq National Market System in August 1993) reflect inter-dealer prices without adjustments for retail markups, markdowns or commissions and may not represent actual transactions. Reference is made to Note I to the Consolidated Financial Statements on page 18 of the Registrant's 1993 Annual Report to Shareholders for information concerning dividend restrictions, which is incorporated herein by reference. ITEM 6.	ITEM 6. SELECTED FINANCIAL DATA - ------------------------------- Reference is made to the table entitled "Five Year Financial Summary" on page 25 of the Registrant's 1993 Annual Report to Shareholders, which is incorporated herein by reference. ITEM 7.	ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND - ----------------------------------------------------------------------- RESULTS OF OPERATIONS --------------------- CoBancorp Inc. is a one-bank holding company with total consolidated assets at year-end 1993 of $492 million. Its subsidiary, PremierBank & Trust, maintains offices in Lorain County, as well as Cuyahoga, Erie, Huron, Richland, Delaware, Crawford and Franklin Counties. This section of the report provides a narrative discussion and analysis of the consolidated financial condition and results of operations of CoBancorp Inc. and PremierBank & Trust for the past three years. The supplemental financial data included in this section should be read in conjunction with the consolidated financial statements and related disclosures presented on pages 8 through 24 of the Registrant's 1993 Annual Report to Shareholders, which are incorporated herein by reference. All shares outstanding and per share data have been adjusted for a four-for-three stock split in February 1994, a four-for-three stock split in July 1993, a four percent stock dividend in 1992, a three percent stock dividend in 1991 and a five percent stock dividend in 1989. Consolidated Selected Financial Data ------------------------------------ Reference is made to the table entitled "Five Year Financial Summary" on page 25 of the Registrant's 1993 Annual Report to Shareholders, which is incorporated herein by reference. Performance Overview -------------------- Net income for 1993 was $5,281,000, or $1.61 per share, compared to $4,378,000, or $1.35 per share in 1992, and $3,254,000, or $1.01 per share in 1991. Two key measures of performance in the banking industry are return on average equity (ROE) and return on average assets (ROA). ROE is the ratio of income earned to average shareholders' equity. ROE for 1993 was 14.6 percent, compared to 13.8 percent in 1992 and 11.3 percent in 1991. ROA measures how effectively a corporation uses its assets to produce earnings. For 1993, return on average assets was 1.10 percent. ROA was 1.01 percent in 1992 and .81 percent in 1991. ROE and ROA have been positively impacted by an upward trend in the net interest margin. The following table sets forth operating and capital ratios of the Corporation. Results of Operations --------------------- Net Interest Income - ------------------- The Corporation's primary source of earnings is net interest income, which is the difference between revenue generated from earning assets and the interest cost of funding those assets. For discussion, net interest income is adjusted to reflect the effect of the tax benefits of certain tax-exempt investments and loans to compare with other sources of interest income. Net interest income on a fully taxable-equivalent basis grew to $23,713,000 in 1993, from $21,828,000 in 1992 and $18,968,000 in 1991. Reference is made to the "Summary of Changes in Net Interest Income" on page 16 of this report for a detailed analysis of factors affecting this trend in net interest income. Net interest margin, which is net interest income divided by average earning assets, was 5.39 percent in 1993 compared with 5.43 percent in 1992 and 5.13 percent for 1991. Average earning assets, as a percentage of total assets, decreased slightly to 91.7 percent this year compared to 92.0 percent in 1992 and 92.1 percent in 1991. The trends in various components of the balance sheet and their respective yields and rates which affect interest income and expense are shown in the following table. The following table sets forth for the periods indicated a summary of the changes in interest income and interest expense on a fully taxable-equivalent basis resulting from changes in volume and changes in rates for the major components of interest-earning assets and interest-bearing liabilities: PROVISION FOR LOAN LOSSES The total provision for loan and real estate losses was $920,000 in 1993, $2,800,000 in 1992 and $2,500,000 in 1991. Additional discussion regarding the provision for loan losses and the allowance for loan losses is contained in this report in the section entitled "Credit Quality and Experience" on page 23. NONINTEREST INCOME Total noninterest income of $4.5 million for 1993 increased $500,000, or 10.5 percent, when compared to 1992. This follows increases of 30.1 percent during 1992 and 6.6 percent during 1991. Service charges on deposit accounts represented $178,000 of the growth in 1992 due principally to growth in transaction and savings deposit accounts coupled with price increases. Income from trust activities increased in 1993, 1992 and 1991 primarily due to the growth in assets under management. Total assets managed by the Trust Department aggregated $220.0 million, $173.0 million and $151.5 million at December 31, 1993, 1992 and 1991, respectively. Gains and losses on the sale of investment securities also impact comparisons. Security transactions resulted in gains of $665,000, $566,000 and $142,000 in 1993, 1992 and 1991, respectively. NONINTEREST EXPENSES Noninterest expenses increased 18.2 percent in 1993, 12.9 percent in 1992 and 2.5 percent in 1991. The increase in 1993 can be attributed to higher levels of expense relative to salaries, advertising, supplies and insurance. Salaries, wages and benefits account for 43.6 percent of total noninterest expense in 1993, compared to 43.2 percent in 1992 and 47.7 percent in 1991. These increases are primarily attributable to increases in the number of employees, the increased cost of benefits and merit raises. Also affecting the increase in 1991 was a one-time cost of the finalization of the outsourcing process of the electronic data processing activities of the Bank. In December 1993 there were 317 full-time equivalent employees, an increase of 12.8 percent from the 281 full-time equivalent employees at December 1992, which was an increase of 12.9 percent from the level of 249 full-time equivalent at December 1991. INCOME TAXES One element of the Corporation's tax planning is the implementation of various investment and loan strategies to maximize after-tax profits. This planning is an ongoing process which considers the levels of tax-exempt securities and loans, investment securities gains or losses and allowable loan loss deductions. The Corporation's effective income tax rate (income tax expense divided by income before income taxes) is less than the statutory rate primarily due to income on tax-exempt securities and loans. It should be recognized that the yield on these types of assets is considerably less than on other investments of the same maturity and risk. The income tax provision was $1,100,000 in 1993, compared with $1,130,000 in 1992 and $761,000 in 1991. The Corporation's effective tax rate was 20.8 percent in 1993, 20.5 percent in 1992 and 19.0 percent in 1991. It has been determined that for the year ended December 31, 1993, a valuation allowance is not required on any of the deferred tax assets recorded due primarily to the earnings history of the Corporation and the significant amount of federal income taxes paid in prior years. FINANCIAL CONDITION The consolidated financial condition of the Corporation and the Bank as of December 31, 1993 and 1992 is presented in the comparative balance sheets on page 8 of the Registrant's 1993 Annual Report to Shareholders, which is incorporated herein by reference. The following discussions address key elements of financial condition, including earning assets, the sources of funds supporting earnings assets, credit quality and experience, asset and liability management and capital adequacy. EARNING ASSETS LOANS Loans comprise the majority of the Corporation's earning assets, representing 59.1 percent of average earning assets in 1993, and 58.5 percent in 1992. Average loans outstanding increased 11.3 percent in 1993 and 1.6 percent in 1992. The largest asset category in the loan portfolio was real estate mortgage loans, which comprised 45.8 percent of total loans at the end of 1993. Commercial and collateral loans totaled 42.4 percent of the portfolio and installment loans comprised 10.8 percent of the portfolio. All other loans were 1.0 percent of the portfolio. In 1992, commercial and collateral loans were 44.3 percent of the loan portfolio, real estate mortgages were 40.5 percent, installment loans were 13.9 percent and other loans were 1.3 percent. The mix within the commercial loan portfolio is diverse and represents loans to a broad range of business interests, located primarily within the Bank's defined market area, with no significant industry concentration. The installment loan portfolio is composed principally of financing to individuals for vehicles and consumer assets. The real estate portfolio is primarily residential mortgages that can qualify for sale into the secondary market. Loans by major category at the end of the last five years were as follows: The maturity distribution and sensitivity to interest rates of the loan portfolio are two factors in management's evaluation of the risk characteristics of the portfolio and the future profitability of the portfolio. Loans at December 31, 1993, reported at the earliest of maturity or repayment for fixed rate loans, and earliest repricing opportunity for variable rate loans, with nonaccrual loans included in the "after 5 years" category, are as follows (in thousands of dollars): Fixed rate loans maturing within one year and loans with adjustable rates that reprice annually or more frequently (exclusive of scheduled repayments) totaled $118,336,000 or 40.9 percent of the loan portfolio at December 31, 1993. INVESTMENT SECURITIES The investment portfolio is comprised of U. S. Treasury and other U. S. Government agency-backed securities, collateralized mortgage-backed securities, tax-exempt obligations of states and political subdivisions, and certain other investments. The quality of obligations of states and political subdivisions will be A, AA, or AAA, the majority of which will be AA or AAA, as rated by a nationally recognized service. As a matter of policy, in support of our service area, we may purchase certain unrated bonds of local schools, townships and municipalities, provided they are of reasonable credit risk. On December 31, 1993, the Corporation adoped FASB Statement No. 115, "Accounting for Certain Investments in Debt and Equity Securities." Accordingly, securities available-for-sale are recorded at market value and the unrecognized gain of $982,000 (net of tax) is included in shareholders' equity. The adoption did not have a material effect on results of operations and prior years' financial statements were not restated. In anticipation of the adoption of FASB Statement No. 115, securities netting to $87,275,000 (adjusted cost basis) were reclassified between the held-to-maturity and available-for- sale portfolios. The portfolio accounting designations were made in order to attain the objectives of the Corporation's investment portfolio, which are to generate interest income, serve as a liquidity source and play an important role in the management of the interest rate sensitivity of the Corporation. Accordingly, securities purchased for the available-for-sale category are those which may be sold prior to their maturity for purposes of bank asset allocations, rate sensitivity or liquidity and, hence, tend to be more liquid. Securities in the held-to-maturity category are purchased with the intent and ability to hold them to maturity and are, therefore, carried at amortized cost. The investment portfolio represented 39.7 percent of average earning assets in 1993 and 39.4 percent in 1992. Average investment securities held increased 11.1 percent in 1993 compared to 1992. The tax-equivalent yield on the entire portfolio was 7.17, 8.19 and 9.07 percent in 1993, 1992 and 1991, respectively. These investments provide a stable yet diversified income stream and serve useful roles in liquidity and interest rate sensitivity management. In addition, they serve as a source of collateral for low-cost funding. The market value of investment securities was higher than book value at December 31, 1993 and 1992. The decision to purchase securities is based upon the assessment of current economic and financial trends. At December 31, 1993, the investment portfolio had a total book value of $152.9 million compared with $172.8 million at the previous year-end. Summary information with respect to the securities portfolio at December 31 follows (in thousands of dollars): The yield at December 31, 1993, was the combined rate for the held-to-maturity and available-for-sale securities portfolios. Mortgage-backed securities and other securities which may have prepayment provisions are assigned to a maturity category based on estimated average life. Securities with a call provision are assigned to a maturity category based on call date. Yield represents the weighted average yield to maturity. The yield on obligations of states and political subdivisions has been calculated on a fully taxable equivalent basis, assuming a 34% tax rate. FEDERAL FUNDS SOLD Short-term federal funds sold are used to manage interest rate sensitivity and to meet liquidity needs. During 1993, 1992 and 1991, these funds represented approximately 1.2 percent, 2.1 percent and 4.4 percent, respectively, of average earning assets. SOURCES OF FUNDS DEPOSITS The Corporation's major source of investable funds is core deposits from retail and business customers. These core deposits consist of interest-bearing and noninterest-bearing deposits, excluding certificates of deposit over $100,000. Average interest-bearing core deposits, comprised of interest-bearing checking accounts, savings, money market and other time accounts, grew 13.4 percent in 1993, compared to 14.3 percent in 1992 and 5.2 percent in 1991. Average demand deposits (noninterest-bearing core deposits) increased 5.7 percent in 1993 and 12.2 percent in 1992, following a decrease of 1.3 percent in 1991. These deposits represent approximately 13.1 and 13.9 percent of average core deposits in the last two years, respectively. The Corporation's core deposit fund position has allowed management to place less emphasis on purchased funds to support loans and investments. Purchased funds include certificates of deposit over $100,000. These funds are used to balance rate sensitivity and as a supplement to core deposits. Average certificates of deposit over $100,000 decreased 30.1 percent in 1993 from 1992 levels, to 3.5 percent of average assets. This followed a decrease of 15.5 percent in 1992 from 1991 levels, to 5.7 percent of average assets in 1992. The following table presents the average amount of and the average rate paid on each of the following deposit categories (dollar amounts in thousands). Average Deposits The maturity distribution of certificates of deposit of $100,000 or more at December 31, 1993, was (in thousands of dollars): Certificates of Deposit Over $100,000 There were three other time deposits of $100,000 or more at December 31, 1993, which will mature in 1994 through 1995. SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE AND OTHER BORROWINGS Other interest-bearing liabilities include securities sold under agreements to repurchase, sweep accounts, federal funds purchased and notes payable TT&L. In 1993, these short-term funds increased slightly to 5.2 percent of average assets compared to 4.2 percent in 1992. The Corporation enters into sales of securities under agreements to repurchase for periods up to 29 days, which are treated as financings and reflected in the consolidated balance sheet as a liability. The following table presents information related to securities sold under agreements to repurchase (repurchase agreements). Securities Sold Under Agreements to Repurchase CREDIT QUALITY AND EXPERIENCE NONPERFORMING LOANS Inherent in the business of providing financial services is the risk involved in extending credit. Management believes the objective of a sound credit policy is to extend quality loans to customers while reducing risk affecting shareholders' and depositors' investments. Risk reduction is achieved through diversity of the loan portfolio as to type, borrower and industry concentration as well as sound credit policy guidelines and procedures. Except for installment and credit cards, loans on which interest and/or principal is 90 days or more past due are placed on nonaccrual status and any previously accrued but uncollected interest is reversed. Such loans remain on a cash basis for recognition of income until both interest and principal are current. Installment and credit cards loans past due greater than 120 days are charged off and previously accrued but uncollected interest is reversed. Nonperforming loans include loans accounted for on a nonaccrual basis, accruing loans which are contractually past due 90 days or more as to principal or interest payments and loans which have been renegotiated. Total nonperforming loans at December 31, 1993, were $1,459,000, compared to $2,540,000 at December 31, 1992 and $4,712,000 at December 31, 1991. The ratio of the allowance for loan losses to nonperforming loans at December 31, 1993, was 358.2 percent compared to 205.3 percent and 87.0 percent at December 31, 1992 and 1991, respectively. Total nonperforming loans as a percentage of total loans decreased to 0.5 percent at December 31, 1993, compared to 1.0 percent at December 31, 1992 and 2.1 percent at December 31, 1991. The following table summarizes nonaccrual, past due and restructured loans. The effect of the nonaccrual loans, on a fully taxable-equivalent basis, for the year ended December 31 was as follows: ALLOWANCE FOR LOAN LOSSES AND LOAN CHARGE-OFFS The allowance for loan losses is the reserve maintained to cover losses that may be incurred in the normal course of lending. The allowance for loan losses is increased by provisions charged against income and recoveries of loans previously charged off. The allowance is decreased by loans that are determined uncollectible by management and charged against the allowance. In determining the adequacy of the allowance for loan losses, management on a regular basis evaluates and gives consideration to the following factors: estimated future losses of significant loans including identified problem credits; historical loss experience based on volume and types of loans; trends in portfolio volume, maturity and composition; off-balance sheet credit risk; volume and trends in delinquencies and nonaccruals; economic conditions in the market area; and any other relevant factors that may be pertinent. Potential problem loans are those loans which are on the Corporation's "watch list." These loans exhibit characteristics that could cause the loans to become nonperforming or require restructuring in the future. Periodically, and at a minimum monthly, this "watch list" is reviewed and adjusted for changing conditions. ASSET AND LIABILITY MANAGEMENT AND CAPITAL ADEQUACY INTEREST RATE SENSITIVITY Balance sheet structure and interest rate changes play important roles in the growth of net interest income. PremierBank & Trust's Asset/Liability Committee manages the overall rate sensitivity and mix of the balance sheet to anticipate and minimize the effects of interest rate fluctuations and maintain a consistent net interest margin. Refer to the following tables for additional information regarding interest rate sensitivity: LIQUIDITY Liquidity is the ability to raise cash quickly and economically when funds are needed. The need for funds primarily arises from deposit withdrawals and demand for new loans. Stable core deposits and other interest-bearing funds are all important components of liquidity. PremierBank & Trust's long-term liquidity sources are a large core deposit base and a strong capital position. Core deposits are the most stable source of liquidity a bank can have due to the long-term relationship with deposit customers. Core deposits averaged 82.7 percent of total average assets during 1993, and 81.6 percent during 1992. Readily marketable assets, particularly short-term investments, provide another source of liquidity. These funds can be quickly converted into cash to meet short-term liquidity demands at minimal cost. CAPITAL ADEQUACY Shareholders' equity is a stable, noninterest-bearing source of funds which provides support for asset growth and is the primary component of capital. Capital adequacy refers to the level of capital required to sustain capital growth over time and to absorb losses on risk assets. It is management's intent to maintain a level of capitalization that allows the flexibility to take advantage of opportunities that may arise. Shareholders' equity at December 31, 1993, was $39.7 million, or $12.16 per share, compared with $34.2 million or $10.53 per share at December 31, 1992 and $30.4 million or $9.42 per share at December 31, 1991. At December 31, 1993, the Corporation's leverage ratio was 7.90 percent. The Corporation's risk-based capital ratios based on Federal Reserve Board guidelines were 13.34 percent for Tier 1, or "core" capital, and 14.60 percent for total qualifying capital. These ratios substantially exceed the minimums that are currently in effect for bank holding companies during 1993. These minimums are 4.00 percent and 8.00 percent for Tier I and total qualifying capital, respectively. It is management's intent to maintain a level of capitalization that allows the flexibility to take advantage of opportunities that may arise in the future. For additional discussion, see "Examination and Supervision," on pages 6 through 8 of this report. COMMON STOCK AND RELATED MARKET DATA COMMON STOCK Reference is made to the "Market and Dividend Information" on page 25 of the Registrant's 1993 Annual Report to Shareholders, which is incorporated herein by reference. DIVIDENDS CoBancorp Inc.'s dividend policy balances shareholders' return with the need to retain an adequate capital level to support future growth opportunities. Dividend payout has ranged from 25.4 to 49.5 percent of earnings over the last five years. Dividends declared in 1993 were $0.41 per share, compared to the $0.34 of dividends declared in 1992. Dividends for 1991 were $0.25 per share. FINANCIAL REPORTING AND CHANGING PRICES Although inflation can have a significant effect on the financial condition and operating results of banks, it is difficult to measure the impact as neither the timing nor the magnitude of interest rate changes necessarily coincide with changes in the consumer price index or any other index of inflation. Inflation can impact the growth of total assets and result in a need to increase capital at a faster than normal rate in order to maintain an appropriate equity to assets ratio. This can result in a smaller proportion of earnings paid out in the form of dividends. The results of operations can also be affected by the impact of inflation on current interest rates. Intermediate to long-term interest rates tend to increase in an inflationary environment, thereby affecting the market value of long-term fixed rate assets. Higher short-term rates tend to increase funding costs. In addition, noninterest expenses are more directly impacted by current inflation rates. ITEM 8.	ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - --------------------------------------------------- Reference is made to pages 8 through 24 of the Registrant's 1993 Annual Report to Shareholders, which is incorporated herein by reference. 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 - ----------------------------------------------------------- ITEM 11.	ITEM 11. EXECUTIVE COMPENSATION - ------------------------------- ITEM 12.	ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT - ------------------------------------------------------------------------ ITEM 13.	ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - ------------------------------------------------------- Reference is made to the Corporation's Proxy Statement dated March 21, 1994, and to information on page 9 of Part I of this report, for the information required by Items 10 through 13, and which information is incorporated herein by reference. PART IV ------- ITEM 14.	ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K - ------------------------------------------------------------------------ (a) (1) and (2) Financial Statements and Schedules The following consolidated financial statements appear on pages 8 through 24 of the Registrant's 1993 Annual Report to Shareholders, which are incorporated herein by reference: Consolidated Balance Sheets at December 31, 1993 and 1992 Consolidated Statements of Income for the Years Ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 Consolidated Statements of Shareholders' Equity for the Years Ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements Report of Independent Auditors Schedules I and II are not required under the related instructions or are inapplicable and, therefore, have been omitted. (3) Listing of Exhibits (b) Reports on Form 8-K No reports on Form 8-K were filed in the last quarter of the Registrant's latest fiscal year. [ERNST & YOUNG LETTERHEAD] REPORT OF INDEPENDENT AUDITORS Board of Directors CoBancorp Inc. We have audited the consolidated financial statements of CoBancorp Inc. and subsidiary listed in the accompanying index to financial statements (Item 14(a)). These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. As audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assesssing 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 consolidated financial position of CoBancorp Inc. and subsidiary at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. As discussed in Note A and R to the consolidated financial statements, in 1993 the corporation changed its methods of accounting for income taxes and accounting for certain investments in debt and equity securities, respectively. /s/ ERNST & YOUNG ERNST & YOUNG January 21, 1994 SIGNATURES ---------- Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. CoBancorp Inc. Date: March 29, 1994 By: /s/ ------------------------------------ Timothy W. Esson Executive Vice President (Principal Financial Officer and Principal Accounting Officer) SIGNATURES ---------- Pursuant to the requirements of the Securities Exchange Act of 1934, this report on Form 10-K has been signed below by the following persons on behalf of the Registrant and in the capacities and on the date indicated.
792397_1993.txt	792397	1993	Item 1. BUSINESS -------- Conner Peripherals, Inc. ("Conner" or the "Company") was incorporated in California in June 1985 and was reincorporated in Delaware in September 1992. The Company's principal executive offices are located at 3081 Zanker Road, San Jose, California 95134, and its telephone number is (408) 456-4500. GENERAL - ------- Conner designs, builds and sells information storage solutions products, including a large selection of hard disk drives, tape drives, software and integrated systems for a wide range of computer storage applications. In June 1992, the Company began the process of repositioning itself from being solely a manufacturer of Winchester disk drives to becoming a leading supplier of total storage solutions for the computer industry. In December 1992 Conner completed the acquisition of Archive Corporation ("Archive") by means of a merger. The acquisition of Archive strengthened Conner's position in the tape drive, software and storage systems markets, thereby supporting its strategy of being a leader in information storage solutions and storage and data protection products. During 1993, the Company took action to rationalize these operations in order to better streamline product development, sales and marketing and support activities. Demand for all of the Company's products is driven by several distinct market trends. First, the shift from centralized computing based on mainframes and minicomputers to networks and client-server architectures has resulted in an increased demand for compact, high capacity, high-performance storage devices and systems for use in networks of personal computers and workstations. Second, the increasing complexity of personal computer operating systems, such as Windows, OS/2, as well as the software applications designed to support them, has resulted in the demand for greater storage capacity in individual computers. Third, the substantial storage requirements necessary to store high resolution images, sound and video data applications is adding significantly to the amount of storage required on personal computer systems, both in the business and home environments. As the amount of data stored on individual computers increases, the need for efficient and reliable data protection also increases. This need is causing an increase in the demand for tape drives and the complex software which manages the transfer of data from disk drives to tape drives on a network and on individual computer systems. The Company's products are sold to original equipment manufacturers ("OEMs"), distributors, Value-Added Resellers ("VARs"), dealers and distributors in the U.S. and abroad, with the exact channel dependent on the product and division. In addition, the Company distributes disk drive, tape drive and software products through its Storage Systems Group, which acts as a VAR to dealers in the U.S. DISK DRIVES - ----------- Disk drives address the escalating requirements of high performance microcomputers and workstations for greater storage capacity, faster access time, lower power consumption and smaller size at increasingly lower costs through the use of advanced technologies. Every disk drive incorporates the same operating concepts. One or more rigid disks are attached to a spin motor assembly, which rotates the disks at a constant speed within a sealed, contamination-free enclosure. Typically, both surfaces of each disk are coated with a thin layer of magnetic material. Magnetic heads record and retrieve data from discrete magnetic domains located on pre-formatted concentric tracks in the magnetic layers of the rotating disks. An actuator positions the head over the proper track upon instructions from the drive's electronic circuitry. Most disk drives are "intelligent" disk drives, which incorporate an embedded controller to manage communications with the computer. Disk Drive Design - ----------------- During the last five years, the Company has pioneered a variety of disk drive innovations, many of which have achieved broad acceptance in the disk drive industry in general. The Company was the first to utilize an architecture employing a high microcode content, resulting in significant flexibility and improved reliability in its drives. In addition, the Company was among the earliest to introduce drives using a high-performance voice coil actuator and on-board electronic diagnostics. As a result of various design innovations, the Company's disk drives achieve high performance with low power consumption. Finally, the Company was the first to introduce drives in a low-profile one inch package. Many of these innovations are protected by patent rights belonging to the Company. The Company believes that its disk drive design has certain important performance characteristics. The benefits to the user include (1) fast access time; (2) low heat dissipation; (3) quiet operation; (4) low power consumption; and, (5) extended product life. Fast access is a performance requirement for systems incorporating 64-bit and 32-bit microprocessors, such as Intel Corporation's ("Intel") Pentium and 80486 and Motorola's 68040 family of microprocessors. Low heat dissipation is an important determinant of a disk drive's reliability because heat may contribute to component failure. Low heat dissipation allows the possibility of eliminating or reducing the size of cooling fans in computers and thus increases the potential for quieter computer system operation. Low power consumption is also a critical factor in all portable computing applications because these computers use battery power supplies and disk drives are a large power consumer in such systems. Consequently, low power consumption in disk drives reduces the need for a computer to incorporate a large power supply as a standard feature. The benefits of the Company's disk drive design include reduced parts count, higher reliability and the built-in ability for self-testing. These benefits may result in the possibility of lower aggregate component costs and reduced requirements for expensive disk drive test equipment, when compared to conventional disk drive designs. Disk Drive Products - ------------------- The Company's disk drive products include 2.5-inch and 3.5-inch disk drives which offer storage capacities ranging from 170 megabytes to over 1 gigabyte of formatted capacity. The Company's products include the following product families: Filepro Series. The Filepro Series products include one- and two-disk, -------------- low-profile (one-inch high) 3.5-inch hard disk drives, in capacities of 210 and 420 megabytes. The Filepro Series is designed to offer the entry level PC user a combination of high capacity, performance, reliability and low price. Filepro Advantage Series. The Filepro Advantage Series of 3.5-inch disk ------------------------ drives offers low cost storage for value systems, including networked and desktop PCs used for advanced applications, databases and multimedia. The Filepro Advantage Series is available in capacities of 340 and 540 megabytes. The Company has announced new versions of these products with storage capacities of 810 and 1080 megabytes. The Company expects to commence volume shipment of these products during the second quarter of 1994. Filepro Performance Series. The Filepro Performance Series disk drives are -------------------------- available with 545 and 1060 megabytes of capacity and feature seek times as fast as 9 milliseconds and data transfer rates of up to 55 megabits per second. These disk drives are primarily used in advanced workstation and network systems. Filepro Notebook Series. The Filepro Notebook Series of 2.5-inch disk ----------------------- drives provide capacities from 170 to 340 megabytes and addresses the needs of mobile users of portable PCs and notebook computers, with low power, light weight and a high degree of shock resistance. TAPE DRIVES - ----------- Tape drives are peripheral hardware devices which enable low cost storage or data protection of large volumes of data through use of digital tape stored on small cartridges used singly or in multiple autoloader applications. Tape Drive Products - ------------------- Computer systems of all types increasingly need dedicated backup storage peripherals that combine high capacity, exceptional performance, low cost and reliability. Conner's full line of minicartridge, DAT and data cartridge tape products meets the needs of the entry, value, performance and portable markets to complement Conner's line of disk drive products. Minicartridge Tape Drives. Conner produces a number of low profile ------------------------- minicartridge tape drives which are designed to provide up to 250 megabytes of reliable data storage on a single low cost removable cartridge. These drives are currently manufactured for Conner in Japan. DAT Drives. High speed, networked computer environments need automatic ---------- data protection and backup in the form of dedicated removable storage peripherals that combine high capacity, absolute reliability, state-of-the-art backup performance and low cost per megabyte in a small form factor. The Conner family of True Computer Grade Digital Audio Tape (DAT) products provides a balance of these features, storing up to 8 gigabytes of data on a single 4mm cartridge. In addition, the Company offers DAT Autoloaders, which enable the storage of up to 96 gigabytes through an automated loading mechanism of up to 12 DAT tape cartridges in a single tape drive. Data Cartridge Drives. Conner Data Cartridge Drives provide high capacity --------------------- and field-proven data storage in a 5.25-inch, half-high form factor. These Data Cartridge drives are available in internal and external models with capacities ranging from 250 megabytes to 1.35 gigabytes, and provide high performance data storage using the industry standard Quarter Inch Cartridge (QIC) format that guarantees full backward read compatibility with previous generations of drives. SOFTWARE PRODUCTS - ----------------- Conner offers a variety of data protection and storage management software through Arcada Holdings, Inc. ("Arcada"), a majority-owned subsidiary. Arcada develops data protection and storage management software products that operate across multiple desktop and client-server environments, including those of Microsoft, Inc. and Novell, Inc. Arcada markets its products worldwide under the Backup Exec(TM) brand name to OEMs, systems integrators, VARs, retailers -- and large corporate users. Backup Exec for NetWare. Backup Exec for NetWare delivers sophisticated ----------------------- client/server based data protection for all servers and workstations on certain networks, including, DOS, Windows, OS/2, Apple Macintosh, and UNIX workstations as well as NetWare 3.x and 4.x, LAN Manager, LAN Server and Lotus Notes servers. Backup Exec is the first storage software certified by Novell for its new NetWare 4.x network operating system. Backup Exec is offered in single server, enterprise wide and Windows workstation editions. Backup Exec for Windows NT. Backup Exec for Windows NT is a 32-bit backup -------------------------- application created for Microsoft Windows NT which offers a comprehensive data storage solution for Windows NT workstations and servers operating in both local and wide area networks. STORAGE SYSTEMS - --------------- Conner Storage Systems integrates hardware and software solutions to allow consumers to meet the demanding requirements of the current mixed network environments. The products offered include those manufactured or developed by Conner, as well as integrated systems which include components or products of third parties. Storage Systems products address the entire storage solutions marketplace, including disk, optical, and tape subsystems and storage management software for local area networks and workstation environments. Conner Storage Systems products are marketed and sold to VARs and distributors for resale to large corporate users and financial institutions to manage their network storage and data protection needs. Storage Systems Products - ------------------------ From basic single-user needs to complex network storage requirements, Conner Storage Systems delivers turn-key solutions, coupled with customized service and support. Conner's Storage Systems products address the needs of users ranging from entry-level PCs to enterprise-wide network administrators. Conner MS Systems. Conner MS Systems disk and tape products offer data ----------------- storage and protection for networks including OS/2, DOS, Macintosh and Windows, workstations, and LAN Manager and NetWare servers. Conner MS Systems are supported by Conner's Backup Exec software. GENERAL SALES AND DISTRIBUTION - ------------------------------ The Company sells its disk and tape drive and software products principally to OEMs through a direct sales force. The Company focuses its sales efforts on manufacturers of desktop computers and workstations, as well as to manufacturers of portable computers and storage subsystems such as servers and arrays. Many of the Company's OEM customers enter into master purchase agreements with the Company. These agreements do not require the OEMs to purchase minimum quantities of the Company's products. Product deliveries are scheduled upon the Company's receipt of purchase orders under the related agreements. Generally, these purchase agreements also allow customers to reschedule delivery dates and cancel purchase orders under certain circumstances without significant penalties. Sales of the Company's disk drives to Compaq Computer Corporation ("Compaq") accounted for approximately 13%, 15% and 12% of the Company's net sales in 1993, 1992 and 1991, respectively. Sales to Peripherals Europe GmbH accounted for 12% of the Company's net sales in 1992. No other customer represented more than 10% of net sales for the three years ended December 31, 1993. The Company's sales to any single OEM customer are subject to significant variability from quarter to quarter based on a variety of factors including new product acceptance, price, end user demand, product availability and competitive offerings. The Company also sells products to non-OEM purchasers, such as distributors. Such sales represented 29%, 31% and 16% of net sales for the years ended December 31, 1993, 1992 and 1991, respectively. The Company's distributors typically enter into non-exclusive agreements for the distribution of the Company's products. Product deliveries are scheduled upon the Company's receipt of purchase orders. Certain of these agreements provide the distributors with price protection with respect to their inventory of drives and also provide limited rights to return the products. The Company also sells its products through VARs and has recently began to expand its marketing efforts to address different channels that sell computer systems through retailers that sell directly to end users. The Company's foreign sales are generally made directly, or through the Company's wholly-owned subsidiaries Peripherals Singapore or Conner Peripherals Europe. Sales to foreign customers may be subject to certain risks, including requirements for the obtaining of export/import licenses, exposure to tariffs and other trade regulations, currency fluctuations and repatriation of profits. The Company's foreign sales represented 54%, 61% and 64% of total net sales for 1993, 1992 and 1991, respectively. Backlog - ------- At December 31, 1993, the Company's backlog of orders was approximately $486 million as compared to a backlog of approximately $241 million (including Archive) at December 31, 1992. Backlog includes only those units for which a customer has specified delivery within six months. Demand for the Company's products is cyclical as the industry has recently experienced alternating periods of severe product shortages and significant overcapacity. During periods of product shortages, the Company's backlog has increased significantly and frequently reflects abnormal customer order patterns, including double ordering, as customers seek to insure the availability of products to support future production. During periods of overcapacity, the Company's backlog has declined precipitously as both OEM customers and distributors seek to reduce their inventories of disk drives or reduce their purchase commitments. During the first quarter of 1994, the Company has also experienced a significantly higher backlog due to increased demand for the Company's new disk drive products. The Company's backlog may fluctuate due to certain OEM practices of submitting single large purchase orders to be shipped over an extended period of time. Lead times for the release of purchase orders from other customers depend upon the scheduling practices of the customers, and the Company anticipates that the rate of new purchase orders will vary significantly from month to month. In addition, the Company's actual shipments depend on its production capacity and component availability. Moreover, the pricing of the Company's products as delivered often depends on the date of delivery as prices may be adjusted between the time an order is booked into backlog and the time the product is actually shipped. Based on its past experience and knowledge of the disk drive industry, the Company anticipates that it will experience significant volatility in the scheduling of present and future orders. For these reasons, the Company's backlog as of any particular date may not be indicative of the Company's actual sales for any succeeding fiscal period. Competition - ----------- The disk drive and tape drive industry is intensely competitive. The principal competitive factors in the industry are price, early product availability, product performance, storage capacity, low cost manufacturing, responsiveness to customers, and increasingly schedule predictability. The Company believes that it is currently able to compete on the basis of all of these factors. The Company believes that its reliance on outside vendors-- which is different from certain other companies in the industry that have become more vertically integrated -- has given it a competitive advantage both in establishing strong relationships with vendors and in permitting maximum flexibility in product design. The Company believes that competition in the OEM sector of the disk drive industry has become more intense as major disk drive manufacturers commit greater resources to the timely introduction of new products. The Company primarily competes against independent manufacturers of 2.5- inch and 3.5-inch disk drives, including companies such as Maxtor Corporation, Quantum Corporation, Seagate Technology, Inc. and Western Digital Corporation. The Company also competes indirectly with disk drive divisions of larger computer manufacturers such as Digital Equipment Corporation, The Hewlett- Packard Company, IBM and Toshiba. Should other major OEMs develop disk drive manufacturing capabilities, the demand for the Company's products would be reduced. The Company's principal competitors in tape drive products are Hewlett-Packard, Exabyte Corp. and Rexon, Inc. MANUFACTURING - ------------- The Company expects that it will continue to purchase a substantial majority of most components from outside sources. However, from time to time the Company may establish limited internal production of certain components, particularly during periods of supply constraints or when internal production capability may contribute to new product development efforts. For example, the Company is currently manufacturing the majority of its media requirements. The Company's disk drive manufacturing operations consist primarily of final assembly of heads and disks in a class-10 clean area as well as the formatting and testing of the assembly. Printed circuit boards are tested before they are assembled with head/disk assemblies into disk drives. After assembly, each disk drive is operated in a self-diagnostic mode where actual data transfers take place and various parameters in the disk drive are tested and adjusted specifically for that disk drive. The Company's testing procedures may vary depending upon the requirements of particular OEM customers. From time-to-time in the past, the Company has experienced production delays due to yield shortfalls and other production difficulties and the Company could experience similar delays in the future. Control and continuous improvement of process yields by both Conner and its suppliers are key determinants of manufacturing output and efficiency, product quality and reliability and overall profitability. Moreover, there can be no assurance that a defect will not escape identification in the factory and require costly recall from customer sites. The Company's business conditions require it to establish high-volume manufacturing capability in anticipation of market demand. The Company's ability to establish high-volume, low-cost manufacturing capacity depends in part on its ability to obtain uninterrupted access to advanced technology components in required volumes and at competitive prices. At the present time, certain of these components are available only from single sources, although the Company maintains ongoing programs to qualify additional sources for such components where practicable. In particular, the Company has recently experienced shortages of certain semiconductor and head components, which shortage has adversely affected the Company's sales and ability to satisfy customer demand in recent periods. There can be no assurance that these supply constraints will not recur. To reduce its exposure to production delays at times of component shortage, the Company often seeks to qualify alternative components when practicable. However, a prolonged interruption, or a reduction in the supply of one or more key components, could nevertheless occur and would adversely affect the Company's operating results and customer relationships. As part of an effort to improve manufacturing costs, the Company continues to shift volume production of its disk drives to Singapore and Malaysia. The Company is currently expanding its Malaysia production facilities and is consolidating its Singapore operations. The Company also began in December 1992 to manufacture in the People's Republic of China through Conner-Shenzhen Peripherals, Ltd., a joint venture with Shenzhen CPC. Through this venture, Conner became the first company to establish disk drive manufacturing in the People's Republic of China. The expansion of production in offshore facilities requires tight inventory and cost controls and employee training. In addition, the transfer of production of a product to a new facility requires qualification of the facility by certain of the Company's major OEM customers. Accordingly, such transfers may have a short-term disruptive effect on the Company's operations. Foreign manufacturing is also subject to certain risks, including changes of governmental policies, transportation delays and interruptions and the imposition of tariffs and import and export controls. There are also risks inherent in being the first company to manufacture disk drives in the People's Republic of China. Furthermore, currency exchange fluctuations could increase the cost of components manufactured abroad. A significant portion of Conner's tape drive manufacturing is done by one outside vendor, Matsushita Kotubuki Electronics ("MKE"). Conner also manufactures and/or assembles some of its own tape drive products at its Singapore facility. Conner has consolidated its existing Singapore facilities with those of Archive. RESEARCH AND DEVELOPMENT - ------------------------ The Company participates in an industry that is subject to rapid technological changes, and its ability to remain competitive depends on, among other things, its ability to maintain a leadership position in technology innovation. As a result, the Company has devoted and will continue to devote substantial resources to product development and process engineering efforts. In 1993, 1992 and 1991 the Company's research and development expenses were $137,465,000, $94,652,000 and $85,007,000, respectively. The Company's research and development expenses have increased substantially in the past year as the Company has expanded prototype production and testing associated with the planned introduction of several new products and technologies. The Company's current research and development efforts are principally directed to the development and prototype production of new high performance 3.5-inch and 2.5-inch disk drives. Disk drives currently in development employ more complex designs and a greater number of technologically advanced components than previous disk drive generations. Accordingly, it is possible that it will be more difficult to introduce these disk drives to volume manufacturing than was the case with previous disk drive generations. The Company's disk drive research and new product development is conducted primarily at its facilities in San Jose, California and Longmont, Colorado. The Company's process engineering and final product development is conducted principally in San Jose and at its facilities in Singapore. PATENTS AND LICENSES - -------------------- The Company has been granted or has acquired 31 United States patents and has approximately 65 patent applications pending related to disk drive technology. The Company's issued patents include a patent covering the Company's microprocessor and microcode based architecture, and a patent covering the self-testing diagnostic features incorporated in its disk drives. In addition, the Company has been granted a patent covering its brushless motor design and a patent covering certain mechanical design features of its low profile drives, including various design features related to the one-inch high form factor. The Company has obtained or applied for a variety of additional patents relating to other aspects of its drives, including certain features used in achieving the low power functionalities of its disk drives which are important for laptop and notebook applications, as well as certain desktop applications. The Company has also acquired or been granted 80 United States patents, and has approximately 25 patent applications pending, as part of the Archive acquisition in December 1992 which relate to tape drive designs or technologies. In addition to patent protection, the Company relies on the laws of unfair competition, copyright and trade secrets to protect its proprietary rights. The Company believes that its technological know-how and abilities, protectable on these bodies of law, are equally important to its business as technical innovations subject to patent protection. As is typical in the disk drive industry, Conner has from time to time been notified that it may be infringing certain patents and other intellectual property rights of others, and the Company is engaged in several patent infringement lawsuits, both as plaintiff and defendant. Although the Company may offer licenses in connection with these claims, there can be no assurance that such claims will not result in litigation in the future regarding patents, mask works, copyrights, trademarks or trade secrets, or that any licenses or other rights can be obtained on acceptable terms. See "Legal Proceedings." FACTORS AFFECTING EARNINGS AND STOCK PRICE - ------------------------------------------ In the past, the Company's sales and earnings have experienced significant fluctuations due to precipitous changes in industry demand, product cycles and pricing pressures. During 1993, the Company experienced substantial losses as a result of distribution problems in Europe, new product introduction delays and severe competition across all the Company's product lines. Although the Company has successfully introduced a range of new disk drive and tape drive products since then, there can be no assurance that the Company will not again experience these problems in the future. In addition, there can be no assurance that the Company will succeed in ramping production of new products in time to take advantage of customer demand or that the Company will achieve profitable operations in any given period or fiscal quarter. Due to the volatility in the Company's business, the Company expects that its stock price will continue to be subject to significant fluctuations. The Company's stock price could decline precipitously due to unsubstantiated rumors or to actual short-term performance that fails to meet analysts' expectations for sales or net income. Investors in the Company's securities must be willing to accept the risk of such fluctuations and stock price volatility. EMPLOYEES - --------- At December 31, 1993, the Company had 9,097 employees, of whom 817 were in research and development or process development engineering; 395 were in marketing, sales and service; 584 were in general administration; and 7,301 were in operations, with 4,851 in direct labor and the remainder in quality assurance, test and manufacturing engineering, procurement and material management and production management. None of the Company's employees, except those in Italy, are represented by a labor union. The Company believes that its relationship with its employees is satisfactory. Item 2.		Item 2. PROPERTIES ---------- Facilities - ---------- The following table sets forth information concerning the principal operating facilities of the Company as of December 31, 1993: The Company believes that it may require additional facilities in the United States to address its near term space requirements and expects to be able to lease such facilities on a short term basis, although there is no assurance such short term leases will be available at attractive rates. Item 3.	Item 3. LEGAL PROCEEDINGS ----------------- The Company and certain officers and directors are defendants in a securities class action lawsuit which purports to represent a class of investors who purchased or otherwise acquired the Company's common stock between January 1992 and May 1993. Certain officers and directors are also defendants in a related shareholders derivative suit. Both complaints seek unspecified damages and other relief. The Company intends to defend the actions vigorously. In August 1993, the Company was served with a patent infringement complaint filed by IBM in the United States District Court for the Northern District of California. The complaint alleges that products manufactured by the Company have infringed nine patents owned by IBM. In addition, the complaint seeks declaratory relief to the effect that drives produced by IBM do not infringe five patents held by the Company and seeks to have such patents declared invalid. The Company answered the complaint, denying all material allegations and counter claiming that IBM disk drives infringe six patents owned by Conner, including the five contained in the IBM complaint. The Company believes that it has meritorious defenses against these allegations, that it has valid claims against IBM and will defend this action vigorously. However, the Company is unable to predict the outcome of the litigation or ultimate effect, if any, on its operations or financial condition. Regardless of the merits of the respective patent claims, the Company believes that the existence of the IBM litigation could have an adverse effect on its business and expects that this litigation will require the Company to incur significant costs and uncertainty, including substantial legal expenses. Although the Company has engaged in continuous discussions with IBM toward an appropriate cross-licensing arrangement, no assurance can be given as to the outcome of the litigation or settlement negotiations. In February 1992, the Company filed a patent infringement lawsuit against Western Digital Corporation ("Western Digital") alleging the infringement of five of the Company's patents by Western Digital. The suit is currently pending in the Northern District of California. Shortly after the commencement of this action, Western Digital filed a claim in the Central District of California alleging infringement of one patent by the Company. Subsequently, Western Digital amended its claim to assert infringement by the Company of two additional disk drive patents. The Western Digital complaint has been transferred to the Northern District of California. Although the Company believes it has valid claims against Western Digital and meritorious defenses to the claims asserted by Western Digital, there can be no assurance as to the outcome of this litigation or that the Company will prevail in its claims and defenses. Item 4.	Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS --------------------------------------------------- Not applicable. PART II Item 5.	Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS --------------------------------------------------------------------- Information regarding the market for the Registrant's common equity and related stockholder matters is set forth under the heading "Consolidated Statements of Stockholders' Equity" on page 18 and under the heading "Market Price of Common Stock" on the inside back cover of the Annual Report, which sections are incorporated herein by reference. Item 6.	Item 6. SELECTED FINANCIAL DATA ----------------------- Information regarding selected financial information is set forth under the headings "Consolidated Statement of Operations Data," "Consolidated Balance Sheet Data," and "Summary Quarterly Data" on page 8 of the Annual Report, which sections are incorporated herein by reference. Item 7.	Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND --------------------------------------------------------------- RESULTS OF OPERATIONS --------------------- Information regarding management's discussion and analysis of financial condition and results of operations is set forth under the heading "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 9-14 of the Annual Report, which section is incorporated herein by reference. Item 8.	Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ------------------------------------------- Consolidated Financial Statements of the Company at January 1, 1994 and January 2, 1993, and for each of the three fiscal years in the period ended January 1, 1994 and the report of independent accountants therein, as well as the Company's unaudited quarterly financial information for the two-year period ended January 1, 1994 is set forth on pages 15 through 29 and on page 8 of the Annual Report, which sections are incorporated herein by reference. Item 9.	Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND --------------------------------------------------------------- FINANCIAL DISCLOSURE -------------------- Not applicable. PART III Certain information required by Part III is omitted from this Report on Form 10-K in that the Company has filed a definitive proxy statement pursuant to Regulation 14A with respect to the Annual Meeting of Stockholders to be held April 19, 1994 (the "Proxy Statement") with the Securities and Exchange Commission and certain information included therein is incorporated herein by reference. Item 10.	Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT -------------------------------------------------- The information required by this Item is incorporated by reference to the information under the caption "PROPOSAL NO. 1-- ELECTION OF DIRECTORS" in the Proxy Statement. The information concerning executive officers of the Company is incorporated by reference to the information under the caption "Proposal No. 1--ELECTION OF DIRECTORS" and under the caption "OTHER INFORMATION--Executive Officers" in the Proxy Statement. Item 11.	Item 11. EXECUTIVE COMPENSATION ---------------------- The information required by this Item is incorporated by reference to the information under the captions "EXECUTIVE OFFICER COMPENSATION--Summary Compensation Table," "--Option Grants in Last Fiscal Year", and "--Aggregate Option Exercises in Last Fiscal Year and Fiscal Year End Option Values" in the Proxy Statement. Item 12.	Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT -------------------------------------------------------------- The information required by this Item is incorporated by reference to the information under the caption "OTHER INFORMATION-- Share Ownership by Principal Stockholders and Management" in the Proxy Statement. Item 13.	Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS ---------------------------------------------- The information required by this Item is incorporated by reference to the information under the captions "CERTAIN TRANSACTIONS" and "EXECUTIVE COMPENSATION--Compensation Committee Interlocks and Insider Participation" in the Proxy Statement. PART IV Item 14.	Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K ---------------------------------------------------------------- (a) The financial statements listed in the following index to consolidated financial statements are filed as part of this Annual Report on Form 10-K. Page in 1. Financial Statements Annual Report ------------- Consolidated Balance Sheets at December 31, 1993 15 and December 31, 1992 Consolidated Statements of Operations for the 16 three years ended December 31, 1993 Consolidated Statements of Cash Flows for the 17 three years ended December 31, 1993 Consolidated Statement of Stockholders' Equity 18 for the three years ended December 31, 1993 Notes to Consolidated Financial Statements 19 Report of Independent Accountants 29 2. Financial Statement Schedules Schedule Description Page ---------- ----------------------------------- ---- I Marketable Securities - Other S-1 Investments VIII Valuation and Qualifying Accounts S-2 Report of Independent Accountants S-3 Schedules not listed above have been omitted because they are either inapplicable or the required information has been provided in the financial statements or notes thereto. 3. Exhibits Refer to (c) below. (b) Reports on Form 8-K No reports on Form 8-K were filed on behalf of Registrant during the quarter ended January 1, 1994. (c) Exhibits ______________________ (1) Incorporated by reference to exhibit filed with Registration Statement No. 33-26831. (2) Incorporated by reference to exhibit filed with Registrant's Report on Form 10-K for the fiscal year ended December 31, 1989. (3) Incorporated by reference to exhibit filed with Registrant's Report on Form 10-K for the fiscal year ended December 31, 1990. (4) Incorporated by reference to exhibit filed with Registrant's Report on Form 10-K for the fiscal year ended December 31, 1991. (5) Incorporated by reference to exhibit filed with Registrant's Registration Statement No. 33-46886. (6) Incorporated by reference to exhibit filed with Registrant's Form 8-B filed with the Securities and Exchange Commission on September 9, 1992. (7) Incorporated by reference to exhibit filed with the Tender Offer Statement on Schedule 14D-1, as amended, of Conner Acquisition Corporation and Conner Peripherals, Inc., filed with the Securities and Exchange Commission on November 24, 1992. (8) Incorporated by reference to exhibit filed with Registrant's Registration Statement No. 33-56878. (9) Incorporated by reference to exhibit filed with Registrant's Report on Form 10-K for the fiscal year ended December 31, 1992. ___________________________ * Denotes a management contract or compensatory plan or arrangement. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of San Jose, State of California, on the 30th day of March, 1994. CONNER PERIPHERALS, INC. By: /s/ P. Jackson Bell ----------------------------------------- P. Jackson Bell, Executive Vice President and Chief Financial Officer POWER OF ATTORNEY KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints David T. Mitchell and Finis F. Conner and each of them, his or her attorneys-in-fact, each with full power of substitution, for him or her in any and all capacities, to sign on behalf of the undersigned any amendments to this Report on Form 10-K and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, and each of the undersigned does hereby ratify and confirm all that each of said attorneys-in-fact, or his substitute or substitutes, may do or cause to be done by virtue hereof. 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. /s/ Finis F. Conner ------------------------- Chairman of the Board March 30, 1994 (Finis F. Conner) of Directors and Chief Executive Officer (Principal Executive Officer) /s/ David T. Mitchell ------------------------- President, Chief March 30, 1994 (David T. Mitchell) Operating Officer and Director /s/ William J. Schroeder ------------------------- Vice Chairman and March 30, 1994 (William J. Schroeder) Director Director March __, 1994 - ------------------------- (John P. Squires) /s/ P. Jackson Bell - ------------------------- Executive Vice President March 30, 1994 (P. Jackson Bell) and Chief Financial Officer (Principal Financial and and Accounting Officer) /s/ William S. Anderson Director March 30, 1994 - ------------------------- (William S. Anderson) /s/ Mark Rossi Director March 30, 1994 - ------------------------- (Mark Rossi) /s/ Linda Wertheimer Hart Director March 30, 1994 - ------------------------- (Linda Wertheimer Hart) /s/ L. Paul Bremer Director March 30, 1994 - ------------------------- (L. Paul Bremer) /s/ Roger S. Penske Director March 30, 1994 - ------------------------- (Roger S. Penske) CONNER PERIPHERALS, INC. 1993 Annual Report on Form 10-K Index to Financial Statement Schedules CONNER PERIPHERALS, INC. ------------------------ SCHEDULE I--MARKETABLE SECURITIES--OTHER INVESTMENTS S-1 CONNER PERIPHERALS, INC. ------------------------ SCHEDULE VIII--VALUATION AND QUALIFYING ACCOUNTS - ----------------------------- /1/ Charged to Other Accounts in 1992 includes reserves relating to Archive Corporation. S-2 REPORT OF INDEPENDENT ACCOUNTANTS ON ------------------------------------ FINANCIAL STATEMENT SCHEDULES ----------------------------- To the Board of Directors of Conner Peripherals, Inc. Our audits of the consolidated financial statements referred to in our report dated January 20, 1994 appearing on page 29 of the 1993 Annual Report to Stockholders of Conner Peripherals, Inc. (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the Financial Statement Schedules listed in item 14(a) of this Form 10-K. In our opinion, these Financial Statement Schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. /s/ PRICE WATERHOUSE Price Waterhouse San Jose, California January 20, 1994 S-3 CONNER PERIPHERALS, INC. 1993 Annual Report on Form 10-K Index to Exhibits Number Description - ------ -----------
789895_1993.txt	789895	1993	Item 1. Business The principal objectives of Polaris Aircraft Income Fund II (PAIF-II or the Partnership) are to purchase and lease used commercial jet aircraft in order to provide quarterly distributions of cash from operations, to maximize the residual values of aircraft upon sale and to protect Partnership capital through experienced management and diversification. PAIF-II was organized as a California limited partnership on June 27, 1984 and will terminate no later than December 2010. PAIF-II has many competitors in the aircraft leasing market, including airlines, aircraft leasing companies, other limited partnerships, banks and several other types of financial institutions. This market is highly competitive and there is no single competitor who has a significant influence on the industry. In addition to other competitors, the general partner, Polaris Investment Management Corporation (PIMC), and its affiliates, including Polaris Aircraft Leasing Corporation (PALC), Polaris Holding Company (PHC) and GE Capital Corporation (GE Capital), acquire, lease, finance and sell aircraft for their own accounts and for existing aircraft- leasing programs sponsored by them. Accordingly, in seeking to re-lease and sell its aircraft, the Partnership may be in competition with the general partner and its affiliates. A brief description of the aircraft owned by the Partnership is set forth in Item 2, on page 4. The following table describes the material terms of the Partnership's leases as of December 31, 1993 to Northwest Territorial Airways, Ltd. (NWT), Trans World Airlines, Inc. (TWA), Viscount Air Services, Inc. (Viscount) and Continental Micronesia, Inc. (Continental Micronesia): (1) The rental rate during the renewal term remains the same as the current rate unless otherwise noted. (2) This aircraft was previously on lease to Air Zaire, Inc. (Air Zaire). The aircraft was re-leased at approximately 45% of the prior rental rate through February 1993, then extended through December 1993 at 80% of the previous rental rate, and again extended through March 1994 at the same rental rate. The Partnership is currently remarketing this aircraft for sale or re-lease. (3) TWA may specify a lease expiration date for each aircraft up to six months before the date shown, provided the average date for the 16 aircraft is February 1998, and the average expiration date for the remaining two aircraft is November 1998. The TWA leases were modified in 1991. The leases for the 16 aircraft were extended for an aggregate of 75 months beyond the initial lease expiration date in November 1991 at approximately 46% of the original lease rates. The leases for the remaining two aircraft were extended for 72 months beyond the initial lease expiration dates in November 1992 at approximately 42% of the original lease rates. The Partnership also agreed to share in the costs of certain Airworthiness Directives (ADs). If such costs are incurred by TWA, they will be credited against rental payments, subject to annual limitations with a maximum of $500,000 per aircraft over the lease terms. On January 31, 1992, TWA commenced reorganization proceedings under Chapter 11 of the federal Bankruptcy Code as discussed further in Note 7 to the financial statements of the Partnerships 1993 Annual Report to the Securities and Exchange Commission on Form 10-K (Form 10-K) (Item 8). TWA emerged from bankruptcy protection in November 1993. TWA has affirmed all of the Partnership's aircraft leases. (4) This aircraft was previously on lease to SABA Airlines, S.A. (SABA). The lease rate is approximately 56% of the prior lease rate. (5) The aircraft currently leased to Continental Micronesia were previously on lease to Alaska Airlines, Inc. (Alaska). The lease rate is approximately 55% of the prior lease rate. The lease stipulates that the Partnership will reimburse costs for cockpit modifications up to $600,000 per aircraft, C-check labor costs up to $300,000 per aircraft and the actual cost of C-check parts for two of the aircraft. In addition, the Partnership will provide financing up to $815,000 for new image modifications to be repaid with interest over the lease term for each aircraft. The Partnership also owns one Boeing 727-200 aircraft formerly leased to Delta Airlines, Inc. (Delta), which is currently being remarketed for sale or lease, and six Boeing 727-200 aircraft, formerly leased to Pan American World Airways, Inc. (Pan Am), which were transferred to aircraft inventory and have been disassembled for sale of their component parts. Approximately 700 commercial aircraft are currently available for sale or lease. The current surplus has negatively affected market lease rates and fair market values of both new and used aircraft. Current depressed demand for air travel has limited airline expansion plans, with new aircraft orders and scheduled delivery being cancelled or substantially deferred. As profitability has declined, many airlines have opted to downsize, liquidate assets or file for bankruptcy protection. The Partnership has been forced to adjust its estimates of the residual values realizable from its aircraft and aircraft inventory, which resulted in an increase in depreciation expense in 1993, 1992 and 1991, as discussed in Note 3 to the financial statements of the Form 10-K (Item 8). A discussion of the current market condition for the type of aircraft owned by the Partnership follows: Boeing 727-200 and Boeing 727-200 Advanced The Boeing 727 was the first tri-jet introduced into commercial service. The Boeing 727 is a short to medium range jet used for trips of up to 1,500 miles. The Boeing 727-200 aircraft was introduced in 1967 and 299 were built between 1967 and 1972. In 1972, Boeing introduced the Boeing 727-200 Advanced model, a higher gross weight version with increased fuel capacity. Noise suppression hardware, commonly known as a "hushkit," has been developed which, when installed on the aircraft, bring the Boeing 727-200 and the Boeing 727-200 Advanced into compliance with Federal Aviation Administration (FAA) Stage 3 noise limits. The cost of the hushkit is approximately $1.75 million for the Boeing 727-200 aircraft and approximately $2.5 million for the Boeing 727-200 Advanced aircraft. However, while technically feasible, hushkits may not be cost effective on all aircraft due to the age of some of the aircraft and the time required to fully amortize the additional investment. Certain ADs applicable to all models of the Boeing 727 have been issued to prevent fatigue cracks and control corrosion. Demand for Boeing 727-200 aircraft is currently very soft due to the general oversupply of narrowbody aircraft. Boeing 737-200 The Boeing 737-200 aircraft was introduced in 1967 and 950 were delivered from 1967 through 1971. This two-engine, two-pilot aircraft provides operators with 107 to 120 seats, meeting their requirements for economical lift in the 1,100 nautical mile range. A domestic company is selling hushkits that bring Boeing 737-200 aircraft into compliance with Stage 3 noise restrictions at a cost of approximately $3.0 million per aircraft. The market for this type of aircraft, as for all Stage 2 narrowbody aircraft, is currently soft. McDonnell Douglas DC-9-30/40 The McDonnell Douglas DC-9-30/40 is a short to medium range twin-engine jet that was introduced in 1967. Providing reliable, inexpensive lift, these aircraft fill thin niche markets, mostly in the United States. Hushkits are available to bring these aircraft into compliance with Stage 3 requirements at a cost of approximately $1.6 million per aircraft. The market for this type of aircraft, as for all Stage 2 narrowbody aircraft, is currently soft. It is expected that the FAA will continue to propose and adopt ADs similar to those discussed above for the Boeing 737s and Boeing 727s, which will require modifications at some point in the future to prevent fatigue cracks and control corrosion. Likewise demand, and hence value, of the aircraft may be diminished to the extent that the costs of bringing McDonnell Douglas DC-9 aircraft into compliance with any ADs reduces the economic efficiency of operating these aircraft. The general partner believes that the current soft market reflects, in addition to the factors cited above, the airline industry's reaction to the significant expenditures potentially necessary to bring these aircraft into compliance with certain ADs issued by the FAA relating to aging aircraft, corrosion prevention and control and structural inspection and modification. Item 2.		Item 2. Properties PAIF-II owns one Boeing 727-200 aircraft formerly leased to Delta, one Boeing 737-200 Combi aircraft leased to NWT, 17 McDonnell Douglas DC-9-30 and one McDonnell Douglas DC-9-40 aircraft leased to TWA, one Boeing 737-200 aircraft leased to Viscount and three Boeing 727-200 Advanced aircraft leased to Continental Micronesia. All leases are operating leases. The Partnership also owns six Boeing 727-200 aircraft, previously leased to Pan Am, which were transferred to aircraft inventory and have been disassembled for sale of their component parts. The following table describes the Partnership's aircraft portfolio in greater detail: Cycles Year of As of 10/31/93 Aircraft Type Serial Number Manufacture (1) Boeing 727-200 19455 1968 52,704 Boeing 727-200 19459 1968 (2) Boeing 727-200 19463 1968 (2) Boeing 727-200 19466 1968 (2) Boeing 727-200 19471 1968 (2) Boeing 727-200 19472 1968 (2) Boeing 727-200 19473 1968 (2) Boeing 727-200A 21426 1977 28,474 Boeing 727-200A 21427 1977 27,212 Boeing 727-200A 21947 1979 23,694 Boeing 737-200 19609 1968 61,119 Boeing 737-200C 19743 1969 62,494 McDonnell Douglas DC-9-30 47082 1967 70,218 McDonnell Douglas DC-9-30 47096 1967 70,722 McDonnell Douglas DC-9-30 47135 1968 71,371 McDonnell Douglas DC-9-30 47137 1968 70,681 McDonnell Douglas DC-9-30 47249 1968 76,783 McDonnell Douglas DC-9-30 47251 1968 75,042 McDonnell Douglas DC-9-30 47343 1969 73,960 McDonnell Douglas DC-9-30 47345 1969 72,112 McDonnell Douglas DC-9-30 47411 1969 69,464 McDonnell Douglas DC-9-30 47412 1969 69,498 McDonnell Douglas DC-9-30 47027 1967 75,530 McDonnell Douglas DC-9-30 47107 1968 75,265 McDonnell Douglas DC-9-30 47108 1968 72,136 McDonnell Douglas DC-9-30 47174 1968 72,821 McDonnell Douglas DC-9-30 47324 1969 69,540 McDonnell Douglas DC-9-30 47357 1969 68,853 McDonnell Douglas DC-9-30 47734 1977 39,957 McDonnell Douglas DC-9-40 47617 1975 38,514 (1) Cycle information as of 12/31/93 is not yet available. (2) Transferred to aircraft inventory and disassembled for sale of component parts. Item 3.	Item 3. Legal Proceedings Air Zaire In 1991 the Partnership commenced legal proceedings in Belgium and the United States against Air Zaire related to Air Zaire's breach of the lease of a Boeing 737-200 Convertible Freighter aircraft. The Partnership has recovered approximately $2,885,000 in damages. Settlement has been performed in full and the litigation has been terminated. Braniff, Inc. (Braniff) Bankruptcy On July 27, 1992, the Bankruptcy Court approved a stipulation embodying a settlement among PIMC, on behalf of the Partnership, the Braniff Creditor committees and Braniff in which it was agreed that First Security Bank of Utah, National Association, acting as trustee for the Partnership, would be allowed an administrative claim in the bankruptcy proceeding of approximately $230,769. The Partnership has received a check from the Bankruptcy estate in full payment of the allowed administrative claim, subject, however, to the requirement of the stipulation that 25% of such proceeds be held by PIMC in a separate, interest-bearing account pending notification by Braniff that all the allowed administrative claims have been satisfied. The Partnership recognized 75% of the total claim in the statement of operations in 1992. As of the end of 1993, the Partnership had not been advised that the 25% portion of the administrative claim payment could be released or that any disposition of the Partnership's general claim in bankruptcy was being considered. TWA TWA has submitted a plan of reorganization which was approved by the Bankruptcy Court and became effective November 3, 1993. TWA has affirmed all of the Partnership's aircraft leases. Prudential Securities Incorporated (Prudential) Settlement - On October 21, 1993, the U.S. Securities and Exchange Commission announced a settlement with Prudential of an administrative proceeding alleging violations of the anti- fraud provisions of the federal securities laws. It is our understanding that, in connection with this settlement, Prudential has agreed to establish certain claim resolution procedures and expedited arbitration procedures for persons with claims against Prudential arising from their purchase of various limited partnership interests through Prudential. Information regarding the Prudential settlement and claims procedures may be obtained by calling toll- free 1-800-774-0700. Other Proceedings - Item 10 discusses certain actions which have been filed against the general partner in connection with certain public offerings, including that of the Partnership. With the exception of Novak, et al v. Polaris Holding Company, et al, where the registrant is named as a nominal defendant, the registrant is not a party to these actions. Item 4.	Item 4. Submission of Matters to a Vote of Security Holders None. PART II Item 5.	Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters a) PAIF-II's limited partnership interests (Units) are not publicly traded. Currently there is no market for PAIF-II's Units and it is unlikely that any market will develop. b) Number of Security Holders: Number of Record Holders Title of Class as of December 31, 1993 Limited Partnership Interest: 16,506 General Partnership Interest: 1 c) Dividends: The Partnership distributed cash to partners on a quarterly basis beginning July 1986. Cash distributions to limited partners during 1993 and 1992 totalled $9,999,940 and $12,499,925, respectively. Cash distributions per limited partnership unit were $20.00 and $25.00 in 1993 and 1992, respectively. Item 7.		Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Polaris Aircraft Income Fund II (PAIF-II or the Partnership) owns a portfolio of 24 used commercial jet aircraft. The portfolio consists of one Boeing 737-200 Combi aircraft leased to Northwest Territorial Airways, Ltd. (NWT), 17 McDonnell Douglas DC-9-30 aircraft and one McDonnell Douglas DC-9-40 aircraft leased to Trans World Airlines, Inc. (TWA), one Boeing 737-200 aircraft leased to Viscount Air Services, Inc. (Viscount) and three Boeing 727-200 Advanced aircraft leased to Continental Micronesia, Inc. (Continental Micronesia). The Partnership also owns one Boeing 727-200 aircraft, formerly leased to Delta Airlines, Inc. (Delta) which is being remarketed for sale or lease, and six Boeing 727-200 aircraft, previously leased to Pan American World Airways, Inc. (Pan Am), which were transferred to aircraft inventory and have been disassembled for sale of their component parts. Partnership Operations For the year ended December 31, 1993, the Partnership recorded net income of $48,114, or an allocated net loss of $1.91 per limited partnership unit, a significant improvement over net losses of $1,709,007 and $1,596,956, or $5.88 and $6.66 per limited partnership unit, for the years ended December 31, 1992 and 1991 respectively. The losses in 1992 and 1991 resulted primarily from adjustments to depreciation expense for declines in estimates of the residual values realizable from the Partnership's aircraft, reflecting industry-wide declines in demand, as discussed in the industry update section. Depreciation adjustments for 1992 and 1991 were approximately $5.8 million and $13.7 million, respectively, compared to $300,000 in 1993. Rental revenues, net of related management fees, continued to decline in 1993 as compared to 1992 and 1991 due to lower lease rates following the lessee defaults and bankruptcy filings discussed in the following sections. The Partnership received lower revenue from TWA at the renegotiated lease rates during 1993 than in 1992 (1992 revenues included two months at the higher pre-bankruptcy rates, whereas all rent from TWA in 1993 is at the lower renegotiated rates). No rental revenue was earned on six of the former Pan Am aircraft during 1993 and 1992, compared to income for nine and one-half months in 1991. The Partnership's two Boeing 727-200 Advanced aircraft formerly on lease to Alaska Airlines, Inc. (Alaska) were re-leased in April and May 1993 to Continental Micronesia at approximately 55% of the prior rate with Alaska. The Boeing 727-200 formerly leased to Delta from September 1991, was returned to the Partnership in September 1993. Partially offsetting these rental reductions are 1993 revenues from Viscount and NWT leases on aircraft that were idle for much of 1992. During 1993, the Partnership sold one of its hushkit sets at a gain of approximately $260,000, one used engine which resulted in a loss of approximately $375,000, and two additional hushkit sets which resulted in a loss of approximately $398,000. This resulted in a net loss of approximately $513,000 for 1993. No equipment sales were concluded in 1992 or 1991. The Air Zaire, Inc. (Air Zaire) settlement was finalized during 1993. Of the approximately $2.9 million that the Partnership received from Air Zaire, approximately $1.6 million was applied to legal and maintenance expenses relating to the lessee default and approximately $915,000 was reflected as other income in the statement of operations of the Form 10-K (Item 8) during 1993. The balance of $400,000 is included in maintenance reserve at December 31, 1993. The lessee defaults as described below also resulted in higher administrative, operating and remarketing expenses, particularly in 1992. During the off-lease period, the Partnership bears the operating costs of all routine expenses associated with the aircraft, including storage, insurance and maintenance, in addition to non-routine costs to prepare the aircraft for re-lease. In 1992, the Partnership incurred substantial operating costs for maintenance and remarketing of the Boeing 737-200 aircraft prior to its lease to Viscount, and for costs associated with the disassembly of the former Pan Am aircraft. In 1993, the Partnership's operating expenses increased from 1992 due primarily to expenses incurred relating to the TWA and Continental Micronesia cost sharing agreements as discussed later. Liquidity and Cash Distributions Liquidity The Partnership continues to receive all the lease payments due from NWT, TWA, Viscount and Continental Micronesia in a timely manner, and has received all payments due from Alaska and Delta through their lease terminations. During 1993, payments of $1,169,483 have been received from sales of parts from the disassembled aircraft. Cash reserves of approximately $13.5 million as of December 31, 1993 will be retained to cover potential costs of maintaining and remarketing the Partnership's off-lease aircraft in addition to meeting obligations under the TWA and Continental Micronesia lease agreements. In accordance with the TWA cost sharing arrangement described later, during 1993, TWA offset expenses for Airworthiness Directives (ADs) against rental payments due the Partnership totalling $2.7 million. TWA may offset rent up to an additional amount of $6.3 million, subject to limitations over the lease terms. In accordance with the Continental Micronesia cost sharing agreement as discussed in Note 3 to the financial statements of the Form 10-K (Item 8), in January 1994, the Partnership reimbursed Continental Micronesia $1.8 million for cockpit modifications and $742,325 for C-check labor and parts. In addition, the Partnership financed $2,177,533 for new image modifications to be repaid with interest over the lease terms of the aircraft. Cash Distributions The cash distributed to limited partners during 1993 totalled $9,999,940, or $20.00 per limited partnership unit, reduced from $12,499,925 or $25.00 per unit in 1992. This reduction reflects the lower cash available for distribution resulting from the lower renegotiated NWT, Continental Micronesia and Viscount lease rates following the lessee defaults and the termination of the Alaska leases discussed in later sections. The timing and amount of future cash distributions will depend on the general partners' success in remarketing the off-lease aircraft, including the NWT Boeing 737-200 Combi aircraft scheduled to return from lease in March 1994, receipt of rental payments, payments generated from sales of parts of the six disassembled aircraft and the Partnership's future cash requirements. Pan Am Lease Modification and Termination In July 1990, the Partnership and Pan Am signed an amendment to their original lease agreement which (i) extended the scheduled lease termination dates; (ii) obligated the Partnership to pay for hushkit modification of the seven aircraft; (iii) required Pan Am to pay supplemental rent to the Partnership after each hushkit was installed; and (iv) required the Partnership to share in the cost of compliance with certain aging aircraft ADs, up to a cost of $500,000 per aircraft. The Partnership paid $415,444 in 1991 to reimburse Pan Am for work done under such ADs and reported that amount as aircraft improvements on the accompanying balance sheets. Four of the seven hushkit modifications were installed in 1990 for a total cost of $7,082,576, financed by the proceeds of a loan from a related party, as discussed in Note 9 to the financial statements of the 1993 Form 10-K (Item 8), and cash reserves. The remaining three hushkits were not installed due to market conditions and Pan Am's bankruptcy filing as described below. Pan Am commenced reorganization proceedings under Chapter 11 of the federal Bankruptcy Code in January 1991. Subsequently, the Partnership and Pan Am agreed to renegotiated lease rates of approximately 75% of the original rates and Pan Am paid rent through mid-September 1991. Pan Am's reorganization under Chapter 11 was ultimately unsuccessful, and Pan Am ceased operations in December 1991. Delta had leased one of the former Pan Am aircraft, including a hushkit, until September 1993 and the remaining six aircraft have been disassembled for sale of their component parts as discussed below. Three hushkits removed from the disassembled aircraft have been sold as discussed below. Sale of Equipment One hushkit set from the aircraft formerly leased to Pan Am was sold in January 1993 to ALG, Inc. (ALG) for $1,750,000, which resulted in a $259,809 gain. ALG paid cash for a portion of the price and issued an interest- bearing promissory note for the balance of $1,132,363, which specifies 23 equal payments and a balloon payment due in January 1995. During 1993, the partnership received all payments due under the note. The note balance as of December 31, 1993 was $1,022,308. In September 1993, two additional hushkit sets from the disassembled Pan Am aircraft were sold to Emery Worldwide Airlines for $1,250,000 each, which resulted in a $398,192 loss. The decline in sales price from the previous hushkit sale in January 1993 reflects a softening market for this equipment. The Partnership sold one used engine, removed from the Partnership's Boeing 737-200 aircraft, to International Aircraft Support, L.P. in July 1993 for $85,000, which resulted in a $375,012 loss. The engine, along with its airframe, was repossessed from the former lessee, SABA Airlines, S.A. (SABA), in February 1992. At the time of its default, SABA had not maintained the aircraft as required under the lease agreement, rendering the engine inoperable. The Partnership determined the costs to repair the engine were excessive in comparison to amounts recoverable from sale or lease. As a result, the engine was sold for its component parts. Disassembly of Aircraft In an attempt to maximize the economic return from the remaining six aircraft formerly leased to Pan Am, the Partnership entered into an agreement with Soundair, Inc. (Soundair) on October 31, 1992, for the disassembly and sale of certain of the Partnership's aircraft. It is anticipated that the disassembly and sales process will take at least three years. The Partnership has borne the cost of disassembly and will receive the proceeds from the sale of such parts net of overhaul expenses, if necessary, and commissions paid to Soundair. Disassembly of the six aircraft is complete. Through December 31, 1993, the Partnership paid approximately $571,000 for aircraft disassembly costs, of which $463,500 was reflected in the book value of aircraft inventory in 1992. The Partnership has received net proceeds from the sale of aircraft inventory of $1,201,943 through December 31, 1993. These aircraft have been recorded as aircraft inventory in the amount of $3.0 million in the balance sheet of the Form 10-K (Item 8) as of December 31, 1992. During 1993, the Partnership recorded downward adjustments of $300,000, which are included in depreciation expense in the statement of operations of the Form 10-K (Item 8), to reflect the current estimate of net realizable aircraft inventory value. TWA Lease Modification During 1991, TWA defaulted under its leases with the Partnership when it failed to pay its March lease payments. On March 28, 1991, TWA and the Partnership entered into lease amendments which specified (i) renegotiated lease rates equal to approximately 70% of the original rates; (ii) payment of the March and April lease payments at the renegotiated rates on March 27, 1991; and (iii) an advance lump sum payment on March 29, 1991 representing the present value of the remaining lease payments due through the end of the leases at the renegotiated rate. The Partnership recorded the lump sum payment from TWA as deferred income, and recognized the rental revenue as it was earned over the lease term. The Partnership also recognized interest expense equal to the difference between the cash received and the rental revenue earned over the lease term. The 16 leases that expired in November 1991 were extended for three months at 57% of the original rates. In December 1991, the leases for all 18 aircraft were amended further, with extensions into various dates in 1998. The renegotiated lease rates represent approximately 46% of the initial lease rates. In addition, the Partnership agreed to share in the costs of certain ADs. If such costs are incurred by TWA, they will be credited against rentals due to the Partnership, subject to annual limitations with a maximum of $500,000 per aircraft over the term of the leases. In January 1992, TWA commenced reorganization proceedings under Chapter 11 of the federal Bankruptcy Code. TWA made all payments due under the leases. TWA received court approval to emerge from bankruptcy protection effective November 3, 1993. TWA notified the partnership of its intention to affirm its leases for all 18 DC-9 aircraft. In addition, while the court had originally granted TWA an additional 90-day period subsequent to its emergence from bankruptcy during which it could exercise its right to reject the Partnerships's leases, TWA has elected to waive that right with respect to the Partnership's aircraft. As previously agreed with TWA, August and September 1993 rentals were drawn from a security deposit held by the Partnership, which had been posted for this purpose by TWA prior to its bankruptcy filing. In accordance with the cost sharing arrangement described above, in 1993, TWA submitted to the Partnership invoices for expenses paid to date by TWA to meet the ADs. These expenses, which are included in operating expense in the statement of operations of the Partnership's 1993 Form 10-K (Item 8), were offset against rental payments totalling $2.7 million that were due the Partnership in 1993. TWA may offset rental payments up to an additional amount of $6.3 million, subject to limitations over the lease terms. Refund of Hushkit Deposits On August 30, 1990, the Partnership agreed to acquire up to seven hushkits for Boeing 727 aircraft from Federal Express Corporation (Federal Express), four of which were purchased and installed on the Pan Am aircraft. Because certain conditions related to the purchase of the remaining three hushkits were not satisfied, the Partnership requested return of its deposit of $270,000 plus interest as provided in the purchase documents. Federal Express refused the Partnership's request, pending resolution with the Partnership of certain allegedly disputed contractual issues. On April 16, 1992, the general partner, on behalf of the Partnership, commenced legal action to require Federal Express to refund the remaining balance of the deposit, with interest, plus legal fees and other damages, and Federal Express filed a cross-complaint against the Partnership alleging breach of contract. A settlement was reached and repayment of the deposit, with interest, was received by the Partnership in November 1992. Claims Related to Lessee Defaults Braniff, Inc. (Braniff) Bankruptcy Claim In July 1992, the Bankruptcy Court approved a stipulation embodying a settlement among Polaris Investment Management Corporation (PIMC), on behalf of the Partnership, the Braniff Creditor committees and Braniff in which it was agreed that First Security Bank of Utah, National Association, acting as trustee for the Partnership, would be allowed an administrative claim in the bankruptcy proceeding of approximately $230,769. In 1992, the Partnership received full payment of the claim, subject, however, to the requirement that 25% of total proceeds be held by PIMC in a separate, interest-bearing account pending notification by Braniff that all of the allowed administrative claims have been satisfied. The Partnership recognized 75% of the total claim in the statement of operations in 1992. As of the end of 1993, the Partnership had not been advised that the 25% portion of the administrative claim payment could be released or that any disposition of the Partnership's general claim in bankruptcy was being considered. Air Zaire As a result of legal action commenced by the general partner, a final settlement was reached with Air Zaire. Air Zaire paid to the Partnership approximately $2,885,000, of which approximately $1,570,000 has been applied to legal and maintenance expenses related to the default. The final expenses were paid in 1993 and approximately $915,000 was reflected as other income in the 1993 statement of operations. The remaining amount of $400,000 is included in maintenance reserves in the December 31, 1993 balance sheet. SABA SABA defaulted under its lease and, in February 1992, the aircraft was repossessed and returned to the United States by the Partnership, although not in compliance with the return conditions specified under the lease. Reconciliation of Book Loss to Taxable Loss The following is a reconciliation between net loss per limited partnership unit reflected in the financial statements of Form 10-K (Item 8) and the information provided to limited partners for federal income tax purposes: The difference between net loss for book purposes and net loss for tax purposes result from timing differences of certain income and deductions. Rentals paid by lessees in advance are deferred as unearned revenue for book purposes but must be recognized as income, when received, for tax purposes. When deferred income is recognized for book purposes, such income is reversed for tax purposes. Certain increases in the Partnership's book maintenance reserve liability were recognized as income for tax purposes. The Partnership computes depreciation using the straight-line method for financial reporting purposes and an accelerated method, switching to the straight-line method in later years, for tax purposes. This difference resulted in a larger tax gain on sale of aircraft than the book gain. The current year tax depreciation expense is greater than the book depreciation expense. Certain aircraft have been disassembled and held in inventory until their component parts can be sold. A net tax loss resulted from the sale of these component parts along with a writedown to tax basis inventory value. For book purposes, such assets are reflected at estimated net realizable value. Finally, certain costs were capitalized for tax purposes and expensed for book purposes. Industry Update Maintenance of Aging Aircraft The process of aircraft maintenance begins at the aircraft design stage. For aircraft operating under Federal Aviation Administration (FAA) regulations, a review board consisting of representatives of the manufacturer, FAA representatives and operating airline representatives is responsible for specifying the aircraft's initial maintenance program. This program is constantly reviewed and modified throughout the aircraft's operational life. Since 1988, the FAA, working with the aircraft manufacturers and operators, has issued a series of ADs which mandate that operators conduct more intensive inspections, primarily of the aircraft fuselages. The results of these mandatory inspections may uncover the need for repairs or structural modifications that may not have been required under previously mandated maintenance programs. In addition, an AD adopted in 1990 requires replacement or modification of certain structural items on a specific timetable. These structural items were formerly subject to periodic inspection, with replacement when necessary. The FAA estimates the cost of compliance with this AD to be approximately $1.0 million and $0.9 million per Boeing 727 and Boeing 737 aircraft, respectively, if none of the required work had been done previously. The FAA also issued several ADs in 1993 updating inspection and modification requirements for Boeing 737 aircraft. The FAA estimates the cost of these requirements to be approximately $90,000 per aircraft. In general, the new maintenance requirements must be completed by the later of March 1994, or 75,000 and 60,000 cycles for each Boeing 737 and 727, respectively. In December 1990, the FAA adopted another AD intended to mitigate corrosion of structural components, which would require repeated inspections from 5 years of age throughout the life of an aircraft, with replacement of corroded components as needed. Integration of the new inspections into each aircraft operator's maintenance program was required by December 31, 1991 on Boeing aircraft. The Partnership's existing leases require the lessees to maintain the Partnership's aircraft in accordance with an FAA-approved maintenance program during the lease term. At the end of the leases, each lessee is generally required to return the aircraft in airworthy condition including compliance with all ADs for which action is mandated by the FAA during the lease term, except for certain instances. In negotiating subsequent leases, market conditions generally require that the Partnership bear some or all of the costs of compliance with future ADs or ADs that have been issued, but which did not require action during the previous lease term. The ultimate effect on the Partnership of compliance with the FAA maintenance standards is not determinable at this time and will depend on a variety of factors, including the state of the commercial aircraft market, the timing of the issuance of ADs, and the status of compliance therewith at the expiration of the current leases. Aircraft Noise Another issue which has affected the airline industry is that of aircraft noise levels. The FAA has categorized aircraft according to their noise levels. Stage 1 aircraft, which have the highest noise level, are, with few exceptions, no longer allowed to operate from civil airports in the United States. Stage 2 aircraft meet current FAA requirements. Stage 3 aircraft are the most quiet and Stage 3 is the standard for all new aircraft. On September 24, 1991, the FAA issued final rules on the phase-out of Stage 2 aircraft by the end of this decade. The current U.S. fleet is comprised of approximately 51% Stage 3 aircraft and 49% Stage 2 aircraft. The key features of the rule include: Compliance can be accomplished through a gradual process of phase-in or phase-out (see below) on each of three interim compliance dates: December 31, 1994, 1996, and 1998 (with waivers available in certain specific cases to December 31, 2003). All operators have the option of achieving compliance through a gradual phase-out of Stage 2 aircraft (i.e., eliminate 25% of its Stage 2 fleet on each of the compliance dates noted above), or a gradual phase-in of Stage 3 aircraft (i.e., 55%, 65% and 75% of an operator's fleet must consist of Stage 3 aircraft by the respective compliance dates noted above). Carryforward credits will be awarded to operators for early additions of Stage 3 aircraft to their fleets. These credits may be used to reduce either the number of Stage 2 aircraft it must phase-out or the number of Stage 3 aircraft it must phase-in by the next interim compliance date. The credits must be used by that operator, however, and cannot be transferred or sold to another operator. The federal rule does not prohibit local airports from issuing more stringent phase-out rules. In fact, several local airports have adopted more stringent noise requirements which restrict the operation of Stage 2 and certain Stage 3 aircraft. Other countries have also adopted noise policies. The European Economic Community (EEC) adopted a non-addition rule in 1989, which directed each member country to pass the necessary legislation to prohibit airlines from adding Stage 2 aircraft to their fleets after November 1, 1990. The rule has specific exceptions for leased aircraft and does allow the continued use of Stage 2 aircraft which were in operation before November 1, 1990, although adoption of rules requiring the eventual phase-out of Stage 2 aircraft is anticipated. Except for one 727-200 with a hushkit, the Partnership's entire fleet consists of Stage 2 aircraft. Hushkit modifications, which allow Stage 2 aircraft to meet Stage 3 requirements, are currently available for the Partnership's aircraft. However, while technically feasible, hushkits may not be cost effective on all models due to the age of some of the aircraft and the time required to fully amortize the additional investment. The general partner will evaluate, as appropriate, the potential benefits of hushkitting some or all of the Partnership's aircraft. It is unlikely, however, that the Partnership will incur such costs unless they can be recovered through a lease. Implementation of the Stage 3 standards have adversely affected the value of Stage 2 aircraft, as these aircraft will require eventual modification to be operated in the U.S. or other countries with Stage 3 standards. Demand for Aircraft Approximately 700 commercial aircraft are currently available for sale or lease. The current surplus has negatively affected market lease rates and fair market values of both new and used aircraft. Current depressed demand for air travel has limited airline expansion plans, with new aircraft orders and scheduled delivery being cancelled or substantially deferred. As profitability has declined, many airlines have opted to downsize, liquidate assets, or file for bankruptcy protection. Effects on the Partnership's Aircraft The Partnership has made downward adjustments to its estimates of aircraft value for certain of its on-lease aircraft. To ensure that the carrying value of each asset equals its estimated residual value at the end of its expected holding period, where appropriate the Partnership has increased depreciation expense. The Partnership also made downward adjustments to the carrying values of certain of its off-lease aircraft and aircraft inventory where depreciated cost exceeded the estimated net realizable value. During 1993, 1992 and 1991, the Partnership recognized downward adjustments totalling $300,000, $5.8 million and $13.7 million, respectively, for certain of its aircraft and aircraft inventory in the case of the 1993 adjustment. These adjustments are included in depreciation expense in the statement of operations. The Partnership's leases expire between March 1994 and November 1998. Current market studies indicate that the Partnership's Boeing and McDonnell Douglas aircraft continue to be adversely affected by industry events. Therefore, the Partnership will evaluate each aircraft as it comes off lease to determine whether a re-lease or a sale at the then current market rates would be most beneficial for unit holders. Other Event Effective October 18, 1993, James F. Walsh resigned as Senior Vice President and Chief Financial Officer of Polaris Investment Management Corporation to assume new responsibilities at GE Capital Corporation. Bobbe V. Sabella has assumed the position of Vice President and Chief Financial Officer. Ms. Sabella has served the general partner in various capacities since September 1986, most recently as Vice President-Finance of Polaris Investment Management Corporation. Item 8.	Item 8. Financial Statements and Supplementary Data POLARIS AIRCRAFT INCOME FUND II (A California Limited Partnership) FINANCIAL STATEMENTS AS OF DECEMBER 31, 1993 AND 1992 TOGETHER WITH AUDITORS' REPORT REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Partners of Polaris Aircraft Income Fund II: We have audited the accompanying balance sheets of Polaris Aircraft Income Fund II (a California Limited Partnership) as of December 31, 1993 and 1992, and the related statements of operations, changes in partners' capital (deficit) and cash flows for each of the three years ended December 31, 1993. These financial statements and the schedules referred to below are the responsibility of the general partner. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by the general partner, 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 financial statements referred to above present fairly, in all material respects, the financial position of Polaris Aircraft Income Fund II as of December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years ended December 31, 1993, in conformity with generally accepted accounting principles. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in the index to the financial statements are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in audits of the basic financial statements and, in our opinion, fairly state 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 & CO. San Francisco, California, January 21, 1994 (except with respect to the matters discussed in Note 13 as to which the date is January 28, 1994) [FN] The accompanying notes are an integral part of these statements. [FN] The accompanying notes are an integral part of these statements. [FN] The accompanying notes are an integral part of these statements. [FN] The accompanying notes are an integral part of these statements. POLARIS AIRCRAFT INCOME FUND II (A California Limited Partnership) NOTES TO FINANCIAL STATEMENTS DECEMBER 31, 1993 1. Accounting Principles and Policies Accounting Method Polaris Aircraft Income Fund II (PAIF-II or the Partnership), a California Limited Partnership, maintains its accounting records, prepares financial statements and files its tax returns on the accrual basis of accounting. Aircraft and Depreciation The aircraft are recorded at cost, which includes acquisition costs. Depreciation to an estimated residual value is computed using the straight-line method over the estimated economic life of the aircraft which was originally estimated to be 30 years from the date of manufacture. Depreciation in the year of acquisition is calculated based upon the number of days that the aircraft are in service. The Partnership periodically reviews the estimated realizability of the residual values at the end of each aircraft's economic life. For any downward adjustment in estimated residual, or change in the estimated remaining economic life, the depreciation expense over the remaining life of the aircraft is increased. If the expected net income generated from the lease (rental revenue, net of management fees, less adjusted depreciation and an allocation of estimated administrative expense) results in a net loss, that loss will be recognized currently. Off-lease aircraft are carried at the lower of depreciated cost or estimated net realizable value. A further adjustment is made for those aircraft, if any, that require substantial maintenance work. Capitalized Costs Aircraft modification and maintenance costs which are determined to increase the value or extend the useful life of the aircraft are capitalized and amortized using the straight-line method over the appropriate period. These costs are also subject to the periodic evaluation discussed above. Aircraft Inventory Aircraft held in inventory for sale are reflected at the lower of depreciated cost or estimated net realizable value. Proceeds from sales are applied against inventory until book value is fully recovered. Operating Leases The aircraft leases are accounted for as operating leases. Lease revenues are recognized in equal installments over the terms of the leases. Other Assets Lease acquisition costs are capitalized as other assets and amortized using the straight-line method over the term of the lease. Income Taxes The Partnership files federal and state information income tax returns only. Taxable income or loss is reportable by the individual partners. Net Income (Loss) Per Limited Partnership Unit Net income (loss) per limited partnership unit is based on the limited partners' share of net income or loss and the number of units outstanding for the years ended December 31, 1993, 1992 and 1991. Short-Term Investments The Partnership classifies all liquid investments with original maturities of three months or less as short-term investments. Operating Expenses Operating expenses include costs incurred to maintain, insure, lease and sell the Partnership's aircraft, including costs related to lessee defaults and costs of disassembling aircraft inventory. Reclassification Certain 1992 balances have been reclassified to conform to the 1993 presentation. 2. Organization and the Partnership The Partnership was formed on June 27, 1984 for the purpose of acquiring and leasing aircraft. The Partnership will terminate no later than December 2010. Upon organization, both the general partner and the initial limited partner contributed $500. The Partnership recognized no profits or losses during the periods ended December 31, 1985 and 1984. The offering of limited partnership units terminated on December 31, 1986, at which time the Partnership had sold 499,997 units of $500, representing $249,998,500. All partners were admitted to the Partnership on or before December 1, 1986. Polaris Investment Management Corporation (PIMC), the sole general partner of the Partnership, supervises the day-to-day operations of the Partnership. PIMC is a wholly-owned subsidiary of Polaris Aircraft Leasing Corporation (PALC). Polaris Holding Company (PHC) is the parent company of PALC. GE Capital Corporation (GE Capital), an affiliate of General Electric Company, owns 100% of PHC's outstanding common stock. Allocations to affiliates are described in Note 11. 3. Aircraft The Partnership owns a portfolio of 24 used commercial jet aircraft, which were purchased and leased as discussed below. All aircraft acquired from an affiliate were purchased within one year of the affiliate's acquisition at the affiliate's original price paid. The aircraft leases are net leases, requiring the lessees to pay all operating expenses associated with the aircraft during the lease term including Airworthiness Directives (ADs) which have been or may be issued by the Federal Aviation Administration (FAA) and require compliance during the lease term. The leases generally state a minimum acceptable return condition for which the lessee is liable under the terms of the lease agreement. Certain leases also provide that if the aircraft are returned at a level above the minimum acceptable level, the Partnership must reimburse the lessee for the related excess, subject to certain limitations. The related liability to these lessees, if any, is currently inestimable and therefore is not reflected in the financial statements. One Boeing 737-200 This aircraft was acquired for $6,766,166 in 1986 and leased to various lessees until 1989, when Braniff, Inc. (Braniff) defaulted on its lease. The aircraft remained off lease until March 1991. The aircraft was then leased to SABA Airlines, S.A. (SABA) at approximately 70% of the prior rate until February 1992, when the aircraft was repossessed by the Partnership after SABA defaulted under its lease. In November 1992, the aircraft was re-leased for five years to Viscount Air Services, Inc. (Viscount) at approximately 56% of the prior lease rate. Viscount, a charter carrier based in Arizona, has the option to purchase the aircraft for the then fair market value at the end of the lease term. An engine for the aircraft has been leased from an affiliate (Note 11) following the return of an inoperable engine from SABA as discussed in Note 4. Seven Boeing 727-200 These aircraft were acquired for $38,986,145 during 1986 and leased to Pan American World Airways, Inc. (Pan Am) until 1991, when the lease was terminated due to Pan Am's bankruptcy filing, as discussed in Note 5. The Partnership has transferred six of these aircraft to aircraft inventory and has disassembled them for sale of the component parts (Note 6). One hushkit set from the aircraft was sold in January 1993 and two additional hushkit sets from the aircraft were sold in September 1993 (Note 4). The remaining aircraft was leased to Delta Airlines, Inc. (Delta) in September 1991. Delta returned the aircraft at the end of September 1993, following several month-by-month lease extensions since the original lease termination date in April 1993. The aircraft is currently being remarketed for sale or re-lease. One Boeing 737-200 Combi This aircraft was acquired for $7,582,572 in 1986 and leased to Presidential Airways, Inc. (Presidential), until Presidential's default in 1989. The aircraft remained off lease until June 1990, when it was leased to Air Zaire, Inc. (Air Zaire). The lease required that Air Zaire maintain the aircraft in accordance with FAA requirements. However, Air Zaire was unable to obtain FAA approval for its proposed maintenance program, thus prompting the early termination of the lease in 1991. Air Zaire provided a $610,000 letter of credit, the proceeds of which the Partnership applied to outstanding rent, reserves and interest due in 1991. Air Zaire paid additional amounts in 1993 and 1992 as a result of legal action commenced by the Partnership (Note 10). In August 1992, the Partnership leased the aircraft to Northwest Territorial Airways, Ltd. (NWT) through February 1993 at approximately 45% of the prior rental rate. The lease was then extended through December 1993 at 80% of the previous rental rate and again through March 1994 at the same rental rate. An engine for the aircraft has been leased from an affiliate (Note 11). The Partnership is currently remarketing this aircraft for sale or re-lease. 17 McDonnell Douglas DC-9-30 and One McDonnell Douglas DC-9-40 These aircraft were acquired for $122,222,040 during 1986 and leased to Ozark Air Lines, Inc. (Ozark). In 1987, Trans World Airlines, Inc. (TWA) merged with Ozark and assumed the leases. The leases were modified and extended prior to TWA's bankruptcy filing discussed in Note 7. Three Boeing 727-200 Advanced These aircraft were acquired for $36,364,929 during 1987 and leased to Alaska Airlines, Inc. (Alaska) until September 1992. Upon return of the aircraft, an additional amount of $509,000 was received for deferred maintenance and applied in 1993 as an offset of maintenance expenses incurred on the aircraft. The aircraft were re-leased to Continental Micronesia, Inc. (Continental Micronesia) at approximately 55% of the prior lease rate from April and May 1993 until April 1998. The lease stipulates that the Partnership will reimburse costs for cockpit modifications up to $600,000 per aircraft, C-check labor costs up to $300,000 per aircraft and the actual cost of C-check parts for two of the aircraft. In addition, the Partnership will provide financing up to $815,000 for new image modifications to be repaid with interest over the lease term for each aircraft. Reimbursements and financing for modifications were made by the Partnership in January 1994 and are partially included in 1993 operating results as discussed in Note 13. The following is a schedule by year of future minimum rental income under the existing leases: Year Amount 1994 $14,239,000 1995 14,074,000 1996 14,074,000 1997 14,041,000 1998 and thereafter 3,660,000 Total $60,088,000 Future minimum rental payments may be offset or reduced by future costs as described above and in Note 7. During 1992 and 1991, the Partnership made downward adjustments to its estimates of aircraft value for certain of its on-lease aircraft. To ensure that the carrying value of each asset equals its estimated residual value at the end of its expected holding period, where appropriate the Partnership has increased depreciation expense as described in Note 1. The Partnership also made downward adjustments to the carrying values of certain of its off-lease aircraft and aircraft inventory where depreciated cost exceeded the estimated net realizable value. During 1993, 1992 and 1991, the Partnership recognized downward adjustments totalling $300,000, $5.8 million and $13.7 million, respectively, for certain of its aircraft and aircraft inventory in the case of the 1993 adjustment. These adjustments are included in depreciation expense in the statements of operations. 4. Sale of Equipment One hushkit set from the aircraft formerly leased to Pan Am was sold in January 1993 to ALG, Inc. (ALG) for $1,750,000, which resulted in a $259,809 gain. ALG paid cash for a portion of the price and issued an interest- bearing promissory note for the balance of $1,132,363, which specifies 23 equal payments and a balloon payment due in January 1995. During 1993, the partnership received all payments due under the note. The note balance as of December 31, 1993 was $1,022,308. In September 1993, two additional hushkit sets from the disassembled Pan Am aircraft were sold to Emery Worldwide Airlines for $1,250,000 each, which resulted in a $398,192 loss. The decline in sales price from the previous hushkit sale in January 1993 reflects a softening market for this equipment. The Partnership sold one used engine to International Aircraft Support, L.P. in July 1993 for $85,000, which resulted in a $375,012 loss. The engine, along with its airframe, was repossessed from the former lessee, SABA in February 1992. At the time of its default, SABA had not maintained the aircraft as required under the lease agreement, rendering the engine inoperable. The Partnership determined the costs to repair the engine were excessive in comparison to amounts recoverable from sale or lease. As a result, the engine was sold for its component parts. 5. Pan Am Lease Modification and Termination In July 1990, the Partnership and Pan Am signed an amendment to their original lease agreement which (i) extended the scheduled lease termination dates; (ii) obligated the Partnership to pay for hushkit modification of the seven aircraft; (iii) required Pan Am to pay supplemental rent to the Partnership after each hushkit was installed; and (iv) required the Partnership to share in the cost of compliance with certain aging aircraft ADs, up to a cost of $500,000 per aircraft. The Partnership paid $415,444 in 1991 to reimburse Pan Am for work done under such ADs and reported that amount as aircraft improvements on the accompanying balance sheets. Four of the seven hushkit modifications were installed in 1990 for a total cost of $7,082,576, financed by the proceeds of a loan from a related party (Note 9) and cash reserves. The remaining three hushkits were not installed due to market conditions and Pan Am's bankruptcy filing and later sold as discussed in Note 4. Pan Am commenced reorganization proceedings under Chapter 11 of the federal Bankruptcy Code in January 1991. Subsequently, the Partnership and Pan Am agreed to renegotiated lease rates of approximately 75% of the original rates and Pan Am paid rent through mid-September 1991. Pan Am's reorganization under Chapter 11 was ultimately unsuccessful, and Pan Am ceased operations in December 1991. Delta had leased one of the Partnership's aircraft until September 1993 as discussed in Note 3 and the remaining six aircraft have been disassembled for sale of their component parts (Note 6). 6. Disassembly of aircraft In an attempt to maximize the economic return from the remaining six aircraft formerly leased to Pan Am, the Partnership entered into an agreement with Soundair, Inc. (Soundair) on October 31, 1992, for the disassembly and sale of certain of the Partnership's aircraft. It is anticipated that the disassembly and sales process will take at least three years. The Partnership has borne the cost of disassembly and will receive the proceeds from the sale of such parts net of overhaul expenses, if necessary, and commissions paid to Soundair. Disassembly of the six aircraft has been completed. Through December 31, 1993, the Partnership paid approximately $571,000 for aircraft disassembly costs, of which $463,500 was reflected in the book value of aircraft inventory in 1992. The Partnership has received net proceeds from the sale of aircraft inventory of $1,201,943 through December 31, 1993. These aircraft have been recorded as aircraft inventory in the amount of $3.0 million in the balance sheet as of December 31, 1992 as described in Note 3. During 1993, the Partnership recorded downward adjustments of $300,000, which are included in depreciation expense in the statement of operations, to reflect the current estimate of net realizable aircraft inventory value. 7. TWA Lease Modification During 1991, TWA defaulted under its leases with the Partnership when it failed to pay its March lease payments. On March 28, 1991, TWA and the Partnership entered into lease amendments which specified (i) renegotiated lease rates equal to approximately 70% of the original rates; (ii) payment of the March and April lease payments at the renegotiated rates on March 27, 1991; and (iii) an advance lump sum payment on March 29, 1991 representing the present value of the remaining lease payments due through the end of the leases at the renegotiated rate. The Partnership recorded the lump sum payment from TWA as deferred income, and recognized the rental revenue as it was earned over the lease term. The Partnership also recognized interest expense equal to the difference between the cash received and the rental revenue earned over the lease term. The 16 leases that expired in November 1991 were extended for three months at 57% of the original rates. In December 1991, the leases for all 18 aircraft were amended further, with extensions into various dates in 1998. The renegotiated lease rates represent approximately 46% of the initial lease rates. In addition, the Partnership agreed to share in the costs of certain ADs. If such costs are incurred by TWA, they will be credited against rentals due to the Partnership, subject to annual limitations with a maximum of $500,000 per aircraft over the term of the leases. In January 1992, TWA commenced reorganization proceedings under Chapter 11 of the federal Bankruptcy Code. TWA made all payments due under the leases. TWA received court approval to emerge from bankruptcy protection effective November 3, 1993. TWA notified the partnership of its intention to affirm its leases for all 18 DC-9 aircraft. In addition, while the court had originally granted TWA an additional 90-day period subsequent to its emergence from bankruptcy during which it could exercise its right to reject the Partnerships's leases, TWA has elected to waive that right with respect to the Partnership's aircraft. As previously agreed with TWA, August and September 1993 rentals were drawn from a security deposit held by the Partnership, which had been posted for this purpose by TWA prior to its bankruptcy filing. In accordance with the cost sharing arrangement described above, in 1993, TWA submitted to the Partnership invoices for expenses paid to date by TWA to meet the ADs. These expenses, which are included in operating expense in the statement of operations, were offset against rental payments totalling $2.7 million that were due the Partnership in 1993. TWA may offset rental payments up to an additional amount of $6.3 million, subject to limitations over the lease term. 8. Refund of Hushkit Deposits On August 30, 1990, the Partnership agreed to acquire up to seven hushkits for Boeing 727 aircraft from Federal Express Corporation (Federal Express), four of which were purchased and installed on the Pan Am aircraft. Because certain conditions related to the purchase of the remaining three hushkits were not satisfied, the Partnership requested return of its deposit of $270,000 plus interest as provided in the purchase documents. Federal Express refused the Partnership's request, pending resolution with the Partnership of certain allegedly disputed contractual issues. On April 16, 1992, the general partner, on behalf of the Partnership, commenced legal action to require Federal Express to refund the remaining balance of the deposit, with interest, plus legal fees and other damages, and Federal Express filed a cross-complaint against the Partnership alleging breach of contract. A settlement was reached and repayment of the deposit, with interest, was received by the Partnership in November 1992. 9. Note Payable to Affiliate In December 1990, the Partnership signed a promissory note payable to PALC in the amount of $1,250,000, with interest at an annual rate of 9.5%. The proceeds of the note were used to pay a portion of the cost of the hushkits discussed in Note 5. The Partnership repaid the note together with interest of $42,945 in April 1991. The note was repaid with a portion of the lump-sum payment from TWA as described in Note 7. 10. Claims Related to Lessee Defaults Braniff Bankruptcy Claim In July 1992, the Bankruptcy Court approved a stipulation embodying a settlement among PIMC, on behalf of the Partnership, the Braniff Creditor committees and Braniff in which it was agreed that First Security Bank of Utah, National Association, acting as trustee for the Partnership, would be allowed an administrative claim in the bankruptcy proceeding of approximately $230,769. In 1992, the Partnership received full payment of the claim, subject, however, to the requirement that 25% of total proceeds be held by PIMC in a separate, interest-bearing account pending notification by Braniff that all of the allowed administrative claims have been satisfied. The Partnership recognized 75% of the total claim as other income in the accompanying 1992 statement of operations. As of the end of 1993, the Partnership had not been advised that the 25% portion of the administrative claim payment could be released or that any disposition of the Partnership's general claim in bankruptcy was being considered. Air Zaire As a result of legal action commenced by the general partner, a final settlement was reached with Air Zaire. Air Zaire paid to the Partnership approximately $2,885,000, of which approximately $1,570,000 has been applied to legal and maintenance expenses related to the default. The final expenses were paid in 1993 and approximately $915,000 was reflected as other income in the 1993 statement of operations. The remaining amount of $400,000 is included in maintenance reserves in the December 31, 1993 balance sheet. 11. Related Parties Under the Limited Partnership Agreement (Partnership Agreement), the Partnership paid or agreed to pay the following amounts to PIMC and/or its affiliates in connection with services rendered: a. An aircraft management fee equal to 5% of gross rental revenues with respect to operating leases or 2% of gross rental revenues with respect to full payout leases of the Partnership, payable upon receipt of the rent. b. Reimbursement of certain out-of-pocket expenses incurred in connection with the management of the Partnership and supervision of its assets. In 1993, 1992 and 1991, $407,582, $275,312 and $331,093, respectively, were reimbursed by the Partnership for administrative expenses. Administrative reimbursements totalling $46,910 and $39,008 were payable at December 31, 1993 and 1992, respectively. The general partner also paid operating costs to vendors resulting from lessee defaults. Reimbursements for such costs totalling $2,608,523, $2,040,505 and $827,669 were paid by the Partnership in 1993, 1992 and 1991, respectively. Operating reimbursements of $5,364 and $1,153,606 were payable at December 31, 1993 and 1992, respectively. c. A 10% interest in all cash distributions and sales proceeds, gross income in an amount equal to 9.09% of distributed cash available from operations and 1% of net income or loss and taxable income or loss, as such terms are defined in the Partnership Agreement. d. A subordinated sales commission of 3% of the gross sales price of each aircraft for services performed upon disposition and reimbursement of out-of-pocket and other disposition expenses. Subordinated sales commissions shall be paid only after limited partners have received distributions in an aggregate amount equal to their capital contributions plus a cumulative non-compounded 8% per annum return on their adjusted capital contributions, as defined in the Partnership Agreement. e. An engine was leased from Polaris Aircraft Income Fund I for eight months in 1993 for use on the aircraft leased to Viscount. The rental payment of $98,000 was offset against rent from operating leases in the statement of operations. f. An engine was leased from PHC for three and one half months in 1993 for use on the aircraft leased to NWT. The rental payment of $42,000 was offset against rent from operating leases in the statement of operations. 12. Income Taxes Federal and state income tax regulations provide that taxes on the income or loss of the Partnership are reportable by the partners in their individual income tax returns. Accordingly, no provision for such taxes has been made in the accompanying financial statements. In 1993, the Partnership adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS 109). One of the requirements of SFAS 109 is for a public enterprise that is not subject to income taxes, because its income is taxed directly to its owners, to disclose the net difference between the tax basis and the reported amounts of the enterprise's assets and liabilities. The net differences between the tax basis and the reported amounts of the Partnership's assets and liabilities at December 31, 1993 are as follows: Reported Amounts Tax Basis Net Difference Assets $129,706,547 120,984,013 $8,722,534 Liabilities 4,310,268 255,838 4,054,430 13. Subsequent Event In accordance with the Continental Micronesia cost sharing agreement as discussed in Note 3, in January 1994, the Partnership reimbursed Continental Micronesia $1.8 million for cockpit modifications, which is included in aircraft at cost in the 1993 balance sheet, and $742,325 for C-check labor and parts, which is included in operating expense in the 1993 statement of operations. In addition, the Partnership financed $2,177,533 for new image modifications, to be repaid with interest over the lease terms of the aircraft, beginning in February 1994. PART III Item 9.	Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. Item 10.	Item 10. Directors and Executive Officers of the Registrant PAIF-II has no directors or officers. PIMC is the General Partner of the Partnership and as such manages and controls the business of the Partnership. The directors and officers of PIMC are: Name Position Herbert D. Depp Chairman of the Board; President; Director Howard L. Feinsand Senior Vice President; Director John E. Flynn Senior Vice President Aircraft Marketing Richard J. Adams Senior Vice President Aircraft Sales and Leasing James T. Caleshu Senior Vice President and General Counsel; Secretary Bobbe V. Sabella Vice President and Chief Financial Officer Robert M.J. Ward Vice President International James R. Weiland Vice President Technical James W. Linnan Vice President Financial Management Robert W. Dillon Vice President Aviation Legal and Insurance Affairs; Assistant Secretary Mr. Depp, 49, assumed the position of the President effective April 1991, previously having served as Executive Vice President of PIMC and PALC since July 1989, Vice President Aircraft Marketing since June 1986, Vice President Commercial Aircraft since August 1984, and Director of Marketing Aircraft since November 1980. Mr. Depp assumed the position of Chairman effective April 1991. He has been a director of PIMC and of PHC since May 1990 and a director of PALC since April 1991. Mr. Feinsand, 46, joined PIMC and PALC as Vice President and General Counsel; Assistant Secretary in April 1989. Effective July 1989, Mr. Feinsand assumed the positions of Senior Vice President which he continues to hold, and previously served as General Counsel and Secretary from July 1989 to August 1992. Mr. Feinsand also serves as a director of PIMC. Mr. Feinsand, an attorney, was a partner in the New York law firm of Golenbock and Barell from 1987 through 1989. In his previous capacities, Mr. Feinsand served as counsel to PIMC and PALC. Mr. Feinsand also serves as a director on the board of Duke Realty Investments, Inc. Mr. Flynn, 53, was elected Senior Vice President Aircraft Marketing effective April 1991, having previously served as Vice President North America of PIMC and PALC since July 1989. Mr. Flynn joined PALC in March 1989 as Vice President Cargo. For the two years prior to the time he joined PALC, Mr. Flynn was a Transportation Consultant. Mr. Adams, 60, serves as Senior Vice President Aircraft Sales and Leasing of PIMC and PALC effective August 1992; having previously served as Vice President Aircraft Sales & Leasing, Vice President North America, and Vice President Corporate Aircraft since he joined PALC in August 1986. Mr. Weiland, 50, joined PIMC and PALC in September 1990 as Vice President Technical. Prior to joining PIMC and PALC, Mr. Weiland had been President and Chief Executive Officer of RAMCO, a company organized to build and operate an aircraft maintenance facility, since 1986. Mr. Caleshu, 54, joined PIMC and PALC in August 1992 as Senior Vice President and General Counsel. Prior to joining PIMC and PALC, Mr. Caleshu, an attorney, was a partner in the San Francisco firm of Pettit and Martin from 1966 to 1992. Ms. Sabella, 37, was elected Vice President and Chief Financial Officer effective October 1993, having previously served as Vice President - Finance since April 1992, Vice President and Controller since January 1990 and Corporate Controller of PIMC and PALC since September 1986. Mr. Ward, 50, has served as Vice President International of PIMC and PALC since October 1987, with responsibility for Asia, Central America, Pacific and Latin America. Mr. Linnan, 52, was elected Vice President Financial Management effective April 1991, having previously served as Vice President Investor Marketing of PIMC and PALC since July 1986. Mr. Dillon, 52, was elected Vice President Aviation Legal and Insurance Affairs effective April 1989. Previously, he has served as General Counsel of PIMC and PALC since January 1986. Disclosure pursuant to Section 16, Item 405 of Regulation S-K: Based solely on its review of the copies of such forms received or written representations from certain reporting persons that no Forms 3, 4, or 5 were required for those persons, the Partnership believes that, during 1993 all filing requirements applicable to its officers, directors and greater than ten percent beneficial owners were met. As reported in the Partnership's 1990 Form 10-K, on June 8, 1990, a purported class action entitled Harner, et al, v Prudential Bache Securities, (to which the Partnership was not a party) was filed by certain purchasers of units in a 1983 and 1984 public offering in several corporate aircraft public partnerships. PALC and PIMC were named as two of the defendants in this action. On September 24, 1991, the court entered an order in favor of PALC and PIMC granting their motion for summary judgement and dismissing the plaintiffs' complaint with prejudice. On March 13, 1992, Plaintiff filed a notice of appeal to the United States Court of Appeals for the Sixth Circuit. On August 21, 1992, the court of Appeals ordered consolidation of the Appellants' causes for the purposes of briefing and submission. This appeal was fully briefed and oral argument was held. Parties are waiting for the Court to issue a decision. On October 27, 1992, a Class Action Complaint entitled Edwin Weisl, Jr. et al, Plaintiffs, v the General Partner of the Partnership, its affiliates and others, Defendants, Index No. 29239/92 was filed in the Supreme Court of the State of New York for the County of New York. The Complaint sets forth various causes of action which include allegations against certain or all of the defendants (i) for alleged fraud in connection with certain public offerings, including that of the Partnership, on the basis of alleged misrepresentation and alleged omissions contained in the written offering materials and all presentations allegedly made to investors; (ii) for alleged negligent misrepresentation in connection with such offerings; (iii) for alleged breach of fiduciary duties; (iv) for alleged breach of third party beneficiary contracts; (v) for alleged violations of the NASD Rules of Fair Practice by certain registered broker dealers; and (vi) for alleged breach of implied covenants in the customer agreements by certain registered brokers. The Complaint seeks an award of compensatory and other damages and remedies. On January 19, 1993, Plaintiff's filed a motion for class certification. On March 1, 1993, Defendants filed motions to dismiss Complaint on numerous grounds, including failure to state a cause of action and statute of limitations. The court has not ruled on the motion for class certification or the motions to dismiss the complaint. The Partnership is not named as a defendant in this action. On or around February 17, 1993, a civil action entitled Einhorn, et al v Polaris Public Income Funds, et al, was filed in the Circuit Court of the 11th Judicial Circuit in and for Dade County, Florida against, among others, PIMC and Polaris Depositary Company. Plaintiffs seek class action certification on behalf of a class of investors in the Polaris Aircraft Income Funds IV, V and VI who purchased their interests while residing in Florida. Plaintiffs allege the violation of Section 517.301, Florida Statutes, in connection with the offering and sale of the Partnerships. Among other things, Plaintiffs assert that the Defendants sold interests in the Partnerships while "omitting and failing to disclose the material facts questioning the economic efficacy of" the Partnerships. Plaintiffs seek rescission or damages, in addition to interest, costs, and attorneys' fees. On April 5, 1993, defendants filed a motion to stay this action pending the final determination of a prior filed action in the Supreme Court for the State of New York entitled Weisl v Polaris Holding Company. On that date, defendants also filed a motion to dismiss the Complaint on the grounds of failure to attach necessary documents, failure to plead fraud with particularity and failure to plead reasonable reliance. On April 13, 1993, the court denied the defendants' motion to stay. On May 7, 1993, the Court stayed the action pending an appeal of the denial of the motion to stay. Defendants subsequently filed with the Third District Court of Appeal a petition for writ of certiorari to review the Circuit Court order denying the motion to stay. On October 19, 1993, the Court of Appeal granted the writ of certiorari, quashed the order, and remanded the action with instruction to grant the stay. On or around May 14, 1993, a purported class action entitled Michael Moross, et al, v Polaris Holding Company, et al, was filed in the United States District Court for the District of Arizona. This purported class action was filed on behalf of investors in the Polaris Aircraft Income Funds I - VI by nine investors in the Polaris Aircraft Income Funds. The Compliant alleges that defendants violated Arizona state securities statues and committed negligent misrepresentation and breach of fiduciary duty by misrepresenting and failing to disclose material facts in connection with the sale of limited partnership units in the above-named funds. An Amended Compliant was filed on September 17, 1993, but has not been served upon defendants. On or around October 4, 1993, defendants filed a notice of removal to the United States District Court for the district of Arizona. Defendants also filed a motion to stay the action pending the final determination of a prior filed action in the Supreme Court for the State of New York entitled Weisl v. Polaris Holding Company ("Weisl") and to defendants' time to respond to the Complaint until 20 days after disposition of the motion to action pending resolution of the motions for class certification and motions to dismiss pending in Weisl. On January 20, 1994, the court stayed the action and required defendants to file status reports every sixty days setting forth the status of the motions in Weisl. On September 21, 1993, a purported derivative action entitled Novak, et al, v. Polaris Holding Company, et al, was filed in the Supreme Court of the State of New York, County of New York. This action was brought on behalf of Polaris Aircraft Income Funds I - III (the "Partnerships"). The Complaint names as defendants Polaris Holding Company, its affiliates and others. Polaris Aircraft Income Funds I - III are named as nominal defendants. The Complaint alleges, among other things, that defendants mismanaged the Partnerships, engaged in self-dealing transactions that were detrimental to the Partnerships and failed to make required disclosure in connection with the sale of the Partnership units. The Complaint alleges claims of breach of fiduciary duty and constructive fraud and seeks, among other things an award of compensatory and punitive damages in an unspecified amount, re-judgment interest, and attorneys' fees and costs. On January 13, 1994, certain of the defendants, including Polaris Holding Company, filed motions to dismiss the Complaint on the grounds of, among others, failure to state a cause of action and failure to plead the alleged wrong in detail. On or around March 13, 1991, a purported class action entitled Kahn v Polaris Holding Company, et al, was filed in the Supreme Court of the State of New York, County of New York. This purported class action on behalf of investors in Polaris Aircraft Income Fund V ("PAIF V") was filed by one investor in the above named fund. The Complaint names as defendants the Company, Polaris Holding Company, its affiliates and others. The Complaint charges defendants with common law fraud, negligent misrepresentation and breach of fiduciary duty in connection with certain misrepresentations and omissions allegedly made in connection with the sale of interest in PAIF V. Plaintiffs seek compensatory and consequential damages in an unspecified amount, plus interest, disgorgement and restitution of all earnings, profits and other benefits received by defendants as a result of their alleged practices, and attorneys' fees and costs. Defendants' time to move, answer or otherwise plead with respect to the Complaint has been extended by stipulation up to and including 30 days after the Court rules on the pending motions to dismiss, or the motions are otherwise resolved, in Weisl v Polaris Holding Company, et al. The Partnership is not named as a defendant in this action. Item 11.	Item 11. Management Remuneration and Transactions PAIF-II has no directors or officers. PAIF-II is managed by PIMC, the General Partner. In connection with management services provided, management and advisory fees of $681,241 were paid to PIMC in 1993. Item 12.	Item 12. Security Ownership of Certain Beneficial Owners and Management a) No person owns of record, or is known by PAIF-II to own beneficially, more than five percent of any class of voting securities of PAIF-II. b) The General Partner of PAIF-II owns the equity securities of PAIF-II as set forth in the following table: c) There are no arrangements known to PAIF-II, including any pledge by any person of securities of PAIF-II, the operation of which may at a subsequent date result in a change in control of PAIF-II. Item 13.	Item 13. Certain Relationships and Related Transactions None. PART IV Item 14.	Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K 1. Financial Statements. The following are included in Part II of this report: Page No. Report of Independent Public Accountants 20 Balance Sheets 21 Statements of Operations 22 Statements of Changes in Partners' Capital (Deficit) 23 Statements of Cash Flows 24 Notes to Financial Statements 25 2. Financial Statement Schedules. a) The following are included in Part II of this report: Page No. Schedule V Property, Plant and Equipment 35 Schedule VI Accumulated Depreciation, Depletion; and Amortization of Property, Plant, and Equipment 35 All other schedules are omitted because they are not applicable, not required or because the required information is included in the financial statements or notes thereto. 3. Exhibits required to be filed by Item 601 of Regulation S-K and Reports on Form 8-K. a) Reports on Form 8-K: None. b) Exhibits required to be filed by Item 601 of Regulation S-K: None.
858470_1993.txt	858470	1993	ITEM 1. BUSINESS GENERAL Cabot Oil & Gas Corporation (or, the "Company") develops, produces, explores for, stores, transports, purchases and markets natural gas and, to a lesser extent, produces and sells crude oil. Substantially all of the Company's operations are in the Appalachian Region of West Virginia, Pennsylvania and New York, and in the Anadarko Region of southwestern Kansas, Oklahoma and the Texas Panhandle. At December 31, 1993, the Company had approximately 825 Bcfe of proved reserves, 98% of which was natural gas. A significant portion of the Company's natural gas reserves is located in long-lived fields with extended production histories. The Company, a Delaware corporation, was organized in 1989 as the successor to the oil and gas business of Cabot Corporation ("Cabot"), which was founded in 1891. In 1990, the Company completed its initial public offering of approximately 18% of the outstanding common stock held by Cabot. Cabot distributed the remaining common stock of the Company to the shareholders of Cabot in 1991. Since that time, the Company has been widely held and publicly traded on the New York Stock Exchange. See Note 1 of the Notes to the Consolidated Financial Statements incorporated herein by reference in Item 8 hereof for further discussion. Unless the context otherwise requires, all references herein to the Company include Cabot Oil & Gas Corporation, its predecessors and subsidiaries. Similarly, all references to Cabot include Cabot Corporation and its affiliates. All references to wells are gross, unless otherwise stated. The following table summarizes certain information, at December 31, 1993, regarding the Company's proved reserves, productive wells, developed and undeveloped acreage and infrastructure. SUMMARY OF RESERVES, PRODUCTION, ACREAGE AND OTHER INFORMATION BY AREAS OF OPERATION (1)(2) - --------------- (1) As of December 31, 1993. For additional information regarding the Company's estimates of proved reserves and other data, see "Business -- Reserves," "Business -- Acreage," "Business -- Productive Well Summary" and "Supplemental Oil and Gas Information to the Consolidated Financial Statements." (2) Certain numbers may not add due to rounding. (3) Includes all properties outside the Appalachian Region, most notably properties located in the Anadarko Region. EXPLORATION, DEVELOPMENT AND PRODUCTION The Company is one of the largest producers of natural gas in the Appalachian Region, where it has conducted operations for more than a century. The Company has had operations in the Anadarko Region for over 50 years. Historically, the Company has maintained its reserve base through low-risk development drilling. The Company continues to focus its operations in the Appalachian and Anadarko Regions through development of undeveloped reserves and acreage, acquisition of oil and gas producing properties and, to a lesser extent, exploration. However, the Company has adopted a strategic plan to continue the exploitation of its existing asset base, exploring possible acquisition opportunities both within and outside of the Company's core areas and expanding its marketing capabilities. APPALACHIAN REGION The Company's exploration, development and production activities in the Appalachian Region are concentrated in Pennsylvania, West Virginia and New York. Operations are managed by a regional office in Pittsburgh. At December 31, 1993, the Company had approximately 557 Bcfe of proved reserves (substantially all natural gas) in the Appalachian Region, constituting 67% of the Company's total proved reserves. The Appalachian Region also accounted for 55 percent of the Company's 1993 production. The Company has 4,017 productive wells (3,688.4 net) of which 3,905 wells are operated by the Company. There are multiple producing intervals which include the Medina, Berea and Big Line trend formations at depths ranging from 1,500 to 8,700 feet. Average net daily production in 1993 was 72.0 MMcfe. While natural gas production volumes from Appalachian reservoirs are relatively low on a per-well basis compared to other areas of the United States, the productive life of Appalachian reserves is relatively long. The Company's finding and development costs for its Appalachian reserves are lower than the U.S. industry average because of the comparatively shallow reservoir depths and a lower incidence of dry holes. In 1993, the Company drilled 126 wells (122.1 net) wells in the Appalachian Region (122 development wells). Capital and exploration expenditures for the year were approximately $86.5 million, including the $46.4 million EMAX Acquisition (described in "Acquisitions" below). In the 1994 drilling program year, the Company has plans to drill approximately 158 wells. At December 31, 1993, the Company had approximately 1.23 million net acres, including 759 thousand net developed acres. At year end, the Company had identified 298.5 additional net development drilling locations. The Company also owns and operates a brine treatment plant near Franklin, Pennsylvania. The plant, which began operating in 1985, processes and treats waste fluid generated during the drilling, completion and subsequent production of oil and gas wells. The plant provides services to the Company and certain other oil and gas producers in southwestern New York, eastern Ohio and western Pennsylvania. The Company believes that it gains operational efficiency, and therefore maximizes the return on its investment in the Appalachian Region because of its large acreage position, its high concentration of wells, its substantial ongoing drilling program conducted over a number of years, its natural gas gathering and pipeline systems and its storage capacity. ANADARKO REGION The Company's exploration, development and production activities in the Anadarko Region are primarily focused in Kansas, Oklahoma and Texas. Operations are managed by a regional office in Oklahoma City. At December 31, 1993, the Company had approximately 269 Bcfe of proved reserves (substantially all natural gas) in the Anadarko Region, constituting 33% of the Company's total proved reserves. The Company has an interest in 1,163 productive wells (547 net) of which 701 wells are operated by the Company. Principal producing intervals are in the Chase, Chester and Marrow formations at depths ranging from 1,500 to 11,000 feet. Average net daily production in 1993 was 59.8 MMcfe. In 1993, the Company drilled 36 wells (27.7 net) in the Anadarko Region (all development wells). Capital and exploration expenditures for the year were approximately $48.7 million, including the non-cash $34.6 million Harvard Acquisition (described in "Acquisitions" below). In the 1994 drilling program year, the Company has plans to drill approximately 30 wells. At December 31, 1993, the Company had approximately 208 thousand net acres, including 176 thousand net developed acres. At year end, the Company had identified 54.3 additional net development drilling locations. ACQUISITIONS As part of its long-term growth strategy, the Company placed greater emphasis on acquiring proved oil and gas properties in 1993. The Company's focus is on the acquisition of producing properties with additional development drilling potential that would complement the Company's existing operations. The objective is to acquire properties where low-risk development drilling or improved production methods can increase proved reserves attributable to acquired oil and gas properties. In May 1993, the Company purchased oil and natural gas properties located in the Anadarko Region of Texas and Oklahoma, and in the East Texas Basin from Harken Anadarko Partners, L.P. (the "Harvard Acquisition"). The Company issued 692,439 shares of $3.125 convertible preferred stock to Harvard University. The preferred stock has a total stated value of $34.6 million, or $50 per share, and is convertible, subject to certain adjustments, into 1,648,662 shares of Common Stock at $21 per share, also subject to certain adjustments. As of the acquisition date, the properties had approximately 38.2 billion cubic feet equivalent of proved reserves which were 80% natural gas and included 518 (166 net) wells. Almost 45% of the wells are operated by the Company. Average net daily production on these properties in 1993 was 10.95 million cubic feet equivalent ("MMcfe"). In September 1993, the Company purchased oil and natural gas properties and related assets located in the Appalachian Region of West Virginia and Pennsylvania from Emax Oil Company (the "EMAX Acquisition") for approximately $44.1 million, subject to certain adjustments. As of the acquisition date, the properties had approximately 47.1 billion cubic feet equivalent of proved reserves of which 99% were natural gas. The properties include 300 (291 net) wells, all but one of which are operated by the Company. Average net daily production on these properties in 1993 was 8.70 MMcfe. As part of the acquisition, the Company entered into a development agreement that provides for the acquisition of additional drilling locations for approximately $106 thousand per location. The agreement provides for the drilling of 78 such wells under a farmout from a local producer. Total expected drilling costs for these 78 wells are estimated at $13.6 million. The Company drilled 22 of these wells in 1993, which added approximately 5.2 Bcfe to the proved reserves acquired and increased the total acquisition cost by $2.3 million. At year end the Company had identified 69 future drilling locations, including the remaining locations associated with the farm-out agreement mentioned above. On February 25, 1994, the Company entered into a merger agreement with Washington Energy Company ("WECO") to merge its subsidiary Washington Energy Resources Company ("WERCO") into COG Acquisition Company, a subsidiary of the Company (the "Merger Agreement"). The Company will acquire the common stock of WERCO in a tax-free exchange for total consideration of $180 million, subject to certain adjustments. As of January 1, 1994, WERCO held 230 Bcfe of proved reserves located in the Green River Basin of Wyoming and in South Texas. The reserves are 82% natural gas. WERCO's current net production is 43 mmcf of natural gas, 450 barrels of natural gas liquids and 1,550 barrels of oil and condensate per day. WERCO produces from 376 wells, 116 net to their interest and operates 184 wells, 87 net. The Company will issue 2,133,000 shares of its common stock, par value $.10 (the "Common Stock") and 1,134,000 shares of a 6% Convertible Redeemable Preferred Stock (the "6% Preferred Stock") in exchange for the common stock of WERCO. The 6% Preferred Stock has a stated value of $50.00 per share and is convertible into 1,972,174 shares of Common Stock at $28.75 per share. Because of the size of WECO's investment in the Company, WECO will be able to nominate two directors to serve on the Company's Board of Directors. In addition, the Company will advance cash to repay intercompany indebtedness outstanding at closing and assume $5.9 of third party debt. The amount of intercompany debt of WERCO at December 31, 1993 was $69,100,000, as adjusted. The Merger Agreement contains a provision that WECO may terminate the transaction if the average of the Company's Common Stock price for the ten trading days ending on the third business day prior to the closing is less than $19.00; provided, however, that the Company may cure such deficit in cash up to $10 million. The closing of the transaction is anticipated to take place three business days following the satisfaction of the conditions of closing. One closing condition is that certain firm transportation, storage and other contractual arrangements be transferred from WERCO's marketing affiliate to a newly formed subsidiary of WECO. The Company anticipates that the closing of the transaction will occur in early spring. GAS MARKETING The Company is engaged in a wide array of marketing activities designed to offer its customers long-term reliable supplies of natural gas. Utilizing its pipeline and storage facilities, gas procurement ability and transportation and natural gas swap expertise, the Company provides a menu of services that include gas supply management, short and long-term supply contracts, capacity brokering and risk management alternatives. The marketing of natural gas has changed significantly as a result of Order 636 (the "Order"), which was issued by the Federal Energy Regulatory Commission (the "FERC") in 1992. The Order required interstate pipelines to unbundle their gas sales, storage and transportation services. As a result, local distribution companies and end-users will separately contract these services from gas marketers and producers. The Order has created greater competition in the industry while providing the Company the opportunity to reach broader markets. In 1993, this has meant an increase in the number of third-party producers that use the Company to market their gas and margin pressures from increased competition for markets. APPALACHIAN REGION The Company's principal markets for Appalachian Region natural gas are in the northeastern United States. The Company's marketing subsidiary purchases substantially all of the Company's natural gas production as well as production from local third-party producers and other suppliers in order to aggregate larger volumes of natural gas for resale. This marketing subsidiary sells natural gas to industrial customers, interstate pipelines, local distribution companies and gas marketers. A substantial portion of the Company's natural gas sales volume in the Appalachian Region currently is sold under short-term contracts (a year or less) at market-responsive prices. The Company's spot market sales are made under month-to-month contracts while the Company's industrial and utility sales generally are made under year-to-year contracts. Spot market and term sales constituted 60% and 40%, respectively, of total Appalachian gas sales in 1993. The Company's Appalachian production is generally sold at a premium price to production from certain other producing regions due to its close proximity to markets. However, that premium has been reduced from historic levels due to increased competition in the market place resulting, in part, from changes in transportation and sales arrangements due to the implementation of pipeline open access tariffs. The Company operates a number of gas gathering and pipeline systems, made up of approximately 3,500 miles of pipeline with interconnects to four interstate and five local distribution companies ("LDCs"). The Company's natural gas gathering and pipeline systems enable the Company to connect new wells quickly and to transport natural gas from the wellhead directly to interstate pipelines, local distribution companies and industrial end-users. Control of its gathering and pipeline systems also enables the Company to purchase, transport and sell natural gas produced by third parties. In addition, the Company can undertake development drilling operations without relying upon third parties to transport its natural gas while incurring only the incremental costs of additions to its system and lease operations. The Company has two natural gas storage fields, with a combined working capacity of approximately 4 Bcf of natural gas, located in West Virginia. The Company uses these storage fields to take advantage of the seasonal variations in the demand for natural gas and the higher prices typically associated with winter natural gas sales, while maintaining its production at a nearly constant rate throughout the year. The storage fields also enable the Company to increase periodically the volume of natural gas it can deliver by more than 35% above the volume that it could deliver solely from its production in the Appalachian Region. The pipeline systems and storage fields are fully integrated with the Company's producing operations. ANADARKO REGION The Company's principal markets for Anadarko Region natural gas are in the midwestern United States. The Company's marketing subsidiary purchases substantially all of the Company's natural gas production. The marketing subsidiary sells natural gas to interstate pipelines, natural gas processors, LDCs, industrial customers and marketing companies. Currently, the Company's natural gas production in the Anadarko Region is being sold primarily under short-term contracts (a year or less) at market-responsive prices. The Anadarko Region properties are connected to the majority of the midwestern interstate pipelines, affording the Company access to multiple markets. RISK MANAGEMENT From time to time, the Company enters into certain transactions to manage price risks associated with the purchase and sale of oil and gas including, swaps and options. The Company utilized certain gas price swap agreements ("price swaps") to manage price risk more effectively and improve the Company's realized gas prices. These price swaps call for payments to (or to receive payments from) counterparties based upon the differential between a fixed and a variable gas price. The current price swaps run for periods of a year or less and have a remaining notional contract amount of 4,080,000 MMbtu of natural gas at December 31, 1993. The Company plans to continue this strategy in the future. RESERVES CURRENT RESERVES The Company's drilling program, combined with acquisitions in its core areas, created a 12 percent increase in proved reserves. Reserve replacement for the Company's drilling program was 127% in 1993, and the 1993 reserve replacement including acquisitions was 287 percent. The following table sets forth information regarding the Company's estimates of its net proved reserves at December 31, 1993. - --------------- (1) Liquids include crude oil and condensate. (2) Natural Gas Equivalents are determined using the ratio of 6.0 Mcf of natural gas to 1.0 Bbl of crude oil or condensate. The reserve estimates presented herein were prepared by the Company and reviewed by Miller and Lents, Ltd., independent petroleum engineers. For additional information regarding the Company's estimates of proved reserves, the review of such estimates by Miller and Lents, Ltd. and certain other information regarding the Company's oil and gas reserves, see the Supplemental Oil and Gas information to the Consolidated Financial Statements incorporated herein by reference in Item 8 hereof. A copy of the review letter by Miller and Lents, Ltd., has been filed as an exhibit to this Form 10-K. The Company's estimates of reserves set forth in the foregoing table do not differ materially from those filed by the Company with other federal agencies. The Company's reserves are sensitive to gas sales prices and their effect on economic producing rates. The Company's reserves are based on oil and gas prices in effect at December 31, 1993. There are numerous uncertainties inherent in estimating quantities of proved reserves, including many factors beyond the control of the Company. The reserve data set forth in this Form 10-K represent only estimates. Reserve engineering is a subjective process of estimating underground accumulations of crude oil and natural gas that cannot be measured in an exact manner, and the accuracy of any reserve estimate is a function of the quality of available data and of engineering and geological interpretation and judgment. As a result, estimates of different engineers often vary. In addition, results of drilling, testing and production subsequent to the date of an estimate may justify revision of such estimate. Accordingly, reserve estimates are often different from the quantities of crude oil and natural gas that are ultimately recovered. The meaningfulness of such estimates is highly dependent upon the accuracy of the assumptions upon which they are based. In general, the volume of production from oil and gas properties owned by the Company declines as reserves are depleted. Except to the extent the Company acquires additional properties containing proved reserves or conducts successful exploration and development activities or both, the proved reserves of the Company will decline as reserves are produced. THREE-YEAR RESERVES The following table sets forth certain information regarding the Company's estimated proved reserves for the periods indicated. - --------------- Note: Natural gas equivalents are determined using the ratio of 6.0 Mcf of natural gas to 1.0 Bbl of crude oil or condensate. VOLUMES AND PRICES; PRODUCTION COSTS The following table sets forth historical information regarding the Company's sales and production volumes of average sales prices received for, and average production costs associated with, its sales of natural gas and crude oil and condensate for the periods indicated. - --------------- (1) Equal to the aggregate of production and the net changes in storage and exchanges less fuel and line loss. (2) Represents the average sales prices for all volumes (including royalty volumes) sold by the Company during the periods shown. (3) Production costs include direct lifting costs (labor, repairs and maintenance, materials and supplies), and the costs of administration of production offices, insurance and property and severance taxes but is exclusive of depreciation and depletion application to capitalized lease acquisition, exploration and development expenditures. ACREAGE The following tables summarize the Company's gross and net developed and undeveloped leasehold and mineral acreage at December 31, 1993. Acreage in which the Company's interest is limited to royalty and overriding royalty interests is excluded. The undeveloped mineral fee acreage in West Virginia is unleased. LEASEHOLD ACREAGE MINERAL FEE ACREAGE TOTAL NET ACREAGE BY AREA OF OPERATION PRODUCTIVE WELL SUMMARY (1) The following table reflects the Company's ownership at December 31, 1993 in natural gas and oil wells in the Appalachian Region (consisting of various fields located in West Virginia, Pennsylvania, New York, Ohio, Virginia and Kentucky) and in the Anadarko Region (consisting of various fields located in Oklahoma, Texas, Kansas, North Dakota and Wyoming). - --------------- (1) "Productive" wells are producing wells and wells capable of production. DRILLING ACTIVITY The Company drilled, participated in the drilling of, or acquired wells as set forth in the table below for the periods indicated: - --------------- (1) At December 31, 1993, the Company had no waterfloods in the process of installation and was not conducting any pressure maintenance operations. (2) Includes the acquisition of net interest in certain wells in the Appalachian Region and in the Anadarko Region in 1993, 1992 and 1991 in which the Company already held an ownership interest. COMPETITION Competition in the Company's primary producing areas is intense. The Company believes that its competitive position is affected by price, contract terms and quality of service, including pipeline connection times, distribution efficiencies and reliable delivery record. The Company believes that its extensive acreage position, substantial ongoing drilling program and existing natural gas gathering and pipeline systems and storage fields give it a competitive advantage over certain other producers in the Appalachian Region which do not have such systems or facilities in place. The Company also believes that its competitive position in the Appalachian Region is enhanced by the absence of significant competition from major oil and gas companies. The Company also actively competes against some companies with substantially larger financial and other resources, particularly in the Anadarko Region. OTHER BUSINESS MATTERS MAJOR CUSTOMER The Company had no sales to any customer that exceeded 10% of the Company's total revenues in 1993. SEASONALITY Demand for natural gas is seasonal in nature, with peak demand and typically higher prices occurring during the colder winter months. REGULATION OF OIL AND GAS PRODUCTION The Company's oil and gas production and transportation operations are subject to various types of regulation, including regulation by state and federal agencies. Although such regulations have an impact on the Company and others in the oil, gas and pipeline industry, the Company does not believe that it is affected in a significantly different manner by these regulations than others in the oil and gas industry. Legislation affecting the oil and gas industry is under constant review for amendment or expansion. Numerous departments and agencies, both federal and state, are authorized by statute to issue, and have issued, rules and regulations binding on the oil and gas industry and its individual members. The failure to comply with such rules and regulations can result in substantial penalties. Many states require permits for drilling operations, drilling bonds and reports concerning operations. Many states also have statutes or regulations addressing, conservation matters, including provisions for the utilization or pooling of oil and gas properties, the establishment of maximum rates of production from oil and gas wells and the regulation of spacing, plugging and abandonment of such wells. Some state statutes and regulations limit the rate at which oil and gas can be produced from the Company's properties. With respect to the establishment of maximum production rates from gas wells, certain producing states, in an attempt to limit production to market demand, have recently adopted (Texas and Oklahoma) or are considering adopting (Louisiana) measures that alter the methods previously used to prorate gas production from wells located in these states. For example, the new Texas rules provide for reliance on information filed monthly by well operators, in addition to historical production data for the well during comparable past periods, to arrive at an allowable. This is in contrast to historic reliance on forecasts of upcoming takes filed monthly by purchasers of natural gas in formulating allowable, a procedure which resulted in substantial excess allowable over volumes actually produced. The Company cannot predict whether other states will adopt similar or other gas prorationing procedures. While it is still unclear how these new regulations will be administered, the effect of these regulations could be to decrease allowable production on the Company's properties, and thereby to decrease revenues. However, management believes that such regulation would not have a significant impact on the Company's revenues. By decreasing the amount of natural gas available in the market, such regulations could also have the effect of increasing prices of natural gas, although there can be no assurance that any such increase will occur. The company cannot predict whether these new prorationing regulations will be challenged in the courts or the outcome of such challenges. The Natural Gas Act of 1938 (the "NGA") regulates the interstate transportation and certain sales for resale of natural gas. The Natural Gas Policy Act of 1978 (the "NGPA") regulated the maximum selling prices of certain categories of natural gas, when sold in so-called "first sales" in interstate or intrastate commerce and provided for phased deregulation of price controls of the first sales of several categories of natural gas. These statutes are administered by the FERC. As a result of the enactment of the Natural Gas Wellhead Decontrol Act of 1989 ("Decontrol Act") on July 26, 1989, all remaining "first sales" price regulations imposed by the NGA and NGPA terminated on January 1, 1993. Commencing in late 1985 and early 1986, the FERC issued a series of orders which significantly altered the marketing and pricing of natural gas. Among other things, the new regulations require interstate pipelines that elect to transport natural gas for others under self-implementing authority to provide transportation services to all shippers (e.g., producers, marketers, local distributors and end-users) on an open and non-discriminatory basis, and permit each existing firm sales customer of such pipelines to modify, over at least a five-year period, its existing firm purchase obligations. Order No. 500 was issued by the FERC on August 7, 1989, in response to the remand of Order No. 436 by the United States Court of Appeals for the District of Columbia. Order No. 500 repromulgated most of the provisions of Order No. 436 and resulted in an almost complete affirmation of the Order No. 500 "open access" rules, with the exception of the pregranted abandonment issue and the use of certain types of pass through mechanisms by interstate pipelines to recover take-or-pay costs. In April 1992, the FERC issued Order 636, a complex regulation which is expected to have a major impact on natural gas pipeline operations, services and rates. Among other things, Order 636 requires each interstate pipeline company to "unbundle" its traditional wholesale services and create and make available on an open and nondiscriminatory basis numerous constituent services (such as gathering services, storage services, firm and interruptible transportation services, and stand-by sales services) and to adopt a new rate making methodology to determine appropriate rates for those services. To the extent the pipeline company or its sales affiliate makes gas sales as a merchant in the future, it will do so in direct competition with all other sellers pursuant to private contracts; however, pipeline companies are not required to remain "merchants" of gas, and many of the interstate pipeline companies have or will become "transporters only." On August 3, 1992, the FERC issued Order 636-A, which largely reaffirmed Order 636 and denied a stay of the implementation of the new rules pending judicial review. On November 27, 1992, the FERC issued Order 636-B which uniformly upheld the requirements and regulations adopted in Order 636 and 636-A. As a result of these events, individual so-called "restructuring" proceedings are on-going before FERC by which each interstate pipeline company will develop and propose particularized features and procedures for its system to implement Order 636 requirements. These new rules are already the subject of appeals in the United States Courts of Appeals. The Company cannot predict whether Order 636 will be affirmed on appeal. However "open access" transportation under Order 636 has provided the Company with the opportunity to market gas to a wide variety of markets. The Company's pipeline systems and storage fields are regulated for safety compliance by the Department of Transportation, the West Virginia Public Service Commission, the Pennsylvania Department of Natural Resources and the New York Department of Public Service. The Company's pipeline systems in each state operate independently and are not interconnected. ENVIRONMENTAL REGULATIONS The Company's operations are subject to extensive federal, state and local laws and regulations relating to the generation, storage, handling, emission, transportation and discharge of materials into the environment. Permits are required for the operation of various facilities of the Company, and these permits are subject to revocation, modification and renewal by issuing authorities. Governmental authorities have the power to enforce compliance with their regulations, and violations are subject to fines, injunctions or both. It is possible that increasingly strict requirements will be imposed by environmental laws and enforcement policies thereunder. The Company is also subject to the Federal Clean Air Act and the Federal Clean Air Act Amendments of 1990 which added significantly to the existing requirements established by the Federal Clean Air Act. It is not anticipated that the Company will be required in the near future to expend amounts that are material in relation to its total capital expenditures program by reason of environmental laws and regulations, but inasmuch as such laws and regulations are frequently changed, the Company is unable to predict the ultimate cost of such compliance. The Company owns and operates a brine treatment plant in Pennsylvania which processes fluids generated by drilling and production operations. See "Exploration, Development and Production -- Appalachian Region." The plant's operations are regulated by Pennsylvania's Department of Environmental Regulation. EMPLOYEES The Company had approximately 433 active employees as of December 31, 1993. The Company believes that its relations with its employees are satisfactory. The Company has not entered into any collective bargaining agreements with its employees. ITEM 2.		ITEM 2. PROPERTIES See "Item 1. Business." ITEM 3.	ITEM 3. LEGAL PROCEEDINGS The Company and its subsidiaries are defendants or parties in numerous lawsuits or other governmental proceedings arising in the ordinary course of business. See Note 10 of the Notes to the Consolidated Financial Statements incorporated herein by reference in Item 8 hereof for a discussion of Company contingencies. ITEM 4.	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted to a vote of security holders during the period from October 1, 1993 to December 31, 1993. EXECUTIVE OFFICERS OF THE REGISTRANT The following table shows certain information about the executive officers of the Company as of March 1, 1994, as such term is defined in Rule 3b-7 promulgated under the Securities Exchange Act of 1934, as amended. With the exception of the following, all officers of the Company have been employed by the Company for more than the last five years. John H. Lollar joined the Company in October 1992 being elected President and Director. In January 1994. Mr. Lollar was elected Chairman of the Board and Chief Executive Officer. Prior to joining the Company, Mr. Lollar was President and Chief Operating Officer of Transco Exploration and Production Company from 1982 to 1992 and Executive Vice President and Chief Operating Officer, in addition to holding other positions, of Gulf Resources & Chemical Corporation from 1968 to 1982. John U. Clarke joined the Company in August 1993 as Executive Vice President -- Chief Financial Officer and Chief Administrative Officer. Prior to joining the Company, he was employed by Transco Energy Company from April 1981 to May 1993, most recently in the position of Senior Vice President, Chief Financial Officer and Treasurer. Previously, he was employed by Tenneco Inc. in the finance department. Richard T. Parrish joined the Company in August 1993 as Vice President, Engineering. Prior to joining the Company, Mr. Parrish was Vice President, Engineering and Planning, for Transco Exploration and Production Company from 1977 to 1992 and Assistant District Engineer, Reservoir and Production for Texaco, Inc. from 1974 to 1977. Prior thereto, Mr. Parrish was employed in various engineering capacities with Texaco, Inc. from 1969 to 1974. Kirk O. Kuwitzky joined the Company in January, 1994 as Vice President, Marketing. Prior to joining the Company, he was employed by Enron Corp. from 1981-1993, most recently as Vice President-Marketing for Enron Gas Marketing. In addition, he previously held various marketing positions with Enron Gas Marketing and several positions in Enron Corp.'s law department. From 1978 until 1981, he was an attorney with Minnesota Power. Steven W. Tholen has been Treasurer of the Company since June 1992. Prior thereto, Mr. Tholen was Assistant Treasurer from January 1992 to June 1992 and was Manager, Treasury Operations from May 1990 to January 1992. Prior to joining the Company, Mr. Tholen was employed in a treasury capacity for Reading & Bates Corporation from February 1989 to May 1990. PART II ITEM 5.	ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company has furnished to the Securities and Exchange Commission pursuant to Rule 14a-3(c) an annual report to security holders for the year ended December 31, 1993 (the "Annual Report"), that contains the information required by Rule 14a-3. The information required by this item appears under the caption "Price Range of Common Stock and Dividends" on page 42 of the Annual Report, which is incorporated herein by reference, and in Note 12 of the Notes to the Consolidated Financial Statements incorporated herein by reference in Item 8 hereof. ITEM 6.	ITEM 6. SELECTED HISTORICAL FINANCIAL DATA The information required by this item appears under the caption "Selected Historical Financial Data" on page 17 of the Annual Report and is incorporated herein by reference. ITEM 7.	ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information required by this item appears under the caption "Financial Review" on pages 18 through 23 of the Annual Report and is incorporated herein by reference. ITEM 8.	ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required by this item appears on pages 24 through 43 of the Annual Report and is incorporated herein by reference. 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 to be set forth under the caption "I. Election of Directors" in the Company's definitive proxy statement ("Proxy Statement") in connection with the 1994 annual stockholders meeting, is incorporated herein by reference. ITEM 11.	ITEM 11. EXECUTIVE COMPENSATION The information appearing under the caption "II. Executive Compensation" in the Proxy Statement is incorporated herein by reference. ITEM 12.	ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information appearing under the caption "I. Election of Directors" in the Proxy Statement is incorporated herein by reference. ITEM 13.	ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS None. PART IV ITEM 14.	ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES AND REPORTS ON FORM 8-K A. INDEX Other financial statement schedules have been omitted because they are inapplicable or the information required therein is included elsewhere in the consolidated financial statements or notes thereto. 3. EXHIBITS The following instruments are included as exhibits to this report. Those exhibits below incorporated by reference herein are indicated as such by the information supplied in the parenthetical thereafter. If no parenthetical appears after an exhibit, copies of the instrument have been included herewith. B. REPORTS ON FORM 8-K (1) Form 8-K/A, Amendment No. 1 to Current Report, dated September 30, 1993. Filed on November 15, 1993. (2) Form 8-K/A, Amendment No. 2 to Current Report, dated September 30, 1993. Filed on December 14, 1993. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Houston, State of Texas, on the 25th day of February 1994. CABOT OIL & GAS CORPORATION By: /s/ JOHN H. LOLLAR John H. Lollar, Chairman of the Board and President Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons in the capacities and on the dates indicated. REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Stockholders and Board of Directors of Cabot Oil & Gas Corporation: Our report on the consolidated financial statements of Cabot Oil & Gas Corporation has been incorporated by reference in this Form 10-K from page 24 of the 1993 Annual Report to Stockholders. In connection with our audits of such financial statements, we have also audited the related financial statement schedules listed in the index on page 17 of this Form 10-K. In our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. COOPERS & LYBRAND Houston, Texas February 25, 1994 S-1 SCHEDULE V CABOT OIL & GAS CORPORATION PROPERTY, PLANT AND EQUIPMENT (DOLLARS IN THOUSANDS) - --------------- (1) Includes a reclassification to accumulated depreciation, depletion and amortization (Schedule VI). S-2 SCHEDULE VI CABOT OIL & GAS CORPORATION ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (DOLLARS IN THOUSANDS) - --------------- (1) Includes a reclassification to accumulated depreciation, depletion and amortization (Schedule VI). (2) Accumulated depreciation, depletion and amortization of property, plant and equipment includes a reserve for dismantlement, restoration and abandonment of proved oil and gas properties. Accordingly, actual expenditures will result in a retirement on Schedule VI without any corresponding retirement on Schedule V. S-3 SCHEDULE X CABOT OIL & GAS CORPORATION SUPPLEMENTAL INCOME STATEMENT INFORMATION (DOLLARS IN THOUSANDS) S-4
789575_1993.txt	789575	1993	Item 1. Business - ----------------- Grenada Sunburst System Corporation (the "Registrant") is a multi-bank holding company headquartered in Grenada, Mississippi. The Registrant was organized under the laws of the state of Delaware on May 20, 1986. The Registrant has two major subsidiaries: Sunburst Bank, Mississippi, and Sunburst Bank, Louisiana. Sunburst Bank, Mississippi, organized in 1890, and Sunburst Bank, Louisiana, acquired in May 1988 (collectively the "Banks"), had approximately $1,952 million and $509 million, respectively, in total assets as of December 31, 1993. The Registrant is engaged in a general commercial banking business, conducting operations in 124 locations in 59 communities in Mississippi and Louisiana. The Banks accept demand deposits and various types of interest bearing transaction and time deposit accounts and utilize funds from such activities to make loans and other investments. In addition, through the Registrant's subsidiary, Sunburst Financial Group, Inc., the Registrant offers full-service brokerage to its customers. The Banks offer a wide range of fiduciary services through their trust divisions, and mortgage services through Sunburst Mortgage Corporation as well as other financial services to their customers. The Registrant has expanded its operations through de novo branch banking and acquisition of banks in Mississippi and Louisiana. Each branch office of the Banks does business under the name "Sunburst Bank". At December 31, 1993 the Registrant had 1,657 full-time equivalent employees. Sunburst Bank, Mississippi is incorporated under the laws of the State of Mississippi, and as such, is subject to regulation by the Department of Banking and Consumer Finance for the State of Mississippi. Sunburst Bank, Louisiana is incorporated under the laws of the State of Louisiana and is subject to regulation by the Office of Financial Institutions for the State of Louisiana. The Registrant is registered as a bank holding company with the Board of Governors of the Federal Reserve System and is governed by its applicable laws and regulations as a bank holding company. The Banks' deposits are insured by the FDIC, and, therefore, both banks are subject to the regulations of the Federal Deposit Insurance Act and to examination by that corporation. XXX BEGIN PAGE 3 HERE XXX EXECUTIVE OFFICERS OF THE REGISTRANT When Name Position Held with the Registrant Age Elected - --------------------------------------------------------------------------- R.E. Kennington, II Chairman of the Board 61 1986 J. T. Boone President & Chief Executive 43 1988 Officer D. L. Holland Chief Financial Officer & 50 1986 Treasurer A. J. Huff President & Chief Operating 51 1990 Officer, Sunburst Bank, LA Don W. Ayres Senior Executive Vice President, 48 1991 Sunburst Bank, MS J. Daniel Garrick, III Senior Executive Vice President, 44 1990 Sunburst Bank, MS Frank W. Smith, Jr. Senior Executive Vice President, 40 1990 Sunburst Bank, MS James L. Brown Regional Executive, Northeast 46 1987 Region, Sunburst Bank, MS Thomas H. Carroll, Jr. Regional Executive, Northwest 54 1987 Region, Sunburst Bank, MS E. Jackson Garner Regional Executive, Central 48 1989 Region, Sunburst Bank, MS Todd Mixon Regional Executive, Southern 44 1990 Region, Sunburst Bank, MS James A. Baker Executive Vice President, 49 1991 Asset Quality Group Jerry A. Pegg Executive Vice President, 50 1990 Corporate Administration There are no family relationships between any of the executive officers of the Registrant. XXX BEGIN PAGE 4 HERE XXX R. E. Kennington, II, served as Chief Executive Officer of the Registrant from 1986 to 1992, as Chairman of the Board and Chief Executive Officer of Sunburst Bank, Mississippi, for the period from 1981 to 1989, and as Chairman of Sunburst Bank, Louisiana for 1988 and 1989. Mr. Boone served as Chief Operating Officer of the Registrant from 1990 to 1992, Chief Executive Officer for Sunburst Bank, Louisiana for the years 1988 and 1989 and as Executive Vice President of Sunburst Bank, Mississippi for the six years prior to that. Mr. Huff served as President of the Laurel, MS branch of Sunburst Bank, MS prior to 1990. Mr. Ayres was hired October 9, 1991. Mr. Garrick served as Executive Vice President of Personnel for Sunburst Bank, MS prior to 1990. Mr. Smith served as Executive Vice President of Investments for Sunburst Bank, MS prior to 1990. Mr. Garner served as Executive Vice President for Grenada Sunburst System Corporation prior to 1989. Mr. Mixon served as Senior Vice President of the Commercial Lending Group for Sunburst Bank, MS prior to 1990. Mr. Pegg served as Senior Vice President for Sunburst Bank, MS prior to 1990. Item 2.		Item 2. Properties - ------------------ The administrative office of the Registrant is presently located in a modern two story glass, steel, and concrete building owned by the Registrant and located in Grenada, Mississippi. Sunburst Bank, Mississippi operates 124 banking locations, the majority of which are owned premises. Sunburst Bank, Louisiana operates from its main offices in Baton Rouge, Louisiana and has 15 full service offices, one drive-in facility and one operations center. Ten of the offices are owned by the Bank, while seven are leased. Sunburst Financial Group, Inc. operates four offices in Mississippi: one modern, leased building in Jackson, Mississippi which is the main office location, one owned building in Grenada, one owned building in Hattiesburg, and one owned building in Meridian. Sunburst Bank's wholly owned subsidiary, Rapid Finance, Inc. operates 13 consumer lending offices in Mississippi, all of which are leased. All buildings are of either brick masonry or glass, steel, and concrete construction. All buildings have been constructed or remodeled in the last 10 to 15 years and are considered adequate for current and future banking needs. Item 3.	Item 3. Legal Proceedings - -------------------------- Various claims and lawsuits, incidental to the ordinary course of business, are pending against the Registrant and its subsidiaries. In the opinion of management, after consultation with legal counsel, resolution of these matters is not expected to have a material effect on the consolidated financial statements. Item 4.	Item 4. Submission of Matters to a Vote of Security Holders - ------------------------------------------------------------ There were no matters submitted to a vote of security holders during the fourth quarter of the year ended December 31, 1993. XXX BEGIN PAGE 5 HERE XXX PART II Item 5.	Item 5. Market for Registrant's Common Stock and Related Stockholder Matters - ----------------------------------------------------------------------------- The information under the caption "Stock Information" on page 57 and Note 13 of Notes to Consolidated Financial Statements on page 30 of Exhibit 13.1 attached hereto is incorporated herein by reference. Item 6.	Item 6. Selected Financial Data - -------------------------------- The information under the caption "Selected Consolidated Financial Information" on page 37 of Exhibit 13.1 attached hereto is incorporated herein by reference. Item 7.	Item 7. Management's Discussion and Analysis of Financial Condition and - ----------------------------------------------------------------------------- Results of Operations --------------------- The information under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 39 thru 64 of Exhibit 13.1 attached hereto is incorporated herein by reference. Item 8.	Item 8. Financial Statements and Supplementary Data - ---------------------------------------------------- The following consolidated financial statements of the Registrant and its subsidiaries, the report of independent certified public accountants thereon, and the quarterly data (unaudited) appearing at the pages set forth below in Exhibit 13.1 attached hereto are incorporated herein by reference. Consolidated Balance Sheets Page 11 Consolidated Statements of Income Page 12 Consolidated Statements of Changes in Stockholders' Equity Page 13 Consolidated Statements of Cash Flows Page 14 Notes to Consolidated Financial Statements Pages 15 - 35 Independent Auditor's Report Page 36 Summary of Quarterly Results of Operations (Unaudited) Page 38 Item 9.	Item 9. Disagreements on Accounting and Financial Disclosures - -------------------------------------------------------------- There have been no disagreements with the Registrant's independent accountants and auditors on any matter of accounting principles or financial statement disclosure. XXX BEGIN PAGE 6 HERE XXX PART III Item 10.	Item 10. Directors and Executive Officers of Registrant - -------------------------------------------------------- Information concerning the directors and nominees of the Registrant appears on pages 3 and 4 of the Registrant's definitive Proxy Statement dated March 18, 1994, and is incorporated herein by reference except for the following information: J. H. Tabb, formerly a director of the Registrant, passed away on March 25, 1994. Information concerning executive officers of the Registrant is presented in Part I hereof. Item 11.	Item 11. Executive Compensation - -------------------------------- Information concerning the remuneration of officers and directors of the Registrant and transactions with such persons appears on pages 5-11 of the Registrant's definitive Proxy Statement dated March 18, 1994, and is incorporated herein by reference. Item 12.	Item 12. Security Ownership of Certain Beneficial Owners and Management - ------------------------------------------------------------------------ Information concerning the security ownership of certain beneficial owners and directors and officers of the Registrant appears on pages 2, 3 and 4 of the Registrant's definitive Proxy Statement dated March 18, 1994, and is incorporated herein by reference. Item 13.	Item 13. Certain Relationships and Related Transactions - -------------------------------------------------------- Not applicable XXX BEGIN PAGE 7 HERE XXX PART IV Item 14:	Item 14: Exhibits, Financial Statement Schedules and Reports on Form 8-K - ------------------------------------------------------------------------- (a) 1. Financial Statements - See Item 8 above 2. Financial Statement Schedules - All schedules applicable to the Registrant are included in Item 8 above, in the financial statements or related notes thereto 3. Exhibits: 3.1 Certificate of Incorporation (filed as Exhibit (3.1) to the Registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 1992 and incorporated herein by reference) 3.2 Bylaws, as amended (filed as Exhibit (3.2) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1992 and incorporated herein by reference) 10.1 Equity Share Bonus Plan and Participation Agreement, as amended (filed as Exhibit (10.1) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1992 and incorporated herein by reference) 10.2 Deferred Compensation Agreement (filed as Exhibit (10.2) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1991 and incorporated herein by reference) 10.3 Management Incentive Compensation Plan (filed as Exhibit (10.3) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1991 and incorporated herein by reference) 10.4 Form of Executive Employment Contracts (filed as Exhibit (10.4) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1991 and incorporated herein by reference) 10.5 Agreement to Merge with Commercial National Bank, Baton Rouge, LA dated September 28, 1989 (filed as Exhibit A of the Registrant's Registration Statement on Form S-4 (Reg. No. 33-31627) and incorporated herein by reference) 10.6 Purchase and Assumption Agreement among Eastover Bank for Savings, the Registrant and Sunburst Bank, Mississippi dated July 22, 1992 (filed as Appendix H of the Registrant's Registration Statement on Form S-4 (Reg. No. 33-53170) and incorporated herein by reference) 13.1 Portions of the Grenada Sunburst System Corporation 1993 Annual Report (filed herewith) 21.1 Subsidiaries of the Registrant (filed herewith) 23.1 Consent of Independent Auditors (filed herewith) ----------------------------------------------------------------- * Management contract or compensatory plan or agreement identified hereby pursuant to Item 14(a)3. (b) No reports were filed on Form 8-K during the quarter ending December 31, 1993. XXX BEGIN PAGE 8 HERE XXX Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Grenada Sunburst System Corporation ----------------------------------- BY: /s/Daniel L. Holland Chief Financial Officer and Treasurer -------------------- (Principal Financial and Accounting Daniel L. Holland Officer) Date: March 30, 1994 ---------------- 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 Date Capacity --------- ---- -------- /s/James T. Boone March 30, 1994 President and Chief - -------------------- Executive Officer James T. Boone (Principal Executive Officer) /s/Daniel L. Holland March 30, 1994 Chief Financial Officer - -------------------- and Treasurer (Principal Daniel L. Holland Financial and Accounting Officer) XXX BEGIN PAGE 9 HERE XXX Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following person on behalf of the Registrant and in their capacity as Director on March 30, 1994. /s/James T. Boone /s/E. Hayes Branscome - --------------------------- --------------------------- Boone, James T. Branscome, E. Hayes /s/J. Russell Flowers /s/John T. Keeton - --------------------------- --------------------------- Flowers, J. Russell Keeton, John T. /s/Robert E. Kennington, II /s/J. M. Robertson, Jr. - --------------------------- --------------------------- Kennington, II, Robert E. Robertson, Jr., J. M. /s/Milton J. Womack - --------------------------- Womack, Milton J. XXX BEGIN PAGE 10 HERE XXX EXHIBIT INDEX ------------- Item 14(a)3. Exhibits Page - --------------------- ---- 3.1 Certificate of Incorporation (filed as Exhibit (3.1) to the Registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 1992 and incorporated herein by reference)......N/A 3.2 Bylaws, as amended (filed as Exhibit (3.2) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1992 and incorporated herein by reference).........N/A 10.1 Equity Share Bonus Plan and Participation Agreement, as amended (filed as Exhibit (10.1) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1992 and incorporated herein by reference)...........................N/A 10.2 Deferred Compensation Agreement (filed as Exhibit (10.2) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1991 and incorporated herein by reference).........N/A 10.3 Management Incentive Compensation Plan (filed as Exhibit (10.3) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1991 and incorporated herein by reference)......................................................N/A 10.4 Form of Executive Employment Contracts (filed as Exhibit (10.4) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1991 and incorporated herein by reference)......................................................N/A 10.5 Agreement to Merge with Commercial National Bank, Baton Rouge, LA dated September 28, 1989 (filed as Exhibit A of the Registrant's Registration Statement on Form S-4 (Reg. No. 33-31627) and incorporated herein by reference).................N/A 10.6 Purchase and Assumption Agreement among Eastover Bank for Savings, the Registrant and Sunburst Bank, Mississippi dated July 22, 1992 (filed as Appendix H of the Registrant's Registration Statement on Form S-4 (Reg. No. 33-53170) and incorporated herein by reference)...............................N/A 13.1 Portions of the Grenada Sunburst System Corporation 1993 Annual Report (filed herewith)...................................11 21.1 Subsidiaries of the Registrant (filed herewith)..................65 23.1 Consent of Independent Auditors (filed herewith).................66 ----------------------------------------------------------------------- * Management contract or compensatory plan or agreement identified hereby pursuant to Item 14(a)3. (b) No reports were filed on Form 8-K during the quarter ending December 31, 1993.
703559_1993.txt	703559	1993	ITEM 1. BUSINESS (a) General Development of Business. HUBCO, Inc. ("HUBCO" or "Registrant" or the "Company") is a bank holding company registered under the Bank Holding Company Act of 1956, as amended (the "Bank Holding Company Act"). HUBCO was organized under the laws of New Jersey in 1982 by Hudson United Bank for the purpose of creating a bank holding company for Hudson United Bank. HUBCO directly owns Hudson United Bank ("the Bank") and a second subsidiary, HUB Financial Services, Inc. HUBCO is also the indirect owner, through Hudson United Bank of an investment subsidiary and an inactive subsidiary. Each of HUBCO's direct and indirect subsidiaries is described below in this Item 1. Growth of Hudson United Bank Hudson United Bank was incorporated in 1890 as a state-chartered commercial bank. The bank took on its present name in a merger with United National Bank of Bergen County in 1972. In 1975, Hudson United Bank acquired an additional branch when it purchased Peoples Trust Company of Dunellen. In 1981, the bank sold one of its branches in Bloomfield, New Jersey. In 1983, the bank acquired another branch when it assumed the deposits and purchased certain assets of Pan American National Bank from the Federal Deposit Insurance Corporation ("FDIC") and began operating the former Pan American National Bank office in Union City, New Jersey as a branch of Hudson United Bank. Additional branches were opened in West New York, North Bergen, and Edgewater, New Jersey in 1986, 1988 and 1990, respectively. Since October 1990, HUBCO has engaged in a series of acquisitions, which are briefly described below. As of the filing of this Form 10-K, the Company has two substantial acquisitions pending. In May, 1993, the Company and the Bank agreed to acquire Statewide Savings Bank, S.L.A. ("Statewide"), a mutual savings and loan association, in a merger-conversion transaction. Under the agreement, the Company will sell shares of its common stock to Statewide's eligible depositors and other voting members at a discounted price (which is the lesser of $18.00 per share, or 95% of the market price of HUBCO stock for the 10 trading days prior to the closing date) in an amount equal to the appraised value of Statewide as determined by an independent appraiser. The independent appraiser has, on a preliminary basis as of December 6, 1993, determined the appraised value of Statewide to be approximately $35 million. The Company's stockholders will be offered any remaining shares at the same price as the shares are offered to Statewide's depositors. Shares not sold to Statewide's eligible depositors, other voting members and the Company stockholders are expected to be sold to the public at the then market price. As part of the transaction and simultaneously with the closing, Statewide will convert from a state savings and loan to a state mutual savings bank charter, from mutual to stock form and finally to a Commercial Bank Charter and then be merged into the Company's banking subsidiary, Hudson United Bank. As of the end of Statewide's last fiscal year on March 31, 1993, Statewide reported total assets, tangible net worth and net income of $518 million, $13.4 million and $5.1 million, respectively and had 13 branch offices serving Northern New Jersey markets. In December 1993, the Company filed a registration statement on Form S-3 for purposes of proceeding with the merger conversion and the sale of the Company's common stock. At about the same time, the Company, the Bank and Statewide filed various regulatory applications with the New Jersey Department of Banking, the Federal Deposit Insurance Corporation ("FDIC") and the Board of Governors of the Federal Reserve System ("FRB"). The New Jersey Department of Banking approved the applications that were filed by the Bank and by Statewide. However, the FDIC proposed a new policy and new interim regulations on mutual to stock conversions in January and February, 1994 and eventually, Statewide was required in March 1994 to file a new notice of conversion with the FDIC. On March 25, 1994, Statewide's notice of conversion was accepted by the FDIC for processing, but such processing may take up to 60 days. The policy of the FDIC on conversions, especially merger conversions, is still evolving and the effect of this on the approval of the Statewide transaction, is difficult to determine at this time. The transaction is subject to the approval of the FDIC and the FRB, neither of which have been received. The transaction is also subject to the approval of Statewide's depositors at a meeting to be held for that purpose. Statewide has the right to terminate the transaction if any of the approvals impose substantial conditions. The parties recently agreed to extend to the date after which either party could terminate the acquisition agreement to June 30, 1994. The acquisition of Statewide has taken longer than the Company anticipated due to a variety of factors. As a consequence, the Company has incurred and continues to incur substantial expenses for legal, accounting and printing costs in connection with the acquisition. If the acquisition were not consummated these expenses, which have been capitalized, would impact the Company's earnings , and there could be in that quarter a decline in earnings compared to the prior quarter. In November, 1993, the Company and its subsidiary bank agreed to acquire Washington Bancorp, Inc. and its subsidiary, Washington Savings Bank (together "Washington") for a combination of cash and convertible preferred stock with an aggregate consideration of approximately $40.5 million. In the transaction, approximately 51% of Washington's common stock will be converted into a new Class A Convertible preferred stock of the Company and 49% of Washington shares will be converted into cash at $16.10 per share, with Washington stockholders having the right to elect either cash or the preferred stock. Each full share of preferred stock will have a stated value of, and be redeemable for, $24.00 or be convertible into one share of Company common stock. The holders of the preferred stock will be entitled to receive an annual dividend to be set annually on the basis of the average market price of the Company's common stock during a twenty consecutive business day period ending two days prior to the date the dividend is set. The dividend will range from $1.00 per share of preferred stock if the common stock is trading at $24.00 or higher, up to $1.68 per share if the common stock is trading below $19.00. If the common stock is trading between $19.00 and $23.99, the dividend will be between $1.56 and $1.10 per share. The shares are immediately convertible whenever HUBCO shares trade at an average price of $24.00 for a ten day period. At December 31, 1993, Washington reported $282.6 million in assets and $2.8 million in earnings for the year and had eight branch offices serving Northern New Jersey markets. Consummation of the transaction contemplated by the Washington Merger Agreement is subject to a number of conditions, including, among others, obtaining all necessary regulatory approvals and the approval of Washington's shareholders, the receipt by Washington of a fairness opinion and, to the extent necessary, the approval of the Company's stockholders. The Company has made a determination that a vote of the Company's stockholders will not be required. The Company has the right to terminate the Washington Merger Agreement for a number of reasons, including if there is a material adverse change in the business, operations or financial condition of Washington. Under the material adverse change clause, but without limiting the definition of a material adverse change, the Company has the right to terminate the Washington Merger Agreement if Washington's largest non-performing loan, a loan of approximately $9.0 million, is not brought to performing status or if substantial steps are not taken to proceed with foreclosure on the loan. Although the Company anticipates that it will proceed with the acquisition of Washington, it continues to examine this loan and the circumstances surrounding the collateral. The Company's acquisition philosophy is to seek in-market or contiguous market opportunities which can be accomplished with little dilution to earnings. Since October 1990, the Company has acquired the assets and liabilities of six institutions, adding to its assets and liabilities a total of $807.2 million in assets and $805.7 million in liabilities and expanding its branch network from 15 branches to 37 branches. Over 80% of these assets and liabilities were acquired through government assisted transactions which allows the Bank to reprice deposits, review loans and purchase only those loans which meet its underwriting criteria. The balance of the assets and liabilities were acquired in traditional negotiated private transactions which the Company believes present a different level of risk than the risk presented in government assisted transactions. Summary of Acquisitions The following chart summarizes the acquisitions undertaken by the Company since October 1990: The Company's profitability and its financial condition may be significantly impacted by the continuing implementation of its acquisition strategy and by the consummation of the acquisition of Statewide and the acquisition of Washington. If the acquisition of Statewide and the acquisition of Washington are both consummated, the Company will add 21 branch offices (some of which it may close) and approximately $781 million in assets, increasing the Company's branches by more than 50% and its assets by 75%. Moreover, it is likely that an expansion of this magnitude will necessitate substantially increased staffing in the Company's operations along with the increased revenue stream. In addition to the other challenges presented by the acquisitions of Statewide and Washington, both institutions have a significant volume of non-performing assets, including non-accrual loans and real estate acquired in connection with collection actions on loans ("OREO properties"). At December 31, 1993, the Company had $11.5 million in non-performing assets, while Statewide had $12.5 million and Washington had $20.0 million. The Company does plan to utilize bulk sales of problem assets to reduce these non-performing assets. The Company intends to continue to seek acquisition opportunities that arise in its market area. There can be no assurance that the Company will be able to acquire additional financial institutions or, if additional financial institutions are acquired, that these acquisitions will be managed successfully to enhance the profitability of the Company. On November 8, 1993, the Company's Board of Directors authorized a stock repurchase plan and authorized management to repurchase up to 10% of its outstanding common stock per year beginning immediately. At that time, the Company had approximately 6.9 million shares outstanding. As of March 1, 1994, the Company had repurchased 455,081 shares at a cost of $10,131,898 , of which 12,300 shares have been reissued by the Company as awards under its restricted stock plan and the balance of the Treasury shares will be reissued in the Statewide merger conversion stock offering. The Company's management currently does not have intentions to purchase additional shares under the stock repurchase plan but intends to re-examine the issue from time to time. The Company's last repurchase of shares was on January 24, 1994. On January 14, 1994, the Company sold $25 million aggregate principal amount of subordinated debt in a private placement. The subordinated debentures bear interest at 7.75% per annum payable semi-annually. The debentures mature in 2004 (i.e., ten years after the date of original issuance) and payment of the principal of the debentures may be accelerated only upon the bankruptcy or insolvency of the Company or its major banking subsidiary. The debt was issued under an indenture intended to comply with the terms and conditions of the Trust Indenture Act of 1939 and the Company is obligated to register the subordinated debt with the SEC by July 13, 1994, for an exchange offer for registered securities or in a resale transaction. The subordinated debt has been structured to comply with the current rules of the Board of Governors of the Federal Reserve System regarding debt which will qualify as Tier 2 capital under the FRB capital adequacy rules. It may also be invested in the banking subsidiary as Tier I capital. The Company sold the debt as part of a long term strategy to raise capital and did not need the additional capital or funds raised to pay for existing acquisitions. The Company intends to use the net proceeds from the sale of the subordinated debt for general corporate purposes, including investments in and advances to the Company's subsidiaries, and for financing possible future acquisitions of deposits and banking assets. Pending such use, the Company or its subsidiaries may temporarily invest the net proceeds in investment grade securities. The Company has outgrown the space at its headquarters office and commencing in the fourth quarter of 1993 the Company actively undertook a search for additional space to expand its headquarters operations. In March of 1994, the Company contracted to purchase a 64,350 square foot building in Mahwah, New Jersey to house the executive offices of the Company and the Company's data processing subsidiary, which will service the Bank's data processing and check processing needs and will offer its services to smaller banks in the New York and New Jersey area. The net increase in the Company's total other expenses directly attributable to this purchase is anticipated to be approximately one percent. Other Subsidiaries HUBCO has a second directly-owned subsidiary called HUB Financial Services, Inc., a data processing subsidiary formed in January 1983, which has primarily serviced automobile and equipment leases for Hudson United Bank, on a fee basis. In 1988 HUB Financial Services, Inc. received approval from the Federal Reserve Board for making, acquiring, selling and servicing real estate mortgage loans, and commenced operations as a mortgage broker. In 1984, Hudson United Bank established a subsidiary corporation in Delaware to manage a portion of its investment portfolio and had contributed $20,033,509 of its investment portfolio to the corporation as of December 31, 1992. In February 1993, the assets of the Delaware Corporation were transferred up to its parent, Hudson United Bank, in the form of a dividend and the subsidiary was dissolved. In 1987, Hudson United Bank established a subsidiary corporation in New Jersey to manage a portion of its investment portfolio and to operate under state tax law as an investment company. As of December 31, 1993, $338,630,069 of the Bank's investment portfolio is being managed by the New Jersey corporation. Hudson United Bank also owns an inactive subsidiary, Lafayette Development Corp. Unionization of Hudson United Bank Hudson United Bank is administratively divided into three divisions: the Northern Division, the Southern Division and the Essex Division. The Southern Division of Hudson United Bank is unionized. Local 153 of the Office and Professional Employees International Union represents the bank's clerical staff in the Southern Division's bargaining unit. In February 1993, a three-year collective bargaining agreement was negotiated which provides for a modest increase in wages, an increase in hours of employment, contributions towards the cost of providing health care benefits and an increase in the annual pension benefit for employees with more than three years of service who were employed as of March 1, 1990. Currently, approximately 49% of the employees in the bargaining unit are members of the union. The collective-bargaining agreement expires February 28, 1996. Regulatory Matters There are a variety of statutory and regulatory restrictions governing the relations among HUBCO and its subsidiaries: Capital Adequacy Guidelines Bank holding companies must comply with the Federal Reserve Board's risk-based capital guidelines, which became effective on February 15, 1989 and were fully phased-in on December 31, 1992. Under the guidelines, risk weighted assets are calculated by assigning assets and certain off-balance sheet items to broad risk categories. The total dollar value of each category is then weighted by the level of risk associated with that category. As of December 31, 1992, minimum risk-based capital to risk based assets ratio of 8.00% must be attained. At least one half of an institution's total risk based capital must consist of Tier 1 capital, and the balance may consist of Tier 2, or supplemental, capital. Tier 1 capital consists primarily of common stockholder's equity along with preferred or convertible preferred stock, minus goodwill. Tier 2 capital consists of an institution's allowance for loan and lease losses, subject to limitation, hybrid capital instruments and certain subordinated debt. The allowance for loan and lease losses which is considered Tier 2 capital is limited to l.25% of an institution's risk-based assets. As of December 31, 1993, HUBCO's total risk-based capital ratio was 14.85% consisting of a Tier 1 ratio of 13.60% and a Tier 2 ratio of l.25%. Both ratios exceed the requirements under these regulations. In addition, the Federal Reserve Board has promulgated a leverage capital standard, with which bank holding companies must comply. Bank holding companies must maintain a minimum Tier l capital to total assets ratio of 3%. However, institutions which are not among the most highly rated by federal regulators must maintain a ratio 100-to-200 basis points above the 3% minimum. As of December 31 1993, HUBCO had a leverage capital ratio of 7.22%. The FDIC also imposes risk based and leverage capital guidelines on Hudson United Bank. These guidelines and the ratios to be met are substantially similar to those imposed by the Federal Reserve Board. If a bank does not satisfy the FDIC's capital requirements, it will be deemed to be operated in an unsafe and unsound manner and will be subject to regulatory action. As of December 31, 1993, Hudson United Bank had a risk weighted capital ratio of 13.94% and a leverage capital ratio of 6.70%. These ratios exceed the requirements under the FDIC regulations. See also "Management's Discussion and Analysis of Financial Condition and Results of Operation - Capital." Restrictions on Dividend Payments The payment of dividends by the Bank to HUBCO is regulated. Under the New Jersey Banking Act of 1948, as amended, Hudson United Bank may pay dividends only out of retained earnings, and out of surplus to the extent that surplus exceeds 50 percent of stated capital. Under the Financial Institutions Supervisory Act, the FDIC has the authority to prohibit a state-chartered bank from engaging in conduct which, in the FDIC's opinion, constitutes an unsafe or unsound banking practice. Under certain circumstances, the FDIC could claim that the payment of a dividend or other distribution by a bank to its sole shareholder constitutes an unsafe or unsound practice. Restrictions on Transactions Between HUBCO and the Bank The Banking Affiliates Act of 1982, as amended, severely restricts loans and extensions of credit by the Bank to HUBCO and HUBCO affiliates (except affiliates which are banks). In general, such loans must be secured by collateral having a market value ranging from 100% to 130% of the loan, depending upon the type of collateral. Furthermore, the aggregate of all loans from the Bank to HUBCO and its affiliates may not exceed 20% of that Bank's capital stock and surplus and, singly to HUBCO or any affiliate, may not exceed l0% of the Bank's capital stock and surplus. Similarly, the Banking Affiliates Act of 1982 also restricts the Bank in the purchase of securities issued by, the acceptance from affiliates of loan collateral consisting of securities issued by, the purchase of assets from, and the issuance of a guarantee or standby letter- of-credit on behalf of, HUBCO or any of its affiliates. Holding Company Supervision Under the Bank Holding Company Act, HUBCO may not acquire directly or indirectly more than 5 percent of the voting shares of, or substantially all of the assets of, any bank without the prior approval of the Federal Reserve Board. HUBCO cannot acquire any bank located outside New Jersey unless the law of such other state specifically permits the acquisition. In general, the Federal Reserve Board, under its regulations and the Bank Holding Company Act, regulates the activities of bank holding companies and non-bank subsidiaries of banks. The regulation of the activities of banks, including bank subsidiaries of bank holding companies, generally has been left to the authority of the supervisory government agency, which for Hudson United Bank is the New Jersey Department of Banking (the "Department"). Interstate Banking Authority New Jersey law allows New Jersey banking organizations to acquire or be acquired by banking organizations in other states on a "reciprocal" basis (i.e., provided the other state's laws permit New Jersey banking organizations to acquire or be acquired by banking organizations in that state on substantially the same terms and conditions applicable to banking acquisitions solely within the state). FIRREA The Financial Institutions Reform, Recovery and Enforcement Act of 1989 ("FIRREA") established new capital standards and enhanced regulatory oversight of the thrift industry. Many thrifts were unable to comply with the new regulations creating opportunities for mergers and acquisitions by commercial banks as well as other thrift institutions. From time to time, HUBCO investigates potential opportunities that arise as the result of this legislation and the enforcement of regulations promulgated thereunder. While FIRREA focuses primarily on the recovery and reform of the savings and loan industry, there are provisions which affect commercial banks. Such provisions include a new deposit insurance system, increased deposit insurance premiums, restrictions on acceptance of brokered deposits and increased consumer-related disclosure requirements. Recent Regulatory Enactments The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") was enacted in December 1991. FDICIA was primarily designed to provide additional financing for the FDIC by increasing its borrowing ability. The FDIC was given the authority to increase deposit insurance premiums to repay any such borrowing. In addition, FDICIA identifies the following capital standard categories for financial institutions: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. As a result of FDICIA, the various banking regulatory agencies have set certain capital and other measures for determining the categories into which financial institutions fall. FDICIA imposes progressively more restrictive constraints on operations, management and capital distributions depending on the category in which an institution is classified. Pursuant to FDICIA, undercapitalized institutions must submit recapitalization plans, and a company controlling a failing institution must guarantee such institution's compliance with its plan. FDICIA also required the various regulatory agencies to prescribe certain non-capital standards for safety and soundness relating generally to operations and management, asset quality and executive compensation, and permits regulatory action against a financial institution that does not meet such standards. The agencies have implemented some of those regulations and have proposed to implement others. The deposits of the Bank are insured up to applicable limits by the FDIC. Accordingly, the Bank is subject to deposit insurance assessments to maintain the Bank Insurance Fund (the "BIF") of the FDIC. As of January 1, 1993, the FDIC began a risk-based insurance assessment system. This approach is designed to ensure that a banking institution's insurance assessment is based on three factors: the probability that the applicable insurance fund will incur a loss from the institution; the likely amount of the loss; and the revenue needs of the insurance fund. Management believes that the provision of FDICIA and the risk-based insurance assessment will not have a material effect upon the financial position of HUBCO. Source of Strength Doctrine According to Federal Reserve Board policy, bank holding companies are expected to act as a source of financial strength to each subsidiary bank and to commit resources to support each such subsidiary. This support may be required at times when a bank holding company may not be able to provide such support. Furthermore, in the event of a loss suffered or anticipated by the FDIC - either as a result of default of a bank subsidiary of the Company or related to FDIC assistance provided to the subsidiary in danger of default - the other bank subsidiaries of the Company may be assessed for the FDIC's loss, subject to certain exceptions. (b) Industry Segments. The Registrant has one industry segment -- commercial banking. (c) Narrative Description of Business. HUBCO exists primarily to hold the stock of its subsidiaries. During 1993, HUBCO had two directly-owned subsidiaries -- Hudson United Bank and HUB Financial Services, Inc. In addition, HUBCO, through Hudson United Bank, indirectly owns two additional subsidiaries. The historical growth of, and regulatory scheme affecting, each of HUBCO's direct and indirect subsidiaries is described in Item 1(a) above, which is incorporated herein by reference. HUBCO is a legal entity separate from its subsidiaries. The stock of the Bank is HUBCO's principal asset. Dividends from Hudson United Bank are the primary source of income for HUBCO. As explained above in Item 1(a), legal and regulatory limitations are imposed on the amount of dividends that may be paid by the Bank to HUBCO. Hudson United Bank currently maintains its head office in Union City, New Jersey. The Bank operates out of 37 offices in six northern New Jersey counties. Of these offices, all but one are located in the northern New Jersey counties of Bergen, Essex, Hudson, Morris and Passaic. One other branch is located in Dunellen, Middlesex County, New Jersey. HUBCO owns a two-story building one block from Hudson United Bank's main office which HUBCO is leasing to the Bank as an operations center. In March of 1994, HUBCO contracted to purchase a 64,350 square foot building in Mahwah, New Jersey to house the executive offices of HUBCO and the Company's data processing subsidiary, which will service the Bank's data processing and check processing needs and will offer its services to smaller banks in the New York and New Jersey area. At December 31, 1993, HUBCO through its subsidiaries had deposits of $935,687,813, net loans of $518,579,459 and total assets of $1,041,824,323. HUBCO ranked 12th among New Jersey commercial banks and bank holding companies in terms of asset size as of December 31, 1993. The Bank is a full service commercial bank and offers the services generally performed by commercial banks of similar size and character, including checking, savings, and time deposit accounts, certificates of deposit, trust services, safe deposit boxes, secured and unsecured personal and commercial loans and residential and commercial real estate loans. The principal focus of the Bank is its local market place. The Bank's deposit accounts are competitive in the current environment and include money market accounts and a variety of interest- bearing transaction accounts. In the lending area, the Bank primarily engages in consumer lending, commercial lending and real estate lending activities. Hudson United Bank offers a variety of trust services. At December 31, 1993, the Trust Department had approximately $99,571,000 of assets under management or in its custodial control. There are over 100 commercial banks throughout New Jersey, many of which have offices in Northern New Jersey. In addition, large banks in New York City compete for the business of New Jersey residents and businesses located in HUBCO's primary areas of trade. A number of other depository institutions compete for the business of individuals and commercial enterprises in New Jersey including savings banks, savings and loan associations, brokerage houses, financial subsidiaries of the retail industry and credit unions. Other financial institutions, such as mutual funds, consumer finance companies, factoring companies, and insurance companies, also compete with HUBCO for both loans and deposits. Competition for depositors' funds, for creditworthy loan customers and for trust business is intense. Despite intense competition with institutions commanding greater financial resources, the Bank's supply of funds has imposed no substantial impediment to its normal lending functions. While the Bank is limited to making commercial loans to a single borrower in an amount not to exceed fifteen percent of its capital and has a "house limit" significantly below that level, it has, on occasion, arranged for participation by other banks in larger loan accommodations. The Bank has focused on becoming an integral part of the communities it serves. Officers and employees are trained to meet the needs of their customers and emphasis is placed on addressing the needs of the local communities served. HUBCO and its subsidiaries had 400 full-time employees and 87 part-time employees as of December 31, 1993, compared to 388 full-time and 68 part-time employees at the end of 1992. (d) Financial Information about foreign and domestic operations and export sales. Not Applicable (e) Executive Officers of the Registrant The following table sets forth certain information as to each executive officer of HUBCO who is not a director. NAME,AGE AND POSITION WITH OFFICER OF PRINCIPAL OCCUPATION HUBCO HUBCO SINCE DURING PAST FIVE YEARS D. Lynn Van Borkulo- 1988 1st Sr. Vice President, Hudson Nuzzo, 44 United Bank, Corporate Secretary, HUBCO; at Hudson United Bank since 1967. Last five years has progressed from V.P. and Sr. Trust Officer to V.P. Commercial Loans, to S.V.P. Corporate Affairs. Was promoted to 1st SVP in 1988. Christina L. Maier, 40 1987 Assistant Treasurer of HUBCO and Senior Vice President and Controller of the Bank; at Hudson United Bank since 1979. Last five years served as Controller; promoted to Senior Vice President in 1988. (f) Statistical Disclosure Required Pursuant to Securities Exchange Act, Industry Guide 3. The statistical disclosures for a bank holding company required pursuant to Industry Guide 3 are contained in HUBCO's 1992 Annual Report on pages 8-10 and 14-17, and on the following pages of this Report on Form 10-K: PAGES(S) OF ITEM OF GUIDE 3 THIS REPORT II. Investment Portfolio . . . . . . . . . . . . . . . . . 17 III. Loan Portfolio . . . . . . . . . . . . . . . . . . . . 18-20 IV. Summary of Loan Loss Experience. . . . . . . . . . . . 21-21a V. Deposits . . . . . . . . . . . . . . . . . . . . . . . 22 VI. Return on Equity and Assets. . . . . . . . . . . . . . 23 VII. Short-Term Borrowings. . . . . . . . . . . . . . . . . 24-25 HUBCO, Inc. and Subsidiaries S.E.C. GUIDE 3 - ITEM II INVESTMENT PORTFOLIO Book Value at End of Each Report Period December 31 1993 1992 1991 (In Thousands of Dollars) U.S. Treasury and Other U.S. Government Agencies and Corporations $391,098 $291,377 $ 89,613 State and Political Subdivisions 25,652 16,068 13,158 Other Securities 4,833 14,424 35,928 Common Stock 5,102 592 155 Preferred Stock 0 61 61 ________ ________ ________ TOTAL $426,685 $322,522 $138,915 ======== ======== ======== Weighted average yields on tax-exempt obligations have been computed on a fully tax-equivalent basis assuming a tax rate of 35 percent. HUBCO, Inc. and Subsidiaries S.E.C. GUIDE 3 - ITEM III LOAN PORTFOLIO Types of Loans At End of Each Reported Period December 31 1993 1992 1991 1990 1989 Commercial, Financial, and Agricultural $119,563 $129,550 $132,090 $118,734 $107,335 Real Estate - Construction 7,117 3,777 3,108 7,422 7,102 Real Estate - Mortgage 330,018 298,995 257,064 157,558 136,101 Installment 77,945 86,903 77,334 86,766 112,510 Lease Financing 122 1,644 6,158 14,258 26,338 Foreign -- -- -- -- -- ________ ________ ________ ________ ________ TOTAL $534,765 $520,869 $475,754 $384,738 $389,386 ======== ======== ======== ======== ======== HUBCO, Inc. and Subsidiaires S.E.C. GUIDE 3 - ITEM III LOAN PORTFOLIO The following table shows the maturity of loans (excluding residential mortgages of 1-4 family residences, installment loans and lease financing) outstanding as of December 31, 1993. Also provided are the amounts due after one year classified according to the sensitivity to changes in interest rates. Maturities and Sensitivity to Changes in Interest Rates MATURING After One After Within But Within Five One Year Five Years Years Total Commercial, Financial, and Agricultural $ 58,037 $32,990 $28,536 $119,563 Real Estate Construction 5,652 1,465 - 0 - 7,117 Real Estate - Mortgage 75,722 43,897 18,571 138,190 ________ _______ _______ ________ TOTAL $139,411 $78,352 $47,107 $264,870 ======== ======= ======= ======== INTEREST SENSITIVITY Fixed Variable Rate Rate Due After One But Within Five Years $48,815 $29,537 Due After Five Years 26,501 20,606 _______ _______ TOTAL $75,316 $50,143 ======= ======= HUBCO, Inc. and Subsidiaries S.E.C. GUIDE 3 - ITEM III LOAN PORTFOLIO Nonaccrual, Past Due and Restructured Loans December 31 1993 1992 1991 1990 1989 ____ ____ ____ ____ ____ (In Thousands of Dollars) Loans accounted for on a nonaccrual basis $5,534 $4,248 $4,160 $8,224 $3,332 Loans contractually past due 90 days or more as to interest or principal payments 1,443 1,409 1,181 894 1,778 Loans whose terms have been renegotiated to provide a reduction or deferral of interest or principal because of a deterioration in the financial position of the borrower 2,177 2,257 3,527 808 - 0 - At the end of the reporting period, there were no loans not disclosed under the preceding two sections where known information about possible credit problems of borrowers causes management of the Company to have serious doubts as to the ability of such borrowers to comply with the present loan repayment terms and which may result in disclosure of such loans in the two preceding sections in the future. At December 31, 1993 and 1992, there were no concentrations of loans exceeding 10% of total loans which are not otherwise disclosed as a category of loans pursuant to Item III.A. of Guide 3. -21a- HUBCO, Inc. and Subsidiaries S.E.C. GUIDE 3 - ITEM V DEPOSITS The following table sets forth average deposits and average rates for each of the years indicated. 1993 1992 1991 Amount Rate Amount Rate Amount Rate (In Thousands of Dollars) Domestic Bank Offices: Non-interest-bearing demand deposits $185,848 $152,397 $113,504 Interest-bearing demand deposits 112,836 2.74% 97,494 3.34% 63,348 4.84% Savings deposits 342,540 2.58 278,925 3.26 174,557 4.86 Time deposits 251,128 3.37 303,029 4.54 197,020 6.53 Foreign bank offices -- -- -- ________ ________ ________ TOTAL $892,352 $831,845 $548,429 ======== ======== ======== Maturities of time certificates of deposit and other time deposits of $100,000 or more issued by domestic offices, outstanding at December 31, 1993 are summarized as follows: Time Certificates Other Time of Deposit Deposits Total 3 months or less $12,000 $--- $12,000 Over 3 through 6 months 5,030 --- 5,030 Over 6 through 12 months 4,636 --- 4,636 Over 12 months 1,985 --- 1,985 _______ ____ _______ $23,651 $--- $23,651 ======= ==== ======= HUBCO, Inc. and Subsidiaries S.E.C. GUIDE 3 - ITEM VI RETURN ON EQUITY AND ASSETS Year Ended December 31, 1993 1992 1991 Return on Average Assets 1.44% 1.05% .82% Return on Average Equity 19.34 17.38 12.75 Dividend Payout Ratio 23.00 25.04 33.44 Average Equity to Average Assets Ratio 7.44 6.04 6.45 HUBCO, Inc. and Subsidiaries S.E.C. GUIDE 3 - ITEM VII SHORT-TERM BORROWINGS The following table shows the distribution of the Company's short-term borrowings and the weighted average interest rates thereon at the end of each of the last three years. Also provided are the maximum amount of borrowings and the average amounts of borrowings as well as weighted average interest rates for the last three years. The term for each type of borrowing disclosed is one day. Federal Funds Purchased and Securities Sold Under Agreement Other Short- to Repurchase Term Borrowings (In Thousand of Dollars) Year ended December 31: 1993 $19,629 $1,000 1992 14,133 1,000 1991 12,040 1,000 Weighted average interest rate at year end: 1993 2.50% 2.95% 1992 2.92 3.05 1991 4.02 4.22 Maximum amount outstanding at any month's end: 1993 $29,269 $1,000 1992 17,010 1,000 1991 24,574 1,000 Average amount outstanding during the year: 1993 $14,603 $ 938 1992 14,500 928 1991 13,790 929 Federal Funds Purchased and Securities Sold Under Agreement Other Short- to Repurchase Term Borrowings (In Thousand of Dollars) Weighted average interest rate during the year: 1993 2.28% 3.09% 1992 3.31 4.00 1991 4.79 6.11 ITEM 2.		ITEM 2. PROPERTIES The corporate headquarters of HUBCO and the main office of Hudson United Bank are located in a four story facility in Union City, New Jersey. The property is approximately 42,400 square feet and is owned by Hudson United Bank. Hudson United Bank occupies 36 additional branch offices, of which 18 are owned and 18 are leased. All leased properties have rental payments at or below fair market value. Of the eighteen properties leased, one has an option to purchase and nine have renewal options for terms of five to sixty-four years. The remaining eight locations have expiration dates ranging from 1995- 2005. The data processing and deposit services center for the Bank is located in a two-story building in Union City, New Jersey, which is approximately 14,000 square feet. The building is owned by HUBCO and leased to Hudson United Bank. HUBCO has outgrown the space at its headquarter's office and commencing in late December 1993, HUBCO actively undertook a search for additional space to expand its headquarter's operations. In March of 1994, HUBCO purchased a 64,350 square foot building in Mahwah, New Jersey, to house the executive offices of HUBCO and the Company's data processing subsidiary. ITEM 3.	ITEM 3. LEGAL PROCEEDINGS In the normal course of business, lawsuits and claims may be brought by and may arise against HUBCO and its subsidiaries. In the opinion of management, no legal proceedings which have arisen in the normal course of the Company's business and which are presently pending or threatened against HUBCO or its subsidiaries, when resolved, will have a material adverse effect on the business or financial condition of HUBCO or any of its subsidiaries. ITEM 4.	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of Shareholders of HUBCO during the fourth quarter of 1993. PART II ITEM 5.	ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. As of December 31, 1993, HUBCO had approximately 1,596 shareholders. HUBCO's common stock was listed on the American Stock Exchange during 1992. Effective March 1, 1993, HUBCO is listed on the Nasdaq National Market. The following represents the high and low sale prices from each quarter during the last two years. The numbers have been restated to reflect a 10% stock dividend paid by HUBCO on June 1, 1993. High Low 1st Quarter $24 5/8 $16 2nd Quarter 24 3/8 19 3rd Quarter 25 1/4 20 1/4 4th Quarter 24 1/4 20 High Low 1st Quarter $12 1/2 $ 8 3/8 2nd Quarter 12 5/8 10 5/8 3rd Quarter 13 11 3/8 4th Quarter 16 7/8 12 The following table shows the per share quarterly cash dividends paid upon the common stock over the last two years. 1993 1992 March 1 $.10 March 1 $.09 June 1 .11 June 1 .09 September 1 .11 September 1 .09 December 1 .12 December 1 .10 December 1 .03 (extra) December 1 .03 (extra) Dividends are generally declared within 30 days prior to the payable date, to stockholders of record l0-20 days after the declaration date. ITEM 6.	ITEM 6. SELECTED FINANCIAL DATA (In Thousands Except For Per Share Amounts) Reference should be made to pages 4-6 of this Report on Form 10-K for a discussion of recent acquisitions which affect the comparability of the information contained in this table. 1993 1992 1991 1990 1989 Net Interest Income $ 47,018 $ 41,013 $ 26,472 $ 22,991 $ 23,293 Provision for Loan 3,600 4,116 2,312 4,150 1,860 Losses Net Income 14,202 9,641 5,021 2,215 3,309 Per Share Data(1) Net Income 2.06 1.58 1.01 .45 .67 Cash Dividends .47 .40 .33 .33 .33 Declared Balance Sheet Totals: Total Assets-12/31 1,041,825 931,911 673,159 595,128 548,132 Long Term Debt-12/31 - - 763 831 899 Average Equity - 73,451 55,467 39,367 37,634 37,123 for year Average Assets - 987,894 918,116 610,297 549,704 530,556 for year (1) Per share data is adjusted retroactively to reflect a 10% stock dividend paid November 15, 1991 to stockholders of record on November 6, 1991, and a 10% stock dividend paid June 1, 1993 to stockholders of record on May 11, 1993. ITEM 7.	ITEM 7. HUBCO'S 1993 Annual Report contains on pages 6 through 22, the information required by Item 7 and that information is incorporated herein by reference. That discussion is supplemented by the following information. On March 18, 1994, HUBCO entered into an interest rate exchange agreement (the "agreement") for the purpose of hedging the interest rate related to the $25,000,000 subordinated debt issued in January, 1994. The agreement is a contractual agreement between HUBCO and its counterparty to exchange fixed and floating rate interest obligations without exchange of the underlying notional amount of $25,000,000. The agreement was entered into in an effort to lower the overall cost of borrowings. such agreement involves interest rate risk. If interest rates increase, the benefit resulting from the agreement will be diminished. The notional principal amount is used to express the volume of the transaction involved in this agreement; however, this amount does not represent exposure to credit loss. HUBCO's counterparty to the agreement is the fixed rate payor on the agreement and HUBCO is the floating rate payor on the agreement. The The floating rate is reset every three months. As of the date of the agreement, the net reduction in the interest rate on the subordinated debt was 1.65%. The original term of this agreement is 3 years. ITEM 8.	ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA HUBCO's 1992 Annual Report contains on pages 23 through 36, the information required by Item 8 and that information is incorporated herein by reference. ITEM 9.	ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE In March 1991, the Audit Committee of the Board of Directors of the Company recommended that Arthur Andersen be engaged as the Company's independent accountants to audit the books and records of the Company for 1991. The Company did not have any disagreement with Ernst & Young on any matter of accounting principles or practice, financial statement disclosure, or auditing scope or procedure. Ernst & Young's year-end reports did not contain an adverse opinion or a disclaimer of opinion and were not qualified as to uncertainty, audit scope, or accounting principles. The Audit Committee's recommendation was approved by the Board of Directors on March 26, 1991. PART III ITEM 10.	ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT HUBCO's Proxy Statement for its 1994 Annual Meeting on pages 4 to 6, under the caption "Proposal I - Election of Directors", contains the information required by Item 10 with respect to directors of HUBCO and certain information with respect to executive officers and that information is incorporated herein by reference. Certain additional information regarding executive officers of HUBCO, who are not also directors, appears under subsection (e) of Item 1 of this Form 10-K. ITEM 11.	ITEM 11. EXECUTIVE COMPENSATION HUBCO's Proxy Statement for its 1994 Annual Meeting contains on pages 10 to 20, under the caption "Executive Compensation", and on page 22 under the caption "Compensation Committee Interlocks and Insider Participation", the information required by Item 11 and that information is incorporated herein by reference. ITEM 12.	ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT HUBCO's Proxy Statement for its 1994 Annual Meeting contains on pages 7 to 9, under the caption "Stock Ownership of Management and Principal Shareholders", the information required by Item 12 and that information is incorporated herein by reference. The Company knows of no person or group which is the beneficial owner of more than five percent of any class of the Company's voting securities, except as set forth on pages 7 and 8 of HUBCO's Proxy Statement for its 1994 Annual Meeting. ITEM 13.	ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS HUBCO's Proxy Statement for its 1994 Annual Meeting on page 22 under the captions "Compensation Committee Interlocks and Insider Participation" and "Certain Transactions with Management", contains the information required by Item 13 and that information is incorporated herein by reference. PART IV ITEM 14.	ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) (1) & (2) List of Financial Statements and Financial Statement Schedules The below listed consolidated financial statements and report of independent public accountants of HUBCO, Inc. and subsidiaries, included in the Annual Report of the Registrant to its Shareholders for the year ended December 31, 1993, are incorporated by reference in Item 8: Reports of Independent Public Accountants Consolidated Balance Sheets at December 31, 1993 and 1992 Consolidated Statements of Income for the Years Ended December 31, 1993, 1992 and 1991 Consolidated Statements of Changes in Stockholders' Equity for the Years Ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements Schedules to the Consolidated Financial Statements required by Article 9 of Regulation S-X are not required under the related instructions or are inapplicable, and therefore have been omitted. (a) (3) Exhibits List of Exhibits (2a) Agreement and Plan of Reorganization dated as of May 21, 1993, between HUBCO, Hudson and Statewide, together with Exhibit A, the Plan of Conversion. (Incorporated by reference from the Company's Current Report on Form 8-K dated May 21, 1993.) (2b) Agreement and Plan of Merger dated as of November 8, 1993, between HUBCO, Inc., Hudson United Bank and Washington Bancorp, Inc. and Washington Savings Bank. (Incorporated by reference from the Company's Current Report on Form 8-K dated November 8, 1993.) (3a) The Certificate of Incorporation of HUBCO, Inc. filed May 5, 1982 and amendments to the Certificate of Incorporation, dated November 22, 1983, January 30,1984 January 11, 1985, July 17, 1986, March 25, 1987, April 26, 1991, November 26, 1991, March 25, 1992 and May 17, 1993. (3b) The By-Laws of HUBCO, Inc. (4) Indenture dated as of January 14, 1994 between HUBCO, Inc. and Summit Bank as Trustee for $25,000,000 7.75% Subordinated Debentures due 2004. (10a) Employment contract with Kenneth T. Neilson. (Incorporated by reference from the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1991, Exhibit (10a). (10b) Employment contract with James E. Schierloh. (Incorporated by reference from the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1991, Exhibit (10b). (10c) Employment contract with D. Lynn Van Borkulo. (Incorporated by reference from the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1991, Exhibit (10c). (10d) Collective Bargaining Agreement with Local 153 of the Office and Professional Employees International Union, dated January 26, 1993. (Incorporated by reference from the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992, Exhibit (10d). (10e) Purchase and Assumption Agreement dated April 14, 1993, among the Company, Hudson United Bank, Ramapo Financial Corporation and The Ramapo Bank. (Incorporated by reference from the Company's Current Report on Form 8-K dated April 14, 1993.) (13) 1993 Annual Report to Shareholders (22) List of Subsidiaries. (24) Consent of Arthur Andersen & Co. (b) Reports on Form 8-K Form 8-K dated November 8, 1993 Item 5. Other Events -- Reported on the announcement by the Company that it and its principal subsidiary, Hudson United Bank, have entered into an Agreement and Plan of Merger with Washington Bancorp, Inc. and Washington Savings Bank, pursuant to which HUBCO will acquire Washington Bancorp, Inc. for a combination of securities and cash. Item 7. Exhibits -- Included Agreement and Plan of Merger dated as of November 8, 1993, Stock Option Agreement between Washington Bancorp, Inc. and HUBCO, Inc. dated November 8, 1993 and press release dated November 8, 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. HUBCO, INC. By:s/ James E. Schierloh James E. Schierloh Chairman of the Board Dated: March 22, 1994 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/James E. Schierloh Chairman of the James E. Schierloh Board and Director March 22, 1994 s/Kenneth T. Neilson President and March 22, 1994 Kenneth T. Neilson Director s/Robert J. Burke Director March 22, 1994 Robert J. Burke s/Henry G. Hugelheim Director March 22, 1994 Henry G. Hugelheim s/Harry J. Leber Director March 22, 1994 Harry J. Leber s/Charles F.X. Poggi Director March 22, 1994 Charles F. X. Poggi s/Sr. Grace Frances Strauber Director March 22, 1994 Sister Grace Frances Strauber s/Edwin Wachtel Director March 22, 1994 Edwin Wachtel s/Christina L. Maier Assistant March 22, 1994 Christina L. Maier Treasurer
96223_1993.txt	96223	1993	Item 1. Business. ------ -------- THE COMPANY GENERAL The Company is a financial services company principally engaged, through its subsidiaries, in personal and commercial lines of property and casualty insurance, life and health insurance primarily marketed directly to older individuals, banking and lending, incentive services and manufacturing. The Company concentrates on profitability and maximizing cash flow in order to build long-term shareholder value, rather than emphasizing volume or market share. Shareholders' equity has grown from a deficit of approximately $7,657,000 at December 31, 1978 (prior to the acquisition of control of and significant ownership interest in the Company by both the Company's Chairman and President), to a positive shareholders' equity of approximately $907,856,000 at December 31, 1993, equal to a book value per common share of negative $.22 at December 31, 1978 and $32.54 at December 31, 1993, respectively. Income before income taxes and the cumulative effects of accounting changes for 1993 was $176,868,000, the highest in the history of the Company. The Company's principal operations are its insurance businesses, where it is a specialty markets provider of property and casualty and life insurance products to niche markets. The Company's principal personal lines insurance products are automobile insurance, homeowners insurance, graded benefit life insurance marketed primarily to the age 50-and-over population and variable annuity products. The Company's principal commercial lines are property and casualty products provided for multi-family residential real estate, retail establishments, and taxicabs in the New York metropolitan area. For the year ended December 31, 1993, the Company's insurance segments contributed approximately 80% of total revenue and, at December 31, 1993, constituted approximately 81% of consolidated assets. The Company's insurance subsidiaries have a diversified investment portfolio of securities, substantially all of which are issued or guaranteed by the U.S. Treasury or by U.S. governmental agencies or are rated "investment grade" by Moody's Investors Service Inc. ("Moody's") and/or Standard & Poor's Corporation ("S&P"). Investments in mortgage loans, real estate and non-investment grade securities represented in the aggregate less than 1% of the insurance subsidiaries' aggregate portfolio at December 31, 1993. The Company's banking and lending operations primarily consist of making instalment loans funded by customer banking deposits ("Deposits") insured by the Federal Deposit Insurance Company (the "FDIC"). The Company has established a niche market for automobile loans to individuals with poor credit histories. Based on its experience with such loans, the Company concluded that excellent opportunities exist for a successful expansion of this business. Accordingly, during 1993 the Company increased, on a controlled basis, its investment in such loans. The Company intends to expand this business in 1994. The Company's incentive services operations consist primarily of trading stamp operations. The Company's manufacturing operations primarily manufacture products for the "do-it-yourself" home improvement market and for industrial and agricultural markets. At December 31, 1993, the Company had aggregate minimum tax loss carryforwards of approximately $197,000,000. The amount and availability of tax loss carryforwards are subject to certain qualifications, limitations and uncertainties, including, with respect to its consolidated subsidiary, Phlcorp, Inc. ("Phlcorp"), tax sharing payments pursuant to a tax settlement agreement with the Internal Revenue Service and the Department of Justice. The Company also has investments, including non-controlling equity interests representing more than 5% of the outstanding capital stock of several public companies. Additionally, the Company continuously evaluates the retention and disposition of its existing operations and investigates possible acquisitions of new businesses in order to maximize its ultimate economic value to shareholders. As used herein, the term "Company" refers to Leucadia National Corporation, a New York corporation organized in 1968, and its subsidiaries, except as the context otherwise may require. Financial Information About Industry Segments --------------------------------------------- Certain information concerning the Company's operations is presented in the following table. INSURANCE OPERATIONS GENERAL The Company engages in the personal property and casualty and the life and health insurance businesses on a nationwide basis and specializes in the commercial property and casualty insurance business in the New York metropolitan area. The Company's principal insurance subsidiaries consist of the CP Group, Charter National Life Insurance Company ("Charter") and the Empire Group. The CP Group consists of Colonial Penn Life Insurance Company ("CPL"), Colonial Penn Franklin Insurance Company ("Franklin"), Colonial Penn Heritage Insurance Company ("Heritage"), Colonial Penn Insurance Company ("CPI") and Intramerica Life Insurance Company ("Intramerica"). The Empire Group consists of Empire Insurance Company ("Empire"), Empire's subsidiary, Allcity Insurance Company ("Allcity") and Colonial Penn Madison Insurance Company ("Madison"). In conducting its insurance operations, the Company focuses primarily on profitability and persistency rather than volume. A.M. Best Company ("Best"), an independent rating agency, has rated CPL, Charter, and Empire "A" (excellent), Intramerica "A-" (excellent) and CPI, Franklin and Heritage "NA-5" (indicating a previously rated company which has experienced a significant change in ownership, management or book of business, as a result of which its operating experience may be interrupted). Demotech, Inc., an independent rating agency, has rated CPI, Franklin and Heritage "A" (exceptional). Ratings may be revised or withdrawn at any time. Restructuring of CP Group The Company's insurance operations were significantly increased as a result of the Company's acquisition of CPG on August 16, 1991. The Company acquired CPG for an aggregate cash purchase price of approximately $128,000,000, including costs. For the year ended December 31, 1992 and for the period from August 16, 1991 to December 31, 1991, CPG contributed approximately $131,757,000 and $59,995,000, respectively, to the Company's consolidated pre-tax income, including gains on sales of securities (approximately $23,543,000 and $16,323,000, respectively) and exclusive of financing costs. Due to changes in the Company's insurance operations it is not practicable to provide meaningful comparable information for CPG for 1993. At the acquisition date, after giving effect to a cash contribution by the seller prior to the closing of approximately $49,827,000, CPG had unaudited shareholder's equity, determined in accordance with generally accepted accounting principles ("GAAP"), of approximately $391,000,000 (or approximately $263,000,000 in excess of the purchase price) and the CP Group had combined unaudited statutory capital and surplus for regulatory purposes determined in accordance with statutory accounting principles ("SAP") of approximately $225,100,000. This acquisition was accounted for as a purchase and the consolidated financial statements included in this Report include the operations of CPG since August 16, 1991. Historically, the CP Group marketed most of its insurance products directly to individuals without the use of commissioned agents through "direct response marketing" methods. Direct response marketing includes any form of marketing in which a company and a customer deal directly with each other rather than through an insurance agent. Direct response marketing methods include print advertising, radio and television advertising, direct mail, telemarketing and customer referral programs. Typical direct response marketing campaigns utilize a variety of these methods in a planned sequence. The costs of certain of these marketing efforts were substantial and the Company believes were not justified by the CP Group's previous operating results. As a result, during the Company's restructuring of the CP Group, the CP Group substantially refined and reduced its marketing efforts. The Company believes that smaller and more focused direct response marketing campaigns have resulted in lower unit costs, resulting in more profitable operations, albeit with an initial substantial reduction in new business. The Company believes that as a result of its restructuring efforts, which are complete, together with the Company's operating experience, the Colonial Penn P&C Group (as defined below) has become a low cost provider of automobile and homeowners insurance to its niche markets, enabling it to charge competitive rates, which should aid the Colonial Penn P&C Group in obtaining new business and retaining existing business. Furthermore, as a result of the Colonial Penn life insurance companies' favorable experience in obtaining new business, the Company has increased its direct response marketing of graded benefit life products, generating significant new premiums at acceptable acquisition costs. The Company believes that its restructuring efforts described above have increased the CP Group's profitability without impairing service to existing policyholders. PROPERTY AND CASUALTY INSURANCE The Company's principal property and casualty insurance operations are conducted through CPI, Franklin and Heritage (collectively, the "Colonial Penn P&C Group") and through the Empire Group. The Colonial Penn P&C Group, which maintains its headquarters in Valley Forge, Pennsylvania, is licensed in all 50 states, the District of Columbia, Puerto Rico and the U.S. Virgin Islands and writes insurance throughout most of the United States. The Colonial Penn P&C Group has regional offices in Devon, Pennsylvania, Tampa, Florida and Phoenix, Arizona. The Empire Group is licensed in twenty- three states and operates primarily in the New York metropolitan area. During the year ended December 31, 1993, approximately 80%, 13% and 7% of net earned premiums of the Company's property and casualty insurance operations were derived from personal and commercial automobile lines of insurance, commercial lines of insurance (other than automobile insurance) and personal lines of insurance (other than automobile insurance), respectively. Total property and casualty insurance net earned premiums for the year ended December 31, 1993 aggregated approximately $712,000,000, of which approximately $452,600,000 was attributable to the Colonial Penn P&C Group. Set forth below is certain statistical information for the Company's property and casualty operations for each of the three years in the period ended December 31, 1993 prepared in accordance with GAAP and SAP. The Combined Ratio is the sum of the Loss Ratio and the Expense Ratio. A Combined Ratio below 100% indicates an underwriting profit and a Combined Ratio above 100% indicates an underwriting loss. The Loss Ratio is the ratio of losses and loss adjustment expenses incurred to net premiums earned. Incurred losses include a provision for claims which have occurred but have not yet been reported. The Expense Ratio is the ratio of underwriting expenses (policy acquisition costs, including commissions, and a portion of administrative, general and other expenses attributable to underwriting operations) to net premiums written, if determined in accordance with SAP, or to net premiums earned, if determined in accordance with GAAP. Certain accident and health insurance business, which is included in the statutory results of operations of the property and casualty insurance segment and is reflected in the SAP Combined Ratio, is reported in the life insurance segment for financial reporting purposes and therefore is not included in the GAAP Combined Ratios reflected herein. The Combined Ratio does not reflect the effect of investment income on the results of operations. The Company believes, based on published reports, that the Colonial Penn P&C Group's SAP Expense Ratio for 1992, the last year for which annual industry data is available, is among the lowest in the industry. The Colonial Penn P&C Group The Colonial Penn P&C Group's primary business is providing private passenger automobile and homeowners insurance coverage to the age 50-and-over population. The Colonial Penn P&C Group's goal is to be one of the lowest cost providers to this market. Substantially all of the policies are written for a one-year period. However, in many states CPI and Franklin offer a "guaranteed lifetime protection" provision in its automobile policies whereby, subject to certain exceptions, policyholders who are age 50 and older are guaranteed that CPI and Franklin will renew their policies at rates then in effect for the insured's appropriate classification. Net earned premiums for the Colonial Penn P&C Group for the year ended December 31, 1993 were concentrated in the states listed below: Prior to 1988, CPI wrote as primary insurer or as a reinsurer certain commercial property and casualty insurance business known as "Special Risks." The Special Risks business consisted of a variety of diverse commercial lines including, among other things, general corporate liability policies issued to public and corporate entities, residual value insurance on leased automobiles, collision insurance to car leasing and rental businesses and professional and directors and officers liability insurance. CPI had realized significant losses in the Special Risks business prior to the acquisition date and had provided for significant additional losses from time to time, both as to policy benefits and non-recoverable reinsurance receivables. The nature of most of this insurance involves exposures which can be expected to develop over a relatively long period of time before a definitive determination of ultimate losses and loss adjustment expenses can be established. As a result, losses with respect to this block are particularly difficult to predict accurately. Based in part upon a recently completed independent actuarial review, the Company believes that the policy reserves for the Special Risks block reflected in the consolidated balance sheet at December 31, 1993 (approximately $74,900,000, before reinsurance) are adequate. In evaluating and administering the Special Risks portfolio, the Company has used its experience gained from the management of certain of the WMAC Companies (as defined below), which also involves managing the run-off of a closed block of commercial property and casualty insurance business. The Company intends to manage the run-off of the Special Risks block and does not intend to offer this aspect of commercial lines insurance either as an insurer or reinsurer. The WMAC Companies are certain legal subsidiaries of Phlcorp which are or have been under the control of the Wisconsin Insurance Commissioner due to the rehabilitation and liquidation proceedings (which were initiated prior to the Company's acquisition of Phlcorp) of certain of Phlcorp's non-consolidated subsidiaries (the "WMAC Companies"). The Empire Group The Empire Group provides personal insurance coverage to automobile owners and homeowners and commercial insurance primarily for residential real estate, restaurants, retail establishments, taxicabs (both medallion and radio-controlled) and several types of service contractors. For the years ended December 31, 1993, 1992 and 1991, net earned premiums and commissions for the Empire Group aggregated approximately $259,400,000, $243,100,000 and $210,700,000, respectively. Substantially all of the Empire Group policies are written in New York for a one-year period; however, some policies are issued for three years with provision for re-rating the policy for premium purposes at each policy anniversary date. The Empire Group is licensed in New York to write all lines of insurance that may be written by a property and casualty insurer except residual value, credit, unemployment, animal and marine protection and indemnity insurance and ocean marine insurance. The Empire Group has acquired blocks of private passenger automobile and commercial automobile assigned risk business from insurance companies required or volunteering to terminate such coverage. These contractual arrangements provide for fees to the Empire Group within parameters established by the New York Insurance Department. In addition, the Empire Group acts for a fee as a "servicing carrier," providing administrative services, including claims processing, underwriting and collection activities, for the New York Public Automobile Pool. This latter arrangement does not involve the assumption of any material underwriting risk by the Empire Group. As is true with the Company's other insurance subsidiaries, the Empire Group's marketing strategy emphasizes profitability rather than volume. The business of the Empire Group is produced through general agents, local agents and insurance brokers, who are compensated for their services by payment of commissions on the premiums they generate. There are five general agents, one of which is owned by Empire, and approximately 426 local agents and insurance brokers presently acting under agreements with the Empire Group. These agents and brokers also represent other competing insurance companies. Losses and Loss Adjustment Expenses Liabilities for unpaid losses, which are not discounted (except for certain workers' compensation liabilities), and loss adjustment expenses ("LAE") are determined using case-basis evaluations, statistical analyses and estimates for salvage and subrogation recoverable and represent estimates of the ultimate claim costs of all unpaid losses and LAE through December 31 of each year. These estimates are subject to the effect of trends in future claim severity and frequency experience. Adjustments to such estimates are made from time to time to represent changes in loss experience (and are reflected in current earnings). In the following table, the liability for losses and LAE of the Company's property and casualty insurance subsidiaries are reconciled for each of the three years ended December 31, 1993. Included therein are current year data and prior year development. The Company's property and casualty insurance subsidiaries rely upon standard actuarial ultimate loss projection techniques to obtain estimates of liabilities for losses and LAE. These projections include the extrapolation of both losses paid and incurred by business line and accident year and implicitly consider the impact of inflation and claims settlement patterns upon ultimate claim costs based upon historical patterns. In addition, methods based upon average loss costs, reported claim counts and pure premiums are reviewed in order to obtain a consistent range of estimates for setting the reserve levels. For further input, loss reserve committees periodically mix, claims management and legal climate. Such input sometimes leads to modifications of the statistical projections. The Company's property and casualty insurance subsidiaries' liability for losses and LAE as of December 31, 1993 was $910,657,000 determined in accordance with SAP and $1,051,868,000 determined in accordance with GAAP. The reconciling differences principally relate to liabilities assumed by reinsurers, which are not deducted from GAAP liabilities (approximately $163,000,000) reduced by approximately $15,000,000, net, included in accounts other than property and casualty loss reserves for GAAP and approximately $6,000,000 for salvage and subrogation. The tables below present the development of balance sheet liabilities for 1983 through 1993 and include periods prior to acquisition for each of the Empire Group and the Colonial Penn P&C Group. The adjusted liability line of the table indicates the estimated liability for unpaid losses and LAE recorded at the balance sheet date for each of the indicated years. This liability represents the estimated amount of losses and LAE for claims that were unpaid at each annual balance sheet date, including provisions for losses estimated to have been incurred but not reported to the Company's property and casualty companies. The middle section of the table shows the re-estimated amount of the previously recorded liability based on experience as of the end of each succeeding year. The estimate is increased or decreased as more information becomes known about the frequency and severity of claims. The lower section of the table shows the cumulative amount paid with respect to the previously recorded liability as of the end of each succeeding year. Thus, for the year 1985, the Empire Group table indicates that an estimated $8,887,000 of losses remain unpaid as of December 31, 1993 (the difference between the currently estimated $155,727,000 of re- estimated liability for that year and the $146,840,000 paid through December 31, 1993). The effect on income during the past three years of changes in estimates of the liabilities for losses and LAE is shown in the reconciliation table above. The "cumulative redundancy (deficiency)" represents the aggregate change in the estimates over all prior years. For example, the initial 1983 liability estimate indicated on the Empire Group table ($153,342,000) has been re-estimated during the course of the succeeding ten years, resulting in a re-estimated liability at December 31, 1993 of $131,556,000, or a redundancy of $21,786,000. If the re-estimation of liability exceeded the liability initially established, a cumulative deficiency would be indicated. As noted in the Colonial Penn P&C Group table below, the loss and LAE development of the Colonial Penn P&C Group from 1985 through 1989 resulted in cumulative deficiencies, indicating that the established reserves for policy claims and LAE were less than subsequently determined to be necessary. The Colonial Penn P&C Group provided additional reserves related to prior years' claims of approximately $107,100,000 in 1990 and $35,100,000 in 1989. Prior to its acquisition by the Company, and in part as a result of the unfavorable loss development, the Colonial Penn P&C Group reviewed its loss ratio and experience on a state-by-state basis, and initiated procedures to improve underwriting standards, increase rates (subject to necessary regulatory approvals) and withdraw from certain states with unfavorable experience, where permissible, on financially acceptable terms. The Company used the knowledge and experience gained from managing Empire and certain of the WMAC Companies to review the adequacy of the Colonial Penn P&C Group reserves and concluded that the existing reserves were adequate. The Company believes that the Empire Group's conservatism in establishing reserves and CP Group's conservatism and improved claims management procedures since acquisition have contributed significantly to the creation of the redundancies included in the tables below. In evaluating this information, it should be noted that each amount shown for "cumulative redundancy (deficiency)" includes the effects of all changes in amounts for prior periods. For example, the amount of the redundancy (deficiency) related to losses settled in 1987, but incurred in 1983, will be included in the cumulative redundancy (deficiency) amount for 1983, 1984, 1985 and 1986. This table is not intended to and does not present accident or policy year loss and LAE development data. Conditions and trends that have affected development of the liability in the past may not necessarily occur in the future. Accordingly, it may not be appropriate to extrapolate future redundancies or deficiencies based on these tables. Because of substantial differences in the development of reserves of the Colonial Penn P&C Group and the Empire Group, loss and LAE development data of the Colonial Penn P&C Group and the Empire Group are each presented separately. LIFE INSURANCE The Company's principal life insurance subsidiaries are Charter, CPL and Intramerica. For the year ended December 31, 1993, the Company's principal life insurance products were "Graded Benefit Life" and variable annuity insurance products. Through its various subsidiaries, the Company is licensed in all 50 states, the District of Columbia, Puerto Rico, Guam and the U.S. Virgin Islands and generally writes its life and health products in most of the United States. Total direct life insurance in force as of December 31, 1993 was approximately $2.7 billion. The following table reflects premiums earned on the Company's life and health insurance products (except investment oriented products) and premium receipts on variable annuity and other investment oriented products for each of the three years in the period ended December 31, 1993. Variable annuity and other investment oriented product premium receipts are not recorded as revenue under GAAP but are recorded in a manner similar to a deposit, and are included below. Life and Health Insurance Products Graded Benefit Life. "Graded Benefit Life" is a guaranteed-issue product. These modified-benefit, whole life policies are offered on an individual basis primarily to persons age 50 to 80, principally in face amounts of $350 to $10,000, without medical examination or evidence of insurability. Premiums are paid as frequently as monthly. Graded Benefit Life is marketed using direct response marketing techniques. New policyholder leads are generated primarily from television advertisements. Consistent with its present marketing program, the Company intends to concentrate its marketing efforts towards soliciting new policyholders where the cost is justified, upgrading existing policyholders' policy packages and obtaining referrals from existing policyholders. The Company believes that premiums on new business written in 1994 will exceed reductions due to death and lapses. During late l993, the Company began offering certain policyholders a rider to their existing Graded Benefit Life policy. This "Accelerated Benefit Rider" pays a policy benefit if the policyholder is suffering from a terminal illness. Initial results are promising and the Company expects to offer this rider to additional policyholders on a limited basis. The Company is exploring the development of other new products. Investment Oriented Products. During 1993, the principal investment oriented product offered by the Company's life insurance subsidiaries was a no-load variable annuity ("VA") product. The VA product is marketed as an investment vehicle to individuals seeking to defer, for federal income tax purposes, the annual increase in their account balance. Premiums from this VA product either are invested at the policyholders' election in unaffiliated mutual funds where the policyholder bears the entire investment risk or in a fixed account where the funds earn interest at rates determined by the Company. The Company's VA product is currently marketed in conjunction with a mutual fund manager. The Company is pursuing cooperative arrangements with other money managers to distribute its VA product. Prior to 1991, the investment oriented products sold by the Company included, among others, single premium deferred annuity ("SPDA") and single premium whole life ("SPWL") products. During 1992, the Company concluded that the profitability of its existing blocks of SPDA and SPWL businesses were unlikely to achieve acceptable operating results in the future. For a discussion of the reinsurance of certain of these products, see "Management's Discussion and Analysis of Financial Condition and Results of Operations." Medicare Supplement. Medicare Supplement products are health insurance products primarily designed to supplement medicare benefits for the older population on an underwritten guaranteed renewable basis. Prior to l993, the Company's Medicare Supplement products were marketed primarily through insurance agents. As a result of recent federal and state legislation mandating standardization of Medicare Supplement products (thereby enhancing an individual's ability to compare various Medicare Supplement products), this market has become more competitive. The Company is no longer actively marketing Medicare Supplement products, but is offering renewals of its non- standardized products to its policyholders. National health care reforms are currently under consideration. It is not possible to predict whether any reforms will be enacted, and, if enacted, what effect such reforms might have on the Company's Medicare Supplement products. INSURANCE OPERATIONS - GENERAL Investments Investment activities represent a significant part of the Company's insurance related revenues and profitability. Investments are managed by the Company's investment advisors under the direction of, and upon consultation with, the Company's several investment committees. The Company's insurance subsidiaries have a diversified investment portfolio of securities substantially all of which are rated "investment grade" by Moody's and/or S&P or issued or guaranteed by the U.S. Treasury or by governmental agencies. The Company's insurance subsidiaries do not generally invest in less than "investment grade" or "non-rated" securities, real estate or mortgages, although the Company's insurance subsidiaries may from time to time make such investments in amounts not expected to be material. For additional information concerning the Company's investments, see "Notes to Consolidated Financial Statements." The composition of the Company's insurance subsidiaries' investment portfolio as of December 31, 1993 and 1992 was as follows: Reinsurance The Company currently obtains reinsurance for certain of its life insurance policies and property and casualty insurance policies. Among the Company's major reinsurers (and their respective Best ratings) are General Reinsurance Corporation (A++), Lincoln National Life Insurance Co. (A+), Munich American Reinsurance Company (A++) and Hartford Fire Insurance Company (A+). Reinsurance is obtained for investment oriented products for face amounts in excess of $500,000 per life. The life insurance subsidiaries generally do not obtain reinsurance for the Graded Benefit Life products because these policies generally do not exceed $10,000 face amount. The Colonial Penn P&C Group obtained reinsurance for casualty risks in excess of $2,000,000 in 1993 ($1,000,000 in 1992). Most Colonial Penn P&C Group automobile policies do not have policy limits in excess of $100,000 per risk and $300,000 per accident. The Empire Group's maximum limit retained for workers' compensation was $500,000 from July 1, 1992 through December 31, 1993 and $200,000 from January 1, 1991 through June 30, 1992 and for other property and casualty lines, the maximum limit retained was $225,000 for 1993 and $175,000 for each of 1992 and 1991. Additionally, the Company's property and casualty insurance subsidiaries have entered into certain excess of loss and catastrophe treaties to protect against certain losses. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." Although reinsurance does not legally discharge an insurer from its primary liability for the full amount of the policy liability, it does make the assuming reinsurer liable to the insurer to the extent of the reinsurance ceded. The Company's reinsurance generally has been placed with certain of the largest reinsurance companies, which the Company believes to be financially capable of meeting their respective obligations. However, to the extent that any reinsuring company is unable to meet its obligations, the Company's insurance subsidiaries would be liable for the reinsured risks. Additionally, certain of CPI's Special Risks reinsurers have experienced financial difficulty and some are in rehabilitation proceedings. CPI has established reserves, which the Company believes are adequate, for nonrecoverable reinsurance on its Special Risks block of insurance. In 1992, 1993 and 1994, unusually severe natural disasters occurred, including Hurricane Andrew (1992), the Midwest floods and California fires (1993) and the Los Angeles Earthquake (1994). These events have resulted in unprecedented industry-wide losses. The Company's insurance subsidiaries also suffered losses as a result of certain of these occurrences, although reinsurance reduced the economic loss to the Company of Hurricane Andrew. However, as a result of the industry's losses, the Company has seen a notable decrease in the availability of catastrophe reinsurance at reasonable rates, particularly at low levels of deductibility. Although the Company has completed its 1994 reinsurance program at acceptable upper loss limits, the insurance subsidiaries in 1993 and 1994 were unable to obtain 1992 levels of deductibility at reasonable cost. Accordingly, the Company increased its retention of lower level losses. The Company did not incur catastrophic losses in excess of its retained limits in 1993 and to date in 1994. Further, in 1992 the Company did not incur losses in excess of its maximum reinsurance. Competition The insurance industry is a highly competitive industry, in which many of the Company's competitors have substantially greater financial resources, larger sales forces, more widespread agency and broker relationships, and more diversified lines of insurance coverage. Additionally, certain competitors market their products with endorsements from affinity groups, while the Company's products are for the most part unendorsed, which may give such other companies a competitive advantage. VA products are subject to regulation both as insurance policies and as securities. As a result, the introduction of a VA product involves significant regulatory and administrative efforts over a substantial period of time. The Company expects sales of its no-load VA product to be cyclical, generally following the securities markets. The attractiveness of VA products as an investment vehicle is closely linked to the tax status of such products. Typically, increases in account values of VA products are not taxed until distributed in the form of either surrenders or annuity payments. The taxable portion of any such distribution is taxed as ordinary income. The property and casualty insurance industry has historically been cyclical in nature, with periods of less intense price competi- tion and high underwriting standards generating significant profits, followed by periods of increased price competition and lower under- writing standards resulting in reduced profitability or loss. Price competition has been significant in recent years. The cyclicality and competitive nature of the property and casualty insurance business historically have contributed to significant industry-wide quarter-to- quarter and year-to-year fluctuations in underwriting results and net income. Its profitability is affected by many factors, including rate competition, severity and frequency of claims, interest rates, state regulation, court decisions and judicial climate, all of which are outside the Company's control. Government Regulation Insurance companies are subject to detailed regulation and supervision in the states in which they transact business. Such regulation pertains to matters such as approving policy forms and various premium rates, minimum reserves and loss ratio requirements, the type and amount of investments, minimum capital and surplus requirements, granting and revoking licenses to transact business, levels of operations and regulating trade practices. There can be no assurance that such regulatory requirements will not become more stringent in the future and have an adverse effect on the Company's operations. The majority of the Company's property and casualty insurance operations are in states requiring prior approval by regulators before proposed rates may be implemented. Certain states have indicated that they may change the bases (e.g., age, sex and geographic location) on which rates traditionally have been established. Rates proposed for life insurance generally become effective immediately upon filing. Insurance companies are required to file detailed annual reports with the supervisory agencies in each of the states in which they do business, and are subject to examination by such agencies at any time. Due to the savings and loan crisis and the seizure by state insurance regulators of certain large financially unstable insurance companies, there has been some erosion of confidence in all financial institutions, including insurance companies. Increased regulation of insurance companies at the state level and new regulation at the federal level is possible, although the Company cannot predict the nature or extent of any such regulation. The National Association of Insurance Commissioners ("NAIC") has adopted model laws incorporating the concept of a "risk based capital" requirement for insurance companies, although the model law is not intended to apply to property and casualty insurance companies until year end 1994 financial statements are available. Generally, Risk Based Capital ("RBC") is designed to measure the adequacy of an insurer's statutory capital in relation to the risks inherent in its business. The RBC formula is used by the states as an early warning tool to identify weakly capitalized companies for the purpose of initiating regulatory action. The RBC formula develops a risk adjusted target level of statutory surplus for insurers by applying certain factors to various asset, premium and reserve items. Higher factors are applied to more risky items and lower factors are applied to less risky items. Thus, the target level of statutory surplus varies not only as a result of the insurer's size, but also on the risk profile of the insurer's operation. The RBC model laws provide for four incremental levels of regulatory attention for insurers whose surplus is below the calculated RBC target. These levels of attention range in severity from requiring the insurer to submit a plan for corrective action to actually placing the insurer under regulatory control. Each of the Company's insurance subsidiaries' RBC ratio as of December 31, 1993 substantially exceeded the minimum requirements. The NAIC also has adopted various ratios for insurance companies which, in addition to the RBC ratio, are designed to serve as a tool to assist state regulators in discovering potential weakly capitalized companies. Generally, life insurance companies having three or more of such ratios outside their "normal" range may be indicative of a weakly capitalized company. Two of the Company's life insurance subsidiaries, Charter and CPL, had three or more "other than normal" NAIC ratios for the year ended December 31, 1993. Charter had five "other than normal" ratios in l993, four of which resulted from reinsurance of the SPWL block of business described under "Management's Discussion and Analysis of Financial Condition and Results of Operations," while CPL had four "other than normal" ratios in l993, three of which resulted from reinsurance transactions, including a transaction with an affiliate. The Company believes that there are no underlying problems or weaknesses at Charter or CPL and that, in view of the strong capital and RBC ratios of Charter and CPL and their strong and conservative investment portfolios, it is unlikely that material adverse regulatory action will be taken. On November 8, 1988, California voters passed Proposition 103, an insurance initiative which requires a 20% rollback in insurance rates for policies written or renewed during the twelve month period beginning November 8, 1988 (the "rollback period") and provided that changes in insurance premiums after November 8, 1989 must be submitted for approval by the California Insurance Commissioner prior to implementation. While the Proposition has the most significant impact on automobile insurance, some of its provisions also apply to other types of property and casualty insurance. In May 1989, the California Supreme Court held that insurance companies may not be deprived of a "fair return." In June 1991, the current California Insurance Commissioner issued revised regulations regarding the rollback period which established an allowable after-tax return of 10% for the rollback period. These regulations were held unconstitutional by the Los Angeles Superior Court in February 1993, because each insurer was entitled to an individual hearing to determine its fair level of profit. The California Insurance Commissioner has appealed this decision, which remains sub judice. The Company has not yet ---------- received any order or determination requiring it to refund any premiums collected. Based upon its operating results in the relevant years, the Company believes the Colonial Penn P&C Group should not be assessed for any rollback rebate and, if assessed a significant amount, intends to vigorously oppose such determination. Voluntary automobile net earned premiums in California represent approximately 8.9% of the Company's total property and casualty net earned premiums. Proposition 103 does not apply to premiums earned on involuntary coverage. It is possible that other states may attempt similar initiatives, although the Company is unable to predict whether and to what extent such regulation may be proposed or adopted. In early 1990, New Jersey adopted new laws to depopulate the deficit-ridden Automobile Joint Underwriting Association (the "JUA"), the New Jersey insurance pool for high-risk drivers. The New Jersey statute, among other things, abolished the JUA, established the Market Transition Facility (the "MTF") as a temporary successor to the JUA, established quotas for depopulation of the MTF and required all automobile insurers to share in the losses of the MTF based on their depopulation share of the JUA, as set by the New Jersey Department of Insurance. The MTF deficit is currently estimated to be $917 million. Based on that amount, the Colonial Penn P&C Group would be assessed approximately $11,100,000. In February 1994, the Colonial Penn P&C Group paid approximately $5,300,000 of this possible assessment into a court mandated escrow account. The balance of this possible assessment has been provided for in the Company's December 31, 1993 balance sheet. The New Jersey Insurance Department has adopted regulations which would permit an insurer, with the approval of the Insurance Department, to recover amounts paid to the MTF through surcharges to policyholders; however, there can be no assurance that the Colonial Penn P&C Group would be permitted to surcharge its policyholders for all or even part of any assessment. The Company's insurance subsidiaries are members of state insurance funds which provide certain protection to policyholders of insolvent insurers doing business in those states. Due to insolvencies of certain insurers in recent years, the Company's insurance subsidiaries have been assessed certain amounts which have not been material and are likely to be assessed additional amounts by state insurance funds. The Company believes that it has provided for all anticipated assessments and that any additional assessments will not have a material adverse effect on the Company's financial condition or results of operations. BANKING AND LENDING GENERAL The Company's banking and lending operations primarily are conducted through its national bank subsidiary, American Investment Bank, N.A. ("AIB"); two wholly owned industrial loan corporations (the "ILCs"), American Investment Financial ("AIF") and Governor Financial ("GF"); and Transportation Capital Corp. ("TCC"), a small business investment company, which is a 99% owned subsidiary of the Company. AIB and the ILCs take money market and other non-demand deposits that are eligible for insurance provided by the FDIC within its applicable limitations. At December 31, 1993, AIB and the ILCs had Deposits of $173,365,000 compared to $186,339,000 at December 31, 1992. In January 1994, the deposits and certain assets of GF were combined into AIF. AIB and AIF currently have several deposit-taking and lending facilities and an administrative office in the Salt Lake City area. TCC, which is not a significant subsidiary of the Company, makes collaterialized loans to operators of medallion taxicabs and limousines. At December 31, 1993, the Company's consolidated banking and lending operations had outstanding loans (net of unearned finance charges) of $205,744,000 compared to $169,552,000 at December 31, 1992. The increase was financed primarily from proceeds of the sale of the Company's consumer loan offices sold in 1992. See "Management's Discussion and Analysis of Financial Conditions and Results of Operations." At December 31, 1993, approximately 36% were loans to individuals generally collateralized by automobiles; approximately 26% were unsecured loans to individuals acquired from others in connection with investments in limited partnerships; approximately 23% were unsecured loans to executives and professionals; approximately 9% were loans to small business concerns collateralized principally by taxicab medallions and other personal property; approximately 5% of the loans were instalment loans to consumers, substantially all of which were collateralized by real or personal property; and approximately 1% were loans generally collateralized by non-residential real estate. It is the Company's policy to charge to income an allowance for losses which, based upon management's analysis of numerous factors, including current economic trends, aging of the loan portfolio and historical loss experience, is deemed adequate to cover reasonably expected losses on outstanding loans. At December 31, 1993, the allowance for loan losses for the Company's entire loan portfolio was approximately $8,341,000 or 4.1% of the net outstanding loans, compared to approximately $6,973,000 or 4.1% of net outstanding loans at December 31, 1992. The funds generated by the Deposits are primarily used to make instalment loans, including collateralized personal automobile loans to individuals who have difficulty in obtaining credit. These automobile loans are made at interest rates above those charged to individuals with good credit histories. In determining which individuals qualify for these loans, the Company takes into account a number of highly selective criteria with respect to the individual as well as the collateral to attempt to minimize the number of defaults. Additionally, the Company monitors these loans and takes prompt possession of the collateral securing such loans in the event of a default. For the three year period ended December 31, 1993, the Company generated an aggregate of approximately $100,754,000 of these loans (approximately $51,000,000 during 1993). At December 31, 1993, the allowance for loan losses for this portfolio was approximately $4,399,000 or 6% of net outstanding loans; actual loss experience has been approximately 1.4% per year of average outstanding loans. The Company is satisfied with the results of this loan portfolio and believes that there is an opportunity for successful growth in this niche market. The Company intends to expand its business in this area. COMPETITION The Company's lending operations compete with banks, savings and loan associations and credit unions, many of which are able to offer financial services on very competitive terms, credit card issuers and consumer finance companies. Additionally, substantial national financial services networks have been formed by major brokerage firms, insurance companies, retailers and bank holding companies. Some competitors have substantial local market positions; others are part of large, diversified organizations. GOVERNMENT REGULATION The Company's principal lending operations are subject to detailed supervision by state authorities, as well as federal regulation pursuant to the Federal Consumer Credit Protection Act and regulations promulgated by the Federal Trade Commission. The Company's banking operations are subject to extensive federal and state regulation and supervision by, among others, the Office of the Comptroller of the Currency (the "OCC"), the FDIC and the State of Utah. AIB's primary federal regulator is the OCC, while the primary federal regulator for the ILCs is the FDIC. AIB and AIF have substantially similar assets. With FDIC approval on January 31, 1994, AIF purchased a substantial portion of the assets and assumed all of the deposit liabilities as well as a significant amount of the remaining liabilities of GF. Following this transaction, GF retained its ILC charter but terminated its FDIC insurance and thus its right under Utah law to accept deposits. The Competitive Equality Banking Act of 1987 ("CEBA") places certain restrictions on the operations and growth of AIB and restricts further acquisitions of banks and savings institutions by the Company. CEBA does not restrict the growth of the ILCs as currently operated. INCENTIVE SERVICES GENERAL For the year ended December 31, 1993, the Company's incentive services business was conducted by The Sperry and Hutchinson Company, Inc. ("S&H"). In early 1993, the Company contributed the net assets of S&H Motivation, Inc. ("SHM") to a new joint venture formed with an unrelated motivation services company and provided a $3,000,000 line of credit to the joint venture in exchange for a 45% equity interest in the joint venture. Operations of the motivation services business historically have not been significant and are not expected to be significant in the future. S&H distributes Green Stamps to retailers under license agreements that give the retailer an exclusive franchise for a particular category of retail establishment in a particular geographic area. Customers of participating retailers receive Green Stamps when they purchase goods and services. Since 1969, when annual sales for the trading stamp industry as a whole peaked, S&H's trading stamp business has been steadily declining. The Company believes that there is a substantial likelihood that the declining trend in trading stamp sales will continue. The Company has attempted, but has not succeeded in, developing new uses for its trading stamp business. REDEMPTION RESERVE-LIQUIDITY When trading stamps are sold, S&H receives cash and accrues as a liability the estimated obligation to deliver merchandise and/or cash associated with those stamps. Demands for redemption generally occur over a considerable period of time. The loss of customers usually results in an acceleration of redemptions and requires the expenditure of available funds to provide the merchandise and/or cash required for such redemptions. At December 31, 1993 and 1992, the liability for unredeemed trading stamps reflected in the Company's consolidated balance sheets was approximately $58,541,000 and $74,964,000, respectively. The most recent statistical studies of trading stamp redemptions have indicated that the historical pattern of redemptions has changed and that the recorded liability for unredeemed trading stamps is in excess of the amount that ultimately will be required to redeem trading stamps outstanding. The amount of this excess may be different than indicated by these studies. Accordingly, the Company is amortizing the apparent excess over a five year period. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." COMPETITION The Company's incentive services businesses compete primarily with other incentive companies and other forms of promotional and merchandising techniques other than trading stamps. Retail establish- ments, for example, frequently utilize store coupons, special advertising programs, games, extra services and related programs. MANUFACTURING The Company's manufacturing operations consist primarily of the manufacture of bathroom vanities and related products for the "do-it- yourself" market, through its General Marble division, and padding, absorbent, erosion control and proprietary plastic netting products for various industrial and agricultural uses, through its Fibers and Plastics divisions. In 1990, the Company acquired a factory in North Carolina and in 1991 equipped it with state-of-the-art manufacturing machinery for its General Marble division. This facility was designed to enable the Company to improve the quality of its products, to manufacture certain of its products on a "ready-to-assemble" basis and to expand capacity. General Marble's products are sold through manufacturers' representatives primarily to home improvement centers. The inefficiencies and start up costs associated with bringing this facility to full production, together with pricing pressures, have adversely affected results of operations for this segment. The Fibers and Plastics divisions manufacture and market padding, absorbent and erosion control products, which may be reinforced with plastic netting, for the furniture, automotive, erosion control and maintenance industries and thermoplastic netting used for a variety of purposes including, among other things, construction, packaging, agriculture, carpet backing and filtration. The manufacturing operations are subject to a high degree of competition, generally on the basis of price, service and quality. Additionally, these manufacturing operations are dependent on cyclical industries, including the construction industry, which have been adversely effected by recent economic conditions. Through its various manufacturing divisions, the Company holds patents on certain improvements to the basic manufacturing processes and on applications thereof. The Company believes that the expiration of these patents, individually or in the aggregate, is unlikely to have a material effect on the business of its manufacturing operations. OTHER OPERATIONS AND INVESTMENTS The Company also owns non-controlling equity interests representing, at December 31, 1993, more than 5% of the outstanding capital stock of each of the following domestic public companies: Carmike Cinemas, Inc. ("Carmike") (approximately 9% of Class A shares), Jones Plumbing Systems, Inc. ("Jones") (approximately 21%), Jordan Industries, Inc. ("JII") (approximately 11%) and Olympus Capital Corporation (approximately 18%). The Company owns interests in two foreign power companies: Compania Boliviana de Energia Electrica, S.A. - Bolivian Power Company Limited ("Bolivian Power") and through Canadian International Power Company Limited Liquidating Trust, The Barbados Light and Power Company Limited. The Company's investments in the power companies were recorded at an aggregate of approximately $5,208,000 at December 31, 1993. The shares of Bolivian Power are traded on the New York Stock Exchange. In November 1993, the Company sold 750,000 common shares of Bolivian Power in an underwritten public offering. The Company currently owns approximately 719,206 common shares of Bolivian Power, representing approximately 17% of Bolivian Power's outstanding common shares. In 1990, the Company received the stock of certain of the WMAC Companies that had been under the control of the Wisconsin Insurance Commissioner. The Company is unable to predict when Commercial Loan Insurance Company ("CLIC") and WMAC Credit Insurance Corporation ("Credit"), two WMAC Companies which constitute substantially all of the WMAC Companies' remaining value expected from the assets under the control of the Wisconsin Insurance Commissioner, will be returned to its control. The Company estimates that the fair value to the Company of the net tangible assets yet to be received is approximately $32,800,000 in excess of their recorded carrying value at December 31, 1993. A subsidiary of the Company is a partner in The Jordan Company and Jordan/Zalaznick Capital Company. These partnerships each specialize in structuring leveraged buyouts in which the partners are given the opportunity to become equity participants. John W. Jordan II, a director of the Company, is the managing partner of the two partnerships. Since 1982, the Company has invested an aggregate of $25,870,000 in these partnerships and related companies and, through December 31, 1993, has received approximately $62,398,000 (consisting of cash, interest bearing notes and other receivables) relating to the disposition of investments and management and other fees. At December 31, 1993, through these partnerships, the Company had interests in an aggregate of 15 companies (the "Jordan Associated Companies"), which are carried in the Company's consolidated financial statements at $13,620,000. The Jordan Associated Companies include JII, Carmike and Jones. Item 2.		Item 2. Properties. ------ ---------- Through its various subsidiaries, the Company owns the following significant properties: an office building in Clayton, Missouri (approximately 66,000 sq. ft.), which is leased to unaffiliated parties; an office building in Valley Forge, Pennsylvania (approxi- mately 94,800 sq. ft.) located on land leased from a third party to a subsidiary of the Company; two offices in Salt Lake City, Utah (totaling approximately 74,000 sq. ft.); three multi-tenant office buildings in Indianapolis, Indiana (totaling approximately 444,000 sq. ft.) which are leased (or are available for lease) to unaffiliated parties; and a warehouse in Fort Worth, Texas (approximately 256,000 sq. ft.) that is leased to a third party. In addition, subsidiaries of the Company own nine facilities (totaling approximately 1,208,000 sq. ft.) primarily used for manufacturing and storage located in Georgia, New Jersey, New York, North Carolina, Pennsylvania, Wisconsin and Canada. The Company's subsidiaries lease numerous manufacturing, warehousing, office and headquarters facilities. The facilities vary in size and have leases expiring at various times, subject in certain instances to renewal options. See Note 15 of Notes to Consolidated Financial Statements. Item 3.	Item 3. Legal Proceedings. ------ ----------------- PHLCORP TENDER OFFER Seven class action complaints were filed against the Company and others in connection with the Company's tender offer to purchase up to 5,200,000 common shares of Phlcorp, which expired in February 1988, and have been consolidated into one action in the United States District Court for the Southern District of New York (the "Southern District"), entitled In re PHLCORP Securities Tender Offer Litigation ------------------------------------------------ (Civil Action No. 88 Civ. 0306 (SS)) ("In Re Phlcorp"). ------------- The consolidated and amended class action complaint (the "Complaint") seeks damages (in an unspecified amount), imposition of a constructive trust and costs and disbursements of the action. Several of the claims were dismissed in 1988 as a result of defendants' motion to dismiss. The remaining claims allege that defendants violated the Securities Exchange Act of 1934, as amended, by causing Phlcorp's directors to issue a recommendation to accept the Company's tender offer, which incorrectly represented that the directors' recommendation was based on a determination that the Company's offer was fair and that defendants breached their fiduciary duties in connection with the tender offer. A class of plaintiff minority shareholders, who owned shares of Phlcorp on January 21, 1988, has been certified. Upon completion of discovery, with the exception of discovery of experts, defendants filed a motion for Summary Judgment. Prior to the time defendants' reply brief was due, the parties reached an agreement in principle for the settlement of the action. A stipulation of settlement was submitted to the Court for its approval on January 24, 1994. At a conference on February 2, 1994, the Court entered an order requiring (a) plaintiffs to mail notice of the proposed settlement to class members by February 22, 1994, (b) class members to submit any objections to the settlement by April 15, 1994 and (c) a hearing to determine whether the settlement should be approved to be held on April 29, 1994. Because of the settlement agreement, defendants withdrew their summary judgment motion, without prejudice to renew the motion in the event that the court does not approve the settlement. Defendants believe that the material allegations of these complaints are without merit and, if not settled, intend to defend these actions vigorously. EMPIRE TRANSACTIONS Beginning in 1988, four separate actions were commenced in the Supreme Court, New York County relating to Empire's conversion from a mutual to a stock company, a 1988 reverse stock split, a subsequent odd lot cash tender offer and adoption of Empire's Section 7118 Plan in l991. Empire, Phlcorp and ten of Empire's directors are named as defendants in some or all of these actions. While the Company believes the material allegations of these actions are without merit, these actions have been settled pursuant to Court approval. The settlement, which will become final during the second quarter of l994, unless appealed, will have no material effect on the Company. PHLCORP MERGER Three actions were filed by minority shareholders of Phlcorp in connection with the August 17, 1992 proposal by the Company to Phlcorp that the Company acquire all outstanding Phlcorp shares not already owned by it and its subsidiaries and the October 12, 1992 public announcement that the Company and Phlcorp had reached an agreement in principle with respect to the merger of Phlcorp (then a 63.1% owned public subsidiary of the Company) with and into a wholly owned subsidiary of the Company (the "Phlcorp Merger"). The actions name the Company and/or Phlcorp and their directors as defendants. Two of the actions were brought in the Supreme Court of the State of New York, County of New York, and one was filed in the Pennsylvania Court of Common Pleas, Philadelphia County. The Pennsylvania action has been voluntarily discontinued. The amended class action complaints in the New York action contain similar allegations, inter alia, that the Company, aided and abetted by its directors, breached its fiduciary duties purportedly owed to Phlcorp's minority shareholders by using its position as controlling shareholder of Phlcorp to effect the Merger on terms which do not reflect the true value of Phlcorp Shares, by failing to disclose material facts concerning Phlcorp's assets, businesses, and future prospects, and by timing the October 12 Proposal to coincide with an abnormally high stock price of Leucadia and an artificially depressed Phlcorp stock price. In addition, one of the New York actions asserts a derivative claim brought on behalf of Phlcorp for corporate waste under state law. In November and December 1992, defendants moved to dismiss the New York actions. In early December 1992, plaintiffs' request for a preliminary injunction barring consummation of the Phlcorp Merger, was denied. The parties have entered into settlement negotiations. On February 19, 1993, the court denied defendants' motions to dismiss the New York actions as moot in light of settlement negotiations. The court indicated that plaintiffs would be able to re-open the cases by way of an order to show cause if the cases are not in fact settled. On September 5, 1993, the parties entered into a memorandum of understanding to settle the matter subject to plaintiffs conducting confirmatory discovery and the court's approval of the settlement. Defendants believe that the material allegations of these complaints are without merit and, if not settled, intend to defend these actions vigorously. OTHER PROCEEDINGS In addition to the foregoing, the Company and its subsidiaries are parties to legal proceedings that are considered to be either ordinary, routine litigation incidental to their business or not material to the Company's consolidated financial position. The Company does not believe that any of the foregoing actions will have a material adverse effect on its consolidated financial position or consolidated results of operations. Item 4.	Item 4. Submission of Matters to a Vote of Security Holders. ------ --------------------------------------------------- Not applicable. Item 10. Executive Officers of the Registrant. ------- ------------------------------------ All executive officers of the Company are elected at the organizational meeting of the Board of Directors of the Company held annually and serve at the pleasure of the Board of Directors. As of March 16, 1994, the executive officers of the Company, their ages, the positions held by them and the periods during which they have served in such positions were as follows: Mr. Cumming has served as a director and Chairman of the Board of the Company since June 1978. In addition, he has served as a director of Bolivian Power since March 1987, as Chairman of the Board of Bolivian Power since September 1988 and as a director of Allcity since February 1988. Mr. Cumming has also been a director of Skywest, Inc., a Utah-based regional air carrier, since June 1986. Mr. Steinberg has served as a director of the Company since December 1978 and as President of the Company since January 1979. In addition, he has served as a director of Bolivian Power since March 1987, as a director of Allcity since February 1988 and as a director of JII since June 1988. Mr. Mara joined the Company in April 1977 and was elected Vice President of the Company in May 1977. He has served as Executive Vice President of the Company since May 1980 and as Treasurer of the Company since January 1993. Mr. Mara also served as Treasurer of the Company from April 1981 to April 1985. Mr. Hershfield has served as Executive Vice President of the Company since July 1993 and prior thereto served as Vice President of the Company since April 1990. Mr. Hershfield has also served as a director of Bolivian Power since January 1992. From 1981 to April 1990, he served in a variety of executive positions with the Company's subsidiary, BRAE Corporation (formerly a public company), including President, Executive Vice President and Vice President. Mr. Kiken, a certified public accountant, was employed by Coopers & Lybrand, certified public accountants, from 1969 until he joined the Company in October 1977 as Vice President and Comptroller. Mr. Borden joined the Company as Vice President in August 1988 and has served in a variety of other capacities with the Company and its subsidiaries. Mr. Hornstein joined the Company as Vice President in July 1983 and has also served as Secretary of Bolivian Power since July 1988. Ms. Klindtworth has been employed by the Company since July 1960 and was appointed Assistant Secretary in May 1973. She has served as Secretary of the Company since February 1976, as Vice President- Corporate Administrator of the Company since January 1990 and prior thereto had served as Assistant Vice President-Corporate Administrator of the Company since February 1979. Mr. Miller has served as Vice President of the Company since January 1989. He has also served as Executive Vice President of a subsidiary of the Company for more than the past five years. Mr. Orlando, a certified public accountant, has served as Vice President of the Company since January 1994. Mr. Orlando served in a variety of capacities with the Company and its subsidiaries since 1987, including serving as Chairman of S & H. Mr. Sherman has served as Vice President of the Company since August 1992. For the five years prior, he served in a variety of capacities with the Company and its subsidiaries. PART II Item 5.	Item 5. Market for Registrant's Common Equity and Related ------------------------------------------------- Stockholder Matters. ------------------- (a) Market Information. ------------------ The common shares of the Company (the "Common Shares") are traded on the New York Stock Exchange and Pacific Stock Exchange under the symbol LUK. The following table sets forth, for the calendar periods indicated, the high and low sales price per Common Share on the consolidated transaction reporting system, as reported by the Dow Jones Historical Stock Quote Reporter Service. On January 8, 1993, the Company effected a two-for-one stock split of the Common Shares in the form of a 100% stock dividend (the "Stock Split"). The dividend was paid to shareholders of record immediately following the close of business on December 31, 1992. Per share amounts set forth in this Report have been adjusted to reflect the Stock Split. (b) Holders. ------- As of March 16, 1993, there were approximately 6,918 record holders of the Common Shares. (c) Dividends. --------- The Company declared and paid on December 15, 1993, a dividend of $.25 per Common Share and on December 31, 1992, a dividend of $.20 per Common Share. Prior thereto, the Company had not paid any cash dividends on the Common Shares since January 1, 1973. In connection with the Phlcorp Merger, the Company agreed to consider, but has not made any commitment to, paying annual dividends in the future. The payment of dividends in the future is subject to the discretion of the Board of Directors and will depend upon general business conditions, legal and contractual restrictions on the payment of dividends and other factors that the Board of Directors may deem to be relevant. In connection with the declaration of dividends or the making of distributions on, or the purchase, redemption or other acquisition of Common Shares, the Company is required to comply with certain restrictions contained in certain of its debt instruments. Item 6.	Item 6. Selected Financial Data. ------ ----------------------- The following selected financial data have been summarized from the Company's consolidated financial statements and are qualified in their entirety by reference to, and should be read in conjunction with, such consolidated financial statements and "Management's Discussion and Analysis of Financial Condition and Results of Operations," below. Item 7.	Item 7. Management's Discussion and Analysis of Financial Condition ----------------------------------------------------------- and Results of Operations. ------------------------- LIQUIDITY AND CAPITAL RESOURCES The Company. During each of the three years in the period ended ----------- December 31, 1993, the Company operated profitably and in the year ended December 31, 1991 net cash was provided from operations. For the years ended December 31, 1993 and 1992, in spite of increased earnings, net cash was used for operations. The 1992 net cash used principally resulted from a 1991 reinsurance transaction, which had the effect of reducing CPI's premium to surplus ratio for 1991, and the 1993 net cash used principally related to the transfer of blocks of insurance described below. Principally as a result of the acquisition of the minority interest in Phlcorp (the "Phlcorp Minority Interest") on December 31, 1992 and the Company's continuing profitable operations, ratings of the Company's debt obligations were upgraded in 1993 by Moody's, S&P and Duff & Phelps Inc., three of the leading bond rating agencies, all of which rated the Company's senior debt as "investment grade." The Company believes the higher ratings have made it substantially easier to raise additional funds, including the offerings described below, on favorable terms. Ratings issued by bond rating agencies are subject to change at any time. In February 1993, the Company sold $100,000,000 principal amount of its newly authorized 5 1/4% Convertible Subordinated Debentures due 2003 (the "Convertible Debentures") in an underwritten public offering. The Convertible Debentures are convertible into Common Shares at $57.50 per Common Share (an aggregate of 1,739,130 Common Shares), subject to anti-dilution provisions. In August 1993, the Company sold $100,000,000 principal amount of its newly authorized 7 3/4% Senior Notes due 2013 (at 99% of principal amount) in an underwritten public offering. The net proceeds of these offerings were added to working capital. Principally as a result of the public offerings and increased cash flow from affiliates, including tax sharing payments, the Company and its non-regulated affiliates had aggregate cash and temporary investments of approximately $204,000,000 at February 28, 1994. Such funds are available for general corporate purposes, including acquisitions. However, the interest rate currently earned on such funds is less than the interest paid on the 1993 debt offerings. In addition, at February 28, 1994 the Company had available aggregate credit agreement facilities of $150,000,000. During 1994, the credit agreements were renewed and now expire in 1997. No amounts were outstanding at February 28, 1994 under these credit agreement facilities. Effective as of January 1, 1993, as described more fully in Note 1(a) of Notes to Consolidated Financial Statements, the Company adopted SFAS 106 (postretirement benefits), SFAS 109 (income taxes), SFAS 112 (postemployment benfits), SFAS 113 (reinsurance) and EITF 93-6 (retrospectively rated reinsurance agreements). Although adoption of these statements resulted in an aggregate credit of $129,195,000 being reported as an element of net income for 1993 and an increase in shareholders' equity of $138,605,000, adoption of such statements will not affect cash flows, actual income taxes paid or the actual utilization of the Company's substantial tax loss carryforwards. However, adoption of SFAS 109 is likely to increase reported provisions for income taxes in most periods. In addition, as of December 31, 1993, the Company adopted SFAS 115. SFAS 115 requires that most securities, other than those meeting the requirements for classification as "held-to-maturity," be carried on the consolidated balance sheet at market value, either through an adjustment to earnings (if classified as "trading securities") or through shareholders' equity (if classified as "available for sale"). The Company has classified substantially all of its investment portfolio as "available for sale," which resulted in an increase of shareholders' equity at December 31, 1993 of approximately $49,500,000. The Company believes SFAS 115 will result in substantial fluctuations in reported shareholders' equity, but is unlikely to have a material effect on results of operations. For additional information with respect to the changes in accounting principles, see "Results of Operations," below and Notes to Consolidated Financial Statements. During 1992, the Company concluded that the profitability of its existing SPDA and SPWL business was unlikely to achieve acceptable operating results in the future. Accordingly, principally starting in the fourth quarter of 1992, the Company offered certain of its existing SPDA policyholders the opportunity to exchange their policies for SPDA policies of an unrelated insurer and entered into a reinsurance agreement (which closed in stages in 1992 and 1993) to reinsure certain blocks of SPDA business with a second unrelated insurer. In connection with the 1993 SPDA closing (which involved reinsurance of policies with account balances of approximately $47,187,000 on the date of closing in 1993), there was no significant net gain or loss. The Company is maximizing the return on any remaining SPDA policies by reducing crediting rates to the minimum permitted. As a result, the Company believes that a substantial portion of the remaining SPDA policyholders will terminate their policies over a period of time. On June 23, 1993, the Company reinsured substantially all of its existing blocks of SPWL business with a subsidiary of John Hancock Mutual Life Insurance Company ("John Hancock"). In connection with the transaction, the Company realized a net pre-tax gain of approximately $16,700,000. Such net pre-tax gain consists of net gains on sales of investments sold in connection with the transaction (approximately $24,100,000), which are included in the caption "Net securities gains," reduced by a net loss of approximately $7,400,000 (principally the write-off of deferred policy acquisition costs of approximately $26,900,000 less the premium received on the transaction), which is included in the caption "Provision for insurance losses and policy benefits." Further, the Company may receive additional consideration based on the subsequent performance of this block of business. For financial reporting purposes, the Company will reflect the policy liabilities assumed by John Hancock (in policy reserves), with an offsetting receivable from John Hancock of the same amount (in reinsurance receivable, net), until the Company is relieved of its legal obligation to the SPWL policyholders. During the first quarter of 1994, the Company and an equal partner agreed to acquire a 60% interest in Caja de Ahorro y Seguro S.A. ("Caja") for a purchase price of approximately $85,000,000, subject to final adjustment. Caja is a holding company whose subsidiaries are engaged in property and casualty insurance, life insurance and banking in Argentina. Caja has (unaudited) assets in excess of approximately $500,000,000. Reliable historical operating data for Caja is not available. The Company believes that Caja will not constitute a "significant subsidiary." On August 16, 1991, the Company acquired CPG. As described in "Results of Operations," CPG has operated profitably and has been a substantial contributor to the Company's performance. Prior to the acquisition of CPG, particularly in 1989 and 1990, the property and casualty insurance operations of CPG had provided significant additional amounts for losses. At December 31, 1991, the Company stated it believed that the reserves established for the Colonial Penn P&C Group were adequate, including amounts applicable to the Special Risks business. Since acquisition, the claims and settlement experience of the acquired business has been satisfactory and the Company continues to believe (in part based on the recent report of an independent consulting actuary) that the reserves established for the Colonial Penn P&C Group, including the Special Risks business and amounts that may be assessed by California and New Jersey, are adequate. The Company records trading stamp revenues and provides for the cost of redemptions at the time trading stamps are furnished to licensees. A liability for unredeemed trading stamps is estimated based on the cost of merchandise, cash and related redemption service expenses required to redeem the trading stamps which are expected to be presented for redemption in the future. The Company periodically reviews the appropriateness of the estimated redemption rates based upon recent experience, statistical evaluations and other relevant factors. At December 31, 1993 and 1992, the liability for unredeemed trading stamps reflected in the Company's consolidated balance sheet was $58,541,000 and $74,964,000, respectively. The most recent statistical studies of trading stamp redemptions have indicated that the historical pattern of redemptions has changed and that the recorded liability for unredeemed trading stamps is in excess of the amount that ultimately will be required to redeem trading stamps outstanding. The amount of this excess may be different than indicated by these studies. Accordingly, the Company is amortizing the aggregate apparent excess over a five year period (starting in 1990 with respect to approximately $34,000,000 of such apparent excess and in 1991 with respect to approximately $28,000,000 of such apparent excess). Based upon the latest studies, the unamortized apparent excess was approximately $17,067,000 at December 31, 1993. The Company will continue to monitor current redemptions and estimates of ultimate redemptions. The government of El Salvador and representatives of the Company had previously reached agreement as to the amount to be paid for the assets of an electric utility in El Salvador in which the Company had an interest. Pursuant to such agreement, on March 30, 1993, the Company received cash of approximately $5,300,000 and approximately $12,000,000 principal amount of 6% U.S. dollar denominated El Salvador Government bonds due in instalments through 1996. The gain recognized during 1993 was not material. As a result of receiving required prepayments and the sale of the bonds, the Company will report a pre- tax gain of approximately $8,458,000 in the first quarter of 1994. In connection with the formation of JII on June 1, 1988, John W. Jordan II, a director and significant shareholder of the Company, acquired from the Company most of the Company's direct interest in JII in exchange for a zero coupon note which matured in 1993. On June 1, 1993 Mr. Jordan delivered to the Company 224,175 of the Company's Common Shares valued at $8,294,000 (the maturity value of the zero coupon note) as payment in full of the zero coupon note. The Common Shares were valued at $37.00 per share, the closing price of a Common Share on the New York Stock Exchange Composite Tape on May 24, 1993, the last full trading day prior to the authorization by the Company's Board of Directors of the agreement. The Company is to receive the residual interest in CLIC and Credit from the Wisconsin Insurance Commissioner without additional consideration. The Company estimates that the value of the net tangible assets of such companies to the Company was approximately $32,800,000 in excess of their carrying amount at December 31, 1993. The underlying assets of such companies are principally invested in high quality interest earning securities. The timing for receipt of such assets is uncertain. During 1993 and 1992, the property and casualty insurance industry suffered unprecedented losses from natural disasters, principally Hurricane Andrew in 1992 and snow storm and fire related losses in 1993. The Company's insurance subsidiaries also suffered certain of such losses, although as described below in "Results of Operations," reinsurance reduced the economic loss to the Company related to Hurricane Andrew. However, as a result of the industry's losses, the Company has seen a notable decrease in the availability of catastrophe reinsurance at reasonable rates, particularly at low levels of deductibility. Although the reinsurance programs were completed at acceptable upper loss limits (albeit at a somewhat increased cost), the insurance subsidiaries have been unable to obtain previous levels of deductibility at reasonable cost. Accordingly, for 1994 and 1993 the Company has increased its retention of lower level losses to $11,000,000. In 1992, the Company did not incur losses in excess of its maximum reinsurance. Further, the Company did not incur catastrophic losses in excess of its retained limits in 1993 and to date in 1994. In January 1994, Los Angeles experienced severe earthquakes. As a result, the Company suffered losses estimated at approximately $7,000,000 to $10,000,000. In addition, severe winter storms in 1994 resulted in unusually high losses. New Jersey's insurance laws require all automobile insurers to share in the losses of the MTF based on their depopulation share of the JUA, as set by the New Jersey Department of Insurance. Although the amount of the MTF deficit has not yet been finalized, based on certain current estimates of the MTF deficit (which are subject to change), the Colonial Penn P&C Group would be assessed approximately $11,100,000. While the New Jersey Insurance Department has adopted regulations which would permit an insurer, with the approval of the Insurance Department, to recover amounts paid to the MTF through surcharges to policyholders, there can be no assurance that the Colonial Penn P&C Group would be permitted to surcharge its policyholders for all or even part of any future deficit assessment. The Colonial Penn P&C Group has provided for its portion of the estimated MTF losses. The NAIC has adopted a model law incorporating the concept of a "risk based capital" ("RBC") requirement for insurance companies, although the model law is not intended to apply to property and casualty insurance companies until year end 1994 financial statements are available. Generally, RBC is designed to measure the adequacy of an insurer's statutory capital in relation to the risks inherent in the business. The RBC formula will be used by the states as an early warning tool to identify weakly capitalized companies for the purpose of initiating regulatory action. The RBC ratios of the Company's insurance subsidiaries as of December 31, 1993 were substantially in excess of the minimum requirements. The Company and certain of its subsidiaries including Phlcorp and its subsidiaries, have substantial loss carryforwards and other tax attributes (see Note 13 of Notes to Consolidated Financial Statements). The amount and availability of tax loss carryforwards are subject to certain qualifications, limitations and uncertainties, including, with respect to Phlcorp and its subsidiaries, tax sharing payments pursuant to a tax settlement agreement with the Internal Revenue Service and the Department of Justice. In order to reduce the possibility that certain changes in ownership could impose limitations on the use of these carryforwards which could reduce their value to the Company, the Company's shareholders, at a special meeting held on December 30, 1992, imposed certain charter restrictions which generally restrict the ability of a person or entity from accumulating five percent or more of the Common Shares and the ability of persons or entities now owning at least five percent of the Common Shares from acquiring additional Common Shares. Upon implementation of SFAS 109, the Company recognized as an asset (net of reserves) certain of the benefits of such loss carryforwards and other tax attributes. However, the amount of the asset recognized only reflects the minimum Phlcorp tax loss carryforwards and assumes that certain proposed regulations affecting the use of Phlcorp's tax loss carryforwards are finalized without significant change. As described in the accompanying financial statements, significant additional amounts may be available under certain circumstances. The Company's fixed maturity investments are generally "investment grade" or U.S. governmental agency issued or guaranteed obligations, although limited investments in "non-rated" or rated less than "investment grade" securities have been made from time to time. The Company believes that it provides for potential losses on its investments upon early indications that a decline in the market value of a particular security may be other than temporary. The cost and market/carrying value of the Company's investments in "non-rated" or less than "investment grade" rated securities was approximately $40,218,000 and $48,351,000 at December 31, 1993, respectively. At December 31, 1993, less than 1% of the insurance subsidiaries fixed maturity investment portfolio was rated by Moody's and/or S&P as less than "investment grade" or was not rated. The Company continuously evaluates its existing operations and investigates possible acquisitions of new businesses and dispositions of businesses in order to maximize its ultimate economic value to shareholders. Accordingly, while the Company does not have any material arrangement, commitment or understanding with respect thereto, except as described in this Report, further acquisitions, divestitures, investments and changes in capital structure are possible. The Company also believes based on discussions with commercial and investment bankers that it has the ability to raise significant additional funds under acceptable conditions for use in its existing businesses or for appropriate investment opportunities. Parent. Leucadia National Corporation (the "Parent") is a ------ holding company whose assets principally consist of the stock of its several direct subsidiaries. As described below, its principal sources of funds are derived from its available cash resources, bank borrowings, public financings, repayment of advances, funds distributed from its subsidiaries as tax sharing payments, management and other fees, and borrowings and dividends from its regulated and non-regulated subsidiaries. It has no substantial recurring cash requirements other than payment of interest and principal on its debt, tax payments and expenses of its corporate offices. The Parent maintains the principal borrowings for the Company and its non-banking subsidiaries and has provided working capital to certain of its wholly owned subsidiaries. These borrowings have primarily been made on an unsecured basis from banks through various credit agreement facilities and term loans, and through public financings. As noted above, during 1993, the Company issued an aggregate of $200,000,000 principal amount of senior debt securities and subordinated convertible debt securities in underwritten public offerings. Although the Company had no specific use for such funds (the proceeds of the offerings were principally invested on a temporary basis), the Company believes that it was prudent to borrow long term funds at rates that were historically attractive. As a result of these offerings and other sources of funds, at February 28, 1994, the Company and its wholly owned non-regulated subsidiaries had cash and temporary investments of approximately $204,000,000. There are no restrictions on distributions from the wholly owned non-regulated subsidiaries and therefore all cash available to these subsidiaries (including proceeds from sales of their investments in marketable securities) is available to the Parent. At December 31, 1993, a maximum of approximately $50,590,000 was available to the Parent as dividends from the regulated subsidiaries without regulatory approval. Additional amounts may be available to the Parent in the form of loans or cash advances from such regulated subsidiaries. The Parent (and Phlcorp) also receive tax sharing payments from their subsidiaries included in consolidated tax returns, including certain regulated subsidiaries. Because of the tax loss carryforwards available to the Parent (and Phlcorp) and current interest deductions, the amount paid by the Parent (and Phlcorp) for income taxes is substantially less than tax sharing payments received from the subsidiaries. In addition, the Company believes significant amounts are available from the regulated and non-regulated entities for services provided by the Parent. The Parent also has borrowed short-term funds from time to time from its regulated subsidiaries (as permitted by applicable regulations), although no amounts were outstanding at December 31, 1993 and no amounts were borrowed to date in 1994. Furthermore, as previously noted, the Parent has recently renewed its credit agreements which provide for aggregate credit agreement facilities of $150,000,000. No significant amounts were borrowed in 1993 or to date in 1994 under such agreements. RESULTS OF OPERATIONS CPG is included in results of operations from its date of acquisition, August 16, 1991. For the year ended December 31, 1992, CPG contributed revenues of approximately $836,552,000 (including net gains on sales of securities of approximately $23,543,000) and contributed approximately $131,757,000 to consolidated pre-tax income (exclusive of financing costs). For the period from August 16, 1991 to December 31, 1991, CPG contributed revenues of approximately $359,088,000 (including net gains on sales of securities of approximately $16,323,000) and contributed approximately $59,995,000 to consolidated pre-tax income (exclusive of financing costs). Due to changes in the Company's insurance operations it is not practicable to provide meanful comparable information for CPG for 1993. Except as disclosed herein, the material changes in results of operations for the year ended December 31, 1992 compared to the preceding year result from the acquisition of CPG. Premium receipts on investment oriented products of the life insurance subsidiaries (which are not reflected as revenues) were approximately $88,312,000 in 1993, $68,035,000 in 1992 and $43,164,000 in 1991. The principal investment oriented product sold during the three year period ended December 31, 1993 was a tax-advantaged VA product marketed directly to consumers. Increases in premium receipts in 1993 and 1992 may in part result from Federal tax law changes anticipated in 1992 and enacted in 1993. Substantially all other life insurance earned premiums relate to the CPG operations. Earned premium revenues of the life and health insurance operations were approximately $181,800,000 for 1993 compared to $233,700,000 for 1992. The decrease reflected the termination of certain assumed life and health reinsurance contracts which had revenues of approximately $28,750,000 for 1992 and minimal profitability (except for termination gains of approximately $6,200,000 recognized in 1992). In addition, earned premium revenues decreased as a result of the run-off of the agent sold medicare supplement business, which the Company ceased marketing at December 31, 1992 due to inadequate profitability. During 1993, based on its experience since acquisition, the Company concluded that it would be able to generate significant new premiums for its Graded Benefit Life business at acquisition cost levels that result in adequate profitability. Accordingly, starting in 1993, the Company increased its marketing efforts with respect to this product. Earned premium revenues and commissions of the property and casualty insurance operations of the Empire Group were approximately $259,400,000 in 1993, $243,100,000 in 1992 and $210,700,000 in 1991. The increases (as compared to the preceding year) are principally due to increases in certain premium rates (4.3% in 1993 and 6.2% in 1992) and increased premium volume (2.4% in 1993 and 9.2% in 1992). Earned premium revenues of the Colonial Penn property and casualty insurance operations were approximately $452,600,000 in 1993 and $456,000,000 in 1992. Earned premiums in 1993 reflect an increase in involuntary auto insurance resulting from assigned risk business. The 1993 decline in other business was anticipated and is principally the result of the substantial reduction in marketing costs incurred prior to acquisition, which the Company believes were not justified by prior operating results. As described more fully elsewhere herein, the Colonial Penn property and casualty insurance operations are using other means to market their products. The Company believes its present marketing efforts have resulted in new business which to some degree offsets the normal attrition of existing business. The Company believes that it is likely that new business generated in 1994 will be greater than business lost through normal attrition, although there can be no assurance that this will be achieved. Manufacturing revenues and cost of goods sold in 1993 and 1992 increased slightly from amounts from the preceding year. Manufacturing gross profit was substantially unchanged in 1993 and lower in 1992 than 1991. The decline in 1992 was due to certain manufacturing inefficiencies and start up costs associated with the Company's new bathroom vanity manufacturing facility, under-utilization of facilities in part due to general unfavorable economic conditions and pricing pressures. These inefficiencies contributed to the manufacturing operations having a small loss in 1991 and a substantially larger loss in 1993 and 1992. Although the new manufacturing plant decreased its inefficiencies in 1993, the plant continues to operate at unacceptable efficiency levels. During 1993, the Company instituted actions that it believes should improve efficiency to acceptable levels in 1994 and 1995, although there can be no assurance as to that effect. Trading stamps revenues were lower in 1993 and 1992 than the preceding year principally due to the loss of business of certain customers. The Company believes the historical decline in usage of trading stamps will continue. The Company provided the liability for unredeemed trading stamps based on the estimate that approximately 75% of stamps issued in each of 1993, 1992 and 1991 ultimately will be redeemed. The gross profit rate was higher in 1992 than in 1991 principally due to lower merchandise costs. In early 1993, the Company contributed the net assets of its motivation services business to a new joint venture formed with an unrelated motivation services company in exchange for a 45% equity interest in the joint venture. The joint venture is recorded on the equity basis of accounting. Results of operations of the motivation services business have historically not been significant and are not expected to be significant in the future. Finance revenues reflect the level of consumer instalment loans. In 1992 the Company sold at a profit substantially all of its consumer loan development offices, which had aggregate consumer instalment loans at the time of sale of approximately $68,500,000. As expected, the operating profit applicable to this segment increased in 1993 as the offices sold in 1992 operated at a loss. Based on its experience since 1988 in providing automobile collateralized loans to individuals with poor credit histories, during 1993 the Company concluded that there were excellent opportunities for successful expansion of this business. Accordingly, on a controlled basis, the Company increased its investment in such loans. Such loans approximated $73,321,000 at December 31, 1993 and $47,890,000 at December 31, 1992. The Company expects to further increase such loans in 1994. Investment and other income decreased in 1993 compared to 1992. The decrease was the result of a lower level of investments due to disposition of the SPWL and SPDA business and lower interest rates. Exclusive of CPG, investment and other income decreased in 1992 compared to 1991. The investment earnings of the non-CPG insurance subsidiaries were lower in 1992 compared to the prior year in part due to a reduction in Charter's investment portfolio to fund a substantial portion of the CPG purchase price. The estimated average yield to maturity of bonds and notes in the Company's investment portfolio was lower at December 31, 1993 and 1992 than at the preceding year end. The decreased yield resulted in part from the reinvestment of sales proceeds at the generally prevailing lower interest rates. Further, other income in 1991 includes approximately $9,359,000 related to the resolution of certain pre-acquisition contingencies related to Cambrian, a consolidated subsidiary. The $12,981,000 gain in 1993 from the sale of a portion of the investment in Bolivian Power and the $12,128,000 gain in 1992 from sale of the consumer loan development offices is reflected in other income. Net securities gains (losses) in each of the three years ended December 31, 1993 were as follows (in thousands): The proceeds from sales of investments were primarily reinvested at the generally lower prevailing interest rates. Since these reinvestment rates were, in certain instances, lower than had previously been expected on certain fixed rate annuity policies issued by the life insurance subsidiaries, in 1993 and 1991 the Company provided approximately $6,800,000 and $8,800,000, respectively, which is included in results of operations under the caption, "Provision for insurance losses and policy benefits." In 1992, as a result of realizing securities gains and reinvestment of sales proceeds at the lower prevailing interest rates, and securities gains realized in connection with the termination or transfer of the SPDA business, the Company recalculated and eliminated deferred policy acquisition costs applicable to certain of its investment oriented products (including the SPDA policies), reviewed the expected and required return on certain fixed income products and, as a result, provided additional reserves of approximately $13,900,000, which is included in the caption "Provision for insurance losses and policy benefits" in 1992 results of operations. These reinvestment risks do not apply to the Company's currently offered variable investment oriented products. The provision for insurance losses and policy benefits of the life and health operations decreased in the 1993 period compared to the 1992 period, principally due to lower earned premiums and insurance in force, (including the SPDA and SPWL business that was sold in late 1992 and 1993). However, the provision for insurance losses and policy benefits of the life and health operations for 1993 includes a net loss of approximately $7,400,000 (principally the write-off of deferred policy acquisition costs less the premium received) applicable to the SPWL business sold to John Hancock and additional provisions of approximately $6,800,000 applicable to certain fixed rate policies due to realization of securities gains and reinvestment of proceeds at the lower prevailing interest rates, as described more fully above. The provision for insurance losses and policy benefits of the life and health operations exclusive of CPG increased in 1992 compared to 1991 principally due to the growth in earned premiums and the additional amounts provided by the life insurance subsidiaries as a result of the realized securities gains described above. Further, the spread between amounts credited to policyholders by the life insurance subsidiaries and amounts earned on investments was reduced in 1992 as compared to 1991. As a result of the termination of certain reinsurance arrangements by the life insurance subsidiaries, approximately $6,200,000, representing amounts provided for policyholder benefits that were no longer required, is reflected as a reduction in the provision for insurance losses and policy benefits for 1992. The Company's property and casualty insurance operations combined ratios as determined under GAAP and SAP were as follows: Year ended December 31, GAAP SAP ------ ------ 1993 96.9% 93.7% 1992 101.7%102.8% 1991 102.1%103.3% For the Colonial Penn P&C Group, the severity of personal automobile claims was substantially more favorable in 1993 than in 1992 and the frequency of such claims was substantially more favorable in 1992 than in the prior year. The Company believes this experience reflects its improved underwriting procedures, emphasis on over 50 year old insureds and prior rate increases. In addition, the combined ratio and the provision for losses applicable to the property and casualty operations for 1993 were favorably affected due to settlement of prior years' claims at amounts less than had been provided. The overall loss experience of the Empire Group's property and casualty insurance subsidiaries was less favorable in 1992 than in 1991 primarily as a result of unfavorable loss experience in automobile lines and an approximately $3,000,000 retroactive assessment for a workers' compensation fund. The Company believes that as a result of the reduction in claims outstanding for the Colonial Penn P&C Group, there will be a reduced positive effect on future results of operations from settlement of claims at less than amounts previously provided in spite of providing loss reserves on current operations at very conservative levels. The provision for insurance losses and policy benefits in 1993 and 1992 (including CPG) also includes catastrophe losses (net of reinsurance recoveries in 1992) estimated at an aggregate of approximately $10,900,000 in 1993 and $12,300,000 in 1992 (including amounts related to Hurricane Andrew in 1992). In addition, in 1992, the Company provided approximately $1,000,000 to reinstate certain reinsurance coverage which was exhausted in connection with Hurricane Andrew. Interest expense principally reflects the level of external borrowings outstanding during the period and, in each year compared to the preceding year, the effect of lower interest rates. Interest expense in 1992 also reflects a lower level of intercompany borrowings from Phlcorp during 1992, which resulted in increased interest charges of approximately $4,880,000 in 1992 compared to 1991. Additionally, interest expense reflects the level of Deposits at AIB and the ILCs. Generally, interest rates on Deposits are lower than on other available funds. Interest on Deposits was approximately $9,001,000 in 1993, $11,954,000 in 1992 and $15,138,000 in 1991. The Company estimates that in 1993, the interest expense on its borrowings which were invested in temporary investments exceeded interest earned by approximately $2,500,000. Selling, general and other expenses in 1991 includes costs applicable to development by the trading stamps subsidiary of a database marketing program of approximately $8,237,000 (including close down costs). In 1991 the Company discontinued development of the program due to a lack of acceptance by food manufacturers. Minority interest in 1992 and 1991 was principally applicable to the Phlcorp Minority Interest. On December 31, 1992, the Company acquired the Phlcorp Minority Interest in exchange for approximately 4,408,000 Common Shares. Income before income taxes and the effects of accounting changes was $176,868,000 in 1993, $143,553,000 in 1992 and $95,030,000 in 1991. The amount for 1993 was the highest in the history of the Company. The provision for income taxes for 1993 was calculated under SFAS 109 which does not reflect the benefit from utilization of tax loss carryforwards. The provisions for income taxes for 1992 and 1991 have been reduced for the benefit from utilization of tax loss carryforwards. The provision for income taxes for 1993 was reduced by approximately $8,315,000 as a result of tax law changes and a reduction in the valuation allowance applicable to certain deferred tax assets. The Company estimates that if the 1993 tax provision had been calculated as it was in 1992 and 1991, such provision would have been lower by, and net income (exclusive of amounts applicable to changes in accounting principles) would have been higher by approximately $42,614,000 (or $1.46 per primary earnings per share and $1.38 per fully diluted earnings per share). The provisions for income taxes for 1992 and 1991 principally consist of state income taxes, the federal alternative minimum income tax, federal income taxes applicable to the life insurance subsidiaries which cannot utilize the Company's tax loss carryforwards and United Kingdom income taxes applicable to Cambrian. The 1991 provision reflects credits of approximately $5,400,000, resulting from the favorable outcome of certain prior years' United Kingdom income tax matters. As noted above, the tax provisions for 1992 and 1991 reflect the benefit from utilization of accounting and tax loss carryforwards, including capital loss carryforwards. The number of shares used to calculate primary earnings per share was 29,270,000, 24,435,000 and 23,704,000 for 1993, 1992 and 1991, respectively. The number of shares used to calculate fully diluted earnings per share was 30,743,000, 24,516,000 and 23,916,000 for 1993, 1992 and 1991, respectively. The increase in 1993 was principally caused by the acquisition of the Phlcorp Minority Interest and, with respect to fully diluted per share amounts, the effect of the assumed conversion of the 5 1/4% Convertible Debentures. The increase in the number of shares utilized in calculating per share amounts in 1992 compared to 1991 was principally caused by the exercise of options to purchase common shares and the increase in the market price per common share. Item 8.	Item 8. Financial Statements and Supplementary Data. ------ ------------------------------------------- Financial Statements and supplementary data required by this Item 8 are set forth at the pages indicated in Item 14(a) below. Item 9.	Item 9. Disagreements on Accounting and Financial Disclosure. ------ ---------------------------------------------------- Not applicable. PART III Item 10.	Item 10. Directors and Executive Officers of the Registrant. ------- -------------------------------------------------- The information to be included under the caption "Nominees for Election as Directors" in the Company's definitive proxy statement to be filed with the Commission pursuant to Regulation 14A of the 1934 Act in connection with the 1994 annual meeting of shareholders of the Company (the "Proxy Statement") is incorporated herein by reference. In addition, reference is made to Item 10 in Part I of this Report. Item 11.	Item 11. Executive Compensation. ------- ---------------------- The information to be included under the caption "Executive Compensation" in the Proxy Statement is incorporated herein by reference. Item 12.	Item 12. Security Ownership of Certain Beneficial Owners and Management. ------- -------------------------------------------------------------- The information to be included under the caption "Present Beneficial Ownership of Common Shares" in the Proxy Statement is incorporated herein by reference. Item 13.	Item 13. Certain Relationships and Related Transactions. ------- ---------------------------------------------- The information to be included under the caption "Executive Compensation - Certain Relationships and Related Transactions" in the Proxy Statement is incorporated herein by reference. PART IV Item 14.	Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. ---------------------------------------- (a)(1)(2) Financial Statements and Schedules. ---------------------------------- Report of Independent Certified Public Accountants . . . . . . . . . . . . . . . Financial Statements: Consolidated Balance Sheets at December 31, 1993 and 1992 . . . . . . . . Consolidated Statements of Income for the years ended December 31, 1993, 1992 and 1991 . . . . . . . . . . . Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991 . . . . . Consolidated Statements of Changes in Shareholders' Equity for the years ended December 31, 1993, 1992 and 1991 . . . . . . . . . . . . . . . . . Notes to Consolidated Financial Statements . . . . . . . . . . . . . . . . Financial Statement Schedules: Schedule I - Summary of Investments Other Than Investments in Affiliates . . . Schedule III - Condensed Financial Information of Registrant . . . . . . . . Schedule V - Supplementary Insurance Information . . . . . . . . . . Schedule VI - Schedule of Reinsurance . . . . . . . . . . . . . . . Schedule VIII - Valuation and Qualifying Accounts . . . . . . . . . . . Schedule IX - Short-Term Borrowings . . . . Schedule X - Schedule of Supplemental Information for Property and Casualty Insurance Underwriters . . . . . (3) Executive Compensation Plans and Arrangements. --------------------------------------------- 1982 Stock Option Plan, as amended August 28, 1991 (filed as Annex B to the Company's Proxy Statement dated July 21, 1992). 1992 Stock Option Plan (filed as Annex C to the Company's Proxy Statement dated July 21, 1992). Agreement made as of March 12, 1984 by and between Leucadia, Inc. and Ian M. Cumming (filed as Exhibit 10.14 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1983 (the "1983 10-K")). Agreement made as of March 12, 1984 by and between Leucadia, Inc. and Joseph S. Steinberg (filed as Exhibit 10.15 to the Company's 1983 10-K). Agreement dated as of August 1, 1988 among the Company, Ian M. Cumming and Joseph S. Steinberg (filed as Exhibit 10.6 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1991 (the "1991 10-K")). Agreement dated as of January 10, 1992 between Ian M. Cumming, certain other persons listed on Schedule A thereto and the Company (filed as Exhibit 10.7 to the Company's 1991 10-K). Agreement dated as of January 10, 1992 between Joseph S. Steinberg, certain other persons listed on Schedule A thereto and the Company (filed as Exhibit 10.8 to the Company's 1991 10-K). Agreement between Leucadia, Inc. and Ian M. Cumming, dated as of December 28, 1992 (filed as Exhibit 10.12(a) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992 (the "1992 10-K")). Escrow and Security Agreement by and among Leucadia, Inc., Ian M. Cumming and Weil, Gotshal & Manges, as escrow agent, dated as of December 28, 1992 (filed as Exhibit 10.12(b) to the 1992 10-K). Agreement between Leucadia, Inc. and Joseph S. Steinberg, dated as of December 28, 1992 (filed as Exhibit 10.13(a) to the 1992 10-K). Escrow and Security Agreement by and among Leucadia, Inc., Joseph S. Steinberg and Weil, Gotshal & Manges, as escrow agent, dated as of December 28, 1992 (filed as Exhibit 10.13(b) to the 1992 10-K). Agreement made as of December 28, 1993 by and between the Company and Ian M. Cumming (filed as Exhibit 10.17 to this Report). Agreement made as of December 28, 1993 by and between the Company and Joseph S. Steinberg (filed as Exhibit 10.18 to this Report). Agreement between the Company and Ian M. Cumming dated as of December 28, 1993 (filed as Exhibit 10.19(a) to this Report). Escrow and Security Agreement by and among the Company, Ian M. Cumming and Weil, Gotshal & Manges, as escrow agent, dated as of December 28, 1993 (filed as Exhibit 10.19(b) to this Report). Agreement between the Company and Joseph S. Steinberg, dated as of December 28, 1993 (filed as Exhibit 10.20(a) to this Report). Escrow and Security Agreement by and among the Company, Joseph S. Steinberg and Weil, Gotshal & Manges, as escrow agent, dated as of December 28, 1993 (filed as Exhibit 10.20(b) to this Report). (b) Reports on Form 8-K. ------------------- Not applicable. (c) Exhibits. -------- 3.1 Restated Certificate of Incorporation (filed as Exhibit 5.1 to the Company's Current Report on Form 8-K dated July 14, 1993).* 3.2 By-laws (as amended) filed as Exhibit 4.5 to the Company's Registration Statement No. 33-57054).* 4.1 The Company undertakes to furnish the Securities and Exchange Commission, upon request, a copy of all instruments with respect to long-term debt not filed herewith. 10.1 1982 Stock Option Plan, as amended August 28, 1991 (filed as Annex B to the Company's Proxy Statement dated July 21, 1992).* 10.2 1992 Stock Option Plan (filed as Annex C to the Company's Proxy Statement dated July 21, 1992).* 10.3(a) Restated Articles and Agreement of General Partnership, effective as of February 1, 1982, of The Jordan Company (filed as Exhibit 10.3(d) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1986).* 10.3(b) Amendments dated as of December 31, 1989 and December 1, 1990 to the Partnership Agreement referred to in 10.3(a) above (filed as Exhibit 10.2(b) to the Company's 1991 10-K).* 10.3(c) Amendment dated as of December 17, 1992 to the Partnership Agreement referred to in 10.3(a) above (filed as Exhibit 10.3(c) to the 1992 10-K).* 10.3(d) Articles and Agreement of General Partnership, effective as of April 15, 1985, of Jordan/Zalaznick Capital Company (filed as Exhibit 10.20 to the Company's Registration Statement No. 33-00606).* 10.4 Agreement made as of March 12, 1984 by and between Leucadia, Inc. and Ian M. Cumming (filed as Exhibit 10.14 to the 1983 10-K).* 10.5 Agreement made as of March 12, 1984 by and between Leucadia, Inc. and Joseph S. Steinberg (filed as Exhibit 10.15 to the 1983 10-K).* ___________________ * Incorporated by reference. 10.6 Stock Purchase and Sale Agreement dated as of April 5, 1991, by and between FPL Group Capital Inc. and the Company (filed as Exhibit B to the Company's Current Report on Form 8-K dated August 23, 1991).* 10.7 Agreement dated as of August 1, 1988 among the Company, Ian M. Cumming and Joseph S. Steinberg (filed as Exhibit 10.6 to the Company's 1991 10- K).* 10.8 Agreement dated as of January 10, 1992 between Ian M. Cumming, certain other persons listed on Schedule A thereto and the Company (filed as Exhibit 10.7 to the Company's 1991 10-K).* 10.9 Agreement dated as of January 10, 1992 between Joseph S. Steinberg, certain other persons listed on Schedule A thereto and the Company (filed as Exhibit 10.8 to the Company's 1991 10-K).* 10.10(a) Agreement dated April 23, 1992 between AIC Financial Services, Inc. (an Alabama corporation), AIC Financial Services (a Mississippi corporation) and AIC Financial Services (a South Carolina corporation) (collectively, "Seller") and Norwest Financial Resources, Inc. (filed as Exhibit 10.10(a) to the 1992 10-K).* 10.10(b) Purchase Agreement between A.I.C. Financial Services, Inc., American Investment Bank, N.A., American Investment Financial and Terracor II d/b/a AIC Financial Fund, Seller, and Associates Financial Services Company, Inc., Buyer, dated November 5, 1992 (filed as Exhibit 10.10(b) to the Company's Registration Statement No. 33-55120).* 10.11(a) Agreement and Plan of Merger, dated as of October 22, 1992, by and among the Company, Phlcorp Acquisition Company and PHLCORP, Inc. (filed as Exhibit 5.2 to the Company's Current Report on Form 8-K dated October 22, 1992).* 10.11(b) Amendment dated December 10, 1992, to the Merger Agreement referred to in 10.11(a) above (filed as Exhibit 5.2 to the Company's Current Report on Form 8-K dated December 14, 1992).* 10.12(a) Agreement between Leucadia, Inc. and Ian M. Cumming, dated as of December 28, 1992 (filed as Exhibit 10.12(a) to the 1992 10-K).* 10.12(b) Escrow and Security Agreement by and among Leucadia, Inc., Ian M. Cumming and Weil, Gotshal & Manges, as escrow agent, dated as of December 28, 1992 (filed as Exhibit 10.12(b) to the 1992 10-K).* 10.13(a) Agreement between Leucadia, Inc. and Joseph S. Steinberg, dated as of December 28, 1992 (filed as Exhibit 10.13(a) to the 1992 10-K).* ___________________ * Incorporated by reference. 10.13(b) Escrow and Security Agreement by and among Leucadia, Inc., Joseph S. Steinberg and Weil, Gotshal & Manges, as escrow agent, dated as of December 28, 1992 (filed as Exhibit 10.13(b) to the 1992 10-K).* 10.14 Settlement Agreement between Baldwin-United Corporation and the United States dated August 27, 1985 concerning tax issues (filed as Exhibit 10.14 to the 1992 10-K).* 10.15 Acquisition Agreement, dated as of December 18, 1992, by and between Provident Mutual Life and Annuity Company of America and Colonial Penn Annuity and Life Insurance Company (filed as Exhibit 10.15 to the 1992 10-K).* 10.16 Reinsurance Agreement, dated as of December 31, 1991, by and between Colonial Penn Insurance Company and American International Insurance Company (filed as Exhibit 10.16 to the 1992 10-K).* 10.17 Agreement made as of December 28, 1993 by and between the Company and Ian M. Cumming. 10.18 Agreement made as of December 28, 1993 by and between the Company and Joseph S. Steinberg. 10.19(a) Agreement between the Company and Ian M. Cumming, dated as of December 28, 1993. 10.19(b) Escrow and Security Agreement by and among the Company, Ian M. Cumming and Weil, Gotshal & Manges, as escrow agent, dated as of December 28, 1993. 10.20(a) Agreement between the Company and Joseph S. Steinberg, dated as of December 28, 1993. 10.20(b) Escrow and Security Agreement by and among the Company, Joseph S. Steinberg and Weil, Gotshal & Manges, as escrow agent, dated as of December 28, 1993. 21 Subsidiaries of the registrant. 23 Consent of independent certified public accountants with respect to the incorporation by reference into the Company's Registration Statements on Form S-8 (File No. 2-84303), Form S-8 and S-3 (File No. 33- 6054), Form S-8 and S-3 (File No. 33-26434), Form S-8 and S-3 (File No. 33-30277). ___________________ * Incorporated by reference. 28 Schedule P of the 1993 Annual Statement to Insurance Departments of the Colonial Penn Insurance Company and Affiliated Fire & Casualty Insurers, the Empire Insurance Company, Principal Insurer, and Colonial Penn Madison Insurance Company. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. LEUCADIA NATIONAL CORPORATION March 23, 1994 By: /s/ Norman P. Kiken ------------------------- Norman P. Kiken Vice President and Comptroller 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 indicated, on the date set forth above. Signature Title --------- ----- /s/ Ian M. Cumming Chairman of the Board ------------------------------ Ian M. Cumming (Principal Executive Officer) /s/ Joseph S. Steinberg President and Director ------------------------------ Joseph S. Steinberg (Principal Executive Officer) /s/ Norman P. Kiken Vice President and Comptroller ------------------------------ Norman P. Kiken (Principal Financial and Accounting Officer) /s/ Paul M. Dougan Director ------------------------------ Paul M. Dougan /s/ Lawrence D. Glaubinger Director ------------------------------ Lawrence D. Glaubinger /s/ James E. Jordan Director ------------------------------ James E. Jordan /s/ John W. Jordan II Director ------------------------------ John W. Jordan II /s/ Jesse Clyde Nichols, III Director ------------------------------ Jesse Clyde Nichols, III REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS To the Board of Directors of Leucadia National Corporation: We have audited the consolidated financial statements and the financial statement schedules of LEUCADIA NATIONAL CORPORATION and SUBSIDIARIES listed in Item 14(a) of this Form 10-K. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of LEUCADIA NATIONAL CORPORATION and SUBSIDIARIES as of December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. As more fully discussed in Note 1 to the consolidated financial statements, in 1993, the Company changed its method of accounting for Income Taxes, Postretirement Benefits Other than Pensions, Postemployment Benefits, Re-insurance of Short-Duration and Long- Duration Contracts, Multiple-Year Retrospectively Rated Contracts, and Certain Investments in Debt and Capital Securities, all as set forth in various pronouncements of the Financial Accounting Standards Board and the Emerging Issues Task Force. COOPERS & LYBRAND New York, New York March 17, 1994 LEUCADIA NATIONAL CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS December 31, 1993 and 1992 (Dollars in thousands, except par value) The accompanying notes are an integral part of these consolidated financial statements. LEUCADIA NATIONAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME For the years ended December 31, 1993, 1992 and 1991 The accompanying notes are an integral part of these consolidated financial statements. LEUCADIA NATIONAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS For the years ended December 31, 1993, 1992 and 1991 The accompanying notes are an integral part of these consolidated financial statements. LEUCADIA NATIONAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS, continued For the years ended December 31, 1993, 1992 and 1991 The accompanying notes are an integral part of these consolidated financial statements. LEUCADIA NATIONAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY For the years ended December 31, 1993, 1992 and 1991 The accompanying notes are an integral part of these consolidated financial statements. LEUCADIA NATIONAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Significant Accounting Policies: ------------------------------- (a) Changes in Accounting Policies: Effective as of January 1, 1993, ------------------------------ the Company adopted Statement of Financial Accounting Standards No. 109 "Accounting for Income Taxes" ("SFAS 109"), Statement of Financial Accounting Standards No. 106 "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("SFAS 106"), Statement of Financial Accounting Standards No. 112 "Employers' Accounting for Postemployment Benefits" ("SFAS 112"), Statement of Financial Accounting Standards No. 113 "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts" ("SFAS 113") and Financial Accounting Standards Board's Emerging Issues Task Force Consensus No. 93-6 "Accounting for Multiple-Year Retrospectively Rated Contracts by Ceding and Assuming Enterprises" ("EITF 93-6"). As a result of adoption of SFAS 106, SFAS 109, SFAS 112 and EITF 93-6, the cumulative effects of such changes through January 1, 1993 were recorded as of the date of adoption and were principally reflected in results of operations as "Cumulative effects of changes in accounting principles." In addition, as a result of adoption of SFAS 109, certain acquired intangibles were reduced (for benefits of acquired tax loss carryforwards) and shareholders' equity was directly increased (as a result of prior stock transactions). SFAS 106, SFAS 112 and EITF 93-6 had no material effect on income before cumulative effects of changes in accounting principles for 1993 and are unlikely to have a material effect on future results of operations. Effective as of December 31, 1993, the Company adopted Statement of Financial Accounting Standards No. 115 "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS 115"). Adoption of SFAS 115 had no material effect on results of operations but did increase shareholders' equity by approximately $49,500,000 at December 31, 1993 as described more fully in Note 1(e). (b) Consolidation Policy: The consolidated financial statements -------------------- include the accounts of the Company and all significant majority-owned subsidiaries. The Company's subsidiary, Phlcorp, Inc. ("Phlcorp") has several legal subsidiaries (the "WMAC Companies") which are, or were, under the control of the Wisconsin Insurance Commissioner (the "Commissioner"). These companies are not consolidated while under the control of the Commissioner. Investments in certain other entities in which the Company owns less than 50% of the voting interest and has the ability to exercise significant influence are accounted for on the equity method of accounting. Amounts related to such companies have not been material. Certain amounts for prior periods have been reclassified to be consistent with the 1993 presentation. (c) Stock Split: On January 8, 1993, a two-for-one stock split was ----------- effected in the form of a 100% stock dividend. The financial statements (and notes thereto) give retroactive effect to the stock split for all periods presented. (d) Statement of Cash Flows: The Company considers short-term ----------------------- investments (generally investments with maturities of less than three months at the time of acquisition) as cash equivalents. As described in Note 2, on August 16, 1991, the Company acquired Colonial Penn Group, Inc. ("Colonial Penn") for cash of approximately $128,000,000. The acquired assets were recorded at an aggregate of The accompanying notes are an integral part of these consolidated financial statements. 1. Significant Accounting Policies, continued: ------------------------------- approximately $1,950,000,000 (principally investments in securities) and the acquired liabilities were recorded at an aggregate of approximately $1,822,000,000 (principally policy reserves and unearned premiums). Also, as described in Note 2, on December 31, 1992, the Company acquired the minority interest in Phlcorp (the "Phlcorp Minority Interest") for approximately 4,408,000 of the Company's Common Shares which were recorded at an aggregate of approximately $142,927,000, including costs. Because Phlcorp was a consolidated subsidiary, the Phlcorp Minority Interest (approximately $92,819,000) was eliminated and the difference between the consideration issued and the minority interest eliminated was principally allocated to investments in associated companies (approximately $11,022,000), amounts related to the WMAC Companies (approximately $16,847,000) and excess of purchase price over net assets acquired (approximately $22,277,000). The amount allocated to excess of purchase price over net assets acquired was eliminated as a result of the adoption of SFAS 109. On June 1, 1993, the Company received 224,175 of the Company's Common Shares (valued at $8,294,000) in settlement of a zero coupon note due from John W. Jordan II, a Director of the Company and a significant shareholder. Based on the market price of the shares on the date the transaction was approved by the Board of Directors, the value of the shares received was equal to the maturity value of the note. (e) Investments: Prior to December 31, 1993, investments were carried ----------- at amortized cost with respect to fixed maturities (other than those classified as held for sale) and policyholder loans. Investments were carried at market with respect to marketable equity securities of the insurance subsidiaries and options that did not meet the accounting definition of a hedge and at the lower of cost or market (in the aggregate) for other marketable equity securities. Prior to adoption of SFAS 115, the Company classified a portion of the insurance subsidiaries' investment portfolios as "held for sale." Such investments were carried at the lower of cost or market. A substantial portion of the proceeds from disposition of the portfolio classified as held for sale were invested in other securities. The Company adopted SFAS 115 on December 31, 1993. Under SFAS 115 marketable debt and equity securities are designated as i) "held to maturity" (carried at cost), ii) "trading" (carried at market with differences between cost and market being reflected in results of operations) or iii) if not otherwise classified, as "available for sale" (carried at market with differences between cost and market being reflected as a separate component of shareholders' equity, net of income tax effect). The adoption of SFAS 115 resulted in an increase in reported shareholders' equity of approximately $49,500,000. The Company does not expect that SFAS 115 will have a material effect on future results of operations, although the Company believes SFAS 115 is likely to result in substantial fluctuations in reported shareholders' equity. The fixed maturity investments of the insurance subsidiaries (other than those classified as "trading") are made with the intention of holding such securities to maturity and the Company has the ability to do so. Both prior and subsequent to adoption of SFAS 115, declines in market value below cost which are considered other than temporary are charged to results of operations. For determining realized gain or loss on securities sold, cost is based on average cost. Net unrealized gain on investments at December 31, 1993 is net of deferred income taxes of $27,091,000. (f) Property, Equipment and Leasehold Improvements: Property, ---------------------------------------------- equipment and leasehold improvements are stated at cost, net of accumulated depreciation and amortization (approximately $73,640,000 and $65,150,000 at 1. Significant Accounting Policies, continued: ------------------------------- December 31, 1993 and 1992, respectively). Depreciation and amortization are provided principally on the straight-line method over the estimated useful lives of the assets or, if less, the term of the lease. (g) Income Recognition from Insurance Operations: Premiums on the -------------------------------------------- property and casualty insurance business are recognized as revenues over the term of the policy using the monthly pro rata basis. The life insurance subsidiaries have had several investment oriented insurance products (collectively the "IOP products"), principally consisting of single premium whole life ("SPWL") products, a variable life ("VL") product, variable annuity ("VA") products and a single premium deferred annuity ("SPDA") product. IOP product premiums are reflected in a manner similar to a deposit; revenues reflect only mortality charges and other amounts assessed against the holder of the insurance policies and annuity contracts. Other life premiums are recognized as revenues when due. Health premiums are recognized as revenues over the premium paying period. Premiums for the VA and VL products are directed by the policyholder to be invested generally in a unit trust solely for the benefit and risk of the policyholder. Such investments are considered a "separate account." Policyholder's accounts are charged for the cost of insurance provided, administrative and certain other charges. The amounts included in the balance sheet as policy reserves for the VA and VL products represent the current value of the policyholders' funds. (h) Policy Acquisition Costs: Policy acquisition costs principally ------------------------ consist of direct response marketing costs, commissions, premium taxes and other underwriting expenses (net of reinsurance allowances). If recoverability of such costs is not anticipated, the amounts not considered recoverable are charged to operations. During the three years ended December 31, 1993, the Company has also written-off or reduced deferred policy acquisition costs in connection with dispositions of blocks of business or reinvestment of proceeds from security sales at the lower prevailing interest rates. Policy acquisition costs applicable to the property and casualty insurance operations are deferred and amortized ratably over the terms of the related policies. Policy acquisition costs applicable to IOP products are deferred and amortized as a level percentage of the present value of expected gross profits over the estimated life of each policy. The Company regularly compares its actual experience to the previously expected gross profit and reviews revised estimates of expected future gross profits. When significant changes occur, deferred policy acquisition costs are recalculated and the resultant adjustment is reflected in results of operations. Policy acquisition costs applicable to other life insurance products are amortized over the expected premium paying period of the policies. (i) Reinsurance: In the normal course of business, the Company seeks ----------- to reduce the loss that may arise from catastrophes or other events that cause unfavorable underwriting results by reinsuring certain levels of risk in various areas of exposure with other insurance enterprises or reinsurers. The Company has also entered into reinsurance transactions in connection with dispositions of blocks of businesses. Reinsurance contracts do not necessarily relieve the Company from its obligations to policyholders. Prior to January 1, 1993, losses, loss adjustment expenses and unearned premiums were stated net of reinsurance ceded, as were premiums earned and other underwriting expenses. Under SFAS 113, which was adopted as of January 1, 1993, the effects of certain reinsurance transactions are no longer deducted from the related asset or liability. As a result of adoption of SFAS 113, at December 31, 1993 certain assets (principally 1. Significant Accounting Policies, continued: ------------------------------- reinsurance receivables) and policy reserves were each greater by approximately $457,621,000, representing reinsured amounts that prior to the adoption of SFAS 113 would have been deducted from the related asset or liability. Under SFAS 113 and the prior accounting, appropriate provisions are made for uncollectible reinsurance receivables. Although SFAS 113 did not have a material effect on results of operations, it is likely to affect the way certain new reinsurance transactions or extensions or amendments of existing reinsurance contracts are reported. (j) Policy Reserves and Unearned Premiums: Policy reserves and ------------------------------------- unearned premiums for life, health and traditional annuity policies are computed on a net level premium method based upon standard and Company developed tables with provision for adverse deviation and estimated withdrawals. Liabilities for unpaid losses and loss adjustment expenses applicable to the property and casualty insurance operations are determined using case basis evaluations, statistical analyses for losses incurred but not reported and estimates for salvage and subrogation recoverable and represent estimates of ultimate claim costs and loss adjustment expenses. Effective as of January 1, 1993, the Company adopted EITF 93-6 which specifies the accounting for certain retrospectively rated reinsurance agreements. EITF 93-6 is applicable to a small number of per risk, excess of loss reinsurance policies entered into in the normal course of the Empire Insurance Company and subsidiaries' (the "Empire Group") property and casualty insurance business. As a result of the adoption of EITF 93-6, the Company (retroactive to January 1, 1993) reduced its policy reserves at January 1, 1993 by approximately $14,654,000 and recorded a credit of approximately $9,672,000 (net of income taxes of $4,982,000) which is included in the caption "Cumulative effects of changes in accounting principles." If the accounting specified by EITF 93-6 had been in effect in 1992 and 1991, the resulting increase in income before cumulative effects of changes in accounting principles for each of those years would not have been material. (k) Trading Stamp Revenue and Liability for Unredeemed Trading Stamps: ----------------------------------------------------------------- The Company records trading stamp revenues and provides for the cost of redemptions at the time trading stamps are furnished to licensees. A liability for unredeemed trading stamps is estimated based upon the cost of merchandise, cash and related redemption service expenses required to redeem the trading stamps which are expected to be presented for redemption in the future. The Company periodically reviews the appropriateness of the estimated redemption rates based upon recent experience, statistical evaluations and other relevant factors. The most recent statistical studies of trading stamp redemptions have indicated that the historical pattern of redemptions has changed and that the recorded liability for unredeemed trading stamps is in excess of the amount that ultimately will be required to redeem trading stamps outstanding. Although the Company believes a significant change in redemption patterns has occurred, the amount of the excess may be different than indicated by these studies. Accordingly, the Company is amortizing the aggregate apparent excess over a five year period (starting in 1990 with respect to approximately $34,000,000 of such apparent excess and in 1991 with respect to approximately $28,000,000 of such apparent excess). As a result, after giving effect to related adjustments, cost of goods sold applicable to the trading stamp operations reflects a credit of approximately $11,900,000, $14,100,000 and $13,700,000 for the years ended December 31, 1993, 1992 and 1991, respectively. Based on the latest studies the unamortized apparent excess at December 31, 1993 was approximately $17,067,000. The Company provided the liability for unredeemed trading stamps based on the estimate that approximately 75% of stamps issued in each of the three years ended December 31, 1993 ultimately will be redeemed. (l) Motivation Services Revenues: Motivation services revenues are ---------------------------- generally recorded when awards are redeemed or travel programs are completed. Customer deposits for travel programs and the Company's related costs are deferred until such programs are completed. In early 1993, the Company contributed the net assets of the motivation service business to a new joint venture formed with an unrelated motivation services company in exchange for a 45% equity interest in the joint venture. Results of operations of the motivation services business have historically not been significant and are not expected to be significant in the future. 1. Significant Accounting Policies, continued: ------------------------------- (m) Pension, Postemployment and Postretirement Costs: There are ------------------------------------------------ non-contributory trusteed pension plans, which cover certain employees, which generally provide for retirement benefits based on salary and length of service. The plans are funded in amounts sufficient to satisfy minimum ERISA funding requirements. Certain subsidiaries provide health care and other benefits to certain eligible retired employees. The plans (most of which require employee contributions) are unfunded. Prior to January 1, 1993, the costs of such benefits were expensed generally as incurred, although liabilities for benefits were recorded in connection with certain acquisitions, including that of Colonial Penn and the Phlcorp Minority Interest. Effective as of January 1, 1993, the Company adopted SFAS 106 and SFAS 112 which require companies to accrue the cost of providing certain postretirement and postemployment benefits during the employees' period of service. The Company does not expect SFAS 106 and SFAS 112 to have a material effect on results of continuing operations exclusive of cumulative effects of changes in accounting principles. (n) Income Taxes: The Company and its domestic subsidiaries, other ------------ than (i) Phlcorp and its subsidiaries prior to January 1, 1993 and (ii) the life insurance subsidiaries of Colonial Penn (acquired in 1991, as described below), file a consolidated federal income tax return. Prior to January 1, 1993, Phlcorp filed a consolidated federal income tax return with its subsidiaries that are not life insurance companies. The life insurance subsidiaries of Colonial Penn file separate or consolidated federal income tax returns. In addition, certain subsidiaries are subject to foreign income taxes. The Company provides for income taxes using the liability method. Effective as of January 1, 1993, the Company adopted SFAS 109. Prior to adoption of SFAS 109, the benefit from utilization of tax loss carryforwards and future deductions was only recognized when utilized and under certain other limited circumstances. Under SFAS 109, the future benefit of certain tax loss carryforwards and future deductions is recorded as an asset (net of valuation allowance) and the provision for income taxes for periods ending after December 31, 1992 is not reduced for the benefit from utilization of tax loss carryforwards. Accordingly, the provision for income taxes for periods ended in 1993 is not comparable to provisions for income taxes for periods ended in 1992 and 1991. Under the liability method, deferred income taxes are provided at the statutorily enacted rates for differences between the tax and accounting bases of substantially all assets and liabilities and for carryforwards. A valuation allowance is provided (and periodically reevaluated) if deferred tax assets are not considered more likely than not to be realized. (o) Translation of Foreign Currency: Foreign currency denominated ------------------------------- investments which are not subject to hedging agreements and currency rate swap agreements not meeting the accounting requirements for "hedges," are converted into U.S. dollars at exchange rates in effect at the end of the period. Resulting net exchange gains or losses were not material. 2. Acquisitions: ------------ Through November 1991, the Company owned approximately 66% of the outstanding common shares of Phlcorp. During 1991 outstanding warrants to acquire approximately 8% of Phlcorp's shares were exercised by other parties at an aggregate purchase price of approximately $14,782,000. After giving effect to certain purchases by the Company, the Company owned approximately 63% of Phlcorp's outstanding common shares at December 31, 1991 and throughout most of 1992. On December 31, 1992, pursuant to a merger agreement, Phlcorp merged with a subsidiary of the Company and became a wholly owned subsidiary of the Company (the "Merger"). Pursuant to the terms of the Merger, the Company issued .812 of a Common Share for each Phlcorp share not held by the Company or its subsidiaries (an aggregate of approximately 4,408,000 of the Company's Common Shares). The aggregate cost of acquiring the Phlcorp Minority Interest (principally based 2. Acquisitions, continued: ------------ on the market price of the Company's Common Shares on the day immediately prior to entering into an agreement in principle as to the terms of the transaction) was approximately $142,927,000. The Company is a partner in The Jordan Company and Jordan/Zalaznick Capital Company, private investment firms whose principal activity is structuring leveraged buy-outs in which the partners are given the opportunity to become equity participants. John W. Jordan II, a director of the Company and a significant shareholder, is a Managing Partner of both firms. Since 1982, through such partnerships, the Company acquired interests in several companies (the "Jordan Associated Companies"), principally engaged in various aspects of manufacturing and distribution. The Company currently accounts for its interests in fourteen of the Jordan Associated Companies on the cost method of accounting and one company (which is not material to the Company) on the equity method of accounting. The investments acquired as a result of the partnership interests are considered Associated Companies. On August 16, 1991, the Company, through its wholly owned subsidiary, Charter National Life Insurance Company ("Charter National"), completed the acquisition of Colonial Penn for an aggregate cash purchase price of approximately $128,000,000, including costs. The Company also made a subsequent $40,000,000 investment in Colonial Penn's principal property and casualty insurance subsidiary. Colonial Penn is a holding company, principally for life and property and casualty insurance companies specializing in direct marketing of personal lines of insurance primarily to individuals over the age of 50. Colonial Penn's principal property and casualty insurance subsidiary also previously wrote certain commercial property and casualty insurance. At the acquisition date, after giving effect to a cash contribution by the seller prior to the closing of approximately $49,827,000, Colonial Penn had (unaudited) shareholder's equity, determined in accordance with generally accepted accounting principles, of approximately $391,000,000 (approximately $263,000,000 in excess of the purchase price). The allocation of the purchase price reflected the elimination of deferred policy acquisition costs, value of insurance in force and property and equipment, and additional amounts for employee severance, postretirement benefits, relocation, lease commitments, restructuring costs and additional reserves for policyholders' benefits. Colonial Penn is included in results of operations from its date of acquisition, August 16, 1991. For the period from date of acquisition to December 31, 1991, Colonial Penn had revenues of approximately $359,088,000 (including net security gains of approximately $16,323,000) and contributed approximately $59,995,000 to consolidated pre-tax income (exclusive of financing costs). For the year ended December 31, 1992, Colonial Penn had revenues of approximately $836,552,000 (including net security gains of approximately $23,543,000) and contributed approximately $131,757,000 to consolidated pre-tax income (exclusive of financing costs). Due to changes in the Company's insurance operations, it is not practicable to provide meaningful comparable information for the acquired Colonial Penn operations for 1993. The following table provides certain unaudited consolidated pro forma results of operations data assuming the acquisition of Colonial Penn and the Phlcorp Minority Interest had occurred on January 1, 1991. (Amounts are in thousands, except per share amounts.) 2. Acquisitions, continued: ------------ The principal pro forma adjustments related to Colonial Penn reflected in the data above consist of elimination and/or reduction of (i) amortization and depreciation of deferred policy acquisition costs, value of insurance in force, goodwill and fixed assets, (ii) rent expense applicable to excess facilities and, (iii) with respect to 1991, income taxes. Such pro forma data also provides for the cost of financing the acquisition. The effects of certain cost savings programs implemented by the Company since the acquisition of Colonial Penn are reflected only to the extent included in the consolidated historical results of operations. The reduction in new business solicitation effort which has been accomplished by the Company since the acquisition was expected to, and has, resulted in a substantial reduction in new business and premium revenues. Colonial Penn's annualized written premiums related to new business generated were approximately $24,563,000 for 1992 compared to $111,277,000 for 1991. However, the effect on operating earnings of such reduction in new business solicitation efforts cannot be reasonably estimated and is not reflected in the pro forma data above. Accordingly, such pro forma data should not necessarily be considered indicative of future results of operations or the results of operations that would have resulted if the acquisitions had actually occurred as reflected in the pro forma data. 3. Investments in Associated Companies: ----------------------------------- The Company owns or held part interests in the following foreign power companies: Compania de Alumbrado Electrico de San Salvador, S.A. ("CAESS"), Compania Boliviana de Energia Electrica, S.A. - Bolivian Power Company Limited ("Bolivian Power") and, through Canadian International Power Company Limited Liquidating Trust, The Barbados Light and Power Company Limited. In March 1993, in settlement of claims related to El Salvador's 1986 seizure of CAESS's assets, the Company received cash of approximately $5,300,000 and approximately $12,000,000 principal amount of 6% U.S. dollar denominated El Salvador Government bonds due in instalments through 1996. The Company, which had an investment in CAESS of $8,188,000 at December 31, 1992, will recognize the gain on the cash basis. Payments of principal and interest are being made in accordance with their terms. Recognized gains in 1993 were not significant. During 1994, the Company disposed of the bonds and will report a pre-tax gain of $8,458,000 in first quarter 1994 results of operations. During 1993 the Company sold 750,000 shares of Bolivian Power common stock in an underwritten public offering and realized a pre-tax gain of approximately $12,981,000, which is reflected in 1993 results of operations in the caption, "Investment and other income." At December 31, 1993, the Company owned 719,206 shares of Bolivian Power common stock. The Company believes that it ultimately will receive the stock of two WMAC Companies, which are the only additional companies expected to be returned to the Company with significant value. However, the timing of such receipt is uncertain. The Company estimates that the fair value to the Company of the net tangible assets yet to be received is approximately $32,800,000 in excess of their recorded cost at December 31, 1993. 4. Insurance Operations: -------------------- SPWL and SPDA policies generally provide the policyholder with a declared rate of cash value increase for a specified initial period and subsequent annual rates as determined by the Company, generally subject to minimum rates; the policyholder is generally subject to early termination penalties designed to recover unamortized policy acquisition costs. 4. Insurance Operations, continued: -------------------- Premiums received on IOP products amounted to approximately $88,312,000, $68,035,000 and $43,164,000 for the years ended December 31, 1993, 1992 and 1991, respectively. The changes in deferred policy acquisition costs and value of insurance in force were as follows (in thousands): During 1992, the Company concluded that the profitability of its existing block of SPDA business was unlikely to achieve acceptable results in the future. Accordingly, principally starting in the fourth quarter of 1992, the Company offered certain of its existing SPDA policyholders' the opportunity to exchange their policies for SPDA policies of an unrelated insurer and entered into a reinsurance agreement (which closed in stages in 1992 and 1993) to reinsure certain blocks of SPDA business with a second unrelated insurer. As a result, during the fourth quarter of 1992, policies with an aggregate policyholders' account balance of approximately $196,648,000 were either terminated by the policyholder, transferred at the policyholder's request or transferred in a reinsurance transaction. In the 1993 transactions, which involved reinsurance of policies with account balances of approximately $47,187,000 on the date of closing, there was no significant gain or loss. The Company is maximizing the return on any remaining SPDA policies by reducing crediting rates to the minimum permitted. As a result, the Company believes a substantial portion of the remaining SPDA policyholders will terminate their policies over a period of time. On June 23, 1993, the Company reinsured substantially all of its existing SPWL business with a subsidiary of John Hancock Mutual Life Insurance Company ("John Hancock"). In connection with the transaction, the Company realized a net pre-tax gain of approximately $16,700,000 during 1993. Such net pre-tax gain consists of net gains on sales of investments sold in connection with the transaction (approximately $24,100,000), which are included in the caption "Net securities gains," reduced by a net loss of approximately $7,400,000 (principally the write-off of deferred policy acquisition costs of approximately $26,900,000 less the premium received on the transaction) which is included in the caption "Provision for insurance losses and policy benefits." Further, the Company may receive additional consideration based on the subsequent performance of this block of business. Under SFAS 113, for financial reporting purposes, the Company will reflect the policy liabilities assumed by John Hancock (in policy reserves), with an offsetting receivable from John Hancock of the same amount (in reinsurance receivable, net), until the Company is relieved of its legal obligation to the SPWL policyholders. During 1993, the Company was legally relieved of SPWL policy liabilities of approximately $200,096,000. During the three years ended December 31, 1993, the Company sold, at gains, substantial amounts of investments (including dispositions in connection with the actual or contemplated transfer of blocks of business) and, in certain cases, reinvested proceeds at the lower prevailing interest rates. Since certain of these rates 4. Insurance Operations, continued: -------------------- were lower than had previously been expected on certain fixed rate annuity policies, the Company provided additional reserves of approximately $6,800,000 in 1993, $2,700,000 in 1992 and $8,800,000 in 1991. In addition, because of the lower anticipated investment earnings, the Company also recalculated deferred policy acquisition costs and provided additional amounts for amortization of deferred policy acquisition costs of $2,100,000 in 1992. The amount deducted from insurance loss and policy reserves for reinsured risks was approximately $179,391,000 at December 31, 1992. The effect of reinsurance on premiums written and earned for the year ended December 31, 1993 is as follows (in thousands): Recoveries recognized on reinsurance contracts were approximately $22,800,000 in 1993. Net income and statutory surplus as determined in accordance with statutory accounting principles as reported to the domiciliary state of the Company's insurance subsidiaries are as follows (in thousands): Certain insurance subsidiaries are owned by other insurance subsidiaries. In the data above, investments in such subsidiary-owned insurance companies are reflected in statutory surplus of both the parent and subsidiary-owned insurance company. As a result, at December 31, 1993 and 1992, statutory surplus of approximately $288,800,000 and $122,000,000, respectively, related to property and casualty operations is included in the statutory surplus of the life insurance parent and the property and casualty insurance subsidiary, and statutory surplus of approximately $42,200,000 and $38,000,000, respectively, related to life operations is included in the statutory surplus of the property and casualty insurance parent and the life insurance subsidiary. The insurance subsidiaries are subject to regulatory restrictions which limit the amount of cash and other distributions available to the Company without regulatory approval. At December 31, 1993, approximately $33,200,000 could be distributed to the Company without regulatory approval. 4. Insurance Operations, continued: -------------------- The Company's insurance subsidiaries are members of state insurance funds which provide certain protection to policyholders of insolvent insurers doing business in those states. Due to insolvencies of certain insurers in recent years, the Company's insurance subsidiaries have been assessed certain amounts and are likely to be assessed additional amounts by the state insurance funds. The Company has provided for all anticipated assessments and does not expect any additional assessments to have a material effect on results of operations. The Colonial Penn property and casualty insurance subsidiaries are subject to a possible rate "roll-back" refund on California insurance premiums for certain pre-acquisition years. The amount of such roll-back refunds are to be determined by the California Insurance Commissioner. The Company has not been notified of the amount, if any, of such roll-back refund. Based on its operating results in the relevant years, the Company believes Colonial Penn should not be assessed for any roll-back refund and, if assessed a significant amount, intends to vigorously oppose such determination. In addition, New Jersey's insurance laws require all automobile insurers to share in the losses of the successor (the "MTF") to its insurance pool for high risk drivers (the "JUA"), based on their depopulation share of the JUA, as set by New Jersey. Although the amount of the MTF deficit has not yet been established, based on certain current estimates (which are subject to change) of the MTF deficit, Colonial Penn could be assessed approximately $11,100,000, which has been accrued. For 1993, voluntary automobile net earned premiums in California and New Jersey together represented approximately 10% of the Company's total property and casualty net earned premiums. 5. Investments: ----------- Certain information with respect to investments (other than short- term) at December 31, 1993 is as follows (in thousands): 5. Investments, continued: ----------- The amortized cost and estimated market value of investments classified as held to maturity and investments classified as available for sale at December 31, 1993 are as follows (in thousands): The amortized cost and estimated market value of investments classified as held to maturity and investments classified as available for sale at December 31, 1993, by contractual maturity are shown below. Expected maturities are likely to differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. 5. Investments, continued: ----------- Certain information with respect to investments (other than short- term) at December 31, 1992 is as follows (in thousands): The amortized cost and estimated market value of fixed maturity investments (other than investments held for sale) at December 31, 1992 are as follows (in thousands): The amortized cost and estimated market value of investments held for sale at December 31, 1992 are as follows (in thousands): Gross unrealized gains and losses on the Company's marketable equity securities were $3,366,000 and $104,000, respectively, at December 31, 1992. At December 31, 1993 and 1992 securities with book values aggregating approximately $55,145,000 and $39,469,000, respectively, were on deposit with various regulatory authorities. 5. Investments, continued: ----------- At December 31, 1993, the Company had common stock equity interests of 5% or more in the following domestic publicly owned non-consolidated companies, some of which are Associated Companies: Carmike Cinemas, Inc. (approximately 9% of Class A shares), Jones Plumbing Systems, Inc. (approximately 21%) and Olympus Capital Corporation (approximately 18%). 6. Receivables, Net: ---------------- A summary of trade, notes and other receivables, net at December 31, 1993 and 1992 is as follows (in thousands): [FN] (a) Contractual maturities of instalment loan receivables at December 31, 1993 were as follows (in thousands): 1994 - $102,524; 1995 - $39,598; 1996 - $21,674; 1997 - $13,942 and 1998 and thereafter - $9,956. Experience shows that a substantial portion of such notes will be repaid or renewed prior to contractual maturity. Accordingly, the foregoing is not to be regarded as a forecast of future cash collections. (b) On June 1, 1993, Mr. Jordan delivered to the Company 224,175 of the Company's Common Shares valued at $8,294,000 (the maturity value of the zero coupon note, after reflecting certain prepayments) as payment in full of the zero coupon note. The Common Shares were valued at $37.00 per share, the closing price of a Common Share on the New York Stock Exchange Composite Tape on the last full trading day prior to the authorization by the Company's Board of Directors of the agreement. Interest and other income recognized in connection with the note was $420,000 for 1993, $929,000 for 1992 and $819,000 for 1991. During 1992, the Company sold substantially all of its consumer loan development offices (which offices had aggregate instalment loan receivables at the time of sale of approximately $68,500,000) and realized pre-tax gains of approximately $12,128,000 in connection with the sales. Such gains are included in 1992 results of operations in the caption, "Investment and other income." Reinsurance receivables are net of allowance for doubtful accounts of approximately $83,825,000 and $43,799,000 at December 31, 1993 and 1992, respectively. Amounts due from reinsurers for 1993 were reclassified in accordance with SFAS 113 resulting in the apparent increase in the allowance for doubtful reinsurance receivables. Had the prior accounting been in effect, reinsurance receivables would have been reduced by approximately $457,621,000 at December 31, 1993. At December 31, 1993, reinsurance receivables, net includes approximately $322,351,000 due from a subsidiary of John Hancock. 7. Prepaids and Other Assets: ------------------------- At December 31, 1993 and 1992, a summary of prepaids and other assets is as follows (in thousands): [CAPTION] 8. Trade Payables, Expense Accruals and Other Liabilities: ------------------------------------------------------ A summary of trade payables, expense accruals and other liabilities at December 31, 1993 and 1992 is as follows (in thousands): 9. Long-term and Other Indebtedness: -------------------------------- The principal amount, stated interest rate and maturity of long-term debt outstanding at December 31, 1993 and 1992 are as follows (dollars in thousands): Credit agreements provide for aggregate contractual credit facilities of $150,000,000 at December 31, 1993 and bear interest based on the prime rate or LIBOR, plus commitment and other fees. Such credit facilities were renewed in 1994 to expire in 1997. Approximately $16,717,000 of the manufacturing division's net property, equipment and leasehold improvements are pledged as collateral for the Industrial Revenue Bonds; and approximately $2,727,000 of other property is pledged for other indebtedness aggregating approximately $1,171,000. The Company has interest rate swap agreements with a bank which expire in 1996, the practical effect of which is to convert the variable interest rate on $50,000,000 of indebtedness into fixed interest rate obligations at an interest rate of approximately 8%. During 1989, the Company entered into long-term hedging transactions whereby substantially all currency rate risk related to the Swiss Franc Bonds for their remaining term was eliminated and the cost of which increased the cost of the issue to approximately 10.4%. In February 1993, the Company sold $100,000,000 principal amount of its newly authorized 5 1/4% Convertible Subordinated Debentures due 2003 (the "Convertible Debentures") in an underwritten public offering. The Convertible Debentures are convertible into Common Shares at $57.50 per Common Share (an aggregate of 1,739,130 Common Shares), subject to anti-dilution provisions. In August 1993, the Company sold $100,000,000 principal amount of its newly authorized 7 3/4% Senior Notes due 2013 (at 99% of principal amount) in an underwritten public offering. The most restrictive of the Company's debt instruments requires maintenance of minimum Tangible Net Worth, as defined, and limit Indebtedness, as defined, to a percentage of Tangible Net Worth and Subordinated 9. Long-term and Other Indebtedness, continued: -------------------------------- Indebtedness, as defined. In addition, the debt instruments contain limitations on dividends, investments, liens, contingent obligations and certain other matters. As of January 1, 1994, cash dividends of approximately $180,600,000 could be paid under the most restrictive covenants. The aggregate annual mandatory redemptions of debt during the five year period ending December 31, 1998 (exclusive of Credit Agreements) are as follows (in thousands): 1994 - $28,821; 1995 - $3,013; 1996 - $35,246; 1997 - $1,017; and, 1998 - $872. 10. Common Shares, Stock Options, Warrants and Preferred Shares: ----------------------------------------------------------- On July 14, 1993, the shareholders approved an increase in authorized Common Shares from 60,000,000 to 150,000,000. The Board of Directors from time to time has authorized acquisitions of the Company's Common Shares. Pursuant to such authorization, during the three year period ended December 31, 1993, the Company acquired 496,031 Common Shares (282,409 in 1993, 110,800 shares in 1992 and 102,822 shares in 1991) at an average price of $30.26 per Common Share. The Common Shares acquired in 1993, include 224,175 Common Shares acquired from John W. Jordan II. A summary of activity with respect to the Company's stock options for the three years ended December 31, 1993 is as follows: The options were granted under plans that provide for the issuance of stock options and stock appreciation rights at not less than the fair market value of the underlying stock at the date the options or rights are granted. Options granted under these plans generally become exercisable in five equal annual instalments starting one year from date of grant; no stock appreciation rights have been granted. At December 31, 1993 and 1992, options to purchase 221,996 and 243,904 Common Shares, respectively, were exercisable. In January 1992, the Company redeemed certain Warrants (which previously had been granted to the Company's Chairman and President pursuant to shareholder approval) for an aggregate cash payment of 10. Common Shares, Stock Options, Warrants and Preferred Shares, ----------------------------------------------------------- continued: approximately $14,700,000, which amount was charged to additional paid-in capital. In January 1992, pursuant to subsequent approval of the shareholders, warrants to purchase 800,000 Common Shares at $20.188 (the then market value of the Company's shares) per Common Share through January 10, 1997 were granted to each of the Company's Chairman and President. The warrants granted in 1992 became exercisable on April 1, 1993. At December 31, 1993 and 1992, the Company's Common Shares were reserved as follows: At December 31, 1993 and 1992, 6,000,000 preferred shares (redeemable and non-redeemable), par value $1 per share, were authorized. Phlcorp, through November 1991, had warrants outstanding which were exercisable for Phlcorp common shares at $13.425 per Phlcorp common share. 1,203,318 of such warrants were exercised (1,176,093 in 1991, including 74,983 exercised by the Company) prior to their expiration in November 1991. 11. Cumulative Effects of Changes in Accounting Principles: ------------------------------------------------------ A summary of the amounts included in cumulative effects of changes in accounting principles and related per share amounts for the year ended December 31, 1993 is as follows (in thousands, except per share amounts): 12. Net Securities Gains: -------------------- The following summarizes net securities gains (losses) for each of the three years in the period ended December 31, 1993 (in thousands): As a result of the realization of significant gains on sales of securities (including dispositions in connection with the termination or transfer of SPDA and SPWL business) and reinvestment of the proceeds of certain dispositions at the lower prevailing interest rates, the Company recalculated or eliminated deferred policy acquisition costs applicable to the IOP products and provided additional amounts for policyholder benefits applicable to certain fixed rate products as indicated above. Proceeds from sales of fixed maturity investments (including securities held for sale) were approximately $1,171,574,000, $2,421,057,000 and $1,016,645,000 during 1993, 1992 and 1991, respectively. Gross gains of approximately $51,839,000, $70,551,000 and $50,797,000 and gross losses (including provisions for write-downs) of approximately $3,587,000, $24,501,000 and $23,677,000 were realized on those sales during 1993, 1992 and 1991, respectively. 13. Income Taxes: ------------ As a result of adoption of SFAS 109 in 1993 the future benefit of certain tax loss carryforwards and future deductions was recorded as an asset (net of valuation allowance) and the provision for income taxes for the year ended December 31, 1993 was not reduced for the benefit from utilization of tax loss carryforwards. Adoption of SFAS 109 at January 1, 1993 was principally reflected as follows (in thousands): 13. Income Taxes, continued: ------------ The principle components of the deferred tax asset at December 31, 1993 are as follows (in thousands): The valuation allowance principally relates to certain acquired tax loss carryforwards, the usage of which is subject to certain limitations and certain other matters which may restrict the availability of reported tax loss carryforwards. In addition, the amounts reflected above are based on the minimum tax loss carryforwards of Phlcorp and assume that certain proposed regulations affecting the use of Phlcorp's tax loss carryforwards are finalized without significant change. As described more fully herein, substantial additional amounts may be available under certain circumstances. The Company believes it is more likely than not that the recorded deferred tax asset will be realized; such realization will principally result from taxable income generated by profitable operations. The provision for income taxes for each of the three years in the period ended December 31, 1993 was as follows (in thousands): 13. Income Taxes, continued: ------------ The table below reconciles the "expected" statutory federal income tax applicable to the actual income tax expense (in thousands). The provision for income taxes for 1993 only was calculated under SFAS 109. Accordingly, the provisions for periods ended in 1993 are not comparable to provisions for periods ended prior to 1993. In August 1993, the Omnibus Budget Reconciliation Act (the "OBRA") was enacted which, among other things, increased certain corporate income tax rates retroactive to the beginning of 1993. Under SFAS 109, deferred income taxes are calculated at the statutory rates scheduled to be in effect when the tax benefit is estimated to be realized. When changes in statutory income tax rates are enacted, current and deferred income taxes are recalculated and any resulting adjustment is reflected in the provision for income taxes in the period in which such legislation is enacted. The valuation allowance applicable to the deferred income tax asset recorded upon adoption of SFAS 109 gave effect to the possible unavailability of certain income tax deductions. During the third quarter of 1993 certain matters were resolved and the Company reduced the valuation allowance, resulting in a reduction in the provision for income taxes for the year ended December 31, 1993. The Company estimates that if SFAS 109 had not been adopted, the provision for income taxes for the year ended December 31, 1993 would have been lower by, and net income (exclusive of amounts applicable to changes in accounting principles) would have been higher by, approximately $42,614,000 (or $1.46 per primary earnings per share and $1.38 per fully diluted earnings per share). As previously noted, the Company, certain of the Colonial Penn life insurance subsidiaries and Phlcorp prior to 1993 filed consolidated federal income tax returns with certain subsidiaries (including, with respect to Phlcorp, the WMAC Companies). Phlcorp is included in the Company's consolidated income tax return in 1993. Phlcorp, in connection with its 1986 reorganization, entered into a tax settlement agreement (the "Tax Settlement Agreement") with the United States whereby, among other things, Phlcorp agreed that upon utilization of certain pre-reorganization tax loss carryforwards, it would pay 25% of any resultant tax savings to the government, subject to certain limitations. The Tax Settlement Agreement provides that the amount of pre-reorganization operating loss carryforwards will be calculated by a method which, among other things, gives 13. Income Taxes, continued: ------------ consideration to the outcome of certain ruling requests made by Phlcorp and provides that post-reorganization net operating losses will be utilized prior to pre-reorganization operating losses in calculating tax sharing payments. In 1991, the Internal Revenue Service ("IRS") issued a favorable ruling on certain rulings requested by Phlcorp. This ruling did not address all matters and, therefore, certain matters remain unresolved. In addition, in the past, the IRS has indicated that it disagrees with Phlcorp's reporting positions on certain post-reorganization deductions and has suggested that such positions violate the Tax Settlement Agreement. Because of these uncertainties, Phlcorp is unable to state with certainty the amount of its available carryforwards. However, Phlcorp believes that it has minimum tax operating loss carryforwards of between $143,000,000 and $302,000,000 at December 31, 1993. The expiration dates for Phlcorp's carryforwards will depend on the outcome of the matters referred to above, although it is unlikely such carryforwards will begin to expire before 1998. At December 31, 1993 the Company had loss carryforwards for income tax purposes as follows (in thousands): [CAPTION] Limitations exist under the tax law which may restrict the utilization of the Phlcorp carryforwards subsequent to December 31, 1993 and an aggregate of approximately $25,000,000 of non-Phlcorp tax loss carryforwards. Further, certain of the future deductions may only be utilized in the tax returns of certain life insurance subsidiaries. These limitations were considered when providing the valuation allowance under SFAS 109. Under certain circumstances, the value of the carryforwards available could be substantially reduced if certain changes in ownership were to occur. In order to reduce this possibility, the Company's shareholders at a special meeting held on December 30, 1992, approved certain charter restrictions which prohibit transfers of the Company's Common Stock under certain circumstances. Under prior law, Charter National had accumulated approximately $19,561,000 of special federal income tax deductions allowed life insurance companies as of December 31, 1993 and the Colonial Penn life insurance subsidiaries had accumulated approximately $161,000,000 of such special deductions. Under certain conditions, such amounts could become taxable in future periods. Except with respect to amounts applicable to Colonial Penn's life insurance subsidiaries for which the seller has assumed such liability contractually, the Company does not anticipate any transaction occurring which would cause these amounts to become taxable. In connection with the IRS's examination of certain pre-acquisition tax returns of the Colonial 13. Income Taxes, continued: ------------ Penn life insurance companies, the IRS has asserted that approximately $93,025,000 of special federal income tax deductions allowed life insurance companies should have been reflected in taxable income in 1986, resulting in a tax (exclusive of interest and penalties) of approximately $42,792,000. As noted above, the seller is contractually liable for any such taxes (including interest and penalties). The seller has contested the IRS assessment. 14. Pension Plans and Other Postemployment and Postretirement Benefits: ------------------------------------------------------------------ Pension expense charged to operations included the following components (in thousands): Settlement and curtailment gains (losses) of approximately ($292,000), ($366,000) and $1,154,000 were realized in the years ended December 31, 1993, 1992 and 1991, respectively. The funded status of the pension plans at December 31, 1993 and 1992 was as follows (in thousands): The plans' assets consist primarily of fixed income securities (principally U.S. government and agencies' bonds). The projected benefit obligation at December 31, 1993 and 1992 was determined using an assumed discount rate of 7.0% and 7.5%, respectively, and an assumed compensation increase rate of 5.9% and 6.6%, respectively. The assumed long-term rate of return on plan assets was 7.3% and 7.5% at December 31, 1993 and 1992, respectively. The Company also has defined contribution pension plans covering certain employees. Contributions and costs are a percent of each covered employee's salary. Amounts charged to expense related to such plans were $2,066,000, $2,106,000 and $2,491,000 for the years ended December 31, 1993, 1992 and 1991, respectively. 14. Pension Plans and Other Postemployment and Postretirement --------------------------------------------------------- Benefits, continued: -------- Several subsidiaries provide certain health care and other benefits to certain retired employees. The costs of such benefits prior to January 1, 1993 were expensed generally as incurred, although liabilities for benefits were recorded in connection with certain acquisitions, including that of Colonial Penn and the Phlcorp Minority Interest. SFAS 106 and SFAS 112 require companies to accrue the cost of providing certain postretirement and postemployment benefits during the employee's period of service. Amounts charged to expense related to such benefits were $2,594,000 in 1993 (principally interest), $1,527,000 in 1992 and $1,256,000 in 1991. The accumulated postretirement benefit obligation at December 31, 1993 is as follows (in thousands): The discount rate used in determining the accumulated postretirement benefit obligation was 7.0% at December 31, 1993. The assumed health care cost trend rates used in measuring the accumulated postretirement benefit obligation were between approximately 8% and 15% for 1993 declining to an ultimate rate of between 5% and 8% by 2006. If the health care cost trend rates were increased by 1%, the accumulated postretirement obligation as of December 31, 1993 would have increased by approximately $1,404,000. The effect of this change on the estimated aggregate of service and interest cost for 1993 would be immaterial. 15. Commitments: ----------- The Company and its subsidiaries rent office space and office equipment under non-cancelable operating leases with terms generally varying from one to fifteen years. Rental expense (net of sublease rental income) charged to operations was approximately $17,555,000 in 1993, $20,791,000 in 1992 and $13,934,000 in 1991. Aggregate minimum annual rentals (exclusive of real estate taxes, maintenance and certain other charges) and related minimum sublease rentals relating to facilities under lease in effect at December 31, 1993 were as follows (in thousands): In connection with the sale of certain subsidiaries, the Company has made or guaranteed the accuracy of certain representations given to the acquirer. No material loss is expected in connection with such matters. 15. Commitments, continued: ----------- In addition, certain of the WMAC Companies that have been returned to the control of the Company have guaranteed the adequacy of certain other matters. The maximum amount of such contingencies is approximately $5,000,000 at December 31, 1993. The Company does not expect a material loss in connection with these guarantees. The insurance subsidiaries and the banking subsidiaries are limited by regulatory requirements and agreements in the amount of dividends and other transfers of funds that are available to the Company. Principally as a result of such restrictions, the net assets of subsidiaries which are subject to limitations on transfer of funds to the Company were approximately $735,000,000 at December 31, 1993. 16. Litigation: ---------- The Company is subject to various litigation which arises in the course of its business. Based on discussions with counsel, management is of the opinion that such litigation will have no material adverse effect on the consolidated financial position of the Company or its consolidated results of operations. 17. Earnings Per Common Share: ------------------------- Earnings per common and dilutive common equivalent share was calculated by dividing net income by the sum of the weighted average number of Common Shares outstanding and the incremental weighted average number of Common Shares issuable upon exercise of warrants for the periods they were outstanding. The number of common and dilutive common equivalent shares used for this calculation was 29,270,000 in 1993, 24,435,000 in 1992 and 23,704,000 in 1991. Fully diluted earnings per share was calculated as described above except that in 1992 the incremental number of shares utilized the year end market price for the Company's Common Shares, since the year end market price was above the average for the year. In addition, in 1993, the calculations assume the Convertible Debentures had been converted into Common Shares for the period they were outstanding and earnings increased for the interest on such debentures, net of the income tax effect. The number of shares used for this calculation was 30,743,000 in 1993, 24,516,000 in 1992 and 23,916,000 in 1991. 18. Fair Value of Financial Instruments: ----------------------------------- Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments" ("SFAS 107"), requires disclosure of fair value information about certain financial instruments, whether or not recognized on the balance sheet. Where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In addition, SFAS 107 excludes certain financial instruments and all non-financial instruments from its disclosure requirements. Therefore, the aggregate fair value amounts presented do not purport to represent and should not be considered representative of the underlying "market" or franchise value of the Company. The methods and assumptions used to estimate the fair values of each class of the financial instruments described below are as follows: (a) Investments: The fair values of marketable equity securities and fixed maturity securities are substantially based on quoted market prices, as disclosed in Note 5. It is not practicable to determine the fair value of policyholder loans since such loans generally have no stated maturity, are not separately transferable and are often repaid by reductions to benefits and surrenders. (b) Cash and short-term investments: For short-term investments, the carrying amount approximates fair value. 18. Fair Value of Financial Instruments, continued: ----------------------------------- (c) Loans receivable of banking and lending subsidiaries: The fair value of loans receivable of the banking and lending subsidiaries is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings for the same remaining maturities. (d) El Salvador Government bonds receivable, net of deferred gain: The fair value of the bonds receivable at December 31, 1993 is based on estimated market prices. (e) Separate and variable accounts: Separate and variable accounts assets and liabilities are carried at market value, which is a reasonable estimate of fair value. (f) Investments in Associated Companies: The fair values of certain foreign power companies are principally estimated based upon quoted market prices. The fair value of CAESS at December 31, 1992 was estimated based upon the agreement with the government of El Salvador as to the amounts to be paid to the Company for the assets which were seized by the government. The carrying value of the remaining investments in associated companies approximates fair value. (g) The WMAC Companies: The fair value of the WMAC Companies is estimated based upon the Company's assessment of the fair value of their underlying net tangible assets to be received. (h) Customer banking deposits: The fair value of customer banking deposits is estimated using rates currently offered for deposits of similar remaining maturities. (i) Long-term and other indebtedness: The fair values of non-variable rate debt are estimated using quoted market prices, estimated rates which would be available to the Company for debt with similar terms and, with respect to the Swiss Franc Bonds, the cost to terminate the currency and interest rate hedging agreement. The fair value of variable rate debt is estimated to be the carrying amount. (j) Investment contract reserves: SPDA reserves are carried at account value, which is a reasonable estimate of fair value. The fair value of other investment contracts is estimated by discounting the future payments at rates which would currently be offered for contracts with similar terms. 18. Fair Value of Financial Instruments, continued: ----------------------------------- The carrying amounts and estimated fair values of the Company's financial instruments at December 31, 1993 and 1992 are as follows (in thousands): 19. Segment Information: ------------------- For information with respect to the Company's business segments, see "Financial Information about Industry Segments" in Item 1 included elsewhere herein, which is incorporated by reference into these consolidated financial statements. 20. Other Results of Operations Information: --------------------------------------- Investment and other income for each of the three years in the period ended December 31, 1993 consist of the following (in thousands): During 1991, settlement of certain litigation related to Cambrian & General, a subsidiary, was approved and, accordingly, reserves which were no longer required were eliminated. In addition, payments on certain investments, which were carried at no value, were received in that year. As a result, during 1991, the Company recognized income of approximately $9,359,000. 20. Other Results of Operations Information, continued: --------------------------------------- Taxes, other than income or payroll, included in operations amounted to approximately $36,839,000 (including $21,295,000 of premium taxes) for the year ended December 31, 1993, $35,051,000 (including $21,153,000 of premium taxes) for the year ended December 31, 1992 and $19,627,000 (including $9,321,000 of premium taxes) for the year ended December 31, 1991. Advertising costs amounted to approximately $10,394,000, $9,578,000 and $10,623,000 for the years ended December 31, 1993, 1992 and 1991, respectively. Research and development costs, principally applicable to development of a database marketing program by the trading stamp subsidiary prior to 1992, approximated $8,928,000 in 1991 and were not material in 1992 and 1993. During 1991, the Company decided to discontinue development of the database marketing program. Accordingly, amounts for 1991 include shutdown costs. 21. Subsequent Event: ---------------- During the first quarter of 1994, the Company and an equal partner agreed to acquire a 60% interest in Caja de Ahorro y Seguro S.A. ("Caja") for a purchase price of approximately $85,000,000, subject to final adjustment. Caja is a holding company whose subsidiaries are engaged in property and casualty insurance, life insurance and banking in Argentina. Caja has (unaudited) assets in excess of approximately $500,000,000. Reliable historical operating data for Caja is not available. 22. Selected Quarterly Financial Data (Unaudited): --------------------------------------------- In 1993 and 1992, the total of quarterly per share amounts do not necessarily equal annual per share amounts. SCHEDULE I - Summary of Investments - Other Than Investments in Affiliates LEUCADIA NATIONAL CORPORATION AND SUBSIDIARIES December 31, 1993 and 1992 SCHEDULE I - Summary of Investments - Other Than Investments in Affiliates, continued LEUCADIA NATIONAL CORPORATION AND SUBSIDIARIES December 31, 1993 and 1992 SCHEDULE III - Condensed Financial Information of Registrant LEUCADIA NATIONAL CORPORATION BALANCE SHEETS December 31, 1993 and 1992 See notes to this schedule. SCHEDULE III - Condensed Financial Information of Registrant, continued: LEUCADIA NATIONAL CORPORATION STATEMENTS OF INCOME For the years ended December 31, 1993, 1992 and 1991 [CAPTION] See notes to this schedule. SCHEDULE III - Condensed Financial Information of Registrant, continued: LEUCADIA NATIONAL CORPORATION STATEMENTS OF CASH FLOWS For the years ended December 31, 1993, 1992 and 1991 See notes to this schedule. SCHEDULE III - Condensed Financial Information of Registrant, continued: LEUCADIA NATIONAL CORPORATION NOTES TO SCHEDULE For the years ended December 31, 1993, 1992 and 1991 A. The notes to consolidated financial statements of Leucadia National Corporation and Subsidiaries are incorporated by reference to this schedule. B. The statements of shareholders' equity are the same as those presented for Leucadia National Corporation and Subsidiaries. C. Equity in the income of the subsidiaries is after reflecting income taxes recorded by the subsidiaries. In 1993, 1992 and 1991, there was no provision for income taxes provided by the parent company. Tax sharing payments received from subsidiaries were $64,566,000 in 1993, $38,773,000 in 1992, and $6,698,000 in 1991. D. The deferred income tax asset of $114,001,000 at December 31, 1993 has not been allocated to the individual subsidiaries. SCHEDULE V - Supplementary Insurance Information LEUCADIA NATIONAL CORPORATION AND SUBSIDIARIES For the years ended December 31, 1993, 1992 and 1991 SCHEDULE VI - Schedule of Reinsurance LEUCADIA NATIONAL CORPORATION AND SUBSIDIARIES For the years ended December 31, 1993, 1992 and 1991 SCHEDULE VIII - Valuation and Qualifying Accounts LEUCADIA NATIONAL CORPORATION AND SUBSIDIARIES For the years ended December 31, 1993, 1992 and 1991 SCHEDULE IX - Short-Term Borrowings LEUCADIA NATIONAL CORPORATION AND SUBSIDIARIES For the years ended December 31, 1993, 1992 and 1991 SCHEDULE X - Schedule of Supplemental Information for Property and Casualty Insurance Underwriters LEUCADIA NATIONAL CORPORATION AND SUBSIDIARIES For the years ended December 31, 1993, 1992 and 1991 EXHIBIT INDEX Exhibit Exemption Number Description Indication ------- ----------- ---------- 3.1 Restated Certificate of Incorporation (filed as Exhibit 5.1 to the Company's Current Report on Form 8-K dated July 14, 1993).* 3.2 By-laws (as amended) (filed as Exhibit 4.5 to the Company's Registration Statement No. 33- 57054).* 4.1 The Company undertakes to furnish the Securities and Exchange Commission, upon request, a copy of all instruments with respect to long-term debt not filed herewith. 10.1 1982 Stock Option Plan, as amended August 28, 1991 (filed as Annex B to the Company's Proxy Statement dated July 21, 1992).* 10.2 1992 Stock Option Plan (filed as Annex C to the Company's Proxy Statement dated July 21, 1992).* 10.3(a) Restated Articles and Agreement of General Partnership, effective as of February 1, 1982, of The Jordan Company (filed as Exhibit 10.3(d) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1986).* 10.3(b) Amendments dated as of December 31, 1989 and December 1, 1990 to the Partnership Agreement referred to in 10.3(a) above (filed as Exhibit 10.2(b) to the Company's 1991 10-K).* 10.3(c) Amendment dated as of December 17, 1992 to the Partnership Agreement referred to in 10.3(a) above (filed as Exhibit 10.3(c) to the l992 10- K).* 10.3(d) Articles and Agreement of General Partnership, effective as of April 15, 1985, of Jordan/Zalaznick Capital Company (filed as Exhibit 10.20 to the Company's Registration Statement No. 33-00606).* 10.4 Agreement made as of March 12, 1984 by and between Leucadia, Inc. and Ian M. Cumming (filed as Exhibit 10.14 to the 1983 10-K).* 10.5 Agreement made as of March 12, 1984 by and between Leucadia, Inc. and Joseph S. Steinberg (filed as Exhibit 10.15 to the 1983 10-K).* 10.6 Stock Purchase and Sale Agreement dated as of April 5, 1991, by and between FPL Group Capital Inc. and the Company (filed as Exhibit B to the Company's Current Report on Form 8-K dated August 23, 1991).* 10.7 Agreement dated as of August 1, 1988 among the Company, Ian M. Cumming and Joseph S. Steinberg (filed as Exhibit 10.6 to the Company's 1991 10-K).* 10.8 Agreement dated as of January 10, 1992 between Ian M. Cumming, certain other persons listed on Schedule A thereto and the Company (filed as Exhibit 10.7 to the Company's 1991 10-K).* _________________________ * Incorporated by reference. EXHIBIT INDEX Exhibit Exemption Number Description Indication ------- ----------- ---------- 10.9 Agreement dated as of January 10, 1992 between Joseph S. Steinberg, certain other persons listed on Schedule A thereto and the Company (filed as Exhibit 10.8 to the Company's 1991 10- K).* 10.10(a) Agreement dated April 23, 1992 between AIC Financial Services, Inc. (an Alabama corporation), AIC Financial Services (a Mississippi corporation) and AIC Financial Services (a South Carolina corporation) (collectively, "Seller") and Norwest Financial Resources, Inc. (filed as Exhibit 10.10(a) to the 1992 10-K).* 10.10(b) Purchase Agreement between A.I.C. Financial Services, Inc., American Investment Bank, N.A., American Investment Financial and Terracor II d/b/a AIC Financial Fund, Seller, and Associates Financial Services Company, Inc., Buyer, dated November 5, 1992 (filed as Exhibit 10.10(b) to the Company's Registration Statement No. 33- 55120).* 10.11(a) Agreement and Plan of Merger, dated as of October 22, 1992, by and among the Company, Phlcorp Acquisition Company and PHLCORP, Inc. (filed as Exhibit 5.2 to the Company's Current Report on Form 8-K dated October 22, 1992).* 10.11(b) Amendment dated December 10, 1992, to the Merger Agreement referred to in 10.11(a) above (filed as Exhibit 5.2 to the Company's Current Report on Form 8-K dated December 14, 1992).* 10.12(a) Agreement between Leucadia, Inc. and Ian M. Cumming, dated as of December 28, 1992 (filed as Exhibit 10.12(a) to the 1992 10-K).* 10.12(b) Escrow and Security Agreement by and among Leucadia, Inc., Ian M. Cumming and Weil, Gotshal & Manges, as escrow agent, dated as of December 28, 1992 (filed as Exhibit 10.12(b) to the 1992 10-K).* 10.13(a) Agreement between Leucadia, Inc. and Joseph S. Steinberg, dated as of December 28, 1992 (filed as Exhibit 10.13(a) to the 1992 10-K).* 10.13(b) Escrow and Security Agreement by and among Leucadia, Inc., Joseph S. Steinberg and Weil, Gotshal & Manges, as escrow agent, dated as of December 28, 1992 (filed as Exhibit 10.13(b) to the 1992 10-K).* 10.14 Settlement Agreement between Baldwin-United Corporation and the United States dated August 27, 1985 concerning tax issues (filed as Exhibit 10.14 to the 1992 10-K).* 10.15 Acquisition Agreement, dated as of December 18, 1992, by and between Provident Mutual Life and Annuity Company of America and Colonial Penn Annuity and Life Insurance Company (filed as Exhibit 10.15 to the 1992 10-K).* 10.16 Reinsurance Agreement, dated as of December 31, 1991, by and between Colonial Penn Insurance Company and American International Insurance Company (filed as Exhibit 10.16 to the 1992 10- K).* _________________________ * Incorporated by reference. EXHIBIT INDEX Exhibit Exemption Number Description Indication ------- ----------- ---------- 10.17 Agreement made as of December 28, 1993 by and between the Company and Ian M. Cumming. 10.18 Agreement made as of December 28, 1993 by and between the Company and Joseph S. Steinberg. 10.19(a) Agreement between the Company and Ian M. Cumming, dated as of December 28, 1993. 10.19(b) Escrow and Security Agreement by and among the Company, Ian M. Cumming and Weil, Gotshal & Manges, as escrow agent, dated as of December 28, 1993. 10.20(a) Agreement between the Company and Joseph S. Steinberg, dated as of December 28, 1993. 10.20(b) Escrow and Security Agreement by and among the Company, Joseph S. Steinberg and Weil, Gotshal & Manges, as escrow agent, dated as of December 28, 1993. 21 Subsidiaries of the registrant. 23 Consent of independent certified public accountants with respect to the incorporation by reference into the Company's Registration Statements on Form S-8 (File No. 2-84303), Form S-8 and S-3 (File No. 33-6054), Form S-8 and S-3 (File No. 33-26434), Form S-8 and S-3 (File No. 33-30277). 28 Schedule P of the 1993 Annual Statement to P Insurance Departments of the Colonial Penn Insurance Company and Affiliated Fire & Casualty Insurers, the Empire Insurance Company, Principal Insurer, and Colonial Penn Madison Insurance Company. _________________________ * Incorporated by reference.
352915_1993.txt	352915	1993			ITEM 2. Properties EXECUTIVE OFFICES The Company owns an office building with 68,000 square feet available for use located on 11 acres of land in King of Prussia, Pennsylvania. The Company currently uses approximately 40,000 square feet of office space in the building and the balance is leased to unrelated entities. HOSPITALS ACUTE CARE HOSPITALS -------------------- AUBURN GENERAL HOSPITAL MCALLEN MEDICAL CENTER(1) VALLEY HOSPITAL MEDICAL Auburn, Washington McAllen, Texas CENTER 149 Beds 428 Beds Las Vegas, Nevada 416 Beds CHALMETTE MEDICAL RIVER PARISHES HOSPITAL(6) CENTER(1) LaPlace and Chalmette, VICTORIA REGIONAL MEDICAL Chalmette, Louisiana Louisiana CENTER 118 Beds 216 Beds Victoria, Texas 154 Beds DALLAS FAMILY HOSPITAL SPARKS FAMILY HOSPITAL(3) Dallas, Texas Sparks, Nevada WELLINGTON REGIONAL 104 Beds 150 Beds MEDICAL CENTER(1) West Palm Beach, Florida DOCTORS' HOSPITAL OF UNIVERSAL MEDICAL CENTER 120 Beds SHREVEPORT(2) Plantation, Florida Shreveport, Louisiana 202 Beds WESTLAKE MEDICAL 180 Beds CENTER(1) Westlake Village, INLAND VALLEY REGIONAL California MEDICAL CENTER(1) 126 Beds Wildomar, California 80 Beds PSYCHIATRIC HOSPITALS --------------------- THE ARBOUR HOSPITAL HRI HOSPITAL RIVER CREST HOSPITAL Boston, Massachusetts Brookline, Massachusetts San Angelo, Texas 118 Beds 68 Beds 80 Beds THE BRIDGEWAY(1) KEYSTONE CENTER(4) RIVER OAKS HOSPITAL North Little Rock, Wallingford, Pennsylvania New Orleans, Louisiana Arkansas 84 Beds 126 Beds 70 Beds DEL AMO HOSPITAL(2) LA AMISTAD RESIDENTIAL TURNING POINT HOSPITAL(4) Torrance, California TREATMENT CENTER Moultrie, Georgia 166 Beds Maitland, Florida 59 Beds 56 Beds TWO RIVERS PSYCHIATRIC FOREST VIEW HOSPITAL MERIDELL ACHIEVEMENT HOSPITAL Grand Rapids, Michigan CENTER(1) Kansas City, Missouri 62 Beds Austin, Texas 80 Beds 114 Beds GLEN OAKS HOSPITAL Greenville, Texas 53 Beds AMBULATORY TREATMENT CENTERS ---------------------------- COLUMBIA RADIATION OUTPATIENT SURGICAL SURGERY CENTER OF ONCOLOGY CENTER OF PONCA CITY(5) LITTLETON(5) Washington, D.C. Ponca City, Oklahoma Littleton, Colorado COMPREHENSIVE CANCER SURGERY CENTER OF CENTER THE REGIONAL CANCER SPRINGFIELD(5) Westlake, California CENTER AT Springfield, Missouri WELLINGTON GOLDRING SURGICAL AND West Palm Beach, Florida SURGERY CENTER OF DIAGNOSTIC CENTER TEXAS(5) Las Vegas, Nevada ST. GEORGE SURGICAL Odessa, Texas CENTER(5) HOPE SQUARE SURGICAL St. George, Utah SURGICAL CENTER OF CENTER(5) NEW ALBANY(5) Rancho Mirage, THE SURGERY CENTER OF New Albany, Indiana California CHALMETTE Chalmette, Louisiana M.D. PHYSICIANS SURGICENTER OF MIDWEST CITY(5) Midwest City, Oklahoma - ---------- (1) Real property leased from UHT (see Item 1. Business). (2) Real property leased with an option to purchase. (3) General partnership interest in limited partnership. (4) Addictive disease facility. (5) General partnership and limited partnership interests in a limited partnership. The real property is leased from third parties. (6) Includes Chalmette Hospital, a 114-bed rehabilitation facility, the real property of which is leased from UHT. Some of these hospitals are subject to mortgages, and substantially all the equipment located at these facilities is pledged as collateral to secure long-term debt. The Company owns or leases medical office buildings adjoining certain of its hospitals. ITEM 3.	ITEM 3. Legal Proceedings The Company is subject to claims and suits in the ordinary course of business, including those arising from care and treatment afforded at the Company's hospitals and is party to various other litigation. However, management believes the ultimate resolution of these pending proceedings will not have a material adverse effect on the Company. ITEM 4.	ITEM 4. Submission of Matters to a Vote of Security Holders Inapplicable. No matter was submitted during the fourth quarter of the fiscal year ended December 31, 1993 to a vote of security holders. PART II ITEM 5.	ITEM 5. Market for Registrant's Common Equity and Related Stockholder Matters See Item 6, Selected Financial Data. ITEM 6.	ITEM 6. Selected Financial Data These prices are the high and low closing sales prices of the Company's Class B Common Stock as reported by the New York Stock Exchange since June 7, 1991 and NASDAQ for all periods prior to June 7, 1991. Class A, C and D Common Stock are convertible on a share-for-share basis into Class B Common Stock. A special dividend of $.20 per share or approximately $2,900,000 in the aggregate was declared and paid in 1989. No cash dividends were declared or paid in any other years. The Company's ability to repurchase its shares, redeem its convertible debentures, and pay dividends is limited by long-term debt convenants to $7.5 million plus 25% of cumulative net income since January 1992. The 1993, 1992 and 1991 earnings per share and average number of shares outstanding have been adjusted to reflect the assumed conversion of the Company's convertible debentures. The common equivalent shares and the corresponding interest savings on the assumed conversion of the convertible debentures were not included in the 1990 or 1989 earnings per share computations because the effect was anti-dilutive. Number of shareholders of record as of January 31, 1994 were as follows: - ------------------------ Class A Common 7 Class B Common 640 Class C Common 7 Class D Common 384 - ------------------------ ITEM 7.	ITEM 7. Management's Discussion and Analysis of Operations and Financial Condition YEAR ENDED DECEMBER 31, 1993 COMPARED TO 1992 During 1993, net revenue growth was experienced in each of the Company's principal business groups: acute care hospitals, psychiatric hospitals and ambulatory treatment centers. Net revenues in 1993 increased 7% over 1992 at acute care hospitals owned during both years, after excluding the effects of additional revenues received from special Medicaid reimbursement programs. Despite the continued shift in the delivery of healthcare services to outpatient care, the Company's acute care hospitals experienced a slight increase in inpatient admissions in 1993 due to the expansion of service lines at many of its hospitals. Outpatient activity also increased this year and gross outpatient revenues now comprise 23% of the Company's gross revenues as compared to 21% in 1992. The increase is primarily the result of advances in medical technologies, which allow more services to be provided on an outpatient basis, and increased pressure from Medicare, Medicaid, health maintenance organizations (HMOs), preferred provider organizations (PPOs) and insurers to reduce hospital stays and provide services, where possible, on a less expensive outpatient basis. To take advantage of the trend toward increased outpatient services, the Company has continued to invest in the acquisition and development of ambulatory treatment centers. During 1993, the Company acquired a radiation treatment center and majority interests in four partnerships which own and operate ambulatory surgery facilities. The Company now operates twelve ambulatory treatment centers, which have contributed to the increase in the Company's outpatient revenues. The Company expects the growth in outpatient services to continue, although the rate of growth may be moderated in the future. Net revenues in 1993 at the Company's psychiatric hospitals increased approximately 6% over 1992. While admissions at these facilities increased 17%, patient days decreased 7% due to shorter average lengths of stay and increased emphasis on outpatient treatment programs. The shift to outpatient care was reflected in higher revenues from outpatient services, which now comprise 13% of gross revenues in the psychiatric group as compared to 10% in the prior year. The trend in outpatient treatment for psychiatric patients is expected to continue as a result of advances in patient care and continued cost containment pressures from payors. The Company received $13.5 million and $29.8 million in 1993 and 1992, respectively, from the special Medicaid reimbursement programs mentioned above. These programs are scheduled to terminate in August 1994 and the Company cannot predict whether these programs will continue beyond the scheduled termination date. An increased proportion of the Company's revenue is derived from fixed payment services, including Medicare and Medicaid which accounted for 40%, 39% and 35% of the Company's net patient revenues during 1993, 1992 and 1991, respectively, excluding the additional revenues from special Medicaid reimbursement programs. The Company expects Medicare and Medicaid revenues to continue to increase due to the general aging of the population and the expansion of state Medicaid programs. In addition to the Medicare and Medicaid programs, other payors continue to actively negotiate the amounts they will pay for services performed. In general, the Company expects the percentage of its business from managed care programs, including HMOs and PPOs, to continue to grow. The consequent growth in managed care networks and the resulting impact of these networks on the operating results of the Company's facilities vary among the markets in which the Company operates. During 1993, continuing the consolidation strategy in which the Company focuses its efforts on those markets where there is a maximum potential for continued growth, the Company sold two acute care hospitals for total proceeds of approximately $11.2 million. These dispositions resulted in a $4.4 million pre-tax loss ($2.2 million after-tax) which is included in operating expenses in the Company's 1993 consolidated statement of income. Since 1991, the Company has closed or sold a total of eight hospitals as part of this strategy. The Company also recorded a pre-tax charge of $4.4 million related to the winding down or disposition of non-strategic businesses which is included in operating expenses in the Company's 1993 consolidated statement of income. Excluding the additional revenues received from special Medicaid reimbursement programs mentioned above and the losses resulting from the disposition of two acute care hospitals and other non-strategic businesses, operating expenses as a percentage of net revenues for 1993 remained relatively flat as compared to the prior year. Although the rate of inflation has not had a significant impact on the results of operations, pressure on operating margins is expected to continue because, while Medicare fixed payment rates are indexed for inflation annually, the increases have historically lagged behind actual inflation. In addition to the trends described above that continue to have an impact on operating results, there are a number of other, more general factors affecting the Company's business. The Company and the healthcare industry as a whole face increased uncertainty with respect to the level of payor payments because of national and state efforts to reform healthcare. These efforts include proposals at all levels of government to contain healthcare costs while making quality, affordable health services available to more Americans. The Company is unable to predict which proposals will be adopted or the resulting implications for providers at this time. However, the Company believes that the delivery of primary care, emergency care, obstetrical and psychiatric services will be an integral component of any strategy for controlling healthcare costs and it also believes it is well positioned to provide these services. Interest expense decreased 24% in 1993 as compared to 1992 due to lower average outstanding borrowings. Depreciation and amortization expense decreased approximately $9.5 million in 1993 compared to 1992, due primarily to a $13.5 million amortization charge in 1992 resulting from the revaluation of certain goodwill balances. Partially offsetting this decrease was a $2.4 million increase in depreciation and amortization expense related to the Company's acquisitions of ambulatory treatment centers. The effective tax rate was 32% in 1993 as compared to 51% in 1992. The decrease in the effective rate for 1993 as compared to 1992 was due to the above-mentioned $13.5 million goodwill amortization recorded in the 1992 period, which was not deductible for income tax purposes, and a reduction in the 1993 state tax provision. The net effect of the impact of the 1993 tax law changes on the current and deferred tax provisions was immaterial. YEAR ENDED DECEMBER 31, 1992 COMPARED TO 1991 Net revenues in 1992 increased 6% over 1991 at hospitals owned during both years after excluding $29.8 million of favorable Medicaid reimbursement increases in 1992 and a $4.8 million pre-tax gain resulting from the sale of the Company's U.K. operations in 1991. The increased revenue resulted from higher utilization of outpatient and ancillary services, general price increases and increased severity of illness of patients admitted. The increase in outpatient services reflects the continuing advancements in medical technologies and pressures from payors to direct less acutely ill patients from inpatient services to outpatient care. The 1992 acquisitions of majority interests in four partnerships which own and operate ambulatory surgery facilites also contributed to an increase in the outpatient revenues. In 1992, in accordance with its consolidation strategy, the Company closed a 96-bed acute care hospital and a 48-bed psychiatric hospital. The closings did not have a material impact on the consolidated financial statements. In 1991, the Company sold its U.K. operations and sold an 88-bed acute care hospital. Admissions at the Company's hospitals which were owned during both years increased 1% in 1992 as compared to 1991. Patient days at these hospitals decreased 4% over 1991 due to a decrease in the average length of stay, particularly at the psychiatric hospitals. Excluding the nonrecurring revenue items described above, operating expenses as a percentage of net revenues remained relatively flat in 1992 compared to 1991. Excluding the $5 million reversal of an unneeded interest accrual in 1991, interest expense decreased 13% in 1992 due to lower average outstanding borrowings and lower average interest rates on floating rate debt. Depreciation and amortization expense increased in 1992 compared to 1991 as a result of a $13.5 million amortization charge recorded in 1992 resulting from the revaluation of certain goodwill balances. The effective tax rate was 51% in 1992, as compared to 34% in 1991. The higher 1992 tax resulted principally from the above-mentioned goodwill amortization which is not deductible for income tax purposes, while the 1991 provision for income taxes was reduced due to the utilization of a capital loss carryforward which offset all of the $4.8 million pre-tax gain resulting from the sale of the Company's U.K. operations. LIQUIDITY AND CAPITAL RESOURCES Net cash provided by operating activities increased to $84.6 million in 1993 from $81.7 million in 1992. The increase resulted primarily from improved operating results at the Company's facilities during 1993 as compared to 1992. The Company received $10.3 million of cash from the disposition of two acute care hospitals in 1993 and also received $8.2 million of cash related to facilities divested in prior years. During each of the past three years, the net cash provided by operating activities substantially exceeded the scheduled maturities of long-term debt. During 1993, the Company used $47.3 million of its operating cash flow to finance capital expenditures, $11.5 million to acquire a radiation therapy center and majority interests in partnerships which own four ambulatory surgery centers, $3.2 million to acquire the real estate assets of a facility previously leased, and $3.2 million to repurchase shares of its outstanding common stock. During 1993, the Company reduced outstanding debt by $44.7 million using funds generated from operations and the proceeds from the disposition of hospitals. Total debt as a percentage of total capitalization declined to 26% at December 31, 1993 from 37% at December 31, 1992. The year-end ratio is the lowest since the Company went public in 1981. Expected capital expenditures for 1994 include approximately $21 million for capital equipment and renovations of existing facilities, $38 million for new projects and $10 million for acquisitions and development of ambulatory treatment centers. The Company believes that its capital expenditures program is adequate to expand, improve and equip its existing hospitals. During 1993, the Company entered into a commercial paper program which currently provides up to $25 million of renewable borrowings which are secured by patient accounts receivable. The Company has sufficient patient receivables to support a larger program and upon the mutual consent of the Company and the participating lending institutions, the commitment can be increased to $65 million. At December 31, 1993, there were no borrowings outstanding under this program. The Company also has a $72.4 million non-amortizing revolving credit agreement which matures in August of 1995. However, 50% of the net proceeds, in excess of $15 million annually, from the sale of assets reduce available borrowing commitments. At December 31, 1993, the Company had $72.4 million of unused borrowing capacity, and there were no borrowings outstanding under this revolving credit facility. The Company has entered into interest rate swap agreements to reduce the impact of changes in interest rates on its floating rate debt. At December 31, 1993, the Company had interest rate swap agreements with commercial banks having a total notional principal amount of $40 million. These agreements call for the payment of fixed rate interest by the Company in return for the assumption by the commercial banks of the variable rate costs, which effectively fixes the Company's interest rate on a portion of its floating rate debt at 10.4%. The interest rate swap agreements in the amounts of $10 million, $20 million and $10 million mature in 1994, 1995 and 1996 respectively. Additionally, the Company is a party to a swap agreement with a notional principal amount of $20 million expiring in 1994, from which it receives interest from a commercial bank at a fixed rate of 5.4% and pays interest at various rates to the bank. The Company is exposed to credit loss in the event of non-performance by the other parties to the interest rate swap agreements. However, the Company does not anticipate nonperformance by the counterparties. The cost to terminate the net swap obligations at December 31, 1993 is approximately $4,922,000. With internally generated funds and amounts available under its long-term debt facilities, the Company expects to have sufficient funds to meet its working capital and capital expenditure requirements. ITEM 8.	ITEM 8. Financial Statements and Supplementary Data The Company's Consolidated Balance Sheets, Consolidated Statements of Income, Statements of Common Stockholders' Equity, and Consolidated Statements of Cash Flows, together with the report of Arthur Andersen & Co., independent public accountants, are included elsewhere herein. Reference is made to the "Index to Financial Statements and Financial Statement Schedules." 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 There is hereby incorporated by reference the information to appear under the caption "Election of Directors" in the Company's Proxy Statement, to be filed with the Securities and Exchange Commission within 120 days after December 31, 1993. See also "Executive Officers of the Registrant" appearing in Part I hereof. ITEM 11.	ITEM 11. Executive Compensation There is hereby incorporated by reference the information to appear under the caption "Executive Compensation" in the Company's Proxy Statement to be filed with the Securities and Exchange Commission within 120 days after December 31, 1993. ITEM 12.	ITEM 12. Security Ownership of Certain Beneficial Owners and Management There is hereby incorporated by reference the information to appear under the caption "Security Ownership of Certain Beneficial Owners and Management" in the Company's Proxy Statement, to be filed with the Securities and Exchange Commission within 120 days after December 31, 1993. ITEM 13.	ITEM 13. Certain Relationships and Related Transactions There is hereby incorporated by reference the information to appear under the caption "Certain Relationships and Related Transactions" in the Company's Proxy Statement, to be filed with the Securities and Exchange Commission within 120 days after December 31, 1993. PART IV ITEM 14.	ITEM 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) 1. and 2. Financial Statements and Financial Statement Schedules. See Index to Financial Statements and Financial Statement Schedules on page 18. (b) Reports on Form 8-K None (c) Exhibits 3.1 Restated Certificate of Incorporation, as amended, previously filed as Exhibit 3.1 to Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1983, Exhibit 3.2 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1985, and Exhibit 3.1 to Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1987, are incorporated herein by reference. 3.2 Bylaws of Registrant as amended, previously filed as Exhibit 3.2 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1987, is incorporated herein by reference. 4.1 Indenture, dated as of April 1, 1983, of Registrant to Manufacturers Hanover Trust Company, Trustee, previously filed as Exhibit 4.2 to Registration Statement No. 2-82718 on Form S-1, is incorporated herein by reference. 4.2 Instrument of Resignation, Appointment and Acceptance, dated as of March 23, 1988 among the Registrant, Manufacturers Hanover Trust Company and the First National Bank of Boston, previously filed as Exhibit 1 to Registrant's Report on Form 8-K dated March 23, 1988, is incorporated herein by reference. 9. Stockholders Agreement, dated September 26, 1985, among Alan B. Miller, Thomas L. Kempner, Sidney Miller, Anthony Pantaleoni and George H. Strong, previously filed as Exhibit 9 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1985, is incorporated herein by reference. 9.1 Amendment No. 1, dated as of November 1, 1989, to Stockholders Agreement, dated September 26, 1985, among Alan B. Miller, Thomas L. Kempner, Sidney Miller, Anthony Pantaleoni and George H. Strong, previously filed as Exhibit 9.1 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1989, is incorporated herein by reference. 10.1 Amended and Restated Credit Agreement, dated as of August 21, 1992 among Universal Health Services, Inc., Certain Participating Banks, and Morgan Guaranty Trust Company of New York, as Agent, previously filed as Exhibit 10.1 to Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1992, is incorporated herein by reference. 10.2 Restated Purchase Agreement, dated June 22, 1981, among Registrant, its preferred stockholders and certain of its officers, previously filed as Exhibit 10.10 to Registration Statement No. 2-72393 on Form S-1, is incorporated herein by reference. 10.3 Restated Employment Agreement, dated as of July 14, 1992, by and between Registrant and Alan B. Miller. 10.4 Purchase and Sale Agreement, dated as of February 8, 1991, by and among Registrant, London Independent Hospital, Inc., UHS International, Inc., UHS Leasing Company, Inc., UHS International Limited, and Compass Group plc, previously filed with Registrant's Current Report on Form 8-K dated February 8, 1991, is incorporated herein by reference. 10.5 Form of Employee Stock Purchase Agreement for Restricted Stock Grants, previously filed as Exhibit 10.12 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1985, is incorporated herein by reference. 10.6 Advisory Agreement, dated as of December 24, 1986, between Universal Health Realty Income Trust and UHS of Delaware, Inc., previously filed as Exhibit 10.2 to Registrant's Current Report on Form 8-K dated December 24, 1986, is incorporated herein by reference. 10.7 Agreement, effective January 1, 1994, to renew Advisory Agreement, dated as of December 24, 1986, between Universal Health Realty Income Trust and UHS of Delaware, Inc. 10.8 Form of Leases, including Form of Master Lease Document for Leases, between certain subsidiaries of the Registrant and Universal Health Realty Income Trust, filed as Exhibit 10.3 to Amendment No. 3 of the Registration Statement on Form S-11 and Form S-2 of Registrant and Universal Health Realty Income Trust (Registration No. 33-7872), is incorporated herein by reference. 10.9 Share Option Agreement, dated as of December 24, 1986, between Universal Health Realty Income Trust and Registrant, previously filed as Exhibit 10.4 to Registrant's Current Report on Form 8-K dated December 24, 1986, is incorporated herein by reference. 10.10 Corporate Guaranty of Obligations of Subsidiaries Pursuant to Leases and Contract of Acquisition, dated December 24, 1986, issued by Registrant in favor of Universal Health Realty Income Trust, previously filed as Exhibit 10.5 to Registrant's Current Report on Form 8-K dated December 24, 1986, is incorporated herein by reference. 10.11 1989 Non-Employee Director Stock Option Plan, previously filed as Exhibit 10.23 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1989, is incorporated herein by reference. 10.12 1990 Employees' Restricted Stock Purchase Plan, previously filed as Exhibit 10.24 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1990, is incorporated herein by reference. 10.13 1992 Corporate Ownership Program, previously filed as Exhibit 10.24 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1991, is incorporated herein by reference. 10.14 1992 Stock Bonus Plan, previously filed as Exhibit 10.25 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1991, is incorporated herein by reference. 10.15 1992 Stock Option Plan, previously filed as Exhibit 10.16 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992, is incorporated herein by reference. 10.16 Sale and Servicing Agreement dated as of November 16, 1993, between Certain Hspitals and UHS Receivables Corp. 10.17 Servicing agreement dated as of November 16, 1993, among UHS Receivables Corp., UHS oof Delaware, Inc. and Continental Bank, National Association. 10.18 Pooling Agreement dated as of November 16, 1993, among UHS Receivables Corp., Sheffield Receivables Corporation and Continental Bank, National Association. 10.19 Guarantee dated as of November 16, 1993, by Universal Health Services, Inc. in favor of UHS Receivables Corp. 10.20 Amendment No. 1 to the 1989 Non-Employee Director Stock Option Plan. 10.21 Amendment No. 1 to the 1992 Stock Bonus Plan. 10.22 1994 Executive Incentive Plan. 11. Statement re: computation of per share earnings. 22. Subsidiaries of Registrant. 24. Consent of Independent Public Accountants. Exhibits, other than those incorporated by reference, have been included in copies of this Report filed with the Securities and Exchange Commission. Stockholders of the Company will be provided with copies of those exhibits upon written request to the Company. SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED. UNIVERSAL HEALTH SERVICES, INC. By: /s/ ALAN B. MILLER ----------------------------------------- ALAN B. MILLER PRESIDENT March 23, 1994 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. UNIVERSAL HEALTH SERVICES, INC. AND FINANCIAL STATEMENT SCHEDULES (ITEM 14(A)) PAGE --------- FORM 10-K --- Consolidated Financial Statements: Report of Independent Public Accountants on Financial Statements and Schedules................................................... 19 Consolidated Statements of Income for the three years ended December 31, 1993............................................... 20 Consolidated Balance Sheets as of December 31, 1993 and 1992....... 21 Consolidated Statements of Common Stockholders' Equity for the three years ended December 31, 1993............................. 22 Consolidated Statements of Cash Flows for the three years ended December 31, 1993............................................... 23 Notes to Consolidated Financial Statements......................... 24 Supplemental Financial Statement Schedules: II Amounts Receivable from Related Parties, Underwriters, Promoters and Employees Other Than Related Parties............ 33 V Property and Equipment........................................ 34 VI Accumulated Depreciation and Amortization of Property and Equipment..................................................... 35 VIII Valuation and Qualifying Accounts............................. 35 X Supplementary Income Statement Information.................... 35 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Stockholders and Board of Directors of Universal Health Services, Inc.: We have audited the accompanying consolidated balance sheets of Universal Health Services, Inc. (a Delaware corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, common stockholders' equity and cash flows for each of the three years in the period ended December 31, 1993. These consolidated financial statements and the schedules referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Universal Health Services, Inc. and subsidiaries as of December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in the Index to Financial Statements and Financial Statement Schedules are presented for the purpose of complying with the Securities and Exchange Commission's rules and are not a required part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in our audits of the basic financial statements and, in our opinion, fairly state 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 & CO. Philadelphia, Pennsylvania February 15, 1994 UNIVERSAL HEALTH SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME For the Years Ended December 31, 1993, 1992 and 1991 UNIVERSAL HEALTH SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS As of December 31, 1993 and 1992 UNIVERSAL HEALTH SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF COMMON STOCKHOLDERS' EQUITY For the Years Ended December 31, 1993, 1992 and 1991 UNIVERSAL HEALTH SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1993, 1992 and 1991 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Universal Health Services, Inc. (the "Company") is primarily engaged in owning and operating acute care and psychiatric hospitals and ambulatory treatment centers. The consolidated financial statements include the accounts of the Company and its majority-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated. The more significant accounting policies follow: NET REVENUES: Net revenues are reported at the estimated net realizable amounts from patients, third-party payors, and others for services rendered, including estimated retroactive adjustments under reimbursement agreements with third-party payors. These net revenues are accrued on an estimated basis in the period the related services are rendered and adjusted in future periods as final settlements are determined. Medicare and Medicaid net revenues represented 40%, 39% and 35% of net patient revenues for the years 1993, 1992 and 1991, respectively, excluding the additional revenues from special Medicaid reimbursement programs described in Note 9. PROPERTY AND EQUIPMENT: Property and equipment are stated at cost. Expenditures for renewals and improvements are charged to the property accounts. Replacements, maintenance and repairs which do not improve or extend the life of the respective asset are expensed as incurred. The Company removes the cost and the related accumulated depreciation from the accounts for assets sold or retired and the resulting gains or losses are included in the results of operations. Depreciation is provided on the straight-line method over the estimated useful lives of buildings and improvements (twenty to forty years) and equipment (five to fifteen years). OTHER ASSETS: The excess of cost over fair value of net assets acquired in purchase transactions, net of accumulated amortization of $47,663,000 in 1993 and $43,828,000 in 1992, is amortized over periods ranging from five to forty years. During 1992 the Company recorded a $13.5 million charge to amortization expense due to a revaluation of certain goodwill balances. EARNINGS PER COMMON AND COMMON EQUIVALENT SHARE: Earnings per share are based on the weighted average number of common shares outstanding during the year adjusted to give effect to common stock equivalents. The 1993, 1992 and 1991 earnings per share have been adjusted to reflect the assumed conversion of the Company's convertible debentures. INCOME TAXES: The Company and its subsidiaries file consolidated Federal tax returns. Deferred taxes are recognized for the amount of taxes payable or deductible in future years as a result of differences between the tax bases of assets and liabilities and their reported amounts in the financial statements. OTHER NONCURRENT LIABILITIES: Other noncurrent liabilities include the long-term portion of the Company's professional and general liability and workers' compensation reserves. STATEMENT OF CASH FLOWS: For purposes of the consolidated statements of cash flows, the Company considers all highly liquid investments purchased with maturities of three months or less to be cash equivalents. Interest expense in the consolidated statements of income is net of interest income of $498,000, $515,000 and $2,188,000 in 1993, 1992 and 1991, respectively. INTEREST RATE SWAP AGREEMENTS: The differential to be paid or received is accrued as interest expense as interest rates change and is recognized over the life of the agreements. 2) ACQUISITIONS, DISPOSITIONS AND CLOSURES 1993 -- During 1993 the Company purchased a radiation therapy center and majority interests in four separate partnerships which own and operate ambulatory surgery facilities for $11.5 million in cash and the assumption of liabilities totaling $300,000. During the fourth quarter, the Company sold the operations and fixed assets of a 124-bed acute care hospital for approximately $7.8 million in cash. The Company also sold the operations and certain fixed assets of a 134-bed acute care hospital for cash of $1.5 million. Concurrently, the Company sold certain related real property to Universal Health Realty Income Trust (the "Trust"), an affiliate and the lessor of this 134-bed acute care hospital, for $1 million in cash and a note receivable of $900,000 (see Note 8). In connection with this transaction, the Company's lease with the Trust for this property was terminated. The disposition of these two facilities resulted in a pre-tax loss of $4.4 million ($2.2 million after tax), which is included in operating expenses in the 1993 consolidated statement of income. Also during 1993, the Company recorded a pre-tax charge of $4.4 million related to the winding down or disposition of other non-strategic businesses which is included in operating expenses in the 1993 consolidated statement of income. 1992 -- During 1992 the Company purchased majority interests in four separate partnerships which own and operate ambulatory surgery facilities for $7.2 million in cash and the assumption of liabilities totaling $5.4 million. Also during 1992, the Company discontinued operations at a 96-bed acute care hospital and sold the fixed assets of this facility for $3.4 million. The closing and sale of this hospital did not have a material impact on the consolidated financial statements. 1991 -- During 1991 the Company sold its entire U.K. operations, consisting of three acute care hospitals and certain other assets. This transaction resulted in a pre-tax gain of approximately $4.8 million (including $4.3 million transferred from cumulative translation adjustment) which is included in net revenues in the 1991 financial statements. The Company received $30.2 million in cash during 1991, an additional $9 million in 1992 and $4.9 million in 1993. The Company is entitled to receive additional consideration of approximately (pounds sterling)2.5 million as well as additional amounts if certain earnings targets are achieved by one of these hospitals. Based upon the year-end exchange rate, the Company expects to receive approximately $3.6 million in 1994. In 1991 the Company entered into a 15-year operating lease agreement for a 166-bed psychiatric hospital. The lease terms include three 5-year renewal terms at the Company's option, annual base lease rentals of $1,620,000 and additional rentals beginning in 1993 based upon revenues in excess of a base year amount ($24,000 in 1993). 3) LONG-TERM DEBT A summary of long-term debt follows: During 1993, the Company commenced a commercial paper program which provides up to $25 million of renewable borrowings which are secured by patient accounts receivable. The Company has sufficient patient receivables to support a larger program, and upon the mutual consent of the Company and the participating lending institutions, the commitment can be increased to $65 million. A fee of .76% is required on this $25 million commitment. The Company has a $72.4 million non-amortizing revolving credit agreement which matures in August of 1995 and provides for interest, at the Company's option, at the prime rate, certificate of deposit rate plus 11/8% or LIBOR plus 1%. A fee of 3/8% is required on the unused portion of this commitment. There are no compensating balance requirements. The agreement contains a provision whereby 50% of the net consideration, in excess of $15 million annually, from the disposition of assets will be applied to reduce commitments. At December 31, 1993, the Company had $72.4 million of unused borrowing capacity, and there were no borrowings outstanding under this revolving credit agreement. The average amounts outstanding during 1993, 1992 and 1991 under the revolving credit notes and commercial paper program were $25,069,000, $47,318,000 and $91,770,000, respectively, with corresponding effective interest rates of 13.9%, 11.2% and 10.0% including commitment fee and interest rate swaps. The maximum amounts outstanding at any month-end were $46,800,000, $91,650,000 and $114,416,000 during 1993, 1992 and 1991 respectively. The Company has entered into interest rate swap agreements to reduce the impact of changes in interest rates on its floating rate debt. At December 31, 1993, the Company had interest rate swap agreements with commercial banks having a total notional principal amount of $40 million. These agreements call for the payment of fixed rate interest by the Company in return for the assumption by the commercial banks of the variable rate costs, which effectively fixes the Company's interest rate on a portion of its floating rate debt at 10.4%. The interest rate swap agreements in the amounts of $10 million, $20 million and $10 million mature in 1994, 1995 and 1996 respectively. Additionally, the Company is a party to a swap agreement with a notional principal amount of $20 million expiring in 1994, from which it receives interest from a bank at a fixed rate of 5.4% and pays interest at various rates to the bank. The Company is exposed to credit loss in the event of non-performance by the other parties to the interest rate swap agreements. However, the Company does not anticipate nonperformance by the counterparties. The cost to terminate the net swap obligations at December 31, 1993 is approximately $4,922,000. Covenants relating to long-term debt require maintenance of a minimum net worth and cash flows, specified debt to net worth and fixed charge coverage ratios. Covenants also limit the Company's ability to incur additional senior debt and to pay cash dividends, repurchase its shares and retire convertible debenture debt and limit capital expenditures, among other restrictions. The fair value of the Company's subordinated debentures at December 31, 1993 was approximately $31,101,000 based on quoted market prices. The Company has the option to redeem these debentures at Par value at any time upon 30 days notice. The fair value of the Company's remaining long-term debt at December 31, 1993 was approximately equal to its carrying value. Substantially all accounts receivable and the stock of subsidiary companies are pledged as collateral to secure long-term debt. Aggregate maturities follow: ---------------------------- 1994 $ 4,313,000 1995 9,671,000 1996 3,815,000 1997 2,284,000 1998 805,000 Later 58,506,000 ---------------------------- Total $79,394,000 ---------------------------- 4) COMMON STOCK During 1993, the Company repurchased 224,800 shares of its Class B Common Stock at an average purchase price of $14.39 per share or an aggregate of approximately $3.2 million. Since January 1, 1992 the Company has repurchased 454,700 shares at an aggregate purchase price of approximately $6.2 million or $13.55 per share. The Company's ability to repurchase its shares is limited by long-term debt covenants to $7.5 million plus 25% of cumulative net income since January, 1992. Under the terms of these covenants, the Company had the ability to repurchase an additional $12.3 million of its Common Stock as of December 31, 1993. The repurchased shares are treated as retired. At December 31, 1993, 3,340,350 shares of Class B Common Stock were reserved for issuance upon conversion of shares of Class A, C and D Common Stock outstanding, for issuance upon exercise of options to purchase Class B Common Stock, for issuance upon conversion of the Company's Convertible Subordinated Debentures and for issuance of stock under other incentive plans. Class A, C and D Common Stock are convertible on a share for share basis into Class B Common Stock. In 1992, the Company adopted a Stock Bonus Plan and a Corporate Ownership Program, both of which were approved by the stockholders at the 1992 annual meeting. Under the terms of the Stock Bonus Plan, eligible employees may elect to receive all or part of their annual bonuses in shares of restricted stock (the "Bonus Shares"). Those electing to receive bonus shares also receive additional restricted shares in an amount equal to 20% of their Bonus Shares (the "Premium Shares"). Restrictions on one-half of the Bonus Shares and one- half of the Premium Shares lapse after one year and the restrictions on the remaining shares lapse after two years. The Company has reserved 150,000 shares of Class B Common Stock for this plan and has issued 46,313 shares at December 31, 1993. Under the terms of the Corporate Ownership Program, eligible employees may purchase shares of common stock, directly from the Company, at the market price. The Company will loan each eligible employee an amount equal to 90% of the purchase price for the shares. The loans, which are partially recourse to the employee, bear interest at the applicable Federal rate and are due five years from the purchase date. Shares purchased under this plan are restricted from sale or transfer. Restrictions on one-half of the shares lapse after one year and restrictions on the remaining shares lapse after two years. The Company has reserved 100,000 shares of Class B Common Stock for this plan. As of December 31, 1993, 19,803 shares were sold under the terms of this plan. The Company also has a Restricted Stock Purchase Plan which allows eligible participants to purchase shares of Class B Common Stock at par value, subject to certain restrictions. Under the terms of this plan, 300,000 shares of Class B Common Stock have been reserved for purchase by officers, key employees and consultants. The restrictions lapse as to one-third of the shares on the third, fourth and fifth anniversary dates of the purchase. The Company has issued 143,000 shares under this plan, of which 45,000 became fully vested during 1993 and 5,333 were cancelled. Compensation expense, based on the difference between the market price on the date of purchase and par value, is being amortized over the restriction period and was $240,000 in 1993, $265,000 in 1992 and $278,000 in 1991. Stock options to purchase Class B Common Stock have been granted to officers, key employees and directors of the Company under various plans. All stock options were granted with an exercise price equal to the fair market value on the date of the grant. Options are exercisable ratably over a four year period beginning one year after the date of the grant. The options expire five years after the date of the grant. Information with respect to these options is summarized as follows: Options for 259,100 shares were available for grant at December 31, 1993. At December 31, 1993, options for 49,313 shares of Class B Common Stock with an aggregate purchase price of $581,273 (average of $11.79 per share) were exercisable. 5) INCOME TAXES Components of income tax expense are as follows: The Company accounts for income taxes under the provisions of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes", (SFAS 109). Under SFAS 109, deferred taxes are required to be classified based on the financial statement classification of the related assets and liabilities which give rise to temporary differences. The effect of adopting SFAS 109 was not material to the Company's 1991 results of operations. The Company had previously accounted for income taxes under the provisions of Statement of Financial Accounting Standards No. 96. The net effect of the impact of the 1993 tax law changes on the current and deferred tax provisions was immaterial. Deferred taxes result from temporary differences between the financial statement carrying amounts and the tax bases of assets and liabilities. The components of deferred taxes are as follows: At December 31, 1990, the Company had capital loss carryforwards of $7,800,000 which were available to offset future capital gains for financial reporting purposes. These capital loss carryforwards were fully utilized in 1991 as a result of the U.K. divestiture transaction. During the current year, the Company disposed of several hospitals and ancillary businesses resulting in the recoupment of previously non-deductible charges. During the year, the Company reviewed its deferred state tax balances and as a result reduced its current year tax provision by $780,000. The net deferred tax assets and liabilities are comprised as follows: The assets and liabilities classified as current relate primarily to the allowance for uncollectible patient accounts and the current portion of the temporary differences related to self-insurance reserves and the change in accounting method. Under SFAS 109, a valuation allowance is required when it is more likely than not that some portion of the deferred tax assets will not be realized. The Company has not provided a valuation allowance since management believes that all of the deferred tax assets will be realized through the reversal of temporary differences that result in deferred tax liabilities and through expected future taxable income. 6) LEASE COMMITMENTS Certain of the Company's hospital and medical office facilities and equipment are held under operating or capital leases which expire through 2013. Certain of these leases also contain provisions allowing the Company to purchase the leased assets during the term or at the expiration of the lease at fair market value. A summary of property under capital lease follows: Future minimum rental payments under lease commitments with a term of more than one year as of December 31, 1993 are as follows: Capital lease obligations of $5,371,000, $7,310,000 and $1,467,000 in 1993, 1992 and 1991 respectively, were incurred when the Company entered into capital leases for new equipment. 7) COMMITMENTS AND CONTINGENCIES The Company is self-insured for its general liability risks for claims limited to $5 million per occurrence and for its professional liability risks for claims limited to $25 million per occurrence. Coverage in excess of these limits up to $100 million is maintained with major insurance carriers. During 1993, the Company purchased a general and professional liability occurrence policy with a commercial insurer for one of its larger acute care facilities. This policy, which is scheduled to terminate in July, 1994, includes coverage up to $25 million per occurrence for general and professional liability risks. As of December 1993 and 1992, the reserve for professional and general liability risks was $65.2 million and $58.6 million, respectively, of which $8.3 million in 1993 and $7.4 million in 1992 is included in current liabilities. Self-insurance reserves are based upon actuarially determined estimates. The Company has outstanding letters of credit totaling $22 million related to the Company's self-insurance programs ($11.3 million), as support for various debt instruments ($2.1 million) and as support for a loan guarantee for an unaffiliated party ($8.6 million). The Company has also guaranteed approximately $2 million of loans. The Company estimates the cost to complete major construction projects in progress at December 31, 1993 will approximate $24 million. The Company has entered into a long term contract with a third party to provide certain data processing services for its acute care and psychiatric hospitals. This contract expires in 1999. Various suits and claims arising in the ordinary course of business are pending against the Company. In the opinion of management, the outcome of such claims and litigation will not materially affect the Company's consolidated financial position or results of operations. 8) RELATED PARTY TRANSACTIONS At December 31, 1993, the Company held approximately 7% of the outstanding shares of Universal Health Realty Income Trust (the "Trust"). Certain officers and directors of the Company are also officers and/or Directors of the Trust. The Company accounts for its investment in the Trust using the equity method of accounting. The Company's pre-tax share of income/(loss) from the Trust was $757,000, ($110,000) and $674,000 in 1993, 1992 and 1991, respectively, and is included in net revenues in the accompanying consolidated statements of income. The carrying value of this investment at December 31, 1993 and 1992 was $7,375,000 and $4,524,000, respectively and is included in other assets in the accompanying consolidated balance sheets. The market value of this investment at December 31, 1993 was $10,352,000. During 1993, pursuant to the terms of its lease with the Trust, the Company purchased the real property of a 48-bed psychiatric hospital located in Texas for $3.2 million. The real property of this hospital was previously leased by the Company and base rental payments continued under the existing lease until the date of sale. Operations at this hospital were discontinued during the first quarter of 1992, however, the facility is currently being utilized for outpatient services at one the Company's acute care hospitals. Also during 1993, the Company sold to the Trust certain real estate assets of a 134-bed hospital located in Illinois for approximately $1.9 million. These assets consisted of additions and improvements made to the facility by the Company since the sale of the major portion of the real estate assets to the Trust in 1986. The operations of this facility were sold during 1993 to an operator unaffiliated with the Company. As of December 31, 1993, the Company leased eight hospital facilities from the Trust with initial terms expiring in 1999 through 2003. These leases contain up to six 5-year renewal options. Future minimum lease payments to the Trust are included in Note 6. The terms of the lease provide that in the event the Company discontinues operations at the leased facility for more than one year, the Company is obligated to offer a substitute property. If the Trust does not accept the substitute property offered, the Company is obligated to purchase the leased facility back from the Trust at a price equal to the greater of its then fair market value or the original purchase price paid by the Trust. Total rent expense under these operating leases was $16,600,000 in 1993, $17,000,000 in 1992 and $16,800,000 in 1991. The Company received an advisory fee of $880,000 in 1993, $913,000 in 1992 and $909,000 in 1991 from the Trust for investment and administrative services provided under a contractual agreement which is included in net revenues in the accompanying consolidated statements of income. In connection with the exercise of stock options by certain officers, the Company agreed to lend these officers an amount equal to the Company's tax savings resulting from the exercise of these options. In 1991, $112,000 of the loan balances, and in 1992 the remaining loan balances of $352,000 were forgiven by the Board of Directors and charged to compensation expense. In 1985, shares of Class A Common Stock were granted to certain officers and key employees, primarily in exchange for notes receivable. The obligations to repay the notes, which lapsed over a seven-year period, terminated during 1992. Compensation expense charged to operations related to these stock grants was $26,000 in 1992 and $136,000 in 1991. At January 1, 1992, the Company had a non-interest bearing demand note from a principal officer which was fully forgiven during 1992. Compensation expense charged to operations related to this note was $393,000 in 1992 and $100,000 in 1991. A member of the Company's Board of Directors is a partner in the law firm used by the Company as its principal outside counsel. 9) QUARTERLY RESULTS (UNAUDITED) The following tables summarize the Company's quarterly financial data for the two years ended December 31, 1993. Net revenues in 1993 include $13.5 million of additional revenues received from special Medicaid reimbursement programs. These programs are scheduled to terminate in August, 1994. Of the amount received, $4.6 million was recorded in each of the first and second quarters, $1.0 million was recorded in the third quarter and $3.3 million was recorded in the fourth quarter. These amounts were recorded in the periods that the Company met all of the requirements to be entitled to these reimbursements. The first quarter operating results also include approximately $4.1 million of expenses related to the disposition of ancillary businesses and the second quarter operating results include a $3.2 million increase in the reserves for the Company's self-insurance programs. Net revenues in the third quarter include $3.0 million of unfavorable adjustments related to prior year reimbursement issues and the fourth quarter operating results includes a $4.7 million pre-tax loss on disposal of two acute care hospitals and the winding down or disposition of non-strategic businesses. The Company's effective tax rate in the fourth quarter was significantly lower than other quarters due to the disposition of two acute care hospitals resulting in the recoupment of previously non- deductible charges. Net revenues in 1992 include $29.8 million of favorable Medicaid reimbursements. Of this amount, $22.2 million was recorded in the first quarter, $3 million was recorded in the third quarter and $4.6 million was recorded in the fourth quarter. These amounts were recorded in the periods that the Company met all of the requirements to be entitled to these reimbursements. The first quarter's operating results also include a $13.5 million amortization charge resulting from the revaluation of certain goodwill balances. Net revenues in the second quarter include a $2.3 million favorable adjustment related to prior year reimbursement issues. UNIVERSAL HEALTH SERVICES, INC. AND SUBSIDIARIES SCHEDULE II -- AMOUNTS RECEIVABLE FROM RELATED PARTIES, UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES UNIVERSAL HEALTH SERVICES, INC. AND SUBSIDIARIES SCHEDULE V -- PROPERTY AND EQUIPMENT UNIVERSAL HEALTH SERVICES, INC. AND SUBSIDIARIES SCHEDULE VI -- ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY AND EQUIPMENT UNIVERSAL HEALTH SERVICES, INC. AND SUBSIDIARIES SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS UNIVERSAL HEALTH SERVICES, INC. AND SUBSIDIARIES SCHEDULE X -- SUPPLEMENTARY INCOME STATEMENT INFORMATION All other items are omitted since the required information is not applicable. ============================================================================== - ------------------------------------------------------------------------------ SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549 -------------- EXHIBITS TO FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED COMMISSION FILE NUMBER DECEMBER 31, 1993 0-10454 -------------- UNIVERSAL HEALTH SERVICES, INC. (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) - ------------------------------------------------------------------------------ ============================================================================== INDEX TO EXHIBITS Exhibit 10.3 Restated Employment Agreement, dated as of July 14, 1992, by and between Registrant and Alan B. Miller. 10.7 Agreement, effective January 1, 1994, to renew Advisory Agreement, dated as of December 24, 1986, between Universal Health Realty Income Trust and UHS of Delaware, Inc. 10.16 Sale and Servicing Agreement dated as of November 16, 1993, between Certain Hospitals and UHS Receivables Corp. 10.17 Servicing Agreement dated as of November 16, 1993, among UHS Receivables Corp., UHS of Delaware, Inc. and Continental Bank, National Association. 10.18 Pooling Agreement dated as of November 16, 1993, among UHS Receivables Corp., Sheffield Receivables Corporation and Continental Bank, National Association. 10.19 Guarantee dated as of November 16, 1993, by Universal Health Services, Inc. in favor of UHS Receivables Corp. 10.20 Amendment No. 1 to the 1989 Non-Employee Director Stock Option Plan. 10.21 Amendment No. 1 to the 1992 Stock Bonus Plan. 10.22 1994 Executive Incentive Plan. 11. Statement re: computation of per share earnings. 22. Subsidiaries of Registrant. 24. Consent of Independent Public Accountants. EXHIBIT 10.3 RESTATED EMPLOYMENT AGREEMENT THIS AGREEMENT, dated as of July 14, 1992, by and between UNIVERSAL HEALTH SERVICES, INC., a Delaware corporation having its principal office at 367 South Gulph Road, King of Prussia, Pennsylvania 19406 (the "Company") and ALAN B. MILLER, residing at 57 Crosby Brown Road, Gladwyne, Pennsylvania 19035 ("Employee"). W I T N E S S E T H: WHEREAS, employee has been and is employed by the Company as its President and Chief Executive Officer pursuant to an Employment Agreement dated as of January 1, 1981, as amended December 1984, July 15, 1987 and June 1, 1989 (the "Employment Agreement"), and Employee has served and is presently serving as a Director of the Company; WHEREAS, the Company and Employee desire that such employment continue pursuant to the terms and conditions hereof; WHEREAS, because of the position Employee now holds with the Company and will hold during the term of this Agreement, the Company's Board of Directors considers it in the best interests of the Company, for an extended period after the term of Employee's active employment, that the Company have the benefit of Employee's services as a consultant and that Employee refrain from competing with the Company; and WHEREAS, after the term of his active employment by the Company, Employee is willing to serve as a consultant to the Company and to refrain from competing with the Company pursuant to the terms and conditions hereof applicable thereto; WHEREAS, the Employment Agreement is hereby amended and restated in its entirety by this Agreement; NOW, THEREFORE, for and in consideration of the mutual premises, representations and covenants herein contained, it is agreed as follows: 1. Term of Active Employment and Consulting Period. The phrase "term of active employment", as used in this Agreement, shall mean the period beginning July 14, 1992 and ending on December 31, 1997, subject, however, to earlier termination as expressly provided herein, and subject further to the right of Employee or the Company to extend the term of active employment until December 31, 2002 by giving written notice thereof to the other within 180 days prior to December 31, 1997. The phrase "consulting period", as used in this Agreement, shall mean, except as otherwise provided herein, the period beginning immediately upon the expiration of the term of active employment, as it may be extended, and continuing for five years after such expiration. The phrase "term of this Agreement", as used in this Agreement, shall mean the term of active employment and the consulting period together. 2. Active Employment. The Company agrees to employ Employee, and Employee agrees to be employed by the Company, as Chief Executive Officer and President of the Company during the term of employment. 3. Duties. (a) Employee agrees in the performance of his duties as Chief Executive Officer and President of the Company during the term of active employment to comply with the policies and reasonable directives of the Board of Directors of the Company (and any subsidiary or subsidiaries of the Company which shall, with the consent of Employee, at the time employ Employee). (b) Employee agrees to devote his full time to the performance of his duties during the term of active employment; and Employee shall not, directly or indirectly, alone or as a member of a partnership, or as an officer, director or employee of any other corporation, partnership or other organization, be actively engaged in or concerned with any other duties or pursuits which interfere with the performance of his duties hereunder. (c) The Company agrees that during the term of active employment Employees' duties shall be such as to allow him to work and live in the Philadelphia Metropolitan Area, and in no event shall Employee be required to move his residence from, or operate (except in accordance with past practice) outside of, the Philadelphia Metropolitan Area. 4. Base Salary. (a) As compensation for the services to be rendered by Employee hereunder, the Company agrees to pay or cause to be paid to Employee for the fiscal year ending December 31, 1992 and each fiscal year thereafter during the term of this Agreement a base salary of six hundred seventy five thousand ($675,000) dollars per annum which salary shall be increased by an amount equal at least to the percentage increase in the Consumer Price Index over the previous year as reported by the United States Department of Labor, Bureau of Labor Statistics, for the Philadelphia Metropolitan Area, and may be increased by such larger amount as the Board of Directors in its discretion may determine, but in no event shall the salary be reduced from the salary paid during the previous fiscal year. (b) The Company also agrees to pay or reimburse Employee during the term of active employment for all reasonable travel and other expenses incurred or paid by Employee in connection with the performance of his services under this Agreement in accordance with past practice. 5. Annual Bonus. It is acknowledged that it has been the practice of the Company to award Employee an annual bonus (the "Annual Bonus"). It is agreed that the Annual Bonus award shall be continued during the term of employment as follows: the Company shall pay to Employee during the term of active employment, within ninety (90) days after the end of the fiscal year ending December 31, 1992 and of each fiscal year of the Company thereafter during the term of active employment, an amount determined by the Board of Directors, but not less than $100,000. 6. Other Bonuses and Benefits. (a) Employee may also be paid during the term of active employment, in addition to the arrangements described above, such bonuses and other compensation as may from time to time be determined by the Board of Directors of the Company. (b) (1) The Company agrees to pay Employee an annual amount of $13,674.00 during the term of this Agreement as payment for premiums under a life insurance policy, Policy No. 158034323 (the "Policy") issued by Manufacturers Life Insurance Company (the "Insurer"), on the life of Employee. (2) Should Employee's employment with the Company cease because of Employee's resignation from employment with the Company or "discharge for cause" under the terms of this Agreement, the Company's obligations under clause (b)(1) hereof shall also cease. At such time, the Company shall be entitled to receive from Employee a payment (based on the year of resignation or "discharge for cause") as follows: Year Amount ---- ------- 1992 $29,090 1993 $38,716 1994 $48,815 1995 $59,410 1996 $70,534 1997 $90,843 1998 $103,774 1999 $117,338 2000 $131,443 2001 $146,119 2002 $151,334 (3) Employee's obligations under clause (b)(2) hereof are non-recourse to Employee and are secured solely by the cash surrender value of the Policy. Should Employee not make the required payment to the Company of the amounts set forth in clause (b)(2) hereof, Employee agrees to surrender the Policy for termination by the Insurer in return for the payment by the Insurer to the Company of the cash surrender value of the Policy. (4) The Company's interest in the Policy shall be limited to the right to recover the cash surrender value of the Policy under the terms of this Agreement. (5) Except as specifically herein granted to the Company, Employee shall retain all incidents of ownership in the Policy, including, but not limited to, the right to change the beneficiary of the Policy, and the right to exercise all settlement options permitted by the terms of the Policy; provided, however, that all rights retained by Employee, transferee and beneficiary shall be subject to the terms and conditions of this Agreement. (6) The Insurer is authorized by this Agreement to recognize the Company's claims to rights hereunder without investigating the reason for any action taken by the Company, the termination of Employees' employment, the giving of any notice required herein, or the application to be made by the Company of any amounts to be paid to the Company. The signature of any officer of the Company shall be sufficient for the exercise of any rights under the Policy and the receipt of the Company for any sums received by it shall be a full discharge and release therefor to the Insurer. (7) If the Insurer is made or elects to become a party to any litigation concerning the proper apportionment under this agreement, Employee and the Company and their transferees agree to be jointly and severally liable for the Insurer's litigation expenses, including reasonable attorney fees. (c) Employee shall also be eligible to and shall participate in, and receive the benefits of, any and all profit sharing, pension, bonus, stock option or insurance plans, or other similar types of benefit plans which may be initiated or adopted by the Company. 7. Fringe Benefits. Employee shall be entitled to and shall receive the following benefits during the term of this Agreement: (a) All prior benefits previously enjoyed in accordance with past practice; and (b) Health, disability and accident insurance as presently in force or as may be improved by the Board of Directors. 8. Consulting Period Retention and Duties. (a) Except as otherwise provided in Sections 9, 10 and 11 hereof, Employee agrees to be retained by the Company, and Company agrees to retain Employee, as a consultant to the Company during the consulting period. (b) During the consulting period Employee will provide such reasonable consulting services concerning the business, affairs and management of the Company as may be requested by the Company's Board of Directors, but Employee shall not be required to devote more than five (5) business days each month to such services, which shall be performed at such place as is mutually convenient to both parties or, in the event there is no agreement as to a mutually convenient place, such services shall be performed at the principal executive offices of the Company. Employee may, subject to the restrictions of Section 13, engage in other employment during the consulting period as is not inconsistent with his consulting obligations hereunder. 9. Consulting Period Compensation. (a) As compensation for the services to be rendered by Employee during the consulting period the Company agrees to pay or cause to be paid to Employee a fee equal to one-half Employee's base salary paid under Section 4 hereof at the date of the expiration of the term of active employment, payable in equal monthly installments during the consulting period. (b) The Company also agrees to pay or reimburse Employee for all reasonable travel and other expenses incurred or paid by Employee in connection with the performance of his services under this Agreement during the consulting period in accordance with the payment or reimbursement practices in effect during the term of active employment. 10. Disability. If during the term of active employment Employee shall become physically or mentally disabled, whether totally or partially, so that he is prevented from performing his usual duties for a period of six consecutive months, or for shorter periods aggregating six months in any twelve-month period, the Company shall, nevertheless, continue to pay Employee his full compensation, when otherwise due, as provided in this Agreement through the last day of the sixth consecutive month of disability or the date on which the shorter periods of disability shall have equalled a total of six months in any twelve-month period. The Company may, by action of all but one of the members of the Company's Board of Directors, at any time on or after such day, by written notice to Employee (the "Disability Notice"), provided Employee has not resumed his usual duties prior to the date of the Disability Notice, terminate (as of the first day of the month following the date of the Disability Notice, provided that Employee shall also be paid a pro rata portion of the Annual Bonus which would otherwise have been payable for such fiscal year in which the Disability Notice is given) the compensation otherwise payable to Employee during the term of active employment and pay to Employee the Disability Payment. The Disability Payment shall mean the payment by the Company to Employee of a sum equal to one-half of Employee's base salary paid under Section 4 hereof at the date of the Disability Notice, payable in twelve equal monthly installments. 11. Death. (a) If Employee shall die during the term of this Agreement, this Agreement shall terminate as of the last day of the month of Employee's death except as set forth in subsection (b) of this Section 11. (b) Anything to the contrary notwithstanding, the Company shall pay to Employee's wife on the date of his death or, in the event Employee is unmarried on the date of his death, to his estate, a pro rata portion of the Annual Bonus which would otherwise have been payable to Employee for the fiscal year in which he died, which pro rata portion shall be determined as of the last day of the month of Employee's death, together with any items of reimbursement or salary owed to Employee as of the date of his death. In addition, the Company shall file claims and take other appropriate action with respect to any life insurance policies maintained on Employee's life by the Company for which Employee had the right to designate the beneficiary. 12. Termination. (a) Discharge for cause. The Company recognizes that during the many ears of Employee's employment by the Company, the Company has become familiar with Employee's ability, competence and judgment. The Company acknowledges, on the basis of such familiarity, that Employee's ability, competence and judgment are satisfactory to the Company. Employee is continuing his employment with the Company hereunder in reliance upon the foregoing expression of satisfaction by the Company. It is therefore agreed that "discharge for cause" shall include discharge by the Company on the following grounds only: (i) Employee's conviction (which, through lapse of time or otherwise, is not subject to appeal) of any crime or offense involving money or other property of the Company or its subsidiaries; or (ii) Employee's conviction (which, through lapse of time or otherwise, is not subject to appeal) of any other crime (whether or not involving the Company or its subsidiaries) which constitutes a felony in the jurisdiction involved; or (iii) Employee's continuing repeated wilful failure or refusal to perform his duties as required by this Agreement, provided that discharge pursuant to this subparagraph (iii) shall not constitute discharge for cause unless Employee shall have first received written notice from the Board of Directors of such failure and refusal and affording Employee an opportunity, as soon as practicable, to correct the acts or omissions complained of. In the event that Employee shall be discharged for cause, all salary and other benefits payable by the Company under this Agreement in respect of periods after such discharge shall terminate upon such discharge, but any benefits payable to or earned by Employee with respect to any period of his employment prior to such discharge shall not be terminated by reason of such discharge. Anything in the foregoing to the contrary notwithstanding, if Employee is convicted of any crime set forth in either Section 12(a)(i) or 12(a)(ii) above, the Company may forthwith suspend Employee without any compensation and choose a new person or persons to perform his duties hereunder during the period between conviction and the time when such conviction, through lapse of time or otherwise, is no longer subject to appeal; provided, however, that if Employee's conviction is subsequently reversed (i) he shall promptly be paid all compensation to which he would otherwise have been entitled during the period of suspension, together with interest thereon (which interest shall be calculated at a rate per annum equal to the rate of interest payable on the date of such reversal on money judgments after entry thereof under the laws of the Commonwealth of Pennsylvania), and (ii) the Company shall have the right (exercisable within sixty (60) days after such reversal) but not the obligation to restore Employee to active service hereunder at full compensation. If the Company elects not to restore Employee to active service after reversal of a conviction, Employee shall thereafter be paid the full compensation which would otherwise have been payable during the balance of the term of active employment and during the consulting period and Employee shall be entitled to obtain other employment, subject however to (i) an obligation to perform consulting services so long as he is receiving compensation pursuant to the terms of this Agreement, (ii) the continued application of the covenants provided in Section 13 and (iii) the condition that, if Employee does obtain other employment during the period ending on December 31, 1997, or December 31, 2002 if this Agreement is extended by Employee or the Company, his total compensation therefrom (whether paid to him or deferred for his benefit) shall reduce, pro tanto, any amount which the Company would otherwise have been required to pay him during the period ending on December 31, 1997, or December 31, 2002 if this Agreement is extended by Employee or the Company. (b) Breach by Company. If Employee shall terminate his employment with the Company because of a material change in the duties of his office or any other breach by the Company of its obligations hereunder, or in the event of the termination of Employee's employment by the Company in breach of this Agreement, Employee shall, except as otherwise provided herein, continue to receive all of the compensation provided hereunder and shall be entitled to all of the benefits otherwise provided herein, during the term of this Agreement notwithstanding such termination and Employee shall have no further obligations or duties under this Agreement. (c) Mitigation. In the event of the termination by Employee of his employment with the Company as a result of a material breach by the Company of any of its obligations hereunder, or in the event of the termination of Employee's employment by the Company in breach of this Agreement, Employee shall not be required to seek other employment in order to mitigate his damages hereunder; provided, however, that if Employee does obtain other employment, his total compensation therefrom, whether paid to him or deferred for his benefit, shall reduce, pro tanto, any amount which the Company would otherwise be required to pay to him as a result of such breach. 13. Non-Competition. Employee agrees that he will not during the term of this Agreement, directly or indirectly, own, manage, operate, join, control, be controlled by, or be connected in any manner with any business of the type conducted by the Company or render any service or assistance of any kind to any competitor of the Company or any of its subsidiaries; provided, however, that (i) in the event Employee terminates his employment with the Company as result of a material breach by the Company of any of its obligations hereunder or in the event the Company discharges Employee without cause, Employee shall continue to be bound by the restrictions of this Section 13 only if Employee is receiving the compensation payable to him in accordance with Section 12(b) hereof and (ii) in the event the Company discharges Employee for cause, Employee shall be bound by the restrictions of this Section for a period of one year following such discharge. 14. Binding Effect. Except as otherwise provided for herein, this Agreement shall inure to the benefit of and be binding upon the heirs, executors, administrators, successors in interest and assigns of the parties hereto. 15. Effective Date. This Agreement shall become effective on July 14, 1992. 16. Notices. All notices provided for herein to be given to any party shall be in writing and signed by the party giving the notice and shall be deemed to have been duly given if mailed, registered or certified mail, return receipt requested, as follows: (i) If to Employee: 57 Crosby Brown Road Gladwyne, Pennsylvania 19035 (ii) If to Company: 367 South Gulph Road King of Prussia, Pennsylvania 19406 Attention: Secretary Either party may change the address to which notices, requests, demands and other communications hereunder shall be sent by sending written notice of such change of address to the other party. 17. Amendment, Modification and Waiver. The terms, covenants, representations, warranties or conditions of this Agreement may be amended, modified or waived only by a written instrument executed by the parties hereto, except that a waiver need only be executed by the party waiving compliance. No waiver by any party of any condition, or of the breach of any term, covenant, representation or warranty contained in this Agreement, whether by conduct or otherwise, in any one or more instances shall be deemed to be or construed as a waiver of any other condition or breach of any other term, covenant, representation or warranty of this Agreement. 18. Governing Law. This Agreement shall be construed in accordance with the laws of the Commonwealth of Pennsylvania applicable to agreements made and to be performed therein. 19. Entire Agreement. This Agreement contains the entire agreement of the parties relating to the subject matter herein contained and supersedes all prior contracts, agreements or understandings between and among the parties, except as set forth herein. IN WITNESS WHEREOF, the parties hereto have executed this Agreement as of the day and year first above written. UNIVERSAL HEALTH SERVICES, INC. By:__________________________________ Executive Vice President ______________________________________ Alan B. Miller EXHIBIT 10.7 January 12, 1994 Mr. Alan B. Miller President UHS of Delaware, Inc. 367 South Gulph Road King of Prussia, PA 19406 Dear Alan: The Board of Trustees of Universal Health Realty Income Trust at their December 1, 1993, meeting authorized the renewal of the current Advisory Agreement between the Trust and UHS of Delaware, Inc. ("Agreement") upon the same terms and conditions. This letter constitutes the Trust's offer to renew the Agreement until December 31, 1994, upon the same terms and conditions. Please acknowledge UHS of Delaware, Inc.'s acceptance of this offer by signing in the space provided below and returning one copy of this letter to me. Sincerely yours, Sidney Miller Secretary SM/jds cc: Warren J. Nimetz, Esquire Charles Boyle AGREED TO AND ACCEPTED: UHS of Delaware, Inc. By: ------------------------- Alan B. Miller, President - ------------------------------------------------------------------------------ SALE AND SERVICING AGREEMENT between the HOSPITAL and UHS RECEIVABLES CORP. - ------------------------------------------------------------------------------ Page ARTICLE I DEFINITIONS . . . . . . . . . . . . 1 1.1. Definitions . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 ARTICLE II PURCHASES AND SALES . . . . . . . . . . 2 2.1. Agreement to Purchase and to Sell . . . . . . . . . . . . . . . . 2 2.2. Purchase of Receivables . . . . . . . . . . . . . . . . . . . . . 2 2.3. Payment of Purchase Price . . . . . . . . . . . . . . . . . . . . 3 ARTICLE III CONDITIONS TO PURCHASE . . . . . . . . 3 3.1. Conditions to Initial Purchase . . . . . . . . . . . . . . . . . 3 3.2. Conditions to All Purchases . . . . . . . . . . . . . . . . . . 4 ARTICLE IV REPRESENTATIONS, WARRANTIES AND COVENANTS OF THE HOSPITAL. . . . . . . . 5 4.1. Representations, Warranties and Covenants of the Hospital . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 4.2. Representations and Warranties Concerning Receivables . . . . . . 9 4.3. Additional Covenants of the Hospital. . . . . . . . . . . . . . . 11 4.4. Removal of Non-qualifying Receivables . . . . . . . . . . . . . . 16 4.5. Representations and Warranties of Finco . . . . . . . . . . . . . 17 ARTICLE V ADMINISTRATION AND COLLECTIONS . . . . . . 18 5.1. Servicing . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 5.2. Collections . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 5.3. Hospital's Obligations as Agent for the Servicer. . . . . . . . . 19 5.4. Claims Against Third Parties. . . . . . . . . . . . . . . . . . . 19 5.5. Hospital Concentration Account. . . . . . . . . . . . . . . . . . 20 ARTICLE VI TERMINATION OF PURCHASE COMMITMENT. . . . . 20 6.1. Exclusion Events. . . . . . . . . . . . . . . . . . . . . . . . . 20 6.2. Remedies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 ARTICLE VII INDEMNIFICATION AND EXPENSES . . . . . . . 25 7.1. Indemnities by the Hospital . . . . . . . . . . . . . . . . . . . 25 7.2. Audits of Hospital, Etc . . . . . . . . . . . . . . . . . . . . . 26 ARTICLE VIII MISCELLANEOUS. . . . . . . . . . . 27 8.1. Notices, Etc. . . . . . . . . . . . . . . . . . . . . . . . . . . 27 8.2. Successors and Assigns. . . . . . . . . . . . . . . . . . . . . . 28 8.3. Severability. . . . . . . . . . . . . . . . . . . . . . . . . . . 28 8.4. Amendments. . . . . . . . . . . . . . . . . . . . . . . . . . . . 28 8.5. The Hospital's Obligations. . . . . . . . . . . . . . . . . . . . 28 8.6. No Recourse . . . . . . . . . . . . . . . . . . . . . . . . . . . 28 8.7. Further Assurances. . . . . . . . . . . . . . . . . . . . . . . . 29 8.8. Survival. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 8.9. Consent to Assignment; Third Party Beneficiaries. . . . . . . . . 29 8.10. Counterparts. . . . . . . . . . . . . . . . . . . . . . . . . . . 31 8.11. Headings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 8.12. No Bankruptcy Petition Against Finco or Sheffield . . . . . . . . 31 8.13. Finco May Act Through Agents. . . . . . . . . . . . . . . . . . . 31 8.14. GOVERNING LAW . . . . . . . . . . . . . . . . . . . . . . . . . . 31 8.15. No Waiver; Cumulative Remedies. . . . . . . . . . . . . . . . . . 31 8.16. SUBMISSION TO JURISDICTION; VENUE; WAIVER OF JURY TRIAL; SERVICE OF PROCESS . . . . . . . . . . . . . . . . . . . 32 8.17. UCC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 8.18. Execution; Effectiveness. . . . . . . . . . . . . . . . . . . . . 33 Exhibits Exhibit A Form of Subordinated Note Exhibit B Form of Confidentiality Agreement Schedules Schedule I Hospital and UHS place of business; List of Insurers; UCCs Filed Schedule II Notifications as to Accreditation and Licensing Schedule III Fiscal Years Open to Audit Schedule IV Governmental Programs for Which the Hospital is a Qualified Provider Schedule V Hospital Concentration Account SALE AND SERVICING AGREEMENT SALE AND SERVICING AGREEMENT, dated as of November 16, 1993 (this "Agreement"), between each hospital company referred to in Section 8.18 (together with its successors and assigns, the "Hospital") and UHS Receivables Corp., a Delaware corporation (together with its successors and assigns, "Finco"). W I T N E S S E T H : WHEREAS, subject to the terms and conditions of this Agreement, Finco wishes to purchase from the Hospital, and the Hospital wishes to sell to Finco, all of the Hospital's Receivables (all capitalized terms used in the recitals without definition, as defined in the Definitions List referred to below) and all related Transferred Property arising during the term of this Agreement; WHEREAS, pursuant to the Pooling Agreement, Finco has agreed to transfer to the Trust, for the benefit of the Participants, and the Trust will acquire from Finco, the Purchased Receivables and other Total Transferred Property on the terms and conditions of the Pooling Agreement; WHEREAS, in order to provide for the collection of all amounts payable under the Receivables, the Interested Parties have required as a condition precedent to the effectiveness of the Operative Documents that the Hospital undertake the primary responsibility for the management and administration of and collection on the Receivables, as such responsibilities are defined and set forth in the Servicing Agreement, and the Hospital, pursuant to the terms and conditions of this Agreement, has agreed to undertake all such responsibilities in consideration for payments to it under this Agreement and other valuable consideration; and WHEREAS, pursuant to the Guarantee, UHS has guaranteed the obligations of the Hospital hereunder and of UHS Delaware under the Servicing Agreement; NOW THEREFORE, the parties hereto agree as follows: ARTICLE I DEFINITIONS Section 1.1. Definitions. As used in this Agreement (unless the context requires a different meaning), capitalized terms used herein shall have the meanings assigned to them in the Definitions List, dated as of November 16, 1993 (the "Definitions List"), that refers to this Agreement, which Definitions List is incorporated herein by reference and shall be deemed to be a part of this Agreement. ARTICLE II PURCHASES AND SALES Section 2.1. Agreement to Purchase and to Sell. Subject to the terms of this Agreement, the Hospital shall sell, assign, transfer and convey all the Receivables and the related Transferred Property generated by it to Finco until an Exclusion Event shall have occurred and, upon the representations, warranties, covenants and agreements of the Hospital hereinafter set forth, and subject to the terms and conditions of this Agreement, Finco shall purchase such Receivables from the Hospital pursuant to Section 2.2 and pay the Hospital for such Receivables pursuant to Section 2.3 from time to time until an Exclusion Event shall have occurred. Section 2.2. Purchase of Receivables. (a) In consideration of the agreements set forth herein, the Hospital hereby sells, assigns, transfers and otherwise conveys to Finco all of its right, title and interest in and to the Receivables and the related Transferred Property now existing and hereafter arising. All of the Hospital's right, title and interest in and to such Receivables and the related Transferred Property, whether now existing or hereafter created, shall be sold, assigned, transferred and conveyed to Finco without any further action by the Hospital. The parties hereto intend that this transfer and conveyance shall be considered a sale; provided, however, in the event that for any reason such transfer is determined by a court of competent jurisdiction not to be a sale, the parties hereby agree that this transfer and conveyance creates a security interest in favor of Finco securing repayment by the Hospital of a loan, in the amount of the aggregate Purchase Price, made by Finco to the Hospital, and the Hospital hereby grants to Finco a first priority security interest in all of the Hospital's right, title and interest in the Receivables and the related Transferred Property, whether now existing or hereafter created, as collateral security for the repayment of such loan and all other amounts owed under and in connection with this Agreement by the Hospital to Finco. (b) All Receivables of the Hospital and the related Transferred Property shall be purchased by Finco immediately upon creation of such Receivables and the related Transferred Property. Payment of the Purchase Price for such Purchased Receivables shall be made on the related Payment Date in accordance with Section 2.3. On the Initial Closing Date, the aggregate Outstanding Balance of Receivables of the Hospital for which the Payment Date is on or prior to the Initial Closing Date will be reported in a Servicer Daily Statement prepared by the Servicer and delivered on the Initial Closing Date in accordance with Section 3.1, and the aggregate Purchase Price for all such Purchased Receivables will be paid on the Initial Closing Date in accordance with Section 2.3. At the close of business on each Business Day after the Initial Closing Date the Servicer will determine, in accordance with the Servicing Agreement, the aggregate Outstanding Balance of the Purchased Receivables created by the Hospital for which the Payment Date is such Business Day, and Finco shall make payment of the aggregate Purchase Price for all such Purchased Receivables on such Payment Date in accordance with Section 2.3. Section 2.3. Payment of Purchase Price. (a) On the Initial Closing Date, Finco shall pay to the Hospital, in cash, as payment in full for the Purchased Receivables and the related Transferred Property for which the Payment Date is on or prior to the Initial Closing Date, an amount equal to the aggregate Purchase Price with respect to all such Purchased Receivables and Transferred Property. (b) On each Business Day after the Initial Closing Date, Finco directs the Trustee, pursuant to Section 7.2(e) of the Pooling Agreement and subject to the terms and conditions of this Agreement and the Pooling Agreement, to pay to the Hospital, on behalf of Finco and as payment in full for the Purchased Receivables and the related Transferred Property for which the Payment Date is such Business Day, an amount equal to the aggregate Purchase Price with respect to such Purchased Receivables and related Transferred Property (after deducting any amounts payable by the Hospital pursuant to Section 4.4 on such Business Day), such payment to be in cash in immediately available funds to the extent of amounts available in accordance with the terms of the Pooling Agreement; provided, however, that to the extent that sufficient cash is not available under Section 7.2(e) of the Pooling Agreement to pay such aggregate Purchase Price in full on such date, then Finco shall deliver a Subordinated Note, substantially in the form of Exhibit A attached hereto, in favor of such Hospital or, if such Subordinated Note has previously been delivered pursuant to this Section, the principal amount thereof shall be increased, in each case in an amount equal to the difference between the aggregate Purchase Price (net of all deductions pursuant to Section 4.4) and the amount of cash so delivered pursuant to this Section 2.3(b). The Hospital hereby agrees to all of the terms and conditions of the Subordinated Note and such terms and conditions are incorporated herein by reference. ARTICLE III CONDITIONS TO PURCHASE Section 3.1. Conditions to Initial Purchase. The initial purchase of Receivables is subject to the satisfaction by the Hospital of all conditions precedent to be satisfied by it pursuant to the Conditions List, which Conditions List is incorporated herein by reference, and of all conditions set forth in Section 3.2. Section 3.2. Conditions to All Purchases. The obligation of Finco to cause the Trustee to make payment of the Purchase Price on any Payment Date with respect to any purchase of Purchased Receivables hereunder from the Hospital is subject to the following conditions precedent: (a) On the Purchase Date and on such Payment Date the Hospital shall have complied with all of its covenants hereunder and shall have fulfilled all of its obligations hereunder; (b) The representations and warranties of the Hospital set forth in Article IV shall be true and correct in all material respects on and as of the applicable Purchase Date after giving effect to any such payment; (c) The Hospital shall be in full compliance with all the terms and conditions of Article V, including, without limitation, those terms and conditions governing the Hospital Concentration Account; (d) All legal matters incident to the execution and delivery by the Hospital of this Agreement and to the purchases by Finco of the Purchased Receivables from the Hospital shall be satisfactory to counsel for Finco; and (e) No Exclusion Event, and no event which, after notice or lapse of time or both, would become an Exclusion Event, shall have occurred and then be continuing. The acceptance by the Hospital of any payment or Subordinated Note for any Purchased Receivables shall be deemed to be a representation and warranty by the Hospital as of such acceptance date as to the matters in paragraphs (a), (b), (c) and (e) of this Section 3.2; provided that if, prior to the Payment Date, Finco shall have been notified of the occurrence of an Exclusion Event and shall have elected to exercise the remedy provided in Section 6.2(a)(i) or (ii) with respect to such Exclusion Event, then the acceptance by the Hospital of any Subordinated Note for any Purchased Receivable shall not be deemed to be a representation and warranty as to the matters in paragraph (e) of this Section 3.2. If, on any Payment Date, any of the conditions precedent set forth in this Section 3.2 with respect to the related purchase of Receivables from the Hospital are not satisfied, Finco shall have the option to (A) make payment for such Purchased Receivables pursuant to the terms hereof and retain its interest therein or (B) reassign to the Hospital without recourse, representation or warranty its interest in such Receivables and the related Transferred Property and not make any payment therefor. ARTICLE IV REPRESENTATIONS, WARRANTIES AND COVENANTS OF THE HOSPITAL Section 4.1. Representations, Warranties and Covenants of the Hospital. The Hospital represents and warrants to and covenants with Finco as of the date hereof, and as of each future Purchase Date and each related Payment Date, that: (a) The Hospital has been duly organized and is validly existing and in good standing as a corporation or limited partnership under the laws of the state of its organization, with full power and authority to own or lease its properties and to conduct its business as presently conducted and to execute, deliver and perform this Agreement and the other Hospital Documents and any other documents related hereto and thereto to which it is a party and to consummate the transactions contemplated hereby and thereby. The Hospital is duly qualified as a foreign corporation or limited partnership and in good standing under the laws of each jurisdiction where its ownership, lease or operation of property or the conduct of its business requires such qualification, except where any such failure or failures to be so qualified would not, alone or in the aggregate, have a material adverse effect on its business, operations, properties, assets or financial condition. (b) The execution, delivery and performance by the Hospital of this Agreement and the other Hospital Documents to which it is a party and the consummation of the transactions contemplated hereby and thereby have been duly and validly authorized by all requisite action and will not (with due notice or lapse of time or both) conflict with or result in a breach of any of the terms or provisions of, or constitute a default under, or result in the creation or imposition of any Lien upon any of its property or assets pursuant to the terms of any indenture, mortgage, deed of trust, lease, loan agreement or other agreement, instrument or undertaking by which it is bound or to which any of its property or assets is subject, nor will such action result in any violation or violations of any applicable Requirement of Law, including, without limitation, any rule or regulation of JCAHO or AOA, as the case may be, or otherwise relating to the eligibility of the Hospital to receive payment and to participate as an accredited and certified provider of healthcare services under Medicare, Medicaid, Champus, Blue Cross/Blue Shield, Worker's Compensation or equivalent programs, which violation or violations would, alone or in the aggregate, have a material adverse effect on the Hospital's ability to perform under the terms of this Agreement or the other Hospital Documents to which it is a party or on the collectibility (other than as a result of the credit quality of any Obligor) or enforceability of the Purchased Receivables purchased on the date on which this representation is made or deemed made or the value of the related Transferred Property; and no consent, approval, authorization, order, registration, filing, qualification, license or permit of or with any Governmental Authority or body or any other Person is required to be obtained by or with respect to the Hospital in connection with the execution, delivery and performance by the Hospital of this Agreement, the other Hospital Documents (other than the actions required to file or record any Security Filings, all of which actions, subject to Section 5.3 of the Pooling Agreement, have been taken) or the consummation of the transactions contemplated hereby or thereby. (c) Each of the Hospital Documents to which the Hospital is a party has been duly and validly authorized, executed and delivered by the Hospital and constitutes a valid and legally binding obligation of the Hospital, enforceable against the Hospital in accordance with its terms, subject as to enforceability to applicable bankruptcy, reorganization, insolvency, moratorium or other similar laws affecting creditors' rights generally, and to general principles of equity (regardless of whether enforcement is sought in a proceeding in equity or at law). (d) There is (i) no effective financing statement (or similar statement or instrument of registration under the law of any jurisdiction) on file or registered in any public office and (ii) no assignment filed or delivered by or on behalf of the Hospital covering any interest of any kind in the Transferred Property or intended so to be filed, delivered or registered, and the Hospital will not execute nor will there be on file in any public office any effective financing statement (or similar statement or instrument of registration under the laws of any jurisdiction) or any assignment or other notification relating to the Transferred Property, except (i) the Security Filings relating to the Permitted Interests and (ii) any such financing statements or notifications as to which the Hospital has submitted to Finco evidence satisfactory to Finco of the termination of the ownership or security interest intended to be perfected by the filing, delivery or registration thereof. The interest of Finco in the Transferred Property purchased on the date on which this representation is made or deemed made is an ownership interest, valid and enforceable against, and prior to, all claims of existing and future creditors of the Hospital and all subsequent purchasers from the Hospital of the Purchased Receivables. (e) All Security Filings which are required to perfect the interests of Finco in the Purchased Receivables purchased on the date on which this representation is made or deemed made and the related Transferred Property have been filed, delivered or received, as the case may be (other than as limited by Section 5.3 of the Pooling Agreement) and are in full force and effect, and the Hospital shall, at its expense, perform all acts and execute all documents reasonably requested by Finco at any time to evidence, perfect, maintain and enforce the first priority ownership, and, in the alternative, security interests of Finco in the Transferred Property. Schedule I attached hereto lists (i) all offices where UCC filings must be made to perfect the Permitted Interests of Finco in the Purchased Receivables purchased on the date on which this representation is made or deemed made and the related Transferred Property and (ii) the insurers or other third-party payors which are Obligors maintaining the ten highest average Outstanding Balances of Receivables, calculated, as of August 31, 1993, on an aggregate basis for all Hospitals that are parties to any Sale and Servicing Agreement. The Hospital will, on the reasonable request of an Authorized Officer of Finco, execute and deliver all such Security Filings (satisfactory in form and substance to Finco) requested by Finco and, where permitted by law, the Hospital authorizes Finco to file one or more such Security Filings signed only by Finco. The Hospital hereby irrevocably appoints Finco its attorney-in-fact to file and deliver, and to receive Confirmations in respect of, one or more such Security Filings signed on behalf of the Hospital by Finco as the attorney-in-fact of the Hospital. (f) There are no actions, proceedings or investigations pending or, to the knowledge of the Hospital, threatened, before any court, administrative agency or other tribunal (i) which, if determined adversely to the Hospital, could, alone or in the aggregate, have a material adverse effect on the business, operations, properties, assets, condition (financial or otherwise) or prospects of the Hospital, (ii) asserting the invalidity of this Agreement or any of the other Hospital Documents, (iii) questioning the consummation by the Hospital of any of the transactions contemplated by this Agreement or the other Hospital Documents or (iv) which, if determined adversely, could, alone or in the aggregate, materially and adversely affect the ability of the Hospital to perform its obligations under, or the validity or enforceability of, this Agreement, the other Hospital Documents or the Purchased Receivables purchased on the date on which this representation is made or deemed made. (g) The place of business of the Hospital is located at the address set forth on Schedule I hereto, which place of business is the place where the Hospital is "located" for the purposes of Section 9-103(3)(d) of the UCC of the state indicated in such Schedule, and the locations of the offices where the Hospital keeps all of the Transferred Property are at the addresses set forth on Schedule I hereto. (h) The Hospital has, and will have on each Purchase Date, all permits, licenses, agreements with third-party payors, accreditations and certifications (including, without limitation, any required accreditations by JCAHO and AOA and any required accreditations and certifications as a provider of healthcare services eligible to receive payment and compensation and to participate under Medicare, Medicaid, Champus, Blue Cross/Blue Shield, Worker's Compensation and similar applicable programs) necessary to own its assets and to carry on its business as now conducted, except where failure to have such permits, licenses, agreements with third-party payors, accreditation and certifications would not, alone or in the aggregate, have a material adverse effect on (i) the business, operations, property or condition (financial or otherwise) of the UHS Entities taken as a whole, (ii) the collectibility (other than as a result of the credit quality of any Obligor) or enforceability of the Purchased Receivables purchased on the date on which this representation is made or deemed made or the value of the related Transferred Property or (iii) the ability of the Hospital to perform its servicing obligations hereunder. Except as set forth on Schedule II hereto, during the last twenty-four months, the Hospital has not been notified by JCAHO, AOA or any relevant Governmental Authority (including, without limitation, any state licensing authority) with respect to a license to operate an acute care or psychiatric facility, as the case may be, of such Person's intention to rescind or not renew any of its respective accreditations or licenses. (i) No material Reportable Event has occurred during the five-year period prior to the date on which this representation is made or deemed made with respect to any Plan, and each Plan has complied in all material respects with the applicable provisions of ERISA and the Code. The present value of all accrued benefits under each Single Employer Plan maintained by the Hospital or any Commonly Controlled Entity (based on those assumptions used to fund such Plans) did not, as of the last annual valuation date prior to the date on which this representation is made or deemed made, materially exceed the value of the assets of such Plan allocable to such accrued benefits. Neither the Hospital nor any Commonly Controlled Entity has had a complete or partial withdrawal from any Multiemployer Plan which has resulted or could result in any material liability under ERISA, and neither the Hospital nor any Commonly Controlled Entity would become subject to any material liability under ERISA if the Hospital or any such Commonly Controlled Entity were to withdraw completely from all Multiemployer Plans as of the valuation date most closely preceding the date on which this representation is made or deemed made. No such Multiemployer Plan is in reorganization or insolvent. The present value (determined using actuarial and other assumptions which are reasonable in respect of the benefits provided and the employees participating) of the liability of the Hospital and each Commonly Controlled Entity for post-retirement benefits to be provided to their current and former employees under Plans which are welfare benefit plans (as defined in Section 3(1) of ERISA) does not, in the aggregate, materially exceed the assets under all such Plans allocable to such benefits. (j) The Hospital has no Subsidiaries. (k) The Hospital has filed or caused to be filed all material federal, state and local tax returns which are required to be filed, and has paid or caused to be paid all taxes as shown on said returns and any other taxes or assessments payable by it (other than any such taxes or assessments the amount or validity of which are currently being contested in good faith by appropriate proceedings and with respect to which reserves in conformity with GAAP have been provided on the books of the Hospital and with respect to which collection has been stayed), and no tax Lien has been filed and, to the knowledge of the Hospital, no claims are being asserted with respect to any such taxes, fees or other charges which, alone or in the aggregate, could reasonably be expected to have a material adverse effect on the rights of Finco or its direct or indirect assignees under the Operative Documents or with respect to the Transferred Property. Except with respect to the fiscal years of the Hospital listed on Schedule III, as of the Initial Closing Date, the federal tax returns previously filed by or on behalf of the Hospital are not subject to future challenge or audit by the Internal Revenue Service. Section 4.2. Representations and Warranties Concerning Receivables. (i) On the date hereof and (ii) with respect to Sections 4.2(a), 4.2(j) and 4.2(l) on each following date and (iii) with respect to Sections 4.2(b) through (i) and 4.2(k), with respect to Purchased Receivables on each related Purchase Date, the Hospital represents and warrants to Finco as follows: (a) The Hospital has, immediately prior to its conveyance of the Purchased Receivables pursuant to Section 2.2, good title to the Purchased Receivables and the related Transferred Property, and the Outstanding Balances are free and clear of any Lien or other claim of any kind or any offset, counterclaim or defense of any kind, other than contractual adjustments in respect of, and in no event greater than, the Applicable Contractual Adjustment and any offsets included in the Offset Reserves. At all times during which this Agreement is in effect, the Transferred Property and the Outstanding Balances in relation thereto will not be subject to any Lien or claim of any kind or to any counterclaim or defense of any other kind other than the Permitted Interests and the offsets included in the Offset Reserves. (b) Each of the Purchased Receivables and the related Transferred Property complies with and will comply with all Requirements of Law (including, in the case of Governmental Receivables, all applicable requirements of the programs listed on Schedule IV) and is not the subject of any litigation, court proceeding or other dispute. (c) Each of the Purchased Receivables (i) is and will be in full force and effect and represents and will represent a valid and legally binding obligation of the related Obligor, enforceable against such Obligor in accordance with its terms and (ii) constitutes an "account" or "general intangible" under the UCC in effect in the state in which the Hospital's place of business is located, or a right to payment under a policy of insurance or proceeds thereof. (d) (i) The statements and information constituting Receivables Information provided by the Hospital are true and correct and do not contain any untrue statement of a material fact or omit any material fact which would make such statements and information, in light of the circumstances in which they were made or given, misleading and (ii) the other statements and information furnished by any Authorized Officer of the Hospital to Finco are true and correct and do not contain any untrue statement of a material fact or omit any material fact which would make such other statement or information, in light of the circumstances in which they were made or given, misleading. (e) This Agreement, together with the Security Filings, vests and at all times will vest in Finco the ownership interest in, or, in the event such interest is recharacterized by a court of competent jurisdiction as a security interest, the security interest in and Lien on, the Transferred Property purported to be conveyed hereby and thereby and in accordance with the terms hereof and thereof, and such conveyance of the Transferred Property constitutes and will constitute a valid sale of, or, if recharacterized as described above, a security interest in, and Lien on, such Transferred Property and the Collections in respect thereof, enforceable against the Hospital and all creditors of and purchasers from the Hospital prior to all sales or other assignments thereof. (f) No Obligor on the Purchased Receivables and other Transferred Property (including, without limitation, any insurance company or other third- party payor or guarantor of such Obligor obligated in respect of any such Purchased Receivables) is bankrupt, insolvent, undergoing composition or adjustment of debts or is unable to make payment of its obligations when due; provided that this representation shall not apply to any Governmental Authority which is an Obligor on Medicaid Receivables and which is currently insolvent but the Receivables of which would not be considered Uncollectible Receivables under clause (c) of the definition of Uncollectible Receivables (taking into account the proviso contained in such definition). (g) The Hospital is a qualified provider in respect of the Purchased Receivables of the Hospital constituting Governmental Receivables. (h) All amounts paid on each Governmental Receivable being purchased on any Purchase Date will be paid to the Hospital in accordance with all Requirements of Law either (i) in the Hospital's name to the Hospital Concentration Account in accordance with Section 4.3(m) or (ii) in the name of UHS, for the benefit of the Hospital, to the Master Receivables Account. (i) Each Non-governmental Receivable of the Hospital being purchased by Finco hereunder is not and will not be payable by an Obligor which is an agency or instrumentality of the federal government of the United States of America unless all applicable requirements of the Assignment of Claims Act of 1940, as amended, including the giving of all requisite notices of assignment to all Persons to whom such notices must be given and the acknowledgement of receipt thereof by all such Persons, have been complied with in all material respects and unless Finco shall have been provided with evidence thereof in form and substance satisfactory to it. (j) All accounting information relating to the Receivables of the Hospital which is provided to Finco hereunder shall be in accordance with the Hospital's accounting policies, including the Hospital's Credit and Collection Policy. (k) Each of the Purchased Receivables, other than any Excluded Receivable and any Self-pay Receivable, is and will be an Eligible Receivable on the Purchase Date for such Purchased Receivable. (l) Each of the Purchased Receivables originated by the Hospital shall at all times be separately identifiable from the Receivables, if any, repurchased by Finco in accordance with Section 4.4, and the Financible Receivables shall at all times be separately identifiable from those Purchased Receivables that are not Financible. Section 4.3. Additional Covenants of the Hospital. The Hospital covenants and agrees with Finco that so long as this Agreement shall remain in effect: (a) The Hospital will preserve and maintain its existence as a corporation or limited partnership, as the case may be, in good standing under the laws of the state of its incorporation or organization and its qualification as a foreign corporation or limited partnership where such qualification is required, except where any such failure or failures to so qualify would not, alone or in the aggregate, be material to the Hospital's performance of its obligations under the Hospital Documents. (b) The Hospital, as agent for the Servicer, will, at its own cost and expense, (i) retain a record of the Receivables generated by the Hospital and copies of all documents relating to each Receivable generated by the Hospital, (ii) mark such record to the effect that the Purchased Receivables generated by the Hospital listed thereon have been sold to Finco and (iii) take any actions necessary to remove reference thereto to Receivables that have been repurchased by it in accordance with the terms of this Agreement. (c) In any suit, proceeding or action brought by Finco for any sum owing with respect to any Receivable, the Hospital will save, indemnify and keep Finco harmless from and against all expense, loss or damage suffered by reason of any defense, set-off, counterclaim, recoupment or reduction of liability whatsoever under such Receivable and the related Transferred Property, in each case arising out of a breach by the Hospital of any obligation under such Receivable or the related Transferred Property or arising out of any other agreement, indebtedness or liability at any time owing to or in favor of any other Person from the Hospital, and all such obligations of the Hospital shall be and remain enforceable against and only against the Hospital and shall not be enforceable against Finco. (d) The Hospital will comply with all Requirements of Law which are applicable to the Purchased Receivables or any part thereof; provided, however, that the Hospital may contest any act, regulation, order, decree or direction in any manner which, in the reasonable opinion of Finco, shall not materially and adversely affect the rights of Finco in the Transferred Property. The Hospital will comply with the terms of its contracts with Obligors relating to Purchased Receivables except where any such non-compliance would not, alone or in the aggregate, reasonably be expected to have a material adverse effect on its ability to receive payments under any such contract. (e) The Hospital will not create, permit or suffer to exist, and will defend Finco's rights against, and take such other actions as are necessary to remove, any Lien on, claim in respect of or right to, the Transferred Property, and will defend the right, title and interest of Finco in and to the Transferred Property against the claims and demands of all Persons whomsoever, other than the Permitted Interests and will not otherwise enter into any agreement or execute any document or instrument or take any other action inconsistent with Finco's ownership of the Receivables and Transferred Property. (f) The Hospital will advise Finco promptly and in reasonable detail of (i) any Lien asserted or offset or claim made against any of the Transferred Property, (ii) the occurrence of any breach by the Hospital of any of its representations, warranties and covenants contained herein, (iii) the occurrence of any Exclusion Event or any other event which, with the giving of notice or lapse of time or both, would become an Exclusion Event and (iv) the occurrence of any event of which the Hospital has knowledge which would reasonably be expected to have a material adverse effect on (A) the business, operations, property or condition (financial or otherwise) of the UHS Entities taken as a whole, (B) the collectibility (other than as a result of the credit quality of any Obligor) or enforceability of the Purchased Receivables or the value of the Transferred Property or (C) the ability of the Hospital to perform its servicing obligations hereunder, (iv) the receipt from any Governmental Authority of a deficiency notice with respect to the Purchased Receivables, (v) the receipt by the Hospital from any Governmental Authority of a Deficiency Notice with respect to the Receivables originated by the Hospital, (vi) the receipt by the Hospital of any notice of preliminary or final determination resulting from any Audit relating to the Hospital or its Receivables. (g) Unless prohibited by any Requirement of Law including, without limitation, any applicable regulations of JCAHO and AOA, Finco and its employees, agents and representatives (A) shall at all times have full and free access during normal business hours to all the books, correspondence and records of the Hospital insofar as they relate to the Transferred Property and may examine the same, take extracts therefrom and make photocopies thereof, and the Hospital agrees to render to Finco (and its employees, agents and representatives), at the Hospital's cost and expense, such clerical and other assistance as may be reasonably requested with regard thereto and (B) may discuss the affairs, finances and accounts of the Hospital with, and be advised as to the same by, executive officers and independent accountants of the Hospital, all as Finco may reasonably deem appropriate for the purpose of verifying the accuracy of any reports or information delivered to Finco pursuant to this Agreement or for otherwise ascertaining compliance with this Agreement; provided, however, that Finco acknowledges that in exercising the rights and privileges conferred in this Section 4.3(g) Finco may, from time to time, obtain knowledge of information, practices, books, correspondence and records of a confidential nature and in which the Hospital has a proprietary interest; and provided, further, that the Hospital and Finco acknowledge that the Operative Documents and documents required to be filed by or on behalf of UHS and its Subsidiaries with the Securities and Exchange Commission and available to the public shall not be considered confidential for purposes of this Agreement (such confidential information, collectively, the "Information"). Finco agrees that the Information is to be regarded as confidential information and that the Information may be subject to laws, rules and regulations regarding patient confidentiality and agrees that subject to the following sentence, (i) it shall, and shall cause its employees, agents and representatives to, retain in confidence and not disclose without the prior written consent of the Hospital any or all of the Information and (ii) it will not, and will ensure that its employees, agents and representatives will not, make any use whatsoever (other than for the purposes contemplated by this Agreement, the Pooling Agreement, the other Operative Documents or for the enforcement of any of the rights granted hereunder or thereunder) of any of the Information without the prior written consent of the Hospital. Notwithstanding the foregoing, Finco may (x) disclose Information to any Person that has executed and delivered to the addressee thereof and UHS a confidentiality agreement, substantially in the form of Exhibit B with respect to the Information, or (y) disclose or use such Information (A) to the extent that such Information is required or appropriate in any reports, statement or testimony submitted to any municipal, state, or federal regulatory body having or claiming to have jurisdiction over Finco or the National Association of Insurance Commissioners or similar organizations or their successors, (B) to the extent such Information is required in response to any summons or subpoena or in connection with any litigation, (C) to the extent that such Information is believed by Finco to be required in order to comply with any law, order, regulation or ruling applicable to Finco, (D) to the extent that such information was publicly available or otherwise known to Finco at the time of disclosure (E) to the extent that such information subsequently becomes publicly available other than through any act or omission of Finco or (F) to the extent that such information subsequently becomes known to Finco other than through a person known to be acting in violation of his or its obligations to the Hospital. (h) The Hospital shall execute and file, at the Hospital's expense, such continuation statements and other documents relating to the Security Filings requested by Finco which may be required by law to fully preserve and protect the interest of Finco hereunder in and to the Transferred Property. (i) The Hospital will not, without providing 30 days' notice to Finco, and without filing such amendments to the Security Filings as Finco may require, (i) change the location of its place of business or the location of the offices where the records relating to the Receivables or the other Transferred Property are kept or (ii) change its name, identity or corporate structure in any manner which would, could or might make any Security Filing or continuation statement filed by the Hospital in accordance with Section 4.1(e) or Section 4.3(h) seriously misleading within the meaning of Section 9-402(7) of any applicable enactment of the UCC. (j) The Hospital shall (i) promptly instruct the Servicer to (A) notify Finco of any insurance provider or other third-party payor which becomes an Obligor after the Initial Closing Date pursuant to a written contract or arrangement which purports to prohibit the assignment of any rights of the Hospital under such contract or arrangement without the consent of such Obligor and (B) deliver or cause to be delivered to such Obligor a Notice of Assignment and receive a Confirmation in respect thereof as may be required by Finco or its counsel and (ii) comply with all other reasonable requests of Finco with respect to the Security Filings. (k) The Hospital shall not change the terms of the payor contracts and agreements relating to the Purchased Receivables and related Transferred Property or its normal policies and procedures with respect to the servicing thereof (including, without limitation, the amount and timing of finance charges, fees and write-offs) except such changes as are permitted under Section 3.1(e) of the Servicing Agreement. (l) The Hospital hereby acknowledges that UHS Delaware will initially be appointed as Servicer for Finco pursuant to the Servicing Agreement and that, pursuant to the Guarantee, UHS will guarantee the performance by UHS Delaware of all of its obligations as Servicer. (m) The Hospital hereby represents and covenants that it has (i) designated personnel and (ii) directed such personnel to deposit all Collections and proceeds thereof in respect of Purchased Receivables on each Business Day upon which Collections are received (or, if such Collections are received by the Hospital on a day which is not a Business Day, on the next Business Day) into the Hospital Concentration Account in accordance with Section 5.2. (n) Subject to Section 4.3(k), the Hospital will duly fulfill all obligations on its part to be fulfilled under or in connection with each Purchased Receivable and will do nothing to impair the rights of Finco in the Transferred Property. (o) Except for the purpose of collection in the ordinary course of business, the Hospital will not sell, discount or otherwise dispose of any Receivable of such Hospital except to Finco as provided hereunder. (p) All financial statements prepared by Finco or any Hospital and made available to any Person other than any UHS Entity shall indicate the sale to Finco of the Purchased Receivables and other Transferred Property. (q) The Hospital shall not terminate the Hospital Concentration Account or modify the conditions upon which such account was established, or establish any other Hospital Concentration Account unless (i) the Hospital has given Finco 10 days' prior written notice of such change and (ii) the Hospital, after such change, remains in full compliance with the terms of Article V. (r) The Hospital shall promptly instruct the Servicer to notify Finco on any date on which the Hospital becomes, applies to become or no longer remains a qualified provider in respect of Governmental Receivables. (s) The Hospital shall have filed, and shall have caused each of its Subsidiaries to file, all federal, state and local tax returns which are required to be filed, and shall have paid or caused to be paid all taxes as shown on said returns or any other taxes or assessments payable by it (other than any taxes or assessments the amount or validity of which are currently being contested in good faith by appropriate proceedings and with respect to which reserves in conformity with GAAP have been provided on the books of the Hospital or such Subsidiary and with respect to which collection has been stayed); and no tax Lien has been filed and, to the knowledge of the Hospital, no claims are being asserted with respect to any such taxes or assessments which could, alone or in the aggregate, reasonably be expected to have a material adverse effect on the rights of Finco hereunder or with respect to the Transferred Property. (t) The Hospital shall cause each contract entered into after the Initial Closing Date with any third-party payor in respect of Non-governmental Receivables to permit the assignment of payments thereunder pursuant to the terms of this Agreement and the other Operative Documents. The Hospital shall also cause each invoice delivered after the Initial Closing Date to each insurance carrier (including, without limitation, each invoice to be transmitted to the Obligor thereunder solely through electronic means) to include a notice that the amounts payable under such invoice have been assigned to Finco and its assignees, including the Trustee, and that future amounts payable by such insurance carrier will be so assigned. (u) The Hospital will take no action to cause any Purchased Receivable to be evidenced by any instrument (as defined in the UCC of the state in which the Hospital is located), except in connection with its enforcement or collection of such Receivable, in which event the Hospital shall deliver such instrument to Finco as soon as reasonably practicable but in no event more than five days after execution thereof. (v) The Hospital will not hold itself out, or permit itself to be held out by any other Person, as having agreed to pay, or as being liable for, any debt or liability of Finco. Section 4.4. Removal of Non-qualifying Receivables; Purchase Price Adjustments. (a) Subject to Section 4.4(b), the Hospital will notify each of the Servicer and Finco of the aggregate Outstanding Balances of those Receivables, if any, which were Non-qualifying Receivables as of the Purchase Date for such Receivables. All Non-qualifying Receivables generated by the Hospital and sold to Finco shall be repurchased by it on any Business Day (a "Repurchase Date") on which Finco shall so request. On the Repurchase Date, the Hospital shall make available to Finco by deposit in the Collateral Account in immediately available funds, or by deduction from the Purchase Price payable by Finco on such date, an amount equal to the acquisition price of each such Non-qualifying Receivable previously sold to Finco. Such acquisition price shall be equal to the Hospital Repurchase Price of such Non- qualifying Receivable as determined by the Servicer. Such payment or deduction of the Hospital Repurchase Price shall be considered a payment in full of each such Non-qualifying Receivable. On the date on which such amount is deposited in the Collateral Account or on which such deduction is made, Finco shall automatically and without further action be deemed to transfer, assign, set-over and otherwise convey to the Hospital, without recourse, representation or warranty, all the right, title and interest of Finco in and to such Non-qualifying Receivables, all monies due or to become due with respect thereto, and all proceeds thereof. Finco shall execute such documents and instruments of transfer or assignment and take such other actions as shall reasonably be requested by the Hospital to effect the conveyance of such Non- qualifying Receivables repurchased pursuant to this Section 4.4. (b) Notwithstanding anything to the contrary in this Section 4.4, the Hospital's obligation in respect of Receivables which are Non-qualifying Receivables solely because the Applicable Contractual Adjustment on the related Purchase Date was less than the Actual Contractual Adjustment shall be to make available to Finco, by deposit in the Collateral Account in immediately available funds, or by deduction from the Purchase Price payable on such date, an amount equal to the difference between the Applicable Contractual Adjustment as calculated on the Purchase Date and the Actual Contractual Adjustment, and such Receivable shall not be repurchased by or transferred to the Hospital from Finco. The deposit or deduction referred to in the immediately preceding sentence shall be made by the Hospital (i) in the case of any Receivable designated as a Financible Receivable on the Payment Date therefor, on any Business Day that Finco shall request and (ii) in the case of any Purchased Receivable that was not designated as a Financible Receivable on the Payment Date therefor, on the Settlement Date next succeeding the Purchase Date for such Receivable. Section 4.5. Representations and Warranties of Finco. Finco represents and warrants to the Hospital that, as of the Initial Closing Date and as of each Purchase Date and each related Payment Date: (a) Finco has been duly organized and is validly existing and in good standing as a corporation under the laws of the State of Delaware, with full corporate power and authority to own its properties and to transact the business in which it is now engaged or in which it proposes to engage. (b) The purchase by Finco of the Purchased Receivables pursuant to this Agreement and the consummation of the transactions herein contemplated will not conflict with, or result in a breach of any of the terms or provisions of, or constitute a default under, any indenture, mortgage, deed of trust, lease, loan agreement or other agreement, instrument or undertaking to which Finco is a party or by which it is bound or to which any of the property or assets of Finco is subject, nor will such action result in any violation of any applicable Requirement of Law; and no consent, approval, authorization, order, registration or qualification of or with any Governmental Authority is required for the purchase by Finco of the Purchased Receivables hereunder except such as have been obtained. (c) This Agreement has been duly authorized, executed and delivered by Finco and constitutes the valid and legally binding obligation of Finco, enforceable against Finco in accordance with its terms, subject as to enforceability to applicable bankruptcy, reorganization, insolvency, moratorium or other similar laws affecting creditors' rights generally, and to general principles of equity (regardless of whether enforcement is sought in a proceeding in equity or at law). ARTICLE V ADMINISTRATION AND COLLECTIONS Section 5.1. Servicing. (a) In further consideration for Finco entering into this Agreement with the Hospital, the Hospital agrees that it shall undertake such obligations in connection with the servicing of the Receivables as shall be delegated to it by the Servicer. In this connection, the Hospital covenants and agrees that it will comply with all the agreements made by the Servicer, and shall perform all the obligations undertaken by the Servicer in Article III of the Servicing Agreement with respect to the Purchased Receivables of such Hospital as if such agreements were set forth herein as covenants of the Hospital and as if such obligations were directly undertaken by the Hospital. (b) In furtherance of Section 5.1(a), the Hospital agrees that it will, in a timely manner, provide the Servicer with all information regarding itself and its Receivables and other Transferred Property necessary for the Servicer or that the Servicer has requested. (c) The obligation of the Hospital to service the Receivables of the Hospital is personal to the Hospital and the parties recognize that it would be difficult for any other Person to perform such obligations. Accordingly, the Hospital's obligation to service the Receivables of the Hospital hereunder shall, to the extent permitted by applicable law, be specifically enforceable and shall be absolute and unconditional in all circumstances, including, without limitation, after the occurrence and during the continuation of any Exclusion Event. (d) The Hospital shall not resign from the obligations and duties hereby imposed on it as servicer of the Receivables of the Hospital. Section 5.2. Collections. (a) All Collections on account of Non- governmental Receivables sold to Finco shall be deposited directly into the Hospital Concentration Account or the Master Receivables Account on the date of receipt thereof by the Hospital or the Servicer. The Hospital agrees to require all Obligors in respect of Non-Governmental Receivables who make payment in the form of electronic or wire transfers to make such payments directly to the Master Receivables Account. All such Collections on account of Non-governmental Receivables will be held in trust by the Hospital for the benefit of Finco pending remittance to the Collateral Account. All Collections on Non-governmental Receivables received by Finco or any of its direct or indirect assignees shall be transferred by Finco or such assignee to the Trustee for deposit in the Collateral Account. (b) All Collections received by the Hospital or the Servicer on account of Governmental Receivables sold to Finco shall be deposited directly into the Hospital Concentration Account on the date of receipt thereof. The Hospital agrees to require all Obligors in respect of Governmental Receivables who make payment in the form of electronic or wire transfers to UHS, for the benefit of the Hospital, to make such payments directly to the Master Receivables Account. Except as provided in the preceding sentence, all Collections on Governmental Receivables received by Finco or any of its direct or indirect assignees shall be transferred to the Hospital payee for deposit into the Hospital Concentration Account or the Master Receivables Account. (c) In no event shall the Hospital deposit any Collections into any account established, held or maintained by the Hospital or any other Person other than the Hospital Concentration Account or the Master Receivables Account or transfer such Collections other than in accordance with the provisions of this Agreement. The Hospital and Finco hereby agree that all available funds received in the Hospital Concentration Account shall be transferred within one Business Day of receipt to the Master Receivables Account. Amounts so transferred from the Hospital Concentration Account or otherwise received in the Master Receivables Account prior to the close of business on any Business Day shall be transferred at the close of business on such Business Day to the Collateral Account. Amounts received in the Master Receivables Account after the close of business on any Business Day or on any day which is not a Business Day shall be transferred to the Collateral Account on the next succeeding day. Amounts transferred to the Collateral Account shall be applied in accordance with Article VII of the Pooling Agreement. Section 5.3. Hospital's Obligations as Agent for the Servicer. The Hospital and Finco expressly agree that the obligations of the Hospital under Sections 5.1 and 5.2 hereof have been undertaken by the Hospital, to the extent permitted by all Requirements of Law, solely as agent for Finco and the Servicer and the Hospital hereby disavows any other interest in such Collections or in any such funds collected on behalf of Finco or the Servicer or transferred by the Hospital for deposit pursuant to this Article V. Section 5.4. Claims Against Third Parties. The Hospital agrees that it will continue to make and pursue claims on the Purchased Receivables to the extent that any Requirement of Law or contractual provision requires the Hospital to directly make and pursue such claims; provided that the Hospital agrees that it is making and pursuing such claims for the benefit of Finco, and that any funds received by the Hospital based on such claims will be transferred in accordance with Section 5.2. Section 5.5. Hospital Concentration Account. (a) The Hospital has, prior to the execution and delivery of this Agreement, established a deposit account with the Hospital's banking institution in the sole name of the Hospital and for the benefit of the Hospital (such account, the "Hospital Concentration Account") into which all Collections are to be deposited by the Hospital by the close of business on each Business Day received, or on the next Business Day if not received on a Business Day. The name, location and account number of the Hospital Concentration Account is set forth on Schedule V to this Agreement. The Hospital Concentration Account shall be maintained with documentation and instructions in form and substance satisfactory to Finco. Available amounts received in the Hospital Concentration Account in respect of Collections shall be transferred within one Business Day to the Collateral Account. The Hospital shall not (i) without 10 days' prior written notice to Finco, change the Hospital Concentration Account or establish any additional Hospital Concentration Account or (ii) change such instructions or documentation at any time so long as Finco or any of its direct or indirect assignees has any interest in the Hospital's Receivables. (b) The Hospital agrees that it shall use its best efforts to ensure that only Collections on Purchased Receivables are deposited into the Hospital Concentration Account and the Master Receivables Account. Finco agrees that, promptly following the establishment to the satisfaction of the Hospital that any funds received in the Hospital Concentration Account or the Master Receivables Account do not constitute Collections on Purchased Receivables, including any payments on Receivables which have been reassigned to the Hospital and any payments to the Hospital not in respect of Receivables, Finco shall remit such funds to the Hospital in immediately available funds. In the event that the Hospital is unable to determine whether funds received by the Hospital or the Servicer constitute Collections on Purchased Receivables, such funds shall be deposited in the Hospital Concentration Account and applied in accordance with Section 5.2. ARTICLE VI TERMINATION OF PURCHASE COMMITMENT Section 6.1. Exclusion Events. If any of the following events occur (any such event, an "Exclusion Event"), Finco may give notice thereof pursuant to Section 6.2, and Finco may exercise the remedies available to it pursuant to Section 6.2: (a) the Hospital shall fail to make any payment to be made by it to any party to any of the Operative Documents when due; or the Hospital shall fail to perform or observe any term, covenant or agreement contained in Sections 4.3(e) through 4.3(i), Section 4.3(k), Sections 4.3(o) through 4.3(r) or Section 7.2 of this Agreement; (b) the Hospital shall default in the performance of any agreement or undertaking hereunder (other than as provided in clause (a) above) and such default shall continue for 30 days after written notice thereof has been given to the Hospital by Finco; or (c) any representation or warranty made by the Hospital in any Hospital Document to which it is a party or in any certificate or financial or other statement furnished pursuant to the terms of any Operative Document (other than as provided in clauses (a) or (b) above) shall prove to have been untrue or incomplete in any material respect when made or deemed made and the Hospital shall fail to cure such breach of representation, warranty or other statement within 15 days after written notice thereof has been given to the Hospital by Finco; provided, however, that no breach of any representation or warranty made by the Hospital under Section 4.2 as to any Receivable on the related Purchase Date shall constitute an "Exclusion Event" hereunder if the Hospital cures such breach in accordance with the terms of Section 4.4 of this Agreement; or (d) (i) the Hospital shall (A) apply for or consent to the appointment of a receiver, trustee, liquidator or custodian or the like of itself or of its property, (B) admit in writing its inability to pay its debts generally as they become due, (C) make a general assignment for the benefit of creditors, (D) be adjudicated a bankrupt or insolvent or (E) commence a voluntary case under the federal bankruptcy laws of the United States of America or file a voluntary petition or answer seeking reorganization, an arrangement with creditors or an order for relief or seek to take advantage of any insolvency law or file an answer admitting the material allegations of a petition filed against it in any bankruptcy, reorganization or insolvency proceeding or take any corporate action for the purpose of effecting any of the foregoing; or (ii) without the application, approval or consent of the Hospital, a proceeding shall be instituted in any court of competent jurisdiction under any law relating to bankruptcy, insolvency, reorganization or relief of debtors, seeking in respect of the Hospital, an order for relief or an adjudication in bankruptcy, reorganization, dissolution, winding up or liquidation, a composition or arrangement with creditors, a readjustment of debts, the appointment of a trustee, receiver, liquidator or custodian or the like of the Hospital or of all or any substantial part of the Hospital's assets, or other like relief in respect thereof under any bankruptcy or insolvency law, and, if such proceeding is being contested by the Hospital in good faith, the same shall (A) result in the entry of an order for relief or any such adjudication or appointment or (B) continue undismissed, or pending and unstayed, for any period of sixty (60) consecutive days; or (e) (i) obligations of the Hospital or any of its Subsidiaries in respect of Debt in excess of $1,000,000 in the aggregate shall be declared to be or shall become due and payable prior to the stated maturity thereof, (ii) principal payments in excess of $1,000,000 in the aggregate in respect of any Debt of the Hospital shall not be paid when due or (iii) any judgment or judgments for the payment of money in an aggregate amount in excess of $500,000 shall have been rendered against the Hospital and the same shall have remained unsatisfied and in effect for any period of 30 consecutive days during which no stay of execution shall have been obtained; or (f) there shall have occurred an Early Amortization Event; or (g) UHS shall cease to (i) have the power to control the board of directors or other managing body of the Hospital, (ii) operate the Hospital, (iii) own, directly or indirectly, through one or more wholly-owned Subsidiaries, at least sixty percent (60%) of the outstanding capital stock or other ownership interests of the Hospital, (iv) any such capital stock or ownership interests shall be subject to any Lien, charge, pledge or encumbrance (other than (A) Liens for taxes which are not then due and payable or which are being contested in good faith through appropriate proceedings and with respect to which reserves in conformity with GAAP have been provided on the books of the Hospital or (B) any Lien of any Financial institution securing Debt of UHS and its subsidiaries) or (v) any pledgee of any such stock of the Hospital pledged as collateral pursuant to clause (ii) shall take any action to realize upon such collateral; or (h) (i) the Hospital or any Commonly Controlled Entity shall engage in any Prohibited Transaction (as defined in Section 406 of ERISA or Section 4975 of the Code) involving any Plan, (ii) any "accumulated funding deficiency" (as defined in Section 302 of ERISA), whether or not waived, shall exist with respect to any Plan, (iii) a Reportable Event shall occur with respect to, or proceedings shall commence to have a trustee appointed, or a trustee shall be appointed, to administer or to terminate, any Single Employer Plan, which Reportable Event or commencement of proceedings or appointment or a trustee is, in the reasonable opinion of Finco, likely to result in the termination of such Plan for purposes of Title IV of ERISA, (iv) any Single Employer Plan shall terminate for purposes of Title IV of ERISA, (v) the Hospital or any Commonly Controlled Entity shall, or in the reasonable opinion of Finco is likely to, incur any liability in connection with a withdrawal from, or the Insolvency or Reorganization of, a Multiemployer Plan or (vi) any other event or condition shall occur or exist, with respect to a Plan; and in each case in clauses (i) through (vi) above, such event or condition, together with all other such events or conditions, if any, could subject the Hospital or any of its Subsidiaries, to any tax, penalty or other liabilities in the aggregate material in relation to the business, operations, property or financial or other condition of the UHS Entities taken as a whole; or (i) there shall have occurred any other circumstance which could, in the sole judgement of Finco have a material adverse impact on the validity or enforceability of this Agreement or any Operative Document or on the enforceability or collectibility (other than as a result of the credit quality of any Obligor) of the Purchased Receivables or the value of the related Transferred Property; or (j) a Voluntary Exclusion Event with respect to the Hospital shall have occurred. Section 6.2. Remedies. (a) If any Exclusion Event shall have occurred and be continuing, Finco, by notice in writing given to the Hospital, may do any or all of the following: (i) continue to purchase Receivables in accordance with this Agreement except that Finco shall only pay for Purchased Receivables with Subordinated Notes, (ii) notify the Servicer that such Purchased Receivables are Excluded Receivables or (iii) cease purchasing Receivables from the Excluded Hospital, and the Excluded Hospital hereby agrees to any and all such remedies taken by Finco; provided, however that if an Exclusion Event described in Section 6.1(d) shall have occurred and be continuing, then the obligation of Finco to acquire Receivables shall immediately terminate without written notice and without presentment, demand, protest, notice of protest or dishonor or any other notice of any other kind, all of which are hereby expressly waived by the Hospital. (b) If an Exclusion Event described in Section 6.1(d) shall have occurred or if Finco ceases to acquire Receivables from the Hospital pursuant to Section 6.2(a)(iii), then the obligation of the Hospital to continue to sell Receivables to Finco shall also immediately terminate and all Collections thereafter received from each Obligor in respect of the Purchased Receivables for which such Obligor is obligated to make payments shall be applied to the Purchased Receivables to which such payments relate. (c) Notwithstanding the occurrence of any Exclusion Event and the remedies elected by Finco in respect thereof, if the Hospital thereafter (i) cures all Exclusion Events at such time continuing and (ii) complies, in the sole judgment of Finco, with all of the terms and conditions of this Agreement for a period of 60 consecutive days during which no Exclusion Event shall have occurred, then, upon the Hospital's provision of all documentation required, in the sole judgment of Finco, to demonstrate such compliance, the Hospital shall cease to be an Excluded Hospital and Finco shall resume purchasing Receivables from the Hospital in accordance with the terms of this Agreement; provided, however, that in no event shall any Receivables which were Excluded Receivables be deemed to be Eligible Receivables. (d) If for any reason (i) the transfer of the Transferred Property is not considered a sale and (ii) an Exclusion Event shall have occurred, in addition to all other rights and remedies granted to it under this Agreement and in any other instrument or agreement securing, evidencing or relating to the rights and remedies hereunder, and by operation of law, Finco shall have all rights and remedies of a secured party under the UCC (and under any other applicable law). Without limiting the generality of the foregoing, and subject to the provisions of Section 8.9 and to the terms and conditions of the Pooling Agreement, Finco, without demand of performance or other demand, presentment, protest, advertisement or notice of any kind (except any notice required by law referred to below) to or upon the Hospital or any other Person (all and each of which demands, defenses, advertisements and notices are hereby waived to the extent permitted by applicable law), may in such circumstances forthwith collect, receive, appropriate and realize upon the Transferred Property, or any part thereof, and/or may forthwith sell, lease, assign, give option or options to purchase, or otherwise dispose of and deliver the Transferred Property or any part thereof (or contract to do any of the foregoing), in one or more parcels at public or private sale or sales, at any exchange, broker's board or office of Finco or elsewhere upon such terms and conditions as it may deem advisable and at such prices as it may deem best, for cash or on credit or for future delivery without assumption of any credit risk. To the extent permitted by applicable law, the Hospital waives all claims, damages and demands it may acquire against each of Finco, its direct and indirect assignees and each of their respective directors, officers, employees and Affiliates arising out of the exercise by any of them of any rights under this Section 6.2(d). If any notice of a proposed sale or other disposition of the Transferred Property shall be required by law, such notice shall be deemed reasonable and proper if given at least 10 days before such sale or other disposition. (e) Notwithstanding any Exclusion Event, Finco shall continue to maintain its interest in all Purchased Receivables. Subject to Section 4.4, all amounts received as payments on Purchased Receivables will continue to be paid by the Hospital to Finco for application in accordance with Article V. In the event that the Hospital shall, after any Exclusion Event, receive payments from any Obligor which is an Obligor with respect to both Purchased Receivables and Receivables not purchased under this Agreement, to the extent that the Servicer is unable to determine the specific Receivables to which such payments relate, the Hospital shall apply all such amounts first to the Outstanding Balance of such Obligor's Purchased Receivables, in the order such Purchased Receivables were created, until such Purchased Receivables have been paid in full. ARTICLE VII INDEMNIFICATION AND EXPENSES Section 7.1. Indemnities by the Hospital. Without limiting any other rights which Finco may have hereunder or under applicable law, the Hospital hereby agrees to indemnify each of Finco, its direct and indirect assignees and each of their respective officers, directors, employees and Affiliates (collectively, the "Indemnified Parties") from and against any and all damages, losses (other than loss of profit), claims, actions, suits, judgments, demands, taxes, liabilities (including liabilities for penalties) and out-of-pocket costs and expenses, including without limitation, reasonable attorneys' fees and expenses but excluding costs and expenses attributable to administrative overhead (all of the foregoing being collectively referred to as "Indemnified Amounts"), awarded against or incurred by any of them arising out of or as a result of this Agreement, the other Hospital Documents or Finco's ownership of any Transferred Property or its assignment thereof pursuant to Section 8.9, excluding, however, Indemnified Amounts resulting from gross negligence or willful misconduct on the part of the Indemnified Party to which such Indemnified Amounts would otherwise be due. Without limiting the generality of the foregoing, the Hospital shall indemnify the Indemnified Parties for Indemnified Amounts relating to or resulting from: (i) the transfer of any Non-qualifying Receivable; (ii) any set-off or adjustment applied by any Obligor against any Non-governmental Receivable conveyed to Finco whether or not the amount of such set-off or adjustment was reflected in the Offset Reserves on the Purchase Date relating to such Purchased Receivable; (iii) reliance on any representation or warranty made by the Hospital (or any of its Authorized Officers) under or in connection with this Agreement, and any information or report delivered by the Hospital pursuant hereto, which shall have been false or incorrect in any material respect when made or deemed made; (iv) the failure by the Hospital to comply with any Requirement of Law with respect to any Purchased Receivable or the related Transferred Property, or the nonconformity of any Purchased Receivable or the related Transferred Property with any Requirement of Law; (v) the failure to take all actions which would be required to maintain in favor of Finco a valid, perfected, first priority security interest in and Lien on the Purchased Receivables and related Transferred Property, together with all Collections and Outstanding Balances related to such Receivables, free and clear of any Lien whether existing at the Initial Closing Date or at any time thereafter; (vi) the failure to file, record, deliver or receive in a timely manner all Security Filings, including without limitation, financing statements or other similar instruments or documents required under the UCC in effect in the state in which the Hospital's place of business is located or under other applicable laws with respect to any Purchased Receivables; (vii) any failure of the Hospital to perform its duties or obligations in accordance with the provisions of this Agreement or the other Hospital Documents; or (viii) the administration or enforcement of this Agreement by Finco or any of its direct or indirect assignees. Section 7.2. Audits of Hospital, Etc. (a) The Hospital shall immediately, but in no event later than five Business Days thereafter, notify Finco (i) of any Deficiency Notice received by it and (ii) of any preliminary or final determination resulting from any audit relating to it or the Receivables generated by it (including, without limitation, any "audit exception" to such determination), or any other investigation, by HHS or any other Governmental Authority or any intermediary thereof (any of the preceding, an "Audit"). (b) If, as a result of any Audit, any Governmental Authority or any intermediary thereof determines that the Hospital shall owe any amounts, (i) to the extent possible, the Hospital shall not permit any claims or adjustments resulting from the Audit to be applied as set-offs or adjustments to the Purchased Receivables and (ii) to the extent any claims or adjustments resulting from any Audit are applied against any Purchased Receivables, the Hospital shall immediately pay to the Hospital Concentration Account the amount so set-off or adjusted as Collections in respect of the Purchased Receivables. ARTICLE VIII MISCELLANEOUS Section 8.1. Notices, Etc. Except where telephonic instructions or notices are authorized herein to be given, all notices, demands, instructions and other communications required or permitted to be given to or made upon any party hereto shall be in writing and shall be personally delivered or sent by registered, certified or express mail, postage prepaid, return receipt requested, or by telecopy (with voice confirmation thereof) or telegram (with messenger delivery specified in the case of a telegram) and shall be deemed to be given when such personal delivery is made or such return receipt or confirmation is received by the party giving such notice, demand, instruction or communication. Unless otherwise specified in a notice sent or delivered in accordance with the foregoing provisions of this Section, notices, demands, instructions and other communications in writing shall be given to or made upon the respective parties hereto at their respective addresses (or to their respective telecopy numbers) indicated below, and, in the case of telephonic instructions or notices, by calling the telephone number or numbers indicated for such party below: If to the Hospital: At the location set forth in Schedule I hereto. If to Finco: UHS Receivables Corp. 27292 Calle Arroyo, Suite B San Juan Capistrano, California 92675 Attention: President Tel. No.: 714-661-9323 Telecopier No.: 714-661-9445 With a copy to: UHS Receivables Corp. c/o Universal Health Services, Inc. Universal Corporate Center 367 South Gulph Road King of Prussia, Pennsylvania 19406 Attention: General Counsel Tel. No.: 215-768-3300 Telecopier No.: 215-768-3318 Section 8.2. Successors and Assigns. This Agreement shall be binding upon the Hospital and Finco and their respective successors and assigns and shall inure to the benefit of the Hospital and Finco and their respective successors and assigns; provided that the Hospital shall not assign any of its rights or obligations hereunder without the prior written consent of Finco. Except as expressly permitted hereunder or in the other Operative Documents, Finco shall not assign any of its rights or obligations hereunder without the prior written consent of the Trustee. Section 8.3. Severability. Any provisions of this Agreement which are prohibited or unenforceable in any jurisdiction shall, as to such jurisdiction, be ineffective to the extent of such prohibition or unenforceability without invalidating the remaining provisions hereof, and any such prohibition or unenforceability in any jurisdiction shall not invalidate or render unenforceable such provision in any other jurisdiction. Section 8.4. Amendments. This Agreement may not be modified, amended, waived, supplemented or surrendered except pursuant to a written instrument executed by the Hospital and Finco, and then such amendment, supplement, waiver or consent shall be effective only in the specific instance and for the specific purpose given. If any amendment, modification, supplement or waiver shall be so consented to by Finco, the Hospital agrees, promptly following a request by Finco, to execute and deliver in its own name and at its own expense, such instruments, consents and other documents as Finco may deem necessary or appropriate in the circumstances. Notwithstanding anything in this Section 8.4, no amendment shall be entered into if such amendment would, in the aggregate, adversely affect the interests of Finco. Section 8.5. The Hospital's Obligations. It is expressly agreed that, anything contained in this Agreement to the contrary notwithstanding, the Hospital shall be obligated to perform all of its obligations under the Receivables to the same extent as if Finco had no interest therein and Finco shall have no obligations or liability under the Receivables or the Transferred Property to any Obligor thereunder by reason of or arising out of this Agreement, nor shall Finco be required or obligated in any manner to perform or fulfill any of the obligations of the Hospital under or pursuant to any Receivables. Section 8.6. No Recourse. (a) No directors, officers, employees or agents of the Hospital shall be under any liability to Finco or any other Person for any action of the Hospital hereunder pursuant to this Agreement; provided, however, that this provision shall not protect the Hospital or any such Person against any liability which would otherwise be imposed by reason of willful misfeasance, bad faith or gross negligence in the performance of duties or by reason of reckless disregard of obligations and duties hereunder. (b) Except as expressly provided in this Agreement, the Hospital shall have no liability for the payment of the Purchased Receivables in excess of the Collections and amounts deemed Collections on all Purchased Receivables. The preceding sentence shall not relieve the Hospital or UHS from any obligations hereunder or under the Guarantee with respect to its respective representations, warranties, covenants and other payment and performance obligations herein or therein described. Section 8.7. Further Assurances. The Hospital agrees to do such further acts and things and to execute and deliver to Finco such additional assignments, agreements, powers and instruments as are required by Finco to carry into effect the purposes of this Agreement or to better assure and confirm unto Finco its rights, powers and remedies hereunder. Section 8.8. Survival. Notwithstanding any termination of this Agreement (whether on account of an Exclusion Event or otherwise) and subject to Section 6.2, and without limiting the survival of any other obligation of the Hospital or Finco hereunder, (i) all representations and warranties of the Hospital and Finco shall survive the execution and delivery of this Agreement, (ii) all of the rights and obligations of the parties (A) under Article VII, shall survive such termination and (B) under any other provision hereof, shall survive such termination as long as any Purchased Receivable is an Outstanding Receivable and (iii) the Hospital shall continue to be obligated to do all things necessary to collect on all Uncollectible Receivables and to apply Collections that it receives with respect thereto in the manner provided in this Agreement and to perform its obligations hereunder with respect thereto. Section 8.9. Consent to Assignment; Third Party Beneficiaries. (a) The Hospital acknowledges that all of Finco's right, title and interest in (i) the Purchased Receivables and related Transferred Property and (ii) the obligations of the Hospital to Finco and the rights of Finco against the Hospital under this Agreement with respect to the Transferred Property have been assigned, transferred and otherwise conveyed by Finco to the Trustee, for the benefit of the Participants, pursuant to the terms and conditions of the Pooling Agreement. It is understood, agreed and acknowledged that Sheffield shall assign to the Liquidity Agent, for the benefit of the Liquidity Banks, all of Sheffield's right, title and interest in, to and under this Agreement and in the Transferred Property. The Hospital consents to such assignment by Finco to the Trustee, and by Sheffield to the Liquidity Agent, and agrees that the Trustee and the Participants (or upon notice by Sheffield or the Liquidity Agent of a default under the Liquidity Agreement or the Security Agreement, and to the extent provided in the Pooling Agreement, the TRIPS Holders and the Liquidity Agent) shall be entitled to enforce the terms of this Agreement and the rights and responsibilities of Finco directly against the Hospital, whether or not any Early Amortization Event or Exclusion Event shall have occurred. The Hospital further agrees that (i) it will not take any action in connection with the Receivables or which could affect the rights of Finco hereunder (other than those actions which are consistent with its obligations hereunder and which occur in the normal course of its operations) without the prior consent of the Trustee or the Participants (or the TRIPs Holders and the Liquidity Agent, as the case may be) and (ii) in respect of its obligations hereunder, the Hospital will act at the direction of and in accordance with all requests and instructions from the Trustee or the Participants (or the TRIPs Holders and the Liquidity Agent, as the case may be). The Hospital and Finco hereby agree that, in the event of any conflict of requests or instructions to the Hospital between Finco on the one hand, and the Trustee or the Participants (or the TRIPs Holders and the Liquidity Agent, as the case may be) on the other hand, the Hospital will at all times act in accordance with the requests and instructions of the Trustee or the Participants (or the TRIPs Holders and the Liquidity Agent, as the case may be), and in the event of any conflict of requests or instructions among Participants, Finco shall act in accordance with the instructions of the Trustee. The Hospital and Finco further agree that, in the event of any conflict of requests or instructions to the Hospital between Sheffield on the one hand and the Liquidity Agent on the other hand, the Hospital will at all times act in accordance with the requests and instructions of the Liquidity Agent. (b) Notwithstanding anything in Section 8.9(a) to the contrary, and without limitation upon the rights and obligations of the parties set forth in such Section, each of the Interested Parties shall have the rights of third- party beneficiaries hereunder. (c) Each of Finco and the Hospital acknowledges that Sheffield has appointed Barclays to act as Managing Agent. Unless otherwise instructed by Sheffield, copies of all notices, requests, demands and other documents to be delivered to Sheffield pursuant to the terms hereof shall be delivered to the Managing Agent. Unless otherwise instructed by Sheffield, all notices, requests, demands and other documents to be executed or delivered, and any action to be taken, by Sheffield pursuant to the terms hereof may be executed, delivered and/or taken by the Managing Agent. The rights and responsibilities of the Managing Agent under this Agreement with respect to any action taken by the Managing Agent or the exercise or non-exercise by the Managing Agent of any option, right, request, judgment or other right or remedy provided to Sheffield herein or resulting or arising out of this Agreement shall, as between the Managing Agent and Sheffield be governed by such agreements with respect thereto as may exist from time to time between them, but, as between the Managing Agent and the Hospital, the Managing Agent shall be conclusively presumed to be acting as agent for Sheffield with full and valid authority so to act or refrain from acting, and neither Finco nor the Hospital shall be under any obligation or entitlement to make any inquiry respecting such authority. Section 8.10. Counterparts. This Agreement may be executed by the Hospital and Finco on the same or separate counterparts, each of which shall be deemed to be an original instrument. Section 8.11. Headings. Section headings used in this Agreement are for convenience of reference only and shall not affect the construction or interpretation of this Agreement. Section 8.12. No Bankruptcy Petition Against Finco or Sheffield. The Hospital covenants and agrees that prior to the date which is one year and one day after the Aggregate Capital is reduced to zero and all other amounts due under or in connection with the Operative Documents are paid in full it will not institute against, or join any other Person in instituting against, Finco or Sheffield any bankruptcy, reorganization, arrangement, insolvency or liquidation proceedings, or other proceedings under any federal or state bankruptcy or similar law. Section 8.13. Finco May Act Through Agents. Finco may exercise any of its rights or perform any of its duties hereunder through agents of its choosing, and any action so taken shall have the same force and effect as if taken by Finco directly. Section 8.14. GOVERNING LAW. THIS AGREEMENT SHALL BE GOVERNED BY, AND CONSTRUED AND INTERPRETED IN ACCORDANCE WITH, THE INTERNAL LAW OF THE STATE OF NEW YORK WITHOUT REFERENCE TO CONFLICTS OF LAW RULES OF THE STATE OF NEW YORK; PROVIDED THAT ALL MATTERS RELATING TO THE PERFECTION AND PRIORITY OF THE OWNERSHIP OR SECURITY INTEREST GRANTED HEREIN IN THE RECEIVABLES AND TRANSFERRED PROPERTY OF THE HOSPITAL SHALL BE GOVERNED BY, AND CONSTRUED AND INTERPRETED IN ACCORDANCE WITH, THE LAWS OF THE STATE WHERE THE HOSPITAL IS LOCATED. Section 8.15. No Waiver; Cumulative Remedies. No failure to exercise and no delay in exercising, on the part of Finco, any right, remedy, power or privilege hereunder, shall operate as a waiver thereof; nor shall any single or partial exercise of any right, remedy, power or privilege hereunder preclude any other or further exercise thereof or the exercise of any other right, remedy, power or privilege. The rights, remedies, powers and privileges herein provided are cumulative and not exhaustive of any rights, remedies, powers and privileges provided by law. Section 8.16. SUBMISSION TO JURISDICTION; VENUE; WAIVER OF JURY TRIAL; SERVICE OF PROCESS. (a) THE HOSPITAL (FOR ITSELF AND ITS RESPECTIVE SUCCESSORS AND ASSIGNS) HEREBY IRREVOCABLY SUBMITS, FOR ITSELF AND ITS PROPERTY, TO THE JURISDICTION OF THE STATE COURTS OF THE STATE OF NEW YORK AND TO THE JURISDICTION OF THE UNITED STATES DISTRICT COURT FOR THE SOUTHERN DISTRICT OF NEW YORK, FOR THE PURPOSES OF ANY SUIT, ACTION OR OTHER PROCEEDING ARISING OUT OF OR BASED UPON THIS AGREEMENT, THE OTHER HOSPITAL DOCUMENTS OR THE SUBJECT MATTER HEREOF OR THEREOF BROUGHT BY FINCO OR ANY OF ITS DIRECT OR INDIRECT ASSIGNEES. THE HOSPITAL (FOR ITSELF AND ITS RESPECTIVE SUCCESSORS AND ASSIGNS), TO THE EXTENT PERMITTED BY ANY REQUIREMENTS OF LAW, HEREBY (A) WAIVES, AND AGREES NOT TO ASSERT, BY WAY OF MOTION, AS A DEFENSE, OR OTHERWISE, IN ANY SUCH SUIT, ACTION OR PROCEEDING BROUGHT IN ANY SUCH COURT, ANY CLAIM THAT IT IS NOT SUBJECT PERSONALLY TO THE JURISDICTION OF THE ABOVE- NAMED COURTS, THAT ITS PROPERTY IS EXEMPT OR IMMUNE FROM ATTACHMENT OR EXECUTION, THAT THE SUIT, ACTION OR PROCEEDING IS BROUGHT IN AN INCONVENIENT FORUM, THAT THE VENUE OF THE SUIT, ACTION OR PROCEEDING IS IMPROPER OR THAT THIS AGREEMENT OR THE OTHER HOSPITAL DOCUMENTS OR THE SUBJECT MATTER HEREOF OR THEREOF MAY NOT BE ENFORCED IN OR BY SUCH COURT AND (B) WAIVES THE RIGHT TO ASSERT IN ANY SUCH ACTION, SUIT OR PROCEEDING ANY SET-OFFS OR COUNTERCLAIMS EXCEPT COUNTERCLAIMS THAT ARE COMPULSORY OR OTHERWISE ARISE FROM THE SAME SUBJECT MATTER. THE HOSPITAL HEREBY AGREES THAT SERVICE OF PROCESS AND OTHER DOCUMENTS ON THE HOSPITAL MAY BE EFFECTED BY CERTIFIED OR REGISTERED MAIL (OR ANY SUBSTANTIALLY SIMILAR FORM OF MAIL) TO ITS ADDRESS AS SET FORTH ON SCHEDULE I AND SUCH SERVICE SHALL CONSTITUTE VALID AND EFFECTIVE SERVICE AGAINST THE HOSPITAL. THE HOSPITAL AGREES THAT ITS SUBMISSION TO JURISDICTION AND CONSENT TO SERVICE OF PROCESS BY MAIL IN ANY SUCH ACTION, SUIT OR PROCEEDING SHALL BE CONCLUSIVE, AND MAY BE ENFORCED IN ANY OTHER JURISDICTION (A) BY SUIT, ACTION OR PROCEEDING ON THE JUDGMENT, A CERTIFIED OR TRUE COPY OF WHICH SHALL BE CONCLUSIVE EVIDENCE OF THE FACT AND THE AMOUNT OF INDEBTEDNESS OR LIABILITY THEREIN DESCRIBED OR (B) IN ANY OTHER MANNER PROVIDED BY OR PURSUANT TO THE LAWS OF SUCH OTHER JURISDICTION, PROVIDED, HOWEVER, THAT FINCO OR ANY DIRECT ASSIGNEE MAY AT ITS OPTION BRING SUIT OR INSTITUTE OTHER JUDICIAL PROCEEDINGS AGAINST THE HOSPITAL OR ANY OF ITS RESPECTIVE ASSETS IN ANY STATE OR FEDERAL COURT OF THE UNITED STATES OR OF ANY COUNTRY OR PLACE WHERE THE HOSPITAL OR SUCH ASSETS MAY BE FOUND. (b) EACH OF FINCO AND THE HOSPITAL (AND THEIR RESPECTIVE SUCCESSORS AND ASSIGNS) HEREBY WAIVES ALL RIGHTS TO TRIAL BY JURY IN ANY ACTION OR PROCEEDING ARISING OUT OF OR RELATING TO ANY OF THE TRANSACTIONS CONTEMPLATED BY THIS AGREEMENT OR THE OTHER HOSPITAL DOCUMENTS. (c) THIS SECTION 8.16 SHALL SURVIVE THE TERMINATION OF THIS AGREEMENT. Section 8.17. UCC. Finco and the Hospital hereby agree that each sale hereunder, to the extent permitted by all Requirements of Law, is intended to be, for all purposes of New York law, a "sale of accounts" (as that term is used in Section 9-102(1)(b) of the New York UCC). Section 8.18. Execution; Effectiveness. (a) This Agreement shall constitute a two-party agreement between Finco on the one hand and the hospital company designated on any signature page hereto (in respect of the hospital indicated as the d/b/a on such signature page) on the other hand. This Agreement shall become effective on the date on which counterparts of such signature page shall have been executed and delivered by each of Finco and such hospital company. To the extent any Schedule referred to in this Agreement designates information applicable to a particular Hospital, only such portion of such Schedule shall be deemed to be delivered by such Hospital and no other portion of such Schedule shall be deemed to be part of the Agreement between Finco and such Hospital. To the extent that the information in any Schedule does not specify which Hospital to which such information applies, such information shall be deemed to be delivered initially by each Hospital; provided that Finco and each such Hospital may amend the information on any such Schedule without affecting the information on such Schedule deemed to be delivered by any other Hospital. All references to the "Hospital", this "Agreement" or this "Sale and Servicing Agreement" or to any Schedule hereto shall be deemed to be a reference to the hospital company executing such signature page, to the agreement between Finco and such hospital company and to the Schedules or portions thereof deemed to be delivered by such hospital company only, without regard to any Sale and Servicing Agreement or schedules executed and delivered by any other hospital company. (b) Any amendment, supplement or other modification of the terms, covenants and conditions contained herein approved by Finco and any Hospital in accordance with the terms of Section 8.4 shall be effective only as between Finco and such Hospital and shall have no effect on such terms, covenants and conditions as they apply to any Sale and Servicing Agreement between Finco and any other Hospital. IN WITNESS WHEREOF, each of the Hospital and Finco have caused this Sale and Servicing Agreement to be duly executed and delivered by its duly authorized officer on the date indicated below. Date: November 16, 1993 CHALMETTE GENERAL HOSPITAL, INC. DALLAS FAMILY HOSPITAL, INC. DEL AMO HOSPITAL, INC. HRI HOSPITAL, INC. LA AMISTAD RESIDENTIAL TREATMENT CENTER, INC. MCALLEN MEDICAL CENTER, INC. MERIDELL ACHIEVEMENT CENTER, INC. RIVER OAKS, INC. TURNING POINT CARE CENTER, INC. UHS OF ARKANSAS, INC. UHS OF AUBURN, INC. UHS OF BELMONT, INC. UHS OF MASSACHUSETTS, INC. UHS OF RIVER PARISHES, INC. UHS OF SHREVEPORT, INC. UNIVERSAL HEALTH SERVICES OF INLAND VALLEY, INC. UNIVERSAL HEALTH SERVICES OF NEVADA, INC. VICTORIA REGIONAL MEDICAL CENTER, INC. WELLINGTON REGIONAL MEDICAL CENTER INCORPORATED By:__________________________ Kirk E. Gorman Treasurer SPARKS RENO PARTNERSHIP L.P. By: Sparks Family Hospital, Inc., General Partner By:__________________________ Kirk E. Gorman Treasurer UHS RECEIVABLES CORP. By:__________________________ Cheryl Ramagano Vice President and Treasurer EXHIBIT A TO SALE AND SERVICING AGREEMENT UHS RECEIVABLES CORP. NON-NEGOTIABLE SUBORDINATED NOTE ___________ __, 1993 For value received, UHS Receivables Corp., a Delaware corporation ("Finco"), promises to pay (but only on a subordinated basis and to the extent of Available Cash, as defined below), to the order of ______________________ (the "Hospital"), the principal amounts indicated on Schedule A attached hereto on the dates shown on such schedule (subject to the terms hereof). This Subordinated Note shall be due and payable on the Trust Termination Date, but may be prepaid at any time without premium. Capitalized terms used herein without definition shall have the meanings set forth in the Definitions List, dated as of November 16, 1993, 1993 that refers to the Sale and Servicing Agreement, dated as of November 16, 1993 (as amended, supplemented, or otherwise modified from time to time, the "Sale and Servicing Agreement"), between Finco and the Hospital. This Subordinated Note is subject to the terms and conditions of the Sale and Servicing Agreement. Finco further promises to pay interest on the unpaid principal hereof from the dates specified in the schedule attached hereto at the annual fixed rate or rates specified therein (but only on a subordinated basis and to the extent of Available Cash from time to time) and payable on each anniversary of the date of this Subordinated Note to the extent funds are available therefor (subject to the terms hereof) until such principal shall have been paid in full; provided, however, that the interest rate or rates shall not be in excess of the Base Rate applicable from time to time. All payments of principal hereof and interest hereon shall be made in Dollars and in immediately available funds. The Hospital agrees that it shall not sell, transfer, assign, negotiate or pledge its rights under this Subordinated Note to any third party; provided that if the Hospital shall cease to be a Subsidiary of UHS, the Hospital shall assign this Subordinated Note to another Hospital or to UHS. Notwithstanding any provision to the contrary in this Subordinated Note or elsewhere, no demand for the payment of principal or interest may be made hereunder, no principal or interest shall be due with respect hereto and the Hospital shall have no claim for the payment of any principal or interest, except to the extent that Finco, pursuant to the terms and conditions of the Pooling Agreement, holds and owns cash ("Available Cash") free and clear of any lien, claim, encumbrance or obligation to make payments under the Sale and Servicing Agreement, and free and clear of any lien, claim, encumbrance or obligation under any similar agreement hereafter entered into by Finco including, without limitation, to the extent provided under the terms of the Pooling Agreement and in any event only to the extent such payments are provided for in the Pooling Agreement. The Hospital understands and agrees that the obligations of Finco under this Subordinated Note are subordinated in right of payment to the prior payment in full of the Participations and all of the other obligations of Finco under the Finco Documents. The Hospital further understands that the Hospital shall have no recourse to any assets or property of Finco or any assignee thereof other than Available Cash and further agrees that in the event of any assignment for the benefit of creditors, marshalling of assets dissolution, winding up or liquidation of Finco, whether voluntary or involuntary, in bankruptcy or insolvency or other similar proceedings, the obligations of Finco to pay principal and interest on this Subordinated Note shall remain fully subordinated and may not be accelerated, claimed or proved. In the event that, notwithstanding the foregoing provision prohibiting such payment or distribution, the Hospital shall receive any payment or distribution on this Subordinated Note from any source other than Available Cash, such payment shall be received and held in trust by the Hospital for the benefit of Finco and its assignees and shall be paid over to the Trustee by the Hospital. The Hospital covenants and agrees that prior to the date which is one year and one day after the Aggregate Capital is reduced to zero it will not institute against, or join any other Person in instituting against, Finco or Sheffield any bankruptcy, reorganization, arrangement, insolvency or liquidation proceedings, or other proceedings under any federal or state bankruptcy or similar law. Finco may prepay all or any portion of this Subordinated Note on any Business Day out of Available Cash only to the extent and in the manner provided under the Pooling Agreement. NOTWITHSTANDING ANYTHING TO THE CONTRARY IN THIS SUBORDINATED NOTE OR ELSEWHERE, NO AMOUNTS OTHERWISE PAYABLE TO THE HOSPITAL BY FINCO UNDER THIS NOTE OR THE SALE AND SERVICING AGREEMENT SHALL BE DUE OR PAYABLE TO THE HOSPITAL IF IT IS AN EXCLUDED HOSPITAL PURSUANT TO THE SALE AND SERVICING AGREEMENT, AND NO INTEREST SHALL BE DUE OR PAYABLE ON ANY AMOUNTS OTHERWISE DUE OR PAYABLE UNDER THIS SUBORDINATED NOTE FOR ANY PERIOD THAT THE HOSPITAL IS AN EXCLUDED HOSPITAL. This Subordinated Note shall be deemed to have been made under and shall be governed by and construed in accordance with the laws of the state of New York. IN WITNESS WHEREOF, Finco has caused this Subordinated Note to be duly executed on the date first above written. UHS RECEIVABLES CORP. By:___________________________ Authorized Officer Schedule A to Subordinated Note Interest Rate: 4% Principal Principal Unpaid Amount Amount Principal Notation Date of Loan Repaid Balance Made By EXHIBIT B TO SALE AND SERVICING AGREEMENT FORM OF CONFIDENTIALITY AGREEMENT [Letterhead of RECIPIENT of Information] ___________ __, 199_ UHS Receivables Corp. 27292 Calle Arroyo Suite B San Juan Capistrano, CA 92675 Universal Health Services, Inc. Universal Corporate Center 367 South Gulph Road King of Prussia, PA 19406 Dear Sirs: Reference is made to the Sale and Servicing Agreement, dated as of November 16, 1993 (as amended from time to time, the "Sale and Servicing Agreement"), UHS Receivables Corp., a Delaware corporation (the "Transferor"), and [Hospital] (the "Hospital"), and to the pending and proposed discussions between the Transferor and [recipient] (the "Recipient") regarding [describe transaction requiring disclosure]. Unless otherwise defined herein, capitalized terms defined in the Sale and Servicing Agreement are used herein as so defined. Pursuant to our discussions, the Transferor hereby agrees to provide to the Recipient certain information, practices, books, correspondence, and records of a confidential nature and in which the Hospital has a proprietary interest (the "Information") on the terms and conditions set forth below. By its execution of this Agreement, the Recipient hereby agrees to all such terms and conditions. The Recipient hereby acknowledges that all Information received by it from the Transferor shall be regarded as confidential information and that the Information may be subject to laws, rules and regulations regarding patient confidentiality. The Recipient agrees that, subject to the following sentence, (i) it shall, and shall cause its employees, agents and representatives to, retain in confidence and not disclose the Information without the prior written consent of the Transferor and (ii) it will not, and will ensure that its employees, agents and representatives will not, make any use whatsoever (other than for the purposes contemplated by the Sale and Servicing Agreement and the other Operative Documents or for the enforcement of any of the rights granted thereunder) of any of the Information without the prior written consent of the Transferor. Notwithstanding the foregoing, the Recipient may (x) disclose Information to any Person that has executed and delivered a confidentiality agreement in substantially the same form as this agreement naming the Transferor and the Hospital as third party beneficiaries thereof and (y) disclose or otherwise use Information (A) to the extent that such Information is required or appropriate in any report, statement or testimony submitted to any municipal, state or federal regulatory body having or claiming to have jurisdiction over the Recipient or submitted to the National Association of Insurance Commissioners or similar organizations or their successors, (B) to the extent such Information is required in response to any summons or subpoena or in connection with any litigation, (C) to the extent that such Information is believed to be required in order to comply with any law, order, regulation or ruling applicable to the Recipient, (D) to the extent that such Information was publicly available or otherwise known to the Recipient at the time of disclosure, (E) to the extent that such Information subsequently becomes publicly available, other than through any act or omission of the Recipient or (F) to the extent that such Information subsequently becomes known to the Recipient, other than through a Person whom the Recipient knows to be acting in violation of its obligations to the Transferor or the Hospital. The parties agree that any breach of this letter agreement would cause damages which cannot be determined in money and that injunction is an appropriate remedy for breach, though not necessarily the sole remedy. This Agreement shall inure to the benefit of the parties hereto, each of their respective successors and permitted assigns and the Hospital, and the Hospital will be deemed to be a third party beneficiary of this Agreement. This Agreement shall be governed by, and construed in accordance with the law of the State of New York, and may be executed in one or more counterparts, each of which shall be deemed an original but all of which together shall constitute one agreement. Please acknowledge your agreement to the foregoing by signing three copies of this letter agreement and returning them to the Transferor. Upon receipt of the executed letter agreement, the Transferor pursuant to the terms of the Sale and Servicing Agreement, will deliver an executed agreement to UHS and the Hospital. Very truly yours, [RECIPIENT] By:_________________________ Title: Acknowledged and Agreed: UHS Receivables Corp. 27292 Calle Arroyo Suite B San Juan Capistrano, CA 92675 By:____________________________ Title: cc: [Hospital Name] [Address] SCHEDULE I Hospital and UHS place of business List of Insurers UCCs Filed A. Locations of Hospital and UHS place of business s Name Place of business Universal Health Services, Inc. 367 South Gulph Road King of Prussia, PA 19406 Chalmette General Hospital, Inc. 9001 Patricia Street Chalmette, LA 70043 and 800 Virtue Street Chalmette, LA 70043 Dallas Family Hospital, Inc. 2929 South Hampton Road Dallas, TX 75224 Del Amo Hospital, Inc. 23700 Camino del Sol Torrance, CA 90505 HRI Hospital, Inc. 227 Babcock Street Brookline, NM 02146 La Amistad Residential Treatment 201 Alpine Drive Center, Inc. Maitland, FL 32751 McAllen Medical Center, Inc. 301 West Expressway 83 McAllen, TX 78503 Meridell Achievement Center, Inc. Highway 29 West Liberty Hill, TX 78642 and 2501 Cypress Creek Road Cedar Park, TX 78613 River Oaks, Inc. 1525 River Oaks Road West New Orleans, LA 70123 Sparks Reno Partnership, L.P. 2375 E. Prater Way Sparks, NV 89434 Turning Point Care Center, Inc. 319 East By-Pass Moultrie, GA 31768 UHS of Arkansas, Inc. 21 BridgeWay Road North Little Rock, AR 72118 UHS of Auburn, Inc. 20 Second Street, N.E. Auburn, WA 98002 UHS of Belmont, Inc. 4058 West Melrose Street Chicago, IL 60641 UHS of Massachusetts, Inc. 49 Robinwood Avenue Boston, MA 02130 UHS of River Parishes, Inc. 500 Rue de Sante LaPlace, LA 70068 UHS of Shreveport, Inc. 1130 Louisiana Avenue Shreveport, LA 71101 Universal Health Services 36485 Inland Valley Drive of Inland Valley, Inc. Wildomar, CA 92395 Universal Health Services of 620 Shadow Lane Nevada, Inc. Las Vegas, NV 89106 Victoria Regional Medical 101 Medical Drive Center, Inc. Victoria, TX 77904 Wellington Regional Medical 10101 Forest Hill Blvd. Center Incorporated West Palm Beach, FL 33414 B. List of Insurers Insurers or other third-party payors which are Obligors maintaining the ten highest average Outstanding Balances of Receivables, calculated as of August 31, 1993, on an aggregate basis for all Hospitals that are parties to any Sale and Servicing Agreement: 1. Aetna $ 1,824,491 2.43% 2. Family Health Plan HMO 1,086,921 1.45% 3. Metropolitan 1,013,152 1.35% 4. Culinary HMO 831,672 1.11% 5. Travelers 781,682 1.04% 6. CIGNA 712,905 .95% 7. Prudential 607,419 .81% 8. King County HMO 495,950 .66% 9. CAC HMO 374,835 .50% 10. Kaiser HMO 365,364 .49% ----------- ---- Total Top 10 8,094,391 10.79% Total Financial Receivables $74,995,728 100% =========== ==== C. UCCs Filed Name Filing Location(s) Universal Health Services, Inc. Secretary of the Commonwealth of Pennsylvania and Montgomery County Prothonotary's Office Chalmette General Hospital, Inc. Clerk of Court of Saint Bernard Parish Dallas Family Hospital, Inc. Secretary of State of State of Texas Del Amo Hospital, Inc. Secretary of State of State of California HRI Hospital, Inc. Secretary of State of State of Massachusetts and Town Clerk's Office of town of Brookline McAllen Medical Center, Inc. Secretary of State of State of Texas Meridell Achievement Center, Inc. Secretary of State of State of Texas River Oaks, Inc. Clerk of Court of Jefferson Parish Sparks Reno Partnership, L.P. Secretary of State of State of Nevada Turning Point Care Center, Inc. Clerk of Superior Court of Colquitt County UHS of Arkansas, Inc. Secretary of State of State of Arkansas and Clerk of Circuit Court and Ex-Officio Recorder of Pulaski County UHS of Auburn, Inc. Licensing Department of State of Washington UHS of Belmont, Inc. Secretary of State of State of Illinois UHS of Maitland, Inc. Florida Department of State UHS of Massachusetts, Inc. Secretary of State of State of Massachusetts and Town Clerk's Office of town of Boston Name Filing Location(s) UHS of River Parishes, Inc. Clerk of Court of St. John the Baptist Parish UHS of Shreveport, Inc. Clerk of Court of Caddo Parish Universal Health Recovery Secretary of the Commonwealth of Centers, Inc. Pennsylvania and Chester County Prothonotary's Office Universal Health Services of Secretary of State of State of Inland Valley, Inc. California Universal Health Services of Secretary of State of State Nevada, Inc. of Nevada Victoria Regional Medical Secretary of State of State Center, Inc. of Texas Wellington Regional Medical Florida Department of State Center Incorporated Westlake Medical Center, Inc. Secretary of State of State of California SCHEDULE II Notifications: Accreditation and Licensing None. SCHEDULE III Fiscal Years Open to Audit Name of Hospital Years Open Chalmette General Hospital, Inc. 1990, 1991, 1992 Dallas Family Hospital, Inc. 1990, 1991, 1992 Del Amo Hospital, Inc. 1991, 1992 HRI Hospital, Inc. 1990, 1991, 1992 McAllen Medical Center, Inc. 1990, 1991, 1992 Meridell Achievement Center, Inc. 1990, 1991, 1992 River Oaks, Inc. 1990, 1991, 1992 Sparks Reno Partnership, L.P. 1990, 1991, 1992 Turning Point Care Center, Inc. 1990, 1991, 1992 UHS of Arkansas, Inc. 1990, 1991, 1992 UHS of Auburn, Inc. 1990, 1991, 1992 UHS of Belmont, Inc. 1990, 1991, 1992 UHS of Maitland, Inc. 1990, 1991, 1992 UHS of Massachusetts, Inc. 1990, 1991, 1992 UHS of River Parishes, Inc. 1990, 1991, 1992 UHS of Shreveport, Inc. 1990, 1991, 1992 Universal Health Recovery Centers, Inc. 1990, 1991, 1992 Universal Health Services of Inland 1990, 1991, 1992 Valley, Inc. Universal Health Services of Nevada, 1990, 1991, 1992 Inc. Victoria Regional Medical Center, Inc. 1990, 1991, 1992 Wellington Regional Medical Center 1990, 1991, 1992 Incorporated Westlake Medical Center, Inc. 1990, 1991, 1992 SCHEDULE IV Governmental Programs for which the Hospital is a Qualified Provider ============================================================================== Governmental Program Hospitals Qualified - ------------------------------------- ------------------------------------- - ------------------------------------- ------------------------------------- - ------------------------------------- ------------------------------------- - ------------------------------------- ------------------------------------- - ------------------------------------- ------------------------------------- - ------------------------------------- ------------------------------------- - ------------------------------------- ------------------------------------- - ------------------------------------- ------------------------------------- - ------------------------------------- ------------------------------------- ============================================================================== SCHEDULE V Location and Identification of Hospital Concentration Accounts Name of Hospital Bank Account Number Chalmette General Hospital, Inc. Hibernia National 8122-2924-9 Bank UHS of De La Ronde, Inc. Hibernia National 8122-2925-7 Bank Dallas Family Hospital, Inc. Bank One -- Texas 9830-10-741-7 Del Amo Hospital, Inc. Bank of America 1233-4-57852 HRI Hospital, Inc. First National 503-11965 Bank of Boston McAllen Medical Center, Inc. Texas Commerce 0960-0370185 Bank Meridell Achievement Center, Inc.Bank One -- Texas 75-0025-5968 River Oaks, Inc. Hibernia National 8122-2923-0 Bank Sparks Reno Partnership, L.P. Bank of America 47-0012378 Turning Point Care Center, Inc. Moultrie National 01-41110-1-01 Bank UHS of Arkansas, Inc. First Commercial 0657433 Bank UHS of Auburn, Inc. Seafirst 62269519 UHS of Belmont, Inc. Park National 16-5301 Bank UHS of Maitland, Inc. Nationsbank of 0088376877 Florida UHS of Massachusetts, Inc. First National 503-52636 Bank of Boston UHS of River Parishes, Inc. Bank of La Place 01-0622-4 UHS of Shreveport, Inc. Hibernia National 762001756 Bank Universal Health Recovery First Fidelity 4004517290 Centers, Inc. Bank Universal Health Services of Bank of America 1233-2-56080 Inland Valley, Inc. Universal Health Services of Bank of America 01-212-2036 Nevada, Inc. Victoria Regional Medical Victoria Bank & 5101017337 Center, Inc. Trust Wellington Regional Medical Sun Bank South 0629-002-005381 Center Incorporated Florida N.A. Westlake Medical Center, Inc. Bank of America 1233-9-56195 - ------------------------------------------------------------------------------ DEFINITIONS LIST dated as of November 16, 1993 - ------------------------------------------------------------------------------ DEFINITIONS LIST The capitalized terms used herein and in the documents listed below shall have the meanings set forth in this Definitions List. 1. Each of the Sale and Servicing Agreements (each as amended, supplemented or otherwise modified from time to time, a "Sale and Servicing Agreement"), in each case between a Hospital and Finco. 2. The Servicing Agreement, dated as of November 16, 1993 (as amended, supplemented or otherwise modified from time to time, the "Servicing Agreement"), among Finco, UHS Delaware, as Servicer, and the Trustee. 3. The Pooling Agreement, dated as of November 16, 1993 (as amended, supplemented or otherwise modified from time to time, the "Pooling Agreement"), among Finco, ONC, Sheffield and the Trustee. 4. The Guarantee, dated as of November 16, 1993 (as amended, supplemented or otherwise modified from time to time, "Guarantee"), executed by UHS in favor of Finco and the Trustee. 5. The Conditions List, dated as of November 16, 1993 (the "Conditions List"), incorporated by reference in certain of the above documents. Accounting Terms - As used in this Definitions List and in all documents incorporating this Definitions List, all accounting terms not otherwise defined shall have the meanings assigned to them under GAAP as in effect at the time of the relevant determination. Other Definitional Provisions - References to "Sections," "Subsections," "Paragraphs," "Subparagraphs," "Appendices," "Recitals" and "Exhibits" shall be to Sections Subsections, Paragraphs, Subparagraphs, Appendices, Recitals and Exhibits of the document in which such references appear unless otherwise specifically provided. Any of the terms defined in this Definitions List may be used in singular or plural form. As used herein, the singular includes the plural, and the masculine gender includes the feminine and neuter genders, and vice versa, unless the context otherwise requires. Except as otherwise provided herein or in any document incorporating this Definitions List, references to any document or instrument are as amended or supplemented or otherwise modified from time to time in accordance with the terms and conditions of such document. The words "hereof," "herein" and "hereunder" and words of similar import when used in any document incorporating this Definitions List shall refer to such document as a whole and not to any particular provision of such document. Acceleration Event: As defined in Section 10.1(h) of the Pooling Agreement. Actual Contractual Adjustment: With respect to each Purchased Receivable, at the time of reference thereto, the amount by which the payment due from the Obligor of such Purchased Receivable is less than the gross amount chargeable by the relevant Hospital for the goods or services reflected on the invoice relating to such Purchased Receivable. The amount due from the Obligor shall be determined for each payor class and for each Hospital and shall result in an amount due which is no greater than the amount of revenue (net of contractual adjustments) which would be reflected in respect of such Receivable for purposes of the consolidated financial statements of UHS and its Subsidiaries. To the extent that a Financible Receivable reflects a discount in excess of the discount which would be reflected in the determination of revenue, such excess shall be a Deleted Receivable. Additional Account: Any lockbox account established by the Trustee, as permitted by Section 7.8 of the Pooling Agreement or Section 3.7 of the Servicing Agreement. Adjusted Aggregate Capital: At any time, the sum of the Adjusted TRIPs Capital and the Adjusted Sheffield Capital. Adjusted Eurodollar Rate: With respect to any Sheffield Tranche for any Fixed Period, an interest rate per annum equal to (a) 1-1/4% plus (b) the Reference Rate for that Fixed Period. Adjusted Sheffield Capital: On any date, the Sheffield Capital on such date minus all funds on deposit in the Sheffield Payment Account on such date (other than funds to be used for payment of Sheffield Yield). Adjusted TRIPs Capital: On any date, the TRIPs Capital on such date minus the amount of all funds on deposit in the TRIPs Payment Account on such date (other than funds to be used for payment of TRIPs Yield or the Make-Whole Payment Amount). Affiliate: As to any specified Person, any other Person controlling or controlled by or under common control with such specified Person. For the purposes of this definition, "control" when used with respect to any specified Person means the power to direct the management and policies of such Person, directly or indirectly, whether through the ownership of voting securities, by contract or otherwise; and the terms "controlling" or "controlled" have meanings correlative to the foregoing. Aggregate Blue Cross/Blue Shield: Collectively, Preferred Blue Cross Blue Shield and Other Blue Cross/Blue Shield. Aggregate Capital: At any time, the sum of the TRIPs Capital and the Sheffield Capital at such time. Aggregate Insurers/HMOs/PPOs: Collectively, Preferred Insurers/HMOs/PPOs and Other Insurers/HMOs/PPOs. Allocable Sheffield Capital: With respect to any Business Day during the Sheffield Revolving Period, the Adjusted Sheffield Capital on the preceding Business Day, and with respect to any Business Day during the Sheffield Amortization Period, the Adjusted Sheffield Capital on the last day of the Sheffield Revolving Period. Allocable TRIPs Capital: With respect to any Business Day during the Adjusted TRIPs Revolving Period, the Sheffield TRIPs Capital on the preceding Business Day, and with respect to any Business Day during the TRIPs Amortization Period, the Adjusted TRIPs Capital on the last day of the TRIPs Revolving Period. Alternative Rate: For any Fixed Period with respect to any Sheffield Tranche, an interest rate per annum equal to the Adjusted Eurodollar Rate or the Base Rate, as Finco shall select in accordance with the terms of the Pooling Agreement; provided, however, that the "Alternative Rate" for any Sheffield Tranche shall be the Base Rate if (i) on or before the first day of such Fixed Period, the Liquidity Agent shall have notified Sheffield that a Eurodollar Disruption Event has occurred, (ii) such Fixed Period is a period of from one to 29 days or (iii) the Sheffield Capital allocated to such Sheffield Tranche is less than $100,000. AOA: The American Osteopathic Association, and any successor thereto. Applicable Contractual Adjustment: With respect to each Purchased Receivable, the amount which the Servicer estimates, to the best of its knowledge in accordance with the Credit and Collection Policy, on the basis of the payor class of the Obligor and the Hospital originating such Receivable, to be the Actual Contractual Adjustment which will be applicable to such Purchased Receivable. Assigned Agreements: Each Sale and Servicing Agreement, the Servicing Agreement, the Pooling Agreement and the Guarantee. Assignors: Each of the Hospitals, UHS, Finco and the Servicer. Audit: As defined in Section 7.2 of each Sale and Servicing Agreement. Authorized Officer: (i) With respect to the Trustee, any officer within its corporate trust office, including any Vice President, Assistant Vice President, Secretary, Assistant Secretary, Trust Officer and any other officer of the Trustee customarily performing functions similar to those customarily performed by any of the above designated officers, and also, with respect to a particular matter, any other officer of the Trustee to whom such matter is referred because of such officer's knowledge of, or familiarity with, the particular subject and (ii) with respect to any party to any Operative Document, each officer whose name appears in an officers' certificate delivered by such party on the Initial Closing Date, as such officers' certificate may be amended from time to time. Available Cash Collections: On any date, the portion of Collections actually received in the Collateral Account in the form of immediately available funds pursuant to the terms of the Operative Documents. Average Financible Turnover Period: As of any Settlement Date, a number, calculated as of the last day of the fiscal month immediately preceding such Settlement Date (such date, the "Reference Date"), equal to (a) the sum, for each Aging Category (as defined below) of the product of (i) the aggregate Outstanding Balance of all Financible Receivables in such Aging Category as of the Reference Date and (ii) the number designated below as the "Midpoint" applicable to such Aging Category, as specified below, divided by (b) the total Outstanding Balance of Financible Receivables as of the Reference Date. For purposes of this definition "Aging Category" shall mean, as of the Reference Date, any of the five categories of Financible Receivables for which the number of days which have elapsed since the date on which Financible Receivables in such category were first billed is as set forth below: Number of Days Elapsed Since Date of Billing Midpoint 1. More than zero days but not more than 60 days. 30 2. More than 60 days but not more than 90 days. 75 3. More than 90 days but not more than 120 days. 105 4. More than 120 days but not more than 150 days. 135 5. More than 150 days but not more than 180 days. 165 Average Pool Turnover Period: On any day during any Settlement Period, (i) the aggregate Outstanding Balance of all Purchased Receivables as of the last day of the preceding Settlement Period divided by (ii) the daily average amount of Purchased Receivables purchased by Finco during such preceding Settlement Period. Average Sheffield Yield Rate: On any day during any Settlement Period, the daily weighted average Sheffield Yield Rate for all Sheffield Tranches outstanding during the immediately preceding Settlement Period. Barclays: Barclays Bank PLC, New York Branch. Base Rate: As of any day, a fluctuating interest rate per annum equal to the higher of (a) the rate of interest announced publicly by Barclays in New York, New York from time to time as Barclays' prime rate in effect on such date and (b) 1% above the weighted average of the rates on overnight Federal funds transactions with members of the Federal Reserve System arranged by Federal funds brokers, as published on the next succeeding Business Day by the Federal Reserve Bank of New York, or, if such rate is not so published for any day which is a Business Day, the average of the quotations for the day of such transactions received by Barclays from three Federal funds brokers of recognized standing selected by it. Borrowing Base: On any date, (a) all cash and Permitted Investments held in the Collateral Account, any sub-account thereof, other than the TRIPs Interest Sub-account, the Sheffield Interest Sub-account or the Expense Sub- account (exclusive of Collections that have not been identified as to Receivables), and any Other Account plus (b) the Financible Pool Balance minus (c) the Loss Reserves minus (d) the Yield Reserves minus (e) the Fee/Expense Reserves minus (f) if the Call Option has been exercised, the excess of the Make-Whole Estimated Amount over the TRIPs Make-Whole Funds; provided, however, that during the TRIPs Amortization Period or the Sheffield Amortization Period, for purposes of calculating any of the reserves set forth in clauses (c), (d) and (f), the TRIPs Capital or the Sheffield Capital, as the case may be, on the last day of the applicable Revolving Period, rather than the Capital on the date of calculation, shall be used to make the related reserve calculation. Business Day: A day of the year on which (a) banks in New York, New York or Chicago, Illinois are not required or authorized to close and (b) if the term "Business Day" is used in connection with the Adjusted Eurodollar Rate, dealings in dollar deposits are carried on in the London interbank market. Call Date: As defined in Section 2.14 of the Pooling Agreement. Call Option: As defined in Section 2.14 of the Pooling Agreement. Champus: The Civilian Health and Medical Program of the Uniformed Services, 32 C.F.R. 199, jointly administered by the Secretary of Defense, the Secretary of Transportation and HHS, as the same may be amended from time to time. Champus Receivable: A Receivable of which the Obligor is the United States and which arises out of charges reimbursable to a Hospital under Champus. Change of Control: As to any specified Person, a Change of Control shall be deemed to have occurred if, at any time after the Initial Closing Date, (i) a majority of the board of directors or other managers of such specified Person shall have first become a director or other manager during the preceding twelve months or (ii) any other Person or group of Persons has during the preceding twelve months acquired or increased its ownership interest in such Person so that it owns, directly or indirectly, 50% or more of such specified Person's stock ordinarily having voting power for the election of directors. Code: The United States Internal Revenue Code of 1986, as the same may be amended from time to time. Collateral Account: An account established under Section 7.1(a) of the Pooling Agreement, including all sub-accounts thereof established from time to time pursuant to the Pooling Agreement. Collections: All amounts due and owing on Purchased Receivables that either (a) have been collected in available funds by any Hospital or by the Servicer, Finco or the Trustee for deposit into the related Hospital Concentration Account or the Master Receivables Account in accordance with the terms of the Sale and Servicing Agreements or (b) have been posted as received by the Servicer pursuant to the Credit and Collection Policy but have not yet become available funds; provided, however, that amounts collected on Purchased Receivables that are not Financible Receivables shall be deemed to be "Collections" only upon satisfaction of clause (b) above. Commercial Paper or Commercial Paper Note: The short-term promissory notes of Sheffield and issued to fund the maintenance of the Sheffield Participation under the Pooling Agreement, which promissory notes shall be denominated in Dollars and shall have a maturity of not more than 120 days. Commonly-Controlled Entity: As to any Person, a Person, whether or not incorporated, which is under common control with such Person within the meaning of Section 4001 of ERISA or is part of a group which includes such Person and which is treated as a single employer under Section 414 of the Code. Concentration Limit: On any date of determination and when used with reference to Eligible Receivables of a specified type held by Finco and in which the Participants have acquired the Participations, the following applicable percentage of the aggregate Outstanding Balance of all Eligible Receivables so held by Finco represented by such type of Eligible Receivables, after giving effect to any purchases by Finco of Eligible Receivables to be effected on such date: Obligor Medicare 40% Medicaid 10% Preferred Blue Cross/Blue Shield 10% Aggregate Blue Cross/Blue Shield 10% Aggregate Insurers/HMOs/PPOs 60% Champus 7% Worker's Compensation 10% Preferred Insurer/HMO/PPO 7% Other Blue Cross/Blue Shield 1% Other Insurer/HMO/PPO 1% Concentration Limit Excess: On any date of determination, the portion of the Outstanding Balance of Eligible Receivables (or portions thereof) as of the last day of the immediately preceding Settlement Period that exceeded the Concentration Limits. Conditions List: As defined on the first page hereof. Confirmation: Each acknowledgement or notice of receipt of or agreement in respect of a related Notice of Assignment which is required to be delivered by or received from the recipient of such Notice of Assignment to any Hospital pursuant to Section 5.3 of the Pooling Agreement. Continental: Continental Bank, National Association, a national banking association. Cost of Funds: In any Settlement Period, and for any Purchased Receivable of any Hospital purchased by Finco on any Purchase Date, the product of (i) the Average Pool Turnover Period then in effect times (ii) the Outstanding Balance of such Purchased Receivable times (iii) the Base Rate plus 1% divided by 365. CP Holders: The holders from time to time of Outstanding Commercial Paper Notes. CP Rate: For any Fixed Period, with respect to any Sheffield Tranche, the rate equivalent to the rate (or if more than one rate, the weighted average of the rates) at which Commercial Paper Notes issued by Sheffield having a term equal to such Fixed Period and to be issued to fund the acquisition or maintenance of, such Sheffield Tranche may be sold by the commercial paper dealer or placement agent selected by Sheffield, as agreed between each such agent or dealer and Sheffield and notified by Sheffield to the Trustee; provided, however, that if the rate (or rates) as agreed between any such agent or dealer and Sheffield is a discount rate (or rates), the "CP Rate" for such Fixed Period shall be the rate (or if more than one rate, the weighted average of the rates) resulting from converting such discount rate (or rates), including the portion of such discount representing dealers' fees, to an interest-bearing equivalent rate per annum. Credit and Collection Policy: Those credit and collection policies and practices of UHS and the Servicer relating to Receivables in existence on the date hereof and attached hereto as Exhibit B, as modified in compliance with Section 4.3(k) of each Sale and Servicing Agreement and 3.1(k) of the Servicing Agreement. Daily Program Expense Amount: On any Business Day, 105% of (a) the Monthly Program Expense Amount divided by (b) the number of days in the current Settlement Period. Daily Sheffield Expense Amount: On any Business Day, 105% of (a) the Monthly Sheffield Expense Amount divided by (b) the number of days in the current Settlement Period. Daily TRIPs Expense Amount: On any Business Day, 105% of (a) the Monthly TRIPs Expense Amount divided by (b) the number of days in the current Settlement Period. Debt: Of a Person at a particular date, the sum at such date of (i) indebtedness for borrowed money or for the deferred purchase price of property or services, (ii) obligations as lessee under leases which shall have been or should be, in accordance with GAAP, recorded as capital leases, (iii) obligations under direct or indirect guarantees in respect of, and obligations (contingent or otherwise) to purchase or otherwise acquire, or otherwise to assure a creditor against loss in respect of, indebtedness or obligations of others of the kinds referred to in clause (i) or (ii) above and (iv) liabilities in respect of unfunded vested benefits under any Plan. Decrease: As defined in Section 2.6(b) of the Pooling Agreement. Deficiency Notice: A notice from any Governmental Authority to UHS or any Subsidiary thereof indicating that UHS or such Subsidiary is required to pay any amounts to such Governmental Authority, to the extent that the failure to pay such amount would, in accordance with applicable law, result in the offset by any Obligor of any amount owed to UHS or any Subsidiary under any Receivable. Defaulted Receivable: Any Receivable as to which the Servicer believes, in its good faith judgment, all amounts due thereunder are not or would not be ultimately recoverable because of the bankruptcy, insolvency or poor credit quality of the Obligor. Deleted Receivable: Any Eligible Receivable or portion thereof designated by the Servicer pursuant to Section 3.6 of the Servicing Agreement to be excluded from the pool of Financible Receivables. Delinquency Ratio: With respect to any Settlement Period, a fraction, the numerator of which is the Outstanding Balance of Financible Receivables which were Delinquent Receivables on the last day or the immediately preceding Settlement Period and the denominator of which is the Outstanding Balance of Financible Receivables as of the last day of the immediately preceding Settlement Period. Delinquent Receivable: As to any date of determination, any Receivable as to which all amounts due and payable thereunder have not been paid and in respect of which the date on which such Receivable was first billed occurred more than 120 days but less than 181 days prior to such date of determination. Deposited Funds: All funds at any time, and from time to time, on deposit or otherwise to the credit of the Collateral Account or any Other Account, including, without limitation, all Permitted Investments. Dollars and $: Lawful money of the United States of America. Early Amortization Event: As defined in Section 10.1 of the Pooling Agreement. Eligible Institution: Any depositary institution or trust company organized under the laws of the United States of America or any state thereof or the District of Columbia; provided that each such institution shall be a member of the FDIC and shall maintain at all times a long-term unsecured debt rating of A or better by Moody's and S&P; provided that Continental shall be an Eligible Institution so long as it either has a rating for its long-term deposits of at least Baa3 from Moody's and at least BBB- from S&P or is otherwise acceptable to the Rating Agencies. Eligible Pool Balance: At any date of determination, (a) the Outstanding Balance of all Eligible Receivables in the Receivables Pool minus (b) the Offset Reserves. Eligible Receivable: On any date, each Receivable other than any Self-pay Receivable, (a) as to which the Obligor is not an Obligor on any Defaulted Receivable, (b) (i) as to which on the Purchase Date of such Receivable each representation and warranty of the Hospital made under Sections 4.1(d), 4.1(e) and 4.2 of the related Sale and Servicing Agreement and Section 4.2 of the Pooling Agreement is true and correct and (ii) which, on each date after the related Purchase Date, satisfies all of the criteria set forth in Sections 4.1(d), 4.1(e), 4.2(a) through 4.2(f), 4.2(h) and 4.2(i) of the related Sale and Servicing Agreement and Sections 4.2(a) through (h), 4.2(j) and 4.2(k) of the Pooling Agreement, (c) as to which every covenant of the Hospital under the Sale and Servicing Agreement shall have been complied with in all material respects, (d) which is not an Uncollectible Receivable, (e) the Obligor of which is located in the United States and is not an affiliate of UHS, (f) which is denominated and payable in United States Dollars in the United States, (g) which is in full force and effect and constitutes the legal, valid and binding obligation of the Obligor in accordance with its terms, (h) which is not subject to any dispute, counterclaim or defense, or any offset other or greater than the Applicable Contractual Adjustment, (i) which is not an Excluded Receivable, (j) which is not a Receivable as to which the Obligor thereof has a guarantee thereof, a letter of credit providing credit support therefor or collateral security therefor unless such guarantee, letter of credit or collateral security shall have been assigned to Finco and the Interested Parties and such guarantee, letter of credit or collateral security is not to Finco's knowledge subject to any Lien in favor of any other Person and (k) which, as of the Payment Date, arose under an invoice (i) delivered to the Obligor within [15] days after the date of discharge of the patient to whose account such Receivable related and (ii) with respect to which the goods or services billed under such invoice were not previously billed to any other third party payor. ERISA: The Employee Retirement Income Security Act of 1974, as amended. Eurocurrency Liabilities: As defined in Regulation D of the Board of governors of the Federal Reserve System, as in effect from time to time. Eurodollar Disruption Event: With respect to any Sheffield Tranche for any Fixed Period, any of the following: (i) a determination by Sheffield that it would be contrary to law or to the directive of any central bank or other Governmental Authority (whether or not having the force of law) to obtain United States Dollars in the London interbank market for the acquisition or maintenance of such Sheffield Tranche for such Fixed Period, (ii) the failure of the Barclays to furnish timely information for purposes of determining the Adjusted Eurodollar Rate, (iii) a determination by Sheffield that the rate at which deposits of United States Dollars are being offered to Sheffield in the London interbank market does not accurately reflect the cost to Sheffield of funding its acquisition or maintenance of such Sheffield Tranche for such Fixed Period or (iv) the inability of Sheffield to obtain United States Dollars in the London interbank market to fund its acquisition of such Sheffield Tranche for such Fixed Period. Eurodollar Reserve Percentage: For any Fixed Period for any Sheffield Tranche, the reserve percentage applicable during such Fixed Period (or, if more than one such percentage shall be so applicable, the daily average of such percentages for those days in such Fixed Period during which any such percentage shall be so applicable) under regulations issued from time to time by the Board of Governors of the Federal Reserve System (or any successor) for determining the maximum reserve requirement (including, without limitation, any emergency, supplemental or other marginal reserve requirement) for Barclays with respect to liabilities or assets consisting of or including Eurocurrency Liabilities having a term equal to such Fixed Period. Exchange Act: The Securities Exchange Act of 1934, as amended from time to time. Excluded Hospital: Any Hospital as to which an Exclusion Event has occurred and as to which Finco has exercised the remedies available to it under Section 6.3(a) of the related Sale and Servicing Agreement. Excluded Receivable: Any Receivable purchased from an Excluded Hospital as to which Finco has exercised on the related Purchase Date its non- exclusive remedy, under Section 6.3(a)(ii) of the related Sale and Servicing Agreement, that no such Purchased Receivable shall be an Eligible Receivable. Exclusion Event: As defined in Section 6.1 of each Sale and Servicing Agreement. Expense Sub-account: A sub-account of the Collateral Account established pursuant to Section 7.1(a) of the Pooling Agreement. Face Amount: With respect to the Commercial Paper Notes, the face amount of any Commercial Paper Note issued on a discount basis and the principal amount of, plus the amount of all interest stated to accrue thereon to the stated maturity date of, any Commercial Paper Note issued on an interest-bearing basis and, with respect to any TRIP, the principal amount of such TRIP. Fee/Expense Reserves: At any date of determination, (a) (i) 105% of the amount of all liabilities of Finco (other than any Capital of or Yield on the Participations) accrued as of such date pursuant to the Operative Documents, including, without limitation, liabilities in respect of the Servicing Fee and all other liabilities included in the calculation of the Monthly Program Expense Amount, the Monthly Sheffield Expense Amount and the Monthly TRIPs Expense Amount minus (ii) the amount on deposit in the Expense Sub-account on such date plus (without duplication) (b) 105% of the amount budgeted to accrue in respect of such liabilities during a period equal to the Average Financible Turnover Period. Final Sheffield Maturity Date: The Transfer Date occurring 12 months after the Sheffield Termination Date. Final TRIPs Maturity Date: The Transfer Date occurring 12 months after the TRIPs Termination Date. Financible Pool Balance: At any date of determination, (a) the Outstanding Balance of all Financible Receivables in the Receivables Pool minus (b) the Offset Reserves and minus (c) the Concentration Limit Excess. Financible Receivables: At any time, all Eligible Receivables, other than all Deleted Receivables. Finco Documents: The collective reference to the Sale and Servicing Agreements, the Servicing Agreement, the Pooling Agreement, the Security Filings in favor of the Trustee and any other agreement or instrument related to any of the foregoing. Finco Transferred Property: All of Finco's right, title and interest in and to the Assigned Agreements and any documents or instruments delivered in connection therewith. Finco: UHS Receivables Corp., a Delaware corporation. Fixed Period: For any Sheffield Tranche, (i) if Sheffield Yield in respect thereof is computed by reference to the CP Rate, a period of 1 to and including 120 days, (ii) if Sheffield Yield in respect thereof is computed by reference to the Adjusted Eurodollar Rate, a period of one, two or three months and (iii) if Sheffield Yield in respect thereof is computed at the Base Rate, a period of 1 to and including 30 days. GAAP: Generally accepted accounting principles in effect from time to time in the United States. Governmental Authority: Any nation or government, any state or other political subdivision thereof and any entity exercising executive, legislative, judicial, regulatory or administrative functions of or pertaining to government. Governmental Receivables: With respect to each Hospital, the Receivables of such Hospital which, consistent with UHS's past accounting practice, are initially classified as (i) Medicare Receivables, (ii) Medicaid Receivables or (iii) Champus Receivables. Guarantee: As defined on the first page hereof. Guaranteed Parties: The collective reference to the Hospitals and UHS Delaware. HCFA: The Health Care Finance Administration, a division of HHS, and any successor thereof. HHS: The United States Department of Health and Human Services, or the Secretary thereof, as the context may require, and successors thereof. Hospital: any hospital or other health care institution which enters into a Sale and Servicing Agreement with Finco, initially as listed on Exhibit A hereto. Hospital Concentration Account: The account or sub-account maintained by each Hospital in the name of such Hospital in accordance with the terms of Section 5.5 of the respective Sale and Servicing Agreements. Hospital Documents: The collective reference, as to each Hospital, to the related Sale and Servicing Agreement, the Security Filings executed on behalf of the Hospital in favor of Finco and the Trustee, and any other agreement or instrument related to any of the foregoing. Hospital Repurchase Price: With respect to any Receivable, the Purchase Price of such Receivable less any amounts collected or received by Finco with respect to such Receivable plus interest at the rate equal to the Base Rate plus 1% on the Purchase Price from the Purchase Date of such Receivable to the Repurchase Date. Increase: As defined in Section 2.6 of the Pooling Agreement. Increase Amount: The amount designated as the Increase Amount in the notice delivered by Finco pursuant to Section 2.6 of the Pooling Agreement and paid to Finco by Sheffield on any Business Day in payment for any Increase. Indemnified Amounts: As defined pursuant to each related Operative Document. Initial Closing Date: The date on which all conditions precedent contained in the Conditions List are first satisfied or waived. Initial Sheffield Capital: The amount specified as the Initial Sheffield Capital in the notice delivered to Sheffield by Finco, and paid to Finco by Sheffield on the Initial Closing Date in respect of the Initial Sheffield Purchase, pursuant to Section 2.5(a) of the Pooling Agreement. Initial Sheffield Purchase: As defined in Section 2.5(a) of the Pooling Agreement. Initial TRIPs Capital: The amount paid to Finco on the TRIPs Closing Date by all TRIPs Holders in respect of their purchases of the TRIPs Participations pursuant to Section 2.5(b) of the Pooling Agreement. Insolvency: With respect to any Multiemployer Plan, the condition that such Plan is insolvent within the meaning of Section 4245 of ERISA. Insolvent: Pertaining to a condition of Insolvency. Interested Parties: The collective reference to the Participants, the Trustee, the Liquidity Agent and the Program Bank. Investment Company Act: The Investment Company Act of 1940, as amended from time to time. JCAHO: The Joint Commission on the Accreditation of Healthcare Organizations, and any successor thereto. Lenders: The collective reference to the Liquidity Agent, the Liquidity Banks, the Program Bank, Barclays (in its capacity as lender under the Stub Loan) and their respective successors. Lien: Any lien, mortgage, security interest, pledge, charge, equity, encumbrance or right of any kind whatsoever. Liquidation Date: The earlier to occur of (a) the fifteenth day preceding the Scheduled Liquidity Commitment Termination Date (as defined in the Liquidity Agreement) and (b) the date of the termination in whole of the commitments of the Liquidity Banks under the Liquidity Agreement. Liquidity Agent: Barclays, in its capacity as Liquidity Agent under the Liquidity Agreement, and its successors in such capacity. Liquidity Agreement: The Liquidity Agreement, dated as of November 16, 1993, among Sheffield, the Liquidity Agent and the Liquidity Banks, as the same may be amended, supplemented or otherwise modified from time to time. Liquidity Bank: Each bank or other financial institution providing liquidity support for the Sheffield Participation pursuant to the Liquidity Agreement. Liquidity Loan: An advance made by the Liquidity Banks to Sheffield pursuant to the Liquidity Agreement in order to pay maturing Commercial Paper or maintain the level of the Sheffield Participation. Loans: The collective reference to Liquidity Loans, Program Loans and Stub Loans. Loss Factor: For any Settlement Period, the percentage equivalent of the greater of (a) .15 and (b) three times the average Loss-to-Liquidation Ratio for the three immediately preceding Settlement Periods. Loss Reserves: On any date, the product of (a) the Loss Factor and (b) the Aggregate Capital on such date. Loss-to-Liquidation Ratio: With respect to any Settlement Period, the percentage equivalent of a fraction, (a) the numerator of which is the sum of (i) the amount of Receivables which were included as Financible Receivables and which became Uncollectible Receivables during such Settlement Period (including any such Uncollectible Receivables which were repurchased pursuant to Section 4.4 of the applicable Sale and Servicing Agreement) and (ii) the aggregate of the Uncollectible Amounts which arose during such Settlement Period with respect to Receivables which were included as Financible Receivables during such Settlement Period (including any such Uncollectible Amounts reimbursed pursuant to Section 4.4 of the Applicable Sale and Servicing Agreement) and (b) the denominator of which is the aggregate amount of Collections during such Settlement Period. Make-Whole Estimated Amount: An amount equal to the present value, discounted, at an interest rate equal to 1/2 of 1% above the interest rate set forth in H.15(519) on the date the Call Option is exercised as the interest rate on United States Treasury securities having a maturity date of the Scheduled TRIPs Termination Date (such rate, the "Estimated Comparison Rate"), from the period from the Call Date to the Scheduled TRIPs Termination Date, of (a) the TRIPs Capital on such date times (b) the excess of (i) the TRIPs Yield Rate over (ii) the Estimated Comparison Rate. Make-Whole Payment Amount: With respect to any repayment of TRIPs Capital on any Transfer Date following the Call Date, an amount equal to the present value, discounted in accordance with standard financial practices, at an interest rate equal to 1/2 of 1% above the interest rate set forth in the Federal Reserve Board publication H.15(519) on the last day of the immediately preceding Settlement Period as the interest rate on United States Treasury securities having a maturity date of the Scheduled TRIPs Termination Date or determined by linear interpolation therefrom (such rate, the "Actual Comparison Rate"), from the period from such Transfer Date to the Scheduled TRIPs Termination Date, of (a) the TRIPs Capital being repaid on such date times (b) the excess of (i) the TRIPs Yield Rate over (ii) the Actual Comparison Rate. Managing Agent: Barclays, in its capacity as managing agent or administrative agent for Sheffield. Master Receivables Account: As defined in Section 3.7 of the Servicing Agreement. Maximum Aggregate Capital. $85,000,000. Maximum Sheffield Capital: $25,000,000, as such amount may be increased from time to time in accordance with Section 2.13 of the Pooling Agreement. Maximum TRIPs Capital: $50,000,000. Medicaid: In any state, the hospital insurance program created by that state's statutes in accordance with Title XIX of the Social Security Act. Medicaid Receivable: With respect to any state, a Receivable of which the Obligor is the state and, to the extent provided by law, the United States, acting through the state Medicaid agency, and which arises out of charges properly reimbursable to a Hospital under Medicaid. Medicare: The hospital insurance program created by Part A of Title XVIII of the Social Security Act. Medicare Receivable: A Receivable of which the Obligor is the United States and which arises out of charges reimbursable to a Hospital under Medicare. Monthly Program Expense Amount: With respect to each Settlement Period, the following fees and expenses payable by Finco during such Settlement Period and to be paid pursuant to Section 7.3(a) of the Pooling Agreement on the subsequent Transfer Date: (i) the Servicing Fee; (iv) all Indemnified Amounts; and (v) all other fees (all of which fees shall have been agreed to by Finco prior to the Initial Closing Date), costs, expenses and indemnities payable by Finco, the Participants or any other party to the Operative Documents other than those fees, costs and expenses to be payable out of the Servicing Fee or included in the Monthly Sheffield Expense Amount or the Monthly TRIPs Expense Amount. Monthly Sheffield Expense Amount: With respect to each Settlement Period, all fees (all of which fees shall have been agreed to by Finco prior to the Initial Closing Date) and expenses payable by Finco during such Settlement Period (other than Sheffield Yield) solely in connection with the issuance and administration of the Commercial Paper Notes, including all commitment fees and other fees payable by Sheffield to the Liquidity Agent, the Liquidity Banks, the Program Bank and Barclays under the Liquidity Agreement, the Program Loan Agreement and any Stub Loan and all fees and expenses set forth in the letter dated the date hereof among Finco, UHS, Sheffield and the Placement Agent. Monthly TRIPs Expense Amount: With respect to each Settlement Period, all fees (which fees shall be specified in writing prior to the TRIPs Closing Date) and expenses payable by Finco during such Settlement Period (other than TRIPs Yield) solely in connection with the issuance and administration of the TRIPs. Moody's: Moody's Investors Service, Inc., and any successor thereof. Multiemployer Plan: A Plan which is a multiemployer plan as defined in Section 4001(a)(3) of ERISA. Non-governmental Receivables: With respect to each Hospital, the Receivables of such Hospital, other than Governmental Receivables, together with any and all rights to receive payments due thereon, and all proceeds thereof in any way derived, whether directly or indirectly. Non-qualifying Receivable: Any Receivable as to which any representation or warranty set forth in Section 4.1(d) or (e) or 4.2 of the related Sale and Servicing Agreement is not true and correct on the related Purchase Date. Notice of Assignment: Each notice of assignment delivered by or on behalf of any Hospital to any insurer or third party intermediary that is an Obligor on such Hospital's Receivables pursuant to the Conditions List and Section 5.3 of the Pooling Agreement, which notice of assignment shall notify such Obligor of the assignment of the Permitted Interests and, to the extent required by Section 5.3 of the Pooling Agreement, request such Obligor to consent to such assignment. Notice Review Date: The date 90 days after the Initial Closing Date or such other date determined pursuant to Section 5.3(b) of the Pooling Agreement. Obligations: As defined in Paragraph 1 of the Guarantee. Obligor: Each Person who is indebted on a Receivable. Offset Reserves: On any date, the sum of (a) $1,000,000, (b) an amount determined as of the last day of the preceding Settlement Period to be equal to the unpaid portion, as reflected in all audited periodic cost reports filed by all Hospitals with the appropriate state and federal Governmental Authorities under the applicable Medicaid programs and with HCFA under Medicare, of the amount payable by all Hospitals for which cost reports indicate amounts payable to such governmental authorities and (c) an additional amount, if greater than zero, determined as of the date of completion of all audits of all periodic cost reports filed during the preceding fiscal year of UHS for all UHS Entities to be equal to (i) the greater of (A) 1.5 times the highest amount (rounded to the nearest $1,000,000) payable to such Governmental Authorities and reflected in the past three annual audited cost reports of all Hospitals for which audits determined amounts to be payable to such Governmental Authorities and (B) three times the amount payable to such Governmental Authorities and reflected in the most recent audited cost reports of all Hospitals for which audits determined amounts to be payable to such governmental authorities minus (ii) an amount equal to the aggregate Collections received in respect of Self-Pay Receivables during the period of two Consecutive Settlement Periods occurring in the fiscal year immediately preceding such date of determination for which such aggregate Collections were the lowest. Operative Documents: The collective reference to the Hospital Documents, the Sheffield Documents, the Finco Documents, the Servicing Agreement, the Guarantee and any other agreement or instrument related to any of the foregoing. Other Accounts: As defined in Section 7.1(d) of the Pooling Agreement. Other Blue Cross/Blue Shield: At any time of reference, individually, an Obligor that is a blue cross or blue shield entity and is not a Preferred Blue Cross/Blue Shield. Other Insurer/HMO/PPO: At any time of reference, individually, a commercial insurer, health maintenance organization, primary pay organization or similar entity (excluding Blue Cross/Blue Shield) which is not a Preferred Insurer/HMO/PPO. Outstanding: At any time, (a) with respect to any Commercial Paper Note, each Commercial Paper Note authenticated and issued by Sheffield, other than (i) each Commercial Paper Note paid upon or following its maturity as provided in such Commercial Paper Note, and (ii) each Commercial Paper Note as to which funds for payment have been deposited with any depositary or paying agent with respect thereto and are not subject to any Lien, (b) with respect to any of the TRIPs, each TRIP authenticated and issued pursuant to the Pooling Agreement, other than each TRIP paid upon, prior to or following its maturity as provided in accordance with its terms and (c) with respect to any Loan, each advance made by any Lender, other than any such advance paid upon, prior to or following its maturity as provided in accordance with its terms. Outstanding Balance: With respect to any Receivable as of any time of determination, (i) the net amount of such Receivable as calculated by the Hospital in accordance with its normal and reasonable billing procedures, after deduction for any contractual or similar allowance or write-off determined based on payor class of Obligor, including the Applicable Contractual Adjustment (or, if determined, the Actual Contractual Adjustment) applicable to such Receivable, minus (ii) all Uncollectible Amounts in respect of such Receivable and minus (iii) Collections received by the Hospital in respect of such Receivable. It is understood that the Outstanding Balance of an Uncollectible Receivable is $0. Outstanding Receivable: With respect to any Receivable as of any time of reference, a Receivable that has not been fully paid, has not become an Uncollectible Receivable or has not been repurchased pursuant to Section 4.4 of the related Sale and Servicing Agreement prior to such time of reference. Participants: The TRIPs Holders (if any) and Sheffield, collectively, as transferees of the Participations pursuant to the Pooling Agreement. Participation: As defined in Section 2.4 of the Pooling Agreement. Payment Date: With respect to any Purchased Receivable, one Business Day following the earlier to occur of (a) the date on which the invoice relating to such Purchased Receivable is sent to the Obligor and (b) the date of discharge of the patient to whose account such Receivable relates. PBGC: The Pension Benefit Guarantee Corporation established pursuant to Subtitle A of title IV of ERISA. Permitted Interests: All rights granted (a) by the Hospitals to Finco pursuant to the Sale and Servicing Agreements and (b) to the Interested Parties pursuant to the Pooling Agreement and the Security Agreement. Permitted Investments: (a) Direct obligations of, or obligations the principal of and interest on which are unconditionally guaranteed by, the full faith and credit of the United States of America (including obligations issued or held in book-entry form on the books of the Department of the Treasury of the United States of America); (b) commercial or finance paper or other similar obligations rated at the time of purchase A-1+ or better by S&P and P-1 or VMIG-1 by Moody's; (c) interest-bearing demand or time deposits (including certificates of deposit) in any issuing bank or trust company rated A-1+ by S&P and P-1 by Moody's and secured at all times, in the manner and to the extent provided by law, by collateral security (described in clause (a) of this definition) of a market value (valued at least quarterly) of no less than the amount of money so invested; (d) negotiable or non-negotiable certificates of deposit, time deposits or other similar banking arrangements issued by any bank or trust company, having the highest short-term rating by S&P and Moody's or fully insured by the Federal Deposit Insurance Corporation; (e) any money market fund having the highest fund rating by S&P and Moody's and the funds of which are invested only in any of the above (including, without limitation, such mutual funds as are offered by the Person who is acting as Trustee or any agent of such Person). Person: An individual, a partnership, a corporation, a business trust, a joint stock company, a trust, an unincorporated association, a joint venture, a Governmental Authority or other entity of whatever nature. Plan: With respect to a particular Person at a particular time, any employee benefit plan which is covered by ERISA and in respect of which such Person or a Commonly Controlled Entity is (or, if such plan were terminated at such time, would under Section 4069 of ERISA be deemed to be) an "employer" as defined in Section 3(5) of ERISA. Pooling Agreement: The Pooling Agreement, as defined on the first page hereof. Preferred Blue Cross/Blue Shield: At any time of reference, individually, any Obligor that is a blue cross or blue shield organization rated at least "A" by S&P and Moody's. Preferred Insurer/HMO/PPO: At any time of reference, individually, any Obligor which is a commercial insurer, health maintenance organization, primary pay organization or similar entity (excluding Blue Cross/Blue Shield) and which is rated at least "A" by S&P and Moody's. Principal Pay-Down: With respect to any Commercial Paper Notes or Loans maturing on any Business Day, the excess of (a) the sum of (i) the Face Amount of such Commercial Paper Notes or principal amount of such Loans, as the case may be, and (ii) all accrued and unpaid Sheffield Yield (except to the extent included in the Face Amount of the applicable Commercial Paper Note) with respect to such Commercial Paper Notes or Loans over (b) the sum of (x) the net proceeds from the sale of any Commercial Paper Notes (after deduction of all fees payable to any issuing and paying agent or commercial paper dealer in connection therewith) or the incurrence of Loans on such Business Day and (y) the amount on deposit in the Sheffield Payment Account on such Business Day. Program Bank: Barclays, in its capacity as Program Bank under the Program Loan Agreement, and its successors in such capacity. Program Loan: An advance made by the Program Bank to Sheffield pursuant to the Program Loan Agreement in order to pay maturing Commercial Paper. Program Loan Agreement: The Irrevocable Program Loan Agreement, dated as of December 12, 1991, between Sheffield and the Program Bank, as the same may be amended, supplemented or otherwise modified from time to time. Prohibited Transaction: The meaning assigned to that term in Section 4975 of the Code. Purchase Date: Each date (commencing with the Initial Closing Date) on which any Receivable is purchased by Finco pursuant to the terms of any Sale and Servicing Agreement. Purchase Price: With respect to any Receivable to be purchased on any Purchase Date, an amount equal to (a) the aggregate Outstanding Balance of such Receivable minus (b) the Cost of Funds. Purchased Receivables: The Receivables, including any Receivables that have become Uncollectible Receivables, purchased by Finco from all Hospitals pursuant to all Sale and Servicing Agreements and not repurchased by the applicable Hospital in accordance with the terms thereof. Rating Agency: Initially, S&P and Moody's, and thereafter, any other such agency or agencies then rating the Commercial Paper Notes at the request of Sheffield or the TRIPs at the request of the TRIPs Holders. Receivables: With respect to each Hospital, the patient accounts existing or hereafter created of that Hospital (including, without limitation, Self-pay Receivables), any and all rights to receive payments due on such accounts from any Obligor or other third-party payor under or in respect of such accounts (including without limitation all insurance companies, Blue Cross/Blue Shield, Medicare, Medicaid, Champus, Workers' Compensation and health maintenance organizations and primary pay organizations) and all proceeds of, or in any way derived, whether directly or indirectly, from any of the foregoing. Receivables Information: Any information provided in writing by an Authorized Officer of any Hospital, Finco, UHS or UHS Delaware to any Interested Party. Receivables Pool: At any date of determination, all Purchased Receivables with an Outstanding Balance, less all Receivables repurchased pursuant to Section 4.4 of any Sale and Servicing Agreement. Record Date: With respect to each Transfer Date, the date occurring five Business Days prior to such Transfer Date. Reference Rate: With respect to each Sheffield Tranche for the relevant Fixed Period, an interest rate per annum determined by Barclays equal to the quotient of (a) the rate at which it would offer deposits in United States dollars to prime banks in the London interbank market for a period equal to such Fixed Period and in a principal amount of not less than $1,000,000 at or about 11:00 A.M. (London time) on the second Business Day before (and for value on) the first day of such Fixed Period divided by (b) one minus the Eurodollar Reserve Percentage (expressed as a decimal) applicable to Barclays for such Fixed Period. Reorganization: With respect to any Multiemployer Plan, the condition that such plan is in reorganization within the meaning of Section 4241 of ERISA. Reportable Event: Any of the events set forth in Section 4043(b) of ERISA, other than those events as to which the thirty day notice period is waived under subsections .13, .14, .16, .18, .19 or .20 of PBGC Reg. Section 2615. Repurchase Date: Any date on which Non-qualifying Receivables are to be purchased by a Hospital in accordance with Section 4.4 of each Sale and Servicing Agreement. Required Coverage Amount: On any date of determination, an amount equal to (a) the sum of (i) the TRIPs Capital on such date, (ii) the Sheffield Capital on such date and (iii) the principal amount of all Loans Outstanding on such date plus (b) the Loss Reserves plus (c) the Yield Reserves plus (d) the Fee/Expense Reserves plus (e) the Make-Whole Estimated Amount minus (f) the Sheffield Retained Funds and minus (g) the TRIPs Make-Whole Funds; provided, however, that during the TRIPs Amortization Period or the Sheffield Amortization Period, (i) the Required Coverage Amount shall be reduced by the amount of all funds in any Other Account (other than funds to be used for the payment of Yield or the Make Whole Payment Amount) and (ii) for purposes of calculating any of the reserves set forth in clauses (b), (c) and (f) above, the TRIPs Capital or Sheffield Capital, as the case may be, on the last day of the applicable Revolving Period, rather than the Capital on the date of calculation, shall be used to make the related reserve calculation. Required Participants: At any time, Participants holding Participations aggregating more than 50% of the Aggregate Capital at such time. Required TRIPs Holders: At any time, TRIPs Holders holding TRIPs Participations aggregating more than 50% of the TRIPs Capital at such time. Requirement of Law: As to any Person, (i) the Certificate of Incorporation and By-laws, corporation agreement or other organizational or governing documents of such Person, and (ii) any law, treaty, rule or regulation, or determination of an arbitrator or a court, in each case applicable to or binding upon such Person or any of its property or to which such Person or any of its property is subject. Revolving Period: The TRIPs Revolving Period or the Sheffield Revolving Period, as the context requires. S&P: Standard & Poor's Corporation, and any successor thereof. Sale and Servicing Agreement: Each Sale and Servicing Agreement, as defined on the first page hereof. Scheduled Sheffield Termination Date: ________, 1998, as such date may be extended pursuant to Section 2.13 of the Pooling Agreement. Scheduled TRIPs Termination Date: The date designated in writing by Finco as the Scheduled TRIPs Termination Date in its notice to Sheffield and the Trustee pursuant to Section 2.5(b) of the Pooling Agreement. Securities Act: The Securities Act of 1933, as amended from time to time. Security Agreement: The Security Agreement, dated as of November 16, 1993, between Sheffield and the Liquidity Agent. Security Filings: All filings and recordations (including, without limitation, those filings pursuant to the UCC in effect in the State in which any Hospital's chief executive office is located), and, subject to Section 5.3 of the Pooling Agreement and the Conditions List, all Notices of Assignments and Confirmations, which are required to be made to perfect (i) the interest of Finco and its assignees in the Purchased Receivables and other Transferred Property, (ii) the interest of the Trustee and the Participants in the Trust Assets and (iii) the interest of the Liquidity Agent and the Liquidity Banks in Sheffield's right, title and interest in and to the Trust Assets. Self-pay Receivable: That portion of any patient account under which the primary obligation to pay for any services rendered under such account is solely and directly that of the patient or a guarantor of such patient's account who is a natural person. Servicer: UHS Delaware, in its capacity as servicer of the Receivables, and any successor under the Servicing Agreement. Servicer Daily Statement: As defined in Section 3.5 of the Servicing Agreement. Servicer Incumbency Certificate: A certificate as to the incumbency and specimen signatures of the Servicing Agents. Servicer Termination Notice: The notice delivered by Finco pursuant to Section 4.2 of the Servicing Agreement terminating all rights and obligations of the Servicer. Servicer's Certificate: The Certificate required to be delivered by the Servicer to Sheffield and the Trustee pursuant to Section 3.2 of the Servicing Agreement. Servicing Agent: Any Secretary or Assistant Secretary of the Servicer, or any other person authorized to act, and to give instructions and notices on behalf of the Servicer under the Servicing Agreement whose name and specimen signature appears on a Servicer Incumbency Certificate signed by any Secretary or Assistant Secretary thereof and delivered to Sheffield and the Trustee. Such Servicing Agents may be designated from time to time by the Servicer. Servicing Agreement: The Servicing Agreement, as defined on the first page hereof. Servicing Fee: The fee set forth in Section 3.1 of the Servicing Agreement. Settlement Date: The date during each month occurring two Business Days prior to the Transfer Date. Settlement Date Statement: The statement required to be delivered by the Servicer, on or before each Settlement Date, pursuant to Section 3.3 of the Servicing Agreement. Settlement Period: The period from the first day of a month (or, in the case of the month in which the Initial Closing Date occurs, the period from the Initial Closing Date) through and including the last day of that month. Sheffield: Sheffield Receivables Corporation, a Delaware corporation. Sheffield Amortization Period: The period commencing on the Sheffield Termination Date and ending on the earliest to occur of (a) the date on which the Sheffield Capital is reduced to zero, (b) the date on which the Outstanding Balance of Purchased Receivables is reduced to zero and (c) the Final Sheffield Maturity Date. Sheffield Bankruptcy Event: Any of the following events: (a) Sheffield shall have made a general assignment for the benefit of creditors; (b) any proceeding shall have been instituted by or against Sheffield seeking to adjudicate it a bankrupt or insolvent, or seeking liquidation, winding up, reorganization, arrangement, adjustment, protection, relief or composition of it or its debts under any law relating to bankruptcy, insolvency or reorganization or relief of debtors, or seeking the entry of an order for relief or the appointment of a receiver, trustee, custodian or other similar official for it or for any substantial part of its property and, in the case of any proceeding against it (but not instituted by it), either such proceeding shall remain unstayed or undismissed for a period of 60 days, or any of the actions sought in such proceeding (including, without limitation, the entry of an order for relief against, or the appointment of a receiver, trustee, custodian or similar official for, it or for any substantial part of its property) shall occur; or (c) Sheffield shall take any corporate action to authorize any of the foregoing actions. Sheffield Capital: With respect to the Sheffield Participation, (a) the Initial Sheffield Capital plus (b) each Increase Amount minus (c) funds received and distributed to Sheffield on account of such Sheffield Capital pursuant to Section 7.4 of the Pooling Agreement; provided, however, that such Sheffield Capital shall not be reduced by any distribution of any portion of Collections if at any time such distribution is rescinded or must be returned for any reason. Sheffield Documents: The Commercial Paper Notes, the Pooling Agreement, the Liquidity Agreement, the Program Loan Agreement, the Security Agreement, the Security Filings executed by Sheffield in favor of the Liquidity Agent and any other agreement or instrument related to any of the foregoing. Sheffield Interest Sub-account: A sub-account of the Sheffield Sub- account established pursuant to Section 7.1(a) of the Pooling Agreement. Sheffield Participation: A senior undivided participating interest in the Trust Assets acquired by Sheffield from Finco pursuant to the terms and conditions of the Pooling Agreement. Sheffield Payment Account: As defined in Section 7.1(c) of the Pooling Agreement. Sheffield Percentage: On any Business Day, the percentage equivalent of a fraction, the numerator of which is the Allocable Sheffield Capital and the denominator of which is the sum of the (i) the Allocable Sheffield Capital and (ii) the Allocable TRIPs Capital. Sheffield Retained Funds: On any date, the aggregate amount of funds in the Sheffield Sub-account on such date which have been retained in such sub-account pursuant to Section 7.2(b)(iv) of the Pooling Agreement. Sheffield Revolving Period: The period commencing on the Initial Closing Date and ending on the Sheffield Termination Date. Sheffield Sub-account: A sub-account of the Collateral Account established pursuant to Section 7.1(a) of the Pooling Agreement. Sheffield Termination Date: The earliest to occur of (a) the Scheduled Sheffield Termination date, (b) the occurrence of an Early Amortization Event (i) described in Section 10.1(f) of the Pooling Agreement or (ii) declared by Sheffield pursuant to Section 10.2 of the Pooling Agreement, (c) the date which occurs three days after the occurrence of any Early Amortization Event described in Section 10.1(o) through (r) of the Pooling Agreement and (d) the date on which Sheffield gives written notice to Finco and the Trustees of the occurrence of (i) the Liquidation Date or (ii) a Sheffield Bankruptcy Event. Sheffield Termination Sale Amount: With respect to any sale of Receivables or interests therein pursuant to Section 14.1(a) of the Pooling Agreement, the product of (a) the sum of (i) $7,500,000 and (ii) (A) one plus the Loss Factor times (B) the Outstanding Balance of Purchased Receivables on such date and (b) the Sheffield Percentage. Sheffield Tranche: Any portion of the Sheffield Capital, as designated by Finco and approved by Sheffield pursuant to Section 2.5, 2.6 or 2.10 of the Pooling Agreement, with respect to which Sheffield Yield is calculated by reference to a specified Sheffield Yield Rate and Fixed Period. Sheffield Yield: With respect to a Sheffield Tranche for any Fixed Period, the product of (a) the Sheffield Yield Rate divided by 365, (b) the portion of the Sheffield Capital allocable to such Sheffield Tranche and (c) the number of days elapsed in such Fixed Period. Sheffield Yield Factor Amount: For any Business Day, (a) (i) the Average Financible Turnover Period plus 10 divided by (ii) 360 times (b) the Base Rate times (c) the Sheffield Capital on such Business Day. Sheffield Yield Rate: For any Fixed Period with respect to a Sheffield Tranche, (a) to the extent Sheffield will fund such Sheffield Tranche through the issuance of Commercial Paper Notes, the CP Rate and (b) to the extent that Sheffield will fund such Sheffield Tranche through the incurrence of Loans, the Alternative Rate. Single Employer Plan: Any Plan which is covered by Title IV of ERISA, but which is not a Multiemployer Plan. Social Security Act: The Social Security Act of 1935, 42 U.S.C. Sections 401 et seq., as the same may be amended, supplemented or otherwise modified from time to time. Statement Delivery Day: As defined in Section 3.5(b) of the Servicing Agreement. Stub Loan: An advance, other than a Liquidity Loan or a Program Loan, made by Barclays to Sheffield, the proceeds of which are used to maintain the Sheffield Participation. Subordinated Interest: As defined in Section 2.9 of the Pooling Agreement. Subordinated Note: A subordinated promissory note, substantially in the form of Exhibit A to any Sale and Servicing Agreement, executed by Finco in favor of the Hospital party to such Sale and Servicing Agreement. Subsidiary: As to any Person, a corporation, partnership or other entity of which shares of stock or other ownership interests having ordinary voting power (other than stock or such other ownership interests having such voting power only by reason of the happening of a contingency) to elect a majority of the board of directors or other managers of such corporation, partnership or other entity are at the time owned, or the management of which is otherwise controlled directly or indirectly through one or more intermediaries, or both, by such Person. Successor Servicer: Any successor servicer as defined pursuant to Section 4.4 of the Servicing Agreement. Taxes: As defined in Section 2.12 of the Pooling Agreement. Total Transferred Property: The collective reference to the Transferred Property and the Finco Transferred Property. Transfer Agent and Registrar: As defined in Section 9.3 of the Pooling Agreement. Transfer Date: The 15th calendar day of each month, or if such day is not a Business Day, the subsequent Business Day, commencing December 15, 1993. Transferred Property: The Purchased Receivables and, subject to confidentiality rights under applicable laws and regulations and under the rules of JCAHO or AOA, as the case may be, all now existing or hereafter arising instruments, documents, agreements, books and records relating to the foregoing. TRIPs: The Trade Receivables Investment Participations, substantially in the form of Exhibit A to the Pooling Agreement, issued by the Trust to the TRIPs Holders pursuant to the Pooling Agreement. TRIPs Amortization Period: The period commencing on the Business Day following the TRIPs Termination Date and ending on the earliest to occur of (a) the date on which the TRIPs Capital is reduced to zero, (b) the date on which the Outstanding Balance of Purchased Receivables is reduced to zero and (c) the Final TRIPs Maturity Date. TRIPs Capital: With respect to the TRIPs Participations, the Initial TRIPs Capital, as reduced from time to time by Collections received and distributed on account of the TRIPs Capital pursuant to Section 7.5 of the Pooling Agreement; provided, however, that the TRIPs Capital shall not be reduced by any distribution of any portion of Collections if at any time such distribution is rescinded or must be returned for any reason. TRIPs Closing Date: Any date after the Initial Closing Date on which all applicable conditions precedent required by Section 3.1 of the Pooling Agreement with respect to such date are satisfied or waived. TRIPs Holders: The holders from time to time of the Outstanding TRIPs. TRIPs Interest Default: The occurrence on any Transfer Date of an excess of (a) the TRIPs Yield payable on such Transfer Date over (b) the amount of funds on deposit in the TRIPs Interest Sub-account on such Transfer Date. TRIPs Interest Sub-account: A sub-account of the TRIPs Sub-account established pursuant to Section 7.1(a) of the Pooling Agreement. TRIPs Make-Whole Funds: On any date, the aggregate amount of funds in the TRIPs Interest Sub-Account on such date which have been deposited in such sub-account pursuant to Section 7.2(c)(iv) of the Pooling Agreement. TRIPs Participation: The aggregate senior undivided participating interest in the Trust Assets acquired by any TRIPs Holder from Finco pursuant to the terms and conditions of the Pooling Agreement and evidenced by a TRIP; collectively, the "TRIPs Participations". TRIPs Payment Account: As defined in Section 7.1(d) of the Pooling Agreement. TRIPs Percentage: On any Business Day, the percentage equivalent of a fraction, the numerator of which is the Allocable TRIPs Capital and the denominator of which is the sum of (i) the Allocable TRIPs Capital and (ii) the Allocable Sheffield Capital. TRIPs Register: As defined in Section 9.3 of the Pooling Agreement. TRIPs Revolving Period: The period commencing on the TRIPs Closing Date and ending on the TRIPs Termination Date. TRIPs Sub-account: A sub-account of the Collateral Account established pursuant to Section 7.1(a) of the Pooling Agreement. TRIPs Termination Date: The earliest to occur of (a) the Scheduled TRIPs Termination Date, (b) the Call Date, (c) the occurrence of an Early Amortization Event (i) described in Section 10.1(f) of the Pooling Agreement or (ii) declared by the TRIPs Holders pursuant to Section 10.2 of the Pooling Agreement and (d) the date which is three days after the occurrence of any Early Amortization Event described in Section 10.1(o) through (r) of the Pooling Agreement. TRIPs Termination Sale Amount: With respect to any sale of Receivables or interests therein pursuant to Section 14.1(b) of the Pooling Agreement, the product of (a) the sum of (i) $7,500,000 and (ii) (A) one plus the Loss Factor times (B) the Outstanding Balance of Purchased Receivables on such date and (b) the TRIPs Percentage. TRIPs Yield: With respect to any date, (a) the TRIPs Yield Rate divided by 360 times (b) the TRIPs Capital on such date. TRIPs Yield Factor Amount: On any date of determination, (i) the TRIPs Yield Rate times (ii) (A) the Average Financible Turnover Period plus 10 divided by (B) 360 times (iii) the TRIPs Capital on such date. TRIPs Yield Rate: The rate specified as the TRIPs Yield Rate in the written notice delivered by Finco pursuant to Section 2.5(b) of the Pooling Agreement. Trust: The UHS Healthcare Receivables Trust created by the Pooling Agreement. Trust Assets: As defined in Section 2.1 of the Pooling Agreement. Trust Termination Date: The later to occur of the Final Sheffield Maturity Date and the Final TRIPs Maturity Date. Trustee: Continental, in its capacity as Trustee under the Pooling Agreement, and any successor in such capacity. Trustee Fee: The fees specified in the Trustee Fee Letter. Trustee Fee Letter: The letter agreement among Finco, UHS and the Trustee setting forth the trustee fee. UCC: The Uniform Commercial Code as in effect in the specified jurisdiction or, if no jurisdiction is specified, as in effect in the state whose law, by agreement of the parties, governs the document or agreement in which the term "UCC" or "security interest" appears. UHS: Universal Health Services, Inc., a Delaware corporation. UHS Delaware: UHS of Delaware, Inc., a Delaware corporation. UHS Entities: The collective reference to UHS, the Hospitals, Finco and UHS Delaware. Uncollectible Amount: With respect to each Receivable other than an Uncollectible Receivable, all reductions in the gross amount due under such Receivable other than the lesser of (a) the Applicable Contractual Adjustment and (b) the Actual Contractual Adjustment (including, without limitation, any write-offs and/or reserves taken in relation to such Receivable). Uncollectible Receivable: On any date of determination, any Receivable as to which all amounts due and payable thereunder have not been paid and (a) as to which the Servicer believes, in its good faith judgment, all amounts due thereunder are not or would not be ultimately recoverable or (b) in respect of which more than 180 days have elapsed since the date on which such Receivable was first billed or (c) as to which any Obligor on such Receivable is bankrupt, insolvent, undergoing composition or adjustment of debts or is otherwise unable to make payments on its obligations when due; provided that a Medicaid Receivable (other than a Medicaid Receivable described in clause (a) or (b) above) shall not be deemed to be an Uncollectible Receivable solely because the Obligor on such Medicaid Receivable is currently insolvent if (i) such Obligor would not reasonably be expected to remain insolvent or otherwise unable or unwilling to make payment under such Receivable and (ii) the Servicer has determined in good faith and in accordance with the Credit and Collection Policy that such Medicaid Receivable should not be deemed an Uncollectible Receivable. Voluntary Exclusion Event: With respect to any UHS Entity, such UHS Entity shall contest or deny that it is bound by, or has any or further liability or obligation under, the terms and conditions of any of the Operative Documents to which it is a party provided that a denial of liability by any Hospital and the Sale and Servicing Agreement to which it is a party as a result of (i) the disposition by UHS of such Hospital or (ii) the occurrence of an Exclusion Event of the type described in Section 6.1(d) of such Sale and Servicing Agreement shall not constitute a Voluntary Exclusion Event. Yield: Sheffield Yield or TRIPs Yield, as the context requires. Yield Reserves: On any date, the sum of (i) the portion of all accrued and unpaid Sheffield Yield which is not on deposit in the Sheffield Interest Sub-account on such date plus (ii) the portion of all accrued and unpaid TRIPs Yield which is not on deposit in the TRIPs Interest Sub-account on such date plus (iii) the Sheffield Yield Factor Amount plus (iv) the TRIPs Yield Factor Amount. EXHIBIT A LIST OF HOSPITALS Names and Principal Place of Business of Hospitals Name Principal Place of Business Chalmette General Hospital, Inc. 9001 Patricia Street Chalmette, LA 70043 and 800 Virtue Street Chalmette, LA 70043 Dallas Family Hospital, Inc. 2929 South Hampton Road Dallas, TX 75224 Del Amo Hospital, Inc. 23700 Camino del Sol Torrance, CA 90505 HRI Hospital, Inc. 227 Babcock Street Brookline, NM 02146 La Amistad Residential 201 Alpine Drive Treatment Center, Inc. Maitland, FL 32751 McAllen Medical Center, Inc. 301 West Expressway 83 McAllen, TX 78503 Meridell Achievement Center, Inc. Highway 29 West Liberty Hill, TX 78642 and 2501 Cypress Creek Road Cedar Park, TX 78613 River Oaks, Inc. 1525 River Oaks Road West New Orleans, LA 70123 Sparks Reno Partnership, L.P. 2375 E. Prater Way Sparks, NV 89434 Turning Point Care Center, Inc. 319 East By-Pass Moultrie, GA 31768 UHS of Arkansas, Inc. 21 BridgeWay Road North Little Rock, AR 72118 UHS of Auburn, Inc. 20 Second Street, N.E. Auburn, WA 98002 UHS of Belmont, Inc. 4058 West Melrose Street Chicago, IL 60641 UHS of Massachusetts, Inc. 49 Robinwood Avenue Boston, MA 02130 UHS of River Parishes, Inc. 500 Rue de Sante LaPlace, LA 70068 UHS of Shreveport, Inc. 1130 Louisiana Avenue Shreveport, LA 71101 Universal Health Services 36485 Inland Valley Drive of Inland Valley, Inc. Wildomar, CA 92395 Universal Health Services of 620 Shadow Lane Nevada, Inc. Las Vegas, NV 89106 Victoria Regional Medical 101 Medical Drive Center, Inc. Victoria, TX 77904 Wellington Regional Medical 10101 Forest Hill Blvd. Center Incorporated West Palm Beach, FL 33414 - ------------------------------------------------------------------------------ SERVICING AGREEMENT among UHS RECEIVABLES CORP., UHS OF DELAWARE, INC. as Servicer and CONTINENTAL BANK, NATIONAL ASSOCIATION, as Trustee dated as of November 16, 1993 - ------------------------------------------------------------------------------ Page ARTICLE I DEFINITIONS . . . . . . . . . . . . . . . 2 ARTICLE II REPRESENTATIONS, WARRANTIES AND COVENANTS. . . . . . . . 2 Section 2.1. Representations, Warranties and Covenants of the Servicer . . . . . . . . . . . . . . . . . . . . . . . 2 Section 2.2. Covenants of the Servicer. . . . . . . . . . . . . . . . . 4 ARTICLE III ADMINISTRATION, COLLECTIONS AND OTHER OBLIGATIONS. . . . . . . . . . . . . 8 Section 3.1. Servicing. . . . . . . . . . . . . . . . . . . . . . . . . 8 Section 3.2. Delivery of Settlement Date Statement. . . . . . . . . . . 13 Section 3.3. Settlement Date Statement. . . . . . . . . . . . . . . . . 13 Section 3.4. Record of Collections. . . . . . . . . . . . . . . . . . . 14 Section 3.5. Servicer Daily Statement . . . . . . . . . . . . . . . . . 14 Section 3.6. Deleted Receivables. . . . . . . . . . . . . . . . . . . . 15 Section 3.7. Master Receivables Account . . . . . . . . . . . . . . . . 16 ARTICLE IV EVENTS OF DEFAULT; SERVICING TERMINATION. . . . . . . 17 Section 4.1. Events of Default. . . . . . . . . . . . . . . . . . . . . 17 Section 4.2. Remedies . . . . . . . . . . . . . . . . . . . . . . . . . 18 Section 4.3. Successor Servicer . . . . . . . . . . . . . . . . . . . . 18 Section 4.4. Appointment of Successor . . . . . . . . . . . . . . . . . 19 Section 4.5. Monitoring . . . . . . . . . . . . . . . . . . . . . . . . 20 ARTICLE V MISCELLANEOUS . . . . . . . . . . . . . . 20 Section 5.1. Notices, Etc.. . . . . . . . . . . . . . . . . . . . . . . 20 Page Section 5.2. Successors and Assigns . . . . . . . . . . . . . . . . . . 21 Section 5.3. Severability Clause. . . . . . . . . . . . . . . . . . . . 21 Section 5.4. Amendments . . . . . . . . . . . . . . . . . . . . . . . . 22 Section 5.5. The Servicer's Obligations . . . . . . . . . . . . . . . . 22 Section 5.6. No Recourse. . . . . . . . . . . . . . . . . . . . . . . . 22 Section 5.7. Further Assurances . . . . . . . . . . . . . . . . . . . . 22 Section 5.8. Termination. . . . . . . . . . . . . . . . . . . . . . . . 23 Section 5.9. Consent to Assignment; Third Party Beneficiaries. . . . . . . . . . . . . . . . . . . . . . . 23 Section 5.10. Counterparts. . . . . . . . . . . . . . . . . . . . . . . . 24 Section 5.11. Headings. . . . . . . . . . . . . . . . . . . . . . . . . . 24 Section 5.12. No Bankruptcy Petition. . . . . . . . . . . . . . . . . . . 24 Section 5.13. Servicer May Act Through Agents . . . . . . . . . . . . . . 25 Section 5.14. GOVERNING LAW . . . . . . . . . . . . . . . . . . . . . . . 25 Section 5.15. No Waiver; Cumulative Remedies. . . . . . . . . . . . . . . 25 Section 5.16. SUBMISSION TO JURISDICTION; VENUE; WAIVER OF JURY TRIAL; SERVICE OF PROCESS . . . . . . . . . . . . . . 25 Section 5.17. Indemnification . . . . . . . . . . . . . . . . . . . . . . 26 Schedule I - Document Locations; Servicer's Principal Place of Business; UHS's Principal Place of Business Schedule II - Master Receivables Account Exhibit A - Settlement Date Statement Exhibit B - Servicer's Certificate Exhibit C - Servicer Daily Statement Exhibit D - Form Confidentiality Agreement SERVICING AGREEMENT SERVICING AGREEMENT (this "Agreement"), dated as of November 16, 1993, among UHS Receivables Corp., a Delaware corporation (together with its successors and assigns, "Finco"), UHS of Delaware, Inc., a Delaware corporation (in its individual capacity, together with its successors and assigns, "UHS Delaware"; as servicer, together with its successors and assigns, the "Servicer"), and Continental Bank, National Association, as trustee (in such capacity, together with its successors and assigns, the "Trustee") under the Pooling Agreement (all capitalized terms used in the preamble and the recitals unless otherwise defined, as defined in the Definitions List referred to below). W I T N E S S E T H : WHEREAS, Sheffield desires to issue and sell its promissory notes in the commercial paper market and Finco desires to issue the TRIPs to certain financial institutions; WHEREAS, subject to the terms and conditions of the several Sale and Servicing Agreements, each between a Hospital and Finco, Finco will purchase from each Hospital and each Hospital will sell to Finco its Receivables, other than Non-qualifying Receivables, and the related Transferred Property; WHEREAS, in order for Finco to pay for the Transferred Property purchased by it from the Hospitals, Finco has entered into a Pooling Agreement under which Finco has conveyed to the Trustee, for the benefit of the Participants, its right, title and interest in and to the Transferred Property and the Finco Transferred Property, and the Participants have offered to acquire from Finco, and Finco has agreed to transfer to the Participants, senior undivided participating interests in the Trust Assets; WHEREAS, Sheffield intends to issue and sell its promissory notes in the commercial paper market and Finco intends to issue the TRIPs to certain financial institutions; WHEREAS, in order to collect the amounts due to Finco under the Purchased Receivables sold to Finco by the Hospitals pursuant to the Sale and Servicing Agreements and in which the Participants have acquired the Participations pursuant to the Pooling Agreement, the Interested Parties have required Finco and the Trustee to enter into an agreement with UHS Delaware requiring UHS Delaware to administer and collect the amounts owing to Finco in respect of the Receivables; WHEREAS, it is contemplated that following the sale and assignment of the Purchased Receivables from the Hospitals to Finco and the transfer of the Participations from Finco to the Participants, the Hospitals will collect the Receivables from the Obligors thereon and will transfer such sums as provided herein and in the Sale and Servicing Agreements; WHEREAS, Finco, the Trustee and UHS Delaware, as Servicer under this Agreement, accordingly wish to enter into this Agreement providing, among other things, for the servicing and administration of, and collection on, such Receivables by the Servicer; and WHEREAS, pursuant to the Guarantee executed by UHS in favor of Finco, UHS has guaranteed all obligations of UHS Delaware as Servicer hereunder and the Hospitals under the Sale and Servicing Agreements. NOW THEREFORE, the parties hereto agree as follows: ARTICLE I DEFINITIONS As used in this Servicing Agreement and unless the context requires a different meaning, capitalized terms used herein shall have the meanings assigned to such terms in the Definitions List, dated as of the date hereof (the "Definitions List"), that refers to this Agreement, which Definitions List is incorporated herein by reference and shall be deemed to be a part of this Agreement. ARTICLE II REPRESENTATIONS, WARRANTIES AND COVENANTS Section 2.1. Representations, Warranties and Covenants of the Servicer. The Servicer, on the Initial Closing Date, the TRIPs Closing Date, each Purchase Date and each Payment Date, represents, warrants and covenants to Finco and the Trustee that: (a) The Servicer has been duly organized and (i) is validly existing and in good standing as a corporation under the laws of the state of its incorporation, with full corporate power and authority to own or lease its properties and to conduct its business as presently conducted and to execute, deliver and perform this Agreement, and to consummate the transactions contemplated hereby, (ii) is duly qualified as a foreign corporation and in good standing under the laws of each jurisdiction where its ownership, lease or operation of property or the conduct of its business requires such qualification, except where any such failure or failures to be so qualified would not, alone or in the aggregate, have a material adverse effect on its business, operations, properties, assets or condition (financial or otherwise), (iii) is in compliance with all Requirements of Law and (iv) is not in default under any mortgage, indenture, deed of trust, loan agreement lease, contract or other agreement, instrument or undertaking to which the Servicer is a party or by which the Servicer or any of its assets may be bound, except to the extent that such defaults would not, alone or in the aggregate, have a material adverse effect on the ability of the Servicer to perform its obligations hereunder. (b) The execution, delivery and performance by the Servicer of this Agreement and the consummation of the transactions contemplated hereby have been duly and validly authorized by all requisite corporate action and will not conflict with, violate or result in a breach of any of the terms or provisions of, or constitute a default under, or result in the creation or imposition of any lien, charge or encumbrance upon any of its property or assets pursuant to the terms of, any indenture, mortgage, deed of trust, loan agreement, lease, contract or other agreement, instrument or undertaking by which it is bound or to which any of its property or assets is subject, nor will such action, result in any violation of any applicable Requirement of Law; and no consent, approval, authorization, order, registration, filing, qualification, license or permit of or with any such court or any such regulatory authority or other such Governmental Authority, other body or any other Person, will be required to be obtained by, or with respect to, the Servicer in connection with the execution, delivery and performance by the Servicer of this Agreement and the consummation of the transactions contemplated hereby and thereby which the Servicer shall not have so obtained. (c) This Agreement has been duly and validly authorized, executed and delivered by the Servicer and constitutes a valid and legally binding obligation of the Servicer, enforceable against the Servicer in accordance with its terms, subject to applicable bankruptcy, reorganization, insolvency, moratorium or other similar laws affecting creditors' rights generally, and subject as to enforceability to general principles of equity (regardless of whether enforcement is sought in a proceeding in equity or at law). (d) All filings, recordings and notices (including pursuant to the UCC) required to perfect the interest of Finco in the Transferred Property and of the Trustee in the Total Transferred Property have been accomplished and are in full force and effect and the Servicer shall at its expense perform all acts and execute all documents reasonably requested by Finco or the Trustee at any time to evidence, perfect, maintain and enforce the interests of Finco and the Trustee. (e) There is (i) no effective financing statement (or similar statement or instrument of registration under the law of any jurisdiction) on file or registered in any public office and (ii) no assignment filed or delivered by or on behalf of the Servicer, in each case covering any interest of any kind in the Transferred Property or intended so to be filed, delivered or registered, and, except to the extent required hereunder, the Servicer will not execute any effective financing statement (or similar statement or instrument of registration under the laws of any jurisdiction) or statements or any assignment or other notification relating to the Total Transferred Property. (f) There are no actions, proceedings or investigations pending or, to the knowledge of the Servicer, threatened, before any court, administrative agency or other tribunal, (i) asserting the invalidity of this Agreement or any of the Security Filings, (ii) questioning the consummation by the Servicer or any of its Subsidiaries of any of the transactions contemplated by the Operative Documents or (iii) which, if determined adversely, alone or in the aggregate, could materially and adversely affect the ability of the Servicer to perform its obligations under, or the validity or enforceability of, this Agreement. (g) The Receivables Information provided by the Servicer on the date hereof or on the Purchase Date on which these representations are made or deemed made does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements in the Receivables Information, in light of the circumstances in which they were made, not misleading. (h) The chief place of business and chief executive office of the Servicer is at the address set forth on Schedule I hereto, which place of business is the place where the Servicer is "located" for the purposes of Section 9-103(3)(d) of the UCC of the state indicated on such Schedule, and the locations of the offices where all of the instruments, documents, agreements, books and records relating to the Receivables are kept are at the addresses shown on the schedule attached hereto as Schedule I. Section 2.2. Covenants of the Servicer. (a) The Servicer will preserve and maintain its existence as a corporation in good standing under the laws of Delaware or any other state in which it is incorporated. The Servicer will preserve and maintain its existence as a foreign corporation in good standing under the laws of each jurisdiction where its ownership, lease or operation of property or the conduct of its business requires such qualification, except where any such failure or failures to be so qualified would not, alone or in the aggregate, have a material adverse effect on its ability to perform its obligations hereunder. (b) The Servicer, will, at its own cost and expense, (i) retain the electronic ledger used by the Servicer as a master record of the Receivables and copies of all documents relating to each Receivable as custodian for Finco and the Interested Parties, (ii) mark such electronic ledger to the effect that the Receivables listed thereon that have been sold to Finco have been transferred and assigned from each of the Hospitals to Finco and (iii) take any actions necessary to remove references to Receivables that have been repurchased by any Hospital in accordance with the Sale and Servicing Agreements. (c) The Servicer will advise Finco and the Trustee promptly, and in reasonable detail, of (i) any Lien asserted or claim made against any of the Transferred Property of which it obtains knowledge, (ii) the occurrence of any breach by the Servicer or any other UHS Entity of any of its respective representations, warranties and covenants contained in any Operative Document of which the Servicer has knowledge, (iii) the occurrence of any event which would be reasonably be expected to have a material adverse effect on the ability of the Servicer to perform its obligations hereunder and (iv) the receipt from any Governmental Authority of a deficiency notice with respect to the Purchased Receivables. (d) Unless prohibited by any Requirement of Law, including, without limitation, by regulations of JCAHO or AOA, as the case may be, Finco, the Trustee and each of their respective employees, agents, representatives (A) shall at all times have full and free access during normal business hours to all the books, correspondence and records of the Servicer insofar as they relate to the Transferred Property, and Finco and the Trustee (and their respective employees, agents and representatives) may examine the same, take extracts therefrom and make photocopies thereof, and the Servicer agrees to render to Finco and the Trustee, at the Servicer's cost and expense, such clerical and other assistance as may be reasonably requested with regard thereto and (B) may discuss the affairs, finances and accounts of the Servicer with, and be advised as to the same by, executive officers and independent accountants of the Servicer, all as Finco or the Trustee may reasonably deem appropriate for the purpose of verifying the accuracy of any reports or information delivered to Finco or the Trustee pursuant to this Agreement or for otherwise ascertaining compliance with this Agreement; provided, however, that each of Finco and the Trustee acknowledges that in exercising the rights and privileges conferred in this Section 2.2(d) it may, from time to time, obtain knowledge of information, practices, books, correspondence and records of a confidential nature and in which the Servicer has a proprietary interest; and provided, further, that the Servicer, Finco and the Trustee acknowledge that the Operative Documents and documents required to be filed by or on behalf of UHS and its Subsidiaries with the Securities and Exchange Commission and available to the public shall not be considered confidential for purposes of this Agreement (such confidential information, collectively, the "Information"). Each of Finco and the Trustee agrees that the Information is to be regarded as confidential information and may be subject to laws, rules and regulations regarding patient confidentiality and agrees that subject to the following sentence, (i) it shall, and shall cause its employees agents and representatives to, retain in confidence not disclose without the prior written consent of the Servicer any or all of the Information and (ii) it will not, and will ensure that its employees, agents and representatives will not, make any use whatsoever (other than for the purposes contemplated by this Agreement, the other Operative Documents or for the enforcement of any of the rights granted hereunder or thereunder) of the Information without the prior written consent of the Servicer. Notwithstanding the foregoing, each of Finco and the Trustee may (x) disclose Information to any Person that executes and delivers to the addressee and UHS a confidentiality agreement, substantially in the form of Exhibit D hereto with respect to the Information or (y) disclose or use such Information (A) to the extent that such Information is required or appropriate in any reports, statement or testimony submitted to any municipal, state, or federal regulatory body having or claiming to have jurisdiction over Finco, the Trustee or the National Association of Insurance Commissioners or similar organization or their successors, (B) to the extent such Information is required in response to any summons or subpoena or in connection with any litigation, (C) to the extent that such Information is believed by Finco or the Trustee to be required in order to comply with any law, order, regulation or ruling applicable to Finco or the Trustee, (D) to the extent that such information was publicly available or otherwise known to Finco or the Trustee at the time of disclosure, (E) to the extent that such information subsequently becomes publicly available other than through any act or omission of Finco, and (F) to the extent that such information subsequently becomes known to Finco or the Trustee other than through a person known to be acting in violation of his or its obligations to the Servicer. (e) The Servicer shall execute and file such UCC financing statements, continuation statements and any other documents, if any, requested by Finco (and in form and substance satisfactory to Finco), or which may be required by law to fully preserve and protect the ownership interests and/or security interests of Finco and the Interested Parties under the Operative Documents in and to the Total Transferred Property. (f) The Servicer will not, without providing 30 days' notice to Finco and without filing such amendments to the Security Filings as Finco may require, (i) change the location of its chief executive office or the location of the offices where the records relating to the Receivables are kept or (ii) change its name, identity or corporate structure in any manner which could make any Security Filing or related continuation statement seriously misleading within the meaning of Section 9-402(7) of any applicable enactment of the UCC applicable thereto or (iii) delete or otherwise modify the marking on the electronic ledger referred to in Section 2.2(b) other than as provided in clause (iii) thereof. (g) The Servicer will preserve all records that it is required to maintain pursuant to this Agreement until the later of (i) four years after the date upon which the Receivable to which such records relate is paid in full or (ii) seven years. (h) The Servicer shall deliver or cause to be delivered to Finco and the Trustee, all such documents, reports, certificates and other matters as are required by the Operative Documents including, without limitation, notice, to the extent required pursuant to the terms of any Sale and Servicing Agreement, of commercial insurers or other third-party payors which are Obligors of any Hospital and which first become Obligors after the Initial Closing Date (with any related Notice of Assignment and Confirmation required pursuant to such Sale and Servicing Agreement) and notice of each change in any Hospital's qualifications and status as a provider in respect of Governmental Receivables. (i) The Servicer will comply with all Requirements of Law which are applicable to the Transferred Property or any part thereof; provided, however, that the Servicer may contest any act, regulation, order, decree or direction in any manner which, in the reasonable opinion of Finco and the Trustee, would not reasonably be expected to materially and adversely affect the rights of Finco or any Interested Party in the Transferred Property or the collectibility (other than as a result of the credit quality of any Obligor) or enforceability of the Purchased Receivables. (j) The Servicer will not create, permit or suffer to exist, and will defend Finco's and the Interested Parties' rights to the Total Transferred Property against, and take such other actions as are necessary to remove, any Lien on, or claim or right in, to or under the Total Transferred Property, and will defend the right, title and interest of Finco and the Interested Parties in and to the Total Transferred Property against the claims and demands of all Persons whomsoever, other than the Liens in respect of the Permitted Interests. (k) Subject to Section 3.1(e), the Servicer will duly fulfill all obligations on its part to be fulfilled under or in connection with each Purchased Receivable and will do nothing to impair the rights of Finco or the Interested Parties in the Transferred Property. (l) Subject to Section 3.1(e), the Servicer will not sell, discount or otherwise dispose of any Purchased Receivable except to Finco or the Interested Parties as provided under the Sale and Servicing Agreements and the Pooling Agreement. (m) The Servicer shall not distribute or assist in the distribution of any financial statements which shall not account for the transactions contemplated by the Sale and Servicing Agreements in a manner which reflects the sale to Finco of the Purchased Receivables, and any publicly available financial statements prepared by the Servicer shall indicate the sale to Finco of the Purchased Receivables originated by the Hospitals. (n) The Servicer shall not merge or consolidate with, or transfer all or substantially all its assets to, any other entity unless the Servicer is the entity surviving such merger or consolidation or unless (i) the surviving or transferee entity expressly assumes all of the covenants, obligations and agreements of the Servicer under this Agreement in a written instrument satisfactory in form and substance to Finco and the Trustee and (ii) such merger, consolidation or other transfer shall not, in the judgment of Finco, result in an Exclusion Event or an Early Amortization Event. (o) The Servicer shall not, without the prior written consent of Finco and the Trustee, which consent shall not be unreasonably withheld, permit any Hospital to alter the hardware or software systems used by such Hospital in generating its reports to the Servicer in respect of the Purchased Receivables and Collections and, in any event, shall not permit any such alteration unless such alteration is designed to improve the Servicer's ability to monitor and collect on the Receivables. (p) The Servicer shall give to Finco and the Trustee prompt notice of any breach of any representation, warranty, covenant or agreement under this Agreement of which it has knowledge. (q) The Servicer will not hold itself out as liable for any Debt of Finco. ARTICLE III ADMINISTRATION, COLLECTIONS AND OTHER OBLIGATIONS Section 3.1. Servicing. (a) Finco and the Trustee hereby appoint the Servicer as their agent to administer and service, in accordance with the terms of this Article III, all Purchased Receivables, and the Servicer hereby accepts such appointment to administer and service the Purchased Receivables for the benefit of Finco and the Interested Parties. Except as otherwise provided herein, the Servicer shall have full power and authority to do any and all things in connection with such administration and servicing as it may deem necessary or desirable, including, without limitation, appointing subservicers to perform its servicing obligations hereunder. Without in any respect limiting the foregoing, the Servicer shall, in accordance with all Requirements of Law, but subject to the terms and conditions of the Operative Documents, manage and administer each of the Purchased Receivables, exercise all discretionary powers involved in such management, collection and administration and bear all costs and expenses incurred in connection therewith that may be necessary or advisable and permitted for carrying out the transactions contemplated by this Agreement and the other Operative Documents. In the management, collection and administration of the Purchased Receivables, the Servicer shall exercise the same care that it exercises in handling similar matters for its own account, and the Servicer will create and administer policies and practices (including those with respect to reserves and write-offs) consistent with the policies and practices applied in handling similar matters for its own account. The Servicer will comply at all times, in all material respects, with good business policies, practices, procedures and internal controls in effect at such time with respect to servicing and collecting the Receivables. Subject to the provisions of Article VII of the Pooling Agreement, the Servicing Fee payable by Finco with respect to the Purchased Receivables shall be 0.35 of 1% per annum of the average Outstanding Balance of the Purchased Receivables during each Settlement Period and shall be paid to the Servicer in accordance with Sections 7.2 and 7.3 of the Pooling Agreement. The Servicer shall be required to pay expenses for its own account, and shall not be entitled to any payment therefor other than the Servicing Fee. The Trustee Fee and the other fees and expenses of the Trustee payable pursuant to Section 11.5 of the Pooling Agreement during any Settlement Period shall be payable by the Servicer solely out of the Servicing Fee paid to the Servicer with respect to such Settlement Period. In no event shall the Servicer be liable for any federal, state or local income or franchise tax, or any interest or penalties with respect thereto, assessed on the Trust, the Trustee or the Participants except as expressly provided herein. To the extent provided in Article VII of the Pooling Agreement, or in the event that the Servicer fails to pay any amount due to the Trustee pursuant to Section 11.5 of the Pooling Agreement, the Trustee shall be entitled, in addition to any other rights it may have under law, to receive such amounts from the Servicing Fee prior to the payment thereof to the Servicer. (b) The Servicer hereby agrees and acknowledges that all Collections on account of Non-governmental Receivables sold to Finco shall be deposited directly into the Hospital Concentration Account or the Master Receivables Account on the date of receipt thereof. Payments in respect of Non-Governmental Receivables in the form of electronic or wire transfers shall be made to the Master Receivables Account. Except as provided in the following sentence, all Collections on account of Governmental Receivables sold to Finco shall be paid to the Hospital and deposited directly into the applicable Hospital Concentration Account on the date of receipt thereof. Collections from Obligors on Governmental Receivables in the form of electronic or wire transfers to UHS, for the benefit of a Hospital, shall be made directly to the Master Receivables Account. Available Collections received in the Hospital Concentration Accounts shall be transferred within one Business Day of receipt to the Master Receivables Account. Amounts so transferred or otherwise received in the Master Receivables Account prior to the close of business on any Business Day shall be transferred to the Collateral Account at the close of business on the Business Day received. Amounts received in the Master Receivables Account after the close of business on any Business Day or on any day which is not a Business Day shall be transferred to the Collateral Account at the close of business on the next succeeding Business Day. Except as provided in Section 3.1(i), the Servicer shall not transfer, or permit to be transferred, any amount from any Hospital Concentration Account or the Master Receivables Account other than to the Collateral Account. Subject to Section 3.1(h), all such Collections received will be endorsed by the Servicer in the name of the Hospital where required. (c) The obligation of UHS Delaware to service the Receivables is personal to UHS Delaware and the parties recognize that another Person may not be qualified to perform such obligations. Accordingly, UHS Delaware's obligation to service the Receivables hereunder, to the extent permitted by applicable law, shall be specifically enforceable and shall be absolute and unconditional in all circumstances, including, without limitation, after the occurrence and during the continuation of any Exclusion Event or Early Amortization Event; provided, however, that a Successor Servicer may be appointed pursuant to Article IV; and provided, further, that nothing contained in this Agreement shall be construed to prevent UHS from performing any obligation hereunder in accordance with the terms of the Guarantee. The provisions of this Section 3.1(c) shall not preclude UHS Delaware from subcontracting any or all of its responsibilities hereunder so long as UHS Delaware shall retain supervisory control of any such subcontractor and UHS Delaware shall obtain the consent of Finco and the Trustee prior to entering into such subcontracting arrangement. UHS Delaware shall insure, as a condition precedent to entering such subcontracting arrangement, that each such subcontractor shall agree to service the Receivables in accordance with all Requirements of Law and pursuant to the terms of this Agreement and the related Sale and Servicing Agreements, including, without limitation, such terms as are related to Collections in respect of Governmental Receivables and Non-governmental Receivables. Notwithstanding the immediately preceding sentence, UHS Delaware shall be fully responsible to Finco and the Interested Parties for any and all acts or failures to act of any such subcontractor to the same extent as if UHS Delaware were performing or directly responsible for such subcontractor's duties and responsibilities. (d) The Servicer shall not resign from the obligations and duties hereby imposed on it as Servicer except upon determination that (i) the performance of its duties hereunder is no longer permissible under applicable law and (ii) there is no reasonable action which the Servicer could take to make the performance of its duties hereunder permissible under applicable law. Any such determination permitting the resignation of the Servicer shall be evidenced as to clause (i) above by an opinion of counsel to the Servicer to such effect and as to clause (ii) above by a certificate of an Authorized Officer of the Servicer, in each case addressed to Finco, the Trustee and the Participants. No such resignation shall become effective until a Successor Servicer shall have assumed the responsibilities and obligations of the Servicer in accordance with Section 4.4. (e) The Servicer shall have the power and authority, with notice to Finco, to make such changes in contracts, agreements and terms in respect of any Purchased Receivable as the Servicer, on behalf of Finco, may reasonably deem advisable to the extent that (i) the Servicer shall reasonably believe that such changes in contracts, agreements or terms in respect of any Purchased Receivables will increase the collectibility of such Receivable without extending the payment date, so long as (A) such change is in accordance with the Credit and Collection Policy and consistent with past practice and (B) such change shall not have a disproportionate effect on the Purchased Receivables as compared with Receivables (or future Receivables) not sold to Finco; and (ii) the Servicer, in the event that such Purchased Receivable becomes an Uncollectible Receivable, shall reasonably believe that such change of contracts, agreements or terms will improve the collectibility of such Uncollectible Receivable; provided that no such change permitted by clause (i) or (ii) shall, in the reasonable belief of Finco, result in an Exclusion Event or an Early Amortization Event; and provided, further, that no such change shall cause the Borrowing Base to be less than the sum of (A) the TRIPs Capital, (B) the Face Amount of Commercial Paper Outstanding and (C) the principal amount of Loans Outstanding. In the enforcement or collection of any such Purchased Receivable, the Servicer shall be entitled to sue thereon in its own name, if possible, or, if, and only if, Finco or the Trustee consents in writing, as agent of Finco or the Trustee, as the case may be. (f) Subject to Section 3.1(e), the Servicer shall not change the terms of the payor contracts and agreements relating to the Purchased Receivables and related Transferred Property or its normal policies and procedures with respect to the servicing thereof (including without limitation the amount and timing of finance charges, fees and write-offs). (g) Finco hereby irrevocably grants to the Servicer an irrevocable power-of-attorney, which power is coupled with an interest, with full power of substitution, to take in the name of Finco or in its own name all steps necessary or advisable to endorse, negotiate or otherwise realize upon any writing or other report of any kind held or owned by Finco or transmitted to or received by the Servicer as payment on account or otherwise in respect of any Purchased Receivables. Finco shall execute and deliver to the Servicer such additional powers-of-attorney as the Servicer may deem necessary or appropriate to enable the Servicer to endorse for payment any check, draft or other instrument delivered in payment of any amount under or in respect of the Purchased Receivables. (h) If, at any time, the Servicer receives any Collections on account or otherwise in respect of Non-governmental Receivables, the Servicer shall hold such Collections in trust for the benefit of Finco and the Interested Parties and shall use its best efforts not to commingle any such amounts with any other funds or property held by the Servicer other than Collections and the Servicer shall cause such Collections (properly endorsed, where required, so that such items may be collected by Finco) to be paid over or delivered to the Trustee (as soon as practicable and in any event within one Business Day) pursuant to the terms of Section 7.1 of the Pooling Agreement, which transmission or delivery shall occur forthwith after any such Collections shall have been identified by the Servicer as being on account of such a Purchased Receivable. If, and at any time, the Servicer receives any such Collections in respect of Governmental Receivables, the Servicer shall transfer all such amounts to the related Hospital payee for immediate deposit by such Hospital into the appropriate Hospital Concentration Account or the Master Receivables Account. (i) The Servicer agrees that it shall use its best efforts to ensure that only Collections on Purchased Receivables are deposited into the Hospital Concentration Accounts and the Master Receivables Account. Finco agrees that, promptly following the establishment to the satisfaction of the Servicer and any Hospital that any funds received in any Hospital Concentration Account or the Master Receivables Account do not constitute Collections on Purchased Receivables, including any payments on Receivables which have been reassigned to such Hospital and any payments to such Hospital not in respect of Receivables, to the extent such funds are available in the Hospital Concentration Account, the Master Receivables Account or the Collateral Account, the Servicer shall remit, or cause the Trustee to remit, such funds to such Hospital in immediately available funds. In the event that the Servicer and any Hospital are unable to determine whether funds received by the Servicer or such Hospital constitute Collections on Purchased Receivables, such funds shall be deposited in the Hospital Concentration Account or the Master Receivables Account and transferred in accordance with Section 3.1(b) hereof and Article V of the applicable Sale and Servicing Agreement. (j) The Servicer shall cause each written contract entered into by any Hospital after the Initial Closing Date with a third-party payor in respect of Non-governmental Receivables to permit the assignment of payments thereunder pursuant to the terms of this Agreement and the Operative Documents. In the alternative the Servicer shall promptly (A) notify Finco of any insurance provider or other third-party payor which becomes an Obligor after the Initial Closing Date pursuant to a written contract or arrangement which purports to prohibit the assignment of any rights of any Hospital under such contract or arrangement without the consent of such Obligor and (B) deliver or cause to be delivered to such Obligor a Notice of Assignment from each Hospital party to any such contract or arrangement and receive a Confirmation in respect thereof as may be required by Finco or its counsel and (ii) comply with all other reasonable requests of Finco with respect to the Security Filings. The Servicer shall also cause each invoice sent after the Initial Closing Date to each insurance carrier or third party intermediary to include a notice that the amount payable under such invoice has been assigned to Finco and its assignees, including the Trustee, and that future amounts payable by such insurance carrier will be so assigned. Section 3.2. Delivery of Settlement Date Statement. On each Settlement Date the Servicer shall report to Finco, the Trustee and such other Persons as Finco or the Trustee may designate, by delivering to them, by 1:00 p.m. (New York City time) on such Settlement Date, the Settlement Date Statement, substantially in the form of Exhibit A hereto (the "Settlement Date Statement"), with a certificate, substantially in the form of Exhibit B hereto (the "Servicer's Certificate"), covering the Settlement Period next preceding such Settlement Date. Section 3.3. Settlement Date Statement. The Servicer shall set forth in the Settlement Date Statement: (a) all Collections respecting Purchased Receivables and Financible Receivables owned by Finco that have been collected during the Settlement Period immediately preceding the Settlement Date; (b) the aggregate Outstanding Balance of Purchased Receivables, the aggregate Outstanding Balance of Eligible Receivables and the aggregate Outstanding Balance of all Financible Receivables then owned by Finco (and in respect of which the Participants have acquired the Participations) as of the last day of the immediately preceding Settlement Period, in each case determined in accordance with GAAP and based on all Receivables created and outstanding on such last day, whether or not invoiced; (c) the aggregate amount of all adjustments to the Purchase Prices to be paid by Finco to the Hospitals on such date; (d) the aggregate balance of all Receivables which were included as Financible Receivables and which became Uncollectible Receivables during the immediately preceding Settlement Date and all Uncollectible Amounts arising during the immediately preceding Settlement Date in respect of Receivables included as Financible Receivables during such Settlement Period; (e) the Loss-to Liquidation Ratio, the Loss Factor, the Sheffield Yield Factor Amount, the TRIPs Yield Factor Amount, the Monthly Program Expense Amount and the aggregate fees and expenses scheduled to accrue during the Average Financible Turnover Period, each calculated as of the last day of the immediately preceding Settlement Period; (f) costs, expenses, fees, taxes, indemnities and other amounts payable from the Collateral Account and due to be paid on the related Transfer Date pursuant to Section 7.3(a) of the Pooling Agreement; (g) the Average Pool Turnover Period and the Average Financible Turnover Period as of the last day of the immediately preceding Settlement Period; (h) the Delinquency Ratio as of the last day of the immediately preceding Settlement Period; and (i) the aggregate amount of all liabilities reflected on the periodic cost reports of all UHS Entities for each of the three most recent reporting periods; the aggregate amount of Collections received during each Settlement Period in the preceding fiscal year in respect of Self-pay Receivables; and any other information required to determine the Offset Reserve. The Servicer shall set forth its determinations in each Settlement Date Statement, which shall contain the numbers, amounts or information called for in each of clauses (a) through (h) above and any additional calculations as the Rating Agencies may reasonably require. Section 3.4. Record of Collections. The Servicer shall keep a computer record of all Collections on Purchased Receivables owned by Finco and deposited in the Collateral Account. Section 3.5. Servicer Daily Statement. (a) As of the close of business on each Business Day, the Servicer shall determine, and set forth its determinations in a statement substantially in the form of Exhibit C (a "Servicer Daily Statement") as to: (i) the aggregate Purchased Receivables, Financible Receivables and the estimated amount of Eligible Receivables owned by Finco and in which the Participants have acquired the Participations, and all required adjustments thereto, as of the end of the preceding Business Day and all Collections received on Purchased Receivables, Eligible Receivables and Financible Receivables; (ii) amounts in the Collateral Account as of the end of the prior Business Day, all Available Cash Collections and other funds received in the Collateral Account since the preceding Business Day and all transfers to the Sub-accounts required to be made since the prior Business Day; (iii) the aggregate Outstanding Balances of all Purchased Receivables, Eligible Receivables and Financible Receivables purchased on such Business Day and to be paid for on the Statement Delivery Day and the aggregate Outstanding Balances of Purchased Receivables, Eligible Receivables and Financible Receivables in the Receivables Pool after giving effect to such purchases; (iv) the Purchase Price of all Receivables to be paid for on the Statement Delivery Day, the aggregate amount of cash available in the Collateral Account to be paid and the Subordinated Notes to be issued to the Hospitals in respect thereof on the Statement Delivery Day; (v) the Servicer's calculations in respect of the Offset Reserves, the Yield Reserves, the Loss Reserves, the Fee/Expense Reserves and the Required Coverage Amount as of such Business Day; (vi) the amount of all Deleted Receivables purchased on such Business Day to be paid for on the Statement Delivery Day; and (vii) such additional calculations as the Trustee or Sheffield shall reasonably require; it being understood that cash deposited from Collections in the Collateral Account shall not be deemed to be available for the purposes of calculating the Borrowing Base or for the determination of any payments to be made to any of UHS Delaware, Finco or any Hospital until the identification of the Receivables to which such Collections relate. (b) The Servicer shall deliver to Finco, the Trustee and such other Persons as Finco or the Trustee may designate, by 1:00 p.m. New York City time on each Business Day (the "Statement Delivery Day"), the Servicer Daily Statement prepared as of the close of business on the previous Business Day, certified by an Authorized Officer of the Servicer; the Trustee and each of the other Interested Parties shall rely on such Servicer Daily Statement in respect of all actions under this Agreement and the other Operative Documents. Each such Servicer Daily Statement shall also contain all information as the Trustee shall require, pursuant to the terms of the Pooling Agreement, to pay all Sheffield Capital and TRIPs Capital of, and all Yield on, all Commercial Paper Notes, Loans and TRIPs, to retain all required amounts in the Collateral Account, each sub-account of the Collateral Account and each Other Account, to purchase Receivables and to make all other payments and transfers, all in accordance with the terms and conditions of the Pooling Agreement. The Servicer shall furnish to the Trustee such further information as it may require in connection with the preparation of the Servicer Daily Statement. Section 3.6. Deleted Receivables. (a) On each Purchase Date, the Servicer shall, in its discretion, designate certain Receivables purchased by Finco on such Purchase Date and to be paid for by Finco on the Statement Delivery Day as Deleted Receivables, which Deleted Receivables shall be excluded from the pool of Financible Receivables; provided, however, that the Servicer shall not so exclude Deleted Receivables from the Financible Pool Balance if, as a result of such designation and exclusion, the quality and collectibility (including as a result of the credit quality of the Obligors on the Financible Receivables) of the pool of Financible Receivables would reasonably be expected to be any worse than the quality and collectibility (including as a result of the credit quality of the Obligors on the Eligible Receivables) of the pool of Eligible Receivables. (b) The aggregate Outstanding Balance of Deleted Receivables identified on each Business Day shall be included in the Daily Servicer Statement delivered by the Servicer on the related Statement Delivery Day. Such disclosure shall constitute a representation and warranty by the Servicer that, after giving effect to the exclusion of such Deleted Receivables from the pool of Financible Receivables, the quality and collectibility (including as a result of the credit quality of the Obligors on the Financible Receivables) of the pool of Financible Receivables is no worse than the quality and collectibility (including as a result of the credit quality of the Obligors on the Eligible Receivables) of the pool of Eligible Receivables. (c) The designation by the Servicer of any Purchased Receivable as a Deleted Receivable is irrevocable, and no such Deleted Receivable shall be considered a Financible Receivable or included in the Financible Pool Balance for any purpose. Section 3.7. Master Receivables Account. UHS has previously established an account with Continental (the "Master Receivables Account") into which Collections received from Obligors by means of electronic transfers shall be deposited by such Obligors. The Master Receivables Account has been designated as an account in the name of UHS, for the benefit of UHS, the Hospitals, Finco and the Interested Parties. The Servicer hereby represents and warrants that set forth on Schedule II hereto is the name, location and account number of the Master Receivables Account. The Servicer shall not, and shall not permit any other Person to, establish, terminate or change the Master Receivables Account designated on Schedule II, unless such action is in conformity with all Requirements of Law and the prior written consent of Finco and the Trustee has been obtained. At any time that the Servicer receives notice that an Early Amortization Event shall have occurred and is continuing, the Servicer agrees, to the extent permitted by applicable Requirements of Law, to immediately take all actions necessary, upon receipt of indemnification satisfactory to it and written directions from Finco or the Trustee as to the nature of such actions to direct those Obligors making payments into the Master Receivables Account to make all payments on the Receivables to an Additional Account or directly to the Trustee for deposit in the Collateral Account. ARTICLE IV EVENTS OF DEFAULT; SERVICING TERMINATION Section 4.1. Events of Default. The occurrence and continuation of any one of the following events shall be an "Event of Default" under this Agreement: (a) The entry of a decree or order for relief by a court having jurisdiction in respect of the Servicer in an involuntary case under the federal bankruptcy laws, as now or hereafter in effect, or any other present or future federal or state bankruptcy, insolvency or similar law, or appointing a receiver, liquidator, assignee, trustee, custodian, sequestrator or other similar official of the Servicer or of any substantial part of its property, or ordering the winding up or liquidation of the affairs of the Servicer and the continuance of any such decree or order unstayed and in effect for a period of 60 consecutive days; or (b) The Servicer shall (i) become insolvent or admit in writing its inability to pay its debts as they come due, (ii) commence a voluntary case under the federal bankruptcy laws, as now or hereafter in effect, or any other present or future federal or state bankruptcy, insolvency or similar law, (iii) consent to the appointment of, or taking possession by a receiver, liquidator, assignee, trustee, custodian, sequestrator or other similar official of the Servicer or of any substantial part of its property, (iv) make an assignment for the benefit of creditors, (v) fail generally to pay its debts as such debts become due or (vi) take any corporate action in furtherance of any of the foregoing; or (c) The Servicer shall fail to pay any amount required to be paid by it under this Agreement or transfer to the Trustee any amount collected by the Servicer in accordance with the terms of this Agreement; or (d) There shall occur a material default by the Servicer in the observance or performance of any other covenant or agreement in this Agreement, and such default shall continue unremedied for a period of 30 days following notice given by Finco or any Interested Party to the Servicer; or (e) Any of the representations or warranties by the Servicer contained in this Agreement shall prove to have been incorrect when made or deemed made in any material respect; or (f) A material adverse change in the business, operations, property or financial or other condition of the Servicer and its Subsidiaries taken as a whole shall have occurred and such change shall materially adversely affect its ability to perform its obligations, hereunder; or (g) The Guarantee shall at any time fail to be in full force and effect. Section 4.2. Remedies. Following the occurrence of an Event of Default hereunder Finco or the Trustee may, by notice given in writing to the Servicer (a "Servicer Termination Notice"), terminate all of the rights and obligations of the Servicer, as Servicer, under this Agreement. Notwithstanding any termination of the rights and obligations of the Servicer pursuant to this Section 4.2, the Servicer shall remain responsible for any acts or omissions to act by it as Servicer prior to such termination. Section 4.3. Successor Servicer. (a) On the date that a Successor Servicer shall have been appointed by Finco and the Trustee pursuant to Section 4.4, all authority and power of the then Servicer under this Agreement shall pass to and be vested in a Successor Servicer; and, without limitation, each of Finco and the Trustee are hereby authorized and empowered (upon the failure of the Servicer to cooperate) to execute and deliver, on behalf of the Servicer, as attorney-in-fact or otherwise, all documents and other instruments upon the failure of the Servicer to execute or deliver such documents or instruments, and to do and accomplish all other acts or things necessary or appropriate to effect the purposes of such transfer of servicing rights. (b) The Servicer agrees to cooperate with Finco and the Successor Servicer in effecting the termination of the responsibilities and rights of the Servicer to conduct servicing hereunder, including, without limitation, the transfer to such Successor Servicer of all authority of the Servicer to service the Receivables provided for under this Agreement, including, without limitation, all authority to receive Collections which shall on the date of transfer be held by the Servicer for deposit, or which shall thereafter be received with respect to the Receivables. (c) Subject to any Requirement of Law, the Servicer shall promptly transfer its electronic records (including, without limitation, the related computer programs necessary to use such electronic records) and all other records relating to the Receivables and the Transferred Property to the Successor Servicer in such electronic form or other forms as the Successor Servicer may reasonably request and shall promptly transfer to the Successor Servicer all other records, correspondence and documents necessary for the continued servicing of the Receivables in the manner and at such times as the Successor Servicer shall reasonably request. To the extent that compliance with this Section 4.3 shall require the Servicer to disclose to the Successor Servicer information of any kind which the Servicer reasonably deems to be confidential or subject to license, the Successor Servicer shall be required to enter into such customary licensing and confidentiality agreements as the Servicer shall deem necessary to protect its interest. (d) At any time following the designation of the Successor Servicer, any Successor Servicer shall be authorized to take any and all steps in UHS Delaware's name as Servicer and on behalf of UHS Delaware necessary or desirable (subject to laws, rules and regulations regarding patient confidentiality), in the determination of the Successor Servicer, to collect all amounts due under any and all Receivables, including, without limitation, endorsing UHS Delaware's name on checks and other instruments representing Collections and enforcing the Receivables. Section 4.4. Appointment of Successor. (a) Notwithstanding the receipt by a Servicer of a Servicer Termination Notice or the resignation of a Servicer pursuant to Section 3.1(d), the Servicer shall continue to perform all of its obligations under this Agreement until the later of (i) the appointment of a Successor Servicer or (ii) the date specified in the Servicer Termination Notice or otherwise specified by Finco or the Trustee in writing or, if no such date is specified in the Servicer Termination Notice, or otherwise specified by Finco or the Trustee, until a date mutually agreed upon by the Servicer, Finco and the Trustee. Finco and the Trustee shall (as promptly as possible after the giving of a Servicer Termination Notice or the resignation of a Servicer pursuant to Section 3.1(d)) appoint a successor servicer (the "Successor Servicer") and such Successor Servicer shall accept its appointment by a written assumption in a form acceptable to Finco and the Trustee. Such Successor Servicer, as a condition precedent to its appointment, shall represent, warrant and covenant on its behalf to each of Finco and the Trustee, for the benefit of the Participants, the representations, warranties and covenants in Section 2.1 in a writing satisfactory to Finco and the Trustee in their sole discretion. Finco and the Trustee may obtain bids from any potential Successor Servicer. (b) Upon its appointment, the Successor Servicer shall be the successor in all respects to the Servicer with respect to servicing functions under this Agreement and shall be subject to all the responsibilities, duties and liabilities relating thereto placed on UHS Delaware or the Servicer by the terms and provisions hereof, and all references in this Agreement to UHS Delaware or the Servicer shall be deemed to refer to the Successor Servicer. Any Successor Servicer, by its acceptance of its appointment, will automatically agree to be bound by the terms and provisions of the Operative Documents, if any are applicable. (c) In connection with the appointment of a Successor Servicer, Finco may make such arrangements to compensate the Successor Servicer out of Collections as it and such Successor Servicer shall agree; provided, however, that the priority of payment of such compensation shall be determined pursuant to Sections 7.2 and 7.3 of the Pooling Agreement and that no such compensation shall be in excess of the Servicing Fee paid to UHS Delaware. (d) All authority and power granted to any Successor Servicer under this Agreement shall automatically cease and terminate upon the termination of this Agreement and upon payment of all amounts due the parties under the Sale and Servicing Agreements, the Pooling Agreement and the other Operative Documents and shall pass to and be vested in UHS Delaware and, without limitation, UHS Delaware is hereby authorized and empowered to execute and deliver, on behalf of the Successor Servicer, as attorney-in-fact or otherwise, all documents and other instruments, and to do and accomplish all other acts or things necessary or appropriate to effect the purposes of such transfer of servicing rights. The Successor Servicer shall transfer its electronic records relating to the Receivables to UHS Delaware in such electronic form as UHS Delaware may reasonably request and shall transfer all other records, correspondence and documents to UHS Delaware in the manner and at such times as UHS Delaware shall reasonably request. Section 4.5. Monitoring. If Finco and the Trustee shall be unable to replace the Servicer with a Successor Servicer, Finco and the Trustee shall have the right to appoint a firm of public accountants to monitor the servicing of the Receivables by the Servicer and to furnish to Finco and the Trustee, at the expense of the Servicer, such letters, certificates or reports thereon as Finco and the Trustee shall reasonably request. The Servicer shall cooperate with such firm in the subsequent monitoring of its servicing of the Receivables pursuant to this Agreement notwithstanding that any fees in connection therewith shall be the expense of Finco. ARTICLE V MISCELLANEOUS Section 5.1. Notices, Etc. Except where telephonic instructions or notices are authorized herein to be given, all notices, demands, instructions and other communications required or permitted to be given to or made upon any party hereto shall be in writing and shall be personally delivered or sent by registered, certified or express mail, postage prepaid, return receipt requested, or by telecopy (with voice confirmation thereof) or telegram (with messenger delivery specified in the case of a telegram) and shall be deemed to be given for purposes of this Agreement when such personal delivery is made or such return receipt or confirmation is received by the party giving such notice, demand, instruction or other communication. Unless otherwise specified in a notice sent or delivered in accordance with the foregoing provisions of this Section, notices, demands, instructions and other communications in writing shall be given to or made upon the respective parties hereto at their respective addresses (or to their respective telecopy numbers) indicated below, and, in the case of telephonic instructions or notices, by calling the telephone number or numbers indicated for such party below: If to Finco: UHS Receivables Corp. 27292 Calle Arroyo, Suite B San Juan Capistrano, California 92675 Attention: President Tel. No.: 714-661-9323 Telecopier No.: 714-661-9445 with a copy to: UHS Receivables Corp. c/o Universal Health Services, Inc. 367 South Gulph Road King of Prussia, PA 19406 If to UHS Delaware: UHS of Delaware, Inc. 367 South Gulph Road King of Prussia, PA 19406 Attention: Tel. No.: 215-768-3300 Telecopier No.: 215-768-3336 If to the Trustee: Continental Bank, National Association 231 South LaSalle Street, 7th Floor Chicago, Illinois 60697 Attention: Steve Charles Tel. No.: (312) 828-7321 Telecopier No.: (312) 828-6528 Section 5.2. Successors and Assigns. This Agreement shall be binding upon the Servicer, Finco and the Trustee and their respective successors and assigns and shall inure to the benefit of the Servicer, Finco and the Trustee and their respective successors and assigns; provided that except as provided hereunder the Servicer shall not assign any of its rights or obligations hereunder without the prior written consent of Finco. Except as expressly permitted hereunder or in any of the Operative Documents, Finco shall not assign any of its rights or obligations hereunder without the prior written consent of the Trustee. Section 5.3. Severability Clause. Any provisions of this Agreement which are prohibited or unenforceable in any jurisdiction shall, as to such jurisdiction, be ineffective to the extent of such prohibition or unenforceability without invalidating the remaining provisions hereof, and any such prohibition or unenforceability in any jurisdiction shall not invalidate or render unenforceable such provision in any other jurisdiction. Section 5.4. Amendments. This Agreement may not be modified, amended, waived, supplemented or surrendered except pursuant to a written instrument executed by the Servicer, Finco and the Trustee, and then such amendment, modification, supplement or waiver shall be effective only in the specific instance and for the specific purpose given. If any such amendment, modification, supplement or waiver shall be so consented to by Finco and the Trustee, the Servicer agrees, promptly following a request by Finco or the Trustee, to execute and deliver in its own name, and at its own expense, such instruments, consents and other documents as Finco and the Trustee may deem necessary or appropriate in the circumstances. Section 5.5. The Servicer's Obligations. It is expressly agreed that, anything contained in this Agreement to the contrary notwithstanding, the Servicer shall be obligated to perform all of its obligations hereunder to the same extent as if the Interested Parties had no interest therein and neither Finco, the Trustee nor any Interested Party shall have obligations or liability under the Purchased Receivables to any Obligor thereunder by reason of or arising out of this Agreement, nor shall Finco, the Trustee or any Interested Party be required or obligated in any manner to perform or fulfill any of the obligations of the Servicer in connection with any Receivables. Section 5.6. No Recourse. (a) No directors or officers or employees or agents of the Servicer shall be under any liability to Finco, the Hospitals, the Interested Parties, the CP Holders or any other Person for any action of the Servicer hereunder pursuant to this Agreement; provided, however, that this provision shall not protect the Servicer or any such Person against any liability which would otherwise be imposed by reason of willful misfeasance, bad faith or gross negligence in the performance of duties or by reason of reckless disregard of obligations and duties hereunder. (b) The obligations of the Interested Parties, if any, under this Agreement are solely the corporate obligations of such entities. No recourse shall be had for the payment of any amount owing in respect of this Agreement or for the payment of any fee hereunder or for any other obligation or claim arising out of or based upon this Agreement against any such entity or against any stockholder, employee, officer, director or incorporator thereof. Section 5.7. Further Assurances. The Servicer agrees to do such further acts and things and to execute and deliver to Finco and the Trustee such additional assignments, agreements, powers and instruments as are required by Finco to carry into effect the purposes of this Agreement or to better assure and confirm unto Finco its rights, powers and remedies hereunder. Section 5.8. Termination. (a) The Servicer's obligations under this Agreement shall terminate with respect to any Hospital upon the termination of the related Sale and Servicing Agreement and all Purchased Receivables owned by Finco and purchased from such Hospital having been paid in full or having become Uncollectible Receivables; provided, however, that the Servicer shall continue to be obligated to do all things necessary to collect such Uncollectible Receivables and to apply Collections with respect thereto that it receives in the manner provided in this Agreement and to perform its obligations hereunder with respect thereto. (b) This Agreement shall terminate (whether on account of a Early Amortization Event or otherwise) when the Outstanding Balance of all Purchased Receivables which are Outstanding Receivables shall be reduced to zero, provided that the Servicer shall continue to be obligated to do all things necessary to collect on all Uncollectible Receivables and to apply all Collections that it receives with respect thereto in the manner provided in this Agreement and to perform its obligations hereunder with respect thereto. (c) The representations and warranties of the Servicer hereunder shall survive the execution and delivery of this Agreement and the purchase of the Participations. Section 5.9. Consent to Assignment; Third Party Beneficiaries. (a) The Servicer acknowledges that all of Finco's right, title and interest in the obligations of the Servicer to Finco and the rights of Finco against the Servicer under this Agreement have been assigned, transferred and otherwise conveyed by Finco to the Trustee, for the benefit of the Participants, pursuant to the terms and conditions of the Pooling Agreement. The Servicer hereby agrees and acknowledges that Sheffield shall assign to the Liquidity Agent, for the benefit of the Liquidity Banks, all of Sheffield's right, title and interest in, to and under this Agreement. The Servicer consents to such assignment and transfer to the Trustee and by Sheffield to the Liquidity Agent and agrees that the Participants (or upon notice by Sheffield or the Liquidity Agent of a default under the Liquidity Agreement or the Security Agreement, and to the extent provided in the Pooling Agreement, the TRIPS Holders and the Liquidity Agent) and the Trustee shall be entitled to enforce the terms of this Agreement directly against the Servicer, whether or not any Early Amortization Event or Exclusion Event shall have occurred. The Servicer and Finco further agree that (i) the Servicer will not take any action (other than those actions which are consistent with its obligations hereunder and which occur in the normal course of its operations) without the prior consent of the Participants (or the TRIPs Holders and the Liquidity Agent, as the case may be) or the Trustee and (ii) in respect of its obligations hereunder the Servicer will act at the direction of and in accordance with all requests and instructions of the Trustee and the Participants (or the TRIPs Holders and the Liquidity Agent, as the case may be). Finco and the Servicer hereby agree that, in the event of any conflict of requests or instructions to the Servicer between Finco on the one hand and the Participants (or the TRIPs Holders and the Liquidity Agent, as the case may be) or the Trustee, on the other hand, the Servicer will at all times act in accordance with the requests and instructions of the Participants(or the TRIPs Holders and the Liquidity Agent, as the case may be) or the Trustee, and in the event of any conflict of requests or instructions among Participants, Finco shall act in accordance with the instructions of the Trustee. The Servicer, Finco and the Trustee agree that in the event of any conflict of requests or instructions to the Servicer between Sheffield and the Liquidity Agent, the Servicer will at all times act in accordance with the requests and instructions of the Liquidity Agent. (b) Notwithstanding anything hereunder to the contrary, each Interested Party shall have the rights of a third-party beneficiary hereunder. (c) Each of Finco, the Trustee and the Servicer acknowledges that Sheffield has appointed Barclays to act as Managing Agent. Unless otherwise instructed by Sheffield, copies of all notices, requests, demands and other documents to be delivered to Sheffield pursuant to the terms hereof shall be delivered to the Managing Agent. Unless otherwise instructed by Sheffield, all notices, requests, demands and other documents to be executed or delivered, and any action to be taken, by Sheffield pursuant to the terms hereof may be executed, delivered and/or taken by the Managing Agent. The rights and responsibilities of the Managing Agent under this Agreement with respect to any action taken by the Managing Agent or the exercise or non- exercise by the Managing Agent of any option, right, request, judgment or other right or remedy provided to Sheffield herein or resulting or arising out of this Agreement shall, as between the Managing Agent and Sheffield, be governed by such agreements with respect thereto as may exist from time to time between them, but, as between the Managing Agent and the parties to this Agreement, the Managing Agent shall be conclusively presumed to be acting as agent for Sheffield, with full and valid authority so to act or refrain from acting, and neither Finco, the Trustee nor the Servicer shall be under any obligation or entitlement to make any inquiry respecting such authority. Section 5.10. Counterparts. This Agreement may be executed in any number of copies, and by the different parties hereto on the same or separate counterparts, each of which shall be deemed to be an original instrument. Section 5.11. Headings. Section headings used in this Agreement are for convenience of reference only and shall not affect the construction or interpretation of this Agreement. Section 5.12. No Bankruptcy Petition. Each of the parties hereto covenants and agrees that prior to the date which is one year and one day after the Aggregate Capital has been reduced to zero and all other amounts due under or in connection with the Operative Documents have been paid, it will not institute against, or join any other Person in instituting against, Finco or Sheffield any bankruptcy, reorganization, arrangement, insolvency or liquidation proceedings, or other proceedings under any federal or state bankruptcy or similar law. Section 5.13. Servicer May Act Through Agents. Subject to the terms and conditions of this Agreement, the Servicer may exercise any of its rights or perform any of its duties hereunder through agents of its choosing, and any action so taken shall have the same force and effect as if taken by the Servicer directly. Section 5.14. GOVERNING LAW. THIS AGREEMENT SHALL BE GOVERNED BY, AND CONSTRUED AND INTERPRETED IN ACCORDANCE WITH, THE INTERNAL LAW OF THE STATE OF NEW YORK WITHOUT REFERENCE TO CONFLICTS OF LAW RULES OF THE STATE OF NEW YORK. Section 5.15. No Waiver; Cumulative Remedies. No failure to exercise, and no delay in exercising, on the part of Finco or any Interested Party, any right, remedy, power or privilege hereunder, shall operate as a waiver thereof; nor shall any single or partial exercise of any right, remedy, power or privilege hereunder preclude any other or further exercise thereof or the exercise of any other right, remedy, power or privilege. The rights, remedies, powers and privileges herein provided are cumulative and not exhaustive of any rights, remedies, powers and privileges provided by law. Section 5.16. SUBMISSION TO JURISDICTION; VENUE; WAIVER OF JURY TRIAL; SERVICE OF PROCESS. (a) EACH OF THE SERVICER AND UHS DELAWARE (FOR ITSELF AND ITS RESPECTIVE SUCCESSORS AND ASSIGNS) HEREBY IRREVOCABLY SUBMITS, FOR ITSELF AND ITS PROPERTY, TO THE JURISDICTION OF THE STATE COURTS OF THE STATE OF NEW YORK AND TO THE JURISDICTION OF THE UNITED STATES DISTRICT COURT FOR THE SOUTHERN DISTRICT OF NEW YORK, FOR THE PURPOSES OF ANY SUIT, ACTION OR OTHER PROCEEDING ARISING OUT OF OR BASED UPON THIS AGREEMENT OR THE SUBJECT MATTER HEREOF BROUGHT BY FINCO OR ANY INTERESTED PARTY. EACH OF THE SERVICER AND UHS DELAWARE (FOR ITSELF AND ITS SUCCESSORS AND ASSIGNS) TO THE EXTENT PERMITTED BY ANY REQUIREMENTS OF LAW (A) HEREBY WAIVES, AND AGREES NOT TO ASSERT, BY WAY OF MOTION, AS A DEFENSE, OR OTHERWISE, IN ANY SUCH SUIT, ACTION OR PROCEEDING BROUGHT IN ANY SUCH COURT, ANY CLAIM THAT IT IS NOT SUBJECT PERSONALLY TO THE JURISDICTION OF THE ABOVE-NAMED COURTS, THAT ITS PROPERTY IS EXEMPT OR IMMUNE FROM ATTACHMENT OR EXECUTION, THAT THE SUIT, ACTION OR PROCEEDING IS BROUGHT IN AN INCONVENIENT FORUM, THAT THE VENUE OF THE SUIT, ACTION OR PROCEEDING IS IMPROPER OR THAT THIS AGREEMENT OR THE SUBJECT MATTER HEREOF MAY NOT BE ENFORCED IN OR BY SUCH COURT, AND (B) HEREBY WAIVES THE RIGHT TO ASSERT IN ANY SUCH ACTION, SUIT OR PROCEEDING ANY OFFSETS OR COUNTERCLAIMS EXCEPT COUNTERCLAIMS THAT ARE COMPULSORY OR OTHERWISE ARISE FROM THE SAME SUBJECT MATTER. THE SERVICER AND UHS DELAWARE HEREBY AGREE THAT SERVICE OF ANY AND ALL PROCESS AND OTHER DOCUMENTS ON THE SERVICER OR UHS DELAWARE, AS THE CASE MAY BE, MAY BE EFFECTED BY CERTIFIED OR REGISTERED MAIL (OR ANY SUBSTANTIALLY SIMILAR FORM OF MAIL) TO ITS RESPECTIVE ADDRESS AS SET FORTH ON SCHEDULE I AND SUCH SERVICE SHALL CONSTITUTE VALID AND EFFECTIVE SERVICE AGAINST UHS DELAWARE OR THE SERVICER, AS THE CASE MAY BE. EACH OF THE SERVICER AND UHS DELAWARE AGREES THAT ITS SUBMISSION TO JURISDICTION AND CONSENT TO SERVICE OF PROCESS BY MAIL IN ANY SUCH ACTION, SUIT OR PROCEEDING SHALL BE CONCLUSIVE, AND MAY BE ENFORCED IN ANY OTHER JURISDICTION (A) BY SUIT, ACTION OR PROCEEDING ON THE JUDGMENT, A CERTIFIED OR TRUE COPY OF WHICH SHALL BE CONCLUSIVE EVIDENCE OF THE FACT AND THE AMOUNT OF INDEBTEDNESS OR LIABILITY THEREIN DESCRIBED OR (B) IN ANY OTHER MANNER PROVIDED BY OR PURSUANT TO THE LAWS OF SUCH OTHER JURISDICTION, PROVIDED, HOWEVER, THAT ANY OF FINCO OR ANY INTERESTED PARTY MAY AT ITS OPTION BRING SUIT, OR INSTITUTE OTHER JUDICIAL PROCEEDINGS AGAINST THE SERVICER OR UHS DELAWARE OR ANY OF ITS RESPECTIVE ASSETS IN ANY STATE OR FEDERAL COURT OF THE UNITED STATES OR OF ANY COUNTRY OR PLACE WHERE THE SERVICER OR UHS DELAWARE OR SUCH ASSETS MAY BE FOUND. (b) EACH OF THE SERVICER, UHS DELAWARE, FINCO, THE TRUSTEE (AND THEIR RESPECTIVE SUCCESSORS AND ASSIGNS) HEREBY WAIVES ALL RIGHTS TO TRIAL BY JURY IN ANY ACTION OR PROCEEDING ARISING OUT OF OR RELATING TO ANY OF THE TRANSACTIONS CONTEMPLATED BY THIS AGREEMENT. (c) THIS SECTION 5.16 SHALL SURVIVE THE TERMINATION OF THIS AGREEMENT. Section 5.17. Indemnification. If at any time any demand, claim, cause of action, damage or liability or any action or other legal proceeding (collectively a "claim") should be asserted against, or incurred by Finco, any Interested Party or any of their respective directors, officers, employees and agents by reason of, or in connection with, any act or failure to act on the part of the Servicer, the Servicer shall indemnify and hold Finco any such Interested Party, and any such directors, officers, employees and agents, as the case may be, harmless of and from any and all loss (other than loss of profit as a result of the credit quality of the Obligor), damage, claim, penalty, liability and/or expense which it may sustain or incur by reason thereof, including the amount of any judgment, plus costs and interest thereon, which may be entered against or incurred by Finco or any Interested Party with respect to any such claim, as well as any and all reasonable attorneys' fees and other disbursements paid or incurred in connection therewith (any of the foregoing, an "Indemnified Amount"), provided the Servicer has been notified thereof in writing and has been given a reasonable opportunity to respond to and to defend same. This indemnity shall survive the termination of this Agreement. IN WITNESS WHEREOF, UHS Delaware, as Servicer, and Finco have caused this Agreement to be duly executed by their duly authorized officers, all on the day and year first above written. UHS OF DELAWARE, INC., as Servicer By:__________________________ Title: UHS RECEIVABLES CORP. By:__________________________ Title: CONTINENTAL BANK, NATIONAL ASSOCIATION, as Trustee By:__________________________ Title: Acknowledged and Agreed: BARCLAYS BANK PLC, as Managing Agent for Sheffield By:____________________________ Title: SCHEDULE I Document Locations Servicer's Principal Place of Business UHS's Principal Place of Business A. Document Locations Hospital Document Locations(s) Chalmette General Hospital, Inc. 9001 Patricia Street Chalmette, LA 70043 and 800 Virtue Street Chalmette, LA 70043 Dallas Family Hospital, Inc. 2929 South Hampton Road Dallas, TX 75224 Del Amo Hospital, Inc. 23700 Camino del Sol Torrance, CA 90505 Doctors' General Hospital, Ltd. 6701 West Sunrise Blvd. Plantation, FL 33313 HRI Hospital, Inc. 227 Babcock Street Brookline, MA 02146 McAllen Medical Center, Inc. 301 West Expressway 83 McAllen, TX 78503 Meridell Achievement Center, Inc. Highway 29 West Liberty Hill, TX 78642 and 2501 Cypress Creek Road Cedar Park, TX 78613 River Oaks, Inc. 1525 River Oaks Road West New Orleans, LA 70123 Sparks Reno Partnership, L.P. 2375 E. Prater Way Sparks, NV 89434 Turning Point Care Center, Inc. 319 East By-Pass Moultrie, GA 31768 UHS of Arkansas, Inc. 21 BridgeWay Road North Little Rock, AR 72118 UHS of Auburn, Inc. 20 Second Street, N.E. Auburn, WA 98002 UHS of Belmont, Inc. 4058 West Melrose Street Chicago, IL 60641 UHS of Maitland, Inc. 201 Alpine Drive Maitland, FL 32751 UHS of Massachusetts, Inc. 49 Robinwood Avenue Boston, MA 02130 UHS of River Parishes, Inc. 500 Rue de Sante LaPlace, LA 70068 UHS of Shreveport, Inc. 1130 Louisiana Avenue Shreveport, LA 71101 Universal Health Recovery Centers, Inc. 2001 Providence Road Chester, PA 19013 Universal Health Services of Inland 36485 Inland Valley Drive Valley, Inc. Wildomar, CA 92395 Universal Health Services of Nevada, Inc. 620 Shadow Lane Las Vegas, NV 89106 Victoria Regional Medical Center, Inc. 101 Medical Drive Victoria, TX 77904 Wellington Regional Medical Center 10101 Forest Hill Blvd. Incorporated West Palm Beach, FL 33414 Westlake Medical Center, Inc. 4415 South Lakeview Canyon Road Westlake Village, CA 91361 B. Servicer's Principal Place of Business 367 South Gulph Road King of Prussia, PA 19406 C. UHS Principal Place of Business 367 South Gulph Road King of Prussia, PA 19406 SCHEDULE II Master Receivables Account Bank: Continental Bank, N.A., Chicago, Illinois Account Name: Universal Health Services, Inc. Master Receivables Account Account Number: 78-27784 EXHIBIT A TO SERVICING AGREEMENT Settlement Date Statement EXHIBIT B TO SERVICING AGREEMENT Servicer's Certificate [Settlement Date Statement] [Servicer Daily Statement] _________________________ hereby certifies that he/she is an Authorized Officer of UHS of Delaware, Inc. (the "Servicer") holding the office set forth beneath his/her signature and that he/she is duly authorized to execute this Servicer's Certificate on behalf of the Servicer and further certifies [with respect to the immediately preceding Settlement Period (________) to (________) that (i) the information set forth in the Settlement Date Statement attached hereto as Exhibit A is true and correct in all material respects as of the date thereof, (ii) the Servicer has, to the best of my knowledge, fully performed its obligations under the Servicing Agreement and (iii) except as set forth on Exhibit A attached, no default in the performance of such obligations has occurred and is continuing] [that the information set forth in the Servicer Daily Statement attached hereto as Exhibit A is true and correct in all material respects as of the Statement Delivery Day]. UHS of Delaware, Inc., as Servicer By: _________________________ Name: Title: Dated: __________________ EXHIBIT C TO SERVICING AGREEMENT Servicer Daily Statement EXHIBIT D TO SERVICING AGREEMENT FORM OF CONFIDENTIALITY AGREEMENT FOR USE BY FINCO [Letterhead of Recipient of Information] ___________ __, 199_ UHS Receivables Corp. 27292 Calle Arroyo, Suite B San Juan Capistrano, CA 92675 Universal Health Services, Inc. Universal Corporate Center 367 South Gulph Road King of Prussia, PA 19406 Dear Sirs: Reference is made to the Servicing Agreement, dated as of _______ __, 1993 (as amended from time to time, the "Servicing Agreement"), among UHS Receivables Corp., a Delaware corporation (the "Transferor"), Universal Health Services, Inc., a Delaware corporation (the "Servicer"), and Continental Bank, a national banking association, not in its individual capacity but solely as Trustee, and to the pending and proposed discussions between the Transferor and [recipient] (the "Recipient") regarding [describe transaction requiring disclosure]. Unless otherwise defined herein, capitalized terms defined in the Servicing Agreement are used herein as so defined. Pursuant to our discussions, the Transferor hereby agrees to provide to the Recipient certain information, practices, books, correspondence, and records of a confidential nature and in which the Servicer has a proprietary interest (the "Information") on the terms and conditions set forth below. By its execution of this Agreement, the Recipient hereby agrees to all such terms and conditions. The Recipient hereby acknowledges that all Information received by it from the Transferor shall be regarded as confidential information and that the Information may be subject to laws, rules and regulations regarding patient confidentiality. The Recipient agrees that, subject to the following sentence, (i) it shall, and shall cause its employees, agents and representatives to, retain in confidence and not disclose the Information without the prior written consent of the Transferor and (ii) it will not, and will ensure that its employees, agents and representatives will not, make any use whatsoever (other than for the purposes contemplated by the Servicing Agreement and the other Operative Documents or for the enforcement of any of the rights granted thereunder) of any of the Information without the prior written consent of the Transferor. Notwithstanding the foregoing, the Recipient may (x) disclose Information to any Person that has executed and delivered a confidentiality agreement in substantially the same form as this agreement naming the Transferor and the Servicer as third party beneficiaries thereof and (y) disclose or otherwise use Information (A) to the extent that such Information is required or appropriate in any report, statement or testimony submitted to any municipal, state or federal regulatory body having or claiming to have jurisdiction over the Recipient or submitted to the National Association of Insurance Commissioners or similar organizations or their successors, (B) to the extent such Information is required in response to any summons or subpoena or in connection with any litigation, (C) to the extent that such Information is believed to be required in order to comply with any law, order, regulation or ruling applicable to the Recipient, (D) to the extent that such Information was publicly available or otherwise known to the Recipient at the time of disclosure, (E) to the extent that such Information subsequently becomes publicly available, other than through any act or omission of the Recipient or (F) to the extent that such Information subsequently becomes known to the Recipient, other than through a Person whom the Recipient knows to be acting in violation of its obligations to the Transferor or the Servicer. The parties agree that any breach of this letter agreement would cause damages which cannot be determined in money and that injunction is an appropriate remedy for breach, though not necessarily the sole remedy. This Agreement shall inure to the benefit of the parties hereto, each of their respective successors and permitted assigns and the Servicer, and the Servicer will be deemed to be a third party beneficiary of this Agreement. This Agreement shall be governed by, and construed in accordance with the law of the State of New York, and may be executed in one or more counterparts, each of which shall be deemed an original but all of which together shall constitute one agreement. Please acknowledge your agreement to the foregoing by signing three copies of this letter agreement and returning them to the Transferor. Upon receipt of the executed letter agreement, the Transferor pursuant to the terms of the Servicing Agreement, will deliver an executed agreement to the Servicer. Very truly yours, [RECIPIENT] By:_________________________ Title: Acknowledged and Agreed: UHS RECEIVABLES CORP. By:____________________________ Title: - ----------------------------------------------------------------------------- POOLING AGREEMENT among UHS RECEIVABLES CORP., SHEFFIELD RECEIVABLES CORPORATION, and CONTINENTAL BANK, NATIONAL ASSOCIATION, Trustee, dated as of November 16, 1993 UHS HEALTHCARE RECEIVABLES TRUST - ------------------------------------------------------------------------------ ********** Page ARTICLE I DEFINITIONS 1.1. Definitions . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 ARTICLE II CONVEYANCE OF THE RECEIVABLES; PARTICIPATIONS; TRIPs 2.1. Conveyance of Receivables and Total Transferred Property . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 2.2. Acceptance by Trustee . . . . . . . . . . . . . . . . . . . . . 3 2.3. Construction of Agreement. . . . . . . . . . . . . . . . . . . . 4 2.4. Participations . . . . . . . . . . . . . . . . . . . . . . . . . 4 2.5. Initial Purchase of the Sheffield Participation and Issuance of the TRIPs. . . . . . . . . . . . . . . . . . . . 4 2.6. Increases and Decreases in the Sheffield Capital. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 2.7. Maintenance of Aggregate Capital . . . . . . . . . . . . . . . . 7 2.8. Borrowing Base Compliance. . . . . . . . . . . . . . . . . . . . 7 2.9. Subordination of Finco Interest. . . . . . . . . . . . . . . . . 8 2.10. Selection of Fixed Periods . . . . . . . . . . . . . . . . . . 8 2.11. Increased Costs; Capital Adequacy; Illegality . . . . . . . . . 10 2.12. Taxes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 2.13. Extension of Sheffield Revolving Period; Increase of Maximum Sheffield Capital . . . . . . . . . . . . 12 2.14. Optional Acceleration of TRIPs Amortization Period. . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 ARTICLE III CONDITIONS TO PAYMENTS 3.1. Conditions to Initial Purchase . . . . . . . . . . . . . . . 14 3.2. Conditions to all Payments . . . . . . . . . . . . . . . . . 14 ARTICLE IV REPRESENTATIONS AND WARRANTIES 4.1. General Representations and Warranties of Finco. . . . . . . 15 4.2. Representations and Warranties of Finco Concerning the Receivables . . . . . . . . . . . . . . . . . 19 ARTICLE V COVENANTS OF FINCO 5.1. General Covenants. . . . . . . . . . . . . . . . . . . . . . 22 Page 5.2. Covenants of Finco Relating to the Receivables . . . . . . . 26 5.3. Notice and Consent Procedures . . . . . . . . . . . . . . . 31 5.4. Removal of Non-qualifying Receivables. . . . . . . . . . . .. 32 5.5. Hospital Concentration Accounts. . . . . . . . . . . . . . . 33 5.6. Performance of Agreements. . . . . . . . . . . . . . . . . . 33 5.7. Amendment of Assigned Agreements; Waivers. . . . . . . . . . 34 ARTICLE VI ADMINISTRATION AND COLLECTIONS 6.1. Servicing. . . . . . . . . . . . . . . . . . . . . . . . . . 35 6.2. Collections. . . . . . . . . . . . . . . . . . . . . . . . . 35 6.3. Claims Against Third Parties . . . . . . . . . . . . . . . . 36 6.4. Deleted Receivables. . . . . . . . . . . . . . . . . . . . . 37 ARTICLE VII COLLATERAL ACCOUNT AND OTHER ACCOUNTS; ALLOCATIONS AND DISTRIBUTIONS 7.1. Establishment of Collateral Account and Other Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . 37 7.2. Daily Allocations. . . . . . . . . . . . . . . . . . . . . . 39 7.3. Monthly Applications . . . . . . . . . . . . . . . . . . . . 42 7.4. Payments to Sheffield. . . . . . . . . . . . . . . . . . . . 44 7.5. Amortization . . . . . . . . . . . . . . . . . . . . . . . . 44 7.6. Allocation and Payment Procedures. . . . . . . . . . . . . . 46 7.7. Permitted Investments. . . . . . . . . . . . . . . . . . . . 47 7.8. Additional Accounts. . . . . . . . . . . . . . . . . . . . . 47 ARTICLE VIII DISTRIBUTIONS AND REPORTS TO PARTICIPANTS 8.1. Distributions. . . . . . . . . . . . . . . . . . . . . . . . 48 8.2. Statements to Participants . . . . . . . . . . . . . . . . . 48 ARTICLE IX TRIPs; RIGHTS OF PARTICIPANTS 9.1. The TRIPs. . . . . . . . . . . . . . . . . . . . . . . . . . 48 9.2. Authentication of TRIPs. . . . . . . . . . . . . . . . . . . 49 9.3. Registration of Transfer and Exchange of TRIPs . . . . . . . 49 9.4. Restrictions on Transfer . . . . . . . . . . . . . . . . . . 50 9.5. Mutilated, Destroyed, Lost or Stolen TRIPs . . . . . . . . . 50 9.6. Persons Deemed Owners. . . . . . . . . . . . . . . . . . . . 51 9.7. Access to List of Participants' Names and Addresses. . . . . . . . . . . . . . . . . . . . . . . . . . 51 9.8. Authenticating Agent . . . . . . . . . . . . . . . . . . . . 52 9.9. Limitation on Rights of Participants . . . . . . . . . . . . 53 9.10. Participations Nonassessable and Fully Paid . . . . . . . . . . 53 9.11. Actions by TRIPs Holders. . . . . . . . . . . . . . . . . . . . 53 Page ARTICLE X EARLY AMORTIZATION EVENTS 10.1. Early Amortization Events . . . . . . . . . . . . . . . . . . . 54 10.2. Remedies. . . . . . . . . . . . . . . . . . . . . . . . . . . . 58 ARTICLE XI THE TRUSTEE 11.1. Duties of Trustee. . . . . . . . . . . . . . . . . . . . . . . 60 11.2. Rights of the Trustee. . . . . . . . . . . . . . . . . . . . . 61 11.3. Trustee Not Liable for Recitals. . . . . . . . . . . . . . . . 62 11.4. Trustee May Own TRIPs. . . . . . . . . . . . . . . . . . . . . 63 11.5. Compensation of Trustee. . . . . . . . . . . . . . . . . . . . 63 11.6. Eligibility Requirements for Trustee . . . . . . . . . . . . . 63 11.7. Resignation or Removal of Trustee. . . . . . . . . . . . . . . 64 11.8. Successor Trustee. . . . . . . . . . . . . . . . . . . . . . . 64 11.9. Merger or Consolidation of Trustee . . . . . . . . . . . . . . 65 11.10. Appointment of Co-Trustee or Separate Trustee. . . . . . . . . 65 11.11. Tax Returns. . . . . . . . . . . . . . . . . . . . . . . . . . 66 11.12. Trustee May Enforce Claims Without Possession of TRIPs. . . . . . . . . . . . . . . . . . . . . . . . . . 67 11.13. Suits for Enforcement. . . . . . . . . . . . . . . . . . . . . 67 11.14. Rights of Participants to Direct Trustee . . . . . . . . . . . 67 11.15. Representations and Warranties of Trustee. . . . . . . . . . . 68 11.16. Maintenance of Office or Agency. . . . . . . . . . . . . . . . 68 ARTICLE XII INDEMNIFICATION AND EXPENSES 12.1. Indemnities by Finco. . . . . . . . . . . . . . . . . . . . . . 69 12.2. Additional Costs. . . . . . . . . . . . . . . . . . . . . . . . 70 12.3. Survival of Indemnities . . . . . . . . . . . . . . . . . . . . 71 12.4. Method of Payment . . . . . . . . . . . . . . . . . . . . . . . 71 ARTICLE XIII TERMINATION OF TRUST 13.1. Final Termination of Participations; Optional Repurchase of TRIPs. . . . . . . . . . . . . . . . . . . . . 72 13.2. Final Payment of the TRIPs. . . . . . . . . . . . . . . . . . . 73 13.3. Termination of Trust. . . . . . . . . . . . . . . . . . . . . . 73 13.4. Finco's Termination Rights. . . . . . . . . . . . . . . . . . . 74 ARTICLE XIV MISCELLANEOUS 14.1. Notices, Etc . . . . . . . . . . . . . . . . . . . . . . . . . 74 14.2. Successors and Assigns; Survival . . . . . . . . . . . . . . . 76 14.3. Severability Clause. . . . . . . . . . . . . . . . . . . . . . 76 14.4. Amendments . . . . . . . . . . . . . . . . . . . . . . . . . . 76 Page 14.5. Finco's Obligations. . . . . . . . . . . . . . . . . . . . . . 77 14.6. Consent to Assignment. . . . . . . . . . . . . . . . . . . . . 77 14.7. Authority of Managing Agent. . . . . . . . . . . . . . . . . . 78 14.8. Further Assurances . . . . . . . . . . . . . . . . . . . . . . 78 14.9. Counterparts . . . . . . . . . . . . . . . . . . . . . . . . . 78 14.10. Headings . . . . . . . . . . . . . . . . . . . . . . . . . . . 78 14.11. No Bankruptcy Petition Against Sheffield or Finco . . . . . . . . . . . . . . . . . . . . . . . . . . . 78 14.12. GOVERNING LAW. . . . . . . . . . . . . . . . . . . . . . . . . 79 14.13. No Waiver; Cumulative Remedies . . . . . . . . . . . . . . . . 79 14.14. SUMISSION TO JURISDICTION; VENUE; WAIVER OF JURY TRIAL; SERVICE OF PROCESS. . . . . . . . . . . . . . . 79 14.15. Acquisition of Participations. . . . . . . . . . . . . . . . . 80 14.16. Waivers. . . . . . . . . . . . . . . . . . . . . . . . . . . . 80 EXHIBIT A Form of TRIP EXHIBIT B Auditors' Report EXHIBIT C Form of Confidentiality Agreement EXHIBIT D Transfer Certificate SCHEDULE I Finco Principal Place of Business SCHEDULE II Accounts POOLING AGREEMENT POOLING AGREEMENT, dated as of November 16, 1993 (as amended, supplemented or otherwise modified from time to time, this "Agreement"), among UHS Receivables Corp., a Delaware corporation (together with its successors and assigns, "Finco"), Sheffield Receivables Corporation, a Delaware corporation (together with its successors and assigns, "Sheffield"), and Continental Bank, National Association, a national banking association, as trustee (in such capacity, together with its successors and assigns, the "Trustee"). WHEREAS, pursuant to the Sale and Servicing Agreements (capitalized terms used without definition in the recitals have the meanings assigned to them in the Definitions List referred to below) the Hospitals have agreed to sell, and Finco has agreed to purchase, the Receivables and other Transferred Property; WHEREAS, Finco wishes to assign and transfer to the Trustee on behalf of the Trust and pursuant to the terms and conditions set forth herein all of its right, title and interest in, to and under the Receivables and other Finco Transferred Property; WHEREAS, the Trust will issue the Sheffield Participation on the Initial Closing Date, which Participation will be subject to increase or decrease as set forth herein; and WHEREAS, it is contemplated that one or more TRIPs Participations will be issued on a TRIPs Closing Date to occur after the Initial Closing Date. In consideration for the premises and the mutual agreements herein contained, each party agrees, for the benefit of the other parties and the Participants, as follows: ARTICLE I DEFINITIONS Section 1.1. Definitions. As used in this Agreement (unless the context requires a different meaning), capitalized terms shall have the meanings assigned to them in the Definitions List, dated as of the date hereof (the "Definitions List"), that refers to this Agreement, which Definitions List is incorporated herein by reference and shall be deemed to be a part of this Agreement, and all terms herein shall be interpreted in accordance with the terms of the Definitions List. ARTICLE II CONVEYANCE OF THE RECEIVABLES; PARTICIPATIONS; TRIPs Section 2.1. Conveyance of Receivables and Total Transferred Property. (a) By execution of this Agreement, Finco does hereby transfer, assign, set over and otherwise convey to the Trustee on behalf of the Trust, in trust for the benefit of the Participants and, to the extent set forth in Section 2.9, Finco, without recourse (except as specifically provided herein), all its right, title and interest in, to and under: (i) the Purchased Receivables and the other Transferred Property with respect to which the Payment Date is the Initial Closing Date and created from time to time thereafter until the Trust Termination Date, all monies due or to become due and all amounts received or to be received with respect thereto and all proceeds thereof (including, without limitation, "proceeds" as defined in Section 9-306 of the UCC in effect in the state in which Finco's chief executive office is located), subject, however, to the repurchase provisions of Section 5.4 and (ii) the Assigned Agreements and the other Finco Transferred Property, including, without limitation, all amounts due and to become due to Finco from the Servicer, the Hospitals, UHS or any other Person under or in connection with the Assigned Agreements, whether payable as interest, fees, expenses, costs, taxes, indemnities, insurance recoveries, damages for breach of any of the Assigned Agreements or otherwise and all proceeds thereof (including, without limitation, "proceeds" as defined in Section 9-306 of the UCC in effect in the state in which Finco's chief executive office is located), and all rights, remedies, powers, privileges and claims of Finco against any or all of the Assignors under or with respect to the respective Assigned Agreements (whether arising pursuant to the terms of the Assigned Agreements or otherwise available to Finco at law or in equity), including, without limitation, the rights of Finco (A) to enforce (x) the Sale and Servicing Agreements against the respective Hospitals thereunder, (y) the Servicing Agreement against the Servicer and (z) the Guarantee against UHS and (B) to give or withhold any and all consents, requests, notices, directions, approvals, extensions or waivers under or with respect to the Assigned Agreements to the same extent as Finco might do but for the assignment of all such rights by Finco to the Trustee in this Section 2.1. Such property, together with all monies from time to time on deposit in the Collateral Account, the Other Accounts and any Additional Account, shall constitute the assets of the Trust (the "Trust Assets"). In exchange for the conveyance of the Trust Assets on the Initial Closing Date, Finco shall receive the Sheffield Participation to be acquired on the Initial Closing Date by Sheffield and the Subordinated Interest. (b) Notwithstanding the foregoing transfer, assignment, set-over and conveyance, subject to Sections 5.6 and 5.7, Finco shall nevertheless be permitted to take all actions, if any, required by the specific terms of any of the Assigned Agreements, and such transfer, assignment, set-over and conveyance (i) does not constitute and is not intended to result in the creation or an assumption by the Trust, the Trustee or any Interested Party of any obligation of Finco, any UHS Entity or any other Person in the Transferred Property, the Assigned Agreements or the other Finco Transferred Property and (ii) shall not relieve Finco from the performance of any term, covenant, condition or agreement on Finco's part to be performed or observed under or in connection with any of the Assigned Agreements, or from any liability to any Assignor under any of the Assigned Agreements, or impose any obligation on any of the Interested Parties to perform or observe any such term, covenant, condition or agreement on Finco's part to be so performed or observed or impose any liability on any of the Interested Parties for any act or omission on the part of Finco or any Assignor or from any breach of any representation or warranty on the part of Finco or any Assignor contained herein or in the other Assigned Agreements, or made in connection herewith or therewith. (c) In connection with such transfer, assignment, set-over and conveyance, and subject to Section 5.3, Finco agrees to file or deliver, as the case may be, at its own expense, all Security Filings with respect to the Purchased Receivables, the other Transferred Property, and the Finco Transferred Property, now existing and hereafter created, meeting the requirements of applicable state laws in such manner and in such jurisdictions as are necessary to perfect the assignment of the Transferred Property and the Finco Transferred Property to the Trustee, and to deliver a file-stamped copy or other evidence of filing of any UCC financing statements and any continuation statements to the Trustee. The Trustee shall be entitled to rely on the Security Filings filed or delivered by Finco without any independent investigation. (d) In connection with such transfer, assignment, set-over and conveyance, Finco further agrees, at its own expense, on or prior to the Initial Closing Date, to indicate in its computer files and to cause the Servicer and the Hospitals to indicate in their computer files that the Purchased Receivables have been conveyed to the Trustee on behalf of the Trust pursuant to this Agreement for the benefit of the Participants. Section 2.2. Acceptance by Trustee. (a) The Trustee hereby acknowledges its acceptance on behalf of the Trust of all right, title and interest to the property, now existing and hereafter created, conveyed to the Trustee on behalf of the Trust pursuant to Section 2.1 and declares that it shall maintain such right, title and interest, upon the trust herein set forth, for the benefit of all Participants. (b) The Trustee shall have no power to create, assume or incur indebtedness or other liabilities in the name of the Trust other than as contemplated in Sections 9.3(b) and 9.8(d) of this Agreement. Section 2.3. Construction of Agreement. (a) Finco hereby grants to the Trustee on behalf of the Trust a security interest in all of Finco's right, title and interest in, to and under the Total Transferred Property to secure all of Finco's obligations hereunder and under the other Finco documents, including, without limitation, Finco's obligation to transfer Receivables hereafter created to the Trustee on behalf of the Trust, and this Agreement shall constitute a security agreement under applicable law. (b) It is the intent of Finco, the Trustee and the Participants that, for federal, state and local income and franchise tax purposes and consolidated financial accounting, the Participations will be considered indebtedness of Finco secured by the Total Transferred Property. Finco and Sheffield, by entering into this Agreement, and each TRIPs Holder, by its acceptance of its TRIP, agree to treat the Participations for federal, state and local income and franchise tax purposes as indebtedness of Finco. Section 2.4. Participations. Subject to the terms of this Agreement, each Participation shall represent senior undivided participating ownership or security interests in the Trust Assets, including the right to receive all Collections and other amounts received in respect of the Purchased Receivables, all funds on deposit in the Collateral Account credited to the sub-accounts maintained for the Participants and all funds in the Other Accounts and any Additional Accounts (each such interest being hereinafter referred to as a "Participation"), all as provided in this Agreement. The TRIPs Participations shall be evidenced by the TRIPs, each substantially in the form of Exhibit A. The TRIPs shall, upon issue, be executed and delivered by Finco to the Trustee for authentication and redelivery as provided in Sections 2.5 and 9.2. Sheffield is hereby authorized to record the date of the Initial Sheffield Purchase and each Increase, the Initial Sheffield Capital and each Increase Amount and the date and amount of each Decrease on its books and records, and any such recordation shall, absent manifest error, constitute prima facie evidence of the Sheffield Capital and the Sheffield Participation. Section 2.5. Initial Purchase of the Sheffield Participation and Issuance of the TRIPs. (a) Subject to the terms and conditions of this Agreement, the Sheffield Participation shall be initially acquired (the "Initial Sheffield Purchase") by Sheffield on the Initial Closing Date and upon request of Finco and acceptance by Sheffield; provided that Finco gives irrevocable written notice to Sheffield prior to 3:00 pm (New York City time) on the Business Day prior to the Initial Closing Date, unless the Sheffield Yield Rate with respect to the Initial Sheffield Capital shall be calculated by reference to the Adjusted Eurodollar Rate, in which case such notice shall be delivered no later than 3:00 pm (New York City time) three Business Days prior to the Initial Closing Date. Such notice shall state (i) the Initial Closing Date, (ii) the Initial Sheffield Capital, which shall not be less than $1,000,000, (iii) the Fixed Period applicable to each Sheffield Tranche comprising such Initial Sheffield Capital and (iv) the Sheffield Yield Rate approved by Sheffield for each such Sheffield Tranche provided that the Fixed Period applicable to any Sheffield Tranche comprising the Initial Sheffield Capital shall be selected in accordance with the requirements of Section 2.10. On the Initial Closing Date, Sheffield shall make available to Finco at Finco's office specified in Section 14.1, in immediately available funds, the Initial Sheffield Capital. Sheffield shall not agree to make the Initial Sheffield Purchase if, after giving effect thereto, the Sheffield Capital would exceed the Maximum Sheffield Capital. (b) On the TRIPs Closing Date, Sheffield may reduce the Sheffield Participation. In exchange therefor, subject to the terms and conditions of this Agreement and payment of any amounts required to be paid in respect of the Sheffield Participation, upon written order of Finco to the Trustee, on the TRIPs Closing Date the Trust shall (i) issue the TRIPs evidencing the TRIPs Participations and (ii) reduce the Sheffield Capital to the extent of the TRIPs Capital of the TRIPs so issued. The TRIPs Participations so issued on the TRIPs Closing Date shall be acquired by the TRIPs Holders and the TRIPs shall be issued in favor of the TRIPs Holders on the TRIPs Closing Date in an aggregate amount equal to the Initial TRIPs Capital; provided that Finco shall give five Business Days' prior written notice to Sheffield, the Rating Agencies and the Trustee of such acquisition, and if such acquisition will result in a Decrease of the Sheffield Capital, Finco shall satisfy the conditions of Section 2.6(b). Such notice shall specify (i) the TRIPs Closing Date, (ii) the Initial TRIPs Capital, (iii) the Scheduled TRIPs Termination Date and (iv) the TRIPs Yield Rate. On the TRIPs Closing Date, each TRIPs Holder shall make available to the Trustee, for deposit in the Collateral Account, in immediately available funds, its portion of the Initial TRIPs Capital; provided, however, that, after giving effect to such deposit and to any Increases and Decreases proposed to be made on the TRIPs Closing Date, the Initial TRIPs Capital shall not exceed the Maximum TRIPs Capital and the sum of the Sheffield Capital and the TRIPs Capital shall not exceed the Maximum Aggregate Capital. On the TRIPs Closing Date, Finco shall execute, and the Trustee, upon written order of Finco, shall duly authenticate and deliver to the TRIPs Holders, TRIPs executed in favor of each TRIPs Holder, in denominations equal to the TRIPs Holders' respective portions of the Initial TRIPs Capital. Section 2.6. Increases and Decreases in the Sheffield Capital. (a) The Sheffield Capital may be increased (an "Increase") on any Business Day upon request of Finco and (subject to the limitations set forth herein) at Sheffield's option; provided that Finco gives irrevocable written notice to Sheffield prior to 3:00 pm (New York City time) on the Business Day prior to the date of such Increase, unless the Sheffield Yield Rate with respect to the Increase Amount shall be calculated by reference to the Adjusted Eurodollar Rate, in which case such notice shall be delivered no later than 3:00 pm three Business Days prior to the date of such Increase. Such notice shall state (i) the Business Day on which such Increase is proposed to occur, (ii) the Increase Amount, which shall not be less than $1,000,000, (iii) the Fixed Period applicable to such Increase Amount and (iv) the Sheffield Yield Rate applicable to such Increase Amount. Promptly upon receipt of such notice, Sheffield shall determine, in its sole discretion, its willingness to acquire the Increase, and shall promptly notify Finco of such determination. If Sheffield agrees to acquire any Increase, on the applicable Business Day on which such Increase is scheduled to occur, Sheffield shall make available to Finco at its office specified in Section 14.1, in immediately available funds, the applicable Increase Amount. Sheffield shall not agree to acquire any Increase if, after giving effect thereto, the Sheffield Capital would exceed the Maximum Sheffield Capital. (b) Prior to 3:00 pm (New York City time) on the last day of any Fixed Period with respect to any Sheffield Tranche, upon election of Finco, the Sheffield Capital may be decreased (a "Decrease") through the distribution to Sheffield of an amount equal to all or any portion of such Sheffield Tranche; provided that (i) Finco shall give written notice of such Decrease prior to 3:00 pm (New York City time) on the Business Day preceding such decrease to Sheffield and the Trustee, (ii) such distribution shall be made from funds (A) retained in the Sheffield Sub-account pursuant to Section 7.2(b)(iv)(B) or (B) allocated to the Collateral Account pursuant to Sections 7.2(b)(v) and 7.2(c)(v) and (iii) after giving effect to such distribution, and to Section 2.10, no Sheffield Tranche shall be less than $100,000. (c) The Sheffield Capital shall not be increased unless each of the following conditions have been satisfied, and delivery by Finco of any request for any Increase pursuant to subsection 2.6(a) shall be deemed to be a representation and warranty by Finco as to the satisfaction of such conditions: (i) On each such date Finco shall have complied, in all material respects, with all its covenants hereunder and shall have fulfilled all its obligations hereunder; (ii) The representations and warranties of Finco set forth in Article IV shall be true and correct in all material respects on and as of such date after giving effect to any such payment; and (iii) Since the previous Business Day, there shall have been no material adverse change or changes in (i) the business, property, assets or condition (financial or otherwise) of the UHS Entities taken as a whole that would reasonably be expected to have, alone or in the aggregate, a material adverse effect on the ability of the UHS Entities to perform their obligations under the Operative Documents or (B) the collectibility (other than as a result of the credit quality of any Obligor) or enforceability of the Purchased Receivables taken as a whole or the value of the related Transferred Property. (d) To the extent that Sheffield elects to maintain the Sheffield Participation and the Sheffield Capital in accordance with Section 2.7, Fixed Periods shall be selected from time to time to apply to each Sheffield Tranche in accordance with Section 2.10. Section 2.7. Maintenance of Aggregate Capital. (a) During the TRIPs Revolving Period, and subject to the terms and conditions of this Agreement, the Trustee, on behalf of the TRIPs Holders, shall maintain the TRIPs Capital by paying to Finco on each Business Day the amounts (if any) required to be paid pursuant to Section 7.2(d). (b) During the Sheffield Revolving Period, and subject to the terms and conditions of this Agreement, the Trustee, on behalf of Sheffield, shall, unless otherwise instructed in writing by Sheffield, maintain the Sheffield Capital, subject to increase or decrease as provided herein, by paying to Finco on each Business Day the amounts (if any) required to be paid pursuant to Section 7.2(d). Nothing in this Agreement shall be deemed to be or construed as a commitment by Sheffield to make the Initial Sheffield Purchase or any Increase or to make any payment to Finco to maintain the Sheffield Capital. Sheffield may elect upon 90 days' prior written notice, in its sole discretion, not to maintain the Sheffield Capital. Sheffield shall send notice of such election to Finco and the Trustee and the Trustee shall thereupon provide notice thereof to each TRIPs Holder. Commencing 90 days after receipt of such notice, the Trustee, on behalf of Sheffield, shall make the allocation provided in Section 7.2(b)(iv)(A). Section 2.8. Borrowing Base Compliance. (a) If, on any Business Day during the Sheffield Revolving Period, after giving effect to all allocations and distributions required pursuant to Sections 7.2(a) through (c), the Aggregate Capital would exceed the Borrowing Base (as reflected in the Servicer Daily Statement), the Sheffield Capital shall be reduced through the repayment of Commercial Paper and Loans by the lesser of (i) the amount of such excess, (ii) the sum of (A) the portion of the Sheffield Capital allocable to all Commercial Paper maturing on such Business Day and (B) the principal amount of all Loans maturing or which may be prepaid on such Business Day and (iii) the amount of funds deposited in the Collateral Account pursuant to Sections 7.2(b)(v)(A) and 7.2(c)(vi)(A) on such Business Day. The amount of new Commercial Paper which could otherwise be issued on such date shall be reduced to the extent of such excess. If no Commercial Paper Notes are scheduled to mature on such date and no Loans are then Outstanding, then the Sheffield Capital shall not be so reduced as a result of such excess. (b) Notwithstanding any provision of this Agreement to the contrary, the amount of any payment to Finco in respect of the Participations, whether in respect of the initial acquisition of any Participation, any Increase or the maintenance of the Aggregate Capital, shall be reduced to the extent that, after giving effect to such payment (absent the reduction required pursuant to this Section) and to all allocations and distributions required pursuant to Article VII on such day, and any reduction in the Sheffield Capital required by Section 2.8(a), the Aggregate Capital would exceed the Borrowing Base. Section 2.9. Subordination of Finco Interest. (a) Finco shall receive an interest in the Trust Assets not represented by the Participations (the "Subordinated Interest"), which interest shall be subordinated to the interests of the Participants in the Trust Assets; provided that, except as specifically provided in Article VII, the Subordinated Interest shall not represent any interest in the Collateral Account, the Other Accounts, any Additional Account or any other account maintained for the benefit of the Participants. Subject to the terms and conditions of this Agreement, Finco shall be entitled to receive the amounts (if any) payable to it pursuant to Section 7.2(d) in respect of the Subordinated Interest. Finco hereby agrees that all its right, title and interest in the Collections on the Purchased Receivables shall be subordinated to the extent of the priorities and in the manner set forth in Article VII. (b) If an Early Amortization Event shall have occurred and be continuing, no amount shall be paid to Finco in respect of the Subordinated Interest or otherwise until (i) the Adjusted Aggregate Capital shall have been reduced to zero, (ii) all Yield and any Make-Whole Payment Amount scheduled to accrue or be paid in respect of the Participations shall have been deposited in the Sheffield Interest Sub-account or the TRIPs Interest Sub-account, as the case may be, and (iii) all fees, costs, expenses and Indemnified Amounts scheduled to accrue or be paid pursuant to the Operative Documents shall have been deposited in the Expense Sub-account. Section 2.10. Selection of Fixed Periods. (a) From time to time hereafter until the Sheffield Termination Date, Finco shall, subject to the limitations described below, select (i) Fixed Periods for each Sheffield Tranche so that all Sheffield Capital is at all times allocated to a Fixed Period and (ii) Sheffield Yield Rates approved by Sheffield to apply to each such Sheffield Tranche for each such Fixed Period. The initial Fixed Periods and Sheffield Yield Rates applicable to the Initial Sheffield Capital and each Increase Amount, respectively, shall be specified in the notice relating to the Initial Sheffield Purchase and each Increase, as described in Sections 2.5 and 2.6. Each subsequent Fixed Period for each Sheffield Tranche shall commence on the last day of the immediately preceding Fixed Period for such Sheffield Tranche, and the duration of, and Sheffield Yield Rate applicable to, such subsequent Fixed Period shall be such as Finco shall select and Sheffield shall approve on notice from Finco received by Sheffield (including notice by telephone, confirmed in writing) not later than 3:00 pm (New York City time) on such last day, except that (i) (A) if Sheffield shall notify Finco on or prior to receipt of such notice that the Sheffield Yield Rate applicable to any Sheffield Tranche shall be the Alternative Rate, then the Sheffield Yield Rate applicable to such Sheffield Tranche shall be the Alternative Rate, (B) no Sheffield Tranche outstanding after the Sheffield Termination Date and calculated by reference to the CP Rate shall have a fixed period ending after the 120th day after the Sheffield Termination Date (or if an Early Amortization Event of a type specified in subsection 10.1(f) or (s) shall have occurred, after the Sheffield Termination Date) and (C) each Fixed Period commencing after the occurrence of an Early Amortization Event of a type specified in subsection 10.1(f) or (s) hereof shall be calculated by reference to the Alternative Rate, (ii) if Sheffield shall not have received such notice before 3:00 pm (New York City time) or Sheffield and Finco shall not have so mutually agreed before 3:00 pm (New York City time) on such last day, such Fixed Period shall be one day and the applicable Sheffield Yield Rate shall be the Base Rate, (iii) if Finco is requesting that Sheffield Yield accrue at the Adjusted Eurodollar Rate for such Fixed Period, such notice must be received by Sheffield no later than 3:00 pm on the third Business Day prior to such last day and (iv) if Sheffield shall have notified Finco of the existence of a Eurodollar Disruption Event, the Applicable Sheffield Yield Rate shall not be calculated by reference to the Adjusted Eurodollar Rate. Any Fixed Period which would otherwise end on a day which is not a Business Day shall be extended to the next succeeding Business Day. In addition, whenever any Fixed Period as to which Sheffield Yield accrues at the Adjusted Eurodollar Rate commences on the last Business Day in a month or on a day for which there is no numerically corresponding day in the month in which such Fixed Period ends, the last day of such Fixed Period shall occur on the last Business Day of the month in which such Fixed Period ends. Any Fixed Period which commences before the Scheduled Sheffield Termination Date and would otherwise end on a date occurring after the Scheduled Sheffield Termination Date shall end on the Scheduled Sheffield Termination Date. Any Fixed Period which commences on or after the Scheduled Sheffield Termination Date shall be of such duration as shall be selected by Sheffield. Sheffield shall, on the first day of each Fixed Period for each Sheffield Tranche, notify the Trustee of the Sheffield Yield Rate for such Sheffield Tranche. (b) Sheffield shall notify Finco in the event that a Eurodollar Disruption Event as described in clause (i) of the definition of "Eurodollar Disruption Event" has occurred, whereupon any Sheffield Tranche in respect of which Sheffield Yield accrues at the Adjusted Eurodollar Rate for the then current Fixed Period shall immediately be converted to accrue at the Base Rate for the remainder of such Fixed Period. (c) If any acquisition of the Initial Sheffield Purchase or any Increase requested by Finco, or any selection of a subsequent Fixed Period and Sheffield Yield Rate approved by Sheffield pursuant to this Section 2.10 for any Sheffield Tranche is not, for any reason (other than as a result of the gross negligence or willful misconduct of Sheffield or any Lender), made or effectuated, as the case may be, on the date specified therefor, or if any Decrease in any Sheffield Tranche is made on any day other than the last day of the Fixed Period with respect to such Sheffield Tranche, Finco shall indemnify Sheffield for any loss, cost or expense incurred by Sheffield, including, without limitation, any loss, cost or expense incurred by reason of the liquidation or reemployment of deposits or other funds acquired by Sheffield to fund such Initial Sheffield Purchase or Increase or to maintain such Sheffield Tranche during the applicable Fixed Period. The agreements and obligations of Finco contained in this Section 2.10(c) shall survive the termination of this Agreement. Section 2.11. Increased Costs; Capital Adequacy; Illegality. (a) If as a result of the introduction of or any change (including, without limitation, any change by way of imposition or increase of reserve requirements) in or in the interpretation of any Requirement of Law or the compliance by any Lender or any Affiliate thereof with any law, guideline, rule, regulation, directive or request from any central bank or other Governmental Authority or agency (whether or not having the force of law), Sheffield is required to compensate any Lender in connection with this Agreement or the funding or maintenance of the Sheffield Participation hereunder, then within ten days after demand by Sheffield, Finco shall pay to Sheffield such additional amount or amounts as may be necessary to reimburse Sheffield for any amounts paid by it. (b) When making a claim under this Section 2.11, Sheffield shall submit to Finco a certificate as to such additional or increased cost or reduction, which certificate shall be conclusive absent manifest error. (c) The agreements and obligations of Finco contained in this Section 2.11 shall survive the termination of this Agreement. Section 2.12. Taxes. (a) Any and all payments in respect of the Participations or any other fees, costs, expenses or Indemnified Amounts hereunder shall be made free and clear of and without deduction for any and all present or future taxes, levies, imposts, deductions, charges or withholdings, and all liabilities with respect thereto, excluding, in the case of each Interested Party, net income taxes that are imposed by the United States and franchise taxes, gross receipts taxes and net income taxes that are imposed on such Interested Party by any state or foreign jurisdiction (as the case may be) under the laws of which such Interested Party is organized or with which such Interested Party is associated other than as a result of this Agreement, or any political subdivision thereof (all such non-excluded taxes, levies, imposts, deductions, charges, withholdings and liabilities being hereinafter referred to as "Taxes"). If Finco or the Servicer shall be required by law to deduct any Taxes from or in respect of any sum payable hereunder to any Interested Party, (i) Finco shall make an additional payment to such Interested Party in an amount sufficient so that, after making all required deductions (including deductions applicable to additional sums payable under this Section 2.12), such Interested Party receives an amount equal to the sum it would have received had no such deductions been made, (ii) Finco or the Servicer, as the case may be, shall make such deductions and (iii) Finco or the Servicer, as the case may be, shall pay the full amount deducted to the relevant taxation authority or other authority in accordance with applicable law. (b) Finco will indemnify each Interested Party for the full amount of Taxes, including, without limitation, any Taxes imposed by any jurisdiction on amounts payable under this Section 2.12 paid by such Interested Party, and any liability (including penalties, interest and expenses) arising therefrom or with respect thereto; provided that, in making a demand for indemnity payment an Interested Party shall provide Finco, at its address referred to in Section 14.1, with a certificate from the relevant taxing authority or from a responsible officer of such Interested Party stating or otherwise evidencing that such Interested Party has made payment of such Taxes and will provide a copy of or extract from documentation, if available, furnished by such taxing authority evidencing assertion or payment of such Taxes. This indemnification shall be made within ten days after the date such Interested Party makes written demand therefor. (c) Within 30 days after the date of any payment of Taxes by Finco, Finco will furnish to the party requesting such payment, at its address referred to in Section 14.1, appropriate evidence of payment thereof. (d) Each Interested Party that is not incorporated under the laws of the United States of America or a state thereof shall, to the extent that it may then do so under applicable laws and regulations, deliver to Finco (i) within 15 days after the date hereof (or after the TRIPs Closing Date in the case of the TRIPs Holders), two (or such other number as may from time to time be prescribed by applicable laws or regulations) duly completed copies of IRS Form 4224 or Form 1001 (or any successor forms or other certificates or statements which may be required from time to time by the relevant United States taxing authorities or applicable laws or regulations), as appropriate, to permit payments to be made hereunder for the account of such Interested Party without deduction or withholding of United States federal income or similar taxes and (ii) upon the obsolescence of or after the occurrence of any event requiring a change in, any form or certificate previously delivered pursuant to this Section 2.12(d), copies (in such numbers as may from time to time be prescribed by applicable laws or regulations) of such additional, amended or successor forms, certificates or statements as may be required under applicable laws or regulations to permit payments to be made hereunder for the account of such Interested Party without deduction or withholding of United States federal income or similar taxes. (e) For any period with respect to which an Interested Party has failed to provide Finco with the appropriate form, certificate or statement required pursuant to Section 2.12(d) (other than if such failure is due to a change in law occurring after the date of this Agreement), such Interested Party shall not be entitled to indemnification under Section 2.12(a) or 2.12(b) with respect to Taxes imposed by the United States. (f) Within 30 days of the written request of Finco therefor, each Interested Party shall execute and deliver to Finco such certificates, forms or other documents which can be furnished consistent with the facts, which are reasonably necessary to assist Finco in applying for refunds of Taxes remitted hereunder and which are not detrimental to such Interested Party. (g) If Sheffield is required to compensate a Lender in respect of taxes under circumstances equivalent to those described in this Section 2.12, then within ten days after demand by Sheffield, Finco shall pay to Sheffield such additional amount or amounts as may be necessary to reimburse Sheffield for any amounts paid by it. (h) The agreements and obligations of Finco contained in this Section 2.12 shall survive the termination of this Agreement. Section 2.13. Extension of Sheffield Revolving Period; Increase of Maximum Sheffield Capital. (a) Finco may request that the Sheffield Revolving Period be extended for one or more additional years by submitting in writing to Sheffield and the Trustee, no later than 90 days prior to the Scheduled Sheffield Termination Date, a request for such extension; provided that at the time of such request (i) no Early Amortization Event shall have occurred and be continuing and (ii) neither Finco nor the Servicer shall be in default in the performance of any covenant or agreement contained herein or in any Operative Document. Sheffield shall, in its sole discretion, accept or reject such request in writing within 45 days of receipt thereof and Finco shall thereupon notify the Trustee in writing of such acceptance or rejection. If Sheffield shall accept such request in writing, the Sheffield Revolving Period shall automatically and without any further action be extended for the period specified in such request. A failure by Sheffield to provide the required response to such request shall be deemed to be a rejection of such request. (b) On any Business Day following the Initial Closing Date, Finco may request, by submission of an irrevocable written request to Sheffield and the Trustee, that the Maximum Sheffield Capital be increased by an amount specified by Finco in such request, provided that, after giving effect to such increase, the Aggregate Capital shall be no greater than $85,000,000; and provided, further, that no such increase shall become effective unless all conditions precedent set forth in subsection (c) shall have been satisfied. Within 30 days of receipt of such request, Sheffield shall, in its sole discretion, accept or reject such request in writing and Finco shall thereupon notify the Trustee in writing of such acceptance or rejection. (c) Any increase requested by Finco and agreed to by Sheffield shall become effective on the first day of the Settlement Period following the satisfaction of the following conditions precedent: (i) Each Rating Agency shall have delivered written confirmation to Finco and the Trustee that the proposed increase will not adversely affect its rating of the TRIPs and/or the Commercial Paper, as the case may be; and (ii) Finco shall have delivered a certificate of an Authorized Officer dated the date of such increase to the effect that, after giving effect to such increase, (A) no Early Amortization Event shall have occurred and (B) neither Finco nor the Servicer shall be in default in the performance of any covenant or agreement contained herein or in any Operative Document. Section 2.14. Optional Acceleration of TRIPs Amortization Period. Upon at least 30 days prior written notice to Sheffield and the Trustee, which notice shall be irrevocable, Finco may elect (such election being referred to herein as the exercise of the "Call Option") to have the TRIPs Amortization Period begin after the close of business on the Transfer Date specified in such written notice (such Transfer Date, the "Call Date"); provided that Finco may not exercise the Call Option if, after giving effect to such exercise, and all allocations and distributions to be made pursuant to Article VII on such date, the Aggregate Capital would exceed the Borrowing Base. The Trustee shall give prompt notice to the TRIPs Holders of the exercise of the Call Option by Finco. If the Call Option is exercised, the TRIPs Holders shall be entitled to receive in repayment of the Participations, in addition to repayments of the TRIPs Capital and all TRIPs Yield accrued thereon, the Make- Whole Payment Amounts as provided in Article VII. ARTICLE III CONDITIONS TO PAYMENTS Section 3.1. Conditions to Initial Purchase. The initial purchase of any Participation on the Initial Closing Date or the TRIPs Closing Date, as the case may be, is subject to the satisfaction, on terms satisfactory to such Participants, the Trustee and the Placement Agent, if any, of all applicable conditions specified in the Conditions List and to all conditions specified in Section 3.2. Section 3.2. Conditions to all Payments. The Trustee shall make payments to Finco on behalf of the Participants as provided in this Agreement on each Business Day unless it shall have received notice from Sheffield or the Required TRIPs Holders or unless an Authorized Officer of the Trustee shall otherwise have actual knowledge (in which case the Trustee shall immediately notify the Participants), that one or more of the following conditions precedent have not been satisfied: (a) Finco and the Servicer shall be in full compliance with all the terms and conditions of Article VI hereof and Article III of the Servicing Agreement, including the terms and conditions regarding the Master Receivables Account; (b) No Early Amortization Event and no event which, after notice or lapse of time or both, would become an Early Amortization Event, shall have occurred and then be continuing; and (c) After giving effect to such payment, and all other allocations and distributions to be made on such date, the Aggregate Capital shall not exceed the Borrowing Base. The acceptance by Finco of any payment by or on behalf of any Participant shall be deemed to be a representation and warranty by Finco to the Trustee and each Participant as of such acceptance date as to the matters in paragraphs (a) through (c) of this Section 3.2. If, on any Business Day, the condition precedent set forth in subsection 3.2(a) is not satisfied, Sheffield or the TRIPs Holders shall have the option to (A) take no action, in which case the Trustee shall make payment to Finco pursuant to the terms hereof, (B) by written notice delivered by Sheffield to the Trustee, instruct the Trustee not to make the portion of such payment hereunder payable from the Sheffield Sub-account and to retain the amount of such payment in the Sheffield Sub- account pursuant to Section 7.2(b)(iv)(A), thereby requiring Finco to increase its Subordinated Interest on such date or (C) by written notice by the Required TRIPs Holders to the Trustee, instruct the Trustee not to make the portion of such payment hereunder payable from the TRIPs Sub-account and to retain the amount of such payment in the TRIPs Sub-account pursuant to Section 7.2(c)(v), thereby requiring Finco to increase its Subordinated Interest on such date. In the event that the condition precedent set forth in Section 3.2(c) is not satisfied, the Trustee shall, without further notice or instruction by any Participant, retain in the Collateral Account pursuant to Section 7.2(d)(ii), such portion of the amount otherwise payable to Finco as shall be necessary to satisfy such condition. In the event that the condition precedent set forth in Section 3.2(b) is not satisfied, the Trustee may, and to the extent required hereunder shall, exercise such rights and remedies as set forth in Article X and make the appropriate allocations set forth in Article VII. ARTICLE IV REPRESENTATIONS AND WARRANTIES Section 4.1. General Representations and Warranties of Finco. Finco represents and warrants to and covenants with the Trustee and the Participants, as of the date hereof, as of the TRIPs Closing Date and as of the date of any Increase as follows: (a) Finco has been duly organized and is validly existing and in good standing as a corporation under the laws of the state of Delaware, with full corporate power and authority to own or lease its properties and to conduct its business as presently conducted and to execute, deliver and perform this Agreement and the other Finco Documents and each other document related hereto and thereto to which it is a party and to consummate the transactions contemplated hereby and thereby. Finco is duly qualified as a foreign corporation and in good standing under the laws of each jurisdiction where its ownership, lease or operation of property or the conduct of its business requires such qualification, except where any such failure or failures to be so qualified would not have, alone or in the aggregate, a material adverse effect on its business, operations, properties, assets or condition (financial or otherwise). (b) The execution, delivery and performance by Finco of this Agreement and the other Finco Documents and the consummation of the transactions contemplated hereby and thereby have been duly and validly authorized by all requisite corporate action and will not (with due notice or lapse of time or both) conflict with or result in a breach of any of the terms or provisions of, or constitute a default under, or result in the creation or imposition of any Lien upon any of its property or assets pursuant to the terms of, any indenture, mortgage, deed of trust, lease, loan agreement or other agreement, instrument or undertaking by which it is bound or to which any of its property or assets is subject, nor will such action result in any violation of any applicable Requirement of Law; and no consent, approval, authorization, order, registration, filing, qualification, license or permit of or with any court or any regulatory authority or other Governmental Authority or body or any other Person is required to be obtained by or with respect to Finco in connection with the execution, delivery and performance by Finco of this Agreement, the other Finco Documents, any other documents related hereto or thereto or the consummation of the transactions contemplated hereby or thereby (other than the actions required to file, deliver or record any Security Filings, all of which actions have been taken). (c) Each of the Finco Documents has been duly authorized, executed and delivered by Finco and constitutes a valid and legally binding obligation of Finco, enforceable against Finco in accordance with its terms, subject as to enforceability to applicable bankruptcy, reorganization, insolvency, moratorium and other similar laws affecting creditors' rights generally, and to general principles of equity (regardless of whether enforcement is sought in a proceeding in equity or at law). (d) There are no actions, proceedings or investigations pending or, to the knowledge of Finco (after due investigation), threatened, before any court, administrative agency or other tribunal (i) which, if determined adversely to Finco, alone or in the aggregate, could have a material adverse effect on the business, operations, properties, assets or condition (financial or otherwise) of Finco, (ii) asserting the invalidity of this Agreement or any of the other Finco Documents, (iii) questioning the consummation by Finco of any of the transactions contemplated by this Agreement or the other Finco Documents, or (iv) which, if determined adversely, alone or in the aggregate, could materially and adversely affect the ability of Finco to perform its obligations under, or the validity or enforceability of, this Agreement, the other Finco Documents or the Participations; and Finco is not in default with respect to any order of any court, arbitrator or Governmental Authority. (e) Each purchase of any Participation hereunder, each Increase and each reinvestment of Collections will constitute a purchase or other acquisition of notes, drafts, acceptances, open accounts receivable or other obligations representing part or all of the sale price of merchandise, insurance or services within the meaning of Section 3(c)(5) of the Investment Company Act. Neither Finco nor the Trust is an "investment company" or a company "controlled" by an "investment company" within the meaning of the Investment Company Act. (f) The chief executive office of Finco is located at the address set forth on Schedule I hereto, which place of business is the place where Finco is "located" for the purposes of Section 9-103(3)(d) of the UCC of the state indicated on such Schedule, and the location of the office where Finco keeps all of the instruments, documents, agreements, books and records relating to the Total Transferred Property is at the address set forth on Schedule I hereto. (g) Finco has no Subsidiaries. (h) Each Hospital (including, without limitation, each Excluded Hospital with respect to Receivables and Transferred Property purchased by Finco prior to exercise by Finco of the remedy set forth in subsection 6.2(a)(iii) of the applicable Sale and Servicing Agreement) is in compliance with the terms and conditions of Article V of the related Sale and Servicing Agreement. (i) Finco has no trade names, fictitious names, assumed names or "doing business as" names. (j) No material Reportable Event has occurred during the five-year period prior to the date on which this representation is made or deemed made with respect to any Plan, and each Plan has complied in all material respects with the applicable provisions of ERISA and the Code. The present value of all accrued benefits under each Single Employer Plan maintained by Finco or any Commonly Controlled Entity (based on those assumptions used to fund the Plans) did not, as of the last annual valuation date prior to the date on which this representation is made or deemed made, materially exceed the value of the assets of such Plan allocable to such accrued benefits. Neither Finco nor any Commonly Controlled Entity has had a complete or partial withdrawal or withdrawals from any Multiemployer Plan which, alone or in the aggregate, has resulted or could result in any material liability under ERISA, and neither Finco nor any Commonly Controlled Entity would become subject to any material liability under ERISA if Finco or any such Commonly Controlled Entity were to withdraw completely from all Multiemployer Plans as of the valuation date most closely preceding the date on which this representation is made or deemed made. No such Multiemployer Plan is in reorganization or Insolvent. The present value (determined using actuarial and other assumptions which are reasonable in respect of the benefits provided and the employees participating) of the liability of Finco and each Commonly Controlled Entity for post-retirement benefits to be provided to their current and former employees under Plans which are welfare benefit plans (as defined in Section 3(1) of ERISA) does not, in the aggregate, materially exceed the assets under all such Plans allocable to such benefits. (k) As of the date of delivery thereof, each Servicer Daily Statement and each Settlement Date Statement were true, correct and complete in all material respects. (l) The Master Receivables Account has been established in accordance with, and is in compliance with, the terms and conditions of Section 3.7 of the Servicing Agreement. (m) Finco has and shall have filed or caused to be filed all material federal, state and local tax returns which are required to be filed, and has and shall have paid or caused to be paid all taxes as shown on said returns or any other taxes or assessments payable by it (other than any such taxes or assessments the amount or validity of which are currently being contested in good faith by appropriate proceedings and with respect to which reserves in conformity with GAAP have been provided on the books of Finco and with respect to which collection has been stayed), and no tax Lien has been filed and, to the knowledge of Finco, no claims are being asserted with respect to any such taxes, fees or other charges which, alone or in the aggregate, could reasonably be expected to have a material adverse effect on the rights of the Interested Parties under the Operative Documents or with respect to the Transferred Property. (n) None of the transactions contemplated in this Agreement (including the use of proceeds from the sale of the TRIPs) will result in a violation of Section 7 of the Securities Exchange Act of 1934, as amended, or any regulations issued pursuant thereto, including Regulations G, T, U, and X of the Board of Governors of the Federal Reserve System, 12 C.F.R., Chapter II. (o) Neither Finco nor anyone acting on its behalf has offered, or will offer, directly or indirectly, any TRIPs, any interest in any TRIPs, or any other similar instrument, or has solicited, or will solicit any offer to buy any of the same, from such type or aggregate number of Persons, or in such manner, as to require the offering, issuance or sale of the TRIPs to be registered pursuant to the provisions of the Securities Act. The offer and sale of the TRIPs to the TRIPs Holders are exempt from the registration requirements of the Securities Act and neither Finco nor any Person acting on behalf of Finco will take any action that will subject the offer and sale of the TRIPs to such registration requirements. Section 4.2. Representations and Warranties of Finco Concerning the Receivables. On the date hereof and (i) with respect to Sections 4.2(a), (e), (f), (l) and (n), on each following date (including each Purchase Date) and (ii) with respect to Sections 4.2(b) through (k) and (m), with respect to the Receivables purchased by Finco on each related Purchase Date, Finco represents and warrants to the Trustee and the Participants as follows: (a) Finco has, immediately prior to each conveyance pursuant to Section 2.1, good title to the Purchased Receivables and other Total Transferred Property conveyed to the Trust, and such Purchased Receivables and other Total Transferred Property are not subject to any Lien or other claim of any kind or to any offset, counterclaim or defense of any kind, other than contractual adjustments in respect of, and in no event greater than, the Applicable Contractual Adjustment and any offsets included in the Offset Reserves. At all times during which this Agreement is in effect, the Purchased Receivables, the Total Transferred Property and the Outstanding Balances in relation thereto conveyed to the Trustee on behalf of the Trust and in which the Participants have purchased the Participations will not be subject to any Lien or claim of any kind or to any counterclaim or defense of any kind other than the Permitted Interests and the offsets included in the Offset Reserves. (b) All of the Purchased Receivables and the other Total Transferred Property comply with and will comply with all Requirements of Law (including, in the case of Governmental Receivables originated by any Hospital, all applicable requirements of the programs listed on Schedule II of the Sale and Servicing Agreement to which such Hospital is a party) and are not the subject of any litigation, court proceeding or other dispute. (c) Each of the Purchased Receivables (i) is and will be in full force and effect and represents and will represent a valid and legally binding obligation of the related Obligor enforceable against such Obligor in accordance with its terms and (ii) constitutes an "account" or a "general intangible" under the UCC in effect in the state in which Finco's chief executive office is located, or a right to payment under a policy of insurance or proceeds thereof; the Assigned Agreements and the other Finco Transferred Property (x) are and will be in full force and effect and represent and will represent valid and legally binding obligations of the Assignors enforceable against the Assignors in accordance with their terms and (y) constitute accounts or general intangibles under the UCC in effect in the state in which Finco's chief executive office is located. (d) (i) The statements and information constituting Receivables Information, as they relate to Finco, are true and correct and do not contain any untrue statement of a material fact or any omission of any material fact which would make such statements and information, in light of the circumstances in which they were made or given, misleading and (ii) the other statements and information furnished by any Authorized Officer of Finco to any Interested Party are true and correct and shall not contain any untrue statement of a material fact or any omission of any material fact which would make such other statements or information, in light of the circumstances in which they were made or given, misleading. (e) There is (i) no effective financing statement (or similar statement or instrument of registration under the law of any jurisdiction) on file or registered in any public office and (ii) no assignment filed or delivered by or on behalf of Finco covering any interest of any kind in the Purchased Receivables or the other Total Transferred Property or intended so to be filed, delivered or registered, and Finco will not execute nor will there be on file in any public office any effective financing statement (or any similar statement or instrument of registration under the laws of any jurisdiction) or any assignment or other notification relating to the Total Transferred Property, except the Security Filings in respect of the Permitted Interests. The interest of the Trustee, on behalf of the Trust, is an ownership or security interest, valid and enforceable against, and prior to, all claims of existing and future creditors of Finco and all subsequent purchasers from Finco of the Total Transferred Property. (f) All Security Filings which are required to perfect the interests of the Participants in the Purchased Receivables and the other Total Transferred Property have been filed, delivered or received, as the case may be (other than as limited by Section 5.3), and are in full force and effect. Schedule I attached hereto lists all offices where UCC filings must be made to perfect the security interests of the Participants in the Purchased Receivables and other Total Transferred Property. (g) This Agreement, together with the Security Filings, vests and at all times will vest in the Trustee on behalf of the Trust, for the benefit of the Participants, the ownership interests or first priority security interests in, and Liens on, the Purchased Receivables and other Total Transferred Property and the Collections purported to be conveyed hereby and in accordance with the terms hereof, and such conveyance of the Purchased Receivables, other Total Transferred Property and Collections constitutes and will constitute a valid transfer of, or security interest in and Lien on, the Purchased Receivables, Total Transferred Property and Collections, enforceable against Finco and all creditors of and purchasers from Finco prior to all sales or other assignments thereof. (h) No Obligor on the Purchased Receivables and other Transferred Property (including, without limitation, any insurance company or other third-party payor or guarantor of such Obligor obligated in respect of any such Purchased Receivables or Transferred Property) is bankrupt, insolvent, undergoing composition or adjustment of debts or is unable to make payment of its obligations when due; provided that this representation shall not apply to any Governmental Authority which is an Obligor on Medicaid Receivables if the Receivables of such Obligor would not be considered Uncollectible Receivables under clause (c) of the definition of Uncollectible Receivables (taking into account the proviso contained in such definition). (i) Each Hospital is a qualified provider in respect of all Purchased Receivables of such Hospital constituting Governmental Receivables. (j) All amounts paid on each Governmental Receivable will be paid to each Hospital in accordance with all Requirements of Law, either (i) in such Hospital's name to the related Hospital Concentration Account in accordance with Section 4.3(m) of the applicable Sale and Servicing Agreement or (ii) in the name of UHS, for the benefit of such Hospital, to the Master Receivables Account. (k) Each Non-governmental Receivable being purchased by Finco from each Hospital pursuant to the Sale and Servicing Agreement to which such Hospital is a party is not and will not be payable by an Obligor which is an agency or instrumentality of the federal government of the United States of America unless all applicable requirements of the Assignment of Claims Act of 1940, as amended, and all regulations promulgated thereunder, including the giving of all requisite notices of assignment to all Persons to whom such notice must be given and the acknowledgement of receipt thereof by all such Persons, have been complied with in all material respects and unless the Participants shall have been provided with evidence thereof in form and substance satisfactory to the Required Participants. (l) All accounting information relating to the Receivables which has been provided to any Participant hereunder is in accordance with each Hospital's accounting policies, including such Hospital's Credit and Collection Policy. (m) Each of the Purchased Receivables, other than any Excluded Receivable, any Self-pay Receivable and any Uncollectible Receivable for which the Payment Date is the Initial Closing Date, is and will be an Eligible Receivable on the Purchase Date for such Purchased Receivable. (n) Each of the Purchased Receivables shall at all times be separately identifiable from those Receivables not transferred by Finco to the Trust, and all Financible Receivables shall at all times be separately identifiable from those Receivables that are not Financible Receivables. ARTICLE V COVENANTS OF FINCO Section 5.1. General Covenants. Finco covenants and agrees with the Trustee and the Participants that, so long as this Agreement shall remain in effect: (a) Finco will preserve and maintain its existence as a corporation in good standing under the laws of the state of its incorporation and its qualification as a foreign corporation where such qualification is required, except where any such failure or failures to so qualify, alone or in the aggregate, could not have a material adverse effect on Finco's performance of its obligations under the Finco Documents. (b) Finco will advise Sheffield and the Trustee promptly and in reasonable detail, and the Trustee shall thereupon provide notice thereof to the TRIPs Holders, of (i) any Lien asserted or offset or claim made against any of the Purchased Receivables or Total Transferred Property, (ii) the occurrence of any breach by any of Finco or any Assignor of any of its respective representations, warranties and covenants contained herein or in any of the other Finco Documents or the Assigned Agreements, as the case may be, (iii) the occurrence of any Early Amortization Event and of any event which, with the giving of notice or passage of time or both would become an Early Amortization Event, (iv) the occurrence of any Exclusion Event and of any event which, with the giving of notice or passage of time or both would become an Exclusion Event, (v) the occurrence of any event or events of which Finco has knowledge which would, alone or in the aggregate, reasonably be expected to have a material adverse effect on (A) the business, operations, property or condition (financial or otherwise) of the UHS Entities taken as a whole, (B) the value of the Total Transferred Property or the collectibility (other than as a result of the credit quality of any Obligor) or enforceability of the Purchased Receivables or (C) the ability of Finco to perform its obligations hereunder, (vi) the receipt from any Governmental Authority of a Deficiency Notice with respect to the Purchased Receivables or otherwise, (vii) the receipt of any notice of preliminary or final determination resulting from any Audit relating to any Hospital or the Receivables (including, without limitation, any "audit exception" to such determination), (viii) any other investigation of any Hospital by HHS or any intermediary thereof or (ix) any investigation by any other Governmental Authority or any intermediary thereof concerning the Receivables or the result of which could alone or in the aggregate materially adversely affect the ability of any UHS Entity to perform its obligations under the Operative Documents. (c) Subject to Section 5.2(i), Finco will duly fulfill all obligations on its part to be fulfilled under or in connection with the conveyance by Finco of the Total Transferred Property to the Trustee on behalf of the Trust and the conveyance of the Participations to the Participants and will do nothing, and shall cause each Assignor to do nothing, to impair the rights of the Interested Parties in the Total Transferred Property. (d) All financial statements prepared by Finco or any Hospital and made available to any Person other than any UHS Entity shall indicate the sale to Finco of the Purchased Receivables and other Transferred Property. (e) Finco shall file or shall cause to be filed all federal, state and local tax returns which are required to be filed, and shall pay or cause to be paid all taxes as shown on said returns and any other taxes or assessments payable by it (other than any such taxes or assessments the amount or validity of which are contested in good faith by appropriate proceedings and with respect to which reserves in conformity with GAAP are provided on the books of Finco and with respect to which collection has been stayed). (f) Finco shall not (i) invest in (by capital contribution or otherwise), suffer to exist any investment in, or acquire or purchase or make any commitment to purchase the obligations or capital stock of, or other indicia of equity rights in, or make any loan, advance or extension of credit to, or purchase any bonds, notes, debentures or other securities of, any Person or (ii) make any expenditure (by long-term or operating lease or otherwise) for capital assets (either realty or personalty). (g) Finco shall not wind up, liquidate or dissolve its affairs or enter into any transaction of merger or consolidation, convey, sell, lease or otherwise dispose of all or any part of its property or assets other than in accordance with the terms of the Operative Documents; enter into any joint venture, syndicate or other combination with any other Person, or issue any shares of capital stock or other securities (other than to UHS or any Hospital) or agree to do any of the foregoing at any future time. (h) Finco shall not declare or pay or permit to be paid any dividends or make or agree to make any other payments to any Affiliate; provided, however, that Finco shall not be prohibited from paying to UHS any amounts received pursuant to Section 7.2(d) and not payable to the Hospitals pursuant to Section 7.2(e). (i) Finco shall not engage in any business, or enter into any contract, agreement or transaction, except as contemplated by its Certificate of Incorporation, its By-Laws and the Operative Documents. (j) Finco shall not, except as approved by the Required Participants, amend any provision of its Certificate of Incorporation, By-Laws or any Operative Document to which it is a party, or waive any rights or claims of substantial value thereunder or enter into any additional Operative Documents. (k) Finco shall not contract, create, incur, assume or suffer to exist any indebtedness for borrowed money or any obligation in respect of a lease of property which is required to be capitalized in accordance with GAAP or any other liability (contingent or otherwise), except as permitted under the Operative Documents. (l) Finco shall: (i) (A) subject to Article V of the Sale and Servicing Agreement, Section 3.1 of the Servicing Agreement and Article VI hereof, maintain its own deposit account or accounts with commercial banking institutions, separate from those of any Affiliate; (B) not divert the funds of Finco to any other Person or for other than corporate uses of Finco nor, subject to Article V of the Sale and Servicing Agreement, Section 3.1 of the Servicing Agreement and Article VI hereof, commingle the funds of Finco with funds of any other person held in any account of any other Person; and (C) use its best efforts to ensure that no funds of any other Person are commingled with funds of Finco held in any account of Finco; (ii) to the extent that it shares the same officers or other employees as any of its stockholders or Affiliates, ensure that the salaries of and the expenses related to providing benefits to such officers and other employees are fairly allocated among such entities, and that each such entity bears its fair share of the salary and benefit costs associated with all such common officers and employees; (iii) to the extent that it jointly contracts with any of its stockholders or Affiliates to do business with vendors or service providers or to share overhead expenses, ensure that the costs incurred in so doing are allocated fairly among such entities, and that each such entity bears its fair share of such costs; to the extent that Finco contracts or does business with vendors or service providers where the goods and services provided are partially for the benefit of any other Person, ensure that the costs incurred in so doing are fairly allocated to or among such entities for whose benefit the goods and services are provided, and that each such entity bears its fair share of such costs; (iv) ensure that all material transactions between Finco and any of its Affiliates are on an arm's length basis; (v) conduct its business separate from that of each other UHS Entity and each other Subsidiary of UHS; and not hold itself out or permit itself to be held out as being liable for the debts of any Affiliate; and (vi) conduct its affairs strictly in accordance with its Certificate of Incorporation and By-laws and observe all necessary, appropriate and customary corporate formalities, including, but not limited to, holding regular and special stockholders' and directors' meetings appropriate to authorize all corporate action, keeping separate and accurate minutes of its meetings, passing all resolutions or consents necessary to authorize actions taken or to be taken, and maintaining accurate and separate books, records and accounts, including, but not limited to, payroll and intercompany transaction accounts. (m) Finco shall furnish to the Trustee and Sheffield, and the Trustee shall promptly deliver to each TRIPs Holder, (i) as soon as practicable and in any event within 90 days after the end of each fiscal year of Finco, (A) a report prepared by Arthur Andersen & Co. or such other firm of independent certified public accountants, substantially in the form of Exhibit B and (B) an unaudited balance sheet of Finco as of the end of such fiscal year and unaudited statements of income and retained earnings and of cash flow of Finco for such fiscal year; (ii) as soon as practicable and in any event within 45 days after the end of each of the first three fiscal quarters of Finco, an unaudited balance sheet of Finco as of the close of such fiscal quarter and unaudited statements of income and retained earnings and of cash flow of Finco for such fiscal quarter and the portion of the fiscal year through such date, setting forth in comparative form the figures for the corresponding periods of the preceding fiscal year; (iii) at the time of the delivery of the financial statements required by clauses (i) and (ii) of this Section 5.2(m), a certificate of an Authorized Officer of Finco to the effect that (i) such financial statements are complete and correct and were prepared in accordance with GAAP applied consistently throughout the periods reflected therein and with prior periods, except as approved by such Authorized Officer and disclosed therein and (ii) there exists no Early Amortization Event or Exclusion Event under any Sale and Servicing Agreement and no condition, event or act which, with the giving of notice or lapse of time, or both, would constitute an Early Amortization Event or an Exclusion Event, or if any such Early Amortization Event, Exclusion Event, condition, event or act exists, specifying the nature thereof, the period of existence thereof and the action Finco proposes to take with respect thereto; and (iv) with reasonable promptness, such further information regarding the business, affairs and financial condition of Finco as the Trustee or any Participant may reasonably request. Section 5.2. Covenants of Finco Relating to the Receivables. Finco covenants and agrees with the Trustee and the Participants that so long as this Agreement shall remain in effect: (a) Finco will cause each Hospital, at such Hospital's own cost and expense, to (i) retain a record of the Receivables generated by such Hospital and copies of all documents relating to each Receivable generated by such Hospital, (ii) mark such record to the effect that the Purchased Receivables generated by such Hospital listed thereon have been sold to Finco, (iii) maintain a record of Receivables that have been repurchased by such Hospital in accordance with the terms of the applicable Sale and Servicing Agreement and (iv) maintain a record of Receivables that have been repurchased by Finco pursuant to Section 5.4 hereof. (b) Finco will take no action and will not permit any Hospital to take any action to cause any Purchased Receivable to be evidenced by any instrument (as defined in the UCC in the state in which the chief executive office of Finco or such Hospital, as the case may be, is located), except in connection with its enforcement or collection of such Receivable, in which event Finco shall deliver such instrument to the Trustee as soon as reasonably practicable but in no event more than 10 days after execution thereof. (c) Finco will comply and cause each Hospital to comply with all Requirements of Law which are applicable to the Purchased Receivables and the other Total Transferred Property or any part thereof; provided, however, that Finco may contest and permit any Hospital to contest any act, regulation, order, decree or direction in any manner which could not reasonably, alone or in the aggregate, materially and adversely affect the Participations or the Interested Parties. Subject to Section 5.2(i) hereof and Section 4.3(k) of each Sale and Servicing Agreement, Finco will, and will cause each Hospital to, comply with the terms of its respective contracts with Obligors relating to such Receivables except where non-compliance would not in the aggregate reasonably be expected to have a material adverse effect on any Hospital's ability to receive payments under such contracts. (d) Finco will not create, permit or suffer to exist, and will defend the Interested Parties' rights to the Total Transferred Property against, and take such other actions as are necessary to remove, any Lien on, claim in respect of, or right to, such Total Transferred Property, and will defend the right, title and interest of the Interested Parties in and to such Total Transferred Property against the claims and demands of all Persons whomsoever, other than the Permitted Interests. (e) Unless prohibited by any Requirement of Law, the Participants and the Trustee and their respective employees, agents and representatives (collectively, the "Recipients") (A) shall at all times have full and free access during normal business hours to all the books, correspondence and records of Finco, the Servicer, UHS and the Hospitals insofar as they relate to the Total Transferred Property, and the Recipients may examine the same, take extracts therefrom and make photocopies thereof, and Finco agrees to render to the Recipients and cause the Servicer, UHS and the Hospitals to render to such Recipients, at Finco's cost and expense, such clerical and other assistance as may be reasonably requested with regard thereto and (B) may discuss the affairs, finances and accounts of Finco, the Servicer, UHS and the Hospitals with, and be advised as to the same by, executive officers and independent accountants of Finco, the Servicer, UHS and the Hospitals (and Finco shall cause the executive officers and independent accountants of Finco, the Servicer, UHS and the Hospitals to so discuss and advise), all as any such Recipient may reasonably deem appropriate for the purpose of verifying the accuracy of any reports or information delivered to the Trustee or the Participants pursuant to this Agreement or for otherwise ascertaining compliance with this Agreement; provided, however, that each of the Recipients acknowledges that in exercising the rights and privileges conferred in this Section 5.2(e) the Recipients may, from time to time, obtain knowledge of information, practices, books, correspondence and records of a confidential nature and in which Finco, the Servicer, UHS or any Hospital has a proprietary interest; and provided, further, that Finco and each Recipient acknowledges that the Operative Documents and documents required to be filed on behalf of UHS and its Subsidiaries with the Securities and Exchange Commission and available to the public shall not be considered confidential for the purposes of this Agreement (all such confidential information, collectively, the "Information"). Each of the Recipients agrees that the Information is to be regarded as confidential information and that the Information may be subject to laws, rules and regulations regarding patient confidentiality and agrees that, subject to the following sentence, (i) it shall, and shall cause its employees, agents and representatives to, retain in confidence and not disclose without the prior written consent of Finco, the Servicer, UHS or such Hospital, as the case may be, any or all of the Information, and (ii) it will not, and will ensure that its employees, agents and representatives will not, make any use whatsoever (other than for the purposes contemplated by this Agreement and the other Operative Documents or for the enforcement of any of the rights granted hereunder or thereunder) of any of the Information without the prior written consent of Finco, the Servicer, UHS or such Hospital, as the case may be. Notwithstanding the foregoing, a Recipient may (x) disclose Information to any Person that has executed and delivered to the addressee and UHS a confidentiality agreement, substantially in the form of Exhibit C hereto, with respect to such Information and (y) disclose Information (A) to the extent that such Information is required or appropriate in any report, statement or testimony submitted to any municipal, state, or federal regulatory body having or claiming to have jurisdiction over the Recipient or to the National Association of Insurance Commissioners or similar organizations or their successors, (B) to the extent such Information is required in response to any summons or subpoena or in connection with any litigation, (C) to the extent that such Information is believed by the Recipient to be required in order to comply with any law, order, regulation or ruling applicable to the Recipient, (D) to the extent that such Information was publicly available or otherwise known to the Recipient at the time of disclosure, (E) to the extent that such information subsequently becomes publicly available, other than through any act or omission of the Recipient or (F) to the extent that such Information subsequently becomes known to the Recipient other than through a Person whom the Recipient knows to be acting in violation of his or its obligations to Finco, the Servicer, UHS or such Hospital. (f) Finco shall execute and file, and shall cause each Hospital to file, at Finco's expense, such continuation statements and other documents relating to the Security Filings which may be required by law to fully preserve and protect the interest of the Interested Parties in and to the Total Transferred Property. Finco shall, at its own expense, perform or cause to be performed all acts and execute all documents necessary to evidence, perfect, maintain and enforce the security interests and Liens of the Interested Parties in the Purchased Receivables and the other Total Transferred Property and the first priority thereof. Finco will, on the reasonable request of the Required Participants or an Authorized Officer of the Trustee, execute and deliver all such Security Filings (satisfactory in form and substance to the Trustee and the Required Participants) and, where permitted by law, Finco authorizes the Trustee to file one or more such Security Filings signed only by the Trustee. Finco hereby irrevocably appoints the Trustee as its attorney-in-fact to file and deliver Security Filings (and receive Confirmations in respect of one or more such Security Filings) signed on behalf of Finco by the Trustee as the attorney-in-fact of Finco. (g) Finco will not, without providing 30 days' notice to the Trustee and Sheffield, and without filing such amendments to the Security Filings as may be required to preserve the priority of the ownership or security interest perfected thereby change or permit any Hospital to change (i) the location of its chief executive office or the location of the offices where the records relating to the Receivables and the other Total Transferred Property are kept or (ii) its name, identity or corporate structure in any manner which would, could or might make any Security Filing or continuation statement filed by Finco or such Hospital in accordance with Section 4.2(f) or Section 5.2(f) of this Agreement or the provisions of the applicable Sale and Servicing Agreement seriously misleading within the meaning of Section 9-402(7) of any enactment of the UCC applicable thereto. (h) Finco shall (i) promptly cause the Servicer to (A) notify the Trustee and Sheffield of any insurance provider or other third-party payor which becomes an Obligor after the Initial Closing Date pursuant to a written contract or arrangement which purports to prohibit the assignment of any rights of the Hospital under such contract or arrangement without the consent of such Obligor and (B) deliver or cause to be delivered to such Obligor a Notice of Assignment and receive a Confirmation with respect thereto; and (ii) comply with and cause each Hospital to comply with all other reasonable requests of the Trustee, the Required Participants or Sheffield with respect to the Security Filings. (i) Finco shall not change, and shall not cause or otherwise allow any Hospital or the Servicer to change, the terms of the payor contracts and agreements relating to the Purchased Receivables and related Transferred Property or the normal policies and procedures with respect to the origination and servicing thereof (including without limitation the amount and timing of finance charges, fees and write-offs) except (i) that Finco or any Hospital may make such changes in connection with Purchased Receivables which increase the collectibility of such Purchased Receivables without extending the payment date thereof, so long as each such change (A) is in accordance with the Credit and Collection Policy and consistent with past practice and (B) shall not have a disproportionate effect on the Purchased Receivables as compared with Receivables (or future Receivables) not sold to Finco; and (ii) in respect of such Purchased Receivables which have become Uncollectible Receivables and only to the extent that Finco or any Hospital shall reasonably believe that such change of terms will improve the collectibility of such Uncollectible Receivables; provided that no such change permitted by clause (i) or (ii) shall, or shall reasonably be expected to, result in an Exclusion Event or an Early Amortization Event; and provided, further, that no such change shall cause the Borrowing Base to be less than the Aggregate Capital. (j) Finco hereby acknowledges and agrees that UHS Delaware will be initially appointed as the Servicer of the Receivables pursuant to the Servicing Agreement, that each Hospital will perform certain servicing functions with respect to the Receivables pursuant to the terms of the Servicing Agreement and the Sale and Servicing Agreements, that UHS Delaware may subcontract certain other servicing functions as permitted under the Servicing Agreement while still retaining liability for performance of such functions and that UHS will guarantee the performance by UHS Delaware and the Hospitals of their respective obligations. Finco shall cooperate with any requests made by the Servicer for information required by the Servicer in connection with the Servicer's determination of amounts due hereunder and under the Servicing Agreement and in connection with the delivery by the Servicer of statements and reports required thereunder. (k) Finco hereby covenants that it will cause each Hospital to designate personnel and to direct such designated personnel to deposit all Collections and proceeds thereof on each Business Day upon which such Collections are received (or, if such Collections are received by any Hospital on a day which is not a Business Day, on the next Business Day) into such Hospital's Hospital Concentration Account in accordance with Section 6.2. (l) Except for the purpose of collection in the ordinary course of business and in accordance with the restrictions set forth in Section 5.2(i), Finco will not, and will not allow any Hospital to, sell, discount or otherwise dispose of any Purchased Receivable except to the Interested Parties as provided hereunder and to Finco as provided under the Sale and Servicing Agreement to which such Hospital is a party. (m) Finco shall not terminate and shall not allow any other Person to terminate any Hospital Concentration Account or establish any other Hospital Concentration Account, unless (i) Finco has provided 10 days' prior written notice of such change to the Trustee and Sheffield and (ii) immediately after any such event, the representations and warranties in Section 4.1(h) shall be true and correct; and Finco shall not terminate and shall not allow any other Person to terminate, or change the instructions governing the operation of, the Master Receivables Account or establish any other Master Receivables Account, unless (i) the Required TRIPs Holders and Sheffield shall have consented to such change or termination and (ii) immediately after such event, the representations and warranties in Section 4.1(h) shall be true and correct. The Trustee shall promptly forward any notice received by it from Finco under this Section 5.2(m) to the TRIPs Holders. (n) Finco shall promptly cause the Servicer to notify the Trustee and Sheffield, and the Trustee shall thereupon promptly notify the TRIPs Holders, on any date on which any Hospital becomes, applies to become, or no longer remains, a qualified provider in respect of Governmental Receivables listed on Schedule II of the Sale and Servicing Agreement to which such Hospital is a party. (o) Finco shall not, without the prior written consent of the Required Participants, which consent shall not be unreasonably withheld, permit any Hospital to materially alter the hardware or software systems used by such Hospital in generating its reports to the Servicer in respect of the Purchased Receivables and the Collections and, in any event, shall not permit any such alteration unless such alteration is designed to improve the Servicer's ability to monitor and collect on the Receivables. Section 5.3. Notice and Consent Procedures. Finco represents and warrants as of the date hereof and as of the TRIPs Closing Date that (i) each Hospital has sent or caused to be sent a Notice of Assignment to each insurer or third-party intermediary that is an Obligor on such Hospital's Non- governmental Receivables and that has a written contract or other written arrangement with one or more of the Hospitals which prohibits assignment of any rights of such Hospital under such contract or arrangement without the consent of such insurer or third party intermediary and (ii) each Hospital has sent or caused to be sent a Notice of Assignment to each of the ten insurers or third-party intermediaries that are Obligors on any Receivables and that maintained the ten highest average Outstanding Balances of Receivables originated by all UHS Entities taken as a whole during the August, 1993 fiscal month. Finco agrees to use its best efforts to ensure that the Trustee and Sheffield promptly receive all Confirmations in respect of the Notices of Assignment described in clauses (i) and (ii). Section 5.4. Removal of Non-qualifying Receivables. (a) In the event that any representation or warranty set forth in Section 4.2 with respect to any Purchased Receivable is not true and correct on the Purchase Date with respect thereto, then Finco shall repurchase such Purchased Receivable by depositing in the Collateral Account or deducting from the amount otherwise payable to Finco pursuant to Article VII, the Outstanding Balance of such Purchased Receivable as of the date of conveyance to the Trust less any Collections received in respect thereof. The deposit or deduction required pursuant to subsection 5.4 hereof shall be made by Finco on any date on which the Trustee shall request. Notwithstanding the foregoing, if any such representation or warranty with respect to such Purchased Receivable was untrue solely because the Applicable Contractual Adjustment on the Purchase Date was less than the Actual Contractual Adjustment, such Purchased Receivable shall not be repurchased, but instead the difference between the Actual Contractual Adjustment and the Applicable Contractual Adjustment shall be deposited in the Collateral Account by Finco or deducted from the amount otherwise payable to Finco under Article VII. Notwithstanding the foregoing provisions of this Section 5.4, no such deduction or repurchase shall be required in respect of any Receivable conveyed to the Trust on the Initial Closing Date that was an Uncollectible Receivable on such date unless and until an Early Amortization Event occurs hereunder. In such event, the amount that would otherwise be payable by Finco or deducted from amounts payable to Finco in respect of such Receivable shall be reduced by the amount of any Collections (if any) on such Receivable received by Finco prior to the date of such Early Amortization Event. (b) In addition, upon notice by any Hospital that Non-qualifying Receivables of such Hospital have been sold to Finco, Finco shall immediately demand that all such Non-qualifying Receivables be repurchased or a portion of the purchase price thereof be reimbursed pursuant to Section 4.4 of the applicable Sale and Servicing Agreement. (c) On the date on which any amount required to be paid to the Collateral Account or deducted from the amount payable to Finco pursuant to Section 5.4(a) or 5.4(b) is so paid or deducted, the Trustee shall automatically and without further action be deemed to sell, transfer, assign, set over and otherwise convey to Finco (or in the case of Non-qualifying Receivables repurchased by a Hospital, to the applicable Hospital), without recourse, representation or warranty, all the right title and interest of the Trustee in and to such repurchased Receivable, all monies due or to become due with respect thereto, and all proceeds thereof. The Trustee shall execute such documents and instruments of transfer or assignment and take such other actions as shall be reasonably requested by Finco to effect the conveyance pursuant to this Section 5.4. Amounts paid to the Trustee pursuant to paragraph (a) above shall be treated as Collections on Non-governmental Receivables. Section 5.5. Hospital Concentration Accounts. Finco represents and warrants to the Trustee and the Participants as of the date hereof and as of the TRIPs Closing Date that each Hospital has previously established in its name a Hospital Concentration Account into which Collections on the Hospital's Purchased Receivables are transferred in accordance with the terms and conditions of Section 5.2 of the Sale and Servicing Agreement to which such Hospital is a party. Finco hereby represents and warrants to the Trustee and the Participants that set forth as Schedule II hereto is the name, location and account number of each such Hospital Concentration Account. Pursuant to Section 5.2(m), Finco will give to the Trustee and Sheffield, and upon receipt thereof the Trustee will give to the TRIPs Holders, prior written notification of the establishment of any Hospital Concentration Account or the termination of any Hospital Concentration Account. Subject to all Requirements of Law, Finco shall not, and shall not instruct or permit any Person to, deposit any Collections into any account other than such designated Hospital Concentration Account or the Master Receivables Account without the prior written consent of the Required TRIPs Holders and Sheffield. Finco hereby agrees that it will promptly notify the Trustee and Sheffield, which notice shall be promptly forwarded by the Trustee to each of the TRIPs Holders, if Finco has received notice or otherwise obtained information that any Hospital is not in full compliance with the provisions of this Section 5.5 or of the related provisions of the Sale and Servicing Agreements. Section 5.6. Performance of Agreements. Finco, for the benefit of the Trust and the Participants, hereby agrees, at its own expense, duly and punctually to perform and observe each of its obligations to the Servicer under the Servicing Agreement and to the Hospitals under the related Sale and Servicing Agreements. In addition, promptly following a request from Sheffield or the Trustee, on behalf of the Participants, to do so, and at Finco's own expense, Finco agrees to take all such lawful action as the Trustee or the Required Participants may request to compel or secure the performance and observance by any or all of the Assignors under or in connection with the respective Assigned Agreements in accordance with the terms thereof, and to exercise any and all rights, remedies, powers and privileges lawfully available to Finco under or in connection with the Assigned Agreements to the extent and in the manner directed by the Trustee or the Required Participants, including, without limitation, the transmission of notices of default on the part of any of the Assignors thereunder and the institution of legal or administrative actions or proceedings to compel or secure performance by such Assignor or Assignors of their obligations under the Assigned Agreements. Finco further agrees that it will not, without the prior written consent of the Trustee and the Required Participants, exercise any right, remedy, power or privilege available to it with respect to any of the Assignors under the respective Assigned Agreements or take any action to compel or secure performance or observance by any of such Assignors of their respective obligations thereunder, or give any consent, request, notice, direction, approval, extension or waiver to any of such Assignors under the Assigned Agreements not required to be exercised, taken, observed or given by Finco pursuant to the terms of the respective Assigned Agreements. Finco agrees promptly to provide, or cause to be provided, to Sheffield and the Trustee copies of all notices, requests, demands and other documents received from any Assignor under any of the Assigned Agreements and to cause all legal opinions and other documents delivered for the benefit of Finco under the Assigned Agreements to be delivered and addressed to each Interested Party. Section 5.7. Amendment of Assigned Agreements; Waivers. Finco agrees that it will not amend, modify, supplement, waive, terminate or surrender, or agree to any amendment, modification, supplement, waiver, termination or surrender of, any of the Total Transferred Property or any portion thereof or any Assigned Agreement or part thereof, or waive timely performance or observance by any of the Assignors of their respective obligations thereunder, or any default on the part of any Assignor under any Assigned Agreement without the prior written consent of the Required Participants; provided, however, that Finco may take whatever action any applicable Hospital reasonably deems necessary (if any) to release Non- qualifying Receivables repurchased pursuant to Section 4.4 of any Sale and Servicing Agreement by such Hospital, so long as such action does not affect the ownership or security interest granted in the Trust Assets other than the Non-qualifying Receivables so repurchased, without obtaining such consent. If any such amendment, modification, supplement or waiver shall be so consented to by the Required Participants, Finco agrees, promptly following a request by the Trustee or the Required Participants, to execute and deliver, in its own name and at its own expense, such agreements, instruments, consents and other documents (in form and substance reasonably satisfactory to the Required Participants) as the Trustee or the Required Participants may reasonably deem necessary or appropriate in the circumstances. ARTICLE VI ADMINISTRATION AND COLLECTIONS Section 6.1. Servicing. (a) In further consideration for the obligations of the Trustee and the Participants hereunder, Finco agrees that it shall service the Purchased Receivables by (i) causing UHS Delaware, pursuant to the Servicing Agreement, to undertake all obligations of the Servicer thereunder in connection with the servicing of the Purchased Receivables and the other Transferred Property, (ii) causing each Hospital, pursuant to the Sale and Servicing Agreement to which such Hospital is a party, to undertake such obligations in connection with the servicing of the Purchased Receivables and the other Transferred Property as the Servicer shall delegate to such Hospital and (iii) causing UHS to comply with the terms of the Guarantee, pursuant to which UHS will guarantee the performance by the Hospitals and UHS Delaware of all of their respective obligations under the Sale and Servicing Agreements and the Servicing Agreement. By their acceptance of the Participations, the Participants consent to UHS Delaware acting as Servicer in accordance with the Servicing Agreement and to the Servicing arrangements described therein and in the previous sentence. (b) In furtherance of Section 6.1(a), Finco agrees, subject to applicable confidentiality requirements under law, that it will provide promptly and shall cause the Servicer, UHS and each Hospital to provide promptly to the Trustee and the Participants and any other Person retained by any of them all information, including, without limitation, all information in relation to the Purchased Receivables and other Total Transferred Property, that any such Person requests, including, without limitation, information with respect to the periodic reports by Arthur Andersen & Co. or other certified public accountant delivered pursuant to Section 5.1(m) or reports by any other agent of Finco, the Servicer, UHS or the Hospitals on the Purchased Receivables and other Total Transferred Property conveyed to the Trust. The Trustee and the Participants agree that all such information is to be regarded as Information subject to the confidentiality provisions of Section 5.2(e). Section 6.2. Collections. (a) Finco shall apply, and shall cause each of the Servicer and each Hospital to apply, all Collections on all Purchased Receivables strictly in accordance with the terms of the Sale and Servicing Agreements, the Servicing Agreement and this Agreement in order to permit the Trustee, for the benefit of the Interested Parties, to make all allocations and payments required hereunder. (b) To the extent held or received by Finco or any Interested Party (other than the Hospital payee), all Collections on account of Non- governmental Receivables will be held in trust for the benefit of the Participants and deposited in the Master Receivables Account pending remittance to the Trustee. (c) Any Collections on Governmental Receivables received by any Interested Party or Finco shall be immediately paid to the Hospital payee for deposit in such Hospital's Hospital Concentration Account or the Master Receivables Account. (d) In no event shall Finco permit any Hospital to deposit any Collections into any account established, held or maintained by such Hospital or any other Person other than the related Hospital Concentration Account or the Master Receivables Account or transfer such Collections other than in accordance with the provisions of this Agreement, the related Sale and Servicing Agreement and the Servicing Agreement. Available amounts in the Hospital Concentration Accounts shall be transferred within one Business Day of receipt to the Master Receivables Account. Amounts so transferred from the Hospital Concentration Accounts and amounts otherwise received in the Master Receivables Account prior to the close of business on any Business Day shall be transferred to the Collateral Account on such Business Day. Amounts received in the Master Receivables Account after the close of business on any Business Day or on any day which is not a Business Day shall be transferred to the Collateral Account on the next succeeding Business Day. Amounts received in the Collateral Account shall be applied in accordance with Article VII. (e) Finco agrees that it shall use its best efforts to ensure that only Collections on Purchased Receivables are deposited into the Hospital Concentration Accounts and the Master Receivables Account. The Participants and the Trustee agree that, promptly following the establishment to the satisfaction of Finco and any Hospital that any funds received in such Hospital's Hospital Concentration Account or the Master Receivables Account do not constitute Collections on Purchased Receivables (including any funds constituting payments on Receivables which have been reassigned to such Hospital and payments to such Hospital not in respect of Receivables) to the extent such funds are available in the Hospital Concentration Accounts, the Master Receivables Account or the Collateral Account, the Servicer shall remit, or cause the Trustee to remit, such funds to such Hospital in immediately available funds. Section 6.3. Claims Against Third Parties. Finco agrees that it will make and pursue, and continue to cause each Hospital to make and pursue, for the benefit of the Interested Parties, claims on the Purchased Receivables sold to Finco and not repurchased pursuant to Section 4.4 of each Sale and Servicing Agreement to the extent that any Requirement of Law or contractual provision requires Finco or such Hospital to directly make and pursue such claims; provided that Finco agrees that it is making and pursuing such claims for the benefit of the Interested Parties and that any funds received by Finco based on such claims will be transferred in accordance with Section 6.2. Section 6.4. Deleted Receivables. Finco agrees that it shall permit the Servicer, in accordance with the terms of Section 3.6 of the Servicing Agreement, to exclude Deleted Receivables from the pool of Financible Receivables only on the Business Day on which Finco is obligated to make payment of the Purchase Price with respect thereto under the Sale and Servicing Agreement and only to the extent that, after giving effect to such exclusion, the quality and collectibility (including as a result of the credit quality of the Obligors on the Financible Receivables) of the pool of Financible Receivables would not be any worse than the quality and collectibility (including as a result of the credit quality of the Obligors on the Eligible Receivables) of the pool of Eligible Receivables. Finco agrees to cause the Servicer, for the benefit of the Interested Parties, to comply with all representations, warranties and covenants of the Servicer with respect to the Deleted Receivables, including, without limitation, the agreement that no Deleted Receivable shall be added to the calculation of the Financible Pool Balance or considered to be a Financible Receivable for any reason. ARTICLE VII COLLATERAL ACCOUNT AND OTHER ACCOUNTS; ALLOCATIONS AND DISTRIBUTIONS Section 7.1. Establishment of Collateral Account and Other Accounts. (a) The Trustee, for the benefit of the Participants, shall maintain a segregated trust account, in the name of the Trust, on behalf of the Trust and in the corporate trust department of an Eligible Institution satisfactory to the Trustee and Finco, bearing a designation clearly indicating that the funds deposited therein are held for the benefit of the Participants (the "Collateral Account" and identified as Account No. 0004359), the operation of which Collateral Account shall be governed by this Article VII. For administrative purposes only, the Trustee shall establish or cause to be established, simultaneously with the Collateral Account (i) the following three sub-accounts of the Collateral Account: (A) for the benefit of Sheffield, the "Sheffield Sub-account", (B) for the benefit of the TRIPs Holders, the "TRIPs Sub-account" and (C) for the benefit of the Participants and certain Persons specified in Section 7.3(a) to whom amounts are payable in connection with the administration of the Trust and the Participations, the "Expense Sub-account" and (ii) a sub-account of each of the Sheffield Sub- account and the TRIPs Sub-account (the "Sheffield Interest Sub-account" and the "TRIPs Interest Sub-account", respectively). The Trustee shall make all transfers, deposits and withdrawals to and from the Collateral Account, all sub-accounts thereof and the Other Accounts pursuant to this Article VII. (b) There shall be deposited in the Collateral Account the following monies, cash and proceeds: (i) all Available Cash Collections received by the Trustee pursuant to Section 3.1 of the Servicing Agreement, Section 5.2 of the Sale and Servicing Agreements and Section 6.2 hereof, (ii) all amounts earned pursuant to Section 7.7, (iii) all proceeds, if any, of Commercial Paper and Loans in excess of the amount required to repay maturing Commercial Paper and Loans and (iv) any and all other monies at any time and from time to time received by or on behalf of the Participants or Finco, and required by the terms of this Agreement, each of the Sale and Servicing Agreements, the Servicing Agreement or any other Operative Document to be deposited in the Collateral Account. (c) The Trustee shall at all times during the term of this Agreement maintain a segregated trust account in the name of the Trust in the corporate trust department of an Eligible Institution satisfactory to the Trustee, Finco and Sheffield, for the exclusive benefit of Sheffield and the Liquidity Agent, for the benefit of the Lenders (the "Sheffield Payment Account" and identified as Account No. 0004365), into which account shall be deposited all amounts required pursuant to this Article VII. (d) The Trustee shall at all times during the term of this Agreement maintain a segregated trust account in the name of the Trust in the corporate trust department of an Eligible Institution satisfactory to the Trustee, Finco and the Required TRIPs Holders, for the benefit of the TRIPs Holders (the "TRIPs Payment Account" and identified as Account No. 0004366; the TRIPs Payment Account and the Sheffield Payment Account, collectively, the "Other Accounts") into which account shall be deposited all amounts required pursuant to this Article VII. (e) Schedule II hereto sets forth the Eligible Institution at which the Collateral Account and each Other Account is held, along with the name and account number of each such account. Subject to all Requirements of Law, the Trustee shall have exclusive dominion and control over the Collateral Account, the Other Accounts and any Additional Accounts, for the exclusive benefit of the Participants and those Persons specified in Section 7.3(a) as their respective interests may appear. Except as expressly provided herein, no Person other than the Trustee shall have any right of withdrawal therefrom. The Servicer shall have no right of set-off or banker's lien against, and no right to otherwise deduct from, any funds held or to be deposited in the Collateral Account, any Other Account or any Additional Account for any amount owed to it by the Trust or any Interested Party. If, at any time the institution holding the Collateral Account, any Other Account or any Additional Account ceases to be an Eligible Institution and the Trustee is notified of such fact, the Trustee shall establish a new account with an Eligible Institution meeting the applicable conditions specified above, transfer any cash and/or any investments to such new account and from the date such new account is established, it shall be the "Collateral Account" or the applicable "Other Account" or "Additional Account", as the case may be. Section 7.2. Daily Allocations. (a) On each Business Day, the Trustee shall allocate Available Cash Collections, all other amounts received on deposit in the Collateral Account and all amounts remaining on deposit in the Collateral Account from the previous Business Day that have not been allocated to any sub-account thereof as follows: (i) an amount equal to the Sheffield Percentage of such amount shall be allocated to the Sheffield Sub-account; and (ii) an amount equal to the TRIPs Percentage of such amount shall be allocated to the TRIPs Sub-account. (b) On each Business Day, amounts allocated to the Sheffield Sub- account (or retained therein on a prior Business Day) shall be applied by the Trustee in the following priority: (i) an amount equal to the imputed or stated Sheffield Yield, as the case may be, accrued since the previous Business Day shall be allocated (to the extent not previously so allocated) to the Sheffield Interest Sub-account; provided that on any date on which a Stub Loan is incurred, five hundred dollars ($500) shall be allocated to the Sheffield Interest Sub-account and no further daily allocation shall be made in respect of the Sheffield Yield to accrue on such Stub Loan; (ii) the following amounts shall be allocated to the Expense Sub- account: (A) an amount equal to the Sheffield Percentage of the Daily Program Expense Amount for such Business Day; provided, however, that for so long as the Servicer is an Affiliate of Finco and no Early Amortization Event shall have occurred, the Sheffield Percentage of the accrued and unpaid Servicing Fee shall not be transferred to the Expense Subaccount but rather shall be paid to the Servicer on such Business Day; and provided, further, that the amount so paid on any Business Day shall be reduced by an amount equal to the excess of (A) the Required Coverage Amount over (B) the Financible Pool Balance on such Business Day (and such excess shall be transferred to the Expense Sub-account); plus (B) any amounts not allocated from the Sheffield Sub-account to the Expense Sub-account as required on any previous Business Day; plus (C) if such Business Day is a Transfer Date, an amount equal to the excess of (1) (x) the Sheffield Percentage of the amount to be withdrawn from the Expense Sub-account on such Business Day in respect of the Monthly Program Expense Amount plus (y) the amount to be withdrawn from the Expense Sub-account in respect of the Monthly Sheffield Expense Amount accrued and unpaid on such date, in each case pursuant to Section 7.3(a) over (2) the total amount on deposit in the Expense Sub-account, after giving effect to all allocations to be made to the Expense Sub-account on such Business Day; (iii) the Daily Sheffield Expense Amount, and any amount in respect of the Daily Sheffield Expense Amount not allocated as required on any prior Business Day, shall be allocated to the Expense Sub-account; (iv) In the event that the Trustee has been directed in writing by either Finco or Sheffield to reserve funds in order to decrease the Sheffield Capital, the following funds shall be retained in the Sheffield Sub-account: (A) upon written notice by Sheffield of (1) the occurrence of the Liquidation Date, (2) an election by Sheffield pursuant to Section 2.7 (and the passage of the appropriate notice period) or (3) the failure by Finco to satisfy a condition precedent set forth in Section 3.2, any funds remaining in the Sheffield Sub-account after application pursuant to Section 7.2(b)(iii); and (B) in the case of an election by Finco pursuant to Section 2.6, an amount specified by the Servicer in the Servicer Daily Statement for such Business Day; and (v) after giving effect to any Principal Pay-Down pursuant to Section 7.4, any remaining funds shall be applied as follows: (A) during the Sheffield Revolving Period, such funds shall be allocated to the Collateral Account and applied pursuant to Section 7.2(d); and (B) during the Sheffield Amortization Period, such funds shall be applied pursuant to Section 7.5. (c) On each Business Day, amounts allocated to the TRIPs Sub- account shall be applied by the Trustee in the following priority: (i) an amount equal to the TRIPs Yield accrued since the previous Business Day shall be allocated (to the extent not previously so allocated) to the TRIPs Interest Sub-account; provided that in the event that a TRIPs Interest Default has occurred on any prior Transfer Date, then the amount to be so allocated shall be an amount equal to the excess of (A) the aggregate TRIPs Yield scheduled to be paid on the subsequent Transfer Date over (B) the amount on deposit in the TRIPs Interest Sub- account on such Business Day; (ii) the following amounts shall be allocated to the Expense Sub- account: (A) an amount equal to the TRIPs Percentage of the Daily Program Expense Amount; provided, however, that for so long as the Servicer is an Affiliate of Finco and no Early Amortization Event shall have occurred, the TRIPs Percentage of the accrued and unpaid Servicing Fee shall not be transferred to the Expense Subaccount but rather shall be paid to the Servicer on such Business Days; and provided, further, that the amount so paid on any Business Day shall be reduced by an amount equal to the excess of (A) the Required Coverage Amount over (B) the Financible Pool Balance on such Business Day (and such excess shall be transferred to the Expense Sub-account); plus (B) any amounts not allocated from the TRIPs Sub-account to the Expense Sub-account as required on any previous Business Day; plus (C) if such Business Day is a Transfer Date, an amount equal to the excess of (1) (x) the TRIPs Percentage of the amount to be withdrawn from the Expense Sub-account on such Business Day in respect of the Monthly Program Expense Amount plus (y) the amount to be withdrawn on such Business Day in respect of the Monthly TRIPs Expense Amount accrued and unpaid on such date, in each case pursuant to section 7.3(a) over (2) the total amount on deposit in the Expense Sub-account, after giving effect to all allocations to be made to the Expense Sub-account on such Business Day; (iii) the Daily TRIPs Expense Amount for such Business Day, and any amount in respect of the Daily TRIPs Expense Amount not allocated as required on any prior Business Day, shall be allocated to the Expense Sub-account; (iv) during the period commencing on the date on which the Call Option is exercised and ending on the Call Date, an amount equal to the excess, if any, of (A) the Make-Whole Estimated Amount over (B) the amount on deposit in the TRIPs Interest Sub-account minus the portion of such amount deposited therein pursuant to Section 7.2(c)(i) shall be deposited in the TRIPs Interest Sub-account; (v) in the event that the Trustee has been directed in writing by the Required TRIPs Holders to retain funds in the TRIPs Sub-account as a result of a failure by Finco to satisfy a condition precedent set forth in Section 3.2, any remaining funds shall be retained in the TRIPs Sub- account; and (vi) any remaining funds shall be applied as follows: (A) during the TRIPs Revolving Period such funds shall be allocated to the Collateral Account and applied pursuant to Section 7.2(d); and (B) during the TRIPs Amortization Period such funds shall be applied pursuant to Section 7.5. (d) On each Business Day, after giving effect to any Principal Pay- Down pursuant to Section 7.4, funds allocated to the Collateral Account (other than any sub-account thereof) pursuant to Sections 7.2(b)(v)(A) and (c)(vi)(A) shall be applied by the Trustee in the following priority: (i) an amount equal to the excess, if any, of (A) the Required Coverage Amount over (B) the Financible Pool Balance shall be retained in the Collateral Account until the following Business Day; and (ii) any remaining funds shall be paid to Finco to maintain the Aggregate Capital as provided in Section 2.7 and in respect of the Subordinated Interest. (e) Amounts paid to Finco pursuant to Section 7.2(d) shall be applied by the Trustee, on behalf of Finco, as follows: (i) first, the aggregate Purchase Price payable on such Business Day pursuant to the Sale and Servicing Agreements (after giving effect to all adjustments thereto) shall, pursuant to Section 2.3 of the Sale and Servicing Agreements, be paid to the Hospitals pro rata in accordance with the respective Purchase Prices payable to such Hospitals; provided that no amount otherwise payable pursuant to this provision shall be paid to any Excluded Hospital; (ii) second, the aggregate principal amount plus all outstanding interest payable on all Subordinated Notes shall be paid to the Hospitals pro rata in accordance with the amounts payable to such Hospitals; provided that no amount otherwise payable pursuant to this provision shall be paid to any Excluded Hospital; and (iii) third, all remaining amounts may be retained by Finco for its own account and applied by Finco in any manner not otherwise prohibited by the Operative Documents. Section 7.3. Monthly Applications. The Trustee shall make the following applications and distributions from the Collateral Account, the applicable sub-accounts thereof and the applicable Other Accounts on each Transfer Date: (a) an amount equal to the sum of (x) the Monthly Program Expense Amount, (y) the Monthly Sheffield Expense Amount and (z) the Monthly TRIPs Expense Amount with respect to the related Settlement Period, and any unpaid amounts in respect of such amounts payable on any prior Transfer Date shall be paid from the Expense Sub-account in the following manner and priority: (i) first, all amounts payable and not paid on any prior Transfer Date shall be paid in the order of priority stated in clauses (ii) through (iv) below; (ii) second, to the extent not otherwise paid by the Servicer prior to such date out of the Servicing Fee pursuant to Section 3.1 of the Servicing Agreement, and subject to the aggregate dollar limitation set forth in such Section of the Servicing Agreement, all reasonable out-of-pocket costs and expenses of the Trustee, including all expenses incurred by the Trustee in compensating the Transfer Agent and Registrar and any authenticating agent or co- trustee, and all Indemnified Amounts owing to the Trustee shall be paid to the Trustee; (iii) third, to the extent not otherwise paid by the Servicer prior to such date pursuant to the Servicing Agreement, and subject to the aggregate dollar limitation set forth in such Section of the Servicing Agreement, the Trustee Fee accrued during the related Settlement Period shall be paid to the Trustee; and (iv) fourth, all other fees in respect of the Monthly Program Expense Amount, the Monthly Sheffield Expense Amount and the Monthly TRIPs Expense Amount and all other fees, costs and expenses shall be paid to the appropriate payees; provided that except in the case of regularly scheduled fees payable to any Interested Party such payees shall have submitted a statement of such expenses to the Trustee at least 10 days prior to such Transfer Date; provided, further, that if sufficient funds are not available to pay all such fees, costs and expenses in full, such fees, costs and expenses shall be paid pro rata according to the respective amounts owed to each such payee; and provided, further, that if the Servicer is an Affiliate of UHS, after giving effect to the payment to the Trustee of any portion of the Servicing Fee payable to it pursuant to Section 3.1 of the Servicing Agreement and subsections 7.3(a)(i), (ii) and (iii) hereof, the Servicing Fee (to the extent not otherwise paid pursuant to Section 7.2(b)(ii)(A) and 7.2(c)(ii)(A)) shall be paid to the Servicer only after all other amounts payable pursuant to this clause (iv) have been paid in full; any amounts remaining in the Expense Sub-account after payment of the above amounts shall be deposited in the Collateral Account and allocated pursuant to Section 7.2(a) on the following Business Day; and (b) an amount equal to the sum of (i) the TRIPs Yield with respect to the related Settlement Period and (ii) any TRIPs Yield previously due but not distributed on any prior Transfer Date shall be transferred from the TRIPs Interest Sub-account to the TRIPs Payment Account and distributed to the TRIPs Holders pursuant to Section 8.1(b). Section 7.4. Payments to Sheffield. (a) On the last day of the Fixed Period with respect to any Sheffield Tranche, in payment of any amounts owing in respect of any Commercial Paper Notes or Loans issued to fund such Sheffield Tranche, the Trustee shall make the following applications: (i) an amount equal to the Sheffield Yield on such Sheffield Tranche shall be transferred from the Sheffield Interest Sub-account to the Sheffield Payment Account; and (ii) an amount equal to the Principal Pay-Down, if any, with respect to such Sheffield Tranche shall be transferred to the Sheffield Payment Account from the Sheffield Sub-account or the Collateral Account (excluding any sub-account thereof). (b) The Principal Pay-Down, if any, plus all accrued and unpaid Sheffield Yield with respect to such Sheffield Tranche shall be distributed by the Trustee to Sheffield on such date. Section 7.5. Amortization. (a) During the Sheffield Amortization Period, the Trustee shall make the following applications: (i) on each Business Day on which the Adjusted Sheffield Capital is greater than zero, an amount equal to the lesser of (A) the amount remaining in the Sheffield Sub-account after application pursuant to Section 7.2(b) and (B) the Adjusted Sheffield Capital shall be deposited in the Sheffield Payment Account to pay maturing Commercial Paper Notes and Loans; and (ii) on each Business Day after the Adjusted Sheffield Capital has been reduced to zero, first, an amount equal to the excess of all Sheffield Yield scheduled to accrue in respect of all Commercial Paper Notes and Loans Outstanding over the amount on deposit in the Sheffield Interest Sub-account shall be deposited in the Sheffield Interest Sub- account and, thereafter, so long as no Early Amortization Event shall have occurred and be continuing, all amounts remaining in the Sheffield Sub-account after application pursuant to Section 7.2(b) shall be paid to Finco. During the Sheffield Amortization Period, no payments shall be made to Finco from the Sheffield Sub-account or any sub-account thereof until the Adjusted Sheffield Capital has been reduced to zero, all unpaid Sheffield Yield scheduled to accrue thereon has been deposited in the Sheffield Interest Sub- account and all unpaid fees, costs and expenses accrued or scheduled to accrue which are allocable to the Sheffield Participation have been deposited in the Expense Sub-account. (b) During the TRIPs Amortization Period, the Trustee shall make the following applications: (i) on each Business Day on which the Adjusted TRIPs Capital is greater than zero, an amount equal to the lesser of (A) the amount remaining in the TRIPs Sub-account after application pursuant to Section 7.2(c) and (B) the Adjusted TRIPs Capital shall be deposited in the TRIPs Payment Account; (ii) on each Business Day after the Adjusted TRIPs Capital has been reduced to zero, first, an amount equal to the excess of the TRIPs Yield payable on the subsequent Transfer Date over the amount on deposit in the TRIPs Interest Sub-account shall be deposited in the TRIPs Interest Sub- account and, thereafter, so long as no Early Amortization Event shall have occurred and be continuing, all amounts remaining in the TRIPs Sub- account after application pursuant to Section 7.2(c) shall be paid to Finco; (iii) on each Transfer Date after the Call Date, the Make-Whole Payment Amount for such Transfer Date shall be transferred from the TRIPs Interest Sub-account to the TRIPs Payment Account; and (iv) on each Transfer Date, the amount on deposit in the TRIPs Payment Account shall be distributed to the TRIPs Holders pursuant to Section 8.1(b) in payment of accrued TRIPs Yield, the Make-Whole Payment Amount, if any, with respect to such Transfer Date and the TRIPs Capital. During the TRIPs Amortization Period, no payments shall be made to Finco from the TRIPs Sub-account or any sub-account thereof until the Adjusted TRIPs Capital has been reduced to zero, all unpaid TRIPs Yield and each unpaid Make- Whole Payment Amount accrued or scheduled to accrue thereon has been deposited in the TRIPs Interest Sub-account and all unpaid fees, costs and expenses accrued or scheduled to accrue which are allocable to the TRIPs Participations have been deposited in the Expense Sub-account. (c) Upon the occurrence and during the continuation of an Early Amortization Event, no amounts shall be payable to Finco or any Affiliate thereof pursuant to the Operative Documents until the date on which (i) the Adjusted Aggregate Capital has been reduced to zero, (ii) all amounts have been allocated to the Sheffield Interest Sub-account and the TRIPs Interest Sub-account pursuant to Sections 7.5(a) and (b) and (iii) all fees, costs and expenses scheduled to accrue shall have been deposited in the Expense Sub- account. Prior to such date, any amounts otherwise payable to Finco or any Affiliate thereof from the Sheffield Sub-account pursuant to Section 7.5(a) shall be deposited in the TRIPs Sub-account for application pursuant to this Article VII, and any amounts otherwise payable to Finco or any Affiliate thereof from the TRIPs Sub-account pursuant to Section 7.5(b) shall be deposited in the Sheffield Sub-account for application pursuant to this Article VII. On any date after the occurrence and continuation of an Early Amortization Event, the priority of allocations to be made pursuant to this Article VII shall be adjusted so that no amount shall be allocated pursuant to this Article unless the full amount of the Servicing Fee with respect to such Settlement Period shall have first been deposited in the Expense Sub-account (or, if the Servicer is an Affiliate of Finco, the portion of the Servicing Fee distributable to the Trustee pursuant to subsections 7.3(a)(i), (ii) and (iii)). (d) On the date on which the Aggregate Capital has been reduced to zero, all Yield and each Make-Whole Payment Amount, if any, has been paid and all fees, expenses and other amounts payable under the Operative Documents have been paid, all amounts remaining in the Master Receivables Account, the Collateral Account, any sub-account thereof, the Other Accounts and any Additional Account shall be paid to Finco. Section 7.6. Allocation and Payment Procedures. (a) All calculations made by the Servicer and any other Person designated by the Participants and delivered to the Trustee in order to effectuate the operation of this Article VII shall be effective upon receipt of written instructions from such Person. The Trustee shall promptly comply with any calculations delivered to it pursuant to this Section 7.6. (b) The Trustee shall from time to time, and at least monthly, provide the Participants, Finco, the Servicer and UHS with statements of account relative to the Collateral Account and the Other Accounts in accordance with the Trustee's customary practices. (c) For purposes of determining the payments to be made to any Person pursuant to Sections 7.2 through 7.5 and in transferring such amounts, the Trustee may rely on certificates or statements furnished to or by it in accordance with the provisions of this Section 7.6. Any application to be made of Deposited Funds by the Trustee pursuant to Section 7.3(a) may be made pursuant to a statement by the payee delivered to the Trustee, Sheffield, Finco, the Servicer and UHS setting forth in reasonable detail the nature of the payee's claim and the amount owing on account thereof. For purposes of determining the application to be made of Deposited Funds payable pursuant to this Article VII (other than pursuant to the immediately preceding sentence), the Trustee may rely exclusively, absent manifest error, upon the Servicer Daily Statement and the Settlement Date Statement. (d) Finco shall cause a copy of each Servicer Daily Statement and each Settlement Date Statement to be provided by Servicer to the Trustee. The Trustee shall not be liable for any application of the Deposited Funds in accordance with any certificate or direction delivered pursuant to this Section 7.6; provided, however, that no application of the Deposited Funds in accordance with any certificate delivered pursuant to this Section 7.6 shall be deemed to restrict or limit the right of the Trustee or Sheffield to contest with purported obligees their respective claims in respect of the amount set forth in such certificate. Section 7.7. Permitted Investments. (a) Monies held in the Collateral Account and the Other Accounts shall be invested by the Trustee exclusively in Permitted Investments (which investments, prior to the occurrence of an Early Amortization Event, shall be specified pursuant to the written direction of the Servicer). Each such direction shall certify that the requested investment constitutes a Permitted Investment. The Trustee shall not be responsible or liable for any loss resulting from the investment performance of any investment or reinvestment of monies held in the Collateral Account or any other account maintained by the Trustee for the purposes of this Agreement in Permitted Investments (other than any Permitted Investment in respect of which the Trustee is the obligor), or from the sale or liquidation of any Permitted Investments in accordance with this Agreement. All Permitted Investments shall be made exclusively in the name of the Trust, shall be payable to the Trustee and shall be held exclusively in the Collateral Account and the Other Accounts. All proceeds from Permitted Investments shall be retained in the Collateral Account or the Other Account in which they are earned. Proceeds from Permitted Investments held in the Collateral Account shall be allocated pursuant to Section 7.2(a). (b) The Trustee may liquidate any Permitted Investment when required to make an application pursuant to this Article VII. Finco agrees to cause the Servicer to use its best efforts to schedule the maturities of such Permitted Investments so as to avoid the necessity of liquidating the same. Section 7.8. Additional Accounts. At any time that the Trustee receives written notice that a bankruptcy, insolvency, reorganization or similar proceeding has been commenced with respect to any Hospital, the Trustee agrees to immediately take all actions necessary, upon receipt of indemnification satisfactory to it and written directions from Required Participants as to the nature of such actions, to obtain a court order directing Obligors to make all payments on the Receivables from such Hospital directly to an Additional Account or to the Trustee for deposit in the Collateral Account. In any such event, the Trustee is hereby authorized to establish an Additional Account for the receipt of such payments, and all such payments shall be promptly transferred from such Additional Account to the Collateral Account by the Trustee after such payments become immediately available funds. The Trustee shall notify each of the Participants, Finco, UHS and the Servicer of the establishment of any Additional Account. The Trustee shall receive such assurances of indemnification for any actions taken by it in good faith pursuant to this Section 7.8 as it shall reasonably request. ARTICLE VIII DISTRIBUTIONS AND REPORTS TO PARTICIPANTS Section 8.1. Distributions. (a) The Trustee shall distribute to Sheffield such amounts from the Sheffield Payment Account on such dates as are specified in Section 7.4. (b) On each Transfer Date, the Trustee shall pay to each TRIPs Holder of record on the Record Date for such Transfer Date, by wire transfer of immediately available funds to an account designated by such TRIPs Holder, such TRIPs Holder's pro rata share (based on the aggregate portion of the TRIPs Capital represented by TRIPs held by such TRIPs Holder) of the amounts on deposit in the TRIPs Payment Account. Section 8.2. Statements to Participants. (a) On each Business Day, Finco shall cause the Servicer, on behalf of the Trustee, to deliver the Servicer Daily Statement to Sheffield. (b) On each Settlement Date, Finco shall cause the Servicer, on behalf of the Trustee, to deliver the Settlement Date Statement to each Participant and the Rating Agency and the Liquidity Agent. (c) On or before January 31 of each calendar year, commencing in 1994, the Trustee shall furnish or cause to be furnished to each Person who was a Participant at any time during the preceding calendar year, a statement on the appropriate Internal Revenue Service form prepared by the Servicer containing the information required to be provided by an issuer of indebtedness under the Code and such other customary information as is necessary to enable the Participants to prepare their tax returns. ARTICLE IX TRIPs; RIGHTS OF PARTICIPANTS Section 9.1. The TRIPs. The TRIPs shall be issued in fully registered form and shall be substantially in the form of Exhibit A. The TRIPs shall, upon issue, be executed and delivered by Finco to the Trustee for authentication and redelivery as provided in Sections 2.5 and 9.2. The TRIPs shall be issued in minimum denominations of $1,000,000 and in integral multiples of $100,000 in excess thereof. Each TRIP shall be executed by manual or facsimile signature on behalf of Finco by an Authorized Officer of Finco. TRIPs bearing the manual or facsimile signature of an individual who was, at the time when such signature was affixed, authorized to sign on behalf of Finco or the Trustee shall not be rendered invalid, notwithstanding that such individual has ceased to be so authorized prior to or on the date of the authentication and delivery of such TRIPs or does not hold such office at the date of such TRIPs. No TRIP shall be entitled to any benefit under this Agreement, or be valid for any purpose, unless there appears on such TRIP a certificate of authentication substantially in the form provided for herein executed by or on behalf of the Trustee by the manual or facsimile signature of an Authorized Officer, and such certificate upon any TRIP shall be conclusive evidence, and the only evidence, that such TRIP has been duly authenticated and delivered hereunder. All TRIPs shall be dated the date of their authentication. Section 9.2. Authentication of TRIPs. On the TRIPs Closing Date, the Trustee shall authenticate and deliver the TRIPs to the TRIPs Holders, executed in favor of the TRIPs Holders upon the order of Finco, against payment to Finco in accordance with Section 2.5(a). The TRIPs shall be duly authenticated by or on behalf of the Trustee in authorized denominations equal to (in the aggregate) the Initial TRIPs Capital. Section 9.3. Registration of Transfer and Exchange of TRIPs. (a) The Trustee shall cause to be kept at the office or agency to be maintained by a transfer agent and registrar (which may be the Trustee) (the "Transfer Agent and Registrar") in accordance with the provisions of Section 11.16 a register (the "TRIPs Register") in which, subject to such reasonable regulations as the Trustee may prescribe, the Transfer Agent and Registrar shall provide for the registration of the TRIPs and of transfers and exchanges of the TRIPs as herein provided. The Trust hereby appoints Continental as the initial Transfer Agent and Registrar for the purpose of registering the TRIPs and transfers and exchanges of the TRIPs as herein provided. Continental shall be permitted to resign as Transfer Agent and Registrar upon 30 days' written notice to Finco, the Trustee and the Participants; provided, however, that such resignation shall not be effective and Continental shall continue to perform its duties as Transfer Agent and Registrar until the Trust has appointed a successor Transfer Agent and Registrar acceptable to Finco and the Required TRIPs Holders. If the Transfer Agent and Registrar does not have an office in New York City, Finco may appoint any co-transfer agent and co- registrar chosen by Finco and acceptable to the Required TRIPs Holders. Any reference in this Agreement to the Transfer Agent and Registrar shall include any co-transfer agent and co-registrar unless the context requires otherwise. (b) The Trustee agrees to pay to the Transfer Agent and Registrar from time to time reasonable compensation for its services under this Section 9.3, and the Trustee shall be entitled to be reimbursed, and the Trustee shall be reimbursed, for such payments in accordance with and subject to Article VII. (c) Upon surrender for registration of transfer of any TRIP at any office or agency of the Transfer Agent and Registrar maintained for such purpose, Finco shall execute, and the Trustee shall authenticate and deliver, in the name of the designated transferee or transferees, one or more new TRIPs in authorized denominations representing a like aggregate portion of the TRIPs Capital. (d) At the option of any TRIPs Holder, TRIPs may be exchanged for other TRIPs in authorized denominations of a like aggregate portion of the TRIPs Capital, upon surrender of the TRIPs to be exchanged at any such office or agency of the Transfer Agent and Registrar maintained for such purpose. Whenever any TRIPs are so surrendered for exchange, Finco shall execute, and the Trustee shall authenticate and (unless the Transfer Agent and Registrar is different than the Trustee, in which case the Transfer Agent and Registrar shall) deliver the TRIPs which the TRIPs Holder making the exchange is entitled to receive. Every TRIP presented or surrendered for registration of transfer or exchange shall be accompanied by a written instrument of transfer in a form satisfactory to the Trustee and the Transfer Agent and Registrar duly executed by the TRIPs Holder thereof or his attorney duly authorized in writing. (e) No service charge shall be made for any registration of transfer or exchange of TRIPs, but the Transfer Agent and Registrar may require payment of a sum sufficient to cover any tax or governmental charge that may be imposed in connection with any transfer or exchange of TRIPs. (f) All TRIPs surrendered for registration of transfer and exchange shall be cancelled and disposed of in a manner satisfactory to the Trustee and Finco. (g) Finco shall execute and deliver to the Trustee or the Transfer Agent and Registrar, as applicable, TRIPs in such amounts and at such times as are necessary to enable the Trustee and the Transfer Agent and Registrar to fulfill their respective responsibilities under this Agreement and the TRIPs. Section 9.4. Restrictions on Transfer. The Trustee shall not register the transfer of any TRIP unless the Trustee shall have received a certificate, substantially in the form of Exhibit D hereto, and an opinion of counsel (which opinion of counsel may be rendered by salaried counsel employed by the holder or prospective holder of such TRIP) reasonably acceptable to the Trustee that such transfer is exempt from, or not subject to, the registration requirements of the Securities Act. Section 9.5. Mutilated, Destroyed, Lost or Stolen TRIPs. If (a) any mutilated TRIP is surrendered to the Transfer Agent and Registrar or the Transfer Agent and Registrar receives evidence to its satisfaction of the destruction, loss or theft of any TRIP and (b) there is delivered to the Transfer Agent and Registrar and the Trustee such security or indemnity as may be required by them to save each of them harmless (any institutional TRIPs Holder's unsecured agreement of indemnity being satisfactory for these purposes), then, in the absence of notice to an Authorized Officer of the Trustee that such TRIP has been acquired by a bona fide purchaser, Finco shall execute, and the Trustee shall authenticate and deliver (in compliance with applicable law), in exchange for or in lieu of any such mutilated, destroyed, lost or stolen TRIP, a new TRIP of like tenor and aggregate portion of the TRIPs Capital. In connection with the issuance of any new TRIP under this Section 9.5, the Trustee or the Transfer Agent and Registrar may require the payment by the TRIPs holder of a sum sufficient to cover any tax or other governmental expenses (including the fees and expenses of the Trustee and the Transfer Agent and Registrar) connected therewith. Any duplicate TRIP issued pursuant to this Section 9.5 shall constitute complete and indefeasible evidence of ownership in the Trust Assets, as if originally issued, whether or not the lost, stolen or destroyed TRIP shall be found at any time. Section 9.6. Persons Deemed Owners. Prior to due presentation of a TRIP for registration of transfer, the Trustee, the Transfer Agent and Registrar and any agent of any of them may treat the Person in whose name any TRIP is registered as the owner of such TRIP for the purpose of receiving distributions pursuant to Article VII and for all other purposes whatsoever, and neither the Trustee, the Transfer Agent and Registrar nor any agent of any of them shall be affected by any notice to the contrary. Notwithstanding the foregoing provisions of this Section 9.6, in determining whether the holders of the requisite portion of the TRIPs Capital have given any request, demand, authorization, direction, notice, consent or waiver hereunder, TRIPs owned by any UHS Entity or any affiliate thereof (as defined in Rule 405 under the Securities Act), shall be disregarded and deemed not to be outstanding, except that, in determining whether the Trustee shall be protected in relying upon any such request, demand, authorization, direction, notice, consent or waiver, only TRIPs which an Authorized Officer of the Trustee knows to be so owned shall be so disregarded. TRIPs so owned which have been pledged in good faith shall not be disregarded and may be regarded as outstanding if the pledgee establishes to the satisfaction of the Trustee the pledgee's right so to act with respect to such TRIPs and that the pledgee is not Finco, any UHS Entity or an affiliate thereof (as defined above). Section 9.7. Access to List of Participants' Names and Addresses. The Trustee will furnish or cause to be furnished by the Transfer Agent and Registrar to Finco, any Participant or the Servicer, within five Business Days after receipt by the Trustee of a request therefor in writing, a list in such form as Finco, such Participant or the Servicer may reasonably require, of the names and addresses of the Participants. Every Participant, by acquiring the Participations, agrees with the Trustee that neither the Trustee, the Transfer Agent and Registrar, nor any of their respective agents shall be held accountable by reason of the disclosure of any such information as to the names and addresses of the Participants hereunder, regardless of the sources from which such information was derived. Section 9.8. Authenticating Agent. (a) The Trustee may appoint one or more authenticating agents with respect to the TRIPs which shall be authorized to act on behalf of the Trustee in authenticating the TRIPs in connection with the issuance, delivery, registration of transfer, exchange or repayment of the TRIPs. Whenever reference is made in this Agreement to the authentication of TRIPs by the Trustee or the Trustee's certificate of authentication, such reference shall be deemed to include authentication on behalf of the Trustee by an authenticating agent and a certificate of authentication executed on behalf of the Trustee by an authenticating agent. Each authenticating agent must be acceptable to the Trustee and Finco. (b) Any institution succeeding to the corporate agency business of an authenticating agent shall continue to be an authenticating agent without the execution or filing of any paper or any further act on the part of the Trustee or such authenticating agent. (c) An authenticating agent may at any time resign by giving written notice of resignation to the Trustee and to Finco, which notice shall be forwarded by the Trustee to the Participants. The Trustee may at any time terminate the agency of an authenticating agent by giving notice of termination to such authenticating agent, the Participants and Finco. Upon receiving such a notice of resignation or upon such a termination, or in case at any time an authenticating agent shall cease to be acceptable to the Trustee or Finco, the Trustee promptly may appoint a successor authenticating agent. Any successor authenticating agent upon acceptance of its appointment hereunder shall become vested with all the rights, powers and duties of its predecessor hereunder, with like effect as if originally named as an authenticating agent. No successor authenticating agent shall be appointed unless acceptable to the Trustee and Finco. (d) The Trustee agrees to pay to each authenticating agent from time to time reasonable compensation for its services under this Section 9.8, and the Trustee shall be entitled to be reimbursed for such payments in accordance with and subject to the provisions of Article VII. (e) The provisions of Sections 11.1, 11.2 and 11.3 shall be applicable to any authenticating agent. (f) Pursuant to an appointment made under this Section 9.8, the TRIPs may have endorsed thereon, in lieu of the Trustee's certificate of authentication, an alternate certificate of authentication in substantially the following form: This is one of the TRIPs described in the Pooling Agreement. _________________________ _________________________ as authenticating agent for the Trustee By _______________________ Authorized Officer Section 9.9. Limitation on Rights of Participants. (a) The death or incapacity of any Participant shall not operate to terminate this Agreement or the Trust, nor shall such death or incapacity entitle such Participant's legal representatives or heirs to claim an accounting or to take any action or commence any proceeding in any court for a partition or winding up of the Trust, nor otherwise affect the rights, obligations and liabilities of the parties hereto or any of them. (b) Except as expressly provided herein, no Participant shall have any right to vote or in any manner otherwise control the operation and management of the Trust, or the obligations of the parties hereto, nor shall anything herein set forth, or contained in the terms of the TRIPs, be construed so as to constitute the Participants from time to time as partners or members of an association; nor shall any Participant be under any liability to any third person by reason of any action taken by the parties to this Agreement pursuant to any provision hereof. Section 9.10. Participations Nonassessable and Fully Paid. It is the intention of the parties to this Agreement that the Participants shall not be personally liable for obligations of the Trust, that the interests in the Trust represented by the Participations shall be nonassessable for any losses or expenses of the Trust or for any reason whatsoever and that the TRIPs upon authentication thereof by the Trustee pursuant to Sections 2.5 and 9.2 are and shall be deemed fully paid. Section 9.11. Actions by TRIPs Holders. Any request, demand, authorization, direction, notice, consent, waiver or other act by a TRIPs Holder shall bind such TRIPs Holder and every subsequent holder of such TRIP issued upon the registration of transfer thereof or in exchange therefor or in lieu thereof in respect of anything done or omitted to be done by the Trustee in reliance thereon, whether or not notation of such action is made upon such TRIP. ARTICLE X EARLY AMORTIZATION EVENTS Section 10.1. Early Amortization Events. If any of the following events occur (each, an "Early Amortization Event"), Sheffield or the Required TRIPs Holders may give notice thereof pursuant to Section 10.2, and the Trustee, on behalf of the Participants, may exercise the remedies available to it pursuant to Section 10.2: (a) Finco shall fail to make any payment to be made by it hereunder to any party to any of the Operative Documents when due; or Finco shall fail to perform or observe any term, covenant or agreement contained in Section 5.1(b), 5.1(d), 5.1(g), 5.1(j), 5.1(k), 5.2(d) through (f), 5.2(i) or 5.2(k) through (n); or (b) Finco shall default in the performance of any covenant or agreement set forth in subsection 5.1(l) and such default shall continue unremedied for a period of three days or Finco shall default in the performance of any other agreement or undertaking hereunder (other than as provided in clause (a) above) and such default shall continue for 30 days after written notice thereof has been given to Finco by the Servicer, any Participant or the Trustee; or (c) any representation or warranty made by Finco, UHS or the Servicer in any Operative Document or in any certificate or financial or other statement furnished pursuant to the terms of such Operative Document (other than as provided in clauses (a) or (b) above) shall prove to have been untrue or incomplete in any material respect when made or deemed made and Finco, UHS or the Servicer, as the case may be, shall fail to cure such breach of representation, warranty or other statement within 15 days after written notice thereof has been given to Finco, UHS or the Servicer by the Servicer, any Participant or the Trustee; provided, however, that no breach of any representation or warranty made by Finco as to any Receivable being an Eligible Receivable on the related Purchase Date shall constitute an "Early Amortization Event" hereunder if Finco cures or causes to be cured such breach in accordance with the terms of Section 5.4 of this Agreement; or (d) any of Finco, the Servicer or UHS shall fail to perform or observe any other term, covenant or agreement contained in any of the Operative Documents to which it is a party (other than as provided in paragraphs (a) through (c) above), and any such failure shall remain unremedied for 30 days after written notice thereof shall have been given to Finco, the Servicer or UHS, as the case may be, by the Servicer, any Participant or the Trustee; or (e) any material provision of any of the Operative Documents shall at any time for any reason cease to be valid and binding on the parties thereto or shall be declared to be null and void, or the validity or enforceability thereof shall be contested by any Governmental Authority, in each case in a manner and to an extent which, either individually or in the aggregate, could have or result in a material adverse effect on any of the Interested Parties or the CP Holders; or (f) (i) any of Finco, UHS or the Servicer shall (A) apply for or consent to the appointment of a receiver, trustee, liquidator or custodian or the like of itself or of its property, (B) admit in writing its inability to pay its debts generally as they become due, (C) make a general assignment for the benefit of creditors, (D) be adjudicated a bankrupt or insolvent, or (E) commence a voluntary case under the Federal bankruptcy laws of the United States of America or file a voluntary petition or answer seeking reorganization, an arrangement with creditors or an order for relief or seeking to take advantage of any insolvency law or file an answer admitting the material allegations of a petition filed against it in any bankruptcy, reorganization or insolvency proceeding; or corporate action shall be taken by it for the purpose of effecting any of the foregoing; or (ii) without the application, approval or consent of Finco, UHS or the Servicer, a proceeding shall be instituted in any court of competent jurisdiction, under any law relating to bankruptcy, insolvency, reorganization or relief of debtors, seeking in respect of Finco, UHS or the Servicer an order for relief or an adjudication in bankruptcy, reorganization, dissolution, winding up, liquidation, a composition or arrangement with creditors, a readjustment of debts, the appointment of a trustee, receiver, liquidator or custodian or the like of Finco, UHS or the Servicer or of all or any substantial part of the assets of Finco, UHS or the Servicer, or other like relief in respect thereof under any bankruptcy or insolvency law, and, if such proceeding is being contested by Finco, UHS or the Servicer in good faith, the same shall (A) result in the entry of an order for relief or any such adjudication or appointment or (B) continue undismissed, or pending and unstayed, for any period of 60 consecutive days; or (g) (i) Finco, UHS, the Servicer or any Hospital or any Commonly Controlled Entity shall engage in any Prohibited Transaction (as defined in Section 406 of ERISA or Section 4975 of the Code) involving any Plan, (ii) any "accumulated funding deficiency" (as defined in Section 302 of ERISA), whether or not waived, shall exist with respect to any Plan, (iii) a Reportable Event shall occur with respect to, or proceedings shall commence to have a trustee appointed, or a trustee shall be appointed, to administer or to terminate, any Single Employer Plan, which Reportable Event or commencement of proceedings or appointment of a trustee is, in the reasonable opinion of the Required TRIPs Holders or Sheffield, likely to result in the termination of such Plan for purposes of Title IV of ERISA, (iv) any Single Employer Plan shall terminate for purposes of Title IV of ERISA, (v) UHS or any Commonly Controlled Entity shall, or in the reasonable opinion of the Required TRIPs Holders or Sheffield is likely to, incur any liability in connection with a withdrawal from, or the Insolvency or Reorganization of, a Multiemployer Plan or (vi) any other event or condition shall occur or exist, with respect to a Plan; and in each case in clauses (i) through (vi) above, such event or condition, together with all other such events or conditions, if any, could subject UHS or any of its Subsidiaries to any tax, penalty or other liabilities in the aggregate material in relation to the business, operations, property or financial or other condition of the UHS Entities taken as a whole; or (h) (i) Except as permitted hereunder, Finco shall incur any Debt or obligations of UHS or any of its Subsidiaries in respect of Debt in excess of $5,000,000 in the aggregate, including Debt assumed or guaranteed by UHS or any of its Subsidiaries, shall be declared to be or shall become due and payable prior to the stated maturity thereof (an "Acceleration Event"); (ii) obligations of UHS or any of its Subsidiaries in respect of Debt in excess of $5,000,000 in the aggregate shall not be paid when the same becomes due and payable (after taking into account any period of grace permitted with respect thereto); (iii) (A) there shall occur and be continuing any other default or defaults by UHS or any of its Subsidiaries under any instruments, agreements or evidences of indebtedness relating to Debt in excess of $5,000,000 in the aggregate and such defaults shall continue unremedied for 30 days beyond any period of grace permitted with respect thereto and (B) the effect of such default or defaults is to permit the holder or holders of such instruments, agreements or evidences of indebtedness, or a trustee, agent or other representative on behalf of such holder or holders, to cause Debt in excess of $5,000,000 in the aggregate to become due prior to its stated maturity; or (i) any judgment or judgments for the payment of money (A) in an aggregate amount in excess of $10,000 shall have been rendered against Finco or (B) in an aggregate amount in excess of $5,000,000 shall have been rendered against UHS or any Subsidiary or Subsidiaries of UHS (other than Finco), and in any such case the same shall have remained unsatisfied and in effect for any period of 30 consecutive days during which no stay of execution shall have been obtained; and any such event, in the reasonable judgment of Sheffield or the Required TRIPs Holders, shall materially impair the ability of any UHS Entity to perform its obligations under the Operative Documents; or (j) (i) UHS shall cease to own, directly or indirectly through one or more wholly owned Subsidiaries, all of the outstanding capital stock of Finco or of UHS Delaware; or (ii) any such capital stock of Finco or UHS Delaware shall be subject to any Lien, charge, pledge or encumbrance (other than (a) any Lien for taxes which may not then be due and payable or which can be discharged thereafter without penalty or (b) any Lien of any financial institution securing Debt of UHS and its Subsidiaries); or (iii) any pledgee of any such stock of Finco or UHS Delaware pledged as collateral as permitted by clause (ii) shall take any action to realize upon such collateral; or (k) this Agreement shall at any time not give the Trustee the ownership or security interests and rights, powers and privileges purported to be created hereby (including, without limitation, a perfected ownership or security interest in, or Lien on, all of the Trust Assets), prior to the rights of all other Persons and subject to no other mortgage, pledge, Lien, security interest or other charge or encumbrance of any kind; or (l) (i) the Servicer or any Hospital shall fail to make any payment or deposit within one Business Day after the date it is required to do so under the terms of the Sale and Servicing Agreements or the Servicing Agreement; or (ii) the Servicer shall fail to deliver a Settlement Date Statement and the related Servicer's Certificate within three Business Days after the date it is required to do so or shall fail to deliver a Servicer Daily Statement within one Business Day after it is required to do so under the terms of the Servicing Agreement; or (iii) any Hospital shall fail to comply with the terms of Section 7.2 of the related Sale and Servicing Agreement; or (m) UHS shall undergo a Change of Control or change in management, unless such event, in the reasonable judgment of Sheffield and the Required TRIPs Holders, would not be expected to materially impair the ability of UHS to perform its obligations under the Guarantee; or (n) a Voluntary Exclusion Event shall have occurred; or (o) the Loss-to-Liquidation Ratio for any Settlement Period shall exceed 12%; or (p) the average Loss-to-Liquidation Ratio for the three most recent Settlement Periods shall exceed 10%; or (q) the Delinquency Ratio shall exceed 12% on any Settlement Date; or (r) at any time (i) the Eligible Pool Balance plus (ii) all cash held in the Collateral Account (other than the TRIPs Interest Sub- account, the Sheffield Interest Sub-account or the Expense Sub-account) shall cease to be at least $7,500,000 greater than the Required Coverage Amount; or (s) there shall have occurred any other circumstance or circumstances which would, alone or in the aggregate, in the sole judgment of Sheffield or the Required TRIPs Holders, have a material adverse impact on the validity or enforceability of this Agreement or any other Operative Document, or on the enforceability or collectibility (other than as a result of the credit quality of any Obligor) of the Participations. Section 10.2. Remedies. (a) If any Early Amortization Event, other than an event described in Section 10.1(f) or (o) through (r), shall have occurred and be continuing, (i) upon written notice given by the Required TRIPs Holders to Finco, Sheffield and the Trustee, the TRIPs Amortization Period shall commence and (ii) upon written notice given by Sheffield to Finco and the Trustee (a copy of which notice the Trustee shall promptly deliver to the TRIPs Holders), the Sheffield Amortization Period shall commence. (b) If any Early Amortization Event described in Section 10.1(f) or (o) through (r) shall have occurred and be continuing, then, without notice or other action on the part of the Trustee or any Participant, (i) in the case of an Early Amortization Event described in Section 10.1(f) or (r), immediately upon the occurrence of such event, (ii) in the case of an Early Amortization Event described in Section 10.1(o) or (q), three days after the Settlement Date on which the occurrence of such event is, or is required to be, reported in the Settlement Date Statement, and (iii) in the case of an Early Amortization Event described in Section 10.1(p), three days after the occurrence of such event, the TRIPs Amortization Period and the Sheffield Amortization Period shall commence. (c) If both the TRIPs Amortization Period and the Sheffield Amortization Period have commenced pursuant to Section 10.2(a) or (b) or if the Sheffield Amortization Period shall have commenced when there are no TRIPs outstanding, Finco shall immediately cease to transfer Purchased Receivables to the Trust. In any such event, all Collections thereafter received from each Obligor in respect of the Purchased Receivables previously conveyed to the Trust shall continue to be a part of the Trust as provided in this Agreement and shall be applied to such Purchased Receivables in the order such Purchased Receivables were created. If both the TRIPs Amortization Period and the Sheffield Amortization Period have commenced pursuant to Section 10.2(a) or (b), the Trustee, for the benefit of the Participants, without demand of performance or other demand, presentment, protest, advertisement or notice of any kind (except any notice required by law referred to below) to or upon Finco or any other Person (all and each of which demands, defenses, advertisements and notices are hereby waived), may forthwith collect, receive, appropriate and realize upon the Total Transferred Property, or any part thereof, and/or may forthwith sell, lease, assign, give option or options to purchase, or otherwise dispose of and deliver the Trust Assets or any part thereof (or contract to do any of the foregoing), in one or more parcels at public or private sale or sales, at any exchange, broker's board or office of the Trustee or elsewhere upon such terms and conditions as it may deem advisable and at such prices as it may deem best, for cash or on credit or for future delivery without assumption of any credit risk. To the extent permitted by applicable law, Finco waives all claims, damages and demands it may acquire against the Trustee and any Participant arising out of the exercise by the Trustee of any rights under this Section 10.2. If any notice of a proposed sale or other disposition of such Total Transferred Property shall be required by law, such notice shall be deemed reasonable and proper if given at least 10 days before such sale or other disposition. Without limiting the generality of the foregoing, the Trustee, for the benefit of the Participants, shall have, in addition to all other rights and remedies granted to it under this Agreement and in any other instrument or agreement securing, evidencing or relating to the rights and remedies hereunder, all rights and remedies of a secured party under the UCC. Nothing in this Section 10.2 shall be construed to prejudice any rights the Trustee or the Participants have as purchasers or owners of the Transferred Property. (d) In case any Early Amortization Event occurs, and as a result thereof the TRIPs Amortization Period commences, by reason of any willful action (or inaction) taken (or not taken) by or on behalf of any UHS Entity with the intention of avoiding payment of any Make-Whole Payment Amount which Finco would have had to pay if Finco had exercised the Call Option pursuant to Section 2.14, then Finco shall pay to the TRIPs Holders, after payment of all Capital and Yield, an amount equal to the sum of each Make-Whole Payment Amount that would have been payable during the TRIPs Amortization Period if such TRIPs Amortization Period had commenced as a result of the exercise of the Call Option. (e) In the event that Finco shall, after any Early Amortization Event, receive payments from any Obligor which is an Obligor with respect to both Purchased Receivables and Receivables which have not been conveyed to the Trustee, on behalf of the Trust, then, to the extent that Finco shall be unable to determine the Receivables to which such payments relate, Finco shall apply all such amounts first to the Outstanding Balance of such Obligor's Purchased Receivables, and in the order such Purchased Receivables were created, until all such Purchased Receivables have been paid in full. (f) Unless the Trustee shall fail to take action required to be taken by it in this Section 10.2 and Article XIV, no Participant shall have any right directly to enforce the ownership or security interests and Liens granted by this Agreement. No CP Holder shall have any right to require the Trustee to take or fail to take any action under this Agreement. ARTICLE XI THE TRUSTEE Section 11.1. Duties of Trustee. (a) The Trustee, prior to the occurrence of an Early Amortization Event of which an Authorized Officer of the Trustee has actual knowledge, undertakes to perform such duties and only such duties as are specifically set forth in this Agreement. If, to the actual knowledge of an Authorized Officer of the Trustee, an Early Amortization Event has occurred (and has not been cured or waived), the Trustee shall exercise such of the rights and powers vested in it by this Agreement and use the same degree of care and skill in their exercise, as a prudent man would exercise or use under the circumstances in the conduct of his own affairs. (b) The Trustee, upon receipt of all resolutions, certificates, statements, opinions, reports, documents, orders or other instruments furnished to the Trustee which are specifically required to be furnished pursuant to any provision of this Agreement, shall, subject to Section 11.2, examine them to determine whether they substantially conform to the requirements of this Agreement. The Trustee shall give prompt written notice to the Participants of any material lack of conformity of any such instrument to the applicable requirements of this Agreement discovered by the Trustee which would entitle a specified percentage of the Participants to take any action pursuant to this Agreement. (c) Subject to Section 11.1(a), no provision of this Agreement shall be construed to relieve the Trustee from liability for its own negligent action, its own negligent failure to act or its own willful misconduct; provided, however, that: (i) The Trustee shall not be liable for an error of judgment made in good faith by an Authorized Officer or Authorized Officers of the Trustee, unless it shall be proved that the Trustee was negligent in ascertaining the pertinent facts; (ii) The Trustee shall not be liable with respect to any action taken, suffered or omitted to be taken by it in good faith in accordance with the direction of the Required TRIPs Holders or Sheffield, or if such directions given by the Required TRIPs Holders, Sheffield conflict or if the Operative Documents so require, the direction of the Required Participants or the Required TRIPs Holders and Sheffield jointly, relating to the time, method and place of conducting any proceeding for any remedy available to the Trustee, or exercising any trust or power conferred upon the Trustee, under this Agreement; and (iii) The Trustee shall not be charged with knowledge of an Early Amortization Event or any default by the Servicer unless an Authorized Officer of the Trustee obtains actual knowledge of such event or the Trustee receives written notice of such event from Finco, the Servicer or any Participant. (d) The Trustee shall not be required to expend or risk its own funds or otherwise incur financial liability in the performance of any of its duties hereunder or in the exercise of any of its rights or powers if there is reasonable ground for believing that the repayment of such funds or adequate indemnity against such risk or liability is not reasonably assured to it, and none of the provisions contained in this Agreement shall in any event require the Trustee to perform, or be responsible for the manner of performance of, any obligations of the Servicer under or pursuant to this Agreement or the Servicing Agreement except during such time, if any, as the Trustee shall be the successor to, and be vested with the rights, duties, powers and privileges of the Servicer. (e) Except for actions expressly authorized by this Agreement, the Trustee shall take no action reasonably likely to impair the interests of the Trust in any Purchased Receivable now existing or hereafter created or to impair the value of any Purchased Receivable now existing or hereafter created. (f) Except as expressly provided in this Agreement, the Trustee shall have no power to vary the corpus of the Trust. (g) In the event that the Transfer Agent and Registrar shall fail to perform any obligation, duty or agreement in the manner or on the day required to be performed by the Transfer Agent and Registrar under this Agreement, the Trustee shall be obligated, promptly upon actual knowledge of an Authorized Officer thereof, to perform such obligation, duty or agreement in the manner so required. Section 11.2. Rights of the Trustee. Except as otherwise provided in Section 11.1: (a) The Trustee may rely on and shall be protected in acting on, or in refraining from acting in accordance with, any resolution, officer's certificate, certificate of auditors or any other certificate, statement, instrument, opinion, report, notice, request, consent, order, appraisal, bond or other paper or document believed by it to be genuine and to have been signed or presented to it pursuant to this Agreement by the proper party or parties; (b) The Trustee may consult with counsel, and any opinion of counsel (other than any such opinion rendered subsequent to the Initial Closing Date by any counsel for any UHS Entity) shall be full and complete authorization and protection in respect of any action taken or suffered or omitted by it hereunder in good faith and in accordance with such opinion of counsel; (c) The Trustee shall not be personally liable for any action taken, suffered or omitted by it in good faith and believed by it to be authorized or within the discretion or rights or powers conferred upon it by this Agreement; (d) The Trustee shall not be bound to make any investigation into the facts of matters stated in any resolution, certificate, statement, instrument, opinion, report, notice, request, consent, order, approval, bond or other paper or document, unless requested in writing to do so by the Required TRIPs Holders or Sheffield; (e) The Trustee may execute any of the trusts or powers hereunder or perform any duties hereunder either directly or by or through agents or attorneys or a custodian or nominee, and the Trustee shall not be responsible for any misconduct or negligence on the part of, or for the supervision of, any such agent, attorney, custodian or nominee appointed with due care by it hereunder; (f) Except as may be required by Section 11.1 hereof, the Trustee shall not be required to make any initial or periodic examination of any documents or records related to the Purchased Receivables or the Transferred Property for the purpose of establishing the presence or absence of defects, the compliance by Finco with its representations and warranties or for any other purpose; and (g) In the event that the Trustee is also acting as Transfer Agent and Registrar hereunder, the rights and protections afforded to the Trustee pursuant to this Article XI shall also be afforded to such Transfer Agent and Registrar. Section 11.3. Trustee Not Liable for Recitals. The Trustee assumes no responsibility for the correctness of the recitals contained herein and in the TRIPs (other than the certificate of authentication on the TRIPs). Except as set forth in Section 11.15, the Trustee makes no representations as to the validity or sufficiency of this Agreement or of the TRIPs (other than the certificate of authentication on the TRIPs) or of any Transferred Property or Finco Transferred Property. The Trustee shall not be accountable for the use or application by Finco of any of the TRIPs or the proceeds of the Participations or for the use or application of any funds paid to Finco in respect of the Transferred Property or deposited in or withdrawn from the Collateral Account, any Other Account or any account hereafter established to effectuate the transactions contemplated herein and in accordance with the terms hereof. Section 11.4. Trustee May Own TRIPs. The Trustee, in its individual or any other capacity, may become the owner or pledgee of TRIPs with the same rights as it would have if it were not the Trustee. Section 11.5. Compensation of Trustee. Subject to the provisions of Section 3.1 of the Servicing Agreement, Article VII hereof and the Trustee Fee Letter, the Trustee shall be entitled to receive reasonable compensation (which shall not be limited by any provision of law in regard to the compensation of a trustee of an express trust), but which shall be limited to the extent of the Servicing Fee, for all services rendered by it in the execution of the trust hereby created and in the exercise and performance of any of the powers and duties hereunder of the Trustee, and, subject to such subsection, shall be entitled to reimbursement for its request for all reasonable expenses (including, without limitation, expenses incurred in connection with notices or other communications to Participants), disbursements and advances incurred or made by the Trustee in accordance with any of the provisions of this Agreement (including the reasonable fees and expenses of its agents, any co-trustee and counsel) except any such expense, disbursement or advance as may arise from its gross negligence or bad faith. All amounts payable pursuant to this Section 11.5 shall be paid from the Collateral Account in accordance with Article VII. Section 11.6. Eligibility Requirements for Trustee. The Trustee hereunder shall at all times be a corporation organized and doing business under the laws of the United States of America or any state thereof authorized under such laws to exercise corporate trust powers, having a combined capital and surplus of at least $50,000,000 and subject to supervision or examination by Federal or State authority and, except in the case of Continental, a long- term unsecured debt rating of A or higher from Moody's and S&P. If such corporation publishes reports of condition at least annually, pursuant to law or to the requirements of the aforesaid supervising or examining authority, then, for the purpose of this Section 11.6, the combined capital and surplus of such corporation shall be deemed to be its combined capital and surplus as set forth in its most recent report of condition so published. In case at any time the Trustee shall cease to be eligible in accordance with the provisions of this Section 11.6, the Trustee shall resign immediately in the manner and with the effect specified in Section 11.7. Section 11.7. Resignation or Removal of Trustee. (a) The Trustee may at any time resign and be discharged from the trust hereby created by giving written notice thereof to Finco and the Participants. Upon receiving such notice of resignation, Finco shall, with the consent of the Required Participants (which consent may not be unreasonably withheld) promptly appoint a successor trustee by written instrument, in duplicate, one copy of which instrument shall be delivered to the resigning Trustee and one copy to the successor trustee. If no successor trustee shall have been so appointed and have accepted appointment within 30 days after the giving of such notice of resignation, the resigning Trustee may petition any court of competent jurisdiction for the appointment of a successor trustee. (b) If at any time the Trustee shall cease to be eligible in accordance with the provisions of Section 11.6 hereof and shall fail to resign after written request therefor by Finco or the Required Participants, or if at any time the Trustee shall be legally unable to act, or shall be adjudged a bankrupt or insolvent, or if a receiver of the Trustee or of its property shall be appointed, or any public officer shall take charge or control of the Trustee or of its property or affairs for the purpose of rehabilitation, conservation or liquidation, then Finco or the Required Participants may remove the Trustee and promptly appoint a successor trustee acceptable to Finco and the Required Participants by written instrument, in duplicate, one copy of which instrument shall be delivered to the Trustee so removed and one copy to the successor trustee. (c) Any resignation or removal of the Trustee and appointment of successor trustee pursuant to any of the provisions of this Section 11.7 shall not become effective until acceptance of appointment by the successor trustee as provided in Section 11.8 hereof. (d) The obligations of Finco described in Sections 12.1 and 11.5 shall survive the removal or resignation of the Trustee as provided in this Agreement. Section 11.8. Successor Trustee. (a) Any successor trustee appointed as provided in Section 11.7 hereof shall execute, acknowledge and deliver to Finco and to its predecessor Trustee an instrument accepting such appointment hereunder, and thereupon the resignation or removal of the predecessor Trustee shall become effective and such successor trustee, without any further act, deed or conveyance, shall become fully vested with all the rights, powers, duties and obligations of its predecessor hereunder, with like effect as if originally named as Trustee herein. The predecessor Trustee shall, at the expense of Finco, deliver to the successor trustee all documents or copies thereof and statements held by it hereunder; and Finco and the predecessor Trustee shall execute and deliver such instruments and do such other things as may reasonably be required for fully and certainly vesting and confirming in the successor trustee all such rights, power, duties and obligations. Finco shall immediately give notice to the Rating Agency upon the appointment of a successor trustee. (b) No successor trustee shall accept appointment as provided in this Section 11.8 unless at the time of such acceptance such successor trustee shall be eligible under the provisions of Section 11.6 hereof. (c) Upon acceptance of appointment by a successor trustee as provided in this Section 11.8, such successor trustee shall mail notice of such succession hereunder to all Participants at their addresses as specified in Section 14.1. Section 11.9. Merger or Consolidation of Trustee. Any Person into which the Trustee may be merged or converted or with which it may be consolidated, or any Person resulting from any merger, conversion or consolidation to which the Trustee shall be a party, or any Person succeeding to the corporate trust business of the Trustee, shall be the successor of the Trustee hereunder, provided such corporation shall be eligible under the provisions of Section 11.6 hereof, without the execution or filing of any paper or any further act on the part of any of the parties hereto, anything herein to the contrary notwithstanding. Section 11.10. Appointment of Co-Trustee or Separate Trustee. (a) Notwithstanding any other provisions of this Agreement, at any time, for the purpose of meeting any legal requirements of any jurisdiction in which any part of the Trust may at the time be located, the Trustee shall have the power and may execute and deliver all instruments to appoint one or more Persons to act as a co-trustee or co-trustees, or separate trustee or separate trustees, of all or any part of the Trust, and to vest in such Person or Persons, in such capacity and for the benefit of the Participants, such title to the Trust, or any part thereof, and, subject to the other provisions of this Section 11.10, such powers, duties, obligations, rights and trusts as the Trustee may consider necessary or desirable. No co-trustee or separate trustee hereunder shall be required to meet the terms of eligibility as a successor trustee under Section 11.6 and no notice to the Participants of the appointment of any co-trustee or separate trustee shall be required under Section 11.8 hereof. (b) Every separate trustee and co-trustee shall, to the extent permitted by law, be appointed and act subject to the following provisions and conditions: (i) all rights, powers, duties and obligations conferred or imposed upon the Trustee shall be conferred or imposed upon and exercised or performed by the Trustee and such separate trustee or co-trustee jointly (it being understood that such separate trustee or co-trustee is not authorized to act separately without the Trustee joining in such act), except to the extent that under any statute of any jurisdiction in which any particular act or acts are to be performed, the Trustee shall be incompetent or unqualified to perform such act or acts, in which event such rights, powers, duties and obligations (including the holding of title to the Trust or any portion thereof in any such jurisdiction) shall be exercised and performed singly by such separate trustee or co-trustee, but solely at the direction of the Trustee; (ii) no trustee hereunder shall be personally liable by reason of any act or omission of any other trustee hereunder; and (iii) the Trustee may at any time accept the resignation of or remove any separate trustee or co-trustee. (c) Any notice, request or other writing given to the Trustee shall be deemed to have been given to each of the then separate trustees and co- trustees, as effectively as if given to each of them. Every instrument appointing any separate trustee or co-trustee shall refer to this Agreement and the conditions of this Article XI. Each separate trustee and co-trustee, upon its acceptance of the trusts conferred, shall be vested with the estates or property specified in its instrument of appointment, either jointly with the Trustee or separately, as may be provided therein, subject to all the provisions of this Agreement, specifically including every provision of this Agreement relating to the conduct of, affecting the liability of, or affording protection to, the Trustee. Every such instrument shall be filed with the Trustee and a copy thereof given to Finco and the Servicer. (d) Any separate trustee or co-trustee may at any time constitute the Trustee its agent or attorney-in-fact with full power and authority, to the extent not prohibited by law, to do any lawful act under or in respect of this Agreement on its behalf and in its name. If any separate trustee or co- trustee shall die, become incapable of acting, resign or be removed, all of its estates, properties, rights, remedies and trusts shall vest in and be exercised by the Trustee, to the extent permitted by law, without the appointment of a new or successor trustee. Section 11.11. Tax Returns. In the event the Trust shall be required to file tax returns, Finco shall cause the Servicer to prepare or cause to be prepared any tax returns required to be filed by the Trust and shall cause the Servicer to remit such returns to the Trustee for signature at least five days before such returns are due to be filed. Finco shall also cause the Servicer to prepare or cause to be prepared all tax information required by law and pursuant to Section 8.2 to be distributed to the Participants and shall cause the Servicer to deliver such information to the Trustee at least five Business Days prior to the date it is required by law to be distributed to the Participants. The Trustee, upon request, will furnish the Servicer with all such information known to the Trustee as may be reasonably required in connection with the preparation of all tax returns of the Trust, and shall, upon request, execute such returns. In no event shall the Trustee in its individual capacity be liable for any liabilities, costs or expenses of the Trust, the Participants or any UHS Entity arising under any tax law or regulation, including, without limitation, federal, state or local income or excise taxes or any other tax imposed on or measured by income (or any interest or penalty with respect thereto or arising from any failure to comply therewith). Section 11.12. Trustee May Enforce Claims Without Possession of TRIPs. All rights of action and claims under this Agreement or the Participations may be prosecuted and enforced by the Trustee and, in the case of the TRIPs Participations, without the possession of any of the TRIPs or the production thereof in any proceeding relating thereto, and any such proceeding instituted by the Trustee shall be brought in its own name as trustee. Any recovery of judgment shall, after provision for the payment of the reasonable compensation, expenses, disbursements and advances of the Trustee, its agents and counsel, be for the ratable benefit of the Participants in respect of which such judgment has been obtained. Section 11.13. Suits for Enforcement. If an Early Amortization Event or a default under the Servicing Agreement shall occur and be continuing, the Trustee, in its discretion may, subject to the provisions of Section 11.1, proceed to protect and enforce its rights and the rights of the Participants under this Agreement and the Servicing Agreement by suit, action or proceeding in equity or at law or otherwise, whether for the specific performance of any covenant or agreement contained in this Agreement or the Servicing Agreement or in aid of the execution of any power granted in this Agreement or the Servicing Agreement for the enforcement of any other legal, equitable or other remedy as the Trustee, being advised by counsel, shall deem most effective to protect and enforce any of the rights of the Trustee or the Participants. Nothing herein contained shall be deemed to authorize the Trustee to authorize or consent to or accept or adopt on behalf of any Participant any plan of reorganization, arrangement, adjustment or composition affecting the Participations or the rights of any Participant, or authorize the Trustee to vote in respect of the claim of any Participant in any such proceeding. Section 11.14. Rights of Participants to Direct Trustee. Either the Required TRIPs Holders or Sheffield shall have the right at any time to direct the Trustee in (i) the granting of any consents, waivers, amendments, terminations or similar actions pertaining to the Participations, (ii) the time, method and place of conducting any proceeding and (iii) the exercise of any right or power conferred on the Trustee pursuant to the Operative Documents; provided that if this Agreement or any other Operative Document specifies that the consent of the Required Participants or the joint consent of Sheffield and the Required TRIPs Holders shall be required with respect to the matters specified in clauses (i), (ii) and (iii) above, then such consent of the Required Participants or such joint consent shall be so required; and provided, further, that if the taking of any action directed by the Required TRIPs Holders or Sheffield, as the case may be, would cause the Trustee to violate any instruction previously given by any Participants in accordance with the Operative Documents, the Trustee shall follow the direction of the Required Participants with respect to such matter; and provided, further, that, subject to Section 11.1, the Trustee shall have the right to decline to follow any such direction if the Trustee being advised by counsel determines that the action so directed may not lawfully be taken, or if the Trustee in good faith shall, by an Authorized Officer or Authorized Officers of the Trustee, determine that the proceedings so directed would be illegal or involve it in personal liability or be unduly prejudicial to the rights of Participants not parties to such direction; and provided, further, that nothing in this Agreement shall impair the right of the Trustee to take any action deemed proper by the Trustee and which is not inconsistent with such direction of the requisite Participants given in accordance with the immediately preceding sentence. Section 11.15. Representations and Warranties of Trustee. The Trustee represents and warrants that: (i) the Trustee is a national banking association organized, existing and in good standing under the laws of the United States of America; (ii) the Trustee has full power, authority and right to execute, deliver and perform this Agreement, and has taken all necessary action to authorize the execution, delivery and performance by it of this Agreement and the Servicing Agreement; and (iii) this Agreement and the Servicing Agreement have been duly executed and delivered by the Trustee. Section 11.16. Maintenance of Office or Agency. The Trustee will maintain at its expense in the Borough of Manhattan, The City of New York, an office or offices or agency or agencies where notices and demands to or upon the Trustee in respect of the Participations and this Agreement may be served. The Trustee will give prompt written notice to Finco, the Servicer and the Participants of any change in the location of the TRIPs Register or any such office or agency. ARTICLE XII INDEMNIFICATION AND EXPENSES Section 12.1. Indemnities by Finco. (a) Without limiting any other rights which the Participants and the Trustee may have hereunder or under applicable law, Finco hereby agrees to indemnify each of the Participants, the Trustee, their respective assignees and each of their respective officers, directors, employees, representatives, agents and Affiliates (collectively, the "Indemnified Parties") from and against any and all damages, losses (other than loss of profit), claims, Taxes, liabilities (including liabilities for penalties), actions, suits, judgments, demands and related costs and expenses, including, without limitation, reasonable attorneys' fees and expenses (all of the foregoing being collectively referred to as "Indemnified Amounts"), awarded against or incurred by any of them arising out of or as a result of this Agreement, the other Finco Documents or the Participations, the Purchased Receivables and the other Total Transferred Property or its assignment thereof to the Trustee pursuant to Section 2.1, excluding however, Indemnified Amounts resulting from gross negligence or willful misconduct on the part of the Indemnified Party to which such Indemnified Amount would otherwise be due. Without limiting the generality of the foregoing, Finco shall indemnify the Indemnified Parties for Indemnified Amounts relating to or resulting from: (i) the transfer of an interest in any Non-qualifying Receivable; (ii) any set-off or adjustment applied by any Obligor against any Purchased Receivable conveyed to the Trustee, whether or not the amount of such set-off or adjustment was reflected in the Offset Reserves on the Purchase Date relating to such Purchased Receivable; (iii) reliance on any representation or warranty made by Finco (or any of its respective Authorized Officers) under or in connection with this Agreement and any information or report delivered by Finco pursuant hereto or thereto, which shall have been false or incorrect in any material respect when made or deemed made; (iv) the failure by Finco to comply with any Requirement of Law with respect to any Purchased Receivable or other Transferred Property, or the nonconformity of any such Purchased Receivable or other Transferred Property with any such Requirement of Law; (v) the failure to take all actions which would be required to maintain in favor of the Trustee, for the bene-fit of the Participants, a valid, perfected, first priority ownership or security interest in, or Lien on, the Purchased Receivables and other Total Transferred Property, together with all Collections and Outstanding Balances related to such Receivables, free and clear of any Lien whether exist-ing at the Initial Closing Date or at any time thereafter; (vi) the failure to file, record, deliver or receive in a timely manner all Security Filings, including, without limitation, financing statements or other similar instru-ments or documents required under the UCC in effect in the state in which Finco's or any Hospital's chief executive office is located or under other applicable laws with respect to any Purchased Receivables or other Total Transferred Property; (vii) any failure of Finco to perform its duties or obligations in accordance with the provisions of this Agreement or the other Finco Documents; or (viii) the administration or enforcement of this Agree-ment or the other Finco Documents by any Interested Party. (b) By entering into this Agreement, Finco agrees to be liable, directly to the injured party, for the entire amount of any losses, claims, damages or liabilities (other than those incurred by a Participant in the capacity of an investor in its Participation) arising out of or based on the arrangement created by this Agreement and the actions of Finco taken pursuant hereto as though the Agreement created a partnership under the New York Uniform Partnership Act with Finco a general partner thereof. Finco agrees to pay, indemnify and hold harmless each Interested Party against and from any and all such losses, claims, damages and liabilities except to the extent that they arise from any action by such Interested Parties other than in accordance with the Operative Documents. Section 12.2. Additional Costs. (a) Whether or not the TRIPs Participations are acquired by the TRIPs Holders or the Sheffield Participation is acquired by Sheffield, Finco agrees to pay all reasonable out-of-pocket costs and expenses of the Participants and the Trustee (including fees and disbursements of counsel) in connection with (i) the preparation, reproduction, execution, delivery and administration of this Agreement, the other Operative Documents and any related documents, (ii) the sale of the Purchased Receivables and other Total Transferred Property to the Trust and the transfer of the Participations in the Trust Assets hereunder, (iii) the perfection as against all third parties whatsoever of the Trust's right, title and interest in, to and under the Purchased Receivables and the other Total Transferred Property, (iv) the enforcement by any Interested Party of the Participations and of the obligations and liabilities of Finco under this Agreement, the other Operative Documents or any related document or of any Obligor under any Purchased Receivable and (v) the maintenance of, and the obligations of the Participants in connection with, the Hospital Concentration Accounts, the Master Receivables Account, the Collateral Account, the Other Accounts and any Additional Accounts established pursuant hereto; provided that in connection with clauses (i) and (ii), Finco shall not be obligated to pay the fees and expenses of more than one counsel representing the TRIPs Holders and shall not be obligated to pay legal fees, taxes or governmental charges in connection with the transfer by any TRIPs Holder of its Participation hereunder. In addition, Finco will pay all reasonable out-of-pocket costs and expenses of the Participants and the Trustee (including fees and disbursements of counsel) in connection with any modifications of, or consents under, this Agreement, the other Finco Documents or any related document or of any Obligor under any Purchased Receivable or any consents under this Agreement, the other Finco Documents or any related document to the extent such modifications or consents are requested by Finco or otherwise required under the aforementioned documents (whether or not any such modification or consent becomes effective), including but not limited to the out-of-pocket expenses and the fees and disbursements of counsel representing the TRIPs Holders and any local counsel engaged by them and the allocated costs and expenses of the in-house counsel of the TRIPs Holders (but exclusive of salaries or compensation payable to the officers or employees of such TRIPs Holders other than such in-house counsel). (b) Determinations and allocations by the TRIPs Holders, Sheffield or the Trustee, as the case may be, for purposes of this Section 12.2 shall be conclusive, absent manifest error, provided that such determinations and allocations are made in good faith and on a reasonable basis and that the TRIPs Holders, Sheffield or the Trustee, as the case may be, delivers a certificate to such effect to Finco and the Servicer. Section 12.3. Survival of Indemnities. All of the rights and obligations set forth in this Article XII shall survive the termination of the Trust, the payment of the Participations and the termination of this Agreement. Section 12.4. Method of Payment. Any Indemnified Amounts due under this Article, and any other fees, costs and expenses payable by Finco to any person pursuant to the terms of any Operative Document shall be payable in immediately available funds to any Person from the Expense Sub-account in accordance with the terms and conditions of Article VII (or from any other source available to Finco consistent with the terms of the Operative Documents); provided that any such amounts to be paid from the Expense Sub- account shall be deposited in the Expense Sub-account only to the extent that, after giving effect to such deposit, no Early Amortization Event shall have occurred; and provided, further, after the occurrence of an Early Amortization Event, amounts payable to the Trustee and, if the Servicer is not an affiliate of Finco, the Servicer, pursuant to subsection 7.3(a), shall be deposited and paid in accordance with the provisions of Article VII without regard to the foregoing proviso. ARTICLE XIII TERMINATION OF TRUST Section 13.1. Final Termination of Participations; Optional Repurchase of TRIPs. (a) All Sheffield Capital and Sheffield Yield with respect to the Sheffield Participation shall be due and payable no later than the Final Sheffield Maturity Date. In the event that the Adjusted Sheffield Capital is greater than zero on the last day of the Settlement Period immediately preceding such date (after giving effect to all allocations and distributions to be made pursuant to Article VII on such date), Finco, on behalf of the Trustee, upon written direction by Sheffield, will promptly sell or cause to be sold an amount of Purchased Receivables or interests in Purchased Receivables (along with all related Transferred Property) having an aggregate Outstanding Balance equal to up to the Sheffield Termination Sale Amount. Proceeds of such sale shall be paid to the Sheffield Payment Account for application pursuant to Section 7.5 and distribution to Sheffield in final payment for all Sheffield Capital of and Sheffield Yield in respect of the Sheffield Participation. Proceeds of such sale in excess of the Adjusted Sheffield Capital shall be paid to the Collateral Account and applied in accordance with Section 7.5. (b) All TRIPs Capital and TRIPs Yield on the TRIPs shall be due and payable no later than the Final TRIPs Maturity Date. In the event that the Adjusted TRIPs Capital is greater than zero on the last day of the Settlement Period immediately preceding such date (after giving effect to all allocations and distributions to be made pursuant to Article VII on such date), the Trustee, upon written direction of the Required TRIPs Holders, will promptly sell or cause to be sold an amount of Purchased Receivables or interests in Purchased Receivables (along with all related Transferred Property) having an aggregate Outstanding Balance equal to the TRIPs Termination Sale Amount. Proceeds of such sale shall be deposited in the TRIPs Payment Account and applied to make final payment of the TRIPs in the manner specified in Section 13.2. Proceeds of such sale in excess of the Adjusted TRIPs Capital shall be paid to the Collateral Account and applied in accordance with Section 7.5. (c) On the Transfer Date during the TRIPs Amortization Period on which the Adjusted TRIPs Capital is reduced to an amount equal to or less than 10% of the TRIPs Capital as of the Business Day preceding the beginning of the TRIPs Amortization Period, Finco shall have the option to repurchase the TRIPs, at a purchase price equal to the outstanding TRIPs Capital plus accrued and unpaid TRIPs Yield and any Make-Whole Payment Amount payable through the date of such purchase (after giving effect to any payment of TRIPs Capital and TRIPs Yield on such date of purchase). The amount of the purchase price will be deposited into the TRIPs Payment Account on the Transfer Date in immediately available funds and distributed to the TRIPs Holders. Following any such repurchase, the TRIPs Holders' interest in the Purchased Receivables shall terminate and the TRIPs Holders will have no further rights with respect thereto. In the event that Finco fails for any reason to deposit the purchase price for such Purchased Receivables, the Trust will continue to hold such interest in the Purchased Receivables and monthly payments will continue to be made to the TRIPs Holders. Section 13.2. Final Payment of the TRIPs. Written notice of the Transfer Date on which TRIPs Holders shall receive payment of the final distribution with respect to their TRIPs shall be given by the Trustee (upon 10 Business Days' prior written notice from the Servicer containing all information required for such Trustee's notice) to the TRIPs Holders of record not less than five Business Days prior to such final Transfer Date. Such notice shall specify (i) the Transfer Date on which final payment will be made, (ii) the amount of the final payment and (iii) the office at which the TRIPs Holders may surrender their TRIPs on or after such date. The Trustee shall deliver such Trustee's notice to the Transfer Agent and Registrar at the time such notice is delivered to the TRIPs Holders. The TRIPs Holders, by their acceptance of the TRIPs, agree to surrender their TRIPs to the Trustee on or promptly after such Transfer Date. Section 13.3. Termination of Trust. (a) The respective obligations and responsibilities of Finco, the Participants and the Trustee created hereby shall (except as expressly provided otherwise herein) terminate on the earlier to occur of (i) the Trust Termination Date and (ii) the date on which Aggregate Capital is reduced to zero and all Yield, any Make-Whole Payment Amount and all other amounts payable under the Operative Documents have been paid, and the Trust shall terminate one year and one day thereafter. If on the last day of the Settlement Period immediately preceding the Trust Termination Date the Adjusted Aggregate Capital is greater than zero (after giving effect to all allocations and distributions to be made on such date pursuant to Article VII), Finco, on behalf of the Trustee, will promptly sell all Purchased Receivables conveyed to the Trust. The proceeds of such sale shall be treated as Collections and allocated in accordance with Article VII. (b) Notwithstanding the termination of the Trust pursuant to subsection 13.3(a) or the occurrence of the Final Sheffield Maturity Date or the Final TRIPs Maturity Date, all funds then on deposit in the Collateral Account, the Other Accounts and any Additional Accounts shall continue to be held in trust for the benefit of the Participants, and the Trustee shall pay such funds to the Participants in accordance with Sections 13.1 and 13.2. (c) All TRIPs surrendered on or after the date of the final distribution with respect to such TRIPs shall be cancelled by the Transfer Agent and Registrar and be disposed of in a manner satisfactory to the Trustee and Finco. Section 13.4. Finco's Termination Rights. Upon payment of all amounts required pursuant to Section 7.5 and the termination of the obligations of the parties hereunder pursuant to Section 13.3, the Trustee shall sell, assign and convey to Finco (without recourse, representation or warranty for no additional consideration other than Finco's interest in the Trust) all right, title and interest of the Trust in the Purchased Receivables, whether then existing or thereafter created, and the Total Transferred Property, and all proceeds thereof, except for amounts held by the Trustee pursuant to Section 13.3(b). The Trustee shall execute and deliver such instruments of transfer and assignment, in each case without recourse, representation or warranty, as shall be reasonably requested by Finco to vest in Finco all right, title and interest which the Trust had in the Purchased Receivables and the Total Transferred Property. ARTICLE XIV MISCELLANEOUS Section 14.1. Notices, Etc. Except where telephonic instructions or notices are authorized herein to be given, all notices, demands, instructions and other communications required or permitted to be given to or made upon any party hereto shall be in writing and shall be personally delivered or sent by registered, certified or express mail, postage prepaid, return receipt requested, or by telecopy (with voice confirmation thereof) or telegram (with messenger delivery specified in the case of a telegram) and shall be deemed to be given for purposes of this Agreement on the day that such personal delivery is made or such return receipt or confirmation is received by the party giving such notice, demand, instruction or communication. Unless otherwise specified in a notice sent or delivered in accordance with the foregoing provisions of this Section, notices, demands, instructions and other communications in writing shall be given to or made upon the respective parties hereto at their respective addresses (or to their respective telecopy numbers) indicated below, and, in the case of telephonic instructions or notices, by calling the telephone number or numbers indicated for such party below: If to Finco: UHS Receivables Corp. 27292 Calle Arroyo, Suite B San Juan Capistrano, California 92675 Attention: President Tel No.: (714) 661-9323 Telecopier No.: (714) 661-9445 with a copy to: UHS Receivables Corp. c/o Universal Health Services, Inc. Universal Corporate Center 367 South Gulph Road King of Prussia, Pennsylvania 19406 Attention: Chief Financial Officer Tel. No.: (215) 768-3300 Telecopier No.: (215) 768-3318 If to Sheffield: Sheffield Receivables Corporation c/o Barclays Bank PLC, New York Branch, as Managing Agent 222 Broadway New York, New York 10038 Attention: Barry Wood Tel. No.: (212) 412-6797 Telecopier No.: (212) 412-6846 If to any TRIPs Holder: to its address set forth in the TRIPs Register If to the Trustee: Continental Bank, National Association 231 South La Salle Street, 7th Floor Chicago, Illinois 60697 Attention: Steve Charles Tel. No.: (312) 828-7321 Telecopier No.: (312) 828-6528 If to the Managing Agent: Barclays Bank PLC, New York Branch 222 Broadway New York, New York 10038 Attention: Barry Wood Tel. No.: (212) 412-6797 Telecopier No.: (212) 412-6846 If to any Lender: c/o Barclays Bank PLC, New York Branch 222 Broadway New York, New York 10038 Attention: Steven McKenna Tel. No.: (212) 412-4084 Telecopier No.: (212) 412-6846 Section 14.2. Successors and Assigns; Survival. (a) This Agreement shall be binding upon Finco, the Participants, the Trustee and their respective successors and assigns and shall inure to the benefit of Finco and the Interested Parties; provided that Finco shall not assign any of its rights or obligations hereunder (including, without limitation, its rights in respect of, or any interest in, the Subordinated Interest) (other than as expressly assigned hereunder) without the prior written consent of each Participant. (b) The representations and warranties of Finco contained in this Agreement shall survive the execution, delivery and termination of this Agreement and the purchase of the Participations. Section 14.3. Severability Clause. Any provisions of this Agreement which are prohibited or unenforceable in any jurisdiction shall, as to such jurisdiction, be ineffective to the extent of such prohibition or unenforceability without invalidating the remaining provisions hereof, and any such prohibition or unenforceability in any jurisdiction shall not invalidate or render unenforceable such provision in any other jurisdiction. Section 14.4. Amendments. This Agreement may not be modified, amended, waived, supplemented or surrendered except in accordance with the provisions of this Section. This Agreement may be amended, supplemented or modified pursuant to a written instrument executed by Finco, Sheffield and the Trustee, and consented to in writing by the Required TRIPs Holders; provided that after an Early Amortization Event occurs, the consent of Finco shall not be necessary to make any such amendment, modification or supplement which does not directly affect the rights of Finco under this Agreement; provided, further, that no such amendment, modification or supplement shall decrease the amount or extend the time for any notification of Rating Agency of Amendment or waivers payment to any Participant hereunder without the consent of such Participant. Any provision of this Agreement may be waived by a written instrument executed by Sheffield, the Required TRIPs Holders and the Trustee; provided that, notwithstanding anything herein to the contrary, Sheffield shall be permitted to waive performance of any provision of this Agreement so long as such waiver shall not affect the rights and duties of the TRIPs Holders or the Trustee; and provided, further, that, notwithstanding anything herein to the contrary, the Required TRIPs Holders shall be permitted to waive performance of any provision of this Agreement so long as such waiver shall not affect the rights and duties of Sheffield or the Trustee. Any amendment, supplement, waiver or consent approved in accordance with this Section shall be effective only in the specific instance and for the specific purpose given. Section 14.5. Finco's Obligations. It is expressly agreed that, anything contained in this Agreement to the contrary notwithstanding, Finco shall be obligated to perform all of its obligations under the Sale and Servicing Agreements and the other Finco Documents to the same extent as if the Interested Parties had no interest therein and no Interested Party shall have any obligation or liability under the Purchased Receivables or the other Total Transferred Property to any Obligor thereunder by reason of or arising out of this Agreement, nor shall any Interested Party be required or obligated in any manner to perform or fulfill any of the obligations of Finco under or pursuant to any Sale and Servicing Agreements and the other Finco Documents, any Receivables or the other Total Transferred Property. Section 14.6. Consent to Assignment. Each of Finco, each TRIPs Holder, by its acceptance of its TRIPs Participation, and the Trustee acknowledges that all of Sheffield's right, title and interest in the obligations of Finco to Sheffield and the rights of Sheffield against Finco under this Agreement have been assigned, transferred and otherwise conveyed by Sheffield to the Liquidity Agent, for the benefit of the Liquidity Banks, pursuant to the terms and conditions of the Security Agreement. Each of Finco, each TRIPs Holder, by its acceptance of its TRIPs Participation, and the Trustee consents to such assignment and transfer to the Liquidity Agent and agrees that the Liquidity Agent shall be entitled to enforce the terms of this Agreement directly against Finco, the TRIPs Holders and the Trustee if any event of default under the Liquidity Agreement shall have occurred and be continuing. Upon notice of any such event by Sheffield or the Liquidity Agent, each of Finco and the Trustee further agrees that in respect of its obligations hereunder it will act at the direction of and in accordance with all requests and instructions of the Liquidity Agent. Finco, each TRIPs Holder and the Trustee further agree that, in the event of any conflict of requests or instructions to Finco or the Trustee, as the case may be, between Sheffield and the Liquidity Agent, Finco or the Trustee, as the case may be, will at all times act in accordance with the requests and instructions of the Liquidity Agent. Section 14.7. Authority of Managing Agent. Each of Finco, the Trustee and each TRIPs Holder, by its acceptance of its TRIPs, acknowledges that Sheffield has appointed Barclays to act as its Managing Agent. Unless otherwise instructed by Sheffield, copies of all notices, requests, demands and other documents to be delivered to Sheffield pursuant to the terms hereof shall be delivered to the Managing Agent. Unless otherwise instructed by Sheffield, all notices, requests, demands and other documents to be executed or delivered, and any action to be taken, by Sheffield pursuant to the terms hereof may be executed, delivered and/or taken by the Managing Agent. The rights and responsibilities of the Managing Agent under this Agreement with respect to any action taken by the Managing Agent or the exercise or non- exercise by the Managing Agent of any option, right, request, judgment or other right or remedy provided to Sheffield herein or resulting or arising out of this Agreement shall, as between the Managing Agent and Sheffield, be governed by such agreements with respect thereto as may exist from time to time between them, but, as between the Managing Agent and Finco or any Interested Party, the Managing Agent shall be conclusively presumed to be acting as agent for Sheffield, with full and valid authority so to act or refrain from acting, and neither Finco nor any Interested Party shall be under any obligation, or entitlement, to make any inquiry respecting such authority. Section 14.8. Further Assurances. Finco agrees to do such further acts and things and to execute and deliver to the Participants and the Trustee such additional assignments, agreements, powers and instruments as are required by Sheffield, the Required TRIPs Holders or the Trustee to carry into effect the purposes of this Agreement or to better assure and confirm unto the Interested Parties their respective rights, powers and remedies hereunder. Section 14.9. Counterparts. This Agreement may be executed in any number of copies, and by the different parties hereto on the same or separate counterparts, each of which shall be deemed to be an original instrument. Section 14.10. Headings. Section headings used in this Agreement are for convenience of reference only and shall not affect the construction or interpretation of this Agreement. Section 14.11. No Bankruptcy Petition Against Sheffield or Finco. Each of Finco, each Participant, by its acceptance of any Participation, and the Trustee covenants and agrees that prior to the date which is one year and one day after the date on which the Aggregate Capital is reduced to zero and all other amounts due under or in connection with the Operative Documents are paid in full, it will not institute against, or join any other Person in instituting against Finco or Sheffield, as the case may be, any bankruptcy, reorganization, arrangement, insolvency or liquidation proceedings, or other proceedings under any federal or state bankruptcy or similar law. Section 14.12. GOVERNING LAW. THIS AGREEMENT SHALL BE GOVERNED BY, AND CONSTRUED AND INTERPRETED IN ACCORDANCE WITH, THE INTERNAL LAW OF THE STATE OF NEW YORK WITHOUT REFERENCE TO CONFLICTS OF LAW RULES OF THE STATE OF NEW YORK. Section 14.13. No Waiver; Cumulative Remedies. No failure to exercise and no delay in exercising, on the part of any Interested Party, any right, remedy, power or privilege hereunder, shall operate as a waiver thereof; nor shall any single or partial exercise of any right, remedy, power or privilege hereunder preclude any other or further exercise thereof or the exercise of any other right, remedy, power or privilege. The rights, remedies, powers and privileges herein provided are cumulative and not exhaustive of any rights, remedies, powers and privileges provided by law. Section 14.14. SUBMISSION TO JURISDICTION; VENUE; WAIVER OF JURY TRIAL; SERVICE OF PROCESS. (a) FINCO (FOR ITSELF AND ITS RESPECTIVE SUCCESSORS AND ASSIGNS) HEREBY IRREVOCABLY SUBMITS, FOR ITSELF AND ITS PROPERTY, TO THE JURISDICTION OF THE STATE COURTS OF THE STATE OF NEW YORK AND TO THE JURISDICTION OF THE UNITED STATES DISTRICT COURT FOR THE SOUTHERN DISTRICT OF NEW YORK, FOR THE PURPOSES OF ANY SUIT, ACTION OR OTHER PROCEEDING ARISING OUT OF OR BASED UPON THIS AGREEMENT, THE OTHER FINCO DOCUMENTS OR THE SUBJECT MATTER HEREOF OR THEREOF BROUGHT BY ANY INTERESTED PARTY. FINCO (FOR ITSELF AND ITS RESPECTIVE SUCCESSORS AND ASSIGNS) TO THE EXTENT PERMITTED BY ANY REQUIREMENTS OF LAW (A) HEREBY WAIVES, AND AGREES NOT TO ASSERT, BY WAY OF MOTION, AS A DEFENSE, OR OTHERWISE, IN ANY SUCH SUIT, ACTION OR PROCEEDING BROUGHT IN SUCH COURTS, ANY CLAIM THAT IT IS NOT SUBJECT PERSONALLY TO THE JURISDICTION OF THE ABOVE-NAMED COURTS, THAT ITS PROPERTY IS EXEMPT OR IMMUNE FROM ATTACHMENT OR EXECUTION, THAT THE SUIT, ACTION OR PROCEEDING IS BROUGHT IN AN INCONVENIENT FORUM, THAT THE VENUE OF THE SUIT, ACTION OR PROCEEDING IS IMPROPER OR THAT THIS AGREEMENT OR THE OTHER FINCO DOCUMENTS OR THE SUBJECT MATTER HEREOF OR THEREOF MAY NOT BE ENFORCED IN OR BY SUCH COURT, AND (B) HEREBY WAIVES THE RIGHT TO ASSERT IN ANY SUCH ACTION, SUIT OR PROCEEDING ANY OFFSETS OR COUNTERCLAIMS EXCEPT COUNTERCLAIMS THAT ARE COMPULSORY OR OTHERWISE ARISE FROM THE SAME SUBJECT MATTER. FOR THE PURPOSE OF PROCEEDINGS IN THE COURTS OF THE STATE OF NEW YORK AND THE UNITED STATES COURTS FOR THE SOUTHERN DISTRICT OF NEW YORK, FINCO AGREES THAT SERVICE OF PROCESS EFFECTED BY CERTIFIED OR REGISTERED MAIL (OR ANY SUBSTANTIALLY SIMILAR FORM OF MAIL), POSTAGE PREPAID, TO FINCO AT ITS ADDRESS SET FORTH IN SECTION 14.1 SHALL CONSTITUTE VALID AND EFFECTIVE SERVICE UPON FINCO. FINCO AGREES THAT ITS SUBMISSION TO JURISDICTION AND CONSENT TO SERVICE OF PROCESS BY MAIL IN ANY SUCH ACTION, SUIT OR PROCEEDING SHALL BE CONCLUSIVE, AND MAY BE ENFORCED IN ANY OTHER JURISDICTION (A) BY SUIT, ACTION OR PROCEEDING ON THE JUDGMENT, A CERTIFIED OR TRUE COPY OF WHICH SHALL BE CONCLUSIVE EVIDENCE OF THE FACT AND THE AMOUNT OF INDEBTEDNESS OR LIABILITY THEREIN DESCRIBED OR (B) IN ANY OTHER MANNER PROVIDED BY OR PURSUANT TO THE LAWS OF SUCH OTHER JURISDICTION, PROVIDED, HOWEVER, THAT ANY INTERESTED PARTY, MAY AT ITS OPTION BRING SUIT, OR INSTITUTE OTHER JUDICIAL PROCEEDINGS AGAINST FINCO OR ANY OF ITS ASSETS IN ANY STATE OR FEDERAL COURT OF THE UNITED STATES OR OF ANY COUNTRY OR PLACE WHERE SUCH HOSPITAL OR SUCH ASSETS MAY BE FOUND. (b) EACH OF THE INTERESTED PARTIES AND FINCO HEREBY WAIVES ALL RIGHTS TO TRIAL BY JURY IN ANY ACTION OR PROCEEDING ARISING OUT OF OR RELATING TO ANY OF THE TRANSACTIONS CONTEMPLATED BY THIS AGREEMENT OR THE OTHER FINCO DOCUMENTS. Section 14.15. Acquisition of Participations. Neither UHS, Finco nor any other UHS Entity will directly or indirectly acquire or make any offer to acquire any TRIPs Participation, or part thereof, unless UHS, Finco or such UHS Entity, as the case may be, shall contemporaneously offer to acquire TRIPs Participations (or parts thereof), pro rata, from all TRIPs Holders and upon the same terms. Section 14.16. Waivers. (a) Finco hereby irrevocably and unconditionally waives, to the maximum extent not prohibited by law, any right it may have to claim or recover in any legal action or proceeding referred to in this paragraph any special, exemplary, punitive or consequential damages. (b) Each Participant and the Trustee, solely in its capacity as representative of the Participants, each hereby irrevocably and unconditionally waives, to the maximum extent not prohibited by law, any right such party may have to claim or recover in any legal action or proceeding relating to this Agreement any special, exemplary, punitive or consequential damages; provided that the waiver contained in this Section 14.16 shall not extend to any right to claim or recover from Finco any special, exemplary, punitive or consequential damages for which the Trustee, Sheffield or such TRIPs Holder is liable to any Person. IN WITNESS WHEREOF, Finco, Sheffield and the Trustee have caused this Agreement to be duly executed by their duly authorized officers, all on the day and year first above written. UHS RECEIVABLES CORP. By: _______________________________ Title: SHEFFIELD RECEIVABLES CORPORATION By: _______________________________ Title: CONTINENTAL BANK, NATIONAL ASSOCIATION, Trustee By: ________________________________ Title: SCHEDULE I The Principal Place of Business of Finco is: UHS Receivables Corp. 27292 Calle Arroyo, Suite B San Juan Capistrano, California 92675 The Locations where documents relating to the Receivables are located are: UHS Receivables Corp. 27292 Calle Arroyo, Suite B San Juan Capistrano, California 92675 The locations where UCC financing statements must be filed are: Name Filing Location(s) Universal Health Services, Inc. Secretary of the Commonwealth of Pennsylvania and Montgomery County Prothonotary's Office Chalmette General Hospital, Inc. Clerk of Court of Saint Bernard Parish Dallas Family Hospital, Inc. Secretary of State of State of Texas Del Amo Hospital, Inc. Secretary of State of State of California Doctors' General Hospital, Ltd. Florida Department of State Doctors' Hospital of Florida Department of State Hollywood, Inc. HRI Hospital, Inc. Secretary of State of State of Massachusetts and Town Clerk's Office of town of Brookline McAllen Medical Center, Inc. Secretary of State of State of Texas Meridell Achievement Center, Inc. Secretary of State of State of Texas River Oaks, Inc. Clerk of Court of Jefferson Parish Sparks Reno Partnership, L.P. Secretary of State of State of Nevada Turning Point Care Center, Inc. Clerk of Superior Court of Colquitt County UHS of Arkansas, Inc. Secretary of State of State of Arkansas and Clerk of Circuit Court and Ex-Officio Recorder of Pulaski County UHS of Auburn, Inc. Licensing Department of State of Washington UHS of Belmont, Inc. Secretary of State of State of Illinois UHS of Maitland, Inc. Florida Department of State UHS of Massachusetts, Inc. Secretary of State of State of Massachusetts and Town Clerk's Office of town of Boston UHS of River Parishes, Inc. Clerk of Court of St. John the Baptist Parish UHS of Shreveport, Inc. Clerk of Court of Caddo Parish Universal Health Recovery Secretary of the Commonwealth of Centers, Inc. Pennsylvania and Chester County Prothonotary's Office Universal Health Services of Secretary of State of State of Inland Valley, Inc. California Universal Health Services of Secretary of State of State Nevada, Inc. of Nevada Victoria Regional Medical Secretary of State of State Center, Inc. of Texas Wellington Regional Medical Florida Department of State Center Incorporated Westlake Medical Center, Inc. Secretary of State of State of California Schedule II Accounts Hospital Concentration Accounts Name of Hospital Bank Account Number Chalmette General Hospital, Inc. Hibernia National Bank 8122-2924-9 UHS of De La Ronde, Inc. Hibernia National Bank 8122-2925-7 Dallas Family Hospital, Inc. Bank One -- Texas 9830-10-741-7 Del Amo Hospital, Inc. Bank of America 1233-4-57852 Doctors' General Hospital, Ltd. Barnett Bank of South Florida, N.A. 1595100654 Doctors' Hospital of Hollywood, Inc. Sun Bank 385 315 1229 HRI Hospital, Inc. First National Bank of Boston 503-11965 McAllen Medical Center, Inc. Texas Commerce Bank 0960-0370185 Meridell Achievement Center, Inc. Bank One -- Texas 75-0025-5968 River Oaks, Inc. Hibernia National Bank 8122-2923-0 Sparks Reno Partnership, L.P. Bank of America 47-0012378 Turning Point Care Center, Inc. Moultrie National Bank 01-41110-1-01 UHS of Arkansas, Inc. First Commercial Bank 0657433 UHS of Auburn, Inc. Seafirst 62269519 UHS of Belmont, Inc. Park National Bank 16-5301 UHS of Maitland, Inc. Nationsbank of Florida 0088376877 USH of Massachusetts, Inc. First National Bank of Boston 503-52636 UHS of River Parishes, Inc. Bank of La Place 01-0622-4 UHS of Shreveport, Inc. Hibernia National Bank 762001756 Universal Health Recovery Centers, Inc. First Fidelity Bank 4004517290 Universal Health Services of Inland Valley, Inc. Bank of America 1233-2-56080 Universal Health Services of Nevada, Inc. Bank of America 01-212-2036 Victoria Regional Medical Center, Inc. Victoria Bank & Trust 5101017337 Wellington Regional Medical Center Sun Bank South Incorporated Florida N.A. 0629-002-005381 Westlake Medical Center, Inc. Bank of America 1233-9-56195 Master Receivables Account Bank: Continental Bank, N.A., Chicago, Illinois Account Name: Universal Health Services, Inc. Master Receivables Account Account Number: 78-27784 EXHIBIT A TO POOLING AGREEMENT FORM OF TRIP Form of Face of TRIP REGISTERED $______________(1) UHS RECEIVABLES CORP. HEALTHCARE RECEIVABLES TRUST TRADE RECEIVABLES INVESTMENT PARTICIPATION THIS TRADE RECEIVABLES INVESTMENT PARTICIPATION ("TRIP") HAS NOT BEEN REGISTERED UNDER THE UNITED STATES SECURITIES ACT OF 1933, AS AMENDED (THE "SECURITIES ACT"). THE HOLDER HEREOF, BY ACQUIRING THIS TRIP, AGREES THAT THIS TRIP MAY NOT BE RESOLD, PLEDGED OR OTHERWISE TRANSFERRED TO A U.S. PERSON EXCEPT PURSUANT TO AN EXEMPTION FROM, OR IN A TRANSACTION NOT SUBJECT TO, THE REGISTRATION REQUIREMENTS OF THE SECURITIES ACT, BUT ONLY UPON DELIVERY TO CONTINENTAL BANK, NATIONAL ASSOCIATION OF A CERTIFICATE OF THE TRANSFEROR AND AN OPINION OF COUNSEL (SATISFACTORY TO THE TRUSTEE) TO THE EFFECT THAT SUCH TRANSFER IS IN COMPLIANCE WITH THE SECURITIES ACT. This TRIP evidences an undivided interest in a trust, the corpus of which consists of healthcare receivables generated from time to time by certain hospital subsidiaries of Universal Health Services, Inc. ("UHS") and purchased by UHS RECEIVABLES CORP. (Not an interest in or obligation of UHS or any affiliate thereof, other than UHS Receivables Corp.) This certifies that ________________________ (the "TRIPs Holder") is the registered owner of a senior, undivided interest (a "Participation") in the assets of the UHS Receivables Corp. Healthcare Receivables Trust (the "Trust"), created pursuant to the Pooling Agreement, dated as of November 16, 1993 (as amended, supplemented or otherwise modified from time to time, the "Pooling Agreement"), by and among UHS Receivables Corp., a Delaware corporation ("Finco"), Sheffield Receivables Corporation, a Delaware corporation ("Sheffield"), and Continental Bank, a national banking association (in such capacity, the "Trustee"). To the extent not defined herein, capitalized terms used herein have the meanings ascribed to them in the Definitions List, dated as of November 16, 1993 (as amended, supplemented or otherwise modified from time to time, the "Definitions List"), incorporated (1) Denominations of $1,000,000 and $100,000 in excess thereof. by reference into the Pooling Agreement. Unless the certificate of authentication hereon has been executed by the Trustee, this TRIP shall not be entitled to any benefit under the Pooling Agreement or be valid for any reason. Reference is hereby made to the further provisions of this TRIP set forth on the reverse hereof, which further provisions shall for all purposes have the same effect as if set forth at this place. IN WITNESS WHEREOF, Finco has caused this TRIP to be duly executed. Dated: __________ __, 199_ UHS RECEIVABLES CORP. By:__________________________ Name: Title: TRUSTEE'S CERTIFICATE OF AUTHENTICATION This is one of the TRIPs described in the within-mentioned Pooling Agreement. CONTINENTAL BANK, NATIONAL ASSOCIATION By:________________________ OR By:_____________________ Authorized Signatory Authenticating Agent By:______________________ Authorized Signatory Form of Reverse of TRIP The corpus of the Trust consists of (i) all receivables meeting certain eligibility requirements generated by certain hospital subsidiaries of UHS and sold to Finco (the "Purchased Receivables"), (ii) all funds collected or to be collected from Obligors in respect of the Purchased Receivables, (iii) all funds which are from time to time on deposit in the Collateral Account and any other account held for the benefit of the TRIPs Holders, (iv) the Finco Transferred Property and (v) all other assets and interests constituting the Trust. Although a summary of certain provisions of the Pooling Agreement is set forth below, this TRIP does not purport to summarize the Pooling Agreement, is qualified in its entirety by the terms and provisions of the Pooling Agreement and reference is hereby made to the Pooling Agreement for information with respect to the interests, rights, benefits, obligations, proceeds and duties evidenced hereby and the rights, duties and obligations of the Trustee. A copy of the Pooling Agreement may be requested by writing to Continental Bank, National Association, 231 South La Salle Street, 7th Floor, Chicago, Illinois 60697. This TRIP is issued under and is subject to the terms of, and entitled to the benefits of, the Pooling Agreement, to which Pooling Agreement the TRIPs Holder, by virtue of the acceptance hereof, assents and agree to be bound. It is the intent of Finco and the Participants that, for federal and state income and franchise tax purposes only, the TRIPs will be evidence of indebtedness of Finco secured by the Purchased Receivables. The TRIPs Holder, by the acceptance hereof, assents and is bound by such intent. The Participations, which include the TRIPs and the interest acquired by Sheffield, constitute senior interests in the Trust Assets and entitle the Participants to, among other things, all Collections received from Obligors in respect of the Purchased Receivables. The Participations are allocated in part to the TRIPs Holders, with the remainder allocated to Sheffield. In addition to the Participations, Finco will receive and maintain a subordinated interest in the Trust Assets subordinated in right of payment to the Participations. The aggregate interest represented by this TRIP at any time in the Purchased Receivables in the Trust shall not exceed an amount equal to the TRIPs Holder's pro rata portion of the TRIPs Capital at such time. The TRIPs Capital on the TRIPs Closing Date is $ . The TRIPs Capital at any time will be equal to the Initial TRIPs Capital, as reduced by Collections received and distributed to the TRIPS Holders on account of the TRIPs Capital pursuant to the Pooling Agreement. Payments of TRIPs Yield with respect to the TRIPs shall be distributed to the TRIPs Holders on each Transfer Date. Payments of TRIPs Yield will be paid in immediately available funds to the person in whose name such TRIP is registered at the close of business on the applicable Record Date to an account specified by such person. During the TRIPs Revolving Period, Collections otherwise allocable to the TRIPs Holders shall be reinvested in new Purchased Receivables as provided in the Pooling Agreement. The TRIPs Revolving Period under the Pooling Agreement shall terminate, and the TRIPs Amortization Period shall commence, on the earliest to occur of (a) the Scheduled TRIPs Maturity Date, (b) the Call Date and (c) certain Early Amortization Events specified in the Agreement or declared by the TRIPs Holders or the Trustee pursuant to the terms of the Pooling Agreement. The TRIPs are subject to optional redemption by Finco (i) upon the exercise of the Call Option, subject to certain conditions described in the Pooling Agreement and (ii) during the TRIPs Amortization Period as described below. During the TRIPs Amortization Period, certain Collections allocable to the TRIPs (other than Collections allocated to the TRIPs Interest Sub- account and the Expense Sub-account in respect of accrued Yield and certain fees, costs and expenses) will be accumulated in the TRIPs Payment Account and distributed to the TRIPs Holders, up to the amount of the TRIPs Capital, on each Transfer Date, but not beyond the date which is twelve months after the commencement of the TRIPs Amortization Period. If the TRIPs Capital has not been reduced to zero prior to such date, the Trustee, upon written direction of the Required TRIPs Holders, will cause to be sold an amount of Purchased Receivables or interests therein having an Outstanding Balance equal to the TRIPs Termination Sale Amount. On the Transfer Date on which the Adjusted TRIPs Capital is reduced to 10% or less of the TRIPs Capital as of the close of business on the last day of the TRIPs Revolving Period, Finco may (but shall not be obligated to) repurchase all of the TRIPs Participations evidenced by the TRIPs. The aggregate purchase price payable with respect to the TRIPs Participations will be equal to the outstanding balance of the TRIPs Capital, all accrued and unpaid TRIPs Yield through the date of such repurchase and all other amounts payable by Finco pursuant to the Pooling Agreement. The Pooling Agreement may be amended by Finco, Sheffield and the Trustee with the prior written consent of the Required TRIPs Holders; provided that after the occurrence of an Early Amortization Event, the consent of Finco shall not be necessary for any amendment to the Pooling Agreement which does not directly affect the rights of Finco thereunder; provided, further, that no such amendment shall extend the time for any payment to any Participant without the consent of such Participant; and provided, further, that Sheffield shall be permitted to waive performance of any provision of the Pooling Agreement so long as such waiver shall not adversely affect the TRIPs Holders. The TRIPs may be transferred upon surrender of the TRIPs to an office of the Trustee where newly executed and authenticated TRIPs in the name of the designated transferee will be delivered. Prior to the date which is three years after the Effective Date, the Trustee shall not register the transfer of any TRIP unless certain conditions stated in the Pooling Agreement are satisfied. As provided in the Pooling Agreement, and subject to certain limitations set forth therein, this TRIP is exchangeable for new TRIPs evidencing a like aggregate portion of the TRIPs Capital, as requested by the TRIPs Holder surrendering this TRIP. No service charge may be imposed for any such transfer or exchange, but the Transfer Agent and Registrar may require payment of a sum sufficient to cover any tax or other governmental charge that may be imposed in connection therewith. By its acceptance of this TRIP, the TRIPs Holder agrees that (a) the Pooling Agreement was executed and delivered, and this TRIP is authenticated, by Continental Bank, National Association, not individually or personally but solely as Trustee of the Trust, in the exercise of the powers and authority conferred and vested in it, (b) except with respect to Section 11.15 of the Pooling Agreement, the representations, undertakings and agreements made on the part of the Trust are made and intended not as personal representations, undertakings and agreements by Continental Bank, National Association, but are made and intended for the purpose of binding only the Trust and (c) under no circumstances shall Continental Bank, National Association be personally liable for the payment of any indebtedness or expenses of the Trust or be liable for the breach or failure of any obligation, representation, warranty or covenant made or undertaken by the Trust under this TRIP or the Pooling Agreement. This TRIP shall be governed by, and construed and interpreted in accordance with, the law of the State of New York. __________________________________ ASSIGNMENT FOR VALUE RECEIVED, the undersigned hereby sells, assigns and transfers unto PLEASE INSERT SOCIAL SECURITY OR OTHER IDENTIFYING NUMBER OF ASSIGNEE(S) - ------------------------------- - ------------------------------- ............. (PLEASE PRINT OR TYPEWRITE NAME AND ADDRESS OF ASSIGNEE) ............................................... ............................................... the within TRIP and all rights thereunder, and hereby irrevocably constitutes and appoints ............................................... attorney, with full power of substitution in the premises, to transfer said TRIP on the books kept for registration thereof. Dated: ....................................... ............................... Note: The signature(s) to this Assignment must correspond with the name(s) as written on the face of the within TRIP in every particular, without alteration or enlargement or any change whatever. EXHIBIT B TO POOLING AGREEMENT Form of Auditors' Report EXHIBIT C TO POOLING AGREEMENT FORM OF CONFIDENTIALITY AGREEMENT [Letterhead of RECIPIENT of Information] ___________ __, 199_ [TRANSFEROR] [Address] Universal Health Services, Inc. Universal Corporate Center 367 South Gulph Road King of Prussia, Pennsylvania 19406 Dear Sirs: Reference is made to the Pooling Agreement, dated as of November 16, 1993 (as amended from time to time, the "Pooling Agreement"), among UHS Receivables Corp. ("Finco"), a Delaware corporation, Sheffield Receivables Corporation, a Delaware corporation, and Continental Bank, National Association, a national banking association, and to the pending and proposed discussions between [transferor] (the "Transferor") and [recipient] (the "Recipient") regarding [describe transaction requiring disclosure]. Unless otherwise defined herein, capitalized terms defined in the Pooling Agreement are used herein as so defined. Pursuant to our discussions, the Transferor hereby agrees to provide to the Recipient certain information, practices, books, correspondence, and records of a confidential nature and in which a UHS Entity has a proprietary interest (the "Information") on the terms and conditions set forth below. By its execution of this Agreement, the Recipient hereby agrees to all such terms and conditions. The Recipient hereby acknowledges that all Information received by it from the Transferor shall be regarded as confidential information and that the Information may be subject to laws, rules and regulations regarding patient confidentiality. The Recipient agrees that, subject to the following sentence, (i) it shall, and shall cause its employees, agents and representatives to, retain in confidence and not disclose the Information without the prior written consent of the Transferor and (ii) it will not, and will ensure that its employees, agents and representatives will not, make any use whatsoever (other than for the purposes contemplated by the Pooling Agreement and the other Operative Documents or for the enforcement of any of the rights granted thereunder) of any of the Information without the prior written consent of the Transferor. Notwithstanding the foregoing, the Recipient may (x) disclose Information to any Person that has executed and delivered a confidentiality agreement in substantially the same form as this agreement naming the Transferor and the UHS Entities as third party beneficiaries thereof and (y) disclose or otherwise use Information (A) to the extent that such Information is required or appropriate in any report, statement or testimony submitted to any municipal, state or federal regulatory body having or claiming to have jurisdiction over the Recipient or submitted to the National Association of Insurance Commissioners or similar organizations or their successors, (B) to the extent such Information is required in response to any summons or subpoena or in connection with any litigation, (C) to the extent that such Information is believed to be required in order to comply with any law, order, regulation or ruling applicable to the Recipient, (D) to the extent that such Information was publicly available or otherwise known to the Recipient at the time of disclosure, (E) to the extent that such Information subsequently becomes publicly available, other than through any act or omission of the Recipient or (F) to the extent that such Information subsequently becomes known to the Recipient, other than through a Person whom the Recipient knows to be acting in violation of its obligations to the Transferor or the UHS Entities. The parties agree that any breach of this letter agreement would cause damages which cannot be determined in money and that injunction is an appropriate remedy for breach, though not necessarily the sole remedy. This Agreement shall inure to the benefit of the parties hereto, each of their respective successors and permitted assigns and each of the UHS Entities, which UHS Entities will be deemed to be third party beneficiaries of this Agreement. This Agreement shall be governed by, and construed in accordance with the law of the State of New York, and may be executed in one or more counterparts, each of which shall be deemed an original but all of which together shall constitute one agreement. Please acknowledge your agreement to the foregoing by signing three copies of this letter agreement and returning them to the Transferor. Upon receipt of the executed letter agreement, the Transferor, pursuant to the terms of the Pooling Agreement, will deliver an executed agreement to each of UHS and Finco. Very truly yours, [RECIPIENT] By:_________________________ Title: Acknowledged and Agreed: [TRANSFEROR] By:____________________________ Title: EXHIBIT D TO POOLING AGREEMENT Transfer Certificate EXHIBIT 10.19 GUARANTEE GUARANTEE, dated as of November 16, 1993 (as amended, supplemented or otherwise modified from time to time, this "Guarantee"), made by UNIVERSAL HEALTH SERVICES, INC., a Delaware corporation ("UHS") in favor of UHS RECEIVABLES CORP., a Delaware corporation ("Finco"). W I T N E S S E T H : WHEREAS, pursuant to each of the Sale and Servicing Agreements (capitalized terms used in the recitals without definition are used as defined in the Definitions List referred to below), Finco has agreed to purchase all of the Receivables and other Transferred Property from the Hospitals; WHEREAS, pursuant to the Pooling Agreement, Finco has assigned and conveyed to the Trustee, in trust for the benefit of the Participants, the Transferred Property and the Finco Transferred Property, and the Participants have offered to acquire from Finco, and Finco has agreed to transfer to the Participants, senior undivided participating interests in the Trust Assets; WHEREAS, in order to collect the amounts due to Finco under the Sale and Servicing Agreements and in which the Participants have acquired their Participations, Finco and UHS Delaware have entered into the Servicing Agreement, pursuant to which UHS Delaware, as Servicer, will provide for the administration of, and servicing on, the Receivables; WHEREAS, each of UHS Delaware and each Hospital is a subsidiary of UHS; WHEREAS, it is a condition precedent to the obligations of Finco and the Interested Parties under the Operative Documents that UHS shall have executed and delivered this Guarantee; NOW, THEREFORE, in consideration of the premises and to induce Finco to enter into the Servicing Agreement and to induce Finco to make its purchases from the Hospitals under the Sale and Servicing Agreements, UHS hereby agrees as follows: 1. Defined Terms. Unless otherwise defined, capitalized terms used herein are used as defined in the Definitions List, dated as of November 16, 1993 (as amended, supplemented or otherwise modified from time to time, the "Definitions List"), that refers to this Guarantee, which Definitions List is incorporated herein by reference and the following term shall have the following meaning: "Obligations": all obligations and liabilities of (i) each Hospital to Finco and the Interested Parties, whether direct or indirect, absolute or contingent, due or to become due, or now existing or hereafter incurred pursuant to the Sale and Servicing Agreements, including, without limitation, the obligations arising under Sections 4.4 and 7.1 and 7.2(b) of each of the Sale and Servicing Agreements and all fees, indemnities, costs and expenses to be paid by the Hospitals pursuant to the terms thereof (including, without limitation, interest accruing after the filing of any petition in bankruptcy, or the commencement of any insolvency, reorganization or like proceeding, relating to any Hospital, whether or not a claim for post-filing or post-petition interest is allowed in such proceeding) and (ii) UHS Delaware to Finco and the Interested Parties, whether direct or indirect, absolute or contingent, due or to become due, or now existing or hereafter incurred pursuant to the Servicing Agreement, including, without limitation, the obligations arising out of Section 5.17 of the Servicing Agreement and all fees, indemnities, costs and expenses to be paid by UHS Delaware pursuant to the terms of the Servicing Agreement (including, without limitation, interest accruing after the filing of any petition in bankruptcy, or the commencement of any insolvency, reorganization or like proceeding, relating to UHS Delaware, whether or not a claim for post-filing or post- petition interest is allowed in such proceeding). 2. Guarantee. (a) UHS hereby unconditionally and irrevocably guarantees to Finco the prompt and complete payment by the Hospital when due (whether at the stated maturity, by acceleration or otherwise) of the Obligations. Such guarantee shall be a guarantee of payment. (b) UHS further unconditionally and irrevocably covenants and agrees with Finco that UHS will cause each Hospital duly and punctually to perform and observe all the terms, conditions, covenants, agreements and indemnities to be performed or observed by it under the Sale and Servicing Agreement to which it is a party and any other document executed and delivered by such Hospital in connection therewith, strictly in accordance with the terms thereof, and that if for any reason whatsoever such Hospital shall fail so to perform and observe such terms, conditions, covenants, agreements and indemnities, UHS will duly and punctually perform and observe the same. (c) UHS further unconditionally and irrevocably covenants and agrees with Finco that UHS will cause UHS Delaware duly and punctually to perform and observe all the terms, conditions, covenants, agreements and indemnities to be performed or observed by it under the Servicing Agreement and any other document executed and delivered by UHS Delaware in connection therewith, strictly in accordance with the terms thereof, and that if for any reason whatsoever UHS Delaware shall fail so to perform and observe such terms, conditions, covenants, agreements and indemnities, UHS will duly and punctually perform and observe the same. (d) UHS further agrees to pay any and all expenses (including, without limitation, all reasonable fees and disbursements of counsel) which may be paid or incurred by Finco or the Interested Parties in enforcing or preserving any of their rights under this Guarantee. (e) UHS agrees that whenever, at any time, or from time to time, it shall make any payment to Finco or any Interested Party on account of its liability hereunder, it will notify Finco in writing that such payment is made under this Guarantee for such purpose. No payment or payments made by any Guaranteed Party or any other Person or received or collected by Finco or any Interested Party from any Guaranteed Party or any other Person by virtue of any action or proceeding or any set-off or appropriation or application, at any time or from time to time, in reduction of or in payment of the Obligations shall be deemed to modify, reduce, release or otherwise affect the liability of UHS hereunder, which shall, notwithstanding any such payment or payments, continue until the Guarantee Termination Date (as hereinafter defined). This Guarantee shall remain in full force and effect until the later to occur of (i) the date on which the Servicing Agreement and all Sale and Servicing Agreement are terminated in accordance their terms and (ii) the date on which all Obligations are paid in full (such later date, the "Guarantee Termination Date"). 3. No Subrogation, Contribution, Reimbursement or Indemnity. Notwithstanding anything to the contrary in this Guarantee, UHS hereby irrevocably waives all rights which may have arisen in connection with this Guarantee to be subrogated to any of the rights (whether contractual, under Title 11 of the United States Code, including Section 509 thereof, under common law or otherwise) of Finco or any Interested Party against any Guaranteed Party or against any right of offset of Finco or any Interested Party with respect to the Obligations. UHS hereby further irrevocably waives all contractual, common law, statutory or other rights of reimbursement, contribution, exoneration or indemnity (or any similar right) from or against any Guaranteed Party or any other Person which may have arisen in connection with this Guarantee. So long as any Obligations remain outstanding or so long as the Servicing Agreement or any Sale and Servicing Agreement remains in effect, if any amount shall be paid by or on behalf of any Guaranteed Party to UHS on account of any of the rights waived in this paragraph, such amount shall be held by UHS in trust, segregated from other funds of UHS, and shall, forthwith upon receipt by UHS, be applied against the Obligations, whether matured or unmatured, in such order as Finco may determine. The provisions of this paragraph shall survive the Guarantee Termination Date. 4. Amendments, etc. with respect to the Obligations. UHS shall remain obligated hereunder notwithstanding that, without any reservation of rights against UHS, and without notice to or further assent by UHS, any demand for payment of any of the Obligations may be rescinded, and any of the Obligations continued, and the Obligations, or the liability of any other Person upon or for any part thereof, or any collateral security or guarantee therefor or right of offset with respect thereto, may, from time to time, in whole or in part, be renewed, extended, amended, modified, accelerated, compromised, waived, surrendered or released, and the Servicing Agreement, any Sale and Servicing Agreement, any other Operative Document or any other documents executed and delivered in connection therewith may be amended, modified, supplemented or terminated, in whole or in part, from time to time, and any collateral security, guarantee or right of offset at any time held by Finco or any Interested Party for the payment of the Obligations may be sold, exchanged, waived, surrendered or released. Finco shall not have any obligation to protect, secure, perfect or insure any Lien at any time held by it as security for the Obligations or for this Guarantee or any property subject thereto. 5. Guarantee Absolute and Unconditional. UHS waives any and all notice of the creation, renewal, extension or accrual of any of the Obligations and notice of or proof of reliance by Finco or any Interested Party upon this Guarantee or acceptance of this Guarantee; the Obligations, and any of them, shall be conclusively deemed to have been created, contracted or incurred in reliance upon this Guarantee; and all dealings between any Guaranteed Party or UHS, on the one hand, and Finco or any Interested Party, on the other, shall likewise be conclusively presumed to have been had or consummated in reliance upon this Guarantee. UHS waives diligence, presentment, protest, demand for payment and notice of default or nonpayment to or upon any Guaranteed Party or UHS with respect to the Obligations. This Guarantee shall be construed as a continuing, absolute and unconditional guarantee without regard to (a) the validity or enforceability of the Servicing Agreement or any Sale and Servicing Agreement, any of the Obligations or any collateral security therefor or guarantee or right of offset with respect thereto at any time or from time to time held by Finco or any Interested Party, (b) any defense which relates, directly or indirectly, to the matters covered by the representations and warranties of the Hospitals set forth in the Sale and Servicing Agreements or of UHS Delaware set forth in the Servicing Agreement, or any set-off, which in any case may at any time be available to or asserted by any Guaranteed Party against Finco or any Interested Party or (c) any other circumstance whatsoever (with or without notice to or knowledge of any Guaranteed Party or UHS) which constitutes, or might be construed to constitute, an equitable or legal discharge of a Guaranteed Party for the Obligations, or of UHS under this Guarantee, in bankruptcy or in any other instance. 6. Reinstatement. Notwithstanding anything contained herein to the contrary, this Guarantee shall continue to be effective, or shall be reinstated, as the case may be, if at any time payment, or any part thereof, of any of the Obligations is rescinded or must otherwise be restored or returned by Finco or any Interested Party upon the insolvency, bankruptcy, dissolution, liquidation or reorganization of any Guaranteed Party or upon or as a result of the appointment of a receiver, intervenor or conservator of, or trustee or similar officer for, any Guaranteed Party or any substantial part of its property, or otherwise, all as though such payments had not been made. 7. Payments. UHS hereby agrees that the Obligations will be paid to the Trustee in immediately available funds without set-off at the office of the Trustee at the address specified in Section 15.1 of the Pooling Agreement. 8. Representations and Warranties. UHS represents and warrants as of each Purchase Date that: (a) UHS has been duly organized and (i) is validly existing and in good standing as a corporation under the laws of the State of Delaware, with full corporate power and authority to own or lease its properties and to conduct its business as presently conducted and to execute, deliver and perform this Guarantee and to consummate the transactions contemplated hereby, (ii) is duly qualified as a foreign corporation and in good standing under the laws of each jurisdiction where its ownership, lease or operation of property or the conduct of its business requires such qualification, except where any such failure or failures to be so qualified would not, alone or in the aggregate, reasonably be expected to have a material adverse effect on its business, operations, properties, assets or condition (financial or otherwise), (iii) is in compliance with all Requirements of Law and (iv) is not in default under any mortgage, indenture, deed of trust, loan agreement, lease, contract or other agreement, instrument or undertaking to which UHS is a party or by which UHS or any of its assets may be bound, except to the extent that such defaults would not, alone or in the aggregate, have a material adverse effect on its business, operations, property or condition (financial or otherwise). (b) The execution, delivery and performance by UHS of this Guarantee and the consummation of the transactions contemplated hereby have been duly and validly authorized by all requisite corporate action and will not conflict with, violate, or result in a breach of any of the terms or provisions of, or constitute a default under, or result in the creation or imposition of any Lien upon any of its property or assets pursuant to the terms of any, indenture, mortgage, deed of trust, loan agreement, lease, contract or other agreement, instrument or undertaking by which it is bound or to which any of its property or assets is subject, nor will such action, result in any violation of any applicable Requirement of Law; and no consent, approval, authorization, order, registration, filing, qualification, license or permit of or with any such court or any such regulatory authority or other such Governmental Authority, other body, or any other Person, will be required to be obtained by, or with respect to, UHS in connection with the execution, delivery and performance by UHS of this Guarantee and the consummation of the transactions contemplated hereby, except those which UHS shall have so obtained. (c) This Guarantee has been duly and validly authorized, executed and delivered by UHS and constitutes a valid and legally binding obligation of UHS, enforceable against UHS in accordance with its terms, subject to applicable bankruptcy, reorganization, insolvency, moratorium or other similar laws affecting creditors' rights generally, and subject as to enforceability to general principles of equity (regardless of whether enforcement is sought in a proceeding in equity or at law). (d) Except for the Security Filings, and those financing statements listed on Schedule I for which executed UCC-3 termination statements have been delivered to Finco for filing in the appropriate filing offices, there is (i) no effective financing statement (or similar statement or instrument of registration under the law of any jurisdiction) on file or registered in any public office and (ii) no assignment filed or delivered by or on behalf of any Subsidiary of UHS, in each case covering any interest of any kind in the Transferred Property or intended so to be filed, delivered or registered, and UHS will not execute or cause any Subsidiary to execute any effective financing statement (or similar statement or instrument of registration under the laws of any jurisdiction) or any assignment or other notification relating to the Transferred Property. (e) There are no actions, proceedings or investigations pending or, to the knowledge of UHS, threatened, before any court, administrative agency or other tribunal, (i) which, if determined adversely, would, alone or in the aggregate, reasonably be expected to have a material adverse effect on the ability of any of the UHS Entities to perform their respective obligations under the Operative Documents, (ii) asserting the invalidity of this Guarantee or any of the Security Filings or (iii) questioning the consummation by UHS or any of its Subsidiaries of any of the transactions contemplated by any of the Operative Documents. (f) The Receivables Information provided by UHS on such Purchase Date does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements in the Receivables Information, in light of the circumstances in which they were made, not misleading. (g) UHS and each of its Subsidiaries has and shall have filed or caused to be filed all material federal, state and local tax returns which are required to be filed, and has and shall have paid or have caused to be paid all taxes or assessments payable by it (other than any the amount or validity of which are currently being contested in good faith through appropriate proceedings and with respect to which reserves in conformity with GAAP have been provided on the books of UHS or such Subsidiary and with respect to which collection has been stayed); and no tax Lien has been filed, and to the knowledge of UHS no claims are being assessed with respect to any such taxes or assessments which, alone or in the aggregate, could reasonably be expected to have a material adverse effect on UHS and its Subsidiaries, taken as a whole, or on the rights of Finco hereunder or with respect to the Transferred Property. (h) (i) No material Reportable Event has occurred during the five-year period prior to the date on which this representation is made or deemed made with respect to any Plan, and each Plan has complied in all material respects with the applicable provisions of ERISA and the Code. The present value of all accrued benefits under each Single Employer Plan maintained by UHS or any Commonly Controlled Entity (based on those assumptions used to fund the Plans) did not, as of the last annual valuation date prior to the date on which this representation is made or deemed made, materially exceed the value of the assets of such Plan allocable to such accrued benefits. Neither UHS nor any Commonly Controlled Entity has had a complete or partial withdrawal from any Multiemployer Plan which has resulted or could result in any material liability under ERISA, and neither UHS nor any Commonly Controlled Entity would become subject to any material liability under ERISA if UHS or any such Commonly Controlled Entity were to withdraw completely from all Multiemployer Plans as of the valuation date most closely preceding the date on which this representation is made or deemed made. No such Multiemployer Plan is in Reorganization or Insolvent. The present value (determined using actuarial and other assumptions which are reasonable in respect of the benefits provided and the employees participating) of the liability of UHS and each Commonly Controlled Entity for post retirement benefits to be provided to their current and former employees under Plans which are welfare benefit plans (as defined in Section 3(1) of ERISA) does not, in the aggregate, materially exceed the assets under all such Plans allocable to such benefits. (ii) From the Initial Closing Date and until the Guarantee Termination Date, UHS and its Subsidiaries shall comply in all material respects with the applicable provisions of ERISA and the regulations and published interpretations thereunder. (i) The audited consolidated balance sheet of UHS at December 31, 1992, and the unaudited consolidated balance sheet of UHS at September 30, 1993 together, in each case, with the related statements of income and cash flow and the related notes have been prepared in accordance with GAAP consistently applied, except as otherwise indicated in the notes to such financial statements and subject in the case of unaudited statements to changes resulting from year-end and audit adjustments. All of such financial statements fairly present the financial position or the results of operations, as the case may be, of UHS and its Subsidiaries at the dates or for the periods indicated, subject to year-end and audit adjustments in the case of unaudited statements, and (in the case of balance sheets, including the notes thereto) reflect all known liabilities, contingent or otherwise, that GAAP requires, as of such dates, to be shown, reserved against or disclosed in notes to such financial statements. 9. Covenants of UHS. (a) UHS will preserve and maintain its existence as a corporation in good standing under the laws of Delaware or any other state in which it is so incorporated. UHS will preserve and maintain its existence as a foreign corporation in good standing under the laws of each jurisdiction where its ownership, lease or operation of property or the conduct of its business requires such qualification, except where any such failure or failures to be so qualified would not, alone or in the aggregate, reasonably be expected to have a material adverse effect on its business, operations, properties, assets or condition (financial or otherwise). (b) UHS shall furnish to Finco and such other parties as Finco may designate (i) as soon as practicable and in any event within 90 days after the end of each fiscal year of UHS, a balance sheet of UHS as of the close of such fiscal year and statements of income and retained earnings and of cash flow of UHS for such fiscal year, setting forth in comparative form corresponding consolidated figures from the preceding annual audit, all in reasonable detail, certified by Arthur Andersen & Co. or such other independent certified public accountants of recognized standing as are selected by UHS and satisfactory to Finco (the scope and substance of the certificate to be reasonably satisfactory to Finco); (ii) within 45 days after the end of each of the first three fiscal quarters of each fiscal year of UHS, a consolidated balance sheet of UHS as of the close of such quarter and consolidated statements of income and retained earnings and of cash flow of UHS for the period from the beginning of such fiscal year to the end of such quarter, setting forth in each case in comparative form the corresponding consolidated figures for the corresponding period in the preceding fiscal year, all in reasonable detail and certified by the chief financial officer of UHS, subject to usual and customary year-end audit adjustments (the scope and substance of such certificate to be reasonably satisfactory to Finco); (iii) at the time of delivery of the financial statements required to be delivered by clauses (i) and (ii) of this paragraph 9(b), a certificate of the chief financial officer of UHS, to the effect that there exists no Early Amortization Event under the Pooling Agreement or any Exclusion Event under any Sale and Servicing Agreement and no condition, event or act which, with the giving of notice or lapse of time, or both, would constitute an Early Amortization Event or an Exclusion Event, or if any such Early Amortization Event, Exclusion Event, condition, event or act exists, specifying the nature thereof, the period of existence thereof and the action UHS proposes to take with respect thereto; (iv) with reasonable promptness, copies of all regular and periodic financial and other reports, if any, which UHS shall provide to its shareholders or to any lending institution pursuant to any revolving credit facility to which UHS is a party, or shall file with the SEC or any other Governmental Authority or any other governmental commission, board, bureau or agency, or any federal or state health care regulatory authority having jurisdiction over UHS, or any national securities exchange; and (v) with reasonable promptness, such further information regarding the business, affairs and financial condition of UHS as Finco may reasonably request. (c) UHS will advise Finco promptly, and in reasonable detail, (i) of any Lien asserted or claim made against any of the Transferred Property of which it obtains knowledge, (ii) of the occurrence of any breach by UHS or any UHS Entity of any of its respective representations, warranties and covenants contained herein or in any Operative Document, (iii) to the extent it has knowledge thereof, of any Exclusion Event or Early Amortization Event or of any event which, with the passage of time or giving of notice will become an Exclusion Event or Early Amortization Event, (iv) of the occurrence of any event of which it obtains knowledge, concerning (A) the business, assets, operations, property or condition (financial or otherwise) of UHS, any Guaranteed Party or any Obligor or (B) any change in any Requirement of Law governing the Purchased Receivables, in either case, alone or in the aggregate, which would reasonably be expected to have a material adverse effect on the value of the Transferred Property or the collectibility or enforceability of the Purchased Receivables (other than as a result of the credit quality) and (v) the receipt from any Governmental Authority of a Deficiency Notice with respect to the Receivables. (d) Unless prohibited by any Requirement of Law, including, without limitation, by regulations of JCAHO or AOA, Finco and its direct and indirect assignees, and its and their respective employees, agents and representatives (collectively, the "Recipients") (A) shall at all times have full and free access during normal business hours to all the books, correspondence and records of UHS insofar as they relate to the Transferred Property, and the Recipients may examine the same, take extracts therefrom and make photocopies thereof, and UHS agrees to render to the Recipients, at UHS's cost and expense, such clerical and other assistance as may be reasonably requested with regard thereto and (B) may discuss the affairs, finances and accounts of UHS with and be advised as to the same by, executive officers and independent accountants of UHS, all as any of the Recipients may reasonably deem appropriate for the purpose of verifying the accuracy of any reports or information delivered to any of the Recipients pursuant hereto or for otherwise ascertaining compliance herewith; provided, however, that Finco acknowledges that in exercising the rights and privileges conferred in this paragraph 9(b) such Recipients may, from time to time, obtain knowledge of information, practices, books, correspondence and records of a confidential nature and in which UHS has a proprietary interest; and provided, further, that UHS acknowledges that the Operative Documents and documents required to be filed on behalf of UHS and its Subsidiaries with the Securities and Exchange Commission and available to the public shall not be considered confidential for the purposes of this Agreement (all such confidential information, collectively, the "Information"). Finco agrees that the Information is to be regarded as confidential information and that the Information may be subject to laws, rules and regulations regarding patient confidentiality and agrees that (i) subject to the following sentence, it shall, and shall cause the Recipients to, retain in confidence and not disclose without the prior written consent of UHS any or all of the Information, and (ii) it will not, and will ensure that the Recipients will not, make any use whatsoever (other than for the purposes contemplated by this Agreement and the other Operative Documents or for the enforcement of any of the rights granted hereunder or thereunder) of any of the Information without the prior written consent of UHS. Notwithstanding the foregoing, a Recipient may (x) disclose Information to any Person that executes and delivers to the addressee and UHS a confidentiality agreement with respect to such Information and (y) disclose or otherwise use Information (A) to the extent that such Information is required or appropriate in any reports, statement or testimony submitted to any municipal, state, or federal regulatory body having or claiming to have jurisdiction over the Recipient or submitted to the National Association of Insurance Commissioners or similar organization or their successors, (B) to the extent such Information is required in response to any summons or subpoena or in connection with any litigation, (C) to the extent that such Information is believed to be required in order to comply with any law, order, regulation or ruling applicable to the Recipient, (D) to the extent that such Information was publicly available or otherwise known to the Recipient at the time of disclosure, (E) to the extent that such information subsequently becomes publicly available other than through any act or omission of the Recipient, (F) to the extent that such Information subsequently becomes known to the Recipient, other than through a person whom the Recipient knows to be acting in violation of his or its obligations to UHS. (e) UHS shall not, and shall not permit any Subsidiary to, change the instructions governing, or make any withdrawal from, or transfer to or from, any of the Hospital Concentration Accounts or the Master Receivables Account, except as permitted pursuant to the Operative Documents. (f) UHS will preserve all records that it is required to maintain in order to fulfill its obligations under this Guarantee until the later of (i) four years after the date upon which the Receivable to which such records relate is paid in full or (ii) seven years. (g) UHS will comply with all Requirements of Law which are applicable to the Transferred Property or any part thereof; provided, however, that UHS may contest any act, regulation, order, decree or direction in any manner which, in the reasonable opinion of Finco, shall not, alone or in the aggregate, materially and adversely affect the rights of Finco or any Interested Party in the Transferred Property or the collectibility or enforceability of the Purchased Receivables. (h) UHS will not create, permit or suffer to exist, and will defend Finco's and the Interested Parties' rights to the Total Transferred Property against, and take such other actions as are necessary to remove, any Lien, claim or right in, to or on the Total Transferred Property, and will defend the right, title and interest of Finco and the Interested Parties in and to the Total Transferred Property against the claims and demands of all Persons whomsoever, other than the Liens in respect of the Permitted Interests. (i) UHS will duly fulfill all obligations on its part to be fulfilled under or in connection with each Purchased Receivable and will do nothing to impair the rights of Finco or the Interested Parties in the Total Transferred Property. (j) UHS will not, and will not permit any of its Subsidiaries to, sell, discount or otherwise dispose of any Purchased Receivable except to Finco or the Interested Parties or as provided under the Sale and Servicing Agreements and the Pooling Agreement. (k) All financial statements prepared by Finco or any Hospital and made available to any Person other than any UHS Entity shall indicate the sale to Finco of the Purchased Receivables and other Transferred Property. (l) UHS shall not merge or consolidate with, or transfer all or substantially all its assets to, any other entity unless UHS is the entity surviving such merger or consolidation or unless (i) the surviving or transferee entity expressly assumes all of the covenants, obligations and agreements of UHS under this Guarantee in a written instrument satisfactory in form and substance to Finco, (ii) the surviving or transferee is organized under the laws of the United States and substantially all of such entity's assets are located in the United States and (iii) such merger, consolidation or other transfer shall not, in the judgment of Finco, result in an Exclusion Event or an Early Amortization Event. (m) UHS shall not, without the prior written consent of Finco, which consent shall not be unreasonably withheld, permit any Hospital to materially alter the hardware or software systems used by such Hospital in generating its reports to UHS Delaware in respect of the Purchased Receivables and Collections. (n) UHS shall cause each Guaranteed Party to duly and punctually perform in all material respects each of the terms, conditions, covenants, obligations, indemnities and warranties under all Operative Documents to which it is a party and under each agreement, contract or other arrangement relating to any Purchased Receivable in accordance with the terms thereof. (o) UHS will not hold itself out as liable for Debt of Finco. 10. Severability. Any provision of this Guarantee which is prohibited or unenforceable in any jurisdiction shall, as to such jurisdiction, be ineffective to the extent of such prohibition or unenforceability without invalidating the remaining provisions hereof, and any such prohibition or unenforceability in any jurisdiction shall not invalidate or render unenforceable such provision in any other jurisdiction. 11. Paragraph Headings. The paragraph headings used in this Guarantee are for convenience of reference only and are not to affect the construction hereof or be taken into consideration in the interpretation hereof. 12. No Waiver; Cumulative Remedies. Neither Finco nor any Interested Party shall by any act (except by a written instrument pursuant to paragraph 13 hereof), delay, indulgence, omission or otherwise be deemed to have waived any right or remedy hereunder or to have acquiesced in any Exclusion Event or Early Amortization Event or in any breach of any of the terms and conditions hereof. No failure to exercise, nor any delay in exercising, on the part of Finco or any Interested Party, any right, power or privilege hereunder shall operate as a waiver thereof. No single or partial exercise of any right, power or privilege hereunder shall preclude any other or further exercise thereof or the exercise of any other right, power or privilege. A waiver by Finco or any Interested Party of any right or remedy hereunder on any one occasion shall not be construed as a bar to any right or remedy which Finco or such Interested Party would otherwise have on any future occasion. The rights and remedies herein provided are cumulative, may be exercised singly or concurrently and are not exclusive of any rights or remedies provided by law. 13. Waivers and Amendments. None of the terms or provisions of this Guarantee may be waived, amended, supplemented or otherwise modified except by a written instrument executed by UHS, and consented to in writing by Finco. 14. Successors and Assigns; Consent to Assignment; Third Party Beneficiaries. (a) This Guarantee shall be binding upon the successors and assigns of UHS and shall inure to the benefit of Finco, the Interested Parties and their successors and assigns. (b) UHS acknowledges that all of Finco's right, title and interest in the obligations of UHS to Finco and the rights of Finco against UHS under this Guarantee have been assigned, transferred and otherwise conveyed by Finco to the Trustee, for the benefit of the Participants. UHS acknowledges that Sheffield shall assign to the Liquidity Agent, for the benefit of the Liquidity Banks all of Sheffield's right, title and interest in, to and under this Guarantee. UHS consents to such assignment and transfer by Finco to the Trustee and by Sheffield to the Liquidity Agent, and agrees that the Trustee and the Participants (or upon notice by Sheffield or the Liquidity Agent of a default under the Liquidity Agreement or the Security Agreement, and to the extent provided in the Pooling Agreement, the TRIPs Holders and the Liquidity Agent), shall be entitled to enforce the terms of this Guarantee directly against UHS, whether or not any Early Amortization Event or Exclusion Event shall have occurred. UHS further agrees that it will not take any action with respect to the Purchased Receivables (other than those actions which are consistent with its obligations hereunder and which occur in the normal course of its operations) without the prior consent of the Participants (or the TRIPs Holders and the Liquidity Agent, as the case may be) or the Trustee, and in respect of its obligations hereunder UHS will act at the direction of and in accordance with all requests and instructions of the Participants (or the TRIPs Holders and the Liquidity Agent, as the case may be) or the Trustee. Finco and UHS hereby agree that, in the event of any conflict of requests or instructions to UHS between Finco and the Participants (or the TRIPs Holders and the Liquidity Agent, as the case may be) or the Trustee, UHS will at all times act in accordance with the requests and instructions of the Participants (or the TRIPs Holders and the Liquidity Agent, as the case may be) or the Trustee and in the event of any conflict of requests or instructions among Participants, UHS shall act in accordance with the instructions of the Trustee. Finco and UHS agree that, in the event of any conflict of requests or instructions to UHS between Sheffield and the Liquidity Agent, UHS will at all times act in accordance with the requests and instructions of the Liquidity Agent. (c) Notwithstanding anything in this Paragraph 14 to the contrary, and without limitation on the rights and obligations of UHS hereunder, each of the Interested Parties shall have the rights of a third-party beneficiary hereunder. 15. Right of Set-off. Upon the occurrence and continuance of an Early Amortization Event or an Exclusion Event, each of Finco and each Interested Party is hereby irrevocably authorized at any time and from time to time, without notice to UHS, any such notice being hereby waived by UHS, to set off and appropriate and apply any and all deposits (general or special, time or demand, provisional or final), in any currency, and any other credits, indebtedness or claims, in any currency, in each case whether direct or indirect, absolute or contingent, matured or unmatured, at any time held or owing by Finco or such Interested Party to or for the credit or the account of UHS, or any part thereof in such amounts as Finco or such Interested Party may elect, on account of the liabilities of UHS hereunder, and claims of every nature and description of Finco or such Interested Party against UHS, in any currency, whether arising hereunder or under the Servicing Agreement or any Sale and Servicing Agreement, as Finco or such Interested Party may elect, whether or not Finco or such Interested Party has made any demand for payment and although such liabilities and claims may be contingent or unmatured. Finco or such Interested Party, as the case may be, shall notify UHS promptly of any such set-off made by it and the application made by it of the proceeds thereof, provided that the failure to give such notice shall not affect the validity of such set-off and application. The rights of Finco and each Interested Party under this paragraph are in addition to other rights and remedies (including, without limitation, other rights of set-off) which Finco or such Interested Party may have. 16. GOVERNING LAW. THIS GUARANTEE AND THE OBLIGATIONS OF UHS HEREUNDER SHALL BE GOVERNED BY, AND CONSTRUED AND INTERPRETED IN ACCORDANCE WITH, THE LAW OF THE STATE OF NEW YORK. 17. Notices. Except where telephonic instructions or notices are authorized herein to be given, all notices, demands, instructions and other communications required or permitted to be given to or made upon any party hereto shall be in writing and shall be personally delivered or sent by registered, certified or express mail, postage prepaid, return receipt requested, or by telecopy (with voice confirmation thereof) or telegram (with messenger delivery specified in the case of a telegram) and shall be deemed to be given for purposes of this Guarantee when such personal delivery is made or such return receipt or confirmation is received by the party giving such notice, demand, instruction or other communication. Unless otherwise specified in a notice sent or delivered in accordance with the foregoing provisions of this paragraph, notices, demands, instructions and other communications in writing shall be given to or made upon the respective parties hereto at their respective addresses (or to their respective telecopy numbers) indicated below, and, in the case of telephonic instructions or notices, by calling the telephone number or numbers indicated for such party below: If to UHS: Universal Corporate Center 367 South Gulph Road King of Prussia, Pennsylvania 19406 Attention: General Counsel Tel. No.: 215-768-3300 Telecopier No: 215-768-3318 If to Finco: UHS Receivables Corp. 27292 Calle Arroyo, Suite B San Juan Capistrano, California 92675 Attention: President Tel. No.: 714-661-9323 Telecopier No.: 714-661-9445 With a copy to: UHS Receivables Corp. c/o Universal Health Services, Inc. Universal Corporate Center 367 South Gulph Road King of Prussia, Pennsylvania 19406 Attention: General Counsel Tel. No.: 215-768-3300 Telecopier No: 215-768-3318 The above-referenced Persons may change their addresses and transmission numbers by written notice to the other Persons listed above. 18. Authority of Managing Agent. UHS hereby acknowledges that Sheffield has appointed Barclays to act as its Managing Agent. Unless otherwise instructed by Sheffield, copies of all notices, requests, demands and other documents to be delivered to Sheffield pursuant to the terms hereof shall be delivered to the Managing Agent. Unless otherwise instructed by Sheffield, all notices, requests, demands and other documents to be executed or delivered, and any action to be taken, by Sheffield pursuant to the terms hereof may be executed, delivered and/or taken by the Managing Agent. The rights and responsibilities of the Managing Agent under this Guarantee with respect to any action taken by the Managing Agent or the exercise or non- exercise by the Managing Agent of any option, right, request, judgment or other right or remedy provided to Sheffield herein or resulting or arising out of this Guarantee shall, as between the Managing Agent and Sheffield be governed by such agreements with respect thereto as may exist from time to time between them, but, as between the Managing Agent and UHS, the Managing Agent shall be conclusively presumed to be acting as agent for Sheffield with full and valid authority so to act or refrain from acting, and UHS shall not be under any obligation, or entitlement, to make any inquiry respecting such authority. 19. Waivers. (a) UHS hereby irrevocably and unconditionally waives, to the maximum extent not prohibited by law, any right it may have to claim or recover in any legal action or proceeding referred to in this paragraph any special, exemplary, punitive or consequential damages. (b) Finco hereby irrevocably and unconditionally waives, to the maximum extent not prohibited by law, any right Finco may have to claim or recover in any legal action or proceeding relating to this Guarantee any special, exemplary, punitive or consequential damages; provided that the waiver contained in this paragraph 19(b) shall not extend to any right to claim or recover from UHS any special, exemplary, punitive or consequential damages for which Finco is liable to any Person. 20. Acknowledgements. UHS hereby acknowledges with respect to the transactions contemplated by the Operative Documents that: (a) it has been advised by counsel in the negotiation, execution and delivery of this Guarantee; (b) no Interested Party has any fiduciary relationship to UHS or the Hospital and the relationship between any Interested Party, on the one hand, and UHS or any Hospital, on the other hand, is solely that of debtor and creditor; and (c) no joint venture exists between UHS or any Hospital on the one hand, and any Interested Party on the other. 21. WAIVERS OF JURY TRIAL. UHS AND, BY FINCO'S ACCEPTANCE HEREOF, FINCO AND THE INTERESTED PARTIES HEREBY IRREVOCABLY AND UNCONDITIONALLY WAIVE TRIAL BY JURY IN ANY LEGAL ACTION OR PROCEEDING RELATING TO THIS GUARANTEE AND FOR ANY COUNTERCLAIM THEREIN. 22. No Bankruptcy Petition. UHS covenants and agrees that prior to the date which is one year and one day after the payment in full of the Sheffield Certificate and all TRIPs issued by Finco and all other amounts due under or in connection with the Operative Documents it will not institute against, or join any other Person in instituting against, Finco, Sheffield or any Hospital any bankruptcy, reorganization, arrangement, insolvency or liquidation proceedings, or other proceedings under any federal or state bankruptcy or similar law. 23. SUBMISSION TO JURISDICTION; VENUE; WAIVER OF JURY TRIAL; SERVICE OF PROCESS. UHS (FOR ITSELF AND ITS SUCCESSORS AND ASSIGNS) HEREBY IRREVOCABLY SUBMITS, FOR ITSELF AND ITS PROPERTY, TO THE JURISDICTION OF THE STATE COURTS OF THE STATE OF NEW YORK AND TO THE JURISDICTION OF THE UNITED STATES DISTRICT COURT FOR THE SOUTHERN DISTRICT OF NEW YORK, FOR THE PURPOSES OF ANY SUIT, ACTION OR OTHER PROCEEDING ARISING OUT OF OR BASED UPON THIS GUARANTEE OR THE SUBJECT MATTER HEREOF BROUGHT BY FINCO OR ANY INTERESTED PARTY. UHS (FOR ITSELF AND ITS SUCCESSORS AND ASSIGNS) TO THE EXTENT PERMITTED BY ANY REQUIREMENTS OF LAW (A) HEREBY WAIVES, AND AGREES NOT TO ASSERT, BY WAY OF MOTION, AS A DEFENSE, OR OTHERWISE, IN ANY SUCH SUIT, ACTION OR PROCEEDING BROUGHT IN ANY SUCH COURT, ANY CLAIM THAT IT IS NOT SUBJECT PERSONALLY TO THE JURISDICTION OF THE ABOVE-NAMED COURTS, THAT ITS PROPERTY IS EXEMPT OR IMMUNE FROM ATTACHMENT OR EXECUTION, THAT THE SUIT, ACTION OR PROCEEDING IS BROUGHT IN AN INCONVENIENT FORUM, THAT THE VENUE OF THE SUIT, ACTION OR PROCEEDING IS IMPROPER OR THAT THIS GUARANTEE OR THE SUBJECT MATTER HEREOF MAY NOT BE ENFORCED IN OR BY SUCH COURT, AND (B) HEREBY WAIVES THE RIGHT TO ASSERT IN ANY SUCH ACTION, SUIT OR PROCEEDING ANY OFFSETS OR COUNTERCLAIMS EXCEPT COUNTERCLAIMS THAT ARE COMPULSORY OR OTHERWISE ARISE FROM THE SAME SUBJECT MATTER. UHS HEREBY AGREES THAT SERVICE OF ANY AND ALL PROCESS AND OTHER DOCUMENTS ON UHS MAY BE EFFECTED BY CERTIFIED OR REGISTERED MAIL (OR ANY SUBSTANTIALLY SIMILAR FORM OF MAIL) TO ITS ADDRESS AS SET FORTH IN PARAGRAPH 17 AND SUCH SERVICE SHALL CONSTITUTE VALID AND EFFECTIVE SERVICE AGAINST UHS. UHS AGREES THAT ITS SUBMISSION TO JURISDICTION AND CONSENT TO SERVICE OF PROCESS BY MAIL IN ANY SUCH ACTION, SUIT OR PROCEEDING SHALL BE CONCLUSIVE, AND MAY BE ENFORCED IN ANY OTHER JURISDICTION (A) BY SUIT, ACTION OR PROCEEDING ON THE JUDGMENT, A CERTIFIED OR TRUE COPY OF WHICH SHALL BE CONCLUSIVE EVIDENCE OF THE FACT AND THE AMOUNT OF INDEBTEDNESS OR LIABILITY THEREIN DESCRIBED OR (B) IN ANY OTHER MANNER PROVIDED BY OR PURSUANT TO THE LAWS OF SUCH OTHER JURISDICTION, PROVIDED, HOWEVER, THAT ANY OF FINCO OR ANY INTERESTED PARTY MAY AT ITS OPTION BRING SUIT, OR INSTITUTE OTHER JUDICIAL PROCEEDINGS AGAINST UHS OR ANY OF ITS ASSETS IN ANY STATE OR FEDERAL COURT OF THE UNITED STATES OR OF ANY COUNTRY OR PLACE WHERE THE SERVICER OR UHS OR SUCH ASSETS MAY BE FOUND. 24. Survival. The representations and warranties of UHS contained herein, and the provisions of Paragraph 23, shall survive the execution and delivery of this Guarantee and the Guarantee Termination Date. IN WITNESS WHEREOF, UHS has caused this Guarantee to be duly executed and delivered in New York, New York by its proper and duly authorized officer as of the day and year first above written. UNIVERSAL HEALTH SERVICES, INC. By: _______________________________ Title: Acknowledged By: UHS RECEIVABLES CORP. By: _______________________________ Title: EXHIBIT 10.20 AMENDMENT NO. 1 TO 1989 NON-EMPLOYEE DIRECTOR STOCK OPTION PLAN The 1989 Non-Employee Director Stock Option Plan is amended by deleting Section 8 thereof and replacing it with the following: "8. Automatic Grant of Options. Each member of the Company's Board of Directors who is neither an employee nor an officer of the Company serving on the date of the approval of Amendment No. 1 to the Plan by the Board of Directors is automatically granted on such approval date without further action by the Board, an option to purchase two thousand five hundred (2,500) shares of the Company's Class B Common Stock. Each person who is first elected to the Board of Directors after the date of approval of Amendment No. 1 to the Plan by the Board of Directors and who is at that time neither an employee nor an officer of the Company shall be automatically granted, on the date of such election and without further action by the Board of Directors, an option to purchase two thousand five hundred (2,500) shares of the Company's Class B Common Stock." EXHIBIT 10.21 AMENDMENT NO. 1 TO 1992 STOCK BONUS PLAN The 1992 Stock Bonus Plan is amended by deleting Section 3.5 thereof and replacing it with the following: "3.5. Composition of Bonuses. Eligible Key Employees other than officers shall elect to take from the mandatory minimum of 20% up to 100% of their annual Bonus in Stock Bonuses, and the Committee shall set forth in the related Stock Bonus Agreement the percentage composition of the Stock Bonus that the Key Employee chooses, the corresponding amount of Stock Bonus Premium that the Key Employee is entitled to and any other terms, conditions and limitations that are applicable to each particular Stock Bonus and Stock Bonus Premium and that are in accordance with provisions of this Plan. Key Employees other than officers may make an election to take more than the mandatory minimum of 20% of their Bonus in the form of a Stock Bonus any time on or before the Grant Date. Officers shall automatically be awarded 20% of their annual Bonus in Stock Bonuses." EXHIBIT 10.22 UNIVERSAL HEALTH SERVICES 1994 EXECUTIVE INCENTIVE PLAN 1. Purpose. The purpose of the Plan is to foster the ability of the Company and its Affiliates to attract, retain and motivate highly qualified senior management and other executive officers of the Company and its Affiliates through the payment of performance-based incentive bonuses. 2. Definitions. Wherever used herein, the masculine includes the feminine, the singular includes the plural, and the following terms have the following meanings unless a different meaning is clearly required by the context. (a) "Affiliate" means any entity (whether or not incorporated) which is required to be aggregated with the Company under Section 414(b) or 414(c) of the Internal Revenue Code of 1986 (the "Code"). (b) "Board" means the Board of Directors of the Company. (c) "Company" means Universal Health Services, Inc. (d) "Committee" means the administrative committee appointed by the Board in accordance with the provisions hereof. (e) "Compensation" means the base salary of a Participant for a calendar year, determined as of the beginning of the calendar year and without regard to increases, if any, made during the calendar year. (f) "Net Income" means the net income of the Company or of an Affiliate, division, hospital or other units, as determined by the Committee. (g) "Participant" means, with respect to any calendar year, an individual who is designated by the Committee as eligible to receive an incentive bonus for the year upon achievement of the applicable performance conditions. (h) "Plan" means the incentive compensation plan as set forth herein and any amendments thereto. (i) "Return on Capital" means Net Income divided by the quarterly average net capital of the Company or of an Affiliate, division, hospital or other unit, as determined by the Committee. 3. Administration. The Plan will be administered by a committee consisting of at least two directors appointed by and serving at the pleasure of the Board. Each member of the Committee will be a "disinterested director" within the meaning and for the purposes of Rule 16b-3 issued by the Securities and Exchange Commission under the Securities Exchange Act of 1934, and an "outside director" within the meaning of Section 162(m) of the Code. Subject to the provisions of the Plan, the Committee, acting in its sole and absolute discretion, will have full power and authority to interpret, construe and apply the provisions of the Plan and to take such action as may be necessary or desirable in order to carry out the provisions of the Plan. A majority of the members of the Committee will constitute a quorum. The Committee may act by the vote of a majority of its members present at a meeting at which there is a quorum or by unanimous written consent. The Committee will keep a record of its proceedings and acts and will keep or cause to be kept such books and records as may be necessary in connection with the proper administration of the Plan. The Company shall indemnify and hold harmless each member of the Committee and any employee or director of the Company or an Affiliate to whom any duty or power relating to the administration or interpretation of the Plan is delegated from and against any loss, cost, liability (including any sum paid in settlement of a claim with the approval of the Board), damage and expense (including legal and other expenses incident thereto) arising out of or incurred in connection with the Plan, unless and except to the extent attributable to such person's fraud or wilful misconduct. 4. Eligibility. Annual incentive bonuses may be awarded under the Plan to any person who is a member of the senior management of the Company and to other executive officers of the Company or an Affiliate. Subject to the provisions hereof, the Committee will select the persons to whom incentive bonuses may be awarded for any calendar year and will fix the terms and conditions of each such award. 5. Annual Performance Bonus. The amount of a Participant's incentive bonus for a year will be equal to the Participant's base bonus amount (described in (a) below) multiplied by the applicable performance factor (described in (b) below). (a) Base Bonus Amount. For each calendar year, the Committee will establish the amount of bonus ("base bonus amount") which will be payable to a Participant if the performance goals for the year are met. A Participants' base bonus amount will be expressed as a percentage of the Participant's Compensation, which percentage may vary from year to year and may be different for each Participant or class of Participants, all as determined by the Committee. (b) Applicable Performance Factor. For each calendar year, the Committee will establish performance targets based upon the following business criteria: increase in Net Income from the preceding calendar year, and Return on Capital. As to any Participant or class of Participants, the performance targets may be based upon either or both of such criteria and on Company-wide figures, local or divisional figures, or a combination thereof. If a Participant's performance targets for a calendar year are achieved, then the Participant will be entitled to receive an incentive bonus equal to 100% of the Participant's base bonus amount for the year. No incentive bonus will be payable for a year if neither performance target is achieved, and a performance bonus (which may be greater than 100% of a Participant's base bonus amount) may be payable if either or both performance targets are exceeded for a calendar year, all in accordance with a Company performance matrix established by the Committee. (c) Performance Conditions to be Pre-Established. Performance targets, as well as percentage factors used to determine base bonus amounts and performance percentages with respect to any calendar year will be established in writing by the Committee before the beginning of that calendar year; provided, however, that the Committee may establish any one or more of said factors during the calendar year if and to the extent permitted by the Treasury Department pursuant to Section 162(m) of the Code. (d) Payment of Stock. Notwithstanding anything to the contrary contained in the Company's 1992 Stock Bonus Plan, an amount equal to 20% of a Participant's incentive bonus for a calendar year will be payable in the form of Common Stock of the Company and no election may be made by the Participant to receive a greater portion of his or her incentive bonus in such form. Subject to the provisions of the 1992 Stock Bonus Plan, a Participant will be entitled to receive an additional bonus, payable in the form of shares of Common Stock of the Company, equal to 4% of the Participant's incentive bonus (determined without regard to this section). (e) Limitation on Amount of Incentive Bonuses. Notwithstanding anything to the contrary contained herein, the maximum incentive bonus which any Participant may earn hereunder for any calendar year is an amount equal to 125% of the Participant's Compensation for that calendar year (130% after taking into account the stock bonus premium described in the preceding subsection). For purposes of the preceding sentence, a Participant's Compensation for any calendar year will be disregarded to the extent it is greater than 25% of the Participant's Compensation (determined with regard to this sentence) for the preceding calendar year. 6. Calculation and Payment of Performance Bonus. As soon as practicable after the end of each calendar year, the Committee, based upon the Company's financial statements for the year, will determine the amount, if any, of the incentive bonus payable to each Participant for that calendar year. A Participant's incentive bonus for a calendar year will be paid to the Participant at such time as the Committee determines; provided, however, that the Committee may authorize an advance payment based upon its preliminary calculations, and provided further that the Committee may establish a procedure pursuant to which payment of all or a portion of a Participant's incentive bonus for a calendar year will be deferred. Unless the Committee determines otherwise, no incentive bonus will be payable to a Participant with respect to a calendar year if the Participant's employment with the Company and its Affiliates terminates at any time prior to the payment thereof. 7. Amendment or Termination. The Board may amend or terminate the Plan at any time. 8. Governing Law. The Plan and each award made under the Plan shall be governed by the laws of the State of Delaware, it being understood, however, that incentive bonuses awarded and paid under the Plan are intended to constitute "performance-based compensation" within the meaning of Section 162(m) of the Code, and the provisions of the Plan and any award made hereunder will be interpreted and construed accordingly. 9. No Rights Conferred. Nothing contained herein will be deemed to give any person any right to receive an incentive bonus award under the Plan or to be retained in the employ or service of the Company or any Affiliate. 10. Decisions of Board or Committee to be Final. Any decision or determination made by the Board pursuant to the provisions hereof and, except to the extent rights or powers under the Plan are reserved specifically to the discretion of the Board, all decisions and determinations of the Committee hereunder, shall be final and binding. EXHIBIT 11 UNIVERSAL HEALTH SERVICES, INC. and Subsidiaries Computation of Earnings Per Share Year Ended December 31, ---------------------------------------- 1993 1992 1991 ---- ---- ---- Weighted Average Shares: Class A common 1,211,850 1,386,267 2,567,652 Class B common 12,276,146 12,148,177 10,814,566 Class C common 121,755 149,165 262,001 Class D common 28,648 49,853 70,383 ---------- ---------- ---------- Total 13,638,399 13,733,462 13,714,602 Less: Effect of shares repurchased (105,795) (58,274) - Less: Incremental number of shares of restricted stock excluded from EPS computation (46,893) (59,096) (87,829) Effect of shares issued 10,250 26,788 18,499 ---------- ---------- ---------- 13,495,961 13,642,880 13,645,272 Common Stock Equivalents: Assumed conversion of 7 1/2 % convertible debentures issued in April 1983 1,271,471 1,274,653 1,275,256 Assumed conversion of options to purchase common stock 51,101 52,784 71,506 ---------- ---------- ---------- Weighted average shares - fully diluted 14,818,533 14,970,317 14,992,034 ========== ========== ========== Income: $24,010,645 $20,019,839 $20,319,444 Interest expense, net of tax effect, on assumed conversion of 7 1/2% convertible debentures $ 1,392,404 $ 1,420,699 $ 1,417,894 ----------- ----------- ----------- Income Applicable to Common Stock - Fully Diluted $25,403,049 $21,440,538 $21,737,338 =========== =========== =========== Earnings per Common and Common Equivalent Share: Fully diluted - $1.71 $1.43 $1.45 =========== =========== =========== EXHIBIT 22 SUBSIDIARIES OF THE COMPANY JURISDICTION NAME OF SUBSIDIARY OF INCORPORATION ..------------------ ---------------- ASC of Canton, Inc........................................ Georgia ASC of Littleton, Inc..................................... Colorado ASC of Midwest City, Inc.................................. Oklahoma ASC of Las Vegas, Inc..................................... Nevada ASC of New Albany, Inc.................................... Indiana ASC of Palm Springs, Inc.................................. California ASC of Ponca City, Inc.................................... Oklahoma ASC of Springfield, Inc................................... Missouri ASC of St. George, Inc.................................... Utah The BridgeWay, Inc........................................ Arkansas Children's Hospital of McAllen, Inc....................... Texas Comprehensive Occupational and Clinical Health, Inc....... Delaware Dallas Family Hospital, Inc............................... Texas Del Amo Hospital, Inc..................................... California Doctors' General Hospital, Ltd. (d/b/a/ Universal Medical Center)....................... Florida Doctors' Hospital of Hollywood, Inc....................... Florida Forest View Psychiatric Hospital, Inc..................... Michigan Glen Oaks Hospital, Inc................................... Texas Health Care Finance & Construction Corp................... Delaware HRI Clinics, Inc.......................................... Massachusetts HRI Hospital, Inc......................................... Massachusetts Hope Square Surgical Center, L.P. (d/b/a Hope Square Surgical Center)..................... Delaware La Amistad Residential Treatment Center, Inc.............. Florida McAllen Medical Center, Inc............................... Texas Meridell Achievement Center, Inc.......................... Texas Merion Building Management, Inc........................... Delaware New Albany Outpatient Surgery, L.P. (d/b/a Surgical Center of New Albany)................... Delaware Panorama Community Hospital, Inc.......................... Delaware Relational Therapy Clinic, Inc............................ Louisiana River Crest Hospital, Inc................................. Texas River Oaks, Inc........................................... Louisiana .Southwest Dallas Hospital, Inc............................ Texas Sparks Family Hospital, Inc............................... Nevada Sparks Reno Partnership, L.P. (d/b/a Sparks Family Hospital).......................... Delaware St. George Surgical Center, L.P. (d/b/a St. George Surgery Center)....................... Delaware Surgery Center of Canton, L.P............................. Delaware Surgery Center of Littleton, L.P. (d/b/a Littleton Day Surgery Center).................... Delaware Surgery Center of Midwest City, L.P. (d/b/a MD Physicians Surgicenter of Midwest City)....... Delaware Surgery Center of Odessa, L.P. (d/b/a Surgery Center of Texas)......................... Delaware Surgery Center of Ponca City, L.P. (d/b/a Outpatient Surgical Center of Ponca City)........ Delaware JURISDICTION NAME OF SUBSIDIARY OF INCORPORATION - ------------------ ---------------- Surgery Center of Springfield, L.P. (d/b/a Surgery Center of Springfield)................... Delaware Tonopah Health Services, Inc.............................. Nevada Turning Point Care Center, Inc. (d/b/a Turning Point Hospital).......................... Georgia Two Rivers Psychiatric Hospital, Inc...................... Delaware UHS of Auburn, Inc. (d/b/a Auburn General Hospital)......................... Washington UHS of Belmont, Inc....................................... Delaware UHS of Bethesda, Inc...................................... Delaware District of UHS of Columbia, Inc...................................... Columbia UHS Croyden Limited....................................... United Kingdom UHS of DeLaRonde, Inc. (d/b/a Chalmette Medical Center)........................ Louisiana UHS of Delaware, Inc...................................... Delaware UHS of Florida, Inc....................................... Florida UHS Holding Company, Inc.................................. Nevada UHS International, Inc.................................... Delaware UHS International Limited................................. United Kingdom UHS Las Vegas Properties, Inc............................. Nevada UHS Leasing Company, Inc.................................. Delaware UHS Leasing Company, Limited.............................. United Kingdom UHS of London, Inc........................................ Delaware UHS London Limited........................................ United Kingdom UHS of Massachusetts, Inc. (d/b/a The Arbour)...................................... Massachusetts UHS of New Orleans, Inc. (d/b/a Chalmette Hospital).............................. Louisiana UHS of Odessa, Inc........................................ Texas UHS of Plantation, Inc.................................... Florida UHSR Corporation.......................................... Delaware UHS Receivables Corp...................................... Delaware UHS of River Parishes, Inc. (d/b/a River Parishes Hospital)......................... Louisiana UHS of Riverton, Inc...................................... Washington UHS of Shreveport, Inc. (d/b/a Doctors' Hospital of Shreveport)................. Louisiana UHS of Springfield, Inc................................... Missouri UHS of Vermont, Inc....................................... Vermont Universal HMO, Inc........................................ Nevada Universal Health Network, Inc............................. Nevada Universal Health Pennsylvania Properties, Inc............. Pennsylvania Universal Health Recovery Centers, Inc. (d/b/a UHS KeyStone Center)............................. Pennsylvania Universal Health Services of Cedar Hill, Inc.............. Texas Universal Health Services of Concord, Inc................. California Universal Health Services of Inland Valley, Inc. (d/b/a Inland Valley Regional Medical Center)........... California Universal Health Services of Nevada, Inc. (d/b/a Valley Hospital Medical Center).................. Nevada Victoria Regional Medical Center, Inc..................... Texas Wellington Regional Medical Center Incorporated........... Florida Westlake Medical Center, Inc.............................. California EXHIBIT 24 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports, included in this Form 10-K, into the Company's previously filed Registration Statements on Forms S-8 (No. 2-80903), (No. 2-98913), (No. 33-43276), (No. 33-49426), (No. 33-49428), and (No. 33-51671). ARTHUR ANDERSEN & CO. Philadelphia, PA March 30, 1994
26172_1993.txt	26172	1993	ITEM 1. BUSINESS ~~~~~~~ ~~~~~~~~ OVERVIEW ~~~~~~~~ Cummins Engine Company, Inc. ("Cummins" or "the Company") is a leading worldwide designer and manufacturer of fuel-efficient diesel engines and related products. Engines ranging from 76 to 2,000 horsepower serve a wide variety of equipment in Cummins' key markets: heavy-duty truck, midrange truck, power generation, bus and light commercial vehicles, industrial products, government and marine. In addition, Cummins produces strategic components and subsystems critical to the engine, including filters, turbochargers and electronic control systems. Cummins sells its products to original equipment manufacturers ("OEMs"), distributors and other customers worldwide and conducts manufacturing, sales, distribution and service activities in most areas of the world. In 1993, approximately 56 percent of net sales were made in the United States. Major international markets include the United Kingdom and Europe (14 percent of net sales); Asia, the Far East and Australia (13 percent of net sales); and Mexico and South America (8 percent of net sales). Cummins' growing presence in international markets and its significant investment in emissions technology have created opportunities for cooperative arrangements with vertically integrated manufacturers worldwide. In addition to agreements with major US equipment manufacturers, Cummins recently developed alliances with Scania of Sweden to develop a fuel system for heavy-duty diesel engines; with Tata Engineering and Locomotive Company ("TELCO") of India to manufacture Cummins B Series engines for TELCO trucks; and with Komatsu of Japan to produce Cummins B Series engines in Japan and to adapt for production high-horsepower Komatsu-designed engines in the United States. BUSINESS MARKETS ~~~~~~~~~~~~~~~~ Heavy-duty Truck ~~~~~~~~~~~~~~~~ The Company has a complete product line of 8-, 10-, 11- and 14-litre diesel engines that range from 260 to 500 horsepower serving the heavy-duty truck market. Cummins' heavy-duty diesel engines are offered as standard or optional power by most major heavy-duty truck manufacturers in North America. The seven largest US heavy-duty truck OEMs produced approximately 98 percent of the heavy-duty trucks sold in North America in 1993. The loss of certain of these customers could have an adverse effect on the Company's business. The Company's largest customer for heavy-duty truck engines in 1993 was Navistar International Corporation, which represented 7.5 percent of the Company's 1993 net sales. In 1993, the Company accounted for 62.7 percent of Navistar's heavy-duty engine purchases. In the heavy-duty truck market, the Company competes with independent engine manufacturers as well as truck producers who manufacture diesel engines for their own products. Certain of these integrated manufacturers also are customers of the Company. In North America, the Company's primary competitors in the heavy-duty truck engine market are Caterpillar, Inc., Detroit Diesel Corporation and Mack Trucks, Inc. The Company's principal competitors in international markets vary from country to country, with local manufacturers generally predominant in each geographic market. Other diesel engine manufacturers in international markets include Mercedes Benz, AB Volvo, Renault Vehicles Industriels, Iveco Diesel Engines, Hino Motors, Ltd., Mitsubishi Heavy Industries, Ltd., Isuzu Motors, Ltd., DAF Group N.V. and SAAB-Scania A.B. The North American heavy-duty truck market is affected significantly by the overall level of economic activity. In 1993, North American heavy-duty truck production grew by 34 percent from the previous year's level. Production was 174,000 trucks in 1993 compared to 130,000 in 1992 and 96,000 in 1991. The Company's share of the North American heavy-duty truck engine market was 35 percent in 1993, which was significantly higher than its nearest competitor. The Company's share of the North American heavy-duty truck engine market was 37 percent in 1992 and 38 percent in 1991. While the European truck market continued at depressed levels during 1993, the UK market began to recover, producing at total of 13,300 units, compared to 10,000 in 1992. Cummins' share of the UK market was approximately 14 percent in 1993. The Mexican heavy-duty truck market declined approximately 18 percent in 1993, from 7,900 units in 1992 to 6,500 units in 1993, due primarily to high interest rates and restrictive economic policies imposed by the Mexican government to reduce inflation. The Company's share of this market was nearly 80 percent in 1993. Midrange Truck ~~~~~~~~~~~~~~ The Company has a product line of diesel engines ranging from 160 to 300 horsepower serving midrange and intercity delivery truck customers. The Company entered the North American midrange diesel engine truck market in 1990. Production of medium-duty trucks in North America grew 5 percent in 1993 from 105,000 units in 1992 to 110,000 units in 1993. The Company's share of the market in 1993 was 30 percent, a major factor of which was sales to Ford Motor Company. In 1993, Ford completed its introduction of the Company's B and C Series engines as exclusive diesel power in its medium-duty truck line. Ford was the Company's largest customer for midrange engines for this market in 1993, representing approximately 5 percent of the Company's net sales. The Company also sells its B and C Series engines and engine components outside North America to midrange truck markets in Asia, Europe and South America. Cummins and TELCO, India's largest truck manufacturer, formed a joint venture in 1993 to manufacture B Series engines in India for TELCO vehicles. Cummins engines will be phased into these vehicles beginning in 1994, with production to begin at the joint venture's plant in 1995. In the midrange truck market, the Company competes with independent engine manufacturers as well as truck producers who manufacture diesel engines for their own products. Certain of these integrated manufacturers also are customers of the Company. Primary engine competitors in the midrange truck market in North America are Navistar International Corporation and Caterpillar, Inc. The Company's principal competitors in international markets vary from country to country, with local manufacturers generally predominant in each geographic market. Other diesel engine manufacturers in international markets include Mercedes Benz, AB Volvo, Renault Vehicles Industriels, Iveco Diesel Engines, Hino-Motors Ltd., Mitsubishi Heavy Industries, Ltd., Isuzu Motors, Ltd., DAF Group N.V., SAAB-Scania A.B., Perkins Engines Ltd., and Nissan. Power Generation ~~~~~~~~~~~~~~~~ In 1993, power generation continued to represent over 20 percent of the Company's net sales. Products include the complete line of Cummins' engines, Onan's gasoline engines, generator sets and switches and Newage alternators. These products serve the stationary power, mobile and alternator markets. In stationary power, Onan's industrial business and Cummins' G-drive groups provide electrical and engine power generation products and services to essentially all major markets worldwide. The product line is the broadest in the industry, ranging from 5 to 1500 kW. In the mobile business, Onan is a leading supplier of power generation sets for the recreational vehicle market in the United States. As part of a Department of Energy contract, Onan recently was selected to develop a 35 kW auxiliary power unit for passenger hybrid electric vehicles. Bus and Light Commercial Vehicles ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ This market includes Cummins-powered pickup trucks, school buses, urban transit buses, delivery trucks and recreational vehicles. In 1993, sales increased almost 20 percent over the 1992 level. Chrysler, which offers the Cummins B Series engines in its Dodge Ram pickup truck, was the Company's largest customer for midrange engines in this market, representing 5.4 percent of the Company's net sales in 1993. Cummins' share of the US transit bus market was 40 percent in 1993, due in part to the introduction of the C Series engines and Cummins' natural gas L10 engine. Cummins' natural gas engine was the first natural gas fueled heavy-duty engine certified by the California Air Resources Board. In 1993, sales of engines for school buses, recreational vehicles and light commercial vehicles, including delivery trucks and panel vans, also were strong. In these markets, the Company also competes with both independent manufacturers of diesel engines and vehicle producers who manufacture diesel engines for their own products. Primary manufacturers of diesel engines for the bus and light commercial truck markets are Detroit Diesel Corporation, General Motors Corporation, Navistar International Corporation, Perkins Engines Ltd., MAN, AB Volvo, Mercedes Benz and SAAB-Scania A.B. Industrial Products ~~~~~~~~~~~~~~~~~~~ Cummins' engines power more than 3,000 models of equipment for the construction, logging, mining, agricultural, petroleum and rail markets. Worldwide sales of Cummins products to this market increased approximately 3 percent in 1993, compared to 1992. The increase in sales was primarily in international markets. Industrial markets are recovering modestly in the United States. Cummins introduced the B Series engine at 200 horsepower in 1993. It was the first engine to be introduced to the marketplace which meets the stringent 1996 California off-highway emissions regulations. In 1993, Cummins and Komatsu formed joint ventures to produce Cummins' B Series engines in Japan and Komatsu's 30-litre engine in the United States. Production at both joint venture sites is expected to commence in 1996. Government ~~~~~~~~~~ Cummins sells engines for a variety of military and civilian applications. Government sales continued to decline in 1993 from a peak of $236 million in 1991. The Company believes that this market may decline further due to reductions in US military expenditures. Cummins Military Systems Co. ("CMSC"), which specialized in rebuilt military vehicles, was one of two bidders competing for a production contract to remanufacture up to 10,000 US Army 2-1/2 ton trucks. CMSC was unsuccessful in its bid and, as a result, the Company has closed CMSC and will dispose of its assets. Marine ~~~~~~ Product applications span 76 to 1,400 horsepower for recreational, commercial and military markets. In 1993, marine sales were approximately 6 percent higher than in 1992, with Asia representing the most rapidly growing market for these products. Fleetguard, Holset and Cummins Electronics ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ Sales of filters, turbochargers and electronic systems represented approximately 11 percent of the Company's sales in 1993, compared to approximately 12 percent in 1992 and 1991. Effective at the beginning of the third quarter of 1993, the Company transferred its 80-percent interest in McCord Heat Transfer Corp., to Behr America Holding, Inc., for a 35-percent interest in Behr America Holding, Inc., a company that also holds all of the North American operations of Julius F. Behr of Germany. The Company's minority interest in Behr America Holding, Inc., has been reported as an unconsolidated company since the third quarter of 1993. Fleetguard is a leading manufacturer of products for the North American heavy-duty filter industry. Its products also are produced and sold in international markets, including Europe, Mexico, India, Australia and the Far East. Holset's products also are sold worldwide. In 1993, Holset introduced a new viscous damper and coupling design, as well as an air compressor for the heavy-duty market. In 1993, Holset also completed the acquisition of Kompressorenbau Bannewitz GmbH near Dresden, Germany, which produces turbochargers for high-horsepower diesel engines. Cummins Electronics provides controls for Cummins' engines and on- board business information and specialized electronics systems for Cummins' customers. BUSINESS OPERATIONS ~~~~~~~~~~~~~~~~~~~ Research and Development ~~~~~~~~~~~~~~~~~~~~~~~~ Cummins conducts an extensive research and engineering program to achieve product improvements, innovations and cost reductions, as well as to satisfy legislated emissions requirements. As disclosed in Note 1 to the Consolidated Financial Statements, research and development expenditures approximated $158 million in 1993, $129 million in 1992 and $99 million in 1991. Sales and Distribution ~~~~~~~~~~~~~~~~~~~~~~ While the Company has several supply contracts for its products in on- and off-highway markets, much of its business is done on open purchase orders. These purchase orders usually may be canceled on reasonable notice without cancellation charges. Therefore, while incoming orders generally are indicative of anticipated future demand, the actual demand for the Company's products may change at any time. The Company's products compete on a number of factors, including price, delivery, quality, warranty and service. Cummins believes that its continued focus on cost, quality and delivery, its extensive technical investment, its full product line and customer-led service and support programs are key elements of its competitive position. The Company's major markets typically experience modest seasonal declines in production during the third quarter of the year, which has an effect on the demand for Cummins' products during that quarter of each year. Cummins warrants its engines, subject to proper use and maintenance, against defects in factory workmanship or materials for either a specified time period or mileage or hours of use. Warranty periods vary by engine family and market segment and are subject to competitive pressures. Cummins sells engines, parts and related products through distributorships worldwide. The Company believes its distribution system is an important part of its marketing strategy and competitive position. Most of its North American distributors are independently owned and operated. The Company has agreements with each of these distributors, which typically are for a term of three years, subject to certain termination provisions. Upon termination or expiration of the agreement, the Company is obligated to purchase various assets of the distributorship. Through an arrangement with Citicorp Dealer Finance, a unit of Citicorp North America, the Company also guarantees certain financing obligations of some of these distributors. There are approximately 5,700 locations in North America, primarily owned and operated by OEMs or their dealers, at which Cummins-trained service personnel and parts are available to maintain and repair Cummins engines. The Company's parts distribution centers are located strategically throughout the world. Supply ~~~~~~ The Company machines many of the components used in its engines, including blocks, heads, rods, turbochargers, crankshafts and fuel systems. Cummins has adequate sources of supply of raw materials and components required for its operations. International ~~~~~~~~~~~~~ Cummins sells its products to major international firms outside North America by exports directly from the United States and shipments from foreign facilities (operated through subsidiaries, affiliates, joint ventures or licensees) which manufacture and/or assemble Cummins' products. The Company's international operations are subject to risks such as currency controls and fluctuations, import restrictions and changes in national governments and policies. The Company has entered into license agreements that provide for the manufacture and sale of licensed engines and engine components for use in certain territories prescribed in the respective agreements. In addition, licensees produce engines and engine components which are available to help meet demand for Cummins' products in the rest of the world. The paragraph under Item 1, "Overview", on page 2 on international markets and operations is incorporated herein by reference. Employment ~~~~~~~~~~ At December 31, 1993, Cummins employed 23,600 persons worldwide, approximately 10,200 of whom are represented by various unions. The Company has labor agreements covering employees in North America, South America and the United Kingdom. In 1993, members of the Diesel Workers Union in Southern Indiana approved an 11-year contract. Production workers at Atlas, Inc., in Fostoria, Ohio, and office and technical workers in Southern Indiana also ratified 3-year contracts during 1993. ENVIRONMENTAL COMPLIANCE ~~~~~~~~~~~~~~~~~~~~~~~~~ Product Environmental Compliance ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ Cummins' engines are subject to extensive statutory and regulatory requirements that directly or indirectly impose standards with respect to emissions and noise. Cummins' products comply with emissions standards that the US Environmental Protection Agency ("EPA") and California Air Resources Board ("CARB") have established for emissions for on-highway diesel engines produced through 1994. Cummins' ability to comply with these and future emissions standards is an essential element in maintaining its leadership position in the North American heavy-duty truck and other automotive markets, as well as in supplying other markets. The Company will make significant capital and research expenditures to comply with these standards. Failure to comply could result in adverse effects on future financial results. Cummins has completed successfully the certification of its 1994 on- highway products, which include both midrange and heavy-duty engines. All of these products underwent extensive laboratory and field testing prior to their release. Emissions Averaging, Banking and Trading regulations were promulgated by the EPA in July 1990. By selling 1991, 1992 and 1993 model year engines with emissions levels below applicable standards and by introducing several of the Company's 1994 configurations early, Cummins generated both nitric oxide and particulate matter credits. Certain of the Company's 1994 products which do not meet 1994 emissions standards will be sold by using these emissions credits. The next major change in emissions requirements for heavy-duty diesel engines occurs in 1998, when the nitric oxide standard is lowered from 5.0 to 4.0 g/bhp-hr. Design and development activity toward meeting this standard is well underway. In 1996, the particulate matter standard for engines used in urban buses changes from 0.07 to 0.05 g/bhp-hr. Contained in the environmental regulations are several means for the EPA to ensure and verify compliance with emissions standards. Two of the principal means are tests of new engines as they come off the assembly line, referred to as selective enforcement audits ("SEA"), and tests of field engines, commonly called in-use compliance tests. The SEA provisions have been used by the EPA to verify the compliance of heavy-duty engines for several years. In 1993, three such audit tests were performed on Cummins engines, all of which passed. The failure of an SEA could result in cessation of production of the noncompliant engines and the recall of engines produced prior to the audit. In the product development process, Cummins anticipates SEA requirements when it sets emissions design targets. No Cummins engines were chosen for in-use compliance testing in 1993. It is anticipated that the EPA will increase the in-use test rate in 1994 and subsequent years, raising the probability that one or more of the Company's engines will be selected. As with SEA testing, if an in-use test is failed, an engine recall may be necessary. Cummins believes that its engines meet the EPA's in-use criteria. In November, 1990, the Clean Air Act Amendments of 1990 were signed into law. These amendments include special provisions for certain truck fleets in nonattainment metropolitan areas and instruct the EPA to consider regulating emissions from engines used in mobile off- highway applications. The EPA completed the mandated study of these sources and concluded that regulations are required. Promulgation of the final rule is anticipated to occur in the second quarter of 1994. Effective in 1995, CARB has promulgated new emissions standards for vehicles from 8,500 to 14,000 pounds gross vehicle weight. Cummins' B Series engines compete in this category. Design and development activity toward meeting these standards is well underway. In January 1992, CARB promulgated regulations for mobile off-highway applications that use engines rated at or above 175 horsepower. The effective date of the first tier of regulations is January 1, 1996. The Company expects that its products will comply with these regulations before the effective date. More stringent emissions standards also are being adopted in international markets, including Europe and Japan. Given the Company's experience in meeting US emissions standards, it believes that it is well positioned to take advantage of opportunities in these markets as the need for emissions-control capability grows. There are several Federal and state regulations which encourage and, in some cases, mandate the use of alternatively fueled heavy-duty engines. The Company currently offers a natural gas fueled version of its L10 engine and has several development programs underway to expand its alternatively fueled product offering. Vehicles and certain industrial equipment in which diesel engines are installed must meet Federal noise standards. The Company believes that applications in which its engines are now installed meet these noise standards and that future installations also will be in compliance. Other Environmental Statutes and Regulations ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ With respect to environmental statutes and regulations applicable to the plants and operations of the Company and its subsidiaries, Cummins believes it is in compliance in all material aspects with applicable laws and regulations. During the last five years, expenditures for environmental control facilities and environmental remediation projects at the Company's operating facilities in the United States have not been a major portion of annual capital outlays and are not expected to be material in 1994. The Company or its subsidiaries have been identified as potentially responsible parties ("PRPs") pursuant to the Comprehensive Environmental Response, Compensation, and Liability Act of 1980, as amended or similar state laws, at a number of waste disposal sites. Under such laws, PRPs typically are jointly and severally liable for any investigation and remediation costs incurred with respect to such sites. The Company's ultimate responsibility, therefore, could be greater than the share of waste contributed by the Company would otherwise indicate. While the Company is unable at this time to determine the aggregate cost of remediation at these sites or the Company's ultimate liability with respect thereto, the Company has attempted to analyze its proportionate and actual liability by analyzing the amounts of hazardous materials contributed by the Company to such sites, the estimated costs, the number and identities of other PRPs and the level of insurance coverage. The Company has entered into administrative agreements at certain of these sites to perform remedial actions. Onan Corporation, a subsidiary of the Company, has entered into an administrative agreement to participate in remediation of the Waste Disposal Engineering landfill in Andover, Minnesota, along with 28 other PRPs. The cost of remediation at this site is estimated to range from $10 million to $15 million, of which Onan expects to contribute approximately $600,000, which has been reserved fully. The parties to the remediation agreement are in the process of seeking contributions from third parties, which may reduce Onan's proportionate share of the remediation costs. Onan also has entered into an administrative agreement for the Oak Grove Sanitary Landfill in Oak Grove Township, Minnesota. The estimated cost to remediate this site is approximately $6 million. Onan has agreed to contribute $127,000 to cover its share of the cost of remediation. Onan is in the process of seeking insurance reimbursement (which is being contested by the insurers) and contributions from other PRPs, which could reduce this amount. At the Old City Landfill in Columbus, Indiana, the Company and two other PRPs have entered into a Consent Order with the Indiana Department of Environmental Management to implement the Record of Decision issued by EPA in 1992. The cost to implement the Consent Order is estimated to be approximately $300,000 based upon current conditions at the site. The Company's share of this expense will be approximately 50 percent. At the Purity Oil Site located in Fresno, California, a subsidiary of the Company has been identified as a PRP and is one of several PRPs who have been issued an order by EPA to undertake remedial action at the site. The Company's subsidiary has contributed $150,000 toward the first phase of remedial action at the site. While the subsidiary's liability for future expenditures has not been determined, the Company estimates that its percentage contribution of hazardous waste to the site was less than 1 percent. It is unclear whether the Company's share of future remediation cost will be based upon its proportionate share of waste contributed to the site. The costs of future remediation have not yet been determined but are likely to exceed the cost of the first phase of remedial action. As a result, the Company's share of such future expenses is likely to exceed amounts spent to date at this site. The Company believes that it has adequate reserves to cover its share of future expenses at each of these sites. With respect to other sites at which the Company or its subsidiaries have been named as PRPs, the Company cannot estimate reasonably the future remediation costs. At several sites, the remedial action to be implemented has not been determined for the site or the Company has been named only recently as a PRP. In addition, the Company presently is contesting any liability at several of these sites. Based upon the Company's prior experiences at similar sites, however, the aggregate future cost of all PRPs to remediate these sites is likely to be significant. While the Company believes that it has good defenses at several of these sites, that its percentage contribution at other sites is likely to be de minimis and that other PRPs will bear most of the future remediation costs, the Company's ultimate responsibility will be based on many factors outside the Company's control and, therefore, could be material in the event that the Company becomes obligated to pay a significant portion of those expenses. Based upon information presently available, the Company believes that such liability is unlikely and that its actual and proportionate costs of participating in the remediation of these sites will not be material. ITEM 2.		ITEM 2. PROPERTIES ~~~~~~~ ~~~~~~~~~~ Cummins' worldwide manufacturing facilities occupy approximately 13 million square feet, including approximately 5 million square feet outside the United States. Principal engine manufacturing facilities in the United States include the Company's plants in Southern Indiana and Jamestown, New York, as well as an engine plant in Rocky Mount, North Carolina, which is operated in partnership with J I Case. Countries of manufacture outside of the United States include England, Scotland, Brazil, Mexico, France, Spain, Australia and Germany. In addition, engines and engine components are manufactured by joint ventures or independent licensees at plants in China, India, Japan, Pakistan, South Korea and Turkey. Cummins believes that all of its plants have been maintained adequately, are in good operating condition and are suitable for its current needs through productive utilization of the facilities. ITEM 3.	ITEM 3. LEGAL PROCEEDINGS ~~~~~~~ ~~~~~~~~~~~~~~~~~ The information appearing in Note 15 to the Consolidated Financial Statements is incorporated herein by reference. On April 5, 1990, Raphael Warkel and Alan J. Stransky filed a complaint in the US District Court for the Southern District of Indiana against the Company, all of its then-current directors and one past director. The complaint purported to be brought as a class action on behalf of persons who purchased the Company's common stock between May 1, 1989 and September 21, 1989. The complaint alleged that the Company and the other defendants violated Section 10(b) and Section 20 of the Securities Exchange Act of 1934 by failing to disclose material financial information concerning the Company in an effort to "artificially inflate" the market price of the Company's common stock. The complaint sought compensatory damages of unspecified amount, costs and attorneys' fees. All defendants answered denying the substantive allegations of the complaint. The plaintiffs moved for class certification, which motion was opposed by the defendants. On November 30, 1992, the court granted defendants' motion for judgment on the pleading and dismissed the complaint. The court held that the complaint failed to state a claim for relief under the Federal securities laws. The court gave the plaintiffs 30 days to file an amended complaint. On December 29, 1992, plaintiffs filed an amended complaint against the same defendants. The amended complaint, which alleges the Company and other defendants violated Section 10(b) and Section 20 of the Securities Exchange Act by failing to disclose material financial information concerning the Company in an effort to "artificially inflate" the market price of the Company's common stock, is also brought as a class action and seeks compensatory damages of unspecified amount, costs and attorneys' fees. On March 3, 1993, defendants moved to dismiss the amended complaint. On September 13, 1993, the court dismissed the claims of plaintiff Stransky with prejudice. The court also dismissed the claims of plaintiff Warkel except for a claim based on an allegedly false and misleading press release issued by the Company in July 1989. Warkel was given until December 13, 1993 to file an amended complaint, which time has passed and no amended complaint has been filed. Plaintiff Stransky has moved the court for reconsideration of the order dismissing his claims, which motion remains pending. Defendants believe the remaining allegations in the amended complaint are without merit and intend to defend the action vigorously. The material in Item 1 "Other Environmental Statutes and Regulations" is incorporated herein by reference. ITEM 4.	ITEM 4. SUBMISSION OF MATTERS TO VOTE OF SECURITY HOLDERS ~~~~~~~ ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ None. PART II ~~~~~~~ ITEM 5.	ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ The Company's common stock is listed on the New York Stock Exchange and the Pacific Stock Exchange under the symbol "CUM". On October 12, 1993, the Board of Directors authorized a two-for-one stock split of the common stock, which was effected by a stock dividend payable to holders of record on October 25, 1993. The following table sets forth, for the calendar quarters shown, the range of high and low composite prices of the common stock on the New York Stock Exchange and the cash dividends declared on the common stock. The information in the table has been adjusted to give effect to the stock split. High Low Dividends Declared ~~~~~~~ ~~~~~~~ ~~~~~~~~~~~~~~~~~~ ~~~~ First quarter $48 3/4 $37 3/8 $.025 Second quarter 49 5/16 38 1/2 .025 Third quarter 45 39 .025 Fourth quarter 54 3/8 38 7/8 .125 ~~~~ First quarter $33 $26 5/8 $.025 Second quarter 38 3/8 28 3/8 .025 Third quarter 35 7/8 30 5/16 .025 Fourth quarter 40 7/16 29 11/16 .025 During the fourth quarter of 1993, the Board of Directors of the Company increased the common stock dividend from $.025 to $.125 per quarter. The declaration and payment of future dividends by the Board of Directors of the Company will be dependent upon the Company's earnings and financial condition, economic and market conditions and other factors deemed relevant by the Board of Directors. At December 31, 1993, the approximate number of holders of record of the Company's common stock was 4,400. Certain of the Company's loan indentures and agreements contain provisions which permit the holders to require the Company to repurchase the obligations upon a change of control of the Company, as defined in the applicable debt instruments. As more fully described in Note 13 to the Consolidated Financial Statements, which information is incorporated herein by reference, the Company has a Shareholders' Rights Plan. The Company's bylaws provide that Cummins is not subject to the provisions of the Indiana Control Share Act. However, Cummins is governed by certain other laws of the State of Indiana applicable to transactions involving a potential change of control of the Company. ITEM 6.	ITEM 6. SELECTED FINANCIAL DATA (Dollars in Millions, except per share amounts) ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ 1993 1992 1991 1990 1989 ~~~~~~~~ ~~~~~~~~ ~~~~~~~~ ~~~~~~~~ ~~~~~~~~ Net sales $4,247.9 $3,749.2 $3,405.5 $3,461.8 $3,519.5 Earnings (loss) before extraordinary items & cumulative effect of accounting changes 182.6 67.1 (65.6) (165.1) (6.1) Net earnings (loss) 177.1 (189.5) (14.1) (137.7) (6.1) Primary earnings (loss) per common share: Before extraordinary items & cumulative effect of accounting changes 4.95 1.77 (2.48) ( 7.23) (.76) Net 4.79 ( 6.01) ( .75) ( 6.13) (.76) Fully diluted earnings (loss) per common share: Before extraordinary items & cumulative effect of accounting changes 4.77 1.77 (2.48) ( 7.23) (.76) Net 4.63 ( 6.01) ( .75) ( 6.13) (.76) Cash dividends per common share .20 .10 .35 1.10 1.10 Total assets 2,390.6 2,230.5 2,041.2 2,086.3 2,030.8 Long-term debt and redeemable preferred stock 189.6 412.4 443.2 411.4 473.7 All pre-share data have been restated to give effect to the October 1993 two-for-one stock split. In December 1993, the Company sold 2.6 million shares of its common stock in a public offering and used a portion of the proceeds to redeem $77.2 in principal amount of the Company's outstanding 9-3/4 percent sinking fund debentures. This early extinguishment of debt resulted in an extraordinary charge of $5.5. In 1992, the Company sold 4.6 million shares of its common stock in a public offering and used a portion of the proceeds to extinguish $71.1 of debt of Consolidated Diesel Company, an unconsolidated, 50-percent owned partnership, $8.2 of the Company's 8-7/8 percent sinking fund debentures and $11.4 of a 15-percent note payable to an insurance company. These early extinguishments of debt resulted in an extraordinary charge of $5.5. In 1992, the Company's results also included a charge of $251.1 for the cumulative effect of changes in accounting as prescribed by SFAS Nos. 106, 109 and 112 related to accounting of retirees' health care and life insurance benefits, income taxes and postemployment benefits. The Company's results for 1991 included a credit of $51.5 for the cumulative effect of changes in accounting to include in inventory certain production-related costs previously charged directly to expense and to adopt a modified units-of-production depreciation method for substantially all engine production equipment. ITEM 7.	ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION (Dollars in Millions, unless otherwise stated) ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ OVERVIEW ~~~~~~~~ Cummins recorded net sales of $4,248 in 1993, the highest level in the Company's history. This was 13 percent higher than in 1992 and 25 percent higher than in 1991. The increase in sales during 1993 was primarily attributable to higher sales of midrange engines worldwide and the strong North American heavy-duty truck market. The Company continued to achieve improvements in its financial results in 1993, generating net earnings of $177.1, or $4.79 per share, due to the increase in sales, continued cost-improvement measures and operating efficiencies, and the ability to reduce a portion of its tax valuation allowance. Effective January 1, 1992, the Company adopted three new accounting rules, which resulted in a one-time, non-cash, after-tax charge of $251.1. This resulted in a net loss of $189.5, or $6.01 per share, in 1992. In both 1993 and 1992, the Company recorded extraordinary charges of $5.5 related to early retirement of debt. The Company reported a net loss of $14.1 in 1991, including a credit of $51.5 for the cumulative effect of changes in accounting for inventory and depreciation. RESULTS OF OPERATIONS ~~~~~~~~~~~~~~~~~~~~~ The percentage relationship between net sales and other elements of the Company's Consolidated Statement of Operations for each of the last three years was: Percent of Net Sales 1993 1992 1991 ~~~~~~~~~~~~~~~~~~~~ ~~~~~ ~~~~~ ~~~~~ Net sales 100.0 100.0 100.0 Cost of goods sold 75.6 77.5 81.5 ~~~~~ ~~~~~ ~~~~~ Gross profit 24.4 22.5 18.5 Selling & administrative expenses 13.6 14.2 13.9 Research & engineering expenses 4.9 4.8 4.3 Interest expense .9 1.1 1.2 Other expenses .2 .4 .4 ~~~~ ~~~~ ~~~~ Earnings (loss) before income taxes 4.8 2.0 (1.3) Provision for income taxes .5 .2 .5 Minority interest - - .1 ~~~~ ~~~~ ~~~~~ Earnings (loss) before extraordinary items & cumulative effect of accounting changes 4.3 1.8 (1.9) Extraordinary items ( .1) ( .1) - Cumulative effect of accounting changes - (6.7) 1.5 ~~~~~ ~~~~~ ~~~~~ Net earnings (loss) 4.2 (5.0) ( .4) ~~~~~ ~~~~~ ~~~~~ Sales by Market ~~~~~~~~~~~~~~~ The Company's sales for each of its key markets during the last three years were: 1993 1992 1991 ~~~~~~~~~~~~~~~~ ~~~~~~~~~~~~~~~~ ~~~~~~~~~~~~~~~~ Dollars Percent Dollars Percent Dollars Percent ~~~~~~~ ~~~~~~~ ~~~~~~~ ~~~~~~~ ~~~~~~~ ~~~~~~~ Heavy-duty truck 1,230 29 1,081 29 940 28 Midrange truck 482 11 221 6 69 2 Power generation 963 23 914 24 813 24 Bus & light commercial vehicles 498 12 423 11 417 12 Industrial products 438 10 425 11 450 13 Government 109 3 173 5 236 7 Marine 68 1 64 2 61 2 Fleetguard, Holset and Cummins Electronics (a) 460 11 448 12 420 12 ~~~~~ ~~ ~~~~~ ~~ ~~~~~ ~~ Net sales 4,248 100 3,749 100 3,406 100 ~~~~~ ~~~ ~~~~~ ~~~ ~~~~~ ~~~ (a) Included sales of McCord prior to the third quarter of 1993. Sales to the heavy-duty truck market in 1993 were 14 percent higher than in 1992 and 31 percent higher than the 1991 level. The increase in sales since 1991 has been due to increasing demand for engines in the North American heavy-duty truck market. In 1993, the Company's heavy-duty engine shipments in this market increased approximately 30 percent over 1992 and were more than double the 1991 level. The Company continued to lead this market with a 35-percent market share in 1993. The Company's market share was 37 percent in 1992 and 38 percent in 1991. Heavy-duty truck engine shipments in international markets in 1993 were approximately 10 percent lower than in 1992 but 5 percent above the 1991 level. While markets in the United Kingdom are showing signs of emerging from recessionary levels, no significant recovery is apparent in European markets. The Company's operations in Brazil were moderately profitable due to cost reductions and operating efficiencies that resulted in their lowering the break-even point. Even though there have been signs that the Brazilian truck market is recovering, uncertainty continues to exist in this market due to inflationary and other economic pressures. The heavy-duty truck market in Mexico also remains depressed due to the tightening of credit, which has limited the ability of fleets to purchase new trucks. Sales to the midrange truck market have more than doubled since 1991. In 1993, the Company completed the first full year of a contract with Ford Motor Company to provide exclusive diesel power for Ford's medium-duty trucks. While some customers made advance purchases of midrange engines at the end of 1993, the current level of demand indicates continued growth in this market. Power generation sales of $963 in 1993 increased 5 percent over the 1992 level and were 18 percent higher than in 1991. During 1993, power generation sales continued to benefit from strong demand for industrial generator sets in international markets, particularly in China where sales were double the 1992 level. The Company also benefited from an increase in demand for generator sets for recreational vehicles in 1993 over 1992. In the bus and light commercial vehicle market, the Company's sales were approximately 18 percent higher than in both 1992 and 1991. Engine shipments for the bus market in North America were significantly higher than prior year's levels. The Company's sales to this market also benefited in 1993 from continued strong demand for midrange engines for Chrysler's Dodge Ram pickup truck. Sales to industrial markets in 1993 were essentially level with those of the two prior years, although sales of engine parts and components, primarily to China and Turkey, increased significantly. Engine shipments to construction and agricultural markets in North America also showed modest gains in 1993; however, there was no improvement in shipments for logging or mining markets, which continue at low levels. Government sales continue to be lower than prior years' levels due primarily to the reduction in US government expenditures. Sales have declined from 1991 peak of 7 percent of the Company's net sales to 5 percent of net sales in 1992 and 3 percent of net sales in 1993. The Company believes this market may decline further due to reductions in US military expenditures. Sales for the marine business continued to increase but represented less than 2 percent of the Company's net sales in the three years' reporting periods. Engine shipments for all markets in 1993 were 263,000, compared to 222,000 in 1992 and 200,600 in 1991. Shipments by engine family for the comparative periods were: 1993 1992 1991 ~~~~~~~~ ~~~~~~~~ ~~~~~~~~ Midrange engines 167,900 139,800 129,700 Heavy-duty engines 86,500 73,900 62,800 High-horsepower engines 8,600 8,300 8,100 ~~~~~~~ ~~~~~~~ ~~~~~~~ Total engine shipments 263,000 222,000 200,600 ~~~~~~~ ~~~~~~~ ~~~~~~~ Sales of filters, turbochargers and electronic systems increased from the 1992 level and were approximately 10 percent higher than in 1991. These businesses have benefited from an increase in sales for both the midrange and heavy-duty engine markets in North America. European markets for these products remained at depressed levels. Prior to the third quarter of 1993, sales of McCord Heat Transfer Co., were reported in this business market. Effective at the beginning of the third quarter of 1993, the Company transferred its 80-percent interest in McCord to Behr America Holding, Inc., for a 35-percent interest in Behr America Holding, Inc. The Company's minority interest in Behr America Holding, Inc., has been reported as an unconsolidated company since the transfer. Gross Profit ~~~~~~~~~~~~ The Company's gross profit percentage increased to 24.4 percent of net sales in 1993 from 22.5 percent in 1992 and 18.5 percent in 1991. The Company continued to benefit from improved margins across all of its engine families during 1993. The key factor contributing to the improved margin in 1993 was the increase in demand for the Company's products, which represented approximately 50 percent of the increase in gross profit. Other factors included the effects of cost- improvement measures implemented since 1991 to improve production systems and throughput time, engine and parts pricing actions subsequent to the first quarter of 1992, and lower costs associated with product coverage programs. The cost of product coverage programs, which includes both warranty and extended coverage, improved to 2.1 percent of net sales in 1993, compared to 2.4 percent in 1992 and 3.8 percent in 1991. Improvements included reduced warranty rates for engines sold in 1993 and adjustments to reduce the product coverage liability for engines previously placed in service. In 1993, members of the Diesel Workers Union in Southern Indiana approved an 11-year contract. The contract provided for a team-based work system designed to increase flexibility, employee involvement and efficiency in exchange for improved pension and health care benefits for future retirees. Based upon the composition of age and service of the labor force, the increased expense associated with prior service of these employees will be recognized during the early years of the contract. In 1991, the Company's margin contribution was low due to a decline in sales of heavy-duty engines, as well as higher costs related to introduction of the 1991 product line, which incorporated electronic controls for the first time. Operating Expenses ~~~~~~~~~~~~~~~~~~ Selling and administrative expenses were $579.2 in 1993, compared to $532.5 in 1992 and $472.3 in 1991. The increase in these expenditures in 1993 was primarily attributable to variable operating expenses to support the higher sales volumes. Research and engineering expenses were $209.6 in 1993, compared to $179.5 in 1992 and $147.0 in 1991. The increase in 1993 of 17 percent compared to 1992 and 43 percent compared to 1991 was due to continued expenditures for fuel systems development, electronic systems and future technology developments. Other Expenses ~~~~~~~~~~~~~~ Interest expense of $36.3 in 1993 was $4.7 lower than in 1992 and $6.2 lower than in 1991 due to the Company's early retirement and redemption of debt obligations during 1993 and 1992 and an overall decline in interest rates. In 1993, the decrease in other expense of $6.3 compared to 1992 and $5.9 compared to 1991 was due to a reduction in interest expense as a result of debt retirement at Consolidated Diesel Company, an unconsolidated 50-percent owned partnership, in the fourth quarter of 1992. This was offset partially by lower income from unconsolidated companies. Provision for Income Taxes ~~~~~~~~~~~~~~~~~~~~~~~~~~ As described in Note 9 to the Consolidated Financial Statements, the Company reduced its valuation allowance for tax benefit carryforwards during 1993 and 1992. The tax provision also included a one-time credit of $4.4 in 1993 as a result of the Omnibus Budget Reconciliation Act of 1993. In 1991, Cummins' effective tax rate varied from the US statutory rate because of operating losses for which no tax benefit was recorded and the recognition of foreign and state taxes. Extraordinary Items ~~~~~~~~~~~~~~~~~~~ As disclosed in Note 7 to the Consolidated Financial Statements, the Company extinguished certain indebtedness in 1993 and 1992 that resulted in an extraordinary charge of $5.5 in each year. Accounting Changes ~~~~~~~~~~~~~~~~~~ As disclosed more fully in Note 1 to the Consolidated Financial Statements, in 1992, the Company changed its method of accounting for retirees' health care and life insurance benefits, postemployment benefits and income taxes, all of which were required by new accounting rules released by the Financial Accounting Standards Board. In 1991, the Company changed its method of accounting for inventory and depreciation. FINANCIAL CONDITION AN CASH FLOW ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ During 1993, the Company's financial position improved significantly. Shareholders' investment increased from $501.1 at year-end 1992 to $821.1 at December 31, 1993. The improvement in financial position was the result of the issuance of 2.6 million shares of common stock, which produced net proceeds of $124.5, the conversion by holders of $48.5 of convertible debt into 1.0 million shares of common stock and the generation of net earnings of $177.1 during the year. In addition, the proceeds from the common stock offering and net cash flow from operations were applied to reduce the Company's indebtedness from $488.0 at December 31, 1992 to $235.6 at December 31, 1993, a 52- percent decrease. The combination of the significantly strengthened equity position and reduced debt level lowered the Company's debt-to- capital ratio from 49.3 percent at December 31, 1992 to 22.3 percent at December 31, 1993. At December 31, 1993, "Other liabilities" in the Consolidated Statement of Financial Position increased $86.8 compared to December 31, 1992. This increase reflects the minimum liability related to improved pension benefits that were granted in 1993 for prior service of employees covered by collectively bargained pension plans. An intangible asset of $68.1 was recorded in "Intangibles, deferred taxes and deferred charges" related to this liability. Key elements of the Consolidated Statement of Cash Flows were: 1993 1992 1991 ~~~~~~ ~~~~~~ ~~~~~~ Net cash provided by (used for): Operating activities $285.6 $197.7 $106.7 Investing activities (148.8) (296.5) (136.3) Financing activities (113.5) 104.9 2.2 Effect of exchange rate changes on cash ( .2) ( 3.4) ( 1.1) ~~~~~~~ ~~~~~~~ ~~~~~~~ Net change in cash and cash equivalents $ 23.1 $ 2.7 $ 28.5) ~~~~~~ ~~~~~~ ~~~~~~~ Net cash flow from operating and investing activities totaled $136.8 in 1993, compared to a net cash outflow of $98.8 in 1992 and $29.6 in 1991. The cash outflow in 1992 included $65.1 to acquire the remaining 36-percent interest in Onan Corporation and a capital contribution of $71.1 to Consolidated Diesel Company to retire indebtedness. Capital expenditures during 1993 increased to $174.2 compared to $139.3 in 1992 and $123.9 in 1991. The increase in 1993 was related to investments for new product introductions and fuel systems. The Company expects that capital expenditures will increase in 1994 to fund continued investments in these areas. The Company also expects to make investments in 1994 in joint ventures announced during 1993, including the joint venture with TELCO to produce midrange engines in India for TELCO vehicles and with Komatsu to produce midrange engines in Japan and high-horsepower engines in the United States. During the fourth quarter of 1993, the Company split its common stock on a two-for-one basis through the declaration of a stock dividend. Concurrently, the common stock dividend was increased from 2.5 cents per share per quarter, on a post-split basis, to 12.5 cents per share. Cash at year-end 1993 was $77.3, an increase of $23.1 above the 1992 year-end level. In addition, the Company had no borrowings outstanding on its $300 revolving credit agreement at December 31, 1993. In 1993, the term of this credit facility was extended to 1997. On January 24, 1994, the Company announced that its outstanding Convertible Exchangeable Preference Stock, which had a face value of $112.2 at December 31, 1993, would be redeemed on February 23, 1994 at a price of $51.05 per depositary share, plus accrued dividends. Holders of the stock elected to convert their shares into 2.9 million shares of common stock. ITEM 8.	ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA ~~~~~~~ ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ See index to Financial Statements and Schedules on page 25. ITEM 9.	ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE ~~~~~~~ ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ None. PART III ~~~~~~~~ ITEM 10.	ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT ~~~~~~~~ ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ The information appearing under the caption "Election of Directors" of the Company's definitive Proxy Statement, dated March 4, 1994, for the Annual Meeting of the Shareholders to be held on April 5, 1994 (hereinafter the "Proxy Statement") is incorporated by reference in partial answer to this item. The executive officers of the Company at December 31, 1993 are set forth below. The Chairman of the Board and President are elected annually by the Board of Directors at the Board's first meeting following the Annual Meeting of the Shareholders. Other officers hold office for such period as the Board of Directors or Chairman of the Board may prescribe. Present Position & Business Experience During Name Age Last 5 Years ~~~~~~~~~~~~~~ ~~~ ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ M. E. Chesnut 47 Vice President - Quality & Organizational Effectiveness (1992 to present), Vice President- Human Resources & Organizational Effectiveness (1989-1992) C. R. Cordaro 44 Group Vice President - Marketing (1990 to present), Vice President - Automotive Marketing (1988 to 1990) J. K. Edwards 49 Vice President - International (1989 to present) R. L. Fealy 42 Vice President - Treasurer (1988 to present) P. B. Hamilton 47 Vice President & Chief Financial Officer (1988 to present) J. A. Henderson 59 President & Chief Operating Officer (1977 to present) M. D. Jones 47 Vice President - Aftermarket Group (1989 to present) F. J. Loughrey 44 Group Vice President - Worldwide Operations (1990 to present), Vice President - Heavy-Duty Engines (1988 to 1990) J. McLachlan 61 Vice President - Corporate Controller (1991 to present), Vice President - Engine Business Controller (1989-1991) G. D. Nelson 53 Vice President - Alternate Fueled Products (1993 to present), Vice President - Research & Development & Chief Technical Officer (1984 to 1993) H. B. Schacht 59 Chairman of the Board of Directors and Chief Executive Officer (1977 to present) T. M. Solso 47 Executive Vice President - Operations (1992 to present), Vice President & General Manager Engine Business (1988 to 1992) R. B. Stoner-Jr. 47 Vice President - Cummins Power Generation Group and President - Onan Corporation (1992 to present), Managing Director - Holset (1986-1992) S. L. Zeller 37 Vice President - Law & External Affairs & Corporate Secretary (1992 to present), Vice President - General Counsel & Secretary (1990 to 1992), Vice President - General Counsel (1989 to 1990) ITEM 11.	ITEM 11. EXECUTIVE COMPENSATION ~~~~~~~~ ~~~~~~~~~~~~~~~~~~~~~~ The information appearing under the following captions in the Company's Proxy Statement is hereby incorporated by reference: "The Board of Directors and Its Committees", "Executive Compensation -- Compensation Tables and Other Information" (including the tables and information contained at pages 16 to 18 of the Proxy Statement), "Executive Compensation -- Change of Control Arrangements" and "Executive Compensation -- Compensation Committee Interlocks and Insider Participation". Except as otherwise specifically incorporated by reference, the Proxy Statement is not to be deemed filed as part of this report. The Company has adopted various benefit and compensation plans covering officers and other key employees under which certain benefits become payable upon a change of control of the Company. Cummins also has adopted an employee retention program covering approximately 350 employees of the Company and its subsidiaries, which provides for the payment of severance benefits in the event of termination of employment following a change of control of Cummins. The Company and its subsidiaries also have severance programs for other exempt employees of the Company whose employment is terminated following a change of control of the Company. Certain of the pension plans covering employees of the Company provide, upon a change of control of Cummins, that excess plan assets become dedicated solely to fund benefits for plan participants. ITEM 12.	ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT ~~~~~~~~ ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ A discussion of the security ownership of certain beneficial owners and management appearing under the captions "Principal Security Ownership", "Election of Directors" and "Executive Compensation -- Security Ownership of Management" in the Proxy Statement is incorporated herein by reference. ITEM 13.	ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS ~~~~~~~~ ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ The information appearing under the captions "The Board of Directors and Its Committees", "Executive Compensation - Compensation Committee Interlocks and Insider Participation" and "Other Transactions and Agreements with Directors, Officers and Certain Shareholders" in the Proxy Statement is incorporated herein by reference. Reference is made to the information on related parties appearing in Note 4 to the Consolidated Financial Statements. PART IV ~~~~~~~ ITEM 14.	ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K ~~~~~~~~ ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ Documents filed as a part of this report: 1. See Index to Financial Statements and Schedules on page 25 for a list of the financial statements and schedules filed as a part of this report. 2. See Exhibit Index on page 59 for a list of the exhibits filed or incorporated herein as a part of this report. No reports on Form 8-K were filed during the fourth quarter of 1993. (page INDEX TO FINANCIAL STATEMENTS AND SCHEDULES ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ Page ~~~~ Management's Responsibility for Financial Statements 26 Report of the Independent Public Accountants 27 Consolidated Statement of Operations 28 Consolidated Statement of Financial Position 29 Consolidated Statement of Cash Flows 31 Consolidated Statement of Shareholders' Investment 33 Notes to Consolidated Financial Statements 35 Quarterly Financial Data 51 Property, Plant and Equipment 52 Accumulated Depreciation of Property, Plant & Equipment 53 Valuation and Qualifying Accounts 54 Short-term Borrowings 55 Supplementary Income Statement Information 56 (page) MANAGEMENT'S RESPONSIBILITY FOR FINANCIAL STATEMENTS ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ Management is responsible for the preparation of the Company's consolidated financial statements and all related information appearing in this Form 10-K. The statements and notes have been prepared in conformity with generally accepted accounting principles and include some amounts which are estimates based upon currently available information and management's judgment of current conditions and circumstances. The Company engaged Arthur Andersen & Company, independent public accountants, to examine the consolidated financial statements. Their report appears on page 27. To provide reasonable assurance that assets are safeguarded against loss from unauthorized use or disposition and that accounting records are reliable for preparing financial statements, management maintains a system of accounting and controls, including an internal audit program. The system of accounting and controls is improved and modified in response to changes in business conditions and operations and to recommendations made by the independent public accountants and the internal auditors. The Board of Directors has an Audit Committee whose members are not employees of the Company. The committee met four times in 1993 with management, internal auditors and representatives of the Company's independent public accountants to review the Company's program of internal controls, audit plans and results and the recommendations of the internal and external auditors and management's responses to those recommendations. (page) REPORT OF THE INDEPENDENT PUBLIC ACCOUNTANTS ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ To the Shareholders and Board of Directors of Cummins Engine Company, Inc.: We have audited the accompanying consolidated statement of financial position of Cummins Engine Company, Inc., (an Indiana corporation) and subsidiaries as of December 31, 1993 and 1992 and the related consolidated statements of operations, cash flows and shareholders' investment for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly in all material respects, the financial position of Cummins Engine Company, Inc., and subsidiaries as of December 31, 1993 and 1992 and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. As explained in Note 1 to the financial statements, effective January 1, 1992, the Company changed its method of accounting for the cost of retirees' health care and life insurance benefits, postemployment benefits and income taxes. Also, as disclosed in Note 1, effective January 1, 1991, the Company changed its method of accounting for inventory and depreciation. Our audits were made for the purpose of forming an opinion on the consolidated statements taken as a whole. The schedules listed under Item 14 are the responsibility of the Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic consolidated financial statements. These schedules have been subjected to the auditing procedures applied to the audit of the basic consolidated financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic consolidated financial statements taken as a whole. Arthur Andersen & Co. Chicago, Illinois, January 26, 1994. (page) CUMMINS ENGINE COMPANY, INC., AND SUBSIDIARIES CONSOLIDATED STATEMENT OF OPERATIONS (Dollars in Millions, except per share amounts) ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ 1993 1992 1991 ~~~~~~~~ ~~~~~~~~ ~~~~~~~~ NET SALES $4,247.9 $3,749.2 $3,405.5 Cost of goods sold 3,211.0 2,906.7 2,776.7 ~~~~~~~~ ~~~~~~~~ ~~~~~~~~ Gross profit 1,036.9 842.5 628.8 Selling & administrative expenses 579.2 532.5 472.3 Research & engineering expenses 209.6 179.5 147.0 Interest expense 36.3 41.0 42.5 Other expenses 6.8 13.1 12.7 ~~~~~~~~ ~~~~~~~~ ~~~~~~~~ Earnings (loss) before income taxes 205.0 76.4 (45.7) Provision for income taxes 22.3 8.9 16.9 Minority interest .1 .4 3.0 ~~~~~~~~ ~~~~~~~~ ~~~~~~~~~ EARNINGS (LOSS) BEFORE EXTRAORDINARY ITEMS AND CUMULATIVE EFFECT OF ACCOUNTING CHANGES 182.6 67.1 (65.6) Extraordinary items (Note 7) (5.5) (5.5) - Cumulative effect of accounting changes (Note 1) - (251.1) 51.5 ~~~~~~~~~ ~~~~~~~~~ ~~~~~~~~~ NET EARNINGS (LOSS) 177.1 (189.5) (14.1) Preference stock dividends 8.0 8.0 8.0 ~~~~~~~~ ~~~~~~~~~ ~~~~~~~~~ EARNINGS (LOSS) AVAILABLE FOR COMMON SHARES $ 169.1 $ (197.5) $ (22.1) ~~~~~~~~ ~~~~~~~~~ ~~~~~~~~~ ~~~~~~~~ ~~~~~~~~~ ~~~~~~~~~ Primary earnings (loss) per common share: Before extraordinary items and cumulative effect of accounting changes $ 4.95 $ 1.77 $ (2.48) Net 4.79 (6.01) (.75) Fully diluted earnings (loss) per common share: Before extraordinary items and cumulative effect of accounting changes $ 4.77 $ 1.77 $ (2.48) Net 4.63 (6.01) ( .75) The accompanying notes are an integral part of this statement. (page) CUMMINS ENGINE COMPANY, INC., AND SUBSIDIARIES CONSOLIDATED STATEMENT OF FINANCIAL POSITION (Millions, except per share amounts) ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ December 31, 1993 1992 ~~~~~~~~ ~~~~~~~~ ASSETS CURRENT ASSETS: Cash and cash equivalents $ 77.3 $ 54.2 Receivables less allowances of $9.5 & $11.8 426.3 372.7 Inventories 440.2 440.4 Other current assets 127.9 128.3 ~~~~~~~~ ~~~~~~~~ 1,071.7 995.6 ~~~~~~~~ ~~~~~~~~ INVESTMENTS AND OTHER ASSETS: Investments in and advances to unconsolidated companies 101.9 146.2 Other assets 88.8 71.7 ~~~~~~~~ ~~~~~~~~ 190.7 217.9 PROPERTY, PLANT AND EQUIPMENT: ~~~~~~~~ ~~~~~~~~ Land and buildings 357.9 351.9 Machinery, equipment and fixtures 1,689.9 1,680.7 Construction in progress 132.7 89.7 ~~~~~~~~ ~~~~~~~~ 2,180.5 2,122.3 Less accumulated depreciation 1,222.3 1,193.6 ~~~~~~~~ ~~~~~~~~ 958.2 928.7 ~~~~~~~~ ~~~~~~~~ INTANGIBLES, DEFERRED TAXES & DEFERRED CHARGES 170.0 88.3 ~~~~~~~~ ~~~~~~~~ TOTAL ASSETS $2,390.6 $2,230.5 ~~~~~~~~ ~~~~~~~~ LIABILITIES AND SHAREHOLDERS' INVESTMENT CURRENT LIABILITIES: Loans payable $ 13.4 $ 50.5 Current maturities of long-term debt 32.6 25.1 Accounts payable 267.5 255.3 Accrued salaries and wages 78.1 71.4 Accrued product coverage & marketing expenses 123.5 139.9 Income taxes payable 21.2 11.5 Other accrued expenses 164.0 170.5 ~~~~~~~~ ~~~~~~~~ 700.3 724.2 ~~~~~~~~ ~~~~~~~~ LONG-TERM DEBT 189.6 412.4 ~~~~~~~~ ~~~~~~~~ OTHER LIABILITIES 679.6 592.8 ~~~~~~~~ ~~~~~~~~ SHAREHOLDERS' INVESTMENT: Convertible preference stock, no par value, .2 shares outstanding 112.2 114.9 Common stock, $2.50 par value, 40.6 & 36.5 shares issued 101.5 91.3 Additional contributed capital 822.8 654.4 Retained earnings (deficit) 4.1 (146.1) Common stock in treasury, at cost, 2.1 shares ( 67.3) ( 67.3) Unearned ESOP compensation ( 59.3) ( 63.5) Cumulative translation adjustments ( 92.9) ( 82.6) ~~~~~~~~~ ~~~~~~~~~ 821.1 501.1 ~~~~~~~~~ ~~~~~~~~~ TOTAL LIABILITIES & SHAREHOLDERS' INVESTMENT $2,390.6 $2,230.5 ~~~~~~~~~ ~~~~~~~~ The accompanying notes are an integral part of this statement. (page) CUMMINS ENGINE COMPANY, INC., AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS (Dollars in Millions) ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ 1993 1992 1991 ~~~~~~~ ~~~~~~~~ ~~~~~~~~ CASH FLOWS FROM OPERATING ACTIVITIES: Net earnings (loss) $ 177.1 $(189.5) $( 14.1) ~~~~~~~ ~~~~~~~~ ~~~~~~~~ Adjustments to reconcile net earnings (loss) to net cash from operating activities: Depreciation and amortization 125.1 122.5 127.2 Extraordinary items & cumulative effect of accounting changes 5.5 256.6 ( 51.5) Accounts receivable ( 59.4) ( 30.9) 5.3 Inventories .9 ( 18.8) 31.1 Accounts payable and accrued expenses 6.6 14.1 ( 10.8) Other 29.8 43.7 19.5 ~~~~~~~~ ~~~~~~~~ ~~~~~~~~ Total adjustments 108.5 387.2 120.8 ~~~~~~~~ ~~~~~~~~ ~~~~~~~~ Net cash provided by operating activities 285.6 197.7 106.7 ~~~~~~~~ ~~~~~~~~ ~~~~~~~~ CASH FLOWS FROM INVESTING ACTIVITIES: Property, plant and equipment: Additions (174.2) (139.3) (123.9) Disposals 12.0 22.9 2.2 Acquisition of new business activities 3.4 ( 66.8) - Net cash proceeds from the disposition of certain business activities - 1.9 19.0 Investments in and advances to affiliates and unconsolidated companies 10.0 (115.2) ( 33.6) ~~~~~~~~ ~~~~~~~~ ~~~~~~~~ Net cash used for investing activities (148.8) (296.5) (136.3) ~~~~~~~~ ~~~~~~~~ ~~~~~~~~ CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from borrowings 56.5 112.3 48.4 Payments on borrowings (247.5) (128.3) ( 26.2) Net borrowings under credit agreements ( 25.5) 16.2 ( .6) Net proceeds from common stock issuances 124.5 126.1 - Payments of dividends ( 15.0) ( 11.3) ( 18.4) Other ( 6.5) ( 10.1) ( 1.0) ~~~~~~~~ ~~~~~~~~ ~~~~~~~~ Net cash (used for) provided by financing activities (113.5) 104.9 2.2 ~~~~~~~~ ~~~~~~~~ ~~~~~~~~ EFFECT OF EXCHANGE RATE CHANGES ON CASH ( .2) ( 3.4) ( 1.1) ~~~~~~~~ ~~~~~~~~ ~~~~~~~~ NET CHANGE IN CASH AND CASH EQUIVALENTS 23.1 2.7 ( 28.5) Cash & cash equivalents at beginning of year 54.2 51.5 80.0 ~~~~~~~ ~~~~~~~ ~~~~~~~ CASH & CASH EQUIVALENTS AT END OF YEAR $ 77.3 $ 54.2 $ 51.5 ~~~~~~~ ~~~~~~~ ~~~~~~~ Cash payments during the year for: Interest $ 39.5 $ 41.5 $ 40.6 Income taxes 18.1 20.6 26.8 The accompanying notes are an integral part of this statement. (page) CUMMINS ENGINE COMPANY, INC., AND SUBSIDIARIES CONSOLIDATED STATEMENT OF SHAREHOLDERS' INVESTMENT (Millions, except per share amounts) ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ 1993 1992 1991 ~~~~~~ ~~~~~~ ~~~~~~ CONVERTIBLE PREFERENCE STOCK, no par value, 1.0 shares authorized (.2 shares): Beginning balance $114.9 $114.9 $114.9 Converted to common stock ( 2.7) - - ~~~~~~ ~~~~~~ ~~~~~~ Ending balance 112.2 114.9 114.9 ~~~~~~ ~~~~~~ ~~~~~~ COMMON STOCK, $2.50 par value, 50.0 shares authorized: Beginning balance (36.5, 31.8 & 31.8 shares) 91.3 79.4 79.4 Retired (.2, .2 and .1 shares) ( .6) ( .6) ( .1) Issued in public offerings (2.6 & 4.6 shares) 6.6 11.5 - Conversion of LYONs and preference stock (1.1 shares) 2.8 - - Other (.6, .3 and .1 shares) 1.4 1.0 .1 ~~~~~~ ~~~~~~ ~~~~~~ Ending balance (40.6, 36.5 & 31.8 shares) 101.5 91.3 79.4 ~~~~~~ ~~~~~~ ~~~~~~ ADDITIONAL CONTRIBUTED CAPITAL: Beginning balance 654.4 537.5 533.0 Retired ( 9.9) ( 7.3) ( 1.1) Issued in public offerings 117.9 114.6 - Conversion of LYONs & preference stock 48.0 - - Other 12.4 9.6 5.6 ~~~~~~ ~~~~~~ ~~~~~~ Ending balance 822.8 654.4 537.5 ~~~~~~ ~~~~~~ ~~~~~~ RETAINED EARNINGS (DEFICIT): Beginning balance (146.1) 48.0 82.0 Net earnings (loss) for the year 177.1 (189.5) (14.1) Cash dividends declared: Convertible preference stock ( 8.0) ( 8.0) ( 8.0) Common stock ( 7.0) ( 3.3) (10.4) Additional minimum liability for pensions ( 11.9) 6.7 ( 1.5) ~~~~~~~ ~~~~~~~ ~~~~~~~ Ending balance 4.1 (146.1) 48.0 ~~~~~~~ ~~~~~~~ ~~~~~~~ COMMON STOCK IN TREASURY, at cost (2.1 (shares) ( 67.3) ( 67.3) (67.3) ~~~~~~~ ~~~~~~~ ~~~~~~~ UNEARNED ESOP COMPENSATION: Beginning balance ( 63.5) ( 67.9) (72.2) Shares allocated to participants 4.2 4.4 4.3 ~~~~~~~ ~~~~~~~ ~~~~~~~ Ending balance ( 59.3) ( 63.5) (67.9) ~~~~~~~ ~~~~~~~ ~~~~~~~ CUMULATIVE TRANSLATION ADJUSTMENTS: Beginning balance ( 82.6) ( 20.8) ( .5) Adjustments ( 10.3) ( 61.8) (20.3) ~~~~~~ ~~~~~~ ~~~~~~ Ending balance ( 92.9) ( 82.6) (20.8) ~~~~~~~ ~~~~~~~ ~~~~~~~ SHAREHOLDERS' INVESTMENT $821.1 $501.1 $623.8 ~~~~~~~ ~~~~~~~ ~~~~~~~ The accompanying notes are an integral part of this statement. (page) CUMMINS ENGINE COMPANY, INC., AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in Millions, unless otherwise stated) ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ NOTE 1. SUMMARY OF ACCOUNTING POLICIES: Principles of Consolidation: The consolidated financial statements include the accounts of Cummins Engine Company, Inc., and its majority-owned subsidiaries. Affiliated companies in which Cummins does not have a controlling interest or in which control is expected to be temporary are accounted for using the equity method. Stock Split: On October 12, 1993, the Company announced a two-for-one common stock split that was distributed on November 11, 1993 to shareholders of record on October 25, 1993. All references to the number of shares issued or outstanding and to per-share information have been adjusted to reflect the stock split on a retroactive basis. Foreign Currency: The Company uses the local currency as the functional currency for its significant manufacturing operations outside the United States, except those in Brazil and Mexico for which it uses the US dollar. At operations which use the local currency as the functional currency, results are translated into US dollars using average exchange rates for the year, while assets and liabilities are translated into US dollars using year-end exchange rates. The resulting translation adjustments are recorded in a separate component of shareholders' investment. Gains and losses from foreign currency transactions are included in net earnings. The financial statements of operations in Brazil and Mexico are translated into US dollars using both current and historical exchange rates, with the resulting translation adjustments reflected in net earnings. The Company enters into forward exchange contracts to hedge the effects of fluctuation currency rates on certain assets and liabilities, such as accounts receivable and payable, that are denominated in foreign currencies. The contracts typically provide for the exchange of different currencies at specified future dates and rates. The gain or loss due to the difference between the forward exchange rates of the contracts and current rates offsets in whole or in part the loss or gain on the assets or liabilities being hedged. Cash Equivalents: Cash equivalents are investments that are readily convertible to known amounts of cash and have original maturities of three months or less. Inventories: The company accounts for substantially all of its US heavy-duty and high-horsepower engine and engine parts inventories on the last-in, first-out (LIFO) cost method. All other inventories are valued at the lower of first-in, first-out (FIFO) cost or net realizable value. LIFO inventories were $144.9 at December 31, 1993 and $147.8 at December 31, 1992. The current cost of these inventories was $49.8 higher than LIFO cost at December 31, 1993 and $52.9 higher than LIFO cost at December 31, 1992. During 1993, 1992 and 1991, certain of the Company's LIFO inventory investment was reduced, resulting in the liquidation of low-cost LIFO inventory layers. The effect of the LIFO liquidation was to reduce cost of goods sold by $2.0 in 1993, $1.4 in 1992 and $6.3 in 1991. Inventory values include the combined costs of purchased materials, labor and manufacturing overhead. Effective January 1, 1991, the Company recognized a credit of $25.0 as a result of a change in accounting to include in inventory certain production-related costs previously charged directly to expense. The Company's operations are integrated vertically, which makes it impracticable to distinguish between raw material and work-in-process on a consolidated basis. At December 31, 1993 and 1992, the FIFO value of finished goods, which represented products available for shipment to the Company's customers, approximated $273 and $251, respectively. Futures Contracts and Interest Rate Swaps: The Company has entered into forward exchange and commodity futures contracts which are accounted for as hedges. The gains or losses on forward exchange contracts are reflected in earnings concurrently with the hedged items while gains or losses on commodity futures contracts are charged or credited to earnings when the contracts are settled. The Company also has entered into interest rate swap agreements that have the effect of fixing interest rates on certain of the Company's floating rate indebtedness. The net difference to be paid or received on the interest rate swaps is charged or credited to interest expense as interest rates change. Property, Plant and Equipment: Property, plant and equipment are recorded at cost. Effective January 1, 1991, the Company changed its accounting for depreciation of substantially all engine production equipment to a modified units-of-production method, which is based upon units produced subject to a minimum level. The cumulative effect of this change in accounting was a credit of $26.5 in 1991. Depreciation of all other equipment is computed using the straight- line method for financial reporting purposes. The estimated service lives to compute depreciation range from 20 to 40 years for buildings and 3 to 20 years for machinery, equipment and fixtures. Where appropriate, the Company uses accelerated depreciation methods for tax purposes. Maintenance and repair costs are charged to earnings as incurred. Technical Investment: Expenditures associated with research and development of new products and major improvements to existing products, as well as engineering expenditures during early production and ongoing efforts to improve existing products, are charged to earnings as incurred, net of contract reimbursements: 1993 1992 1991 ~~~~~~ ~~~~~~ ~~~~~~ Research & engineering expenses $209.6 $179.5 $147.0 Reimbursements 28.8 36.9 28.6 Other technical spending 38.1 31.0 33.1 ~~~~~~ ~~~~~~ ~~~~~~ Technical investment expenditures $276.5 $247.4 $208.7 ~~~~~~ ~~~~~~ ~~~~~~ Included above in research and engineering expenses are research and development costs approximating $158 in 1993, $129 in 1992 and $99 in 1991. Product Coverage Programs: Estimated costs of warranty and extended coverage are charged to earnings at the time the Company sells its products. Retirement and Postemployment Benefits: The Company charges the cost of all retirement benefits to earnings during employees' active service as a form of deferred compensation. The change in accounting from a cash basis to this policy for health care and life insurance, effective January 1, 1992, resulted in an after-tax charge of $228.6 for prior service. This change resulted in an incremental annual expense of $11.4, net of taxes, during 1992. The cost of postemployment benefits, such as long-term disability, is charged to earnings at the time employees leave active service. The cumulative effect of the change to this accounting from a cash basis, effective January 1, 1992, was $22.5, net of taxes. This change resulted in an incremental expense of $3.2, net of taxes, in 1992. Income Tax Accounting: Deferred tax assets and liabilities are recognized for the future tax effects of temporary differences between the financial statement basis and the tax basis of assets and liabilities. Future tax benefits of tax loss and tax credit carryforwards also are recognized as deferred tax assets. Deferred tax assets are offset by a valuation allowance to the extent the Company concludes there is uncertainty as to their ultimate realization. Earnings (Loss) Per Common Share: Primary earnings per share of common stock are computed by subtracting preference stock dividend requirements from net earnings (loss) and dividing that amount by the weighted average number of common shares outstanding during each year. The weighted average number of shares, which includes the exercise of certain stock options granted to employees, was 35.3 million in 1993, 32.9 million in 1992 and 29.7 million in 1991. Fully diluted earnings per share are computed by dividing net earnings (loss) by the weighted average number of shares assuming the exercise of stock options and the conversion of debt and preference stock to common stock. NOTE 2. SUBSEQUENT EVENT: On January 24, 1994, the Company announced that its outstanding Convertible Exchangeable Preference Stock, which had a face value of $112.2 at December 31, 1993, would be redeemed on February 23, 1994 at a price of $51.05 per depositary share, plus accrued dividends. Holders of the stock elected to convert their shares into 2.9 million shares of common stock. Had the stock conversion and cash redemption occurred on January 1, 1993, pro forma net earnings per share would have approximated $4.63 in 1993. NOTE 3. ACQUISITION: On June 15, 1992, the Company acquired for $64 in cash the remaining 36 percent of Onan Corporation from Hawker Siddeley Overseas Investments Limited, a UK company. Cummins had owned the majority interest in Onan since 1986. The acquisition was accounted for as a purchase. Had the acquisition occurred as of January 1, 1991, the pro forma net loss per share for 1992 would have approximated $6.00 and the pro forma net loss per share for 1991 would have approximated 63 cents. Such pro forma per share information is not necessarily indicative of what the results of operations would have been had the acquisition actually occurred earlier, nor is it indicative of what may occur in the future. NOTE 4. RELATED PARTIES: In 1990, Ford Motor Company and Tenneco Inc., each purchased from Cummins 3.2 million shares of the Company's common stock. The shares were purchased pursuant to separate investment agreements between Cummins and the investors. Both Ford and Tenneco have agreed to certain voting, standstill and other provisions and each has the right to designate a representative to the Company's Board of Directors. The Company also entered into an option agreement with Ford pursuant to which Ford has the right, exercisable until 1996, to purchase up to 2.96 million additional shares of the Company's common stock at a price equal to 120 percent of the market price of the common stock for the 30 trading days prior to the exercise of the option but for no less than $31.25 per share. In December 1993, Tenneco transferred the shares of Cummins common stock it held to a trust that funds pension plans sponsored by Tenneco. The shares will continue to be subject to the terms of the investment agreement, and the trust has agreed to assume all of Tenneco's rights and obligations under such agreement. Cummins' sales of diesel engines and parts and related products to Ford approximated $343 in 1993, $182 in 1992 and $56 in 1991. In addition, Cummins' purchases of gasoline engines and parts from Ford approximated $4 in 1993 and $3 in both 1992 and 1991. At December 31, 1993 and 1992, the Company had accounts receivable outstanding of approximately $27 and $20, respectively, with Ford. Cummins and J I Case, a subsidiary of Tenneco Inc., are partners in the manufacture of midrange diesel engines at Consolidated Diesel Company. In 1993, 1992 and 1991, Cummins' sales of heavy-duty midrange diesel engines, components, service parts and related products and services to J I Case and other subsidiaries of Tenneco approximated $43, $52 and $61, respectively. Cummins' purchases from J I Case approximated $1 in both 1993 and 1992 and $7 in 1991. At both December 31, 1993 and 1992, the Company had accounts receivable outstanding of $6 with subsidiaries of Tenneco. NOTE 5. SALE OF RECEIVABLES: The Company has an agreement to sell, without recourse, up to $110.0 of eligible trade receivables. The amount of receivables outstanding was $108.0 under this agreement at December 31, 1993 and $100.0 at December 31, 1992. As collections reduce previously sold receivables, new receivables customarily are sold up to the $110.0 level. NOTE 6. INVESTMENTS IN UNCONSOLIDATED COMPANIES: December 31, Location Ownership 1993 1992 ~~~~~~~~~~~~~ ~~~~~~~~~ ~~~~~~ ~~~~~~ Consolidated Diesel Company United States 50% $ 50.9 $100.1 Kirloskar Cummins Limited India 50% 16.9 17.3 Behr America Holding, Inc. United States 35% 12.1 - Other investments Various Various 22.0 28.8 ~~~~~~ ~~~~~~ $101.9 $146.2 ~~~~~~ ~~~~~~ Included above in other investments at December 31, 1993 and 1992 were $18.5 and $21.8, respectively, related to temporarily owned distributorships. Cummins' sales to temporarily owned distributorships approximated $57 in 1993, $49 in 1992 and $143 in 1991. Summary financial information for Consolidated Diesel Company, Kirloskar Cummins Limited, Behr America Holding, Inc., and other 50-percent or less owned companies follows: Earnings Statement Data 1993 1992 1991 ~~~~~~~~~~~~~~~~~~~~~~~ ~~~~~~ ~~~~~~ ~~~~~~ Net sales $746.4 $695.9 $733.1 Earnings before extraordinary item 3.4 14.4 12.4 Earnings 3.4 6.4 12.4 Cummins' share of earnings .4 3.4 6.4 December 31, Balance Sheet Data 1993 1992 ~~~~~~~~~~~~~~~~~~~ ~~~~~~ ~~~~~~ Current assets $151.4 $178.1 Noncurrent assets 207.0 220.6 Current liabilities (127.0) (111.2) Noncurrent liabilities ( 38.2) ( 41.9) ~~~~~~~ ~~~~~~~ Net assets $193.2 $245.6 ~~~~~~ ~~~~~~ Cummins' share of net assets $ 82.7 $123.4 ~~~~~~ ~~~~~~ NOTE 7. LONG-TERM DEBT: December 31, 1993 1992 ~~~~~~ ~~~~~~ Senior debt: 9.74%-10.65% medium-term notes, due 1993 to 1998 $126.2 $136.2 9-3/4% sinking fund debentures, due 1998 to 2016 - 77.2 8.76% guaranteed notes of ESOP Trust, due 1998 70.7 71.8 9.45% note payable to insurance company, due through 1999 - 18.6 3.875%-10.4% notes payable to banks due through 1998 8.0 63.4 Mortgage, capitalized leases and other notes, due through 2005 17.3 25.1 Subordinated debt: LYONs - 45.2 ~~~~~~ ~~~~~~ Total indebtedness 222.2 437.5 Less current maturities 32.6 25.1 ~~~~~~ ~~~~~~ Long-term debt $189.6 $412.4 ~~~~~~ ~~~~~~ Aggregate maturities of long-term debt for the five years subsequent to December 31, 1993 are $32.6, $36.3, $41.5, $23.7 and $16.7. In December 1993, the Company sold 2.6 million shares of its common stock in a public offering for $49 per share. A portion of the proceeds was used to redeem $77.2 in principal amount of the Company's outstanding 9-3/4 percent sinking fund debentures. This early extinguishment of debt resulted in an extraordinary charge of $5.5. The Company also called for redemption of all the outstanding LYONs. Holders submitted 112,808 LYONs with an accreted value of $48.5 for conversion into 1.0 million shares of common stock, and the remaining were redeemed for $.2. Had the stock issuance, debt repayments and conversion of LYONs occurred as of January 1, 1993, pro forma net earnings per share would have approximated $4.65 in 1993. In April 1992, the Company sold 4.6 million shares of its common stock in a public offering for $28.50 per share. A portion of the net proceeds was used at the time of the issuance to repay borrowings under the Company's revolving credit agreement. During the fourth quarter of 1992, the Company extinguished $71.1 of debt of Consolidated Diesel Company, an unconsolidated, 50-percent owned partnership, $8.2 of the Company's 8-7/8 percent sinking fund debentures and $11.4 of a 15-percent note payable to an insurance company. These early extinguishments of debt resulted in an extraordinary charge of $5.5. Had the stock issuance and debt repayments occurred as of January 1, 1992, the pro forma net loss per share would have approximated $5.80 in 1992. The Company maintains a $300 revolving credit agreement, under which there were no outstanding borrowings at December 31, 1993. At December 31, 1992, there were $90.0 outstanding borrowings under the revolving credit agreement. In 1993, the term of the revolving credit agreement was extended to 1997. The Company also maintains other domestic and international credit lines with approximately $170 available at December 31, 1993. The Company has guaranteed the outstanding borrowings of its ESOP Trust. The ESOP was established for certain of the Company's domestic salaried employees who participate in the qualified benefit savings plans. The Company's cash contributions to the ESOP Trust, together with the dividends accumulated on the common stock held by the ESOP Trust, are used to pay interest and principal due on the notes. Cash contributions and dividends to the ESOP Trust approximated $7 in 1993 and 1992 to fund its principal payment of $1 and interest payment of $6. The Company's compensation expense was $10.0 in 1993, $10.3 in 1992 and $9.9 in 1991. The unearned compensation, which is reflected as a reduction to shareholders' investment, represents the historical cost of the ESOP Trust's shares of common stock that have not yet been allocated to participants. Based on borrowing rates currently available to the Company for bank loans and similar terms and average maturities, the fair value of total indebtedness approximated $237 at December 31, 1993 and $436 at December 31, 1992. NOTE 8. OTHER LIABILITIES: December 31, 1993 1992 ~~~~~~ ~~~~~~ Accrued retirement & postemployment benefits $521.8 $436.4 Accrued product coverage & marketing expenses 90.5 102.9 Deferred taxes 17.3 9.3 Accrued compensation expenses 5.6 4.3 Other 44.4 39.9 ~~~~~~ ~~~~~~ Other liabilities $679.6 $592.8 ~~~~~~ ~~~~~~ NOTE 9. INCOME TAXES: Income Tax Provision 1993 1992 1991 ~~~~~~~~~~~~~~~~~~~~ ~~~~~ ~~~~~ ~~~~~ Current: US federal and state $ 4.7 $ 1.8 $(4.2) Foreign 19.1 15.6 23.6 ~~~~~ ~~~~~ ~~~~~ 23.8 17.4 19.4 ~~~~~ ~~~~~ ~~~~~ Deferred: US federal and state (12.3) (8.5) (1.9) Foreign 10.8 - ( .6) ~~~~~~ ~~~~~~ ~~~~~~ ( 1.5) (8.5) (2.5) ~~~~~~ ~~~~~~ ~~~~~~ Income tax provision $22.3 $ 8.9 $16.9 ~~~~~~ ~~~~~~ ~~~~~~ Prior to 1992, losses at the Company's operations in the United States and United Kingdom had eliminated the need for virtually all deferred income taxes. Effective January 1, 1992, the Company adopted an asset and liability approach to income tax accounting. At the same time, the Company recorded substantial obligations for retirement and other postemployment benefits that are tax deductible only on a cash basis. The tax benefit of the future tax deduction represented by these accruals is recognized as a deferred asset along with the effect of all other temporary differences between the tax basis and financial statement basis of assets and liabilities. Deferred income taxes also reflect the value of the tax benefit carryforwards and an offsetting valuation allowance. December 31, Net Deferred Tax Asset 1993 1992 ~~~~~~~~~~~~~~~~~~~~~~ ~~~~~~ ~~~~~~ Tax effects of future tax deductible differences related to: Accrued health care, life insurance & postemployment benefits $174.0 $161.6 Other accrued employee benefit expenses 29.9 31.1 Accrued product coverage & marketing expenses 63.4 67.3 Other net deductible differences 19.3 9.7 Tax effects of future taxable differences related to: Accelerated tax depreciation & other tax over book deductions related to US plant & equipment (114.1) (107.9) Net UK taxable differences related primarily to plant and equipment ( 10.2) - Miscellaneous net foreign taxable differences ( 1.3) ( .7) ~~~~~~~ ~~~~~~~ Net tax effects of temporary differences 161.0 161.1 ~~~~~~~ ~~~~~~~ Tax effects of carryforward benefits: US federal net operating loss carryforwards, expiring 2006 to 2007 18.7 58.6 US federal foreign tax credits, expiring 1998 4.7 - US federal general business tax credits, expiring 1996 to 2008 71.6 58.4 US federal minimum tax credits with no expiration 7.1 3.1 UK net tax benefit carryforwards with no expiration - 4.1 ~~~~~~ ~~~~~~~ Tax effects of carryforwards 102.1 124.2 ~~~~~~ ~~~~~~~ Tax effects of temporary differences & carryforwards 263.1 285.3 Less valuation allowance (100.7) (124.4) ~~~~~~~ ~~~~~~~ Net deferred tax asset $162.4 $160.9 ~~~~~~~ ~~~~~~~ Classified in the Consolidated Statement of Financial Position as: Current assets $ 89.2 $ 96.4 Noncurrent assets 90.5 73.8 Noncurrent liabilities ( 17.3) ( 9.3) ~~~~~~~ ~~~~~~~ Net deferred tax asset $162.4 $160.9 ~~~~~~~ ~~~~~~~ While the company believes all tax assets ultimately will be realized, such realization is dependent upon future earnings in specific tax jurisdictions. Dependent upon the level of profitability, the Company's net operating loss carryforwards may be utilized but replaced with foreign tax credit carryforwards, which have a shorter life and significant limitations on utilization. The Company's other carryforwards also have significant usage limitations which can be overcome only by generating earnings at considerably higher levels than have been generated in all but the most recent two years. The Company, therefore, has recorded a full valuation allowance against those tax assets which represent carryforwards of tax benefits because of previous unprofitable operations. While the need for this valuation allowance is subject to periodic review, it is expected that the allowance will be reduced and the tax benefits of the carryforwards will thereby be recorded in future operations as a reduction of income tax expense as the carryforwards actually are realized by future earnings. Such reductions in the valuation allowance and realizations of carryforwards amounted to $41.5 in 1993 and $17.4 in 1992. The Omnibus Budget Reconciliation Act ("OBRA") of 1993 retroactively extended the research tax credit from its 1992 expiration date through June 30, 1995. Research tax credits of $6.1 for 1992 and an estimated $8.0 for 1993 have increased both the general business credit carryforwards and the offsetting valuation allowance disclosed above as of December 31, 1993. Earnings (loss) before income taxes and differences between the effective tax rate at US federal income tax rate were: 1993 1992 1991 ~~~~~~ ~~~~~~ ~~~~~~ Earnings (loss) before income taxes: Domestic $110.7 $(36.4) $(142.7) Foreign 94.3 112.8 97.0 ~~~~~~ ~~~~~~~ ~~~~~~~~ $205.0 $ 76.4 $( 45.7) ~~~~~~ ~~~~~~ ~~~~~~~~ Tax (benefit) at US statutory tax rate $ 71.8 $ 25.9 $( 15.5) Increase in the value of net US deferred tax assets as a result of the OBRA change in the tax rate from 34% to 35% ( 4.4) - - Utilization of net operating loss and tax credit carryforwards from prior years (41.5) (17.4) - Current year operating losses & tax credits for which no benefit has been recognized - - 31.7 Other ( 3.6) .4 .7 ~~~~~~~ ~~~~~~ ~~~~~~~ Income tax provision $ 22.3 $ 8.9 $ 16.9 ~~~~~~~ ~~~~~~ ~~~~~~~ NOTE 10. OPERATING LEASES: Certain of the Company's manufacturing plants, warehouses and offices are leased facilities. The Company also leases automobiles and manufacturing and office equipment. Most of these leases require fixed rental payments, expire over the next 10 years and can be renewed or replaced with similar leases. Rental expense under these leases in 1993, 1992 and 1991 was $50.8, $45.3 and $44.0, respectively. Future minimum payments for operating leases with original terms of more than one year are $28.7 in 1994, $22.8 in 1995, $17.6 in 1996, $16.1 in 1997, $14.5 in 1998 and $114.4 thereafter. NOTE 11. RETIREMENT PLANS: The Company and its subsidiaries have several contributory and noncontributory pension plans covering substantially all employees. Benefits for salaried plans generally are based upon the employee's compensation during the three to five years preceding retirement. Under the hourly plans, benefits generally are based upon various monthly amounts for each year of credited service. It is the Company's policy to make contributions to these plans sufficient to meet the funding requirements of applicable laws and regulations, plus such additional amounts, if any, as the Company deems appropriate. Plan assets consist principally of equity securities and corporate and Government fixed-income obligations. Net Periodic Pension Cost 1993 1992 1991 ~~~~~~~~~~~~~~~~~~~~~~~~~ ~~~~~~ ~~~~~~ ~~~~~~ Service cost for benefits earned during the year $ 30.9 $ 28.7 $ 28.2 Interest cost on projected benefit obligation 80.7 78.1 82.1 Return on plan assets: Actual (202.5) (79.6) (235.4) Deferred gain (loss) 99.5 (26.2) 135.0 Amortization of transition asset ( 9.2) ( 9.6) ( 9.6) Other amortization, net 2.4 ( 2.2) 3.1 ~~~~~~~~ ~~~~~~~ ~~~~~~~ Net periodic pension cost (credit) $ 1.8 $(10.8) $ 3.4 ~~~~~~~~ ~~~~~~~ ~~~~~~~ Funded Status Overfunded Underfunded Combined ~~~~~~~~~~~~~ ~~~~~~~~~~ ~~~~~~~~~~~ ~~~~~~~~ ~~~~ Actuarial present value of: Vested benefit obligation $(569.2) $(425.5) $( 994.7) ~~~~~~~~ ~~~~~~~~ ~~~~~~~~~~ Accumulated benefit obligation $(642.3) $(522.8) $(1,165.1) ~~~~~~~~ ~~~~~~~~ ~~~~~~~~~~ Projected benefit obligation $(736.0) $(539.8) $(1,275.8) Plan assets at fair value 780.8 401.2 1,182.0 ~~~~~~~~ ~~~~~~~~ ~~~~~~~~~~ Excess of assets over (under) projected benefit obligation 44.8 (138.6) ( 93.8) Unrecognized net experience loss 17.6 3.1 20.7 Unrecognized prior service cost 22.7 98.5 121.2 Additional minimum liability - ( 87.7) ( 87.7) Unamortized transition asset ( 36.1) ( 11.5) ( 47.6) ~~~~~~~~ ~~~~~~~~ ~~~~~~~~~~ Accrued pension asset (liability) $ 49.0 $(136.2) $( 87.2) ~~~~~~~~ ~~~~~~~~ ~~~~~~~~~~ ~~~~ Actuarial present value of: Vested benefit obligation $(358.5) $(393.0) $ (751.5) ~~~~~~~~ ~~~~~~~~ ~~~~~~~~~~ Accumulated benefit obligation $(414.2) $(480.7) $ (894.9) ~~~~~~~~ ~~~~~~~~ ~~~~~~~~~~ Projected benefit obligation $(468.6) $(529.8) $ (998.4) Plan assets at fair value 542.4 481.1 1,023.5 ~~~~~~~~ ~~~~~~~~ ~~~~~~~~~~ Excess of assets over (under) projected benefit obligation 73.8 ( 48.7) 25.1 Unrecognized net experience gain ( 23.1) ( 28.1) ( 51.2) Unrecognized prior service cost 9.7 66.8 76.5 Additional minimum liability - ( 4.3) ( 4.3) Unamortized transition asset ( 32.8) ( 24.2) ( 57.0) ~~~~~~~~ ~~~~~~~~ ~~~~~~~~~~ Accrued pension asset (liability) $ 27.6 $( 38.5) $ ( 10.9) ~~~~~~~~ ~~~~~~~~ ~~~~~~~~~~ In 1993, the projected benefit obligation was determined using weighted average discount rates ranging from 6.75 percent for the US plans to 8 percent for the international plans and in 1992 rates ranging from 8 percent to 9 percent, respectively. The assumed long- term rates of compensation increase for salaried plans approximated expected inflation in both 1993 and 1992. The long-term rates of return on assets were assumed to be 9.25 percent in 1993 and 9.6 percent in 1992 for the US plans and 10 percent in 1993 and 11 percent in 1992 for the international plans. The Company has a non-qualified excess benefit plan that provides certain employees with defined retirement benefits in excess of qualified plan limits imposed by US tax law. In addition, the Company has a supplementary life insurance plan that provides officers and other key employees with term life protection during their active employment and supplemental retirement benefits upon retirement. The cost of these plans was $3.6 in 1993, $3.2 in 1992 and $2.7 in 1991. At December 31, 1993 and 1992, the accrued pension liability for these plans was $18.7 and $15.9, respectively. In addition to the pension plans, the Company provides certain health care and life insurance benefits to eligible retirees and their dependents. The plans are contributory, with retirees' contributions adjusted annually, and contain other cost-sharing features, such as deductibles, coinsurance and spousal contributions. The general policy is to fund these benefits as claims and premiums are incurred. In 1992, Cummins adopted a new accounting rule for these benefits and chose to recognize immediately the unfunded liability for prior service. Prior to 1992, the cost of benefits for eligible retirees and their dependents was included in costs as funded and totaled $13.6 in 1991. Net Periodic Cost 1993 1992 ~~~~~~~~~~~~~~~~~ ~~~~~~ ~~~~~~ Service cost for benefits earned during the year $ 5.7 $ 5.2 Interest cost on benefit obligation 29.5 29.7 Other (.1) - ~~~~~~~ ~~~~~~ Net periodic cost $ 35.1 $ 34.9 ~~~~~~~ ~~~~~~ Funded Status ~~~~~~~~~~~~~ Actuarial present value of accumulated benefit obligation for: Retirees $210.0 $241.7 Employees eligible to retire 102.1 55.6 Other active plan participants 191.7 99.9 Unrecognized prior service cost (24.5) - Unrecognized net experience loss (69.2) (1.9) ~~~~~~~ ~~~~~~~ Accrued benefit liability $410.1 $395.3 ~~~~~~~ ~~~~~~~ The weighted average discount rate used in determining the accumulated benefit obligation was 6.75 percent in 1993 and 8 percent in 1992. The trend rate for medical benefits provided prior to Medicare eligibility is 15.5 percent, grading down to an ultimate rate of 4.5 percent by 2006. For medical benefits provided after Medicare eligibility, the trend rate is 8 percent, grading down to an ultimate rate of 4.5 percent by 1997. The health care cost trend rate assumption has a significant effect on the determination of the accumulated benefit obligation. For example, increasing the rate by 1 percent would increase the accumulated benefit obligation by $29 and net periodic cost by $2. NOTE 12. EMPLOYEE STOCK PLANS: The Company has various stock incentive plans under which officers and other eligible employees may be awarded stock options, stock appreciation rights and restricted stock during the next 10 years. Under the provisions of the plans, up to 1 percent of the Company's outstanding shares of common stock on December 31 of the preceding year is available for issuance under the plans each year. At December 31, 1993, there were 439,820 shares of common stock available for grant under the plans. There were 78,220 options exercisable under the plans at December 31, 1993. Number of Shares Option Price per Share ~~~~~~~~~ ~~~~~~~~~~~~~~~~~~~~~~ Outstanding options at 12/31/91 261,360 $15.94 to $38.91 Granted 4,900 $30.94 to $35.28 Exercised (67,260) $15.94 to $31.38 Canceled or expired ( 3,740) $20.88 to $30.72 ~~~~~~~~ Outstanding options at 12/31/92 195,260 $15.94 to $38.91 Granted 456,150 $37.41 to $52.56 Exercised (123,740) $15.94 to $40.25 Canceled or expired ( 2,600) $24.20 to $31.63 ~~~~~~~~~ Outstanding options at 12/31/93 525,070 $15.94 to $52.56 ~~~~~~~~ NOTE 13. SHAREHOLDERS' RIGHTS PLAN: The Company has a Shareholders' Rights Plan which it first adopted in 1986. The Rights Plan provides that each share of the Company's common stock has associated with it a stock purchase right. The Rights Plan becomes operative when a person or entity acquires 15 percent of the Company's common stock or commences a tender offer to purchase 20 percent or more of the Company's common stock without the approval of the Company's Board of Directors. In the event a person or entity acquires 15 percent of the Company's common stock, each right, except for the acquiring person's rights, can be exercised to purchase $400 worth of the Company's common stock for $200. In addition, for a period of 10 days after such acquisition, the Board of Directors can exchange such right for a new right which permits the holders to purchase one share of the Company's common stock for $1 per share. If a person or entity commences a tender offer to purchase 20 percent or more of the Company's common stock, unless the Board of Directors redeems the rights within 10 days of the event, each right can be exercised to purchase one share for $200. If the person or entity becomes an acquiring person, the provisions noted above apply. The Rights Plan also allows holders of the rights to purchase shares of the acquiring person's stock at a discount if the Company is acquired or 50 percent of the assets or earnings power of the Company is transferred to an acquiring person. NOTE 14. SEGMENTS OF THE BUSINESS: The Company operates in a single industry segment -- designing, manufacturing and marketing diesel engines and related products. Manufacturing, marketing and technical operations are maintained in major areas of the world. Summary financial information is listed below for each geographic area. Earnings (loss) for each area may not be a meaningful representation of each area's contribution to consolidated operating results because of significant sales of products between and among the Company's various domestic and foreign operations. UK/ All Corp. Items & US Europe Other Eliminations Combined 1993 ~~~~~~ ~~~~~~ ~~~~~ ~~~~~~~~~~~~ ~~~~~~~~ ~~~~ Net sales: To customers in the area $2,374 $590 $439 $ - $3,403 To customers outside the area 589 251 5 - 845 Intergeographic transfers 317 149 84 (550) - ~~~~~~ ~~~~ ~~~~ ~~~~~~ ~~~~~~ Total $3,280 $990 $528 $(550) $4,248 ~~~~~~ ~~~~ ~~~~ ~~~~~~ ~~~~~~ Earnings (loss) before income taxes $ 140 $ 89 $ 19 $( 43) $ 205 ~~~~~~ ~~~~ ~~~~ ~~~~~~ ~~~~~~ Identifiable assets $1,487 $407 $340 $ 157 $2,391 ~~~~~~ ~~~~ ~~~~ ~~~~~~ ~~~~~~ ~~~~ Net sales: To customers in the area $1,996 $616 $418 $ - $3,030 To customers outside the area 508 209 2 - 719 Intergeographic transfers 273 129 69 (471) - ~~~~~~ ~~~~ ~~~~ ~~~~~~ ~~~~~~ Total $2,777 $954 $489 $(471) $3,749 ~~~~~~ ~~~~ ~~~~ ~~~~~~ ~~~~~~ Earnings (loss) before income taxes $ 32 $ 93 $ 5 $( 54) $ 76 ~~~~~~ ~~~~ ~~~~ ~~~~~~ ~~~~~~ Identifiable assets $1,432 $404 $322 $ 72 $2,230 ~~~~~~ ~~~~ ~~~~ ~~~~~~ ~~~~~~ ~~~~ Net sales: To customers in the area $1,946 $568 $427 $ - $2,941 To customers outside the area 276 188 1 - 465 Intergeographic transfers 250 117 80 (447) - ~~~~~~ ~~~~ ~~~~ ~~~~~~ ~~~~~~ Total $2,472 $873 $508 $(447) $3,406 ~~~~~~ ~~~~ ~~~~ ~~~~~~ ~~~~~~ Earnings (loss) before income taxes $ (74) $ 62 $ 21 $( 55) $ (46) ~~~~~~~ ~~~~ ~~~~ ~~~~~~ ~~~~~~~ Identifiable assets $1,148 $462 $322 $ 109 $2,041 ~~~~~~~ ~~~~ ~~~~ ~~~~~~ ~~~~~~~ Total sales for each geographic area are classified by manufacturing source and include sales to customers within and outside the area and intergeographic transfers. Transfer prices for sales between the Company's various operating units generally are at arm's length, based upon business conditions, distribution costs and other costs which are expected to be incurred in producing and marketing products. Corporate items include interest and other income and expense. Identifiable assets are those resources associated with the operations in each area. Corporate assets are principally cash and investments. The Company generally sells its products on open account under credit terms customary to the region of distribution. The Company performs ongoing credit evaluations of its customers and generally does not require collateral to secure its customers' receivables. Net Sales by Marketing Territory 1993 1992 1991 ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ ~~~~~~ ~~~~~~ ~~~~~~ United States $2,389 $2,016 $1,955 United Kingdom/Europe 600 629 582 Asia/Far East/Australia 559 455 340 Mexico/South America 330 355 290 Canada 257 187 161 Africa/Middle East 113 107 78 ~~~~~~ ~~~~~~ ~~~~~~ Net sales $4,248 $3,749 $3,406 ~~~~~~ ~~~~~~ ~~~~~~ NOTE 15. GUARANTEES, COMMITMENTS AND CONTINGENT LIABILITIES: In connection with the disposition of certain products and operations in 1989, the Company sold substantially all of the loan and lease portfolios of its former finance subsidiary. Under the terms of the sale, the purchaser has recourse to Cummins should certain amounts of the loans or leases prove to be uncollectible. At December 31, 1993, the loan and lease portfolios amounted to $14.3. Accounts receivable that have been sold with recourse amounted to $26.5 at December 31, 1993. At December 31, 1993, the Company was a party to interest rate swap agreements, maturing in 1994 and having an aggregate notional amount of $12.0. The Company had $258.3 of foreign exchange contracts outstanding at December 31, 1993. The foreign exchange contracts mature through 1995 and are denominated primarily in UK sterling, Japanese yen and European currencies. The Company had a currency swap with a notional amount of $202.6 at December 31, 1993, which matures in 1994. Commodity futures contracts of $5.2 were outstanding at December 31, 1993. These contracts mature through 1995. At December 31, 1993, commitments under outstanding letters of credit, guarantees and contingencies approximated $100. Cummins and its subsidiaries are defendants in a number of pending legal actions, including actions relating to use and performance of the Company's products. The Company carries product liability insurance covering significant claims for damages involving personal injury and property damage. The Company also has been identified as a potentially responsible party at several waste disposal sites under US and related state environmental statutes and regulations. The Company denies liability with respect to many of these legal actions and environmental proceedings and vigorously is defending such actions or proceedings. The Company has established reserves for its expected future liability in such actions and proceedings when the nature and extent of such liability can be estimated reasonably based upon presently available information. In the event the Company is determined to be liable for damages in connection with such actions and proceedings, the unreserved and uninsured portion of such liability is not expected to be material. NOTE 16. QUARTERLY FINANCIAL DATA (unaudited): First Second Third Fourth Full 1993 Quarter Quarter Quarter Quarter Year ~~~~ ~~~~~~~ ~~~~~~~ ~~~~~~~ ~~~~~~~ ~~~~~~~~ Net sales $1,048.4 $1,093.4 $988.3 $1,117.8 $4,247.9 Gross profit 251.0 260.6 239.4 285.9 1,036.9 Earnings before the extraordinary item 41.1 48.2 40.7 52.6 182.6 Net earnings 41.1 48.2 40.7 47.1 177.1 Primary earnings per common share: Before the extra- ordinary item $ 1.12 $ 1.32 $ 1.11 $ 1.42 $ 4.95 Net 1.12 1.32 1.11 1.26 4.79 Fully diluted earnings per common share: Before the extra- ordinary item 1.07 1.25 1.06 1.36 4.77 Net 1.07 1.25 1.06 1.22 4.63 ~~~~ Net sales $ 881.3 $ 948.1 $903.6 $1,016.2 $3,749.2 Gross profit 190.4 211.7 202.7 237.7 842.5 Earnings before the extraordinary item & cumulative effect of accounting changes 5.0 18.8 13.8 29.5 67.1 Net earnings (loss) (246.1) 18.8 13.8 24.0 (189.5) Primary & fully diluted earnings (loss) per common share: Before the extra- ordinary item & cumulative effect of accounting changes $ .10 $ .50 $ .34 $ .79 $ 1.77 Net (8.33) .50 .34 .63 (6.01) Net earnings in the third quarter of 1993 included a one-time tax credit of $4.4 resulting from the OBRA. As disclosed in Note 7, net earnings in the fourth quarter of 1993 and 1992 included extraordinary charges of $5.5 related to early extinguishments of debt. (page) CUMMINS ENGINE COMPANY, INC., AND SUBSIDIARIES SCHEDULE V PROPERTY, PLANT AND EQUIPMENT (Dollars in Million) ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ Balance Retirements Balance Jan. 1 Adds. or Sales Other Dec. 31 ~~~~~~~~ ~~~~~~ ~~~~~~~~ ~~~~~~ ~~~~~~~~ ~~~~ Land and buildings $ 351.9 $ 8.3 $ 5.5 $ 3.2 $ 357.9 Machinery, equipment and fixtures 1,680.7 46.4 109.5 72.3 1,689.9 Construction in progress 89.7 129.0 2.0 (84.0) 132.7 ~~~~~~~~ ~~~~~~ ~~~~~~ ~~~~~~~ ~~~~~~~~ Total $2,122.3 $183.7 $117.0 $( 8.5) $2,180.5 ~~~~~~~~ ~~~~~~ ~~~~~~ ~~~~~~~ ~~~~~~~~ ~~~~ Land and buildings $ 354.3 $ 1.4 $ .4 $( 3.4) $ 351.9 Machinery, equipment and fixtures 1,666.8 38.4 56.9 32.4 1,680.7 Construction in progress 89.9 100.8 .4 (99.6) 89.7 ~~~~~~~~ ~~~~~~ ~~~~~~ ~~~~~~~ ~~~~~~~~ Total $2,110.0 $140.6 $ 57.7 $(70.6) $2,122.3 ~~~~~~~~ ~~~~~~ ~~~~~~ ~~~~~~~ ~~~~~~~~ ~~~~ Land and buildings $ 330.7 $ 19.5 $ 2.5 $ 6.6 $ 354.3 Machinery, equipment and fixtures 1,588.9 34.1 44.9 88.7 1,666.8 Construction in progress 107.7 88.6 2.3 (105.1) 88.9 ~~~~~~~~ ~~~~~~ ~~~~~~ ~~~~~~~~ ~~~~~~~~ Total $2,027.3 $142.2 $ 49.7 $( 9.8) $2,110.0 ~~~~~~~~ ~~~~~~ ~~~~~~ ~~~~~~~ ~~~~~~~~ The net change in "Other" primarily represents translation adjustments per SFAS No. 52. (page) CUMMINS ENGINE COMPANY, INC., AND SUBSIDIARIES SCHEDULE VI ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT (Dollars in Millions) ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ Balance Retirements Balance Jan. 1 Adds. or Sales Other Dec. 31 ~~~~~~~~ ~~~~~~ ~~~~~~~~ ~~~~~~ ~~~~~~~~ ~~~~ Buildings $ 156.8 $ 11.9 $ 2.5 $( 1.9) $ 164.3 Machinery, equipment and fixtures 1,036.8 110.0 86.5 ( 2.3) 1,058.0 ~~~~~~~~ ~~~~~~ ~~~~~~ ~~~~~~~ ~~~~~~~~ Total $1,193,6 $121.9 $ 89.0 $( 4.2) $1,222.3 ~~~~~~~~ ~~~~~~ ~~~~~~ ~~~~~~~ ~~~~~~~~ ~~~~ Buildings $ 149.1 $ 11.9 $ .1 $( 4.1) $ 156.8 Machinery, equipment and fixtures 1,007.9 108.5 52.2 (27.4) 1,036.8 ~~~~~~~~ ~~~~~~ ~~~~~~ ~~~~~~~ ~~~~~~~~ Total $1,157.0 $120.4 $ 52.3 $(31.5) $1,193.6 ~~~~~~~~ ~~~~~~ ~~~~~~ ~~~~~~~ ~~~~~~~~ ~~~~ Buildings $ 139.2 $ 11.7 $ 1.3 $( .5) $ 149.1 Machinery, equipment and fixtures 966.9 113.3 42.0 ( 30.3) 1,007.9 ~~~~~~~~ ~~~~~~ ~~~~~~ ~~~~~~~ ~~~~~~~~ Total $1,106.1 $125.0 $ 43.3 $(30.8) $1,157.0 ~~~~~~~~ ~~~~~~ ~~~~~~ ~~~~~~~ ~~~~~~~~ The net change in "Other" primarily represents translation adjustments per SFAS No. 52. (page) CUMMINS ENGINE COMPANY, INC., AND SUBSIDIARIES SCHEDULE VIII VALUATION AND QUALIFYING ACCOUNTS (Dollars in Millions) ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ 1993 1992 1991 ~~~~ ~~~~ ~~~~ Allowance for Doubtful Accounts: ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ Balance beginning of period $11.8 $14.4 $14.6 Additions: Provisions 4.9 1.8 2.8 Recoveries and translation adjustments .1 (.1) .7 Deductions: Write-offs 7.3 4.3 3.7 ~~~~ ~~~~ ~~~~ Balance end of period $ 9.5 $11.8 $14.4 ~~~~~ ~~~~~ ~~~~~ Tax Valuation Allowance: ~~~~~~~~~~~~~~~~~~~~~~~~ Balance beginning of period $124.4 Additions to offset increases in deferred tax assets related to: Tax benefit carryforwards recognized as assets upon the initial January 1, 1992 adoption of SFAS No. 109 - $139.9 Additional general business tax credits for 1992 and 1993 research tax credits generated 14.1 - Increase in the value of net operating tax carryforwards as a result of the OBRA tax rate increase 1.7 - Reduction in the utilization of net operating loss carryforwards due to extraordinary charges for early extinguishment of debt 1.9 1.9 Deductions to reflect reductions in deferred tax assets related to actual utilization of tax benefit carryforwards (41.5) (17.4) Other .1 - ~~~~~~ ~~~~~~ $100.7 $124.4 ~~~~~~ ~~~~~~ (page) CUMMINS ENGINE COMPANY, INC., AND SUBSIDIARIES SCHEDULE IX SHORT-TERM BORROWINGS (Dollars in Millions) ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ At Year-end During the Year ~~~~~~~~~~~~~~~~~~~~ ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ Average Average Interest Maximum Average Interest Borrowed Rate Outstanding Outstanding Rate ~~~~~~~~ ~~~~~~~~ ~~~~~~~~~~~ ~~~~~~~~~~~ ~~~~~~~~ ~~~~ Domestic $ - - $40.0 $25.9 4.0% Foreign 13.4 18.4% 42.2 11.6 11.5% ~~~~~ ~~~~~ ~~~~~ Total $13.4 $82.2 $37.5 ~~~~~ ~~~~~ ~~~~~ ~~~~ Domestic $40.0 4.8% $61.0 $38.9 4.4% Foreign 10.5 11.9% 12.5 17.7 13.0% ~~~~~ ~~~~~ ~~~~~ Total $50.5 $73.5 $56.6 ~~~~~ ~~~~~ ~~~~~ ~~~~ Domestic $10.0 6.4% $35.3 $26.6 6.5% Foreign 11.3 12.3% 17.7 15.0 12.7% ~~~~~ ~~~~~ ~~~~~ Total $21.3 $53.0 $41.6 ~~~~~ ~~~~~ ~~~~~ Average outstanding borrowings during the year were calculated for each entity based on the sum of daily outstanding balances divided by 365 days, or using the average monthly balances. Average interest rates during the year were calculated by dividing related interest expense for the year by average outstanding borrowings. Short-term borrowings are payable to banks and include amounts outstanding under various formal and informal credit arrangements including certain amounts where related interest rates are subsidized to promote trade exports. The Company also maintains a $300 revolving credit agreement available for short- and/or long-term borrowings with banks. At December 31, 1993, there were no outstanding borrowings under this agreement. At December 31, 1992, the Company had $40.0 outstanding short-term borrowings and $50.0 outstanding long-term borrowings under this agreement. At December 31, 1991, the Company had $20.0 of outstanding long-term borrowings under this agreement. (page) CUMMINS ENGINE COMPANY, INC., AND SUBSIDIARIES SCHEDULE X SUPPLEMENTARY INCOME STATEMENT INFORMATION (Dollars in Millions) ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ 1993 1992 1991 ~~~~~~ ~~~~~~ ~~~~~~ Maintenance and repairs $145.0 $125.1 $118.7 Depreciation & amortization of intangibles $125.1 $122.5 $127.2 (page) SIGNATURES ~~~~~~~~~~ Pursuant to the requirements of Section 13 or 15(d) of the Securities Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. CUMMINS ENGINE COMPANY, INC. By /s/Peter B. Hamilton By /s/John McLachlan ~~~~~~~~~~~~~~~~~~~~ ~~~~~~~~~~~~~~~~~ P. B. Hamilton J. McLachlan Vice President & Chief Vice President - Corporate Financial Officer Controller (Principal (Principal Financial Accounting Officer) 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. Signatures Title Date ~~~~~~~~~~ ~~~~~ ~~~~ Director & Chairman of the Board 3/4/94 * of Directors & Chief Executive ~~~~~~~~~~~~~~~~~~~~~ Officer (Principal Executive Officer) (H. B. Schacht) * Director and President & Chief 3/4/94 ~~~~~~~~~~~~~~~~~~~~~ Operating Officer (J. A. Henderson) * 3/4/94 ~~~~~~~~~~~~~~~~~~~~~ Director (H. Brown) * ~~~~~~~~~~~~~~~~~~~~~ Director 3/4/94 (R. J. Darnall) * ~~~~~~~~~~~~~~~~~~~~~ Director 3/4/94 (J. D. Donaldson) * ~~~~~~~~~~~~~~~~~~~~~ Director 2/24/94 (W. Y. Elisha) * ~~~~~~~~~~~~~~~~~~~~~ Director 2/22/94 (H. H. Gray) ~~~~~~~~~~~~~~~~~~~~~ Director (D. G. Mead) * ~~~~~~~~~~~~~~~~~~~~~ Director 3/4/94 (J. I. Miller) * ~~~~~~~~~~~~~~~~~~~~~ Director 2/22/94 (W. I. Miller) * ~~~~~~~~~~~~~~~~~~~~~ Director 3/4/94 (D. S. Perkins) ~~~~~~~~~~~~~~~~~~~~~ Director (W. D. Ruckelshaus) * ~~~~~~~~~~~~~~~~~~~~~ Director 2/22/94 (F. A. Thomas) * 3/4/94 ~~~~~~~~~~~~~~~~~~~~~ Director (J. L. Wilson) By /s/Steven L. Zeller ~~~~~~~~~~~~~~~~~~~ Steven L. Zeller Attorney-in-fact (page) CUMMINS ENGINE COMPANY, INC., AND SUBSIDIARIES EXHIBIT INDEX ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ 3(a) Restated Articles of Incorporation of Cummins Engine Company, Inc., as amended (incorporated by reference to Quarterly Report on Form 10-Q for the quarter ended October 1, 1989 and by reference to Form 8-K, dated July 16, 1990). 3(b) By-laws, as amended and restated, of the Company (incorporated by reference to Annual Report on Form 10-K for the year ended December 31, 1988 and by reference to Quarterly Report on Form 10-Q for the quarter ended April 2, 1980). 4(b) Revolving Credit Agreement dated as of June 4, 1993, among Cummins Engine Company, Inc., certain banks, Chemical Bank as Administrative Agent and Morgan Guaranty Trust Company of New York as Co-Agent (incorporated by reference to Quarterly Report on Form 10-Q for the quarter ended July 4, 1993). 4(c) Rights Agreement, as amended (incorporated by reference to Annual Report on Form 10-K for the year ended December 31, 1989, by reference to Form 8-K, dated July 26, 1990, by reference to Form 8, dated November 6, 1990, by reference to Form 8-A12B/A, dated November 1, 1993, and by reference to Form 8-A12B/A, dated January 12, 1994). 10(a) Target Bonus Plan (incorporated by reference to Annual Report on Form 10-K for the year ended December 31, 1992). 10(b) Five-Year Performance Plan, as amended (incorporated by reference to Annual Report on Form 10-K for the year ended December 31, 1988). 10(c) Key Employee Stock Investment Plan, as amended (incorporated by reference to Annual Report on Form 10-K for the year ended December 31, 1988). 10(d) Supplemental Life Insurance and Deferred Income Program, as amended (incorporated by reference to Annual Report on Form 10-K for the year ended December 31, 1988). 10(e) Financial Counseling Program, as amended (incorporated by reference to Annual Report on Form 10-K for the year ended December 31, 1983). 10(f) 1986 Stock Option Plan (incorporated by reference to Quarterly Report on Form 10-Q for the quarter ended March 30, 1986). 10(g) Deferred Compensation Plan for Non-Employee Directors, as amended (incorporated by reference to Annual Report on Form 10-K for the year ended December 31, 1988). 10(h) Key Executive Compensation Protection Plan (incorporated by reference to Annual Report on Form 10-K for the year ended December 31, 1988). 10(i) Excess Benefit Retirement Plan, as amended (incorporated by reference to Annual Report on Form 10-K for the year ended December 31, 1988). 10(j) Performance Share Plan, as amended (incorporated by reference to Annual Report on Form 10-K for the year ended December 31, 1988). 10(k) Restated Sponsors Agreement between Case Corporation and Cummins Engine Company, Inc., dated December 7, 1990, together with the Restated Partnership Agreement between Case Engine Holding Company, Inc., and Cummins Engine Holding Company, Inc., dated December 7, 1990 (incorporated by reference to Annual Report on Form 10-K for the year ended December 31, 1990). 10(l) Retirement Plan for Non-Employee Directors of Cummins Engine Company, Inc., (incorporated by reference to Annual Report on Form 10-K for the year ended December 31, 1989). 10(m) Stock Unit Appreciation Plan (incorporated by reference to Annual Report on Form 10-K for the year ended December 31, 1990). 10(n) Investment Agreement between Ford Motor Company and Cummins Engine Company, Inc., dated July 16, 1990 (incorporated by reference to Form 8-K, dated July 26, 1990). 10(o) Investment Agreement between Tenneco Inc., and Cummins Engine Company, Inc., dated July 16, 1990 (incorporated by reference to Form 8-K, dated July 26, 1990). 10(p) Investment Agreement between Kubota Corporation and Cummins Engine Company, Inc., dated July 16, 1990 (incorporated by reference to Form 8-K, dated July 26, 1990). 10(q) Three Year Performance Plan (incorporated by reference to Annual Report on Form 10-K for the year ended December 31, 1992). 10(r) Consulting Arrangement with Harold Brown (incorporated by reference to the description thereof provided in the Company's definitive Proxy Statement, dated March 4, 1994). 10(s) 1992 Stock Incentive Plan (incorporated by reference to Quarterly Report on Form 10-Q for the quarter ended April 4, 1993). 11 Schedule of Computation of Per Share Earnings for each of the three years ended December 31, 1993 (filed herewith). 21 Subsidiaries of the Registrant (filed herewith). 23 Consent of Arthur Andersen & Co. (filed herewith). 24 Powers of Attorney (filed herewith).
71304_1993.txt	71304	1993	Item 1. Business General Commonwealth Energy System, a Massachusetts trust, is an unincorporated business organization with transferable shares. It is organized under a Declaration of Trust dated December 31, 1926, as amended, pursuant to the laws of Massachusetts. It is an exempt public utility holding company under the provisions of the Public Utility Holding Company Act of 1935, holding all of the stock of four operating public utility companies. Commonwealth Energy System, the parent company, is referred to in this report as the "System" and, together with its subsidiaries, is collectively referred to as "the system." The operating utility subsidiaries of the System are engaged in the generation, transmission and distribution of electricity and the distribution of natural gas, all within Massachusetts. These subsidiaries are: Electric Gas Cambridge Electric Light Company Commonwealth Gas Company Canal Electric Company Commonwealth Electric Company In addition to the utility companies, the System also owns all of the stock of a steam distribution company (COM/Energy Steam Company), five real estate trusts and a liquefied natural gas (LNG) and vaporization facility (Hopkinton LNG Corp.). Subsidiaries of the System have common executive and financial management and receive technical assistance as well as financial, data processing, accounting, legal and other services from a wholly-owned services company subsidiary (COM/Energy Services Company). The five real estate subsidiaries are: Darvel Realty Trust, which is a joint-owner of the Riverfront Office Park complex in Cambridge; COM/Energy Acushnet Realty, which leases land to Hopkinton LNG Corp.; COM/Energy Research Park Realty, which was organized to develop a research building in Cambridge; COM/Energy Cambridge Realty, which was organized to hold various properties; and COM/Energy Freetown Realty (Freetown), which was organized in 1986 to purchase and develop 596 acres of land in Freetown, Massachusetts. As a result of unsuccessful efforts to develop an energy park on this site, the System announced on January 23, 1992 its decision to write down its investment in the Freetown project. This action resulted in the recognition of a charge (net of tax) of $14.8 million in 1991. Each of the operating utility subsidiaries previously listed serves retail customers except for Canal Electric Company (Canal) which operates an electric generating station located at the eastern end of the Cape Cod Canal in Sandwich, Massachusetts. The station consists of two oil-fired steam electric generating units: Canal Unit 1, with a rated capacity of 569 MW, wholly-owned by Canal; and Canal Unit 2, with a rated capacity of 580 MW, jointly-owned by Canal and Montaup Electric Company (Montaup) (an unaffiliated company). Canal Unit 2 is operated under an agreement with Montaup which provides for the equal sharing of output, fixed charges and operating expen- ses. In October 1993, Canal reached an agreement with Montaup and Algonquin COMMONWEALTH ENERGY SYSTEM Gas Transmission Company to build a natural gas pipeline that will serve Unit 2, subject to regulatory approvals. The project will improve air quality on Cape Cod, enable the plant to exceed the stringent 1995 air quality standards established by the Massachusetts Department of Environmental Protection and strengthen Canal's bargaining position as it seeks to secure the lowest-cost fuel for its customers. Plant conversion and pipeline construction are expected to be completed in 1996. Electric service is furnished by Cambridge Electric Light Company (Cam- bridge Electric) and Commonwealth Electric Company (Commonwealth Electric) at retail to approximately 304,000 year-round customers in 41 communities in eastern Massachusetts covering 1,112 square miles and having an aggregate population of 645,000. The system also serves approximately 48,000 seasonal retail customers. The territory served includes the communities of Cambridge, New Bedford and Plymouth and the geographic area comprising Cape Cod and Martha's Vineyard. Cambridge Electric also sells power at wholesale to the Town of Belmont, Massachusetts. Natural gas is distributed by Commonwealth Gas Company (Commonwealth Gas) to approximately 232,000 customers in 49 communities in central and eastern Massachusetts covering 1,067 square miles and having an aggregate population of 1,128,000. Twelve of these communities are also served by system companies with electricity. Some of the larger communities served by Commonwealth Gas include Cambridge, Somerville, New Bedford, Plymouth, Worcester, Framingham, Dedham and the Hyde Park area of Boston. The results of the 1990 federal census taken in the system's electric and gas service areas indicated an increase in population of 15.2% and 12%, respectively, since 1980. Steam, which is produced by Cambridge Electric in connection with the generation of electricity, is purchased by COM/Energy Steam and, together with its own production, is distributed to 20 customers in Cambridge and 1 customer (Massachusetts General Hospital) in Boston. Steam is used for space heating and other purposes. On August 17, 1993 COM/Energy Steam began providing steam service to Genzyme Corporation (Genzyme), a biotechnology company that is expected to become one of the largest customers of COM/Energy Steam. Genzyme's steam need for 1994 is estimated to be 160 million pounds, which represents approximately 10% of steam unit sales, for heating, air conditioning and testing processes. After 1994, Genzyme's annual requirement is estimated to reach approximately 230 million pounds upon commercial manufacturing of a biotherapeutic product in 1995. New England Confectionery Company (Necco), began receiving steam service in October 1992 and is the fourth largest customer of COM/Energy Steam. Industry in the territories served by system companies is highly diversified. The larger industrial customers include high-technology firms and manufacturers of such products as photographic equipment and supplies, rubber products, textiles, wire and other fastening devices, abrasives and grinding wheels, candy, copper and alloys, and chemicals. Among customers served are several major educational institutions, including Harvard University and the Massachusetts Institute of Technology (MIT). COMMONWEALTH ENERGY SYSTEM Presently, MIT is constructing a 19 MW natural gas-fired cogeneration facility which is expected to be completed in January 1995. MIT expects that this cogeneration facility will meet approximately 94% of its power, heating and cooling requirements. Sales to MIT in 1993 accounted for approximately 1.9% of consolidated unit sales. MIT and Cambridge Electric are presently negotiating a buy and sell arrangement which will require the approval of the Massachusetts Department of Public Utilities (DPU). Electric Power Supply To satisfy demand requirements and provide required reserve capacity, the system supplements its generating capacity by purchasing power on a long and short-term basis through capacity entitlements under power contracts with other New England and Canadian utilities and with Qualifying Facilities and other non-utility generators through a competitive bidding process that is regulated by the DPU. System companies own generating facilities with a capability totaling 967.1 MW. Included in this amount is 569 MW provided by Canal Unit 1, of which three-quarters (427 MW) is sold to neighboring utilities under long-term contracts, and 220.5 MW provided by Canal Unit 2. In 1991, Canal executed an exchange transaction with Central Vermont Public Service Corporation (CVPS) whereby 50 MW of Canal Unit 2 was exchanged for 25 MW each of CVPS's entitle- ment in the Vermont Yankee nuclear power plant and the Merrimack 2 coal-fired unit through October 1995. These contracts are designed to reduce the system's reliance on oil. Additionally, in 1993, Canal executed an exchange transaction with New England Power Company (NEP) whereby 20 MW of Canal Unit 2 was exchanged for 20 MW of Bear Swamp Unit Nos. 1 and 2 through October 1993. As of November 1, 1993, the exchange was increased to 50 MW through April 1997. The Bear Swamp Units are pumped storage hydro electric generating facilities. Another 128.3 MW is provided by various smaller system units. Of the 540.3 MW available to the system, 65.3 MW are used principally for peaking purposes. A 3.52% ownership interest in the Seabrook 1 nuclear power plant provides 40.5 MW of capability to the system and Central Maine Power Company's Wyman Unit 4, an oil-fired facility in which the system has a 1.4% joint- ownership interest, provides 8.8 MW. In addition, through Canal's equity ownership in Hydro-Quebec Phase II, the system has an entitlement of 67.9 MW. Long-term purchase arrangements are also in place with the following natural gas-fired cogenerating units in Massachusetts: 23.8 MW from the Consolidated Power Company, 31.4 MW from Pep- perell Power Associates and 43.9 MW from Northeast Energy Associates and effective July 31 and September 1, 1993, 51 MW and 55 MW from Masspower and Altresco Pittsfield, respectively. Additionally, the system receives 67.0 MW from the SEMASS waste-to-energy plant (which includes 20.8 MW from the expansion unit which went on-line May 17, 1993); has entitlements totaling 41.6 MW through contracts with five (5) hydroelectric suppliers, including 29.1 MW of pumped storage capacity from New England Power's Bear Swamp Units 1 and 2 and 10 MW from Boott Hydropower, Inc., in Lowell, Massachusetts; and also receives 61.8 MW from a natural gas-fired independent power producer, Dartmouth Power Associates. The system anticipates providing for future peak load plus reserve requirements through existing and planned system generation, including purchasing available capacity from neighboring utilities and/or non- utility generators. COMMONWEALTH ENERGY SYSTEM In addition, the system has available 140.7 MW from four (4) nuclear units in which system distribution companies have life-of-the-unit contracts for power. Information with respect to these units is as follows: Connecticut Maine Vermont Yankee Yankee Yankee Pilgrim (Dollars in Thousands) Location Haddam Neck, Wiscasset, Vernon, Plymouth, Connecticut Maine Vermont Massachusetts Year of Initial Operation 1968 1972 1972 1972 Contract Expiration Date 1998 2008 2012 2012 System Percent of Equity Ownership 4.50% 4.00% 2.50% - System Percent of Plant Entitlement 4.50% 3.59% 2.25% 11.0% Plant Capability (MW) 560.0 870.0 496.0 664.7 System Entitlement (MW) 25.2 31.2 11.2 73.1 1991 Actual Cost $ 9,692 $5,900 $3,383 $30,992 1992 Actual Cost 9,508 6,671 3,970 37,516 1993 Actual Cost 10,016 7,050 4,076 40,578 1994 Estimated Cost 10,005 6,755 3,755 41,963 On February 26, 1992, the Yankee Atomic Electric Company (Yankee) board of directors agreed to permanently cease power operation of the Yankee nuclear power plant in Rowe, Massachusetts. For additional information, refer to Note 2(e) of the Notes to Consolidated Financial Statements filed under Item 8 of this report. On October 1, 1992, Commonwealth Electric ceased power generation at its 60 MW Cannon Street generating station located in New Bedford, Massachusetts. During the past few years, the plant had been used primarily to meet peak electric demand and as a backup unit for Commonwealth Electric and the New England Power Pool (NEPOOL) when other area units were taken off line. A sharp decline in electric demand brought about by the present economic slowdown was the key factor in management's decision to close the plant. Additionally, forecasts for electric demand indicated an excess regional supply in the near term and no need for increased generating capacity until the late-1990s or beyond. Commonwealth Electric made the decision during the second quarter of 1993 to abandon the plant and transfer its net book value to a regulatory asset subsequent to FERC approval. This decision was viewed as the most cost effective among several alternatives and leaves Commonwealth Electric with the most flexibility for future capacity planning. Cambridge Electric, Canal and Commonwealth Electric, together with other electric utility companies in the New England area, are members of NEPOOL, which was formed in 1971 to provide for the joint planning and operation of electric systems throughout New England. NEPOOL operates a centralized dispatching facility to ensure reliability of service and to dispatch the most economically available generating units of the member companies to fulfill the region's energy requirement. This concept COMMONWEALTH ENERGY SYSTEM is accomplished by use of computers to monitor and forecast load requirements and provide for the economic dispatching of generation. NEPOOL, on behalf of its members entered into an Interconnection Agree- ment with Hydro-Quebec, a Canadian utility operating in the Province of Quebec. The agreement provided for construction of an interconnection (Phase I) between the electrical systems of New England and Quebec. The parties have also entered into an Energy Contract and an Energy Banking Agreement; the former obligates Hydro-Quebec to offer NEPOOL participants up to 33 million MWH of surplus energy during an eleven-year term that began September 1, 1986 and the latter provides for energy transfers between the two systems. The Phase I Interconnection began operation in October 1986. NEPOOL has also entered into Phase II agreements for an additional purchase from Hydro-Quebec of 7 million MWH per year for a twenty-five year period which began in late 1990. The System's electric subsidiaries are also members of the Northeast Power Coordinating Council (NPCC), an advisory organization that includes the major power systems in New England and New York plus the Provinces of Ontario and New Brunswick in Canada. NPCC establishes criteria and standards for reliability and serves as a vehicle for coordination in the planning and operation of these systems in enhancing reliability. The reserve requirements used by the NEPOOL participants in planning future additions are determined by NEPOOL to meet the reliability criteria recommended by NPCC. The system estimates that, during the next ten years, reserve requirements so determined will be in the range of 23% to 29% of peak load. Power Supply Commitments and Support Agreements Cambridge Electric and Commonwealth Electric, through Canal, secure cost savings for their respective customers by planning for bulk power supply on a single system basis. Additionally, Cambridge Electric and Commonwealth Electric have long-term contracts for the purchase of electricity from various sources. Generally, these contracts are for fixed periods and require payment of a demand charge for the capacity entitlement and an energy charge to cover the cost of fuel. The system's 3.52% interest in the Seabrook nuclear power plant is owned by Canal to provide for a portion of the capacity and energy needs of Cam- bridge Electric and Commonwealth Electric. Canal began recovering 100% of its Seabrook investment through a power contract with Cambridge Electric and Commonwealth Electric in June 1990, subject to refund pending a full review of Canal's investment in the unit by the Federal Energy Regulatory Commission (FERC). In November 1991, the FERC approved a settlement agreement which resolved all Seabrook cost-of-service issues (except rate of return). In December 1991, a FERC Administrative Law Judge (ALJ) affirmed the prudence of Canal's investment in Seabrook and on January 29, 1992, the FERC approved a settlement proposal that allows a return on equity of 11.72%. The ALJ's decision was approved by the full commission in a final order issued on COMMONWEALTH ENERGY SYSTEM August 4, 1992. For additional information concerning Seabrook 1, refer to Note 2(b) of Notes to Consolidated Financial Statements filed under Item 8 of this report. In response to solicitations made to NEPOOL member companies by Northeast Utilities (NU), Canal, on behalf of Commonwealth Electric and Cambridge Electric, agreed to purchase entitlements through various contracts ranging up to five years in length. The terms of the five-year agreement stipulate the purchase of 50 MW, on average, from NU annually from November 1989 through October 1994. Commonwealth Electric and Cambridge Electric are each appropriated a portion of the power received from NU based on need. These and other bulk electric power purchases are necessary in order to fulfill the system's NEPOOL obligation and to meet Commonwealth Electric and Cambridge Electric capacity requirements. Canal has entered into support agreements for Phase I and Phase II of the Hydro-Quebec Project. Canal is obligated to pay its share of operating and capital costs for Phase II over a 25 year period ending in 2015. Future minimum lease payments for Phase II have an estimated present value of $14.2 million at December 31, 1993. In addition, Canal has an equity interest in Phase II which amounted to $3.9 million in 1993 and $4.2 million in 1992. Electric Fuel Supply (a) Oil Imported residual oil is the fuel used in the generation of power in system generating plants, producing approximately 31% of the system's total energy requirement for 1993. Effective July 1, 1993, Canal executed a twenty-two month contract with Coastal Oil of New England, Inc. (Coastal) for the purchase of residual fuel oil. The contract provides for delivery of a set percentage of Canal's fuel requirement, the balance (a maximum of 20%) to be met by spot purchases or by Coastal at the discretion of Canal. Energy Supply and Credit Corporation (ESCO) operates Canal's oil terminal for the purchase, receipt and payment of oil under assignment of Canal's supply contracts to ESCO (Massachusetts), Inc. Oil in the terminal's tanks is held in inventory by ESCO and delivered upon demand to Canal's tanks. Fuel oil storage facilities at the Canal site have a capacity of 1,199,000 barrels, representing 60 days of normal operation of the two units. During 1993, ESCO maintained an average daily inventory of 583,000 barrels of fuel oil which represents 30 days of normal operation of the two units. This supply is maintained by tanker deliveries approximately every ten to fifteen days. Reference is made to Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations," for a discussion of the cost of fuel oil. COMMONWEALTH ENERGY SYSTEM (b) Nuclear Fuel Supply and Disposal Approximately 26% of the system's total energy requirement for 1993 was generated by nuclear plants. The nuclear fuel contract and inventory information for Seabrook 1 has been furnished to the system by North Atlantic Energy Services Corporation (NAESCO), the plant manager responsible for operation of the unit. The supply of fuel for nuclear generating plants generally involves the acquisition of uranium concentrate, its conversion to uranium hexafluoride, enrichment, fabrication of the nuclear fuel assemblies and disposition through reprocessing or storage of spent fuel. Seabrook's requirements for each of these fuel components are 100% covered through 1999 by existing contracts. There are no spent fuel reprocessing or disposal facilities currently operating in the United States. Instead, commercial nuclear electric generating units operating in the United States are required to retain high level wastes and spent fuel on-site. As required by the Nuclear Waste Policy Act of 1982 (the Act), as amended, the joint-owners entered into a contract with the Department of Energy for the transportation and disposal of spent fuel and high level radioactive waste at a national nuclear waste repository. Owners or generators of spent nuclear fuel or its associated wastes are required to bear all of the costs for such transportation and disposal through payment of a fee of approximately 1 mill/KWH based on net electric generation to the Nuclear Waste Fund. Under the Act, a temporary storage facility for nuclear waste was anticipated to be in operation by 1998; however, a reassess- ment of the project's schedule requires extending the completion date of the permanent facility until at least 2010. Seabrook 1 is currently licensed for enough on-site storage to accommodate all spent fuel expected to be accumulat- ed through the year 2010. Gas Supply In April 1992, the FERC issued Order 636 which became effective on November 1, 1993 and requires interstate pipelines to unbundle existing gas sales contracts into separate components (gas sales, transportation and storage services). Order 636 provides mechanisms which will allow customers such as Commonwealth Gas to reduce the level of firm services from the pipelines and "broker" excess capacity on a temporary or permanent basis. Order 636 also requires pipelines to provide transportation services that allow customers to receive the same level of service they had with the bundled contracts. In the past, Commonwealth Gas purchased the majority of its gas supplies from either Tennessee Gas Pipeline Company (Tennessee) or Algonquin Gas Transmission Company (Algonquin), a wholly-owned subsidiary of Texas Eastern Transmission Company (Texas Eastern), supplemented with third-party firm gas purchases and firm transportation from the various pipelines. Presently, Commonwealth Gas has only transportation, storage, and balancing contracts with these pipelines (and other upstream pipelines that bring gas from the supply wells to the final transporting pipelines), and contracts with a variety of independent vendors for firm gas supply. Twelve new firm gas supply contracts have been negotiated with suppliers and filed with the DPU. During the interim, Commonwealth Gas is operating under short-term firm agreements with these same vendors to provide firm supplies under similar terms and conditions as the long-term agreements, which are presently under review. Approvals are expected during the first half of 1994. COMMONWEALTH ENERGY SYSTEM In addition to firm transportation and gas supplies mentioned above, Commonwealth Gas utilizes contracts for underground storage and LNG facilities to meet its winter peaking demands. The underground storage contracts are a combination of existing agreements, that have been in existence for many years, and new agreements which are the result of Order 636 requirements for total service unbundling. The LNG facilities, described below, are used to liquefy and store pipeline gas during the warmer months for use during the heating season. During 1993, over 99% of the gas utilized by Commonwealth Gas was delivered by the interstate pipeline system, the remaining small quantity (approximately 360,000 MMBTU) was delivered as liquid LNG from Distrigas of Massachusetts. Commonwealth Gas entered into a multi-party agreement to assume a portion of Boston Gas Company's contracts to purchase Canadian gas supplies from Alberta Northeast (ANE), and have the volumes delivered by the Iroquois Gas Transmission System and Tennessee pipelines. The ANE gas supply contract was filed with the DPU and hearings were completed in April 1993. Commonwealth Gas is currently awaiting an order from the DPU. Commonwealth Gas began transporting gas on its distribution system in 1990 for end-users. There are currently only eleven customers using this transportation service, accounting for only 1,623 BBTU of throughput in 1993 which represented approximately 3.5% of system throughput. Hopkinton LNG Facility A portion of the system's gas supply during the heating season is provided by Hopkinton LNG Corp. (Hopkinton), a wholly-owned subsidiary of the System. The facility consists of a liquefaction and vaporization plant and three above-ground cryogenic storage tanks having an aggregate capacity of 3 million MCF of natural gas. In addition, Hopkinton owns a satellite vaporization plant and two above-ground cryogenic storage tanks located in Acushnet, Massachusetts with an aggregate capacity of 500,000 MCF of natural gas and are filled with LNG trucked from Hopkinton. Commonwealth Gas has a contract for LNG service with Hopkinton extending through 1996, thereafter renewable year to year with notice of termination due five years in advance. Contract payments include a demand charge sufficient to cover Hopkinton's fixed charges and an operating charge which covers liquefaction and vaporization expenses. Commonwealth Gas furnishes pipeline gas during the period April 15 to November 15 each year for liquefaction and storage. As the need arises, LNG is vaporized and placed in the distribution system of Commonwealth Gas. Based upon information presently available regarding projected growth in demand and estimates of availability of future supplies of pipeline gas, the System believes that its present sources of gas supply are adequate to meet existing load and allow for future growth in sales. COMMONWEALTH ENERGY SYSTEM Rates, Regulation and Legislation Certain of the System's utility subsidiaries operate under the jurisdic- tion of the DPU, which regulates retail rates, accounting, issuance of secur- ities and other matters. In addition, Canal and Cambridge Electric file their respective wholesale rates with the FERC. (a) Most Recent Rate Case Proceedings Electric On May 28, 1993, the DPU issued an order increasing Cambridge Electric's retail revenues by approximately $7.2 million, or 6.4%. The rates, based on a June 30, 1992 test-year and effective June 1, 1993, provide an overall return of 9.95%, including an equity return of 11% and represented approximately 70% of the amount requested. The new rates will have a positive impact on net income for the balance of 1993 and beyond. More than 80% of the increase related to: 1) plant additions since Cambridge Electric's last retail rate proceeding in 1989; 2) capacity costs associated with certain purchased power contracts; and 3) costs of postretirement benefits other than pensions. The costs associated with these postretirement benefits were determined in accordance with Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," issued in 1990 and adopted as of January 1, 1993. The DPU authorized recovery of these costs over a four-year period with carrying costs on the deferred portion. The new base rates also reflect the roll-in of costs associated with the Seabrook nuclear power plant which are billed to Cambridge Electric by Canal. Previously these costs were recovered through Cambridge Electric's Fuel Charge decimal. On May 17, 1989, Cambridge Electric filed for an increase in its base rates using a 1988 test-year. On August 31, 1989, the DPU approved an Offer of Settlement between the parties which resolved all revenue requirements issues. Cambridge Electric was allowed to increase annual revenues by $4,438,000 or 5.5% of total test-year revenue, approximately 73% of the $6,111,000 originally requested. The new rates became effective on December 18, 1989 and represented the first increase in Cambridge Electric's rates since 1982. On July 1, 1991, the DPU issued an order increasing Commonwealth Elec- tric's retail electric revenues by $10.9 million, or 3.1%. The requested increase was $17.3 million. The order, based on a June 30, 1990 test-year, provided an overall return of 10.49%, including a return on equity of 12%. The DPU ordered the restructuring of the Company's rates to more closely reflect the actual cost of providing service to each customer class. The DPU also ordered Commonwealth Electric to undertake an independent management audit to address, among other areas, its management, planning and control practices. In February 1992, Ernst & Young was selected by the DPU from three management consulting firms submitted by Commonwealth Electric to perform the audit which began on March 6, 1992. On October 9, 1992, the DPU released the results of the audit which evaluated existing activities and processes and identified opportunities for improved operations in the areas of strategic planning, budget development, control of capital and operations costs, management of outside services, employment policies and customer services. COMMONWEALTH ENERGY SYSTEM Throughout 1993, follow-up discussions were held between Commonwealth Electric and the DPU regarding the status of each audit recommendation with both parties expressing overall satisfaction with their progress. Changes in the implementation plan were discussed, with the plan expected to be completed in 1994. In January 1989, Commonwealth Electric received authorization from the DPU to increase base revenues by $18 million or 6.6% of total test-year revenues. This increase, representing approximately 77% of its original $23.3 million request, included an overall rate of return of 10.89% and a return on common equity of 13%. It represented the first increase in Commonwealth Elec- tric's base rates since 1982. Gas On April 16, 1991, Commonwealth Gas requested a $27.7 million (11.3%) revenue increase in a filing with the DPU using a test-year ended December 31, 1990. On September 16, 1991, the DPU approved a settlement of the revenue requirements portion of the filing authorizing a $22.8 million increase in annual revenues, approximately 82% of the original request. The agreement included a return on equity, for accounting purposes, of 13%. The DPU later ruled on the rate design portion of the request and the new rates went into effect on November 1, 1991. The increase was necessitated by the rising costs of providing service to customers and substantial expenditures to upgrade, improve and maintain the Commonwealth Gas distribution system. (b) Wholesale Rate Proceedings Cambridge Electric requires FERC approval to increase its wholesale rates to the Town of Belmont, Massachusetts (Belmont), a "partial requirements" customer since 1986. These rates include a fuel adjustment clause which reflects changes in costs of fuels and purchased power used to supply Belmont. On March 23, 1990, Cambridge Electric filed a request with the FERC to increase its wholesale rates to Belmont by $2,252,000 annually. The request was largely due to increased purchased power costs and major additions to plant-in-service. The proposed rates were accepted by the FERC, subject to refund, on August 1, 1990. On September 19, 1990, Cambridge Electric and Belmont filed an uncontested Offer of Settlement which the FERC approved on December 6, 1990 resolving all issues with the exception of Seabrook 1 costs which were subject to change based upon the results of the FERC's final review of Canal's investment in the unit. This settlement required Cambridge Electric to adjust its Belmont rate to reflect the final allocation of power purchased by Canal on behalf of Cambridge Electric and Commonwealth Electric. Cambridge Electric made a refund to Belmont in August 1991 and filed the requisite compliance report with the FERC on September 16, 1991. A settlement agreement between Canal and Belmont addressing all Seabrook cost-of-service issues (except rate of return on common equity) was filed with the FERC on April 16, 1991 and subsequently approved by the FERC on November 13, 1991. In addition, this settlement changed the effective date of the Belmont Service Agreement from August 1, 1990 to June 30, 1990. The charges and refunds resulting from this settlement were applied to Belmont's bill in January 1992. COMMONWEALTH ENERGY SYSTEM On November 12, 1991 a settlement agreement between Canal and Belmont addressing the rate of return on common equity in the Seabrook Power Contract was filed with the FERC. The return on equity settlement, which was approved by the FERC on January 29, 1992, allowed a return on equity of 11.72% and required Canal to refund certain sums to Cambridge Electric and Commonwealth Electric and to make a compliance report to the FERC. On March 12, 1992, Canal made its compliance filing with the FERC indicating that all refunds were made to Cambridge Electric and Commonwealth Electric on February 27, 1992. As a result of the return on equity settlement, Cambridge Electric was required to refund certain sums to Belmont. On April 2, 1992 Cambridge made its requisite compliance filing with the FERC indicating that refunds were made to Belmont in the March 1992 billings. (c) Automatic Adjustment Clauses Electric Both Commonwealth Electric and Cambridge Electric have Fuel Charge rate schedules which generally allow for current recovery, from retail customers, of fuel used in electric production, purchased power and transmission costs. These schedules require a quarterly computation and DPU approval of a Fuel Charge decimal based upon forecasts of fuel, purchased power, transmission costs and billed unit sales for each period. To the extent that collections under the rate schedules do not match actual costs for that period, an appropriate adjustment is reflected in the calculation of the next subsequent calendar quarter decimal. Cambridge Electric and Commonwealth Electric collect a portion of the capacity-related purchased power costs associated with certain long-term power arrangements through base rates. The recovery mechanism for these costs uses a per kilowatthour (KWH) factor that is calculated using historical (test- period) capacity costs and unit sales. This factor is then applied to current monthly KWH sales. When current period capacity costs and/or unit sales vary from test-period levels, Cambridge Electric and Commonwealth Electric experience a revenue excess or shortfall which can have a significant impact on net income. All other capacity and energy-related purchased power costs are recovered through the Fuel Charge. Cambridge Electric and Commonwealth Electric made a filing in late 1992 with the DPU seeking an alternative method of recovery. This request was denied in a letter order issued on October 6, 1993. However, Cambridge Electric and Commonwealth Electric were encouraged by the DPU's acknowledgement that the issues presented warrant further consideration. The DPU encouraged each company to continue to work with other interested parties, including the Attorney General of Massachusetts, to reach a consensus solution on the issue for consideration in each company's next base rate proceeding. Both Commonwealth Electric and Cambridge Electric have separately stated Conservation Charge rate schedules which allow for current recovery, from retail customers, of Conservation and Load Management program costs. For further information, refer to Management's Discussion and Analysis of Financial Condition and Results of Operations filed under Item 7 of this report. COMMONWEALTH ENERGY SYSTEM Gas Commonwealth Gas has a Standard Seasonal Cost of Gas Adjustment rate schedule (CGA) which provides for the recovery, from firm customers, of purchased gas costs not collected through base rates. These schedules, which require DPU approval, are estimated semi-annually and include credits for gas pipeline refunds and profit margins applicable to interruptible sales. Actual gas costs are reconciled annually as of October 31 and any difference is included as an adjustment in the calculation of the decimals for the two subsequent six-month periods. The DPU and the Massachusetts Energy Facilities Siting Council (the Council) were merged in 1992. The Council is now a division of the DPU. Periodically, Commonwealth Gas is required to file a long-range forecast of the energy needs and requirements of its market area and annual supplements thereto with the Council. To approve a long-range forecast, the Council must find, among other things, that Commonwealth Gas plans for construction of new gas manufacturing or storage facilities and certain high-pressure gas pipelines are consistent with current health, environmental protection, and resource use and development policies as adopted by the Commonwealth of Massachusetts. Commonwealth Gas filed a long-range forecast with the Council on July 20, 1990 and updated aspects of the filing in March 1991. This forecast was combined with the DPU review of the ANE contract. Both dockets remain pending before the DPU. (d) Gas Demand, Take-or-Pay Costs and Transition Costs Commonwealth Gas is obligated, as part of its pipeline transportation contracts and supplier gas purchase contracts, to pay monthly demand charges which are recovered from customers through the CGA. In June 1991, Tennessee filed a settlement with the FERC dealing with a variety of contract restructuring issues, including the allocation of take-or- pay costs to Tennessee's customers including Commonwealth Gas. This comprehensive settlement was approved and implemented on July 1, 1992. As part of the settlement, the allocation of take-or-pay costs was changed from a deficiency basis to a contract demand basis which increased Commonwealth Gas' allocation. Future take-or-pay costs will be included in Tennessee's Temporary Gas Inventory Charge and transition costs under Tennessee's restructuring pursuant to Order 636. Algonquin made a series of filings with the FERC to recover from its customers take-or-pay charges imposed on it by its upstream suppliers. Algonquin billed Commonwealth Gas for gas supply inventory charges from Texas Eastern and others through the Algonquin commodity rate. With the implementation of Order 636, Algonquin allocated the remaining costs utilizing a formula based on actual purchases for the twelve months prior to May 1, 1993. Commonwealth Gas' allocation was in excess of $5 million. Commonwealth Gas successfully appealed Algonquin's allocation method to the FERC. The change in allocation, combined with issues being settled in Algonquin's current rate case will reduce Commonwealth Gas' allocated share by $1.5 million to $2.5 million. As a direct result of implementation of Order 636, most pipeline companies are incurring transition costs which include the cost of COMMONWEALTH ENERGY SYSTEM restructuring gas supply contracts, the value of facilities that were supporting the gas sales function and are no longer used and useful for transportation only services, the cost of contracts with upstream pipeline companies and various miscellaneous costs. For additional information on these transition costs refer to Note 2(g) of Notes to Financial Statements filed under Item 8 of this report. Commonwealth Gas is collecting take-or-pay and other contract restructuring costs from its customers through the CGA as permitted by the DPU. The remaining take-or-pay costs to be billed to Commonwealth Gas from both Algonquin and Tennessee are estimated at approximately $431,000 as of December 31, 1993, subject to change upon FERC approval. (e) Economic Development Rate Commonwealth Electric implemented an Economic Development Rate (EDR) on October 1, 1991. The rate is available to new or existing industrial customers who have an electric demand of 500 kilowatts or more and meet specific financial criteria. For additional information concerning the EDR, refer to the "Economic Development Rate" section of "Management's Discussion and Analysis of Financial Condition and Results of Operations" filed under Item 7 of this report. (f) Other Storm Damage Costs In August 1991, Commonwealth Electric's service territory was partic- ularly hard hit by Hurricane Bob. Its transmission and distribution system suffered such extensive damage that its entire service territory (with minor exceptions) was without power at one point. Commonwealth Electric's franchise is located entirely within four of the ten Massachusetts counties which were declared federal disaster zones. In April 1992, the DPU approved an offer of settlement between Commonwealth Electric, the Attorney General of Massachusetts and a Cape Cod consumer group relating to certain costs associated with this storm. For further information on this settlement, refer to Note 3 of Notes to Consolidated Financial Statements filed under Item 8 of this report. Segment Information System companies provide electric, gas and steam services to retail customers in service territories located in central and eastern Massachusetts and, in addition, sell electricity at wholesale to Massachusetts customers. Other operations of the system include the development and management of new real estate ventures and operation of rental properties and other investment activities which do not presently contribute significantly to either revenues or operating income. Reference is made to additional industry segment information in Note 11 of Notes to Consolidated Financial Statements filed under Item 8 of this re- port. COMMONWEALTH ENERGY SYSTEM Environmental Matters The system is subject to laws and regulations administered by federal, state and local authorities relating to the quality of the environment. Compliance with these laws and regulations has required capital expenditures by the system for the period 1968 through 1993 of approximately $51.8 million, $29.7 million of which was for facilities and studies at Seabrook. Additional capital expenditures through 1998 will require an estimated $25.1 million. For additional information concerning environmental issues including those relating to former gas manufacturing sites, refer to the "Environmental Matters" section of "Management's Discussion and Analysis of Financial Condi- tion and Results of Operations" filed under Item 7 of this report. Construction and Financing For information concerning the system's financing and construction programs refer to Management's Discussion and Analysis of Financial Condition and Results of Operations filed under Item 7 and Note 2(a) of the Notes to Consolidated Financial Statements filed under Item 8 of this report. Employees The total number of full-time employees for the system declined 8.2% to 2,217 in 1993 from 2,414 employees at year-end 1992 due to a second quarter work force reduction. Of the current total, 1,338 (60%) are represented by various collective bargaining units. Existing agreements are for varying periods and expire in 1994 and thereafter. Employee relations have generally been satisfactory and management views the current work force level to be appropriate to service the system's customers. Item 2.		Item 2. Properties The system's principal electric properties consist of Canal Unit 1, a 569 MW oil-fired steam electric generating unit, and its one-half ownership in Canal Unit 2, a 580 MW oil-fired steam electric generating unit, both located at Canal Electric's facility in Sandwich, Massachusetts. Other electric properties include an integrated system of distribution lines and substations together with Commonwealth Electric's 60 MW steam electric generating station located in New Bedford, Massachusetts. This unit, which ceased operations in October 1992, was abandoned in 1993. As a result, the net book value of the plant of approximately $4 million was reclassified from property, plant and equipment to a regulatory asset in anticipation of future recovery. Cambridge Electric has two steam electric generating stations with a net capability of 76.5 MW located in Cambridge, Massachusetts. In addition, the system has a 3.52% interest (40.5 MW of capacity) in Seabrook 1 and a 1.4% or 8.8 MW joint-ownership interest in Central Maine Power Company's Wyman Unit 4. The system also owns smaller generating units totaling 65.3 MW used primarily for peaking and emergency purposes. In addition, the system's other principal properties consist of an electric division office building in Wareham, Massachusetts and other structures such as garages and service buildings. COMMONWEALTH ENERGY SYSTEM At December 31, 1993, the electric transmission and distribution system consisted of 5,784 pole miles of overhead lines, 4,095 cable miles of under- ground line, 359 substations and 371,594 active customer meters. The principal natural gas properties consist of distribution mains, ser- vices and meters necessary to maintain reliable service to customers. At the end of 1993, the gas system included 2,739 miles of gas distribution lines, 151,192 services and 237,318 customer meters together with the necessary measuring and regulating equipment. In addition, the system owns a lique- faction and vaporization plant, a satellite vaporization plant and above- ground cryogenic storage tanks having an aggregate storage capacity equivalent to 3.5 million MCF of natural gas. The system's gas division owns a central headquarters and service building in Southborough, Massachusetts, five district office buildings and several natural gas receiving and take stations. Item 3.	Item 3. Legal Proceedings Refer to the "Environmental Matters" section of "Management's Discussion and Analysis of Financial Condition and Results of Operations" section of the Notice of 1994 Annual Meeting, Proxy Statement and 1993 Financial Information dated April 1, 1994, page 42. Item 4.	Item 4. Submission of Matters to a Vote of Security Holders None COMMONWEALTH ENERGY SYSTEM PART II. Item 5.	Item 5. Market for the Registrant's Securities and Related Stockholder Matters (a) Principal Markets The System's common shares are listed on the New York, Boston and Pacific Stock Exchanges. The table below sets forth the high and low closing prices as reported on the New York Stock Exchange composite transactions tape. 1993 by Quarter First Second Third Fourth High $48 7/8 $48 5/8 $50 1/8 $49 3/4 Low 40 1/2 43 3/8 46 3/4 43 1992 by Quarter First Second Third Fourth High $39 $40 $43 $43 Low 36 3/8 34 7/8 39 1/2 40 1/4 (b) Number of Shareholders at December 31, 1993 15,877 shareholders (c) Frequency and Amount of Dividends Declared in 1993 and 1992 1993 1992 Per Per Share Share Declaration Date Amount Declaration Date Amount March 25, 1993 $ .73 March 26, 1992 $ .73 June 24, 1993 .73 June 25, 1992 .73 September 23, 1993 .73 September 24, 1992 .73 December 16, 1993 .73 December 17, 1992 .73 $2.92 $2.92 (d) Future dividends may vary depending upon the System's earnings and capital requirements as well as financial and other conditions existing at that time. Item 6.	Item 6. Selected Financial Data Information required by this item is incorporated herein by reference to Exhibit A to the Notice of 1994 Annual Meeting, Proxy Statement and 1993 Financial Information dated April 1, 1994, page 67. Item 7.	Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Information required by this item is incorporated herein by reference to Exhibit A to the Notice of 1994 Annual Meeting, Proxy Statement and 1993 Financial Information dated April 1, 1994, pages 33 through 45. COMMONWEALTH ENERGY SYSTEM Item 8.	Item 8. Financial Statements and Supplementary Data The following consolidated financial statements and supplementary data of the System and its subsidiaries are incorporated herein by reference to Exhibit A to the Notice of 1994 Annual Meeting, Proxy Statement and 1993 Financial Information dated April 1, 1994 on pages 46 through 66. Proxy Page Reference Management's Report 46 Report of Independent Public Accountants 47 Consolidated Balance Sheets - At December 31, 1993 and 1992 48-49 Consolidated Statements of Income - Years Ended December 31, 1993, 1992 and 1991 50 Consolidated Statements of Cash Flows - Years Ended December 31, 1993, 1992 and 1991 51 Consolidated Statements of Capitalization - At December 31, 1993 and 1992 52 Consolidated Statements of Changes in Common Shareholders' Investment and in Redeemable Preferred Shares - Years Ended December 31, 1993, 1992 and 1991 53 Notes to Consolidated Financial Statements 54-66 Quarterly Information pertaining to the results of operations for the years ended December 31, 1993 and 1992 67 Item 9.	Item 9. Changes In and Disagreements With Accountants on Accounting and Financial Disclosure None COMMONWEALTH ENERGY SYSTEM PART III. Item 10.	Item 10. Trustees and Executive Officers of the Registrant a. Trustees of the Registrant: Information required by this item is incorporated herein by reference to the Notice of 1994 Annual Meeting, Proxy Statement and 1993 Financial Information dated April 1, 1994, pages 3-5. b. Executive Officers of the Registrant: Age at December Name of Officer Position and Business Experience 31, 1993 William G. Poist President, Chief Executive Officer and 60 Trustee of the System and Chairman and Chief Executive Officer of its principal subsidiary companies since January 1, 1992; President and Chief Operating Officer of Commonwealth Gas Company* from 1983 to 1991 and Hopkinton LNG Corp.* from 1985 to 1991; Vice President of the System and COM/Energy Services Company* effective September 1, 1991. James D. Rappoli Financial Vice President and Treasurer of 42 the System and its subsidiary companies effective March 1, 1993; Treasurer of System subsidiary companies 1990; Assistant Treasurer of System subsidiary companies 1989. Russell D. Wright President and Chief Operating Officer of 47 Cambridge Electric Light Company, Canal Electric Company, COM/Energy Steam Company, and Commonwealth Electric Company (effective March 1, 1993); Financial Vice President and Treasurer of the System and Financial Vice President of its subsidiary companies (July 1987 to March 1993); Treasurer of System subsidiary companies (December 1989 to December 1990), Assistant Vice President- Finance of System subsidiary companies 1986. Kenneth M. Margossian President and Chief Operating Officer of 45 Commonwealth Gas Company* and Hopkinton LNG Corp.* effective September 1, 1991; Vice President of Operations from 1988 to 1991; Vice President of Facilities Develop- ment from 1987 to 1988; Vice President of Human Resources and Administration of Commonwealth Gas Company from 1985 to 1987. Subsidiary of the System. COMMONWEALTH ENERGY SYSTEM b. Executive officers of the Registrant (Continued): Age at December Name of Officer Position and Business Experience 31, 1993 Michael P. Sullivan Vice President, Secretary, and 45 General Counsel of the System and subsidiary companies (effective June 1993); Vice President, Secretary, and General Attorney of the System and subsidiary companies since 1981. John A. Whalen Comptroller of the System and subsidiary 46 companies since 1978. Subsidiary of the System. The term of office for System officers expires May 5, 1994, the date of the next Annual Organizational Meeting. There are no family relationships between any trustee and executive officer and any other trustee or executive of the System. There were no arrangements or understandings between any officer or trustee and any other person pursuant to which he was or is to be selected as an officer, trustee or nominee. There have been no events under any bankruptcy act, no criminal pro- ceedings and no judgments or injunctions material to the evaluation of the ability and integrity of any trustee or executive officer during the past five years. Item 11.	Item 11. Executive Compensation Information required by this item is incorporated herein by reference to the Notice of 1994 Annual Meeting, Proxy Statement and 1993 Financial Informa- tion dated April 1, 1994, pages 6-10. Item 12.	Item 12. Security Ownership of Certain Beneficial Owners and Management Information required by this item is incorporated herein by reference to the Notice of 1994 Annual Meeting, Proxy Statement and 1993 Financial Inform- ation dated April 1, 1994, pages 3-5. Item 13.	Item 13. Certain Relationships and Related Transactions Information required by this item is incorporated herein by reference to the Notice of 1994 Annual Meeting, Proxy Statement and 1993 Financial Inform- ation dated April 1, 1994, pages 3-5. COMMONWEALTH ENERGY SYSTEM PART IV. Item 14.	Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) 1. Index to Financial Statements Consolidated financial statements and notes thereto of Commonwealth Energy System and Subsidiary Companies together with the Report of Independent Public Accountants, as detailed on page 19 in Item 8 of this Form 10-K, have been incorporated herein by reference to Exhibit A to the Notice of 1994 Annual Meeting, Proxy Statement and 1993 Financial Information dated April 1, 1994. (a) 2. Index to Financial Statement Schedules Commonwealth Energy System and Subsidiary Companies Filed herewith at page(s) indicated - Report of Independent Public Accountants on Schedules (page 46). Schedule III - Investments in, Equity in Earnings of, and Dividends Received from Related Parties - Years Ended December 31, 1993, 1992 and 1991 (pages 47-49). Schedule V - Property, Plant and Equipment - Years Ended December 31, 1993, 1992 and 1991 (pages 50-52). Schedule VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment - Years Ended December 31, 1993, 1992 and 1991 (page 53). Schedule VIII - Valuation and Qualifying Accounts - Years Ended December 31, 1993, 1992 and 1991 (page 54). Schedule IX - Short-Term Borrowings - Years Ended December 31, 1993, 1992 and 1991 (page 55). All other schedules have been omitted because they are not applicable, not required or because the required information is included in the financial statements or notes thereto. Subsidiaries not Consolidated and Fifty-Percent or Less Owned Persons Financial statements of 50% or less owned persons accounted for by the equity method have been omitted because they do not, considered individ- ually or in the aggregate, constitute a significant subsidiary. Form 11-K, Annual Reports of Employee Stock Purchases, Savings and Similar Plans Pursuant to Rule 15(d)-21 of the Securities and Exchange Act of 1934, the information, financial statements and exhibits required by Form 11-K with respect to the Employees Savings Plan of Commonwealth Energy System and Subsidiary Companies will be filed as an amendment to this report under cover of Form 10-K/A or Form SE no later than May 2, 1994. COMMONWEALTH ENERGY SYSTEM (a) 3. Exhibits: Notes to Exhibits - a. Unless otherwise designated, the exhibits listed below are incorporated by reference to the appropriate exhibit numbers and the Securities and Exchange Commission file numbers indicated in parentheses. b. If applicable, as designated by an asterisk, certain documents prev- iously filed by the System or its subsidiary companies have been dis- posed of by the Commission pursuant to its Records Control Schedule and are hereby being refiled by the appropriate registrant and to the appropriate file number. c. During 1981, New Bedford Gas and Edison Light Company sold its gas business and properties to Commonwealth Gas Company and changed its corporate name to Commonwealth Electric Company. d. The following is a glossary of Commonwealth Energy System and subsid- iary companies' acronyms that are used throughout the following Exhibit Index: CES ......................Commonwealth Energy System CE .......................Commonwealth Electric Company CEL ......................Cambridge Electric Light Company CEC ......................Canal Electric Company CG .......................Commonwealth Gas Company NBGEL ....................New Bedford Gas and Edison Light Company HOPCO ....................Hopkinton LNG Corp. Exhibit Index Exhibit 3. Declaration of Trust Commonwealth Energy System (Registrant) 3.1.1 Declaration of Trust of CES dated December 31, 1926, as amended by vote of the shareholders and trustees May 7, 1987 (Exhibit 1 to the CES Form 10-Q (March 1987), File No. 1-7316). Exhibit 4. Instruments defining the rights of security holders, including indentures Commonwealth Energy System (Registrant) Debt Securities - 4.1.1 CES Note Agreement ($40 Million Privately Placed Senior Notes) dated June 28, 1989 (Exhibit 1 to the CES Form 10-Q (September 1989), File No. 1-7316). COMMONWEALTH ENERGY SYSTEM Subsidiary Companies of the Registrant Cambridge Electric Light Company Indenture of Trust or Supplemental Indenture of Trust - 4.2.1 Original Indenture on Form S-1 (April, 1949) (Exhibit 7(a), File No. 2-7909) 4.2.2 First Supplemental on Form S-9 (Jan., 1958) (Exhibit 2(b)2, File No. 2-13783) 4.2.3 Second Supplemental on Form 8-K (Feb., 1962) (Exhibit A, File No. 2-7909) 4.2.4 Third Supplemental on Form 10-K (1984) (Exhibit 1, File No. 2-7909) 4.2.5 Fourth Supplemental on Form 10-K (1984) (Exhibit 2, File No. 2-7909) 4.2.6 Fifth Supplemental on Form 10-K (1983) (Exhibit 1, File No. 2-7909) 4.2.7 Sixth Supplemental on Form 10-Q (June 1989) (Exhibit 1, File No. 2- 7909) 4.2.8 Seventh Supplemental on Form 10-Q (June 1992), (Exhibit 1, File No 2-7909). Canal Electric Company Indenture of Trust and First Mortgage or Supplemental Indenture of Trust and First Mortgage - 4.3.1 Indenture of Trust and First Mortgage with State Street Bank and Trust Company, Trustee, dated October 1, 1968 (Exhibit 4(b) to Form S-1, File No. 2-30057). 4.3.2 First and General Mortgage Indenture with Citibank, N.A., Trustee, dated September 1, 1976 (Exhibit 4(b)2 to Form S-1, File No. 2- 56915). 4.3.3 First Supplemental dated October 1, 1968 with State Street Bank and Trust Company, Trustee, dated September 1, 1976 (Exhibit 4(b)3 to Form S-1, File No. 2-56915). 4.3.4 Second Supplemental dated September 1, 1976 with Citibank, N.A., New York, N.Y., Trustee, dated December 1, 1983 (Exhibit 1 to 1983 Form 10-K, File No. 2-30057). 4.3.5 Third Supplemental dated September 1, 1976 with Citibank, N.A., New York, NY, Trustee, dated December 1, 1990 (Exhibit 3 to 1990 Form 10-K, File No. 2-30057). 4.3.6 Fourth Supplemental dated September 1, 1976 with Citibank, N.A., New York, NY, Trustee, dated December 1, 1990 (Exhibit 4 to 1990 Form 10-K, File No. 2-30057). COMMONWEALTH ENERGY SYSTEM Commonwealth Gas Company Indenture of Trust or Supplemental Indenture of Trust - 4.4.1 Original Indenture on Form S-1 (Feb., 1949) (Exhibit 7(a), File No. 2-7820) 4.4.2 First Supplemental on Form S-1 (Mar., 1950) (Exhibit 7(a), File No. 2-8418) 4.4.3 Second and Third Supplemental on Form S-1 (Nov., 1952) (Exhibits 4(a)(2) and 4(a)(3), File No. 2-10445) 4.4.4 Fourth Supplemental on Form S-9 (Oct., 1954) (Exhibit 2(b)(5), File No. 2-15089) 4.4.5 Fifth Supplemental on Form S-9 (Mar., 1956) (Exhibit 2(b)(6), File No. 2-15089) 4.4.6 Sixth Supplemental on Form S-9 (April, 1957) (Exhibit 2(b)(7), File No. 2-15089) 4.4.7 Seventh Supplemental on Form S-9 (June 1959) (Exhibit 2(b)(8), File No. 2-20532) 4.4.8 Eighth Supplemental on Form S-9 (Sept., 1961) (Exhibit 2(b)(9), File No. 2-20532) 4.4.9 Ninth Supplemental on Form 8-K (Aug., 1962) (Exhibit A, File No. 2- 1647) 4.4.10 Tenth Supplemental on Form 10-K (1970) (Exhibit 2, File No. 2-1647) 4.4.11 Eleventh Supplemental on Form S-1 (June, 1972) (Exhibit 4(b)(2), File No. 2-48556) 4.4.12 Twelfth Supplemental on Form S-1 (Aug., 1973) (Exhibit 4(b)(3), File No. 2-48556) 4.4.13 Thirteenth Supplemental on Form 10-K (1992) (Refiled as Exhibit 1, File No. 2- 1647) 4.4.14 Fourteenth Supplemental on Form 10-K (1990) (Exhibit 1, File No. 2- 1647) 4.4.15 Fifteenth Supplemental on Form 10-K (1982) (Exhibit 1, File No. 2- 1647) 4.4.16 Sixteenth Supplemental on Form 10-K (1986) (Exhibit 1, File No. 2- 1647) 4.4.17 Seventeenth Supplemental on Form 10-K (1990) (Exhibit 2, File No. 2-1647) COMMONWEALTH ENERGY SYSTEM Commonwealth Electric Company Indenture of Trust or Supplemental Indenture of Trust - 4.5.1 Original Indenture on Form S-1 (Nov., 1948) (Exhibit 7(a), File No. 2-7749) 4.5.2 First Supplemental on Form S-1 (Oct., 1950) (Exhibit 7(a-1), File No. 2-8605) 4.5.3 Second Supplemental on Form 10-K (1984) (Exhibit 1, File No. 2- 7749) 4.5.4 Third Supplemental on Form 8-K (Feb., 1962) (Exhibit A, File No. 2- 7749) 4.5.5 Fourth Supplemental on Form 10-K (1984) (Exhibit 2, File No. 2- 7749) 4.5.6 Fifth Supplemental on Form 10-K (1984) (Exhibit 3, File No. 2-7749) 4.5.7 Sixth Supplemental on Form 10-K (1984) (Exhibit 4, File No. 2-7749) 4.5.8 Seventh Supplemental on Form S-1 (Dec., 1975) (Exhibit 4(b)2, File No. 2-54955) Cape & Vineyard Electric Company 4.5.9 Original Indenture on Form S-1 (Apr., 1957) (Exhibit 4(b)1, File No. 2-26429) 4.5.10 First Supplemental on Form 10-K (1984) (Exhibit 5, File No. 2-7749) 4.5.11 Second Supplemental on Form 10-K (1984) (Exhibit 6, File No. 2- 7749) Merged with Commonwealth Electric Company January 1, 1971. Exhibit 10. Material Contracts 10.1 Power contracts. 10.1.1 Power contracts between CEC (Unit 1) and NBGEL and CEL dated December 1, 1965 (Exhibit 13(a)(1-4) to the CEC Form S-1, File No. 2-30057). 10.1.2 Power contract between Yankee Atomic Electric Company (YAEC) and CEL dated June 30, 1959, as amended April 1, 1975 (Refiled as Exhibit 1 to the 1991 CEL Form 10-K, File No. 2-7909). 10.1.2.1 Second, Third and Fourth Amendments to 10.1.2 as amended October 1, 1980, April 1, 1985 and May 6, 1988, respectively (Exhibit 2 to the CEL Form 10-Q (June 1988), File No. 2-7909). COMMONWEALTH ENERGY SYSTEM 10.1.2.2 Fifth and Sixth Amendments to 10.1.2 as amended June 26, 1989 and July 1, 1989, respectively (Exhibit 1 to the CEL Form 10-Q (September 1989), File No. 2-7909). 10.1.3 Power Contract between YAEC and NBGEL dated June 30, 1959, as amended April 1, 1975 (Refiled as Exhibit 2 to the 1991 CE Form 10-K, File No. 2-7749). 10.1.3.1 Second, Third and Fourth Amendments to 10.1.3 as amended October 1, 1980, April 1, 1985 and May 6, 1988, respectively (Exhibit 1 to the CE Form 10-Q (June 1988), File No. 2-7749). 10.1.3.2 Fifth and Sixth Amendments to 10.1.3 as amended June 26, 1989 and July 1, 1989, respectively (Exhibit 3 to the CE Form 10-Q (September 1989), File No. 2-7749). 10.1.4 Power Contract between Connecticut Yankee Atomic Power Company (CYAPC) and CEL dated July 1, 1964 (Exhibit 13-K1 to the System's Form S-1, (April 1967) File No. 2-25597). 10.1.4.1 Additional Power Contract providing for extension on contract term between CYAPC and CEL dated April 30, 1984 (Exhibit 5 to the CEL Form 10-Q (June 1984), File No. 2-7909). 10.1.4.2 Second Supplementary Power Contract providing for decommissioning financing between CYAPC and CEL dated April 30, 1984 (Exhibit 6 to the CEL Form 10-Q (June 1984), File No. 2-7909). 10.1.5 Power contract between Vermont Yankee Nuclear Power Corporation (VYNPC) and CEL dated February 1, 1968 (Exhibit 3 to the CEL 1984 Form 10-K, File No. 2-7909). 10.1.5.1 First Amendment dated June 1, 1972 (Section 7) and Second Amendment dated April 15, 1983 (decommissioning financing) to 10.1.5 (Exhibits 1 and 2, respectively, to the CEL Form 10-Q (June 1984), File No. 2-7909). 10.1.5.2 Third Amendment dated April 1, 1985 and Fourth Amendment dated June 1, 1985 to 10.1.5 (Exhibits 1 and 2, respectively, to the CEL Form 10-Q (June 1986), File No. 2-7909). 10.1.5.3 Fifth and Sixth Amendments to 10.1.5 dated February 1, 1968, both as amended May 6, 1988 (Exhibit 1 to the CEL Form 10-Q (June 1988), File No. 2-7909). 10.1.5.4 Seventh Amendment to 10.1.5 dated February 1, 1968, as amended June 15, 1989 (Exhibit 2 to the CEL Form 10-Q (September 1989), File No. 2-7909). 10.1.5.5* Additional Power Contract dated February 1, 1984 between CEL and VYNPC providing for decommissioning financing and contract extension (Refiled as Exhibit 1 to CEL 1993 Form 10-K, File No. 2- 7909). COMMONWEALTH ENERGY SYSTEM 10.1.6 Power contract between Maine Yankee Atomic Power Company (MYAPC) and CEL dated May 20, 1968 (Exhibit 5 to the System's Form S-7, File No. 2-38372). 10.1.6.1 First Amendment dated March 1, 1984 (decommissioning financing) and Second Amendment dated January 1, 1984 (supplementary payments) to 10.1.6 (Exhibits 3 and 4 to the CEL Form 10-Q (June 1984), File No. 2-7909). 10.1.6.2 Third Amendment to 10.1.6 dated October 1, 1984 (Exhibit 1 to the CEL Form 10-Q (September 1984), File No. 2-7909). 10.1.7 Agreement between NBGEL and Boston Edison Company (BECO) for the purchase of electricity from BECO's Pilgrim Unit No. 1 dated August 1, 1972 (Exhibit 7 to the CE 1984 Form 10-K, File No. 2- 7749). 10.1.7.1 Service Agreement between NBGEL and BECO for purchase of stand-by power for BECO's Pilgrim Station dated August 16, 1978 (Exhibit 1 to the CE 1988 Form 10-K, File No. 2-7749). 10.1.7.2 System Power Sales Agreement by and between CE and BECO dated July 12, 1984 (Exhibit 1 to the CE Form 10-Q (September 1984), File No. 2-7749). 10.1.7.3 Power Exchange Agreement by and between BECO and CE dated December 1, 1984 (Exhibit 16 to the CE 1984 Form 10-K, File No. 2-7749). 10.1.7.4 Power Exchange Agreement by and between BECO and CEL dated December 1, 1984 (Exhibit 5 to the CEL 1984 Form 10-K, File No. 2- 7909). 10.1.7.5 Service Agreement for Non-Firm Transmission Service between BECO and CEL dated July 5, 1984 (Exhibit 4 to the CEL 1984 Form 10-K, File No. 2-7909). 10.1.8 Agreement for Joint-Ownership, Construction and Operation of New Hampshire Nuclear Units (Seabrook) dated May 1, 1973 (Exhibit 13(N) to the NBGEL Form S-1 dated October 1973, File No. 2-49013 and as amended below: 10.1.8.1 First through Fifth Amendments to 10.1.8 as amended May 24, 1974, June 21, 1974, September 25, 1974, October 25, 1974 and January 31, 1975, respectively (Exhibit 13(m) to the NBGEL Form S-1 (November 7, 1975), File No. 2-54995). 10.1.8.2 Sixth through Eleventh Amendments to 10.1.8 as amended April 18, 1979, April 25, 1979, June 8, 1979, October 11, 1979 and December 15, 1979, respectively (Refiled as Exhibit 1 to the CEC 1989 Form 10-K, File No. 2-30057). 10.1.8.3 Twelfth through Fourteenth Amendments to 10.1.8 as amended May 16, 1980, December 31, 1980 and June 1, 1982, respectively (Refiled as Exhibits 1, 2, and 3 to the CE 1992 Form 10-K, File No. 2-7749). COMMONWEALTH ENERGY SYSTEM 10.1.8.4 Fifteenth and Sixteenth Amendments to 10.1.8 as amended April 27, 1984 and June 15, 1984, respectively (Exhibit 1 to the CEC Form 10-Q (June 1984), File No. 2-30057). 10.1.8.5 Seventeenth Amendment to 10.1.8 as amended March 8, 1985 (Exhibit 1 to the CEC Form 10-Q (March 1985), File No. 2-30057). 10.1.8.6 Eighteenth Amendment to 10.1.8 as amended March 14, 1986 (Exhibit 1 to the CEC Form 10-Q (March 1986), File No. 2-30057). 10.1.8.7 Nineteenth Amendment to 10.1.8 as amended May 1, 1986 (Exhibit 1 to the CEC Form 10-Q (June 1986), File No. 2-30057). 10.1.8.8 Twentieth Amendment to 10.1.8 as amended September 19, 1986 (Exhibit 1 to the CEC 1986 Form 10-K, File No. 2-30057). 10.1.8.9 Twenty-First Amendment to 10.1.8 as amended November 12, 1987 (Exhibit 1 to the CEC 1987 Form 10-K, File No. 2-30057). 10.1.8.10 Settlement Agreement and Twenty-Second Amendment to 10.1.8, both dated January 13, 1989 (Exhibit 4 to the CEC 1988 Form 10-K, File No. 2-30057). 10.1.9 Interim Agreement to Preserve and Protect the Assets of and Investment in the New Hampshire Nuclear Units dated April 27, 1984 (Exhibit 2 to the CEC Form 10-Q (June 1984), File No. 2-30057). 10.1.10 Resolutions proposed by Merrill Lynch Capital Markets and adopted by the Joint-Owners of the Seabrook Nuclear Project regarding Project financing, dated May 14, 1984 (Exhibit 1 to the CEC Form 10-Q (March 1984), File No. 2-30057). 10.1.11 Agreement for Seabrook Project Disbursing Agent establishing YAEC as the disbursing agent under the Joint-Ownership Agreement, dated May 23, 1984 (Exhibit 4 to the CEC Form 10-Q (June 1984), File No. 2-30057). 10.1.11.1 First Amendment to 10.1.11 as amended March 8, 1985 (Exhibit 2 to the CEC Form 10-Q (March 1985), File No. 2-30057). 10.1.11.2 Second through Fifth Amendments to 10.1.11 as amended May 20, 1985, June 18, 1985, January 2, 1986 and November 12, 1987, respectively (Exhibit 4 to the CEC 1987 Form 10-K, File No. 2- 30057). 10.1.12 Agreement to Share Certain Costs Associated with the Tewksbury- Seabrook Transmission Line dated May 8, 1986 (Exhibit 2 to the CEC 1986 Form 10-K, File No. 2-30057). 10.1.13 Purchase and Sale Agreement together with an implementing Addendum dated December 31, 1981, between CE and CEC, for the purchase and sale of the CE 3.52% joint-ownership interest in the Seabrook units, dated January 2, 1981 (Refiled as Exhibit 4 to the CE 1992 Form 10-K, File No. 2-7749). COMMONWEALTH ENERGY SYSTEM 10.1.14 Agreement to transfer ownership, construction and operational interest in the Seabrook Units 1 and 2 from CE to CEC dated January 2, 1981 (Refiled as Exhibit 3 to the 1991 CE Form 10-K, File No. 2-7749). 10.1.15 Termination Supplement between CEC, CE and CEL for Seabrook Unit 2, dated December 8, 1986 (Exhibit 3 to the CEC 1986 Form 10-K, File No. 2-30057). 10.1.16 Power Contract, as amended to February 28, 1990, superseding the Power Contract dated September 1, 1986 and amendment dated June 1, 1988, between CEC (seller) and CE and CEL (purchasers) for seller's entire share of the Net Unit Capability of Seabrook 1 and related energy (Exhibit 1 to the CEC Form 10-Q (March 1990), File No. 2-30057). 10.1.17 Agreement between NBGEL and Central Maine Power Company (CMP), for the joint-ownership, construction and operation of William F. Wyman Unit No. 4 dated November 1, 1974 together with Amendment No. 1 dated June 30, 1975 (Exhibit 13(N) to the NBGEL Form S-1, File No. 2-54955). 10.1.17.1 Amendments No. 2 and 3 to 10.1.17 as amended August 16, 1976 and December 31, 1978 (Exhibit 5(a) 14 to the System's Form S-16 (June 1979), File No. 2-64731). 10.1.18 Agreement between the registrant and Montaup Electric Company (MEC) for use of common facilities at Canal Units I and II and for allocation of related costs, executed October 14, 1975 (Exhibit 1 to the CEC 1985 Form 10-K, File No. 2-30057). 10.1.18.1 Agreement between the registrant and MEC for joint-ownership of Canal Unit II, executed October 14, 1975 (Exhibit 2 to the CEC 1985 Form 10-K, File No. 2-30057). 10.1.18.2 Agreement between the registrant and MEC for lease relating to Canal Unit II, executed October 14, 1975 (Exhibit 3 to the CEC 1985 Form 10-K, File No. 2-30057). 10.1.19 Contract between CEC and NBGEL and CEL, affiliated companies, for the sale of specified amounts of electricity from Canal Unit 2 dated January 12, 1976 (Exhibit 7 to the System's 1985 Form 10-K, File No. 1-7316). 10.1.20 Capacity Acquisition Agreement between CEC,CEL and CE dated September 25, 1980 (Refiled as Exhibit 1 to the 1991 CEC Form 10- K, File No. 2-30057). 10.1.20.1 Supplement to 10.1.20 consisting of three Capacity Acquisition Commitments each dated May 7, 1987, concerning Phases I and II of the Hydro-Quebec Project and electricity acquired from Connecticut Light and Power Company CL&P) (Exhibit 1 to the CEC Form 10-Q (September 1987), File No. 2-30057). COMMONWEALTH ENERGY SYSTEM 10.1.20.2 Supplements to 10.1.20 consisting of two Capacity Acquisition Commitments each dated October 31, 1988, concerning electricity acquired from Western Massachusetts Electric Company and/or CL&P for periods ranging from November 1, 1988 to October 31, 1994 (Exhibit 2 to the CEC Form 10-Q (September 1989), File No. 2- 30057). 10.1.20.3 Amendment to 10.1.20 as amended and restated June 1, 1993, henceforth referred to as the Capacity Acquisition and Disposition Agreement, whereby Canal Electric Company, as agent, in addition to acquiring power may also sell bulk electric power which Cambridge Electric Light Company and/or Commonwealth Electric Company owns or otherwise has the right to sell (Exhibit 1 to Canal Electric's Form 10-Q (September 1993), File No. 2-30057). 10.1.20.4 Capacity Disposition Commitment dated June 25, 1993 by and between Canal Electric Company (Unit 2) and Commonwealth Electric Company for the sale of a portion of Commonwealth Electric's entitlement in Unit 2 to Green Mountain Power Corporation (Exhibit 2 to Canal Electric's Form 10-Q (September 1993), File No. 2-30057). 10.1.21 Phase 1 Vermont Transmission Line Support Agreement and Amendment No. 1 thereto between Vermont Electric Transmission Company, Inc. and certain other New England utilities, dated December 1, 1981 and June 1, 1982, respectively (Exhibits 5 and 6 to the CE 1992 Form 10-K, File No. 2-7749). 10.1.21.1 Amendment No. 2 to 10.1.21 as amended November 1, 1982 (Exhibit 5 to the CE Form 10-Q (June 1984), File No. 2-7749). 10.1.21.2 Amendment No. 3 to 10.1.21 as amended January 1, 1986 (Exhibit 2 to the CE 1986 Form 10-K, File No. 2-7749). 10.1.22 Participation Agreement between MEPCO and CEL and/or NBGEL dated June 20, 1969 for construction of a 345 KV transmission line between Wiscasset, Maine and Mactaquac, New Brunswick, Canada and for the purchase of base and peaking capacity from the NBEPC (Exhibit 13 to the CES 1984 Form 10-K, File No. 1-7316). 10.1.22.1 Supplement Amending 10.1.22 as amended June 24, 1970 (Exhibit 8 to the CES Form S-7, Amendment No. 1, File No. 2-38372). 10.1.23 Power Purchase Agreement between Weweantic Hydro Associates and CE for the purchase of available hydro-electric energy produced by a facility located in Wareham, Massachusetts, dated December 13, 1982 (Exhibit 1 to the CE 1983 Form 10-K, File No. 2-7749). 10.1.23.1 Power Purchase Agreement (Revised) between Weweantic Hydro Associ- ates and Commonwealth Electric (CE) for the purchase of available hydro-electric energy produced by a facility located in Wareham, MA, originally dated December 13, 1982, revised and dated March 12, 1993 (Exhibit 1 to the CE Form 10-Q (June 1993), File No. 2- 7749). COMMONWEALTH ENERGY SYSTEM 10.1.24* Power Purchase Agreement between Pioneer Hydropower, Inc. and CE for the purchase of available hydro-electric energy produced by a facility located in Ware, Massachusetts, dated September 1, 1983 (Refiled as Exhibit 1 to the CE 1993 Form 10-K, File No. 2-7749). 10.1.25* Power Purchase Agreement between Corporation Investments, Inc. (CI), and CE for the purchase of available hydro-electric energy produced by a facility located in Lowell, Massachusetts, dated January 10, 1983 (Refiled as Exhibit 2 to the CE 1993 Form 10-K, File No. 2-7749). 10.1.25.1 Amendment to 10.1.25 between CI and Boott Hydropower, Inc., an assignee therefrom, and CE, as amended March 6, 1985 (Exhibit 8 to the CE 1984 Form 10-K, File No. 2-7749). 10.1.26 Phase 1 Terminal Facility Support Agreement dated December 1, 1981, Amendment No. 1 dated June 1, 1982 and Amendment No. 2 dated November 1, 1982, between New England Electric Transmission Corporation (NEET), other New England utilities and CE (Exhibit 1 to the CE Form 10-Q (June 1984), File No. 2-7749). 10.1.26.1 Amendment No. 3 to 10.1.26 (Exhibit 2 to the CE Form 10-Q (June 1986), File No. 2-7749). 10.1.27 Preliminary Quebec Interconnection Support Agreement dated May 1, 1981, Amendment No. 1 dated September 1, 1981, Amendment No. 2 dated June 1, 1982, Amendment No. 3 dated November 1, 1982, Amendment No. 4 dated March 1, 1983 and Amendment No. 5 dated June 1, 1983 among certain New England Power Pool (NEPOOL) utilities (Exhibit 2 to the CE Form 10-Q (June 1984), File No. 2-7749). 10.1.28 Agreement with Respect to Use of Quebec Interconnection dated December 1, 1981, Amendment No. 1 dated May 1, 1982 and Amendment No. 2 dated November 1, 1982 among certain NEPOOL utilities (Exhibit 3 to the CE Form 10-Q (June 1984), File No. 2-7749). 10.1.28.1 Amendatory Agreement No. 3 to 10.1.28 as amended June 1, 1990, among certain NEPOOL utilities (Exhibit 1 to the CEC Form 10-Q (September 1990), File No. 2-30057). 10.1.29 Phase I New Hampshire Transmission Line Support Agreement between NEET and certain other New England Utilities dated December 1, 1981 (Exhibit 4 to the CE Form 10-Q (June 1984), File No. 2-7749). 10.1.30 Agreement, dated September 1, 1985, with Respect To Amendment of Agreement With Respect To Use Of Quebec Interconnection, dated December 1, 1981, among certain NEPOOL utilities to include Phase II facilities in the definition of "Project" (Exhibit 1 to the CEC Form 10-Q (September 1985), File No. 2-30057). COMMONWEALTH ENERGY SYSTEM 10.1.31 Agreement to Preliminary Quebec Interconnection Support Agree- ment - Phase II among Public Service Company of New Hampshire (PSNH), New England Power Co. (NEP), BECO and CEC whereby PSNH assigns a portion of its interests under the original Agreement to the other three parties, dated October 1, 1987 (Exhibit 2 to the CEC 1987 Form 10-K, File No. 2-30057). 10.1.32 Preliminary Quebec Interconnection Support Agreement - Phase II among certain New England electric utilities dated June 1, 1984 (Exhibit 6 to the CE Form 10-Q (June 1984), File No. 2-7749). 10.1.32.1 First, Second and Third Amendments to 10.1.32 as amended March 1, 1985, January 1, 1986 and March 1, 1987, respectively (Exhibit 1 to the CEC Form 10-Q (March 1987), File No. 2-30057). 10.1.32.2 Fifth, Sixth and Seventh Amendments to 10.1.32 as amended October 15, 1987, December 15, 1987 and March 1, 1988, respectively (Exhibit 1 to the CEC Form 10-Q (June 1988), File No. 2-30057). 10.1.32.3 Fourth and Eighth Amendments to 10.1.32 as amended July 1, 1987 and August 1, 1988, respectively (Exhibit 3 to the CEC Form 10-Q (September 1988), File No. 2-30057). 10.1.32.4 Ninth and Tenth Amendments to 10.1.32 as amended November 1, 1988 and January 15, 1989, respectively (Exhibit 2 to the CEC 1988 Form 10-K, File No. 2-30057). 10.1.32.5 Eleventh Amendment to 10.1.32 as amended November 1, 1989 (Exhibit 4 to the CEC 1989 Form 10-K, File No. 2-30057). 10.1.32.6 Twelfth Amendment to 10.1.32 as amended April 1, 1990 (Exhibit 1 to the CEC Form 10-Q (June 1990), File No. 2-30057). 10.1.33 Phase II Equity Funding Agreement for New England Hydro- Transmission Electric Company, Inc. (New England Hydro) (Massachusetts), dated June 1, 1985, between New England Hydro and certain NEPOOL utilities (Exhibit 2 to the CEC Form 10-Q (September 1985), File No. 2-30057). 10.1.34 Phase II Massachusetts Transmission Facilities Support Agreement dated June 1, 1985, refiled as a single agreement incorporating Amendments 1 through 7 dated May 1, 1986 through January 1, 1989, respectively, between New England Hydro and certain NEPOOL utilities (Exhibit 2 to the CEC Form 10-Q (September 1990), File No. 2-30057). 10.1.35 Phase II New Hampshire Transmission Facilities Support Agreement dated June 1, 1985, refiled as a single agreement incorporating Amendments 1 through 8 dated May 1, 1986 through January 1, 1990, respectively, between New England Hydro-Transmission Corporation (New Hampshire Hydro) and certain NEPOOL utilities (Exhibit 3 to the CEC Form 10-Q (September 1990), File No. 2-30057). COMMONWEALTH ENERGY SYSTEM 10.1.36 Phase II Equity Funding Agreement for New Hampshire Hydro, dated June 1, 1985, between New Hampshire Hydro and certain NEPOOL utilities (Exhibit 3 to the CEC Form 10-Q (September 1985), File No. 2-30057). 10.1.36.1 Amendment No. 1 to 10.1.36 dated May 1, 1986 (Exhibit 6 to the CEC Form 10-Q (March 1987), File No. 2-30057). 10.1.36.2 Amendment No. 2 to 10.1.36 as amended September 1, 1987 (Exhibit 3 to the CEC Form 10-Q (September 1987), File No. 2-30057). 10.1.37 Phase II New England Power AC Facilities Support Agreement, dated June 1, 1985, between NEP and certain NEPOOL utilities (Exhibit 6 to the CEC Form 10-Q (September 1985), File No. 2-30057). 10.1.37.1 Amendments Nos. 1 and 2 to 10.1.37 as amended May 1, 1986 and February 1, 1987, respectively (Exhibit 5 to the CEC Form 10-Q (March 1987), File No. 2-30057). 10.1.37.2 Amendments Nos. 3 and 4 to 10.1.37 as amended June 1, 1987 and September 1, 1987, respectively (Exhibit 5 to the CEC Form 10-Q (September 1987), File No. 2-30057). 10.1.38 Phase II Boston Edison AC Facilities Support Agreement, dated June 1, 1985, between BECO and certain NEPOOL utilities (Exhibit 7 to the CEC Form 10-Q (September 1985), File No. 2-30057). 10.1.38.1 Amendments Nos. 1 and 2 to 10.1.38 as amended May 1, 1986 and February 1, 1987, respectively (Exhibit 2 to the CEC Form 10-Q (March 1987), File No. 2-30057). 10.1.38.2 Amendments Nos. 3 and 4 to 10.1.38 as amended June 1, 1987 and September 1, 1987, respectively (Exhibit 4 to the CEC Form 10-Q (September 1987), File No. 2-30057). 10.1.39 Agreement Authorizing Execution of Phase II Firm Energy Contract, dated September 1, 1985, among certain NEPOOL utilities in regard to participation in the purchase of power from Hydro-Quebec (Exhibit 8 to the CEC Form 10-Q (September 1985), File No. 2- 30057). 10.1.40 System Power Sales Agreement by and between CE, as seller, and Central Vermont Public Service Corporation (CVPS), as buyer, dated September 15, 1984 (Exhibit 2 to the CE Form 10-Q (September 1984), File No. 2-7749). 10.1.40.1 System Sales Agreement by CVPS, as seller, and CE, as buyer, dated September 15, 1984 (Exhibit 9 to the CE 1984 Form 10-K, File No. 2-7749). 10.1.40.2 System Sales and Exchange Agreement by and between CVPS and CE on energy transactions, dated September 15, 1984 (Exhibit 10 to the CE 1984 Form 10-K, File No. 2-7749). COMMONWEALTH ENERGY SYSTEM 10.1.40.3 System Exchange Agreement by and between CE and CVPS for the exchange of capacity and associated energy, dated September 3, 1985 (Exhibit 1 to the CE 1985 Form 10-K, File No. 2-7749). 10.1.40.4 Purchase Agreement by and between CEC and CVPS for the purchase of capacity from CEC for the term March 1, 1991 to October 31, 1995, dated March 1, 1991 (Exhibit 1 to CEC Form 10-Q (June 1991), File No. 2-30057). 10.1.40.5 Power Sale Agreement by and between CEC and CVPS for the purchase of 50 MW of capacity from CVPS's units (25 MW from Vermont Yankee and 25 MW from Merrimack 2) for the term of March 1, 1991 to October 31, 1995, dated March 1, 1991 (Exhibit 2 to CEC Form 10-Q (June 1991), File No. 2-30057). 10.1.41 Agreements by and between Swift River Company and CE for the purchase of available hydro-electric energy to be produced by units located in Chicopee and North Willbraham, Massachusetts, both dated September 1, 1983 (Exhibits 11 and 12 to the CE 1984 Form 10-K, File No. 2-7749). 10.1.41.1 Transmission Service Agreement between Northeast Utilities' companies (NU) - The Connecticut Light and Power Company (CL&P) and Western Massachusetts Electric Company (WMECO), and CE for NU companies to transmit power purchased from Swift River Company's Chicopee Units to CE, dated October 1, 1984 (Exhibit 14 to the CE 1984 Form 10-K, File No. 2-7749). 10.1.41.2 Transformation Agreement between WMECO and CE whereby WMECO is to transform power to CE from the Chicopee Units, dated December 1, 1984 (Exhibit 15 to the CE 1984 Form 10-K, File No. 2-7749). 10.1.42 System Power Sales Agreement by and between CL&P and WMECO, as buyers, and CE, as seller, dated January 13, 1984 (Exhibit 13 to the CE 1984 Form 10-K, File No. 2-7749). 10.1.43 System Power Sales Agreement by and between CL&P, WMECO, as sellers, and CEL, as buyer, of power in excess of firm power customer requirements from the electric systems of the NU Companies, dated June 1, 1984, as effective October 25, 1985 (Exhibit 1 to CEL 1985 Form 10-K, File No. 2-7909). 10.1.44 Power Purchase Agreement with Respect to South Meadow Unit Nos. 11, 12, 13, and 14 of the NU system company of CL&P (seller) and CE (buyer), dated November 1, 1985 (Exhibit 1 to the CE Form 10-Q (June 1986), File No. 2-7749). 10.1.45 Power Purchase Agreement by and between SEMASS Partnership, as seller, to construct, operate and own a solid waste disposal facility at its site in Rochester, Massachusetts and CE, as buyer of electric energy and capacity, dated September 8, 1981 (Exhibit 17 to the CE 1984 Form 10-K, File No. 2-7749). COMMONWEALTH ENERGY SYSTEM 10.1.45.1 Power Sales Agreement to 10.1.45 for all capacity and related energy produced, dated October 31, 1985 (Exhibit 2 to the CE 1985 Form 10-K, File No. 2-7749). 10.1.45.2 Amendment to 10.1.45 for all additional electric capacity and related energy to be produced by an addition to the Original Unit, dated March 14, 1990 (Exhibit 1 to the CE Form 10-Q (June 1990), File No. 2-7749). 10.1.45.3 Amendment to 10.1.45 for all additional electric capacity and related energy to be produced by an addition to the Original Unit, dated May 24, 1991 (Exhibit 1 to CE Form 10-Q (June 1991), File No. 2-7749). 10.1.46 System Power Sales Agreement by and between CE (seller) and NEP (buyer), dated January 6, 1984 (Exhibit 1 to the CE Form 10-Q (June 1985), File No. 2-7749). 10.1.47 Service Agreement by and between CE and NEP dated March 24, 1984, whereas CE agrees to purchase short-term power applicable to NEP'S FERC Electric Tariff Number 5 (Exhibit 1 to the CE Form 10-Q (June 1987), File No. 2-7749). 10.1.48 Power Sale Agreement by and between CE (buyer) and Northeast Energy Associated, Ltd. (NEA) (seller) of electric energy and capacity, dated November 26, 1986 (Exhibit 1 to the CE Form 10-Q (March 1987), File No. 2-7749). 10.1.48.1 First Amendment to 10.1.48 as amended August 15, 1988 (Exhibit 1 to the CE Form 10-Q (September 1988), File No. 2-7749). 10.1.48.2 Second Amendment to 10.1.48 as amended January 1, 1989 (Exhibit 2 to the CE 1988 Form 10-K, File No. 2-7749). 10.1.48.3 Power Sale Agreement dated August 15, 1988 between NEA and CE for the purchase of 21 MW of electricity (Exhibit 2 to the CE Form 10-Q (September 1988), File No. 2-7749). 10.1.48.4 Amendment to 10.1.48.3 as amended January 1, 1989 (Exhibit 3 to the CE 1988 Form 10-K, File No. 2-7749). 10.1.49 Power Sale Agreement by and between CE (buyer) and CPC Lowell Cogeneration Corp.(seller) of all capacity and related energy produced, dated September 29, 1986 (Exhibit 2 to the CE Form 10-Q (March 1987), File No. 2-7749). 10.1.49.1 Restatement of 10.1.49 as restated March 30, 1987 (Exhibit 2 to the CE Form 10-Q (June 1987), File No. 2-7749). 10.1.50 Power Sale Agreement by and between CE (buyer) and Pepperell Power Associates Limited Partnership (seller) of all electricity produced from a 38 KW generating unit, dated April 13, 1987 (Exhibit 3 to the CE Form 10-Q (March 1987), File No. 2-7749). COMMONWEALTH ENERGY SYSTEM 10.1.51 Power Contract between CEC (seller) and CE and CEL (purchasers) dated August 14, 1989 whereby purchasers agree to purchase the capacity and energy from seller's "Slice-of-System" entitlement from CL&P for the term of November 1, 1989 to October 31, 1994 (Exhibit 1 to the CEC Form 10-Q (September 1989), File No. 2-30057). 10.1.51.1 Power Sale Agreement dated November 1, 1988, by and between CEC (buyer) and CL&P (seller), whereby buyer will purchase generating capacity totaling 250 MW from various seller's units ("Slice of System") for the term November 1, 1989 to October 31, 1994 (Exhibit 3 to the CEC 1988 Form 10-K, File No. 2-30057). 10.1.52 Exchange of Power Agreement between Montaup Electric Company and CE dated January 17, 1991 (Exhibit 2 to CE Form 10-Q (September 1991) File No. 2-7749). 10.1.52.1 First Amendment, dated November 24, 1992, to Exchange of Power Agreement between Montaup Electric Company and Commonwealth Electric Company (CE) dated January 17, 1991 (Exhibit 1 to CE Form 10-Q (March 1993) File No. 2-7749). 10.1.53 System Power Exchange Agreement by and between Commonwealth Electric Company (CE) and New England Power Company dated January 16, 1992 (Exhibit 1 to CE Form 10-Q (March 1992), File No. 2- 7749). 10.1.53.1 First Amendment, dated September 8, 1992, to System Power Exchange Agreement by and between Commonwealth Electric Company (CE) and New England Power Company dated January 16, 1992 (Exhibit 1 to CE Form 10-Q (September 1992), File No. 2-7749). 10.1.53.2 Second Amendment, dated March 2, 1993, to System Power Exchange Agreement by and between CE and New England Power Company (NEP) dated January 16, 1992 (Exhibit 2 to CE Form 10-Q (March 1993) File No. 2-7749). 10.1.54 Power Purchase Agreement and First Amendment, dated September 5, 1989 and August 3, 1990, respectively, by and between Commonwealth Electric (CE) (buyer) and Dartmouth Power Associates Limited Partnership (seller), whereby buyer will purchase all of the energy (67.6 MW) produced by a single gas turbine unit (Exhibit 1 to the CE Form 10-Q (June 1992), File No. 2-7749). 10.1.55 Power Exchange Contract, dated March 24, 1993, between NEP and Canal Electric Company (Canal) for an exchange of unit capacity in which NEP will purchase 20 MW of Canal Unit 2 capacity in exchange for Canal's purchase of 20 MW of NEP's Bear Swamp Units 1 and 2 (10 MW per unit) commencing May 31, 1993 through April 28, 1997 and NEP will purchase 50 MW of Canal's Unit 2 capacity in exchange for Canal's purchase of 50 MW of NEP's Bear Swamp Units 1 and 2 (25 MW per unit) commencing November 1, 1993 through April 28, 1997 (Exhibit 1 to Canal's Form 10-Q (March 1993) File No. 2- 30057). COMMONWEALTH ENERGY SYSTEM 10.1.56 Power Purchase Agreement by and between Masspower (seller) and Commonwealth Electric Company (buyer) for a 11.11% entitlement to the electric capacity and related energy of a 240 MW gas-fired cogeneration facility, dated February 14, 1992 (Exhibit 1 to Commonwealth Electric's Form 10-Q (September 1993), File No. 2- 7749). 10.1.57 Power Sale Agreement by and between Altresco Pittsfield, L.P. (seller) and Commonwealth Electric Company (buyer) for a 17.2% entitlement to the electric capacity and related energy of a 160 MW gas-fired cogeneration facility, dated February 20, 1992 (Exhibit 2 to Commonwealth Electric's Form 10-Q (September 1993), File No. 2-7749). 10.1.58.1 System Exchange Agreement by and among Altresco Pittsfield, L.P., Cambridge Electric Light Company, Commonwealth Electric Company and New England Power Company, dated July 2, 1993 (Exhibit 3 to Commonwealth Electric's Form 10-Q (September 1993), File No 2- 7749). 10.1.58.2 Power Sale Agreement by and between Altresco Pittsfield, L. P. (seller) and Cambridge Electric Light Company (Cambridge Electric) (buyer) for a 17.2% entitlement to the electric capacity and related energy of a 160 MW gas-fired cogeneration facility, dated February 20, 1992 (Exhibit 1 to Cambridge Electric's Form 10-Q (September 1993), File No. 2-7909). 10.2 Natural gas purchase contracts. 10.2.1 Natural gas purchase contracts between Algonquin Gas Transmission Company (AGT) and the gas subsidiaries of the System: Firm Service contracts dated October 28, 1969 and July 10, 1972; Winter Service contracts dated August 14, 1968 and July 10, 1972 (Exhibits 1, 2, 3, and 4, respectively, to the CG 1984 Form 10-K, File No. 2- 1647). 10.2.2 Service Agreement Applicable to Rate Schedule between AGT and CG for Firm natural gas services, dated January 28, 1981 (Exhibit 1 to the CG Form 10-Q (March 1987), File No. 2-1647). 10.2.3 Service Agreement Applicable to Rate Schedule between AGT and CG for the purchase of certain quantities of natural gas acquired by AGT from CGS, dated April 11, 1985 (Exhibit 2 to the CG Form 10-Q (March 1987), File No. 2-1647). 10.2.4 Service Agreement Applicable to Rate Schedule between AGT and CG for the purchase of certain quantities of natural gas acquired by AGT from National Fuel Gas Supply Corporation, dated April 11, 1985 (Exhibit 3 to the CG Form 10-Q (March 1987), File No. 1- 1647). COMMONWEALTH ENERGY SYSTEM 10.2.5 Service Agreement Applicable to Rate Schedule between AGT and CG for the purchase of certain quantities of natural gas acquired by AGT from Texas Eastern Transmission Company, dated December 26, 1985 (Exhibit 4 to the CG Form 10-Q (March 1987), File No. 2- 1647). 10.2.6 Gas Service Contract between HOPCO and NBGEL for the performance of liquefaction, storage and vaporization service and the operation and maintenance of an LNG facility located at Acushnet, MA dated September 1, 1971 (Exhibit 8 to the CG 1984 Form 10-K, File No. 2-1647). 10.2.6.1 Gas Service Contract between HOPCO and CG for the performance of liquefaction, storage and vaporization services and the operation of LNG facilities located in Hopkinton, MA dated September 1, 1971 (Exhibit 9 to the CG 1984 Form 10-K, File No. 2-1647). 10.2.6.2 Amendments to 10.2.6 and 10.2.6.1 as amended December 1, 1976 (Exhibits 2 and 3 to the CG 1986 Form 10-K, File No. 2-1647). 10.2.6.3 Supplement 1 to Gas Service Contract between HOPCO and NBGEL dated September 1, 1973 and September 14, 1977 (Exhibit 5(c)5 to the CES Form S-16 (June 1979), File No. 2-64731). 10.2.6.4 Supplement 1 to 10.2.6.1 dated September 14, 1977 (Exhibit 5(c)6 to the CG Form S-16 (June 1979), File No. 2-64731). 10.2.6.5 Supplement 2 to 10.2.6.1 dated September 30, 1982 (Refiled as Exhibit 2 to the CG 1992 Form 10-K, File No. 2-1647). 10.2.6.6 1986 Consolidating Supplement to CG Service Contract and NBGEL Service Contract by and between CG and HOPCO dated December 31, 1986 amending and consolidating the CG Service Contract and the NBGEL Service Contract both as amended December 1, 1976 and supplemented September 14, 1977 (Exhibit 2 to CG Form 10-Q (March 1988), File No. 2-1647). 10.2.7 Operating Agreement between Air Products and Chemicals, Inc., (APC) and HOPCO, dated as of September 1, 1971, as supplemented by Supplements No. 1, No. 2 and No. 3 dated as of July 1, 1974, August 1, 1975 and January 1, 1985, respectively, with respect to the operation and maintenance by APC of HOPCO's liquefied natural gas facilities located at Hopkinton, MA (Exhibit 11 to the CES 1984 Form 10-K, File No. 1-7316). 10.2.7.1 Engineering and Prime Contracting Agreement between APC and HOPCO for performance of engineering services and capital project construction at LNG facility in Hopkinton, MA (Exhibit 12 to the CES 1984 Form 10-K, File No. 1-7316). 10.2.8 Firm Storage Service Transportation Contract by and between TGP and CG providing for firm transportation of natural gas from CGT, dated December 15, 1985 (Exhibit 1 to the CG 1985 Form 10-K, File No. 2-1647). COMMONWEALTH ENERGY SYSTEM 10.2.9 Agency Agreement for Certain Transportation Arrangements by and between CG and Citizens Resources Corporation (CRC) whereby CRC arranges for a third party transportation of natural gas acquired by CG, dated April 14, 1986 (Exhibit 1 to the CG Form 10-Q (June 1986), File No. 2-1647). 10.2.9.1 Natural Gas Sales Agreement between CG and CRC, dated April 14, 1986 (Exhibit 2 to CG Form 10-Q (June 1986), File No. 2-1647). 10.2.10 Gas Sales Agreement by and between Enron Gas Marketing, Inc. and CG relating to the sale and purchase of natural gas on an interruptible basis, dated June 17, 1986 (Exhibit 3 to the CG Form 10-Q (June 1986), File No. 2-1647). 10.2.11 Agency Agreement for Certain Transportation Arrangements, dated June 18, 1985 and Gas Purchase and Sales Agreement dated August 6, 1985 by and between CG and Tenngasco Corporation and other related entities (Exhibit 4 to the CG Form 10-Q (June 1986), File No. 2-1647). 10.2.12 Service Agreement dated December 14, 1985 and an amendment thereto dated May 15, 1986 by and between Texas Eastern Transmission Corporation (TET) and CG to receive, transport and deliver to points of delivery natural gas for the account of CG, dated December 14, 1985 (Exhibit 5 to the CG Form 10-Q (June 1986), File No. 2-1647). 10.2.13 Gas Transportation Agreement by and between TET and CG to receive, transport and deliver on an interruptible basis, certain quantities of natural gas for the account of CG, dated January 31, 1986 (Exhibit 6 to the CG Form 10-Q (June 1986), File No. 2-1647). 10.2.14 Service Agreement dated May 19, 1988, by and between TET and CG, whereby TET agrees to receive, transport and deliver natural gas to CG (Exhibit 1 to the CG Form 10-Q (September 1988), File No. 2- 1647). 10.2.15 Gas Sales Agreement by and between Texas Eastern Gas Trading Company and CG providing for the sale of certain quantities of natural gas to CG, dated May 15, 1986 (Exhibit 7 to the CG Form 10-Q (June 1986), File No. 2-1647). 10.2.16 Service Agreement applicable to Rate Schedule TS-3 between TET and CG for Firm natural gas service, dated April 16, 1987 (Exhibit 1 to the CG Form 10-Q (June 1987), File No. 2-1647). 10.2.17 Natural Gas Sales Agreement between Summit Pipeline and Producing Company and CG, dated April 16, 1987 (Exhibit 2 to the CG Form 10-Q (June 1987), File No. 2-1647). 10.2.18 Natural Gas Sales Agreement between Natural Gas Supply Company and CG, dated May 12, 1987 (Exhibit 3 to the CG Form 10-Q (June 1987), File No. 2-1647). COMMONWEALTH ENERGY SYSTEM 10.2.19 Natural Gas Sales Agreement between Stellar Gas Company and CG, dated April 15, 1988 (Exhibit 1 to the CG Form 10-Q (March 1988), File No. 2-1647). 10.2.20 Natural Gas Sales Agreement between Amalgamated Gas Pipeline Company and CG dated April 5, 1988 (Exhibit 1 to the CG Form 10-Q (June 1988), File No. 2-1647). 10.2.21 Natural Gas Sales Agreement between Gulf Ohio Pipeline Corporation and CG dated May 18, 1988 (Exhibit 2 to the CG Form 10-Q (June 1988), File No. 2-1647). 10.2.22 Natural Gas Sales Agreement between Phillips Petroleum Company and CG dated May 18, 1988 (Exhibit 3 to the CG Form 10-Q (June 1988), File No. 2-1647). 10.2.23 Natural Gas Sales Agreement between TXO Gas Marketing Corp. and CG dated April 25, 1988 (Exhibit 1 to the CG 1988 Form 10-K, File No. 2-1647). 10.2.24 Gas Transportation Agreement by and between AGT and CG to receive, transport and deliver certain quantities of natural gas on a firm basis for the account of CG dated December 1, 1988 (Exhibit 2 to the CG 1988 Form 10-K, File No. 2-1647). 10.2.25 Natural Gas Sales Agreement between Enermark Gas Gathering Corporation and CG dated January 6, 1989 (Exhibit 3 to the CG 1988 Form 10-K, File No. 2-1647). 10.2.26 Gas Sales Agreement between BP Gas Inc. (seller) and CG (purchaser) for the purchase of spot market gas, dated March 31, 1989 with a contract term of at least one year (Exhibit 1 to the CG Form 10-Q (March 1989), File No. 2-1647). 10.2.27 Gas Sales Agreement between Tejas Power Corporation (seller) and CG (purchaser) for the purchase of spot market gas, dated February 21, 1989 with a contract term of at least one year (Exhibit 2 to the CG Form 10-Q (March 1989), File No. 2-1647). 10.2.28 Gas Sales Agreement between Catamount Natural Gas, Inc. (seller) and CG (purchaser) for the purchase of spot market gas, dated April 5, 1988, with a contract term of at least one year (Exhibit 1 to the CG Form 10-Q (June 1989), File No. 2-1647). 10.2.29 Gas Sales Agreement between Transco Energy Marketing Company (seller) and CG (purchaser) for the purchase of spot market gas, dated March 1, 1989, with a contract term of at least one year (Exhibit 2 to the CG Form 10-Q (June 1989), File No. 2-1647). 10.2.30 Gas Sales Agreement between V.H.C. Gas Systems, L.P. (seller) and CG (purchaser) for the purchase of spot market gas, dated June 2, 1989, with a contract term of at least one year (Exhibit 3 to the CG Form 10-Q (June 1989), File No. 2-1647). COMMONWEALTH ENERGY SYSTEM 10.2.31 Gas Sales Agreement between End-Users Supply System (seller) and CG (purchaser) for the purchase of spot market gas, dated June 29, 1989, with a contract term of at least one year (Exhibit 1 to the CG Form 10-Q (September 1989), File No. 2-1647). 10.2.32 Gas Sales Agreement between Entrade Corporation (seller) and CG (purchaser) for the purchase of spot market gas, dated August 14, 1989, with a contract term of at least one year (Exhibit 2 to the CG Form 10-Q (September 1989), File No. 2-1647). 10.2.33 Gas Sales Agreement between Fina Oil and Chemical Company (seller) and CG (purchaser) for the purchase of spot market gas, dated July 10, 1989, with a contract term of at least one year (Exhibit 3 to the CG Form 10-Q (September 1989), File No. 2-1647). 10.2.34 Gas Sales Agreement between Mobil Natural Gas Inc. (seller) and CG (purchaser) for the purchase of spot market gas, dated August 14, 1989, with a contract term of at least one year (Exhibit 4 to the CG Form 10-Q (September 1989), File No. 2-1647). 10.2.35 Gas Storage Agreement between Steuben Gas Storage Company (Steuben) and CG (customer) for the storage and delivery of customer's natural gas to and from underground gas storage facilities, dated May 23, 1989, with a contract term of at least one year (Exhibit 4 to the CG Form 10-Q (June 1989), File No. 2- 1647). 10.2.35.1 Amendment, dated August 28, 1989, to 10.2.35 dated May 23, 1989 (Exhibit 5 to the CG Form 10-Q (September 1989), File No. 2-1647). 10.2.36 Gas Sales Agreement between PSI, Inc. (seller) and CG (purchaser) for the purchase of spot market gas, dated September 25. 1989, with a term of at least one year (Exhibit 1 to the CG 1989 Form 10-K, File No. 2-1647). 10.2.37 Gas Sales Agreement between Hadson Gas Systems (seller) and CG (purchaser) for the purchase of firm gas, dated August 15, 1990, with a contract term of at least six years (Exhibit 1 to the CG Form 10-Q (September 1990), File No. 2-1647). 10.2.38 Gas Sales Agreement between Odeco Oil Company (seller) and CG (purchaser) for the purchase of firm gas, dated August 15, 1990, with a contract term of at least five years (Exhibit 2 to the CG Form 10-Q (September 1990), File No. 2-1647). 10.2.39 Operating Agreement between AGT, CG and Distrigas of Massachusetts Corporation in connection with the deliveries of regasified liquified natural gas into the Algonquin J-system, dated August 1, 1990 (Exhibit 3 to the CG Form 10-Q (September 1990), File No.2- 1647). 10.2.40 Gas Sales Agreement between TEX/CON Marketing Gas Company (seller) and CG (purchaser) for the purchase of firm gas, dated September 12, 1990, with a contract term of five years (Exhibit 3 to the CG 1990 Form 10-K, File No. 2-1647). COMMONWEALTH ENERGY SYSTEM 10.2.41 Transportation Agreement between AGT and CG to provide for firm transportation of natural gas on a daily basis, dated December 1, 1988 (Exhibit 3 to the CG 1991 Form 10-K, File No. 2-1647). 10.2.42 Transportation Assignment Agreement between AGT and CG regarding Rate Schedule ATAP Agreement No. 9020016 which provides for the assignment, on an interruptible basis, of firm service rights on TET's system under Rate Schedule FT-1, dated January 3, 1990, for a term ending October 31, 1999 (Exhibit 4 to the CG 1991 Form 10- K, File No. 2-1647). 10.2.43 Gas Sales Agreement between AFT and CG to reduce the volume of Rate Schedule, dated October 15, 1990 (Exhibit 5 to the CG 1991 Form 10-K, File No. 2-1647). 10.2.44 Transportation Agreement between AFT and CG for Rate Schedule AFT- 1, dated November 1, Agreement No. 90103, 1990 (Exhibit 6 to the CG 1991 Form 10-K, File No. 2-1647). 10.2.45 Transportation Assignment Agreement between AFT and CG regarding Rate Schedule ATAP Agreement No. 90202, which provides for the assignment, on a firm basis, of firm service rights on TET's system under Rate Schedule FT-1 dated November 1, 1990 (Exhibit 7 to the CG 1991 Form 10-K, File No. 2-1647). 10.2.46 Gas Sales Agreement between TGP and CG under TGP's CD-6 Rate Schedules dated September 1, 1991 (Exhibit 8 to the CG 1991 Form 10-K, File No. 2-1647). 10.2.47 Transportation Agreement between TGP and CG dated September 1, 1991 (Exhibit 9 to the CG 1991 Form 10-K, File No. 2-1647). 10.2.48 Transportation Agreement between CNG and CG to provide for transportation of natural gas on a daily basis from Steuben Gas Storage Company to TGP (Exhibit 10 to the CG 1991 Form 10-K, File No. 2-1647). 10.2.49 Service Line Agreement by and between Commonwealth Gas Company (CG) and Milford Power Limited Partnership dated March 12, 1992 for a term ending January 1, 2013. (Exhibit 1 to the CG Form 10-Q (March 1992), File No. 2-1647. 10.3 Other agreements. 10.3.1 Pension Plan for Employees of Commonwealth Energy System and Subsidiary Companies as amended and restated January 1, 1993 (Exhibit 1 to CES Form 10-Q (September 1993), File No. 1-7316). 10.3.2 Employees Savings Plan of Commonwealth Energy System and Subsid- iary Companies as amended and restated January 1, 1993.(Exhibit 2 to CES Form 10-Q (September 1993), File No. 1-7316). COMMONWEALTH ENERGY SYSTEM 10.3.3 New England Power Pool Agreement (NEPOOL) dated September 1, 1971 as amended through August 1, 1977, between NEGEA Service Corporation, as agent for CEL, CEC, NBGEL, and various other electric utilities operating in New England together with amendments dated August 15, 1978, January 31, 1979 and February 1, 1980. (Exhibit 5(c)13 to New England Gas and Electric Association's Form S-16 (April 1980), File No. 2-64731). 10.3.3.1 Thirteenth Amendment to 10.3.3 as amended September 1, 1981 (Refiled as Exhibit 3 to the System's 1991 Form 10-K, File No. 1-7316). 10.3.3.2 Fourteenth through Twentieth Amendments to 10.3.3 as amended December 1, 1981, June 1, 1982, June 15, 1983, October 1, 1983, August 1, 1985, August 15, 1985 and September 1, 1985, respectively (Exhibit 4 to the CES Form 10-Q (September 1985), File No. 1-7316). 10.3.3.3 Twenty-first Amendment to 10.3.3 as amended to January 1, 1986 (Exhibit 1 to the CES Form 10-Q (March 1986), File No. 1-7316). 10.3.3.4 Twenty-second Amendment to 10.3.3 as amended to September 1, 1986 (Exhibit 1 to the CES Form 10-Q (September 1986), File No. 1- 7316). 10.3.3.5 Twenty-third Amendment to 10.3.3 as amended to April 30, 1987 (Exhibit 1 to the CES Form 10-Q (June 1987), File No. 1-7316). 10.3.3.6 Twenty-fourth Amendment to 10.3.3 as amended March 1, 1988 (Exhibit 1 to the CES Form 10-Q (March 1989), File No. 1-7316). 10.3.3.7 Twenty-fifth Amendment to 10.3.3. as amended to May 1, 1988 (Exhibit 1 to the CES Form 10-Q (March 1988), File No. 1-7316). 10.3.3.8 Twenty-sixth Agreement to 10.3.3 as amended March 15, 1989 (Exhibit 1 to the CES Form 10-Q (March 1989), File No. 1-7316). 10.3.3.9 Twenty-seventh Agreement to 10.3.3 as amended October 1, 1990 (Exhibit 3 to the CES 1990 Form 10-K, File No. 1-7316) 10.3.4 Fuel Supply, Facilities Lease and Operating Contract by and between, on the one side, ESCO (Massachusetts), Inc. and Energy Supply and Credit Corporation, and on the other side, CEC, dated as of February 1, 1985 (Exhibit 1 to the CEC 1984 Form 10-K, File No. 2-30057 10.3.4.1 Amendments Nos. 1 and 2 to 10.3.5 as amended July 1, 1986 and November 15, 1989, respectively (Exhibit 3 to the CEC 1989 Form 10-K, File No. 2-30057). 10.3.5 Assignment and Sublease Agreement and Canal's Consent of Assignment thereto whereby ESCO-Mass assigns its rights and obligations under Part II of the Resupply Agreement dated February 1, 1985 to ESCO Terminals Inc., dated June 4, 1985 (Exhibit 4 to CEC Form 10-Q (June 1985), File No. 2-30057). COMMONWEALTH ENERGY SYSTEM 10.3.6 Oil Supply Contract by and between CEC (buyer) and Coastal Oil New England, Inc. (seller) for a portion of CEC's requirements of No. 6 residual fuel oil, dated July 1, 1991 (Exhibit 3 to CEC Form 10-Q (June 1991), File No. 2-30057). 10.3.6.1 Assignment Agreement between CEC and ESCO (Massachusetts), Inc. (ESCO-Mass) and Energy Supply and Credit Corporation whereby CEC assigns to ESCO-Mass rights and obligations under 10.3.7 (above) dated July 1, 1991 (Exhibit 4 to CEC Form 10-Q (June 1991), File No. 2-30057). 10.3.7 Guarantee Agreement by CEL (as guarantor) and MYA Fuel Company (as initial lender) covering the unconditional guarantee of a portion of the payment obligations of Maine Yankee Atomic Power Company under a loan agreement and note initially between Maine Yankee and MYA Fuel Company (Exhibit 3 to the CEL Form 10-K for 1985, File No. 2-7909). 10.3.8 Stock Purchase Agreement by and among Texas Eastern Corporation (purchaser) and Eastern Gas and Fuel Associates, Commonwealth Energy System and Providence Energy Corporation (sellers) for the purchase and sale of ownership interests in Algonquin Energy, Inc., dated June 10, 1986 (Exhibit 1 to the CEC Form 10-Q (June 1986), File No. 1-7316). Exhibit 22. Subsidiaries of the Registrant Incorporated by reference to Exhibit 2 (page 101) to the System's 1988 Annual Report on Form 10-K, File No. 1-7316. Exhibit 99. Additional Exhibit Filed herewith as Exhibit 1 is the Notice of 1994 Annual Meeting, Proxy Statement and 1993 Financial Information dated April 1, 1994. (b) Reports on Form 8-K No reports on Form 8-K were filed during the three months ended December 31, 1993. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Commonwealth Energy System: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements of Commonwealth Energy System appearing in Exhibit A to the proxy statement for the 1994 annual meeting of shareholders incorporated by reference in this Form 10-K, and have issued our report thereon dated February 17, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed in Part IV, Item 14 of this Form 10-K are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state 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 & CO. Arthur Andersen & Co. Boston, Massachusetts, February 17, 1994. SCHEDULE VIII COMMONWEALTH ENERGY SYSTEM AND SUBSIDIARY COMPANIES VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 Additions Balance Provision Deductions Balance Beginning Charged to Accounts at End Description of Year Operations Recoveries Written-Off of Year Year Ended December 31, 1993 Allowance for Doubtful Accounts $6 861 $ 9 468 $2 142 $10 710 $7 761 Year Ended December 31, 1992 Allowance for Doubtful Accounts $5 233 $12 082 $1 918 $12 372 $6 861 Year Ended December 31, 1991 Allowance for Doubtful Accounts $4 506 $10 943 $2 042 $12 258 $5 233 SCHEDULE IX COMMONWEALTH ENERGY SYSTEM AND SUBSIDIARY COMPANIES SHORT-TERM BORROWINGS(A) FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 and 1991 (Dollars in Thousands) Weighted Average Maximum Average Weighted Category of Interest Amount Amount Average Aggregate Rate OutstandingOutstanding Interest Short-Term Balance at at End During During the Rate During Borrowings End of Period of Period the Period Period (B) the Period (C) Year Ended December 31, 1993 Notes Payable to Banks $ 71 975 3.4% $165 525 $103 100 3.5% Year Ended December 31, 1992 Notes Payable to Banks $165 600 4.0% $165 600 $126 321 4.0% Year Ended December 31, 1991 Notes Payable to Banks $145 800 5.5% $150 875 $120 567 6.3% (A) Refer to Note 5 of Notes to Financial Statements filed under Item 8 of this report for the general terms of notes payable to banks. (B) The average amount outstanding during the period is determined by averaging the level of month-end principal balances outstanding using a rolling thirteen-month period through December 31. (C) The weighted average interest rate during the period is determined by averaging the interest rates in effect on all loans transacted for the twelve-month period ended December 31. COMMONWEALTH ENERGY SYSTEM FORM 10-K DECEMBER 31, 1993 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. COMMONWEALTH ENERGY SYSTEM (Registrant) By: WILLIAM G. POIST William G. Poist, 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 date indicated. Principal Executive Officer: WILLIAM G. POIST March 24, 1994 William G. Poist, President and Chief Executive Officer Principal Financial Officer: JAMES D. RAPPOLI March 24, 1994 James D. Rappoli, Financial Vice President and Treasurer Principal Accounting Officer: JOHN A. WHALEN March 24, 1994 John A. Whalen, Comptroller A majority of the Board of Trustees: SINCLAIR WEEKS, JR. March 24, 1994 Sinclair Weeks, Jr., Chairman of the Board SHELDON A. BUCKLER March 24, 1994 Sheldon A. Buckler, Trustee HENRY DORMITZER March 24, 1994 Henry Dormitzer, Trustee B. L. FRANCIS March 24, 1994 Betty L. Francis, Trustee FRANKLIN M. HUNDLEY March 24, 1994 Franklin M. Hundley, Trustee COMMONWEALTH ENERGY SYSTEM FORM 10-K DECEMBER 31, 1993 SIGNATURES (Continued) March , 1994 William J. O'Brien, Trustee WILLIAM G. POIST March 24, 1994 William G. Poist, Trustee G. L. WILSON March 24, 1994 Gerald L. Wilson, Trustee CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation by reference in this Form 10-K of our report dated February 17, 1994 included in Exhibit A to the proxy statement for the 1994 annual meeting of shareholders and the incorporation of our reports included and incorporated by reference in this Form 10-K into the System's previously filed Registration Statements on Form S-8 File No. 33-28435 and on Form S-3 File No. 33-44161. It should be noted that we have not audited any financial statements of the System subsequent to December 31, 1993 or performed any audit procedures subsequent to the date of our report. ARTHUR ANDERSEN & CO. Arthur Andersen & Co. Boston, Massachusetts, March 30, 1994
794323_1993.txt	794323	1993	ITEM 1. BUSINESS. Peter Kiewit Sons', Inc. (the "Company") was incorporated in Delaware in 1941 to continue a construction business founded in Omaha, Nebraska in 1884. The Company entered the coal mining business in 1943 and the telecommunications business in 1988. Since 1990, the Company's subsidiary, PKS Information Services, Inc. has provided computer services to third parties. Financial information about the construction, mining, and telecommunications segments, as well as geographical information, is contained in Note 17 to the Company's consolidated financial statements. In connection with a reclassification of the Company's securities in January 1992, the business units of the Company were realigned into two groups. The Construction & Mining Group contains the Company's traditional construction operations and Kiewit Mining Group Inc., which performs mining management services for the Company's mining properties. The Diversified Group (through Kiewit Diversified Group Inc., or "KDG") contains mining properties and miscellaneous investments, as well as interests in MFS Communications Company, Inc., California Energy Company, Inc., and C-TEC Corporation. Additional detailed information about each of those three companies can be obtained from their separate Forms 10-K filed with the U.S. Securities and Exchange Commission. CONSTRUCTION The construction business is conducted by operating subsidiaries of Kiewit Construction Group Inc., a wholly-owned subsidiary of the Company (collectively, "KCG"). KCG and its joint ventures perform construction services for a wide range of public and private customers primarily in North America. New contract awards during 1993 were distributed among the following construction markets: transportation, including highways, bridges, airports and railroads (58%), sewer and waste disposal (13%), buildings (11%), oil and gas (7%), power (6%), residential (2%), and water supply systems (1%), with smaller awards in the dams and reservoirs, marine, and mining markets. As general contractors, KCG's operating subsidiaries are responsible for the overall direction and management of construction projects and for completion of each contract in accordance with terms and specifications. KCG plans and schedules the projects, procures materials, hires workers as needed, and awards subcontracts. KCG generally requires performance and payment bonds or other assurances of operational capability and financial capacity from its subcontractors. KCG's construction contracts generally provide for the payment of a fixed price for the work performed. Profit is realized by the difference between the contract price and the actual cost of construction, and the contractor bears the risk that it may not be able to perform all the work for the specified amount. The contracts generally provide for progress payments as work is completed, with a retainage to be paid when performance is substantially complete. Construction contracts frequently contain penalties or liquidated damages for late completion and infrequently provide bonuses for early completion. Government Contracts. Public contracts accounted for 67% of the combined prices of contracts awarded to KCG during 1993. Most of these contracts were awarded by government agencies after competitive bidding. Most public contracts are subject to termination at the election of the government. In the event of termination, the contractor is entitled to receive the contract price on completed work and payment of termination related costs. The volume of available government work is affected by budgetary and political considerations. A significant decrease in the amount of new government contracts, for whatever reasons, would have a material adverse effect on KCG. Demand. The volume and profitability of KCG's construction work depends to a significant extent upon the general state of the economies of the United States and Canada, and the volume of work available to contractors. Fluctuating demand cycles are typical of the industry, and such cycles determine to a large extent the degree of competition for available projects. KCG's construction operations could be adversely affected by labor stoppages or shortages, adverse weather conditions, shortages of supplies, or governmental action. Joint Ventures. KCG enters into joint ventures to efficiently allocate expertise and resources among the venturers and to spread risks associated with particular projects. In most joint ventures, if one venturer is financially unable to bear its share of costs and expenses, the other venturers may be required to pay those costs and expenses. KCG prefers to act as the sponsor of joint ventures. KCG's share of joint venture revenue accounted for 24% of its 1993 total revenue. Locations. KCG structures its construction operations around 20 principal operating offices located throughout the U.S. and Canada, with headquarters in Omaha, Nebraska. Through its decentralized system of management, KCG has been able to quickly respond to changes in the local markets. Internationally, a KCG subsidiary is participating in the construction of a tunnel under Denmark's Great Belt Channel and other subsidiaries have operations in Hermosillo, Mexico. Backlog. At the end of 1993, KCG had a backlog (work contracted for but not yet completed) of $2.1 billion. Of this amount, $700 million is not expected to be completed during 1994. Backlog was $2.2 billion at the end of 1992. Competition. A substantial portion of KCG's business involves construction contracts obtained through competitive bidding. A contractor's competitive position is based primarily on its prices for construction services and its reputation for quality, reliability and timeliness. The construction industry is highly competitive and lacks firms with dominant market power. For 1992, Engineering News Record ranked KCG as the 22nd largest contractor in the United States. It ranked KCG 6th in the transportation market and 7th in the domestic heavy construction market. These rankings were based on the prices of contracts awarded in 1992. The U.S. Department of Commerce reports that the total value of construction put in place in 1993 was $486 billion. KCG's U.S. revenues for the same period were $1.8 billion, or 0.4% of the total market. In 1993 KCG was low bidder on 253 contracts, three of which had a contract price exceeding $50 million; the average contract price was $5.8 million. Properties. KCG has 20 district offices, of which 14 are in owned facilities and 6 are leased. KCG owns or leases numerous shops, equipment yards, storage facilities, warehouses, and construction material quarries. Since construction projects are inherently temporary and location-specific, KCG owns approximately 800 portable offices and shops, and 400 transport trailers. KCG has a large equipment fleet, including approximately 3,000 trucks, pickups, and automobiles, and 1,500 heavy construction vehicles, such as graders, scrapers, backhoes, and cranes. Subsequent Event. On February 28, 1994, KCG acquired APAC-Arizona, Inc. ("APAC") from Ashland Oil Company, Inc. for $49 million cash, subject to various adjustments. APAC is engaged in construction and construction materials businesses in Arizona. The APAC businesses will be divided between PKS' construction and mining segments. MINING The Company is engaged in coal mining through its subsidiaries, Kiewit Mining Group Inc. ("KMG") and Kiewit Coal Properties Inc. ("KCP"). KCP has a 50% interest in three mines, which are operated by KMG. Decker Coal Company ("Decker") is a joint venture with Western Minerals, Inc., a subsidiary of NERCO, Inc. Black Butte Coal Company ("Black Butte") is a joint venture with Bitter Creek Coal Company, a subsidiary of Union Pacific Corporation. Walnut Creek Mining Company ("Walnut Creek") is a general partnership with Phillips Coal Company, a subsidiary of Phillips Petroleum Company. The Decker Mine is located in southeastern Montana, the Black Butte Mine is in southwestern Wyoming, and the Walnut Creek Mine is in east-central Texas. Kiewit also has interests in two smaller coal mines, a precious metals mine, and construction aggregate quarries. Production and Distribution. The coal mines use the surface mining method. During surface mining operations, topsoil is removed and stored for later use in land reclamation. After removal of topsoil, overburden in varying thicknesses is stripped from above coal seams. Stripping operations are usually conducted by means of large, earth-moving machines called draglines, or by fleets of trucks, scrapers and power shovels. The exposed coal is fractured by blasting and is loaded into haul trucks or onto overland conveyors for transportation to processing and loading facilities. Coal delivered by rail from Decker originates on the Burlington Northern Railroad. Coal delivered by rail from Black Butte originates on the Union Pacific Railroad. Coal is also hauled by trucks from Black Butte to the nearby Jim Bridger Power Plant. Coal is delivered by trucks from Walnut Creek to the adjacent facilities of the Texas-New Mexico Power Company. Customers. The coal is sold primarily to electric utilities, which burn coal in order to generate steam to produce electricity. Approximately 94% of sales are made under long-term contracts, and the remainder are made on the spot market. Approximately 84, 55, and 58 percent of KCP's revenues in 1993, 1992 and 1991, respectively, were derived from long-term contracts with Commonwealth Edison Company (with Decker and Black Butte) and The Detroit Edison Company (with Decker). The sole customer of Walnut Creek is the Texas- New Mexico Power Company. Contracts. Customers enter into long-term contracts for coal primarily to secure a reliable source of supply at a predictable price. KCP's major long-term contracts have remaining terms ranging from 6 to 35 years. A majority of KCP's long-term contracts provide for periodic price adjustments. The price is typically adjusted through the use of various indices for items such as materials, supplies, and labor. Other portions of the price are adjusted for changes in production taxes, royalties, and changes in cost due to new legislation or regulation, and in most cases, such cost items are passed through directly to the customer as incurred. In most cases the price is also adjusted based on the heating content of the coal. Beginning in 1993 the amended contract between Commonwealth Edison Company and Black Butte Coal Company provides that Commonwealth's delivery commitments will be satisfied, not with coal produced from the Black Butte mine, but with coal purchased from two unaffiliated mines in the Powder River Basin of Wyoming and Decker. Coal Production. Coal production commenced at the Decker, Black Butte, and Walnut Creek mines in 1972, 1979, and 1989, respectively. Coal mined in 1993 at the Decker, Black Butte, and Walnut Creek mines was 11, 3, and 2 million tons, respectively. Revenue. KCP's total revenue in 1993 was $210 million. Revenue attributable to the Decker, Black Butte, and Walnut Creek entities, and other mining operations was $98 million, $92 million, $19 million, and $1 million, respectively. Backlog. At the end of 1993, the backlog of coal sold under KCP's long- term contracts approximated $2.0 billion, based on December 1993 market prices. Of this amount, approximately $243 million is to be sold in 1994. Reserves. At the end of 1993, KCP's share of assigned coal reserves at Decker, Black Butte, and Walnut Creek was 184, 60, and 90 million tons, respectively. Of these amounts, KCP's share of the committed reserves of Decker, Black Butte, and Walnut Creek was 68, 7, and 22 million tons, respectively. Assigned reserves represent coal which can be mined using KCP's current mining practices. Committed reserves (excluding alternate source coal) represent KCP's maximum contractual amounts. These coal reserve estimates represent total proved and probable reserves. Leases. The coal reserves and deposits of the mines are held pursuant to leases with the federal government through the Bureau of Land Management, with two state governments (Montana and Wyoming), and with numerous private parties. Competition. The coal industry is highly competitive. KCP competes not only with other domestic and foreign coal suppliers, some of whom are larger and have greater capital resources than KCP, but also with alternative methods of generating electricity and alternative energy sources. In 1992, KCP's production represented 2.0% of total U.S. coal production. Demand for KCP's coal is affected by economic, political and regulatory factors. For example, recent "clean air" laws may stimulate demand for low sulphur coal. KCP's western coal reserves generally have a low sulfur content (less than one percent) and are currently useful principally as fuel for coal- fired steam-electric generating units. KCP's sales of its western coal, like sales by other western coal producers, typically provide for delivery to customers at the mine. A significant portion of the customer's delivered cost of coal is attributable to transportation costs. Most of the coal sold from KCP's western mines is currently shipped by rail to utilities outside Montana and Wyoming. The Decker and Black Butte mines are each served by a single railroad. Many of their western coal competitors are served by two railroads and such competitors' customers often benefit from lower transportation costs because of competition between railroads for coal hauling business. Other western coal producers, particularly those in the Powder River Basin of Wyoming, have lower stripping ratios (i.e. the amount of overburden that must be removed in proportion to the amount of minable coal) than the Black Butte and Decker mines, often resulting in lower comparative costs of production. Environmental Regulation. Kiewit is required to comply with various federal, state and local laws and regulations concerning protection of the environment. KCP's share of land reclamation expenses in 1993 was $5 million. KCP's share of accrued estimated reclamation costs was $99 million at the end of 1993. Kiewit does not expect to make significant capital expenditures for environmental compliance in 1994. Kiewit believes its compliance with environmental protection and land restoration laws will not affect its competitive position since its competitors in the industry are similarly affected by such laws. TELECOMMUNICATIONS The Company provides telecommunication services through two partially- owned subsidiaries, MFS Communications Company, Inc. and C-TEC Corporation. MFS COMMUNICATIONS COMPANY, INC. The Company owns 71% of the common stock of MFS Communications Company, Inc. ("MFS"). The remaining shares are publicly-owned and are traded on the NASDAQ National Market System. Shares were sold in an initial public offering in May of 1993 and in another public offering in September of 1993. MFS operates in two business segments: telecommunications services, and network systems integration and facilities management services. Telecommunications Services. MFS Telecom, Inc. ("MFS Telecom") is a major competitive access provider, offering business and government users an alternative to the local telephone companies for various telecommunication services. At the end of 1993, MFS Telecom operated telecommunication networks in 14 metropolitan areas: New York City, Los Angeles, Chicago, San Francisco, Philadelphia, Boston, Washington, D.C., Dallas, Houston, Minneapolis, Baltimore, Pittsburgh, Atlanta and northern New Jersey. At the end of 1993, MFS Telecom provided service to over 900 users. Its network covers approximately 1,300 route miles, including approximately 62,000 miles of optical fiber, with nearly 1,600 office buildings connected to the network. MFS Telecom's primary service offerings are special access and private line. Special access service connects a long distance carrier to an end user or another carrier. Private line service consists of dedicated circuits connecting two end users, typically two offices of a single business. To the extent that transmissions over circuits on the MFS Telecom network do not pass through facilities of the local telephone company, access charges for long distance service are avoided. MFS Telecom's digital fiber optic networks employ advanced fault-tolerant electronics and dual path architecture to ensure reliable and secure telecommunications. MFS Telecom has an active program to expand its existing networks and to develop new networks in other metropolitan areas throughout the United States and internationally. It currently contemplates expansion into more than 60 additional markets (including a number of international markets) over the next three to five years. In 1993, MFS Telecom commenced construction of new fiber optic networks in London, England, the San Jose-Silicon Valley area of California, and Tampa, Florida. In 1993, MFS developed two new services which utilize the existing MFS Telecom networks. MFS Datanet, Inc. offers high-speed data telecommunications services, including an innovative service designed to connect geographically separate local area networks ("LAN"') at the same native speed and protocol at which each LAN operates. MFS Intelenet, Inc. ("Intelenet") is providing a single source for local and long distance telecommunication services to small and medium sized businesses in New York City. As regulatory barriers are removed, the services offered by Intelenet will be provided in all of MFS Telecom's network cities. Network Systems Integration and Facilities Management Services. MFS' subsidiary, MFS Network Technologies, Inc. ("MFS-NT"), designs, engineers, develops and manages the installation of MFS Telecom's new fiber optic networks and its network expansions. MFS-NT also offers its network systems integration services and facilities management services to third parties. MFS-NT had a third-party backlog of approximately $110 million at the end of 1993, an increase of 49% from year-end 1992. A substantial portion of the backlog is related to federal, state or local government contracts. Although some of these contracts are subject to cancellation and/or to a revision of funding, MFS believes that MFS-NT is adequately protected for all incurred costs and the reasonable costs of termination. Customers. MFS Telecom's customers include long distance carriers as well as financial service companies, government departments and agencies, and academic, scientific and other major institutions, each of which has a significant volume of traffic and/or requires extremely reliable communications. During 1993, MFS Telecom's top ten customers accounted for approximately 50% of its total recurring revenue; however, no single customer of MFS Telecom accounted for more than 10% of MFS' consolidated revenues. MFS-NT's third party customers include major local and long distance carriers, cable television operators, government units, and large corporations. During 1993, a contract with the State of Iowa for remote interactive learning facilities accounted for 30% of MFS' consolidated revenues. Competition. In each of its markets, MFS Telecom faces significant competition for its special access and private line telecommunications services from local telephone companies, which currently dominate their local telecommunications markets. Existing competition for private line and special access services is not based on proprietary technology, but on the quality and reliability of the network facilities, customer service, and service features and price. As a result of the comparatively recent installation of its fiber optic networks, its dual path architecture and the state-of-the-art technology used in its networks, MFS Telecom may, in some cases, have cost and service quality advantages over some currently available local telephone company networks. MFS-NT's network systems integration and facilities management competitors are primarily the regional Bell operating companies, long distance carriers, equipment manufacturers and major independent telephone companies. Regulation. MFS is subject to varying degrees of federal, state and local regulation. MFS is not subject to price cap or rate of return regulation, nor is it currently required to obtain Federal Communication Commission ("FCC") authorization for installation or operation of its network facilities used for domestic services. FCC approval is required, however, for the installation and operation of its international facilities and services. The FCC has determined that nondominant carriers, such as MFS, are required to file interstate tariffs on an ongoing basis. MFS subsidiaries that provide intrastate service are generally subject to certification and tariff filing requirements by state regulators. C-TEC CORPORATION On October 29, 1993, the Company purchased a controlling interest in C-TEC Corporation ("C-TEC") for $207 million. Through subsidiaries, the Company acquired 7.5% of the outstanding shares of C-TEC common stock and 59.6% of the C-TEC Class B common stock. Holders of common stock are entitled to one vote per share; holders of Class B stock are entitled to 15 votes per share. The Company thus owns 34.5% of the outstanding shares, but is entitled to 56.6% of the available votes. C-TEC common stock is traded on the NASDAQ National Market System, and the Class B Stock is quoted on NASDAQ and traded over the counter. C-TEC Corporation has headquarters in Wilkes-Barre, Pennsylvania (it has announced plans to move certain key corporate and operating group functions to Princeton, New Jersey). C-TEC has five operating groups. Commonwealth Telephone Company provides local telephone service in 19 counties in eastern Pennsylvania. With more than 211,000 main access lines, Commonwealth is the 20th largest U.S. telephone company. The Cable Group is a cable television operator with systems located in New York, New Jersey, Michigan, Delaware, and Pennsylvania. The Cable Group owns and operates systems serving 224,000 customers and manages systems with an additional 34,000 customers, ranking it among the top 35 U.S. multiple systems operators. The Mobile Services Group offers cellular telephone service in northeastern and central Pennsylvania and southeastern Iowa, as well as paging and message management services in northeastern Pennsylvania. The Long Distance Group sells long distance telephone services in the Commonwealth Telephone local service area and resells services elsewhere. The Communications Group provides telecommunications- related engineering and technical services in the northeastern U.S. Regulation. Commonwealth Telephone Company and C-TEC's long distance telephone subsidiary are subject to FCC regulation. Commonwealth Telephone Company is subject to extensive regulation by the Pennsylvania Public Utility Commission, including its rate-making process. Consequently, the ability of Commonwealth Telephone Company to generate increased income is largely dependent on its ability to increase its subscriber base, obtain higher message volume, and control its expenses. C-TEC's cable television operations are regulated by local and state franchise authorities and by the FCC. The federal Cable Television Consumer Protection and Competition Act of 1992 has increased FCC oversight, including increased regulation of subscriber rates. OTHER OPERATIONS CALIFORNIA ENERGY COMPANY, INC. California Energy Company, Inc. ("CECI") is an independent power producer and a developer and owner of geothermal and other environmentally responsible power generating facilities. CECI currently operates five geothermal facilities, producing in excess of 250 megawatts of electricity, and controls leases to 450,000 areas of geothermal development property in the western United States. CECI, with KCG and others, is developing geothermal facilities in the Philippines. Kiewit Energy Company ("KEC"), a Company subsidiary, owns 21 percent of the outstanding common stock (7.4 million shares) of CECI; CECI common stock is traded on the New York Stock Exchange. KEC has options to purchase 5.5 million common shares, at exercise prices below the current market price. In 1991, KEC purchased $50 million of CECI voting convertible preferred stock, on which dividends are payable at an 8.125% rate. The combined common stock and preferred stock voting rights presently entitle KEC to 28% of the available votes. If the options were exercised and the preferred stock converted, KEC would own approximately 37% of CECI's common stock. A 1991 agreement provides for three KEC representatives on the CECI board of directors and prohibits KEC from acquiring more than 49% of CECI's voting stock before March 1996. In December 1993, KDG and KCG (together "Kiewit") signed a joint venture agreement with CECI, covering international power project development activities in Asia, particularly in the Philippines and Indonesia, and in other regions (excluding the Caribbean, South America, and Central America). The agreement, which has an initial term of three years, provides each party a right of first refusal to pursue jointly all "build, own and operate" or "build, own, operate and transfer" power projects identified by the other party or its affiliates. If both parties agree to participate in a project, they will share all development costs equally, each of CECI and Kiewit will provide 50% of the equity required for financing a project developed by the joint venture, and CECI will operate and manage any such project. The agreement contemplates a joint development structure under which, on a project by project basis, CECI will be the development manager, managing partner and/or project operator, an equal equity participant with Kiewit and a preferred participant in the construction consortium and Kiewit will be an equal equity participant and the preferred turnkey construction contractor, with the construction consortium providing customary security to project lenders (including CECI) for liquidated damages and completion guarantees. INFORMATION SERVICES In addition to providing information services to the Company and its subsidiaries, PKS Information Services, Inc. ("PKSIS") provides remote computing services, or "computer outsourcing", to users of IBM and DEC systems under long-term contracts. The primary focus of PKSIS is on the systems operations segment of the computer outsourcing market. Voice and data telecommunications services and professional services practices are in place to support existing and prospective customers. PKSIS provides its services to firms who desire to focus resources on their core businesses while avoiding the capital and overhead costs of operating their own computer centers. In 1993, 55 percent of PKSIS' revenue was from external customers. PKSIS operations and computing equipment are located in a specially designed 50,000 square foot computer center in Omaha, Nebraska. Construction will begin in 1994 on a 39,000 square foot addition to the existing facility. GENERAL INFORMATION Environmental Protection. Compliance with federal, state, and local provisions regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment, has not and is not expected to have a material effect upon the capital expenditures, earnings, or competitive position of the Company and its subsidiaries. Employees. At the end of 1993, the Company and its majority-owned subsidiaries employed approximately 10,620 people -- 7,200 in construction, 750 in mining, 2,200 in telecommunications (920 at MFS, 1,280 at C-TEC), 140 in information services, and 330 in corporate positions. ITEM 2.		ITEM 2. PROPERTIES. The properties used in the construction segment are described under a separate heading in Item 1 above. Properties relating to the Company's mining and telecommunications segments are described as part of the general business descriptions of those segments in Item 1 above. The Company considers its properties to be adequate for its present and foreseeable requirements. ITEM 3.	ITEM 3. LEGAL PROCEEDINGS. General. The Company and its subsidiaries are parties to many pending legal proceedings. Management believes that any resulting liabilities for legal proceedings, beyond amounts reserved, will not materially affect the Company's financial condition and results of operations. Environmental Proceedings. In a large number of proceedings, the Company or its predecessors is one of numerous defendants who may be "potentially responsible parties" liable for the cleanup of hazardous substances deposited in landfills or other sites. Management believes that any resulting liabilities for environmental legal proceedings, beyond amounts reserved, will not materially affect the Company's financial condition. Whitney Litigation. In 1974, a subsidiary of the Company ("Kiewit"), entered into a lease with Whitney Benefits, Inc., a Wyoming charitable corporation ("Whitney"). Whitney is the owner, and Kiewit is the lessee, of a coal deposit underlying a 1,300 acre tract in Sheridan County, Wyoming. The coal was rendered unmineable by the Surface Mining Control and Reclamation Act of 1977 ("SMCRA"), which prohibited surface mining of coal in certain alluvial valley floors significant to farming. In 1983, Kiewit and Whitney filed an action, now titled Whitney Benefits, Inc. and Peter Kiewit Sons' Co. v. The United States, in the U.S. Court of Federal Claims ("Claims Court"), alleging that the enactment of SMCRA constituted a taking of their coal without just compensation. In 1989, the Claims Court ruled that a taking had occurred and awarded plaintiffs the 1977 fair market value of the property ($60 million) plus interest. In 1991, the U.S. Court of Appeals for the Federal Circuit affirmed the decision of the Claims Court and the U.S. Supreme Court denied certiorari. On February 10, 1994, the Claims Court issued an opinion which provided that the $60 million judgment would bear interest compounded annually from 1977 until payment. Kiewit has calculated the interest for the 1977-1993 period to be $230 million. Kiewit and Whitney have agreed that Kiewit and Whitney will receive 67.5 and 32.5 percent, respectively, of any award. At year-end 1993, Kiewit and Whitney would be entitled to $196 million and $94 million, respectively. The government filed two post-trial motions in the Claims Court during 1992. The government requested a new trial to redetermine the 1977 value of the property. The government also filed a motion to reopen and set aside the 1989 judgment as void and to dismiss plaintiffs' complaint for lack of jurisdiction. In August 1992, the Claims Court indicated that both motions would be denied, but a written order has not yet been entered. The government may appeal from that order, as well as the order regarding compound interest. It is not presently known when these proceedings will be concluded, what amount Kiewit will ultimately receive, nor when payment will occur. MFS Litigation. On March 4, 1994, several former stockholders of MFS Telecom filed a lawsuit against MFS, KDG, and the chief executive officer of MFS, in the United States District Court for the Northern District of Illinois, Case No. 94C-1381. These shareholders sold shares of MFS Telecom to MFS in September 1992. MFS completed an initial public offering in May 1993. Plaintiffs allege that MFS fraudulently concealed material information about its plans from them, causing them to sell their shares at an inadequate price. Plaintiffs have alleged damages of at least $100 million. Defendants have meritorious defenses and intend to vigorously contest this lawsuit. Prior to the initial public offering, KDG agreed to indemnify MFS against any liabilities arising from the September 1992 sale; if MFS is deemed to be liable to plaintiffs, KDG will be required to satisfy MFS's liabilities in accordance with the indemnification agreement. If KDG does make payments as a result of this litigation, the Company's earnings and stockholders' equity will not immediately decline, because such payments will be recorded in the financial statements as an increase to the original purchase price of the MFS Telecom shares, resulting in goodwill which will be amortized against earnings in future periods. ITEM 4.	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. No matters were submitted to a vote of security holders during the fourth quarter of 1993. EXECUTIVE OFFICERS OF THE REGISTRANT. The table below shows information as of March 15, 1994 about each executive officer of the Company, including his business experience during the past five years (1989-1994). The Company considers its executive officers to be its directors who are employed by the Company or one of its subsidiaries. The Company's directors and officers are elected annually and each was elected on June 5, 1993 to serve until his successor is elected and qualified or until his death, resignation or removal. Name Business Experience (1989-1994) Age Walter Scott, Jr. Chairman of the Board and President 62 William L. Grewcock Vice Chairman 68 Robert E. Julian Executive Vice President-Chief Financial 54 Officer (since 1991); Vice President- Chief Financial Officer (1989-1991); Treasurer (1990-1993) Kenneth E. Stinson Executive Vice President (since 1991) 51 Vice President (1989-1991) John Bahen President, Peter Kiewit Sons Co. 66 Ltd. (1989-1993) Richard Geary Executive Vice President, KCG; President, 59 Kiewit Pacific Co. Leonard W. Kearney Vice President, KCG; President, Kiewit 53 Construction Company and Kiewit Western Co. James Q. Crowe Chairman and Chief Executive Officer 44 of MFS Richard R. Jaros Executive Vice President (since 1993); 42 Vice President (1990-1992); Chairman (since 1993), President and CEO (1992-1993) of CECI; Vice President, KDG (1989-1990) George B. Toll, Jr. Executive Vice President, KCG (1994); Vice 58 President, Kiewit Pacific Co. PART II ITEM 5.	ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. Market Information. There is no established public trading market for the Company's common stock. Under the Company's Restated Certificate of Incorporation effective January 1992, the Company now has three classes of common stock: Class B Construction & Mining Group Nonvoting Restricted Redeemable Convertible Common Stock ("Class B"), Class C Construction & Mining Group Restricted Redeemable Convertible Exchangeable Common Stock ("Class C"), and Class D Diversified Group Convertible Exchangeable Common Stock ("Class D"). In connection with a reclassification in January 1992, each "old" Class B share was exchanged for one "new" Class B share and one Class D share, and each "old" Class C share was exchanged for one "new" Class C share and one Class D share. New Class B and Class C shares can be issued only to Company employees and can be resold only to the Company at a formula price based on the year-end book value of the Construction & Mining Group. The Company is generally required to repurchase Class B and Class C shares for cash upon stockholder demand. Class D shares have a formula price based on the year- end book value of the Diversified Group. The Company must generally repurchase Class D shares for cash upon stockholder demand at the formula price, unless the Class D shares become publicly traded. Although the Class D shares are predominantly owned by employees and former employees, such shares are not subject to ownership or transfer restrictions. Dividends. During 1992 and 1993 the Company declared the following dividends on its common stock: Date Declared Date Paid Dividend Per Share Class January 4, 1992 January 4, 1992 $0.50 Old B&C March 20, 1992 May 1, 1992 0.15 New B&C March 20, 1992 May 1, 1992 0.35 D March 20, 1992 June 1, 1992 1.00 D October 23, 1992 January 5, 1993 0.30 B&C October 23, 1992 January 5, 1993 0.35 D March 19, 1993 May 1, 1993 0.30 B&C March 19, 1993 May 1, 1993 0.35 D March 19, 1993 June 1, 1993 0.15 D October 29, 1993 January 6, 1994 0.40 B&C The Board of Directors announced on August 27, 1993 that the Company did not intend to pay dividends on Class D shares in the foreseeable future. Holders. On March 1, 1994, the Company had the following number of stockholders for each class of its common stock: Holders Class 4 B 1121 C 1327 D ITEM 6.	ITEM 6. SELECTED FINANCIAL DATA. _________________________________ PETER KIEWIT SONS', INC. SELECTED CONSOLIDATED FINANCIAL DATA The Selected Financial Data of Peter Kiewit Sons', Inc. ("PKS") and the Kiewit Construction & Mining Group ("B&C Stock") and the Kiewit Diversified Group ("D Stock") appear below and on the next four pages. The consolidated data of PKS are presented below with the exception of per common share data which is presented in the Selected Financial Data of the respective groups. Fiscal Year Ended (dollars in millions, _________________________________________________ except per share amounts) 1993 1992 1991 1990 1989 _______________________________________________________________________________ Results of Operations: Revenue (1) $ 2,179 $ 2,020 $ 2,086 $ 1,917 $ 1,701 Earnings from continuing operations before cumulative effect of change in accounting principle (2) 261 150 49 108 92 Net earnings (2) 261 181 441 80 140 Financial Position: Total assets (1) 3,684 2,599 2,632 2,966 3,762 Current portion of long-term debt (1) 15 3 15 31 178 Long-term debt, less current portion (1) 462 30 110 269 302 Stockholders' equity (3) 1,671 1,458 1,396 1,185 1,141 _______________________________________________________________________________ (1) In October 1993, the Company acquired 34.5% of the outstanding shares of C-TEC Corporation that have 56.6% of the available voting rights. (2) In 1993, through two public offerings, the Company sold 29% of its subsidiary, MFS Communications Company, Inc., resulting in a $137 million after-tax gain. (3) The aggregate redemption value of common stock at December 25, 1993 was $1.6 billion. KIEWIT CONSTRUCTION & MINING GROUP SELECTED FINANCIAL DATA The following selected financial data for each of the years in the period 1989 to 1993 have been derived from audited financial statements. The historical financial information for the Kiewit Construction & Mining and Kiewit Diversified Groups supplements the consolidated financial information of PKS and, taken together, includes all accounts which comprise the corresponding consolidated financial information of PKS. Fiscal Year Ended (dollars in millions, ____________________________________________ except per share amounts) 1993 1992 1991 1990 1989 ____________________________________________________________________________ Results of Operations: Revenue $ 1,777 $ 1,671 $ 1,834 $ 1,671 $ 1,481 Earnings before cumulative effect of change in accounting principle 80 69 23 57 52 Net earnings 80 82 23 57 52 Per Common Share (1): Earnings before cumulative effect of change in accounting principle 4.63 3.79 1.12 2.47 2.13 Net earnings 4.63 4.48 1.12 2.47 2.13 Dividends (2) 0.70 0.70 0.30 0.25 0.30 Stock price (3) 22.35 18.70 14.40 10.35 8.40 Book value 27.43 23.31 19.25 14.99 12.65 Financial Position: Total assets 889 862 849 762 678 Current portion of long-term debt 4 2 7 15 26 Long-term debt, less current portion 10 12 13 14 11 Stockholders' equity (4) 480 437 400 350 313 Formula value (3) 391 351 299 249 215 ____________________________________________________________________________ KIEWIT CONSTRUCTION & MINING GROUP SELECTED FINANCIAL DATA (continued) (1) In connection with the January 8, 1992 reorganization, each share of previous Class B and Class C Stock was exchanged for one share of new Class B&C Stock and one share of new Class D Stock. Therefore, for purposes of computing Class B&C Stock per share data, the number of shares for years 1989 to 1991 are assumed to be the same as the corresponding number of shares of previous Class B and Class C Stock. Fully diluted earnings per share have not been presented because it is not materially different from earnings per share. (2) The 1993 and 1992 dividends include $.40 and $.30 for dividends declared in 1993 and 1992, respectively, but paid in January of the subsequent year. Years 1989 to 1991 reflect dividends paid by PKS on its previous Class B and Class C Stock that have been attributed to Kiewit Construction & Mining Group and Kiewit Diversified Group based upon the relative formula values of each group which were determined at the end of each preceding year. Accordingly, the dividends may bear no relationship to the dividends that would have been declared by the Board in such years had the new Class B&C Stock and the Class D Stock been outstanding. (3) Pursuant to the Restated Certificate of Incorporation, the stock price and formula value calculations are computed annually at the end of the fiscal year. (4) Ownership of the Class B&C Stock is restricted to certain employees conditioned upon the execution of repurchase agreements which restrict the employees from transferring the stock. PKS is generally committed to purchase all Class B&C Stock at the amount computed, when put to PKS by a stockholder, pursuant to the Restated Certificate of Incorporation. The aggregate redemption value of the B&C Stock at December 25, 1993 was $391 million. KIEWIT DIVERSIFIED GROUP SELECTED FINANCIAL DATA The following selected financial data for each of the years in the period 1989 to 1993 have been derived from audited financial statements. The historical financial information for the Kiewit Diversified and Kiewit Construction & Mining Groups supplements the consolidated financial information of PKS and, taken together, includes all accounts which comprise the corresponding consolidated financial information of PKS. Fiscal Year Ended (dollars in millions ______________________________________ except per share amounts) 1993 1992 1991 1990 1989 _____________________________________________________________________________ Results of Operations: Revenue (1) $ 402 $ 349 $ 252 $ 246 $ 220 Earnings from continuing operations before cumulative effect of change in accounting principle (2) 181 81 26 51 40 Net earnings (2) 181 99 418 23 88 Per Common Share (3): Earnings from continuing operations before cumulative effect of change in accounting principle 9.08 4.00 1.26 2.20 1.63 Net earnings 9.08 4.92 20.30 1.03 3.59 Dividends (4) 0.50 1.95 0.70 0.70 0.90 Stock price (5) 59.40 50.65 47.85 35.00 32.65 Book value 59.52 50.75 47.93 35.75 33.47 Financial Position: Total assets (1) 2,809 1,759 1,801 2,204 3,084 Current portion of long-term debt (1) 11 1 8 16 152 Long-term debt, less current portion (1) 452 18 97 255 291 Stockholders' equity (6) 1,191 1,021 996 835 828 Formula value (5) 1,191 1,021 996 835 828 _____________________________________________________________________________ KIEWIT DIVERSIFIED GROUP SELECTED FINANCIAL DATA (continued) (1) In October 1993, the Group acquired 34.5% of the outstanding shares of C-TEC Corporation that have 56.6% of the available voting rights. (2) In 1993, through two public offerings, the Group sold 29% of MFS Communications Company, Inc., resulting in a $137 million after-tax gain. (3) In connection with the January 8, 1992 reorganization, each share of previous Class B and Class C Stock was exchanged for one share of new Class B&C Stock and one share of new Class D Stock. Therefore, for purposes of computing Class D Stock per share data, the number of shares for years 1989 to 1991 are assumed to be the same as the corresponding number of shares of previous Class B and Class C Stock. Fully diluted earnings per share have not been presented because it is not materially different from earnings per share. (4) The 1992 dividends include $.35 for dividends declared in 1992 but paid January 5, 1993. Years 1989 to 1991 reflect dividends paid by PKS on its previous Class B and Class C Stock that have been attributed to Kiewit Diversified Group and Kiewit Construction & Mining Group based upon the relative formula values of each group which were determined at the end of each preceding year. Accordingly, the dividends may bear no relationship to the dividends that would have been declared by the Board in such years had the new Class D Stock and the new Class B&C Stock been outstanding. (5) Pursuant to the Restated Certificate of Incorporation, the stock price and formula value calculations are computed annually at the end of the fiscal year. (6) Until public trading begins, PKS is generally committed to purchase all Class D Stock at the amount computed, in accordance with the Restated Certificate of Incorporation, when put to PKS by a stockholder. The aggregate redemption value of the Class D Stock at December 25, 1993 was $1.2 billion. ITEM 7.	ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Separate management's discussion and analysis of financial condition and results of operations for the Kiewit Construction & Mining Group and the Kiewit Diversified Group have been filed as Exhibits 99.A and 99.B to this report. The Company will furnish without charge a copy of such exhibits upon the written request of a stockholder addressed to Stock Registrar, Peter Kiewit Sons', Inc., 1000 Kiewit Plaza, Omaha, Nebraska 68131. Revenue from each of the Company's business segments was (in millions): 1993 1992 1991 _______ _______ _______ Construction $ 1,757 $ 1,659 $ 1,825 Mining 230 246 219 Telecommunications 189 109 37 Other Operations 3 6 5 _______ _______ _______ $ 2,179 $ 2,020 $ 2,086 ======= ======= ======= General _______ Additional financial information about the Company's industry segments, including operating earnings, identifiable assets, capital expenditures and depreciation, depletion and amortization, as well as geographic information, is contained in Note 17 to the Company's consolidated financial statements. Results of Operations 1993 vs. 1992 ___________________________________ Construction ____________ Construction revenue increased by $98 million or 6% in 1993. The Company's share of joint venture revenue rose by 60% and accounted for 24% of total construction revenue for the period as compared to 16% for 1992. Several large contracts awarded in 1992 and early 1993 contributed to the overall increase, the largest of which was the San Joaquin Toll Road Joint Venture ("San Joaquin"). The increase in joint venture revenue was partially offset by a small decrease in sole contract revenue due to a decrease in the average size of sole contracts awarded. Contract backlog at December 25, 1993 was $2.1 billion, of which 6% is attributable to foreign operations, principally, Canada. Projects on the west coast comprise 50% of the total backlog of which San Joaquin accounts for $435 million. San Joaquin is scheduled for completion in 1997. Direct costs associated with construction contracts increased $66 million or 4% to $1.569 billion in 1993. The increase is net of a $20 million reduction in reserves previously established for the non-sponsored Denmark tunnel project. The overall rise in costs is directly attributable to the increase in volume. Costs as a percentage of revenue, excluding the reduction in reserves, approximated 90% and 91% for 1993 and 1992, respectively. Results of Operations 1993 vs. 1992 (continued) _______________________________________________ Construction (continued) ________________________ Management of the non-sponsored Denmark tunnel project completed a cost estimate which indicated a favorable variance in the estimated costs of the project. As a result of this revised cost estimate and negotiations with the owner, management reduced reserves maintained to provide for the Company's share of estimated losses on the project. This reduction contributed to the increase in gross margin to 11% in 1993 from 9% in 1992. Mining ______ Mining revenue decreased 6.5% in 1993. The renegotiation of the agreements with Commonwealth Edison Company ("Commonwealth"), ceased sales of undivided interests in coal reserves. Such sales accounted for approximately $40 million or 16% of the total mining revenue recognized in 1992. The absence of the sale of undivided interests to Commonwealth in 1993, was partially offset by a $9 million increase in precious metal sales, a rise in tonnage shipped and an approximate $4 increase in the average price per ton of coal shipped. The sales of precious metals improved in 1993 due to improved market conditions. Alternate source coal sales by the Black Butte mine produced the increase in the average price per ton of coal shipped. Alternate source coal consists of coal purchased from two unaffiliated mines located in the Powder River Basin area of Wyoming and from the Company's Decker mine. The purchased coal is sold to Commonwealth under terms of the renegotiated agreements. Alternate source coal sales in 1993 comprised 31% of 1993 mining revenue. The gross margin on mining revenue increased to 48% in 1993 from 43% in 1992. Alternate source coal sales, which result in larger margins than mined coal, led to the increase. See "Legal Proceedings" with respect to the Whitney Benefits case. Telecommunications __________________ In 1993, the components of telecommunications revenue were as follows: 37% - MFS Communications Company, Inc. ("MFS") telecommunications services; 38% - MFS network systems integration and facilities management services; and 25% - C-TEC operations (two months). In 1992, revenue was comprised of 44% telecommunications services and 56% network systems integration and facilities management services. MFS telecommunications revenue increased from $48 million to $70 million, an increase of 46%. The majority of the increase in revenue resulted from sales of additional services to existing customers and, to a lesser extent, further market penetration. The growth of services in New York City, the expansion of networks in Boston, Chicago and the Washington, D.C. metropolitan area, and new services provided by MFS Datanet and MFS Intelenet also contributed to the revenue increase. Results of Operations 1993 vs. 1992 (continued) _______________________________________________ Telecommunications (continued) ______________________________ Third party revenue from services offered by the MFS network systems integration and facilities management segment increased from $61 million in 1992 to $71 million in 1993, a 16% increase. The increase primarily resulted from network systems integration projects in the United Kingdom and for the State of Iowa. MFS purchased the other 50% interest in a partnership providing network systems integration services to customers in the United Kingdom, thereby increasing revenue from that country. The network systems integration and facilities management services segment had third party backlog of $110 million at December 31, 1993. Two months of C-TEC activity accounted for $48 million of telecommunications revenues. The telephone and cable television groups generated the majority of the revenues. Telecommunications operating expenses increased 78% in 1993. Components of 1993 operating expenses were: 45% - MFS telecommunications services; 32% - MFS network systems integration and facilities management services; and 23% - C-TEC operating expenses. In 1992, operating expenses were 51% MFS telecommunications services and 49% MFS network systems integration and facilities management services. MFS telecommunications operating expenses increased from $48 million to $80 million in 1993, a 67% increase. The increase reflects operating costs associated with MFS Datanet and MFS Intelenet services and higher costs associated with the new and expanded networks. Increased depreciation of existing networks accounted for nearly 41% of the increase. MFS network systems integration and facilities management services operating expenses increased from $49 million to $55 million in 1993, a 12% increase. The increase directly relates to increased activity on several network systems integration projects, primarily direct costs associated with the projects in the United Kingdom and for the State of Iowa. Two months of C-TEC activity accounted for $42 million of telecommunications operating expenses. The telephone and cable television groups generated the majority of these costs. Progress on the network systems integration project for the State of Iowa was delayed in June and July 1993 by significant rainfall and flooding. Management believes that any additional costs resulting from the floods will not materially impact the Company's telecommunications operations. Other Income ____________ Other income decreased from $128 million in 1992 to $62 million in 1993, a decrease of 52%. The decline primarily relates to a $40 million increase in realized losses and permanent valuation adjustments on marketable securities, including certain derivative securities. Interest income declined by $20 million due to lower interest rates and to a change in portfolio mix. Dividend income decreased by $10 million due to dividends accrued in 1992 on an investment in United States Can Company preferred stock redeemed in March of 1993. Slight increases in equity earnings and miscellaneous income partially offset the declines noted above. Results of Operations 1993 vs. 1992 (continued) _______________________________________________ Selling and Administrative Expenses ___________________________________ Selling and administrative expenses increased 15% or $26 million in 1993. Costs incurred in developing MFS Datanet and MFS Intelenet account for a large portion of the increase. MFS expects to incur significant expense developing the high-speed data communications and integrated, single-source telecommunication services in 1994. Increased legal costs, primarily reserves established for environmental matters (see "Legal Proceedings"), also contributed to the increase. Interest Expense ________________ Interest expense increased by $3 million or 27% in 1993. The increase is due to the C-TEC debt assumed in the acquisition. Interest on C-TEC debt during the last two months, approximated $6 million. The extinguishment of significant debt in 1992 partially offset C-TEC interest. The Company anticipates significant increases in interest expense due to the C-TEC acquisition, the MFS debt issuance of $500 million in January 1994, and project financing on the Company's 65% equity interest in a privately-owned toll road in southern California. Gain on Sale of Subsidiary's Stock __________________________________ In May 1993, MFS sold 12.7 million shares of common stock to the public at an initial offering price of $20 per share for $233 million, net of certain transaction costs. An additional 4.6 million shares were sold to the public on September 15, 1993 at a price of $50 per share for $218 million, net of certain transaction costs. These transactions have reduced the Company's ownership interest in MFS to 71% at December 25, 1993. Substantially all of the net proceeds from the offerings are intended to fund MFS' growth. Prior to the initial public offering, MFS was a wholly-owned subsidiary of the Company. As a result of the above transactions, the Company recognized a pre-tax gain of $211 million representing the increase in the Company's equity in the underlying net assets of MFS. Deferred income taxes have been provided on this gain. Income Taxes ____________ The effective income tax rate for earnings from continuing operations is 30% in 1993 and 32% in 1992. The decrease in rates is due to adjustments to prior year tax provisions which more than offset the effects of the increase in 1993 Federal income tax rates. In both years, dividend exclusions and mineral depletion expenses also reduced the overall effective rate. Results of Operations - 1992 vs. 1991 _____________________________________ Construction ____________ Revenue from construction activity in 1992 decreased 9% compared to 1991. Although the number of new contracts awarded in 1992 increased approximately 15%, the average size of new contracts, excluding the $520 million contract awarded to San Joaquin, decreased by approximately 20%. Contract backlog at the end of 1992 was $2.2 billion, a $300 million increase from backlog at the end of 1991. Of the 1992 backlog, 9% related to foreign projects mainly in Canada and the remainder related to projects in the United States. Sixty-four percent of the U.S. projects were on the west coast. The decrease in revenue as well as in contract backlog (excluding San Joaquin) was the result of the general state of the economy in Canada and the United States. Fluctuating demand cycles are typical of the industry. The gross margin was 9% in 1992 and 6% in 1991. The 1991 gross margin was unfavorably impacted primarily by losses on the Denmark tunnel project and on several U.S. projects. In 1992, management of the nonsponsored Denmark tunnel project completed negotiations with respect to the settlement of claims against the project owner and equipment supplier. The new agreement with the project owner covered the reimbursement of certain costs incurred and time extensions due to differing soil conditions at the site of the tunnels. Costs incurred with respect to the flooding of two of the four tunnels being drilled as part of the project have been covered by insurers. Because of the remaining uncertainties involved in completing the tunnels, due primarily to the adverse soil conditions, no adjustments were made in 1992 for the Company's share of the estimated losses. Management believes that the resolution of the uncertainties should not materially effect of the Company's financial position. Mining ______ Mining revenue increased 12% in 1992 as compared to 1991. The increase was due to the mines collectively shipping 20% more tons of coal and lignite in 1992. The increase in tonnage was due principally to new short-term contracts at the Black Butte mine and sales on the spot market. This increase was partially offset by a 4% decrease in the average price per ton, the result of increased lower-priced spot sales from the Decker mine. Revenue recognition on previously consummated sales of undivided interests in coal reserves to be mined in the future represented $40 million of 1992 revenue and $39 million of 1991 revenue. The gross margin on mining revenue, including reserve coal, approximated 43% in 1992, exceeds the gross margin in 1991. The 1991 gross margin was unfavorably impacted by certain one-time charges for production taxes and reclamation costs, and expenses expenses incurred to repair a dragline. In 1992, the agreements with Commonwealth Edison Company ("Commonwealth") were renegotiated. Beginning January 1, 1993, the Black Butte mine discontinued coal shipments to Commonwealth. Coal is now purchased from two unaffiliated mines located in the Powder River Basin area of Wyoming and from the Company's Decker mine to satisfy the delivery commitments under the renegotiated Commonwealth agreements. Results of Operations 1992 vs. 1991 (continued) _______________________________________________ Mining (continued) __________________ Also in accordance with the renegotiation, there were no sales of interests in coal reserves subsequent to January 1, 1993. The Company does not expect that the financial impact of the renegotiation will be material to its mining operations, cash flows, or financial position. Telecommunications __________________ Revenue in 1992 was comprised of 56% network systems integration and facilities management and 44% telecommunications services. Revenue in 1991 was comprised of 38% network systems integration and facilities management and 62% telecommunications services. Network systems integration and facilities management backlog at December 26, 1992 was $74 million, of which $16 million relates to the United Kingdom joint venture and the remainder relates mainly to the State of Iowa project. Revenue increased from $37 million in 1991 to $109 million in 1992, representing a 192% increase. Of the increase, 66% was from network systems integration and facilities management. This increase resulted primarily from network systems integration projects in Iowa, Minnesota and the United Kingdom. Telecommunications services accounted for the remaining increase in total revenue. This increase in revenue primarily reflects increased services provided on networks in New York City and Dallas which commenced operations in early 1991 and a full year of results for the Washington, D.C. metropolitan area network which was acquired in October 1991. The balance of the increase in telecommunications services revenue resulted from continued market growth of other networks. The Atlanta network became operational during the fourth quarter of 1992, but generated insignificant revenues. The cost of revenue in 1992 increased 112% compared to 1991. Seventy-three percent of the increase relates to direct costs incurred on network systems integration and facilities management projects for third parties. Another 17% of the increase is due to increased depreciation and amortization expense primarily on the telecommunications networks in Washington, D.C., New York City and Dallas. The balance of the increase relates to an increase in other costs associated directly with network operations; primarily from the Washington, D.C., New York City and Dallas networks. The cost of revenue, as a percentage of total revenue, has decreased from 123% in 1991 to 89% in 1992. This change resulted generally from increased utilization of existing network capacity. Results of Operations 1992 vs. 1991 (continued) _______________________________________________ Other Income ____________ The Company recognized investment income of $98 million in 1992 and $108 million in 1991. The decrease in investment income is generally attributable to the collection of various receivables from the sales of the discontinued packaging operations. In 1992 the Company recognized $11 million of interest on these receivables compared to $20 million in 1991. Included in 1992 investment income are $4 million of dividends in kind received from an investment in California Energy Company, Inc. ("California Energy") preferred stock and $11 million of dividends accrued on an investment in United States Can Company ("U.S. Can") preferred stock which was redeemed in March 1993. Included in 1991 investment income is $12 million of dividends received from U.S. Can preferred stock. Other Income in 1992 and 1991 also reflects gains on the sales of timberlands of $5 million and $3 million, respectively, net equity earnings from an investment in California Energy of $4 million and $3 million, respectively, and information services income of $7 million and $5 million, respectively. The increase in Other Income in 1992 was partially offset by a decline in market value considered to be other than temporary of $12 million recorded for two of the Company's marketable securities, one of which was sold in 1993. Selling and Administrative Expenses ___________________________________ Selling and administrative expenses increased 5% in 1992 compared to 1991 due in part to increases within the telecommunications operations. The Company incurred $4 million in 1992 developing new telecommunications services. The increase is also attributable to modest increases in several of the Company's administrative departments. Interest Expense ________________ Interest expense in 1992 reflects the anticipated decrease due to the significant reductions during 1991 in both short-term borrowings and long-term debt. All short-term borrowings were repaid in July 1991 and no new borrowings were incurred until December 1992. The Company also redeemed $150 million of debt in October 1991 and extinguished $73 million of debt in 1992 with no new material debt incurred since year-end 1991. Taxes _____ The effective income tax rate, with respect to continuing operations before cumulative effect of change in accounting principle, is 32% in 1992 and 46% in 1991. The 1992 rate is lower than the 1991 rate primarily due to 1991 foreign taxes and adjustments to the prior year tax provision. In both 1992 and 1991, dividend exclusions and mineral depletion expenses reduced the overall effective rate. Results of Operations 1992 vs. 1991 (continued) _______________________________________________ Discontinued Packaging Operations _________________________________ The gain on disposal of discontinued operations in 1992 resulted from a $19 million adjustment to prior year tax estimates and an $8 million payment, net of tax, received from BTR Nylex Limited and a $1 million accrual, net of tax, relating to additional sales proceeds from the 1990 sale of Continental PET Technologies, Inc. The gain was partially offset by miscellaneous sales adjustments related to the 1991 and 1990 sales of certain discontinued packaging operations. The gain on disposal of discontinued operations in 1991 reflects the sales of the European packaging operations, Continental Can International Corporation, Continental White Cap, Inc. and Continental Plastic Containers, Inc. The significant decrease in 1992 in earnings from discontinued operations is due to the sales of the remaining packaging operations in 1991. Earnings in 1992 reflect the equity earnings from the Company's investment in a plastics joint venture, which was sold to Ball Corporation in July 1992. No significant gain or loss was recognized as a result of this transaction. Financial Condition - December 25, 1993 _______________________________________ The Company's working capital increased $227 million or 20% to $1,365 million in 1993. For the year, the Company generated positive cash flows of $286 million from operating activities, an increase of $86 million over 1992. Cash used in investing activities in 1993 includes the net purchase of marketable securities of $304 million, capital expenditures of $192 million which consists of $127 million for communications, $48 million for construction and $5 and $12 million for mining and corporate, respectively, and the purchase of a controlling interest in C-TEC Corporation for $146 million, net of cash acquired. These investments were necessary to support existing operations and develop new opportunities for future growth. Overall, net cash used in investing activities was $655 million in 1993. Cash from financing activities was derived principally from the issuances of the common stock of MFS and PKS. The Company raised $451 million in cash from the sale of 17.3 million shares or 29% of MFS' common stock in two public offerings. The net proceeds are intended to fund MFS' growth. The Company also raised $24 million in cash from the sale of its Class C and Class D common stock, which will be used for general corporate purposes. Uses of cash in financing activities in 1993 consisted of paying dividends of $27 million to Class B & C and Class D stockholders, repurchasing Class C and Class D common stock for $54 million and repaying 1992 short-term borrowings of $80 million. Throughout 1993, the Company borrowed funds to meet short-term liquidity needs. These additional borrowings have all been repaid. During 1993, the Company collected $110 million related to notes receivable from sales of discontinued operations. The Company's existing working capital position together with anticipated cash flows from operations, debt issuances and existing lines of credit, should be sufficient for 1994's working capital and investing requirements. It is expected that C-TEC will be able to independently finance its working capital and investment requirements in 1994. In addition to investing between $45 million and $85 million annually in its construction and mining businesses, the Company anticipates making significant investments in its energy business - including its joint venture agreement with California Energy covering international power project development activities - and searching for opportunities to acquire operating businesses that are capital intensive and provide long-term growth. In February 1994, the Company completed the purchase of APAC-Arizona, Inc. from Ashland Oil Company, Inc. for approximately $49 million, subject to adjustments. APAC is engaged in the construction materials and contracting businesses in Arizona and surrounding states. The Company has been and continues to investigate other investment opportunities. These investments, along with the payment of income taxes and the repurchases of common stock, will be the significant long-term uses of liquidity. The Company's existing cash and cash equivalents, marketable securities, cash flows from future operations and existing borrowing capacity are expected to fund these expenditures. Financial Condition - December 25, 1993 (continued) ___________________________________________________ MFS requires significant capital to fund future building, expansion or acquisition of communications networks in major metropolitan areas. In January 1994, MFS issued $500 million of Senior Discount Notes due in 2004. In June 1993, MFS entered into a secured revolving credit agreement in the amount of $75 million. The indenture pursuant to which the Senior Discount Notes were issued permits MFS to have a $150 million secured credit facility. These transactions will provide liquidity to fund future expansion, including the proposed acquisition of Centex Telemanagement, Inc., for net consideration of approximately $150 million, announced by MFS on March 16, 1994. MFS may fund future capital expenditures and acquisitions through additional issuances of debt and equity securities. MFS intends to invest $250 million in 1994 and in excess of $1 billion over the next five years to expand its networks to an additional 55 markets. In July 1993, financing was approved to construct a 10-mile privately-owned toll road in southern California. The Company has a 65% interest in this project. Management expects $107 million of third party debt to be incurred. by the project's completion in 1995. ITEM 8.	ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. Financial statements and supplementary financial information for Peter Kiewit Sons', Inc. and Subsidiaries begin on page P1. Separate financial statements and financial statement schedules for the Kiewit Construction & Mining Group and the Kiewit Diversified Group have been filed as Exhibits 99.A and 99.B to this report. The Company will furnish without charge a copy of such exhibits upon the written request of a stockholder addressed to Stock Registrar, Peter Kiewit Sons', Inc., 1000 Kiewit Plaza, Omaha, Nebraska 68131. 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. ITEM 11.	ITEM 11. EXECUTIVE COMPENSATION. ITEM 12.	ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. ITEM 13.	ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information required by Part III is incorporated by reference from the Company's definitive proxy statement for the Annual Meeting of Stockholders to be held on June 4, 1994. However, certain information is set forth under the caption "Executive Officers of the Registrant" following Item 4 above. PART IV ITEM 14.	ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) Financial statements and financial statement schedules required to be filed for the registrant under Items 8 or 14 are set forth following the index page at page P1. Exhibits filed as a part of this report are listed below. Exhibits incorporated by reference are indicated in parentheses. Exhibit Number Description 3.1 Restated Certificate of Incorporation, effective January 8, 1992 (Exhibit 3.1 to Company's Form 10-K for 1991). 3.4 By-laws, composite copy, including all amendments, as of March 19, 1993 (Exhibit 3.4 to Company's Form 10-K for 1992). 10.11 Kiewit Construction and Mining Long-Term Incentive Plan, Construction and Mining Appreciation Rights (Exhibit 10.11 to Company's Form 10-K for 1988). 10.12 Kiewit Long-Term Incentive Plan, Stock Appreciation Rights (Exhibit 10.12 to Company's Form 10-K for 1988). 21 List of subsidiaries of the Company. 99.A Kiewit Construction & Mining Group Financial Statements and Financial Statement Schedules and Management's Discussion and Analysis of Financial Condition and Results of Operations. 99.B Kiewit Diversified Group Financial Statements and Financial Statement Schedules and Management's Discussion and Analysis of Financial Condition and Results of Operations. (b) No Form 8-K was filed during the fourth quarter of 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 24th day of March, 1994. PETER KIEWIT SONS', INC. By: /s/ R. E. Julian ________________________ Robert E. Julian Executive Vice President - Chief Financial 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 indicated on the 24th day of March, 1994. /s/ Walter Scott, Jr. _________________________ Chairman of the Board Walter Scott, Jr. and President (principal executive officer) /s/ R. E. Julian _________________________ Director, Executive Vice Robert E. Julian President-Chief Financial Officer (principal financial officer) /s/ Frank V. Yelick _________________________ Vice President and Controller Frank V. Yelick (principal accounting officer) _________________________ ___________________________ John Bahen, Director Charles M. Harper, Director /s/ Richard L. Coyne /s/ Richard R. Jaros _________________________ ___________________________ Richard L. Coyne, Director Richard R. Jaros, Director /s/ James Q. Crowe /s/ Leonard W. Kearney _________________________ ___________________________ James Q. Crowe, Director Leonard W. Kearney, Director _________________________ ___________________________ Robert B. Daugherty, Director Peter Kiewit, Jr., Director /s/ Richard Geary /s/ Kenneth E. Stinson _________________________ ___________________________ Richard Geary, Director Kenneth E. Stinson, Director /s/ W. L. Grewcock /s/ George B. Toll, Jr. _________________________ ___________________________ William L. Grewcock, Director George B. Toll, Jr., Director PETER KIEWIT SONS', INC. AND SUBSIDIARIES Index to Financial Statements and Financial Statement Schedules Pages ___________________________________________________________________________ Report of Independent Accountants Consolidated Financial Statements as of December 25, 1993 and December 26, 1992 and for the three years ended December 25, 1993: Consolidated Statements of Earnings Consolidated Balance Sheets Consolidated Statements of Cash Flows Consolidated Statements of Changes in Stockholders' Equity Notes to Consolidated Financial Statements Consolidated Financial Statement Schedules for the three years ended December 25, 1993: VIII--Valuation and Qualifying Accounts and Reserves IX--Short-Term Borrowings X--Supplementary Income Statement Information ___________________________________________________________________________ Schedules not indicated above have been omitted because of the absence of the conditions under which they are required or because the information called for is shown in the consolidated financial statements or in the notes thereto. REPORT OF INDEPENDENT ACCOUNTANTS _________________________________ The Board of Directors and Stockholders Peter Kiewit Sons', Inc. We have audited the consolidated financial statements and the financial statement schedules of Peter Kiewit Sons', Inc. and Subsidiaries as listed in the index on the preceding page of this Form 10-K. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Peter Kiewit Sons', Inc. and Subsidiaries as of December 25, 1993 and December 26, 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 25, 1993 in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. As discussed in Note 1 to the financial statements, the Company has changed its method of accounting for income taxes in 1992, and its method of accounting for certain investments in debt and equity securities in 1993. COOPERS & LYBRAND Omaha, Nebraska March 18, 1994 PETER KIEWIT SONS', INC. AND SUBSIDIARIES Consolidated Statements of Earnings For the three years ended December 25, 1993 (dollars in millions) 1993 1992 1991 _____________________________________________________________________________ Revenue $ 2,179 $ 2,020 $ 2,086 Other Income 62 128 125 _______ _______ _______ 2,241 2,148 2,211 Costs and Expenses: Cost of revenue 1,866 1,741 1,905 Selling and administrative 203 177 169 Interest 14 11 47 _______ _______ _______ 2,083 1,929 2,121 _______ _______ _______ 158 219 90 Gain on Sale of Subsidiary's Stock 211 - - _______ _______ _______ Earnings from Continuing Operations Before Income Taxes, Minority Interest and Cumulative Effect of Change in Accounting Principle 369 219 90 Provision for Income Taxes (111) (69) (41) Minority Interest in Loss of Subsidiaries 3 - - _______ _______ _______ Earnings from Continuing Operations Before Cumulative Effect of Change in Accounting Principle 261 150 49 Cumulative Effect of Change in Accounting Principle - 12 - _______ _______ _______ Earnings from Continuing Operations 261 162 49 Discontinued Operations: Earnings from discontinued operations net of income taxes of $- and $26 in 1992 and 1991, respectively - 1 19 Gain on disposal of discontinued operations net of income taxes (benefit) of $(19) and $221 in 1992 and 1991, respectively - 18 373 _______ _______ _______ Net Earnings $ 261 $ 181 $ 441 ======= ======= ======= _____________________________________________________________________________ See accompanying notes to consolidated financial statements. PETER KIEWIT SONS', INC. AND SUBSIDIARIES Consolidated Statements of Earnings (continued) For the three years ended December 25, 1993 (dollars in millions, except per share data) 1993 1992 1991 _____________________________________________________________________________ Earnings Attributable to Class B&C Stock: Earnings Before Cumulative Effect of Change in Accounting Principle $ 80 $ 69 $ 23 Cumulative Effect of Change in Accounting Principle - 13 - _______ _______ _______ Net Earnings $ 80 $ 82 $ 23 ======= ======= ======= Earnings Attributable to Class D Stock: Earnings from Continuing Operations Before Cumulative Effect of Change in Accounting Principle $ 181 $ 81 $ 26 Cumulative Effect of Change in Accounting Principle - (1) - _______ _______ _______ Earnings from Continuing Operations 181 80 26 Discontinued Operations: Earnings - 1 19 Gain on disposal - 18 373 _______ _______ _______ Net Earnings $ 181 $ 99 $ 418 ======= ======= ======= Earnings Per Common and Common Equivalent Share: Class B&C: Earnings Before Cumulative Effect of Change in Accounting Principle $ 4.63 $ 3.79 $ 1.12 Cumulative Effect of Change in Accounting Principle - .69 - _______ _______ _______ Net Earnings $ 4.63 $ 4.48 $ 1.12 ======= ======= ======= Class D: Continuing Operations: Earnings Before Cumulative Effect of Change in Accounting Principle $ 9.08 $ 4.00 $ 1.26 Cumulative Effect of Change in Accounting Principle - (.05) - _______ _______ _______ Earnings from Continuing Operations 9.08 3.95 1.26 Discontinued Operations: Earnings - .04 .94 Gain on disposal - .93 18.10 _______ _______ _______ Net Earnings $ 9.08 $ 4.92 $ 20.30 ======= ======= ======= _____________________________________________________________________________ See accompanying notes to consolidated financial statements. PETER KIEWIT SONS', INC. AND SUBSIDIARIES Consolidated Balance Sheets December 25, 1993 and December 26, 1992 (dollars in millions) 1993 1992 ____________________________________________________________________________ Assets Current Assets: Cash and cash equivalents $ 296 $ 203 Marketable securities 1,082 905 Receivables, less allowance of $7 and $7 291 271 Note receivable from sale of discontinued operations 5 60 Costs and earnings in excess of billings on uncompleted contracts 79 53 Investment in construction joint ventures 81 48 Deferred income taxes 66 55 Other 54 90 _______ _______ Total Current Assets 1,954 1,685 Property, Plant and Equipment, at cost: Land 29 26 Buildings 200 48 Equipment 1,251 895 _______ _______ 1,480 969 Less accumulated depreciation and amortization (636) (575) _______ _______ Net Property, Plant and Equipment 844 394 Note Receivable from Sale of Discontinued Operations 29 84 Investments 233 180 Intangible Assets, net 415 75 Other Assets 209 181 _______ _______ $ 3,684 $ 2,599 ======= ======= ____________________________________________________________________________ See accompanying notes to consolidated financial statements. PETER KIEWIT SONS', INC. AND SUBSIDIARIES Consolidated Balance Sheets December 25, 1993 and December 26, 1992 (dollars in millions, except share data) 1993 1992 ____________________________________________________________________________ Liabilities and Stockholders' Equity Current Liabilities: Accounts payable $ 260 $ 198 Short-term borrowings - 80 Current portion of long-term debt: Telecommunications 7 - Other 8 3 Accrued costs and billings in excess of revenue on uncompleted contracts 107 107 Accrued insurance costs 67 66 Other 140 93 _______ _______ Total Current Liabilities 589 547 Long-Term Debt, less current portion: Telecommunications 420 - Other 42 30 Deferred Income Taxes 385 267 Retirement Benefits 71 74 Accrued Reclamation Costs 92 94 Other Liabilities 116 117 Minority Interest 298 12 Stockholders' Equity: Preferred stock, no par value, authorized 250,000 shares: no shares outstanding in 1993 and 1992 - - Common stock, $.0625 par value, $1.6 billion aggregate redemption value: Class B, authorized 8,000,000 shares: 1,180,400 outstanding in 1993 and 1,257,000 outstanding in 1992 - - Class C, authorized 125,000,000 shares: 16,316,070 outstanding in 1993 and 17,505,535 outstanding in 1992 1 1 Class D, authorized 50,000,000 shares: 20,010,696 outstanding in 1993 and 20,104,478 outstanding in 1992 1 1 Additional paid-in capital 164 145 Foreign currency adjustment (3) 3 Net unrealized holding gain 9 - Retained earnings 1,499 1,308 _______ _______ Total Stockholders' Equity 1,671 1,458 _______ _______ $ 3,684 $ 2,599 ======= ======= ____________________________________________________________________________ See accompanying notes to consolidated financial statements. PETER KIEWIT SONS', INC. AND SUBSIDIARIES Consolidated Statements of Cash Flows For the three years ended December 25, 1993 (dollars in millions) 1993 1992 1991 ___________________________________________________________________________ Cash flows from operations: Earnings from continuing operations $ 261 $ 162 $ 49 Adjustments to reconcile earnings from continuing operations to net cash provided by continuing operations: Cumulative effect of change in accounting principle - (12) - Depreciation, depletion and amortization 99 86 82 (Gain) loss on sale of property, plant and equipment, and other investments 23 (18) (11) Gain on sale of subsidiary's stock (211) - - Decline in market value of investments 21 12 - Retirement benefits paid (17) (8) (5) Change in retirement benefits and other noncurrent liabilities 10 19 68 Deferred income taxes 49 (4) (4) Change in working capital items: Receivables 9 (16) 13 Other current assets (48) 18 4 Payables 47 (12) 23 Other liabilities 13 (33) 10 Other 30 6 (38) _______ _______ _______ Net cash provided by continuing operations 286 200 191 Cash flows from investing activities: Proceeds from sales and maturities of marketable securities 4,927 6,542 3,717 Purchases of marketable securities (5,231) (6,629) (4,116) Acquisition of C-TEC, excluding cash acquired (146) - - Proceeds from sale of property, plant and equipment, and other investments 38 31 34 Capital expenditures (192) (129) (122) Investments in affiliates (14) (42) (135) Acquisition of minority interest (2) (27) - Deferred development costs and other (35) 6 (6) _______ _______ _______ Net cash used in investing activities (655) (248) (628) ____________________________________________________________________________ See accompanying notes to consolidated financial statements. PETER KIEWIT SONS', INC. AND SUBSIDIARIES Consolidated Statements of Cash Flows For the three years ended December 25, 1993 (continued) (dollars in millions) 1993 1992 1991 ___________________________________________________________________________ Cash flows from financing activities: Long-term debt borrowings 21 3 21 Payments on long-term debt, including current portion (8) (98) (199) Net change in short-term borrowings (80) 80 (231) Issuances of common stock 24 24 21 Issuances of subsidiary's stock 458 - - Repurchases of common stock (54) (85) (137) Dividends paid (27) (40) (21) Other - (1) (3) _______ _______ _______ Net cash provided by (used in) financing activities 334 (117) (549) Cash flows from discontinued packaging operations: Proceeds from sales of discontinued packaging operations 110 163 1,285 USW ERISA Litigation settlement installment payment - - (207) Other cash provided by (used in) discontinued packaging operations 20 (34) (105) _______ _______ _______ Net cash provided by discontinued packaging operations 130 129 973 Effect of exchange rates on cash (2) (4) - _______ _______ _______ Net increase (decrease) in cash and cash equivalents 93 (40) (13) Cash and cash equivalents at beginning of year 203 243 256 _______ _______ _______ Cash and cash equivalents at end of year $ 296 $ 203 $ 243 ======= ======= ======= Supplemental disclosure of cash flow information for continuing and discontinued operations: Taxes $ 83 $ 183 $ 213 Interest 7 14 53 ___________________________________________________________________________ See accompanying notes to consolidated financial statements. PETER KIEWIT SONS', INC. AND SUBSIDIARIES Consolidated Statements of Changes in Stockholders' Equity For the three years ended December 25, 1993 (dollars in millions) Class Class Net B & C D Additional Foreign Unrealized Common Common Paid-in Currency Holding Retained Stock Stock Capital Adjustment Gain Earnings Total _______________________________________________________________________________ Balance at December 30, 1990 $ 1 $ 1 $ 123 $ 102 $ - $ 958 $ 1,185 Issuances of stock - - 21 - - - 21 Repurchases of stock - - (16) - - (121) (137) Foreign currency adjustment - - - (93) - - (93) Net earnings - - - - - 441 441 Dividends ($1.00 per common share) - - - - - (21) (21) _____ _____ _____ _____ _____ _______ _______ Balance at December 28, 1991 1 1 128 9 - 1,257 1,396 Issuances of stock - - 24 - - - 24 Repurchases of stock - - (7) - - (78) (85) Foreign currency adjustment - - - (6) - - (6) Net earnings - - - - - 181 181 Dividends: (a) Class B&C ($.70 per common share) - - - - - (13) (13) Class D ($1.95 per common share) - - - - - (39) (39) _____ _____ _____ _____ _____ _______ _______ Balance at December 26, 1992 1 1 145 3 - 1,308 1,458 ______________________________________________________________________________ See accompanying notes to consolidated financial statements. PETER KIEWIT SONS', INC. AND SUBSIDIARIES Consolidated Statements of Changes in Stockholders' Equity For the three years ended December 25, 1993 (continued) (dollars in millions) Class Class Net B & C D Additional Foreign Unrealized Common Common Paid-in Currency Holding Retained Stock Stock Capital Adjustment Gain Earnings Total ________________________________________________________________________________ Balance at December 26, 1992 $ 1 $ 1 $ 145 $ 3 $ - $ 1,308 $ 1,458 Issuances of stock - - 24 - - - 24 Repurchases of stock - - (5) - - (49) (54) Foreign currency adjustment - - - (6) - - (6) Net unrealized holding gain - - - - 9 - 9 Net earnings - - - - - 261 261 Dividends: (b) Class B&C ($.70 per common share) - - - - - (11) (11) Class D ($.50 per common share) - - - - - (10) (10) ___ ___ _____ _____ ____ ________ _______ Balance at December 25, 1993 $ 1 $ 1 $ 164 $ (3) $ 9 $ 1,499 $ 1,671 === === ===== ===== ==== ======== ======= _______________________________________________________________________________ (a) Includes $.30 and $.35 per share for dividends on Class B & C Stock and Class D Stock, respectively, declared in 1992 but paid in January 1993. (b) Includes $.40 per share for dividends on Class B&C Stock declared in 1993 but paid on January 6, 1994. See accompanying notes to consolidated financial statements. PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (1) Summary of Significant Accounting Policies __________________________________________ Principles of Consolidation ___________________________ The consolidated financial statements include the accounts of Peter Kiewit Sons', Inc. and subsidiaries in which it owns more than 50% of the voting stock ("PKS" or "the Company"), which are engaged in enterprises primarily related to construction, mining and telecommunications. See Note 2 with respect to discontinued packaging operations. Fifty-percent-owned mining joint ventures are consolidated on a pro rata basis. All significant intercompany accounts and transactions have been eliminated. Investments in other companies in which the Company exercises significant influence over operating and financial policies and construction joint ventures are accounted for by the equity method. The Company accounts for its share of the operations of the construction joint ventures on a pro rata basis in the consolidated statements of earnings. Construction Contracts ______________________ The Company operates generally within North America as a general contractor and engages in various types of construction projects for both public and private owners. Credit risk is minimal with public (government) owners since the Company ascertains that funds have been appropriated by the governmental project owner prior to commencing work on public projects. Most public contracts are subject to termination at the election of the government. In the event of termination, the Company is entitled to receive the contract price on completed work and reimbursement of termination related costs, plus a reasonable profit on such costs. Credit risk with private owners is minimized because of statutory mechanics liens, which give the Company high priority in the event of lien foreclosures following financial difficulties of private owners. The Company recognizes revenue on long-term construction contracts and joint ventures on the percentage-of-completion method based upon engineering estimates of the work performed on individual contracts. Provisions for losses are recognized on uncompleted contracts when they become known. Claims for additional revenue are recognized in the period when allowed. Assets and liabilities arising from construction activities, the operating cycle of which extends over several years, are classified as current in the financial statements. A one-year time period is used as the basis for classification of all other current assets and liabilities. PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (1) Summary of Accounting Policies (continued) __________________________________________ Coal Sales Contracts ____________________ The Company and its mining ventures have entered into various agree- ments with its customers which stipulate delivery and payment terms for the sale of coal. Prior to 1993, one of the primary customers deferred receipt of certain commitments by purchasing undivided fractional interests in coal reserves of the Company and the mining ventures. Under the arrangements, revenue was recognized when cash was received. The agreements with this customer were renegotiated in 1992. In accordance with the renegotiated agreements, there were no sales of interests in coal reserves subsequent to January 1, 1993. The Company has the obligation to extract and deliver the coal reserves to the customer in the future if the customer exercises its option. If the option is exercised, the Company presently intends to deliver coal from an unaffiliated mine. In the opinion of management, the Company has sufficient coal reserves to cover the above sales commitments. The Company's coal sales contracts are with several electric utility and industrial companies. In the event that these customers do not fulfill contractual responsibilities, the Company would pursue the available legal remedies. Telecommunications Revenues ___________________________ A subsidiary of the Company, MFS Communications Company, Inc. ("MFS"), provides private line and special access telecommunications services to major businesses, governmental entities and long distance carriers in major metropolitan areas of the United States through a competitive access provider subsidiary. Another subsidiary of MFS is a network systems integrator that designs, engineers, develops and installs telecommunications networks and systems and also provides facilities management services. MFS recognizes revenue on telecommunications services in the month the related service is provided. Network systems integration revenue is recognized on the percentage-of-completion method of accounting. In October 1993, the Company acquired 34.5% of the outstanding shares of C-TEC Corporation ("C-TEC") that have 56.6% of the available voting rights. C-TEC's results of operations have been consolidated from the acquisition date. C-TEC's most significant operating groups are its local telephone service and cable system operations. C-TEC's telephone network access revenues are derived from net access charges, toll rates and settlement arrangements for traffic that originates or terminates within C-TEC's local telephone company. Revenues from basic and premium cable programming services are recorded in the month the service is provided. Concentration of credit risk with respect to accounts receivable are limited due to the dispersion of customer base among different industries and geographic areas and remedies provided by terms of contracts and statutes. PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (1) Summary of Significant Accounting Policies (continued) ______________________________________________________ Depreciation and Amortization _____________________________ Depreciation and amortization for the majority of the Company's property, plant and equipment are computed on accelerated and straight-line methods. Depletion of mineral properties is provided primarily on a units-of-extraction basis determined in relation to estimated reserves. In accordance with industry practice, certain telephone plant owned by C-TEC valued at $216 million is depreciated based on the estimated remaining lives of the various classes of depreciable property and straight-line composite rates. When property is retired, the original cost, plus cost of removal, less salvage, is charged to accumulated depreciation. Intangible Assets _________________ Intangible assets consist of amounts allocated upon purchase of assets of existing operations and development costs. These assets are amortized on a straight-line basis over the expected period of benefit, which does not exceed 40 years. Pension Plans _____________ The Company maintains defined benefit plans primarily for retired packaging employees. Benefits paid under the plans are based on years of service for hourly employees and years of service and rates of pay for salaried employees. Substantially all of C-TEC's employees are included in a trusteed noncontributory defined benefit plan. Upon retirement, employees are provided a monthly pension based on length of service and compensation. The plans are funded in accordance with the requirements of the Employee Retirement Income Security Act of 1974. Reserves for Reclamation ________________________ The Company follows the policy of providing an accrual for reclamation of mined properties, based on the estimated cost of restoration of such properties, in compliance with laws governing strip mining. Foreign Currencies __________________ The local currencies of foreign subsidiaries are the functional currencies for financial reporting purposes. Assets and liabilities are translated into U.S. dollars at year-end exchange rates. Revenue and expenses are translated using average exchange rates prevailing during the year. Gains or losses resulting from currency translation are recorded as adjustments to stockholders' equity. PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (1) Summary of Significant Accounting Policices (continued) _______________________________________________________ Subsidiary Stock Sales ______________________ The Company recognizes gains and losses from the sales of stock by its subsidiaries. Earnings Per Share __________________ Primary earnings per share of common stock have been computed using the weighted average number of shares outstanding during each year. For purposes of computing earnings per share data for periods prior to January 8, 1992, the number of Class B&C and Class D shares are assumed to be the same as the aggregate number of previous Class B and Class C shares. Fully diluted earnings per share have not been presented because it is not materially different from primary earnings per share. The number of shares used in computing earnings per share was as follows: 1993 1992 1991 __________ __________ __________ Class B&C 17,290,971 18,262,680 20,588,236 Class D 19,941,885 20,126,768 20,588,236 Marketable Securities and Investments _____________________________________ On December 25, 1993, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 115, "Accounting for Certain Investments in Debt and Equity Securities," which addresses the accounting and reporting of investments in equity securities with readily determinable fair values and all investments in debt securities. The statement does not apply to investments in equity securities accounted for under the equity method nor to investments in consolidated subsidiaries. At December 25, 1993, a net unrealized holding gain of $9 million, net of income taxes, was reported in stockholders' equity. See Note 6 for additional disclosures. Income Taxes ____________ At the beginning of 1992, the Company adopted SFAS No. 109, "Accounting for Income Taxes," which requires recognition of deferred tax liabilities and assets for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred tax liabilities and assets are determined based on the difference between the financial and tax basis for assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. In 1992, the Company recorded income of $12 million which represented the decrease in the net deferred tax liabilities as a result of the accounting change. This amount has been reflected in the consolidated statements of earnings as a cumulative effect of a change in accounting principle. PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (1) Summary of Significant Accounting Policies (continued) ______________________________________________________ Reclassifications _________________ Where appropriate, items within the consolidated financial statements and notes thereto have been reclassified from previous years to conform to current year presentation. Fiscal Year ___________ The Company's fiscal year ends on the last Saturday in December. There were 52 weeks each in the fiscal years 1993, 1992 and 1991. MFS and C-TEC's fiscal years end on December 31. (2) Discontinued Operations _______________________ In 1990, the Company's management authorized the disposition of its packaging businesses. As a result, the consolidated financial statements reflect the packaging businesses as discontinued operations. Discontinued Packaging Operations for the year ended December 26, 1992 reflect the equity earnings of the Company's investment in a plastics joint venture, net of tax at the statutory rate. Summary financial information relative to the discontinued packaging operations, which primarily reflects earnings from packaging operations which were sold during 1991, for the year ended December 28, 1991 is provided below: (dollars in millions) 1991 _____________________________________________________________________ Revenue $ 1,145 Earnings Before Income Taxes 45 Net Earnings 19 _____________________________________________________________________ The effective income tax rate for 1991 is higher than the statutory rate of 34%, primarily resulting for the effects of purchase accounting, state income taxes, higher taxes on foreign earnings and minority interest. PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (3) Acquisitions ____________ In October 1993, the Company acquired 34.5% of the outstanding shares of C-TEC that have 56.6% of the available voting rights. The acquisition of C-TEC for $207 million in cash was accounted for as a purchase, and accordingly, the purchase price was allocated to the assets acquired and liabilities assumed, as follows: Assets: Cash and cash equivalents $ 61 Other current assets 49 Property, plant and equipment 354 Investments 17 Intangible assets 303 Other 8 Liabilities: Current liabilities (64) Deferred income taxes (46) Other liabilities (8) Long-term debt (427) Minority interest (40) _______ $ 207 ======= Results of C-TEC operations are included in the Company's consolidated results of operations since the date of acquisition. The following unaudited pro forma information shows the results of the Company as though the acquisition occurred at the beginning of 1992. These results include certain adjustments, primarily increased amortization, and are not necessarily indicative of what the results would have been had the acquisition been made as of that date or results that will occur in the future. 1993 1992 _______ _______ Revenue $ 2,415 $ 2,277 Net Earnings 255 175 Earnings Per Share of Class D Stock 8.78 4.63 PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (4) MFS Stock Sales _______________ In May 1993, MFS sold 12.7 million shares of common stock to the public at an initial offering price of $20 per share for $233 million, net of certain transaction costs. An additional 4.6 million shares were sold to the public in September 1993, at a price of $50 per share for $218 million, net of certain transaction costs. These transactions have reduced the Company's ownership interest in MFS to 71% at December 25, 1993. Substantially all of the net proceeds from the offerings are intended to fund MFS' growth. Prior to the initial public offering, MFS was a wholly-owned subsidiary of the Company. The 29% outside ownership interest has been included in the consolidated condensed balance sheet minority interest caption. As a result of the above transactions, the Company recognized a gain of $211 million representing the increase in the Company's equity in the underlying net assets of MFS. Deferred income taxes have been provided on this gain. (5) Disposal of Packaging Businesses ________________________________ In July 1992, the Company sold its equity investment in a plastics joint venture to Ball Corporation for $7 million. No significant gain or loss was recognized as a result of this transaction. The gain on disposal of discontinued operations in 1992 resulted from a $19 million adjustment to prior year tax estimates and an $8 million payment, net of tax, received from BTR Nylex Limited and a $1 million accrual, net of tax, relating to additional sales proceeds from the 1990 sale of Continental PET Technologies, Inc. This gain was partially offset by miscellaneous sales adjustments related to the 1991 and 1990 sales of certain discontinued packaging operations. In April 1991, certain subsidiaries of the Company sold their European packaging operations ("Europe") to VIAG Aktiengesellschaft, a German company. The transaction closed in June 1991. Europe was engaged in developing, manufacturing and marketing metal and plastic containers, closures and related packaging products principally in western Europe. Revenue from these businesses was $818 million prior to the transaction close in 1991. Europe's net earnings for this same period was $34 million. The net proceeds were $853 million in cash. With the net proceeds, the Company repaid in July 1991 short-term borrowings of $252 million. The short-term borrowings consisted of $123 million which was borrowed in June 1991 to repay intercompany loans made to the Company by a subsidiary of Europe and $129 million which was directly related to financing Europe's capital expenditures. In May 1991, the Company sold Continental Can International Corporation ("CCIC"), a wholly-owned subsidiary that held the Company's interests in metal packaging operations in Latin America, the Far East and the Middle East, to Crown Cork & Seal Company, Inc. Revenue and net earnings were not material during the period prior to closing in 1991. Proceeds from the transaction consisted of $35 million paid in cash at closing and a receivable of $94 million which was collected in November 1991. PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (5) Disposal of Packaging Businesses (continued) ____________________________________________ In August 1991, the Company sold Continental White Cap, Inc. ("White Cap"), a wholly-owned subsidiary that manufactured metal, plastic and composite closures for food vacuum-packed in both glass and plastic containers to Schmalbach Lubeca A.G., a German company, for $279 million, after certain adjustments. Revenue from this business was $119 million prior to the transaction close in 1991. Net earnings for this same period was $13 million. The proceeds consisted of a promissory note, with interest at the LIBOR rate plus .625%, receivable in installments over the next five years with the final installment due on December 31, 1995. The first installment payment of $50 million was received in October 1991. Additional payments totalling $25 million were received in December 1991 and January 1992, $60 million was received in December 1992, and $110 million was received in 1993. In November 1991, the Company sold Continental Plastic Containers, Inc. and Continental Caribbean Containers, Inc. (collectively "PCD"), two wholly-owned subsidiaries that manufactured blow-molded rigid plastic containers for household, automotive, industrial and food products, to Plastic Containers, Inc., a newly formed corporation, for approximately $150 million, after adjustments. Revenue from this business was $190 million prior to the transaction close in 1991. Net earnings for this same period was $4 million. The proceeds consisted of $50 million in cash at the closing and a $100 million bridge note receivable which was collected in April 1992. The table below summarizes the gain on disposal for each sale and for the combined sales (in millions) during 1991: Europe CCIC White Cap PCD Total ______ _____ _________ _____ _______ Net Proceeds $ 853 $ 129 $ 279 $ 150 $ 1,411 Financial Reporting Basis 560 41 109 96 806 _____ _____ _____ _____ _______ Pre-Tax Gain 293 88 170 54 605 Estimated Tax Provision 94 33 78 28 233 _____ _____ _____ _____ _______ Gain on Disposal $ 199 $ 55 $ 92 $ 26 $ 372 ===== ===== ===== ===== ======= The effective income tax rates differ from the expected statutory income tax rates due to state income taxes and the tax bases being different than the financial reporting bases. Included in the gain on disposal of Europe is $43 million of cumulative translation adjustments, consisting of $95 million of foreign currency adjustments, recorded at December 29, 1990, offset by $52 million of foreign currency losses incurred in 1991. PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (5) Disposal of Packaging Businesses (continued) ____________________________________________ The difference between the gain summarized above and the gain per the consolidated statement of earnings is $1 million, net of tax, consisting of the following (in millions): Purchase price adjustment for Continental PET Technologies, Inc. $ 17 Gain on sale of investment in unconsolidated subsidiary 6 Reserves for various sales of discontinued packaging operations (22) _____ $ 1 ===== During 1991, the Company received $176 million in cash related to the remaining receivable, along with accrued interest, from the sale of the Company's domestic Beverage and Food packaging businesses in 1990. In 1990, the Company sold Continental PET Technologies, Inc. ("PET") to BTR Nylex Limited ("BTR"), an Australian company. Closing date proceeds, subject to adjustment, approximated $110 million. BTR paid an additional $40 million for revenue recognized by PET during 1991-1993 from certain new products. At closing, the Company received a note receivable of $110 million, which was collected in cash in January 1991. PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (6) Disclosures about Fair Value of Financial Instruments _____________________________________________________ The following methods and assumptions were used to determine classification and fair values of financial instruments: Cash and Cash Equivalents _________________________ Cash equivalents generally consist of highly liquid debt instruments purchased with an original maturity of three months or less. The securities are stated at cost, which approximates fair value. Marketable Securities and Investments _____________________________________ The Company has classified all marketable securities and non-current investments not accounted for under the equity method as available- for-sale. The amortized cost of the securities used in computing unrealized and realized gains and losses are determined by specific identification. Fair values are estimated based on quoted market prices for the securities on hand or for similar investments. Fair values of certificates of deposit approximate cost. Net unrealized holding gains and losses are reported as a separate component of stockholders' equity, net of tax. At December 26, 1992 the cost of marketable securities approximated fair value. At December 25, 1993 the cost, unrealized holding gains and losses, and estimated fair values of marketable securities and noncurrent investments are as follows: Unrealized Unrealized Amortized Holding Holding Fair Cost Gains Losses Value _________ __________ __________ _____ Marketable Securities: Equity securities $ 79 $ 2 $ 2 $ 79 U.S. debt securities 536 - - 536 State and political subdivision debt securities 136 1 - 137 Foreign government debt securities 84 - - 84 Corporate debt securities 204 - 1 203 Collateralized mortgage obligations 27 - - 27 Certificates of deposit 16 - - 16 _______ ____ ____ _______ $ 1,082 $ 3 $ 3 $ 1,082 ======= ==== ==== ======= Noncurrent Investments: Equity Securities $ 80 $ 13 $ - $ 93 ======= ==== ==== ======= For debt securities, amortized costs do not vary significantly from principal amounts. Realized gains and losses on sales of marketable securities were $31 million and $64 million, respectively, in 1993. PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (6) Disclosures about Fair Value of Financial Instruments (continued) _________________________________________________________________ The contractual maturities of the debt securities are as follows: Amortized Cost Fair Value ______________ __________ U.S. debt securities: less than 1 year $ 517 $ 517 1-5 years 19 19 _______ _______ $ 536 $ 536 ======= ======= State and political subdivision debt securities: less than 1 year $ 4 $ 4 1-5 years 114 115 5-10 years 5 5 over 10 years 13 13 _______ _______ $ 136 $ 137 ======= ======= Foreign government debt securities: 1-5 years $ 67 $ 67 5-10 years 17 17 _______ _______ $ 84 $ 84 ======= ======= Corporate debt securities: less than 1 year $ 65 $ 65 1-5 years 103 102 5-10 years 16 16 over 10 years 20 20 _______ _______ $ 204 $ 203 ======= ======= Certificates of deposit: less than 1 year $ 16 $ 16 ======= ======= Maturities for the collateralized mortage obligations have not been presented as they do not have a single maturity date. PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (6) Disclosures about Fair Value of Financial Instruments (continued) _________________________________________________________________ Note Receivable from Sale of Discontinued Operations: ____________________________________________________ The carrying amount approximates fair value for both the current and the long-term portion due to the interest rate provided in the note. Short-term Borrowings and Long-term Debt: ________________________________________ The fair value of debt was estimated using the incremental borrowing rates of the Company for debt of the same remaining maturities and approximates the carrying amount, except for certain Rural Telephone Bank debt which C-TEC may refinance. (See Note 11). (7) Retainage on Construction Contracts ___________________________________ Marketable securities at December 25, 1993 and December 26, 1992 include approximately $56 million and $48 million, respectively, of investments which are being held by the owners of various construction projects in lieu of retainage. Receivables at December 25, 1993 and December 26, 1992 include approximately $37 million and $35 million, respectively, of retainage on uncompleted projects, the majority of which is expected to be collected within one year. (8) Investment in Construction Joint Ventures _________________________________________ The Company has entered into a number of construction joint venture arrangements. Under these arrangements, if one venturer is financially unable to bear its share of costs, the other venturers will be required to pay those costs. PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (8) Investment in Construction Joint Ventures (continued) _____________________________________________________ Summary joint venture financial information follows: Financial Position (dollars in millions) 1993 1992 _____________________________________________________________________ Total Joint Ventures ____________________ Current assets $ 563 $ 395 Other assets (principally construction equipment) 71 39 ______ ______ 634 434 Current liabilities (481) (181) ______ ______ Net assets $ 153 $ 253 ====== ====== Company's Share _______________ Equity in net assets $ 80 $ 51 Receivable (payable) from (to) joint ventures 1 (3) ______ ______ Investment in construction joint ventures $ 81 $ 48 ====== ====== _____________________________________________________________________ Operations (dollars in millions) 1993 1992 1991 _____________________________________________________________________ Total Joint Ventures ____________________ Revenue $ 906 $ 575 $ 565 Costs 841 522 703 ______ ______ ______ Operating income (loss) $ 65 $ 53 $ (138) ====== ====== ====== Company's Share _______________ Revenue $ 430 $ 269 $ 337 Costs 372 243 352 ______ ______ ______ Operating income (loss) $ 58 $ 26 $ (15) ====== ====== ====== _____________________________________________________________________ Management of the nonsponsored Denmark tunnel project completed a cost estimate in 1993 which indicated a favorable variance in the estimated costs of the project. As a result of this cost estimate and negotiations with the owner, the Company's management reduced reserves by $20 million which had been maintained to provide for the Company's share of estimated losses on the project. Management believes that the resolution of the the uncertainties in completing the tunnel, primarily due to adverse soil conditions, should not materially affect the Company's financial position. PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (8) Investment in Construction Joint Ventures (continued) _____________________________________________________ Operating income in 1991 was unfavorably impacted by losses on certain joint venture contracts including recording estimated losses on the nonsponsored Denmark tunnel project of $32 million. (9) Investments ___________ During 1992, the Company purchased additional shares of California Energy Company, Inc. ("California Energy") common stock for $23 million, increasing its ownership interest to 21%. The cumulative investment in common stock, accounted for on the equity method, totals $80 million. The Company has certain options to purchase additional shares of California Energy common stock. The excess purchase price over the under- lying equity is being amortized over 20 years. Equity earnings, net of the amortization of the excess purchase price over the underlying equity, were $7 million, $4 million and $3 million in 1993, 1992 and 1991, respectively. California Energy common stock is traded on the New York Stock Exchange. On December 25, 1993, the market value of the Company's investment in California Energy common stock was $138 million. In 1993 and 1992, the Company also recorded dividends in kind declared by California Energy consisting of voting convertible preferred stock valued at $5 million and $4 million, respectively. The stock dividends brought the Company's total investment in convertible preferred stock to $59 million at December 25, 1993. Investments also include equity securities classified as noncurrent and carried at the fair value of $93 million (See Note 6). (10) Intangible Assets _________________ Intangible assets consist of the following at December 25, 1993 and December 26, 1992 (dollars in millions): 1993 1992 _____ _____ Goodwill $ 234 $ 52 Franchise and subscriber lists 60 5 Noncompete agreements 36 - Licenses and right-of-ways 32 11 Deferred development costs 64 13 _____ _____ 426 81 Less accumulated amortization (11) (6) _____ _____ $ 415 $ 75 ===== ===== PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (11) Long-Term Debt and Unutilized Borrowing Arrangements ____________________________________________________ At December 25, 1993 and December 26, 1992, long-term debt was as follows: (dollars in millions) 1993 1992 ______________________________________________________________________ C-TEC Long-term Debt (with recourse only to C-TEC) ____________________ Mortgage notes payable to the United States of America - Rural Telephone Bank (RTB) 5% - 6.05%, with monthly payments through 2009 $ 64 $ - 6.5% - 7%, with quarterly sinking fund payments through 2015 58 - Federal Financing Bank (FFB) 7.69% - 8.36%, with quarterly sinking fund payments through 2012 14 - Senior Secured Notes 9.65%, with annual principal payments 1996 through 1999 (includes unamortized premium of $7 based on imputed rate of 6.12%) 157 - 9.52%, with annual principal payments 1996 through 2001 (includes unamortized premium of $4 based on imputed rate of 6.93%) 104 - Revolving Credit Agreements and Other 30 - _____ _____ 427 - Other PKS Long-term Debt ________________________ 7.5% to 11.6% Notes to former stockholders due 1994-2001 16 17 6.25% to 10.5% Convertible debentures due 1999-2003 7 5 Other 27 11 _____ _____ 50 33 _____ _____ 477 33 Less current portion (15) (3) _____ _____ $ 462 $ 30 ===== ===== _______________________________________________________________________ PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (11) Long-term Debt and Unutilized Borrowing Arrangements (continued) ________________________________________________________________ Substantially all of the assets of C-TEC's telephone group ($353 million) collateralize the mortgage notes payable to the United States of America. These note agreements restrict telephone group dividends. The Senior Secured notes are collateralized by pledges of the stock of C-TEC's telephone, mobile services, and cable group subsidiaries. The notes contain restrictive covenants which require, among other things, specific debt to cash flow ratios. C-TEC's Revolving Credit agreements are collaterlized by a pledge of the stock of C-TEC's telephone and mobile services subsidiaries. The convertible debentures are convertible during October of the fifth year preceding their maturity date. Each annual series may be redeemed in its entirety prior to the due date except during the conversion period. Debentures were converted into 14,322, 10,468, and 36,598, shares of Class C and Class D common stock in 1993, 1992 and 1991, respectively. At December 25, 1993, 215,180 shares of Class C common stock and 86,736 shares of Class D common stock are reserved for future conversions. Other PKS long-term debt consists primarily of construction financing of a privately owned toll road which will be converted to term debt upon completion of the project. Variable interest rates on this debt ranged from 5% to 9% at December 25, 1993. Scheduled maturities of long-term debt through 1998 are as follows (in millions): 1994 - $11; 1995 - $25; 1996 - $56; 1997 - $68 and $70 in 1998. The Company has the following unutilized borrowing arrangements at December 25, 1993: C-TEC's telephone group's agreement with the RTB provides for an additional $23 million of borrowings. The agreement requires C-TEC to invest in RTB stock for approximately 5% of the available amount. C-TEC's Revolving Credit agreements provide for an additional $11 million of borrowings collateralized by stock pledges. The total commitments are reduced on a quarterly basis through maturity in September 1996. An additional $50 million Credit Agreement collateralized by stock pledges may be utilized by C-TEC. The agreement provides revolving borrowings through June 1, 1994 at which time the outstanding balance converts to a term loan with quarterly payments through 1997. Under the arrangement, C-TEC must maintain specified debt to cash flow ratios. PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (11) Long-term Debt and Unutilized Borrowing Arrangements (continued) ________________________________________________________________ C-TEC also has an unused line of credit for $13 million under which unsecured borrowings may be made. Unused lines are cancelable at the option of the lenders. MFS has a $75 million secured revolving credit agreement dependent in part on their ability to attain certain cash flow requirements. PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (12) Income Taxes ____________ An analysis of the provision for income taxes related to continuing operations before minority interest and cumulative effect of change in accounting principle for the three years ended December 25, 1993 follows: (dollars in millions) 1993 1992 1991 _____________________________________________________________________ Current: U.S. federal $ 52 $ 62 $ 32 Foreign 2 5 7 State 8 6 6 _____ _____ _____ 62 73 45 _____ _____ _____ Deferred: U.S. federal 51 (2) (4) Foreign (1) (4) - State (1) 2 - _____ _____ _____ 49 (4) (4) _____ _____ _____ $ 111 $ 69 $ 41 ===== ===== ===== _____________________________________________________________________ The United States and foreign components of earnings, for tax reporting purposes, from continuing operations before minority interest, income taxes and cumulative effect of change in accounting principle follow: (dollars in millions) 1993 1992 1991 ____________________________________________________________________ United States $ 362 $ 215 $ 74 Foreign 7 4 16 _____ _____ _____ $ 369 $ 219 $ 90 ===== ===== ===== ____________________________________________________________________ The components of the deferred income tax benefit, prior to adopting SFAS No. 109, in 1991 were as follows: (dollars in millions) 1991 ____________________________________________________________________ Depreciation and fixed assets $ 4 Retirement benefits and other compensation 1 Mining revenue and costs 5 Insurance reserves (3) Construction contract accounting (18) Equity earnings 4 Accrued revenue 4 Other (1) _____ $ (4) ===== ____________________________________________________________________ PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (12) Income Taxes (continued) ________________________ A reconciliation of the actual provision for income taxes and the tax computed by applying the U.S. federal rate (35% in 1993 and 34% in 1992 and 1991) to the earnings from continuing operations before minority interest, income taxes and cumulative effect of change in accounting principle for the three years ended December 25, 1993 follows: (dollars in millions) 1993 1992 1991 ___________________________________________________________________ Computed tax at statutory rate $ 129 $ 74 $ 31 State income taxes 4 5 4 Depletion (4) (4) (4) Dividend exclusion (4) (3) (2) Equity earnings - (3) - Foreign taxes - - 3 Prior year tax adjustments (13) - 3 Nondeductible expenses - - 3 Other (1) - 3 _____ ____ ____ $ 111 $ 69 $ 41 ===== ==== ==== ___________________________________________________________________ The Company and its domestic subsidiaries file a consolidated federal income tax return. Possible taxes, beyond those provided, on remittances of undistributed earnings of foreign subsidiaries are not expected to be material. The components of the net deferred tax liabilities for the years ended December 25, 1993 and December 26, 1992 were as follows: (dollars in millions) 1993 1992 _____________________________________________________________________ Deferred tax liabilities: Investments in joint ventures $ 112 $ 108 Investments in subsidiaries 84 - Asset bases - accumulated depreciation 198 149 Deferred coal sales 26 25 Other 48 34 _____ _____ Total deferred tax liabilities 468 316 _____ _____ Deferred tax assets: Construction accounts 16 8 Insurance claims 20 22 Compensation - retirement benefits 22 38 Provision for estimated expenses 8 10 Net operating losses of subsidiaries 52 7 Alternative minimum tax credits realizable by subsidiary 11 - Other 37 26 Valuation adjustments (17) (7) _____ _____ Total deferred tax assets 149 104 _____ _____ Net deferred tax liabilities $ 319 $ 212 ===== ===== _____________________________________________________________________ PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (12) Income Taxes (continued) ________________________ The Company's subsidiaries have federal income tax net operating loss carryforwards of $120 million which begin to expire in 2001. (13) Employee Benefit Plans ______________________ The Company makes contributions, based on collective bargaining agreements related to its construction operations, to several multi-employer union pension plans. These contributions are included in the cost of revenue. Under federal law, the Company may be liable for a portion of plan deficiencies; however, there are no known deficiencies. The Company's defined benefit pension plans cover primarily packaging employees who retired prior to the disposition of the packaging operations. The expense related to these plans was approximately $7 million in 1993 and $1 million in 1992 and 1991. C-TEC maintains a separate defined benefit plan for substantially all of its employees. The prepaid pension cost and income related to this plan is not significant at December 25, 1993 or for the period from the acquisition date through December 25, 1993. The Company also has a long-term incentive plan, consisting of stock appreciation rights, for certain employees. The expense related to this plan was $3 million, $6 million, and $8 million in 1993, 1992 and 1991, respectively. Substantially all employees of the Company, with the exception of stockholders and MFS and C-TEC employees, are covered under the Company's profit sharing plans. The expense related to these plans was $2 million, $3 million and $2 million in 1993, 1992 and 1991, respectively. PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (14) Postretirement Benefits _______________________ In addition to providing pension and other supplemental benefits, the Company provides certain health care and life insurance benefits primarily for packaging employees who retired prior to the disposition of certain packaging operations and C-TEC employees. Employees become eligible for these benefits if they meet minimum age and service requirements or if they agree to contribute a portion of the cost. These benefits have not been funded. The net periodic costs for health care benefits were $4 million in 1993, 1992, and 1991. The net perioidic costs for life insurance benefits were $2 million, $2 million, and $1 million in 1993, 1992, and 1991, respectively. In all years, the costs related entirely to interest on accumulated benefits. The accrued postretirement benefit liability as of December 25, 1993 was as follows: Health Life (dollars in millions) Insurance Insurance ______________________________________________________________________ Retirees $ 34 $ 17 Fully eligible active plan participants - - Other active plan participants - - _____ _____ Total accumulated postretirement benefit obligation 34 17 Unrecognized prior service cost 24 1 Unrecognized net loss (7) (2) _____ _____ Accrued postretirement benefit liability $ 51 $ 16 ===== ===== ______________________________________________________________________ The unrecognized prior service cost resulted from certain modifications to the postretirement benefit plan which reduced the accumulated postretirement benefit obligation. The Company may make additional modifications in the future. A 8.3% increase in the cost of covered health care benefits was assumed for fiscal 1993. This rate is assumed to gradually decline to 6.2% in the year 2020 and remain at that level thereafter. A 1% increase in the health care trend rate would increase the accumulated postretirement benefit obligation ("APBO") by $1 million at year-end 1993. The weighted average discount rate used in determining the APBO was 7.0%. PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (15) Stockholders' Equity ____________________ Under the Company's Restated Certificate of Incorporation, effective January 8, 1992, the Company now has three classes of common stock: Class B Construction and Mining Group Nonvoting Restricted Redeemable Convertible Common Stock ("Class B"), Class C Construction and Mining Group Restricted Redeemable Convertible Exchangeable Common Stock ("Class C"), and Class D Diversified Group Convertible Exchangeable Common Stock ("Class D"). In connection with a reclassification in January 1992, each "old" Class B share was exchanged for one "new" Class B share and one Class D share, and each "old" Class C share was exchanged for one "new" Class C share and one Class D share. New Class B and Class C shares can be issued only to Company employees and can be resold only to the Company at a formula price based on the book value of the Construction & Mining Group. The Company is generally required to repurchase Class B and Class C shares for cash upon stockholder demand. Class D shares have a formula price based on the book value of the Diversified Group. The Company must generally repurchase Class D shares for cash upon stockholder demand at the formula price, unless the Class D shares become publicly traded. Although the Class D shares are predominantly owned by employees and former employees, such shares are not subject to ownership or transfer restrictions. In accordance with the January 8, 1992 reorganization, the number of authorized shares of Class B, C and D common stock were increased to 8 million, 125 million and 50 million, respectively. In the event of liquidation, after the holders of any preferred stock have been paid the par value and any accrued and unpaid dividends, the Board of Directors will establish two liquidation accounts, the "B&C Liquidation Account" and the "D Liquidation Account." The assets of the liquidation accounts will be distributed as follows: first, Class B&C stockholders will receive an amount equal to $1.00 per share, reducing the B&C Liquidation Account; second, Class D stockholders will receive an amount equal to $2.00 per share, reducing the D Liquidation Account; and third, any amount remaining in the B&C Liquidation Account shall be distributed pro rata to the Class B&C stockholders, and any amount remaining in the D Liquidation Account shall be distributed pro rata to the Class D stockholders. For comparative purposes, the table below presents issuances and repurchases of common shares assuming the plan of exchange was effected at the beginning of 1991 since each outstanding share of existing Class B and Class C stock was exchanged for one share of new Class B&C stock and one share of new Class D stock. PETER KIEWIT SONS' INC. Notes to Consolidated Financial Statements (15) Stockholders' Equity (continued) ________________________________ For the three years ended December 25, 1993, issuances and repurchases of common shares including conversions were as follows: _______________________________________________________________________ Class B Class C Class D Common Common Common Stock Stock Stock ______ _______ _______ Shares issued in 1991 - 514,518 514,518 Shares repurchased in 1991 206,000 2,897,335 3,103,335 Shares issued in 1992 - 2,886,418 1,019,553 Shares repurchased in 1992 137,000 4,765,161 1,693,353 Shares issued in 1993 - 1,027,657 748,026 Shares repurchased in 1993 76,600 2,217,122 841,808 ______________________________________________________________________ (16) Other Income ____________ Other income includes net investment income of $16 million, $86 million, and $108 million in 1993, 1992 and 1991, respectively, gains and losses on sales of property, plant and equipment and other assets, and other miscellaneous income. Net investment income in 1993 includes $59 million of losses on the sale and permanent writedown of certain derivative securities. PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (17) Industry and Geographic Data ____________________________ The Company operates primarily in three reportable segments: construction, mining and telecommunications. The packaging segment is reported as discontinued operations. A summary of the Company's operations by geographic area and industry follows: Geographic Data (dollars in millions) 1993 1992 1991 _____________________________________________________________________ Revenue: United States $ 1,930 $ 1,808 $ 1,834 Canada 175 182 238 Other 74 30 14 _______ _______ _______ $ 2,179 $ 2,020 $ 2,086 ======= ======= ======= Operating earnings: United States $ 107 $ 131 $ 48 Canada 4 (2) 13 Other 22 - (32) _______ _______ _______ 133 129 29 Gain on sales of subsidiary's stock 211 - - Interest income, net 41 63 35 Nonoperating income (expense), net (16) 27 26 _______ _______ _______ Earnings from continuing operations before income taxes, minority interest and cumulative effect of change in accounting principle $ 369 $ 219 $ 90 ======= ======= ======= Identifiable assets: United States $ 2,445 $ 1,049 $ 861 Canada 82 90 102 Other areas 17 10 - Corporate (1) 1,140 1,450 1,657 Discontinued packaging operations - - 12 _______ _______ _______ $ 3,684 $ 2,599 $ 2,632 ======= ======= ======= _____________________________________________________________________ (1) Principally cash, cash equivalents, marketable securities, notes receivable from sales of discontinued operations and investments in all years. PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (17) Industry and Geographic Data (continued) ________________________________________ Industry Data (dollars in millions) 1993 1992 1991 ______________________________________________________________________ Revenue: Construction $ 1,757 $ 1,659 $ 1,825 Mining 230 246 219 Telecommunications 189 109 37 Other 3 6 5 _______ _______ _______ $ 2,179 $ 2,020 $ 2,086 ======= ======= ======= Operating earnings: Construction $ 94 $ 72 $ 29 Mining 99 96 71 Telecommunications (26) (12) (27) Other (34) (27) (44) _______ _______ _______ 133 129 29 Gain on sale of subsidiary's stock 211 - - Interest income, net 41 63 35 Nonoperating income (expense), net (16) 27 26 _______ _______ _______ Earnings from continuing operations before income taxes, minority interest and cumulative effect of change in accounting principle $ 369 $ 219 $ 90 ======= ======= ======= Identifiable assets: Construction $ 594 $ 543 $ 527 Mining 206 217 196 Telecommunications 1,682 363 205 Other 62 26 35 Corporate 1,140 1,450 1,657 Discontinued packaging - - 12 _______ _______ _______ $ 3,684 $ 2,599 $ 2,632 ======= ======= ======= Capital expenditures: Construction $ 48 $ 37 $ 57 Mining 5 8 6 Telecommunications 127 80 51 Other - - 5 Corporate 12 4 3 _______ _______ _______ $ 192 $ 129 $ 122 ======= ======= ======= Depreciation, depletion and amortization: Construction $ 43 $ 45 $ 53 Mining 13 12 11 Telecommunications 35 21 12 Other 2 3 3 Corporate 6 5 3 _______ _______ _______ $ 99 $ 86 $ 82 ======= ======= ======= ____________________________________________________________________ PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (18) Summarized Financial Information ________________________________ Holders of Class B&C Stock (Construction & Mining Group) and Class D Stock (Diversified Group) are stockholders of PKS. The Construction & Mining Group contains the Company's traditional construction operations performed by Kiewit Construction Group Inc. and certain mining services, performed by Kiewit Mining Group Inc. The Diversified Group contains coal mining properties owned by Kiewit Coal Properties Inc., communications companies owned by MFS, the 34.5% interest in C-TEC, a minority interest in California Energy and miscellaneous investments. Corporate assets and liabilities which are not separately identified with the ongoing operations of the Construction & Mining Group or the Diversified Group are allocated equally between the groups. A summary of the results of operations and financial position for the Construction & Mining Group and the Diversified Group follows. These summaries were derived from the audited financial statements of the respective groups which are exhibits to this Annual Report. All significant intercompany accounts and transactions, except those directly between the Construction & Mining Group and the Diversified Group, have been eliminated. Construction & Mining Group: 1993 1992 1991 _______ _______ _______ Results of Operations: Revenue $ 1,777 $ 1,671 $ 1,834 ======= ======= ======= Earnings before cumulative effect of change in acounting principle $ 80 $ 69 $ 23 Cumulative effect of change in accounting principle - 13 - _______ _______ _______ Net Earnings $ 80 $ 82 $ 23 ======= ======= ======= Earnings per Share: Earnings before cumulative effect of change in accounting principle $ 4.63 $ 3.79 $ 1.12 Cumulative effect of change in accounting principle - .69 - _______ _______ _______ Net Earnings $ 4.63 $ 4.48 $ 1.12 ======= ======= ======= PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (18) Summarized Financial Information (continued) _____________________________________________ Construction & Mining Group (continued): 1993 1992 1991 _______ _______ _______ Financial Position: Working capital $ 372 $ 342 $ 285 Total assets 889 862 849 Long-term debt, less current portion 10 12 13 Stockholders' equity 480 437 400 Included within earnings before income taxes is mine service income from the Diversified Group of $29 million in 1993 and 1992 and $8 million in 1991. Diversified Group: 1993 1992 1991 _______ _______ _______ Results of Operations: Revenue $ 402 $ 349 $ 252 ======= ======= ======= Earnings from continuing operations before cumulative effect of change in accounting principle $ 181 $ 81 $ 26 Cumulative effect of change in accounting principle - (1) - Discontinued Operations - 19 392 _______ _______ _______ Net Earnings $ 181 $ 99 $ 418 ======= ======= ======= Earnings per Share: Earnings from continuing operations before cumulative effect of change in accounting principle $ 9.08 $ 4.00 $ 1.26 Cumulative effect of change in accounting principle - (.05) - Discontinued operations - .97 19.04 _______ ______ _______ Net Earnings $ 9.08 $ 4.92 $ 20.30 ======= ====== ======= PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (18) Summarized Financial Information (continued) _____________________________________________ Diversified Group: 1993 1992 1991 _______ _______ _______ Financial Position: Working capital $ 993 $ 796 $ 788 Total assets 2,809 1,759 1,801 Long-term debt, less current portion 452 18 97 Stockholders' equity 1,191 1,021 996 Included within earnings from continuing operations before income taxes is mine management fees paid to the Kiewit Construction & Mining Group of $29 million in 1993 and 1992 and $8 million in 1991. (19) Other Matters _____________ The Company is involved in various lawsuits, claims and regulatory proceedings incidental to its business. Management believes that any resulting liability, beyond that provided, should not materially affect the Company's financial position or results of operations. In many pending proceedings, the Company is one of numerous defendants who may be "potentially responsible parties" liable for the cleanup of hazardous substances deposited in landfills or other sites. The Company has established reserves to cover its probable liabilities for environmental cases and believes that any additional liabilities will not materially affect the Company's financial condition or results of operations. On March 4, 1994, several former stockholders of an MFS subsidiary filed a lawsuit against MFS, Kiewit Diversified Group, Inc. ("KDG") and the chief executive officer of MFS, in the United States District Court for the Northern District of Illinois, Case No. 94C-1381. These shareholders sold shares of the subsidiary to MFS in September 1992. MFS completed an initial public offering in May 1993. Plaintiffs allege that MFS fraudulently concealed material information about its plans from them, causing them to sell their shares at an inadequate price. Plaintiffs have alleged damages of at least $100 million. Defendants have meritorious defenses and intend to vigorously contest this lawsuit. Prior to the initial public offering, KDG agreed to indemnify MFS against any liabilities arising from the September 1992 sale; if MFS is deemed to be liable to plaintiffs, KDG will be required to satisfy MFS' liabilities pursuant to the indemnity agreement. Any settlement amount would be treated as an adjustment of the original purchase price and recorded as additional goodwill. PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (19) Other Matters (continued) _________________________ It is customary in the Company's industries to use various financial instruments in the normal course of business. These instruments include items such as letters of credit. Letters of credit are conditional commitments issued on behalf of the Company in accordance with specified terms and conditions. As of December 25, 1993, the Company had outstanding letters of credit of approximately $141 million. A subsidiary of the Company, Continental Holdings Inc. remains contingently liable as a guarantor of $111 million of debt relating to various businesses which have been sold. The Company leases various buildings and equipment under both operating and capital leases. Minimum rental payments on buildings and equipment subject to noncancelable operating leases during the next 24 years aggregate $104 million. In 1974, a subsidiary of the Company ("Kiewit"), entered into a lease agreement with Whitney Benefits, Inc., a Wyoming charitable corporation ("Whitney"). Whitney is the owner, and Kiewit is the lessee, of a coal deposit underlying approximately a 1,300 acre tract in Sheridan County, Wyoming. The coal was rendered unmineable by the Surface Mining Control and Reclamation Act of 1977 ("SMCRA"), which prohibited surface mining of coal in certain alluvial valley floors significant to farming. In 1983, Whitney and Kiewit filed an action now titled Whitney Benefits, Inc. and Peter Kiewit Sons', Co. v. The United States, in the U.S. Court of Federal Claims ("Claims Court") alleging that the enactment of SMCRA constituted a taking of their coal without just compensation. In 1989, the Claims Court ruled that a taking had occurred and awarded plaintiffs the 1977 fair market value of the property ($60 million) plus interest. In 1991, the U.S. Court of Appeals for the Federal Circuit affirmed the decision of the Claims Court. In 1991, the U.S. Supreme Court denied certiorari. On February 10, 1994, the Claims Court issued an opinion which provided that the $60 million judgement would bear interest compounded annually from 1977 until payment. Interest for the 1977-1993 period is $230 million. Kiewit and Whitney have agreed that Kiewit and Whitney will receive 67.5 and 32.5 percent, respectively, of any award. The government filed two post-trial motions in the Claims Court during 1992. The government requested a new trial to redetermine the value of the property. The government also filed a motion to reopen and set aside the 1989 judgement as void and to dismiss plaintiffs' complaint for lack of jurisdiction. In August 1992, the Claims Court indicated that both motions would be denied. A written order has not yet been entered. The government may appeal from the order, as well as the order regarding compound interest. It is not presently known when these proceedings will be concluded, what amount Kiewit will ultimately receive, nor when payment of that amount will occur. PETER KIEWIT SONS', INC. Notes to Consolidated Financial Statements (19) Other Matters (continued) _________________________ C-TEC has an outstanding interest rate swap agreement which expires in December 1994. Under this agreement, the Company received a fixed rate of 9.52% on $100 million and pays a floating rate of LIBOR plus 502 basis points (8.52% at December 31, 1993), as determined in six-month intervals. The transaction effectively changes C-TEC's interest rate exposure from a fixed-rate to a floating-rate basis on the $100 million underlying debt. The counter-party to the interest rate swap contract is a major financial institution. C-TEC is exposed to economic loss in the event of nonperformance by the counter-party, however, it does not anticipate such non-performance. (20) Subsequent Events _________________ On January 19, 1994, MFS issued 9 3/8% Senior Discount Notes due January 15, 2004. Cash interest will not accrue on the notes prior to January 15, 1999. Commencing July 15, 1999 cash interest will be payable semi-annually. Accordingly, MFS will initially record the proceeds it received from the offering of $500 million and accrue to the principal amount of the notes of $788 million through January 1999. On or after January 15, 1999, the notes will be redeemable at the option of MFS, in whole or in part, as stipulated in the note agreement. The notes contain certain covenants which, among other things, will restrict MFS' ability to incur additional debt, create liens, enter into sale and leaseback transactions, pay dividends, make certain restricted payments, enter into transactions with affiliates, and sell assets or merge with another company. On February 28, 1994 the Company completed the purchase of APAC- Arizona, Inc. ("APAC") from Ashland Oil Company, Inc. for approximately $49 million, subject to adjustments. APAC is engaged in the construction materials and contracting businesses in Arizona and surrounding states. The acquisition will be accounted for as a purchase, and accordingly, the purchase price will be allocated to the assets and liabilities of APAC based upon their estimated fair values at the acquisition date. Results of operations of APAC will be included in the Company's consolidated results of operations subsequent to the date of acquisition. On March 16, 1994, MFS made an offer to purchase all outstanding shares of common stock and associated preferred share purchase rights to Centex Telemanagement, Inc. at $9 per share. The net consideration of the offer approximates $150 million. The offer, which will expire on April 12, 1994, is conditioned upon, among other things, acquiring a majority of the common shares and the preferred share purchase rights being redeemed or invalidated. SCHEDULE VIII PETER KIEWIT SONS', INC. AND SUBSIDIARIES Valuation and Qualifying Accounts and Reserves Amounts Balance, Charged to Charged Balance Beginning Costs and to End of (dollars in millions) of Period Expenses Reserves Other Period _____________________________________________________________________________ Year ended December 25, 1993 ____________ Allowance for doubtful trade accounts $ 7 $ 5 $ (6) $ 1 $ 7 Reserves: Insurance claims 66 14 (13) - 67 Retirement benefits 74 12 (17) 2 71 Year ended December 26, 1992 ____________ Allowance for doubtful trade accounts $ 7 $ 1 $ (1) $ - $ 7 Reserves: Insurance claims 61 20 (15) - 66 Retirement benefits 58 8 (8) 16 (a) 74 Year ended December 28, 1991 ___________________ Allowance for doubtful trade accounts $ 8 $ 1 $ (2) $ - $ 7 Reserves: Insurance claims 45 25 (9) - 61 Retirement benefits 21 37 (5) 5 58 _____________________________________________________________________________ (a) In 1992, adjustments made in accordance with SFAS No. 109 to adjust remaining retirement benefits, acquired in prior business acquisitions, recorded net of tax, to their pre-tax amounts. SCHEDULE IX PETER KIEWIT SONS', INC. AND SUBSIDIARIES Short-Term Borrowings Weighted Maximum Weighted Average Month-End Average Average Interest Amount Amount Interest Balance, Rate, Outstanding Outstanding Rate End of End of During the During the During (dollars in milions) Period Period Period Period (a) the Period ____________________________________________________________________________ Year ended December 25, 1993 ___________________ Bank Borrowings $ - -% $ 50 $ 24 3.4% Year ended December 26, 1992 ___________________ Bank Borrowings $ 80 3.4% $ 80 $ - -% Year ended December 28, 1991 ___________________ Bank Borrowings $ - -% $ 264 $ 92 10.8% __________________________________________________________________________ (a) Determined on the basis of average daily balances of short-term borrowings. The 1992 bank borrowings were made during the last week of the year. The bank borrowings provided for interest at various rates and matured on various dates within one year. SCHEDULE X PETER KIEWIT SONS', INC. AND SUBSIDIARIES Supplementary Income Statement Information Charged to Costs and Expenses _____________________________ (dollars in millions) 1993 1992 1991 ____________________________________________________________________________ Royalties (a) $ 22 $ 27 $ 24 Production taxes (a) 16 26 19 ____________________________________________________________________________ (a) The Company incurred royalty costs and production taxes with respect to its mining operations based on the tons of coal mined or sold from various properties. Advertising costs and amortization of intangible assets are not presented as such amounts represent less than one percent of revenue as reported in the related consolidated statements of earnings. The costs to repair equipment used on construction contracts, which are charged against such contracts, are excluded because it is impractical to segregate them from other contract costs. Maintenance and repair costs in 1993 and 1992 were less than one percent of revenue. Maintenance and repair costs, primarily related to the Company's discontinued packaging operations, were $50 million in 1991. PETER KIEWIT SONS', INC. AND SUBSIDIARIES INDEX TO EXHIBITS Exhibit No. Description of Exhibit ____________________________________________________________________________ 21 List of Subsidiaries of the Company. 99.A Kiewit Construction & Mining Group Financial Statements and Financial Statement Schedules and Management's Discussion and Analysis of Financial Condition and Results of Operations. 99.B Kiewit Diversified Group Financial Statements and Financial Statement Schedules and Management's Discussion and Analysis of Financial Condition and Results of Operations.
18651_1993.txt	18651	1993	Item 1. Business THE COMPANY AND ITS SUBSIDIARIES CILCORP Inc. (CILCORP or the Company) was incorporated as a holding company in the state of Illinois in 1985. The financial condition and operating results of CILCORP primarily reflect the operations of Central Illinois Light Company (CILCO), the Company's principal business subsidiary. The Company's other core business subsidiary is Environmental Science & Engineering, Inc. (ESE). The Company also has three other first-tier subsidiaries, CILCORP Development Services Inc., CILCORP Investment Management Inc. (CIM) and CILCORP Ventures Inc. (CVI), whose operations, combined with those of the holding company itself, are collectively referred to herein as Other Businesses. The Company owns 100% of the common stock of CILCO. CILCO is engaged in the generation, transmission, distribution and sale of electric energy in an area of approximately 3,700 square miles in central and east-central Illinois, and the purchase, distribution, transportation and sale of natural gas in an area of approximately 4,500 square miles in central and east-central Illinois. ESE, a wholly-owned subsidiary, was formed in February 1990 to conduct the environmental consulting and analytical services businesses acquired from Hunter Environmental Services, Inc. (Hunter) during that year. ESE provides engineering and environmental consulting, analysis, and laboratory services to a variety of governmental and private customers. ESE has seven wholly-owned subsidiaries: Keck Instruments, Inc., which manufactures geophysical instruments used in environmental applications; Chemrox, Inc., which has reduced its presence in the ethylene oxide and chloroflurocarbon control-equipment market by maintaining only a minimal staff, primarily to concentrate on warranty work; ESE Biosciences, Inc. whose on-site biological treatment of contaminated soil and groundwater is now performed primarily by ESE; ESE Architectural Services, Inc. which provides architecture and design services; National Professional Casualty Co., which provides professional liability insurance to ESE; ESE International Ltd., which provides engineering and consulting services in foreign countries; and ESE Michigan, Inc. which formerly conducted business as ESE Environmental Science and Engineering, Inc., provided the same services as its parent, ESE. CIM, a wholly-owned subsidiary, manages the Company's investment portfolio. CIM manages seven leveraged lease investments through three wholly-owned subsidiaries: CILCORP Lease Management Inc. which was formed in 1985, and CIM Leasing Inc. and CIM Air Leasing Inc., which were formed in 1993. CIM's other subsidiary is CIM Energy Investments Inc. which was formed in 1989 to invest in non-regulated, independent power production facilities (see Other Businesses). CVI, a wholly-owned subsidiary, is a venture capital company which pursues investment opportunities in new ventures and the expansion of existing ventures in environmental services, biotechnology and health care. The following table summarizes the relative contribution of each business group to consolidated assets, revenue and net income for the year ended December 31, 1993. CILCORP is an intrastate exempt holding company under the Public Utility Holding Company Act of 1935 (PUHCA). In 1989, the Securities and Exchange Commission (SEC) issued proposed rules regarding diversification by exempt intrastate utility holding companies. The proposed rules, which are intended to take effect three years after adoption in final form, would establish two safe harbors which specify those circumstances in which the SEC would not find diversification detrimental to interests protected under the PUHCA. If the rules are adopted, CILCORP will be required to apply for a formal exemptive order from the SEC or come within one of the safe harbors by either seeking passage of Illinois legislation permitting diversification or reducing its interest in non-utility businesses to less than 10% of consolidated assets. Although certain members of the U.S. Congress continue to explore this issue, the SEC has not taken any public action towards adopting final diversification rules since the proposed rules were issued. BUSINESS OF CILCO CILCO was incorporated under the laws of Illinois in 1913. CILCO's principal business is the generation, transmission, distribution and sale of electric energy in an area of approximately 3,700 square miles in central and east-central Illinois, and the purchase, distribution, transportation and sale of natural gas in an area of approximately 4,500 square miles in central and east-central Illinois. In addition to its principal business, CILCO has two wholly-owned subsidiaries, CILCO Exploration and Development Company (CEDCO) and CILCO Energy Corporation (CECO). CEDCO was formed to engage in the exploration and development of gas, oil, coal and other mineral resources. CECO was formed to research and develop new sources of energy, including the conversion of coal and other minerals into gas. The operations of these subsidiaries are not significant. CILCO is continuing to experience, in varying degrees, the issues common to the electric and gas utility industries. These include uncertainties as to the future demand for electricity and natural gas, structural and competitive changes in the markets for these commodities, the high cost of compliance with environmental and safety laws and regulations, and uncertainties in regulatory and political processes. At the same time, CILCO has sought to provide reliable service at reasonable rates for its customers and a fair return on its common equity. ELECTRIC SERVICE CILCO furnishes electric service to retail customers in 136 Illinois communities (including Peoria, Pekin, Lincoln and Morton). At December 31, 1993, CILCO had approximately 190,000 retail electric customers. In 1993, 67% of CILCO's total operating revenue was derived from the sale of electricity. Approximately 39% of electric revenue resulted from residential sales, 30% from commercial sales, 28% from industrial sales, 2% from sales for resale and 1% from other sales. Electric sales, particularly residential and commercial sales during the summer months, fluctuate based on weather conditions. The electric operating revenues of CILCO were derived from the following sources: CILCO owns and operates two coal-fired base load generating plants and two natural gas combustion turbine-generators which are used for peaking service (see Item 2.		Item 2. Properties CILCO CILCO owns and operates two steam-electric generating plants and two combustion turbine-generators. These facilities had an available summer capability of 1,136 MW in 1993. In December 1993, CILCO announced it will acquire a cogeneration plant to be financed and built by CILCORP at the site of a Midwest Grain Inc. facility (see Capital Resources & Liquidity - CILCO under Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations). The major generating facilities of CILCO (representing 97.4% of CILCO's available summer generating capability projected for 1994), all of which are fueled with coal, are as follows: CILCO's transmission system includes approximately 285 circuit miles operating at 138,000 volts, 48 circuit miles operating at 345,000 volts and 14 principal substations with an installed capacity of 3,343,200 kilovolt-amperes. The electric distribution system includes approximately 6,210 miles of overhead pole and tower lines and 1,912 miles of underground distribution cables. The distribution system also includes 106 substations with an installed capacity of 1,996,995 kilovolt-amperes. The gas system includes approximately 3,406 miles of transmission and distribution mains. CILCO has an underground gas storage facility located about ten miles southwest of Peoria near Glasford, Illinois. The facility has a present recoverable capacity of approximately 4.5 billion cubic feet (bcf). An additional storage facility near Lincoln, Illinois, has a present recoverable capacity of approximately 5.2 bcf. ESE ESE owns approximately 55 acres of land in Gainesville, Florida, containing 110,000 square feet of offices, laboratory and other space. In Peoria, Illinois, ESE owns approximately 27,000 square feet of offices, laboratory and other space, secured by mortgages of $315,000 and leases approximately 21,000 square feet of additional space for offices. ESE and its subsidiaries lease additional facilities for offices, laboratories and warehouse space in 32 cities throughout the United States. ESE believes its facilities are suitable and adequate for its current businesses and does not expect to make any material acquisitions of real property in the near future. However, in 1994 ESE plans to spend $1.2 million to expand its Gainesville, Florida, laboratory by approximately 8,000 square feet. Item 3.	Item 3. Legal Proceedings Reference is made to Environmental Matters under Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations for certain pending legal proceedings and/or proceedings known to be contemplated by governmental authorities. Reference is also made to Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - Gas Take-or-Pay Charges and CILCO Gas Operations and CILCORP Note 3 - Federal Income Tax Audit Settlement included herein. Pursuant to CILCO's By Laws, CILCO has advanced legal and other expenses actually and reasonably incurred by employees, and former employees, in connection with the investigation of CILCO's Springfield gas operations described in Item 7. Management's Discussion and Anaylsis of Financial Condition and Results of Operations - CILCO Gas Operations. CILCO and ESE are subject to certain claims and lawsuits in connection with work performed in the ordinary course of their businesses. In the opinion of management, all claims unless otherwise currently pending will not result in a material adverse effect on the financial position and results of operations of the Company as a result of one or more of the following reasons: (i) insurance coverage; (ii) contractual or statutory indemnification, or (iii) reserves for potential losses. ESE ESE leases a building in Shelton, Connecticut, under a lease agreement which expires February 15, 2000. In January 1991, ESE gave notice of its intent to exercise an option to purchase the building at fair market value pursuant to a provision of the lease. Due to a dispute with the lessor regarding the definition of fair market value, exercise of the option was delayed pending a declaratory judgment by a federal district court in Connecticut. On February 25, 1994, the court issued its final order which declared the purchase option void. ESE filed its notice of appeal on March 2, 1994. Management cannot predict whether its appeal will be successful. Future minimum rental payments are reflected in Note 10 to the financial statements. The building is not currently occupied by ESE or a sublessor, as ESE's Shelton operations ceased in 1991. If the purchase option is ultimately voided, ESE will record an after-tax loss of approximately $500,000, which is equal to the present value of the future rental payments, net of income taxes and estimated sublease revenues. Item 4.	Item 4. Submission of Matters to a Vote of Security Holders CILCORP There were no matters submitted to a vote of security holders during the fourth quarter of 1993. CILCO There were no matters submitted to a vote of security holders during the fourth quarter of 1993. Executive Officers of CILCORP Age at Positions Held During Initial Name 3/31/94 Past Five Years Effective Date(2) R. O. Viets 50 President and Chief Executive Officer February 1, 1988 J. G. Sahn(1) 47 Vice President, General March 1, 1994 Counsel and Secretary Vice President and General Counsel February 1, 1989 R. J. Sprowls 36 Treasurer and Assistant Secretary October 1, 1990 Treasurer - CILCO February 1, 1988 T. D. Hutchinson 39 Controller February 1, 1988 Notes: (1) M. J. Murray served as Secretary and Assistant Treasurer from January 22, 1985, until February 28, 1994, when he retired and was replaced as Secretary by J. G. Sahn. (2) The term of each executive officer extends to the organization meeting of CILCORP's Board of Directors following the next annual election of Directors. Executive Officers of CILCO Age as of Positions Held During Initial Name 3/31/94 Past Five Years(1) Effective Date(2) R. W. Slone 58 Chairman of the Board, President and Chief Executive Officer April 23, 1991 President and Chief Executive Officer February 1, 1988 T. S. Kurtz 46 Vice President November 1, 1988(3) T. S. Romanowski 44 Vice President October 1, 1986(3) W. M. Shay 41 Vice President January 1, 1993(3) J. F. Vergon 46 Vice President October 1, 1986(3)(4) W. R. Dodds 39 Treasurer and Manager of Treasury Department October 1, 1990 Controller and Manager of Accounting February 1, 1988 R. L. Beetschen 48 Controller and Manager of Accounting October 1, 1990 Supervisor - General Accounting May 1, 1988 J. G. Sahn 47 Secretary March 1, 1993 Notes: (1) The officers listed have been employed by CILCO in executive or management positions for more than five years except Mr. Shay and Mr. Sahn. Mr. Shay was Vice President and Chief Financial Officer of CILCO's parent, CILCORP Inc., from August 15, 1988 through December 31, 1992. Mr. Sahn also serves as Vice President and General Counsel of CILCORP Inc., a position he has held since February 1, 1989. (2) The term of each executive officer extends to the organization meeting of CILCO's Board of Directors following the next annual election of Directors. (3) T. S. Kurtz, T. S. Romanowski, W. M. Shay and J. F. Vergon head the Electric Production Group, the Finance and Administrative Services Group, the Electric Operations Group, and the Gas Operations Group, respectively. T. S. Romanowski also serves as CILCO's Principal Financial Officer. J. F. Vergon also serves as Chairman of the Board, President and Chief Executive Officer of CILCORP Investment Management Inc. (4) J. F. Vergon was Vice President of CILCO from October 1, 1986 through December 31, 1992. From January 1, 1993 through February 28, 1993, Mr. Vergon was Vice President and Chief Financial Officer of CILCO's parent, CILCORP Inc. Effective March 1, 1993, Mr. Vergon became a Vice President of CILCO. PART II Item 5.	Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters CILCORP The Company's common stock is listed on the New York and Chicago Stock Exchanges (ticker symbol CER). At December 31, 1993, there were 15,830 holders of record of the Company's common stock. The following table sets forth, for the periods indicated, the dividends per share of common stock and the high and low prices of the common stock as reported in New York Stock Exchange Composite Transactions. CILCO CILCO's common stock is not traded on any market. As of March 15, 1994, 13,563,871 shares of CILCO's Common Stock, no par value, were issued, and outstanding and privately held, beneficially and of record, by CILCORP Inc. CILCO's requirement for retained earnings before common stock dividends may be paid as described in Note 4 of CILCO's Notes to Financial Statements contained in Item 8. Financial Statements and Supplementary Data. Item 6.	Item 6. Selected Financial Data CILCORP INC. Selected Financial Data CILCO Item 7.	Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations CILCORP AND SUBSIDIARIES The financial condition and operating results of CILCORP (the Company) primarily reflect the operations of Central Illinois Light Company (CILCO), the Company's principal business subsidiary. The Company's other core business subsidiary is Environmental Science & Engineering, Inc. (ESE). The Other Businesses segment includes the operations of the holding company itself (Holding Company), its investment subsidiary, CILCORP Investment Management Inc. (CIM), and its venture capital subsidiary, CILCORP Ventures Inc. (CVI). CILCO is a regulated public utility engaged in the generation, transmission and distribution of electric energy and the purchase, transportation and distribution of natural gas in Central Illinois. ESE is an environmental consulting and engineering firm with additional capabilities in laboratory analysis and equipment manufacturing. ESE provides a full-service approach to private, industrial and government clients, commencing with problem identification and analysis, continuing through regulatory negotiation and engineering, and concluding with preparation and implementation of remediation plans. OVERVIEW Contributions to the Company's earnings per share for the last three calendar years are shown below: CILCO's earnings increased approximately 8% in 1993 due to higher electric retail sales. Cooling degree days were near normal in 1993 but were 23% below normal in 1992. The effect of higher gas sales resulting from increased heating degree days was more than offset by higher operations, maintenance, and depreciation expense resulting from increased repairs and replacements to the gas distribution system. As a result, gas operating income again declined. In January 1994, CILCO filed a request with the Illinois Commerce Commission (ICC) for an 8.9% increase in gas base rates (see Gas Rate Increase Request). ESE's results decreased the Company's earnings by $2.3 million in 1993 compared to a positive earnings contribution of $1.9 million in 1992. ESE's revenues declined due to continued economic uncertainty, delays in government enforcement actions, and a more cautious approach by ESE's customers toward environmental compliance. During 1993, ESE continued to close and consolidate offices with low personnel utilization and took steps to control administrative costs. Other Businesses' results improved by $2.6 million from 1992. In late 1993, the Company and the Internal Revenue Service (IRS) settled certain tax issues related to the Company's leveraged lease portfolio. The settlement resulted in a $.24 per share increase in the Company's 1993 earnings. The following table summarizes each business segment's contribution to net income (see Results of Operations for further discussion). Return on average common equity was 10% in 1993 compared to 9.5% in 1992 and 12.3% in 1991. The ratio of common equity to total capitalization, including minority interest and short-term debt, remained stable in 1993 at approximately 45%. The fixed charge coverage ratio also remained stable at 2.4. Inflation may have a significant impact on the Company's future operations, its ability to contain costs, and the need to seek timely and adequate utility rate increases. Over the past five years, the rate of inflation as measured by the Consumer Price Index has ranged from 2.6% to 5.4% annually. To help protect CILCO from the effects of inflation, substantially all electric and gas sales rates include a fuel adjustment clause (FAC) or a purchased gas adjustment clause (PGA) to provide for the recovery of changes in electric fuel costs, excluding coal transportation, and changes in the cost of gas. CAPITAL RESOURCES AND LIQUIDITY The Company believes that internal and external sources of capital which are, or are expected to be, available to the Holding Company and its subsidiaries will be adequate during the coming year to fund the Company's capital expenditures program, pay interest and dividends, meet working capital needs and retire (or refinance) debt as it matures. THE COMPANY In December 1993, the Company issued 62,220 shares of common stock through the CILCO Employees' Savings Plan (ESP) and the CILCORP Automatic Reinvestment and Stock Purchase Plan (DRIP). These shares were issued at an average price of $38 per share for total proceeds of $2.4 million. Previously, the ESP and DRIP plans purchased shares of CILCORP common stock on the open market. Depending on market conditions, the Company may choose to issue new shares of common stock through the ESP and DRIP or have the plans resume purchasing CILCORP stock on the open market. However, the Company may not change its strategy more frequently than every 90 days. The Company plans to issue up to $30 million of common stock through these plans by 1996, depending on market conditions and corporate needs, but is under no commitment to do so. The proceeds from newly issued stock will be used to retire CILCORP short-term debt, to meet working capital and capital expenditure requirements at CILCO, and for other corporate purposes. During 1993, CILCORP's Board of Directors authorized an increase in the Holding Company's short-term borrowing limit from $35 million to $40 million. At December 31, 1993, the Holding Company had $35 million of committed bank lines and $5 million of discretionary bank lines, of which $18.8 million was used, compared to $20 million committed and $2 million outstanding at December 31, 1992. The Company established a $75 million private medium-term note program in 1991. To date, $26 million has been issued. The Company may issue additional notes during 1994-1997 to retire short-term debt incurred to partially fund new investments by CIM, to retire maturing debt of CILCORP Lease Management Inc. (CLM), a wholly-owned subsidiary of CIM, and to provide funds for other corporate purposes. In December 1993, the Holding Company announced that it will initially finance the $11 million construction cost of a cogeneration facility to be located at the site of one of CILCO's current industrial customers (see Electric Competition). Upon receiving ICC approval for the project, CILCO will acquire the steam boilers and other equipment from the Holding Company and invest an additional $5.8 million to install a 20 megawatt turbine generator and related equipment. In December 1993, the IRS and the Company reached agreement on certain disputed issues relating to the IRS audit of the Company's 1985 and 1986 income tax returns (see Note 3). OTHER BUSINESSES At December 31, 1992, CIM and CLM had cash and temporary cash investments of $20.6 million. During 1993, CIM invested $13 million in leveraged leases of passenger railway equipment and an aircraft. The two assets had a total cost of $67 million. The balance of CIM's investment was financed with non-recourse debt. During 1993, CLM retired $6 million of debt and paid the tax liability relating to the gain on the 1992 sale of an office building. At year-end, CIM and CLM had $300,000 of cash and temporary cash investments. As part of the 1992 restructuring of the Springerville Unit No. 1 lease, CLM received approximately 1.2 million shares of Tucson Electric Power Company (TEP) common stock, and warrants to purchase approximately 895,000 additional shares. During 1993, CLM sold one million shares at an average price per share of $3.57, realizing a pre-tax gain of $2 million. CLM plans to sell the remaining TEP stock during 1994, depending upon market conditions. In December 1993, CIM acquired the 19% minority interest in CLM. CILCO In 1993, CILCO spent $73 million for capital additions and improvements. These expenditures consisted primarily of replacements and improvements to the existing electric and gas systems, including $17.5 million to replace certain portions of the Springfield gas distribution system (see Results of Operations, CILCO Gas Operations). This project was substantially completed in September 1993, at an ultimate cost of approximately $24 million. Utility capital projects were financed during 1993 with funds from operating activities. CILCO's cash flow from operations in 1993 was $92 million. During 1993, CILCO issued $108 million of first mortgage pollution control bonds and medium term notes (see Note 7), $22 million of perpetual preferred stock and $25 million of flexible auction rate preferred stock (see Note 6). CILCO retired $96.4 million of first mortgage bonds and $45.5 million of perpetual preferred stock during 1993. The balance of the financing proceeds was used to retire short-term debt. Annual interest expense will decrease $730,000 as a result of the bond refinancings. Also, annual preferred dividend requirements are expected to decrease by $1.3 million as a result of refinancing fixed-rate preferred stock with lower fixed-rate preferred stock and with flexible auction rate preferred stock. CILCO's short-term debt decreased to $12.4 million at December 31, 1993, from $24.5 million at December 31, 1992. CILCO expects to issue short-term commercial paper periodically during 1994, and is currently authorized by its Board of Directors to issue up to $66 million of short-term debt. At December 31, 1993, committed bank lines of credit totalled $30 million, all of which were unused. CILCO expects these bank lines will remain unused through 1994. Estimated capital expenditures for 1994 and 1995 are $90 million and $73 million, respectively. The 1994 estimate includes $34 million for electric energy supply and transmission projects, $5 million for gas supply and transmission projects, and $43 million for electric and gas distribution system improvements. CILCO's expected purchase of the cogeneration plant being initially financed by the Holding Company is included in 1994 capital expenditures. CILCO plans to finance its 1994 and 1995 capital requirements with funds provided by operating activities and the issuance of approximately $30 million of additional long-term debt during 1994. Anticipated total capital expenditures for 1996-1998 are $213 million. These expenditures are expected to be financed primarily with internally-generated funds. In October 1993, Standard & Poor's (S&P) released revised financial ratio benchmarks for rating electric utilities' debt which reflect increased business risk in the industry. As a result, S&P revised CILCO's rating outlook from "stable" to "negative." A "negative" outlook means a long-term debt rating may be lowered, but it is not necessarily a precursor of a rating change. CILCO's current S&P long-term debt rating is AA. ESE ESE spent $4.3 million for capital additions and improvements in 1993, and expects to spend $5.0 million in 1994. ESE's 1993 cash flow from operations was $11.5 million, which was used to fund capital expenditures and to reduce debt. A decrease in accounts receivable contributed $4.8 million to 1993 cash flow. ESE had borrowed $23 million from the Holding Company and $8.1 million from third parties at December 31, 1992. In May 1993, ESE and the Holding Company entered into a credit agreement to consolidate ESE's outstanding debt at that time. The proceeds from this borrowing were used, in part, to retire loans from the Holding Company under the prior agreement. Under this new agreement, ESE can draw on a $15 million revolving line of credit which expires May 2, 1996. At December 31, 1993, ESE had $.9 million outstanding on this line. ESE also borrowed $20 million from the Holding Company on a term credit basis with the principal due on May 2, 1998. ESE reduced borrowings from the Holding Company by $2.1 million during 1993 and retired $7.6 million of its debt to third parties. ESE had an unused $1 million bank line of credit at December 31, 1993, to provide for working capital needs and had a separate $5 million bank line of credit, of which $2.6 million was used, to collateralize performance bonds issued to companies in connection with ESE projects. ESE expects to finance its capital expenditures and working capital needs for 1994 with a combination of funds generated internally and periodic short-term borrowing from the Holding Company. GAS RATE INCREASE REQUEST On January 14, 1994, CILCO filed a request with the ICC to increase gas base rates to reflect both the current costs of providing gas service and its additional investment in the gas system, including the replacement of certain portions of the Springfield gas distribution system (see Capital Resources and Liquidity-CILCO). The revised rates are designed to increase annual gas revenues approximately $15 million, or 8.9% based upon an adjusted test year ended December 31, 1995. The filing requests a 9.4% return on original cost rate base and a 12% return on common equity. Management cannot predict the outcome of the filing. A decision from the ICC is not expected until late 1994. ENVIRONMENTAL MATTERS CILCO's capital expenditures relating to pollution control facilities are estimated to be $9 million and $5 million for 1994 and 1995, respectively. The acid rain provisions of the Clean Air Act Amendments of 1990 (Amendments) will require additional sulfur dioxide (SO2) and nitrogen oxide (NOx) emission reductions at CILCO's generating facilities. CILCO's facilities are exempt in Phase I of the Amendments due to previous emission reductions, but are subject to Phase II of the Amendments, which require additional emission reductions by the year 2000. CILCO's final compliance strategy will depend upon regulations issued under the Amendments; therefore, CILCO cannot currently determine definitive compliance costs and schedules. CILCO's present strategy includes use of an existing SO2 scrubber and limited fuel switching to reduce SO2 emissions, and combustion control modifications to reduce NOx emissions. CILCO's generating units will not require additional SO2 scrubbers. CILCO cannot determine the extent to which greater market demand for low-sulfur compliance coal in Phase II may increase fuel costs. CILCO spent $3.5 million through 1993 to install replacement burners on one of its generating units to reduce NOx emissions. Total costs for boiler retrofits and emissions monitoring equipment are expected to be $15.8 million through 1995. CILCO will install additional NOx controls at its generating units as needed to meet the compliance provisions under Title IV of the Clean Air Act. Other provisions of the Amendments call for new permitting programs, new monitoring and enforcement programs, and several power plant emissions studies which could eventually result in further emission regulation and additional emission controls for hazardous air pollutants. Also, the Clean Water Act and the Resource Conservation and Recovery Act, which deal with water and solid waste pollution control, may be reauthorized during 1994. CILCO will continue to monitor regulatory actions and develop compliance strategies to minimize any financial impact. Under current regulatory policies, CILCO expects to recover compliance costs associated with the Amendments and other environmental regulations through rates charged to customers. In March 1993, the U.S. Environmental Protection Agency (EPA) issued a final rule which specified the number of acid rain emission allowances allocated to power plants in Phase II of the Amendments and established various allowance reserves. Allowances are transferable from one utility to another at market prices. The number of allowances allocated to CILCO approximates its future needs, so CILCO expects it will buy or sell minimal amounts of allowances. Some studies suggest that magnetic fields produced by electric current, known as "electric and magnetic fields" or EMF, may be associated with illness or disease. However, research conducted to date has found no conclusive evidence that EMF has an adverse impact on health. CILCO is participating in utility industry funded studies on this subject. There also are claims that EMF may contribute to losses in the market value of property near electric power lines. CILCO will continue to monitor these issues; their ultimate impact cannot be predicted at this time. CILCO continues to investigate former gas manufacturing plant sites to determine if it is responsible for the remediation of any remaining waste materials (coal tar) at those sites. The sites of five former gas manufacturing plants are located within CILCO's present gas service territory. CILCO previously operated three of the five plants, and of the three sites, it currently owns two. In cooperation with the Illinois Environmental Protection Agency (IEPA), CILCO has completed remedial action, at a cost of $3.3 million, at one of the two owned sites at which it operated a plant. CILCO developed an investigation plan in 1992 to define the extent of remediation for the other owned site at which it formerly operated a plant. That investigation plan has been reviewed and approved by the IEPA, and CILCO implemented the investigation plan in 1993. A remediation plan for this site is currently being developed. CILCO has not yet formulated a remediation plan for the previously owned site where it formerly operated a gas manufacturing plant. CILCO does not currently own the two sites at which it did not operate a plant. Through 1993, CILCO paid approximately $500,000 to outside parties to investigate and/or test former gas manufacturing plant sites. CILCO expects to spend approximately $200,000 for site monitoring and feasibility studies in 1994. Until more detailed site specific testing has been completed, CILCO cannot determine the ultimate extent or cost of any remediation of the two remaining sites where it operated plants. CILCO has recorded a $4.4 million liability and a corresponding regulatory asset on its balance sheet for coal tar investigation and remediation costs. The $4.4 million represents the minimum amount of the estimated range of such future costs which CILCO expects to incur. CILCO has not yet determined the extent, if any, of its remediation responsibility for the non-owned sites at which it never operated a gas manufacturing plant. In August 1991, the ICC approved a rate rider which authorized CILCO to recover prudently incurred coal tar investigation and remediation costs from gas customers during the respective years the costs were incurred. The rider provided that the incurred costs would be subject to a yearly prudence review and a reconciliation of actual costs with amounts recovered through the rider. Future recoveries were to be adjusted to reflect prior under-recoveries or over-recoveries of costs. In 1992, the ICC issued a generic order which authorized Illinois utilities to recover prudently incurred expenditures paid to outside parties to investigate and remediate coal tar sites. Under the generic order, expenses would be recovered over a five-year period, with no carrying costs allowed on the unrecovered balance. CILCO was directed by the ICC to make its rider consistent with the generic order. The 1991 decision relating to CILCO and the 1992 generic order were appealed to the Illinois Appellate Court by various parties, including CILCO. In December 1993, the Illinois Appellate Court affirmed the ICC's generic order and directed the ICC to make the 1991 CILCO order consistent with the generic order. Based upon CILCO's interpretation of existing law, it believes that coal tar expenses prudently incurred and collected prior to the Appellate Court's decision are not subject to refund. However, if no appeal is granted from the Appellate Court's decision or if that decision is affirmed by the Illinois Supreme Court, expenses incurred after the Appellate Court's decision will be subject to the generic order. CILCO has been advised that at least one party plans to appeal the generic order to the Illinois Supreme Court. Coal tar remediation costs incurred through 1993 have been deferred on the Balance Sheets, net of amounts recovered from customers. CILCO began recovering remediation costs under its coal tar rider on October 1, 1991, and through 1993 has recovered approximately $4 million. CILCO cannot predict the outcome of any appeal to the Illinois Supreme Court, or whether amounts previously recovered will be subject to refund, but believes most or all of its future coal tar remediation costs will continue to be recoverable from customers. Although the total cost to CILCO of any action with respect to the unremediated sites and the possibility of recovering that cost from insurance carriers or any potentially responsible parties cannot now be determined, management believes that such cost will not have a material adverse effect on CILCO's financial position or results of operations. ELECTRIC COMPETITION The electric utility industry is expected to become more competitive as a result of the passage in 1992 of the National Energy Policy Act. This Act encourages competition by allowing both utilities and non-utilities to form non-regulated generation subsidiaries to supply additional electric demand without being restricted by the Public Utility Holding Company Act of 1935. Also, the Federal Energy Regulatory Commission (FERC) may order access to utility transmission systems by third-party energy producers on a case-by-case basis and may order electric utilities to enlarge their transmission systems to transport (wheel) power, subject to certain conditions. The Act specifically bans federally-mandated wheeling of power for retail customers, but several state public utility regulatory commissions, including Illinois, are currently studying retail wheeling. To prepare for an increasingly competitive environment, CILCO implemented a new electric tariff in 1993 which permits it to negotiate contractual rates with individual customers who find it economically feasible and practical to use cogeneration, independent power production, or other power arrangements in place of CILCO-supplied energy. CILCO currently has one customer on this contractual rate. In December 1993, CILCO and one of its current large industrial customers, Midwest Grain Products, Inc. (Midwest Grain), announced an agreement to build a cogeneration plant. The plant, which will be located at a Midwest Grain facility in CILCO's service territory, will utilize natural gas to provide steam heat to the facility and electricity for sale to Midwest Grain and other CILCO customers (see Capital Resources and Liquidity-The Company). With growing competition in the electric utility industry, CILCO's largest customers may have increased opportunities to select their electric supplier. CILCO formed a Corporate Sales Department in 1993 to work with its larger customers to address their unique electric power requirements and business needs so that CILCO may remain their supplier of choice. To date, CILCO has entered into long-term contracts with four of its industrial customers to provide them with their electric power requirements. FEDERAL ENERGY REGULATORY COMMISSION ORDER 636 In 1992, the FERC issued Orders 636, 636A, and 636B (collectively Order 636). The orders have been appealed to the United States Court of Appeals by various parties. As a result of Order 636 and subsequent regulatory filings by interstate pipelines, the pipelines will continue to transport gas to local gas distribution companies such as CILCO, but this service will be administered independently of the pipelines' sales of gas. Interstate pipelines serving CILCO have generally ceased sales of gas and have become transporters only. CILCO currently arranges for the purchase of gas from a variety of suppliers and has contracted for additional gas storage capacity to meet customer demands for gas. CILCO believes it is well-positioned to ensure the continued acquisition of adequate and reliable gas supplies despite the regulatory changes. Order 636 also permits pipelines to file new tariffs to provide for the recovery from their customers, including CILCO, of prudently incurred costs resulting from the transition to services under Order 636 ("transition costs"). Thus far, CILCO's pipeline suppliers have filed with the FERC to directly bill CILCO, subject to refund, for approximately $1.4 million of transition costs, including interest, as of December 31, 1993. CILCO has been billed approximately $394,000 through December 31, 1993. These charges are being recovered from CILCO's customers through its PGA. The PGA allows CILCO to immediately reflect increases or decreases in the cost of natural gas in its charges to customers. Approximately $332,000 has been recovered from customers through December 31, 1993. CILCO has recorded a liability of approximately $1 million and a corresponding regulatory asset on its balance sheet, representing the minimum amount of the estimated range of such future transition costs which CILCO expects to incur. On September 15, 1993, the ICC ordered an investigation into the appropriate recovery of transition costs by Illinois gas utilities. CILCO estimates that it could ultimately be billed up to $3 million, excluding interest, for pipeline transition costs. While CILCO cannot at this time determine its actual allocation of suppliers' transition costs or the outcome of the ICC proceeding, management believes that based on existing law and regulatory practice, any transition charges or other billings by the pipelines to CILCO as a result of Order 636 should be recoverable from customers through CILCO's gas rates. Therefore, management does not expect the orders will materially impact CILCO's financial position or results of operations. GAS TAKE-OR-PAY CHARGES Under FERC Order 500, and subsequent Orders 528 and 528A, interstate gas pipelines may bill gas distribution utilities for take-or-pay charges, including interest. In response to the latter two orders, pipelines serving CILCO filed new tariff allocations, entered into system-wide negotiations and reached settlements with their customers. Based on these and subsequent FERC-approved settlements, CILCO estimates it will ultimately be directly billed a total of approximately $19.6 million of take-or-pay costs, excluding interest. This number includes $3.2 million of take-or-pay charges for the Liquefied Natural Gas Settlement (discussed below). Through December 1993, pipelines have billed CILCO $19.4 million for take-or-pay charges, including $3.6 million of interest. In 1988, the ICC issued an order allowing Illinois gas utilities to recover from customers take-or-pay charges, including interest, billed to utilities by interstate pipelines. Upon appeal, the Illinois Supreme Court affirmed that ruling, and a subsequent petition for issuance of a writ of certiorari to the U.S. Supreme Court was denied. CILCO is currently recovering take-or-pay charges via a factor incorporated into the PGA, and has thus far recovered $18.6 million from its customers. LIQUEFIED NATURAL GAS SETTLEMENT A joint settlement proposal before the FERC among Trunkline LNG Company (Trunkline), Panhandle Eastern Pipeline Company (Panhandle), and others, including CILCO, became effective in September 1992. The settlement allows Panhandle to recover certain costs related to Trunkline's liquefied natural gas project and various other matters. As a result of this settlement, disputed issues were resolved, and CILCO was billed approximately $4.4 million. CILCO began recovering the cost through the PGA beginning in 1993. Approximately $3.2 million of this billing relates to gas take-or-pay, and is included in the discussion of gas take-or-pay charges above. Of the remaining $1.2 million, approximately $330,000 has been billed as of December 31, 1993. Through 1993, CILCO has recovered approximately $270,000 from its customers. CILCO has recorded a regulatory asset and corresponding liability of $1 million on the Balance Sheets. This $1 million represents the minimum amount of the estimated range of such future costs which CILCO expects to incur. ACCOUNTING PRONOUNCEMENTS In 1992, the Financial Accounting Standards Board (FASB) issued Statement No. 109, "Accounting for Income Taxes" (SFAS 109), and Statement No. 112, "Employer's Accounting for Postemployment Benefits" (SFAS 112). CILCO adopted SFAS 109 effective January 1, 1993 (see Note 2). CILCO will adopt SFAS 112 on January 1, 1994 (see Note 1). RESULTS OF OPERATIONS ELECTRIC OPERATIONS The following table summarizes electric operating revenue and expenses by component. Electric gross margin increased 6% in 1993, primarily due to a 7% increase in retail kilowatt hour sales. The increase in retail sales was partially offset by a decrease in sales for resale revenue. The ratio of gross margin to revenue has remained constant at 62%. Residential sales volumes increased 10%, while commercial sales volumes increased 5%. These increases were primarily due to warmer summer weather. Cooling degree days were 30% higher in 1993 than in 1992. Industrial sales volumes increased 6% compared to 1992 due to greater demand by several of CILCO's large industrial customers. The overall level of business activity in CILCO's service territory and weather conditions are expected to continue to be the primary factors affecting electric sales in the near term. CILCO's electric sales may also be affected in the long-term by increased competition in the electric utility industry (see Electric Competition). The 1993 increase in purchased power expense was partially offset by a decrease in cost of fuel. Sales for resale and purchased power vary based on the energy requirements of neighboring utilities, CILCO's available capacity for bulk power sales, its need for energy, and the price of power available for sale or purchase. CILCO expects increased competition to continue in the bulk power market due to certain provisions of the Energy Policy Act of 1992 (see Electric Competition). Electric gross margin in 1992 decreased 5% from 1991, primarily due to decreased sales. Residential sales volumes decreased 10% while commercial sales volumes remained relatively constant. Industrial sales volumes decreased 4% in 1992 compared to 1991, primarily due to reduced demand at several of CILCO's large industrial customers during 1992. Cooling degree days for 1992 were 40% lower than in 1991, which contributed to the revenue decreases. Electric operation and maintenance expenses increased 6% in 1993 and increased slightly in 1992. The 1993 increase was primarily due to greater power plant maintenance costs and the cancellation of a combustion turbine which CILCO had planned to construct to meet electric peak demand in the late 1990's. Instead, CILCO's increased energy needs will be met through firm power purchases and by the Midwest Grain cogeneration facility (see Electric Competition). Operation and maintenance expenses were also affected by general inflationary trends. A decrease in medical expenses partially offset this trend. On December 31, 1993, CILCO changed the discount rate assumption used to calculate pension and postretirement medical benefit obligations from 8% to 7% (see Note 1). This change will increase benefit costs for electric operations employees by approximately $640,000 in 1994 and $550,000 in 1995. The increases in depreciation and amortization expense in 1993 and 1992 reflect additions and replacements of utility plant at costs in excess of the original cost of the property retired. The changes in income taxes in 1993 and 1992 were primarily the result of changes in pre-tax income. Higher federal corporate income tax rates also contributed to the 1993 increase (see Note 2). GAS OPERATIONS The following table summarizes gas operating revenue and expenses by component. Gas gross margin increased 6% in 1993, primarily due to an 8% increase in retail sales volumes. Residential and commercial sales volumes increased 10% and 9%, respectively, primarily due to colder weather during the heating season. Heating degree days were 11% higher in 1993 than in 1992. Gas gross margin for 1992 increased 1% from 1991 while total retail sales volumes decreased 2%. Residential and commercial sales volumes each decreased 3% primarily due to a milder heating season. Heating degree days in 1992 were 2% lower than the previous year. While total gas revenues decreased 2% in 1992 from 1991 levels, cost of sales decreased 5%, primarily due to a 5% decrease in the cost of gas. This decrease was a result of lower sales and lower take-or-pay charges, partially offset by higher natural gas prices. Revenue from gas transportation services decreased 4% in 1993 and 5% in 1992, while the volume of gas transported decreased 11% in 1993 and increased 12% in 1992. Revenues declined primarily due to decreased purchases of gas by industrial transportation customers from suppliers other than CILCO. The changes in 1993 and 1992 revenue were not proportional to the changes in volume because certain large volume transportation customers can negotiate lower unit charges for service. There were 668 transportation customers in 1993 compared to 635 customers in 1992 and 617 in 1991. Transportation arrangements have made it practical for certain industrial customers to continue to use gas instead of switching to alternate fuels. Weather conditions, the ability of large customers to purchase gas on the open market at competitive rates, the continuing trend toward more efficient gas appliances, and overall economic conditions in CILCO's service area will affect future gas sales. On January 14, 1994, CILCO filed a request with the ICC to increase its gas base rates (see Gas Rate Increase Request). After a significant number of leaks were detected in the Springfield gas distribution system in mid-1992, CILCO began a detailed examination of its Springfield gas distribution system and related operating practices and procedures. The objective of this examination was to detect and repair gas main leaks and to identify and correct any operating deficiencies. This project was substantially completed on September 30, 1993 (see Capital Resources and Liquidity-CILCO). In September 1992, the ICC staff began an informal review of CILCO's Springfield gas operations and recordkeeping practices. Subsequently, at the request of the ICC, the U.S. Department of Transportation and the U.S. Department of Justice began conducting investigations, which management believes to be focused principally on CILCO's Springfield gas operations. These reviews could potentially lead to criminal charges, regulatory actions (see Gas Rate Increase Request), as well as certain sanctions and civil penalties. Management cannot currently determine the outcome of these reviews or their regulatory effect, but does not believe they will have a material adverse impact on CILCO's financial position or results of operations. Gas operation and maintenance expenses increased 12% in 1993 and 5% in 1992. These increases were primarily due to increased repairs to the Springfield gas distribution system, partially offset by lower injury and damage claims expenses. Operation and maintenance expenses are also affected by general inflationary trends. The December 31, 1993, change in the discount rate assumption used to calculate pension and postretirement medical benefit obligations (see Note 1) will increase benefit costs for gas operations employees by approximately $330,000 in 1994 and $280,000 in 1995. The increases in depreciation and amortization expenses in 1993 and 1992 reflect additions and replacements of utility plant at costs in excess of the original cost of the property retired. The changes in income taxes in 1993 and 1992 were primarily the result of changes in taxable income. Higher federal corporate income tax rates (see Note 2) also contributed to the 1993 increase. OTHER INCOME AND DEDUCTIONS Utility other income and deductions changed slightly from 1992 to 1993. Interest expense decreased due to lower interest rates on bonds refinanced in 1993 (see Capital Resources and Liquidity-CILCO). Interest expense increased during 1992 due to interest on overcollection of take-or-pay charges and settlement of utility-related tax issues arising from an IRS audit, partially offset by lower interest expense on bonds refinanced during 1992. ESE The following table summarizes environmental and engineering services revenue and expenses. Revenues decreased by 11% in 1993 following revenue increases of 8% in 1992 and 35% in 1991. ESE experienced difficulty in obtaining new contracts to replace completed projects due to continued economic uncertainty, delays in government enforcement actions, and a more cautious approach by ESE's customers toward environmental compliance. In late 1992, ESE was awarded a contract by the U.S. Environmental Protection Agency (USEPA) to determine the effectiveness of new air quality regulations. This five-year contract has a total value of $81 million, assuming annual contract renewals and authorization of task by the USEPA. ESE currently estimates total revenues for this project to be $50 million. Due to delays in task approvals, this project provided only $5 million of revenue in 1993. ESE closed two offices and one laboratory during 1993 in response to market factors. The closed facilities contributed $11 million in revenue in 1992 and less than $.5 million in 1993. Direct non-labor costs as a percentage of gross revenue fluctuate primarily due to subcontractor usage. Direct non-labor costs decreased by 17% due to decreased business activity and the completion of a large turnkey project in 1992. This turnkey project constituted 24% of the direct non-labor costs for 1992 and less than 1% of the direct non-labor costs for 1993. Direct and indirect salary expense decreased by 4% in 1993 primarily as a result of a reduction in work force associated with the overall decline in business volume. Because the consulting business is labor intensive, ESE can adjust staffing levels to appropriately recognize changing business conditions. The increase of 4% in 1992 resulted from wage increases. General and administrative expenses increased by 5% in 1993 due to general inflation and higher employee medical benefit costs. Additionally, a more competitive marketplace has led to increased overhead costs as utilization of staff on projects declined, and bid and proposal costs increased. The 6% decrease in general and administrative costs in 1992 resulted from the closing of certain offices and reduced insurance costs resulting from the establishment of a wholly-owned subsidiary to provide professional liability insurance. Depreciation expense increased each year as a result of additions to fixed assets. Amortization expense relates to a non-compete agreement, which is being amortized over its five-year duration, and to the Cost in Excess of Net Assets of the Acquired Company, which is being amortized over forty years. Interest expense decreased because of lower interest rates and lower average debt balances during 1993 and 1992. The reduction in income taxes results primarily from the decrease in ESE's pre-tax income. ESE's future business activity will continue to be affected by the level of demand for consulting services and by the enforcement of various federal and state statutes and regulations dealing with the environment and the use, control, disposal and clean-up of hazardous wastes. The market for ESE's services is competitive; however, no single entity currently dominates the environmental and engineering consulting services marketplace. OTHER BUSINESSES The following table summarizes Other Businesses' revenue and expenses. Other Businesses' results include income earned and expenses incurred at the Holding Company, CIM, CVI, and non-operating interest income of CILCO. The increase in Other Businesses' net income resulted primarily from the December 1993 settlement of the Company's dispute with the IRS concerning certain leveraged lease tax issues, including the proper depreciable life of the Springerville Unit No. 1 generating station (see Note 3). As a result of the settlement, income tax expense was reduced by $3.1 million in 1993 to reverse tax expense which had been recorded in prior years to reflect the potential unfavorable outcome of the dispute. During 1993, the Company adjusted leveraged lease revenues and related income taxes to reflect higher corporate income tax rates enacted during the year. Statement of Financial Accounting Standards No. 13, "Accounting for Leases," requires that the amount and timing of leveraged lease income be adjusted when tax rates change. The Company will recognize less income over the life of its existing lease portfolio due to the tax rate change; therefore, the Company recorded a one-time charge of $1.1 million against 1993 lease portfolio net income. Leveraged lease revenue in 1992 included a $1.5 million one-time adjustment related to the December 1992 restructuring of the Springerville Unit No. 1 lease. This adjustment offset revenue declines from other leases during 1992. Generally accepted accounting principles pertaining to leveraged leases cause revenues to decline as the lease portfolio matures. A slight decline in 1993 revenues from the Company's maturing leveraged leases was partially offset by revenues from two new leveraged lease investments made in late 1993 (see Capital Resources and Liquidity-Other Businesses). During 1994, the Company expects leveraged lease revenues to increase by $2.6 million as a result of the two new leases. Other revenues in 1993 reflect a $2 million gain from the sale of one million shares of TEP stock. Other revenues in 1992 included the fair market value of approximately 1.2 million shares of TEP stock the Company received in December 1992 as part of the Springerville Unit No. 1 lease restructuring. Other revenues also included a 1992 gain from the sale of an office building from the Company's lease portfolio. Interest income on temporary cash investments, which is included in other revenues, declined due to lower interest rates and investment balances. Operating expenses declined due to fewer employees assigned to the Holding Company, greater utilization of Holding Company staff by operating subsidiaries, and lower legal and professional services expenses. In late 1993, CIM purchased the 19% minority interest in CLM (see Capital Resources and Liquidity-Other Businesses). Since the purchase occurred prior to the Company's settlement of the leveraged lease tax issues with the IRS, there was no minority interest in the resulting reduction in income tax expense. In 1991, CIM sold CLM Inc.-IX, a subsidiary which owned three leveraged lease investments. Income and other taxes for 1991 included income taxes from the sale of this subsidiary, which were partially offset by a capital loss carryforward from 1987. Income tax expense in 1991 and 1992 also included a reserve for potential income taxes and interest in the event the Company's position regarding the depreciable life of Springerville Unit No. 1 was not upheld. ITEM 8.	ITEM 8.: FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Index to Financial Statements: Page CILCORP Inc. Management's Report to the Stockholders of CILCORP Inc. 50 Report of Independent Public Accountants 51 Consolidated Statements of Income 52-53 Consolidated Balance Sheets 54-55 Consolidated Statements of Cash Flows 56-57 Consolidated Statements of Common Stockholders' Equity 58 Statements of Segments of Business 59-61 Notes to Consolidated Financial Statements 62-77 CILCO Management's Report 78 Report of Independent Public Accountants 79 Consolidated Statements of Income 80 Consolidated Balance Sheets 81-82 Consolidated Statements of Cash Flows 83-84 Consolidated Statements of Retained Earnings 85 Statements of Segments of Business 86-87 Notes to Consolidated Financial Statements 88-100 Management's Report To the Stockholders of CILCORP Inc.: Management has prepared the accompanying financial statements and notes for CILCORP Inc. and its consolidated subsidiaries in accordance with generally accepted accounting principles. Estimates and judgments used in developing these statements are the responsibility of management. Financial data presented throughout this report is consistent with these statements. CILCORP Inc. maintains a system of internal accounting controls which management believes is adequate to provide reasonable assurance as to the integrity of accounting records and the protection of assets. Such controls include established policies and procedures, a program of internal audit, and the careful selection and training of qualified personnel. The financial statements have been audited by CILCORP's independent public accountants, Arthur Andersen & Co., whose appointment was ratified by stockholders. Their audit was conducted in accordance with generally accepted auditing standards and included an assessment of selected internal accounting controls only to determine the scope of their audit procedures. The report of the auditors is contained in this annual report. The Audit Committee of the Board of Directors, consisting solely of outside directors, meets periodically with the independent public accountants, internal auditors and management to review accounting, auditing, internal accounting control, and financial reporting matters. The auditors have direct access to the Audit Committee. R. O. Viets R. O. Viets President and Chief Executive Officer T. D. Hutchinson T. D. Hutchinson Controller Report of Independent Public Accountants To the Stockholders of CILCORP Inc.: We have audited the accompanying consolidated balance sheets of CILCORP Inc. (an Illinois corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, cash flows, stockholders' equity and segments of business for each of the three years in the period ended December 31, 1993. These financial statements and the schedules referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of CILCORP Inc. and its subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. As explained in Note 2, effective January 1, 1993, the Company changed its method of accounting for income taxes. As explained in Note 1, effective January 1, 1991, the Company changed its method of accounting for postemployment health care benefits. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The financial statement schedules listed in Item 14(a)2 are presented for purposes of complying with the Securities and Exchange Commission's rules and are not a required part of the basic financial statements. These financial statement schedules have been subjected to the auditing procedures applied in our audits of the basic financial statements and, in our opinion, fairly state 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 & Co. Chicago, Illinois February 4, 1994 Consolidated Statements of Income CILCORP Inc. and Subsidiaries Consolidated Balance Sheets CILCORP Inc. and Subsidiaries Consolidated Balance Sheets CILCORP Inc. and Subsidiaries Consolidated Statements of Cash Flows CILCORP Inc. and Subsidiaries Consolidated Statements of Stockholders' Equity CILCORP Inc. and Subsidiaries Statements of Segments of Business CILCORP Inc. and Subsidiaries CILCORP INC. AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of CILCORP Inc. (CILCORP or Company), Central Illinois Light Company (CILCO), Environmental Science & Engineering, Inc. (ESE) and CILCORP's other subsidiaries after elimination of significant intercompany transactions. Prior year amounts have been reclassified on a basis consistent with the 1993 presentation. REGULATION CILCO is a public utility subject to regulation by the Illinois Commerce Commission (ICC) and the Federal Energy Regulatory Commission (FERC) with respect to accounting matters, and maintains its accounts in accordance with the Uniform System of Accounts prescribed by these agencies. UTILITY OPERATING REVENUES, FUEL COSTS, AND COST OF GAS Electric and gas revenues include service provided but unbilled at year end. Substantially all electric rates and gas system sales rates of CILCO include a fuel adjustment clause and a purchased gas adjustment clause, respectively. These clauses provide for the recovery of changes in electric fuel costs, excluding coal transportation, and changes in the cost of gas on a current basis in billings to customers. CILCO adjusts the cost of fuel and cost of gas to recognize over or under recoveries of allowable costs. The cumulative effects are deferred in the Balance Sheet as a current asset or current liability and adjusted by refunds or collections through future billings to customers. CONCENTRATION OF CREDIT RISK CILCO, as a public utility, must provide service to customers within its defined service territory and may not discontinue service to residential customers when certain weather conditions exist. CILCO continually reviews customers' creditworthiness and requests deposits or refunds deposits based on that review. At December 31, 1993, CILCO had net receivables of $34.2 million, of which approximately $4.9 million was due from its major industrial customers. See Note 5 for a discussion of receivables related to CILCORP's leveraged lease portfolio. FAIR VALUE OF FINANCIAL INSTRUMENTS The carrying amount of Cash and Temporary Cash Investments, Investment in Marketable Securities and Other, Preferred Stock with Mandatory Redemption, and Notes Payable approximates fair value, with the exception of the Company's investment in Tucson Electric Power Company (TEP) stock and warrants, which had a value at December 31, 1993 approximately $1.6 million greater than its $266,000 carrying amount. At December 31, 1992, the carrying amount of this investment was $1.6 million and its fair market value was $2.9 million. The estimated fair value of the Company's Long-Term Borrowings was $358 million at December 31, 1993, and $343 million at December 31, 1992, based on current market interest rates for other companies with comparable credit ratings, capital structures, and size. ENVIRONMENTAL AND ENGINEERING SERVICES REVENUES ESE performs professional environmental and engineering consulting services under time and material, cost-plus, and fixed-price contracts. Consulting services revenues include amounts for services provided but unbilled at year end. Revenues from time and material and cost-plus contracts are recognized as costs are incurred. Revenues from fixed-price contracts are recognized under the percentage-of-completion method. DEPRECIATION AND MAINTENANCE Provisions for depreciation of property for financial reporting purposes are based on straight-line composite rates. The annual provisions for utility plant depreciation, expressed as a percentage of average depreciable property, were as follows: Maintenance and repair costs are charged directly to expense. Renewals of units of property are charged to the utility plant account, and the original cost of depreciable property replaced or retired, together with the removal cost less salvage, is charged to the accumulated provision for depreciation. Non-utility property is depreciated over estimated lives ranging from 5 to 30 years. COST IN EXCESS OF NET ASSETS OF ACQUIRED BUSINESSES Cost in excess of net assets of acquired businesses is being amortized using the straight-line method over forty years. INCOME TAXES The Company follows a policy of comprehensive interperiod income tax allocation. Investment tax credits have been deferred and are amortized over the estimated useful lives of the related property. CILCORP and its subsidiaries file a consolidated federal income tax return. Income taxes are allocated to the individual companies based on their respective taxable income or loss. CONSOLIDATED STATEMENTS OF CASH FLOWS The Company considers all highly liquid debt instruments purchased with a maturity of three months or less to be cash equivalents for purposes of the Consolidated Statements of Cash Flows. Cash paid for interest and income taxes was as follows: During 1991, $18,979,000 of CILCORP convertible preferred stock was converted to CILCORP common stock. POSTEMPLOYMENT BENEFITS OTHER THAN PENSIONS AND HEALTH CARE In November 1992, the Financial Accounting Standards Board (FASB) issued Statement No. 112, "Employer's Accounting for Postemployment Benefits" (SFAS 112). The Company will adopt SFAS 112 on January 1, 1994. This accounting standard requires the accrual of a liability for certain benefits other than pensions or health care provided to former or inactive employees. The Company will record a pre-tax expense of approximately $1.1 million upon adoption of SFAS 112 to establish the liability for these benefits. PENSION BENEFITS Substantially all of CILCO's full-time employees, including those assigned to the Holding Company, are covered by trusteed, non-contributory defined benefit pension plans. Benefits under these plans reflect the employee's years of service, age at retirement, and maximum total compensation for any consecutive sixty-month period prior to retirement. Pension costs for the past three years were charged as follows: Provisions for pension expense are determined under the rules prescribed by Statement of Financial Accounting Standards No. 87, including the use of the projected unit credit actuarial cost method. Information on the plans' funded status, on an aggregate basis follows: POSTEMPLOYMENT HEALTH CARE BENEFITS Substantially all of CILCO's full-time employees, including those assigned to the Holding Company, are currently covered by a trusteed, non-contributory defined benefit postemployment health care plan. The plan pays stated percentages of most necessary medical expenses incurred by retirees, after subtracting payments by Medicare or other providers and after a stated deductible has been met. Participants become eligible for the benefits if they retire from CILCO after reaching age 55 with 10 or more years of service. ESE does not provide health care benefits to retired employees. On January 1, 1991, CILCO adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" (SFAS 106), which requires that the expected cost of postemployment health care benefits be charged to expense during the years in which employees render service. CILCO has elected to amortize the unfunded obligation at January 1, 1991, over a period of 18.6 years, which represents the average remaining service period. Postemployment health care benefit costs were charged as follows: For measurement purposes, a health care cost trend rate of 9% annually was assumed for 1994; the rate was assumed to decrease to 8% for 1995, then decrease gradually to 6% by 2020 and remain at that level thereafter. Increasing the assumed health care cost trend rate by 1% in each year would increase the accumulated postemployment benefit obligation at December 31, 1993, by $5.2 million and the aggregate of the service and interest cost components of net postemployment health care cost for 1993 by $376,000. The discount rate used in determining the accumulated postemployment benefit obligation at December 31, 1993, was 7% and at December 31, 1992, was 8%. The weighted average expected return on assets net of taxes was 8.1%, where taxes are assumed to decrease return by 0.4%. COMPANY-OWNED LIFE INSURANCE POLICIES The following amounts related to company-owned life insurance contracts, issued by one major insurance company, are included in Investments and Other Property. Interest expense related to borrowings against company-owned life insurance, included in "Other" on the Consolidated Statements of Income, was $1.4 million, $930,000 and $870,000 for 1993, 1992 and 1991. NOTE 2: INCOME TAXES The Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS 109), on January 1, 1993, and accounted for its initial application as a cumulative change in accounting principle. SFAS 109 requires the use of the liability method to account for income taxes. Under the liability method, deferred income taxes are recognized at currently enacted income tax rates to reflect the tax effect of temporary differences between the financial reporting basis and the tax basis of assets and liabilities. Temporary differences occur because the income tax law either requires or permits certain items to be reported on the Company's income tax return in a different year than they are reported in the financial statements. Adoption of SFAS 109 did not have a material impact on the Company's financial position, results of operations or cash flows; however, the adoption of SFAS 109 required reclassification of accumulated deferred income taxes on the balance sheet. CILCO established a regulatory liability to account for the net effect of expected future regulatory actions related to unamortized investment tax credits, income tax liability initially recorded at tax rates in excess of current rates, the equity component of Allowance for Funds Used During Construction, and other items for which deferred taxes had not previously been provided. The temporary differences related to the consolidated net deferred income tax liability at December 31, 1993, and January 1, 1993, were as follows: The following table represents a reconciliation of the effective tax rate with the statutory federal income tax rate. NOTE 3: FEDERAL INCOME TAX AUDIT SETTLEMENT In December 1990, the Internal Revenue Service (IRS) completed a review of the Company's 1985 and 1986 consolidated federal income tax returns. The IRS proposed to disallow depreciation deductions claimed in 1985 and 1986 for assets purchased and leased to four lessees during those years by CLM or CLM's wholly-owned subsidiaries (collectively CLM). The IRS asserted that these transactions were financing arrangements and that CLM did not own the properties for federal income tax purposes. Alternatively, the IRS contended that one of the properties, the Springerville Unit No. 1 generating station, should be depreciated over 15 years rather than 5 years. The potential tax deficiency from the depreciable life issue was $9.4 million, plus interest, for 1985-1993. In January 1991, the Company protested the proposed adjustments to the Appeals Division of the IRS, and in December 1993, the Company and the IRS entered into a closing agreement settling the disputed issues. The IRS recognized the Company as owner of the properties and allowed it to depreciate a significant portion of the Springerville Unit No. 1 generating station over five years. To reflect the settlement, the Company reduced its 1993 income tax expense by $3.1 million to reverse income tax expense which it had recorded in prior years to reflect the potential unfavorable resolution of this dispute. NOTE 4: SHORT-TERM DEBT Short-term debt at December 31, 1993, consisted of $18.8 million of Holding Company bank borrowings and $12.4 million of CILCO commercial paper. Short-term debt at December 31, 1992, included $24.5 million of commercial paper and $4.8 million of other notes payable. CILCO had arrangements for bank lines of credit totalling $30 million at December 31, 1993, all of which were unused. These lines of credit consisted of $6.65 million maintained by compensating balances and $23.35 million maintained by commitment fees ranging from 1/16 to 3/16 of 1% per annum in lieu of balances. The compensating bank balance arrangements provide that CILCO maintain bank deposits to average annually 3% to 5% of the line, such balances being available to CILCO for operating purposes and as compensation to the bank for other bank services. These bank lines of credit also support CILCO's issuance of commercial paper. At December 31, 1993, ESE had a $1 million bank line of credit to provide for working capital needs. In addition, ESE had a $5 million bank line of credit, of which $2.6 million was used at year-end, to collateralize performance bonds issued by insurance companies. NOTE 5: LEVERAGED LEASE INVESTMENTS The Company, through subsidiaries of CIM is a lessor in seven leveraged lease arrangements under which mining equipment, electric production facilities, warehouses, office buildings, passenger railway equipment and an aircraft are leased to third parties. The economic lives and lease terms vary with the leases. CIM's share of total equipment and facilities cost was approximately $305 million and $239 million at December 31, 1993 and 1992. During 1993, CIM invested $13 million, net of non-recourse debt, in leveraged leases of passenger railway equipment and an aircraft (see Capital Resources and Liquidity-Other Businesses). The cost of the equipment and facilities owned by CIM is partially financed by non-recourse debt provided by lenders, who have been granted as their sole remedy in the event of a lessee default an assignment of rents due under the leases and a security interest in the leased property. Such debt amounted to $229 million at December 31, 1993, and $180 million at December 31, 1992. Leveraged lease residual value assumptions, which are conservative in relation to independently appraised residual values, are tested on a periodic basis. The Company's net investment in leveraged leases at December 31, 1993 and 1992 is shown below: The table above includes CLM's approximately 7% investment in the Springerville Unit No. 1 electric generating station, which is leased pursuant to TEP's comprehensive financial restructuring plan that was consummated in December 1992. NOTE 6: PREFERRED STOCK PREFERRED STOCK OF SUBSIDIARY All classes of preferred stock are entitled to receive cumulative dividends and rank equally as to dividends and assets, according to their respective terms. The total annual dividend requirement for preferred stock outstanding at December 31, 1993, is $2.8 million, assuming a continuation of the auction dividend rate at December 31, 1993, for the flexible auction rate series. PREFERRED STOCK WITHOUT MANDATORY REDEMPTION The call provisions of preferred stock redeemable at CILCO's option outstanding at December 31, 1993, are as follows: PREFERRED STOCK WITH MANDATORY REDEMPTION CILCO's 5.85% Class A preferred stock may be redeemed in 2003 at $100 per share. A mandatory redemption fund must be established on July 1, 2003. The fund will provide for the redemption of 11,000 shares for $1.1 million on July 1 of each year through July 1, 2007. On July 1, 2008, the remaining 165,000 shares will be retired for $16.5 million. PREFERENCE STOCK OF SUBSIDIARY, CUMULATIVE No Par Value, Authorized 2,000,000 shares, of which none have been issued. PREFERRED STOCK OF HOLDING COMPANY No Par Value, Authorized 4,000,000 shares, of which none were outstanding at December 31, 1993 and 1992. NOTE 7: LONG-TERM DEBT The first mortgage bonds of CILCO are secured by a lien on substantially all of its property and franchises. Unamortized borrowing expense, premium and discount on outstanding long-term debt are being amortized over the lives of the respective issues. Total consolidated maturities of long-term debt for 1995-1998 are $21 million, $19 million, $23 million, and $22 million, respectively. The 1994 maturities of long-term borrowings have been classified as current liabilities. NOTE 8: COMMITMENTS & CONTINGENCIES CILCO's capital expenditures for 1994 are estimated to be $90 million, in connection with which CILCO has normal and customary purchase commitments at December 31, 1993. CILCO's policy is to act as a self-insurer for certain insurable risks resulting from employee health and life insurance programs. ESE's capital expenditures for 1994 are estimated to be $5 million, in connection with which ESE has normal and customary purchase commitments at December 31, 1993. ESE's policy is to act as a self-insurer for certain insurable risks resulting from employee health programs and professional liability claims. In August 1990, CILCO entered into a firm, wholesale bulk power purchase agreement with CIPS. This agreement, which expires in 1998, provides for an initial purchase of 30 MW of capacity, increasing to 90 MW in 1997. CILCO can increase purchases to a maximum of 100 MW during the contract period, provided CIPS then has the additional capacity available. In November 1992, CILCO entered into a limited-term power agreement to purchase 100 MW of CIPS' capacity from June 1998 through May 2002. At CILCO's request, purchases may be increased to a maximum of 150 MW during the contract period, provided CIPS has the additional capacity available. Reference is made to Management's Discussion and Analysis of Financial Condition and Results of Operations, Environmental Matters (regarding former gas manufacturing sites) for a discussion of that item and Gas Operations, for a discussion of contingencies related to CILCO's Springfield gas system. NOTE 9: RATE MATTERS Reference is made to Management's Discussion and Analysis of Financial Condition and Results of Operations, Gas Rate Increase Request, Environmental Matters, Electric Competition, Gas Take-or-Pay, and Liquefied Natural Gas Settlement for a discussion of gas and electric rate matters. NOTE 10: LEASES The Company and its subsidiaries lease certain equipment, buildings, and other facilities under capital and operating leases. Several of the operating leases provide that the Company pay taxes, maintenance and other occupancy costs applicable to these premises. Minimum future rental payments under non-cancelable capital and operating leases having remaining terms in excess of one year as of December 31, 1993, are $35.3 million in total. Payments due during the years ending December 31, 1994, through December 31, 1998, are $8.5 million; $5.7 million; $5.0 million; $4.3 million; and $3.5 million, respectively. NOTE 11: SELECTED QUARTERLY FINANCIAL DATA (Unaudited) The following quarterly operating results are unaudited, but, in the opinion of management, include all adjustments (consisting of normal recurring accruals) necessary for a fair presentation of CILCORP Inc.'s operating results for the periods indicated. The results of operations for each of the fiscal quarters are not necessarily comparable to, or indicative of, the results of an entire year due to the seasonal nature of the Company's business and other factors. The sums of earnings per average common share for the four quarters of 1992 do not equal the totals for the year because the average number of shares outstanding changed. MANAGEMENT'S REPORT The accompanying financial statements and notes for CILCO and its consolidated subsidiaries have been prepared by management in accordance with generally accepted accounting principles. Estimates and judgments used in developing these statements are the responsibility of management. Financial data presented throughout this report is consistent with these statements. CILCO maintains a system of internal accounting controls which management believes is adequate to provide reasonable assurance as to the integrity of accounting records and the protection of assets. Such controls include established policies and procedures, a program of internal audit, and the careful selection and training of qualified personnel. The financial statements have been audited by CILCO's independent accountants, Arthur Andersen & Co. Their audit was conducted in accordance with generally accepted auditing standards and included an assessment of selected internal accounting controls only to determine the scope of their audit procedures. The report of the auditors is contained in this Form 10-K annual report. The Audit Committee of the CILCORP Inc. Board of Directors, consisting solely of outside directors, meets periodically with the independent public accountants, internal auditors and management to review accounting, auditing, internal accounting control, and financial reporting matters. The auditors have direct access to the Audit Committee. R. W. Slone R. W. Slone Chairman of the Board, President and Chief Executive Officer T. S. Romanowski T. S. Romanowski Vice President and Chief Financial Officer R. L. Beetschen R. L. Beetschen Controller and Manager of Accounting February 4, 1994 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Central Illinois Light Company: We have audited the accompanying consolidated balance sheets of Central Illinois Light Company (an Illinois corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, cash flows, segments of business, and retained earnings for each of the three years in the period ended December 31, 1993. These financial statements and the schedules referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Central Illinois Light Company and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. As explained in Note 2 effective January 1, 1993, the Company changed its method of accounting for income taxes. As explained in Note 1, effective January 1, 1991, the Company changed its method of accounting for postemployment health care benefits. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The financial statement schedules listed in Item 14(a)2 are presented for purposes of complying with the Securities and Exchange Commission's rules and are not a required part of the basic financial statements. These financial statement schedules have been subjected to the auditing procedures applied in our audits of the basic financial statements and, in our opinion, fairly state 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 & CO. Chicago, Illinois February 4, 1994 CENTRAL ILLINOIS LIGHT COMPANY NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION The consolidated financial statements of CILCO include the accounts of CILCO and its subsidiaries, CILCO Exploration and Development Corporation and CILCO Energy Corporation. CILCO is a subsidiary of CILCORP Inc. In accordance with FERC Order 529, sales of electricity for resale, which had been previously recorded as an offset to purchased power expense, have been reclassified to electric revenues. Prior year amounts have been reclassified on a basis consistent with the 1993 presentation. REGULATION CILCO is subject to regulation by the ICC and the FERC with respect to accounting matters and maintains its accounts in accordance with the Uniform System of Accounts prescribed by these agencies. OPERATING REVENUES, FUEL COSTS, AND COST OF GAS Electric and gas revenues include service provided but unbilled at year end. Substantially all electric rates and gas system sales rates include a fuel adjustment clause and a purchased gas adjustment clause, respectively. These clauses provide for the recovery of changes in electric fuel costs, excluding coal transportation, and in the cost of gas on a current basis in billings to customers. CILCO adjusts the cost of fuel and cost of gas to recognize over or under recoveries of allowable costs. The cumulative effects are deferred in the Balance Sheet as a current asset or current liability and adjusted by refunds or collections through future billings to customers. CONCENTRATIONS OF CREDIT RISK CILCO, as a public utility, is required to provide service to customers within its defined service territory and is precluded from discontinuing service to residential customers when certain weather conditions exist. CILCO continually reviews customers' credit worthiness and requests deposits or refunds deposits based on that review. At December 31, 1993 CILCO had net receivables of $34.2 million, of which approximately $4.9 million was due from its major industrial customers. TRANSACTIONS WITH AFFILIATES CILCO, which is a subsidiary of CILCORP, incurs certain corporate expenses such as legal, shareholder and accounting fees on behalf of CILCORP and its other subsidiaries. These expenses are billed monthly to CILCORP and its other subsidiaries based on specific identification of costs except for shareholder-related costs which are based on the relative equity percentages of CILCORP and its subsidiary corporations. A return on CILCO assets used by CILCORP and its other subsidiaries is also calculated and billed monthly. Total billings to CILCORP and its other subsidiaries amounted to $2.3 million, $3.3 million and $4 million, in 1993, 1992 and 1991, respectively. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION (AFUDC) The allowance, representing the cost of equity and borrowed funds used to finance construction, is capitalized as a component of the cost of utility plant. The amount of the allowance varies depending on the rate used and the size and length of the construction program. The Uniform System of Accounts defines AFUDC, a non-cash item, as the net cost for the period of construction of borrowed funds used for construction purposes and a reasonable rate upon other funds when so used. On the income statement, the cost of borrowed funds capitalized is reported as a reduction of total interest expense and the cost of equity funds capitalized is reported as other income. In accordance with the FERC formula, the composite AFUDC rates used in 1993, 1992 and 1991 were 3.5%, 5.7% and 10.6%, respectively. DEPRECIATION AND MAINTENANCE Provisions for depreciation for financial reporting purposes are based on straight-line composite rates. The annual provisions expressed as a percentage of average depreciable property were as follows: Maintenance and repair costs are charged directly to expense. Renewals of units of property are charged to the utility plant account, and the original cost of depreciable property replaced or retired, together with the removal cost less salvage, is charged to the accumulated provision for depreciation. INCOME TAXES CILCO follows a policy of comprehensive interperiod income tax allocation. Investment tax credits (except for amounts applicable to the Employee Stock Ownership Plan) have been deferred and are amortized over the estimated useful lives of the related property. CILCORP and its subsidiaries file a consolidated federal income tax return. Income taxes are allocated to the individual companies, including CILCO, based on their respective taxable income or loss. CONSOLIDATED STATEMENTS OF CASH FLOWS CILCO considers all highly liquid debt instruments purchased with a maturity of three months or less to be cash equivalents for purposes of the Consolidated Statements of Cash Flows. POSTEMPLOYMENT BENEFITS OTHER THAN PENSIONS AND HEALTH CARE In November 1992, the Financial Accounting Standards Board (FASB) issued Statement No. 112, "Employer's Accounting for Postemployment Benefits" (SFAS 112). CILCO will adopt SFAS 112 on January 1, 1994. This standard requires accrual of benefits other than pensions or health care provided to former or inactive employees. The cumulative effect to CILCO of initially applying SFAS 112 will be a pre-tax charge of approximately $1 million in January 1994, a portion of which will be capitalized. PENSION BENEFITS Substantially all of CILCO's full-time employees, including those assigned to the Holding Company, are covered by trusteed, non-contributory defined benefit pension plans. Benefits under these plans reflect the employee's years of service, age at retirement and maximum total compensation for any consecutive sixty-month period prior to retirement. Pension costs for the past three years were charged as follows: Provisions for pension costs were determined under the rules prescribed by Statement of Financial Accounting Standards No. 87, including the use of the projected unit credit actuarial cost method. Information on the plans' funded status, on an aggregate basis, at December 31, 1993 and 1992 follows: POSTEMPLOYMENT HEALTH CARE BENEFITS Substantially all of CILCO's full-time employees, including those assigned to the Holding Company, are currently covered by a trusteed, non-contributory defined benefit postemployment health care plan. The plan pays stated percentages of most necessary medical expenses incurred by retirees, after subtracting payments by Medicare or other providers and after a stated deductible has been met. Participants become eligible for the benefits if they retire from CILCO after reaching age 55 with 10 or more years of service. On January 1, 1991, CILCO adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" (SFAS 106). This standard requires that the expected cost of postemployment health care benefits be charged to expense during the years in which employees render service. CILCO has elected to amortize the unfunded obligation at January 1, 1991, over a period of 18.6 years, which represents the average remaining service period. Postemployment health care benefit costs were charged as follows: Information on the plans' funded status, on an aggregate basis at December 31, 1993 and 1992, follows: For measurement purposes, a health care cost trend rate of 9% annually was assumed for 1994; the rate was assumed to decrease to 8% for 1995, then decrease gradually to 6% by 2020 and remain at that level thereafter. Increasing the assumed health care cost trend rate by 1% in each year would increase the accumulated postemployment benefit obligation at December 31, 1993, by $5.2 million and the aggregate of the service and interest cost components of net postemployment health care cost for 1993 by $376,000. The discount rate used in determining the accumulated postemployment benefit obligation at December 31, 1993 was 7% and at December 31, 1992 was 8%. The weighted average expected return on assets net of taxes was 8.1% where taxes are assumed to decrease return by 0.4%. CILCO-OWNED LIFE INSURANCE POLICIES The following amounts related to CILCO-owned life insurance contracts, with one major insurance company, are recorded on the consolidated balance sheets: Interest expense for CILCO-owned life insurance borrowings included in CILCO-owned Life Insurance, Net in the Consolidated Statements of Income was $1.4 million, $930,000 and $870,000 for 1993, 1992 and 1991, respectively. FAIR VALUE OF FINANCIAL INSTRUMENTS The carrying amount of Cash and Temporary Cash Investments, Other Investments, and Notes Payable approximates fair value. At December 31, 1993 and 1992, CILCO had $278.3 million and $266.7 million, respectively, in long-term debt, including current maturities, consisting of first mortgage bonds, pollution control bonds, and medium-term notes, recorded on the Balance Sheet. The estimated fair value of these financial instruments at December 31, 1993 and 1992 is $305.2 million and $267.3 million, respectively, based on current market interest rates for other companies with comparable credit ratings, capital structures, and size. NOTE 2: INCOME TAX EXPENSE CILCO adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS 109), on January 1, 1993, and accounted for its initial application as a cumulative change in accounting principle. SFAS 109 requires the use of the liability method to account for income taxes. Under the liability method, deferred income taxes are recognized at currently enacted income tax rates to reflect the tax effect of temporary differences between the financial reporting basis and the tax basis of assets and liabilities. Temporary differences occur because the income tax law either requires or permits certain items to be reported on CILCO's income tax return in a different year than they are reported in the financial statements. Adoption of SFAS 109 did not have a material impact on CILCO's financial position, results of operations or cash flows; however, the adoption of SFAS 109 required reclassification of accumulated deferred income taxes on the balance sheet. CILCO established a regulatory liability to account for the net effect of expected future regulatory actions related to unamortized investment tax credits, income tax liability initially recorded at tax rates in excess of current rates, the equity component of Allowance for Funds Used During Construction, and other items for which deferred taxes had not previously been provided. The temporary differences related to CILCO's net deferred income tax liability at December 31, 1993, and January 1, 1993, were as follows: Of the $5,027,000 increase in the net deferred income tax liability from January 1, 1993 to December 31, 1993, $182,000 is due to current year deferred federal and state income tax expense. The remaining increase is primarily the result of a decrease in the net regulatory liability. Total deferred income taxes, net, include deferred state income taxes of $332,000, $435,000 and $775,000 for 1993, 1992 and 1991, respectively. NOTE 3: SHORT-TERM FINANCING ARRANGEMENTS CILCO had arrangements for bank lines of credit totaling $30 million at December 31, 1993, all of which were unused. These lines of credit consisted of $6.65 million maintained by compensating balances and $23.35 million maintained by commitment fees ranging from 1/16 to 3/16 of 1% per annum in lieu of balances. The compensating bank balance arrangements provide that CILCO maintain bank deposits to average annually from 3% to 5% of the line, such balances being available to CILCO for operating purposes and as compensation to the bank for other bank services. These bank lines of credit are also used to support CILCO's issuance of commercial paper. Short-term borrowings consisted of commercial paper totaling $12.4 million at December 31, 1993. NOTE 4: RETAINED EARNINGS CILCO's Articles of Incorporation provide that no dividends shall be paid on the common stock if, at the time of declaration, the balance of retained earnings does not equal at least two times the annual dividend requirement on all outstanding shares of preferred stock. The amount of retained earnings so required at December 31, 1993 was $5.6 million. NOTE 5: PREFERRED STOCK All classes of preferred stock are entitled to receive cumulative dividends and rank equally as to dividends and assets, according to their respective terms. The total annual dividend requirement for preferred stock outstanding at December 31, 1993 is $2.8 million, assuming the auction dividend rate at December 31, 1993 for the flexible auction rate series. Preferred Stock Without Mandatory Redemption The call provisions of preferred stock redeemable at CILCO's option outstanding at December 31, 1993 are as follows: CILCO's first mortgage bonds are secured by a lien on substantially all property and franchises. Unamortized borrowing expense, call premiums, premium and discount on outstanding long-term debt are being amortized over the lives of the respective issues. Scheduled maturities of long-term debt for the five-year period ending December 31, 1998 are $16 million due in 1996, $20 million due in 1997 and $10.65 million due in 1998. NOTE 7: COMMITMENTS & CONTINGENCIES CILCO's capital expenditures for utility plant for 1994 are estimated to be $90 million, in connection with which CILCO has normal and customary purchase commitments at December 31, 1993. It is the policy of CILCO to act as a self-insurer for certain insurable risks resulting from employee health and life insurance programs. In August 1990, CILCO entered into a firm, wholesale bulk power purchase agreement with Central Illinois Public Service Company (CIPS). This agreement, which expires in 1998, provides for an initial purchase of 30 megawatts (MW) of capacity, increasing to 90 MW in 1997. CILCO can increase purchases to a maximum of 100 MW during the contract period, provided CIPS then has the additional capacity available. In November 1992, CILCO entered into a limited-term power agreement to purchase 100 MW of CIPS' capacity from June 1998 through May 2002. At CILCO's request, purchases may be increased to a maximum of 150 MW during the contract period, provided CIPS has the additional capacity available. Reference is made to the following sections in Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operation for a discussion of additional commitments and contingencies: Environmental Matters (regarding former gas manufacturing sites) and Gas Operations for a discussion regarding contingencies related to CILCO's Springfield gas system. NOTE 8: RATE MATTERS Reference is made to Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations, Gas Rate Increase Request, Environmental Matters, Electric Competition, and Gas Take-or-Pay Charges for a discussion of gas and electric rate matters. NOTE 9: LEASES CILCO leases certain equipment, buildings, and other facilities under capital and operating leases. Minimum future rental payments under non-cancelable capital and operating leases having remaining terms in excess of one year as of December 31, 1993, are $24 million in total. Payments due during the years ending December 31, 1994 through December 31, 1998, are $5.2 million; $3.1 million; $2.9 million; $2.9 million; and $2.9 million, respectively. NOTE 10: SELECTED QUARTERLY FINANCIAL DATA (Unaudited) The following quarterly consolidated operating results are unaudited, but, in the opinion of management, include all adjustments (consisting of normal recurring accruals) necessary for a fair presentation of CILCO's operating results for the periods indicated (see Note 1). The results of operations for each of the fiscal quarters are not necessarily comparable or necessarily indicative of the results of an entire year due to, among other factors, the seasonal nature of CILCO's business. Item 9.	Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure CILCORP Not applicable. CILCO Not applicable. PART III Item 10.	Item 10. Directors and Executive Officers of the Registrant CILCORP The information required by Item 10 relating to directors is set forth in the Company's definitive proxy statement for its 1994 Annual Meeting of Stockholders filed with the Commission pursuant to Regulation 14A. Such information is incorporated herein by reference to the material appearing under the caption "Election of Directors" on pages 3 through 11 of such proxy statement. Information required by Item 10 relating to executive officers of the Company is set forth under a separate caption in Part I hereof. CILCO The information required by Item 10 relating to directors is set forth in CILCO's definitive proxy statement for its 1994 Annual Meeting of Stockholders filed with the Commission pursuant to Regulation 14A. Such information is incorporated herein by reference to the material appearing under the caption "Election of Directors" on pages 2 through 7 of such proxy statement. Information required by Item 10 relating to executive officers of CILCO is set forth under a separate caption in Part I hereof. Item 11.	Item 11. Executive Compensation CILCORP The Company has filed with the Commission a definitive proxy statement pursuant to Regulation 14A. The information required by Item 11 is incorporated herein by reference to the material appearing under the caption "Executive Compensation" on pages 13 through 19 of such proxy statement. CILCO CILCO has filed with the Commission a definitive proxy statement pursuant to Regulation 14A. The information required by Item 11 is incorporated herein by reference to the material appearing under the caption "Executive Compensation" on pages 8 through 13 of such proxy statement. Item 12.	Item 12. Security Ownership of Certain Beneficial Owners and Management CILCORP The Company has filed with the Commission a definitive proxy statement pursuant to Regulation 14A. The information required by Item 12 is incorporated herein by reference to the material appearing under the caption "Voting Securities and Principal Holders" on pages 2 through 4 of such proxy statement. CILCO CILCO has filed with the Commission a definitive proxy statement pursuant to Regulation 14A. The information required by Item 12 is incorporated herein by reference to the material appearing under the caption "Voting Securities and Principal Holders" on pages 1 and 2 of such proxy statement. Item 13.	Item 13. Certain Relationships and Related Transactions CILCORP CILCORP Inc. (CILCORP or Company), a holding company, is the parent of its subsidiaries Central Illinois Light Company (CILCO), CILCORP Development Services Inc., CILCORP Investment Management Inc., CILCORP Ventures Inc., and Environmental Science & Engineering, Inc. (ESE). In the course of business, the Company carries on certain relations with affiliated companies such as shared facilities, utilization of employees and other business transactions. Central Illinois Light Company is reimbursed at cost by the Company and the other subsidiaries for any services it provides. ESE and the Holding Company entered into an agreement to consolidate ESE's outstanding debt. Under this agreement, ESE can draw on a $15 million revolving line of credit which expires May 2, 1996. ESE also borrowed $20 million from the Holding Company on a term credit basis with the principal due May 2, 1998. Additionally, at December 31, 1993, ESE had borrowed $20.9 million from CILCORP. At December 31, 1993, CILCORP guaranteed $21 million of outstanding debt of CILCORP Lease Management Inc. CILCORP receives a fee for the guarantee. CIM has guaranteed the performance of CIM Leasing Inc. and CIM Air Leasing Inc. with respect to certain obligations arising from the leveraged lease investments held by these subsidiaries. CILCO Certain members of the Board of Directors of CILCORP Inc. are also members of the Board of Directors of CILCO and the secretary of CILCO is also a Vice President of CILCORP Inc. PART IV Item 14.	Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K CILCORP Page No. Form 10-K (a) 1. Financial Statements The following are included herein: Management's Report 50 Report of Independent Public Accountants 51 Consolidated Statements of Income for the three years ended December 31, 1993 52-53 Consolidated Balance Sheets as of December 31, 1993 and December 31, 1992 54-55 Consolidated Statements of Cash Flows for the three years ended December 31, 1993 56-57 Consolidated Statements of Common Stockholders' Equity for the three years ended December 31, 1993 58 Consolidated Statements of Segments of Business for the three years ended December 31, 1993 59-61 Notes to the Consolidated Financial Statements 62-77 (a) 2. Financial Statement Schedules The following schedules are included herein. Schedule V - Property, Plant and Equipment for the three years ended December 31, 1993 109-114 Schedule VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment for the three years ended December 31, 1993 115-120 Schedule VIII - Valuation and Qualifying Accounts and Reserves 121 Schedule IX - Short-term Borrowings for the three years ended December 31, 1993 122 Schedule XIII -Investment in Leveraged Leases at December 31, 1993 123 Other schedules are omitted because of the absence of conditions under which they are required or because the required information is given in the financial statements or notes thereto. (a) 3. Exhibits (3) Articles of Incorporation (Designated in Form 10-K for the year ended December 31, 1991, File No. 1-8946, as Exhibit (3)). (3)a By-laws as amended December 4, 1990 (Designated in Form 10-K for the year ended December 31, 1990, File No. 1-8946, as Exhibit (3)a). (4) Indenture of Mortgage and Deed of Trust between Illinois Power ** Company and Bankers Trust Company, as Trustee, dated as of April 1, 1933, Supplemental Indenture between the same parties dated as of June 30, 1933, Supplemental Indenture between the Company and Bankers Trust Company, as Trustee, dated as of July 1, 1933 and Supplemental Indenture between the same parties dated as of January 1, 1935, securing First Mortgage Bonds, and indentures supplemental to the foregoing through January 1, 1993. (Designated in Registration No. 2-1937 as Exhibit B-1, in Registration No. 2-2093 as Exhibit B-1(a), in Form 8-K for April 1940, File No. 1-2732-2, as Exhibit A, in Form 8-K for December 1949, File No. 1-2732-2, as Exhibit A, in Form 8-K for December 1951, File No. 1-2732, as Exhibit A, in Form 8-K for July 1957, File No. 1-2732, as Exhibit A, in Form 8-K for July 1958, File No. 1-2732, as Exhibit A, in Form 8-K for March 1960, File No. 1-2732, as Exhibit A, in Form 8-K for September 1961, File No. 1-2732, as Exhibit B, in Form 8-K for March 1963, File No. 1-2732, as Exhibit A, in Form 8-K for February 1966, File No. 1-2732, as Exhibit A, in Form 8-K for March 1967, File No. 1-2732, as Exhibit A, in Form 8-K for August 1970, File No. 1-2732, as Exhibit A, in Form 8-K for September 1971, File No. 1-2732, as Exhibit A, in Form 8-K for September 1972, File No. 1-2732, as Exhibit A, in Form 8-K for April 1974, File No. 1-2732, as Exhibit 2(b), in Form 8-K for June 1974, File No. 1-2732, as Exhibit A, in Form 8-K for March 1975, File No. 1-2732, as Exhibit A, in Form 8-K for May 1976, File No. 1-2732, as Exhibit A, in Form 10-Q for the quarter ended June 30, 1978, File No. 1-2732, as Exhibit 2, in Form 10-K for the year ended December 31, 1982, File No. 1-2732, as Exhibit (4)(b), in Form 8-K dated January 30, 1992, File No. 1-2732, as Exhibit (4) and in Form 8-K dated January 29, 1993, File No. 1-2732, as Exhibit (4).) (4)a Supplemental Indenture dated August 1, 1993. (10) CILCO Executive Deferral Plan as amended through February 22, 1994. (10)a Executive Deferral Plan II (Designated in Form 10-K for the year ended December 31, 1989, File No. 1-8946, as Exhibit (10)b). (10)b Economic Value Added Incentive Compensation Plan (Designated in Form 10-K for the year ended December 31, 1989, File No. 1-8946, as Exhibit (10)c). (10)c CILCO Compensation Protection Plan (Designated in Form 10-K for the year ended December 31, 1990, File No. 1-8946, as Exhibit (10)d). (10)d CILCO Benefit Replacement Plan (Designated in Form 10-K for the year ended December 31, 1991, File No. 1-8946, as Exhibit (10)e). (10)e Deferred Compensation Stock Plan (Designated in Form 10-K for the year ended December 31, 1991, File No. 1-8946, as Exhibit (10)f). (10)f Shareholder Return Incentive Compensation Plan (included as part of Company's definitive proxy in 1993 Anuual Meeting of Stockholders, filed with the Commission on March 26,1993.) (12) Computation of Ratio of Earnings to Fixed Charges (13) Annual Report to Security Holders (24) Consent of Arthur Andersen & Co. (25) Power of Attorney *(b) Reports on Form 8-K A Form 8-K was filed on December 17, 1993, to disclose an agreement between CILCO and one of its largest customers to develop a cogeneration plant. A Form 8-K was filed on December 31, 1993, to disclose CILCORP Inc., through its wholly-owned subsidiary, CILCORP Investment Management Inc., (CIM), acquired a 40% partnership interest in a McDonnell Douglas MD-11F cargo plane through a leveraged lease transaction. The plane will be leased to a U. S. corporation which will use it in its fleet operations. A Form 8-K was filed on January 14, 1994, to disclose CILCO's filing with the Illinois Commerce Commission (ICC) to increase gas base rates. These exhibits have been previously filed with the Securities and Exchange Commission (SEC) as exhibits to registration statements or to other filings of CILCO with the SEC and are incorporated herein as exhibits by reference. The file number and exhibit number of each such exhibit (where applicable) are stated in the description of such exhibit. **Pursuant to Paragraph (b)(4)(iii)(A) of Item 601 of Regulation S-K, the Company has not filed as an exhibit to this Form 10-K any instrument with respect to long-term debt as the total amount of securities authorized thereunder does not exceed 10 percent of the total assets of the Company and its subsidiaries on a consolidated basis, but hereby agrees to furnish to the SEC on request any such instruments. CILCO Page No. Form 10-K (a) 1. Financial Statements The following are included herein: Management's Report 78 Report of Independent Public Accountants 79 Consolidated Statements of Income for the three years ended December 31, 1993 80 Consolidated Balance Sheets as of December 31, 1993 and December 31, 1992 81-82 Consolidated Statements of Cash Flows for the three years ended December 31, 1993 83-84 Consolidated Statements of Retained Earnings for the three years ended December 31, 1993 85 Consolidated Statements of Segments of Business for the three years ended December 31, 1993 86-87 Notes to the Consolidated Financial Statements 88-100 (a) 2. Financial Statement Schedules The following schedules are included herein: Schedule II - Amounts Receivable from Related Parties and Underwriters, Promoters and Employees Other Than Related Parties 124 Schedule V - Property, Plant and Equipment for the three years ended December 31, 1993 125-130 Schedule VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment for the three years ended December 31, 1993 131-136 Schedule VIII - Valuation and Qualifying Accounts and Reserves for the three years ended December 31, 1993 137 Schedule IX - Short-Term Borrowings for the three years ended December 31, 1993 138 Other schedules are omitted because of the absence of conditions under which they are required or because the required information is given in the financial statements or notes thereto. (a) 3. Exhibits (3) Articles of Incorporation. (Designated in Form 10-K for the fiscal year ended December 31, 1980, File No. 1-2732, as Exhibit 3). (3)a Bylaws. (Designated in Form 10-K for the year ended December 31, 1990, File No. 1-2732, as Exhibit (3) a). (4) Indenture of Mortgage and Deed of Trust between Illinois Power Company and Bankers Trust Company, as Trustee, dated as of April 1, 1933, Supplemental Indenture between the same parties dated as of June 30, 1933, Supplemental Indenture between the Company and Bankers Trust Company, as Trustee, dated as of July 1, 1933 and Supplemental Indenture between the same parties dated as of January 1, 1935, securing First Mortgage Bonds, and indentures supplemental to the foregoing through January 1, 1993. (Designated in Registration No. 2-1937 as Exhibit B-1, in Registration No. 2-2093 as Exhibit B-1(a), in Form 8-K for April 1940, File No. 1-2732-2, as Exhibit A, in Form 8-K for December 1949, File No. 1-2732-2, as Exhibit A, in Form 8-K for December 1951, File No. 1-2732, as Exhibit A, in Form 8-K for July 1957, File No. 1-2732, as Exhibit A, in Form 8-K for July 1958, File No. 1-2732, as Exhibit A, in Form 8-K for March 1960, File No. 1-2732, as Exhibit A, in Form 8-K for September 1961, File No. 1-2732, as Exhibit B, in Form 8-K for March 1963, File No. 1-2732, as Exhibit A, in Form 8-K for February 1966, File No. 1-2732, as Exhibit A, in Form 8-K for March 1967, File No. 1-2732, as Exhibit A, in Form 8-K for August 1970, File No. 1-2732, as Exhibit A, in Form 8-K for September 1971, File No. 1-2732, as Exhibit A, in Form 8-K for September 1972, File No. 1-2732, as Exhibit A, in Form 8-K for April 1974, File No. 1-2732, as Exhibit 2(b), in Form 8-K for June 1974, File No. 1-2732, as Exhibit A, in Form 8-K for March 1975, File No. 1-2732, as Exhibit A, in Form 8-K for May 1976, File No. 1-2732, as Exhibit A, in Form 10-Q for the quarter ended June 30, 1978, File No. 1-2732, as Exhibit 2, in Form 10-K for the year ended December 31, 1982, File No. 1-2732, as Exhibit (4)(b), in Form 8-K dated January 30, 1992, File No. 1-2732, as Exhibit (4) and in Form 8-K dated January 29, 1993, File No. 1-2732, as Exhibit (4).) (4)a Supplemental Indenture dated August 1, 1993. (10) Executive Deferral Plan as amended February 2, 1994. (Designated in Form 10-K for the year ended December 31, 1993, File No. 1-8946, as Exhibit (10).) (10)a Executive Deferral Plan II. (Designated in Form 10-K for the year ended December 31, 1989, File No. 1-2732, as Exhibit (10)b.) (10)b Compensation Protection Plan. (Designated in Form 10-K for the year ended December 31, 1990, File No. 1-2732, as Exhibit (10)c.) (10)c Deferred Compensation Stock Plan. (Designated in Form 10-K for the year ended December 31, 1990, File No. 1-2732, as Exhibit (10)d.) (10)d Economic Value Added Incentive Compensation Plan. (Designated in Form 10-K for the year ended December 31, 1990, File No. 1-2732, as Exhibit (10)e.) (10)e Benefit Replacement Plan. (Designated in Form 10-K for the year ended December 31, 1991, File No. 1-2732, as Exhibit (10)f.) (10)f Shareholder Return Incentive Compensation Plan (12) Computation of Ratio of Earnings to Fixed Charges (25) Power of Attorney (b) Reports on Form 8-K A Form 8-K was filed on December 17, 1993 to disclose an agreement between CILCO and one of its largest customers to develop a cogeneration plant. A Form 8-K was filed on January 14, 1994 to disclose CILCO's filing with the Illinois Commerce Commission (ICC) to increase gas base rates. These exhibits have been previously filed with the Securities and Exchange Commission (SEC) as exhibits to registration statements or to other filings of CILCO with the SEC and are incorporated herein as exhibits by reference. The file number and exhibit number of each such exhibit (where applicable) are stated in the description of such exhibit. Schedule V Page 1 of 6 Schedule V Page 3 of 6 Schedule V Page 5 of 6 Schedule VI Page 1 of 6 Schedule VI Page 3 of 6 Schedule VI Page 5 of 6 Schedule VIII Schedule XIII Schedule II Schedule V Page 1 of 6 Schedule V Page 3 of 6 Schedule V Page 5 of 6 Schedule VI Page 1 of 6 Schedule VI Page 3 of 6 Schedule VI Page 5 of 6 Schedule VIII Schedule IX SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. CILCORP INC. March 15, 1994 By R. O. Viets R. O. Viets 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 (i) and (ii) Principal executive officer, director and principal financial officer: R. O. Viets R. O. Viets President, Chief March 15, 1994 Executive Officer and Director (iii) Controller T. D. Hutchinson T. D. Hutchinson Controller March 15, 1994 (iv) A majority of the Directors (including the director named above): M. Alexis* Director March 15, 1994 J. R. Brazil* Director March 15, 1994 D. E. Connor* Director March 15, 1994 R. V. O'Keefe* Director March 15, 1994 H. S. Peacock* Director March 15, 1994 R. W. Slone* Director March 15, 1994 K. E. Smith* Director March 15, 1994 R. N. Ullman* Director March 15, 1994 J. M. Unland* Director March 15, 1994 M. M. Yeomans* Director March 15, 1994 R. O. Viets R. O. Viets Director March 15, 1994 By R. O. Viets R. O. Viets Attorney-in-fact SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. CENTRAL ILLINOIS LIGHT COMPANY March 15, 1994 By R. W. Slone R. W. Slone Chairman of the Board, 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 (i) Principal executive officer and director: R. W. Slone R. W. Slone Chairman of the Board, March 15, 1994 President, Chief Executive Officer and Director (ii) Principal financial officer: T. S. Romanowski T. S. Romanowski Vice President March 15, 1994 (iii) Controller R. L. Beetschen R. L. Beetschen Controller and March 15, 1994 Manager of Accounting (iv) A majority of the Directors (including the director named above): M. Alexis Director March 15, 1994 J. R. Brazil* Director March 15, 1994 W. Bunn III* Director March 15, 1994 D. E. Connor* Director March 15, 1994 H. S. Peacock* Director March 15, 1994 W. M. Shay* Director March 15, 1994 K. E. Smith* Director March 15, 1994 R. N. Ullman* Director March 15, 1994 J. M. Unland* Director March 15, 1994 J. F. Vergon* Director March 15, 1994 M. M. Yeomans* Director March 15, 1994 R. W. Slone R. W. Slone Director March 15, 1994 *By R. W. Slone R. W. Slone Attorney-in-fact EXHIBIT (12) EXHIBIT (12) Exhibit 24 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation by reference of our reports, dated February 4, 1994, included herein in this Form 10-K, into CILCORP Inc.'s previously filed Registration Statements File No. 33-45318, 33-51315 and 33-51241. ARTHUR ANDERSEN & CO. Chicago, Illinois March 11, 1994
52428_1993.txt	52428	1993	Item 1. Business IDS Certificate Company (IDSC) is incorporated under the laws of Delaware. Its principal executive offices are located in the IDS Tower, Minneapolis, Minnesota, and its telephone number is (612) 671-3131. IDS Financial Corporation (IDS), a Delaware corporation, IDS Tower 10, Minneapolis, Minnesota 55440-0010, owns 100% of the outstanding voting securities of IDSC. IDS is a wholly owned subsidiary of American Express Company (American Express), a New York Corporation, with headquarters at American Express Tower, World Financial Center, New York, New York. IDSC is a face-amount certificate investment company registered under the Investment Company Act of 1940 (1940 Act). IDSC is in the business of issuing face-amount certificates. Face-amount certificates issued by IDSC entitle the certificate holder to receive, at maturity, a stated amount of money and interest or credits declared from time to time by IDSC, in its discretion. IDSC is continuously engaged in new product development. IDSC currently offers seven certificates to the public: "IDS Future Value Certificate", "IDS Cash Reserve Certificate", "IDS Flexible Savings Certificate" (formerly "IDS Variable Term Certificate"), "IDS Installment Certificate", "IDS Stock Market Certificate", "IDS Investors Certificate" and "IDS Special Deposits". The IDS Special Deposits is only offered for sale in London, England, and is not registered for sale in the United States. All certificates are currently sold without a sales charge. The IDS Installment Certificate, the IDS Flexible Savings Certificate, the IDS Stock Market Certificate, the IDS Investors Certificate and the IDS Special Deposits currently bear surrender charges for premature surrenders. All of the above described certificates, except the IDS Special Deposits, are distributed pursuant to a Distribution Agreement with IDS Financial Services Inc., an affiliate of IDSC. With respect to the IDS Investors Certificate and the IDS Stock Market Certificate, IDS Financial Services Inc., in turn, has a Selling Agent Agreement with American Express Bank International, a subsidiary of American Express, for selling the certificate. IDS Financial Services Inc. also distributes the IDS Stock Market Certificate. With respect to the IDS Special Deposits, IDSC has a Marketing Agreement with American Express Bank Ltd., a subsidiary of American Express, for marketing the certificate. IDSC also offers one certificate in connection with certain employee benefit plans available to eligible IDS employees, financial planners and retirees. This certificate is called the Series D-1 Investment Certificate. Except for the IDS Investors Certificate and the IDS Special Deposits, all of the certificates are available as qualified investments for Individual Retirement Accounts (IRAs), or 401(k) plans and other qualified retirement plans. The specified maturities of the certificates range from four to twenty years. Within that maturity period, most certificates have terms ranging from three to thirty-six months. Interest rates change and certificateholders can surrender their certificates without penalty at term end. The IDS Future Value Certificate is a single payment certificate that guarantees interest in advance for a 4, 5, 6, 7, 8, 9 or 10-year maturity, at the buyer's option. The IDS Cash Reserve Certificate is a single pay certificate that permits additional investments and guarantees interest in advance for a three-month term. The IDS Flexible Savings Certificate is a single payment certificate that permits a limited amount of additional payments and guarantees interest in advance for a term of 6, 12, 18, 24, 30 or 36 months, at the buyer's option. The IDS Installment Certificate is an installment payment certificate that declares interest in advance for a three-month period and offers bonuses in the third through sixth years for regular investments. The IDS Stock Market Certificate is a single payment certificate that offers the certificate holder the opportunity to have all or part of his interest tied to stock market performance, as measured by a broad stock market index, with guaranteed return of principal. The holder can also choose to earn a guaranteed fixed rate of interest. In addition to being sold to IDS clients pursuant to a Distribution Agreement with IDS Financial Services Inc., this certificate is sold by American Express Bank International (AEBI), under a Selling Agent Agreement with IDS Financial Services Inc. to AEBI's clients who are neither citizens nor residents of the United States. The IDS Investors Certificate is a single payment certificate that permits additional payments within 15 days of term renewal. Interest rates are guaranteed in advance for a term of 1, 2, 3, 6, 12, 24 or 36 months, at the buyer's option. This certificate is currently sold by AEBI, through a Selling Agent Agreement with IDS Financial Services Inc., only to AEBI's clients who are neither citizens nor residents of the United States. The IDS Special Deposits is a single payment certificate that permits additional payments within 15 days of term renewal. Interest rates are guaranteed in advance for a term of 1, 2, 3, 6, 12, 24 or 36 months, at the buyer's option. This certificate is currently sold by American Express Bank Ltd. ("AEB") in the London office, through a Marketing Agreement with IDSC, only to AEB's clients who are neither citizens nor residents of the United States. This certificate is not registered for sale in the United States. IDSC is by far the largest issuer of face-amount certificates in the United States. However, such certificates compete with many other investments offered by banks, savings and loan associations, mutual funds, broker-dealers and others, which may be viewed by potential clients as offering a comparable or superior combination of safety and return on investment. In particular, some of IDSC's products are designed to be competitive with the types of investment offered by banks and thrifts. Since IDSC's face-amount certificates are securities, their offer and sale are subject to regulation under federal and state securities laws. IDSC's certificates are backed by its qualified assets on deposit and are not insured by any governmental agency. For all of the certificates, except for the IDS Investors Certificate and the IDS Special Deposits, IDSC's current policy is to re-evaluate the certificate rates weekly to respond to marketplace changes. For the IDS Investors Certificate and the IDS Special Deposits, IDSC's current policy is to re-evaluate the rates on a daily basis. For each product, IDSC refers to an independent index to set the rates for new sales. Except for IDS Special Deposits, IDSC must set the rates within a specified range of the rate from such index. For renewals, IDSC uses such rates as an indication of the competitors' rates, but is not required to set rates within a specified range. For the IDS Flexible Savings Certificate, IDS Cash Reserve Certificate and the IDS Series D-1 Investment Certificate, the published rates of the BANK RATE MONITOR National Index (trademark) for various length bank certificates of deposit are used as the guide in setting rates. For the IDS Installment Certificate, the average interest rate for money market deposit accounts, as published by the BANK RATE MONITOR National Index (trademark), North Palm Beach, FL, is used as a guide in setting rates. For the IDS Future Value Certificate, the average quoted yields of certain U.S. Treasury Bonds for similar maturities, as published in the Wall Street Journal and the New York Times, are used as a guide in setting rates. For the IDS Investors Certificate and IDS Special Deposits, the published average rates for comparable length dollar deposits available on an interbank basis, referred to as the London Interbank Offered Rates (LIBOR), are used as a guide in setting rates. To compete with popular short-term investment vehicles such as certificates of deposit, money market certificates and money market mutual funds that offer comparable yields, liquidity and safety of principal, IDSC offers the IDS Cash Reserve Certificate and the IDS Flexible Savings Certificate. The yields and features on these products are designed to be competitive with such short-term products. The IDS Investors Certificate and IDS Special Deposits also compete with short-term products but use LIBOR rates. The IDS Future Value Certificate has certain features similar to those of zero coupon bonds and is intended to compete with that type of investment as well as with intermediate to long-term certificates of deposit. The IDS Installment Certificate is intended to help clients save systematically and may compete with passbook savings and NOW accounts. The IDS Stock Market Certificate is designed to offer interest tied to a major stock market index and guaranteed principal. Certain banks offer certificates of deposit that have features similar to the Stock Market Certificate. IDSC's gross income is derived principally from interest and dividends generated by its investments. IDSC's net income is determined by deducting from such gross income its provision for certificate reserves, and other expenses, including taxes, the fee paid to IDS for advisory and other services and the distribution fees paid to IDS Financial Services Inc. and AEBI and marketing fees paid to AEB. The following table shows IDSC's sales and surrenders of certificates for the three years ended December 31, 1993: 1993 1992 1991 Single Payment* (Cash Basis) ($ in millions) Non-Qualified Sales $ 822.5 $1,046.3 $1,208.0 Surrenders 1,162.9 1,368.3 1,536.0 Qualified Sales 115.4 136.5 157.6 Surrenders 220.4 249.1 232.6 Installment Payment (Face-amount Basis) Non-Qualified Sales 369.0 392.7 358.3 Surrenders 327.5 330.9 333.8 Qualified Sales 6.1 9.9 20.2 Surrenders 23.1 48.5 47.6 *Includes Cash Reserve, Flexible Savings, Single Payment, Future Value, Investors, Stock Market and IDS Special Deposits certificates. In 1993 approximately 12% of single payment certificate sales and 2% of installment certificate sales were of tax-qualified certificates for use in IRAs, and 401(k) plans and other qualified retirement plans. The certificates offered by IDS Financial Services Inc. are sold pursuant to a distribution agreement which is terminable on 60 days' notice and is subject to annual approval by IDSC's Board of Directors, including a majority of the directors who are not "interested persons" of IDS Financial Services Inc. or IDSC as that term is defined in the 1940 Act. The agreement provides for the payment of distribution fees to IDS Financial Services Inc. for services provided thereunder. IDS Financial Services Inc. is a wholly owned subsidiary of IDS. For the distribution of the IDS Investors Certificate, IDS Financial Services Inc., in turn, has a Selling Agent Agreement with AEBI. For distribution of IDS Special Deposits, IDSC has a Marketing Agreement with AEB. Both agreements are terminable upon 60 days' notice and similarly subject to annual approval of the disinterested directors of IDSC. IDSC receives advice, statistical data and recommendations with respect to the acquisition and disposition of securities for its portfolio from IDS, under an investment management agreement which is subject to annual renewal by IDSC's Board of Directors, including a majority of the directors who are not "interested persons" of IDS or IDSC. IDSC is required to maintain "qualified investments" meeting the standards of Section 28(b) of the 1940 Act. The carrying value of said investments must be at least equal to IDSC's net liabilities on all outstanding face-amount certificates plus $250,000. IDSC's qualified assets consist of cash and cash equivalents, first mortgage loans on real estate, U.S. government and government agency securities, municipal bonds, corporate bonds, preferred stocks and other securities meeting specified standards. IDSC is subject to annual examination and supervision by the State of Minnesota, Department of Commerce (Banking Division). Distribution fees on sale of certain certificates are deferred and amortized over the estimated lives of the related certificates, which is approximately 10 years. Upon surrender, unamortized deferred distribution fees are charged against income. Thus, these certificates must remain in effect for a period of time to permit IDSC to recover such costs. Item 2.		Item 2. Properties None. Item 3.	Item 3. Legal Proceedings Registrant has no material pending legal proceedings other than ordinary routine litigation incidental to its business. Item 4.	Item 4. Submission of Matters to a Vote of Security Holders Item omitted pursuant to General Instructions J(1)(a) and (b) of Form 10-K. PART II Item 5.	Item 5. Market for the Registrant's Common Stock and Related Stockholder Matters There is no market for the Registrant's common stock since it is a wholly owned subsidiary of IDS and, indirectly, of American Express. Frequency and amount of dividends declared during the past two years are as follows: Dividend Payable Date Cash In-Kind* For year ended December 31, 1993: February 9, 1993 $11,000,000 $ - May 13, 1993 13,000,000 - August 10, 1993 13,000,000 - November 10, 1993 12,500,000 - December 31, 1993 15,000,000 - Total $64,500,000 $ - Dividend Payable Date Cash In-Kind* For year ended December 31, 1992: February 10, 1992 $ 7,300,000 $ - May 8, 1992 15,200,000 - August 10, 1992 21,250,000 - November 10, 1992 40,000,000 - December 30, 1992 - 64,557,994 Total $83,750,000 $64,557,994 * Consisted of an investment security at amortized cost. Restriction on the Registrant's present or future ability to pay dividends: Certain series of installment certificates outstanding provide that cash dividends may be paid by IDSC only in calendar years for which additional credits of at least 1/2 of 1% on such series of certificates have been authorized by IDSC. This restriction has been removed for 1994 and 1995 by action of IDSC on additional credits in excess of this requirement. Appropriated retained earnings resulting from the predeclaration of additional credits to IDSC's certificate holders are not available for the payment of dividends by IDSC. In addition, IDSC will discontinue issuance of certificates subject to the predeclaration of additional credits and will make no further predeclaration as to outstanding certificates if at any time the capital and unappropriated retained earnings of IDSC should be less than 5% of net certificate reserves (certificate reserves less certificate loans). At December 31, 1993, the capital and unappropriated retained earnings amounted to 5.84% of net certificate reserves. Item 7.		Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations RESULTS OF OPERATIONS IDS Certificate Company's (IDSC) earnings are derived from the after-tax yield on invested assets less investment expenses and interest credited on certificate reserve liabilities. Significant changes and trends occur largely due to interest rate changes and the difference between rates of return on investments, rates of interest credited to certificate holder accounts and the mix of fully taxable and tax-advantaged investments in the IDSC portfolio. In 1989 and 1990, total assets and certificate reserve liabilities increased due to certificate sales exceeding certificate maturities and surrenders. The increases in total assets in 1989 and 1990 also reflect capital contributions from its parent, IDS Financial Corporation (IDS). (See Liquidity and Cash Flow Discussion) Total assets and certificate reserve liabilities decreased in 1993, 1992 and 1991 due to certificate maturities and surrenders exceeding certificate sales. The excess of certificate maturities and surrenders over certificate sales in 1993, 1992 and 1991 resulted primarily from lower accrual rates declared by IDSC in those years, reflecting lower interest rates available in the marketplace. 1993 Compared to 1992 Gross investment income decreased 20 percent due to a lower balance of invested assets and lower investment yields. The 6.1 percent decrease in investment expenses resulted primarily from lower distribution fees due to lower certificate sales, and lower investment advisory and services fee due to a lower asset base on which the fee is calculated. These decreases were partially offset by higher amortization of interest rate caps. The higher amortization reflects additional purchases and accelerated amortization of certain interest rate caps in 1993. Net provision for certificate reserves decreased 31 percent reflecting lower accrual rates and a lower average balance of certificate reserves. The $7.1 million decrease in income tax benefit resulted primarily from lower tax-advantaged income in 1993. The impact of the change in Federal statutory income tax rate in 1993 was an increase in income tax benefit of $.6 million of which $.4 million reflects the increase in rate on the Dec. 31, 1992 balance of temporary differences. 1992 Compared to 1991 Net investment income of $58.7 million in 1992 was 16 percent higher than in 1991. The primary reason was an interest rate environment in 1992, that resulted in slightly lower long-term investment yields than in 1991 while short-term rates declined significantly. As a result, IDSC's investment yields decreased, however, interest rates credited on certificate reserve liabilities were significantly lower due to the short-term repricing nature of certificate products. Gross investment income decreased 16 percent due to a lower balance of invested assets and lower investment yields. The 10 percent increase in investment expenses resulted primarily from higher amortization of premiums paid for interest rate caps and index options used as hedges against changes in rates credited on certificate liabilities. Distribution fees were lower due primarily to lower certificate sales. Investment advisory and services fee was lower due a lower asset base on which the fee is calculated. Net provision for certificate reserves decreased 31 percent reflecting lower accrual rates and a lower average balance of certificate reserves. The decrease in income tax benefit resulted primarily from higher pretax income and lower tax-advantaged income in 1992. LIQUIDITY AND CASH FLOW IDSC's principal sources of cash are reserve payments from sales of face-amount certificates and cash flows from investments. In turn, IDSC's principal uses of cash are payments to certificate holders for matured and surrendered certificates, purchase of investments and payments of dividends to IDS. Although certificate sales volume decreased 18 percent in 1993, total sales remained strong reflecting clients' ongoing desire for safety of principal. Sales of single payment certificates totaled $.9 billion compared to $1.1 billion during 1992, $1.4 billion during 1991 and $1.6 billion during both 1990 and 1989. IDSC, as an issuer of face-amount certificates, is affected whenever there is a significant change in interest rates. In view of the uncertainty in the investment markets and due to the short-term repricing nature of certificate reserve liabilities, IDSC continues to invest in securities with relatively short maturities and in securities that provide for more immediate, periodic interest/principal payments, resulting in improved liquidity. To accomplish this, IDSC continues to invest much of its cash flow in mortgage-backed securities and in sinking-fund preferred stock. IDSC's investment program is designed to maintain an investment portfolio that will produce the highest possible after-tax yield within acceptable risk standards with additional emphasis on liquidity. The program considers investment securities as investments acquired with the intent and ability to hold for the foreseeable future and is designed to meet anticipated certificate holder obligations. IDSC normally holds its portfolio securities until maturity or retirement, at which time the carrying values are expected to be recovered. At Dec. 31, 1993, securities carried at cost decreased to $2.4 billion from $2.9 billion at Dec. 31, 1992. These securities, which comprise 85 percent of IDSC's total invested assets, are highly rated and well diversified. 96 percent are of investment grade and, other than U.S. Government Agency mortgage-backed securities, no one issuer represents more than two percent of these securities. See note 3 to Financial Statements for additional information on ratings and diversification. Gross unrealized gains and gross unrealized losses on investment securities carried at cost were $119 million and $6.5 million, respectively, at Dec. 31, 1993. In 1993, in reaction to the changing interest rate environment, IDSC continued to restructure a portion of its investment security portfolio by selling $349 million of investment securities. The sales included $253 million of mortgage-backed securities purchased at a premium. These securities were sold to decrease exposure to prepayment activity on the underlying pool of mortgages that could have had a negative impact on future yields on these securities. Cash flows of $897 million from operating activities, scheduled maturities, and redemptions of investments in 1993, were more than adequate to fund the net cash outflow of $603 million related to certificate obligations. During 1992, IDSC charged earnings with $23.7 million of write-downs in the value of certain interest-only, mortgage-backed securities that resulted from high prepayments due to refinancing and additional payment activity on the underlying pool of mortgages due to declining interest rates. At Dec. 31, 1992, the carrying value of these securities was $30.2 million. During 1993, additional write-downs of $.6 million were recorded and all of these securities with a carrying value of $27.4 million were sold for $14.3 million. During 1993, IDSC's reserve for possible losses on its below investment grade securities was reduced by $12.2 million from $14.2 million at Dec. 31, 1992 to $2.0 million at Dec. 31, 1993. The reduction reflects sales and exchanges of certain of these issues in 1993. IDSC does not generally invest in below investment grade securities and is limited by regulation as to the amount of such securities it can hold. IDSC's holdings in these securities result principally from the downgrading of the securities subsequent to purchase by IDSC. Management believes that reserves for possible losses on securities owned at Dec. 31, 1993, are adequate, however, future economic factors could impact the ratings of securities owned and additional reserves for losses may need to be recognized. Impact of New Accounting Standards In May of 1993, the Financial Accounting Standards Board issued SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," which IDSC will implement, effective Jan. 1, 1994. Underthe new rules, debt securities that IDSC has both the positive intent and ability to hold to maturity will be carried at amortized cost. Debt securities that IDSC does not have the positive intent and ability to hold to maturity and all marketable equity securities will be classified as available-for-sale and carried at fair value. Unrealized gains and losses on securities classified as available-for-sale will be carried as a separate component of Stockholder's Equity. The effect of the new rules will be to increase Stockholder's Equity by approximately $4 million, net of taxes, as of Jan. 1, 1994. SFAS No. 114, "Accounting by Creditors for Impairment of a Loan," is expected to have no material impact on IDSC's results of operations or financial condition. Dividends Cash dividends ranging from $17.9 million to $83.8 million were declared during each of the years 1989 to 1993. In addition, dividends-in-kind were declared consisting of an investment security of $64.6 million in 1992 and a reduction in the notes receivable from IDS of $25.5 million and $1.5 million in 1991 and 1989, respectively. As a result of projected adequate earnings in 1994 and capital in excess of regulatory requirements, IDSC anticipates declaring regular cash dividends of approximately $50 million in 1994. Capital Contributions IDSC received capital contributions from IDS of $54.7 million in Fund American Companies, Inc. preferred stock in 1990 and $18.5 million in cash and $85.9 million in Fund American Companies, Inc. preferred stock in 1989. American Express Company made capital contributions to several subsidiaries in 1989 and IDSC, through IDS, was able to take advantage of this special opportunity. The contributions benefited IDSC by providing support for the increased certificate sales volumes in 1991, 1990 and 1989, allowing for future growth and for payment of regular dividends. Due to the decrease in IDSC's assets in 1992, IDSC felt its holding in Fund American Companies, Inc. preferred stock was too large an exposure to a single credit risk, resulting in IDSC's dividend-in-kind of the issue to IDS. IDS subsequently contributed capital to IDSC of $52.3 million. The contribution was necessary in management of IDSC's regulatory capital requirements. Ratios The ratio of stockholder's equity to total assets less certificate loans at Dec. 31, 1993, was 5.59 percent, compared to 5.34 percent in 1992. IDSC intends to manage this ratio to five percent in 1994, which meets current regulatory requirements. IDS CERTIFICATE COMPANY Item 8.	Item 8. Financial Statements and Supplementary Data 1. Financial Statements and Schedules Required under Regulation S-X Index to Financial Statements and Schedules Page Financial Statements: Report of Independent Auditors 21 Responsibility for Preparation of Financial Statements 22 Balance Sheet, December 31, 1993 and 1992 23-24 Statement of Operations, year ended December 31, 1993, 1992 and 1991 25-26 Statement of Stockholder's Equity, year ended December 31, 1993, 1992 and 1991 27 Statement of Cash Flows, year ended December 31, 1993, 1992 and 1991 28 Notes to Financial Statements 29-43 Schedules: I - Investments in Securities of Unaffiliated Issuers, December 31, 1993 II - Investments in and Advances to Affiliates and Income Thereon, December 31, 1993, 1992 and 1991 III - Mortgage Loans on Real Estate and Interest earned on Mortgages, year ended December 31, 1993 V - Qualified Assets on Deposit, December 31, 1993 IX - Supplementary Profit and Loss Information, three years ended December 31, 1993 XI - Certificate Reserves, year ended December 31, 1993 XII - Valuation and Qualifying Accounts, year ended December 31, 1993, 1992 and 1991 Schedules III and XI for the year ended December 31, 1992 and Schedule XI for the year ended December 31, 1991 are included in Registrant's Annual Reports on Form 10-K for the fiscal years ended December 31, 1992 and December 31, 1991, respectively, Commission file 2-23772, and are incorporated herein by reference. 2. Supplementary Data None Item 9.	Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure None PART III Items omitted pursuant to General Instructions J(1)(a) and (b) of Form 10-K. PART IV Item 14.					Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) List the following documents filed as a part of the report: 1. All financial statements. See Item 8. 2. Financial statement schedules. See Item 8. 3. Exhibits (1)a. The Distribution Agreement dated November 18, 1988, between Registrant and IDS Financial Services Inc., filed electronically as Exhibit 1(a) to the Registration Statement for the American Express International Investment Certificate (now called the IDS Investors Certificate), is incorporated herein by reference. (1)b. Form of the Distribution Agreement for the American Express Savings Certificate between Registrant and American Express Service Corporation, filed electronically as Exhibit 1(b) to the Registration Statement for the American Express International Investment Certificate (now called the IDS Investors Certificate), is incorporated herein by reference. (1)c. Selling Agent Agreement dated June 1, 1990, between American Express Bank International and IDS Financial Services Inc., for the IDS Investors and IDS Stock Market Certificates, filed electronically as Exhibit 1(c) to the Post-Effective Amendment No. 5 to Registration Statement No. 33-26844 for the IDS Investors Certificate, is incorporated herein by reference. (1)d. Marketing Agreement dated October 10, 1991, between Registrant and American Express Bank Ltd., filed electronically as Exhibit 1(d) to Post-Effective Amendment No. 31 to Registration Statement No. 2-55252 for the Series D-1 Investment Certificate, is incorporated herein by reference. (3)a. The ISA Certificate of Incorporation and ISA By- Laws, filed electronically as Exhibit 3(a) and 3(c) to Post-Effective Amendment No. 2 to Registration Statement No. 2-95577 are incorporated herein by reference. (3)c. Certificate of Amendment, dated April 2, 1984, to ISA's Certificate of Incorporation filed electronically as Exhibit 3(b) to Post-Effective Amendment No. 2 to Registration Statement No. 2-95577 is incorporated herein by reference. (4) Forms of Cash Reserve Certificate, Future Value Certificate, Installment Investment Certificate, Series D-1 Investment Certificate and Variable Term Certificate filed electronically as Exhibit 4 to Post- Effective Amendment No. 2 to Registration Statement No. 2-95577 are incorporated by reference. Form of Certificate for IDS Stock Market Certificate filed electronically as Exhibit 4 to Pre-Effective Amendment No. 2 to Registration Statement No. 33-22503, is incorporated herein by reference. (10)a. The Investment Advisory and Services Agreement between ISA and IDS/American Express Inc. dated January 12, 1984 filed electronically as Exhibit 10(a) to Post- Effective Amendment No. 2 to Registration Statement No. 2-95577 is incorporated herein by reference. (10)b. Depository and Custodial Agreement dated September 30, 1985 between IDS Certificate Company and IDS Trust Company, filed electronically as Exhibit 10(b) to Registrant's Post-Effective Amendment No. 2 to Registration Statement No. 2-95577 is incorporated herein by reference. (10)c. Loan Agreement between Registrant and Investors Syndicate Development Corporation dated October 13, 1970, filed electronically as Exhibit 10(c) to Post- Effective Amendment No. 2 to Registration Statement No. 2-95577 is incorporated herein by reference. (10)d. Agreement for the servicing of Residential Mortgage Loans between ISA and Advance Mortgage Company, Ltd., dated August 31, 1980, filed electronically as Exhibit 10(d) to Post-Effective Amendment No. 2 to Registration Statement No. 2-95577 is incorporated herein by reference. (10)e. Agreement for the servicing of Commercial Mortgage Loans between ISA and FBS Mortgage Corporation, dated October 1, 1980, filed electronically as Exhibit 10(e) to Post-Effective Amendment No. 2 to Registration Statement No. 2-95577 is incorporated herein by reference. (10)f. Agreement by and between registrant and IDS/American Express Inc. ("IDS") providing for the purchase by IDS of a block of portfolio securities from registrant, filed as Exhibit 10.5 to the September 30, 1981 Quarterly Report on Form 10-Q of Alleghany Corporation, is incorporated herein by reference. (10)g. Transfer Agent Agreements for the servicing of the American Express Savings Certificate, filed electronically as Exhibit 10(g) to Pre-Effective Amendment No. 1 to Registration Statement No. 33-25385, are incorporated herein by reference. (10)h. Foreign Deposit Agreement dated November 21, 1990, between IDS Certificate Company and IDS Bank & Trust, filed electronically as Exhibit 10(h) to Post- Effective Amendment No. 5 to Registration Statement No. 33-26844, is incorporated herein by reference. (25)a. Officers' Power of Attorney dated February 1, 1994, filed as Exhibit 25(a) to Post-Effective Amendment No. 34 to Registration Statement No. 2-55252, is incorporated herein by reference. (25)b. Directors' Power of Attorney dated February 1, 1994, filed as Exhibit 25(b) to Post-Effective Amendment No. 34 to Registration Statement No. 2-55252, is incorporated herein by reference. (b) Reports on Form 8-K filed during the last quarter of the period covered by this report. None SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. REGISTRANT IDS CERTIFICATE COMPANY /s/ Stuart A. Sedlacek BY BRUCE A. KOHN NAME AND TITLE Stuart A. Sedlacek* ** President DATE March 29, 1994 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. BY BRUCE A. KOHN NAME AND TITLE Stuart A. Sedlacek* ** President Principal Executive Officer and Director DATE March 29, 1994 BY BRUCE A. KOHN NAME AND TITLE John M. Knight,* Controller (Principal Accounting Officer) DATE March 29, 1994 BY BRUCE A. KOHN NAME AND TITLE Morris Goodwin,* Treasurer and Principal Financial Officer DATE March 29, 1994 BY BRUCE A. KOHN NAME AND TITLE David R. Hubers, Director DATE March 29, 1994 BY BRUCE A. KOHN NAME AND TITLE Charles W. Johnson, Director DATE March 29, 1994 BY BRUCE A. KOHN NAME AND TITLE Edward Landes,** Director DATE March 29, 1994 BY BRUCE A. KOHN NAME AND TITLE Peter A. Lefferts,* Director DATE March 29, 1994 BY BRUCE A. KOHN NAME AND TITLE John V. Luck, Director DATE March 29, 1994 BY BRUCE A. KOHN NAME AND TITLE James A. Mitchell, Director DATE March 29, 1994 BY BRUCE A. KOHN NAME AND TITLE Harrison Randolph, Director DATE March 29, 1994 BY BRUCE A. KOHN NAME AND TITLE Gordon H. Ritz,** Director DATE March 29, 1994 * Signed pursuant to Officers' Power of Attorney dated February 1, 1994 filed as Exhibit 25(a) to Post-Effective Amendment No. 34 to Registration Statement No. 2-55252, incorporated herein by reference. _______________________ Bruce A. Kohn ** Signed pursuant to Directors' Power of Attorney dated February 1, 1994 filed as Exhibit 25(b) to Post-Effective Amendment No. 34 to Registration Statement No. 2-55252, incorporated herein by reference. _______________________ Bruce A. Kohn REPORT OF INDEPENDENT AUDITORS The Board of Directors and Security Holders IDS Certificate Company: We have audited the accompanying balance sheets of IDS Certificate Company as of December 31, 1993 and 1992, and the related statements of operations, stockholder's equity, and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the index at item 8. These financial statements and schedules are the responsibility of the management of IDS Certificate Company. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements and schedules are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements and schedules. Our procedures included confirmation of investments owned as of December 31, 1993 and 1992 by correspondence with custodians and brokers. 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 financial statements referred to above present fairly, in all material respects, the financial position of IDS Certificate Company at December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. ERNST & YOUNG Minneapolis, Minnesota February 3, 1994 IDS Certificate Company Responsibility for Preparation of Financial Statements The management of IDS Certificate Company is responsible for the preparation of the financial statements and related notes included in this Form 10-K. The statements have been prepared in conformity with generally accepted accounting principles appropriate in the circumstances, and include amounts based on the best judgment of management. Financial information included elsewhere in this Form 10-K is consistent with these financial statements. In recognition of its responsibility for the integrity and objectivity of data in the financial statements, management maintains a system of internal accounting controls. This system includes an organizational structure with clearly defined lines of responsibility and delegation of authority. To ensure the effective administration of internal control, employees are carefully selected and trained, written policies and procedures are developed and disseminated, and appropriate communication channels are provided to foster an environment conducive to the effective functioning of controls. The system is supported by an internal auditing function that reports its findings to management throughout the year. IDS Certificate Company's independent auditors are engaged to express an opinion on the year-end financial statements. They objectively and independently review the performance of management in carrying out its responsibility for reporting operating results and financial condition. With the coordinated support of the internal auditors, they review and test the system of internal accounting controls and the data contained in the financial statements. Notes to Financial Statements ($ in thousands unless indicated otherwise) - ------------------------------------------------------------------- 1. Summary of Significant Accounting Policies IDS Certificate Company (IDSC) is a wholly owned subsidiary of IDS Financial Corporation (IDS), which is a wholly owned subsidiary of American Express Company. IDSC is in the business of issuing face-amount investment certificates. Described below are certain accounting policies that are important to an understanding of the accompanying financial statements. Basis of Financial Statement Presentation The accompanying financial statements are presented on a historical cost basis without adjustment of the net assets attributable to the 1984 acquisition of IDS by American Express Company. They include only the accounts of IDSC. IDSC uses the equity method of accounting for its investment in its wholly owned unconsolidated subsidiary, which is the method prescribed by the Securities and Exchange Commission (SEC) for issuers of face-amount certificates. Certain amounts from prior years have been reclassified to conform to the current year presentation. Fair Values of Financial Instruments The fair values of financial instruments disclosed in the notes to financial statements are estimates based upon current market conditions and perceived risks, and require varying degrees of management judgment. Preferred Stock Dividend Income IDSC recognizes dividend income from cumulative redeemable preferred stocks with fixed maturity amounts on an accrual basis similar to that used for recognizing interest income on debt securities. Securities Cash equivalents are carried at amortized cost, which approximates fair value. IDSC has defined cash and cash equivalents as cash in banks and highly liquid investments with a maturity of three months or less at acquisition and are not interest rate sensitive. IDSC's investment program considers investment securities as long-term investments and is designed to meet contractual investment certificate obligations. IDSC has the ability to hold these securities to their maturities and has the intent to hold them for the foreseeable future. Notes to Financial Statements (continued) - ------------------------------------------------------------------- Marketable equity securities and other securities without fixed maturity dates are carried at aggregate cost or market value, whichever is lower. A valuation allowance is established for net unrealized depreciation on marketable equity securities and is charged against stockholder's equity. Bonds and notes, and preferred stocks that either must be redeemed by the issuer or may be redeemed by the issuer at the holder's request are carried at amortized cost. The basis for determining realized gains and losses on securities is the amortized cost of bonds and notes on a "first-in, first-out" basis and the average cost of individual issues of stocks. When there is a decline in value, that is other than temporary, the securities are carried at estimated realizable value. First Mortgage Loans on Real Estate Mortgage loans are carried at amortized cost, less reserves for losses, which is the basis for determining any realized gains or losses. When economic evaluations of the underlying real estate indicate a loss on a loan is likely to occur, an allowance for such loss is recorded. IDSC generally stops accruing interest on loans for which interest is delinquent more than three months. Certificates Investment certificates may be purchased either with a lump-sum payment or by installment payments. Certificate holders are entitled to receive at maturity a definite sum of money. Payments from certificate holders are credited to investment certificate reserves. Investment certificate reserves accumulate at specified percentage rates. Reserves also are maintained for advance payments made by certificate holders, accrued interest thereon, and for additional credits and accrued interest thereon. On certificates allowing for the deduction of a surrender charge, the cash surrender values may be less than accumulated investment certificate reserves prior to maturity dates. Cash surrender values on certificates allowing for no surrender charge are equal to certificate reserves. The payment distribution, reserve accumulation rates, cash surrender values, reserve values and other matters are governed by the Investment Company Act of 1940 ("the 1940 Act"). Deferred Distribution Fee Expense On certain series of certificates, distribution fees are deferred and amortized over the estimated lives of the related certificates, which is approximately 10 years. Upon surrender, unamortized deferred distribution fees are charged against income. Federal Income Taxes IDSC's taxable income or loss is included in the consolidated federal income tax return of American Express Company. IDSC provides for income taxes on a separate return basis, except that, Notes to Financial Statements (continued) - ------------------------------------------------------------------- under an agreement between IDS and American Express Company, tax benefits are recognized for losses to the extent they can be used in the consolidated return. It is the policy of IDS and its subsidiaries that IDS will reimburse a subsidiary for any tax benefits recorded. 2. Deposit of Assets and Maintenance of Qualified Assets A. Under the provisions of its certificates and the 1940 Act, IDSC was required to have qualified assets (as that term is defined in Section 28(b) of the 1940 Act) in the amount of $2,767,057 and $3,244,505 at Dec. 31, 1993 and 1992, respectively. IDSC had qualified assets of $2,931,737 at Dec. 31, 1993 and $3,411,173 at Dec. 31, 1992, including investment securities loaned to brokers of $nil and $1,643 at Dec. 31, 1993 and 1992, respectively. Qualified assets are valued in accordance with such provisions of the Code of the District of Columbia as are applicable to life insurance companies. Qualified assets for which no provision for valuation is made in such Code are valued in accordance with rules, regulations or orders prescribed by the SEC. These values are the same as financial statement carrying values, except for securities which are carried at the lower of aggregate cost or market in the financial statements but are valued at cost for qualified asset and deposit maintenance purposes. B. Pursuant to provisions of the certificates, the 1940 Act, the central depositary agreement and to requirements of various states, qualified assets of IDSC were deposited as follows: Net unrealized gains on fixed maturities amounted to $112,712 and $77,435 at Dec. 31, 1993 and 1992, respectively. IDSC's reserve for possible losses on its below investment grade securities was $2,049 at Dec. 31, 1993 compared to $14,210 at Dec. 31, 1992. The decrease reflects sales and exchanges of certain of these issues in 1993. The amortized cost and fair value of investments in securities with fixed maturities by contractual maturity, are shown below. Cash flows will differ from contractual maturities because issuers may have the right to call or prepay obligations. Proceeds from sales of investments in securities with fixed maturities during 1993 and 1992 were $330,851 and $420,713, respectively. Gross gains of $3,272 and $17,514 and gross losses of $19,927 and $2,730 were realized on those sales during 1993 and 1992, respectively.Notes to Financial Statements (continued) - ------------------------------------------------------------------- B. Investments in securities with fixed maturities comprised 85 percent and 88 percent of IDSC's total invested assets at Dec. 31, 1993 and 1992, respectively. Securities are rated by Moody's and Standard & Poors (S&P), or by IDS internal analysts, using criteria similar to Moody's and S&P, when a public rating does not exist. A summary of investments in securities with fixed maturities by rating of investment is as follows: Rating 1993 1992 - ------------------------------------------ Aaa/AAA...................... 35% 35% Aa/AA........................ 4 4 Aa/A......................... 1 1 A/A.......................... 22 21 A/BBB........................ 3 6 Baa/BBB...................... 31 28 Below investment grade....... 4 5 - ------------------------------------------ 100% 100% - ------------------------------------------ Of the securities rated Aaa/AAA, 87 percent at Dec. 31, 1993 and 89 percent at Dec. 31, 1992, are U.S. Government Agency mortgage-backed securities that are not rated by a public rating agency. Approximately 23 percent at Dec. 31, 1993 and 25 percent at Dec, 31, 1992 of other securities with fixed maturities are rated by IDS internal analysts. No investment in any one issuer at Dec. 31, 1993 and 1992, is greater than two percent and one percent, respectively, of IDSC's total investment in securities with fixed maturities. At Dec. 31, 1993 and 1992, approximately ten percent and seven percent, respectively, of IDSC's invested assets were first mortgage loans on real estate. A summary of first mortgage loans by region and by type of real estate is as follows: Region 1993 1992 Property Type 1993 1992 - -------------------------------- -------------------------------------- South Atlantic....... 23% 21% Apartments................. 40% 46% East North Central... 23 25 Retail/shopping centers.... 28 19 West North Central... 21 24 Industrial buildings....... 13 11 Middle Atlantic...... 14 16 Office buildings........... 10 12 West South Central... 8 6 Hotels/motels.............. 1 2 Mountain............. 6 3 Retirement homes........... 1 1 Pacific.............. 3 2 Residential................ - 3 New England.......... 2 3 Other...................... 7 6 - -------------------------------- -------------------------------------- 100% 100% 100% 100% - -------------------------------- -------------------------------------- Notes to Financial Statements (continued) - ------------------------------------------------------------------- The carrying amounts and fair values of first mortgage loans on real estate are as follows at Dec. 31. The fair values are estimated using discounted cash flow analysis, using market interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. At Dec. 31, 1993 and 1992, commitments for fundings of first mortgage loans, at market interest rates, aggregated $nil and $30.6 million, respectively. IDSC employs policies and procedures to ensure the creditworthiness of the borrowers and that funds will be available on the funding date. IDSC's first mortgage loan fundings are restricted to 75 percent or less of the market value of the real estate at the time of the loan funding. Management believes there is no fair value for these commitments. C. IDSC reserves freedom of action with respect to its acquisition of restricted securities that offer advantageous and desirable investment opportunities. In a private negotiation, IDSC may purchase for its portfolio all or part of an issue of restricted securities. Since IDSC would intend to purchase such securities for investment and not for distribution, it would not be "acting as a distributor" if such securities are resold by IDSC at a later date. The fair values of restricted securities are determined by the Board of Directors using the procedures and factors described in paragraph A of note 3.Notes to Financial Statements (continued) - ------------------------------------------------------------------- In the event IDSC were to be deemed to be a distributor of the restricted securities, it is possible that IDSC would be required to bear the costs of registering those securities under the Securities Act of 1933, although in most cases such costs would be borne by the issuer of the restricted securities. D. IDSC will implement, effective Jan. 1, 1994, Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities". Under the new rules, debt securities that IDSC has both the positive intent and ability to hold to maturity will be carried at amortized cost. Debt securities that IDSC does not have the positive intent and ability to hold to maturity and all marketable equity securities will be classified as available-for-sale and carried at fair value. Unrealized gains and losses on securities classified as available- for-sale will be carried as a separate component of Stockholder's Equity. The effect of the new rules will be to increase Stockholder's Equity by approximately $4,304, net of taxes, as of Jan. 1, 1994. The measurement of unrealized securities gains and losses in Stockholder's Equity is affected by market conditions, and therefore, subject to volatility. The new rules will not have a material impact on IDSC's results of operations. 4. Certificate Reserves Reserves maintained on outstanding certificates have been computed in accordance with the provisions of the certificates and Section 28 of the 1940 Act. The average rates of accumulation on certificate reserves at Dec. 31, 1993 and 1992 were: Notes to Financial Statements (continued) - ------------------------------------------------------------------- A. There is no minimum rate of accrual on these reserves. Interest is declared periodically, quarterly or annually, in accordance with the terms of the separate series of certificates. B. On certain series of single payment certificates, additional interest is predeclared for periods greater than one year. At Dec. 31, 1993, $2,726 of retained earnings had been appropriated for the predeclared additional interest, which represents the difference between certificate reserves on these series, calculated on a statutory basis, and the reserves maintained per books. C. Certain series of installment certificates guarantee accrual of interest on advance payments at an average of 3.05 percent. IDSC has increased the rate of accrual to 3.51 percent through April 30, 1995. An appropriation of retained earnings amounting to $25 has been made, which represents the estimated additional accrual that will result from the increase granted by IDSC. D. IDS Stock Market Certificate enables the certificate holder to participate in any relative rise in a major stock market index without risking loss of principal. Generally the certificate has a term of 12 months and may continue for up to 14 successive terms. The reserve balance at Dec. 31, 1993 and 1992 was $402,801 and $445,021, respectively. E. The carrying amounts and fair values of certificate reserves consisted of the following at Dec. 31, 1993 and 1992. Fair values of certificate reserves with interest rate terms of one year or less approximated the carrying values less any applicable surrender charges. The fair values for other certificate reserves is a discounted cash flow analysis using interest rates currently offered for certificates with similar remaining terms, less any applicable surrender charges.Notes to Financial Statements (continued) - ------------------------------------------------------------------- 5. Dividend Restriction Certain series of installment certificates outstanding provide that cash dividends may be paid by IDSC only in calendar years for which additional credits of at least one-half of 1 percent on such series of certificates have been authorized by IDSC. This restriction has been removed for 1994 and 1995 by action of IDSC on additional credits in excess of this requirement. 6. Fees Paid to IDS and Affiliated Companies ($ not in thousands) A. The basis of computing fees paid or payable to IDS for investment advisory and services is: The investment advisory and services agreement with IDS provides for a graduated scale of fees equal on an annual basis to 0.75 percent on the first $250 million of total book value of assets of IDSC, 0.65 percent on the next $250 million, 0.55 percent on the next $250 million, 0.50 percent on the next $250 million and 0.45 percent on the amount in excess of $1 billion. The fee is payable monthly in an amount equal to one-twelfth of each of the percentages set forth above. Excluded from assets for purposes of this computation are first-mortgage loans, real estate and any other asset on which IDSC pays a service fee.Notes to Financial Statements (continued) - ------------------------------------------------------------------- B. The basis of computing fees paid or payable to IDS Financial Services Inc. (an affiliate) for distribution services is: Fees payable to IDS Financial Services Inc. on sales of IDSC's certificates are based upon terms of agreements giving IDS Financial Services Inc. the exclusive right to distribute the certificates covered under the agreements. The agreements provide for payment of fees over a period of time. The aggregate fees payable under the agreements per $1,000 face amount of installment certificates and $1,000 purchase price of single payments, and a summary of the periods over which the fees are payable, shown by series are: Fees on Cash Reserve and Flexible Savings (formerly Variable Term) certificates are paid at a rate of 0.25 percent of the purchase price at time of issuance and 0.25 percent of the reserves maintained for these certificates at the beginning of the second and subsequent quarters from issue date. Fees on the Investors Certificate are paid at an annualized rate of 1 percent of the reserves maintained for the certificates. Fees are paid at the end of each term on certificates with a one, two or three-month term. Fees are paid each quarter from date of issuance on certificates with a six, 12, 24 or 36-month term. Fees on the Stock Market Certificate are paid at a rate of 1.25 percent of the purchase price on the first day of the certificate's term and 1.25 percent of the reserves maintained for these certificates at the beginning of each subsequent term. (a) At the end of the sixth through the 10th year, an additional fee is payable of 0.5 percent of the daily average balance of the certificate reserve maintained during the sixth through the 10th year, respectively.Notes to Financial Statements (continued) - ------------------------------------------------------------------- C. The basis of computing depositary fees paid or payable to IDS Bank & Trust (an affiliate) is: - ------------------------------------------------------------------- Maintenance charge per account..... 5 cents per $1,000 of assets on deposit Transaction charge................. $20 per transaction Security loan activity: Depositary Trust Company receive/deliver................ $20 per transaction Physical receive/deliver......... 25 per transaction Exchange collateral.............. 15 per transaction - ----------------------------------------------------------------------- A transaction consists of the receipt or withdrawal of securities and commercial paper and/or a change in the security position. The charges are payable quarterly except for maintenance, which is an annual fee. D. The basis for computing fees paid or payable to American Express Service Corporation (an affiliate) in connection with the American Express Savings certificate was: Distribution Fees - Fees were paid at a rate of 0.25 percent of the reserves maintained at the end of the first and subsequent calendar quarters. Transfer Agent Fees - Fees of $3.50 per certificate account were paid each month. E. The basis for computing fees paid or payable to American Express Bank Ltd. (an affiliate) for the distribution of the IDS Special Deposits certificate on an annualized basis is 0.80 percent of the reserves maintained for the certificates on an amount from $250,000 to $499,000, 0.65 percent on an amount from $500,000 to $999,000 and 0.50 percent on an amount $1,000,000 or more. Fees are paid at the end of each term on certificates with a one, two or three-month term. Fees are paid at the end of each quarter from date of issuance on certificates with a six, 12, 24 or 36-month term. Notes to Financial Statements (continued) - ------------------------------------------------------------------- 7. Income Taxes Income tax expense (benefit) as shown in the statement of operations for the three years ended Dec. 31, consists of: Income tax expense (benefit) differs from that computed by using the U.S. statutory rate of 35 percent for 1993 and 34 percent for 1992 and 1991. The principal causes of the difference in each year are shown below: Deferred income taxes result from the net tax effects of temporary differences. Temporary differences are differences between the tax bases of assets and liabilities and their reported amounts in the financial statements that will result in differences between income for tax purposes and income for financial statement purposes in future years. Principal components of IDSC's deferred tax assets and liabilities as of Dec. 31, are as follows: 9. Options IDSC offers a series of certificates which pay interest based upon the relative change in a major stock market index between the beginning and end of the certificates' term. The certificate holders have the option of participating in the full amount of increase in the index during the term (subject to a specified maximum) or a lesser percentage of the increase plus a guaranteed minimum rate of interest. As a means of hedging its obligations under the provisions of these certificates, IDSC purchases and writes call options on the major market index. The options are cash settlement options, that is, there is no underlying security to deliver at the time the contract is closed out. There is the risk that the counterparties to the purchased call option contracts may be unable to fulfill their obligations. IDSC employs policies and procedures to ensure the adequacy of the creditworthiness of counterparties. Following is a summary of open option contracts at Dec. 31, 1993 and 1992. Notes to Financial Statements (continued) - ------------------------------------------------------------------- The option contracts are less than one year in term and are carried at the aggregate of the amortized cost and underlying intrinsic value of the contracts. These carrying amounts may be different than fair value depending on market conditions and other factors. The amortization of the cost of purchased and the proceeds of written call options is included net in investment expenses and the changes in the intrinsic value of the contracts are included net in provision for certificate reserves, in the statement of operations. The purchased options are included in other qualified assets and the written options are included in other liabilities. The carrying amounts and fair values of options consisted of the following at Dec. 31, 1993 and 1992. Fair values are determined using the procedures and factors described in paragraph A of note 3. PAGE 44 SCHEDULE I NOTES: (a) The classification "residential" includes single dwellings only. business". (b) Real estate taxes and easements, which in the opinion of the Company are not undue burden on the properties, have been excluded from the determination of "prior liens". (c) In this schedule III, carrying amount of mortgage loans represents unpaid principal balances plus unamortized premiums less unamortized dicounts and allowance for loss. (d) Interest in arrears for less than three months has been disregarded in computing the total amount of principal subject to delinquent interest. The amounts of mortgage loans being forclosed are also included in amounts subject to delinquent interest. (e) Information as to interest due and accrued at the end of the period is shown by type of mortgage loan. Information as to interest due and accrued for the various classes within the types of mortgage loans is not readily available and the obtaining thereof would involve unreasonable effort and expense. The Company does not accrue interest on loans which are over three months delinquent. (f) Information as to interest income by type and class of loan has been omitted because it is not readily available and the obtaining thereof would involve unreasonable effort and expense. In lieu thereof, the average gross interest rates (exclusive of amort- tization of discounts and premiums) on mortgage loans held at December 31, 1993 are shown by type and class of loan. The average gross interest rates on mortgage loans held at December 31, 1993, 1992 and 1991 are summarized as follows: 1993 1992 1991 First mortgages: ----- ----- ----- Insured by Federal Housing Administration 7.076% 5.817% 5.765% Partially guaranteed under Servicemen's Readjustment Act of 1944, as amended 8.000 6.719 6.447 Other 9.055 9.282 9.628 ----- ----- ----- Combined average 9.055% 9.207% 9.433% ===== ===== ===== (g) Following is a reconciliation of the carrying amount of mortgage loans for the years ended December 31, 1993, 1992 and 1991. 1993 1992 1991 ---- ---- ---- [S] [C] [C] [C] Balance at beginning of period $ 233,796 $ 145,055 $ 96,083 Additions during period: New loans acquired: Nonaffiliated companies 59,183 98,314 61,990 Allowance for loss transferred to real estate 530 350 0 Allowance for loss real estate 220 0 0 Amortization of discount/premium 90 61 129 ---------- ---------- ---------- Total additions 60,023 98,725 62,119 ---------- ---------- ---------- 293,819 243,780 158,202 ---------- ---------- ---------- Deductions during period: Collections of principal 5,908 9,484 12,147 Cost of mortgages sold 6,046 0 0 Allowance for loss 0 500 782 Writeoff 0 0 218 ---------- ---------- ---------- Total deductions 11,954 9,984 13,147 ---------- ---------- ---------- Balance at end of period $ 281,865 $ 233,796 $ 145,055 ========== ========== ========== (h) The aggregate cost of mortgage loans for federal income tax purposes at December 31, 1993 was $282,865. (i) At December 31, 1993, an allowance for loss of $961 is recorded to reduce the carrying value of conventional loans since evidence indicates that a loss is likely to occur. Part 4 - Amounts Periodically Credited to Certificate Holders' Accounts to Accumulate the Maturity Amount of Installment Certificates. Information as to (1) amounts periodically credited to each class of security holders' accounts from installment payments and (2) such other amounts periodically credited to accumulate the maturity amount of the certificate (on a $1,000 face-amount certificate basis for the term of the certificate), is filed in Part 4 of Schedule IX as part of Post- effective Amendment No. 9 to Registration Statement No. 2-17681, Post effective Amendment No. 1 to Registration Statement No. 2-23772 and Post-effective Amendment No. 1 to Registration Statement No. 2-258081 and is incorporated herein by reference.
856716_1993.txt	856716	1993				ITEM 3. LEGAL PROCEEDINGS Toca On March 4, 1993, the Company filed a complaint against Warren Petroleum Company, Arco Oil & Gas Co., Conoco Inc., Trident NGL, Inc. and other owners of the Yscloskey Gas Plant located in Louisiana (the "Owners") in the United States District Court for the Eastern District of Louisiana, alleging various violations by the defendants of the federal anti-trust laws in connection with a Hydrocarbon Fractionation Agreement at its Toca plant between the Company and the Owners of the Yscloskey plant. The Company also filed a companion state-court action involving the same parties in Civil District Court for the Parish of Orleans, State of Louisiana, which the defendants removed to United States District Court for the Eastern District of Louisiana. The Company and Warren Petroleum Company (in its capacity as the designated Operator for the Yscloskey Plant) have recently negotiated a new Hydrocarbon Fractionation Agreement, which has been executed by substantially all of the Owners of the Yscloskey Plant. The new 15-year agreement provides for a reduced fractionation fee of 9.25% and eliminates the uncertainty regarding uneconomic performance of the Yscloskey plant. The Company anticipates dismissing the various complaints with prejudice. Edgewood On January 16, 1991, problems at the Company's Edgewood Plant relating to both equipment that removes hydrogen sulfide from unprocessed natural gas and the monitoring equipment owned by the purchaser of the residue gas, Enserch Corporation, doing business as Lone Star Gas Company ("Lone Star"), allowed residue gas containing hydrogen sulfide to enter Lone Star's transmission line supplying residue gas to Emory, Texas. The Company has been named as a co-defendant, along with Lone Star, in the following complaints relating to the incident: Gary Prather, et al. v. Enserch ------------------------------- Corporation, et al., filed March 15, 1993, Barbara Rogers, et al., v. Enserch ------------------- ---------------------------------- Corporation, et al. filed March 16, 1993, Judy Silvey, et al. v. Enserch, et ------------------- ---------------------------------- al., filed May 13, 1993, Floyd Rogers, et al. v. Enserch, et al., filed May --- --------------------------------------- 14, 1993, Blair Schamlain, et al. v. Enserch, et al., filed May 25, 1993, ------------------------------------------ Betty Adair v. Enserch, et al., filed on July 14, 1993, Doris Hass v. Enserch ------------------------------ --------------------- Corporation, et al., filed on December 17, 1993, Allie Ruth Harris v. Enserch ------------------- ---------------------------- Corporation, et al., filed on December 17, 1993, Sandra Parker, et al. v ------------------- ----------------------- Enserch Corporation, et al., filed on January 13, 1994, and Carma Brumit v. --------------------------- --------------- Enserch, et al., filed on January 18, 1994. --------------- All the cases have been filed in the District Court, Rains County, Texas, 354th Judicial District, and make similar claims, asserting, among other things, that the defendants breached an implied warranty of merchantability, falsely represented that the residue gas was safe, were negligent and are liable under a strict liability theory. The plaintiffs have alleged a variety of respiratory and neurological illnesses and are seeking treble damages, exemplary damages and attorneys' fees. Prior to the filing of the complaints, the Company received demand letters from the plaintiffs that sought, in the aggregate, approximately $36 million. Damages claimed in the lawsuits are in excess of $13.5 million. The Company believes that it has meritorious defenses to the claims and intends to defend vigorously against any such claims. The Company is currently conducting extensive pre-trial discovery. The underwriters of the Company's general liability insurance policy have indicated preliminarily that such policy appears to cover the types of claims that have been asserted, subject to their right to deny coverage based upon, among other things, final determination of causation and the exact nature of the damages. Granger On December 6, 1993, Green River Gathering Company ("Green River") and Mountain Gas filed a complaint against Washington Energy Exploration, Inc. ("Washington Energy") in District Court in Arapahoe County, Colorado seeking the payment of certain outstanding receivables from Washington Energy and a declaratory judgment that the gathering agreement between Washington Energy and Green River is in full force and effect. Mountain Gas is a wholly-owned subsidiary of the Company and Green River is a partnership owned by the Company and Mountain Gas. Washington Energy is the operator of wells producing approximately 33% of the natural gas transported through the Green River Gathering system to Mountain Gas' Granger facility. On December 27, 1993, Washington Energy filed an answer, counterclaim, crossclaim and request for trial by jury, denying the substance of the allegations and asserting certain affirmative defenses. Washington Energy has also made certain counterclaims seeking monetary damages relating to Green River's performance under the gathering agreement and under a processing agreement between the parties, along with a declaratory judgment that both agreements have been terminated. In addition, Washington Energy has made a crossclaim against two unaffiliated entities, each of which owned a portion of Green River during a portion of the period in question. The Company believes that Green River is in compliance with the gathering agreement and the processing agreement and that both are in full force and effect. The Company believes that it has meritorious defenses to the counterclaims and intends to defend vigorously against any such claims. The Company is currently conducting extensive pre-trial discovery. Katy Commencing in March 1993 and continuing through July 1993, Western Gas Resources Storage, Inc. ("Storage"), a wholly-owned subsidiary of the Company, filed a total of 165 condemnation actions in the County Court at Law No. 1 and No. 2 of Fort Bend County, Texas to obtain certain storage rights and rights- of-way relating to its Katy Gas Storage Facility. The County Court appointed panels of Special Commissioners that have awarded compensation to the owners whose rights were condemned. Certain of the land and mineral owners are seeking in County Court a declaration that Storage does not possess the right to condemn, or, in the alternative, that they should be awarded more compensation than previously awarded by the Special Commissioners. The Company believes that the outcome of such proceedings will not materially affect operation of the Katy Gas Storage Facility. The likelihood of any particular result, however, cannot be determined because the condemnation law under which the proceedings are being brought has never been interpreted by the courts. Woods/Moncrief In February 1994, the United States Appeals Court for the Tenth Circuit affirmed a district court judgment against the Company in the amount of $2.9 million, including interest, in Western Gas Processors Ltd. v. Woods Petroleum ---------------------------------------------- Corporation and W.A. Moncrief, Jr., d/b/a Moncrief Oil Company, which related -------------------------------------------------------------- to claims by certain producers that they had been underpaid. The Company has taken a charge to litigation reserves in the year ended December 31, 1993, in the amount of $2.4 million, as a result of the appellate court decision. The Company will not take any further action. ITEM 4.	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted to a vote of security holders during the quarter ended December 31, 1993. PART II ITEM 5.	ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS As of March 1, 1994, there were 25,703,829 shares of Common Stock outstanding held by 490 holders of record. The Common Stock is traded on the New York Stock Exchange under the symbol "WGR". The following table sets forth quarterly high and low closing sales prices as reported by the NYSE Composite Tape for the quarterly periods indicated. The Company paid annual dividends on the Common Stock aggregating $.20 per share during the years ended December 31, 1993 and 1992. The Company has declared a dividend of $.05 per share of common stock for the quarter ending March 31, 1994 to holders of record as of such date. Declarations of dividends are within the discretion of the Board of Directors and are dependent upon various factors, including the earnings, cash flow, capital requirements and financial condition of the Company. In addition, the Company's ability to pay dividends is restricted by certain covenants in its credit facilities including a prohibition on declaring or paying dividends that exceed, in the aggregate, the sum of $25 million plus 50% of the Company's consolidated net income earned after March 31, 1993 plus 50% of the cumulative net proceeds received from the sale of any equity securities sold after March 31, 1993. At December 31, 1993, this threshold amounted to $39 million, or $106 million subsequent to the issuance of 2,760,000 shares of $2.625 Convertible Preferred Stock in February 1994. ITEM 6.	ITEM 6. SELECTED CONSOLIDATED FINANCIAL AND OPERATING DATA The following table sets forth selected consolidated financial and operating data for the Company. Certain prior year amounts have been reclassified to conform to the presentation used in 1993. The data for the three years ended December 31, 1993 should be read in conjunction with the Company's Consolidated Financial Statements included elsewhere in this document. The selected consolidated financial data for the two years ended December 31, 1990 is derived from the Company's historical Consolidated Financial Statements. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." ($000s, except per share amounts and operating data): ITEM 7.	ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis relates to factors which have affected the consolidated financial condition and results of operations of the Company for the three years ended December 31, 1993. Certain prior year amounts have been reclassified to conform to the presentation used in 1993. Reference should also be made to the Company's Consolidated Financial Statements and related Notes thereto and the Selected Consolidated Financial and Operating Data included elsewhere in this document. Results of Operations Year ended December 31, 1993 compared to year ended December 31, 1992. Net income decreased $1.6 million and net cash provided by operating activities increased $7.9 million for the year ended December 31, 1993 compared to the same period in 1992. Revenues from the sale of residue gas increased $284.1 million for the year ended December 31, 1993 compared to the same period in 1992 due to an increase in residue gas prices of $.30 per Mcf and an increase in sales volumes of 315 MMcf per day. Of this volume increase, 246 MMcf per day is attributable to an increase in the sale of residue gas purchased from third parties, in part due to the acquisition of Citizens. The remaining volume increase is the result of increased production volumes at the Company's facilities, primarily due to the Mountain Gas and Black Lake acquisitions as well as new well hookups at the Midkiff/Benedum and Giddings facilities. Revenues from the sale of NGLs increased $43.7 million for the year ended December 31, 1993 compared to the same period in 1992 due to an increase in NGL sales volumes of 545 MGal per day which was somewhat offset by a $.01 per gallon decrease in the price of NGLs. Of the volume increase, 377 MGal per day is attributable to an increase in the sale of NGLs purchased from third parties. The remaining volume increase is the result of increased production volumes at the Company's facilities, primarily due to the Mountain Gas and Black Lake acquisitions as well as new well hookups at the Midkiff/Benedum and Giddings facilities. Other revenues increased approximately $1 million for the year ended December 31, 1993 compared to the same period in 1992 due to the termination of certain hedging transactions and interest rate swap agreements in 1993 which resulted in an increase of approximately $5.5 million compared to the same period in 1992. This increase was offset by the sale in 1992 of a 20% undivided interest in the Midkiff/Benedum gas processing plants to the major producer in the area of the plant for a pre-tax gain of approximately $4.5 million. Historically, product purchases as a percentage of residue gas and NGL sales from the Company's plant production approximated 70%. Product purchases as a percentage of residue gas and NGL sales from third-party purchases is substantially higher than the historical percentage and approximates 95%. The increase in the Company's combined percentage is primarily due to a significantly larger increase in the sales volume of products purchased from third parties compared to the sales volume sold from the Company's facilities. As a result, total product purchases as a percentage of residue gas and NGL sales increased approximately 6.3% to 81.5% for the year ended December 31, 1993 compared to the same period in 1992. Plant operating expense increased $7.3 million for the year ended December 31, 1993 compared to the same period in 1992 primarily due to the Mountain Gas and Black Lake acquisitions and an increase in repair and maintenance charges incurred at facilities acquired from UTP. Selling and administrative expense increased $4.2 million as a result of higher payroll and benefit charges and professional fees resulting from the Company's growing operations and its preparation for the Katy Gas Storage Facility, a litigation reserve established for the Woods/Moncrief lawsuit and franchise taxes resulting from the Company's expansion into states which do not charge income taxes, somewhat offset by increased overhead capitalized to the Company's construction projects. In 1993, overhead capitalized to the Company's construction projects increased approximately $3.3 million when compared to the same period in 1992. Amounts capitalized to such projects in 1994 are expected to decline due to the completion of several major projects and fewer projects currently under construction by the Company. Depreciation, depletion and amortization expense increased $17.5 million for the year ended December 31, 1993 compared to the same period in 1992 is primarily due to the Mountain Gas and Black Lake acquisitions. In January 1994, the Katy Gas Storage Facility commenced operations and, as a result, depreciation, depletion and amortization expense associated with the Katy Gas Storage Facility will be approximately $3.0 million per year. Interest expense increased $2.5 million for the year ended December 31, 1993 compared to the same period in 1992 due to higher average long-term debt outstanding. In 1993, interest incurred and capitalized during the construction period of new projects increased approximately $2.8 million when compared to the same period in 1992. Amounts capitalized to such projects in 1994 are expected to decline due to the completion of several major projects and fewer projects currently under construction by the Company. This increase will be more than offset by a reduction in interest expense related to the application of the net proceeds of $133.5 million from the sale of 2,760,000 shares of $2.625 Convertible Preferred Stock in February 1994 against the Company's Revolving Credit Facility. In 1993, the corporate income tax rate was increased from 34% to 35%. This rate increase resulted in an increase in deferred income taxes of approximately $2.1 million for the year ended December 31, 1993. Year ended December 31, 1992 compared to year ended December 31, 1991. Net income and net cash provided by operating activities increased $18.8 million and $58.5 million, respectively, for the year ended December 31, 1992 compared to the same period in 1991. Average gas prices increased $.13 per Mcf and average NGL prices decreased $.04 per gallon for the year ended December 31, 1992 compared to the same period in 1991, while average gas sales increased 132 MMcf per day and average NGL sales increased 1,303 MGal per day. Revenues from the sale of residue gas and NGLs increased $99.3 million and $140.0 million, respectively, for the year ended December 31, 1992 compared to the same period in 1991. These increases were primarily the result of increased production from Company facilities due to the acquisition of 12 plants from UTP in November 1991 and an increase in the sale of products purchased from third parties. Other revenues increased $6.0 million, primarily as a result of a $4.5 million gain on the sale of a 20% interest in the Midkiff and Benedum facilities in the fourth quarter of 1992. Product purchases as a percentage of residue gas and NGL sales increased 1.3% to 75.2% in 1992 compared to 1991. Product purchases as a percentage of residue gas and NGL sales of production from the Company's facilities is approximately 70%. Increasing the historical percentage are purchases of third party products which typically have a lower profit margin. The increase in plant operating expense for the year ended December 31, 1992 compared to the same period in 1991 was primarily due to the acquisition of the UTP facilities. Selling and administrative expense increased $8.7 million for the year ended December 31, 1992 compared to the same period in 1991 primarily due to higher salary and benefit costs, insurance and other administrative expenses related to the Company's acquisition of the UTP facilities. In addition, selling and administrative expenses increased as a result of additional franchise taxes due to increased operations in Texas and increased costs related to the Company's ongoing evaluation of potential acquisitions. The increase in depreciation expense for the year ended December 31, 1992 compared to the same period in 1991 was primarily due to the acquisition of the UTP facilities. Effective January 1, 1992, the Company reviewed the economic useful lives of its plant assets. As a result of this review, the lives of certain of these assets were changed to reflect more closely their remaining economic useful lives. The effect of this change was not material to the results of operations for the year ended December 31, 1992. The decrease in interest expense for the year ended December 31, 1992 compared to the same period in 1991 was due to lower bank rates on variable rate borrowings and lower average long-term debt outstanding. The decrease in the provision for income taxes as a percentage of income before taxes resulted from a reduction in the deferred income tax rate as prescribed by SFAS No. 109. Liquidity and Capital Resources The Company's sources of liquidity and capital resources historically have been net cash provided by operating activities, funds available under its financing facilities and proceeds from offerings of equity securities. In the past, these sources have been sufficient to meet the needs and finance the growth of the Company's business. Net cash provided by operating activities has been primarily affected by product prices, the Company's success in increasing the number and efficiency of its facilities and the volumes of natural gas processed by such facilities and the margin on third party residue gas purchased for resale. The Company's continued growth will be dependent upon success in the areas of additions to dedicated plant reserves, acquisitions, new project development and marketing. In the three years ended December 31, 1993, the Company's total sources of funds aggregated $823.9 million and was comprised of net cash provided by operating activities of $233.4 million, net borrowings under its credit agreement of $426.7 million, net proceeds received from the exercise of common stock options of $1.3 million, net proceeds from the issuance of the $2.28 Cumulative Preferred Stock of $33.4 million, net proceeds from the issuance of the 7.25% Convertible Preferred Stock of $38.2 million, net proceeds from the issuance of Common Stock of $71.3 million and net proceeds received from the disposition of property and equipment of $19.6 million. During the same period, the Company's use of such funds aggregated $819.5 million which were used primarily to make capital investments of $793.9 million, to pay dividends to holders of Common Stock of $12.3 million, to pay dividends to holders of 7.25% Convertible Preferred Stock and $2.28 Cumulative Preferred Stock of $9.1 million and to make distributions to minority interest holders in predecessor company of $4.2 million. On November 12, 1993, the Registration on Form S-3 (Registration No. 33-66516) was declared effective. The Registration provides for the sale of up to $200 million of debt securities and preferred stock and up to 4 million shares of common stock. On February 28, 1994, the Company sold, pursuant to the Registration, 2,760,000 shares of $2.625 Convertible Preferred Stock for net proceeds of $133.5 million, which have been used to repay a portion of the debt incurred under the Company's Revolving Credit facility in the Mountain Gas and Black Lake acquisitions. The Company has been successful overall in replacing production with new reserves. However, volumes of natural gas dedicated to some of the Company's plants have declined during recent years because additions to dedicated plant reserves have not fully offset production. In 1993, excluding reserves acquired in the Mountain Gas and Black Lake acquisitions and including reserves associated with Westana, the Company connected new reserves to its gathering systems replacing 118% of 1993 production. On a Company-wide basis, dedicated reserves, including certain proved undeveloped properties, totaled approximately 1.95 Tcf at December 31, 1993. An additional source of liquidity to the Company is volumes of residue gas and NGLs in storage facilities. The Company stores volumes of residue gas and NGLs primarily to assure an adequate supply for long-term sales contracts and for resale during periods when prices are favorable. At December 31, 1993, the Company held in storage approximately 17.3 million gallons of NGLs at an average cost of $.30 per gallon and 7.9 Bcf of residue gas at an average cost of $1.97 per Mcf ($1.81 per MMbtu). From time to time, the Company contracts on the futures market for the purchase and/or sale of stored residue gas and NGL products as a hedge against price changes. At December 31, 1993, 296 net contracts (10,000 MMbtus per contract) for the sale of residue gas in February 1994 through March 1995 at prices ranging from $1.87 per Mcf to $2.56 per Mcf were outstanding. At December 31, 1993, no such contracts for NGLs were outstanding. Capital Investment Program Between January 1, 1991 and December 31, 1993, the Company expended approximately $793.9 million on new projects and currently has authorized an additional $94.0 million for 1994. For the year ended December 31, 1993, the Company expended $491.4 million on the Mountain Gas and Black Lake acquisitions, the construction of the Katy Gas Storage Facility, connection of new reserves, acquire consolidating assets for existing systems and upgrades to existing and newly acquired facilities. For the year ended December 31, 1992, the Company expended a total of $68.4 million on the Katy Gas Storage Facility, the acquisition of gathering systems connecting new reserves to existing systems and upgrades to newly acquired facilities. For the year ended December 31, 1991, the Company expended a total of $234.1 million for the acquisition, construction and development of various facilities, including the UTP, Edgewood and Midkiff systems and the Reno Junction Isomerization facility, and the acquisition of producing gas wells. The Company financed the UTP acquisition by the private placement of $40 million of Convertible Preferred Stock with an institutional investor and with $100 million of long- term debt from its existing bank group. This long-term debt was subsequently reduced with the net proceeds of $71.3 million received from a common stock offering in November 1991. The Company has completed the construction of the Katy Gas Storage Facility. Lease acquisition and construction costs incurred through December 31, 1993, including pad gas, approximate $90 million and excludes capitalized pre-operating costs. The Katy Gas Storage Facility commenced operations in January 1994. The complex consists of a partially depleted natural gas reservoir with over 17 Bcf of working gas and the capability to deliver up to 400 MMcf/D of natural gas as well as a pipeline header system currently connecting seven pipelines with the capability to connect six additional pipelines. In order to maintain the volumes of natural gas dedicated to or processed by the Company's existing facilities, future capital expenditures for gathering systems needed to connect new reserves, acquire consolidating assets and to maintain existing facilities are anticipated to be approximately $25 million to $30 million per year. The availability of new reserves at existing facilities is somewhat affected by the price of crude oil or natural gas (depending on whether the natural gas is associated gas or gas well gas) which in turn stimulates new drilling at higher price levels. The Company anticipates spending an additional $64 million to $69 million on other capital projects. Depending on the timing of the Company's future projects, it may be required to seek additional sources of capital. The Company's ability to secure such capital is restricted by its credit facilities, although it may request additional borrowing capacity from the banks, seek waivers from the banks to permit it to borrow funds from third parties, seek replacement credit facilities from other lenders or issue additional equity securities. While the Company believes that it would be able to secure additional financing, if required, no assurance can be given that it will be able to do so or as to the terms of any such financing. Financing Facilities Revolving Credit Facility. In August 1993, the Company renegotiated a Revolving Credit Facility with its agent bank, and in September 1993 the agent bank completed the syndication of the facility with seven additional banks. The Company's variable rate Revolving Credit Facility provides for a maximum borrowing of $400 million, of which $345 million was outstanding at December 31, 1993, and, if not renewed, on August 31, 1996 any outstanding balance thereunder converts to a four-year term during which such balance will be repaid in equal quarterly installments. At the Company's option, the Revolving Credit Facility bears interest at certain spreads over the Eurodollar rate or at the agent bank's prime rate. The interest rate spreads were adjusted based on the Company's earnings ratio (earnings before interest and taxes divided by interest expense). At December 31, 1993, the spread was 1.0% for the Eurodollar rate resulting in an interest rate of 4.13% at December 31, 1993. The Company will pay a commitment fee on the unused commitment of .25% if the earnings ratio is greater than or equal to 4.5 to 1.0 or .375% if the ratio is less than 4.5 to 1.0. For the year ended December 31, 1993, the Company's earnings ratio was approximately 4.4 to 1.0. Term Loan Facility. The Company also has a Term Loan Facility with four banks for $50 million which bears interest at 9.87%. Payments on the Term Loan Facility of $25 million, $12.5 million and $12.5 million are due in September 1995, 1996 and 1997, respectively. The Company's Revolving Credit and Term Loan Facilities are subject to certain mandatory prepayment terms. If funded debt under these facilities exceeds four times the sum of the Company's last four quarters' cash flow (as defined in the agreement), the overage must be repaid in no more than six monthly payments commencing 90 days from notification. This mandatory prepayment threshold will be reduced to 3.75 to 1.00 at December 31, 1994 and 3.50 to 1.00 at December 31, 1995. The Term Loan Facility and Revolving Credit Facility are unsecured. The Company is required to maintain a current ratio of at least 1.0 to 1.0, a tangible net worth of at least $247 million, a debt to capitalization ratio of no more than 65% through March 31, 1994, 60% from April 1, 1994 through October 31, 1995 and 55% thereafter and an earnings ratio of not less than 2.0 to 1.0. The Company is prohibited from declaring or paying dividends that exceed the sum of $25 million plus 50% of consolidated net income earned after March 31, 1993 plus 50% of the cumulative net proceeds received from the sale of any equity securities sold after March 31, 1993. At December 31, 1993, this threshold amounted to $39 million, or $106 million subsequent to the issuance of the 2,760,000 shares of $2.625 Convertible Preferred Stock in February 1994. The Company generally utilizes excess daily funds to reduce any outstanding revolving credit balances to minimize interest expense and intends to continue such practice. Master Shelf Agreement. In December 1991, the Company entered into a Master Shelf Agreement (the "Master Shelf") with The Prudential Insurance Company of America ("Prudential") pursuant to which Prudential agreed to quote, from time-to-time, an interest rate at which Prudential or its nominee would be willing to purchase up to $100 million of the Company's senior promissory notes (the "Senior Notes"). Any such Senior Notes must mature in no more than 12 years, with an average life not in excess of 10 years, and will be unsecured. On October 27, 1992, the Company sold $25 million of 7.51% Senior Notes due 2000 and $25 million of 7.99% Senior Notes due 2003. Principal payments on the $50 million of Senior Notes of $8.3 million will be due on October 27 of each year from 1998 through 2003. On September 22, 1993, the Company sold $25 million of 6.77% Senior Notes due in a single payment on September 22, 2003 and on December 27, 1993, the Company sold $25 million of 7.23% Senior Notes due in a single payment on December 27, 2003. The Master Shelf contains certain financial covenants which conform with those contained in the Revolving Credit Facility. In July 1993, Prudential and the Company amended the Master Shelf to provide for an additional $50 million of borrowing capacity (for a total borrowing capacity of $150 million) and to extend the term of the Master Shelf to October 31, 1995. Senior Notes. On April 28, 1993 the Company sold $50 million of 7.65% Senior Notes due 2003 to a group of insurance companies led by Connecticut General Life Insurance Company. Principal payments on the $50 million of Senior Notes of $7.1 million will be due on April 30th of each year from 1997 through 2002 with any remaining principal and interest outstanding due on April 30, 2003. The Senior Notes contain certain financial covenants which conform with those contained in the Revolving Credit Facility. Covenant Compliance. At December 31, 1993, the Company was in compliance with or has obtained necessary waivers related to all of its debt covenants. Interest Rate Swap Agreements. From time to time, the Company enters into interest rate swap agreements to manage exposure to changes in interest rates. The transactions generally involve the exchange of fixed and floating interest payment obligations without the exchange of the underlying principal amounts. In 1993, the Company terminated certain interest rate swap agreements, totaling $175 million of notional principal amount, resulting in a pre-tax gain of approximately $3.6 million. The Company believes that the amounts available to be borrowed under the Revolving Credit Facility and the Master Shelf together with cash provided from operations, will provide it with sufficient financing to connect new reserves, maintain its existing facilities and complete its current capital improvement projects. The Company also believes that cash provided from operations will be sufficient to meet its debt service and preferred stock dividend requirements. Miscellaneous The construction and operation of the Company's gathering lines, plants and other facilities used for the gathering, transporting, processing, treating or storing of residue gas and NGLs are subject to federal, state and local environmental laws and regulations, including those that can impose obligations to clean up hazardous substances at the Company's facilities or at facilities to which the Company sends wastes for disposal. In most instances, the applicable regulatory requirements relate to water and air pollution control or solid waste management procedures. The Company believes that it is in substantial compliance with applicable material environmental laws and regulations. Environmental regulation can increase the cost of planning, designing, constructing and operating the Company's facilities. The Company believes that the costs for compliance with current environmental laws and regulations have not and will not have a material effect on the Company's results of operation. In 1990, the Congress enacted the Clean Air Act Amendments of 1990 (the "Clean Air Act") which impose more stringent standards on emissions of certain pollutants and require the permitting of certain existing air emissions sources. Many of the regulations have not been promulgated and until their promulgation, the Company cannot make a final assessment of the impact of the Clean Air Act. However, based upon its preliminary review of the proposed regulations, the Company does not anticipate that compliance with the Clean Air Act will require any material capital expenditures, although it will increase permitting costs in 1994 and 1995 and may increase certain operating costs on an on-going basis. The Company does not believe that such cost increases will have a material effect on the Company's results of operations, but cannot rule out that possibility. The Company believes that it is reasonably likely that the trend in environmental legislation and regulation will continue to be towards stricter standards. The Company is unaware of future environmental standards that are reasonably likely to be adopted that will have a material effect on the Company's results of operations. The Company is in the process of cleaning up certain releases of non-hazardous substances at facilities that it operates. In addition, the former owner of certain facilities that the Company acquired in 1992 is conducting cleanups at those facilities pursuant to contractual obligations. The Company's expenditures for environmental evaluation and remediation at existing facilities have not been significant in relation to the results of operations of the Company and totaled approximately $1.4 million for the year ended December 31, 1993. For the year ended December 31, 1993, the Company paid an aggregate of approximately $565,000 in air emissions fees to the states in which it operated. Although the Company anticipates that such air emissions fees will increase over time, the Company does not believe that such increases will have a material effect on the Company's results of operations. The Company employs six environmental engineers to monitor environmental compliance and potential liabilities at its facilities. Prior to consummating any major acquisition, the Company's environmental engineers perform audits on the facilities to be acquired. In addition, on an on-going basis, the environmental engineers perform informal environmental assessments of the Company's existing facilities. To date, the Company has not found any material environmental noncompliance or cleanup liabilities, the costs of which would reasonably be expected to have, in the aggregate, a material effect on the Company's results of operations. ITEM 8.	ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Index to Consolidated Financial Statements Western Gas Resources, Inc.'s Consolidated Financial Statements as of December 31, 1993 and 1992 and for the three years ended December 31, 1993: REPORT OF MANAGEMENT The financial statements and other financial information included in this Annual Report on Form 10-K are the responsibility of management. The financial statements have been prepared in conformity with generally accepted accounting principles appropriate in the circumstances and include amounts that are based on management's informed judgments and estimates. Management relies on the Company's system of internal accounting controls to provide reasonable assurance that assets are safeguarded and that transactions are properly recorded and executed in accordance with management's authorization. The concept of reasonable assurance is based on the recognition that there are inherent limitations in all systems of internal accounting control and that the cost of such systems should not exceed the benefits to be derived. The internal accounting controls in place during the periods presented are considered adequate to provide such assurance. The Company's financial statements are audited by Price Waterhouse, independent accountants. Their report states that they have conducted their audit in accordance with generally accepted auditing standards. These standards include an evaluation of the system of internal accounting controls for the purpose of establishing the scope of audit testing necessary to allow them to render an independent professional opinion on the fairness of the Company's financial statements. The Audit Committee of the Board of Directors, composed solely of directors who are not employees of the Company, reviews the Company's financial reporting and accounting practices. The Audit Committee meets periodically with the independent accountants and management to review the work of each and to ensure that each is properly discharging its responsibilities. Signature Title --------- ----- /s/ BILL M. SANDERSON ------------------------- Bill M. Sanderson President, Chief Operating Officer and Director /s/ WILLIAM J. KRYSIAK ------------------------- William J. Krysiak Vice President - Controller (Principal Financial and Accounting Officer) REPORT OF INDEPENDENT ACCOUNTANTS --------------------------------- To the Board of Directors and Stockholders of Western Gas Resources, Inc. In our opinion, the accompanying consolidated balance sheet and the related consolidated statements of cash flows, of operations, and of changes in stockholders' equity present fairly, in all material respects, the financial position of Western Gas Resources, Inc. and its subsidiaries at December 31, 1993 and 1992, and the results of their cash flows and their operations for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. PRICE WATERHOUSE Denver, Colorado February 25, 1994 WESTERN GAS RESOURCES, INC. CONSOLIDATED BALANCE SHEET ($000s) - Continued on following page - WESTERN GAS RESOURCES, INC. CONSOLIDATED BALANCE SHEET ($000s, except share amounts) - Continued from previous page - The accompanying notes are an integral part of the consolidated financial statements. WESTERN GAS RESOURCES, INC. CONSOLIDATED STATEMENT OF CASH FLOWS ($000s) - Continued on following page - WESTERN GAS RESOURCES, INC. CONSOLIDATED STATEMENT OF CASH FLOWS ($000s) - Continued from previous page - The accompanying notes are an integral part of the consolidated financial statements. WESTERN GAS RESOURCES, INC. CONSOLIDATED STATEMENT OF OPERATIONS ($000s, except share and per share amounts) The accompanying notes are an integral part of the consolidated financial statements. WESTERN GAS RESOURCES, INC. CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY ($000s, except share amounts) The accompanying notes are an integral part of the consolidated financial statements. WESTERN GAS RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 - ORGANIZATION, ACCOUNTING POLICIES AND OTHER MATTERS ------------------------------------------------------------- Western Gas Resources, Inc., a Delaware corporation, is an independent gas gatherer and processor with operations in major oil and gas-producing basins in the Rocky Mountain, Gulf Coast and Southwestern regions of the United States. Western Gas Resources, Inc. owns and operates natural gas gathering, processing and storage facilities and markets and transports natural gas and natural gas liquids ("NGLs"). Western Gas Resources, Inc. was formed in October 1989 to acquire a majority interest in Western Gas Processors, Ltd. (the "Partnership") and to assume the duties of WGP Company, the general partner of the Partnership. The Partnership had been a Colorado limited partnership formed in 1977 to engage in the gathering and processing of natural gas. The reorganization was accomplished in December 1989 through an exchange for common stock of partnership units held by the former general partners of WGP Company (the "Principal Stockholders") and an initial public offering of Western Gas Resources, Inc. common stock. At December 31, 1990, Western Gas Resources, Inc. held a 51.8% partnership interest in the Partnership and the Principal Stockholders owned 65.7% of Western Gas Resources, Inc.'s common stock and a 40.2% direct interest in the Partnership. The remaining 8.0% of the interest in the Partnership was owned by public holders of the Partnership's $1.80 cumulative participating preference units ("PPUs") (including 7.8% of the PPUs held by the Principal Stockholders). On May 1, 1991, a further restructuring of the Partnership and Western Gas Resources, Inc. (together with its predecessor, WGP Company, collectively, the "Company") was approved by a vote of the security holders. As a result of the affirmative vote on the restructuring, the Partnership prepaid the remaining preference distributions to the PPU holders in the second quarter of 1991 and the Company acquired all of the remaining limited partner units in exchange for 10.2 million shares of newly issued common stock of the Company, all of the Partnership's assets were transferred to the Company by operation of law as a result of the merger, the Company directly owned all assets and was subject to all obligations of the Partnership, and the Partnership ceased to exist. The combinations described above were reorganizations of entities under common control and have been accounted for at historical cost in a manner similar to poolings of interests. The Company has restated all historical financial information to reflect the restructuring. WESTERN GAS RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) In October 1991, the Company issued 400,000 shares of 7.25% cumulative perpetual convertible preferred stock ("7.25% Convertible Preferred Stock") with a liquidation preference of $100 per share to an institutional investor. In November 1991, the Company issued 4,115,000 shares of common stock at a public offering price of $18.375 per share. In November 1992, the Company issued 1,400,000 shares of $2.28 cumulative preferred stock ("$2.28 Cumulative Preferred Stock"), with a liquidation preference of $25 per share, at a public offering price of $25 per share. On November 12, 1993, the Company's registration statement filed with the Securities and Exchange Commission (the "Registration") on Form S-3 (Registration No. 33-66516) was declared effective. The Registration provides for the sale of up to $200 million of debt securities and preferred stock and up to 4 million shares of common stock. On February 17, 1994, the Company filed a Prospectus Supplement under the Registration for the sale of 2,760,000 shares of $2.625 cumulative convertible preferred stock ("$2.625 Convertible Preferred Stock"). On February 25, 1994 the Company closed the offering providing for net proceeds of $133.5 million. Significant Business Acquisitions and Dispositions Mountain Gas On July 29, 1993, effective January 1, 1993, the Company acquired the stock of Mountain Gas Resources, Inc. ("Mountain Gas") from Morgan Stanley Leveraged Equity Fund II, L.P. for total consideration of approximately $168.2 million, including the payment of certain transaction costs and the assumption and repayment of $35 million of long-term debt of Mountain Gas. Mountain Gas owns the Red Desert and Granger facilities, both located near the Company's Lincoln Road gas processing plant and gathering system. The 22% interest in the Granger facility previously not owned by Mountain Gas was purchased by the Company in two separate transactions in November and December 1993 for an aggregate of $27.7 million. At the date of acquisition, the Red Desert facility consisted of a cryogenic plant and the Granger plant consisted of a refrigeration unit and a cryogenic unit. In December 1993, the Company completed construction of an additional cryogenic processing plant at Granger, at a total cost of $15.2 million. WESTERN GAS RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) In December 1993, a fire at the Granger facility's NGL tank farm required the facility to be shut down for one week. The new cryogenic processing plant as well as the smaller existing cryogenic unit were also damaged. Gas throughput at the facility has since reached levels experienced before the fire, and the Company expects it to be fully operational in May 1994 when the construction of a new tank farm and repairs to the cryogenic units are expected to be completed. The Company believes that insurance will cover, subject to certain deductibles, substantially all of the costs related to rebuilding the NGL tank farm and the other affected facilities, the interruption of business and third-party claims, if any. Black Lake On September 27, 1993, effective January 1, 1993, the Company purchased Black Lake gas processing plant and related reserves ("Black Lake") from Nerco Oil & Gas, Inc. ("Nerco") for approximately $136.2 million. The acquisition includes a 68.9% working interest in the Black Lake field in Louisiana and a gas processing plant. The purchase also includes 50% of the stock of Black Lake Pipeline Company, which owns a 240 mile liquids pipeline extending from Cotton Valley, Louisiana to Mont Belvieu, Texas and transports NGLs for Black Lake and three unaffiliated gas processing plants. Pro forma condensed results of operations for the years ended December 31, 1993 and 1992 give effect to the acquisition and financing of Mountain Gas and Black Lake and the issuance and sale by the Company of 2,760,000 shares of $2.625 Convertible Preferred Stock assuming that each transaction occurred on January 1 for each year presented below. The pro forma results have been prepared for comparative purposes only and are not indicative of the results of operations which actually would have resulted had the acquisitions occurred on the dates indicated, or which may result in the future (in $000s). WESTERN GAS RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Westana Joint Venture Effective August 1, 1993, the Company formed Westana Gathering Company ("Westana"), a general partnership, with Panhandle Eastern Pipe Line Corporation ("PEPL"). Westana provides gas gathering and processing services in the Anadarko Basin in Oklahoma and markets residue gas and NGLs for producers connected to its system. The Company is the principal operator with each partner holding a 50% ownership interest. The Company contributed its Chester gas processing plant and gathering system, with a net book value of $13.8 million, to Westana. Westana also operates PEPL's 400 mile gathering system, which will be contributed to Westana, after abandonment approval by the FERC. The Company is committed to provide an additional partnership contribution of $8.3 million, of which $4.8 million was contributed through December 31, 1993, for necessary modifications to the gathering system. This contribution will be recouped by the Company through preferential partnership distributions. UTP System On November 1, 1991, the Company purchased the gas processing division of Union Texas Products Corporation, a subsidiary of Union Texas Petroleum Holdings, Inc. (collectively referred to as the "UTP system"). The total consideration was $142.7 million. The acquisition included 12 plants in Texas, Oklahoma and Louisiana. Edgewood System Effective January 1, 1991, the Company purchased the Edgewood Gas Processing Plant and a majority interest in the related production (collectively called the "Edgewood system") from Amoco Production Company for $36 million. The Edgewood system includes a gas processing plant and a sulfur recovery unit. Effective July 1, 1991, the Company also acquired an approximate 80% working interest in three producing gas wells in the Fruitvale field behind the Edgewood plant. Midkiff/Benedum System Effective October 1, 1992, the Company sold a 20% undivided interest (which interest may increase based upon future expansion of the plants to accommodate increased gas volumes) in the Midkiff and Benedum gas processing plants to the major producer in the area of the plant for $22 million, or an increase to net income of $2.9 million, or $.11 per share of common stock. WESTERN GAS RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Accounting Policies The significant accounting policies followed by the Company and the Company's wholly-owned subsidiaries are presented here to assist the reader in evaluating the financial information contained herein. The Company's accounting policies are in accordance with generally accepted accounting principles. Principles of Consolidation The consolidated financial statements include the accounts of the Company and the Company's wholly-owned subsidiaries. All material intercompany transactions have been eliminated in consolidation. The Company's interest in certain investments is accounted for by the equity method. Revenue Recognition Revenue for sales or services is recognized at the time the gas or NGLs are sold or at the time the service is performed. Reclassification Certain prior years' amounts in the consolidated financial statements and related notes have been reclassified to conform to the presentation used in 1993. Earnings Per Share of Common Stock Earnings per share of common stock is computed by dividing the net income available to shares of common stock by the weighted average number of shares of common stock outstanding. Net income available to shares of common stock is net income less dividends declared on the 7.25% Convertible Preferred Stock and $2.28 Cumulative Preferred Stock. The computation of fully diluted earnings per share of common stock for the years ended December 31, 1993 and 1992 was antidilutive, therefore, only primary earnings per share of common stock is presented. Inventories Product inventory includes $15.5 million and $11.6 million of residue gas and $5.2 million and $5.4 million of NGLs at December 31, 1993 and 1992, respectively. Prior to 1992, the cost of residue gas and NGL inventories was determined by the weighted average cost and the first-in, first-out WESTERN GAS RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) (FIFO) methods, respectively, on a location by location basis. Effective January 1, 1992, the Company changed its method of accounting for NGL inventories to the last-in, first-out (LIFO) method. The effect of this change was not material to the Company's results of operations for the year ended December 31, 1992. Inventories are valued at the lower of cost or net realizable value. At December 31, 1991, NGL inventories were written down to reflect market value, resulting in a $1.4 million reduction in inventory value and a related charge to earnings. Property and Equipment Depreciation is provided using the straight-line method based on the estimated useful life of each facility which ranges from three to 45 years. Useful lives are determined based on the shorter of the life of the equipment or the reserves serviced by the equipment. The cost of certain gas purchase contracts is amortized using the units-of-production method. Effective January 1, 1992, the Company reviewed the economic useful lives of its plant assets. As a result of this review, the lives of certain of these assets were changed to reflect more closely their remaining economic useful lives. The effect of this change was not material to the results of operations for the year ended December 31, 1992. The Company follows the successful efforts method of accounting for oil and gas exploration and production activities. Acquisition costs, development costs and successful exploration costs are capitalized. Exploratory dry hole costs, lease rentals and geological and geophysical costs are charged to expense as incurred. If the undiscounted future net revenue of all proved developed properties does not exceed the net book value of such properties, a charge for impairment would be made against income of the period affected. Upon surrender of undeveloped properties, the original cost is charged against income. Producing properties and related equipment are depleted and depreciated by the units-of-production method based on estimated proved developed reserves of oil and gas. Interest incurred during the construction period of new projects is capitalized and amortized over the life of the associated assets. Such capitalized interest was $4.9 million, $2.1 million and $1.3 million, respectively, for the three years ended December 31, 1993. WESTERN GAS RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Income Taxes In the fourth quarter of 1992, the Company adopted the provisions of Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes", retroactive to January 1, 1992. SFAS No. 109 requires the recognition of deferred tax liabilities and assets for the expected future tax consequences of events that have been recognized in the financial statements or income tax returns. Under this method, deferred tax liabilities and assets are determined based on the difference between the financial statement carrying amounts and tax bases of assets and liabilities using enacted tax rates in effect in the years in which the differences are expected to reverse. Adoption of SFAS No. 109 did not have a material effect on the Company's results of operations for the year ended December 31, 1992. Prior years' financial statements have not been restated to apply the provisions of SFAS No. 109. Deferred income taxes for 1993 and 1992 reflect the impact of "temporary differences" between amounts of assets and liabilities for financial reporting purposes and such amounts as measured by tax laws. These temporary differences are determined in accordance with SFAS No. 109 and are more inclusive in nature than "timing differences" as determined under previously applicable accounting principles. A pro forma provision for income taxes has been provided in the financial statements of the Company for the year ended December 31, 1991 for comparability to its taxable status after the restructuring. Prior to the restructuring, the Predecessor Company was not subject to Federal income tax since the tax effects of its activities accrued to its partners. Futures Contracts The Company, from time to time, enters into futures contracts to hedge against a portion of the price risk associated with residue gas and NGLs. Changes in the market value of futures contracts are accounted for as additions to or reductions in inventory. Gains and losses resulting from changes in the market value of futures contracts are recognized when the related inventory is sold. At December 31, 1993, 296 such contracts (net) (10,000 MMbtus per contract) for the sale of residue gas in February 1994 through March 1995 at prices ranging from $1.87 per Mcf to $2.56 per Mcf were outstanding. At December 31, 1993, no such contracts for NGLs were outstanding. WESTERN GAS RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Interest Rate Swap Agreements The Company has entered into various interest rate swap agreements to manage exposure to changes in interest rates. The transactions generally involve the exchange of fixed and floating interest payment obligations without the exchange of the underlying principal amounts. At December 31, 1993 and 1992, the total notional principal amount of outstanding interest rate swap agreements was $50 million. In addition to the financial risk that will vary during the life of these swap agreements in relation to the maturity of the underlying debt and market interest rates, the Company is subject to credit risk exposure from nonperformance of the counterparties to the swap agreements. Cash and Cash Equivalents Cash and cash equivalents includes all cash balances and highly liquid investments with a maturity of three months or less. Supplementary Cash Flow Information Interest paid was $16.4 million, $12.5 million and $12.9 million, respectively, for the three years ended December 31, 1993. Income taxes paid were $10.2 million, $12.5 million and $6.6 million, respectively, for the three years ended December 31, 1993. Payments for business acquisitions during the year ended December 31, 1993 include the following payments for working capital and other liabilities assumed (in $000s): NOTE 2-RELATED PARTIES The Company purchases a significant portion of the Williston Gas Company ("Williston") and Westana production for resale to unrelated third parties. Such purchases from Williston included in the Consolidated Statement of Operations were $8.6 million, $4.0 million and $7.4 million, respectively, for the three years ended WESTERN GAS RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) December 31, 1993. Purchases from Westana totaled $5.3 million for the year ended December 31, 1993. The Company performs various operational and administrative functions for Williston and Westana and allocates the actual expenses incurred in performing the services to each Company. Such charges for Williston totaled $2.4 million, $3.2 million, and $4.0 million, respectively, for the three years ended December 31, 1993. Charges to Westana totaled $933,000 for the year ended December 31, 1993. During the year ended December 31, 1990, an officer and director of the Company borrowed $748,000 from the Company for the purpose of exercising options to purchase 294,524 shares of common stock in the Company. Interest is accrued at a rate equal to the interest rate paid by the Company on its Revolving Credit Facility and is payable annually on December 31 during the term of the note with all unpaid principal and accrued interest due and payable on January 1, 1996. The note is secured by the common stock and is accounted for as a reduction of stockholders' equity. The Company has entered into agreements committing the Company to loan to certain key employees an amount sufficient to exercise their options as each portion of their options vests under the Key Employees' Incentive Stock Option Plan and the Employee Option Plan. The Company will forgive the loan and accrued interest if the employee has been continuously employed by the Company for periods specified under the agreements. As of December 31, 1993 and 1992 loans totaling $1.2 million and $730,000, respectively, were outstanding to key employees under these programs. The loans are secured by the common stock and are accounted for as a reduction of stockholders' equity. NOTE 3-LONG-TERM DEBT The following summarizes the consolidated long-term debt at the dates indicated (in $000s): WESTERN GAS RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Financing Facilities Revolving Credit Facility. In August 1993, the Company renegotiated a Revolving Credit Facility with its agent bank, and in September 1993 the agent bank completed the syndication of the facility with seven additional banks. The Company's variable rate Revolving Credit Facility provides for a maximum borrowing of $400 million, of which $345 million was outstanding at December 31, 1993, and, if not renewed, on August 31, 1996 any outstanding balance thereunder converts to a four-year term during which such balance will be repaid in equal quarterly installments. At the Company's option, the Revolving Credit Facility bears interest at certain spreads over the Eurodollar rate or at the agent bank's prime rate. The interest rate spreads were adjusted based on the Company's earnings ratio (earnings before interest and taxes divided by interest expense). At December 31, 1993, the spread was 1.0% for the Eurodollar rate resulting in an interest rate of 4.13% at December 31, 1993. Term Loan Facility. The Company also has a Term Loan Facility with four banks for $50 million which bears interest at 9.87%. Payments on the Term Loan Facility of $25 million, $12.5 million and $12.5 million are due in September 1995, 1996 and 1997, respectively. The Company will pay a commitment fee on the unused commitment of .25% if the earnings ratio is greater than or equal to 4.5 to 1.0 or .375% if the ratio is less than 4.5 to 1.0. For the year ended December 31, 1993, the Company's earnings ratio was approximately 4.4 to 1.0. The Company's Revolving Credit and Term Loan Facilities are subject to certain mandatory prepayment terms. If funded debt under these facilities exceeds four times the sum of the Company's last four quarters' cash flow (as defined in the agreement), the overage must be repaid in no more than six monthly payments commencing 90 days from notification. This mandatory prepayment threshold will be reduced to 3.75 to 1.00 at December 31, 1994 and 3.50 to 1.00 at December 31, 1995. The Term Loan Facility and Revolving Credit Facility are unsecured. The Company is required to maintain a current ratio of at least 1.0 to 1.0, a tangible net worth of at least $247 million, a debt to capitalization ratio of no more than 65% through March 31, 1994, 60% from April 1, 1994 through October 31, 1995 and 55% thereafter and an earnings ratio of not less than 2.0 to 1.0. The Company is prohibited from declaring or paying dividends that exceed the sum WESTERN GAS RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) of $25 million plus 50% of consolidated net income earned after March 31, 1993 plus 50% of the cumulative net proceeds received from the sale of any equity securities sold after March 31, 1993. The Company generally utilizes excess daily funds to reduce any outstanding revolving credit balances to minimize interest expense and intends to continue such practice. Master Shelf Agreement. In December 1991, the Company entered into a Master Shelf Agreement (the "Master Shelf") with The Prudential Insurance Company of America ("Prudential") pursuant to which Prudential agreed to quote, from time-to-time, an interest rate at which Prudential or its nominee would be willing to purchase up to $100 million of the Company's senior promissory notes (the "Senior Notes"). Any such Senior Notes must mature in no more than 12 years, with an average life not in excess of 10 years, and will be unsecured. On October 27, 1992, the Company sold $25 million of 7.51% Senior Notes due 2000 and $25 million of 7.99% Senior Notes due 2003. Principal payments on the $50 million of Senior Notes of $8.3 million will be due on October 27 of each year from 1998 through 2003. On September 22, 1993, the Company sold $25 million of 6.77% Senior Notes due in a single payment on September 22, 2003 and on December 27, 1993, the Company sold $25 million of 7.23% Senior Notes due in a single payment on December 27, 2003. The Master Shelf contains certain financial covenants which conform with those contained in the Revolving Credit Facility. In July 1993, Prudential and the Company amended the Master Shelf to provide for an additional $50 million of borrowing capacity (for a total borrowing capacity of $150 million) and to extend the term of the Master Shelf to October 31, 1995. Senior Notes. On April 28, 1993 the Company sold $50 million of 7.65% Senior Notes due 2003 to a group of insurance companies led by Connecticut General Life Insurance Company. Principal payments on the $50 million of Senior Notes of $7.1 million will be due on April 30th of each year from 1997 through 2002 with any remaining principal and interest outstanding due on April 30, 2003. The Senior Notes contain certain financial covenants which conform with those contained in the Revolving Credit Facility. Covenant Compliance. At December 31, 1993, the Company was in compliance with or has obtained necessary waivers related to all of its debt covenants. Interest Rate Swap Agreements. From time to time, the Company enters into interest rate swap agreements to manage exposure to changes in interest rates. The transactions generally involve the WESTERN GAS RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) exchange of fixed and floating interest payment obligations without the exchange of the underlying principal amounts. Approximate future maturities of long-term debt are as follows (in $000s): NOTE 4-INCOME TAXES The provisions for income taxes for the years ended December 31, 1993 and 1992 and the pro forma provision for income taxes for the year ended December 31, 1991 are comprised of (in $000s): WESTERN GAS RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Temporary differences and carryforwards which give rise to the deferred tax liability at December 31, 1993 and 1992 are as follows (in $000s): During the year ended December 31, 1991, deferred income taxes principally were provided for significant timing differences in the recognition of revenue and expenses for tax and financial statement purposes. These items principally consisted of the excess of tax depreciation, depletion and amortization over that deducted for financial reporting purposes. The differences between the provision for income taxes at the statutory rate and the actual provision for income taxes are summarized as follows (in $000s): WESTERN GAS RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 5-COMMITMENTS AND CONTINGENT LIABILITIES Toca On March 4, 1993, the Company filed a complaint against Warren Petroleum Company, Arco Oil & Gas Co., Conoco Inc., Trident NGL, Inc. and other owners of the Yscloskey Gas Plant located in Louisiana (the "Owners") in the United States District Court for the Eastern District of Louisiana, alleging various violations by the defendants of the federal anti-trust laws in connection with a Hydrocarbon Fractionation Agreement at its Toca plant between the Company and the Owners of the Yscloskey plant. The Company also filed a companion state-court action involving the same parties in Civil District Court for the Parish of Orleans, State of Louisiana, which the defendants removed to United States District Court for the Eastern District of Louisiana. The Company and Warren Petroleum Company (in its capacity as the designated Operator for the Yscloskey Plant) have recently negotiated a new Hydrocarbon Fractionation Agreement, which has been executed by substantially all of the Owners of the Yscloskey Plant. The new 15-year agreement provides for a reduced fractionation fee of 9.25% and eliminates the uncertainty regarding uneconomic performance of the Yscloskey plant. The Company anticipates dismissing the various complaints with prejudice. Edgewood On January 16, 1991, problems at the Company's Edgewood Plant relating to both equipment that removes hydrogen sulfide from unprocessed natural gas and the monitoring equipment owned by the purchaser of the residue gas, Enserch Corporation, doing business as Lone Star Gas Company ("Lone Star"), allowed residue gas containing hydrogen sulfide to enter Lone Star's transmission line supplying residue gas to Emory, Texas. The Company has been named as a co-defendant, along with Lone Star, in the following complaints relating to the incident: Gary Prather, et al. v. Enserch ------------------------------- Corporation, et al., filed March 15, 1993, Barbara Rogers, et al., v. Enserch ------------------- ---------------------------------- Corporation, et al. filed March 16, 1993, Judy Silvey, et al. v. Enserch, et ------------------- ---------------------------------- al., filed May 13, 1993, Floyd Rogers, et al. v. Enserch, et al., filed May --- --------------------------------------- 14, 1993, Blair Schamlain, et al. v. Enserch, et al., filed May 25, 1993, ------------------------------------------ Betty Adair v. Enserch, et al., filed on July 14, 1993, Doris Hass v. Enserch ------------------------------ --------------------- Corporation, et al., filed on December 17, 1993, Allie Ruth Harris v. Enserch ------------------- ---------------------------- Corporation, et al., filed on December 17, 1993, Sandra Parker, et al. v ------------------- ----------------------- Enserch Corporation, et al., filed on --------------------------- WESTERN GAS RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) January 13, 1994, and Carma Brumit v. Enserch, et al., filed on January 18, ------------------------------- 1994. All the cases have been filed in the District Court, Rains County, Texas, 354th Judicial District, and make similar claims, asserting, among other things, that the defendants breached an implied warranty of merchantability, falsely represented that the residue gas was safe, were negligent and are liable under a strict liability theory. The plaintiffs have alleged a variety of respiratory and neurological illnesses and are seeking treble damages, exemplary damages and attorneys' fees. Prior to the filing of the complaints, the Company received demand letters from the plaintiffs that sought, in the aggregate, approximately $36 million. Damages claimed in the lawsuits are in excess of $13.5 million. The Company believes that it has meritorious defenses to the claims and intends to defend vigorously against any such claims. The Company is currently conducting extensive pre-trial discovery. The underwriters of the Company's general liability insurance policy have indicated preliminarily that such policy appears to cover the types of claims that have been asserted, subject to their right to deny coverage based upon, among other things, final determination of causation and the exact nature of the damages. Granger On December 6, 1993, Green River Gathering Company ("Green River") and Mountain Gas filed a complaint against Washington Energy Exploration, Inc. ("Washington Energy") in District Court in Arapahoe County, Colorado seeking the payment of certain outstanding receivables from Washington Energy and a declaratory judgment that the gathering agreement between Washington Energy and Green River is in full force and effect. Mountain Gas is a wholly-owned subsidiary of the Company and Green River is a partnership owned by the Company and Mountain Gas. Washington Energy is the operator of wells producing approximately 33% of the natural gas transported through the Green River Gathering system to Mountain Gas' Granger facility. On December 27, 1993, Washington Energy filed an answer, counterclaim, crossclaim and request for trial by jury, denying the substance of the allegations and asserting certain affirmative defenses. Washington Energy has also made certain counterclaims seeking monetary damages relating to Green River's performance under the gathering agreement and under a processing agreement between the parties, along with a declaratory judgment that both WESTERN GAS RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) agreements have been terminated. In addition, Washington Energy has made a crossclaim against two unaffiliated entities, each of which owned a portion of Green River during a portion of the period in question. The Company believes that Green River is in compliance with the gathering agreement and the processing agreement and that both are in full force and effect. The Company believes that it has meritorious defenses to the counterclaims and intends to defend vigorously against any such claims. The Company is currently conducting extensive pre-trial discovery. Katy Commencing in March 1993 and continuing through July 1993, Western Gas Resources Storage, Inc. ("Storage"), a wholly-owned subsidiary of the Company, filed a total of 165 condemnation actions in the County Court at Law No. 1 and No. 2 of Fort Bend County, Texas to obtain certain storage rights and rights- of-way relating to its Katy Gas Storage Facility. The County Court appointed panels of Special Commissioners that have awarded compensation to the owners whose rights were condemned. Certain of the land and mineral owners are seeking in County Court a declaration that Storage does not possess the right to condemn, or, in the alternative, that they should be awarded more compensation than previously awarded by the Special Commissioners. The Company believes that the outcome of such proceedings will not materially affect operation of the Katy Gas Storage Facility. The likelihood of any particular result, however, cannot be determined because the condemnation law under which the proceedings are being brought has never been interpreted by the courts. Woods/Moncrief In February 1994, the United States Appeals Court for the Tenth Circuit affirmed a district court judgment against the Company in the amount of $2.9 million, including interest, in Western Gas Processors Ltd. v. Woods Petroleum ---------------------------------------------- Corporation and W.A. Moncrief, Jr., d/b/a Moncrief Oil Company, which related -------------------------------------------------------------- to claims by certain producers that they had been underpaid. The Company has taken a charge to litigation reserves in the year ended December 31, 1993, in the amount of $2.4 million, as a result of the appellate court decision. The Company will not take any further action. WESTERN GAS RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 6-EMPLOYEE BENEFIT PLANS A discretionary profit sharing plan exists for all Company employees meeting certain service requirements. The Company makes annual contributions to the plan as determined by the Board of Directors. Contributions are made to bank trust funds administered by an independent investment manager. Contributions were $2.2 million, $2.0 million and $1.4 million, respectively, in the three years ended December 31, 1993. The Board of Directors of the Company has adopted a Key Employees' Incentive Stock Option Plan and a Non-Employee Director Stock Option Plan that authorize the granting of options to purchase 250,000 and 20,000 common shares of the Company, respectively. The Board of Directors has granted options to purchase 240,000 common shares to certain officers and 15,000 common shares to three non-employee directors of the Company, at exercise prices ranging from $10.71 to $34.00. Each of these options became exercisable as to 25% of the shares covered by it on the later of January 1, 1992, or one year from the date of grant, subject to the continuation of the optionee's relationship with the Company, and became exercisable as to an additional 25% of the covered shares on each subsequent January 1 through 1995 or on the later of each subsequent date of grant anniversary, subject to the same condition. The Company has entered into agreements committing the Company to loan certain key employees an amount sufficient to exercise their options as each portion of their options vests. The Company will forgive the loan and accrued interest if the employee has been continuously employed by the Company for four years after the date of the loan. In April 1987, the Partnership adopted an employee option plan that authorizes granting options to employees to purchase 430,000 common units in the Partnership. Pursuant to the Restructuring, the Company assumed the Partnership's obligation under the Employee option plan. The plan was amended upon the Restructuring to allow each holder of existing options to exercise such options and acquire one share of common stock for each common unit they were originally entitled to purchase. The exercise price and all other terms and conditions for the exercise of such options issued under the amended plan were the same as under the plan, except that the Restructuring accelerated the time after which certain options may be exercised. Through December 31, 1993 and 1992, the Board of Directors has granted options under the plan to purchase shares of common stock at $5.40 per share to approximately 355 and 350 employees, respectively. As of December 31, 1993 and 1992, approximately 415,000 and 390,000 options were vested and WESTERN GAS RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) approximately 325,000 and 240,000 options for common shares had been exercised, respectively. In February 1994, the Board of Directors retroactively approved, adopted and ratified approximately 53,000 options which were granted to employees in excess of the 430,000 options originally authorized. No more options may be granted under this plan. Options may be exercised only at the rate of 20% of the common shares subject to such option for each year of continuous service by the optionee commencing from the later of July 2, 1987 or the optionee's employment commencement date. The Company has entered into agreements committing the Company to loan to certain key employees an amount sufficient to exercise their options, provided that the Company will not loan in excess of 25% of the total amount available to the employee in any one year. The Company will forgive any loan and accrued interest on July 2, 1997, if the employee is then employed by the Company. As of December 31, 1993 and 1992, loans related to 162,998 and 98,297 options, totaling $1.2 million and $730,000, were extended under these terms. The 1993 Stock Option Plan (the "1993 Plan") became effective on May 24, 1993 after approval by the Company's stockholders. The 1993 Plan is intended to be an incentive stock option plan in accordance with the provisions of Section 422 of the Internal Revenue Code of 1986, as amended. The Company has reserved 1,000,000 shares of Common Stock for issuance upon exercise of options under the 1993 Plan. The 1993 Plan will terminate on the earlier of March 28, 2003 or the date on which all options granted under the 1993 Plan have been exercised in full. The Board of Directors of the Company will determine and designate from time to time those employees of the Company to whom options are to be granted. If any option terminates or expires prior to being exercised, the shares relating to such option shall be released and may be subject to reissuance pursuant to a new option. The Board of Directors has the right to, among other things, fix the price, terms and conditions for the grant or exercise of any option. The purchase price of the stock under each option shall be the fair market value of the stock at the time such option is granted. Options granted will vest 20% a year after the date of grant. The employee must exercise the option within five years of the date each portion vests. If an employee's employment with the Company terminates, the employee may, within the 60 day period immediately following such termination of employment, but in no event later than the expiration date specified in the Option Agreement, exercise any options that have vested as of the date of such WESTERN GAS RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) termination. If employment terminates by reason of death or disability, the employee (in the event of disability) or the person or persons to whom rights under the option shall pass by will or by the applicable laws of decent and distribution (in the event of death), shall be entitled to exercise 100% of the options granted regardless of the employee's years of service; provided however, that no such option may be exercised after 180 days from the date of death or termination of employment with the Company as a result of disability. Through December 31, 1993, the Board of Directors has granted approximately 384,000 options at exercise prices ranging from $28.25 to $35.50 per share of common stock to approximately 455 employees. No options granted under the 1993 Plan have vested. NOTE 7 - SUPPLEMENTAL INFORMATION ON OIL AND GAS PRODUCING ACTIVITIES (UNAUDITED): Costs The following tables set forth capitalized costs at December 31, 1993 and costs incurred for oil and gas producing activities for the year ended December 31, 1993 (in $000s): WESTERN GAS RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Results of Operations The results of operations for oil and gas producing activities, excluding corporate overhead and interest costs, for the year ended December 31, 1993 are as follows (in $000s): Reserve Quantity Information Reserve estimates are subject to numerous uncertainties inherent in the estimation of quantities of proved reserves and in the projection of future rates of production and the timing of development expenditures. The accuracy of such estimates is a function of the quality of available data and of engineering and geological interpretation and judgement. Results of subsequent drilling, testing and production may cause either upward or downward revisions of previous estimates. Further, the volumes considered to be commercially recoverable fluctuate with changes in prices and operating costs. Reserve estimates, by their nature, are generally less precise than other financial statement disclosures. WESTERN GAS RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The following table sets forth information for the year ended December 31, 1993 with respect to changes in the Company's proved reserves, all of which are in the United States. The Company has no significant undeveloped reserves. () Primarily represents acquisition of Black Lake oil and gas properties on September 27, 1993, from Nerco. Standardized Measures of Discounted Future Net Cash Flows Estimated discounted future net cash flows and changes therein were determined in accordance with SFAS No. 69. Certain information concerning the assumptions used in computing the valuation of proved reserves and their inherent limitations are discussed below. The Company believes such information is essential for a proper understanding and assessment of the data presented. Future cash inflows are computed by applying year-end prices of oil and gas relating to the Company's proven reserves to the year-end quantities of those reserves. Future price changes are considered only to the extent provided by contractual arrangements in existence at year-end. The assumptions used to compute estimated future net revenues do not necessarily reflect the Company's expectations of actual revenues or costs, nor their present worth. In addition, variations from the expected production rate also could result directly or indirectly from factors outside of the Company's control, such as unintentional delays in development, changes in prices or regulatory controls. The reserve valuation further assumes that all reserves will be disposed of by production. However, if reserves are sold in place additional economic considerations could also affect the amount of cash eventually realized. WESTERN GAS RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Future development and production costs are computed by estimating the expenditures to be incurred in developing and producing the proved oil and gas reserves at the end of the year, based on year-end costs and assuming continuation of existing economic conditions. Future income tax expenses are computed by applying the appropriate year-end statutory tax rates, with consideration of future tax rates already legislated, to the future pretax net cash flows relating to the Company's proved oil and gas reserves. Permanent differences in oil and gas related tax credits and allowances are recognized. An annual discount rate of 10% was used to reflect the timing of the future net cash flows relating to proved oil and gas reserves. Information with respect to the Company's estimated discounted future cash flows from its oil and gas properties for the year ended December 31, 1993 is as follows (in $000s): WESTERN GAS RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Principal changes in the Company's estimated discounted future net cash flows for the year ended December 31, 1993 are as follows (in $000s): NOTE 8 - QUARTERLY RESULTS OF OPERATIONS (UNAUDITED): The following summarizes certain quarterly results of operations (in $000s, except per share amounts): Excludes selling and administrative, interest and income tax expenses. 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 ITEM 11.	ITEM 11. EXECUTIVE COMPENSATION ITEM 12.	ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT ITEM 13.	ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Pursuant to instruction G(3) to Form 10-K, Items 10, 11, 12 and 13 are omitted because the Company will file a definitive proxy statement (the "Proxy Statement") pursuant to Regulation 14A under the Securities Exchange Act of 1934 not later than 120 days after the close of the fiscal year. The information required by such Items will be included in the definitive proxy statement to be so filed for the Company's annual meeting of stockholders scheduled for May 11, 1994 and is hereby incorporated by reference. PART IV ITEM 14.	ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) The following documents are filed as part of this report: (1) Financial Statements: Reference is made to the listing on page 34 for a list of all financial statements filed as a part of this report. (2) Financial Statement Schedules: All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission have been omitted because they are not applicable. (3) Exhibits: 2.1 Agreement for the Sale and Purchase of Assets dated as of May 1, 1990 between Parker Gas Companies, Inc. and its subsidiaries and Western Gas Processors, Ltd. (Filed as exhibit 2.1 to Western Gas Resources, Inc.'s Form 10-Q for the quarter ended March 31, 1990 and incorporated herein by reference). 2.2 Agreement for Sale and Purchase of Assets concerning the Treating Business of Parker Gas Treating Company, dated May 24, 1990 (Filed as exhibit 2.6 to Western Gas Processors, Ltd.'s Form 10-Q for the quarter ended June 30, 1990 and incorporated herein by reference). 2.3 Addendum and Agreement concerning the Treating Agreement and Giddings Agreement (Filed as exhibit 2.6 to Western Gas Processors, Ltd.'s Form 10-Q for the quarter ended June 30, 1990 and incorporated herein by reference). 2.4 Agreement for the Sale and Purchase of Assets dated as of November 2, 1990 between Giddings, Ltd. and Western Gas Processors, Ltd. (Filed as exhibit 10.26 to Western Gas Resources, Inc.'s Registration Statement on Form S-4, Registration No. 33-39588 dated March 27, 1991 and incorporated herein by reference). 2.5 Letter of intent for the Sale and Purchase of Assets dated as of September 24, 1990 between Amoco Production Company and Western Gas Processors, Ltd. (Filed as exhibit 10.27 to Western Gas Resources, Inc.'s Registration Statement on Form S-4, Registration No. 33- 39588 dated March 27, 1991 and incorporated herein by reference). 2.6 Purchase and sale agreement by and between Amoco Production Company and Western Gas Processors, Ltd. dated as of January 7, 1991 (Filed as exhibit 10.28 to Western Gas Resources, Inc.'s Registration Statement on Form S-4, Registration No. 33-39588 dated March 27, 1991 and incorporated herein by reference). 2.7 Amendment to purchase and sale agreement by and between Amoco Production Company and Western Gas Processors, Ltd. dated February 13, 1991 (Filed as exhibit 10.29 to Western Gas Resources, Inc.'s Registration Statement on Form S-4, Registration No. 33-39588 dated March 27, 1991 and incorporated herein by reference). 2.8 Second amendment to purchase and sale agreement by and between Amoco Production Company and Western Gas Processors, Ltd. dated February 11, 1991 (Filed as exhibit 10.30 to Western Gas Resources, Inc.'s Registration Statement on Form S-4, Registration No. 33- 39588 dated March 27, 1991 and incorporated herein by reference). 3.1 Certificate of Incorporation of Western Gas Resources, Inc. (Filed as exhibit 3.1 to Western Gas Resources, Inc.'s Registration Statement on Form S-1, Registration No. 33-31604 and incorporated herein by reference). 3.2 Certificate of Amendment to the Certificate of Incorporation of Western Gas Resources, Inc. (Filed as exhibit 3.2 to Western Gas Resources, Inc.'s Registration Statement on Form S-1, Registration No. 33-31604 and incorporated herein by reference). 3.3 Bylaws of Western Gas Resources, Inc. (Filed as exhibit 3.3 to Western Gas Resources, Inc.'s Registration Statement on Form S-1, Registration No. 33-31604 and incorporated herein by reference). 3.4 Assistant Secretary's Certificate regarding amendment to bylaws of Western Gas Resources, Inc. (Filed as exhibit 3.4 to Western Gas Resources, Inc.'s Registration Statement on Form S-4, Registration No. 33-39588 dated March 27, 1991 and incorporated herein by reference). 3.5 Certificate of Designation of 7.25% Cumulative Senior Perpetual Convertible Preferred Stock of the Company (Filed as exhibit 3.5 to Western Gas Resources, Inc.'s Registration Statement on Form S-1, Registration No. 33-43077 dated November 14, 1991 and incorporated herein by reference). 3.6 Certificate of Designation of $2.28 Cumulative Preferred Stock of the Company. (Filed as exhibit 3.6 to Western Gas Resources, Inc.'s Registration Statement of Form S-1, Registration No. 33- 53786 dated November 12, 1992 and incorporated herein by reference). 3.7 Amendments of the By-Laws of Western Gas Resources, Inc. as adopted by the Board of Directors on December 13, 1993. (See page 89). 4.1 Subscription Agreements between the respective Founders and Western Gas Resources, Inc. regarding such Founders' initial subscription for shares of common stock (Filed as exhibit 10.31 to Western Gas Resources, Inc.'s Registration Statement on Form S-4, Registration No. 33-39588 dated March 27, 1991 and incorporated herein by reference). 4.2 Commitment letter between DLJ Bridge Finance, L.P., and the Company dated September 16, 1991 (Filed as exhibit 4.1 to Western Gas Resources, Inc.'s Registration Statement on Form S-1, Registration No. 33-43077 dated November 14, 1991 and incorporated herein by reference). 4.3 Amendment No. 1 to Registration Rights Agreement as of May 1, 1991 between Western Gas Resources, Inc., Bill Sanderson, WGP, Inc., Dean Phillips, Inc., Heetco, Inc. NV, Sauvage Gas Company and Sauvage Gas Service, Inc. (Filed as exhibit 4.2 to Western Gas Resources, Inc.'s Form 10-Q for the quarter ended June 30, 1991 and incorporated herein by reference). 10.1 Amended and Restated Agreement of Limited Partnership of the Partnership dated June 1, 1987 (Filed as exhibit 10.1 to Western Gas Resources, Inc.'s Registration Statement on Form S-4, Registration No. 33-39588 , dated March 27, 1991 and incorporated herein by reference). 10.2 Transfer Restriction Agreement between Western Gas Resources, Inc. and Western Gas Processors, Ltd. (Filed as exhibit 10.4 to Western Gas Resources, Inc.'s Registration Statement on Form S-4, Registration No. 33-39588 dated March 27, 1991 and incorporated herein by reference). 10.3 Reinvestment Agreement among Western Gas Processors, Ltd., Western Gas Resources, Inc., WGP, Inc., Heetco, Inc. NV, Dean Phillips, Inc., Sauvage Gas Company and Sauvage Gas Service, Inc. (Filed as exhibit 10.5 to Western Gas Resources, Inc.'s Registration Statement on Form S-4, Registration No. 33-39588 dated March 27, 1991 and incorporated herein by reference). 10.4 Fifth Restated Loan Agreement dated as of September 21, 1988 between Western Gas Processors, Ltd., and NCNB Texas National Bank (Filed as exhibit 4.8 to Western Gas Processors, Ltd.'s Annual Report on Form 10-K for the fiscal year ended December 31, 1988 and incorporated herein by reference). 10.5 First Amendment to Fifth Restated Loan Agreement dated as of February 7, 1989 between Western Gas Processors, Ltd. and NCNB Texas National Bank (Filed as exhibit 4.9 to Western Gas Processors, Ltd.'s Annual Report on Form 10-K for the fiscal year ended December 31, 1988 and incorporated herein by reference). 10.6 Second Amendment to Fifth Restated Loan Agreement dated as of October 20, 1989 between Western Gas Processors, Ltd. and NCNB Texas National Bank (Filed as exhibit 10.6 to Western Gas Resources, Inc.'s Registration Statement on Form S-1, Registration No. 33-31604 and incorporated herein by reference). 10.7 Restated Profit-Sharing Plan and Trust Agreement of Western Gas Resources, Inc. (Filed as exhibit 10.8 to Western Gas Resources, Inc.'s Registration Statement on Form S-4, Registration No. 33- 39588 dated March 27, 1991 and incorporated herein by reference). 10.8 Employees Common Units Option Plan of Western Gas Processors, Ltd. (Filed as exhibit 10.9 to Western Gas Resources, Inc.'s Registration Statement on Form S-4, Registration No. 33-39588 dated March 27, 1991 and incorporated herein by reference). 10.9 Amendment to Employees Common Units Option Plan of Western Gas Processors, Ltd. (Filed as exhibit 10.10 to Western Gas Resources, Inc.'s Registration Statement on Form S-4, Registration No. 33-39588 dated March 27, 1991 and incorporated herein by reference). 10.10 Western Gas Resources, Inc. Non-Employee Director Stock Option Plan (Filed as exhibit 10.12 Western Gas Resources, Inc.'s Registration Statement on Form S-4, Registration No. 33-39588 dated March 27, 1991 and incorporated herein by reference). 10.11 Western Gas Resources, Inc. Key Employees' Incentive Stock Option Plan (Filed as exhibit 10.13 to Western Gas Resources, Inc.'s Registration Statement on Form S-4, Registration No. 33-39588 dated March 27, 1991 and incorporated herein by reference). 10.12 Registration Rights Agreement among Western Gas Resources, Inc., WGP, Inc., Heetco, Inc., NV, Dean Phillips, Inc., Sauvage Gas Company and Sauvage Gas Service, Inc. (Filed as exhibit 10.14 to Western Gas Resources, Inc.'s Registration Statement on Form S-4, Registration No. 33-39588 dated March 27, 1991 and incorporated herein by reference). 10.13 Agreement of Sale Concerning the Midkiff Plant and Spraberry Gathering System (without exhibits) dated as of May 12, 1989 between El Paso Natural Gas Company and Western Gas Processors, Ltd. (Filed as exhibit 10.13 to Western Gas Resources, Inc.'s Registration Statement on Form S-1, filed December 8, 1989, Registration No. 33- 31604 and incorporated herein by reference). 10.14 Interim Operating Agreement for the Midkiff system (Filed as exhibit 10.14 to Western Gas Resources, Inc.'s Registration Statement on Form S-1, filed December 8, 1989, Registration No. 33-31604 and incorporated herein by reference). 10.15 Amendment Number One to the Amended and Restated Agreement of Limited Partnership of Western Gas Processors, Ltd. dated as of December 4, 1989 (Filed as exhibit 10.2 to Western Gas Resources, Inc.'s Registration Statement on Form S-4, Registration No. 33-39588 dated March 27, 1991 and incorporated herein by reference). 10.16 Guaranty of Western Gas Resources, Inc. in favor of NCNB Texas National Bank (Filed as exhibit 10.17 to Western Gas Resources, Inc.'s Registration Statement on Form S-4, Registration No. 33-39588 dated March 27, 1991 and incorporated herein by reference). 10.17 Form of Agreement to be Bound of Western Gas Resources, Inc. (Filed as exhibit 10.18 to Western Gas Resources, Inc.'s Registration Statement on Form S-4, Registration No. 33-39588 dated March 27, 1991 and incorporated herein by reference). 10.18 Assumption Agreement of Western Gas Resources, Inc. (Filed as exhibit 10.19 to Western Gas Resources, Inc.'s Registration Statement on Form S-4, Registration No. 33-39588 dated March 27, 1991 and incorporated herein by reference). 10.19 Distribution Reinvestment Plan of Western Gas Processors, Ltd. (Filed as exhibit 10.19 to Western Gas Resources, Inc.'s Registration Statement on Form S-1, filed December 8, 1989, Registration No. 33-31604 and incorporated herein by reference). 10.20 Second Amendment to Amended and Restated Agreement of Limited Partnership of Western Gas Processors, Ltd. (Filed as exhibit 10.3 to Western Gas Resources, Inc.'s Registration Statement on Form S-4, Registration No. 33-39588 dated March 27, 1991 and incorporated herein by reference). 10.21 Sixth Restated Loan Agreement dated as September 26, 1990 between Western Gas Processors, Ltd. and NCNB Texas National Bank (Filed as exhibit 10.6 to Western Gas Resources, Inc.'s Registration Statement on Form S-4 dated March 27, 1991 and incorporated herein by reference). 10.22 First Amendment to Sixth Restated Loan Agreement dated as of October 26, 1990 between Western Gas Processors, Ltd. and NCNB Texas National Bank (Filed as exhibit 10.7 to Western Gas Resources, Inc.'s Registration Statement on Form S-4, Registration No. 33-39588 dated March 27, 1991 and incorporated herein by reference). 10.23 Loan Agreement dated as of May 1, 1991 between the Company and NCNB Texas National Bank as Agent and Certain Banks as Lenders (Filed as exhibit 10.1 to Western Gas Resources, Inc.'s Registration Statement on Form S-1, Registration No. 33-43077 dated November 14, 1991 and incorporated herein by reference). 10.24 First Amendment to Loan Agreement dated as of August 12, 1991 by and among the Company and NCNB Texas National Bank and Various Lenders (Filed as exhibit 10.2 to Western Gas Resources, Inc.'s Registration Statement on Form S-1, Registration No. 33-43077 dated November 14, 1991 and incorporated herein by reference). 10.25 Second Amendment and First Restatement of Western Gas Processors, Ltd. Employees' Common Units Option Plan (Filed as exhibit 10.6 to Western Gas Resources, Inc.'s Registration Statement on Form S-1, Registration No. 33-43077 dated November 14, 1991 and incorporated herein by reference). 10.26 Agreement to provide loans to exercise key employees' common stock options (Filed as exhibit 10.26 to Western Gas Resources, Inc.'s Annual Report on Form 10-K for the fiscal year ended December 31, 1991 and incorporated herein by reference). 10.27 Agreement to provide loans to exercise employees' common stock options (Filed as exhibit 10.27 to Western Gas Resources, Inc.'s Annual Report on Form 10-K for the fiscal year ended December 31, 1991 and incorporated herein by reference). 10.28 Agreement and Plan of Restructuring among the Company, the Partnership and the Founders (Filed as exhibit 10.10 to Western Gas Resources, Inc.'s Registration Statement on Form S-1, Registration No. 33-43077 dated November 14, 1991 and incorporated herein by reference). 10.29 Asset Purchase Agreement among Union Texas Petroleum Holdings, Inc., Union Texas Products Corporation and the Company dated September 17, 1991 (without exhibits) (Filed as exhibit 10.11 to Western Gas Resources, Inc.'s Registration Statement on Form S-1, Registration No. 33-43077 dated November 14, 1991 and incorporated herein by reference). 10.30 Stock Purchase Agreement dated October 23, 1991 between the Company and The 1818 Fund, L.P. (Filed as exhibit 10.19 to Western Gas Resources, Inc.'s Registration Statement on Form S-1, Registration No. 33-43077 dated November 14, 1991 and incorporated herein by reference). 10.31 Registration Rights Agreement dated October 23, 1991 between the Company and The 1818 Fund, L.P. (Filed as exhibit 10.20 to Western Gas Resources, Inc.'s Registration Statement on Form S-1, Registration No. 33-43077 dated November 14, 1991 and incorporated herein by reference). 10.32 First Restated Loan Agreement dated as of October 31, 1991 by and among the Company and NCNB Texas National Bank as Agent and NCNB Texas National Bank and Bankers Trust Company as Co-Managers of the Acquisition Loan and Certain Banks as Lenders (Filed as exhibit 10.21 to Western Gas Resources, Inc.'s Registration Statement on Form S-1, Registration No. 33-43077 dated November 14, 1991 and incorporated herein by reference). 10.33 First Restated Loan Agreement (Inventory) dated as of October 31, 1991 by and among the Company and NCNB Texas National Bank as Agent and Certain Banks as Lenders (Filed as exhibit 10.22 to Western Gas Resources, Inc.'s Registration Statement on Form S-1, Registration No. 33-43077 dated November 14, 1991 and incorporated herein by reference). 10.34 First Amendment to First Restated Loan Agreement dated December 23, 1991 by and among the Company and NCNB Texas National Bank as Agent and NCNB Texas National Bank and Bankers Trust Company as Co- Managers (Filed as exhibit 10.34 to Western Gas Resources, Inc.'s Annual Report on Form 10-K for the fiscal year ended December 31, 1991 and incorporated herein by reference). 10.35 Loan Agreement dated as of May 1, 1991 between Western Gas Resources, Inc. and NCNB Texas National Bank (Filed as exhibit 10.27 to Western Gas Resources, Inc.'s Form 10-Q for the quarter ended June 30, 1991 and incorporated herein by reference). 10.36 Letter Agreement dated June 10, 1992 amending the Stock Purchase Agreement dated October 23, 1991 between the Company and the 1818 Fund, L.P. (Filed as exhibit 10.36 to Western Gas Resources, Inc.'s Form 10-Q for the quarter ended June 30, 1992 and incorporated herein by reference). 10.37 Second Restated Loan Agreement dated as of October 20, 1992 by and among the Company and NationsBank of Texas, N.A. as Agent and Certain Banks as Lenders (Filed as exhibit 10.21 to Western Gas Resources, Inc.'s Registration Statement on Form S-1, Registration No. 33-53786 dated November 12, 1992 and incorporated herein by reference). 10.38 Second Restated Loan Agreement (Inventory) dated as of October 20, 1992 by and among the Company and NationsBank of Texas, N.A. as Agent and Certain Banks as Lenders (Filed as exhibit 10.22 to Western Gas Resources, Inc.'s Registration Statement on Form S-1, Registration No. 33-53786 dated November 12, 1992 and incorporated herein by reference). 10.39 $100,000,000 Senior Notes Master Shelf Agreement dated as of December 19, 1991 by and between the Company and the Prudential Insurance Company of America (Filed as exhibit 10.23 to Western Gas Resources, Inc.'s Registration Statement on Form S-1, Registration No. 33-53786 dated November 12, 1992 and incorporated herein by reference). 10.40 Letter Amendment No. 1 dated October 22, 1992 to $100,000,000 Senior Notes Master Shelf Agreement (Filed as exhibit 10.40 to Western Gas Resources, Inc's Form 10-K for the year ended December 31, 1992 and incorporated herein by reference). 10.41 Asset Purchase Agreement (without exhibits) dated October 21, 1992 between the Company and Parker & Parsley Gas Processing Co. (Filed as exhibit 10.25 to Western Gas Resources, Inc.'s Registration Statement on Form S-1, Registration No. 33-53786 dated November 12, 1992 and incorporated herein by reference) 10.42 Consulting Agreement dated as of January 1, 1993 by and between the Company and Walter L. Stonehocker (Filed as exhibit 10.42 to Western Gas Resources Inc.'s Form 10-K for the year ended December 31, 1992 and incorporated herein by reference). 10.43 Consulting Agreement dated as of January 1, 1993 by and between the Company and Ward Sauvage (Filed as exhibit 10.43 to Western Gas Resources Inc.'s Form 10-K for the year ended December 31, 1992 and incorporated herein by reference). 10.44 Consulting Agreement dated as of January 1, 1993 by and between the Company and Dean Phillips (Filed as exhibit 10.44 to Western Gas Resources Inc.'s Form 10-K for the year ended December 31, 1992 and incorporated herein by reference). 10.45 Stock Purchase Agreement (without exhibits) dated March 30, 1993 by and between the Company and The Morgan Stanley Leveraged Equity Fund II, L.P. (Filed as exhibit 10.45 to Western Gas Resources Inc.'s Form 10-Q for the six months ended June 30, 1993 and incorporated herein by reference). 10.46 Amendment No. 1 (without exhibits) to Stock Purchase Agreement dated as of March 30, 1993 by and between the Company and The Morgan Stanley Leveraged Equity Fund II, L.P. (Filed as exhibit 10.46 to Western Gas Resources Inc.'s Form 10-Q for the six months ended June 30, 1993 and incorporated herein by reference). 10.47 $150,000,000 Amended and Restated Master Shelf Agreement (without exhibits) effective as of July 22, 1993 by and between the Company and Prudential Insurance Company of America (Filed as exhibit 10.47 to Western Gas Resources Inc.'s Form 10-Q for the six months ended June 30, 1993 and incorporated herein by reference). 10.48 Note Purchase Agreement (without exhibits) dated as of April 1, 1993 by and between the Company and the Purchasers for $50,000,000, 7.65% Senior Notes Due April 30, 2003 (Filed as exhibit 10.48 to Western Gas Resources Inc.'s Form 10-Q for the six months ended June 30, 1993 and incorporated herein by reference). 10.49 $15,000,000 Credit Agreement dated July 30, 1993 by and between the Company and NationsBank of Texas, N.A. (Filed as exhibit 10.49 to Western Gas Resources Inc.'s Form 10-Q for the six months ended June 30, 1993 and incorporated herein by reference). 10.50 General Partnership Agreement (without exhibits), dated August 10, 1993 for Westana Gathering Company by and between Western Gas Resources - Oklahoma, Inc. (a subsidiary of the Company) and Panhandle Gathering Company (Filed as exhibit 10.50 to Western Gas Resources Inc.'s Form 10-Q for the six months ended June 30, 1993 and incorporated herein by reference). 10.51 Amendment to General Partnership Agreement dated August 10, 1993 by and between Western Gas Resources - Oklahoma, Inc. (a subsidiary of the Company) and Panhandle Gathering Company (Filed as exhibit 10.51 to Western Gas Resources Inc.'s Form 10-Q for the six months ended June 30, 1993 and incorporated herein by reference). 10.52 Operating and Maintenance Agreement (without exhibits) dated August 10, 1993 by and between Western Gas Resources - Oklahoma, Inc. (a subsidiary of the Company) and Panhandle Gathering Company (Filed as exhibit 10.52 to Western Gas Resources Inc.'s Form 10-Q for the six months ended June 30, 1993 and incorporated herein by reference). 10.53 Amendment to Operating and Maintenance Agreement dated August 10, 1993 by and between Western Gas Resources -Oklahoma, Inc. (a subsidiary of the Company) and Panhandle Gathering Company (Filed as exhibit 10.53 to Western Gas Resources Inc.'s Form 10-Q for the six months ended June 30, 1993 and incorporated herein by reference). 10.54 Interim Agreement (without exhibits) dated August 10, 1993 by and between Westana Gathering Company and Panhandle Eastern Pipe Line Company (Filed as exhibit 10.54 to Western Gas Resources Inc.'s Form 10-Q for the six months ended June 30, 1993 and incorporated herein by reference). 10.55 Amendment to Interim Agreement dated August 10, 1993 by and between Westana Gathering Company and Panhandle Eastern Pipe Line Company (Filed as exhibit 10.55 to Western Gas Resources Inc.'s Form 10-Q for the six months ended June 30, 1993 and incorporated herein by reference). 10.56 Pipeline Operating Agreement (without exhibits) dated August 10, 1993 by and between Westana Gathering Company and Panhandle Eastern Pipe Line Company (Filed as exhibit 10.56 to Western Gas Resources Inc.'s Form 10-Q for the six months ended June 30, 1993 and incorporated herein by reference). 10.57 $400,000,000 Loan Agreement (Revolver) (without exhibits) dated as of August 31, 1993 among the Company and NationsBank of Texas, N.A. as Agent and Certain Banks as Lenders (Filed as exhibit 10.57 to Western Gas Resources Inc.'s Form 10-Q for the nine months ended September 30, 1993 and incorporated herein by reference). 10.58 Third Restated Loan Agreement (Term) (without exhibits) dated as of August 31, 1993 among the Company and NationsBank of Texas, N.A. as Agent and Certain Banks as Lenders (Filed as exhibit 10.58 to Western Gas Resources Inc.'s Form 10-Q for the nine months ended September 30, 1993 and incorporated herein by reference). 10.59 Letter Amendment No. 1 to the Amended and Restated Master Shelf Agreement effective as of June 30, 1993 by and between the Company and Prudential Insurance Company of America (Filed as exhibit 10.59 to Western Gas Resources Inc.'s Form 10-Q for the nine months ended September 30, 1993 and incorporated herein by reference). 10.60 Asset Purchase Agreement (without exhibits) dated July 18, 1993 by and between the Company and Nerco Oil & Gas, Inc. (Filed as exhibit 10.60 to Western Gas Resources Inc.'s Form 10-Q for the nine months ended September 30, 1993 and incorporated herein by reference). 10.61 Amendment No. 1 to Note Purchase Agreement dated as of August 31, 1993 by and among the Company and the Purchasers (Filed as exhibit 10.61 to Western Gas Resources Inc.'s Form 10-Q for the nine months ended September 30, 1993 and incorporated herein by reference). 10.62 First Amendment to Stock Purchase Agreement, amending the Stock Purchase Agreement dated October 23, 1991 between Western Gas Resources, Inc. and the 1818 Fund, L.P. (See page 92). 10.63 First Amendment to Loan Agreement (Revolver) as of December 31, 1993 among Western Gas Resources, Inc. and NationsBank of Texas, N.A. as Agent and Certain Banks as Lenders (See page 96). 10.64 First Amendment to Third Restated Loan Agreement (Term) as of December 31, 1993 among Western Gas Resources, Inc. and NationsBank of Texas, N.A. as Agent and Certain Banks as Lenders (See page 107). 11.1 Statement regarding computation of per share earnings (See page 116) 21.1 List of Subsidiaries of Western Gas Resources, Inc. (See page 118). 23.1 Consent of Price Waterhouse, independent accountants (See page 120). (b) Reports on Form 8-K: None. (c) Exhibits required by Item 601 of Regulation S-K. See (a) (3) above. (d) Financial statement schedules required by Regulation S-X. See (a) (2) above. REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors and Stockholders of Western Gas Resources, Inc. Our audits of the Consolidated Financial Statements referred to in our report dated February 25, 1994 appearing on page 36 also included an audit of the Financial Statement Schedules listed in Item 14(a) of this Form 10-K. In our opinion, these Financial Statement Schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related Consolidated Financial Statements. PRICE WATERHOUSE Denver, Colorado February 25, 1994 SCHEDULE II WESTERN GAS RESOURCES, INC. NOTES RECEIVABLE FROM RELATED PARTIES ($000s) - Continued on following page - SCHEDULE II WESTERN GAS RESOURCES, INC. NOTES RECEIVABLE FROM RELATED PARTIES ($000s, except share amounts) - Continued from previous page - (1) In July 1990, the Company loaned Mr. Sanderson $748 to purchase 294,524 shares of the Company's common stock. Interest is accrued at a rate equal to that paid by the Company on its Revolving Credit Facility, which was 4.1%, 4.4% and 5.9% at December 31, 1993, 1992, and 1991, respectively. Interest is payable annually on December 31 during the term of the note with all unpaid principal and accrued interest due and payable on January 1, 1996. The note is secured by the common stock and is accounted for as a reduction of stockholders' equity. (2) In 1991, the Company entered into agreements committing the Company to loan to certain key employees an amount sufficient to exercise their options, provided that the Company will not loan in excess of 25% of the total amount available to the employee in one year. The Company will forgive the loan and accrued interest on July 2, 1997,if the employee is then employed by the Company or four years after the date of the loan, depending on the option exercised. The interest on each loan is based on the Applicable Federal Rate on the date the loan is made. SCHEDULE V WESTERN GAS RESOURCES, INC. PROPERTY AND EQUIPMENT ($000s) -Continued on following page - SCHEDULE V WESTERN GAS RESOURCES, INC. PROPERTY AND EQUIPMENT ($000s) - Continued from previous page - (1) Additions for the year ended December 31, 1993 include Black Lake, Mountain Gas, Citizens, Sand Wash, Olympic Pipeline, Rocker B and other small acquisitions totaling $338,900. Additionally, construction projects at existing facilities totaled $140,800, including $74,400 for the Katy Gas Storage Facility, $15,700 for acquired construction in progress, $13,900 for improvements to the Midkiff/Benedum facility, $5,800 for improvements to the Chaney Dell/Lamont facility, $9,800 for improvements to the acquired Mountain Gas Plants, $12,200 for improvements to Giddings and $8,900 for miscellaneous projects. (2) Additions for the year ended December 31, 1992 include the Wakita, Manchester, Burro and other small acquisitions totaling $11,000. Additionally, construction projects at existing facilities totaled $60,000, including $24,000 on the Katy storage facility, $11,000 for improvements to plants acquired in the UTP acquisition, $10,000 for improvements to the Giddings Plant, $5,000 for improvements to the Midkiff Plant, $4,000 for improvements to the Hilight Plant and $6,000 for miscellaneous projects. (3) Sales or retirements for the year ended December 31, 1992 includes the sale of a 20% undivided interest in the Midkiff and Benedum gas processing plants for approximately $22,000. (4) Additions for the year ended December 31, 1991 include the UTP, Edgewood and Fruitvale acquisitions totalling $190,000. Additionally, construction projects at existing facilities totaled approximately $36,000, including $16,000 for the butane isomerization unit, $6,000 for improvements to the Midkiff plant, $2,000 for improvements to the Giddings plant, $3,000 for the acquisition of the Company's headquarters and $9,000 for miscellaneous projects. SCHEDULE VI WESTERN GAS RESOURCES, INC. ACCUMULATED DEPRECIATION AND DEPLETION OF PROPERTY AND EQUIPMENT ($000s) - Continued on following page - SCHEDULE VI WESTERN GAS RESOURCES, INC. ACCUMULATED DEPRECIATION AND DEPLETION OF PROPERTY AND EQUIPMENT ($000s) - Continued from previous page - (1) Depreciation is provided using the straight-line method based on estimated useful lives ranging from three to forty-five years. (2) Total depreciation and amortization expense for the three years ended December 31, 1993, 1992 and 1991, as presented on the Consolidated Statement of Operations, includes amortization expense of $5,787, $1,630 and $1,641, respectively. SCHEDULE X WESTERN GAS RESOURCES, INC. SUPPLEMENTARY INCOME STATEMENT INFORMATION ($000s) Consent of Independent Accountants We hereby consent to the incorporation by reference in the Prospectus constituting part of the Registration Statement on Form S-3 (No.33-66516) and in the Registration Statement on Form S-8 (No. 33-67834) of Western Gas Resources, Inc. of our report dated February 25, 1994 appearing on page 36 of this Form 10-K. We also consent to the incorporation by reference of our report on the Financial Statement Schedules, which appears on page 79 of this Form 10-K. PRICE WATERHOUSE Denver, Colorado March 17, 1994 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Denver, State of Colorado on March 14, 1994. WESTERN GAS RESOURCES, INC. --------------------------- (Registrant) By: /s/ BRION G. WISE ----------------------- Brion G. Wise Chairman of the Board 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. /s/ BRION G. WISE Chairman of the Board, March 14, 1994 - ------------------------ Chief Executive Officer Brion G. Wise and Director /s/ BILL M. SANDERSON President, Chief March 14, 1994 - ------------------------ Operating Officer and Bill M. Sanderson Director /s/ WALTER L. STONEHOCKER Vice Chairman of the Board March 14, 1994 - ------------------------ and Director Walter L. Stonehocker /s/ RICHARD B. ROBINSON Director March 14, 1994 - ------------------------ Richard B. Robinson Director March 14, 1994 - ------------------------ Dean Phillips Director March 14, 1994 - ------------------------ Ward Sauvage Director March 14, 1994 - ------------------------ James A. Senty /s/ WALTER F. IMHOFF Director March 14, 1994 - ------------------------ Walter F. Imhoff Director March 14, 1994 - ------------------------ Walter W. Grist /s/ WILLIAM J. KRYSIAK Vice President - Controller March 14, 1994 - ------------------------ (Principal Financial and William J. Krysiak Accounting Officer)
40779_1993.txt	40779	1993	ITEM 1. BUSINESS. General Public Utilities Corporation ("GPU" or the "Corporation"), a Pennsylvania corporation, organized in 1946, is a holding company registered under the Public Utility Holding Company Act of 1935 (1935 Act). GPU does not operate any utility properties directly, but owns all of the outstanding common stock of three electric utilities serving customers in New Jersey - Jersey Central Power & Light Company (JCP&L) - and Pennsylvania - Metropolitan Edison Company (Met-Ed) and Pennsylvania Electric Company (Penelec). The business of these subsidiaries (the Subsidiaries) consists predominantly of the generation, transmission, distribution and sale of electricity. GPU also owns all of the common stock of GPU Service Corporation (GPUSC), a service company; GPU Nuclear Corporation (GPUN), which operates and maintains the nuclear units of the Subsidiaries; and General Portfolios Corporation (GPC), parent of Energy Initiatives, Inc. (EI), which develops, owns and operates nonutility generating facilities. Met-Ed owns all of the common stock of York Haven Power Company, the owner of a small hydroelectric generating station. Penelec owns all of the common stock of the Waverly Electric Light & Power Company, the owner of electric distribution facilities in the Village of Waverly, New York that are leased to Penelec. The Subsidiaries own all of the common stock of the Saxton Nuclear Experimental Corporation (Saxton), which owns a small demonstration nuclear reactor that has been partially decommissioned. All of these companies considered together are referred to as the "GPU System." The income of GPU consists almost exclusively of earnings on the common stock of the Subsidiaries. As a registered holding company, GPU is subject to regulation by the Securities and Exchange Commission (SEC) under the 1935 Act. Retail rates, conditions of service, issuance of securities and other matters are subject to regulation in the state in which each Subsidiary operates - in New Jersey by the New Jersey Board of Regulatory Commissioners (NJBRC) and in Pennsylvania by the Pennsylvania Public Utility Commission (PaPUC). The Nuclear Regulatory Commission (NRC) regulates the construction, ownership and operation of nuclear generating stations. The Subsidiaries are also subject to wholesale rate and other regulation by the Federal Energy Regulatory Commission (FERC) under the Federal Power Act. (See "Regulation.") INDUSTRY DEVELOPMENTS The Energy Policy Act of 1992 (Energy Act) has made significant changes to the 1935 Act and the Federal Power Act. As a result of this legislation, the FERC is now authorized to order utilities to provide transmission or wheeling service to third parties for wholesale power transactions provided specified reliability and pricing criteria are met. In addition, the legislation amends the 1935 Act to permit the development and ownership of a broad category of independent power production facilities by utilities and nonutilities alike without subjecting them to regulation under the 1935 Act. These and other aspects of the Energy Act are expected to accelerate the changing character of the electric utility industry. The electric utility industry appears to be undergoing a major transition as it proceeds from a traditional rate regulated environment based on cost recovery to some combination of a competitive marketplace and modified regulation of certain market segments. The industry challenges resulting from various instances of competition, deregulation and restructuring thus far have been minor compared with the impact that is expected in the future. The Public Utility Regulatory Policies Act of 1978 (PURPA) facilitated the entry of competitors into the electric generation business. Since then, more competition has been introduced through various state actions to encourage cogeneration and, most recently, the Energy Act. The Energy Act is intended to promote competition among utility and nonutility generators in the wholesale electric generation market, accelerating the industry restructuring that has been underway since the enactment of PURPA. This legislation, coupled with increasing customer demands for lower-priced electricity, is generally expected to stimulate even greater competition in both the wholesale and retail electricity markets. These competitive pressures may create opportunities to compete for new customers and revenues, as well as increase risk which could lead to the loss of customers. Operating in a competitive environment will place added pressures on utility profit margins and credit quality. Utilities with significantly higher cost structures than supportable in the marketplace may experience reduced earnings as they attempt to meet their customers' demands for lower- priced electricity. This prospect of increasing competition in the electric utility industry has already led the major credit rating agencies to address and apply more stringent guidelines in making credit rating determinations. Among its provisions, the Energy Act allows the FERC, subject to certain criteria, to order owners of electric transmission systems, such as the Subsidiaries, to provide third parties with transmission access for wholesale power transactions. The Energy Act did not give the FERC the authority, however, to order retail transmission access. Movement toward opening the transmission network to retail customers is currently under consideration in several states. The competitive forces have also begun to influence some retail pricing in the industry. In a few instances, industrial customers, threatening to pursue cogeneration, self-generation or relocation to other service territories, have leveraged price concessions from utilities. Recent state regulatory actions, such as in New Jersey, suggest that utilities may have limited success with attempting to shift costs associated with such discounts to other customers. Utilities may have to absorb, in whole or part, the effects of price reductions designed to retain large retail customers. State regulators may put a limit or cap on prices, especially for those customers unable to pursue alternative supply options. Insofar as the Subsidiaries are concerned, unrecovered costs will most likely be related to generation investment, purchased power contracts, and "regulatory assets", which are deferred accounting transactions whose value rests on the strength of a state regulatory decision to allow future recovery from ratepayers. In markets where there is excess capacity (as there currently is in the region including New Jersey and Pennsylvania) and many available sources of power supply, the market price of electricity may be too low to support full recovery of capital costs of certain existing power plants, primarily the capital intensive plants such as nuclear units. Another significant exposure in the transition to a competitive market results if the prices of a utility's existing purchased power contracts, consisting primarily of contractual obligations with nonutility generators, are higher than future market prices. Utilities locked into expensive purchased power arrangements may be forced to value the contracts at market prices and recognize certain losses. A third source of exposure is regulatory assets which, if not supported by regulators, would have no value in a competitive market. Financial Accounting Standard No. 71 (FAS 71), "Accounting for the Effects of Certain Types of Regulation", applies to regulated utilities that have the ability to recover their costs through rates established by regulators and charged to customers. If a portion of the GPU System's operations continues to be regulated, FAS 71 accounting may only be applied to that portion. Write-offs of utility plant and regulatory assets may result for those operations that no longer meet the requirements of FAS 71. In addition, under deregulation, the uneconomical costs of certain contractual commitments for purchased power and/or fuel supplies may have to be expensed. Management believes that to the extent that the GPU System no longer qualifies for FAS 71 accounting treatment, a material adverse effect on its results of operations and financial position may result. At this time, it is difficult for management to project the future level of stranded assets or other unrecoverable costs, if any, without knowing what the market price of electricity will be, or if regulators will allow recovery of industry transition costs from customers. Corporate Realignment In February 1994, the Corporation announced a corporate realignment and related actions as a result of its ongoing strategic planning studies. GPU Generation Corporation (GPU Generation) will be formed to operate and maintain the fossil-fueled and hydroelectric generating units of the GPU System; Subsidiary ownership of the generating assets will remain with the Subsidiaries. GPU Generation will also build new generation facilities as needed by the Subsidiaries in the future. Involvement in the independent power generation market will continue through EI (See "Nonutility Businesses"). Additionally, the management and staff of Penelec and Met-Ed will be combined but the two companies will not be merged and will retain their separate corporate existence. This action is intended to increase effectiveness and lower cost. Included in this effort will be a search for parallel opportunities at GPUN and JCP&L. Completion of these realignment initiatives will be subject to various regulatory reviews and approvals from the SEC, FERC, NJBRC and the PaPUC. The GPU System is also developing a performance improvement and cost reduction program to help assure ongoing competitiveness, and, among other matters, will also address workforce issues in terms of compensation, size and skill mix. The GPU System is seeking annual cost savings of approximately $80 million by the end of 1996 as a result of these organizational changes. Duquesne Transaction In September 1990, the GPU System entered into a series of interdependent agreements with Duquesne Light Company (Duquesne) for the purchase of a 50% ownership interest in Duquesne's 300 megawatt (MW) Phillips Generating Station and the joint construction and ownership of associated high voltage bulk transmission facilities. The Subsidiaries' share of the total cost of these agreements was estimated to be $500 million, the major part of which was expected to be incurred after 1994. In addition, JCP&L and Met-Ed simultaneously entered into a related agreement with Duquesne to purchase 350 MW of capacity and energy from Duquesne for 20 years beginning in 1997. The Subsidiaries and Duquesne filed several petitions with the PaPUC and the NJBRC seeking certain of the regulatory authorizations required for the transactions. In December 1993, the NJBRC denied JCP&L's request to participate in the proposed transactions. As a result of this action and other developments, the Subsidiaries notified Duquesne that they were exercising their rights under the agreements to withdraw from and thereby terminate the agreements. Consequently, the Subsidiaries wrote off a total of approximately $25 million they had invested in the project. THE SUBSIDIARIES The electric generating and transmission facilities of the Subsidiaries are physically interconnected and are operated as a single integrated and coordinated system serving a population exceeding 4.8 million in New Jersey and Pennsylvania. For the year 1993, the Subsidiaries' revenues were about equally divided between Pennsylvania customers and New Jersey customers. During 1993, residential sales accounted for about 42% of operating revenues from customers and 36% of kilowatt-hour (KWH) sales to customers; commercial sales accounted for about 34% of operating revenues from customers and 32% of KWH sales to customers; industrial sales accounted for about 22% of operating revenues from customers and 29% of KWH sales to customers; and sales to rural electric cooperatives, municipalities (primarily for street and highway lighting) and others accounted for about 2% of operating revenues from customers and 3% of KWH sales to customers. The Subsidiaries also make interchange and spot market sales of electricity to other utilities. Reference is made to "System Statistics" on page, for additional information concerning the GPU System's sales and revenues. The area served by the Subsidiaries extends from the Atlantic Ocean to Lake Erie, is generally comprised of small communities, rural and suburban areas and includes a wide diversity of industrial enterprises, as well as substantial farming areas. The Subsidiaries' transmission facilities are physically interconnected with neighboring nonaffiliated utilities in Pennsylvania, New Jersey, Maryland, New York and Ohio. The Subsidiaries are members of the Pennsylvania-New Jersey-Maryland Interconnection (PJM) and the Mid-Atlantic Area Council, an organization providing coordinated review of the planning by utilities in the PJM area. The interconnection facilities are used for substantial capacity and energy interchange and purchased power transactions as well as emergency assistance. The Subsidiaries along with the other members of the PJM power pool, experienced an electric emergency due to extremely cold temperature from January 18 through January 20, 1994. In order to maintain the electric system and to avoid a total black-out, intermittent black-outs for periods typically of one to two hours were instituted on January 19, 1994 to control peak loads. In February 1994, the NJBRC, the PaPUC and the FERC initiated investigations of the energy emergency, and forwarded data requests to all affected utilities. In addition, the United States House of Representatives' Energy and Power Subcommittee, among others, has held hearings on this matter. At this time, Management is unable to estimate the impact, if any, from any conclusions that may be reached by the regulators. In May 1993, the Pennsylvania Office of Consumer Advocate (Consumer Advocate) filed a petition for review of Met-Ed's rate order with the Pennsylvania Commonwealth Court seeking to set aside a March 1993 decision which allowed Met-Ed to (a) recover in the future certain Three Mile Island Unit 2 (TMI-2) retirement costs (radiological decommissioning and nonradiological cost of removal) and (b) defer the incremental costs associated with the adoption of the Statement of Financial Accounting Standards No. 106 (FAS 106) "Employers' Accounting for Postretirement Benefits Other Than Pensions." If the 1993 rate order is reversed, Met-Ed and Penelec would be required to write off a total of approximately $170 million for TMI-2 retirement costs. In addition, the Consumer Advocate is contesting utility deferral of FAS 106 costs in a proceeding involving another utility. The outcome of this proceeding may affect the recovery of FAS 106 costs for Met-Ed and Penelec. This matter is pending before the court. (See "Rate Proceedings.") Competition in the electric utility industry has already played a significant role in wholesale transactions, affecting the pricing of energy sales to electric cooperatives and municipal customers. During 1993, Penelec successfully negotiated power supply agreements with several existing GPU System wholesale customers in response to offers made by other utilities seeking to provide electric service at rates lower than those of Met-Ed or JCP&L. Penelec has made similar offers to certain wholesale customers now being served by other utilities. Although wholesale customers represent a relatively small portion of GPU System sales, the Subsidiaries will continue their efforts to retain and add customers. NUCLEAR FACILITIES The Subsidiaries have made investments in three major nuclear projects -- Three Mile Island Unit 1 (TMI-1) and Oyster Creek, both of which are operational generating facilities, and TMI-2, which was damaged during the 1979 accident. At December 31, 1993, the Subsidiaries' net investment in TMI-1 and Oyster Creek, including nuclear fuel, was $670 million and $784 million, respectively. TMI-1 and TMI-2 are jointly owned by JCP&L, Met-Ed and Penelec in the percentages of 25%, 50% and 25%, respectively. Oyster Creek is owned by JCP&L. Costs associated with the operation, maintenance and retirement of nuclear plants have continued to increase and become less predictable, in large part due to changing regulatory requirements and safety standards and experience gained in the construction and operation of nuclear facilities. The GPU System may also incur costs and experience reduced output at its nuclear plants because of the design criteria prevailing at the time of construction and the age of the plants' systems and equipment. In addition, for economic or other reasons, operation of these plants for the full term of their now assumed lives cannot be assured. Also, not all risks associated with ownership or operation of nuclear facilities may be adequately insured or insurable. Consequently, the ability of electric utilities to obtain adequate and timely recovery of costs associated with nuclear projects, including replacement power, any unamortized investment at the end of the plants' useful life (whether scheduled or premature), the carrying costs of that investment and retirement costs, is not assured. Management intends, in general, to seek recovery of any such costs described above through the ratemaking process, but recognizes that recovery is not assured. TMI-1 TMI-1, a 786-MW pressurized water reactor, was licensed by the NRC in 1974 for operation through 2008. The NRC has extended the TMI-1 operating license through April 2014, in recognition of the plant's approximate six- year construction period. During 1993, TMI-1 operated at a capacity factor of approximately 87%. A scheduled refueling outage that year lasted 36 days; the next refueling outage is scheduled for late 1995. Oyster Creek The Oyster Creek station, a 610-MW boiling water reactor, received a provisional operating license from the NRC in 1969 and a full term operating license in 1991. In April 1993, the NRC extended the station's operating license from 2004 to 2009 in recognition of the plant's approximate four- year construction period. The plant operated at a capacity factor of approximately 87% during 1993. A scheduled refueling outage lasted 81 days and the plant returned to service on February 16, 1993. The next refueling outage is scheduled for September 1994. TMI-2 The 1979 TMI-2 accident resulted in significant damage to, and contamination of, the plant and a release of radioactivity to the environment. The cleanup program was completed in 1990, and, after receiving NRC approval, TMI-2 entered into long-term monitored storage in December 1993. As a result of the accident and its aftermath, individual claims for alleged personal injury (including claims for punitive damages), which are material in amount, have been asserted against the Corporation and the Subsidiaries. Approximately 2,100 of such claims are pending in the U.S. District Court for the Middle District of Pennsylvania. Some of the claims also seek recovery for injuries from alleged emissions of radioactivity before and after the accident. Questions have not yet been resolved as to whether the punitive damage claims are (a) subject to the overall limitation of liability set by the Price-Anderson Act ($560 million at the time of the accident) and (b) outside the primary insurance coverage provided pursuant to that Act (remaining primary coverage of approximately $80 million as of December 1993). If punitive damages are not covered by insurance or are not subject to the Price-Anderson liability limitation, punitive damage awards could have a material adverse effect on the financial position of the GPU System. In June 1993, the Court agreed to permit pre-trial discovery on the punitive damage claims to proceed. A trial of twelve allegedly representative cases is scheduled to begin in October 1994. In February 1994, the Court held that the plaintiffs' claims for punitive damages are not barred by the Price-Anderson Act to the extent that the funds to pay punitive damages do not come out of the U.S. Treasury. The Court also denied the defendants' motion seeking a dismissal of all cases on the grounds that the defendants complied with applicable federal safety standards regarding permissible radiation releases from TMI-2 and that, as a matter of law, the defendants therefore did not breach any duty that they may have owed to the individual plaintiffs. The Court stated that a dispute about what radiation and emissions were released cannot be resolved on a motion for summary judgment. NUCLEAR PLANT RETIREMENT COSTS Retirement costs for nuclear plants include decommissioning the radiological portions of the plants and the cost of removal of nonradiological structures and materials. The disposal of spent nuclear fuel is covered separately by contracts with the U.S. Department of Energy (DOE). See Note 2 to consolidated financial statements for further information regarding nuclear fuel disposal costs. In 1990, the Subsidiaries submitted a report, in compliance with NRC regulations, setting forth a funding plan (employing the external sinking fund method) for the decommissioning of their nuclear reactors. Under this plan, the Subsidiaries intend to complete the funding for Oyster Creek and TMI-1 by the end of the plants' license terms, 2009 and 2014, respectively. The TMI-2 funding completion date is 2014, consistent with TMI-2 remaining in long-term storage and being decommissioned at the same time as TMI-1. Under the NRC regulations, the funding targets (in 1993 dollars) for TMI-1 and Oyster Creek are $143 million and $175 million, respectively. Based on NRC studies, a comparable funding target for TMI-2 (in 1993 dollars), which takes into account the accident, is $228 million. The NRC is currently studying the levels of these funding targets. Management cannot predict the effect that the results of this review will have on the funding targets. NRC regulations and a regulatory guide provide mechanisms, including exemptions, to adjust the funding targets over their collection periods to reflect increases or decreases due to inflation and changes in technology and regulatory requirements. The funding targets, while not actual cost estimates, are reference levels designed to assure that licensees demonstrate adequate financial responsibility for decommissioning. While the regulations address activities related to the removal of the radiological portions of the plants, they do not establish residual radioactivity limits nor do they address costs related to the removal of nonradiological structures and materials. In 1988, a consultant to GPUN performed site-specific studies of TMI-1 and Oyster Creek that considered various decommissioning plans and estimated the cost of the radiological portions of decommissioning each plant to range from approximately $205 to $285 million and $220 to $320 million, respectively (adjusted to 1993 dollars). In addition, the studies estimated the cost of removal of nonradiological structures and materials for TMI-1 and Oyster Creek at $72 million and $47 million, respectively. The ultimate cost of retiring the GPU System's nuclear facilities may be materially different from the funding targets and the cost estimates contained in the site-specific studies and cannot now be more reasonably estimated than the level of the NRC funding target because such costs are subject to (a) the type of decommissioning plan selected, (b) the escalation of various cost elements (including, but not limited to, general inflation), (c) the further development of regulatory requirements governing decommissioning, (d) the absence to date of significant experience in decommissioning such facilities and (e) the technology available at the time of decommissioning. The Subsidiaries charge to expense and contribute to external trusts amounts collected from customers for nuclear plant decommissioning and nonradiological costs. In addition, the Subsidiaries have contributed to external trusts amounts written off for nuclear plant decommissioning in 1990 and 1991. TMI-1 and Oyster Creek JCP&L is collecting revenues for decommissioning, which are expected to result in the accumulation of its share of the NRC funding target for each plant. JCP&L has also begun collecting revenues based on estimates, adopted in a February 26, 1993 summary rate order issued by the NJBRC, for the cost of removal of nonradiological structures and materials at each plant based on its share of an estimated $15.3 million for TMI-1 and $31.6 million for Oyster Creek. In January 1993, the PaPUC granted Met-Ed revenues for decommissioning costs of TMI-1 based on its share of the NRC funding target and nonradiological cost of removal as estimated in the site-specific study. Effective October 1993, the PaPUC approved a rate change for Penelec which increased the collection of revenues for decommissioning costs for TMI-1 to a basis equivalent to that granted Met-Ed. Collections from customers for decommissioning expenditures are deposited in external trusts. These external trust funds, including the interest earned, are classified as Decommissioning Funds on the balance sheet. Provision for the future expenditure of these funds has been made in accumulated depreciation, amounting to $29 million for TMI-1 and $80 million for Oyster Creek at December 31, 1993. Management believes that TMI-1 and Oyster Creek retirement costs, in excess of those currently recognized for ratemaking purposes, should be recoverable through the ratemaking process. TMI-2 The Corporation and its Subsidiaries have recorded a liability amounting to $229 million as of December 31, 1993, for the radiological decommissioning of TMI-2, reflecting the NRC funding target. The Subsidiaries record escalations, when applicable, in the liability based upon changes in the NRC funding target. The Subsidiaries have also recorded a liability in the amount of $20 million for incremental costs specifically attributable to monitored storage. Such costs are expected to be incurred between 1994 and 2014, when decommissioning is forecast to begin. In addition, the Subsidiaries have recorded a liability in the amount of $71 million for nonradiological cost of removal. The above amounts for retirement costs and monitored storage are reflected as Three Mile Island Unit 2 Future Costs on the balance sheet. JCP&L has made a nonrecoverable contribution of $15 million to an external decommissioning trust. Met-Ed and Penelec have made nonrecoverable contributions of $40 million and $20 million, respectively, to external decommissioning trusts relating to their shares of the accident- related portion of the decommissioning liability. The NJBRC and the PaPUC have granted JCP&L and Met-Ed, respectively, decommissioning revenues for the remainder of the NRC funding target and allowances for the cost of removal of nonradiological structures and materials, although the PaPUC's order has been appealed by the Consumer Advocate (see "Rate Proceedings"). Penelec intends to request decommissioning revenues and an allowance for the cost of removal of nonradiological structures and materials, equivalent to its share of the amounts granted to Met-Ed, in its next retail base rate filing. Management intends to seek recovery for any increases in TMI-2 retirement costs, but recognizes that recovery cannot be assured. As a result of TMI-2's entering long-term monitored storage, the Subsidiaries are incurring incremental storage costs currently estimated at $1 million annually. The Subsidiaries have deferred the $20 million for the total estimated incremental costs attributable to monitored storage through 2014, the expected retirement date of TMI-1. The JCP&L share of these costs has been recognized in rates by the NJBRC. Met-Ed and Penelec believe these costs should be recoverable through the ratemaking process. INSURANCE The GPU System has insurance (subject to retentions and deductibles) for its operations and facilities including coverage for property damage, liability to employees and third parties, and loss of use and occupancy (primarily incremental replacement power costs). There is no assurance that the GPU System will maintain all existing insurance coverages. Losses or liabilities that are not completely insured, unless allowed to be recovered through ratemaking, could have a material adverse effect on the financial position of the GPU System. The decontamination liability, premature decommissioning and property damage insurance coverage for the TMI station (TMI-1 and TMI-2 are considered one site for insurance purposes) and for Oyster Creek totals $2.7 billion per site. In accordance with NRC regulations, these insurance policies generally require that proceeds first be used for stabilization of the reactors and then to pay for decontamination and debris removal expenses. Any remaining amounts available under the policies may then be used for repair and restoration costs and decommissioning costs. Consequently, there can be no assurance that in the event of a nuclear incident, property damage insurance proceeds would be available for the repair and restoration of the stations. The Price-Anderson Act limits the GPU System's liability to third parties for a nuclear incident at one of its sites to approximately $9.4 billion. Coverage for the first $200 million of such liability is provided by private insurance. The remaining coverage, or secondary protection, is provided by retrospective premiums payable by all nuclear reactor owners. Under secondary protection, a nuclear incident at any licensed nuclear power reactor in the country, including those owned by the GPU System, could result in assessments of up to $79 million per incident for each of the GPU System's three reactors, subject to an annual maximum payment of $10 million per incident per reactor. In 1993, GPUN requested an exemption from the NRC to eliminate the secondary protection requirements for TMI-2. This matter is pending before the NRC. The GPU System has insurance coverage for incremental replacement power costs resulting from an accident-related outage at its nuclear plants. Coverage commences after the first 21 weeks of the outage and continues for three years at decreasing levels beginning at weekly amounts of $1.8 million and $2.6 million for Oyster Creek and TMI-1, respectively. Under its insurance policies applicable to nuclear operations and facilities, the GPU System is subject to retrospective premium assessments of up to $52 million in addition to those payable under the Price-Anderson Act. NONUTILITY AND OTHER POWER PURCHASES The Subsidiaries have entered into power purchase agreements with independently owned power production facilities (nonutility generators) for the purchase of energy and capacity for periods up to 25 years. The majority of these agreements are subject to penalties for nonperformance and other contract limitations. While a few of these facilities are dispatchable, most are must-run and generally obligate the Subsidiaries to purchase all of the power produced up to the contract limits. The agreements have been approved by the state regulatory commissions and permit the Subsidiaries to recover energy and demand costs from customers through their energy clauses. These agreements provide for the sale of approximately 2,452 MW of capacity and energy to the GPU System by the mid-to-late 1990s. As of December 31, 1993, facilities covered by these agreements having 1,193 MW of capacity were in service, and 215 MW were scheduled to commence operation in 1994. Payments made pursuant to these agreements were $491 million for 1993 and are estimated to aggregate $551 million for 1994. The price of the energy and capacity to be purchased under these agreements is determined by the terms of the contracts. The rates payable under a number of these agreements are substantially in excess of current market prices. While the Subsidiaries have been granted full recovery of these costs from customers by the state commissions, there can be no assurance that the Subsidiaries will continue to be able to recover these costs throughout the term of the related contracts. The emerging competitive market has created additional uncertainty regarding the forecasting of the System's energy supply needs which, in turn, has caused the Subsidiaries to change their supply strategy to seek shorter term agreements offering more flexibility. At the same time, the Subsidiaries are attempting to renegotiate, and in some cases buy out, high cost long-term nonutility generation contracts where opportunities arise. The extent to which the Subsidiaries may be able to do so, however, or recover associated costs through rates, is uncertain. Moreover, these efforts have led to disputes before both the NJBRC and the PaPUC, as well as to litigation, and may result in claims against the Subsidiaries for substantial damages. There can be no assurance as to the outcome of these matters. In July 1993, the PaPUC acted to initiate a rulemaking proceeding which, in general, would establish a mandatory all-source competitive bidding program by which utilities would meet their future capacity and energy needs. Also in July, a NJBRC Advisory Council recommended in a report that all New Jersey electric utilities be required to submit integrated resource plans for review and approval by the NJBRC. The NJBRC has asked all electric utilities in the state to assess the economics of their purchased power contracts with nonutility generators to determine whether there are any candidates for potential buy-out or other remedial measures. In response, JCP&L initially identified a 100 MW project now under development, which it believes is economically undesirable based on current cost projections. In November 1993, the NJBRC directed JCP&L and the developer to negotiate contract repricing to a level more consistent with JCP&L's current avoided cost projections or a contract buy-out. The parties have been unable to reach agreement and on February 10, 1994 the NJBRC decided to conduct a hearing on the matter. The developer has filed a declaratory judgement action in federal court contesting the NJBRC's jurisdiction in this matter and is seeking to enjoin the NJBRC proceeding. The matter is pending before the District Court and the NJBRC. In November 1993, the NJBRC granted two nonutility generators, having a total of 200 MW under contract with JCP&L, a one-year extension in the in- service dates for projects which were originally scheduled to be operational in 1997. JCP&L is awaiting a final written NJBRC order and may appeal this decision. Also in November 1993, JCP&L received approval from the NJBRC to withdraw its request for proposals for the purchase of 150 MW from nonutility generators. In its petition requesting withdrawal, JCP&L cited, among other reasons, that solicitations for long-term contracts would have limited its ability to compete in a deregulated environment. As a result of the NJBRC's decision, in January 1994, JCP&L issued an all source solicitation for the short-term supply of energy and/or capacity to determine and evaluate the availability of competitively priced power supply options. JCP&L is seeking proposals from utility and nonutility generation suppliers for periods of one to eight years in length and capable of delivering electric power beginning in 1996. Although the intention of the solicitation is to procure short- term and medium-term supplies of electric power, JCP&L is willing to give some consideration to proposals in excess of eight-year terms. In November 1993, Penelec filed an appeal with the Commonwealth Court seeking to overturn a PaPUC order which directs Penelec to enter into two power purchase agreements with nonutility generators for a total of 160 MW under long-term contracts commencing in 1997 or later. Penelec believes it does not need this additional capacity and believes the costs associated with these contracts are not in the economic interests of its customers. The matter is pending before the Commonwealth Court. JCP&L and Met-Ed have entered into arrangements for two peaking generation projects. JCP&L plans to install a gas-fired combustion turbine at its Gilbert Generating Station and retire two steam units for an 88 MW net increase in peaking capacity at an expected cost of $50 million. JCP&L expects to complete the project by 1996. Met-Ed has received the PaPUC's approval to build a 134 MW gas-fired combustion turbine adjacent to its Portland Generating Station at a cost of $50 million. The approval has been appealed by a nonutility generator seeking to sell Met-Ed an equivalent amount of baseload capacity. The Subsidiaries have entered into agreements with other utilities for the purchase of capacity and energy for various periods through 1999. These agreements provide for up to 2,130 MW in 1994, declining to 1,307 MW in 1995 and 183 MW by 1999. Payments pursuant to these agreements are estimated to aggregate $244 million in 1994. The price of the energy purchased under these agreements is determined by contracts providing generally for the recovery by the sellers of their costs. RATE PROCEEDINGS Pennsylvania In April 1992, Met-Ed filed with the PaPUC a petition requesting a net $55 million annual increase in retail base rates. The request for additional revenues included provisions for higher operating expenses, capital costs and nuclear plant decommissioning costs. In January 1993, the PaPUC issued a rate order denying revenues for certain TMI-2 retirement and incremental monitored storage costs and the collection of costs associated with the adoption of FAS 106. In March 1993, in response to a petition filed by Met-Ed for clarification, reconsideration and amendment, the PaPUC modified portions of its January 1993 rate order to allow for the future recovery of certain TMI- 2 retirement costs (radiological decommissioning and nonradiological cost of removal). (See "Nuclear Plant Retirement Costs.") In addition, the PaPUC action allowed both Met-Ed and Penelec to defer the incremental costs associated with the adoption of FAS 106. The PaPUC directed Met-Ed to reduce its amortization of TMI-2 to $8.3 million, retroactive to January 1993. The recovery of certain TMI-2 retirement costs will begin when the amortization of the TMI-2 investment ends in 1994 at the same annual amount ($6.3 million for recovery of radiological decommissioning and $2.0 million for nonradiological cost of removal, net of gross receipts tax). In May 1993, the Consumer Advocate filed a petition for review with the Pennsylvania Commonwealth Court seeking to set aside the PaPUC 1993 rate order. The matter is pending before the court. If the 1993 rate order is reversed, Met-Ed and Penelec would be required to write off a total of approximately $170 million for TMI-2 retirement costs. Penelec intends to request decommissioning revenues and an allowance for the cost of removal of nonradiological structures and materials, equivalent to its share of the amounts granted to Met-Ed, in its next retail base rate filing. Management intends to seek recovery for any increases in TMI-2 retirement costs, but recognizes that recovery cannot be assured. The PaPUC has recently completed its generic investigation into demand- side management (DSM) cost recovery mechanisms and issued a cost recovery and ratemaking order in December 1993. Penelec and Met-Ed are currently developing plans which will reflect changes since their original plans were filed in 1991. In December 1993, the Pennsylvania Industrial Energy Coalition (PIEC) appealed to the Commonwealth Court to reverse the PaPUC Order. On February 4, 1994, Met-Ed and Penelec filed a petition seeking a stay of the PaPUC's Order until the PIEC's appeal is resolved. (See "Demand Side Management.") In February 1994, Met-Ed made an annual filing with the PaPUC for an increase in its Energy Cost Rate (ECR) of $4.7 million. The new rate is expected to become effective April 1, 1994. In March 1994, Penelec made its annual filing with the PaPUC for an increase in its ECR of $38.3 million. The new rate is expected to become effective April 1, 1994. The PaPUC is considering generic nuclear performance standards for Pennsylvania utilities. In January 1994, Met-Ed and Penelec submitted a proposal which, along with proposals submitted by the other Pennsylvania utilities, may result in the PaPUC adopting a generic nuclear performance standard. New Jersey In December 1993, JCP&L filed a proposal with the NJBRC seeking approval to implement a new rate initiative designed to retain and expand the economic base in New Jersey. Under the proposed contract rate service, large retail customers could enter into contracts for existing electric service at prevailing rates, with limitations on their exposure to future rate increases. With this rate initiative, JCP&L would have to absorb any differential in price resulting from changes in costs not provided for in the contracts. This matter is pending before the NJBRC. Proposed legislation has been introduced in New Jersey which is intended to allow the NJBRC, at the request of an electric or gas utility, to adopt a plan of regulation other than traditional ratemaking methods to encourage economic development and job creation. This legislation would allow electric utilities to be more competitive with nonutility generators who are not subject to NJBRC regulation. Combined with other economic development initiatives, this legislation, if enacted, would provide more flexibility in responding to competitive pressures, but may also serve to accelerate the growth of competitive pressures. JCP&L's two operating nuclear units are subject to the NJBRC's annual nuclear performance standard. Operation of these units at an aggregate generating capacity factor below 65% or above 75% would trigger a charge or credit based on replacement energy costs. At current cost levels, the maximum annual effect on net income of the performance standard charge at a 40% capacity factor would be approximately $10 million. While a capacity factor below 40% would generate no specific monetary charge, it would require the issue to be brought before the NJBRC for review. The annual measurement period, which begins in March of each year, coincides with that used for the Levelized Energy Adjustment Clause (LEAC). The NJBRC has instituted a generic proceeding to address the appropriate recovery of capacity costs associated with electric utility power purchases from nonutility generation projects. The proceeding was initiated, in part, to respond to contentions of the New Jersey Public Advocate, Division of Rate Counsel (Rate Counsel), that by permitting utilities to recover such costs through the LEAC, an excess or "double recovery" may result when combined with the recovery of the utilities' embedded capacity costs through their base rates. In September 1993, JCP&L and the other New Jersey electric utilities filed motions for summary judgment with the NJBRC requesting that the NJBRC dismiss contentions being made by Rate Counsel that adjustments for alleged "double recovery" in prior periods are warranted. Rate Counsel has filed a brief in opposition to the utilities' summary judgment motions including a statement from its consultant that in his view, the "double recovery" for JCP&L for the 1988-92 period would be approximately $102 million. Management believes that the position of Rate Counsel is without merit. This matter is pending before the NJBRC. CONSTRUCTION PROGRAM General During 1993, the Subsidiaries had gross plant additions of approximately $520 million attributable principally to improvements and modifications to existing generating stations, additions to the transmission and distribution system and clean air requirements. During 1994, JCP&L, Met-Ed, Penelec and GPUSC contemplate gross plant additions of approximately $275 million, $167 million, $218 million and $3 million, respectively. The Subsidiaries' gross plant additions are expected to total approximately $589 million in 1995. The anticipated decrease in construction expenditures during 1995 is principally attributable to an anticipated reduction in the level of expenditures associated with clean air requirements and nuclear generation. The principal categories of the 1994 anticipated expenditures, which include an allowance for other funds used during construction, are as follows: (In Millions) Generation - Nuclear $ 93 Nonnuclear 228 Total Generation 321 Transmission & Distribution 291 Other 51 Total $663 In addition, expenditures for maturing debt are expected to be $133 million and $91 million for 1994 and 1995, respectively. Subject to market conditions, the Subsidiaries intend to redeem during these periods outstanding senior securities pursuant to optional redemption provisions thereof should it prove economical to do so. Management estimates that approximately one-half of the GPU System's total capital needs for 1994 and 1995 will be satisfied through internally generated funds. The Subsidiaries expect to obtain the remainder of these funds principally through the sale of first mortgage bonds and preferred stock, subject to market conditions. The Subsidiaries' bond indentures and articles of incorporation include provisions that limit the amount of long- term debt, preferred stock and short-term debt the Subsidiaries may issue. The Subsidiaries' interest and preferred stock dividend coverage ratios are currently in excess of indenture or charter restrictions. Present plans call for the Subsidiaries to issue long-term debt and preferred stock during the next three years to finance construction activities and, depending on the level of interest rates, refinance outstanding senior securities. The GPU System's 1994 construction program includes $120 million in connection with the federal Clean Air Act Amendments of 1990 (Clean Air Act) requirements (see "Environmental Matters-Air"). The 1995 construction program currently includes approximately $75 million for Clean Air Act compliance. GPU's gross plant additions exclude nuclear fuel requirements provided under capital leases that amounted to $46 million in 1993. When consumed, the presently leased material, which amounted to $150 million at December 31, 1993, is expected to be replaced by additional leased material at an average rate of approximately $60 million annually. In the event the replacement nuclear fuel needs cannot be leased, the associated capital requirements would have to be met by other means. The GPU System has a projected need, due in large part to anticipated peak load growth, of 644 MW of additional capacity by the year 1998 based on an average growth in sales to customers of about 1.7% annually with growth rates for the Subsidiaries projected from about 1.1% to 2.3%. GPU intends to provide for this increased energy need through a mix of economic sources. In response to the increasingly competitive business climate and excess capacity of nearby utilities, the GPU System's supply plan places an emphasis on maintaining flexibility. Supply planning focuses increasingly on short to intermediate term commitments, reliance on "spot" markets, and avoidance of long-term firm commitments. Through 1998, GPU's plan consists of the continued utilization of most existing generating facilities, retirement of certain older units, power purchases, construction of new facilities, and the continued promotion of economic energy conservation and load management programs. Given the future direction of the industry, GPU's present strategy includes minimizing the financial exposure associated with new long-term purchase commitments and the construction of new facilities by including projected market prices in the evaluation of these options. The GPU System will resist efforts to compel it to add or contract for new capacity at costs that may exceed future market prices. In addition, the Subsidiaries will seek regulatory support to renegotiate or buy out contracts with nonutility generators where the pricing is in excess of projected market prices. Demand-Side Management The regulatory environments in both New Jersey and Pennsylvania encourage the development of new conservation and load management programs. This is evidenced by DSM incentive regulations adopted in New Jersey in 1992 and recent approval of a cost recovery mechanism for DSM in Pennsylvania. DSM includes utility sponsored activities designed to improve energy efficiency in customer end-use, and includes load management programs (i.e., peak reduction) and conservation programs (i.e., energy and peak reduction). In New Jersey, the NJBRC approved JCP&L's DSM plan in 1992 reflecting DSM initiatives of 67 MW of summer peak reduction by the end of 1994. Under the approved regulation, qualified Performance Program DSM investments are recovered over a six-year period with a return earned on the unrecovered amounts. Lost revenues will be recovered on an annual basis and JCP&L can also earn a performance-based incentive for successfully implementing cost effective programs. In addition, JCP&L will continue to make certain NJBRC mandated Core Program DSM investments which are recovered annually. In 1990, Met-Ed and Penelec jointly filed a proposal with the PaPUC on demand-side management (DSM) issues. The proposal recommends that the PaPUC preapprove DSM programs of utilities to enable the collection of their costs and that the PaPUC issue an order on a generic basis. In December 1993, the PaPUC issued an order adopting generic guidelines for recovery of DSM expenses. Also, in December 1993, the Consumer Advocate and the Pennsylvania Energy Office filed separate petitions for clarification and reconsideration of the PaPUC's order and the PIEC appealed to the Commonwealth Court to reverse the PaPUC order. On February 4, 1994, Met-Ed and Penelec filed a petition seeking a stay of the PaPUC's order until the PIEC's appeal is resolved. FINANCING ARRANGEMENTS The Corporation and its affiliates expect to have short-term debt outstanding from time to time throughout the year. The peak in short-term debt outstanding is expected to occur in the spring coinciding with normal cash requirements for revenue tax payments. The Corporation and the Subsidiaries have $398 million of credit facilities, which includes a Revolving Credit Agreement (Credit Agreement) with a consortium of banks that permits total borrowing of $150 million outstanding at any one time. The credit facilities generally provide for the payment of a commitment fee on the unborrowed amount of 1/8 of 1% annually. Borrowings under these credit facilities generally bear interest based on the prime rate or money market rates. Notes issued under the Credit Agreement, which expires April 1, 1995, are subject to various covenants and acceleration under certain conditions. In 1993, the Subsidiaries refinanced higher cost long-term debt in the principal amount of $723 million resulting in an estimated annualized after- tax savings of $6 million. Total GPU System long-term debt issued during 1993 amounted to $957 million. In addition, the Subsidiaries redeemed $156 million of high-dividend rate preferred stock issues. During 1993, GPU sold four million shares of common stock at $33 1/8 per share through an underwritten public offering. The net proceeds of $128.7 million were used primarily to reimburse the Subsidiaries for the preferred stock redemptions. In January 1994, Penelec issued an aggregate of $90 million of first mortgage bonds, of which a portion of the net proceeds were used to redeem $38 million principal amount of 6 5/8% series bonds in February 1994. Met- Ed issued, in February 1994, an aggregate of $50 million of first mortgage bonds, of which a portion of the net proceeds will be used to redeem $26 million principal amount of 7% series bonds in March 1994. The Subsidiaries have regulatory authority to issue and sell first mortgage bonds, which may be issued as secured medium-term notes, and preferred stock for various periods through 1995. Under existing authorization, JCP&L, Met-Ed and Penelec may issue senior securities in the amount of $275 million, $250 million and $330 million, respectively, of which $100 million for each Subsidiary may consist of preferred stock. The Subsidiaries also have regulatory authority to incur short-term debt, a portion of which may be through the issuance of commercial paper. Under the Subsidiaries' nuclear fuel lease agreements with nonaffiliated fuel trusts, an aggregate of up to $250 million ($125 million each for Oyster Creek and TMI-1) of nuclear fuel costs may be outstanding at any one time. It is contemplated that when consumed, portions of the presently leased material will be replaced by additional leased material. The Subsidiaries are responsible for the disposal costs of nuclear fuel leased under these agreements. REGULATION As a registered holding company, GPU is subject to regulation by the SEC under the 1935 Act. The GPU System companies are also subject to regulation under the 1935 Act with respect to accounting, the issuance of securities, the acquisition and sale of utility assets, securities or any other interest in any business, the entering into, and performance of, service, sales and construction contracts, and certain other matters. The SEC has determined that the electric facilities of the Subsidiaries constitute a single integrated public utility system under the standards of the 1935 Act. The 1935 Act also limits the extent to which the GPU System may engage in nonutility businesses. Each Subsidiary's retail rates, conditions of service, issuance of securities and other matters are subject to regulation in the state in which such Subsidiary operates - in New Jersey by the NJBRC and in Pennsylvania by the PaPUC. Moreover, with respect to wholesale rates, the transmission of electric energy, accounting, the construction and maintenance of hydroelectric projects and certain other matters, the Subsidiaries are subject to regulation by the FERC under the Federal Power Act. The NRC regulates the construction, ownership and operation of nuclear generating stations and other related matters. (See "Electric Generation and the Environment - Environmental Matters" for additional regulation to which the Subsidiaries are or may be subject.) The rates charged by the Subsidiaries for electric service are set by regulators under statutory requirements that they be "just and reasonable." As such, they are subject to adjustment, up or down, in the event they vary from that statutory standard. In 1989, the NJBRC issued proposed regulations designed to establish a mechanism to evaluate the earnings of New Jersey utilities to determine whether their rates continue to be just and reasonable. As proposed, the regulations would permit the NJBRC to establish interim rates subject to refund without prior hearing. There has been no activity concerning this matter since JCP&L filed comments with the NJBRC. In 1992, as a result of a rulemaking proceeding, the PaPUC established quarterly financial reporting requirements to monitor public utility earnings. NONUTILITY BUSINESSES GPC was organized to make investments apart from the businesses of the Subsidiaries. Currently, these are conducted by EI, a subsidiary of GPC, and its subsidiaries. EI is in the business of developing, owning, operating and investing in cogeneration and other nonutility power production facilities. As of December 31, 1993, EI had 223 MW of capacity in operation and an option to acquire a 20% equity interest in projects having an additional 350 MW of capacity. EI's potential business activities and markets have been significantly expanded as a result of the regulatory changes brought about by the Energy Act. In 1993, EI entered into an agreement to invest up to $8.5 million over the next four years to acquire an up to 29% equity interest in a private independent power development company, which has commitments or prospects to provide more than 200 MW of electricity to utilities in Canada and plans to develop other projects in the United States. EI also obtained the right to operate several of the projects. In addition, EI has been active as a bidder and has proposals pending for the development and acquisition of additional capacity in the United States. EI is also pursuing international development projects in Latin America and has been designated as a successful bidder on a proposed 750 MW repowering project in Colombia, South America. EI is also investigating other international opportunities. At December 31, 1993, GPU's investment in GPC was $39 million. GPU intends to make additional investments in the development and ownership of nonutility generating facilities in an effort to expand these business activities. The timing and amounts of these investments, however, will depend upon the development of appropriate opportunities. GPU does not expect investments apart from the activities of EI to be a major part of its business activities; however, this may change as GPU's strategic plan is developed. (See "Regulation.") ELECTRIC GENERATION AND THE ENVIRONMENT Fuel Of the portion of their energy requirements supplied by their own generation, the Subsidiaries utilized fuels in the generation of electric energy during 1993 in approximately the following percentages: Coal--60%; Nuclear--38%; Gas--1% and Oil--1%. Approximately 42% of the Subsidiaries' energy requirements in 1993 was supplied by purchases (including net interchange) from other utilities and nonutility generators. For 1994, the Subsidiaries estimate that their generation of electric energy will be in the following proportions: Coal--64%; Nuclear--33%; Gas--2% and Oil--1%. The anticipated changes in 1994 fuel utilization percentages are principally attributable to the refueling outage scheduled during 1994 for the Oyster Creek nuclear generating station. Approximately 43% of the Subsidiaries' 1994 energy requirements are expected to be supplied by purchases (including net interchange) from other utilities and nonutility generators. Fossil: The Subsidiaries have entered into long-term contracts with nonaffiliated mining companies for the purchase of coal for certain generating stations in which they have ownership interests. The contracts, which expire between 1994 and the end of the expected service lives of the generating stations, require the purchase of fixed amounts of coal. The price of the coal under the contracts is generally based on adjustments of indexed cost components. One contract also includes a provision for the payment of environmental and post-employment benefits. Another coal contract sets coal prices that generally provide for the recovery by the mining companies of their costs of production. The Subsidiaries' share of the cost of coal purchased under these agreements is expected to aggregate $89 million for 1994. The Subsidiaries' coal-fired generating stations now in service are estimated to require an aggregate of 160 million tons of coal over the next twenty years. Of this total requirement, approximately 13 million tons are expected to be supplied by nonaffiliated mine-mouth coal companies with the balance supplied through long-term contracts and spot market purchases. At the present time, adequate supplies of fossil fuels are readily available to the Subsidiaries, but this situation could change rapidly as a result of actions over which they have no control. Nuclear: Preparation of nuclear fuel for generating station use involves various manufacturing stages for which the GPU System contracts separately. Stage I involves the mining and milling of uranium ores to produce natural uranium concentrates. Stage II provides for the chemical conversion of the natural uranium concentrates into uranium hexafluoride. Stage III involves the process of enrichment to produce enriched uranium hexafluoride from the natural uranium hexafluoride. Stage IV provides for the fabrication of the enriched uranium hexafluoride into nuclear fuel assemblies for use in the reactor core at the nuclear generating station. For TMI-1, under normal operating conditions, there is, with minor planned modifications, sufficient on-site storage capacity to accommodate spent nuclear fuel through the end of its licensed life while maintaining the ability to remove the entire reactor core. While Oyster Creek currently has sufficient on-site storage capacity to accommodate, under normal operating conditions, its spent nuclear fuel while maintaining the ability to remove the entire reactor core, additional on-site storage capacity will be required at the Oyster Creek station beginning in 1996 in order to continue operation of the plant. Contract commitments, with an outside vendor, have been made for on-site incremental spent fuel dry storage capacity at Oyster Creek for 1996 and 1998. Currently, public hearings on plans to build an interim spent fuel facility at the plant are underway. Environmental Matters The Subsidiaries are subject to federal and state water quality, air quality, solid waste disposal and employee health and safety legislation and to environmental regulations issued by the U.S. Environmental Protection Agency (EPA), state environmental agencies and other federal agencies. In addition, the Subsidiaries are subject to licensing of hydroelectric projects by the FERC and of nuclear power projects by the NRC. Such licensing and other actions by federal agencies with respect to projects of the Subsidiaries are also subject to the National Environmental Policy Act. As a result of existing and proposed legislation and regulations, and ongoing legal proceedings dealing with environmental matters, including but not limited to acid rain, water quality, air quality, global warming, electromagnetic fields, and storage and disposal of hazardous and/or toxic wastes, the GPU System may be required to incur substantial additional costs to construct new equipment, modify or replace existing and proposed equipment, remediate or clean up waste disposal and other sites currently or formerly used by it, including formerly owned manufactured gas plants and mine refuse piles, and with regard to electromagnetic fields, postpone or cancel the installation of, or replace or modify, utility plant, the costs of which could be material. The consequences of environmental issues, which could cause the postponement or cancellation of either the installation or replacement of utility plant are unknown. Management believes the costs described above should be recoverable through the ratemaking process but recognizes that recovery cannot be assured. Water: The federal Water Pollution Control Act (Clean Water Act) generally requires, with respect to existing steam electric power plants, the application of the best conventional or practicable pollutant control technology available and compliance with state-established water quality standards. With respect to future plants, the Clean Water Act requires the application of the "best available demonstrated control technology, processes, operating methods or other alternatives" to achieve, where practicable, no discharge of pollutants. Congress may amend the Clean Water Act during 1994. The EPA has adopted regulations that establish thermal and other limitations for effluents discharged from both existing and new steam electric generating stations. Standards of performance are developed and enforcement of effluent limitations is accomplished through the issuance by the EPA, or states authorized by the EPA, of discharge permits that specify limitations to be applied. Discharge permits, which have been issued for all of the GPU System's generating stations, where required, have expiration dates ranging through 1998. Timely reapplications for such permits have been filed as required by regulations. The discharge permit received by JCP&L for the Oyster Creek station may, among other things, require the installation of a closed-cycle cooling system, such as a cooling tower, to meet New Jersey state water quality- based thermal effluent limitations. Although construction of such a system is not required in order to meet the EPA's regulations setting effluent limitations for the Oyster Creek station (such regulations would accept the use of the once-through cooling system now in operation at this station), a closed-cycle cooling system may be required in order to comply with the water quality standards imposed by the New Jersey Department of Environmental Protection and Energy (NJDEPE) for water quality certification and incorporated in the station's discharge permit. If a cooling tower is required, the capital costs could exceed $150 million. In 1988, the NJDEPE prepared a draft evaluation that assessed the impact of cooling water intake and discharge from Oyster Creek. This evaluation concluded that the thermal impact of water discharge from Oyster Creek operation was small and localized but that the impact of cooling water intake was inconclusive, requiring further study. In 1993, the NJDEPE advised GPUN that rather than conduct hearings, it will determine GPUN's water quality standards in the context of renewing the discharge permit. The NJDEPE has indicated that water quality standards (on an interim basis) will be set as requested by GPUN and that physical or operational changes to the intake structure will not be necessary at this time. Final standards will be established based upon results of a study to determine the optimum operational schedule for the dilution pumps. The NJDEPE has proposed thermal and other conditions for inclusion in the discharge permits for JCP&L's Gilbert and Sayreville generating stations which, among other things, could require JCP&L to install cooling towers and/or modify the water intake/discharge systems at these facilities. JCP&L has objected to these conditions and has requested an adjudicatory hearing with respect thereto. Implementation of these permit conditions has been stayed pending action on JCP&L's hearing request. JCP&L has made filings with the NJDEPE that JCP&L believes demonstrate compliance with state water quality standards at the Gilbert generating station and justify the issuance of a thermal variance at the Sayreville generating station to permit the continued use of the present once-through cooling system. Based on the NJDEPE's review of these demonstrations, substantial modifications may be required at these stations, which may result in material capital expenditures. The Subsidiaries are also subject to environmental and water diversion requirements adopted by the Delaware River Basin Commission and the Susquehanna River Basin Commission as administered by those commissions or the Pennsylvania Department of Environmental Resources (PaDER) and the NJDEPE. During 1993, Met-Ed entered into an agreement with various agencies to construct a fish passage facility at its York Haven hydroelectric project by the year 2000. The present estimated installed cost of the facility is $6.5 million. Nuclear: Reference is made to "Nuclear Facilities" for information regarding the TMI-2 accident, its aftermath and the GPU System's other nuclear facilities. New Jersey and Pennsylvania have each established, in conjunction with other states, a low level radioactive waste (radwaste) compact for the construction, licensing and operation of low level radwaste disposal facilities to service their respective areas by the year 2000. New Jersey and Connecticut have established the Northeast Compact. The estimated cost to license and build a low level radwaste disposal facility in New Jersey is approximately $74 million. GPUN's expected $29.5 million share of the cost for this facility is to be paid annually over an eight year period ending in 1999. In its February 1993 rate order, the NJBRC granted JCP&L's request to recover these amounts currently from customers. The facility would be available for disposal of low level waste from Oyster Creek. Similarly, Pennsylvania, Delaware, Maryland and West Virginia have established the Appalachian Compact, which will build a single facility to dispose of low level radwaste in their areas, including low level radwaste from TMI-1. The estimated cost to license and build this facility is approximately $60 million, of which GPUN's share is $12 million. These payments are considered advance waste disposal fees and will be recovered during the facility's operation. The Subsidiaries have provided for future contributions to the Decontamination and Decommissioning Fund (part of the Energy Act) for the cleanup of enrichment plants operated by the Federal government. The total liability at December 31, 1993 amounted to $47 million. The Subsidiaries made their initial payment in 1993. The remaining amount recoverable from ratepayers is $48 million at December 31, 1993. Air: The Subsidiaries are subject to certain state environmental regulations of the NJDEPE, the New Jersey Department of Health and the PaDER. The Subsidiaries are also subject to certain federal environmental regulations of the EPA. The PaDER, NJDEPE and the EPA have adopted air quality regulations designed to implement Pennsylvania, New Jersey and federal statutes relating to air quality. Current Pennsylvania environmental regulations prescribe criteria that generally limit the sulfur dioxide content of stack gas emissions from generating stations constructed before 1972 and stations constructed after 1971 but before 1978, to 3.7 pounds and 1.2 pounds per million BTU of heat input, respectively. On a weighted average basis, the Subsidiaries have been able to obtain coal having a sulfur content meeting these criteria. If, and to the extent that, the Subsidiaries cannot continue to meet such limitations with processed coal, it may be necessary to retrofit operating stations with sulfur removal equipment that may require substantial capital expenditures as well as substantial additional operating costs. Such retrofitting, if it could be accomplished to permit continued reliable operation of the facilities concerned, would take approximately five years. As a result of the Clean Air Act, which requires substantial reductions in sulfur dioxide and nitrogen oxide (NOx) emissions by the year 2000, it will be necessary for the GPU System to install and operate emission control equipment as well as switch to slightly lower sulfur coal at some of the GPU System's coal-fired plants in order to achieve compliance. To comply with Title IV of the Clean Air Act, the GPU System expects to expend up to $590 million by the year 2000 for air pollution control equipment, of which approximately $91 million has been spent as of December 31, 1993. These capital expenditures for Penelec, Met-Ed and JCP&L are estimated to amount to $295 million, $150 million and $145 million, respectively, for the installation of scrubbers, low NOx burner technology and various precipitator upgrades. The capital costs of this equipment and the increased operating costs of the affected stations are expected to be recoverable through the ratemaking process. Met-Ed and the other owners of the Conemaugh Generating Station have awarded contracts for the installation of scrubbers, and construction is underway, on the two coal units at Conemaugh; Met-Ed's estimated 16.45% share of these costs is $64 million. This action is part of the GPU System's plans to comply with Phase I sulfur dioxide emission limitations. The current construction schedule provides for Conemaugh Units 1 and 2 scrubbers to be in service by January of 1995 and 1996, respectively. In its January 1993 rate order, the PaPUC approved Met-Ed's request for $24.5 million of current expenditures to be included in rate base representing certain costs associated with the installation of scrubbers at the Conemaugh Generating Station and other environmental compliance projects. The plan for Portland Station is to meet its Phase I compliance obligation through the use of emission allowances, including allowances allocated directly to Portland station by the EPA and allowances resulting from the scrubbing of Conemaugh station. The GPU System's current strategy for Phase II compliance under the Clean Air Act is to install scrubbers at the Keystone station and evaluate the installation of scrubbers or fuel switching at the Homer City Unit 3 station. Switching to lower sulfur coal is currently planned for the Titus, Portland, Seward, and Warren Stations. Homer City Units 1 and 2 will use existing coal cleaning technology. The GPU System continues to review available options to comply with the Clean Air Act, including those which may result from the development of an emission allowance trading market. The GPU System's compliance strategy, especially with respect to Phase II, could change as a result of further review, discussions with co-owners of jointly owned stations and changes in federal and state regulatory requirements. The ultimate impact of Title I of the Clean Air Act, which deals with the attainment of ambient air quality standards, is highly uncertain. In particular, this Title has established an ozone transport or emission control region that includes 11 northeast states. Pennsylvania and New Jersey are part of this transport region, and will be required to control NOx emissions to a level that will provide for the attainment of the ozone standard in the northeast. As an initial step, major sources of nitrogen oxide will be required to implement Reasonably Available Control Technology (RACT) by May 31, 1995. This will affect the GPU System's steam generating stations. PaDER's RACT regulations have been approved by the Environmental Quality Board and became effective in January 1994. Large coal-fired combustion units are required to comply with a presumptive RACT emission limitation (technology) or may elect to use a case-by-case analysis to establish RACT requirements. In order to comply with these RACT regulations, low NOx burners with separate overfire air are being installed at the Portland and Conemaugh Stations. A RACT compliance plan for Titus Station will be finalized in early 1994. NJDEPE's RACT regulations became effective in December 1993. These regulations establish maximum allowable emission rates for utility boilers based on fuel used and boiler type, and on combustion turbines based on fuel used. Existing units are eligible for emissions averaging upon approval of an averaging plan by the NJDEPE. The ultimate impact of Title III of the Clean Air Act, which deals with emissions of hazardous air pollutants, is also highly uncertain. Specifically, the EPA has not completed a Clean Air Act study to determine whether it is appropriate to regulate emissions of hazardous air pollutants from electric utility steam generating units. However, the Homer City Coal Processing Plant is being studied to determine if it is a major stationary source of air toxins. Both the EPA and PaDER are questioning the attainment of National Ambient Air Quality Standards (NAAQS) for sulfur dioxide in the vicinity of the Chestnut Ridge Energy Complex (Homer City, Conemaugh, Keystone and Seward generating stations). The Homer City, Conemaugh and Keystone generating stations are jointly owned with nonaffiliated utilities. The EPA and the PaDER have approved the use of a nonguideline air quality model. This model is more representative and less conservative than the EPA guideline model and will be used in the development of a compliance strategy for all generating stations in the Chestnut Ridge Energy Complex. The area around the Warren generating station has been designated as nonattainment for sulfur dioxide. In the case of the Warren Generating station area, Penelec began a model evaluation study in early 1993. The results of the study will be used to determine if a nonguideline model can be used. The study results will be available in 1994. A Consent Order and Agreement has been negotiated to allow the PaDER to revise the implementation plan for Warren Station. A model evaluation study is also being conducted at Shawville Station. The results of this study will be available in 1995. The attainment issue has been taken into account as part of the design of the Conemaugh Station scrubbers. Met-Ed has initiated ambient air quality modeling studies for its Portland and Titus Stations that will take several years to complete. While the results are uncertain, these studies may result in a revised Pennsylvania State Implementation Plan (PaSIP) in order to attain NAAQS for sulfur dioxide. If sulfur dioxide emissions need to be reduced to meet the new PaSIP, Met-Ed will reevaluate its options available for Portland and Titus Stations. Based on the results of the studies pursuant to NAAQS, significant sulfur dioxide reductions may be required at one or more of these stations which could result in material capital and additional operating expenditures. Certain other environmental regulations limit the amount of particulate matter emitted into the environment. The Subsidiaries have installed equipment at their coal-fired generating stations and may find it necessary to either upgrade or install additional equipment at certain of their stations to consistently meet particulate emission requirements. In the fall of 1993, the Clinton Administration announced its climate change action plan which intends to reduce greenhouse gas emissions to 1990 levels by the year 2000. The climate action plan relies heavily on voluntary action by industry. GPU notified the DOE that it supported the voluntary approach proposed by the President and expressed its intent to work with the DOE. Title IV of the Clean Air Act requires Phase I and Phase II affected units to install a continuous emission monitoring system (CEMS) and quality assure the data for sulfur dioxide, nitrogen oxides, opacity and volumetric flow. In addition, Title VIII requires all affected sources to monitor carbon dioxide emissions. Monitoring systems have been installed and certified on Met-Ed's Phase I and Penelec's Phase I and Phase II affected units as required by EPA and PaDER regulations. Monitoring systems have been installed on Met-Ed's Phase II affected units and will be certified in 1994. The PaDER has a CEMS enforcement policy to ensure consistent compliance with air quality regulations under federal and state statutes. The CEMS enforcement policy includes matters such as visible emissions, sulfur dioxide emission standards, nitrogen oxide emissions and a requirement to maintain certified continuous emission monitoring equipment. In addition, this policy provides a mechanism for the payment of certain prescribed amounts to the Pennsylvania Clean Air Fund (Clean Air Fund) for air pollutant emission excesses or monitoring failures. With respect to the operation of Met-Ed's and Penelec's generating stations for 1994, it is not anticipated that payments to be made to the Clean Air Fund will be material in amount. The Clean Air Act has also expanded the enforcement options available to the EPA and the states and contains more stringent enforcement provisions and penalties. Moreover, citizen suits can seek civil penalties for violations of this act. The EPA has established Best Available Retrofit Technology (BART) sulfur dioxide emission standards to be used for Penelec's Shawville and Seward generating stations under the Good Engineering Practice stack height regulation. Dependent upon the Chestnut Ridge Compliance Strategy and the results of the Shawville Model evaluation study mentioned above, lower sulfur coal purchases may be necessary for compliance. Discussions with the EPA regarding this matter are continuing. In 1988, the Environmental Defense Fund (EDF), the New Jersey Conservation Foundation, the Sierra Club and Pennsylvanians for Acid Rain Control requested that the NJDEPE and the NJBRC seek to reduce sulfur deposition in New Jersey, either by reducing emissions from both in-state and out-of-state sources, or by requiring that certain electricity imported into New Jersey be generated from facilities meeting minimum emission standards. JCP&L purchases a substantial portion of its net system requirements from out-of-state coal-fired facilities, including the 1,700 MW Keystone Station in Pennsylvania in which it owns a 16.67% interest. In addition, coal-fired generating facilities owned by Met-Ed and Penelec supply electric energy to JCP&L and other New Jersey members of PJM. Hearings on the EDF petition were held during 1989 and 1990, and the matter is pending before the NJDEPE and the NJBRC. In New Jersey, where the bulk of the GPU System's oil-fired generating capacity is located, NJDEPE regulations establish the maximum sulfur content of oil, which may not exceed .3% for most of JCP&L's generating stations and 1% for the balance. In 1993, the Subsidiaries made capital expenditures of approximately $70 million in response to environmental considerations and have included approximately $121 million for this purpose in their 1994 construction programs. The operating and maintenance costs, including the incremental costs of low-sulfur fuel, for such equipment were approximately $105 million in 1993 and are expected to be approximately $108 million in 1994. Electromagnetic Fields: There have been a number of scientific studies regarding the possibility of adverse health effects from electric and magnetic fields (EMF) that are found everywhere there is electricity. While some of the studies have indicated some association between exposure to EMF and cancer, other studies have indicated no such association. The studies have not shown any causal relationship between exposure to EMF and cancer, or any other adverse health effects. In 1990, the EPA issued a draft report that identifies EMF as a possible carcinogen, although it acknowledges that there is still scientific uncertainty surrounding these fields and their possible link to adverse health effects. On the other hand, a 1992 White House Office of Science and Technology policy report states that "there is no convincing evidence in the published literature to support the contention that exposures to extremely low frequency electric and magnetic fields generated by sources such as household appliances, video display terminals, and local power lines are demonstrable health hazards." Additional studies, which may foster a better understanding of the subject, are presently underway. Certain parties have alleged that the exposure to EMF associated with the operation of transmission and distribution facilities will produce adverse impacts upon public health and safety and upon property values. Furthermore, regulatory actions under consideration by the NJDEPE and bills introduced in the Pennsylvania legislature could, if enacted, establish a framework under which the intensity of EMF produced by electric transmission and distribution lines would be limited or otherwise regulated. The Subsidiaries cannot determine at this time what effect, if any, this matter will have on them. Residual Waste: The PaDER has finalized the residual waste regulations which became effective in July 1992. These regulations impose additional restrictions on operating existing ash disposal sites and for siting future disposal sites and will increase the costs of establishing and operating these facilities. The main objective of these regulations is to prevent degradation of groundwater and to abate any existing degradation. One of the first significant compliance requirements of the regulations is conducting groundwater assessments of landfills if existing groundwater monitoring indicates the possibility of degradation. The assessments require the installation of additional monitoring wells and the evaluation of one year's worth of data. All of Penelec's active landfills require assessments. If the assessments show degradation of the groundwater, then the next step is to develop abatement plans. However, there is no specific timetable on the implementation of abatement activities, if required. Penelec and Met-Ed's landfills are to have preliminary permit modification applications submitted to the PaDER by July 1994, and complete permit applications under evaluation by July 1997. Met-Ed's Portland and Titus landfills have had preliminary assessments conducted which are currently under review by the PaDER. The Titus Station ash disposal site was upgraded in 1991 and subsequently meets all lined facility requirements. The Portland station ash disposal site will require significant modifications under the new regulations. Various alternatives for upgrading the site are being evaluated. In addition, the regulations can also be enforced at sites closed since 1980 at the PaDER's option. Other compliance requirements at Penelec that will be implemented in the future include the lining of currently unlined disposal sites and storage impoundments. Impoundments also will eventually require groundwater monitoring systems and assessments of impact on groundwater. Groundwater abatement may be necessary at locations where pollution problems are identified. The removal of all the residual waste or "clean closed" will be done at some impoundments to eliminate the need for future monitoring and abatement requirements. Storage impoundments must have implemented groundwater monitoring plans by 2002, but PaDER can require this at any time prior to this date or defer full compliance beyond 2002 for some storage impoundments at their discretion. Also being evaluated are the exercising of beneficial use options authorized by the regulations, and source reductions. Preliminary groundwater assessment plans have also been conducted at Met-Ed's Portland and Titus Stations' industrial waste treatment impoundments and are currently under review by the PaDER. Additional data will be collected and evaluated to determine if abatement will be required. The Portland Station impoundments were upgraded in 1987 and meet the requirements for lined impoundments. The Titus Station impoundments will require significant modifications by 2002. There are also a number of issues still to be resolved regarding certain waivers related to Penelec's existing landfill and storage impoundment compliance requirements. These waivers could significantly reduce the cost of many of the Company's facility compliance upgrades. Another aspect of the regulations deals with the storage and disposal of polychlorinated biphenyl (PCB) wastes between two and 50 parts per million (ppm). Federal regulations only deal with wastes over 50 ppm. The compliance requirements for this regulation are currently being evaluated. Hazardous/Toxic Wastes: Under the Toxic Substances Control Act (TSCA), the EPA has adopted certain regulations governing the use, storage, testing, inspection and disposal of electrical equipment that contains PCBs. Such regulations permit the continued use and servicing of certain electrical equipment (including transformers and capacitors) that contain PCBs. The Subsidiaries have met all requirements of the TSCA necessary to allow the continued use of equipment containing PCBs and have taken substantive voluntary actions to reduce the amount of PCB containing electrical equipment in the System. Prior to 1953, the Subsidiaries owned and operated manufactured gas plants in New Jersey and Pennsylvania. Wastes associated with the operation and dismantlement of these gas manufacturing plants were disposed of both on-site and off-site. Claims may be asserted against the Subsidiaries for the cost of investigation and remediation of these waste disposal sites. The amount of such remediation costs and penalties may be significant and may not be covered by insurance. JCP&L has identified 17 such sites to date. JCP&L has entered into cost sharing agreements with New Jersey Natural Gas Company and Elizabethtown Gas Company under which JCP&L is responsible for 60% of all costs incurred in connection with the remediation of 12 of these sites. JCP&L has entered into Administrative Consent Orders (ACOs) with the NJDEPE for seven of these sites and has entered into Memoranda of Agreement (MOAs) with the NJDEPE for eight of these sites. JCP&L anticipates entering into MOAs for the remaining sites. The ACOs specify the agreed upon obligations of both JCP&L and the NJDEPE for remediation of the sites. The MOAs afford JCP&L greater flexibility in the schedule for investigation and remediation of sites. JCP&L is seeking NJDEPE approval of its plans for the remediation of these sites. The NJDEPE has approved JCP&L's implementation program for five of these sites. At December 31, 1993, JCP&L has an estimated environmental liability of $35 million recorded on its balance sheet relating to these sites. The estimated liability is based upon ongoing site investigations and remediation efforts, including capping the sites and pumping and treatment of ground water. If the periods over which the remediation is currently expected to be performed are lengthened, JCP&L believes that it is reasonably possible that the ultimate costs may range as high as $60 million. Estimates of these costs are subject to significant uncertainties: JCP&L does not presently own or control most of these sites; the environmental standards have changed in the past and are subject to future change; the accepted technologies are subject to further development; and the related costs for these technologies are uncertain. If JCP&L is required to utilize different remediation methods, the costs could be materially in excess of $60 million. In June 1993, the NJBRC approved a mechanism for the recovery of future manufactured gas plant remediation costs through JCP&L's Levelized Energy Adjustment Clause (LEAC) when expenditures exceed prior collections. The NJBRC decision provides for interest to be credited to customers until the overrecovery is eliminated and for future costs to be amortized over seven years with interest. JCP&L is currently awaiting a final NJBRC order. JCP&L is pursuing reimbursement of the above costs from its insurance carriers, and will seek to recover costs to the extent not covered by insurance through this mechanism. The federal Resource Conservation and Recovery Act of 1976, the Comprehensive Environmental Response, Compensation and Liability Act of 1980 (CERCLA) and the Superfund Amendment and Reauthorization Act of 1986 authorize the EPA to issue an order compelling responsible parties to take cleanup action at any location that is determined to present an imminent and substantial danger to the public or to the environment because of an actual or threatened release of one or more hazardous substances. Pennsylvania and New Jersey have enacted legislation giving similar authority to the PaDER and the NJDEPE, respectively. Because of the nature of the Subsidiaries' business, various by-products and substances are produced and/or handled that are classified as hazardous under one or more of these statutes. The Subsidiaries generally provide for the treatment, disposal or recycling of such substances through licensed independent contractors, but these statutory provisions also impose potential responsibility for certain cleanup costs on the generators of the wastes. The GPU System companies have been notified by the EPA and state environmental authorities that they are among the potentially responsible parties (PRPs) who may be jointly and severally liable to pay for the costs associated with the investigation and remediation at 10 hazardous and/or toxic waste sites (including those described below). In addition, the GPU System companies have been requested to supply information to the EPA and state environmental authorities on several other sites for which the GPU System companies have not as yet been named as PRPs. Met-Ed and Penelec have also been named in lawsuits requesting damages for hazardous and/or toxic substances allegedly released into the environment. The Subsidiaries received notification in 1986 from the EPA that they are among the more than 800 PRPs under CERCLA who may be liable to pay for the cost associated with the investigation and remediation of the Maxey Flats disposal site, located in Fleming County, Kentucky. JCP&L, Met-Ed, Penelec and Saxton are alleged to have contributed, in the aggregate, approximately 2.3% of the total volume of waste shipped to the Maxey Flats site. On September 30, 1991, the EPA issued a Record of Decision (ROD) advising that a remedial alternative had been selected. The PRPs estimate the cost of the remedial alternative selected and associated activities identified in the ROD at more than $60 million, for which all responsible parties would be jointly and severally liable. The EPA has initiated a suit under CERCLA and other laws for the initial cleanup of hazardous materials deposited at a waste disposal site at Harper Drive, Millcreek Township, Pennsylvania (Millcreek site). Penelec is one of over 50 PRPs at this site. Penelec does not know whether its insurance carriers will assume the responsibility to defend and indemnify it in connection with this matter. Two lawsuits involving property owners at or near the Millcreek site have been filed against Penelec and other PRPs. Penelec's insurance carriers are defending these actions but may not provide coverage in the event compensatory damages are awarded. In addition, claims have also been made for punitive damages which may not be covered by insurance. Penelec, together with 24 others, has been named as a third party defendant in an action commenced under the CERCLA by the EPA in the U.S. District Court in Ohio. The EPA is seeking to recover costs for the cleanup of hazardous and toxic materials disposed at the New Lyme landfill site in Ashtabula, Ohio. Penelec, together with 22 others, has also been named as a third party defendant in an action under the CERCLA by the state of Ohio seeking to recover costs it has incurred and will incur in the future at the New Lyme landfill site. Met-Ed, together with 35 others, has been named as a third party defendant in an action commenced under CERCLA by the EPA in the U.S. District Court for the Eastern District of Pennsylvania. The EPA is seeking to recover response costs for hazardous materials disposed at the Mabry/Oswald Site in Upper Macungie and Longswamp Townships, Pennsylvania. Met-Ed has reached settlement of its liability in this matter and expects to be dismissed from the litigation. The ultimate cost of remediation of these sites will depend upon changing circumstances as site investigations continue, including (a) the technology required for site cleanup, (b) the remedial action plan chosen and (c) the extent of site contamination and the portion attributed to the GPU System companies. The GPU System companies are unable to estimate the extent of possible remediation and associated costs of additional environmental matters. Management believes the costs described above should be recoverable through the ratemaking process. EMPLOYEE RELATIONS At February 28, 1994, the GPU System had 11,939 full-time employees. The nonsupervisory production and maintenance employees of the Subsidiaries and certain of their nonsupervisory clerical employees are represented for collective bargaining purposes by local unions of the International Brotherhood of Electrical Workers (IBEW) at JCP&L, Met-Ed and Penelec and the Utility Workers Union of America (UWUA) at Penelec. Penelec's five-year contracts with the IBEW and UWUA expire on May 14, 1998 and June 30, 1998, respectively. Met-Ed's three-year contract with the IBEW expires on April 30, 1994. JCP&L's three-year contract with the IBEW expires on October 31, 1994. ITEM 2.		ITEM 2. PROPERTIES. Generating Stations At December 31, 1993, the generating stations of the GPU System had an aggregate effective summer capability of 6,739,000 net kilowatts (KW), as follows: Name of Year of Name of Year of Station Installation Net KW Station Installation Net KW COAL-FIRED: GAS/OIL-FIRED: Homer City(a) 1969-1977 942,000 (gas or oil) Shawville 1954-1960 597,000 Sayreville(d) 1930-1958 313,000 Portland 1958-1962 401,000 Gilbert 1930-1949 117,000 Keystone(b) 1967-1968 283,000 Combustion Conemaugh(c) 1970-1971 280,000 (gas or oil) Titus 1951-1953 241,000 Turbines 1960-1989 1,160,000 Seward 1950-1957 196,000 Werner (oil) 1953 58,000 Warren 1948-1949 82,000 Other(e) 1968-1977 332,000 NUCLEAR: HYDROELECTRIC 1905-1969 64,000 TMI-1 1974 786,000 PUMPED STORAGE:(f) Oyster Creek 1969 610,000 Yards Creek 1965 190,000 Seneca 1969 87,000 TOTAL 6,739,000 (a) Represents Penelec's undivided 50% interest in the station. (b) Represents JCP&L's undivided 16.67% interest in the station. (c) Represents Met-Ed's undivided 16.45% interest in the station. (d) Effective February 1, 1994, 84,000 KW of capability were retired. (e) Consists of internal combustion and combined cycle units. (f) Represents the Subsidiaries' undivided interests in these stations which are net users rather than net producers of electric energy. All the GPU System's coal-fired, hydroelectric (other than the Deep Creek Station) and pumped storage stations (other than the Yards Creek station) are located in Pennsylvania. The TMI-1 nuclear station is also located in Pennsylvania. The GPU System's gas-fired and oil-fired stations (other than some combustion turbines in Pennsylvania), the Yards Creek pumped storage station and the Oyster Creek nuclear station are located in New Jersey. The Deep Creek hydroelectric station is located in Maryland. Substantially all of the Subsidiaries' properties are subject to the lien of their respective first mortgage bond indentures. The peak load of the GPU System, which occurred on July 9, 1993, was 8,533,000 KW. Transmission and Distribution System At December 31, 1993, the GPU System owned 1,249 transmission and distribution substations that had an aggregate installed transformer capacity of 49,562,096 kilovoltamperes (KVA), and 6,714 circuit miles of transmission lines, of which 441 miles were operated at 500 KV, 149 miles at 345 KV, 1,603 miles at 230 KV, 14 miles at 138 KV, 1,909 miles at 115 KV and the balance of 2,598 miles at 69 KV, 46 KV and 34.5 KV. The Subsidiaries' distribution system included 21,142,583 KVA of line transformer capacity, 50,085 pole miles of overhead lines and 9,897 trench miles of underground cables. ITEM 3.	ITEM 3. LEGAL PROCEEDINGS. Reference is made to "Nuclear Facilities - TMI-2," "Rate Proceedings" and "Environmental Matters" under Item 1 and to Note 1 to consolidated financial statements contained in Item 8 for a description of certain pending legal proceedings involving the GPU System. ITEM 4.	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. None. PART II ITEM 5.	ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. Stock Trading General Public Utilities Corporation is listed as GPU on the New York Stock Exchange. On February 28, 1994, there were approximately fifty-thousand registered holders of GPU common stock. Dividends Dividend declaration dates are the first Thursdays of April, June, October and December. Dividend payment dates fall on the last Wednesdays of February, May, August and November. Dividend declarations and quarterly stock price ranges for 1993 and 1992 are set forth below. Common Stock Dividends Declared Price Ranges* 1993 1992 1993 1992 Quarter High/Low High/Low April $.40 $.40 First $30 1/4 $25 3/4 $27 3/8 $24 1/2 June .425 .40 Second 32 3/8 28 5/8 26 3/8 24 1/4 October .425 .40 Third 34 3/4 31 5/8 27 3/8 25 1/2 December .425 .40 Fourth 34 28 3/4 27 7/8 25 3/8 * Based on New York Stock Exchange Composite Transactions as reported in the Wall Street Journal. ITEM 6.	ITEM 6. SELECTED FINANCIAL DATA. See page for reference to Selected Financial Data required by this item. ITEM 7.	ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. See page for reference to Management's Discussion and Analysis of Financial Condition and Results of Operations required by this item. ITEM 8.	ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. See page for reference to Financial Statements and Quarterly Financial Data (unaudited) required by this item. 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. Information regarding GPU's directors is incorporated by reference to pages 2 through 5 of GPU's Proxy Statement for the 1994 Annual Meeting of Stockholders. GPU's executive officers, their ages, positions held and business experience during the past five years are as follows: Year First Name Age Position Elected J. R. Leva (a) 61 Chairman, President and 1992 Chief Executive Officer I. H. Jolles (b) 55 Senior Vice President & 1990 General Counsel J. G. Graham (c) 55 Senior Vice President & 1987 Chief Financial Officer F. A. Donofrio (d) 51 Vice President, Comptroller 1985 & Chief Accounting Officer P. C. Mezey (e) 54 Senior Vice President, GPUSC 1992 D. W. Myers (f) 49 Vice President & Treasurer 1993 M. A. Nalewako (g) 59 Secretary 1988 P. R. Clark (h) 63 President, GPUN 1983 R. L. Wise (i) 50 President, Penelec 1986 F. D. Hafer (j) 52 President, Met-Ed 1986 D. Baldassari (k) 44 President, JCP&L 1992 R. C. Arnold (l) 56 Executive Vice President, GPUSC 1990 (a) Mr. Leva became Chairman, President and Chief Executive Officer of GPU in 1992. He is also Chairman, President, Chief Executive Officer and a director of GPUSC, Chairman of the Board, Chief Executive Officer and a director of JCP&L, Met-Ed, Penelec and GPC, and Chairman of the Board and a director of GPUN. Prior to assuming his present positions, Mr. Leva served as President of JCP&L since 1986. (b) Mr. Jolles became Senior Vice President and General Counsel of GPU in 1990. He is also Executive Vice President, General Counsel and a director of GPUSC. He was previously a partner in the law firm of Berlack, Israels & Liberman. (c) Mr. Graham became Senior Vice President in 1989 and Chief Financial Officer of GPU in 1987. He is also Executive Vice President, Chief Financial Officer and a director of GPUSC; Vice President, Chief Financial Officer and a director of JCP&L, Met-Ed and Penelec; Vice President and Chief Financial Officer of GPUN; President and a director of GPC and a director of EI. (d) Mr. Donofrio became a Vice President of GPU in 1989, and in 1985 he became Comptroller and Chief Accounting Officer of GPU. He is also Senior Vice President - Financial Controls of GPUSC and a director of GPUSC, GPC and EI. (e) Mr. Mezey became Senior Vice President - System Services of GPUSC in 1992. He previously served as Vice President of GPUSC from January 1991 through March 1992 and President of EI from February 1990 through December 1991. Prior to joining GPU, he was Vice President - Finance and CFO of Edgcore Technology. (f) Mr. Myers became a Vice President and Treasurer of GPU in 1993. He is also Vice President and Treasurer of GPUSC, JCP&L, Met-Ed, Penelec, GPUN and GPC. Prior to assuming his present positions, Mr. Myers served as Vice President and Comptroller of GPUN since 1986. (g) Mrs. Nalewako became Secretary of GPU, GPUSC and GPC in 1988. She is also Assistant Secretary of GPUN, JCP&L, Met-Ed and Penelec. (h) Mr. Clark was elected President of GPUN in 1983. He was elected a director of GPUN in 1980 and served as Executive Vice President from 1980 to 1983. He was designated Chief Executive Officer of GPUN in 1984. (i) Mr. Wise became President and a director of Penelec in December 1986. He is also a director of GPUSC and GPUN. (j) Mr. Hafer became President of Met-Ed in March 1986. He is also a director of Met-Ed, GPUSC and GPUN. (k) Mr. Baldassari became President of JCP&L and a director of GPUSC and GPUN in February 1992. Prior to assuming his present positions, Mr. Baldassari served as Vice President - Rates and a director of JCP&L since 1982. He also served as Vice President - Materials and Services of JCP&L since 1990, and as Treasurer of JCP&L from October 1979 through December 31, 1989. (l) Mr. Arnold became Executive Vice President-Power Supply of GPUSC in 1990. He was Senior Vice President-Power Supply from 1987 to 1989. He is also a director of GPUSC, JCP&L, Met-Ed and Penelec. The executive officers of the GPU System are elected each year by their respective Boards of Directors at the first meeting of the Board held following the annual meeting of stockholders. Executive officers hold office until the next meeting of directors following the annual meeting of stockholders and until their respective successors are duly elected and qualified. There are no family relationships among GPU's executive officers. Section 16(a) of the Securities Exchange Act of 1934 requires the Corporation's executive officers and directors, and persons who beneficially own more than ten percent of the Corporation's equity securities, to file reports of ownership and changes in ownership with the Securities and Exchange Commission and the New York Stock Exchange. Officers, directors and greater than ten-percent shareholders are required by SEC regulation to furnish the Corporation with copies of all Section 16(a) forms they file. Based on its review of the copies of such forms received by it, or written representations from these reporting persons, the Corporation believes that, during 1993 all such filing requirements applicable to its officers and directors (the Corporation not being aware of any ten percent holder) were complied with, with the exception that a report relating to one transaction involving the redemption by Pennsylvania Electric Company of shares of its cumulative preferred stock owned by Mr. Appell's wife was filed five days late. ITEM 11.	ITEM 11. EXECUTIVE COMPENSATION. The information required by this Item is incorporated by reference to pages 9 through 18 of GPU's Proxy Statement for the 1994 Annual Meeting of Stockholders. ITEM 12.	ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information required by this Item is incorporated by reference to page 8 of GPU's Proxy Statement for the 1994 Annual Meeting of Stockholders. ITEM 13.	ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. None. PART IV ITEM 14.	ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) See page for reference to Financial Statement Schedules required by this item. 1. Exhibits: 3-A GPUN By-Laws, as amended. 10-A General Public Utilities Corporation Restricted Stock Plan for Outside Directors 10-B 1990 Stock Plan for Employees of General Public Utilities Corporation and Subsidiaries 10-C Form of Restricted Units Agreement under the 1990 Stock Plan. 10-D Retirement Plan for Outside Directors of General Public Utilities Corporation. 10-E Incentive Compensation Plan for Officers of GPU System Companies. 23 Consent of Independent Accountants. (b) Reports on Form 8-K: For the month of December 1993, dated December 10, 1993, under Item 5 (Other Events). For the month of February 1994, dated February 16, and February 28, 1994, under Item 5 (Other Events). SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. GENERAL PUBLIC UTILITIES CORPORATION Dated: March 10, 1994 BY: /s/ J. R. Leva J. R. Leva, Chairman and President Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signature and Title Date /s/ J. R. Leva March 10, 1994 J. R. Leva, Chairman (Chief Executive Officer) President and Director /s/ J. G. Graham March 10, 1994 J. G. Graham, Senior Vice President (Chief Financial Officer) /s/ F. A. Donofrio March 10, 1994 F. A. Donofrio, Vice President and Comptroller (Chief Accounting Officer) /s/ L. J. Appell, Jr. March 10, 1994 L. J. Appell, Jr., Director /s/ D. J. Bainton March 10, 1994 D. J. Bainton, Director /s/ T. H. Black March 10, 1994 T. H. Black, Director /s/ T. B. Hagen March 10, 1994 T. B. Hagen, Director /s/ H. F. Henderson, Jr. March 10, 1994 H. F. Henderson, Jr., Director /s/ J. M. Pietruski March 10, 1994 J. M. Pietruski, Director /s/ C. A. Rein March 10, 1994 C. A. Rein, Director /s/ P. R. Roedel March 10, 1994 P. R. Roedel, Director /s/ C. A. H. Trost March 10, 1994 C. A. H. Trost, Director /s/ P. K. Woolf March 10, 1994 P. K. Woolf, Director GENERAL PUBLIC UTILITIES CORPORATION INDEX TO SUPPLEMENTARY DATA, FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES Supplementary Data Page System Statistics Selected Financial Data Management's Discussion and Analysis of Financial Condition and Results of Operations Quarterly Financial Data Financial Statements Report of Independent Accountants Statements of Income for the Years Ended December 31, 1993, 1992 and 1991 Balance Sheets as of December 31, 1993 and 1992 Statements of Retained Earnings for the Years Ended December 31, 1993, 1992 and 1991 Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 Notes to Financial Statements Financial Statement Schedules Schedule V - Property, Plant and Equipment for the Years 1991-1993 Schedule VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment for the Years 1991-1993 Schedule VIII - Valuation and Qualifying Accounts for the Years 1991-1993 Schedule IX - Short-Term Borrowings for the Years 1991-1993 Schedules other than those listed above have been omitted since they are not required, are inapplicable or the required information is presented in the Financial Statements or Notes thereto. General Public Utilities Corporation and Subsidiary Companies MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS In 1993, earnings per share were $2.65 compared to $2.27 per share in 1992 and net income increased $44.0 million to $295.7 million. The increase in earnings was principally due to additional revenues resulting from a February 1993 retail base rate increase at JCP&L and higher customer sales due primarily to the significantly warmer-than-normal summer temperatures as compared with the mild weather in 1992. These gains were partially offset by an increase in operation and maintenance expense, the write-off of $25 million of costs related to the cancellation of proposed energy-related agreements, and increased depreciation expense associated with additions to utility plant. In June 1993, GPU increased its quarterly common stock dividend by 6.3% to $0.425 per share. GPU's return on average common equity was 11.9% for 1993 as compared to 10.7% for 1992. Net income for 1992 was $251.6 million, or $2.27 per share, compared to $275.9 million, or $2.49 per share in 1991. Earnings in 1992 were primarily affected by a reduction in weather-related sales and increased capital costs, partially offset by increased revenues from new residential and commercial customers. In 1991, increased revenues due to warmer-than-normal summer weather, the effect of a base rate increase at JCP&L and an increase in customer additions were substantially offset by higher reserve capacity expense and capital costs. OPERATING REVENUES: Revenues increased 4.7% to $3.6 billion in 1993 after increasing 1.9% to $3.4 billion in 1992. The components of these changes are as follows: (In Millions) 1993 1992 Kilowatt-hour (KWH) revenues $ 61.0 $(29.9) (excluding energy portion) Rate increases 108.7 - Energy revenues (24.1) 72.5 Other revenues 16.3 20.0 Increase in revenues $161.9 $ 62.6 Kilowatt-hour revenues KWH revenues increased principally due to higher third quarter sales in the JCP&L service territory resulting from the significantly warmer-than- normal summer temperatures as compared to the milder weather during the same General Public Utilities Corporation and Subsidiary Companies period in 1992. An increase in weather-related sales in the Met-Ed service territory, a 1.2% increase in the average number of customers and a slight increase in nonweather-related usage also contributed to the increase in KWH revenues. New customer growth, which occurred in the commercial and residential sectors, was partially offset by a slight reduction in the number of industrial customers. KWH revenues decreased primarily due to mild weather during the third quarter of 1992 as compared with warmer-than-normal weather during the same period in 1991. This decrease was partially offset by a 1.2% increase in the average number of customers and a slight increase in nonweather-related usage. New customer growth mostly occurred in the JCP&L service territory in the residential and commercial sectors. The increase in nonweather-related usage was reflected primarily in the residential and commercial sectors in the JCP&L and Met-Ed service territories, while the dampening effects of the economy continued to impact customer usage in the Penelec service territory. Customer Sales by Service Class 1988 1989 1990 1991 1992 1993 In millions of MWH 38.4 38.5 38.7 39.6 39.3 40.3 Industrial and Other 36% 35% 35% 34% 33% 32% Commercial 29% 30% 30% 31% 32% 32% Residential 35% 35% 35% 35% 35 36 Rate increases In February 1993, the New Jersey Board of Regulatory Commissioners (NJBRC) authorized a $123 million increase in JCP&L retail base rates, or approximately 7% annually. Energy revenues 1993 and 1992 Changes in energy revenues do not affect net income as they reflect corresponding changes in the energy cost rates billed to customers and expensed. The 1993 decrease in energy revenues is principally due to lower electric sales to other utilities as compared to 1992 when the GPU System experienced a significant increase in sales to other utilities. Energy revenues also increased in 1992 as a result of increases in the energy cost rates in effect. General Public Utilities Corporation and Subsidiary Companies Other revenues 1993 and 1992 Generally, changes in other revenues do not affect net income as they are offset by corresponding changes in expense, such as taxes other than income taxes. However, earnings in 1993 were favorably affected by a one- time benefit from the recognition of prior period transmission service revenues approved by the Pennsylvania Public Utility Commission (PaPUC). Other revenues increased in 1992 as a result of a timing difference in the receipt of Pennsylvania tax surcharge revenues received during the year for state tax increases enacted in the third quarter of 1991. OPERATING EXPENSES: Power purchased and interchanged 1993 and 1992 Generally, changes in the energy component of power purchased and interchanged expense do not significantly affect earnings as they are substantially recovered through the Subsidiaries' energy clauses. Earnings in 1993, however, were favorably impacted by a reduction in reserve capacity expense primarily resulting from the expiration of a purchase contract with another utility. Power purchased and interchanged increased in 1992 as a result of an increase in nonutility generation purchases offset partially by a reduction in purchases from other utilities. Other operation and maintenance Other operation and maintenance (O&M) expense increased primarily due to emergency and storm-related activities, higher than normal tree trimming expenses and increased costs related to fossil plant outages. The decrease is due largely to the absence of $33.8 million of estimated costs recognized in 1991 for preparing the TMI-2 plant for long-term monitored storage. Excluding that amount, other O&M expense remained relatively stable. Depreciation and amortization 1993 and 1992 Depreciation and amortization expense increased $20.2 million and $10.8 million, respectively, in 1993 and 1992 mostly due to additions to utility plant, exclusive of a $60 million charge in 1991 for certain TMI-2 decommissioning costs. Additions to utility plant primarily consist of additions to existing generating facilities to enhance system reliability and additions to the transmission and distribution system related to new customer growth. General Public Utilities Corporation and Subsidiary Companies Taxes, other than income taxes 1993 and 1992 Generally, changes in taxes other than income taxes do not significantly affect earnings as they are substantially recovered in revenues. OTHER INCOME AND DEDUCTIONS: The reduction in other income, net is principally due to the write-off of $25 million of costs related to the cancellation of proposed power supply and transmission facilities agreements between the Subsidiaries and Duquesne Light Company (Duquesne). The decrease is also due to the absence of carrying charges on certain tax payments made by JCP&L in 1992 which are now being recovered through rates. The decrease is mainly attributable to a reduction in interest income resulting from the 1991 collection of federal income tax refunds, offset partially by an increase in other income related to the anticipated recovery of carrying charges. INTEREST CHARGES AND PREFERRED DIVIDENDS: 1993 and 1992 Interest on long-term debt increased in both years primarily due to the issuance of additional long-term debt, offset partially by decreases associated with the refinancing of higher cost debt at lower interest rates in 1993 and 1992. The decrease in other interest in 1992 was mainly the result of a lower federal income tax deficiency accrual level as tax deficiency payments relating to the 1983 and 1984 tax years were made in 1991. Other interest in 1992 also declined due to a reduction in the average level of short-term borrowing outstanding. Preferred dividends decreased in 1993 primarily due to the redemption of $156 million of preferred stock. LIQUIDITY AND CAPITAL RESOURCES CAPITAL NEEDS: The GPU System's capital needs were $525 million in 1993, consisting of cash construction expenditures of $496 million and amounts for maturing obligations of $29 million. During 1993, construction funds were primarily used to continue to maintain and improve existing generating facilities and add to the transmission and distribution system. Construction expenditures are estimated to be $663 million in 1994, consisting mainly of $485 million for ongoing system development and $120 million for clean air requirements. Expenditures for maturing debt are expected to be $133 million for 1994 and $91 million for 1995. In the mid 1990s, construction expenditures may include substantial amounts for clean air requirements, the construction of new General Public Utilities Corporation and Subsidiary Companies generation facilities and other system needs. Management estimates thatapproximately one-half of the GPU System's 1994 capital needs will be satisfied through internally generated funds. The Subsidiaries' capital leases consist primarily of leases for nuclear fuel. These nuclear fuel leases are renewable annually, subject to certain conditions. An aggregate of up to $250 million ($125 million each for Oyster Creek and TMI-1) of nuclear fuel costs may be outstanding at any one time. Nuclear fuel capital leases at December 31, 1993 totaled $150 million. When consumed, portions of the presently leased material will be replaced by additional leased material at a rate of approximately $60 million annually. In the event these nuclear fuel needs cannot be leased, the associated capital requirements would have to be met by other means. Cash Construction Expenditures (In millions of dollars) 1989 1990 1991 1992 1993 1994 $487 $491 $467 $460 $496 $663* * Forecast FINANCING: In 1993, the Subsidiaries refinanced higher cost long-term debt in the principal amount of $723 million resulting in an estimated annualized after- tax savings of $6 million. Total GPU System long-term debt issued during 1993 amounted to $957 million. In addition, the Subsidiaries redeemed $156 million of high-dividend rate preferred stock issues. During 1993, GPU sold four million shares of common stock at $33 1/8 per share through an underwritten public offering. The net proceeds of $128.7 million were used primarily to reimburse the Subsidiaries for the preferred stock redemptions. In January 1994, Penelec issued an aggregate of $90 million of first mortgage bonds, of which a portion of the net proceeds will be used to redeem $38 million principal amount of 6 5/8% series bonds in late February 1994. Met-Ed issued, in February 1994, an aggregate of $50 million of first mortgage bonds, of which a portion of the net proceeds will be used to redeem $26 million principal amount of 7% series bonds in March 1994. The Subsidiaries have regulatory authority to issue and sell first mortgage bonds, which may be issued as secured medium-term notes, and preferred stock for various periods through 1995. Under existing authorization, JCP&L, Met-Ed and Penelec may issue senior securities in the amount of $275 million, $250 million and $330 million, respectively, of which $100 million for each Subsidiary may consist of preferred stock. The Subsidiaries also have regulatory authority to incur short-term debt, a portion of which may be through the issuance of commercial paper. General Public Utilities Corporation and Subsidiary Companies The GPU System's cost of capital and ability to obtain external financing is affected by the Subsidiaries' security ratings, which continue to remain above minimum investment grade. The Subsidiaries' first mortgage bonds are currently rated at an equivalent of either an A or A- rating by the three major credit rating agencies, while an equivalent of either an A- or BBB+ rating is assigned to the preferred stock issues. In addition, the Subsidiaries' commercial paper is rated as having good to high credit quality. During 1993, Standard & Poor's revised its financial benchmarking standards for rating the debt of electric utilities to reflect the changing risk profiles resulting primarily from the intensifying competitive pressures in the industry. These guidelines now include an assessment of the company's business risk. Standard & Poor's new rating structure changed the business outlook for the debt ratings of approximately one-third of the industry, including JCP&L, which moved from "A-stable" to "A-negative", meaning their credit ratings may be lowered. JCP&L was classified as "below average" in its business risk position due to the perceived credit risk associated with large purchased power requirements, relatively high rates and a sluggish local economy. Met-Ed and Penelec were both classified as having "average" business risk positions. Moody's announced that it expects to reduce its average credit ratings for the electric utility industry within the next three years to take into account the effects of the new competitive environment. Duff & Phelps also indicated that it intends to introduce a forecast element to its quantitative analysis to, among other things, "alert investors to the possibility of equity value reduction and credit quality deterioration." The Subsidiaries' bond indentures and articles of incorporation include provisions that limit the amount of long-term debt, preferred stock and short- term debt the Subsidiaries may issue. The Subsidiaries' interest and preferred stock coverage ratios are currently in excess of indenture or charter restrictions. The ability to issue securities in the future will depend on coverages at that time. Present plans call for the Subsidiaries to issue long-term debt and preferred stock during the next three years to finance construction activities and, depending on the level of interest rates, refinance outstanding senior securities. CAPITALIZATION: The GPU System supports its credit quality rating by maintaining capitalization ratios that permit access to capital markets at a competitive cost. The targets and actual capitalization ratios are as follows: Capitalization Target Range 1993 1992 1991 Common equity 45-48% 47% 46% 46% Preferred stock 8-10 5 9 9 Notes payable and long-term debt 47-42 48 45 45 100% 100% 100% 100% General Public Utilities Corporation and Subsidiary Companies The sale of GPU common stock in 1993 was used primarily to reimburse the Subsidiaries for preferred stock redemptions. Management believes these actions strengthened GPU's capital structure by increasing common equity without increasing the overall cost of capital or diluting shareholder earnings. Recent evaluations of the industry by credit rating agencies indicate that the Subsidiaries may have to increase their equity ratios to maintain their current credit ratings. In 1993, the quarterly dividend on common stock was increased by 6.3% to an annualized rate of $1.70 per share. In addition, GPU set a target payout ratio of 70-75% to be reached over the next few years. GPU will continue to review its dividend policy to determine how to best serve the long-term interests of shareholders. NONUTILITY BUSINESS: General Portfolios Corporation (GPC) was organized to make investments apart from the businesses of the Subsidiaries. Currently, these are conducted by Energy Initiatives, Inc. (EI), a subsidiary of GPC, and its subsidiaries. EI is in the business of developing, operating and investing in cogeneration and other nonutility power production facilities. As of December 31, 1993, EI had five combined-cycle cogeneration plants in service aggregating 223 MW of capacity and an option to acquire a 20% equity interest in projects having an additional 350 MW of capacity. As a result of the federal Energy Policy Act of 1992 (Energy Act), EI has expanded its business activities to include development of exempt wholesale generating facilities in both the domestic and limited international markets. In 1993, EI entered into an agreement to invest up to $8.5 million over the next four years to acquire a 29% equity interest in a private independent power development company, which has commitments or prospects to provide more than 200 MW of electricity to utilities in Canada and plans to develop other projects in the United States. EI also obtained the right to invest in and operate several of the projects. In addition, EI has been active as a bidder and has proposals pending for the development of additional capacity in the United States. EI is also pursuing international development projects in Latin America while investigating other international opportunities. At December 31, 1993, GPU's investment in GPC was $39 million. GPU intends to make additional investments in the development and ownership of nonutility generating facilities in an effort to expand these business activities. The timing and amounts of these investments, however, will depend upon the development of appropriate opportunities. GPU does not expect investments apart from these activities to be a major part of its business activities. General Public Utilities Corporation and Subsidiary Companies COMPETITIVE ENVIRONMENT: The Push Toward Competition The electric utility industry appears to be undergoing a major transition as it proceeds from a traditional rate regulated environment based on cost recovery to some combination of competitive marketplace and modified regulation of certain market segments. The industry challenges resulting from various instances of competition, deregulation and restructuring thus far have been minor compared with the impact that is expected in the future. The Public Utility Regulatory Policies Act of 1978 (PURPA) facilitated the entry of competitors into the electric generation business. Since then, more competition has been introduced through various state actions to encourage cogeneration and, most recently, the Energy Act. The Energy Act is intended to promote competition among utility and nonutility generators in the wholesale electric generation market, accelerating the industry restructuring that has been underway since the enactment of PURPA. This legislation, coupled with increasing customer demands for lower-priced electricity, is generally expected to stimulate even greater competition in both the wholesale and retail electricity markets. These competitive pressures may create opportunities to compete for new customers and revenues, as well as increase risk which could lead to the loss of customers. Operating in a competitive environment will place added pressures on utility profit margins and credit quality. Utilities with significantly higher cost structures than supportable in the marketplace may experience reduced earnings as they attempt to meet their customers' demands for lower- priced electricity. This prospect of increasing competition in the electric utility industry has already led the credit rating agencies to address and apply more stringent guidelines in making credit rating determinations. Among its provisions, the Energy Act allows the Federal Energy Regulatory Commission (FERC), subject to certain criteria, to order owners of electric transmission systems, such as the Subsidiaries, to provide third parties transmission access for wholesale power transactions. The Energy Act did not give the FERC the authority, however, to order retail transmission access. That authority lies with the individual states and movement toward opening the transmission network to retail customers is currently under consideration in several states. Recent Events Competition in the electric utility industry has already played a significant role in wholesale transactions, affecting the pricing of energy sales to electric cooperatives and municipal customers. During 1993, Penelec successfully negotiated power supply agreements with several existing GPU System wholesale customers in response to offers made by other utilities seeking to provide electric service at rates lower than those of Met-Ed or JCP&L. Penelec has made similar offers to certain wholesale customers now being served by other utilities. Although wholesale customers represent a relatively small portion of GPU System sales, the Subsidiaries will continue their efforts to retain and add customers by offering competitive rates. General Public Utilities Corporation and Subsidiary Companies The competitive forces have also begun to influence some retail pricing in the industry. In a few instances, industrial customers, threatening to pursue cogeneration, self-generation or relocation to other service territories, have leveraged price concessions from utilities. Recent state regulatory actions, such as in New Jersey, suggest that utilities may have limited success with attempting to shift costs associated with such discounts to other customers. Utilities may have to absorb, in whole or part, the effects of price reductions designed to retain large retail customers. State regulators may put a limit or cap on prices, especially for those customers unable to pursue alternative supply options. In December 1993, JCP&L filed a proposal with the NJBRC seeking approval to implement a new rate initiative designed to retain and expand the economic base in New Jersey. Under the proposed contract rate service, large retail customers could enter into contracts for existing electric service at prevailing rates, with limitations on their exposure to future rate increases. With this rate initiative, JCP&L will have to absorb any differential in price resulting from changes in costs not provided for in the contracts. This matter is pending before the NJBRC. Proposed legislation has been introduced in New Jersey which is intended to allow the NJBRC, at the request of an electric or gas utility, to adopt a plan of regulation other than traditional ratemaking methods to encourage economic development and job creation. This flexible ratemaking would allow electric utilities to be more competitive with nonutility generators, who are not subject to NJBRC regulation. Combined with other economic development initiatives, this legislation, if enacted, would provide more flexibility in responding to competitive pressures, but may also serve to accelerate the growth of competitive pressures. Financial Exposure In the transition from a regulated to competitive environment, there can be a significant change in the economic value of a utility's assets. Traditional utility regulation provides an opportunity for recovery of the cost of plant assets, along with a return on investment, through ratemaking. In a competitive market, the value of an asset may be determined by the market price of the services derived from that asset. If the cost of operating existing assets results in above market prices, a utility may be unable to recover all of its costs, resulting in "stranded assets" and other unrecoverable costs. This may result in write-downs to remove stranded assets from a utility's balance sheet in recognition of their reduced economic value and the recognition of other losses. Unrecovered costs will most likely be related to generation investment, purchased power contracts, and "regulatory assets", which are deferred accounting transactions whose value rests on the strength of a state regulatory decision to allow future recovery from ratepayers. In markets where there is excess capacity (as there currently is in the region including New Jersey and Pennsylvania) and many available sources of power supply, the market price of electricity may be too low to support full recovery of capital costs of certain existing power plants, primarily the capital intensive plants General Public Utilities Corporation and Subsidiary Companies such as nuclear units. Another significant exposure in the transition to a competitive market results if the prices of a utility's existing purchase power contracts, consisting primarily of contractual obligations with nonutility generators, are higher than future market prices. Utilities locked into expensive purchase power arrangements may be forced to value the contracts at market prices and recognize certain losses. A third source of exposure is regulatory assets which if not supported by regulators would have no value in a competitive market. Financial Accounting Standard No. 71 (FAS 71), "Accounting for the Effects of Certain Types of Regulation", applies to regulated utilities that have the ability to recover their costs through rates established by regulators and charged to customers. If a portion of the GPU System's operations continues to be regulated, FAS 71 accounting may only be applied to that portion. Write-offs of utility plant and regulatory assets may result for those operations that no longer meet the requirements of FAS 71. In addition, under deregulation, the uneconomical costs of certain contractual commitments for purchased power and/or fuel supplies may have to be expensed. Management believes that to the extent that the GPU System no longer qualifies for FAS 71 accounting treatment, a material adverse effect on its results of operations and financial position may result. At this time, it is difficult for management to project the future level of stranded assets or other unrecoverable costs, if any, without knowing what the market price of electricity will be, or if regulators will allow recovery of industry transition costs from customers. Positioning the GPU System The typical electric utility today is vertically integrated, operating its plant assets to serve all customers within a franchised service territory. In the future, franchised service territories may be replaced by markets whose boundaries are defined by price, available capacity and transmission access. This may result in changes to the organizational structure of utilities and an emphasis on certain segments of the business among generation, transmission and distribution. In order to achieve a strong competitive position in a less regulated future, the GPU System has in place a strategic planning process. In the initial phases of the program, task forces are defining the principal challenges facing GPU, exploring opportunities and risks, and defining and evaluating strategic alternatives. Management is now analyzing issues associated with various competition and regulatory scenarios to determine how best to position the GPU System for a competitive environment. An initial outcome of the GPU System ongoing strategic planning process was a realignment proposed in February 1994, of certain system operations. Subject to necessary regulatory approval, a new subsidiary, GPU Generation Corporation, will be formed to operate and maintain the GPU System's fossil-fueled and hydroelectric generating stations, which are now owned and operated by the Subsidiaries. It is also intended to combine the remaining Met-Ed and Penelec operations without merging the two companies. GPU is also developing a performance improvement and cost reduction program to help assure ongoing competitiveness, and, among other matters, will also address workforce issues in terms of compensation, size and skill mix. General Public Utilities Corporation and Subsidiary Companies MEETING ENERGY DEMANDS: The Subsidiaries have a projected need, due in large part to peak load growth, of 644 MW of additional capacity by the year 1998 based on an average growth in sales to customers of about 1.7% annually, with growth rates for the Subsidiaries projected from 1.1% to 2.3%. GPU intends to provide for this increased energy need through a mix of economic sources. Current and projected capacity and sources of energy are as follows: Capacity 1993 1998 MW % MW % Coal 3,022 30 3,040 29 Nuclear 1,396 14 1,406 13 Gas, hydro & oil 2,321 23 2,605 24 Contracted purchases 3,233 33 3,034 29 Uncommitted sources - - 531 5 Total 9,972 100 10,616 100 Sources of Energy 1993 1998 GWH % GWH % Coal 16,969 35 17,949 35 Nuclear 10,614 22 9,766 19 Gas, hydro & oil 575 1 1,177 2 Contracted purchases 14,717 30 18,103 36 Uncommitted sources & interchange 5,650 12 4,233 8 Total 48,525 100 51,228 100 In response to the increasingly competitive business climate and excess capacity of nearby utilities, the GPU System's supply plan places an emphasis on maintaining flexibility. Supply planning focuses increasingly on short to intermediate term commitments, reliance on "spot" markets, and avoidance of long-term firm commitments. Through 1998, GPU's plan consists of the continued utilization of existing generating facilities combined with power purchases, the construction of new facilities, and the continued promotion of economic energy conservation and load management programs. Given the future direction of the industry, GPU's present strategy includes minimizing the financial exposure associated with new long-term purchase commitments and the construction of new facilities by including projected market prices in the evaluation of these options. The GPU System will resist efforts to compel it to add new capacity at costs that may exceed future market prices. In addition, GPU will seek regulatory support to renegotiate or buy out contracts with nonutility generators where the pricing is in excess of projected avoided costs. New Energy Supplies The GPU System's supply plan includes the addition of 1,259 MW of presently contracted capacity by 1998 from nonutility generation suppliers and reflects the construction of new peaking units. The supply plan also includes the addition of 531 MW of currently uncommitted capacity, which may be filled General Public Utilities Corporation and Subsidiary Companies by a combination of utility and nonutility purchases as well as company owned facilities. Additions are principally related to the expiration of existing commitments rather than to serve new customer load. In July 1993, the PaPUC acted to initiate a rulemaking proceeding which, in general, would establish a mandatory all source competitive bidding program by which utilities would meet their future capacity and energy needs. Also in July, a NJBRC Advisory Council recommended in a report that all New Jersey electric utilities be required to submit integrated resource plans for review and approval by the NJBRC. The NJBRC has asked all electric utilities in the state to assess the economics of their purchase power contracts with nonutility generators to determine whether there are any candidates for potential buy out or other remedial measures. JCP&L identified a 100 MW project now under development, which it believes is economically undesirable based on current cost projections. In November 1993, the NJBRC directed JCP&L and the developer to negotiate contract repricing to a level more consistent with JCP&L's current avoided cost projections or a contract buy out. The developer has filed a federal court action contesting the NJBRC's jurisdiction in this matter. In November 1993, the NJBRC granted two nonutility generators, having a total of 200 MW under contract with JCP&L, a one-year extension in the in-service date for projects originally scheduled to be operational in 1997. JCP&L is awaiting a final written NJBRC order. Also in November 1993, JCP&L received approval from the NJBRC to withdraw its request for proposals for the purchase of 150 MW from nonutility generators. In its petition, JCP&L cited, among other reasons, that solicitations for long-term contracts would have limited its ability to compete in a deregulated environment. In November 1993, Penelec filed an appeal with the Commonwealth Court seeking to overturn a PaPUC order which directs Penelec to enter into two power purchase agreements with nonutility generators for a total of 160 MW under long-term contracts commencing in 1997 or later. Penelec does not need this additional capacity and believes the costs associated with these contracts are not in the economic interests of its customers. JCP&L and Met-Ed have entered into arrangements for two peaking generation projects. JCP&L plans to install a gas-fired combustion turbine at its Gilbert Generating Station and retire two steam units for an 88 MW net increase in peaking capacity at an expected cost of $50 million. JCP&L expects to complete the project by 1996. Met-Ed has filed an application with the PaPUC for approval to build a 134 MW gas-fired combustion turbine adjacent to its Portland Generating Station at a cost of $50 million. The application has been opposed by a nonutility generator seeking to sell Met-Ed an equivalent amount of baseload capacity. In December 1993, the NJBRC denied JCP&L's petition to participate in the proposed power supply and transmission facilities agreements between the Subsidiaries and Duquesne. As a result of this action and other developments, the Subsidiaries notified Duquesne that they were exercising their rights General Public Utilities Corporation and Subsidiary Companies under the agreements to withdraw from and thereby terminate the agreements. The capital costs of these transactions would have totaled approximately $500 million. In January 1994, JCP&L issued an all source solicitation for the short- term supply of energy and/or capacity to determine and evaluate the availability of competitively priced power supply options. JCP&L is seeking proposals from utility and nonutility generation suppliers for periods of one to eight years in length and capable of delivering electric power beginning in 1996. This solicitation is expected to fulfill a significant part of the uncommitted sources identified in GPU's supply plan. Conservation and Load Management The regulatory environments in both New Jersey and Pennsylvania encourage the development of new conservation and load management programs. This is evidenced by demand-side management (DSM) incentive regulations adopted in New Jersey in 1992 and recent approval of a cost recovery mechanism for DSM in Pennsylvania. DSM includes utility sponsored activities designed to improve energy efficiency in customer end-use, and includes load management programs (i.e., peak reduction) and conservation programs (i.e., energy and peak reduction). In New Jersey, the NJBRC approved JCP&L's DSM plan in 1992 reflecting DSM initiatives of 67 MW of summer peak reduction by the end of 1994. Under the approved regulation, qualified Performance Program DSM investments are recovered over a six-year period with a return earned on the unrecovered amounts. Lost revenues will be recovered on an annual basis and JCP&L can also earn a performance-based incentive for successfully implementing cost effective programs. In addition, JCP&L will continue to make certain NJBRC mandated Core Program DSM investments which are recovered annually. The PaPUC has recently completed its generic investigation into DSM cost recovery mechanisms and issued a cost recovery and ratemaking order in December 1993. Penelec and Met-Ed are currently developing plans which will reflect changes since their original plans were filed in 1991. New targets for DSM initiatives are currently being determined and will be identified when the new DSM plans are filed in the first quarter of 1994. ENVIRONMENTAL ISSUES: The GPU System is committed to complying with all applicable environmental regulations in a responsible manner. Compliance with the federal Clean Air Act Amendments of 1990 (Clean Air Act) and other environmental needs will present a major challenge to the GPU System through the late 1990s. The Clean Air Act will require substantial reductions in sulfur dioxide and nitrogen oxide emissions by the year 2000. The GPU System's current plan includes installing and operating emission control equipment at some of the Subsidiaries' coal-fired plants as well as switching to lower sulfur coal at other coal-fired plants. To comply with the Clean Air Act, the GPU System General Public Utilities Corporation and Subsidiary Companies control equipment. GPU reviews its plans and alternatives to comply with the expects to expend up to $590 million by the year 2000 for air pollutionClean Air Act on a least-cost basis taking into account advances in technology and the emission allowance market and assesses the risk of recovering capital investments in a competitive environment. GPU may be able to defer sub- stantial capital investments while attaining the required level of compliance if an alternative such as increased participation in the emission allowance market is determined to result in the least-cost plan. This and other compliance alternatives may result in the substitution of increased operating expenses for capital costs. At this time, costs associated with the capital invested in this pollution control equipment and the increased operating costs of the affected stations are expected to be recoverable through the ratemaking process, but management recognizes that recovery is not assured. For more information, see the Environmental Matters section of Note 1 to the consolidated financial statements. LEGAL MATTERS - TMI-2 ACCIDENT CLAIMS: As a result of the TMI-2 accident and its aftermath, individual claims for alleged personal injury (including claims for punitive damages), which are material in amount, have been asserted against GPU and the Subsidiaries and are still pending. For more information, see Note 1 to the consolidated financial statements. EFFECTS OF INFLATION: The GPU System is affected by inflation since the regulatory process results in a time lag during which increased operating expenses are not fully recovered in rates. Inflation may have an even greater effect in a period of increasing competition and deregulation as GPU and the utility industry attempt to keep rates competitive. Inflation also affects the GPU System in the form of higher replacement costs of utility plant. In the past, GPU anticipated the recovery of these cost increases through the ratemaking process. However, as competition and deregulation accelerate throughout the industry, there can be no assurance of the recovery of these increased costs. The GPU System is committed to long-term cost control and is continuing to seek measures to reduce or limit the growth in operating expenses. The prudent expenditure of capital and debt refinancing programs have kept down increases in debt levels and capital costs. ACCOUNTING ISSUES: In May 1993, the Financial Accounting Standards Board issued FAS 115, "Accounting for Certain Investments in Debt and Equity Securities", which is effective for fiscal years beginning after December 15, 1993. FAS 115 requires the recording of unrealized gains and losses with a corresponding offsetting entry to earnings or shareholders' equity. The impact on the GPU System's financial position is expected to be immaterial and there will be no impact on the results of operations. FAS 115 will be implemented in 1994. General Public Utilities Corporation and Subsidiary Companies REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors General Public Utilities Corporation Parsippany, New Jersey We have audited the consolidated financial statements and financial statement schedules of General Public Utilities Corporation and Subsidiary Companies as listed in the index on page of this Form 10-K. These financial statements and financial statement schedules are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of General Public Utilities Corporation and Subsidiary Companies as of December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules referred to above, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. As more fully discussed in Note 1 to the consolidated financial statements, the Corporation is unable to determine the ultimate consequences of certain contingencies which have resulted from the accident at Unit 2 of the Three Mile Island Nuclear Generating Station ("TMI-2"). The matters which remain uncertain are (a) the extent to which the retirement costs of TMI-2 could exceed amounts currently recognized for ratemaking purposes or otherwise accrued, and (b) the excess, if any, of amounts which might be paid in connection with claims for damages resulting from the accident over available insurance proceeds. As discussed in Notes 6 and 8 to the consolidated financial statements, the Corporation was required to adopt the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes", and the provisions of SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" in 1993. Also, as discussed in Note 2 to the consolidated financial statements, the Corporation changed its method of accounting for unbilled revenues in 1991. COOPERS & LYBRAND New York, New York February 2, 1994 General Public Utilities Corporation and Subsidiary Companies NOTES TO CONSOLIDATED FINANCIAL STATEMENTS General Public Utilities Corporation (the Corporation) is a holding company registered under the Public Utility Holding Company Act of 1935. The Corporation does not directly operate any utility properties, but owns all the outstanding common stock of three electric utilities -- Jersey Central Power & Light Company (JCP&L), Metropolitan Edison Company (Met-Ed) and Pennsylvania Electric Company (Penelec) (the Subsidiaries). The Corporation also owns all the common stock of GPU Service Corporation (GPUSC), a service company; GPU Nuclear Corporation (GPUN), which operates and maintains the nuclear units of the Subsidiaries; and General Portfolios Corporation (GPC), parent of Energy Initiatives, Inc., which develops, owns and operates nonutility generating facilities. All of these companies considered together with their subsidiaries are referred to as the "GPU System." 1. COMMITMENTS AND CONTINGENCIES NUCLEAR FACILITIES The Subsidiaries have made investments in three major nuclear projects -- Three Mile Island Unit 1 (TMI-1) and Oyster Creek, both of which are operational generating facilities, and Three Mile Island Unit 2 (TMI-2), which was damaged during a 1979 accident. At December 31, 1993, the Subsidiaries' net investment in TMI-1 and Oyster Creek, including nuclear fuel, was $670 million and $784 million, respectively. TMI-1 and TMI-2 are jointly owned by JCP&L, Met-Ed and Penelec in the percentages of 25%, 50% and 25%, respectively. Oyster Creek is owned by JCP&L. Costs associated with the operation, maintenance and retirement of nuclear plants have continued to increase and become less predictable, in large part due to changing regulatory requirements and safety standards and experience gained in the construction and operation of nuclear facilities. The GPU System may also incur costs and experience reduced output at its nuclear plants because of the design criteria prevailing at the time of construction and the age of the plants' systems and equipment. In addition, for economic or other reasons, operation of these plants for the full term of their now assumed lives cannot be assured. Also, not all risks associated with ownership or operation of nuclear facilities may be adequately insured or insurable. Consequently, the ability of electric utilities to obtain adequate and timely recovery of costs associated with nuclear projects, including replacement power, any unamortized investment at the end of the plants' useful life (whether scheduled or premature), the carrying costs of that investment and retirement costs, is not assured. Management intends, in general, to seek recovery of any such costs described above through the ratemaking process, but recognizes that recovery is not assured. General Public Utilities Corporation and Subsidiary Companies TMI-2: The 1979 TMI-2 accident resulted in significant damage to, and contamination of, the plant and a release of radioactivity to the environment. The cleanup program was completed in 1990. After receiving Nuclear Regulatory Commission (NRC) approval, TMI-2 entered into long-term monitored storage in December 1993. As a result of the accident and its aftermath, individual claims for alleged personal injury (including claims for punitive damages), which are material in amount, have been asserted against the Corporation and the Subsidiaries. Approximately 2,100 of such claims are pending in the U.S. District Court for the Middle District of Pennsylvania. Some of the claims also seek recovery for injuries from alleged emissions of radioactivity before and after the accident. Questions have not yet been resolved as to whether the punitive damage claims are (a) subject to the overall limitation of liability set by the Price-Anderson Act ($560 million at the time of the accident) and (b) outside the primary insurance coverage provided pursuant to that Act (remaining primary coverage of approximately $80 million as of December 31, 1993). If punitive damages are not covered by insurance or are not subject to the Price-Anderson liability limitation, punitive damage awards could have a material adverse effect on the financial position of the GPU System. In June 1993, the Court agreed to permit pre-trial discovery on the punitive damage claims to proceed. A trial of twelve allegedly representative cases is scheduled to begin in October 1994. In February 1994, the Court held that the plaintiffs' claims for punitive damages are not barred by the Price- Anderson Act to the extent that the funds to pay punitive damages do not come out of the U.S. Treasury. The Court also denied the defendants' motion seeking a dismissal of all cases on the grounds that the defendants complied with applicable federal safety standards regarding permissible radiation releases from TMI-2 and that, as a matter of law, the defendants therefore did not breach any duty that they may have owed to the individual plaintiffs. The Court stated that a dispute about what radiation and emissions were released cannot be resolved on a motion for summary judgment. NUCLEAR PLANT RETIREMENT COSTS Retirement costs for nuclear plants include decommissioning the radiological portions of the plants and the cost of removal of nonradiological structures and materials. As described in the Nuclear Fuel Disposal Fee section of Note 2, the disposal of spent nuclear fuel is covered separately by contracts with the U.S. Department of Energy (DOE). In 1990, the Subsidiaries submitted a report, in compliance with NRC regulations, setting forth a funding plan (employing the external sinking fund method) for the decommissioning of their nuclear reactors. Under this plan, the Subsidiaries intend to complete the funding for Oyster Creek and TMI-1 by the end of the plants' license terms, 2009 and 2014, respectively. The TMI-2 funding completion date is 2014, consistent with TMI-2 remaining in long-term storage and being decommissioned at the same time as TMI-1. Under the NRC regulations, the funding targets (in 1993 dollars) for TMI-1 and Oyster Creek General Public Utilities Corporation and Subsidiary Companies are $143 million and $175 million, respectively. Based on NRC studies, a comparable funding target for TMI-2 (in 1993 dollars), which takes into account the accident, is $228 million. The NRC is currently studying the levels of these funding targets. Management cannot predict the effect that the results of this review will have on the funding targets. NRC regulations and a regulatory guide provide mechanisms, including exemptions, to adjust the funding targets over their collection periods to reflect increases or decreases due to inflation and changes in technology and regulatory requirements. The funding targets, while not actual cost estimates, are reference levels designed to assure that licensees demonstrate adequate financial responsibility for decommissioning. While the regulations address activities related to the removal of the radiological portions of the plants, they do not establish residual radioactivity limits nor do they address costs related to the removal of nonradiological structures and materials. In 1988, a consultant to GPUN performed site-specific studies of TMI-1 and Oyster Creek that considered various decommissioning plans and estimated the cost of decommissioning the radiological portions of each plant to range from approximately $205 to $285 million and $220 to $320 million, respectively (adjusted to 1993 dollars). In addition, the studies estimated the cost of removal of nonradiological structures and materials for TMI-1 and Oyster Creek at $72 million and $47 million, respectively. The ultimate cost of retiring the GPU System's nuclear facilities may be materially different from the funding targets and the cost estimates contained in the site-specific studies and cannot now be more reasonably estimated than the level of the NRC funding target because such costs are subject to (a) the type of decommissioning plan selected, (b) the escalation of various cost elements (including, but not limited to, general inflation), (c) the further development of regulatory requirements governing decommissioning, (d) the absence to date of significant experience in decommissioning such facilities and (e) the technology available at the time of decommissioning. The Subsidiaries charge to expense and contribute to external trusts amounts collected from customers for nuclear plant decommissioning and nonradiological costs. In addition, the Subsidiaries have contributed to external trusts amounts written off for nuclear plant decommissioning in 1990 and 1991. TMI-1 and Oyster Creek: JCP&L is collecting revenues for decommissioning, which are expected to result in the accumulation of its share of the NRC funding target for each plant. JCP&L is also collecting revenues based on estimates, adopted in rate orders issued in 1991 and 1993 by the New Jersey Board of Regulatory Commissioners (NJBRC), for the cost of removal of nonradiological structures and materials at each plant based on its share of an estimated $15.3 million for TMI-1 and $31.6 million for Oyster Creek. In January 1993, the Pennsylvania Public Utility Commission (PaPUC) granted Met-Ed revenues for decommissioning costs of TMI-1 based on its share of the NRC funding target and nonradiological cost of removal as estimated in the site-specific study. Effective October 1993, the PaPUC approved a rate change for Penelec which increased the collection of revenues for decommissioning costs for TMI-1 to a basis equivalent to that granted Met-Ed. Collections from customers for General Public Utilities Corporation and Subsidiary Companies decommissioning expenditures are deposited in external trusts and are classified as Decommissioning Funds on the balance sheet, which includes the interest earned on these funds. Provision for the future expenditure of these funds has been made in accumulated depreciation, amounting to $29 million for TMI-1 and $80 million for Oyster Creek at December 31, 1993. Management believes that any TMI-1 and Oyster Creek retirement costs, in excess of those currently recognized for ratemaking purposes, should be recoverable through the ratemaking process. TMI-2: The Corporation and its Subsidiaries have recorded a liability amounting to $229 million as of December 31, 1993, for the radiological decommissioning of TMI-2, reflecting the NRC funding target. The Subsidiaries record escalations, when applicable, in the liability based upon changes in the NRC funding target. The Subsidiaries have also recorded a liability in the amount of $20 million for incremental costs specifically attributable to monitored storage. Such costs are expected to be incurred between 1994 and 2014, when decommissioning is forecast to begin. In addition, the Subsidiaries have recorded a liability in the amount of $71 million for nonradiological cost of removal. The above amounts for retirement costs and monitored storage are reflected as Three Mile Island Unit 2 Future Costs on the balance sheet. JCP&L has made a nonrecoverable contribution of $15 million to an external decommissioning trust. Met-Ed and Penelec have made nonrecoverable contributions of $40 million and $20 million, respectively, to external decommissioning trusts relating to their shares of the accident-related portion of the decommissioning liability. The NJBRC and the PaPUC have granted JCP&L and Met-Ed, respectively, decommissioning revenues for the remainder of the NRC funding target and allowances for the cost of removal of nonradiological structures and materials. In March 1993, a PaPUC rate order for Met-Ed allowed for the future recovery of certain TMI-2 retirement costs. The recovery of these TMI-2 retirement costs will begin when the amortization of the TMI-2 investment ends, at the same annual amount ($6.3 million for recovery of radiological decommissioning and $2.0 million for nonradiological cost of removal, net of gross receipts tax). In May 1993, the Pennsylvania Office of Consumer Advocate filed a petition for review with the Pennsylvania Commonwealth Court seeking to set aside the PaPUC's 1993 rate order. The matter is pending before the court. If the 1993 rate order is reversed, Met-Ed and Penelec would be required to write off a total of approximately $170 million for retirement costs. Penelec intends to request decommissioning revenues and an allowance for the cost of removal of nonradiological structures and materials, equivalent to its share of the amounts granted to Met-Ed, in its next retail base rate filing. Management intends to seek recovery for any increases in TMI-2 retirement costs, but recognizes that recovery cannot be assured. Upon TMI-2's entering long-term monitored storage, the Subsidiaries will incur currently estimated incremental annual storage costs of $1 million. The Subsidiaries have deferred the $20 million for the total estimated incremental General Public Utilities Corporation and Subsidiary Companies costs attributable to monitored storage. The JCP&L share of these costs has been recognized in rates by the NJBRC. Met-Ed and Penelec believe these costs should be recoverable through the ratemaking process. INSURANCE The GPU System has insurance (subject to retentions and deductibles) for its operations and facilities including coverage for property damage, liability to employees and third parties, and loss of use and occupancy (primarily incremental replacement power costs). There is no assurance that the GPU System will maintain all existing insurance coverages. Losses or liabilities that are not completely insured, unless allowed to be recovered through ratemaking, could have a material adverse effect on the financial position of the GPU System. The decontamination liability, premature decommissioning and property damage insurance coverage for the TMI station (TMI-1 and TMI-2 are considered one site for insurance purposes) and for Oyster Creek totals $2.7 billion per site. In accordance with NRC regulations, these insurance policies generally require that proceeds first be used for stabilization of the reactors and then to pay for decontamination and debris removal expenses. Any remaining amounts available under the policies may then be used for repair and restoration costs and decommissioning costs. Consequently, there can be no assurance that in the event of a nuclear incident, property damage insurance proceeds would be available for the repair and restoration of the stations. The Price-Anderson Act limits the GPU System's liability to third parties for a nuclear incident at one of its sites to approximately $9.4 billion. Coverage for the first $200 million of such liability is provided by private insurance. The remaining coverage, or secondary protection, is provided by retrospective premiums payable by all nuclear reactor owners. Under secondary protection, a nuclear incident at any licensed nuclear power reactor in the country, including those owned by the GPU System, could result in assessments of up to $79 million per incident for each of the GPU System's three reactors, subject to an annual maximum payment of $10 million per incident per reactor. In 1993, GPUN requested an exemption from the NRC to eliminate the secondary protection requirements for TMI-2. This matter is pending before the NRC. The GPU System has insurance coverage for incremental replacement power costs resulting from an accident-related outage at its nuclear plants. Coverage commences after the first 21 weeks of the outage and continues for three years at decreasing levels beginning at $1.8 million for Oyster Creek and $2.6 million for TMI-1, per week. Under its insurance policies applicable to nuclear operations and facilities, the GPU System is subject to retrospective premium assessments of up to $52 million in any one year, in addition to those payable under the Price-Anderson Act. General Public Utilities Corporation and Subsidiary Companies ENVIRONMENTAL MATTERS As a result of existing and proposed legislation and regulations, and ongoing legal proceedings dealing with environmental matters, including but not limited to acid rain, water quality, air quality, global warming, electromagnetic fields, and storage and disposal of hazardous and/or toxic wastes, the GPU System may be required to incur substantial additional costs to construct new equipment, modify or replace existing and proposed equipment, remediate or clean up waste disposal and other sites currently or formerly used by it, including formerly owned manufactured gas plants and mine refuse piles, and with regard to electromagnetic fields, postpone or cancel the installation of, or replace or modify, utility plant, the costs of which could be material. Management intends to seek recovery through the ratemaking process for any additional costs, but recognizes that recovery cannot be assured. To comply with the federal Clean Air Act Amendments of 1990, the GPU System expects to expend up to $590 million for air pollution control equipment by the year 2000. Costs associated with the capital invested in this equipment and the increased operating costs of the affected stations should be recoverable through the ratemaking process. The GPU System companies have been notified by the Environmental Protection Agency (EPA) and state environmental authorities that they are among the potentially responsible parties (PRPs) who may be jointly and severally liable to pay for the costs associated with the investigation and remediation at ten hazardous and/or toxic waste sites. In addition, the GPU System companies have been requested to supply information to the EPA and state environmental authorities on several other sites for which they have not yet been named as PRPs. The Subsidiaries have also been named in lawsuits requesting damages for hazardous and/or toxic substances allegedly released into the environment. The ultimate cost of remediation will depend upon changing circumstances as site investigations continue, including (a) the existing technology required for site cleanup, (b) the remedial action plan chosen and (c) the extent of site contamination and the portion attributed to the GPU System companies. JCP&L has entered into agreements with the New Jersey Department of Environmental Protection and Energy for the investigation and remediation of 17 formerly-owned manufactured gas plant sites. One of these sites has been repurchased by JCP&L. JCP&L has also entered into various cost sharing agreements with other utilities for some of the sites. At December 31, 1993, JCP&L has an estimated environmental liability of $35 million recorded on its balance sheet relating to these sites. The estimated liability is based upon ongoing site investigations and remediation efforts, including capping the sites and pumping and treatment of ground water. If the periods over which General Public Utilities Corporation and Subsidiary Companies the remediation is currently expected to be performed are lengthened, JCP&L believes that it is reasonably possible that the ultimate costs may range as high as $60 million. Estimates of these costs are subject to significant uncertainties as JCP&L does not presently own or control most of these sites; the environmental standards have changed in the past and are subject to future change; the accepted technologies are subject to further development; and the related costs for these technologies are uncertain. If JCP&L is required to utilize different remediation methods, the costs could be materially in excess of $60 million. In June 1993, the NJBRC approved a mechanism for the recovery of future manufactured gas plant remediation costs through JCP&L's Levelized Energy Adjustment Clause (LEAC) when expenditures exceed prior collections. The NJBRC decision provides for interest to be credited to customers until the overrecovery is eliminated and for future costs to be amortized over seven years with interest. JCP&L is currently awaiting a final NJBRC order. JCP&L is pursuing reimbursement of the above costs from its insurance carriers, and will seek to recover costs to the extent not covered by insurance through this mechanism. The GPU System companies are unable to estimate the extent of possible remediation and associated costs of additional environmental matters. Also unknown are the consequences of environmental issues, which could cause the postponement or cancellation of either the installation or replacement of utility plant. Management believes the costs described above should be recoverable through the ratemaking process. OTHER COMMITMENTS AND CONTINGENCIES The NJBRC has instituted a generic proceeding to address the appropriate recovery of capacity costs associated with electric utility power purchases from nonutility generation projects. The proceeding was initiated, in part, to respond to contentions of the New Jersey Public Advocate, Division of Rate Counsel (Rate Counsel), that by permitting utilities to recover such costs through the LEAC, an excess or "double recovery" may result when combined with the recovery of the utilities' embedded capacity costs through their base rates. In September 1993, JCP&L and the other New Jersey electric utilities filed motions for summary judgment with the NJBRC requesting that the NJBRC dismiss contentions being made by Rate Counsel that adjustments for alleged "double recovery" in prior periods are warranted. Rate Counsel has filed a brief in opposition to the utilities' summary judgment motions including a statement from its consultant that in his view, the "double recovery" for JCP&L for the 1988-92 period would be approximately $102 million. Management believes that the position of Rate Counsel is without merit. This matter is pending before the NJBRC. General Public Utilities Corporation and Subsidiary Companies JCP&L's two operating nuclear units are subject to the NJBRC's annual nuclear performance standard. Operation of these units at an aggregate annual generating capacity factor below 65% or above 75% would trigger a charge or credit based on replacement energy costs. At current cost levels, the maximum annual effect on net income of the performance standard charge at a 40% capacity factor would be approximately $10 million. While a capacity factor below 40% would generate no specific monetary charge, it would require the issue to be brought before the NJBRC for review. The annual measurement period, which begins in March of each year, coincides with that used for the LEAC. At the request of the PaPUC, Met-Ed and Penelec, as well as the other Pennsylvania utilities, have supplied the PaPUC with proposals which may result in the PaPUC adopting a generic nuclear performance standard in the future. In December 1993, the NJBRC denied JCP&L's request to participate in the proposed power supply and transmission facilities agreements between the Subsidiaries and Duquesne Light Company (Duquesne). As a result of this action and other developments, the Subsidiaries notified Duquesne that they were exercising their rights under the agreements to withdraw from and thereby terminate the agreements. Consequently, the Subsidiaries wrote off the $25 million they had invested in the project. The GPU System's construction programs, for which substantial commitments have been incurred and which extend over several years, contemplate expenditures of $663 million during 1994. As a consequence of reliability, licensing, environmental and other requirements, substantial additions to utility plant may be required relatively late in their expected service lives. If such additions are made, current depreciation allowance methodology may not make adequate provision for the recovery of such investments during their remaining lives. Management intends to seek recovery of any such costs through the ratemaking process, but recognizes that recovery is not assured. As a result of the Energy Policy Act of 1992 (Energy Act) and actions of regulatory commissions, the electric utility industry appears to be moving toward a combination of competition and a modified regulatory environment. In accordance with Statement of Financial Accounting Standards No. 71, "Accounting for the Effects of Certain Types of Regulation" (FAS 71), the GPU System's financial statements reflect assets and costs based on current cost- based ratemaking regulations. Continued accounting under FAS 71 requires that the following criteria be met: a) A utility's rates for regulated services provided to its customers are established by, or are subject to approval by, an independent third-party regulator; b) The regulated rates are designed to recover specific costs of providing the regulated services or products; and General Public Utilities Corporation and Subsidiary Companies c) In view of the demand for the regulated services and the level of competition, direct and indirect, it is reasonable to assume that rates set at levels that will recover a utility's costs can be charged to and collected from customers. This criteria requires consideration of anticipated changes in levels of demand or competition during the recovery period for any capitalized costs. A utility's operations can cease to meet those criteria for various reasons, including deregulation, a change in the method of regulation, or a change in the competitive environment for the utility's regulated services. Regardless of the reason, a utility whose operations cease to meet those criteria should discontinue application of FAS 71 and report that discontinuation by eliminating from its balance sheet the effects of any actions of regulators that had been recognized as assets and liabilities pursuant to FAS 71 but which would not have been recognized as assets and liabilities by enterprises in general. If a portion of the GPU System's operations continues to be regulated and meets the above criteria, FAS 71 accounting may only be applied to that portion. Write-offs of utility plant and regulatory assets may result for those operations that no longer meet the requirements of FAS 71. In addition, under deregulation, the uneconomical costs of certain contractual commitments for purchased power and/or fuel supplies may have to be expensed. Management believes that to the extent that the GPU System no longer qualifies for FAS 71 accounting treatment, a material adverse effect on its results of operations and financial position may result. The Subsidiaries have entered into long-term contracts with nonaffiliated mining companies for the purchase of coal for certain generating stations in which they have ownership interests. The contracts, which expire between 1994 and the end of the expected service lives of the generating stations, require the purchase of either fixed or minimum amounts of the stations' coal requirements. The price of the coal is determined by formulas providing for the recovery by the mining companies of their costs of production. The Subsidiaries' share of the cost of coal purchased under these agreements is expected to aggregate $89 million for 1994. The Subsidiaries have entered into agreements with other utilities for the purchase of capacity and energy for various periods through 1999. These agreements provide for up to 2,130 MW in 1994, declining to 1,307 MW in 1995 and 183 MW by 1999. Payments pursuant to these agreements are estimated to aggregate $244 million in 1994. The price of the energy purchased under these agreements is determined by contracts providing generally for the recovery by the sellers of their costs. The Subsidiaries have also entered into power purchase agreements with independently owned power production facilities (nonutility generators) for the purchase of energy and capacity for periods up to 25 years. The majority of these agreements are subject to penalties for nonperformance and other contract limitations. While a few of these facilities are dispatchable, most are must-run and generally obligate the Subsidiaries to purchase all of the General Public Utilities Corporation and Subsidiary Companies power produced up to the contract limits. The agreements have been approved by the state regulatory commissions and permit the Subsidiaries to recover energy and demand costs from customers through their energy clauses. These agreements provide for the sale of approximately 2,452 MW of capacity and energy to the GPU System by the mid-to-late 1990s. As of December 31, 1993, facilities covered by these agreements having 1,193 MW of capacity were in service, and 215 MW were scheduled to commence operation in 1994. Payments made pursuant to these agreements were $491 million, $471 million and $343 million for 1993, 1992 and 1991, respectively, and are estimated to aggregate $551 million for 1994. The price of the energy and capacity to be purchased under these agreements is determined by the terms of the contracts. The rates payable under a number of these agreements are substantially in excess of current market prices. While the Subsidiaries have been granted full recovery of these costs from customers by the state commissions, there can be no assurance that the Subsidiaries will continue to be able to recover these costs throughout the term of the related contracts. The emerging competitive market has created additional uncertainty regarding the forecasting of the System's energy supply needs which, in turn, has caused the Subsidiaries to change their supply strategy to seek shorter term agreements offering more flexibility. At the same time, the Subsidiaries are attempting to renegotiate, and in some cases buy out, high cost long-term nonutility generation contracts where opportunities arise. The extent to which the Subsidiaries may be able to do so, however, or recover associated costs through rates, is uncertain. Moreover, these efforts have led to disputes before both the NJBRC and the PaPUC, as well as to litigation, and may result in claims against the Subsidiaries for substantial damages. There can be no assurance as to the outcome of these matters. During the normal course of the operation of their businesses, in addition to the matters described above, the GPU System companies are from time to time involved in disputes, claims and, in some cases, as defendants in litigation in which compensatory and punitive damages are sought by customers, contractors, vendors and other suppliers of equipment and services and by employees alleging unlawful employment practices. It is not expected that the outcome of these matters will have a material effect on the GPU System's financial position or results of operations. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES SYSTEM OF ACCOUNTS The consolidated financial statements include the accounts of all subsidiaries. Certain reclassifications of prior years' data have been made to conform with current presentation. The Subsidiaries' accounting records are maintained in accordance with the Uniform System of Accounts prescribed by the Federal Energy Regulatory Commission (FERC) and adopted by the PaPUC and NJBRC. General Public Utilities Corporation and Subsidiary Companies REVENUES The Corporation and its Subsidiaries recognize electric operating revenues for services rendered and, beginning in 1991, an estimate of unbilled revenues to record services provided to the end of the respective accounting period. DEFERRED ENERGY COSTS Energy costs are recognized in the period in which the related energy clause revenues are billed. UTILITY PLANT It is the policy of the GPU System to record additions to utility plant (material, labor, overhead and an allowance for funds used during construction) at cost. The cost of current repairs and minor replacements is charged to appropriate operating and maintenance expense and clearing accounts and the cost of renewals is capitalized. The original cost of utility plant retired or otherwise disposed of is charged to accumulated depreciation. DEPRECIATION The GPU System provides for depreciation at annual rates determined and revised periodically, on the basis of studies, to be sufficient to depreciate the original cost of depreciable property over estimated remaining service lives, which are generally longer than those employed for tax purposes. The Subsidiaries used depreciation rates which, on an aggregate composite basis, resulted in annual rates of 3.19%, 3.17% and 3.20% for the years 1993, 1992 and 1991, respectively. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION (AFUDC) The Uniform System of Accounts defines AFUDC as "the net cost for the period of construction of borrowed funds used for construction purposes and a reasonable rate on other funds when so used." AFUDC is recorded as a charge to construction work in progress, and the equivalent credits are to interest charges for the pretax cost of borrowed funds and to other income for the allowance for other funds. While AFUDC results in an increase in utility plant and represents current earnings, it is realized in cash through depreciation or amortization allowances only when the related plant is recognized in rates. On an aggregate composite basis, the annual rates utilized were 6.80%, 7.33% and 8.39% for the years 1993, 1992 and 1991, respectively. General Public Utilities Corporation and Subsidiary Companies AMORTIZATION POLICIES Accounting for TMI-2 and Forked River Investments: JCP&L is collecting annual revenues for the amortization of TMI-2 of $9.6 million. This level of revenue will be sufficient to recover the remaining investment by 2008. In its 1993 base rate decision, the PaPUC reduced Met-Ed's annual retail revenues for the amortization of the TMI-2 investment to $8.3 million, a level sufficient for Met-Ed to recover its remaining investment in TMI-2 in 1994. Penelec has collected all of its TMI- 2 investment attributable to its retail customers. At December 31, 1993, $97 million is included in Unamortized Property Losses on the balance sheet for JCP&L's Forked River project. JCP&L is collecting annual revenues for the amortization of this project of $11.2 million, which will be sufficient to recover its remaining investment by the year 2006. Because the Subsidiaries have not been provided revenues for a return on the unamortized balances of the damaged TMI-2 facility and the cancelled Forked River project, these investments are being carried at their discounted present values. The related annual accretion, which represents the carrying charges that are accrued as the asset is written up from its discounted value, is recorded in Other Income, Net. Nuclear Fuel: Nuclear fuel is amortized on a unit of production basis. Rates are determined and periodically revised to amortize the cost over the useful life. The Subsidiaries have provided for future contributions to the Decontamination and Decommissioning Fund (part of the Energy Act) for the cleanup of enrichment plants operated by the federal government. The total liability at December 31, 1993 amounted to $47 million and is primarily reflected in Deferred Credits and Other Liabilities - Other. Utilities with nuclear plants will contribute a total of $150 million annually, based on an assessment computed on prior enrichment purchases, over a 15 year period up to a total of $2.3 billion (in 1993 dollars). The Subsidiaries made their initial payment to this fund in 1993. The Subsidiaries have recorded an asset for remaining amounts recoverable from ratepayers of $48 million at December 31, 1993 in Deferred Debits and Other Assets - Other. NUCLEAR OUTAGE MAINTENANCE COSTS The GPU System accrues incremental nuclear outage maintenance costs anticipated to be incurred during scheduled nuclear plant refueling outages. NUCLEAR FUEL DISPOSAL FEE The Subsidiaries are providing for estimated future disposal costs for spent nuclear fuel at Oyster Creek and TMI-1 in accordance with the Nuclear Waste Policy Act of 1982. The Subsidiaries entered into contracts in 1983 General Public Utilities Corporation and Subsidiary Companies with the DOE for the disposal of spent nuclear fuel. The total liability under these contracts, including interest, at December 31, 1993, all of which relates to spent nuclear fuel from nuclear generation through April 1983, amounted to $147 million, and is reflected in Deferred Credits and Other Liabilities - Other. As the actual liability is substantially in excess of the amount recovered to date from ratepayers, the Subsidiaries have reflected such excess of $25 million at December 31, 1993 in Deferred Debits and Other Assets - Other. The rates presently charged to customers provide for the collection of these costs, plus interest, over remaining periods of 13 years for JCP&L, 14 years for Met-Ed and 4 years for Penelec. The Subsidiaries are collecting 1 mill per kilowatt-hour from their customers for spent nuclear fuel disposal costs resulting from nuclear generation subsequent to April 1983. These amounts are remitted quarterly to the DOE. INCOME TAXES The GPU System files a consolidated federal income tax return and all participants are jointly and severally liable for the full amount of any tax, including penalties and interest, which may be assessed against the group. Deferred income taxes, which result primarily from liberalized depreciation methods, deferred energy costs, decommissioning funds and discounted Forked River and TMI-2 investments, are provided for differences between book and taxable income. Investment tax credits (ITC) are amortized over the estimated service lives of the related facilities. Effective January 1, 1993, the GPU System implemented Statement of Financial Accounting Standards No. 109 (FAS 109), "Accounting for Income Taxes" which requires the use of the liability method of financial accounting and reporting for income taxes. Under FAS 109, deferred income taxes reflect the impact of temporary differences between the amount of assets and liabilities recognized for financial reporting purposes and the amounts recognized for tax purposes. STATEMENTS OF CASH FLOWS For the purpose of the consolidated statements of cash flows, temporary investments include all unrestricted liquid assets, such as cash deposits and debt securities, with maturities generally of three months or less. 3. SHORT-TERM BORROWING ARRANGEMENTS At December 31, 1993, the GPU System had $216 million of short-term notes outstanding, of which $37 million was commercial paper and the remainder was issued under bank lines of credit (credit facilities). General Public Utilities Corporation and Subsidiary Companies The Corporation and the Subsidiaries have $398 million of credit facilities, which includes a Revolving Credit Agreement (Credit Agreement) with a consortium of banks that permits total borrowing of $150 million outstanding at any one time. The credit facilities generally provide for the payment of a commitment fee on the unborrowed amount of 1/8 of 1% annually. Borrowings under these credit facilities generally bear interest based on the prime rate or money market rates. Notes issued under the Credit Agreement which expires April 1, 1995, are subject to various covenants and acceleration under certain conditions. 4. LONG-TERM DEBT At December 31, 1993, the Corporation's subsidiaries had long-term debt outstanding, as follows: Interest Rates 4 5/8% to 7% to 9% to Maturities 6.97% 8 7/8% 10 1/2% Total (In Thousands) First mortgage bonds: 1994-2003 $555,005 $ 410,191 $188,500 $1,153,696 2004-2013 145,120 338,300 - 483,420 2014-2023 55,000 517,200 50,000 622,200 2025 150,000 - - 150,000 Total $905,125 $1,265,691 $238,500 2,409,316 Amounts due within one year (130,000) Total 2,279,316 Other long-term debt (net of $3,232 due within one year) 46,204 Unamortized net discount (5,136) Total $2,320,384 The above amounts do not include $125 million of 10 1/8 % first mortgage bonds as a result of depositing with the trustee, in 1993, an amount needed for their early redemption in April 1994. For the years 1994, 1995, 1996, 1997 and 1998, the Subsidiaries have long-term debt maturities of $133 million, $91 million, $119 million, $145 million and $103 million, respectively. Substantially all of the utility plant owned by the Subsidiaries is subject to the lien of their respective mortgages. The estimated fair value of the Corporation's long-term debt, as of December 31, 1993 and 1992 is as follows: (In Thousands) Carrying Fair Amount Value 1993 $2,320,384 $2,446,407 1992 2,221,617 2,304,701 General Public Utilities Corporation and Subsidiary Companies The fair value of the Corporation's long-term debt is estimated based on the quoted market prices for the same or similar issues or on the current rates offered to the Corporation for debt of the same remaining maturities. 5. CAPITAL STOCK COMMON STOCK The following table presents information relating to the common stock ($2.50 par value) of the Corporation: 1993 1992 Authorized shares 150,000,000 150,000,000 Issued shares 125,783,338 125,783,338 Reacquired shares 10,816,561 14,965,309 Outstanding shares 114,966,777 110,818,029 Restricted units 74,076 38,816 In 1993, the Corporation sold four million shares of common stock through an underwritten public offering. In 1993 and 1992, pursuant to the 1990 Restricted Stock Plan, the Corporation issued to officers restricted units representing rights to receive shares of common stock, on a one-for-one basis, at the end of the restriction period. The restricted units do not affect the issued and outstanding shares of common stock until conversion at the end of the restriction period. However, the restricted units are considered common stock equivalents and therefore are included in average common shares outstanding for the earnings per share computation on the income statement. The restricted units accrue dividends on a quarterly basis. In 1993 and 1992, the Corporation awarded to plan participants 32,740 and 39,735 restricted units, respectively. In 1993, 1992 and 1991, the Corporation issued a total of 3,200, 3,053 and 39,600 restricted shares, respectively, from previously reacquired shares. No shares of common stock were reacquired in 1993, 1992 or 1991. The Corporation has standby authorization from the Securities and Exchange Commission to repurchase up to five million shares of common stock through 1995. PREFERRED STOCK At December 31, 1993, the Subsidiaries had the following issues of cumulative preferred stock outstanding: General Public Utilities Corporation and Subsidiary Companies Stated Value Shares (In Thousands) Series per Share Outstanding Stated Value With mandatory redemption: 7.52% - 8.65% $100 1,500,000 $150,000 Without mandatory redemption: 3.70% - 4.70% $100 723,912 $ 72,391 7.68% - 8.36% $100 850,000 85,000 Total 1,573,912 157,391 Premium 851 Total $158,242 During 1993, the Subsidiaries redeemed preferred stock as follows: JCP&L redeemed all of its outstanding 8.12% Series and 8% Series cumulative preferred stock (aggregate stated value of $50 million) at a total cost of $52.4 million. Met-Ed redeemed all of its outstanding 8.32% Series H, 8.32% Series J, 8.12% Series I and its 8.12% cumulative preferred stock (aggregate stated value of $81 million) at a total cost of $85.3 million. Penelec redeemed all of its outstanding 8.12% Series I cumulative preferred stock (aggregate stated value of $25 million) at a total cost of $26.0 million. These redemptions resulted in a net $6.9 million charge to Retained Earnings. During 1992, JCP&L issued 500,000 shares of 7.52% series cumulative preferred stock with mandatory redemption provisions. The series is callable beginning in the year 2002 at various prices above its stated value. The series is to be redeemed ratably over twenty years beginning in the year 1998. This issue provides that JCP&L may, at its option, redeem an amount of shares equal to its mandatory sinking fund requirement at such time as the mandatory sinking fund redemption is made. Expenses of $0.5 million incurred in connection with the issuance of the cumulative preferred stock were charged to Capital Surplus on the balance sheet. During 1992, JCP&L redeemed all its outstanding 8.75% Series H cumulative preferred stock (aggregate stated value of $50 million), at a total cost of $51.6 million. This resulted in a $1.6 million charge to Retained Earnings. Additional preferred stock expenses of $0.7 million were charged to Retained Earnings. During 1991, Penelec redeemed all its outstanding 9% Series L cumulative preferred stock (aggregate stated value of $35 million), at a total cost of $36.4 million. This resulted in a $1.4 million charge to Retained Earnings. The issued and outstanding shares of preferred stock without mandatory redemption are callable at various prices above their stated values. At December 31, 1993, the aggregate amount at which these shares could be called by the Subsidiaries was $164 million. The issued and outstanding shares with mandatory redemption have aggregate redemption requirements of $32.5 million for the years 1994 through 1998. General Public Utilities Corporation and Subsidiary Companies At December 31, 1993 and 1992, the Subsidiaries were authorized to issue 37,035,000 shares of cumulative preferred stock. If dividends on any of the preferred stock of any of the Subsidiaries are in arrears for four quarters, the holders of preferred stock, voting as a class, are entitled to elect a majority of the board of directors of that subsidiary until all dividends in arrears have been paid. A Subsidiary may not redeem preferred stock unless dividends on all of that Subsidiary's preferred stock for all past quarterly dividend periods have been paid or declared and set aside for payment. 6. INCOME TAXES Effective January 1, 1993, the GPU System implemented FAS 109 "Accounting for Income Taxes". In 1993, the cumulative effect on net income of this accounting change was immaterial. Also in 1993, the federal income tax rate changed from 34% to 35%, retroactive to January 1, 1993, resulting in an increase in the deferred tax assets of $9 million and an increase in the deferred tax liabilities of $48 million. The tax rate change did not have a material effect on net income as the changes in deferred taxes were substantially offset by the recording of regulatory assets and liabilities. The balance sheet effect as of December 31, 1993 of implementing FAS 109 resulted in a regulatory asset for income taxes recoverable through future rates of $555 million (related to liberalized depreciation), and a regulatory liability for income taxes refundable through future rates of $111 million (related to unamortized ITC), substantially due to the recognition of amounts not previously recorded. A summary of the components of deferred taxes as of December 31, 1993 follows: (In Millions) Deferred Tax Assets Deferred Tax Liabilities Current: Non-current: Revenue taxes $ 12 Liberalized Unbilled revenue 14 depreciation: Deferred energy 6 previously flowed Other 2 through $ 327 Total $ 34 future revenue requirements 228 $ 555 Non-current: Unamortized ITC $111 Liberalized Decommissioning 48 depreciation 726 Contribution in aid Forked River 30 of construction 22 Other 78 Other 94 Total $1,389 Total $275 General Public Utilities Corporation and Subsidiary Companies The reconciliations from net income to book income subject to tax and from the federal statutory rate to combined federal and state effective tax rates are as follows: (In Millions) 1993 1992 1991 Net income $296 $252 $276 Preferred stock dividends 29 37 36 Income tax expense 197 174 165 Book income subject to tax $522 $463 $477 Federal statutory rate 35% 34% 34% Effect of difference between tax and book depreciation for which deferred taxes were not provided 2 2 3 Amortization of ITC (2) (3) (3) State tax, net of federal benefit 4 5 3 Other (1) - (2) Effective income tax rate 38% 38% 35% Federal and state income tax expense is comprised of the following: (In Millions) 1993 1992 1991 Provisions for taxes currently payable $127 $165 $161 Deferred income taxes: Liberalized depreciation 32 34 36 New Jersey revenue tax 32 3 (7) Deferral of energy costs 6 (16) 5 Accretion income 7 9 11 TMI-2 pre-monitored storage costs 3 8 (14) Other 2 (16) (11) Deferred income taxes, net 82 22 20 Amortization of ITC, net (12) (13) (16) Income tax expense $197 $174 $165 The Internal Revenue Service has completed its examinations of the GPU System's federal income tax returns through 1986. The GPU System and the Internal Revenue Service have reached an agreement to settle the Corporation's claim that TMI-2 has been retired for tax purposes. When approved by the Joint Congressional Committee on Taxation, this settlement will provide refunds for previously paid taxes. The Corporation estimates General Public Utilities Corporation and Subsidiary Companies that the Subsidiaries would receive net refunds totaling $17 million, which would be credited to their customers. The GPU System would also be entitled to receive net interest estimated to total $45 million (before income taxes) through December 31, 1993, which would be credited to income. The years 1987, 1988 and 1989 are currently under audit. 7. SUPPLEMENTARY INCOME STATEMENT INFORMATION Maintenance expense and other taxes charged to operating expenses consisted of the following: (In Millions) 1993 1992 1991 Maintenance $275 $251 $239 Other taxes: New Jersey unit tax $202 $197 $201 Pennsylvania state gross receipts 68 67 66 Real estate and personal property 21 22 22 Other 53 42 44 Total $344 $328 $333 8. EMPLOYMENT BENEFITS Pension Plans: The GPU System maintains defined benefit pension plans covering substantially all employees. The GPU System's policy is to currently fund net pension costs within the deduction limits permitted by the Internal Revenue Code. A summary of the components of net periodic pension cost follows: (In Millions) 1993 1992 1991 Service cost-benefits earned during the period $ 28.6 $ 26.3 $ 28.2 Interest cost on projected benefit obligation 91.8 87.8 80.0 Less: Expected return on plan assets (96.6) (89.5) (84.3) Amortization (2.2) (2.5) (2.6) Net periodic pension cost $ 21.6 $ 22.1 $ 21.3 The actual return on the plans' assets for the years 1993, 1992 and 1991 were gains of $145.9 million, $53.2 million and $191.3 million, respectively. General Public Utilities Corporation and Subsidiary Companies The funded status of the plans and related assumptions at December 31, 1993 and 1992 were as follows: (In Millions) 1993 1992 Accumulated benefit obligation (ABO): Vested benefits $ 982.3 $ 820.6 Nonvested benefits 122.9 93.6 Total ABO 1,105.2 914.2 Effect of future compensation levels 197.2 194.3 Projected benefit obligation (PBO) $ 1,302.4 $ 1,108.5 PBO $(1,302.4) $(1,108.5) Plan assets at fair value 1,288.6 1,167.1 PBO (in excess of) less than plan assets (13.8) 58.6 Less: Unrecognized net (gain) loss 19.8 (56.7) Unrecognized prior service cost (5.9) (12.7) Unrecognized net transition asset (8.6) (9.5) Adjustment required to recognize minimum liability (2.3) - Accrued pension liability $ (10.8) $ (20.3) Principal actuarial assumptions(%): Annual long-term rate of return on plan assets 8.5 8.5 Discount rate 7.5 8.5 Annual increase in compensation levels 5.0 6.0 Changes in assumptions in 1993 primarily due to reducing the discount rate assumption from 8.5% to 7.5%, resulted in a $122 million change in the PBO as of December 31, 1993. The assets of the plans are held in a Master Trust and generally invested in common stocks, fixed income securities and real estate equity investments. The unrecognized net gain represents actual experience different from that assumed, which is deferred and not included in the determination of pension cost until it exceeds certain levels. Both the unrecognized prior service cost resulting from retroactive changes in benefits and the unrecognized net transition asset arising out of the adoption of Statement of Financial Accounting Standards No. 87 are being amortized as a credit to pension cost over the average remaining service periods for covered employees. At December 31, 1993, GPUSC had an accumulated pension obligation in excess of amounts accrued, as a result, an additional minimum liability of $2.3 million was accrued with a corresponding charge to Retained Earnings. Savings Plans: The GPU System also maintains savings plans for substantially all employees. These plans provide for employee contributions up to specified limits. The GPU System's savings plans provide for various levels of matching contributions. The matching contributions for the GPU System for 1993, 1992 and 1991 were $12.2 million, $11.2 million and $9.7 million, respectively. General Public Utilities Corporation and Subsidiary Companies Postretirement Benefits Other than Pensions: The GPU System provides certain retiree health care and life insurance benefits for substantially all employees who reach retirement age while working for the GPU System. Health care benefits are administered by various organizations. A portion of the costs are borne by the participants. For 1992 and 1991, the annual premium costs associated with providing these benefits totaled approximately $16.6 million and $16.3 million, respectively. Effective January 1, 1993, the GPU System adopted Statement of Financial Accounting Standards No. 106 (FAS 106), "Employers' Accounting for Postretirement Benefits Other Than Pensions." FAS 106 requires that the estimated cost of these benefits, which are primarily for health care, be accrued during the employee's active working career. The GPU System has elected to amortize the unfunded transition obligation existing at January 1, 1993, over a period of 20 years. A summary of the components of the net periodic postretirement benefit cost for 1993 follows: (In Millions) Service cost-benefits attributed to service during the period $ 12.5 Interest cost on the accumulated postretirement benefit obligation 34.3 Expected return on plan assets (3.4) Amortization of transition obligation 18.1 Net periodic postretirement benefit cost 61.5 Less, deferred for future recovery (27.5) Postretirement benefit cost, net of deferrals $ 34.0 The actual return on the plans' assets for the year 1993 was a gain of $3.9 million. The funded status of the plans at December 31, 1993, was as follows: Accumulated Postretirement Benefit Obligation: Retirees $ 207.1 Fully eligible active plan participants 72.4 Other active plan participants 223.1 Total accumulated postretirement benefit obligation (APBO) $ 502.6 APBO $(502.6) Plan assets at fair value 47.1 APBO (in excess of) plan assets (455.5) Less: Unrecognized net loss 65.2 Unrecognized prior service cost 2.9 Unrecognized transition obligation 343.6 Accrued postretirement benefit liability $ (43.8) General Public Utilities Corporation and Subsidiary Companies Principal actuarial assumptions (%): Annual long-term rate of return on plan assets 8.5 Discount rate 7.5 The GPU System intends to continue funding amounts for postretirement benefits collected from customers and other amounts with an independent trustee, as deemed appropriate from time to time. The plan assets include equities and fixed income securities. In JCP&L's most recent base rate proceeding, the NJBRC allowed JCP&L to collect $3 million annually of the incremental postretirement benefit costs, charged to expense, recognized as a result of FAS 106. Based on the final order and in accordance with Emerging Issues Task Force (EITF) Issue Number 92-12, "Accounting for OPEB Costs by Rate-Regulated Enterprises", JCP&L is deferring the amounts above that level. Both Met-Ed and Penelec have begun to defer the incremental postretirement benefit costs, charged to expense, associated with the adoption of FAS 106 and in accordance with EITF Number 92-12 as authorized by the PaPUC in 1993. A portion of the increase in annual costs recognized under FAS 106 of approximately $27.5 million is being deferred and should be recoverable through the ratemaking process. The Consumer Advocate in Pennsylvania is contesting utility deferral of FAS 106 costs in a proceeding involving another utility. The outcome of this proceeding may affect the recovery of deferred FAS 106 costs for Met-Ed and Penelec. The accumulated postretirement benefits obligation was determined by application of the terms of the medical and life insurance plans, including the effects of established maximums on covered costs, together with relevant actuarial assumptions and health-care cost trend rates of 14% for those not eligible for Medicare and 11% for those eligible for Medicare for 1994, decreasing gradually to 7% in 2000 and thereafter. These costs also reflect the implementation of a cost cap of 6% for individuals who retire after December 1, 1995. The effect of a 1% annual increase in these assumed cost trend rates would increase the accumulated postretirement benefit obligation by approximately $49 million and the aggregate of the service and interest cost components of net postretirement health-care cost for 1994 by approximately $5 million. Postemployment Benefits: In November 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" (FAS 112) which addresses accounting by employers who provide benefits to former or inactive employees after employment but before retirement, which is effective for fiscal years beginning after December 15, 1993. The GPU System adopted the accrual method required under FAS 112 during 1993, which did not have a material impact on the financial position or results of operations of GPU. General Public Utilities Corporation and Subsidiary Companies 9. JOINTLY OWNED STATIONS Each participant in a jointly owned station finances its portion of the investment and charges its share of operating expenses to the appropriate expense accounts. The Subsidiaries participated with nonaffiliated utilities in the following jointly owned stations at December 31, 1993: Balance (In Millions) % Accumulated Station Owner Ownership Investment Depreciation Homer City Penelec 50 $428.9 $151.3 Conemaugh Met-Ed 16.45 119.4 28.5 Keystone JCP&L 16.67 77.9 20.8 Yards Creek JCP&L 50 24.3 6.3 Seneca Penelec 20 16.5 4.4 10. LEASES The GPU System's capital leases consist primarily of leases for nuclear fuel. Nuclear fuel capital leases at December 31, 1993 and 1992 totaled $150 million and $156 million, respectively (net of amortization of $199 million and $153 million, respectively). The recording of capital leases has no effect on net income because all leases, for ratemaking purposes, are considered operating leases. The Subsidiaries have nuclear fuel lease agreements with nonaffiliated fuel trusts. An aggregate of up to $250 million ($125 million each for Oyster Creek and TMI-1) of nuclear fuel costs may be outstanding at any one time. It is contemplated that when consumed, portions of the presently leased material will be replaced by additional leased material. The Subsidiaries are responsible for the disposal costs of nuclear fuel leased under these agreements. These nuclear fuel leases are renewable annually. Lease expense consists of an amount designed to amortize the cost of the nuclear fuel as consumed plus interest costs. For the years ended December 31, 1993, 1992 and 1991 these amounts were $66 million, $74 million and $66 million, respectively. The leases may be terminated at any time with at least five months notice by either party prior to the end of the current period. Subject to certain conditions of termination, the Subsidiaries are required to purchase all nuclear fuel then under lease at a price that will allow the lessor to recover its net investment. JCP&L and Met-Ed have sold and leased back substantially all of their respective ownership interests in the Merrill Creek Reservoir Project. The minimum lease payments under these operating leases, which have remaining terms of 39 years, average approximately $3 million annually for each company. GENERAL PUBLIC UTILITIES CORPORATION and Subsidiary Companies SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT (continued) (In Thousands) See Note 2 to consolidated financial statements contained on page for information concerning the cost of property, plant and equipment and the depreciation and amortization methods used during the three years ended December 31, 1993. Also see Note 10 to consolidated financial statements contained on page for information concerning the capital lease agreements. (a) Reflects a reclassification of $55,500 of nuclear fuel costs associated with decontamination of the government's enrichment plants to Deferred Debits and Other Assets - Other to conform with current presentation. (b) Includes an increase in property under capital leases of $2,334, which is comprised primarily of additions and amortization of $62,988 and $59,874, respectively. (c) Includes a reduction in property under capital leases of $20,172, which is comprised primarily of additions and amortization of $48,087 and $67,820, respectively. (d) Includes a reduction in property under capital leases of $7,820, which is comprised primarily of additions and amortization of $57,609 and $62,781, respectively; and a decrease of $15,433 and $6,115 due to the write-offs of prior years' expenditures related to the Duquesne Project and certain nuclear equipment, respectively.
43960_1993.txt	43960	1993	ITEM 1. BUSINESS. INTRODUCTION The following discussion relates to Greyhound Financial Corporation ("GFC" or the "Company"), a wholly owned subsidiary of GFC Financial Corporation ("GFC Financial"). On March 3, 1992, The Dial Corp's ("Dial") shareholders approved the spin-off to its shareholders of GFC Financial, a newly-formed Delaware corporation, which comprised Dial's former commercial lending and mortgage insurance subsidiaries. In connection with the spin-off, the holders of common stock of Dial received a distribution of one share of common stock of GFC Financial for every two shares of Dial common stock (the "Distribution"). Prior to the Distribution, Dial contributed its 100% ownership interest in companies constituting the Greyhound European Financial Group ("GEFG") and Greyhound BID Holding Corp. to GFC and contributed all of the common stock of GFC to GFC Financial. Certain contractual arrangements continue between Dial and GFC Financial or its subsidiaries for a limited period of time following the Distribution. GFC Financial and Dial entered into certain agreements providing for (i) the orderly separation of GFC Financial from Dial and the making of the Distribution; (ii) the provision by Dial of certain interim services to GFC Financial; (iii) the assignment of the "Greyhound" and "Image of the Running Dog" trademarks for use in all of GFC Financial's business activities; (iv) a sublease of certain office space currently used by GFC Financial; and (v) the administration of tax returns and allocation of certain tax liabilities and benefits. GENERAL GFC was incorporated in 1965 in Delaware and is the successor to a California corporation that commenced operations in 1954. GFC has conducted business continuously since that time. Foreign financial services are provided primarily in the United Kingdom, where GEFG has provided such services since 1964. Domestic and foreign financial operations, prior to the Distribution, had been conducted independently of each other for many years. Following the Distribution, they have been conducted as a consolidated enterprise; however, during the second quarter of 1992, GFC announced its intention to phase out the London based financing operations of GEFG. This phase out is expected to be substantially completed within a two to three year period. FINANCIAL SERVICES The Company engages in the business of providing collateralized financing of selected commercial and real estate activities in the United States and intermediate-term lending on a secured basis in foreign countries. The Company accomplishes this through secured loans and leases. The Company generates interest and other income through charges assessed on outstanding loans, loan servicing, leasing and other fees. The Company's primary expenses are the costs of funding its loan business (including interest paid on debt), provisions for possible credit losses, marketing expenses, salaries and employee benefits, servicing and other operating expenses and income taxes. The Company's current emphasis is on secured lending to businesses in specific industry niches, where the group's expertise in evaluating the needs and creditworthiness of prospective customers enables it to provide specialized financing services. The Company's strategy has been to seek to maintain a high-quality portfolio using clearly defined underwriting standards in an effort to minimize the level of nonearning assets and write- offs. Lines of Business The Company's activities now include the following lines of business: - Corporate Finance. The Corporate Finance group provides financing, generally in the range of $2 million to $25 million, focusing on middle market businesses nationally, including distribution, wholesale, retail, manufacturing and services industries. The group's lending is primarily in the form of term loans secured by the assets of the borrower, with significant emphasis on cash flow as the source of repayment of the secured loan. - Transportation Finance. Through the Transportation Finance group, the Company structures secured financings for specialized areas of the transportation industry, principally involving domestic and foreign used aircraft, as well as domestic short-line railroads and used rail equipment. Typical transactions involve financing up to 80% of the fair market value of used equipment in the $3 million to $30 million range. Traditionally focused on the domestic marketplace, Transportation Finance established a London, England office in 1992, broadening its product line to include international aircraft loans. - Communications Finance. The Communications Finance group specializes in radio and television. Other markets include cable television, print and outdoor media services in the United States. The Company extends secured loans to communications businesses requiring funds for recapitalization, refinancing or acquisition. Loan sizes generally are from $3 million to $35 million. - Commercial Real Estate Finance. The Commercial Real Estate group provides cash-flow-based financing primarily for acquisitions and refinancings to experienced real estate developers and owner tenants of income-producing properties in the United States and the United Kingdom. The Company concentrates on secured financing opportunities, generally between $3 million and $30 million, involving senior mortgage term loans on owner-occupied commercial real estate. The Company's portfolio of real estate leveraged leases is also managed as part of the commercial real estate portfolio. - Resort Finance. The Resort Finance group focuses on successful, experienced resort developers, primarily of timeshare resorts, second home resort communities, golf resorts and resort hotels. Extending funds through a variety of lending options, the Resort Finance group provides loans and lines of credit ranging from $3 million to $30 million for construction, acquisitions, receivables financing and purchases and other uses. Through its subsidiary, GFC Portfolio Services, Inc. ("GPSI"), the Resort Finance group offers expanded convenience and service to its customers. Professional receivables collections and cash management gives developers the ability of having loan-related administrative functions performed for them by GFC. - Asset Based Finance. Acquired in early 1993, the Asset Based Finance group ("ABF") offers a full range of nationwide collateral-oriented lending programs to middle-market businesses including manufacturers, wholesalers and distributors. GFC's ABF group mainly provides revolving lines of credit ranging between $2 million and $25 million, often partnering with the Corporate Finance group to offer convenient "one-stop" financing to businesses. - Consumer Rediscount Group. The Consumer Rediscount Group ("CRG") offers $2 million to $25 million revolving credit lines to regional consumer finance companies, which in turn extend credit to consumers. GFC's customers provide credit to consumers to finance home improvements, automobile purchases, insurance premiums and for a variety of other financial needs. - Ambassador Factors. On February 14, 1994, GFC purchased Fleet Factors Corp, better known as Ambassador Factors Corporation ("Ambassador") from Fleet Financial Group, Inc. Ambassador provides accounts receivable factoring and asset- based lending principally to small and medium-sized textile and apparel manufacturers and importers. See Note N of Notes to Consolidated Financial Statements included in Annex A. - TriCon Capital Corporation. On March 4, 1994, GFC Financial announced the signing of a definitive purchase agreement under which GFC will acquire all the stock of TriCon Capital Corporation ("TriCon"), an indirect wholly-owned subsidiary of Bell Atlantic Corporation ("Bell Atlantic"), in an all cash transaction. This transaction is subject to regulatory approvals and certain other conditions. TriCon is a $1.8 billion niche-oriented provider of commercial and equipment leasing services. TriCon's marketing orientation fits well with GFC's emphasis on value-added products and services in focused niches of the commercial finance business and further diversifies GFC's asset base. See Pending Acquisition of TriCon Capital Corporation under Optional Items in Part I and Note N of Notes to Consolidated Financial Statements included in Annex A. In conjunction with the liquidation of the GEFG portfolio, GEFG surrendered the banking license of its United Kingdom bank, Greyhound Bank PLC, and renamed the company Greyhound Guaranty Limited ("GGL"). GGL operates a finance group that was primarily involved in lending to individuals in the United Kingdom secured by second mortgages on residential real estate. The group ceased writing new consumer finance business in the first quarter of 1991 but continues to administer and collect loans previously made. The Company's operations are conducted primarily in the United States and Europe. For a description of its assets owned, interest earned from financing transactions, interest margins earned and income before income taxes for domestic and European operations, see Note L of Notes to Consolidated Financial Statements included in Annex A. Investment in Financing Transactions At December 31, 1993, 1992, 1991, 1990 and 1989, the Company's investment in financing transactions (before reserve for possible credit losses) was $2,846,571,000, $2,485,844,000, $2,281,872,000, $2,198,441,000 and $1,950,372,000, respectively, and consisted of the following: An analysis of nonaccruing contracts and repossessed assets at December 31 of each year shown is as follows: 1993 1992 1991 1990 1989 ------------------------------------------------ (dollars in thousands) Nonaccruing contracts: Domestic $ 13,263 $ 24,031 $ 39,276 $ 41,201 $ 38,040 Foreign 12,320 22,400 43,875 39,777 19,231 -------- -------- -------- -------- -------- 25,583 46,431 83,151 80,978 57,271 -------- -------- -------- -------- -------- Latin America: Brazil 22,775 22,998 Ecuador 40,487 42,195 Other 3,380 7,187 -------- -------- -------- -------- -------- 66,642 72,380 -------- -------- -------- -------- -------- Total nonaccruing contracts 25,583 46,431 83,151 147,620 129,651 -------- -------- -------- -------- -------- Repossessed assets: Domestic 77,001 53,931 27,319 13,288 12,288 Foreign 23 60 826 2,611 Latin America 99 -------- -------- -------- -------- -------- Total repossessed assets 77,024 53,991 28,145 15,899 12,387 -------- -------- -------- -------- -------- Total nonaccruing contracts and repossessed assets $102,607 $100,422 $111,296 $163,519 $142,038 ======== ======== ======== ======== ======== Nonaccruing contracts and repossessed assets as a percentage of investment in financing transactions 3.6% 4.0% 4.9% 7.4% 7.3% ======== ======== ======== ======== ======== In addition to the repossessed assets in the above table, GFC had repossessed assets, with a total carrying amount of $49.0 million and $21.5 million at December 31, 1993 and 1992, respectively, which earned income of $2.7 million and $1.9 million during 1993 and 1992, respectively. The following is an analysis of the reserve for possible credit losses for the years ended December 31: 1993 1992 1991 1990 1989 ----------------------------------------------- (dollars in thousands) Balance, beginning of year: Domestic $65,100 $72,387 $67,363 $62,158 $44,938 Foreign 4,191 15,213 9,735 10,478 32,668 ------- ------- ------- ------- ------- 69,291 87,600 77,098 72,636 77,606 ------- ------- ------- ------- ------- Provision for possible credit losses (Note 1): Domestic 5,206 144 57,210 10,094 25,252 Foreign 500 6,596 20,477 435 (17,301) ------- ------- ------- ------- ------- 5,706 6,740 77,687 10,529 7,951 ------- ------- ------- ------- ------- Write-offs (Note 1): Domestic (7,548) (7,823) (52,753) (6,114) (8,764) Foreign (5,027) (15,838) (15,593) (1,748) (20,675) ------- ------- ------- ------- ------- (12,575) (23,661) (68,346) (7,862) (29,439) ------- ------- ------- ------- ------- Recoveries: Domestic 221 392 567 1,225 732 Foreign (Note 2) 496 357 96 22 16,014 ------- ------- ------- ------- ------- 717 749 663 1,247 16,746 ------- ------- ------- ------- ------- Other: Domestic 1,286 Foreign (145) (2,137) 498 548 (228) ------- ------- ------- ------- ------- 1,141 (2,137) 498 548 (228) ------- ------- ------- ------- ------- Balance, end of year: Domestic 64,265 65,100 72,387 67,363 62,158 Foreign 15 4,191 15,213 9,735 10,478 ------- ------- ------- ------- ------- $64,280 $69,291 $87,600 $77,098 $72,636 ======= ======= ======= ======= ======= NOTES: (1) In 1991, the Company recorded a special provision for possible credit losses of $65 million and recorded a $47.8 million write-down of Latin American assets (included in the domestic portfolio) and recorded write-offs of $15 million in the foreign operations (GEFG) portfolio. (2) In 1989, the foreign operations (GEFG) made recoveries of $16.0 million related to its shipping (maritime) portfolio. The Company does not allocate a dollar amount of its reserve for possible credit losses to specific categories of loans and financing contracts. It does, however, allocate reserves between domestic and foreign portfolios. Write-offs by major loan and collateral types, experienced by the Company during the years ended December 31, are as follows: A further breakdown of the portfolio by collateral type can be found in Note C of Notes to Consolidated Financial Statements in Annex A. Cost and Utilization of Borrowed Funds The Company relies on borrowed funds as well as internal cash flow to finance its operations. The Company follows a policy of relating provisions under its loans and leases to the terms on which it obtains funds so that, to the extent feasible, floating-rate assets are funded with floating-rate borrowings and fixed-rate assets are funded with fixed-rate borrowings. The following table reflects the approximate average pre-tax effective cost of borrowed funds and pre-tax equivalent rate earned on accruing assets for the Company for each of the periods listed: Year Ended December 31, --------------------------------- 1993 1992 1991 1990 1989 --------------------------------- Domestic: Short-term debt and variable rate long-term debt (1) 4.6% 5.0% 6.9% 8.8% 9.9% Fixed-rate long-term debt (1) 11.4% 10.6% 10.9% 11.4% 12.3% Aggregate borrowed funds (1) 6.4% 7.2% 8.8% 10.1% 11.2% Rate earned on accruing assets (2) (3) 10.1% 10.7% 12.2% 12.7% 13.6% Spread percentage (4) 4.8% 4.4% 4.6% 4.2% 3.9% Foreign: Short-term debt and variable rate long-term debt 5.6% 9.3% 12.3% 15.5% 13.0% Customer deposits 6.2% 10.2% 14.2% 15.4% 14.4% Rate earned on accruing assets (3) 15.1% 17.6% 16.7% 20.1% 16.0% Spread percentage (4) 10.4% 9.8% 6.2% 8.2% 6.6% _____________________ NOTES: (1) Includes the effect of interest rate conversion agreements. (2) Accruing assets are net of deferred taxes applicable to leveraged leases. (3) Earnings include gains on sale of assets. (4) Spread percentages represent interest margins earned as a percentage of earning assets, net of deferred taxes applicable to leveraged leases. _____________________________________ The effective costs presented above include costs of commitment fees and related borrowing costs and do not purport to predict the costs of funds in the future. For further information on the Company's cost of funds, refer to Note D of the Notes to Consolidated Financial Statements included in Annex A. Following are the ratios of income to combined fixed charges and preferred stock dividends ("ratio") for each of the past five years: Year Ended December 31, --------------------------------- 1993 1992 1991 1990 1989 --------------------------------- 1.47 1.35 ---- 1.24 1.23 ===== ===== ===== ===== ===== Variations in interest rates generally do not have a substantial impact on the ratio because fixed-rate and floating-rate assets are generally matched with liabilities of similar rate and term. Income available for fixed charges, for purposes of the computation of the ratio of income to combined fixed charges and preferred stock dividends, consists of the sum of income before income taxes (adjusted for the effect of reduced tax rates on income from leveraged leases) and fixed charges. Combined fixed charges include interest and related debt expense and a portion of rental expense determined to be representative of interest and preferred stock dividends grossed up to a pre-tax basis. For the year ended December 31, 1991, earnings were inadequate to cover combined fixed charges by $35.3 million. The decline in the ratio in 1991 was due to restructuring and other charges and transaction costs recorded in the fourth quarter of 1991. Those charges and costs were recorded in connection with the spin-off of the Company from Dial. Credit Ratings GFC currently has investment-grade credit ratings from the following rating agencies. Commercial Senior Subordinated Paper Debt Debt ------------------------------------- Duff & Phelps D1- A- BBB+ Fitch Investors Services, Inc. A A- Moody's Investors Service P2 Baa2 Ba1 Standard & Poor's Corp. A2 BBB BBB- There can be no assurance that GFC's ratings will be maintained. None of the Company's other subsidiaries have received credit ratings. Duff & Phelps Credit Rating Company ("Duff & Phelps") has placed GFC's senior and senior subordinated debt ratings on Rating Watch with negative implications. Duff & Phelps indicated that its action follows GFC Financial's announcement on March 4, 1994 indicating that it has signed a definitive purchase agreement to acquire TriCon from Bell Atlantic Corporation. Fitch Investors Services, Inc. ("Fitch") announced that it has placed GFC's senior debt, subordinated debt and commercial paper ratings on Fitch Alert with negative implications. This action also follows GFC Financial's announcement of the proposed acquisition of TriCon. Both Duff & Phelps and Fitch indicated that their actions resulted from their need to observe GFC management's ability to successfully integrate the new businesses and maintain appropriate controls in light of the significant increase in the size of GFC. Moody's Investors Services and Standard & Poor's Corp. affirmed GFC's current ratings. Interest and Other Core Income The Company has pursued a strategy of focusing on lending activities producing a predictable stream of revenues, as opposed to the less predictable gains on asset sales associated with leasing activities. For the year ended December 31, 1993, core income (i.e., net income before a $4.9 million adjustment to deferred income taxes made in 1993, restructuring and other charges recorded in 1991 and gains on sale of assets (after-tax) realized in each of the years) was $38.0 million, $34.6 million and $24.8 million for the years 1993, 1992 and 1991, respectively. Core income represented 92% of net income (before the adjustment to deferred income taxes) in 1993, up from 50% in 1987. Residual Realization Experience In each of the last 38 years, the Company has realized, in the aggregate, proceeds from the sale of assets upon lease terminations (other than foreclosures) in excess of carrying amounts; however, there can be no assurance that such results will be realized in future years. Sales proceeds upon lease terminations in excess of carrying amounts are reported as income when the assets are sold. Income from leasing activities is significantly affected by gains from asset sales upon lease termination and, hence, can be less predictable than income from non-leasing activities. During the five years ended December 31, 1993, the proceeds to the Company from sales of assets upon early termination of leases and at the expiration of leases have exceeded the respective carrying amounts and estimated residual values as follows: Terminations at End of Lease Early Terminations Term (Note 3) (Notes 1, 2 and 4) ------------------------------ ------------------------------------ Proceeds Proceeds Carrying as a % Estimated as a % of Amount of Residual Estimated Sales of Carrying Sales Value of Residual Year Proceeds Assets Amount Proceeds Assets Value ------------------------------------ ------------------------------ (dollars in thousands) (dollars in thousands) 1993 $ --- $ --- --- $ 486 $ 248 196% 1992 20,493 17,527 117% 2,164 1,768 122% 1991 25,027 21,904 114% 10,114 6,553 154% 1990 10,854 7,127 152% 20,210 11,719 172% 1989 30,894 16,616 186% 14,559 11,305 129% NOTES: (1) Excludes foreclosures for credit reasons which are immaterial to the above amounts. (2) Excludes proceeds of $3,201,000 in 1993 on assets held for sale. (3) Excludes proceeds of $2,000,000 in 1993 received on guarantees. (4) Excludes proceeds of $460,000 in 1990 from the disposal of warrants. __________________________________ The estimated residual value of leased assets in the accounts of the Company at December 31, 1993 aggregated 39.0% of the original cost of such assets (21.9% excluding the original costs of the assets and residuals applicable to real estate leveraged leases, which typically have higher residuals than other leases). The financing contracts and leases outstanding at that date had initial terms ranging generally from one to 25 years. The average initial term weighted by carrying amount at inception and the weighted average remaining term of financing contracts at December 31, 1993 for financing contracts excluding leveraged leases were 7.3 and 3.7 years, respectively, and for leveraged leases were approximately 20 and 12 years, respectively. The comparable average initial term and remaining term at December 31, 1992 for financing contracts excluding leveraged leases were 7.7 and 3.7 years, respectively, and for leveraged leases were approximately 20 and 13 years, respectively. The Company utilizes either employed or outside appraisers to determine the collateral value of assets to be leased or financed and the estimated residual or collateral value thereof at the expiration of each lease. For a discussion of accounting for lease transactions, refer to Notes A and B of Notes to Consolidated Financial Statements included in Annex A. Business Development and Competition The Company develops business primarily through direct solicitation by its own sales force. Customers are also introduced by independent brokers and referred by other financial institutions. At December 31, 1993, the Company had 912 financing contracts with 604 customers (excluding 2,886 contracts with consumer finance customers), compared to 874 financing contracts with 570 customers (excluding 3,481 contracts with consumer finance customers) at December 31, 1992. The Company is engaged in an extremely competitive activity. It competes with banks, insurance companies, leasing companies, the credit units of equipment manufacturers and other finance companies. Some of these competitors have substantially greater financial resources and are able to borrow at costs below those of the Company. The Company's principal means of competition is through a combination of service and the interest rate charged for money. The interest rate is a function of borrowing costs, operating costs and other factors. While many of the Company's larger competitors are able to offer lower interest rates based upon their lower borrowing costs, the Company seeks to maintain the competitiveness of the interest rates it offers by emphasizing strict control of its operating costs. Credit Quality As a result of the use of clearly defined underwriting standards, portfolio management techniques, monitoring of covenant breaches and active collections and workout departments, the Company believes it maintains a high-quality customer base. Risk Management The Company generally conducts investigations of its prospective customers through a review of historical financial statements, published credit reports, credit references, discussions with management, analysis of location feasibility, personal visits and property inspections. In many cases, depending upon the results of its credit investigations and the nature and type of property involved, the Company obtains additional collateral or guarantees from others. As part of its underwriting process, the Company gives close attention to the management, industry, financial position and level of collateral of any proposed borrower. The purpose, term, amortization and amount of any proposed transaction must be clearly defined and within established corporate policy. In addition, underwriters attempt to avoid undue concentrations in any one credit, industry or regional location. - Management. The Company considers the reputation, experience and depth of management; quality of product or service; adaptability to changing markets and demand; and prior banking, finance and trade relationships. - Industry. The Company evaluates critical aspects of each industry to which it lends, including the seasonality and cyclicality of the industry; governmental regulation; the effects of taxes; the economic value of goods or services provided; and potential environmental liability. - Financial. The Company's review of a prospective borrower includes a comparison of certain financial ratios among periods and among other industry participants. Items considered include net worth; composition of assets and liabilities; debt coverage and servicing requirements; liquidity; sales growth and earning power; and cash flow needs and generation. - Collateral. The Company regards collateral as an important factor in a credit evaluation and has established maximum loan to value ratios, normally ranging from 60% - 95%, for each of its lines of business. However, collateral is only one of the many factors considered. The underwriting process includes, in addition to the analysis of the factors set forth above, the design and implementation of transaction structures and strategies to mitigate identified risks; a review of transaction pricing relative to product-specific return requirements and acknowledged risk elements; a multi-step, interdepartmental review and approval process, with varying levels of authority based on the size of the transaction; and periodic, interdepartmental reviews and revision of underwriting guidelines. The Company also monitors loan portfolio concentrations in the areas of aggregate exposure to a single borrower and related entities, within a given geographical area and with respect to an industry and/or product type within an industry. The Company has established concentration guidelines for each line of business it conducts for the various product types it may entertain within that line of business. Geographical concentrations are reviewed periodically and evaluated based on historical loan experience and prevailing market and economic conditions. The Company's financing contracts and leases generally require the customer to pay taxes, license fees and insurance premiums and to perform maintenance and repairs at the customer's expense. Contract payment rates are based on several factors, including the cost of borrowed funds, term of contract, creditworthiness of the prospective customer, type and nature of collateral and other security and, in leasing transactions, the timing of tax effects and estimated residual values. In leasing transactions, lessees generally are granted an option to purchase the equipment at the end of the lease term at its then fair market value or, in some cases, are granted an option to renew the lease at its then fair rental value. The extent to which lessees exercise their options to purchase leased equipment varies from year to year, depending on, among other factors, the status of the economy, the financial condition of the lessee, interest rates and technological developments. Portfolio Management In addition to the review at the time of original underwriting, the Company attempts to preserve and enhance the earnings quality of its portfolio through proactive management of its financing relationships with its clients and its underlying collateral. This process includes the periodic appraisal or verification of the collateral to determine loan exposure and residual values; sales of residual and warrant positions to generate supplemental income; and review and management of covenant compliance. The Portfolio Management department regularly reviews financial statements to assess customer cash flow performance and trends; periodically confirms operations of the customer; conducts periodic reappraisals of the underlying collateral; seeks to identify issues concerning the vulnerability of debt service capabilities of the customer; disseminates such information to relevant members of the Company's staff; resolves outstanding issues with the borrower; and prepares quarterly summaries of the aggregate portfolio quality for management review. To facilitate the monitoring of a client's account, each client is assigned to a customer service representative who is responsible for all follow-up with that client. Delinquencies and Workouts The Company monitors timely payment of all accounts. Generally, when an invoice is 10 days past due, the customer is contacted, and a determination is made as to the extent of the problem, if any. A commitment for immediate payment is pursued and the account is observed closely. If payment is not received after this contact, all guarantors of the account are contacted within the next 20 days. If an invoice becomes 31 days past due, it is reported as delinquent. A notice of default is sent prior to an invoice becoming 45 days past due and, between 60 and 90 days past the due date, if satisfactory negotiations are not underway, outside counsel is generally retained to help protect the Company's rights and to pursue its remedies. When accounts become more than 90 days past due (or in the case of consumer finance accounts, 180 days past due), income recognition is suspended, and the Company vigorously pursues its legal remedies. Foreclosed or repossessed assets are considered to be nonperforming, and are reported as such unless such assets generate sufficient cash to result in a reasonable rate of return. Such accounts are continually reviewed, and write-downs are taken as deemed necessary. While pursuing collateral and obligors, the Company generally continues to negotiate the restructuring or other settlement of the debt, as appropriate. Management believes that collateral values significantly reduce loss exposure and that the reserve for possible credit losses is adequate. For additional information regarding the reserve for possible credit losses, see Note C of Notes to Consolidated Financial Statements included in Annex A. Governmental Regulation The Company's domestic activities, including the financing of its operations, are subject to a variety of federal and state regulations such as those imposed by the Federal Trade Commission, the Securities and Exchange Commission, the Consumer Credit Protection Act, the Equal Credit Opportunity Act and the Interstate Land Sales Full Disclosure Act. Additionally, a majority of states have ceilings on interest rates chargeable to customers in financing transactions. The Company's international activities are also subject to a variety of laws and regulations promulgated by the governments and various agencies of the countries in which the business is conducted. EMPLOYEES At December 31, 1993, the Company and its subsidiaries had 261 employees, consisting of 230 and 31 employees in GFC and GEFG, respectively. None of such employees were covered by collective bargaining agreements. The Company believes its employee relations are satisfactory. ITEM 2.		ITEM 2. PROPERTIES The principal executive offices of the Company are located in premises leased from Dial in Phoenix, Arizona. The Company operates five additional offices in the United States and one office in Europe. All such properties are leased. Alternative office space could be obtained without difficulty in the event leases are not renewed. ITEM 3.	ITEM 3. LEGAL PROCEEDINGS. The Company and certain of its subsidiaries are parties either as plaintiffs or defendants to various actions, proceedings and pending claims, including legal actions, which involve claims for compensatory, punitive or other damages in material amounts. Litigation is subject to many uncertainties and it is possible that some of the legal actions, proceedings or claims referred to above could be decided against the Company. Although the ultimate amount for which the Company or its subsidiaries may be held liable with respect to matters where the Company is defendant is not ascertainable, the Company believes that any resulting liability should not materially affect the Company's financial position or results of operations. Through a Report on Form 8-K, dated January 5, 1993, the Company reported litigation titled Cabana Limited Partnership, a South Carolina Partnership v. Greyhound Real Estate Finance Company, et al., and related litigation (collectively, the "Litigation"). On January 31, 1994, the court in the above-named case granted summary judgment in favor of the Company and the other defendants on all counts. On motion of defendants, the court dismissed the plaintiffs' claims without prejudice. The parties subsequently entered into a global settlement agreement whereby all rights to appeal and to pursue the related litigation have been waived by Plaintiffs. The terms of the settlement agreement are confidential but involve the payment by the defendants to plaintiffs' counsel of a relatively nominal amount, to secure finality, which the Company believes will cover a portion of plaintiffs' counsels' litigation costs and expenses. The summary judgment in the Company's and related defendants' favor remains unchanged. ITEM 4.	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Omitted. OPTIONAL ITEMS. 1. PENDING ACQUISITION OF TRICON CAPITAL CORPORATION. The acquisition of TriCon, combined with the acquisition of Ambassador, would increase GFC's total assets on a pro forma basis to $5 billion with pro forma 1993 income from continuing operations on a combined basis of approximately $72 million before the $4.9 million adjustment to deferred taxes applicable to leveraged leases. This acquisition of TriCon is expected to give the Company significant critical mass and important economies of scale. Management believes it puts the Company among the largest independent commercial finance companies in the United States and allows it to compete over a greater range of services. TriCon's marketing orientation fits well with GFC's emphasis on value-added products and services in focused niches of the commercial finance business and further diversifies GFC's asset base. Following is a brief description of TriCon and the various business activities in which it engages. GENERAL TriCon is a niche oriented provider of commercial finance and equipment leasing services to a highly segmented group of borrowers and lessees throughout the United States. TriCon conducts its operations through seven specialized business groups which provide financial products and services to three specific market sectors of the finance and leasing industry. End-User Sector The customers in the end-user sector use the assets which TriCon finances or leases for the ongoing operation of their businesses. The equipment which TriCon leases to its customers is typically purchased from an equipment manufacturer, vendor or dealer selected by the customer. The three specialized business groups associated with this market sector and the services provided by TriCon to customers of each business group include: - Medical Finance Group. Equipment and real estate financing and asset management services targeting the top 2,400 health care providers in the United States. - Commercial Equipment Finance Group. Direct finance leasing of, and lending for, general business equipment to quality commercial business enterprises which lack ready access to public finance markets. - Government Finance Group. Primarily tax-exempt financing to state and local governments. Program Finance Sector TriCon's business groups in the Program Finance Sector provide financing programs to help manufacturers, distributors, vendors and franchisors facilitate the sale of their products or services. The three specialized business groups associated with this market sector and the services provided by TriCon to customers of each business group include: - Vendor Service Group. Point-of-sale financing programs and support services for regional and national manufacturers, distributors and vendors of equipment classified as "small ticket" in transaction size (generally transactions with an equipment cost of less than $250,000). The equipment which TriCon leases to the ultimate end-user is typically sold to TriCon by the vendor participating in the financing program. - Franchise Finance Group. Equipment and total facility financing programs for the franchise-based food service industry. The equipment which TriCon leases to the ultimate end-user is typically purchased by TriCon from the equipment manufacturer, vendor or dealer selected by the end-user. - Commercial Credit Services Group. Accounts receivable and inventory lending for manufacturers and major distributors, manufacturer-sponsored inventory financing for office equipment dealers, and telecommunications receivables financing for the regional providers of long distance operator services. Capital Services Sector The Capital Services Sector has one business group which focuses on the management and origination of highly structured financing of "large ticket" commercial equipment (generally transactions involving the sale or lease of equipment with a cost in excess of $15 million) primarily leveraged leases for major corporations. The equipment which TriCon leases to its customers is typically purchased from an equipment manufacturer, vendor or dealer selected by the customer. The commercial finance and equipment leasing industry is highly competitive. While price is an important consideration, many customers value a high level of service which is the primary basis on which TriCon competes. Although TriCon has only a small share of the total commercial leasing market, the "Asset Finance and Leasing Digest" ranked TriCon Leasing Corporation as one of the top 50 leasing companies in the world for 1992 based on volume and total assets. Portfolio Composition The total assets under the management of TriCon consist of the TriCon portfolio of owned lease and loan assets (the "Portfolio Assets") plus certain assets that are owned by others but managed by TriCon and are not reflected on TriCon's balance sheet. At December 31, 1993, the Portfolio Assets were approximately $1.8 billion. At that date, the assets of others managed by TriCon were approximately $1.3 billion, consisting of approximately $344 million of securitized assets (the "Securitizations") and approximately $976 million of net lease receivables relating to the leveraged lease and project finance portfolio of Bell Atlantic. TriCon's primary financing products are finance leases, operating leases, collateralized loans and inventory and receivable financing. The Portfolio Assets are diversified across types of financed equipment with the largest equipment concentrations being data processing equipment, health care equipment, communications equipment, furniture and fixtures, office machines and diversified commercial use equipment. The Portfolio Assets also include real estate-related assets, consisting primarily of real estate held as collateral in conjunction with its health care and franchise-based food service equipment financings and, to a lesser extent, a portfolio of general commercial real estate mortgages currently being managed for liquidation. TriCon's investment exposure to both the aircraft-related and energy-related sectors is less than 1% of the Portfolio Assets. TriCon's current customer base includes approximately 70,000 customer accounts; its largest exposure to any single customer is approximately $33 million or approximately 2% of the Portfolio Assets and Securitizations. Approximately 80% of the Portfolio Assets and Securitizations are located in 20 states with the five largest concentrations being California (15.8%), Texas (10.5%), New Jersey (5.7%), Florida (5.5%) and Pennsylvania (5.3%). 2. TRICON CAPITAL CORPORATION AUDITED FINANCIAL STATEMENTS. The following financial statements contain references to a proposed public offering of stock of TriCon and certain restructuring of the business. The acquisition by GFC supersedes that public offering and the purchase agreement makes certain changes to the proposed restructuring. Page TRICON CAPITAL CORPORATION - PREDECESSOR BUSINESS Report of Independent Accountants 22 Consolidated Balance Sheets as of December 31, 1993 and 1992 23 Consolidated Statements of Income for the Years Ended December 31, 1993, 1992 and 1991 24 Consolidated Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 25 Notes to Consolidated Financial Statements 26 Exhibit 12 - Computation of Ratio of Earnings to Fixed Charges 39 REPORT OF INDEPENDENT ACCOUNTANTS To the Stockholder and Board of Directors of Bell Atlantic TriCon Leasing Corporation: We have audited the consolidated balance sheets of TriCon Capital Corporation--Predecessor Business (see Note 1 to the Consolidated Financial Statements) at December 31, 1993 and 1992, and the related consolidated statements of income and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of TriCon Capital Corporation--Predecessor Business at December 31, 1993 and 1992, and the consolidated results of their operations and cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in Notes 2 and 9 to the Consolidated Financial Statements, in 1993 the Company adopted the method of accounting for income taxes prescribed by Statement of Financial Accounting Standards No. 109 and the method of accounting for postemployment benefits prescribed by Statement of Financial Accounting Standards No. 112, and in 1991 adopted the method of accounting for postretirement benefits other than pensions prescribed by Statement of Financial Accounting Standards No. 106. COOPERS & LYBRAND New York, New York February 7, 1994 TRICON CAPITAL CORPORATION--PREDECESSOR BUSINESS CONSOLIDATED BALANCE SHEETS (DOLLARS IN THOUSANDS) DECEMBER 31, ------------------------- 1993 1992 ----------- ---------- ASSETS Cash . . . . . . . . . . . . . . . . . . . . . $ 4,483 $ 4,503 Notes receivable and finance leases: Investment in notes receivable . . . . . . . . 912,964 833,487 Investment in finance leases . . . . . . . . . 647,055 639,592 ----------- ---------- Total notes receivable and finance leases 1,560,019 1,473,079 Less: Allowance for credit losses . . . . . . . . . . 43,191 48,279 ----------- ---------- Net investment in notes receivable and finance leases . . . . . . . . . . . . . . 1,516,828 1,424,800 Investment in operating leases, net of accumulated depreciation . . . . . . . 240,057 230,721 Other assets . . . . . . . . . . . . . . . . . 27,091 32,222 ----------- ---------- Total Assets . . . . . . . . . . . . . . . $ 1,788,459 $1,692,246 =========== ========== LIABILITIES AND EQUITY Liabilities: Notes payable . . . . . . . . . . . . . . . . . $ 709,508 $ 919,642 Accounts payable and accrued expenses . . . . . 75,302 71,951 Due to affiliates . . . . . . . . . . . . . . . 611,194 349,842 Deferred income taxes . . . . . . . . . . . . . 81,100 93,908 ----------- ---------- Total Liabilities . . . . . . . . . . . . . . . 1,477,104 1,435,343 ----------- ---------- Total Equity . . . . . . . . . . . . . . . . . 311,355 256,903 ----------- ---------- Total Liabilities and Equity . . . . . . . $ 1,788,459 $1,692,246 =========== ========== The accompanying notes are an integral part of these Consolidated Financial Statements. TRICON CAPITAL CORPORATION--PREDECESSOR BUSINESS CONSOLIDATED STATEMENTS OF INCOME (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) FOR THE YEARS ENDED DECEMBER 31, ---------------------------------- 1993 1992 1991 -------- -------- -------- REVENUE Interest income . . . . . . . . . . . . $ 80,477 $ 77,170 $ 90,788 Finance lease revenue . . . . . . . . . 65,835 77,009 94,503 Operating lease revenue . . . . . . . . 63,806 46,337 34,679 Other . . . . . . . . . . . . . . . . . 35,182 41,751 33,879 -------- -------- -------- Total Revenue . . . . . . . . . . 245,300 242,267 253,849 -------- -------- -------- EXPENSES Interest . . . . . . . . . . . . . . . 80,211 90,298 115,190 Selling, general and administrative . . 48,128 49,638 46,533 Provision for credit losses . . . . . . 21,634 28,057 29,876 Depreciation . . . . . . . . . . . . . 41,582 31,496 23,881 -------- -------- -------- Total Expenses . . . . . . . . . . 191,555 199,489 215,480 -------- -------- -------- Income before provision for income taxes and cumulative effect of changes in accounting principles . . . 53,745 42,778 38,369 Provision for income taxes . . . . . . 22,164 15,414 15,014 -------- -------- -------- Income before cumulative effect of changes in accounting principles . . 31,581 27,364 23,355 Cumulative effect of changes in accounting principles . . . . . . . . 5,530 -- (1,471) -------- -------- -------- NET INCOME . . . . . . . . . . . . $ 37,111 $ 27,364 $ 21,884 ======== ======== ======== Pro forma earnings per share before cumulative effect of changes in accounting principles (unaudited). . . . . . . . . . . . . . $ 2.20 The accompanying notes are an integral part of these Consolidated Financial Statements. TRICON CAPITAL CORPORATION--PREDECESSOR BUSINESS CONSOLIDATED STATEMENTS OF CASH FLOWS (DOLLARS IN THOUSANDS) FOR THE YEARS ENDED DECEMBER 31, ----------------------------------------- 1993 1992 1991 ----------- ----------- ----------- CASH FLOWS FROM OPERATING ACTIVITIES: Net income . . . . . . . . . $ 37,111 $ 27,364 $ 21,884 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 43,538 33,436 25,329 Provision for credit losses 21,634 28,057 29,876 Amortization of initial direct costs . . . . . . . 8,946 10,417 12,081 Foreign currency transaction gain . . . . -- -- (2,857) Valuation adjustment . . . -- (6,000) -- Cumulative effect of changes in accounting principles . (5,530) -- 1,471 Gain on sale of equipment and real estate held under operating leases . . (2,548) (72) (29) Gain on transfer of receivables . . . . . . . . (11,290) (13,065) (11,745) Deferred income taxes . . . (6,893) 593 (41) Changes in certain assets and liabilities: (Increase) decrease in other assets . . . . . . . (628) 2,491 28,404 Increase (decrease) in accounts payable and accrued expenses . . . . . 7,461 (8,320) (4,171) ----------- ----------- ----------- Net cash provided by operating activities . . . . . 91,801 74,901 100,202 ----------- ----------- ----------- CASH FLOWS FROM INVESTING ACTIVITIES: Additions to notes receivable and finance leases . . . . . . (1,844,466) (1,355,261) (1,198,591) Principal payments received on notes receivable and finance leases . . . . . . 1,553,092 1,053,913 969,786 Additions to equipment and real estate held under operating leases . . (60,270) (57,686) (63,420) Proceeds from sale of equipment and real estate under operating leases . . 8,236 4,166 461 Proceeds from transfer of receivables . . . . . . 183,242 275,049 291,053 ----------- ----------- ----------- Net cash used in investing activities . . . . . . . . . . (160,166) (79,819) (711) ----------- ----------- ----------- CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from borrowings . . 128,529 204,223 283,067 Principal repayments of borrowings . . . . . . . (338,663) (254,155) (458,595) Increase in amounts due to affiliates . . . . . . . 261,352 32,703 73,579 Capital contributions . . . 21,438 40,416 6,073 Capital distributions . . . (3,932) (17,932) (3,677) Other . . . . . . . . . . . (395) -- (42) ----------- ----------- ----------- Net cash provided by (used in) financing activities . . . . . 68,329 5,255 (99,595) ----------- ----------- ----------- EFFECTS OF EXCHANGE RATE CHANGES ON CASH . . . . . . . 16 (31) (164) ----------- ----------- ----------- (DECREASE) INCREASE IN CASH . . (20) 306 (268) CASH, BEGINNING OF YEAR . . . . 4,503 4,197 4,465 ----------- ----------- ----------- CASH, END OF YEAR . . . . . . . $ 4,483 $ 4,503 $ 4,197 =========== =========== =========== The accompanying notes are an integral part of these Consolidated Financial Statements. TRICON CAPITAL CORPORATION--PREDECESSOR BUSINESS NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS) 1. BACKGROUND AND BASIS OF PRESENTATION BACKGROUND: TriCon Capital Corporation, a wholly-owned subsidiary of Bell Atlantic Investments, Inc. and, ultimately, Bell Atlantic Corporation ("Bell Atlantic"), was incorporated on December 3, 1993 and will be the successor entity to certain businesses of Bell Atlantic TriCon Leasing Corporation ("Old TriCon") which is wholly owned by Bell Atlantic Capital Corporation. Prior to a planned restructuring (the "Restructuring") in contemplation of a public offering of the Company's common stock, the Company will be capitalized with amounts sufficient to acquire from Old TriCon certain assets which comprise the Predecessor Business (described below). Pursuant to the Restructuring, the Company will acquire substantially all of the assets and assume certain liabilities of Old TriCon, other than its leveraged lease portfolio, project finance portfolio and certain other assets to be retained by Old TriCon (the "Transferred Assets" and "Excluded Assets," respectively). The purchase price will be equivalent to the net book value of the Transferred Assets, subject to certain adjustments, and will be paid in part by the issuance of notes payable to Old TriCon. Pursuant to the Restructuring, the Company will also, among other things, assume the rights and obligations of Old TriCon under its securitization agreements and enter into a five-year agreement to manage, for a fee, the leveraged lease and project finance portfolios retained by Old TriCon. BASIS OF PRESENTATION: The consolidated financial statements reflect the financial position, results of operations and cash flows of TriCon Capital Corporation--Predecessor Business, which consists of the assets and liabilities to be acquired or assumed by the Company in the contemplated Restructuring described above. Use of "the Company" in these financial statements refers to the Predecessor Business, unless the context indicates reference to TriCon Capital Corporation. The consolidated financial statements include the accounts of a Canadian division and all wholly owned subsidiaries which are included in the Predecessor Business. All significant intercompany balances are eliminated. The consolidated financial statements include allocations of certain liabilities and expenses relating to the Predecessor Business to be transferred to the Company in the Restructuring. Debt and related interest expense were allocated between the Transferred Assets and the Excluded Assets based upon the internal "match funding" and debt-to-equity ratio policies of Old TriCon in place during such periods. Common expenses were allocated on a proportional basis between the Transferred Assets and the Excluded Assets. Management believes that these allocation methods are reasonable. Pro Forma Earnings Per Share (unaudited) Pro forma earnings per share is calculated based on pro forma net income divided by the number of shares of common stock of TriCon Capital Corporation to be outstanding after the proposed offering of approximately 13,500,000 shares of common stock and grants of 11,972 shares to non-management employees in connection therewith. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Investment in Finance Leases Investment in finance leases consists of the minimum lease payments receivable, estimated residual value of the equipment and initial direct costs less unearned income and security deposits. The unearned income represents the excess of the gross lease payments receivable plus the estimated residual value over the cost of the equipment leased. Unearned income is amortized to income so as to provide an approximate level rate of return on the net outstanding investment. The original lease terms of the direct finance leases are generally from 36 to 84 months. Investment in Operating Leases Investment in operating leases consist predominantly of medical equipment and health care facilities. The Company recognizes operating lease revenue on a straight-line basis over the term of the lease. The cost of equipment and facilities held under operating leases is depreciated to the estimated residual value, on a straight-line basis, over the shorter of the estimated economic life or the period specified under the lease term. Initial direct costs are deferred and amortized over the lease term on a straight-line basis. Residual Values Residual values are reviewed by the Company at least annually. Declines in residual values for finance leases are recognized as charges to income. Declines in residual values for operating leases are recognized as adjustments to depreciation on operating leases over the shorter of the useful life of the asset or the remaining term of the lease. Allowance for Credit Losses In connection with the financing of leases and other receivables, the Company records an allowance for credit losses to provide for estimated losses in the portfolio. The allowance for credit losses is based on a detailed analysis of delinquencies, an assessment of overall risks, management's review of historical loss experience and evaluation of probable losses in the portfolio as a whole given its diversification. An account is fully reserved for or written off when analysis indicates that the probability of collection of the account is remote. Income Taxes For federal income tax purposes, the results of the Company's operations are included in Bell Atlantic's consolidated tax return. In accordance with the Bell Atlantic Consolidated Federal Income Tax Allocation Policy, the Company is allocated federal income tax, or benefit, to the extent it contributes taxable income or loss, and credits, which are utilized in consolidation. The Company and each of its subsidiaries file separate state tax returns in the jurisdictions in which they conduct business. The Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS 109), which the Company adopted effective January 1, 1993. SFAS 109 requires the determination of deferred taxes using the liability method. Under the liability method, deferred taxes must be provided on all book and tax basis differences and deferred tax balances must be adjusted to reflect enacted changes in income tax rates. The cumulative impact of adopting SFAS 109 on the earnings of the Company is a tax benefit of $5,763. Prior to January 1, 1993, deferred taxes were provided for differences in the measurement of revenue and expenses for financial accounting and income tax purposes using the deferral method under Accounting Principles Board Opinion No. 11 (APB 11), "Accounting for Income Taxes." Interest Rate Swaps Interest rate swaps are contracts between two parties to exchange interest payments without the exchange of the underlying notional principal amounts. The Company enters into interest rate swap agreements primarily to hedge interest rate risks. The Company records a net receivable or payable related to the interest to be paid or received as an adjustment to interest expense. In the event of an early termination of an interest rate swap contract, the gain or loss would be amortized over the remaining life of the swap. Foreign Currency Translation Adjustments The financial statements of foreign operations are translated in accordance with the provisions of Statement of Financial Accounting Standards No. 52, "Foreign Currency Translation." Under the provisions of the statement, assets and liabilities are translated at year-end exchange rates, and revenues and expenses are translated at average exchange rates prevailing during the year. The related translation adjustments are recorded as a separate component of Total Equity. Transactions denominated in foreign currencies are translated at rates in effect at the time of the transaction. Gains or losses resulting from foreign currency transactions are included in results of operations. 3. INVESTMENT IN NOTES RECEIVABLE AND FINANCE LEASES Investment in notes receivable consists primarily of amounts due the Company relating to commercial inventory and accounts receivable financing and first mortgage notes which are collateralized by the underlying commercial real estate. The notes bear interest at rates ranging from 5.1% to 15.4% and mature between the years 1994 and 2015. The components of investment in notes receivable as of December 31 are as follows: 1993 1992 -------- -------- Notes receivable . . . . . . . . . . . . . . .. $883,122 $803,009 Initial direct costs . . . . . . . . . . . . . 5,002 4,272 Non-accrual accounts . . . . . . . . . . . . . 24,840 26,206 -------- -------- Investment in notes receivable . . . . . . . . $912,964 $833,487 ======== ======== Investment in finance leases consists of various types of equipment including diversified commercial use equipment, health care equipment and data processing equipment. The original lease terms are generally from 36 to 84 months. The components of investment in finance leases as of December 31 are as follows: 1993 1992 -------- -------- Minimum lease payments . . . . . . . . . . . . $685,578 $659,097 Estimated residual value . . . . . . . . . . . 64,004 75,834 Less: Unearned income . . . . . . . . . . . . . . . . 133,991 134,364 Security deposits . . . . . . . . . . . . . . . 20,737 20,171 Plus: Initial direct costs . . . . . . . . . . . . . 15,259 13,426 Net investment in non-accrual accounts . . . . 36,942 45,770 -------- -------- Investment in finance leases . . . . . . . . . . $647,055 $639,592 ======== ======== TRICON CAPITAL CORPORATION--PREDECESSOR BUSINESS NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS) 3. INVESTMENT IN NOTES RECEIVABLE AND FINANCE LEASES(Continued) At December 31, 1993, estimated minimum annual receipts from notes receivable and finance leases based upon contractual terms are as follows: NOTES FINANCE YEAR ENDING DECEMBER 31 RECEIVABLE LEASES ----------------------- ---------- --------- 1994 . . . . . . . . . . . . . . . . . . . . $338,390 $ 223,413 1995 . . . . . . . . . . . . . . . . . . . . 113,977 177,670 1996 . . . . . . . . . . . . . . . . . . . . . 95,010 130,487 1997 . . . . . . . . . . . . . . . . . . . . 81,733 82,128 1998 . . . . . . . . . . . . . . . . . . . . . 51,897 38,629 Thereafter . . . . . . . . . . . . . . . . . . 202,115 33,251 -------- --------- $883,122 $ 685,578 ======== ========= 4. INVESTMENT IN OPERATING LEASES Operating leases have original terms from 12 to 120 months. Investment in operating leases consists of the following at December 31: 1993 1992 -------- -------- Medical equipment, at cost . . . . . . . . . . $215,951 $193,828 Commercial real estate, at cost . . . . . . . . 99,943 95,926 Other, at cost . . . . . . . . . . . . . . . . 6,466 6,466 -------- -------- Total cost . . . . . . . . . . . . . . . . . . 322,360 296,220 Less accumulated depreciation . . . . . . . . . (82,303) (65,499) -------- -------- Net investment in operating leases . . . . . . $240,057 $230,721 ======== ======== Depreciation expense relating to equipment and real estate held under operating leases was $39,012, $28,645 and $21,191 in 1993, 1992 and 1991, respectively. Estimated minimum annual lease receipts from noncancelable operating leases as of December 31, 1993 are as follows: YEAR ENDING DECEMBER 31, - ---------------------------------------------------------------------------- 1994 . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 58,934 1995 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000 1996 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36,454 1997 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27,273 1998 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,989 Thereafter . . . . . . . . . . . . . . . . . . . . . . . . . 61,893 -------- $250,543 ======== TRICON CAPITAL CORPORATION--PREDECESSOR BUSINESS NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS) 5. NOTES PAYABLE Notes payable at December 31 consist of the following: 1993 1992 -------- -------- Recourse notes payable with interest rates from 3.31% to 11.0% and maturity dates through 2005 . . . . . . . . . . . . . . . . . $709,508 $918,617 Nonrecourse notes payable with fixed interest rates from 8.5% to 9.3% and retired in 1993 . -- 1,025 -------- -------- Total notes payable . . . . . . . . . . . . $709,508 $919,642 ======== ======== At December 31, 1992, all nonrecourse notes were collateralized by specific lease receivables and the underlying equipment. During 1993, 1992 and 1991, the Company paid $82,656, $91,434 and $113,925, respectively, in interest. The above recourse note amounts are allocated from aggregate recourse notes of Old TriCon of $847,917 and $1,066,193 at December 31, 1993 and 1992, respectively (see Note 1). Under the terms of various recourse notes and receivable transfer agreements, Old TriCon was subject to certain restrictive covenants. The most restrictive of these covenants require Old TriCon to maintain a minimum net worth of $150,000; an interest coverage ratio of at least 1.2:1; and a ratio of indebtedness (as defined in the various agreements) to net worth not to exceed 8:1. Old TriCon was in compliance with all covenants as of the balance sheet dates. In addition, certain affiliates have agreed to maintain Old TriCon's compliance with certain financial covenants pursuant to agreements covering the majority of recourse borrowings at December 31, 1993. During 1993 and 1992, Old TriCon participated with an affiliate in the issuance of medium-term notes. Old TriCon's share of the issuance was $184,567 and $60,750 in 1993 and 1992, respectively, which is included in recourse notes payable above. The notes bear interest at varying rates from 4.33% to 6.625% and have maturity dates through December 1999. The Company recognized interest expense on these medium-term notes of $8,054 and $217 in 1993 and 1992, respectively. Maturities of notes payable are as follows: YEAR ENDING DECEMBER 31, - ---------------------------------------------------------------------------- 1994 . . . . . . . . . . . . . . . . . . . . . . . . . . . . $218,627 1995 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220,072 1996 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135,824 1997 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,011 1998 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,045 Thereafter . . . . . . . . . . . . . . . . . . . . . . . . . 56,929 -------- $709,508 ======== TRICON CAPITAL CORPORATION--PREDECESSOR BUSINESS NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS) 6. TOTAL EQUITY The following are transactions affecting total equity: 1993 1992 1991 -------- -------- -------- Balance at beginning of year . . . . $256,903 $206,674 $185,069 Capital contributions . . . . . . . . 21,438 40,416 6,073 Net income . . . . . . . . . . . . . 37,111 27,364 21,884 Capital distributions . . . . . . . . (3,932) (17,932) (3,677) Foreign currency translation adjustments . . . . . . . . . . . . . 230 381 (2,633) Other . . . . . . . . . . . . . . . . (395) -- (42) -------- -------- -------- Total Equity at end of year . . . $311,355 $256,903 $206,674 ======== ======== ======== 7. INCOME TAXES In 1990, Bell Atlantic was subject to the alternative minimum tax (AMT) provisions of the 1986 Tax Reform Act on a tax return basis. The Company has provided for its share of Bell Atlantic's consolidated current AMT liability and for the deferred benefit relating to the corresponding AMT credit carryforward.Bell Atlantic was able to utilize all AMT carryforwards in 1991 and 1992. The Company's income tax expense for the years 1993, 1992 and 1991 would not have differed materially from that reported had the Company filed tax returns on a stand alone basis. The provision for income taxes (exclusive of the tax effect of the cumulative effect of changes in accounting principles in 1993 and 1991) for the years ended December 31 consists of the following: 1993 1992 1991 -------- ------- ------- Current: Federal . . . . . . . . . . . . . . . $ 28,912 $14,065 $15,045 State and local . . . . . . . . . . . 145 756 10 -------- ------- ------- 29,057 14,821 15,055 -------- ------- ------- Deferred: Federal . . . . . . . . . . . . . . . (11,365) (3,071) (4,012) State and local . . . . . . . . . . . 4,472 3,664 3,971 -------- ------- ------- (6,893) 593 (41) -------- ------- ------- Provision for income taxes . . . $ 22,164 $15,414 $15,014 ======== ======= ======= TRICON CAPITAL CORPORATION--PREDECESSOR BUSINESS NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS) 7. INCOME TAXES (Continued) Deferred tax liabilities (assets) are comprised of the following: -------- Gross deferred tax liabilities: Lease related differences . . . . . . . . . . . . . . . . $ 75,263 Other . . . . . . . . . . . . . . . . . . . . . . . . . . 57,704 -------- Gross deferred tax liabilities . . . . . . . . . . . . . . 132,967 -------- Gross deferred tax assets: Allowance for credit losses and accrued liabilities for securitizations . . . . . . . . . . . . . . . . . . . (23,031) Other . . . . . . . . . . . . . . . . . . . . . . . . . . (28,836) -------- Gross deferred tax assets . . . . . . . . . . . . . . . . . (51,867) -------- Net deferred taxes . . . . . . . . . . . . . . . $ 81,100 ======== Under APB 11, deferred taxes resulted from timing differences in the recognition of revenue and expenses for federal and state tax and for financial statement purposes. The tax effects of the timing differences that resulted in the provision for deferred income taxes are summarized as follows: 1992 1991 -------- -------- Accelerated depreciation . . . . . . . . . . . $ (407) $ 3,151 Direct finance and operating leases . . . . . . (23,681) (10,653) State taxes . . . . . . . . . . . . . . . . . 2,418 2,621 Deferred AMT credits . . . . . . . . . . . . . 7,937 6,597 Asset backed securitizations . . . . . . . . 7,834 103 Provision for credit losses . . . . . . . . . . 3,227 (9,195) Other, net . . . . . . . . . . . . . . . . . . 3,265 7,335 -------- -------- Total . . . . . . . . . . . . . . . . $ 593 $ (41) ======== ======== During 1993, 1992 and 1991 the Company paid $24,989, $23,415 and $8,322, respectively, in income taxes. The provision for income taxes recorded for financial reporting purposes differs from the expense computed at the statutory federal income tax rate as follows: 1993 1992 1991 ---- ---- ---- Federal income tax provision at the statutory rate . . . . . . . . . . . . . . 35.0% 34.0% 34.0% State income tax provision, net of federal tax benefit . . . . . . . . . . . 5.6 6.8 6.8 Adjust prior years' tax provision . . . . . (.1) (1.1) -- Income tax expense related to acquisition of business . . . . . . . . . .5 1.4 2.1 Income tax benefit related to tax exempt income . . . . . . . . . . . . (4.3) (3.8) (3.9) Impact of 1% rate change . . . . . . . . . 4.4 -- -- Other . . . . . . . . . . . . . . . . . . . .1 (1.3) .1 ---- ---- ---- Provision for income taxes . . . . . . . 41.2% 36.0% 39.1% ==== ==== ==== TRICON CAPITAL CORPORATION--PREDECESSOR BUSINESS NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS) 8. TRANSACTIONS WITH AFFILIATES The Company purchased equipment from affiliates of Bell Atlantic totaling $4,574, $7,793 and $10,923 in 1993, 1992 and 1991, respectively, which is being leased to third parties under financing lease arrangements. In 1990, the Company purchased $11,800 of equipment from an affiliate in return for a non-interest bearing note payable due in 1991. During 1991, the Company returned such equipment to the affiliate in full payment of the note. During 1993, 1992 and 1991, the Company leased various equipment to affiliates under direct finance and operating leases and recognized earned income of $1,540, $1,143 and $1,481, respectively. During 1993, 1992 and 1991, the Company earned $100, $1,174 and $234, respectively, of management fees from an affiliate. The Company has entered into a short-term borrowing arrangement with an affiliate that bears interest at a rate which approximates the affiliate's average daily cost of funds (weighted average effective rates of 3.28%, 3.83% and 6.04% for the years ended December 31, 1993, 1992 and 1991, respectively). The Company recognized interest expense of $13,844, $13,910 and $19,727 in 1993, 1992 and 1991, respectively, under these arrangements. Due to Affiliates consists of the following at December 31: 1993 1992 1991 -------- -------- -------- Advances under short-term borrowing arrangements . . . . . $603,501 $347,260 $311,029 Payables to affiliates . . . . . 4,437 3,855 4,723 Receivables from affiliates . . . (2,148) (2,825) (2,846) Income tax payable. . . . . . . . 5,404 1,552 4,235 -------- -------- -------- $611,194 $349,842 $317,141 ======== ======== ======== 9. EMPLOYEE BENEFITS Pension Plans Substantially all of the Company's employees are covered under a noncontributory defined benefit pension plan sponsored by Bell Atlantic Capital Corporation and its subsidiaries. The pension benefit formula used is based on a stated percentage of adjusted career average income. The funding objective of the plan is to accumulate funds at a relatively stable rate over participants' working lives so that benefits are fully funded at retirement. Amounts contributed to the plan are determined actuarially, principally under the aggregate cost method, and are subject to applicable federal income tax regulations. Plan assets consist principally of investments in domestic and foreign corporate equity securities, U.S. Government and corporate debt securities, and real estate. In addition, the Company participates in the Executive Management Retirement Plan, a non-qualified pension plan, sponsored by Bell Atlantic and its subsidiaries. Aggregate pension costs are as follows: YEAR ENDED DECEMBER 31, ---------------------------- 1993 1992 1991 ------- ------- ------- Current year cost . . . . . . . . . $1,306 $1,417 $1,464 Percentage of salaries and wages . 3.7% 4.0% 4.6% The decrease in pension cost from 1991 to 1993 is the net result of changes in plan provisions and other actuarial assumptions, and amortization of actuarial gains and losses relating to demographic and investment experience. Statement of Financial Accounting Standards No. 87, "Employers Accounting for Pensions" requires a comparison of the actuarial present value of projected benefit obligations with the fair value of plan assets, the disclosure of the components of net periodic pension costs, and a reconciliation of the funded status of the plan with amounts recorded on the balance sheets. Such disclosures are not presented for the Company because the structure of the plan does not allow for the determination of this information on an individual company basis. The assumed discount rate used to measure the projected benefit obligation was 7.25% at December 31, 1993 and 7.75% at December 31, 1992 and 1991. The assumed rate of future increases in compensation levels was 5.25% at December 31, 1993, 1992 and 1991. The expected long-term rate of return on plan assets was 8.25% for December 31, 1993 and 1992 and, 7.5% for December 31, 1991. Postretirement Benefits Other than Pensions Effective January 1, 1991, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" (SFAS 106) which requires accrual accounting for all postretirement benefits other than pensions. Under the prescribed accrual method, the Company's obligation for these postretirement benefits is to be fully accrued by the date employees attain full eligibility for such benefits. Prior to this adoption, the Company charged costs relating to such benefits to expense as paid. In conjunction with the 1991 adoption of SFAS 106, the Company elected to immediately recognize the accumulated postretirement benefit obligation for current and future retirees, net of the fair value of any plan assets, and recognized accrued postretirement benefit cost (transition obligation) in the amount of $1,471, net of a deferred income tax benefit of $758. Substantially all of the Company's employees are covered under postretirement health benefit plans sponsored by Bell Atlantic Capital Corporation and its subsidiaries. The determination of benefit cost for the postretirement health benefit plan is based on comprehensive hospital, medical and surgical benefit provisions. Aggregate postretirement benefit cost for the year ended December 31, 1993, 1992 and 1991 was $571, $394 and $332, respectfully. There were no amounts paid for postretirement health benefits in 1990. SFAS 106 requires a comparison of the actuarial present value of the accumulated postretirement benefit obligation with the fair value of the plan assets, the disclosure of the components of net periodic postretirement benefit cost, and a reconciliation of the funded status of the plan with the amount recorded on the balance sheet. Such disclosures are not presented for the Company because the structure of the Bell Atlantic plan does not allow for the determination of this information on an individual company basis. The assumed discount rate used to measure the accumulated postretirement benefit obligation was 7.25% at December 31, 1993 and 7.75% at December 31, 1992 and 1991. The assumed rate of future increases in compensation levels was 5.25% at December 31, 1993 and 1992. The expected long-term rate of return on plan assets was 8.25% for 1993 and 1992 and 7.50% for 1991. The medical cost trend rate in 1993 was approximately 13.0%, grading down to an ultimate rate in year 2003 of approximately 5.0%. Employee Stock Ownership Plans The Company maintains savings plans which cover substantially all of its employees. Under these plans, the Company matches a certain percentage of eligible contributions made by the employees. In 1989, Bell Atlantic established two leveraged employee stock ownership plans (ESOPs) within two existing employee savings plans. Under the ESOP provisions, which began January 1, 1990, a substantial portion of Company matching contributions are allocated to the employees in the form of Bell Atlantic stock from the ESOP trusts. Bell Atlantic stock allocated by the ESOP trusts to the participating employees is based on the proportion that principal and interest paid in a year bears to remaining principal and interest due over the life of the notes. Leveraged ESOP expense for the years ended December 31, 1993, 1992 and 1991 is $786, $912 and $803, respectively. Employers' Accounting for Postemployment Benefits Effective January 1, 1993 the Company adopted Statement of Financial Accounting Standard No. 112 "Employers' Accounting for Postemployment Benefits" (SFAS 112) which requires employers who provide benefits to former or inactive employees to recognize the obligation relative to such future benefits on an accrual basis. This change principally affects the Company's accounting for long-term disability benefits which were previously charged to expenses as benefits were paid. The cumulative impact at January 1, 1993 of adopting SFAS 112 was a reduction of net income of $232, net of a deferred income tax benefit of $151. 10. COMMITMENTS At December 31, 1993, the Company's commitments under noncancelable operating leases having remaining terms in excess of one year, primarily for office space are as follows: YEAR ENDING DECEMBER 31, - ------------------------- 1994 . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,803 1995 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,543 1996 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,488 1997 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,251 1998 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,741 Thereafter . . . . . . . . . . . . . . . . . . . . . . . . . 3,739 ------- $15,565 ======= Such leases generally include escalation and renewal clauses and require that the Company pay for utilities, taxes, insurance and maintenance. Rent expense under operating lease agreements was $2,972, $2,985 and $2,952 in 1993, 1992 and 1991, respectively. At December 31, 1993, the Company has outstanding commitments to finance notes receivable of $171,985. The anticipated expirations of such commitments are $167,487 in 1994, $0 in 1995, $0 in 1996, and $4,498 in 1997. 11. FINANCIAL INSTRUMENTS Concentrations of Credit Risk Concentrations of credit risk exist when changes in economic, industry or geographic factors similarly affect groups of customers whose aggregate credit exposure is material in relation to the Company's total credit exposure. Although the Company's portfolio is broadly diversified along industry, customer, equipment and geographic lines, there does exist a concentration of transactions within the health care industry (approximately 22% of total assets plus transferred receivables at December 31, 1993 and 1992). The Company's exposure to credit risk in these and other industries is mitigated by the diversity of customers in the customer base and in many cases by the quality of the underlying collateral. Receivable Transfer Agreements (Securitizations) During 1993, 1992 and 1991, the Company transferred its interests in approximately $179,206, $248,048 and $246,721, respectively, of its direct finance lease portfolio for $200,447, $275,049 and $270,621, respectively. These transfers provide limited recourse for credit losses to the Company and certain of its assets. As of December 31, 1993, $60,153 of finance lease receivables are the sole collateral for certain limited recourse provisions. In addition to such finance lease receivables, the Company has recourse exposure at December 31, 1993 limited to $106,429. At December 31, 1993 and 1992, an outstanding allowance for estimated losses under these recourse provisions of $14,146 and $17,360, respectively, is included in Accounts Payable and Accrued Expenses. The outstanding gross receivable balance of transferred receivables was $495,906 and $541,834 at December 31, 1993 and 1992, respectively. The Company will service these lease contracts for the transferee, and a portion of the proceeds on the transfer has been deferred representing service fees to be earned over the term of the agreements. Interest Rate Swaps The Company has entered into a number of interest rate swap agreements which have effectively fixed interest rates on $424,432 of floating rate instruments including debt and receivable transfer agreements. Under these interest rate swap agreements, the Company will pay the counterparties interest at a fixed rate and the counterparties will pay the Company interest at a variable rate based on the London Interbank Offered Rate (LIBOR), the A1/P1 commercial paper rate or a money market yield. The fixed rates payable under these agreements range from 4.08% to 7.96% with terms expiring at various dates from February 1994 to August 1996. Cash flows resulting from the above are classified with the transactions being hedged. The Company would be exposed to increased interest costs in the event of non-performance by the counterparties for the fixed to floating interest rate swap agreements. However, because of the stature of the counterparties, the Company does not anticipate non-performance. Fair Value of Financial Instruments Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments" (SFAS 107), requires the disclosure of the fair value of financial instruments, both recognized and unrecognized on the consolidated balance sheet, for which it is practicable to estimate fair value. Leases are not considered financial instruments under SFAS 107 and are accordingly excluded from the fair value disclosures. The estimated fair value amounts have been determined by the Company using available market information and appropriate valuation methodologies. However, considerable judgment is necessarily required to interpret market data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts the Company could realize in a current market exchange nor can they be substantiated by comparison to independent markets. The following methods and assumptions were used to estimate the fair value of each class of financial instruments: Cash, Accounts Payable, Accrued Expenses, Other Amounts Due to Affiliates and Recourse Provisions under Receivable Transfer Agreements The carrying amount approximates fair value. Notes Receivable Fair values of notes receivable are based principally on the net present value of the future expected cash flows using current interest rates. Notes Payable and Advances under Short-term Borrowing Arrangements with Affiliates The fair values of notes payable and advances under short-term borrowing arrangements with affiliates is estimated based on the quoted market prices for the same or similar issues, where available or is based on the net present value of the future expected cash flows using current interest rates. Interest Rate Swap Agreements The fair value of interest rate swap agreements is the estimated amount that the Company would have to pay to terminate the swap agreements at December 31, 1993, taking into account current interest rates and the creditworthiness of the swap counterparties. Loan Commitments The fair value of loan commitments is estimated using the fees currently charged to enter into similar commitments. The carrying amounts and estimated fair values of the Company's financial instruments are as follows: DECEMBER 31, 1993 DECEMBER 31, 1992 --------------------- --------------------- CARRYING FAIR CARRYING FAIR AMOUNT VALUE AMOUNT VALUE --------- --------- --------- --------- FINANCIAL INSTRUMENTS ON THE BALANCE SHEETS Notes Receivable net of Allowance for Credit Losses . . . . $ 894,486 $ 896,051 $ 818,216 $ 827,264 Notes Payable . . . . . (709,508) (740,970) (919,642) (973,021) Advances under Short-term Borrowing Arrangements with Affiliates . . . . . (603,501) (603,793) (347,260) (348,897) FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK Interest Rate Swap Agreements . . . . . -- $ (1,160) -- $ 1,321 Loan Commitments . . . -- 6,516 -- 4,383 12. SUPPLEMENTAL CASH FLOW ACTIVITIES During 1992 and 1991 the Company transferred $5,859 and $57,050, respectively, of investment in notes receivable to other assets. In addition, during 1992 the Company transferred $41,585 of property foreclosed in 1991 and included in other assets to investment in operating leases, following the determination to hold such property for operating purposes. The resultant valuation adjustment of $6,000 is reflected in other revenues in 1992. TRICON CAPITAL CORPORATION--PREDECESSOR BUSINESS NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS) 13. QUARTERLY INFORMATION (Unaudited) FIRST SECOND THIRD FOURTH TOTAL ------- ------- ------- ------- -------- Total revenue . . . . $57,258 $58,629 $62,253 $67,160 $245,300 Interest expense . . 20,795 20,956 19,564 18,896 80,211 Provision for credit losses . . . 7,384 7,606 2,966 3,678 21,634 Depreciation . . . . 10,416 9,902 10,138 11,126 41,582 Cumulative effect of changes in accounting principles . . . . . 5,763 -- -- (233) 5,530 Net income . . . . . 9,815 5,368 8,111 13,817 37,111 Total revenue . . . . $53,980 $54,217 $59,137 $74,933 $242,267 Interest expense . . 23,736 22,804 22,012 21,746 90,298 Provision for credit losses . . . 5,606 6,671 9,355 6,425 28,057 Depreciation . . . . 6,960 7,193 8,049 9,294 31,496 Net income . . . . . 2,706 4,892 4,859 14,907 7,364 Net income in the fourth quarter of 1993 and 1992 was increased by certain securitization transactions (see Note 11). EXHIBIT 12 TRICON CAPITAL CORPORATION - PREDECESSOR BUSINESS COMPUTATION OF RATIO OF EARNINGS TO FIXED CHARGES At or for the Year Ended December 31, ------------------------------------------------ 1993 1992 1991 1990 1989 ------------------------------------------------ (Dollars in Thousands) Income before income taxes and cumulative effect of changes in accounting principles $ 53,745 $ 42,778 $ 38,369 $ 39,380 $ 30,391 Add: Fixed charges 81,201 91,293 116,174 121,039 97,424 -------- -------- -------- -------- -------- Income as adjusted $134,946 $134,071 $154,543 $160,419 $127,815 Fixed Charges: Interest or indebtedness $ 80,211 $ 90,298 $115,190 $119,965 $ 96,347 Interest factor of annual rentals (1) 990 995 984 1,074 1,077 -------- -------- -------- -------- -------- Fixed Charges $ 81,201 $ 91,293 $116,174 $121,039 $ 97,424 -------- -------- -------- -------- -------- Ratio of earnings to fixed charges 1.66x 1.47x 1.33x 1.33x 1.31x ======== ======== ======== ======== ======== ____________ (1) The interest portion of annual rentals is estimated to be one- third of such rentals. PART II ITEM 5.	ITEM 5. MARKET PRICE OF AND DIVIDENDS ON THE REGISTRANT'S COMMON EQUITY & RELATED STOCKHOLDER MATTERS. There is no market for the Company's common stock or redeemable preferred stock as the Company is wholly owned by GFC Financial. The preferred stock is subject to mandatory redemption on July 1, 1997. Dividends paid on the common stock for the first through fourth quarters of 1993 were $3,200,000, $3,200,000, $3,600,000 and $3,600,000, respectively. Dividends paid on the common stock for the first through fourth quarters of 1992 were $3,000,000, $3,000,000, $2,900,000 and $2,900,000, respectively. See Note D of Notes to Consolidated Financial Statements and Management's Discussion and Analysis of Financial Condition and Results of Operations included in Annex A for a discussion of restrictions on the ability of GFC to pay dividends and Note E thereof for a discussion on dividends relating to the preferred stock. ITEM 6.	ITEM 6. SELECTED FINANCIAL DATA. Omitted. ITEM 7.	ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. See pages 1 - 7 of Annex A. ITEM 8.	ITEM 8. FINANCIAL STATEMENTS & SUPPLEMENTARY DATA. 1. Financial Statements - See Item 14 hereof. 2. Supplementary Data - See Condensed Quarterly Results included in Note M of Notes to Consolidated Financial Statements included in Annex A. ITEM 9.	ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING & FINANCIAL DISCLOSURE. NONE. PART III ITEM 10.	ITEM 10. DIRECTORS & EXECUTIVE OFFICERS OF THE REGISTRANT. Omitted. ITEM 11.	ITEM 11. EXECUTIVE COMPENSATION. Omitted. ITEM 12.	ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS & MANAGEMENT. Omitted. ITEM 13.	ITEM 13. CERTAIN RELATIONSHIPS & RELATED TRANSACTIONS. Omitted. PART IV ITEM 14.	ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) Documents filed. 1. Financial Statements. (i) The following financial statements of Greyhound Financial Corporation are included in Annex A: Annex Page ------- Management's Discussion and Analysis of Financial Condition and Results of Operations 1 - 7 Report of Management and Independent Auditors' Report 8 Consolidated Balance Sheet 9 - 10 Statement of Consolidated Operations 11 Statement of Consolidated Stockholder's Equity 12 Statement of Consolidated Cash Flows 13 Notes to Consolidated Financial Statements 14 - 45 (ii) The Financial Statements of TriCon Capital Corporation are included in Part I, Optional Item 2. 2. All Schedules have been omitted because they are not applicable or the required information is shown in the financial statements or notes thereto. 3. Exhibits. Exhibit No. ----------- (3-A) The Company's Certificate of Incorporation, as amended through the date of this filing (incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1991 (the "1991 10-K"), Exhibit 3-A). (3-B) The Company's By-Laws, as amended through the date of this filing (incorporated by reference from the Company's 1991 10- K, Exhibit 3-B). (4.A) Instruments with respect to issues of long-term debt have not been filed as exhibits to this Annual Report on Form 10-K if the authorized principal amount of any one of such issues does not exceed 10% of total assets of the Company and its subsidiaries on a consolidated basis. The Company agrees to furnish a copy of each such instrument to the Securities and Exchange Commission upon request. (4-B-1) Form of Common Stock Certificate of the Company from the Company's Annual Report on Form 10-K for the year ended December 31, 1992 (the "1992 10-K"), Exhibit 4-B-1. (4-B-2) Form of the Company's Series A Redeemable Preferred Stock Certificate from the 1992 10-K, Exhibit 4-B-2. (4-C) Certificate of Designations of Series A Redeemable Preferred Stock of the Company (incorporated by reference from the 1992 GFC Financial Annual Report on Form 10-K for the year ended December 31, 1992 (the "GFC Financial 1992 10-K", Exhibit 10- MM)). (4-D) Relevant portions of the Company's Certificate of Incorporation and Bylaws are included in Exhibits 3-A and 3-B above, respectively. (4-E) Indenture dated as of November 1, 1990 between the Company and the Trustee named therein (incorporated by reference from the Company's Registration Statement on Form S-3, Registration No. 33-37743, Exhibit 4). (4-F) Fourth Supplemental Indenture dated as of April 17, 1992 between the Company and the Trustee named therein, supplementing the Indenture referenced in Exhibit 4-E above, is hereby incorporated by reference from the GFC Financial 1992 10-K, Exhibit 4-F. (4-G) Prospectus and Prospectus Supplement dated April 17, 1992, relating to $350,000,000 principal amount of the Company's Medium-Term Notes, Series A, is hereby incorporated by reference from the GFC Financial 1992 10-K, Exhibit 4-G. (4-H) Form of Floating-rate, Medium-Term Notes, Series A, is hereby incorporated by reference from the 1992 GFC Financial 10-K, Exhibit 4-H. (4-I) Form of Fixed-rate, Medium-Term Notes, Series A, is hereby incorporated by reference from the GFC Financial 1992 10-K, Exhibit 4-I. (4-J) Form of Indenture dated as of September 1, 1992 between the Company and the Trustee named therein (incorporated by reference from the Company's Registration Statement on Form S-3, Registration No. 33-51216, Exhibit 4). (4-K) Prospectus and Prospectus Supplement dated September 25, 1992 regarding $250,000,000 principal amount of the Company's Medium-Term Notes, Series B, is hereby incorporated by reference from the GFC Financial 1992 10-K, Exhibit 4-K. (4-L) Form of Floating-rate Medium-Term Notes, Series B, is hereby incorporated by reference from the GFC Financial 1992 10-K, Exhibit 4-L. (4-M) Form of Fixed-rate Medium-term Notes, Series B, is hereby incorporated by reference from the GFC Financial 1992 10-K, Exhibit 4-M. (4-N) Indenture dated as of June 1, 1985 between the Company and the trustee named therein is hereby incorporated by reference from the 1992 10-K, Exhibit 4-N. (4-O) Prospectus and Prospectus Supplement dated February 16, 1994 regarding $250,000,000 principal amount of the Company's Medium-Term Notes, Series B is hereby incorporated by reference from the Company's Registration Statement on Form S-3, Registration No. 33-51216, as amended on that date. (4-P) Prospectus, dated February 16, 1994, and Prospectus Supplement dated February 17, 1994 regarding $100,000,000 principal amount of the Company's Floating-Rate Notes, is hereby incorporated by reference from the Company's Registration Statement on Form S-3, Registration No. 33- 51216, as amended on that date. (9) Form of Distribution Agreement among the Company, GFC Financial Corporation, The Dial Corp and certain other parties named therein, dated as of January 28, 1992 (incorporated by reference from GFC Financial's Registration Statement on Form S-1, Registration No. 33-45452, Annex II to the Prospectus and Exhibit 2.1) (containing section 2.08(b), regarding the voting of the Greyhound Financial Corporation preferred stock). (10-A) Fifth Amendment and Restatement dated as of May 18, 1993 of the Credit Agreement dated as of May 31, 1976 among the Company and the banking institutions listed on the signature pages thereto, and Bank of America National Trust and Savings Association, Chemical Bank and Citibank, N.A., as agents (incorporated by reference from the Corporation's Current Report on Form 8-K dated February 14, 1994, Exhibit 7(c)). (10.A1) Amendment dated as of January 31, 1994, to the Fifth Amendment and Restatement, noted in 10-A above incorporated by reference from the GFC Financial 1992 10-K, Exhibit 10. A1.* (10-C) Sublease dated as of April 1, 1991 among the Company, GFC Financial, Dial and others, relating to the Company principal office space is hereby incorporated by reference from the GFC Financial 1992 Form 10-K, Exhibit 10-NN. (10-D) Interim Service Agreement dated January 28, 1992 among the Company, GFC Financial, Dial and others is hereby incorporated by reference from the GFC Financial 1992 Form 10-K, Exhibit 10-JJ. (10-E) Tax Sharing Agreement dated February 19, 1992 among the Company, GFC Financial, Dial and others is hereby incorporated by reference from the GFC Financial 1992 Form 10-K, Exhibit 10-KK. (10.F) Stock Purchase Agreement between the Company and Bell Atlantic TriCon Leasing Corporation dated as of March 4, 1994.* (10.G) Form of Assets Purchase Agreement between Bell Atlantic TriCon Leasing Corporation and TriCon Capital Corporation.* (12) Computation of Ratio of Income to Combined Fixed Charges and Preferred Stock Dividends.* (23) Consent of Independent Accountants - Deloitte & Touche.* (23.A) Consent of Independent Accountants - Coopers & Lybrand.* (23.B) Consent of Independent Accountants - Coopers & Lybrand.* (23.C) Consent of Independent Accountants - KPMG Peat Marwick.* * Filed herewith. (b) Reports on Form 8-K: A Report on Form 8-K dated January 18, 1994 was filed by Registrant, which reported under Item 5 the revenues, net income and selected financial data and ratios for the fourth quarter and twelve months ended 1993 (unaudited). Reports on Form 8-K dated January 21, 1994 were filed by Registrant, which reported under Item 5 the settlement of the litigation between Cabana Limited Partnership, a South Carolina Limited Partnership v. Greyhound Real Estate Finance Company, et al, a subsidiary of Greyhound Financial Corporation, the principal operating subsidiary of the Registrant. Reports on Form 8-K, 8-K/A and 8-K-A-1, dated February 14, 1994 were filed by Registrant, which reported under Items 2 and 7 the signing of an agreement by the registrant to purchase Ambassador Factors from Fleet Financial Group, Inc. and the Fifth Amendment and Restatement, dated as of May 18, 1993, of Credit Agreement dated as of May 31, 1976 among Greyhound Financial Corporation, Bank of America National Trust and Savings Association, Chemical Bank and Citibank, N.A., as agents, and the financial institutions listed. 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 in the capacities indicated, in Phoenix, Arizona on the 10th day of March, 1994. Greyhound Financial Corporation By: /s/ Samuel L. Eichenfield _________________________________________ Samuel L. Eichenfield President and Chief Executive Officer (Chief Executive Officer) By: /s/ Robert J. Fitzsimmons _________________________________________ Robert J. Fitzsimmons Vice President - Treasurer (Chief Financial Officer) By: /s/ Bruno A. Marszowski _________________________________________ Bruno A. Marszowski Vice President - Controller (Chief Accounting Officer) Pursuant to the requirements of the Securities 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: _________________________________ ________________________________ W. Carroll Bumpers (Director) Samuel L. Eichenfield (Chairman) March 10, 1994 March 10, 1994 _________________________________ ________________________________ Robert J. Fitzsimmons (Director) Bruno A. Marszowski (Director) March 10, 1994 March 10, 1994 ANNEX A Page Management's Discussion and Analysis of Financial Condition and Results of Operations 1 - 6 Report of Management and Independent Auditors' Report 7 Consolidated Balance Sheet at December 31, 1993 and 1992 8 - 9 Statement of Consolidated Operations for the Years Ended December 31, 1993, 1992 and 1991 10 Statement of Consolidated Stockholder's Equity for the Years Ended December 31, 1993, 1992 and 1991 11 Statement of Consolidated Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 12 Notes to Consolidated Financial Statements for the Years Ended December 31, 1993, 1992 and 1991 13 - 37 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion relates to Greyhound Financial Corporation ("GFC" or the "Company"), including the European Financial Group ("GEFG") and Greyhound BID Holding Corporation ("BID"), the subsidiaries contributed to GFC prior to the Distribution as discussed in Note A of Notes to the Consolidated Financial Statements. The following comments and information should be read in conjunction with the Annual Report as a whole. GFC is a wholly owned subsidiary of GFC Financial Corporation ("GFC Financial"). GFC Financial is a holding company, the principal subsidiaries of which are GFC and Verex Corporation ("Verex"), a mortgage insurance company that was sold on July 16, 1993. Results of Operations 1993 Compared to 1992 Net income for 1993 was $36.4 million compared to $36.8 million in 1992. The 1993 results included a $4.9 million adjustment in the third quarter for deferred taxes applicable to leveraged leases and $1.6 million (pre-tax) of expenses that can no longer be allocated to Verex. Excluding these amounts, net income for 1993 was $42.3 million, an increase of 15% over 1992. The $4.9 million adjustment in 1993 represented the effects of the recent increases in federal and state income tax rates as they applied to deferred income taxes generated by the Company's leveraged lease portfolio. Financial Services. Interest Margins Earned. Interest margins earned, which represent the difference between interest earned from financing transactions and interest expense, increased by 17% in 1993 compared to 1992. These margins were improved significantly by more favorable debt costs in 1993 when compared to 1992 (approximately a 1% reduction in the aggregate cost of debt). Also contributing to the improved margins was the growth of the domestic portfolio and higher prepayment fees, partially offset by the effects of larger foreign exchange gains reported by GEFG in 1992 and the continued winding down of the GEFG portfolio. The $10.0 million reduction in interest expense primarily is attributable to more favorable debt costs in 1993. The more favorable debt costs, in comparison to 1992, primarily relate to the Company's ability to consistently maintain a matched position throughout 1993 relative to financing its floating-rate assets with floating-rate debt. During the second and third quarters of 1992, GFC, because of the significant refinancing done in connection with the spin-off, had to finance a major portion of its floating-rate assets with fixed-rate debt. That fixed-rate debt was subsequently converted to floating-rate debt through interest rate conversion agreements. However, the timing between the issuance of fixed- rate debt and the execution of the interest rate conversion agreements caused interest margins to shrink by approximately $2.8 million in 1992. Non-Interest Expense. Although the provision for possible credit losses was lower in 1993, in the opinion of management, such provision was adequate to cover the growth and risk in the portfolio. The reserve for possible credit losses, which is increased by the loss provisions and reduced by write-offs, was 2.3% of funds employed at December 31, 1993. Details of the write-offs by collateral type can be found in Note C of Notes to Consolidated Financial Statements. Selling, administrative and other operating expenses increased during 1993 due to the addition of the Asset Based Finance ("ABF") operations acquired from U.S. Bancorp Financial, Inc. (see "Recent Developments and Business Outlook"), expenses that are no longer allocated to discontinued operations and legal expenses incurred in connection with certain problem accounts. See Note K of Notes to Consolidated Financial Statements. Gains on Sale of Assets. Gains on sale of assets were higher in 1993 than in 1992 due to the amount and type of assets sold. Income Taxes. Income taxes, excluding the $4.9 million adjustment applicable to deferred taxes, were higher in 1993 and more in the range of an ongoing effective tax rate (approximately 36% of income before income taxes) for the Company. The higher income taxes were attributable to the effects of a 1% increase in both federal and state income tax rates, which increased the provision for taxes by approximately $1 million, and to higher income before income taxes. Additionally, in 1992, income taxes were reduced by $3.1 million representing tax adjustments related to the refinancing of the Company's debt. See Note F of Notes to Consolidated Financial Statements. Cash Flow. Net cash provided by operating activities in 1993 was $42.7 million, an increase of $10.0 million when compared to 1992. This increase was principally due to the increase in deferred income taxes, partially offset by a decline in customer deposits in GEFG's subsidiary bank, Greyhound Bank, PLC ("GBL") and a decrease in interest payable. Net cash used by investing activities was $369.4 million in 1993, up by $107.2 million from 1992. The major reasons for the increase in 1993 were the record amount of expenditures for new business and the purchase of ABF, partially offset by the collection of advances made to Verex. Also offsetting the increase was higher principal collections on financing transactions (which included a significant amount of prepayments in 1993). Net cash provided by financing activities was $310.5 million, an increase of $99.7 million from 1992. The increase primarily consisted of higher advances from GFC Financial representing the proceeds received on the sale of its discontinued mortgage insurance operations (Verex) and higher net borrowings primarily used to finance new business. 1992 Compared to 1991 Net income for 1992 was $36.8 million compared to a loss of $38.7 million in 1991. The 1991 results include $69 million (after-tax) of restructuring and other charges as part of the spin-off from The Dial Corp ("Dial"). Excluding the effects of the restructuring and other charges made in 1991, net income in 1992 increased by 21% over 1991 ($36.8 million compared to $30.3 million). The following discussion of results of operations excludes the $69 million (after-tax) of restructuring and other charges recorded in 1991. Interest Margins Earned. Interest margins earned increased by 11% in 1992 compared to 1991. This increase is attributable primarily to higher margins in the domestic portfolio ($83.4 million in 1992 compared to $73.6 million in 1991) due to the growth of $334.9 million in the domestic portfolio in 1992. GEFG's interest margins earned increased by $1.0 million in 1992 as a result of the $47.2 million of additional capital infused by Dial in December 1991 as part of the spin-off. The effect of this capital infusion helped to offset the reduction in margins caused by the continued liquidation of the GEFG portfolio. During the second and third quarters of 1992, GFC, because of the significant refinancing done in connection with the spin-off, had to finance a major portion of its floating-rate assets with fixed-rate funds. Those fixed-rate funds were subsequently converted to floating-rate funds through interest rate conversion agreements. The timing between the issuance of fixed-rate funds and the execution of interest rate conversion agreements resulted in a decrease in margins of approximately $2.8 million. GFC was able to liquidate a substantial portion of its Latin American assets for gains of $3.1 million, which offset the adverse effect of the temporary imbalance of rate-sensitive assets and liabilities. Also contributing to the improved interest margins were the effects of lower nonaccruals, which averaged $114 million in 1992 compared to $185 million in 1991, higher prepayment fees and interest expense reductions related to the refinancing of high cost fixed-rate debt during 1991 and 1992. These increases were partially offset by the effect of recognizing $6.3 million of additional income in 1991, related to the leveraged lease portfolio, with no comparable amount being recognized in 1992. Non-Interest Expense. Provisions for possible credit losses were lower in 1992 but, nevertheless, were adequate to cover the growth and risk in the portfolio. A breakdown of the write-offs by collateral type can be found in Note C of Notes to Consolidated Financial Statements. Selling, administrative and other operating expenses increased during 1992 due to additional costs associated with being a subsidiary of a public company, the liquidation of GEFG (which included $1.3 million of after-tax employee termination costs) and normal cost increases. See Note K of Notes to Consolidated Financial Statements. Gains on Sale of Assets. Gains on sale of assets were lower in 1992 than in 1991 due to reduced quantities and values of assets coming off lease. This reduction was the result of the gradual liquidation of the Company's lease portfolio and is in line with the Company's strategy of improving core income (i.e., net income excluding after-tax gains on sale of assets). Income Taxes. The effective income tax rate for 1992 is lower than the statutory rate primarily because of a $3.1 million reduction in taxes for tax benefits related to the expenses of refinancing the Company's debt. See Note F of Notes to Consolidated Financial Statements. Cash Flow. Cash provided by operating activities was $32.7 million in 1992, an improvement of $101.8 million over 1991. The improvement was due to higher earnings and reduced uses of cash in 1992. The lower uses of cash, when compared to 1991, primarily related to withdrawals of customer deposits in GBL, reductions in deferred income taxes and lower interest paid resulting from lower effective interest rates in 1992. Partially offsetting these increases in cash was the payment in 1992 of restructuring and other charges and transaction costs related to the spin-off. Net cash used by investing activities was $262.3 million in 1992, up $105.0 million from 1991. The major reasons for the higher use of cash were the increases in expenditures for financing transactions, net advances of $57.3 million made to Verex in 1992 to refinance its debt obligations and lower proceeds from the sale of assets, partially offsetting these items was an increase in principal collections from financing transactions in the domestic portfolio, increased prepayments and the principal and interest recovered from the sale of certain Latin American assets. Net cash provided by financing activities was $210.8 million during 1992, a decline of $28.1 million from 1991. The decline was due primarily to lower net borrowings, partially reduced by amounts received from a subsidiary of Dial in connection with the spin-off to purchase GFC preferred stock and settle intercompany balances. Liquidity and Capital Resources Funds employed (i.e., investment in financing transactions before the reserve for possible credit losses) increased by $361 million, or approximately 15%, to $2,847 million at December 31, 1993 from $2,486 million at December 31, 1992. This increase was due to approximately $1 billion of new business being added during 1993 and the acquisition of $63 million of ABF assets, partially offset by $702 million of portfolio runoff, early terminations, translation adjustments, write-offs and collections on net advances made to Verex ($57 million). The primary focus of ABF, which was acquired on February 1, 1993, is financing through revolving lines of credit secured by accounts receivable and inventories. This acquisition extends the financial services the Company can provide. The GEFG portfolio continued to wind down in 1993 reflecting a reduction of $58.6 million to $124.3 million at December 31, 1993 from $182.9 million at December 31, 1992. In conjunction with the winding down of the GEFG portfolio, GEFG, in December 1993, surrendered the banking license of the United Kingdom bank and, therefore, will not be taking in any more customer deposits. Additional geographic information can be found in Note L of Notes to Consolidated Financial Statements. The reserve for possible credit losses ("reserve") declined in 1993 by $5.0 million to $64.3 million at December 31, 1993 from $69.3 million at December 31, 1992. The decline was principally attributable to write-offs of $12.6 million ($5.0 million of which were in GEFG), partially offset by provisions for possible credit losses made in connection with the growth in funds employed. The reserve is believed to be adequate at December 31, 1993 at 2.3% of funds employed and 62.6% of nonaccruing assets. Nonaccruing contracts and repossessed assets were $102.6 million at December 31, 1993 compared to $100.4 million at December 31, 1992. This increase is comprised of a $12.3 million increase in the domestic portfolio (to $90.3 million at December 31, 1993) partially offset by a decrease of $10.1 million in GEFG's portfolio (to $12.3 million at December 31, 1993). Nonaccruing contracts and repossessed assets as a percent of funds employed declined to 3.6% at December 31, 1993 from 4.0% at December 31, 1992. For more information on write-offs and nonaccruing assets see Note C of Notes to Consolidated Financial Statements. The Company's outstanding debt of approximately $2,107 million (including $25 million of redeemable preferred stock) was 6.1 times its equity base of $345 million at December 31, 1993. The Company also had deferred taxes of $198 million at that date to help finance its lending activities. Growth in funds employed is typically financed by internally generated cash flow and additional borrowings. During 1993, GFC issued $200 million of new senior debt, which, together with general corporate funds and net borrowings through the issuance of commercial paper, was used to finance new business and redeem or retire $200 million of maturing debt. GFC satisfies a significant portion of its cash requirements from a diversified group of worldwide funding sources and is not dependent upon any one lender. Additionally, GFC relies on the issuance of commercial paper as a major funding source. During 1993, GFC issued $3.3 billion of commercial paper (with an average of $294 million outstanding during the year) and raised $200 million through new long-term senior notes of two to ten year durations. Commercial paper and short-term borrowings are supported by a $700 million unused long-term revolving bank credit agreement. Debt repayments in 1993 included the prepayment ($145 million) of six term loans due February 1994 to August 1996. GFC generally mitigates the volatility of interest rate changes by matching the terms of its investments in new and existing transactions with approximate similar terms and duration applicable to its funding sources. Generally, fixed-rate assets are financed with fixed-rate debt and floating- rate assets are financed with floating-rate debt. GFC also balances the maturities of its investments so that sufficient cash flow is available to service anticipated debt requirements. In the third quarter of 1993, GFC entered into four three-year interest rate hedge agreements on $750 million of floating-rate borrowings to effectively guarantee a spread of approximately 2.3% between its borrowing rate (LIBOR) and the Prime interest rate. GFC had outstanding 31 interest rate conversion agreements with notional principal amounts totaling $1.3 billion. Six agreements with notional principal amounts of $180 million were arranged to effectively convert certain floating interest rate obligations into fixed interest rate obligations and require interest payments on the stated principal amount at rates ranging from 8.3% to 9.8% (remaining terms of three months to five years) in return for receipts calculated on the same notional amounts at floating interest rates. In addition, 25 agreements with notional principal amounts of $1.1 billion were arranged to effectively convert certain fixed interest rate obligations into floating interest rate obligations and require interest payments on the stated principal amount at the three month or six month LIBOR (remaining terms of five months to nine years) in return for receipts calculated on the same notional amounts at fixed interest rates of 4.9% to 7.6%. The agreements have been entered into with major financial institutions which are expected to fully perform under the terms of the agreements, thereby mitigating the credit risk from the transactions. GFC's aggregate cost of funds has declined to 6.3% for 1993 from 7.2% in 1992. GFC's cost of and access to capital resources is significantly influenced by its debt ratings. Recent Developments and Business Outlook On February 1, 1993, GFC purchased the Asset Based Lending Division of U.S. Bancorp Financial, Inc., a wholly owned subsidiary of U.S. Bancorp, for approximately $70 million in cash. The primary focus of the Asset Based Finance group, which is based in Los Angeles and recently opened an office in Chicago, is to offer revolving lines of credit and term loans secured by accounts receivable and inventories on a national basis. GFC established a new line of business (in August 1993), the Consumer Rediscount Group, which provides senior financing to independent consumer finance companies. Based in Dallas, Texas, this type of secured lending, known as rediscounting, represents another niche-business for GFC. On February 14, 1994, GFC acquired Fleet Financial Group, Inc.'s factoring and asset-based lending subsidiary, Fleet Factors Corp, operating under the trade name Ambassador Factors ("Ambassador"). As of November 30, 1993, Ambassador had a $336 million loan portfolio and generated $810 million of factoring volume in 1993. Its customer base primarily consists of small to medium-sized textile and apparel manufacturers in the factoring operation and similar sized manufacturers, distributors and wholesalers in the asset-based lending business. See Note N of Notes to Consolidated Financial Statements. On March 4, 1994, GFC Financial announced the signing of a definitive purchase agreement under which it will acquire all of the stock of TriCon Capital Corporation ("TriCon"), an indirect wholly-owned subsidiary of Bell Atlantic Corporation, in an all cash transaction. The transaction is subject to regulatory approvals and certain other conditions. TriCon is a $1.8 billion niche-oriented provider of commercial and equipment leasing services. TriCon's marketing orientation fits well with GFC's focus on value-added products and services in focused niches of the commercial finance business and further diversifies GFC's asset base. See Note N to Notes to Consolidated Financial Statements. The expanding and improving U.S. and United Kingdom economies, are predicted to stimulate business investment and pave the way for stronger growth. Signs of these changes are becoming evident to the Company by the improved liquidity in its domestic Commercial Real Estate and Communication Finance businesses, as well as reduced nonaccruals in the European Consumer Finance portfolio. Strategies implemented during 1993 position the Company to take advantage of the improving domestic economy and to expand its financial services operations into three new niche businesses. New Accounting Standards In November 1992, the Financial Accounting Standards Board ("FASB") issued Statement of Accounting Standards ("SFAS") No. 112, "Employers' Accounting for Postemployment Benefits". Analogous to SFAS No. 106 for postretirement benefits, this standard requires companies to accrue for estimated future postemployement benefit expenses during the periods when employees are working. Postemployment benefits are any benefits other than retirement benefits that are provided after employment is discontinued. This standard must be adopted for fiscal years beginning after December 15, 1993, which for the Company would be 1994. Based on management's review, the adoption of the new standard will not have a material impact on the Company's financial position or results of operations. The FASB has issued a new accounting standard, SFAS No. 114, "Accounting by Creditors for Impairment of a Loan" ("SFAS 114"). This standard requires that impaired loans that are within the scope of this statement generally be measured based on the present value of expected cash flows discounted at the loan's effective interest rate or the fair value of the collateral, if the loan is collateral dependent. Under SFAS 114, a loan is considered impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts due. Presently, the reserve for possible credit losses represents management's estimate of the amount necessary to cover potential losses in the portfolio considering delinquencies, loss experience and collateral. The impact of the new standard, which is effective for fiscal years beginning after December 15, 1994, has not yet been determined. New accounting standards adopted by GFC in 1993 included SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("OPEB"). The disclosure required by this statement is included in Note G of Notes to Consolidated Financial Statements. MANAGEMENT'S REPORT ON RESPONSIBILITY FOR FINANCIAL REPORTING The management of Greyhound Financial Corporation is responsible for the preparation, integrity and objectivity of the financial statements and other financial information included in this Annual Report. The financial statements are presented in accordance with generally accepted accounting principles reflecting, where applicable, management's best estimates and judgments. Management of the Company has established and maintains a system of internal controls to reasonably assure the fair presentation of the financial statements, the safeguarding of the Company's assets and the prevention or detection of fraudulent financial reporting. The internal control structure is supported by careful selection and training of personnel, documented policies and procedures and regular review by both internal auditors and the independent auditors. The Board of Directors, through its Audit Committee, also oversees the financial reporting of the Company and its adherence to established procedures and controls. Periodically, the Audit Committee meets, jointly and separately, with management, the internal auditors and the independent auditors to review auditing, accounting and financial reporting matters. The Company's financial statements have been audited by Deloitte & Touche, independent auditors. Management has made available to Deloitte & Touche all of the Company's financial records and related data, and has made valid and complete written and oral representations and disclosures in connection with the audit. Management believes it is essential to conduct its business in accordance with the highest ethical standards, which are characterized and set forth in the Company's written Code of Conduct. These standards are communicated to all of the Company's employees. Samuel L. Eichenfield Chairman, President & Chief Executive Officer Bruno A. Marszowski Vice President - Controller Derek C. Bruns Director - Internal Audit GFC Financial Corporation INDEPENDENT AUDITORS' REPORT To the Board of Directors and Stockholders of Greyhound Financial Corporation We have audited the accompanying consolidated balance sheet of Greyhound Financial Corporation and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, stockholder's equity and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Greyhound Financial Corporation and subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Deloitte & Touche Phoenix, Arizona March 4, 1994 CONSOLIDATED BALANCE SHEET (Dollars in Thousands) ASSETS - ---------------------------------------------------------------------------- December 31, 1993 1992 - ---------------------------------------------------------------------------- Cash and cash equivalents $ 2,859 $ 19,120 Investment in financing transactions: Loans and other financing contracts, less unearned income of $72,747 and $122,381, respectively 2,343,755 1,919,371 Leveraged leases 283,782 269,370 Operating and direct financing leases 219,034 239,782 Related party advances 57,321 - ---------------------------------------------------------------------------- 2,846,571 2,485,844 Less reserve for possible credit losses (64,280) (69,291) - ---------------------------------------------------------------------------- Investment in financing transactions - net 2,782,291 2,416,553 Other assets and deferred charges 49,747 44,653 - ---------------------------------------------------------------------------- $ 2,834,897 $ 2,480,326 ============================================================================ See notes to consolidated financial statements. LIABILITIES AND STOCKHOLDER'S EQUITY - ---------------------------------------------------------------------------- December 31, 1993 1992 - ---------------------------------------------------------------------------- Liabilities: Accounts payable and accrued expenses $ 30,158 $ 27,613 Due to Parent 130,760 Customer deposits 3,064 15,064 Interest payable 23,633 29,062 Short-term debt 510 1,360 Senior debt 1,991,986 1,806,433 Subordinated debt 86,790 75,916 Deferred income taxes 197,705 174,090 - ---------------------------------------------------------------------------- 2,464,606 2,129,538 - ---------------------------------------------------------------------------- Redeemable preferred stock 25,000 25,000 - ---------------------------------------------------------------------------- Stockholder's equity: Common stock, $1 par value, 100,000 shares authorized, 25,000 shares outstanding 25 25 Additional capital 298,665 298,665 Retained income 54,374 33,783 Cumulative translation adjustments (7,773) (6,685) - ---------------------------------------------------------------------------- 345,291 325,788 - ---------------------------------------------------------------------------- $ 2,834,897 $ 2,480,326 ============================================================================ See notes to consolidated financial statements. STATEMENT OF CONSOLIDATED OPERATIONS (Dollars in Thousands) - ---------------------------------------------------------------------------- Years Ended December 31, 1993 1992 1991 - ---------------------------------------------------------------------------- Interest and other income $218,171 $210,873 $212,706 Lease income 30,529 29,933 38,766 - ---------------------------------------------------------------------------- Interest earned from financing 248,700 240,806 251,472 transactions Interest expense 126,152 136,107 157,560 - ---------------------------------------------------------------------------- Interest margins earned 122,548 104,699 93,912 - ---------------------------------------------------------------------------- Provision for possible credit losses 5,706 6,740 12,687 Restructuring and other charges 65,000 - ---------------------------------------------------------------------------- 5,706 6,740 77,687 - ---------------------------------------------------------------------------- Net interest margins earned 116,842 97,959 16,225 Gains on sale of assets 5,439 3,362 6,684 - ---------------------------------------------------------------------------- 122,281 101,321 22,909 - ---------------------------------------------------------------------------- Selling, administrative and other 58,158 50,728 46,923 operating expenses Transaction costs of the Distribution 13,000 - ---------------------------------------------------------------------------- 58,158 50,728 59,923 - ---------------------------------------------------------------------------- Income (loss) before income taxes 64,123 50,593 (37,014) Income taxes: Current and deferred 22,825 13,843 1,728 Adjustment to deferred taxes 4,857 - ---------------------------------------------------------------------------- 27,682 13,843 1,728 - ---------------------------------------------------------------------------- NET INCOME (LOSS) $36,441 $36,750 $(38,742) ============================================================================ See notes to consolidated financial statements. STATEMENT OF CONSOLIDATED STOCKHOLDER'S EQUITY (Dollars in Thousands) - ---------------------------------------------------------------------------- Years Ended December 31, 1993 1992 1991 - ---------------------------------------------------------------------------- COMMON STOCK: Balance, beginning and end of year $25 $25 $25 - ---------------------------------------------------------------------------- ADDITIONAL CAPITAL: Balance, beginning of year 298,665 270,680 272,355 Contributions from (distribution to) The Dial Corp 27,985 (1,675) - ---------------------------------------------------------------------------- Balance, end of year 298,665 298,665 270,680 - ---------------------------------------------------------------------------- RETAINED INCOME: Balance, beginning of year 33,783 10,605 64,382 Net income (loss) 36,441 36,750 (38,742) Dividends (15,850) (13,572) (15,035) - ---------------------------------------------------------------------------- Balance, end of year 54,374 33,783 10,605 - ---------------------------------------------------------------------------- CUMULATIVE TRANSLATION ADJUSTMENTS: Balance, beginning of year (6,685) (1,639) 351 Unrealized translation loss (1,088) (5,046) (1,990) - ---------------------------------------------------------------------------- Balance, end of year (7,773) (6,685) (1,639) - ---------------------------------------------------------------------------- STOCKHOLDER'S EQUITY $345,291 $325,788 $279,671 ============================================================================ See notes to consolidated financial statements. STATEMENT OF CONSOLIDATED CASH FLOWS (Dollars in Thousands) - ---------------------------------------------------------------------------- Years Ended December 31, 1993 1992 1991 - ---------------------------------------------------------------------------- OPERATING ACTIVITIES: Net income (loss) $36,441 $36,750 $(38,742) Adjustments to reconcile net income (loss) to net cash provided (used) by operating activities: Provision for possible credit losses 5,706 6,740 77,687 Gains on sale of assets (5,439) (3,362) (6,684) Deferred income taxes 21,608 (4,837) (17,760) Increase in accounts payable and accrued expenses 2,545 4,418 19,275 Decrease in customer deposits (12,287) (577) (126,979) (Decrease) increase in interest payable (5,429) 3,576 (4,906) Other (475) (10,019) 29,035 - ---------------------------------------------------------------------------- Net cash provided (used) by operating activities 42,670 32,689 (69,074) - ---------------------------------------------------------------------------- INVESTING ACTIVITIES: Proceeds from sale of assets 5,681 22,657 35,141 Principal collections on financing transactions 644,939 454,390 338,451 Expenditures for financing transactions (1,007,794) (682,369) (525,659) Purchase of subsidiary (69,808) Net related party advances 57,321 (57,321) Other 221 392 (5,213) - ---------------------------------------------------------------------------- Net cash used by investing activities (369,440) (262,251) (157,280) - ---------------------------------------------------------------------------- FINANCING ACTIVITIES: Borrowings 646,701 974,232 760,947 Repayment of borrowings (451,102) (829,212) (539,609) Issuance of preferred stock 25,000 Advances and contributions from The Dial Corp 54,331 32,575 Net advances from Parent 130,760 Dividends (15,850) (13,572) (15,035) - ---------------------------------------------------------------------------- Net cash provided by financing 310,509 210,779 238,878 activities - ---------------------------------------------------------------------------- (Decrease) increase in cash and cash equivalents (16,261) (18,783) 12,524 Cash and cash equivalents, beginning of year 19,120 37,903 25,379 - ---------------------------------------------------------------------------- Cash and cash equivalents, end of year $2,859 $19,120 $37,903 ============================================================================ See notes to consolidated financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (Dollars in Thousands in Tables) NOTE A SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation and Principles of Consolidation--On March 3, 1992, The Dial Corp's ("Dial") shareholders approved the spin-off to its shareholders of GFC Financial Corporation ("GFC Financial"), a newly-formed Delaware corporation, which comprised Dial's former commercial lending and mortgage insurance subsidiaries. In connection with the spin-off, the holders of common stock of Dial received a distribution of one share of common stock of GFC Financial for every two shares of Dial common stock (the "Distribution"). Prior to the Distribution, Dial contributed its 100% ownership interest in companies constituting the Greyhound European Financial Group ("GEFG") and Greyhound BID Holding Corp. ("BID") to Greyhound Financial Corporation ("GFC") and contributed all of the common stock of GFC (collectively the "Company") to GFC Financial. The historical consolidated financial statements of GFC and subsidiaries have been retroactively restated to include the accounts and results of operations of GFC, GEFG and BID for all periods presented as if a pooling of interests of companies under common control. All intercompany accounts and transactions have been eliminated from the consolidated financial statements. These consolidated financial statements are prepared in accordance with generally accepted accounting principles. Described below are those accounting policies particularly significant to GFC, including those selected from acceptable alternatives. Financing Transactions--For loans and other financing contracts earned income is recognized over the life of the contract, using the interest method. Leases that are financed by nonrecourse borrowings and meet certain other criteria are classified as leveraged leases. For leveraged leases, aggregate rentals receivable are reduced by the related nonrecourse debt service obligation including interest ("net rentals receivable"). The difference between (a) the net rentals receivable and (b) the cost of the asset less estimated residual value at the end of the lease term is recorded as unearned income. Earned income is recognized over the life of the lease at a constant rate of return on the positive net investment, which includes the effects of deferred income taxes. For operating leases, earned income is recognized on a straight-line basis over the lease term and depreciation is taken on a straight-line basis over the estimated useful life. Operating lease income is net of depreciation and related expenses. For leases classified as direct financing leases, the difference between (a) aggregate lease rentals and (b) the cost of the related assets less estimated residual value at the end of the lease term is recorded as unearned income. Earned income is recognized over the life of the contracts using the interest method. Income recognition is generally suspended for leases, loans and other financing contracts at the earlier of the date at which payments become 90 days past due (other than consumer finance accounts of GEFG, which are considered nonaccruing when 180 days past due) or when, in the opinion of management, a full recovery of income and principal becomes doubtful. Income recognition is resumed when the loan becomes contractually current and performance is demonstrated to be resumed. The reserve for possible credit losses is available to absorb credit losses. The provision for possible credit losses is the charge to income to increase the reserve for possible credit losses to the level that management estimates to be adequate considering delinquencies, loss experience and collateral. Other factors include changes in geographic and product diversification, size of the portfolio and current economic conditions. Accounts are either written-off or written-down when the probability of loss has been established in amounts determined to cover such losses after giving consideration to the customer's financial condition, the value of the underlying collateral and any guarantees. Any deficiency between the carrying amount of an asset and the ultimate sales price of repossessed collateral is charged to the reserve for possible credit losses. Recoveries of amounts previously written-off as uncollectible are credited to the reserve for possible credit losses. Repossessed assets are carried at the lower of cost or fair value. Loans classified as in-substance foreclosures are included in repossessed assets. Loans are classified as in-substance foreclosed assets, even though legal foreclosure has not occurred, when (i) the borrower has little or no equity in the collateral at its current fair value, (ii) proceeds for repayment are expected to come only from the operation or sale of the collateral and (iii) it is doubtful that the borrower will rebuild equity in the collateral or otherwise repay the loan in the foreseeable future. The Financial Accounting Standards Board ("FASB") has issued a new accounting standard, SFAS No. 114, "Accounting by Creditors for Impairment of a Loan" ("SFAS 114"). This standard requires that impaired loans that are within the scope of this statement generally be measured based on the present value of expected cash flows discounted at the loan's effective interest rate or the fair value of the collateral, if the loan is collateral dependent. Under SFAS 114, a loan is considered impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts due. Presently, the reserve for possible credit losses represents management's estimate of the amount necessary to cover potential losses in the portfolio considering delinquencies, loss experience and collateral. The impact of the new standard, which is effective for fiscal years beginning after December 15, 1994, has not yet been determined. Pension and Other Benefits--Trusteed, noncontributory pension plans cover substantially all employees. Benefits are based primarily on final average salary and years of service. Net periodic pension cost for GFC is based on the provisions of SFAS No. 87, "Employers' Accounting for Pensions". Funding policies provide that payments to pension trusts shall be at least equal to the minimum funding required by applicable regulations. Effective January 1, 1993, the Company adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", which requires accrual of such benefits during the years the employees provide services. Prior to 1993, the costs of such benefits were expensed as incurred. See Note G of Notes to Consolidated Financial Statements for further information. In November 1992, the FASB issued SFAS No. 112, "Employers' Accounting for Postemployment Benefits". Analogous to SFAS No. 106 for postretirement benefits, this standard requires companies to accrue for estimated future postemployement benefits during the periods when employees are working. Postemployment benefits are any benefits other than retirement benefits that are provided after employment is discontinued. This standard must be adopted for fiscal years beginning after December 15, 1993, which for the Company would be 1994. Based on management's review, the adoption of the new standard will not have a material impact on the Company's financial position or results of operations. Income Taxes--Income taxes are provided based upon the provisions of SFAS No. 109, "Accounting for Income Taxes" ("SFAS 109"). Under SFAS 109, deferred tax assets and liabilities are recognized for the estimated future tax effects attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax law. Cash Equivalents--For purposes of the Statement of Consolidated Cash Flows, the Company has classified highly liquid investments with original maturities of three months or less from date of purchase as cash equivalents. Reclassifications--Certain reclassifications have been made to the 1992 financial statements to conform to the 1993 presentation. NOTE B INVESTMENT IN FINANCING TRANSACTIONS The Company provides secured financing to commercial and real estate enterprises principally under financing contracts (such as loans and other financing contracts, leveraged leases, operating leases and direct financing leases). At December 31, 1993 and 1992, the carrying amount of the investment in financing transactions, including the estimated residual value of leased assets upon lease termination, was $2,846,571,000 and $2,485,844,000 (before reserve for possible credit losses), respectively, and consisted of the following types of loans and collateral: - ---------------------------------------------------------------------------- Percent of Total Carrying Amount - ---------------------------------------------------------------------------- 1993 1992 - ---------------------------------------------------------------------------- Resort receivables 19.8% 18.3% Aircraft and related equipment 19.6 19.1 Communications finance 17.8 16.2 Commercial real estate 12.4 18.1 Real estate leveraged leases 6.9 7.3 Asset based finance 6.2 Production and processing equipment 4.7 5.8 Land receivables 2.6 3.7 Railroad equipment 2.6 2.5 Consumer finance (GEFG) 1.6 2.3 Commercial vehicles 0.4 1.4 Other (1) 5.4 5.3 - ---------------------------------------------------------------------------- 100.0% 100.0% ============================================================================ (1) The category "Other" includes different classes of commercial and industrial contract receivables, none of which accounted for more than 1% of the aggregate carrying amount of the net investment in financing transactions. The Company's investment in financing transactions outside of the United States at December 31 consisted of the following: - ---------------------------------------------------------------------------- 1993 1992 - ---------------------------------------------------------------------------- Europe, primarily United Kingdom $ 196,499 $ 206,893 Mexico 30,952 33,827 Other countries 17,740 38,168 - ---------------------------------------------------------------------------- $ 245,191 $ 278,888 ============================================================================ The Company's investment in financing transactions is primarily settled in U.S. dollars, except for approximately $100,000,000 and $128,000,000 at December 31, 1993 and 1992, respectively, which is primarily due in British pounds. The exchange rate of British pounds to dollars at December 31, 1993 and 1992 was 1.48:1 and 1.52:1, respectively. Aggregate installments on loans and other financing contracts, leveraged leases, operating leases and direct financing leases at December 31, 1993 (excluding repossessed assets of $77,024,000 and estimated residual values) are due during each of the years ending December 31, 1994 to 1998 and thereafter as follows: - ---------------------------------------------------------------------------- There- 1994 1995 1996 1997 1998 after - ---------------------------------------------------------------------------- Domestic: Loans and other financing contracts: Commercial: Fixed interest rate $ 80,796 $ 77,294 $ 72,707 $ 45,984 $ 31,600 $ 81,838 Floating interest rate 179,164 211,921 218,987 141,294 126,221 75,418 Real Estate: Fixed interest rate 61,416 43,634 39,777 27,935 18,702 46,941 Floating interest rate 147,101 167,375 147,507 92,831 53,461 39,204 Leveraged leases 4,834 5,385 7,282 13,862 8,395 171,883 Operating and direct financing leases, primarily at fixed interest rates 21,120 20,389 29,295 17,907 16,873 115,737 - ---------------------------------------------------------------------------- 494,431 525,998 515,555 339,813 255,252 531,021 - ---------------------------------------------------------------------------- Foreign, primarily at floating interest rates: Loans and other financing contracts 10,078 6,429 8,915 16,007 23,700 Consumer Finance 14,122 7,858 7,212 9,617 5,255 1,200 Operating and direct financing leases 4,284 3,038 4,343 2,496 2,870 - ---------------------------------------------------------------------------- 28,484 17,325 20,470 28,120 31,825 1,200 - ---------------------------------------------------------------------------- $522,915 $543,323 $536,025 $367,933 $287,077 $532,221 ============================================================================ The net investment in leveraged leases at December 31 consisted of the following: - ---------------------------------------------------------------------------- 1993 1992 - ---------------------------------------------------------------------------- Rentals receivable $1,377,107 $1,451,925 Less principal and interest payable on nonrecourse debt (1,165,466) (1,237,776) - ---------------------------------------------------------------------------- Net rentals receivable 211,641 214,149 Estimated residual values 306,894 306,691 Less unearned income (234,753) (251,470) - ---------------------------------------------------------------------------- Investment in leveraged leases 283,782 269,370 Less deferred taxes arising from leveraged leases (223,006) (206,342) - ---------------------------------------------------------------------------- Net investment in leveraged leases $60,776 $63,028 ============================================================================ The components of income from leveraged leases, before the effects of interest on nonrecourse debt and other related expenses, for the years ended December 31 were as follows: - ---------------------------------------------------------------------------- 1993 1992 1991 - ---------------------------------------------------------------------------- Lease and other income $11,376 $ 9,172 $16,421 Income tax expense 8,363 2,757 4,903 - ---------------------------------------------------------------------------- The investment in operating and direct financing leases at December 31 consisted of the following: - ---------------------------------------------------------------------------- 1993 1992 - ---------------------------------------------------------------------------- Operating leases $147,222 $100,911 Direct financing leases: Rentals receivable 91,153 154,463 Estimated residual values 23,121 42,158 Unearned income (42,462) (57,750) - ---------------------------------------------------------------------------- 71,812 138,871 - ---------------------------------------------------------------------------- Investment in operating and direct financing leases $219,034 $239,782 ============================================================================ The investment in operating leases is net of accumulated depreciation of $10,601,000 and $4,110,000 as of December 31, 1993 and 1992, respectively. Depreciation expense relating to equipment held under operating leases was $6,491,000, $2,531,000 and $1,685,000 in 1993, 1992 and 1991, respectively. The Company has a substantial number of loans and leases with payments that fluctuate with changes in index rates, primarily Prime interest rates and the London Interbank Offered Rate ("LIBOR"). The investment in loans and leases with floating interest rates (excluding nonaccruing contracts and repossessed assets) at December 31 was as follows: - ---------------------------------------------------------------------------- 1993 1992 - ---------------------------------------------------------------------------- Receivables due on financing transactions $1,661,602 $1,368,412 Estimated residual values 8,162 Less unearned income (25,928) (34,899) - ---------------------------------------------------------------------------- Investment in loans and leases $1,635,674 $1,341,675 ============================================================================ Interest earned from financing transactions with floating interest rates was approximately $154,000,000 in 1993, $127,000,000 in 1992 and $128,000,000 in 1991. The adjustments, which arise from changes in index rates, can have a significant effect on interest earned from financing transactions; however, the effects on interest margins earned and net income are substantially offset by related interest expense changes on debt obligations with floating interest rates. At December 31, 1993, the Company had a committed backlog of new business of approximately $420,000,000 compared to $317,000,000 at December 31, 1992. NOTE C RESERVE FOR POSSIBLE CREDIT LOSSES The following is an analysis of the reserve for possible credit losses for the years ended December 31: - ---------------------------------------------------------------------------- 1993 1992 1991 - ---------------------------------------------------------------------------- Balance, beginning of year $69,291 $87,600 $77,098 Provision for possible credit losses (1) 5,706 6,740 77,687 Write-offs (1) (12,575) (23,661) (68,346) Recoveries 717 749 663 Other 1,141 (2,137) 498 - ---------------------------------------------------------------------------- Balance, end of year $64,280 $69,291 $87,600 ============================================================================ (1) In the fourth quarter of 1991, the Company recorded a special provision for possible credit losses of $65,000,000 and recorded write-offs of $15,000,000 related to nonearning assets in the GEFG portfolio and a $47,759,000 write-down to reduce Latin American assets to current market value. Write-offs by major loan and collateral types experienced by the Company during the years ended December 31 are as follows: - ---------------------------------------------------------------------------- 1993 1992 1991 - ---------------------------------------------------------------------------- Consumer finance (GEFG) $ 4,071 $ 10,176 $ 13,687 Commercial real estate 3,082 8,904 2,894 Manufacturing and processing equipment 2,242 1,908 604 Commercial vehicles 1,579 67 Communications finance 1,488 1,500 1,200 Maritime 906 Latin America 47,759 Other 113 267 2,135 - ---------------------------------------------------------------------------- $ 12,575 $ 23,661 $ 68,346 ============================================================================ Write-offs as a percentage of investment in financing transactions 0.44% 0.95% 3.00% ============================================================================ An analysis of nonaccruing contracts and repossessed assets at December 31 is as follows: - ---------------------------------------------------------------------------- 1993 1992 - ---------------------------------------------------------------------------- Nonaccruing contracts: Domestic $ 13,263 $ 24,031 Foreign 12,320 22,400 - ---------------------------------------------------------------------------- Total nonaccruing contracts 25,583 46,431 - ---------------------------------------------------------------------------- Repossessed assets: Domestic 77,001 53,931 Foreign 23 60 - ---------------------------------------------------------------------------- Total repossessed assets 77,024 53,991 - ---------------------------------------------------------------------------- Total nonaccruing contracts and repossessed assets $ 102,607 $ 100,422 ============================================================================ Nonaccruing contracts and repossessed assets as a percentage of investment in financing transactions 3.6% 4.0% ============================================================================ In addition to the repossessed assets included in the above table, the Company had repossessed assets, with a total carrying amount of $48,956,000 and $21,509,000 at December 31, 1993 and 1992 which earned income of $2,700,000 and $1,900,000 during 1993 and 1992, respectively. In the normal course of business, the Company has renegotiated and modified certain contracts with respect to rates and other terms. At December 31, 1993 and 1992, the Company had approximately $47,000,000 and $68,000,000, respectively, of these rewritten contracts requiring disclosure under the provisions of SFAS No. 15, "Accounting by Debtors and Creditors for Troubled Debt Restructurings". These contracts are yielding, on a weighted average basis, a return of approximately 9.3%. Had all contracts placed in a nonaccrual status outstanding at December 31, 1993, 1992 and 1991, respectively, remained accruing, interest earned would have been increased by approximately $6,000,000, $7,500,000 and $11,300,000, respectively, for domestic contracts and $5,000,000, $5,100,000 and $9,100,000, respectively, for foreign contracts. Income recognized on these accounts was approximately $1,732,000, $589,000 and $1,100,000 for domestic contracts during the years 1993, 1992 and 1991, respectively. NOTE D DEBT The Company satisfies its short-term financing requirements from bank lines of credit, other bank loans, public medium-term notes and the issuance of commercial paper. In conjunction with the winding down of the GEFG portfolio, GEFG, in December 1993, surrendered the banking license of the United Kingdom bank and, therefore, will not be taking in any more customer deposits. At December 31, 1993, short-term bank loans and commercial paper of $515,876,000 (net of unamortized discount) are considered to be long-term debt because they are supported by an unused long-term revolving bank credit agreement of $700,000,000. The following information pertains to all short-term financing, including bank loans and commercial paper (considered to be long-term debt), for the years ended December 31: - --------------------------------------------------------------------------- 1993 1992 1991 - --------------------------------------------------------------------------- Maximum amount of short-term debt outstanding during year $ 516,386 $ 504,829 $ 533,446 Average short-term debt outstanding during year 336,672 322,176 448,174 Weighted average short-term interest rates at end of year: Short-term borrowings 3.5% 4.1% 8.1% Commercial paper* 3.6% 4.2% 5.6% Weighted average interest rate on short- term debt outstanding during year* 3.5% 4.3% 6.9% - ---------------------------------------------------------------------------- * Exclusive of the cost of maintaining bank lines in support of outstanding commercial paper and the effects of interest rate conversion agreements. Senior and subordinated debt at December 31 was as follows: - ---------------------------------------------------------------------------- 1993 1992 - ---------------------------------------------------------------------------- Senior debt: Commercial paper and short-term bank loans supported by unused long-term bank revolving credit agreements, less unamortized discount $515,876 $330,141 Medium-term notes due to 2003, 4.6% to 12.5% 751,500 591,433 Term loans payable to banks due to 1996, 4.2% 150,000 310,000 Senior notes due to 2002, 8.3% to 16.0%, less unamortized discount 555,666 555,147 Nonrecourse installment notes due to 2002, 10.6% (assets of $25,613 and $25,579, respectively, pledged as collateral) 18,944 19,712 - ---------------------------------------------------------------------------- Total senior debt 1,991,986 1,806,433 - ---------------------------------------------------------------------------- Subordinated debt: Senior subordinated loans, due 1994, 14.1% 92,270 92,270 Less unamortized discount (5,480) (16,354) - ---------------------------------------------------------------------------- Total subordinated debt 86,790 75,916 - ---------------------------------------------------------------------------- TOTAL $2,078,776 $1,882,349 ============================================================================ Aggregate commitments under the Company's domestic revolving credit agreement availability was $700,000,000 at December 31, 1993. Under the terms of this agreement, the Company has the option to periodically select either domestic dollars or Eurodollars as the basis of borrowings. Interest is based on the banks' Prime rate for domestic dollar advances or LIBOR for Eurodollar advances. The agreements also provide for a commitment fee on the unused credit. The Company, in the event it becomes advisable, intends to exercise its right under this agreement to borrow for the purpose of refinancing commercial paper and short-term bank loans. The credit agreement for $700,000,000, described in the preceding paragraph, will be subject to renewal in May 1996. If the credit facility with any or all of the participating banks is not renewed, the Company may, at its option, repay the non-renewing banks' outstanding participation, if any, immediately or in equal quarterly installments over a four year period. As of December 31, 1993, the Company had outstanding 31 interest rate conversion agreements with notional principal amounts totaling $1,320,000,000. Six agreements with notional principal amounts of $180,000,000 were arranged to effectively convert certain floating interest rate obligations into fixed interest rate obligations and require interest payments on the stated principal amount at rates ranging from 8.3% to 9.8% (remaining terms of three months to five years) in return for receipts calculated on the same notional amounts at floating interest rates. In addition, 25 agreements with notional principal amounts of $1,140,000,000 were arranged to effectively convert certain fixed interest rate obligations into floating interest rate obligations and require interest payments on the stated principal amount at the three month or six month LIBOR (remaining terms of five months to nine years) in return for receipts calculated on the same notional amounts at fixed interest rates of 4.9% to 7.6%. In the third quarter of 1993, GFC entered into four three-year interest rate hedge agreements on $750 million of floating-rate borrowings to effectively guarantee a spread of approximately 2.3% between its borrowing rate (LIBOR) and the Prime interest rate. The agreements have been entered into with major financial institutions, which are expected to fully perform under the terms of the agreements, thereby mitigating the credit risk from the transactions. Annual maturities of long-term debt outstanding at December 31, 1993 due through June 2003 (excluding the amount supported by the revolving credit agreements expected to be renewed) will approximate $179,392,000 (1994), $192,135,000 (1995), $163,030,000 (1996), $198,747,000 (1997), $204,072,000 (1998) and $625,524,000 (thereafter). The agreements pertaining to long-term debt of GFC include various restrictive covenants and require the maintenance of certain defined financial ratios with which GFC has complied. Under one of these covenants, dividend payments are limited to 50 percent of accumulated earnings after December 31, 1991. As of December 31, 1993, GFC had $7,174,000 of excess accumulated earnings available for distribution. Total interest paid is not significantly different from interest expense. NOTE E REDEEMABLE PREFERRED STOCK On July 30, 1993, GFC Financial acquired 2,500 shares of GFC's Series A Redeemable Preferred Stock ("GFC Preferred Stock") from a subsidiary of Dial. The GFC Preferred Stock was issued in connection with the Distribution for a purchase price of $25 million in cash. The GFC Preferred Stock, par value of $10,000 per share, entitles the holder thereof to receive cash dividends at the annual rate of 9%, payable quarterly, but only, when, as and if declared by the Board of Directors of GFC, and such dividends shall be cumulative (provided that such rate shall increase to 15% per annum in the event that GFC fails to redeem such shares on July 1, 1997). The GFC Preferred Stock has a liquidation preference of $10,000 per share, and ranks prior to the common stock, par value $1 per share, of GFC (the "GFC Common Stock"), both as to payment of dividends and as to distribution of assets upon liquidation, dissolution or winding up of GFC. The GFC Preferred Stock is redeemable, in whole or in part, at the option of GFC, at $10,000 in cash per share plus accrued and unpaid dividends, and must be redeemed, on July 1, 1997, for $10,000 per share. In addition, the GFC Preferred Stock must be redeemed if, prior to July 1, 1997, GFC receives at least $25 million of proceeds from the issuance of additional preferred or common stock or other contributions to its capital. With the consent of the holders of at least two thirds of the GFC Preferred Stock, GFC may defer the mandatory redemption beyond July 1, 1997, for a specified period of time. Each share of GFC Preferred Stock has one vote and votes together with the GFC Common Stock on all matters submitted to a vote of the shareholders of GFC. There are 25,000 shares of GFC Common Stock issued and outstanding, all of which are owned by GFC Financial. Thus, the GFC Preferred Stock represents approximately 9% of the voting securities of GFC. NOTE F INCOME TAXES Prior to the Distribution, Dial credited or charged the Company an amount equal to the tax reductions realized or tax payments made by Dial as a result of including the Company's tax results and credits in Dial's consolidated federal and other applicable income tax returns. In all other respects, the Company's tax provisions have been computed on a separate return basis. The consolidated provision (benefit) for income taxes consist of the following for the years ended December 31: - ---------------------------------------------------------------------------- 1993 1992 1991 - ---------------------------------------------------------------------------- Current: United States: Federal $4,976 $16,265 $20,087 State 1,254 2,069 1,364 Foreign (156) 346 (1,963) - ---------------------------------------------------------------------------- 6,074 18,680 19,488 - ---------------------------------------------------------------------------- Deferred: United States 21,608 (2,377) (17,760) Foreign (2,460) - ---------------------------------------------------------------------------- 21,608 (4,837) (17,760) - ---------------------------------------------------------------------------- Provision for income taxes $27,682 $13,843 $1,728 ============================================================================ Deferred income taxes relate to the following principal temporary differences: - ---------------------------------------------------------------------------- 1993 1992 1991 - ---------------------------------------------------------------------------- Lease and other contract income and related depreciation $13,791 $3,882 $6,244 Gains on sale of assets (1,377) 1,726 (16,732) Provision for possible credit losses (277) 1,551 (8,175) Recognition of deferred intercompany gain (7,531) Adjustment to deferred taxes related to the increase in the U.S. federal statutory income tax rate 4,857 Operating expense deferrals 2,365 Recognition of tax benefit on refinancing charges accrued in 1991 (3,153) Minimum tax credit carryforward 1,456 Other 793 1,148 903 - ---------------------------------------------------------------------------- Provision (benefit) for deferred income taxes $21,608 $(2,377) $(17,760) ============================================================================ The benefit for foreign deferred income taxes for the year ended December 31, 1992 relates to operating losses of GEFG. Income taxes paid in 1993, 1992 and 1991 amounted to $10,511,000, $19,096,000 and $16,769,000, respectively. The federal statutory income tax rate is reconciled to the effective income tax rate as follows: - ---------------------------------------------------------------------------- 1993 1992 1991 - ---------------------------------------------------------------------------- Federal statutory income tax rate 35.0% 34.0% (34.0%) State income tax 3.4% 2.7% 2.3% Foreign tax effects (2.1%) (2.4%) 11.7% Tax provision on intercompany gains resulting from the Distribution 21.6% Recognition of tax benefits on refinancing charges accrued in 1991 (6.2%) Permanent differences on transaction costs 12.0% Other (0.7%) (0.7%) (8.9%) - ---------------------------------------------------------------------------- Current provision for income tax 35.6% 27.4% 4.7% Adjustment to deferred taxes 7.6% - ---------------------------------------------------------------------------- Provision for income taxes 43.2% 27.4% 4.7% ============================================================================ NOTE G PENSION AND OTHER BENEFITS Pension Benefits Net periodic pension (income) cost for the years ended December 31, included the following components: - ---------------------------------------------------------------------------- United States Foreign - ---------------------------------------------------------------------------- 1993 1992 1993 1992 - ---------------------------------------------------------------------------- Service cost benefits earned during period $603 $493 $215 $341 Interest cost on projected benefit obligation 638 499 293 345 Actual return on plan assets (1,504) (1,071) (736) (382) Net amortization and deferral 625 303 459 79 - ---------------------------------------------------------------------------- Periodic pension cost 362 224 231 383 Curtailment gain (777) - ---------------------------------------------------------------------------- Net periodic pension (income) cost $(415) $224 $231 $383 ============================================================================ Assumptions regarding the determination of net periodic pension (income) costs were: - ---------------------------------------------------------------------------- United States Foreign - ---------------------------------------------------------------------------- 1993 1992 1993 1992 - ---------------------------------------------------------------------------- Discount rate for obligation 8.5% 9.0% 9.0% 9.0% Rate of increase in compensation levels 5.5% 6.0% 8.0% 8.0% Long-term rate of return on assets 9.5% 9.5% 9.0% 9.0% - ---------------------------------------------------------------------------- GFC participated in a Dial pension plan and was allocated pension credits of $21,000 for 1991. The following table indicates the plans' funded status and amounts recognized in the Company's consolidated balance sheet at December 31, 1993 and 1992: - ---------------------------------------------------------------------------- United States Foreign - ---------------------------------------------------------------------------- 1993 1992 1993 1992 - ---------------------------------------------------------------------------- Actuarial present value of benefit obligations: Vested benefit obligations $12,000 $3,195 $3,440 $3,088 ============================================================================ Accumulated benefit obligations $12,600 $3,835 $3,440 $3,088 ============================================================================ Projected benefit obligation $14,400 $6,724 $3,755 $3,548 Market value of plan assets, primarily equity and fixed income securities 17,606 9,625 3,781 3,319 - ---------------------------------------------------------------------------- Plan asset over (under) projected benefit obligation 3,206 2,901 26 (229) Unrecognized transition asset (451) (285) (109) (123) Unrecognized prior service cost reduction 404 450 72 96 Unrecognized net loss 1,804 539 101 254 - ---------------------------------------------------------------------------- Prepaid (accrued) pension costs $4,963 $3,605 $90 $(2) ============================================================================ Assumptions regarding the funded status of pension plans are: - ---------------------------------------------------------------------------- United States Foreign - ---------------------------------------------------------------------------- 1993 1992 1993 1992 - ---------------------------------------------------------------------------- Discount rate for obligation 7.75% 8.50% 8.00% 9.00% Rate of increase in compensation levels 4.25% 5.50% 6.00% 8.00% Long-term rate of return on assets 9.50% 9.50% 9.00% 9.00% - ---------------------------------------------------------------------------- There are restrictions on the use of excess pension plan assets in the event of a defined change in control of the Company. Postretirement Benefits Other Than Pensions Effective January 1, 1993, the Company adopted the provisions of SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("OPEB"), which requires the accrual of retiree benefits during the years the employees provide services. OPEB requires the recognition of a transition obligation that represents the aggregate amount that would have accrued in the years prior to adoption of OPEB had the standard been in effect for those years. The Company elected to accrue the transition obligation over 20 years. The adoption of SFAS No. 106 has no cash impact because the plans are not funded and the pattern of benefit payments did not change. Net periodic postretirement benefit cost for the year ended December 31, 1993 included the following components: - ---------------------------------------------------------------------------- Service cost benefits earned during period $ 55 Interest cost on accumulated postretirement benefit obligation 143 Net amortization and deferral 85 - ---------------------------------------------------------------------------- Net periodic postretirement benefit cost $ 283 ============================================================================ Assumptions regarding the determination of net periodic postretirement benefit costs were: - ---------------------------------------------------------------------------- Discount rate for obligation 8.5% Rate of increase in compensation levels 5.5% Rate of increase in health care costs (1) 14.0% ============================================================================ (1) Rate of increase in health care costs was 14.0% in 1993, graded to 7.0% in 2000 and thereafter. OPEB benefit costs for 1993 are $223,000 higher than postretirement benefits paid and expensed in 1992 due to the adoption of SFAS No. 106. Amounts paid for postretirement benefits in 1992 and 1991 were approximately $60,000 and $38,000, respectively. The following table indicates the amounts recognized in the Company's consolidated balance sheet at December 31, 1993: - --------------------------------------------------------------------------- Accumulated postretirement benefit obligation: Retirees $ 1,680 Actives eligible for full benefits 230 Other actives 370 - --------------------------------------------------------------------------- Total accumulated postretirement benefit obligation 2,280 Unrecognized transition obligation 1,607 Unrecognized net loss 437 - --------------------------------------------------------------------------- Accrued postretirement benefit cost $ 236 =========================================================================== Assumptions regrading the accrued postretirement benefit at December 31, 1993 were: - ---------------------------------------------------------------------------- Discount rate for obligation 7.75% Rate of increase in compensation levels 4.25% Rate of increase in health care costs (1) 13.25% - ---------------------------------------------------------------------------- (1) Rate of increase in health care costs was 13.25% in 1993, graded to 6.25% in 2000 and thereafter. A one percentage point increase in the assumed health care cost trend rate for each year would increase the accumulated postretirement benefit obligation as of December 31, 1993 by approximately 7% and the ongoing annual expense by approximately 5%. NOTE H TRANSACTIONS WITH DIAL Pursuant to the Distribution, the Company and Dial entered into several agreements, including the Distribution Agreement, Tax Sharing Agreement, Sublease Agreement, Interim Services Agreement and Trademark Assignment and Agreement. These agreements do not result in significant additional expenses. The Company leases its corporate office facilities from Dial under an agreement which expires March 31, 2001. Annual rentals under the lease are approximately $1,616,000 to 1996 and $1,806,000 thereafter. NOTE I LITIGATION AND CLAIMS The Company and certain of its subsidiaries are parties either as plaintiffs or defendants to various actions, proceedings and pending claims, including legal actions, certain of which involve claims for compensatory, punitive or other damages in material amounts. Litigation is subject to many uncertainties and it is possible that some of the legal actions, proceedings or claims referred to above could be decided against the Company. Although the ultimate amount for which the Company or its subsidiaries may be held liable is not ascertainable, the Company believes that any resulting liability should not materially affect the Company's financial position or results of operations. NOTE J SFAS NO. 107 - "DISCLOSURE ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS" The following disclosure of the estimated fair value of financial instruments is made in accordance with the requirements of SFAS No. 107, "Disclosures About Fair Value of Financial Instruments". The estimated fair value amounts have been determined by the Company using available market information and valuation methodologies described below. However, considerable judgment is required in interpreting market data to develop the estimates of fair value. Accordingly, the estimates presented herein may not be indicative of the amounts that the Company could realize in a current market exchange. The use of different market assumptions or valuation methodologies may have a material effect on the estimated fair value amounts. The carrying amounts and estimated fair values of the Company's financial instruments are as follows for the years ended December 31: - --------------------------------------------------------------------------- 1993 1992 - --------------------------------------------------------------------------- Carrying Estimated Carrying Estimated Amount Fair Value Amount Fair Value - --------------------------------------------------------------------------- Balance Sheet - Financial Instruments: Assets: Loans and other financing contracts $ 2,192,192 $ 2,172,154 $ 1,854,761 $ 1,812,864 Liabilities: Senior debt 1,991,986 2,149,387 1,806,433 1,847,875 Subordinated debt 86,790 88,390 75,916 83,915 Off-Balance Sheet - Financial Instruments: Interest rate conversion agreements --- 36,361 ---- 4,536 - ---------------------------------------------------------------------------- The carrying values of cash and cash equivalents, accounts payable and accrued expenses, customer deposits, interest payable and short-term debt approximate fair values due to the short-term maturities of these instruments. The methods and assumptions used to estimate the fair values of other financial instruments are summarized as follows: Loans and other financing contracts: The fair value of loans and other financing contracts was estimated by discounting expected cash flows using the current rates at which loans of similar credit quality, size and remaining maturity would be made as of December 31, 1993 and 1992. Management believes that the risk factor embedded in the entry-value interest rates applicable to performing loans for which there are no known credit concerns results in a fair valuation of such loans on an entry value basis. As of December 31, 1993 and 1992, the fair value of nonaccruing contracts with a carrying amount of $25,583,000 and $46,431,000, respectively, was not estimated because it is not practicable to reasonably assess the credit adjustment that would be applied in the market place for such loans. As of December 31, 1993 and 1992, the carrying amount of loans and other financing contracts excludes repossessed assets with a total carrying amount of $125,980,000 and $75,500,000, respectively. Senior and subordinated debt: The fair value of senior and subordinated debt was estimated by discounting future cash flows using rates currently available for debt of similar terms and remaining maturities. The carrying values of commercial paper and borrowings under revolving credit facilities were assumed to approximate fair values due to their short maturities. Interest rate conversion agreements: The fair values of interest conversion agreements is based on quoted market prices obtained from participating banks and dealers. The fair value estimates presented herein were based on information available as of December 31, 1993 and 1992. Although management is not aware of any factors that would significantly affect the estimated fair values, such values have not been updated since December 31, 1993 and 1992; therefore, current estimates of fair value may differ significantly from the amounts presented herein. NOTE K SELLING, ADMINISTRATIVE AND OTHER OPERATING EXPENSES: The following represents a summary of the major components of selling, administrative and other operating expenses for the three years ended December 31: - -------------------------------------------------------------------------- 1993 1992 1991 - -------------------------------------------------------------------------- Salaries and employee benefits $ 29,502 $ 27,247 $ 24,362 Problem account costs 11,822 7,642 5,790 Occupancy expense 4,160 4,494 3,444 Depreciation and amortization 2,803 1,970 1,502 Other 9,871 9,375 11,825 - -------------------------------------------------------------------------- $ 58,158 $ 50,728 $ 46,923 ========================================================================== NOTE L GEOGRAPHIC INFORMATION The Company operates primarily in the United States and Europe. Geographic information for the three years ended December 31, 1993 is shown below: - ---------------------------------------------------------------------------- Domestic Europe Consolidated - ---------------------------------------------------------------------------- Assets at year end: 1993 $ 2,699,030 $ 135,867 $ 2,834,897 1992 2,272,036 208,290 2,480,326 1991 1,960,520 351,332 2,311,852 - ---------------------------------------------------------------------------- Interest earned from financing transactions: 1993 225,688 23,012 248,700 1992 202,472 38,334 240,806 1991 197,080 54,392 251,472 - ---------------------------------------------------------------------------- Interest margins earned: 1993 106,651 15,897 122,548 1992 83,390 21,309 104,699 1991 73,647 20,265 93,912 - ---------------------------------------------------------------------------- Income (loss) before income taxes: 1993 62,822 1,301 64,123 1992 54,937 (4,344) 50,593 1991 (19,076) (17,938) (37,014) - ---------------------------------------------------------------------------- NOTE M CONDENSED QUARTERLY RESULTS (UNAUDITED) - ---------------------------------------------------------------------------- First Second Third Fourth Quarter Quarter Quarter Quarter - ---------------------------------------------------------------------------- Interest earned from financing transactions: 1993 $ 58,262 $ 62,356 $ 63,450 $ 64,632 1992 57,842 60,219 63,100 59,645 - ---------------------------------------------------------------------------- Interest expense: 1993 30,568 31,423 30,788 33,373 1992 35,263 33,896 34,580 32,368 - ---------------------------------------------------------------------------- Gains on sale of assets: 1993 2,061 179 --- 3,199 1992 --- 1,617 196 1,549 - ---------------------------------------------------------------------------- Non-interest expenses (includes provision for possible credit losses): 1993 16,339 15,022 14,389 18,114 1992 11,860 14,934 12,760 17,914 - ---------------------------------------------------------------------------- Net income: 1993 8,545 10,323 6,750 (1) 10,823 1992 7,185 8,969 10,087 10,509 - ---------------------------------------------------------------------------- (1) Income from continuing operations and net income for the third quarter of 1993 include an adjustment of $4,857,000 representing the effect of recent federal and state income tax increases applicable to deferred income taxes generated by the Company's leveraged lease portfolio. NOTE N SUBSEQUENT EVENT (Unaudited) - PURCHASE OF AMBASSADOR FACTORS AND TRICON CAPITAL CORPORATION On February 14, 1994, GFC acquired Fleet Financial Group, Inc.'s ("Fleet") factoring and asset based lending subsidiary, Fleet Factors Corporation, which operates under the trade name Ambassador Factors ("Ambassador"). The cash purchase price of the acquisition was $248,285,000 and represented Ambassador's stockholder's equity, including a premium ($76,285,000), and repayment of the intercompany balance due from Ambassador to Fleet ($172,000,000). In addition, GFC assumed $111,526,000 due to to factored clients, $4,843,000 of accrued liabilities and $8,800,000 of additional liabilities and transaction costs. The acquisition will be accounted for as a purchase and will create approximately $30,400,000 of goodwill, which will be amortized on a straight line basis over 20 years. The acquisition was financed with proceeds received from the sale of GFC Financial's discontinued mortgage insurance subsidiary and cash generated from operations. GFC Financial, simultaneously with the acquisition, increased its investment in GFC by contributing $40,000,000 of intercompany loans as additional paid in capital of GFC. On March 4, 1994, GFC signed a definitive purchase agreement under which it will acquire all of the stock of TriCon Capital Corporation ("TriCon") from Bell Atlantic Corporation ("Bell Atlantic"), in an all-cash transaction. This transaction is subject to regulatory approvals and certain other conditions. Accordingly, there can be no assurance that the acquisition will be consummated. The cash purchase price of the acquisition is $344,250,000. In addition, GFC will assume outstanding indebtedness and liabilities of TriCon totaling $1,453,201,000 and additional accrued liabilities and acquisition costs of $7,500,000. The acquisition is expected to be accounted for as a purchase and will create approximately $69,817,000 of goodwill, which will be amortized on a straight line basis over 20 years. The cash purchase price is expected to be financed initially with the proceeds of interim debt and internally generated funds. A portion of the interim debt is expected to be replaced with additional equity to be raised in the near future by GFC Financial in public or private offerings which, together with the remaining intercompany loans from GFC Financial to GFC and other assets, will be contributed as additional paid in capital of GFC. It is not expected that such equity securities of GFC Financial will be issued prior to the consummation of the acquisition of TriCon by GFC. There can be no assurance that such an offering or the raising of the interim debt will occur. The Company's obligation to consummate the acquisition of TriCon is conditioned upon the receipt of waivers or consents from lenders under certain of the Company's credit and loan agreements with respect to certain financial covenants contained therein. The Company is in the process of obtaining such consents and waivers, believes they will be obtained and will not complete the acquisition until they are obtained. Upon receipt, such waivers and consents will be conditioned upon the receipt by the Company, not later than 120 days following the consummation of the acquisition of TriCon, of the equity investment from GFC Financial referred to above. The failure of GFC Financial to complete the equity offering or offerings and invest the required proceeds in the Company by such date would constitute a default under such credit and loan agreements, unless the Company could obtain additional waivers, consents or amendments to such credit and loan agreements. The Company's inability to obtain additional waivers, consents or amendments to such credit and loan agreements would allow GFC's lenders to declare an event of default and could result in the acceleration of the indebtedness due thereunder. Such default and/or acceleration would constitute a default under other borrowing arrangements and could result in the acceleration of substantially all of the Company's outstanding indebtedness, which would have a material adverse effect on the Company's business, financial condition and results of operations. There can be no assurance that GFC Financial will complete such equity offering or offerings and make the required investment in the Company by the required date or at any other date. The following Pro Forma Consolidated Balance Sheet (unaudited) of GFC as of December 31, 1993 and Pro Forma Statement of Consolidated Income From Continuing Operations (unaudited) for the year ended December 31, 1993 have been prepared to reflect the historical financial position and income from continuing operations as adjusted to reflect the acquisition of Ambassador and the pending acquisition of TriCon by GFC. The Pro Forma Consolidated Balance Sheet has been prepared as if such acquisitions occurred on December 31, 1993 and the Pro Forma Statement of Consolidated Income From Continuing Operations has been prepared as if such acquisitions occurred on January 1, 1993. The pro forma consolidated financial information is unaudited and is not necessarily indicative of the results that would have occurred if the acquisitions had been consummated as of December 31, 1993 or January 1, 1993. Total assets on a pro forma basis increased to $5,010,959,000 at December 31, 1993. Pro forma income from continuing operations would have been $66,693,000 after a $4,857,000 adjustment for deferred taxes applicable to leveraged leases. Excluding the $4,857,000 charge, pro forma income from continuing operations would be approximately $72 million. NOTES TO PRO FORMA CONSOLIDATED FINANCIAL STATEMENTS (1) The Pro Forma Consolidated Balance Sheet, as of December 31, 1993 and the Pro Forma Statement of Consolidated Income From Continuing Operations for the year ended December 31, 1993 include the historical balance sheet of Ambassador, incorporated herein by reference from the Company's Current Report on Form 8-K, dated February 14, 1994, as amended, as of November 30, 1993 and the historical statement of income of Ambassador for the eleven months ended November 30, 1993. ACQUISITION OF AMBASSADOR (2) To record the purchase of Ambassador, including the accrual of various liabilities and the resulting goodwill, using the proceeds advanced to GFC upon the sale of GFCFC's discontinued mortgage insurance subsidiary and cash generated from operations. (3) To record repayment of Ambassador's intercompany payable to Fleet using the proceeds advanced to GFC upon the sale of GFCFC's discontinued mortgage insurance subsidiary and cash generated from operations. (4) To record the contribution by GFCFC of $40,000,000 of intercompany loans from GFCFC to GFC as additional paid in capital of GFC. (5) Adjustments to reflect interest expense of debt repaid in 1993 with proceeds received from the sale of GFCFC's discontinued mortgage insurance operation and cash generated from operations. Such debt is assumed to be outstanding for the entire pro forma period. The adjustment is partially offset by interest saved as a result of the $40,000,000 equity contribution in item (4). (6) To record amortization of goodwill based on an amortization period of twenty years and amortization of the covenant not to compete over one year (see item (20)). (7) To record additional administrative expenses for additional employees and general overhead. (8) To record the income tax effect of items (5), (6) and (7) at GFC's effective incremental income tax rate of 40%. (9) To adjust income taxes for the lower state income tax rate applicable to GFC. ACQUISITION OF TRICON (10) To record the original capital contribution by Bell Atlantic as part of the incorporation of TriCon. (11) To transfer assets and the related debt of TriCon, not purchased by GFC, to Bell Atlantic and reduce interest earned from financing transactions for the income recorded on such assets in 1993. (12) To record issuance of notes payable to fund the deferred tax payment to Bell Atlantic for an amount equal to the deferred taxes of TriCon, exclusive of deferred tax assets. (13) To record a dividend from TriCon to Bell Atlantic and the issuance of a note payable to Bell Atlantic for the remaining principal amount of the short-term borrowings from affiliates of TriCon. (14) To record the purchase of TriCon. The acquisition of TriCon is expected to be financed initially with interim debt, the assumption of outstanding indebtedness of TriCon to Bell Atlantic, the assumption of TriCon's third party debt and liabilities and internally generated funds. A portion of the interim debt is assumed to be replaced with equity raised by GFCFC and, such equity, together with the outstanding preferred stock of GFC held by GFCFC, the remaining intercompany loans due to GFCFC from GFC and other assets will be contributed to GFC as additional paid in capital of GFC. The pro forma adjustment assumes the equity contributions were made at the beginning of the pro forma period. The interest expense related to the debt that is being replaced with equity and, therefore, nonrecurring and excluded from the pro forma consolidated statement of income from continuing operations is approximately $2,000,000. Including new debt, the debt assumed, the accrual of various additional liabilities and acquisition costs, the total purchase price of the acquisition is estimated to be $1,804,951,000 resulting in $69,817,000 of goodwill. The purchase will result in a new tax basis for TriCon's assets, eliminating the remaining deferred tax asset. (15) To reflect base fees and incremental costs related to an agreement to manage leveraged leases for Bell Atlantic. (16) To record additional interest expense resulting from additional debt to Bell Atlantic and interim debt not replaced with the proceeds from the GFCFC equity issuance in item (14). The adjustment is partially offset by the interest saved on the debt transferred to Bell Atlantic and interest saved as a result of equity contribution of the intercompany loans in item (14). (17) To record amortization of goodwill based on an amortization period of twenty years (see item (20)). (18) To reduce TriCon's income taxes for the effect of increases in income tax rates for 1993 (principally the increase in the federal tax rate) due to the deferred tax payment and new tax basis in assets at the beginning of the pro forma period. (19) To record the income tax effect of adjustments (11) and (15) through (17) at GFC's effective incremental income tax rate of 40%. (20) Goodwill may be adjusted as the final allocation of the values of the purchased assets and liabilities is established. GREYHOUND FINANCIAL CORPORATION COMMISSION FILE NUMBER 1-7543 EXHIBIT INDEX DECEMBER 31, 1993 FORM 10-K Page No. in Sequentially Numbered Form 10-K No. Title Report - --------- ------------------------------------------------------ ---------- (3-A) The Company's Certificate of Incorporation, as amended through the date of this filing (incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1991 (the "1991 10-K"), Exhibit 3-A. (3-B) The Company's By-Laws, as amended through the date of this filing, (incorporated by reference from the Company's 1991 10-K, Exhibit 3-B. (4-A) Instruments with respect to issues of long-term debt have not been filed as exhibits to this Annual Report on Form 10-K if the authorized principal amount of any one of such issues does not exceed 10% of total assets of the Company and its subsidiaries on a consolidated basis. The Company agrees to furnish a copy of each such instrument to the Securities and Exchange Commission upon request. (4-B-1) Form of Common Stock Certificate of the Company from the Company's Annual Report on Form 10-K for the year ended December 31, 1992 (the "1992 10-K", Exhibit 4-B-1. (4-B-2) Form of the Company's Series A Redeemable Preferred Stock Certificate from the 1993 10-K, Exhibit 4-B-2. (4-C) Certificate of Designations of Series A Redeemable Preferred Stock of the Company (incorporated by reference from the 1992 GFC Financial Annual Report on Form 10-K for the year ended December 31, 1992 (the "GFC Financial 1992 10-K", Exhibit 10-MM). (4-D) Relevant portions of the Company's Certificate of Incorporation and Bylaws are included in Exhibits 3- A and 3-B above, respectively. (4-E) Indenture dated as of November 1, 1990 between the ompany and the Trustee named therein (incorporated by reference from the Company's Registration Statement on Form S-3, Registration No. 33-37743, Exhibit 4). (4-F) Fourth Supplemental Indenture dated as of April 17, 1992 between the Company and the Trustee named therein, supplementing the Indenture referenced in Exhibit 4-E above, is hereby incorporated by reference from the GFC Financial 1992 10-K, Exhibit 4-F. (4-G) Prospectus and Prospectus Supplement dated April 17, 1992, relating to $350,000,000 principal amount of the Company's Medium-Term Notes, Series A, is hereby incorporated by reference from the GFC Financial 1992 10-K, Exhibit 4-G. (4-H) Form of Floating-rate, Medium-Term Notes, Series A, is hereby incorporated by reference from the 1992 GFC Financial 10-K, Exhibit 4-H. (4-I) Form of Fixed-rate, Medium-Term Notes, Series A, is hereby incorporated by reference from the GFC Financial 1992 10-K, Exhibit 4-I. (4-J) Form of Indenture dated as of September 1, 1992 between the Company and the Trustee named therein (incorporated by reference from the Company's Registration Statement on Form S-3, Registration No. 33-51216, Exhibit 4). (4-K) Prospectus and Prospectus Supplement dated September 25, 1992 regarding $250,000,000 principal amount of the Company's Medium-Term Notes, Series B, is hereby incorporated by reference from the GFC Financial 1992 10-K, Exhibit 4-K. (4-L) Form of Floating-rate Medium-Term Notes, Series B, is hereby incorporated by reference from the GFC Financial 1992 10-K, Exhibit 4-L. (4-M) Form of Fixed-rate Medium-term Notes, Series B, is hereby incorporated by reference from the GFC Financial 1992 10-K, Exhibit 4-M. (4-N) Indenture dated as of June 1, 1985 between the Company and the trustee named therein is hereby incorporated by reference from the 1992 10-K, Exhibit 4-N. (4-O) Prospectus and Prospectus Supplement dated February 16, 1994 regarding $250,000,000 principal amount of the Company's Medium-Term Notes, Series B is hereby incorporated by reference from the Company's Registration Statement on Form S-3, Registration No. 33-51216, as amended on that date. (4-P) Prospectus, dated February 16, 1994, and Prospectus Supplement dated February 17, 1994 regarding $100,000,000 principal amount of the Company's Floating-Rate Notes, is hereby incorporated by reference from the Company's Registration Statement on Form S-3, Registration No. 33-51216, as amended on that date. (9) Form of Distribution Agreement among the Company, GFC Financial Corporation, The Dial Corp and certain other parties named therein, dated as of January 28, 1992 (incorporated by reference from GFC Financial's Registration Statement on Form S-1, Registration No. 33-45452, Annex II to the Prospectus and Exhibit 2.1) (containing section 2.08(b), regarding the voting of the Greyhound Financial Corporation preferred stock). (10-A) Fifth Amendment and Restatement dated as of May 18, 1993 of the Credit Agreement dated as of May 31, 1976 among the Company and the banking institutions listed on the signature pages thereto, and Bank of America National Trust and Savings Association, Chemical Bank and Citibank, N.A., as agents (incorporated by reference from the Corporation's Current Report on Form 8-K dated February 14, 1994, Exhibit 7(c)). (10.A1) Amendment dated as of January 31, 1994, to the Fifth Amendment and Restatement, noted in 10-A above incorporated by reference from the GFC Financial 1992 10-K, Exhibit 10-A1.* (10-C) Sublease dated as of April 1, 1991 among the Company, GFC Financial, Dial and others, relating to the Company's principal office space is hereby incorporated by reference from the GFC Financial 1992 Form 10-K, Exhibit 10-NN. (10-D) Interim Service Agreement dated January 28, 1992 among the Company, GFC Financial, Dial and others is hereby incorporated by reference from the GFC Financial 1992 Form 10-K, Exhibit 10-JJ. (10-E) Tax Sharing Agreement dated February 19, 1992 among the Company, GFC Financial, Dial and others is hereby incorporated by reference from the GFC Financial 1992 Form 10-K, Exhibit 10-KK. (10.F) Stock Purchase Agreement between the Company and Bell Atlantic TriCon Leasing Corporation dated as of March 4, 1994.* (10.G) Form of Assets Purchase Agreement between Bell Atlantic TriCon Leasing Corporation and TriCon Capital Corporation.* (12) Computation of Ratio of Income to Combined Fixed Charges and Preferred Stock Dividends.* (23) Consent of Independent Accountants - Deloitte & Touche.* (23.A) Consent of Independent Accountants - Coopers & Lybrand.* (23.B) Consent of Independent Accountants - Coopers & Lybrand.* (23.C) Consent of Independent Accountants - KPMG Peat Marwick.*
278041_1993.txt	278041	1993						ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS. The information called for by Item 5 is included in the 1993 Annual Report to Shareholders in the section entitled "Common Stock Prices and Dividends for Each Quarterly Period of 1992 and 1993" and is incorporated herein by reference to page 19 of Exhibit 13 filed with this 10-K. ITEM 6.	ITEM 6. SELECTED FINANCIAL DATA The information called for by Item 6 is included in the 1993 Annual Report to Shareholders in the section entitled "Summary of Selected Consolidated Financial Data" and is incorporated herein by reference to page 1 of Exhibit 13 filed with this 10-K. ITEM 7.	ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information called for by Item 7 is included in the 1993 Annual Report to Shareholders in the section entitled "Management Discussion and Analysis of Financial Condition and Results of Operations" and is incorporated herein by reference to pages 2 through 4 of Exhibit 13 filed with this 10-K. ITEM 8.	ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The consolidated balance sheets as of December 31, 1993, and December 31, 1992, and the related consolidated statements of income, changes in stockholders' investment and cash flows for each of the three years in the period ended December 31, 1993 are included in the 1993 Annual Report to the Shareholders and are incorporated herein by reference to pages 5 through 9 of Exhibit 13 filed with this 10-K. Such statements have been audited by Arthur Andersen & Co., independent public accountants, as set forth in their report included in such Annual Report and incorporated herein by reference to page 20 of Exhibit 13 filed with this 10-K. 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 called for by Item 10 is incorporated herein by reference to Item 4a, Executive Officers and Directors of the Registrant. ITEM 11.	ITEM 11. EXECUTIVE COMPENSATION The information called for by Item 11 is included on pages 6, 7 and 8 of the Company's definitive proxy statement dated March 11, 1994, filed pursuant to Section 14(a) of the Securities Exchange Act of 1934, and is incorporated herein by reference. ITEM 12.	ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information called for by Item 12 is included on pages 2, 3, 4 and 5 of the Company's definitive proxy statement dated March 11, 1994, filed pursuant to Section 14(a) of the Securities Exchange Act of 1934, and is incorporated herein by reference. ITEM 13.	ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information called for by Item 13 is included on pages 2, 3, 4, 5, 8 and 9 of the Company's definitive proxy statement dated March 11, 1994, filed pursuant to Section 14(a) of the Securities Exchange Act of 1934, and is incorporated herein by reference. PART IV ITEM 14.	ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K The following financial statements, schedules and exhibits are filed as part of this report: (a) 1. Financial Statements ____________________ The following financial statements and related notes are included in the Company's 1993 Annual Report to Shareholders and are incorporated herein by reference to pages 5 through 20 of Exhibit 13 filed with this 10-K. Consolidated Balance Sheets at December 31, 1993 and 1992 Consolidated Statements of Income for the years ended December 31, 1993, 1992, and Consolidated Statements of Changes in Stockholders' Investment for the years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements Report of Independent Public Accountants 2. Financial Statement Schedules _____________________________ The list of financial statement schedules required by Item 8 and Item 14 are incorporated herein by reference to pages 27, 28, 29 and 30 of this document. Report of Independent Public Accountants on Supplemental Schedules Supplemental Schedules (Consolidated) Schedule V - Property Schedule VI - Accumulated Depreciation Schedule X - Supplemental Income Statement Information 3. Exhibits ________ (3) Restated Certificate of Incorporation,as amended, and By-Laws of the Registrant (filed with the Securities and Exchange Commission as Exhibit 3 to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1987 and incorporated herein by reference) (4) Specimen of Common Stock Certificate (filed as an exhibit to the Company's Form 8-A filed with the Securities and Exchange Commission on April 25, 1980 and incorporated herein by reference) (4.1) Form of Indenture between the Company and The Bank of New York, as Trustee with respect to the 9% Senior Notes (filed with the Securities and Exchange Commission on May 5, 1993 as Exhibit 4(c) to the Company's Registration Statement on Form S-2 [Registration No. 33-62168] and incorporated herein by reference) (4.2) Form of 9% Senior Note (filed with the Securities and Exchange Commission on May 5, 1993 as Exhibit 4(d) to the Company's Registration Statement on Form S-2 [Registration No. 33-62168] and incorporated herein by reference) (11) Statement regarding Computation of Earnings per Share (13) 1993 Annual Report to Shareholders (21) Subsidiaries of International Shipholding Corporation (b) No reports on Form 8-K were filed during the last quarter of the period covered by this Report. (c) The Index of Exhibits and required Exhibits are included following the Financial Statement Schedules beginning at page 31 of this Report. (d) The Index to Consolidated Financial Statements and Supplemental Schedules are included following the signatures beginning at page 26 of this Report. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. INTERNATIONAL SHIPHOLDING CORPORATION (Registrant) /s/ Gary L. Ferguson March 23, 1994 By ______________________________ Gary L. Ferguson Vice President, Chief Financial Officer and Principal Accounting 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. INTERNATIONAL SHIPHOLDING CORPORATION (Registrant) /s/ Niels W. Johnsen March 23, 1994 By ____________________________ Niels W. Johnsen Chairman of the Board, Director and Chief Executive Officer /s/ Erik F. Johnsen March 23, 1994 By _____________________________ Erik F. Johnsen President and Director /s/ Harold S. Grehan, Jr. March 23, 1994 By _____________________________ Harold S. Grehan, Jr. Vice President and Director /s/ Laurance Eustis March 23, 1994 By __________________________ Laurance Eustis Director /s/ Edwin Lupberger March 23, 1994 By __________________________ Edwin Lupberger Director /s/ Raymond V. O'Brien, Jr. March 23, 1994 By ___________________________ Raymond V. O'Brien, Jr. Director /s/ Niels M. Johnsen March 23, 1994 By ___________________________ Niels M. Johnsen Vice President and Director /s/ Gary L. Ferguson March 23, 1994 By ____________________________ Gary L. Ferguson Vice President, Chief Financial Officer and Principal Accounting Officer INTERNATIONAL SHIPHOLDING CORPORATION INDEX TO CONSOLIDATED FINANCIAL STATEMENT SCHEDULES All other schedules are not submitted because they are not applicable or because the required information is included in the financial statements or notes thereto. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SUPPLEMENTAL SCHEDULES To International Shipholding Corporation: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements included in the Company's 1993 Annual Report to Shareholders incorporated by reference in this Form 10-K, and have issued our report thereon dated January 18, 1994. Our audit was made for the purpose of forming an opinion on those financial statements taken as a whole. Schedules V, VI, and X are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements taken as a whole. These schedules have been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly state 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 & CO. New Orleans, Louisiana January 18, 1994 SCHEDULE V INTERNATIONAL SHIPHOLDING CORPORATION PROPERTY (All Amounts in Thousands) SCHEDULE VI INTERNATIONAL SHIPHOLDING CORPORATION ACCUMULATED DEPRECIATION (All Amounts in Thousands) SCHEDULE X INTERNATIONAL SHIPHOLDING CORPORATION SUPPLEMENTARY INCOME STATEMENT INFORMATION (All Amounts in Thousands) INTERNATIONAL SHIPHOLDING CORPORATION EXHIBIT INDEX Page Exhibit Number _______ ______ (3) Restated Certificate of Incorporation, as amended, and By-Laws of the Registrant (filed with the Securities and Exchange Commission as Exhibit 3 to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1987 and incorporated herein by reference) -- (4) Specimen of Common Stock certificate (filed as an exhibit to the Company's Form 8-A filed with the Securities and Exchange Commission on April 25, 1980 and incorporated herein by reference) -- (4.1) Form of Indenture between the Company and The Bank of New York, as Trustee with respect to the 9% Senior Notes (filed with the Securities and Exchange Commission on May 5, 1993 as Exhibit 4(c) to the Company's Registration Statement on Form S-2 [Registration No. 33-62168] and incorporated herein by reference) -- (4.2) Form of 9% Senior Note (filed with the Securities and Exchange Commission on May 5, 1993 as Exhibit 4(d) to the Company's Registration Statement on Form S-2 [Registration No. 33-62168] and incorporated herein by reference) -- (11) Statement Regarding Computation of Earnings per Share, included herein -- (13) 1993 Annual Report to Shareholders, included herein -- (21) Subsidiaries of International Shipholding Corporation, included herein --
22606_1993.txt	22606	1993	ITEM 1. BUSINESS. THE COMPANY Commonwealth Edison Company (Company) is engaged principally in the production, purchase, transmission, distribution and sale of electricity to a diverse base of residential, commercial and industrial customers. The Company was organized in the state of Illinois on October 17, 1913 as a result of the merger of Cosmopolitan Electric Company into the original corporation named Commonwealth Edison Company. The latter had been incorporated on September 17, 1907. The Company's electric service territory has an area of approximately 11,540 square miles and an estimated population of approximately 8.1 million as of December 31, 1991, approximately 8.2 million as of December 31, 1992 and approximately 8.1 million as of December 31, 1993. It includes the city of Chicago, an area of about 225 square miles with an estimated population of three million from which the Company derived approximately one-third of its ultimate consumer revenues in 1993. The Company had approximately 3.3 million electric customers at December 31, 1993. The Company's principal executive offices are located at 10 South Dearborn Street, Post Office Box 767, Chicago, Illinois 60690-0767, and its telephone number is 312/394-4321. The Company's financial condition is dependent upon its ability to generate revenues to cover its costs. To maintain a satisfactory financial condition, the Company must recover the costs of and a return on completed construction projects, including its three most recently completed generating units, and maintain adequate debt and preferred and preference stock coverages and common stock equity earnings. The Company has no significant revenues other than from the sale of electricity. Under the economic and political conditions prevailing in Illinois, the Company's management recognizes that competitive and regulatory circumstances may limit the Company's ability to raise its rates. Therefore, the Company's financial condition will depend in large measure on the Company's levels of sales, expenses and capital expenditures. See "Rate Proceedings" and "Business and Competition" below. In response to the adverse regulatory and judicial decisions in the proceedings relating to the level of the Company's rates, the Company implemented a cost reduction plan in 1992 involving various management workforce reductions through early retirement and voluntary and involuntary separations. Such reductions, when combined with other actions, are estimated by the Company to have saved approximately $130 million in operation and maintenance expenses during 1993. The management workforce reduction resulted in a charge to income of approximately $23 million (net of income tax effects) in 1992. In addition, the Company reached agreement in August 1993 with its unions regarding certain cost reduction actions. The agreement provides for a wage freeze until April 1, 1994, changes to reduce health care plan cost, increased use of part-time employment and changes in holiday provisions. The agreement also includes a continuation of negotiations relative to other issues. Further, the Company has reduced planned construction program expenditures by approximately $200 million compared with the common years (1994-95) of the previously approved three-year construction program. The Company and union representatives reached agreement in February 1994 and announced an offer of a voluntary early retirement program. This program is available to management, non-union and union employees. Participants currently eligible will be given a 45-day period during which to consider and elect to participate in this voluntary program. In addition, the quarterly common stock dividends, payable on and since November 1, 1992, were reduced by 47% from the seventy-five cents per share amount paid quarterly since 1982 to forty cents per share. Dividends have been declared on the outstanding shares of the Company's preferred and preference stocks at their regular quarterly rates. The Company's Board of Directors will continue to review quarterly the payment of dividends. See "Fuel Supply," "Regulation" and "Item 3. Legal Proceedings" herein for information concerning administrative and legal proceedings and certain other matters involving the Company, Commonwealth Edison Company of Indiana, Inc. (Indiana Company) and Cotter Corporation, a wholly-owned subsidiary of the Company. The outcome of certain of the proceedings or matters described or referred to therein, if not favorable to the Company and the Indiana Company (companies), could have a material adverse effect on the future business and operating results of the companies. NET ELECTRIC GENERATING CAPABILITY The owned (non-summer) generating capability of the companies is considered by the companies to be 22,522,000 kilowatts. After deducting summer limitations of 557,000 kilowatts, the net summer generating capability of the companies is considered by the companies to be 21,965,000 kilowatts. The net generating capability available for operation at any time may be less due to regulatory restrictions, fuel restrictions, efficiency of cooling facilities and to generating units being temporarily out of service for inspection, maintenance, refueling, repairs or modifications required by regulatory authorities. See "Item 2.		ITEM 2. PROPERTIES. The Company's electric properties are located in Illinois and the Indiana Company's electric facilities are located in Indiana. In management's opinion, the companies' operating properties are adequately maintained and are substantially in good operating condition. The electric generating, transmission, distribution and general facilities of the companies represent approximately 69%, 9%, 19% and 3%, respectively, of their gross investment in electric plant and equipment in service. The electric generating stations, substations and a portion of the transmission rights of way of the companies are owned in fee. A significant portion of the electric transmission and distribution facilities are located over or under highways, streets, other public places or property owned by others, for which permits, grants, easements or licenses (deemed satisfactory by the Company, but without examination of underlying land titles) have been obtained. The principal plants and properties of the Company are subject to the lien of the Company's Mortgage dated July 1, 1923, as amended and supplemented, under which the Company's first mortgage bonds are issued. The net generating capability of the Company and the Indiana Company is derived from the following electric generating facilities: - -------- (1) Excludes the 25% undivided interest of Iowa-Illinois Gas and Electric Company in the Quad-Cities station. (2) Generating units normally designed for use only during the maximum load period of a designated time interval. Such units are capable of starting and coming on-line quickly. Major electric transmission lines owned and in service are as follows: The Company's electric distribution system includes 37,275 pole line miles of overhead lines and 29,666 cable miles of underground lines. A total of approximately 1,315,024 poles are included in the Company's distribution system, of which about 589,957 are owned jointly with telephone companies. ITEM 3.	ITEM 3. LEGAL PROCEEDINGS. During 1989 and 1991, actions were brought in federal and state courts in Colorado against the Company and its subsidiary, Cotter Corporation (Cotter), alleging that Cotter has permitted radioactive and other hazardous material to be released from its mill into areas owned or occupied by the plaintiffs resulting in property damage and potential adverse health effects. The plaintiffs seek from Cotter and the Company unspecified compensatory, exemplary and medical monitoring fund damages, unspecified response costs under CERCLA, and temporary and permanent injunctive relief. Although the cases will necessarily involve the resolution of numerous contested issues of fact and law, the Company's determination is that these actions will not have a material adverse impact on the Company's financial statements. In October 1990, the Company filed a complaint in the Circuit Court of Cook County, Illinois (Circuit Court), against Westinghouse Electric Corporation (Westinghouse) and certain of its employees. The complaint alleges that the defendants knowingly concealed information regarding the durability of the metal used in the steam generators (a major component of the nuclear steam supply systems) at the Zion, Byron and Braidwood stations. The complaint further alleges that the defects in the steam generators will prevent the plants from maintaining their full power output through their forty year design life without costly remanufacture or replacement of the steam generators. Damages, including punitive damages, in an unspecified amount are claimed. Westinghouse has filed a counterclaim against the Company which seeks recovery of Westinghouse's costs of defense and damages of approximately $13 million. Shareholder derivative lawsuits were filed on October 1, 1992 and on April 14, 1993 in the Circuit Court against current and former directors of the Company alleging that they breached their fiduciary duty and duty of care to the Company in connection with the management of the activities associated with the construction of the Company's four most recently completed nuclear generating units. The lawsuits sought restitution to the Company by the defendants for unquantified and undefined losses and costs alleged to have been incurred by the Company. Both lawsuits were dismissed by the Circuit Court; however, appeals are pending before the Illinois Appellate Court. A number of complaints have been filed by former employees with the Equal Employment Opportunity Commission, and several lawsuits have been filed by former employees in the United States District Court, alleging that the employees' terminations (which occurred as part of the Company's management workforce reductions that were implemented in the second half of 1992) involved discrimination on the basis of age, race, sex, national origin and/or disabilities, in violation of applicable law. The complainants are seeking, among other things, awards of back pay and lost benefits, reinstatement, pecuniary damages, and costs and attorneys' fees. See "Item 1. Business," subcaptions "Construction Program," "Rate Proceedings," "Fuel Supply" and "Regulation" above for information concerning legal proceedings involving various regulatory agencies. ITEM 4.	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. None. PART II ITEM 5.	ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The current ratings of the Company's securities by three principal securities rating agencies are as follows: The foregoing ratings reflect downgradings during 1992 and in January 1993 as a result of developments in the proceedings leading to, and the issuance of, the Remand Order. In December 1993, Standard & Poor's affirmed its ratings of the Company's debt, although on October 27, 1993, it changed its "outlook" on the Company's ratings from stable to negative as part of its larger assessment of the electric utility industry. In December 1993, Moody's and Duff & Phelps affirmed their ratings of the Company's securities, and Moody's rating outlook on the Company remained stable. The above ratings reflect only the views of such rating agencies and each rating should be evaluated independently of any other rating. Generally, rating agencies base their ratings on information furnished to them by the issuing company and on investigations, studies and assumptions by the rating agencies. There is no assurance that any particular rating will continue for any given period of time or that it will not be changed or withdrawn entirely if in the judgment of the rating agency circumstances so warrant. Such ratings are not a recommendation to buy, sell or hold securities. The following is a brief summary of the meanings of the above ratings and the relative rank of the above ratings within each rating agency's classification system. Moody's top four long-term debt ratings (Aaa, Aa, A and Baa) are generally considered "investment grade." Obligations rated Baa are considered as medium grade obligations, neither highly protected nor poorly secured. Such obligations lack outstanding investment characteristics and in fact have speculative characteristics. (A numerical modifier in Moody's system shows relative standing within the principal rating category, with 1 indicating the high end of that category, 2 the mid-range and 3 the low end.) Standard & Poor's top four bond ratings (AAA, AA, A and BBB) are generally considered to describe obligations in which investment characteristics predominate. Obligations rated BBB are regarded as having an adequate capacity to pay interest and repay principal. It normally exhibits adequate protection parameters, but adverse economic conditions or changing circumstances are more likely to lead to weakened capacity to pay. (A plus or minus sign in Standard & Poor's system shows relative standing within the major rating categories.) Both Moody's and Standard & Poor's preferred stock ratings represent relative security of dividends. Moody's top four preferred stock ratings (aaa, aa, a and baa) are generally considered "investment grade." Moody's baa rating describes a medium grade preferred stock, neither highly protected nor poorly secured. Standard & Poor's top four preferred stock ratings (AAA, AA, A and BBB) are generally considered "investment grade." Standard & Poor's BBB rating applies to medium grade preferred stock which is below A ("sound") and above BB ("lower grade"). Duff & Phelps' credit rating scale has 17 alphabetical categories, of which ratings AAA through BBB (with AAA being the highest rating) represent investment grade securities. Ratings of BBB+, BBB and BBB- represent the lowest category of "investment grade" rating. This category describes securities with below average protection factors but which are considered sufficient for institutional investment. Considerable variability in risk occurs during economic cycles. Ratings of BB+, BB and BB- describe below investment grade securities which are deemed likely to meet obligations when due. Present or prospective financial protection factors of these securities fluctuate according to industry conditions or company fortunes. Moody's Prime-2 (P-2) rating of commercial paper is the second highest of three possible ratings; P-2 describes a strong capacity for repayment of short- term promissory obligations. Standard & Poor's rates commercial paper in four basic categories with A-2 being the second highest category. Duff & Phelps rates commercial paper in three basic categories, with Duff 2 indicating the middle category. Further explanations of the significance of ratings may be obtained from the rating agencies. Additional information required by Item 5 is incorporated herein by reference to the "Price Range and Dividends Paid Per Share of Common Stock" on page 26 of the January 28, 1994 Form 8-K/A-1 Report. ITEM 6.	ITEM 6. SELECTED FINANCIAL DATA. ITEM 7.	ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. ITEM 8.	ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The information required by Items 6, 7 and 8 is incorporated herein by reference to the "Summary of Selected Consolidated Financial Data" on page 26, "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 10 through 22, and the audited consolidated financial statements and notes thereto on pages 25 and 27 through 51 of the January 28, 1994 Form 8-K/A-1 Report. 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 required by Item 10 relating to directors and nominees for election as directors at the Company's Annual Meeting of shareholders to be held on May 10, 1994 is incorporated herein by reference to pages 12 through 14 of the Company's definitive Proxy Statement (1994 Proxy Statement) filed with the Securities and Exchange Commission pursuant to Regulation 14A under the Securities Exchange Act of 1934. The information required by Item 10 relating to executive officers is set forth in Part I of this Annual Report on Form 10-K under "Item 1. Business," subcaption "Executive Officers of the Registrant." ITEM 11.	ITEM 11. EXECUTIVE COMPENSATION. The information required by Item 11 is incorporated herein by reference to the paragraph labelled "Compensation of Directors" on page 14, under the heading "Executive Compensation--Summary Compensation Table" on page 16 and under the heading "Executive Compensation--Service Annuity System Plan" on page 17 of the 1994 Proxy Statement. ITEM 12.	ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information required by Item 12 is incorporated herein by reference to the stock ownership information under the heading "Security Ownership of Certain Beneficial Owners and Management" on pages 10 and 11 of the 1994 Proxy Statement. ITEM 13.	ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. None. PART IV ITEM 14.	ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a)FINANCIAL STATEMENTS, FINANCIAL STATEMENT SCHEDULES AND EXHIBITS: The following schedules are omitted as not applicable or not required under rules of Regulation S-X: I, II, III, IV, XI, XII, XIII and XIV. Significant information required by Schedule X--Supplementary Income Statement Information is included as Note 15 of Notes to Financial Statements incorporated herein by reference to the January 28, 1994 Form 8-K/A-1 Report. Individual financial statements and schedules of the Company have been omitted because it is primarily an operating company and all subsidiaries included in the consolidated financial statements are totally-held subsidiaries. Financial statements and schedules of the Company's nonconsolidated subsidiaries have been omitted because the investments are not material in relation to the Company's financial position and results of operations. As of December 31, 1993, the assets of the nonconsolidated subsidiaries in the aggregate approximated 1% of the Company's consolidated assets and for the year 1993 annual revenues of the nonconsolidated subsidiaries in the aggregate were less than 1% of the Company's consolidated annual revenues. The following exhibits are filed herewith or incorporated herein by reference. Documents indicated by an asterisk () are incorporated herein by reference to the File No. indicated. Pursuant to Item 601(b)(4)(iii) of Regulation S-K, the Company hereby agrees to furnish to the Securities and Exchange Commission, upon request, any instrument defining the rights of holders of long-term debt of the Company not filed as an exhibit herein. No such instrument authorizes securities in excess of 10% of the total assets of the Company. (B) REPORTS ON FORM 8-K: None. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SUPPLEMENTAL SCHEDULES To Commonwealth Edison Company: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements of Commonwealth Edison Company and subsidiary companies incorporated by reference in this Annual Report on Form 10-K, and have issued our report thereon dated March 18, 1994. Our report on the financial statements includes an explanatory paragraph that describes the Company's change in its method of accounting for postretirement health care benefits and income taxes as discussed in Notes 13 and 14, respectively, to the financial statements. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed on page 23, Item 14.(a), are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state 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 & Co. Chicago, Illinois March 18, 1994 SCHEDULE V (PAGE 1 OF 2) COMMONWEALTH EDISON COMPANY AND SUBSIDIARY COMPANIES SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT (a) --THOUSANDS OF DOLLARS-- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- See Notes on Page 2 of 2. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SCHEDULE V (PAGE 2 OF 2) COMMONWEALTH EDISON COMPANY AND SUBSIDIARY COMPANIES SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT--CONCLUDED (a) --THOUSANDS OF DOLLARS-- - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- Notes: (a) Reference is made to Note 1 of Notes to Financial Statements in the Current Report on Form 8-K/A-1 dated January 28, 1994, incorporated herein by reference, for information relating to the accounting policies for depreciation of plant and equipment and amortization of nuclear fuel. (b) The 1991 balance includes a reduction of $733,759 from plant in service reflecting the write-offs in March and November 1991 of disallowed plant costs relating to Byron Unit 2 and Braidwood Units 1 and 2. (c) Transfers to and from nonutility property and between other plant and equipment accounts. (d) Includes plant and equipment under capital leases of $11,266, $6,877 and $10,639 at December 31, 1991, 1992 and 1993, respectively. (e) Leased plant and equipment capitalized net of amortization. (f) Net of transfers to plant in service and to nonutility property. (g) Includes investment in coal reserves of $78,678, $79,961 and $43 during the years 1991, 1992 and 1993, respectively. (h) Net of transfers of property to construction work in progress. (i) Coal reserves transferred to fuel inventory. (j) Excludes nuclear fuel expenditures related to nonutility property of $2,470, $2,473 and $667 for 1991, 1992 and 1993, respectively, for uranium exploration and mine development. (k) Includes additions of $148,652, $230,454 and $286,977 for discharged nuclear fuel assemblies previously leased during the years 1991, 1992 and 1993, respectively. (l) Includes reductions for nuclear fuel sold and leased back to the Company of $240,263, $190,830 and $204,254 for the years 1991, 1992 and 1993, respectively. (m) Includes net additions/(reductions) for leased nuclear fuel capitalized of $94,880, $(37,145) and $(81,508) for the years 1991, 1992 and 1993, respectively. (n) Charged to expense for writedowns of $3,300 and $9,241 for the years 1991 and 1992, respectively, to reflect the decline in realizable value of uranium ore inventory. (o) Includes leased nuclear fuel capitalized of $1,362,433, $1,325,287 and $1,243,779 at December 31, 1991, 1992 and 1993, respectively. (p) Write-off of expenditures for preliminary engineering and analysis deemed to be not useful. - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- SCHEDULE VI (PAGE 1 OF 2) COMMONWEALTH EDISON COMPANY AND SUBSIDIARY COMPANIES SCHEDULE VI--ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (a) --THOUSANDS OF DOLLARS-- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- See Notes on Page 2 of 2. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SCHEDULE VI (PAGE 2 OF 2) COMMONWEALTH EDISON COMPANY AND SUBSIDIARY COMPANIES SCHEDULE VI--ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT--CONCLUDED (a) --THOUSANDS OF DOLLARS-- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Notes: (a) Reference is made to Note 1 of Notes to Financial Statements in the Current Report on Form 8-K/A-1 dated January 28, 1994, incorporated herein by reference, for information relating to the accounting policies for depreciation of plant and equipment, nuclear plant decommissioning and amortization of nuclear fuel. (b) The year 1991 includes reversal of prior years' depreciation on disallowed plant costs recorded in March and November 1991 discussed on page 30 note (b). The year 1993 includes net adjustments of prior years' provisions relating to additional disallowed plant costs recorded in October 1989 and May 1990 for Byron Unit 1. (c) Transfers between reserves for plant and equipment and to and from nonutility property. Also includes a reclassification, in 1991, of nuclear chemical cleaning from accumulated provision for depreciation of plant and equipment for years prior to 1991 of $48,373, to other noncurrent liabilities. (d) Reimbursements for highway relocations. (e) Includes removal costs, less salvage, of plant and equipment retired. (f) Includes discharged nuclear fuel assemblies previously leased of $148,652, $230,454 and $286,977 for the years 1991, 1992 and 1993, respectively. (g) Includes net additions/(reductions) for accumulated amortization for leased nuclear fuel capitalized of $80,012, $13,018 and $(39,602) for the years 1991, 1992 and 1993, respectively. (h) Includes accumulated amortization for leased nuclear fuel capitalized of $793,973, $806,991 and $767,389 for the years 1991, 1992 and 1993, respectively. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SCHEDULE VII COMMONWEALTH EDISON COMPANY AND SUBSIDIARY COMPANIES SCHEDULE VII--GUARANTEES OF SECURITIES OF OTHER ISSUERS DECEMBER 31, 1993 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Notes: (a) Edison Development Company is a wholly-owned subsidiary which owns coal land, land rights, and mineral rights to low-sulfur coal, owns certain other real estate investments, and has an interest in uranium ore deposits for the purpose of furnishing Commonwealth Edison Company with a future source of fuel for electric generation. (b) Represents portion of purchase cost of coal land. (c) Excludes interest, which is at a rate of prime plus 1%. (d) Cotter Corporation is a wholly-owned subsidiary which owns uranium mining properties in Colorado and other Western states and a mineral processing plant to furnish a supply of uranium concentrate for Commonwealth Edison Company's nuclear fuel requirements. (e) Cotter Corporation received from the state of Colorado the renewal and amendment of its existing license to operate its uranium mill and associated tailings impoundment at its Canon City uranium mill by obtaining a $10,500,000 Performance Bond. An insurance company agreed to provide Cotter Corporation with the required bond for a premium of $65,625 per year. In addition, Cotter Corporation obtained Performance Bonds principally for the reclamation of certain Western Slope mines and the Charlie Orebody mine, and other related facilities. An insurance company agreed to provide Cotter Corporation with Performance Bonds in the amount of $3,981,825 for premiums of $25,779 per year. Commonwealth Edison Company guaranteed payment of these premiums and any losses sustained by the insurance company under the bonds. (f) CommEd Fuel Company, Inc. (CommEd Fuel Company) is a non-affiliated company established to lease nuclear fuel materials to the Company under a nuclear fuel lease agreement. CommEd Fuel Company owns the nuclear fuel materials and finances the purchase of such materials through its sale of commercial paper and intermediate term notes, and bank borrowings. (g) A maximum of $700,000,000 of obligations may be incurred, consisting of $300,000,000 of commercial paper or bank borrowings and $400,000,000 of intermediate term notes. (h) The Company has agreed in its nuclear fuel lease agreement with CommEd Fuel Company to make rent payments thereunder in amounts sufficient to cover the principal, interest and other financing costs of CommEd Fuel Company incurred in connection with its purchase and lease of nuclear fuel materials to the Company. (i) Northwind Inc. is an indirect, wholly-owned subsidiary which has been formed to provide energy-related services to the Company's customers and others. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SCHEDULE VIII COMMONWEALTH EDISON COMPANY AND SUBSIDIARY COMPANIES SCHEDULE VIII--VALUATION AND QUALIFYING ACCOUNTS --THOUSANDS OF DOLLARS-- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Notes: (a) Bad debt losses, net of recoveries, and provisions for uncollectible accounts were charged to operating expense and amounted to $27,541, $33,708 and $28,867 in 1991, 1992 and 1993, respectively. (b) Transfer to Reserve for Depreciation of Electric Plant in Service. (c) Expenditures for site investigation and cleanup costs. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SCHEDULE IX COMMONWEALTH EDISON COMPANY AND SUBSIDIARY COMPANIES SCHEDULE IX--SHORT-TERM BORROWINGS --THOUSANDS OF DOLLARS-- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Notes: (a) Maximum amount outstanding at any month end during the year. (b) Computed by dividing the sum of the daily ending balances by the number of days in the year. (c) Computed by dividing the interest expense for the year by the average amount outstanding during the year. (d) Unsecured promissory notes with terms of nine months or less. (e) Unsecured promissory notes with various banks which mature within twelve months and which can be renegotiated at maturity. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED, IN THE CITY OF CHICAGO AND STATE OF ILLINOIS ON THE 28TH DAY OF MARCH 1994. COMMONWEALTH EDISON COMPANY /s/ James J. O'Connor By_____________________________ James J. O'Connor, Chairman 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 INDICATED ON THE 28TH DAY OF MARCH 1994. SIGNATURE TITLE - ---------------------------- --------------------- /s/ James J. O'Connor - ---------------------------- Chairman and Director James J. O'Connor (principal executive officer) /s/ John C. Bukovski - ---------------------------- Vice President (principal John C. Bukovski financial officer) /s/ Roger F. Kovack - ---------------------------- Comptroller (principal Roger F. Kovack accounting officer) Jean Allard Director James W. Compton* Director Sue L. Gin* Director Donald P. Jacobs* Director George E. Johnson* Director Harvey Kapnick* Director Byron Lee, Jr.* Director Edward A. Mason* Director Frank A. Olson* Director Samuel K. Skinner* President and Director Lando W. Zech, Jr.* Director /s/ David A. Scholz By____________________________ David A. Scholz, Attorney-in- fact EXHIBIT INDEX The following exhibits are filed herewith or incorporated herein by reference. Documents indicated by an asterisk () are incorporated herein by reference to the File No. indicated.
96831_1993.txt	96831	1993	ITEM 1. BUSINESS GENERAL Tecumseh Products Company (the Company) is a full-line, independent global manufacturer of hermetic compressors for air conditioning and refrigeration products, gasoline engines and power train components for lawn and garden applications, and pumps. The Company believes it is the largest independent producer of hermetically sealed compressors in the world, as well as one of the world's leading manufacturers of small gasoline engines and power train products used in lawn and garden applications. In 1993, the Company's products were sold in over 100 countries around the world. The Company groups its products into three principal industry segments: Compressor Products, Engine and Power Train Products, and Pump Products. Compressor Products include a broad range of air conditioning and refrigeration compressors and compressor parts as well as refrigeration condensing units. The Company's compressor products range from fractional horsepower units used in small refrigerators and dehumidifiers to large units used in commercial air conditioning applications. The Company sells compressors in four major compressor market segments: household refrigerators and freezers; room air conditioners; commercial and residential unitary central air conditioning systems; and commercial devices including freezers, dehumidifiers and vending machines. The Company sells compressors to original equipment manufacturers ("OEMs") as well as in the aftermarket. Engine and Power Train Products consist of (i) two- and four-cycle gasoline engines for use in a wide variety of lawn and garden applications as well as other consumer and light commercial applications and (ii) transmissions, transaxles and related parts for use principally in lawn and garden tractors and riding lawn mowers. The Company sells engine and power train products to OEMs and aftermarket distributors. Pump Products include (i) small submersible pumps used in a wide variety of industrial, commercial, and consumer applications and (ii) heavy duty centrifugal type pumps used in the construction, mining, agricultural, marine, and transportation industries. FOREIGN OPERATIONS AND SALES In recent years, international operations and sales have become increasingly important to the Company's business as a whole. In 1993, sales to customers outside the United States represented approximately 45% of total consolidated net sales, up from approximately 30% in 1988. Additionally, a substantial portion of the Company's products are manufactured overseas. Compressor products are produced by the Company's plants in both Brazil and France, while engines are produced in Italy. Products sold outside the United States are manufactured at both U.S. and foreign plants. The Company's European compressor subsidiary, L'Unite Hermetique, S.A., ("L'Unite Hermetique"), generally sells the compressor products it manufactures in Europe, the Middle East, Africa, Latin America and Asia. Sociedade Intercontinental De Compressores Hermeticos-SICOM, Ltda. ("SICOM"), the Company's Brazilian compressor subsidiary, sells its products principally in Latin America and, to a lesser extent, in North America and Europe. In the engine business, the Company's two principal markets are North America, which is generally served by the Company's U.S. manufacturing operations, and Europe, which is served both by the manufacturing operations of the Company's European engine subsidiary, Tecnamotor, S.r.l. ("Tecnamotor") in Italy and, to a lesser extent, by U.S. export sales. Of the Company's sales to customers outside the United States in 1993, approximately 36% were to customers of compressor and engine products in Europe. Sales of compressors are also significant in markets in Latin America, Asia and the Far East. The Company's dependence on sales in foreign countries entails certain risks, including currency fluctuations, unstable economic or political conditions in some areas and the possibility of U.S. government embargoes on sales to certain countries. The Company's foreign manufacturing operations are subject to the same risks and others as well, including risks of governmental expropriation, governmental regulations which may be disadvantageous to businesses owned by foreign nationals and instabilities in the work force due to changing political and social conditions. These considerations are especially significant in the context of the Company's Brazilian operations given the importance of SICOM's performance to the Company's total operating results. Political, social, and economic conditions in Brazil are less stable than those which prevail in the United States and many other countries, and this instability is reflected in SICOM's operating results, which can vary dramatically from period to period. COMPRESSOR PRODUCTS The Compressor Products segment is the Company's largest industry segment. A compressor is a device which compresses a refrigerant gas. When the gas is later permitted to expand, it absorbs and transfers heat, and the cooling effect thus produced forms the basis for a wide variety of refrigeration products. The Company's compressors range from fractional horsepower units used in small refrigerators and dehumidifiers to large units used in commercial air conditioning applications. All of the compressors produced by the Company are hermetically sealed. The Company's current compressor line includes reciprocating and rotary designs and the Company is in the process of developing a line of scroll compressors. The Company's compressors are used in each of four major compressor market segments: household refrigerators and freezers; room air conditioners; residential and commercial unitary central air conditioning systems; and commercial devices, including freezers, dehumidifiers, refrigerated display cases, water coolers and vending machines. The Company believes it is the world's only independent manufacturer of compressor products for all four of these market segments. PRODUCT LINE The Company manufactures and sells a wide variety of traditional, reciprocating compressors suitable for use in all of the market segments described above. The Company also produces rotary compressors for use in room air conditioning applications. Rotary compressors generally provide increased operating efficiency, lower equipment space requirements, and reduced sound levels when compared to reciprocating designs. In November 1993, the Company reached an agreement with General Electric's appliance operations in Columbia, Tennessee to purchase certain rotary compressor manufacturing equipment. After being relocated and retooled, this equipment will be utilized in the production of room air conditioning rotary compressors in smaller sizes that will complement the Company's present product offering. During 1992, the Company introduced its new line of "Quadro-Flex" reciprocating compressors offering improved efficiency for the commercial unitary market. Early production runs of certain Quadro-Flex models resulted in unacceptable failure rates in the field. The Company believes that appropriate corrective actions have been taken to assure the high level of quality expected in this product. In light of the competitive advantages of the Quadro-Flex design, the Company anticipates increasing demand for its current Quadro-Flex products as customers become comfortable that the early problems have been corrected. In addition, the Company plans to use the Quadro-Flex design in a broad range of products for commercial refrigeration applications. Scroll compressors offer energy efficiency and reduced noise levels compared to traditional reciprocating designs and are generally preferred by OEMs for certain products, including unitary central air conditioning systems and certain commercial applications. The Company does not currently offer scroll compressors while some of its competitors do, which the Company believes puts it at a competitive disadvantage. However, the Company has developed a residential unitary air conditioning compressor using scroll technology and is currently evaluating samples of this scroll compressor with key customers. In January 1994, the Company's Board of Directors authorized funding for a scroll compressor manufacturing facility, which is expected to be in limited production by the end of 1994. MANUFACTURING OPERATIONS Compressor Products manufactured in the Company's U.S. plants accounted for approximately 55% of 1993 compressor sales. The balance was produced at the Company's manufacturing facilities in Brazil and France. The compressor operations are substantially vertically integrated, and the Company manufactures a significant portion of its component needs internally, including electric motors, metal stampings and glass terminals. Raw materials essential to the conduct of business are purchased from a variety of non-affiliated suppliers. The Company utilizes multiple sources of supply and the required raw materials and purchased components have generally been available in sufficient quantities. SALES AND MARKETING The Company markets its Compressor Products globally under the "Tecumseh" brand, as well as under the "SICOM" brand in Latin America and the "L'Unite Hermetique" brand in Europe. The Company sells its Compressor Products in North America primarily through its own sales staff. Major OEM customers are assigned to sales staff on an account basis. Other customers (aftermarket wholesalers and smaller commercial OEM's) are served by sales personnel assigned to specified geographic regions. Each of the Company's Brazilian and French subsidiaries has its own sales staff. In certain foreign markets, the Company also uses local independent sales representatives. Substantially all of the Company's sales of Compressor Products for room air conditioning applications are to OEMs. Sales of Compressor Products for unitary central air conditioning systems and commercial applications include substantial amounts of both OEM and aftermarket customers. SICOM's Compressor Products are sold primarily in Brazil and other Latin American countries. SICOM also furnishes component parts to the Company's North American plants and finished compressors for resale in North America. L'Unite Hermetique, which does not sell products in North America, sells a majority of its products in Europe but also has substantial sales outside Europe. The Company has over 1,200 customers for Compressor Products, the majority of which are commercial customers. In 1993, the two largest customers for Compressor Products accounted for 9.0% and 4.0%, respectively, of consolidated net sales of the Company's Compressor Products, or 5.5% and 2.5%, respectively, of consolidated net sales. Loss of either of these customers could have a material adverse effect on the results of operations of the Compressor Products segment and, at least temporarily, on the Company's business as a whole. Generally, the Company does not enter into long-term contracts with its customers in this segment. However, the present business relationships with all major customers have existed for a substantial period of time. In 1993, approximately 34% of the Compressor Products produced by the Company in its U.S. plants were exported to foreign countries. The Company exports to over 100 countries worldwide. Approximately two-thirds of these exported products were sold in the Far and Middle East. COMPETITION All of the compressor market segments in which the Company operates are highly competitive. Participants compete on the basis of price, efficiency, reliability, noise level, and delivery. The Company competes not only with other independent compressor producers but also with manufacturers of end products which have internal compressor manufacturing operations. The domestic unitary air conditioning compressor market consists of original equipment manufacturers and a significant compressor aftermarket. The Company competes primarily with two U. S. manufacturers, Copeland Corporation, a subsidiary of Emerson Electric, Inc., and Bristol, a division of York International Corporation. Copeland Corporation enjoys a larger volume of the domestic unitary air conditioning compressor business than either Bristol or the Company. Several important OEMs in the unitary air conditioning market have decided to significantly reduce the use of traditional reciprocating compressors in 1994 as part of an industry trend toward the use of scroll compressors. Since the Company does not currently produce scroll compressors in commercial quantities, this accelerating trend will reduce, at least temporarily, the Company's share of this important market and is expected to intensify price competition for the remaining available reciprocating compressor business. In anticipation of this trend, the Company has developed its own scroll compressor, which it is currently sampling with key customers. In January 1994, the Company's Board of Directors authorized funding for a scroll compressor manufacturing facility, which is expected to be in limited production by the end of 1994. In the domestic room air conditioning compressor market, the Company competes primarily with foreign companies, which import compressors to the United States but are also increasing U. S. manufacturing capabilities. The Company also competes to a lesser extent with U. S. manufacturers. In the domestic markets for water coolers, dehumidifiers, vending machines, refrigerated display cases and other commercial refrigeration products, the Company competes primarily with manufacturers from the Far East, Europe and South America, and to a lesser extent, the United States. The non-captive portion of the household refrigerator and freezer segment is substantially dominated by Far Eastern manufacturers, which import compressors to the United States but are also increasing U.S. manufacturing capabilities. In the geographic regions in which the Company supplies a significant portion of its domestically produced export compressors, the primary competitors are Bristol, Copeland Corporation and several Far East manufacturers, most of which are substantially larger and have greater resources than the Company. L'Unite Hermetique sells the major portion of its manufactured compressors in Western Europe, and competes in those markets primarily with several large European manufacturers, some of which are captive suppliers, and to a lesser but increasing extent, with manufacturers from the Far East. SICOM sells the major portion of its manufactured compressors in Brazil and other Latin American countries and competes directly with Embraco S.A., an affiliate of Whirlpool Corporation, in Brazil and with Embraco and several other foreign manufacturers in Latin America. The ability to successfully bring new products to market in a timely manner has rapidly become a critical factor in competing in the compressor products business as a result of, among other things, the imposition of energy efficiency standards and environmental regulations. NEW REGULATORY REQUIREMENTS Chloroflourocarbon compounds ("CFCs"), the primary refrigerants used in household refrigerators and freezers and in commercial refrigeration equipment, have been identified as one of the leading factors causing depletion of the Earth's ozone layer. Under a 1992 international agreement, CFCs are scheduled to be phased out by January 1, 1996. Several OEMs have already begun to offer products which do not utilize CFCs. Under current U.S. industry plans, the replacement for CFCs in the refrigerator and freezer market will be a refrigerant known as HFC-134a. The Company has already designed, and tested with customers, and is prepared to begin production of its new TPY line of refrigerator and freezer compressors which use HFC-134a. The U.S. government has not yet determined which refrigerant or refrigerants will be approved as replacements for CFCs in the commercial market segment, but the Company anticipates that one approved replacement will be HFC-134a. The Company has been producing commercial compressors using HFC-134a since late 1992. By the end of 1993 it could cover approximately 75% of its volume in this market segment with compressors using this refrigerant. Pursuant to the National Appliance Energy Conservation Act of 1987 (the "NAECA") the U.S. government requires higher energy efficiency ratings on certain unitary air conditioning products by January 1, 1994 and on room air conditioning products during 1997. The Company's unitary products meet the relevant 1994 standard for unitary products. The standard for room air-conditioning products has not been finalized, but the Company will need to improve the efficiency of its rotary compressors to meet the standard. The NAECA also required higher efficiency ratings for refrigerator and freezer products beginning in 1993, and still higher standards, not yet specified, will be required in 1998. Currently, the Company only participates to a very limited extent in the U.S. refrigerator and freezer market. The Company is pursuing this U.S. market with its new TPY compressor line, which meets the 1993 energy efficiency standards while using the HFC-134a refrigerant. ENGINE AND POWER TRAIN PRODUCTS Small gasoline engines account for a majority of the net sales of the Company's Engine and Power Train Products segment. The Company manufactures gasoline engines, both two- and four-cycle types, with aluminum diecast bodies ranging in sizes from 1.6 through 16.5 horsepower and with cast iron bodies ranging in size from 12 through 18 horsepower. These engines are used in a broad variety of consumer products, including lawn mowers (both riding and walk-behind types), snow blowers, small lawn and garden tractors, small power devices used in outdoor chore products, and certain kinds of self-propelled vehicles. The Company's power train products include transmissions, transaxles and related parts used principally in lawn and garden tractors and riding lawn mowers. MANUFACTURING OPERATIONS The Company manufactures engines and related components in its four plants in the United States and one plant in Italy. All of the Company's power train products are manufactured in one facility in the United States. Operations of the Company in this segment are partially vertically integrated as the Company produces most of its plastic parts and carburetors, as well as a substantial portion of the aluminum diecastings used in its engines and power trains. SALES AND MARKETING The Company markets its Engine and Power Train Products worldwide under the "Tecumseh" and "Peerless" brands, and in Europe under the "Tecnamotor" brand. A substantial portion of the Company's engines are incorporated into lawn mowers sold under brand labels, including the "Craftsman" brand of its largest engine products customer, Sears, Roebuck and Co. ("Sears"). A majority of the Company's Engine and Power Train Products are sold directly to OEMs. The Company also sells engines and parts to its authorized dealers and distributors, who service its engines both in the United States and abroad. Marketing of Engine and Power Train Products is handled by the Company's own sales staff and by local sales representatives in certain foreign countries. Sales to Sears and its suppliers in the aggregate accounted for approximately 6% of the Company's 1993 consolidated net sales and approximately 20% of its net sales of Engine and Power Train Products. Sales to the Company's second largest customer in this segment accounted for approximately 16% of the segment's net sales in 1993 and 5% of the Company's 1993 consolidated net sales. Loss of either of the Company's two largest customers would have a material adverse effect on the results of operations of this segment and, at least temporarily, on the Company's business as a whole. There are no long-term contracts between the Company and its major customers in this segment, but the present business relationships have existed for a substantial period of time. COMPETITION The Company believes it is the second largest independent producer of small gasoline engines in the United States and that the largest such producer, with a broader product range, is Briggs & Stratton Corporation. The Company competes not only with other engine manufacturers but also with manufacturers of end products which produce their own engines and power transmission components. North America and Europe are the principal markets for lawn and garden products. Foreign competition for sales has been limited in the past but is increasing, particularly as foreign manufacturers have begun establishing U.S. manufacturing facilities. In Europe, the late 1992 devaluation of the Italian lira relative to the U.S. dollar has enabled the Company's Italian-produced products to become more cost-competitive with other products available in the European market. Competition in the Company's engine business is based principally on price, service, product performance and features. As mass merchandisers have captured a larger portion of the sales of lawn and garden products in the United States, price competition and the ability to offer customized styling and feature choices have become even more significant factors. The Company believes that it competes effectively on these bases. The Company's power train business has been under significant competitive pressure over the last several years with certain of its competitors aggressively competing for market share primarily on the basis of price. As a result, the Company's power train sales have been steadily decreasing since 1987. In response to this, the Company executed a plan to reduce product cost and increase efficiency, by consolidating its power train production operations into one plant. In addition, the Company has recently introduced a new line of affordable hydrostatic, fluid-type transmissions aimed at volume segments of the market. NEW EMISSION STANDARDS The California Air Resources Board ("CARB") has promulgated exhaust emission standards for off-road utility engines which cover the two- and four-cycle engine products manufactured by the Company. The Clean Air Act Amendments of 1990 require EPA approval of the CARB regulations prior to implementation. The approval from the EPA is pending. The California regulations require certain emission reductions by January 1, 1995 and additional, more stringent reductions by 1999. A portion of the Company's engine products, as presently designed and manufactured, do not meet all the 1995 CARB standards; however, engineering efforts have resulted in select engine certification to CARB requirements, and an adequate cross section of the Company's current four-cycle products will be modified to meet the 1995 requirements. The Clean Air Act Amendments of 1990 also allow other states either to adopt the California regulations after EPA approval or a federal standard which the EPA is formulating. The EPA continues its emissions studies but, as yet, has not promulgated regulations containing standards; the Company anticipates public hearings (in advance of proposed federal Phase I standards) during the second quarter of 1994. The Company is also participating through appropriate trade associations, in the negotiated regulation process currently being conducted to develop a federal Phase II exhaust emission standard. Continuing design and other efforts will be expended to meet the emission standards; however, it is not currently possible to determine the cost thereof nor the impact on future operating results or competitive position of the Company. PUMP PRODUCTS The Company manufactures and sells small submersible pumps and related products through its subsidiary, Little Giant Pump Company ("Little Giant"). Little Giant's pumps are used in a broad range of commercial, industrial, and consumer products, including parts washers, machine tools, evaporative coolers, sump pumps, swimming pool equipment, statuary, fountains and water gardening. Little Giant's products are sold throughout the United States, Canada, Europe, and the Middle East, to OEMs and distributors and to retailers directly. Marketing is carried out both through Little Giant's own sales staff and also through manufacturer's representatives. The Company's other pump subsidiary, MP Pumps Inc. ("MP Pumps"), manufactures and sells a variety of heavy duty centrifugal pumps ranging in capacity from 15 to 300 gallons per minute, that are used in the construction, mining, agricultural, marine and transportation industries. MP Pumps sells both to OEMs, which incorporate its pumps into their end products, and through an extensive network of distributors located throughout the United States, which sell to end-users. A limited number of pumps are also sold to departments and agencies of the U.S. government. Most of MP Pumps' products are sold in the United States. MP Pumps markets its products through its own sales staff. The Company markets its pump products globally under the "Little Giant," "Jaeger" and "MP Pumps" brand names. The pump industry is highly fragmented, with many relatively small producers competing for sales. Little Giant has been particularly successful in competing in this industry by targeting specific market niches where opportunities exist and then designing and marketing corresponding products. Though still a relatively small portion of the Company as a whole, during the last five years the pump business has been its fastest growing business, with sales increasing from $48.5 million in 1989 to $77.9 million in 1993. BACKLOG AND SEASONAL VARIATIONS Most of the Company's production is against short-term purchase orders, and backlog is not significant to its business. Both Compressor Products and Engine and Power Train Products are subject to some seasonal variation. Generally, the Company's sales and operating profit are stronger in the first two quarters of the year than in the last two quarters. PATENTS, LICENSES AND TRADEMARKS The Company owns a substantial number of patents, licenses and trademarks and deems them to be important to certain of its lines of business; however, the success of the Company's overall business is not considered primarily dependent on them. The Company owns and uses in the conduct of its business a variety of registered trademarks, the most familiar of which is the trademark consisting of the word "Tecumseh" in combination with a Native American Indian head symbol. RESEARCH AND DEVELOPMENT The Company must continually develop new and improved products in order to compete effectively and to meet evolving regulatory standards in all of its major lines of business. The Company expended approximately $24.9 million, $27.0 million and $25.1 million during 1993, 1992 and 1991 on research activities relating to the development of new products and the development of improvements to existing products. None of this research was customer sponsored. ENVIRONMENTAL LEGISLATION The Company has been named by the EPA as a potentially responsible party in connection with the Sheboygan River and Harbor Superfund Site in Wisconsin. It is also the subject of an EPA administrative proceeding relating to its Somerset, Kentucky facility. The Company is also participating with the EPA and various state agencies in investigating possible remedial action that may be necessary at other sites. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources" on pages 14 to 15 and "Note 9" on page 23 in the Company's Annual Report to Shareholders for the year ended December 31, 1993 for a discussion of the impact of these matters on the Company's financial condition and results of operations. Also see Item 3. Legal Proceedings. INDUSTRY SEGMENT AND GEOGRAPHIC LOCATION INFORMATION The results of operations and other financial information by industry segment and geographic location (including the footnotes thereto) for each of the years ended December 31, 1993, 1992 and 1991 appear at page 12 of The Company's Annual Report to Shareholders for the year ended December 31, 1993 and are incorporated herein by reference. EMPLOYEES On December 31, 1993 the Company employed approximately 12,600 persons, 40% of which were employed in foreign locations. Approximately 3,400 of the U.S. employees were represented by labor unions, with no more than approximately 1,300 persons represented by the same union. The majority of foreign location personnel are represented by national trade unions. The number of the Company's employees is subject to some seasonal variation; during 1993, the maximum number of persons employed at one time was approximately 12,800, and the minimum was 11,900. The Company believes it has a good relationship with its employees. EXECUTIVE OFFICERS OF THE REGISTRANT The following are the executive officers of the Company. (1) Since 1986. Served as Chairman of the Board of Directors and Chief Executive Officer from 1970 to 1986. Kenneth G. Herrick is the father of Todd W. Herrick. (2) Since 1986. Served as Vice President from 1974 until 1984; as Executive Vice President and Assistant to the President from January, 1984 until June, 1984; and as President and Chief Operating Officer from June, 1984 until 1986. (3) Since 1986. Served as Executive Vice President from 1979 until 1986. ITEM 2.		ITEM 2. PROPERTIES The Company's headquarters are located in Tecumseh Michigan, approximately 50 miles southwest of Detroit. At December 31, 1993 the Company had 28 principal properties worldwide occupying approximately 5.9 million square feet with the majority, approximately 5.6 million square feet devoted to manufacturing. Ten facilities with approximately 2.1 million square feet were located in four countries outside the United States. The following table shows the approximate amount of space devoted to each of the Company's three principal business segments. Three domestic facilities, including land, building and certain machinery and equipment were financed and leased through industrial revenue bonds, all of which are owned or have been repaid by the Company. All owned and leased properties are suitable, well maintained and equipped for the purposes for which they are used. The Company considers that its facilities are suitable and adequate for the operations involved. ITEM 3.	ITEM 3. LEGAL PROCEEDINGS The Company has been named by the U.S. EPA as a potentially responsible party in connection with the Sheboygan River and Harbor Superfund Site in Wisconsin. This matter is discussed in "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Note 9 of the Notes to Consolidated Financial Statements in the Company's Annual Report to Shareholders for the year ended December 31, 1993, both of which are incorporated herein by reference. As pointed out in the said Note 9, the ultimate costs to the Company will be dependent upon factors beyond its control such as the scope and methodology of the remedial action requirements to be established by the EPA (in consultation with the State of Wisconsin), rapidly changing technology, and the outcome of any related litigation. In 1993, the Company and the EPA signed a Consent Agreement and Consent Order ("CACO") to resolve certain alleged violations of the federal Resource Conservation and Recovery Act at the Company's Somerset, Kentucky plant. Under the terms of the CACO, the Company has paid a civil penalty of $94,990, has installed certain equipment and will undertake certain investigations. Following the completion of the investigations, the Company could also be obliged to implement certain other remedial measures. Although management expects the total expenditures to be made in complying with the CACO to exceed $100,000, it does not believe the total will be material to its consolidated financial condition. In addition to the matters discussed in the two preceding paragraphs, the Company is currently participating with the EPA and various state agencies at certain other sites to determine the nature and extent, if any, of any remedial action which may be required of the Company with regard to such other sites. Various lawsuits and claims, including those involving ordinary routine litigation incidental to its business, to which the Company is a party, are pending, or have been asserted, against the Company. Although the outcome of the various lawsuits and claims asserted or pending against the Company or its subsidiaries, including those discussed in the immediately preceding paragraph, cannot be predicted with certainty, and some may be disposed of unfavorably to the Company, its management has no reason to believe that their ultimate disposition will have a materially adverse effect on the future consolidated financial position or income from continuing operations of the Company. ITEM 4.	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matter was submitted during the fourth quarter of 1993 to a vote of security holders through the solicitation of proxies or otherwise. PART II ITEM 5.	ITEM 5. MARKET FOR THE COMPANY'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The information under the caption "Financial Summary" and "Information Concerning Equity Securities" on pages 1 and 27, respectively, of the Company's Annual Report to Shareholders for year ended December 31, 1993 is incorporated herein by reference. As of March 11 1994, there were 1,065 holders of record of the Company's Class A common stock and 1,044 holders of the Class B common stock. ITEM 6.	ITEM 6. SELECTED FINANCIAL DATA The information under the caption "Selected Financial Data" on page 26 of the Company's Annual Report to Shareholders for the year ended December 31, 1993 is incorporated herein by reference. ITEM 7.	ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 13, 14, and 15 of the Company's Annual Report to Shareholders for the year ended December 31, 1993 is incorporated herein by reference. ITEM 8.	ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information on pages 16 to 27, inclusive, of the Company's Annual Report to Shareholders for the year ended December 31, 1993 is incorporated herein by reference. See Item 14 on page 18 of this report for financial statement schedules. 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 COMPANY The information pertaining to directors under the caption "Election of Directors" in the Company's definitive Proxy Statement relating to its 1994 Annual Meeting of Shareholders is incorporated herein by reference. Information regarding executive officers required by Item 401 of Regulation S-K is furnished in Part I of this report. ITEM 11.	ITEM 11. EXECUTIVE COMPENSATION The information under the captions "Executive Compensation," "Executive Compensation Committee Report," "Shareholder Return Performance Presentation," Compensation Committee Interlocks and Insider Participation" and in the last paragraph of the caption "Election of Directors - Directors' Meetings and Committees" in the Company's definitive Proxy Statement relating to its 1994 Annual Meeting of Shareholders is incorporated herein by reference. ITEM 12.	ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information under the captions "Principal Shareholders" and "Election of Directors - Ownership by Management of Equity Securities" in the Company's definitive Proxy Statement relating to its 1994 Annual Meeting of Shareholders is incorporated herein by reference. ITEM 13.	ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information under the caption "Compensation Committee Interlocks and Insider Participation" in the Company's definitive Proxy Statement relating to its 1994 Annual Meeting of Shareholders is incorporated herein by reference. PART IV ITEM 14.	ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) The following documents are filed as part of this report: (1) The following described financial statements, notes and report on pages 16 through 25 of the Company's Annual Report to Shareholders for the year ended December 31, 1993: . Report of Independent Accountants . Consolidated Balance Sheets as of December 31, 1993 and 1992 . Statements of Consolidated Income for the years ended December 31, 1993, 1992 and 1991 . Consolidated Statements of Stockholders' Equity for the years ended December 31, 1993, 1992 and 1991 . Statements of Consolidated Cash Flows for the years ended December 31, 1993, 1992 and 1991 . Notes to Consolidated Financial Statements (2) Financial Statement Schedules: Schedules other than those listed above are omitted because they are either not applicable or are not required. (3) Exhibits: (b) No Reports on Form 8-K were filed by the Company during the last quarter of the period covered by this Report. TECUMSEH PRODUCTS COMPANY AND SUBSIDIARIES SCHEDULE V. PROPERTY, PLANT AND EQUIPMENT for the years ended December 31, 1993, 1992 and 1991 (Dollars in Millions) Notes: (A) Column D includes normal sales and retirements of assets. Retirements in 1991 include $21.8 million from the sales of assets of Ilo Motorenwerk, GmbH, along with the sale of contract machining business in Tecumseh, Michigan. Retirements also include $15.8, $13.1, and $23.1 million write - off of fully depreciated assets for 1993, 1992 and 1991, respectively. (B) Column E represents the amount of adjustments resulting from translating foreign currency to U.S. dollars pursuant to FASB Statement No. 52 (C) Except for the certain highly automated and specialized machinery which is depreciated using the units of production method, depreciation is determined on the straight line method generally as follows: TECUMSEH PRODUCTS COMPANY AND SUBSIDIARIES SCHEDULE VI. ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT for the years ended December 31, 1993, 1992 and 1991 (Dollars in Millions) Notes: (A) Column C for 1991 includes $9.0 million from the write-down of certain long-term assets. (B) Column D represents accumulated depreciation on normal sales and retirements of assets. Retirements in 1991 include $12.7 million from the sales of assets of Ilo Motorenwerk, GmbH, along with the sale of contract machining business in Tecumseh, Michigan. Retiremenets also include $15.8, $13.1, and $23.1 million write-off of fully depreciated assets for 1993, 1992 and 1991, respectively. (C) Column E represents the amount of adjustments resulting from translating foreign currency to U.S. dollars pursuant to FASB Statement No. 52. TECUMSEH PRODUCTS COMPANY AND SUBSIDIARIES SCHEDULE VIII, VALUATION AND QUALIFYING ACCOUNTS for the years ended December 31, 1993, 1992 and 1991 (Dollars in Millions) Notes: (A) Represents the total of accounts charged against the allowance for doubtful accounts and adjustments from the translation of foreign currency. (B) Represents the total of payments made during the year and adjustments from the translation of foreign currency. TECUMSEH PRODUCTS COMPANY AND SUBSIDIARIES SCHEDULE IX. SHORT-TERM BORROWINGS for the years ended December 31, 1993, 1992 and 1991 (Dollars in Millions) Notes: (A) Notes payable to banks represent borrowings under revolving agreements. (B) The average amount outstanding during the period was computed by dividing the total of month-end outstanding principle balances by 12. (C) The weighted average interest rate was computed by dividing the actual interest expense by average short-term debt outstanding. TECUMSEH PRODUCTS COMPANY AND SUBSIDIARIES SCHEDULE X. SUPPLEMENTARY INCOME STATEMENT INFORMATION for the years ended December 31, 1993, 1992 and 1991 (Dollars in Millions) Column A Column B -------- -------- Charged to Costs and Item Expenses - ------------------------ ------------- Maintenance and repairs 1993 $37.9 ----- ----- 1992 $38.6 ----- ----- 1991 $33.6 ----- ----- Note: Amounts for depreciation and amortization of intangible assets, taxes other than payroll and income taxes, royalties and advertising costs have been omitted as the amounts are less than one percent of total sales and revenues. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. TECUMSEH PRODUCTS COMPANY By /s/ TODD W. HERRICK -------------------------------- Todd W. Herrick President and Chief Executive Officer Dated: March 23, 1994 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. EXHIBIT INDEX
96977_1993.txt	96977	1993	Item 1. BUSINESS ________ Introduction ____________ PTI was organized in 1955 to provide telephone service to suburban and rural communities principally in the Pacific Northwest. Since that time, the Company has grown significantly through acquisitions and expanded its service offerings in several areas within the telecommunications industry. This expansion included the provision of long distance services in the State of Alaska, investments in cellular telephone operations and international communications, including the construction of a trans-Pacific fiber optic cable. Over the past few years, the Company's strategy has been to focus on its core business of providing local exchange service to suburban and rural markets and to divest its diversified portfolio of noncore businesses. This strategy is being implemented through the acquisition of LECs, the sale of certain international operations, the consolidation and sale of cellular holdings, and ongoing efforts to achieve a satisfactory restructuring of the Alaska long distance marketplace. With the completed sale of TRT and upon closing of the pending sale of two additional noncore operations, the Company will have exited from all of its material noncore businesses. PTI has been a majority-owned subsidiary of PacifiCorp since 1973. At December 31, 1993, PacifiCorp beneficially owned approximately 87 percent of PTI's common stock. Telecommunications Operations _____________________________ Local Exchange Companies ________________________ The Company's LECs operate under a common business name and logo, PTI Communications. This marketing concept was established in 1991 to create a unified identity for the local operations, improve communication with customers and assist in the marketing of new products and services. As one of the major independent telephone companies in the U.S., the Company's LECs provide both local telephone service and access to the long distance network for customers in their respective service areas. The Company presently operates 20 LECs within eleven states comprised of 398,700 access lines in 253 exchanges. The average number of access lines per exchange is approximately 1,576, reflecting the lower population density generally found in the Company's service areas which are rural in nature. The Company's largest exchange in terms of access lines is in Kalispell, Montana, which had 21,976 access lines at December 31, 1993. Service areas are located primarily in the states of Alaska, Montana, Oregon, Washington and Wisconsin. States also served, but to a lesser extent, include Colorado, Idaho, Iowa, Minnesota, Nevada and Wyoming. (See "Regulation - General.") The Company provides service to its suburban and rural customer base through centralized administrative services. During the five years ended December 31, 1993, the number of access lines served by the Company increased from 239,600 to 398,700. Approximately 69,000, 3,200 and 1,100 access lines were added in 1990, 1992 and 1993, respectively, as a result of the acquisitions of several LECs located in the Midwest. The LECs have also experienced strong internal access line growth in certain service areas, as evidenced by a five percent increase in access lines served during 1993. The Company anticipates that access line growth in the future will come from population growth in current service areas and acquisitions. - 4 - The Company's LECs have replaced virtually all of their electromechanical switches with digital switches that provide significant space savings, higher reliability and expanded business and residential service capabilities. High volume traffic routes continue to be upgraded with fiber optic or digital microwave systems to meet customer needs for special services. The fiber optic systems provide increased transmission capabilities at a lower cost. Basic exchange telecommunications radio systems have been installed to provide local service to new and existing customers in more remote areas. The Company has nearly completed the conversion of all multi-party lines to single-party lines. Approximately one percent of the Company's access lines were multi-party at the end of 1993. The LECs have contracts with interexchange carriers under which the Company provides billing and collection services. During 1992, the Company signed an agreement to provide these services for AT&T through 2001, and an agreement with Independent NECA Services, a clearinghouse service bureau, to provide these services for other carriers for a minimum of two years. In Alaska, the Company's LECs have similar agreements with Alascom. In addition to its basic telephone service, the Company offered enhanced services, such as caller identification, name display, automatic call back, auto recall and call trace, to certain areas of Washington on a trial basis under the Custom Local Area Signaling Service (CLASS). The Company began providing these services in Washington on a permanent basis in January 1994 and plans to make enhanced services available on a trial basis to other service areas during 1994. The Company's existing switching equipment provides these services with minimal software and hardware enhancements. Some of the Company's switching equipment also has other enhanced service capabilities, such as voice messaging and call forwarding, that are being offered to certain of its customers in Washington. The LECs also sell and lease, on a nonregulated basis, customer premise (i.e., telephone) equipment primarily for use by residential customers. As part of this program, residential and business customers are offered maintenance services on a monthly fee basis. The Company continues to seek expansion of its local exchange operations through acquisition. In July 1993, the Company acquired Casco Telephone Company (Casco), an LEC in Wisconsin, for cash and shares of the Company's common stock aggregating approximately $4.7 million. The Company acquired shares in the market in an amount approximating those used in the acquisition. Casco has approximately 1,100 access lines, 1,100 cable television subscribers and 18,900 pro-rata cellular POPs in Wisconsin. In August 1993, the Company signed a definitive agreement with USWC under which the Company would acquire certain rural telephone exchange properties in Colorado. The properties represent 45 exchanges that serve approximately 50,000 access lines. The Company will pay approximately $207 million for these properties at closing, subject to a purchase price adjustment mechanism, based principally on the estimated book value of the assets to be acquired. Current estimates of book value indicate that the purchase price may be less than $207 million. The Company intends to fund the Colorado acquisition through external debt and internally generated funds. In an attempt to satisfy certain regulatory concerns in Colorado, the Company also entered into a construction contract with USWC in July 1993 that requires the Company to construct and upgrade plant in the properties subject to the agreement. Under the contract, the Company acts as general contractor for USWC. The construction and upgrade program will accelerate single-party - 5 - service and digital switching required by the CPUC. During 1993, the Company spent $5.7 million under this contract. Expenditures of $28 million are projected to be made under the contract in 1994. If the transaction does not close, USWC is required to reimburse the Company for all of the Company's expenditures under the construction contract including interest. The Company filed an application for approval of the transaction with the CPUC in August 1993 and approval, with conditions, was received in early March 1994. The parties to the transaction are reviewing the conditions of the CPUC approval. The Company has also submitted filings with the FCC in which the Company has requested waivers from the FCC to reclassify the exchanges from USWC's study area in Colorado to the Company's study area in Colorado and to permit rate of return regulation on the exchanges being acquired. Approval of the study area waiver would qualify these exchanges for receipt of support from the USF, as the cost to provide service in these exchanges exceeds the national average. Approval of rate of return regulation would allow the Company to replace the incentive regulation adopted for these exchanges by USWC. (See "Regulation - Local Exchange Companies.") Certain local government approvals may also be needed. Transition planning efforts have commenced and the Company expects to close the transaction in late 1994. On March 15, 1994, the Company signed letters of intent with USWC to acquire certain rural exchange properties located in Oregon and Washington from USWC for $183 million in cash, subject to certain purchase price adjustments at closing. These properties represent 49 exchanges that serve approximately 34,100 access lines. Many of these exchanges are contiguous to or located near exchanges that the Company owns and operates in these states. The transaction is subject to negotiation of a definitive purchase agreement with USWC, which is expected to be completed in early April. Completion of the transaction will also be dependent on corporate, regulatory and governmental approvals, all of which should be received by late 1994 or early 1995. The Company expects to fund the acquisition of these properties through the issuance of external debt and the use of internally generated funds. Long Lines __________ Through Alascom, the Company provides intrastate and interstate MTS, WATS, private line, leased channel and other communications services within Alaska and between Alaska and the rest of the world. Alascom's facilities interconnect with 22 LECs and the military bases within Alaska and with the interstate and international long distance network. Virtually all services are provided in accordance with tariffs filed with the appropriate regulatory agencies. (See "Regulation - Long Lines - Interstate Revenues" for information concerning Alascom's settlements arrangement with AT&T for interstate services.) Alascom uses both satellite and terrestrial facilities in providing service. In August 1991, Alascom transferred all interstate MTS and certain interstate private line services from satellite facilities to the Alaska Spur. (See "Telecommunications Operations - Pacific Telecom Cable.") Satellite facilities continue to provide intrastate MTS, WATS and private line services, link remote areas of Alaska to the long distance network (both interstate and intrastate) and serve as alternate routing for vital customer services. - 6 - Alascom operates 17 satellite transponders on Aurora II, a communication satellite that replaced Alascom's original satellite in 1991. Alascom purchased one transponder in July 1993 and leases 16 transponders under an operating lease that expires in mid-1998. Telemetry, tracking, control and in-orbit protection services are provided under contract by GE American Communications, Inc. for the projected service life of the satellite. Alascom owns 168 satellite transmit and receive earth stations (including nine transportable earth stations), a 50 percent interest in 46 earth stations used generally for service throughout Alaska and 10 additional earth stations located in the lower 48 states, Hawaii, Panama, Russia and Saudi Arabia. Alascom routinely upgrades earth stations with digital technology to provide enhanced communication services. Approximately 70 percent of the earth station circuits are digital. Alascom has digital switching equipment located at its toll centers in Anchorage, Fairbanks and Juneau. It also owns and operates major terrestrial microwave systems (primarily digital) that provide communications between Anchorage and Fairbanks and Anchorage and the cities on the Kenai Peninsula. The microwave system also interconnects Anchorage with leased Canadian facilities at the Canadian border and with Haines, Juneau and Ketchikan in the rugged terrain of southeastern Alaska. Alascom owns and operates the communications system along the Trans-Alaska Pipeline that is used to monitor and control the flow of oil through the pipeline. Alaska's geographic location makes the state strategically important for the military. Alascom has numerous private line facilities serving the government, including several transportable earth stations used to support military communication needs. In 1993, the Company sold four transportable earth stations to the U.S. Department of Defense. Alascom continues to operate one transportable earth station in Saudi Arabia, which provides telecommunication services under an agreement with the U.S. Department of Defense. Alascom is participating in a joint venture providing international MTS and private line service to several locations in the eastern part of Russia. Alaska Market Restructuring ___________________________ In 1985, the FCC established a Federal-State Joint Board (FCC CC Docket No. 83-1376) to review the interstate market structure of Alaska and to reconcile various existing and emerging federal policies affecting universal service, rate integration and competition. On October 29, 1993, the Federal-State Joint Board released a Final Recommended Decision (FRD), which proposed modifications to the existing structure for interstate service in and to Alaska. Among other matters, the FRD proposed termination of the JSA between Alascom and AT&T, effective September 1, 1995; the payment by AT&T to Alascom of $150 million for accelerated cost recovery in two equal installments of $75 million each on March 1, 1994 and September 1, 1995; a requirement that AT&T continue to utilize Alascom's facilities for the origination and termination of interstate traffic on a declining scale for a period of two and one-half years following termination of the JSA; and the creation by Alascom of an interstate tariff for carrier services based upon an as yet to be developed allocation of costs between rural and nonrural locations. On November 29, 1993, Alascom filed an Application for Review (Application) of the FRD with the FCC. In the Application, Alascom cited multiple substantive and procedural errors contained in the FRD, which it believes render the FRD legally defective and contrary to the public interest. - 7 - AT&T and GCI subsequently made filings in opposition to Alascom's Application. To date, the FCC has taken no action on either the FRD or Alascom's Application. By statute, the FCC has the sole and final authority with respect to issues in this proceeding, and may adopt, modify and adopt, or reject the FRD. As a practical matter, since a majority of the FCC Commissioners sit on the Joint Board, final actions taken by the FCC often reflect the recommendations of the Joint Board. On October 12, 1993, the Company and AT&T entered into an agreement, under which the parties may exchange proprietary information relating to Alascom's structure and operations. The purpose of the agreement was to promote the possibility of a negotiated resolution of some or all of the outstanding issues relating to the JSA and the restructuring of the Alaska interstate market. Under the terms of the agreement, the substance and progress of any negotiations between the parties are generally not disclosable. Alascom continues its efforts to correct perceived errors in the FRD and to achieve a satisfactory alternative resolution to the Alaska interstate market issues, but is unable to predict the outcome of this matter. Cellular Operations ___________________ The Company's wholly-owned subsidiary, PT Cellular, is a holding company with subsidiaries in Alaska, Michigan, Minnesota, Oregon, South Dakota, Washington and Wisconsin. The Company has ownership interests with respect to 29 MSAs and RSAs and manages 11 of these interests in Alaska, Michigan, South Dakota and Wisconsin. The Company also manages five other RSA interests in Minnesota. Revenues from cellular operations represented approximately two percent of total Company revenues in 1993. Cellular mobile telephone service is being provided or developed in areas designated as RSAs or MSAs within boundaries defined by the FCC. Cellular systems provide local and long distance telephone services through mobile radio telephones (cellular phones) that are generally either hand-held or mounted in vehicles. These cellular phones transmit and receive radio signals to and from transmitter, receiver and signaling equipment (cell sites). Cell sites in an RSA or MSA are located in a manner that will allow for the most complete coverage of an area. Each cell site is connected to a switching facility that controls the cellular system of the specific RSA or MSA and connects the cellular customer to the conventional wireline local and long distance telephone networks or to other cellular phone users in the area. The following table sets forth the Company's POP ownership by state as of December 31, 1993. (1) Represents interests with respect to RSAs and MSAs where the Company has an ownership position and manages the operations. - 8 - The Company plans to increase its ownership interests in certain cellular properties in order to achieve ownership control and to consolidate the Company's cellular service areas into larger contiguous units for operating efficiencies. This plan may be accomplished through the exchange of existing cellular interests and/or future acquisitions. In 1993, the Company sold its interests in an RSA where it had a noncontrolling position and exchanged an RSA where it had a controlling position. In 1993, the Company also increased its ownership interests in an RSA and gained a controlling interest in an MSA, both of which are in Wisconsin. The Company recognized after-tax gains on these transactions totaling $.8 million. The Company has budgeted $17.9 million for the development of cellular operations over the next three years. In 1993, the Company obtained 18,900 pro-rata POPs through an LEC acquisition in Wisconsin and another 75,150 POPs in Wisconsin through the purchase of certain cellular ownership interests. All of the cellular properties in which the Company has an ownership interest are operational. Customers served by the cellular operations controlled by the Company increased 65 percent in 1993, 70 percent in 1992 and 100 percent in 1991. Pacific Telecom Cable _____________________ PTC, which is owned 80 percent by PTI and 20 percent by Cable & Wireless plc (C&W), a United Kingdom corporation, is involved in the operation, maintenance and sale of capacity of a submarine fiber optic cable between the U.S. and Japan, known as the North Pacific Cable. The eastern end of the cable is operated by PTC. The western end is operated by International Digital Communications, Inc. (IDC), a Japanese corporation. Major IDC shareholders include C. Itoh & Co., Ltd, Toyota Motor Corporation, Pacific Telesis International and C&W. The North Pacific Cable is the first submarine fiber optic cable to provide direct service between the U.S. and Japan. In addition, through the Alaska Spur, it provides the first digital fiber optic link between Alaska and the lower 48 states. Service between the U.S. and Japan is carried on three, 420 Mbit/s digital fiber optic pairs, providing a total capacity of 1,260 Mbit/s. Service between Alaska and the lower 48 states is carried on one, 420 Mbit/s digital fiber optic pair. On the eastern end, the cable lands at Pacific City, Oregon and Seward, Alaska. From the landing stations, traffic is transmitted to carrier access centers near Portland, Oregon and Anchorage, Alaska for interconnection with digital communications facilities serving the lower 48 states and Alaska and with facilities transmitting traffic to foreign countries. In 1991, PTC sold capacity on the Alaska Spur and capacity in the landing station facilities at Pacific City, Oregon and Seward, Alaska to Alascom for approximately $56 million. In December 1992, Alascom sold 11 percent of the Alaska Spur's capacity to GCI. On the western end, the cable lands at Miura, Japan, and traffic is transmitted to IDC's carrier access centers in Tokyo, Yokohama and Osaka for interconnection with Japanese domestic service providers. For service to points beyond Japan, IDC has constructed a 75-mile submarine cable from Miura to Chikura where it interconnects with other international cables. IDC also participates in the Asia Pacific Cable system that links Miura with Hong Kong, Singapore, Taiwan and Malaysia. Construction and laying of the North Pacific Cable were completed in December 1990, the system was made available for commercial traffic in May 1991 and final system acceptance occurred in November 1991. - 9 - Forty-one private and government-owned telecommunications firms representing 25 countries have purchased approximately 51 percent of the cable's 17,010 circuit capacity. PTC recognized revenues of $4.9 million in 1993, $10.8 million in 1992 and $30.9 million in 1991 related to cable and backhaul capacity sales, excluding the Alaska Spur revenues. The cable system is operating under a warranty of one to eight years depending on the component of the system. The cable contractor has agreed to certain remedies, including providing industry support programs and enhanced repair arrangements. The Company reduced the cable inventory carrying value by $19.2 million in 1993 as a result of the agreement with the cable contractor and increased cash and accounts receivable by a corresponding aggregate amount. PTC continues to market the remaining 49 percent of unsold capacity. Marketing efforts have included the completion of tests demonstrating the feasibility of transmitting international high-quality television signals via fiber optics using the North Pacific Cable. Based on the Company's estimates of growth in trans-Pacific demand for communications capacity and the availability of other sources of capacity over the next five years, PTC believes that a majority of the remaining capacity can be sold in that time frame. PTC, IDC and C&W (Founders) are responsible for procuring maintenance for the North Pacific Cable and have renewed the existing maintenance arrangements with Cable & Wireless (Marine) Limited for an additional five- year period beginning in April 1994. Thereafter, the contract has annual renewal options for up to five years. The Founders continue to seek arrangements for a maintenance vessel to be available for service on the western end of the cable. The majority of maintenance service costs are passed on to owners of capacity on the cable. PT Transmission provides restoration services for the eastern end of the North Pacific Cable under the terms of its tariff. In the event of a cable failure, restoration services are provided via a PT Transmission satellite earth station located at Moores Valley, Oregon. International Communications ____________________________ Since 1990, the Company had reported ICH as a discontinued operation for financial statement reporting purposes. In October 1993, the Company purchased the remaining minority interest in ICH, which held investments in international telecommunications subsidiaries, including TRT. TRT provides international record messaging, message telephone and private line service between the U.S. and foreign countries, as well as special domestic communications services. The 14.9 percent minority interest in ICH was purchased from a subsidiary of France Cables et Radio. On September 23, 1993, the Company completed the sale of TRT, the major operating subsidiary of ICH, and a smaller subsidiary, to IDB for 4.5 million shares of IDB common stock and $1 million in cash. The agreement provided for the transfer of certain tangible assets and lease obligations from TRT to ICH. Based on the market value of IDB stock at closing, the Company recognized an after-tax gain from discontinued operations of $60.4 million on the sale of TRT and the smaller subsidiary. The IDB common stock was registered and sold in a secondary public offering in November 1993 and the Company received $45 per share before commissions and expenses. The $190.9 million in proceeds received by ICH from the sale of IDB - 10 - stock was paid to PTI in the form of intercompany note repayments and dividends. PTI used these funds to reduce its long-term and short-term debt. (See Notes 3, 4 and 12 to the Consolidated Financial Statements incorporated herein by reference.) Other Communications Subsidiaries and Partnerships __________________________________________________ In May 1984, the Company entered into a 50 percent partnership, Bay Area Teleport, involved in designing, constructing, operating and marketing a regional microwave system and satellite earth station complex near San Francisco, California. During 1991, the partnership was restructured. Under the restructure agreement, the Company received 100 percent of Bay Area Teleport, which is currently held by PTI Harbor Bay, Inc., a wholly-owned subsidiary. After the restructure, Bay Area Teleport was reorganized into two corporations, Niles Canyon Earth Station, Inc. (Niles Canyon), which provides satellite uplink and downlink services, and Bay Area Teleport, Inc., which provides transmission services principally in the greater San Francisco Bay Area. In the transaction involving the sale of TRT, the Company also sold Niles Canyon to IDB. Proceeds related to the sale of the IDB stock received in exchange for the stock of Niles Canyon amounted to $4.3 million. (See "Telecommunications Operations - International Communications" concerning this transaction.) The Company also owns Upsouth Corporation (Upsouth), which owns an earth station complex near Atlanta, Georgia and another near Carteret, New Jersey. In October 1993, the Company agreed to sell PTI Harbor Bay and Upsouth to IntelCom Group, Inc. (IntelCom:ITR) for 853,147 shares of IntelCom stock and $.2 million in cash. The Company will also receive at least 250,000 more shares of IntelCom common stock in lieu of debt that will not be assumed by the purchaser. The Company will be granted certain demand and piggyback registration rights for the IntelCom stock it receives and expects the transaction to close in the first half of 1994. Based on recent prices for IntelCom stock, the Company could record a pre-tax gain ranging from $7 million to $10 million on this transaction, excluding selling commissions and other expenses. The actual gain or loss realized will be dependent on IntelCom's stock price when the shares are sold. The transaction is subject to necessary regulatory approvals. IntelCom provides alternative local network access, local area networks and systems integration, as well as operating a full-service domestic and international satellite uplink teleport. In 1989, the Company acquired three AM/FM combination radio stations in Oregon, Nevada and Idaho in an effort to protect an investment made when the Company was investing in non-telecommunications businesses. In 1992, the AM radio station in Idaho was contributed to an institution of higher education. The Company also has signed a letter of intent to sell the FM station in Idaho and is waiting for regulatory approval of the sale, which is expected to close in the first half of 1994. - 11 - Regulation __________ General _______ Alascom and the Company's LECs operate in an industry that is subject to extensive regulation by the FCC and state regulatory agencies. Virtually all services, both local and long distance, are provided in accordance with tariffs filed with the appropriate regulatory agencies. The telecommunications industry continues to undergo change as a result of a series of regulatory and judicial proceedings regarding the deregulation of certain aspects of the industry. The FCC and some state regulatory agencies are exploring alternative forms of regulation that depart from traditional rate of return regulation for telecommunications companies. These alternatives include possibilities of opening local exchange franchises to encourage greater competition. The effects of any such alternative form of regulation on the Company's LECs is uncertain. Interstate and certain international services provided by Alascom are governed by tariffs filed with the FCC. The Company's LECs are governed by tariffs filed with the FCC for interstate access services provided to interexchange carriers. The FCC also licenses other aspects of the Company's telecommunications operations, including the construction and operation of its microwave, cable and radio facilities and its satellite and earth stations. As part of its regulation, the FCC prescribes a Uniform System of Accounts (USOA) that dictates the account structure and accounting policies used by both Alascom and the LECs. The FCC also establishes the principles and procedures (separations procedures) that allocate telephone investment, operating expenses and taxes between interstate and intrastate jurisdictions for the Company's LEC operations and Alascom. Generally, the state regulatory agencies have adopted the USOA and the principles and procedures prescribed by the FCC. To discourage carriers from subsidizing the cost of nonregulated business activities and to protect customers from unjust and unreasonable rates, the FCC and certain state regulatory commissions have adopted accounting and cost allocation rules for segregating the costs of regulated services and nonregulated services. The rules are based on fully distributed costing principles. In addition to segregating costs, the accounting policies prescribe guidelines for recording transactions between affiliates, require monitoring of jurisdictional earnings of various services and set forth a process for auditing the allocation procedures. The Company's cellular interests are regulated by the FCC with respect to the construction, operation and technical standards of cellular systems and the licensing and designation of geographic boundaries of service areas. Certain states also require operators of cellular systems to satisfy a state certification process to serve as cellular operators. Local Exchange Companies ________________________ The facilities of the Company's LECs are used principally to provide local telephone service and customer access to the long distance network. The costs of providing services are allocated between the interstate and intrastate jurisdictions. Interstate service costs (both traffic sensitive and nontraffic sensitive) are recovered through an access charge plan under which LEC and NECA tariffs filed with the FCC allow for charges to interexchange carriers for access to customers. The traffic sensitive costs are recovered - 12- either directly through access charges or through settlements with NECA. The nontraffic sensitive portion (subscriber loop) of these interstate-related costs is recovered through a settlement process with NECA. The nontraffic sensitive revenue pool administered by NECA is funded by a subscriber line charge to individual customers, interexchange carrier access charges and long-term support payments by nonpooling LECs. Since January 1, 1991, the interstate rate-of-return authorized by the FCC for LECs' interstate access services, has been 11.25 percent. The USF administered by NECA compensates companies whose nontraffic sensitive costs per subscriber are greater than an established threshold over the national average. Due to the suburban and rural nature of its operations, most of the Company's LECs receive this compensation, as the cost of providing local service in rural areas generally exceeds the national average. In November 1993, based on a concern over recent growth in the size of the USF, a Federal-State Joint Board issued a recommended decision to the FCC proposing the adoption of interim USF rules. These interim rules recommend that an indexed cap be placed on USF growth to allow the USF to grow at a rate no greater than the rate of growth in the U.S.'s total working local loops. The interim rules are intended to allow moderate growth in the total level of the USF while the FCC and the Federal-State Joint Board undertake a re-evaluation of the USF assistance mechanism. The Federal-State Joint Board proposed that the interim rules remain in effect for two years. The FCC adopted the Joint Board recommendation at the end of 1993. As most of the Company's LEC operations receive USF compensation, significant changes to the USF assistance mechanism could affect the Company's future results. The Company believes that placing the indexed cap on USF growth may have a negative impact on the Company's revenues, but the impact is not expected to be material. In addition, the Company may request a revenue increase at the state level to offset some or all of the lost assistance where USF proceeds are used to maintain lower rates. As an alternative for rate-of-return regulation, the FCC adopted optional incentive regulation for LECs beginning in 1991. Due to specific constraints, including the requirement that all LECs under common ownership must adopt incentive regulation when it is adopted by any LEC in the group, it is unlikely that the Company will adopt this form of regulation in the near future. NECA has recently filed with the FCC its own recommendation for an incentive regulation plan. The Company intends to monitor the progress of NECA's efforts and evaluate its options if an alternative regulation plan is implemented. In September 1993, the Company filed, in compliance with FCC Docket No. 91-213, to restructure its interstate switched access transport prices consistent with the related proposal of the Telephone Utilities Exchange Carrier Association, which was ultimately approved by the FCC in December 1993 and made effective January 1, 1994. The local transport restructure proceeding accomplished a further unbundling of exchange carrier switched access services. The new structure is expected to promote network efficiency by moving access prices for local transport closer to cost. In 1993, the Wisconsin Public Service Commission (WPSC) mandated a new service, effective December 1, 1993, called Extended Community Calling (ECC). This service extends local calling areas to allow customers to reach their local areas of interest without incurring long distance charges, even if exchange boundaries are crossed. These areas of interest generally extend 15-miles from the customer's home exchange. The Company believes that ECC - 13 - will cause immaterial reductions in the Company's billing and collection revenues and access revenues, which reductions are expected to be offset in part by ECC revenues. In Washington, a process was started in 1990 to restructure rates to allow the conversion of all multi-party to single-party lines, to eliminate touchtone charges and to offer certain customers Extended Area Service (EAS). In August 1993, the Company proposed additional revisions to rates for further extension of EAS to substantially all of its Washington customers. By the end of 1994, all lines in Washington are expected to be single-party, with approximately 98 percent having EAS capabilities. In May 1993, toll free calling was implemented for the entire Flathead Valley in Montana. Evolution to single-party service in Montana was completed during 1993. These changes are not expected to have a significant effect on the financial results of the Company. The Company received authorization from the Oregon Public Utilities Commission to implement revised depreciation rates retroactive to January 1, 1993. This adjustment increased the depreciation rate and increased operating expenses by $2.2 million. In addition, the Company has a depreciation study on file with the WUTC for its LEC operations in the state of Washington. The Company is in negotiation with the WUTC to resolve issues relating to the proposed depreciation rate increase. The Company has also agreed to provide a depreciation study to the APUC. Long Lines - Interstate Revenues ________________________________ Alascom's interstate MTS and WATS revenues are presently derived through the JSA with AT&T providing for cost-based settlements determined in accordance with historical practices and regulatory procedures. The entire Alaska interstate long distance market, including these procedures and the settlement arrangement, have been under review by a Joint Board for several years. Prior to 1991, AT&T, GCI and Alascom submitted proposals to the Joint Board recommending alternative market structures in Alaska. None of these proposals were acted upon by the Joint Board or the FCC. In December 1991, the Company and AT&T signed an agreement to transfer to AT&T the provision of interstate and international MTS and WATS services then currently provided in Alaska by Alascom. This agreement terminated in January 1993 without implementation. In October 1993, the Joint Board issued a final recommendation concerning the restructuring of the interstate telecommunications market for Alaska. That recommendation is awaiting FCC action. (See "Telecommunications Operations - Alaska Market Restructuring.") Long Lines - Access Charges ___________________________ While Alascom's interstate MTS and WATS revenues continue to be determined under the JSA with AT&T, Alascom purchases access to the local network under an access tariff and billing and collection services under a separate contract. These charges for interstate access services are determined using access charge procedures used by LECs in the contiguous 48 states. (See "Regulation - Local Exchange Companies.") Interstate access charges and billing and collection charges are included under the JSA with AT&T. Alascom makes payments for intrastate access charges through a state access tariff. The access charge system was implemented in 1991 to accommodate intrastate competitive entry. (See "Competition - Long Lines - - - -Intrastate.") - 14 - The Alaska Exchange Carriers Association coordinates the filing of access tariffs and the pooling of costs. The adoption of intrastate access charges has had no material adverse effect on the Company's results of operations. Alascom purchases intrastate billing and collection services under a separate contract. Long Lines - Alaska Spur ________________________ In November 1989, Alascom filed an application with the FCC seeking authorization to acquire the Alaska Spur. (See "Telecommunications Operations-Pacific Telecom Cable.") On May 13, 1991, the FCC granted Alascom authorization to acquire and operate the Alaska Spur, subject to certain conditions. Alascom requested the FCC to issue a revised order without the conditions and did not accept the authorization. Subsequently, the FCC issued temporary authorization for Alascom to acquire and operate the Alaska Spur, subject to periodic renewal. The Alaska Spur was placed into service in August 1991. The request for reconsideration of the order is still pending before the FCC. The FCC has granted Alascom a renewal of the temporary authorization through August 8, 1994. In December 1992, Alascom sold 11 percent of the Alaska Spur's capacity to GCI. Competition ___________ Local Exchange Companies ________________________ The Company's LECs have experienced little competition in providing basic services, primarily due to the suburban and rural nature of their service territories. Competition from the development of alternative networks by other carriers and of private networks (bypass) by government agencies and large corporate customers has resulted in minor diversions of traffic from the Company's LECs. To date, the Company has also experienced little competition from cable TV providers and wireless technologies. Competition from these sources may increase if regulators open basic telephone service to cable TV operators and as wireless technologies advance. However, investment by others in facilities will be required to provide competitive service and these investments will be based on appropriate economic opportunities and demand for such services. The Company believes it is well positioned to meet this type of competition and that price and service are the significant competitive factors in dealing with alternative networks, bypass and other forms of competition. With respect to access service, the Company's LECs may face competition from several sources in the future. Alternative or competitive access carriers (CAPs) have, in various parts of the country, constructed facilities which bypass those of the local exchange carrier to provide access between customers and interexchange carriers. The location and extent of such activity is determined by a number of factors, including applicable state and federal regulatory policies, and economic and market conditions in the area. A number of interexchange carriers have also announced or implemented programs to construct facilities which bypass those of local exchange companies. AT&T has entered into an acquisition agreement with a major cellular company, McCaw Cellular Communication, in part for the apparent purpose of reducing its dependence upon local exchange companies for access services. MCI has announced a program for construction of facilities in twenty major metropolitan areas, also for the purpose, in part, of reducing its dependence upon local exchange companies for access services. - 15 - The Company believes that the activities of CAPs and the major interexchange carriers, at present, do not pose a direct, material threat to the Company's revenues due to the rural nature of its operations. The Company anticipates that competition in services and facilities will evolve over time in its LEC service areas. The Company is reviewing the potential effect such competitive activity may have on its operations and is analyzing ways to benefit from changes which may occur as competition increases. Long Lines - Interstate _______________________ In 1982, the FCC authorized a variety of carriers to provide interstate services in Alaska in competition with Alascom. GCI, a carrier providing private line, MTS and WATS equivalent services to and from Alaska, attracted a significant number of customers as LECs converted to equal access in Anchorage, Fairbanks, Juneau and other areas. Although rates were a significant competitive issue during the introduction of equal access, the rate advantage enjoyed by GCI prior to rate integration was reduced with the integration of toll rates in January 1987 and subsequent nationwide annual rate reductions through 1990. As a result of these rate reductions and other factors, Alascom has experienced growth in interstate billed minutes of 6.2 percent in 1993, 11.9 percent in 1992 and 10.4 percent in 1991. The Company believes that with minimal rate differences, service is currently the predominant competitive factor in the Alaska interstate market. In January 1990, GCI filed a petition for rulemaking with the FCC seeking to abolish the present prohibition against construction of duplicate earth station facilities in rural Alaska. GCI stated that it desired to extend its services to rural Alaska over a five-year period. Alascom opposed GCI's petition, as being contrary to the public interest. The FCC has taken no action with regard to the GCI petition. Long Lines - Intrastate _______________________ In 1990, the Alaska Legislature enacted legislation that authorized intrastate competition and the APUC established specific regulations for competition that allowed facilities-based competition in some areas, but prohibited construction of duplicative facilities in most remote locations. The APUC also designed a competitive framework under which high costs of providing service in rural locations are shared by Alascom and its competitors through the LEC access charge pooling mechanism. Intrastate competition in Alaska commenced in May 1991. Competition has been introduced in approximately 90 percent of the Company's intrastate market. The Company's intrastate long distance service revenues, net of related access charges, accounted for approximately five percent of the Company's total revenues for 1993 and six percent in 1992 and 1991. As a result of competition, intrastate minute volumes increased 1.7 percent in 1993 and decreased 7.3 percent in 1992 and 4.9 percent in 1991. The Company has mounted a marketing campaign in response to this competition and believes that price and service are the significant competitive factors in this market. - 16 - Cellular Operations ___________________ Under FCC guidelines, two licenses were granted in each MSA and RSA to provide cellular service. All of the MSAs and RSAs in which the Company has an ownership interest are operational. The Company believes that price and service are significant competitive factors in the cellular market. A competitive threat to cellular operations from other wireless communications technologies also exists. This threat may increase as these technologies are developed in the future. In September 1993, the FCC allocated 160 megahertz (MHz) of spectrum for Personal Communications Services (PCS). The FCC created seven licensed frequency blocks representing 120 MHz of spectrum and identified 40 MHz of spectrum for unlicensed PCS. The licensed spectrum was channelized into two 30 MHz blocks, one 20 MHz block and four 10 MHz blocks. The FCC defined the PCS license areas based on 51 Major and 492 Basic Trading Areas (MTA and BTA, respectively), as defined by Rand McNally. PCS licenses will be awarded through an auction process starting not earlier than May 1994. The Company's cellular operations are eligible to participate in the PCS auction subject to certain limitations established by the FCC. The PCS license term is set at 10 years with requirements to cover 33 percent of the POPs within five years, 67 percent within seven years and 90 percent of the POPs within ten years. The Company is monitoring PCS developments and evaluating its alternatives under the proposed PCS licensing rules. Cable Operations ________________ The North Pacific Cable is currently the only operating cable between the U.S. and the western Pacific that has available capacity for sale. AT&T placed a cable into service between the U.S. and Japan in late 1992. This cable competed directly with the North Pacific Cable for subscribers. AT&T has stated that all capacity on its cable has been subscribed. AT&T has announced plans for an additional cable system between the eastern and western Pacific for completion in the period from 1995 to 1997. The North Pacific Cable also competes with available capacity on international satellites. Environment ___________ Compliance with federal, state and local provisions relating to protection of the environment has had no significant effect on the capital expenditures or earnings of the Company. Future effects of compliance with environmental laws are not expected to be material, but environmental laws could become more stringent over time. Employees _________ At December 31, 1993, the Company had 2,834 employees, approximately 41 percent of whom were members of seven different bargaining units. These units are represented by one of the International Brotherhood of Teamsters, the International Brotherhood of Electrical Workers, Communication Workers of America or the NTS Employee Committee. During 1993, negotiations were completed on two collective bargaining agreements governing 144 employees. Negotiations on six contracts covering 1,180 employees are planned in 1994. Relations with represented and non-represented employees continue to be generally good. - 17 - Construction Program ____________________ The Company financed its 1993 construction program primarily through internally generated funds. Construction expenditures for 1993 and estimated expenditures for 1994 through 1996, excluding expenditures for the construction contract with USWC amounting to $5.7 million in 1993 and estimated at $28 million for 1994, are as follows (in millions): The estimates of construction costs set forth above are subject to continuing review and adjustment. The Company anticipates that it will be able to finance substantially all of its construction programs for 1994 from internally generated funds. Estimated increases in LEC construction expenditures in 1995 and 1996 relates mainly to the acquisition of USWC properties in Colorado anticipated at the end of 1994. Acquisition Program ___________________ The Company expects to complete additional acquisitions as attractive opportunities become available. The Company's strategy is to acquire rural or suburban local exchange properties with operating characteristics similar to existing properties of the Company. These opportunities will allow the Company to leverage LEC investments by providing data processing and administration through its centralized systems. The Company seeks to realize economies of scale through these acquisitions, particularly where the properties are near the Company's current operations or are of sufficient size to support moving into a new geographic area. (See "Item 1. Business - Telecommunications Operations - Local Exchange Companies" for information regarding pending acquisitions of USWC properties in Colorado, Oregon and Washington.) Item 2.		Item 2. PROPERTIES _______ The telephone properties of the Company's LECs include central office equipment, microwave and radio equipment, poles, cables, rights of way, land and buildings, customer premise equipment, vehicles and other work equipment. Most of the Company's division headquarters buildings, telephone exchange buildings, business offices, warehouses and storage areas are owned by the Company's LECs and are pledged to secure long-term debt. In addition, certain of the LECs' microwave facilities, central office equipment and warehouses are located on leased land. Such leases are not considered material, and their termination would not substantially interfere with the operation of the Company's business. (See "Item 1. Business - Telecommunications Operations - Local Exchange Companies" for information regarding the states in which the Company has LEC operations.) The properties of Alascom include toll centers with toll switching facilities, microwave and radio equipment, satellite transmit and receive - 18 - earth stations, submarine cables (including the Alaska Spur), land, warehouse and administrative buildings, as well as transportation and other work equipment. Although Alascom owns most of its buildings, much of its telecommunications equipment is located on leased property. In addition, Alascom leases certain microwave and satellite circuits to carry both interstate and intrastate communications. The Company owned 16 transponders on Aurora II until October 1992 when the transponders were sold and leased back on an operating lease basis for a 69-month period. Aurora II was launched in May 1991 to replace the Company's original satellite and was placed in service in July 1991. The Company purchased and placed in service one additional transponder on Aurora II in 1993. (See "Item 1. Business - Telecommunications Operations - Long Lines" for information concerning other properties of Alascom.) PT Cellular's subsidiaries are partners in partnerships that own or lease switching facilities, cell site towers, cell site radio equipment and other equipment required to furnish cellular service to the areas they serve. (See "Item 1. Business - Telecommunications Operations - Cellular Operations" for information regarding the states in which the Company has cellular operations.) The properties of PTC and PT Transmission include a satellite transmit and receive earth station, located at Moores Valley, Oregon, fiber optic cables, land, buildings, operating facilities and business offices, all of which are owned. In addition, PTC leases a duplicate cable for backup between Pacific City, Oregon and Portland, Oregon and business office space. PTC also holds in inventory its portion of the unsold capacity in the North Pacific Cable and backhaul facilities. Almost all the properties of ICH were sold in 1993 to IDB. However, ICH owns land, buildings and office equipment in Florida. ICH is obligated under a lease for office space in Washington D.C., which housed TRT's administrative offices. ICH is actively pursuing the lease or sublease of these properties. ICH has leased the Florida building and equipment to IDB for three years with renewal options for an additional four years. (See Item 1. "Business - Telecommunications Operations - International Communications" for information concerning the sale of ICH's major operating subsidiary to IDB.) The Company's executive, administrative, purchasing and certain engineering functions are headquartered in Vancouver, Washington. The Company has a 50 percent ownership interest in its headquarters building and, through a long-term lease, occupies approximately 72 percent of the 225,000 square-foot building. The Company leases most of the equipment used in conjunction with providing data processing services. Item 3.	Item 3. LEGAL PROCEEDINGS _________________ The Company is a party to various legal claims, actions and complaints, one of which is described below. Although the ultimate resolution of legal proceedings cannot be predicted with certainty, management believes that disposition of these matters will not have a material adverse effect on the Company's consolidated results of operations. - 19 - Loewen, et al. v. Galligan, et al. (Circuit Court for the State of Oregon, __________________________________________________________________________ County of Multnomah) ____________________ In November 1991, former shareholders of American Network, Inc. (AmNet) filed a third amended complaint against PTI and others, suing individually and also derivatively on behalf of AmNet for damages allegedly arising out of the acquisition of AmNet by United States Transamerica Systems, Inc. (USTS), a subsidiary of ITT Corporation, in 1988 and various alleged wrongs in connection with certain transactions that occurred in 1984 and 1986 between AmNet or its subsidiaries and PTI or between AmNet and other parties. At the time of the acquisition by USTS, PTI owned 36.4 percent of the common shares of AmNet. The third amended complaint revised the plaintiffs' 1984 and 1986 fraud claims and changed the plaintiffs under all claims. As a result, differing plaintiff groups are now suing PTI and other defendants for state securities and common law fraud allegedly committed in 1984, 1986 and 1988 and four plaintiffs are suing PTI alone for breach of an alleged promise to provide financial support to AmNet in 1984. Plaintiffs seek to recover damages from PTI in the amount of plaintiffs' lost investments, plaintiffs' costs, disbursements and reasonable attorney fees, and punitive damages of $100 million. On August 19, 1992, the court granted defendants' motions for summary judgment against all claims in the third amended complaint. Judgment in favor of defendants was entered on November 23, 1992 and plaintiffs' appeal to the Oregon Court of Appeals is pending. Item 4.	Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS ___________________________________________________ No information is required to be reported pursuant to this item. Item 4A. EXECUTIVE OFFICERS OF THE REGISTRANT ____________________________________ The executive officers of PTI are as set forth below: Name Age Position ____ ___ ________ Charles E. Robinson 60 Chairman, President, Chief Executive Officer and Director James H. Huesgen 44 Executive Vice President and Chief Financial Officer Donn T. Wonnell 47 Vice President, Regulatory Affairs and Corporate Secretary Wesley E. Carson 43 Vice President, Human Resources Brian M. Wirkkala 53 Vice President, Treasurer Donald A. Bloodworth 37 Vice President, Revenue Requirements and Controller - 20 - The executive officers of PTI are elected annually for one year and hold office until their successors are elected and qualified. There are no family relationships among them. Mr. Robinson was elected Chairman of the Board in February 1989. In April 1982, he was elected Director, President and Chief Operating Officer. He became Chief Executive Officer in April 1985. Mr. Robinson is also President and Chairman of the Board of Alascom and a member of PacifiCorp's Corporate Policy Group. Mr. Huesgen, a CPA, was elected Executive Vice President and Chief Financial Officer in October 1990. He had served as Vice President, Accounting and Financial Planning since February 1989 and as Controller since July 1986. Mr. Wonnell, an attorney, was elected Vice President, Regulatory Affairs and Corporate Secretary in February 1991. Prior to joining the Company, he was engaged in the private practice of law and in corporate development activities. Mr. Carson, an attorney, was elected Vice President, Human Resources in November 1991. He had served as Manager, Employee Relations since February 1990 and as Manager, Labor Relations since February 1989. Prior to joining PTI in 1989, he had served as Manager, Industrial Relations at TRT Telecommunications Corporation since May 1984. Mr. Wirkkala was elected Vice President, Treasurer in February 198l. Mr. Bloodworth, a CPA, was elected Vice President, Revenue Requirements and Controller in April 1993. From October 1987 to April 1993, he was employed by PacifiCorp Financial Services, Inc., most recently as Vice President and Treasurer. Additionally, from January 1992 to April 1993, he served as Vice President and Treasurer of PacifiCorp Holdings, Inc. and Assistant Treasurer of PacifiCorp. Mr. Bloodworth served in various management and supervisory accounting positions at the Company from March 1983 to October 1987. - 21 - PART II Item 5.	Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS _________________________________________________ The information required by this item is included under "Common Stock Prices/Dividends" on page 41 of the Company's 1993 Annual Report to Shareholders and is incorporated herein by reference. See page 62 attached hereto. Item 6.	Item 6. SELECTED FINANCIAL DATA _______________________ The information required by this item is included under "Selected Financial Data" on page 16 of the Company's 1993 Annual Report to Shareholders and is incorporated herein by reference. See page 37 attached hereto. Item 7.	Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS _________________________________________________ The information required by this item is included under "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 17 through 24 of the Company's 1993 Annual Report to Shareholders and is incorporated herein by reference. See pages 38 through 45 attached hereto. Item 8.	Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ___________________________________________ The information required by this item is incorporated by reference from the Company's 1993 Annual Report to Shareholders or filed with this Report as listed in Item 14 hereof. Item 9.	Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE ________________________________________________ No information is required to be reported pursuant to this item. - 22 - PART III Item 10.	Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT _______________________________________ The information required by this item is incorporated by reference to "Election of Directors" in the Company's definitive proxy statement for its 1994 Annual Meeting of Shareholders filed or to be filed not later than 120 days after the end of the fiscal year covered by this Report. Information about the executive officers of the Company is included in Part I of this Report under Item 4A. Item 11.	Item 11. EXECUTIVE COMPENSATION ______________________ The information required by this item is incorporated by reference to "Executive Compensation" in the Company's definitive proxy statement for its 1994 Annual Meeting of Shareholders filed or to be filed not later than l20 days after the end of the fiscal year covered by this Report. Item 12.	Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT ________________________________________ The information required by this item is incorporated by reference to "Security Ownership of Certain Beneficial Owners and Management" in the Company's definitive proxy statement for its 1994 Annual Meeting of Shareholders filed or to be filed not later than 120 days after the end of the fiscal year covered by this Report. Item 13.	Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS ______________________________________________ The information required by this item is incorporated by reference to "Certain Transactions" in the Company's definitive proxy statement for its 1994 Annual Meeting of Shareholders filed or to be filed not later than 120 days after the end of the fiscal year covered by this Report. - 23 - PART IV * Page references are to the incorporated portion of the Annual Report to Shareholders of the Registrant for the year ended December 31, 1993, which portion is appended hereto. ** All other schedules have been omitted because of the absence of the conditions under which they are required or because the required information is included elsewhere in the financial statements incorporated by reference in this Report. - 24 - (3) Exhibits: 2 Agreement for Purchase and Sale of Exchanges between US WEST Communications, Inc. and the Registrant dated August 30, 1993. 3A Restated Articles of Incorporation of the Registrant, as amended June 13, 1990. (Incorporated by reference to Exhibit 3A of the Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1990, File No. 0-873.) 3B Bylaws of the Registrant, as amended and restated effective April 30, 1993. 4 Indenture dated as of September 20, 1991, between the Company and The First National Bank of Chicago, as Trustee for the Series B Medium- Term Notes. (Incorporated by reference to Exhibit 4 of the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1991, File No. 0-873.) In reliance upon Item 601(4)(iii) of Regulation S-K, various instruments defining the rights of holders of long-term debt of the Registrant and its subsidiaries are not being filed because the total amount authorized under each such instrument does not exceed 10 percent of the total assets of the Registrant and its subsidiaries on a consolidated basis. The Registrant hereby agrees to furnish a copy of any such instrument to the Commission upon request. 10A Executive Bonus Plan, dated October 26, 1990. (Incorporated by reference to Exhibit 10B of the Registrant's Annual Report on Form 10-K for the year ended December 31, 1990, File No. 0-873.) 10B Intercompany Borrowing Agreement between the Registrant, Inner PacifiCorp, Inc. (now PacifiCorp Holdings, Inc.) and certain other affiliated companies dated as of April 1, 1991. (Incorporated by reference to Exhibit 10A of the Registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 1991, File No. 0-873.) 10C Management Services Agreement between the Registrant and Pacific Power & Light Company. (Incorporated by reference to Exhibit 10D of the Registrant's Annual Report on Form 10-K for the year ended December 31, 1980, File No. 0-873.) 10D Lease Agreement between Northwestel, Inc. and Alascom, Inc., dated January 3, 1990. (Incorporated by reference to Exhibit 10D of the Registrant's Annual Report on Form 10-K for the year ended December 31, 1992, File No. 0-873.) 10E PacifiCorp Supplemental Executive Retirement Plan 1988 Restatement. (Incorporated by reference to Exhibit 10(q) of PacifiCorp's Form 10-K for the year ended December 31, 1987, File No. 1-5152.) 10F Pacific Telecom, Inc. Long-Term Incentive Plan 1994 Restatement dated as of January 1, 1994. - 25 - 10G PacifiCorp Long-Term Incentive Plan 1993 Restatement. 10H Form of Restricted Stock Agreement under the PacifiCorp Long-Term Incentive Plan 1993 Restatement. 10I Credit Agreement dated as of November 13, 1991. (Incorporated by reference to Exhibit 10M of the Registrant's Annual Report on Form 10-K for the year ended December 31, 1991, File No. 0-873.) 10J Lease Intended for Security dated March 12, 1993, among Alascom, Inc., as lessee, Norwest Bank Minnesota, as Agent, and certain institutions as lessors. (Incorporated by reference to Exhibit 10K of the Registrant's Annual Report on Form 10-K for the year ended December 31, 1992, File No. 0-873.) 10K Non-employee Directors' Stock Compensation Plan dated April 5, 1993. (Incorporated by reference to Exhibit 10L of the Registrant's Annual Report on Form 10-K for the year ended December 31, 1992, File No. 0- 873.) 10L Executive Deferred Compensation Plan dated as of January 1, 1994. 12 Statements re Computation of Ratios. 13 Registrant's Annual Report to Shareholders for the year ended December 31, 1993. Except as specifically incorporated by reference herein, the Annual Report shall not be deemed filed as part of this Report on Form 10-K. 21 Subsidiaries 23 Independent Auditors' Consent and Report on Schedules - Included on page 29 of this Annual Report on Form 10-K. _________________ This exhibit constitutes a management contract or compensatory plan or arrangement. (b) Reports on Form 8-K. On Form 8-K dated November 19, 1993, under Item 5. "Other Events," the Company reported the sale of IDB Communications Group, Inc. common stock. - 26 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. PACIFIC TELECOM, INC. March 25, 1994 By JAMES H. HUESGEN (Date) _____________________________ James H. Huesgen Executive Vice President and Chief Financial 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 AND CAPACITY DATE ______________________ ____ CHARLES E. ROBINSON ____________________________________ (Charles E. Robinson) March 25, 1994 Chairman, President, Chief Executive Officer and Director JAMES H. HUESGEN ____________________________________ (James H. Huesgen) March 25, 1994 Executive Vice President and Chief Financial Officer (Principal Financial Officer) DONALD A. BLOODWORTH ____________________________________ (Donald A. Bloodworth) March 25, 1994 Vice President Revenue Requirements/Controller - 27 - SIGNATURE AND CAPACITY DATE ______________________ ____ JOYCE E. GALLEHER ____________________________________ (Joyce E. Galleher) March 25, 1994 Director ROY M. HUHNDORF ____________________________________ (Roy M. Huhndorf) March 25, 1994 Director DONALD L. MELLISH ____________________________________ (Donald L. Mellish) March 25, 1994 Director SIDNEY R. SNYDER ____________________________________ (Sidney R. Snyder) March 25, 1994 Director NANCY WILGENBUSCH ____________________________________ (Nancy Wilgenbusch) March 25, 1994 Director - 28 - EXHIBIT 23 DELOITTE & TOUCHE _____________________________________________________ _________________ 3900 US Bancorp Tower Telephone: (503)222-1341 [LOGO] 111 SW Fifth Avenue Facsimile: (503)224-2172 Portland, Oregon 97204-3698 INDEPENDENT AUDITORS' CONSENT AND REPORT ON SCHEDULES Pacific Telecom, Inc.: We consent to the incorporation by reference in Registration Statement No. 33- 42577 on Form S-3 and Registration Statement No. 33-52600 on Form S-8 of our report dated January 26, 1994 (which expresses an unqualified opinion and includes an explanatory paragraph relating to a change in method of accounting for other postretirement benefits and income taxes in the year ended December 31, 1993), incorporated by reference in this Annual Report on Form 10-K of Pacific Telecom, Inc. Our audits of the financial statements referred to in our aforementioned report also included the financial statement schedules of Pacific Telecom, Inc., listed in Item 14.
54507_1993.txt	54507	1993	ITEM 1. BUSINESS GENERAL Western Resources, Inc. (formerly The Kansas Power and Light Company, KPL) is a combination electric and natural gas public utility engaged in the generation, transmission, distribution and sale of electric energy in Kansas and the purchase, transmission, distribution, transportation and sale of natural gas in Kansas, Missouri and Oklahoma. As used herein, the terms "Company and Western Resources" include its wholly-owned subsidiaries, Astra Resources, Inc., Kansas Gas and Electric Company (KG&E) since March 31, 1992, and KPL Funding Corporation (KFC), unless the context otherwise requires. KG&E owns 47 percent of Wolf Creek Nuclear Operating Corporation, the operating company for Wolf Creek Generating Station (Wolf Creek). Corporate headquarters of the Company is located at 818 Kansas Avenue, Topeka, Kansas 66612. At December 31, 1993, the Company had 5,192 employees. On January 31, 1994, the Company sold substantially all of its Missouri natural gas distribution properties and operations to Southern Union Company (Southern Union). The Company sold the remaining Missouri properties to United Cities Gas Company (United Cities) on February 28, 1994. The properties sold to Southern Union and United Cities are referred to herein as the "Missouri Properties". With the sales the Company is no longer operating as a utility in the State of Missouri. The portion of the Missouri Properties purchased by Southern Union, were sold for an estimated sale price of $400 million, in cash, based on a calculation as of December 31, 1993. The final sale price will be calculated as of January 31, 1994, within 120 days of closing. Any difference between the estimated and final sale price will be adjusted through a payment to or from the Company. United Cities purchased the Company's natural gas distribution system in and around the City of Palmyra, Missouri, for $665,000 in cash. The operating revenues and operating income (unaudited) related to the Missouri Properties approximated $350 million and $21 million representing approximately 18 percent and seven percent, respectively, of the Company's total for 1993, and $299 million and $11 million representing approximately 19 percent and five percent, respectively, of the Company's total for 1992. Net utility plant (unaudited) for the Missouri Properties, at December 31, 1993, approximated $296 million and $272 million at December 31, 1992. This represents approximately seven percent at December 31, 1993, and six percent at December 31, 1992, of the total Company net utility plant. Separate audited financial information was not kept by the Company for the Missouri Properties. This unaudited financial information is based on assumptions and allocations of expenses of the Company as a whole. For additional information see Note 13 of the Notes to Consolidated Financial Statements. On March 31, 1992, the Company through its wholly-owned subsidiary KCA Corporation (KCA), acquired all of the outstanding common and preferred stock of Kansas Gas and Electric Company for $454 million in cash and 23,479,380 shares of common stock (the Merger). The Company also paid approximately $20 million in costs to complete the Merger. Simultaneously, KCA and Kansas Gas and Electric Company merged and adopted the name of Kansas Gas and Electric Company (KG&E). Additional information relating to the Merger can be found in Management's Discussion and Analysis of Financial Condition and Results of Operations and Note 3 of Notes to Consolidated Financial Statements. The following information includes the operations of KG&E since March 31, 1992. The percentages of Total Operating Revenues and Operating Income Before Income Taxes attributable to the Company's electric and natural gas operations for the past five years were as follows: Total Operating Income Operating Revenues Before Income Taxes Year Electric Natural Gas Electric Natural Gas 1993 58% 42% 85% 15% 1992 57% 43% 89% 11% 1991 41% 59% 84% 16% 1990 40% 60% 85% 15% 1989 40% 60% 81% 19% The difference between the percentage of electric operating revenues in relation to the percentage of electric operating income as compared to the same percentages for gas operations is due to the Company's level of investment in plant and its fuel costs in each of these segments. The amount of the Company's plant in service (net of accumulated depreciation) at December 31, for each of the past five years was as follows: Year Electric Natural Gas Total (Thousands of Dollars) 1993 $3,641,154 $759,619 $4,400,773 1992 3,645,364 696,036 4,341,400 1991 1,080,579 628,751 1,709,330 1990 1,092,548 567,435 1,659,983 1989 1,092,534 511,733 1,604,267 As a regulated utility, the Company does not have direct competition for retail electric service in its certified service area. However, there is competition, based largely on price, from the generation, or potential generation, of electricity by large commercial and industrial customers, and independent power producers. Electric utilities have been experiencing problems such as controversy over the safety and use of coal and nuclear power plants, compliance with changing environmental requirements, long construction periods required to complete new generating units resulting in high fixed costs for those facilities, difficulties in obtaining timely and adequate rate relief to recover these high fixed costs, uncertainties in predicting future load requirements, competition from independent power producers and cogenerators, and the effects of changing accounting standards. The problems which most significantly affect the Company are the use, or potential use, of cogeneration or self-generation facilities by large commercial and industrial customers and compliance with environmental requirements. For additional information see Management's Discussion and Analysis and Notes 4 and 5 of the Notes to Consolidated Financial Statements included herein. Discussion of other factors affecting the Company is set forth in the Notes to Consolidated Financial Statements and Management's Discussion and Analysis included herein. ELECTRIC OPERATIONS General. The Company supplies electric energy at retail to approximately 585,000 customers in 462 communities in Kansas. These include Wichita, Topeka, Lawrence, Manhattan, Salina, and Hutchinson. On September 20 1993, the Company completed the purchase of the electric distribution system in DeSoto Kansas. This acquisition added approximately 880 customers to the Company's system. The Company also supplies electric energy at wholesale to the electric distribution systems of 67 communities and 5 rural electric cooperatives. The Company has contracts for the sale, purchase or exchange of electricity with other utilities. The Company also receives a limited amount of electricity through parallel generation. The Company's electric sales for the last five years were as follows (includes KG&E since March 31, 1992): 1993 1992 1991 1990 1989 (Thousands of MWH) Residential 4,960 3,842 2,556 2,403 2,248 Commercial 5,100 4,473 3,051 2,952 2,814 Industrial 5,301 4,419 1,947 1,954 1,925 Other 4,628 3,119 1,984* 1,820 2,077 Total 19,989 15,853 9,538* 9,129 9,064 * Includes cumulative effect to January 1, 1991, of change in revenue recognition. The cumulative effect of this change increased electric sales by 256,000 MWH. The Company's electric revenues for the last five years were as follows (includes KG&E since March 31, 1992): 1993 1992 1991 1990 1989 (Thousands of Dollars) Residential $ 384,618 $296,917 $160,831 $152,509 $142,308 Commercial 319,686 271,303 149,152 146,001 139,567 Industrial 261,898 211,593 78,138 79,225 78,267 Other 138,335 103,072 83,718 85,972 92,201 Total $1,104,537 $882,885 $471,839 $463,707 $452,343 Capacity. The accredited generating capacity of the Company's system is presently 5,184 megawatts (MW). The system comprises interests in 22 fossil fueled steam generating units, one nuclear generating unit (47 percent interest), seven combustion peaking turbines and one diesel generator located at eleven generating stations. Two units of the 22 fossil fueled units have been "mothballed" for future use (see Item 2, Properties). The Company's 1993 peak system net load occurred on August 16, 1993 and amounted to 3,821 MW. The Company's net generating capacity together with power available from firm interchange and purchase contracts, provided a capacity margin of approximately 23 percent above system peak responsibility at the time of the peak. The Company and ten companies in Kansas and western Missouri have agreed to provide capacity (including margin), emergency and economy services for each other. This arrangement is called the MOKAN Power Pool. The pool participants also coordinate the planning of electric generating and transmission facilities. In January 1994, the Company entered into an agreement with Oklahoma Municipal Power Authority (OMPA), whereby, the Company received a prepayment of approximately $41 million for capacity and transmission charges through the year 2013. Future Capacity. The Company does not contemplate any significant expenditures in connection with construction of any major generating facilities through the turn of the century (see Management's Discussion and Analysis, Liquidity and Capital Resources). Although the Company's management believes, based on current load-growth projections and load management programs, it will maintain adequate capacity margins through 2000, in view of the lead time required to construct large operating facilities, the Company may be required before 2000 to consider whether to reschedule the construction of Jeffrey Energy Center (JEC) Unit 4 or alternatively either build or acquire other capacity. Fuel Mix. The Company's coal-fired units comprise 3,186 MW of the total 5,184 MW of generating capacity and the Company's nuclear unit provides 533 MW of capacity. Of the remaining 1,465 MW of generating capacity, units that can burn either natural gas or oil account for 1,373 MW, and the remaining units which burn only oil or diesel account for 92 MW (see Item 2, Properties). During 1993, low sulfur coal was used to produce 79 percent of the Company's electricity. Nuclear produced 17 percent and the remainder was produced from natural gas, oil, or diesel. Based on the Company's estimate of the availability of fuel, coal will continue to be used to produce approximately 78 percent of the Company's electricity and 18 percent from nuclear. The Company anticipates the fuel mix to fluctuate with the operation of nuclear powered Wolf Creek which operates on an 18-month refueling and maintenance schedule. The 18-month schedule permits uninterrupted operation every third calendar year. Beginning March 5, 1993, Wolf Creek was taken off- line for its sixth refueling and maintenance outage. The refueling outage took approximately 73 days to complete, during which time electric demand was met primarily by the Company's coal-fired generating units. Nuclear. The owners of Wolf Creek have on hand or under contract 73 percent of the uranium required for operation of Wolf Creek through the year 2001. The balance is expected to be obtained through spot market and contract purchases. Contractual arrangements are in place for 100 percent of Wolf Creek's uranium enrichment requirements for 1993-1996, 70 percent for 1997-1998 and 100 percent for 2003-2014. The balance of the 1997-2002 requirements is expected to be obtained through a combination of spot market and contract purchases. The decision not to contract for the full enrichment requirements is one of cost rather than availability of service. Contractual arrangements are in place for the conversion of uranium to uranium hexafluoride sufficient to meet Wolf Creek's requirements through 1995 as well as the fabrication of fuel assemblies to meet Wolf Creek's requirements through 2012. During 1994, the Company plans to begin securing additional arrangements for uranium conversion for the post 1995 period. The Nuclear Waste Policy Act of 1982 established schedules, guidelines and responsibilities for the Department of Energy (DOE) to develop and construct repositories for the ultimate disposal of spent fuel and high-level waste. The DOE has not yet constructed a high-level waste disposal site and has announced that a permanent storage facility may not be in operation prior to 2010 although an interim storage facility may be available earlier. Wolf Creek contains an on-site spent fuel storage facility which, under current regulatory guidelines, provides space for the storage of spent fuel through 2006 while still maintaining full core off-load capability. The Company believes adequate additional storage space can be obtained, as necessary. Coal. The Company has a long-term coal supply contract with Amax Coal West, Inc. (AMAX) a subsidiary of Cyprus Amax Coal Company, to supply low sulfur coal to JEC from AMAX's Eagle Butte Mine or an alternate mine source of AMAX's Belle Ayr Mine, both located in the Powder River Basin in Cambell County, Wyoming. The contract expires December 31, 2020. The contract contains a schedule of minimum annual delivery quantities with deficient mmBTU provisions applicable to deficiencies in the scheduled delivery. The coal to be supplied is surface mined and has an average BTU content of approximately 8,300 BTU per pound and an average sulfur content of .43 lbs/mmBTU (see Environmental Matters). The average delivered cost of coal for JEC was approximately $1.045 per mmBTU or $17.35 per ton during 1993. Coal is transported from Wyoming under a long-term rail transportation contract with Burlington Northern (BN) and Union Pacific (UP) to JEC through December 31, 2013. Rates are based on net load carrying capabilities of each rail car. The Company provides 770 aluminum rail cars, under a 20 year lease, to transport coal to JEC. During 1994, the Company will provide an additional 120 rail cars under a similar lease. The two coal fired units at La Cygne generating station have an aggregate generating capacity of 677 MW (KG&E's 50 percent share) (see Item 2.		ITEM 2. PROPERTIES The Company owns or leases and operates an electric generation, transmission, and distribution system in Kansas, a natural gas integrated storage, gathering, transmission and distribution system in Kansas, and a natural gas distribution system in Kansas, Missouri and Oklahoma (see page 3 with respect to the sale of the Missouri Properties). During the five years ended December 31, 1993, the Company's gross property additions totalled $852,650,000 and retirements were $125,287,000. ELECTRIC FACILITIES Unit Year Principal Unit Capacity Name No. Installed Fuel (MW) (2) Abilene Energy Center: Combustion Turbine 1 1973 Gas 67 Gordon Evans Energy Center: Steam Turbines 1 1961 Gas--Oil 150 2 1967 Gas--Oil 367 Hutchinson Energy Center: Steam Turbines 1 1950 Gas 18 2 1950 Gas 20 3 1951 Gas 31 4 1965 Gas 196 Combustion Turbines 1 1974 Gas 53 2 1974 Gas 51 3 1974 Gas 55 4 1975 Oil 89 Jeffrey Energy Center (84%): Steam Turbines 1 1978 Coal 587 2 1980 Coal 566 3 1983 Coal 588 La Cygne Station (50%): Steam Turbines 1 1973 Coal 342 2 1977 Coal 335 Lawrence Energy Center: Steam Turbines 2 1952 Gas 0 (1) 3 1954 Coal 56 4 1960 Coal 102 5 1971 Coal 380 Murray Gill Energy Center: Steam Turbines 1 1952 Gas--Oil 46 2 1954 Gas--Oil 69 3 1956 Gas--Oil 107 4 1959 Gas--Oil 105 Neosho Energy Center: Steam Turbines 3 1954 Gas--Oil 0 (1) Unit Year Principal Unit Capacity Name No. Installed Fuel (MW) (2) Tecumseh Energy Center: Steam Turbines 7 1957 Coal 83 8 1962 Coal 147 Combustion Turbines 1 1972 Gas 19 2 1972 Gas 19 Wichita Plant: Diesel Generator 5 1969 Diesel 3 Wolf Creek Generating Station (47%): Nuclear 1 1985 Uranium 533 Total 5,184 (1) These units have been "mothballed" for future use. (2) Based on MOKAN rating. The Company jointly-owns Jeffrey Energy Center (84%), La Cygne Station (50%) and Wolf Creek Generating Station (47%). NATURAL GAS COMPRESSOR STATIONS AND STORAGE FACILITIES The Company's transmission and storage facility compressor stations, all located in Kansas, as of December 31, 1993, are as follows: Mfr Ratings of MCF/Hr Capacity at Driving Type of Mfr hp 14.65 Psia Location Units Year Installed Fuel Ratings at 60 F Abilene . . . . . 4 1930 Gas 4,000 5,920 Bison . . . . . . 1 1951 Gas 440 316 Brehm Storage . . 2 1982 Gas 800 486 Calista . . . . . 3 1987 Gas 4,400 7,490 Hope. . . . . . . 1 1970 Electric 600 44 Hutchinson. . . . 2 1989 Gas 1,600 707 Manhattan . . . . 1 1963 Electric 250 313 Marysville. . . . 1 1964 Electric 250 202 McPherson . . . . 1 1972 Electric 3,000 7,040 Minneola. . . . . 5 1952 - 1978 Gas 9,650 14,018 Pratt . . . . . . 3 1963 - 1983 Gas 1,700 3,145 Spivey. . . . . . 4 1957 - 1964 Gas 7,200 1,368 Ulysses . . . . . 12 1949 - 1981 Gas 26,630 15,244 Yaggy Storage . . 3 1993 Electric 7,500 5,000 The Company owns and operates an underground natural gas storage facility, the Brehm field in Pratt County, Kansas. This facility has a working storage capacity of approximately 1.6 BCF. The Company withdrew up to 16,930 MCF per day from this field to meet 1993 winter peaking requirements. The Company owns and operates an underground natural gas storage field, the Yaggy field in Reno County, Kansas. This facility has a working storage capacity of approximately 0.8 BCF to be expanded to 2 BCF. The Company withdrew up to 6,280 MCF per day from this field to meet 1993 winter peaking requirements. The Company has contracted with Williams Natural Gas Company for additional underground storage in the Alden field in Kansas. The contract, expiring March 31, 1998, enables the Company to supply customers with up to 75 million cubic feet per day of gas supply during winter peak periods. See Item I. Business, Gas Operations for proven recoverable gas reserve information. ITEM 3.	ITEM 3. LEGAL PROCEEDINGS Information on legal proceedings involving the Company is set forth in Note 15 of Notes to Consolidated Financial Statements included herein. ITEM 4.	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matter was submitted during the fourth quarter of the fiscal year covered by this report to a vote of security holders, through the solicitation of proxies or otherwise. PART II ITEM 5.	ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Stock Trading. Western Resources common stock, which is traded under the ticker symbol WR, is listed on the New York Stock Exchange. As of March 14, 1994, there 45,317 common shareholders of record. For information regarding quarterly common stock price ranges for 1993 and 1992, see Note 16 of Notes to Consolidated Financial Statements included herein. Dividend Policy. Western Resources common stock is entitled to dividends when and as declared by the Board of Directors. At December 31, 1993, the Company's retained earnings were restricted by $857,600 against the payment of dividends on common stock. However, prior to the payment of common dividends, dividends must be first paid to the holders of preferred stock and second to the holders of preference stock based on the fixed dividend rate for each series. Dividends have been paid on the Company's common stock throughout the Company's history. Quarterly dividends on common stock normally are paid on or about the first of January, April, July, and October to shareholders of record as of about the third day of the preceding month. Future dividends depend upon future earnings, the financial condition of the Company and other factors. For information regarding quarterly dividend declarations for 1993 and 1992, see Note 16 of Notes to Consolidated Financial Statements included herein. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FINANCIAL CONDITION General: Earnings were $2.76 per share of common stock based on 59,294,091 average common shares for 1993, an increase from $2.20 in 1992 on 52,271,932 average common shares. The increase resulted from a return to near normal temperatures compared to unusually mild winter and summer temperatures in 1992, reduced interest costs, and the full twelve month effect of the merger with Kansas Gas and Electric Company (KG&E) on March 31, 1992 (the Merger). Dividends per common share were $1.94 in 1993, an increase of four cents from 1992. In January 1994, the Board of Directors declared a quarterly dividend of 49 1/2 cents per common share, an increase of one cent over the previous quarter. The book value per share was $23.08 at December 31, 1993, compared to $21.51 at December 31, 1992. The increase in book value is primarily the result of the issuance of additional common stock and an increase in retained earnings. The 1993 closing stock price of $34 7/8 was 151 percent of book value. There were 61,617,873 common shares outstanding at December 31, 1993. On January 31, 1994, the Company sold substantially all of its Missouri natural gas distribution properties and operations to Southern Union Company (Southern Union). The Company sold the remaining Missouri properties to United Cities Gas Company (United Cities) on February 28, 1994. The properties sold to Southern Union and United Cities are referred to herein as the "Missouri Properties." With the sales the Company is no longer operating as a utility in the State of Missouri. The portion of the Missouri Properties purchased by Southern Union was sold for an estimated sale price of $400 million, in cash, based on a calculation as of December 31, 1993. The final sale price will be calculated as of January 31, 1994, within 120 days of closing. Any difference between the estimated and final sale price will be adjusted through a payment to or from the Company. United Cities purchased the Company's natural gas distribution system in and around the City of Palmyra, Missouri, for $665,000 in cash. The operating revenues and operating income (unaudited) related to the Missouri Properties approximated $350 million and $21 million representing approximately 18 percent and seven percent, respectively, of the Company's total for 1993, and $299 million and $11 million representing approximately 19 percent and five percent, respectively, of the Company's total for 1992. Net utility plant (unaudited) for the Missouri Properties, at December 31, 1993, approximated $296 million and $272 million at December 31, 1992. This represents approximately seven percent at December 31, 1993, and six percent at December 31, 1992, of the total Company net utility plant. Separate audited financial information was not kept by the Company for the Missouri Properties. This unaudited financial information is based on assumptions and allocations of expenses of the Company as a whole. Liquidity and Capital Resources: The Company's liquidity is a function of its ongoing construction program, designed to improve facilities which provide electric and natural gas service and meet future customer service requirements. During 1993, construction expenditures for the Company's electric system were approximately $138 million and nuclear fuel expenditures were approximately $6 million. It is projected that adequate capacity margins will be maintained without the addition of any major generating facilities through the turn of the century. The construction expenditures for improvements on the natural gas system, including the Company's service line replacement program, were approximately $94 million during 1993, of which construction expenditures for the Missouri Properties were approximately $39 million. Capital expenditures for 1994 to 1996 are anticipated to be as follows: Electric Nuclear Fuel Natural Gas (Dollars in Thousands) 1994 $131,483 $ 20,995 $ 64,608 1995 143,391 21,469 69,482 1996 151,100 9,890 68,747 These expenditures are estimates prepared for planning purposes and are subject to revisions from time to time (see Note 4). The Company's net cash flow to capital expenditures was 100 percent for 1993 and during the last five years has averaged 87 percent. The Company anticipates net cash flow to capital expenditures to be approximately 100 percent in 1994. The Company's capital needs through 1998 are approximately $33.6 million for bond maturities and cash sinking fund requirements for bonds and preference stock. This capital as well as capital required for construction will be provided from internal and external sources available under then existing financial conditions. The Company anticipates using the net proceeds from the sale of the Missouri Properties to reduce the Company's outstanding debt. The embedded cost of long-term debt was 7.7% at December 31, 1993, a decrease from 7.9% at December 31, 1992. The decrease was primarily accomplished through refinancing of higher cost debt. The Company's short-term financing requirements are satisfied, as needed, through the sale of commercial paper, short-term bank loans, and borrowings under other unsecured lines of credit maintained with banks. At December 31, 1993, short-term borrowings amounted to $441 million, of which $126 million was commercial paper (see Notes 8 and 9). On September 20, 1993, KG&E terminated a long-term revolving credit agreement which provided for borrowings of up to $150 million. The loan agreement, which was effective through October 1994, was repaid without penalty. At December 31, 1993, the Company had $200 million of First Mortgage Bonds available to be issued under a shelf registration filed August 24, 1993. Also at December 31, 1993, KG&E had $150 million of First Mortgage Bonds available to be issued under a shelf registration filed on August 24, 1993. On January 20, 1994, KG&E issued $100 million of First Mortgage Bonds, 6.20% Series due January 15, 2006, under the KG&E shelf registration. The net proceeds were used to reduce short-term debt. On January 31, 1994, the Company redeemed the remaining $2,466,000 principal amount of Gas Service Company 8 1/2% Series First Mortgage Bonds due 1997. KG&E has a long-term agreement that expires in 1995 which contains provisions for the sale of accounts receivable and unbilled revenues (receivables) and phase-in revenues up to a total of $180 million. Amounts related to receivables are accounted for as sales while those related to phase-in revenues are accounted for as collateralized borrowings. At December 31, 1993, KG&E had receivables amounting to $56.8 million which were considered sold. The issuance and retirement of long-term debt, borrowings against the cash surrender value of corporate-owned life insurance policies (COLI), and the issuance of common stock during 1993 are summarized in the table below. - ------------------------------------------------------------------------------ \| Date Issued Retired \| \| (Dollars in Millions) \| \|Long-term debt \| \|----------------------------------------------------------------------------\| \|7 3/8% due 2002 - KG&E \| 11/22/93 \| \| $ 25.0\| \|8 3/8% due 2006 - KG&E \| \| \| 25.0\| \|8 1/2% due 2007 - KG&E \| \| \| 25.0\| \|----------------------------------------------------------------------------\| \|9.35% due 1998 \| 10/15/93 \| \| 75.0\| \|----------------------------------------------------------------------------\| \|6 1/2% due 2005 - KG&E \| 08/12/93 \| $ 65.0\| \| \|8 1/8% due 2001 - KG&E \| 08/20/93 \| \| 35.0\| \|8 7/8% due 2008 - KG&E \| \| \| 30.0\| \|----------------------------------------------------------------------------\| \|7.65% due 2023 \| 04/27/93 \| 100.0\| \| \|8 3/4% due 2000 \| 05/12/93 \| \| 20.0\| \|8 5/8% due 2005 \| \| \| 35.0\| \|8 3/4% due 2008 \| \| \| 35.0\| \|----------------------------------------------------------------------------\| \|6% Pollution Control Revenue Refunding \| \| \| \| \| Bonds due 2033 \| 02/09/93 \| 58.5\| \| \|9 5/8% Pollution Control Refunding and \| \| \| \| \| Improvement Revenue Bonds due 2013 \| \| \| 58.5\| \|----------------------------------------------------------------------------\| \|Bank term loan \| 01/26/93 \| \| 230.0\| \|----------------------------------------------------------------------------\| \|Revolving credit agreements (net) \| various \| \| 35.0\| \|----------------------------------------------------------------------------\| \|Other long-term debt and sinking funds \| various \| 4.1\| \| \|----------------------------------------------------------------------------\| \|COLI borrowings (net) (1) \| various \| 183.3\| \| \|----------------------------------------------------------------------------\| \|Common stock \| \| \| \| \| 3,425,000 shares (2) \| 08/25/93 \| 124.2\| \| \| 147,323 shares (3) \| various \| 5.3\| \| \|----------------------------------------------------------------------------\| (1) The COLI borrowings will be repaid upon receipt of proceeds from death benefits under the contracts. See Note 1 of Notes to Consolidated Financial Statements for additional information on the accumulated cash surrender value of COLI policies. (2) Issued in public offering for net proceeds of $121 million. (3) Issued under the Dividend Reinvestment and Stock Purchase Plan (DRIP). The net proceeds from these issues of approximately $5.3 million were added to the general corporate funds of the Company. Shares issued under the DRIP may either be original issue shares or shares purchased on the open market. The Company has a Customer Stock Purchase Plan (CSPP) under which retail electric and natural gas customers and employees of the Company may purchase common stock through monthly installments. The initial installment period runs from September 1993, through June 1994, with monthly installments plus accumulated interest converted to shares in August 1994. Shares issued under the CSPP may either be original issue shares or shares purchased on the open market. Approximately $14.7 million has been pledged for this installment period. The capital structure at December 31, 1993, was 45 percent common stock equity, 6 percent preferred and preference stock, and 49 percent long-term debt. The capital structure at December 31, 1993, including short-term debt and current maturities of long-term debt and preference stock, was 40 percent common stock equity, 5 percent preferred and preference stock, and 55 percent debt. RESULTS OF OPERATIONS The following is an explanation of significant variations from prior year results in revenues, operating expenses, other income and deductions, interest charges and preferred and preference dividend requirements. The results of operations of the Company include the activities of KG&E since the Merger on March 31, 1992. Additional information relating to changes between years is provided in the Notes to Consolidated Financial Statements. Revenues: The operating revenues of the Company are based on sales volumes and rates, authorized by certain state regulatory commissions and the FERC, charged for the sale and delivery of natural gas and electricity. Rates are designed to recover the cost of service and allow investors a fair rate of return. Future natural gas and electric sales will continue to be affected by weather conditions, competing fuel sources, customer conservation efforts, and the overall economy of the Company's service area. The Kansas Corporation Commission (KCC) order approving the Merger provided a moratorium on increases, with certain exceptions, in the Company's jurisdictional electric and natural gas rates until August 1995. The KCC ordered refunds totalling $32 million to the combined companies' customers to share with customers the Merger-related cost savings achieved during the moratorium period. The first refund of $8.5 million was made in April 1992. A refund of the same amount was made in December 1993, and an additional refund of $15 million will be made in September 1994 (see Note 3). On March 26, 1992, in connection with the Merger, the KCC approved the elimination of the Energy Cost Adjustment Clause for most Kansas retail electric customers of both the Company and KG&E effective April 1, 1992. The fuel costs are now included in base rates and were established at a level intended by the KCC to equal the projected average cost of fuel through August 1995. Any increase or decrease in fuel costs from the projected average will be absorbed by the Company. Future natural gas revenues will be reduced as a result of the sale of the Missouri Properties by approximately $350 million annually based on Missouri revenues recorded in 1993 (see Note 2). 1993 COMPARED TO 1992: Electric revenues increased significantly in 1993 as a result of the Merger. Also contributing to the increase were increased electric sales for space heating, resulting from colder winter temperatures in the first quarter of 1993, and increased sales for cooling load, resulting from warmer temperatures in the second and third quarters of 1993. KG&E electric revenues of $617 million have been included in the Company's 1993 electric revenues. This compares to KG&E revenues of $424 million, from April 1, 1992, through December 31, 1992, included in the Company's 1992 electric revenues. Partially offsetting these increases in electric revenues was the amortization of the Merger-related customer refund. Electric revenues for 1993 compared to pro forma revenues for 1992, giving effect to the Merger as if it had occurred at January 1, 1992, would have increased as a result of the warmer summer and colder winter temperatures in 1993. Retail sales of kilowatt hours on a pro forma comparative basis increased from approximately 14.6 billion for 1992 to approximately 15.5 billion for 1993, or six percent. Natural gas revenues increased approximately 20 percent as a result of increased sales caused by colder winter temperatures, the full impact of increased retail natural gas rates (see Note 5), and an eleven percent increase in the unit cost of gas passed on to customers through the purchased gas adjustment clauses (PGA). The colder winter temperatures are reflected in a 17 percent increase in natural gas sales to residential customers. 1992 COMPARED TO 1991: Electric revenues increased significantly in 1992 as a result of the Merger. KG&E electric revenues for the nine months ended December 31, 1992, of $424 million have been included in the Company's electric revenues. Partially offsetting this increase in revenues were reduced retail electric sales as a result of the abnormally mild summer temperatures in 1992 and the amortization of the Merger-related customer refund. Electric revenues for 1992 compared to pro forma revenues for 1991, giving effect to the Merger as if it had occurred at January 1, 1991, also would have been lower as a result of the mild summer and winter temperatures in 1992. Retail sales of kilowatthours on a pro forma comparative basis decreased from approximately 15.1 billion for 1991 to approximately 14.6 billion for 1992, or four percent. Natural gas revenues decreased over two percent due to a nine percent decrease in natural gas deliveries, excluding sales related to the cumulative effect of the unbilled revenue adjustment in 1991. Also contributing to the decrease was an approximately four percent decrease in the unit cost of natural gas which is passed on to customers through the PGA. The decrease in sales can be attributed to mild winter temperatures in 1992. Partially offsetting the decreased sales were increased retail rates in Kansas and Missouri beginning early in 1992. Operating Expenses: 1993 COMPARED TO 1992: Operating expenses increased for 1993 primarily as a result of the Merger. KG&E operating expenses of $470 million have been included in the Company's operating expenses for the year ended December 31, 1993. This compares to KG&E operating expenses of $316 million, from April 1, 1992, through December 31, 1992, included in the Company's 1992 operating expenses. Other factors, excluding the Merger, contributing to the increase in operating expenses were higher fuel and purchased power expenses caused by increased electric sales to meet cooling load and increased natural gas purchases caused by a 16 percent increase in natural gas sales and an 11 percent higher unit cost of gas which is passed on to customers through the PGA. Also contributing to the increase were higher general taxes due to increases in plant, the property tax assessment ratio, and higher mill levies. A constitutional amendment in Kansas changed the assessment on utility property from 30 to 33 percent. As a result of this change the Company had an increased property tax expense of approximately $6.1 million in 1993. Partially offsetting the increases were savings as a result of the Merger and reduced net lease expense for La Cygne 2 (see Note 10). At December 31, 1993, KG&E completed the accelerated amortization of deferred income tax reserves related to the allowance for borrowed funds used during construction capitalized for Wolf Creek Generating Station. The amortization of these deferred income tax reserves amounted to approximately $12 million in 1993. In accordance with the provisions of the Merger order (see Note 3), the Company is precluded from recovering the $12 million annual amortization in rates until the next rate filing. Therefore the Company's earnings will be impacted negatively until these income taxes are recovered in future rates. 1992 COMPARED TO 1991: Operating expenses increased significantly for 1992 as a result of the Merger. KG&E operating expenses for the nine months ended December 31, 1992, of $316 million have been included in the Company's operating expenses. Other factors, excluding the Merger, contributing to increased operating expenses were a one-time charge for the Company's portion of the early retirement plan and voluntary separation program of approximately $11 million; higher depreciation and amortization expense caused by increased plant investment and the beginning of the amortization of previously deferred safety-related expenditures in Kansas; and increased property taxes due to increases in plant and tax mill levies. Partially offsetting those increases in operating expenses was the commencement of savings as a result of the Merger. The Company also changed the depreciable life of Jeffrey Energy Center, for book purposes, to 40 years, resulting in a reduction to depreciation expense of approximately $5.4 million annually. Lower natural gas purchases as a result of the mild temperatures and a reduced unit cost also partially offset the increase in operating expenses. As permitted under the La Cygne 2 generating station lease agreement, KG&E requested the Trustee Lessor to refinance $341,127,000 of secured facility bonds of the Trustee and owner of La Cygne 2. The transaction was requested to reduce the Company's recurring future net lease expense. To accomplish this transaction, a one-time payment of approximately $27 million was made which will be amortized over the remaining life of the lease and will be included in operating expense as part of the future lower lease expense. On September 29, 1992, the Trustee Lessor refinanced bonds with a coupon rate of approximately 11.7% with bonds having a coupon rate of approximately 7.7%. Other Income and Deductions: Other income and deductions, net of taxes, increased $1.3 million in 1993 compared to 1992. KG&E other income and deductions, net of taxes, of $19 million have been included in the Company's total for 1993 compared to $17 million in 1992 from April 1, through December 31, 1992. Income from KG&E's COLI totalled $8 million in 1993. Other income and deductions, net of taxes, was significantly higher in 1992 compared to 1991 as a result of the Merger. KG&E contributed, for the nine months ended December 31, 1992, $17 million to other income and deductions, net of taxes. Significant items of other income include approximately $9 million from KG&E's COLI and KG&E's recognition of the recovery of approximately $4.2 million of a previously written-off investment in commercial paper. Interest Charges and Preferred and Preference Dividend Requirements: Interest charges for 1993 were higher as a result of the Merger. KG&E interest charges of $59 million for 1993 have been included in the Company's total interest charges compared to $53 million for the nine months ended December 31, 1992. The full twelve month effect of interest on debt to acquire KG&E also contributed to the increase in total interest charges. The increased interest charges have been partially offset through lower debt balances and reduced interest charges from refinancing higher cost long-term debt and lower interest rates on variable-rate debt. The Company's embedded cost of long-term debt decreased to 7.7% at December 31, 1993, compared to 7.9% and 8.6% at December 31, 1992 and 1991, respectively, primarily as a result of the refinancing of higher cost debt. Total interest charges increased significantly for 1992 compared to 1991 as a result of the Merger. Partially offsetting this increase were lower short-term and long-term interest rates. Preferred and preference dividend requirements increased six percent in 1993 and significantly in 1992 compared to 1991 as a result of the issuance of $50 million of 7.58% preference stock in the second quarter of 1992. Merger Implementation: In accordance with the KCC Merger order, amortization of the acquisition adjustment will commence August 1995. The amortization will amount to approximately $19.6 million per year for 40 years. The Company can recover the amortization of the acquisition adjustment through cost savings under a sharing mechanism approved by the KCC as described in Note 3 of the Notes to the Consolidated Financial Statements. While the Company has achieved savings from the Merger, there is no assurance that the savings achieved will be sufficient to, or the cost savings sharing mechanism will operate as to fully offset the amortization of the acquisition adjustment. In 1992 the Company completed the consolidation of certain operations of the Company and KG&E. In conjunction with these efforts the Company incurred costs of consolidating facilities, transferring certain employees, and other costs associated with completing the Merger. Certain of these costs related to KG&E have been considered in purchase accounting for the Merger. Other costs, including costs of the early retirement incentive programs and other employee severance compensation programs for former Kansas Power and Light Company employees were charged to expense in 1992. See Note 6 of Notes to Consolidated Financial Statements for a discussion regarding the early retirement and Merger severance plans. OTHER INFORMATION Inflation: Under the ratemaking procedures prescribed by the regulatory commissions to which the Company is subject, only the original cost of plant is recoverable in revenues as depreciation. Therefore, because of inflation, present and future depreciation provisions are inadequate for purposes of maintaining the purchasing power invested by common shareholders and the related cash flows are inadequate for replacing property. The impact of this ratemaking process on common shareholders is mitigated to the extent depreciable property is financed with debt that can be repaid with dollars of less purchasing power. While the Company has experienced relatively low inflation in the recent past, the cumulative effect of inflation on operating costs requires the Company to seek regulatory rate relief to recover these higher costs. FERC Order No. 636: On April 8, 1992, the FERC issued Order No. 636 which the FERC intended to complete the deregulation of natural gas production and facilitate competition in the gas transportation industry. Order No. 636 is expected to affect the Company in several ways. The rules provide greater protection for pipeline companies by providing for recovery of all fixed costs through contracts with local distribution companies and other customers choosing to transport gas on a firm (non-interruptible) basis. The order also separates the purchase of natural gas from the transportation and storage of natural gas, shifting additional responsibility to distribution companies for the provision (through purchase and/or storage) of long-term gas supply and transportation to distribution points. Under the new rules, distribution companies elect the amount and type of services taken from pipelines. The Company may be liable to one or more of its pipeline suppliers for costs related to the transition from its traditional sales service to the restructured services required by Order No. 636. The Company believes substantially all of these costs will be recovered from its customers and any additional transition costs will be immaterial to the Company's financial position or results of operations. The Company was an active participant in pipeline restructuring negotiations and does not anticipate any material difficulty in obtaining the pipeline services the Company needs to meet the requirements of its gas operations. Environmental: The Company has recognized the importance of environmental responsibility and has taken a proactive position with respect to the potential environmental liability associated with former manufactured gas sites. The Company has an agreement with the Kansas Department of Health and Environment to systematically evaluate these sites in Kansas (see Note 4). The Company currently has no Phase I affected units under the Clean Air Act of 1990. Until such time that additional regulations become final the Company will be unable to determine its compliance options or related compliance costs (see Note 4). Energy Policy Act: The 1992 Energy Policy Act (Act) requires increased efficiency of energy usage and will potentially change the way electricity is marketed. The Act also provides for increased competition in the wholesale electric market by permitting the FERC to order third party access to utilities' transmission systems and by liberalizing the rules for ownership of generating facilities. As part of the Merger, the Company agreed to open access to its transmission system. Another part of the Act requires a special assessment to be collected from utilities for a uranium enrichment, decontamination, and decommissioning fund. KG&E's portion of the assessment for Wolf Creek is approximately $7 million, payable over 15 years. Management expects such costs to be recovered through the ratemaking process. Statement of Financial Accounting Standards No. 106 (SFAS 106) and No. 112 (SFAS 112): For discussion regarding the effect of SFAS 106 and SFAS 112 on the Company see Note 6 of Notes to the Consolidated Financial Statements. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA TABLE OF CONTENTS PAGE Independent Auditors' Report 33 Financial Statements: Consolidated Balance Sheets, December 31, 1993 and 1992 34 Consolidated Statements of Income for the years ended December 31, 1993, 1992 and 1991 35 Consolidated Statements of Cash Flows for the years ended 1993, 1992 and 1991 36 Consolidated Statements of Taxes for the years ended December 31, 1993, 1992 and 1991 37 Consolidated Statements of Capitalization, December 31, 1993 and 1992 38 Consolidated Statements of Common Stock Equity for the years ended December 31, 1993, 1992 and 1991 39 Notes to Consolidated Financial Statements 40 Financial Statement Schedules: V- Utility Plant for the years ended December 31, 1993, 1992 and 1991 67 VI- Accumulated Depreciation of Utility Plant for the years ended December 31, 1993, 1992 and 1991 70 SCHEDULES OMITTED The following schedules are omitted because of the absence of the conditions under which they are required or the information is included in the financial statements and schedules presented: I, II, III, IV, VII, VIII, IX, X, XI, XII and XIII. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Shareholders and Board of Directors of Western Resources, Inc.: We have audited the accompanying consolidated balance sheets and statements of capitalization of Western Resources, Inc., and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, cash flows, taxes and common stock equity for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We did not audit the financial statements of Kansas Gas and Electric Company, a wholly- owned subsidiary of Western Resources, Inc., as of and for the year ended December 31, 1992, which statements reflect assets and revenues of 61 percent and 27 percent, respectively, of the consolidated totals for 1992. Those statements were audited by other auditors whose report has been furnished to us and our opinion, insofar as it relates to the amounts included for that entity, is based solely on the report of other auditors. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits and the report of other auditors provide a reasonable basis for our opinion. In our opinion, based on our audit and the report of other auditors, the financial statements referred to above present fairly, in all material respects, the financial position of Western Resources, Inc., and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As explained in Note 1 to the consolidated financial statements, effective January 1, 1991, the Company changed to a preferred method of accounting for revenue recognition. As explained in Note 12 to the consolidated financial statements, effective January 1, 1992, the Company changed its method of accounting for income taxes. As explained in Note 6 to the consolidated financial statements, effective January 1, 1993, the Company changed its method of accounting for postretirement benefits. Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole. The financial statement schedules listed in the table of contents on page 32 are the responsibility of the Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not a part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion and the opinion of other auditors, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. Kansas City, Missouri, ARTHUR ANDERSEN & CO. January 28, 1994 WESTERN RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES General: The consolidated financial statements of Western Resources, Inc. (the Company, Western Resources), include the accounts of its wholly-owned subsidiaries, Astra Resources, Inc., Kansas Gas and Electric Company (KG&E) since March 31, 1992 (see Note 3), and KPL Funding Corporation (KFC). KG&E owns 47 percent of Wolf Creek Nuclear Operating Corporation (WCNOC), the operating company for Wolf Creek Generating Station (Wolf Creek). The Company records its proportionate share of all transactions of WCNOC as it does other jointly-owned facilities. All significant intercompany transactions have been eliminated. The operations of Astra Resources, Inc., and KFC are not material to the Company's results of operations. The accounting policies of the Company are in accordance with generally accepted accounting principles as applied to regulated public utilities. The accounting and rates of the Company are subject to requirements of certain state regulatory commissions and the Federal Energy Regulatory Commission (FERC). The Company is doing business as KPL, Gas Service, and, through its wholly-owned subsidiary, KG&E. Utility Plant: Utility plant is stated at cost. For constructed plant, cost includes contracted services, direct labor and materials, indirect charges for engineering, supervision, general and administrative costs, and an allowance for funds used during construction (AFUDC). The AFUDC rate was 4.10% in 1993, 5.99% in 1992, and 6.25% in 1991. The cost of additions to utility plant and replacement units of property is capitalized. Maintenance costs and replacement of minor items of property are charged to expense as incurred. When units of depreciable property are retired, they are removed from the plant accounts and the original cost plus removal charges less salvage are charged to accumulated depreciation. Depreciation: Depreciation is provided on the straight-line method based on estimated useful lives of property. Composite provisions for book depreciation approximated 3.02% during 1993, 3.03% during 1992, and 3.34% during 1991 of the average original cost of depreciable property. Cash and Cash Equivalents: For purposes of the Consolidated Statements of Cash Flows, cash and cash equivalents include cash on hand and highly liquid collateralized debt instruments purchased with maturities of three months or less. Income Taxes: Income tax expense includes provisions for income taxes currently payable and deferred income taxes calculated in conformance with income tax laws, regulatory orders, and Statement of Financial Accounting Standards No. 109 (SFAS 109) (see Note 12). Investment tax credits are deferred as realized and amortized to income over the life of the property which gave rise to the credits. Revenues: Effective January 1, 1991, the Company changed its method of accounting for recognizing electric and natural gas revenues to provide for the accrual of estimated unbilled revenues. The accounting change provides a better matching of revenues with costs of services provided to customers and also serves to conform the Company's accounting treatment of unbilled revenues with the tax treatment of such revenues. Unbilled revenues represent the estimated amount customers will be billed for service provided from the time meters were last read to the end of the accounting period. Meters are read and services are billed on a cycle basis and, prior to the accounting change, revenues were recognized in the accounting period during which services were billed. The after-tax effect of the change in accounting method for the year ended December 31, 1991, was an increase in net income of $15.9 million or $0.46 per share. This increase was a combination of an increase of $17.3 million or $0.50 per share, attributable to the cumulative effect of the accounting change prior to January 1, 1991, and a decrease of $1.4 million or $0.04 per share in the 1991 income before cumulative effect of a change in accounting principle. Unbilled revenues of $99 and $86 million are recorded as a component of accounts receivable on the consolidated balance sheets as of December 31, 1993 and 1992, respectively. Certain amounts of unbilled revenues have been sold (see Note 8). The Company had reserves for doubtful accounts receivable of $4.3 and $3.3 million at December 31, 1993 and 1992, respectively. Fuel Costs: The cost of nuclear fuel in process of refinement,conversion, enrichment, and fabrication is recorded as an asset at original cost and is amortized to expense based upon the quantity of heat produced for the generation of electricity. The accumulated amortization of nuclear fuel in the reactor at December 31, 1993 and 1992, was $17.4 million and $26.0 million, respectively. Cash Surrender Value of Life Insurance Contracts: The following amounts related to corporate-owned life insurance contracts (COLI), primarily with one highly rated major insurance company, are recorded on the consolidated balance sheets (millions of dollars): 1993 1992 Cash surrender value of contracts. . . $ 326.3 $ 256.3 Prepaid COLI . . . . . . . . . . . . . 11.9 7.0 Borrowings against contracts . . . . . (321.5) (109.6) COLI (net). . . . . . . . . . $ 16.7 $ 153.7 The decrease in COLI (net) is a result of increased borrowings against the accumulated cash surrender value of the COLI policies. The COLI borrowings will be repaid with proceeds from death benefits. Management expects to realize increases in the cash surrender value of contracts resulting from premiums and investment earnings on a tax free basis upon receipt of proceeds from death benefits under the contracts. Interest expense included in other income and deductions, net of taxes, related to KG&E's COLI for 1993 and the nine months ended December 31, 1992, was $11.9 and $5.3 million, respectively. As approved by the Kansas Corporation Commission (KCC) and Missouri Public Service Commission (MPSC), the Company is using a portion of the net income stream generated by COLI policies purchased in 1993 and 1992 by the Company (see Note 6) to offset Statement of Financial Accounting Standards No. 106 (SFAS 106) expenses. Reclassifications: Certain amounts in prior years have been reclassified to conform with classifications used in the current year presentation. 2. SALE OF MISSOURI NATURAL GAS DISTRIBUTION PROPERTIES On January 31, 1994, the Company sold substantially all of its Missouri natural gas distribution properties and operations to Southern Union Company (Southern Union). The Company sold the remaining Missouri properties to United Cities Gas Company (United Cities) on February 28, 1994. The properties sold to Southern Union and United Cities are referred to herein as the "Missouri Properties." With the sales the Company is no longer operating as a utility in the State of Missouri. The portion of the Missouri Properties purchased by Southern Union was sold for an estimated sale price of $400 million, in cash, based on a calculation as of December 31, 1993. The final sale price will be calculated as of January 31, 1994, within 120 days of closing. Any difference between the estimated and final sale price will be adjusted through a payment to or from the Company. United Cities purchased the Company's natural gas distribution system in and around the City of Palmyra, Missouri, for $665,000 in cash. The operating revenues and operating income (unaudited) related to the Missouri Properties approximated $350 million and $21 million representing approximately 18 percent and seven percent, respectively, of the Company's total for 1993, and $299 million and$11 million representing approximately 19 percent and five percent, respectively, of the Company's total for 1992. Net utility plant (unaudited) for the Missouri Properties, at December 31, 1993, approximated $296 million and $272 million at December 31, 1992. This represents approximately seven percent at December 31, 1993, and six percent at December 31, 1992, of the total Company net utility plant. Separate audited financial information was not kept by the Company for the Missouri Properties. This unaudited financial information is based on assumptions and allocations of expenses of the Company as a whole. 3. ACQUISITION AND MERGER On March 31, 1992, the Company, through its wholly-owned subsidiary KCA Corporation (KCA), acquired all of the outstanding common and preferred stock of Kansas Gas and Electric Company for $454 million in cash and 23,479,380 shares of common stock (the Merger). The Company also paid $20 million in costs to complete the Merger. Simultaneously, KCA and Kansas Gas and Electric Company merged and adopted the name of Kansas Gas and Electric Company (KG&E). The Merger was accounted for as a purchase. For income tax purposes the tax basis of the KG&E assets was not changed by the Merger. As the Company acquired 100 percent of the common and preferred stock of KG&E, the Company recorded an acquisition premium of $490 million on the consolidated balance sheet for the difference in purchase price and book value. This acquisition premium and related income tax requirement of $294 million under SFAS 109 have been classified as plant acquisition adjustment in electric plant in service on the consolidated balance sheets. The total cost of the acquisition was $1.066 billion. Under the provisions of orders of the KCC and the MPSC the acquisition premium is recorded as an acquisition adjustment and not allocated to the other assets and liabilities of KG&E. In the November 1991 KCC order approving the Merger, a mechanism was approved to share equally between the shareholders and ratepayers the cost savings generated by the Merger in excess of the revenue requirement needed to allow recovery of the amortization of a portion of the acquisition adjustment, including income tax, calculated on the basis of a purchase price of KG&E's common stock at $29.50 per share. The order provides an amortization period for the acquisition adjustment of 40 years commencing in August 1995, at which time the full amount of cost savings is expected to have been implemented. Merger savings will be measured by application of an inflation index to certain pre-merger operating and maintenance costs at the time of the next Kansas rate case. While the Company has achieved savings from the Merger, there is no assurance that the savings achieved will be sufficient to, or the cost savings sharing mechanism will operate as to fully offset the amortization of the acquisition adjustment. The order further provides a moratorium on increases, with certain exceptions, in the Company's Kansas electric and natural gas rates until August 1995. The KCC ordered refunds totalling $32 million to the combined companies' customers to share with customers the Merger-related cost savings achieved during the moratorium period. The first refund was made in April 1992 and amounted to $8.5 million. A refund of the same amount was made in December 1993 and an additional refund of $15 million will be made in September 1994. The KCC order approving the Merger requires the legal reorganization of KG&E so that it is no longer held as a separate subsidiary after January 1, 1995, unless good cause is shown why such separate existence should be maintained. The Securities and Exchange Commission order relating to the Merger granted the Company an exemption under the Public Utilities Holding Company Act until January 1, 1995. In connection with a requested ruling that a merger of KG&E into Western Resources would not adversely affect the tax structure of the merger, KG&E received a response from the Internal Revenue Service that the IRS would not issue the requested ruling. In light of the IRS response, KG&E withdrew its request for a ruling. The Company will consider alternative forms of combination or seek regulatory approvals to waive the requirements for a combination. There is no certainty as to whether a combination will occur or as to the form or timing thereof. As the Merger did not occur until March 31, 1992, the twelve months ended December 31, 1992, results of operations for the Company reported in its statements of income, cash flows, and common stock equity reflect KG&E's results of operations for only the nine months ended December 31, 1992. The pro forma combined revenues, operating income, net income, and earnings per common share of the Company presented below give effect to the Merger as if it had occurred at January 1, 1991. This pro forma information is not necessarily indicative of the results of operations that would have occurred had the Merger been consummated for the period for which it is being given effect nor is it necessarily indicative of future operating results. Year Ended December 31, 1992 1991 (Dollars in Thousands, except per share amounts) Revenues. . . . . . . . . . . . $1,684,885 $1,748,844 Operating Income. . . . . . . . 268,772 279,458 Net Income. . . . . . . . . . . 131,524 110,290(1) Earnings Per Common . . . . . . $ 2.03 $ 1.72(1) (1) Reflects information before the cumulative effect of the January 1, 1991 change in accounting method of recognizing revenues. 4. COMMITMENTS AND CONTINGENCIES As part of its ongoing operations and construction program, the Company has commitments under purchase orders and contracts which have an unexpended balance of approximately $86 million at December 31, 1993. Approximately $36 million is attributable to modifications to upgrade the turbines at Jeffrey Energy Center to be completed by December 31, 1998. Plans for future construction of utility plant are discussed in the "Management's Discussion and Analysis" section. Environmental: The Company has been associated with 28 (20 in Kansas and 8 in Missouri) former manufactured gas sites which may contain coal tar and other potentially harmful materials. These sites were operated decades ago by other companies, and were acquired by the Company after they had ceased operation. The Environmental Protection Agency (EPA) has performed preliminary assessments of eleven of these sites (EPA sites), six of which are under site investigation. The Company has not received any indication from the EPA that further action will be taken at the EPA sites, nor does the Company have reason to believe there will be any fines or penalties assessed related to these sites. The Company and the Kansas Department of Health and Environment (KDHE) entered into a consent agreement to conduct separate preliminary assessments of the 20 former manufactured gas sites located in Kansas. The preliminary assessments of these 20 sites have been completed at a total cost of approximately $500,000. The Company plans to initiate site investigation and risk assessments at the two highest priority sites in 1994 at a total cost of approximately $500,000. Until such time that risk assessments are completed at these or the remaining sites, it will be impossible to predict the cost of remediation. However, the Company is aware of other utilities in Region VII of the EPA (Kansas, Missouri, Nebraska, and Iowa) which have incurred remediation costs for such sites ranging between $500,000 and $10 million, depending on the site. The Company is also aware that the KCC has permitted another Kansas utility to recover a portion of the remediation costs through rates. To the extent that such remediation costs are not recovered through rates, the costs could be material to the Company's financial position or results of operations depending on the degree of remediation and number of years over which the remediation must be completed. The Company has been identified as one of numerous potentially responsible parties in four hazardous waste sites listed by the EPA as Superfund sites. One site is a groundwater contamination site in Wichita, Kansas, and one is an oil soil contamination site in Springfield, Missouri. The other two sites are solid waste land fills located in Edwardsville and Hutchinson, Kansas. The Company's obligation at these sites appears to be limited, and it is the opinion of the Company's management that the resolution of these matters will not have a material impact on the Company's financial position or results of operations. As part of the sale of the Company's Missouri Properties to Southern Union, Southern Union assumed responsibility under an agreement for any environmental matters now pending or that may arise after closing. For any environmental matters now pending or discovered within two years of the date of the agreement, and after pursuing several other potential recovery options, the Company may be liable for up to a maximum of $7.5 million under a sharing arrangement with Southern Union provided for in the agreement. Spent Nuclear Fuel Disposal: Under the Nuclear Waste Policy Act of 1982, the U.S. Department of Energy (DOE) is responsible for the ultimate storage and disposal of spent nuclear fuel removed from nuclear reactors. Under a contract with the DOE for disposal of spent nuclear fuel, the Company pays a quarterly fee to DOE of one mill per kilowatthour on net nuclear generation. These fees are included as part of nuclear fuel expense and amounted to $3.5 million for 1993 and $1.6 million for 1992. Decommissioning: The Company's share of Wolf Creek decommissioning costs, currently authorized in rates, was estimated to be approximately $97 million in 1988 dollars. Decommissioning costs are being charged to operating expenses. Amounts so expensed are deposited in an external trust fund and will be used solely for the physical decommissioning of the plant. Electric rates charged to customers provide for recovery of these decommissioning costs over the estimated life of Wolf Creek. At December 31, 1993, and December 31, 1992, $13.2 and $9.3 million, respectively, were on deposit in the decommissioning fund. On September 1, 1993, WCNOC filed an application with the KCC for an order approving a 1993 Wolf Creek Decommissioning Cost Study which estimates the Company's share of Wolf Creek decommissioning costs at approximately $174 million in 1993 dollars. If approved by the KCC, management expects substantially all such cost increases to be recovered through the ratemaking process. The Company carries $164 million in premature decommissioning insurance in the event of a shortfall in the trust fund. The insurance coverage has several restrictions. One of these is that it can only be used if Wolf Creek incurs an accident exceeding $500 million in expenses to safely stabilize the reactor, to decontaminate the reactor and reactor station site in accordance with a plan approved by the Nuclear Regulatory Commission (NRC), and to pay for on-site property damages. If the amount designated as decommissioning insurance is needed to implement the NRC-approved plan for stabilization and decontamination, it would not be available for decommissioning purposes. Nuclear Insurance: The Price-Anderson Act limits the combined public liability of the owners of nuclear power plants to $9.4 billion for a single nuclear incident. The Wolf Creek owners (Owners) have purchased the maximum available private insurance of $200 million and the balance is provided by an assessment plan mandated by the NRC. Under this plan, the Owners are jointly and severally subject to a retrospective assessment of up to $79.3 million ($37.3 million, Company's share) in the event there is a nuclear incident involving any of the nation's licensed reactors. This assessment is subject to an inflation adjustment based on the Consumer Price Index. There is a limitation of $10 million ($4.7 million, Company's share) in retrospective assessments per incident per year. The Owners carry decontamination liability, premature decommissioning liability, and property damage insurance for Wolf Creek totalling approximately $2.8 billion ($1.3 billion, Company's share). This insurance is provided by a combination of "nuclear insurance pools" ($1.3 billion) and Nuclear Electric Insurance Limited (NEIL) ($1.5 billion). In the event of an accident, insurance proceeds must first be used for reactor stabilization and site decontamination. The remaining proceeds from the $2.8 billion insurance coverage ($1.3 billion, Company's share), if any, can be used for property damage up to $1.1 billion (Company's share) and premature decommissioning costs up to $117.5 million (Company's share) in excess of funds previously collected for decommissioning (as discussed under "Decommissioning"), with the remaining $47 million (Company's share) available for either property damage or premature decommissioning costs. The Owners also carry additional insurance with NEIL to cover costs of replacement power and other extra expenses incurred during a prolonged outage resulting from accidental property damage at Wolf Creek. If losses incurred at any of the nuclear plants insured under the NEIL policies exceed premiums, reserves, and other NEIL resources, the Company may be subject to retrospective assessments of approximately $9 million per year. There can be no assurance that all potential losses or liabilities will be insurable or that the amount of insurance will be sufficient to cover them. Any substantial losses not covered by insurance, to the extent not recoverable through rates, could have a material adverse effect on the Company's financial condition and results of operations. Clean Air Act: The Clean Air Act Amendments of 1990 (the Act) require a two-phase reduction in sulfur dioxide and nitrous oxide emissions effective in 1995 and 2000 and a probable reduction in toxic emissions. To meet the monitoring and reporting requirements under the acid rain program, the Company is installing continuous monitoring and reporting equipment at a total cost of approximately $10 million. At December 31, 1993, the Company had completed approximately $4 million of these capital expenditures with the remaining $6 million of capital expenditures to be completed in 1994 and 1995. The Company does not expect additional equipment to reduce sulfur emissions to be necessary under Phase II. The Company currently has no Phase I affected units. The nitrous oxide and toxic limits, which were not set in the law, will be specified in future EPA regulations. The EPA has issued for public comment preliminary nitrous oxide regulations for Phase I group 1 units. Nitrous oxide regulations for Phase II units and Phase I group 2 units are mandated in the Act to be promulgated by January 1, 1997. Although the Company has no Phase I units, the final nitrous oxide regulations for Phase I group 1 may allow for early compliance for Phase II group 1 units. Until such time as the Phase I group 1 nitrous oxide regulations are final, the Company will be unable to determine its compliance options or related compliance costs. Federal Income Taxes: During 1991, the Internal Revenue Service (IRS) completed an examination of KG&E's federal income tax returns for the years 1984 through 1988. In April 1992, KG&E received the examination report and upon review filed a written protest in August 1992. In October 1993, KG&E received another examination report for the years 1989 and 1990 covering the same issues identified in the previous examination report. Upon review of this report, KG&E filed a written protest in November 1993. The most significant proposed adjustments reduce the depreciable basis of certain assets and investment tax credits generated. Management believes there are significant questions regarding the theory, computations, and sampling techniques used by the IRS to arrive at its proposed adjustments, and also believes any additional tax expense incurred or loss of investment tax credits will not be material to the Company's financial position and results of operations. Additional income tax payments, if any, are expected to be offset by investment tax credit carryforwards, alternative minimum tax credit carryforwards, or deferred tax provisions. Fuel Commitments: To supply a portion of the fuel requirements for its generating plants, the Company has entered into various commitments to obtain nuclear fuel, coal, and natural gas. Some of these contracts contain provisions for price escalation and minimum purchase commitments. At December 31, 1993, WCNOC's nuclear fuel commitments (Company's share) were approximately $18.0 million for uranium concentrates expiring at various times through 1997, $123.6 million for enrichment expiring at various times through 2014, and $45.5 million for fabrication through 2012. At December 31, 1993, the Company's coal and natural gas contract commitments in 1993 dollars under the remaining term of the contracts were $2.8 billion and $20.4 million, respectively. The largest coal contract was renegotiated early in 1993 and expires in 2020, with the remaining coal contracts expiring at various times through 2013. The majority of natural gas contracts continue through 1995 with automatic one-year extension provisions. In the normal course of business, additional commitments and spot market purchases will be made to obtain adequate fuel supplies. Energy Act: As part of the 1992 Energy Policy Act, a special assessment is being collected from utilities for a uranium enrichment, decontamination, and decommissioning fund. The Company's portion of the assessment for Wolf Creek is approximately $7 million, payable over 15 years. Management expects such costs to be recovered through the ratemaking process. 5. RATE MATTERS AND REGULATION The Company, under rate orders from certain state regulatory commissions and the FERC, recovers increases in fuel and natural gas costs through fuel adjustment clauses for wholesale and certain retail electric customers and various purchased gas adjustment clauses (PGA) for natural gas customers. Certain state regulatory commissions require the annual difference between actual gas cost incurred and cost recovered through the application of the PGA be deferred and amortized through rates in subsequent periods. Elimination of the Energy Cost Adjustment Clause (ECA): On March 26, 1992, in connection with the Merger, the KCC approved the elimination of the ECA for most Kansas retail electric customers of both the Company and KG&E effective April 1, 1992. The provisions for fuel costs included in base rates were established at a level intended by the KCC to equal the projected average cost of fuel through August 1995, and to include recovery of costs provided by previously issued orders relating to coal contract settlements. Any increase or decrease in fuel costs from the projected average will be absorbed by the Company. MPSC Rate Proceedings: On October 5, 1993, the MPSC approved an agreement among the Company, the MPSC staff, and intervenors to increase natural gas rates $9.75 million annually, effective October 15, 1993. Also on October 15, 1993, the Company discontinued the deferral of service line replacement program costs deferred since July 1, 1991, and began amortizing the balance to expense over twenty years. At December 31, 1993, approximately $8.3 million of these deferrals have been included in other deferred charges on the consolidated balance sheet. On January 22, 1992, the MPSC issued an order authorizing the Company to increase natural gas rates $7.3 million annually. KCC Rate Proceedings: On January 24, 1992, the KCC issued an order allowing the Company to continue the deferral of service line replacement program costs incurred since January 1, 1992, including depreciation, property taxes, and carrying costs for recovery in the next general rate case. At December 31, 1993, approximately $2.9 million of these deferrals have been included in other deferred charges on the consolidated balance sheet. On December 30, 1991, the KCC approved a permanent natural gas rate increase of $39 million annually and the Company discontinued the deferral of accelerated line survey costs on January 1, 1992. Approximately $8.3 million of deferred costs remain in other deferred charges on the consolidated balance sheet at December 31, 1993, with the balance being included in rates and amortized to expense during a 43-month period, commencing January 1, 1992. Gas Transportation Charges: On September 12, 1991, the KCC authorized the Company to begin recovering, through the PGA, deferred supplier gas transportation costs of $9.9 million incurred through December 31, 1990, based on a three-year amortization schedule. On December 30, 1991, the KCC authorized the Company to recover deferred transportation costs of approximately $2.8 million incurred subsequent to December 31, 1990, through the PGA over a 32-month period. At December 31, 1993, approximately $4.8 million of these deferrals remain in other deferred charges on the consolidated balance sheet. Tight Sands: In December 1991, the KCC, MPSC, and Oklahoma Corporation Commission (OCC) approved agreements authorizing the Company to refund to customers approximately $40 million of the proceeds of the Tight Sands antitrust litigation settlement to be collected on behalf of Western Resources' natural gas customers. To secure the refund of settlement proceeds, the Commissions authorized the establishment of an independently administered trust to collect and maintain cash receipts received under Tight Sands settlement agreements and provide for the refunds made. The trust has a term of ten years. Rate Stabilization Plan: In 1988, the KCC issued an order requiring that the accrual of phase-in revenues be discontinued by KG&E effective December 31, 1988. Effective January 1, 1989, KG&E began amortizing the phase-in revenue asset on a straight-line basis over 9 1/2 years. Coal Contract Settlements: In March 1990, the KCC issued an order allowing KG&E to defer its share of a 1989 coal contract settlement with the Pittsburgh and Midway Coal Mining Company amounting to $22.5 million. This amount was recorded as a deferred charge on the consolidated balance sheets. The settlement resulted in the termination of a long-term coal contract. The KCC permitted KG&E to recover this settlement as follows: 76 percent of the settlement plus a return over the remaining term of the terminated contract (through 2002) and 24 percent to be amortized to expense with a deferred return equivalent to the carrying cost of the asset. In February 1991, KG&E paid $8.5 million to settle a coal contract lawsuit with AMAX Coal Company and recorded the payment as a deferred charge on the consolidated balance sheet. The KCC approved the recovery of the settlement plus a return, equivalent to the carrying cost of the asset, over the remaining term of the terminated contract (through 1996). FERC Order No. 528: In 1990, the FERC issued Order No. 528 which authorized new methods for the allocation and recovery of take-or-pay settlement costs by natural gas pipelines from their customers. Settlements have been reached between the Company's two largest gas pipelines and their customers in FERC proceedings related to take-or-pay issues. The settlements address the allocation of take-or-pay settlement costs between the pipelines and their customers. However, the amount which one of the pipelines will be allowed to recover is yet to be determined. Litigation continues between the Company and a former upstream pipeline supplier to one of the Company's pipeline suppliers concerning the amount of such costs which may ultimately be allocated to the Company's pipeline supplier. A portion of any costs allocated to the Company's pipeline supplier will be charged to the Company. Due to the uncertainty concerning the amount to be recovered by the Company's current suppliers and of the outcome of the litigation between the Company and its current pipeline's upstream supplier, the Company is unable to estimate its future liability for take-or-pay settlement costs. However, the KCC and MPSC have approved mechanisms which are expected to allow the Company to recover these take-or-pay costs from its customers. 6. EMPLOYEE BENEFIT PLANS Pension: The Company maintains noncontributory defined benefit pension plans covering substantially all employees. Pension benefits are based on years of service and the employee's compensation during the five highest paid consecutive years out of ten before retirement. The Company's policy is to fund pension costs accrued, subject to limitations set by the Employee Retirement Income Security Act of 1974 and the Internal Revenue Code. The following tables provide information on the components of pension cost, funded status, and actuarial assumptions for the Company's pension plans: Year Ended December 31, 1993 1992 1991 (Dollars in Thousands) Pension Cost: Service cost................... $ 9,778 $ 9,847 $ 6,589 Interest cost on projected benefit obligation........... 35,688 29,457 20,985 Return on plan assets.......... (64,113) (38,967) (59,161) Deferred gain on plan assets... 29,190 7,705 38,015 Net amortization............... (669) (948) (131) Net pension cost........... $ 9,874 $ 7,094 $ 6,297 December 31, 1993 1992 1991 (Dollars in Thousands) Funded Status: Actuarial present value of benefit obligations: Vested . . . . . . . . . . . $353,023 $316,100 $200,435 Non-vested . . . . . . . . . 26,983 19,331 13,935 Total. . . . . . . . . . . $380,006 $335,431 $214,370 Plan assets (principally debt and equity securities) at fair value . . . . . . . . . . . $490,339 $452,372 $324,780 Projected benefit obligation . . . 468,996 424,232 282,062 Plan assets in excess of projected benefit obligation . . 21,343 28,140 42,718 Unrecognized transition asset. . . (2,756) (3,092) (1,253) Unrecognized prior service costs . 64,217 55,886 27,216 Unrecognized net gain. . . . . . . (108,783) (106,486) (69,494) Accrued pension costs. . . . . . . $(25,979) $(25,552) $ (813) Year Ended December 31, 1993 1992 1991 Actuarial Assumptions: Discount rate. . . . . . . . . . 7.0-7.75% 8.0-8.5% 8.0% Annual salary increase rate. . . 5.0 % 6.0% 6.0% Long-term rate of return . . . . 8.0-8.5 % 8.0-8.5% 8.0% Retirement and Voluntary Separation Plans: In January 1992, the Board of Directors approved early retirement plans and voluntary separation programs. The voluntary early retirement plans were offered to all vested participants in the Company's defined pension plan who reached the age of 55 with 10 or more years of service on or before May 1, 1992. Certain pension plan improvements were made, including a waiver of the actuarial reduction factors for early retirement and a cash incentive payable as a monthly supplement up to 60 months or as a lump sum payment. Of the 738 employees eligible for the early retirement option, 531, representing ten percent of the combined Company's work force, elected to retire on or before the May 1, 1992, deadline. Seventy-one of those electing to retire were employees of KG&E acquired March 31, 1992 (see Note 3). Another 67 employees, with 10 or more years of service, elected to participate in the voluntary separation program. Of those, 29 were employees of KG&E. In addition, 68 employees received Merger-related severance benefits, including 61 employees of KG&E. The actuarial cost, based on plan provisions for early retirement and voluntary separation programs, and Merger-related severance benefits for the KG&E employees, were considered in purchase accounting for the Merger. The actuarial cost of the former Kansas Power and Light Company employees, of approximately $11 million, was expensed in 1992. Postretirement: The Company adopted the provisions of Statement of Financial Accounting Standards No. 106 (SFAS 106) in the first quarter of 1993. This statement requires the accrual of postretirement benefits other than pensions, primarily medical benefit costs, during the years an employee provides service. Based on actuarial projections and adoption of the transition method of implementation which allows a 20-year amortization of the accumulated benefit obligation, the annual expense under SFAS 106 was approximately $26.5 million in 1993 (as compared to approximately $9.6 million on a cash basis) and the Company's total obligation was approximately $166.5 million at December 31, 1993. To mitigate the impact of SFAS 106 expense, the Company has implemented programs to reduce health care costs. In addition, the Company has received orders from the KCC and MPSC permitting the initial deferral of SFAS 106 expense. To mitigate the impact SFAS 106 expense will have on rate increases, the Company will include in the future computation of cost of service the actual SFAS 106 expense and an income stream generated from corporate-owned life insurance (COLI). To the extent SFAS 106 expense exceeds income from the COLI program, this excess will be deferred (as allowed by the FASB Emerging Issues Task Force Issue No. 92-12) and offset by income generated through the deferral period by the COLI program. The OCC is reviewing the Company's application for similar treatment in Oklahoma. Should the OCC require recognition of postretirement benefit costs for regulatory purposes under a different method than that proposed under the Company's application, the impact on earnings would not be material. Should the income stream generated by the COLI program not be sufficient to offset the deferred SFAS 106 expense, the KCC and MPSC orders allow recovery of such deficit through the ratemaking process. Prior to the adoption of SFAS 106 the Company's policy was to recognize the cost of retiree health care and life insurance benefits as expense when claims and premiums for life insurance policies were paid. The cost of providing health care and life insurance benefits to 2,928 retirees was $8.1 million in 1992. The following table summarizes the status of the Company's postretirement plans for financial statement purposes and the related amount included in the consolidated balance sheet: December 31, 1993 (Dollars in Thousands) Actuarial present value of postretirement benefit obligations: Retirees. . . . . . . . . . . . . . . . . . . . $ 111,499 Active employees fully eligible . . . . . . . . 11,848 Active employees not fully eligible . . . . . . 43,109 Unrecognized prior service cost . . . . . . . . 18,195 Unrecognized transition obligation. . . . . . . (160,731) Unrecognized net loss . . . . . . . . . . . . . (7,100) Balance sheet liability . . . . . . . . . . . . . . $ 16,820 For measurement purposes, an annual health care cost growth rate of 13% was assumed for 1994, decreasing to 6% by 2002 and thereafter. The accumulated post retirement benefit obligation was calculated using a weighted-average discount rate of 7.75%, a weighted-average compensation increase rate of 5.0%, and a weighted-average expected rate of return of 8.5%. The health care cost trend rate has a significant effect on the projected benefit obligation. Increasing the trend rate by 1% each year would increase the present value of the accumulated projected benefit obligation by $11.1 million and the aggregate of the service and interest cost components by $1.5 million. Postemployment: The FASB has issued Statement of Financial Accounting Standards No. 112 (SFAS 112), which establishes accounting and reporting standards for postemployment benefits. The new statement will require the Company to recognize the liability to provide postemployment benefits when the liability has been incurred. The Company adopted SFAS 112 effective January 1, 1994. To mitigate the impact adopting SFAS 112 will have on rate increases, the Company will file applications with the KCC and OCC for orders permitting the initial deferral of SFAS 112 transition costs and expenses and its inclusion in the future computation of cost of service net of an income stream generated from COLI. However, if the state regulatory commissions were to recognize postemployment benefit costs under a different method, 1994 earnings could be impacted negatively. At December 31, 1993, the Company estimates SFAS 112 liability to total approximately $11 million. Savings: The Company maintains savings plans in which substantially all employees participate. The Company matches employees' contributions up to specified maximum limits. The funds of the plans are deposited with a trustee and invested at each employee's option in one or more investment funds, including a Company stock fund. The Company's contributions were $5.4, $5.4, and $3.3 million for 1993, 1992, and 1991, respectively. Missouri Property Sale: Effective January 31, 1994, the Company transferred a portion of the assets and liabilities of the Company's pension plan to a pension plan established by Southern Union. The amount of assets transferred equal the projected benefit obligation for employees and retirees associated with Southern Union's portion of the Missouri Properties plus an additional $9 million. 7. FAIR VALUE OF FINANCIAL INSTRUMENTS The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value as set forth in Statement of Financial Accounting Standards No. 107: Cash and Cash Equivalents- The carrying amount approximates the fair value because of the short-term maturity of these investments. Decommissioning Trust- The fair value of the decommissioning trust is based on quoted market prices at December 31, 1993 and 1992. Variable-rate Debt- The carrying amount approximates the fair value because of the short-term variable rates of these debt instruments. Fixed-rate Debt- The fair value of the fixed-rate debt is based on the sum of the estimated value of each issue taking into consideration the interest rate, maturity, and redemption provisions of each issue. Redeemable Preference Stock- The fair value of the redeemable preference stock is based on the sum of the estimated value of each issue taking into consideration the dividend rate, maturity, and redemption provisions of each issue. The estimated fair values of the Company's financial instruments are as follows: Carrying Value Fair Value December 31, 1993 1992 1993 1992 (Dollars in Thousands) Cash and cash equivalents. . . . . . . $ 1,217 $ 875 $ 1,217 $ 875 Decommissioning trust. . . 13,204 9,272 13,929 9,500 Variable-rate debt . . . . 931,352 758,449 931,352 758,449 Fixed-rate debt. . . . . . 1,364,886 1,508,077 1,473,569 1,563,375 Redeemable preference stock. . . . . . . . . . 150,000 152,733 160,780 161,733 8. LONG-TERM DEBT The amount of first mortgage bonds authorized by the Western Resources Mortgage and Deed of Trust, dated July 1, 1939, as supplemented, is unlimited. The amount of first mortgage bonds authorized by the KG&E Mortgage and Deed of Trust, dated April 1, 1940, as supplemented, is limited to a maximum of $2 billion. Amounts of additional bonds which may be issued are subject to property, earnings, and certain restrictive provisions of each Mortgage. On January 20, 1994, KG&E issued $100 million of First Mortgage Bonds, 6.20% Series due January 15, 2006. On January 31, 1994, the Company redeemed the remaining $2,466,000 principal amount of Gas Service Company (GSC) 8 1/2% Series First Mortgage Bonds due 1997. In addition, the Company took measures to have the GSC Mortgage and Deed of Trust discharged. Debt discount and expenses are being amortized over the remaining lives of each issue. The Western Resources and KG&E improvement and maintenance fund requirements for certain first mortgage bond series can be met by bonding additional property. The sinking fund requirements for certain Western Resources and KG&E pollution control series bonds can be met only through the acquisition and retirement of outstanding bonds. Bonds maturing and acquisition and retirement of bonds for sinking fund requirements for the five years subsequent to December 31, 1993, are as follows: Maturing Retiring Year Bonds Bonds (Dollars in Thousands) 1994. . . . . $ 2,466 $ 738 1995. . . . . - 753 1996. . . . . 16,000 770 1997. . . . . - 1,333 1998. . . . . - 1,550 Long-term debt outstanding at December 31, 1993 and 1992, was as follows: 1993 1992 (Dollars in Thousands) Western Resources First mortgage bond series: 9.35 % due 1998. . . . . . . . . . . . . $ - $ 75,000 7 1/4% due 1999. . . . . . . . . . . . . 125,000 125,000 7 5/8% due 1999. . . . . . . . . . . . . 19,000 19,000 8 3/4% due 2000. . . . . . . . . . . . . - 20,000 8 7/8% due 2000. . . . . . . . . . . . . 75,000 75,000 7 1/4% due 2002. . . . . . . . . . . . . 100,000 100,000 8 5/8% due 2005. . . . . . . . . . . . . - 35,000 8 1/8% due 2007. . . . . . . . . . . . . 30,000 30,000 8 3/4% due 2008. . . . . . . . . . . . . - 35,000 8 5/8% due 2017. . . . . . . . . . . . . 50,000 50,000 8 1/2% due 2022. . . . . . . . . . . . . 125,000 125,000 7.65% due 2023. . . . . . . . . . . . . 100,000 - 624,000 689,000 Pollution control bond series: 5.90 % due 2007. . . . . . . . . . . . . 31,000 31,500 6 3/4% due 2009. . . . . . . . . . . . . 45,000 45,000 9 5/8% due 2013. . . . . . . . . . . . . - 58,500 6% due 2033. . . . . . . . . . . . . 58,500 - 134,500 135,000 KG&E First mortgage bond series: 5 5/8% due 1996. . . . . . . . . . . . . 16,000 16,000 8 1/8% due 2001. . . . . . . . . . . . . - 35,000 7 3/8% due 2002. . . . . . . . . . . . . - 25,000 7.60% due 2003. . . . . . . . . . . . . 135,000 135,000 6 1/2% due 2005. . . . . . . . . . . . . 65,000 - 8 3/8% due 2006. . . . . . . . . . . . . - 25,000 8 1/2% due 2007. . . . . . . . . . . . . - 25,000 8 7/8% due 2008. . . . . . . . . . . . . - 30,000 216,000 291,000 Pollution control bond series: 6.80% due 2004. . . . . . . . . . . . . 14,500 14,500 5 7/8% due 2007. . . . . . . . . . . . . 21,940 21,940 6% due 2007. . . . . . . . . . . . . 10,000 10,000 7.0% due 2031. . . . . . . . . . . . . 327,500 327,500 373,940 373,940 GSC First mortgage bond series: 8 1/2% due 1997. . . . . . . . . . . . . 2,466 4,932 2,466 4,932 Bank term loan . . . . . . . . . . . . . . - 230,000 Other pollution control obligations. . . . 13,980 14,205 Revolving credit agreement . . . . . . . . 115,000 150,000 Other long term agreement. . . . . . . . . 53,913 46,640 Less: Unamortized debt discount. . . . . . . . 6,607 6,730 Long-term debt due within one year . . . 3,204 1,961 $1,523,988 $1,926,026 In January 1993, the Company renegotiated its $600 million bank term loan and revolving credit facility used to finance the Merger into a $350 million revolving credit facility, secured by KG&E common stock. The revolver has an initial term of three years with options to renew for an additional two years with the consent of the banks. The unused portion of the revolving credit facility may be used to provide support for outstanding short-term debt. At December 31, 1993, $115 million was outstanding under the facility. On September 20, 1993, KG&E terminated a long-term revolving credit agreement which provided for borrowings of up to $150 million. The loan agreement, which was effective through October 1994, was repaid without penalty. KG&E has a long-term agreement, expiring in 1995, which contains provisions for the sale of accounts receivable and unbilled revenues (receivables) and phase-in revenues up to a total of $180 million. Amounts related to receivables are accounted for as sales while those related to phase-in revenues are accounted for as collateralized borrowings. Additional receivables are continually sold to replace those collected. At December 31, 1993 and 1992, outstanding receivables amounting to $56.8 and $47.7 million, respectively, were considered sold under the agreement. The credit risk associated with the sale of customer accounts receivable is considered minimal. The weighted average interest rate, including fees, was 3.7% for the year ended December 31, 1993, and 6.6% for the nine months ended December 31, 1992. At December 31, 1993, an additional $16.4 million was available under the agreement. 9. SHORT-TERM DEBT The Company's short-term financing requirements are satisfied, as needed, through the sale of commercial paper, short-term bank loans and borrowings under other unsecured lines of credit maintained with banks. Information concerning these arrangements for the years ended December 31, 1993, 1992, and 1991, is set forth below: Year Ended December 31, 1993 1992 1991 (Dollars in Thousands) Lines of credit at year end. . . . $145,000 $250,000(1) $185,000(2) Short-term debt out- standing at year end . . . . . . 440,895 222,225 135,800 Weighted average interest rate on debt outstanding at year end (including fees) . . . . . . 3.67% 4.70% 5.07% Maximum amount of short- term debt outstanding during the period. . . .. . . . . . . . $443,895 $263,900 $175,000 Monthly average short-term debt. . 347,278 179,577 125,968 Weighted daily average interest rates during the year (including fees) . . . . . . . . 3.44% 4.90% 6.69% (1) Decreased to $155 million in January 1993. (2) Increased to $200 million in January 1992. In connection with the commitments, the Company has agreed to pay certain fees to the banks. Available lines of credit and the unused portion of the revolving credit facility are utilized to support the Company's outstanding short-term debt. 10. LEASES At December 31, 1993, the Company had leases covering various property and equipment. Certain lease agreements meet the criteria, as set forth in Statement of Financial Accounting Standards No. 13, for classification as capital leases. Rental payments for capital and operating leases and estimated rental commitments are as follows: Capital Operating Year Ending December 31, Leases Leases (Dollars in Thousands) 1991 $ 1,217 $21,501 1992 2,426 52,701 1993 3,272 55,011 Future Commitments: 1994 $ 4,002 $47,729 1995 3,752 45,825 1996 3,627 44,176 1997 1,209 41,644 1998 - 41,019 Thereafter - 771,157 Total $12,590 $ 991,550 Less Interest 1,466 Net obligation $11,124 In 1987, KG&E sold and leased back its 50 percent undivided interest in La Cygne 2. The lease has an initial term of 29 years, with various options to renew the lease or repurchase the 50 percent undivided interest. KG&E remains responsible for its share of operation and maintenance costs and other related operating costs of La Cygne 2. The lease is an operating lease for financial reporting purposes. As permitted under the lease agreement, the Company in 1992 requested the Trustee Lessor to refinance $341.1 million of secured facility bonds of the Trustee and owner of La Cygne 2. The transaction was requested to reduce recurring future net lease expense. In connection with the refinancing on September 29, 1992, a one-time payment of approximately $27 million was made by the Company which has been deferred and is being amortized over the remaining life of the lease and included in operating expense as part of the future lease expense. Future minimum annual lease payments, included in the table above, required under the lease agreement are approximately $34.6 million for each year through 1998 and $715 million over the remainder of the lease. The gain of approximately $322 million realized at the date of the sale has been deferred for financial reporting purposes, and is being amortized over the initial lease term in proportion to the related lease expense. KG&E's lease expense, net of amortization of the deferred gain and a one-time payment, was approximately $22.5 million for the year ended December 31, 1993, and $20.6 million for the nine months ended December 31, 1992. 11. JOINT OWNERSHIP OF UTILITY PLANTS Company's Ownership at December 31, 1993 In-Service Invest- Accumulated Net Per- Dates ment Depreciation (MW) cent (Dollars in Thousands) La Cygne 1 (a) Jun 1973 $ 150,265 $ 91,175 342 50 Jeffrey 1 (b) Jul 1978 277,087 116,526 587 84 Jeffrey 2 (b) May 1980 274,018 106,301 566 84 Jeffrey 3 (b) May 1983 386,925 124,158 588 84 Wolf Creek (c) Sep 1985 1,366,387 281,819 533 47 (a) Jointly owned with Kansas City Power & Light Company (KCPL) (b) Jointly owned with UtiliCorp United Inc. and a third party (c) Jointly owned with KCPL and Kansas Electric Power Cooperative, Inc. Amounts and capacity represent the Company's share. The Company's share of operating expenses of the plants in service above, as well as such expenses for a 50 percent undivided interest in La Cygne 2 (representing 335 MW capacity) sold and leased back to the Company in 1987, are included in operating expenses in the statements of income. The Company's share of other transactions associated with the plants is included in the appropriate classification in the Company's consolidated financial statements. 12. INCOME TAXES The Company adopted the provisions of SFAS 109 in the first quarter of 1992. KG&E adopted the provisions of SFAS 96 in 1987 and SFAS 109 in 1992. These statements require the Company to establish deferred tax assets and liabilities, as appropriate, for all temporary differences, and to adjust deferred tax balances to reflect changes in tax rates expected to be in effect during the periods the temporary differences reverse. In accordance with various rate orders received from the KCC, the MPSC, and the OCC, the Company has not yet collected through rates the amounts necessary to pay a significant portion of the net deferred income tax liabilities. As management believes it is probable that the net future increases in income taxes payable will be recovered from customers through future rates, it has recorded a deferred asset for these amounts. These assets are also a temporary difference for which deferred income tax liabilities have been provided. Accordingly, the adoption of SFAS 109 did not have a material impact on the Company's results of operations. At December 31, 1993, KG&E has unused investment tax credits of approximately $7.1 million available for carryforward which, if not utilized, will expire in the years 2000 through 2002. In addition, the Company has alternative minimum tax credits generated prior to April 1, 1992, which carryforward without expiration, of $57.2 million which may be used to offset future regular tax to the extent the regular tax exceeds the alternative minimum tax. These credits have been applied in determining the Company's net deferred income tax liability and corresponding deferred future income taxes at December 31, 1993. Deferred income taxes result from temporary differences between the financial statement and tax basis of the Company's assets and liabilities. The sources of these differences and their cumulative tax effects are as follows: December 31, 1993 Debits Credits Total (Dollars in Thousands) Sources of Deferred Income Taxes: Accelerated depreciation and other property items . . . . . . $ - $ (647,202) $ (647,202) Energy and purchased gas adjustment clauses . . . . . . . 2,452 - 2,452 Phase-in revenues. . . . . . . . . - (35,573) (35,573) Natural gas line survey and replacement program. . . . . . . - (7,721) (7,721) Deferred gain on sale-leaseback. . 116,186 - 116,186 Alternative minimum tax credits. . 39,882 - 39,882 Deferred coal contract settlements. . . . . . . . . . . - (14,980) (14,980) Deferred compensation/pension liability. . . . . . . . . . . . 11,301 - 11,301 Acquisition premium. . . . . . . . - (301,394) (301,394) Deferred future income taxes . . . - (117,549) (117,549) Other. . . . . . . . . . . . . . . - (14,039) (14,039) Total Deferred Income Taxes. . . . . $ 169,821 $(1,138,458) $ (968,637) December 31, 1992 Debits Credits Total (Dollars in Thousands) Sources of Deferred Income Taxes: Accelerated depreciation and other property items . . . . . . $ - $ (607,303) $ (607,303) Energy and purchased gas adjustment clauses . . . . . . . - (7,717) (7,717) Phase-in revenues. . . . . . . . . - (37,564) (37,564) Natural gas line survey and replacement program. . . . . . . - (7,473) (7,473) Deferred gain on sale-leaseback. . 104,573 - 104,573 Alternative minimum tax credits. . 39,882 - 39,882 Deferred coal contract settlements. . . . . . . . . . . - (9,318) (9,318) Deferred compensation/pension liability. . . . . . . . . . . . 8,488 - 8,488 Acquisition premium. . . . . . . . - (314,241) (314,241) Deferred future income taxes . . . - (158,102) (158,102) Other. . . . . . . . . . . . . . . - (1,380) (1,380) Total Deferred Income Taxes. . . . . $ 152,943 $(1,143,098) $ (990,155) 13. SEGMENTS OF BUSINESS The Company is a public utility engaged in the generation, transmission, distribution, and sale of electricity in Kansas and the transportation, distribution, and sale of natural gas in Kansas, Missouri, and Oklahoma. Year Ended December 31, 1993 1992(1) 1991 (Dollars in Thousands) Operating revenues: Electric. . . . . . . . . . . $1,104,537 $ 882,885 $ 471,839 Natural gas . . . . . . . . . 804,822 673,363 690,339 1,909,359 1,556,248 1,162,178 Operating expenses excluding income taxes: Electric. . . . . . . . . . . 791,563 632,169 337,150 Natural gas . . . . . . . . . 747,755 642,910 664,825 1,539,318 1,275,079 1,001,975 Income taxes: Electric. . . . . . . . . . . 73,425 41,184 32,239 Natural gas . . . . . . . . . 4,553 816 (1,657) 77,978 42,000 30,582 Operating income: Electric. . . . . . . . . . . 239,549 209,532 102,450 Natural gas . . . . . . . . . 52,514 29,637 27,171 $ 292,063 $ 239,169 $ 129,621 Identifiable assets at December 31: Electric. . . . . . . . . . . $4,231,277 $4,390,117 $1,196,023 Natural gas . . . . . . . . . 1,040,513 918,729 840,692 Other corporate assets(2) . . 140,258 130,060 75,798 $5,412,048 $5,438,906 $2,112,513 Other Information-- Depreciation and amortization: Electric. . . . . . . . . . . $ 126,034 $ 105,842 $ 53,632 Natural gas . . . . . . . . . 38,330 38,171 32,103 $ 164,364 $ 144,013 $ 85,735 Maintenance: Electric. . . . . . . . . . . $ 87,696 $ 73,104 $ 34,240 Natural gas . . . . . . . . . 30,147 28,507 26,275 $ 117,843 $ 101,611 $ 60,515 Capital expenditures: Electric. . . . . . . . . . . $ 137,874 $ 95,465 $ 43,714 Nuclear fuel. . . . . . . . . 5,702 15,839 - Natural gas . . . . . . . . . 94,055 91,189 81,961 $ 237,631 $ 202,493 $ 125,675 (1)Information reflects the merger with KG&E on March 31, 1992. (2)Principally cash, temporary cash investments, non-utility assets, and deferred charges. The portion of the table above related to the Missouri Properties is as follows (unaudited): (Dollars in Thousands) Natural gas revenues. . . . . . . . . . $ 349,749 Operating expenses excluding income taxes. . . . . . . . . 326,329 Income taxes. . . . . . . . . . . . . . 2,672 Operating income. . . . . . . . . . . . 20,748 Identifiable assets . . . . . . . . . . 398,464 Depreciation and amortization . . . . . 12,668 Maintenance . . . . . . . . . . . . . . 10,504 Capital expenditures. . . . . . . . . . 38,821 14. COMMON STOCK AND CUMULATIVE PREFERRED AND PREFERENCE STOCK The Company's Restated Articles of Incorporation, as amended, provides for 85,000,000 authorized shares of common stock. During 1993, the Company issued 3,572,323 shares of common stock and at December 31, 1993, 61,617,873 shares were outstanding. Not subject to mandatory redemption: The cumulative preferred stock is redeemable in whole or in part on 30 to 60 days notice at the option of the Company. Subject to mandatory redemption: On October 1, 1993, the Company redeemed the remaining 22,000 shares of the 8.70% Series preference stock. The mandatory sinking fund provisions of the 8.50% Series preference stock require the Company to redeem 50,000 shares annually beginning on July 1, 1997, at $100 per share. The Company may, at its option, redeem up to an additional 50,000 shares on each July 1, at $100 per share. The 8.50% Series also is redeemable in whole or in part, at the option of the Company, subject to certain restrictions on refunding, at a redemption price of $107.37, $106.80, and $106.23 per share beginning July 1, 1993, 1994, and 1995, respectively. The mandatory sinking fund provisions of the 7.58% Series preference stock require the Company to redeem 25,000 shares annually beginning on April 1, 2002, and each April 1 through 2006 and the remaining shares on April 1, 2007, all at $100 per share. The Company may, at its option, redeem up to an additional 25,000 shares on each April 1 at $100 per share. The 7.58% Series also is redeemable in whole or in part, at the option of the Company, subject to certain restrictions on refunding, at a redemption price of $106.82, $106.06, and $105.31 per share beginning April 1, 1993, 1994, and 1995, respectively. 15. LEGAL PROCEEDINGS The Company and its subsidiaries are involved in various legal and environmental proceedings. Management believes that adequate provision has been made within the consolidated financial statements for these matters and accordingly believes their ultimate dispositions will not have a material adverse effect upon the business, financial position, or results of operations of the Company. 16. QUARTERLY RESULTS (UNAUDITED) The amounts in the table are unaudited but, in the opinion of management, contain all adjustments (consisting only of normal recurring adjustments) necessary for a fair presentation of the results of such periods. The business of the Company is seasonal in nature and, in the opinion of management, comparisons between the quarters of a year do not give a true indication of overall trends and changes in operations. First Second Third Fourth (Dollars in Thousands, except Per Share Amounts) Operating revenues. . . . . . . $579,581 $400,411 $419,018 $510,349 Operating income. . . . . . . . 85,950 60,282 81,225 64,606 Net income. . . . . . . . . . . 54,814 30,723 56,807 35,026 Earnings applicable to common stock. . . . . . . . . 51,468 27,320 53,405 31,671 Earnings per share. . . . . . . $ 0.89 $ 0.47 $ 0.90 $ 0.51 Dividends per share . . . . . . $ 0.485 $ 0.485 $ 0.485 $ 0.485 Average common shares outstanding . . . . . . . . . 58,046 58,046 59,441 61,603 Common stock price: High. . . . . . . . . . . . . $ 35 3/4 $ 36 1/8 $ 37 1/4 $ 37 Low . . . . . . . . . . . . . $ 30 3/8 $ 32 3/4 $ 35 $ 32 3/4 1992(1) Operating revenues. . . . . . . $373,620 $341,715 $380,745 $460,168 Operating income. . . . . . . . 42,684 45,830 77,010 73,645 Net income. . . . . . . . . . . 27,984 18,434 42,185 39,281 Earnings applicable to common stock. . . . . . . . . 25,472 15,113 38,726 35,822 Earnings per share. . . . . . . $ 0.74 $ 0.26 $ 0.67 $ 0.62 Dividends per share . . . . . . $ 0.475 $ 0.475 $ 0.475 $ 0.475 Average common shares outstanding . . . . . . . . . 34,566 58,046 58,046 58,046 Common stock price: High. . . . . . . . . . . . . $ 29 1/2 $ 26 7/8 $ 30 1/2 $ 32 5/8 Low . . . . . . . . . . . . . $ 25 3/8 $ 25 1/4 $ 26 3/4 $ 28 1/2 (1) Information reflects the merger with KG&E on March 31, 1992. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information relating to the Company's Directors required by Item 10 is set forth in the Company's definitive proxy statement for its 1994 Annual Meeting of Shareholders to be filed with the Commission. Such information is incorporated herein by reference to the material appearing under the caption Election of Directors in the proxy statement to be filed by the Company with the Commission. See EXECUTIVE OFFICERS OF THE COMPANY on page 18 for the information relating to the Company's Executive Officers as required by Item 10. ITEM 11. EXECUTIVE COMPENSATION The information required by Item 11 is set forth in the Company's definitive proxy statement for its 1994 Annual Meeting of Shareholders to be filed with the Commission. Such information is incorporated herein by reference to the material appearing under the captions Information Concerning the Board of Directors, Executive Compensation, Compensation Plans, and Human Resources Committee Report in the proxy statement to be filed by the Company with the Commission. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by Item 12 is set forth in the Company's definitive proxy statement for its 1994 Annual Meeting of Shareholders to be filed with the Commission. Such information is incorporated herein by reference to the material appearing under the caption Beneficial Ownership of Voting Securities in the proxy statement to be filed by the Company with the Commission. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by Item 13 is set forth in the Company's definitive proxy statement for its 1994 Annual Meeting of Shareholders to be filed with the Commission. Such information is incorporated herein by reference to the material appearing under the caption Transactions with Management in the proxy statement to be filed by the Company with the Commission. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K The following financial statements are included herein. FINANCIAL STATEMENTS Report of Independent Public Accountants Consolidated Balance Sheets - December 31, 1993 and 1992 Consolidated Statements of Income - years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows - years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Taxes - years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Capitalization - December 31, 1993 and Consolidated Statements of Common Stock Equity - years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements The following supplemental schedules are included herein. SCHEDULES Schedule V - Utility Plant - years ended December 31, 1993, 1992 and 1991 Schedule VI - Accumulated Depreciation of Utility Plant - years ended December 31, 1993, 1992 and 1991 Schedules omitted as not applicable or not required under the Rules of regulation S-X: I, II, III, IV, VII, VIII, IX, X, XI, XII, and XIII REPORTS ON FORM 8-K Form 8-K dated February 2, 1994 EXHIBIT INDEX All exhibits marked "I" are incorporated herein by reference. Description 3(a) -Restated Articles of Incorporation of the Company, as amended I May 25, 1988. (filed as Exhibit 4 to Registration Statement No. 33-23022) 3(b) -Certificate of Correction to Restated Articles of Incorporation. I (filed as Exhibit 3(b) to the December 1991 Form 10-K) 3(c) -By-laws of the Company, as amended July 15, 1987. (filed as I Exhibit 3(d) to the December 1987 Form 10-K) 3(d) -Certificate of Designation of Preference Stock, 8.50% Series, without par value. (filed electronically) 3(e) -Certificate of Designation of Preference Stock, 7.58% Series, without par value. (filed electronically) 4(a) -Mortgage and Deed of Trust dated July 1, 1939 between the Company I and Harris Trust and Savings Bank, Trustee. (filed as Exhibit 4(a) to Registration Statement No. 33-21739) 4(b) -First through Fifteenth Supplemental Indentures dated July 1, I 1939, April 1, 1949, July 20, 1949, October 1, 1949, December 1, 1949, October 4, 1951, December 1, 1951, May 1, 1952, October 1, 1954, September 1, 1961, April 1, 1969, September 1, 1970, February 1, 1975, May 1, 1976 and April 1, 1977, respectively. (filed as Exhibit 4(b) to Registration Statement No. 33-21739) 4(c) -Sixteenth Supplemental Indenture dated June 1, 1977. (filed as I Exhibit 2-D to Registration Statement No. 2-60207) 4(d) -Seventeenth Supplemental Indenture dated February 1, 1978. I (filed as Exhibit 2-E to Registration Statement No. 2-61310) 4(e) -Eighteenth Supplemental Indenture dated January 1, 1979. (filed I as Exhibit (b) (1)-9 to Registration Statement No. 2-64231) 4(f) -Nineteenth Supplemental Indenture dated May 1, 1980. (filed as I Exhibit 4(f) to Registration Statement No. 33-21739) 4(g) -Twentieth Supplemental Indenture dated November 1, 1981. (filed I as Exhibit 4(g) to Registration Statement No. 33-21739) 4(h) -Twenty-First Supplemental Indenture dated April 1, 1982. (filed I as Exhibit 4(h) to Registration Statement No. 33-21739) 4(i) -Twenty-Second Supplemental Indenture dated February 1, 1983. I (filed as Exhibit 4(i) to Registration Statement No. 33-21739) 4(j) -Twenty-Third Supplemental Indenture dated July 2, 1986. (filed I as Exhibit 4(j) to Registration Statement No. 33-12054) 4(k) -Twenty-Fourth Supplemental Indenture dated March 1, 1987. (filed I as Exhibit 4(k) to Registration Statement No. 33-21739) 4(l) -Twenty-Fifth Supplemental Indenture dated October 15, 1988. I (filed as Exhibit 4 to the September 1988 Form 10-Q) 4(m) -Twenty-Sixth Supplemental Indenture dated February 15, 1990. I (filed as Exhibit 4(m) to the December 1989 Form 10-K) 4(n) -Twenty-Seventh Supplemental Indenture dated March 12, 1992. I (filed as exhibit 4(n) to the December 1991 Form 10-K) 4(o) -Twenty-Eighth Supplemental Indenture dated July 1, 1992. I (filed as exhibit 4(o) to the December 1992 Form 10-K) 4(p) -Twenty-Ninth Supplemental Indenture dated August 20, 1992. I (filed as exhibit 4(p) to the December 1992 Form 10-K) Description 4(q) -Thirtieth Supplemental Indenture dated February 1, 1993. I (filed as exhibit 4(q) to the December 1992 Form 10-K) 4(r) -Thirty-First Supplemental Indenture dated April 15, 1993. I (filed as exhibit 4(r) to Form S-3, Registration Statement No. 33-50069) Instruments defining the rights of holders of other long-term debt not required to be filed as exhibits will be furnished to the Commission upon request. 10(a) -Agreement between the Company and AMAX Coal West Inc. effective March 31, 1993. (filed electronically) 10(b) -Agreement between the Company and Williams Natural Gas Company dated October 1, 1993. (filed electronically) 10(c) -Agreement between the Company and Williams Natural Gas Company dated October 1, 1993. (filed electronically) 10(d) -Agreement between the Company and Williams Natural Gas Company dated October 1, 1993. (filed electronically) 10(e) -Executive Salary Continuation Plan of The Kansas Power and Light I Company, as revised, effective May 3, 1988. (filed as Exhibit 10(b) to the September 1988 Form 10-Q) 10(f) -Letter of Agreement between The Kansas Power and Light Company and I John E. Hayes, Jr., dated November 20, 1989. (filed as Exhibit 10(w) to the December 1989 Form 10-K) 10(g) -Amended Agreement and Plan of Merger by and among The Kansas I Power and Light Company, KCA Corporation, and Kansas Gas and Electric Company, dated as of October 28, 1990, as amended by Amendment No. 1 thereto, dated as of January 18, 1991. (filed as Annex A to Registration Statement No. 33-38967) 10(h) -Deferred Compensation Plan 10(i) -Long-term Incentive Plan 10(j) -Short-term Incentive Plan 10(k) -Outside Directors' Deferred Compensation Plan 12 -Computation of Ratio of Consolidated Earnings to Fixed Charges. (filed electronically) 16 -Letter re Change in Certifying Accountant. (filed as Exhibit 16 I to the Current Report on Form 8-K dated March 8, 1993) 21 -Subsidiaries of the Registrant. (filed as Exhibit 22 to the I December 1992 Form 10-K) 23(a) -Consent of Independent Public Accountants, Arthur Andersen & Co. (filed electronically) 23(b) -Consent of Independent Public Accountants, Deloitte & Touche (filed electronically)) 23(c) -Consent of K&A Energy Consultants, Inc. (filed as Exhibit 24(b) I to the December 1988 Form 10-K) 99(a) -Kansas Gas and Electric Company's Annual Report on Form 10-K for the year ended December 31, 1993 (filed electronically) 99(b) -Report of K&A Energy Consultants, Inc. (filed as Exhibit 28 to I the December 1988 Form 10-K) SIGNATURE Pursuant to the requirements of Sections 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. WESTERN RESOURCES, INC. March 18, 1994 By JOHN E. HAYES, JR. (John E. Hayes, Jr., Chairman of the Board, President, and Chief Executive Officer) SIGNATURES 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 Chairman of the Board, President, JOHN E. HAYES, JR. and Chief Executive Officer March 18, 1994 (John E. Hayes, Jr.) (Principal Executive Officer) Executive Vice President and S. L. KITCHEN Chief Financial Officer March 18, 1994 (S. L. Kitchen) (Principal Financial and Accounting Officer) FRANK J. BECKER (Frank J. Becker) GENE A. BUDIG (Gene A. Budig) C. Q. CHANDLER (C. Q. Chandler) THOMAS R. CLEVENGER (Thomas R. Clevenger) JOHN C. DICUS Directors March 18, 1994 (John C. Dicus) DAVID H. HUGHES (David H. Hughes) RUSSELL W. MEYER, JR. (Russell W. Meyer, Jr.) JOHN H. ROBINSON (John H. Robinson) MARJORIE I. SETTER (Marjorie I. Setter) LOUIS W. SMITH (Louis W. Smith) KENNETH J. WAGNON (Kenneth J. Wagnon)		ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FINANCIAL CONDITION General: Earnings were $2.76 per share of common stock based on 59,294,091 average common shares for 1993, an increase from $2.20 in 1992 on 52,271,932 average common shares. The increase resulted from a return to near normal temperatures compared to unusually mild winter and summer temperatures in 1992, reduced interest costs, and the full twelve month effect of the merger with Kansas Gas and Electric Company (KG&E) on March 31, 1992 (the Merger). Dividends per common share were $1.94 in 1993, an increase of four cents from 1992. In January 1994, the Board of Directors declared a quarterly dividend of 49 1/2 cents per common share, an increase of one cent over the previous quarter. The book value per share was $23.08 at December 31, 1993, compared to $21.51 at December 31, 1992. The increase in book value is primarily the result of the issuance of additional common stock and an increase in retained earnings. The 1993 closing stock price of $34 7/8 was 151 percent of book value. There were 61,617,873 common shares outstanding at December 31, 1993. On January 31, 1994, the Company sold substantially all of its Missouri natural gas distribution properties and operations to Southern Union Company (Southern Union). The Company sold the remaining Missouri properties to United Cities Gas Company (United Cities) on February 28, 1994. The properties sold to Southern Union and United Cities are referred to herein as the "Missouri Properties." With the sales the Company is no longer operating as a utility in the State of Missouri. The portion of the Missouri Properties purchased by Southern Union was sold for an estimated sale price of $400 million, in cash, based on a calculation as of December 31, 1993. The final sale price will be calculated as of January 31, 1994, within 120 days of closing. Any difference between the estimated and final sale price will be adjusted through a payment to or from the Company. United Cities purchased the Company's natural gas distribution system in and around the City of Palmyra, Missouri, for $665,000 in cash. The operating revenues and operating income (unaudited) related to the Missouri Properties approximated $350 million and $21 million representing approximately 18 percent and seven percent, respectively, of the Company's total for 1993, and $299 million and $11 million representing approximately 19 percent and five percent, respectively, of the Company's total for 1992. Net utility plant (unaudited) for the Missouri Properties, at December 31, 1993, approximated $296 million and $272 million at December 31, 1992. This represents approximately seven percent at December 31, 1993, and six percent at December 31, 1992, of the total Company net utility plant. Separate audited financial information was not kept by the Company for the Missouri Properties. This unaudited financial information is based on assumptions and allocations of expenses of the Company as a whole. Liquidity and Capital Resources: The Company's liquidity is a function of its ongoing construction program, designed to improve facilities which provide electric and natural gas service and meet future customer service requirements. During 1993, construction expenditures for the Company's electric system were approximately $138 million and nuclear fuel expenditures were approximately $6 million. It is projected that adequate capacity margins will be maintained without the addition of any major generating facilities through the turn of the century. The construction expenditures for improvements on the natural gas system, including the Company's service line replacement program, were approximately $94 million during 1993, of which construction expenditures for the Missouri Properties were approximately $39 million. Capital expenditures for 1994 to 1996 are anticipated to be as follows: Electric Nuclear Fuel Natural Gas (Dollars in Thousands) 1994 $131,483 $ 20,995 $ 64,608 1995 143,391 21,469 69,482 1996 151,100 9,890 68,747 These expenditures are estimates prepared for planning purposes and are subject to revisions from time to time (see Note 4). The Company's net cash flow to capital expenditures was 100 percent for 1993 and during the last five years has averaged 87 percent. The Company anticipates net cash flow to capital expenditures to be approximately 100 percent in 1994. The Company's capital needs through 1998 are approximately $33.6 million for bond maturities and cash sinking fund requirements for bonds and preference stock. This capital as well as capital required for construction will be provided from internal and external sources available under then existing financial conditions. The Company anticipates using the net proceeds from the sale of the Missouri Properties to reduce the Company's outstanding debt. The embedded cost of long-term debt was 7.7% at December 31, 1993, a decrease from 7.9% at December 31, 1992. The decrease was primarily accomplished through refinancing of higher cost debt. The Company's short-term financing requirements are satisfied, as needed, through the sale of commercial paper, short-term bank loans, and borrowings under other unsecured lines of credit maintained with banks. At December 31, 1993, short-term borrowings amounted to $441 million, of which $126 million was commercial paper (see Notes 8 and 9). On September 20, 1993, KG&E terminated a long-term revolving credit agreement which provided for borrowings of up to $150 million. The loan agreement, which was effective through October 1994, was repaid without penalty. At December 31, 1993, the Company had $200 million of First Mortgage Bonds available to be issued under a shelf registration filed August 24, 1993. Also at December 31, 1993, KG&E had $150 million of First Mortgage Bonds available to be issued under a shelf registration filed on August 24, 1993. On January 20, 1994, KG&E issued $100 million of First Mortgage Bonds, 6.20% Series due January 15, 2006, under the KG&E shelf registration. The net proceeds were used to reduce short-term debt. On January 31, 1994, the Company redeemed the remaining $2,466,000 principal amount of Gas Service Company 8 1/2% Series First Mortgage Bonds due 1997. KG&E has a long-term agreement that expires in 1995 which contains provisions for the sale of accounts receivable and unbilled revenues (receivables) and phase-in revenues up to a total of $180 million. Amounts related to receivables are accounted for as sales while those related to phase-in revenues are accounted for as collateralized borrowings. At December 31, 1993, KG&E had receivables amounting to $56.8 million which were considered sold. The issuance and retirement of long-term debt, borrowings against the cash surrender value of corporate-owned life insurance policies (COLI), and the issuance of common stock during 1993 are summarized in the table below. - ------------------------------------------------------------------------------ \| Date Issued Retired \| \| (Dollars in Millions) \| \|Long-term debt \| \|----------------------------------------------------------------------------\| \|7 3/8% due 2002 - KG&E \| 11/22/93 \| \| $ 25.0\| \|8 3/8% due 2006 - KG&E \| \| \| 25.0\| \|8 1/2% due 2007 - KG&E \| \| \| 25.0\| \|----------------------------------------------------------------------------\| \|9.35% due 1998 \| 10/15/93 \| \| 75.0\| \|----------------------------------------------------------------------------\| \|6 1/2% due 2005 - KG&E \| 08/12/93 \| $ 65.0\| \| \|8 1/8% due 2001 - KG&E \| 08/20/93 \| \| 35.0\| \|8 7/8% due 2008 - KG&E \| \| \| 30.0\| \|----------------------------------------------------------------------------\| \|7.65% due 2023 \| 04/27/93 \| 100.0\| \| \|8 3/4% due 2000 \| 05/12/93 \| \| 20.0\| \|8 5/8% due 2005 \| \| \| 35.0\| \|8 3/4% due 2008 \| \| \| 35.0\| \|----------------------------------------------------------------------------\| \|6% Pollution Control Revenue Refunding \| \| \| \| \| Bonds due 2033 \| 02/09/93 \| 58.5\| \| \|9 5/8% Pollution Control Refunding and \| \| \| \| \| Improvement Revenue Bonds due 2013 \| \| \| 58.5\| \|----------------------------------------------------------------------------\| \|Bank term loan \| 01/26/93 \| \| 230.0\| \|----------------------------------------------------------------------------\| \|Revolving credit agreements (net) \| various \| \| 35.0\| \|----------------------------------------------------------------------------\| \|Other long-term debt and sinking funds \| various \| 4.1\| \| \|----------------------------------------------------------------------------\| \|COLI borrowings (net) (1) \| various \| 183.3\| \| \|----------------------------------------------------------------------------\| \|Common stock \| \| \| \| \| 3,425,000 shares (2) \| 08/25/93 \| 124.2\| \| \| 147,323 shares (3) \| various \| 5.3\| \| \|----------------------------------------------------------------------------\| (1) The COLI borrowings will be repaid upon receipt of proceeds from death benefits under the contracts. See Note 1 of Notes to Consolidated Financial Statements for additional information on the accumulated cash surrender value of COLI policies. (2) Issued in public offering for net proceeds of $121 million. (3) Issued under the Dividend Reinvestment and Stock Purchase Plan (DRIP). The net proceeds from these issues of approximately $5.3 million were added to the general corporate funds of the Company. Shares issued under the DRIP may either be original issue shares or shares purchased on the open market. The Company has a Customer Stock Purchase Plan (CSPP) under which retail electric and natural gas customers and employees of the Company may purchase common stock through monthly installments. The initial installment period runs from September 1993, through June 1994, with monthly installments plus accumulated interest converted to shares in August 1994. Shares issued under the CSPP may either be original issue shares or shares purchased on the open market. Approximately $14.7 million has been pledged for this installment period. The capital structure at December 31, 1993, was 45 percent common stock equity, 6 percent preferred and preference stock, and 49 percent long-term debt. The capital structure at December 31, 1993, including short-term debt and current maturities of long-term debt and preference stock, was 40 percent common stock equity, 5 percent preferred and preference stock, and 55 percent debt. RESULTS OF OPERATIONS The following is an explanation of significant variations from prior year results in revenues, operating expenses, other income and deductions, interest charges and preferred and preference dividend requirements. The results of operations of the Company include the activities of KG&E since the Merger on March 31, 1992. Additional information relating to changes between years is provided in the Notes to Consolidated Financial Statements. Revenues: The operating revenues of the Company are based on sales volumes and rates, authorized by certain state regulatory commissions and the FERC, charged for the sale and delivery of natural gas and electricity. Rates are designed to recover the cost of service and allow investors a fair rate of return. Future natural gas and electric sales will continue to be affected by weather conditions, competing fuel sources, customer conservation efforts, and the overall economy of the Company's service area. The Kansas Corporation Commission (KCC) order approving the Merger provided a moratorium on increases, with certain exceptions, in the Company's jurisdictional electric and natural gas rates until August 1995. The KCC ordered refunds totalling $32 million to the combined companies' customers to share with customers the Merger-related cost savings achieved during the moratorium period. The first refund of $8.5 million was made in April 1992. A refund of the same amount was made in December 1993, and an additional refund of $15 million will be made in September 1994 (see Note 3). On March 26, 1992, in connection with the Merger, the KCC approved the elimination of the Energy Cost Adjustment Clause for most Kansas retail electric customers of both the Company and KG&E effective April 1, 1992. The fuel costs are now included in base rates and were established at a level intended by the KCC to equal the projected average cost of fuel through August 1995. Any increase or decrease in fuel costs from the projected average will be absorbed by the Company. Future natural gas revenues will be reduced as a result of the sale of the Missouri Properties by approximately $350 million annually based on Missouri revenues recorded in 1993 (see Note 2). 1993 COMPARED TO 1992: Electric revenues increased significantly in 1993 as a result of the Merger. Also contributing to the increase were increased electric sales for space heating, resulting from colder winter temperatures in the first quarter of 1993, and increased sales for cooling load, resulting from warmer temperatures in the second and third quarters of 1993. KG&E electric revenues of $617 million have been included in the Company's 1993 electric revenues. This compares to KG&E revenues of $424 million, from April 1, 1992, through December 31, 1992, included in the Company's 1992 electric revenues. Partially offsetting these increases in electric revenues was the amortization of the Merger-related customer refund. Electric revenues for 1993 compared to pro forma revenues for 1992, giving effect to the Merger as if it had occurred at January 1, 1992, would have increased as a result of the warmer summer and colder winter temperatures in 1993. Retail sales of kilowatt hours on a pro forma comparative basis increased from approximately 14.6 billion for 1992 to approximately 15.5 billion for 1993, or six percent. Natural gas revenues increased approximately 20 percent as a result of increased sales caused by colder winter temperatures, the full impact of increased retail natural gas rates (see Note 5), and an eleven percent increase in the unit cost of gas passed on to customers through the purchased gas adjustment clauses (PGA). The colder winter temperatures are reflected in a 17 percent increase in natural gas sales to residential customers. 1992 COMPARED TO 1991: Electric revenues increased significantly in 1992 as a result of the Merger. KG&E electric revenues for the nine months ended December 31, 1992, of $424 million have been included in the Company's electric revenues. Partially offsetting this increase in revenues were reduced retail electric sales as a result of the abnormally mild summer temperatures in 1992 and the amortization of the Merger-related customer refund. Electric revenues for 1992 compared to pro forma revenues for 1991, giving effect to the Merger as if it had occurred at January 1, 1991, also would have been lower as a result of the mild summer and winter temperatures in 1992. Retail sales of kilowatthours on a pro forma comparative basis decreased from approximately 15.1 billion for 1991 to approximately 14.6 billion for 1992, or four percent. Natural gas revenues decreased over two percent due to a nine percent decrease in natural gas deliveries, excluding sales related to the cumulative effect of the unbilled revenue adjustment in 1991. Also contributing to the decrease was an approximately four percent decrease in the unit cost of natural gas which is passed on to customers through the PGA. The decrease in sales can be attributed to mild winter temperatures in 1992. Partially offsetting the decreased sales were increased retail rates in Kansas and Missouri beginning early in 1992. Operating Expenses: 1993 COMPARED TO 1992: Operating expenses increased for 1993 primarily as a result of the Merger. KG&E operating expenses of $470 million have been included in the Company's operating expenses for the year ended December 31, 1993. This compares to KG&E operating expenses of $316 million, from April 1, 1992, through December 31, 1992, included in the Company's 1992 operating expenses. Other factors, excluding the Merger, contributing to the increase in operating expenses were higher fuel and purchased power expenses caused by increased electric sales to meet cooling load and increased natural gas purchases caused by a 16 percent increase in natural gas sales and an 11 percent higher unit cost of gas which is passed on to customers through the PGA. Also contributing to the increase were higher general taxes due to increases in plant, the property tax assessment ratio, and higher mill levies. A constitutional amendment in Kansas changed the assessment on utility property from 30 to 33 percent. As a result of this change the Company had an increased property tax expense of approximately $6.1 million in 1993. Partially offsetting the increases were savings as a result of the Merger and reduced net lease expense for La Cygne 2 (see Note 10). At December 31, 1993, KG&E completed the accelerated amortization of deferred income tax reserves related to the allowance for borrowed funds used during construction capitalized for Wolf Creek Generating Station. The amortization of these deferred income tax reserves amounted to approximately $12 million in 1993. In accordance with the provisions of the Merger order (see Note 3), the Company is precluded from recovering the $12 million annual amortization in rates until the next rate filing. Therefore the Company's earnings will be impacted negatively until these income taxes are recovered in future rates. 1992 COMPARED TO 1991: Operating expenses increased significantly for 1992 as a result of the Merger. KG&E operating expenses for the nine months ended December 31, 1992, of $316 million have been included in the Company's operating expenses. Other factors, excluding the Merger, contributing to increased operating expenses were a one-time charge for the Company's portion of the early retirement plan and voluntary separation program of approximately $11 million; higher depreciation and amortization expense caused by increased plant investment and the beginning of the amortization of previously deferred safety-related expenditures in Kansas; and increased property taxes due to increases in plant and tax mill levies. Partially offsetting those increases in operating expenses was the commencement of savings as a result of the Merger. The Company also changed the depreciable life of Jeffrey Energy Center, for book purposes, to 40 years, resulting in a reduction to depreciation expense of approximately $5.4 million annually. Lower natural gas purchases as a result of the mild temperatures and a reduced unit cost also partially offset the increase in operating expenses. As permitted under the La Cygne 2 generating station lease agreement, KG&E requested the Trustee Lessor to refinance $341,127,000 of secured facility bonds of the Trustee and owner of La Cygne 2. The transaction was requested to reduce the Company's recurring future net lease expense. To accomplish this transaction, a one-time payment of approximately $27 million was made which will be amortized over the remaining life of the lease and will be included in operating expense as part of the future lower lease expense. On September 29, 1992, the Trustee Lessor refinanced bonds with a coupon rate of approximately 11.7% with bonds having a coupon rate of approximately 7.7%. Other Income and Deductions: Other income and deductions, net of taxes, increased $1.3 million in 1993 compared to 1992. KG&E other income and deductions, net of taxes, of $19 million have been included in the Company's total for 1993 compared to $17 million in 1992 from April 1, through December 31, 1992. Income from KG&E's COLI totalled $8 million in 1993. Other income and deductions, net of taxes, was significantly higher in 1992 compared to 1991 as a result of the Merger. KG&E contributed, for the nine months ended December 31, 1992, $17 million to other income and deductions, net of taxes. Significant items of other income include approximately $9 million from KG&E's COLI and KG&E's recognition of the recovery of approximately $4.2 million of a previously written-off investment in commercial paper. Interest Charges and Preferred and Preference Dividend Requirements: Interest charges for 1993 were higher as a result of the Merger. KG&E interest charges of $59 million for 1993 have been included in the Company's total interest charges compared to $53 million for the nine months ended December 31, 1992. The full twelve month effect of interest on debt to acquire KG&E also contributed to the increase in total interest charges. The increased interest charges have been partially offset through lower debt balances and reduced interest charges from refinancing higher cost long-term debt and lower interest rates on variable-rate debt. The Company's embedded cost of long-term debt decreased to 7.7% at December 31, 1993, compared to 7.9% and 8.6% at December 31, 1992 and 1991, respectively, primarily as a result of the refinancing of higher cost debt. Total interest charges increased significantly for 1992 compared to 1991 as a result of the Merger. Partially offsetting this increase were lower short-term and long-term interest rates. Preferred and preference dividend requirements increased six percent in 1993 and significantly in 1992 compared to 1991 as a result of the issuance of $50 million of 7.58% preference stock in the second quarter of 1992. Merger Implementation: In accordance with the KCC Merger order, amortization of the acquisition adjustment will commence August 1995. The amortization will amount to approximately $19.6 million per year for 40 years. The Company can recover the amortization of the acquisition adjustment through cost savings under a sharing mechanism approved by the KCC as described in Note 3 of the Notes to the Consolidated Financial Statements. While the Company has achieved savings from the Merger, there is no assurance that the savings achieved will be sufficient to, or the cost savings sharing mechanism will operate as to fully offset the amortization of the acquisition adjustment. In 1992 the Company completed the consolidation of certain operations of the Company and KG&E. In conjunction with these efforts the Company incurred costs of consolidating facilities, transferring certain employees, and other costs associated with completing the Merger. Certain of these costs related to KG&E have been considered in purchase accounting for the Merger. Other costs, including costs of the early retirement incentive programs and other employee severance compensation programs for former Kansas Power and Light Company employees were charged to expense in 1992. See Note 6 of Notes to Consolidated Financial Statements for a discussion regarding the early retirement and Merger severance plans. OTHER INFORMATION Inflation: Under the ratemaking procedures prescribed by the regulatory commissions to which the Company is subject, only the original cost of plant is recoverable in revenues as depreciation. Therefore, because of inflation, present and future depreciation provisions are inadequate for purposes of maintaining the purchasing power invested by common shareholders and the related cash flows are inadequate for replacing property. The impact of this ratemaking process on common shareholders is mitigated to the extent depreciable property is financed with debt that can be repaid with dollars of less purchasing power. While the Company has experienced relatively low inflation in the recent past, the cumulative effect of inflation on operating costs requires the Company to seek regulatory rate relief to recover these higher costs. FERC Order No. 636: On April 8, 1992, the FERC issued Order No. 636 which the FERC intended to complete the deregulation of natural gas production and facilitate competition in the gas transportation industry. Order No. 636 is expected to affect the Company in several ways. The rules provide greater protection for pipeline companies by providing for recovery of all fixed costs through contracts with local distribution companies and other customers choosing to transport gas on a firm (non-interruptible) basis. The order also separates the purchase of natural gas from the transportation and storage of natural gas, shifting additional responsibility to distribution companies for the provision (through purchase and/or storage) of long-term gas supply and transportation to distribution points. Under the new rules, distribution companies elect the amount and type of services taken from pipelines. The Company may be liable to one or more of its pipeline suppliers for costs related to the transition from its traditional sales service to the restructured services required by Order No. 636. The Company believes substantially all of these costs will be recovered from its customers and any additional transition costs will be immaterial to the Company's financial position or results of operations. The Company was an active participant in pipeline restructuring negotiations and does not anticipate any material difficulty in obtaining the pipeline services the Company needs to meet the requirements of its gas operations. Environmental: The Company has recognized the importance of environmental responsibility and has taken a proactive position with respect to the potential environmental liability associated with former manufactured gas sites. The Company has an agreement with the Kansas Department of Health and Environment to systematically evaluate these sites in Kansas (see Note 4). The Company currently has no Phase I affected units under the Clean Air Act of 1990. Until such time that additional regulations become final the Company will be unable to determine its compliance options or related compliance costs (see Note 4). Energy Policy Act: The 1992 Energy Policy Act (Act) requires increased efficiency of energy usage and will potentially change the way electricity is marketed. The Act also provides for increased competition in the wholesale electric market by permitting the FERC to order third party access to utilities' transmission systems and by liberalizing the rules for ownership of generating facilities. As part of the Merger, the Company agreed to open access to its transmission system. Another part of the Act requires a special assessment to be collected from utilities for a uranium enrichment, decontamination, and decommissioning fund. KG&E's portion of the assessment for Wolf Creek is approximately $7 million, payable over 15 years. Management expects such costs to be recovered through the ratemaking process. Statement of Financial Accounting Standards No. 106 (SFAS 106) and No. 112 (SFAS 112): For discussion regarding the effect of SFAS 106 and SFAS 112 on the Company see Note 6 of Notes to the Consolidated Financial Statements. ITEM 8.	ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA TABLE OF CONTENTS PAGE Independent Auditors' Report 33 Financial Statements: Consolidated Balance Sheets, December 31, 1993 and 1992 34 Consolidated Statements of Income for the years ended December 31, 1993, 1992 and 1991 35 Consolidated Statements of Cash Flows for the years ended 1993, 1992 and 1991 36 Consolidated Statements of Taxes for the years ended December 31, 1993, 1992 and 1991 37 Consolidated Statements of Capitalization, December 31, 1993 and 1992 38 Consolidated Statements of Common Stock Equity for the years ended December 31, 1993, 1992 and 1991 39 Notes to Consolidated Financial Statements 40 Financial Statement Schedules: V- Utility Plant for the years ended December 31, 1993, 1992 and 1991 67 VI- Accumulated Depreciation of Utility Plant for the years ended December 31, 1993, 1992 and 1991 70 SCHEDULES OMITTED The following schedules are omitted because of the absence of the conditions under which they are required or the information is included in the financial statements and schedules presented: I, II, III, IV, VII, VIII, IX, X, XI, XII and XIII. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Shareholders and Board of Directors of Western Resources, Inc.: We have audited the accompanying consolidated balance sheets and statements of capitalization of Western Resources, Inc., and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, cash flows, taxes and common stock equity for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We did not audit the financial statements of Kansas Gas and Electric Company, a wholly- owned subsidiary of Western Resources, Inc., as of and for the year ended December 31, 1992, which statements reflect assets and revenues of 61 percent and 27 percent, respectively, of the consolidated totals for 1992. Those statements were audited by other auditors whose report has been furnished to us and our opinion, insofar as it relates to the amounts included for that entity, is based solely on the report of other auditors. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits and the report of other auditors provide a reasonable basis for our opinion. In our opinion, based on our audit and the report of other auditors, the financial statements referred to above present fairly, in all material respects, the financial position of Western Resources, Inc., and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As explained in Note 1 to the consolidated financial statements, effective January 1, 1991, the Company changed to a preferred method of accounting for revenue recognition. As explained in Note 12 to the consolidated financial statements, effective January 1, 1992, the Company changed its method of accounting for income taxes. As explained in Note 6 to the consolidated financial statements, effective January 1, 1993, the Company changed its method of accounting for postretirement benefits. Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole. The financial statement schedules listed in the table of contents on page 32 are the responsibility of the Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not a part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion and the opinion of other auditors, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. Kansas City, Missouri, ARTHUR ANDERSEN & CO. January 28, 1994 WESTERN RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES General: The consolidated financial statements of Western Resources, Inc. (the Company, Western Resources), include the accounts of its wholly-owned subsidiaries, Astra Resources, Inc., Kansas Gas and Electric Company (KG&E) since March 31, 1992 (see Note 3), and KPL Funding Corporation (KFC). KG&E owns 47 percent of Wolf Creek Nuclear Operating Corporation (WCNOC), the operating company for Wolf Creek Generating Station (Wolf Creek). The Company records its proportionate share of all transactions of WCNOC as it does other jointly-owned facilities. All significant intercompany transactions have been eliminated. The operations of Astra Resources, Inc., and KFC are not material to the Company's results of operations. The accounting policies of the Company are in accordance with generally accepted accounting principles as applied to regulated public utilities. The accounting and rates of the Company are subject to requirements of certain state regulatory commissions and the Federal Energy Regulatory Commission (FERC). The Company is doing business as KPL, Gas Service, and, through its wholly-owned subsidiary, KG&E. Utility Plant: Utility plant is stated at cost. For constructed plant, cost includes contracted services, direct labor and materials, indirect charges for engineering, supervision, general and administrative costs, and an allowance for funds used during construction (AFUDC). The AFUDC rate was 4.10% in 1993, 5.99% in 1992, and 6.25% in 1991. The cost of additions to utility plant and replacement units of property is capitalized. Maintenance costs and replacement of minor items of property are charged to expense as incurred. When units of depreciable property are retired, they are removed from the plant accounts and the original cost plus removal charges less salvage are charged to accumulated depreciation. Depreciation: Depreciation is provided on the straight-line method based on estimated useful lives of property. Composite provisions for book depreciation approximated 3.02% during 1993, 3.03% during 1992, and 3.34% during 1991 of the average original cost of depreciable property. Cash and Cash Equivalents: For purposes of the Consolidated Statements of Cash Flows, cash and cash equivalents include cash on hand and highly liquid collateralized debt instruments purchased with maturities of three months or less. Income Taxes: Income tax expense includes provisions for income taxes currently payable and deferred income taxes calculated in conformance with income tax laws, regulatory orders, and Statement of Financial Accounting Standards No. 109 (SFAS 109) (see Note 12). Investment tax credits are deferred as realized and amortized to income over the life of the property which gave rise to the credits. Revenues: Effective January 1, 1991, the Company changed its method of accounting for recognizing electric and natural gas revenues to provide for the accrual of estimated unbilled revenues. The accounting change provides a better matching of revenues with costs of services provided to customers and also serves to conform the Company's accounting treatment of unbilled revenues with the tax treatment of such revenues. Unbilled revenues represent the estimated amount customers will be billed for service provided from the time meters were last read to the end of the accounting period. Meters are read and services are billed on a cycle basis and, prior to the accounting change, revenues were recognized in the accounting period during which services were billed. The after-tax effect of the change in accounting method for the year ended December 31, 1991, was an increase in net income of $15.9 million or $0.46 per share. This increase was a combination of an increase of $17.3 million or $0.50 per share, attributable to the cumulative effect of the accounting change prior to January 1, 1991, and a decrease of $1.4 million or $0.04 per share in the 1991 income before cumulative effect of a change in accounting principle. Unbilled revenues of $99 and $86 million are recorded as a component of accounts receivable on the consolidated balance sheets as of December 31, 1993 and 1992, respectively. Certain amounts of unbilled revenues have been sold (see Note 8). The Company had reserves for doubtful accounts receivable of $4.3 and $3.3 million at December 31, 1993 and 1992, respectively. Fuel Costs: The cost of nuclear fuel in process of refinement,conversion, enrichment, and fabrication is recorded as an asset at original cost and is amortized to expense based upon the quantity of heat produced for the generation of electricity. The accumulated amortization of nuclear fuel in the reactor at December 31, 1993 and 1992, was $17.4 million and $26.0 million, respectively. Cash Surrender Value of Life Insurance Contracts: The following amounts related to corporate-owned life insurance contracts (COLI), primarily with one highly rated major insurance company, are recorded on the consolidated balance sheets (millions of dollars): 1993 1992 Cash surrender value of contracts. . . $ 326.3 $ 256.3 Prepaid COLI . . . . . . . . . . . . . 11.9 7.0 Borrowings against contracts . . . . . (321.5) (109.6) COLI (net). . . . . . . . . . $ 16.7 $ 153.7 The decrease in COLI (net) is a result of increased borrowings against the accumulated cash surrender value of the COLI policies. The COLI borrowings will be repaid with proceeds from death benefits. Management expects to realize increases in the cash surrender value of contracts resulting from premiums and investment earnings on a tax free basis upon receipt of proceeds from death benefits under the contracts. Interest expense included in other income and deductions, net of taxes, related to KG&E's COLI for 1993 and the nine months ended December 31, 1992, was $11.9 and $5.3 million, respectively. As approved by the Kansas Corporation Commission (KCC) and Missouri Public Service Commission (MPSC), the Company is using a portion of the net income stream generated by COLI policies purchased in 1993 and 1992 by the Company (see Note 6) to offset Statement of Financial Accounting Standards No. 106 (SFAS 106) expenses. Reclassifications: Certain amounts in prior years have been reclassified to conform with classifications used in the current year presentation. 2. SALE OF MISSOURI NATURAL GAS DISTRIBUTION PROPERTIES On January 31, 1994, the Company sold substantially all of its Missouri natural gas distribution properties and operations to Southern Union Company (Southern Union). The Company sold the remaining Missouri properties to United Cities Gas Company (United Cities) on February 28, 1994. The properties sold to Southern Union and United Cities are referred to herein as the "Missouri Properties." With the sales the Company is no longer operating as a utility in the State of Missouri. The portion of the Missouri Properties purchased by Southern Union was sold for an estimated sale price of $400 million, in cash, based on a calculation as of December 31, 1993. The final sale price will be calculated as of January 31, 1994, within 120 days of closing. Any difference between the estimated and final sale price will be adjusted through a payment to or from the Company. United Cities purchased the Company's natural gas distribution system in and around the City of Palmyra, Missouri, for $665,000 in cash. The operating revenues and operating income (unaudited) related to the Missouri Properties approximated $350 million and $21 million representing approximately 18 percent and seven percent, respectively, of the Company's total for 1993, and $299 million and$11 million representing approximately 19 percent and five percent, respectively, of the Company's total for 1992. Net utility plant (unaudited) for the Missouri Properties, at December 31, 1993, approximated $296 million and $272 million at December 31, 1992. This represents approximately seven percent at December 31, 1993, and six percent at December 31, 1992, of the total Company net utility plant. Separate audited financial information was not kept by the Company for the Missouri Properties. This unaudited financial information is based on assumptions and allocations of expenses of the Company as a whole. 3. ACQUISITION AND MERGER On March 31, 1992, the Company, through its wholly-owned subsidiary KCA Corporation (KCA), acquired all of the outstanding common and preferred stock of Kansas Gas and Electric Company for $454 million in cash and 23,479,380 shares of common stock (the Merger). The Company also paid $20 million in costs to complete the Merger. Simultaneously, KCA and Kansas Gas and Electric Company merged and adopted the name of Kansas Gas and Electric Company (KG&E). The Merger was accounted for as a purchase. For income tax purposes the tax basis of the KG&E assets was not changed by the Merger. As the Company acquired 100 percent of the common and preferred stock of KG&E, the Company recorded an acquisition premium of $490 million on the consolidated balance sheet for the difference in purchase price and book value. This acquisition premium and related income tax requirement of $294 million under SFAS 109 have been classified as plant acquisition adjustment in electric plant in service on the consolidated balance sheets. The total cost of the acquisition was $1.066 billion. Under the provisions of orders of the KCC and the MPSC the acquisition premium is recorded as an acquisition adjustment and not allocated to the other assets and liabilities of KG&E. In the November 1991 KCC order approving the Merger, a mechanism was approved to share equally between the shareholders and ratepayers the cost savings generated by the Merger in excess of the revenue requirement needed to allow recovery of the amortization of a portion of the acquisition adjustment, including income tax, calculated on the basis of a purchase price of KG&E's common stock at $29.50 per share. The order provides an amortization period for the acquisition adjustment of 40 years commencing in August 1995, at which time the full amount of cost savings is expected to have been implemented. Merger savings will be measured by application of an inflation index to certain pre-merger operating and maintenance costs at the time of the next Kansas rate case. While the Company has achieved savings from the Merger, there is no assurance that the savings achieved will be sufficient to, or the cost savings sharing mechanism will operate as to fully offset the amortization of the acquisition adjustment. The order further provides a moratorium on increases, with certain exceptions, in the Company's Kansas electric and natural gas rates until August 1995. The KCC ordered refunds totalling $32 million to the combined companies' customers to share with customers the Merger-related cost savings achieved during the moratorium period. The first refund was made in April 1992 and amounted to $8.5 million. A refund of the same amount was made in December 1993 and an additional refund of $15 million will be made in September 1994. The KCC order approving the Merger requires the legal reorganization of KG&E so that it is no longer held as a separate subsidiary after January 1, 1995, unless good cause is shown why such separate existence should be maintained. The Securities and Exchange Commission order relating to the Merger granted the Company an exemption under the Public Utilities Holding Company Act until January 1, 1995. In connection with a requested ruling that a merger of KG&E into Western Resources would not adversely affect the tax structure of the merger, KG&E received a response from the Internal Revenue Service that the IRS would not issue the requested ruling. In light of the IRS response, KG&E withdrew its request for a ruling. The Company will consider alternative forms of combination or seek regulatory approvals to waive the requirements for a combination. There is no certainty as to whether a combination will occur or as to the form or timing thereof. As the Merger did not occur until March 31, 1992, the twelve months ended December 31, 1992, results of operations for the Company reported in its statements of income, cash flows, and common stock equity reflect KG&E's results of operations for only the nine months ended December 31, 1992. The pro forma combined revenues, operating income, net income, and earnings per common share of the Company presented below give effect to the Merger as if it had occurred at January 1, 1991. This pro forma information is not necessarily indicative of the results of operations that would have occurred had the Merger been consummated for the period for which it is being given effect nor is it necessarily indicative of future operating results. Year Ended December 31, 1992 1991 (Dollars in Thousands, except per share amounts) Revenues. . . . . . . . . . . . $1,684,885 $1,748,844 Operating Income. . . . . . . . 268,772 279,458 Net Income. . . . . . . . . . . 131,524 110,290(1) Earnings Per Common . . . . . . $ 2.03 $ 1.72(1) (1) Reflects information before the cumulative effect of the January 1, 1991 change in accounting method of recognizing revenues. 4. COMMITMENTS AND CONTINGENCIES As part of its ongoing operations and construction program, the Company has commitments under purchase orders and contracts which have an unexpended balance of approximately $86 million at December 31, 1993. Approximately $36 million is attributable to modifications to upgrade the turbines at Jeffrey Energy Center to be completed by December 31, 1998. Plans for future construction of utility plant are discussed in the "Management's Discussion and Analysis" section. Environmental: The Company has been associated with 28 (20 in Kansas and 8 in Missouri) former manufactured gas sites which may contain coal tar and other potentially harmful materials. These sites were operated decades ago by other companies, and were acquired by the Company after they had ceased operation. The Environmental Protection Agency (EPA) has performed preliminary assessments of eleven of these sites (EPA sites), six of which are under site investigation. The Company has not received any indication from the EPA that further action will be taken at the EPA sites, nor does the Company have reason to believe there will be any fines or penalties assessed related to these sites. The Company and the Kansas Department of Health and Environment (KDHE) entered into a consent agreement to conduct separate preliminary assessments of the 20 former manufactured gas sites located in Kansas. The preliminary assessments of these 20 sites have been completed at a total cost of approximately $500,000. The Company plans to initiate site investigation and risk assessments at the two highest priority sites in 1994 at a total cost of approximately $500,000. Until such time that risk assessments are completed at these or the remaining sites, it will be impossible to predict the cost of remediation. However, the Company is aware of other utilities in Region VII of the EPA (Kansas, Missouri, Nebraska, and Iowa) which have incurred remediation costs for such sites ranging between $500,000 and $10 million, depending on the site. The Company is also aware that the KCC has permitted another Kansas utility to recover a portion of the remediation costs through rates. To the extent that such remediation costs are not recovered through rates, the costs could be material to the Company's financial position or results of operations depending on the degree of remediation and number of years over which the remediation must be completed. The Company has been identified as one of numerous potentially responsible parties in four hazardous waste sites listed by the EPA as Superfund sites. One site is a groundwater contamination site in Wichita, Kansas, and one is an oil soil contamination site in Springfield, Missouri. The other two sites are solid waste land fills located in Edwardsville and Hutchinson, Kansas. The Company's obligation at these sites appears to be limited, and it is the opinion of the Company's management that the resolution of these matters will not have a material impact on the Company's financial position or results of operations. As part of the sale of the Company's Missouri Properties to Southern Union, Southern Union assumed responsibility under an agreement for any environmental matters now pending or that may arise after closing. For any environmental matters now pending or discovered within two years of the date of the agreement, and after pursuing several other potential recovery options, the Company may be liable for up to a maximum of $7.5 million under a sharing arrangement with Southern Union provided for in the agreement. Spent Nuclear Fuel Disposal: Under the Nuclear Waste Policy Act of 1982, the U.S. Department of Energy (DOE) is responsible for the ultimate storage and disposal of spent nuclear fuel removed from nuclear reactors. Under a contract with the DOE for disposal of spent nuclear fuel, the Company pays a quarterly fee to DOE of one mill per kilowatthour on net nuclear generation. These fees are included as part of nuclear fuel expense and amounted to $3.5 million for 1993 and $1.6 million for 1992. Decommissioning: The Company's share of Wolf Creek decommissioning costs, currently authorized in rates, was estimated to be approximately $97 million in 1988 dollars. Decommissioning costs are being charged to operating expenses. Amounts so expensed are deposited in an external trust fund and will be used solely for the physical decommissioning of the plant. Electric rates charged to customers provide for recovery of these decommissioning costs over the estimated life of Wolf Creek. At December 31, 1993, and December 31, 1992, $13.2 and $9.3 million, respectively, were on deposit in the decommissioning fund. On September 1, 1993, WCNOC filed an application with the KCC for an order approving a 1993 Wolf Creek Decommissioning Cost Study which estimates the Company's share of Wolf Creek decommissioning costs at approximately $174 million in 1993 dollars. If approved by the KCC, management expects substantially all such cost increases to be recovered through the ratemaking process. The Company carries $164 million in premature decommissioning insurance in the event of a shortfall in the trust fund. The insurance coverage has several restrictions. One of these is that it can only be used if Wolf Creek incurs an accident exceeding $500 million in expenses to safely stabilize the reactor, to decontaminate the reactor and reactor station site in accordance with a plan approved by the Nuclear Regulatory Commission (NRC), and to pay for on-site property damages. If the amount designated as decommissioning insurance is needed to implement the NRC-approved plan for stabilization and decontamination, it would not be available for decommissioning purposes. Nuclear Insurance: The Price-Anderson Act limits the combined public liability of the owners of nuclear power plants to $9.4 billion for a single nuclear incident. The Wolf Creek owners (Owners) have purchased the maximum available private insurance of $200 million and the balance is provided by an assessment plan mandated by the NRC. Under this plan, the Owners are jointly and severally subject to a retrospective assessment of up to $79.3 million ($37.3 million, Company's share) in the event there is a nuclear incident involving any of the nation's licensed reactors. This assessment is subject to an inflation adjustment based on the Consumer Price Index. There is a limitation of $10 million ($4.7 million, Company's share) in retrospective assessments per incident per year. The Owners carry decontamination liability, premature decommissioning liability, and property damage insurance for Wolf Creek totalling approximately $2.8 billion ($1.3 billion, Company's share). This insurance is provided by a combination of "nuclear insurance pools" ($1.3 billion) and Nuclear Electric Insurance Limited (NEIL) ($1.5 billion). In the event of an accident, insurance proceeds must first be used for reactor stabilization and site decontamination. The remaining proceeds from the $2.8 billion insurance coverage ($1.3 billion, Company's share), if any, can be used for property damage up to $1.1 billion (Company's share) and premature decommissioning costs up to $117.5 million (Company's share) in excess of funds previously collected for decommissioning (as discussed under "Decommissioning"), with the remaining $47 million (Company's share) available for either property damage or premature decommissioning costs. The Owners also carry additional insurance with NEIL to cover costs of replacement power and other extra expenses incurred during a prolonged outage resulting from accidental property damage at Wolf Creek. If losses incurred at any of the nuclear plants insured under the NEIL policies exceed premiums, reserves, and other NEIL resources, the Company may be subject to retrospective assessments of approximately $9 million per year. There can be no assurance that all potential losses or liabilities will be insurable or that the amount of insurance will be sufficient to cover them. Any substantial losses not covered by insurance, to the extent not recoverable through rates, could have a material adverse effect on the Company's financial condition and results of operations. Clean Air Act: The Clean Air Act Amendments of 1990 (the Act) require a two-phase reduction in sulfur dioxide and nitrous oxide emissions effective in 1995 and 2000 and a probable reduction in toxic emissions. To meet the monitoring and reporting requirements under the acid rain program, the Company is installing continuous monitoring and reporting equipment at a total cost of approximately $10 million. At December 31, 1993, the Company had completed approximately $4 million of these capital expenditures with the remaining $6 million of capital expenditures to be completed in 1994 and 1995. The Company does not expect additional equipment to reduce sulfur emissions to be necessary under Phase II. The Company currently has no Phase I affected units. The nitrous oxide and toxic limits, which were not set in the law, will be specified in future EPA regulations. The EPA has issued for public comment preliminary nitrous oxide regulations for Phase I group 1 units. Nitrous oxide regulations for Phase II units and Phase I group 2 units are mandated in the Act to be promulgated by January 1, 1997. Although the Company has no Phase I units, the final nitrous oxide regulations for Phase I group 1 may allow for early compliance for Phase II group 1 units. Until such time as the Phase I group 1 nitrous oxide regulations are final, the Company will be unable to determine its compliance options or related compliance costs. Federal Income Taxes: During 1991, the Internal Revenue Service (IRS) completed an examination of KG&E's federal income tax returns for the years 1984 through 1988. In April 1992, KG&E received the examination report and upon review filed a written protest in August 1992. In October 1993, KG&E received another examination report for the years 1989 and 1990 covering the same issues identified in the previous examination report. Upon review of this report, KG&E filed a written protest in November 1993. The most significant proposed adjustments reduce the depreciable basis of certain assets and investment tax credits generated. Management believes there are significant questions regarding the theory, computations, and sampling techniques used by the IRS to arrive at its proposed adjustments, and also believes any additional tax expense incurred or loss of investment tax credits will not be material to the Company's financial position and results of operations. Additional income tax payments, if any, are expected to be offset by investment tax credit carryforwards, alternative minimum tax credit carryforwards, or deferred tax provisions. Fuel Commitments: To supply a portion of the fuel requirements for its generating plants, the Company has entered into various commitments to obtain nuclear fuel, coal, and natural gas. Some of these contracts contain provisions for price escalation and minimum purchase commitments. At December 31, 1993, WCNOC's nuclear fuel commitments (Company's share) were approximately $18.0 million for uranium concentrates expiring at various times through 1997, $123.6 million for enrichment expiring at various times through 2014, and $45.5 million for fabrication through 2012. At December 31, 1993, the Company's coal and natural gas contract commitments in 1993 dollars under the remaining term of the contracts were $2.8 billion and $20.4 million, respectively. The largest coal contract was renegotiated early in 1993 and expires in 2020, with the remaining coal contracts expiring at various times through 2013. The majority of natural gas contracts continue through 1995 with automatic one-year extension provisions. In the normal course of business, additional commitments and spot market purchases will be made to obtain adequate fuel supplies. Energy Act: As part of the 1992 Energy Policy Act, a special assessment is being collected from utilities for a uranium enrichment, decontamination, and decommissioning fund. The Company's portion of the assessment for Wolf Creek is approximately $7 million, payable over 15 years. Management expects such costs to be recovered through the ratemaking process. 5. RATE MATTERS AND REGULATION The Company, under rate orders from certain state regulatory commissions and the FERC, recovers increases in fuel and natural gas costs through fuel adjustment clauses for wholesale and certain retail electric customers and various purchased gas adjustment clauses (PGA) for natural gas customers. Certain state regulatory commissions require the annual difference between actual gas cost incurred and cost recovered through the application of the PGA be deferred and amortized through rates in subsequent periods. Elimination of the Energy Cost Adjustment Clause (ECA): On March 26, 1992, in connection with the Merger, the KCC approved the elimination of the ECA for most Kansas retail electric customers of both the Company and KG&E effective April 1, 1992. The provisions for fuel costs included in base rates were established at a level intended by the KCC to equal the projected average cost of fuel through August 1995, and to include recovery of costs provided by previously issued orders relating to coal contract settlements. Any increase or decrease in fuel costs from the projected average will be absorbed by the Company. MPSC Rate Proceedings: On October 5, 1993, the MPSC approved an agreement among the Company, the MPSC staff, and intervenors to increase natural gas rates $9.75 million annually, effective October 15, 1993. Also on October 15, 1993, the Company discontinued the deferral of service line replacement program costs deferred since July 1, 1991, and began amortizing the balance to expense over twenty years. At December 31, 1993, approximately $8.3 million of these deferrals have been included in other deferred charges on the consolidated balance sheet. On January 22, 1992, the MPSC issued an order authorizing the Company to increase natural gas rates $7.3 million annually. KCC Rate Proceedings: On January 24, 1992, the KCC issued an order allowing the Company to continue the deferral of service line replacement program costs incurred since January 1, 1992, including depreciation, property taxes, and carrying costs for recovery in the next general rate case. At December 31, 1993, approximately $2.9 million of these deferrals have been included in other deferred charges on the consolidated balance sheet. On December 30, 1991, the KCC approved a permanent natural gas rate increase of $39 million annually and the Company discontinued the deferral of accelerated line survey costs on January 1, 1992. Approximately $8.3 million of deferred costs remain in other deferred charges on the consolidated balance sheet at December 31, 1993, with the balance being included in rates and amortized to expense during a 43-month period, commencing January 1, 1992. Gas Transportation Charges: On September 12, 1991, the KCC authorized the Company to begin recovering, through the PGA, deferred supplier gas transportation costs of $9.9 million incurred through December 31, 1990, based on a three-year amortization schedule. On December 30, 1991, the KCC authorized the Company to recover deferred transportation costs of approximately $2.8 million incurred subsequent to December 31, 1990, through the PGA over a 32-month period. At December 31, 1993, approximately $4.8 million of these deferrals remain in other deferred charges on the consolidated balance sheet. Tight Sands: In December 1991, the KCC, MPSC, and Oklahoma Corporation Commission (OCC) approved agreements authorizing the Company to refund to customers approximately $40 million of the proceeds of the Tight Sands antitrust litigation settlement to be collected on behalf of Western Resources' natural gas customers. To secure the refund of settlement proceeds, the Commissions authorized the establishment of an independently administered trust to collect and maintain cash receipts received under Tight Sands settlement agreements and provide for the refunds made. The trust has a term of ten years. Rate Stabilization Plan: In 1988, the KCC issued an order requiring that the accrual of phase-in revenues be discontinued by KG&E effective December 31, 1988. Effective January 1, 1989, KG&E began amortizing the phase-in revenue asset on a straight-line basis over 9 1/2 years. Coal Contract Settlements: In March 1990, the KCC issued an order allowing KG&E to defer its share of a 1989 coal contract settlement with the Pittsburgh and Midway Coal Mining Company amounting to $22.5 million. This amount was recorded as a deferred charge on the consolidated balance sheets. The settlement resulted in the termination of a long-term coal contract. The KCC permitted KG&E to recover this settlement as follows: 76 percent of the settlement plus a return over the remaining term of the terminated contract (through 2002) and 24 percent to be amortized to expense with a deferred return equivalent to the carrying cost of the asset. In February 1991, KG&E paid $8.5 million to settle a coal contract lawsuit with AMAX Coal Company and recorded the payment as a deferred charge on the consolidated balance sheet. The KCC approved the recovery of the settlement plus a return, equivalent to the carrying cost of the asset, over the remaining term of the terminated contract (through 1996). FERC Order No. 528: In 1990, the FERC issued Order No. 528 which authorized new methods for the allocation and recovery of take-or-pay settlement costs by natural gas pipelines from their customers. Settlements have been reached between the Company's two largest gas pipelines and their customers in FERC proceedings related to take-or-pay issues. The settlements address the allocation of take-or-pay settlement costs between the pipelines and their customers. However, the amount which one of the pipelines will be allowed to recover is yet to be determined. Litigation continues between the Company and a former upstream pipeline supplier to one of the Company's pipeline suppliers concerning the amount of such costs which may ultimately be allocated to the Company's pipeline supplier. A portion of any costs allocated to the Company's pipeline supplier will be charged to the Company. Due to the uncertainty concerning the amount to be recovered by the Company's current suppliers and of the outcome of the litigation between the Company and its current pipeline's upstream supplier, the Company is unable to estimate its future liability for take-or-pay settlement costs. However, the KCC and MPSC have approved mechanisms which are expected to allow the Company to recover these take-or-pay costs from its customers. 6. EMPLOYEE BENEFIT PLANS Pension: The Company maintains noncontributory defined benefit pension plans covering substantially all employees. Pension benefits are based on years of service and the employee's compensation during the five highest paid consecutive years out of ten before retirement. The Company's policy is to fund pension costs accrued, subject to limitations set by the Employee Retirement Income Security Act of 1974 and the Internal Revenue Code. The following tables provide information on the components of pension cost, funded status, and actuarial assumptions for the Company's pension plans: Year Ended December 31, 1993 1992 1991 (Dollars in Thousands) Pension Cost: Service cost................... $ 9,778 $ 9,847 $ 6,589 Interest cost on projected benefit obligation........... 35,688 29,457 20,985 Return on plan assets.......... (64,113) (38,967) (59,161) Deferred gain on plan assets... 29,190 7,705 38,015 Net amortization............... (669) (948) (131) Net pension cost........... $ 9,874 $ 7,094 $ 6,297 December 31, 1993 1992 1991 (Dollars in Thousands) Funded Status: Actuarial present value of benefit obligations: Vested . . . . . . . . . . . $353,023 $316,100 $200,435 Non-vested . . . . . . . . . 26,983 19,331 13,935 Total. . . . . . . . . . . $380,006 $335,431 $214,370 Plan assets (principally debt and equity securities) at fair value . . . . . . . . . . . $490,339 $452,372 $324,780 Projected benefit obligation . . . 468,996 424,232 282,062 Plan assets in excess of projected benefit obligation . . 21,343 28,140 42,718 Unrecognized transition asset. . . (2,756) (3,092) (1,253) Unrecognized prior service costs . 64,217 55,886 27,216 Unrecognized net gain. . . . . . . (108,783) (106,486) (69,494) Accrued pension costs. . . . . . . $(25,979) $(25,552) $ (813) Year Ended December 31, 1993 1992 1991 Actuarial Assumptions: Discount rate. . . . . . . . . . 7.0-7.75% 8.0-8.5% 8.0% Annual salary increase rate. . . 5.0 % 6.0% 6.0% Long-term rate of return . . . . 8.0-8.5 % 8.0-8.5% 8.0% Retirement and Voluntary Separation Plans: In January 1992, the Board of Directors approved early retirement plans and voluntary separation programs. The voluntary early retirement plans were offered to all vested participants in the Company's defined pension plan who reached the age of 55 with 10 or more years of service on or before May 1, 1992. Certain pension plan improvements were made, including a waiver of the actuarial reduction factors for early retirement and a cash incentive payable as a monthly supplement up to 60 months or as a lump sum payment. Of the 738 employees eligible for the early retirement option, 531, representing ten percent of the combined Company's work force, elected to retire on or before the May 1, 1992, deadline. Seventy-one of those electing to retire were employees of KG&E acquired March 31, 1992 (see Note 3). Another 67 employees, with 10 or more years of service, elected to participate in the voluntary separation program. Of those, 29 were employees of KG&E. In addition, 68 employees received Merger-related severance benefits, including 61 employees of KG&E. The actuarial cost, based on plan provisions for early retirement and voluntary separation programs, and Merger-related severance benefits for the KG&E employees, were considered in purchase accounting for the Merger. The actuarial cost of the former Kansas Power and Light Company employees, of approximately $11 million, was expensed in 1992. Postretirement: The Company adopted the provisions of Statement of Financial Accounting Standards No. 106 (SFAS 106) in the first quarter of 1993. This statement requires the accrual of postretirement benefits other than pensions, primarily medical benefit costs, during the years an employee provides service. Based on actuarial projections and adoption of the transition method of implementation which allows a 20-year amortization of the accumulated benefit obligation, the annual expense under SFAS 106 was approximately $26.5 million in 1993 (as compared to approximately $9.6 million on a cash basis) and the Company's total obligation was approximately $166.5 million at December 31, 1993. To mitigate the impact of SFAS 106 expense, the Company has implemented programs to reduce health care costs. In addition, the Company has received orders from the KCC and MPSC permitting the initial deferral of SFAS 106 expense. To mitigate the impact SFAS 106 expense will have on rate increases, the Company will include in the future computation of cost of service the actual SFAS 106 expense and an income stream generated from corporate-owned life insurance (COLI). To the extent SFAS 106 expense exceeds income from the COLI program, this excess will be deferred (as allowed by the FASB Emerging Issues Task Force Issue No. 92-12) and offset by income generated through the deferral period by the COLI program. The OCC is reviewing the Company's application for similar treatment in Oklahoma. Should the OCC require recognition of postretirement benefit costs for regulatory purposes under a different method than that proposed under the Company's application, the impact on earnings would not be material. Should the income stream generated by the COLI program not be sufficient to offset the deferred SFAS 106 expense, the KCC and MPSC orders allow recovery of such deficit through the ratemaking process. Prior to the adoption of SFAS 106 the Company's policy was to recognize the cost of retiree health care and life insurance benefits as expense when claims and premiums for life insurance policies were paid. The cost of providing health care and life insurance benefits to 2,928 retirees was $8.1 million in 1992. The following table summarizes the status of the Company's postretirement plans for financial statement purposes and the related amount included in the consolidated balance sheet: December 31, 1993 (Dollars in Thousands) Actuarial present value of postretirement benefit obligations: Retirees. . . . . . . . . . . . . . . . . . . . $ 111,499 Active employees fully eligible . . . . . . . . 11,848 Active employees not fully eligible . . . . . . 43,109 Unrecognized prior service cost . . . . . . . . 18,195 Unrecognized transition obligation. . . . . . . (160,731) Unrecognized net loss . . . . . . . . . . . . . (7,100) Balance sheet liability . . . . . . . . . . . . . . $ 16,820 For measurement purposes, an annual health care cost growth rate of 13% was assumed for 1994, decreasing to 6% by 2002 and thereafter. The accumulated post retirement benefit obligation was calculated using a weighted-average discount rate of 7.75%, a weighted-average compensation increase rate of 5.0%, and a weighted-average expected rate of return of 8.5%. The health care cost trend rate has a significant effect on the projected benefit obligation. Increasing the trend rate by 1% each year would increase the present value of the accumulated projected benefit obligation by $11.1 million and the aggregate of the service and interest cost components by $1.5 million. Postemployment: The FASB has issued Statement of Financial Accounting Standards No. 112 (SFAS 112), which establishes accounting and reporting standards for postemployment benefits. The new statement will require the Company to recognize the liability to provide postemployment benefits when the liability has been incurred. The Company adopted SFAS 112 effective January 1, 1994. To mitigate the impact adopting SFAS 112 will have on rate increases, the Company will file applications with the KCC and OCC for orders permitting the initial deferral of SFAS 112 transition costs and expenses and its inclusion in the future computation of cost of service net of an income stream generated from COLI. However, if the state regulatory commissions were to recognize postemployment benefit costs under a different method, 1994 earnings could be impacted negatively. At December 31, 1993, the Company estimates SFAS 112 liability to total approximately $11 million. Savings: The Company maintains savings plans in which substantially all employees participate. The Company matches employees' contributions up to specified maximum limits. The funds of the plans are deposited with a trustee and invested at each employee's option in one or more investment funds, including a Company stock fund. The Company's contributions were $5.4, $5.4, and $3.3 million for 1993, 1992, and 1991, respectively. Missouri Property Sale: Effective January 31, 1994, the Company transferred a portion of the assets and liabilities of the Company's pension plan to a pension plan established by Southern Union. The amount of assets transferred equal the projected benefit obligation for employees and retirees associated with Southern Union's portion of the Missouri Properties plus an additional $9 million. 7. FAIR VALUE OF FINANCIAL INSTRUMENTS The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value as set forth in Statement of Financial Accounting Standards No. 107: Cash and Cash Equivalents- The carrying amount approximates the fair value because of the short-term maturity of these investments. Decommissioning Trust- The fair value of the decommissioning trust is based on quoted market prices at December 31, 1993 and 1992. Variable-rate Debt- The carrying amount approximates the fair value because of the short-term variable rates of these debt instruments. Fixed-rate Debt- The fair value of the fixed-rate debt is based on the sum of the estimated value of each issue taking into consideration the interest rate, maturity, and redemption provisions of each issue. Redeemable Preference Stock- The fair value of the redeemable preference stock is based on the sum of the estimated value of each issue taking into consideration the dividend rate, maturity, and redemption provisions of each issue. The estimated fair values of the Company's financial instruments are as follows: Carrying Value Fair Value December 31, 1993 1992 1993 1992 (Dollars in Thousands) Cash and cash equivalents. . . . . . . $ 1,217 $ 875 $ 1,217 $ 875 Decommissioning trust. . . 13,204 9,272 13,929 9,500 Variable-rate debt . . . . 931,352 758,449 931,352 758,449 Fixed-rate debt. . . . . . 1,364,886 1,508,077 1,473,569 1,563,375 Redeemable preference stock. . . . . . . . . . 150,000 152,733 160,780 161,733 8. LONG-TERM DEBT The amount of first mortgage bonds authorized by the Western Resources Mortgage and Deed of Trust, dated July 1, 1939, as supplemented, is unlimited. The amount of first mortgage bonds authorized by the KG&E Mortgage and Deed of Trust, dated April 1, 1940, as supplemented, is limited to a maximum of $2 billion. Amounts of additional bonds which may be issued are subject to property, earnings, and certain restrictive provisions of each Mortgage. On January 20, 1994, KG&E issued $100 million of First Mortgage Bonds, 6.20% Series due January 15, 2006. On January 31, 1994, the Company redeemed the remaining $2,466,000 principal amount of Gas Service Company (GSC) 8 1/2% Series First Mortgage Bonds due 1997. In addition, the Company took measures to have the GSC Mortgage and Deed of Trust discharged. Debt discount and expenses are being amortized over the remaining lives of each issue. The Western Resources and KG&E improvement and maintenance fund requirements for certain first mortgage bond series can be met by bonding additional property. The sinking fund requirements for certain Western Resources and KG&E pollution control series bonds can be met only through the acquisition and retirement of outstanding bonds. Bonds maturing and acquisition and retirement of bonds for sinking fund requirements for the five years subsequent to December 31, 1993, are as follows: Maturing Retiring Year Bonds Bonds (Dollars in Thousands) 1994. . . . . $ 2,466 $ 738 1995. . . . . - 753 1996. . . . . 16,000 770 1997. . . . . - 1,333 1998. . . . . - 1,550 Long-term debt outstanding at December 31, 1993 and 1992, was as follows: 1993 1992 (Dollars in Thousands) Western Resources First mortgage bond series: 9.35 % due 1998. . . . . . . . . . . . . $ - $ 75,000 7 1/4% due 1999. . . . . . . . . . . . . 125,000 125,000 7 5/8% due 1999. . . . . . . . . . . . . 19,000 19,000 8 3/4% due 2000. . . . . . . . . . . . . - 20,000 8 7/8% due 2000. . . . . . . . . . . . . 75,000 75,000 7 1/4% due 2002. . . . . . . . . . . . . 100,000 100,000 8 5/8% due 2005. . . . . . . . . . . . . - 35,000 8 1/8% due 2007. . . . . . . . . . . . . 30,000 30,000 8 3/4% due 2008. . . . . . . . . . . . . - 35,000 8 5/8% due 2017. . . . . . . . . . . . . 50,000 50,000 8 1/2% due 2022. . . . . . . . . . . . . 125,000 125,000 7.65% due 2023. . . . . . . . . . . . . 100,000 - 624,000 689,000 Pollution control bond series: 5.90 % due 2007. . . . . . . . . . . . . 31,000 31,500 6 3/4% due 2009. . . . . . . . . . . . . 45,000 45,000 9 5/8% due 2013. . . . . . . . . . . . . - 58,500 6% due 2033. . . . . . . . . . . . . 58,500 - 134,500 135,000 KG&E First mortgage bond series: 5 5/8% due 1996. . . . . . . . . . . . . 16,000 16,000 8 1/8% due 2001. . . . . . . . . . . . . - 35,000 7 3/8% due 2002. . . . . . . . . . . . . - 25,000 7.60% due 2003. . . . . . . . . . . . . 135,000 135,000 6 1/2% due 2005. . . . . . . . . . . . . 65,000 - 8 3/8% due 2006. . . . . . . . . . . . . - 25,000 8 1/2% due 2007. . . . . . . . . . . . . - 25,000 8 7/8% due 2008. . . . . . . . . . . . . - 30,000 216,000 291,000 Pollution control bond series: 6.80% due 2004. . . . . . . . . . . . . 14,500 14,500 5 7/8% due 2007. . . . . . . . . . . . . 21,940 21,940 6% due 2007. . . . . . . . . . . . . 10,000 10,000 7.0% due 2031. . . . . . . . . . . . . 327,500 327,500 373,940 373,940 GSC First mortgage bond series: 8 1/2% due 1997. . . . . . . . . . . . . 2,466 4,932 2,466 4,932 Bank term loan . . . . . . . . . . . . . . - 230,000 Other pollution control obligations. . . . 13,980 14,205 Revolving credit agreement . . . . . . . . 115,000 150,000 Other long term agreement. . . . . . . . . 53,913 46,640 Less: Unamortized debt discount. . . . . . . . 6,607 6,730 Long-term debt due within one year . . . 3,204 1,961 $1,523,988 $1,926,026 In January 1993, the Company renegotiated its $600 million bank term loan and revolving credit facility used to finance the Merger into a $350 million revolving credit facility, secured by KG&E common stock. The revolver has an initial term of three years with options to renew for an additional two years with the consent of the banks. The unused portion of the revolving credit facility may be used to provide support for outstanding short-term debt. At December 31, 1993, $115 million was outstanding under the facility. On September 20, 1993, KG&E terminated a long-term revolving credit agreement which provided for borrowings of up to $150 million. The loan agreement, which was effective through October 1994, was repaid without penalty. KG&E has a long-term agreement, expiring in 1995, which contains provisions for the sale of accounts receivable and unbilled revenues (receivables) and phase-in revenues up to a total of $180 million. Amounts related to receivables are accounted for as sales while those related to phase-in revenues are accounted for as collateralized borrowings. Additional receivables are continually sold to replace those collected. At December 31, 1993 and 1992, outstanding receivables amounting to $56.8 and $47.7 million, respectively, were considered sold under the agreement. The credit risk associated with the sale of customer accounts receivable is considered minimal. The weighted average interest rate, including fees, was 3.7% for the year ended December 31, 1993, and 6.6% for the nine months ended December 31, 1992. At December 31, 1993, an additional $16.4 million was available under the agreement. 9. SHORT-TERM DEBT The Company's short-term financing requirements are satisfied, as needed, through the sale of commercial paper, short-term bank loans and borrowings under other unsecured lines of credit maintained with banks. Information concerning these arrangements for the years ended December 31, 1993, 1992, and 1991, is set forth below: Year Ended December 31, 1993 1992 1991 (Dollars in Thousands) Lines of credit at year end. . . . $145,000 $250,000(1) $185,000(2) Short-term debt out- standing at year end . . . . . . 440,895 222,225 135,800 Weighted average interest rate on debt outstanding at year end (including fees) . . . . . . 3.67% 4.70% 5.07% Maximum amount of short- term debt outstanding during the period. . . .. . . . . . . . $443,895 $263,900 $175,000 Monthly average short-term debt. . 347,278 179,577 125,968 Weighted daily average interest rates during the year (including fees) . . . . . . . . 3.44% 4.90% 6.69% (1) Decreased to $155 million in January 1993. (2) Increased to $200 million in January 1992. In connection with the commitments, the Company has agreed to pay certain fees to the banks. Available lines of credit and the unused portion of the revolving credit facility are utilized to support the Company's outstanding short-term debt. 10. LEASES At December 31, 1993, the Company had leases covering various property and equipment. Certain lease agreements meet the criteria, as set forth in Statement of Financial Accounting Standards No. 13, for classification as capital leases. Rental payments for capital and operating leases and estimated rental commitments are as follows: Capital Operating Year Ending December 31, Leases Leases (Dollars in Thousands) 1991 $ 1,217 $21,501 1992 2,426 52,701 1993 3,272 55,011 Future Commitments: 1994 $ 4,002 $47,729 1995 3,752 45,825 1996 3,627 44,176 1997 1,209 41,644 1998 - 41,019 Thereafter - 771,157 Total $12,590 $ 991,550 Less Interest 1,466 Net obligation $11,124 In 1987, KG&E sold and leased back its 50 percent undivided interest in La Cygne 2. The lease has an initial term of 29 years, with various options to renew the lease or repurchase the 50 percent undivided interest. KG&E remains responsible for its share of operation and maintenance costs and other related operating costs of La Cygne 2. The lease is an operating lease for financial reporting purposes. As permitted under the lease agreement, the Company in 1992 requested the Trustee Lessor to refinance $341.1 million of secured facility bonds of the Trustee and owner of La Cygne 2. The transaction was requested to reduce recurring future net lease expense. In connection with the refinancing on September 29, 1992, a one-time payment of approximately $27 million was made by the Company which has been deferred and is being amortized over the remaining life of the lease and included in operating expense as part of the future lease expense. Future minimum annual lease payments, included in the table above, required under the lease agreement are approximately $34.6 million for each year through 1998 and $715 million over the remainder of the lease. The gain of approximately $322 million realized at the date of the sale has been deferred for financial reporting purposes, and is being amortized over the initial lease term in proportion to the related lease expense. KG&E's lease expense, net of amortization of the deferred gain and a one-time payment, was approximately $22.5 million for the year ended December 31, 1993, and $20.6 million for the nine months ended December 31, 1992. 11. JOINT OWNERSHIP OF UTILITY PLANTS Company's Ownership at December 31, 1993 In-Service Invest- Accumulated Net Per- Dates ment Depreciation (MW) cent (Dollars in Thousands) La Cygne 1 (a) Jun 1973 $ 150,265 $ 91,175 342 50 Jeffrey 1 (b) Jul 1978 277,087 116,526 587 84 Jeffrey 2 (b) May 1980 274,018 106,301 566 84 Jeffrey 3 (b) May 1983 386,925 124,158 588 84 Wolf Creek (c) Sep 1985 1,366,387 281,819 533 47 (a) Jointly owned with Kansas City Power & Light Company (KCPL) (b) Jointly owned with UtiliCorp United Inc. and a third party (c) Jointly owned with KCPL and Kansas Electric Power Cooperative, Inc. Amounts and capacity represent the Company's share. The Company's share of operating expenses of the plants in service above, as well as such expenses for a 50 percent undivided interest in La Cygne 2 (representing 335 MW capacity) sold and leased back to the Company in 1987, are included in operating expenses in the statements of income. The Company's share of other transactions associated with the plants is included in the appropriate classification in the Company's consolidated financial statements. 12. INCOME TAXES The Company adopted the provisions of SFAS 109 in the first quarter of 1992. KG&E adopted the provisions of SFAS 96 in 1987 and SFAS 109 in 1992. These statements require the Company to establish deferred tax assets and liabilities, as appropriate, for all temporary differences, and to adjust deferred tax balances to reflect changes in tax rates expected to be in effect during the periods the temporary differences reverse. In accordance with various rate orders received from the KCC, the MPSC, and the OCC, the Company has not yet collected through rates the amounts necessary to pay a significant portion of the net deferred income tax liabilities. As management believes it is probable that the net future increases in income taxes payable will be recovered from customers through future rates, it has recorded a deferred asset for these amounts. These assets are also a temporary difference for which deferred income tax liabilities have been provided. Accordingly, the adoption of SFAS 109 did not have a material impact on the Company's results of operations. At December 31, 1993, KG&E has unused investment tax credits of approximately $7.1 million available for carryforward which, if not utilized, will expire in the years 2000 through 2002. In addition, the Company has alternative minimum tax credits generated prior to April 1, 1992, which carryforward without expiration, of $57.2 million which may be used to offset future regular tax to the extent the regular tax exceeds the alternative minimum tax. These credits have been applied in determining the Company's net deferred income tax liability and corresponding deferred future income taxes at December 31, 1993. Deferred income taxes result from temporary differences between the financial statement and tax basis of the Company's assets and liabilities. The sources of these differences and their cumulative tax effects are as follows: December 31, 1993 Debits Credits Total (Dollars in Thousands) Sources of Deferred Income Taxes: Accelerated depreciation and other property items . . . . . . $ - $ (647,202) $ (647,202) Energy and purchased gas adjustment clauses . . . . . . . 2,452 - 2,452 Phase-in revenues. . . . . . . . . - (35,573) (35,573) Natural gas line survey and replacement program. . . . . . . - (7,721) (7,721) Deferred gain on sale-leaseback. . 116,186 - 116,186 Alternative minimum tax credits. . 39,882 - 39,882 Deferred coal contract settlements. . . . . . . . . . . - (14,980) (14,980) Deferred compensation/pension liability. . . . . . . . . . . . 11,301 - 11,301 Acquisition premium. . . . . . . . - (301,394) (301,394) Deferred future income taxes . . . - (117,549) (117,549) Other. . . . . . . . . . . . . . . - (14,039) (14,039) Total Deferred Income Taxes. . . . . $ 169,821 $(1,138,458) $ (968,637) December 31, 1992 Debits Credits Total (Dollars in Thousands) Sources of Deferred Income Taxes: Accelerated depreciation and other property items . . . . . . $ - $ (607,303) $ (607,303) Energy and purchased gas adjustment clauses . . . . . . . - (7,717) (7,717) Phase-in revenues. . . . . . . . . - (37,564) (37,564) Natural gas line survey and replacement program. . . . . . . - (7,473) (7,473) Deferred gain on sale-leaseback. . 104,573 - 104,573 Alternative minimum tax credits. . 39,882 - 39,882 Deferred coal contract settlements. . . . . . . . . . . - (9,318) (9,318) Deferred compensation/pension liability. . . . . . . . . . . . 8,488 - 8,488 Acquisition premium. . . . . . . . - (314,241) (314,241) Deferred future income taxes . . . - (158,102) (158,102) Other. . . . . . . . . . . . . . . - (1,380) (1,380) Total Deferred Income Taxes. . . . . $ 152,943 $(1,143,098) $ (990,155) 13. SEGMENTS OF BUSINESS The Company is a public utility engaged in the generation, transmission, distribution, and sale of electricity in Kansas and the transportation, distribution, and sale of natural gas in Kansas, Missouri, and Oklahoma. Year Ended December 31, 1993 1992(1) 1991 (Dollars in Thousands) Operating revenues: Electric. . . . . . . . . . . $1,104,537 $ 882,885 $ 471,839 Natural gas . . . . . . . . . 804,822 673,363 690,339 1,909,359 1,556,248 1,162,178 Operating expenses excluding income taxes: Electric. . . . . . . . . . . 791,563 632,169 337,150 Natural gas . . . . . . . . . 747,755 642,910 664,825 1,539,318 1,275,079 1,001,975 Income taxes: Electric. . . . . . . . . . . 73,425 41,184 32,239 Natural gas . . . . . . . . . 4,553 816 (1,657) 77,978 42,000 30,582 Operating income: Electric. . . . . . . . . . . 239,549 209,532 102,450 Natural gas . . . . . . . . . 52,514 29,637 27,171 $ 292,063 $ 239,169 $ 129,621 Identifiable assets at December 31: Electric. . . . . . . . . . . $4,231,277 $4,390,117 $1,196,023 Natural gas . . . . . . . . . 1,040,513 918,729 840,692 Other corporate assets(2) . . 140,258 130,060 75,798 $5,412,048 $5,438,906 $2,112,513 Other Information-- Depreciation and amortization: Electric. . . . . . . . . . . $ 126,034 $ 105,842 $ 53,632 Natural gas . . . . . . . . . 38,330 38,171 32,103 $ 164,364 $ 144,013 $ 85,735 Maintenance: Electric. . . . . . . . . . . $ 87,696 $ 73,104 $ 34,240 Natural gas . . . . . . . . . 30,147 28,507 26,275 $ 117,843 $ 101,611 $ 60,515 Capital expenditures: Electric. . . . . . . . . . . $ 137,874 $ 95,465 $ 43,714 Nuclear fuel. . . . . . . . . 5,702 15,839 - Natural gas . . . . . . . . . 94,055 91,189 81,961 $ 237,631 $ 202,493 $ 125,675 (1)Information reflects the merger with KG&E on March 31, 1992. (2)Principally cash, temporary cash investments, non-utility assets, and deferred charges. The portion of the table above related to the Missouri Properties is as follows (unaudited): (Dollars in Thousands) Natural gas revenues. . . . . . . . . . $ 349,749 Operating expenses excluding income taxes. . . . . . . . . 326,329 Income taxes. . . . . . . . . . . . . . 2,672 Operating income. . . . . . . . . . . . 20,748 Identifiable assets . . . . . . . . . . 398,464 Depreciation and amortization . . . . . 12,668 Maintenance . . . . . . . . . . . . . . 10,504 Capital expenditures. . . . . . . . . . 38,821 14. COMMON STOCK AND CUMULATIVE PREFERRED AND PREFERENCE STOCK The Company's Restated Articles of Incorporation, as amended, provides for 85,000,000 authorized shares of common stock. During 1993, the Company issued 3,572,323 shares of common stock and at December 31, 1993, 61,617,873 shares were outstanding. Not subject to mandatory redemption: The cumulative preferred stock is redeemable in whole or in part on 30 to 60 days notice at the option of the Company. Subject to mandatory redemption: On October 1, 1993, the Company redeemed the remaining 22,000 shares of the 8.70% Series preference stock. The mandatory sinking fund provisions of the 8.50% Series preference stock require the Company to redeem 50,000 shares annually beginning on July 1, 1997, at $100 per share. The Company may, at its option, redeem up to an additional 50,000 shares on each July 1, at $100 per share. The 8.50% Series also is redeemable in whole or in part, at the option of the Company, subject to certain restrictions on refunding, at a redemption price of $107.37, $106.80, and $106.23 per share beginning July 1, 1993, 1994, and 1995, respectively. The mandatory sinking fund provisions of the 7.58% Series preference stock require the Company to redeem 25,000 shares annually beginning on April 1, 2002, and each April 1 through 2006 and the remaining shares on April 1, 2007, all at $100 per share. The Company may, at its option, redeem up to an additional 25,000 shares on each April 1 at $100 per share. The 7.58% Series also is redeemable in whole or in part, at the option of the Company, subject to certain restrictions on refunding, at a redemption price of $106.82, $106.06, and $105.31 per share beginning April 1, 1993, 1994, and 1995, respectively. 15. LEGAL PROCEEDINGS The Company and its subsidiaries are involved in various legal and environmental proceedings. Management believes that adequate provision has been made within the consolidated financial statements for these matters and accordingly believes their ultimate dispositions will not have a material adverse effect upon the business, financial position, or results of operations of the Company. 16. QUARTERLY RESULTS (UNAUDITED) The amounts in the table are unaudited but, in the opinion of management, contain all adjustments (consisting only of normal recurring adjustments) necessary for a fair presentation of the results of such periods. The business of the Company is seasonal in nature and, in the opinion of management, comparisons between the quarters of a year do not give a true indication of overall trends and changes in operations. First Second Third Fourth (Dollars in Thousands, except Per Share Amounts) Operating revenues. . . . . . . $579,581 $400,411 $419,018 $510,349 Operating income. . . . . . . . 85,950 60,282 81,225 64,606 Net income. . . . . . . . . . . 54,814 30,723 56,807 35,026 Earnings applicable to common stock. . . . . . . . . 51,468 27,320 53,405 31,671 Earnings per share. . . . . . . $ 0.89 $ 0.47 $ 0.90 $ 0.51 Dividends per share . . . . . . $ 0.485 $ 0.485 $ 0.485 $ 0.485 Average common shares outstanding . . . . . . . . . 58,046 58,046 59,441 61,603 Common stock price: High. . . . . . . . . . . . . $ 35 3/4 $ 36 1/8 $ 37 1/4 $ 37 Low . . . . . . . . . . . . . $ 30 3/8 $ 32 3/4 $ 35 $ 32 3/4 1992(1) Operating revenues. . . . . . . $373,620 $341,715 $380,745 $460,168 Operating income. . . . . . . . 42,684 45,830 77,010 73,645 Net income. . . . . . . . . . . 27,984 18,434 42,185 39,281 Earnings applicable to common stock. . . . . . . . . 25,472 15,113 38,726 35,822 Earnings per share. . . . . . . $ 0.74 $ 0.26 $ 0.67 $ 0.62 Dividends per share . . . . . . $ 0.475 $ 0.475 $ 0.475 $ 0.475 Average common shares outstanding . . . . . . . . . 34,566 58,046 58,046 58,046 Common stock price: High. . . . . . . . . . . . . $ 29 1/2 $ 26 7/8 $ 30 1/2 $ 32 5/8 Low . . . . . . . . . . . . . $ 25 3/8 $ 25 1/4 $ 26 3/4 $ 28 1/2 (1) Information reflects the merger with KG&E on March 31, 1992. 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 relating to the Company's Directors required by Item 10 is set forth in the Company's definitive proxy statement for its 1994 Annual Meeting of Shareholders to be filed with the Commission. Such information is incorporated herein by reference to the material appearing under the caption Election of Directors in the proxy statement to be filed by the Company with the Commission. See EXECUTIVE OFFICERS OF THE COMPANY on page 18 for the information relating to the Company's Executive Officers as required by Item 10. ITEM 11.	ITEM 11. EXECUTIVE COMPENSATION The information required by Item 11 is set forth in the Company's definitive proxy statement for its 1994 Annual Meeting of Shareholders to be filed with the Commission. Such information is incorporated herein by reference to the material appearing under the captions Information Concerning the Board of Directors, Executive Compensation, Compensation Plans, and Human Resources Committee Report in the proxy statement to be filed by the Company with the Commission. ITEM 12.	ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by Item 12 is set forth in the Company's definitive proxy statement for its 1994 Annual Meeting of Shareholders to be filed with the Commission. Such information is incorporated herein by reference to the material appearing under the caption Beneficial Ownership of Voting Securities in the proxy statement to be filed by the Company with the Commission. ITEM 13.	ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by Item 13 is set forth in the Company's definitive proxy statement for its 1994 Annual Meeting of Shareholders to be filed with the Commission. Such information is incorporated herein by reference to the material appearing under the caption Transactions with Management in the proxy statement to be filed by the Company with the Commission. PART IV ITEM 14.	ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K The following financial statements are included herein. FINANCIAL STATEMENTS Report of Independent Public Accountants Consolidated Balance Sheets - December 31, 1993 and 1992 Consolidated Statements of Income - years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows - years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Taxes - years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Capitalization - December 31, 1993 and Consolidated Statements of Common Stock Equity - years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements The following supplemental schedules are included herein. SCHEDULES Schedule V - Utility Plant - years ended December 31, 1993, 1992 and 1991 Schedule VI - Accumulated Depreciation of Utility Plant - years ended December 31, 1993, 1992 and 1991 Schedules omitted as not applicable or not required under the Rules of regulation S-X: I, II, III, IV, VII, VIII, IX, X, XI, XII, and XIII REPORTS ON FORM 8-K Form 8-K dated February 2, 1994 EXHIBIT INDEX All exhibits marked "I" are incorporated herein by reference. Description 3(a) -Restated Articles of Incorporation of the Company, as amended I May 25, 1988. (filed as Exhibit 4 to Registration Statement No. 33-23022) 3(b) -Certificate of Correction to Restated Articles of Incorporation. I (filed as Exhibit 3(b) to the December 1991 Form 10-K) 3(c) -By-laws of the Company, as amended July 15, 1987. (filed as I Exhibit 3(d) to the December 1987 Form 10-K) 3(d) -Certificate of Designation of Preference Stock, 8.50% Series, without par value. (filed electronically) 3(e) -Certificate of Designation of Preference Stock, 7.58% Series, without par value. (filed electronically) 4(a) -Mortgage and Deed of Trust dated July 1, 1939 between the Company I and Harris Trust and Savings Bank, Trustee. (filed as Exhibit 4(a) to Registration Statement No. 33-21739) 4(b) -First through Fifteenth Supplemental Indentures dated July 1, I 1939, April 1, 1949, July 20, 1949, October 1, 1949, December 1, 1949, October 4, 1951, December 1, 1951, May 1, 1952, October 1, 1954, September 1, 1961, April 1, 1969, September 1, 1970, February 1, 1975, May 1, 1976 and April 1, 1977, respectively. (filed as Exhibit 4(b) to Registration Statement No. 33-21739) 4(c) -Sixteenth Supplemental Indenture dated June 1, 1977. (filed as I Exhibit 2-D to Registration Statement No. 2-60207) 4(d) -Seventeenth Supplemental Indenture dated February 1, 1978. I (filed as Exhibit 2-E to Registration Statement No. 2-61310) 4(e) -Eighteenth Supplemental Indenture dated January 1, 1979. (filed I as Exhibit (b) (1)-9 to Registration Statement No. 2-64231) 4(f) -Nineteenth Supplemental Indenture dated May 1, 1980. (filed as I Exhibit 4(f) to Registration Statement No. 33-21739) 4(g) -Twentieth Supplemental Indenture dated November 1, 1981. (filed I as Exhibit 4(g) to Registration Statement No. 33-21739) 4(h) -Twenty-First Supplemental Indenture dated April 1, 1982. (filed I as Exhibit 4(h) to Registration Statement No. 33-21739) 4(i) -Twenty-Second Supplemental Indenture dated February 1, 1983. I (filed as Exhibit 4(i) to Registration Statement No. 33-21739) 4(j) -Twenty-Third Supplemental Indenture dated July 2, 1986. (filed I as Exhibit 4(j) to Registration Statement No. 33-12054) 4(k) -Twenty-Fourth Supplemental Indenture dated March 1, 1987. (filed I as Exhibit 4(k) to Registration Statement No. 33-21739) 4(l) -Twenty-Fifth Supplemental Indenture dated October 15, 1988. I (filed as Exhibit 4 to the September 1988 Form 10-Q) 4(m) -Twenty-Sixth Supplemental Indenture dated February 15, 1990. I (filed as Exhibit 4(m) to the December 1989 Form 10-K) 4(n) -Twenty-Seventh Supplemental Indenture dated March 12, 1992. I (filed as exhibit 4(n) to the December 1991 Form 10-K) 4(o) -Twenty-Eighth Supplemental Indenture dated July 1, 1992. I (filed as exhibit 4(o) to the December 1992 Form 10-K) 4(p) -Twenty-Ninth Supplemental Indenture dated August 20, 1992. I (filed as exhibit 4(p) to the December 1992 Form 10-K) Description 4(q) -Thirtieth Supplemental Indenture dated February 1, 1993. I (filed as exhibit 4(q) to the December 1992 Form 10-K) 4(r) -Thirty-First Supplemental Indenture dated April 15, 1993. I (filed as exhibit 4(r) to Form S-3, Registration Statement No. 33-50069) Instruments defining the rights of holders of other long-term debt not required to be filed as exhibits will be furnished to the Commission upon request. 10(a) -Agreement between the Company and AMAX Coal West Inc. effective March 31, 1993. (filed electronically) 10(b) -Agreement between the Company and Williams Natural Gas Company dated October 1, 1993. (filed electronically) 10(c) -Agreement between the Company and Williams Natural Gas Company dated October 1, 1993. (filed electronically) 10(d) -Agreement between the Company and Williams Natural Gas Company dated October 1, 1993. (filed electronically) 10(e) -Executive Salary Continuation Plan of The Kansas Power and Light I Company, as revised, effective May 3, 1988. (filed as Exhibit 10(b) to the September 1988 Form 10-Q) 10(f) -Letter of Agreement between The Kansas Power and Light Company and I John E. Hayes, Jr., dated November 20, 1989. (filed as Exhibit 10(w) to the December 1989 Form 10-K) 10(g) -Amended Agreement and Plan of Merger by and among The Kansas I Power and Light Company, KCA Corporation, and Kansas Gas and Electric Company, dated as of October 28, 1990, as amended by Amendment No. 1 thereto, dated as of January 18, 1991. (filed as Annex A to Registration Statement No. 33-38967) 10(h) -Deferred Compensation Plan 10(i) -Long-term Incentive Plan 10(j) -Short-term Incentive Plan 10(k) -Outside Directors' Deferred Compensation Plan 12 -Computation of Ratio of Consolidated Earnings to Fixed Charges. (filed electronically) 16 -Letter re Change in Certifying Accountant. (filed as Exhibit 16 I to the Current Report on Form 8-K dated March 8, 1993) 21 -Subsidiaries of the Registrant. (filed as Exhibit 22 to the I December 1992 Form 10-K) 23(a) -Consent of Independent Public Accountants, Arthur Andersen & Co. (filed electronically) 23(b) -Consent of Independent Public Accountants, Deloitte & Touche (filed electronically)) 23(c) -Consent of K&A Energy Consultants, Inc. (filed as Exhibit 24(b) I to the December 1988 Form 10-K) 99(a) -Kansas Gas and Electric Company's Annual Report on Form 10-K for the year ended December 31, 1993 (filed electronically) 99(b) -Report of K&A Energy Consultants, Inc. (filed as Exhibit 28 to I the December 1988 Form 10-K) SIGNATURE Pursuant to the requirements of Sections 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. WESTERN RESOURCES, INC. March 18, 1994 By JOHN E. HAYES, JR. (John E. Hayes, Jr., Chairman of the Board, President, and Chief Executive Officer) SIGNATURES 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 Chairman of the Board, President, JOHN E. HAYES, JR. and Chief Executive Officer March 18, 1994 (John E. Hayes, Jr.) (Principal Executive Officer) Executive Vice President and S. L. KITCHEN Chief Financial Officer March 18, 1994 (S. L. Kitchen) (Principal Financial and Accounting Officer) FRANK J. BECKER (Frank J. Becker) GENE A. BUDIG (Gene A. Budig) C. Q. CHANDLER (C. Q. Chandler) THOMAS R. CLEVENGER (Thomas R. Clevenger) JOHN C. DICUS Directors March 18, 1994 (John C. Dicus) DAVID H. HUGHES (David H. Hughes) RUSSELL W. MEYER, JR. (Russell W. Meyer, Jr.) JOHN H. ROBINSON (John H. Robinson) MARJORIE I. SETTER (Marjorie I. Setter) LOUIS W. SMITH (Louis W. Smith) KENNETH J. WAGNON (Kenneth J. Wagnon)
709145_1993.txt	709145	1993	Item 1. Business GENERAL Leaservice Income Fund-I (the "Partnership") was organized as a limited partnership under the Uniform Limited Partnership Law of the State of California on April 22, 1983. During the period from June 23, 1983 to October 9, 1984, the Partnership sold an aggregate of 76,328 units of limited partnership interests ("Units") in the Partnership at a purchase price of $100 per Unit pursuant to a Registration Statement on Form S-1 (File No. 2-80216) declared effective by the Securities and Exchange Commission on June 23, 1983. The Partnership actively engaged in the equipment leasing business from 1983 until June 1986 during which it purchased equipment subject to nineteen operating leases having an aggregate purchase price of approximately $9,462,615. Since June 1986 the Partnership has not purchased any equipment. Since May 24, 1991, when the Partnership was dissolved by virtue of the dissolution of its sole general partner, Leaservice Partners, a New York general partnership, the Partnership has been in the process of winding up its business. By December 31, 1993, all operating leases to which the Partnership's equipment had been subject had expired and all of its equipment, which by then had been fully depreciated, was written off. A Certificate of Cancellation was filed with the Secretary of State of the State of California on December 17, 1997 DISSOLUTION OF THE PARNERSHIP The Partnership's sole general partner was Leaservice Partners, a New York general partnership which initially consisted of three corporate partners: (i) National Industrial Services Corp., a New York corporation (which changed its name to Capital Market Services Corp and was merged with and into Pittsburgh Annealing Box Company, a Pennsylvania corporation ("PAB")in October 1987), and which served as the managing partner of Leaservice Partners; (ii) Mid-States Resources, Inc., a Missouri corporation which dissolved on March 1, 1996; and (iii) Mid-States Leasing, Inc., a Missouri corporation which on May 24, 1991 withdrew from Leaservice Partners causing the general partnership's dissolution; Mid-States Leasing, Inc. was formally dissolved on June 29, 1991. The dissolution of Leaservice Partners on May 24, 1991, caused the dissolution of the Partnership pursuant to the terms of the Partnership's Amended and Restated Agreement of Limited Partnership (the "Limited Partnership Agreement") . The Partnership's limited partners were advised of the dissolution of Leaservice Partners and its effect on the Partnership and were given the opportunity, pursuant to the terms of the Limited Partnership Agreement to continue the Partnership and elect a new general partner at a meeting of limited partners scheduled for July 8, 1991. At this meeting, the requisite number of limited partners failed to vote to continue the Partnership. Accordingly, since May 1991, the Partnership has been in the process of winding up its affairs. From May 1991 until January 1998, PAB, (as the successor to the sole managing partner of Leaservice Partners, the general partnership that served as the sole general partner of the Partnership) oversaw the winding up of the business of Leaservice Partners and the Partnership. On January 7, 1998, Capital Resource Group, L.L.C., a Pennsylvania limited liability company ("CRG") assumed all of the rights and all of the obligations of PAB in the Partnership and in Leaservice Partners. CRG is overseeing the final stages of the winding up of the affairs of the Partnership. Item 2.		Item 2. Properties During the year ended December 31, 1993 and thereafter, the Partnership has not owned or leased any material property. Item 3.	Item 3. Legal Proceedings None. Item 4.	Item 4. Submission of Matters to a Vote of Security Holders No matters were submitted to a vote of security holders, through the solicitation of proxies or otherwise, during the fourth quarter of the year covered by this report or at anytime thereafter. PART II Item 5.	Item 5. Market for the Partnership's Common Equity and Related Stockholder Matters (a) The Partnership's Units have never been publicly traded. Pursuant to the terms of the Partnership's Limited Partnership Agreement, a Unit could be transferred only after certain requirements were satisfied and transferees could become limited partners only with the consent of the general partner, which consent could be granted or withheld at the sole discretion of the general partner. There has never been a market for such Units and no public trading market ever developed for the Units. (b) As of December 31, 1993 and through the date of the filing of this Annual Report on Form 10-K, there were approximately 800 holders of record of the Partnership's Units and one holder of a general partnership interest in the Partnership. 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 The Partnership was dissolved in fiscal 1991 and continued to wind up its affairs during the fiscal year ended December 31, 1993. See Item 1 "Business". The Partnership ceased purchasing equipment subject to operating leases in June 1986, because, in the opinion of the general partner, total prospective returns attainable on such leases (taking into consideration residual equipment value risks which the Partnership would be subject to) were not been favorable to the Partnership. During the fiscal year ended December 31, 1993, all operating leases to which the Partnership's equipment had been subject expired or were otherwise terminated and all equipment then owned by the Partnership (which had an original cost of $104,197 and which had been fully depreciated) was written off. During the fiscal year ended December 31, 1993, customer deposits totaling $81,212 which were to be applied to the final months rent upon termination of the applicable operating leases were recognized as income. During the fiscal year ended December 31, 1993 operating lease rentals were $300 compared to $0.00 and $34,884 for the years ended December 31, 1992 and December 31, 1991, respectively. The decreases in income from operating lease rentals were due to the maturity of certain operating lease agreements, the sale of equipment subject to leases, and the inability of the Partnership to acquire additional leases. Operating expenses declined from $81,110 in 1991 to $26,735 in 1992 and to $4,450 in 1993 primarily as a result of decreases in marketing and management fees. Net income (loss) for the years ended December 31, 1993, 1992 and 1991 was $81,637, ($21,115) and ($34,620), respectively. Net income in 1993 and was allocated $69,381 (85%) to the limited partners and $12,246 (15%) to the general partner. Net (loss) for the years December 31, 1992 and 1991 was allocated ($20,904) and ($34,274) (99%), respectively, to the limited partners and ($211) (1%) and ($346) (1%), respectively, to the general partner. For the years ended December 31, 1993, 1992 and 1991, income (loss) per Unit on a weighted average basis was $.91, ($.27) and ($.45), respectively. LIQUIDITY AND CAPITAL RESOURCES The Partnership had sufficient funds to cover its diminishing expenses in 1994. Item 8.	Item 8. Financial Statements and Supplementary Data (Annexed hereto starting on page) Item 9.	Item 9. Changes in and Disagreements on Accounting and Financial Disclosure As reported in the Company's Annual Report on Form 10-K for the year ended December 31, 1992, on May 14, 1993 the Company notified Deloitte & Touche, which had previously been the independent accountant of the Company, that it had been dismissed. On September 10, 1992 Capuano & Hartley CPAs was selected to audit the Company's financial statements for the year ended December 31, 1991. Capuano & Hartley, CPAs served as the Partnership's independent accountants from September 10, 1992 until they were formally dismissed on December 31, 1997. As reported in the Company's Current Report on Form 8-K dated February 5, 1998, on December 31, 1997, the Partnership formally dismissed Capuano & Hartley, CPAs as its independent accountant because Capuano & Hartley, CPAs had disbanded in 1996. On December 23, 1997, the Partnership engaged Wiss & Co. to serve as its independent accountants to audit the Partnership's financial statements for the years ended December 31, 1993, 1994, 1995, 1996 and 1997 as part of the Partnership's effort to complete winding up its affairs following the Partnership's dissolution on May 24, 1991. As reported in the Company's Current Report on Form 8-K dated February 5, 1998, while serving as the Partnership's independent accountants from September 10, 1992 until December 31, 1997, Capuano & Hartley, CPAs audited the Registrant's annual financial statements for the years ended December 31, 1991 and 1992 and their reports on these financial statements did not contain an adverse opinion or disclaimer of opinion and were not qualified or modified as to uncertainty, scope or accounting principals. Until December 23, 1997, the Partnership had not requested Capuano & Hartley, CPAs or any other independent accountant to audit the Partnership's financial statements for the years ended December 31, 1993, 1994, 1995, 1996 and 1997 because as more particularly described in Item 1 above, the Partnership has been in the process of winding up its affairs since its dissolution during fiscal 1991, has engaged in no new business since June 1986 and believed that the cost of annual audits exceeded the value to be derived from same in light of the Partnership's small and diminishing assets and the lack of a public market for its Units of limited partnership interest. PART III Item 10.	Item 10. Directors and Executive Officers of the Registrant The general partner of the Partnership was Leaservice Partners, a New York general partnership which has dissolved on May 21, 1991. From May 1991 until January 1998, PAB, (as the successor to the sole managing partner of Leaservice Partners, the general partnership that served as the sole general partner of the Partnership) oversaw the winding up of the business of Leaservice Partners and the Partnership. On January 7, 1998, CRG assumed all of the rights and all of the obligations of PAB in the Partnership and in Leaservice Partners. CRG is overseeing the final stages of the winding up of the affairs of the Partnership. The executive officers and directors of PAB during the year ended December 31, 1993 were Sam Michaels, Chief Executive Officer, President and Director, Edward J. Landau, Secretary and Director and John A. Kenna, Vice President The executive officers and managers of CRG are Sam Michaels, Chairman of the Board and Manager, Edward J. Landau, Secretary and Manager and Gary Hitechew, President and Manager. Item 11.	Item 11. Management Remuneration and Transactions (Certain of the capitalized terms used in this section are defined at the end of the section.) The Partnership's Limited Partnership Agreement provides that the general partner is compensated for services performed in connection with, among other things, managing the operations of the Partnership. As compensation for the management services it performs the general partner receives a management fee payable quarterly in an amount equal to 3% of the Partnership's gross revenues derived from full payout leases, 6% of the partnership's gross revenues derived from operating leases and 3% of the Partnership's gross revenues derived from the sale of equipment. If the Partnership does not generate sufficient cash from operations to pay the management fee or even if it does, at the discretion of the General Partner, such fees will be accrued as debt of the Partnership payable out of cash available for distribution. In addition to the management fee, the general partner is allocated 1% of the Partnership's net losses and 15% of the Partnership's net income. The general partner also is reimbursed for any direct expenses incurred by it, its employees or agents in connection with the Partnership's business and on behalf of the Partnership, except that the general partner is not reimbursed for any general and administrative expenses or other overhead expenses of the general partner and is not reimbursed for any organizational and offering expenses in excess of 3% of the gross proceeds of the offering of Units. During the fiscal year ended December 31, 1993, the Partnership did not pay or accrue a management fee applicable to the general partner; the general partner was allocated $12,246 (15%) of the net income of the Partnership for such year. Item 12.	Item 12. Security Ownership of Certain Beneficial Owners and Management (a) No person owns of record, or is known by the Partnership to own beneficially, more than 5% of any class of the voting securities of the Partnership (b)The general partner's general partnership interest in the Partnership represents a 15% interest in the Partnership's annual net income for financial reporting purposes and tax allocations of 1% of net losses and 15% of net income. Item 13.	Item 13. Certain Relationships and Related Transactions None. Item 14.	Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) Exhibits (3) Restated and Amended Agreement of Limited Partnership of the Partnership dated as of June 23, 1983. Incorporated by reference to Exhibit A to the definitive Prospectus dated June 23, 1983 filed with the Securities and Exchange Commission pursuant to Rule 424(b) under the Securities Act of 1933. (b) Financial Statements and Schedules Financial Statements Page No. -------------------- -------- Independent Auditors' Reports Balance Sheets as of December 31, 1993 and 1992 Statements of Operations for the years ended December 31, 1993, 1992 and 1991 Statements of Changes in Partners' Equity (Deficiency) for the years ended December 31, 1993, 1992 and 1991 Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991 Notes to Financial Statements Financial Statement Schedules Schedule V - Property, Plant and Equipment for the years ended December 31, 1993, 1992 and 1991 Schedule VI - Accumulated Depreciation of Property, Plant and Equipment for the years ended December 31, 1993, 1992 and 1991 All other schedules are omitted because they are not required or because the required information is presented in the financial statements or related notes. (c) Reports on Form 8-K The Partnership did not file any Current Reports on Form 8-K during the last quarter of the fiscal year ended December 31, 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. LEASERVICE INCOME FUND - I (dissolved) By: LEASERVICE PARTNERS (dissolved) By: CAPITAL RESOURCE GROUP LLC (successor to the managing partner of Leaservice Partners) Dated: September 29, 1998 By: /s/ Edward J. Landau -------------------- Edward J. Landau Secretary 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/ Sam Michaels Chairman of the Board September 29, 1998 - ---------------- and Manager Sam Michaels (Principal Executive Officer) /s/ Patrick Costello Consultant September 29, 1998 - -------------------- Principal Accounting and Patrick Costello Financial Officer /s/ Edward J. Landau Secretary and Manager September 29, 1998 - -------------------- Edward J. Landau INDEPENDENT AUDITORS' REPORT General Partner and Limited Partners Leaservice Income Fund - I We have audited the accompanying balance sheet of Leaservice Income Fund - I (A California Limited Partnership) as of December 31, 1993 and the related statements of operations, changes in partners' equity (deficiency), cash flows, and Schedules V and VI of Item 13(b) of annual report on Form 10-K to Securities and Exchange Commission for the year ended December 31, 1993. These financial statements and schedules are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audit. The financial statements of Leaservice Income Fund - - I as of December 31, 1992 were audited by other auditors whose report dated March 1, 1993 expressed an unqualified opinion on those statements including Schedules V and VI of item 13(b) on annual report on Form 10-K to Securities and Exchange Commission. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements and schedules are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements and schedules. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement and schedules presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the financial statements and schedules referred to above present fairly, in all material respects, the financial position of Leaservice Income Fund - I (A California Limited Partnership) as of December 31, 1993 and the results of its operations and its cash flows for the year ended December 31, 1993 in conformity with generally accepted accounting principles. As indicated in the Notes to the financial statements, the Partnership has not purchased any new equipment for lease, has not entered into any new agreements and does not have any equipment out on lease. WISS & COMPANY, LLP Livingston, New Jersey January 3, 1998 INDEPENDENT AUDITOR'S REPORT General Partner and Limited Partners Leaservice Income Fund - I White Plains, New York We have audited the accompanying balance sheet of Leaservice Income Fund - I (a California limited partnership) as of December 31, 1992 and 1991 and the related statements of operations, changes in partners' equity, cash flows, and Schedules V and VI of Item 13(b) of annual report on Form 10-K to Securities and Exchange Commission for the years ended December 31, 1992 and 1991. These financial statements and schedules are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audit. The financial statements of Leaservice Income Fund - - I as of December 31,1990 were audited by other auditors whose report dated January 29, 1991 expressed an unqualified opinion on those statements including Schedules V and VI of item 13(b) on annual report on Form 10-K to Securities and Exchange Commission. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements and schedules are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements and schedules. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement and schedules presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, such financial statements and schedules present fairly, in all material respects, the financial position of Leaservice Income Fund - I (a California limited partnership) as of December 31, 1992 and 1991 and the results of its operations and its cash flows for the years ended December 31, 1992 and 1991 in conformity with generally accepted accounting principles. As indicated in Note B to the financial statements, the Partnership has not purchased any new equipment for lease and has not entered into any new agreements. CAPUANO & HARTLEY, CPAs March 1,1993 LEASERVICE INCOME FUND - I (A CALIFORNIA LIMITED PARTNERSHIP) BALANCE SHEETS December 31, ------------ 1993 1992 ---------- ---------- ASSETS CASH AND CASH EQUIVALENTS ............................ $ 144,469 $ 173,479 Computer equipment held for rental at cost, net of accumulated depreciation and provision for impairment in carrying value - $0 in 1993 and $104,197 in 1992 ............................... -- -- ---------- ---------- $ 144,469 $ 173,479 LIABILITIES AND PARTNERS' EQUITY (DEFICIENCY) LIABILITIES: Customer deposits .................................. $ -- $ 81,212 Accrued expenses ................................... 3,239 22,674 Sales tax payable .................................. 44,216 54,216 Due to General Partner ............................. 23,515 23,515 --------- --------- 70,970 181,617 --------- --------- PARTNERS' EQUITY (DEFICIENCY): Limited Partners ................................ 81,594 12,203 General Partners ................................ (8,095) (20,341) --------- --------- Total Partners' Equity (Deficiency) 73,499 (8,138) --------- --------- $ 144,469 $ 173,479 See the accompanying notes to financial statements. LEASERVICE INCOME FUND - I (A CALIFORNIA LIMITED PARTNERSHIP) STATEMENTS OF OPERATIONS Year Ended December 31, ----------------------- 1993 1992 1991 -------- -------- -------- INCOME: Operating lease rentals ................... $ 296 $ -- $ 34,884 Lease termination ......................... 81,212 -- -- Gain on sale of equipment ................. -- -- 2,000 Interest .................................. 4,579 5,620 9,606 -------- -------- -------- 86,087 5,620 46,490 OPERATING EXPENSES .......................... 4,450 26,735 81,110 -------- -------- -------- NET INCOME (LOSS) ........................... $ 81,637 $(21,115) $(34,620) ======== ======== ======== ALLOCATION OF NET INCOME (LOSS): Net income (loss) allocable to General Partner ....................... $ 12,246 $ (211) $ (346) ======== ======== ======== Net income (loss) allocable to Limited Partners ...................... $ 69,391 $(20,904) $(34,274) ======== ======== ======== Net income (loss) per weighted average Limited Partnership Unit ................. $ 0.91 $ (0.27) $ (0.45) ======== ======== ======== See the accompanying notes to financial statements. See the accompanying notes to financial statements. LEASERVICE INCOME FUND - I (A CALIFORNIA LIMITED PARTNERSHIP) NOTES TO FINANCIAL STATEMENTS Note 1 - Nature of the Business and Summary of Significant Accounting Policies: NATURE OF THE BUSINESS - Leaservice Income Fund - I ("the Partnership") is a California Limited Partnership formed for the purpose of acquiring various types of capital equipment and leasing same to third parties primarily on a short-term basis. On August 18, 1983, the first limited partners were admitted to the Partnership. The leasing of acquired equipment commenced on October 1, 1983. Leaservice Partners ("Leaservice"), a New York General Partnership, was the sole General Partner of the Partnership until May 24, 1991. The Partnership was informed that effective as of such date, Leaservice had been dissolved due to the withdrawal from that partnership of one of its general partners. Section 14.1.1 of the Amended and Restated Partnership Agreement of the Partnership provides that the Partnership is dissolved upon the dissolution of a general partner. A meeting of limited partners was scheduled for the purposes of considering whether the Partnership should be continued and a new general partner elected. However, limited partners owning 50% or more of the total outstanding Units of the Fund voting in person or by proxy did not vote to continue the existence of the Partnership or to elect a new general partner. The sole remaining entity that once constituted Leaservice is winding up the business of the Partnership. 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 disclosures 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. ALLOCATION OF INCOME AND LOSSES - Net income is allocated 15% to the General Partner, and 85% to the Limited Partners. Net losses incurred as a result of operations are allocated 1% to the General Partner, and 99% to the Limited Partners. DISTRIBUTIONS - To the extent that cash available for distribution allows, distributions to limited partners will not be less than an amount equal to 50% of the limited partners' share of the net income of the Partnership. LEASERVICE INCOME FUND - I (A CALIFORNIA LIMITED PARTNERSHIP) NOTES TO FINANCIAL STATEMENTS FINANCIAL INSTRUMENTS - Financial instruments include cash and accrued expenses. The amounts reported for financial instruments are considered to be reasonable approximations of their fair values, based on market information available to management. CASH AND CASH EQUIVALENTS - Includes cash and interest bearing deposits with original maturity dates of less than 90 days. The Partnership maintains its cash balances in a financial institution which is insured by the Federal Deposit Insurance Corporation for up to $100,000. At December 31, 1993, the Partnership had uninsured balances totalling approximately $121,000. INCOME TAXES - Leaservice Income Fund - I is classified as a partnership for Federal income tax purposes. Net income and losses are allocated between the General and Limited Partners in the same ratio as for financial reporting purposes. RECLASSIFICATION - Certain amounts in the 1992 financial statements have been reclassified for comparability. Note 2 - Operations: The Partnership has not purchased any equipment subject to operating leases since June 1986 and no equipment was held for rental under operating leases at December 31, 1993. During 1993, fully depreciated equipment previously held for rental under operating leases with a cost of $104,197 was written off as none of the equipment was reclaimed from the lessees. Customer deposits totalling $81,212 which were to be applied to the final month's rent upon termination of the lease have been recognized as income during the year ended December 31, 1993. Note 3 - Partners' Equity (Deficiency): From August 8, 1983 to October 9, 1984, the expiration date of the offering, Limited Partners representing 76,328 units were admitted to the Partnership. As a result thereof, the Partnership realized net proceeds of $7,022,176 from the sale of such units. Pursuant to the limited partnership agreement, Leaservice receives from the Partnership as General Partner, a quarterly management fee equal to 3% of the Partnership's gross revenues derived from full payout leases, 6% of the Partnership's gross revenues derived from operating leases and 3% of the Partnership's gross revenues derived from the sale of equipment. For the years ended December 31,1993, 1992 and 1991, terms of such agreement amounted to $-0-, $-0- and $1,283, respectively. Net income is allocated 15% to the General Partner and 85% to the Limited Partners. In addition, the General Partner is entitled to receive an annual cash distribution an amount equal to 15% of the Partnership's net income subject to certain limitations. Net losses are allocated 1% to the General Partner and 99% to the Limited Partners. LEASERVICE INCOME FUND - I (A CALIFORNIA LIMITED PARTNERSHIP) NOTES TO FINANCIAL STATEMENTS Organization and offering expenses up to a maximum of 3% of the gross proceeds of the offering have been reimbursed to the General Partner by the Partnership from the proceeds of the public offering. Net income (loss) per weighted average limited partnership unit has been computed based on the weighted average number of limited partnership units outstanding as of the first day of each month during the years ended December 31, 1993, 1992 and 1991. LEASERVICE INCOME FUND - I (A CALIFORNIA LIMITED PARTNERSHIP) PROPERTY, PLANT AND EQUIPMENT COMPUTER EQUIPMENT HELD FOR RENTAL: December 31, 1991: Balance, Additions Balance, Beginning of Period at Cost Disposals End of Period ------------------- ----------- ----------- ------------- $ 1,275,132 $ -- $(1,170,935) $ 104,197 ----------- ----------- ----------- ----------- December 31, 1992: Balance, Additions Balance, Beginning of Period at Cost Disposals End of Period ------------------- ----------- ----------- ------------- $ 104,197 $ -- $ -- $ 104,197 ----------- ----------- ----------- ----------- December 31, 1993: Balance, Additions Balance, Beginning of Period at Cost Disposals End of Period ------------------- ----------- ----------- ------------- $ 104,197 $ -- $ 104,197 $ -- ----------- ----------- ----------- ----------- See the accompanying notes to financial statements. LEASERVICE INCOME FUND - I (A CALIFORNIA LIMITED PARTNERSHIP) ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT COMPUTER EQUIPMENT HELD FOR RENTAL: December 31, 1991: Additions Charged Balance, to Costs Balance, Beginning of Period and Expenses Retirements End of Period ------------------- ------------ ----------- ------------- $ 1,275,132 $ -- $(1,170,935) $ 104,197 ----------- ----------- ----------- ----------- December 31, 1992: Additions Charged Balance, to Costs Balance, Beginning of Period and Expenses Retirements End of Period ------------------- ------------ ----------- ------------- $ 104,197 $ -- $ -- $ 104,197 ----------- ----------- ----------- ----------- December 31, 1993: Additions Charged Balance, to Costs Balance, Beginning of Period and Expenses Retirements End of Period ------------------- ------------ ----------- ------------- $ 104,197 $ -- $ 104,197 $ -- ----------- ----------- ----------- -----------
778439_1993.txt	778439	1993	ITEM 1. BUSINESS INTRODUCTION Rayonier Timberlands, L.P. (the Partnership or RTLP) is a Delaware limited partnership formed by Rayonier Inc. (Rayonier) in October 1985 to succeed to substantially all of Rayonier's timberlands business. Rayonier Forest Resources Company (RFR or Managing General Partner), a wholly owned subsidiary of Rayonier formed in September 1985, is the Managing General Partner of the Partnership and Rayonier is the Special General Partner. On November 19, 1985, Rayonier contributed approximately 1.19 million acres of its timberlands owned in fee or held under long-term leases (the Timberlands) to the Partnership in exchange for 20,000,000 Class A Depositary Units (Class A Units) representing Class A limited partners' interests in the Partnership and 20,000,000 Class B Depositary Units (Class B Units) representing Class B limited partners' interests in the Partnership. Also on such date, in a registered public offering, Rayonier offered and sold 5,060,000 Class A Units. Therefore, at all times after such date to and including December 31, 1993, Rayonier has held 74.7 percent of the Partnership's issued and outstanding Class A Units and 100 percent of the Partnership's issued and outstanding Class B Units. On February 28, 1994, ITT Corporation (ITT), Rayonier's sole shareholder, distributed all the Common Shares of Rayonier to ITT's shareholders. In connection with the distribution, Rayonier changed its name from ITT Rayonier Incorporated to Rayonier Inc. and became a publicly traded company listed on the New York Stock Exchange under the symbol "RYN". RTLP will continue to be listed separately and trade under the symbol "LOG." Class A unitholders' financial interest will not be affected in any manner by ITT's distribution of Rayonier to its shareholders. DESCRIPTION OF BUSINESS The Partnership is engaged in the timberlands business, which includes forestry management, reforestation, timber thinning and the marketing and sale of standing timber from the Timberlands. The Partnership will occasionally purchase, for short term resale, standing timber from other ownerships. The Partnership's business plan is to operate the Timberlands for sustained long- range harvest and to satisfy the Partnership's need to generate regular cash flow in light of its cash distribution policy as determined from time to time by the Managing General Partner's Board of Directors. The Partnership operates through Rayonier Timberlands Operating Company, L.P. (the Operating Partnership or RTOC), a Delaware limited partnership formed by Rayonier in October 1985 in which the Partnership holds a 99 percent limited partner's interest. RFR is the Managing General Partner of the Partnership and the Operating Partnership, and Rayonier is the Special General Partner of both partnerships. As general partners, Rayonier and RFR hold an aggregate 1 percent interest in each partnership and, therefore, have an aggregate 1.99 percent interest in the Partnership and the Operating Partnership on a combined basis. Unless the context otherwise requires, all references in this Form 10-K to the Partnership are also references to the Operating Partnership. The Partnership negotiates and contracts for the sale of standing timber (stumpage) with buyers who generally cut and pay for the trees during the contract period. Current contracts usually entail a 20 percent deposit and/or performance bond and generally have a 12 to 24 month life. The Partnership conducts, or contracts for third parties to conduct, harvesting operations if the Managing General Partner believes that the timber cannot be sold as profitably as stumpage or that the tract in question is particularly environmentally sensitive. In addition, the Partnership may sell or exchange portions of the Timberlands and acquire additional timber properties for cash, additional Units or other consideration. Partnership sales to Rayonier for use in Rayonier's specialty pulp, log trading and wood products businesses are an important contributor to Partnership results. For further information, see "Timber Markets and Sales; Affiliated Party Transactions." - 1 - In 1993, two customers under common ownership (not affiliated with the Partnership) accounted for approximately 15 percent of total revenues while in 1992 two unaffiliated customers accounted for approximately 34 percent of total revenues. See Item 7 - "Management's Discussion and Analysis of Financial Condition and Results of Operations - Results of Operations." No unaffiliated customer accounted for sales in excess of 10 percent of total revenues in 1991. The Partnership and the Operating Partnership have no officers, directors or employees; in addition, RFR has no employees. Officers of RFR and officers and employees of Rayonier perform all management functions for the Partnership. As of December 31, 1993, Rayonier had approximately 2,600 employees of which approximately 150 are active in its Forest Resources Division. FORESTRY OPERATIONS The Partnership's forest management operations and harvesting schedules are based on biological information, environmental issues, and other data concerning species, site index, classification of soils, estimates of timber inventory and the types, size and age classification of the timber base. From this information the Partnership routinely refines its long-term harvest schedule based on existing and anticipated economic and market conditions, with a view toward maximizing the value of its timber and timberland assets. Particular forestry practices vary by geographic region and depend upon factors such as soil productivity, tree size, age and stocking. Forest stands may be thinned periodically to improve stand quality until they are harvested. Different areas within a forest may be planted or seeded in successive years to provide a distribution of age classes within the forest. A distribution of age classes will tend to provide a regular source of cash flow as the various timber stands reach harvestable age. The Partnership's forest management practices include thinning of timber stands, controlled burning, fertilization of timber plantations, disease and insect control and reforestation. Reforestation activities include intensive land preparation and planting. The Partnership has a fully established tree improvement program in the Southeast which, in conjunction with its seed orchards and seedling nursery, supplies up to 100 percent of the annual planting requirements with first and second generation genetically improved planting stock. The Partnership also maintains a genetics program in the Northwest, but it cannot yet fully supply that region's seedling needs. The Partnership's activities include the maintenance and building of roads as necessary for timber access within the Timberlands. In the Northwest either the Partnership or the timber purchaser will build and maintain roads, depending on contract requirements. In the Southeast it is typically the obligation of the landowner. Each of the major regions within the Timberlands has well established road systems that permit access to substantially the entire area throughout the year. The Timberlands contain over 4,000 miles of roads that, together with public roads and roads built by other private landowners, provide such access. The timing of harvest of merchantable timber depends in part on the maturing cycles of timber and on economic conditions. Timber on the Partnership's 369,000 acres of timberlands in the state of Washington (the Northwestern Timberlands), consisting predominantly of conifer species, is currently thinned at approximately 15 years of age and is harvested after attaining approximately 45-50 years of age. The Partnership's long standing policy has been to reach a sustainable annual harvest level in the Northwest by gradually reducing its harvest volume each year. Although 1994's harvest volume is expected to include 1993's shortfall, management's projection of the annual harvest in this region from 1995 through 2000 remains at approximately 80 percent of the 1992 harvest. Timber on the Partnership's 793,000 acres of timberland in Georgia, Florida and South Carolina (the Southeastern Timberlands) typically has a shorter maturity cycle than timber in the Northwestern United States. Pine plantations in the Southeastern Timberlands are harvested after they reach approximately 20-25 years of age. Due to intensive forest and land management as well as silvicultural investment, pine volume available for harvest on the Southeastern Timberlands is expected generally to increase 2 to 3 percent annually. See Item 7 - "Management's Discussion and Analysis of Financial Condition and Results of Operations - Results of Operations." By the year 2000, the annual pine harvest rate in this region is now expected to be nearly 16 percent greater than the 1993 harvest. See "Federal and State Regulation" for a description of issues which may impact Partnership's timber harvest rates. DESCRIPTION OF TIMBERLANDS The Timberlands consist of approximately 1.16 million acres, as of December 31, 1993, located in the state of Washington, primarily on the Olympic Peninsula, and in Georgia, Florida and South Carolina. Approximately 1.03 - 2 - million acres are owned in fee, while approximately 137,000 acres are held under long-term lease. Each of these regions contains tracts of timber located within the operating radius of a number of pulp and paper mills, sawmills, plywood mills, and wood treating plants. ACREAGE. The following table sets forth, as of December 31, 1993, the location and type of ownership that the Partnership has with respect to the Timberlands. 1 The long-term leases permit the Partnership as lessee to manage and harvest timberlands throughout the term of the lease. These leases typically have initial terms of approximately 30 to 65 years, with renewal provisions in some cases. The remaining portions of the initial terms of these leases averaged 23 years as of December 31, 1993. Annual rentals are paid to the lessor and, in some cases, the leases provide for payment of a percentage of stumpage values to the lessor as timber is cut. In addition, the leases impose certain duties on the lessee regarding management and reforestation of the leased acres. In general, leased acreage has less value than the same acreage would have if owned in fee because of the obligations imposed upon the lessee under the terms of the lease. TIMBER INVENTORY. The Timberlands owned in fee or held under long-term leases include, as of December 31, 1993, total estimated merchantable timber inventory of approximately 10.3 million cunits of wood, of which approximately 81 percent is softwood (see definition of "Merchantable Timber"). A cunit represents 100 cubic feet of fiber and is the customary common unit of measure to consolidate regional information based on local commercial measurements such as board feet or tons. The following table sets forth the volumes of merchantable timber on the Timberlands by location and type, as of December 31, 1993. 1 The merchantable timber inventory volumes represent estimates by the Partnership for management purposes based on its continuing inventory system, which involves periodic statistical sampling of the Timberlands, with updating adjustments made on the basis of growth estimates and harvest information. It is not a reflection of the amount of timber that will be available to cut in any specific period of time (see "Forestry Operations") as future growth is not predicted. - 3- THE NORTHWESTERN TIMBERLANDS. The Northwestern Timberlands are located in Washington, primarily on the Olympic Peninsula. All of these Timberlands are owned in fee. The Northwestern Timberlands include approximately 314,000 acres of conifer (softwood) stands, approximately 74 percent of which is stocked with hemlock and the remainder of which is stocked with Douglas fir, western red cedar and white fir. The Northwestern Timberlands also include approximately 18,000 acres of hardwood timber stands, consisting principally of alder and maple, with lesser amounts of conifers. The remaining 37,000 acres are classified as non-forest lands. Rain, site and soil conditions typically cause softwood timber in the Northwest, particularly hemlock, to maintain a relatively high growth rate for a longer period of time in comparison with softwood timber in other parts of the United States, resulting in longer rotation cycles. Site indices for conifer lands in the Northwestern United States generally range from 90 to 145, and average approximately 105. The average site index of the conifer lands in the Northwestern Timberlands is also 90 to 145 and averages approximately 110. The Northwestern Timberlands are near ocean ports and are well-positioned to serve the Pacific Rim export market. Approximately 70 percent of the timber sold from the Northwestern Timberlands has been of export quality. Rayonier operates a pulp mill at Port Angeles. There are also eight pulp and paper mills and numerous sawmills, plywood plants, and other wood converting facilities in the region. THE SOUTHEASTERN TIMBERLANDS. The Southeastern Timberlands are located in Georgia, Florida and South Carolina and include approximately 656,000 acres of timberlands owned in fee and approximately 137,000 acres held under long-term leases. The Southeastern Timberlands include approximately 508,000 acres of pine (softwood) lands, approximately 270,000 acres of hardwood lands and approximately 15,000 non-forest acres. The predominant pine species are loblolly and slash pine. Site indices for pine lands in the Southeastern United States generally range from 55 to 65 and average approximately 60. The pine lands included in the Southeastern Timberlands have an average site index of 60. Hardwood lands included in the Southeastern Timberlands are principally bottomlands. Principal hardwood species are red oak, sweet gum, black gum, red maple, cypress and green ash. The Southeastern region is generally recognized as being the most competitive timberlands area in the United States. There are 19 pulp and paper mills and numerous sawmills, plywood plants and treating plants for poles and pilings located in the area of the Southeastern Timberlands. Rayonier operates two sawmills and two pulp mills in this region. STUMPAGE PRICES AND INDUSTRY CONDITIONS Stumpage prices vary depending on the market for end use products which rely on timber and wood fiber as raw materials. Stumpage values tend to be higher for larger diameter trees because of higher value end uses. Larger diameter trees are used as sawtimber which is processed into lumber, plywood, and poles, while smaller diameter trees are used as pulpwood for the manufacture of paper and pulp. International, as well as domestic, supply and demand forces (including the value of the U.S. dollar in foreign exchange markets) also affect U.S. regional stumpage prices. Local stumpage prices are dependent upon factors such as geographic location of the property, proximity to a mill or export facility, logging conditions, accessibility of the timber, size and quality of the timber, species composition of the stand and the timber volume per acre. The Northwest and the Southeast represent major timber growing regions of the United States. In both areas, timber markets are very competitive, but each region has different types of timber, markets and competitive factors. For further information see Item 7 - "Management's Discussion and Analysis of Financial Condition and Results of Operations - Results of Operations" and "Future Operations." - 4 - COMPETITION Timber and wood fiber consuming facilities tend to purchase raw materials within relatively small geographic areas, generally within a 100 mile radius. Competitive factors within a market area generally will include price, species and grade, proximity to wood consuming facilities and ability to meet delivery requirements. The Partnership competes in the timber market with numerous private industrial and non-industrial land and timber owners as well as with the Department of Natural Resources of Washington State and the U.S. Government, principally the U.S. Forest Service and the Bureau of Land Management. Currently, timber availability continues to be restricted by legislation, litigation and pressure from various preservationist groups. See "Federal and State Regulation." TIMBER MARKETS AND SALES; AFFILIATED PARTY TRANSACTIONS The Partnership sells timber provided by the Timberlands to Rayonier and to unaffiliated domestic purchasers. See "Stumpage Prices and Industry Conditions" for a discussion of end-use markets for the Partnership's timber. Since the inception of the Partnership, 38 percent of its timber sales in the Northwest and 14 percent of its timber sales in the Southeast have been to Rayonier. The following table shows the volumes of timber sold by the Partnership to Rayonier for the three years ended December 31, 1993. It also shows the volumes of timber on the Timberlands that were sold to unaffiliated purchasers for the periods indicated. Rayonier continues to rely on the Timberlands as one of its major sources of timber for its pulp mills, sawmill facilities and its log export business. For example, although Rayonier purchased directly only 13 percent of the Partnership's 1993 Southeast harvest volume, the Partnership estimates that an additional 9 percent of its pulpwood timber sold in the Southeast in 1993 was purchased by Rayonier on the open market from Partnership customers. See "Conflicts of Interest." Any shutdowns of plants or curtailments of sales by customers for Partnership timber, including Rayonier, could adversely affect future volumes of timber sales by the Partnership or the prices at which such sales are made. Rayonier's Forest Resources Division is responsible for management of the Timberlands for the benefit of the Partnership; its organization is separate from Rayonier's log export and wood procurement organizations, which are responsible for timber procurement by Rayonier. In conducting the activities described in the following paragraphs with respect to negotiations and other relationships between the Partnership and Rayonier, employees of Rayonier's Forest Resources Division act on behalf of the Partnership and employees of Rayonier's log export and wood procurement organizations act on behalf of Rayonier. The Partnership develops an annual sales plan identifying the specific tracts to be sold. The Partnership's strategy is to award contracts during those periods of the year (typically the first and fourth quarters) in which it expects to receive the best prices. However, under current market conditions, the Partnership is placing fewer sales out for bid at one time. See Item 7 - "Management's Discussion and Analysis of Financial Condition and Results of Operations - Results of Operations." - 5 - Before the Partnership offers a tract for sale, it determines whether the highest price is likely to be achieved through public bid or direct negotiation. The decision considers such factors as timber quality, unusual logging conditions, number of potential bidders, and general market activity. In 1993, approximately 95 percent in the Northwest and 73 percent in the Southeast of the total contract value of contracts entered into by the Partnership were awarded through public bid; when Rayonier submits a bid, it is treated no differently than bids from unaffiliated parties. Occasionally, tract and market circumstances favor a negotiated sale to a target buyer. Of the contract value awarded through direct negotiation in 1993, approximately 7 percent in the Southeast were purchased by Rayonier. In 1993, there were no directly negotiated sales with Rayonier in the Northwest. Typically, the Partnership attempts to structure sales contracts with Rayonier and unaffiliated purchasers as transactions in which the Partnership retains title to timber until it is severed and the purchaser assumes responsibility for delivery. In these cases the Partnership recognizes income for both financial statement and tax purposes when and as the timber is cut and measured. Accordingly, there is a time lag between the signing of a sales contract and the recognition by the Partnership of income therefrom. The Partnership's contracts, whether with Rayonier or with unaffiliated purchasers, generally provide for payment of a fixed price per unit (by species and volume in the Northwest and by weight in the Southeast), cutting over periods of up to 24 months in the Northwest and up to 18 months in the Southeast, an initial deposit and utilization standards which the buyer must satisfy when cutting and removing timber from the property. The Partnership's contracts with unaffiliated purchasers may require a performance bond from the buyer, whereas the Partnership does not require such a bond from Rayonier. All contracts between Rayonier and the Partnership are subject to review by the Conflicts Committee established by RFR's Board of Directors. See "Conflicts of Interest." For information as to timber sales contracts in effect at December 31, 1993, see Item 7 - "Management's Discussion and Analysis of Financial Condition and Results of Operations - Results of Operations." CONFLICTS OF INTEREST Conflicts of interest can arise in selecting, pricing and scheduling timber sold to Rayonier. Other conflicts of interest can arise in allocating revenues and costs between the Class A Units and the Class B Units, in scheduling timber sales to occur before or after the Initial Term expires, and in setting the terms of any loans between the Partnership and Rayonier. The Conflicts Committee of the Board of Directors of RFR, which is comprised of non-employee directors, reviews these transactions and obtains opinions from outside consultants as to their fairness. ENVIRONMENTAL PROTECTION Management of the Timberlands to protect the environment is a continuing concern of the Partnership. The Partnership expends considerable efforts to comply with regulatory requirements for the use of pesticides and minimization of stream sedimentation and soil erosion. From time to time the Partnership volunteers to, or may be required to, clean up certain dump sites created by the general public. The Partnership also participates in cooperative projects with environmental agencies such as a program with the Georgia Department of Natural Resources to monitor hairy rattleweed, a threatened species, and another effort with the U.S. Fish and Wildlife Service to develop an information base on whether Bartram's Ixia constitutes an endangered species. See "Federal and State Regulation." The costs of environmental compliance by the Partnership have not been significant and are not expected to be significant in the future. The Partnership does not project any significant capital expenditures for environmental protection. - 6 - FEDERAL AND STATE REGULATION In the management and operation of the Timberlands, the Partnership is subject to various state and federal laws regulating land use. To some degree, these laws may operate as constraints on the manner in which portions of the Timberlands are managed and operated and the markets into which the timber from the Timberlands may be sold. Regional timber availability continues to be restricted by legislation, litigation and pressure from various preservationist groups. Over the past three years, harvest of timber from private lands in the state of Washington has been restricted as a result of the listing of the northern spotted owl as a threatened species under the Endangered Species Act (ESA). These restrictions have caused the Partnership to restructure and reschedule some of its harvest plans. The U.S. Fish and Wildlife Service (FWS) is developing a proposed rule under the ESA to redefine protective measures for the northern spotted owl on private lands. This rule, as currently drafted, would reduce the harvest restrictions on private lands except within specified Special Emphasis Areas, where restrictions would be increased. One proposed Special Emphasis Area is on the Olympic Peninsula, where a significant portion of the Partnership's Washington timberlands is located. The new rule may also include guidelines for the protection of the marbled murrelet, also recently listed as a threatened species. Separately, the state of Washington Forest Practices Board is in the process of adopting new harvest regulations to protect the northern spotted owl and the marbled murrelet. The state Department of Natural Resources draft of this rule also provides for a special emphasis area to protect the northern spotted owl on the Olympic Peninsula, which would increase harvest restrictions on the Partnership's lands. The Partnership is unable at this time to predict the form in which the federal or state rules will eventually be adopted. However, if either rule is adopted in the form proposed by the respective agencies, the result will be some reduction in the volume of Partnership timber available for harvest. The Partnership's operations are subject to laws restricting or regulating to some extent development and/or logging activity near coastal shorelines. In addition, land located in areas exposed to flood hazard are subject to regulations specifying acceptable types of development. The federal government regulates the use of "wetlands" pursuant to the Clean Water Act, the Rivers and Harbors Act and the Federal Water Pollution Control Act. The Timberlands include property designated as wetlands, and the Partnership is subject to permit procedures imposed by both federal and state agencies in connection with any logging or developmental activity on such land. In addition, activity is regulated on lands adjacent to scenic rivers designated under federal and state Wild and Scenic Rivers Acts. Reforestation by independent contractor crews is regulated by the federal Migrant and Seasonal Worker Protection Act, which imposes upon the landowner the burden of insuring to the federal government regulatory compliance by the contractor. Portions of the Timberlands are located within, or adjacent to, National Forests. Access to such parcels may be obtained generally through road use permits subject to the terms and conditions of applicable regulations. Access across Forest Service land may be restricted where habitat of threatened or endangered species is involved. The state of Washington has enacted several laws that regulate or limit forestry operations. The most comprehensive of these is the Forest Practices Act, which addresses many growing, harvesting and processing activities on forest lands. Among other requirements, the Forest Practices Act imposes certain reforestation obligations on the owner of forest land. The Act restricts the size of clear-cut harvests, restricts timber harvest to protect wildlife listed as threatened or endangered and requires that timber be left standing in stream buffers and wildlife management areas. Other Washington state laws regulate timber slash burning, operations during fire hazard periods, logging activities affecting or utilizing watercourses or in proximity to certain ocean and inland shorelines and some grading and road construction activities. The states of Georgia and Florida also regulate forestry operations. Subsequent to July 1, 1993, Georgia statutory law mandates all timber sales to be by tonnage or actual measured volume, prohibiting sales where payment is based upon conversion factors from volume to tonnage or vice-versa. Florida and Georgia both regulate slash burns, control burns and logging activities within streamside management zones. Florida law and regulation limits activities allowable or permittable in wetlands, and is developing integrated regulations under statutory mandate for ecosystem management. Under one such rule, the St. Johns Water Management District (a semi-autonomous Florida agency whose regulatory jurisdiction includes much of the Partnership's Florida timberlands) published regulations for July 1, 1994 implementation which would regulate timber road grading, construction, maintenance and management and a variety of surface water management restrictions. The final form of the rule may change before implementation, however the District must have an ecosystem management rule of this sort adopted by July 1, 1994. The Partnership is complying, and intends to comply, with these Federal and state laws regulating its use of the Timberlands and does not expect them, as currently enacted, to be materially burdensome. There can be no assurance, however, that future legislative, regulatory or judicial decisions would not adversely affect the Partnership or its ability to harvest the Timberlands in the manner otherwise contemplated. In particular, although recently imposed restrictions on - 7 - the export of logs from the Northwest have only affected state lands, political pressure to restrict log exports from the Northwest continues. If in the future restrictions should be imposed on the export of logs from private lands, the revenue and earnings of the Partnership could be adversely affected. PARTNERSHIP'S TITLE; CLAIMS AND INTERESTS OF OTHERS Rayonier transferred record title to the Timberlands, excluding any oil, gas or mineral interests, to the Partnership without warranty. The Partnership's title to the Timberlands is subject to presently existing easements, rights of way, flowage rights, servitudes, cemeteries, camp sites, hunting and other leases, licenses, permits, undertakings and any other existing encumbrances or title defects. Properties acquired by the Partnership in the future generally will be acquired and held on record in the Partnership's name, but Rayonier will have the right to purchase the underlying mineral interests. The Partnership owns only the merchantable timber rights (except for 50 trees per acre) on approximately 18,000 acres of real estate owned by Rayonier and Rayland Company, Inc., a real estate subsidiary of Rayonier. Pursuant to the right given to it under the Partnership Agreement, Rayonier has withdrawn 3,309 acres of the Southeastern Timberlands from the Partnership. This withdrawal will not have a material impact on Partnership operations during the Initial Term of the Partnership and was reviewed by the Conflicts Committee of the Board of Directors of RFR. The state of Florida claims title to lands within Florida that were under navigable waters in 1845 when Florida became a state. Affected lands include not only those still under water but lands that are now uplands due to drainage, fill or other category. The Partnership does not believe that the encumbrances or defects to which its title is subject or any possible reclamation by the state of Florida would have a material adverse impact on the Timberlands as a whole. DESCRIPTION OF PARTNERSHIP ALLOCATIONS OF PARTNERSHIP INTEREST. The Partnership records all of its activities in two accounts, the Primary Account and the Secondary Account. Income and expenses are recorded in the Primary Account if they affect timber that is expected to be harvested on or before December 31, 2000 (the Initial Term), and in the Secondary Account if they relate to the Partnership's other assets (including timber that is not planned to be harvested until after December 31, 2000). During the Initial Term, the Secondary Account is essentially an investment account to which the expenditures and debt related to longer-term harvests are assigned. The Class A unitholders, the Class B unitholders, and the General Partners all participate in both accounts, but in different percentages. The participation of the partners in the revenues and expenses of the Partnership is as follows: Primary Secondary Account Account ------- --------- Class A unitholders 95% 4% Class B unitholders 4% 95% General Partners 1% 1% When the Partnership makes a sale of timberland that includes timber, the proceeds are divided between the Primary and Secondary Accounts. Proceeds arising from trees that would have been harvested prior to December 31, 2000 are allocated to the Primary Account. The balance of the proceeds, which apply to the underlying land and timber planned to be harvested beyond the year 2000, are allocated to the Secondary Account. TERMS OF THE PARTNERSHIP AGREEMENT. The Partnership Agreement provides that the Partnership continues in existence until December 31, 2035, but that the Initial Term of the Partnership will end on December 31, 2000. At the end of the Initial Term there will be no distributions of the partners' capital accounts, but the Primary Account will be closed following distribution of any cash remaining in that account (after the repayment of all Partnership borrowings attributed to the Primary Account) concurrently to all partners in accordance with their respective Primary Account percentage interests as indicated in the above table. The Managing General Partner expects that most of the cash credited to the Primary Account (and not used to repay borrowings) will have been distributed prior to the end of the Initial Term. Therefore, unitholders should not expect to receive a return of their original investment, or any substantial amount of cash, as a result of the end of the Initial Term on December 31, 2000. After 2000, all unitholders and General Partners will only participate in the Secondary Account, so that Class A unitholders will then have a 4 percent interest in all Partnership activities. Through the Initial Term, the Secondary Account will incur substantial debt attributable to reforestation and the - 8 - management of the timber base to be cut after the year 2000. This debt will have to be repaid from future cash flow beginning in 2001 and will reduce the amount available for distribution after the end of the Initial Term. CLASS A UNITHOLDERS SHOULD EXPECT THAT THE MARKET PRICE OF CLASS A UNITS WILL BEGIN TO DECREASE SUBSTANTIALLY SOMETIME PRIOR TO DECEMBER 31, 2000. AS INDICATED ABOVE, THEY WILL PROBABLY NOT RECEIVE ANY SIGNIFICANT AMOUNT OF CASH AS A RESULT OF THE END OF THE INITIAL TERM IN THE YEAR 2000. THE PERCENTAGE OF CASH AVAILABLE TO THEM FROM PARTNERSHIP HARVESTING ACTIVITIES AFTER THAT YEAR (AFTER ALLOWING FOR THE REPAYMENT OF SECONDARY ACCOUNT DEBT) WILL DECLINE FROM 95 PERCENT TO 4 PERCENT. DISTRIBUTIONS. A unitholder (Limited Partner) of Rayonier Timberlands, L.P., assuming there are sufficient sales and profits, will receive cash distributions from the Primary Account activity. In accordance with the Partnership Agreement, the distribution policy is to make quarterly distributions to Class A unitholders from cash available from operations after provision for working capital, capital expenditures, asset acquisitions and such other reserves as the Managing General Partner's Board of Directors deems appropriate. On February 8, 1994, the Board declared a special distribution of $4.00 per Class A Unit, payable on March 31, 1994 to unitholder's of record February 28, 1994. A portion of these distributions represents a return of capital, depending on each unitholder's tax basis. The special distribution was declared since the Managing General Partner estimated that cash and investment balances were substantially in excess of funding requirements for the balance of the Initial Term ending December 31, 2000. As of March 31, 1994, approximately $1.00 per Class A Unit will remain for capital expenditure, working capital and other funding requirements. TAXES. Rayonier Timberlands, L.P., is a partnership and is not taxed as a corporation. Each unitholder is responsible for taxes on his or her proportionate share of the Partnership's income. Each year, the Managing General Partner will provide unitholders with the necessary tax information based on the unitholder's apportioned share of income and expense from the Partnership. The income reported for each individual unitholder will vary substantially from the income reported in the financial statements, as the unitholder's income is based on his or her costs of acquisition (the market price of the unit at the time of acquisition), and not on the Partnership's historical cost basis as reported in the financial statements. During 1993, the Partnership made distributions totaling $4.60 per Class A Unit. TO THE EXTENT DISTRIBUTIONS EXCEED THE INCOME REPORTED FOR A UNITHOLDER AND THE UNITHOLDER HAS REMAINING TAX BASIS IN THE UNITS, SUCH DISTRIBUTIONS ARE TREATED AS A RETURN OF CAPITAL AND ARE NOT TAXABLE. As such, the distributions serve to reduce the unitholder's basis in the units. For tax-exempt entities (including individual retirement accounts (IRAs) and other retirement plans) that acquired Partnership units after December 17, 1987, the gross income through 1993 attributable to their investment in the Partnership constitutes unrelated business taxable income. Such entities may be required to report income from the Partnership to the Internal Revenue Service and to pay taxes on such income. Beginning with 1994, only a small portion of the Partnership's income will constitute such unrelated business income. - 9 - GLOSSARY OF FORESTRY TERMS The terms defined below relate to the timber industry in general. BOARD FOOT (BF): A unit of measure for sawtimber as well as lumber which is 12 inches square and one inch thick. BOTTOMLANDS: The flood plains of streams, creeks and rivers which generally support quality hardwood stands. CLEAR-CUT: Harvesting all trees in a stand of timber at the same time. Usually done to prepare for establishing a plantation or for converting the land to crop, pasture or other use. CONTROLLED BURNING: Setting fire to the forest floor to reduce the accumulation of logging debris, dead and fallen timber, weeds and underbrush which pose a wildfire hazard or compete with the trees for water and nutrients. CORD: A unit of measure equal to a stack of wood 4x4x8 feet, or 128 cubic feet of wood, bark and air. A common unit of measure for pricing pulpwood. CUNIT: A unit of measure for standing timber equal to one hundred cubic feet of solid wood. It is the customary common unit of measure to consolidate regional information based on local commercial measurements such as board feet or tons. A cunit equals approximately .43 MBF or 3.83 tons. CUTTING CONTRACTS: A contractual right to cut certain described timber over a specified period of time on a specified tract of property. D.B.H.: The abbreviation means "diameter at breast height," a term frequently used to describe a tree measurement taken 4 1/2 feet above the average ground level. HARDWOODS: Trees that usually have broad leaves and are deciduous (losing leaves every year). MBF: One thousand board feet. A common unit of measure for pricing standing timber as well as lumber. MERCHANTABLE TIMBER: Minimum size timber for which there might be a commercial market. In the South, trees as small as five inches D.B.H. can be used by the industry while in the Northwest trees must be much larger to be usable. For convenience, the Partnership follows the convention that timber older than 13 years in the Southeast and 40 years in the Northwest is of minimum merchantable size. It should be recognized that timber of minimum merchantable size has not yet reached its optimum economic value and the typical harvest cycle is about 25 years in the Southeast and 55 years in the Northwest. NATURAL REGENERATION: The process of a forest regenerating itself with seeds from mature trees or sprouts from stumps or roots. Natural regeneration results in new tree growth without regard to genetic quality of the trees. NATURAL STAND: A forest stand resulting from natural regeneration. NON-FOREST LANDS: Lands consisting of or containing roads, water or easements, such as gas and electric transmission lines, timbered buffers not harvested due to environmental concerns, currently non-commercially viable acreage and certain wastelands. PLANTATION: A timber stand established by planting seedlings in a prepared seedbed. Trees in a plantation are of the same age and size, which tends to simplify harvesting. POLES: Straight, tall trees suitable for manufacturing telephone poles, wharf pilings or the like, typically at least eight inches in diameter at the base and at least 25 feet tall. Trees suitable for use as poles generally command a superior price. PRE-MERCHANTABLE TIMBER: Usually young, or small size timber for which no commercial market exists. For example, in the Southeast, pine trees under five inches D.B.H. and in the Northwest, timber stands less than 40 years of age. PULPWOOD: Wood used to produce pulp in the manufacture of paper and other cellulose products; normally cut from trees that are approximately five to eight inches D.B.H., or trees over eight inches D.B.H. which are either too small, of inferior quality or the wrong species to be used in the manufacture of lumber or plywood. - 10 - SAWTIMBER: Trees containing logs of sufficient size and quality to be suitable for conversion into lumber or plywood. SEEDLINGS: Live trees less than one inch in diameter at ground level. SILVICULTURE: The practice of cultivating forest crops based on the knowledge of forestry; more particularly, controlling the establishment, composition and growth of forests. SITE INDEX: A measure of forest site quality, which takes into account topography, soil fertility, moisture and other factors affecting forest growth rates. A site index indicates the height (in feet) an average dominant tree of a given species will attain on that site in a well-stocked stand in a given period, generally 50 years in the Northwest and 25 years in the Southeast. SOFTWOODS: Coniferous trees, usually evergreen and having needle or scale-like leaves, such as Douglas fir, white pine, spruce and loblolly pine. In the Pacific Northwest, softwood timber is commonly referred to as conifer. STAND: An area of trees possessing sufficient uniformity of age, size and composition to be distinguishable from adjacent areas so as to form a management unit. The term is usually applied to forests of commercial value. STOCKING: An indication of the number of trees in a stand as compared to the desirable number for best growth and management, such as well-stocked, over-stocked or partially stocked. STUMPAGE VALUE: The value of standing timber (timber as it stands uncut in the woods). SUPERIOR SEEDLINGS: Seedlings that are the product of a genetic breeding program. Superior seedlings produce trees that grow faster, are of higher quality and are more disease resistant than their ordinary counterparts. THINNING: Removal of selected trees, usually to eliminate overcrowding, to remove diseased trees and to promote more rapid growth of desired trees. TIMBER DEED: An instrument conveying certain described timber on a specific tract of property and providing a term during which the timber may be cut and removed. TIMBER INVENTORY: As defined under "Description of Timberlands - Timber Inventory." WOOD FIBER: Generally refers to pulpwood or chips used in the manufacture of pulp and paper. ITEM 2.		ITEM 2. PROPERTIES See "Item 1. Business." ITEM 3.	ITEM 3. LEGAL PROCEEDINGS The Partnership is a party to several legal proceedings incidental to its business. Neither the Partnership nor its counsel believes that any liability or costs related to such proceedings will have a material adverse effect on the financial position or results of operations of the Partnership. ITEM 4.	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the period covered by this report. - 11 - PART II ITEM 5.	ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The above table reflects the range of market prices of RTLP Class A Units as reported in the consolidated transaction reporting system of the New York Stock Exchange, the principal market in which this security is traded, under the trading symbol "LOG." During the two-month period ended February 28, 1994, the high and low market prices of RTLP Class A Units were $40.00 and $27.63. Class A Units - Distributions (dollars) --------------------------------------- 1993 1992 QUARTER ENDED ------------- March 31 $1.15 $ .90 June 30 1.15 .90 September 30 1.15 .90 December 31 1.15 .90 On February 8, 1994, the Board of Directors of RFR declared a special distribution of $4.00 per Class A Unit as well as a first quarter distribution of $1.30 per Class A Unit, payable on March 31, 1994 to all unitholders of record as of February 28, 1994. See Item 7 - "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Cash Flow." There were approximately 2,850 unitholders of record of Class A Units as of February 28, 1994. ITEM 6.	ITEM 6. SELECTED FINANCIAL DATA The selected historical financial information set forth below is derived from the financial statements of Rayonier Timberlands, L.P. Such selected historical financial information should be read in conjunction with such financial statements and notes thereto appearing elsewhere herein. - 12 - 1 The consolidated harvest activity is expressed in cunits, a unit of measure for standing timber equal to one hundred cubic feet of solid wood. A cunit is the customary common unit of measure that is used to consolidate regional information based on local commercial measurements such as thousand board feet (MBF) or tons. A cunit equals approximately .43 MBF or 3.83 tons. 2 The Northwestern Timberlands are in the state of Washington and consist of approximately 369,000 acres owned in fee, and contain approximately 2.3 million MBF of wood, approximately 92 percent of which is softwood. Stumpage volumes for 1992, 1991 and 1990 exclude the Quinault timberland sales. 3 The Southeastern Timberlands are in the states of Georgia, Florida and South Carolina and consist of approximately 793,000 acres owned in fee or held under long-term leases, and contain approximately 19.8 million tons of wood, approximately 67 percent of which is pine. - 13 - ITEM 7.	ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS In 1993, limited timber availability, particularly in the Northwest United States, fueled a period of strongly rising prices, leading to a record year in timber sales. Excluding the effect of two timberland sales that occurred in 1992, year over year partnership income increased 17 percent. The following table summarizes the sales and operating income of the Partnership, for the periods indicated, by United States geographic region (in thousands of dollars): Timber and timberland sales in 1993 of $116.0 million were $0.4 million lower than 1992 sales of $116.4 million with a current year increase of $16.3 million in timber sales offsetting $16.8 million realized in 1992 from two timberland sales. Partnership income for 1993 of $82.2 million decreased $3.4 million, or 4 percent, compared to 1992, which included $15.6 million from the timberland sales. Sales in 1992 increased 15 percent from 1991 sales of $101.2 million, and Partnership income in 1992 increased 17 percent from 1991 income of $73.0 million. Timber sales for 1993 of $114.9 million represented an increase of $16.3 million or 17 percent versus the prior year's timber sales, following an increase of 8 percent from 1991 to 1992. Higher 1993 sales reflected an overall improvement in prices due to worldwide concern over timber availability and increased harvest activity in the Southeast region, partially offset by reduced harvest volume in the Northwest region. In 1992, timber sales increased $7.4 million from 1991 levels as prices improved due to stronger demand for exportable timber from increased harvest activity in the Northwest region, partially offset by reduced harvest volume in the Southeast region. In both 1993 and 1992, timber sales to Rayonier represented 17 percent of total timber sales as compared to 32 percent in 1991. In addition, timber sales to two customers under common ownership (not affiliated with the Partnership) accounted for approximately 15 percent and 10 percent of total timber sales in 1993 and 1992, respectively. In 1992, the Partnership also had one other unaffiliated customer who accounted for approximately 12 percent of timber sales. See Note 4 of the accompanying Notes to Financial Statements for further information. Timberland sales in 1993 of $1.1 million were $16.7 million lower than 1992 levels which, in turn, were $7.8 million higher than 1991. Sales for 1992 and 1991 include $16.8 million and $8.0 million, respectively, from major timberland tract sales in the Northwest region to the Quinault Indian Nation. The two tracts sold in 1992 completed the Partnership's program to divest land within the Quinault Indian Reservation. The Quinault sales contributed $15.6 million and $7.6 million to Partnership income in 1992 and 1991, respectively. - 14 - Income per publicly traded Class A Unit was $4.45 in 1993, a decrease of 4 cents or 1 percent from 1992's income of $4.49 per Class A Unit. Excluding the effect of last year's Quinault timberland sales, income per publicly traded Class A Unit improved 57 cents. Results in 1992 reflected a per unit increase of 56 cents or 14 percent compared to the 1991's level of $3.93. Income per Class A Unit in 1992 and 1991 include 61 cents and 31 cents respectively from the timberland sales. Operating cash flow allocable to Class A unitholders, after capital expenditures and certain provisions for working capital, was $92.5 million in 1993, a decrease of $0.4 million from the 1992 level of $92.9 million, and, on a per unit basis, a decrease of 6 cents, or 1 percent, to $4.66 from the 1992 level of $4.72 per unit. Excluding the effect of last year's Quinault timberland sales, operating cash flow improved 57 cents. Operating cash flow in 1992 was $10.6 million higher than the 1991 level of $82.3 million and represented an increase of 50 cents per unit from the $4.22 generated in 1991. The amounts for operating cash flow allocable to a Class A Unit include 63 cents and 32 cents in 1992 and 1991, respectively, from the timberland sales. In the Northwest, most of the timber from Partnership lands is resold by the Partnership's customers into log export markets, primarily in Japan, Korea and China. Timber sales in the Northwest of $70.6 million increased $5.6 million from 1992 sales levels, after having increased $9.8 million from 1991 levels. Operating income in 1993 of $56.2 million decreased $12.1 million reflecting lower 1993 Northwest timberland sales. In 1992, operating income increased $16.2 million from 1991's level as a result of higher 1992 timber and timberland sales in the region. Average stumpage prices in the Northwest were 53 percent above 1992 levels as limited timber availability throughout the Northwest, due to environmental restrictions and litigation, caused contract stumpage prices to rise steadily late in 1992 and into the second quarter of 1993. During the second half of 1993 prices declined due to high consumer inventories and a marked increase in alternative global timber supplies. In 1992, average stumpage prices increased 10 percent from 1991 prices as the decline in the availability of competitive timber resulting from an overall reduced level of harvest-eligible timber, as well as environmental and legal restrictions related to the spotted owl, caused stumpage prices to increase throughout the year, particularly in the second half. Total 1993 sales volume in the Northwest of 143 million board feet represented a decrease of 27 percent from the 1992 levels as harvesting of contract timber slowed in response to changing market conditions and the Partnership's continuing program of gradually reducing the amount of timber offered in the region. See "Future Operations." This decrease followed a 5 percent increase from 1991 to 1992, as a result of customers accelerating their harvesting at the end of 1992 to take advantage of higher selling prices for logs. In the Southeast, pulpwood timber harvested from Partnership lands is sold by our customers to mills for the production of pulp and paper with sawlog timber sold to lumber and plywood manufacturers. Timber sales in 1993 in the Southeast of $44.3 million rose $10.7 million from 1992 reflecting both improved pricing and increased harvest volumes which, in turn, caused operating income in the Southeast of $33.5 million to rise $9.9 million from 1992. Timber sales of $33.6 million in 1992 declined $2.4 million from 1991 while operating income decreased $2.9 million from 1991's level of $26.5 million reflecting lower harvest volumes in 1992 partially offset by improved pricing. Southeast pine prices in 1993 were 24 percent greater than 1992 levels, benefiting from the worldwide concern over timber availability and from strong demand for lumber as a result of the resurgence in U.S. housing. In 1992, average pine prices were 6 percent higher than 1991, as log demand from lumber mills and a continuation of wet weather conditions limited the supply of available pulpwood in the region to the Partnership's primary customers. In 1993, Southeast pine volume was 1.7 million tons, increasing 7 percent from 1992. In 1992, pine volume was 13 percent below the 1991 level due to a planned reduction in available harvest volumes to balance 1991's higher than planned harvest. Corporate and other operating income is comprised of general and administrative expenses not specifically attributable to either the Northwest or Southeast region. Corporate expenses decreased $1.0 million during 1993 to $2.3 million reflecting lower commission expenses paid to a foreign sales corporation affiliated with the Partnership's Special General Partner, Rayonier Inc. (Rayonier). In 1992, corporate expenses decreased $1.0 million from 1991's level of $4.3 million reflecting lower commission and software amortization costs in 1992. Overall harvesting activity in 1993 and 1992 followed the historical cutting pattern that is more concentrated in the first half of the year, with 59 percent and 60 percent, respectively, of the total cut completed by June 30. During 1991, harvesting activity was more evenly distributed with 45 percent being cut in the first half. Early in 1991, customers in both the Northwest and Southeast regions delayed harvesting to the second half of the year due to environmental and market concerns. The Partnership is continuing its strategy of gradually reducing the amount of timber offered each year in the Northwest until it reaches a sustainable harvest level. See "Future Operations." However, because customers postponed harvesting under 1993 contracts, Northwest harvest volume in 1994 is expected to be higher than the 1993 level. At - 15 - December 31, 1993 approximately 25 percent of 1994's Northwest harvest plan, including volume remaining on delayed 1993 harvesting, was under contract compared to 49 percent of 1993's harvest that was under contract as of the prior year-end. Three customers under common ownership (not affiliated with the Partnership) accounted for approximately 78 percent of the harvest volume under contract as of December 31, 1993. Average prices on uncut contracts at December 31, 1993 were 52 percent higher than the average of harvest prices realized in 1993. The Southeast 1994 harvest plan anticipates a volume increase of approximately 6 percent versus 1993. In the Southeast, in anticipation of more favorable prices occurring early in 1994, the Partnership had awarded contracts for only 16 percent of the 1994 harvest plan volume as of December 31, 1993 as compared to 18 percent as of December 31, 1992. Two customers (not affiliated with the Partnership) accounted for approximately 12 percent and 10 percent, respectively, of the harvest volume under contract as of December 31, 1993. Average prices on uncut contracts at December 31, 1993 were approximately 2 percent higher than those realized for the 1993 actual harvest in the region. Operating costs and expenses in 1993 were $30.9 million, representing an increase of $1.1 million over 1992, after an increase of $1.0 million from 1991 to 1992. Cost of timber sold rose $2.7 million in 1993, reflecting higher logging costs in the Northwest region resulting from increased contract logging and pre-commercial thinning activities. Cost of timber sold rose $0.2 million from 1991 to 1992, reflecting the introduction of a timber severance tax on harvest volume in Georgia partially offset by lower depletion costs resulting from a decreased Southeast harvest. Cost of timberland sold decreased $1.7 million during 1993 due primarily to the Quinault timberland sales in 1992. Legislation, enacted effective August 10, 1993, eliminated tax benefits related to log exports for foreign sales corporations. Accordingly, commission expense for sales agency services, paid to a foreign sales corporation affiliated with the Partnership's Special General Partner, Rayonier, declined $1.0 million during 1993 to $0.7 million. The Partnership's commission expense had been fully allocated to Rayonier and the General Partners, and therefore the legislation did not impact the earnings or cash flows of the publicly traded Class A Units. See Note 1 of the accompanying Notes to Financial Statements for further information. Commission expense in 1992 was $0.5 million lower than 1991 due to lower timber sales to Rayonier. Interest income, earned mainly from the Primary Account's short-term investment notes of Rayonier, decreased by $0.8 million to $5.1 million in 1993 due to lower interest rates. Interest expense of $9.5 million, primarily on Rayonier's loans and advances to the Secondary Account, was $1.4 million higher than 1992 levels due to higher loan balances. FUTURE OPERATIONS The Partnership's harvesting plans and therefore its earnings and cash flow can be substantially affected by the cyclical nature of timber markets both in general and on a geographical basis. In addition, various legislative initiatives, such as major restrictions on timber clear-cutting, export restrictions on logs sourced from privately owned properties, harvest restrictions to protect threatened or endangered species and limitations on timber harvesting on wetlands, could adversely affect Partnership results. Moreover, in certain economic situations, Partnership results can be adversely affected by reductions in the rate at which stumpage is harvested as well as the failure of buyers to fulfill their contractual obligations. The Partnership's long standing policy has been to reach a sustainable annual harvest level in the Northwest by gradually reducing its harvest volume each year. Although 1994's harvest volume is expected to include 1993's shortfall, the projected annual harvest in this region from 1995 through 2000 remains at approximately 80 percent of the 1992 harvest. In the Southeast, due to intensive forest and land management as well as silvicultural investment, pine volume available for harvest is expected to increase 2 to 3 percent annually. Regional timber availability continues to be restricted by legislation, litigation and pressure from various preservationist groups. Over the past three years, harvest of timber from private lands in the state of Washington has been restricted as a result of the listing of the northern spotted owl as a threatened species under the Endangered Species Act (ESA). These restrictions have caused the Partnership to restructure and reschedule some of its harvest plans. The U.S. Fish and Wildlife Service (FWS) is developing a proposed rule under the ESA to redefine protective measures for the northern spotted owl on private lands. This rule, as currently drafted, would reduce the harvest restrictions on private lands except within specified Special Emphasis Areas, where restrictions would be increased. One proposed Special Emphasis Area is on the Olympic Peninsula, where a significant portion of the Partnership's Washington timberlands is located. The new rule may also include guidelines for the protection of the marbled murrelet, also recently listed as a threatened species. Separately, the state of Washington Forest Practices Board is in the process of adopting new harvest regulations to protect the northern spotted owl and the marbled murrelet. The state Department of Natural Resources draft of this rule also provides for a special emphasis area to protect the northern spotted owl on the Olympic Peninsula, which - 16 - would increase harvest restrictions on the Partnership's lands. The Partnership is unable at this time to predict the form in which the federal or state rules will eventually be adopted. However, if either rule is adopted in the form proposed by the respective agencies, the result will be some reduction in the volume of Partnership timber available for harvest. LIQUIDITY AND CASH FLOW As of December 31, 1993, the Partnership was due trade and intercompany receivables from Rayonier and affiliates of $4.1 million. In addition, the Primary Account of the Partnership held short-term investment notes of Rayonier of $106.2 million primarily resulting from the cumulative net cash flow, since inception, of the Primary Account after distributions to unitholders. The Partnership can call the short-term investment notes at any time to fund Partnership working capital requirements, capital expenditures, asset acquisitions and reserves. See Note 5 of the accompanying Notes to Financial Statements for further information. The Secondary Account of the Partnership had total outstanding debt of $121.8 million at December 31, 1993 including long-term notes payable to Rayonier of $120.9 million that mainly represent the obligations incurred as a result of Secondary Account advances by Rayonier. See Note 6 of the accompanying Notes to Financial Statements for further information. Capital expenditures for reforestation, capitalized lease payments, property taxes and other improvements to the land and timber assets were $13.4 million in 1993, $14.0 million in 1992 and $13.7 million in 1991. Capital expenditures are expected to be approximately $13.3 million in 1994. Funding of future capital requirements is expected to continue from Rayonier. The Partnership distributed $92.0 million ($4.60 per Class A Unit) in 1993 and $72.0 million ($3.60 per Class A Unit) in both 1992 and 1991 to all outstanding Class A unitholders. An additional $4.8 million in 1993 and $3.8 million in both 1992 and 1991 was distributed in cash to Class B unitholders and to the General Partners. Recontributions of $1.0 million, $1.7 million and $2.3 million were made in 1993, 1992 and 1991, respectively, by Rayonier and the General Partners of RTLP relating to the commission expense paid to a Rayonier affiliated foreign sales corporation. On February 8, 1994, the Board of Directors of Rayonier Forest Resources Company declared a special distribution of $4.00 per Class A Unit as well as a first quarter distribution of $1.30 per Class A Unit (representing an increase of 15 cents over the previous regular quarterly distribution), payable on March 31, 1994 to unitholders of record February 28, 1994. A portion of these distributions represents a return of capital, depending on each unitholder's tax basis. The special distribution was declared following a determination by the Managing General Partner that cash and investment balances would likely exceed funding requirements for the balance of the Initial Term ending December 31, 2000. As of the distribution date, it is expected that approximately $1.00 per Class A Unit will be available for normal capital expenditure, working capital and other funding requirements. The increase in the quarterly distribution resulted from projections of increased operating cash flows. When the Initial Term ends on December 31, 2000, the Primary Account of the Partnership will be closed but there will not be any redemption of the partners' capital accounts. The interest of Class A unitholders in the Partnership's future revenues, expenses and cash flows will then decrease from 95 percent to 4 percent. Positive cash flows will be substantially affected by Secondary Account debt that will have to be repaid. As a result, it is expected that the market price of Class A Units should begin to decrease substantially sometime prior to December 31, 2000. ITEM 8.	ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA See "Index to Financial Statements" on Page ii. ITEM 9.	ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. - 17 - PART III ITEM 10.	ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Neither the Partnership nor the Operating Partnership has any directors or officers. Set forth below is certain information concerning directors and executive officers of RFR. Presently, all directors and officers of RFR are elected annually. DIRECTORS AND EXECUTIVE OFFICERS 1 Member of the Conflicts and Audit Committees of RFR's Board of Directors. 2 Served as a Director of RFR from 1985 to 1991. 3 Served as a Director of RFR from 1987 to 1991. RONALD M. GROSS, 60, is Chairman, President and Chief Executive Officer of Rayonier. He joined Rayonier in March 1978 as President and Chief Operating Officer and a Director. He was elected Chief Executive Officer in 1981 and Chairman in 1984. From 1968 to 1978, he was with Canadian Cellulose Company Limited of Vancouver, British Columbia, where he held various senior positions before becoming President and Chief Executive Officer and Director in 1973. Mr. Gross is currently a director of Lukens Inc. He serves as a member of the Executive Committee of the Board of Directors of the American Forest and Paper Association (AFPA) and is Vice Chairman of the AFPA International Business Committee. He is a member of the Investment Policy Advisory Committee of the United States Trade Representative. WILLIAM J. ALLEY, 64, is Chairman of the Board and Chief Executive Officer of American Brands, Inc., a diversified manufacturing and other businesses company. He joined The Franklin Life Insurance Company in 1967 and was Chairman, President and Chief Executive Officer of that organization when it was acquired by American Brands, Inc. in 1979. He was elected to the Board of Directors of American Brands in 1979 and subsequently held various senior executive positions with American Brands before being elected to his present position on June 15, 1987. He is also a director of Rayonier Inc., CIPSO Incorporated, Bunn-O-Matic Corporation, Moorman Manufacturing Company, The Business Council of Southwestern Connecticut (SACIA), Co-operation Ireland, United Way of Tri-State and the Connecticut Business for Education Coalition, Inc. and on the Advisory Board of Governors of the National Women's Economic Alliance Foundation. He is a member of the Business Roundtable and is also a member of The Conference - 18 - Board, The Board of Overseers of the Executive Council on Foreign Diplomats, The Ambassadors' Roundtable Advisory Council and The Economic Club of New York. GEORGE S. ARESON, 58, was elected Acting Corporate Controller of Rayonier and RFR on October 11, 1993. He joined Rayonier in February 1984 as Pulp Products Controller and became Operations Controller, Pulp and Forest Products in February 1988. Prior to employment at Rayonier, he was the Director of Finance of Continental Corrugated, Inc. Currently he is a member of both the American Institute of Certified Public Accountants and the New York State Society of Certified Public Accountants. Mr. Areson did not file a Form 3 reporting that he owned no Class A Units until March 1994. MACDONALD AUGUSTE, 45, was elected Treasurer of Rayonier effective February 27, 1989 and Treasurer of RFR on March 6, 1989. From 1983 to February 1989, he was Assistant Treasurer of Rayonier, which he joined in April 1975 as Cash and Financial Planning Coordinator. Previously he was employed by St. Regis Paper Company. WILLIAM S. BERRY, 52, was elected Senior Vice President, Forest Resources and Corporate Development, of Rayonier in January 1994. He was Senior Vice President, Land and Forest Resources, of Rayonier from January 1986 to January 1994. From October 1981 to January 1986 he was Vice President and Director of Forest Products Management. Mr. Berry joined Rayonier in 1980 as Director of Wood Products Management. Since May 1988 he has served as a Senior Vice President of RFR after having been Vice President of RFR from September 1985. He also serves on the Executive Boards of the American Forest Council and the Center for Streamside Studies. Prior to joining Rayonier, Mr. Berry was employed with Champion International and Kimberly-Clark Corporation. JOHN B. CANNING, 50, has served as Corporate Secretary and Associate General Counsel of Rayonier since February 1985 and as Corporate Secretary of RFR since September 1985. Mr. Canning joined Rayonier in 1977 as Associate General Counsel - Financial. He is a member of the American Bar Association and of the Corporate Bar Association of Westchester and Fairfield, Inc. DONALD W. GRIFFIN, 57, is President and Chief Operating Officer of the Olin Corporation, a diversified manufacturing corporation. He joined Olin in 1961 and was part of its Brass Division marketing organization beginning in 1963. He advanced through various managerial positions and in 1983 was elected an Olin corporate vice president and appointed president of the Brass Division. He became president of the Winchester Division of Olin in 1985, was appointed president of Olin's Defense Systems Group in 1986 and was elected an executive vice president of Olin in 1987. He became a director of Olin in 1990 and was elected Vice Chairman of the Board for Operations on January 12, 1993. He was elected President and Chief Operating Officer on February 24, 1994. He is also a director of Rayonier Inc., the Sporting Arms and Ammunition Manufacturers Institute, the Wildlife Management Institute, the National Shooting Sports Foundation, River Bend Bancshares, Inc. and Illinois State Bank and Trust in East Alton, Illinois. He is a trustee of the Buffalo Bill Historical Center, the Olin Charitable Trust and the National Security Industrial Association. He is a member of the American Society of Metals, the Association of the U.S. Army and the American Defense Preparedness Association. He is a life member of the Navy League of the United States and the Surface Navy Association. THOMAS W. KEESEE, JR. 79, is a former Director, President and Chief Executive Officer of Bessemer Securities Corporation and Bessemer Trust Company. He is a corporate director and financial consultant. He is a director of King Ranch Inc. and a director emeritus of ITT Corporation (ITT) and of Duke University Asset Management Co. He is former Chairman of the Board of Directors of the National Audubon Society. From 1985 to 1991, Mr. Keesee served on the Board of Directors of RFR. GERALD J. POLLACK, 52, was elected Senior Vice President and Chief Financial Officer of Rayonier in May 1992. From July 1986 until May 1992, he was Vice President and Chief Financial Officer. Mr. Pollack joined Rayonier in June 1982 as Vice President and Controller. He served as Controller of RFR from September 1985 until August 1986, when he became a Vice President as well. He was elected Chief Financial Officer of RFR on March 6, 1989 and a Senior Vice President of RFR on July 27, 1992. Prior to joining Rayonier, Mr. Pollack was employed with Avis, Inc. where he held a number of positions, including Vice President and Corporate Comptroller and finally Vice President-Operations, Europe, Africa and Middle East Divisions in England. DEROY C. THOMAS, 68, is a partner in the law firm of LeBoeuf, Lamb, Greene & MacRae. He is retired President and Chief Operating Officer of ITT. Prior to moving to the parent ITT, Mr. Thomas was Chairman, President and Chief Executive Officer of The Hartford Insurance Group. Before going to The Hartford, Mr. Thomas was assistant general counsel of the Association of Casualty and Surety Companies in New York City and was an associate professor of law at Fordham School of Law. Mr. Thomas serves on the board of directors of ITT Hartford, as well as Connecticut Natural - 19 - Gas Corporation and Houghton Mifflin Company. He also serves as Chairman of the Old State House, Hartford, CT; Chairman of the Connecticut Health System, Inc., Hartford, CT; Director, Goodspeed Opera House; Trustee, Fordham University; Trustee, Wheelock College; Trustee Emeritus, University of Hartford and as a member of the Advisory Board of Iona College. From 1987 to 1991, Mr. Thomas served on the Board of Directors of RFR. - 20 - ITEM 11.	ITEM 11. EXECUTIVE COMPENSATION Neither Rayonier nor RFR receive any compensation as general partners of the Partnership and the Operating Partnership in the form of promotional interests, management fees, acquisition fees, incentive compensation or otherwise. The Partnership and the Operating Partnership reimburse Rayonier and RFR for all direct costs incurred in organizing and managing such partnerships and indirect costs (principally general and administrative and overhead costs) reasonably allocable to such partnerships. The allocations of direct and indirect costs incurred by Rayonier between the Partnership and Rayonier's other activities will be made solely by Rayonier. Neither the Partnership nor the Operating Partnership has any officers or directors. No officers or directors of Rayonier or RFR are compensated by the Partnership or the Operating Partnership. The allocable share of Rayonier's and RFR's general and administrative overhead expenses charged to the Partnership includes a portion of the compensation paid by Rayonier and RFR to their officers and directors. The three directors of RFR who were not employed by ITT or Rayonier received a fee of $1,000 for each RFR Board meeting or Committee meeting attended. These fees were paid by RFR and charged to the Partnership. During 1993, the Partnership was charged for compensation paid to 13 officers and directors of RFR in an amount totaling $186,000. The Partnership was not charged for cash compensation to any officer or director of RFR in excess of $100,000. ITEM 12.	ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT All references to beneficial ownership in this Item 12 are as of March 14, 1994. * Mrs. Ronald M. Gross owns 100 Class A Units of the Partnership. Her husband, who is President of Rayonier and RFR, disclaims any beneficial interest in those units. ITEM 13.	ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS See "Item 1. Business" for a description of transactions between the Partnership and Rayonier. There are no other transactions or relationships to be reported in response to this item. PART IV ITEM 14.	ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) Documents filed as a part of this report: 1. See Index to Financial Statements on page ii for a list of the financial statements filed as part of this report. 2. See Index to Financial Statement Schedules on page ii for a list of the financial statement schedules filed as a part of this report. 3. See Exhibit Index on page B for a list of the exhibits filed or incorporated herein as a part of this report. (b) No report on Form 8-K was filed by the registrant during the period covered by this report. - 21 - REPORT OF MANAGEMENT Rayonier Timberlands, L.P. (RTLP), through the management of both Rayonier Inc. (Rayonier) (the Special General Partner) and Rayonier Forest Resources Company (RFR) (the Managing General Partner), is responsible for the preparation and integrity of the information contained in the accompanying financial statements and other sections of the Annual Report. The financial statements are prepared in accordance with generally accepted accounting principles, and, where necessary, include amounts that are based on management's informed judgments and estimates. Other information in the Annual Report is consistent with the financial statements. RTLP's financial statements are audited by Arthur Andersen & Co., independent public accountants. Management has made available to Arthur Andersen & Co. RTLP's financial records and related data and believes that the representations made to the independent public accountants are valid and complete. A system of internal controls is a major element in management's responsibility for the fair presentation of the financial statements. These internal controls, including accounting controls and the internal auditing program, are designed to provide reasonable assurance that the assets are safeguarded, that transactions are executed in accordance with management's authorization and are properly recorded, and that fraudulent financial reporting is prevented or detected. An important part of the internal controls system is the involvement of the General Partners who provide all required services to ensure the adequacy of internal controls. Procedures also exist to assess compliance with the terms of the Partnership Agreement and to identify and resolve any business issues arising between the Partnership and the General Partners. Internal controls provide for the careful selection and training of personnel and for appropriate division of responsibility. The controls are documented in written codes of conduct, policies and procedures that are communicated to employees of Rayonier and RFR. Management continually monitors the system of internal controls for compliance. Internal auditors independently assess the effectiveness of internal controls and make recommendations for improvement. Arthur Andersen & Co. also evaluate internal controls and perform tests of procedures and accounting records to enable them to express their opinion on RTLP's financial statements. They also make recommendations for improving internal controls, policies and practices. Management takes appropriate action in response to each recommendation from the internal auditors and the independent public accountants. The Board of Directors of RFR monitors management's administration of the Partnership's financial and accounting policies and practices and the preparation of financial reports. The Audit Committee of the Board of Directors of RFR, which is comprised of non-employee directors, meets periodically with management and with the internal and external auditors to evaluate the effectiveness of the work performed by them in discharging their respective responsibilities and to assure their independent and free access to the Committee. Rayonier controls RFR, and depends partially on the Partnership timberlands for timber for use in Rayonier's mills and log export business. Conflicts of interest can arise in selecting, pricing and scheduling timber sold to Rayonier. Other conflicts of interest can arise in allocating revenues and costs between the Class A Units and the Class B Units, in scheduling timber sales to occur before or after the Initial Term expires, and in setting the terms of any loans between the Partnership and Rayonier. The Conflicts Committee of the Board of Directors of RFR, which is comprised of non-employee directors, reviews these transactions and obtains opinions from outside consultants as to their fairness. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Partners of Rayonier Timberlands, L.P.: We have audited the accompanying balance sheets of Rayonier Timberlands, L.P. (a Delaware limited partnership) as of December 31, 1993 and 1992 and the related statements of income, cash flows and partners' capital for each of the three years in the period ended December 31, 1993. These financial statements and schedules referred to below are the responsibility of Rayonier Timberlands, L.P., through the management of both Rayonier Inc., the Special General Partner, and Rayonier Forest Resources Company, the Managing General Partner of the Partnership. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Rayonier Timberlands, L.P. as of December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in the Index to Financial Statement Schedules are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state 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 & CO. Stamford, Connecticut March 1, 1994 RAYONIER TIMBERLANDS, L.P. STATEMENTS OF INCOME FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (thousands of dollars, except per unit data) The accompanying Notes to Financial Statements are an integral part of these financial statements. RAYONIER TIMBERLANDS, L.P. BALANCE SHEETS AS OF DECEMBER 31, 1993 AND 1992 (thousands of dollars) ASSETS LIABILITIES AND PARTNERS' CAPITAL The accompanying Notes to Financial Statements are an integral part of these financial statements. RAYONIER TIMBERLANDS, L.P. STATEMENTS OF CASH FLOWS FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (thousands of dollars) The accompanying Notes to Financial Statements are an integral part of these financial statements. RAYONIER TIMBERLANDS, L.P. STATEMENTS OF PARTNERS' CAPITAL FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (thousands of dollars) The accompanying Notes to Financial Statements are an integral part of these financial statements. RAYONIER TIMBERLANDS, L.P. NOTES TO FINANCIAL STATEMENTS 1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES ORGANIZATION AND CONTROL Rayonier Timberlands, L.P. (RTLP), a Delaware limited partnership, began operations on November 20, 1985 succeeding to substantially all of the timberlands business of Rayonier Inc. (Rayonier). Rayonier Forest Resources Company (RFR), a wholly owned subsidiary of Rayonier, is the Managing General Partner of RTLP and Rayonier is the Special General Partner of RTLP. RTLP operates through Rayonier Timberlands Operating Company, L.P. (RTOC), a Delaware limited partnership, in which RTLP holds a 99 percent limited partner interest, and RFR and Rayonier together hold a 1 percent general partner interest. RFR is the Managing General Partner of RTOC and Rayonier is the Special General Partner of RTOC. In addition to its General Partners' interests, Rayonier is also a Limited Partner and owns 74.7 percent of RTLP's issued and outstanding Class A Units and 100 percent of RTLP's issued and outstanding Class B Units. RTLP and RTOC have no officers, directors or employees. The officers, directors and employees of Rayonier and RFR perform all management and business activities for RTLP and RTOC. ALLOCATIONS OF PARTNERSHIP INTEREST RTLP records all of its activities in two accounts, the Primary Account and the Secondary Account. The Class A unitholders, the Class B unitholders and the General Partners all participate in both accounts, but in different percentages. The participation in the revenues and expenses of RTLP is as follows: IN ACCORDANCE WITH RTLP'S PARTNERSHIP AGREEMENT THE PRIMARY ACCOUNT WILL BE CLOSED AT THE END OF THE INITIAL TERM ON DECEMBER 31, 2000. SUBSEQUENT TO THAT DATE THE CLASS A UNITHOLDERS WILL ONLY PARTICIPATE IN 4 PERCENT OF THE REVENUES AND EXPENSES OF RTLP, AND CASH FLOW ONLY AFTER ALL SECONDARY ACCOUNT DEBT HAS BEEN REPAID. INVESTING AND FINANCING ACTIVITIES The excess of operating cash flow generated by the Primary Account over amounts distributed to unitholders is invested with Rayonier in accordance with the Partnership Agreement and is repayable on demand. Interest is due quarterly and the stated interest rates are at least equivalent to the rate Rayonier would be charged by an outside party for equivalent short-term borrowings. The Partnership has expenditures that relate primarily to timber that will be harvested after the Initial Term, such as costs of site preparation, planting, reforestation, pre-commercial thinning and similar activities, all of which are allocated to the Secondary Account of the Partnership. Rayonier funds these expenditures on behalf of the Partnership and, in accordance with the Partnership Agreement, RTLP incurs obligations to Rayonier which mature on January l, 2001. Under the terms of the Partnership Agreement, cash credited to the Primary Account may not be loaned or otherwise used for the benefit of the Secondary Account. Accordingly, the Partnership is not permitted to use proceeds from the Primary Account Short-Term Investment Notes of Rayonier to repay the Secondary Account Long-Term Notes Payable to Rayonier. See Notes 5 and 6 for further information. NOTES TO FINANCIAL STATEMENTS (CONTINUED) SPECIAL ALLOCATIONS In 1989, the Partnership Agreements of RTLP and RTOC were amended to provide for the special allocation of certain costs to Rayonier's and RFR's interests as General Partners of both Partnerships and to Rayonier's interest as a Limited Partner of RTLP. These costs reduce Rayonier's and RFR's income from RTLP and RTOC, and the cash flow attributed to their Partnership interests. The special allocations do not impact the interest of publicly traded Class A Units nor their cash distributions. On January 1, 1989, RTOC entered into a sales agency agreement with a Rayonier-affiliated foreign sales corporation. The affiliate, RayFor Foreign Sales Corporation (FSC), acts as a commission agent in selling Rayonier's interest in stumpage that is eventually exported from the United States. As a result, Rayonier gains certain tax benefits that are basically only available to tax-paying corporations. Effective with the first quarter of 1989, a commission expense was paid by RTOC to FSC. The Board of Directors of the Managing General Partner approved amendments to the Partnership Agreements of both RTLP and RTOC that allow for the allocation of FSC commission expense and associated administrative expenses only to Rayonier and RFR, as General Partners of RTOC and RTLP, and to Rayonier as a Limited Partner of RTLP, and do not affect the earnings or cash flow of publicly traded Class A Units. Effective August 10, 1993, legislation was enacted eliminating tax benefits related to log exports for foreign sales corporations. Since the Partnership's commission expense had been fully allocated to Rayonier and the General Partners, the legislation did not impact the earnings or cash flows of publicly traded Class A Units. CONSOLIDATION The financial statements consolidate the accounts of RTLP and RTOC. Intercompany transactions have been eliminated. The Rayonier and RFR 1 percent general partner interest in RTOC is presented as minority interest in these financial statements. Certain reclassifications have been made to prior years' financial statements to conform to current year presentation. REVENUE RECOGNITION Timber sales are generally recognized when legal ownership and the risk of loss passes to the purchaser and the quantity sold is determinable. This generally occurs when the purchaser severs and measures the timber. Revenues have been based on actual harvest volumes multiplied by contractually agreed upon prices awarded in sealed-bid auctions or negotiated at arm's length with the purchasers, including Rayonier. These prices are periodically and independently tested for reasonability to market prices in comparable geographic areas. Bulk timber sales are generally recognized when legal ownership and the risk of loss passes to the purchaser and the amount of profit is determinable. Timberland and land sales are recognized when legal ownership passes, the amount of profit is determinable, and specified levels of down payment are received. DEFERRED SOFTWARE COSTS Software costs related to the development of the initial tax data collection and computation system necessary to prepare the pro forma tax return information for individual unitholders had been capitalized and were amortized over a period of 60 months, ending in March 1992. TIMBER AND TIMBERLANDS The acquisition cost of land, timber, real estate taxes, lease payments, site preparation and other costs relating to the planting and growing of timber are capitalized. Such costs attributed to merchantable timber are charged against revenue at the time the timber is harvested based on the relationship of harvested timber to the estimated volume of currently recoverable timber. Timber and timberlands are stated at the lower of original acquisition cost, net of timber cost depletion or market value. The timber originally contributed by Rayonier is stated at Rayonier's historical cost. NOTES TO FINANCIAL STATEMENTS (CONTINUED) LOGGING ROADS Logging roads, including bridges, are stated at cost, less accumulated amortization. The costs of roads developed for reforestation activities are amortized using the straight-line method over their useful lives estimated at 40 years for roads and 20 years for bridges. Road costs associated with harvestable timber access are charged to a prepaid account and amortized as the related timber is sold, generally within two years. PARTNERS' CAPITAL The partners' capital accounts have been included on a historical cost basis as determined by the cash and net book value of assets originally contributed to RTLP by Rayonier and RFR. These accounts have been adjusted for the allocation of revenues and costs in accordance with the Partnership Agreement, for distributions made to partners and for recontributions made by Rayonier and RFR. Revenues and costs are allocated to Primary and Secondary Accounts based upon their relationship to the harvest plan of the Initial Term (through December 31, 2000) or to the harvest plan subsequently (2001 and thereafter). The partners' capital accounts were adjusted for RTLP distributions, recontributions to RTLP and a 1991 land withdrawal by Rayonier (see Note 3 for further information) as follows (thousands of dollars): The amount recontributed by Rayonier and RFR is equal to the foreign sales commission expense paid by the Partnership during the year, which is fully allocated to Rayonier and the General Partners. (See Special Allocations). In addition to the RTLP distributions, RTOC distributed $978,000 in 1993 and $764,000 in 1992 and 1991 to its General Partners. Recontributions were also made to RTOC by the General Partners for their interest in the commission expense paid. 2. INCOME AND OTHER TAXES RTLP is not a separate taxable entity for Federal or state income tax purposes. Any taxable income or loss is reported by the partners in accordance with the Partnership Agreement. Accrued taxes relating to obligations of RTLP as of December 31 were as follows (thousands of dollars): 3. RELATED PARTY TRANSACTIONS RTLP is a major supplier of timber to Rayonier for use in its log export business, and pulp and lumber manufacturing facilities. Timber sales to Rayonier for the years ended December 31, 1993, 1992 and 1991 totaled $19,929,000, $16,982,000 and $29,012,000, respectively. RTLP's related-party revenues represent the fair market value of timber sold to Rayonier. In 1990, Rayonier designated 3,309 acres of Southeast timberland to be withdrawn from RTLP in accordance with the original Partnership Agreement, which granted Rayonier the right to designate on or before December 31, 1990 up to 15,000 acres to be retained by Rayonier. RTLP recorded the distribution of land to Rayonier at historical cost in 1991 after review by the Conflicts Committee of RFR's Board of Directors. NOTES TO FINANCIAL STATEMENTS (CONTINUED) RTLP engages in various transactions with Rayonier and its affiliates that are characteristic of a consolidated group under common control. Receipts, disbursements and net cash position are currently managed by Rayonier through an RTLP centralized treasury system. Accordingly, cash generated by and cash requirements of RTLP flow through intercompany accounts. Any loans to or borrowings from Rayonier are made at an interest rate equivalent to that which would be charged Rayonier by an unrelated third party for a comparable loan for the same period. The balances in the current RTLP intercompany accounts with Rayonier as of December 31 were as follows (thousands of dollars): Interest income received from Rayonier on the Primary Intercompany Account balance was $147,000 and $193,000 in 1993 and 1992 on an average outstanding receivable of $4,185,000 and $4,381,000, respectively. Interest expense paid to Rayonier on the Secondary Intercompany Account was $334,000 and $371,000 in 1993 and 1992 on an average outstanding payable of $11,740,000 and $9,313,000, respectively. RTLP is charged by Rayonier with direct costs and expenses associated with RTLP's operations. In addition, indirect costs were allocated to RTLP for forest management, overhead and general and administrative expenses related to RTLP's operations. Such allocated costs totaled $6,850,000 in 1993, $6,031,000 in 1992 and $6,156,000 in 1991. 4. MAJOR UNAFFILIATED CUSTOMERS Sales for 1992 and 1991 include $16,800,000 and $8,000,000, respectively, from major timberland tract sales in the Northwest to the Quinault Indian Nation. In addition, 1993 and 1992 sales include timber stumpage sales of $16,900,000 and $10,200,000, respectively, to two customers affiliated with the Quinault Indian Nation. In 1992, the Partnership also had one other unaffiliated customer in the Northwest to whom sales of timber stumpage represented $12,100,000 of total sales. No unaffiliated customer accounted for sales in excess of 10 percent of total revenues in 1991. 5. SHORT-TERM INVESTMENT NOTES OF RAYONIER Cash balances including the excess of operating cash flow generated by the Primary Account over amounts distributed to unitholders are being invested in Rayonier as short-term investment notes. These funds are invested in accordance with the Partnership Agreement and are repayable on demand. Interest is due quarterly and the interest rates are at least equivalent to the rate Rayonier would be charged by an outside party for equivalent short-term borrowings. At both December 31, 1993 and 1992 the RTLP Primary Account included short-term investment notes of Rayonier of $106,200,000. The notes bear fixed interest rates that range from 3.9 to 4.2 percent, as of December 31, 1993, and 3.8 to 5.4 percent, as of December 31, 1992. The fair value of the short-term investment notes of Rayonier approximates its carrying value. The weighted average interest rate, based on the principal amount, was 4.1 percent as of December 31, 1993 and 4.6 percent as of December 31, 1992. Interest income earned by the Primary Account on the investment notes of Rayonier was $4,964,000 in 1993, $5,718,000 in 1992 and $6,062,000 in 1991. 6. LONG-TERM NOTES PAYABLE TO RAYONIER The Partnership has expenditures that relate primarily to timber that will be harvested after the Initial Term, such as costs of site preparation, planting, reforestation, pre-commercial thinning and similar activities, all of which are allocated to the Secondary Account of the Partnership. Rayonier funds these expenditures on behalf of the Partnership and, in accordance with the Partnership Agreement, RTLP incurs obligations to Rayonier which mature on January 1, 2001. Advances made by Rayonier to the Secondary Account in any year bear interest through December 31 of that year at the actual average rate of Rayonier's revolving credit borrowings. On each such December 31, advances made in that year including interest are converted into a note bearing interest through January 1, 2001 at a fixed rate determined as of that December 31 equal to an appropriate spread over the yield on U. S. Government Notes having a maturity date in early 2001. Interest is due quarterly, and all or any part of the unpaid principal may be prepaid at any time without penalty or premium. The long-term notes payable to Rayonier amounted to $120,900,000 and $98,100,000 as of December 31, 1993 and 1992, respectively. Based on the spread over the current rates of U. S. Government Notes having a maturity date in early 2001, the fair value of the long-term notes payable to Rayonier is $135,800,000. NOTES TO FINANCIAL STATEMENTS (CONTINUED) As of December 31, 1993 interest rates on the individual notes range from 6.5 to 10.6 percent, with a weighted average interest rate of 8.7 percent. As of December 31, 1992 the range of interest rates on the individual notes was 7.8 to 10.6 percent, with a weighted average interest rate of 9.2 percent. Interest expense incurred by the Secondary Account on the notes payable to Rayonier was $9,118,000 in 1993, $7,737,000 in 1992 and $6,237,000 in 1991. 7. LONG-TERM TIMBER OBLIGATIONS As of December 31, 1993 and 1992 total timber obligations amounted to $931,000 and $1,254,000, respectively. Interest rates ranged from 6.0 to 8.6 percent, with a weighted average interest rate of 8.4 and 8.3 percent at December 31, 1993 and 1992, respectively. The obligations are payable as follows: 1994 - $138,000; 1995 - $148,000; 1996 - - $159,000; 1997 - $149,000; 1998 - $162,000; and $175,000 during 1999 to 2003. 8. ENVIRONMENTAL MATTERS Over the past three years, harvest of timber from private lands in the state of Washington has been restricted as a result of the listing of the northern spotted owl as a threatened species under the Endangered Species Act (ESA). These restrictions have caused the Partnership to restructure and reschedule some of its harvest plans. The U.S. Fish and Wildlife Service (FWS) is developing a proposed rule under the ESA to redefine protective measures for the northern spotted owl on private lands. This rule, as currently drafted, would reduce the harvest restrictions on private lands except within specified Special Emphasis Areas, where restrictions would be increased. One proposed Special Emphasis Area is on the Olympic Peninsula, where a significant portion of the Partnership's Washington timberlands is located. The new rule may also include guidelines for the protection of the marbled murrelet, also recently listed as a threatened species. Separately, the state of Washington Forest Practices Board is in the process of adopting new harvest regulations to protect the northern spotted owl and the marbled murrelet. The state Department of Natural Resources draft of this rule also provides for a special emphasis area to protect the northern spotted owl on the Olympic Peninsula, which would increase harvest restrictions on the Partnership's lands. The Partnership is unable at this time to predict the form in which the federal or state rules will eventually be adopted. However, if either rule is adopted in the form proposed by the respective agencies, the result will be some reduction in the volume of Partnership timber available for harvest. 9. SUBSEQUENT EVENTS On February 8, 1994, the Board of Directors of Rayonier Forest Resources Company declared a special distribution of $4.00 per Class A Unit as well as a first quarter distribution of $1.30 per Class A Unit (representing an increase of 15 cents over the previous regular quarterly distribution), payable on March 31, 1994 to unitholders of record on February 28, 1994. A portion of these distributions represents a return of capital, depending on each unitholder's tax basis. The special distribution was declared following a determination by the Managing General Partner that cash and investment balances would likely exceed funding requirements for the balance of the Initial Term ending December 31, 2000. As of March 31, 1994, approximately $1.00 per Class A Unit will remain for normal capital expenditure, working capital and other funding requirements. The increase in the quarterly distribution resulted from projections of increased operating cash flows. On February 28, 1994, ITT Corporation (ITT), Rayonier's sole shareholder, distributed all the Common Shares of Rayonier to ITT's shareholders. In connection with the distribution, Rayonier changed its name from ITT Rayonier Incorporated to Rayonier Inc. and became a publicly traded company listed on the New York Stock Exchange under the symbol "RYN." RTLP will continue to be listed separately and trade under the symbol "LOG." Class A unitholder's financial interest will not be affected in any manner by ITT's distribution of Rayonier to its shareholders. NOTES TO FINANCIAL STATEMENTS (CONTINUED) 10. COMPUTATION OF INCOME PER CLASS A UNIT The Partnership Agreement provides for the allocation of Partnership income among the General and Limited Partners. The following tables present the computation of income per Class A Unit for the three years ended December 31, 1993 (thousands of dollars, except per unit data): NOTES TO FINANCIAL STATEMENTS (CONTINUED) 11. OPERATING CASH FLOW ALLOCABLE TO CLASS A UNITS Operating cash flow allocable to a Class A Unit is calculated by multiplying 99 percent (Limited Partners' interest in RTLP) of operating cash flow allocated to the Primary and Secondary Accounts by the respective 95 percent and 4 percent Class A Unit interest in those accounts. In determining operating cash flow, Partnership results are adjusted for non-cash costs and expenses without the effects of changes in working capital. The following tables present the calculations of operating cash flow allocable to Class A Units for the three years ended December 31, 1993 (thousands of dollars, except per unit data): QUARTERLY RESULTS FOR 1993 AND 1992 (Unaudited) (thousands of dollars, except per unit data): RAYONIER TIMBERLANDS, L.P. SCHEDULE V - PLANT, PROPERTY AND EQUIPMENT (thousands of dollars) NOTES (a) Represents timber depletion charged to income and applied directly against the asset accounts. S-1 RAYONIER TIMBERLANDS, L.P. SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PLANT, PROPERTY AND EQUIPMENT (thousands of dollars) S-2 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. By: RAYONIER FOREST RESOURCES COMPANY Managing General Partner By: GEORGE S. ARESON --------------------------------- George S. Areson March 30, 1994 Acting Corporate Controller 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. RAYONIER FOREST RESOURCES COMPANY -A- EXHIBIT INDEX - B - EXHIBIT INDEX (CONTINUED) * Registrant's only subsidiary is Rayonier Timberlands Operating Company, L.P., a Delaware limited partnership in which Registrant holds a 99% limited partner's interest. See Item 1 - "Business - Description of Business." - C -
51644_1993.txt	51644	1993	Item 1. Business The Interpublic Group of Companies, Inc. was incorporated in Delaware in September 1930 under the name of McCann-Erickson Incorporated as the successor to the advertising agency businesses founded in 1902 by A.W. Erickson and in 1911 by Harrison K. McCann. It has operated under the Interpublic name since January 1961. As used in this Annual Report, the "Registrant" or "Interpublic" refers to The Interpublic Group of Companies, Inc. while the "Company" refers to Interpublic and its subsidiaries. The advertising agency business is the primary business of the Company. This business is carried on throughout the world through three advertising agency systems, McCann-Erickson Worldwide, Lintas Worldwide and The Lowe Group. The Company also offers advertising agency services through association arrangements with local agencies in various parts of the world. Other activities conducted by the Company within the area of "marketing communications" include market research, sales promotion, product development, direct marketing, telemarketing and other related services. The principal functions of an advertising agency are to plan and create advertising programs for its clients and to place advertising in various media such as television, cable, radio, magazines, newspapers, transit, direct response media and outdoor. The planning function involves analysis of the market for the particular product or service, evaluation of alternative methods of distribution and choice of the appropriate media to reach the desired market most efficiently. The advertising agency then creates an advertising program, within the limits imposed by the client's advertising budget, and places orders for space or time with the media that have been selected. The principal advertising agency subsidiaries of Interpublic operating within the United States directly or through subsidiaries and the locations of their respective corporate headquarters are: McCann-Erickson USA, Inc. ........ New York, New York Lintas Campbell-Ewald Company ......................... Detroit (Warren), Michigan Lintas, Inc. ..................... New York, New York Dailey & Associates .............. Los Angeles, California Lowe & Partners Inc. ............. New York, New York - 3 - PAGE In addition to domestic operations, the Company provides advertising services for clients whose business is international in scope as well as for clients whose business is restricted to a single country or a small number of countries. It has offices in Canada as well as in one or more cities in each of the following countries: EUROPE, AFRICA AND THE MIDDLE EAST Austria Germany Namibia South Africa Belgium Greece Netherlands Spain Croatia Hungary Norway Sweden Czech Republic Ireland Poland Switzerland Denmark Italy Portugal Turkey Finland Ivory Coast Russia United Arab Emirates France Kenya Slovakia United Kingdom Slovenia Zimbabwe LATIN AMERICA AND THE CARIBBEAN Argentina Costa Rica Honduras Peru Barbados Dominican Republic Jamaica Puerto Rico Bermuda Ecuador Mexico Trinidad Brazil El Salvador Panama Uruguay Chile Guatemala Paraguay Venezuela Colombia ASIA AND THE PACIFIC Australia Japan People's Republic South Korea Hong Kong Malaysia of China Taiwan India Nepal Philippines Thailand New Zealand Singapore Operations in the foregoing countries are carried on by one or more operating companies, at least one of which is either wholly owned by Interpublic or a subsidiary or is a company in which Interpublic or a subsidiary owns a 51% interest or more, except in India and Nepal, where Interpublic or a subsidiary holds a minority interest. The Company also offers advertising agency services in Aruba, the Bahamas, Bahrain, Belize, Bolivia, Cambodia, Cameroon, Egypt, Gabon, Ghana, Grand Cayman, Guadeloupe, Guyana, Haiti, Reunion, Indonesia, Iran, Ivory Coast, Kuwait, Lebanon, Martinique, Mauritius, Morocco, Nicaragua, Nigeria, Oman, Pakistan, Paraguay, Saudi Arabia, Senegal, Slovakia, Slovenia, Sri Lanka, Surinam, Tunisia, Uganda, United Arab Emirates (Dubai), Venezuela and Zaire through association arrangements with local agencies operating in those countries. - 4 - PAGE For information concerning revenues, operating profits and identifiable assets on a geographical basis for each of the last three years, reference is made to Note 13: Geographic Areas of the Notes to the Consolidated Financial Statements in the Company's Annual Report to Stockholders for the year ended December 31, 1993, which Note is hereby incorporated by reference. Developments in 1993 The Company completed several acquisitions and divestitures within the United States and abroad in 1993. Effective as of September 30, 1993, Scali, McCabe, Sloves, Inc. ("Scali"), an advertising agency with headquarters in New York City, was acquired. Scali, in turn, owns other advertising agencies in Virginia and in Canada, France, Spain and Mexico. Other transactions included the purchase in May 1993 of a nineteen and nine-tenths percent (19.9%) interest in Atlantis Communications Inc., a Canadian-based distributor and producer of television programming, and the acquisition in August 1993 of the remaining interest in McCann-Erickson Taiwan, an advertising agency. In September 1993, the Company invested in a joint venture called Brockway Direct Response Television, which is involved in the production and distribution of infomercials. McCann-Erickson Hakuhodo Inc. became a wholly-owned subsidiary of Interpublic when the Company purchased the remaining forty-nine percent (49%) interest in that Japanese advertising agency in December 1993. The Company sold GJW & Malmgren Golt, a U.K. corporation, in January 1993. In July 1993, the Company completed the sale of Hawley Martin Partners, Inc., an advertising agency, located in Richmond, Virginia. Income from Commissions, Fees and Publications The Company generates income from planning, creating and placing advertising in various media. Historically, the commission customary in the industry was 15% of the gross charge ("billings") for advertising space or time; more recently lower commissions have frequently been negotiated, but often with additional incentives for better performance. Under commission arrangements, media bill the Company at their gross rates. The Company bills these amounts to its clients, remits the net charges to the media and retains the balance as its commission. Some clients, however, prefer to compensate the Company on a fee basis, under which the Company bills its client for the net charges billed by the media plus an agreed-upon fee. These fees usually are calculated to reflect the Company's salary costs and out-of- pocket expenses incurred on the client's behalf, plus proportional overhead and a profit mark-up. - 5 - PAGE Normally, the Company, like other advertising agencies, is primarily responsible for paying the media with respect to firm contracts for advertising time or space. This is a problem only if the client is unable to pay the Company because of insolvency or bankruptcy. The Company makes serious efforts to reduce the risk from a client's insolvency, including (1) carrying out credit clearances, (2) requiring in some cases payment of media in advance, or (3) agreeing with the media that the Company will be solely liable to pay the media only after the client has paid the Company for the media charges. The Company also receives commissions from clients for planning and supervising work done by outside contractors in the physical preparation of finished print advertisements and the production of television and radio commercials. This commission is customarily 17.65% of the outside contractor's net charge, which is the same as 15% of the outside contractor's total charges including commission. With the spread of negotiated fees, the terms on which outstanding contractors' charges are billed are subject to wide variations and even include in some instances the elimination of commissions entirely provided that there are adequate negotiated fees. The Company derives income in many other ways, including the maintenance of specialized media placement facilities; the creation and publication of brochures, billboards, point of sale materials and direct marketing pieces for clients; the planning and carrying out of specialized marketing research; managing special events at which clients' products are featured; and designing and carrying out interactive programs for special uses. The five clients of the Company that made the largest contribution in 1993 to income from commissions and fees accounted individually for 3% to 10% of such income and in the aggregate accounted for over 33% of such income. Twenty clients of the Company accounted for approximately 47% of such income. Based on income from commissions and fees, the three largest clients of the Company are General Motors Corporation, Unilever and The Coca-Cola Company. General Motors Corporation first became a client of one of the Company's agencies in 1916 in the United States. Predecessors of several of the Lintas agencies have supplied advertising services to Unilever since 1893. Interpublic acquired SSC&B, Inc. (now Lintas, Inc.) and its minority interest in the Lintas agencies (49% in most cases) in September 1979. It acquired the balance of the ownership of the Lintas agencies (51% in most cases) in 1982. The client relationship with The Coca- Cola Company began in 1942 in Brazil and in 1955 in the United States. While the loss of the entire business of one of the Company's three largest clients might have a material adverse effect upon the business of the Company, the Company believes that it is very unlikely that the entire business of any of these clients would be lost at the same time, because it represents several different brands or divisions of each of these clients in a number of geographical markets - often through more than one of the Company's agency systems. - 6 - PAGE Representation of a client rarely means that the Company handles advertising for all brands or product lines of the client in all geographical locations. Any client may transfer its business from an advertising agency within the Company to a competing agency, and a client may reduce its advertising budget at any time. The Company's advertising agencies in many instances have written contracts with their clients. As is customary in the industry, these contracts provide for termination by either party on relatively short notice, usually 90 days but sometimes shorter or longer. In 1993, however, 43% of income from commissions and fees was derived from clients that had been associated with one or more of the Company's agencies or their predecessors for 20 or more years. Personnel As of January 1, 1994, the Company employed approximately 17,600 persons, of whom approximately 4,500 were employed in the United States. Because of the personal service character of the marketing communications business, the quality of personnel is of crucial importance to continuing success. There is keen competition for qualified employees. Interpublic considers its employee relations to be satisfactory. The Company has an active program for training personnel. The program includes meetings and seminars throughout the world. It also involves training personnel in its offices in New York and in its larger offices worldwide. Competition and Other Factors The advertising agency and other marketing communications businesses are highly competitive. The Company's agencies must compete with other agencies, both large and small, and also with other providers of creative or media services which are not themselves advertising agencies, in order to maintain existing client relationships and to obtain new clients. Competition in the advertising agency business depends to a large extent on the client's perception of the quality of an agency's "creative product." An agency's ability to serve clients, particularly large international clients, on a broad geographic basis is also an important competitive consideration. Increasing size brings limitations to an agency's potential for securing new business, because many clients prefer not to be represented by an agency that represents a competitor. Moreover, clients frequently wish to have different products represented by different agencies. The fact that the Company owns three separate worldwide agency systems and interests in other advertising agencies gives it additional competitive opportunities. - 7 - PAGE The advertising business is subject to government regulation, both domestic and foreign. There has been an increasing tendency in the United States on the part of advertisers to resort to the courts to challenge comparative advertising on the grounds that the advertising is false and deceptive. Through the years, there has been a continuing expansion of specific rules, prohibitions, media restrictions, labeling disclosures and warning requirements with respect to the advertising for certain products. Representatives within state governments and the federal government as well as foreign governments continue to initiate proposals to ban the advertising of specific products and to impose taxes on or deny deductions for advertising which, if successful, may have an adverse effect on advertising expenditures. Some countries are relaxing commercial restrictions as part of their efforts to attract foreign investment. However, with respect to other nations, the international operations of the Company still remain exposed to certain risks which affect foreign operations of all kinds, such as local legislation, monetary devaluation, exchange control restrictions and unstable political conditions. In addition, international advertising agencies are from time to time exposed to the threat of forced divestment in favor of local investors because they are considered an integral factor in the communications process. A provision of the present constitution in the Philippines is an example. Item 2.		Item 2. Properties Most of the advertising operations of the Company are carried on in leased premises, and its physical property consists primarily of leasehold improvements, furniture, fixtures and equipment. These facilities are located in various cities in which the Company does business throughout the world. However, subsidiaries of the Company own office buildings in Louisville, Kentucky; Warren, Michigan; Frankfurt, Germany; Sao Paulo, Brazil; Lima, Peru; and Brussels, Belgium and own office condominiums in Buenos Aires, Argentina; Bogota, Colombia; and Manila, the Philippines. In England, subsidiaries of the Company own office buildings in London, Manchester, Birmingham and Stoke-on-Trent. The office building located in Warren, Michigan is held by the Company subject to a mortgage which will terminate in April, 2000. The Company's ownership of the office building in Frankfurt is subject to three mortgages which became effective on or about February 1993. These mortgages terminate at different dates, with the last to expire in February 2003. Reference is made to Note 14: Commitments and Contingent Liabilities of the Notes to the Consolidated Financial Statements in the Company's Annual Report to Stockholders for the year ended December 31, 1993, which Note is hereby incorporated by reference. - 8 - PAGE Item 3.	Item 3. Legal Proceedings Two of the Company's advertising agencies, McCann-Erickson USA, Inc. and Lintas, Inc., are defendants in an action commenced on May 13, 1984 and currently being prosecuted by two plaintiffs in the Circuit Court of Kanawha County, West Virginia, against various manufacturers and distributors of tobacco products and advertising agencies that promoted and advertised tobacco products. In each of two counts, the plaintiffs seek $260,000,000 in compensatory and punitive damages against each defendant advertising agency for alleged injuries claimed to have been caused by the use of tobacco products advertised by them. The Company's advertising agencies believe that they have meritorious defenses to this action and are vigorously contesting it. A motion to dismiss for lack of jurisdiction is pending. Item 4.	Item 4. Submission of Matters to a Vote of Security Holders Not applicable. Executive Officers of the Registrant There follows the information disclosed in accordance with Item 401 of Regulation S-K of the Securities and Exchange Commission (the "Commission") as required by Item 10 of Form 10-K with respect to executive officers of the Registrant. Name Age Office Philip H. Geier, Jr. 59 Chairman of the Board, President and Chief Executive Officer Eugene P. Beard 58 Executive Vice President-Finance and Operations and Chief Financial Officer Robert L. James 57 Chairman of the Board and Chief Executive Officer of McCann- Erickson Worldwide Frank B. Lowe 52 Chairman of The Lowe Group Kenneth L. Robbins 58 Chairman of the Board and Chief Executive Officer of Lintas Worldwide C. Kent Kroeber 55 Senior Vice President - Human Resources Christopher Rudge 56 Senior Vice President, General Counsel and Secretary Also a Director. - 9 - PAGE Name Age Office Thomas J. Volpe 58 Senior Vice President-Financial Operations Salvatore F. LaGreca 40 Vice President and Controller Joseph M. Studley 41 Vice President and Controller Through March 31, 1994. Effective as of April 1, 1994. There is no family relationship among any of the executive officers. The employment histories for the past five years of Messrs. Geier, Beard, James, Lowe and Robbins are incorporated by reference to the Proxy Statement for Interpublic's 1994 Annual Meeting of Stockholders. Mr. Kroeber joined Interpublic in January 1966 as Manager of Compensation and Training. He was elected a Vice President in 1970 and Senior Vice President in May 1980. Mr. Rudge has been associated with Interpublic since January 1, 1973, when he joined it as an Attorney in its Law Department. He was elected Vice President and Assistant General Counsel on May 15, 1984 and was elected to the additional office of Assistant Secretary on May 20, 1986. Effective January 1, 1989, he was elected General Counsel and Secretary. On May 15, 1990, Mr. Rudge was elected a Senior Vice President of Interpublic. Mr. Volpe joined Interpublic on March 3, 1986. He was appointed Senior Vice President-Financial Operations on March 18, 1986. He served as Treasurer from January 1, 1987 through May 17, 1988 and the Treasurer's office continues to report to him. He was Vice President and Treasurer of Colgate-Palmolive Company from February 1981 to February 1986 and Assistant Corporate Controller prior thereto. Mr. LaGreca, a partner in the independent accounting firm of KPMG Peat Marwick from 1986 until 1992, returned to Interpublic in September 1992. While at KPMG Peat Marwick, he was the audit partner in charge of the firm's advertising agency practice. In that capacity, he supervised the technical accounting for, and auditing of, financial statements of various advertising agency clients. He was elected Vice President and Controller of Interpublic on October 20, 1992. Mr. LaGreca, who began his career with the Company as Assistant Treasurer of Lintas, Inc., a subsidiary of Interpublic, remained in that position from 1981 through 1984. He was Assistant Controller of Interpublic from 1984 through 1986. - 10 - PAGE Mr. Studley who has been elected as Vice President and Controller of Interpublic effective as of April 1, 1994, has been Senior Vice President and Chief Financial Officer of EC Television, a division of Interpublic, since January 1, 1990. He was a Vice President of Lintas New York, a division of one of Interpublic's subsidiaries, from August 1, 1987 until December 31, 1989. PART II Item 5.	Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters The response to this Item is incorporated by reference to the Registrant's Annual Report to Stockholders for the year ended December 31, 1993. See Note 12: Results by Quarter (Unaudited), of the Notes to the Consolidated Financial Statements and information under the heading Transfer Agent and Registrar for Common Stock. Item 6.	Item 6. Selected Financial Data The response to this Item is incorporated by reference to the Registrant's Annual Report to Stockholders for the year ended December 31, 1993 under the heading Selected Financial Data for Five Years. Item 7.	Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The response to this Item is incorporated by reference to the Registrant's Annual Report to Stockholders for the year ended December 31, 1993 under the heading Management's Discussion and Analysis of Financial Condition and Results of Operations. Item 8.	Item 8. Financial Statements and Supplementary Data The response to this Item is incorporated in part by reference to the Registrant's Annual Report to Stockholders for the year ended December 31, 1993 under the headings Financial Statements and Notes to the Consolidated Financial Statements. Reference is also made to the Financial Statement Schedules listed under Item 14(a) of this Report on Form 10-K. Item 9.	Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure Not applicable. - 11 - PAGE PART III Item 10.	Item 10. Directors and Executive Officers of the Registrant The information required by this Item is incorporated by reference to the Registrant's Proxy Statement for its 1994 Annual Meeting of Stockholders (the "Proxy Statement") to be filed not later than 120 days after the end of the 1993 calendar year, except for the description of Interpublic's Executive Officers which appears in Part I of this Report on Form 10-K under the heading Executive Officers of the Registrant. Item 11.	Item 11. Executive Compensation The information required by this Item is incorporated by reference to the Proxy Statement. Such incorporation by reference shall not be deemed to specifically incorporate by reference the information referred to in Item 402(a)(8) of Regulation S-K. Item 12.	Item 12. Security Ownership of Certain Beneficial Owners and Management The information required by this Item is incorporated by reference to the Proxy Statement. Item 13.	Item 13. Certain Relationships and Related Transactions The information required by this Item is incorporated by reference to the Proxy Statement. Such incorporation by reference shall not be deemed to specifically incorporate by reference the information referred to in Item 402(a)(8) of Regulation S-K. - 12 - PAGE PART IV Item 14.	Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) Listed below are all financial statements, financial statement schedules and exhibits filed as part of this Report on Form 10-K. 1. Financial Statements: See the Index to Financial Statements on page. 2. Financial Statement Schedules: See the Index to Financial Statement Schedules on page. 3. Exhibits: (Numbers used are the numbers assigned in Item 601 of Regulation S-K and the EDGAR Filer Manual. An additional copy of this exhibit index immediately precedes the exhibits filed with this Report on Form 10-K and the exhibits transmitted to the Commission as part of the electronic filing of the Report.) - 13 - PAGE Exhibit No. Description 3 (i) The Restated Certificate of Incorporation of the Registrant, as amended is incorporated by reference to its Report on Form 10-K for the year ended December 31, 1992. See Commission file number 1- 6686. (ii) The By-Laws of the Registrant, amended as of February 19, 1991, are incorporated by reference to its Report on Form 10-K for the year ended December 31, 1990. See Commission file number 1-6686. 4 Instruments Defining the Rights of Security Holders. Indenture, dated as of April 1, 1992, between Interpublic and Morgan Guaranty Trust Company of New York is not included as an Exhibit to this Report but will be furnished to the Commission upon its request. 10 Material Contracts. (a) Underwriting Agreement, dated March 30, 1992, by and between Interpublic and Goldman Sachs International Limited is incorporated by reference to Registrant's Report on Form 10-K for the year ended December 31, 1992. See Commission file number 1-6686. (b) Employment, Consultancy and other Compensatory Arrangements with Management. Employment and Consultancy Agreements and any amendments or supplements thereto and other compensatory arrangements filed with the Registrant's Reports on Form 10-K for the years ended December 31, 1980 through December 31, 1992, inclusive, are incorporated by reference in this Report on Form 10- K. See Commission file number 1-6686. Listed below are agreements or amendments to agreements between the Registrant and its executive officers which remain in effect on and after the date hereof or were executed during the year ended December 31, 1993 and thereafter, which are filed as exhibits to this Report on Form 10-K. (i) Eugene P. Beard (a) Supplemental Agreement made as of January 5, 1994 to an Employment Agreement made as of January 1, 1983. (b) Supplemental Agreement made as of January 1, 1994 to an Employment Agreement made as of January 1, 1983. - 14 - PAGE (ii) Robert L. James (a) Supplemental Agreement dated as of January 1, 1994 to an Employment Agreement made as of January 1, 1991. (b) Supplemental Agreement made as of July 21, 1992 to an Executive Severance Agreement made as of July 21, 1987. (iii) Frank B. Lowe Supplemental Agreement dated as of January 1, 1994 to an Employment Agreement dated as of January 1, 1991. (iv) Salvatore F. LaGreca Supplemental Agreement made as of March 1, 1994 to an Employment Agreement made as of September 1, 1992. (c) Executive Compensation Plans. (i) Trust Agreement, dated as of June 1, 1990 between The Interpublic Group of Companies, Inc., Lintas Campbell-Ewald Company, McCann-Erickson USA, Inc., McCann-Erickson Marketing, Inc., Lintas, Inc. and Manufacturers Hanover Trust Company, as Trustee, is incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1990. See Commission file number 1-6686. (ii) The Stock Option Plan (1988) and the Achievement Stock Award Plan of the Registrant are incorporated by reference to Appendices C and D of the Prospectus dated May 4, 1989 forming part of its Registration Statement on Form S-8 (No. 33-28143). (iii) The Management Incentive Compensation Plan of the Registrant is incorporated by reference to the Appendix of the Prospectus dated March 21, 1988 forming part of its Registration Statement on Form S- 8 (No. 33-20291). (iv) The 1986 Stock Incentive Plan of the Registrant. - 15 - PAGE (v) The 1986 United Kingdom Stock Option Plan of the Registrant is incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992. See Commission file number 1-6686. (vi) The Employee Stock Purchase Plan (1985) of the Registrant, as amended to date. (vii) The Long-Term Performance Incentive Plan of the Registrant is incorporated by reference to Appendix A of the Prospectus dated December 12, 1988 forming part of its Registration Statement on Form S-8 (No. 33-25555). (viii) Resolution of the Board of Directors adopted on February 16, 1993, amending the Long-Term Performance Incentive Plan is incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992. See Commission file number 1-6686. (ix) Resolution of the Board of Directors adopted on May 16, 1989 amending the Long-Term Performance Incentive Plan is incorporated by reference to Registrant's Report on Form 10-K for the year ended December 31, 1989. See Commission file number 1-6686. (d) Loan Agreements. (i) Amendment No. 2, dated as of October 5, 1993, between Interpublic and Morgan Guaranty Trust Company of New York ("Morgan") to a Credit Agreement, dated as of September 30, 1992 and effective as of December 28, 1992, between Interpublic and Morgan. (ii) Letter, dated November 1, 1993, between Interpublic and Morgan. (iii) Amendment No. 2, dated as of October 5, 1993, between Interpublic and Chemical Bank ("Chemical") to a Credit Agreement, dated as of September 30, 1992, and effective as of December 23, 1992, between Interpublic and Chemical. (iv) Letter, dated September 14, 1993, between Interpublic and Chemical. - 16 - PAGE (v) Amendment No. 2, dated as of October 5, 1993, between Interpublic and Citibank, N.A. ("Citibank") to a Credit Agreement, dated as of September 30, 1992, and effective as of December 22, 1992, between Interpublic and Citibank. (vi) Letter, dated October 8, 1993, between Interpublic and Citibank. (vii) Amendment No. 2, dated as of October 5, 1993, between Interpublic and NBD Bank, N.A. ("NBD") to a Credit Agreement, dated as of September 30, 1992, and effective as of December 23, 1992, between Interpublic and NBD. (viii) Letter, dated October 25, 1993, between Interpublic and NBD. (ix) Amendment No. 3, dated as of October 5, 1993, between Interpublic and NBD to a Term Loan Agreement, dated as of March 14, 1991, between Interpublic and NBD. (x) Letter, dated October 25, 1993, between Interpublic and NBD. (xi) Amendment No. 2, dated as of October 5, 1993, between Interpublic and Trust Company Bank ("Trust") to a Credit Agreement, dated as of September 30, 1992, and effective as of December 30, 1992, between Interpublic and Trust. (xii) Letter, dated October 12, 1993, between Interpublic and Trust. (xiii) Amendment No. 4, dated as of October 5, 1993, between Interpublic and Trust to a Credit Agreement, dated as of March 14, 1991, between Interpublic and Trust. (xiv) Letter, dated October 12, 1993, between Interpublic and Trust. (xv) Amendment No. 2, dated as of October 5, 1993, between Interpublic and Union Bank of Switzerland ("UBS") to a Credit Agreement, dated as of September 30, 1992, and effective as of December 29, 1992, between Interpublic and UBS. (xvi) Letter, dated October 14, 1993, between Interpublic and UBS. - 17 - PAGE (xvii) Amendment No. 2, dated as of October 5, 1993, between Interpublic and The Fuji Bank, Limited ("Fuji") to a Credit Agreement, dated as of September 30, 1992, and effective as of December 16, 1992, between Interpublic and Fuji. (xviii) Letter, dated October 19, 1993, between Interpublic and Fuji. (xix) Amendment No. 2, dated as of October 5, 1993, between Interpublic and The Bank of New York ("BONY") to a Credit Agreement, dated as of September 30, 1992, and effective as of December, 30, 1992, between Interpublic and BONY. (xx) Letter, dated August 23, 1993, between Interpublic and BONY. (xxi) Amendment No. 2, dated as of October 5, 1993, between Interpublic and Swiss Bank Corporation ("SBC") to a Credit Agreement, dated as of September 30, 1992, and effective as of December 18, 1992, between Interpublic and SBC. (xxii) Letter, dated October 12, 1993, between Interpublic and SBC. (xxiii) Amendment No. 3, dated as of November 17, 1993, to a Note Purchase Agreement, dated as of August 20, 1991, by and among Interpublic, McCann-Erickson Advertising of Canada Ltd. ("McCann Canada"), MacLaren Lintas Inc. ("MacLaren Lintas"), The Prudential Insurance Company of America ("Prudential") and Prudential Property and Casualty Insurance Company ("Prudential Property"). (xxiv) Letter, dated November 17, 1993, among Interpublic, McCann Canada, MacLaren Lintas, Prudential and Prudential Property. (xxv) Supplemental Agreement made October 27, 1993, between Lowe International Limited, Lowe Worldwide Holdings B.V., Lowe & Partners Inc. and Lloyds Bank plc as Agent ("Lloyds"). (xxvi) Amendment No. 3, dated as of October 27, 1993, between Interpublic and Lloyds to a Guarantee, dated December 17, 1991. - 18 - PAGE (xxvii) Other Loan and Guaranty Agreements filed with the Registrant's Annual Report on Form 10-K for the years ended December 31, 1988 and December 31, 1986 are incorporated by reference in this Report on Form 10- K. Other Credit Agreements, amendments to various Credit Agreements, Termination Agreements, Loan Agreements, a Note Purchase Agreement, dated August 20, 1991, Guarantee, dated December 17, 1991, Notification dated March 14, 1991 by Registrant and Intercreditor Agreements filed with the Registrant's Report on Form 10-K for the years ended December 31, 1989 through December 31, 1992, inclusive and filed with Registrant's Reports on Form 10-Q for the periods ended March 31, 1993 and June 30, 1993 are incorporated by reference into this Report on Form 10-K. See Commission file number 1-6686. (e) Leases. Material leases of premises are incorporated by reference to the Registrant's Annual Report on Form 10-K for the years ended December 31, 1980 and December 31, 1988. See Commission file number 1- 6686. (f) Acquisition Agreement for Purchase of Real Estate. (i) Acquisition Agreement (in German) between Treuhandelsgesellschaft Aktiengesellschaft & Co. Grundbesitz OHG and McCann-Erickson Deutschland GmbH & Co. Management Property KG ("McCann-Erickson Deutschland") and the English translation of the Acquisition Agreement are incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992. See Commission file number 1-6686. (g) Mortgage Agreements and Encumbrances. (i) Summaries In German and English of Mortgage Agreements between McCann-Erickson Deutschland and Frankfurter Hypothekenbank Aktiengesellschaft ("Frankfurter Hypothekenbank"), Mortgage Agreement, dated January 22, 1993, between McCann-Erickson Deutschland and Frankfurter Hypothekenbank, Mortgage Agreement, dated January 22, 1993, between McCann- Erickson Deutschland and Hypothekenbank, Summaries In German and English of Mortgage Agreement, between McCann-Erickson Deutschland and Frankfurter Sparkasse and Mortgage Agreement, dated January 7, 1993, between McCann-Erickson Deutschland and Frankfurter Sparkasse are incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992. See Commission file number 1-6686. - 19 - PAGE (ii) Summaries In German and English of Documents Creating Encumbrances In Favor of Frankfurter Hypothekenbank and Frankfurter Sparkasse In Connection With the Aforementioned Mortgage Agreements, Encumbrance, dated January 15, 1993, In Favor Of Frankfurter Hypothekenbank, and Encumbrance, dated January 15, 1993, In Favor of Frankfurter Sparkasse are incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992. See Commission file number 1-6686. (iii) Loan Agreement (in English and German), dated January 29, 1993 between Lintas Deutschland GmbH and McCann- Erickson Deutschland is incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992. See Commission file number 1-6686. 11 Computation of Earnings Per Share. 13 This Exhibit includes: (a) those portions of the Annual Report to Stockholders for the year ended December 31, 1993 which are included therein under the following headings: Financial Highlights; Management's Discussion and Analysis of Financial Condition and Results Of Operations; Consolidated Balance Sheet; Consolidated Statement of Income; Consolidated Statement of Cash Flows; Consolidated Statement of Stockholders' Equity; Notes to Consolidated Financial Statements (the aforementioned consolidated financial statements together with the Notes to Consolidated Financial Statements hereinafter shall be referred to collectively as the "Consolidated Financial Statements"); Report of Independent Accountants; Selected Financial Data For Five Years; Report of Management; and Stockholders' Information; and (b) Appendix to Exhibit 13. 21 Subsidiaries of the Registrant. 23 Consent of Independent Accountants. 24 Power of Attorney to sign Form 10-K and resolution of Board of Directors re Power of Attorney. - 20 - PAGE 29 (a) Supplemental Agreements filed with Registrant's Annual Report on Form 10-K for the year ended December 31, 1990 are incorporated by reference into this Report on Form 10-K. See Commission file number 1-6686. (b) The Preferred Share Purchase Rights Plan as adopted on July 18, 1989 is incorporated by reference to Registrant's Registration Statement on Form 8-A dated August 1, 1989 (No. 00017904) and, as amended, by reference to Registrant's Registration Statement on Form 8 dated October 3, 1989 (No. 00106686). b) No reports on Form 8-K were filed during the quarter ended December 31, 1993. - 21 - PAGE 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. THE INTERPUBLIC GROUP OF COMPANIES, INC. (Registrant) March 30, 1994 BY: Philip H. Geier, Jr. Philip H. Geier, Jr., Chairman of the Board, 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. Name Title Date Chairman of the Board, March 30, 1994 President and Chief Executive Philip H. Geier, Jr. Officer (Principal Executive Philip H. Geier, Jr. Officer) and Director Executive Vice President March 30, 1994 -Finance and Operations Eugene P. Beard (Principal Financial Eugene P. Beard Officer) and Director Vice President and March 30, 1994 Salvatore F. LaGreca Controller (Principal Salvatore F. LaGreca Accounting Officer) Robert L. James Director March 30, 1994 Robert L. James Frank B. Lowe Director March 30, 1994 Frank B. Lowe - 22 - PAGE Kenneth L. Robbins Director March 30, 1994 Kenneth L. Robbins Leif H. Olsen Director March 30, 1994 Leif H. Olsen J. Phillip Samper Director March 30, 1994 J. Phillip Samper Joseph J. Sisco Director March 30, 1994 Joseph J. Sisco Frank Stanton Director March 30, 1994 Frank Stanton Jacqueline G. Wexler Director March 30, 1994 Jacqueline G. Wexler *By Philip H. Geier, Jr. Philip H. Geier, Jr. Attorney-in-fact - 23 - PAGE The Financial Highlights, Management's Discussion and Analysis of Financial Condition and Results of Operations, Consolidated Financial Statements, Selected Financial Data for Five Years, Report of Management appearing in the accompanying Annual Report to Stockholders for the year ended December 31, 1993, together with the report thereon of Price Waterhouse dated February 9, 1994 thereof, are incorporated by reference in this report on Form 10- K. With the exception of the aforementioned information and the information incorporated in Items 5, 6, 7 and 8, no other data appearing in the Annual Report to Stockholders for the year ended December 31, 1993 is deemed to be filed as part of this report on Form 10-K. The following financial statement schedules should be read in conjunction with the financial statements in such Annual Report to Stockholders for the year ended December 31, 1993. Financial statement schedules not included in this report on Form 10-K have been omitted because they are not applicable or the required information is shown in the financial statements or the notes thereto. Separate financial statements for the companies which are 50% or less owned and accounted for by the equity method have been omitted because, considered in the aggregate as a single subsidiary, they do not constitute a significant subsidiary. INDEX TO FINANCIAL STATEMENT SCHEDULES Page Report of Independent Accountants on Financial Statement Schedules Consent of Independent Accountants Financial Statement Schedules Required to be Filed by Item 8 of this form: II Amounts Receivable from Related Parties and Underwriters, Promoters, and Employees Other than Related Parties VIII Valuation and Qualifying Accounts IX Short-Term Borrowings X Supplementary Income Statement Information PAGE REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors of The Interpublic Group of Companies, Inc. Our audits of the consolidated financial statements referred to in our report dated February 9, 1994 appearing in the 1993 Annual Report to Stockholders of The Interpublic Group of Companies, Inc. (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the Financial Statement Schedules listed in Item 14 (a) of this Form 10-K. In our opinion, these Financial Statement Schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. PRICE WATERHOUSE New York, New York February 9, 1994 CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Registration Statements on Form S-8 of The Interpublic Group of Companies, Inc. (the "Company"), of our report dated February 9, 1994, appearing in the 1993 Annual Report to Stockholders which is incorporated in this Annual Report on Form 10-K: Registration Statements No. 2-79071; No. 2-43811; No. 2-56269; No. 2-61346; No. 2-64338; No. 2-67560; No. 2-72093; No. 2-88165; No. 2-90878, No. 2-97440 and No. 33-28143, relating variously to the Stock Option Plan (1971), the Stock Option Plan (1981), the Stock Option Plan (1988) and the Achievement Stock Award Plan of the Company; Registration Statements No. 2-53544; No. 2-91564, No. 2-98324, No. 33-22008 and No. 33-64062, relating variously to the Employee Stock Purchase Plan (1975) and the Employee Stock Purchase Plan (1985) of the Company; Registration Statements No. 33-20291 and No. 33-2830 relating to the Management Incentive Compensation Plan of the Company; Registration Statement No. 33-5352 and No. 33- 21605 relating to the 1986 Stock Incentive Plan and 1986 United Kingdom Stock Option Plan of the Company; and Registration Statement No. 33-10087 and No. 33-25555 relating to the Long-Term Performance Incentive Plan of the Company. We also consent to the incorporation by reference in the Prospectus constituting part of the Registration Statement on Form S-3 (No. 33-37346) of our report dated February 9, 1994, appearing in the 1993 Annual Report to Stockholders which is incorporated in this Annual Report on Form 10-K. We also consent to the incorporation by reference of our report on the Financial Statement Schedules, which appears above. PRICE WATERHOUSE New York, New York March 25, 1994 PAGE SCHEDULE II THE INTERPUBLIC GROUP OF COMPANIES, INC. AND ITS SUBSIDIARIES AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES. For the Years Ended December 31, 1993, 1992 and 1991 (Dollars in Thousands) COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E Balance at Deductions - Balance Beginning Amounts at End Name of Debtor of Period Additions Collected Other of Period 1993: A. Gomes $ 137 $ -0- $ (45) $(24) $ 68 G. Bowen $ 300 $ -0- $(300) $-0- $-0- 1992: A. Gomes $ -0- $ 137 $ -0- $-0- $137 G. Bowen $ -0- $ 300 $ -0- $-0- $300 1991: T. Goodgoll $ -0- $ 159 $(159) $-0- $-0- Effect of currency translation. Loan is due December 31, 1994 and interest is charged at the prevailing market rate. PAGE SCHEDULE VIII THE INTERPUBLIC GROUP OF COMPANIES, INC. AND ITS SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS For the Years Ended December 31, 1993, 1992 and 1991 (Dollars in Thousands) COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E Additions (1) (2) Charged Charged to to other Balance costs & accounts- Deductions- Balance Description January 1 expenses describe describe December Allowance for Doubtful Accounts - deducted from Receivables in the Consolidated Balance Sheet: 1993 $15,559 $5,600 $ 764 $3,823 $16,834 $ 898 $2,360 $ 196 1992 $18,553 $4,320 $ 449 $5,497 $15,559 $2,266 1991 $18,815 $3,434 $ 447 $4,143 $18,553 Notes: Allowance for doubtful accounts of acquired and newly consolidated companies, net of divestitures. Foreign currency translation adjustment. Principally amounts written off. Reversal of previously written off accounts. Miscellaneous. PAGE PAGE SCHEDULE X THE INTERPUBLIC GROUP OF COMPANIES, INC. AND ITS SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION For the Years Ended December 31, 1993, 1992 and 1991 (Dollars in Thousands) COLUMN A COLUMN B Item Charged to Costs and Expenses 1993 1992 1991 Maintenance and repairs $20,127 $22,196 $19,582 Amortization of Intangible Assets $18,730 $19,573 $17,004 Taxes Other Than Payroll and Income Taxes $16,561 $18,519 $13,099 PAGE INDEX TO DOCUMENTS Exhibit No. Description 3 (i) The Restated Certificate of Incorporation of the Registrant, as amended is incorporated by reference to its Report on Form 10-K for the year ended December 31, 1992. See Commission file number 1-6686. (ii) The By-Laws of the Registrant, amended as of February 19, 1991, are incorporated by reference to its Report on Form 10-K for the year ended December 31, 1990. See Commission file number 1-6686. 4 Instruments Defining the Rights of Security Holders. Indenture, dated as of April 1, 1992, between Interpublic and Morgan Guaranty Trust Company of New York is not included as an Exhibit to this Report but will be furnished to the Commission upon its request. 10 Material Contracts. (a) Underwriting Agreement, dated March 30, 1992, by and between Interpublic and Goldman Sachs International Limited is incorporated by reference to Registrant's Report on Form 10-K for the year ended December 31, 1992. See Commission file number 1-6686. (b) Employment, Consultancy and other Compensatory Arrangements with Management. Employment and Consultancy Agreements and any amendments or supplements thereto and other compensatory arrangements filed with the Registrant's Reports on Form 10-K for the years ended December 31, 1980 through December 31, 1992, inclusive, are incorporated by reference in this Report on Form 10-K. See Commission file number 1-6686. Listed below are agreements or amendments to agreements between the Registrant and its executive officers which remain in effect on and after the date hereof or were executed during the year ended December 31, 1993 and thereafter, which are filed as exhibits to this Report on Form 10-K. INDEX - 1 PAGE (i) Eugene P. Beard (a) Supplemental Agreement made as of January 5, 1994 to an Employment Agreement made as of January 1, 1983. (b) Supplemental Agreement made as of January 1, 1994 to an Employment Agreement made as of January 1, 1983. (ii) Robert L. James (a) Supplemental Agreement dated as of January 1, 1994 to an Employment Agreement made as of January 1, 1991. (b) Supplemental Agreement made as of July 21, 1992 to an Executive Severance Agreement made as of July 21, 1987. (iii) Frank B. Lowe Supplemental Agreement dated as of January 1, 1994 to an Employment Agreement dated as of January 1, 1991. (iv) Salvatore F. LaGreca Supplemental Agreement made as of March 1, 1994 to an Employment Agreement made as of September 1, 1992. (c) Executive Compensation Plans. (i) Trust Agreement, dated as of June 1, 1990 between The Interpublic Group of Companies, Inc., Lintas Campbell-Ewald Company, McCann- Erickson USA, Inc., McCann-Erickson Marketing, Inc., Lintas, Inc. and Manufacturers Hanover Trust Company, as Trustee, is incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1990. See Commission file number 1-6686. (ii) The Stock Option Plan (1988) and the Achievement Stock Award Plan of the Registrant are incorporated by reference to Appendices C and D of the Prospectus dated May 4, 1989 forming part of its Registration Statement on Form S-8 (No. 33-28143). (iii) The Management Incentive Compensation Plan of the Registrant is incorporated by reference to the Appendix of the Prospectus dated March 21, 1988 forming part of its Registration Statement on Form S-8 (No. 33-20291). INDEX - 2 PAGE (iv) The 1986 Stock Incentive Plan of the Registrant. (v) The 1986 United Kingdom Stock Option Plan of the Registrant is incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992. See Commission file number 1-6686. (vi) The Employee Stock Purchase Plan (1985) of the Registrant, as amended to date. (vii) The Long-Term Performance Incentive Plan of the Registrant is incorporated by reference to Appendix A of the Prospectus dated December 12, 1988 forming part of its Registration Statement on Form S-8 (No. 33-25555). (viii) Resolution of the Board of Directors adopted on February 16, 1993, amending the Long-Term Performance Incentive Plan is incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992. See Commission file number 1-6686. (ix) Resolution of the Board of Directors adopted on May 16, 1989 amending the Long-Term Performance Incentive Plan is incorporated by reference to Registrant's Report on Form 10-K for the year ended December 31, 1989. See Commission file number 1-6686. (d) Loan Agreements. (i) Amendment No. 2, dated as of October 5, 1993, between Interpublic and Morgan Guaranty Trust Company of New York ("Morgan") to a Credit Agreement, dated as of September 30, 1992 and effective as of December 28, 1992, between Interpublic and Morgan. INDEX - 3 PAGE (ii) Letter, dated November 1, 1993, between Interpublic and Morgan. (iii) Amendment No. 2, dated as of October 5, 1993, between Interpublic and Chemical Bank ("Chemical") to a Credit Agreement, dated as of September 30, 1992, and effective as of December 23, 1992, between Interpublic and Chemical. (iv) Letter, dated September 14, 1993, between Interpublic and Chemical. (v) Amendment No. 2, dated as of October 5, 1993, between Interpublic and Citibank, N.A. ("Citibank") to a Credit Agreement, dated as of September 30, 1992, and effective as of December 22, 1992, between Interpublic and Citibank. (vi) Letter, dated October 8, 1993, between Interpublic and Citibank. (vii) Amendment No. 2, dated as of October 5, 1993, between Interpublic and NBD Bank, N.A. ("NBD") to a Credit Agreement, dated as of September 30, 1992, and effective as of December 23, 1992, between Interpublic and NBD. (viii) Letter, dated October 25, 1993, between Interpublic and NBD. (ix) Amendment No. 3, dated as of October 5, 1993, between Interpublic and NBD to a Term Loan Agreement, dated as of March 14, 1991, between Interpublic and NBD. (x) Letter, dated October 25, 1993, between Interpublic and NBD. (xi) Amendment No. 2, dated as of October 5, 1993, between Interpublic and Trust Company Bank ("Trust") to a Credit Agreement, dated as of September 30, 1992, and effective as of December 30, 1992, between Interpublic and Trust. (xii) Letter, dated October 12, 1993, between Interpublic and Trust. (xiii) Amendment No. 4, dated as of October 5, 1993, between Interpublic and Trust to a Credit Agreement, dated as of March 14, 1991, between Interpublic and Trust. (xiv) Letter, dated October 12, 1993, between Interpublic and Trust. INDEX - 4 PAGE (xv) Amendment No. 2, dated as of October 5, 1993, between Interpublic and Union Bank of Switzerland ("UBS") to a Credit Agreement, dated as of September 30, 1992, and effective as of December 29, 1992, between Interpublic and UBS. (xvi) Letter, dated October 14, 1993, between Interpublic and UBS. (xvii) Amendment No. 2, dated as of October 5, 1993, between Interpublic and The Fuji Bank, Limited ("Fuji") to a Credit Agreement, dated as of September 30, 1992, and effective as of December 16, 1992, between Interpublic and Fuji. (xviii) Letter, dated October 19, 1993, between Interpublic and Fuji. (xix) Amendment No. 2, dated as of October 5, 1993, between Interpublic and The Bank of New York ("BONY") to a Credit Agreement, dated as of September 30, 1992, and effective as of December, 30, 1992, between Interpublic and BONY. (xx) Letter, dated August 23, 1993, between Interpublic and BONY. (xxi) Amendment No. 2, dated as of October 5, 1993, between Interpublic and Swiss Bank Corporation ("SBC") to a Credit Agreement, dated as of September 30, 1992, and effective as of December 18, 1992, between Interpublic and SBC. (xxii) Letter, dated October 12, 1993, between Interpublic and SBC. (xxiii) Amendment No. 3, dated as of November 17, 1993, to a Note Purchase Agreement, dated as of August 20, 1991, by and among Interpublic, McCann-Erickson Advertising of Canada Ltd. ("McCann Canada"), MacLaren Lintas Inc. ("MacLaren Lintas"), The Prudential Insurance Company of America ("Prudential") and Prudential Property and Casualty Insurance Company ("Prudential Property"). (xxiv) Letter, dated November 17, 1993, among Interpublic, McCann Canada, MacLaren Lintas, Prudential and Prudential Property. INDEX - 5 PAGE (xxv) Supplemental Agreement made October 27, 1993, between Lowe International Limited, Lowe Worldwide Holdings B.V., Lowe & Partners Inc. and Lloyds Bank plc as Agent ("Lloyds"). (xxvi) Amendment No. 3, dated as of October 27, 1993, between Interpublic and Lloyds to a Guarantee, dated December 17, 1991. (xxvii) Other Loan and Guaranty Agreements filed with the Registrant's Annual Report on Form 10-K for the years ended December 31, 1988 and December 31, 1986 are incorporated by reference in this Report on Form 10-K. Other Credit Agreements, amendments to various Credit Agreements, Termination Agreements, Loan Agreements, a Note Purchase Agreement, dated August 20, 1991, Guarantee, dated December 17, 1991, Notification dated March 14, 1991 by Registrant and Intercreditor Agreements filed with the Registrant's Report on Form 10-K for the years ended December 31, 1989 through December 31, 1992, inclusive and filed with Registrant's Reports on Form 10-Q for the periods ended March 31, 1993 and June 30, 1993 are incorporated by reference into this Report on Form 10-K. See Commission file number 1-6686. (e) Leases. Material leases of premises are incorporated by reference to the Registrant's Annual Report on Form 10-K for the years ended December 31, 1980 and December 31, 1988. See Commission file number 1-6686. (f) Acquisition Agreement for Purchase of Real Estate. (i) Acquisition Agreement (in German) between Treuhandelsgesellschaft Aktiengesellschaft & Co. Grundbesitz OHG and McCann-Erickson Deutschland GmbH & Co. Management Property KG ("McCann-Erickson Deutschland") and the English translation of the Acquisition Agreement are incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992. See Commission file number 1-6686. INDEX - 6 PAGE (g) Mortgage Agreements and Encumbrances. (i) Summaries In German and English of Mortgage Agreements between McCann-Erickson Deutschland and Frankfurter Hypothekenbank Aktiengesellschaft ("Frankfurter Hypothekenbank"), Mortgage Agreement, dated January 22, 1993, between McCann-Erickson Deutschland and Frankfurter Hypothekenbank, Mortgage Agreement, dated January 22, 1993, between McCann-Erickson Deutschland and Hypothekenbank, Summaries In German and English of Mortgage Agreement, between McCann- Erickson Deutschland and Frankfurter Sparkasse and Mortgage Agreement, dated January 7, 1993, between McCann-Erickson Deutschland and Frankfurter Sparkasse are incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992. See Commission file number 1-6686. (ii) Summaries In German and English of Documents Creating Encumbrances In Favor of Frankfurter Hypothekenbank and Frankfurter Sparkasse In Connection With the Aforementioned Mortgage Agreements, Encumbrance, dated January 15, 1993, In Favor Of Frankfurter Hypothekenbank, and Encumbrance, dated January 15, 1993, In Favor of Frankfurter Sparkasse are incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992. See Commission file number 1-6686. (iii) Loan Agreement (in English and German), dated January 29, 1993 between Lintas Deutschland GmbH and McCann-Erickson Deutschland is incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992. See Commission file number 1-6686. 11 Computation of Earnings Per Share. INDEX - 7 PAGE 13 This Exhibit includes: (a) those portions of the Annual Report to Stockholders for the year ended December 31, 1993 which are included therein under the following headings: Financial Highlights; Management's Discussion and Analysis of Financial Condition and Results Of Operations; Consolidated Balance Sheet; Consolidated Statement of Income; Consolidated Statement of Cash Flows; Consolidated Statement of Stockholders' Equity; Notes to Consolidated Financial Statements (the aforementioned consolidated financial statements together with the Notes to Consolidated Financial Statements hereinafter shall be referred to as the "Consolidated Financial Statements"); Report of Independent Accountants; Selected Financial Data For Five Years; Report of Management; and Stockholders' Information; and (b) Appendix to Exhibit 13. 21 Subsidiaries of the Registrant. 23 Consent of Independent Accountants. 24 Power of Attorney to sign Form 10-K and resolution of Board of Directors re Power of Attorney. 29 (a) Supplemental Agreements filed with Registrant's Annual Report on Form 10-K for the year ended December 31, 1990 are incorporated by reference into this Report on Form 10- K. See Commission file number 1-6686. (b) The Preferred Share Purchase Rights Plan as adopted on July 18, 1989 is incorporated by reference to Registrant's Registration Statement on Form 8-A dated August 1, 1989 (No. 00017904) and, as amended, by reference to Registrant's Registration Statement on Form 8 dated October 3, 1989 (No. 00106686). INDEX - 8
19719_1993.txt	19719	1993	Item 1. Business GENERAL Bell Atlantic - Washington, D.C., Inc. (formerly The Chesapeake and Potomac Telephone Company) (the "Company") is incorporated under the laws of the State of New York and has its principal offices at 1710 H Street, N.W., Washington, D.C. 20006 (telephone number 202-392-9900). The Company is a wholly owned subsidiary of Bell Atlantic Corporation ("Bell Atlantic"), which is one of the seven regional holding companies ("RHCs") formed in connection with the court- approved divestiture (the "Divestiture"), effective January 1, 1984, of those assets of the American Telephone and Telegraph Company ("AT&T") related to exchange telecommunications, exchange access functions, printed directories and cellular mobile communications. The Company presently serves a territory consisting of a single Local Access and Transport Area ("LATA"). A LATA is generally centered on a city or based on some other identifiable common geography and, with certain limited exceptions, a LATA marks the boundary within which the Company may provide telephone service. The Company provides two basic types of telecommunications services. First, the Company transports telecommunications traffic between subscribers located within the same LATA ("intraLATA service"), including both local and toll services. Local service includes the provision of local exchange ("dial tone"), local private line and public telephone services (including dial tone service for pay telephones owned by the Company and other pay telephone providers). Among other local services provided are Centrex (telephone company central office-based switched telephone service enabling the subscriber to make both intercom and outside calls) and a variety of special and custom calling services. Toll service includes message toll service (calling service beyond the local calling area) within LATA boundaries, and intraLATA Wide Area Toll Service (WATS)/800 services (volume discount offerings for customers with highly concentrated demand). Second, the Company provides exchange access service, which links a subscriber's telephone or other equipment to the transmission facilities of interexchange carriers which, in turn, provide telecommunications service between LATAs ("interLATA service") to their customers. See "Competition - IntraLATA Toll Competition." The communications industry is currently undergoing fundamental changes driven by the accelerated pace of technological innovation, the convergence of the telecommunications, cable television, information services and entertainment businesses, and a regulatory environment in which many traditional regulatory barriers are being lowered and competition permitted or encouraged. Although no definitive prediction can be made of the market opportunities these changes will present or whether Bell Atlantic and its subsidiaries, including the Company, will be able successfully to take advantage of these opportunities, Bell Atlantic is positioning itself to be a leading communications, information services and entertainment company. BELL ATLANTIC - WASHINGTON, D.C., INC. OPERATIONS During 1993, Bell Atlantic reorganized certain functions formerly performed by each of the seven Bell System operating companies ("BOCs") transferred to it pursuant to the Divestiture, including the Company (collectively, the "Network Services Companies"), into nine lines of business ("LOBs") organized across the Network Service Companies around specific market segments. The Network Services Companies, however, remain responsible within their respective service areas for the provision of telephone services, for financial performance and for regulatory matters. The nine LOBs are: The Consumer Services LOB markets communications services to residential ----------------- customers within the service territories of the Network Services Companies, including the service territory of the Company, and plans in the future to market information services and entertainment programming. The Carrier Services LOB markets (i) switched and special access to the ---------------- Company's local exchange network, and (ii) billing and collection services, including recording, rating, bill processing and bill rendering. The principal customers of this LOB are interexchange carriers; AT&T is the largest single customer. Other customers include business customers and government agencies with their own special access network connections, wireless customers and other local exchange carriers ("LECs") which resell network connections to their own customers. The Small Business Services LOB markets communications and information ----------------------- services to small businesses (customers having up to 20 access lines or 100 Centrex lines). The Large Business Services LOB markets communications and information ----------------------- services to large businesses (customers having more than 20 access lines or more than 100 Centrex lines). These services include voice switching/processing services (e.g., dedicated private lines, custom Centrex, call management and voice messaging), end-user networking (e.g., credit and debit card transactions, and personal computer-based conferencing, including data and video), internetworking (establishing links between the geographically disparate networks of two or more companies or within the same company), network integration (integrating multiple geographically disparate networks into one system), network optimization (disaster avoidance, 911, intelligent vehicle highway systems), video services (distance learning, telemedicine, surveillance, videoconferencing) and integrated multi-media applications services. The Directory Services LOB manages the provision of (i) advertising and ------------------ marketing services to advertisers, and (ii) listing information (e.g., White Pages and Yellow Pages). These services are currently provided primarily through print media, but the Company expects that use of electronic formats will increase in the future. In addition, the Directory Services LOB manages the provision of photocomposition, database management and other related products and services to publishers. The Public and Operator Services LOB markets pay telephone and operator ---------------------------- services in the service territories of the Network Services Companies to meet consumer needs for accessing public networks, locating and identifying network subscribers, providing calling assistance and arranging billing alternatives (e.g., calling card, collect and third party calls). The Federal Systems LOB markets communications and information technology and --------------- services to departments, agencies and offices of the executive, judicial and legislative branches of the federal government. BELL ATLANTIC - WASHINGTON, D.C., INC. The Information Services LOB has been established to provide programming -------------------- services, including on-demand entertainment, transactions and interactive multimedia applications within the Territory and in selected other markets. See "FCC Regulation and Interstate Rates - Telephone Company Provision of Video Dial Tone and Video Programming". The Network LOB manages the technologies, services and systems platforms ------- required by the other eight LOBs and the Network Services Companies, including the Company, to meet the needs of their respective customers, including, without limitation, switching, feature development and on-premises installation and maintenance services. The Company has been making and expects to continue to make significant capital expenditures on its networks to meet the demand for communications services and to further improve such services. Capital expenditures were approximately $109 million in 1991, $103 million in 1992, and $106 million in 1993. The total investment in plant, property and equipment decreased from approximately $1.41 billion at December 31, 1991 to approximately $1.31 billion at December 31, 1992 and 1993, in each case after giving effect to retirements, but before deducting accumulated depreciation at such date. The Company is projecting capital expenditures for 1994 at an amount similar to 1993. However, subject to regulatory approvals, the Network Services Companies, including the Company, plan to allocate capital resources to the deployment of broadband network platforms (technologies ultimately capable of providing a switched facility for access to and transport of high-speed data services, video-on-demand, and image and interactive multimedia applications). Most of the funds for these expenditures are expected to be generated internally. Some additional external financing may be necessary or desirable. LINE OF BUSINESS RESTRICTIONS The consent decree entitled "Modification of Final Judgment" ("MFJ") approved by the United States District Court for the District of Columbia (the "D.C. District Court") which, together with the Plan of Reorganization ("Plan") approved by the D.C. District Court set forth the terms of Divestiture also established certain restrictions on the post-Divestiture activities of the RHCs, including Bell Atlantic. The MFJ's principal restrictions on post-Divestiture RHC activities included prohibitions on (i) providing interexchange telecommunications, (ii) providing information services, (iii) engaging in the manufacture of telecommunications equipment and customer premises equipment ("CPE"), and (iv) entering into any non-telecommunications businesses, in each case without the approval of the D.C. District Court. Since Divestiture, the D.C. District Court has retained jurisdiction over the construction, modification, implementation and enforcement of the MFJ. In September 1987, the D.C. District Court rendered a decision which eliminated the need for the RHCs to obtain its approval prior to entering into non-telecommunications businesses. However, the D.C. District Court refused to eliminate the restrictions relating to equipment manufacturing or providing interexchange services. With respect to information services, the Court issued a ruling in March 1988 which permitted the RHCs to engage in a number of information transport functions as well as voice storage and retrieval services, including voice messaging, electronic mail and certain information gateway services. However, the RHCs were generally prohibited from providing the content of the data they transmitted. As the result of an appeal of the D.C. District Court's September 1987 and March 1988 decisions by the RHCs and other parties, the United States Court of Appeals for the District of Columbia Circuit ordered the D.C. District Court to reconsider the RHCs' request to provide information content and determine whether removal of the restrictions thereon would be in the BELL ATLANTIC - WASHINGTON, D.C., INC. public interest. In July 1991, the D.C. District Court removed the remaining restrictions on RHC participation in information services, but imposed a stay pending appeal of that decision. In October 1991, the United States Court of Appeals for the District of Columbia Circuit vacated the stay, thereby permitting the RHCs to provide information services, and in May 1993 affirmed the D.C. District Court's July 1991 decision. The United States Supreme Court denied certiorari in November 1993. Several bills have been introduced in the current session of Congress pursuant to which the line of business restrictions established by the MFJ could be eliminated or modified. No definitive prediction can be made as to whether or when any such legislation will be enacted, the provisions thereof or their impact on the business or financial condition of the Company. FCC REGULATION AND INTERSTATE RATES The Company is subject to the jurisdiction of the Federal Communications Commission ("FCC") with respect to interstate services and certain related matters. The FCC prescribes a uniform system of accounts for telephone companies, interstate depreciation rates and the principles and standard procedures used to separate plant investment, expenses, taxes and reserves between those applicable to interstate services under the jurisdiction of the FCC and those applicable to intrastate services under the jurisdiction of the respective state regulatory authorities ("separations procedures"). The FCC also prescribes procedures for allocating costs and revenues between regulated and unregulated activities. Interstate Access Charges The Company provides intraLATA service and does not participate in the provision of interLATA service except through offerings of exchange access service. The FCC has prescribed structures for exchange access tariffs to specify the charges ("Access Charges") for use and availability of the Company's facilities for the origination and termination of interstate interLATA service. Access Charges are intended to recover the related costs of the Company which have been allocated to the interstate jurisdiction ("Interstate Costs") under the FCC's separations procedures. In general, the tariff structures prescribed by the FCC provide that Interstate Costs of the Company which do not vary based on usage ("non-traffic sensitive costs") are recovered from subscribers through flat monthly charges ("Subscriber Line Charges"), and from interexchange carriers through usage- sensitive Carrier Common Line ("CCL") charges. See "FCC Regulation and Interstate Rates - FCC Access Charge Pooling Arrangements". Traffic-sensitive Interstate Costs are recovered from carriers through variable access charges based on several factors, primarily usage. In May 1984, the FCC authorized the implementation of Access Charge tariffs for "switched access service" (access to the local exchange network) and of Subscriber Line Charges for multiple line business customers (up to $6.00 per month per line). In 1985, the FCC authorized Subscriber Line Charges for residential and single-line business customers at the rate of $1.00 per month per line, which increased in installments to $3.50 effective April 1, 1989. As a result of the phasing in of Subscriber Line Charges, a substantial portion of non-traffic sensitive Interstate Costs is now recovered directly from subscribers, thereby reducing the per-minute CCL charges to interexchange carriers. This significant reduction in CCL charges has tended to reduce the BELL ATLANTIC - WASHINGTON, D.C., INC. incentive for interexchange carriers and their high-volume customers to bypass the Company's switched network via special access lines or alternative communications systems. However, competition for this access business has increased in recent years. See "Competition - Alternative Access and Local Services". FCC Access Charge Pooling Arrangements The FCC previously required that all LECs, including the Company, pool revenues from CCL and Subscriber Line Charges that cover the non-traffic sensitive costs of the local exchange network, that is, the Interstate Costs associated with the lines from subscribers' premises to telephone company central offices. To administer such pooling arrangements, the FCC mandated the formation of the National Exchange Carrier Association, Inc. Some LECs received more revenue from the pool than they billed their interexchange carrier customers using the nationwide average CCL rate. Other companies, including the Company, received substantially less from the pool than the amount billed to their interexchange carrier customers. By an order adopted in 1987, the FCC changed its mandatory pooling requirements. These changes, which became effective April 1, 1989, permitted all of the Network Services Companies as a group to withdraw from the pool and to charge CCL rates which more closely reflect their non-traffic sensitive costs. The Network Services Companies, including the Company, are still obligated to make contributions of CCL revenues to companies who choose to continue to pool non-traffic sensitive costs so that the pooling companies can charge a CCL rate no greater than the nationwide average CCL rate. In addition to this continuing obligation, the Network Services Companies, including the Company, have a transitional support obligation to high cost companies who left the pool in 1989 and 1990. This transitional support obligation phases out over five years. These long-term and transitional support requirements will be recovered in the Network Services Companies' (including the Company's) CCL rates. Depreciation Depreciation rates provide for the recovery of the Company's investment in telephone plant and equipment, and are revised periodically to reflect more current estimates of remaining service lives and future net salvage values. In October 1993, the FCC issued an order simplifying the depreciation filing process by reducing the information required for certain categories of plant and equipment whose remaining service life, salvage estimates and depreciation rates fall within an approved range. Petitions for reconsideration of that order were filed in December 1993. In November 1993, the FCC issued a further order inviting comments on proposed ranges for an initial group of categories of plant and equipment. Price Caps In September 1990, the FCC adopted "price cap" regulation to replace the traditional rate of return regulation of LECs. LEC price cap regulation became effective on January 1, 1991. The price cap system places a cap on overall prices for interstate services and requires that the cap decrease annually, in inflation-adjusted terms, by a fixed percentage which is intended to reflect expected increases in productivity. The price cap level can also be adjusted to reflect "exogenous" changes, such as changes in FCC separations procedures or accounting rules. LECs subject to price caps have somewhat increased flexibility to change the prices of existing services within certain groupings of interstate services, known as "baskets". BELL ATLANTIC - WASHINGTON, D.C., INC. Under price cap regulation, the FCC set an authorized rate of return of 11.25% for the years 1991 and beyond. To the extent that a company is able to earn a higher rate of return through improved efficiency, the FCC's price cap rules permit them to retain the full amount of this higher return up to 100 basis points above the authorized rate of return (currently, up to a 12.25% rate of return). If a company's rate of return is between 100 and 500 basis points above the authorized rate of return (that is, currently, between 12.25% and 16.25%), the company must share 50% of the earnings above the 100-basis-point level with customers by reducing rates prospectively. All earnings above the 500-basis-point level must be returned to customers in the form of prospective rate decreases. If, on the other hand, a company's rate of return is more than 100 basis points below the authorized rate of return (that is, currently, below 10.25%), the company is permitted to increase rates prospectively to make up the deficiency. Under FCC-approved tariffs, the Network Services Companies are charging uniform rates for interstate access services (with the exception of Subscriber Line Charges) throughout their service areas and are regarded as a single unit by the FCC for rate of return measurement. On February 16, 1994, the FCC initiated a rulemaking proceeding to determine the effectiveness of LEC price cap rules and decide what changes, if any, should be made to those rules. This rulemaking is expected to be concluded by the end of 1994. In January 1993, the FCC denied the Company exogenous treatment of the increased expense for postretirement benefits required under Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", which the Company adopted effective January 1, 1991. The Company has appealed this decision. The appeal is likely to be decided during the second half of 1994. Computer Inquiry III In August 1985, the FCC initiated Computer Inquiry III to re-examine its regulations requiring that "enhanced services" (e.g., voice messaging services, electronic mail, videotext gateway, protocol conversion) be offered only through a structurally separated subsidiary. In 1986, the FCC eliminated this requirement, permitting the Company to offer enhanced services, subject to compliance with a series of nonstructural safeguards designed to promote an effectively competitive market. These safeguards include detailed cost accounting, protection of customer information and certain reporting requirements. In June 1990, the United States Court of Appeals for the Ninth Circuit vacated and remanded the Computer Inquiry III decisions to the FCC, finding that the FCC had not fully justified those decisions. In December 1991, the FCC adopted an order which reinstated relief from the separate subsidiary requirement upon a company's compliance with the FCC's Computer III Open Network Architecture ("ONA") requirements and strengthened some of the nonstructural safeguards. In the interim, the Network Services Companies, including the Company, had filed interstate tariffs implementing the ONA requirements. Those tariffs became effective in February 1992, subject to further investigation. That investigation was completed on December 15, 1993, when an order was released making minor changes to the Network Services Companies' ONA rates. In March 1992, the Company certified to the FCC that it had complied with all initial ONA obligations and therefore should be granted structural relief for enhanced services. The FCC granted the Company structural relief in June 1992. Other parties have appealed this decision, which remains in effect pending the outcome of the appeal. A decision on the appeal is likely by the end of 1994. BELL ATLANTIC - WASHINGTON, D.C., INC. The FCC's December 1991 order has been appealed to the United States Court of Appeals for the Ninth Circuit by several parties. Pending decision on those appeals, the FCC's decision remains in effect. If a court again reverses the FCC, the Company's right to offer enhanced services could be impaired. FCC Cost Allocation and Affiliate Transaction Rules In 1987, the FCC adopted rules governing (i) the allocation of costs between the regulated and unregulated activities of a communications common carrier and (ii) transactions between the regulated and unregulated affiliates of a communications common carrier. The cost allocation rules apply to certain unregulated activities: activities that have never been regulated as communications common carrier offerings and activities that have been preemptively deregulated by the FCC. The costs of these activities are removed prior to the separations procedures process and are allocated to unregulated activities in the aggregate, not to specific services for pricing purposes. Other activities must be accounted for as regulated activities, and their costs are subject to separations procedures. These activities include (i) those which have been deregulated by the FCC without preempting state regulation, (ii) those which have been deregulated by a state but not the FCC and (iii) "incidental activities," which cannot, in the aggregate, generate more than 1% of a company's revenues. Since the Network Services Companies, including the Company, engage in these types of activities, the Network Services Companies, including the Company, pursuant to the FCC's cost allocation rules, filed a cost allocation manual, which has been approved by the FCC. The affiliate transaction rules govern the pricing of assets transferred to and services provided by affiliates. These rules generally require that assets be transferred between affiliates at "market price", if such price can be established through a tariff or a prevailing price actually charged to third parties. In the absence of a tariff or prevailing price, "market price" cannot be established, in which case (i) asset transfers from a regulated to an unregulated affiliate must be valued at the higher of cost or fair market value, and (ii) asset transfers from an unregulated to a regulated affiliate must be valued at the lower of cost or fair market value. The affiliate transaction rules require that a service provided by one affiliate to another affiliate, which service is also provided to unaffiliated entities, must be valued at tariff rates or market prices. If the affiliate does not also provide the service to unaffiliated entities, the price must be determined in accordance with the FCC's cost allocation principles. In October 1993, the FCC proposed new affiliate transaction rules which would essentially eliminate the different rules for the provision of services and apply the asset transfer rules to all affiliate transactions. The Network Services Companies, including the Company, have filed comments opposing the proposed rules. The FCC has not attempted to make its cost allocation or affiliate transaction rules preemptive. State regulatory authorities are free to use different cost allocation methods and affiliate transaction rules for intrastate ratemaking and to require carriers to keep separate allocation records. Telephone Company Provision of Video Dial Tone and Video Programming In 1987, the FCC initiated an inquiry into whether developments in the cable and telephone industries warranted changes in the rules prohibiting telephone companies such as the Company from providing video programming in their respective service territories directly or indirectly through an affiliate. BELL ATLANTIC - WASHINGTON, D.C., INC. In November 1991, the FCC released a Further Notice of Proposed Rulemaking in these proceedings. In August 1992, the FCC issued an order permitting telephone companies such as the Company to provide "video dial tone" service. Video dial tone permits telephone companies to provide video transport to multiple programmers on a non-discriminatory common carrier basis. The FCC has also ruled that neither telephone companies that provide video dial tone service, nor video programmers that use these services, are required to obtain local cable franchises. Other parties have appealed these orders, which remain in effect pending the outcome of the appeal. In December 1992, two Bell Atlantic Companies, Bell Atlantic - Virginia, Inc. and Bell Atlantic Video Services Company, filed a lawsuit against the federal government in the United States District Court for the Eastern District of Virginia seeking to overturn the prohibition in the Cable Communications Policy Act of 1984 against LECs providing video programming in their respective service areas. In a decision rendered in August 1993 and clarified in October 1993, the court struck down this prohibition as a violation of the First Amendment's freedom of speech protections and enjoined its enforcement against Bell Atlantic, the Network Services Companies, including the Company, and Bell Atlantic Video Services Company. This decision has been appealed to the United States Court of Appeals for the Fourth Circuit. In early 1993, the FCC granted Bell Atlantic authority to test a new technology known as Asynchronous Digital Subscriber Line ("ADSL") for use in delivering video entertainment and information over existing copper telephone lines. Beginning in March 1993, Bell Atlantic began a one-year technical trial of ADSL serving up to 400 Bell Atlantic employees in northern Virginia. In the Fall of 1993, Bell Atlantic petitioned the FCC for authorization to expand and convert this technical trial upon its completion into a six month market trial serving up to 2,000 customers. Bell Atlantic also requested authority to offer a commercial video dial tone service to customers served by 25 central offices in part of northern Virginia and southern Maryland upon completion of the six month market trial. These applications are pending at the FCC. Interconnection and Collocation In October 1992, the FCC issued an order allowing third parties to collocate their equipment in telephone company offices to provide special access (private line) services to the public. The FCC's stated purpose was to encourage greater competition in the provision of interstate special access services. The order permits collocating parties to pay LECs an interconnection charge that is lower than the existing tariffed rates for similar non-collocated services; it allows LECs limited additional pricing flexibility for their own special access services when collocated interconnection is operational. In February 1993, Bell Atlantic's seven telephone subsidiaries, including the Company, filed an interstate tariff to allow collocation for special access services. This tariff is currently effective. Bell Atlantic and certain other parties have appealed the FCC's special access collocation order. Bell Atlantic expects the appeal to be decided in 1994. On September 2, 1993, the FCC extended collocation to switched access services. The terms and conditions for switched access collocation are similar to those for special access collocation. On November 18, 1993, Bell Atlantic's seven telephone subsidiaries, including the Company, filed an interstate tariff to allow collocation for switched access services. This tariff became effective on February 16, 1994. Bell Atlantic and certain other parties have appealed the FCC's switched access collocation order. Appeals of this order have been stayed pending a decision on the appeals of the special access collocation order. BELL ATLANTIC - WASHINGTON, D.C., INC. Increased competition through collocation will adversely affect the revenues of the Company, although some of the lost revenues could be offset by increased demand of the Company's own special access services as a result of the slightly increased pricing flexibility that the FCC has permitted. The Company does not expect the net revenue impact of special access collocation to be material. Revenue losses from switched access collocation, however, may be larger than from special access collocation. Intelligent Networks In December 1991, the FCC issued a Notice of Inquiry into the plans of the BOCs, including the Company, to deploy new "modular" network architectures, such as Advanced Intelligent Network ("AIN") technology. The Notice of Inquiry asks what, if any, regulatory action the FCC should take to assure that such architectures are deployed in a manner that is "open, responsive, and procompetitive". On August 31, 1993, the FCC issued a Notice of Proposed Rulemaking proposing a schedule for AIN deployment. The proposals in that Notice of Proposed Rulemaking generally follow those that Bell Atlantic proposed in its response to the Notice of Inquiry. The Company cannot estimate when the FCC will conclude this proceeding. The results of this proposed rulemaking could include a requirement that the Company offer individual components of its services, such as switching and transport, to competitors who will provide the remainder of such services through their own facilities. Such increased competition could divert revenues from the Company. However, deployment of AIN technology may also enable the Company to respond more quickly and efficiently to customer requests for new services. This could result in increased revenues from new services that could at least partially offset losses resulting from increased competition. STATE REGULATION AND INTRASTATE RATES The communications services of the Company are subject to regulation by the District of Columbia Public Service Commission (the "PSC") with respect to intrastate rates and services and other matters. In January 1993, as the outcome of a process begun by a Company proposal to the PSC in 1988, the PSC adopted a regulatory reform plan for the in-territory services of the Company. Under the plan, the PSC adopted a banded rate of return on equity (based on earnings from all services) with 12.5% as the midpoint: the Company would be allowed to seek rate increases if its return on equity falls below 11.5% and would be required to share, through prospective rate cuts, 50% of any earnings in excess of a return on equity of 13.5%. The Company's rates for most residential services were frozen at the levels set in the prior rate proceeding in March 1992. The PSC granted pricing flexibility, including custom contracting and 14-day tariffing, for all Centrex services and for high capacity private line services since these services were found to be subject to competition. The PSC also established a screen for determining what other services are competitive and BELL ATLANTIC - WASHINGTON, D.C., INC. therefore should be subject to flexible pricing in the future. The plan will be in effect for three years after which the PSC will investigate the Company's performance and determine what regulatory structure is appropriate at that time. Pursuant to the PSC's January 1993 regulatory reform plan, in December 1993, the PSC re-set the Company's banded rate of return on equity to range from 10.45% to 12.45%, with a midpoint of 11.45%. However, the PSC also found that the Company was entitled to increased annual revenues of $15.8 million. The PSC increased the rates for public telephone service, increased the message unit rate for business customers and increased certain other business and residential rates to cover the increased revenue requirement. Rates for basic residential service remain frozen at the level set in March 1992. Under the plan, the Company also applied for and received pricing flexibility for several competitive services, including digital data services, paging services, speed calling, Repeat Call, Home Intercom and Home Intercom Extra. NEW PRODUCTS AND SERVICES The following were among the new products and services introduced by the Company in 1993: IntelliLinQ PRI (Integrated Service Digital Network - Primary Rate Interface --------------- (ISDN-PRI)) is an optional arrangement for local exchange access, directed at medium and large business customers with PBX service, which enables customers to increase the efficacy of their current trunking and to transmit 64Kbps circuit-switch data over the public network. Frame Relay Service allows for data connectivity between or among widely ------------------- distributed locations through the use of Frame Relay Subscriber Network Access Lines from the customer's premises to Bell Atlantic's serving wire centers. Centrex Extend permits multi-location Centrex intercom service for a closed -------------- end user group of a single Centrex customer. The Company also introduced the Centrex/Direct Inward Dialing Intercept --------------------------------------- Service, Switched Redirect, Fiber Distributed Data Interface and Individual Line - ------- ----------------- --------------------------------- ---------------- Business (ISDN) products. - -------- COMPETITION Regulatory proceedings, as well as new technology, are continuing to expand the types of available communications services and equipment and the number of competitors offering such services. An increasing amount of this competition is from large companies which have substantial capital, technological and marketing resources, many of which do not face the same regulatory constraints as the Company. Alternative Access and Local Services A substantial portion of the Company's revenues from business and government customers is derived from a relatively small number of large, multiple-line subscribers. The Company faces competition from alternative communications systems, constructed by large end users, interexchange carriers and alternative access vendors, which are capable of originating and/or terminating calls without the use of the local telephone company's plant. In Washington, D.C., BELL ATLANTIC - WASHINGTON, D.C., INC. Institutional Communications Company has deployed an optical fiber network to compete with the Company in the provision of switched and special access services and local services. The ability of such alternative access providers to compete with the Company has been enhanced by the FCC's orders requiring the Company to offer collocated interconnection for special and switched access services. Other potential sources of competition are cable television systems, shared tenant services and other non-carrier systems which are capable of bypassing the Company's local plant, either partially or completely, through substitution of special access for switched access or through concentration of telecommunications traffic on fewer of the Company's lines. Well-financed competitors are seeking authority, or are likely soon to seek authority, to offer competing local exchange services, such as dial tone and local usage, in some of the most lucrative of the Company's local telephone service areas. Southwestern Bell Corporation provides cellular service in the Washington, D.C. Metropolitan area. The two largest long-distance carriers are also positioning themselves to begin to offer services that will compete with the Company's local exchange services. In November 1992, AT&T announced its intention to acquire a controlling interest in McCaw Cellular Communications Inc. ("McCaw"), the largest cellular company in the United States, and to integrate McCaw's wireless local service network with AT&T's long distance network. In December 1993, MCI Communications Corporation ("MCI") announced its intention to invest $2 billion to begin building competing local exchange and access networks in twenty major markets in the United States, some of which are likely to be in the Company's service territory. In March 1994, MCI also announced its intention to acquire a substantial interest in Nextel Communications Inc. (formerly Fleet Call Inc.), and to integrate Nextel's wireless local service network with MCI's long distance network in at least 10 major markets, one or more of which might be in the Company's service territory. The entry of these and other local exchange service competitors will almost certainly reduce the local exchange service revenues of the Company, at least in the market segments and geographical areas in which the competitors operate. Depending on such competitors' success in marketing their services, and the conditions of interconnection established by the regulatory commissions, these reductions could be significant. These revenue reductions may be offset to some extent by revenues from interconnection charges to be paid to the Company by these competitors. The Company seeks to meet such competition by establishing and/or maintaining competitive cost-based prices for local exchange services (to the extent the FCC and state regulatory authorities permit the Company's prices to move toward costs), by keeping service quality high and by effectively implementing advances in technology. See "FCC Regulation and Interstate Rates - Interstate Access Charges" and "- FCC Access Charge Pooling Arrangements". Personal Communications Services Radio-based personal communications services ("PCS") also constitute potential sources of competition to the Company. PCS consists of wireless portable telephone services which would allow customers to make and receive telephone calls from any location using small handsets, and which could also be used for data transmission. The FCC has authorized trials of such services, using a variety of technologies, by numerous companies. BELL ATLANTIC - WASHINGTON, D.C., INC. In September 1993, the FCC issued a report and order allocating radio spectrum to be licensed for use in providing PCS. Under the order, seven separate bandwidths of spectrum, ranging in size from 10 MHz to 30 MHz, would be auctioned to potential PCS providers in each geographic area of the United States; five of the spectrum blocks would be auctioned by "basic trading area" and the remaining two would be auctioned by larger "major trading area" (as such trading areas are defined by Rand McNally). LECs and companies with LEC subsidiaries, such as Bell Atlantic, are eligible to bid for PCS licenses, except that cellular carriers, such as Bell Atlantic, are limited to obtaining only 10 MHz of PCS bandwidth in areas where they provide cellular service. Bidders other than cellular providers may obtain multiple licenses aggregating up to 40 MHz of bandwidth in any area. Bell Atlantic has stated that it intends to pursue PCS licenses in the auctions, which are expected to be held in 1994 or in early 1995. In December 1993, the FCC awarded pioneer's preference PCS licenses to, among other entities, American Personal Communications ("APC"), which is owned in part by The Washington Post Company. APC's license authorizes it to provide PCS service in competition with the local exchange services of the Network Services Companies in all or large portions of Pennsylvania, the District of Columbia, Maryland, Virginia and West Virginia. APC has announced its intention to build out an operational system by the first quarter of 1995. If implemented, PCS and other similar services would compete with services currently offered by the Company, and could result in losses of revenues. Centrex The Company offers Centrex service, which is a telephone company central office-based communications system for business, government and other institutional customers consisting of a variety of integrated software-based features located in a centralized switch or switches and extended to the customer's premises primarily via local distribution facilities. In the provision of Centrex, the Company is subject to significant competition from the providers of CPE systems, such as private branch exchanges ("PBXs"), which perform similar functions with less use of the Company's switching facilities. Users of Centrex systems generally require more subscriber lines than users of PBX systems of similar capacity. The FCC increased the maximum Subscriber Line Charge on embedded Centrex lines to $6.00 per month per line effective April 1, 1989. Increases in Subscriber Line Charges result in Centrex users incurring higher charges than users of comparable PBX systems. The PSC has approved Centrex tariff revisions designed to offset the effects of such higher Subscriber Line Charges. Directories The Company continues to face significant competition from other providers of directories as well as competition from other advertising media. In particular, the former sales representative of several of the Network Services Companies, including the Company, publishes directories in competition with those published by the Company in its service territory. BELL ATLANTIC - WASHINGTON, D.C., INC. Public Telephone Services The Company faces increasing competition in the provision of pay telephone services from other pay telephone service providers. In addition, the growth of wireless communications negatively impacts usage of public telephones. Operator Services Alternative operator services providers have entered into competition with the Company's operator services product line. CERTAIN CONTRACTS AND RELATIONSHIPS Certain planning, marketing, procurement, financial, legal, accounting, technical support and other management services are provided on behalf of the Company on a centralized basis by Bell Atlantic's wholly owned subsidiary, Bell Atlantic Network Services, Inc. ("NSI"). Bell Atlantic Network Funding Corporation provides short-term financing and cash management services to the Company. The seven RHCs each own (directly or through subsidiaries) a one-seventh interest in Bell Communications Research, Inc. ("Bellcore"). Pursuant to the Plan, Bellcore furnishes the RHCs and their BOC subsidiaries with technical assistance such as network planning, engineering and software development, as well as various other consulting services that can be provided more effectively on a centralized basis. Bellcore is the central point of contact for coordinating the efforts of the RHCs in meeting the national security and emergency preparedness requirements of the federal government. It also helps to mobilize the combined resources of the RHCs in times of natural disasters. EMPLOYEE RELATIONS As of December 31, 1993, the Company employed approximately 2,900 persons, including employees of the centralized staff at NSI. This represents approximately a 1% decrease from the number of employees at December 31, 1992. The Company's workforce is augmented by members of the centralized staff of NSI, who perform services for the Company on a contract basis. Approximately 88% of the employees of the Company are represented by the Communications Workers of America, which is affiliated with the American Federation of Labor - Congress of Industrial Organizations. Under the terms of the three-year contracts ratified in October 1992 by unions representing associate employees of the Network Services Companies, including the Company, and NSI, represented associates received a base wage increase of 3.74% in August 1993. Under the same contracts, associates received a Corporate Profit Sharing payment of $495 per person in 1994 based upon Bell Atlantic's 1993 financial performance. BELL ATLANTIC - WASHINGTON, D.C., INC. Item 2.		Item 2. Properties The principal properties of the Company do not lend themselves to simple description by character and location. At December 31, 1993, the Company's investment in plant, property and equipment consisted of the following: "Connecting lines" consists primarily of aerial cable, underground cable, poles, conduit and wiring. "Central office equipment" consists of switching equipment, transmission equipment and related facilities. "Land and buildings" consists of land owned in fee and improvements thereto, principally central office buildings. "Telephone instruments and related equipment" consists primarily of public telephone terminal equipment and other terminal equipment. "Other" property consists primarily of furniture, office equipment, vehicles and other work equipment, capital leases, leasehold improvements and plant under construction. The Company's central offices are served by various types of switching equipment. At December 31, 1993 and 1992, the number of local exchanges and the percent of subscriber lines served by each type of equipment were as follows: BELL ATLANTIC - WASHINGTON, D.C., INC. Item 3.	Item 3. Legal Proceedings Pre-Divestiture Contingent Liabilities and Litigation The Plan provides for the recognition and payment by AT&T and the former BOCs (including the Company) of liabilities that are attributable to pre-Divestiture events but do not become certain until after Divestiture. These contingent liabilities relate principally to litigation and other claims with respect to the former Bell System's rates, taxes, contracts and torts (including business torts, such as alleged violations of the antitrust laws). Except to the extent that affected parties otherwise agree, contingent liabilities that are attributable to pre-Divestiture events are shared by AT&T and the BOCs in accordance with formulas prescribed by the Plan, whether or not an entity was a party to the proceeding and regardless of whether an entity was dismissed from the proceeding by virtue of settlement or otherwise. Each company's allocable share of liability under these formulas depends on several factors, including the type of contingent liability involved and each company's relative net investment as of the effective date of Divestiture. Under the formula generally applicable to most of the categories of these contingent liabilities, the Company's aggregate allocable share of liability is approximately 0.5%. AT&T and various of its subsidiaries and the BOCs (including, in some cases, the Company) have been and are parties to various types of litigation relating to pre-Divestiture events, including actions and proceedings involving environmental claims and allegations of violations of equal employment laws. Damages, if any, ultimately awarded in the remaining actions relating to pre- Divestiture events could have a financial impact on the Company whether or not the Company is a defendant since such damages will be treated as contingent liabilities and allocated in accordance with the allocation rules established by the Plan. While complete assurance cannot be given as to the outcome of any contingent liabilities or litigation, in the opinion of the Company's management, any monetary liability or financial impact to which the Company would be subject after final adjudication of all of the remaining potential or actual pre- Divestiture claims would not be material in amount to the financial position of the Company. BELL ATLANTIC - WASHINGTON, D.C., INC. PART I Item 4.	Item 4. Submission of Matters to a Vote of Security Holders (Omitted pursuant to General Instruction J(2).) PART II Item 5.	Item 5. Market for Registrant's Common Equity and Related Stockholder Matters (Inapplicable.) Item 6.	Item 6. Selected Financial Data (Omitted pursuant to General Instruction J(2).) BELL ATLANTIC - WASHINGTON, D.C., INC. Item 7.	Item 7. Management's Discussion and Analysis of Results of Operations (Abbreviated pursuant to General Instruction J (2).) This discussion should be read in conjunction with the Financial Statements and Notes to Financial Statements included in the index set forth on page. RESULTS OF OPERATIONS Net income for 1993 decreased $8,157,000 or 23.0% from the same period last year. Results for 1993 reflect an after-tax charge of $4,221,000 for the adoption of Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" (Statement No. 112) and a $4,494,000 extraordinary charge, net of tax, for the early extinguishment of debt. OPERATING REVENUES Operating revenues increased $9,843,000 or 1.8% in 1993. The increase in operating revenues was comprised of the following: Local service revenues are earned from the provision of local exchange, local private line and public telephone services. Local service revenues increased $3,666,000 or 1.3% in 1993. The increase was primarily due to higher demand for value-added central office services such as Custom Calling and Caller ID. Also contributing to the higher revenues was growth in private line services and directory assistance revenues due to higher demand for these services. These increases were offset in part by a decrease in rates for basic service. Access lines in service at December 31, 1993 were substantially unchanged from 1992. Network access revenues are received from interexchange carriers (IXCs) for their use of local exchange facilities in providing interstate long-distance services to IXCs' customers, and from end-user subscribers. Switched access revenues are derived from usage-based charges paid by IXCs for access to the Company's network. Special access revenues arise from access charges paid by customers who have private lines, and end-user access revenues are earned from local exchange carrier customers who pay for access to the network. Network access revenues decreased $780,000 or .6% in 1993, due to the effect of interstate rate reductions filed by the Company with the Federal Communications Commission (FCC) which became effective on July 2, 1993 and July 1, 1992, and by related estimated price cap sharing liabilities. This decrease was partly offset by a 5.8% growth in access minutes of use, and lower support payments to the National Exchange Carrier Association (NECA) interstate common line pool. Toll service revenues are earned from interexchange usage services such as Message Telecommunication Services. Toll service revenues remained substantially unchanged from 1992. Directory advertising, billing services and other revenues include revenues earned from directory advertising, billing and collection services provided to IXCs and others, premises services such as inside wire installation and maintenance services, rent of Company facilities by affiliates and non- affiliates and certain nonregulated enhanced network services. BELL ATLANTIC - WASHINGTON, D.C., INC. Directory advertising, billing services and other revenues increased $5,764,000 or 4.3% in 1993. This increase was primarily due to increased customer demand for premises services and for Answer Call, a nonregulated enhanced network service. These revenue increases were offset in part by decreased billing and collection revenue in 1993 as a result of reductions in services provided under long-term contracts with certain IXCs and decreased directory advertising revenue due to decreasing volumes attributable primarily to competition. The provision for uncollectibles, expressed as a percentage of total operating revenues was .8% in 1993 and 1.0% in 1992. The decrease in the provision reflects favorable collection experience. OPERATING EXPENSES Operating expenses increased $12,446,000 or 2.7% in 1993. The increase in operating expenses was comprised of the following: Employee costs consist of salaries, wages and other employee compensation, employee benefits, and payroll taxes paid directly by the Company. Similar costs incurred by employees of Bell Atlantic Network Services, Inc. (NSI) are allocated to the Company and are included in other operating expenses. Employee costs increased $7,817,000 or 5.2% in 1993. Higher employee costs from salary and wage increases and overtime were offset in part by savings resulting from workforce reduction programs implemented in 1992. The Company continues to evaluate ways to streamline and restructure its operations and reduce its workforce requirements in an effort to improve its cost structure. Depreciation and amortization expense decreased $2,600,000 or 2.4% in 1993, principally due to lower depreciation expense as a result of reduction in the level of depreciable plant in 1993. Taxes other than income decreased $3,138,000 or 7.3% in 1993 due to lower property assessments and a reduction in the use tax paid to the District of Columbia. Other operating expenses consist primarily of contracted services, including centralized service expenses allocated from NSI, rent, network software costs, and other general and administrative expenses. Other operating expenses increased $10,367,000 or 6.5% in 1993, primarily reflecting higher costs for contracted services as a result of higher employee costs and taxes allocated from NSI and increased network software costs associated with enhancing the Company's network. OPERATING INCOME TAXES The provision for income taxes decreased $1,337,000 or 7.3% in 1993. The Company's effective income tax rate was 31.0% in 1993 compared to 33.9% in 1992. The decrease in the effective tax rate resulted primarily from the effect of recording in 1992 an adjustment to deferred taxes associated with the retirement of certain plant investments. This decrease was offset in part by the effect of the recently enacted federal tax legislation which increased the federal corporate tax rate from 34% to 35%. A reconciliation of the statutory federal income tax rate to the effective rate for each period is provided in Note 5 of Notes to Financial Statements. BELL ATLANTIC - WASHINGTON, D.C., INC. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (Statement No. 109). In connection with the adoption of Statement No. 109, the Company recorded a charge to income of $381,000 in the first quarter of 1993 (see Note 5 of Notes to Financial Statements). OTHER INCOME AND EXPENSE Other income, net of expense, decreased $90,000 in 1993, principally due to the effect of interest income recognized in 1992 in connection with the settlement of various federal income tax matters relating to prior periods. This decrease was substantially offset by an increase in the allowance for funds used during construction as a result of higher telephone plant under construction in 1993. INTEREST EXPENSE Interest expense decreased $1,914,000 or 9.0% in 1993, principally due to the effects of lower short-term interest rates and long-term debt refinancings. EXTRAORDINARY ITEM The Company called $90,000,000 in 1993 of long-term debentures which were refinanced at more favorable interest rates. As a result of this early retirement, the Company incurred an after-tax charge of $4,494,000 in 1993. This debt refinancing will reduce interest costs on the refinanced debt by approximately $1,400,000 annually. CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE In connection with the adoption of Statement No. 112, effective January 1, 1993, the Company recorded a one-time, cumulative effect after-tax charge of $4,221,000 in 1993 (see Note 4 of Notes to Financial Statements). The adoption of Statement No. 112 did not have a significant effect on the Company's ongoing level of expense in 1993 and is not expected to have a significant effect in future periods. COMPETITION AND REGULATORY ENVIRONMENT The telecommunications industry is currently undergoing fundamental changes which may have a significant impact on future financial performance of all telecommunications companies. These changes are driven by a number of factors, including the accelerated pace of technology change, customer requirements, a changing industry structure characterized by strategic alliances and the convergence of telecommunications and cable television, and a changing regulatory environment in which traditional regulatory barriers are being lowered and competition encouraged. The convergence of cable television, computer technology, and telecommunications can be expected to dramatically increase competition in the future. The Company is already subject to competition from numerous sources, including competitive access providers for network access services, competing cellular telephone companies and others. During 1993, a number of business alliances were announced that have the potential to significantly increase competition both within the industry and within the areas currently served by Bell Atlantic. Over the past several years, Bell Atlantic has taken a number of actions in anticipation of the increasingly competitive environment. Cost reductions have been achieved, giving greater pricing flexibility for services exposed to competition. A new lines of business organization structure was adopted. Subject to regulatory approval, the Company plans to allocate capital resources to the deployment of broadband network platforms. On the regulatory front, an alternative regulation plan has been approved on a trial basis by the District of Columbia Public Service Commission (PSC). BELL ATLANTIC - WASHINGTON, D.C., INC. The Company conducts ongoing evaluations of its accounting practices, many of which have been prescribed by regulators. These evaluations include the assessment of whether costs that have been deferred as a result of actions of regulators and the cost of the Company's telephone plant will be recoverable in the future. In the event recoverability of costs becomes unlikely due to decisions by the Company to accelerate deployment of new technology in response to specific regulatory actions or increasing levels of competition, the Company may no longer apply the provisions of Statement of Financial Accounting Standards No. 71, "Accounting for the Effects of Certain Types of Regulation" (Statement No. 71). The discontinued application of Statement No. 71 would require the Company to write off its regulatory assets and liabilities and may require the Company to adjust the carrying amount of its telephone plant should it determine that such amount is not recoverable. The Company believes that it continues to meet the criteria for continued financial reporting under Statement No. 71. A determination in the future that such criteria are no longer met may result in a significant one-time, non-cash, extraordinary charge, if the Company determines that a substantial portion of the carrying value of its telephone plant may not be recoverable. In September 1993, the FCC issued a report and order allocating radio spectrum to be licensed for use in providing personal communications services (PCS). Under the order, seven separate bandwidths of spectrum, ranging in size from 10 MHz to 30 MHz, would be auctioned to potential PCS providers in each geographic area of the United States. The geographical units by which the licenses would be allocated will be "basic trading areas" or larger "major trading areas." Five of the spectrum blocks are to be auctioned on a basic trading area basis, and the remaining two are to be auctioned by major trading area. Local exchange carriers such as the Company are eligible to bid for PCS licenses, except that cellular carriers are limited to obtaining 10 MHz of PCS bandwidth in areas where they provide cellular service. Bidders other than cellular providers may obtain multiple licenses aggregating up to 40 MHz of bandwidth in any area. Bell Atlantic has stated that it intends to pursue PCS licenses in the auctions, which are expected to be held in 1994. In August 1993, the United States District Court for the Eastern District of Virginia ruled unconstitutional the 1984 Cable Act's limitation on in-territory provision of programming by local exchange carriers such as the Company. The Cable Act currently prohibits local exchange carriers from owning more than 5% of any company that provides cable programming in their local service area. In a case originally brought by two Bell Atlantic subsidiaries, the court ruled that this prohibition violates the First Amendment's freedom of speech protections, and enjoined enforcement of the prohibition against Bell Atlantic and its telephone subsidiaries. The ruling has been appealed. STATE REGULATORY ENVIRONMENT The communications services of the Company are subject to regulation by the PSC with respect to intrastate rates and services and other matters. BELL ATLANTIC - WASHINGTON, D.C., INC. In January 1993, as the outcome of a process begun by a Company proposal to the PSC in 1988, the PSC adopted a regulatory reform plan for the in-territory services of the Company. Under the plan, the PSC adopted a banded rate of return on equity (based on earnings from all services) with 12.5% as the midpoint: the Company would be allowed to seek rate increases if its return on equity falls below 11.5% and would be required to share, through prospective rate cuts, 50% of any earnings in excess of a return on equity of 13.5%. The Company's rates for most residential services were frozen at the levels set in the prior rate proceeding in March 1992. The PSC granted pricing flexibility, including custom contracting and 14-day tariffing, for all Centrex services and for high capacity private line services since these services were found to be subject to competition. The PSC also established a screen for determining what other services are competitive and therefore should be subject to flexible pricing in the future. The plan will be in effect for three years after which the PSC will investigate the Company's performance and determine what regulatory structure is appropriate at that time. Pursuant to the PSC's January 1993 regulatory reform plan, in December 1993, the PSC re-set the Company's banded rate of return on equity to range from 10.45% to 12.45%, with a midpoint of 11.45%. However, the PSC also found that the Company was entitled to increased annual revenues of $15.8 million. The PSC increased the rates for public telephone service, increased the message unit rate for business customers and increased certain other business and residential rates to cover the increased revenue requirement. Rates for basic residential service remain frozen at the level set in March 1992. Under the plan, the Company also applied for and received pricing flexibility for several competitive services, including digital data services, paging services, speed calling, Repeat Call, Home Intercom and Home Intercom Extra. FINANCIAL CONDITION Management believes that the Company has adequate internal and external resources available to meet ongoing requirements including network expansion and modernization, and payment of dividends. Management expects that presently foreseeable capital requirements will be financed primarily through internally generated funds, although additional long-term debt may be needed to fund development activities and to maintain the Company's capital structure within management's guidelines. During 1993, as in prior years, the Company's primary source of funds continued to be cash generated from operations. Revenue growth, cost containment measures and savings on interest costs contributed to cash provided from operations of $149,902,000 for the year ended December 31, 1993. The primary use of capital resources continued to be capital expenditures. The Company invested $106,265,000 in 1993 in the network. This level of investment is expected to continue in 1994. The Company plans to allocate capital resources to the deployment of broadband network platforms, subject to regulatory approval. As of December 31, 1993, the Company's debt ratio was 46.3% compared to 45.3% at December 31, 1992. On February 1, 1993, the Company sold $90,000,000 of Thirty Year 7 3/4% Debentures through a public offering. The debentures are not redeemable prior to February 1, 2003. The net proceeds were used on February 22, 1993 to redeem $90,000,000 of Forty Year 9 3/8% Debentures. This debt refinancing will reduce annual interest costs on the refinanced debt by approximately $1,400,000. As of December 31, 1993, the Company had $60,000,000 outstanding under a shelf registration statement filed with the Securities and Exchange Commission. BELL ATLANTIC - WASHINGTON, D.C., INC. PART II Item 8.	Item 8. Financial Statements and Supplementary Data The information required by this Item is set forth on pages through. 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 (Omitted pursuant to General Instruction J(2).) Item 11.	Item 11. Executive Compensation (Omitted pursuant to General Instruction J(2).) Item 12.	Item 12. Security Ownership of Certain Beneficial Owners and Management (Omitted pursuant to General Instruction J(2).) Item 13.	Item 13. Certain Relationships and Related Transactions (Omitted pursuant to General Instruction J(2).) BELL ATLANTIC - WASHINGTON, D.C., INC. PART IV Item 14.	Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) The following documents are filed as part of this report: (1) Financial Statements See Index to Financial Statements and Financial Statement Schedules appearing on Page. (2) Financial Statement Schedules See Index to Financial Statements and Financial Statement Schedules appearing on Page. (3) Exhibits Exhibits identified in parentheses below, on file with the SEC, are incorporated herein by reference as exhibits hereto. Exhibit Number (Referenced to Item 601 of Regulation S-K) --------------------------------------------------------- 3a Restated Certificate of Incorporation of the registrant, as amended September 14, 1990. (Exhibit 3a to the registrant's Annual Report on Form 10-K for the year ended December 31, 1990, File No. 1-7368.) 3a(i) Certificate of Amendment of the registrant's Certificate of Incorporation, dated January 12, 1994 and filed January 13, 1994. 3b By-Laws of the registrant, as amended June 18, 1992. (Exhibit 3b to the registrant's Annual Report on Form 10-K for the year ended December 31, 1992, File No. 1-7368.) 4 No instrument which defines the rights of holders of long and intermediate term debt of the registrant is filed herewith pursuant to Regulation S-K, Item 601(b)(4)(iii)(A). Pursuant to this regulation, the registrant hereby agrees to furnish a copy of any such instrument to the SEC upon request. 10a Agreement Concerning Contingent Liabilities, Tax Matters and Termination of Certain Agreements among AT&T, Bell Atlantic Corporation, and the Bell Atlantic Corporation telephone subsidiaries, and certain other parties, dated as of November 1, 1983. (Exhibit 10a to Bell Atlantic Corporation Annual Report on Form 10-k for the year ended December 31, 1993, File No. 1-8606.) 10b Agreement among Bell Atlantic Network Services, Inc. and the Bell Atlantic Corporation telephone subsidiaries, dated November 7, 1983. (Exhibit 10b to Bell Atlantic Corporation Annual Report on Form 10-K for the year ended December 31, 1993, File No. 1-8606.) 23 Consent of Coopers & Lybrand. 24 Powers of attorney. (b) Reports on Form 8-K There were no Current Reports on Form 8-K filed during the quarter ended December 31, 1993. BELL ATLANTIC - WASHINGTON, D.C., INC. SIGNATURES ---------- Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Bell Atlantic - Washington, D.C., Inc. By /s/ Sheila D. Shears -------------------------------- Sheila D. Shears Controller March 29, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of this registrant and in the capacities and on the date indicated. ] ] Principal Executive Officer: ] William M. Freeman President and ] Chief Executive ] Officer ] ] Principal Financial Officer: ] Sheila D. Shears Controller ] ] ] ] Directors: ] By /s/ Sheila D. Shears ] ----------------------- Joseph T. Ambrozy ] Sheila D. Shears Sherry F. Bellamy ] (individually and Samuel L. Foggie ] as attorney-in- William M. Freeman ] fact March 29, Franklyn G. Jenifer ] 1994 Eduardo Pena, Jr. ] (constituting a majority ] of the registrant's ] Board of Directors) ] ] ] BELL ATLANTIC - WASHINGTON, D.C., INC. Index to Financial Statements and Financial Statement Schedules Financial statement schedules other than those listed above have been omitted either because the required information is contained in the financial statements and the notes thereto, or because such schedules are not required or applicable. BELL ATLANTIC - WASHINGTON, D.C., INC. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareowner of Bell Atlantic - Washington, D.C., Inc. We have audited the financial statements and financial statement schedules of Bell Atlantic - Washington, D.C., Inc. as listed in the index on page of this Form 10-K. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Bell Atlantic - Washington, D.C., Inc. as of December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. As discussed in Notes 1, 4 and 5 to financial statements, the Company changed its method of accounting for income taxes and postemployment benefits in 1993 and postretirement benefits other than pensions in 1991. /s/ COOPERS & LYBRAND 2400 Eleven Penn Center Philadelphia, Pennsylvania February 7, 1994 BELL ATLANTIC - WASHINGTON, D.C., INC. STATEMENTS OF INCOME AND REINVESTED EARNINGS For the Years Ended December 31 (Dollars in Thousands) The accompanying notes are an integral part of these financial statements. BELL ATLANTIC - WASHINGTON, D.C., INC. BALANCE SHEETS (Dollars in Thousands) The accompanying notes are an integral part of these financial statements. BELL ATLANTIC - WASHINGTON, D.C., INC. BALANCE SHEETS (Dollars in Thousands) The accompanying notes are an integral part of these financial statements. BELL ATLANTIC - WASHINGTON, D.C., INC. STATEMENTS OF CASH FLOWS For the Years Ended December 31 (Dollars in Thousands) The accompanying notes are an integral part of these financial statements. BELL ATLANTIC - WASHINGTON, D.C., INC. NOTES TO FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation Bell Atlantic - Washington, D.C., Inc. (formerly The Chesapeake and Potomac Telephone Company) (the Company), a wholly owned subsidiary of Bell Atlantic Corporation (Bell Atlantic), maintains its accounts in accordance with the Uniform System of Accounts (USOA) prescribed by the Federal Communications Commission (FCC) and makes certain adjustments necessary to present the accompanying financial statements in accordance with generally accepted accounting principles applicable to regulated entities. Such principles differ in certain respects from those used by unregulated entities, but are required to appropriately reflect the financial and economic impacts of regulation and the ratemaking process. Significant differences resulting from the application of these principles are disclosed elsewhere in these Notes to Financial Statements where appropriate. Revenue Recognition Revenues are recognized as earned on the accrual basis, which is generally when services are rendered based on the usage of the Company's local exchange network and facilities. Cash and Cash Equivalents The Company considers all highly liquid investments with a maturity of 90 days or less when purchased to be cash equivalents. Cash equivalents are stated at cost, which approximates market value. Material and Supplies New and reusable materials are carried in inventory, principally at average original cost, except that specific costs are used in the case of large individual items. Nonreusable material is carried at estimated salvage value. Prepaid Directory Costs of directory production and advertising sales are deferred until the directory is published. Such costs are amortized to expense and the related advertising revenues are recognized over the average life of the directory, which is generally 12 months. Plant and Depreciation The Company's provision for depreciation is based principally on the remaining life method of depreciation and straight-line composite rates. The provision for depreciation is based on the following estimated remaining service lives: buildings, 25 to 35 years; central office equipment, 3 to 10 years; telephone instruments and related equipment, 3 to 6 years; poles, 19 years; cable and wiring, 5 to 17 years; conduit, 34 years; office equipment and furniture, 5 to 8 years; and vehicles and other work equipment, 3 to 8 years. This method provides for the recovery of the remaining net investment in telephone plant, less anticipated net salvage value, over the remaining service lives authorized by regulatory commissions. Depreciation expense also includes amortization of certain classes of telephone plant (and certain identified depreciation reserve deficiencies) over periods authorized by regulatory commissions. When depreciable plant is replaced or retired, the amounts at which such plant has been carried in plant, property and equipment are removed from the respective accounts and charged to accumulated depreciation, and any gains or losses on disposition are amortized over the remaining service lives of the remaining net investment in telephone plant. BELL ATLANTIC - WASHINGTON, D.C., INC. Maintenance and Repairs The cost of maintenance and repairs of plant, including the cost of replacing minor items not constituting substantial betterments, is charged to operating expenses. Allowance for Funds Used During Construction Regulatory commissions allow the Company to record an allowance for funds used during construction, which includes both interest and equity return components, as a cost of plant and, for interstate, as an item of other income. Such income is not recovered in cash currently, but will be recoverable over the service life of the plant through higher depreciation expense recognized for regulatory purposes. Employee Benefits Pension Plans Substantially all employees of the Company are covered under multi-employer noncontributory defined pension benefit plans sponsored by Bell Atlantic and its subsidiaries, including the Company. The Company uses the projected unit credit actuarial cost method for determining pension cost for financial reporting purposes. Amounts contributed to the Company's pension plans are actuarially determined, principally under the aggregate cost actuarial method, and are subject to applicable federal income tax regulations. Postretirement Benefits Other Than Pensions Substantially all employees of the Company are covered under postretirement health and life insurance benefit plans. Effective January 1, 1991, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," which requires accrual accounting for all postretirement benefits other than pensions. Under the prescribed accrual method, the Company's obligation for these postretirement benefits is to be fully accrued by the date employees attain full eligibility for such benefits. A portion of the postretirement accrued benefit obligation is contributed to 501(c)(9) trusts and 401h accounts under applicable federal income tax regulations. The amounts contributed to these trusts and accounts are actuarially determined, principally under the aggregate cost actuarial method. Postemployment Benefits The Company provides employees with postemployment benefits such as disability benefits, workers' compensation, and severance pay. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits," which requires accrual accounting for the estimated cost of benefits provided to former or inactive employees after employment but before retirement. Prior to 1993, the cost of these benefits was charged to expense as the benefits were paid. Income Taxes Bell Atlantic and its domestic subsidiaries, including the Company, file a consolidated federal income tax return. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (Statement No. 109), which requires the determination of deferred taxes using the liability method. Under the liability method, deferred taxes are provided on book and tax basis differences and deferred tax balances are adjusted to reflect enacted changes in income tax rates. BELL ATLANTIC - WASHINGTON, D.C., INC. The consolidated amount of current and deferred tax expense is allocated by applying the provisions of Statement No. 109 to each subsidiary as if it were a separate taxpayer. Prior to 1993, the Company accounted for income taxes based on the provisions of Accounting Principles Board Opinion No. 11, "Accounting for Income Taxes" (APB No. 11). Under APB No. 11, deferred taxes were generally provided to reflect the effect of timing differences on the recognition of revenue and expense determined for financial and income tax reporting purposes. The Tax Reform Act of 1986 repealed the investment tax credit (ITC) as of January 1, 1986, subject to certain transitional rules. ITCs were deferred and are being amortized as a reduction to income tax expense over the estimated service lives of the related assets. Reclassifications Certain reclassifications of prior years' data have been made to conform to 1993 classifications. 2. DEBT Long-Term Long-term debt consists principally of debentures issued by the Company. Interest rates and maturities of the amounts outstanding at December 31 are as follows: Long-term debt outstanding at December 31, 1993 includes $155,000,000 that is callable by the Company. The call prices range from 102.8% to 100.0% of face value, depending upon the remaining term to maturity of the issue. On February 1, 1993, the Company sold $90,000,000 of Thirty Year 7 3/4% Debentures, due February 1, 2023, through a public offering. The debentures are not redeemable by the Company prior to February 1, 2003. The net proceeds from this issue were used on February 22, 1993 to redeem $90,000,000 of Forty Year 9 3/8% Debentures due in 2026, at a call price of 107.5% of the face value of the issue. As a result of the early extinguishment of this debt, which was called on January 23, 1993, the Company recorded a charge of $7,576,000, before an income tax benefit of $3,082,000, in the first quarter of 1993. At December 31, 1993, the Company had $60,000,000 outstanding under a shelf registration statement filed with the Securities and Exchange Commission. BELL ATLANTIC - WASHINGTON, D.C., INC. The fair value of long-term debt is estimated based on the quoted market prices for the same or similar issues. At December 31, 1993 and 1992, the fair value of the Company's long-term debt, excluding unamortized discount and premium and capital lease obligations, is estimated at $251,000,000 and $241,000,000, respectively. Maturing Within One Year Debt maturing within one year consists of the following at December 31: * Amounts represent average daily face amount of the note. ** Weighted average interest rates are computed by dividing the average daily face amount of the note into the aggregate related interest expense. At December 31, 1993, the Company had an unused line of credit balance of $125,000,000 with an affiliate, Bell Atlantic Network Funding Corporation (BANFC) (Note 7). 3. LEASES The Company has entered into both capital and operating leases for facilities and equipment used in operations. Plant, property and equipment included capital leases of $15,227,000 and $11,252,000 and related accumulated amortization of $9,067,000 and $7,535,000 at December 31, 1993 and 1992, respectively. In 1993, 1992, and 1991, the Company incurred initial capital lease obligations of $4,346,000, $26,000, and $76,000, respectively. Total rent expense amounted to $11,062,000 in 1993, $11,864,000 in 1992, and $15,393,000 in 1991. Of these amounts, the Company incurred rent expense of $7,558,000, $6,876,000, and $7,416,000 in 1993, 1992, and 1991, respectively, from affiliated companies. BELL ATLANTIC - WASHINGTON, D.C., INC. At December 31, 1993, the aggregate minimum rental commitments under noncancelable leases for the periods shown are as follows: 4. EMPLOYEE BENEFITS Pension Plans Substantially all of the Company's management and associate employees are covered under multi-employer noncontributory defined benefit pension plans sponsored by Bell Atlantic and certain of its subsidiaries, including the Company. The pension benefit formula is based on a flat dollar amount per year of service according to job classification under the associate plan and a stated percentage of adjusted career average earnings under the plans for management employees. The Company's objective in funding the plans is to accumulate funds at a relatively stable level over participants' working lives so that benefits are fully funded at retirement. Plan assets consist principally of investments in domestic and foreign corporate equity securities, U.S. and foreign Government and corporate debt securities, and real estate. Aggregate pension cost for the plans is as follows: The decrease in pension cost in 1993 is due to the net effect of the elimination of one-time charges associated with special termination benefits that were recognized in the preceding years, favorable investment experience, and changes in plan demographics due to retirement and severance programs. In 1992, the Company recognized $1,838,000 of special termination benefit costs related to the early retirement of associate employees. The special termination benefit costs and the net effect of changes in plan provisions, certain actuarial assumptions, and the amortization of actuarial gains and loss related to demographic and investment experience increased pension cost in 1992. A change in the expected long-term rate of return on plan assets resulted in a $3,119,000 reduction in pension cost (which reduced operating expenses by $2,807,000 after capitalization of amounts related to the construction program) and substantially offset the 1992 cost increase. BELL ATLANTIC - WASHINGTON, D.C., INC. Statement of Financial Accounting Standards No. 87, "Employers' Accounting for Pensions" (Statement No. 87) requires a comparison of the actuarial present value of projected benefit obligations with the fair value of plan assets, the disclosure of the components of net periodic pension costs and a reconciliation of the funded status of the plans with amounts recorded on the balance sheets. The Company participates in multi-employer plans and therefore, such disclosures are not presented for the Company because the structure of the plans does not allow for the determination of this information on an individual participating company basis. Significant actuarial assumptions are as follows: The Company has in the past entered into collective bargaining agreements with unions representing certain employees and expects to do so in the future. Pension benefits have been included in these agreements and improvements in benefits have been made from time to time. Additionally, the Company has amended the benefit formula under pension plans maintained for its management employees. Expectations with respect to future amendments to the Company's pension plans have been reflected in determining the Company's pension cost under Statement No. 87. Postretirement Benefits Other Than Pensions Effective January 1, 1991, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pension," (Statement No. 106). Statement No. 106 requires accrual accounting for all postretirement benefits other than pensions. Under the prescribed accrual method, the Company's obligation for these postretirement benefits is to be fully accrued by the date employees attain full eligibility for such benefits. In conjunction with the adoption of Statement No. 106, the Company elected, for financial reporting purposes, to recognize immediately the accumulated postretirement benefit obligation for current and future retirees, net of the fair value of plan assets and recognized accrued postretirement benefit cost (transition obligation), in the amount of $79,725,000, net of a deferred income tax benefit of $54,927,000. For purposes of measuring the interstate rate of return achieved by the Company, the Federal Communications Commission (FCC) permits recognition of postretirement benefit costs, including amortization of the transition obligation, in accordance with the prescribed accrual method included in Statement No. 106. In January 1993, the FCC denied adjustments to the interstate price cap formula which would have permitted tariff increases to reflect the incremental postretirement benefit cost resulting from the adoption of Statement No. 106. For intrastate ratemaking purposes, regulators issued an order on December 21, 1993, as part of a general rate preceding, which provided for the recognition of accrued postretirement benefits cost, including amortization of the transition benefit obligation over a twenty year period. Pursuant to Statement of Financial Accounting Standards No. 71, "Accounting for the Effects of Certain Types of Regulation" (Statement No. 71), a regulatory asset associated with the recognition of the transition obligation was not recorded because of uncertainties as to the timing and extent of recovery given the Company's assessment of its long-term competitive environment. BELL ATLANTIC - WASHINGTON, D.C., INC. Substantially all of the Company's management and associate employees are covered under postretirement health and life insurance benefit plans sponsored by Bell Atlantic and certain of its subsidiaries, including the Company. The determination of benefit cost for postretirement health benefit plans is based on comprehensive hospital, medical, surgical and dental benefit plan provisions. The postretirement life insurance benefit formula used in the determination of postretirement benefit cost is primarily based on annual basic pay at retirement. The Company funds the postretirement health and life insurance benefits of current and future retirees. Plan assets consist principally of investments in domestic and foreign corporate equity securities, and U.S. Government and corporate debt securities. The aggregate postretirement benefit cost for the year ended December 31, 1993, 1992, and 1991 was $13,694,000, $12,084,000, and $11,875,000, respectively. As a result of the 1992 collective bargaining agreements, Bell Atlantic amended the postretirement medical benefit plan for associate employees and certain associate retirees of the Company. The increases in the postretirement benefit cost between 1993 and 1991 were primarily due to the change in benefit levels and claims experience. Also contributing to these increases were changes in actuarial assumptions and demographic experience. Statement No. 106 requires a comparison of the actuarial present value of projected benefit obligations with the fair value of plan assets, the disclosure of the components of net periodic postretirement benefit costs, and a reconciliation of the funded status of the plan with amounts recorded on the balance sheets. The Company participates in multi-employer plans and therefore, such disclosures are not presented for the Company because the structure of the plans does not provide for the determination of this information on an individual participating company basis. The assumed discount rate used to measure the accumulated postretirement benefit obligation was 7.25% at December 31, 1993 and 7.75% at December 31, 1992. The assumed rate of future increases in compensation levels was 5.25% at December 31, 1993 and 1992. The expected long-term rate of return on plan assets was 8.25% for 1993 and 1992 and 7.5% for 1991. The medical cost trend rate in 1993 was approximately 13.0%, grading down to an ultimate rate in 2003 of approximately 5.0%. The dental cost trend rate in 1993 and thereafter is approximately 4.0%. Postretirement benefits other than pensions have been included in collective bargaining agreements and have been modified from time to time. The Company has periodically modified benefits under plans maintained for its management employees. Expectations with respect to future amendments to the Company's postretirement benefit plans have been reflected in determining the Company's postretirement benefit cost under Statement No. 106. Postemployment Benefits Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" (Statement No. 112). Statement No. 112 requires accrual accounting for the estimated cost of benefits provided to former or inactive employees after employment but before retirement. This change principally affects the Company's accounting for disability and workers' compensation benefits, which previously were charged to expense as the benefits were paid. The cumulative effect at January 1, 1993 of adopting Statement No. 112 reduced net income by $4,221,000, net of a deferred tax benefit of $2,891,000. The adoption of Statement No. 112 did not have a significant effect on the Company's ongoing level of operating expense in 1993. BELL ATLANTIC - WASHINGTON, D.C., INC. 5. INCOME TAXES Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (Statement No. 109). Statement No. 109 requires the determination of deferred taxes using the liability method. Under the liability method, deferred taxes are provided on book and tax basis differences and deferred tax balances are adjusted to reflect enacted changes in income tax rates. Prior to 1993, the Company accounted for income taxes based on the provisions of Accounting Principles Board Opinion No. 11. Statement No. 109 has been adopted on a prospective basis and amounts presented for prior years have not been restated. As of January 1, 1993, the Company recorded a charge to income of $381,000, representing the cumulative effect of adopting Statement No. 109, which has been reflected in Operating Income Taxes in the Statement of Income and Reinvested Earnings. Upon adoption of Statement No. 109, the effects of required adjustments to deferred tax balances were primarily deferred on the balance sheet as regulatory assets and liabilities in accordance with Statement of Financial Accounting Standards No. 71, "Accounting for the Effects of Certain Types of Regulation" (Statement No. 71). At January 1, 1993, the Company recorded income tax-related regulatory assets totaling $19,245,000 in Other Assets. These regulatory assets represent the anticipated future regulatory recognition of the Statement No. 109 adjustments to recognize (i) temporary differences for which deferred taxes had not been provided and (ii) the increase in the deferred state tax liability which resulted from increases in state income tax rates subsequent to the dates the deferred taxes were recorded. In addition, income tax-related regulatory liabilities totaling $40,199,000 were recorded in Deferred Credits and Other Liabilities - Other. These regulatory liabilities represent the anticipated future regulatory recognition of the Statement No. 109 adjustments to recognize (i) a reduced deferred tax liability resulting from decrease in federal income tax rates subsequent to the dates the deferred taxes were recorded and (ii) a deferred tax benefit required to recognize the effects of the temporary differences attributable to the Company's policy of accounting for investment tax credits using the deferred method. These deferred taxes and regulatory assets and liabilities have been increased for the tax effect of future revenue requirements. These regulatory assets and liabilities are amortized at the time the related deferred taxes are recognized in the ratemaking process. Prior to the adoption of Statement No. 109, the Company had income tax timing differences for which deferred taxes had not been provided pursuant to the ratemaking process of $18,484,000 and $24,273,000 at December 31, 1992 and 1991, respectively. These timing differences principally related to the allowance for funds used during construction and certain taxes and payroll-related construction costs capitalized for financial statement purposes, but deducted currently for income tax purposes, net of applicable depreciation. The Omnibus Budget Reconciliation Act of 1993, which was enacted in August 1993, increased the federal corporate income tax rate from 34% to 35%, effective January 1, 1993. In the third quarter of 1993, the Company recorded a net benefit to the tax provision of $131,000, which included a $919,000 charge for the nine month effect of the 1% rate increase, more than offset by a one- time net benefit of $1,050,000 related to adjustments to deferred tax assets associated with the postretirement benefit obligation of the Company. Pursuant to Statement No. 71, the effect of the income tax rate increase on deferred tax balances was primarily deferred through the establishment of regulatory assets of $722,000 and the reduction of regulatory liabilities of $4,319,000. The Company did not recognize regulatory assets and liabilities related to the postretirement benefit obligation or the associated deferred income tax asset. BELL ATLANTIC - WASHINGTON, D.C., INC. The components of income tax expense are as follows: Income tax benefits which relates to non-operating income and expense and is included in Miscellaneous-net were $665,000, $10,000, and $352,000 in 1993, 1992, and 1991, respectively. For the years ended December 31, 1992 and 1991, deferred income tax expense resulted from timing differences in the recognition of revenue and expense for financial and income tax accounting purposes. The sources of these timing differences and the tax effects of each were as follows: The provision for income taxes varies from the amount computed by applying the statutory federal income tax rate to income before provision for income taxes. The difference is attributable to the following factors: At December 31, 1993, the significant components of deferred tax assets and liabilities were as follows: BELL ATLANTIC - WASHINGTON, D.C., INC. Total deferred tax assets include approximately $58,000,000 related to postretirement benefit costs recognized in accordance with Statement No. 106. This deferred tax asset will gradually be realized over the estimated lives of current retirees and employees. 6. SUPPLEMENTAL CASH FLOW AND ADDITIONAL FINANCIAL INFORMATION For the years ended December 31, 1993, 1992, and 1991, revenues generated from services provided to AT&T, principally network access, billing and collection, and sharing of network facilities, were $42,983,000, $57,144,000 and $60,879,000 respectively. At December 31, 1993 and 1992, Accounts receivable, net, included $14,672,000 and $13,205,000 respectively, from AT&T. Financial instruments that potentially subject the Company to concentrations of credit risk consist of trade receivables with AT&T, as noted above. Credit risk with respect to other trade receivables is limited due to the large number of customers included in the Company's customer base. At December 31, 1992, $510,000 of negative cash was classified as Accounts payable. 7. TRANSACTIONS WITH AFFILIATES The Company has contractual arrangements with an affiliated company, Bell Atlantic Network Services, Inc. (NSI), for the provision of various centralized corporate, administrative, planning, financial and other services. These arrangements serve to fulfill the common needs of Bell Atlantic's telephone subsidiaries on a centralized basis. In connection with these services, the Company recognized $103,684,000, $99,153,000, and $94,619,000 in operating expenses for the years ended December 31, 1993, 1992, and 1991, respectively. Included in these expenses were $6,908,000 in 1993, $9,450,000 in 1992, and $7,673,000 in 1991 billed to NSI and allocated to the Company by Bell Communications Research, Inc., another affiliated company owned jointly by the seven regional holding companies. In 1991, these charges included $2,680,000, associated with NSI's adoption of Statement No. 106. In addition, in 1991, the Company recognized $27,124,000 representing the Company's proportionate share of NSI's accrued transition obligation under Statement No. 106. In connection with the adoption of Statement No. 112 in 1993, the cumulative effect included $555,000, net of a deferred income tax benefit of $380,000, representing the Company's proportionate share of NSI's accrued cost of postemployment benefits at January 1, 1993. BELL ATLANTIC - WASHINGTON, D.C., INC. The Company has a contractual agreement with an affiliated company, BANFC, for the provision of short-term financing and cash management services. BANFC issues commercial paper and secures bank loans to fund the working capital requirements of the telephone subsidiaries and NSI and invests funds in temporary investments on their behalf. In connection with this arrangement, the Company recognized interest expense of $124,000, $818,000, and $1,587,000 in 1993, 1992, and 1991, respectively, and $214,000, $54,000, and $2,000 in interest income in 1993, 1992, and 1991, respectively. In 1993, the Company received $59,750,000 in revenue from affiliates, principally related to rent received for the use of Company facilities and equipment, and paid $7,973,000 in other operating expense to affiliated companies. These amounts were $57,326,000 and $6,876,000, respectively, in 1992, and $56,856,000 and $7,416,000, respectively, in 1991. On February 1, 1994, the Company declared and paid a dividend in the amount of $7,672,000 to Bell Atlantic. 8. QUARTERLY FINANCIAL INFORMATION (unaudited) Net income for the first quarter of 1993 has been restated to include a charge of $4,221,000, net of a deferred income tax benefit of $2,891,000, related to the adoption of Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" (Note 4). BELL ATLANTIC - WASHINGTON, D.C., INC. SCHEDULE V - PLANT, PROPERTY AND EQUIPMENT ------------------------------------------ For the Year Ended December 31, 1993 (Dollars in Thousands) The notes on page are an integral part of this schedule. BELL ATLANTIC - WASHINGTON, D.C., INC. SCHEDULE V - PLANT, PROPERTY AND EQUIPMENT For the Year Ended December 31, 1992 (Dollars in Thousands) The notes on page are an integral part of this schedule. BELL ATLANTIC - WASHINGTON, D.C., INC. SCHEDULE V - PLANT, PROPERTY AND EQUIPMENT For the Year Ended December 31, 1991 (Dollars in Thousands) The notes on page are an integral part of this schedule. BELL ATLANTIC - WASHINGTON, D.C., INC. NOTES TO SCHEDULE V - PLANT, PROPERTY AND EQUIPMENT - -------------- (a) These additions include (1) the original cost (estimated if not specifically determinable) of reused material, which is concurrently credited to material and supplies, and (2) allowance for funds used during construction. Transfers between Plant in Service, Plant Under Construction and Other are also included in Additions at Cost. (b) Items of plant, property and equipment are deducted from the property accounts when retired or sold at the amounts at which they are included therein, estimated if not specifically determinable. (c) The Company's provision for depreciation is principally based on the remaining life method and straight-line composite rates prescribed by regulatory authorities. The remaining life method provides for the full recovery of the remaining net investment in plant, property and equipment. In 1992, the Company implemented changes in depreciation rates approved by regulatory authorities. These changes reflect decreases in estimated service lives of the Company's plant, property and equipment in service. This ruling will allow a more rapid recovery of the Company's investment in plant, property and equipment through closer alignment with current estimates of its remaining economic useful life. For the years 1993, 1992, and 1991, depreciation expressed as a percentage of average depreciable plant was 8.4%, 8.5%, and 7.0%, respectively. (d) See Note 1 of Notes to Financial Statements for the Company's depreciation policies. BELL ATLANTIC - WASHINGTON, D.C., INC. SCHEDULE VI - ACCUMULATED DEPRECIATION For the Years Ended December 31, 1993, 1992, and 1991 (Dollars in Thousands) - ---------------------------------------- (a) Includes any gains or losses on disposition of plant, property and equipment. These gains and losses are amortized to depreciation expense over the remaining service lives of remaining net investment in plant, property and equipment. BELL ATLANTIC - WASHINGTON, D.C., INC. SCHEDULE VIII - VALUATION OF QUALIFYING ACCOUNTS For the Years Ended December 31, 1993, 1992, and 1991 (Dollars in Thousands) - ------------------------------------------- (a) (i) Amounts previously written off which were credited directly to this account when recovered; and (ii) accruals charged to accounts payable for anticipated uncollectible charges on purchases of accounts receivable from others which were billed by the Company. (b) Amounts written off as uncollectible. BELL ATLANTIC - WASHINGTON, D.C., INC. SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION For the Years Ended December 31, 1993, 1992, and 1991 (Dollars in Thousands) Advertising costs for 1993, 1992, and 1991 are not presented, as such amounts are less than 1 percent of total operating revenues. Amounts reported for 1992 and 1991 for maintenance and repairs have been revised to include certain additional costs. EXHIBITS FILED WITH ANNUAL REPORT FORM 10-K UNDER THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 1993 Bell Atlantic - Washington, D.C., Inc. COMMISSION FILE NUMBER 1-7368 Form 10-K for 1993 File No. 1-7368 Page 1 of 1 EXHIBIT INDEX Exhibits identified in parentheses below, on file with the Securities and Exchange Commission (SEC), are incorporated herein by reference as exhibits hereto. Exhibit Number (Referenced to Item 601 of Regulation S-K) - ---------------------------------------------------------- 3a Restated Certificate of Incorporation of the registrant, as amended September 14, 1990. (Exhibit 3a to the registrant's Annual Report on Form 10-K for the year ended December 31, 1990, File No. 1-7368.) 3a(i) Certificate of Amendment of the registrant's Certificate of Incorporation, dated January 12, 1994 and filed January 13, 1994. 3b By-Laws of the registrant, as amended June 18, 1992. (Exhibit 3b to the registrant's Annual Report on Form 10-K for the year ended December 31, 1992, File No. 1-7368.) 4 No instrument which defines the rights of holders of long and intermediate term debt of the registrant is filed herewith pursuant to Regulation S-K, Item 601(b)(4)(iii)(A). Pursuant to this regulation, the registrant hereby agrees to furnish a copy of any such instrument to the SEC upon request. 10a Agreement Concerning Contingent Liabilities, Tax Matters and Termination of Certain Agreements among AT&T, Bell Atlantic Corporation, and the Bell Atlantic Corporation telephone subsidiaries, and certain other parties, dated as of November 1, 1983. (Exhibit 10a to Bell Atlantic Corporation Annual Report on Form 10-K for the year ended December 31, 1993, File No. 1-8606.) 10b Agreement among Bell Atlantic Network Services, Inc. and the Bell Atlantic Corporation telephone subsidiaries, dated November 7, 1983. (Exhibit 10b to Bell Atlantic Corporation Annual Report on Form 10-K for the year ended December 31, 1993, File No. 1-8606.) 23 Consent of Coopers & Lybrand. 24 Powers of attorney.
11860_1993.txt	11860	1993	ITEM 1. BUSINESS. Bethlehem (1) is the second largest steel producer in the United States and is engaged primarily in the manufacture and sale of a wide variety of steel mill products. Bethlehem also produces and sells coal and other raw materials, repairs ships and offshore drill rigs and manufactures and sells forgings and castings. For financial reporting purposes, Bethlehem has disaggregated the results of its operations and certain other financial information into two segments, Basic Steel Operations and Steel Related Operations. Note C to the Consolidated Financial Statements sets forth certain financial information relating to Bethlehem's industry segments for 1993, 1992 and 1991. The table below shows the percentage contribution to Bethlehem's net sales of each segment and of major classes of products for each of the years 1991 through 1993: 1993 1992 1991 ---- ---- ---- Basic Steel Operations Steel mill products: Sheets and tin mill products 63.1% 59.1% 48.4% Plates 13.6 13.3 13.0 Structural shapes and piling 8.5 9.6 8.9 Rail products 3.6 2.8 2.4 Bars, rods and semifinished 1.2 2.6 10.1 Other steel mill products .8 1.2 4.0 Other products and services (including raw materials) 6.8 7.5 7.8 ---- ---- ---- 97.6 96.1 94.6 Steel Related Operations 2.4 3.9 5.4 ---- ---- ---- 100.0% 100.0% 100.0% ====== ====== ====== Basic Steel Operations Bethlehem's Basic Steel Operations produces a wide variety of steel mill products, including hot rolled, cold rolled and coated sheets and strip, plates, structural shapes, piling, tin mill products, specialty blooms, carbon and alloy bars, rail and pipe. Basic Steel Operations includes the following business units: the Burns Harbor Division, the Sparrows Point Division, Bethlehem Structural Products Corporation and Pennsylvania Steel Technologies, Inc. Also included in Basic Steel Operations are iron ore and coal operations (which provide raw materials to Bethlehem's steelmaking facilities and sell such materials to trade customers), railroad operations (which primarily transport raw materials and semifinished steel products within various Bethlehem operations) and lake shipping operations (which primarily transport raw materials to the Burns Harbor Division). See "ITEM 2.		ITEM 2. PROPERTIES. Properties Relating to the Basic Steel Operations Segment - 11 - Burns Harbor Division The principal operations of the Burns Harbor Division are located along the shore of Lake Michigan near Chicago, Illinois. The principal products of the Burns Harbor Division are hot rolled and cold rolled sheets and coated sheets for the automotive, service center, container, office furniture and appliance markets and plates for the construction, machinery and service center markets. Principal facilities include a sintering plant, two coke oven batteries, two blast furnaces, three basic oxygen furnaces with a combined annual raw steel production capability of approximately five million tons, a vacuum degassing facility, two continuous slab casters with a combined annual production capability of four million tons, a 50 x 96-inch slabbing mill, two sheared plate mills (110-inch and 160-inch), an 80-inch hot-strip mill, an 80-inch five stand cold reducing mill, sheet finishing mills, a continuous heat treating line, batch annealing facilities, a 48-inch continuous electrogalvanizing line and a new 72-inch hot- dip galvanizing line. About 80 percent of the steel produced at Burns Harbor is continuously cast; the remaining 20 percent is ingot cast. Ingot cast slabs are used primarily to make heavy steel plates. The Galvanized Products Division, an operating unit of the Burns Harbor Division, is located in Lackawanna, New York. Facilities of the Galvanized Products Division include a continuous pickling line, a four stand cold reducing mill, a sheet finishing complex and a 72-inch hot-dip galvanizing line. The Burns Harbor Division also operates coke-making facilities at Lackawanna, New York. The Burns Harbor Division's utilization of raw steel production capability was 106 percent during 1993. Sparrows Point Division The operations of the Sparrows Point Division are located along the Chesapeake Bay near Baltimore, Maryland. The principal products of the Sparrows Point Division are hot rolled and cold rolled sheets, tin mill products, galvanized sheet, Galvalume sheet, plates and semifinished steel products for service centers and the container, construction, appliance and other metals markets. Principal facilities include a sintering plant, three coke oven batteries (which are cold idled), a large blast furnace, two basic oxygen furnaces with an annual raw steel production capability of approximately 3.5 million tons, a two strand continuous slab caster with a present annual production capability of approximately 3.5 million tons, a 160-inch sheared plate mill, a recently modernized 68-inch hot-strip mill, three cold reducing mills (66-inch, 56-inch and 48-inch), continuous and batch annealing facilities, a galvanizing line, two Galvalume lines, recently modernized tin mill facilities and a new 48-inch hot-dip galvanizing line. Sparrows Point is currently obtaining coke from Structural Products and from various commercial sources. The Division continuously casts essentially 100 percent of its total production volume. The Sparrows Point Division's utilization of raw steel production capability was 92 percent during 1993. Bethlehem Structural Products Corporation The operations of Bethlehem Structural Products Corporation are located in Bethlehem, Pennsylvania. Its principal products are structural steel shapes and piling products primarily for the - 12 - building and construction markets and ingot molds for the metals industry. Principal facilities include three coke oven batteries, one blast furnace (an additional blast furnace provides backup capacity), two basic oxygen furnaces with a combined annual raw steel production capability of 1.5 million tons, two blooming mills (40-inch and 46-inch), a 48-inch structural rolling mill, a 44-inch structural rolling mill, an induction furnace and an ingot mold foundry. The existing iron and steelmaking operations, which include the blast furnaces, basic oxygen furnaces and related facilities, will be discontinued by 1996. Structural Products' utilization of raw steel production capability was 81 percent during 1993. On January 26, 1994, Bethlehem announced a revised modernization plan for Structural Products. Under the plan, Structural Products will focus on the production and sale of light and medium wide-flange sections, which comprise about 80 percent of the wide-flange market in the United States. The revised plan is the result of a number of market developments, including a reduction in the demand for heavy wide-flange sections caused by reduced high-rise building construction activity, continued low occupancy rates in commercial buildings, trends toward lighter construction in buildings and delays in the rebuilding of the nation's infrastructure. Structural Products will continue to manufacture heavy wide- flange structurals (which accounted for approximately one-third of this business' 1993 production) until it phases out its iron and steelmaking operations by 1996, as previously announced. Its 44- inch structural rolling mill complex will be upgraded and modernized and will be sourced with lower cost, continuously cast steel produced primarily at Pennsylvania Steel Technologies' newly modernized state-of-the-art operations in Steelton, Pennsylvania. The revised plan is expected to result in competitive costs with substantially lower investment requirements (expected to be in the range of $25-$35 million) than the previously announced modernization plan and should permit production of wide-flange sections of up to 27 inches. Other benefits include higher utilization of the 44-inch structural rolling mill, higher utilization of the steelmaking facilities at Pennsylvania Steel Technologies, improved product quality and better utilization of Bethlehem's overall financial and other resources. Pennsylvania Steel Technologies, Inc. The operations of Pennsylvania Steel Technologies, Inc. are located near Harrisburg, Pennsylvania. Its principal products are railroad rails, specialty blooms, carbon and alloy bars, and large diameter pipe for the rail transportation, forging, rerollers and oil and gas industries. Principal facilities include three electric arc furnaces with a combined annual raw steel production capability of 1.3 million tons, a continuous bloom caster, a 44- inch blooming mill, a 20-inch bar mill, a 28-inch rail mill, finishing and shipping facilities for long-length (80 foot) rails and an electric fusion welded pipe mill. Pennsylvania Steel Technologies' utilization of raw steel production capability was 40 percent during 1993. Bethlehem also owns another rail mill located in Monessen, Pennsylvania, which is not operating. Bethlehem has announced it is seeking buyers for the production equipment of this mill. - 13 - A $70 million modernization program is under way at Pennsylvania Steel Technologies, which will enable this business to produce premium head-hardened rails and includes the installation of state-of-the-art steelmaking facilities, including a new DC electric arc furnace, a ladle furnace and a vacuum degassing unit. This program is expected to be completed during the second half of 1994. Joint Ventures Bethlehem is participating in a joint venture, known as Double G Coatings Company, L.P., which is building a 270,000 ton per year sheet coating line near Jackson, Mississippi. The new line, which is scheduled to start up in the second quarter of 1994, will produce galvanized and Galvalume coated sheets primarily for the construction market. Sparrows Point will provide cold rolled coils for approximately half of Double G's annual capacity and will be responsible for marketing its share of the finished product. Bethlehem participates in a joint venture which owns and operates a 400,000 ton per year electrogalvanizing line at Walbridge, Ohio. This facility produces corrosion resistant sheet steel primarily for the automobile industry and other consumer durables markets. Burns Harbor provides cold rolled coils for 75 percent of Walbridge's annual capacity and is responsible for marketing its share of the finished product. In order to better serve the needs of the Burns Harbor Division's automotive customers, Bethlehem has announced that it intends to form a joint venture with a steel service center to produce tailored welded steel blanks for automotive stampings through use of a technologically advanced welding process. Bethlehem also has indirect equity interests in various iron ore properties. See "Raw Material Properties and Interests" below. Raw Material Properties and Interests Iron Ore. Bethlehem has indirect equity interests in various iron ore operating properties, which (excluding tonnages applicable to interests owned by others) it estimates contained recoverable reserves at December 31, 1993, sufficient to produce at least 13 million tons of direct shipping iron ore located in Brazil and 445 million tons of iron ore concentrates and pellets, of which 191 million tons are located in Minnesota and 254 million tons in Canada. In addition to the estimated reserves at operating properties, Bethlehem also has indirect equity interests in undeveloped or nonoperating iron ore properties, which (excluding tonnages applicable to interests owned by others) it estimates contained recoverable reserves at December 31, 1993, sufficient to produce at least 31 million tons of direct shipping iron ore located in Brazil and 126 million tons of iron ore pellets located in Minnesota. The iron ore operating properties in which Bethlehem has interests have mining and processing facilities that are capable of supplying the major portion of Bethlehem's current annual iron ore requirements. However, taking into account the location of Bethlehem's steel plants and the iron ore products best suited to these facilities, Bethlehem has found it advantageous to engage in iron ore sales and exchanges with other consumers and to purchase a portion of its iron ore requirements. These purchases have been from various sources, including sources in which it has - 14 - ownership interests, under a variety of contractual arrangements extending over varying periods of time. Bethlehem's share of the annual iron ore pellet production by enterprises in which it had ownership interests, for Bethlehem's use or sale to trade customers, was 12.5 million tons in 1993 and 12.8 million tons in 1992. In addition to these sources, Bethlehem purchased 1.7 million tons and 2.3 million tons of iron ore in 1993 and 1992, respectively, from sources in which it had no ownership interests. In 1993, Bethlehem obtained approximately 70 percent of its iron ore requirements from operations in which it had ownership interests, compared to 71 percent in 1992. Of the iron ore consumed by Bethlehem in 1993, approximately 57 percent consisted of pellets and 43 percent of sinter. Through December 31, 1998, Bethlehem is committed to purchase 0.6 million tons of iron ore from sources in which it has no ownership interests. Bethlehem is also committed to purchase from sources in which it has ownership interests 0.2 million tons of iron ore in excess of such ownership interests. Bethlehem had trade sales of iron ore in 1993 and 1992 of 2.0 million tons and 2.3 million tons, respectively. Additional iron ore trade sales commitments through December 31, 1998, presently aggregate 3.4 million tons. The interests in foreign iron ore properties described above are subject to the risks associated with investments in foreign countries, including the risk of nationalization. Coal and Coke. Bethlehem owns coal operating properties in Pennsylvania and West Virginia, which it estimates contained recoverable reserves at December 31, 1993, sufficient to produce at least 134 million tons of coal, of which approximately 52 percent and 48 percent, respectively, are metallurgical and steam coal. In addition to the estimated reserves at operating properties, Bethlehem also owns undeveloped or nonoperating coal properties in Pennsylvania and West Virginia, which it estimates contained recoverable reserves at December 31, 1993, sufficient to produce at least 122 million tons of coal, of which approximately 85 percent and 15 percent, respectively, are metallurgical and steam coal. During 1993, Bethlehem's coal operations produced 3.9 million tons of coal compared to 6.1 million tons in 1992. Trade shipments of coal were 2.5 million tons in 1993 compared to 4.0 million tons in 1992. In 1993, Bethlehem obtained approximately 31 percent of its coal requirements from its own mines, compared to 41 percent in 1992. The balance of Bethlehem's requirements is purchased from commercial sources. In December 1991, Bethlehem suspended all coke production at its Sparrows Point Division, and is currently assessing implementation of the most cost-effective method for supplying coke and completing an emissions control program to meet environmental regulations. Sparrows Point is obtaining coke from the coke ovens at Structural Products and from various commercial sources. - 15 - Bethlehem continues to operate coke-making facilities at Structural Products, Burns Harbor and at Lackawanna, New York. During 1993, a rebuild was commenced of one of the two coke oven batteries at Burns Harbor which is expected to be completed in mid-1995. During this period, Burns Harbor's coke needs are being supplied by other Bethlehem coke operations and from commercial sources. Other Raw Materials. Bethlehem purchases its other raw material requirements from commercial sources. Transportation. Bethlehem owns five subsidiary shortline railroads which primarily transport raw materials and semifinished steel products within various Bethlehem operations. Bethlehem also owns one line- haul railroad serving a coal mine near Johnstown, Pennsylvania. The Burns Harbor Division operates two 1,000 foot ore vessels (one owned and one under long-term charter), which are used for the transportation of iron ore on the Great Lakes. Properties Relating to the Steel Related Operations Segment BethForge, Inc. has a facility for the production of forgings and castings located in Bethlehem, Pennsylvania. An ingot teeming facility and vacuum degassing unit are being installed for BethForge's use at Pennsylvania Steel Technologies, Inc. in order to take advantage of the new DC electric arc furnace and ladle refining station being installed as part of Pennsylvania Steel Technologies' modernization program. This new facility, with its lower cost, higher quality ingots, will replace BethForge's existing steelmaking facility during 1995. CENTEC, Bethlehem's joint venture with a subsidiary of Usinor-Sacilor, a French Steelmaker, has a facility for the production of centrifugally cast rolls located in Bethlehem, Pennsylvania. Bethlehem's BethShip Division has marine construction facilities consisting of a ship repair yard at Sparrows Point, Maryland, and a dry dock facility for the repair and inspection of offshore drill rigs and other vessels at Port Arthur, Texas. The dry dock facility at Port Arthur, Texas is for sale. General While Bethlehem's principal plants and facilities are adequately maintained, they are of varying ages, technologies and operating efficiencies. Bethlehem believes that most of its plants and facilities currently are competitive with the plants and facilities of its principal competitors in the domestic steel industry. Bethlehem continues to invest substantial amounts to maintain and modernize its plants and facilities. See "ITEM 1. BUSINESS--General--Capital Expenditures" of this Report for a discussion of Bethlehem's capital expenditures. All principal plants and facilities are owned in fee by Bethlehem except for two continuous casters at Sparrows Point and Burns Harbor, a coal cleaning and processing facility at High Power Mountain in West Virginia and the drill rig repair facility at Port - 16 - Arthur, Texas, each of which is being leased. As discussed in Note G to the Consolidated Financial Statements, Bethlehem has capitalized the expenditures related to the leases for two continuous casters. As discussed in Note F to the Consolidated Financial Statements, Bethlehem has borrowed $270 million to finance the construction of two new hot-dip galvanizing lines at its Burns Harbor and Sparrows Point plants and has pledged these two facilities as collateral for the borrowings. ITEM 3.	ITEM 3. LEGAL PROCEEDINGS. Bethlehem is a party to numerous legal proceedings incurred in the ordinary course of its business, including the matters specifically discussed below. On October 4, 1990, the State of Maryland Department of the Environment ("MDE") filed a civil action against Bethlehem in the Circuit Court of Baltimore County, Maryland seeking civil penalties for alleged violations of the Maryland air pollution regulations arising out of exceedances of the visible emissions standards established for various sources at the Sparrows Point Division by an October 1987 Consent Order, as amended in June 1989. On April 30, 1991, the MDE filed a complaint in intervention in a civil action filed on April 25, 1991 by the Justice Department on behalf of the EPA against Bethlehem, alleging violations of the Clean Air Act resulting from alleged violations of Maryland air pollution regulations at the Sparrows Point Division. The complaint in intervention, which was approved by the Court on June 14, 1991, incorporated all of the violations alleged in the MDE complaint. On May 1, 1992, a settlement between the parties to the EPA action was memorialized in a Consent Decree which was entered by the Court on July 1, 1992. The Consent Decree resolved all of the issues in both the federal and state actions except for a single count in the MDE action dealing with alleged violations from the basic oxygen furnace. The Consent Decree requires Bethlehem to pay a civil penalty of $3.5 million over a three year period in equal annual installments beginning in 1992. Bethlehem and the MDE have entered into discussions concerning potential settlement of the remaining count in the MDE action. On October 16, 1990, the Justice Department on behalf of the EPA filed a civil action against Bethlehem in the United States District Court for the Northern District of Indiana seeking injunctive relief and civil penalties for alleged violations of RCRA and the Safe Drinking Water Act with respect to the Burns Harbor Division, including failure to manage certain of the plant's sludges as hazardous wastes, and failure to begin a corrective action program pursuant to the terms of a previously issued underground injection permit. On March 19, 1993, the Court issued a Memorandum Opinion and Order granting Partial Summary Judgment for the government concerning the liability issues in the case and ordering Bethlehem to comply with interim status requirements of RCRA for its terminal polishing lagoons and landfill and to comply with the corrective action requirements of Bethlehem's underground injection well permits. A hearing on the civil penalty issue was concluded on July 21, 1993, and on August 31, 1993 the Court entered a judgment against Bethlehem for $6 million. This sum consisted of $4.2 million for alleged permit violations and $1.8 million for the alleged landfill violations. Bethlehem continues to believe that it has meritorious defenses and that the trial court's decisions are erroneous. Bethlehem has filed separate Notices of Appeal with the United States Court of Appeals for the Seventh Circuit appealing the trial court's grant of - 17 - summary judgment and its penalty determination. On November 8, 1993, the Seventh Circuit issued an Order staying the trial court's injunction with respect to the terminal polishing lagoons and the landfill. On May 28, 1992, the New York State Department of Environmental Conservation ("DEC") sent Bethlehem a proposed Order on Consent to resolve various alleged violations of the New York air pollution control regulations for emissions from the Lackawanna coke ovens. The Order, which originally covered alleged violations for the period from May 1, 1990 through October 7, 1991, has been supplemented to cover all alleged violations of state air pollution regulations up to the date of execution of the proposed Order. The updated Order also cites Bethlehem for failure to properly operate its sulfur recovery system in the coal chemical by-products plant and failure to properly certify opacity monitors on the under fire stacks of the coke oven batteries. In addition, the Order proposes a civil penalty of $1.5 million. Bethlehem has entered into negotiations with the DEC to attempt to resolve this matter. If those negotiations are unsuccessful, Bethlehem believes it has meritorious defenses and will vigorously defend the action. BethEnergy Mines Inc. (formerly Bethlehem Minerals Company), a subsidiary of Bethlehem, is a party to an action entitled Church and Mullins, et al v. Bethlehem Minerals Company, et al. The case involves a dispute concerning title to coal mined by Bethlehem under a parcel of land in eastern Kentucky. The trial court opinion, delivered February 25, 1987, held that the coal in question was owned by the Church and Mullins interests and awarded damages in the amount of $16.9 million. On appeal, on January 12, 1990, the Kentucky Court of Appeals reversed the trial court judgment in part and affirmed it in part, essentially upholding the trial court's finding on the issue of title but limiting the award of damages. The Court of Appeals decision was further appealed to the Supreme Court of Kentucky, and on June 4, 1992, the Supreme Court of Kentucky, by a vote of four to three, reinstated the decision of the trial court, making Bethlehem liable for damages and interest aggregating approximately $34 million. On June 24, 1992, Bethlehem petitioned the Kentucky Supreme Court to reconsider its ruling. On August 28, 1992, the Kentucky Supreme Court granted oral argument on Bethlehem's motion. The motion was argued on December 15, 1993 and a decision has not yet been rendered. Bethlehem continues to believe that the trial court made a number of fundamental errors, including the issue as to title, and intends to contest the decision vigorously through all appropriate means. Nevertheless, Bethlehem increased its reserve for loss contingencies by recording a $25 million charge against earnings for the second quarter of 1992 and has continued to increase the reserve for interest accrued thereon. Bethlehem will revise the reserve in the event the Kentucky Supreme Court grants the relief Bethlehem has requested and believes is warranted. An adverse final resolution of the case would not have any other effect on Bethlehem's results of operations because Bethlehem sold its Kentucky coal operations in 1988. The Justice Department, the EPA and the Texas Natural Resource Conservation Commission (formerly Texas Water Commission) have instituted a criminal investigation into certain environmental practices involving the operations of the BethShip Sabine Yard in Port Arthur, Texas. The basic operations of the Yard comprise the drydocking of marine vessels to clean and paint exterior surfaces and internal tanks, as well as performing steel hull plate repairs and other general repairs. These operations use blasting grit, paint thinner and other materials. The investigation includes the - 18 - above operations and the usage, treatment, storage and disposal of those materials. Bethlehem is cooperating with the authorities as to the conduct of the investigation, which is continuing. No criminal charges have been brought or fines or penalties proposed, and it is not possible at this time to reach any conclusions as to the outcome of the investigation or the future decisions or actions by the governmental agencies. On September 10, 1992, the Justice Department on behalf of the EPA filed a complaint against Bethlehem in the United States District Court for the Eastern District of Pennsylvania for penalties for alleged violations of the coke-by-product recovery plant benzene NESHAP at Bethlehem Structural Products Corporation and the Sparrows Point Division. The complaint alleges that Bethlehem failed to meet the regulatory deadlines for operation of certain sources covered by benzene NESHAP regulations at the two facilities. The complaint also alleges that Bethlehem failed to submit certain monthly reports in a timely fashion. Bethlehem has met with representatives of the Justice Department and the EPA and a tentative settlement of this action has been reached whereby Bethlehem would agree to pay a civil penalty of $650,000 and to continue to comply with all applicable requirements of the benzene NESHAP regulations at Bethlehem Structural Products Corporation and at the Sparrows Point Division. On January 13, 1993, the EPA issued an Administrative Complaint alleging that Bethlehem had failed to report certain spills of hazardous substances from various locations at the Burns Harbor Division as required by Section 103 of CERCLA. The EPA has proposed a civil penalty of $207,750. Bethlehem and the EPA have entered into discussions concerning potential settlement of the action. In the event those settlement negotiations do not succeed, Bethlehem believes it has meritorious defenses and will vigorously defend the action. On December 30, 1993, the EPA sent Bethlehem a letter alleging that Bethlehem was in violation of the Partial Consent Decree entered on May 20, 1991, between Bethlehem and the United States concerning alleged violations of the Clean Air Act at the Burns Harbor Division. The letter alleges that Bethlehem violated the door emission limits stated in the Decree for coke oven battery number 2 located at the facility at various times from October 1991 through September 1993 and demands payment of a stipulated penalty of $255,750. On January 18, 1994, Bethlehem and the EPA met to discuss the demand letter and associated issues concerning future compliance with the Decree. At the meeting, Bethlehem provided the EPA with additional information which is being evaluated for its impact, if any, on the penalty demand. See "ITEM 1. BUSINESS--General--Environmental Control and Cleanup Expenditures" of this Report for a discussion of Bethlehem's potential responsibilities for environmental cleanup at certain sites under RCRA and CERCLA. Bethlehem cannot predict with any certainty the outcome of any legal proceedings to which it is a party. However, in the opinion of Bethlehem's management, adequate reserves have been recorded for losses which are likely to result from these proceedings. To the extent that such reserves prove to be inadequate, Bethlehem would incur a charge to earnings which could be material to its future results of operations in particular quarterly or annual periods. The outcome of these proceedings, however, is not currently expected to have a material adverse effect on Bethlehem's consolidated financial position. - 19 - ITEM 4.	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. There were no matters submitted to a vote of security holders during the fourth quarter of 1993. - ----------------------------------------- - 20 - Executive Officers of the Registrant. The executive officers of Bethlehem as of March 15, 1994, are as follows: Name Age Position Curtis H. Barnette 59 Chairman (Chief Executive Officer) Roger P. Penny 57 President (Chief Operating Officer) Gary L. Millenbruch 56 Executive Vice President (Chief Financial Officer) John A. Jordan, Jr. 58 Senior Vice President (Administration) David P. Post 60 Senior Vice President (Commercial) Lonnie A. Arnett 48 Vice President and Controller (Accounting) Dr. Walter N. Bargeron 51 President, Services Division (Chief Technology Officer) Benjamin C. Boylston 61 Vice President (Human Resources) Stephen G. Donches 48 Vice President (Public Affairs) Duane R. Dunham 52 President, Sparrows Point Division Joseph F. Emig 56 President, Burns Harbor Division George T. Fugere 60 Vice President (Materials Management)* Andrew R. Futchko 51 President, Pennsylvania Steel Technologies, Inc. William H. Graham 48 General Counsel G. Penn Holsenbeck 47 Secretary and Deputy General Counsel John L. Kluttz 51 Vice President (Union Relations) Timothy Lewis 56 President, Bethlehem Structural Products Corporation - 21 - Dr. Carl F. Meitzner 54 Vice President (Planning) Dr. Augustine E. Moffitt, Jr. 48 Vice President (Safety, Health and Environment) Andrew M. Weller 47 Vice President and Treasurer (Finance) William E. Wickert, Jr. 62 Vice President (Federal Government Affairs) All of the executive officers have held responsible management or professional positions with Bethlehem or its subsidiaries for more than the past five years. The By-laws of Bethlehem provide that the officers shall be chosen annually by the Board of Directors and that each officer shall hold office until his successor shall have been elected and shall qualify or until his earlier death or his earlier resignation or removal in the manner provided in the By-laws. *George T. Fugere will retire as Vice President, effective March 31, 1994. - 22 - PART II ITEM 5.	ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS. As of March 15, 1994, there were 108,876,296 shares of Bethlehem Common Stock outstanding held by approximately 42,000 stockholders of record. The principal market for Bethlehem Common Stock is the New York Stock Exchange. Bethlehem Common Stock is also listed on the Chicago Stock Exchange. Dividends on Bethlehem Common Stock are paid quarterly when declared by Bethlehem's Board of Directors. Under the provisions of Bethlehem's 10-3/8% Senior Notes due 2003, Bethlehem's ability to pay dividends on its Common Stock is restricted. See Note M to the Consolidated Financial Statements. At March 15, 1994, $394 million was available for the payment of Common Stock dividends under these provisions. Bethlehem has not paid a dividend on its Common Stock since the fourth quarter of 1991. In accordance with Bethlehem's policy, future dividends will be determined by the Board of Directors (subject to any applicable restrictions) on the basis of attained results and the business outlook. The following table sets forth, for the periods indicated, the high and low sales prices of Bethlehem Common Stock as reported in the consolidated transaction reporting system. The closing sale price of Bethlehem Common Stock on March 15, 1994, as reported in the consolidated transaction reporting system, was $21.50. 1993 1992 ---- ---- Sales Prices Sales Prices ------------ ------------ Period High Low High Low ---- --- ---- --- First Quarter $20.000 $14.875 $17.250 $12.750 Second Quarter 21.000 16.375 16.625 12.875 Third Quarter 19.125 12.875 15.375 11.500 Fourth Quarter 20.625 13.750 16.625 10.000 ITEM 6.	ITEM 6. SELECTED FINANCIAL DATA. The information required by this Item is incorporated by reference from page 31 of Bethlehem's 1993 Annual Report to Stockholders. With the exception of the information specifically incorporated by reference, the 1993 Annual Report to Stockholders is not to be deemed filed as part of this Report for purposes of this Item. ITEM 7.	ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The information required by this Item is incorporated by reference from pages 2 to 4 and 15 to 19, inclusive, of Bethlehem's 1993 Annual Report to Stockholders. With the exception of the - 23 - information specifically incorporated by reference, the 1993 Annual Report to Stockholders is not to be deemed filed as part of this Report for purposes of this Item. ITEM 8.	ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The information required by this Item is incorporated by reference from pages 20 to 29, inclusive, of Bethlehem's 1993 Annual Report to Stockholders. With the exception of the information specifically incorporated by reference, the 1993 Annual Report to Stockholders is not to be deemed filed as part of this Report for purposes of this Item. 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. In addition to the information set forth under the caption "Executive Officers of the Registrant" in Part I of this Report, the information required by this Item is incorporated by reference from pages 2 to 6, inclusive, of Bethlehem's Proxy Statement for the 1994 Annual Meeting of Stockholders. With the exception of the information specifically incorporated by reference, Bethlehem's Proxy Statement is not to be deemed filed as part of this Report for purposes of this Item. ITEM 11.	ITEM 11. EXECUTIVE COMPENSATION. The information required by this Item is incorporated by reference from pages 16 to 22, inclusive, of Bethlehem's Proxy Statement for the 1994 Annual Meeting of Stockholders. With the exception of the information specifically incorporated by reference, Bethlehem's Proxy Statement is not to be deemed filed as part of this Report for purposes of this Item. ITEM 12.	ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information required by this Item is incorporated by reference from pages 7 and 23 to 24, inclusive, of Bethlehem's Proxy Statement for the 1994 Annual Meeting of Stockholders. With the exception of the information specifically incorporated by reference, Bethlehem's Proxy Statement is not to be deemed filed as part of this Report for purposes of this Item. ITEM 13.	ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information required by this Item is incorporated by reference from the material appearing under the headings "Compensation Committee Interlocks and Insider Participation" and "Indemnification Assurance Agreements" appearing, respectively, on pages 8 to 9, inclusive, and page 23 of Bethlehem's Proxy Statement - 24 - for the 1994 Annual Meeting of Stockholders. With the exception of the information specifically incorporated by reference, Bethlehem's Proxy Statement is not to be deemed filed as part of this Report for purposes of this Item. PART IV ITEM 14.	ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) Documents filed as part of this Report: The following is an index of the financial statements, schedules and exhibits included in this Report or incorporated herein by reference. (1) Financial Statements. BETHLEHEM STEEL CORPORATION AND CONSOLIDATED SUBSIDIARIES Page Consolidated Statements of Income for the years 1993, 1992 and 1991 . . . . . . . . . . . . . . . . . . . . . . * Consolidated Balance Sheets, December 31, 1993 and December 31, 1992. . . . . . . . . . . . . . . . . . . * Consolidated Statements of Cash Flows for the years 1993, 1992 and 1991. . . . . . . . . . . . . . . . . . . . . * Notes to Consolidated Financial Statements (Including Quarterly Financial Data) . . . . . . . . . * (2) Consolidated Financial Statement Schedules. Report of Independent Accountants On Consolidated Financial Statement Schedules . . . . . . . . . . . . . . . . . Schedules: V -- Property, Plant and Equipment, years ended December 31, 1993, 1992 and 1991 . . . . . . . . . VI -- Accumulated Depreciation of Property, Plant and Equipment, years ended December 31, 1993, 1992 and 1991. . . . . . . . . . . . . . . . . . . . . . VIII -- Valuation and Qualifying Accounts and Reserves, years ended December 31, 1993, 1992 and 1991. . . . X -- Supplementary Income Statement Information, years ended December 31, 1993, 1992 and 1991 . . . . . . * Incorporated in this Report by reference from pages 20 to 29, inclusive, of Bethlehem's 1993 Annual Report to Stockholders referred to below. The Consolidated Financial Statements, together with the report thereon of Price Waterhouse dated January 26, 1994, appearing on pages 20 to 30, inclusive, of the accompanying 1993 Annual Report to Stockholders are incorporated by reference in this Form 10-K Annual Report. With the exception of those pages, the 1993 Annual Report to Stockholders is not to be deemed filed as part of this Report for purposes of this Item. The Schedules listed above should be read in conjunction with the consolidated financial statements in such 1993 Annual Report to Stockholders. - 25 - Schedules not included have been omitted because they are not applicable or the required information is shown in the consolidated financial statements or notes thereto. Separate financial statements of subsidiaries not consolidated and 50 per cent or less owned persons accounted for by the equity method have been omitted because considered in the aggregate as a single subsidiary they do not constitute a significant subsidiary. (3) Exhibits. The following is an index of the exhibits included in this Report or incorporated herein by reference. (3)(a) Restated Certificate of Incorporation, as corrected by the certificate of Correction relating thereto (Incorp reference from Exhibit 28 to Bethlehem's quarterly report on Form 10-Q for the quarter ended June 30, 1988). (b) By-laws of Bethlehem Steel Corporation, as amended October 1, 1988. (4)(a) Rights Agreement, dated as of September 28, 1988, between Bethlehem Steel Corporation and Morgan Shareholder Services Trust Company. (b) Certificate of the Voting Powers, Designation, Preferences and Relative, Participating, Optional or Other Special Rights, and the Qualifications, Limitations or Restrictions Thereof, of the Employee Stock Ownership Plan Convertible Preference Stock, Series B (Par Value $1 Per Share; Stated Value $40 Per Share) of Bethlehem Steel Corporation, as amended and supplemented by the Certificate of Decrease relating thereto (Incorporated by reference from Exhibit 4 to Bethlehem's quarterly report on Form 10-Q for the quarter ended March 31, 1991). (c) Certificate of the Voting Powers, Designation Preferences and Relative, Participating, Optional or Other Special Rights, and the Qualifications, Limitations or Restrictions Thereof, of the $3.50 Cumulative Convertible Preferred Stock (Par Value $1 Per Share) of Bethlehem Steel Corporation, as amended and supplemented by the Certificate of Increase relating thereto (Incorporated by reference from Exhibit 4(c) to Bethlehem's Annual Report on Form 10-K for the fiscal year ended December 31, 1992). (10)(a) Subsidiary Companies, as amended July 29, 1992 (Incorporated by reference from Exhibit 10(a) to Bethlehem's quarterly report on form 10-Q for the quarter ended June 30, 1992). * (b) 1988 Stock Incentive Plan of Bethlehem Steel Corporation (Incorporated by reference from Exhibit 10(b) to Bethlehem's Annual Report on Form 10-K for the fiscal year ended December 31, 1992). * (c) Special Incentive Compensation Plan of Bethlehem Steel Corporation, which is contained in Article Seventh of the Restated Certificate of Incorporation referred to in Exhibit 3(a) to this Report. - 26 - * (d) Supplemental Benefits Plan of Bethlehem Steel Corporation and Subsidiary Companies, as amended July 29, 1992 (Incorporated by reference from Exhibit 10(b) to Bethlehem's quarterly report on Form 10-Q for the quarter ended June 30, 1992). * (e) Post-Retirement Retainer Plan for Non-Officer Directors (Incorporated by reference from Exhibit (10)(o) to Bethlehem's Annual Report on Form 10-K for the fiscal year ended December 31, 1992). (f) Form of Indemnification Assurance Agreement between Bethlehem Steel Corporation and each of its directors and executive officers listed on Schedule A thereto. (11) Statement regarding computation of per share earnings. (13) Those portions of the 1993 Annual Report to Stockholders of Bethlehem Steel Corporation which are incorporated by reference into this Form 10-K Annual Report. (21) Subsidiaries of Bethlehem Steel Corporation. (23) Consent of Independent Accountants (included on page of this Report). (24) Powers of Attorney. ------------- * Compensatory plans in which Bethlehem's directors and executive officers participate. (b) Reports on Form 8-K. During the quarter ended December 31, 1993, no reports on Form 8-K were filed by Bethlehem. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, Bethlehem Steel Corporation has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 24th day of March, 1994. BETHLEHEM STEEL CORPORATION, by /s/ Lonnie A. Arnett --------------------- Lonnie A. Arnett Vice President and Controller - 27 - Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this Report has been signed below by the following persons on behalf of Bethlehem Steel Corporation and in the capacities indicated on the 24th day of March, 1994. /s/ Curtis H. Barnette * ---------------------------- --------------------------- Curtis H. Barnette John B. Curcio Chairman and Director Director (principal executive officer) /s/ Gary L. Millenbruch * ----------------------------- --------------------------- Gary L. Millenbruch William C. Hittinger Executive Vice President Director and Director (principal financial officer) /s/ Lonnie A. Arnett * ----------------------------- --------------------------- Lonnie A. Arnett Thomas L. Holton Vice President and Director Controller (principal accounting officer) * * ------------------------ --------------------------- Benjamin R. Civiletti Harry P. Kamen Director Director * * ------------------------ --------------------------- Worley H. Clark Winthrop Knowlton Director Director * * ------------------------ --------------------------- Herman E. Collier, Jr. Robert McClements, Jr. Director Director * * ------------------------ --------------------------- Roger P. Penny William A. Pogue Director Director * * ------------------------ --------------------------- Dean P. Phypers John F. Ruffle Director Director By /s/ Lonnie A. Arnett --------------------- Lonnie A. Arnett (Attorney-in-Fact) - 28 - REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors and Stockholders of Bethlehem Steel Corporation Our audits of the consolidated financial statements referred to in our report dated January 26, 1994 appearing on page 30 of the 1993 Annual Report to Stockholders of Bethlehem Steel Corporation (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the Financial Statement Schedules listed in Item 14(a)(2) of this Form 10-K. In our opinion, these Financial Statement Schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. /s/ PRICE WATERHOUSE - -------------------- PRICE WATERHOUSE 1177 Avenue of the Americas New York, NY 10036 January 26, 1994 CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Prospectuses constituting part of the Registration Statements on Form S-8 (No. 2-90795, No. 2-71699, No. 2-53880, No. 2-90796, No. 2-67314, No. 33-23516, No. 33-23688, and No. 33-52267) of our report dated January 26, 1994, which appears on page 30 of the 1993 Annual Report to Stockholders of Bethlehem Steel Corporation, which is incorporated by reference in Bethlehem Steel Corporation's Annual Report on Form 10-K for the year ended December 31, 1993. We also consent to the incorporation by reference of our report on the Financial Statement Schedules, which appears on page of such Annual Report on Form 10-K. /s/ PRICE WATERHOUSE - --------------------- PRICE WATERHOUSE 1177 Avenue of the Americas New York, NY 10036 March 24, 1994 SCHEDULE V Property, Plant and Equipment (dollars in millions) (1) Includes $457.3 million and $1,025.2 million for assets included in the estimated restructuring losses recorded in 1993 and 1991. (2) Represents the reclassification of completed construction to property, plant and equipment and investments in associated enterprises. SCHEDULE VI Accumulated Depreciation of Property, Plant and Equipment (dollars in millions) Balance at Charged Retirements Balance at Classification 12/31/92 to income or Sales(1) 12/31/93 - -------------- --------- --------- ----------- --------- Buildings 427.2 $11.2 ($18.9) $419.5 Machinery and Equipment 3,827.9 266.3 (406.7) 3,687.5 ------- ------ -------- ------- Total $4,255.1 $277.5 ($425.6) $4,107.0 ======= ====== ======== ======= Balance at Charged Retirements Balance at Classification 12/31/91 to income or Sales 12/31/92 - -------------- ---------- --------- ----------- --------- Buildings $437.3 $10.9 ($21.0) $427.2 Machinery and Equipment 3,692.4 250.8 (115.3) 3,827.9 ------- ------ -------- ------- Total $4,129.7 $261.7 ($136.3) $4,255.1 ======= ====== ======== ======= Balance at Charged Retirements Balance at Classification 12/31/90 to income or Sales(1) 12/31/91 - -------------- ----------- --------- ----------- ---------- Buildings $511.1 $12.5 ($86.3) $437.3 Machinery and Equipment 4,474.5 228.9 (1,011.0) 3,692.4 ------- ------ ---------- ------- Total $4,985.6 $241.4 ($1,097.3) $4,129.7 ======= ====== ========== ======= (1) Includes $251.5 and $829.6 million for assets included in the estimated restructuring losses recorded in 1993 and 1991. SCHEDULE VIII Valuation and Qualifying Accounts and Reserves (dollars in millions) (a) Amounts written-off less collections and reinstatements. (b) During 1993, Bethlehem changed the method of valuing inventories from the last-in, first-out (LIFO) method to the to the first-in, first-out (FIFO) method. Prior years' financial statements have been restated to reflect this change. See Note B to the Consolidated Financial Statements. (c) Represents the valuation allowance recorded for a $60.5 million ($50 million after tax) adjustment to equity required to recognize the minimum pension liability. See Note I to the Consolidated Financial Statements. SCHEDULE X Supplementary Income Statement Information (dollars in millions) Year Ended December 31, 1993 Charged to Classification Expense - -------------- ---------- Repairs and maintenance $656.1 Taxes other than payroll and income taxes 39.8 Research and development 23.9 Year Ended December 31, 1992 Charged to Classification Expense - -------------- ---------- Repairs and maintenance $706.7 Taxes other than payroll and income taxes 43.2 Research and development 27.0 Year Ended December 31, 1991 Charged to Classification Expense - -------------- ---------- Repairs and maintenance $723.2 Taxes other than payroll and income taxes 51.3 Research and development 29.9 EXHIBIT INDEX The following is an index of the exhibits included in this Report or incorporated herin by reference. Item No. Exhibit Page No. -------- ------- -------- (3)(a) Restated Certificate of Incorporation, as corrected by the Certificate of Correction relating thereto (Incorporated by reference from Exhibit 28 to Bethlehem's quarterly report on Form 10-Q for the quarter ended June 30, 1988). (b) By-laws of Bethlehem Steel Corporation, as amended October 1, 1988. (4)(a) Rights Agreement, dated as of September 28, 1988, between Bethlehem Steel Corporation and Morgan Shareholder Services Trust Company. (b) Certificate of the Voting Powers, Designation, Preferences and Relative, Participating, Optional or Other Special Rights, and the Qualifications, Limitations or Restrictions Thereof, of the Employee Stock Ownership Plan Convertible Preference Stock, Series B (Par Value $1 Per Share; Stated Value $40 Per Share) of Bethlehem Steel Corporation, as amended and supplemented by the Certificate of Decrease relating thereto (Incorporated by reference from Exhibit 4 to Bethlehem's quarterly report on Form 10-Q for the quarter ended March 31, 1991). (c) Certificate of the Voting Powers, Designation Preferences and Relative, Participating, Optional or Other Special Rights, and the Qualifications, Limitations or Restrictions Thereof, of the $3.50 Cumulative Convertible Preferred Stock (Par Value $1 Per Share) of Bethlehem Steel Corporation, as amended and supplemented by the Certificate of Increase relating thereto (Incorporated by reference from Exhibit 4(c) to Bethlehem's Annual Report on Form 10-K for the fiscal year ended December 31, 1992). (10)(a) Excess Benefit Plan of Bethlehem Steel Corporation and Subsidiary Companies, as amended July 29, 1992 (Incorporated by reference from Exhibit 10(a) to Bethlehem's quarterly report on Form 10-Q for the quarter ended June 10, 1992). (b) 1988 Stock Incentive Plan of Bethlehem Steel Corporation (Incorporated by reference from Exhibit 10(b) to Bethlehem's Annual Report on Form 10-K for the fiscal year ended December 31, 1992). (c) Special incentive Compensation Plan of Bethlehem Steel Corporation, which is contained in Article Seventh of the Restated Certificate of Incorporation referred to in Exhibit 3(a) to this Report. (d) Supplemental Benefits Plan of Bethlehem Steel Corporation and Subsidiary Companies, as amended July 29, 1992 (Incorporated by reference from Exhibit 10(b) to Bethlehem's quarterly report on Form 10-Q for the quarter ended June 30, 1992). (e) Post-Retirement Retainer Plan for Non-Officer Directors (Incorporated by reference from Exhibit (10)(o) to Bethlehem's Annual Report on Form 10- K for the fiscal year ended December 31, 1992). (f) Form of Indemnification Assurance Agreement between Bethlehem Steel Corporation and each of its directors and executive officers listed on Schedule A thereto. (11) Statement regarding computation of per share earnings. (13) Those portions of the 1993 Annual Report to Stockholders of Bethlehem Steel Corporation which are incorporated by reference into this Form 10-K Annual Report. (21) Subsidiaries of Bethlehem Steel Corporation. (23) Consent of Independent Accountants (included on page of this Report). (24) Powers of Attorney. - ----------------- * Compensatory plans in which Bethlehem's directors and executive officers participate. Exhibit (3)(b) BY-LAWS of BETHLEHEM STEEL CORPORATION ---------------------------- Incorporated under the Laws of the State of Delaware --------------------------- As Amended October 1, 1988 BY-LAWS OF BETHLEHEM STEEL CORPORATION Page ---- ARTICLE I - Meetings of Stockholders, Etc. Section 1.01 Annual Meeting . . . . . . . . . . . . . . . . . 1 Section 1.02 Business to be Brought Before an Annual Meeting of Stockholders. . . . . . . . . . . . . 1 Section 1.03 Special Meeting. . . . . . . . . . . . . . . . . 2 Section 1.04 Place of Meetings. . . . . . . . . . . . . . . . 2 Section 1.05 Notice of Meetings . . . . . . . . . . . . . . . 2 Section 1.06 Quorum . . . . . . . . . . . . . . . . . . . . . 3 Section 1.07 Organization . . . . . . . . . . . . . . . . . . 4 Section 1.08 Order of Business. . . . . . . . . . . . . . . . 4 Section 1.09 Voting . . . . . . . . . . . . . . . . . . . . . 4 Section 1.10 List of Stockholders . . . . . . . . . . . . . . 5 Section 1.11 Inspectors of Votes. . . . . . . . . . . . . . . 6 Section 1.12 Consent of Stockholders in lieu of Meeting . . . 6 ARTICLE II - Board of Directors Section 2.01 General Powers . . . . . . . . . . . . . . . . . 8 Section 2.02 Number and Term of Office. . . . . . . . . . . . 8 Section 2.03 Nominations for the Election of Directors. . . . 8 Section 2.04 Election of Directors. . . . . . . . . . . . . . 9 Section 2.05 Organization . . . . . . . . . . . . . . . . . . 9 Section 2.06 Resignations . . . . . . . . . . . . . . . . . . 9 Section 2.07 Vacancies, etc.. . . . . . . . . . . . . . . . . 9 Section 2.08 Place of Meeting, etc. . . . . . . . . . . . . . 9 Section 2.09 First Meeting. . . . . . . . . . . . . . . . . . 10 Section 2.10 Regular Meetings . . . . . . . . . . . . . . . . 10 Section 2.11 Special Meetings; Notice . . . . . . . . . . . . 10 Section 2.12 Quorum and Manner of Acting. . . . . . . . . . . 10 Section 2.13 Removal of Directors . . . . . . . . . . . . . . 11 Section 2.14 Compensation . . . . . . . . . . . . . . . . . . 11 ARTICLE III - Committees Section 3.01 Executive Committee; How Constituted and Powers. 12 Section 3.02 Organization, etc. . . . . . . . . . . . . . . . 12 Section 3.03 Meetings . . . . . . . . . . . . . . . . . . . . 12 Section 3.04 Quorum and Manner of Acting. . . . . . . . . . . 13 Section 3.05 Resignations; Removal; Vacancies . . . . . . . . 13 Section 3.06 Other Committees . . . . . . . . . . . . . . . . 13 Section 3.07 Procedures . . . . . . . . . . . . . . . . . . . 14 Section 3.08 Action by Consent in Writing . . . . . . . . . . 14 ARTICLE IV - Officers Section 4.01 Number . . . . . . . . . . . . . . . . . . . . . 15 Section 4.02 Election and Term of Office. . . . . . . . . . . 15 Section 4.03 Agents, etc. . . . . . . . . . . . . . . . . . . 15 Section 4.04 Removal. . . . . . . . . . . . . . . . . . . . . 15 Section 4.05 Resignations . . . . . . . . . . . . . . . . . . 15 Section 4.06 Vacancies. . . . . . . . . . . . . . . . . . . . 16 Section 4.07 Chief Executive Officer. . . . . . . . . . . . . 16 Section 4.08 Chairman . . . . . . . . . . . . . . . . . . . . 16 Section 4.09 President. . . . . . . . . . . . . . . . . . . . 16 Section 4.10 Vice Chairmen. . . . . . . . . . . . . . . . . . 16 Section 4.11 Executive Office . . . . . . . . . . . . . . . . 17 Section 4.12 Vice Presidents. . . . . . . . . . . . . . . . . 17 Section 4.13 Assistant Vice Presidents. . . . . . . . . . . . 17 Section 4.14 Controller . . . . . . . . . . . . . . . . . . . 17 Section 4.15 Assistant Controllers. . . . . . . . . . . . . . 18 Section 4.16 General Counsel. . . . . . . . . . . . . . . . . 18 Section 4.17 Treasurer. . . . . . . . . . . . . . . . . . . . 18 Section 4.18 Assistant Treasurers . . . . . . . . . . . . . . 19 Section 4.19 Secretary. . . . . . . . . . . . . . . . . . . . 19 Section 4.20 Assistant Secretaries. . . . . . . . . . . . . . 20 Section 4.21 Salaries . . . . . . . . . . . . . . . . . . . . 20 ARTICLE V - Contracts, Checks, Drafts, Bank Accounts, Etc. Section 5.01 Contracts with Governmental Authorities. . . . . 20 Section 5.02 Appointment of Agents. . . . . . . . . . . . . . 21 Section 5.03 Execution of Other Contracts, etc. . . . . . . . 21 Section 5.04 Loans. . . . . . . . . . . . . . . . . . . . . . 21 Section 5.05 Checks, Drafts, etc. . . . . . . . . . . . . . . 22 Section 5.06 Deposits . . . . . . . . . . . . . . . . . . . . 22 Section 5.07 General and Special Bank Accounts. . . . . . . . 22 Section 5.08 Proxies in Respect of Stock or Other Securities of Other Corporations . . . . . . . . 22 ARTICLE VI - Shares and Their Transfer Section 6.01 Certificates for Stock . . . . . . . . . . . . . 23 Section 6.02 Transfer of Stock. . . . . . . . . . . . . . . . 23 Section 6.03 Regulations. . . . . . . . . . . . . . . . . . . 24 Section 6.04 Lost, Stolen, Destroyed and Mutilated Certificates.. . . . . . . . . . . . . . . . . . 24 Section 6.05 Fixing Date for Determination of Stockholders of Record in Certain Case. . . . . . . . . . . . 24 ARTICLE VII - Offices, Etc. Section 7.01 Registered Office. . . . . . . . . . . . . . . . 25 Section 7.02 Other Offices. . . . . . . . . . . . . . . . . . 25 ARTICLE VIII - Dividends, Surplus, Etc. Section 8.01 Dividends, Surplus, etc. . . . . . . . . . . . . 25 ARTICLE IX - Indemnification of Directors, Officers, Employees and Agents Section 9.01 Third Party Actions. . . . . . . . . . . . . . . 26 Section 9.02 Derivative Actions . . . . . . . . . . . . . . . 27 Section 9.03 Determination of Entitlement to Indemnification. . . . . . . . . . . . . . . . . 28 Section 9.04 Right to Indemnification Upon Successful Defense and For Service as a Witness . . . . . . 28 Section 9.05 Advance of Expenses. . . . . . . . . . . . . . . 29 Section 9.06 Indemnification Not Exclusive. . . . . . . . . . 29 Section 9.07 Accrual of Claims; Successors. . . . . . . . . . 30 Section 9.08 Corporate Obligations; Reliance. . . . . . . . . 30 Section 9.09 Insurance. . . . . . . . . . . . . . . . . . . . 30 Section 9.10 Definitions of Certain Terms . . . . . . . . . . 30 Section 9.11 Saving Clause. . . . . . . . . . . . . . . . . . 31 ARTICLE X - Seal Section 10.01 Seal . . . . . . . . . . . . . . . . . . . . . . 31 ARTICLE XI - Fiscal Year Section 11.01 Fiscal Year. . . . . . . . . . . . . . . . . . . 31 ARTICLE XII - Waiver of Notices Section 12.01 Waiver of Notices. . . . . . . . . . . . . . . . 32 ARTICLE XIII - Gender Section 13.01 Gender . . . . . . . . . . . . . . . . . . . . . 32 ARTICLE XIV - Amendments Section 14.01 Amendments . . . . . . . . . . . . . . . . . . . 32 BY-LAWS OF BETHLEHEM STEEL CORPORATION --------------------------- ARTICLE I. Meetings of Stockholders, Etc. SECTION 1.01. Annual Meeting. The annual meeting of the stockholders of Bethlehem Steel Corporation (herein called the "Corporation") shall, unless the Board of Directors (herein called the "Board") shall designate another time or place, be held on the Tuesday immediately preceding the last Wednesday in April in each year (or, if that day shall be a legal holiday, then on the next preceding business day) at such hour as may be specified in the notice thereof, in the City of Wilmington, in the State of Delaware, and at such place within said City as shall be fixed by the Board, for the purpose of electing directors and for the transaction of such other business as may properly be brought before such meeting. If any annual meeting shall not be held on the day designated herein or the directors shall not have been elected thereat or at any adjournment thereof, the Board shall cause a special meeting of the stockholders to be held as soon thereafter as practicable for the election of directors. At such special meeting, the stockholders may elect directors and transact other business with the same force and effect as at an annual meeting of the stockholders duly called and held. SECTION 1.02. Business to be Brought Before an Annual Meeting of Stockholders. Any business properly brought before an annual meeting of the stockholders of the Corporation may be transacted at such meeting. To be properly brought before an annual meeting, business must be (i) specified in the notice of the meeting (or any supplement thereto) given by or at the direction of the Board, (ii) brought before the meeting by or at the direction of the Board pursuant to a vote of not less than four-fifths of the whole Board or (iii) otherwise properly brought before the meeting by a stockholder. For business to be properly brought before an annual meeting by a stockholder, the stockholder must have given such written notice of the proposed business, either by personal delivery or by United States mail, postage prepaid, to the Secretary of the Corporation, that the Secretary shall receive such notice at least 90 days prior to the anniversary date of the immediately preceding annual meeting or not later than ten days after notice or public disclosure of the date of the annual meeting shall be given or made to stockholders, whichever date shall be earlier. Subject to Section 2.03 hereof, any such notice shall set forth as to each item of business the stockholder shall propose to bring before the annual meeting (i) a brief description of such item of business and the reasons for conducting it at such meeting and, in the event that such item of business shall include a proposal to amend or to recommend the amendment of either the Restated Certificate of Incorporation of the Corporation (which term as used herein shall include any amendments to the Restated Certificate) or these By-laws, the text of the proposed amendment, (ii) the name and address of the stockholder proposing such item of business, (iii) a representation that the stockholder is a holder of record of stock of the Corporation entitled to vote at such meeting and intends to appear in person or by proxy at the meeting to propose such item of business and (iv) any material interest of the stockholder in such item of business. Only business which shall have been properly brought before an annual meeting of stockholders in accordance with these By-laws shall be conducted at such meeting, and the Chairman of such meeting may refuse to permit any business to be brought before such meeting which shall not have been properly brought before it in accordance with these By-laws. SECTION 1.03. Special Meeting. Except as otherwise required by law, special meetings of the stockholders for any purpose or purposes may be called only by (i) the Chairman, (ii) the President, (iii) the Secretary or (iv) the majority of the whole Board. Only such business as shall be specified in the notice of any special meeting of the stockholders shall come before such meeting. SECTION 1.04. Place of Meetings. Any meeting of the stockholders for the election of directors shall, unless the Board shall designate another place, be held in the City of Wilmington, in the State of Delaware, and at such place within said City as shall be fixed by the Board. All other meetings of the stockholders shall be held at such places, within or without the State of Delaware, as may from time to time be designated by the Board or in the respective notices or waivers of notice thereof. SECTION 1.05. Notice of Meetings. Every stockholder shall furnish the Secretary with an address at which notices of meetings and all other corporate notices may be served on or mailed to him. Except as otherwise expressly required by law, notice of each meeting of the stockholders, whether annual or special, shall, not less than ten (l0) nor more than sixty (60) days before the date of the meeting, be given to each stockholder of record entitled to vote at such meeting by delivering a typewritten or printed notice thereof to him personally or by depositing such notice in the United States mail, in a postage prepaid envelope, directed to him at his post-office address furnished by him to the Secretary for such purpose, or, if he shall not have furnished to the Secretary his post-office address for such purpose, but his address shall otherwise appear on the records of the Corporation, then at his address as it shall so appear on the records of the Corporation, or, if he shall not have furnished to the Secretary his post-office address for such purpose and his address shall not otherwise appear on the records of the Corporation, then at the registered office of the Corporation in the State of Delaware. If mailed, notice shall be deemed given when deposited in the United States mail, postage prepaid. Except when expressly required by law, no publication of any notice of a meeting of the stockholders shall be required. Every notice of a meeting of the stockholders shall state the place, date and hour of the meeting and, in the case of a special meeting, the purpose or purposes for which the meeting shall be called. Nevertheless, notice of any meeting of the stockholders shall not be required to be given to any stockholder who shall attend such meeting in person or by proxy except a stockholder who shall attend such meeting for the express purpose of objecting, at the beginning of the meeting, to the transaction of any business on the grounds that the meeting shall not have been lawfully called or convened; and, if any stockholder shall, in person or by attorney thereunto authorized, in writing or by telegraph, cable, wireless, telex, telefax or other form of recorded communication, waive notice of any meeting of the stockholders, notice thereof need not be given to him. It shall not be necessary to state in any notice of a meeting of the stockholders as a purpose thereof any matter relating to the conduct of such meeting. Except when expressly required by law, notice of any adjourned meeting of the stockholders need not be given if the time and place thereof shall be announced at the meeting at which the adjournment shall be taken, unless such adjournment shall be for more than 30 days or a new record date shall be fixed for an adjourned meeting. SECTION 1.06. Quorum. At each meeting of the stockholders, with the exception of any meeting for the election of directors summarily ordered as provided by the General Corporation Law of the State of Delaware, stockholders holding of record a majority of the shares of stock of the Corporation entitled to be voted thereat shall be present in person or by proxy to constitute a quorum for the transaction of business. In the absence of a quorum at any such meeting or any adjournment or adjournments thereof, a majority in voting interest of those present in person or by proxy and entitled to vote thereat, or in the absence therefrom of all the stockholders, any officer entitled to preside at, or to act as secretary of, such meeting may adjourn such meeting from time to time. At any such adjourned meeting at which a quorum may be present any business may be transacted which might have been transacted at the meeting as originally called. The absence from any meeting of stockholders holding the number of shares of stock of the Corporation required by the laws of the State of Delaware or by the Restated Certificate of Incorporation of the Corporation or by these By-laws for action upon any given matter shall not prevent action at such meeting upon any other matter or matters which may properly come before the meeting, if there shall be present thereat in person or by proxy stockholders holding the number of shares of stock of the Corporation required in respect of such other matter or matters. SECTION 1.07. Organization. At each meeting of the stockholders the Chairman, or, if he shall be absent therefrom, the President, or if he shall be absent therefrom, a Vice Chairman, or, if there shall not be any Vice Chairman in office or if all the Vice Chairmen also shall be absent therefrom, a Vice President or another officer of the Corporation chosen as chairman of such meeting by a majority in voting interest of the stockholders present in person or by proxy and entitled to vote thereat, or, if all the officers of the Corporation shall be absent therefrom, a stockholder holding of record shares of stock of the Corporation so chosen, shall act as chairman of the meeting and preside thereat; and the Secretary, or, if he shall be absent from such meeting or shall be required pursuant to the provisions of this Section 1.07 to act as chairman of such meeting, the person (who shall be an Assistant Secretary, if an Assistant Secretary shall be present thereat) whom the chairman of such meeting shall appoint shall act as secretary of such meeting and keep the minutes thereof. SECTION 1.08. Order of Business. The order of business at each meeting of the stockholders shall be determined by the chairman of such meeting, but such order of business may be changed by the vote of a majority in voting interest of those present in person or by proxy at such meeting and entitled to vote thereat. SECTION 1.09. Voting. Except as otherwise provided in the Restated Certificate of Incorporation of the Corporation, each stockholder shall be entitled to one vote in person or by proxy for each share of stock of the Corporation held by him and registered in his name on the books of the Corporation on the date fixed pursuant to the provisions of Section 6.05 hereof as the record date for the determination of stockholders who shall be entitled to notice of and to vote at the meeting of stockholders, or to express consent to corporate action in writing without a meeting, as the case may be. Shares of its own stock belonging to the Corporation or to another corporation, if a majority of the shares entitled to vote in the election of directors of such other corporation shall be held by the Corporation, shall not be entitled to vote. Persons holding in a fiduciary capacity stock of the Corporation shall be entitled to vote such stock so held, and persons whose stock shall be pledged shall be entitled to vote such stock, unless in the transfer by the pledgor on the books of the Corporation he shall have expressly empowered the pledgee to vote thereon, in which case only the pledgee, or his proxy, may represent such stock and vote thereon. If shares of stock of the Corporation shall stand of record in the names of two or more persons, whether fiduciaries, members of a partnership, joint tenants, tenants in common, tenants by the entirety or otherwise, or if two or more persons shall have the same fiduciary relationship respecting the same shares of stock of the Corporation, unless the Secretary shall have been given written notice to the contrary and have been furnished with a copy of the instrument or order appointing them or creating the relationship wherein it is so provided, their acts with respect to voting shall have the following effect: (i) if only one shall vote, his act shall bind all; (ii) if more than one shall vote, the act of the majority so voting shall bind all; and (iii) if more than one shall vote, but the vote shall be evenly split on any particular matter, then, except as otherwise required by the General Corporation Law of the State of Delaware, each faction may vote the shares in question proportionally. If the instrument so filed shall show that any such tenancy shall be held in unequal interests, the majority or even-split for the purpose of the next foregoing sentence shall be a majority or even-split in interest. Any vote on stock of the Corporation at any meeting of the stockholders by the stockholder entitled thereto, and any expression of consent or dissent to corporate action without a meeting by the stockholder entitled to express such consent or dissent, may be given in person or by his proxy appointed by an instrument in writing subscribed by such stockholder or by his attorney thereunto authorized and delivered to the Secretary of the Corporation or in the case of a vote at a meeting to such Secretary or to the Secretary of the meeting; provided, however, that no proxy shall be voted or acted upon after three (3) years from its date, unless said proxy shall provide for a longer period. At all meetings of the stockholders all matters, except those specified in Section 2.04 of these By-laws, and except also those the manner of decidin shall be otherwise expressly regulated by law or by the Restated Certificate of Incorporation of the Corporation, shall be decided by the vote of a majority in voting interest of the stockholders present in person or by proxy and entitled to vote thereat, a quorum being present. Except in the case of votes for the election of directors, unless demanded by a stockholder of the Corporation present in person or by proxy at any meeting of the stockholders and entitled to vote thereat or so directed by the chairman of the meeting, the vote thereat on any other question need not be by ballot. Upon a demand of any such stockholder for a vote by ballot on any question or at the direction of such chairman that a vote by ballot be taken on any question, such vote shall be taken. On a vote by ballot each ballot shall be signed by the stockholder voting, or by his proxy, if there be such proxy, and shall state the number of shares voted. SECTION 1.10. List of Stockholders. It shall be the duty of the Secretary or other officer of the Corporation who shall have charge of its stock ledger, either directly or through another officer of the Corporation designated by him or through a transfer agent appointed by the Board, to prepare and make, at least ten (10) days before every meeting of the stockholders, a complete list of the stockholders entitled to vote thereat, arranged in alphabetical order, and showing the address of each stockholder and the number of shares registered in the name of each stockholder. Such list shall be open to the examination of any stockholder, for any purpose germane to the meeting, during ordinary business hours, for a period of at least ten (10) days prior to said meeting, either at a place within the city where said meeting is to be held, which place shall be specified in the notice of said meeting, or, if not so specified, at the place where said meeting is to be held. The list shall also be produced and kept at the time and place of said meeting during the whole time thereof, and may be inspected by any stockholder who shall be present thereat. Upon the willful neglect or refusal of the directors to produce such list at any meeting for the election of directors, they shall be ineligible for election to any office at such meeting. The stock ledger shall be the only evidence as to who are the stockholders entitled to examine the stock ledger, such list or the books of the Corporation, or to vote in person or by proxy at any meeting of stockholders. SECTION 1.11. Inspectors of Votes. At each meeting of the stockholders the chairman of such meeting may appoint two Inspectors of Votes to act thereat. Each Inspector of Votes so appointed shall first subscribe an oath or affirmation faithfully to execute the duties of an Inspector of Votes at such meeting with strict impartiality and according to the best of his ability. Such Inspectors of Votes, if any, shall take charge of the ballots at such meeting and after the balloting thereat on any question shall count the ballots cast thereon and shall make a report in writing to the secretary of such meeting of the results thereof. An Inspector of Votes need not be a stockholder of the Corporation, and any officer of the Corporation may be an Inspector of Votes on any question other than a vote for or against his election to any position with the Corporation or on any other question in which he may be directly interested. SECTION 1.12. Consent of Stockholders in lieu of Meeting. (a) Anything in these By-laws to the contrary notwithstanding, any action required by the General Corporation Law of the State of Delaware to be, or which may be, taken at any annual or special meeting of the stockholders may be taken without a meeting, without prior notice and without a vote, if a consent or consents in writing, setting forth the action so taken, shall be signed in person or by proxy by the holders of outstanding stock having not less than the minimum number of votes that would be necessary to authorize or take such action at a meeting at which all shares entitled to vote thereon were present and voted and if the procedures in this Section 1.12 shall be complied with. (b) A record date for determining stockholders entitled to express consent to stockholder action in writing without a meeting shall be fixed by the Board of Directors of the Corporation (a "Consent Record Date"), which record date shall not precede the date upon which the resolution fixing the Consent Record Date shall be adopted by the Board and which shall not be more than ten days after the date upon which such resolution shall have been adopted. Any stockholder seeking to have the stockholders authorize or take action by written consent without a meeting shall give written notice either by personal delivery or by United States mail, postage prepaid, to the Secretary, of the intent of such stockholder to take action by written consent, which notice shall request the Board of Directors to fix a Consent Record Date. The Board of Directors shall, within 10 days of the receipt of such notice, fix as the Consent Record Date a date which shall not precede the date upon which the resolution fixing the Consent Record Date shall be adopted by the Board and which shall not be more than ten days after the date upon which such resolution shall have been adopted. (c) Every written consent pursuant to this Section 1.12 shall bear the date of signature of each stockholder who shall sign such consent and no written consent shall be effective to take the corporate action referred to therein unless, within sixty (60) days of the date of earliest dated consent delivered to the Corporation in the manner required by this Section 1.12, written consents signed by a sufficient number of stockholders to take action shall be delivered to the Corporation by delivery to its registered office in the State of Delaware, its principal place of business or to an officer or agent of the Corporation having custody of the books in which meetings and proceedings of the stockholders shall be recorded. Delivery made to said registered office of the Corporation shall be by hand or by certified or registered mail, return receipt requested. (d) The date for determining if an action shall have been validly consented to by the holders of shares of outstanding stock of the Corporation having the requisite voting power to authorize or take such action shall be the earliest of (i) the date on which the required minimum number of votes have been received and the validity of the actions have been reviewed, (ii) the 60th day after the Consent Record Date or (iii) the 60th day after the date of the earliest consent delivered to the Corporation. (e) Prompt notice of the taking of the corporate action without a meeting by less than unanimous written consent shall be given to those stockholders who shall not have consented in writing. ARTICLE II. Board of Directors. SECTION 2.01. General Powers. The property, business and affairs of the Corporation shall be managed by or under the direction of the Board. SECTION 2.02. Number and Term of Office. Subject to the requirements of the laws of the State of Delaware and of the Restated Certificate of Incorporation of the Corporation, the Board may from time to time by the vote of the majority of the whole Board determine the number of directors. Until the Board shall otherwise so determine or Section 6 of Article FOURTH of such Restated Certificate of Incorporation shall otherwise so require, the number of directors shall be fifteen (15). Each of the directors of the Corporation shall hold office until his successor shall be elected and shall qualify, or until his death or until he shall resign or shall have been removed in the manner hereinafter provided. SECTION 2.03. Nominations for the Election of Directors. Subject to the rights of the holders of any class or series of stock having a preference over the Common Stock as to dividends or upon liquidation and otherwise subject to the rights of stockholders under the General Corporation Law of the State of Delaware, nominations for the election of directors shall be made by the Board. Any stockholder entitled to vote for the election of directors at a meeting may recommend for nomination by the Board persons for election as directors. Written notice of the recommendation of such stockholder shall be given, either by personal delivery or by United States mail, postage prepaid, to the Secretary of the Corporation not later than (i) with respect to an election to be held at an annual meeting of stockholders, on the date designated in Section 1.01 hereof, 90 days in advance of such meeting and (ii) with respect to an election to be held at a special meeting of stockholders for the election of directors, the close of business on the tenth day following the date on which notice of such meeting shall first be given to stockholders. Each such notice shall set forth: (a) the name and address of the stockholder who shall make such recommendation and of the person or persons to be nominated; (b) a representation that the stockholder is a holder of record of stock of the Corporation entitled to vote at such meeting; (c) a description of all arrangements or understandings between the stockholder and each nominee and any other person or persons (naming such person or persons) pursuant to which the nomination or nominations are recommended by the stockholder; (d) such other information regarding each recommended person proposed by such stockholder as would have been required to be included in a proxy statement filed pursuant to the proxy rules of the Securities and Exchange Commission had each such person been nominated, or intended to be nominated, by the Board of Directors; and (e) the consent in writing of each such person to serve as a director of the Corporation if so elected. The chairman of the meeting may refuse to acknowledge the nomination of any person not recommended in compliance with the foregoing procedure. SECTION 2.04. Election of Directors. At each meeting of the stockholders entitled to vote for the election of directors at which a quorum shall be present, the persons receiving the greatest number of votes, up to the number of directors to be elected, shall be the directors. Such election shall be by ballot in accordance with the provisions of Section 1.09 hereof. SECTION 2.05. Organization. At each meeting of the Board the Chairman, or, if he shall be absent therefrom, the President, or, if he shall be absent therefrom, a Vice Chairman or, if there shall not be any Vice Chairman in office or if all the Vice Chairmen also shall be absent therefrom, a director chosen by a majority of the directors present thereat, shall act as chairman of such meeting and preside thereat. The Secretary, or in case of his absence the person whom the chairman of such meeting shall appoint, shall act as secretary of such meeting and keep the minutes thereof. SECTION 2.06. Resignations. Any director may resign at any time by giving written notice of his resignation to the Corporation. Any such resignation shall take effect at the time specified therein, or, if the time when it shall become effective shall not be specified therein, then it shall take effect immediately upon its receipt by the Chairman, the President, any of the Vice Chairmen, or the Secretary; and, unless otherwise specified therein, the acceptance of such resignation shall not be necessary to make it effective. SECTION 2.07. Vacancies, etc. In case of any increase in the number of directors, the additional director or directors, and, in case of any vacancy in the Board due to death, resignation, disqualification, removal or any other cause, the successor to fill the vacancy shall be elected by the holders of shares of stock entitled to vote at an annual or special meeting of said holders or by a majority of the directors then in office, though less than a quorum, or by a sole remaining director. When one or more directors shall resign from the Board, effective at a future date, a majority of the directors then in office, including those who shall have so resigned, shall have the power to fill such vacancy or vacancies, the vote thereon to take effect when such resignation or resignations shall become effective. SECTION 2.08. Place of Meeting, etc. The Board may hold its meetings at such place or places within or without the State of Delaware as the Board may from time to time by resolution determine or as shall be designated in the respective notices or waivers of notice thereof. SECTION 2.09. First Meeting. As soon as practicable after each annual election of directors, the Board shall meet for the purpose of organization and the transaction of other business. SECTION 2.10. Regular Meetings. Regular meetings of the Board shall be held at such times as the Board shall from time to time by resolution determine. If any day fixed for a regular meeting shall be a legal holiday at the place where the meeting is to be held, then the meeting which would otherwise be held on that day shall be held at the same hour on the next succeeding business day. Except as otherwise provided by law, notices of regular meetings need not be given. SECTION 2.11. Special Meetings; Notice. Special meetings of the Board shall be held whenever called by the Chairman, the President, the Secretary or a majority of the directors at the time in office. A notice shall be given as hereinafter in this Section 2.11 provided of each such special meeting, in which shall be stated the time and place of such meeting, but, except as otherwise expressly provided by law or by these By-laws, the purposes thereof need not be stated in such notice. Except as otherwise provided by law, notice of each such meeting shall be mailed to each director, addressed to him at his residence or usual place of business, at least two (2) days before the day on which such meeting is to be held, or shall be sent addressed to him at such place by telegraph, cable, wireless, telex, telefax or other form of recorded communication or be delivered personally or by telephone not later than the day before the day on which such meeting is to be held. Notice of any meeting of the Board need not, however, be given to any director who shall attend such meeting except a director who shall attend such meeting for the express purpose of objecting, at the beginning of the meeting, to the transaction of any business on the grounds that the meeting shall not have been lawfully called or convened; and, if any director shall, in writing or by telegraph, cable, wireless, telex, telefax or other form of recorded communication, waive notice of any meeting of the Board, notice thereof need not be given to him. SECTION 2.12. Quorum and Manner of Acting. Subject to the provisions of Section 2.07 hereof, a majority of the whole Board shall be present in person at any meeting of the Board (participation in a meeting by means of conference telephone or similar communications equipment by means of which all persons participating in the meeting can hear each other to constitute presence in person at such meeting) in order to constitute a quorum for the transaction of business at such meeting and, except as specified in Sections 1.02, 1.03, 2.02, 2.07, 3.01, 3.05, 3.06, 3.07, 3.08, 4.01, 4.04, 4.07, and 4.21 hereof, and except also as otherwise expressly provided by law, the vote of a majority of the directors present at any such meeting at which a quorum is present shall be the act of the Board; provided, however, that any person who shall both be in the employ of the Corporation or of one or more of its subsidiary companies and be a director of the Corporation (herein "Executives of the Corporation") shall not as a member of the Board have any vote in the determination of the amount that shall be paid to him as a fixed salary or as any other form of compensation and provided further that in the case of a vote in good faith authorizing any contract or transaction between the Corporation and one or more of its directors or officers, or between the Corporation and any other corporation, partnership, association or other organization in which one or more of its directors or officers are directors or officers or have a financial interest, if the material facts as to the relationship or interest of the directors or officers of the Corporation as to the contract or transaction are disclosed or known to the Board, the affirmative votes of a majority of the disinterested directors of the Corporation, even though the disinterested directors shall be less than a quorum, shall be the act of the Board. In the absence of a quorum from any such meeting, a majority of the directors present thereat may adjourn such meeting from time to time until a quorum shall be present thereat. Notice of any adjourned meeting need not be given. The directors shall act only as a board and the individual directors shall have no power as such. Anything in these By-laws to the contrary notwithstanding, any action required or permitted to be taken at any meeting of the Board may be taken without a meeting if all members of the Board consent thereto in writing and the writing or writings are filed with the minutes of proceedings of the Board. SECTION 2.13. Removal of Directors. Any director may be removed, either with or without cause, at any time, by the affirmative vote of stockholders of record of the Corporation holding of record a majority of the shares then entitled to vote at an election of directors; and the vacancy in the Board caused by any such removal may be filled as provided in Section 2.07 hereof. In the case of the removal of a director for cause, "Cause" is hereby defined as the willful and continuous failure substantially to perform one's duties to the Corporation or the willful engaging in gross misconduct materially and demonstrably injurious to the Corporation. SECTION 2.14. Compensation. Unless otherwise expressly provided by resolution adopted by the Board, neither any of the directors nor any of the members of any committee of the Corporation contemplated by these By-laws or otherwise provided for by resolution of the Board shall, as such, receive any stated compensation for his services; but the Board may at any time or from time to time by resolution provide that a specified sum shall be paid to any director of the Corporation or to any member of any such committee who shall not otherwise be in the employ of the Corporation or of any of its subsidiary companies, either as his annual compensation as such director or member or as compensation for his attendance at meetings of the Board or of such committee. The Board may also likewise provide that the Corporation shall reimburse each such director or member of such committee for any expenses paid by him on account of his attendance at any such meeting. Nothing in this Section 2.14 contained shall be construed to preclude any director from serving the Corporation in any other capacity and receiving compensation therefor. ARTICLE III. Committees. SECTION 3.01. Executive Committee; How Constituted and Powers. The Board, by resolution adopted by a majority of the whole Board, may designate not less than two (2) of the directors then in office, who shall include the Chairman and the President, to constitute an Executive Committee (herein called the "Executive Committee") which during the intervals between meetings of the Board of Directors shall have and may exercise all the delegable powers of the Board to the extent permitted by law and as provided in said resolution or in another resolution or other resolutions so adopted by the Board; and it shall have power to authorize the seal of the Corporation to be affixed to all papers which may require it. SECTION 3.02. Organization, etc. The Chairman or, if he shall be absent therefrom, the President shall act as chairman at all meetings of the Executive Committee and the Secretary shall act as secretary thereof. In case of the absence from any meeting of the Committee of the Chairman, the President, or the Secretary, the Committee may appoint a chairman or secretary, as the case may be, of the meeting. SECTION 3.03. Meetings. Regular meetings of the Executive Committee, of which notice shall not be necessary, shall be held on such days and at such places, within or without the State of Delaware, as shall be fixed by resolution adopted by a majority of the Committee and communicated to all its members. Special meetings of the Committee shall be held whenever called by the Chairman, the President, the Secretary or a majority of the members of such Committee then in office. Notice of each special meeting of the Committee shall be given by mail, telegraph, cable, wireless, telex, telefax or other form of recorded communication or be delivered personally or by telephone to each member of the Committee not later than the day before the day on which such meeting is to be held. Notice of any such meeting need not, however, be given to any member of the Committee who shall attend such meeting except a member of the Committee who shall attend such meeting for the express purpose of objecting, at the beginning of the meeting, to the transaction of any business on the grounds that the meeting shall not have been lawfully called or convened; and, if any member of the Committee shall, in writing or by telegraph, cable, wireless, telex, telefax or other form of recorded communication, waive notice of any meeting of the Committee, notice thereof need not be given to him. Subject to provisions of this Article III, the Committee, by resolution adopted by a majority of the whole Committee, shall fix its own rules of procedure, and it shall keep a record of its proceedings and report them to the Board at the next regular meeting thereof after such proceedings shall have been taken. All such proceedings shall be subject to revision or alteration by the Board; provided, however, that third parties shall not be prejudiced by any such revision or alteration. SECTION 3.04. Quorum and Manner of Acting. A majority of the Executive Committee shall be present in person at any meeting of the Committee (participation in a meeting by means of conference telephone or similar communications equipment by means of which all persons participating in the meeting can hear each other to constitute presence in person at such meeting) in order to constitute a quorum for the transaction of business, and the act of a majority of those present at a meeting thereof at which a quorum shall be present shall be the act of the Committee; provided, however, that in the case of a vote in good faith authorizing any contract or transaction between the Corporation and one or more of its directors or officers, or between the Corporation and any other corporation, partnership, association or other organization in which one more of its directors or officers shall be directors or officers or have a financial interest, if the material facts as to the relationship or interest of the directors or officers of the Corporation as to the contract or transaction shall be disclosed or known to the Executive Committee, the vote of a majority of the disinterested members of the Committee, even though the disinterested members shall be less than a quorum, shall be the act of the Committee. The members of the Committee shall act only as a committee, and the individual members shall have no power as such. SECTION 3.05. Resignations; Removal; Vacancies. Any member of the Executive Committee may resign therefrom at any time by giving written notice of his resignation to the Corporation. Any such resignation shall take effect at the time specified therein, or, if the time when it shall become effective shall not be specified therein, then it shall take effect immediately upon its receipt by the Corporation; and, unless otherwise specified therein, the acceptance of such resignation shall not be necessary to make it effective. The Board by resolution adopted by a majority of the whole Board may remove any member of the Executive Committee. Any vacancy in the Executive Committee shall be filled by the vote of a majority of the whole Board. SECTION 3.06. Other Committees. The Board, by resolution adopted by a majority of the whole Board, shall constitute a Finance Committee, which shall consist of not less than three (3) members, the majority of whom shall be directors and one of whom shall be designated by the Board to act as chairman of such Committee. Subject to any limitations prescribed by the Board, the Finance Committee shall have authority to advise with the Board, the Executive Committee and the officers and employees of the Corporation with respect to all activities, plans and policies affecting the financial affairs of the Corporation. The Board, by resolution adopted by a majority of the whole Board, shall constitute an Audit Committee, an Executive Compensation Committee, a Nominating Committee and such other committees as it may determine, which shall in each case consist of such directors and, at the discretion of the Board, such officers of the Corporation who shall not be directors and shall have and may exercise such powers as the Board may by resolution determine and specify in the respective resolutions appointing them; provided, however, that (a) unless all the members of any committee shall be directors, such committee shall not have authority to exercise any of the powers of the Board in the management of the business and affairs of the Corporation, and (b) if any committee shall have the power to determine the amounts of the respective fixed salaries of the Executives of the Corporation or any of them, such committee shall consist of not less than three (3) members and none of its members shall have any vote in the determination of the amount that shall be paid to him as a fixed salary. SECTION 3.07. Procedures. A majority of all the members of the Finance Committee or of any other Committee organized pursuant to Section 3.06 hereof may fix its rules of procedure, determine its action and fix the time and place, whether within or without the State of Delaware, of its meetings (participation in a meeting by means of conference telephone or similar communications equipment by means of which all persons participating in the meeting can hear each other to constitute presence in person at such meeting) and specify what notice thereof, if any, shall be given, unless the Board shall otherwise by resolution provide. The Board, by resolution adopted by a majority of the whole Board, shall have power to change the members of any committee referred to in this Section 3.07 at any time, to fill vacancies therein and to discharge any such committee, either with or without cause, at any time. SECTION 3.08. Action by Consent in Writing. Anything in these By-laws to the contrary notwithstanding, any action required or permitted to be taken at any meeting of any committee referred to in this Article III may be taken without a meeting if all members of the committee shall consent thereto in writing and the writing or writings shall be filed with the minutes of proceedings of the committee. ARTICLE IV. Officers. SECTION 4.01. Number. The Corporation shall have the following officers as determined by a resolution or resolutions adopted by a majority of the whole Board: a Chairman (who shall be a director), a President (who shall be a director), one or more Vice Chairmen (one or more of whom may be directors), one or more Vice Presidents (one or more of whom may be directors and may be designated an Executive Vice President, a Group Executive Vice President or a Senior Vice President), one or more Assistant Vice Presidents, a Controller, one or more Assistant Controllers, a General Counsel, a Treasurer, one or more Assistant Treasurers, a Secretary and one or more Assistant Secretaries. SECTION 4.02. Election and Term of Office. The officers determined as in Section 4.01 hereof provided shall be chosen annually by the Board. Each such officer shall hold office until his successor shall have been elected and shall qualify or until his earlier death or his earlier resignation or removal in the manner hereinafter provided. SECTION 4.03. Agents, etc. In addition to the officers determined as in Section 4.01 hereof provided, the Board may appoint such agents as the Board may deem necessary or advisable, each of which agents shall have such authority and perform such duties as are provided in these By-laws or as the Board may from time to time determine. The Board may delegate to any officer or to any committee the power to appoint or remove any such agents. SECTION 4.04. Removal. Any officer may be removed, either with or without cause, at any time, by resolution adopted by a majority of the whole Board. In the case of the removal of an officer for cause, "Cause" is hereby defined as the willful and continuous failure substantially to perform one's duties to the Corporation or the willful engaging in gross misconduct materially and demonstrably injurious to the Corporation. SECTION 4.05. Resignations. Any officer may resign at any time by giving written notice of his resignation to the Corporation. Any such resignation shall take effect at the time specified therein, or, if the time when it shall become effective shall not be specified therein, then it shall take effect immediately upon its receipt by the Corporation; and, unless otherwise specified therein, the acceptance of such resignation shall not be necessary to make it effective. SECTION 4.06. Vacancies. A vacancy in any office due to death, resignation, removal, disqualification or any other cause may be filled for the unexpired portion of the term in the manner prescribed in these By-laws for regular appointments or elections to such office. SECTION 4.07. Chief Executive Officer. The Chief Executive Officer shall be designated from time to time by a resolution adopted by a majority of the whole Board and shall, unless otherwise determined by the Board, be either the Chairman or the President. He shall have, subject to the direction and control of the Board, general and active supervision over the business and affairs of the Corporation and over its several officers. He shall perform all duties incident to his position and such other duties as from time to time may be assigned to him by the Board. He shall see that all orders and resolutions of the Board shall be carried into effect. He may sign, execute and deliver in the name of the Corporation all deeds, mortgages, bonds, contracts or other instruments authorized by the Board, except in cases where the signing, execution or delivery thereof shall be expressly delegated by the Board or by a duly authorized committee of the Board or by these By-laws to some other officer or agent of the Corporation or where any of them shall be required by law otherwise to be signed, executed or delivered, and he may cause the seal of the Corporation to be affixed to any documents the execution of which on behalf of the Corporation shall have been duly authorized. SECTION 4.08. Chairman. The Chairman shall perform such duties as from time to time may be assigned to him by the Board. He shall, if present, preside at all meetings of the stockholders and at all meetings of the Board. He shall make a report of the state of the business of the Corporation at each annual meeting of the stockholders and from time to time he shall report to the stockholders and to the Board all matters within his knowledge which in his judgment the interests of the Corporation may require to be brought to their notice. SECTION 4.09. President. The President shall perform such duties as from time to time may be assigned to him by the Board. At the request of the Chairman or in the case of his absence or inability to act, the President shall perform the duties of the Chairman and, when so acting, shall have the powers of, and shall be subject to all restrictions upon, the Chairman. SECTION 4.10. Vice Chairmen. Each of the Vice Chairmen shall have such powers and perform such duties as the Chief Executive Officer or the Board may from time to time assign to him and shall perform such other duties as may be prescribed by these By-laws. At the request of the Chairman or the President, or in case of their absence or inability to act, any Vice Chairman shall perform the duties of the Chairman or the President and, when so acting, shall have the powers of, and be subject to all the restrictions upon, the Chairman and the President. SECTION 4.11. Executive Office. The Chairman, the President and such other officers as shall from time to time be designated by the Chief Executive Officer, shall constitute the Executive Office of the Corporation. Each officer in the Executive Office shall consult with the Chief Executive Officer as to matters relating to the business and affairs of the Corporation, and each shall have such powers and perform such duties as the Chief Executive Officer or the Board may from time to time assign to him and each shall perform such other duties as may be prescribed for him by these By-laws. SECTION 4.12. Vice Presidents. Each of the Vice Presidents (including each of the Executive Vice Presidents, Group Executive Vice Presidents and Senior Vice Presidents) shall have such powers and perform such duties as the officer in the Executive Office to whom he shall report, the Chief Executive Officer or the Board may from time to time assign to him and shall perform such other duties as may be prescribed by these By-laws. At the request of any officer in the Executive Office, or, in case of their absence or inability to act, any Vice President (including any Executive Vice President, Group Executive Vice President and any Senior Vice President) who shall report to an officer in the Executive Office shall perform the duties of that officer and, when so acting, shall have all the powers of, and be subject to all the restrictions upon, that officer. SECTION 4.13. Assistant Vice Presidents. At the request of any Vice President, or in case of his absence or inability to act, the Assistant Vice President, if there shall be one, or, if there shall be more than one, any of the Assistant Vice Presidents shall perform the duties of the Vice President to whom he shall report, and, when so acting, shall have all the powers of, and be subject to all the restrictions upon, that Vice President. Each of the Assistant Vice Presidents shall perform such other duties as from time to time may be assigned to him by the Vice President to whom he shall report, the officer in the Executive Office to whom such Vice President shall report, the President, the Chairman or the Board. SECTION 4.14. Controller. The Controller shall keep or cause to be kept correct records of the business and transactions of the Corporation and shall, upon request, at all reasonable times exhibit or cause to be exhibited such records to any of the directors of the Corporation at the place where such records shall be kept. He shall perform such other duties as from time to time may be assigned to him by the officer to whom he shall report, any officer in the Executive Office, the Chief Executive Officer or the Board. SECTION 4.15. Assistant Controllers. At the request of the Controller, or in case of his absence or inability to act, the Assistant Controller, or, if there be more than one, any of the Assistant Controllers, shall perform the duties of the Controller, and, when so acting, shall have all the powers of, and be subject to all the restrictions upon, the Controller. Each of the Assistant Controllers shall perform such other duties as from time to time may be assigned to him by the Controller, the officer to whom the Controller shall report, any officer in the Executive Office, the Chief Executive Officer or the Board. SECTION 4.16. General Counsel. The General Counsel shall be the chief legal officer of the Corporation and shall have, subject to the control of the Chief Executive Officer, the officer to whom he shall report, and the Board, general and active supervision and direction over the legal affairs of the Corporation. He shall have such other powers and perform such other duties as the Chief Executive Officer, the officer to whom he shall report, or the Board may from time to time prescribe and shall perform such other duties as may be prescribed by these By- laws. SECTION 4.17. Treasurer. If required by the Board, the Treasurer shall give a bond for the faithful discharge of his duties in such sum and with such surety or sureties as the Board shall determine. He shall: (a) have charge and custody of, and be responsible for, all funds, securities, notes and valuable effects of the Corporation; receive and give receipt for moneys due and payable the Corporation from any sources whatsoever; deposit all such moneys to the credit of the Corporation or otherwise as any Chairman, the President, the officer to whom he shall report, or the Board shall direct in such banks, trust companies or other depositaries as shall be selected in accordance with the provisions of Section 5.07 hereof; cause such funds to be disbursed by checks or drafts on the authorized depositaries of the Corporation signed as provided in Section 5.05 hereof; and be responsible for the accuracy of the amounts of, and cause to be preserved proper vouchers for, all moneys so disbursed; (b) have the right to require from time to time reports or statements giving such information as he may desire with respect to any and all financial transactions of the Corporation from the officers or agents transacting the same; (c) render to the Chairman, the President, the officer to whom he shall report, or the Board, whenever they, respectivel shall request him so to do, an account of the financial condition of the Cor- poration and of all his transactions as Treasurer; (d) upon request, exhibit or cause to be exhibited at all reasonable times, at the place where they shall be kept, his cash books and other records to the Controller, the Chairman, the President, the officer to whom he shall report, or the Board; and (e) in general, perform all duties incident to the office of Treasurer and such other duties as from time to time may be assigned to him by the Chairman, the President, the officer to whom he shall report, or the Board. SECTION 4.18. Assistant Treasurers. If required by the Board, each of the Assistant Treasurers shall give a bond for the faithful discharge of his duties in such sums and with such surety or sureties as the Board shall determine. At the request of the Treasurer, or in case of his absence or inability to act, the Assistant Treasurer, or, if there be more than one, any of the Assistant Treasurers, shall perform the duties of the Treasurer, and, when so acting, shall have all the powers of, and be subject to all the restrictions upon, the Treasurer. Each of the Assistant Treasurers shall perform such other duties as from time to time may be assigned to him by the Treasurer, the Chairman, the President or the Board. SECTION 4.19. Secretary. The Secretary shall: (a) record all the proceedings of the meetings of the stockholders, the Board, the Executive Committee and the Finance Committee in one or more books kept for that purpose; (b) see that all notices shall be duly given in accordance with the provisions of these By-laws or as required by law; (c) be custodian of the seal of the Corporation, and shall see that such seal, or, if authorized by the Board, a facsimile thereof, shall be affixed to any documents the execution of which on behalf of the Corporation shall be duly authorized and may attest such seal when so affixed; (d) have charge, directly or through the transfer agent or transfer agents and registrar or registrars appointed as in Section 6.03 hereof provided, of the issue, transfer and registration of certificates for stock of the Corporation and of the records thereof, such records to be kept in such manner as to show the information specified in Section 6.01 hereof; (e) upon request, exhibit or cause to be exhibited at all reasonable times to the Board, at the place where they shall be kept, such records of the issue, transfer and registration of the certificates for stock of the Corporation; (f) sign with a Vice President, a Vice Chairman, the Chairman or the President certificates for stock of the Corporation; (g) see that the books, reports, statements, certificates and all other documents and records required by law shall be properly kept and filed; (h) see that the duties prescribed by Section 1.09 hereof shall be performed; and (i) in general, perform all duties incident to the office of Secretary and such other duties as from time to time may be assigned to him by the Chairman, the President, the officer to whom he shall report, or the Board. SECTION 4.20. Assistant Secretaries. At the request of the Secretary, or in case of his absence or inability to act, the Assistant Secretary, or, if there shall be more than one, any of the Assistant Secretaries, shall perform the duties of the Secretary and, when so acting, shall have all the powers of, and be subject to all the restrictions upon, the Secretary. Each of the Assistant Secretaries shall perform such other duties as from time to time may be assigned to him by the Secretary, the Chairman, the President or the Board. SECTION 4.21. Salaries. The salaries and other forms of compensation (other than those the fixing of which shall have been specifically delegated to a committee of the Board) of the officers of the Corporation shall be fixed from time to time by the Board or by any one or more committees (none of which shall consist of less than three (3) members) appointed by a resolution passed by a majority of the whole Board with power to fix such salaries or such compensation, and none of such officers shall be prevented from receiving a salary by reason of the fact that he shall be also a member of the Board or of any such committee; but none of such officers who shall also be a member of the Board or of any such committee shall have any vote in the determination of the amount of salary that shall be paid to him. ARTICLE V. Contracts, Checks, Drafts, Bank Accounts, Etc. SECTION 5.01. Contracts with Governmental Authorities. All bids and proposals for contracts with the Federal or with any municipal, county, territorial or state government or with any authority, branch or division thereof, or with any foreign government or with any authority, branch or division thereof, and all contracts between the Corporation and any such government or authority, branch or division thereof, and all bonds and undertakings for the faithful performance of such contracts, and all vouchers and receipts in connection therewith, may be executed and delivered in the name of the Corporation and on its behalf by the Chairman, the President, a Vice Chairman, a Vice President, the Treasurer or the Secretary; and no further authority, whether by resolution of the Board or otherwise, shall be necessary to make such instrument valid and binding upon the Corporation. SECTION 5.02. Appointment of Agents. The Board, by resolution, or the Chairman, the President, a Vice Chairman, a Vice President, the Treasurer or the Secretary, by an instrument in writing filed with the Secretary, may from time to time appoint agents and grant to such agents the power to execute and deliver in the name of the Corporation and on its behalf (i) any bid or proposal for any contract with the Federal or with any municipal, county, territorial or state government or with any authority, branch or division thereof, or with any foreign government or with any authority, branch or division thereof, (ii) any contract between the Corporation and any such government or authority, branch or division thereof, (iii) any bond or undertaking for the faithful performance of any such contract and (iv) any voucher or receipt in connection therewith. SECTION 5.03. Execution of Other Contracts, etc. Except as otherwise required by law or by these By-laws, any contract or other instrument may be executed and delivered in the name of the Corporation and on its behalf by the Chairman, the President, a Vice Chairman, a Vice President, the Treasurer or the Secretary; and the Board, by resolution, or the Chairman, the President, a Vice Chairman, a Vice President, the Treasurer or the Secretary, by an instrument in writing filed with the Secretary, may authorize any other officer or officers or agent or agents to execute and deliver any contract or other instrument in the name of the Corporation and on its behalf, and such authority may be general or confined to specific instances. SECTION 5.04. Loans. Unless the Board shall otherwise determine, any two (2) of the following officers, to wit: the Chairman, the President, a Vice Chairman, a Vice President, the Treasurer and the Secretary, acting together, or any officer or officers authorized by a resolution of the Board may effect loans and advances at any time for the Corporation from any bank, trust company or other institution or from any firm or individual and for such loans and advances may make, execute and deliver promissory notes or other evidences of indebtedness of the Corporation, but no officer or officers shall mortgage, pledge, hypothecate or otherwise transfer for security any property whatsoever owned or held by the Corporation except when authorized by resolution adopted by the Board. SECTION 5.05. Checks, Drafts, etc. All checks, drafts, orders for the payment of money, bills of lading, warehouse receipts, obligations, bills of exchange and insurance certificates shall be signed or endorsed (except endorsements for collection for the account of the Corporation or for deposit to its credit) by such officer or officers or agent or agents of the Corporation and in such manner as shall from time to time be determined by resolution of the Board. SECTION 5.06. Deposits. All funds of the Corporation not otherwise employed shall be deposited from time to time to the credit of the Corporation or otherwise as the Board, the Chairman, the President, any Vice Chairman, or the Treasurer shall direct in such banks, trust companies or other depositaries as the Board may select or as may be selected by any officer or officers or agent or agents of the Corporation to whom power in that respect shall have been delegated by the Board. For the purpose of deposit and for the purpose of collection for the account of the Corporation, checks, drafts and other orders for the payment of money which shall be payable to the order of the Corporation may be endorsed, assigned and delivered by any officer or agent of the Corporation. SECTION 5.07. General and Special Bank Accounts. The Board may from time to time authorize the opening and keeping of general and special bank accounts with such banks, trust companies or other depositaries as the Board may select, or as may be selected by any officer or officers or agent or agents of the Corporation to whom power in that respect shall have been delegated by the Board. The Board may make such special rules and regulations with respect to such bank accounts, not inconsistent with the provisions of these By-laws, as it may deem expedient. SECTION 5.08. Proxies in Respect of Stock or Other Securities of Other Corporations. Unless otherwise provided by resolution adopted by the Board, the Chairman, the President, a Vice Chairman, a Vice President or the Secretary may from time to time appoint an attorney or attorneys or an agent or agents of the Corporation to exercise in the name and on behalf of the Corporation the powers and rights which the Corporation may have as the holder of stock or other securities in any other corporation to vote or consent in respect of such stock or other securities, and the Chairman, the President, a Vice Chairman, a Vice President or the Secretary may instruct the person or persons so appointed as to the manner of exercising such powers and rights; and the Chairman, the President, a Vice Chairman, a Vice President or the Secretary may execute or cause to be executed in the name and on behalf of the Corporation and under its corporate seal, or otherwise, all such written proxies or other instruments as he may deem necessary or proper in order that the Corporation may exercise its said powers and rights. ARTICLE VI. Shares and Their Transfer. SECTION 6.01. Certificates for Stock. Every owner of stock of the Corporation of any class (or, if stock of any class shall be issuable in series, any series of such class) shall be entitled to have a certificate registered in his name in such form as the Board shall prescribe, certifying the number of shares of stock of the Corporation of such class, or such class and series, owned by him. The certificates representing shares of stock of each class (or, if there shall be more than one series of any class, each series of such class) shall be numbered in the order in which they shall be issued and shall be signed in the name of the Corporation by the Chairman or the President or a Vice Chairman or a Vice President and by the Secretary or an Assistant Secretary. Any of or all the signatures on any such certificate may be facsimiles. In case any officer or officers or transfer agent or registrar of the Corporation who shall have signed, or whose facsimile signature or signatures shall have been placed upon, any such certificate shall cease to be such officer or officers or transfer agent or registrar before such certificate shall have been issued, such certificate may be issued by the Corporation with the same effect as though the person or persons who shall have signed such certificate, or whose facsimile signature or signatures shall have been placed thereupon, were such officer or officers or transfer agent or registrar at the date of issue. Records shall be kept of the amount of the stock of the Corporation issued and outstanding, the manner in which and the time when such stock was paid for, the respective names, alphabetically arranged, and the addresses, of the persons, firms or corporations owning of record the stock represented by certificates for stock of the Corporation, the number, class and series of shares represented by such certificates, respectively, the time when each became an owner of record thereof, and the respective dates of such certificates, and in case of cancellation, the respective dates of cancellation. Every certificate surrendered to the Corporation for exchange or transfer shall be canceled and a new certificate or certificates shall not be issued in exchange for any existing certificate until such existing certificate shall have been so canceled except in cases provided for in Section 6.04 hereof. SECTION 6.02. Transfers of Stock. Transfers of shares of stock of the Corporation shall be made only on the books of the Corporation by the registered owner thereof, or by his attorney thereunto authorized by power of attorney duly executed and filed with the Secretary, or with a transfer agent appointed as in Section 6.03 hereof provided, and upon surrender of the certificate or certificates for such shares properly endorsed and payment of all taxes thereon. The person in whose name shares of stock shall be registered on the books of the Corporation shall be deemed the owner thereof for all purposes as regards the Corporation. Whenever any transfer of shares shall be made for collateral security and not absolutely, such fact shall be so expressed in the entry of transfer if, when the certificate or certificates shall be presented to the Corporation for transfer, both the transferor and the transferee shall in writing request the Corporation to do so. SECTION 6.03. Regulations. The Board may make such rules and regulations as it may deem expedient, not inconsistent with these By-laws, concerning the issue, transfer and registration of certificates for stock of the Corporation. The Board may appoint, or authorize any officer or officers to appoint, one or more transfer agents and one or more registrars, and may require all certificates for stock to bear the signature or signatures of any of them. SECTION 6.04. Lost, Stolen, Destroyed and Mutilated Certificates. The registered owner of any stock of the Corporation shall immediately notify the Corporation of any loss, theft, destruction or mutilation of the certificate therefor, and the Corporation may issue a new certificate for stock in the place of any certificate theretofore issued by it and alleged to have been lost, stolen or destroyed, and the Corporation may, in its discretion, require the registered owner of the lost, stolen or destroyed certificate or his legal representatives to give the Corporation a bond in such sum, limited or unlimited, and in such form and with such surety or sureties, as the Corporation shall in its uncontrolled discretion determine, to indemnify the Corporation against any claim that may be made against it on account of the alleged loss, theft or destruction of any such certificate, or the issuance of such new certificate. The Corporation may, however, in its discretion refuse to issue any such new certificate except pursuant to legal proceedings under the laws of the State of Delaware in such case made and provided. SECTION 6.05. Fixing Date for Determination of Stockholders of Record in Certain Case. (a) In order that the Corporation may determine the stockholders entitled to notice of or to vote at any meeting of stockholders or any adjournment thereof, the Board may fix a record date, which record date shall not precede the date upon which the resolution fixing the record date shall be adopted by the Board, and which record date shall not be more than sixty (60) nor less than ten (l0) days before the date of such meeting. If no record date shall be fixed by the Board the record date for determining stockholders entitled to notice of or to vote at a meeting of stockholders shall be at the close of business on the day next preceding the day on which notice shall be given, or, if notice shall be waived, at the close of business on the day next preceding the day on which the meeting is held. A determination of stockholders of record entitled to notice of or to vote at a meeting of stockholders shall apply to any adjournment of the meeting; provided, however, that the Board may fix a new record date for the adjourned meeting. (b) In order that the Corporation may determine the stockholders entitled to receive payment of any dividend or other distribution or allotment of any rights or the stockholders entitled to exercise any rights in respect of any change, conversion or exchange of stock, or for the purpose of any other lawful action, the Board may fix a record date, which record date shall not precede the date upon which the resolution fixing the record date shall be adopted, and which record date shall be not more than sixty (60) days prior to such action. If no record date shall be fixed, the record date for determining stockholders for any such purpose shall be at the close of business on the day on which the Board shall adopt the resolution relating thereto. ARTICLE VII. Offices, Etc. SECTION 7.01. Registered Office. The registered office of the Corporation in the State of Delaware shall be in the City of Wilmington, County of New Castle, and the registered agent of the Corporation in said State is The Corporation Trust Company. SECTION 7.02. Other Offices. The Corporation may also have one or more offices other than said registered office at such place or places, either within or without the State of Delaware, as the Board may from time to time appoint or as the business of the Corporation may require and may keep the books and records of the Corporation in such place or places within or without said State as the Board may from time to time by resolution determine. ARTICLE VIII. Dividends, Surplus, Etc. SECTION 8.01. Dividends, Surplus, Etc. Subject to the provisions of law, of the Restated Certificate of Incorporation of the Corporation and of these By-laws, the Board may declare and pay dividends upon the shares of the stock of the Corporation either (a) out of its surplus as defined in and computed in accordance with the provisions of the laws of the State of Delaware or (b), in case it shall not have any such surplus, out of its net profits for the fiscal year in which the dividend shall be declared and/or the preceding fiscal year, whenever and in such amounts as, in the opinion of the Board, the condition of the affairs of the Corporation shall render it advisable. The Board in its discretion may use and apply any of such surplus or such net profits in purchasing or acquiring any of the shares of the stock of the Corporation in accordance with law, or any of its bonds, debentures, notes, scrip or other securities or evidences of indebtedness, or from time to time may set aside from such surplus or such net profits such sum or sums as it, in its absolute discretion, may think proper, as a reserve fund to meet contingencies, or for equalizing dividends, or for the purpose of maintaining or increasing the property or business of the Corporation, or for any other purpose it may think conducive to the best interests of the Corporation; provided, however, that the Corporation shall not use its funds or property for the purchase of shares of its stock when the capital of the Corporation shall be impaired or when such use would cause any impairment of its capital. All such surplus or such net profits, until actually declared in dividends, or used and applied as aforesaid, shall be deemed to have been so set aside by the Board for one or more of said purposes. ARTICLE IX. Indemnification of Directors, Officers, Employees and Agents. SECTION 9.01. Third Party Actions. (a) The Corporation, to the full extent permitted, and in the manner required, by the laws of the State of Delaware as in effect at the time of the adoption of this Article IX or as such laws may be amended from time to time, shall indemnify any person who shall have been or shall be made a party to or is threatened to be made a party to any threatened, pending or completed action, suit or proceeding (including any appeal thereof), whether civil, criminal, administrative or investigative (other than an action by or in the right of the Corporation), by reason of the fact that such person shall have been or shall be a director or officer of the Corporation, or, if at a time when he shall have been or shall be a director or officer of the Corporation, shall have been or shall be serving at the request of the Corporation as a director, officer, partner, trustee, fiduciary, employee or agent (a "Subsidiary Officer") of another corporation, partnership, joint venture, trust, employee benefit plan or other enterprise (an "Affiliated Entity"), against expenses (including attorneys' fees), costs, judgments, fines, penalties and amounts paid in settlement actually and reasonably incurred by such person in connection with such action, suit or proceeding if such person shall have acted in good faith and in a manner such person shall have reasonably believed to be in or not opposed to the best interest of the Corporation, and, with respect to any criminal action or proceeding, shall have had no reasonable cause to believe his or her conduct was unlawful; provided, however, that the Corporation shall not be obligated to indemnify against any amount paid in settlement unless the Corporation shall have consented to such settlement, which consent shall not be unreasonably withheld. The termination of any action, suit or proceeding by judgment, order, settlement, conviction or upon a plea of nolo contendere or its equivalent shall not, of itself, create a presumption that the person shall not have acted in good faith and in a manner which such person shall have reasonably believed to be in or not opposed to the best interests of the Corporation, and, with respect to any criminal action or proceeding, that such person shall have had reasonable cause to believe that his conduct was unlawful. Notwithstanding anything to the contrary in the foregoing provisions of this paragraph (a), a person shall not be entitled, as a matter of right, to indemnification pursuant to this paragraph (a) against costs or expenses incurred in connection with any action, suit or proceeding commenced by such person against any person who shall have been or shall be a director, officer, fiduciary, employee or agent of the Corporation or a Subsidiary Officer of an Affiliated Entity, but such indemnification may be provided by the Corporation in any specific case as permitted by Section 9.06 hereof. (b) The Corporation may indemnify any employee or agent of the Corporation in the manner and to the extent that it shall indemnify any director or officer under this Section 9.01, including indemnity in respect of service at the request of the Corporation as a Subsidiary Officer of an Affiliated Entity. SECTION 9.02. Derivative Actions. (a) The Corporation, to the full extent permitted, and in the manner required, by the laws of the State of Delaware as in effect at the time of the adoption of this Article IX or as such laws may be amended from time to time, shall indemnify any person who shall have been or shall be made a party to or shall be threatened to be made a party to any threatened, pending or completed action or suit (including any appeal thereof) brought in the right of the Corporation to procure a judgment in its favor by reason of the fact that such person shall have been or shall be a director or officer of the Corporation, or, if at a time when he shall have been or shall be a director or officer of the Corporation shall have been or shall be serving at the request of the Corporation as a Subsidiary Officer of an Affiliated Entity against expenses (including attorneys' fees) and costs actually and reasonably incurred by such person in connection with such action or suit if such person shall have acted in good faith and in a manner such person shall have reasonably believed to be in or not opposed to the best interests of the Corporation, except that no indemnification shall be made in respect of any claim, issue or matter as to which such person shall have been adjudged to be liable to the Corporation unless, and except to the extent that, the Court of Chancery of the State of Delaware or the court in which such judgment shall have been rendered shall determine upon application that despite the adjudication of liability but in view of all the circumstances of the case, such person shall be fairly and reasonably entitled to indemnity for such expenses and costs as the Court of Chancery of the State of Delaware or such other court shall deem proper. Notwithstanding anything to the contrary in the foregoing provisions of this paragraph (a), a person shall not be entitled, as a matter of right, to indemnification pursuant to this paragraph (a) against costs and expenses incurred in connection with any action or suit in the right of the Corporation commenced by such person, but such indemnification may be provided by the Corporation in any specific case as permitted by Section 9.06 hereof. (b) The Corporation may indemnify any employee or agent of the Corporation in the manner and to the extent that it shall indemnify any director or officer under this Section 2, including indemnity in respect of service at the request of the Corporation as a Subsidiary Officer of an Affiliated Entity. SECTION 9.03. Determination of Entitlement to Indemnification. Any indemnification under Section 9.01 or Section 9.02 hereof (unless ordered by a court) shall be made by the Corporation only as authorized in the specific case upon a determination that indemnification of the director, officer, employee or agent is proper under the circumstances because such person has met the applicable standard of conduct set forth in Section 9.01 or Section 9.02 hereof. Such determination shall be made (i) by the Board of Directors by a majority vote of a quorum consisting of directors who shall not have been and shall not be parties to the action, suit or proceeding in respect of which indemnification shall be sought or by majority vote of the members of a committee of the Board of Directors composed of at least three members each of whom shall not have been and shall not be a party to such action, suit or proceeding, or (ii) if such a quorum shall not be obtainable and/or such a committee shall not be established or obtainable, or, even if obtainable, if a quorum of disinterested directors shall so direct, by independent legal counsel in a written opinion, or (iii) by the stockholders. In the event a request for indemnification shall be made by any person referred to in paragraph (a) of Section 9.01 hereof or paragraph (a) of Section 9.02 hereof, the Corporation shall cause such determination to be made not later than 60 days after such request shall be made. SECTION 9.04. Right to Indemnification Upon Successful Defense and For Service as a Witness. (a) Notwithstanding the other provisions of this Article IX to the extent that a director, officer, employee or agent of the Corporation shall have been successful on the merits or otherwise in defense of any action, suit or proceeding referred to in Section 9.01 or Section 9.02 hereof or in defense of any claim, issue or matter therein, such person shall be indemnified against expenses (including attorneys' fees) and costs actually and reasonably incurred by such person in connection therewith. (b) To the extent any person who shall have been or shall be a director or officer of the Corporation shall have served or prepared to serve as a witness in any action, suit or proceeding, whether civil, criminal, administrative or investigative, or in any investigation by the Corporation or the Board of Directors thereof or a committee thereof or by any securities exchange on which securities of the Corporation shall have been or shall be listed on any national securities association, by reason of his services as a director or officer of the Corporation or, if at a time when he shall have been a director or officer of the Corporation shall have been or shall be serving at the request of the Corporation as a Subsidiary Officer of an Affiliated Entity, the Corporation shall indemnify such person against expenses (including attorneys' fees) and costs actually and reasonably incurred by such person in connection therewith within 30 days after the receipt by the Corporation from such person of a statement requesting such indemnification, averring such service and reasonably evidencing such expenses and costs. The Corporation may indemnify any employee or agent of the Corporation to the same extent it is required to indemnify any director or officer of the Corporation pursuant to the foregoing sentence of this paragraph (b). SECTION 9.05. Advance of Expenses. (a) Expenses and costs incurred by any person referred to in paragraph (a) of Section 9.01 hereof or paragraph (a) of Section 9.02 hereof in defending a civil, criminal, administrative or investigative action, suit or proceeding shall be paid by the Corporation in advance of the final disposition of such action, suit or proceeding upon receipt of an undertaking by or on behalf of such person to repay such amount if it shall ultimately be determined that such person shall not be entitled to be indemnified by the Corporation as authorized by this Article IX. (b) Expenses and costs incurred by any person referred to in paragraph (b) of Section 9.01 hereof or paragraph (b) of Section 9.02 hereof in defending a civil, criminal, administrative or investigative action, suit or proceeding may be paid by the Corporation in advance of the final disposition of such action, suit or proceeding as authorized by the Board of Directors, a committee thereof or an officer of the Corporation or a committee thereof authorized to so act by the Board of Directors upon receipt of an undertaking by or on behalf of such person to repay such amount if it shall ultimately be determined that such person shall not be entitled to be indemnified by the Corporation as authorized by this Article IX. SECTION 9.06. Indemnification Not Exclusive. The provision of indemnification to or the advancement of expenses and costs to any person under this Article IX, or the entitlement of any person to indemnification or advancement of expenses and costs under this Article IX, shall not limit or restrict in any way the power of the Corporation to indemnify or advance expenses and costs to such person in any other way permitted by law or be deemed exclusive of any right to which any person seeking indemnification or advancement of expenses and costs may be entitled under any law, agreement, vote of stockholders or disinterested directors or otherwise, both as to any action relating to such person in the capacity of an officer, director, employee or agent of the Corporation and any action relating to him in any other capacity while holding any such position. SECTION 9.07. Accrual of Claims; Successors. The indemnification provided or permitted under this Article IX shall apply in respect of any expense, cost, judgment, fine, penalty or amount paid in settlement, whether or not the claim or cause of action in respect thereof accrued or arose before or after the effective date of this Article IX. The right of any person who shall have been or shall be a director, officer, employee or agent of the Corporation to indemnification under this Article IX shall continue after he shall have ceased to be a director, officer, employee or agent and shall inure to the benefit of the heirs, distributees, executors, administrators and other legal representatives of such person. SECTION 9.08. Corporate Obligations; Reliance. This Article IX shall be deemed to create a binding obligation on the part of the Corporation to its current and former officers and directors and their heirs, distributees, executors, administrators and other legal representatives, and each director or officer in acting in such capacity shall be entitled to rely on the provisions of this Article IX, without giving notice thereof to the Corporation. SECTION 9.09. Insurance. The Corporation may purchase and maintain insurance on behalf of any person who shall have been or shall be a director, officer, employee or agent of the Corporation, or shall have been or shall be serving at the request of the Corporation as a Subsidiary Officer of any Affiliated Entity, against any liability asserted against such person and incurred by such person in any such capacity, or arising out of such person's status as such, whether or not the Corporation would have had the power to indemnify such person against such liability under the provisions of this Article IX or applicable law. SECTION 9.10. Definitions of Certain Terms. (a) For purposes of this Article IX, references to "the Corporation" shall include, in addition to the resulting corporation, any constituent corporation (including any constituent of a constituent) absorbed in a consolidation or merger which, if its corporate existence had continued, would have been permitted under applicable law to indemnify its directors, officers, employees or agents, so that any person who shall have been or shall be a director, officer, employee or agent of such constituent corporation, or shall have been or shall be serving at the request of such constituent corporation as a Subsidiary Officer of any Affiliated Entity shall stand in the same position under the provisions of this Article IX with respect to the resulting or surviving corporation as such person would have had with respect to such constituent corporation if its separate existence had continued. (b) For purposes of this Article IX, references to "fines" shall include any excise taxes assessed on a person with respect to an employee benefit plan; references to "serving at the request of the Corporation" shall include any service as a director, officer, employee or agent of the Corporation which shall impose duties on, or involves services by, such director, officer, employee or agent with respect to an employee benefit plan, its participants, or beneficiaries; and a person who shall have acted in good faith and in a manner such person shall have reasonably believed to be in the interest of the participants and beneficiaries of an employee benefit plan shall be deemed to have acted in a manner "not opposed to the best interest of the Corporation" as referred to in this Article IX. SECTION 9.11. Saving Clause. In the event any provision of this Article IX shall be held invalid by any court of competent jurisdiction, such holding shall not invalidate any other provision of this Article IX, and the remaining provisions of this Article IX shall be construed as if such invalid provision had not been included in these By-laws. ARTICLE X. Seal. SECTION 10.01. Seal. The Board shall provide a corporate seal, which shall be in the form of a circle and shall bear the full name of the Corporation and the words and figures "Incorporated 1919 Delaware", or words and figures of similar import. ARTICLE XI. Fiscal Year. SECTION 11.01. Fiscal Year. The fiscal year of the Corporation shall end on the thirty-first day of December in each year. ARTICLE XII. Waiver of Notices. SECTION 12.01. Waiver of Notices. Whenever notice shall be required to be given by these By-laws or by the Restated Certificate of Incorporation of the Corporation or by the General Corporation Law of the State of Delaware, a written waiver thereof, signed by the person or persons entitled to said notice, whether before or after the time stated therein, shall be deemed equivalent to notice. ARTICLE XIII. Gender. SECTION 13.01. Gender. Any words in the masculine gender in these By-laws shall be deemed to include the feminine gender. ARTICLE XIV. Amendments. SECTION 14.01. Amendments. These By-laws as they shall be at any time, may be amended or repealed by the Board. Exhibit (4)(a) RIGHTS AGREEMENT RIGHTS AGREEMENT, dated as of September 28, 1988 (the "Agreement"), between Bethlehem Steel Corporation, a Delaware corporation (the "Company"), and Morgan Shareholder Services Trust Company, a New York corporation, as Rights Agent (the "Rights Agent"). W I T N E S S E T H WHEREAS, on September 28, 1988 (the "Rights Dividend Declaration Date"), the Board of Directors of the Company authorized and declared a dividend distribution of one Right for each share of common stock, par value $1.00 per share, of the Company (the "Common Stock") outstanding at the close of business on October 18, 1988 (the "Record Date"), and has authorized the issuance of one Right (as such number may hereinafter be adjusted pursuant to the provisions of Section 11(p) hereof) for each share of Common Stock of the Company issued between the Record Date (whether originally issued or delivered from the Company's treasury) and the Distribution Date, each Right initially representing the right to purchase one one-hundredth of a share of Series A Junior Participating Preference Stock of the Company having the rights, powers and preferences set forth in the form of Certificate of Designation, Preferences and Rights attached hereto as Exhibit A, upon the terms and subject to the conditions hereinafter set forth (the "Rights"); NOW, THEREFORE, in consideration of the premises and the mutual agreements herein set forth, the parties hereby agree as follows: Section 1. Certain Definitions. For purposes of this Agreement, the following terms have the meanings indicated: (a) "Acquiring Person" shall mean any Person who or which, together with all Affiliates and Associates of such Person, shall be the Beneficial Owner of 20% or more of the shares of Common Stock then outstanding, but shall not include the Company, any Subsidiary of the Company, any employee benefit plan of the Company or of any Subsidiary of the Company, or any Person or entity organized, appointed or established by the Company for or pursuant to the terms of any such plan. (b) "Affiliate" and "Associate" shall have the respective meanings ascribed to such terms in Rule 12b-2 of the General Rules and Regulations under the Securities Exchange Act of 1934, as amended and in effect on the date of this Agreement (the "Exchange Act"). (c) A Person shall be deemed the "Beneficial Owner" of, and shall be deemed to "beneficially own," any securi- ties: (i) which such Person or any of such Person's Affiliates or Associates, directly or indirectly, has the right to acquire (whether such right is exercisable immediately or only after the passage of time) pursuant to any agreement, arrangement or understanding (whether or not in writing) or upon the exercise of conversion rights, exchange rights, rights, warrants or options, or otherwise; provided, however, that a Person shall not be deemed the "Beneficial Owner" of, or to "beneficially own," (A) securities tendered pursuant to a tender or exchange offer made by such Person or any of such Person's Affiliates or Associates until such tendered securities are accepted for purchase or exchange, or (B) securities issuable upon exercise of Rights at any time prior to the occurrence of a Triggering Event, or (C) securities issuable upon exercise of Rights from and after the occurrence of a Triggering Event which Rights were acquired by such Person or any of such Person's Affiliates or Associates prior to the Distribution Date or pursuant to Section 3(a) or Section 22 hereof (the "Original Rights") or pursuant to Section 11(i) hereof in connection with an adjustment made with respect to any Original Rights; (ii) which such Person or any of such Person's Affiliates or Associates, directly or indirectly, has the right to vote or dispose of or has "beneficial ownership" of (as determined pursuant to Rule 13d-3 of the General Rules and Regulations under the Exchange Act), including pursuant to any agreement, arrangement or understanding, whether or not in writing; provided, however, that a Person shall not be deemed the "Beneficial Owner" of, or to "beneficially own," any security under this subparagraph (ii) as a result of an agreement, arrangement or understanding to vote such security if such agreement, arrangement or understanding: (A) arises solely from a revocable proxy given in response to a public proxy or consent solicitation made pursuant to, and in accordance with, the applicable provisions of the General Rules and Regulations under the Exchange Act, and (B) is not also then reportable by such Person on Schedule 13D under the Exchange Act (or any comparable or successor report); or (iii) which are beneficially owned, directly or indirectly, by any other Person (or any Affiliate or Associate thereof) with which such Person (or any of such Person's Affiliates or Associates) has any agreement, arrangement or understanding (whether or not in writing), for the purpose of acquiring, holding,voting (except pursuant to a revocable proxy as described in the proviso to subparagraph (ii) of this paragraph (c)) or disposing of any voting securities of the Company; provided, however, that nothing in this paragraph (c) shall cause a person engaged in business as an underwriter of securities to be the "Beneficial Owner" of, or to "beneficially own," any securities Acquired through such person's participation in good faith in a firm commitment underwriting until the expiration of forty days after the date of such acquisition. (d) "Business Day" shall mean any day other than a Saturday, Sunday or a day on which banking institutions in the State of New York are authorized or obligated by law or executive order to close. (e) "Close of business" on any given date shall mean 5:00 P.M., New York City time, on such date; provided, howev- er, that if such date is not a Business Day it shall mean 5:00 P.M., New York City time, on the next succeeding Business Day. (f) "Common Stock" shall mean the common stock, par value $1.00 per share, of the Company, except that "Common Stock" when used with reference to any Person other than the Company shall mean the capital stock of such Person with the greatest voting power, or the equity securities or other equity interest having power to control or direct the management, of such Person. (g) "Continuing Director" shall mean (i) any member of the Board of Directors of the Company, while such Person is a member of the Board, who is not an Acquiring Person, or an Affiliate or Associate of an Acquiring Person, or a representative of an Acquiring Person or of any such Affiliate or Associate, and was a member of the Board prior to the date of this Agreement, or (ii) any Person who subsequently becomes a member of the Board, while such Person is a member of the Board, who is not an Acquiring Person, or an Affiliate or Associate of an Acquiring Person, or a representative of an Acquiring Person or of any such Affiliate or Associate, if such Person's nomination for election or election to the Board is recommended or approved by a majority of the Continuing Directors. (h) "Distribution Date" shall have the meaning set forth in Section 3(a) hereof. (i) "Person" shall mean any individual, firm, corporation, partnership or other entity. (j) "Preference Stock" shall mean shares of Series A Junior Participating Preference Stock, par value $1.00 per share, of the Company, and, to the extent that there are not a sufficient number of shares of Series A Junior Participating Preference Stock authorized to permit the full exercise of the Rights, any other series of Preference Stock, par value $1.00 per share, of the Company designated for such purpose containing terms substantially similar to the terms of the Series A Junior Partici- pating Preference Stock. (k) "Section 11(a)(ii) Event" shall mean any event described in Section 11(a)(ii) (A), (B) or (C) hereof. (l) "Section 13 Event" shall mean any event described in clauses (x), (y) or (z) of Section 13(a) hereof. (m) "Stock Acquisition Date" shall mean the first date of public announcement (which, for purposes of this defini- tion, shall include, without limitation, a report filed pursuant to Section 13(d) under the Exchange Act) by the Company or an Acquiring Person that an Acquiring Person has become such. (n) "Subsidiary" shall mean, with reference to any Person, any corporation of which an amount of voting securities sufficient to elect at least a majority of the directors of such corporation is beneficially owned, directly or indirectly, by such Person, or otherwise controlled by such Person. (o) "Triggering Event" shall mean any Section 11(a)(ii) Event or any Section 13 Event. Section 2. Appointment of Rights Agent. The Company hereby appoints the Rights Agent to act as agent for the Company and the holders of the Rights (who, in accordance with Section 3 hereof, shall prior to the Distribution Date also be the holders of the Common Stock) in accordance with the terms and conditions hereof, and the Rights Agent hereby accepts such appointment. The Company may from time to time appoint such Co-Rights Agents as it may deem necessary or desirable. Section 3. Issue of Rights Certificates. (a) Until the earliest of (i) the close of busi- ness on the tenth day after the Stock Acquisition Date (or, if the tenth day after the Stock Acquisition Date occurs before the Record Date, the close of business on the Record Date) or (ii) the close of business on the tenth business day (or such later date as may be determined by the Company's Board of Directors) after the date that a tender or exchange offer by any Person (other than the Company, any Subsidiary of the Company, any employee benefit plan of the Company or of any Subsidiary of the Company, or any Person or entity organized, appointed or established by the Company for or pursuant to the terms of any such plan) is first published or sent or given within the meaning of Rule 14d-2(a) of the General Rules and Regulations under the Exchange Act, if upon consummation thereof, such Person would be the Beneficial Owner of 20% or more of the shares of Common Stock then outstanding (the earliest of (i) and (ii) being herein referred to as the "Distribution Date"), (x) the Rights will be evidenced (subject to the provisions of paragraph (b) of this Section 3) by the certificates for the Common Stock registered in the names of the holders of the Common Stock (which certificates for Common Stock shall be deemed also to be certificates for Rights) and not by separate certificates, and (y) the Rights will be transferable only in connection with the transfer of the underlying shares of Common Stock (including a transfer to the Company). As soon as practicable after the Dis- tribution Date, the Rights Agent will send by first-class, insured, postage prepaid mail, to each record holder of the Common Stock as of the close of business on the Distribution Date, at the address of such holder shown on the records of the Company, one or more right certificates, in substantially the form of Exhibit B hereto (the "Rights Certificates"), evidencing one Right for each share of Common Stock so held, subject to adjustment as provided herein. In the event that an adjustment in the number of Rights per share of Common Stock has been made pursuant to Section 11(p) hereof, at the time of distribution of the Rights Certificates, the Company shall make the necessary and appropriate rounding adjustments (in accordance with Section 14(a) hereof) so that Rights Certificates representing only whole numbers of Rights are distributed and cash is paid in lieu of any fractional Rights. As of and after the Distribution Date, the Rights will be evidenced solely by such Rights Certificates. (b) The Company shall send a copy of a Summary of Rights, in substantially the form attached hereto as Exhibit C (the "Summary of Rights"), by first-class, postage prepaid mail, to each record holder of the Common Stock as of the close of business on the Record Date, at the address of such holder shown on the records of the Company. With respect to certificates for the Common Stock outstanding as of the Record Date, until the Distribution Date, the Rights will be evidenced by such certificates for the Common Stock and the registered holders of the Common Stock shall also be the registered holders of the associated Rights. Until the earlier of the Distribution Date or the Expiration Date (as such term is defined in Section 7 hereof), the transfer of any certificates representing shares of Common Stock in respect of which Rights have been issued shall also constitute the transfer of the Rights associated with such shares of Common Stock. (c) Rights shall be issued in respect of all shares of Common Stock which are issued (whether originally issued or from the Company's treasury) after the Record Date but prior to the earlier of the Distribution Date or the Expiration Date. Certificates representing such shares of Common Stock shall also be deemed to be certificates for Rights, and shall bear the following legend: This certificate also evidences and entitles the holder hereof to certain Rights as set forth in the Rights Agreement between Bethlehem Steel Corporation (the "Company") and Morgan Shareholder Services Trust Company (the "Rights Agent") dated as of September 28, 1988 (the "Rights Agreement"), the terms of which are hereby incorporated herein by reference and a copy of which is on file at the principal offices of the Company. Under certain circumstances, as set forth in the Rights Agreement, such Rights will be evidenced by separate certificates and will no longer be evidenced by this certificate. The Company will mail to the holder of this certificate a copy of the Rights Agreement, as in effect on the date of mailing, without charge promptly after receipt of a written request therefor. Under certain circumstances set forth in the Rights Agreement, Rights issued to, or held by, any Person who is, was or becomes an Acquiring Person or any Affiliate or Associate thereof (as such terms are defined in the Rights Agreement), whether currently held by or on behalf of such Person or by any subsequent holder, may become null and void. With respect to such certificates containing the foregoing legend, until the earlier of (i) the Distribution Date or (ii) the Expiration Date, the Rights associated with the Common Stock represented by such certificates shall be evidenced by such certificates alone and registered holders of Common Stock shall also be the registered holders of the associated Rights, and the transfer of any of such certificates shall also constitute the transfer of the Rights associated with the Common Stock represented by such certificates. Section 4. Form of Rights Certificates. (a) The Rights Certificates (and the forms of election to purchase and of assignment to be printed on the re- verse thereof) shall each be substantially in the form set forth in Exhibit B hereto and may have such marks of identification or designation and such legends, summaries or endorsements printed thereon as the Company may deem appropriate and as are not inconsistent with the provisions of this Agreement, or as may be required to comply with any applicable law or with any rule or regulation made pursuant thereto or with any rule or regulation of any stock exchange on which the Rights may from time to time be listed, or to conform to usage. Subject to the provisions of Section 11 and Section 22 hereof, the Rights Certificates, whenever distributed, shall be dated as of the Record Date and on their face shall entitle the holders thereof to purchase such number of one one-hundredth of a share of Preference Stock as shall be set forth therein at the price set forth therein (such exercise price per one one-hundredth of a share, the "Purchase Price"), but the amount and type of securities purchasable upon the exercise of each Right and the Purchase Price thereof shall be subject to adjustment as provided herein. (b) Any Rights Certificate issued pursuant to Section 3(a) or Section 22 hereof that represents Rights benefi- cially owned by: (i) an Acquiring Person or any Associate or Affiliate of an Acquiring Person, (ii) a transferee of an Acquiring Person (or of any such Associate or Affiliate) who becomes a transferee after such Acquiring Person becomes such, or (iii) a transferee of an Acquiring Person (or of any such Associate or Affiliate) who becomes a transferee prior to or concurrently with the Acquiring Person becoming such and receives such Rights pursuant to either (A) a transfer (whether or not for consideration) from the Acquiring Person to holders of equity interests in such Acquiring Person or to any Person with whom such Acquiring Person has any continuing agreement, arrangement or understanding regarding the transferred Rights or (B) a transfer which the Board of Directors of the Company has determined is part of a plan, arrangement or understanding which has as a primary purpose or effect avoidance of Section 7(e) hereof, and any Rights Certificate issued pursuant to Section 6 or Section 11 hereof upon transfer, exchange, replacement or adjustment of any other Rights Certificate referred to in this sentence, shall contain (to the extent feasible) the following legend: The Rights represented by this Rights Certificate are or were beneficially owned by a Person who was or became an Acquiring Person or an Affiliate or Associate of an Acquiring Person (as such terms are defined in the Rights Agreement). Accordingly, this Rights Certificate and the Rights represented hereby may become null and void in the circumstances specified in Section 7(e) of such Agreement. Section 5. Countersignature and Registration. (a) The Rights Certificates shall be executed on behalf of the Company by its Chairman, its President or any Vice President, either manually or by facsimile signature, and shall have affixed thereto the Company's seal or a facsimile thereof which shall be attested by the Secretary or an Assistant Secretary of the Company, either manually or by facsimile signature. The Rights Certificates shall be manually countersigned by the Rights Agent and shall not be valid for any purpose unless so countersigned. In case any officer of the Company who shall have signed any of the Rights Certificates shall cease to be such officer of the Company before countersignature by the Rights Agent and issuance and delivery by the Company, such Rights Certificates, nevertheless, may be countersigned by the Rights Agent and issued and delivered by the Company with the same force and effect as though the person who signed such Rights Certificates had not ceased to be such officer of the Company; and any Rights Certificates may be signed on behalf of the Company by any person who, at the actual date of the execution of such Rights Certificate, shall be a proper officer of the Company to sign such Rights Certificate, although at the date of the execution of this Rights Agreement any such person was not such an officer. (b) Following the Distribution Date, the Rights Agent will keep or cause to be kept, at its principal office or offices designated as the appropriate place for surrender of Rights Certificates upon exercise or transfer, books for registration and transfer of the Rights Certificates issued hereunder. Such books shall show the names and addresses of the respective holders of the Rights Certificates, the number of Rights evidenced on its face by each of the Rights Certificates and the date of each of the Rights Certificates. Section 6. Transfer, Split Up, Combination and Exchange of Rights Certificates; Mutilated, Destroyed, Lost or Stolen Rights Certificates. (a) Subject to the provisions of Section 4(b), Section 7(e) and Section 14 hereof, at any time after the close of business on the Distribution Date, and at or prior to the close of business on the Expiration Date, any Rights Certificate or Certif- icates may be transferred, split up, combined or exchanged for another Rights Certificate or Certificates, entitling the regis- tered holder to purchase a like number of one one-hundredth of a share of Preference Stock (or, following a Triggering Event, Common Stock, other securities, cash or other assets, as the case may be) as the Rights Certificate or Certificates surrendered then entitled such holder (or former holder in the case of a transfer) to purchase. Any registered holder desiring to transfer, split up, combine or exchange any Rights Certificate or Certificates shall make such request in writing delivered to the Rights Agent, and shall surrender the Rights Certificate or Certificates to be transferred, split up, combined or exchanged at the principal office or offices of the Rights Agent designated for such purpose. Neither the Rights Agent nor the Company shall be obligated to take any action whatsoever with respect to the transfer of any such surrendered Rights Certificate until the registered holder shall have completed and signed the certificate contained in the form of assignment on the reverse side of such Rights Certificate and shall have provided such additional evidence of the identity of the Beneficial Owner (or former Beneficial Owner) or Affiliates or Associates thereof as the Company shall reasonably request. Thereupon the Rights Agent shall, subject to Section 4(b), Section 7(e) and Section 14 hereof, countersign and deliver to the Person entitled thereto a Rights Certificate or Rights Certificates, as the case may be, as so requested. The Company may require payment of a sum sufficient to cover any tax or governmental charge that may be imposed in connection with any transfer, split up, combination or exchange of Rights Certificates. (b) Upon receipt by the Company and the Rights Agent of evidence reasonably satisfactory to them of the loss, theft, destruction or mutilation of a Rights Certificate, and, in case of loss, theft or destruction, of indemnity or security reasonably satisfactory to them, and reimbursement to the Company and the Rights Agent of all reasonable expenses incidental thereto, and upon surrender to the Rights Agent and cancellation of the Rights Certificate if mutilated, the Company will execute and deliver a new Rights Certificate of like tenor to the Rights Agent for countersignature and delivery to the registered owner in lieu of the Rights Certificate so lost, stolen, destroyed or mutilated. Section 7. Exercise of Rights; Purchase Price; Expira- tion Date of Rights. (a) Subject to Section 7(e) hereof, the registered holder of any Rights Certificate may exercise the Rights evidenced thereby (except as otherwise provided herein including, without limitation, the restrictions on exercisability set forth in Section 9(c), Section 11(a)(iii) and Section 23(a) hereof) in whole or in part at any time after the Distribution Date upon surrender of the Rights Certificate, with the form of election to purchase and the certificate on the reverse side thereof duly executed, to the Rights Agent at the principal office or offices of the Rights Agent designated for such purpose, together with payment of the aggregate Purchase Price with respect to the total number of one one-hundredth of a share (or other securities, cash or other assets, as the case may be) as to which such surrendered Rights are then exercisable, at or prior to the earlier of (i) the close of business on October 18, 1998 (the "Final Expiration Date"), or (ii) the time at which the Rights are redeemed as provided in Section 23 hereof (the earlier of (i) and (ii) being herein referred to as the "Expiration Date"). (b) The Purchase Price for each one one-hundredth of a share of Preference Stock pursuant to the exercise of a Right shall initially be $80, and shall be subject to adjustment from time to time as provided in Sections 11 and 13(a) hereof and shall be payable in accordance with paragraph (c) below. (c) Upon receipt of a Rights Certificate repre- senting exercisable Rights, with the form of election to purchase and the certificate duly executed, accompanied by payment, with respect to each Right so exercised, of the Purchase Price per one one-hundredth of a share of Preference Stock (or other shares, securities, cash or other assets, as the case may be) to be purchased as set forth below and an amount equal to any applicable transfer tax, the Rights Agent shall, subject to Section 20(k) hereof, thereupon promptly (i)(A) requisition from any transfer agent of the shares of Preference Stock (or make available, if the Rights Agent is the transfer agent for such shares) certificates for the total number of one one-hundredth of a share of Preference Stock to be purchased and the Company hereby irrevocably authorizes its transfer agent to comply with all such requests, or (B) if the Company shall have elected to deposit the total number of shares of Preference Stock issuable upon exercise of the Rights hereunder with a depositary agent, requisition from the depositary agent depositary receipts representing such number of one one- hundredth of a share of Preference Stock as are to be purchased (in which case certificates for the shares of Preference Stock represented by such receipts shall be deposited by the transfer agent with the depositary agent) and the Company will direct the depositary agent to comply with such request, (ii) requisition from the Company the amount of cash, if any, to be paid in lieu of fractional shares in accordance with Section 14 hereof, (iii) after receipt of such certificates or depositary receipts, cause the same to be delivered to or upon the order of the registered holder of such Rights Certificate, registered in such name or names as may be designated by such holder, and (iv) after receipt thereof, deliver such cash, if any, to or upon the order of the registered holder of such Rights Certificate. The payment of the Purchase Price (as such amount may be reduced pursuant to Section 11(a)(iii) hereof) shall be made in cash or by certified bank check or money order payable to the order of the Company. In the event that the Company is obligated to issue other securities (including Common Stock) of the Company, pay cash and/or distribute other property pursuant to Section 11(a) hereof, the Company will make all arrangements necessary so that such other securities, cash and/or other property are available for distribution by the Rights Agent, if and when appropriate. The Company reserves the right to require prior to the occurrence of a Triggering Event that, upon any exercise of Rights, a number of Rights be exercised so that only whole shares of Preference Stock would be issued. (d) In case the registered holder of any Rights Certificate shall exercise less than all the Rights evidenced thereby, a new Rights Certificate evidencing Rights equivalent to the Rights remaining unexercised shall be issued by the Rights Agent and delivered to, or upon the order of, the registered holder of such Rights Certificate, registered in such name or names as may be designated by such holder, subject to the provi-sions of Section 14 hereof. (e) Notwithstanding anything in this Agreement to the contrary, from and after the first occurrence of a Section 11(a)(ii) Event, any Rights beneficially owned by (i) an Acquiring Person or an Associate or Affiliate of an Acquiring Person, (ii) a transferee of an Acquiring Person (or of any such Associate or Affiliate) who becomes a transferee after the Acquiring Person becomes such, or (iii) a transferee of an Acquiring Person (or of any such Associate or Affiliate) who becomes a transferee prior to or concurrently with the Acquiring Person becoming such and receives such Rights pursuant to either (A) a transfer (whether or not for consideration) from the Acquiring Person to holders of equity interests in such Acquiring Person or to any Person with whom the Acquiring Person has any continuing agreement, arrangement or understanding regarding the transferred Rights or (B) a transfer which the Board of Directors of the Company has determined is part of a plan, arrangement or understanding which has as a primary purpose or effect the avoidance of this Section 7(e), shall become null and void without any further action and no holder of such Rights shall have any rights whatsoever with respect to such Rights, whether under any provision of this Agreement or otherwise. The Company shall use all reasonable efforts to insure that the provisions of this Section 7(e) and Section 4(b) hereof are complied with, but shall have no liability to any holder of Rights Certificates or other Person as a result of its failure to make any determinations with respect to an Acquiring Person or any of its Affiliates, Associates or transferees hereunder. (f) Notwithstanding anything in this Agreement to the contrary, neither the Rights Agent nor the Company shall be obligated to undertake any action with respect to a registered holder upon the occurrence of any purported exercise as set forth in this Section 7 unless such registered holder shall have (i) completed and signed the certificate contained in the form of election to purchase set forth on the reverse side of the Rights Certificate surrendered for such exercise, and (ii) provided such additional evidence of the identity of the Beneficial Owner (or former Beneficial Owner) or Affiliates or Associates thereof as the Company shall reasonably request. Section 8. Cancellation and Destruction of Rights Certificates. All Rights Certificates surrendered for the purpose of exercise, transfer, split up, combination or exchange shall, if surrendered to the Company or any of its agents, be delivered to the Rights Agent for cancellation or in cancelled form, or, if surrendered to the Rights Agent, shall be cancelled by it, and no Rights Certificates shall be issued in lieu thereof except as expressly permitted by any of the provisions of this Agreement. The Company shall deliver to the Rights Agent for cancellation and retirement, and the Rights Agent shall so cancel and retire, any other Rights Certificate purchased or acquired by the Company otherwise than upon the exercise thereof. The Rights Agent shall deliver all cancelled Rights Certificates to the Company, or shall, at the written request of the Company, destroy such cancelled Rights Certificates, and in such case shall deliver a certificate of destruction thereof to the Company. Section 9. Reservation and Availability of Capital Stock. (a) The Company covenants and agrees that it will cause to be reserved and kept available out of its authorized and unissued shares of Preference Stock (and, following the occurrence of a Triggering Event, out of its authorized and unissued shares of Common Stock and/or other securities or out of its authorized and issued shares held in its treasury), the number of shares of Preference Stock (and, following the occurrence of a Triggering Event, Common Stock and/or other securities) that, as provided in this Agreement including Section 11(a)(iii) hereof, will be sufficient to permit the exercise in full of all outstanding Rights. (b) So long as the shares of Preference Stock (and, following the occurrence of a Triggering Event, Common Stock and/or other securities) issuable and deliverable upon the exercise of the Rights may be listed on any national securities exchange, the Company shall use its best efforts to cause, from and after such time as the Rights become exercisable, all shares reserved for such issuance to be listed on such exchange upon official notice of issuance upon such exercise. (c) The Company shall use its best efforts to (i) file, as soon as practicable following the earliest date after the first occurrence of a Section 11(a)(ii) Event on which the consideration to be delivered by the Company upon exercise of the Rights has been determined in accordance with Section 11(a)(iii) hereof, a registration statement under the Securities Act of 1933 (the "Act"), with respect to the securities purchasable upon exercise of the Rights on an appropriate form, (ii) cause such registration statement to become effective as soon as practicable after such filing, and (iii) cause such registration statement to remain effective (with a prospectus at all times meeting the requirements of the Act) until the earlier of (A) the date as of which the Rights are no longer exercisable for such securities, and (B) the date of the expiration of the Rights. The Company will also take such action as may be appropriate under, or to ensure compliance with, the securities or "blue sky" laws of the various states in connection with the exercisability of the Rights. The Company may temporarily suspend, for a period of time not to exceed ninety (90) days after the date set forth in clause (i) of the first sentence of this Section 9(c), the exercisability of the Rights in order to prepare and file such registration statement and permit it to become effective. Upon any such suspension, the Company shall issue a public announcement stating that the exercisability of the Rights has been temporarily suspended, as well as a public announcement at such time as the suspension is no longer in effect. In addition, if the Company shall determine that a registration statement is required following the Distribution Date, the Company may temporarily suspend the exercisability of the Rights until such time as a registration statement has been declared effective. Notwithstanding any provision of this Agreement to the contrary, the Rights shall not be exercisable in any jurisdiction if the requisite qualification in such jurisdiction shall not have been obtained, the exercise thereof shall not be permitted under applicable law or a registration statement shall not have been declared effective. (d) The Company covenants and agrees that it will take all such action as may be necessary to ensure that all one one-hundredth of a share of Preference Stock (and, following the occurrence of a Triggering Event, Common Stock and/or other securities) delivered upon exercise of Rights shall, at the time of delivery of the certificates for such shares (subject to payment of the Purchase Price), be duly and validly authorized and issued and fully paid and nonassessable. (e) The Company further covenants and agrees that it will pay when due and payable any and all federal and state transfer taxes and charges which may be payable in respect of the issuance or delivery of the Rights Certificates and of any certificates for a number of one one-hundredth of a share of Preference Stock (or Common Stock and/or other securities, as the case may be) upon the exercise of Rights. The Company shall not, however, be required to pay any transfer tax which may be payable in respect of any transfer or delivery of Rights Certificates to a Person other than, or the issuance or delivery of a number of one one-hundredth of a share of Preference Stock (or Common Stock and/or other securities, as the case may be) in respect of a name other than that of, the registered holder of the Rights Certificates evidencing Rights surrendered for exercise or to issue or deliver any certificates for a number of one one-hun-dredth of a share of Preference Stock (or Common Stock and/or other securities, as the case may be) in a name other than that of the registered holder upon the exercise of any Rights until such tax shall have been paid (any such tax being payable by the holder of such Rights Certificate at the time of surrender) or until it has been established to the Company's satisfaction that no such tax is due. Section 10. Preference Stock Record Date. Each person in whose name any certificate for a number of one one-hundredth of a share of Preference Stock (or Common Stock and/or other securities, as the case may be) is issued upon the exercise of Rights shall for all purposes be deemed to have become the holder of record of such fractional shares of Preference Stock (or Common Stock and/or other securities, as the case may be) represented thereby on, and such certificate shall be dated, the date upon which the Rights Certificate evidencing such Rights was duly surrendered and payment of the Purchase Price (and all applicable transfer taxes) was made; provided, however, that if the date of such surrender and payment is a date upon which the Preference Stock (or Common Stock and/or other securities, as the case may be) transfer books of the Company are closed, such Person shall be deemed to have become the record holder of such shares (fractional or otherwise) on, and such certificate shall be dated, the next succeeding Business Day on which the Preference Stock (or Common Stock and/or other securities, as the case may be) transfer books of the Company are open. Prior to the exercise of the Rights evidenced thereby, the holder of a Rights Certificate shall not be entitled to any rights of a stockholder of the Company with respect to shares for which the Rights shall be exercisable, including, without limitation, the right to vote, to receive dividends or other distributions or to exercise any preemptive rights, and shall not be entitled to receive any notice of any proceedings of the Company, except as provided herein. Section 11. Adjustment of Purchase Price, Number and Kind of Shares or Number of Rights. The Purchase Price, the number and kind of shares covered by each Right and the number of Rights outstanding are subject to adjustment from time to time as provided in this Section 11. (a)(i) In the event the Company shall at any time after the date of this Agreement (A) declare a dividend on the Preference Stock payable in shares of Preference Stock, (B) subdivide the outstanding Preference Stock, (C) combine the out- standing Preference Stock into a smaller number of shares, or (D) issue any shares of its capital stock in a reclassification of the Preference Stock (including any such reclassification in connection with a consolidation or merger in which the Company is the continuing or surviving corporation), except as otherwise provided in this Section 11(a) and Section 7(e) hereof, the Pur- chase Price in effect at the time of the record date for such dividend or of the effective date of such subdivision, combination or reclassification, and the number and kind of shares of Preference Stock or capital stock, as the case may be, issuable on such date, shall be proportionately adjusted so that the holder of any Right exercised after such time shall be entitled to receive, upon payment of the Purchase Price then in effect, the aggregate number and kind of shares of Preference Stock or capital stock, as the case may be, which, if such Right had been exercised immediately prior to such date and at a time when the Preference Stock transfer books of the Company were open, he would have owned upon such exercise and been entitled to receive by virtue of such dividend, subdivision, combination or reclassification. If an event occurs which would require an adjustment under both this Section 11(a)(i) and Section 11(a)(ii) hereof, the adjustment provided for in this Section 11(a)(i) shall be in addition to, and shall be made prior to, any adjustment required pursuant to Section 11(a)(ii) hereof. (ii) In the event: (A) any Acquiring Person or any Assoc- ciate or Affiliate of any Acquiring Person, at any time after the date of this Agreement, directly or indirectly, (1) shall merge into the Company or otherwise combine with the Company and the Company shall be the continuing or surviving corporation of such merger or combination and the Common Stock of the Company shall remain outstanding and unchanged, (2) shall, in one transaction or a series of transactions, transfer any assets to the Company or to any of its Subsidiaries in exchange (in whole or in part) for shares of Common Stock, for shares of other equity securities of the Company, or for securities exercisable for or convertible into shares of equity securities of the Company (Common Stock or otherwise) or otherwise obtain from the Company, with or without consideration, any additional shares of such equity securities or securities exercisable for or convertible into shares of such equity securities (other than pursuant to a pro rata distribution to all holders of Common Stock), (3) shall sell, purchase, lease, exchange, mortgage, pledge, transfer or otherwise acquire or dispose of, in one transaction or a series of transactions, to, from or with (as the case may be) the Company or any of its Subsidiaries, assets on terms and conditions less favorable to the Company than the Company would be able to obtain in arm's-length negotiation with an unaf- filiated third party, other than pursuant to a transaction set forth in Section 13(a) hereof, (4) shall sell, purchase, lease, exchange, mortgage, pledge, transfer or otherwise acquire or dispose of in one transaction or a series of transactions, to, from or with (as the case may be) the Company or any of the Company's Subsidiaries (other than incidental to the lines of business, if any, engaged in as of the date hereof between the Company and such Acquiring Person or Associate or Affiliate) assets having an aggregate fair market value of more than 3% of the total assets of the Company, other than pursuant to a transaction set forth in Section 13(a) hereof, (5) shall receive any compensation from the Company or any of the Company's Subsidiaries other than compensation for full-time employ- ment as a regular employee at rates in accordance with the Company's (or its Subsidiaries') past practices, or (6) shall receive the benefit, directly or indirectly (except proportionately as a stock- holder and except if resulting from a requirement of law or governmental regulation), of any loans, advances, guarantees, pledges or other financial assistance or any tax credits or other tax advantage provided by the Company or any of its Subsidiaries, or (B) any Person (other than the Company, any Subsidiary of the Company, any employee benefit plan of the Company or of any Subsidiary of the Company, or any Person or entity organized, appointed or established by the Company for or pursuant to the terms of any such plan), alone or together with its Affiliates and Associates, shall, at any time after the Rights Dividend Declaration Date, become the Beneficial Owner of 20% or more of the shares of Common Stock then outstanding, unless the event causing the 20% threshold to be crossed is a transaction set forth in Section 13(a) hereof, or is an acquisition of shares of Common Stock pursuant to a tender offer or an exchange offer for all outstanding shares of Common Stock at a price and on terms determined by at least a majority of the members of the Board of Directors who are not officers of the Company and who are not representatives, nominees, Affiliates or Associates of an Acquiring Person, after receiving advice from one or more investment banking firms, to be (a) at a price which is fair to stockholders (taking into account all factors which such members of the Board deem relevant including, without limitation, prices which could reasonably be achieved if the Company or its assets were sold on an orderly basis designed to realize maximum value) and (b) otherwise in the best interests of the Company and its stockholders, or (C) during such time as there is an Acquiring Person, there shall be any reclassification of securities (including any reverse stock split), or recapitalization of the Company, or any merger or consolidation of the Company with any of its Subsidiaries or any other transaction or series of transactions involving the Company or any of its Subsidiaries, other than a transaction or transactions to which the provisions of Section 13(a) apply (whether or not with or into or otherwise involving an Acquiring Person) which has the effect, directly or indirectly, of increasing by more than 1% the proportionate share of the outstanding shares of any class of equity securities of the Company or any of its Subsidiaries which is directly or indirectly beneficially owned by any Acquiring Person or any Associate or Affiliate of any Acquiring Person, then, promptly following the first occurrence of an event described in Section 11(a)(ii)(A), (B) or (C) hereof, proper provision shall be made so that each holder of a Right (except as provided below and in Section 7(e) hereof) shall thereafter have the right to receive, upon exercise thereof at the then current Purchase Price in accordance with the terms of this Agreement, in lieu of a number of one one-hundredth of a share of Preference Stock, such number of shares of Common Stock of the Company as shall equal the result obtained by (x) multiplying the then current Purchase Price by the then number of one one-hundredth of a share of Preference Stock for which a Right was exercisable immediately prior to the first occurrence of a Section 11(a)(ii) Event, and (y) dividing that product (which, following such first occurrence, shall thereafter be referred to as the "Purchase Price" for each Right and for all purposes of this Agreement) by 50% of the current market price (determined pursuant to Section 11(d) hereof) per share of Common Stock on the date of such first occurrence (such number of shares, the "Adjustment Shares"). (iii) In the event that the number of shares of Common Stock which are authorized by the Company's certificate of incorporation but not outstanding or reserved for issuance for purposes other than upon exercise of the Rights are not sufficient to permit the exercise in full of the Rights in accordance with the foregoing subparagraph (ii) of this Section 11(a), the Company shall: (A) determine the excess of (1) the value of the Adjustment Shares issuable upon the exercise of a Right (the "Current Value") over (2) the Purchase Price (such excess, the "Spread"), and (B) with respect to each Right, make adequate provision to substitute for the Adjustment Shares, upon payment of the applicable Purchase Price, (1) cash, (2) a reduction in the Purchase Price, (3) Common Stock or other equity securities of the Company (including, without limita- tion, shares, or units of shares, of preference stock, such as the Preference Stock, which the Board of Directors of the Company has deemed to have substantially the same economic right as shares of Common Stock (such shares of preference stock, "common stock equivalents")), (4) debt securities of the Company, (5) other assets, or (6) any combination of the foregoing, having an aggregate value equal to the Current Value, where such aggregate value has been determined by the Board of Directors of the Company based upon the advice of a nationally recognized investment banking firm selected by the Board of Directors of the Company; provided, however, if the Company shall not have made adequate provision to deliver value pursuant to clause (B) above within thirty (30) days following the later of (x) the first occurrence of a Section 11(a)(ii) Event and (y) the date on which the Company's right of redemption pursuant to Section 23(a) expires (the later of (x) and (y) being referred to herein as the "Section 11(a)(ii) Trigger Date"), then the Company shall be obligated to deliver, upon the surrender for exercise of a Right and without requiring payment of the Purchase Price, shares of Common Stock (to the extent available) and then, if necessary, cash, which shares and/or cash have an aggregate value equal to the Spread. If the Board of Directors of the Company shall determine in good faith that it is likely that sufficient additional shares of Common Stock could be authorized for issuance upon exercise in full of the Rights, the thirty (30) day period set forth above may be extended to the extent necessary, but not more than ninety (90) days after the Section 11(a)(ii) Trigger Date, in order that the Company may seek stockholder approval for the authorization of such additional shares (such period, as it may be extended, the "Substitution Period"). To the extent that the Company determines that some action need be taken pursuant to the first and/or second sentences of this Section 11(a)(iii), the Company (x) shall provide, subject to Section 7(e) hereof, that such action shall apply uniformly to all out-standing Rights, and (y) may suspend the exercisability of the Rights until the expiration of the Substitution Period in order to seek any authorization of additional shares and/or to decide the appropriate form of distribution to be made pursuant to such first sentence and to determine the value thereof. In the event of any such suspension, the Company shall issue a public announcement stating that the exercisability of the Rights has been temporarily suspended, as well as a public announce- ment at such time as the suspension is no longer in effect. For purposes of this Section 11(a)(iii), the value of the Common Stock shall be the current market price (as determined pursuant to Section 11(d) hereof) per share of the Common Stock on the Section 11(a)(ii) Trigger Date and the value of any "common stock equivalent" shall be deemed to have the same value as the Common Stock on such date. (b) In case the Company shall fix a record date for the issuance of rights, options or warrants to all holders of Preference Stock entitling them to subscribe for or purchase (for a period expiring within forty-five (45) calendar days after such record date) Preference Stock (or shares having the same rights, privileges and preferences as the shares of Preference Stock ("equivalent preference stock")) or securities convertible into Preference Stock or equivalent preference stock at a price per share of Preference Stock or per share of equivalent preference stock (or having a conversion price per share, if a security convertible into Preference Stock or equivalent preference stock) less than the current market price (as determined pursuant to Section 11(d) hereof) per share of Preference Stock on such record date, the Purchase Price to be in effect after such record date shall be determined by multiplying the Purchase Price in effect immediately prior to such record date by a fraction, the numerator of which shall be the number of shares of Preference Stock outstanding on such record date, plus the number of shares of Preference Stock which the aggregate offering price of the total number of shares of Preference Stock and/or equivalent preference stock so to be offered (and/or the aggregate initial conversion price of the convertible securities so to be offered) would purchase at such current market price, and the denominator of which shall be the number of shares of Preference Stock outstanding on such record date, plus the number of additional shares of Preference Stock and/or equivalent preference stock to be offered for subscription or purchase (or into which the convertible securities so to be offered are initially convertible). In case such subscription price may be paid by delivery of consideration part or all of which may be in a form other than cash, the value of such consideration shall be as determined in good faith by the Board of Directors of the Company, whose determination shall be described in a statement filed with the Rights Agent and shall be binding on the Rights Agent and the holders of the Rights. Shares of Preference Stock owned by or held for the account of the Company shall not be deemed outstanding for the purpose of any such computation. Such adjustment shall be made successively whenever such a record date is fixed, and in the event that such rights or warrants are not so issued, the Purchase Price shall be adjusted to be the Purchase Price which would then be in effect if such record date had not been fixed. (c) In case the Company shall fix a record date for a distribution to all holders of Preference Stock (including any such distribution made in connection with a consolidation or merger in which the Company is the continuing corporation) of evidences of indebtedness, cash (other than a regular quarterly cash dividend out of the earnings or retained earnings of the Company), assets (other than a dividend payable in Preference Stock, but including any dividend payable in stock other than Preference Stock) or subscription rights or warrants (excluding those referred to in Section 11(b) hereof), the Purchase Price to be in effect after such record date shall be determine by multiplying the Purchase Price in effect immediately prior to such record date by a fraction, the numerator of which shall be the current market price (as determined pursuant to Section 11(d) hereof) per share of Preference Stock on such record date, less the fair market value (as determined in good faith by the Board of Directors of the Company, whose determination shall be described in a statement filed with the Rights Agent) of the portion of the cash, assets or evidences of indebtedness so to be distributed or of such subscription rights or warrants applicable to a share of Preference Stock and the denominator of which shall be such current market price (as determined pursuant to Section 11(d) hereof) per share of Preference Stock. Such adjustments shall be made successively whenever such a record date is fixed, and in the event that such distribution is not so made, the Purchase Price shall be adjusted to be the Purchase Price which would have been in effect if such record date had not been fixed. (d)(i) For the purpose of any computation hereunder, other than computations made pursuant to Section 11(a)(iii) hereof, the "current market price" per share of Common Stock on any date shall be deemed to be the average of the daily closing prices per share of such Common Stock for the thirty (30) consecutive Trading Days (as such term is hereinafter defined) immediately prior to such date, and for purposes of computations made pursuant to Section 11(a)(iii) hereof, the "current market price" per share of Common Stock on any date shall be deemed to be the average of the daily closing prices per share of such Common Stock for the ten (10) consecutive Trading Days immediately following such date; provided, however, that in the event that the current market price per share of the Common Stock is determined during a period following the announcement by the issuer of such Common Stock of (A) a dividend or distribution on such Common Stock payable in shares of such Common Stock or securities convertible into shares of such Common Stock (other than the Rights), or (B) any subdivision, combination or reclassification of such Common Stock, and prior to the expiration of the requisite thirty (30) Trading Day or ten (10) Trading Day period, as set forth above, after the ex-dividend date for such dividend or distribution, or the record date for such subdivision, combination or reclassification, then, and in each such case, the "current market price" shall be properly adjusted to take into account exdividend trading. The closing price for each day shall be the last sale price, regular way, or, in case no such sale takes place on such day, the average of the closing bid and asked prices, regular way, in either case as reported in the principal consolidated transaction reporting system with respect to securities listed or admitted to trading on the New York Stock Exchange or, if the shares of Common Stock are not listed or admitted to trading on the New York Stock Exchange, as reported in the principal consolidated transaction reporting system with respect to securities listed on the principal national securities exchange on which the shares of Common Stock are listed or admitted to trading or, if the shares of Common Stock are not listed or admitted to trading on any national securities exchange, the last quoted price or, if not so quoted, the average of the high bid and low asked prices in the over-the-counter market, as reported by the National Association of Securities Dealers, Inc. Automated Quotation System ("NASDAQ") or such other system then in use, or, if on any such date the shares of Common Stock are not quoted by any such organization, the average of the closing bid and asked prices as furnished by a professional market maker making a market in the Common Stock selected by the Board of Directors of the Company. If on any such date no market maker is making a market in the Common Stock, the fair value of such shares on such date as determined in good faith by the Board of Directors of the Company shall be used. The term "Trading Day" shall mean a day on which the principal national securities exchange on which the shares of Common Stock are listed or admitted to trading is open for the transaction of business or, if the shares of Common Stock are not listed or admitted to trading on any national securities exchange, a Business Day. If the Common Stock is not publicly held or not so listed or traded, "current market price" per share shall mean the fair value per share as determined in good faith by the Board of Directors of the Company, whose determination shall be described in a statement filed with the Rights Agent and shall be conclusive for all purposes. (ii) For the purpose of any computation hereunder, the "current market price" per share of Preference Stock shall be determined in the same manner as set forth above for the Common Stock in clause (i) of this Section 11(d) (other than the last sentence thereof). If the current market price per share of Preference Stock cannot be determined in the manner provided above or if the Preference Stock is not publicly held or listed or traded in a manner described in clause (i) of this Section 11(d), the "current market price" per share of Preference Stock shall be conclusively deemed to be an amount equal to 100 (as such number may be appropriately adjusted for such events as stock splits, stock dividends and recapitalizations with respect to the Common Stock occurring after the date of this Agreement) multiplied by the current market price per share of the Common Stock. If neither the Common Stock nor the Preference Stock is publicly held or so listed or traded, "current market price" per share of the Preference Stock shall mean the fair value per share as determined in good faith by the Board of Directors of the Company, whose determination shall be described in a statement filed with the Rights Agent and shall be conclusive for all purposes. For all purposes of this Agreement, the "current market price" of one one-hundredth of a share of Preference Stock shall be equal to the "current market price" of one share of Preference Stock divided by 100. (e) Anything herein to the contrary not- withstanding, no adjustment in the Purchase Price shall be required unless such adjustment would require an increase or decrease of at least one percent (1%) in the Purchase Price; provided, however, that any adjustments which by reason of this Section 11(e) are not required to be made shall be carried forward and taken into account in any subsequent adjustment. All calculations under this Section 11 shall be made to the nearest cent or to the nearest ten-thousandth of a share of Common Stock or other share or one-millionth of a share of Preference Stock, as the case may be. Notwithstanding the first sentence of this Section 11(e), any adjustment required by this Section 11 shall be made no later than the earlier of (i) three (3) years from the date of the transaction which mandates such adjustment, or (ii) the Expiration Date. (f) If as a result of an adjustment made pursuant to Section 11(a)(ii) or Section 13(a) hereof, the holder of any Right thereafter exercised shall become entitled to receive any shares of capital stock other than Preference Stock, thereafter the number of such other shares so receivable upon exercise of any Right and the Purchase Price thereof shall be subject to adjustment from time to time in a manner and on terms as nearly equivalent as practicable to the provisions with respect to the Preference Stock contained in Sections 11(a), (b), (c), (e), (g), (h), (i), (j), (k) and (m), and the provisions of Sections 7, 9, 10, 13 and 14 hereof with respect to the Preference Stock shall apply on like terms to any such other shares. (g) All Rights originally issued by the Company subsequent to any adjustment made to the Purchase Price hereunder shall evidence the right to purchase, at the adjusted Purchase Price, the number of one one-hundredth of a share of Preference Stock purchasable from time to time hereunder upon exercise of the Rights, all subject to further adjustment as provided herein. (h) Unless the Company shall have exercised its election as provided in Section 11(i), upon each adjustment of the Purchase Price as a result of the calculations made in Sections 11(b) and (c), each Right outstanding immediately prior to the making of such adjustment shall thereafter evidence the right to purchase, at the adjusted Purchase Price, that number of one one-hundredth of a share of Preference Stock (calculated to the nearest one-millionth) obtained by (i) multiplying (x) the number of one one-hundredth of a share covered by a Right immediately prior to this adjustment, by (y) the Purchase Price in effect immediately prior to such adjustment of the Purchase Price, and (ii) dividing the product so obtained by the Purchase Price in effect immediately after such adjustment of the Purchase Price. (i) The Company may elect on or after the date of any adjustment of the Purchase Price to adjust the number of Rights, in lieu of any adjustment in the number of one one-hundredth of a share of Preference Stock purchasable upon the exercise of a Right. Each of the Rights outstanding after the adjustment in the number of Rights shall be exercisable for the number of one one- hundredth of a share of Preference Stock for which a Right was exercisable immediately prior to such adjustment. Each Right held of record prior to such adjustment of the number of Rights shall become that number of Rights (calculated to the nearest one ten-thousandth) obtained by dividing the Purchase Price in effect immediately prior to adjustment of the Purchase Price by the Purchase Price in effect immediately after adjustment of the Purchase Price. The Company shall make a public announcement of its election to adjust the number of Rights, indicating the record date for the adjustment, and, if known at the time, the amount of the adjustment to be made. This record date may be the date on which the Purchase Price is adjusted or any day thereafter, but, if the Rights Certificates have been issued, shall be at least ten (10) days later than the date of the public announcement. If Rights Certificates have been issued, upon each adjustment of the number of Rights pursuant to this Section 11(i), the Company shall, as promptly as practicable, cause to be distributed to holders of record of Rights Certificates on such record date Rights Certificates evidencing, subject to Section 14 hereof, the additional Rights to which such holders shall be entitled as a result of such adjustment, or, at the option of the Company, shall cause to be distributed to such holders of record in substitution and replacement for the Rights Certificates held by such holders prior to the date of adjustment, and upon surrender thereof, if required by the Company, new Rights Certificates evidencing all the Rights to which such holders shall be entitled after such adjustment. Rights Certificates so to be distributed shall be issued, executed and countersigned in the manner provided for herein (and may bear, at the option of the Company, the adjusted Purchase Price) and shall be registered in the names of the holders of record of Rights Certificates on the record date specified in the public announcement. (j) Irrespective of any adjustment or change in the Purchase Price or the number of one one-hundredth of a share of Preference Stock issuable upon the exercise of the Rights, the Rights Certificates theretofore and thereafter issued may continue to express the Purchase Price per one one-hundredth of a share and the number of one one-hundredth of a share which were expressed in the initial Rights Certificates issued hereunder. (k) Before taking any action that would cause an adjustment reducing the Purchase Price below the then stated value, if any, of the number of one one-hundredth of a share of Preference Stock issuable upon exercise of the Rights, the Company shall take any corporate action which may, in the opinion of its counsel, be necessary in order that the Company may validly and legally issue fully paid and nonassessable such number of one one-hundredth of a share of Preference Stock at such adjusted Purchase Price. (l) In any case in which this Section 11 shall require that an adjustment in the Purchase Price be made effective as of a record date for a specified event, the Company may elect to defer until the occurrence of such event the issuance to the holder of any Right exercised after such record date the number of one one-hundredth of a share of Preference Stock and other capital stock or securities of the Company, if any, issuable upon such exercise over and above the number of one one-hundredth of a share of Preference Stock and other capital stock or securities of the Company, if any, issuable upon such exercise on the basis of the Purchase Price in effect prior to such adjustment; provided, however, that the Company shall deliver to such holder a due bill or other appropriate instrument evidencing such holder's right to receive such additional shares (fractional or otherwise) or securities upon the occurrence of the event requiring such adjustment. (m) Anything in this Section 11 to the contrary notwithstanding, the Company shall be entitled to make such reductions in the Purchase Price, in addition to those adjustments expressly required by this Section 11, as and to the extent that in their good faith judgment the Board of Directors of the Company shall determine to be advisable in order that any (i) consolidation or subdivision of the Preference Stock, (ii) issuance wholly for cash of any shares of Preference Stock at less than the current market price, (iii) issuance wholly for cash of shares of Preference Stock or securities which by their terms are convertible into or exchangeable for shares of Preference Stock, (iv) stock dividends or (v) issuance of rights, options or warrants referred to in this Section 11, hereafter made by the Company to holders of its Preference Stock shall not be taxable to such stockholders. (n) The Company covenants and agrees that it shall not, at any time after the Distribution Date, (i) consolidate with any other Person (other than a Subsidiary of the Company in a transaction which complies with Section 11(o) hereof), (ii) merge with or into any other Person (other than a Subsidiary of the Company in a transaction which complies with Section 11(o) hereof), or (iii) sell or transfer (or permit any Subsidiary to sell or transfer), in one transaction, or a series of related transactions, assets or earning power aggregating more than 50% of the assets or earning power of the Company and its Subsidiaries (taken as a whole) to any other Person or Persons (other than the Company and/or any of its Subsidiaries in one or more transactions each of which complies with Section 11(o) hereof), if (x) at the time of or immediately after such consolidation, merger or sale there are any rights, warrants or other instruments or securities outstanding or agreements in effect which would substantially diminish or otherwise eliminate the benefits intended to be afforded by the Rights or (y) prior to, simultaneously with or immediately after such consolidation, merger or sale, the stockholders of the Person who constitutes, or would constitute, the "Principal Party" for purposes of Section 13(a) hereof shall have received a distribution of Rights previously owned by such Person or any of its Affiliates and Associates. (o) The Company covenants and agrees that, after the Distribution Date, it will not, except as permitted by Section 23 or Section 26 hereof, take (or permit any Subsidiary to take) any action if at the time such action is taken it is reasonably foreseeable that such action will diminish substantially or other-wise eliminate the benefits intended to be afforded by the Rights. (p) Anything in this Agreement to the contrary notwithstanding, in the event that the Company shall at any time after the Rights Dividend Declaration Date and prior to the Distribution Date (i) declare a dividend on the outstanding shares of Common Stock payable in shares of Common Stock, (ii) subdivide the outstanding shares of Common Stock, (iii) combine the outstanding shares of Common Stock into a smaller number of shares, or (iv) issue any shares by reclassification of its shares of Common Stock, the number of Rights associated with each share of Common Stock then outstanding, or issued or delivered thereafter but prior to the Distribution Date, shall be proportionately adjusted so that the number of Rights thereafter associated with each share of Common Stock following any such event shall equal the result obtained by multiplying the number of Rights associated with each share of Common Stock immediately prior to such event by a fraction the numerator of which shall be the total number of shares of Common Stock outstanding immediately prior to the occurrence of the event and the denominator of which shall be the total number of shares of Common Stock outstanding immediately following the occurrence of such event. Section 12. Certificate of Adjusted Purchase Price or Number of Shares. Whenever an adjustment is made as provided in Section 11 and Section 13 hereof,the Company shall (a) promptly prepare a certificate setting forth such adjustment and a brief statement of the facts accounting for such adjustment, (b) promptly file with the Rights Agent, and with each transfer agent for the Preference Stock and the Common Stock, a copy of such certificate, and (c) mail a brief summary thereof to each holder of a Rights Certificate (or, if prior to the Distribution Date, to each holder of a certificate representing shares of Common Stock) in accordance with Section 25 hereof. The Rights Agent shall be fully protected in relying on any such certificate and on any adjustment therein contained. Section 13. Consolidation, Merger or Sale or Transfer of Assets or Earning Power. (a) In the event that, following the Stock Acquisition Date, directly or indirectly, (x) the Company shall consolidate with, or merge with and into, any other Person (other than a Subsidiary of the Company in a transaction which complies with Section 11(o) hereof), and the Company shall not be the continuing or surviving corporation of such consolidation or merger,(y) any Person (other than a Subsidiary of the Company in a transaction which complies with Section 11(o) hereof) shall consolidate with, or merge with or into, the Company, and the Company shall be the continuing or surviving corporation of such consolidation or merger and, in connection with such consolidation or merger, all or part of the outstanding shares of Common Stock shall be changed into or exchanged for stock or other securities of any other Person or cash or any other property, or (z) the Company shall sell or otherwise transfer (or one or more of its Subsidiaries shall sell or otherwise transfer), in one transaction or a series of related transactions, assets or earning power aggregating more than 50% of the assets or earning power of the Company and its Subsidiaries (taken as a whole) to any Person or Persons (other than the Company or any Subsidiary of the Company in one or more transactions each of which complies with Section 11(o) hereof), then, and in each such case (except as may be contemplated by Section 13(d) hereof), proper provision shall be made so that: (i) each holder of a Right, except as provided in Section 7(e) hereof, shall thereafter have the right to receive, upon the exercise thereof at the then current Purchase Price in accordance with the terms of this Agreement, such number of validly authorized and issued, fully paid, nonassessable and freely tradeable shares of Common Stock of the Principal Party (as such term is hereinafter defined), not subject to any liens, encumbrances, rights of first refusal or other adverse claims, as shall be equal to the result obtained by (1) multiplying the then current Purchase Price by the number of one one-hundredth of a share of Preference Stock for which a Right is exercisable immediately prior to the first occurrence of a Section 13 Event (or, if a Section 11(a)(ii) Event has occurred prior to the first occurrence of a Section 13 Event, multiplying the number of such one one-hundredth of a share for which a Right was exercisable immediately prior to the first occurrence of a Section 11(a)(ii) Event by the Purchase Price in effect immediately prior to such first occurrence), and dividing that product (which, following the first occurrence of a Section 13 Event, shall be referred to as the "Purchase Price" for each Right and for all purposes of this Agreement) by (2) 50% of the current market price (determined pursuant to Section 11(d)(i) hereof) per share of the Common Stock of such Principal Party on the date of consummation of such Section 13 Event, (ii) such Principal Party shall there-after be liable for, and shall assume, by virtue of such Section 13 Event, all the obligations and duties of the Company pursuant to this Agreement, (iii) the term Company" shall thereafter be deemed to refer to such Principal Party, it being specifically intended that the provisions of Section 11 hereof shall apply only to such Principal Party following the first occurrence of a Section 13 Event, (iv) such Principal Party shall take such steps (including, but not limited to, the reservation of a sufficient number of shares of its Common Stock) in connection with the consummation of any such transaction as may be necessary to assure that the provisions hereof shall thereafter be applicable, as nearly as reasonably may be, in relation to its shares of Common Stock thereafter deliverable upon the exercise of the Rights, and (v) the provisions of Section 11(a)(ii) hereof shall be of no effect following the first occurrence of any Section 13 Event. (b) "Principal Party" shall mean (i) in the case of any transaction described in clause (x) or (y) of the first sentence of Section 13(a), the Person that is the issuer of any securities into which shares of Common Stock of the Company are converted in such merger or consolidation, and if no securities are so issued, the Person that is the other party to such merger or consolidation; and (ii) in the case of any transaction described in clause (z) of the first sentence of Section 13(a), the Person that is the party receiving the greatest portion of the assets or earning power transferred pursuant to such transaction or transactions; provided, however, that in any such case, (1) if the Common Stock of such Person is not at such time and has not been continuously over the preceding twelve (12) month period registered under Section 12 of the Exchange Act, and such Person is a direct or indirect Subsidiary of another Person the Common Stock of which is and has been so registered, "Principal Party" shall refer to such other Person, and (2) in case such Person is a Subsidiary, directly or indirectly, of more than one Person, the Common Stocks of two or more of which are and have been so registered, "Principal Party" shall refer to whichever of such Persons is the issuer of the Common Stock having the greatest aggregate market value. (c) The Company shall not consummate any such consolidation, merger, sale or transfer unless the Principal Party shall have a sufficient number of authorized shares of its Common Stock which have not been issued or reserved for issuance to permit the exercise in full of the Rights in accordance with this Section 13 and unless prior thereto the Company and such Principal Party shall have executed and delivered to the Rights Agent a supplemental agreement providing for the terms set forth in paragraphs (a) and (b) of this Section 13 and further providing that, as soon as practicable after the date of any consolidation, merger or sale of assets mentioned in paragraph (a) of this Section 13, the Principal Party will (i) prepare and file a registration statement under the Act, with respect to the Rights and the securities purchasable upon exercise of the Rights on an appropriate form, and will use its best efforts to cause such registration statement to (A) become effective as soon as practicable after such filing and (B) remain effective (with a prospectus at all times meeting the requirements of the Act) until the Expiration Date, and (ii) will deliver to holders of the Rights historical financial statements for the Principal Party and each of its Affiliates which comply in all respects with the requirements for registration on Form 10 under the Exchange Act. The provisions of this Section 13 shall similarly apply to successive mergers or consolidations or sales or other transfers. In the event that a Section 13 Event shall occur at any time after the occurrence of a Section 11(a)(ii) Event, the Rights which have not theretofore been exercised shall thereafter become exercisable in the manner described in Section 13(a). (d) Notwithstanding anything in this Agreement to the contrary, Section 13 shall not be applicable to a transaction described in subparagraphs (x) and (y) of Section 13(a) if (i) such transaction is consummated with a Person or Persons who acquired shares of Common Stock pursuant to a tender offer or exchange offer for all outstanding shares of Common Stock which complies with the provisions of Section 11(a)(ii)(B) hereof (or a wholly owned subsidiary of any such Person or Persons), (ii) the price per share of Common Stock offered in such transaction is not less than the price per share of Common Stock paid to all holders of shares of Common Stock whose shares were purchased pursuant to such tender offer or exchange offer and (iii) the form of consideration being offered to the remaining holders of shares of Common Stock pursuant to such transaction is the same as the form of consideration paid pursuant to such tender offer or exchange offer. Upon consummation of any such transaction contemplated by this Section 13(d), all Rights hereunder shall expire. Section 14. Fractional Rights and Fractional Shares. (a) The Company shall not be required to issue fractions of Rights, except prior to the Distribution Date as provided in Section 11(p) hereof, or to distribute Rights Certificates which evidence fractional Rights. In lieu of such fractional Rights, there shall be paid to the registered holders of the Rights Certificates with regard to which such fractional Rights would otherwise be issuable, an amount in cash equal to the same fraction of the current market value of a whole Right. For purposes of this Section 14(a), the current market value of a whole Right shall be the closing price of the Rights for the Trading Day immediately prior to the date on which such fractional Rights would have been otherwise issuable. The closing price of the Rights for any day shall be the last sale price, regular way, or, in case no such sale takes place on such day, the average of the closing bid and asked prices, regular way, in either case as reported in the principal consolidated transaction reporting system with respect to securities listed or admitted to trading on the New York Stock Exchange or, if the Rights are not listed or admitted to trading on the New York Stock Exchange, as reported in the principal consolidated transaction reporting system with respect to securities listed on the principal national securities exchange on which the Rights are listed or admitted o trading, or if the Rights are not listed or admitted to trading on any national securities exchange, the last quoted price or, if not so quoted, the average of the high bid and low asked prices in the over- he-counter market, as reported by NASDAQ or such other system then in use or, if on any such date the Rights are not quoted by any such organization, the average of the closing bid and asked prices as furnished by a professional market maker making a market in the Rights selected by the Board of Directors of the Company. If on any such date no such market maker is making a market in the Rights, the fair value of the Rights on such date as determined in good faith by the Board of Directors of the Company shall be used. (b) The Company shall not be required to issue fractions of shares of Preference Stock (other than fractions which are integral multiples of one one-hundredth of a share of Preference Stock) upon exercise of the Rights or to distribute certificates which evidence fractional shares of Preference Stock (other than fractions which are integral multiples of one one-hundredth of a share of Preference Stock). In lieu of fractional shares of Preference Stock that are not integral multiples of one one-hundredth of a share of Preference Stock, the Company may pay to the registered holders of Rights Certificates at the time such Rights are exercised as herein provided an amount in cash equal to the same fraction of the current market value of one one-hundredth of a share of Preference Stock. For purposes of this Section 14(b), the current market value of one one-hundredth of a share of Preference Stock shall be one one-hundredth of the closing price of a share of Preference Stock (as determined pursuant to Section 11(d)(ii) hereof) for the Trading Day immediately prior to the date of such exercise. (c) Following the occurrence of a Triggering Event, the Company shall not be required to issue fractions of shares of Common Stock upon exercise of the Rights or to distribute certificates which evidence fractional shares of Common Stock. In lieu of fractional shares of Common Stock, the Company may pay to the registered holders of Rights Certificates at the time such Rights are exercised as herein provided an amount in cash equal to the same fraction of the current market value of one (1) share of Common Stock. For purposes of this Section 14(c), the current market value of one share of Common Stock shall be the closing price of one share of Common Stock (as determined pursuant to Section 11(d)(i) hereof) for the Trading Day immediately prior to the date of such exercise. (d) The holder of a Right by the acceptance of the Rights expressly waives his right to receive any fractional Rights or any fractional shares upon exercise of a Right, except as permitted by this Section 14. Section 15. Rights of Action. All rights of action in respect of this Agreement are vested in the respective registered holders of the Rights Certificates (and, prior to the Distribution Date, the registered holders of the Common Stock); and any registered holder of any Rights Certificate (or, prior to the Distribution Date, of the Common Stock), without the consent of the Rights Agent or of the holder of any other Rights Certificate (or, prior to the Distribution Date, of the Common Stock), may, in his own behalf and for his own benefit, enforce, and may institute and maintain any suit, action or proceeding against the Company to enforce, or otherwise act in respect of, his right to exercise the Rights evidenced by such Rights Certificate in the manner provided in such Rights Certificate and in this Agreement. Without limiting the foregoing or any remedies available to the holders of Rights, it is specifically acknowledged that the holders of Rights would not have an adequate remedy at law for any breach of this Agreement and shall be entitled to specific performance of the obligations hereunder and injunctive relief against actual or threatened violations of the obligations hereunder of any Person subject to this Agreement. Section 16. Agreement of Rights Holders. Every holder of a Right by accepting the same consents and agrees with the Company and the Rights Agent and with every other holder of a Right that: (a) prior to the Distribution Date, the Rights will be transferable only in connection with the transfer of Common Stock; (b) after the Distribution Date, the Rights Certificates are transferable only on the registry books of the Rights Agent if surrendered at the principal office or offices of the Rights Agent designated for such purposes, duly endorsed or accompanied by a proper instrument of transfer and with the appropriate forms and certificates fully executed; (c) subject to Section 6(a) and Section 7(f) hereof, the Company and the Rights Agent may deem and treat the person in whose name a Rights Certificate (or, prior to the Distribution Date, the associated Common Stock certificate) is registered as the absolute owner thereof and of the Rights evidenced thereby (notwithstanding any notations of ownership or writing on the Rights Certificates or the associated Common Stock certificate made by anyone other than the Company or the Rights Agent) for all purposes whatsoever, and neither the Company nor the Rights Agent, subject to the last sentence of Section 7(e) hereof, shall be required to be affected by any notice to the contrary; and (d) notwithstanding anything in this Agreement to the contrary, neither the Company nor the Rights Agent shall have any liability to any holder of a Right or other Person as a result of its inability to perform any of its obligations under this Agreement by reason of any preliminary or permanent injunction or other order, decree or ruling issued by a court of competent jurisdiction or by a governmental, regulatory or administrative agency or commission, or any statute, rule, regulation or executive order promulgated or enacted by any governmental authority, prohibiting or otherwise restraining performance of such obligation; provided, however, the Company must use its best efforts to have any such order, decree or ruling lifted or otherwise overturned as soon as possible. Section 17. Rights Certificate Holder Not Deemed a Stockholder. No holder, as such, of any Rights Certificate shall be entitled to vote, receive dividends or be deemed for any purpose the holder of the number of one one-hundredth of a share of Preference Stock or any other securities of the Company which may at any time be issuable on the exercise of the Rights represented thereby, nor shall anything contained herein or in any Rights Certificate be construed to confer upon the holder of any Rights Certificate, as such, any of the rights of a stockholder of the Company or any right to vote for the election of directors or upon any matter submitted to stockholders at any meeting thereof, or to give or withhold consent to any corporate action, or to receive notice of meetings or other actions affecting stockholders (except as provided in Section 24 hereof), or to receive dividends or subscription rights, or otherwise, until the Right or Rights evidenced by such Rights Certificate shall have been exercised in accordance with the provisions hereof. Section 18. Concerning the Rights Agent. (a) The Company agrees to pay to the Rights Agent reasonable compensation for all services rendered by it hereunder and, from time to time, on demand of the Rights Agent, its reasonable expenses and counsel fees and disbursements and other disbursements incurred in the administration and execution of this Agreement and the exercise and performance of its duties hereunder. The Company also agrees to indemnify the Rights Agent for, and to hold it harmless against, any loss, liability, or expense, incurred without negligence, bad faith or willful misconduct on the part of the Rights Agent, for anything done or omitted by the Rights Agent in connection with the acceptance and administration of this Agreement, including the costs and expenses of defending against any claim of liability in the premises. (b) The Rights Agent shall be protected and shall incur no liability for or in respect of any action taken, suffered or omitted by it in connection with its administration of this Agreement in reliance upon any Rights Certificate or certificate for Common Stock or for other securities of the Company, instrument of assignment or transfer, power of attorney, endorsement, affidavit, letter, notice, direction, consent, certificate, statement, or other paper or document believed by it to be genuine and to be signed, executed and, where necessary, verified or acknowledged, by the proper Person or Persons. Section 19. Merger or Consolidation or Change of Name of Rights Agent. (a) Any corporation into which the Rights Agent or any successor Rights Agent may be merged or with which it may be consolidated, or any corporation resulting from any merger or consolidation to which the Rights Agent or any successor Rights Agent shall be a party, or any corporation succeeding to the corporate trust or stock transfer business of the Rights Agent or any successor Rights Agent, shall be the successor to the Rights Agent under this Agreement without the execution or filing of any paper or any further act on the part of any of the parties hereto; provided, however, that such corporation would be eligible for appointment as a successor Rights Agent under the provisions of Section 21 hereof. In case at the time such successor Rights Agent shall succeed to the agency created by this Agreement, any of the Rights Certificates shall have been countersigned but not delivered, any such successor Rights Agent may adopt the countersignature of a predecessor Rights Agent and deliver such Rights Certificates so countersigned; and in case at that time any of the Rights Certificates shall not have been countersigned, any successor Rights Agent may countersign such Rights Certificates either in the name of the predecessor or in the name of the successor Rights Agent; and in all such cases such Rights Certificates shall have the full force provided in the Rights Certificates and in this Agreement. (b) In case at any time the name of the Rights Agent shall be changed and at such time any of the Rights Certificates shall have been countersigned but not delivered, the Rights Agent may adopt the countersignature under its prior name and deliver Rights Certificates so countersigned; and in case at that time any of the Rights Certificates shall not have been countersigned, the Rights Agent may countersign such Rights Certificates either in ts prior name or in its changed name; and in all such cases such Rights Certificates shall have the full force provided in the Rights Certificates and in this Agreement. Section 20. Duties of Rights Agent. The Rights Agent undertakes the duties and obligations imposed by this Agreement upon the following terms and conditions, by all of which the Company of Rights Certificates, by their acceptance thereof,shall be bound: (a) The Rights Agent may consult with legal counsel (who may be legal counsel for the Company), and the opinion of such counsel shall be full and complete authorization and protection to the Rights Agent as to any action taken or omitted by it in good faith and in accordance with such opinion. (b) Whenever in the performance of its duties under this Agreement the Rights Agent shall deem it necessary or desirable that any fact or matter (including, without limitation, the identity of any Acquiring Person and the determination of "current market price") be proved or established by the Company prior to taking or suffering any action hereunder, such fact or matter (unless other evidence in respect thereof be herein specifically prescribed) may be deemed to be conclusively proved and established by a certificate signed by the Chairman, any Vice Chairman, the President, any Vice President, the Treasurer, any Assistant Treasurer, the Secretary or any Assistant Secretary of the Company and delivered to the Rights Agent; and such certificate shall be full authorization to the Rights Agent for any action taken or suffered in good faith by it under the provisions of this Agreement in reliance upon such certificate. (c) The Rights Agent shall be liable hereunder only for its own negligence, bad faith or willful misconduct. (d) The Rights Agent shall not be liable for or by reason of any of the statements of fact or recitals contained in this Agreement or in the Rights Certificates or be required to verify the same (except as to its countersignature on such Rights Certificates), but all such statements and recitals are and shall be deemed to have been made by the Company only. (e) The Rights Agent shall not be under any responsibility in respect of the validity of this Agreement or the execution and delivery hereof (except the due execution hereof by the Rights Agent) or in respect of the validity or execution of any Rights Certificate (except its countersignature thereof); nor shall it be responsible for any breach by the Company of any covenant or condition contained in this Agreement or in any Rights Certificate; nor shall it be responsible for any adjustment required under the provisions of Section 11 or Section 13 hereof or responsible for the manner, method or amount of any such adjustment or the ascertaining of the existence of facts that would require any such adjustment (except with respect to the exercise of Rights evidenced by Rights Certificates after actual notice of any such adjustment); nor shall it by any act hereunder be deemed to make any representation or warranty as to the authorization or reservation of any shares of Common Stock or Preference Stock to be issued pursuant to this Agreement or any Rights Certificate or as to whether any shares of Common Stock or Preference Stock will, when so issued, be validly authorized and issued, fully paid and nonassessable. (f) The Company agrees that it will perform, execute, acknowledge and deliver or cause to be performed, executed, acknowledged and delivered all such further and other acts, instruments and assurances as may reasonably be required by the Rights Agent for the carrying out or performing by the Rights Agent of the provisions of this Agreement. (g) The Rights Agent is hereby authorized and directed to accept instructions with respect to the performance of its duties hereunder from the Chairman, any Vice Chairman, the President, any Vice President, the Secretary, any Assistant Secretary, the Treasurer or any Assistant Treasurer of the Company, and to apply to such officers for advice or instructions in connection with its duties, and it shall not be liable for any action taken or suffered to be taken by it in good faith in accordance with instructions of any such officer. (h) The Rights Agent and any stockholder, director, officer or employee of the Rights Agent may buy, sell or deal in any of the Rights or other securities of the Company or become pecuniarily interested in any transaction in which the Company may be interested, or contract with or lend money to the Company or otherwise act as fully and freely as though it were not Rights Agent under this Agreement. Nothing herein shall preclude the Rights Agent from acting in any other capacity for the Company or for any other legal entity. (i) The Rights Agent may execute and exercise any of the rights or powers hereby vested in it or perform any duty hereunder either itself or by or through its attorneys or agents, and the Rights Agent shall not be answerable or accountable for any act, default, neglect or misconduct of any such attorneys or agents or for any loss to the Company resulting from any such act, default, neglect or misconduct; provided, however, reasonable care was exercised in the selection and continued employment thereof. (j) No provision of this Agreement shall require the Rights Agent to expend or risk its own funds or otherwise incur any financial liability in the performance of any of its duties hereunder or in the exercise of its rights if there shall be reasonable grounds for believing that repayment of such funds or adequate indemnification against such risk or liability is not reasonably assured to it. (k) If, with respect to any Rights Certificate surrendered to the Rights Agent for exercise or transfer, the certificate attached to the form of assignment or form of election to purchase, as the case may be, has either not been completed or indicates an affirmative response to clause 1 and/or 2 thereof, the Rights Agent shall not take any further action with respect to such requested exercise of transfer without first consulting with the Company. Section 21. Change of Rights Agent. The Rights Agent or any successor Rights Agent may resign and be discharged from its duties under this Agreement upon thirty (30) days' notice in writing mailed to the Company, and to each transfer agent of the Common Stock and Preference Stock, by registered or certified mail, and to the holders of the Rights Certificates by first-class mail. The Company may remove the Rights Agent or any successor Rights Agent upon thirty (30) days' notice in writing, mailed to the Rights Agent or successor Rights Agent, as the case may be, and to each transfer agent of the Common Stock and Preference Stock, by registered or certified mail, and to the holders of the Rights Certificates by first-class mail. If the Rights Agent shall resign or be removed or shall otherwise become incapable of acting, the Company shall appoint a successor to the Rights Agent. If the Company shall fail to make such appoint- ment within a period of thirty (30) days after giving notice of such removal or after it has been notified in writing of such resignation or incapacity by the resigning or incapacitated Rights Agent or by the holder of a Rights Certificate (who shall, with such notice, submit his Rights Certificate for inspection by the Company), then any registered holder of any Rights Certificate may apply to any court of competent jurisdiction for the appointment of a new Rights Agent. Any successor Rights Agent, whether appointed by the Company or by such a court, shall be (i) a corporation organized and doing business under the laws of the United States or of the States of New York or Pennsylvania (or of any other state of the United States so long as such corporation is authorized to do business as a banking institution in the States of New York or Pennsylvania), in good standing, having a principal office in the States of New York or Pennsylvania, which is authorized under such laws to exercise corporate trust or stock transfer powers and is subject to supervision or examination by federal or state authority and which has at the time of its appointment as Rights Agent a combined capital and surplus of at least $100,000,000 or (ii) an affiliate of a corporation described in clause (i) of this sentence. After appointment, the successor Rights Agent shall be vested with the same powers, rights, duties and responsibilities as if it had been originally named as Rights Agent without further act or deed; but the predecessor Rights Agent shall deliver and transfer to the successor Rights Agent any property at the time held by it hereunder, and execute and deliver any further assurance, conveyance, act or deed necessary for the purpose. Not later than the effective date of any such appointment, the Company shall file notice thereof in writing with the predecessor Rights Agent and each transfer agent of the Common Stock and the Preference Stock, and mail a notice thereof in writing to the registered holders of the Rights Certificates. Failure to give any notice provided for in this Section 21, however, or any defect therein, shall not affect the legality or validity of the resignation or removal of the Rights Agent or the appointment of the successor Rights Agent, as the case may be. Section 22. Issuance of New Rights Certificates. Notwithstanding any of the provisions of this Agreement or ofthe Rights to the contrary, the Company may, at its option, issue new Rights Certificates evidencing Rights in such form as may be approved by its Board of Directors to reflect any adjustment or change in the Purchase Price and the number or kind or class of shares or other securities or property purchasable under the Rights Certificates made in accordance with the provisions of this Agreement. In addition, in connection with the issuance or sale of shares of Common Stock following the Distribution Date and prior to the redemption or expiration of the Rights, the Company (a) shall, with respect to shares of Common Stock so issued or sold pursuant to the exercise of stock options or under any employee plan or arrangement, granted or awarded as of the Distribution Date, or upon the exercise, conversion or exchange of securities hereinafter issued by the Company, and (b) may, in any other case, if deemed necessary or appropriate by the Board of Directors of the Company, issue Rights Certificates representing the appropriate number of Rights in connection with such issuance or sale; provided, however, that (i) no such Rights Certificate shall be issued if, and to the extent that, the Company shall be advised by counsel that such issuance would create a significant risk of material adverse tax consequences to the Company or the Person to whom such Rights Certificate would be issued, and (ii) no such Rights Certificate shall be issued if, and to the extent that, appropriate adjustment shall otherwise have been made in lieu of the issuance thereof. Section 23. Redemption and Termination. (a) The Board of Directors of the Company may, at its option, at any time prior to the earlier of (i) the close of business on the tenth day following the Stock Acquisition Date (or, if the Stock Acquisition Date shall have occurred prior to the Record Date, the close of business on the tenth day following the Record Date), or (ii) the Final Expiration Date, redeem all but not less than all the then outstanding Rights at a redemption price of $.01 per Right, as such amount may be appropriately adjusted to reflect any stock split, stock dividend or similar transaction occurring after the date hereof (such redemption price being hereinafter referred to as the "Redemption Price"); provided, however, if the Board of Directors of the Company authorizes redemption of the Rights in either of the circumstances set forth in clauses (i) and (ii) below, then there must be Continuing Directors then in office and such authorization shall require the concurrence of a majority of such Continuing Directors: (i) such authorization occurs on or after the time a Person becomes an Acquiring Person, or (ii) such authorization occurs on or after the date of a change (resulting from a proxy or consent solicitation) in a majority of the directors in office at the commencement of such solicitation if any Person who is a participant in such solicitation has stated (or, if upon the commencement of such solicitation, a majority of the Board of Directors of the Company has determined in good faith) that such Person (or any of its Affiliates or Associates) intends to take, or may consider taking, any action which would result in such Person becoming an Acquiring Person or which would cause the occurrence of a Triggering Event unless, concurrent with such solicitation, such Person (or one or more of its Affiliates or Associates) is making a cash tender offer pursuant to a Schedule 14D-1 (or any successor form) filed with the Securities and Exchange Commission for all outstanding shares of Common Stock not beneficially owned by such Person (or by its Affiliates or Associates). Notwithstanding anything contained in this Agreement to the contrary, the Rights shall not be exercisable after the first occurrence of a Section - 11(a)(ii) Event until such time as the Company's right of redemption hereunder has expired. The Company may, at its option, pay the Redemption Price in cash, shares of Common Stock (based on the "current market price", as defined in Section 11(d)(i) hereof, of the Common Stock at the time of redemption) or any other form of consideration deemed appropriate by the Board of Directors. (b) Immediately upon the action of the Board of Directors of the Company ordering the redemption of the Rights, evidence of which shall have been filed with the Rights Agent and without any further action and without any notice, the right to exercise the Rights will terminate and the only right thereafter of the holders of Rights shall be to receive the Redemption Price for each Right so held. Promptly after the action of the Board of Directors ordering the redemption of the Rights, the Company shall give notice of such redemption to the Rights Agent and the holders of the then outstanding Rights by mailing such notice to all such holders at each holder's last address as it appears upon the registry books of the Rights Agent or, prior to the Distribution Date, on the registry books of the Transfer Agent for the Common Stock. Any notice which is mailed in the manner herein provided shall be deemed given, whether or not the holder receives the notice. Each such notice of redemption will state the method by which the payment of the Redemption Price will be made. Section 24. Notice of Certain Events. (a) In case the Company shall propose, at any time after the Distribution Date, (i) to pay any dividend payable in stock of any class to the holders of Preference Stock or to make any other distribution to the holders of Preference Stock (other than a regular quarterly cash dividend out of earnings or retained earnings of the Company), or (ii) to offer to the holders of Preference Stock rights or warrants to subscribe for or to purchase any additional shares of Preference Stock or shares of stock of any class or any other securities, rights or options, or (iii) to effect any reclassification of its Preference Stock (other than a reclassification involving only the subdivision of outstanding shares of Preference Stock), or (iv) to effect any consolidation or merger into or with any other Person (other than a Subsidiary of the Company in a transaction which complies with Section 11(o) hereof), or to effect any sale or other transfer (or to permit one or more of its Subsidiaries to effect any sale or other transfer), in one transaction or a series of related transactions, of more than 50% of the assets or earning power of the Company and its Subsidiaries (taken as a whole) to any other Person or Persons (other than the Company and/or any of its Subsidiaries in one or more transactions each of which complies with Section 11(o) hereof), or (v) to effect the liquidation, dissolution, or winding up of the Company, then, in each such case, the Company shall give to each holder of a Rights Certificate, to the extent feasible and in accordance with Section 25 hereof, a notice of such proposed action, which shall specify the record date for the purposes of such stock dividend, distribution of rights or warrants, or the date on which such reclassification, consolidation, merger, sale, transfer, liquidation, dissolution, or winding up is to take place and the date of participation therein by the holders of the shares of Preference Stock, if any such date is to be fixed, and such notice shall be so given in the case of any action covered by clause (i) or (ii) above at least twenty (20) days prior to the record date for determining holders of the shares of Preference Stock for purposes of such action, and in the case of any such other action, at least twenty (20) days prior to the date of the taking of such proposed action or the date of participation therein by the holders of the shares of Preference Stock whichever shall be the earlier. (b) In case any of the events set forth in Section 11(a)(ii) hereof shall occur, then, in any such case, (i) the Company shall as soon as practicable thereafter give to each holder of a Rights Certificate, to the extent feasible and in accordance with Section 25 hereof, a notice of the occurrence of such event, which shall specify the event and the consequences of the event to holders of Rights under Section 11(a)(ii) hereof, and (ii) all references in the preceding paragraph to Preference Stock shall be deemed thereafter to refer to Common Stock and/or, if appropriate, other securities. Section 25. Notices. Notices or demands authorized by this Agreement to be given or made by the Rights Agent or by the holder of any Rights Certificate to or on the Company shall be sufficiently given or made if sent by first-class mail, postage prepaid, addressed (until another address is filed in writing with the Rights Agent) as follows: Bethlehem Steel Corporation 1170 Eighth Avenue Bethlehem, Pennsylvania 18016-7699 Attention: Corporate Secretary Subject to the provisions of Section 21, any notice or demand authorized by this Agreement to be given or made by the Company or by the holder of any Rights Certificate to or on the Rights Agent shall be sufficiently given or made if sent by first-class mail, postage prepaid, addressed (until another address is filed in writing with the Company) as follows: Morgan Shareholder Services Trust Company 30 West Broadway New York, New York 10007-2192 Attention: Tenders and Exchanges Notices or demands authorized by this Agreement to be given or made by the Company or the Rights Agent to the holder of any Rights Certificate (or, if prior to the Distribution Date, to the holder of certificates representing shares of Common Stock) shall be sufficiently given or made if sent by first-class mail, postage prepaid, addressed to such holder at the address of such holder as shown on the registry books of the Company. Section 26. Supplements and Amendments. Prior to the Distribution Date and subject to the penultimate sentence of this Section 26, the Company and the Rights Agent shall, if the Company so directs, supplement or amend any provision of this Agreement without the approval of any holders of certificates representing shares of Common Stock. From and after the Distribution Date and subject to the penultimate sentence of this Section 26, the Company and the Rights Agent shall, if the Company so directs, supplement or amend this Agreement without the approval of any holders of Rights Certificates in order (i) to cure any ambiguity, (ii) to correct or supplement any provision contained herein which may be defective or inconsistent with any other provisions herein, (iii) to shorten or lengthen any time period hereunder (which lengthening or shortening, following the first occurrence of an event set forth in clauses (i) and (ii) of the first proviso to Section 23(a) hereof, shall be effective only if there are Continuing Directors and shall require the concurrence of a majority of such Continuing Directors), or (iv) to change or supplement the provisions hereunder in any manner which the Company may deem necessary or desirable and which shall not adversely affect the interests of the holders of Rights Certificates; provided, this Agreement may not be supplemented or amended to lengthen, pursuant to clause (iii) of this sentence, (A) a time period relating to when the Rights may be redeemed at such time as the Rights are not then redeemable, or (B) any other time period unless such lengthening is for the purpose of protecting, enhancing or clarifying the rights of, and/or the benefits to, the holders of Rights. Upon the delivery of a certificate from an appropriate officer of the Company which states that the proposed supplement or amendment is in compliance with the terms of this Section 26, the Rights Agent shall execute such supplement or amendment. Notwithstanding anything contained in this Agreement to the contrary, no supplement or amendment shall be made which changes the Redemption Price, the Final Expiration Date, the Purchase Price or the number of one one-hundredth of a share of Preference Stock for which a Right is exercisable. Prior to the Distribution Date, the interests of the holders of Rights shall be deemed coincident with the interests of the holders of Common Stock. Section 27. Successors. All the covenants and provisions of this Agreement by or for the benefit of the Company or the Rights Agent shall bind and inure to the benefit of their respective successors and assigns hereunder. Section 28. Determinations and Actions by the Board of Directors, etc. For all purposes of this Agreement, any calculation of the number of shares of Common Stock outstanding at any particular time, including for purposes of determining the particular percentage of such outstanding shares of Common Stock of which any Person is the Beneficial Owner, shall be made in accordance with the last sentence of Rule 13d-3(d)(1)(i) of the General Rules and Regulations under the Exchange Act. The Board of Directors of the Company (with, where specifically provided for herein, the concurrence of the Continuing Directors) shall have the exclusive power and authority to administer this Agreement and to exercise all rights and powers specifically granted to the Board (with, where specifically provided for herein, the concurrence of the Continuing Directors) or to the Company, or as may be necessary or advisable in the administration of this Agreement, including, without limitation, the right and power to (i) interpret the provisions of this Agreement, and (ii) make all determinations deemed necessary oradvisable for the administration of this Agreement (including a determination to redeem or not Rights or to amend the Agreement). All such actions, calculations, interpretations and determinations (including, for purposes of clause (y) below, all omissions with respect to the foregoing) which are done or made by the Board (with, where specifically provided for herein, the concurrence of the Continuing Directors) in good faith, shall (x) be final, conclusive and binding on the Company, the Rights Agent, the holders of the Rights and all other parties, and (y) not subject the Board or the Continuing Directors to any liability to the holders of the Rights. Section 29. Benefits of this Agreement. Nothing in this Agreement shall be construed to give to any Person other than the Company, the Rights Agent and the registered holders of the Rights Certificates (and, prior to the Distribution Date, registered holders of the Common Stock) any legal or equitable right, remedy or claim under this Agreement; but this Agreement shall be for the sole and exclusive benefit of the Company, the Rights Agent and the registered holders of the Rights Certificates (and, prior to the Distribution Date, registered holders of the Common Stock). Section 30. Severability. If any term, provision, covenant or restriction of this Agreement is held by a court of competent jurisdiction or other authority to be invalid, void or unenforceable, the remainder of the terms, provisions, covenants and restrictions of this Agreement shall remain in full force and effect and shall in no way be affected, impaired or invalidated; provided, however, that notwithstanding anything in this Agreement to the contrary, if any such term, provision, covenant or restriction is held by such court or authority to be invalid, void or unenforceable and the Board of Directors of the Company determines in its good faith judgment that severing the invalid language from this Agreement would adversely affect the purpose or effect of this Agreement, the right of redemption set forth in Section 23 hereof shall be reinstated and shall not expire until the close of business on the tenth day following the date of such determination by the Board of Directors. Section 31. Governing Law. This Agreement, each Right and each Rights Certificate issued hereunder shall be deemed to be a contract made under the laws of the State of Delaware and for all purposes shall be governed by and construed in accordance with the laws of such State applicable to contracts made and to be performed entirely within such State, except for Sections 18, 19, 20 and 21 hereof which for all purposes shall be governed by and construed under the laws of the State of New York. Section 32. Counterparts. This Agreement may be executed in any number of counterparts and each of such counterparts shall for all purposes be deemed to be an original, and all such counterparts shall together constitute but one and the same instrument. Section 33. Descriptive Headings. Descriptive headings of the several Sections of this Agreement are inserted for convenience only and shall not control or affect the meaning or construction of any of the provisions hereof. IN WITNESS WHEREOF, the parties hereto have caused this Agreement to be duly executed as of the day and year first above written. BETHLEHEM STEEL CORPORATION By /s/ Walter F. Williams ---------------------- Walter F. Williams Chairman and Chief Executive Officer MORGAN SHAREHOLDER SERVICES TRUST COMPANY, as Rights Agent By /s/ Sal Russo --------------------- Sal Russo Assistant Vice President Exhibit (10)(f) FORM OF INDEMNIFICATION ASSURANCE AGREEMENT [Bethlehem Steel Corporation] [Name and Address of Director or Officer] Dear : This letter will confirm the agreement and understanding between Bethlehem Steel Corporation (the "Company") and you regarding your service as a [Director/Officer] of the Company. It is and has been the policy of the Company to indemnify its officers and directors against any costs, expenses and other liabilities to which they may become subject by reason of their service to the Company, and to insure its directors and officers against such liabilities, as and to the extent permitted by applicable law and in accordance with the principles of good corporate governance. In this regard, the Company's By-laws (Article IX) require that the Company indemnify and advance costs and expenses to (collectively, "indemnify") its directors and officers as permitted by Delaware law. A copy of the relevant provisions of the Company's By-laws, as amended, is attached hereto. In consideration of your service as a [Director/Officer] of the Company, the Company shall indemnify you, and hereby confirms its agreement to indemnify you, to the full extent provided by applicable law and the By-laws of the Company as currently in effect. In particular, as provided by the By-laws, the Company shall make any necessary determination as to your entitlement to indemnification in respect of any liability within 60 days of receiving a written request from you for indemnification against such liability. You have agreed to provide the Company with such information or documentation as the Company may reasonably request to evidence the liabilities against which indemnification is sought or as may be necessary to permit the Company to submit a claim in respect thereof under any applicable directors and officers liability insurance or other liability insurance policy. You have further agreed to cooperate with the Company in the making of any determination regarding your entitlement to indemnification. If the Company does not make a determination within the required 60-day period, a favorable determination will be deemed to be made, and you shall be entitled to payment, subject only to your written agreement to refund such payment if a contrary determination is later made and the delay was by reason of the inability of the Company to make such determination within the 60-day period. In the event the Company shall determine that you are not entitled to indemnification, the Company shall give you written notice thereof specifying the reason therefor, including any determinations of fact or conclusions of law relied upon in reaching such determination. Notwithstanding any determination made by the Company that you are not entitled to indemnification, you shall be entitled to seek a de novo judicial determination of your right to indemnification under the By-laws and this agreement by commencing an appropriate action therefor within 180 days after the Company shall notify you of its determination. The Company shall not oppose any such action by reason of any prior determination made by it as to your right to indemnification or, except in good faith, raise any objection not specifically relating to the merits of your indemnification claim or not considered by the Company in making its own determination. In any such proceeding, the Company shall bear the burden of proof in showing that your conduct did not meet the applicable standard of conduct required by the By-laws or applicable law for indemnification. It is understood that, as provided in Section 4 of Article IX of the By-laws, any expenses incurred by you in any investigation or proceeding by the Company or before any court commenced for the purpose of making any such determination shall be reimbursed by the Company. No future amendment of the By-laws shall diminish your rights under this agreement, unless you shall have consented to such amendment. Your right to indemnification as aforesaid shall be in addition to any right to remuneration to which you may from time to time be entitled as a [Director/Officer]. It is understood and agreed that your right to indemnification shall not entitle you to continue in your present position with the Company or any future position to which you may be appointed or elected and that you shall be entitled to indemnification under the By-laws only in respect to liabilities arising out of acts or omissions or alleged acts or omissions by you as a [Director/Officer] or as otherwise provided by the By- laws, but you shall be entitled to such indemnification with respect to any such liability, whether incurred or arising during or after your service as a [Director/Officer] and whether before or after the date of this letter, in respect of any claim, cause, action, proceeding or investigation, whether commenced, accruing or arising during or after your service as a [Director/Officer] and whether before or after the date of this letter. In further consideration of your service as a [Director/Officer] of the Company, the Company in connection with its indemnification policy has arranged for the issuance of, and you shall be entitled to the benefits of, an "Irrevocable Straight Standby Letter of Credit" issued by Morgan Guaranty Trust Company of New York. Said letter of credit has been arranged for the purpose of assuring payment to you, certain other current and former directors and officers of the Company and future directors, officers and employees of the Company and its affiliates designated by the Board of Directors of the Company ("Indemnitees") of any amounts to which you and they may become entitled as indemnification pursuant to the By-laws in the event that, for any reason, the Company shall fail promptly to pay to you, upon written request therefor, any such indemnification, said assurance for all Indemnitees being limited at any time to $5,000,000 in aggregate amount. The Company understands that there has been established an irrevocable trust, the Bethlehem Indemnification Trust, for which First Valley Bank, Bethlehem, Pennsylvania, acts as trustee, for the purpose, among other things, of administering the respective interests of the Indemnitees in said letter of credit, and the Company has consented to the issuance and delivery of said letter of credit to the Bethlehem Indemnification Trust. Unless renewed or replaced by a comparable letter of credit in the amount of $5,000,000, the full undrawn amount of said letter of credit may be drawn upon prior to the expiration thereof. Drawings on said letter of credit may be arranged through the Bethlehem Indemnification Trust, as provided by the trust agreement therefor, by contacting the First Valley Bank, One Bethlehem Plaza, Bethlehem, Pennsylvania 18018. You have agreed to repay to the Bethlehem Indemnification Trust any amount paid to you by such trust (i) if it shall ultimately be determined (by the Company and upon expiration of the 180-day period for commencement of a judicial proceeding for a de novo determination or by a final judicial determination) that you are not entitled under this agreement or otherwise to indemnification from Bethlehem in respect of the liability for which you shall have received payment or (ii) if you shall subsequently receive payment in respect of such liability from any liability insurer or from Bethlehem or any successor thereto. It is agreed that, in addition to the rights of any other person to do so, the Company shall have the right to compel any repayment to the Bethlehem Indemnification Trust so required. This agreement shall terminate upon the later of (i) the tenth anniversary of the date on which you shall cease to be a director or officer of the Company or (ii) the final termination or resolution of all actions, suits, proceedings or investigations commenced within such ten-year period and relating to the Company or any of its affiliates or your services thereto to which you may be or become a party and of all claims for indemnification by you under this agreement or against the Bethlehem Indemnification Trust asserted within such ten-year period. This agreement supersedes any and all prior agreements between the Company and you relating to the subject matter hereof. It is understood and agreed that this agreement is binding upon the Company and its successors and shall inure to your benefit and that of your heirs, distributees and legal representatives. This agreement, and the interpretation and enforcement hereof, shall be governed by the laws of the State of Delaware. In confirmation of the provisions of the Company's By-laws, the Company hereby agrees to pay, and you shall be held harmless from and indemnified against, any costs and expenses (including attorneys' fees) which you may reasonably incur in connection with any challenge to the validity of, or the performance and enforcement of, this agreement, in the same manner as provided by the Company's By-laws. If the foregoing is in accordance with your understanding of our agreement, kindly countersign the enclosed copies of this letter, whereupon this letter shall become a binding agreement in accordance with the laws of the State of Delaware. Very truly yours, BETHLEHEM STEEL CORPORATION By:_______________________________ ______________________________ [Signature of Director/Officer] Schedule A 1. Indemnification Assurance Agreement dated August 22, 1986 between Bethlehem Steel Corporation and Curtis H. Barnette. 2. Indemnification Assurance Agreement dated August 22, 1986 between Bethlehem Steel Corporation and Silas S. Cathcart. 3. Indemnification Assurance Agreement dated August 22, 1986 between Bethlehem Steel Corporation and George P. Jenkins. 4. Indemnification Assurance Agreement dated August 22, 1986 between Bethlehem Steel Corporation and Reginald H. Jones. 5. Indemnification Assurance Agreement dated August 22, 1986 between Bethlehem Steel Corporation and Winthrop Knowlton. 6. Indemnification Assurance Agreement dated August 22, 1986 between Bethlehem Steel Corporation and Russell E. Palmer. 7. Indemnification Assurance Agreement dated August 22, 1986 between Bethlehem Steel Corporation and Ellmore C. Patterson. 8. Indemnification Assurance Agreement dated August 22, 1986 between Bethlehem Steel Corporation and Dean P. Phypers. 9. Indemnification Assurance Agreement dated August 22, 1986 between Bethlehem Steel Corporation and William W. Scranton. 10. Indemnification Assurance Agreement dated August 22, 1986 between Bethlehem Steel Corporation and Donald H. Trautlein. 11. Indemnification Assurance Agreement dated August 22, 1986 between Bethlehem Steel Corporation and Lonnie A. Arnett. 12. Indemnification Assurance Agreement dated August 22, 1986 between Bethlehem Steel Corporation and D. Sheldon Arnot. 13. Indemnification Assurance Agreement dated August 22, 1986 between Bethlehem Steel Corporation and Robert W. Cooney. 14. Indemnification Assurance Agreement dated August 22, 1986 between Bethlehem Steel Corporation and Frank S. Dickerson, III. 15. Indemnification Assurance Agreement dated August 22, 1986 between Bethlehem Steel Corporation and George T. Fugere. 16. Indemnification Assurance Agreement dated August 22, 1986 between Bethlehem Steel Corporation and John A. Jordan, Jr. 17. Indemnification Assurance Agreement dated August 22, 1986 between Bethlehem Steel Corporation and James F. Kegg. 18. Indemnification Assurance Agreement dated August 22, 1986 between Bethlehem Steel Corporation and David H. Klinges. 19. Indemnification Assurance Agreement dated August 22, 1986 between Bethlehem Steel Corporation and Edward H. Kottcamp, Jr. 20. Indemnification Assurance Agreement dated August 22, 1986 between Bethlehem Steel Corporation and James H. Leonard. 21. Indemnification Assurance Agreement dated August 22, 1986 between Bethlehem Steel Corporation and Gary L. Millenbruch. 22. Indemnification Assurance Agreement dated August 22, 1986 between Bethlehem Steel Corporation and C. Adams Moore. 23. Indemnification Assurance Agreement dated August 22, 1986 between Bethlehem Steel Corporation and Reynold Nebel. 24. Indemnification Assurance Agreement dated August 22, 1986 between Bethlehem Steel Corporation and James C. Van Vliet. 25. Indemnification Assurance Agreement dated August 22, 1986 between Bethlehem Steel Corporation and Robert C. Wilkins. 26. Indemnification Assurance Agreement dated December 29, 1986 between Bethlehem Steel Corporation and Larry L. Adams. 27. Indemnification Assurance Agreement dated December 29, 1986 between Bethlehem Steel Corporation and Benjamin C. Boylston. 28. Indemnification Assurance Agreement dated January 28, 1987 between Bethlehem Steel Corporation and Herman E. Collier. 29. Indemnification Assurance Agreement dated January 28, 1987 between Bethlehem Steel Corporation and Edwin A. Gee. 30. Indemnification Assurance Agreement dated January 28, 1987 between Bethlehem Steel Corporation and Thomas L. Holton. 31. Indemnification Assurance Agreement dated March 1, 1987 between Bethlehem Steel Corporation and Roger P. Penny. 32. Indemnification Assurance Agreement dated May 27, 1987 between Bethlehem Steel Corporation and Andrew M. Weller. 33. Indemnification Assurance Agreement dated January 27, 1988 between Bethlehem Steel Corporation and John B. Curcio. 34. Indemnification Assurance Agreement dated January 27, 1988 between Bethlehem Steel Corporation and William C. Hittinger. 35. Indemnification Assurance Agreement dated January 27, 1988 between Bethlehem Steel Corporation and William A. Pogue. 36. Indemnification Assurance Agreement dated September 27, 1989 between Bethlehem Steel Corporation and Robert McClements, Jr. 37. Indemnification Assurance Agreement dated September 27, 1989 between Bethlehem Steel Corporation and John L. Kluttz. 38. Indemnification Assurance Agreement dated June 27, 1990 between Bethlehem Steel Corporation and Duane R. Dunham. 39. Indemnification Assurance Agreement dated September 26, 1990 between Bethlehem Steel Corporation and John F. Ruffle. 40. Indemnification Assurance Agreement dated May 1, 1991 between Bethlehem Steel Corporation and Carl F. Meitzner. 41. Indemnification Assurance Agreement dated July 1, 1991 between Bethlehem Steel Corporation and Walter N. Bargeron. 42. Indemnification Assurance Agreement dated March 1, 1992 between Bethlehem Steel Corporation and David P. Post. 43. Indemnification Assurance Agreement dated November 1, 1992 between Bethlehem Steel Corporation and Stephen G. Donches. 44. Indemnification Assurance Agreement dated November 1, 1992 between Bethlehem Steel Corporation and William H. Graham. 45. Indemnification Assurance Agreement dated November 1, 1992 between Bethlehem Steel Corporation and G. Penn Holsenbeck. 46. Indemnification Assurance Agreement dated March 1, 1993 between Bethlehem Steel Corporation and Benjamin R. Civiletti. 47. Indemnification Assurance Agreement dated March 1, 1993 between Bethlehem Steel Corporation and Worley H. Clark. 48. Indemnification Assurance Agreement dated March 1, 1993 between Bethlehem Steel Corporation and Harry P. Kamen. 49. Indemnification Assurance Agreement dated April 28, 1993 between Bethlehem Steel Corporation and Joseph F. Emig. 50. Indemnification Assurance Agreement dated April 28, 1993 between Bethlehem Steel Corporation and Andrew R. Futchko. 51. Indemnification Assurance Agreement dated April 28, 1993 between Bethlehem Steel Corporation and Timothy Lewis. 52. Indemnification Assurance Agreement dated April 28, 1993 between Bethlehem Steel Corporation and William E. Wickert, Jr. 53. Indemnification Assurance Agreement dated March 1, 1994 between Bethlehem Steel Corporation and Augustine E. Moffitt, Jr. 54. Indemnification Assurance Agreement dated March 16, 1994 between Bethlehem Steel Corporation and Lewis B. Kaden. Exhibit (11) Bethlehem Steel Corporation Statement Regarding Computation of Earnings Per Share (dollars in millions and shares in thousands, except per share data) Year Ended December 31 ---------------- Primary Earnings Per Share 1993 1992 1991 - -------------------------- ------ ------ ------ Net Income (Loss) ($266.3) ($550.3) ($812.7) Less Dividend Requirements: $2.50 Preferred Dividend (10.0) (10.0) (10.0) $5.00 Preferred Dividend (12.5) (12.5) (12.5) $3.50 Preferred Dividend (14.8) - - 5% Preference Dividend (2.5) (1.8) (2.2) -------- -------- -------- Total Preferred and Preference Dividend (39.8) (24.3) (24.7) -------- -------- -------- Net Income (Loss) Applicable to Common Stock ($306.1) ($574.6) ($837.4) ======== ======== ======== Average Shares of Common Stock and Equivalents Outstanding: Common Stock 90,940 81,980 76,071 Stock Options * * * ------ ------ ------ Total 90,940 81,980 76,071 ====== ====== ====== Primary Earnings Per Share ($3.37) ($7.01) ($11.01) ======= ======= ======== Fully Diluted Earnings Per Share - -------------------------------- Net Income (Loss) ($266.3) ($550.3) ($812.7) Less Dividend Requirements: $2.50 Preferred Dividend (10.0) (10.0) (10.0) $5.00 Preferred Dividend (12.5) (12.5) (12.5) $3.50 Preferred Dividend (14.8) - - 5% Preference Dividend (2.5) (1.8) (2.2) -------- -------- -------- Net Income (Loss) Applicable to Common Stock ($306.1) ($574.6) ($837.4) ======== ======== ======== Average Shares of Common Stock and Equivalents and Other Potentially Dilutive Securities Outstanding: Common Stock 90,940 81,980 76,071 Stock Options * * * $2.50 Preferred Stock * * * $5.00 Preferred Stock * * * $3.50 Preferred Stock * * * 5% Preference Stock * * * ------- ------- -------- Total 90,940 81,980 76,071 ======= ======= ======== Fully Diluted Earnings Per Share ($3.37) ($7.01) ($11.01) ======= ======= ======== * Antidilutive Exhibit 13 1993 Annual Report to Stockholders of Bethlehem Steel Corporation Chairman's Letter 1993 was a year of change at Bethlehem. We focused on Customers and Quality, as indicated on the cover of this Report, on returning to profitability, and we implemented plans to realign our operations to make Bethlehem more competitive. As the result of further restructuring actions, including a revised modernization program at our Structural Products Division, Bethlehem recorded a $290 million after-tax restructuring charge in its results for 1993. Excluding restructuring charges and the cumulative effect of accounting changes, Bethlehem had net income of $24 million for 1993, a significant improvement over the net loss of $210 million for 1992. We showed steady improvement in 1993, and in the fourth quarter, without the restructuring charge, made $47 million compared to a net loss of $56 million in the fourth quarter of 1992. The progress we made during 1993 toward our goal of returning Bethlehem to sustained profitability was accomplished by reducing our costs and upgrading our product mix and, as the demand for steel strengthened, by increasing shipments and beginning to restore fair value for our products. Since becoming chairman in November of 1992, I have visited all of Bethlehem's business units and most other facilities and have spoken with many of our employees. We are dedicated to the same goal--to make the company successful and profitable for the long term. Change will help bring that about, but change does not come easily. To serve our customers and be responsive to an intensely competitive world steel marketplace, we will make constructive change a way of life. Our principal objective for 1994 and the years ahead is to sustain and improve Bethlehem's profitability. While many changes have taken place, our vision for Bethlehem remains steadfast--to be recognized by our customers as a premier supplier of high-quality steel products, based on our contribution to their success. Our core business will be primarily our flat-rolled operations, but we will also have strong positions in rail and structural products. We will have a decentralized organizational structure, and our business units will achieve their competitive advantage from technological leadership, low costs and a strong market position. They will focus primarily on the North American construction, automotive, service center, machinery, transportation and container markets. Overall, we expect to achieve significant growth in our annual corporate revenues and to strengthen our financial condition. We will have a corporate culture characterized by values associated with being a good corporate citizen--safety, health, environment, code of conduct--and by employees who are dedicated and empowered to help make our business successful. Initiatives Taken During 1993 - - Perhaps the most significant change during 1993 involved our flat-rolled facilities-the Burns Harbor Division and the Sparrows Point Division, which account for about 80 percent of our steel segment sales. They began operating as individual business units, responsible for their own marketing, production and financial performance--committed to achieving closer partnerships with customers and responding faster to their needs. Sparrows Point returned to profitability in 1993 and Burns Harbor improved its operating results, shipped a record 4.8 million tons of steel products, and had the safest year in its history. - - The Burns Harbor and Sparrows Point business units began full-scale operation of their new galvanizing lines, which provide an additional 700,000 tons a year of coated sheet capacity for the growing automotive and light-construction markets. We will add more coated sheet capacity this year when our Double G Coatings joint venture begins production, providing us with approximately half of its 270,000 ton per year capacity. - - We began two major capital programs to further improve Burns Harbor's competitiveness--a new facility to provide coal injection for the blast furnaces and the rebuilding of one of two coke oven batteries. - 2 - - - Pennsylvania Steel Technologies, Inc. (PST) completed its first full year of operation as a wholly owned subsidiary--producing railroad rail, specialty blooms and large-diameter pipe--and progressed with its modernization program. In 1993, PST shipped a record tonnage of railroad rails and specialty blooms. - - We also established our structural products and forging operations as separate business units and took actions to increase the competitiveness of these operations in response to changing market conditions. - - We negotiated new agreements with the United Steelworkers of America at all of our principal business units, which should assure our customers of an uninterrupted supply of steel for the rest of the decade, improve productivity through work-rule flexibility and labor-management partnerships, and increase job security for employees. - - We began operating under a 10-year partnership agreement with Electronic Data Systems, under which EDS provides all our information technology requirements--increasing our access to the latest technology and providing better service to customers at more competitive costs. - - We formed a new Services Division to assure a smooth, cost-effective transition to separate business units by consolidating and reengineering the services provided to business units and corporate operations. - - We completed two major financings, providing proceeds of more than $350 million, which were used for pension funding, for the new coal injection facility at Burns Harbor and for other capital expenditures. Actions to Improve Competitiveness Each of our business units is benchmarking itself against its most efficient competitor and taking actions to be the low-cost producer of high-quality steel in its markets. Our Burns Harbor Division is, we believe, the lowest cost integrated steel producer in North America. It is cost competitive with new minimill sheet facilities, and the quality and sophistication of its products are superior. Burns Harbor has the advantages of an efficient plant layout, world-class production equipment, and access to low-cost, high-quality iron ore. It can ship about five million tons a year of higher-value-added steel products and has the best productivity of any integrated steel plant. Our Sparrows Point Division has undergone extensive modernization over the last decade and virtually all of its production is now continuously cast. With its many excellent facilities and skilled work force, it has achieved significant improvements in its operating costs and quality. In 1993, Sparrows Point became the first steel production facility in the United States to be certified by the International Organization for Standardization under its ISO 9000 program. This is a major step for Sparrows Point since most of our customers, and manufacturers throughout the world, will be specifying products made under ISO quality standards. Other Bethlehem business units are also well on the way to achieving ISO certification. Sparrows Point has several programs under way to further improve its competitiveness by improving productivity through more efficient use of employees, renegotiated supply agreements, improved yields and material flows, and lower energy consumption. Sparrows Point is also increasing the percentage of higher-value-added sheet products in its product mix, principally through its new 260,000 ton per year galvanizing line and recently modernized hot-strip mill. Pennsylvania Steel Technologies is one of only two rail producers in the United States and has a significant share of the rail market. It is operating under a new, separate competitive labor agreement. It continuously casts 100 percent of its production and is proceeding with a steelmaking and rail production modernization program scheduled for completion in 1994. This modernization program and competitive labor agreement will establish Pennsylvania Steel Technologies as the low-cost North American producer of high-quality rails and specialty blooms. PST will also benefit from the higher utilization of its steelmaking facilities when it begins supplying semifinished steel to Bethlehem Structural Products Corporation in 1996. Our Bethlehem Structural Products Corporation has many strengths--a strong market position in the Northeast, an established customer base, high-quality products and customized technical services. Its revised modernization plans focus on increasing its competitiveness in the market for medium and light wide-flange structural sections, which account for about 80 percent of the U.S. wide-flange market. Concurrent with the establishment of separate business units, we are also taking actions to reduce corporate overhead costs by reengineering and slimming down administrative functions. - 3 - At Bethlehem, in addition to focusing on customers and quality, we believe that environmental compliance and providing a safe and healthful workplace are integral parts of being a successful business. We are committed to these objectives, and we have established new initiatives to help achieve them. Products for the Future We are continuing our commitment to developing new, more sophisticated steel products that will meet our customers' needs into the 21st Century. We are strengthening our position as the producer of the widest variety of coated sheet products in the domestic industry with such products as bake-hardenable sheets, zinc-nickel electrogalvanized sheets and galvannealed sheets. Through the Automotive Steel Partnership, made up of major steel producers and automakers, we are evaluating new automotive designs using a new approach that considers an automotive body as a single integrated system rather than an assembly of separate components. By reducing automobile weight and cost while maintaining strength and rigidity, this approach should increase steel's advantage over competitive materials. To allow automakers to optimize the use of sheet steel in vehicles, we recently formed a joint venture to produce tailored welded blanks for automotive stampings. Automakers will be able to stamp a complex part from a single blank made up of steels of various thicknesses, strengths or surface finishes--a definite competitive advantage over other steel producers and materials. Public Policy Issues Our competitiveness is also affected by key public policy issues such as national health care reform and international trade. Bethlehem shares the concern of the President and the Congress about the increasing cost burden to both companies and individuals as the result of rapidly rising and uncontrolled health care costs. We are committed to working constructively to help bring about fair and effective national health care reform. Meanwhile, we continue to seek ways for Bethlehem to provide quality health care at the most economical cost. Our new agreement with the USWA provides for improvements in employee health care management, and in 1993 we opened our first Bethlehem Family Health Care Center. The Center is completely equipped and staffed to provide health care for the many employees, retirees and dependents in the Bethlehem, Pa., area. It is vitally important that we achieve fairness in international steel trade. During 1993, we achieved significant but only partial relief in the countervailing and antidumping cases filed against foreign steel producers. Bethlehem and other American steel producers have filed appeals in those countervailing and antidumping cases in which the International Trade Commission did not grant warranted relief from unfairly traded steel. We are also vigorously defending appeals brought by foreign producers involving decisions favorable to domestic producers. We commend the Administration for the successful conclusion of the GATT and NAFTA negotiations. We believe that--properly implemented and administered--GATT and NAFTA will produce opportunities both for our customers to export manufactured products and for us to export steel products. Outlook The U.S. economy continues along a path of recovery, and we expect to see continued improvement in demand in 1994 from major steel markets, such as automotive, construction and machinery. The trend is also encouraging for increased demand for higher-value-added products, such as the coated sheets being produced on our new galvanizing lines at Burns Harbor and Sparrows Point, and for further restoration of fair value for our products. Overall, domestic steel industry shipments in 1994 are expected to match or exceed 1993's 88 million tons. During January 1994, we had increased operating costs and reduced shipments as a result of severe winter weather conditions and, as expected, are continuing to incur additional costs in connection with capital projects under way at Burns Harbor. Despite these higher costs, we believe that with our ongoing implementation of cost reductions, efficiencies and quality improvements -- and a continuation of economic and steel market recoveries -- Bethlehem will be profitable for the year 1994. /s/ Curtis H. Barnette, Chairman - -------------------------------- Curtis H. Barnette, Chairman January 26, 1994 - 4 - Financial Review and Operating Analysis General Bethlehem reported a net loss of $266 million in 1993 compared to net losses of $550 million in 1992 and $813 million in 1991. The net loss for 1993 includes a $350 million restructuring charge ($290 million after tax) for further restructuring actions to implement its corporate strategy. The restructuring actions include a revised modernization plan for Bethlehem's structural products business and a charge for the remaining book value of the idled coke plant at its Sparrows Point Division. See Note D to the Consolidated Financial Statements. Excluding restructuring charges and the cumulative effect of accounting changes, Bethlehem had net income of $24 million for 1993 compared to net losses of $210 million for 1992 and $178 million for 1991. Results for 1993 also include a one-time tax benefit of $25 million (see Note E to the Consolidated Financial Statements) resulting from new tax legislation and approximately $20 million in unusual costs incurred in connection with the negotiation of new labor contracts during 1993. See "Employees and Employment Costs" on page 18. During 1993, Bethlehem changed the method of valuing its inventories from the last-in, first-out (LIFO) method to the first- in, first-out (FIFO) method. This change had no effect on the 1993 loss per share. Prior years' financial statements have been restated to reflect the change. See Note B to the Consolidated Financial Statements. The net loss for 1992 included a $340 million net charge for the cumulative effect of changes in accounting, a $25 million litigation charge and a $31 million gain at the BethShip Division for recovery of losses reported in prior years on a United States Navy contract. The net loss for 1991 included an after-tax restructuring charge of $635 million. See Note D to the Consolidated Financial Statements. Segment Results Basic Steel Operations. The Basic Steel Operations segment had a loss from operations of $274 million in 1993 compared to losses from operations of $214 million in 1992 and $754 million in 1991. This segment's results for 1993 and 1991 include the previously mentioned restructuring charges. Excluding the effects of these charges, the Basic Steel Operations segment had income from operations of $76 million in 1993 compared to losses from operations of $214 million in 1992 and $119 million in 1991. The improvement in Basic Steel Operations' 1993 operating results compared to 1992, excluding restructuring charges, was principally due to increased shipments of sheet and plate products, reduced operating costs per ton and an improved product mix. Despite higher natural gas prices and approximately $20 million in unusual costs incurred in connection with negotiating new labor contracts, operating costs per ton were substantially lower at the Sparrows Point and Burns Harbor Divisions. Increased shipments at these Divisions, primarily of coated, cold rolled and plate products, and an improved product mix due to the successful start-up and operation of the two new hot-dip galvanizing lines also contributed to improved results. Excluding shipments of discontinued facilities, this segment shipped 9.0 million net tons of steel products in 1993 compared to 8.4 million net tons in 1992 and 7.6 million net tons in 1991. The increase in 1993 shipments was primarily due to increased demand from the automotive, machinery and construction markets. Raw steel production of the Basic Steel Operations segment (excluding discontinued facilities) was 10.3 million net tons in 1993 compared to 10.0 million net tons in 1992 and 9.3 million net tons in 1991. Operating results for 1993 also benefited from higher realized steel prices, principally for hot and cold rolled sheet products. However, Bethlehem's average realized steel prices on a constant mix basis were only one percent higher in 1993 than in 1992. The effects of changes in volume, average realized prices and product mix on total steel mill product revenues during the last two years were as follows: Increase (Decrease) from prior year ------------------ 1993 1992 ----- ----- Volume 7% 10% Realized prices 1 (3) Product mix 3 (2) ----- ----- Total Revenues 11% 5% ===== ===== The Burns Harbor Division operated at record levels during 1993 and shipped 4.8 million tons of steel products compared to 4.4 million tons in 1992 and 4.0 million tons in 1991. Operating results at this Division improved in 1993 over 1992 primarily due to increased shipments of higher-value-added coated sheet, plate and cold rolled products, higher realized steel prices for hot rolled and cold rolled sheet products and reduced operating costs per ton. The successful operation of the new hot-dip galvanizing line, which started up in December 1992, also contributed to Burns Harbor's improved operating performance by increasing the proportion of its shipments of higher margin coated products. - 15 - The Sparrows Point Division had significantly improved operating results and returned to profitability in 1993. The principal factors contributing to its improved results were reduced operating costs, an improved product mix and higher realized prices for hot rolled, cold rolled and coated sheet products. The improved operating performance of its recently modernized hot-strip mill and the successful operation of the new hot-dip galvanizing line that started up in December 1992 contributed significantly to the improved results of this Division. The Sparrows Point Division shipped 2.8 million tons of steel products in 1993 compared to 2.7 million tons in 1992 and 2.2 million tons in 1991. During 1993, Bethlehem Structural Products Corporation's results were adversely affected by a number of market developments. In January 1994, Bethlehem announced a revised modernization plan for Structural Products under which Structural Products will focus on the production and sale of light and medium wide-flange sections, which make up about 80 percent of the wide-flange market in the United States. The revised plan is the result of a number of market developments, including a reduction in the demand for heavy wide- lange sections caused by reduced high-rise building construction activity, continued low occupancy rates in commercial buildings, trends toward lighter construction in buildings and delays in the rebuilding of the nation's infrastructure. Percentage of Bethlehem's Net Sales by Segment and Major Product 1993 1992 1991 ------ ------ ------ Basic Steel Operations Steel mill products: Sheets and tin mill products 63.1% 59.1% 48.4% Plates 13.6 13.3 13.0 Structural shapes and piling 8.5 9.6 8.9 Rail products 3.6 2.8 2.4 Bars, rods and semifinished 1.2 2.6 10.1 Other steel mill products .8 1.2 4.0 Other products and services (including raw materials) 6.8 7.5 7.8 ------ ------ ------ 97.6 96.1 94.6 Steel Related Operations 2.4 3.9 5.4 ------ ------ ------ 100.0% 100.0% 100.0% ====== ====== ====== Percentage of Steel Mill Product Shipments by Principal Market (Based on net tons shipped) 1993 1992 1991 ------ ------ ------ Principal Market Service Centers, Processors and Converters (including semifinished customers) 47.3% 46.3% 40.0% Transportation (including automotive) 22.2 19.9 20.5 Construction 15.5 16.0 15.8 Containers 5.4 4.8 5.3 Machinery 5.1 5.5 6.0 Other 4.5 7.5 12.4 ------ ------ ------ 100.0% 100.0% 100.0% ====== ====== ====== Includes shipments to Bethlehem's manufacturing and fabricating operations. Structural Products will continue to manufacture heavy wide-flange structurals until it phases out its iron and steelmaking operations by 1996, as previously announced. Its 44- inch structural rolling mill complex will be upgraded and modernized and will be sourced with lower cost, continuously cast steel produced primarily at Pennsylvania Steel Technologies' newly modernized state-of-the-art operations in Steelton, Pa. The revised plan is expected to result in competitive costs with substantially lower investment requirements (expected to be in the range of $25 million to $35 million) than the previously announced modernization plan and should permit production of wide-flange sections of up to 27 inches. Other benefits include higher utilization of the 44-inch structural rolling mill, higher utilization of the steelmaking facilities at Pennsylvania Steel Technologies, improved product quality and better utilization of Bethlehem's overall financial and other resources. Pennsylvania Steel Technologies' modernization program is progressing on schedule and is expected to be completed during the second half of 1994. Despite higher scrap costs for its electric furnace, operating results at Pennsylvania Steel Technologies were better in 1993 than in 1992 principally as a result of increased shipments of rail and semifinished products and higher prices for rail products. Under the revised modernization plan for Structural Products, Pennsylvania Steel Technologies expects to begin supplying Structural Products with continuously cast blooms in 1995. Steel Related Operations. This segment reported a loss from operations of $22 million in 1993 compared to income from operations of $11 million in 1992 and a loss from operations of $21 million in 1991. Results for 1992 included a $31 million gain at the BethShip Division for reimbursement of a portion of the losses reported in prior years on a ship construction contract for the United States Navy. During 1993, the BethShip Division completed work on a tunnel fabrication contract for the Boston Harbor tunnel; however, results for 1993 were adversely affected by costs incurred in connection with a two-week strike after which a new labor agreement was reached. The Division has received contracts to renovate five vessels for the United States Ready Reserve fleet in 1994. BethForge, Inc. and the CENTEC joint venture continued to experience losses during 1993 due to weak markets for forgings, castings and cast rolls and to higher operating costs. An ingot teeming facility and vacuum degassing unit are being installed for BethForge's use at Pennsylvania Steel Technologies in order to - 16 - take advantage of the new DC electric arc furnace and ladle refining station being installed as part of Pennsylvania Steel Technologies' modernization program. This new facility, with its lower cost, higher quality ingots, will replace BethForge's existing steelmaking facility during 1995. Liquidity and Financial Resources Cash and cash equivalents were $229 million at December 31, 1993 compared to $208 million at December 31, 1992. Cash provided by operating activities in 1993 was $203 million compared to $135 million in 1992 and $119 million in 1991. Principal uses of cash during 1993 were for capital expenditures, pension funding, debt repayments and an increase in working capital. Receivables were $100 million higher at December 31, 1993 than at December 31, 1992 primarily because of a higher level of shipments at the Burns Harbor and Sparrows Point Divisions. In March 1993, Bethlehem sold 5.1 million shares of Cumulative Convertible Preferred Stock in a private offering, realizing net proceeds of approximately $248 million. Bethlehem contributed $125 million of the proceeds from the offering to its pension fund, with the balance of the proceeds being used for capital expenditures, primarily for modernization. During 1993, Bethlehem contributed a total of $260 million to its pension fund compared to $40 million in 1992 and $130 million in 1991. Despite these contributions, Bethlehem's pension liability increased to $1.6 billion in 1993 from $1.2 billion in 1992 due principally to the decline in long-term interest rates and additional pension benefits agreed to in connection with the new labor agreement with the United Steelworkers of America ("USWA"). The increase in pension liability arising from the decline in long-term interest rates resulted in a reduction in stockholders' equity of $50 million at December 31, 1993. In August 1993, Bethlehem sold $105 million of 10-3/8% Senior Notes due 2003 ("Senior Notes"), realizing net proceeds of approximately $102 million. The proceeds are being used to fund the construction of a coal injection facility at the Burns Harbor Division. See "Capital Expenditures" on page 18. The Senior Notes contain covenants that impose certain limitations on Bethlehem's ability to incur or repay debt, to pay dividends and make other distributions on or redeem capital stock, or to sell, merge, transfer or encumber assets. See Note F to the Consolidated Financial Statements. At December 31, 1993, no amounts were outstanding under Bethlehem's revolving credit agreement and $106 million was used for letters of credit, leaving $294 million available for borrowing under such agreement. At December 31, 1992, $80 million in loans and $104 million in letters of credit were outstanding under Bethlehem's revolving credit agreement. Bethlehem's accounts receivable and inventories are pledged as collateral under the credit agreement. This agreement expires at the end of 1996. During 1993, Bethlehem borrowed the remaining $49 million available under a $270 million loan agreement entered into to fund construction of the two hot-dip galvanizing lines at the Sparrows Point and Burns Harbor Divisions. Borrowings are collateralized by the galvanizing lines. Borrowings bear interest based on the London Interbank Offered Rate with an option to convert to a fixed rate. During 1993, borrowings of $120 million were fixed at 5.99 percent per annum, with the balance fixed at 5.69 percent in January 1994. Repayment of this loan began during the third quarter of 1993 and is being amortized ratably in equal semiannual installments over a seven-year period. Debt and capital lease obligations totaling $154 million were repaid during 1993, including repayments of $80 million outstanding at December 31, 1992 under Bethlehem's revolving credit agreement. Major uses of funds during 1994 include an estimated $450 million of capital expenditures, repayment of approximately $96 million of debt and capital lease obligations and contributions to the pension fund. Bethlehem expects to maintain an adequate level of liquidity throughout 1994 from cash flow from operations, reductions in working capital and available borrowings under its revolving credit agreement. In addition, because Bethlehem has made contributions to its pension fund substantially in excess of current requirements under the Employee Retirement Income Security Act of 1974, it could defer all pension funding for at least two years, although it presently has no plans to do so. Legislation is currently pending in Congress that could potentially increase Bethlehem's future required annual pension contributions and reduce its ability to defer pension funding. The prospects for passage of such legislation are currently uncertain. Common Stock Market and Dividend Information 1993 1992 ------- ------- Prices* Prices* ------- ------- Period High Low High Low ------- ------- ------- ------- First Quarter $20.000 $14.875 $17.250 $12.750 Second Quarter 21.000 16.375 16.625 12.875 Third Quarter 19.125 12.875 15.375 11.500 Fourth Quarter 20.625 13.750 16.625 10.000 The principal market for Bethlehem Common Stock is the New York Stock Exchange. Bethlehem Common Stock is also listed on the Chicago Stock Exchange. The high and low sales prices of the Common Stock as reported in the consolidated transaction reporting system are shown. The trading symbol for Bethlehem Common Stock is BS. Bethlehem has not paid a dividend on its Common Stock since the fourth quarter of 1991. - 17 - Capital Expenditures Capital expenditures were $327 million in 1993 compared to $329 million in 1992 and $564 million in 1991. Capital expenditures for 1994 are currently estimated to increase to approximately $450 million, primarily because of projects under way at the Burns Harbor Division. During 1993, a rebuild was commenced of one of the two coke oven batteries at Burns Harbor, which is expected to be completed in mid-1995. During this period, Burns Harbor's coke needs are being supplied by other Bethlehem coke operations and from commercial sources. Also, expenditures of $55 million were made during 1993 for construction of a new coal injection facility at Burns Harbor that will lower this Division's operating costs through elimination of the consumption of natural gas and reduction in the use of coke in the blast furnaces. Construction of this facility is expected to be completed early in 1995 and is being funded with the net proceeds of approximately $102 million from the sale in August 1993 of Senior Notes and with $30 million in financial assistance from the Department of Energy. One of Burns Harbor's two blast furnaces has also been scheduled to be relined during the third quarter of 1994. Operating costs per ton will increase at Burns Harbor while these projects are under way, due primarily to lower raw steel production and increased costs for purchased coke and semifinished steel. During 1993, progress continued on a $70 million modernization program for Pennsylvania Steel Technologies, Inc., which will enable this business to produce premium head-hardened rails. The program includes the installation of state-of-the-art steelmaking facilities, including a new DC electric arc furnace, a ladle refining furnace and a vacuum degassing unit. The modernization is expected to be completed during the second half of 1994. Approximately $385 million of additional capital expenditures were authorized in 1993. At December 31, 1993, the estimated cost of completing authorized capital expenditures was approximately $676 million compared to $620 million at December 31, 1992. Such authorized capital expenditures are expected to be completed during the 1994-1995 period. New Joint Ventures Bethlehem is participating in a joint venture, known as Double G Coatings Company, L.P., which is building a 270,000 ton per year sheet coating line near Jackson, Miss. The new line, which is scheduled to start up in the second quarter of 1994, will produce galvanized and Galvalume coated sheets primarily for the construction market. Sparrows Point will provide cold rolled coils for approximately half of Double G's annual capacity and will be responsible for marketing its share of the finished product. In order to better serve the needs of the Burns Harbor Division's automotive customers, Bethlehem has announced that it intends to form a joint venture with a steel service center to produce tailored welded steel blanks for automotive stampings through use of a technologically advanced welding process. Employees and Employment Costs On August 1, 1993, Bethlehem and the USWA entered into a new six- year labor agreement for the Burns Harbor and Sparrows Point Divisions. The agreement provides for a reopening after three years, subject to binding arbitration, of wage and certain benefit provisions (excluding pensions). Under the new agreement, represented employees will receive improved pension benefits, bonuses to be paid over the term of the agreement, a $.50 per hour wage increase in August 1995 and profit sharing. A new profit- sharing plan has been established, effective January 1, 1994, equal to eight percent of annual corporate income before taxes, unusual items and expenses applicable to the plan and two percent of adjusted profits at each covered operation. The new agreement also provides for opportunities to reduce health care costs and for flexible work practices and opportunities to reduce manning levels through attrition in exchange for improved employment security. Under the terms of this agreement, on March 1, 1994 and March 1, 1995, each eligible USWA-represented employee will receive a bonus of either $500 or 25 shares of Bethlehem Common Stock, at the election of the employee. If all eligible employees were to elect to receive payment of the March 1, 1994 bonus in shares of stock, approximately 180,000 shares of Common Stock would be issued. During 1993, Bethlehem and the USWA also reached agreement on new, six-year labor agreements for its wholly owned subsidiaries, Bethlehem Structural Products Corporation and BethForge, Inc., and for the CENTEC joint venture. The agreements provide for more flexible work rules and lower overall costs by combining jobs and lessening work-rule restrictions. The agreements at Structural Products and BethForge, however, included a "snap back" arrangement providing that in the event Bethlehem did not install a continuous caster at Structural Products, USWA-represented employees at those business units would then be covered by the 1993 labor agreement negotiated for the Burns Harbor and Sparrows Point Divisions. The revised modernization plan announced for Structural Products does not provide for installation of a continuous caster at Structural Products, and discussions are being held with the USWA concerning the implementation and possible modification of the "snap back" arrangement. Bethlehem does not expect any material increase in its overall labor costs as a result of these developments. The announcement of a revised modernization program for Structural Products will not affect the labor agreement for the CENTEC joint venture. A new, three-year labor agreement was also reached during 1993 with union employees at BethShip Division's Sparrows Point ship repair yard, and a six-year agreement was reached with USWA- represented employees at the Hibbing iron ore joint venture. In 1992, a new and more competitive labor agreement was negotiated with the USWA covering the employees at Pennsylvania Steel Technologies. This agreement expires in 1999 with the other USWA agreements. Under the terms of the profit-sharing plan provided for in the 1989 labor agreement with the USWA, no material profit-sharing payments were required for the 1992 and 1993 plan years. Under other provisions of the 1989 labor agreement, Bethlehem issued approximately 211,380 shares of Series B Preference Stock in 1993 to the trustee for the benefit of employees for 1992. Bethlehem expects to issue approximately 133,500 shares of Series B Preference Stock in 1994 to the trustee for the benefit of employees for 1993. - 18 - In January 1994, a new five-year agreement was reached with the United Mine Workers of America covering approximately 600 employees at three coal operations of Bethlehem subsidiaries. At the end of 1993, Bethlehem had approximately 20,600 employees compared to 22,600 employees at the end of 1992 and 26,400 employees at the end of 1991. Bethlehem expects to continue to reduce the number of its employees. Approximately two- thirds of Bethlehem's employees are covered by its labor agreements with the USWA. For additional information concerning Bethlehem's employment costs, see the table below. Employment Cost Summary -- All Employees (Dollars in millions) 1993 1992 1991 --------- -------- -------- Salaries and Wages $ 950.9 $1,058.0 $1,105.7 Employee Benefits (including retirees): Pension Plans: Actives 86.8 88.9 89.1 Retirees 97.7 101.4 97.5 Medical and Insurance: Actives 122.1 129.2 119.4 Retirees 129.7 125.6 119.9 Payroll Taxes 89.1 88.7 103.5 Workers' Compensation 43.8 48.6 48.6 Supplemental Unemployment, Savings Plan and Other 27.0 23.4 30.3 Union Employee Investment and Profit-Sharing Plans - .2 6.8 -------- -------- -------- Total Benefit Costs 596.2 606.0 615.1 -------- -------- -------- Total Employment Costs $1,547.1 $1,664.0 $1,720.8 ======== ======== ======== Employment Costs as a Percent of Net Sales 35.8% 41.5% 39.9% ======== ======== ======== Environmental Matters Bethlehem is subject to stringent federal, state and local environmental laws and regulations concerning, among other things, air emissions, waste water discharges, and solid and hazardous waste disposal. During the five years ended December 31, 1993, Bethlehem spent approximately $257 million for environmental control equipment. Expenditures for new environmental control equipment totaled approximately $35 million in 1993, $18 million in 1992 and $102 million in 1991. The costs incurred in 1993 to operate and maintain existing environmental control equipment were approximately $125 million (excluding interest costs but including depreciation charges of $28 million) compared to $130 million in 1992 and $145 million in 1991. Under the Clean Air Act, as amended, coke-making facilities will have to meet progressively more stringent standards over the next 30 years. Bethlehem idled coke production at the Sparrows Point Division in 1991 and continues to assess the most cost-effective method of supplying coke and completing an emissions reduction program to meet environmental regulations. Based on a continuing review of the current and projected coke market, however, Bethlehem recently concluded that it could not expect to recover both the remaining book value and, if determined to be appropriate, any future investment necessary to rebuild and operate the idled coke plant. Accordingly, Bethlehem recorded a charge in its 1993 financial statements for the remaining book value of the idled coke plant at Sparrows Point. See Note D to the Consolidated Financial Statements. Bethlehem continues to operate coke-making facilities at the Burns Harbor Division, at Structural Products and at Lackawanna, N.Y. While Bethlehem continues to evaluate the impact applicable emission control regulations have on these operations, it believes that these operations will be able to comply. Negotiations between Bethlehem and federal and state regulatory agencies are being conducted to resolve differences in interpretation of certain environmental control requirements. In some instances, those negotiations are being held in connection with the resolution of pending environmental proceedings. Bethlehem believes that there will not be any significant curtailment or interruptions of any of its important operations as a result of these proceedings and negotiations. Existing environmental laws may be amended and new laws may be enacted by Congress and state legislatures and new environmental regulations may be issued by regulatory agencies. For these reasons, Bethlehem cannot predict the specific environmental control requirements that it will face in the future. Based on existing and anticipated regulations promulgated under presently enacted legislation, Bethlehem currently estimates that capital spending for installation of new environmental control equipment will range from $35 million to $50 million in each of the next two years. However, estimates of the future capital expenditures and operating costs required for environmental compliance are imprecise due to numerous uncertainties, including the evolving nature of the regulations, the possible imposition of more stringent requirements, the availability of new technologies and the timing of expenditures. Although it is possible that Bethlehem's future results of operations in particular quarterly or annual periods could be materially affected by the future costs of environmental compliance, Bethlehem does not believe the future costs of environmental compliance will have a material adverse effect on its consolidated financial position or on its competitive position with respect to other integrated domestic steelmakers that are subject to the same environmental requirements. Consolidated Statements of Income Year Ended December 31 ----------------------- (Dollars in millions, except per share data) 1993 1992 1991 ----- ----- ----- Net Sales $4,323.4 $4,007.9 $4,317.9 -------- -------- -------- Costs and Expenses: Cost of sales 3,834.2 3,789.9 4,045.4 Depreciation (Note A) 277.5 261.7 241.4 Selling, administration and general expense 156.9 159.3 171.0 Estimated restructuring losses (Note D) 350.0 - 635.0 -------- -------- -------- Total Costs and Expenses 4,618.6 4,210.9 5,092.8 -------- -------- -------- Loss from Operations (295.2) (203.0) (774.9) Financing Income (Expense): Interest and other income 7.1 4.9 9.7 Interest and other financing costs (63.2) (57.2) (45.5) ---------- -------- -------- Loss Before Income Taxes and Cumulative Effect of Changes in Accounting (351.3) (255.3) (810.7) Benefit (Provision) for Income Taxes (Note E) 85.0 45.0 (2.0) ---------- -------- ------- Loss Before Cumulative Effect of Changes in Accounting [($3.37), ($2.86) and ($11.01) per share] (266.3) (210.3) (812.7) Cumulative Effect of Changes in Accounting [($4.15) per share] (Note B) - (340.0) - ---------- -------- -------- Net Loss (266.3) (550.3) (812.7) Dividends on Preferred and Preference Stock 39.8 24.3 24.7 Net Loss Applicable to Common Stock [($3.37),($7.01) and ($11.01) per --------- ---------- -------- share] $ (306.1) $ (574.6) $(837.4) ========= ========== ======== The accompanying Notes are an integral part of the Consolidated Financial Statements. Consolidated Balance Sheets December 31 -------------------- (Dollars in millions, except per share data) 1993 1992 -------- -------- Assets Current Assets: Cash and cash equivalents (Note A) $ 228.9 $ 208.2 Receivables, less allowances of $16.3 and $15.7 (Note F) 503.2 403.3 Inventories (Notes A, B and F) Raw materials and supplies 341.9 373.7 Finished and semifinished products 494.8 455.0 Contract work in progress less billings of $10.3 and $5.3 15.8 23.8 ------- ------- Total Inventories 852.5 852.5 Other Current assets 6.5 5.5 ------- ------- Total Current Assets 1,591.1 1,469.5 Property, Plant and Equipment, less accumulated depreciation of $4,107.0 and 4,255.1 (Note A) 2,634.3 2,804.5 Investments and Miscellaneous Assets (Note A) 124.0 150.2 Deferred Income Tax Asset-net (Note E) 926.7 829.2 Intangible Asset-Pensions (Note I) 600.6 239.6 -------- -------- Total Assets $5,876.7 $5,493.0 ======== ======== Liabilities and Stockholders' Equity Current Liabilities: Accounts payable $ 360.9 $ 375.7 Accrued employment costs 130.1 132.8 Postretirement benefits other than pensions (Note J) 132.3 122.0 Accrued taxes (Note E) 65.4 67.5 Debt and capital lease obligations (Notes F and G) 95.5 69.2 Other current liabilities 130.0 126.0 -------- -------- Total Current Liabilities 914.2 893.2 Pension Liability (Notes D and I) 1,613.6 1,188.7 Postretirement Benefits Other Than Pensions (Notes D and J) 1,448.3 1,417.9 Long-term Debt and Capital Lease Obligations (Notes F and G) 718.3 726.8 Other Long-term Liabilities 485.7 477.0 Stockholders' Equity (Notes K, L and M): Preferred Stock-at $1 per share par value (aggregate liquidation preference of $481.2); Authorized 20,000,000 shares 11.6 6.5 Preference Stock-at $1 per share par value (aggregate liquidation preference of $95.1); Authorized 20,000,000 shares 2.8 2.9 Common Stock-at $1 per share par value; Authorized 150,000,000 shares; Issued 93,412,852 and 92,511,105 shares 93.4 92.5 Held in Treasury, 2,003,760 and 2,001,677 shares at cost (59.7) (59.7) Additional Paid-in Capital 1,588.4 1,420.8 Retained Deficit (Note B) (939.9) (673.6) --------- --------- Total Stockholders' Equity 696.6 789.4 --------- --------- Total Liabilities and Stockholders' Equity $5,876.7 $5,493.0 ========= ========= The accompanying Notes are an integral part of the Consolidated Financial Statements. Consolidated Statements of Cash Flows Year Ended December 31 ---------------------- (Dollars in millions) 1993 1992 1991 ---- ---- ---- Operating Activities: Net loss $(266.3) $(550.3) $(812.7) -------- -------- -------- Adjustments for items not affecting cash from operating activities: Estimated restructuring losses (Note D) 350.0 - 635.0 Cumulative effect of changes in accounting (Note B) - 340.0 - Depreciation 277.5 261.7 241.4 Deferred income taxes (87.0) (45.0) - Other-net 19.6 26.5 11.4 Working capital: Receivables (99.9) 5.2 33.2 Inventories - 172.8 (41.6) Accounts payable - (59.2) 18.4 Employment costs and other (5.6) (17.6) 13.0 Other-net 14.9 1.0 20.6 ------ ------ ------- Cash Provided from Operating Activities 203.2 135.1 118.7 ------- ------- ------- Investing Activities: Capital expenditures (327.1) (328.7) (563.9) Cash proceeds from sales of businesses and assets 15.2 124.9 83.7 Other-net 5.6 7.2 0.4 ------- ------- ------- Cash Used for Investing Activities (306.3) (196.6) (479.8) ------- ------- ------- Financing Activities: Pension financing (funding) (Note I): Pension expense 183.6 188.7 184.6 Pension funding (261.1) (40.2) (130.7) Revolving and other credit borrowings (payments)-net (80.0) (74.0) 144.0 Long-term debt borrowings (Note F) 171.2 104.0 125.8 Long-term debt and capital lease payments (Notes F and G) (73.8) (105.3) (68.6) Restructured facilities payments (28.4) (36.1) (30.8) Cash dividends paid (Note M) (36.1) (22.5) (52.9) Preferred Stock issued (Note M) 248.4 - - Common Stock issued (Note M) - 171.3 - ------- ------- -------- Cash Provided from Financing Activities 123.8 185.9 171.4 ------- ------- ------- Net Increase (Decrease) in Cash and Cash Equivalents 20.7 124.4 (189.7) Cash and Cash Equivalents -Beginning of Period 208.2 83.8 273.5 ------- ------- ------- -End of Period $ 228.9 $ 208.2 $ 83.8 ======= ======= ======= Supplemental Cash Payment Information: Interest, net of amount capitalized $ 55.7 $ 57.1 $ 44.4 Income taxes (Note E) $ 3.7 $ 1.3 $ 1.9 Excludes Financing Activities and Investing Activities. The accompanying Notes are an integral part of the Consolidated Financial Statements. Notes to Consolidated Financial Statements A. Accounting Policies Principles of Consolidation - The consolidated financial statements include the accounts of Bethlehem Steel Corporation and all majority-owned subsidiaries and joint ventures. Cash and Cash Equivalents - Cash equivalents consist primarily of overnight investments, certificates of deposit and other short-term, highly liquid instruments generally with original maturities at the time of acquisition of three months or less. Cash equivalents are stated at cost plus accrued interest, which approximates market. Inventories - Inventories are valued at the lower of cost (principally FIFO) or market. See Note B. Contract work in progress is valued at cost less billings. Estimated losses are recognized when first apparent and partial profits are based on percentage of completion. Investments - Investments in associated enterprises accounted for by the equity method were $59.3 million and $63.0 million at December 31, 1993 and 1992. Associated enterprises are primarily 50% or less interests in coating and mining operations. Property, Plant and Equipment - Property, plant and equipment is stated at cost. Maintenance, repairs and renewals which neither materially add to the value of the property nor appreciably prolong its life are charged to expense. Gains or losses on dispositions of property, plant and equipment are recognized in income. Interest is capitalized on significant construction projects and totaled $8.8, $17.3 and $26.8 million in 1993, 1992 and 1991. Our property, plant and equipment by major classification is: December 31 --------------- (Dollars in millions) 1993 1992 ---- ---- Land (net of depletion) $ 50.9 $ 53.3 Buildings 670.1 694.2 Machinery and equipment: Steel manufacturing 4,960.2 5,381.8 Other 739.5 754.1 --------- --------- 6,420.7 6,883.4 Accumulated depreciation (4,107.0) (4,255.1) --------- --------- 2,313.7 2,628.3 Construction-in-progress 320.6 176.2 -------- -------- Total $ 2,634.3 $ 2,804.5 ========= ========= Depreciation - Depreciation, which includes amortization of assets under capital leases, is based upon the estimated useful lives of each asset group. The estimated useful life is 18 years for most steel producing assets. Steel assets, other than blast furnace linings, and most raw material producing assets are depreciated on a straight-line basis adjusted by an activity factor. This factor is based on the ratio of production and shipments for the current year to the average production and shipments for the current and preceding four years at each operating location. Annual depreciation after adjustment for this activity factor is not less than 75% nor more than 125% of straight-line depreciation. Depreciation after adjustment for this activity factor was $4.3 million more than straight-line in 1993 and $6.1 and $21.9 million less than straight-line in 1992 and 1991. Through December 31, 1993, $37.4 million less accumulated depreciation has been recorded under this method than would have been recorded under straight-line depreciation. The cost of blast furnace linings is depreciated on a unit-of-production basis. All other assets are depreciated on a straight-line basis. B. Accounting Changes During 1993, we changed the method of valuing inventories from the last-in, first-out (LIFO) method to the first-in, first-out (FIFO) method. We believe the FIFO method of inventory valuation provides a more meaningful presentation of the financial position of the Corporation since it reflects more recent cost in the balance sheet. Also, in the current environment of low inflation, higher productivity and lower production costs, the use of LIFO has not had a significant effect on operating results. FIFO will eliminate the distortions in reported financial results caused by liquidations of inventories which flow through cost of sales at lower costs prevailing many years ago. It will also improve the reporting of interim results by eliminating the requirement to estimate whether liquidations that occur in interim periods will be replaced by year end, which tends to cause liquidations and other LIFO adjustments to be recognized in the fourth quarter. This change in the method of valuing inventories had no effect on our loss per share for the year 1993. Prior years' financial statements have been restated to reflect this change. The restatement increased the 1992 loss before the cumulative effect of changes in accounting by about $10 million or $.12 per share and the 1992 cumulative effect of changes in accounting by $90 million or $1.10 per share; increased the 1991 net loss by $45 million or $.59 per share, which includes increasing the estimated loss on restructuring by $60 million; and increased retained earnings as of January 1, 1991 by about $560 million. During 1992, we adopted two new Financial Accounting Standards Board Statements, No. 106, Accounting for Postretirement Benefits Other Than Pensions, and No. 109, Accounting for Income Taxes. The cumulative effect of these changes in accounting recorded as of January 1, 1992 was a $340 million net charge to income. Prior years' financial statements were not restated for these changes. Statement No. 106 requires postretirement benefits other than pensions, principally health care and life insurance, to be accrued as an expense over the period active employees become eligible for the benefits. Previously, such retiree benefits were generally expensed as claims were incurred. The cumulative effect of adopting Statement No. 106 was a $745 million charge, net of a $380 million deferred income tax benefit. Statement No. 109 requires financial statements to reflect deferred taxes for the future tax consequences of events recognized in different years for financial reporting and tax reporting purposes. The cumulative effect of adopting Statement No. 109 was a $405 million credit for the net deferred income tax asset. C. Industry Segment Information (Dollars in millions) 1993 1992 1991 ---- ---- ---- Sales: Trade: Basic Steel Operations $4,217.5 $3,849.7 $4,085.7 Steel Related Operations 105.9 158.2 232.2 Intersegment: Basic Steel Operations 1.7 8.1 21.0 Steel Related Operations 13.7 21.6 18.7 Eliminations (15.4) (29.7) (39.7) --------- --------- --------- Total $4,323.4 $4,007.9 $4,317.9 ========= ========= ========= Estimated Restructuring Losses: Basic Steel Operations $ 350.0 $ - $ 635.0 ========= ========= ========= Income (Loss) from Operations: Basic Steel Operations $ (273.6) $ (214.3) $ (753.6) Steel Related Operations (21.6) 11.3 (21.3) --------- --------- --------- Total $ (295.2) $ (203.0) $ (774.9) ========= ========= ========= Shipments (tons in thousands): Basic Steel Operations 8,997 8,431 8,303 ========= ========= ========= Identifiable Assets: Basic Steel Operations $3,930.6 $3,896.3 $4,253.6 Steel Related Operations 119.9 139.0 139.5 Corporate 1,826.2 1,457.7 315.2 --------- --------- --------- Total $5,876.7 $5,493.0 $4,708.3 ========= ========= ========= Depreciation: Basic Steel Operations $ 271.9 $ 256.0 $ 235.1 Steel Related Operations 5.6 5.7 6.3 --------- --------- --------- Total $ 277.5 $ 261.7 $ 241.4 ========= ========= ========= Capital Expenditures: Basic Steel Operations $ 323.8 $ 325.8 $ 554.3 Steel Related Operations 3.3 2.9 9.6 --------- --------- --------- Total $ 327.1 $ 328.7 $ 563.9 ========= ========= ========= A general description of our segments and their products and services is contained under the heading "Bethlehem's Segments" on page 14 of this Report. Intersegment sales are generally at market prices. Corporate assets consist primarily of cash and cash equivalents, investments, deferred income tax asset and an intangible asset-pensions. D. Estimated Restructuring Losses On January 26, 1994, we announced a revised modernization plan for our Bethlehem Structural Products subsidiary which will result in a substantial reduction in the work force and an elimination of certain products currently produced. Also, based on our continuing review of the current and projected coke market, we have concluded that we cannot expect to recover both the remaining book value and required future investment if we rebuild and operate the idled coke plant at our Sparrows Point Division. Principally as a result of these actions, we recorded a restructuring loss in 1993 of $350 million ($290 million after tax or $3.19 per share). This loss includes certain employee benefit costs for pensions of about $75 million and postretirement benefits other than pensions cost of about $20 million for the reduction of employees related to these decisions. On January 29, 1992, we announced our plans to exit the business of our Bar, Rod and Wire Division and to reduce forces throughout the Corporation during 1992. We also announced that it was not feasible to make the necessary repairs to meet the ever more stringent environmental requirements at our Sparrows Point Division coke plant and, therefore, the coke plant had been idled and a significant portion of its book value had been written off. Principally as a result of these actions, we recorded a restructuring loss of $635 million ($8.35 per share with no tax effect). This loss includes certain employee benefit costs for pensions of about $190 million and postretirement benefits other than pensions of about $140 million for the reduction of employees related to the decisions. E. Taxes Our benefit (provision) for income taxes consisted of: (Dollars in millions) 1993 1992 1991 ---- ---- ---- Federal-current $ - $ - $ - State and foreign-current (2.0) - (2.0) ------ ------ ------ Total current (2.0) - (2.0) Federal-deferred 87.0 45.0 - ------ ------ ------ Total benefit (provision) $85.0 $45.0 $(2.0) ====== ====== ====== The benefit (provision) for income taxes differs from the amount computed by applying the federal statutory rate to pre-tax income (loss). The computed amounts and the items comprising the total differences follow: (Dollars in millions) 1993 1992 1991 --------- --------- --------- Pre-tax income (loss): United States $ (353.3) $ (260.4) $ (818.7) Foreign 2.0 5.1 8.0 --------- --------- --------- Total $ (351.3) $ (255.3) $ (810.7) ========= ========= ========= Computed benefit $ 123.0 $ 86.8 $ 275.6 Effect of change in rate on prior years (a) 50.0 - - Percentage depletion 5.6 6.8 - Dividend received deduction 2.4 2.7 - Valuation allowance (87.0) (50.4) - Loss in excess of allowable carrybacks - - (275.6) State and foreign taxes (2.0) - (2.0) Other differences-net (7.0) (.9) - ---------- --------- --------- Total benefit (provision) $ 85.0 $ 45.0 $ (2.0) ========== ========= ========= (a) The 1993 Omnibus Budget Reconciliation Act increased the federal corporate income tax rate to 35% from 34%. This increase in the tax rate resulted in an increase in our deferred income tax asset of $25 million, net of a valuation allowance, which we recorded in 1993. The components of our net deferred income tax asset are as follows: December 31 ----------- (Dollars in millions) 1993 1992 ---- ---- Temporary differences: Employee benefits $ 980 $ 950 Depreciable assets (240) (310) Other 44 (12) ------ -------- Total 784 628 Operating loss carryforward 550 510 ------ -------- Deferred income tax asset 1,334 1,138 Valuation allowance (407) (309) ------- -------- Deferred income tax asset-net $ 927 $ 829 ======= ======== Temporary differences represent the cumulative taxable or deductible amounts recorded in our financial statements in different years than recognized in our tax returns. Our employee benefits temporary difference includes amounts expensed in our financial statements for pensions, health care, life insurance and other postretirement benefits which become deductible in our tax return upon payment or funding in qualified trusts. The depreciable assets temporary difference represents generally tax depreciation in excess of financial statement depreciation. Other temporary differences represent principally various expenses accrued for financial reporting purposes which are not deductible for tax reporting purposes until paid. At December 31, 1993, we had regular tax net operating loss carryforwards of $1.6 billion and alternative minimum tax loss carryforwards of $800 million. Regular federal tax net operating loss carryforwards of $420 million expire in 1998 with the balance expiring in varying amounts from 1999 through 2008. Statement No. 109 requires that we record a valuation allowance when it is "more likely than not that some portion or all of the deferred tax assets will not be realized." It further states, "forming a conclusion that a valuation allowance is not needed is difficult when there is negative evidence such as cumulative losses in recent years." The ultimate realization of this deferred tax asset depends on our ability to generate sufficient taxable income in the future. Bethlehem reported income before income taxes, restructuring charges and extraordinary gains in 1987 through 1990 and incurred higher costs in 1991 and 1992 relating to unusual repair costs at a coke plant that has subsequently been temporarily idled and start-up costs of certain modernized facilities. Bethlehem has undergone substantial restructuring and made substantial strategic capital expenditures during the last several years. As a result, Bethlehem has a significantly lower and more competitive cost structure and our operating results before income taxes improved by about $250 million in 1993 over 1992 excluding the 1993 restructuring charge. Also, we have significant tax planning opportunities to manage taxable income including selection of depreciation methods and timing of contributions to our pension trust. While we believe that our total deferred tax asset will be fully realized by future operating results together with tax planning opportunities, our losses in recent years make it appropriate to record a valuation allowance. Accordingly, we have provided a valuation allowance at December 31, 1993 and 1992 equal to 50% of the total deferred tax asset related to our operating loss carryforward and our temporary differences exclusive of postretirement benefits other than pensions. We expect our annual financial statement expense for postretirement benefits other than pensions to exceed the annual amount deductible in our tax returns for several years. Furthermore, if we have a tax loss in any year in which our tax deduction exceeds our financial statement expense, the tax law currently provides for a 15-year carryforward of that loss against future taxable income. Under current law, we have a very long time to realize these future tax benefits. We believe, therefore, a valuation allowance is not necessary for the deferred tax asset related to our temporary difference for postretirement benefits other than pensions. If we are unable to generate sufficient taxable income in the future through operating results or tax planning opportunities, we will be required to increase our valuation allowance through a charge to expense (reducing our stockholders' equity). On the other hand, if we achieve sufficient profitability to use all of our deferred income tax asset, we will reduce the valuation allowance through a decrease to expense (increasing our stockholders' equity). In addition to income taxes, we incurred costs for certain other taxes as follows: (Dollars in millions) 1993 1992 1991 ---- ---- ---- Employment taxes $ 89.1 $ 88.7 $ 103.5 Property taxes 27.5 26.7 27.4 State and foreign taxes 9.0 11.2 16.8 Federal excise tax on coal 3.3 5.3 7.1 ------- ------- ------- Total other taxes $ 128.9 $ 131.9 $ 154.8 ======= ======= ======= F. Long-term Debt December 31 ----------- (Dollars in millions) 1993 1992 ---- ---- Hot-dip galvanizing lines financing $262.0 $220.5 Revolving and other credit agreements - 80.0 Debentures: 6-7/8% Due 1999 18.8 18.8 9% Due 2000 39.9 41.3 8-3/8% Due 2001 41.6 41.6 8.45% Due 2005 90.7 90.7 Pollution control and industrial revenue bonds: 5-1/4%-8%, Due 1994-2002 78.1 90.7 Variable interest at 50%-70% of prime rate, Due 1994-1996 27.0 35.0 Notes and loans: 10-3/8% Senior Notes, Due 2003 105.0 - 9-5/8-12.75%, Due 1994-1997 34.8 35.0 Unamortized debt discount (2.0) (2.1) Amounts due within one year (57.4) (33.2) ------- ------- Total long-term debt $638.5 $618.3 ======= ======= Maturities and sinking fund requirements at December 31, 1993 for the next five years were $57.4 million in 1994, $61.8 million in 1995, $88.9 million in 1996, $71.9 million in 1997 and $75.6 million in 1998. During 1993, we sold $105 million of Senior Notes to finance the construction of a coal injection facility at our Burns Harbor Division. The Notes are unsecured senior obligations and are senior in right of payment to all existing and future subordinated indebtedness of Bethlehem. As unsecured senior obligations of Bethlehem, the Notes will effectively be subordinate to secured senior indebtedness of Bethlehem. These Notes contain covenants which impose certain limitations on Bethlehem's ability to incur or repay debt, to pay dividends and make other distributions on or redeem capital stock, or to sell, merge, transfer or encumber assets. See Note M, Stockholders' Equity. A major portion of the costs to construct hot-dip galvanizing lines at our Sparrows Point and Burns Harbor Divisions are financed through a $270 million loan agreement. Borrowings are collateralized by the coating lines and originally incurred interest based on the London Interbank Offered Rate (LIBOR). At December 31, 1993, $112 million of this debt incurs a fixed rate of 5.99% with the balance converted to a fixed rate of 5.69% in January 1994. This loan will be repaid in equal semiannual installments over a seven-year period. Repayment on $120 million of the loan began in 1993 with repayment on the balance beginning in 1994. Our revolving credit agreement expires on December 31, 1996, and is nonreducing with initial bank commitments of $400 million. The agreement permits additional banks to be added and the total commitment amount to be increased to $500 million. Borrowings under the revolver are subject to collateral coverage requirements and incur interest based on the prime rate, Federal Funds rate, certificate of deposit rates or LIBOR. Our accounts receivable and inventories are pledged as collateral for borrowings and letters of credit under the credit agreement and certain other obligations to participating banks. No borrowings were outstanding at December 31, 1993. We pay five eighths of 1% per annum commitment fee on the unused available credit. Our revolving credit and hot-dip galvanizing lines financing agreements contain restrictive covenants which require Bethlehem to maintain a minimum adjusted tangible net worth. At December 31, 1993, our adjusted tangible net worth exceeded the more restrictive of these requirements by about $1 billion. At December 31, 1993, interest rate swap agreements with notional amounts totaling $225 million effectively fix the interest rate on a like amount of our floating rate debt at 7.99% to 11.95%. These agreements expire from 1995 through 2001. Net payments or receipts under these agreements are included in interest expense. We estimate the aggregate fair value of our debt and related obligations exceeds the total debt recorded at December 31, 1993 by approximately $30 million and approximately equals the total debt recorded at December 31, 1992. We based our estimates on quoted market prices or current rates offered for debt with similar terms and maturities. G. Leases We lease certain manufacturing facilities and equipment under capital leases, the most significant of which covers the two continuous casters at our Sparrows Point and Burns Harbor plants. The lease requires quarterly rental payments of $9 million plus interest at 1-1/4% above LIBOR. The amounts included in property, plant and equipment for capital leases were $319.5 million (net of $222.1 million accumulated amortization) and $337.9 million (net of $184.4 million accumulated amortization) at December 31, 1993 and 1992. Future minimum payments under noncancellable operating leases at December 31, 1993 were $18.1 million in 1994, $15.9 million in 1995, $14.9 million in 1996, $7.7 million in 1997, $5.9 million in 1998 and $32.6 million thereafter. Total rental expense under operating leases was $40.5, $49.8 and $46.6 million in 1993, 1992 and 1991. H. Commitments and Contingent Liabilities Based generally on our proportionate ownership in an iron ore associated enterprise, we are entitled to receive our share of the ore produced and are committed to pay our share of their costs. We received 2.7 million net tons of such iron ore in each of the years 1993, 1992 and 1991 at a net cost of $88.8 million, $89.1 million and $84.4 million. At December 31, 1993, we had outstanding approximately $192 million of purchase orders for additions and improvements to our properties. We, as well as other steel companies, are subject to various environmental laws and regulations imposed by federal, state and local governments. Because of the continuing evolution of the specific regulatory requirements and available technology to comply with the requirements, we cannot reasonably estimate the future capital expenditures and operating costs required to comply with these laws and regulations. Although it is possible that our future operating results in a particular quarterly or annual period could be materially affected by the future costs of environmental compliance, we do not believe the future costs of environmental compliance will have a material adverse effect on our consolidated financial position or on our competitive position with respect to other integrated domestic steelmakers subject to the same environmental requirements. In the ordinary course of our business, we are involved in various pending or threatened legal actions. In our opinion, adequate reserves have been recorded for losses which are likely to result from these proceedings. If such reserves prove to be inadequate, however, we would incur a charge to earnings which could be material to the results of operations in a particular future quarterly or annual period. We believe that any ultimate liability arising from these actions will not have a material adverse effect on our consolidated financial position. I. Postretirement Pension Benefits We have noncontributory defined benefit pension plans which provide benefits for substantially all employees. Defined benefits are based on years of service and the five highest consecutive years of pensionable earnings during the last ten years prior to retirement or a minimum amount based on years of service. We fund annually the amount required under ERISA minimum funding standards plus additional amounts as appropriate. The following sets forth the plans' actuarial assumptions used and funded status at year end together with amounts recognized in our consolidated balance sheets: December 31 ----------- (Dollars in millions) 1993 1992 ---- ---- Assumptions: Discount rate 7.5% 8.5% Average rate of compensation increase 3.3% 4.4% Actuarial present value of benefit obligations: Vested benefit obligation $4,816.4 $4,357.9 Accumulated benefit obligation 4,979.4 4,490.1 Projected benefit obligation 5,208.6 4,822.7 Plan assets at fair value: Fixed income securities 1,955.0 1,979.8 Equity securities 1,232.2 1,006.0 Cash and marketable securities 178.6 315.6 -------- ------- Total plan assets $3,365.8 3,301.4 -------- ------- Projected benefit obligations in excess of plan assets 1,842.8 1,521.3 Unrecognized net loss (289.7) (58.3) Remaining unrecognized net obligation resulting from adoption of Statement No. 87 (293.5) (339.0) Unrecognized prior service cost from plan amendments (307.1) (174.9) Adjustment required to recognize minimum liability -Intangible asset 600.6 239.6 -Additional paid-in capital (pre-tax) (Note M) 60.5 - -------- -------- Pension liability $1,613.6 $1,188.7 ======== ======== The assumptions used in each year and the components of our annual pension cost are as follows: (Dollars in millions) 1993 1992 1991 ---- ---- ---- Assumptions: Return on plan assets 9.50% 9.50% 10.25% Discount rate 8.50% 8.50% 9.25% Pension cost: Service cost-benefits earned during the period $ 39.3 $ 45.0 $ 45.6 Interest on projected benefit obligation 380.4 394.2 386.6 Return on plan assets -actual (308.8) (250.0) (582.7) -deferred 4.3 (62.2) 265.5 Amortization of initial net obligation 37.7 37.8 43.9 Amortization of unrecognized prior service cost from plan amendments 19.8 18.8 21.0 ------- ------- ------- Total defined benefit plans 172.7 183.6 179.9 PBGC premiums, administration fees, etc. 10.9 5.1 4.7 ------- ------- ------- Total cost $ 183.6 $ 188.7 $ 184.6 ======= ======= ======= J. Postretirement Benefits Other Than Pensions In addition to providing pension benefits, we currently provide health care and life insurance benefits for most retirees, and their dependents. Information regarding our plans' actuarial assumptions, funded status and liability follows: December 31 ------------- (Dollars in millions) 1993 1992 ---- ---- Assumptions: Discount rate 7.5% 8.5% Trend rate -beginning 9.0% 9.5% -ending (year 2000) 4.6% 5.5% Accumulated postretirement benefit obligation: Retirees $1,506.7 $1,413.7 Fully eligible active plan participants 126.8 105.1 Other active plan participants 236.1 176.2 -------- ------- Total 1,869.6 1,695.0 Plan assets at fair value: Fixed income securities 158.5 159.6 ------- ------- Accumulated postretirement benefit obligation in excess of plan assets 1,711.1 1,535.4 Unrecognized net (loss) gain (130.5) 4.5 -------- ------- Balance sheet liability $1,580.6 $1,539.9 ========= ======== The assumptions used in each year and the components of our postretirement benefit cost follow: (Dollars in millions) 1993 1992 ---- ---- Return on plan assets 9.5% 9.5% Discount rate 8.5% 8.5% Trend rate-beginning 9.5% 9.5% -ending (2000) 5.5% 5.5% Service cost $ 9.0 $ 9.0 Interest on accumulated postretirement benefit obligation 144.1 139.0 Return on plan assets-actual (17.9) (18.4) -deferred 3.8 4.5 Multi-employer plans 5.9 7.1 ------ ------ Total cost $144.9 $141.2 ====== ====== A 1% increase or decrease in the assumed health care trend rate would increase or decrease the accumulated postretirement benefit obligation by about $135 million and 1993 expense by about $13 million. In 1991, these postretirement benefits were expensed generally as claims were incurred except the estimated cost of postretirement life insurance was accrued over the working lives of those employees expected to qualify for such benefits. The 1991 expense was $112.9 million including multi-employer plans of $7 million. During 1992, legislation was enacted to replace the health care plan for certain former mine workers and their dependents with a new multi-employer plan. We estimate that this legislation will increase our annual future cost between $3 and $5 million. Based on the number of participants that have been assigned to us, our estimate of the net present value of the future payments to this fund at December 31, 1993 is $75 million. K. Stockholder Rights Plan We have a Stockholder Rights Plan under which holders of Common Stock have rights to purchase a new series of Preference Stock. When exercisable, each right entitles the holder to purchase a hundredth of a share of Series A Junior Participating Preference Stock at an exercise price of $80 per unit. The rights will become exercisable only if a person or group acquires 20% or more of Common Stock or begins a tender offer or exchange offer which would result in that person or group beneficially owning 20% or more of Common Stock. Subsequently, upon the occurrence of certain events, holders of rights will be entitled to purchase Common Stock of Bethlehem or a third-party acquiror worth twice the right's exercise price. Until the rights become exercisable, we will be able to redeem them at one cent per right. The rights expire on October 18, 1998. L. Stock Options At December 31, 1993, we had options outstanding under our Stock Option Plans. The 1988 Stock Incentive Plan was approved by our stockholders on April 26, 1988. New options can be granted only under the 1988 Plan, which reserved 3,000,000 shares of Common Stock for such use. At December 31, 1993, options on 60,870 shares of Common Stock were available for granting under the 1988 Plan. The option price is the fair market value of our Common Stock on the date the option is granted. Options issued under the 1988 Plan become exercisable either one or two years after the date granted and expire ten years from the date granted. Exercisable options may be surrendered for the difference between the option price and the fair market value of the Common Stock on the date of surrender. Depending on the circumstances, option holders receive either Common Stock, cash or a combination of Common Stock and cash. Changes in options outstanding during 1993 and 1992 under the Plans were as follows: Number of Option Price Options or Range ---------- ---------- Balance December 31, 1991 2,542,223 7-3/4 to 27-l/8 Granted 492,200 14-l/8 Terminated or cancelled (123,104) 14 to 27-1/8 ---------- Balance December 31, 1992 2,911,319 7-3/4 to 27-l/8 Granted 532,600 19 Terminated or cancelled (348,102) 8 to 27-1/8 Surrendered or Exercised (215,902) 7-3/4 to 17-5/8 ---------- Balance December 31, 1993 2,879,915 8 to 26-1/8 ========== 2,104,465 options outstanding were exercisable at December 31, 1993. M. Stockholders' Equity During 1993, we issued 5.1 million shares of $3.50 Cumulative Convertible Preferred Stock for $248 million. Each share is convertible into 2.39 shares of Common Stock, subject to certain events. Each share of the $5.00 Cumulative Convertible Preferred Stock and the $2.50 Cumulative Convertible Preferred Stock issued in 1983 is convertible into 1.77 and .84 shares of Common Stock, respectively, subject to certain events. In accordance with our labor agreements, we issue Preference Stock to a trustee under the Employee Investment Program. Series "A" and Series" B" of Preference Stock have a cumulative dividend of 5% per annum payable at our option in cash, Common Stock or additional shares of Preference Stock. Each share of Preference Stock is entitled to vote with Common Stock on all matters and is convertible into one share of Common Stock. Under the covenants of our 10-3/8% Senior Notes, we can pay future dividends on our common stock, among certain other restrictions, only if such cumulative dividends do not exceed the aggregate net cash proceeds from the sale of capital stock plus 50% of a consolidated net income and minus 100% of a consolidated net loss since the second quarter of 1993, excluding certain restructuring charges. The amount available at December 31, 1993 under this covenant was $39 million. N. Quarterly Financial Data (Unaudited) (a) Includes $90 million ($1.18 per share) for the cumulative effect of changes in accounting. Report of Independent Accountants To the Board of Directors and Stockholders of Bethlehem Steel Corporation We have audited the accompanying consolidated balance sheets of Bethlehem Steel Corporation and its subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income and of cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements audited by us present fairly, in all material respects, the financial position of Bethlehem Steel Corporation and its subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in Note B to the financial statements, the Company changed its methods of accounting for the cost of inventories in 1993 and for income taxes and postretirement benefits other than pensions in 1992. /s/ Price Waterhouse ----------------- Price Waterhouse 1177 Avenue of the Americas New York, NY 10036 January 26, 1994 Management Statement on Responsibility for Financial Information The accompanying consolidated financial statements of Bethlehem Steel Corporation have been prepared in accordance with generally accepted accounting principles. Management has the primary responsibility for the information contained in the financial statements and in other sections of the Annual Report to Stockholders. In preparing the financial statements, management must make estimates and judgments based upon available information. To facilitate this financial reporting, management has communicated to all appropriate employees the requirements for accurate records and accounting. Bethlehem maintains a system of internal accounting controls designed to provide reasonable assurance for the safeguarding of assets and the reliability of financial records. The system is subject to continuous review through a corporate-wide internal audit program with appropriate management follow-up action. Management recognizes the limits that are inherent in all systems of internal accounting control. Management believes, however, that through the careful selection of employees, the division of responsibilities and the application of formal policies and procedures, Bethlehem has an effective and responsive system of internal accounting controls. Bethlehem's independent accountants, Price Waterhouse, examine Bethlehem's financial statements in accordance with generally accepted auditing standards. They express their professional opinion which is shown above. This examination includes evaluating our internal accounting control systems to establish the audit scope, testing our accounting records and transactions and performing such other audit procedures as they deem appropriate. The Audit Committee of the Board of Directors is composed of Bethlehem's non-employee directors, who meet at appropriate times and met three times during 1993. The Audit Committee is responsible for recommending to the Board of Directors, subject to approval by the Board and ratification by stockholders, the independent accountants to perform audit and related work for Bethlehem; for reviewing with the independent accountants the scope of their examination of Bethlehem's financial statements; for reviewing with Bethlehem's internal auditors the scope of the plan of audit; for meeting with the independent accountants and Bethlehem's internal auditors to review the results of their audits and Bethlehem's internal accounting controls; and for reviewing other professional services performed for Bethlehem by the independent accountants. From time to time, the Audit Committee meets with the independent accountants and with Bethlehem's internal auditors without members of Bethlehem's management being present. The meetings permit the Audit Committee to have private communications with the independent accountants and the internal auditors about the results of their examinations, their evaluation of Bethlehem's internal accounting controls, the overall quality of Bethlehem's financial reporting and any other appropriate topics. Management believes that the system of internal accounting controls, including Bethlehem's Code of Business Conduct, provides reasonable assurances that (1) business activities are conducted in a manner consistent with Bethlehem's commitment to a high standard of business conduct and (2) Bethlehem's financial accounting system contains the integrity and objectivity necessary to maintain accountability for assets and to prepare Bethlehem's financial statements in accordance with generally accepted accounting principles. /s/ Curtis H. Barnette /s/ Gary L. Millenbruch - ---------------------- ------------------------ Curtis H. Barnette Gary L. Millenbruch Chairman Chief Financial Officer Five-Year Financial and Operating Summaries (Dollars in millions, except per share and average employment cost data) 1993 1992 1991 1990 1989 -------- -------- -------- -------- ------- Earnings Statistics Net sales $4,323.4 $4,007.9 $4,317.9 $4,899.2 $5,250.9 -------- -------- -------- -------- -------- Operating charges: Employment costs 1,547.1 1,664.0 1,720.8 1,752.0 1,731.6 Materials and services 2,403.9 2,242.0 2,444.3 2,679.3 2,760.1 Depreciation 277.5 261.7 241.4 305.7 325.3 Taxes (other than employment and income taxes) 40.1 43.2 51.3 51.3 52.7 Estimated restructuring losses 350.0 - 635.0 550.0 105.0 -------- -------- -------- -------- -------- 4,618.6 4,210.9 5,092.8 5,338.3 4,974.7 -------- -------- -------- -------- -------- Income (loss) from operations (295.2) (203.0) (774.9) (439.1) 276.2 Financing income (expense): Interest and other financing costs (63.2) (57.2) (45.5) (44.1) (64.7) Interest and other income 7.1 4.9 9.7 29.9 55.0 Benefit (provision) for income taxes 85.0 45.0 (2.0) (6.0) (12.0) Cumulative effect of changes in accounting - (340.0) - - - Net income (loss) (266.3) (550.3) (812.7) (459.3) 254.5 Dividends on Preferred and Preference Stock 39.8 24.3 24.7 24.2 26.0 --------- --------- -------- --------- ------- Net income (loss) applicable to Common Stock $ (306.1) $ (574.6) $(837.4) $ (483.5) $ 228.5 ========= ========= ======== ========= ======== Net income (loss) per Common share $ (3.37) $ (7.01) $ (11.01) $(6.39) $ 3.05 Dividends per Common share - - .40 .40 .20 Dividends paid on Common Stock - - 30.4 30.3 15.0 --------- --------- --------- ------- --------- Balance Sheet Statistics Cash and cash equivalents $ 228.9 $ 208.2 $ 83.8 $273.5 $ 530.5 Receivables, inventories and other current assets 1,362.2 1,261.3 1,454.0 1,494.7 1,465.7 Current liabilities (914.2) (893.2) (931.0) (831.4) (838.0) --------- -------- --------- ---------- -------- Working capital $ 676.9 $ 576.3 $ 606.8 $ 936.8 $1,158.2 Current ratio 1.7 1.6 1.7 2.1 2.4 Property, plant and equipment-net $2,634.3 $2,804.5 $2,864.8 $2,796.4 $2,916.7 Total assets 5,876.7 5,493.0 4,708.3 4,947.1 5,354.3 Total debt and capital lease obligations 813.8 796.0 871.2 663.8 724.1 Stockholders' equity 696.6 789.4 1,186.1 2,046.0 2,555.7 Total debt as a percent of invested capital 54% 50% 42% 24% 22% -------- -------- --------- --------- ------- Other Statistics Capital expenditures $ 327.1 $ 328.7 $ 563.9 $ 488.0 $421.3 Raw steel production capability (net tons in thousands) 11,500 16,000 16,000 16,000 16,000 Raw steel production (net tons in thousands) 10,303 10,544 10,022 10,924 12,181 Steel products shipped (net tons in thousands) 9,016 9,062 8,376 8,865 9,779 Pensioners receiving benefits at year end 70,900 70,500 70,200 70,500 70,000 Average number of employees receiving pay 20,700 24,900 27,500 29,600 30,500 Common Stock outstanding at year end (shares in thousands) 91,409 90,509 76,380 75,867 75,218 Common stockholders at year end 43,000 46,000 50,000 52,000 55,000 Exhibit (21) Subsidiaries of Bethlehem Steel Corporation Unless otherwise stated, the following subsidiaries were 100% owned and were consolidated by the Corporation at December 31, 1993. State or Other Jurisdiction Name of Subsidiary In Which Incorporated ----------------------- --------------------------- BethEnergy Mines Inc. West Virginia Bethlehem Steel International Corporation Delaware Bethlehem Hibbing Corporation Minnesota * BethEnergy Mines Inc. does business in the Commonwealth of Pennsylvania and the State of West Virginia under the name "Bethlehem Mines Corporation". The names of other subsidiaries, both consolidated and unconsolidated, have been omitted as these unnamed subsidiaries, considered in the aggregate as a single subsidiary, do not constitute a significant subsidiary. Exhibit 24 POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS that each of the undersigned directors and officers of Bethlehem Steel Corporation, a Delaware corporation, constitutes and appoints Curtis H. Barnette, Gary L. Millenbruch, and Lonnie A. Arnett, and each of them, with full power to act without the others, as his true and lawful attorney-in-fact and agent, with full and several power of substitution, for him and in his name, place and stead, in any and all capacities, to sign Bethlehem Steel Corporation's Annual Report on Form 10-K, and to file the same, with all exhibits thereto, and other documents in connection therewit including any amendments thereto, with the Securities and Exchange Commission under the provisions of the Securities and Exchange Act of 1934, as amended, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as they or he might or could do in person, hereby ratifying and confirming all the said attorneys-in-fact and agents, or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. IN WITNESS WHEREOF, the undersigned have hereunto set their hands and seals as of the 24th day of March, 1994. /s/ Curtis H. Barnette /s/ Gary L. Millenbruch - ------------------------ ------------------------- Curtis H. Barnette Gary L. Millenbruch Chairman, Chief Executive Officer Executive Vice President (principal executive officer) (principal financial officer) and Director and Director /s/ Lonnie A. Arnett /s/ Harry P. Kamen - ---------------------------------- -------------------------------- Lonnie A. Arnett Harry P. Kamen, Director Vice President and Controller (principal accounting officer) /s/ Benjamin R. Civiletti /s/ Winthrop Knowlton - ---------------------------------- -------------------------------- Benjamin R. Civiletti, Director Winthrop Knowlton, Director /s/ Worley H. Clark /s/ Robert McClements, Jr. - ---------------------------------- ------------------------------- Worley H. Clark, Director Robert McClements, Jr., Director /s/ Herman E. Collier, Jr. /s/ Roger P. Penny - ---------------------------------- ------------------------------- Herman E. Collier, Jr., Director Roger P. Penny, Director /s/ John B. Curcio /s/ Dean P. Phypers - ---------------------------------- ------------------------------- John B. Curcio, Director Dean P. Phypers, Director /s/ William C. Hittinger /s/ William A. Pogue - ---------------------------------- -------------------------------- William C. Hittinger, Director William A. Pogue, Director /s/ Thomas L. Holton - ---------------------------------- Thomas L. Holton, Director POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS that the undersigned director of Bethlehem Steel Corporation, a Delaware corporation, hereby constitutes and appoints Curtis H. Barnette, Gary L. Millenbruch and Lonnie A. Arnett, and each of them, with full power to act without the others, as his true and lawful attorney-in-fact and agent, with full and several power of substitution, for him and in his name, place and stead, in any and all capacities, to sign Bethlehem Steel Corporation's Annual Report on Form 10-K, and to file the same with all exhibits thereto, and other documents in connection therewith, including any amendments thereto, with the Securities and Exchange Commission under the provisions of the Securities and Exchange Act of 1934, as amended, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as the undersigned might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents, or any of them, or their or his substitutes or substitutes, may lawfully do or cause to be done by virtue thereof. IN WITNESS WHEREOF, the undersigned has hereunto set his hand and seal as of the 24th day of March, 1994. /s/ John F. Ruffle ------------------------- John F. Ruffle, Director
35214_1993.txt	35214	1993	ITEM 1 Business - --------------- Ferro Corporation ("Ferro"), which was incorporated under the laws of Ohio in 1919, is a worldwide producer of specialty materials by organic and inorganic chemistry for industry. It operates (either directly or through wholly owned subsidiaries or partially owned affiliates) in 22 countries worldwide. Ferro produces a variety of specialty coatings, specialty colors, specialty chemicals, specialty ceramics, specialty plastics and related products and services. Ferro's most important product is frit produced for use in porcelain enamels and ceramic glazes. Most of the products produced by Ferro are classified as specialty materials, rather than commodities, because they are formulated or designed to perform a specific and important function in the manufacturing processes of Ferro customers or in their end products. These specialty materials are not sold in the high volume normally associated with commodity businesses. - 2 - Ferro specialty materials require a high degree of technical service on an individual customer basis. The value of these specialty materials stems not just from their raw materials composition, but from the result and performance they achieve in actual use. A further description of Ferro's business, its principal products, their markets and applications is contained under all headings on pages 4 through 13 of Ferro's 1993 Annual Report to Shareholders which is attached hereto as Exhibit 13 (the "Annual Report"). The information contained under the aforementioned headings on pages 4 through 13 of the Annual Report (excluding those pages on which only pictures appear and the pictures and text describing such pictures on pages 7, 9, 11, and 13) is incorporated herein by reference. Information concerning Ferro's business during 1993, 1992, and 1991 and certain transactions consummated during those years is included under the heading "Management's Discussion and Analysis" on pages 15 through 20 of the Annual Report and in Note 6 to Ferro's Consolidated Financial Statements, which are included in the Annual Report. Note 6 appears at page 29 of the Annual Report. Such information is incorporated herein by reference. Additional information about Ferro's industry segments, including financial information relating thereto, is set forth in Note 11 to Ferro's Consolidated Financial Statements, which appears on pages 33 through 35 of the Annual Report and is incorporated herein by reference. Raw Materials ------------- For the most part the raw materials essential to Ferro's operations both in the United States and overseas are obtainable from multiple sources worldwide. Ferro did not encounter significant raw material shortages in 1993 and does not anticipate such shortages in 1994. Patents and Licenses -------------------- Ferro owns a substantial number of patents relating to its various products and their uses. While these patents are of importance to Ferro, it does not consider that the invalidity or expiration of any single patent or group of patents would have a material adverse effect on its business. Ferro patents expire at various dates through the year 2010. Ferro does not hold any licenses, franchises or concessions which it considers to be material. Customers --------- Ferro does not consider that a material part of its business is dependent on any single customer or group of customers. Backlog of Orders ----------------- In general there is no significant lead time between order and delivery in any of Ferro's business segments. As a result, Ferro does not consider that the dollar amount of - 3 - backlog of orders believed to be firm as of any particular date is material for an understanding of its business. Ferro does not regard any material part of its business to be seasonal. Competition ----------- With respect to most of its products, Ferro competes with a substantial number of companies, none of which is dominant. An exception is frit, as to which Ferro believes that it is the largest worldwide supplier. The details of foreign competition necessarily vary with respect to each foreign market. Because of the specialty nature of Ferro's products, product performance characteristics and customer service are the most important components of the competition which Ferro encounters in the sale of nearly all of its products. However, in some of the markets served by Ferro, strong price competition is encountered from time to time. Research and Development ------------------------ A substantial number of Ferro's employees are involved in technical activities concerned with products required by the ever-changing markets of its customers. Laboratories are located at each of Ferro's major subsidiaries around the globe, where technical efforts are applied to the customer and market needs of that geographical area. In the United States, laboratories are maintained in each of its divisions. Backing up these divisional customer services laboratories is Corporate research activity involving approximately 52 scientists and support personnel in the Cleveland area. Expenditures for research and development activities relating to the development or significant improvement of new and/or existing products, services and techniques were approximately $19,334,000, $15,440,000, and $17,643,000 in 1993, 1992 and 1991, respectively. Expenditures for individual customer requested research and development were not material. Environmental Matters --------------------- Ferro's manufacturing facilities, like those of industry generally, are subject to numerous laws and regulations designed to protect the environment, particularly in regard to plant wastes and emissions. In general, Ferro believes that it is in substantial compliance with the environmental regulations to which its operations are subject and that, to the extent Ferro may not be in compliance with such regulations, such non-compliance has not had a material adverse effect on Ferro. Moreover, while Ferro has not generally experienced substantial difficulty in complying with environmental requirements, compliance has required a continuous management effort and significant expenditures. Ferro and its international subsidiaries authorized approximately $8,970,000, $9,622,000 and $3,287,000 in capital expenditures for environmental control during 1993, 1992 - 4 - and 1991, respectively. Three major projects accounted for the high level of environmental control capital expenditures in 1992. They were: Three major projects accounted for the high level of environmental control capital expenditures in 1993. They were: During 1993, the Company became involved in two separate environmental claims regarding Keil Chemical, a production facility owned and operated by Ferro in Hammond, Indiana. The Company has been named as one of several defendants, including three local municipalities, one local government agency (a sewer district) and four other area industrial concerns in a suit filed by the United States Environmental Protection Agency alleging violation of the Clean Water Act and the River and Harbors Act. The suit was filed in the Federal District Court for the Northern District of Indiana on August 2, 1993. The suit alleges violation of pre-treatment requirements for removal of pollutants prior to discharge of wastewater into the Grand Calumet and Little Calumet Rivers. Relief sought includes orders to comply with environmental regulations, civil penalties of up to $25,000 per day for each violation, and contribution to the cost of removing contaminated sediments from the west branch of the Grand Calumet River. The Company believes it is in substantial compliance with applicable law and intends to vigorously defend this litigation. However, the Company will also explore settlement - 5 - possibilities, and if it is more economical to settle than to defend, the Company will pursue that course of action. In a separate matter, in late July 1993, the United States Environmental Protection Agency, the Indiana Department of Environmental Management and the Hammond Department of Environmental Management alleged violation of air emission regulations by the Keil Chemical facility. The allegations relate to materials used in the manufacture of flame retardants. The notices from the governmental authorities threaten the possibility of proceedings to suspend operations in the manufacture of flame retardants and threaten civil penalties of up to $25,000 per day of violation. The Company has voluntarily commenced a capital program, estimated to cost $3.0 million, to reduce air emissions related to its flame retardant process at Keil Chemical and in consultation with the agencies, has taken interim measures to reduce air emissions pending completion of the capital program. The Company has been working with the appropriate environmental agencies and is exploring whether the agencies' claims can be settled on reasonable terms. If reasonable settlement cannot be reached, the Company intends to vigorously defend against the agencies' claims. Employees --------- At December 31, 1993, Ferro employed approximately 6,627 full-time employees, including 4,325 employees in its foreign subsidiaries and affiliates and 2,302 in the United States. Set forth below is a table of union contracts showing name of union, expiration date of union agreement, number of employees covered by the union agreement, and percentage of United States work force covered by the union agreement. - 6 - As indicated by the foregoing table, only 2.6% of Ferro's domestic work force is affected by union agreements which expire in 1994. - 7 - Foreign Operations ------------------ Financial information about Ferro's domestic and foreign operations is set forth under the heading "Geographic Operating Data" on page 35 of the Annual Report and is incorporated herein by reference. Ferro's products are produced and distributed in foreign as well as domestic markets. Ferro commenced its international operations in 1927. Wholly-owned subsidiaries operate manufacturing facilities in Argentina, Australia, Brazil, Canada, England, France, Germany, Holland, Italy, Mexico, New Zealand, Spain and Taiwan. Partially-owned affiliates manufacture in Ecuador, Indonesia, Italy, Japan, Portugal, Taiwan, Thailand, Turkey and Venezuela. Foreign operations (excluding Canada) accounted for 50% of the consolidated net sales and 57% of Ferro's consolidated operating income for the fiscal year 1993; comparable amounts for the fiscal year 1992 were 55% and 74% and for fiscal year 1991 were 55% and 159%. The split of operating income between foreign and domestic operations in 1991 was skewed heavily against domestic results due to the one time restructuring charge. Except for the sales of Ferro Enamel Espanola S.A. (Spain), Ferro France, S.a R.L. (France), Ferro Chemicals S.A. (France), Ferro (Holland) B.V., Ferro Mexicana S.A. de C.V. (Mexico), Ferro (Great Britain) Ltd., Ferro Industrial Products Limited (Taiwan), Ferro Toyo Co., Ltd. (Taiwan) and Metal Portuguesa S.A. (Portugal), the sales of each of Ferro's subsidiaries are principally for delivery in the country in which the subsidiary is located. Ferro's European Community subsidiaries continue to reduce and eliminate, to the extent practical, duplication of product lines with the intended result being that only one subsidiary will be the primary provider of each line of Ferro specialty products to the entire European Community market. Ferro receives technical service fees and/or royalties from many of its foreign subsidiaries. Under historical practice, as a matter of general corporate policy, the foreign subsidiaries were normally expected to remit a portion of their annual earnings to the parent by way of dividends. Under current practice, earnings of the Company's European subsidiaries are being reinvested in European operations. Several of the countries where Ferro has subsidiaries control the transfer of currency out of the country, but in recent years Ferro has been able to receive such remittances without material hindrance from foreign government restrictions. To the extent earnings of foreign subsidiaries are not remitted to Ferro, such earnings are intended to be indefinitely invested in those subsidiaries. - 8 - ITEM 2		ITEM 2 Properties - ------------------- Ferro's research and development center is located in leased space in Cleveland, Ohio. The corporate headquarters office is located at 1000 Lakeside Avenue, Cleveland, Ohio, and such property is owned by the Company. The business segments in which Ferro's plants are used and the locations of the principal manufacturing plants it owns in the United States are as follows: Coatings, Colors and Ceramics -- Cleveland, Ohio, Lake Park, Florida, Nashville, Tennessee, Pittsburgh, Pennsylvania, Toccoa, Georgia, Orrville, Ohio, Penn Yan, New York, East Liverpool, Ohio, Crooksville, Ohio, and East Rochester, New York; Plastics -- Plymouth, Indiana, Evansville, Indiana, Stryker, Ohio, Edison, New Jersey and South Plainfield, New Jersey; Chemicals - -- Bedford, Ohio, Hammond, Indiana and Baton Rouge, Louisiana. In addition, Ferro leases manufacturing facilities in Santa Barbara, California (Coatings); Schaumburg, Illinois (Plastics) and Lake Park, Florida (Coatings). Outside the United States, Ferro or its subsidiaries own manufacturing plants in Argentina, Australia, Brazil, Canada, France, Germany, Indonesia, Italy, Japan, Mexico, the Netherlands, Portugal, Spain, Taiwan, Thailand and the United Kingdom. Ferro or its subsidiaries lease manufacturing plants in Italy, the Netherlands and New Zealand. In many instances, the manufacturing facilities outside of the United States are used in multiple business segments of Ferro. Ferro believes that all of the foregoing facilities are generally well maintained and adequate for their present use. During the past year, several of Ferro's plants have been operating near capacity. ITEM 3	ITEM 3 Legal Proceedings - -------------------------- The information set forth in Note 7 to Ferro's Consolidated Financial Statements on page 29 of the Annual Report is incorporated herein by reference. Information regarding certain legal proceedings with respect to environmental matters is contained under Part I of this Annual Report on Form 10-K. The law firm of Squire, Sanders & Dempsey, of which Paul B. Campbell is a partner, provided legal services to Ferro in 1993 and Ferro plans to continue the use of such firm in 1994. Mr. Campbell is the Secretary and a Director of Ferro. ITEM 4	ITEM 4 Submission of Matters to a Vote of Security Holders - ------------------------------------------------------------ No matters were submitted to a vote of Ferro's security holders during the fourth quarter of the fiscal year covered by this report. - 9 - Executive Officers of the Registrant ------------------------------------ There is set forth below the name, age, positions and offices held by each of Ferro's executive officers as of March 15, 1994 as well as their business experience during the past five years. Years indicate the year the individual was named to the indicated position. There is no family relationship between any of Ferro's executive officers. Albert C. Bersticker - 59 President and Chief Executive Officer, 1991 President and Chief Operating Officer, 1988 Werner F. Bush - 54 Executive Vice President and Chief Operating Officer, 1993 Senior Vice President, Coatings, Colors and Ceramics, 1991 Group Vice President, Coatings, Colors and Electronic Materials, 1988 David G. Campopiano - 45 Vice President, Corporate Development, 1989 Senior Vice President, Prescott, Ball & Turben, Inc., 1987 Frank A. Carragher - 62 Senior Vice President, Chemicals and Polymers, 1991 Group Vice President, Chemicals, 1979 R. Jay Finch - 52 Vice President, Specialty Plastics, 1991 Vice President and General Manager, Plastics & Rubber Division, Mobay Corporation, 1984 James F. Fisher - 56 Senior Vice President, Coatings, Colors and Ceramics, 1993 Group Vice President, International, 1991 Vice President, International, 1988 D. Thomas George - 46 Treasurer, 1991 Director, Treasury Operations, 1989 Area Controller, Latin America and Far East, 1988 Marino Lopez-Vega - 52 Vice President, Frit, 1992 Managing Director of Ferro Spain, 1984 - 10 - Hector R. Ortino - 51 Executive Vice President and Chief Financial-Administrative Officer, 1993 Senior Vice President and Chief Financial Officer, 1991 Vice President, Finance and Chief Financial Officer, 1987 Richard C. Oudersluys - 55 Vice President, Pigments and Glass/Ceramics Colorants, 1992 General Manager, Color Division, 1987 Robert E. Price - 55 Vice President, International, 1993 Managing Director, Asia-Pacific, 1989 President, Ferro Far East Ltd., 1987 Thomas O. Purcell, Jr. - 50 Vice President, Research and Development, 1991 Associate Director Research, Plastics, 1990 Manager, Technology Assessment Operation, General Electric Plastics, 1988 Gary H. Ritondaro - 47 Vice President, Finance, 1993 Vice President, Controller, 1991 Controller, 1986 PART II ------- ITEM 5	ITEM 5 Market for Registrant's Common Equity and Related Stockholder Matters - ---------------------------------------------------------- Information regarding the recent price and dividend history of Ferro's Common Stock, the principal market for its Common Stock and the number of holders thereof is set forth under the heading "Quarterly Data" on page 38 of the Annual Report. Said information is incorporated herein by reference. Information concerning dividend restrictions is contained in Note 3 to Ferro's Consolidated Financial Statements on pages 26 and 27 of the Annual Report and said information is incorporated herein by reference. ITEM 6	ITEM 6 Selected Financial Data - -------------------------------- The summary of selected financial data for each of the last five years set forth under the heading "Selected Financial Data" on pages 36 and 37 of the Annual Report is incorporated herein by reference. - 11 - ITEM 7	ITEM 7 Management's Discussion and Analysis of Financial Conditions and Results of Operation - ---------------------------------------------------------- The information contained under the heading "Management's Discussion and Analysis" on pages 15 through 20 of the Annual Report is incorporated herein by reference. ITEM 8	ITEM 8 Financial Statements and Supplementary Data - ---------------------------------------------------- The Consolidated Financial Statements of Ferro and its subsidiaries contained on pages 21 through 35, inclusive, of the Annual Report, including the Notes to Consolidated Financial Statements, are incorporated herein by reference. ITEM 9	ITEM 9 Changes in and Disagreements With Accountants on Accounting and Financial Disclosure - ------------------------------------------------------------------------ There are no such changes or disagreements. PART III -------- ITEM 10	ITEM 10 Directors and Executive Officers of the Registrant - ----------------------------------------------------------- The information regarding directors of Ferro contained under the headings "Election of Directors" and "Certain Matters Pertaining to the Board of Directors" on pages 1 through 9, inclusive, of Ferro's Proxy Statement dated March 14, 1994 is incorporated herein by reference. Information regarding executive officers of Ferro is contained under Part I of this Annual Report on Form 10-K. ITEM 11	ITEM 11 Executive Compensation - ------------------------------- The information required by this Item 11 is set forth under the heading "Information Concerning Executive Officers" on pages 15 through 20, inclusive, of Ferro's Proxy Statement dated March 14, 1994 and is incorporated herein by reference. ITEM 12	ITEM 12 Security Ownership of Certain Beneficial Owners and Management - ----------------------------------------------------------------------- The information required by this Item 12 is set forth under the headings "Election of Directors" and "Security Ownership of Directors, Officers and Certain Beneficial Owners" on pages 1 through 8 of Ferro's Proxy Statement dated March 14, 1994 and is incorporated herein by reference. - 12 - ITEM 13	ITEM 13 Certain Relationships and Related Transactions - ------------------------------------------------------- There are no relationships or transactions that are required to be reported. PART IV ------- ITEM 14	ITEM 14 Exhibits, Financial Statement Schedules and Reports on Form 8-K - ------------------------------------------------------------ 1. Documents filed as part of this Annual Report on Form 10-K (a) The following Consolidated Financial Statements of Ferro Corporation and its subsidiaries, contained on pages 21 through 35, inclusive, of the Annual Report are incorporated herein by reference: Consolidated Statements of Income for the Years ended December 31, 1993, 1992 and 1991 Consolidated Balance Sheets at December 31, 1993 and 1992 Consolidated Statements of Shareholders' Equity for the years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows for the Years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements (b) Financial Statement Schedules V, VI, VIII, IX and X, together with the independent Auditor's Report thereon, are contained on pages through of this Annual Report on Form 10-K. (c) Exhibits (3) Articles of Incorporation and by-laws (a) Eleventh Amended Articles of Incorporation. (Reference is made to Exhibit 3 to Ferro Corporation's Quarterly Report on Form 10-Q for the three months ended September 30, 1989, which Exhibit is incorporated herein by reference.) - 13 - (b) Amended Code of Regulations. (Reference is made to Exhibit (3)(b) to Ferro Corporation's Quarterly Report on Form 10-Q for the three months ended June 30, 1987, which Exhibit is incorporated herein by reference.) (4) Instruments defining rights of security holders, including indentures (a) Revolving Credit Agreement by and between Ferro and four commercial banks dated August 22, 1990. (Reference is made to Exhibit 10 to Ferro Corporation's Quarterly Report on Form 10-Q for the three months ended September 30, 1990, which Exhibit is incorporated herein by reference.) (b) Amendment Number 1 dated May 31, 1991, to the Revolving Credit Agreement by and between Ferro and four commercial banks. (Reference is made to Exhibit 4(b)(1) to Ferro Corporation's Quarterly Report on Form 10-Q for the three months ended June 30, 1991, which Exhibit is incorporated herein by reference.) (c) Amendment Number 2 dated July 30, 1991, to the Revolving Credit Agreement by and between Ferro and four commercial banks. (Reference is made to Exhibit 4(b)(2) to Ferro Corporation's Quarterly Report on Form 10-Q for the three months ended June 30, 1991, which Exhibit is incorporated herein by reference.) (d) Amendment Number 3 dated December 31, 1991, to the Revolving Credit Agreement by and between Ferro and four commercial banks. (Reference is hereby made to Exhibit 4 to Ferro Corporation's Form 10-K for the year ended December 31, 1991, which Exhibit is incorporated herein by reference.) (e) Amendment Number 4 dated July 21, 1992, to the Revolving Credit Agreement by and between Ferro and four commercial banks. (Reference is hereby made to Exhibit 4 to Ferro Corporation's Form 10-Q for the three months ended June 30, 1992, which Exhibit is incorporated herein by reference.) (f) Amendment Number 5 dated April 20, 1993, to the Revolving Credit Agreement by and between Ferro and four commercial banks. (Reference is hereby made to Exhibit 4(b)(4) to Ferro Corporation's Form 10-Q for the three months ended June 30, 1993, which Exhibit is incorporated herein by reference.) - 14 - (g) The rights of the holders of Ferro's 11-3/4% Debentures due October 15, 2000 are described in the form of Indenture filed as Exhibit 4(b) to Amendment No. 1 to the Registration Statement on Form S- 3 filed with the Commission on October 8, 1985 (Registration No. 33-529). Said Exhibit is incorporated herein by reference. (h) Rights Agreement between Ferro Corporation and National City Bank, Cleveland, Ohio, as Rights Agent, dated as of March 21, 1986. (Reference is made to Exhibit 1.2 to the Registration Statement on Form 8-A dated March 26, 1986, which Exhibit is incorporated herein by reference.) (i) Amendment No. 1 to Rights Agreement between Ferro Corporation and National City Bank, Cleveland, Ohio, as Rights Agent, dated as of March 31, 1989. (Reference is made to Exhibit 1 to Form 8-K filed with the Commission on March 31, 1989, which Exhibit is incorporated herein by reference.) (j) The rights of the holders of Ferro's Debt Securities to be issued pursuant to an Indenture between Ferro and Society National Bank, as Trustee, are described in the form of Indenture dated May 1, 1993 filed as Exhibit 4(j) to Ferro Corporation's Form 10-Q for the three months ended June 30, 1993. Said Exhibit is incorporated herein by reference. (10) Material Contracts (a) Key elements of Ferro's Incentive Compensation Plan are set forth under the heading "Report of the Compensation and Organization Committee" on pages 11 through 13 of the Proxy Statement dated March 14, 1994. Said description is incorporated herein by reference. (b) Key elements of Ferro's Performance Share Plan are set forth under the heading "Performance Share Plan Awards" on pages 15, note 1, 17 and 18 of Ferro Corporation's Proxy Statement dated March 15, 1993. Said description is incorporated herein by reference. (c) Ferro Corporation Savings and Stock Ownership Plan. (Reference is made to Exhibit 4.3 to Ferro Corporation's Quarterly Report on Form 10-Q for the three months ended March 31, 1989, which Exhibit is incorporated herein by reference.) - 15 - (d) Ferro's 1985 Employee Stock Option Plan for Key Personnel (Amended and Restated). (Reference is hereby made to Exhibit A to Ferro Corporation's Proxy Statement dated March 11, 1991, which Exhibit is hereby incorporated by reference.) (e) Form of Indemnification Agreement (adopted January 25, 1991 for use from and after that date). (Reference is hereby made to Exhibit 10 to Ferro Corporation's Form 10-K for the year ended December 31, 1990, which Exhibit is incorporated herein by reference.) (f) Form of Executive Employment Agreement (adopted October 1, 1991 for use from and after that date). (Reference hereby is made to Exhibit 10 to Ferro Corporation's Form 10-K for the year ended December 31, 1991, which Exhibit is incorporated herein by reference.) (g) Schedule I listing the officers with whom Ferro has entered into currently effective executive employment agreements. A copy of such Schedule I is attached hereto as Exhibit 10. (h) Agreement between Ferro Corporation and Frank A. Carragher dated October 18, 1993 is attached hereto as Exhibit 10.1. (11) Statement Regarding Computation of Earnings Per Share. (12) Ratio of Earnings to Fixed Charges. (13) Annual Report to Shareholders for the year ended December 31, 1993. (21) List of Subsidiaries. (23) Consent of KPMG Peat Marwick to the incorporation by reference of their audit report on the Consolidated Financial Statements contained in the Annual Report into Ferro's Registration Statements on Form S-8 Registration Nos. 2-61407, 33-28520 and 33-45582 and Ferro's Registration Statement on Form S-3 Registration No. 33-51284. 2. No reports on Form 8-K were filed for the three months ended December 31, 1993. - 16 - SIGNATURES Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the Registrant has duly caused this Annual Report on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized. FERRO CORPORATION By /s/Albert C. Bersticker ----------------------------------- Albert C. Bersticker, President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this Annual Report on Form 10-K has been signed below by the following persons on behalf of the Registrant and in their indicated capacities and as of this 28th day of March, 1994. - 17 - - 18 - FERRO CORPORATION AND SUBSIDIARIES Supporting Schedules to Consolidated Financial Statements and Schedules Submitted in Response to Part IV -- Form 10-K December 31, 1993, 1992 and 1991 KPMG PEAT MARWICK CERTIFIED PUBLIC ACCOUNTANTS 1500 National City Center 1800 East Ninth Street Cleveland, OH 44114-3495 INDEPENDENT AUDITORS' REPORT ---------------------------- The Shareholders and Board of Directors Ferro Corporation: Under date of January 27, 1994, we reported on the consolidated balance sheets of Ferro Corporation and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, shareholders' equity, and cash flows for each of the years in the three- year period ended December 31, 1993, as contained in the 1993 annual report to shareholders. These consolidated financial statements and our report thereon are incorporated by reference in the annual report on Form 10-K for the year 1993. In connection with our audits of the aforementioned consolidated financial statements, we also have audited the related financial statement schedules listed in the accompanying table of contents. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. /s/ KPMG PEAT MARWICK Cleveland, Ohio January 27, 1994 FERRO CORPORATION AND SUBSIDIARIES ----------------- Financial Statements -------------------- Audited Consolidated Balance Sheets - December 31, 1992 and 1991 Consolidated Statements of Income - Years ended December 31, 1993, 1992, and 1991 Consolidated Statements of Shareholders' Equity - Years ended December 31, 1993, 1992, and 1991 Consolidated Statements of Cash Flows - Years ended December 31, 1993, 1992, and 1991 Notes to Consolidated Financial Statements - December 31, 1993, 1992, and 1991 Schedules --------- Plant and Equipment - Years ended December 31, 1993, 1992, and 1991 Schedule V Accumulated Depreciation of Plant and Equipment - Years ended December 31, 1993, 1992, and 1991 Schedule VI Valuation and Qualifying Accounts and Reserves - Years ended December 31, 1993, 1992, and 1991 Schedule VIII Short-Term Borrowings - Years ended December 31, 1993, 1992, and 1991 Schedule IX Supplementary Income Statement Information - Years ended December 31, 1993, 1992, and 1991 Schedule X All other schedules have been omitted because the material is not applicable or is not required as permitted by the rules and regulations of the Securities and Exchange Commission, or the required information is included in notes to consolidated financial statements. Financial statements of foreign affiliates in which Company ownership exceeds 20 percent, accounted for on the equity method, are not included herein since, in the aggregate, these companies do not constitute a significant subsidiary. Financial statements are incorporated herein by reference to the Company's annual report to its shareholders, the required number of copies of which were furnished to the Commission pursuant to Rule 14A-3. Schedule V ---------- Schedule VI ----------- Schedule VIII ------------- Schedule IX ----------- Schedule X ---------- EXHIBIT INDEX -------------
716133_1993.txt	716133	1993	ITEM 1. BUSINESS GENERAL Cincinnati Bell Inc. (including its wholly owned subsidiaries, except as the context may otherwise require, the "Company") is incorporated under the laws of Ohio and has its principal executive offices at 201 East Fourth Street, Cincinnati, Ohio 45202 (telephone number 513 397-9900). The Company is a holding company engaged in operations through its subsidiaries. The major subsidiaries are Cincinnati Bell Telephone Company ("CBT"), Cincinnati Bell Information Systems Inc. ("CBIS") and MATRIXX Marketing Inc. ("MATRIXX"). CBT provides telecommunications network services, CBIS designs, markets and manages information systems related to the telecommunications industry, and MATRIXX provides telephone marketing and research, fulfillment and data base services. Other subsidiaries include Cincinnati Bell Long Distance Inc. ("CBLD") which provides resale of long distance telecommunications services and products as well as voice mail and paging services, Cincinnati Bell Directory Inc. ("CBD") which provides Yellow Pages and other directory products and services and information and advertising services, and companies having interests in cellular mobile telephone service, the purchase, sale and reconditioning of telecommunications and computer equipment, and the ownership of real estate used by the Company. CINCINNATI BELL TELEPHONE COMPANY CBT is engaged principally in the business of furnishing telecommunications network services, mainly local exchange, access and toll telephone service, in four counties in southwestern Ohio, six counties in northern Kentucky and parts of two counties in southeastern Indiana. On December 31, 1993, CBT had approximately 848,000 network access lines in service. The principal cities in which CBT furnishes local service are Cincinnati, Norwood and Hamilton in Ohio and Covington, Newport and Florence in Kentucky. Approximately 98% of CBT's network access lines are in a single local service area. Other communications services offered by CBT include voice, data and video transmission, custom calling services and billing services. In addition, CBT is a sales agent for certain products and services of American Telephone and Telegraph Company ("AT&T") and also sells products of other companies. CBT's local exchange, access and toll telephone operations are subject to regulation by the regulatory authorities of the states in which it operates with respect to intrastate rates and services, issuance of securities and other matters. CBT is also subject to the jurisdiction of the Federal Communications Commission ("FCC") with respect to interstate rates, services and other matters. The FCC prescribes a uniform system of accounts and the principles and standard procedures used to separate CBT's investments, revenues, expenses, taxes and reserves between those applicable to interstate services under the jurisdiction of the FCC and to intrastate services under the jurisdiction of the state regulatory authorities. TELEPHONE OPERATIONS. The lines provided by CBT to customer premises can be interconnected with the lines of other telephone companies in the United States and with telephone systems in most other countries. Interconnection is made through the facilities of interexchange carriers and local exchange carriers. The following table sets forth for CBT the number of network access lines at December 31: Thousands ------------------------------------- 1993 1992 1991 1990 1989 ---- ---- ---- ---- ---- Network Access Lines 848 827 808 800 781 Recurring charges for network access lines and other local services for the year ended December 31, 1993 accounted for approximately 45% of CBT revenues and sales. INTRASTATE RATES. Rates for intrastate services offered by CBT are either non-regulated by state regulatory authorities in Ohio and Kentucky or regulated by such state regulatory authorities which are The Public Utilities Commission of Ohio (the "PUCO") and the Public Service Commission of Kentucky (the "PSCK"). Approximately 78% of CBT's 1993 revenues and sales was derived from intrastate service. Approximately 83% of 1993 intrastate revenues was derived from Ohio service, approximately 17% was derived from Kentucky service and minor amounts were derived from Indiana and other states service. Of the total 1993 intrastate revenues, local service accounted for approximately 68%, intrastate long distance service and network access accounted for approximately 14% and miscellaneous revenue accounted for approximately 18% of such revenues and sales. In 1984, the PUCO issued orders providing the format to be employed by local exchange telephone companies in Ohio for setting charges for intrastate access by interexchange carriers. The PUCO determined that the Ohio intrastate access charges should mirror the interstate access charges set by the FCC (see "Interstate Rates"), with the exception that the PUCO did not order mirroring of subscriber line charges or carrier common line charges. Pursuant to procedures established by the PUCO, local exchange companies are permitted to file plans proposing alternative forms of regulation for competitive services and basic service rates. On March 12, 1993, CBT filed a notice of intent to file an application for approval of an alternative regulation plan and for a threshold rate adjustment. Pursuant to CBT's proposal, services would be categorized into various cells depending on the nature of the services, with varying degrees of pricing flexibility. Also, CBT's proposal requested an across-the-board (with a few noted exceptions) increase of approximately 9% in its rates. - 2 - CBT filed its application on May 4, 1993. On November 25, CBT voluntarily filed several modifications to its initial proposal in response to concerns raised by various intervenors. The initial and modified plans sought a threshold rate increase of $17.1 million, or approximately a 5.5% increase in annual revenues. On January 31, 1994, the PUCO staff issued its evaluation of CBT's filing and recommended an annual revenue increase in the range of $6.6 million to $11.1 million. Thereafter, CBT and the intervenors filed objections to the staff's recommendation. The parties are involved in negotiations to settle the case. In the event that a settlement is not reached, hearings are expected to begin in April 1994. In 1991, the PSCK issued an order amending its prior format to be used by local exchange companies in Kentucky for setting charges for intrastate access for interexchange carriers. In this order, the PSCK ordered that rates and regulations should mirror those of the FCC with certain exceptions that may be considered for future mirroring based on the merits of each situation. INTERSTATE RATES. Approximately 22% of CBT's 1993 revenues and sales was derived from interstate and foreign services under FCC tariffs. The FCC has regulatory jurisdiction over services, rates and other matters relating to CBT's interstate operations. The FCC prescribes a uniform system of accounts applicable to telephone companies, separations procedures to be utilized in separating investments, expenses, taxes and reserves between the federal and state regulatory jurisdictions, and depreciation rates for interstate plant and facilities. The FCC's cost allocation rules specify requirements relative to the allocation of costs between regulated and non-regulated activities, as well as transactions between affiliated entities. CBT's cost allocation manual, setting forth its method for separating regulated and non-regulated activities consistent with the FCC's cost allocation rules, was approved, as modified by the FCC. CBT continues to review its cost allocation manual and to modify it as appropriate to reflect CBT's circumstances. The FCC also prescribes the rate of return which regulated carriers are authorized to earn on their regulated interstate business. The currently effective authorized rate of return is 11.25%. The FCC has yet to design a valid refund mechanism to replace its automatic refund rule to address instances where earnings exceed authorized levels for any monitoring period. The U.S. Court of Appeals for the District of Columbia Circuit previously found the FCC's automatic refund rule to be arbitrary and capricious. In the absence of FCC action, several complaints were filed pursuant to Section 208 of the Communications Act seeking refunds related to prior access periods in which CBT had allegedly exceeded the authorized rate of return. The FCC has awarded damages in these cases, thereby attempting to achieve the same results that were found improper in the previously overturned FCC rule. Cincinnati Bell has filed appeals to those FCC orders. CBT receives its principal interstate compensation from access charges paid by interexchange carriers and end users. Specifically, traffic sensitive switched access charges apply on a usage sensitive basis to recover costs associated with the use of CBT's switching and transmission - 3 - facilities. Special access charges recover costs of private line connections. CBT's non-traffic sensitive costs are recovered from subscribers on a flat rate basis (Subscriber Line Charges) and from interexchange carriers on a usage sensitive basis (Carrier Common Line Charges). Effective April 1, 1989, with the final step increase in the Subscriber Line Charges, the cap on residential and single line business Subscriber Line Charges increased to $3.50. Multi-line customers' Subscriber Line Charges have a $6.00 cap. The Carrier Common Line rate recovers the remaining non-traffic sensitive costs. The Regional Bell Operating Companies and certain Tier 1 local exchange carriers have converted to price cap regulation. During 1993, CBT elected to remain under traditional rate of return regulation. However, CBT has filed, and the FCC has approved effective January 15, 1994, CBT's Optional Incentive Regulation tariff which allows CBT to move from traditional rate of return regulation. COMPETITION. Regulatory, legislative and judicial decisions, new technologies and the convergence of other industries with the telecommunications industry are causes of increasing competition in the telecommunications industry. The range of communications services, the equipment available to provide and access such services and the number of competitors offering such services continue to increase. Federal and state regulators are encouraging changes that promote competition in the industry in the belief that increased competition will drive technological innovation, lower prices and improve service levels. Other means of communications that permit bypass of CBT's local exchange facilities either completely or partially are available and are growing, although CBT is unable to determine precisely to what extent such bypass may occur. Alternative Access Providers (AAPs), cable companies and wireless providers have all made clear their intent to compete for segments of the local exchange business. AAPs, who initially focused only on interstate private lines, are now gaining credibility and are offering an ever-expanding range of telecommunications services to large business customers, including switched services. Cable companies are upgrading and using their broadband networks to experiment with new video, data and voice services for both residential and business customers, as well as transport for intermediary customers. Wireless providers are testing new technologies, like Personal Communications Service (PCS), to provide an alternative to traditional local service lines. In addition, interexchange carriers are creating new value-added services based on Signaling System 7 and Advanced Intelligent Network technologies, similar to those under development by the local exchange companies. CBT's competitors range from small service bureaus to large interexchange carriers and multi-state cellular companies to joint ventures and other combinations of telecommunications and other companies. To stay competitive, CBT has upgraded and will continue to upgrade its telephone plant and network and to explore new services and technologies as sound business judgment dictates. It has constructed several optical fiber rings in and around the metropolitan Cincinnati area to permit it to offer redundancy in telecommunications services for business customers. CBT offers custom calling features that include Caller ID, Call Return, Call Block, Priority Forward, Repeat - 4 - Dialing and Number Privacy. In addition, CBT is attempting to determine the most effective means for it to participate in the PCS technology, the spectrums for which will be auctioned by the FCC in the fall of 1994. The effect of this competition on CBT will ultimately be determined by federal and state regulatory and legislative actions and the type, quality and cost of CBT's services. CBT continues to position itself in this rapidly changing and convergent environment in order to remain competitive. CINCINNATI BELL INFORMATION SYSTEMS INC. CBIS designs, markets and manages information systems and provides software products, consulting services, customer-care systems, billing systems and technical assistance for the global telecommunications industry. CBIS sells the majority of its products and services domestically but also serves clients in Australia, Canada, Japan, Mexico, Switzerland, The Netherlands and the United Kingdom. Its principal clients are telecommunications carriers, cellular communications providers and their resellers, and owners and operators of private communications networks. CBIS is the leading supplier of billing and customer-care systems for the rapidly growing U.S. cellular telephone industry. CBIS continues to develop open-systems, client-server architecture for customer-care and billing applications that could serve wireline, wireless and interexchange companies. These new systems form a foundation for more advanced solutions that CBIS expects to deliver to current and future clients. CBIS's new system for the cellular telephone industry is expected to be ready for initial client testing in mid-1994. The telecommunications information systems and services market is highly competitive. Such competition has increased in recent years and is likely to increase in the future. Some of CBIS's competitors have substantially greater financial and other resources more readily available than CBIS. Competition is based mainly on product quality, performance, price and the quality of customer service. Except for the U.S. cellular telephone market (where CBIS serves cellular companies that have a significant portion of the market), CBIS has small market shares in the other areas of its business and faces vigorous competition. In late 1993, the Company determined the need to reorganize CBIS. This reorganization focused on two phases. The first phase was the elimination of non-strategic and underperforming operations. This resulted in CBIS taking action to divest its holdings in its federal operation (CBIS Federal), consolidating its foreign data center's operations, and eliminating unprofitable domestic and international activities. The second phase of the plan was to reorganize the remaining operations into strategic business units. These actions began in 1993 and are expected to be completed in 1994. - 5 - MATRIXX MARKETING INC. MATRIXX concentrates on servicing business needs in the telephone marketing and related marketing service areas by offering an integrated package of services to its customers including, without limitation, inbound and outbound telephone marketing, marketing research, fulfillment, customer service centers, direct mail, database management and facilities management. MATRIXX has seven divisions: Custom Services, Business, Inbound Mountain, Inbound Central, Outbound, International and Research. The Custom Services Division designs customized client solutions for consumer markets with a dedicated staff and services uniquely tailored to the needs of each client. The Inbound Mountain, Inbound Central and Outbound Divisions enable clients to manage high volumes of inbound and outbound customer contacts in an environment of shared resources. The Inbound Mountain, Inbound Central and Outbound Divisions increase market awareness with rapid response to consumer requests for information or service. These divisions handle the needs of packaged goods manufacturers, financial services institutions and telecommunications companies. The Business Division provides sales and customer service personnel who act as the sales arm and/or marketing service representatives for the client. They take orders, sell by telephone and provide information about the client's promotion plans, quantity discounts and new products, both to retailers and distributors. The International Division operates in Europe from its headquarters in Paris and an office in the United Kingdom, offering business-to-business and business-to- customer telephone marketing, including toll-free services, direct response services and facilities management. The Research Division assists MATRIXX's clients to find and qualify customers before they offer a new product or service to the market. By offering full-service marketing research, MATRIXX can support its clients in their strategic planning and tactical decision-making process. The telephone marketing agency business in the United States is highly competitive, with MATRIXX's competitors ranging in size from very small firms offering special applications or short term projects to large independent firms and "in-house" divisions of potential client companies with size and capabilities equal to those of MATRIXX. The telephone marketing agency business in Europe is in the early stages of development. The business is very competitive and overcapacity exists in a market that has not developed very rapidly during the past several years. MATRIXX is one of several companies that have a leading position in Europe. OTHER BUSINESSES Most of the Company's business other than CBT, CBIS and MATRIXX is conducted by other subsidiaries of the Company or by partnerships in which the Company owns an interest. CBD provides printed Yellow Pages directories and other directory services. In addition, CBD publishes and provides the White Pages directories for CBT. CBD continually evaluates new product offerings in both the print and emerging electronic categories of distribution. CBLD is a reseller of long distance telecommunications services. CBLD sells high-quality, competitively-priced long distance services to residence customers and small to medium-sized businesses in Ohio, Indiana, Kentucky, Western Pennsylvania and Michigan. - 6 - Cincinnati Bell Supply Company engages in the purchase, sale and reconditioning of telecommunications and computer equipment to customers nationwide. CBD, CBLD and Cincinnati Bell Supply Company are faced with fierce competition from businesses offering similar products and services. Their success will be determined by how well they meet the changing market needs of their customers. Cincinnati Bell Properties Inc. owns certain real estate used by the Company. The Company (through its wholly owned subsidiary, Cincinnati Bell Cellular Systems Company) is a limited partner with a 45% interest in a limited partnership (of which Ameritech Mobile Phone Service of Cincinnati, Inc. is the general partner) in the cellular mobile telephone service business in the Greater Cincinnati, Columbus and Dayton areas. Cincinnati Bell Cellular Systems Company has commenced a lawsuit against Ameritech Mobile Phone Service of Cincinnati, Inc. asking that the partnership be dissolved. See "Legal Proceedings." Until January 1, 1994, the Company was a joint venturer with Anixter Bros., Inc. (a materials management firm) in the supply and distribution of telecommunications and electrical equipment and material in Ohio and Kentucky. The term of the joint venture expired as of December 31, 1993, and the joint venture was dissolved as of that date. Anixter Bros., Inc. has continued the business of the joint venture for its benefit, and the Company has commenced a lawsuit against Anixter Bros., Inc. See "Legal Proceedings." RELATIONSHIP WITH AT&T The Company and its subsidiaries are parties to several agreements with AT&T and its affiliates pursuant to which the Company and its subsidiaries either purchase equipment, materials, services and advice from AT&T and its affiliates or provide the same to AT&T and its affiliates. As a result of these agreements, during 1993 the Company and its subsidiaries together sold to AT&T and its affiliates approximately $127,925,000 of goods and services (excluding access line charges) and purchased from AT&T and its affiliates approximately $64,495,000 of goods and services. CAPITAL ADDITIONS The Company has been making large expenditures for construction of telephone plant and investments in its existing subsidiaries and new businesses. By reinvesting in its telephone plant, the Company expects to be able to introduce new products and services, respond to competitive challanges and increase the operating efficiency and productivity of its network. The following is a summary of capital additions for the years 1989 through 1993: - 7 - The total investment in telephone plant increased from approximately $1,229,539,000 at December 31, 1988 to approximately $1,430,822,000 at December 31, 1993, after giving effect to retirements but before deducting accumulated depreciation at either date. Anticipated capital additions in 1994 for the Company including all subsidiaries are approximately $160,000,000, of which $95,000,000 is for telephone plant. EMPLOYEES At December 31, 1993 the Company and its subsidiaries had approximately 14,700 employees, of whom approximately 18% are covered under collective bargaining agreements with the Communications Workers of America ("CWA"), which is affiliated with the AFL-CIO. Those agreements expire in May 1996 for CBT and September 1996 for CBIS. The number of employees at December 31, 1993 increased over December 31, 1992. The increase is due to the acquisition of WATS Marketing of America in November 1993. The Company expects to reduce the number of employees at CBIS as part of its reorganization plan that is expected to be completed in 1994. As part of the reorganization plan, CBIS plans to sell its federal operations which has approximately 1,000 employees. BUSINESS SEGMENT INFORMATION The amounts of revenues and sales, operating income, assets, capital additions and depreciation and amortization attributable to each of the business segments of the Company for the year ended December 31, 1993 is set forth in the table relating to business segment information in note (r) of the Notes to the Financial Statements in the Company's annual report to security holders, and such table is incorporated herein by reference. ITEM 2.		ITEM 2. PROPERTIES The property of the Company is principally the telephone plant of CBT, which does not lend itself to description by character and location of principal units. Central office equipment represents 40% of CBT's investment in telephone plant in service; land and buildings (occupied principally by central offices), including capitalized leases, represent 13%; telephone instruments and related wiring and equipment (including private branch exchanges), substantially all of which - 8 - are on the premises of customers, represent 2%; and connecting lines not on customers' premises, the majority of which are on or under public roads, highways or streets and the remainder on or under private property, represent 39%. Other property of the Company is principally computer equipment, computer software, furniture and fixtures. Substantially all of the installations of central office equipment and garages are located in buildings owned by CBT situated on land which it owns. Some CBT business and administrative offices are in rented quarters, most of which are included in capitalized leases. The Company owns and occupies a 120,000 square foot building in Erlanger, Kentucky, which is a training and education facility. CBIS, MATRIXX and other Company subsidiaries lease office space in various cities on commercially reasonable terms. Upon the expiration or termination of any such leases, these companies could obtain comparable office space. CBIS also leases some of the computer hardware, computer software and office equipment necessary to conduct its business pursuant to short term leases, some of which are capitalized leases. ITEM 3.	ITEM 3. LEGAL PROCEEDINGS None, except as described below. Cincinnati Bell Cellular Systems Company ("CBCSC") is a limited partner in a partnership (of which Ameritech Mobile Phone Service of Cincinnati, Inc. is the general partner) which provides cellular mobile telephone service in the Greater Cincinnati, Dayton and Columbus areas. The partnership operates in a 9,500 square mile area that contains a population of approximately four million people. On February 23, 1994, CBCSC filed an action in the Court of Chancery of the State of Delaware for New Castle County in which CBCSC seeks a dissolution of the limited partnership, the appointment of a liquidating trustee and damages against the general partner. CINCINNATI BELL CELLULAR SYSTEMS COMPANY V. AMERITECH MOBILE PHONE SERVICE OF CINCINNATI, INC., ET AL. On April 20, 1983, the Company and Anixter Bros., Inc. ("Anixter") formed a joint venture (the "Joint Venture") for the purpose of engaging in the distribution of electrical wire and cable, cable television products and telephone and communications products. The Joint Venture was to continue for approximately ten years, terminating on December 31, 1993. In 1993, several issues arose relating to the operation and the winding up of the Joint Venture. On November 11, 1993, the Company filed a Complaint against Anixter and the Joint Venture in the Court of Common Pleas for Hamilton County, Ohio. In its Complaint, the Company contends that (1) Anixter has refused to compensate the Company for the going concern value of the Joint Venture which Anixter had converted and/or will retain; and (2) Anixter, as the managing partner of the Joint Venture, has failed to account properly for the revenues and expenses of the Joint Venture. On December 14, 1993, Anixter removed the case to the federal district court for the Southern District of Ohio. On December 16, 1993, Anixter filed its Answer and Counterclaim. In its Counterclaim, Anixter alleges that the Company wrongfully - 9 - competed with the Joint Venture. CINCINNATI BELL INC. V. ANIXTER BROS., INC., ET AL. The Federal Communications Commission has issued orders that require CBT to refund to interexchange carriers certain amounts based on CBT's having exceeded targeted earning levels for interstate access services for the 1987-1988 access period. CBT has appealed the FCC orders, and its appeals have been consolidated with numerous other appeals involving similar issues pending in the U.S. Circuit Court of Appeals for the District of Columbia. MCI TELECOMMUNICATIONS CORP., ET AL. V. FCC AND USA. ITEM 4.	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matter was submitted to a vote of security holders in the fourth quarter of the fiscal year covered by this report. - -------------------------------------------- - 10 - EXECUTIVE OFFICERS AND SIGNIFICANT EMPLOYEES OF THE REGISTRANT (DURING 1993). The names, ages and positions of the executive officers and significant employees of the Company are as follows: Name Age Title - ---- --- ----- as of 3/31/94) Dwight H. Hibbard (a,b,c) 70 Chairman of the Board John T. LaMacchia (a,b,c) 52 President and Chief Executive Officer Raymond R. Clark (a) 56 Executive Vice President President and Chief Executive Officer of Cincinnati Bell Telephone Company Brian C. Henry 37 Executive Vice President and Chief Financial Officer Sheldon Horing (d) 57 Executive Vice President President and Chief Executive Officer of CBIS David J. Lahey (e) 55 Executive Vice President Chairman of MATRIXX Marketing Inc. William H. Zimmer III 40 Secretary and Treasurer Donald E. Hoffman 55 Senior Vice President-Administration of Cincinnati Bell Telephone Company Scott Aiken 58 Vice President - Public Relations of Cincinnati Bell Telephone Company James F. Orr (f) 48 President and Chief Executive Officer of MATRIXX Marketing Inc. William D. Baskett III (g) 54 General Counsel and Chief Legal Officer - ---------------------------------------- - 11 - (a) Member of Board of Directors. (b) Member of Executive Committee of Board of Directors. (c) Mr. Hibbard also served as the Chief Executive Officer ("CEO") until October 1, 1993. Mr. LaMacchia was elected CEO on October 1, 1993. Since October 1, 1993 Mr. Hibbard has continued to serve as Chairman. (d) Effective February 4, 1994, Mr. Horing resigned as an executive officer of the Company and as President and Chief Executive Officer of CBIS. (e) Effective February 4, 1994, Mr. Lahey was appointed President and Chief Executive Officer of CBIS. (f) Effective February 4, 1994, Mr. Orr was appointed Chief Operating Officer of CBIS. (g) Mr. Baskett is a significant employee as defined by Item 401(c) of Regulation S-K. Officers are elected annually but are removable at the discretion of the Board of Directors. DWIGHT H. HIBBARD, Chairman of the Company since January 1, 1985; Chief Executive Officer of the Company, 1985-September 30, 1993; President of the Company, 1983-1987; Chairman of Cincinnati Bell Telephone Company, 1985-October 31, 1993. Director of The Ohio National Life Insurance Company and Teradyne, Inc. JOHN T. LAMACCHIA, President and Chief Executive Officer of the Company since October 1, 1993; President of the Company since January 1, 1988; Chief Operating Officer of the Company, 1988-September 30, 1993; Chairman of Cincinnati Bell Telephone Company since November 1, 1993; Chairman of Cincinnati Bell Information Systems Inc. since October 1988 and President, 1983-1987. Director of Multimedia, Inc. and The Kroger Co. RAYMOND R. CLARK, Executive Vice President of the Company since January 1, 1987; Chief Executive Officer of Cincinnati Bell Telephone Company since January 1, 1988; President since January 1, 1987. Director of Star Banc Corporation and Xtek, Inc. BRIAN C. HENRY, Executive Vice President and Chief Financial Officer of the Company since March 29, 1993; Vice President and Chief Financial Officer of Mentor Graphics, February 1986 to March 28, 1993. SHELDON HORING, President and Chief Executive Officer of CBIS, January 1, 1991-February 4, 1994; Executive Vice President of the Company, January 1, 1993-February 4, 1994; President of CBIS Federal from January 1, 1990 to December 31, 1990; AT&T Network Systems Data Networking Vice President from January 1, 1989 to December 30, 1989. - 12 - DAVID J. LAHEY, President and Chief Executive Officer of CBIS since February 4, 1994; Executive Vice President of the Company since January 1, 1993; Chairman of MATRIXX Marketing Inc. since January 1, 1993; President and Chief Executive Officer of MATRIXX Marketing Inc., February 2, 1989 to December 31, 1992; Senior Vice President - Market Development of Cincinnati Bell Enterprises Inc., April 1, 1988 to February 1, 1989. WILLIAM H. ZIMMER III, Secretary and Treasurer of the Company since August 1, 1991; Secretary and Assistant Treasurer of the Company, December 1, 1988 to July 31, 1991. Assistant Secretary and Assistant Treasurer of the Company, April 20, 1987 to November 30, 1988. DONALD E. HOFFMAN, Senior Vice President-Administration of Cincinnati Bell Telephone Company since January 1, 1990; Vice President-Administration of Cincinnati Bell Telephone Company, February 1, 1988 to December 31, 1989; President of Cincinnati Bell Cellular Systems Inc., January 1, 1987 to January 31, 1988. SCOTT AIKEN, Vice President-Public Relations of Cincinnati Bell Telephone Company since May 13, 1985. JAMES F. ORR, Chief Operating Officer of CBIS since February 4, 1994; President and Chief Executive Officer of MATRIXX Marketing Inc. since January 1, 1993; Vice President Market Development January 1, 1989 to December 31, 1992; Vice President of Crush International Inc. January 1, 1986 to December 31, 1988. WILLIAM D. BASKETT III, General Counsel and Chief Legal Officer of the Company since July 1993; partner of Frost & Jacobs since 1970. - 13 - PART II ITEMS 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SECURITY HOLDER MATTERS. Cincinnati Bell Inc. (symbol: CSN) common shares are listed on the New York Stock Exchange and on the Cincinnati Stock Exchange. As of February 28, 1994 there were approximately 22,391 holders of record of the 65,094,358 outstanding Common Shares of the Company. The high and low sales prices and dividends declared per common share each quarter for the last two fiscal years are listed below. ITEMS 6 THROUGH 8. The information required by these items is included in the registrant's annual report to security holders for the fiscal year ended December 31, 1993 included in Exhibit 13 and is incorporated herein by reference pursuant to General Instruction G(2). ITEM 9.					ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. No disagreements with accountants on any accounting or financial disclosure occurred during the period covered by this report. PART III ITEMS 10 THROUGH 13. Information regarding executive officers required by Item 401 of Regulation S-K is furnished in a separate disclosure in Part I of this report under the caption "Executive Officers and Significant Employees of the Registrant" since the registrant did not furnish such information in its definitive proxy statement prepared in accordance with Schedule 14A. - 14 - The other information required by these items is included in the registrant's definitive proxy statement dated March 14, 1994 in the last paragraph on page 1, the accompanying notes on page 2 and the last paragraph on page 2, the information under "Election of Directors" on pages 5 through 7, the information under "Share Ownership of Directors and Officers" on pages 4 and 5, the information under, "Compensation Committee Report on Executive Compensation," "Executive Compensation" and "Performance Graphs" on pages 7 through 17, and the information under "Compensation Committee Interlocks and Insider Participation" on page 4. The foregoing is incorporated herein by reference pursuant to General Instruction G(3). - 15 - PART IV ITEM 14.					ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) Documents filed as a part of the report: (1) Consolidated Financial Statements: Page ---- Report of Management. . . . . . . . . . . . . . . . . . . . * Report of Independent Accountants . . . . . . . . . . . . . * Statements: Consolidated Statements of Income. . . . . . . . . . * Consolidated Statements of Common Shareowners' Equity . . . . . . . . . . . . . . . . . . . . . . . * Consolidated Balance Sheets. . . . . . . . . . . . . * Consolidated Statements of Cash Flows. . . . . . . . * Notes to Financial Statements. . . . . . . . . . . . * (2) Financial Statement Schedules: Report of Independent Accountants . . . . . . . . . . . . . 25 V - Telephone Plant and Other Property. . . . . . . . . 26 VI - Accumulated Depreciation. . . . . . . . . . . . . . 30 VIII - Valuation and Qualifying Accounts . . . . . . . . . 32 Financial statements and financial statement schedules other than those listed above have been omitted because the required information is contained in the financial statements and notes thereto, or because such schedules are not required or applicable. - ------------------------- Incorporated herein by reference to the appropriate portions of the registrant's annual report to security holders for the fiscal year ended December 31, 1993. (See Part II.) - 16 - (3) Exhibits: Exhibits identified in parentheses below, on file with the Securities and Exchange Commission ("SEC"), are incorporated herein by reference as exhibits hereto. Exhibit Number - ------- (3)(a) Amended Articles of Incorporation effective November 9, 1989. (Exhibit (3)(a) to Form 10-K for 1989, File No. 1-8519). (3)(b) Amended Regulations of the Registrant. (Exhibit 3.2 to Registration Statement No. 2-96054). (4)(a) Provisions of the Amended Articles of Incorporation and the Amended Regulations of the registrant which define the rights of holders of Common Shares and the Preferred Shares are incorporated by reference to such Amended Articles filed as Exhibit (3)(a) hereto and such Amended Regulations filed as Exhibit (3)(b) hereto. (4)(b)(i) Rights Agreement dated as of October 27, 1986 between the Company and Morgan Shareholder Services Trust Company, Rights Agent. (Exhibit (1) to Form 8-A, File No. 1-8519). (4)(b)(ii) First Amendment to Rights Agreement, dated as of October 3, 1988, between the Company and Morgan Shareholder Services Trust Company, Rights Agent. (Exhibit (4)(b)(ii) to Form 10-K for 1988, File No. 1-8519). (4)(c)(i) Indenture dated June 15, 1990 between Cincinnati Bell Inc. and The Bank of New York, Trustee, in connection with $75,000,000 of Cincinnati Bell Inc. Ten Year 9.10% Notes Due June 15, 2000. (Exhibit (4)(c)(ii) to Form 10-K for 1990, File No. 1-8519). Indenture dated December 15, 1992 between Cincinnati Bell Inc., Issuer, and The Bank of New York, Trustee, in connection with $100,000,000 of Cincinnati Bell Inc. 6.70% Notes Due December 15, 1997. A copy of this Indenture is not being filed because it is similar in all material respects to the Indenture filed as Exhibit (4)(c)(i) above. Indenture dated July 1, 1993 between Cincinnati Bell Inc., Issuer, and The Bank of New York,Trustee, in connection with $50,000,000 of Cincinnati Bell, Inc. 7 1/4% Notes Due June 15, 2023. Exhibit 4-A to Form 8-K, date of report July 12, 1993, File No. 1-8519. - 17 - (4)(c)(ii) Indenture dated December 27, 1989 among Cincinnati Bell Telephone Company, Issuer, Cincinnati Bell Inc., Guarantor, and The Bank of New York (Delaware), Trustee, in connection with $40,000,000 of Cincinnati Bell Telephone Company Guaranteed Ten Year 8 5/8% Notes, Due December 15, 1999. (Exhibit 4(c)(ii) to Form 10-K for 1992, File No. 1-8519). Indenture dated April 30, 1986 among Cincinnati Bell Telephone Company, Issuer, Cincinnati Bell Inc., Guarantor, and The Bank of New York (Delaware), Trustee, in connection with $40,000,000 of Cincinnati Bell Telephone Company Guaranteed Ten Year 7.30% Notes, Due April 30, 1996. A copy of this Indenture is not being filed because it is similar in all material respects to the Indenture filed as Exhibit (4)(c)(ii) above. (4)(c)(iii) Indenture dated August 1, 1962 between Cincinnati Bell Telephone Company and Bank of New York, Trustee (formerly, The Central Trust Company was trustee), in connection with $20,000,000 of Cincinnati Bell Telephone Company Forty Year 4 3/8% Debentures, Due August 1, 2002. (Exhibit 4(c)(iii) to Form 10-K for 1992, File No. 1-8519). Indenture dated October 1, 1958 between Cincinnati Bell Telephone Company and Bank of New York, Trustee (formerly, The Central Trust Company was trustee), in connection with $25,000,000 of Cincinnati Bell Telephone Company Thirty-Five Year 4 l/2% Debentures, Due October 1, 1993. A copy of this Indenture is not being filed because it is similar in all material respects to the Indenture filed as Exhibit (4)(c)(iii) above. Indenture dated August 1, 1971 between Cincinnati Bell Telephone Company and Bank of New York, Trustee (formerly The Fifth Third Bank was trustee), in connection with $50,000,000 of Cincinnati Bell Telephone Company Forty Year 7 3/8% Debentures, Due August 1, 2011. A copy of this Indenture is not being filed because it is similar in all material respects to the Indenture filed as Exhibit (4)(c)(iii) above. (4)(c)(iv) Indenture dated as of October 27, 1993 among Cincinnati Bell Telephone Company, as Issuer, Cincinnati Bell Inc., as Guarantor, and The Bank of New York, as Trustee. (Exhibit 4-A to Form 8-K, date of report October 27, 1993, File No. 1-8519). (4)(c)(v) No other instrument which defines the rights of holders of long term debt of the registrant is filed herewith pursuant to Regulation S-K, Item 601(b)(4)(iii)(A). Pursuant to this regulation, the registrant hereby agrees to furnish a copy of any such instrument to the SEC upon request. - 18 - (10)(ii)(B) Agreement Establishing Cincinnati SMSA Limited Partnership between Advanced Mobile Phone Service, Inc. and Cincinnati Bell Inc. executed on December 9, 1982. (Exhibit (10)(k) to Registration Statement No. 2-82253). (10)(iii)(A)(1)(i) Short Term Incentive Plan of Cincinnati Bell Inc., as amended February 3, 1986. (Exhibit (10)(iii)(A)1 to Form 10-K for 1986, File No. 1-8519). (10)(iii)(A)(1)(ii)* Amendment to Short Term Incentive Plan of Cincinnati Bell Inc. (effective December 5, 1988). (Exhibit (10)(iii)(A)(1)(ii) to Form 10-K for 1988, File No. 1-8519). (10)(iii)(A)(2)(i)* Cincinnati Bell Inc. Senior Management Long Term Incentive Plan, as amended January 1, 1984. (Exhibit (10)(iii)(A)2 to Form 10-K for 1986, File No. 1-8519). (10)(iii)(A)(2)(ii)* Amendment to Cincinnati Bell Senior Management Long Term Incentive Plan (effective December 5, 1988). (Exhibit (10)(iii)(A) (2)(ii) to Form 10-K for 1988, File No. 1-8519). (10)(iii)(A)(3)* Cincinnati Bell Inc. Deferred Compensation Plan for Non-Employee Directors, as amended July 1, 1983. (Exhibit (10)(iii)(A)3 to Form 10-K for 1986, File No. 1-8519). (10)(iii)(A)(4)* Cincinnati Bell Inc. Pension Program, as amended effective June 5, 1989. (Exhibit (10)(iii)(A)4 to Form 10-K for 1989, File No. 1-8519). (10)(iii)(A)5* Cincinnati Bell Inc. 1988 Incentive Award Deferral Plan, as amended (effective November 11, 1988). (Exhibit (10)(iii)(A)5 to Form 10-K for 1988, File No. 1-8519). (10)(iii)(A)(6)(i)* Cincinnati Bell Inc. Senior Management Incentive Award Deferral Plan, as amended January 1, 1984. (Exhibit (10)(iii)(A)6 to Form 10-K for 1986, File No. 1-8519). (10)(iii)(A)(6)(ii)* Amendment to Cincinnati Bell Senior Management Incentive Award Deferral Plan (effective December 5, 1988). (Exhibit (10)(iii)(A)(6)(ii) to Form 10-K for 1988, File No. 1-8519). (10)(iii)(A)(7)(i)* Cincinnati Bell Inc. 1984 Stock Option Plan, as amended January 7, 1987. (Exhibit (10) (iii)(A)7 to Form 10-K for 1986, File No. 1-8519). - --------------------------------------- * Management contract or compensatory plan required to be filed as an exhibit pursuant to Item 14(c) of Form 10-K. - 19 - (10)(iii)(A)(7)(ii)* Amendment to Cincinnati Bell 1984 Stock Option Plan (effective December 5, 1988). (Exhibit (10)(iii)(A)(7)(ii) to Form 10-K for 1988, File No. 1-8519). (10)(iii)(A)(8)(i)* Executive Employment Agreement dated December 1, 1987 between the Company and Dwight H. Hibbard. (Exhibit (10)(iii)(A)8 to Form 10-K for 1987, File No. 1-8519). (10)(iii)(A)(8)(ii)* Amendment to Executive Employment Agreement dated November 4, 1991 between the Company and Dwight H. Hibbard. (Exhibit (10)(iii) (A)(8)(ii) to Form 10-K for 1991, File No. 1-8519). (10)(iii)(A)(8)(iii)* Amendment to Executive Employment Agreement dated February 4, 1994 between the Company and Dwight H. Hibbard. (10)(iii)(A)(9)* Executive Employment Agreement dated December 1, 1987 between the Company and John T. LaMacchia. (Exhibit (10)(iii)(A)(10) to Form 10-K for 1987, File No. 1-8519). (10)(iii)(A)(10)* Executive Employment Agreement dated December 1, 1987 between the Company and Raymond R. Clark. (Exhibit (10)(iii)(A)11 to Form 10-K for 1987, File No. 1-8519). (10)(iii)(A)(11)* Compensation Agreement between the Company and Sheldon Horing, effective January 1, 1991. (Exhibit (10)(iii)(A)12 to Form 10-K for 1991, File No. 1-8519). (10)(iii)(A)(12)* Employment Agreement dated as of April 1, 1988 between the Company and David J. Lahey. (Exhibit (10)(iii)(A)16 to Form 10-K for 1991, as amended, File No. 1-8519). (10)(iii)(A)(13)* Employment Agreement dated as of February 7, 1994 between the Company and David J. Lahey. 10(iii)(A)(14)* Executive Employment Agreement dated as of March 29, 1993 between the Company and Brian C. Henry. 10(iii)(A)(15)(i)* Employment Agreement dated as of January 1, 1989 between the Company and James F. Orr. (10)(iii)(A)(15)(ii)* Amendment to Employment Agreement dated as of June 30, 1993 between the Company and James F. Orr. - ------------------------------------ * Management contract or compensatory plan required to be filed as an exhibit pursuant to Item 14(c) of Form 10-K. - 20 - 10(iii)(A)(16)* Employment Agreement dated as of December 31, 1993 between the Company and James F. Orr. 10(iii)(A)(17)* Cincinnati Bell Inc. Executive Deferred Compensation Plan (10)(iii)(A)(18)(i)* Cincinnati Bell Inc. 1988 Long Term Incentive Plan. (Exhibit (10)(iii)(A)(12) (i) to Form 10-K for 1988, File No. 1-8519). (10)(iii)(A)(18)(ii)* Amendment to Cincinnati Bell Inc. 1988 Long Term Incentive Plan (effective December 5, 1988). (Exhibit (10)(iii)(A)(12)(ii) to Form 10-K for 1988, File No. 1-8519). (10)(iii)(A)(19)* Cincinnati Bell Inc. 1988 Stock Option Plan for Non-Employee Directors. (Exhibit (10)(iii)(A)13 to Form 10-K for 1988, File No. 1-8519). (10)(iii)(A)(20)* Cincinnati Bell Inc. 1989 Stock Option Plan. (Exhibit (10)(iii)(A)14 to Form 10-K for 1989, File No. 1-8519). (10)(iii)(A)(21)* Cincinnati Bell Inc. Retirement Plan for Outside Directors. (11) Computation of Earnings per Common Share. (12) Computation of Ratio of Earnings to Combined Fixed Charges and Preferred Dividends. (13) Portions of the Cincinnati Bell Inc. annual report to security holders for the fiscal year ended December 31, 1993 as incorporated by reference including the Selected Financial Data, Management's Discussion and Analysis and Consolidated Financial Statements. (21) Subsidiaries of the Registrant. (23) Consent of Independent Accountants. (24) Powers of Attorney. (28)(a) Annual Report on Form 11-K for the Cincinnati Bell Inc. Retirement Savings Plan (formerly the Cincinnati Bell Inc. Savings Plan for Salaried Employees) for the year 1993 will be filed by amendment on or before April 30, 1994. - ------------------------------------- Management contract or compensatory plan required to be filed as an exhibit pursuant to Item 14(c) of Form 10-K. - 21 - (28)(b) Annual Report on Form 11-K for the Cincinnati Bell Inc. Savings and Security Plan for the year 1993 will be filed by amendment on or before April 30, 1994. (28)(c) Annual Report on Form 11-K for the MATRIXX Marketing Inc. Profit Sharing/401(k) Plan for the year 1993 will be filed by amendment on or before April 30, 1994. The Company will furnish, without charge, to a security holder upon request, a copy of the documents, portions of which are incorporated by reference (Annual Report to security holders and proxy statement), and will furnish any other exhibit at cost. (b) Reports on Form 8-K. (1) Form 8-K, dated October 26, 1993, reporting that Cincinnati Bell Inc. announced its earnings for the third quarter of 1993. (2) Form 8-K, dated October 27, 1993, reporting that Cincinnati Bell Telephone Company had set up its Medium-Term Note program with Morgan Stanley & Co., Incorporated, Merrill Lynch & Co., and Merrill Lynch, Pierce, Fenner & Smith Incorporated. - 22 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. CINCINNATI BELL INC. March 29, 1994 By /s/JOHN T. LAMACCHIA --------------------------- John T. LaMacchia, 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 date indicated. SIGNATURE TITLE DATE --------- ----- ---- Principal Executive Officer; President, Chief Executive JOHN T. LAMACCHIA Officer and Director - ------------------------------ Principal Accounting and Financial Officer; Executive Vice President and BRIAN C. HENRY* Chief Financial Officer - ------------------------------ Brian C. Henry JOHN F. BARRETT* Director - ------------------------------ John F. Barrett PAUL W. CHRISTENSEN, JR.* Director - ------------------------------ Paul W. Christensen, Jr. RAYMOND R. CLARK* Director - ------------------------------ Raymond R. Clark PHILLIP R. COX* Director - ------------------------------ Phillip R. Cox - 23 - SIGNATURE TITLE --------- ----- WILLIAM A. FRIEDLANDER* Director - ------------------------------ William A. Friedlander Chairman of the Board DWIGHT H. HIBBARD* and Director - ------------------------------ Dwight D. Hibbard ROBERT P. HUMMEL, M.D.* Director - ------------------------------ Robert P. Hummel, M.D. JAMES D. KIGGEN* Director - ------------------------------ James D. Kiggen DAVID B. SHARROCK* Director - ------------------------------ David B. Sharrock *By /s/JOHN T. LAMACCHIA March 29, 1994 --------------------------- John T. LaMacchia as attorney-in-fact and on his own behalf as President and Chief Executive Officer and Director - 24 - REPORT OF INDEPENDENT ACCOUNTANTS To the Shareowners of Cincinnati Bell Inc. Our report on the consolidated financial statements of Cincinnati Bell Inc. has been incorporated by reference in this Form 10-K from page 39 of the 1993 annual report of Cincinnati Bell Inc. In connection with our audits of such consolidated financial statements, we have also audited the related financial statement schedules listed in the index on page 16 of this Form 10-K. In our opinion, the financial statement schedules referred to above, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. /s/ COOPERS & LYBRAND COOPERS & LYBRAND Cincinnati, Ohio February 11, 1994 - 25 - Schedule V - Sheet 1 CINCINNATI BELL INC. SCHEDULE V - TELEPHONE PLANT AND OTHER PROPERTY (Thousands of Dollars) - 26 - Schedule V - Sheet 2 CINCINNATI BELL INC. SCHEDULE V - TELEPHONE PLANT AND OTHER PROPERTY (Thousands of Dollars) - 27 - Schedule V - Sheet 3 CINCINNATI BELL INC. SCHEDULE V - TELEPHONE PLANT AND OTHER PROPERTY (Thousands of Dollars) - 28 - Schedule V - Sheet 4 (a) Additions shown include (1) the original cost (estimated if not known) of reused material, which is concurrently credited to Material and supplies, and (2) Interest charged construction. Transfers between the classifications listed are included in this column, except as indicated in note (c). (b) Items of telephone plant when retired or sold are deducted from the property accounts at the amounts at which they are included therein, estimated if not known. (c) Transferred (to) from non-telephone company operations. (d) The Company's provision for depreciation is based on the remaining life method of depreciation and straight-line composite rates. The remaining life method provides for the full recovery of the investment in telephone plant. The provision for depreciation of information systems property and other property is based on the straight-line method over the estimated useful life. (e) Other changes include the following: 1) Reclassification of property and 2) Revaluation of assets acquired during the year as part of a business acquisition in order to record them at their fair value in accordance with APB 16 "Business Combinations". (f) Capitalized lease balances were adjusted to remove executory costs that were originally capitalized. (g) Includes certain capitalized software costs which were written-down as the result of the information systems segment determination of the need to re- direct the development of some of its software products. (h) Includes amounts removed from property accounts related to the reserve set up the prior year for the write down of certain capitalized software costs. The primary product that was reserved for in 1991 was NS/90, a cellular customer billing support system. - 29 - Schedule VI - Sheet 1 CINCINNATI BELL INC. SCHEDULE VI - ACCUMULATED DEPRECIATION (Thousands of Dollars) - 30 - Schedule VI - Sheet 2 (a) Comprised principally of (1) proceeds from sales of telephone plant accounted for as required by the FCC and (2) depreciation provision for vehicles and other work equipment charged initially to clearing accounts and apportioned to Maintenance, Telephone Plant and other accounts on the basis of the usage of such equipment. Other, also includes recoveries from retired property. (b) Includes accumulated depreciation on assets which were acquired during the year as part of a business acquisition. In accordance with APB 16, the assets have been recorded at their fair value by recording original cost less accumulated depreciation. (c) Includes $17 million and $10.5 million recorded in 1993 and 1991, respectively to reduce the carrying value of certain capitalized software costs to net realizable value. (d) Includes amounts removed from the reserve recorded in the prior year related to the write down of certain capitalized software costs to net realizable value. - 31 - Schedule VIII CINCINNATI BELL INC. SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS (Thousands of Dollars) - 32 -
316901_1993.txt	316901	1993	ITEM 1. BUSINESS GENERAL DESCRIPTION OF BUSINESS UST Corp. (the "Company"), a bank holding company registered with the Board of Governors of the Federal Reserve System (the "Federal Reserve Board"), was organized as a Massachusetts business corporation in 1967. The Company is also subject to examination by, and is required to file reports with, the Commissioner of Banks of the Commonwealth of Massachusetts (the "Massachusetts Commissioner"). The Company's banking subsidiaries are USTrust and United States Trust Company ("USTC"); each headquartered in Boston and each a Massachusetts trust company and UST Bank/Connecticut ("UST/Conn") headquartered in Bridgeport, a Connecticut trust company. All of the common stock of USTrust, USTC, and UST/Conn is issued to and owned by the Company. In addition, the Company owns, directly or indirectly, all of the outstanding stock of three active nonbanking subsidiaries, all Massachusetts corporations: UST Leasing Corporation, UST Data Services Corp. and UST Capital Corp. Through its banking and nonbanking subsidiaries, the Company provides a broad range of financial services, principally to individuals and small-and medium-sized companies in New England. In addition, an important component of the Company's financial services is the provision of trust and money management services to professionals, corporate executives, nonprofit organizations, labor unions, foundations, mutual funds and owners of closely-held businesses in the New England region. As of the close of business on December 31, 1993, the Company's total assets were approximately $2.0 billion and USTrust, the lead bank, had over $1.9 billion or 93% of the Company's consolidated assets. THE SUBSIDIARY BANKS USTrust and UST/Conn are engaged in a general commercial banking business and accept deposits which are insured by the Federal Deposit Insurance Corporation ("FDIC"). USTC, which has full banking powers and accepts deposits which are insured by the FDIC, focuses its activity on trust and money management and other fee generating businesses. Two of the Company's banking subsidiaries are located in Massachusetts and one is located in Connecticut. RECENT DEVELOPMENTS Recent Operating History The Company reported a loss of $20.1 million, or $1.31 per share, for 1993, resulting primarily from a loan loss provision of $42.7 million in the second quarter and writedowns of certain nonperforming assets. In addition, the Company incurred net losses in each of the two preceding recent fiscal years. See Note 19 to Consolidated Financial Statements of the Company. Proposed New Standards on Safety and Soundness -- Asset Quality Proposed regulations covering standards for safety and soundness at banks and bank holding companies have been put forth by the Company's primary federal banking regulators as required by Section 132 of the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"). Included in the proposal are standards (1) dealing with the maximum amount of classified assets an institution may have and (2) defining a minimum earnings amount. Failure to meet these standards would require the filing of a compliance action plan with and acceptable to the Company's supervisory agencies. If the proposed regulations were to be adopted in their present form, the Company would not have been in compliance with the first standard at December 31, 1993. The federal banking regulators have not publicly indicated at this time when passage of final regulations in this area will occur or whether final regulations will be substantially similar to those proposed. At December 31, 1993, the Company had approximately $49.3 million in nonaccrual loans, $.5 million in accruing loans 90 days or more past due, $41.5 million in restructured loans, $19.5 million in other real estate owned and $12 million in Special Mention loans 30 to 89 days past due and accruing. In addition, the Company had approximately $185 million of accruing commercial and real estate loans which, while current, have nonetheless been classified as Special Mention or Substandard in the Company's internal risk rating profile. Under the Company's definition, Substandard assets are characterized by the distinct possibility that some loss will be sustained if the credit deficiencies are not corrected. The Substandard classification, however, does not necessarily imply ultimate loss for each individual asset so classified. Special Mention assets, as defined by the Company, have potential weaknesses that deserve management's close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the assets. The risk ratings assigned to these loans were an important factor in the Company's analysis of the adequacy of its reserve for loan losses. The above-described, proposed regulations, if implemented in their current form, however, may require the Company to reduce significantly the level of these loans. Among the responses available to the Company, in this event, is a further acceleration of the Company's strategy to handle problem credits expeditiously. It is not possible to predict the future effects on the Company's financial condition or results of operations of actions which may be taken by the Company in response to final regulations in this area. Management of the Company has identified the reduction of the aggregate amount of non-performing and classified assets as a high priority. Management will continue to assess its alternatives with a view to implementing the most effective means of achieving such reduction. Potential Regulatory Sanctions Certain apparent and inadvertent violations of the insider lending provisions (and related lending limit provisions) of Regulation O of the FRB related to extensions of credit by USTrust to Director Francis X. Messina have led the FDIC to require that corrective action be taken and to advise USTrust orally that the FDIC may consider the imposition of civil money penalties with respect to such matters. No FDIC representative has suggested to USTrust or the Company that there was any willful or intentional misconduct on the part of USTrust, Director Messina or USTrust's other institution-affiliated parties in connection with these matters. To address these issues, USTrust and Director Messina have undertaken a program to reduce the aggregate balance of Mr. Messina's outstanding loans from USTrust and to improve the collateral support for the remaining outstanding loan balance. The elements of this program have been communicated to and reviewed by the FDIC. In furtherance of the program, since late 1993, the outstanding principal of the aggregate loans to Director Messina and his related interests has been reduced by more than $11 million from approximately $30 million to less than $19 million, and such loans are now below all applicable lending limits. To date, the Company has incurred no losses with respect to any of these loans, although they are characterized as "Substandard" in the Company's internal risk rating profile, and all such loans are current as to both principal and interest. There has been no further action taken by any bank regulatory agency to date. The FDIC has the authority to levy civil money penalties of various amounts for violations of law or regulations, orders and written conditions and agreements, which, depending upon the nature and severity of the violations, may be, in situations where conduct has been egregious, as high as $1 million per day for the period during which such violation continues. In connection with the apparent violations described above, the FDIC has the authority to impose penalties on any of USTrust, its Board of Directors, officers of the Bank, Director Messina personally, "institution-affiliated parties" of USTrust or any combination thereof. While it is not possible to predict with certainty the probability of penalties being assessed, the person or persons upon whom any penalty would be assessed or the amounts of any such penalties, were they to be assessed, management of the Company believes that it is unlikely that this matter will have a material adverse effect on the Company's financial condition or results of operations. Consequently, no provision in respect of penalties has been made in the Company's Consolidated Financial Statements. See Note 15 to Consolidated Financial Statements of the Company. Bank Regulatory Agreements and Orders In February 1992, USTC and USTrust entered into separate consent agreements and orders with the FDIC and the Massachusetts Commissioner. In mid-1992 and 1993, UST/Conn agreed to two addenda to its 1991 stipulation and agreement with the Connecticut Commissioner. The Company also entered into a written agreement with the Federal Reserve Bank of Boston (the "FRB-Boston") and the Massachusetts Commissioner in August 1992 (The foregoing are hereinafter collectively referred to as the "Regulatory Agreements."). In February 1994, the FDIC and the Massachusetts Commissioner terminated and lifted the Consent Agreement and Order with USTC. The Regulatory Agreements require that the Company, USTrust and UST/Conn refrain from paying dividends without prior regulatory consent and the Company has not paid a cash dividend to its stockholders since July 1991. Despite the termination of its Regulatory Agreement, USTC has agreed to continue to request regulatory consent prior to the payment of dividends. The Regulatory Agreements further require USTrust and UST/Conn to maintain Tier I leverage capital ratios at or in excess of 6%. Each of the Company's subsidiary banks is currently in compliance with its respective capital requirements. As provided in the Regulatory Agreements, the Company, USTrust and UST/Conn have instituted plans to reduce levels of nonperforming assets and have developed written plans and policies concerning, among other matters, credit administration, loan review and intercompany transactions. USTrust and UST/Conn have also revised and expanded their investment and funds management policies as required by the Regulatory Agreements. Moreover, the Company has agreed to give the FRB-Boston and the Massachusetts Commissioner prior notice of certain significant expenditures and certain increases in management compensation. The Company has filed (and will continue to file) with the regulatory agencies a broad range of periodic reports. For a discussion of capital in the context of the Regulatory Agreements, see "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Capital" below. For a discussion of related-party transactions, see Note 14 to Consolidated Financial Statements. BUSINESS SERVICES USTrust and UST/Conn provide commercial banking services, including deposit, investment, cash management, payroll, wire transfer, leasing and lending services throughout New England. Commercial and industrial lending takes the form primarily of direct loans and includes lines of credit, revolving credits, domestic and foreign letters of credit, term loans, mortgage loans, receivable, inventory and equipment loans and other specialized lending services. USTrust also provides merchant credit card services. USTC provides deposit services and other banking services, but focuses its activities on money management and other fee generating services. Through loan participations, each bank is able to provide credit to businesses in its area up to the limit available to the combined banks. At December 31, 1993, the combined lending limit to a single borrower of the subsidiary banks was approximately $28 million. CONSUMER SERVICES Consumer services are provided by USTrust and UST/Conn to customers in their respective areas. These services include savings and checking accounts, NOW and money market accounts, consumer loans, night depositories, credit cards (through a private label arrangement), safe deposit box facilities and travelers' checks. In late 1993, the Company introduced a Choice Checking retail account product which combines a relatively modest fee structure with ancillary travel, insurance and other "lifestyle" benefits. Consumer loans include residential first mortgage and home equity loans and loans to finance education costs as well as open-ended credit via cash reserve facilities. In 1993, the Company introduced an Affordable Mortgage Program designed to provide certain customers who may not qualify for traditional mortgage financing with an alternate means of financing or refinancing a residence. The Company's banking subsidiaries, which currently have an aggregate of 34 banking offices, maintain an automated teller machine system which through membership in the NYCE, Cirrus and Yankee 24 ATM networks provides the Company's customers with access to their accounts at locations throughout the United States. The Company provides a broad range of services in connection with its consumer automobile lending program. The Company's banking subsidiaries offer an integrated Preferred Banking Services which combines a wide range of the Company's retail banking products. SPECIALIZED SERVICES FOR INDIVIDUALS The Company provides services to meet the financial needs of individuals, such as self-employed professionals, corporate executives and entrepreneurs. The Company's services include deposit accounts, specialized credit facilities, an account management system for escrow funds, consumer banking and other personal financial products. REAL ESTATE SERVICES USTrust and UST/Conn provide a broad range of industrial and commercial real estate lending services, residential mortgage banking services and other related financial services. ASSET AND MONEY MANAGEMENT AND TRUST SERVICES Asset and money management, custodial and trust services are provided by USTC. In addition, USTC provides services as executor, administrator and trustee of estates and acts, under the terms of agreements, in various capacities such as escrow agent, bond trustee and trustee and agent of pension, profit-sharing and other employee benefit trusts. At December 31, 1993, the total assets under management of USTC were approximately $3.3 billion. INVESTMENTS The subsidiary banks maintain securities portfolios consisting primarily of U.S. Government Agency, corporate and municipal securities. USTrust's investment portfolio also includes certain other equity investments as allowed within limits prescribed by Massachusetts law. The Treasury Division of the Company provides investment portfolio advisory services to its affiliated banks. PRINCIPAL NONBANKING SUBSIDIARIES UST Leasing Corporation, organized in 1987 and a subsidiary of USTrust provides a broad range of equipment leasing services to major corporations headquartered throughout the United States. In 1994, UST Leasing Corporation intends to develop a line of leasing products designed to meet the needs of the Company's small business customers and other business entities with similar needs. UST Data Services Corp., organized in 1981 and a subsidiary of USTrust provides a full range of electronic data processing services to the Company and its affiliates. UST Capital Corp., organized in 1961, was acquired by the Company in 1969, is a subsidiary of USTC and is a licensed Small Business Investment Company. It specializes in equity and long-term debt financing for growth-oriented companies. COMPETITIVE CONDITIONS The Company's banking and nonbanking subsidiaries face substantial competition throughout Massachusetts and Connecticut. This competition is provided by commercial banks, savings banks, credit unions, consumer finance companies, insurance companies, "nonbank banks," money market mutual funds, government agencies, investment management companies, investment advisors, brokers and investment bankers. In addition, the Company anticipates increased competition from out-of-state and foreign banks and bank holding companies as those entities increase their usage of interstate banking powers granted during the past few years. During the past several years, acquisitions of small-and medium-sized banks and bank holding companies by the largest New England bank holding companies and the closing by regulators of a number of banks and bank holding companies in Eastern Massachusetts and Connecticut has resulted in fewer but financially stronger competitors in the local markets served by the Company's banking subsidiaries. SUPERVISION AND REGULATION OF THE COMPANY AND ITS SUBSIDIARIES GENERAL As a bank holding company registered under the Bank Holding Company Act of 1956, as amended, the Company is subject to substantial regulation and supervision by the Federal Reserve Board. As state-chartered banks, USTC, USTrust and UST/Conn (collectively, the "Subsidiary Banks") are subject to substantial regulation and supervision by the FDIC and the applicable state bank regulatory agencies. Such activities are often intended primarily for the protection of depositors or are aimed at carrying out broad public policy goals that may not be directly related to the financial services provided by the Company and its subsidiaries. Federal and state banking and other laws impose a number of requirements and restrictions on the business operations, investments and other activities of depository institutions and their affiliates. Since 1992, the Company and its banking subsidiaries have been operating under regulatory agreements and orders with state and federal bank regulatory authorities. In February 1994, the order under which USTC was operating was lifted and terminated. See "Recent Developments -- Bank Regulatory Agreements and Orders" above. GENERAL SUPERVISION AND REGULATION The Company, as a bank holding company under the Bank Holding Company Act of 1956, as amended in 1970 (the "BHC Act"), is registered with the Federal Reserve Board and is regulated under the provisions of the BHC Act. Under the BHC Act the Company is prohibited, with certain exceptions, from acquiring direct or indirect ownership or control of more than 5% of the voting shares of any company which is not a bank and from engaging in any business other than that of banking, managing or controlling banks or furnishing services to, or acquiring premises for, its affiliated banks, except that the Company may engage in and own voting shares of companies engaging in certain activities determined by the Federal Reserve Board, by order or by regulation, to be so closely related to banking or to managing or controlling banks "as to be a proper incident thereto." The location of nonbank subsidiaries of the Company is not restricted geographically under the BHC Act. In 1989, after the passage of the Financial Institutions Reform, Recovery and Enforcement Act of 1989 ("FIRREA"), the Federal Reserve Board amended its regulations under the BHC Act to permit bank holding companies, as a nonbanking activity, to own and operate savings associations without geographical restrictions. The Company is required by the BHC Act to file with the Federal Reserve Board an annual report and such additional reports as the Federal Reserve Board may require. The Federal Reserve Board also makes examinations of the Company and its subsidiaries. The BHC Act requires every bank holding company to obtain the prior approval of the Federal Reserve Board before it may acquire substantially all of the assets of any bank, or ownership or control of any voting shares of any bank, if, after such acquisition, it would own or control, directly or indirectly, more than 5% of the voting shares of such bank. Because the Company is also a bank holding company under the Massachusetts General Laws, the Massachusetts Commissioner has authority to require certain reports from the Company from time to time and to examine the Company and each of its subsidiaries. The Massachusetts Commissioner also has enforcement powers designed to prevent banks from engaging in unfair methods of competition or unfair or deceptive acts or practices involving consumer transactions. Prior approval of the Massachusetts Board of Bank Incorporation is also required before the Company may acquire any additional commercial banks located in Massachusetts or in those states which permit acquisitions of banking institutions located in their states by Massachusetts bank holding companies. The Connecticut General Statutes require that the Company furnish to the Connecticut Commissioner such reports as the Connecticut Commissioner deems appropriate to the proper supervision of the Company. The Connecticut Commissioner is also authorized to make examinations of the Company and its Connecticut subsidiaries including UST/Conn, and to order the Company to cease and desist from engaging in any activity which constitutes a serious risk to the financial safety, soundness or stability of a Connecticut subsidiary bank, or is inconsistent with sound banking principles or the provisions of Chapter 658 (the banking statute) of the Connecticut General Statutes. The Subsidiary Banks, whose deposits are insured by the FDIC, and the subsidiaries of such banks are subject to a number of regulatory restrictions, including certain restrictions upon: (i) extensions of credit to the Company and the Company's nonbanking affiliates (collectively with the Company, the "Affiliates"), (ii) the purchase of assets from Affiliates, (iii) the issuance of a guarantee, acceptance of letter of credit on behalf of Affiliates and (iv) investments in stock or other securities issued by Affiliates or acceptance thereof as collateral for an extension of credit. In addition. all transactions among the Company and its direct and indirect subsidiaries must be made on an arm's length basis and valued on fair market terms. The Subsidiary Banks pay substantial deposit insurance premiums to the FDIC. Such deposit premium rates were substantially increased in 1992. They were further increased for the first half of 1993 and decreased in the second half of 1993 pursuant to regulations issued under the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"). Federal Reserve Board Policy requires bank holding companies to serve as a source of strength to their subsidiary banks by standing ready to use available resources to provide adequate capital funds to subsidiary banks during periods of financial stress or adversity. A bank holding company also can be liable under certain provisions of FDICIA for the capital deficiencies of an undercapitalized bank subsidiary. In the event of a bank holding company's bankruptcy under Chapter 11 of the U.S. Bankruptcy Code, the trustee will be deemed to have assumed and is required to cure immediately any deficit under any commitment by the debtor to any of the federal banking agencies to maintain the capital of an insured depository institution, and any claim for breach of such obligation will generally have priority over most other unsecured claims. Under the cross-guarantee provisions of the Federal Deposit Insurance Act, if any or all of the Subsidiary Banks were placed in conservatorship or receivership, the Company, as sole stockholder, would likely lose its investment in the applicable Subsidiary Bank or Subsidiary Banks. The Company and all its subsidiaries are also subject to certain restrictions with respect to engaging in the issue, flotation, underwriting, public sale or distribution of certain types of securities. In addition, under both Section 106 of the 1970 Amendments to the BHC Act and regulations which have been issued by the Federal Reserve Board, the Company and its subsidiaries are prohibited from engaging in certain tie-in arrangements in connection with any extension of credit, lease or sale of any property or the furnishing of any service. Various consumer laws and regulations also affect the operations of the Subsidiary Banks. The Subsidiary Banks, two of which are chartered under Massachusetts law and one of which is chartered under Connecticut law, are subject to federal requirements to maintain cash reserves against deposits, and to state mandated restrictions upon the nature and amount of loans which may be made by the banks (including restrictions upon loans to "insiders" of the Company and its subsidiary banks) as well as to restrictions relating to dividends, investments, branching and other bank activities. See "Recent Developments -- Potential Regulatory Sanctions." FDICIA prescribes the supervisory and regulatory actions that will be taken against undercapitalized insured depository institutions for the purposes of promptly resolving problems at such institutions at the least possible long-term loss to the FDIC. Five categories of depository institutions have been established by FDICIA in accordance with their capital levels: "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized," and "critically undercapitalized." The federal banking agencies have adopted uniform regulations to implement the prompt regulatory action provisions of FDICIA. Under the uniform regulations, a well-capitalized institution has a minimum tier 1 capital-to-total risk-based assets ratio of 6 percent, a minimum total capital-to-total risk-based assets ratio of 10 percent and a minimum leverage ratio of 5 percent and is not subject to any written capital order or directive. An adequately capitalized institution meets all of its minimum capital requirements under the existing capital adequacy guidelines. An undercapitalized institution is one that fails to meet any one of the three minimum capital requirements. A significantly undercapitalized institution has a tier 1 capital-to-total risk-based assets ratio of less than 3 percent, a tier 1 leverage ratio of less than 3 percent or a total capital-to-total risk-based assets ratio of less than 6 percent. A critically undercapitalized institution has a tier 1 leverage ratio of 2 percent or less. An institution whose capital ratios meet the criteria for a well capitalized institution may be classified as an adequately capitalized institution due to qualitative and/or quantitative factors other than capital adequacy. An adequately capitalized institution or undercapitalized institution, may under certain circumstances, be required to comply with supervisory action as it if were in the next lower category. An undercapitalized institution is required to submit a capital restoration plan for acceptance by the appropriate federal banking agency and will be subject to close monitoring of both its condition and compliance with. and progress made pursuant to, its capital restoration plan. The capital restoration plan will be accepted only if (i) it specifies the steps that will be taken to become adequately capitalized and the activities in which the institution will engage, (ii) it is based upon realistic assumptions and it is likely to succeed in restoring the institution's capital, (iii) it does not appreciably increase the institution's risk exposure and (iv) each holding company that controls the institution provides appropriate assurances of performance and guaranties that the institution will comply with the plan until the institution is adequately capitalized on an average basis for each of four consecutive quarters. Liability under the guaranty is the lesser of (i) five percent of the institution's total assets at the time it become undercapitalized and (ii) the amount necessary to bring the institution into compliance with all applicable capital standards as of the time the institution fails to comply with the plan. An institution that fails to submit an acceptable plan may be placed into conservatorship or receivership unless its capital restoration plan is accepted. An undercapitalized institution will also be subject to restrictions on asset growth, acquisitions, branching, new activities, capital distributions and the payment of management fees. FDICIA requires the appropriate regulatory agencies to take one or more specific actions against significantly undercapitalized institutions and undercapitalized institutions that fail to submit capital restoration plans, which actions include but are not limited to (i) requiring the institution to sell shares or other obligations to raise capital, (ii) limiting deposit interest rates, (iii) requiring the election of a new board of directors and/or dismissing senior executive officers and directors who held such positions for more than 180 days before the institution became undercapitalized, (iv) prohibiting receipt of deposits from correspondent banks, (v) requiring divestiture or liquidation of one or more subsidiaries and (vi) requiring the parent company to divest the institution if such divestiture will improve the institution's financial condition and future prospects. In addition, an insured institution that receives a less-than-satisfactory rating for asset quality, management, earnings or liquidity may be deemed by its appropriate federal banking regulator to be engaging in an unsafe or unsound practice for purposes of issuing an order to cease and desist or to take certain affirmative actions. If the unsafe or unsound practice is likely to weaken the institution, cause insolvency or substantial dissipation of assets or earnings or otherwise seriously prejudice the interest of depositors or the FDIC, a receiver or conservator could be appointed. Finally, subject to certain exceptions FDICIA requires critically undercapitalized institutions to be placed into receivership or conservatorship within 90 days after becoming critically undercapitalized. The Federal Reserve Board has indicated that it will consult with each federal banking agency regulating the bank subsidiaries of a holding company to monitor required supervisory actions, and based upon an assessment of these developments, will take appropriate action at the holding company level. Under FDICIA, federal bank regulators are also required to see that changes are made in the operations and/or management of a bank or bank holding company if the financial institution is deemed to be "undercapitalized." Under FDICIA. a depository institution that is "adequately capitalized" but not "well capitalized" is generally prohibited from accepting brokered deposits and offering interest rates on deposits higher than the prevailing rate in its market. In addition, "pass through" insurance coverage may not be available for certain employee benefit accounts. The Company believes that the application of these limitations to it would not have a material effect on its funding or liquidity. USTC is currently classified as "well capitalized" and USTrust and UST/Conn are each currently classified as "adequately capitalized". New regulations adopted pursuant to FDICIA include: (1) real estate lending standards for depository institutions, which provide guidelines concerning loan-to-value ratios for various types of real estate loans; (2) rules requiring depository institutions to develop and implement internal procedures to evaluate and control credit and settlement exposure to their correspondent banks: (3) rules implementing the FDICIA provisions prohibiting, with certain exceptions, insured state banks from making equity investments or engaging in activities of the types and amounts not permissible for national banks; and (4) rules and guidelines for enhanced financial reporting and audit requirements. Rules currently proposed for adoption pursuant to FDICIA include: (1) revisions to the risk-based capital guidelines regarding interest rate risk, concentrations of credit risk and the risks posed by "nontraditional activities;" and (2) rules addressing various "safety and soundness" issues, including operations and managerial standards, standards for asset quality, earnings and compensation standards. See "Recent Developments -- Proposed New Standards on Safety and Soundness -- Asset Quality." The status of the Company as a registered bank holding company does not exempt it from certain federal and state laws and regulations applicable to corporations generally, including, without limitation, certain provisions of the federal securities laws and the Massachusetts corporate laws. With the passage of FIRREA in 1989, the Crime Control Act in 1990 and FDICIA in 1991, federal bank regulatory agencies including the Federal Reserve Board and the FDIC were granted substantially broader enforcement powers to restrict the activities of financial institutions and to impose or seek the imposition of increased civil and/or criminal penalties upon financial institutions, the individuals who manage or control such institutions and "institution affiliated parties" of such entities. Pursuant to the Community Reinvestment Act ("CRA"), federal regulatory authorities review the performance of the Company and its subsidiary banks in meeting the credit needs of the communities served by the subsidiary banks. The applicable federal regulatory authority considers compliance with this law in connection with applications for, among other things, approval of branches, branch relocations and acquisitions of banks and bank holding companies. USTrust's current CRA rating is "outstanding" and UST/Conn's current CRA rating is "satisfactory." The FDIC has determined that it will no longer examine USTC, which focuses upon trust and asset management activities, for CRA compliance. The Massachusetts Commissioner has not yet determined whether it will continue to examine USTC for CRA compliance. Supervision, regulation and examination of the Subsidiary Banks by the bank regulatory agencies are not intended for the protection of the Company's security holders. From time to time various proposals are made in the United States Congress as well as state legislatures which would alter the powers of, and place restrictions on, different types of bank organizations as well as bank and nonbank activities. Such legislative proposals include interstate branching and expansion of bank powers. It is impossible to predict whether any of the proposals will be adopted and the impact of such adoption on the business of the Company or its subsidiaries. GOVERNMENTAL POLICIES, ECONOMIC CONDITIONS AND CREDIT RISK CONCENTRATION The earnings and business of the Company's subsidiaries are and will be affected by a number of external influences, including general economic conditions in the United States and particularly in New England and the policies of various regulatory authorities of the United States, including the Federal Reserve Board. The Federal Reserve Board regulates the supply of money and of bank credit to influence general economic conditions within the United States and throughout the world. From time to time, the Federal Reserve Board takes specific steps to dampen domestic inflation and to control the country's money supply. The instruments of monetary policy employed by the Federal Reserve Board for these purposes (including the level of cash reserves banks, including nonmember banks such as all three of the Company's banking subsidiaries, are required to maintain against deposits) influence in various ways the interest rates paid on interest-bearing liabilities and the interest received on earning assets, and the overall level of bank loans, investments and deposits. The impact upon the future business and earnings of the Company of prospective domestic economic conditions, and of the policies of the Federal Reserve Board as well as other U.S. regulatory authorities, cannot be predicted accurately. The Company's primary loan market, the New England region, continues to experience an uneven and slow recovery. Most of the loans outstanding are from Eastern Massachusetts and a substantial portion of these loans are various types of real estate loans; still others have real estate as additional collateral. At year-end 1993, the Company's exposure to credit risk for which the primary source of repayment is real estate collateral included $499 million of loans. Recent economic studies have concluded that the region's economy will remain sluggish for at least the balance of this year. While there have been pockets of growth, they have been rather anemic, and the forecast is for small increases in the overall job market with some industries increasing modestly and others not at all. Real estate prices and activity have both improved somewhat from extremely depressed levels. See "Management's Discussion and Analysis of Financial Conditions and Results of Operations" below. GENERAL No significant portion of the deposits of any of the Company's banking subsidiaries results from one or several accounts, the loss of which would materially affect its business. The Company does not experience significant seasonal fluctuations in its business. EMPLOYEES As of December 31, 1993, the Company and its subsidiaries employed approximately 870 people. ITEM 2.		ITEM 2. PROPERTIES USTrust owns a twelve-story brick and steel building constructed in 1915 and located at Government Center, 30-40 Court Street, Boston, Massachusetts. The banking premises of USTrust, USTC and the offices of the Company and all of its nonbanking subsidiaries utilize approximately 99% of the 89,014 square feet in the building and the remaining space is leased as offices to a variety of tenants. The Company currently leases a three-story brick office building of approximately 37,900 square feet as well as 29,003 square feet in a recently-constructed adjacent office tower at 141 Portland Street, Cambridge, Massachusetts, all of which is used by USTrust and UST Data Services Corp. USTrust also leases approximately 19,160 square feet of space at 25-55 Court Street, Boston which is used primarily to house staff support services. In 1991, USTC sold the 25-55 Court Street, Boston building to a third party, unaffiliated with the Company. USTrust owns six branch offices in Boston, Milton Village, Norwood, Randolph, Stoughton and Swampscott, Massachusetts, all of which were acquired by the Company in 1991 from the Resolution Trust Corporation as part of the acquisition and assumption of certain assets, deposits and branches of Home Owners Savings Bank F.S.B. USTrust also owns four branch offices in Canton, Gloucester, Milton, and Natick, Massachusetts. UST/Conn owns two branch offices in Huntington and Shelton, Connecticut. The remaining branch offices of the Company occupy leased premises. The 1994 annual leasehold commitment for all premises leased by the Company's subsidiaries totals approximately $4,031,000. ITEM 3.	ITEM 3. LEGAL PROCEEDINGS. In the ordinary course of operations, the Company and its subsidiaries become defendants in a variety of judiciary and administrative proceedings. In the opinion of management, however, other than as noted in item 1 above under "Recent Developments -- Potential Regulatory Sanctions" there is no proceeding pending, or to the knowledge of management threatened, which in the event of an adverse decision would be likely to result in a material adverse change in the financial condition or results of operations of the Company and its subsidiaries. ITEM 4.	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. --None-- PART II ITEM 5.	ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS Such over-the-counter market quotations reflect inter-dealer prices, without retail markup, markdown or commission and may not represent actual transactions. The number of holders of record of common stock of the Company was 2,091 at January 31, 1994. There were no dividends declared during 1993 and 1992. Future dividends, including any extra cash dividends, will depend upon the earnings of the Company and its subsidiaries, their need for funds, their financial condition and other factors, including applicable government regulations and regulatory consent. See "Recent Developments -- Bank Regulatory Agreements and Orders" in Part I, Item 1. and the discussion of capital in Management's Discussion and Analysis of Financial Condition and Results of Operations on page 16 of this Form 10-K. In connection with the $20 million senior debt private placement transaction of August 1986 (see Note 9 to Consolidated Financial Statements of the Company), the Company agreed not to make dividend payments in excess of 60% of cumulative net earnings since December 31, 1985 plus $7 million. The Company does not expect that these provisions will adversely affect its ability to pay future dividends which it deems appropriate. ITEM 6.	ITEM 6. SELECTED FINANCIAL DATA UST CORP. AND SUBSIDIARIES SUMMARY OF SELECTED FINANCIAL DATA(1) - --------------- (1) This information should be read in connection with Management's Discussion and Analysis of Financial Condition and Results of Operations on pages 12 to 30 of this Form 10-K with particular reference to Credit Quality and Reserve for Loan Loss. (2) The Company declared a 5% stock dividend to holders of record on September 30, 1991. All share and per share data have been adjusted to reflect this transaction. (3) Includes federal funds purchased, repurchase agreements, short-term and other borrowings. ITEM 7.	ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FINANCIAL CONDITION AT DECEMBER 31, 1993 INTRODUCTION The Company's primary loan market, the New England region, continues to experience an uneven and slow recovery from the weak economic environment of 1990 to 1993. Recent economic studies have concluded that the region's economy will remain sluggish for at least the balance of 1994. This climate has contributed to the decline in commercial and residential real estate values, although there is recent evidence that these values are stabilizing. Generally, real estate prices and activity have both improved from extremely depressed levels. Specifically, in the Commonwealth of Massachusetts, home sales and home construction are both rising due to the prevailing low mortgage rates. The harsh economic environment over the last few years has adversely affected both the net worth of certain borrowing customers of the Company's subsidiary banks and the Company's collateral position with respect to certain loans. Massachusetts has seen both an exodus and failure of a number of businesses and unemployment continues to remain high although somewhat lower than experienced during the 1990 to 1993 period. While there have been pockets of growth, they have been sluggish, and the forecast is for small increases in the overall job market with some industries increasing modestly and others not at all. The foregoing factors continued to influence the Company's financial results for 1993, particularly in the areas of provision for loan losses and expenses related to foreclosed asset and workout expense, and are likely to continue to influence such results. This discussion should be read in conjunction with the financial statements, notes, and tables included elsewhere in this Form 10-K. Certain previous year numbers have been reclassified to conform with the 1993 presentation. ASSETS Total assets of $2.04 billion at December 31, 1993 have declined slightly from $2.18 billion at December 31, 1992. This was primarily caused by weak loan demand in the Company's market area consistent with the sluggish local economy and a reduction due to the chargeoffs of certain credits. As illustrated in the table on page 24, almost all categories of loans decreased. See also "Credit Quality and Reserve for Loan Loss" below. Presently, the Company does not plan a significant increase in assets. Therefore, any increase in loans outstanding would likely be funded by the sale of securities available-for-sale. Securities at $473.9 million remained essentially unchanged from December 31, 1992. In 1993, the Company adopted Statement of Financial Accounting Standards No. 115 (SFAS 115), issued by the Financial Accounting Standards Board. This Standard deals with the classification of all debt securities and equity securities that have a ready market. According to SFAS 115, these securities must be classified as either held-to-maturity, available-for-sale, or trading and are reported at either amortized cost or fair value, depending upon the classification. At December 31, 1993, all securities in the Company's portfolio were classified as available-for-sale. This change in accounting method resulted in an increase of $3.3 million to stockholders' equity, representing the after-tax effect of the unrealized gain on securities available-for-sale at December 31, 1993. LIQUIDITY AND FUNDING Liquidity is defined as a company's ability to fulfill its existing and anticipated financial obligations. It is provided either through the maturity or sale of an entity's assets, such as loans and securities, liability sources such as increased deposits and purchased or borrowed funds, or access to the capital markets. At December 31, 1993, liquidity, which includes excess cash, excess funds sold and unpledged securities totaled approximately $310 million or 15% of year end assets, a $35 million increase from 1992. The funds needed to support the Company's loan and securities portfolios are provided primarily by UST Corp.'s retail deposits which are relatively low cost and account for 73% of total deposits. The Company's deposits have decreased $151 million, or 8.4% during 1993, in the present low interest rate environment. Generally, high-yielding certificates of deposit which matured were not renewed at the prevailing rates, as investors are utilizing mutual funds and other non-bank vehicles to obtain higher returns. Short-term borrowings have been increased $24 million, or 12%, to maintain needed liquidity. As shown in the Consolidated Statements of Cash Flow, cash and cash equivalents decreased by approximately $26.3 million during 1993. This decrease primarily reflected the use of $107.2 million for financing activities, offset in part by $56.8 million in net cash provided by operations and $24.1 million provided by investments. Net cash used for financing activities was primarily the result of decreases in deposits offset in part by sales of common stock (see below). Cash provided by operations resulted largely from net interest income from loans (before provision for loan losses) and securities. This was reduced by $16 million due to writedowns of other real estate owned and the net difference of noninterest expense over noninterest income. Net cash provided by investing activities was due principally to the net decreases in loans through repayment and other real estate owned through sales, which offset an increase in short-term investments. Other borrowings decreased $4.3 million in 1993. On July 30, 1993 the parent company, UST Corp., paid the second annual installment of $4 million on its 8.5% senior notes. On June 2, 1993, the Company sold 500 thousand shares of its unregistered common stock in a private placement for cash proceeds of $3,750,000. Substantially all of the net proceeds of that placement were used to repay principal on the 8.5% senior notes. On August 12, 1993, the Company sold 2.87 million shares of its common stock in a European offering. These shares were placed with more than sixty institutional investors, and the offering was made under Regulation S of the United States Securities and Exchange Commission. Net proceeds of this placement were approximately $21 million after expenses. Substantially all of the net proceeds continue to be held in the general funds of the Company to be used for general corporate purposes. At December 31, 1993, the parent company had cash and liquid investments totaling approximately $23.3 million. Separately, during the last half of 1993, USTC received approval from the appropriate regulators to dividend $5.25 million to the Company. Of that total, $1.7 million was contributed by the Company as capital to its Connecticut banking subsidiary, UST Bank/Connecticut ("UST/Conn"), and $3.55 million was contributed by the Company as capital to its lead bank, USTrust. INTEREST RATE RISK Volatility in interest rates requires the Company to manage interest rate risk. Interest rate risk arises from mismatches between the repricing or maturity characteristics of assets and the liabilities which fund them. Management monitors and adjusts the difference between interest-sensitive assets and interest-sensitive liabilities ("GAP" position) within various time frames. An institution with more assets repricing than liabilities within a given time frame is considered asset sensitive ("positive GAP") and in time frames with more liabilities repricing than assets it is liability sensitive ("negative GAP"). Over a positive GAP time frame an institution will generally benefit from rising interest rates and over a negative GAP time frame will generally benefit from falling rates. With GAP limits established by the Board of Directors, the Company seeks to balance the objective of insulating the net interest margin from rate exposure with that of taking advantage of anticipated changes in rates in order to enhance income. The Company manages its interest rate GAP primarily by lengthening or shortening the maturity structure of the Company's portfolio of securities. The following table summarizes the Company's GAP position at December 31, 1993. Approximately eighty percent of the loans are included in the 0-30 day category as they reprice in response to changes in the interest rate environment. Securities and Demand Deposits are categorized according to their expected lives. They are evaluated in conjunction with the Company's asset/liability management strategy and may be sold in response to changes in interest rates, repayment risk, loan growth and similar factors. The reserve for loan losses is included in the "Over 1 Year" category of loans. At December 31, 1993, the one-year cumulative GAP position was slightly positive at $68 million, or approximately 3.3% of total assets. INTEREST SENSITIVITY PERIODS CREDIT QUALITY AND RESERVE FOR LOAN LOSS The Company maintains a reserve for loan losses to reduce the carrying value of its loans to an amount estimated to be collectible. Adequacy of the reserve for loan losses is determined using a consistent methodology which analyzes the size and risk of the loan portfolio on a monthly basis. Factors in this analysis include past loan loss experience and asset quality, as reflected by trends of delinquent, nonaccrual and restructured loans and the Company's credit risk rating profile. Consideration is also given to the current and expected economic conditions and in particular how such conditions affect the types of credits in the portfolio and the market area in general. Toward the end of the second quarter of 1993, a strategy was adopted which recognized that many troubled credit situations will need to be handled in an expeditious manner (including the possibility of bulk sales) in order to reduce the management and staff involvement and, in some cases, carrying costs of these workouts. This would allow the Company's resources to be redirected toward new business. It would increase the up-front cost of the workouts, however. As a result, the reserve for loan losses was increased by $19.8 million during the second quarter. To achieve the higher reserve level, the Company recorded a $42.7 million provision for loan losses in the second quarter. Included in that amount was a special provision of $30 million. This special provision was management's estimate of the additional losses to be incurred from the strategic change referred to above, the continued sluggish economic climate and losses occurring during the remainder of 1993 on these and other credits as a result of recent events or new facts. The provision for the year ended December 31, 1993 totaled $64.3 million. Net chargeoffs in 1993 were $51.8 million compared with $41.9 million in 1992. At December 31, 1993, the reserve for loan losses was $62.5 million and equaled 4.74% of loans outstanding, 127% of nonaccrual loans and 56% of total nonperforming assets. As a result of the Company's strategy adopted in the second quarter of 1993 to resolve troubled credits more aggressively, net chargeoffs increased as noted above, for 1993 compared with 1992. These chargeoffs and decline in other real estate owned through sales, contributed to a $65 million or 37% decrease in nonperforming assets in 1993. Adverse economic conditions in the future could result in further deterioration of the Company's loan portfolio and the value of its OREO portfolio. The effect of this would likely include increases in delinquencies, nonperforming assets, restructured loans, and OREO writedowns which individually or collectively could have a material negative effect on future earnings. These factors affect the Company's income statement negatively through reduced interest income, increased provisions for loan losses, and higher costs to collect loans and maintain repossessed collateral. In addition to loans on nonaccrual, loans over 90 days and accruing, troubled debt restructurings, other real estate owned and Special Mention accruing loans 30 to 89 days past due, the Company has approximately $185 million of loans which, while current, have nonetheless been classified as Special Mention or Substandard in the Company's internal risk rating profile. See information following the table titled "Nonaccrual, Restructured and Past Due Loans with Percentages of Loan Categories" on page 27 of this Form 10-K. The risk ratings assigned to these loans were an important factor in the Company's analysis of the adequacy of its reserve for loan losses. Proposed regulations if implemented in their current form, however, may require the Company to reduce significantly the level of these loans. See "Proposed New Standards on Safety and Soundness -- Asset Quality" in Part I, Item 1 of this Form 10-K. Among the responses available to the Company, in this event, is a further acceleration of the Company's strategy to handle problem credits expeditiously. It is not possible to predict the future effects on the Company's financial condition or results of operations of actions which may be taken by the Company in response to final regulations in this area. Management of the Company has identified the reduction of the aggregate amount of non-performing and classified assets as a high priority. Management will continue to assess its alternatives with a view to implementing the most effective means of achieving such reduction. Decisions regarding loan loss provisions and the reserve may be influenced by the views of the regulators having jurisdiction over the Company and its subsidiaries. CAPITAL There are three capital requirements which bank and bank holding companies must meet. Two requirements take into consideration risk inherent in investments, loans and other assets for both on-balance and off-balance sheet items on a weighted basis ("risk-based assets"). Under these requirements, the Company must meet minimum Tier 1 and Total risk-based capital ratios (capital as defined in the regulations divided by risk-based assets) of 4% and 8%, respectively. Tier 1 capital is essentially shareholders' equity, net of intangible assets and Tier 2 capital is the allowable portion of the loan loss reserve (as defined) and discounted subordinated debt. Total capital is the combination of Tier 1 and Tier 2. The Company's risk-based assets were $1.64 billion at December 31, 1993 and $1.81 billion at December 31, 1992. The third requirement is a leverage capital ratio, defined as Tier 1 capital divided by total average assets, net of intangibles. It requires a minimum of 3% for the highest rated institutions and higher percentages for others. In February 1992, the Company's two Massachusetts-based banking subsidiaries, USTC and USTrust, each entered into a Consent Agreement and Order with the FDIC and the Commissioner of Banks in the Commonwealth of Massachusetts. In accordance with these agreements, the banks agreed to, among other things, maintain a Tier 1 leverage capital ratio at or in excess of 6% by February 1993. At December 31, 1993 the Tier 1 leverage capital ratios based on average assets were 6.49% for USTrust and 23.75% for USTC. Since June 1991, UST/Conn has been operating under a Stipulation and Agreement with the Commissioner of Banks for the State of Connecticut. This agreement was amended in August 1992 and November 1993 and requires UST/Conn to maintain a 6% Tier 1 leverage capital ratio. UST/Conn Tier 1 leverage capital ratio based on average assets at December 31, 1993 was 6.21%. At December 31, 1993, the Company had a Tier 1 leverage capital ratio of 7.06% compared to 6.21% at December 31, 1992. Additionally, per these agreements, the Company has agreed not to pay any dividends to stockholders, nor take any dividends from its banking subsidiaries, without prior regulatory approval. Similarly, the banking subsidiaries have agreed to refrain from transferring funds in the form of dividends to the Company without prior regulatory approval. As previously mentioned in this Form 10-K regulatory approval was obtained for dividends totaling $5.25 million from USTC and these dividends were then contributed by the Company to its other banking subsidiaries. In February 1994, the FDIC and Massachusetts commissioner terminated and lifted the consent agreement and order with USTC. Despite the terminations of its Regulatory Agreement, USTC has agreed to continue to request regulatory consent prior to the payment of dividends. RESULTS OF OPERATIONS COMPARISON OF 1993 WITH 1992 The $64.3 million provision for loan losses coupled with a $3.1 million increase in foreclosed asset and workout expenses when compared with those of 1992 are the primary reasons the Company reported a $20.1 million loss, or $1.31 per share, for 1993. Positive factors in 1993 included a $21 million reduction in the costs to fund lending operations. The decreased cost outpaced the decrease in the yield on assets. As previously mentioned, nonperforming assets were reduced from $175.8 million at December 31, 1992 to $110.8 at December 31, 1993, a decrease of 37%. These factors were the principal reasons that net interest income increased in 1993. The Company's net interest income on a fully taxable equivalent basis was $4.2 million higher in 1993 compared with 1992. This compares with a $4.6 million increase on a reporting basis. The difference is due to the decline in tax-free income from 1992 to 1993. The Company's interest rate spread and margin also showed considerable improvement. See "Net Interest Income Analysis" below. Return on Average Equity -- Component Analysis Core Earnings The Company defines core earnings as pretax income before loan loss provision, foreclosed asset and workout expense, securities gains, and other nonrecurring income and expense items. Management believes that core earnings are a useful measure of a bank's ability to withstand the adverse effects of nonperforming assets. The following table reflects the Company's core earnings components on a comparative basis. Net Interest Income Analysis Substantial decreases continue to occur in the cost of the Company's interest-bearing liabilities while average noninterest-bearing funds volume has increased significantly since 1992. Specifically, the cost of interest-bearing funds declined to 3.13% in 1993 compared with 3.92% for 1992. The decreased cost has outpaced the decrease in the yield on assets. Noninterest-bearing funds averaged $274 million for 1992 and in 1993 averaged $335 million. This is due primarily to higher balances needed to offset costs associated with maintaining corporate demand deposit accounts. Due to these conditions and the decline in nonperforming assets (and the interest-related costs associated with these assets), the interest rate spread and margin (as these terms are defined on page 22) both increased significantly during 1993. The spread in 1993 was 4.47% compared with 3.88% for 1992. The margin was 5.03% in 1993 compared with 4.41% in 1992. These factors caused an increase of $4.2 million in net interest income on a taxable equivalent basis for 1993 compared with 1992. Current spreads are at historically high rates and, therefore, probably will not continue at these levels into the future. The following table attributes changes in interest income, interest expense and the related net interest income for the year ended December 31, 1993 when compared with 1992, either to changes in average balances or to the changes in average rates on interest-bearing assets and liabilities. In this table, changes attributable to both rate and volume are allocated on a weighted basis. Noninterest Income Total noninterest income of $36.7 million declined $5.6 million in 1993. Gains on sale of securities decreased $9.3 million. Asset management fees continued their positive trend due to new business and appreciation of existing clients' asset portfolios. This resulted in a $3.3 million increase in asset management fees, partly offsetting the decrease in securities gains noted above. Corporate services income increased $985 thousand, or 13%, in 1993. This was due to changes in the fee system and the continued expansion of the product base. Other noninterest income decreased $466 thousand in 1993 and the following are the more significant reasons: Leasing fee income declined $251 thousand as the Company continued to minimize its activity in this area until taxable income increases sufficiently. Real estate appraisal fees decreased $207 thousand due to a curtailment of third-party activities. Home equity loans purchased from the Resolution Trust Corporation at a substantial discount in late 1991 returned principal on a schedule closer to the original contractual amount. This accounted for an increase of $350 thousand compared with 1992 and partially offset the decreases noted above. Additionally, in the first quarter of 1992, the Company sold $5.7 million of its credit card portfolio to an unaffiliated bank. This transaction produced a gain of $161 thousand for the quarter ended March 31, 1992. All other miscellaneous noninterest income declined $197 thousand. Noninterest Expense Noninterest expense of $97.5 million remained essentially flat in 1993 compared with 1992. Increases in foreclosed asset and workout expense amounted to $3.1 million. Increases in writedowns to fair value minus estimated costs to sell foreclosed real estate properties totaled $1.7 million while other foreclosed asset and workout expenses increased $1.4 million. Writedown costs decreased $1.6 million in the fourth quarter of 1993 compared with the same period in 1992. However, as previously discussed under "Credit Quality and Reserve for Loan Loss," this trend may not continue. Other noninterest expense decreased $5.9 million in 1993. In 1992, the Company added $3.8 million to a reserve for losses arising from securitized loans. There was no comparable expense for 1993 as there were no loans securitized. The remaining decrease in other noninterest expense was principally due to a reduction in the Company's provision for litigation in 1993 as compared with 1992. Income Taxes The Company had a tax benefit of $11.5 million in 1993 compared with $2.9 million in 1992. The variations in income taxes are attributable to the level and composition of pretax income or loss. In 1993 the Company adopted Financial Accounting Standard No. 109 "Accounting for Income Taxes." This Standard changed the accounting for deferred income tax to the "liability method." This change, a one-time event, increased net income by $750 thousand in January 1993 representing the cumulative effect of adopting the new standard on the balance sheet. Refer to Note 1 to the financial statements of this Form 10-K for a discussion of this matter. Fair Value of Financial Instruments In December 1991, the FASB approved SFAS No. 107, "Disclosures about Fair Value of Financial Instruments," effective for fiscal year ending December 31, 1992. The methods and assumptions used by the Company to estimate the fair value of each class of Financial Instruments as of December 31, 1993 and 1992 are disclosed in Note 18 of the financial statements of this Form 10-K. Financial Instruments do not include all of the assets and liabilities recorded on a company's balance sheet. Therefore, the aggregate fair value amounts of the Financial Instruments do not represent the underlying value of a company. As a result of those assumptions and valuation methodologies, the estimated fair value of Financial Instrument assets and liabilities of the Company as of December 31, 1993 was $1.93 billion and $1.89 billion, respectively. The estimated fair value of Financial Instrument assets and liabilities of the Company as of December 31, 1992 was $2.03 billion and $2.02 billion, respectively. In the opinion of management, the excess in the valuation of Financial Instrument assets and liabilities over their carrying values for 1993 and 1992 is attributed primarily to the continued decline in interest rates. COMPARISON OF 1992 WITH 1991 Net Interest Income Analysis The following table attributes changes in interest income, interest expense and the related net interest income for the year ended December 31, 1992 when compared with the year ended December 31, 1991, either to changes in average balances or to the changes in average rates on interest-bearing assets and liabilities. In this table, changes attributable to both rate and volume are allocated on a weighted basis. Noninterest Income Total noninterest income decreased by $1.3 million in 1992 from 1991. Asset management fees increased $3.5 million in 1992 compared with 1991. Assets under management increased, including appreciation of existing assets, to nearly $3 billion from approximately $2.5 billion in the previous year. Net gains on securities were $13.5 million in 1992 compared with $10.5 million in 1991. Corporate services income increased $391 thousand, or 6%, in 1992. This was due to the expansion of the product base, growth in the number of clients, and increases in fees charged. A gain on the sale of real estate during 1991 accounted for $3 million of noninterest income. Lease residual income declined $2.6 million due to a reduction in the number of leases maturing. Other noninterest income decreased $2.7 million in 1992 and the following are the more significant reasons. Loan servicing fees decreased $575 thousand as a servicing contract with the Resolution Trust Corporation ended during 1992. Leasing fee income declined $680 thousand as the Company made a decision to minimize its activity in this area until taxable income increases sufficiently. Other fee income which the Company generates, including fees on acceptances and retail banking fees, declined $673 thousand as a result of a drop in the interest rates of the acceptances and a decrease in the levels of both acceptances and deposits. Noninterest Expense Total noninterest expense in 1992 increased to $96.2 million from $89.3 million in 1991. Foreclosed asset and workout expense rose $5.8 million, primarily due to writedowns to fair value minus estimated costs to sell foreclosed real estate properties. These writedowns totaled $14.4 million, an increase of $5.4 million over 1991. Increases in the amortization of core deposit intangibles of $450 thousand, legal fees of $262 thousand, plus additions to the reserves for litigation of $1.8 million, were partially offset by decreases in controllable expenses such as postage and telephone expense of $293 thousand. FDIC deposit assessment expense declined in 1992 due to the aforementioned reduction in deposits. In 1992, the FDIC voted to restructure the assessment system. This restructuring, which would be based on the strength of a bank and the amount of capital it has, could lead to higher assessments in the future, if the Company fails to maintain its capital ratios. In December 1992, the Company adopted Statement of Position 92-3 ("SOP 92-3"), issued by the American Institute of Certified Public Accountants. This statement concluded that foreclosed assets are presumed to be held for sale. Therefore, they should be carried at the lower of cost or fair value minus estimated costs to sell. For 1992, the pretax charge to income resulting from implementation of SOP 92-3 was $750 thousand and is included in the writedown expense of $14.4 million noted above. AVERAGE BALANCES, INTEREST RATES AND INTEREST RATE DIFFERENTIAL SECURITIES The Company has a policy of purchasing primarily securities rated A or better by Moody's Investors Services and in U.S. Government securities. Due to the Tax Reform Act of 1986, and the resulting reduction in their tax free nature, the Company has decided to forego major new investments in its tax exempt portfolio. The following table sets forth the book value of the securities owned by the Company. Data presented for 1993 includes only securities available-for-sale. Data presented for 1992 and 1991 includes both the investment portfolio and securities held for sale. In 1993 securities available-for-sale were $473.9 million. In 1992 and 1991, securities held for sale were $468.6 million and $425.8 million, respectively. - --------------- (1) Non-Taxable At December 31, 1993 the Company owned the following corporate notes, whose aggregate fair value was in excess of 10% of stockholders' investment: These securities are unsecured corporate notes of investment grade. They carry the normal credit risk associated with such instruments. All securities carry interest rate risk. Additionally, mortgage-backed securities carry prepayment risk. (See Footnote 1, Summary of Significant Accounting Policies on page 37 of this Form 10-K for a discussion of prepayment risk). COMPOSITION OF LOAN PORTFOLIO Indirect automobile installment loans represent loans purchased without recourse from automobile dealers. Automobile loans made directly to consumers are not a significant portion of the business and are included in the other consumer loan category. In 1989, a total of $80 million of indirect automobile installment loans was segregated for sale and not included in the above table. Unfavorable market conditions in 1990 and the assumption of longer-term deposits in connection with the Home Owners purchase and assumption transaction (See Note 2 on page 39 of this Form 10-K) resulted in a decision by the Company not to sell those loans and, consequently, they were reclassified to indirect automobile loans in that year. As a result of the Home Owners transaction, the Company had $513.6 million of loans held for sale at December 31, 1990, and, therefore, not included in the above table. All of these loans were put back to the Resolution Trust Corporation in 1991. LOAN MATURITY DISTRIBUTION The Company does not have an automatic rollover (renewal) policy for maturing loans. Renewal requests are reviewed and approved in substantially the same manner as applications by new customers for extensions of credit. Additionally, any renewal of a loan rated Substandard or lower in the Company's risk rating profile, irrespective of size, requires Senior Lending Management and Board of Directors approval. CREDIT QUALITY MONITORING Credit quality within the commercial and commercial real estate loan portfolios of each subsidiary is quantified by a corporate credit rating system designed to parallel regulatory criteria and categories of loan risk. Lenders monitor their loans to ensure appropriate rating assignments are made on a timely basis. Risk ratings and overall loan quality are also assessed on a regular basis by an independent Loan Review Department which reports to the Company's Board of Directors. Loan Review personnel conduct ongoing portfolio trend analyses and individual credit reviews to evaluate loan risk and compliance with corporate lending policies. Results and recommendations from this process provide senior management with independent information on loan portfolio condition. Installment and credit card loan quality is evaluated on the basis of delinquent data due to the large number of such loans and relatively small size of individual credits. Historical trend analysis reports are reviewed on a monthly basis by senior lending officers and the Company's Board of Directors. All past due loans, nonaccrual loans, and troubled debt restructurings are reviewed at least quarterly by the Loan Review Department management and Senior Credit Committee whose membership includes the most senior executive officers in the Company and the most senior lending officers in each subsidiary bank and major lending divisions. Loans are placed on nonaccrual when there is doubt as to the collectibility of interest or principal or if loans are 90 days or more past due unless they are both well secured and in the process of collection. In every case, a loan reaching 180 days past due is placed on nonaccrual. Greater levels of Board and Management attention are being focused on asset quality. In 1992 an asset quality committee of the Company's Board of Directors was established which monitors asset quality trends, reviews the loan loss reserve analyses in depth monthly and actively monitors the large credit exposures. Also in 1992 new loan administration function, the Credit Risk Control Department, was assigned the responsibility of ensuring compliance with the lending policies, procedures and administrative guidelines of the commercial lending portfolio. The Department reports to the Company's Board. An appraisal review function was established within the group to review third-party appraisals for adherence to Federal requirements and to establish policies relating to collateral appraisal. In a further step to increase the level of control over the troubled loan portfolio and in order to focus specialized expertise, a Workout Department was established during 1992 and most nonaccrual and other troubled loans are now largely handled by this group or in the Commercial Real Estate Department. In 1993, under the direction of new management, staffing was increased in both the Loan Review and the Credit Risk Control Departments. Furthermore, a number of systems changes were initiated to improve control over credit administration, and smaller commercial loans were transferred to the Installment Lending Department where they can be more efficiently monitored. As a result, the commercial loan officers' workload has been reduced. NONACCRUAL, PAST DUE, RESTRUCTURED LOANS, OTHER AUTOMOBILES OWNED AND OTHER REAL ESTATE OWNED. In addition to the amounts in the above table, accruing loans 30 to 89 days past due and rated Special Mention in the Company's internal risk rating profile amounted to $12 million at December 31, 1993. Also at December 31, 1993 there were approximately $185 million of accruing commercial and real estate loans which, while current, have nonetheless been classified as Special Mention or Substandard an increase from approximately $130 million at the end of 1992. There were no loans classified "Doubtful" in either year which were not disclosed in the above table. Approximately 84 percent of these loans were in the Substandard category. Under the Company's definition, Substandard assets are characterized by the distinct possibility that some loss will be sustained if the credit deficiencies are not corrected. The Substandard classification, however, does not necessarily imply ultimate loss for each individual asset so classified. Special Mention assets, as defined by the Company, have potential weaknesses that deserve management's close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the assets. The Company uses the internal risk rating profile along with a number of other factors in determining the adequacy of its reserve for loan loss. See Credit Quality and Reserve for Loan Losses on page 14 of this Form 10-K for a further discussion. ALLOCATION OF LOAN LOSS RESERVE The Company charges off loans or portions of loans when they are considered uncollectible. Therefore, no portion of the Reserve for Loan Losses is restricted to any loan or group of loans, and the entire Reserve is available to absorb all probable losses inherent in the portfolio. However, for internal analytical purposes the Company allocates its Reserve in conjunction with its risk rating profile. Since conditions within the profile are subject to change, the allocation presented below should not be interpreted as an indication that chargeoffs in 1994 will occur in these amounts or proportions, or that the allocation indicates future trends. - --------------- (1) Consumer loans include indirect automobile installment loans, residential mortgages and home equity lines of credit, credit cards, and check credit loans. (2) Prior to 1990 the Company assigned all of the Reserve in its analysis and, therefore, did not utilize an unallocated portion. SUMMARY OF LOAN LOSS EXPERIENCE - --------------- (1) This information is available separately for 1993 and 1992 only. Prior to 1992 the information is included in the other consumer category. (2) Refer to the discussion of the factors used in determining the reserve for loan losses in Management's Discussion of Financial Condition and Results of Operations on page 14 of this Form 10-K. DEPOSITS The following table sets forth the remaining maturities of certificates of deposit in the amount of $100 thousand or more at December 31, 1993, in thousands: SHORT-TERM BORROWINGS The Company's short-term borrowings consist primarily of federal funds purchased and securities sold under agreements to repurchase. These instruments are generally overnight funds. The following information relates to federal funds purchased and securities sold under agreements to repurchase which represents more than thirty percent of stockholders' equity: ITEM 8.	ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY MATERIAL. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Stockholders and Board of Directors of UST Corp.: We have audited the accompanying consolidated balance sheets of UST Corp. (a Massachusetts corporation) and Subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, changes in stockholders' investment and cash flows for each of the three years in the period ended December 31, 1993. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements 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 consolidated 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 UST Corp. and Subsidiaries as of December 31, 1993 and 1992, and the results of their operations and cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As explained in Note 1 to the consolidated financial statements, the Company changed its method of accounting for income taxes and investments by adopting Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" and Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities," effective January 1, 1993 and December 31, 1993, respectively. Arthur Andersen & Co. Boston, Massachusetts January 31, 1994 The accompanying notes are an integral part of these consolidated financial statements. The accompanying notes are an integral part of these consolidated financial statements. The accompanying notes are an integral part of these consolidated financial statements. The accompanying notes are an integral part of these consolidated financial statements. UST CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The accounting and reporting policies of UST Corp. and Subsidiaries conform with generally accepted accounting principles and general practice in the banking industry. The significant policies are summarized below. PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All material intercompany balances and transactions have been eliminated. The parent company only financial statements contained in Note 17 reflect investments in Subsidiaries using the equity method of accounting. Certain reclassifications have been made to prior year balances to conform with the current year presentation. Assets owned by others held in a fiduciary or agency capacity are not included in the consolidated balance sheets. SECURITIES On December 31, 1993, the Company adopted Statement of Financial Accounting Standards No. 115 (SFAS 115), "Accounting for Certain Investments in Debt and Equity Securities." This statement addresses the accounting and reporting for investments in equity securities that have readily determinable fair values and for all investments in debt securities. Under this statement securities are classified as held-to-maturity, available-for-sale, or trading. Debt securities which management has the positive intent and ability to hold to maturity are classified as held-to-maturity, and are carried at cost adjusted for the amortization of premium or the accretion of discount. At December 31, 1993 the Company had no securities classified as held-to-maturity. Debt and equity securities with readily determinable market values that are bought and held principally for the purpose of selling them in the near term are classified as trading securities and are carried at fair value, with unrealized gains and losses included in current earnings. At December 31, 1993 and 1992, the Company had no securities classified as trading. Debt and equity securities not classified as either held-to-maturity or trading are classified as available-for-sale and carried at fair value, with unrealized after-tax gains and losses reported as a separate component of stockholders' investment. The cumulative effect of adopting SFAS 115 was $5,749,000 before reduction for the income tax effect of $2,414,000. Prior to December 31, 1993, debt securities were designated at the time they were purchased as either held-for-sale or held to maturity, based on management intent at the time. Securities which management had the ability and intent to hold on a long-term basis or until maturity were classified as investment portfolio. Securities which were to be held for indefinite periods of time and not intended to be held to maturity or on a long-term basis were classified as securities held for sale and carried at the lower of aggregate cost or market value. Prior to the adoption of FASB 115 trading account securities were valued at market. For mortgage-backed securities, the Company recalculates the effective yield on the investment to reflect the actual prepayment results and anticipated future payments. The net investment in these securities is adjusted to the amount that would have existed had the new estimated average life and effective yield been applied since the acquisition of the securities. Such adjustments are charged or credited to interest income in the current period. UST CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The Company determined the securities sold by the specific identification method. The amount of taxes paid on gains is dependent upon the overall results of operations of the subsidiary incurring the gain. PREMISES, FURNITURE AND EQUIPMENT Premises, furniture and equipment are stated at cost, less accumulated depreciation and amortization. The Company provides for depreciation using the straight-line method by charges to expense in amounts estimated to amortize the cost over the estimated useful lives of the respective assets as follows: Leasehold improvements are amortized over the life of the lease agreements. LOAN INCOME AND FEES Certain installment loans and commercial time loans are made on a discounted basis. The unearned discount applicable to such installment loans is taken into income monthly by use of the actuarial method. Interest income on nondiscounted loans is accrued based on the principal amount of loans outstanding. Loans are placed on nonaccrual, with the reversal of all accrued interest receivable, when there is doubt as to the collectibility of interest or principal or if loans are 90 days or more past due unless they are both well secured and in the process of collection. In every case, a loan reaching 180 days past due is placed on nonaccrual. Interest received on nonaccrual loans is applied to principal if collection of principal is doubtful; otherwise, it is reflected in interest income on a cash basis. In May 1993, the FASB issued Statement of Financial Accounting Standards No. 114 (SFAS No. 114), "Accounting by Creditors for Impairment of a Loan," which is to become effective for fiscal years beginning after December 15, 1994. SFAS No. 114 addresses the accounting by creditors for impairment of certain loans by requiring that the carrying value of impaired loans, as defined, be measured based upon the present value of expected future cash flows discounted at the loan's effective interest rate or the fair value of the collateral if the loan is collateral dependent. Management is currently evaluating the effect that this new standard will have on the Company's reported consolidated financial position and results of operations. RESERVE FOR LOAN LOSSES The reserve for loan losses is maintained at a level considered adequate by management to provide for possible losses from loans, leases and commitments to extend credit. Adequacy of the reserve is determined by management using a consistent methodology which analyzes the size and risk of the loan portfolio on a monthly basis. Factors in this analysis include past loan loss experience and asset quality, as reflected by trends of delinquent, nonaccrual and restructured loans and the Company's credit risk rating profile. Consideration is also given to the current and expected economic conditions and, in particular, how such conditions affect the types of credits in the portfolio and the market area in general. The reserve is based on estimates, and ultimate losses may vary from current estimates. These estimates are reviewed periodically and, as adjustments become necessary, they are reported in earnings in the current period. OTHER REAL ESTATE OWNED Other real estate owned includes both actual and in-substance repossessions. In December 1992 the Company adopted Statement of Position No. 92-3 ("SOP 92-3") issued by the American Institute of Certified Public Accountants. This SOP states that foreclosed assets are presumed to be held for sale. Therefore, they should be carried at the lower of cost or fair value, minus estimated costs to sell. In 1992 the pretax charge to income resulting from implementation was $750,000. UST CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) INCOME TAXES The Company provides for income taxes in accordance with the comprehensive income tax allocation method. This method recognizes the tax effects of all income and expense transactions in each year's statement of income regardless of the year in which the transactions are reported for tax purposes. The Company follows the deferral method of accounting for investment tax credits. Under the deferral method, the credit is reflected as a reduction of tax expense ratably over the period during which the asset is depreciated for financial reporting purposes. FASB has issued SFAS No. 109 "Accounting for Income Taxes," a modification of SFAS No. 96, effective January 1, 1993. While the FASB retained the existing requirement to record deferred taxes for transactions that are reported in different years for financial reporting and tax purposes, it revised the computation of deferred taxes so that the amount of deferred taxes on the balance sheet is adjusted whenever tax rates or other provisions of the income tax law are changed. This is known as the "liability method" of providing deferred income taxes. This change in accounting principle increased net income $750,000 in January 1993, representing the cumulative effect of the new standard on the balance sheet at the date of adoption. EARNINGS (LOSS) PER SHARE Earnings per share is computed using the weighted average number of shares of common stock and common stock equivalents outstanding. Common stock equivalents consist primarily of dilutive outstanding stock options computed under the treasury stock method. Loss per share computations do not include antidilutive common stock equivalents. GOODWILL Cost of purchased businesses in excess of net assets acquired includes amount being amortized over twenty-and forty-year periods. Amortization expense was $122,500 in 1993, 1992 and 1991. RETIREMENT BENEFITS The Company's policy is to fund pension costs accrued. In December 1990, the FASB issued SFAS No. 106, "Employer's Accounting for Post Retirement Benefits Other Than Pensions." SFAS No. 106 is effective for fiscal years beginning after December 15, 1992. This statement did not have any impact on the Company's financial position or results of operations. In November 1992, the FASB issued SFAS No. 112, "Employers' Accounting for Postemployment Benefits." SFAS No. 112 is effective for fiscal years beginning after December 15, 1993. It is not expected that this statement will have any impact on the Company's financial position or results of operations. STATEMENT OF CASH FLOWS For purpose of reporting cash flows, cash and cash equivalents include cash on hand, amounts due from banks and interest-bearing deposits. (2) HOME OWNERS PURCHASE AND ASSUMPTION On September 7, 1990, United States Trust Company ("USTC"), the Company's principal banking subsidiary at the time, assumed approximately $2 billion in deposits and acquired certain assets and branches located in the greater Boston area of the former Home Owners Savings Bank F.S.B. ("Home Owners") in a transaction with the Resolution Trust Corporation ("RTC"), an arm of the Federal Government. The UST CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Company paid the RTC cash of $6.1 million, approximately the amount allocated to core deposit intangible which is being amortized over seven years. As part of the approval process, the Company agreed with the Board of Governors of the Federal Reserve System and the Federal Deposit Insurance Corporation to restore the Company's and USTC's consolidated capital ratios to the levels at which they stood prior to the Home Owners transaction. Management developed a plan to achieve these objectives which included putting the $513.6 million loans held for sale back to the RTC in 1991 and continuing to reduce assets as the high rate Home Owners certificates of deposit rolled off. This plan is complete. (3) RESTRICTIONS ON CASH AND DUE FROM BANKS At December 31, 1993 and 1992, cash and due from banks included $42,072,000 and $23,659,000, respectively, to satisfy the reserve requirements of the Federal Reserve Bank. (4) SECURITIES Data presented for 1993 includes only securities available-for-sale. Data presented for 1992 in this footnote includes both the investment portfolio, consisting primarily of securities of states and municipalities, and other equity securities, with an amortized cost of $8,122,000, and securities held-for-sale, consisting primarily of U.S. Treasuries, mortgage-backed and auto-backed securities, and corporate notes, with an amortized cost of $468,643,000. UST CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The amortized cost and estimated market value of debt securities at December 31, 1993 and 1992, by contractual maturity, are shown in the table below. Actual maturities are expected to differ from contractual maturities because some borrowers have the right to prepay without prepayment penalty. Mortgage-backed securities are shown at their final maturity but are expected to have shorter average lives. Equity securities, which have no contractual maturity, are presented in the aggregate. Gross unamortized premiums and discounts on mortgage-backed securities were $355,000 and $973,000, respectively, at December 31, 1992. Proceeds from sales of debt securities held in the investment portfolio, held-for-sale and trading accounts during 1993 were $162,956,000 and $514,072,000 during 1992. Gross gains of $3,038,000 for 1993 and $8,315,000 for 1992 and gross losses of $137,000 for 1993 and $939,000 for 1992 were realized on those sales. Gains on sales of all securities held in the investment portfolio, held-for-sale and trading accounts were $4,403,000, $13,724,000, and $10,560,000 for 1993, 1992, and 1991, respectively. UST CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) At December 31, 1993, securities carried at $223,156,000 were pledged to secure public and trust deposits, securities sold under agreements to repurchase and for other purposes as required by law. (5) LOANS The composition of the loan portfolio (net of unearned discount) at December 31, 1993 and 1992 was as follows: Nonaccrual loans were $49.3 million and $86.6 million at December 31, 1993 and December 31, 1992, respectively. Accruing restructured loans totaled $41.5 million and $44.9 million at December 31, 1993 and 1992, respectively. Had nonaccruing and accruing restructured loans been paying in accordance with their original terms, approximately $6,247,000 and $7,728,000 of additional interest income would have been recorded in 1993 and 1992, respectively. Most of the Company's business activity is with customers located within the states of Massachusetts and Connecticut. At year-end 1993, the Company's exposure to credit risk principally secured by real estate included $499 million of loans. See Note 16 for additional discussion of concentration of credit risk. An analysis of the reserve for loan losses for the years ended December 31, 1993, 1992 and 1991 is as follows: In June 1993, the Company recorded a special $30 million provision for loan losses which is included in the above table. See footnote 19 for information regarding this special provision. UST CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (6) PREMISES, FURNITURE AND EQUIPMENT Depreciation and amortization expenses reflected in the consolidated statements of income were $3,661,558, $3,665,392 and $4,776,896 in 1993, 1992 and 1991, respectively. On January 3, 1991, the Company sold one of its buildings to a third party for $8.2 million. A portion of the building, which houses certain staff support functions of the Company, was leased back from the purchaser. This transaction resulted in a gain of approximately $5 million of which $3 million was recognized in 1991 with the difference amortized to income over the life of the lease. (7) OTHER REAL ESTATE OWNED Other real estate owned includes in-substance foreclosures of $8,197,000 and $14,861,000 at December 31, 1993 and 1992, respectively. The balance is stated net of valuation allowances of $6,553,000 in 1993 and $750,000 in 1992. In 1993 provisions charged to foreclosed asset and workout expense were $14,514,000 and chargeoffs were $8,711,000. The net cost of other real estate owned included in foreclosed asset and workout expense in the income statement was $21,256,000, $18,276,000 and $12,621,000 in 1993, 1992 and 1991, respectively. These costs include reductions in fair value, net gain or loss on sales and cost of maintaining and operating the properties. (8) SHORT-TERM BORROWINGS The average outstanding short-term borrowings were $227,944,000 in 1993 and $247,185,000 in 1992. The approximate weighted average interest rates were 2.7% in 1993 and 3.1% in 1992. The maximum amount of short-term borrowings outstanding at any month end was $320,338,000 in 1993 and $300,489,000 in 1992. UST CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (9) OTHER BORROWINGS Other borrowings consisted of the following at December 31, 1993 and 1992: During 1986, the Company issued $20,000,000 of 8.5% subordinated notes to an insurance company. The debt is payable in annual installments of $4 million from 1992 through 1996. Under the terms of the agreement, the Company may not make dividend payments in excess of 60% of cumulative net earnings since December 31, 1985 plus $7 million. Payments required under the above obligations were $4,321,000 in 1993 and will amount to $4,321,000 in 1994, $5,822,000 in 1995, and the balance of $4,143,000 in 1996. The Company has an employee stock ownership plan which covers substantially all of its employees. The plan is administered by a committee designated by the Board of Directors and is maintained in a separate trust established for that purpose. The trustee obtained financing to purchase shares of UST Corp. common stock and UST Corp. has guaranteed this debt. The purchased shares are allocated to the participants on a pro-rata basis, over the period in which they are earned. (10) EMPLOYEE BENEFIT PLANS The Company has a noncontributory retirement plan covering all employees who meet specified age and employment requirements. The plan provides pension benefits that are based on the employee's compensation during the highest consecutive five of the last ten years before retirement. The following summary sets forth the plan's funded status and amounts included in the Company's consolidated balance sheets as of December 31, 1993 and 1992: UST CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The weighted-average discount rate and rate of increase of future compensation levels used in determining the actuarial present value of the projected benefit obligation was 7.0% and 5.0%, respectively, for 1993 and 8.5% and 6%, respectively, for 1992. The expected long-term rate of return on assets used was 9.5% and 12%, respectively, for 1993 and 1992. The Company has a qualified profit-sharing plan covering substantially all employees. Under the plan, up to six percent of net income before income taxes, as defined, may be contributed to the profit-sharing trust. The Company did not make a contribution to the profit-sharing trust in 1993, 1992 or 1991. In January 1994, the Company added an Employee's Savings feature to the existing Profit-Sharing Plan that qualifies as a deferred salary arrangement under Section 401(k) of the Internal Revenue Code. The revised plan was renamed the UST Corp. Employee Savings Plan. Under the Savings Plan, participating employees may defer a portion up to 4% of their pretax earnings not to exceed the Internal Revenue Service annual contribution limits. The Company matches 25% of each employee's contributions up to 4% of the employee's earnings. Since the Savings Plan started in 1994, the Company did not make a contribution in 1993. The Company also has an employee stock ownership plan for substantially all salaried employees. Under the plan, the Company shall contribute either a fixed amount or a percentage of compensation of all participants as determined by the Board of Directors. The Company has a restricted stock ownership plan for key employees under which 389,375 shares of common stock have been granted. The shares vest to the employee from the first to the seventh year after the date of grant. The unvested shares granted are excluded from outstanding shares and included in the calculation of earnings per share, if dilutive, in periods of profit. Expenses (income) relating to the plans were as follows: (11) STOCK OPTIONS At December 31, 1993, 479,759 shares of the Company's common stock were reserved for future grants to officers and key employees. Under the Company's incentive stock option plan, options may be granted at prices not less than the fair market value of the Company's common stock at the date of grant. In May 1990, the stockholders approved a director's stock option plan under which each outside director would receive a grant of 5,250 shares. The total number of shares issuable under this plan is 63,000. All shares UST CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) to current outside directors have been granted. Each option is exercisable to the extent of 20% after one year from the date of grant and an additional 20% each succeeding year. In addition, the Company has a Director's Deferred Compensation Program under which up to 250,000 shares of the Company's common stock may be granted to Directors of the Company or its banking subsidiaries who choose to receive their Director's fees or stipend in shares of the Company in lieu of cash. The shares vest when the person ceases to be a Director. In 1993, 24,233 restricted shares vested under the Company's restricted stock ownership plan. In December 1989, April 1990, and April 1991, the Board of Directors authorized an option substitution program permitting employees to surrender options with an option price of more than $14.29, $10.00, and $6.07, respectively, in exchange for new options. Outstanding options for 149,331, 513,817, and 516,502, respectively, were exchanged under the program. Options were exchanged on a one-for-one basis at an option price of $14.29, $10.00, and $6.07, respectively, per share, the fair market value of the Company's common stock on the date of authorization. The new options vest ratably over a five-year period. (12) INCOME TAXES The income tax benefit shown on the consolidated statements of income consisted of the following: UST CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The deferred tax provisions (benefit) consisted of the following: At December 31, 1993 and 1992, cumulative deferred income tax benefits amounting to $10,911,000 and $6,177,000 were included in the balance sheet as other assets. Additionally, at December 31, 1993 and December 31, 1992 there were tax refund receivables of $9,549,000 and $7,400,000, respectively, included in other assets (in thousands): The components of the net deferred tax asset at December 31, 1993 were as follows: UST CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (13) CAPITAL AND REGULATORY AGREEMENTS On June 2, 1993 the Company sold 500,000 shares of its unregistered common stock in a private placement for a cash price of $3,750,000. Substantially all of the net proceeds of that placement were used to repay principal on the Company's long-term debt. On August 12, 1993, the Company sold 2.87 million shares of its common stock in a European offering. These shares were placed with more than sixty institutional investors and the offering was made under Regulation S of the United States Securities and Exchange Commission. Net proceeds of this placement were approximately $21 million after expenses. The Company and its banking subsidiaries' ability to pay dividends is subject to certain limitations imposed by statutes of the Commonwealth of Massachusetts and the State of Connecticut, and limitations imposed by bank and bank holding company regulators. Massachusetts statutes restrict the amount of dividends payable by banks to be the balance of their undivided profits, net of any amount transferred to capital in excess of par value. In the case of Connecticut law, the limit is undivided profits plus reserve for loan losses. In any event, it is not likely that bank and bank holding company regulators would allow an institution to dividend any amounts which would reduce that institution's capital to below the minimum capital requirement in effect at that time. The Company and its two Massachusetts-based banking subsidiaries, United States Trust Company ("USTC") and USTrust, have signed written agreements with the FRB, FDIC and the Banking Commissioner of the Commonwealth of Massachusetts ("Massachusetts Commissioner"). In accordance with the agreements the Company has agreed not to pay any dividends to stockholders, nor take any dividends from its banking subsidiaries, without prior regulatory approval. Similarly, the banking subsidiaries have agreed to refrain from transferring funds in the form of dividends to the Company without prior regulatory approval. In 1993, the Company and USTC received approval from the appropriate regulators such that USTC was allowed to transfer $5,250,000 in dividends to the Company. These proceeds were then contributed as equity to USTrust and the Company's Connecticut banking subsidiary, UST Bank/Connecticut ("UST/Conn"). The banks also agreed to, among other matters, maintain a Tier 1 leverage capital ratio at or in excess of 6% beginning in February 1993. Tier 1 leverage capital ratio is defined by the Company's Federal regulators to be essentially stockholders' equity, less intangible assets, divided by total average assets, less intangible assets. In February 1994, the FDIC and the Massachusetts Commissioner terminated and lifted the Consent Agreement and Order with USTC. Despite the termination of its Regulatory Agreement, USTC has agreed to continue to request regulatory consent prior to the payment of dividends. UST/Conn is under a Stipulation and Agreement with the Banking Commissioner of the State of Connecticut. In accordance with the agreement, the bank, among other matters, must maintain a Tier 1 leverage capital ratio of 6%. Based on average total assets, at December 31, 1993, the Tier 1 leverage capital UST CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) ratio was 23.75% for United States Trust Company, 6.49% for USTrust, and 6.21% for UST Bank/Connecticut. Additionally, the Company agreed to maintain its capital at levels consistent with the FRB's Capital Adequacy Guidelines. At December 31, 1993, based on period-end assets the Company's consolidated Tier 1 leverage capital ratio was 6.96% compared with 6.21% at December 31, 1992. Based on average total assets, this ratio was 7.06% at December 31, 1993. (14) RELATED PARTY TRANSACTIONS In the ordinary course of business, the Company's banking subsidiaries have granted loans to certain of the Company's directors and executive officers. All such transactions are made on substantially the same terms as those prevailing at the same time for individuals not affiliated with the Company and its subsidiaries and do not involve more than the normal risk of collectibility. At December 31, 1993, none of these transactions were on nonaccrual status, nor did they involve delinquent or restructured loans. However, at December 31, 1993 loans to a Director of the Company or to his affiliated companies in the amount of approximately $25 million were characterized as Substandard, in the Company's internal risk rating profile. Under the Company's definition, Substandard assets are characterized by the distinct possibility that some loss will be sustained if the credit deficiencies are not corrected. However, the Substandard classification does not imply ultimate loss for each individual asset so classified. Subsequent to December 31, 1993, $6.4 million of these loans were repaid. See Footnote 15 hereunder. (15) COMMITMENTS AND CONTINGENCIES Rent expense for the years ended December 1993, 1992 and 1991 was $3,932,074, $4,432,156 and $4,179,740, respectively. In the ordinary course of business, the Company and its subsidiaries become defendants in a variety of judicial and administrative proceedings. In the opinion of management there is no proceeding pending, or to UST CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) the knowledge of management threatened, which in the event of an adverse decision, would be likely to result in a material adverse change in the financial condition or results of operations of the Company and its subsidiaries. POTENTIAL REGULATORY SANCTIONS Certain apparent and inadvertent violations of the insider lending provisions (and related lending limit provisions) of Regulation O of the FRB related to extensions of credit by USTrust to Director Francis X. Messina have led the FDIC to require that corrective action be taken and to advise USTrust orally that the FDIC may consider the imposition of civil money penalties with respect to such matters. No FDIC representative has suggested to USTrust or the Company that there was any willful or intentional misconduct on the part of USTrust, Director Messina or USTrust's other institution-affiliated parties in connection with these matters. See Note 14 to Consolidated Financial Statements. To address these issues, USTrust and Director Messina have undertaken a program to reduce the aggregate balance of Mr. Messina's outstanding loans from USTrust and to improve the collateral support for the remaining outstanding loan balance. The elements of this program have been communicated to and reviewed by the FDIC. In furtherance of the program since late 1993, the outstanding principal of the aggregate loans to Director Messina and his related interests has been reduced by more than $11 million from approximately $30 million to less than $19 million, and such loans are now below all applicable lending limits. To date, the Company has incurred no losses with respect to any of these loans, although they are characterized as "Substandard" in the Company's internal risk rating profile, and all such loans are current as to both principal and interest. There has been no further action taken by any bank regulatory agency to date. The FDIC has the authority to levy civil money penalties of various amounts for violations of law or regulations, orders and written conditions and agreements, which, depending upon the nature and severity of the violations, may be, in situations where conduct has been egregious, as high as $1 million per day for the period during which such violation continues. In connection with the apparent violations described above, the FDIC has the authority to impose penalties on any of USTrust, its Board of Directors, officers of the Bank, Director Messina personally, "institution-affiliated parties" of USTrust or any combination thereof. While it is not possible to predict with certainty the probability of penalties being assessed, the person or persons upon whom any penalty would be assessed or the amounts of any such penalties, were they to be assessed, management of the Company believes that it is unlikely that this matter will have a material adverse effect on its financial condition or results of operations. Consequently, no provision in respect of penalties has been made in the Company's Consolidated Financial Statements. (16) FINANCIAL INSTRUMENTS WITH ON-AND OFF-BALANCE-SHEET RISK The Company is party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extent credit, standby letters of credit and financial guarantees. Those instruments involve, to varying degrees, credit risk in excess of the amount contained in the balance sheet. The contract or notional amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments. The Company's exposure to credit loss in the event of nonperformance by the other party to the financial instrument or commitments to extend credit and standby letters of credit and financial guarantees written is represented by the contractual notional amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. UST CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract during its term. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being fully drawn upon and, in fact, have a maturity of less than one year, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer's credit worthiness on a case-by-case basis. Of the total commitments to extend credit, approximately $31 million and $33 million were secured by real estate at December 31, 1993 and 1992, respectively. The amount of collateral obtained is based on management's evaluation of the credit risk. Collateral held on commitments and loans varies but may include cash, accounts receivable, inventory, property, plant and equipment. Standby and commercial letters of credit and financial guarantees written are conditional commitments issued by the Company to guarantee the performance of, or payment by, a customer to a third party. Those guarantees are primarily issued to support private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Company holds various collateral to support these commitments including (but not limited to) cash, accounts receivables, inventory, property plant and equipment. The extent of collateral held for those commitments varies from zero to one hundred percent. Of the total standby and commercial letters of credit, approximately $4 million and $13 million were secured by real estate at December 31, 1993 and 1992, respectively. The Company's primary loan market is the New England region. Most of the loans outstanding are from eastern Massachusetts and a substantial portion of these loans are various types of real estate loans; still others have real estate as additional collateral. Over 90% of the Company's outstanding commercial and real estate loans are collateralized. The Company's securities portfolio consists largely of mortgage-backed securities. These securities carry prepayment risk due to the fact that prevailing interest rates could continue to decline. Under such circumstances an unusually high percentage of homeowners may choose to refinance their first mortgages to take advantage of these lower rates with the result that, under the Company's accounting policy, adjustments reducing gross unamortized premiums would be required. See Note (1), Securities and Trading Account Policies. UST CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (17) PARENT COMPANY FINANCIAL INFORMATION Summarized information relative to the balance sheets at December 31, 1993 and 1992 and statements of income and cash flows for the three years in the period ended December 31, 1993 of UST Corp. are presented as follows. All dividend income in the periods shown below are from banking subsidiaries: UST CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) STATEMENTS OF CASH FLOWS -- PARENT COMPANY ONLY Cash dividends paid to the Company in 1993 by bank subsidiaries totaled $5,250,000. There were no cash dividends paid to the Company in 1992. In 1991 the amount was $2,250,000. No cash dividends were paid to the Company by other subsidiaries in these years. (18) FINANCIAL INSTRUMENTS In December 1991, the FASB issued SFAS No. 107, "Disclosures about Fair Value of Financial Instruments." SFAS No. 107 is effective for fiscal years ending after December 15, 1992. SFAS 107 requires disclosure of the fair market value of financial instruments, whether assets, liabilities or off-balance sheet commitments, if practicable. The following methods and assumptions were used to estimate the fair value of each class of financial instruments. Fair value estimates which were derived from discounted cash flows or UST CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) broker quotes cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instrument. CASH AND DUE FROM BANKS, EXCESS FUNDS SOLD AND OTHER SHORT-TERM INVESTMENTS For these short-term instruments the carrying amount is a reasonable estimate of fair value. INVESTMENT PORTFOLIO AND SECURITIES HELD FOR SALE For marketable securities fair values are based on quoted market prices or dealer quotes. Nonmarketable investment securities are valued at cost. LOANS For certain homogenous categories of loans, such as residential mortgages and home equity loans, fair value is estimated based on broker quotes on sales of similar loans. The fair value of fixed rate loans was estimated by discounting anticipated future cash flows using current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. The fair value of performing variable rate loans is the same as the book value at the reporting date because the loans reprice when the market changes. DEPOSIT LIABILITIES The fair value of noncertificate deposit accounts is the amount payable on demand at the reporting date. The fair value of fixed-maturity certificates of deposit is estimated by discounting the anticipated future cash payments using the rates currently offered for deposits of similar remaining maturities. SHORT-TERM BORROWINGS For these short-term instruments the carrying amount is a reasonable estimate of fair value. OTHER BORROWINGS The fair value of other borrowings were determined by discounting the anticipated future cash payments by using the rates currently available to the Company for debt with similar terms and remaining maturities. COMMITMENTS TO EXTEND CREDIT/SELL LOANS The great majority of commitments, standby letters of credit and commercial letters of credit are short term in nature and therefore have been valued at their carrying amount. VALUES NOT DETERMINED SFAS No. 107 excludes certain assets from its disclosure requirements including real estate included in banking premises and equipment, and the intangible value inherent in the Company's deposit relationships (i.e., core deposits). Accordingly, the aggregate fair value amounts presented below do not represent the underlying value of the Company. UST CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (19) CONSOLIDATED SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) As shown above, the Company recorded high provisions for loan losses in the second quarter of 1993 and third and fourth quarters of 1992. Provisions for loan loss are recorded as necessary in order to maintain an adequate reserve for loan loss based upon the Company's methodology for quantifying the risk inherent in the loan portfolio. Toward the end of the second quarter of 1993, management changed its strategy regarding troubled credit situations. While the change would result in the handling of these situations in an expeditious manner, it was UST CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) recognized that the up-front costs of these workouts would increase. As a result, the reserve for loan losses was increased by $19.8 million during the second quarter. To achieve the higher reserve level, the Company recorded a $42.7 million provision for loan losses in the second quarter. Included in that amount was a special provision of $30 million. This special provision was management's estimate of the additional losses to be incurred from the strategic change referred to above and the continued sluggish economic climate and losses occurring during the remainder of 1993 on these and other credits. An increase in nonaccruals in the third quarter of 1992 was a major factor in the increased provisions for the last two quarters of 1992. In the third quarter of 1992, the Company achieved gains on sale of securities of $10.8 million, which was a significant factor in the results for that quarter. Noninterest income decreased after the first quarter of 1993 due primarily to a decrease in gains on sale of securities. Noninterest expense increased or decreased over the quarters presented due primarily to increases or decreases in the writedowns to fair value of foreclosed real estate properties. ITEM 9.	ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE -- NONE -- PART III ITEM 10.	ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY EXECUTIVE POLICY COMMITTEE In 1987, the Board of Directors of the Company created an Executive Policy Committee which is the primary management forum of the Company for all strategic and policy decisions. All decisions of the Executive Policy Committee are subject to the review and approval of the Board of Directors of the Company. The Executive Policy Committee has been directed by the Board of Directors to make recommendations to the Board concerning adoption of policies, strategies and programs concerning the following, among other matters: (a) acquisitions and dispositions of corporate entities, assets and/or investments; (b) the issuance of equity and/or debt; (c) engaging in new business activities; (d) the hiring, termination, training and motivation of senior management; (e) the development of marketing programs concerning financial services; (f) improvements to operations, service delivery and implementation of procedures for cost control, (g) improvements to the financial reporting and financial controls systems; (h) improvements to the business information systems; and (i) improvements concerning risk management and legal and regulatory compliance programs. As of March 25, 1994, there were 11 members of the Executive Policy Committee. The members of the Committee are identified and the background of each Committee member is set forth below under "Executive Officers." EXECUTIVE OFFICERS The names and ages of the executive officers of the Company and each executive officer's position with the Company and its subsidiaries are listed below. Each such executive officer is elected annually by the Directors of the Company (or the Directors of the applicable subsidiary of the Company) and serves until his or her successor is duly chosen and qualified or until his or her earlier death, removal or disqualification. - --------------- * Member, Executive Policy Committee The following sets forth the principal occupation during the past five years of each of the executive of officers of the Company. Mr. Finnegan has served as President and Chief Executive Officer of the Company since April 1993. During the prior five years, Mr. Finnegan was Executive Vice President in charge of Private Banking at Bankers Trust Company, New York, New York. From 1986 to 1988, Mr. Finnegan was President and Chief Operating Officer of Bowery Savings Bank in New York City. From 1982 to 1986 he was Vice Chairman of Shawmut Corporation in Boston. Mr. Finnegan also serves as Vice Chairman of the Board of Trustees of Northeastern University. Mr. Finnegan is also a Director and President of USTrust and a Director and Chairman of the Executive Committee of USTC. Mr. Schwartz has served as Chairman of the Company since April 1993. Mr. Schwartz has been Vice Chairman of the Board of Directors of the Company since 1981. Mr. Schwartz is Vice President/Academic Affairs at Yeshiva University and is of counsel to the New York law firm of Cadwalader, Wickersham & Taft. Mr. Schwartz formerly served as Dean of Boston University School of Law. Mr. Siskind has served as Chairman of the Board of the Company since 1967. He was Chief Operating Officer of the Company from 1976 through 1984 and General Counsel of the Company in 1984 and 1985. From 1966 through 1976, Mr. Siskind served as Dean of Boston University School of Law. Mr. Huskins was elected Executive Vice President/Administration of the Company in August 1993. Mr. Huskins is also responsible for the leasing and retail banking activities of the Company. Prior to joining the Company, Mr. Huskins served as President, Sterling Protection Company, Watertown, MA (security systems) from 1990 to 1993 and as Vice Chairman of Chancellor Corporation, Boston, MA (leasing) from 1977 to 1989. Mr. Colasacco was elected Executive Vice President and a Director of the Company in 1990. In 1993, he was also elected Chairman of the Board and President of USTC. Prior to that time, he served as an Executive Vice President of USTC. He also directs the asset management and investment activities of the Company and its subsidiaries. Mr. Colasacco has been an officer of the Company or of one of its subsidiaries since 1974. Mr. Fischer was elected Executive Vice President, General Counsel and Clerk of the Company in 1992. Prior to 1992, he served as Senior Vice President, General Counsel and Assistant Clerk of the Company. Before joining the Company in 1986. he served as Assistant General Counsel of Bank of Boston Corporation and its principal subsidiary, The First National Bank of Boston. Mr. Fischer is, and has been since 1984, a member of the faculty of the Morin Center for Banking Law Studies of Boston University School of Law. He also serves as Executive Vice President, General Counsel and Secretary of USTC and USTrust, as a Director and Clerk of UST Leasing Corporation, as Clerk of UST Data Services Corp. and UST Capital Corp. and as Assistant Secretary of UST Bank/Connecticut. Mr. Brooks has been a Senior Vice President of the Company since 1984 and Treasurer since 1980. He is Chairman of the Asset and Liability Management Committee of the Company. In addition. he serves as a Director of UST Data Services Corp. and as a Director and Treasurer of UST Leasing Corporation. Mr. Brooks has been an officer of the Company since 1967. Ms. Lerner has served as Senior Vice President of the Company since she joined the Company in 1988. She directs the Human Resources activities of the Company. Prior to her joining the Company, Ms. Lerner served in a similar capacity for the Provident institution for Savings in Boston. Mr. Shediac was elected Chairman of the Board of USTrust in 1993. Prior to that time, he served as President of USTrust. His primary responsibilities involve of the retail banking operations of the Company's banking subsidiaries. Mr. Shediac has been an officer of the Company or its subsidiaries since 1980. Ms. Stevens was elected Executive Vice President and Senior Lending Officer of USTrust in 1993. Since joining the Company in 1985 and until 1993, Ms. Stevens served in the commercial banking function of USTC as Senior Vice President from 1985 through 1990 and as Executive Vice President from 1990 until 1993. Mr. Sullivan has served as President of UST Data Services Corp. since he joined the Company in 1988. In that capacity, he has responsibility for the data processing and information systems of the Company as well as for its operations activities. Prior to 1988, Mr. Sullivan served as Executive Vice President of Operations with BayBanks Systems, Inc. in Waltham, MA. Mr. McAlear has served as Vice Chairman of USTrust since he joined the Company in 1990. His primary responsibilities involve the supervision of the controlled loan and real estate lending and workout functions of USTrust and the Company Prior to 1990, Mr. McAlear served as an Executive Vice President in the lending area of the Bank of New England. Ms. Armstrong was named Senior Vice President/Credit Administration of USTrust in February 1994. She has served in the credit administration and credit risk control functions of USTrust since she joined the Company in 1985. Ms. Armstrong is the Chairman of the Senior Credit Committee of the Company and USTrust. Mr. Clarke has served as Vice President and Controller of the Company since 1988. Prior to joining the Company, Mr. Clarke was Deputy Comptroller of The First National Bank of Boston. Mr. Dwyer was elected Senior Vice President/Chief Loan Review Officer of the Company in August 1993. Prior to joining the Company, Mr. Dwyer served as Senior Vice President/Loan Workout at First New Hampshire Bank, Manchester, NH, from 1990 through mid-1993. Prior to 1990, Mr. Dwyer was Senior Vice President of Corporate Credit Review at Shawmut Bank, N.A. in Boston, MA. There are no arrangements or understandings between any executive officer and any other person pursuant to which he or she was selected as an executive officer. Other than the information provided in the preceding paragraph, this item has been omitted since the Company will have filed a definitive proxy statement within 120 days after December 31, 1993, the close of its fiscal year. The additional information required by this item is incorporated by reference to such proxy statement. ITEM 11.	ITEM 11. EXECUTIVE COMPENSATION This item has been omitted since the Company will have filed a definitive proxy statement within 120 days after December 31, 1993, the close of its fiscal year. The information required by this item is incorporated by reference to such proxy statement. ITEM 12.	ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT This item has been omitted since the Company will have filed a definitive proxy statement within 120 days after December 31, 1993, the close of its fiscal year. The information required by this item is incorporated by reference to such proxy statement. Section 16(a) of the Securities Exchange Act of 1934 requires the Company's executive officers and directors to file reports of ownership and changes in ownership with the Securities and Exchange Commission. Executive Officers and Directors are required by the SEC regulation to furnish the Company with copies of all Section 16(a) forms they file. Based solely on its review of the copies of such forms received by it, the Company believes that, during 1993, all such filing requirements applicable to its executive officers and directors were complied with by such individuals. ITEM 13.	ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS This item has been omitted since the Company will have filed a definitive proxy statement within 120 days after December 31, 1993, the close of its fiscal year. The information required by this item is incorporated by reference to such proxy statement. PART IV ITEM 14.	ITEM 14. EXHIBITS. FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K a) List the following documents filed as part of this report: 1. All financial statements UST Corp. and Subsidiaries See Index to Financial Statements on page 31. 2. Financial statement schedules required to be filed by Item 8 of Form 10-K and by Item 14(d) None (Information included in Financial Statements). 3. Exhibits required to be filed by Item 501 of Regulation S-K and by Item 13(c) (3) Articles: By-Laws 3(a) Articles of Organization of the Company as amended to date. 3(b) By-laws of the Company as amended to date. (4) Instruments defining the rights of security holders, including indentures: 4(a) Specimen of the Company's Common Stock Certificate. (Exhibit 4.1 to Registrant's Registration Statement No. 2-67787 on Form S-1.) 4(b) Description of rights of the holders of the Company's Common Stock (Appearing on Page 76 of Registrant's Registration Statement No. 33-11118 on Form S-4). 4(c) Note Agreement, dated August 8, 1986, between the Company and holders of the Company's 8.5% Senior Notes Due August 1, 1996. (Exhibit 4(d) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1986.) (10) Material Contracts 10(a) Deferred Compensation Program, as amended to June 16, 1992. (Exhibit to Form 10-K for year ended December 31, 1992) 10(b) Incentive Stock Option Plan, as amended to May 15, 1990. (Exhibit to Form 10-K for year ended December 31, 1992) l0(c) Pension Plan, as amended to January 1, 1990. (Exhibit to Form 10-K for year ended December 31, 1991) 10(d) Employee Stock Ownership Plan, as amended to January 1, 1991. (Exhibit to Form 10-K for year ended December 31, 1991) 10(e) Profit-Sharing Plan, as amended to January 1, 1991. (Exhibit to Form 10-K for year ended December 31, 1991) 10(f) Stock Compensation Plan, (Registration Statement Nos. 33-54390 and 2-77803) 10(g) Dividend Reinvestment Plan, as amended. (Exhibit to Registration Statement No. 33-38836 on Form S-3.) 10(h) Directors Stock Option Plan (Exhibit to Form 10-K for year ended December 31, 1989) 10(i) Purchase Agreement, dated as of June 1, 1993, between the Company and Kidder, Peabody Group, Inc. related to the private placement of 500,000 shares of UST Corp. Common Stock. (Exhibit to Form 8-K for quarter ended June 30, 1993) 10(j) Registration Rights Agreement, dated as of June 1, 1993, between the Company and Kidder, Peabody Group, Inc. related to the private placement of 500,000 shares of UST Corp. Common Stock. (Exhibit to Form 8-K for quarter ended June 30, 1993) 10(k) Employment Agreement, dated as of April 20, 1993, between the Company and Neal F. Finnegan, President and Chief Executive Officer of the Company. (Exhibit to Form 8-K dated March 25, 1993) 10(1) Placing Agreement, dated July 28, 1993, between the Company and Fox-Pitt Kelton N.V., relating to the placement overseas of 2,870,000 shares of the Company's Common Stock. (Exhibit to Form 10-Q for quarter ended September 30, 1993) 10(m) Transition Agreement, dated as of June 30, 1993, between the Company and James V. Sidell, former President and Chief Executive Officer of the Company. (Exhibit to Form 10-Q for quarter ended September 30, 1993) 10(n) Separation Agreement dated August 16, 1993 between the Company and Robert G. Truslow, former President of the Company's wholly-owned subsidiary, USTrust. (Exhibit to Form 10-Q for quarter ended September 30, 1993) 10(o) Separation Agreement dated September 20, 1993 between the Company Frank A. Morse, former President of the Company's wholly-owned subsidiary UST Bank/Connecticut. (Exhibit to Form 10-Q for quarter ended September 30, 1993)** (11) Statement re: computation of per share earnings (See Note 1 to Financial Statements.)* (21) Subsidiaries of the Registrant* (23) Consent of Arthur Andersen & Co.* - --------------- * Filed herewith ** Filed as part of a previous Commission filing and incorporated herein by reference. (b) Reports on Form 8-K Reports on Form 8-K or Form 8-K/A were filed by the Company on March 25, 1993 (UST Corp. Press Release naming new Chief Executive Officer); April 21, 1993 (Holding Company Director Falcone renounces claim against USTrust and USTC); July 16, 1993 (UST Corp. Press Release announcing loan loss provision and second quarter loss); and March 18, 1994 (filing of the Company's financial statements as of December 31, 1993). (c) Exhibits being filed See Exhibit Index (d) Financial Statement Schedules included in Financial Statements. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. UST CORP. 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.
25757_1993.txt	25757	1993	Item 1. Business General The Registrant, Crompton & Knowles Corporation (sometimes hereinafter referred to as the "Corporation"), was incorporated in Massachusetts in 1900. The Corporation has engaged in the manufacture and sale of specialty chemicals since 1954 and, since 1961, in the manufacture and sale of specialty process equipment and controls. The Corporation expanded its specialty chemical business in 1988 with the acquisitions of Ingredient Technology Corporation, a leading supplier of ingredients for the food and pharmaceutical industries, and Townley Dyestuffs Auxiliaries Company, Ltd., one of the largest independent suppliers of dyes for Great Britain's textile and paper industries. The Corporation made two acquisitions in calendar year 1990, acquiring the business and certain assets and liabilities of Atlantic Industries, Inc., a domestic dye manufacturer, and APV Chemical Machinery, Inc., which manufactured the Sterling line of extruders, extrusion systems and industrial blow molding equipment for the plastics industry. In 1991, the Corporation acquired a wire and cable equipment business from Clipper Machines, Inc. In 1992, the Corporation acquired a pre-metallized dyes business and facility located in Oissel, France. Information as to the sales, operating profit, and identifiable assets attributable to each of the Corporation's business segments during each of its last three fiscal years is set forth in the Notes to Consolidated Financial Statements on page 24 of the Corporation's 1993 Annual Report to Stockholders, and such information is incorporated herein by reference. Products and Services The principal products and services offered by the Corporation are described below. SPECIALTY CHEMICALS Textile dyes manufactured and sold by the Corporation are used on both synthetic and natural fibers for knit and woven garments, home furnishings such as carpets, draperies, and upholstery, and automotive furnishings including carpeting, seat belts, and upholstery. Industrial dyes and chemicals are marketed to the paper, leather, and ink industries for use on stationery, tissue, towels, shoes, apparel, luggage, and other products and for transfer printing inks. The Corporation also markets organic chemical intermediates and a line of chemical auxiliaries for the textile industry, including leveling agents, dye fixatives, and scouring agents. Sales of this class of products accounted for 57%, 59%, and 57% of the total revenues of the Corporation in 1993, 1992, and 1991, respectively. The Corporation manufactures and sells reaction and compounded flavor ingredients for the food processing, bakery, beverage and pharmaceutical industries; colors certified by the Food & Drug Administration for sale to domestic producers of food and pharmaceuticals; inactive ingredients for the pharmaceutical industry; and fragrance formulations used in personal care and household products. The Corporation is also a leading supplier of specialty sweeteners, including edible molasses, molasses blends, malt extracts, and syrups for the bakery, confectionery and food processing industries and a supplier of seasonings and seasoning blends for the food processing industry. Sales of this class of products accounted for 16%, 17%, and 19% of the total revenues of the Corporation in 1993, 1992, and 1991, respectively. SPECIALTY PROCESS EQUIPMENT AND CONTROLS The Corporation, through its Davis-Standard Division, manufactures and sells plastics and rubber extrusion equipment, industrial blow molding equipment, electronic controls, and integrated extrusion systems and offers specialized service and modernization programs for in-place extrusion systems. Sales of this class of products accounted for 27%, 24%, and 24% of the total revenues of the Corporation in 1993, 1992, and 1991, respectively. Integrated extrusion systems, which include extruders in combination with controls and other accessory equipment, are used to process plastic resins and rubber into various products such as plastic sheet used in appliances, automobiles, home construction, sports equipment, and furniture; blown film used to package many consumer products; and extruded shapes used as house siding, furniture trim, and substitutes for wood molding. Integrated extrusion systems are also used to compound engineered plastics, to recycle and reclaim plastics, and to apply plastic or rubber insulation to high voltage power cable for electrical utilities and to wire for the communications, construction, automotive, and appliance industries. Industrial blow molding equipment produced by the Corporation is sold to manufacturers of non-disposable plastic parts such as tool cases and beverage coolers. The Corporation's HES unit produces electrical and electronic controls primarily for use with extrusion systems. The Davis- Standard Division is a major user of such controls. Sources of Raw Materials Chemicals, steel, castings, parts, machine components, edible molasses, spices, and other raw materials required in the manufacture of Crompton & Knowles' products are generally available from a number of sources, some of which are foreign. Significant sales of the dyes and auxiliary chemicals business consist of dyes manufactured from intermediates purchased from foreign sources. Patents and Licenses Crompton & Knowles owns patents, trade names, and trademarks and uses know-how, trade secrets, formulae, and manufacturing techniques which assist in maintaining the competitive position of certain of its products. Patents, formulae, and know-how are of particular importance in the manufacture of a number of the dyes and flavor ingredients sold in the Corporation's specialty chemicals business, and patents and know-how are also significant in the manufacture of certain wire insulating and plastics processing machinery product lines. The Corporation believes that no single patent, trademark, or other individual right is of such importance, however, that expiration or termination thereof would materially affect its business. The Corporation is also licensed to use certain patents and technology owned by foreign companies to manufacture products complementary to its own products, for which it pays royalties in amounts not considered material to the consolidated results of the enterprise. Products to which the Corporation has such rights include certain dyes and plastics machinery. Seasonal Business No material portion of any segment of the business of the Corporation is seasonal. Customers The Corporation does not consider any segment of its business dependent on a single customer or a few customers, the loss of any one or more of whom would have an adverse effect on the segment. No one customer's business accounts for more than ten percent of the Corporation's gross revenues nor more than ten percent of its earnings before taxes. Backlog Because machinery production schedules range from about 60 days to 10 months, backlog is important to Crompton & Knowles' specialty process equipment and controls business. Firm backlog of customers' orders at December 25, 1993, for this business, totalled approximately $38 million compared with $33.8 million at December 26, 1992. It is expected that most of the December 25, 1993, backlog will be shipped during 1994. Orders for specialty chemicals and equipment repair parts are filled primarily from inventory stocks and thus are excluded from backlog. Competitive Conditions Crompton & Knowles is among the largest suppliers of dyes in the United States and is a leading domestic producer of specialty dyes for nylon, polyester, acrylics, and cotton. The Corporation is less of a factor in other segments of the domestic dyes industry and in the European market. The Corporation is also a major United States and Canadian supplier of edible molasses, a major United States supplier of malt extracts, and a significant supplier of other sugar-based specialty products. As a supplier of flavors and seasonings, the Corporation has many competitors in the United States and abroad. Crompton & Knowles is a leading producer of extrusion machinery for the plastics industry and a leading domestic producer of industrial blow molding equipment and competes with domestic and foreign producers of such products. The Corporation is one of a number of producers of other types of plastics processing machinery. Product performance, service, and competitive prices are all important factors in competing in the specialty chemicals and specialty process equipment and controls product lines. No one competitor or small number of competitors is believed to be dominant in any of the Corporation's major markets. Research and Development Crompton & Knowles employs about 240 engineers, draftsmen, chemists, and technicians responsible for developing new and improved chemical products and process equipment systems for the industries served by the Corporation. Often, new products are developed in response to specific customer needs. The Corporation's process of developing and commercializing new products and product improvements is ongoing and involves many products, no one of which is large enough to significantly impact the Corporation's results of operations from year to year. Research and development expenditures totalled $11.2 million for the year 1993, $10.1 million for the year 1992 and $9.7 million for the year 1991. Environmental Matters The Corporation's manufacturing facilities are subject to various federal, state and local requirements with respect to the discharge of materials into the environment or otherwise relating to the protection of the environment. Although precise amounts are difficult to define, in 1993, the Corporation spent approximately $13.0 million to comply with those requirements, including approximately $4.1 million in capital expenditures. The Corporation has been designated, along with others, as a potentially responsible party under the Comprehensive Environmental Response, Compensation, and Liability Act of 1980, or comparable state statutes, at two waste disposal sites; and two inactive subsidiaries have been designated, along with others, as potentially responsible parties at a total of four other sites. While the cost of compliance with existing environmental requirements is expected to increase, based on the facts currently known to the Corporation, management expects that those costs, including the cost to the Corporation of remedial actions at the waste disposal sites where it has been named a potentially responsible party, will not have a material effect on the Corporation's liquidity and financial condition and that the cost to the Corporation of any remedial actions will not be material to the results of the Corporation's operations in any given year. Employees The Corporation had 2,352 employees on December 25, 1993. Financial Information Concerning Foreign Operations and Export Sales The information with respect to sales, operating profit, and identifiable assets attributable to each of the major geographic areas served by the Corporation and export sales, for each of the Corporation's last three fiscal years, set forth in the Notes to Consolidated Financial Statements on page 24 of the Corporation's 1993 Annual Report to Stockholders, is incorporated herein by reference. The Corporation considers that the risks relating to operations of its foreign subsidiaries are comparable to those of other U.S. companies which operate subsidiaries in developed countries. All of the Corporation's international operations are subject to fluctuations in the relative values of the currencies in the various countries in which its activities are conducted. Item 2.		Item 2. Properties The following table sets forth information as to the principal operating properties of the Corporation and its subsidiaries: Ownership Business Segment Dates or Lease and Location Products Built Expiration Specialty Chemicals: Carrollton, TX Seasonings 1982 1994 office and plant Des Plaines, IL Flavors and 1968 Owned office and plant fragrances Elyria, OH Seasonings 1978 2001 office and plant Gibraltar, PA Textile and other 1964- office, laboratory dyes 1980 Owned and chemical plant Lowell, NC Textile dyes, chemical plant organic chemicals 1961 Owned Mahwah, NJ Flavors, 1984- 1999 office, laboratory fragrances, 1989 seasonings and color dispersions Newark, NJ Textile dyes, 1949- chemical plant organic chemicals 1985 Owned Nutley, NJ Textile and 1949- office, laboratory, other dyes 1977 Owned and chemical plant Oissel, France Textile and 1946- Owned office, laboratory other dyes 1992 and chemical plant Pennsauken, NJ Food and 1975 1994 office and plant pharmaceutical ingredients Reading, PA Textile dyes, 1910- chemical plant organic chemicals, 1979 Owned and food colors Tertre, Belgium Textile and office, laboratory, other dyes 1970 Owned and chemical plant Specialty Process Equipment and Controls: Edison, NJ Blow Molding and 1974- 1995 office and extrusion 1979 machine shop equipment Pawcatuck, CT Plastics and 1965- office and machine rubber extrusion 1985 Owned shop and electronic control equipment and systems Pawcatuck, CT Extrusion 1968 1996 office, machine systems shop and warehouse All plants are built of brick, tile, concrete, or sheet metal materials and are of one-floor construction except parts of the plants located in Reading and Gibraltar, Pennsylvania, Nutley, New Jersey, Oissel, France and Tertre, Belgium. All are considered to be in good operating condition, well maintained, and suitable for the Corporation's requirements. Item 3.	Item 3. Legal Proceedings Kem Manufacturing Corporation ("Kem"), a wholly-owned subsidiary of the Corporation acquired in 1976, has been named, along with others, a potentially responsible party under the New Jersey Spill Compensation and Control Act by the New Jersey Department of Environmental Protection and Energy with respect to the Evor Phillips waste disposal site located in central New Jersey. It appears that Kem held title to the site between 1970 and 1974, prior to the acquisition of Kem by the Corporation, but that Kem did not own or operate any facility at the site. Based on the facts currently known to the Corporation, the Corporation does not believe that the cost to the Corporation of any remedial actions at the site will have a material effect on the Corporation's liquidity and financial condition or the results of the Corporation's operations in any given year. Item 4.	Item 4. Submission of Matters to a Vote of Security Holders No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year covered by this report. PART II Item 5.	Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters The information concerning the range of market prices for the Corporation's Common Stock on the New York Stock Exchange and the amount of dividends paid thereon during the past two years, set forth in the Notes to Consolidated Financial Statements on page 23 of the Corporation's 1993 Annual Report to Stockholders, is incorporated herein by reference. The number of registered holders of Common Stock of the Corporation on December 25, 1993 was 3,973. Item 6.	Item 6. Selected Financial Data The selected financial data for the Corporation for each of its last five fiscal years, set forth under the heading "Eleven Year Selected Financial Data" on pages 26 and 27 of the Corporation's 1993 Annual Report to Stockholders, is incorporated herein by reference. Item 7.	Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Management's discussion and analysis of the Corporation's financial condition and results of operations, set forth under the heading "Management's Discussion and Analysis" on pages 10 through 13 of the Corporation's 1993 Annual Report to Stockholders, is incorporated herein by reference. Item 8.	Item 8. Financial Statements and Supplementary Data The financial statements of the Corporation, notes thereto, and supplementary data, appearing on pages 14 through 25 of the Corporation's 1993 Annual Report to Stockholders, are incorporated herein by reference. Item 9.	Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure Not applicable. PART III Item 10.	Item 10. Directors and Executive Officers of the Registrant Information called for by this Item concerning directors of the Corporation is included in the definitive proxy statement for the Corporation's Annual Meeting of Stockholders to be held on April 12, 1994, which has been filed with the Commission pursuant to Regulation 14A, and such information is incorporated herein by reference. The executive officers of the Corporation are as follows: Vincent A. Calarco, age 51, has served as President and Chief Executive Officer of the Registrant since 1985 and Chairman of the Board since 1986. He is former Vice President for Strategy and Development, Uniroyal, Inc. (1984-1985), and former President of Uniroyal Chemical Company (1979-1984). Mr. Calarco has been a member of the Board of Directors of the Registrant since 1985. Mr. Calarco also serves as a director of Caremark International Inc. and J.M. Huber Corporation. Robert W. Ackley, age 52, has served as a Vice President of the Registrant since 1986 and as President of the Registrant's Davis-Standard Division since 1983. Peter Barna, age 50, has served as Treasurer of the Registrant since 1980 and as Principal Accounting Officer since 1986. John T. Ferguson, II, age 47, has served as Chief Legal Officer and Secretary of the Registrant since 1989. Nicholas Fern, Ph.D., age 50, has served as President of the Registrant's International Dyes and Chemicals Division since 1992, and as Managing Director of Crompton & Knowles Europe, S.A. (formerly Crompton & Knowles Tertre) since 1978. Edmund H. Fording, Jr., age 57, has served as Vice President of the Registrant since 1991 and as President of the Registrant's Dyes and Chemicals Division since 1989. He is the former General Manager of the Dyes Division of Hilton Davis Co. (1988-1989) and Director of the Organic Department of Mobay Corporation (1980-1988). Marvin H. Happel, age 54, has served as Vice President - Organization of the Registrant since 1986. He is the former Director of Human Resources of Uniroyal Chemical Company (1979-1986). Charles J. Marsden, age 53, has served as Vice President - Finance and Chief Financial Officer and as a member of the Board of Directors of the Registrant since 1985. Frank H. Schoonyoung, age 51, has served as President of the Corporation's Ingredient Technology Division since July 1992. He is the former Vice President and General Manager of Universal Flavors - U.S.A., Inc. (1990-1992) and Senior Vice President and Director, Flavor Division, Fritzsche Dodge & Olcott, a unit of BASF K&F Corporation (1965-1990). The term of office of each of the above-named executive officers is until the first meeting of the Board of Directors following the next annual meeting of stockholders and until the election and qualification of his successor. There is no family relationship between any of such officers, and there is no arrangement or understanding between any of them and any other person pursuant to which any such officer was selected as an officer. Item 11.	Item 11. Executive Compensation Information called for by this Item is included in the definitive proxy statement for the Corporation's Annual Meeting of Stockholders to be held on April 12, 1994, which has been filed with the Commission pursuant to Regulation 14A, and such information is incorporated herein by reference. Item 12.	Item 12. Security Ownership of Certain Beneficial Owners and Management Information called for by this Item is included on page 5 of the definitive proxy statement for the Corporation's Annual Meeting of Stockholders to be held on April 12, 1994, and such information is incorporated herein by reference. Item 13.	Item 13. Certain Relationships and Related Transactions Information called for by this Item is included in the definitive proxy statement for the Corporation's Annual Meeting of Stockholders to be held on April 12, 1994, and such information is incorporated herein by reference. PART IV Item 14.	Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) The following documents are filed as a part of this report: 1. The financial statements and financial statement schedules listed in the Index on page of Exhibit 27 hereof. 2. The Exhibits listed in paragraph (c), below. (b) There were no reports on Form 8-K filed during the last quarter of the period covered by this report. (c) The following Exhibits are either filed with this report on Form 10-K or incorporated herein by reference to the respective reports and registration statements of the Registrant identified in the parenthetical clause following the description of the Exhibit: Exhibit Description Sequential No. of Exhibit Page No. 3(i) Restated Articles of Organization of the Corp- oration filed with the Commonwealth of Massachusetts on October 27, 1988, as amended on April 10, 1990 and on April 14, 1992. (Exhibit 3(a) to Form 10-K for the fiscal year ended December 26, 1992.) -- 3(ii) By-laws of the Corporation as amended to date. (Exhibit 3(b) to Form 10-K for the fiscal year ended December 30, 1989.) -- 4(a)(1) Rights Agreement dated as of July 20, 1988, between the Registrant and The Chase Manhattan Bank, N.A., as Rights Agent. (Exhibit 1 to Form 8-K dated July 29, 1988.) -- 4(a)(2) Agreement dated as of March 28, 1991, amending Rights Agreement dated as of July 20, 1988, between the Registrant and The Chase Manhattan Bank, N.A., as Rights Agent. (Exhibit 4(i)(i) to Form 10-K for the fiscal year ended December 29, 1990.) -- 4(b) Credit Agreement dated as of September 28, 1992, among the Registrant, five banks, and Bankers Trust Company as Agent. (Exhibit 10.1 to Registration Statement No. 33-52642 on Form S-3.) (Other instruments defining the rights of holders of long-term debt of the Registrant are not being filed herewith pursuant to the provisions of Instruction 4(iii) to Item 601 of Regulation S-K. The Registrant agrees to furnish a copy of any such instrument to the Commission upon request.) 10(a) 1983 Stock Option Plan of Crompton & Knowles Corporation, as amended through April 14, 1987. (Exhibit 10(c) to Form 10-Q for the quarter ended March 28, 1987.) -- 10(b) 1977 Stock Option Plan of Crompton & Knowles Corporation, as amended. (Exhibit 28(b) to Registration Statement No. 2-83339 on Form S-8.) -- 10(c) Amendments to Crompton & Knowles Corporation Stock Option Plans adopted February 22, 1988. (Exhibit 10(d) to Form 10-K for the fiscal year ended December 26, 1987.) -- 10(d) Amended Annual Incentive Compensation Plan * for "A" Group of Senior Executives dated January 24, 1994. -- 10(e) Summary of Management Incentive Bonus Plan for selected key management personnel. (Exhibit 10(m) to Form 10-K for the fiscal year ended December 27, 1980.) -- 10(f) Supplemental Medical Reimbursement Plan. (Exhibit 10(n) to Form 10-K for the fiscal year ended December 27, 1980.) -- 10(g) Supplemental Dental Reimbursement Plan. (Exhibit 10(o) to Form 10-K for the fiscal year ended December 27, 1980.) -- 10(h) Employment Agreement dated February 22, 1988, between the Registrant and Vincent A. Calarco. (Exhibit 10(j) to the Form 10-K for the fiscal year ended December 26, 1987.) -- 10(i) Form of Employment Agreement entered into in 1988, 1989 and 1992 between the Registrant and seven of its executive officers. (Exhibit 10(k) to Form 10-K for the fiscal year ended December 26, 1987.) -- 10(j) Amended Supplemental Retirement Agreement dated * October 20, 1993 between the Registrant and Vincent A. Calarco. -- *10(k) Form of Amended Supplemental Retirement Agreement dated October 20, 1993 between the Registrant and three of its executive officers. -- *10(l) Supplemental Retirement Agreement Trust Agreement dated October 20, 1993 between the Registrant and Shawmut Bank, N.A. -- *10(m) Amended Benefit Equalization Plan dated October 20, 1993. -- *10(n) Amended Benefit Equalization Plan Trust Agreement dated October 20, 1993 by and between the Registrant and Shawmut Bank, N.A. -- *10(o) Amended 1988 Long Term Incentive Plan. -- 10(p) Trust Agreement dated as of May 15, 1989, by and between the Registrant and Shawmut Worcester County Bank, N.A. and First Amendment thereto dated as of February 8, 1990. (Exhibit 10(w) to Form 10-K for the fiscal year ended December 30, 1989.) -- 10(q) Form of 1989 - 1991 Long Term Performance Award Agreement (as amended). (Exhibit 10(x) to Form 10-K for the fiscal year ended December 30, 1989.) -- 10(r) Form of 1992 - 1994 Long Term Performance Award Agreement. (Exhibit 10(y) to Form 10-K for the fiscal year ended December 28, 1991.) -- 10(s) Crompton & Knowles Corporation Restricted Stock Plan for Directors approved by the stockholders on April 9, 1991. (Exhibit 10(z) to Form 10-K for the fiscal year ended December 28, 1991.) -- 10(t) Share Purchase Agreement dated as of April 30, 1992 between Crompton & Knowles Europe, S.A., a subsidiary of the Registrant, and Imperial Chemical Industries PLC. (Exhibit 10(z) to Form 10-K for the fiscal year ended December 26, 1992.) -- 10(u) 1993 Stock Option Plan for Non-Employee Directors __ * 11 Statement re computation of per share earnings. -- 13 1993 Annual Report to Stockholders of Crompton & Knowles Corporation. (Not to be deemed to be filed with the Securities and Exchange Commission except for those portions thereof which are expressly incorporated by reference into this report on Form 10-K.) -- 21 Subsidiaries of the Registrant. (Exhibit 22 to Form 10-K for the fiscal year ended December 26, 1992.) -- 23 Consent of independent auditors. 24 Power of attorney from directors and executive officers of the Registrant authorizing signature of this report. (Original on file at principal executive offices of Registrant.) 27 Financial Statements and Financial Statement Schedules. 29 Annual Report on Form 11-K of Crompton & Knowles Corporation Employee Stock Ownership Plan for the fiscal year ended December 31, 1993. Copies of these Exhibits are annexed to this report on Form 10-K provided to the Securities and Exchange Commission and the New York Stock Exchange. This Exhibit is a compensatory plan, contract or arrangement in which one or more directors or executive officers of the Registrant participate. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. CROMPTON & KNOWLES CORPORATION (Registrant) Date: March 25, 1994 By: /s/ Charles J. Marsden Charles J. Marsden, Vice President-Finance Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the date indicated. Name Title Vincent A. Calarco Chairman of the Board, President, and Director (Principal Executive Officer) Charles J. Marsden* Vice President-Finance and Director (Principal Financial Officer) Peter Barna* Treasurer (Principal Accounting Officer) James A. Bitonti* Director Harry W. Buchanan* Director Robert A. Fox* Director Roger L. Headrick* Director Leo I. Higdon, Jr.* Director Michael W. Huber* Director Warren A. Law* Director C. A. Piccolo* Director Howard B. Wentz, Jr. * Director Date: March 25, 1994 *By: /s/ Charles J. Marsden Charles J. Marsden, as attorney-in-fact
10497_1993.txt	10497	1993	ITEM 1. BUSINESS GENERAL COMPANY INFORMATION As used herein, the "Company" means BayBanks, Inc. alone or BayBanks, Inc. together with its consolidated subsidiaries, depending on the context, and the "BayBanks" means the Company's three bank subsidiaries. BayBanks, Inc., established in 1928, is one of the largest bank holding companies in Massachusetts and is headquartered in Boston, Massachusetts. At December 31, 1993, the Company had total assets of $10.1 billion, total deposits of $8.8 billion, total stockholders' equity of $703 million, and 5,571 full-time equivalent employees. The Company's largest subsidiary is BayBank, a Massachusetts commercial bank based in Burlington, Massachusetts, that had total assets of $9.2 billion at December 31, 1993. BayBank Boston, N.A. is based in the Company's headquarter's city and BayBank Connecticut, N.A. is located in Hartford, Connecticut. The Company also maintains a loan production office in Portland, Maine. The Company has an extensive banking network with 201 full-service offices and 356 automated banking facilities serving 156 cities and towns in Massachusetts and two in Connecticut. The Company uses state-of-the-art computer and telecommunications technology to process customer transactions, provide customer information, and increase the efficiency of its data processing activities. BayBank Systems, Inc., a nonbank subsidiary of the Company, engages in data processing, product and systems development, and other technologically oriented operations, principally for the Company but also for franchisees and correspondents. In particular, BayBank Systems, Inc., operates the Company's proprietary X-Press 24(R) automated teller machine ("ATM") network. BayBanks Credit Corp. (a subsidiary of BayBank Systems, Inc.) and BayBanks Mortgage Corp. (a subsidiary of BayBank) provide instalment loan, credit card, and mortgage loan operations and services, and BayBanks Mortgage Corp. also services approximately $2.0 billion of residential mortgage loans originated by the BayBanks and placed in the secondary market. Other subsidiaries provide brokerage, investment management, and general management services to the BayBanks and other affiliates. The following presents selected financial information for the Company's three banking subsidiaries: GENERAL BANKING BUSINESS The Company provides a complete range of banking and related financial services, with particular emphasis on retail and middle market business customers. In addition to its normal deposit and lending activities, the Company aggressively pursues fee income opportunities, both in traditional and automated banking services and in the investment field, including acting as investment adviser and shareholder servicing agent for BayFunds(R), a proprietary mutual fund family. Retail Banking The Company -- a recognized leader in consumer banking -- has the largest retail market share in Massachusetts. More households in Massachusetts do business with the BayBanks than with any other banking organization. The Company offers a wide variety of retail banking products, including FDIC-insured checking, money market, savings, and time deposit accounts; credit cards; home mortgages and home equity financing; instalment loans; and trust and private banking services. The Company's proprietary X-Press 24 network, the 11th largest ATM network in the country, operates over 1,000 ATMs in Massachusetts and Connecticut and produces approximately 11 million transactions per month; the Company has approximately 1 million ATM cards in use. In addition, the BayBank X-Press 24 Cash(R) network operates cash machines located in major retail stores in Massachusetts. Approximately 88 nonaffiliated financial institutions are X-Press 24 network members. X-Press 24 cardholders can perform automated banking transactions at over 65,000 CIRRUS(R) and NYCE(R) terminals worldwide. Qualifying cardholders can also use their cards to make point-of-sale purchases at retail establishments worldwide, including Mobil(R) stations, grocery stores and, through BayBank X-Press Check(R), anywhere MasterCard(R) is accepted. The Company provides a broad range of support and maintenance services to the X-Press 24 network member institutions. In addition to its branch and ATM networks, the Company operates a customer service center twenty-four hours a day, seven days a week, that provides customer service and product information, opens consumer banking accounts, and fills customer orders, including those from its catalog of banking services. Corporate Banking The Company provides a comprehensive range of cash management, credit, deposit, international banking, and related services to businesses, hospitals, educational institutions, and local governments, with particular emphasis on the Massachusetts middle market. Specialized products available to BayBanks' business and governmental customers include personal computer-based cash management services with which a customer may perform a range of deposit account transactions; X-Press Trade(R), offering automated international letter of credit services; BayBank X-Press Tax(R) for automated payroll tax depositing; a Collateralized Municipal Money Market Account; and the Escrow Client Account Service. BayBank also acts as corporate trustee for bond offerings and as trustee or custodian for employee benefit and pension plans. Specific lending groups focus on healthcare and educational institutions, municipalities, retailers, automobile dealers, and emerging technology companies. The Company also provides secured financing, in the form of asset-based lending, leasing, and real estate lending, for commercial customers. The Company's general corporate lending activities are directed toward small and middle market companies in the New England region, with a primary emphasis on Massachusetts enterprises. Investment Services The Company's subsidiaries offer a wide range of investment services to individuals and business customers. The government and municipal securities dealerships at BayBank Boston, N.A., participate in the underwriting of Massachusetts municipal obligations and engage in private placement activities. BayBanks Brokerage Services, Inc., provides retail brokerage services. BayBanks Investment Management, Inc., a registered investment adviser, provides portfolio advice and asset management for individuals and businesses and manages the BayBank trust department's common and collective trust funds. As of December 31, 1993, the BayBank trust department had total assets of $5.2 billion under management or in custody. BayBanks Investment Management, Inc., acts as investment adviser to several portfolios of BayFunds, a proprietary mutual fund family, and BayBank Boston, N.A. acts as investment adviser to one other BayFunds portfolio. BayFunds added equity and bond portfolios to its existing money market portfolio during the first quarter of 1993. COMPETITION The BayBanks operate in a highly competitive banking market. All of the banks compete with other commercial banks in their respective service areas, with several large commercial banks located in the City of Boston, and with a number of large regional and national commercial banks located throughout the country. Legislation enacted in recent years and changing regulatory interpretations have substantially increased the geographic and product competition among commercial banks, thrift institutions, mortgage companies, leasing companies, credit unions, finance companies, and nonbanking institutions, including mutual funds, insurance companies, brokerage firms, investment banks, and a variety of financial services and advisory companies. In the international business, the BayBanks compete with other domestic banks having foreign operations and with major foreign banks and other financial institutions. GOVERNMENT MONETARY POLICY The earnings and growth of the banking industry in general are affected by the policies of regulatory authorities, including the Board of Governors of the Federal Reserve System ("Federal Reserve Board"). An important function of the Federal Reserve Board is to regulate the national money supply. Among the instruments of monetary policy used by the Federal Reserve Board to implement its objectives are open market operations in U.S. Government securities, changes in the discount rates on member bank borrowings, and changes in amount or methods of calculating reserve requirements against member banks' deposits. These means, used in varying combinations, influence the overall growth of bank loans, investments, and deposits as well as the rates charged on loans or paid for deposits. The monetary policies of the Federal Reserve Board have had a significant effect on the operating results of commercial banks in the past and are expected to continue to have such an effect in the future. The effect of such policies upon the future business and earnings of the Company cannot be predicted. GENERAL BANKING REGULATION The Company is a bank holding company subject to supervision and regulation by the Federal Reserve Board under the Bank Holding Company Act of 1956. As a bank holding company, the activities of the Company and its bank and nonbank subsidiaries are limited to the business of banking and activities closely related or incidental to banking. The Company may not acquire the ownership or control of more than 5% of any class of voting shares or substantially all of the assets of any company, including a bank, without the prior approval of the Federal Reserve Board. The Company is also subject to the Massachusetts and Connecticut bank holding company laws that, respectively require the Company to obtain the prior approval of the Massachusetts Board of Bank Incorporation and the Connecticut Banking Commissioner for holding company mergers and bank acquisitions. The Company's largest subsidiary bank, BayBank, is subject to supervision and examination by the Federal Deposit Insurance Corporation ("FDIC") and the Commissioner of Banks of the Commonwealth of Massachusetts ("Bank Commissioner"). BayBank Boston, N.A. and BayBank Connecticut, N.A., are national banking associations subject to supervision and examination by the Office of the Comptroller of the Currency ("OCC"). All of the Company's subsidiary banks are insured by and subject to certain regulations of the FDIC. They are also subject to various requirements and restrictions under federal and state law, which include requirements to obtain regulatory approval of certain business transactions, including establishing and closing bank branches; requirements to maintain reserves against deposits; restrictions on the types and amounts of loans that may be granted and the interest that may be charged thereon; and limitations on the types of investments that may be made and the types of services that may be offered. Various consumer laws and regulations also affect the operations of the Company's subsidiary banks. Under the Financial Institutions Reform, Recovery and Enforcement Act of 1989, a depository institution insured by the FDIC can be held liable for any loss incurred by, or reasonably expected to be incurred by, the FDIC in connection with (i) the default of a commonly controlled FDIC-insured depository institution or (ii) any assistance provided by the FDIC to a commonly controlled FDIC-insured depository institution in danger of default. Because the Company is a holding company, its right to participate in the assets of any subsidiary upon the latter's liquidation or reorganization will be subject to the prior claims of the subsidiary's creditors (including depositors in the case of bank subsidiaries), except to the extent that the Company may itself be a creditor with recognized claims against the subsidiary. The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") provided for increased funding for FDIC deposit insurance and for expanded regulation of the banking industry. Among other things, FDICIA requires the federal banking regulators to take prompt corrective action with respect to depository institutions that do not meet minimum capital requirements. FDICIA establishes five capital ratio categories: "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized," and "critically undercapitalized." A depository institution is well capitalized if it significantly exceeds the minimum level required by regulation for each relevant capital measure, adequately capitalized if it meets each such measure, undercapitalized if it fails to meet any such measure, significantly undercapitalized if it is significantly below any such measure, and critically undercapitalized if it fails to meet any critical capital level set forth in the regulations. The critical capital level must be a level of tangible equity equal to at least 2% of total assets, but may be fixed at a higher level by regulation. A depository institution may be deemed to be in a capitalization category that is lower than is indicated by its actual capital position if it receives an unsatisfactory examination rating and may be reclassified to a lower category by action based on other supervisory criteria. For an institution to be well capitalized it must have a total risk-based capital ratio of at least 10%, a Tier 1 risk-based capital ratio of at least 6%, and a leverage ratio of at least 5% and not be subject to any specific capital order or directive. For an institution to be adequately capitalized it must have a total risk-based capital ratio of at least 8%, a Tier 1 risk-based capital ratio of at least 4%, and a leverage ratio of at least 4% (3% in some cases). FDICIA generally prohibits a depository institution from making any capital distribution (including payment of a dividend) or paying any management fee to its holding company if the depository institution would thereafter be undercapitalized. Undercapitalized depository institutions are subject to increased regulatory monitoring and growth limitations and are required to submit capital restoration plans. A depository institution's holding company must guarantee the capital plan, up to an amount equal to the lesser of 5% of the depository institution's assets at the time it becomes undercapitalized or the amount needed to comply with the plan. The federal banking agencies may not accept a capital plan without determining, among other things, that the plan is based on realistic assumptions and is likely to succeed in restoring the depository institution's capital. If a depository institution fails to submit an acceptable plan, it is treated as if it is significantly undercapitalized. Significantly undercapitalized depository institutions may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become adequately capitalized, requirements to reduce total assets, and cessation of receipt of deposits from correspondent banks. Critically undercapitalized depository institutions are subject to appointment of a receiver or conservator. Each of the bank subsidiaries of the Company exceeds current minimum regulatory capital requirements and qualify as well capitalized under the regulations relating to prompt corrective action (see "Regulatory Capital Requirements"). The FDIC has adopted regulations governing the receipt of brokered deposits that require certain banks, depending on their capital ratios and other factors, to obtain a waiver from the FDIC before they may accept brokered deposits, and that limit the interest rates certain banks can offer on deposits. Although the Company does not solicit brokered deposits, all of its bank subsidiaries are free to do so without restraint under the regulation. Under FDIC's risk-based deposit insurance premium system for the Bank Insurance Fund ("BIF"), which went into effect on January 1, 1993, banks currently pay within a range of 23 cents per $100 of domestic deposits (the prior rate for all institutions) to 31 cents per $100 of domestic deposits, depending on their risk classification. To arrive at a risk-based assessment for each bank, the FDIC places the bank in one of nine risk categories, using a two-step process based first on capital ratios and then on other relevant supervisory information. Each institution is assigned to one of three groups (well capitalized, adequately capitalized, or undercapitalized) based on its capital ratios. For these purposes, a well capitalized institution is one that has at least a 10% total risk-based capital ratio, a 6% Tier 1 risk-based capital ratio, and a 5% Tier 1 leverage capital ratio. An adequately capitalized institution must have at least an 8% total risk-based capital ratio, a 4% Tier 1 risk-based capital ratio, and a 4% Tier 1 leverage capital ratio. An undercapitalized institution is one that does not meet either of the foregoing definitions. Each institution is also assigned to one of three supervisory subgroups based on an evaluation of the risk posed by the institution to the BIF. Well capitalized banks presenting the lowest risk to the BIF pay the lowest assessment rate, while undercapitalized banks presenting the highest risk pay the highest rate. The BayBanks' capital ratios at December 31, 1993, placed them in the well capitalized category for assessment purposes. The assessment will depend upon the level of deposit balances and the BayBanks' applicable risk categories (see "Regulatory Capital Requirements"). Other significant provisions of FDICIA require federal banking regulators to draft standards in a number of areas to assure bank safety and soundness, including internal controls; credit underwriting; asset growth; management compensation; ratios of classified assets to capital; and earnings. The legislation also contains provisions that require the adoption of capital guidelines applicable to interest rate risks; tighten independent auditing requirements; restrict the activities and investments of state-chartered insured banks; strengthen various consumer banking laws; limit the ability of undercapitalized banks to borrow from the Federal Reserve's discount window; and require regulators to perform annual on-site bank examinations and set standards for real estate lending. The full impact of FDICIA will not be completely known until the adoption by the various federal banking agencies of all of the implementing regulations. However, FDICIA has resulted in increased costs for the banking industry due to higher FDIC assessments and increased compliance burdens. Otherwise, FDICIA has not had an adverse effect on the Company's operations. REGULATORY CAPITAL REQUIREMENTS Under the three federal banking regulators' risk-based capital measures for banks and bank holding companies a banking organization's reported balance sheet is converted to risk-based amounts by assigning each asset to a risk category, which is then multiplied by the risk weight for that category. Off-balance sheet exposures are converted to risk-based amounts through a two-step process. First, off-balance sheet assets and credit equivalent amounts (e.g., interest rate swaps) are multiplied by a credit conversion factor depending on the defined categorization of the particular item. Then the converted items are assigned to a risk category that weights the items according to their relative risk. The total of the risk-weighted on-and off-balance sheet amounts represents a banking organization's risk-adjusted assets for purposes of determining capital ratios under the risk-based guidelines. Risk-adjusted assets can either exceed or be less than reported assets, depending on the risk profile of the banking organization. Risk-adjusted assets for institutions such as the Company will generally be less than reported assets because retail banking activities include proportionally more residential real estate loans with a lower risk rating and a relatively small off-balance sheet position. A banking organization's total qualifying capital includes two components, core capital (Tier 1 capital) and supplementary capital (Tier 2 capital). Core capital, which must comprise at least half of total capital, includes common stockholders' equity, qualifying perpetual preferred stock, and minority interests, less goodwill. Supplementary capital includes the allowance for loan losses (subject to certain limitations), other perpetual preferred stock, certain other capital instruments, and term subordinated debt, which is discounted at 20% a year during its final five years of maturity. The Company's major capital components include stockholders' equity in core capital, and the allowance for loan losses and grandfathered floating rate notes, subject to a 40% discounting in the fourth quarter of 1993, in supplementary capital. At December 31, 1993, the minimum risk-based capital requirements were 4.00% for core capital and 8.00% for total capital. Federal banking regulators have also adopted leverage capital guidelines to supplement the risk-based measures. The leverage ratio is determined by dividing Tier 1 capital as defined under the risk-based guidelines by average total assets (not risk-adjusted) for the preceding quarter. The minimum leverage ratio is 3.00%, although banking organizations are expected to exceed that amount by 100 or 200 basis points or more, depending upon their circumstances. At December 31, 1993, the Company's consolidated risk-based capital ratios were 10.68% for core capital and 12.40% for total capital, and at December 31, 1992, were 10.37% and 12.30%, respectively. The Company's consolidated leverage ratio was 7.26% at December 31, 1993, and 6.79% at December 31, 1992. These ratios exceeded the minimum regulatory guidelines. During the fourth quarter of 1992, the Company completed a public offering of 2.3 million shares of common stock that raised $79.3 million in capital. The Company contributed $8 million in capital to its subsidiaries during 1992 and $22 million during 1993, with the remaining funds held in the parent company's cash and securities portfolios. The Company reinstated its quarterly cash dividend in the first quarter of 1993 at an initial rate of $.20 per share; an equal amount was paid in the second quarter. In the third quarter of 1993, the Company increased its quarterly cash dividend to $.25 per share, which dividend was also paid in the fourth quarter. Total dividends declared for 1993 were $.90 per share. On January 27, 1994, the Board of Directors raised the quarterly dividend amount when it declared a dividend of $.35 per share paid on March 1, 1994. The following table presents the risk-based and leverage capital ratios required for depository institutions to be considered well capitalized under applicable federal regulations and the reported capital ratios of the Company and its bank subsidiaries at December 31, 1993: - --------------- (1) Under Federal Prompt Corrective Action and Risk-based Deposit Insurance Assessment Regulations. n/a -- not applicable The Company and its bank subsidiaries are not subject to any agreements or understandings with their regulatory authorities and all prior regulatory commitments made have been fulfilled. STATISTICAL DISCLOSURES Securities Act Guide 3, Statistical Disclosure by Bank Holding Companies, requires certain statistical disclosures. The statistical information required is either incorporated by reference from the Company's 1993 Annual Report as indicated in the index below, presented in statistical tables within this section, or is not applicable. This information should be read in conjunction with the Financial Review incorporated by reference in Item 7 and the consolidated financial statements and related notes incorporated by reference in Item 8 in this report. - --------------- n/a -- not applicable * The dividend payout ratio was 25.2% in 1993 and 45.6% in 1989; the dividend payout ratio was not meaningful in 1990. There were no dividends paid in 1991 or 1992. ** The average equity to average assets ratio was 7.01% in 1993, 5.67% in 1992, 5.10% in 1991, 5.55% in 1990, and 6.05% in 1989. ANALYSIS OF NET INTEREST INCOME - --------------- (1) The rate/volume variance is allocated to the average balance category. (2) Presented on a tax equivalent basis at the combined effective federal and state tax rate of 43.2% for 1993 and 42.3% for 1992. (3) Loan income includes loan fees, primarily related to commercial and residential real estate loans, of $6.2 million in 1993, $6.8 million in 1992, and $7.4 million in 1991. Nonperforming loans (nonaccrual loans) are included in average loan balances. Interest income is recorded on an accrual basis. Thus, nonperforming loans do not contribute to net interest income and affect the net interest margin. SECURITIES AVAILABLE FOR SALE (1) AT DECEMBER 31 - --------------- (1) There were no securities available for sale as of December 31, 1991. INVESTMENT SECURITIES AT DECEMBER 31 MATURITY DISTRIBUTION OF COMMERCIAL AND COMMERCIAL REAL ESTATE LOANS AT DECEMBER 31, 1993 - --------------- (1) Of the total commercial and commercial real estate loans above with remaining maturities in excess of one year, 50% have adjustable rates of interest. (2) Excludes $47,751 of commercial and $49,014 of commercial real estate nonperforming loans. SUMMARY OF LOAN LOSS EXPERIENCE DISTRIBUTION OF ALLOWANCE FOR LOAN LOSSES (1) - --------------- (1) The distribution of the allowance for loan losses is based on an assessment of an aggregate potential for future losses in the respective year-end loan portfolios. While the allowance has been distributed to individual loan categories, it is available to absorb losses in the total portfolio. The distribution of the allowance includes both allocations assigned to specifically identified problem loans and unallocated amounts that are not specifically identified as to any individual loan. The unallocated amounts related to commercial and commercial real estate loans were $85 million as of December 31, 1993, as described in the CREDIT QUALITY section incorporated by reference in Item 7 (see 1993 Annual Report, "Allowance for Loan Losses," page 15). REMAINING MATURITIES OF TIME DEPOSITS -- $100,000 OR MORE AT DECEMBER 31, 1993 - --------------- (1) Included in this amount are $35 million of large certificates of deposits and $45 million of consumer certificates of deposit of $100,000 or more. SHORT-TERM BORROWINGS ITEM 2.		ITEM 2. PROPERTIES. BayBanks, Inc., and its subsidiaries occupy both owned and leased premises. The offices occupied by the Company in Boston, Massachusetts, include its principal executive offices and are leased from nonaffiliated companies. Property occupied by the three subsidiary banks represents the majority of the Company's property, and is generally considered to be in good condition and adequate for the purpose for which it is used. Bank properties include bank buildings and branches, and free-standing automated banking facilities. The Company owns the 11-story 208,000 square foot headquarters building of BayBank, its principal bank subsidiary, of which 5% is leased to nonaffiliates. Of the 201 branch offices of the subsidiary banks at December 31, 1993, 98 were located in owned buildings and 103 were located in leased buildings. In addition, the Company leases sites for 356 automated banking facilities. In 1992, BayBank Systems, Inc., the Company's principal nonbank subsidiary, occupied a new $38 million, 185,000 square foot owned technology center that enabled the Company to consolidate personnel located in various leased and owned locations, thereby increasing operating efficiency. Also during 1992, BayBank Systems updated an adjoining 121,000 square foot owned facility that houses its principal data processing equipment. At December 31, 1993, there was an aggregate $38 million mortgage on these facilities to an affiliated bank at market terms and in conformity with banking regulations that cover transactions between affiliated parties. ITEM 3.	ITEM 3. LEGAL PROCEEDINGS. There were no material pending legal proceedings other than ordinary routine litigation incidental to the conduct of the Company's business. ITEM 4.	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. No matters were submitted to a vote of security holders during the fourth quarter of 1993. PART II ITEM 5.	ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. (a) The stock of BayBanks, Inc. is traded over the counter through the NASDAQ National Market System under the symbol BBNK. The Quarterly Share Data information that appears on page 38 in the Company's 1993 Annual Report is incorporated herein by reference. (b) As of March 10, 1994, there were approximately 4,500 holders of record of the Company's common stock. (c) The Company paid dividends of $.90 per share during 1993. The Company paid a dividend quarterly from 1928 through 1990. During 1991 and 1992, the Company did not pay any dividends. For additional information on dividend payments, reference is made to the CAPITAL AND DIVIDENDS section that is incorporated by reference from pages 15 and 16 of the Company's 1993 Annual Report, and Note 1 to the consolidated financial statements, incorporated by reference under Item 8. ITEM 6.	ITEM 6. SELECTED FINANCIAL DATA. The Average Balances and Summary of Operations* appearing on pages 34 and 35 of the Company's 1993 Annual Report are incorporated herein by reference. * The caption "Dividends paid per share" in the Summary of operations should read "Dividends declared per share." ITEM 7.	ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS. The Financial Review appearing on pages 4 through 16 of the Company's 1993 Annual Report is incorporated herein by reference. ITEM 8.	ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The following consolidated financial statements and notes thereto of the Company and its subsidiaries appearing on pages 17 through 32 of the Company's 1993 Annual Report are incorporated herein by reference: ITEM 9.	ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. There have been no changes in or matters of disagreement on accounting and financial disclosure with the Company's independent auditors. PART III ITEM 10.	ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. Information concerning directors on pages 1 through 4 of the Company's proxy statement dated March 21, 1994, is incorporated herein by reference. The following are the executive officers of the registrant as of March 15, 1994: Mr. Crozier has been an officer of BayBanks, Inc. since 1967 and was elected Chairman of the Board and Director in 1974. In 1977, Mr. Crozier was elected to the additional post of President. Mr. Arena has been a director since 1977 and was elected Vice Chairman in 1992 when he joined the Company to head its investment, private banking, and personal trust services activities. Prior to joining the Company, Mr. Arena was an independent investment management consultant from 1990 to 1992 and a trustee of an investment management firm from 1987 to 1990. Mr. Isaacs was elected Vice Chairman in 1992, Executive Vice President in 1985, Senior Vice President in 1979, and Vice President in 1978, and joined the Company in 1974. Mr. Isaacs is also the Chairman and CEO of BayBank Systems, Inc., the Company's technology subsidiary. Mr. Pollard was elected Vice Chairman and Director in 1983 and Executive Vice President in 1979 and had been a Senior Vice President since 1976. Mr. Pollard is also President and CEO of BayBank Boston, N.A., and is the senior lending officer of the Company. Ms. Beal was elected Executive Vice President in 1985, Senior Vice President in 1979, and Vice President in 1977, and has been with the Company since 1972. Mr. Vasily was elected Chief Financial Officer in 1991, Executive Vice President in 1987, Senior Vice President in 1980, and Vice President upon joining the Company in 1978, and was the Controller of the Company from 1983 to 1989. Ms. Tonra was elected Senior Vice President of BayBanks, Inc., in 1985 and Controller in 1989, and joined the Company in 1985. She is the Principal Accounting Officer of the Company. Information concerning reports of transactions in BayBanks, Inc. stock on page 12 of the Company's proxy statement dated March 21, 1994 is incorporated herein by reference. ITEM 11.	ITEM 11. EXECUTIVE COMPENSATION. Information concerning management remuneration and transactions on pages 5 through 7 of the Company's proxy statement dated March 21, 1994, is incorporated herein by reference. ITEM 12.	ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Information concerning securities ownership of management on pages 1 and 2, and concerning securities ownership of certain beneficial owners on page 12, of the Company's proxy statement dated March 21, 1994, is incorporated herein by reference. ITEM 13.	ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Information concerning relationships and transactions of the Company's executive officers and directors on page 4 of the Company's proxy statement dated March 21, 1994, is incorporated herein by reference. PART IV ITEM 14.	ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) 1. Financial Statements The following financial statements of the Company and its subsidiaries included in its 1993 Annual Report are incorporated by reference in Item 8: Independent Auditors' Report Consolidated Balance Sheet-December 31, 1993 and 1992 Consolidated Statement of Income-Years Ended December 31, 1993, 1992, and 1991 Consolidated Statement of Changes in Stockholders' Equity-Years Ended December 31, 1993, 1992, and 1991 Consolidated Statement of Cash Flows-Years Ended December 31, 1993, 1992, and 1991 Notes to Financial Statements 2. Financial Statement Schedules All schedules are omitted because either the required information is shown in the financial statements or notes incorporated by reference, or they are not applicable, or the data is not significant. 3. Appendix containing narrative descriptions of graphical and image material omitted from text of Form 10-K and from Exhibit 13 thereto. 4. Exhibits See the Exhibit List and Index on pages 17 and 18. (b) Reports on Form 8-K There were no reports on Form 8-K filed during the fourth quarter of 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. BAYBANKS, INC. (Registrant) By: /s/ MICHAEL W. VASILY MICHAEL W. VASILY Executive Vice President March 24, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below on March 24, 1994, by the following persons on behalf of the registrant and in the capacities indicated. BAYBANKS, INC. EXHIBIT LIST AND INDEX - --------------- * Incorporated by reference to the document indicated in parentheses.
66025_1993.txt	66025	1993	ITEM 1. Business. Incorporated by reference in pages 2 through 11 and 26 of the Registrant's 1993 Annual Report to Shareholders. The number of persons employed by the Registrant was approximately 980 at December 31, 1993. ITEM 2.		ITEM 2. Properties. Incorporated by reference in pages 2 through 11 of the Registrant's 1993 Annual Report to Shareholders. ITEM 3.	ITEM 3. Legal Proceedings. None other than ordinary routine litigation incidental to the business of the Company and its subsidiaries. ITEM 4.	ITEM 4. Submission of Matters to a Vote of Security Holders. None during the fourth quarter. PART II ITEM 5.	ITEM 5. Market for the Registrant's Common Stock and Related Security Holder Matters. Incorporated by reference to pages 25 and 26 (Note 13), and 28 and 29 of the Registrant's 1993 Annual Report to Shareholders. ITEM 6.	ITEM 6. Selected Financial Data. Incorporated by reference to page 13 of the Registrant's 1993 Annual Report to Shareholders. ITEM 7.	ITEM 7. Management's Discussion And Analysis of Financial Condition And Results of Operations. Incorporated by reference to pages 14 and 15 of the Registrant's 1993 Annual Report to Shareholders. ITEM 8.	ITEM 8. Financial Statements and Supplementary Data. Incorporated by reference to pages 16 through 28 of the Registrant's 1993 Annual Report to Shareholders. ITEM 9.	ITEM 9. Disagreements on Accounting and Financial Disclosures. None. PART III ITEM 10.	ITEM 10. Directors and Executive Officers of the Registrant. Incorporated by reference to the Registrant's Proxy Statement dated March 18, 1994. PART III (Continued) Executive Officers Of The Company- J. P. Hayden, Jr. - Age 64 - Chairman and Chief Executive Officer Michael J. Conaton - Age 60 - President and Chief Operating Officer John R. LaBar - Age 62 - Vice President and Secretary Robert W. Hayden - Age 55 - Vice President John I. Von Lehman - Age 41 - Vice President, Treasurer and Chief Financial Officer Thomas J. Rohs - Age 52 - Vice President J. P. Hayden III - Age 41 - Vice President John W. Hayden - Age 36 - Vice President Robert N. Thornbladh - Age 41 - Vice President Michael L. Flowers - Age 42 - Vice President, Assistant Secretary and Chief In-House Counsel J. P. Hayden, Jr. and Robert W. Hayden are brothers. J. P. Hayden, III and John W. Hayden are sons of J. P. Hayden, Jr. During 1988, Michael J. Conaton was elected President and Chief Operating Officer (formerly Executive Vice President and Chief Financial Officer). During 1988, John I. Von Lehman was elected Vice President and Chief Financial Officer and retained the title of Treasurer (formerly Treasurer and Chief Accounting Officer). During 1990, Robert N. Thornbladh joined the Company as Vice President. He was formerly employed by Nutmeg Industries. During 1991, Michael L. Flowers (formerly Assistant Secretary) was elected Vice President. The officers listed above have served in the positions indicated for the past five years (except as noted above). ITEM 11.	ITEM 11. Executive Compensation. Incorporated by reference to the Registrant's Proxy Statement dated March 18, 1994. ITEM 12.	ITEM 12. Security Ownership of Certain Beneficial Owners and Management. Incorporated by reference to the Registrant's Proxy Statement dated March 18, 1994. ITEM 13.	ITEM 13. Certain Relationships and Related Transactions. Incorporated by reference to the Registrant's Proxy Statement dated March 18, 1994. PART IV ITEM 14.	ITEM 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) 1. Financial Statements. Incorporated by reference in Part II of this report: PART IV (Continued) Data pertaining to The Midland Company and Subsidiaries - Report of Independent Public Accountants. Consolidated Balance Sheets, December 31, 1993 and 1992. Consolidated Statements of Income and Retained Earnings for the Years Ended December 31, 1993, 1992 and 1991. Consolidated Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991. Notes to Consolidated Financial Statements. (a) 2. Financial Statement Schedules. Included in Part IV of this report: Data pertaining to The Midland Company and Subsidiaries - Page Independent Auditors' Consent and Report on Schedules 7 Schedule I - Marketable Securities - Other Investments, December 31, 1993 8 Schedule V - Property, Plant and Equipment for the Years Ended December 31, 1993, 1992 and 1991 9 Schedule VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment for the Years Ended December 31, 1993, 1992 and 1991 10 Schedule VIII - Allowance for Losses for the Years Ended December 31, 1993, 1992 and 1991 11 Schedule IX - Short-Term Borrowings for the Years Ended December 31, 1993, 1992 and 1991 12 Schedule X - Supplementary Income Statement Information for the Years Ended December 31, 1993, 1992 and 1991 13 All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted. (a) 3. Exhibits. 3. Articles of Incorporation and By-Laws - Filed as Exhibit 3 to the Registrant's 1980 Annual Report on Form 10-K, and incorporated herein by reference. 10. A description of the Company's Stock Option Plan and Profit Sharing Plan - Incorporated by reference to the Registrant's Proxy Statement dated March 18, 1994. 11. Computation of Consolidated Net Income Per Share for the years ended December 31, 1993, 1992 and 1991 13. Annual Report to security holders - Incorporated by reference to the Registrant's 1993 Annual Report to Shareholders 21. Subsidiaries of the Registrant 22. Registrant's Proxy Statement dated - Incorporated by reference to the Registrant's Proxy Statement dated March 18, 1994. (b) Reports on Form 8-K. None. SIGNATURES 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. THE MIDLAND COMPANY Signature Title Date S/ George R. Baker Director March 3, 1994 (George R. Baker) S/ James H. Carey Director and Member March 3, 1994 (James H. Carey) of Audit Committee S/ Michael J. Conaton President, Chief Operating March 3, 1994 (Michael J. Conaton) Officer and Director S/ J. P. Hayden, Jr. Chairman, Chief Executive March 3, 1994 (J. P. Hayden, Jr.) Officer and Director S/ J. P. Hayden, III Vice President and Director March 3, 1994 (J. P. Hayden, III) S/ John W. Hayden Vice President and Director March 3, 1994 (John W. Hayden) S/ Robert W. Hayden Vice President and Director March 3, 1994 (Robert W. Hayden) S/ William J. Keating Director March 3, 1994 (William J. Keating) S/ William McD. Kite Director March 3, 1994 (William McD. Kite) S/ John R. LaBar Vice President, Secretary March 3, 1994 (John R. LaBar) and Director S/ John M. O'Mara Director and Member March 3, 1994 (John M. O'Mara) of Audit Committee S/ John R. Orther Director and Member March 3, 1994 (John R. Orther) of Audit Committee S/ William F. Plettner Director March 3, 1994 (William F. Plettner) S/ Glenn E. Schembechler Director and Member March 3, 1994 (Glenn E. Schembechler) of Audit Committee S/ John I. Von Lehman Vice President, Treasurer, March 3, 1994 (John I. Von Lehman) Chief Financial Officer, Chief Accounting Officer and Director SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has dully caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. THE MIDLAND COMPANY Signature Title Date S/ J. P. Hayden, Jr. Chairman and Chief Executive March 3, 1994 (J. P. Hayden, Jr.) Officer S/ John I. Von Lehman Vice President, Treasurer, March 3, 1994 (John I. Von Lehman) Chief Financial Officer and Chief Accounting Officer INDEPENDENT AUDITORS' CONSENT AND REPORT ON SCHEDULES ----------------------------------------------------- To the Shareholders of The Midland Company: We consent to the incorporation by reference in Registration Statement No. 33-48511 of The Midland Company on Form S-8 of our report dated February 10, 1994, incorporated by reference in this Annual Report on Form 10-K and our report (appearing below) on the financial statement schedules of The Midland Company for the year ended December 31, 1993. Our audits of the consolidated financial statements referred to in our aforementioned report also included the financial statement schedules of The Midland Company and its subsidiaries, listed in Item 14. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. March 14, 1994 SCHEDULE I THE MIDLAND COMPANY AND SUBSIDIARIES SCHEDULE I - MARKETABLE SECURITIES - OTHER INVESTMENTS DECEMBER 31, 1993 . . . . . . .December 31, 1993. . . . . . . - -------------------------------------------------------------------------------- Column A Column C Column D Column E - ------------------------------------------------------------------------------- Amount at which shown Market in the Type of Investment Cost Value balance sheet - -------------------------------------------------------------------------------- Bonds and notes: United States Government and government agencies and authorities $ 69,482,000 $ 72,477,000 $ 72,477,000 States, municipalities and political subdivisions 61,642,000 64,998,000 64,998,000 All other corporate 56,479,000 56,942,000 56,942,000 -------------------------------------------- Total bonds and notes 187,603,000 194,417,000 194,417,000 -------------------------------------------- Preferred stocks 294,000 419,000 419,000 -------------------------------------------- Common stocks: Star Banc Corporation 2,073,000 9,457,000 9,457,000 All other common stocks 14,497,000 17,466,000 17,466,000 -------------------------------------------- Total common stocks 16,570,000 26,923,000 26,923,000 -------------------------------------------- Accrued investment income 2,855,000 2,855,000 2,855,000 -------------------------------------------- Total investments $207,322,000 $224,614,000 $224,614,000 ============================================ NOTE: The individual issue disclosed above is the only individual issue requiring separate disclosure. SCHEDULE V THE MIDLAND COMPANY AND SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 COLUMN A COLUMN B COLUMN C COLUMN D COLUMN F BALANCE AT BALANCE BEGINNING ADDITIONS AT END CLASSIFICATION OF PERIOD AT COST RETIREMENTS OF PERIOD - -------------------------------------------------------------------------------- YEAR ENDED DECEMBER 31, 1993: Land $ 488,000 $ 813,000 $ 45,000 $ 1,256,000 Buildings, improvements, fixtures, etc. 27,516,000 17,028,000 3,378,000 41,166,000 Vessels and barges 122,193,000 14,394,000 1,988,000 134,599,000 River transportation equipment under capital leases 8,143,000 -- -- 8,143,000 Construction-in-progress 4,881,000 (4,881,000) -- -- ---------------------------------------------------- TOTAL $163,221,000 $27,354,000 $5,411,000 $185,164,000 ==================================================== YEAR ENDED DECEMBER 31, 1992: Land $ 488,000 $ -- $ -- $ 488,000 Buildings, improvements, fixtures, etc. 23,754,000 5,240,000 1,478,000 27,516,000 Vessels and barges 115,578,000 7,487,000 872,000 122,193,000 River transportation equipment under capital leases 8,143,000 -- -- 8,143,000 Construction-in-progress -- 4,881,000 -- 4,881,000 ---------------------------------------------------- TOTAL $147,963,000 $17,608,000 $2,350,000 $163,221,000 ==================================================== YEAR ENDED DECEMBER 31, 1991: Land $ 488,000 $ -- $ -- $ 488,000 Buildings, improvements, fixtures, etc. 22,119,000 2,676,000 1,041,000 23,754,000 Vessels and barges 105,389,000 10,285,000 96,000 115,578,000 River transportation equipment under capital leases 8,143,000 -- -- 8,143,000 ---------------------------------------------------- TOTAL $136,139,000 $12,961,000 $1,137,000 $147,963,000 ==================================================== SCHEDULE VI THE MIDLAND COMPANY AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 COLUMN A COLUMN B COLUMN C COLUMN D COLUMN F ADDITIONS BALANCE AT CHARGED TO BALANCE BEGINNING COSTS AND AT END CLASSIFICATION OF PERIOD EXPENSES RETIREMENTS OF PERIOD - -------------------------------------------------------------------------------- YEAR ENDED DECEMBER 31, 1993: Buildings, improvements, fixtures, etc. $ 9,756,000 $ 3,699,000 $1,145,000 $12,310,000 Vessels and barges 54,574,000 5,778,000 1,763,000 58,589,000 River transportation equipment under capital leases 5,849,000 524,000 -- 6,373,000 ---------------------------------------------------- TOTAL $70,179,000 $10,001,000 $2,908,000 $77,272,000 ==================================================== YEAR ENDED DECEMBER 31, 1992: Buildings, improvements, fixtures, etc. $ 7,883,000 $ 2,839,000 $ 966,000 $ 9,756,000 Vessels and barges 49,356,000 5,787,000 569,000 54,574,000 River transportation equipment under capital leases 5,325,000 524,000 -- 5,849,000 ---------------------------------------------------- TOTAL $ 62,564,000 $ 9,150,000 $1,535,000 $70,179,000 ==================================================== YEAR ENDED DECEMBER 31, 1991: Buildings, improvements, fixtures, etc. $ 6,028,000 $ 2,417,000 $ 562,000 $ 7,883,000 Vessels and barges 44,129,000 5,301,000 74,000 49,356,000 River transportation equipment under capital leases 4,801,000 524,000 -- 5,325,000 ---------------------------------------------------- TOTAL $ 54,958,000 $ 8,242,000 $ 636,000 $62,564,000 ==================================================== SCHEDULE VIII THE MIDLAND COMPANY AND SUBSIDIARIES SCHEDULE VIII - ALLOWANCE FOR LOSSES FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 ADDITIONS BALANCE AT CHARGED TO BALANCE BEGINNING COSTS AND DEDUCTIONS AT END DESCRIPTION OF PERIOD EXPENSES (ADDITIONS) OF PERIOD - -------------------------------------------------------------------------------- YEAR ENDED DECEMBER 31, 1993: Allowance For Losses $1,192,000 $357,000 $432,000 (1) $1,117,000 YEAR ENDED DECEMBER 31, 1992: Allowance For Losses $1,133,000 $297,000 $238,000 (1) $1,192,000 YEAR ENDED DECEMBER 31, 1991: Allowance For Losses $ 943,000 $195,000 $ 5,000 (1) $1,133,000 NOTES: (1) Accounts written off are net of recoveries. SCHEDULE IX THE MIDLAND COMPANY AND SUBSIDIARIES SCHEDULE IX - SHORT-TERM BORROWINGS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 -- END OF PERIOD --- ------ DURING THE PERIOD ---------- WEIGHTED WEIGHTED CATEGORY OF AVERAGE MAXIMUM AVERAGE AVERAGE SHORT-TERM INTEREST AMOUNT AMOUNT INTEREST BORROWINGS BALANCE RATE OUTSTANDING OUTSTANDING RATE - -------------------------------------------------------------------------------- YEAR ENDED DECEMBER 31, 1993: Bank Borrowings $22,000,000 3.5% $27,000,000 $13,583,000 3.5% Commercial Paper 14,302,000 3.3% 15,129,000 11,096,000 3.7% YEAR ENDED DECEMBER 31, 1992: Bank Borrowings $27,000,000 4.1% $27,000,000 $ 2,669,000 3.8% Commercial Paper 8,866,000 4.1% 10,208,000 9,135,000 4.7% YEAR ENDED DECEMBER 31, 1991: Bank Borrowings $12,000,000 5.2% $12,000,000 $ 323,000 7.7% Commercial Paper 8,568,000 5.1% 9,686,000 8,097,000 6.5% NOTE: The weighted average interest rate is computed by dividing actual interest expense on borrowings by the average amount of such borrowings during the year. SCHEDULE X THE MIDLAND COMPANY AND SUBSIDIARIES SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 CHARGED TO COSTS AND EXPENSES 1993 1992 1991 ---------------------------------- Maintenance and repairs $4,972,000 $5,662,000 $3,015,000 ================================== Taxes, other than payroll and income taxes: Insurance premium taxes $5,971,000 $4,766,000 $3,995,000 Other 2,742,000 2,060,000 2,056,000 ---------------------------------- Total $8,713,000 $6,826,000 $6,051,000 ==================================
88034_1993.txt	88034	1993	ITEM 1. BUSINESS The Company is a diversified media company operating principally in two segments: broadcasting and cable television. In 1993 the Company announced plans to introduce the Home & Garden Television Network, a 24- hour cable channel. In February 1994 the Company acquired Cinetel Productions, one of the largest independent producers of cable television programming. See "Business - New Businesses." The Company is controlled by Scripps Howard, Inc. ("SHI"), an Ohio corporation, which owns 86.1% of the Company's Common stock. SHI is a wholly-owned subsidiary of The E.W. Scripps Company ("EWS"), a Delaware corporation. In February 1994 EWS announced it had offered to acquire the 13.9% of the Company that it does not already own. See Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations - Proposed Merger." A summary of segment information for the three years ended December 31, 1993 is set forth on page of this Form 10-K. Broadcasting General - The Company's broadcast operations consist of six network- affiliated VHF television stations and three Fox-affiliated UHF television stations. The Company acquired or divested the following broadcast operations in the three years ended December 31, 1993: 1993 - The Company sold its radio stations and its Memphis television station. 1991 - The Company purchased its Baltimore television station. Revenues - The composition of the Company's broadcasting operating revenues for the most recent five years is as follows: Substantially all of the Company's broadcasting operating revenues are derived from advertising. Local advertising consists of short announcements and sponsored programs on behalf of advertisers in the area served by the station. National advertising consists of short announcements and sponsored programs on behalf of regional and national advertisers. The first and third quarters of each year generally have lower advertising revenues than the second and fourth quarters, due in part to higher retail advertising during the holiday seasons and political advertising in election years. Advertising rates charged by the stations are based primarily upon the population of the market, the number of stations competing in the market, as well as the station's ability to attract audiences. Information concerning the Company's stations and the markets in which they operate is as follows: Competition - Competition occurs primarily in local markets. The Company's television stations compete for advertising revenues with other television stations and other providers of video entertainment in their market, and in varying degrees with other media, such as newspapers and magazines, radio, and direct mail. Competition for advertising revenues is based upon audience levels, demographics, price, and effectiveness. The Company's television stations compete for viewers' time with other information and entertainment media. All of the Company's television markets are highly competitive. Network Affiliation and Programming - The Company's television stations are affiliated with national television networks under standard two-year affiliation agreements. These agreements are customarily renewed for successive two-year terms. The networks offer a variety of programs to affiliated stations, which have the right of first refusal before such programming may be offered to other television stations in the same market. Pursuant to the affiliation agreements, compensation is paid to the affiliated station for carrying network programming. The network has the right to decrease the amount of such compensation during the terms of the affiliation agreements but, upon any such decrease, an affected station has the right to terminate the agreement. The ranking of a station in its local market is affected by fluctuations in the national ranking of the affiliated network. Management believes such fluctuations are normal and has not sought to change the Company's network affiliations because of declines in national rankings of the affiliated networks. In addition to network programs, the Company's television stations broadcast locally produced programs, syndicated programs, sports events, movies, and public service programs. Local news is the focus of the Company's network-affiliated stations' locally produced programming and is an integral factor in developing the station's ties to its community and viewer loyalty. Advertising relating to local news and information programs generally represent more than 30% of a station's revenues. The Company's Kansas City Fox-affiliated station began broadcasting local news in 1993 and the Company expects to add local news programming at its Phoenix and Tampa stations. Federal Regulation of Broadcasting - Television broadcasting is subject to the jurisdiction of the Federal Communications Commission ("FCC") pursuant to the Communications Act of 1934, as amended ("Communications Act"). The Communications Act prohibits the operation of television broadcasting stations except in accordance with a license issued by the FCC and empowers the FCC to revoke, modify, and renew broadcasting licenses, approve the transfer of control of any corporation holding such licenses, determine the location of stations, regulate the equipment used by stations, and adopt and enforce necessary regulations. Television broadcast licenses are granted for a maximum of five years, and are renewable upon application. Application for renewal of the license for the Company's Phoenix station was filed in 1993 and is still pending. While there can be no assurances the Company's existing licenses will be renewed, the Company has never been denied a renewal and all previous renewals have been for the maximum term. The Company's application for renewal of the FCC license for its Baltimore station has been challenged by a competing applicant. The FCC is required to hold a hearing to assess which applicant's proposal would better serve the public interest. That hearing is proceeding on qualifications issues added by the presiding judge against both applicants, but the FCC has "frozen" its consideration of the comparative issues in light of an appeals court decision invalidating one of the principal criteria the FCC had used in assessing new applicants' qualifications. Revising the process so as to permit continuation of the comparative hearing may take an extended period of time, but the Company will continue to operate the station while its renewal of license application is pending. Management believes that granting of the Company's renewal would best serve the public interest and thus expects the renewal application to be granted. FCC regulations govern the multiple ownership of television stations and other media. Under the multiple ownership rule, a license for a television station will generally not be granted or renewed if (i) the applicant already owns, operates, or controls a television station serving substantially the same area, or (ii) the grant of the license would result in the applicant's owning, operating, or controlling, or having an interest in, more than twelve television stations or in television stations whose total national audience reach exceeds 25% of all television households. FCC rules also generally prohibit "cross-ownership" of a television station and daily newspaper or cable television system in the same service area. The Company's television station and EWS's daily newspaper in Cincinnati were owned by the Company at the time the cross-ownership rules were enacted and enjoy "grandfathered" status. These properties would become subject to the cross-ownership rules upon their sale. Under the Cable Television Consumer Protection and Competition Act of 1992 ("1992 Act"), each television broadcast station gained "must-carry" rights on any cable system defined as "local" with respect to that station. Stations may waive their must-carry rights and instead negotiate retransmission consent agreements with local cable companies. The Company's stations have generally elected to negotiate retransmission consent agreements with cable companies. Management believes the Company is in substantial compliance with all applicable regulatory requirements. Cable Television General - The Company operates cable television systems in Lake County, Florida; Sacramento, California; and Longmont, Colorado. In the three years ended December 31, 1993 the Company purchased several cable television systems adjacent to existing service areas. Revenues - The composition of the Company's cable television operating revenues for the most recent five years is as follows: Substantially all of the Company's cable television operating revenues are derived from services provided to subscribers of the Company's systems. Subscriber information as of December 31 for the Company's cable television systems is as follows: The Company's cable television systems carry a wide variety of entertainment and information services. Basic cable generally consists of video programming broadcast by local television stations, locally produced programming, and distant broadcast television signals. Advertiser- supported video programming such as ESPN and CNN and other entertainment and information services are included in various "enhanced basic" service packages. Premium programming consists of non-advertiser supported entertainment services such as Home Box Office and Showtime. Certain of the Company's systems are equipped with addressable decoding converters which enable the Company to offer interactive services, such as pay-per- view programming, and to change customer services without visiting the customer's home. Other monthly services includes revenues from services such as remote control and converter rental and audio programming. Competition - Competition occurs primarily in local markets. The Company's cable television systems compete for subscribers with other cable television systems in certain of its franchise areas. All of the Company's cable television systems compete for subscribers with other methods of delivering entertainment and information programming to the subscriber's home, such as broadcast television, multi-point distribution systems, master and satellite antenna systems, television receive-only satellite dishes, and home systems such as video cassette and laser disc players. In the future the Company's cable television systems may compete with new technologies such as more advanced "wireless cable systems" and broadcast satellite delivery services, as well as "video dial tone" services whereby the local telephone company leases video distribution lines to programmers on a common carrier basis. Management believes additional technologies for delivering entertainment and information programming to the home will continue to be developed, and that some of these competitive services will be capable of offering interactive services. Programming - The Company purchases programming from a variety of suppliers, the charge for which is generally based upon the number of subscribers receiving the service. Programming expenses as a percentage of basic and premium programming service revenues have risen in recent years, primarily due to additional and improved services provided to basic subscribers and to discounts offered to subscribers receiving multiple premium channels. See Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations." Under the Copyright Act of 1976 cable television system operators are granted compulsory licenses permitting the carriage of the copyrighted works of local and distant broadcast signals for a statutory fee. The Copyright Royalty Tribunal is empowered to review and adjust such fees. FCC rules on syndicated exclusivity provide that if a local broadcast licensee has purchased the exclusive local distribution rights for a particular syndicated program, such licensee is generally entitled to insist that a local cable television system operator delete that program from any distant television signal carried by the cable television system. Regulation and Legislation - Cable television systems are regulated by federal, local, and in some instances, state authorities. Certain powers of regulatory agencies and officials, as well as various rights and obligations of cable television operators, are specified under the Cable Communications Policy Act of 1984 ("1984 Act") and the 1992 Act. Pursuant to the 1984 Act, local franchising authorities are given the right to award and renew one or more franchises for the community over which they have jurisdiction, the fees for which are prohibited from exceeding 5% of a cable television system's gross annual revenues. The 1992 Act, among other things: (i) reimposes rate regulations on most cable television systems; (ii) reimposes "must carry" rules with respect to local broadcast television signals (see "Federal Regulation of Broadcasting"); (iii) grants all broadcasters the option to refuse carriage of their signals; (iv) requires that vertically integrated cable television companies not unreasonably refuse to deal with any multichannel programming distributor or discriminate in the price, terms, and conditions of carriage of programming between cable television operators and other multichannel programming distributors if the effect would be to impede retail competition; and (v) establishes cross-ownership rules with respect to cable television systems and direct broadcast satellite systems, multi- channel multipoint distribution systems, and satellite master antenna systems. In April 1993 the FCC issued rules that established allowable rates for cable television services (other than programming offered on a per-channel or per-program basis) and for cable equipment based on benchmarks established by the FCC. The rules require rates for equipment to be cost- based, and require reasonable rates for regulated cable television services based upon, at the election of the cable television system operator, application of the benchmarks established by the FCC or a cost-of-service showing based upon standards established by the FCC. The rules became effective in September 1993 and were recently revised to further reduce regulated rates. The revised rules are expected to become effective in May 1994. Management believes the Company is in substantial compliance with all applicable regulatory requirements. New Businesses Entertainment - The Company plans to introduce the Home & Garden Television Network ("Home & Garden") in late 1994. This network will feature 24 hours of daily programming focused on home repair and remodeling, gardening, decorating, and home electronics. While most of the programming will be produced by the new network, local television stations affiliated with the network will have the opportunity for daily programming and advertised inserts. The subscriber base of the new network will be established through a collaboration of local television stations and cable television systems. Several cable television system operators, including Time Warner Cable and Continental Cablevision, the nation's second- and third-largest cable television system operators, have entered into agreements to carry the new network in exchange for permission to carry the signals of local television stations affiliated with the network. The Company is discussing carriage agreements with other cable television systems and intends to expand the network's affiliate group to include additional broadcast stations. The Company's cable television systems will carry the network and all of the Company's television stations (except the Fox-affiliated stations) are members of the network's affiliate group. In February 1994 the Company announced that it had agreed to purchase Cinetel Productions in Knoxville, Tennessee. Cinetel is one of the largest independent producers of cable television programming. Cinetel's production facility will also be the primary production facility for Home & Garden. Employees As of December 31, 1993 the Company had approximately 1,700 full-time employees, of whom approximately 1,200 were engaged in broadcasting and 500 in cable television. Less than 20% of the Company's employees are represented by labor unions. The Company considers its relationship with employees to be generally satisfactory. ITEM 2.		ITEM 2. PROPERTIES The Company's broadcasting operations require offices and studios and other real property for towers upon which broadcasting transmitters and antenna equipment are located. Ongoing advances in the technology for delivering video signals to the home, such as "high definition television" may, in the future, require a high level of expenditures by the Company for new equipment in order to maintain its competitive position of the Company's television stations. The properties required to support the Company's cable television operations generally include offices and other real property for towers, antennas, and satellite earth stations. The Company is currently upgrading the distribution system for its Sacramento system. Ongoing advances in the technology for delivering video signals to the home and emergence of the multimedia marketplace could require a high level of expenditures to further upgrade the Company's cable television distribution systems. The Company's new entertainment operations will require offices and studios and other real and personal property to deliver programming product. The Company plans to expand the 60,000 square foot Cinetel production facility by approximately one-third to accommodate Home & Garden. Management believes the Company's present facilities are generally well- maintained and are sufficient to serve its present needs. ITEM 3.	ITEM 3. LEGAL PROCEEDINGS In September 1991 Four Jacks Broadcasting, Inc., a company whose principals own and operate an existing Baltimore television station, submitted to the FCC an application for a construction permit to build and operate a new television station on channel 2 in Baltimore. This application is mutually exclusive with the Company's application for renewal of its license for its Baltimore television station. See Item 1 "Business - Broadcasting - Federal Regulation of Broadcasting." The Company is involved in other litigation arising in the ordinary course of business, such as defamation actions. In addition, the Company is involved from time to time in various governmental and administrative proceedings relating to, among other things, renewal of broadcast licenses, none of which is expected to result in material loss. ITEM 4.	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted to a vote of security holders for the quarter ended December 31, 1993. PART II ITEM 5.	ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS Shares of the Company's Common stock are traded on the Nasdaq Stock Exchange under the symbol "SCRP." There are approximately 600 owners of the Company's Common stock, based on security position listings. The range of market prices of the Company's Common stock, which represents the high and low sales prices for each full quarterly period, and quarterly cash dividends are as follows: Future dividends are subject to the Company's earnings, financial condition, and capital requirements. ITEM 6.	ITEM 6. SELECTED FINANCIAL DATA The information required by this item is filed as part of this Form 10- K. See Index to Consolidated Financial Statement Information at page F- 1 of this Form 10-K. ITEM 7.	ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information required by this item is filed as part of this Form 10- K. See Index to Consolidated Financial Statement Information at page F- 1 of this Form 10-K. ITEM 8.	ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required by this item is filed as part of this Form 10- K. See Index to Consolidated Financial Statement Information at page F- 1 of this Form 10-K. ITEM 9.	ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES Not applicable. PART III ITEM 10.	ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The directors of the Company are as follows: Director Principal Occupation or Name Age Since Occupations/Business Daniel J. Castellini (1) 54 1987 Senior Vice President/Finance and Administration of EWS, parent of the Company,since September 1986; Financial Vice President of EWS from January 1985 to September 1986. Lawrence A. Leser (2) 58 1981 President and Chief Executive Officer of EWS since July 1985. President of the Company since September 16, 1992. Donald L. Perris 70 1966 President and Chief Executive Officer of the Company from May 1974 to May 1988. Charles E. Scripps (3) 74 1983 Chairman of the Board of Directors of EWS and Chairman of the Board of Trustees of The Edward W. Scripps Trust. Gordon E. Heffern 70 1989 President and Chief Executive Officer of Akron Community Foundation since 1990; Director of Society Corporation a Society National Bank from 1983 to 1990. Robert E. Stautberg 59 1989 Retired; former partner and Director of KPMG Peat Marwick. John H. Burlingame 60 1990 Executive Partner of Baker & Hostetler; Director of EWS since 1990. (1) Mr. Castellini is a director of the Gradison Growth Trust (a regulated investment trust). (2) Mr. Leser is a director of Union Central Life Insurance Company, KeyCorp, and EWS. (3) Mr. Scripps is a director of EWS. Directors who are also officers or former officers of the Company or officer or directors of the Company's affiliates receive no separate remuneration for their services as directors or committee members. All other directors receive an annual fee of $15,000 and an additional $1,000 for each meeting of the Board of Directors or committee thereof that they attend. The executive officers of the Company are as follows: Name Age Position Lawrence A. Leser 58 President and Chief Executive Officer of the Company (since 1992); President, Chief Executive Officer and Director of EWS (since 1985) Paul F. Gardner 51 Executive Vice President (since 1993); Senior Vice President, News Programming, Fox Broadcasting Company (1991 to 1993); Vice President and General Manager, WCPO (1989 to 1991) Daniel J. Castellini 54 Secretary and Treasurer of the Compa ny; Senior Vice President, Finance and Administration of EWS (since 1986) E. John Wolfzorn 48 Assistant Treasurer of the Company; Treasurer of EWS (since 1979) Albert J. Schottelkotte 67 Senior Vice President (since 1981) Warren P. Happel 62 Vice President, Engineering (since 1 983) Kenneth W. Lowe 44 Vice President (since 1989) Terry H. Schroeder 40 Vice President, Administration (since 1989) William J. Brooks 60 Vice President and General Manager, WPTV (since 1986) J. B. Chase 57 Vice President and General Manager, WCPO (since 1990); Assistant General Manager, WCPO (1986 to 1990) William J. Donahue 53 Vice President and General Manager, KJRH (since 1989) Charlotte M. English 45 Vice President and General Manager, KSHB (since 1992); Station Manager, KSHB (1990 to 1992); Assistant General Manager, Programming, WMC (1987 to 1990) Thomas C. Griesdorn 44 Vice President and General Manager, WXYZ (since 1989) Raymond Hunt 50 Vice President (since 1991) and Gene ral Manager, KNXV (since 1990); General Sales Manager, KNXV (1989 to 1990) H. Joseph Lewin 54 Vice President and General Manager, WMAR (since 1993); General Manager, WRIC, Richmond, Virginia (1984 to 1993) James F. Major 59 Vice President and General Manager, WFTS (since 1989) Garland R. Robinson 52 Vice President and General Manager, WEWS (since 1992); Vice President and General Manager, WLWT, Cincinnati, Ohio (1991 to 1992); Vice President and General Manager, WCMH, Columbus, Ohio (1982 to 1991) The executive officers of the Company serve at the pleasure of the Board of Directors. ITEM 11.	ITEM 11. EXECUTIVE COMPENSATION Report on Executive Compensation Introduction - This report is submitted by the members of the Compensation Committee, Messrs. Charles E. Scripps and John H. Burlingame. The Committee makes decisions on the compensation of the Company's senior executives. All Committee actions are reviewed by the full Board. Philosophy - The Company is approximately 86% owned by SHI, which in turn is 100% owned by EWS. In recognition of its close relationship with its parent, the Company has endorsed the compensation philosophy of EWS. This philosophy is designed to accomplish three goals. First, the policy is designed to attract a well-qualified management team. Second, the compensation policy supports a pay-for-performance program designed to motivate executives to achieve target operating results set forth in the Company's strategic plan and to reward them for accomplishing these targets. Finally, the policy is designed to retain a competent management team, which is critical to the Company's long-term success. The compensation program is comprised primarily of cash compensation, including salary and annual bonus, and grants of restricted stock and non- qualified stock options under EWS's 1987 Long-Term Incentive Plan. The Company believes its compensation policy is fair to both its employees and its shareholders and is competitive within the broadcasting industry. Descriptions of the Components of the Compensation Program Base Salary - EWS participates annually in the Towers Perrin Media Industry Compensation Survey (the "Survey") which is widely used in the media industry and gives relevant compensation information on executive positions. The Company strives to place fully competent and high performing executives at the median level of compensation no later than two to three years after attaining their position. The 75th percentile may be in reach for exceptional performers. The Survey provides compensation analyses for executives in the media industry based on revenues, industry segments (e.g., publishing, broadcasting, cable) and market type and size. The statistical information, including revenues and compensation levels, provided by survey participants is utilized by the Survey to develop statistical equations based on revenues, industry segments and markets. These equations, along with other data, are used by the Company to determine the median and other levels of compensation of executives of media companies with profiles comparable to those of the Company. In deciding if an annual base salary increase is appropriate for a specific individual, consideration is given to several factors, including the following: a qualitative review of the individual's contributions to the Company during the year and over the course of his employment by the Company; his expected future performance; the performance of the Company during the year; and information received from the Survey. In determining eligibility for base salary increases, the Company considers overall corporate performance during the year, i.e. operating profit and cash flow figures, as opposed to specific measures of corporate performance. Mr. Lawrence A. Leser is President and Chief Executive Officer of the Company. He is also President and Chief Executive Officer of EWS and his compensation is paid solely by EWS. Mr. Leser receives no additional compensation from the Company. The other senior executives were granted salary increases effective January 1, 1994. These increases were based on a recommendation by the President, the Survey results and a review of their individual performance during 1993. Annual Bonus - The purpose of the annual bonus plan is to motivate and reward executives so that they consistently achieve specific financial targets. This incentive is a pay-for-performance essential which aids in maximizing shareholder value. The bonus is payable on an annual basis, although executives may elect to defer payment of the bonus until retirement. Financial goals for 1993 focused on a comparison of actual operating cash flow versus planned operating cash flow. The Executive Vice President of the Company was eligible for a target bonus equal to 40% of his annual base salary. The other named executives were eligible for a target bonus 30% of their base salary. Because operating cash flow goals were achieved, each of the eligible executives received his full target bonus. Long-Term Incentives - The Company does not have an independent long-term incentive plan. In 1987, however, EWS adopted a Long-Term Incentive Plan (the "Plan") for its key employees, including executives of the Company. Although the Plan allows for several different types of stock-based awards, to date only two types of awards have been granted: 1) stock options, which represent a right to purchase shares of EWS's Class A Common stock at the fair market value per share as of the date the option is granted, and 2) restricted stock, which represents shares of EWS's Class A Common stock which the recipient cannot sell or otherwise dispose of until the applicable restriction period lapses and which are subject to forfeiture. When this report refers to "stock" in the next two sections of this report, the stock referred to is that of the Class A Common stock of EWS. Restricted Stock - Generally executives receive restricted stock awards with a three-year vesting period when they first attain an executive position. When executives are promoted to new positions or assume additional responsibility, they may be granted additional restricted stock awards. When awarding the shares of restricted stock, consideration is not given to the total number of shares of restricted stock outstanding. Of the named executives, only Mr. Gardner received a restricted stock award in 1993. The award was made by EWS's Compensation Committee based on additional responsibilities that he assumed. Stock Options - The Committee agrees with EWS's compensation committee in that stock option grants are a valuable motivating tool and provide a long- term incentive to management. Annual stock option grants reinforce long- term goals by providing the proper nexus between the interests of management and the interests of the Company's shareholders. A determination of the number of stock options to be granted to senior executives in 1993 was made by EWS's Compensation Committee which reviewed an analysis that was provided by its compensation consultant. Awards were based on a multiple of base pay, using four times salary for Mr. Gardner. Awards for the other named executives were based on a proportionally lesser multiple of base salary which reflects their respective organizational levels. The shares will be exercisable one year after the grant date, at $26.44, the fair market value on the date of the grant. However, in Mr. Gardner's case, the shares will be exercisable at a range of prices between $26.44 and $34. The compensation tables which follow are intended to better enable our shareholders to understand the compensation practices of the Company. The Compensation Committee John H. Burlingame, Chairman Charles E. Scripps The following table sets forth information regarding the compensation of the Company's five most highly compensated officers during each of the Company's last three fiscal years. The following table sets forth certain information regarding options for shares of Class A Common stock granted to the Company's named executives under EWS's Long-Term Incentive Plan in 1993. The 12,500 option shares granted to Mr. Gardner, which expire on April 1, 2003, will be 100% exercisable on April 1, 1995. All other option awards to the named executives during 1993 will be 100% execisable on and after December 16, 1995. The following table sets forth certain information regarding the number of options for shares of Class A Common stock exercised by the Company's named executives. Only Mr. Schroeder exercised options in 1993. The table also sets forth certain information regarding option values for each named executive. Set forth below is a line graph comparing the cumulative and total return on the Company's Common stock, assuming a $100 investment as of December 31, 1988, based on the market prices at the end of each year and assuming reinvestment of dividends, with the cumulative total return of the Standard & Poor's Composite-500 Index and an index based on a group of communications media companies which are peers of EWS. A narrative description of the performance graph points is as follows (a hard copy of the graph has been submitted to the Secruities and Exchange Commission): 1988 1989 1990 1991 1992 1993 S&P 500 100 132 127 166 179 197 Scripps 100 98 65 60 68 122 Media Index 100 123 97 116 133 152 The Companies in the peer group index are A.H. Belo Corporation, Gannett Co. Inc., Knight-Ridder, Inc., Multimedia, Inc., The New York Times Company, Times Mirror Company, Tribune Company and The Washington Post Company. The index is weighted based on market capitalization at December 31, 1988. The companies to be included in the peer group are approved by the Compensation Committee of EWS. Compensation Committee Interlocks and Insider Participation - Charles E. Scripps and John H. Burlingame are the members of the Company's compensation committee. Mr. Scripps is a member of the Company's Board of Directors and is Chairman of the Board of Directors of SHI and EWS. Mr. Scripps is also a member of EWS's compensation committee. Mr. Lawrence A. Leser, President and Chief Executive Officer and a director of the Company, is also President and Chief Executive Officer of SHI and EWS, and a member of the SHI and EWS Boards of Directors and the executive committees of each. Mr. Burlingame is the Executive Partner of Baker & Hostetler, which is general counsel to the Company, SHI, EWS and The Edward W. Scripps Trust (the "Trust"). Baker & Hostetler performed legal services for the Company, EWS, SHI, and the Trust during 1993 and is expected to perform such services in 1994. In 1993, Mr. Scripps and Mr. Burlingame served as trustees of the Trust and will continue to do so in 1994. The Trust is the controlling shareholder of EWS. Pension Plan - The Company's executive officers and substantially all other nonunion employees of the Company are participants in a non-contributory defined benefit pension plan (the "Pension Plan"). Contributions to the Pension Plan are based on separate actuarial computations for each business unit and are made by the business unit compensating the particular individual. The following table shows the annual normal retirement benefits which, absent the maximum benefit limitations (the "Benefit Limitations") imposed by Section 415(b) of the Internal Revenue Code of 1986, as amended (the "Code"), would be payable pursuant to the Pension Plan upon retirement at age 65 (based upon the 1994 Social Security integration level under the Pension Plan) pursuant to a straight life annuity option, for employees in the compensation ranges specified and under various assumptions with respect to average final annual compensation and years of credited service. Annual Normal Retirement Benefits (Straight Life Annuity Option) Final Annual for Years of Credited Service Indicated Compensation 15 Years 20 Years 25 Years 30 Years 35 Years $150,000 $27,000 $ 36,000 $ 46,000 $ 55,000 $ 64,000 200,000 37,000 49,000 61,000 73,000 86,000 250,000 46,000 61,000 77,000 92,000 107,000 300,000 55,000 74,000 92,000 111,000 129,000 350,000 65,000 86,000 108,000 130,000 151,000 400,000 74,000 99,000 124,000 148,000 173,000 450,000 87,000 111,000 145,000 167,000 203,000 500,000 93,000 124,000 155,000 186,000 217,000 In general, the Benefit Limitations limit the annual retirement benefits that may be paid pursuant to the Pension Plan to $118,800 (subject to further cost of living increases promulgated by the United States Secretary of Treasury). The Company will supplement payments under the Pension Plan with direct pension payments from the Company in an amount equal to the amount, if any, by which the benefits that otherwise would be payable under the Pension Plan exceed the benefits that are permitted to be paid from the Pension Plan under the Benefit Limitations. Annual normal retirement benefits are computed at the rate of 1% of average final annual compensation up to the applicable Social Security integration level plus 1.25% of average final annual compensation in excess of the Social Security integration level, multiplied by the employee's years of credited service. An employee's benefits are actuarially adjusted if paid in a form other than a life annuity. An employee's average final annual compensation is the average annual amount of his total pensionable compensation (generally salary and bonus, excluding any compensation pursuant to the Medium Term Bonus Plan, the Medium Savings and Thrift Plan and any other annual or long-term compensation reflected in the Summary Compensation Table) for service during the five consecutive years within the last ten years of his employment for which his total compensation was greatest. The employee's years of credited service equal the number of years of his employment with the Company. As of December 31, 1993, the years of credited service of the individuals named in the foregoing cash compensation table were as follows: Mr. Gardner-9; Mr. Griesdorn-8; Mr. Schroeder-6; Mr. Robinson-2; and Mr. Chase-22. ITEM 12.	ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Security Ownership of Certain Beneficial Owners - As of March 1, 1994, SHI, 312 Walnut Street, Cincinnati, Ohio was the only beneficial owner of more than 5% of the Company's outstanding Common stock known to management of the Company. As of such date, SHI beneficially owned 8,890,199 shares of Common stock, representing 86.1% of the outstanding shares of such stock as of such date. SHI shares the power to vote and dispose of the shares of Common stock with EWS, owner of 100% of the outstanding common shares of SHI. The directors of SHI are also directors of EWS. The Edward W. Scripps Trust owns approximately 79.5% of the Common Voting stock and approximately 59.7% of the Class A Common stock of EWS. Security Ownership of Management - The table below sets forth information with respect to the shares of the Company's Common stock and the shares of the Class A Common stock of EWS beneficially owned as of March 1, 1994, by each director of the Company and by each of the named officers in the compensation section (the "named officers"), and by all directors and all officers of the Company as a group. Unless otherwise indicated, the persons named in the table have sole voting and investment power with respect to all shares shown as being beneficially owned by them. ITEM 13.	ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS At December 31, 1993, the outstanding principal balance under the Company's credit facilities with SHI was $99,900,000. The interest rate on $80,000,000 is fixed at 8.5%. Interest on the remainder is charged at the average rate (3.4% at December 31, 1993) SHI is able to obtain under its short-term credit facilities. The Company receives certain management services from SHI which provides such services to its parent, EWS, and all of its subsidiaries. Among these services are the services of certain management officers, a portion of the services of an independent public accounting firm, legal services of general counsel, preparation of federal, state, and county tax returns, and preparation of the reports required by certain regulatory agencies. Each entity's share of the cost of such services is based on the proportion of its revenues to the revenues of all entities, except for the cost of providing certain management services specifically on behalf of particular entities. This method of allocation of expenses was determined by the directors of EWS. In 1993, such expenses allocated to the Company amounted to $8,104,000. Of this amount, $3,491,000 represented expenses incurred specifically on behalf of the Company and was not shared by other entities; $1,068,000 represented the Company's share of the costs of SHI's cable television management services; and $3,545,000 represented the Company's share of the cost of providing management services generally for all of the aforesaid entities. This latter amount represented 32.5% of the total cost of providing such general management services. Garland R. Robinson, a Vice President of the Company, received an $80,000 relocation loan from the Company on July 22, 1992. The note is non- interest bearing, due on demand, and was outstanding at December 31, 1993. PART IV ITEM 14.	ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K Financial Statements and Supplemental Schedules (a) The consolidated financial statements of the Company are filed as part of this Form 10-K. See Index to Consolidated Financial Statement Information at page. The report of Deloitte & Touche, Independent Auditors, dated January 26, 1994 is filed as part of this Form 10-K. See Index to Consolidated Financial Statement Information at page. (b) The consolidated supplemental schedules of the Company are filed as part of this Form 10-K. See Index to Consolidated Financial Statement Schedules at page S-1. Exhibits The information required by this item appears at page E-1 of this Form 10-K. Reports on Form 8-K No reports on Form 8-K were filed for the quarter ended December 31, 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities and Exchange Act of 1934 the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereby duly authorized, on March 28, 1994. SCRIPPS HOWARD BROADCASTING COMPANY By /s/ Lawrence A. Leser Lawrence A. Leser 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 in the capacities indicated, on March 28, 1994. Signature Title /s/ Lawrence A. Leser President, Chief Executive Officer and Director Lawrence A. Leser (Principal Executive Officer) /s/ Daniel J. Castellini Secretary and Treasurer and Director Daniel J. Castellini (Principal Financial and Accounting Officer) /s/ Charles E. Scripps Director Charles E. Scripps /s/ Donald L. Perris Director Donald L. Perris /s/ John H. Burlingame Director John H. Burlingame Director Gordon E. Heffern /s/ Robert E. Stautberg Director Robert E. Stautberg SCRIPPS HOWARD BROADCASTING COMPANY Index to Consolidated Financial Statement Information Selected Financial Data Management's Discussion and Analysis of Financial Condition and Results of Operations Independent Auditors' Report Consolidated Balance Sheets Consolidated Statements of Income and Retained Earnings Consolidated Statements of Cash Flows Notes to Consolidated Financial Statements MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Consolidated results of operations were as follows: The following items affected the comparability of the Company's reported results of operations: (i) The Company sold its Memphis television station and its radio stations. The stations, and any related gains on the sales, are hereinafter referred to as the "Divested Operations." See Note 3B to the Consolidated Financial Statements. The following items related to Divested Operations affected the comparability of the Company's reported results of operations: (ii) In 1993 management changed the estimate of the additional amount of copyright fees the Company would owe when a dispute between the television industry and the American Society of Composers, Authors and Publishers was resolved ("ASCAP Adjustment"). The adjustment increased broadcasting operating income $4,300,000 and net income $2,700,000, $.26 per share. See Note 4 to the Consolidated Financial Statements. (iii) In August 1993 the federal income tax rate was increased to 35%, retroactive to January 1, 1993, and management changed its estimate of the tax basis and lives of certain assets ("Income Tax Changes"). The net effect was to decrease net income $100,000, $.01 per share. See Note 5 to the Consolidated Financial Statements. (iv) In 1991 the Company agreed to settle a lawsuit filed in 1988 by Pacific West Cable Company that alleged violations of antitrust and unfair trade practice laws ("Sacramento Settlement"). The resultant charge reduced cable television operating income by $12,000,000 and net income by $7,900,000, $.77 per share. See Note 4 to the Consolidated Financial Statements. The items above are excluded from the consolidated and segment operating results presented in the following pages of this Management's Discussion and Analysis. Management believes they are not relevant to understanding the Company's ongoing operations. Net income per share was as follows: The Company's average advances from parent company in 1993 were $70,600,000 less than in 1992. The combined effects of reduced advances and lower interest rates resulted in the decrease in interest expense in 1993. Average advance balances were $14,000,000 greater in 1992 than in 1991, primarily due to the May 30, 1991 acquisition of Baltimore television station WMAR. Interest expense decreased in 1992 as the effect of the increase in average advance balances on interest expense was more than offset by the effect of lower interest rates. Miscellaneous includes the gains referred to in (i) above. The effective income tax rate decreased in 1993 and 1992 because pre-tax income increased, thereby reducing the relative impact of non-deductible amortization of goodwill. The rate in 1993 was also affected by the Income Tax Changes. See Note 5 to the Consolidated Financial Statements. The effective income tax rate in 1994 is expected to be approximately 42%. RESULTS OF OPERATIONS CONSOLIDATED - Operating results, excluding the Divested Operations, ASCAP Adjustment, and Sacramento Settlement, were as follows: SEGMENTS - Operating results, excluding the Divested Operations, ASCAP Adjustment, and Sacramento Settlement, for each of the Company's business segments are presented on the following pages. Earnings before interest, income taxes, depreciation, and amortization ("EBITDA") is included in the discussion of segment results because: - Acquisitions of communications media businesses are based on multiples of EBITDA. - Financial analysts use EBITDA to value communications media companies. - Changes in depreciation and amortization are often unrelated to current performance. Management believes the year-over-year change in EBITDA is a more useful measure of year-over-year performance than the change in operating income because, combined with information on capital spending plans, it is a more reliable indicator of results that may be expected in future periods. - Banks and other lenders use EBITDA to determine the Company's borrowing capacity. EBITDA should not, however, be construed as an alternative measure of the amount of the Company's income or cash flows from operating activities. BROADCASTING - Operating results for the broadcasting segment, excluding the Divested Operations and ASCAP Adjustment, were as follows: Revenues increased at most of the Company's television stations in 1993 and in 1992. Revenues at the Fox affiliates have been particularly strong. Program costs decreased in 1993 as several syndicated programs previously aired by the Company's stations were replaced with less-costly programs. Revenues and operating expenses in 1992 were affected by the inclusion of Baltimore television station WMAR, acquired May 30, 1991, for the full year. Capital expenditures in 1994 are expected to be approximately $14,000,000. Depreciation and amortization is expected to increase approximately 5% in 1994. CABLE TELEVISION - Operating results for the cable television segment, excluding the Sacramento Settlement, were as follows: The legislation passed in October 1992 to re-regulate the cable television industry affected the Company's cable television operations in 1993. Basic rates were frozen April 5, 1993 and new regulated rates became effective September 1, 1993. The Federal Communications Commission recently announced revised rules that will further reduce regulated rates. Based upon the revised rules, revenues and EBITDA will decline in 1994. Revenue growth also slowed in 1993 as the weak California economy inhibited subscriber growth at the Company's Sacramento cable television system, which serves 72% of the Company's total basic subscribers. Basic subscribers at the Sacramento system increased 2.9% in 1993. Program costs as a percent of basic and premium programming service revenues increased from 27.0% in 1991 to 28.3% in 1993, primarily due to expanded and improved programming offered to basic subscribers and discounts provided to customers receiving multiple premium channels. Program costs as a percentage of basic and premium programming service revenues are expected to increase in 1994. The estimated useful life of the distribution system for the Company's Sacramento system was reduced as the Company is upgrading the system, contributing to the increase in depreciation and amortization. Capital expenditures on the rebuild and other projects are expected to be approximately $30,000,000 in 1994. Depreciation and amortization is expected to increase approximately 10% in 1994. LIQUIDITY AND CAPITAL RESOURCES Cash flow from operating activities was $88,400,000 in 1993 compared to $92,300,000 in 1992. Cash flow from operations and cash received in the sales of subsidiary companies totaled $183,000,000 in 1993 and was used primarily for capital expenditures of $30,900,000, reduction of advances of $138,900,000, and dividend payments of $12,400,000. The debt to total capitalization ratio at December 31 was .25 in 1993 and .53 in 1992. Consolidated capital expenditures are expected to total approximately $50,000,000 in 1994, including The Home & Garden Television Network ("Home & Garden"), a 24-hour cable channel set for launch in late 1994. The Company expects to finance its capital requirements and start-up costs for Home & Garden primarily through cash flow from operations. PROPOSED MERGER On February 17, 1994 The E.W. Scripps Company ("EWS"), which through Scripps Howard, Inc. (its wholly-owned subsidiary) owns 86.1% of the Company's common stock, announced it had offered to acquire the 13.9% of the Company that it does not already own. In a merger proposal made to the Company's board of directors, EWS offered to exchange three shares of Class A Common stock for each of the Company's shares. Directors of the Company have formed a special committee to evaluate the offer. The merger is subject to the execution of a mutually agreeable definitive agreement, regulatory approvals, and a vote of the Company's shareholders. There can be no assurance that the merger will be entered into or that any transaction will be consummated. INDEPENDENT AUDITORS' REPORT To the Board of Directors and Stockholders, Scripps Howard Broadcasting Company: We have audited the accompanying consolidated balance sheets of Scripps Howard Broadcasting Company and subsidiary companies (Company) as of December 31, 1993 and 1992, and the related consolidated statements of income and retained earnings and of cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Company at December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. DELOITTE & TOUCHE Cincinnati, Ohio January 26, 1994 CONSOLIDATED BALANCE SHEETS CONSOLIDATED STATEMENTS OF INCOME AND RETAINED EARNINGS NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Consolidation - The consolidated financial statements include the accounts of Scripps Howard Broadcasting Company and its majority-owned subsidiary companies ("Company"). The Company is 86.1% owned by Scripps Howard, Inc. ("SHI"), a wholly-owned subsidiary of The E.W. Scripps Company ("EWS"). Goodwill and Other Intangible Assets - Goodwill and other intangible assets are stated at the lower of unamortized cost or fair value. Fair value is estimated based upon estimated future net cash flows. An impairment loss is recognized when the undiscounted estimated future net cash flows exceed the unamortized cost of the asset. Goodwill represents the cost of acquisitions in excess of tangible assets and identifiable intangible assets received. Cable television franchises are amortized generally over the remaining terms of acquired cable systems' franchise agreements and non- competition agreements over the terms of the agreements. Goodwill acquired after October 1970, customer lists, and other intangible assets are amortized over periods of up to 40 years. Goodwill acquired before November 1970 ($6,500,000) is not amortized. Income Taxes - Deferred income tax liabilities are provided for temporary differences between the tax basis and reported amounts of assets and liabilities that will result in taxable or deductible amounts in future years. The Company's temporary differences primarily result from accelerated depreciation and amortization for tax purposes and accrued expenses not deductible for tax purposes until paid. Also, the Company received a tax certificate from the Federal Communications Commission upon the sale of the Memphis television and radio stations, enabling the Company to defer payment of income taxes on the $60,500,000 tax-basis gain for a minimum of two years. The Company is included in the consolidated federal income tax return of EWS. However, the provision is computed as if the Company filed a separate federal income tax return. Property, Plant, and Equipment - Depreciation is computed using the straight-line method over estimated useful lives. Interest costs related to major capital projects are capitalized and classified as property, plant, and equipment. Program Rights - Program rights are recorded at the time such programs become available for broadcast. Program rights are stated at the lower of unamortized cost or fair value. Amortization is computed using the straight-line method based on the license period or based on usage, whichever yields the greater accumulated amortization for each program. The portion of the unamortized balance expected to be amortized within one year is classified as a current asset. The liability for program rights is not discounted for imputed interest. Estimated fair values (which are based on current rates available to the Company for debt of the same remaining maturity) and the carrying amounts of the Company's program rights liabilities were as follows: Cash and Cash Equivalents - Cash and cash equivalents represent cash on hand, bank deposits, and highly liquid debt instruments with an original maturity of up to three months. Cash equivalents are stated at cost plus accrued interest, which approximates fair value. Net Income Per Share - Net income per share computations are based upon the weighted average common shares outstanding. Weighted average shares outstanding were as follows: Reclassifications - For comparison purposes certain 1992 and 1991 items have been reclassified to conform with 1993 classifications. 2. ACCOUNTING CHANGES The Company adopted Financial Accounting Standard No. 112 - Employers' Accounting for Postemployment Benefits in 1993. The change had no effect on the Company's financial statements. 3. ACQUISITIONS AND DIVESTITURES A. Acquisitions 1993 and 1992 - The Company purchased several cable television systems. 1991 - The Company purchased Baltimore television station WMAR for $125,000,000 in cash and assumed liabilities totaling $29,000,000. The Company also purchased several cable television systems. The following table presents additional information about the acquisitions: The acquisitions have been accounted for as purchases, and accordingly the purchase prices were allocated to assets and liabilities based on the estimated fair value as of the dates of acquisition. The acquired operations have been included in the consolidated statements of income from the dates of acquisition. The following table summarizes, on an unaudited, pro forma basis, the estimated combined results of the Company and WMAR for 1991, assuming the acquisition was completed at the beginning of the year. These results include certain adjustments, primarily increased interest expense and depreciation and amortization, and are not necessarily indicative of what the results would have been had the Company owned WMAR during 1991: Pro forma results are not presented for the cable television acquisitions because the combined results of operations would not be significantly different from the reported amounts. B. Divestitures 1993 - The Company sold its Memphis television station and its radio stations. The following table presents additional information about the divestitures: Included in the consolidated financial statements are the following results of divested operations (excluding gains on sales): 4. UNUSUAL CREDITS AND CHARGES The Company's 1993 operating results include net after-tax gains on the sales of subsidiary companies of $53,000,000, $5.13 per share (see Note 3B). 1993 - Management changed the estimate of the additional amount of copyright fees the Company would owe when a dispute between the television industry and the American Society of Composers, Authors and Publishers ("ASCAP") was resolved. The adjustment increased operating income $4,300,000 and net income $2,700,000, $.26 per share. The U.S. television industry challenged the copyright fees required to be paid to ASCAP under a formula established in 1950. The dispute concerned payments for the past ten years. The U.S. District Court of the Southern District of New York ruled on February 26, 1993, and the change in estimate was based on that ruling. In August 1993 the federal income tax rate was increased to 35%, retroactive to January 1, 1993, and management changed its estimate of the tax basis and lives of certain assets. The net effect was to decrease net income $100,000, $.01 per share (see Note 5). 1991 - The Company agreed to settle a lawsuit filed in 1988 by Pacific West Cable Company that alleged violations of antitrust and unfair trade practice laws. The resultant charge reduced operating income by $12,000,000 and net income by $7,900,000, $.77 per share. 5. INCOME TAXES The Internal Revenue Service ("IRS") is currently examining the consolidated income tax returns of EWS for the years 1985 through 1990. Management believes that adequate provision for income taxes has been made for all open years. In 1991 the Company reached agreement with the IRS to settle the audits of its 1982 through 1984 federal income tax returns. The IRS required the Company's broadcast operations to change to the accrual method of accounting for income tax purposes. There was no charge to income resulting from the settlement. In 1991 SHI reached agreement with the State of Ohio to settle the audits of its 1980 through 1987 consolidated state franchise tax returns, which included the Company. The Company recorded additional income tax expense of $1,900,000 as a result of the settlement. In August 1993 the federal income tax rate was increased to 35%, retroactive to January 1, 1993. The change in the tax rate increased the Company's deferred tax liabilities $2,100,000. The resultant charge to income taxes reduced net income $2,100,000, $.20 per share. Also in 1993, management changed its estimate of the tax basis and lives of certain assets. The resulting change in the estimated tax liabilities for prior years increased net income $2,000,000, $.19 per share. The approximate effect of the temporary differences giving rise to the Company's deferred income tax liabilities (assets) are as follows: The Company's state net operating loss carryforwards expire from 2000 through 2006. The provision for income taxes consists of the following: The difference between the statutory rate for federal income tax and the effective income tax rate is summarized as follows: 6. ADVANCES FROM PARENT COMPANY Advances from SHI consisted of the following at December 31: The Company has a credit facility with SHI which, at December 31, 1993 permitted maximum borrowings up to $75,000,000 ("Credit Facility"). Maximum borrowing under the Credit Facility is changed as the Company's anticipated needs change and is not indicative of the Company's short-term borrowing capacity. The Credit Facility expires in September 1995 and may be extended upon mutual agreement. In 1993 the Company prepaid the scheduled 1994 payment on the 10.3% advance and the scheduled 1997 and 1998 payments on the 8.5% advance. 7. PROPERTY, PLANT, AND EQUIPMENT AND INTANGIBLE ASSETS Property, plant, and equipment consisted of the following at December 31: Goodwill and other intangible assets consisted of the following at December 31: 8. EMPLOYEE BENEFIT PLANS The Company sponsors defined benefit plans covering substantially all employees. Benefits are generally based on the employees' compensation and years of service. Funding is based on the requirements of the plans and applicable federal laws. The Company also sponsors defined contribution plans covering substantially all employees. The Company matches a portion of employees' voluntary contributions to these plans. Retirement plans expense consisted of the following: Assumptions used in the accounting for the defined benefit pension plans were as follows: The funded status of the defined benefit pension plans at December 31 was as follows: Plan assets consist of marketable equity and fixed-income securities. 9. SEGMENT INFORMATION Broadcasting operating income in 1993 was increased by $4,300,000 as a result of the change in estimate of the additional amount of copyright fees owed ASCAP (see Note 4). Cable television operating income was reduced in 1991 by the $12,000,000 charge related to settlement of the Sacramento cable television litigation (see Note 4). Financial information relating to the Company's business segments is as follows: Corporate assets are primarily cash and deferred income taxes. 10. TRANSACTIONS WITH PARENT COMPANY Intercompany payable (receivable) balances with SHI at December 31 were as follows: SHI provides general management services to all of its subsidiaries. SHI also provides management specifically for its cable television operations. The Company's share of such services was as follows: 11. COMMITMENTS AND CONTINGENCIES The Company is involved in litigation arising in the ordinary course of business, none of which is expected to result in material loss. The Company is committed to purchase approximately $68,000,000 of program rights currently not available for broadcast, including programs not yet produced. If such programs are not produced the Company's commitment would expire without obligation. The Company is diversified geographically and has a diverse customer base. The Company grants credit to substantially all of its customers. Management believes bad debt losses resulting from default by a single customer, or defaults by customers in any depressed region or business sector, would not have a material effect on the Company's financial position. Minimum payments on non-cancelable leases at December 31, 1993 were $1,600,000. Rental expense for cancelable and non-cancelable leases was as follows: 12. SUMMARIZED QUARTERLY FINANCIAL INFORMATION (Unaudited) Summarized financial information is as follows: The sum of the quarterly net income per share amounts may not equal the reported annual amount because each is computed independently based upon the weighted average number of shares outstanding for that period. SCRIPPS HOWARD BROADCASTING COMPANY Index to Consolidated Financial Statement Schedules Indebtedness to Related Parties S-2 Property, Plant, and Equipment S-3 Accumulated Depreciation of Property, Plant, and Equipment S-4 Valuation and Qualifying Accounts S-5 Supplementary Income Statement Information S-6 In 1993 the Company prepaid the scheduled 1994 payment on the 10.3% advance, and the scheduled 1997 and 1998 payments on the 8.5% advance. In 1991 the Company prepaid the scheduled 1999 payment on the 8.5% advance.
717829_1993.txt	717829	1993	Item 1. Business Gibson Greetings, Inc. and its wholly-owned and majority-owned subsidiaries (the "Company") operate in a single industry segment -- the design, manufacture and sale of everyday and seasonal greeting cards, gift wrap and accessories, paper partywares and related specialty products. Products The Company's major products are extensive lines of greeting cards (both everyday and seasonal) and gift wrap. Everyday cards are categorized as conventional greeting cards and alternative market cards. Seasonal cards are devoted to holiday seasons, which include, in declining order of net sales, Christmas, Valentine's Day, Mother's Day, Easter, Father's Day, Graduation and Thanksgiving. In 1993, approximately 58% of net sales of cards were derived from everyday cards and approximately 42% from seasonal cards. The Company produces gift wrap and gift wrap accessories (including tissue and kraft paper, tags, ribbons, bows and gift trims) predominately for the Christmas season. The Company's products also include paper partywares, candles, calendars, gift items and holiday decorations. The following table sets forth, in thousands of dollars for the years indicated, the Company's net sales attributable to each of the principal classes of the Company's products: Years Ended December 31, ---------------------------------- 1993 1992 1991 -------- -------- -------- Greeting cards $268,952 $243,647 $270,579 Gift wrap 192,862 187,965 196,352 Other products 84,351 52,506 55,235 -------- -------- -------- Total net sales $546,165 $484,118 $522,166 ======== ======== ======== Many of the Company's products incorporate well-known proprietary characters. Net sales associated with licensed properties accounted for approximately 14% of overall 1993 net sales. The Company believes it benefits from the publication of cartoon strips, television programming, advertising and other promotional activities by the creators of such licensed characters. The Company has also developed proprietary properties of its own. See "Trademarks, Copyrights and Licenses." PAGE Approximately 2% of the Company's revenues in 1993 were attributable to export sales and royalty income from foreign sources. During 1993, the Company acquired The Paper Factory of Wisconsin, Inc. ("The Paper Factory"), a Wisconsin corporation, to strengthen the Company's position in the rapidly-growing party segment of the industry. During 1992, the Company formed Gibson de Mexico, S.A. de C.V., a Mexican corporation, which purchased the net assets of a Mexican manufacturer and marketer of greeting cards, to market the Company's products primarily in Mexico. During 1991, the Company formed Gibson Greetings International Limited, a Delaware corporation, to market the Company's products in the United Kingdom and other European countries. Sales and Marketing The Company's products are sold in more than 50,000 retail outlets worldwide. Because of the value consumers place on convenience, the Company continues to concentrate its distribution through one-stop-shopping outlets. To market effectively through these outlets, the Company has developed specific product programs and new product lines and introduced new in-store displays. The Company's products are primarily sold under the Gibson and Cleo brand names and are primarily distributed to supermarkets, deep discounters, mass merchandisers, variety stores and drug stores. During 1993, the Company's five largest customers accounted for approximately 35% of the Company's net sales and only one customer, Wal-Mart Stores Inc., accounted for more than 10% of the Company's net sales The Company's products under the Gibson brand name are usually stocked in a department where only these products are displayed. Product displays are expressly designed for the presentation of greeting cards, gift wrap, paper partywares, candles and other products. The Company also supplies corrugated displays for seasonal specialties. The Company's method of selling greeting cards requires frequent and attentive merchandising service and fast delivery of reorders. The Company employs a direct field sales force that regularly visits most of the Company's customers, supported by a larger, nationwide merchandising service force. PAGE In order to properly display and service these products, a sizable initial investment is made in store display fixtures, sometimes totaling 300 linear feet, and in the hiring and training of service associates. To minimize costs and disruption, in the short-term, caused by the loss of a customer, the Company has entered into longer term contracts with certain retailers, consistent with general industry practice. These contracts generally have terms of from three to six years, and sometimes specify a minimum sales volume commitment. Some of the advantages to the Company include: less disruption to its distribution channels; the ability to plan product offerings into the future; and establishment of a reliable service network to ensure the best product display and salability. In certain of these contracts, cash payments or credits are negotiated constituting advance discounts against future sales. These payments are capitalized and amortized over the initial term of the contract. In the event of contract default by a retailer, such as bankruptcy or liquidation, a contract may be deemed impaired and unamortized amounts may be charged against operations immediately following the default. Use of these contracts has expanded in recent years within the industry and the Company currently has contracts with a number of customers including two of its top five customers. Most of the Company's gift wrap is Christmas-related and is sold under the Cleo brand name. These products are usually shipped in corrugated cartons which may be used as temporary free-standing displays. Separate free-standing product displayers and display planning services are also made available for the purpose of enhancing the presentation of Cleo products. The Company's Cleo brand gift wrap is typically sold at lower unit retail price levels than the Company's other brands of gift wrap. In general, the Company does not provide in-store merchandising services with respect to Cleo products but rather ships these products directly to the retailers' stores or their warehouses for subsequent distribution to individual stores. It is characteristic of the Company's business and of the industry that accounts receivable for seasonal merchandise are carried for relatively long periods, typically as long as six months. Consistent with general industry practice, the Company allows customers to return for credit certain seasonal greeting cards. Design and Production Most of the Company's greeting cards are designed, printed and finished at its Cincinnati, Ohio facility and then sent to its facilities in Berea or Covington, Kentucky for shipment directly to retail stores. Most of the Company's gift wrap is designed, printed and finished at the Company's facilities in Memphis, Tennessee and distributed from the Company's facilities in Memphis, Tennessee and Cerritos, California. The Company also purchases for resale certain finished and semi-finished products, such as gift items, from both domestic and foreign sources. The Company maintains a full-time staff of artists, writers, art directors and creative planners who design a majority of the Company's products. Design of everyday products begins approximately 12 months in advance of shipment. The Company's seasonal greeting cards and other items are designed and printed over longer periods than the everyday cards. Designing seasonal products begins approximately 18 months before the holiday date. Seasonal designs go into production about 12 months before the holiday date. Production of the Company's products increases throughout the year until late September. Because a substantial portion of the Company's shipments are typically concentrated in the latter half of the year, the Company normally is required to carry large inventories. The Company believes that adequate quantities of raw materials used in its business are and will continue to be available from many suppliers. Paper costs are the most significant component of the Company's product cost structure. Competition The greeting card and gift wrap industry is highly competitive. Based upon its general knowledge of the industry and the limited public information available about its competitors, the Company believes it is the third largest producer of greeting cards and gift wrap in the United States. The Company's principal competitors are Hallmark Cards, Inc. and American Greetings Corporation, which are predominant in the industry, and CPS/Artfaire, Inc. Certain of the Company's competitors have greater financial and other resources than the Company. The Company believes that the principal areas of competition with respect to its products are quality, design, service to the retail outlet, price and terms, which may include payments and other concessions to retail customers under long-term agreements, and that it is competitive in all of these areas. See "Sales and Marketing". Trademarks, Copyrights and Licenses The Company has approximately 40 registrations of trademarks in the United States and foreign countries. Although the Company does not generally register its creative artwork and editorial text with the U.S. Copyright Office, it does obtain certain copyright protection by printing notice of a claim of copyright on its products. The Company has rights under various license agreements to incorporate well-known proprietary characters into its products. These licenses, most of which are exclusive, are generally for terms of one to four years and are subject to certain renewal options. There can be no assurance that the Company will be able to renew license agreements as to any particular proprietary character. The Company believes that its business is not dependent upon any individual trademark, copyright or license. Employees As of December 31, 1993, the Company employed approximately 4,600 persons on a full-time basis. In addition, as of December 31, 1993, the Company employed approximately 4,800 persons on a part-time basis. Because of the seasonality of the Company's sales, the number of the Company's production and warehousing employees varies during the year, normally reaching a peak level in September. Approximately 800 hourly employees in the Company's Memphis, Tennessee facilities are represented by a local union affiliated with the United Paper Workers International Union and are employed under a contract which expires in 1996. Approximately 300 hourly employees currently on the payroll at the Company's Berea, Kentucky facility are represented by a local union affiliated with the International Brotherhood of Firemen and Oilers Union. Unfair labor practice charges have been filed against the Company as an outgrowth of a strike at the Berea facility in 1989. See "Legal Proceedings." Environmental Issues The Company, over the past ten years, has taken a proactive approach to environmental concerns. In 1986, Cleo, Inc. ("Cleo") converted its printing operations to water-based inks. Likewise, since early 1990, the Company's subsidiary, the Gibson Card Division ("Gibson") has converted its card and related products production to water-based inks. Previously, Gibson had its Cincinnati-produced waste solvents incinerated. All but one underground storage tank on Company owned and leased premises were removed in or before 1988. In 1990, the last underground storage tank, which had contained isopropyl alcohol, was also removed in accordance with governmental closure regulations. For the past seven years, the Company has consulted with professional firms for environmental audits before entering into potential long-term real estate transactions. Historically, expenditures associated with managing and limiting pollution or hazardous substances, as well as expenditures to remediate previously contaminated sites, have not been material to the Company's financial statements. At December 31, 1993, the Company was aware of two environmental liabilities as discussed below: DIAZ REFINERY - JACKSON COUNTY, ARKANSAS In 1989, the Company was identified by the Arkansas Department of Pollution Control and Ecology ("ADPC&E") as a potentially responsible party ("PRP") in connection with the Diaz Refinery Site in Jackson County, Arkansas. The Company is participating with approximately 700 other PRPs in a settlement with ADPC&E for remediation of the Site. To date, the Company's share of total Site costs has been approximately $46,000. The nature and extent of the contamination, if any, is still being investigated. Thus, it is not possible at this time to provide an estimate of total clean-up costs for the Site or the Company's share of such costs. PAGE KIRK LANDFILL - DYER COUNTY, TENNESSEE In December 1993, the Company was advised by the Tennessee Department of Environment and Conservation ("TDEC") that Cleo had been identified by the State as a potentially liable party for reimbursement of Superfund Expenditures made by the State of Tennessee for site identification, investigation, containment and clean-up, including monitoring and maintenance activities. The Company has ascertained that Cleo's alleged responsibility involves the alleged disposal of certain waste solvents at the Site during the period 1972-1975. At this time, insufficient information is available to determine the Company's potential liability, if any; however, the TDEC has requested payment of approximately $13,000, representing full reimbursement of costs incurred to date. The Company is investigating whether insurance provisions under policies in existence during the time period will be applicable. PAGE Item 2.		Item 2. Properties The following is a summary of the Company's principal manufacturing, distribution and administrative facilities: Approximate Floor Space Location Principal Use (Sq Ft) - -------------------- ------------------------------------- ----------- Cincinnati, Ohio Corporate headquarters, manufacturing and administration 593,700 Memphis, Tennessee Manufacturing, distribution and administration 1,002,800 Berea, Kentucky Manufacturing and distribution 597,100 Mexico City, Mexico Manufacturing and distribution 26,900 Telford, England Manufacturing, distribution and administration 58,800 Memphis, Tennessee Manufacturing and distribution 1,153,200 Covington, Kentucky Manufacturing and distribution 293,000 Florence, Kentucky Manufacturing and distribution 80,000 Reynosa, Tamaulipas, Mexico Manufacturing 86,700 Bloomington, Indiana Distribution 167,700 Memphis, Tennessee Distribution (3 facilities) 796,600 Cerritos, California Distribution 214,600 Neenah, Wisconsin Distribution 31,000 --------- Total 5,102,100 ========= The first three facilities listed above are all currently leased for an initial term expiring in 2002. The Company has the right to renew the lease for two additional terms of five years each. The Company also has an option to purchase these facilities in 2002 at the higher of $35,400,000 or the fair market value of the properties at that time. For accounting purposes, this lease has been treated as an operating lease. See Note 11 of Notes to Consolidated Financial Statements set forth in Item 8 below. PAGE The Company's 1.1 million square foot manufacturing and distribution facility in Memphis, Tennessee has been financed primarily through the issuance, by the Industrial Development Board of the City of Memphis and County of Shelby, Tennessee (the "Board"), of both taxable and tax-exempt economic development revenue bonds for the benefit of the Company's subsidiary, Cleo. Title to the facility will be held until 2004 by the Board. See Note 6 of Notes to Consolidated Financial Statements set forth in Item 8 below. The Telford, England, Covington, Kentucky and Bloomington, Indiana manufacturing and distribution facilities are owned by the Company. The Covington, Kentucky facility has been financed principally through tax-exempt debt and is pledged to secure the repayment of such debt. See Note 6 of Notes to Consolidated Financial Statements set forth in Item 8 below. The Florence, Kentucky facility, the Mexico City, Mexico facility, the Reynosa, Tamaulipas, Mexico facility and the distribution facilities at Memphis, Tennessee, Cerritos, California and Neenah, Wisconsin are leased. The Company also leases sales offices, other manufacturing, distribution and administrative facilities and, on a temporary basis, uses public warehouse space in various locations throughout the United States. The Paper Factory leases approximately 140 stores averaging approximately 3,000 to 4,000 square feet per store. Certain of these leases contain contingent payments based upon individual store sales. Leases for such facilities expire at various dates through 2003. The Company believes that its facilities are adequate for its present needs and that its properties, including machinery and equipment, are generally in good condition, well maintained and suitable for their intended uses. Item 3.	Item 3. Legal Proceedings In 1989, unfair labor practice charges were filed against the Company as an outgrowth of a strike at its Berea, Kentucky facility. Remedies sought include back pay from August 8, 1989 and reinstatement of employment for approximately 200 employees. In February 1990, the General Counsel of the National Labor Relations Board ("NLRB") issued a complaint based on certain of the allegations of these charges (In the Matter of Gibson Greetings, Inc. and International Brotherhood of Fireman and Oilers, AFL-CIO, Cases 9-CA-26706, 27660, 26875.) On December 18, 1991, an Administrative Law Judge of the NLRB issued a recommended order, which included reinstatements and back pay affecting approximately 160 strikers, based on findings that the Company had violated certain provisions of the National Labor Relations Act. On May 7, 1993, the NLRB upheld the Administrative Law Judge's decision in some respects, and enlarged the number of strikers entitled to back pay to approximately 240. A prompt notice of appeal was filed in the PAGE United States Court of Appeals for the District of Columbia Circuit. The Company believes it has substantial defenses to the charges, and these defenses will be presented in briefs in the Company's appeal. The appeal is scheduled to be heard on September 14, 1994. In addition, the Company is a defendant in certain other litigation. Management does not believe that an adverse outcome as to any or all of these matters would have a material adverse effect on the Company's net worth or total cash flows; however, the impact on the statement of operations in a given year could be material. Item 4.	Item 4. Submission of Matters to a Vote of Security Holders Not applicable. Executive Officers of the Registrant See Item 10. Directors and Executive Officers of the Registrant. PAGE PART II Item 5.	Item 5. Market for the Registrant's Common Stock and Related Stockholder Matters The Company's debt agreements contain certain covenants including limitations on dividends based on a formula related to net income, stock sales and certain restricted investments. At December 31, 1993, the amount of unrestricted retained earnings available for dividends (in thousands of dollars) was $50,760. The Company's business is seasonal with a significant amount of its net sales and net income historically occurring in the last two quarters of the year. The following table presents certain consolidated quarterly financial data (unaudited) for 1993 and 1992: [FN] (1) Per share prices are based on the closing price as quoted in the Nasdaq National Market. (2) Quarterly results for 1992 have been restated to reflect the adoption of Statement of Financial Accounting Standards (SFAS) No. 106 and SFAS No. 109 in the first quarter. The impact of the adoption of these standards was to reduce income before cumulative effect of accounting changes by $73 and $74 in the first and second quarters, respectively, and reduce earnings per share in the second quarter by $.01. PAGE Item 6.	Item 6. Selected Financial Data The following summaries set forth selected financial data for the Company for each of the five years in the period ended December 31, 1993. Selected financial data should be read in conjunction with the Consolidated Financial Statements set forth in Item 8 below. [FN] (1) Includes the current portion of long-term debt which consisted of $3,917 in 1993, $1,811 in 1992, $708 in 1991, $6,702 in 1990 and $2,697 in 1989. PAGE Item 7.	Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Unless specifically stated otherwise, dollars in thousands except per share amounts. Results of Operations The Company's 1993 results reflected a recovery from the prior year which was adversely impacted by the Chapter 11 bankruptcy filing by Phar-Mor, Inc. (Phar-Mor) during 1992. Total revenues in 1993 increased 12.6% to $546.9 million compared to a decrease of 7.3% in 1992 and an increase of 2.2% in 1991. The revenue gains in 1993 were attributable to The Paper Factory of Wisconsin, Inc. (The Paper Factory) which was acquired in June 1993, as well as increased domestic and international sales of greeting cards, partially offset by a modest decline in sales of gift wrap and related products. Consistent with general industry practice, the Company allows customers to return for credit certain seasonal greeting cards. Also, consistent with general industry practice, and where deemed prudent to secure substantial long-term volume commitments, the Company enters into long-term sales contracts with certain retailers, some of which include advance payments. Returns and allowances were 13.3% in 1993 compared to 15.9% in 1992 and 17.2% in 1991. The decline in 1993 returns and allowances was due to lower returns of certain seasonal products and lower allowances for certain everyday products. The Company does not believe that its 1993 results were materially affected by recessionary pressures. Royalty income of $.8 million for 1993 declined by $.9 million from 1992 primarily due to the expiration of certain international licensing agreements. The Company's 1992 results reflected lower revenues from Phar-Mor of $28.1 million, including the write-off of long-term contracts totaling $16.4 million. In addition, lower unit sales for everyday and seasonal greeting cards, partially offset by higher unit sales of gift wrap and lower returns of certain seasonal products contributed to the decline. The 1991 increase in total revenues resulted from higher selling prices and unit sales for everyday and seasonal greeting cards partially offset by unit decreases in gift wrap and increased returns and allowances. PAGE Total costs and expenses were $503.0 million or 92.0% of total revenues in 1993 compared to 97.3% in 1992 and 87.0% in 1991. Cost of products sold was 49.1% of total revenues in 1993 compared to 50.9% and 48.1% in 1992 and 1991, respectively. The decline in 1993 compared to 1992 was due to higher revenues and product sales mix, reflecting the acquisition of The Paper Factory. The increase in 1992 compared to 1991 was due to lower revenues and product sales mix. Selling, distribution and administrative expenses were 41.7% of total revenues in 1993 compared to 45.0% in 1992 and 37.2% in 1991. The decline in these expenses, as a percentage, reflected higher revenues, partially offset by acquisition costs associated with The Paper Factory and start-up costs for international operations. Additionally, 1992 expenses included Phar-Mor related items including write-offs of accounts receivable of $5.9 million and card display fixtures of $5.1 million. Expenses associated with international operations as well as domestic restructuring charges also adversely impacted 1992. Interest expense, net of interest income, decreased to 1.2% of total revenues in 1993 compared to 1.4% and 1.7% in 1992 and 1991, respectively. Lower interest rates were partially offset by higher average borrowings, largely resulting from the acquisition of The Paper Factory as well as higher working capital levels. The decrease in the 1992 percentage versus 1991 was attributable to lower average borrowing levels combined with lower interest rates. Also included in 1991 were a $.5 million prepayment penalty on the Company's 13.625% senior notes which were retired and increased interest expense associated with debt incurred to finance a new manufacturing and distribution center. Income before income taxes and cumulative effect of accounting changes was $44.0 million, an increase of $30.9 million over 1992 compared to a decrease in 1992 of $55.1 million from 1991 and an increase of $4.3 million in 1991 over 1990. This represented 8.0% of total revenues in 1993 compared to 2.7% and 13.0% in 1992 and 1991, respectively. The effective income tax rate for 1993 was 41.2% compared to 38.9% in 1992 and 38.6% in 1991. See Notes 1 and 7 of Notes to Consolidated Financial Statements set forth in Item 8	Item 8. Financial Statements and Supplementary Data [FN] See accompanying notes to consolidated financial statements. PAGE [FN] See accompanying notes to consolidated financial statements. PAGE [FN] See accompanying notes to consolidated financial statements. PAGE [FN] See accompanying notes to consolidated financial statements. PAGE Gibson Greetings, Inc. Notes to Consolidated Financial Statements Years Ended December 31, 1993, 1992 and 1991 (Dollars in thousands except per share amounts) Note 1--Nature of Business and Statement of Accounting Policies Principles of consolidation The consolidated financial statements include the accounts of Gibson Greetings, Inc. and its wholly-owned and majority-owned subsidiaries (the Company). All intercompany transactions have been eliminated. Nature of business The Company operates in a single industry segment: the design, manufacture and sale of greeting cards, gift wrap and related products. The Company sells to customers in several channels of the retail trade principally located in the United States. The Company recognizes sales at the time of shipment from its facilities. Provisions for sales returns are recorded at the time of the sale, based upon current conditions and the Company's historic experience. The Company conducts business based upon periodic credit evaluations of its customers' financial condition and generally does not require collateral. The Company does not believe a concentration of risk exists due to the diversity of channels of distribution and geographic location of its retail customers. During the year ended December 31, 1993, the Company's largest customer accounted for approximately 12% of total revenues and during the year ended December 31, 1992, the same customer accounted for approximately 11% of total revenues. During the year ended December 31, 1991, a different customer accounted for approximately 13% of total revenues. International Operations During 1992, the Company formed Gibson de Mexico, S.A. de C.V. (Gibson de Mexico) to purchase certain assets and assume certain liabilities of Pagina Once, S.A. de C.V. (Pagina Once). Pagina Once was primarily engaged in the manufacturing and marketing of greeting cards. Minority stockholders of Gibson de Mexico are principal officers of Gibson de Mexico. The total cost of the acquisition exceeded the fair value of the net assets by $583. During 1991, the Company formed Gibson Greetings International Limited (Gibson International) to market the Company's products primarily in the United Kingdom and other European countries. The minority stockholders of Gibson International are principal officers of Gibson International. The activities of these subsidiaries were not material to consolidated operations in either 1993 or 1992. PAGE Retail Operations On June 1, 1993, the Company acquired The Paper Factory of Wisconsin, Inc. (The Paper Factory) for $25.1 million in a business combination accounted for as a purchase. The Paper Factory operates retail stores located primarily in manufacturers' outlet shopping centers. The results of The Paper Factory are not material and are included in the consolidated financial statements since the date of acquisition. The total cost of the acquisition exceeded the fair value of the net assets of The Paper Factory by $26.2 million. In connection with the acquisition, the Company assumed liabilities of approximately $11.6 million. Accumulated goodwill amortization at December 31, 1993 was $792. Cash and equivalents Cash and equivalents are stated at cost. Cash equivalents include time deposits, money market instruments and short-term debt obligations with original maturities of three months or less. The carrying amount approximates fair value because of the short maturity of these instruments. Inventories Inventories are stated at the lower of cost (first-in, first-out) or market. Plant and equipment Plant and equipment are stated at cost. Plant and equipment, except for leasehold improvements, are depreciated over their related estimated useful lives, using the straight-line method. Leasehold improvements are amortized over the terms of the respective leases, using the straight-line method. Expenditures for maintenance and repairs are charged to operations currently; renewals and betterments are capitalized. Other assets Other assets include deferred and prepaid costs, goodwill and other intangibles. Deferred and prepaid costs represent costs incurred relating to long-term customer sales agreements. Deferred and prepaid costs are amortized ratably over the terms of the agreements, generally three to six years. Goodwill and other intangibles are amortized over periods ranging from three to twenty years, using the straight-line method. PAGE Income taxes Effective January 1, 1992, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 109 - "Accounting for Income Taxes." This Statement utilizes the liability method of accounting for income taxes. Deferred taxes are determined based on the estimated future tax effects of differences between the financial statement and tax bases of assets and liabilities given the provisions of currently enacted tax laws. Prior to 1992, the Company accounted for income taxes using Accounting Principles Board Opinion No. 11. Investment tax credits are amortized to income over the lives of the related assets. Excess of fair value of companies acquired over cost The excess of fair value of companies acquired over cost was amortized to income over ten years, using the straight-line method. Amortization was complete in 1991. Accumulated amortization at December 31, 1993 and 1992 was $14,480. Interest rate swap agreements The difference between the amount of interest to be paid and the amount of interest to be received under interest rate swap agreements due to changing interest rates is charged or credited to interest expense over the life of the agreements. The fair value of interest rate swaps (used for hedging purposes) is the estimated amount that the Company would receive or pay to terminate the swap agreements at the reporting date, taking into account current interest rates and the current creditworthiness of the swap counterparties. Other Postretirement Benefits Effective January 1, 1992, the Company adopted SFAS No. 106 - "Employers' Accounting for Postretirement Benefits Other Than Pensions" (OPEB). This Statement requires that the cost of these benefits be recognized in the financial statements during the employee's active working career. Computation of net income per share The computation of net income per share is based upon the weighted average number of shares of common stock and equivalents outstanding during the year: 16,102,709 shares for 1993, 16,103,897 shares for 1992, and 16,039,259 shares for 1991. PAGE Reclassifications Certain prior year amounts in the consolidated financial statements have been reclassified to conform to the 1993 presentation. Note 2--Trade Receivables Trade receivables at December 31, 1993 and 1992, consist of the following: Note 3--Inventories Inventories at December 31, 1993 and 1992, consist of the following: PAGE Note 4--Plant and Equipment Plant and equipment at December 31, 1993 and 1992, consist of the following: Note 5--Other Assets Other assets at December 31, 1993 and 1992, consist of the following: PAGE Note 6--Debt Debt at December 31, 1993 and 1992, consists of the following: PAGE In 1991, the Company privately placed $50,000 in long-term senior notes with proceeds being used for general corporate purposes. In 1993, the Company entered into a new three-year revolving credit agreement, replacing a similar existing facility, which expires April 26, 1996. The amount which can be borrowed under this agreement is $210,000. The fair value of the Corporation's long-term debt is estimated based on the quoted market prices for the same or similar issues or on the current rates offered to the Corporation for debt of the same remaining maturities. The estimated fair value of the Company's gross long-term debt at December 31, 1993 was $83,992. The Company periodically enters into interest rate swap or derivative transactions with the intent to manage the interest rate sensitivity of portions of its debt. At December 31, 1993, the Company had four outstanding interest rate swap/derivative positions with a total notional amount of $96,000. Two agreements, with terms similar to the related bonds, are constituted as hedges and effectively change the Company's interest rate on $3,000 of industrial revenue bonds to 6.67% through February 1998. One of the other two agreements attempts to limit the Company's exposure against rising short-term rates on a notional amount of $60,000 through 1995. The last position provides the Company with a maximum 1.0% annuity on $30,000 through August 1994 predicated on short-term rates remaining in a specified range. Based on the estimated cost of terminating these two positions, the Company has an unrealized net loss at December 31, 1993 of approximately $1,000. On March 4, 1994, the Company announced that, based on trading of swap/derivative positions subsequent to year-end, the Company entered into two new contracts which will result in a minimum loss of $3,000 and a maximum potential loss of $27,500. The new contracts, which mature in June and August 1995, may be liquidated at any time prior to maturity and have an estimated cost of termination of approximately $17,500 at March 4, 1994. The annual principal payments due on long-term debt for each of the years in the five-year period ended December 31, 1998, are $3,917, $11,164, $11,269, $11,116 and $9,205, respectively. Capitalized interest for the years ended December 31, 1993, 1992 and 1991 were $0, $74 and $322, respectively. PAGE The Company's debt agreements contain certain covenants including limitations on dividends based on a formula related to net income, stock sales and certain restricted investments. At December 31, 1993, the amount of unrestricted retained earnings available for dividends was $50,760. Note 7--Income Taxes The Company adopted the provisions of SFAS No. 109 effective January 1, 1992, and recorded a credit of $1,038 and increased earnings per share by $.06 for the cumulative effect of this change in accounting principle. There was no effect on income before income taxes for the year ended December 31, 1992, resulting from the adoption of SFAS No. 109. The provision for income taxes for the years ended December 31, 1993, 1992 and 1991, consists of the following: PAGE For the year ended December 31, 1992, provision for income taxes was included in the financial statements as follows: Recently enacted tax laws raised the statutory tax rate for corporations from 34% to 35%, retroactive to January 1, 1993. Partially offsetting the adverse impact of the 1% increase in effective tax rates in 1993 and future periods is the favorable adjustment of $.7 million recorded in 1993 due to the revaluation of certain deferred tax assets. The effective income tax rate for the years ended December 31, 1993, 1992 and 1991, varied from the statutory federal income tax rate as follows: PAGE The tax effect of significant temporary differences representing deferred tax assets and liabilities is as follows for the year ended December 31, 1991: Deferred taxes are determined based on the estimated future tax effects of differences between the financial statement and tax bases of assets and liabilities given the provisions of currently enacted tax laws. The net deferred taxes are comprised of the following: The Company did not record any valuation allowances against deferred tax assets at January 1, 1992, December 31, 1992 or December 31, 1993, due to the substantial amounts of taxable income generated over the last three to five years. PAGE The tax balances of significant temporary differences representing deferred tax assets and liabilities for the years ended December 31, 1993 and 1992 were as follows: Note 8--Other Current Liabilities Other current liabilities at December 31, 1993 and 1992, consist of the following: PAGE Note 9--Postretirement Benefits The Company sponsors a defined benefit pension plan (the Retirement Plan) covering substantially all employees who meet certain eligibility requirements. Benefits are based upon years of service and average compensation levels. The Company's general funding policy is to contribute amounts deductible for federal income tax purposes. Contributions are intended to provide not only for benefits earned to date, but also for benefits expected to be earned in the future. The following table sets forth the Retirement Plan's funded status on the measurement dates, September 30, 1993 and 1992, and a reconciliation of the funded status to the amounts recognized in the Company's consolidated balance sheets at December 31, 1993 and 1992: The fair market value of the Retirement Plan's assets at December 31, 1993 and 1992, was $61,559 and $58,474, respectively. The changes in asset values relative to the measurement dates are primarily due to fluctuations in the market value of the plan's equity investments. PAGE In 1990, the Company established a nonqualified defined benefit plan for employees whose benefits under the Retirement Plan are limited by provisions of the Internal Revenue Code. Additionally in 1990, the Company established a nonqualified defined benefit plan to provide supplemental retirement benefits for selected executives in addition to benefits provided under other Company plans. A nonqualified plan was also established to provide retirement benefits for members of the Company's Board of Directors who are not covered under any of the Company's other plans. All plans established in 1990 were unfunded at December 31, 1993 and 1992, although assets for those plans are held in certain grantor tax trusts known as "Rabbi" trusts. These assets are subject to claims of the Company's creditors but otherwise must be used only for purposes of providing benefits under the plans. The following table sets forth the nonqualified defined benefit plans' benefit obligations on the measurement dates, September 30, 1993 and 1992, and a reconciliation of those obligations to the amounts recognized in the Company's consolidated balance sheets at December 31, 1993 and 1992: PAGE The assumed weighted average discount rate and rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligation for the plans was 7.0% and 5.0% in 1993 and 8.0% and 6.0% in 1992, respectively. The assumed long-term rate of return on plan assets used for valuation purposes was 9.0% for 1993 and 1992. A summary of the components of net pension expense for all of the Company's defined benefit plans for the years ended December 31, 1993, 1992 and 1991, is as follows: The Company has a defined contribution pension plan for employees who are members of a collective bargaining unit. Benefits under this plan are determined based upon years of service and an hourly contribution rate. Pension expense for this plan for the years ended December 31, 1993, 1992 and 1991, was $451, $479 and $410, respectively. The Company has two defined contribution plans pursuant to Section 401(k) of the Internal Revenue Code. The plans provide that employees meeting certain eligibility requirements may defer a portion of their salary subject to certain limitations. The Company pays certain administrative costs of the plans and contributes to the plans based upon a percentage of the employee's salary deferral and an annual additional contribution at the discretion of the Board of Directors. The total expense for these plans for the years ended December 31, 1993, 1992 and 1991, was $501, $481 and $511, respectively. In addition to providing pension benefits, the Company provides medical and life insurance benefits for certain eligible employees upon retirement from the Company. Substantially all employees may become eligible for such benefits upon retiring from active employment of the Company. Medical and life insurance benefits for employees and retirees are paid by a combination of company and employee or retiree contributions. Retiree insurance benefits are provided by insurance companies whose premiums are based on claims paid during the year. The PAGE Company adopted the provisions of SFAS No. 106 effective January 1, 1992. This standard requires companies to accrue an actuarially determined charge for postretirement benefits during the period in which active employees become eligible, under existing plan agreements, for such future benefits. The cumulative effect of this change resulted in a charge to net income of $2,487 or $.15 per share, after taxes of $1,609. Prior to January 1, 1992, the Company recognized these costs, which were not significant to operations, on a cash basis. Net periodic cost of these benefits for the years ended December 31, 1993 and 1992 is as follows: A reconciliation of the accumulated postretirement benefit obligation (APBO) measured as of September 30, 1993 and 1992 to the Company's consolidated balance sheets at December 31, 1993 and 1992 was as follows: PAGE The accumulated benefit obligation for 1993 and 1992 was determined using the following assumptions: 1993 1992 ----------------------- ----------------------- Discount rate 7% 8% Health care cost trend rate 11% for 1994 graded down 16% for 1993 and 1994, 1% per year to 5% in the gradually declining to year 2000, 5% thereafter a rate of 6% by 2003 The health care cost trend rate assumption does not have a significant effect on the amounts reported. For example, a 1% increase in the health care cost trend rate would increase the accumulated postretirement benefit obligation as of December 31, 1993, and the net periodic cost for the year then ended by approximately 5% and 4%, respectively. Note 10--Stockholders' Equity Employee stock plans Under various stock option and incentive plans, the Company may grant incentive and nonqualified stock options to purchase its common stock. All incentive options are granted at the fair market value on the date of grant. Incentive stock options generally become exercisable one year after the date granted and expire ten years after the date granted, if not earlier expired due to termination of employment. Nonqualified stock options become exercisable according to a vesting schedule determined at the date granted and expire on the date set forth in the option agreement, if not earlier expired due to termination of employment. A summary of stock option activity during the years ended December 31, 1993, 1992 and 1991, is as follows: The exercise prices of options granted in 1993 ranged from $18.88 to $21.25. The exercise prices of options granted in 1992 ranged from $18.38 to $28.63 and the exercise price of options granted in 1991 ranged from $24.75 to $28.00. Options exercised were at prices of $2.38 to $23.50, in 1993, 1992 and 1991. Options outstanding at December 31, 1993, are at prices ranging from $11.38 to $28.63. Under certain stock incentive plans, the Company may grant the right to purchase restricted shares of its common stock. Such shares are subject to restriction on transfer and to repurchase by the Company. The purchase price of restricted shares is determined by the Company and may be nominal. In 1993, 1992 and 1991, 0, 5,000 and 38,500 restricted shares, respectively, were purchased at a price of $1.00 per share. At December 31, 1993, 621,192 shares were available under the stock option and incentive plans, of which 563,166 shares could be issued as restricted shares. Stock rights On December 4, 1987, the Company's Board of Directors declared a dividend distribution of one right for each outstanding share of the Company's common stock to stockholders of record on December 21, 1987. Each right entitles the holder to purchase, for the exercise price of $40 per share, 1/100th of a share of Series A Preferred Stock. Until exercisable, the rights are attached to all shares of the Company's common stock outstanding. The rights are exercisable only in the event that a person or group of persons (i) acquires 20% or more of the Company's common stock and there is a public announcement to that effect, (ii) announces an intention to commence or commences a tender or exchange offer which would result in that person or group owning 30% or more of the Company's common stock, or (iii) beneficially owns a substantial amount (at least 15%) of the Company's common stock and is declared to be an Adverse Person (as defined in the Rights Agreement) by the Company's Board of Directors. Upon a merger or other business combination transaction, each right may entitle the holder to purchase common stock of the acquiring company worth two times the exercise price of the right. Under certain other circumstances (defined in the Rights Agreement) each right may entitle the holder (with certain exceptions) to purchase common stock, or in certain circumstances, cash, property or other securities of the Company, having a value worth two times the exercise price of the right. The rights are redeemable at one cent per right at anytime prior to 20 days after the public announcement that a person or group has acquired 20% of the Company's common stock. Unless exercised or redeemed earlier by the Company, the rights expire on December 28, 1997. PAGE Note 11--Commitments Lease commitments The Company has a long-term lease agreement for certain of its principal facilities. The initial lease term runs through January 31, 2002, with two five-year renewal options available. The basic rent under the lease is subject to adjustment based on changes in the Consumer Price Index for the preceding five years, effective March 1, 1987, and every five years thereafter including renewal periods. The lease provides a purchase option exercisable in 2002. The option price is the higher of $35,400 or the fair market value on the date of exercise. As a condition of the lease, all property taxes, insurance costs and operating expenses are to be paid by the Company. The Company also leases additional manufacturing, distribution and administrative facilities, sales offices and personal property under noncancellable leases which expire on various dates through 2003. Certain of these leases contain renewal and escalating rental payment provisions. Rental expense for the years ended December 31, 1993, 1992 and 1991, on all real and personal property, was $20,297, $15,846 and $13,777, respectively. Minimum future annual rentals under noncancellable leases for each of the years in the five-year period ended December 31, 1998 are $17,444, $16,242, $14,190, $12,759 and $9,842, respectively. After 1998, these commitments aggregate $25,364. Contract commitments The Company has several long-term customer sales agreements which require payments and credits for each of the years in the five-year period ended December 31, 1998, of $3,959, $1,347, $707, $443 and $242, respectively. After December 31, 1998, these commitments aggregate $100. All of these amounts have been recorded as other current liabilities or other liabilities in the accompanying balance sheet as of December 31, 1993. Employment agreements The Company has employment agreements with certain executives which provide for, among other things, minimum annual salaries adjusted for cost-of-living changes, continued payment of salaries in certain circumstances and incentive bonuses. Certain agreements further provide for signing bonuses, deferred compensation payable upon expiration of the agreements and employment termination payments, including payments contingent upon any person becoming the beneficial owner of 50% or greater of the Company's outstanding stock. PAGE Note 12--Legal Proceedings In 1990, a complaint was issued against the Company alleging certain unfair labor practices in connection with a strike at one of its facilities. On December 18, 1991, an Administrative Law Judge of the National Labor Relations Board ("NLRB") issued a recommended order, which included reinstatement and back pay affecting approximately 160 strikers, based on findings that the Company had violated certain provisions of the National Labor Relations Act. On May 7, 1993, the NLRB upheld the Administrative Law Judge's decision in some respects, and enlarged the number of strikers entitled to back pay to approximately 240. A prompt notice of appeal was filed in the United States Court of Appeals for the District of Columbia Circuit. Management believes it has substantial defenses to these charges and these defenses will be presented in briefs in the Company's appeal. In addition, the Company is a defendant in certain other litigation. Management does not believe that an adverse outcome as to any or all of these matters would have a material adverse effect on the Company's net worth or total cash flows; however, the impact on the statement of operations in a given year could be material. PAGE Report of Independent Public Accountants To Gibson Greetings, Inc.: We have audited the accompanying consolidated balance sheets of Gibson Greetings, Inc. (a Delaware corporation) and its subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, cash flows and changes in stockholders' equity for each of the three years in the period ended December 31, 1993. These financial statements and the schedules referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Gibson Greetings, Inc. and its subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. As discussed in notes to consolidated financial statements, effective January 1, 1992, the Company changed its methods of accounting for postretirement benefits other than pensions and income taxes. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in the index of financial statements are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state 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 & CO. Cincinnati, Ohio, March 4, 1994. PAGE Item 9.	Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure Not applicable. PART III Except as set forth below, the information required by this Part is included in the Company's definitive Proxy Statement, filed with the Securities and Exchange Commission in connection with the Company's 1994 Annual Meeting of Stockholders, and is incorporated by reference herein. Item 10.	Item 10. Directors and Executive Officers of the Registrant The Executive Officers of the Company (at March 18, 1994) are as follows: Name Age Title ------------------- --- ---------------------------- Benjamin J. Sottile 56 Chairman of the Board, President and Chief Executive Officer Ralph J. Olson 49 Vice President and Director William L. Flaherty 46 Vice President, Finance and Chief Financial Officer James H. Johnsen 52 Vice President, Controller and Treasurer Stephen M. Sweeney 57 Vice President, Human Resources Information about Mr. Sottile is incorporated by reference from the Company's definitive Proxy Statement for the 1994 Annual Meeting of Stockholders. RALPH J. OLSON. Mr. Olson is a Vice President of the Company and is President and Chief Operating Officer of the Company's Gibson Card Division, positions he has held since 1991. From 1989 until 1991, he was President of the E-Z Go Division of Textron, Inc., a manufacturer of golf and utility vehicles. During the period from 1984 until 1989, he was President of the Material Handling Division of Interlake Corp., specializing in material handling, automation and storage systems. WILLIAM L. FLAHERTY. Mr. Flaherty has been Vice President, Finance and Chief Financial Officer of the Company since November 1993. Prior to that time, he served as Vice President and Corporate Treasurer of FMR Corp., the parent company of Fidelity Investments Group, a mutual fund management and discount stock brokerage firm (1989 - 1992) and as Vice President and Treasurer of James River Corporation , an integrated manufacturer of pulp, paper and converted paper and plastic products (1987 - 1989). JAMES H. JOHNSEN. Mr. Johnsen is the Company's Vice President, Controller and Treasurer and Assistant Secretary. He joined the Accounting Department of the Company in 1964 and served as the Company's Corporate Controller from 1978 until 1986 and as its Treasurer from 1980 until 1986, at which time he was elected Vice President, Control and Treasurer. STEPHEN M. SWEENEY. Mr. Sweeney joined the Company as Vice President, Human Resources in 1987. He held similar positions with Coca Cola Enterprises, Inc. from 1985 until 1987, the Tribune Company from 1983 until 1985 and Contel, Inc. from 1976 to 1983. Officers serve with the approval of the Board of Directors. PAGE PART IV Item 14.				Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K a) The following documents are filed as part of this report: 1. Financial Statements: Page Herein Financial Statement ------ ----------------------------------------------------- 11 Consolidated Statements of Income for the years ended December 31, 1993, 1992 and 1991 12 Consolidated Balance Sheets as of December 31, 1993 and 1992 13 Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991 14 Consolidated Statements of Changes in Stockholders' Equity for the years ended December 31, 1993, 1992 and 1991 15 Notes to Consolidated Financial Statements 26 Report of Independent Public Accountants 2. Financial Statement Schedules required to be filed by Item 8 of this Form 10-K: Schedules Filed: Page Herein Schedule ------ ----------------------------------------------------- 30 II Amounts Receivable from Related Parties 31 VIII Valuation and Qualifying Accounts 32 IX Short-term Borrowings 33 X Supplementary Income Statement Information All other schedules are omitted because of the absence of conditions under which they are required or because the information is shown in the financial statements or notes thereto. 3. Exhibits: See Index of Exhibits (page 34) for a listing of all exhibits filed with this annual report on Form 10-K b) Reports on Form 8-K: None. PAGE SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized as of the 18th day of March 1994. Gibson Greetings, Inc. By /s/ Benjamin J. Sottile ----------------------- Benjamin J. Sottile President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities indicated as of the 18th day of March 1994. Signature Title ---------- ----- Chairman of the Board, /s/ Benjamin J. Sottile President and Chief Executive Officer ------------------------- Benjamin J. Sottile (principal executive officer) Vice President, Finance /s/ William L. Flaherty Chief Financial Officer ------------------------- William L. Flaherty (principal financial officer) Vice President, Controller /s/ James H. Johnsen and Treasurer ------------------------- James H. Johnsen (principal accounting officer) /s/ Thomas M. Cooney ------------------------- Thomas M. Cooney Director /s/ Julius Koppelman ------------------------- Julius Koppelman Director /s/ Charles D. Lindberg ------------------------- Charles D. Lindberg Director /s/ Ralph J. Olson ------------------------- Ralph J. Olson Director /s/ Albert R. Pezzillo ------------------------- Albert R. Pezzillo Director /s/ Thomas J. Smith ------------------------- Thomas J. Smith Director /s/ Burton B. Staniar ------------------------- Burton B. Staniar Director /s/ Frank Stanton ------------------------- Frank Stanton Director /s/ Charlotte St. Martin ------------------------- Charlotte St. Martin Director /s/ Roger T. Staubach ------------------------- Roger T. Staubach Director /s/ C. Anthony Wainwright ------------------------- C. Anthony Wainwright Director ------------------------- Harry N. Walters Director PAGE [FN] - ----------------------- (A) Includes foreign currency translation adjustments. (B) Real estate assistance loan, secured, bearing interest at 12% if note not repaid by May 12, 1993 or upon sale of principal residence, whichever occurs first. (C) Real estate assistance loan, secured, bearing interest at 12% if note not repaid by November 14, 1992 or upon sale of principal residence, whichever occurs first. (D) Real estate assistance loan, secured, bearing interest at 12% if note not repaid by September 15, 1992 or upon sale of principal residence, whichever occurs first. PAGE [FN] - -------------------- (A) Accounts that were judged to be uncollectible and charged to the reserve, net of recoveries. (B) Includes actual cash discounts taken by customers and sales returns and allowances that were granted to customers, all of which were charged to the reserve. PAGE [FN] - ---------------------- (A) The maximum amount outstanding during the period was determined as of month-end. (B) The average amount outstanding during the period was computed based on the average daily outstanding balance. (C) The weighted average interest rate during the period was computed by dividing actual short-term interest expense by the average amount outstanding during the period. (D) See Note 6 of Notes to fiscal year 1993 and 1992 Consolidated Financial Statements and Note 8 of Notes to fiscal year 1991 Consolidated Financial Statements, each Note contained in or incorporated by reference into the Company's annual report on Form 10-K for that year, for information on short-term borrowing facilities. PAGE PAGE Index of Exhibits Exhibit Number Description ------- ----------------------------------------------------------------- 3(a) Restated Certificate of Incorporation as amended (1) 3(b) Bylaws 4(a) Article 4.01 of Restated Certificate of Incorporation (included in Exhibit 3(a)) 4(b) Rights Agreement dated as of December 4, 1987, between Gibson Greetings, Inc. and The First National Bank of Boston, Rights Agent, including Certificate of Designation, Preferences and Rights of Series A Preferred Stock (2) 10(a) Lease Agreement dated January 25, 1982 between Corporate Property Associates 2 and Corporate Property Associates 3 and Gibson Greeting Cards, Inc. (3) 10(b) Sublease Agreement dated January 1, 1977 between B.F. Goodrich and Cleo Wrap Division of Gibson Greetings Card, Inc. (3) 10(c) Amendment and Extension of Term of Sublease dated June 26, 1983, between B.F. Goodrich Company and Gibson Greeting Cards, Inc. (4) 10(d) Amendment dated June 25, 1985, to Lease Agreement, dated January 25, 1982, by and between Corporate Property Associates 2 and Corporate Property Associates 3 and Gibson Greeting Cards, Inc. (5) 10(e) Lease and Agreement dated March 7, 1986 between Associated Warehouses, Inc. and Cleo Wrap Division of Gibson Greetings, Inc. (5) 10(f) Commercial Paper Issuing Agent Agreement dated as of July 11, 1986, between Gibson Greetings, Inc. and Irving Trust Corporation (6) 10(g) Commercial Paper Dealer Agreement dated July 16, 1986, between Gibson Greetings, Inc. and The First Boston Corporation (6) 10(h) Credit Agreement, dated as of April 26, 1993, by and among Gibson Greetings, Inc.; Bankers Trust Company; The Bank of New York; Mellon Bank, N.A.; The Fifth Third Bank; Harris Trust and Savings Bank; NBD Bank, N.A.; Royal Bank of Canada; The Sanwa Bank, Ltd.; Society National Bank; Union Bank of Switzerland; Wachovia Bank of Georgia, N.A.; and Bankers Trust Company, as agent (7) 10(i) Form of Note Agreement between Gibson Greetings, Inc. and Connecticut Mutual Life, The Minnesota Mutual Life Insurance Company, The Reliable Life Insurance Company, Federated Life Insurance Company, The Variable Annuity Life Insurance Company and Nationwide Life Insurance Company, dated May 15, 1991 (8) 10(j) Executive Compensation Plans and Arrangements (i) 1982 Stock Option Plan (ii) 1983 Stock Option Plan (iii) 1985 Stock Option Plan (iv) 1987 Stock Option Plan (v) 1989 Stock Option Plan (vi) 1989 Stock Option Plan for Nonemployee Directors (vii) 1991 Stock Option Plan (viii) Employment Agreement with Mr. Cooney (9) (ix) Form of Second Amendment to Employment Agreement with Mr. Cooney (1) PAGE Exhibit Number Description ------- ----------------------------------------------------------------- (x) Employment Agreement between Gibson Greetings, Inc. and Benjamin J. Sottile, dated April 1, 1993 (7) (xi) Compensatory agreements (10) (xii) ERISA Makeup Plan (11) (xiii) Supplemental Executive Retirement Plan (11) (xiv) Agreements dated January 2, 1991 and December 10, 1993 between Gibson Greetings, Inc. and Stephen M. Sweeney (xv) Agreement dated November 18, 1993 between Gibson Greetings, Inc. and William L. Flaherty (xvi) Agreement dated February 22, 1994 between Gibson Greetings, Inc. and Michael A. Pietrangelo 11 Computation of Income per Share 21 Subsidiaries of the Registrant 23 Consent of Independent Public Accountants - ---------------------- Filed as an Exhibit to the document indicated and incorporated herein by reference: (1) The Company's Report on Form 10-K for the year ended December 31, 1988. (2) The Company's Report on Form 8-K dated December 28, 1987, filed January 4, 1988. (3) The Company's Registration Statement on Form S-8 (No. 2-82990). (4) The Company's Registration Statement on Form S-8 (No. 2-96396). (5) The Company's Report on Form 10-K for the year ended December 31, 1985. (6) The Company's Report on Form 10-Q for the quarter ended September 30, 1986. (7) The Company's Report on Form 10-Q for the quarter ended June 30, 1993. (8) The Company's Report on Form 10-Q for the quarter ended June 30, 1991. (9) The Company's Report on Form 10-K for the year ended December 31, 1986. (10) The Company's Report on Form 10-K for the year ended December 31, 1991. (11) The Company's Report on Form 10-K for the year ended December 31, 1992. - ---------------------- The Company will furnish to the Commission upon request its long-term debt instruments not listed above.
91928_1993.txt	91928	1993	Item 1. Business General The registrant, South Jersey Industries, Inc. (the Company), a New Jersey corporation, was formed in 1969 for the purpose of owning and holding all of the outstanding common stock of South Jersey Gas Company (South Jersey Gas), a public utility, and acquiring and developing nonutility lines of business. Energy & Minerals, Inc. (EMI), a wholly-owned subsidiary of the Company, was formed in 1977 to own, finance and further develop certain nonutility businesses. Through a subsidiary, EMI is engaged in the mining, processing and marketing of construction, commercial, industrial and other specialty sands and gravels. South Jersey Energy Company, a wholly-owned subsidiary of the Company, provides services for the acquisition and transportation of natural gas for commercial and industrial users. R&T Group, Inc. (R&T), a wholly-owned subsidiary of the Company, was formed in 1989 to own, finance and further develop certain utility construction, general construction and environmental remediation businesses. R&T engages in these businesses through several operating subsidiaries. Financial Information About Industry Segments Information regarding the Industry Segments is incorporated by reference to Note 2 on page 16 of the Company's Annual Report to Shareholders for the year ended December 31, 1993, which Annual Report is attached to this report. See Item 14(c)(13). Description of Business The Company is engaged in the business of operating, through subsidiaries, various business enterprises. The Company's most significant subsidiary is South Jersey Gas. South Jersey Gas, a New Jersey corporation, is an operating public utility company engaged in the purchase, transmission and sale of natural gas for residential, commercial and industrial use in an area of approximately 2,500 square miles in the southern part of New Jersey. South Jersey Gas also transports natural gas purchased directly by some of its customers. South Jersey Gas' service territory includes 112 municipalities throughout Atlantic, Cape May, Cumberland and Salem Counties and portions of Burlington, Camden and Gloucester Counties, with an estimated permanent population of 1,004,000. South Jersey Gas serves 235,067 residential, commercial and industrial customers (at December 31, 1993) in southern New Jersey. Gas sales and transportation for 1993 amounted to 59,080,000 Mcf (thousand cubic feet), of which 48,084,000 Mcf was firm sales and transportation, 7,433,000 Mcf was interruptible sales and transportation and 3,563,000 Mcf was off system sales. The breakdown of firm sales includes 40.3% residential, 19.1% commercial, 14.0% cogeneration and electric generation, 5.4% industrial and other, and 21.2% transportation. At year-end 1993, the Company served 218,484 residential customers, 16,206 commercial customers and 377 industrial customers. This includes 1993 net additions of 5,545 residential customers and 357 commercial customers. The decrease of 17 industrial customers is mainly attributed to transfers between customer classifications. South Jersey Gas generates transportation revenues for delivering such supplies. - 2 - Under a five-year agreement executed in 1990 with Atlantic Electric, an electric utility serving southern New Jersey, South Jersey Gas supplies natural gas to Atlantic Electric's combustion turbine facility in Cumberland County. This gas service is being provided under the terms of a firm electric service tariff approved by the New Jersey Board of Regulatory Commissioners (BRC) on a demand/commodity basis. In 1993, 2.9 Bcf (billion cubic feet) was delivered under this agreement. South Jersey Gas serviced eight cogeneration facilities in 1993 and one additional facility is expected to come into service later in 1994. Combined sales and transportation of natural gas to such customers amounted to approximately 9 Bcf in 1993. During 1993, South Jersey Gas began making wholesale non-jurisdictional gas sales for resale to gas marketers for ultimate delivery to end users. These "off-system" sales were made possible through the issuance of FERC Order No. 547. This order issues blanket certificates of public convenience and necessity authorizing all parties, which are not interstate pipelines, to make FERC jurisdictional gas sales for resale at negotiated rates. During 1993, off- system sales amounted to 3.6 Bcf. Gas supply utilized to make said sales was gas available in excess of the requirements of its jurisdictional customers. Supplies of natural gas available to South Jersey Gas that are in excess of the quantity required by those customers who use gas as their sole source of fuel (firm customers) make possible the sale of gas on an interruptible basis to commercial and industrial customers whose equipment is capable of using natural gas or other fuels, such as fuel oil and propane. The term "interruptible" is used in the sense that deliveries of natural gas may be terminated by South Jersey Gas at any time if this action is necessary to meet the needs of customers purchasing gas under firm rate tariffs. Usage by interruptible customers in 1993 amounted to approximately 11.0 Bcf. (Approximately 18.6 percent of the total volume of gas delivered). No material part of South Jersey Gas business is dependent upon a single customer or a few customers. The majority of the South Jersey Gas residential customers reside in the northern and western portions of its service territory in Burlington, Camden, Salem and Gloucester counties. Approximately 50 percent of new customers reside in this section of the service territory, which includes the residential suburbs of Wilmington and Philadelphia. The franchise area to the east is centered on Atlantic City and the neighboring resort communities in Atlantic and Cape May counties, which experience large population increases in the summer months. The impact of the casino gaming industry on the Atlantic City area has resulted in the creation of new jobs and the expansion of the residential and commercial infrastructure necessary to support a developing year-round economy. Atlantic City is experiencing a second wave of development as a result of casino gaming. The centerpiece of this development is the new $254 million dollar multi-purpose convention center, accompanied with a planned billion dollar hotel and entertainment complex. These facilities will be used to attract large conventions as well as making Atlantic City into a family resort on a year around basis. The convention center is expected to be in operation as early as 1996. Manufacturers or processors of sand, glass, farm products, paints, chemicals and petroleum products are located in the western and southern sectors of the service territory. New commercial establishments and high technology industrial parks and complexes are expected to be part of the economic growth of this area. - 3 - South Jersey Gas' service area includes parts of the Pinelands region, a largely undeveloped area in the heart of southern New Jersey. Future construction in this area is expected to be limited by statute and by a master plan adopted by the New Jersey Pinelands Commission; however, in terms of potential growth, significant portions of South Jersey Gas' service area are not affected by these limitations. As a public utility, South Jersey Gas is subject to regulation by the BRC. Additionally, the Natural Gas Policy Act, which was enacted in November 1978, contains provisions for Federal regulation of certain aspects of South Jersey Gas' business. South Jersey Gas is affected by Federal regulation with respect to transportation and pricing policies applicable to its natural gas purchases from Transcontinental Gas Pipeline Corporation (Transco), South Jersey Gas' major supplier, and Columbia Gas Transmission Corporation (Columbia), since such purchases are made under rates and terms established under the jurisdiction of the Federal Energy Regulatory Commission (FERC). Retail sales by South Jersey Gas are made under rate schedules within a tariff filed with and subject to the jurisdiction of the BRC. These rate schedules provide primarily for either block rates or demand/commodity rate structures. The tariff contains provisions permitting South Jersey Gas to pass on to customers increases and decreases in the cost of purchased gas supplies. The tariff also contains provisions permitting the recovery of environmental remediation costs associated with former gas plant sites and for the adjustment of revenues due to the impact of degree day fluctuations which approximate 7% greater or less than an established 10-year normal. Revenue requirements for ratemaking purposes are established on the basis of firm and interruptible sales projections. In August 1992, the BRC granted SJG a rate increase of $3.35 million based on an overall rate of return of 10.34% including a 12.1% return on equity. As part of this rate increase, SJG is allowed to retain the first $3.9 million of base revenues generated by interruptible sales and 20% of base revenues generated by such sales above that level until it realizes a 12.1% return on equity. SJG also received authority to implement the environmental remediation cost recovery mechanism as part of this order. In January 1994, South Jersey Gas petitioned the BRC for a general base rate increase of approximately $26.6 million, including a 12.75% return on equity. Additional information on regulatory affairs and the 1994 rate petition is incorporated by reference to Note 1 on page 14 and Notes 9 and 10 on pages 17 and 18 of the Company's Annual Report to Shareholders for the year ended December 31, 1993, which Annual Report is attached to this report. See Item 14(c)(13). South Jersey Energy Company (Energy Company), a New Jersey corporation, is a wholly owned non-regulated subsidiary of the Company and is engaged in providing services for the acquisition and transportation of natural gas for industrial and commercial users. Energy & Minerals, Inc., a New Jersey corporation, is a holding company that owns all of the outstanding common stock of The Morie Company, Inc. (Morie Company), and an inactive company, South Jersey Fuel, Inc. (Fuel Company). Morie Company, a New Jersey corporation, is engaged in the mining, processing and marketing of a broad range of industrial and commercial sands and gravels. Its principal products are glass sand used for manufacturing cookware, containers and flat glass, foundry sand used as the core and molding medium in iron and steel foundries, and construction sand and gravels. Morie Company also produces sandblasting sands, filter sands and gravels, well gravels, special sand mixes for athletic tracks and golf courses, resin-coated sands, clay products and a wide variety of specialty products, including specially processed silica for the electronics industry. - 4 - Total customers of Morie Company number in the thousands, and no single customer accounts for as much as 10% of annual sales. Tonnage sales in 1993 were approximately 9.5% higher than 1992, and Morie Company attributes this increase to slowly improving economic activity. Keen competition and railroad deregulation are factors affecting prices on a delivered basis. All Morie Company facilities are in good operating condition and, along with ample high- quality mineral reserves, are capable of handling expanding markets and of supporting increased market share. Fuel Company, a New Jersey corporation, sold its operating assets in November 1985 and is no longer in the business of distributing petroleum products. R&T, a New Jersey corporation, is a holding company that owns all the common stock of R and T Castellini Company, Inc. (Castellini Company), S.W. Downer, Jr. Company, Inc. (Downer Company), Onshore Construction Company, Inc. (Onshore), Cape Atlantic Crane Co., Inc. (Cape Atlantic) and, beginning in 1993, R & T Castellini Construction Company, Inc. (R & T Construction). In 1993, approximately 50% of R&T net sales related to competitive-bid work performed for South Jersey Gas. No other customer accounted for as much as 10% of R&T's consolidated revenues in 1993. Castellini Company, a New Jersey corporation, is engaged in the installation of gas, water and sewer lines, plant maintenance, site work and environmental cleanup and remediation. Downer Company, a New Jersey corporation, is engaged in the installation of gas, water and sewer lines, plant maintenance, site work and environmental cleanup and remediation. Onshore, a New Jersey corporation, is principally engaged in the installation of large diameter pipe, sewerage plants, bridges, dams and other heavy construction projects. Cape Atlantic, a New Jersey corporation, is principally engaged in the rental of cranes. R & T Construction, a Delaware Corporation, is engaged in the installation of gas, water and sewer lines, plant maintenance, site work and environmental cleanup and remediation. In 1993, the Company made no public announcement of, or otherwise made public information about, a new product or industry segment that would require the investment of a material amount of the assets of the Company or which otherwise was material. Raw Materials South Jersey Gas Pipeline Supply South Jersey Gas has direct connections to two interstate pipelines, Transcontinental Gas Pipe Line (Transco) and Columbia Gas Transmission (Columbia). During 1993, services provided to South Jersey Gas from these pipelines along with same provided by CNG Transmission Corporation (CNG) were subject to changes as directed by the Federal Energy Regulatory Commission (FERC) when it issued its Order No. 636 "Pipeline Service Obligations and Revisions to Regulations Governing Self-Implemented Transportation Under Part 284 of the Commission's Regulations" issued on April 8, 1992. This order required significant alterations in the structure of interstate natural gas pipeline services. - 5 - Order No. 636 and its companion series of orders (636-A and 636-B) were intended by the FERC to complete the transition to a competitive natural gas industry initiated by the Natural Gas Policy Act of 1978 whereby all natural gas suppliers are able to compete for gas purchases on an equal footing. The pipeline suppliers mentioned above filed Order No. 636 compliance filings late in 1992 and also submitted revised compliance filings during 1993. In these compliance filings each pipeline was required to submit a comprehensive explanation as to how it intended to implement the restructuring of its pipeline system services. The FERC subsequently approved these revised compliance filings in time for the pipelines to implement the provisions of Order No. 636 in advance of the 1993-94 winter heating season. Transco Transco, during 1991, unbundled its sales and transportation services as a result of a FERC approved settlement that was negotiated with its customers. At that time South Jersey Gas replaced its Commodity and Demand (CD) gas purchase contract with Transco with a Firm Transportation (FT) service and a gas purchase agreement (FS service). The FS service is a FERC approved service that provides a guaranteed supply of up to 111,869 Mcf per day of gas and gives the Company the option to buy gas from other suppliers to be transported under the firm transportation capacity if such supplies are available at lower costs. The initial term of the FS agreement extends through March 31, 2001. On May 14, 1993, in response to Transco's compliance filing, the FERC issued an order in Transco's Order No. 636 restructuring proceeding. In said order, the FERC required, among other things, that Transco unbundle that portion of its Eminence Storage Field (approximately 3.1 billion cubic feet (Bcf)), previously reserved for use by Transco in rendering "swing supply" service to its sales (FS) customers. The FERC also directed that Transco should make its unbundled Eminence Storage capacity available on a priority basis to its existing FS customers and South Jersey Gas was allocated 316,177 Mcf of this storage capacity. In addition to FS service, South Jersey Gas has a ten-year gas supply agreement with Vastar Gas Marketing (Vastar - formerly Arco Natural Gas) for delivery to its service territory by way of Transco FT service. During the 1992-93 winter season, South Jersey Gas began receiving delivery of up to 24,700 Mcf per day of gas under a firm transportation agreement that was entered into with Transco as part of the Texas Gas-CNG Transmission-Transco project that was developed to provide additional firm pipeline capacity to deliver gas to the U.S. Northeast under Transco's Rate Schedule FT-NT. The gas source that is available for transportation on the Transco-CNG Transmission- Texas Gas pipeline capacity is purchased from Amerada Hess under a 15 year gas supply agreement. Additionally, South Jersey Gas has a winter season peaking transportation service on the Transco system which is available for the period December 1 through the last day of February of each year. South Jersey Gas' maximum daily entitlement under this service is 2,900 Mcf per day. South Jersey Gas can transport third party gas via said service and has contracted with Amerada Hess for a long-term firm gas supply to fill its capacity during each winter season. - 6 - Columbia As part of its FERC Order No. 636 restructuring, Columbia unbundled its traditional sales service from its firm transportation service and as such has eliminated its previous long term sales service under Rate Schedule CDS. South Jersey Gas previously held a CDS sales agreement with Columbia which provided for a maximum daily sales entitlement of 33,816 Mcf per day. As a result of Columbia's restructuring, South Jersey Gas has been assigned an equivalent 33,816 Mcf per day of firm transportation capacity on both Columbia and its affiliate Columbia Gulf Transmission Company (Columbia Gulf). As a result of the above, during 1993, South Jersey Gas entered into long- term gas purchase agreements with Vastar, Texaco Gas Marketing, and Union Pacific Fuels for a total of 33,816 Mcf of gas per day to fill this firm pipeline capacity on the Columbia and Columbia Gulf pipeline systems. Additionally during 1993, 483,092 Mcf of storage capacity previously rendered to South Jersey Gas under Columbia's Rate Schedule WS was converted to storage service rendered under Rate Schedule FSS on a one-for-one basis. On July 31, 1991, Columbia and its parent, Columbia Gas Systems, Inc. filed for Chapter 11 bankruptcy protection. Columbia has stated to its customers that it would fulfil all contractual obligations pending reorganization. To date Columbia has met all contractual obligations and it is anticipated this will be the case in the future. On January 18, 1994 Columbia filed a reorganization plan with the U.S. Bankruptcy Court for the District of Delaware. An order on this filing is still pending. CNG As part of its Order No. 636 restructuring, CNG has abandoned gas sales service under its Rate Schedule SCQ. South Jersey Gas previously had an SCQ Service Agreement with CNG which provided for the delivery of 9,662 Mcf per day to Transco at Leidy, PA for ultimate delivery to the Company during the period November 16 through March 31 of each winter season. As a result of Order No. 636 CNG has replaced the 9,662 Mcf per day of SCQ sales service with 5,357 Mcf per day of Firm Transportation (FT) service from various Appalachian aggregation points located in Pennsylvania and West Virginia and 408,670 Mcf of storage capacity with 4,305 Mcf per day of storage withdrawal demand in CNG's GSS Storage Service. During 1993 to facilitate the utilization of these new services, South Jersey Gas entered into separate gas sales and capacity management agreements with CNG Gas Services Corporation, a non-jurisdictional affiliate of CNG. Through these agreements South Jersey Gas has assigned to CNG Gas Services its pipeline FT and storage entitlements on the CNG pipeline system for use to provide South Jersey Gas with up to 9,662 Mcf per day of gas during the winter seasons, November 16 through March 31 of each year. Peak-Day Supply South Jersey Gas plans for a winter season peak-day demand on the basis of an average daily temperature of 5 degrees F. Gas demand on such a design day was estimated for the 1993-94 winter season to be 357,980 Mcf versus a design day supply of 400,521 Mcf. On January 19, 1994, South Jersey Gas experienced a peak-day demand of 365,629 Mcf with an average temperature of 2.68 degrees F. - 7 - Storage Services In addition to its normal gas suppliers, South Jersey Gas has nine storage services that are capable of storing 11.7 Bcf of gas and provide a total daily delivery capacity of 111,607 Mcf. While these storage services do not represent an additional source of gas, they do provide South Jersey Gas with flexibility to acquire gas during periods of low demand and store it until it is needed during winter heating seasons and other times of high demand. South Jersey Gas has the following contracts for gas storage service: Contract Term Storage Capacity 1972 - 1994 1,362,980 Mcf 1980 - 1998 4,257,135 Mcf Year-to-Year 137,813 Mcf Year-to-Year 207,770 Mcf (1) 1984 - 1994 1,182,609 Mcf 1987 - 2002 500,000 Mcf 1988 - 2008 1,307,400 Mcf 1989 - 2009 1,099,346 Mcf 1990 - 2005 1,705,000 Mcf (1) Contract is for storage of liquefied natural gas; the amount shown is natural gas equivalent. Supplemental Gas Supplies In 1993, South Jersey Gas injected 371,653 Mcf of vaporized liquefied natural gas (LNG) into its distribution system from its McKee City, New Jersey LNG facility. This LNG was obtained through a long-term LNG purchase agreement with Distrigas of Massachusetts Corporation and from gas liquefaction services that were provided by Transco and UGI Utilities, Inc. South Jersey Gas' three propane-air vaporization plants enable it to augment natural gas supplies during periods of peak demand by vaporizing liquid propane and mixing the vaporized propane with air to form a gas that is compatible with natural gas. During 1993, 2,097 Mcf of propane-air gas was utilized by South Jersey Gas. Gas Prices During 1993 South Jersey Gas purchased and had delivered to it approximately 44.9 Bcf of natural gas for distribution to its customers in New Jersey. Of this total, 39.3 Bcf was transported on the Transco pipeline system and 5.6 Bcf was transported on the Columbia pipeline system. The Company's average cost of gas purchased in 1993 was $3.72 per Mcf, which unit cost includes all demand and commodity charges. Energy & Minerals, Inc. Morie Company Morie Company obtains substantially all of the materials which it processes from its owned or leased properties in New Jersey, Tennessee, Georgia and Alabama. (See Item 2.		Item 2. Properties The principal property of South Jersey Gas consists of its gas transmission and distribution systems that include mains, service connections and meters. The transmission facilities carry the gas from the connections with Transco and Columbia to South Jersey Gas' distribution systems for delivery to customers. As of December 31, 1993, there were approximately 335 miles of mains in the transmission systems and 4,407 miles of mains in the distribution systems. South Jersey Gas owns office and service buildings, including its corporate headquarters, at eight locations in the territory, a liquefied natural gas storage and vaporization facility, and three propane-air vaporization plants. Also, South Jersey Gas owns a bus parking lot in Atlantic City, N.J. As of December 31, 1993, the South Jersey Gas utility plant had a gross book value of $473,066,666 and a net book value, after accumulated depreciation, of $346,344,340. In 1993, $33,367,803 was spent on additions to utility plant and there were retirements of property having an aggregate gross book cost of $2,583,711. Construction expenditures for 1994 are currently expected to approximate $38.0 million. Virtually all of the South Jersey Gas transmission pipeline, distribution mains and service connections are in streets or highways or on the property of others. The South Jersey Gas transmission and distribution systems are maintained under franchises or permits or rights-of-way, many of which are perpetual. The South Jersey Gas properties (other than property specifically excluded) are subject to a lien of mortgage under which its first mortgage bonds are outstanding. South Jersey Gas' properties are well-maintained and in good operating condition . EMI owns two properties in Atlantic City, N.J., which include commercial space that is being rented to others. EMI also owns and rents two commercial properties in Millville, N.J., one of which is rented to Morie Company. Morie Company owns ten plants, six of which are located in New Jersey, two in Tennessee, one in Georgia and one in Alabama. The Morie Company owns approximately 5,800 acres of land and leases approximately 5,100 acres of land. The combined acreage includes approximately 1,400 acres of mineable reserves. The mineral leases typically grant the right to mine sand and gravel for an initial period with several renewal options. The mineral leases typically provide for a royalty per ton mined and sold. Morie Company estimates its proven reserves of sand at approximately 129,000,000 tons of raw aggregates which may be profitably extracted and processed, based on present methods of operation and prevailing prices. Reserves have been estimated on the basis of laboratory and field analyses of samples produced by techniques such as split spoon, core drillings and excavating experience on the sites. R&T operating companies share land and buildings at two principal locations used for administrative operations and housing facilities for vehicles, heavy equipment and supplies. - 11 - The Company owns approximately 139 acres of land in Folsom, New Jersey, approximately 9.29 acres of land in Linwood, New Jersey, and an office building in Chester, Pennsylvania. Item 3.	Item 3. Legal Proceedings The Company is not aware of any pending or potential legal proceedings that it believes will have a material effect on its operations or consolidated financial position. Reference is made to Notes 9 and 10 on pages 17 and 18 of the Company's Annual Report to Shareholders for the year ended December 31, 1993, which Annual Report is attached to this report. See Item 14(c)(13). Item 4.	Item 4. Submission Of Matters To A Vote of Security Holders No matter was submitted to a vote of security holders during the fourth quarter of the 1993 fiscal year. Item 4 - A. Executive Officers (Other Than Directors) of the Registrant Name Age Positions with the Company Gerald S. Levitt 49 Vice President George L. Baulig 51 Secretary and Assistant Treasurer Richard B. Tonielli 54 Treasurer There is no family relationship among the officers of the registrant. Gerald S. Levitt was elected Vice President of the Company and Senior Vice President of South Jersey Gas effective November 1, 1983. He has served as Chief Financial Officer of the Company since October 1, 1989. He was elected Executive Vice President of South Jersey Gas on November 1, 1986. Mr. Levitt was Vice President of EMI from November 1983 to November 1986. Mr. Levitt is also a member of the Board of Directors of Morie Company. Richard B. Tonielli was elected Treasurer of the Company effective September 1981. He has served as Senior Vice President, Finance since April 1, 1988 and he has served in other officer positions of South Jersey Gas since 1983. Mr. Tonielli serves as Vice President and Treasurer of EMI (September 1981 to date) and Treasurer of R&T Group, Inc. (October 1989 to date). George L. Baulig was elected Secretary and Assistant Treasurer of the Company, South Jersey Gas and EMI effective November 1, 1980. Mr. Baulig is also Secretary of R&T Group, Inc. (October 1989 to date), South Jersey Energy Company and Morie Company. Executive officers of the Company are elected annually and serve at the pleasure of the Board of Directors. - 12 - PART II Item 5.	Item 5. Market for the Registrant's Common Stock and Related Stockholder Matters Information required by this Item is incorporated by reference to Note 6 on page 17 and the bottom of page 22 of the Company's Annual Report to Shareholders for the year ended December 31, 1993, which Annual Report is attached to this report. See Item 14(c)(13). Item 6.	Item 6. Selected Financial Data Information required by this Item is incorporated by reference to page 1 of the Company's Annual Report to Shareholders for the year ended December 31, 1993, which Annual Report is attached to this report. See Item 14(c)(13). Item 7.	Item 7. Management's Discussion and Analysis of Results of Operations and Financial Condition Information required by this Item is incorporated by reference to pages 19, 20 and 21 of the Company's Annual Report to Shareholders for the year ended December 31, 1993, which Annual Report is attached to this report. See Item 14(c)(13). Item 8.	Item 8. Financial Statements and Supplementary Data Information required by this Item is incorporated by reference to pages 10 through 19 and page 22 of the Company's Annual Report to Shareholders for the year ended December 31, 1993, which Annual Report is attached to this report. See Item 14(c)(13). Item 9.	Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures None - 13 - PART III Item 10.	Item 10. Directors and Executive Officers of the Registrant Information required by this Item relating to the directors of the Company is incorporated by reference to pages 2 through 5 of the Company's definitive Proxy Statement, dated March 9, 1994, filed with the Commission, File number 1-6364, in connection with the Company's 1994 Annual Meeting of Shareholders. Information required by this Item relating to the executive officers (other than Directors) of the Company is set forth in Item 4 - A of this report. Item 11.	Item 11. Executive Compensation Information required by this Item is incorporated by reference to pages 5 through 11 (except for the Report of the Compensation/Pension Committee on page 9 and the Stock Performance Graph on page 10, which are not so incorporated) of the Company's definitive Proxy Statement, dated March 9, 1994, filed with the Commission, File number 1-6364, in connection with the Company's 1994 Annual Meeting of Shareholders. Item 12.	Item 12. Security Ownership of Certain Beneficial Owners and Management Information required by this Item is incorporated by reference to pages 2 through 5 of the Company's definitive Proxy Statement, dated March 9, 1994, filed with the Commission, File number 1-6364, in connection with the Company's 1994 Annual Meeting of Shareholders. Item 13.	Item 13. Certain Relationships and Related Transactions Information required by this Item is incorporated by reference to page 6 of the Company's definitive Proxy Statement, dated March 9, 1994, filed with the Commission, File number 1-6364, in connection with the Company's 1994 Annual Meeting of Shareholders. - 14 - PART IV Item 14.	Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) Listed below are all financial statements and schedules filed as part of this report: 1 - The consolidated financial statements and notes to consolidated financial statements together with the report thereon of Deloitte & Touche, dated February 16, 1994, are incorporated herein by reference to pages 10 through 19 of the Company's Annual Report to Shareholders for the year ended December 31, 1993, which Annual Report is attached to this report. See Item 14(c)(13). 2 - Supplementary Financial Information Page(s) Information regarding selected quarterly financial data is incorporated herein by reference to page 22 of the Company's Annual Report to Shareholders for the year ended December 31, 1993, which Annual Report is attached to this report. See Item 14(c)(13). Supplemental Schedules as of December 31, 1993, 1992 and 1991 and for the three years ended December 31, 1993, 1992, and 1991: The Independent Auditors' Report of Deloitte & Touche, Auditors of the Company 25 Schedule V - Property, Plant and Equipment 26-34 Schedule VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment 35-43 Schedule VIII - Valuation and Qualifying Accounts 44 Schedule IX - Short-Term Borrowings 45 Schedule X - Supplementary Income Statement Information 46 (All Schedules, other than those listed above, are omitted because the information called for is included in the financial statements filed or because they are not applicable or are not required. Separate financial statements are not presented because all consolidated subsidiaries are wholly-owned.) 3 - See Item 14(c)(13) (b) No reports on Form 8-K have been filed by the Company during the quarter ended December 31, 1993. - 15 - (c) List of Exhibits (Exhibit Number is in Accordance with the Exhibit Table in Item 601 of Regulation S-K) Exhibit Incorporated by Reference From Number Exhibit Reference Document (3)(a)(i) Certificate of Incorporation (4)(a) Form S-2 of the Company, as amended (2-91515) through April 19, 1984. (3)(a)(ii) Amendment to Certificate of (4)(e)(1) Form S-3 Incorporation relating to (33-1320) two-for-one stock split effective as of April 28, 1987. (3)(a)(iii) Amendment to Certificate of (4)(e)(2) Form S-3 Incorporation relating to (33-1320) director and officer liability. (3)(b) Bylaws of the Company as (3)(c) Form 10-K amended and restated for 1990 through October 1, 1990. (1-6364) (4)(a) Form of Stock Certificate (4)(a) Form 10-K for common stock. for 1985 (1-6364) (4)(b)(i) First Mortgage Indenture (4)(b)(i) Form 10-K dated October 1, 1947 for 1987 (1-6364) (4)(b)(vi) Form of South Jersey Gas (4)(b)(vi) Form 10-K Company First Mortgage for 1980 Bond, 7-7/8% Series due 1994. (1-6364) (4)(b)(vii) Form of South Jersey Gas (4)(b)(vii) Form 10-K Company First Mortgage for 1980 Bond, 8-1/4% Series due 1996. (1-6364) (4)(b)(viii) Form of South Jersey Gas (4)(b)(viii) Form 10-K Company First Mortgage for 1980 Bond, 8-1/4% Series due 1998. (1-6364) (4)(b)(x) Twelfth Supplemental Inden- 5(b) Form S-7 ture, dated as of June 1, (2-68038) 1980. - 16 - Exhibit Incorporated by Reference From Number Exhibit Reference Document (4)(b)(xii) Fifteenth Supplemental (4)(b)(xiii) Form 10-K Indenture, dated July for 1986 1, 1986, 9.2% Series (1-6364) due 1998. (4)(b)(xiv) Sixteenth Supplemental (4)(b)(xv) Form 10-Q Indenture dated as of for quarter April 1, 1988, 10-1/4% ended Series due 2008. March 31, 1988 (1-6364) (4)(b)(xv) Seventeenth Supplemental (4)(b)(xv) Form 10-K Indenture dated as of for 1989 May 1, 1989. (1-6364) (4)(b)(xvi) Eighteenth Supplemental (4)(e) Form S-3 Indenture, dated as of (33-36581) March 1, 1990. (4)(b)(xvii) Nineteenth Supplemental (4)(b)(xvii) Form 10-K Indenture, dated as of for 1992 April 1, 1992. (1-6364) (4)(b)(xviii) Twentieth Supplemental Indenture, dated as of June 1, 1993. (filed herewith) (9) None (10)(d) Gas storage agreement (GSS) between South Jersey Gas Company and Transco, dated October 1, 1993. (filed herewith) (10)(e) Gas storage agreement (S-2) (5)(h) Form S-7 between South Jersey Gas (2-56223) Company and Transco, dated December 16, 1953. (10)(f) Gas storage agreement (LG-A) (5)(f) Form S-7 between South Jersey Gas (2-56223) Company and Transco, dated June 3, 1974. - 17 - Exhibit Incorporated by Reference From Number Exhibit Reference Document (10)(h) Gas storage agreement (WSS) (10)(h) Form 10-K between South Jersey Gas for 1991 Company and Transco, dated (1-6364) August 1, 1991. (10)(i) Gas storage agreement (LSS) between South Jersey Gas Company and Transco, dated October 1, 1993. (filed herewith) (10)(i)(a) Gas storage agreement (10)(i)(a) Form 10-K (SS-1) between South Jersey for 1988 Gas Company and Transco, (1-6364) dated May 10, 1987 (effective April 1, 1988). (10)(i)(b) Gas storage agreement (ESS) between South Jersey Gas Company and Transco, dated November 1, 1993. (filed herewith) (10)(i)(c) Gas transportation service (10)(i)(c) Form 10-K agreement between South for 1989 Jersey Gas Company and (1-6364) Transco, dated April 1, 1986. (10)(i)(e) Service agreement (FS) (10)(i)(e) Form 10-K between South Jersey Gas For 1991 Company and Transco, dated (1-6364) August 1, 1991. (10)(i)(f) Service agreement (FT) (10)(i)(f) Form 10-K between South Jersey Gas for 1991 Company and Transco, dated (1-6364) February 1, 1992. (10)(i)(g) Service agreement (10)(i)(g) Form 10-K (Incremental FT) for 1991 between South Jersey Gas Company (1-6364) and Transco, dated August 1, 1991. (10)(i)(i) Gas storage agreement (SS-2) (10)(i)(i) Form 10-K between South Jersey Gas for 1991 company and Transco, dated (1-6364) July 25, 1990. - 18 - Exhibit Incorporated by Reference From Number Exhibit Reference Document (10)(i)(j) Gas Transportation Service Agreement between South Jersey Gas Company and Transco, dated December 20, 1991. (filed herewith) (10)(i)(k) Amendment to Gas Transportation Agreement, dated December 20, 1991 between South Jersey Gas Company and Transco, dated October 5, 1993. (filed herewith) (10)(j)(a) Gas Transportation Service (10)(j)(a) Form 10-K Agreement (FTS) between South for 1989 Jersey Gas Company and (1-6364) Equitable Gas Company, dated November 1, 1986. (10)(k)(h) Gas Transportation Service Agreement (TF) between South Jersey Gas Company CNG Transmission Corporation dated October 1, 1993. (filed herewith) (10)(k)(i) Gas purchase agreement (10)(k)(i) Form 10-K between South Jersey Gas for 1989 Company and ARCO Gas Market- (1-6364) ing, Inc., dated March 5, 1990. (10)(k)(k) Gas Transportation Service Agreement (FTS 1) between South Jersey Gas Company and Columbia Gulf Transmission Company, dated November 1, 1993. (filed herewith) (10)(k)(l) Assignment Agreement capacity and service rights (FTS-2) between South Jersey Gas Company and Columbia Gulf Transmission Company, dated November 1, 1993. (filed herewith) - 19 - Exhibit Incorporated by Reference From Number Exhibit Reference Document (10)(k)(m) FTS Service Agreement No. 39556 between South Jersey Gas Company and Columbia Gas Transmission Corporation, dated November 1, 1993. (filed herewith) (10)(k)(n) FTS Service Agreement No. 38099 between South Jersey Gas Company and Columbia Gas Transmission Corporation, dated November 1, 1993. (filed herewith) (10)(k)(o) NTS Service Agreement No. 39305 between South Jersey Gas Company and Columbia Gas Transmission Corporation, dated November 1, 1993. (filed herewith) (10)(k)(p) FSS Service Agreement No. 38130 between South Jersey Gas Company and Columbia Gas Transmission Corporation, dated November 1, 1993. (filed herewith) (10)(k)(q) SST Service Agreement No. 38086 between South Jersey Gas Company and Columbia Gas Transmission Corporation, dated November 1, 1993. (filed herewith) (10)(l) Deferred Payment Plan for (10)(l) Form 10-K Directors of South Jersey for 1986 Industries, Inc., South (1-6364) Jersey Gas Company and Energy & Minerals, Inc. as amended and restated August 22, 1986. - 20 - Exhibit Incorporated by Reference From Number Exhibit Reference Document (10)(l)(a) Form of Deferred Compen- (10)(j)(a) Form 10-K sation Agreement between for 1980 the Company and/or a sub- (1-6364) sidiary and eleven of its officers. (10)(l)(b) Schedule of Deferred Com- (10)(l)(b) Form 10-K pensation Agreements. for 1992 (1-6364) (10)(l)(c) Supplemental Executive (10)(l)(c) Form 10-K Retirement Program, as for 1992 amended and restated ef- (1-6364) fective September 1, 1991, and form of Agreement between certain Company or subsidiary Company officers. (10)(l)(d) Form of Officer Employment (10)(i)(l) Form 10-K Agreement between certain for 1991 officers and either the Company (1-6364) or its Subsidiaries. (10)(l)(e) Schedule of Officer (10)(i)(e) Form 10-K Employment Agreements. for 1991 (1-6364) (10)(l)(f) Officer Severance Benefit (10)(l)(g) Form 10-K Program for all officers. for 1985 (1-6364) (10)(l)(g) Discretionary Incentive (10(l)(h) Form 10-K Bonus Program for all for 1985 officers and management (1-6364) employees. (10)(l)(h) The 1987 Stock Option and (10)(l)(i) Form 10-K Stock Appreciation Rights for 1987 Plan including Form of (1-6364) Agreement. (10)(p) Retirement Plan for Non- (10)(p) Form 10-K employee Members of the for 1988 Board of Directors. (1-6364) (10)(q) Executive Employment (10)(q) Form 10-K Agreement dated August 1, for 1991 1991 between the Company (1-6364) and William F. Ryan, President and Chief Executive Officer. - 21 - Exhibit Incorporated by Reference From Number Exhibit Reference Document (11) Not Applicable (12) Calculation of Ratio of Earnings to Fixed Charges (Before Federal Income Taxes) (filed herewith). (13) The Annual Report to Shareholders of the Company for the year ended December 31, 1993 is filed as an exhibit hereto solely to the extent portions are specifically incorporated by reference herein. (16) Not Applicable (18) Not Applicable (21) Subsidiaries of the Registrant (filed herewith). (22) None (23) Independent Auditors' Consent (filed herewith) (24) Power of Attorney (filed herewith). (99) None - 22 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. SOUTH JERSEY INDUSTRIES, INC. BY /s/ G. S. Levitt G. S. Levitt, Vice President Date March 23, 1994 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 F. Ryan President and Director March 23, 1994 (William F. Ryan) (Principal Executive Officer) /s/ G. S. Levitt Vice President March 23, 1994 (G. S. Levitt) (Principal Financial Officer) /s/ Richard B. Tonielli Treasurer (Principal March 23, 1994 (Richard B. Tonielli) Accounting Officer) /s/ Frank L. Bradley, Jr. Director March 23, 1994 (Frank L. Bradley, Jr.) /s/ Richard L. Dunham Director March 23, 1994 (Richard L. Dunham) /s/ W. Cary Edwards Director March 23, 1994 (W. Cary Edwards) /s/ Thomas L. Glenn, Jr. Director March 23, 1994 (Thomas L. Glenn, Jr.) /s/ Vincent E. Hoyer Director March 23, 1994 (Vincent E. Hoyer) /s/ Herman D. James Director March 23, 1994 (Herman D. James) /s/ Marilyn Ware Lewis Director March 23, 1994 (Marilyn Ware Lewis) /s/ Clarence D. McCormick Director March 23, 1994 (Clarence D. McCormick) - 23 - /s/ Peter M. Mitchell Director March 23, 1994 (Peter M. Mitchell) /s/ Jackson Neall Director March 23, 1994 (Jackson Neall) /s/ Shirli M. Vioni Director March 23, 1994 (Shirli M. Vioni) /s/ Frederick A. Westphal Director March 23, 1994 (Frederick A. Westphal) - 24 - INDEPENDENT AUDITORS' REPORT South Jersey Industries, Inc.: We have audited the consolidated financial statements of South Jersey Industries, Inc. and its subsidiaries as of December 31, 1993 and 1992 and for each of the three years in the period ended December 31, 1993 and have issued our report thereon dated February 16, 1994, which report includes an explanatory paragraph as to the Company changing its method of accounting for income taxes, effective January 1, 1993, to conform with Statement of Financial Standards No. 109 and its method of accounting for postretirement benefits other than pensions, effective January 1, 1993, to conform with Statement of Financial Accounting Standards No. 106; such financial statements and report are included in your 1993 Annual Report to Shareholders and are incorporated herein by reference. Our audits also included the financial statement schedules of South Jersey Industries, Inc. and its subsidiaries, listed in Item 14. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. DELOITTE & TOUCHE Cherry Hill, New Jersey February 16, 1994 - 25 - SOUTH JERSEY INDUSTRIES, INC. NUMBER ONE SOUTH JERSEY PLAZA ROUTE 54 FOLSOM, NEW JERSEY 08037 FORM 10-K FYE 12/31/93 EXHIBIT INDEX Incorporated by Reference From Reference Reference Number Description of Exhibit Exhibit Document (3)(a)(i) Certificate of Incorporation (4)(a) Form S-2 of the Company, as amended (2-91515) through April 19, 1984. (3)(a)(ii) Amendment to Certificate of (4)(e)(1) Form S-3 Incorporation relating to (33-1320) two-for-one stock split effective as of April 28, 1987. (3)(a)(iii) Amendment to Certificate of (4)(e)(2) Form S-3 Incorporation relating to (33-1320) director and officer liability. (3)(b) Bylaws of the Company as (3)(c) Form 10-K amended and restated for 1990 through October 1, 1990. (1-6364) (4)(a) Form of Stock Certificate (4)(a) Form 10-K for common stock. for 1985 (1-6364) (4)(b)(i) First Mortgage Indenture (4)(b)(i) Form 10-K dated October 1, 1947 for 1987 (1-6364) (4)(b)(vi) Form of South Jersey Gas (4)(b)(vi) Form 10-K Company First Mortgage for 1980 Bond, 7-7/8% Series due 1994. (1-6364) (4)(b)(vii) Form of South Jersey Gas (4)(b)(vii) Form 10-K Company First Mortgage for 1980 Bond, 8-1/4% Series due 1996. (1-6364) (4)(b)(viii) Form of South Jersey Gas (4)(b)(viii) Form 10-K Company First Mortgage for 1980 Bond, 8-1/4% Series due 1998. (1-6364) (4)(b)(x) Twelfth Supplemental Inden- 5(b) Form S-7 ture, dated as of June 1, (2-68038) 1980. SOUTH JERSEY INDUSTRIES, INC. NUMBER ONE SOUTH JERSEY PLAZA ROUTE 54 FOLSOM, NEW JERSEY 08037 FORM 10-K FYE 12/31/93 EXHIBIT INDEX Incorporated by Reference From Reference Reference Number Description of Exhibit Exhibit Document (4)(b)(xii) Fifteenth Supplemental (4)(b)(xiii) Form 10-K Indenture, dated July 1, for 1986 1986, 9.2% Series due 1998. (1-6364) (4)(b)(xiv) Sixteenth Supplemental (4)(b)(xv) Form 10-Q Indenture dated as of for quarter April 1, 1988, 10-1/4% ended Series due 2008. March 31, 1988 (1-6364) (4)(b)(xv) Seventeenth Supplemental (4)(b)(xv) Form 10-K Indenture dated as of for 1989 May 1, 1989. (1-6364) (4)(b)(xvi) Eighteenth Supplemental (4)(e) Form S-3 Indenture, dated as of (33-36581) March 1, 1990. (4)(b)(xvii) Nineteenth Supplemental Form 10-K Indenture, dated as of for 1992 April 1, 1992. (1-6364) (4)(b)(xviii) Twentieth Supplemental Indenture, dated as of June 1, 1993. (filed herewith) (9) None (10)(d) Gas storage agreement GSS between South Jersey Gas Company and Transco, dated October 1, 1993. (filed herewith) (10)(e) Gas storage agreement (5)(h) Form S-7 between South Jersey Gas (2-56223) Company and Transco, dated December 16, 1953. SOUTH JERSEY INDUSTRIES, INC. NUMBER ONE SOUTH JERSEY PLAZA ROUTE 54 FOLSOM, NEW JERSEY 08037 FORM 10-K FYE 12/31/93 EXHIBIT INDEX Incorporated by Reference From Reference Reference Number Description of Exhibit Exhibit Document (10)(f) Gas storage agreement (5)(f) Form S-7 between South Jersey Gas (2-56223) Company and Transco, dated June 3, 1974. (10)(h) Gas storage agreement (WSS) (10)(h) Form 10-K between South Jersey Gas for 1991 Company and Transco dated (1-6364) August 1, 1991. (10)(i) Gas storage agreement (LSS) between South Jersey Gas Company and Transco, dated October 31, 1993. (filed herewith) (10)(i)(a) Gas storage and sales (10)(i)(a) Form 10-K agreement between South for 1988 Jersey Gas Company and (1-6364) Transco, dated May 10, 1987 (effective April 1, 1988). (10)(i)(b) Gas storage agreement (ESS) between South Jersey Gas Company and Transco, dated November 1, 1993. (filed herewith) (10)(i)(c) Gas Transportation Service (10)(i)(c) Form 10-K Agreement between South for 1989 Jersey Gas Company and (1-6364) Transco, dated April 1, 1986. (10)(i)(e) Service agreement (FS) (10)(i)(e) Form 10-K between South Jersey Gas for 1991 Company and Transco, (1-6364) dated August 1, 1991. SOUTH JERSEY INDUSTRIES, INC. NUMBER ONE SOUTH JERSEY PLAZA ROUTE 54 FOLSOM, NEW JERSEY 08037 FORM 10-K FYE 12/31/93 EXHIBIT INDEX Incorporated by Reference From Reference Reference Number Description of Exhibit Exhibit Document (10)(i)(f) Service agreement (FT) between (10)(i)(f) Form 10-K South Jersey Gas Company for 1991 and Transco, dated February 1, (1-6364) 1992. (10)(i)(g) Service agreement (Incremental (10)(i)(g) Form 10-K FT) between South Jersey Gas for 1991 Company and Transco, dated (1-6364) August 1, 1991. (10)(i)(i) Gas storage agreement (SS-2) (10)(i)(i) Form 10-K between South Jersey Gas for 1991 Company and Transco, dated (1-6364) July 25, 1990. (10)(i)(j) Gas Transportation Service Agreement between South Jersey Gas Company and Transco, dated December 20, 1991. (filed herewith) (10)(i)(k) Amendment to Gas Transportation Agreement, dated December 20, 1991 between South Jersey Gas Company and Transco, dated October 5, 1993. (filed herewith) (10)(j)(a) Gas Transportation Service (10)(j)(a) Form 10-K Agreement (FTS) between South for 1989 Jersey Gas Company and (1-6364) Equitable Gas Company, dated November 1, 1986. (10)(k)(h) Gas Transportation Service (10)(k)(h) Form 10-K Agreement (TF) between South for 1989 Jersey Gas Company and (1-6364) Consolidated Gas Trans- mission Corporation, dated November 21, 1987. SOUTH JERSEY INDUSTRIES, INC. NUMBER ONE SOUTH JERSEY PLAZA ROUTE 54 FOLSOM, NEW JERSEY 08037 FORM 10-K FYE 12/31/93 EXHIBIT INDEX Incorporated by Reference From Reference Reference Number Description of Exhibit Exhibit Document (10)(k)(i) Gas purchase agreement (10)(k)(i) Form 10-K between South Jersey Gas for 1989 Company and ARCO Gas Market- (1-6364) ing, Inc., dated March 5, 1990. (10)(k)(k) Gas Transportation Service Agreement (FTS 1) between South Jersey Gas Company and Columbia Gulf Transmission Company, dated November 1, 1993. (filed herewith) (10)(k)(l) Assignment Agreement capacity and service rights (FTS-2) between South Jersey Gas Company and Columbia Gulf Transmission Company, dated November 1, 1993. (filed herewith) (10)(k)(m) FTS Service Agreement No. 39556 between South Jersey Gas Company and Columbia Gas Transmission Corporation, dated November 1, 1993. (filed herewith) (10)(k)(n) FTS Service Agreement No. 38099 between South Jersey Gas Company and Columbia Gas Transmission Corporation, dated November 1, 1993. (filed herewith) SOUTH JERSEY INDUSTRIES, INC. NUMBER ONE SOUTH JERSEY PLAZA ROUTE 54 FOLSOM, NEW JERSEY 08037 FORM 10-K FYE 12/31/93 EXHIBIT INDEX Incorporated by Reference From Reference Reference Number Description of Exhibit Exhibit Document (10)(k)(o) NTS Service Agreement No. 39305 between South Jersey Gas Company and Columbia Gas Transmission Corporation, dated November 1, 1993. (filed herewith) (10)(k)(p) FSS Service Agreement No. 38130 between South Jersey Gas Company and Columbia Gas Transmission Corporation, dated November 1, 1993. (filed herewith) (10)(k)(q) SST Service Agreement No. 38086 between South Jersey Gas Company and Columbia Gas Transmission Corporation, dated November 1, 1993. (filed herewith) (10)(l) Deferred Payment Plan for (10)(l) Form 10-K Directors of South Jersey for 1986 Industries, Inc., South (1-6364) Jersey Gas Company and Energy & Minerals, Inc. as amended and restated August 22, 1986. (10)(l)(a) Form of Deferred Compen- (10)(j)(a) Form 10-K sation Agreement between for 1980 the Company and/or a sub- (1-6364) sidiary and eleven of its officers. (10)(l)(b) Schedule of Deferred Com- (10)(l)(b) Form 10-K pensation Agreements. for 1992 (1-6364) SOUTH JERSEY INDUSTRIES, INC. NUMBER ONE SOUTH JERSEY PLAZA ROUTE 54 FOLSOM, NEW JERSEY 08037 FORM 10-K FYE 12/31/93 EXHIBIT INDEX Incorporated by Reference From Reference Reference Number Description of Exhibit Exhibit Document (10)(l)(c) Supplemental Executive (10)(l)(c) Form 10-K Retirement Program, as for 1992 amended and restated ef- (1-6364) fective September 1, 1991, and form of Agreement between certain Company or subsidiary Company officers. (10)(l)(d) Form of Officer Employment (10)(i)(d) Form 10-K Agreement between certain for 1991 officers and either the Company (1-6364) or its Subsidiaries. (10)(l)(e) Schedule of Officer (10)(i)(e) Form 10-K Employment Agreements. for 1991 (1-6364) (10)(l)(f) Officer Severance Benefit (10)(l)(g) Form 10-K Program for all officers. for 1985 (1-6364) (10)(l)(g) Discretionary Incentive (10(l)(h) Form 10-K Bonus Program for all for 1985 officers and management (1-6364) employees. (10)(l)(h) The 1987 Stock Option and (10)(l)(i) Form 10-K Stock Appreciation Rights for 1987 Plan including Form of (1-6364) Agreement. (10)(p) Retirement Plan for Non- (10)(p) Form 10-K employee Members of the for 1988 Board of Directors. (1-6364) (10)(q) Executive Employment Agreement (10)(q) Form 10-K dated August 1, 1991 between the for 1991 Company and William F. Ryan, (1-6364) President and Chief Executive Officer. SOUTH JERSEY INDUSTRIES, INC. NUMBER ONE SOUTH JERSEY PLAZA ROUTE 54 FOLSOM, NEW JERSEY 08037 FORM 10-K FYE 12/31/93 EXHIBIT INDEX Incorporated by Reference From Reference Reference Number Description of Exhibit Exhibit Document (11) Not Applicable (12) Calculation of Ratio of Earnings to Fixed Charges (Before Federal Income Taxes) (filed herewith). (13) The Annual Report to Shareholders of the Company for the year ended December 31, 1993 is filed as an exhibit hereto solely to the extent portions are specifically incorporated by reference herein. (16) Not Applicable (18) Not Applicable (21) Subsidiaries of the Registrant. (filed herewith) (22) None (23) Independent Auditors' Consent (filed herewith) (24) Power of Attorney (filed herewith) (99) None

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